A Look at Rising Household Debt in Australia and the Implications for Policy

Viewpoint June 15 Your Global Investment Authority A Look at Rising Household Debt in Australia and the Implications for Policy Australia s economy is giving off mixed signals: Even as GDP growth and income slow, household debt appears to be rising. Understanding what is driving household behavior has important implications for policy and interest rates. Aaditya Thakur Vice President Portfolio Manager During Australia s most recent economic upswing, national income outpaced output, but with larger-than-anticipated commodity price drops over the past year, this trend has reversed. This is apparent on a per capita basis, with net national disposable income actually falling, as seen in Figure 1. At the same time, the main macro variables of unemployment, private final demand, wages, inflation and confidence have all weakened. (For a discussion of how the Australian terms-of-trade cycle is now weighing on nominal growth and national incomes, see Australia Credit Perspectives, August 14.) FIGURE 1: NET NATIONAL DISPOSABLE INCOME AND GDP PER CAPITA 8.0 6.0 Laura Ryan, Ph.D. Vice President Quantitative Research Analyst 4.0 2.0 0.0-2.0-4.0 86 88 90 94 96 00 02 06 08 12 14 GDP per capita % chg Real net national disposable income per capita % chg Source: Australian Bureau of Statistics, Bloomberg, 31 December 14

The Reserve Bank of Australia (RBA) has tried to cushion these macro headwinds by lowering the cash rate to historically low levels but is now faced with the risk of over-stimulating the housing market. Indeed, common metrics of household leverage and house price valuations remain elevated in Australia, particularly compared with those in other developed markets (see Figure 2). FIGURE 2: HOUSEHOLD DEBT TO NET WORTH (%) 30 25 15 10 90 AUS 94 96 US 00 02 06 08 12 Source: Australian Bureau of Statistics, Bloomberg, 31 December 14 14 How household leverage evolves will have implications for policymakers and the potential path of interest rates. A positive response to leverage in the face of weakening fundamentals may increase the economy s vulnerability to a more severe downturn. This complicates the RBA s reaction function when setting policy by introducing financial stability risk. Therefore, it is important to understand what is driving household debt and how it may evolve. The evolution of Australian household leverage The run-up in debt at the household level was incurred during a very buoyant period when nominal growth and wages were high, as seen in Figure 3. From 00 08 debt relative to income accelerated from 80% to 130%, while nominal growth averaged nearly 8% and wages grew at 4% annually. FIGURE 3: HOUSEHOLD LEVERAGE 160 1 1 100 80 60 0 80 83 86 89 95 Household debt to income Average nominal growth 8% Average wage growth 4% 01 07 Nominal growth 3% Average wage growth 3% Source: Australian Bureau of Statistics, Bloomberg, 31 December 14 13 More recently, the end of the commodity cycle has resulted in a larger-than-expected negative income shock. In fact, over the past three years, nominal growth and wages have only averaged gains of around 3% per annum, with the trend continuing to fall. If this downward move persists over the medium term, as expected by the RBA, household expectations could start to deteriorate, leading to a slow but persistent need to decrease leverage. As a result, consumers could increase savings, and the response to low interest rates may be more subdued than history would suggest. However, it is also possible that lower mortgage rates and asset price appreciation may drive a more irrational response relative to the macro fundamentals, a herd mentality that assumes continued capital price appreciation and creates the fear of missing out. The role of debt Households often decide to incur debt to finance assets that will provide a future expected payoff and maximize their net worth. Therefore, the level of debt incurred is typically tied to: expected future capital gains in the asset expected future income related to the productivity of the asset debt-servicing costs 2 JUNE 15 VIEWPOINT

