Bird's-eye view of household indebtedness: We have, not completely arbitrarily, grouped these into Scandinavia, Anglo-Saxon, Peripheral Europe and Core Europe - and also used data for Japan and Korea. We were unsure about where to classify Ireland (part of the European periphery but in terms of economic structure essentially an Anglo-Saxon economy) so we have included it in both the peripheral and Anglo-Saxon groups for illustrative purposes.
We look at the absolute change in the debt/disposable income ratio across economies in the three years between 4Q07 (the onset of the recession in the US) and 4Q10 (the most recent data point for most economies).
Leverage is alive and well: A few quick observations, bearing in mind the caveats that regarding leverage, one size does not - and should not - fit all; and that different economies have different abilities to carry debt:
1. US households are the champions in deleveraging, having brought down debt in relation to disposable income by nearly 16pp since the onset of the Great Recession.
2. At the other end of the spectrum, Danish and Dutch households have increased their indebtedness further from very high initial levels of leverage (and despite - contained - banking crises and sizeable real estate busts): Danish households now owe more than three times their disposable income, while Dutch household indebtedness is only slightly below that.
3. Crisis-stricken Irish households have nevertheless managed to reduce debt (by some 13pp) though the level remains very high at 210%. Portuguese and Spanish households have also delevered somewhat.
4. With the exception of the Netherlands, core European households have relatively low levels of indebtedness; indeed, German households have reduced their indebtedness in both absolute terms (not shown here) and relative to disposable income.
Deleveraging has weighed on consumption spending: As one would expect, there is a relationship between growth in household indebtedness and growth in consumption: deleveraging (negative growth in real indebtedness) is associated with low or negative growth in real consumption and vice versa.
US: Getting there... For how long will household indebtedness weigh on spending? There is, actually, some good news from the champions of deleveraging, the US. American households are actually very close to sustainable levels for both debt service and debt in relation to disposable income, our US team thinks: it estimates the former at 11-12% of disposable income; the latter in an 80-100% range. As of 1Q11, these metrics stand at 11.5% and 106.5%, respectively. This informs our view that the consumer sector will not be the headwind to the US economic outlook that many expect it to be.
...while the UK consumer should remain soft: As we have seen above, the UK consumer has also made some headway on debt reduction (and the increase in the household saving rate is similar to the US). However, our UK team expects ongoing weakness for the household sector: not only is the stock of debt as a share of disposable income substantially higher than in the US (at 148% as of 4Q10). The UK consumer also faces a number of additional headwinds: elevated inflation that eats into disposable income, and weak jobs generation as public sector jobs are shed and private firms likely make use of currently underemployed labour rather than hire out of the pool of the unemployed.
Easy does it: ZIRP and QE at work: Importantly, super-easy monetary policy (ZIRP and QE) was and remains instrumental in enabling US and UK households to deleverage to the extent they have, as debt-service costs have come down drastically. Monetary policy has helped - as intended by central banks - through:
1. Low policy rates which have reduced mortgage interest costs in economies where mortgage rates are tied to the front end of the curve (e.g., the UK);
2. The (implicit or explicit) commitment to keep policy rates low for a sustained period of time has lowered rates further out the curve;
3. The outright buying of bonds (including, in the case of the Fed, of Agency securities) has also lowered yields further out the curve, including long-term mortgage rates.
Addicted to low rates: We think that continued monetary policy support is vital for a meaningful recovery in consumer spending and a sustainable improvement in the labour market. Households will likely therefore remain dependent on low debt-service costs for a long time - as, by the way, will governments, in our view.
High levels of debt create incentive to inflate... We have for a while now argued that the monumental levels of debt in both the private and public sector across most industrialised economies generate an incentive for central banks to help with the debt burden by generating (somewhat) higher inflation (see "Debtflation Temptation", The Global Monetary Analyst, March 31 2010). This is particularly true in the case of private debt. Not only are principal payments fixed (as in the case of non-indexed government debt), but compared to government debt, private nominal interest costs also tend to be much less responsive to inflation: far from all household credit, whether mortgages or consumer loans, are at variable rates (there is significant variation across countries and products here); credit to households rolls much less frequently than credit to governments (which have to refinance on the markets constantly); and pass-through from market interest rates to the cost of household credit products is likely to be imperfect, at least in the short run.
...and constrain interest rate-setting: Just as importantly, due to the need for low debt-service costs, private and public indebtedness are a manifest constraint for the monetary policy of inflation-targeting central banks. Recall that an inflation-targeting monetary authority is supposed to raise nominal interest rates faster than inflation so that real interest rates increase. This would dent spending and defuse inflationary pressures (economists call this the Taylor Principle). That is, inflation targeting done properly implies increased debt-service burdens by construction.
Conclusion: Three years on from the onset of the Great Recession and household indebtedness as a share of income remains elevated in many economies. Households in some of the economies that experienced a combined banking crisis-cum-real estate bubble have achieved meaningful deleveraging - most notably the US. Crucially, this has been achieved with a lot of monetary policy help, as super-expansionary monetary policy has reduced debt-service costs drastically. Correspondingly, household (and public) indebtedness should be a constraint to interest rate-setting going forward, as application of the inflation-targeting principles would automatically imply an increase in the debt-service burden.
For the accompanying charts, see The Global Monetary Analyst, July 27, 2011.
Economic Implications of the Elections
How Much Should We Expect on Economic Stimulus?
The market usually expects the ruling party to pump up the economy in order to be re-elected; while there is also expectation that a new government will boost the economy as soon as it comes to office. Does the Korean government have capacity for stimulus measures if it wants to? The Korean government has a solid fiscal position and low public debt level. Korea posted consecutive years of fiscal surplus from 2000 until 2008 when the global financial crisis hit the economy. Thanks to a quick turnaround in the economy, the fiscal balance is expected to return to surplus this year.
