Wealth ,Debt and Snowballs

In the past week the Central Bank published its latest figures on the balance sheet of Irish households, covering the third quarter of last year, while the Department of Finance produced its annual thoughts on Government debt. The latter tends to generate more column inches, raising the question of whether the level of debt owed by the State is too high or in some way represents a major problem, while the ongoing extraordinary shift in household debt and wealth receives less attention.

On the latter Irish households are continuing the process of deleveraging which started in 2009 with debt of just over €200bn, equivalent to 210% of disposable income at the time. Since then the economy has recovered and then boomed, moving to full employment in 2019, while interest rates have fallen sharply , including mortgage rates which are currently at all-time lows, yet household debt has continued to fall in cash terms, declining to €130bn on the latest figures. The change in term of disposable income is more pronounced still, with the ratio at 107%, back to the range last seen twenty years ago.

Housing is the main asset on the other side of the balance sheet, and the property crash was the main driver of a collapse in net household wealth (i.e, assets minus debt); from 2008 to 2012 if fell from over €700bn to a low of €430bn. Since then the recovery in the housing market has been a big driver of the rise in household net wealth, which reached a new high of €831bn in q3. The long rally in equity markets has also helped boost pension assets while the past year has also seen a significant increase in holdings of liquid assets in the form of cash and bank deposits. This had started before Lockdowns but in effect households have become forced savers given the reduced options to spend.

As a result households now hold €163bn in cash and deposits which exceeds debt owed by €33bn, a far cry from 2008 when debt exceed deposits by €85bn. Of course these are aggregate figures and some households have few or no assets and a lot of debt while the reverse is also true. The change has been bad news for Irish banks, which have seen assets fall and deposits surge in relation to shrinking loan books.

The path of Government debt has been very different. Gross debt soared in response to the financial crash, reaching €215bn or 120% of GDP in 2015. From there it fell a little in cash terms but very significantly relative to GDP given the growth of the Irish economy, declining to 57.2% in 2019, one of the lowest ratios in the EA and below the 60% figure required under the Stability and Growth pact. The Irish Government responded to the Covid pandemic by significantly increasing transfer payments to households and firms, as elsewhere, and the debt figure ended last year at some €220bn, albeit still with a low debt ratio of around 61% given that Irish GDP probably grew.

Government Debt is potential problematical for two reasons. One is the annual cost of servicing it, which means Government spending diverted from other areas. That cost will in turn depend upon the debt stock and the average interest rate on that debt and thanks to the ECB the latter has tumbled; the average cost of Irish debt is now under 2% , less than half the rate in 2013, because Ireland can refinance maturing debt at a rate close to zero and even below for shorter dated borrowing. As a result debt payments costs the Government under 5% of total revenue, versus 17% five years ago.

Governments rarely run large budget surpluses for any period of time so debt is generally simply rolled over rather than repaid out of revenue i.e. if €15bn is due to mature in a given year the authorities will issue €15bn to fund it, plus any additional borrowing if there is a fiscal deficit. That raises the second issue for Debt- can the Government readily refinance maturing bonds. That depends on investor appetite and in general is affected by who owns the debt and expectations about repayment, with the debt ratio playing a key role in that expectation.

Japan has a debt ratio of 240% but few expect a default, in large part because most of the debt is held internally, by banks, the Central Bank, insurance companies and pension funds. So Japan owes the debt to itself and these holders are also far less likely to sell it before maturity. That example also highlights that expressing the debt relative to the population is not meaningful, as it ignores the ownership issue. In Ireland’s case domestic ownership is actually not high but over €40bn of the total is owed to the EU on very long maturities and of the €140bn of bonds at issue over €50bn is held by the Central Bank and the ECB .These bonds have to be repaid of course but the interest is largely recycled back to the Exchequer and the large holdings under QE and PEPP means less bonds available to investors who might sell before maturity, perhaps precipitating a spike in bond yields and hence raising issues about refinancing, as happened in 2010.

On the debt ratio itself, its evolution over time depends largely on two factors ( ignoring one-off impacts like asset sales) – the fiscal balance excluding debt interest (the primary balance ) and the difference between the rate of interest on the debt and the growth rate of GDP. In Ireland’s case, and indeed in many developed economies in recent years, the interest rate (r) is now well below the growth rate (g) and this ‘snowball effect, as it is known, has been a big factor in the fall in the debt ratio. So, let’s say,. Irish GDP grew at 5% a year over the next five years with the interest rate at 2%, the debt ratio would fall by around 3% a year, assuming a primary budget balance, down to 53% from the current 61%. By extension, given that snowball effect the Irish Government could actually run a primary fiscal deficit of around 3% per annum and maintain the existing debt ratio.

