Worries about the level of debt in the UK household sector have re-emerged over the last year. The period of – rather modest – retrenchment that took place during and since the global financial crisis saw debt fall from a peak of 163% of income to 141%. But debt has risen steadily in the last year, reaching 143% of income by end-2016. And in the last Office for Budget Responsibility (OBR) forecast shows the ratio reaching 153% by the start of 2022. How much of a concern is this?
One way of answering this is to look at the burden of servicing that debt. According to the Bank for International Settlements (BIS), the UK household sector spent 9.7% of its income on debt service costs in 2016Q4. That is significantly lower than the peak of 13.3% seen in the financial crisis and like levels seen in 2003. From this perspective, the situation does not feel too uncomfortable.
How will this change if debt evolves as the OBR expects and borrowing costs rise? The table below provides a few scenarios.
Even with no change in rates, if debt levels increase to 153% of income as the OBR anticipate, the servicing cost rise to 10.4% of income. However, the OBR expect the bank rate to rise 85bp to 1.1% by Q2 2022. If that were passed onto the rates borrowers face on average, then the service cost rises to 11.7% of income.
If the average consumer interest rate were to rise 200bp then the picture looks quite uncomfortable. That is true even if the OBR prediction of a significant rise in debt to income ratio fails to materialise. In the scenario where debt does follow that higher path, the service costs reaches 13.4%. This was a level of stress last seen during the global financial crisis.
It is important to distinguish between policy rates and those faced by consumers. In the global financial crisis, cuts were not fully passed on to consumers and the same might be true of rate rises. And macro data only tell a partial story at a household level where many will be very indebted and others will have no debt at all.
But the overall picture is one where the high level of debt in the UK household sector makes it particularly vulnerable to higher borrowing costs. Both are likely to rise in the next five years. Given the forward-looking view of expected loss required under IFRS 9, these trends should be on the radar of risk managers.