John Loos discusses how interest rate levels affect the household sector

Posted On Wednesday, 28 January 2015 11:38 Published by
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How appropriate are interest rate levels for the household sector?

House Prices

Current interest rate levels have been sufficient to keep Household Sector indebtedness measure declining and the residential market free of widespread speculation. But the savings rate remains a huge problem.

This week's Monetary Policy Committee (MPC) Meeting of the Reserve Bank (SARB) culminates in tomorrow afternoon's interest rate announcement, and our FNB expectation is for an unchanged rate decision yet again.

This would see the SARB's policy Repo Rate remain at 5.75%, while the Prime Rate of the major banks would remain at 9.25%. In fact, due to big global oil and food price drops, a sharply improved inflation outlook has led us to adjust our expectations, and we now project the Repo rate to remain unchanged for the entire 2015. We now only expect the SARB to hike again in the 1st half of 2016.

From a Household Sector and Consumer Banking point of view, the question needs to be continuously asked as to whether such low interest rates are "appropriate" from the point of view of promoting an improvement in overall household financial health. Key here for me is how interest rate levels affect the level of indebtedness as well as the level of household savings, 2 numbers that have been "extremely troublesome" over the past decade or so.

Strongly related to the credit health of the Household Sector is the highly credit-driven Residential Property Market, and here we believe it is important that this market remains "rational" and largely free of speculative activity. The level of lending rates is very important in this regard too.

As things now stand, perhaps surprisingly to some, our "very low" interest rate levels have appeared more-or-less appropriate so as to avoid large-scale "exuberance". Most crucially, Household Sector Credit growth remains at rates below Nominal Disposable Income growth, which in turn has translated into ongoing gradual decline in the Household Debt-to-Disposable Income Ratio. In short as at late last year the Household Indebtedness situation was still gradually improving, crucial given the still very high level of indebtedness.

From an all-time peak of 89.3% back around 2008, the ratio has declined noticeably to 78.3% by the 3rd quarter of 2014 – still high but still moving in the right direction.

HOUSEHOLD DEBT-SERVICE COSTS NOT QUITE AS LOW AS WE MAY THINK

But this is not to say that the current level of SARB interest rates will always have the same desired impact on household borrowing and indebtedness. A key contributing factor is arguably lending institutions' memory of the 2008/9 "financial crisis", and the high level of non-performing loans at that time.

This brought about key improvement to general credit "appetite", especially on the mortgage lending front. The post 2008/9 era also brought about more "appropriate" risk-related pricing of home loans, as well as a shift in household demand towards certain higher-priced non-mortgage loans. The result has been that average interest rate levels on household debt are not quite as low as the current 9.25% Prime Rate suggests.

Using the SARB's calculations of Household Sector Debt Service Ratio, i.e. the total interest cost on the Household Sector debt burden expressed as a percentage of Household Sector Disposable Income, we calculate the estimated "Effective Average Interest Rate on Household Debt". While Prime Rate sits at 9.25%, which is lower than the previous interest rate cycle trough of 10.25% around 2005, what we call the "Average Effective Lending Rate" currently sits at 11.62% (3rd quarter of 2014), which is somewhat higher than its 10.66% trough in 2005.

Therefore, part of the explanation as to why the current low interest rate levels have not elicited the same dangerous level of household borrowing growth as was the case about a decade ago, is that the shift to higher priced forms of credit, along with an essential "re-pricing" of the home loans market, implies that the average effective lending rate remains slightly higher than the low point of a decade ago.

But the Effective Average Interest Rate level remains low nonetheless, thus not explaining all of the subdued borrowing behavior. A further contributing factor is the still-high level of the Debt-to-Disposable Income Ratio, which together with the shift in recent years to higher priced forms of credit translates into a Household Debt Service Ratio which is noticeably higher than the trough of a decade ago.

In 2004, the debt Service Ratio bottomed at a lowly 6.6%. As at the 3rd Quarter of last year it was 9.1%. The high level of household indebtedness itself, an overhang from that extreme borrowing period of a decade ago, thus also serves to contain further borrowing growth.

Still, the Debt-Service Ratio is not high relative to many of the cyclical peaks. So the explanation for subdued household credit growth goes further to the memory of many lending institutions as to the bad debt pain back in 2008/9, keeping lending "appetite" generally more conservative than a decade ago too.

CURRENT INTEREST RATE LEVELS DON'T ENCOURAGE WIDESPREAD PROPERTY SPECULATION

The currently more conservative lending stance compared to the boom years has never allowed the housing market to achieve extreme house price inflation. The net result is that even the SARB's low interest rate levels have also been sufficient for home loan interest rates to by-and-large stay ahead of average house price inflation.

This is crucial in preventing widespread speculative activity, where speculators use cheap credit to buy houses in order to make a very quick profit on rampant capital growth. Back in 2005 we had one of the great "speculators' paradises". At the stage 30%+ house price inflation meant that our "Alternative Real Prime Rate" was as low as -25% at a stage. This Real Prime Rate is calculated by adjusting prime rate with house price inflation instead of consumer price inflation. When this rate becomes significantly negative, it makes sense to speculate on property.

Given more modest house price inflation these days, our Alternative Real Prime Rate remains in positive territory, and there is thus limited opportunity for unhealthy speculation.

All in all, therefore, as the SARB deliberates on interest rates this week it doesn't have to concern itself too much with the pace of household credit growth. Up until now, the current low levels of the Repo rate have been sufficient as to contain this growth and keep the Debt-to-Disposable Income Ratio declining. This is not to say that things can't change, however, should lenders and borrowers alike gradually become more confident as rates stay at these levels. But for now, the SARB interest rate levels seem appropriate.

BUT WHEN IT COMES TO HOUSEHOLD SAVING, BIG QUESTIONS MUST STILL BE ASKED

Finally, though, it is important to emphasis that this is not to say that interest rate levels are appropriate in all ways. When one starts to examine the Household Sector Savings Rate, one starts to think that higher interest rates are needed. This is a debatable point, however, as the low savings "crisis" is probably driven by far more than just low interest rates. Low interest rates on money market investments may indeed hamper the popularity of these savings "vehicles". But then there are other savings "vehicles" such as equities and property, whose performance is often boosted by low interest rates.

It's a tough question, but one does get the feeling that higher interest rate levels should play some role in influencing the consumption culture of a country in the right direction (i.e. towards les consumption). The low savings rate question becomes particularly troublesome when one considers that SA's fastest growing age cohorts are in their 50s and 60s and thus heading for retirement age.

So, when the SARB MPC considers household savings, and indeed the dismal level of overall domestic savings (by households, Government and Private Sector combined), which is far short of levels needed to fund domestic capital expenditure, thus translating into a massive current account deficit, it must surely ask some hard question as to the appropriateness of these low interest rate levels.

It has signaled its intention to "normalize" interest rates upwards from what can perhaps be called "abnormally" low levels. The currently declining trend in CPI inflation will perhaps put this upward normalization on hold. But ultimately higher rates appear to be necessary for the longer term financial health and stability of a country still living far beyond its means.

Last modified on Wednesday, 28 January 2015 12:18

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