SA Property - Household Sector Debt-Service Risk

Importantly, indebtedness-wise, the Household Sector continues to slowly make the necessary improvements, reducing its vulnerability to interest rate hikes.

Contrary to a common perception, while Household Sector-wide indebtedness remains high, it does not currently appear to be spiraling upward and “further out of control”. And further recent gradual decline in the Debt-to-Disposable Income ratio continues to gradually reduce the level of vulnerability to interest rate or economic “shocks”. But there is still much work to be done.

OUR HOUSEHOLD SECTOR DEBT-SERVICE RISK INDEX DECLINED (IMPROVED) FURTHER IN THE 2ND QUARTER OF 2014

The release of the SARB (South African Reserve Bank) Quarterly Bulletin gave us the 2nd quarter 2014 picture of household sector income and indebtedness.

From this data, we calculate our FNB Household Debt-Service Risk Index, which indicates that the vulnerability of the country’s household sector when it comes to being able to service its debt in future, declined (improved) further in the 2nd quarter of 2014. From a revised 1st Quarter 2014 index level of 5.54 (on a scale of 1 to 10), the 2nd quarter saw a further noticeable decline to 5.33. This continued a declining trend since the 6.56 high recorded in the 3rd quarter of 2012.

The level of the Household Sector Debt-Service Risk Index still remains a little above the long term (33 year) average level of 5.21, but is now steadily moving in the right direction, i.e down. Furthermore, the index has recently exited what we deem to be the “High Risk” Zone, moving down into the upper end of the “Medium Risk” Zone.

This is a positive development, pointing to reduced Household Sector vulnerability to interest rate or disposable income “shocks”. The most recent index level is well-below the 7.19 peak reached in the 1st quarter of 2006, back in the Household Credit boom just before that start of the previous interest rate hiking cycle. However, a balanced perspective is needed. The level is still far above the lowest risk level of 2.62 reached late in 1998 before the start of the consumer boom, so there is still much improvement needed.

The index is compiled from 3 variables, namely, the debt-todisposable income ratio of the household sector, the trend in the debt-to-disposable income ratio, and the level of interest rates relative to long term average (5-year average) consumer price inflation.

The higher the debt-to-disposable income ratio, the more vulnerable the household sector becomes to unwanted “shocks” such as interest rate hikes or downward pressure on disposable income. An upward trend in the debt-to disposable income ratio contributes negatively to the overall risk index and vice versa for a downward trend. Then, the nearer prime rate gets to the “structural” inflation rate (using a 5-year average consumer inflation rate as a proxy), i.e. the lower this estimate of real interest rates becomes, the more vulnerable the household sector becomes, the reasoning being that the nearer we may be getting to the bottom of the interest rate cycle and the end of rate cutting relief, the more the risk of the next rate move being upward becomes, or at least the less the chance becomes of further cuts. In addition, households tend to make poorer borrowing and financial decisions, on average, when money is cheap, and far better ones when interest rates are relatively high. That’s a common human weakness, and hence an additional part of the logic of viewing low interest rate periods as ones where risk generally builds up.

A DECLINE IN THE LEVEL OF HOUSEHOLD INDEBTEDNBESS HAS BEEN KEY IN DRIVING THE OVERALL RISK RATING LOWER

Examining the 3 sub-indices of the overall Household Debt-Service Risk Index, the Indebtedness Risk Sub-Index remains the highest at 7.99. However, this source of risk has been declining broadly from a level of 10 as at the 1st quarter of 2009, the quarter in which the Household Debt-To-Disposable Income Ratio reached its all-time high.

This broad declining trend stalled temporarily in 2012 due a mounting unsecured lending boom driving an acceleration in household sector credit growth up to levels more-or-less matching disposable income growth. However, we have since seen the positive impact of 2012’s “verbal intervention” from the Minister of Finance aimed at slowing the pace of unsecured lending, and this has led to a resumption of the declining trend in the debt-to-disposable income ratio.

Given the start of interest rate hiking in January, and with a huge current account deficit putting South Africa’s Rand at high risk, it has been important to keep household credit growth at levels slower than the Household Disposable Income growth rate, in order to lower the Debt-to-Disposable Income ratio further. Because, although our forecast is for mild interest rate hiking, the combination of a wide current account deficit for South Africa, and the prospect of the US Federal Reserve withdrawing its “cheap money flows” from the world economy, poses the risk of a more significant interest rate rise than predicted, driven by further Rand weakening and higher than expected domestic inflation driven from imported sources.

In addition, the prospect of weak economic growth continuing, in the absence of any major positive structural changes, keeps household income growth under pressure. Fortunately, overall Household Sector Credit growth has been contained, thanks to the slowdown in unsecured lending as well as outstanding mortgage credit growth continuing at a snails pace, to a slow growth rate of 4.71% year-on-year in the 2nd quarter, down on the prior quarter’s 5.35%. This remains well-below Nominal Household Disposable Income growth of 7.84%. The net result was a further decline in the Household Debt-to-Disposable Income Ratio, from a previous quarter’s 74.4% to 73.5% in the 2nd quarter of 2014. This is now moving towards 10 percentage points below the early-2009 83% all time peak. Long may it continue.

