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Sunday, January 1, 2012
Word of caution

According to FNB’s Household Debt-Service Risk Index, the country’s household sector continues to improve. From a previous quarter’s index level of 6.10 (on a scale of 1 to 10), the 3rd quarter 2011 saw a further mild decline to a level of 6.03. “This represents the third consecutive quarter of decline in our simple measure of household debt-service risk,” notes John Loos, Household Sector and Property Strategist at FNB Home Loans.


“Whilst we have seen a gradual improvement in the household debt-service risk during last year due to a declining trend in the household debt-to-disposable income ratio, it must however be said that the 6.03 index level remains relatively high. It is still well-above the 31-year average of 5.2. It is not, therefore, yet time for the household/consumer sector to declare victory in any balance sheet rebuilding exercise.”
The index is compiled from three variables, namely: the debt-to-disposable 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 index owes its improvement to the declining trend in the household debt-to-disposable income ratio, as the growth in disposable income outpaces that of borrowing.
The one variable, however, that contributes negatively to the overall index is our measure of real interest rates. This has continued to decline as the five-year average inflation rate has risen, bringing it nearer to the currently static 9% prime rate. “This increases the risk that we are near the bottom of the interest rate cycle, so there is a risk of future upward moves in interest rates. Note that the bottom of an interest rate cycle is generally the riskier period both in which to lend or to borrow, as compared to the peak of an interest rate cycle. This is something that is not always understood by lenders or borrowers.”
The reduction in debt-service risk has been brought about by the on-going decline in the household debt-to-disposable income ratio to 75% in the 3rd quarter, down from 75.8% in the previous quarter of 2011 and now down significantly from the revised 82.7% as at the 2nd quarter of 2008. But the 75% level remains high by historic standards, and the household sector thus relies heavily on the Reserve Bank (SARB) to maintain interest rate levels that are low by SA’s historic standards. Indeed, it has been the SARB’s huge reduction in interest rates from 15.5% prime as at late-2008 to the current 9% that has been the major contributor to bringing down the all-important debt-service ratio. Note this ratio is the cost of servicing the household debt (interest plus capital) expressed as a percentage of household sector disposable income. This ratio has fallen from a painful all-time high of 16.3% in 2008 to the far more comfortable 3rd quarter 2011 level of 11.5%.This in turn has significantly improved household credit quality. It is perhaps not surprising that insolvencies have dropped dramatically from 2009 to 2011.
Loos warns that should the recent 11.5% debt-service ratio turn out to represent a bottom turning point in the current cycle, this would be the highest bottom turning point in history, suggesting that it would probably be desirable for the household sector to continue to reduce its debt-to-disposable income ratio further.
“Looking at it another way, I am of the admittedly subjective opinion that a 13% debt-service ratio represents an acceptable maximum at the peak of the cycle. When this ratio rises higher than 13% that would appear to be where matters become unacceptably painful for the household sector as well as lending institutions, as was the case from around 2007.”
At the current level of household indebtedness, what would it take for the debt-service ratio to reach a 13% “upper acceptable limit”? Using the debt-service ratio at the current debt-to-disposable income ratio, for different hypothetical interest rate scenarios, a prime rate of 12% would cause the household debt-service ratio to reach 13% at a 3rd quarter household debt-to-disposable income ratio of 75%.


 

Copyright © Insurance Times and Investments® Vol:25.1 1st January, 2012
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