The Bank of International Settlements has sent a warning in its latest report with Australia highlighted as one of G20 economies with particularly high debt. This has implications for spending, consumption, interest rates and inflation
The Bank of International Settlements (BIS) is a global organisation comprising 60 of the world’s largest central banks. In a new report out this week, they increased their forecast for the global economy’s rate of growth, emphasising that the next global recession would likely come from a financial market bust rather than economic factors such as excessive inflation.
Global growth is projected to reach 3.5 % - in line with the long term historical average…
The warning was particularly aimed at a handful of G20 economies with particularly high household debt, including Australia, Canada, China, Hong Kong, and some of the Nordic countries who escaped the worst of the 2007-2009 global financial crisis (GFC).
One of the most telling sections of the report for Australia is the impact that household debt growth can have on bringing forward economic growth. BIS and Princeton University studied 54 economies over the past 25 years to examine the impact of household debt on economic growth. Their results debunked common wisdom that household spending was linked to home values, and showed that it was actually driven by cycles of increases in debt followed by periods of subdued spending as repayments reduced discretionary capacity.
This impact could well explain the flaw in most economists’ models – which lead to years of overly optimistic forecasts that GDP growth would rebound faster after the GFC.
They also found that:
- The impact of household debt was much higher once the household debt to GDP ratio passed 80% (Australia’s passed 80% in 2004)
- The impact is also higher in countries like Australia with greater rights of lenders to pursue defaulted borrowers
- The adverse effects of excessive credit growth can be magnified by the banks’ stronger willingness to extend mortgages, leading to an unsustainable housing boom and overinvestment in the construction sector
- In the tail end of a credit fuelled economic expansion, banks respond to slowing consumption spending by reducing their willingness to lend, exacerbating the slowdown
- Australia’s debt servicing burden is already 4% of GDP – higher than its own long term average – compared to around 0.8% higher in the UK, 2.2% higher in Canada and Norway and 1% lower than the long term average in the US. This is a clear indicator of the headwind (or tailwind in the case of the US) created by household debt increases in recent years
- The worst of the G20 economies – in terms of debt service ratios for households were rates to rise – are China, Canada, Turkey, Australia and Brazil; whereas countries with the greatest potential growth from increased credit are Spain, the UK, Italy, India and then the US
The BIS analysis concluded that a 1% increase in household debt, relative to GDP this year, will contribute 0.1% of growth for the economy this year and next. We see a very small impact in year three and then shifts to five years or more of a negative impact. Overall the impact is relatively neutral – so it isn’t that debt is evil, but the BIS is pointing out that we have already seen positive impacts of debt growth, so we should prepare for the debt service effect as households have to pay back some of this money.
Using the same measure of household debt that the BIS uses, Australia’s household debt to GDP ratio was 106% in 2009 and is now 123%, peaking in 2016 at 125%. The most dramatic increase was in 2015/16.
Figure 1 shows the implications of the BIS analysis for the Australian economy. We applied the BIS impact of a change in household debt to the growth in Australia’s household debt. This then shows the historic GDP growth that is attributable to increased household debt, and also the expected future impact as that debt is repaid with interest.
Thanks to household debt increases in 2009 and 2015, the GDP growth impact was highly positive in those years and the year after. But if we assume that household debt does not increase further from current levels, the debt service effect takes over and becomes deeply negative, reaching a low point of negative 1.45% of GDP in 2020.
Australia’s position seems to be perfectly aligned to the BIS’s script – household spending is stubbornly weak; our banks’ favouring of mortgages over other types of credit seems to have created a housing boom which may or may not wind up be unsustainable. Only time will tell, as construction is starting to slow sharply and banks are starting to wind back willingness to lend.
If the BIS is right, the outlook for domestic GDP growth faces severe headwinds, the government’s budget forecasts of higher GDP growth in 2020 will prove impossible, and interest rates will not be able to rise – possibly even falling unless the AUD falls with it.
All a bit glum, and of course like any economic model, subject to errors. But this analysis makes intuitive sense. The way to avoid this forecast is to either find another source of economic growth to replace lower household spending, such as the mining investment boom, or to allow household debt to rise even further and kick the problem down the road. Assuming neither of those scenarios plays out, Australian interest rates will be range bound near current levels for several years to come.