Household Debt and Financial Stability

Global household debts (consumer and mortgage) have been consistently on the rise with around USD152 trillion in 2015. The top five countries with high household debts to GDP include:

	%
(i)         Switzerland	127.7
(ii)        Denmark	123.6
(iii)       Australia	123.0
(iv)       Netherlands	111.3
(v)        Canada	99.8

Malaysia’s household debt (% of GDP) from 2002 to 2016 was as follows:

According to the IMF, although finance is generally believed to contribute to long-term economic growth, “recent studies have shown that the growth benefits start declining when aggregate leverage is high”. From experience and past crises, increases in private sector credit, including household debt, may raise the likelihood of a financial crisis and could lead to lower growth. In 2016, on average the household debt to GDP ratio reached 63% in advanced economies and 21% in emerging market economies.

Globally, household debt has continued to grow in the past decade. The IMF had a sample of 80 advanced and emerging market economies to study the relationship between debt, growth and stability.

Findings show there is a trade-off between the short-term benefits of rising household debt to growth and its medium-term costs to macroeconomic and financial stability. In the short term, an increase in the household debt-to-GDP ratio is typically associated with higher economic growth and lower unemployment, but the effects are reversed in three to five years. Moreover, higher growth in household debt is associated with a greater probability of banking crisis. These adverse effects are stronger when household debt is higher and become more pronounced for advanced than for emerging market economies.

The impact of household debt on financial stability from a balance sheet and cash flow point of view was examined by IMF staff. The result of which is shown below:

Figure 1 – First and second round effects of the build-up of household debts on financial stability

Note

The above figure depicts the interactions between household debt, the financial sector, and the real economy. The balance sheet view (panel 1) shows assets and liabilities (debt) at the household level, whereas the cash flow view (panel 2) shows household income and expenses in the form of consumption and debt service. The two main channels through which household debt and consumption interact are deleveraging and debt overhang. Debt overhang may adversely affect aggregate demand through deleveraging or a crowding out of consumption by the debt service burden. Deleveraging can occur through forced or accelerated repayment of debt, reduction in new credit, and increased defaults or personal bankruptcies. From a legal standpoint, default follows from a situation in which assets and income are insufficient to cover debt-servicing costs, and bankruptcy from lack of sufficient assets and income to repay the debt. There may be second-round effects, such as Fisher-type debt-deflation dynamics, that may be caused by downward asset price spirals.

However, country characteristics and institutions can mitigate the risks associated with rising household debt. Even in countries where household debt is high, the growth-stability trade-off can be significantly mitigated through a combination of sound institutions, regulations, and policies. With better financial regulation and supervision, less dependence on external financing, flexible exchange rates and lower income inequality may reduce the impact of rising household debt on risks to growth.

The IMF concludes that overall, policymakers should carefully balance the benefits and risks of household debt over various time horizons while harnessing the benefits of financial inclusion and development.

Sources: Trading Economics, CEIC and IMF (Oct 2017)