FIGURE 4: HOUSEHOLD LEVERAGE BY COUNTRY Price-to-rent ratio 30 25 15 10 Australia Canada Denmark France Germany Greece Ireland Italy Japan Korea Netherlands New Zealand Norway Spain Sweden Switzerland United Kingdom United States Euro area Total OECD 00 80 60 0 Price-to-income ratio Australia Canada Denmark France Germany Greece Ireland Italy Japan Korea Netherlands New Zealand Norway Spain Sweden Switzerland United Kingdom United States Euro area Total OECD Source: OECD Economic Outlook, Volume 14 Issue 1 Should expectations rise for future capital price or income gains and/or should debt-servicing costs fall, households may increase their desired levels of debt. The problem is that expected future capital price gains may become unrealistic when extrapolated from recent history ( irrational exuberance ), leading to excess borrowing, which, when unwound, can lead to large negative externalities. Rather than commenting on the appropriateness of any given debt level, we have focused on what is driving the change in debt metrics. Due to the importance of household debt ratios in consumption, which is ultimately what policymakers are concerned about, we use debt-to-income as our preferred measure of household leverage. Australian housing in an international context Given the importance of expected future capital gains in household behavior, it is worthwhile putting Australian house prices in an international context. Based on data from the OECD (14), two commonly used valuation metrics place Australian house prices at the higher end of international comparisons, as seen in Figure 4. With this starting point, it seems questionable to embed expectations of continued high price growth. Analyzing household behavior In a recent speech (April 15), RBA Governor Glenn Stevens touched on the vulnerabilities created by household leverage: Household leverage starts from a high level the extent to which further increases in leverage should be encouraged is not easily answered. He described dwelling prices as having already risen considerably from their previous lows, at a time when income growth has been slowing, adding that it is hard to escape the conclusion that Sydney prices up by a third since 12 look rather exuberant. He also acknowledged the importance of financial stability issues: The conduct of monetary policy can t allow these financial considerations to dominate the real economy ones completely, nor can it simply ignore them. A balance has to be found. Given the increased weight the RBA places on these vulnerabilities when setting monetary policy, analyzing what drives household debt is highly relevant. To determine which factors drive household leverage, we statistically tested the response (the change) in household leverage against changes in several key variables including wages, unemployment, asset prices, confidence and the cost of credit. VIEWPOINT JUNE 15 3

We first tested the explanatory variables individually to see whether they are significant, and from that subset, we tested them together to see how they interacted and whether some variables dominate others. Importantly, we also tested various lags in these explanatory variables to proxy for expectations. That is to say, individuals expectations and responses may change under a persistent set of conditions. So, for example, a quarter of strong wage growth may not be sufficient to shift expectations, but over several quarters, strong wage growth may result in an increase in leverage as expectations for future income are revised higher. (An upcoming paper, A Model of Australian Household Leverage, will provide a detailed explanation of our methodology.) Conclusions The modelling results reveal that asset prices and mortgage rates largely explain the change in household leverage. These two factors appear to dominate all other variables regardless of how significant they are individually. Based on our model for household leverage alone, if an exogenous shock sparked a deleveraging cycle in Australia, it would be expected to be quite severe given the large coefficient for asset prices and the quicker household response. wclearly other factors not captured in the model may mitigate such a severe outcome, and no model is perfect, but as a starting point this statistically highlights the potential vulnerability of high and rising household leverage incurred on the basis of past asset price movements. We believe macroprudential measures should be strengthened to address financial stability risk and give the RBA maximum flexibility when setting policy for the aggregate economy. Finally, given the sensitivity of households to mortgage rates, the peak in the cash rate in the RBA s next hiking cycle is likely to be much lower than in previous cycles. This is in accordance with PIMCO s New Neutral view that calls for much lower policy rates for an extended period. From this we infer several probable outcomes in Australia: Households decision to incur debt is dominated by the cost of debt (the mortgage rate) and recent asset price appreciation, which may not be sustainable or linked to the productivity of the asset. Of concern, households are exhibiting irrational exuberance because they are placing little weight on broader fundamentals like unemployment that may be more representative of future incomes or asset price returns, increasing the likelihood of asset price bubbles. Australian households appear to respond rather quickly, needing only two quarters of favourable changes in asset prices and mortgage rates to increase leverage. Australian households will react faster and more vigorously to a shock in asset prices or mortgage rates. This could result in a feedback loop where falling asset values induce further deleveraging. 4 JUNE 15 VIEWPOINT

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