Household finance pay today

In his March 2004 speech(1) at the Association of Corporate Treasurers' annual conference, Sir Andrew Large, Deputy Governor responsible for financial stability, considers the potential impact on monetary and financial stability of high levels of household debt. The speech assesses recent trends in household debt and the demand and supply factors that have contributed to them. Sir Andrew notes that while in extreme circumstances potential vulnerabilities stemming from higher debt levels could crystallise at some point and trigger a sharp demand slowdown, this is not the central case. In concluding, he explains that household debt is just one of many factors that are considered each month by the Monetary Policy Committee and that it is considered and weighed together with the whole gamut of demand and supply data.

Leverage and debt: benefit and vulnerability

A key economic debate of the day is whether we, as a society, should be concerned about the level of debt borne by families, businesses and, indeed, governments. We are all aware of the positive role of debt in the development of market economies and social well-being. But equally we are aware that increasing leverage can give rise to vulnerabilities-think of LTCM in 1998-and increase the possibility that external shocks or changes in perceptions will lead to unexpected results that affect the stability of the financial system and the setting of monetary policy.

On the whole, the increasing availability of debt is beneficial. Debt helpfully allows households, companies and even countries to smooth their spending patterns. But as with many things in life, there are potential downsides. It is often said that central bankers and regulators tend to look on the pessimistic side and to see 'the glass as half empty'. As a former regulator, and now a central banker, I am perhaps likely to be doubly cautious and to focus on the potential vulnerabilities!

Improved access to debt may indeed be beneficial overall, although high levels of debt can cause difficulties for companies and for countries. Evidence also suggests that the burden of debt does pose a genuine problem for a minority of households. And, as I will discuss in more detail below, a rise in indebtedness may increase the sensitivity of households-and the economy in general-to future shocks, although by how much is very uncertain.

For public policy makers, the evaluation of these vulnerabilities and the appropriate policy response is a matter of continued debate. What levels of debt arc sustainable? And what could be the impact of a breakdown or crisis of one sort or another?

At the Bank of England we take an interest in this subject at several levels. We look at it from the points of view of governments or sovereign countries; corporate entities; and individuals or households.

At each level there are two aspects that we consider. First, what are the implications for financial stability oversight? We look for vulnerabilities that could lead to pressures on counterparties, with the possible failure of institutions and ultimately financial instability. Such crises can lead to immense social and economic cost, as financial intermediation is disrupted and confidence in the monetary system is weakened.

Second, we look at debt from the point of view of monetary policy. In this case we look at the possible impact on our ability to meet the inflation target set by the Chancellor via, for example, its effect on overall levels of demand and supply.

At the level of sovereign entities we have two different types of concern about the working out of sovereign debt positions. First, the potential implications of sharp exchange rate movements for countries that borrow in their own currencies (for example the United States). second, for countries that borrow large amounts in foreign currency concerns about debt sustainability, which lead to our working on crisis prevention and resolution issues in the sovereign area, including the role of the IMF and issues raised by the present Argentinean default.

At the corporate level, the question you all face is what amount of debt is not only sustainable, but will lead to maximisation of shareholder value over Lime? Here our interest is in trying to spot vulnerabilities, or debt concentrations across the market place, which could give rise to problems down the track. In the face of shocks, such factors could have an impact on demand in the economy and on the stability of the financial system.

Household debt: introduction

It is the third level of our interest-household debt-that I would like to focus on today. It is clearly significant for all of us. For you in the corporate world through your customers. And for us in the world of public policy.

I would like to examine, first, why has debt built up in the way it has? second, what are the facts and how great are the vulnerabilities? And, third, what are the implications for those of us involved in financial stability oversight and monetary policy, quite apart from society as a whole?

The household debt build-up: why has it happened?

It is worth reflecting on why the build-up in household debt has occurred. On one side there have been a series of demand factors. Lower real and nominal interest rates have held out the prospect that interest costs and debt-servicing burdens will remain within acceptable bounds-in terms of the burdens on both real incomes and households' cash flows. And lower inflationary expectations have held out the prospect that nominal interest rates will remain low. The lower inflation environment has also increased predictability and made it easier for households to plan ahead. Risks seem more acceptable to households because of confidence in a stable economy, and secure job prospects, perhaps in part due to the current accommodating monetary policy.

In the meantime, wealth has risen and stocks of financial assets have built up. In the light of this, it is not surprising that households, taken together, are happy to have higher debts relative to their incomes. And the rise in house prices, combined with a high level of owner-occupation, has encouraged equity-enabled homeowners to borrow accordingly. These factors have given households the confidence that present levels of debt are quite rational from the point of view of their balance sheets. In addition, the rise in house prices has itself necessitated an increase in borrowing as the average mortgage size increases.

There have been supply-side factors too. Competition amongst lenders has been intense. There have been new entrants to the market. Not only the traditional lenders but specialist providers of credit cards and the like. Liberalisation of markets has meant new approaches to lending and new credit instruments, enabling credit to be available to a wider variety of participants and reducing credit constraints.

I will come to the vulnerabilities in a moment, but overall this combination of demand and supply-side factors has led debt to rise to today's historically high levels.

The debt build-up: what are the facts? How great is the vulnerability?

It is not just in the United Kingdom that domestic indebtedness has risen: its build-up, alongside globally lower levels of inflation, has been a global phenomenon. The ratio of household debt to annual household income has increased in most industrial countries (see Chart 1)-reflecting, over the longer term, increased financial liberalisation, the greater efficiency of financial intermediaries and, in some countries, housing market developments. While the ratio in the United Kingdom is high, at over 130% (see Chart 2), there are other countries where it is higher, and where it has grown more quickly.

In the United Kingdom household debt amounts to just under 18 months' worth of household disposable income. Mortgage debt is the biggest component of this, and lolal secured debt accounts for about 75% of total debt. Unsecured debt-personal loans, credit card debt and the like-is still a much lower proportion, but has nearly doubled over the past decade.

The actual statistics of stocks and flows are of course one thing. But the real question is in relation to sustainability: suslainability of debt-servicing burdens and sustainability of consumption growth.

Household debt in the United Kingdom has been increasing more rapidly than post-Lax income since the end of 1997, and the difference in annual growth rates over the past year has been around 8 percentage points (see Chart 3). This has been one of the factors that have permitted consumer spending growth to outstrip income growth on average over the past few years. Mortgage equity withdrawal, in particular, has risen sharply relative to consumption. Some of this will have helped to finance consumer spending even though much is used Lo pay off other debts or build up other assets.