Conventional wisdom holds that Australia’s high level of household debt is a massive risk that now threatens to engulf us as the COVID-19 inspired recession destroys jobs and causes forced property sales.
While the day of reckoning may not yet be here because of government income support such as the Job Keeper and Job Seeker payments, once the frozen loan payments start to thaw and the payments stop then things will get really ugly.
Even those who have been eagerly awaiting lower house prices might be disappointed as the banks clam up on lending and the massive loss of wealth and income caused by the recession makes it difficult to save a deposit or take out a loan.
RBA finds Australian debt really is different
Interestingly, the Reserve Bank is holding out some hope that things may not be as bad as we think they are due to some peculiar aspects of Australia’s love affair with debt, which depending on how it is measured is either the highest in the world relative to income or very close to it.
Three economists from the bank’s financial stability department, Jonathan Kearns, Mike Major and David Norman, have released a paper which points out some reasons why our debt pile is not as concerning as many might think.
Certainly, they agree that household debt has been climbing rapidly – up from just 63% of total household income in 1988 to an alarming 187% today.
As worrying as it seems to be faced with working for a couple of years just to pay off household debt – assuming you could somehow suspend living costs for that long – there are some quirks in the Australian economy that better explain those numbers.
Private sector housing dominates down-under
One is that Australia’s property market is a uniquely private affair.
An amazing 97.4% of Australian housing is owned by Australian households – either directly as owner occupiers or through the negative gearing fuelled obsession of buying rental properties and becoming a landlord.
Overseas, a lot of that rental housing is owned by governments, companies and even by listed trusts – here “social housing” is a very small and shrinking sector and corporate involvement in providing rental housing is predominantly at the short-term end such as hotels.
That wrinkle has the effect of inflating the amount of household debt in Australia relative to other countries, although it still does not make that level of debt any less risky.
Reasons behind the growing debt bomb
What the RBA research also shows is that there are specific reasons why Australian household debt rose so spectacularly – more specifically, through easier lending, growth in incomes and lower real (after inflation) interest rates.
As Australians became wealthier, they saw investing in rental properties as a great way to grow their wealth and household balance sheet.
The really important thing to note here is who is making these investments – predominantly households that are better off and have strong incomes that are hopefully more resistant to sudden unemployment.
They are the households that the banks are happier to lend to because of their more secure balance sheets and they are also the households which are aspirational enough and have enough leeway to become landlords.
The real question that we need to ask is whether these wealthier households will be hard hit by COVID job losses and so far, the jury is out.
What we do know already is that the brunt of the job losses have been borne by younger workers and women who are more likely to work in hard hit industries such as retail, travel and hospitality.
Modelling shows banks should survive coming crisis
The RBA research used some complex modelling to show that if unemployment rose by 8% and house prices fell by 40%, the proportion of housing loans that are at risk of foreclosure would rise from 0.8% to 2.1%.
Now such modelling can never really mirror the variables that happen in real life but the encouraging thing is that such a rise in loan foreclosures would cause plenty of heartache for the people involved and the Australian banks but would not be catastrophic for the economy.
Bank capital levels are more than strong enough to cope with that sort of increase in bad loans – indeed, we have seen much worse numbers in real life in previous recessions, even though that excludes the lived experience of a lot of people given almost 30 years of consistent growth.
What we do know from those previous recessions is that a lot more goes on than simply housing loans going bad.
Unemployment stays high for many years; commercial, retail and industrial property prices can suffer even bigger losses than housing and consumer spending and confidence goes down the toilet and stays there.
In simple terms, a lot of things go bad together so even though the RBA modelling of 40% property price falls looks extreme, it is the only way you can get the figures to move so much without introducing a whole range of other variables.
Wealth effect can be bigger than unemployment
In the real world a whole lot of bad things can happen at once and crucially, we have already learned that the wealth effect of falling property and share prices can have a bigger impact on consumer spending than even unemployment.
It makes sense when you think about it – if you lose your job and collect unemployment benefits your household spending will go down but you will still be buying the essentials to provide food, clothing and shelter.
If your major investments such as property fall in value by even 10%, you are likely to cut back on your consumer spending quite hard because you literally feel a lot poorer due to the shrinking equity you have in housing and the bigger relative size of your loans.
Out goes the overseas trip and restaurant meals – all fondly remembered at this stage of COVID-19 lockdowns – and the spending belt is brought in several notches, with more money directed to paying down debts to try to stabilise the household balance sheet.
That has already happened to some extent, with savings actually going up since the COVID_19 lockdowns started.
Even in a bad recession, there are still a lot more people working than unemployed, so the wealth effect of falling house prices is even more powerful than the effect of unemployment because it hits a lot more people.
Wealthier households should be more resilient
What is a positive for Australia is that the households holding high levels of household debt on the whole have the ability to change their spending habits and keep up with loan repayments – assuming they keep their jobs.
Banks have written most of their loans below loan to valuation ratios of 90% and falling interest rates have caused many of these loans to be ahead of scheduled repayments because those with the mortgage decided to keep repayments higher.
It is certainly a fact that Australia’s massive level of household debt increases risks within the economy because it reduces resilience to external shocks and magnifies the impact of falling prices because of the leverage involved.
It is not a good thing that the average Australian household faces around two years of using all of their income just to pay off their debts, which in reality is a task that would take decades when you account for other spending.
But it might not be quite as bad as we thought if those with the biggest debts also have the greatest wealth to cope with the losses coming their way.
Real life test will arrive with thawing of $274 billion of loans
Anyway, we are not too far away from getting a real-life test rather than an RBA simulation with a staggering $274 billion of frozen household and small business loans that have had repayments paused during the COVID-19 crisis to be put out to thaw in January 2021.
By then we should have a clearer idea of how bad unemployment is and how big the fall in property prices will be and how deep and enduring the recession will be.
It is still a high wire act and the net underneath the acrobats is smaller than anyone would like but there is a chance that there could be a softer landing than some have been predicting.