How Risky is Australian Household Debt?

The Reserve Bank of Australia (RBA) published a research report in August entitled “How Risky is Australian Household Debt?”  The RBA believes existing household debt levels are very high though the level is manageable but it may ultimately undermine the economy’s expansion. 

According to the RBA, Australia’s household debt was driven by low interest rates and inflation combined with relatively strong growth in real wages.  The central bank stated in its report “structural changes that increase the ability of households to afford more debt (specifically, higher incomes and lower inflation) can account for around one-third of the increase in the debt-to-income ratio in Australia.”

The RBA deems the usual measure of risk, the debt-to-income ratio (DTI) as a poor measure of the extent of the risk saying “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”.   Although the aggregate Australian household debt level is very high, the RBA determines the level is relatively “safe” as it is mostly directly linked to loans in the residential housing market.  The RBA noted Australian housing stock is mainly held by households, unlike other countries whereby the rental properties (and the debt associated) belongs to the government or corporate sectors.

The RBA believes Australian banks have high lending standards and loans with low loan-to-valuation ratios and operate with high capital levels.  Australian lenders are assessed as very resilient to severe economic scenarios because of the significant amount of collateral backing their mortgage lending as evidenced by the RBA’s stress tests of Australian banks.

The RBA’s research found the distribution of debt is concentrated in households that are “well educated, thereby reducing their risk of experiencing unemployment, and have significantly higher-than-average income….This means they are less likely to experience income shocks that will reduce their ability to meet mortgage repayments”.  However, the RBA noted the most highly indebted households “seem to have only modest wealth as they tend to be younger-than-average, with less time to have accumulated wealth”.   As such, highly indebted households were less likely to spend during an economic downturn.  With consumer spending accounting for more than 60% of economic activity, a major decrease in consumer spending would worsen the economy. 

The RBA therefore believes “the consequences of household indebtedness seem more likely to manifest through weaker economic growth than large bank losses.”  The RBA found that “aggregate bank losses are higher when risks are concentrated among a small group of borrowers (for example, if households in a particular region simultaneously experience larger falls in employment and housing prices)….In contrast, falls in consumption are larger if aggregate wealth effects are dispersed over a large number of highly indebted households.” 

In summary, the RBA’s “findings confirm Australian household indebtedness has important implications but they are sometimes misconstrued. The level and growth of household debt reflects high incomes and direct ownership of rental housing, not evidence of widespread excessive leverage. Household borrowing is a large share of banks’ assets and so is important for their performance, but overall high lending standards, low loan-to-valuation ratios and banks’ high level of capital mean they are highly resilient to adverse shocks to households. Rather, the implications for consumption of household indebtedness are an important mechanism to take into account when targeting macroeconomic policy to respond to economic shocks.”

The RBA’s report is positive in that it supports the resilience of the banks and the banking system, but suggests to Amicus interest rates will be lower for longer as if the issue is financially stretched households being unable to spend, then it will be difficult to increase demand within the economy to recover from the current recession.  Raising interest rates will only exacerbate the problem as it will constrain household spending even further.

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