All of this means that the Household Sector is moderately better positioned to weather an interest rate hiking “storm” this time around compared with 2008/9, due to its overall level of indebtedness being considerably lower these days compared to back then. The declining trend in the Debt-to-Disposable Income ratio also lowers the 2nd Risk sub-index, namely the “Indebtedness Growth Risk Index”, which is now relatively low at a level of 2.8, due to indebtedness being on a declining trend.

The third component of the Household Sector Debt-Service Risk Index is the Interest Rate Risk Index, which remains significant at a level of 5.4 as at the 2nd Quarter of 2014, but has been declining of late. The reason for its still- significant contribution to the overall Risk Index is the fact that prime rate remains at moderate levels relative to SA’s long term average inflation rate. This sub-index’s contribution to the overall Debt-Service Risk Index became significant following the sharp decline in interest rates from late- 2008, from 15.5% prime to the 8.5% by the 3rd quarter of 2012. Those rate cuts moved interest rates to abnormally low levels by SA’s historic standards, given that “structural consumer inflation appears to be somewhere between 5% and 6%. This extreme decline in interest rates from late-2008 was in part due to an abnormal global and domestic economic situation requiring significant monetary policy support.

Further decline in the 5-year average consumer price inflation rate has, however, translated into a decline (improvement) in the Interest Rate Risk Index as the Prime Rate/5-Year Inflation Rate Ratio started to rise slightly through last year, and more recently the start of interest rate hiking by the SARB (Reserve Bank) has further helped to lower this sub-index’s risk rating.

SO OUR SIMPLE MEASURE OF DEBT-SERVICE RISK CONTINUES TO TREND IN THE RIGHT DIRECTION

Therefore, the Debt Service Risk Index in the 2ND quarter of 2014 remained on an improving (declining) trend, although not yet at a level which can be deemed to be “low”. The index has moved lower due to further decline in the Household Debt-to-Disposable Income Ratio, as well as the start of rising interest rates. This decline could not come soon enough, as we know now that it was essential to “prepare” for the next interest rate hiking cycle, which started in January 2014 with a 50 basis point Repo Rate hike by the SARB, and a further 25 basis points in July.

BUT WHAT OF ACTUAL DEBT-SERVICING PERFORMANCE IN RECENT YEARS?

Debt servicing performances have been good in recent years. However, risk and current performance are 2 completely different things, and for this improved credit performance, the household sector has been relying heavily on the Reserve Bank (SARB) to maintain interest rates at very low levels. Indeed, it was been the SARB’s huge reduction in interest rates from 15.5% prime as at late-2008 to 8.5% by 2012 that was the major contributor to bringing down the all-important debt-service ratio (cost of servicing the household debt, interest only, expressed as a percentage of household sector disposable income) from a painful high of 12.9% back in 2008 to a far more comfortable level of 7.6% by end-2013. This, in turn, significantly improved household credit performance, and the accompanying graph shows insolvencies having dropped dramatically from 2009 to 2013 as a result. However, the “low risk” way of reducing the debt-service ratio, and thus the more desirable way, would be through lowering the debt-to-disposable income ratio of the household sector instead of relying on low interest rates. Interest rates have started to rise, the Debt-Service ratio is off its lows up to 7.9% by the 2nd quarter, and more hiking is expected to exert further upward pressure on the Debt-Service Ratio and thus the level of bad debt. The only way to cushion this impact is to contain the magnitude of the rise in the debt-service ratio by reducing the level of indebtedness relative to disposable income further.

IN CONCLUSION – DEBT SERVICE RISK REMAINS ON THE DECLINE IN 2014, BUT HOUSEHOLD CREDIT GROWTH STILL NEEDS TO REMAIN PEDESTRIAN IN A WEAK INCOME GROWTH ENVIRONMENT

Therefore, contrary to a common perception, while Household Sector-wide indebtedness remains high, it does not appear to be currently spiraling upward and “further out of control”. Actually, further recent gradual decline in the Debt-to-Disposable Income ratio has reduced the level of vulnerability of South Africa’s Household Sector to interest rate or economic “shocks”. However, this is NOT to say that the level of vulnerability is low yet, and there is still much work to be done. Our Household Debt-Service Risk Index is an attempt to provide a simple indication of the Household Sector’s level of vulnerability to future economic and interest rate shocks when it comes to ability to service its debt. Fortunately, the Debt-Service Risk Index has been trending lower, and is now substantially down from its 2006 high, suggesting that if the same magnitude of interest rate hiking as the 2006-2008 hiking cycle were to occur this time around, the Household Sector would weather the “storm” considerably better.

And given the start of interest rate hiking in January, this improvement is crucial. It becomes even more crucial given the “upside risks” to interest rates that appear to exist. South Africa has a huge current account deficit, which depends on large levels of net foreign capital inflows to finance, and thus puts the Rand at high risk of weakness. Any bouts of severe Rand weakness can mean surges in imported price inflation, in turn exerting upward pressure on local consumer price inflation and ultimately on interest rates. The situation risks being exacerbated by the prospect of the US Federal Reserve starting to withdraw its “cheap money stimulus” from the World.

In addition, the prospect of weak economic growth continuing, in the absence of any major positive structural changes domestically, looks set to keep household income growth under pressure. Therefore, it remains crucial that household credit growth remains at pedestrian levels, slower than the Household Disposable Income growth rate, in order to lower the Debt-to- Disposable Income ratio further. So far so good.

Source: John Loos (FNB)

Courtesy: The EAAB - Estate Agency Affairs Board

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