Part 3 of the series on Australia’s looming debt danger

In the first part of this three-part series, we outlined why real wages were in decline, not just in Australia but across the world. In part 2 we added the burden of rising bank interest rates, showing that together those factors are making it more difficult to service mortgage debt.

Now it’s time to throw changing macroeconomic factors into the mix.

The US Federal Open Market Committee has just raised official interest rates by one-quarter of a percent to 0.5% – the first increase since 2006 – as the US economy is now in its sixth year of expansion.

On the way up

The rise marks the beginning of an upward trend for the US, albeit possibly one of the slowest in history as the Fed is conscious of sparking another global financial crisis.

Higher interest rates strengthen the US dollar and syphon money out of the rest of the world as investors chase returns on their funds. For many weaker emerging market economies with substantial US dollar debt, the extra cost of servicing that debt may be hard to bear.

In Australia, it means our dollar will decline further, making imported goods such as cars and electronics more expensive. The cost of sourcing funds on the international markets for the major financial institutions will also rise as the US becomes more expensive. As a result, borrowing rates here may increase to compensate regardless of what the Reserve Bank of Australia does with the overnight cash rate.

Debt is not your friend

That’s bad news for Australian consumers, who are living with average debt now equal to 1.5 years of income (up from about half the annual income) according to a Bankwest Curtin Economics Centre study entitled Beyond Our Means?

The study says household debt has grown at an annual rate of 10.3% over the past 20 years and now stands at more than $2 trillion dollars. Average mortgage debt as a proportion of property values has almost tripled over the past 25 years, rising to 28% from 10% in 1990.

While we have become accustomed to living with higher debt, the situation is only sustainable with a certain stream of income, and as we showed in part 1 of this series, real wages are in decline.

Short, sharp shock

Aaditya Thakur and Laura Ryan from the global investment management firm PIMCO say Australian households would react quickly to a sharp rise in mortgage rates and demand for real estate would decline, which could result in a cycle where falling asset values induce further debt reduction.

“Based on our model for household leverage alone, if an exogenous shock sparked a deleveraging cycle in Australia, it would be expected to be quite severe given the larger co-efficient for asset prices and the quicker household response,” they say in a recent report.

“No model is perfect, but as a starting point this statistically highlights the potential vulnerability of high and rising household leverage incurred on the basis of past asset price movements.”

Conclusion

Given the stagnation of wages that we explained in Part 1, the increase in average debt levels in Part 2 and now the increase in US interest rates; the trifecta of debts, low (or no) savings and low incomes presents an unenviable challenge to Australians to continue consumption levels and ways of life experienced over the last decade.

Worse still, if people are forced to use superannuation savings to pay off mortgages at the end of their working lives, their financial security may be put in jeopardy, with a resulting heavier burden on the public purse.

With most domestic economists forecasting an increase in official interest rates in Australia next year, there remains a real possibility of a sharp slowdown in economic activity in 2016.