Examining explosive growth in debt ratios

Growth of debt has surged in developed nations in the past 30 years. Now similar growth is occurring throughout the developing world, especially the leading new developers such as China, India, Russia and Brazil.

As previously reported, in recent years growth of global money (and credit) in the developing nations has greatly exceeded that in the developed nations. This growth has fed the massive asset boom we are enjoying so much now.

For a group of 16 developed nations, including Australia, the "debt ratio" - the ratio of debt to GDP - has risen since the mid-1970s from about 60 per cent to 130 per cent.

Over the same period, Australian debt has risen from less than 50 per cent of GDP to about 160 per cent.

We are grateful to Reserve Bank deputy-governor Ric Battellino and The Economist for presenting these facts. Battellino has gone further and shown some long-term data for Australia from the middle of the 19th century.

During this long period, the debt ratio rose from 30 per cent to almost 75 per cent in the boom of the 1880s, then fell back to a bit more than 25 per cent, after which it rose again to almost 50 per cent in the boom of the 1920s. Now, after super-exponential growth in the past 30 years, the debt ratio is close to 160 per cent and still rising.

The explosion of debt in the past 30 years is mainly due to an orgy of lending to households.

Battellino says that "deregulation, innovation and lower inflation have simultaneously increased the supply, and reduced the cost, of finance to households", which have responded by using it on a far greater scale.

This is the overt message of Battellino's talk. The explosive growth of debt ratios is all about consenting adults optimising their portfolios.

The US sub-prime fiasco is about overlending by financial institutions and overborrowing by people who mostly cannot afford the debt they have acquired. Australians, it seems, are more careful, or perhaps this is an example of the US leading edge (of financial innovation) turning into the bleeding edge.

The ripples from the US sub-prime crisis have spread widely. Parcels of dud loans have been passed from investor to investor, and end holders have not always been at all sure of what is in their parcels. This uncertainty has spooked markets and in Britain there was an ugly run on a mortgage bank, Northern Rock, which greatly embarrassed the Bank of England and was quelled only by a hasty government guarantee of its deposits.

The big fear is that the crisis is far from over. Many sub-prime loans have yet to have their interest rates "reset" from below market (in many cases zero) to well above market (to compensate for the initial concession and the theoretical risk of default). The "reset" effect is expected to peak in early 2008.

Central banks have lent freely, although not at penal rates, as the central bankers were too nervous to risk this classic response. The US central bank has cut cash rates 50 basis points, stimulating a large bounce in share prices.

Australia has been relatively immune from the effects of the sub-prime ripples. One or two banks have been the subject of rumours but the Reserve Bank has reportedly begun to mop up the excess liquidity.

The graph shows the official cash rate while the slightly higher line shows an average market-based bill rate. The gap is a measure of stress in cash markets. The normal gap is 10 to 15 points, but this blew out to more than 50 basis points during the crisis. Note the subsequent fall back, not all the way but signalling a clear relaxation of market stress.

Two very recent bits of economic data suggest the overall effect on the economy has been effectively unnoticeable. With the sub-prime crisis and the August rate hike, credit growth was expected to moderate. Instead it accelerated. Total credit grew 1.5 per cent for the month and 15.6 per cent for the year to August. Housing credit grew a "robust" 0.9 per cent for the month, while business credit grew a "staggering" 2.7 per cent for the month and 22.4 per cent for the year.

Job vacancies are growing strongly, by 2.9 per cent in the three months to August and 11.9 per cent over 12 months. Unemployment is set to fall below 4 per cent for the first time for a generation and may fall further.

The boom goes on and may be accelerating. Monthly data on inflation suggests outcomes close to the top of the target range of 2-3 per cent.

Battellino concludes by saying there are two issues that arise from the developments in household finances over the past decade or two.

"The first is that the rise in household debt has made the household sector more sensitive to changes in interest rates. This has meant that central banks have been able to achieve their monetary policy objectives with smaller interest rate adjustments."

This general point has made the Reserve Bank cautious - too cautious it will be judged if indeed the boom is accelerating.

"Second, the household sector is running a highly mismatched balance sheet, with assets consisting mainly of property and equities, and liabilities made up of debt. This balance sheet structure is very effective in generating wealth during good economic times, but households need to recognise that it leaves them exposed to economic or financial shocks that cause asset values to fall and/or interest rates to rise."

A third point, which was not made, is that the great credit bubble of the past 30 years has been caused in part by monetary policy that has been too easy. If this great boom is followed by a great bust, this will be the main point.

It was entirely appropriate that Battellino's talk was delivered in Melbourne, the focal point of Australia's great asset and credit bubble of the 1880s.

Could the deputy-governor in fact be more subtle than he seems?