By G. Sharmila
Household debt was the prime concern during the global financial crisis, making the subsequent recession more severe and drawn-out than expected. However, it seems that lessons have not been learned, as household debt is growing rapidly in advanced and developed economies.
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A recent report by the McKinsey Global Institute (MGI) has revealed some rather disturbing facts and analyses about global household debt. According to MGI, while household debt levels have fallen mainly in the countries most affected by the global financial crisis (such as Ireland and the United States), in most advanced economies, household debt has continued to grow and in some cases has reached much higher levels than pre-crisis peaks in the United States and the United Kingdom.
“In developing economies, household debt is generally at much lower levels, but is growing rapidly. In Thailand and Malaysia, household leverage exceeds US levels. The question today is whether countries with high levels of household debt are at risk of a crisis, or whether high debt levels can be sustained,” MGI opined in its report.
According to MGI, in most developing economies, household debt relative to income has grown rapidly. This has happened particularly where urbanisation is raising property values and access to credit is expanding.
Debt relative to household income has risen by 13 percentage points on average since 2007 in developing economies. However, the debt level in developing economies is still very low (42% of income), compared with an average of 110% in advanced economies.
MGI pointed out that Chinese household debt has quadrupled since 2007, rising by US$2.8 trillion (RM10.3 trillion), but this debt is still only 58% of disposable income, only slightly more than half of the current US level.
“Notable exceptions among developing economies are Malaysia, whose household debt ratio is 146% of income, and Thailand, at 121%. These debt ratios are similar to those in the United States and the United Kingdom (Figure 1). Given the lower income levels in those countries, this raises questions about sustainability of household debt,” MGI cautioned.
Real estate and land prices major drivers of debt
The real question on everyone’s minds is no doubt what lies behind the continuous rise of global household debt? The answer is not rocket science; according to MGI rising mortgage debt is the main cause.
An example is the United States, where household debt grew from 16% of disposable income in 1945 to 125% at the peak in 2007, with mortgage debt accounting for 78% of the growth.
Mortgage debt also represents the majority of household debt growth in other countries, MGI said. “Our data show that mortgages now account for 74% of household debt in advanced economies and 43% of household debt in developing economies (where household loans also include borrowing for small family businesses).”
According to MGI, the steady increase of mortgage debt reflects four factors: rising home-ownership rates, real estate prices, tax incentives that favour debt, and interest rates.
“Household debt, not surprisingly, is lower in countries where more people rent rather than buy their homes. Home-ownership rates vary significantly across countries, from a low of 53% in Germany to a high of 90% in Singapore. However, home-ownership rates do not change substantially over time and so cannot explain the significant growth of household debt in many countries prior to the crisis,” MGI explained.
What does explain most of the growth in household debt prior to the crises is rising real estate prices, driven higher by readily available mortgage for buyers. “As house prices increase, households must take out larger loans to buy them. When values are rising, banks are willing to lend more against collateral that appears to be gaining in value, which in turn creates more demand in the real estate market, driving prices higher still,” MGI said. (For a better understanding of the correlation between growth in real estate prices and household debt across countries, see Figure 2).
Land and housing prices aside, the level of mortgage debt households take on is determined by the type of mortgages used in an economy and national tax policies. For example, in the Netherlands, not only is mortgage interest deductible, but many households also use deferred, interest-only loans, MGI pointed out. “In Germany, by contrast, there is no tax incentive for using debt, and households typically pay off mortgages as soon as they can,” it added.
Interest rates also influence the level of household debt as it determines monthly debt service payments. “Over the past 30 years, real interest rates have declined in advanced economies, and central bank monetary policy in the years since the crisis has pushed rates even lower. Low interest rates have enabled households to borrow more, since debt service payments are more modest.
“However, in countries where many households have variable rate mortgages, such as the United Kingdom (and more recently Denmark), households are exposed to interest rate risk. When rates rise and monthly debt service charges are adjusted upward, some households may find they cannot afford their mortgages,” MGI observed.
