BIS warning on Australian high debt

The prolonged period of very low interest rates intended to help the Australian economy transition from the mining investment boom could be setting it up for a financial crisis, warns the Bank for International Settlements (BIS).

Such low interest rates only encourage the accumulation of further household debt, instead of discouraging it, leaving Australia very vulnerable when interest rates rise,

In its annual report published on Sunday, BIS examined where countries are in the financial cycle. Financial cycles are much longer than business cycles but inevitably financial booms end in busts which tend to coincide with banking crises. They’re best measured by credit aggregates and property prices.

Australia, along with Canada and Nordic countries, were experiencing financial booms in the lead up to the global financial crisis (GFC). However the China-led rise in commodity prices helped insulate some countries from the crisis meaning it merely dented the financial boom and households continued to borrow, although at a slower pace.

As a result, over the last 12 months real property price and total credit growth in Australia and Canada has picked up to levels approaching large emerging market economies.

Early indicators

BIS maintains there are three proven early indicators of financial distress, namely the gap between the credit-to-GDP ratio and its historical trend, deviations in real residential property services and how far the debt service ratio has moved from its long-term average since 1985.

Currently Australia looks fine on all three counts, but if money market rates rose by 250 basis points as they did in the 2004 three-year rate tightening cycle, its debt service ratio would move into critical territory, as it would in many other economies.

“Experience indicates that debt service ratios tend to remain low for long periods, only to shoot up rapidly one or two years before a crisis, typically in response to interest rate increases,” said BIS.

“Low values therefore do not necessarily mean that the financial system is safe.”

Weaker output growth is another trigger for financial strain so as a commodity exporter, Australia could be especially sensitive to a sharp deceleration in China.

BIS said outstanding debt in Australia, Canada and Norway remains high therefore a slowdown in GDP due to lower commodity exports could cause repayment difficulties.

Demographic challenge

Quite apart from the cyclical impact of interest rates and commodity prices, the ageing population could be a long-term source of trouble. That’s because the level of sustainable debt is partly determined by wealth and ageing demographics imply weaker demand for assets, particularly housing.

The demographic tailwinds that pushed up house prices in Canada, the US, Norway and Australia in the 40 years since 1970 will become headwinds in the 40 years through to 2050. However, the demographic challenge in those countries is nothing like Korea, Japan, Portugal and Denmark will face.

BIS concludes low interest rates are no solution to high debt. Rather, by encouraging the accumulation of debt instead of discouraging it, low rates amplify the inevitable pain of returning debt to sustainable levels.

“Avoiding the debt trap requires policies that encourage the orderly running-down of debt through balance sheet repair and, above all, raise the long-term run growth prospects of the economy.”

Bank for International Settlements, BIS, debt, household, property
Marion Williams,
Article Posted:
June 30, 2014

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