The fact r<g in many economies has been a big factor in changing attitudes to debt, with the IMF, for one, completely changing tack from its pro-austerity stance of recent years, now arguing for large fiscal stimulus. Of course rates may rise in the future and QE may one day end but that is likely to be some way off. So as it stands Ireland does not have a debt problem given the debt ratio , the interest rate and the ownership of that debt. Why then are some concerned? One answer is that it is argued GDP is not a good measure of Irish income and as such a better denominator to use is modified national income, a specifically Irish concept which adjusts GDP for various multinational related flows. On that metric the ratio is thought to be around 107% in 2020, a lot higher than 61% but still not excessive by EU standards. In this writer’s view the concept is not useful anyway and was an overreaction by the CSO to the 2016 GDP figures (the release precipitating the ‘leprechaun’ saga). No other statistical agency recognises the concept, it is impossible to forecast and in any event appears to have a very similar tax elasticity to GDP anyway (indeed Corporation tax is more closely related to GDP).

Ireland now a nation of savers, not borrowers

Much has changed in Ireland over the past decade and one of the most striking in economic terms is the  tranformation in Irish households from borrowers to savers although much of the coverage in the media  still concentrates on credit and the cost of new loans and so does not reflect this new reality. Ireland has morphed into Germany and we are now closer to Berlin than Boston.

Irish household borrowing peaked over ten years ago, in mid 2008, at €204bn, and most of this debt had been used to purchase residential property , which of course at the time had soared in value over a long period, leaving households with net worth of over €700bn. By 2012 the latter figure had collapsed to under €450bn, largely reflecting the 50% fall in house prices, but debt was also declining, given little or no new borrowing and the ongoing repayment of mortgages.

Indeed, household debt is still falling, at least on the figures to the third quarter of 2018 as published by the Central Bank, to €137bn , a reduction of €67bn from the peak.  Household income is growing strongly again and so the debt/ income ratio, a standard measure of the debt burden , is now down at 126% , a level last seen in 2003. Rising house prices and  the recovery in equity markets in recent years has boosted wealth, leaving net worth well above the previous peak, at €769bn.

Interest rates are historically low ( the average rate on new  mortgage loans is around 3%)  and wealth is at record levels so one might imagine that households would be reducing savings and increasing debt but that is not the case. New mortgage lending  has certainly picked up, reaching €8.7bn in 2018 as a whole, but that was largely offset by redemptions, leaving the net change in mortgage credit  on the balance sheet of Irish  banks at only €1.1bn. A rise nonetheless, but that is not inconsistent with the overall data on household debt, as that relates to the third quarter and includes money owed on mortgages no longer on the balance sheet of the original lender.

Central Bank controls now limit the degree of leverage allowed in the mortgage market and the relatively limited supply of new housing is also a contraint  so we are unlikely to see an explosion in household borrowing, even in an environment with less economic uncertainty. However, the savings side of the balance sheet is also witnessing a profound change, with a huge increase in the amount of wealth held in cash and deposits; the q3 figure was € 143bn , a €15bn increase in the past three years. So Irish households now hold more in cash and deposits than they owe in outstanding loans (€137bn), quite a change,  and this  has also had a major effect on Irish headquarterd banks, as they are now in effect Credit Unions, with loans amounting to only 93% of total deposits.

The returns on these deposits are also extraordinarily low of course, amounting to an average of 0.29% for outstanding deposits (the euro average is 0.3%) and a meagre 0.04% on new term deposits ( euro average 0.3%). Monetary policy is based on the notion that the economy responds to a change in interest rates, and that a substantial decline in rates will boost credit growth and encourage savers to spend and borrow. That certainly has not been the case in Ireland and so it is not clear what the impact of higher rates will be on what is now a net savings economy, if and when that day arrives. As it stands that  day seems far off, with the market not priced for an ECB rate rise till around June 2020, although that can and will change with the flow of economic events.

Irish household wealth is rising but debt repayment ongoing

Mario Draghi may be doing his best to encourage European consumers to borrow and spend but the evidence in Ireland still points to ongoing deleveraging, despite rising household wealth. The debt burden is now falling steadily, however, in contrast to the situation over recent years, but is still extremely high by international standards and it is anyone’s guess when the deleveraging process will come to a close.

