It may be misleading to say that high debt levels leave Australian households more vulnerable to economic shocks than households in other countries, the Reserve Bank has concluded in its latest review of the riskiness of Australian household debt.
The biggest risk is the potential decline in consumption by heavily indebted households in response to a severe downturn in the economy.
In a research paper published yesterday, the RBA says the risk posed by Australian household debt is “material” but the usual measure of risk, the debt-to-income ratio, is a poor measure of the extent of the risk.
A cause of concern for many economists is that Australia’s household DTI ratio has increased at a faster rate and to a higher level than in most countries, giving rise to questions about how much additional risk this creates.
The RBA paper says: “Based on DTI ratios, the increase in Australian household debt has been more pronounced than in most of other countries, rising from the bottom half of the distribution across advanced economies in the late 1980s to the top quartile in 2018.”
But it says DTI has proven to be an imperfect predictor of future stress. During the GFC some countries, such as Spain and the United States, suffered from serious household debt stress but did not stand out on the basis of their DTI levels.
On the other hand, some countries, including Australian, the Netherlands, Norway and Switzerland, had comparatively high DTI ratios but emerged from the crisis relatively unscathed.
“The problem with DTI is that it does not capture the distribution of debt, the quality of lending and the resilience of the financial system,” the paper says.
The paper says that for Australia, almost all of the 125 percentage point rise in the DTI ratio between 1988 and 2018 can be attributed to the effect of lower real interest rates and inflation, financial liberalisation and higher real income.
It says higher incomes and lower inflation are structural changes that suggest the rise in household debt has not created additional risk.
It is possible that the other factors, lower real interest rates and financial liberalisation, have contributed to excessive borrowing that may be disruptively unwound in the future.
“However, the ability of the Reserve Bank to limit the pace of future increases in real rates and the considerable time elapsed since the pace of liberalisation slowed suggest these risks are small.”
One important element in the picture of Australian household debt, compared with other countries, is the fact the housing rental stock is almost fully owned by the household sector, which is unusual.
The paper says this gives rise to a “measurement issue” because the ownership structure of housing in Australia is not obviously associated with additional risk but has an important bearing on the level of the DTI ratio compared with other countries.
To the extent that financial deregulation allowed households to fund investment in housing stock, it is unlikely to have increased household vulnerability.
“Consistent with previous research we find that debt is held by those who are well placed to service it. Highly indebted households have significantly higher than average income,” the paper says.
When assessing a severe downturn scenario, the paper says: “We find that the potential decline in consumption in response to a severe downturn in the economy could be large, and possibly larger than commonly assumed in past bank stress tests. The sensitivity of consumption to severe shocks appears to have increased over the past decade or two, as indebtedness has risen.
Banks would likely be resilient to a severe downturn because of the significant amount of collateral backing their mortgage lending.
“The Australian banking system remains robust to losses stemming from rising household debt largely because they participate in very little high LVR lending and are well capitalised.”