Executives should monitor household debt

Executives closely monitor the course of high-profile economic variables like growth, unemployment, inflation, the stock market, interest rates and exchange rates.  They do so because there is a direct connection to running a business successfully.  It is time to add a not so high-profile variable to the list for executive monitoring:  household debt.  Household debt should be on the front burner in the Canadian executive suite.

Household debt is the personal and mortgage debt of Canadian consumers.  It has been on a tear.  According to Statistics Canada, Canadian household debt reached a record 148 percent of disposable income in the third quarter of 2010 before closing the year at 147 percent.  It was 50 percent in 1990 and 110 percent in 2000.

One aspect of Canadian household debt is particularly noteworthy.  The Bank of Canada estimates home equity lines of credit and loans may be up as much as 170 percent in the last decade while mortgage debt at is about half that rate.  Home-equity lines of credit and loans are now about 12 percent of household debt and often end up financing non-housing related purchases like vacations and vehicles.  At the margin, too many Canadians are living off their homes.

U.S. households get the headlines for debt imprudence but their household debt to GDP ratio has now been surpassed by Canada.  Incredibly, the Canadian household debt to GDP ratio was 130 percent versus 160 percent in the U.S. only four years ago.

The other side of debt is savings.  It will come as no surprise that the run up in Canadian household debt has been accompanied by a corresponding decline in savings.  Big savers do not tend to be big borrowers.  In the 1980s, the Canadian personal savings rate was about 15 percent; today it is under 5 percent.

It is important to note what, at the moment anyway, is a mitigating factor in the level of household debt in Canada.  While household debt relative to disposable income is in record territory, interest on consumer debt and interest on mortgage debt relative to disposable income have remained stable and are not particularly alarming.

The reason is that while household debt has taken off, the interest rate on it is very low.  But much of that debt is either variable interest rate or short term, leaving the question of what happens in even a modest interest rate run up or rise in the unemployment rate.  Interest cost to household debt ratios can get very unpleasant, very quickly.

The finances of many Canadian households can be summed up as follows:  Up to their ears in debt with little savings and going deeper faster than their incomes are growing.  An interesting logic seems to have taken hold in Canadian homes:  Financial institutions would not lend to us if they did not think us creditworthy, so why should we dispute the judgement of financial experts.

Mark Carney, Governor of the Bank of Canada, summed up the reality of Canadian household finances up in a December 13, 2010 speech to the Economic Club of Canada:  “The proportion of households with stretched financial positions has grown significantly.  In a series of analyses over the past year the Bank has found that Canadian households are increasingly vulnerable to an adverse shock and that this vulnerability is rising more quickly than had been previously anticipated …  Without a significant change in behaviour, the proportion of households that would be susceptible to serious financial stress from an adverse shock will continue to grow”.

The federal government’s move in January of this year to toughen mortgage regulations illustrates just how concerned government is with Canadian household debt.  Minority governments getting old in the tooth do not take the punch bowl away from the voters unless they are really worried.  Specifically, the maximum government-backed insured mortgage amortization period goes from 35 to 30 years, home secured lines of credit will no longer be guaranteed by government, and the limits on mortgage refinancing drop from 90 percent to 85 percent of home value.  This is the third effort in three years by government to cool household debt growth.

Of course, price is dominant in most economic matters, so really cooling Canadian household debt growth will await seriously rising interest rates.  The reason Canadians have borrowed so much, so fast has more to do with record low borrowing costs than anything else.  The trouble for government is, as much as they know, that Canadians are way over their heads financially; they also know that those low interest rates are driving consumer spending that is crucial to sustaining the recovery.  This is not an environment for faint-hearted policymakers.

For executives, household debt may be coming into its own as a barometer for the course of the economy going forward.  If you know the course of the economy, many business decisions that keep executives up at night all of a sudden become easier.  For example, investment, acquisition, financing, compensation and hiring decisions all look a lot different if you are headed into strong growth versus major slowdown.  A genie that could give an executive a peak now at the GDP accounts for the next three years is a genie whose services would be well worth retaining.

The link between household debt and the course of the economy is straightforward.  The consumer is about 60 percent of the economy, so where the consumer is going tells you a lot about where the economy will go.  The more household debt, the less willing lenders are to keep lending to households and the more nervous households get about taking on more debt.  It is not a long step from there to a slowdown in consumer spending, which becomes a slowdown in the economy.

Investment spending on plant, equipment, machinery, inventories and housing, plus government spending and exports, make up the other 40 percent of the economy.  These, however, just do not have the scale to offset the effect of a serious pullback in consumer spending on the whole economy.

Ernest Hemingway in The Sun Also Rises (1926) offers important insight into debt that executives should heed.  Bill and Mike are talking:

Mike:  “Frightful blow … when I went bankrupt.”

Bill:    “How did you go bankrupt?”

Mike:  “Two ways.  Gradually and then suddenly.”

The rise in Canadian household debt relative to disposable income has been a gradual but accelerating process.  It did not happen overnight.  It seems a benign process that can always accommodate the next dollar of debt with no noticeable adverse consequences.

That is not always the way things work with debt.  Suddenly, for reasons that will be hard to pinpoint, lenders and borrowers may decide enough is enough.  Specifically, borrowers may suddenly greatly reduce their borrowing and spending; lenders may suddenly greatly reduce their lending.  It can happen literally overnight.

If “gradually” becomes “suddenly” with household debt, the effects on the economy will be bigger and faster than most think possible.  At 60 percent of GDP, consumer spending does not have to suddenly slow all that much to trip the economy back into major slowdown.  Slowdowns are always difficult for executives to manage; slowdowns that seemingly come right out of the blue are the worst kind.

Executives should watch household debt closely.  The more it grows, the greater the risk of an abrupt hiccup in the economy.  This is one hiccup that executives should be thinking about now.  Most of the time there is probably not much upside for executives in monitoring household debt.  This is not one of those times.  Household debt may be the canary in the economy’s coalmine.