Urbanisation influences household debt levels
Perhaps one of the more interesting findings of the MGI report is that urbanisation policies influence household debt levels. “We find that in countries where a large share of the population flocks to a single centre of economic activity or to a handful of mega cities housing prices are higher than in countries where economic activity is more distributed,” MGI observed in its report.
To study this relationship, MGI looked at the number of metropolitan areas with greater than three million people within an economy. (The results of this study are displayed in Figure 3 below.)
The results, MGI said, confirms that countries with higher urban concentrations also have higher real estate prices and higher levels of household debt. “Singapore and Hong Kong are two extremes, in which the entire population lives in one urban agglomeration—and both have among the highest real estate prices per square meter in the world,” MGI highlighted in its report.
It noted also that the Netherlands, the United Kingdom, France, and Canada are other examples of countries with high urban concentration, high urban real estate prices (in Amsterdam, London, Paris, and Toronto, respectively), and high levels of household debt.
In contrast, countries with multiple cities and a more dispersed urban population have lower real estate prices and less household debt, MGI said. “We observe that Germany has much lower real estate prices (in purchasing power parity terms) than the United Kingdom. The same pattern holds in developing economies. Indonesia has five urban agglomerations, while Vietnam has two and the Philippines only one. We find that Indonesia’s real estate prices per square meter are the lowest, while Vietnam’s are higher and the Philippines’ are the highest.”
High household debt can hurt the economy
The rise and fall of household debt affect the magnitude of a recession, MGI said. “In the years prior to the crisis, when credit was flowing and asset prices were rising, economic growth appeared robust, but it was artificially inflated by debt-fuelled consumption.”
“Then, after the crisis hit and credit dried up, the decline in consumption was especially sharp as households could no longer borrow and had to make payments on previous debts, often for homes in which their equity has been wiped out,” it explained further.
Rising house prices and larger mortgages can create an upward spiral, conversely, falling prices trigger a dangerous downward spiral. Compared with other households, highly leveraged ones are more sensitive to income shocks as a result of job losses, costly health problems,or increases in debt servicing costs, MGI said.
“When highly indebted households run into trouble, they cut back on consumption, which contributes to the severity of the recession. Eventually, many overburdened households in the United States defaulted and lenders foreclosed, which created a downward spiral in housing prices in the surrounding areas,” MGI explained.
“During the depths of the recession, nearly one-quarter of US mortgages were “underwater,” meaning borrowers had negative equity in their homes. Some of those homeowners chose a “strategic default” and walked away from their debts because their properties were not worth keeping. This created further downward pressure on housing prices and additional losses in the financial system,” MGI said.
“Therefore, monitoring the sustainability of household debt is an imperative for policy makers. Today, in countries where household debt ratios exceed the levels seen in the crisis countries, the question of assessing sustainability is especially important,” MGI emphasised.
Household debt may be unsustainable in some countries
According to the MGI report, seven countries (the Netherlands, South Korea, Canada, Sweden, Australia, Malaysia and Thailand) appear to have household debt levels that would make them most vulnerable.
“Their debt-to-income ratios are not only the highest, but they also have grown significantly since 2007. Apart from Canada, these countries also have some of the highest debt service ratios in our sample.
“These figures suggest potential risk but do not signal imminent crises. The creditworthiness of borrowers, the ability of lenders to assess risk, and the state of the macroeconomy will all influence the outcome. Nonetheless, these countries should, at a minimum, be monitoring the situation very carefully,” MGI cautioned. (See Figure 4 for the comparison of household debt levels across countries.)
At the other end of the spectrum of advanced economies lie the United States, Germany and Italy, which have much lower household debt-to-income ratios. Debt service ratios in these countries are among the lowest in MGI’s sample.
“In the middle of the list are European countries with more moderate household debt levels (the United Kingdom, Spain, and Portugal), some of which have stabilised or declined. Developing economies on the list often have rapidly rising household debt ratios (for instance, China, Brazil, and Russia) but are starting from lower levels than advanced economies,” MGI explained.
Given the seriousness of the global debt situation, including that of household debt, solutions are called for and we will discuss them at length in our next article.
Yesterday: World borrowing gallops ahead of GDP
Tomorrow: Living with and managing debt
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