Meanwhile, Korea's central government debt level at 32% of GDP is one of the lowest among OECD countries, which average 74% of GDP. Korea's tax revenue at 14.3% of GDP is also higher than other tiger economies in the region. We believe that the government has room for stimulus spending or tax cuts if it wants to. This is why the government had the ability to swiftly execute a sizeable stimulus package in 2009 that helped the Korean economy to avoid a recession during the global financial crisis. However, will the government use fiscal stimulus for election purposes? It seems not.
In the last two presidential election years (2002 and 2007), the fiscal surplus was particularly high, indicating that the government did not use fiscal stimulus to boost the economy for election purposes. Why is fiscal stimulus missing during election years in Korea?
First, the president only serves one term and cannot be re-elected. As a result, we think there would be less incentive for the incumbent president to introduce any aggressive stimulus measures. This will be especially true if the president and the ruling party have different opinions on policy direction.
Second, since the presidential term lasts for five years, the desire for implementing supportive economic policies during the first year may not be strong as the government may save its ammunition for later. Also, the Ministry of Finance is in charge of budgeting and we think it is placing fiscal discipline as a top priority. Politicians need a very strong case to fight for extra spending.
Is it Going to Be Different This Time?
Just as before, we do not think that we are going to see aggressive stimulus. Neither the ruling party nor the opposition party has yet to release any comprehensive agenda on how to support the economy. This is probably because the private sector appears to be sustaining the economy's growth rate through strong export sales and thus the need to use fiscal deficits is less justified. At the same time, President Lee and the ruling Grand National Party (GNP) are divided on tax issues. President Lee and the government have passed laws to cut individual income tax rates and corporate tax rates which are scheduled to be implemented in 2012. However, GNP wants to scrap the planned tax cut for the highest income tax brackets as well as for corporates. GNP believes that welfare policies should focus on helping low-income earners, not the wealthy. These issues are under debate, but we think such ideological differences will delay the implementation of any economic policy changes before the elections. We do not expect much on tax stimulus over the next 18 months.
Employment and Inflation Rather Than Growth
Ahead of the elections, we believe that the government is not focusing on high GDP growth. After all, GDP growth in Korea has been resilient, but the popularity of the ruling party does not always go in line with GDP growth. Strong GDP growth needs to be translated into improved living for the general public. We believe that the government will emphasize employment and inflation, rather than the GDP growth rate. If tax cuts are not likely to be the focus, we believe that the ruling party should consider raising infrastructure spending, which can, in turn, create employment. The government budget on infrastructure spending saw a jump in 2009-10 to average KRW24.9 trillion annually, as part of the stimulus package amid the global crisis then underway.
Although the infrastructure spending projected in 2011-14 averages KRW23.3 trillion per year, this is still higher than the pre-crisis level of KRW18.9 trillion. In fact, we think that there is room for the Korean government to allocate more resources to infrastructure development, regardless of elections, for long-term growth. In order to sustain growth potential, Korea needs to balance the economy through developing the provincial areas. More transportation networks are needed to link Seoul to the provincial areas and jobs need to be created in the provinces to narrow income gaps. We believe that industrial clusters, especially for new growth industries, should be built in the provinces to create jobs.
Key Priority - Winning the Low-to-Mid Income Group
Meanwhile, winning the support of low-to-mid income groups is a priority of the current government. In this regard, fighting inflation becomes even more important since soaring prices affect low income groups the most. We believe that the government will continue its dialogue with producers and distributors of food & beverages, white goods, fuel, electronics and service providers to limit price growth. Further utilities price increases also seem difficult while the anti-inflation task remains important. A marginal increase in social welfare spending can also be expected, but we do not think that it will have any meaningful impact on economic growth.
High Household Debt Constraints
While the government's fiscal position appears healthy, we think that there are also constraints due to high household leverage. Korea's household debt/GDP ratio is one of the highest in the region. Household loan increases have not been for mortgage growth on home purchases, but rather we have noticed that home equity loans are being used for consumption purposes, and consumer loans by private lenders have been soaring since 2010. The number of credit cards per worker is also at a record high now. We are warning that Koreans are overspending and some could be relying on credit to consume (see Caution on Overspending, June 27, 2011). In fact, the government is paying close attention to household loan problems and is likely to tighten consumer loan growth. In this context, it will be difficult for the government to introduce any measures that will blindly boost consumption without creating jobs and income first.
Should We Expect Monetary Stimulus?
Apart from using fiscal stimulus, which seems limited at the current juncture, should we expect to see monetary stimulus over the next 18 months? We do not expect interest rate cuts, but we think the level of rate hikes could be slowed down. The Bank of Korea has raised interest rates five times since July last year, which has brought the policy rate from a record low of 2% to 3.25% currently. Inflation is still a concern for the economy, and we believe that headline inflation can remain above 4% in 3Q, i.e., higher than the central bank's target range.
Real interest rates are still in negative territory and have been for a prolonged period. We think the central bank should raise interest rates further to normalize monetary conditions. However, given concerns about rising household loans and the debt burden, especially on low-income groups, we believe that we may only see one more rate hike of 25bp in the next 18 months, which will likely happen in 3Q11. The policy rate will stand at 3.5% after one more rate hike. Real interest rates should return to be positive in 4Q11 or beginning of 1Q12, but they will remain at very low level. We think that monetary conditions will be accommodative enough for the next 18 months.
For full details, see S. Korea Strategy and Economics: 2012 Korean Election Year: Market Implications, July 28, 2011.
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