“High levels of debt are fine, until they’re not”

“It’s not what you own that gets you into trouble, but what you owe”

Australia has a low level of total debt compared to other major countries. But while public and corporate debt is low, one area of greater vulnerability is household debt.

A chronic current account deficit in Australia also means a degree of vulnerability to foreign investor sentiment – although this has been the case for decades.

While Australia is not without debt risk, it is still relatively low in part due to the flexibility to cut interest rates further, the buffer the $A provides during extreme shocks, pent up demand in the non-mining parts of the economy and the unlikelihood of a hard landing in China.

Introduction

Since the GFC excessive debt has been a source of volatility and constraint for various countries, notably the US and Europe. Initially the focus was on the private sector, more recently the public sector. Australia has relatively low public debt but how does it stack up in terms of total debt? This is particularly relevant in assessing the vulnerability of Australia should something go wrong, eg if China collapses and our trends of trade plummeted.

Total debt outstanding

The next table shows total debt outstanding, ie public and private, as a percentage of GDP. Quite clearly Australia ranks a fair way down the list. As is well known, Australia’s level of public debt is very low. Where Australia is a bit more vulnerable is in terms of private debt and this is largely due to a relatively high level of household debt.

Household debt in Australia rose strongly over the twenty years prior to the GFC as interest rates trended down, financial competition led to increased access to debt and relatively stable economic conditions and rising asset prices encouraged households to gear up.

Source: OECD, ABS, RBA, AMP Capital

Debt outstanding, % GDP

Source: IMF, Haver Analytics, Ned Davis Research, AMP Capital

The GFC has brought a more cautious attitude to debt on the part of Australians thanks to weaker asset prices, worries that house prices might go the same way as those in the US and parts of Europe and increased job insecurity and this has been accentuated by a tightening in lending standards. Nevertheless debt levels have basically stabilised relative to income in contrast to other countries where they have fallen, although this in large part reflects defaults in the US. See the previous chart. What’s more with soft share markets and house prices and rising incomes in recent years, Australian household balance sheets as measured by net wealth (assets less liabilities) relative to income have deteriorated.

Source: OECD, RBA, AMP Capital

Similarly, soft asset prices at a time of stable debt levels have seen gearing, as measured by debt to assets, rise.

Source: OECD, RBA, AMP Capital

Against this several things are worth noting. First, reflecting household caution the household saving rate is now very high in Australia at around 10 per cent compared to just 3 to 4 per cent in the US. This has been mainly flowing into bank deposits.

Source: OECD, AMP Capital

Finally, the riskiness of Australian housing loans has been falling. Non-performing loans remain low. Low doc loans are only around 5 per cent of outstanding housing loans and less than 2 per cent of new approvals. And around 50 per cent of home borrowers are ahead on repayments. And all mortgages are full recourse, meaning Australian’s cannot simply walk away from their homes if they have negative equity. And, there is plenty of scope for the RBA to cut interest rates further.

Foreign liabilities

One area where Australia clearly is more vulnerable is in foreign debt. Thanks to a chronic current account deficit ranging between 2 and 6 per cent of GDP – even through the mining boom – Australia has remained reliant on foreign capital. As a result net foreign liabilities which includes debt and equity and is labelled net international investment position in the next chart, is relatively high at 60 per cent of GDP.

Source: IMF, ABS, AMP Capital

Quite clearly Australia would be vulnerable should foreign investors change their view of investing in Australia. Mind you this has been a risk since the 1980s!

What’s the risk?

While Australia’s debt levels are not causing problems now this is not to say they are not without risk. For example, just before the GFC Ireland’s public debt to GDP ratio was the same as Australia’s is now but this changed when house prices collapsed and banks had to be recapitalised.

The main risk is that something happens that severely affects the ability of households to service their mortgages and results in foreign investors changing their attitudes towards investing in Australia. Obviously, the RBA is unlikely to trigger the former by raising interest rates too far as it seems very sensitive to household fragility.

The prime risk is that China has a hard landing causing a slump in Australia’s export earnings, a sharp rise in unemployment, defaults, bank problems necessitating recapitalisation by the Government and a loss of confidence on the part of foreign investors.

However, while this is clearly a risk several factors are worth noting: Firstly, the tolerance for a hard landing in China is very low in view of the social unrest it would trigger and in any case recent Chinese economic indicators suggest that growth there may be bottoming around 7.5 per cent.

Secondly, while house prices remain overvalued the risk of a house price collapse remains low given undersupply, low loan to valuation ratios and full recourse loans in Australia.

Thirdly, if the economic environment for Australia sours significantly there is still plenty of scope for the RBA to cut interest rates. In fact 325 basis points worth, which would translate roughly into a fall in the standard variable mortgage rate to 4 per cent if the banks’ continue to pass though 80 per cent of RBA cuts. This would translate to an annual interest bill saving of around $6500 for someone with a $300,000 mortgage.

Fourthly, unlike the situation in countries like Japan or peripheral countries in Europe, Australia’s currency acts as a countercyclical buffer and would likely collapse if there were a big collapse in Australia’s export prices (they haven’t really fallen so much so far, so the fact that the $A is around $US1.04 is not surprising). This could see the $A easily fall back towards $US0.60 delivering a massive boost to industries such as manufacturing, tourism and higher education that have struggled through the mining boom.

Finally, pent up demand exists in big parts of the Australian economy, in part due to measures to make way for the mining boom. Housing construction and retailing have been running well below capacity. This can be unleashed as mining slows and lower interest rates and possibly a lower $A would be part of the mechanism to achieve this.

Concluding comments

Australia is not without its risks on the debt front and to be safe needs to continue to head back towards a budget surplus (to cap public debt) and for households to continue to run relatively high savings in order to boost their net wealth and cap household debt. However, the probability of a major debt crisis occurring is likely low as China is unlikely to have a hard landing, there is still plenty of scope to cut interest rates and the Australian dollar is likely to fulfil its role as a shock absorber in the event of a big loss to national income.