The implications of household debt - by John Loos

JOHANNESBURG (May 13) - Given a far higher household debt-to-disposable income ratio in South Africa these days compared with the 1990s, it would take the SA Reserve Bank (SARB) far less effort, in terms of raising interest rates, to inflict the same financial pain on the household sector as it did in the late 1990s.

While the economic environment is admittedly different in many ways from 1998, it is possible that a prime rate of 18% today would have a similar effect to the 25,5% prime rate peak of 1998. Should the SARB stop hiking rates very soon, perhaps at prime of 15,5%, the debt-service ratio (a good indicator of trends in household sector financial pressure and thus of housing market performance to come) could peak at fairly “normal levels” by historic standards.

While many analysts seem to focus on the household debt-to-disposable income ratio, i.e. the amount of household sector debt outstanding expressed as a percentage of total household sector disposable income, it is the debt-service ratio, which has a stronger link to residential property performance.

The debt service ratio refers to the cost of servicing the household debt burden per period (interest+capital), expressed as a percentage of household sector disposable income in the same period.

The debt service ratio takes into account the level of household debt, as well as the level of disposable income, but goes further in that it also takes prevailing interest rate levels into account. Not surprisingly, it has a very good inverse relationship with house price inflation, with a low debt-service ratio reflective of a household sector with room to spend, and vice versa for a relatively high ratio.

A close study of data explains much of the splendid residential property boom of a few years ago. Interest rates fell spectacularly in 1999 from a prime rate of 25,5% at a stage of 1998, and after a brief rise in prime from 13% in 2001 to 17% by September 2002 there was a second aggressive cutting session to reduce prime rate to 10,5% by mid-2005

Half the story

But that was only half the story of the boom. The other main part (improved economic growth aside) was that the debt-to-disposable income ratio had also fallen dramatically from around 61% at the end of 1997 to 50% at the end of 2002, with the household sector having gone through a more conservative period in borrowing after the big interest rate shock of 1998.

It was the drop in both interest rates as well as the household debt-to-disposable income ratio post-1998 that created the space for a massive credit-driven spending spree by households, because the debt-service ratio had fallen to 6,3% by the end of 2003, a low last seen in the late-1980s.Therefore, the 400 basis points’ worth of interest rate hikes in 2002 understandably had only limited impact on a housing market in the process of gathering steam, because it only raised the debt-service ratio to 8,8% early in 2003. That, by historic standards, is low for South Africa.

If that is low, what is regarded as a high debt service ratio? If one looks back on historical data, a normal debt cycle would appear to be where the debt-service ratio peaks at around 12%. Indeed this is what happened in 1986, 1990/91 and again in 1997. 1998, I believe, can be regarded as abnormally bad, with the debt-service ratio having peaked at near 14%.

Fortunately that spell was short lived, with the SARB reversing the interest rate trend fairly speedily after having raised rates by 725 basis points in less than 2 months towards mid-1998.

But while the 1998 shock lasted, it was known to have brought quite extreme suffering on a portion of the household sector, and it is not something that we would wish to be repeated. Equally abnormal, but on the positive side, was the 2002 cycle, and that small rise in the debt service ratio should not be used as a benchmark for evaluating subsequent cycles.

This begs the question as to where the household sector is headed in terms of financial stress levels during the current cycle.

Unfortunately, the fact that since a few years ago the sector as a whole has adjusted its debt-to-disposable income ratio upwards to just short of 80%, means that it is not in a great position to handle interest rate levels as high as at stages of the 1990s. This means that to have the same negative impact on the household sector that it did for instance in 1998, i.e. raising the debt-service ratio to around 14%, the SARB would not need to go as far with interest rates as it did back then.


Admittedly, there are some simplifications to my scenarios. The most important one is that the debt-to-disposable income projection for this year is the same in all three interest rate scenarios, i.e. ending the year on 78%, a very similar level to the end-2007 ratio of 77.6%.

In real life different interest rate scenarios would cause different outcomes in this ratio. In addition, different rates of economic growth since the 1990s, higher real per capita income today, and high food price inflation this time around, are some non-interest rate forces which make the environment not 100% comparable with those days.

Nevertheless, given the debt-service ratios good correlation both with bad debt trends as well as with housing market performance, the scenario exercise is useful, and can be put into a nutshell. Under a situation of the household debt-to-disposable income ratio hovering at around 80% this year, should the SARB hike by a further 50 basis points in June and then put rate changes on hold for the rest of the year (a scenario I call the “1997 Hopeful Scenario”), we would probably have a very normal peak in the debt-service ratio cycle at just above 12%.

Concerning, however, is that the SARB would only need to raise rates to where prime rate is 18% by the end of the year, in order to raise the debt-service ratio to around 14%, and inflict a similar level of financial pain on the households to what it did in the 1998 interest rate shock. I call this the “1998 Extreme Pain Scenario”.

Finally, what would it take to get us back to around 6,5% debt-service ratio, similar to the low of late-2003? That would require a prime rate of 8% by year-end, a scenario that I call the “Impossible Scenario”.

In short, therefore, higher levels of indebtedness these days bring down the household sector’s “pain threshold” in terms of what levels of interest rates it can take. Therefore, an 18% prime rate today may be more or less comparable with the 25,5% prime rate peak of 1998 in terms of impact on the household sector and therefore the housing market, given that the debt-service ratio is a good explanatory variable for much of the housing market’s performance.

Article by: John Loos -