By Zac Tate, Economic Strategist, Hottinger Investment Management
Is total debt in the UK too high? Have governments borrowed too much? Are the balance sheets of British businesses too stretched? Does debt even matter?
The UK is a rich country. The Office for National Statistics found that at the end of 2017 the UK’s total net worth – which measures the difference between the country’s assets and its liabilities, including debts – stood at £10.2 trillion, or £155,000 per person. So in principle, if all debtholders called in their funds, there are more than enough assets to cover their claims.
Of course, it is not as simple as this. For one thing, such an occurrence would likely cause a liquidity event that would heavily cut the realisable value of the assets. Given that a big share of the UK’s net worth is based on land and housing (see Figure 1), assets whose value is determined by financial conditions and liquidity, this is not such a trivial point.
However, it is important to make this point because the UK is generally not insolvent. Even the government’s sub-£2 trillion excess of debts over its assets seems more manageable in this context.
What of course matters for economic performance is the distribution of debt, and it is here where the UK’s addiction to credit remains problematic. Figure 2 shows how skewed the UK’s wealth distribution is, where the net wealth belonging to the bottom half of the population amounts to a little over £1 trillion, or just 9% of the national total. People in this segment will not only have lower incomes but also have debt balances that are a greater share of their disposable income compared to people in higher deciles. Negative equity is likely to be a bigger problem for some individuals in the first two or three deciles of the wealth distribution. In general, levels of debt and interest will therefore bear more heavily on the consumption of the bottom half of the population, on which the economy relies to remain buoyant.
Where debt becomes too high, consumption can suffer, reducing demand in the economy. Tax revenues can therefore fall, making it harder for the government to honour its commitments to bondholders and increasing the likelihood that it turns to inflationary policies to ease the burden.
So when we learn that, according to the Trade Union Congress, unsecured borrowings in the UK are at an all-time high of over £430bn, with the average credit card balance standing at over £15,000 per household (or 30% of median income), that should make us sit up and take notice. For comparison, on the eve of the financial crisis, the equivalent figure was £286bn. The Bank for International Settlements finds that the UK’s total household debt to GDP ratio has increased modestly from 85% during 2015 to 86.5% last month.
It is in this context that we should consider this striking chart in Figure 3. The graphic shows the sectoral balances in the UK economy. Each series illustrates the net lending or borrowing of one of four economic sectors – households, corporations, governments and the rest of the world. As the world is a closed economy, the balances should sum to zero. Or in other words, the net lenders fund the net borrowers.
The chart shows two things. The first is that the foreign sector continues to fund the UK economy. This is a natural consequence of the UK’s running of a current account deficit for much of the last three decades. Since the Great Recession, finance sourced from outside the UK was funding UK government deficits and corporate borrowing. As households and corporates deleveraged after the crash, they were also net lenders to government until 2012, after which companies started borrowing again.
However, since 2015 a new trend has emerged, in which either foreigners or sales of foreign assets by UK residents are now funding households. There has been a collapse in household saving rates as wages have struggled to outstrip inflation in the last decade and poor households have received lower transfers and benefits from government.
The basic point here is that if the country as a whole chooses to live beyond its means – which is what a persistent trade deficit implies – then someone has to either borrow from the outside world or rely on sales of foreign assets held by domestic individuals or organisations. If government is cutting spending and corporates reduce their appetite for funds, then – logically – to maintain the excess of UK consumption over production that a trade deficit implies, households must use funds sourced from overseas to meet their demands.
In 2017, analysts at the Bank of England found that sales of foreign assets by British residents (amounting to £650bn of sales between 2012 and 2016) and not foreign direct investment have done most of the legwork for funding current account deficits. At the time they said that the UK’s stock of foreign assets stood at a vast 420% of GDP, so this trend of asset drawdown to fund consumption could be sustained. We might not, therefore, be concerned about a sudden stop that could have resulted if the UK relied on flows of hot money instead.
However, while it is possible for households to continue to lever up through further growth in credit demand for some time, that does not mean it is advisable. It is highly abnormal for an economy’s household sector to be a net borrower; even in the boom years of the 2000s this was not the case. Households should be accumulating assets and funding corporates and governments. Instead they are building up debts, and the reason for this is that the bottom 50% of households are struggling to meet the costs of living based on their labour incomes.
This is the fundamental reason why, in our view, the Bank of England cannot afford to raise rates too steeply. The global consensus is moving to lower for longer, and if the BoE pushes against the tide by tightening policy, it could engineer a recession irrespective of what is going on with Brexit.
We shouldn’t, however, be alarmist. First, it is possible for the trend to reverse if wages continue to grow above inflation, the government stimulates through tax cuts or spending increases, or businesses borrow to invest in productivity-raising projects. Second, the household debt to GDP ratio has been higher according to the Bank for Independent Settlements. In 2010, it was as high as 96% of GDP at the height of the mortgage boom. As it stands, however, household debt is on a rising trend that in the past has shown itself to be unsustainable.