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Household debt a major risk: RBA

The long-run rise in household indebtedness has increased concerns about the risks this poses globally to banking sectors and economies more broadly, according to the Reserve Bank of Australia.

In a new paper titled How Risky is Australian Household Debt? the RBA said the current level of household debt relative to income in Australia is high compared to many other countries.

"We find that the high level and strong growth over recent decades of Australian household debt relates to a measurement issue and the strength of the Australian economy," the RBA said.

"In Australia the housing rental stock is mostly owned directly by the household sector and so debt financing is owed directly by households, while in many other countries rental housing is owned by corporations, the government or not-for-profits and so debt financing is owed by other sectors."

The RAB said falls in nominal interest rates and the deregulation of the financial system, mostly in the 1980s, accounts for most of the rise in household debt in Australia and globally.

"Further, stronger real income growth in Australia compared with many other countries accounts for at least part of the stronger growth, and so higher level, of household indebtedness in Australia," it said.

The RBA also pointed to the distribution of debt across households saying it has contrasting implications for risks to the banking sector and household consumption.

"We show that aggregate bank losses are higher when risks are concentrated among a small group of borrowers (for example, if households in a particular region simultaneously experience larger falls in employment and housing prices)," the RBA said.

"In contrast, falls in consumption are larger if aggregate wealth effects are dispersed over a large number of highly indebted households."

The RBA said a key driver of this result is that highly indebted households tend to have fewer assets than those without debt - particularly wealthy retirees.

"An additional factor underpinning this result is that there is a limit to how much households can cut back on consumption in response to wealth shocks," it said.

The central bank said the consequences of household indebtedness seem more likely to manifest through weaker economic growth than large bank losses.

"Bank stress tests highlight the resilience of the banking sector to severe scenarios, in large part because debt is not concentrated among households with high loan-to-valuation ratios," the RBA said.

"In fact, most of this debt is held by households whose risk of unemployment is relatively low, while households that are most at risk of experiencing very large changes in asset values (relative to income) tend to have little leverage.

Overall, the bank said the findings confirm that Australian household indebtedness has important implications, but they are "sometimes misconstrued".

"The level and growth of household debt reflects high incomes and direct ownership of rental housing, not evidence of widespread excessive leverage," it said.

"Household borrowing is a large share of banks' assets and so is important for their performance, but overall high lending standards, low loan-to-valuation ratios and banks' high level of capital mean they are highly resilient to adverse shocks to households.

"Rather, the implications for consumption of household indebtedness are an important mechanism to take into account when targeting macroeconomic policy to respond to economic shocks."

The report comes as the Commonwealth Bank released its most recent PMI data which showed the ongoing economic effects of COVID-19.

The latest PMI data showed business activity across Australia falling back into decline during August as the re-imposition of COVID-19 measures in parts of the country disrupted business operations and hit demand, with the service sector particularly affected.

New order inflows dropped after two months of growth while employment contracted at a steeper rate.

Inflationary pressures intensified. Business confidence weakened slightly, but remained positive overall.

CBA's head of Australian economics Gareth Aird said: "The decline in business activity over August is hardly surprising given the lockdown measures in Victoria. With the August composite flash PMI showing only modest contraction it is highly likely that outside of Victoria private output in the rest of Australia continued to expand over the month."

Workforce numbers continued to fall across the services and manufacturing sectors as Australian businesses continued to cut back on staff.

"The fall in employment is the inevitable consequence of shutting down large parts of the Victorian economy," Aird said.

Read our full COVID-19 news coverage and analysis here.

Read more: Household DebtReserve Bank of AustraliaGareth AirdCBA
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