The Irish Central bank publishes financial accounts data which tracks each sector’s assets and liabilities and the figures for the first quarter have just been released. Loans to households fell by €1.9bn in q1, bringing the total decline since the peak in mid-2008 to over €39bn. That deleveraging has dwarfed any new lending, which explains why the outstanding amount of personal credit is still falling despite a pick up in new loans. The absolute debt figure is now back to the level last seen in mid-2006.

Of more significance is the debt burden, which is generally expressed relative to disposable income. On that metric the burden peaked at 218% in late 2009 but did not fall materially for some time after that despite deleveraging because household income, the denominator, was also falling, reflecting rising unemployment, falling wages and an increase in the tax burden. Income finally stabilized  in 2012, ( although it is still volatile even on the four quarter total used by the Central Bank ) and has started to inch higher, so the debt ratio has started to fall at a steady clip, declining to 182% in the first quarter of 2014 from 185% in the previous quarter and 198% a year earlier. The household debt burden is now also back at 2006 levels, although a long way above the 133% recorded a decade ago.

Households are reducing their liabilities but their financial assets are climbing, and indeed have been rising for the past five years, largely reflecting growth in the value of assets held in pension and insurance funds. Household’s financial assets amounted to €339bn in q1, leaving net financial worth of €165bn, a record, and some €100bn above that recorded at the nadir of the financial crash.

Most Irish household wealth is in the form of housing, however, and when that is added we arrive at a  total net worth figure of €509bn. The housing component actually fell in the quarter ( national house prices declined in q1) and wealth  is still some €200bn below the peak but it has recovered by €50bn over the past year.

House prices rose again in q2 so that alongside the pick up in house building ( up an annual 37% in h1) will have boosted wealth  in recent months. The data on bank lending implies that debt repayment has remained a feature as well so the net household wealth figure will probably record a further rise in q2. Rising wealth is generally seen as positive for consumer spending but we have never seen the pace of deleveraging evident in Ireland of late (households have been net lenders rather than borrowers for over five years now) and we do not know how long that will continue to dampen personal consumption.

Irish Household debt, Deleveraging and Wealth

Consumer spending in Ireland accounts for around half of GDP and in 2013 probably amounted to some €83bn or €11bn below the peak year of 2008. Consumption is largely driven by  real household income  which has fallen sharply in recent years, but household wealth also plays a role and so the housing collapse has also had an impact, with households deleveraging in order to rebuild net wealth. Annual consumption appears to have fallen again in 2013 but picked up through the year after a very weak first quarter and the  latest retail sales data showed a strong end to the year in term of High street spending, with sales excluding cars rising by 2.8% in volume terms over November  and December. The consensus view sees that upturn translate into a rise in real consumption this year (the Budget is predicated on a 1.8% increase), largely driven by a recovery in household income, and the latest data from the Central Bank is also  potentially supportive in terms of the trend in household wealth although deleveraging is still very much in evidence, adding downside risks.

Household wealth comprises financial assets and housing, with the latter dominating in Ireland. Net wealth (i.e. the value of assets minus debt) peaked at well over €700bn in 2008  and then plunged to less than €450bn largely as a result of the collapse in house prices. Indeed, the net financial worth of the household sector bottomed in late 2009 and has been on a rising trend since, increasing to €148bn in the third quarter of 2013 ( on a 4-quarter moving average, the measure preferred by the Central bank), which is a new high. Around a half of gross financial wealth is in the form of equity reserves in pension  and insurance funds and the recovery in stock markets  has had a big influence as the amount held by households in cash and bank deposits has not greatly changed of late. The pick up in house prices is also significant as it has boosted housing wealth with the result that total net wealth is now some €50bn higher than it was a year ago, rising to €490bn in the third quarter.

The improvement in the net worth position also reflects a significant decline in household debt. That peaked in the final quarter of 2008 at €204bn (total liabilities were and still are around €10bn higher but the Central bank concentrates on loans owed to financial institutions) and has fallen by €35bn since then, to €169bn in the third quarter of 2013. Deleveraging on that scale has also resulted in a fall in the debt burden (debt relative to disposable income) but the decline in the latter has been slower reflecting falls in the denominator, with the latest reading at 196% of income from a peak of 214%, recorded as recently as the second quarter of 2011. The debt ratio is still very high by international standards and  although the rise in net wealth is a positive for the economy and will have some influence on the future pace of deleveraging no one really knows when the latter will come to an end and that adds to the degrees of uncertainty surrounding any consumption forecast.