Half empty: the effect of bad debt

Both the optimists and the pessimists can claim that the latest batch of
economic statistics support their argument, which means, as so often in the
past, that nobody really knows what is going on.

The numbers on which the policymakers tend to make their decisions present a
picture of an economy that is performing fairly robustly. Other figures,
however, not only point in the opposite direction, but also suggest that there
is a significant change in attitude taking place among consumers. The
longer-term implication of this possible behavioural change is perhaps the most
interesting aspect of the present situation.

Raising rates in November was not an unexpected move. Above-target consumer
price inflation and the buoyant growth of activity were the key factors in the
MPC’s decision to tighten policy. And there are those who argue that even more
will be needed on the interest rate front to ensure that price rises are
contained within the 2% target and growth eases back to trend.

At HSBC, we believe that optimism about growth in 2007 is misplaced. While
not forecasting a slide into recession, it seems to us that the day of reckoning
has finally arrived for the sector that has been the key driver of growth.
Annual rises of 3% plus in consumer spending have been contributing at least 2%
to GDP every year. This now looks like stalling because of a variety of
pressures on households.

Taxes have been steadily rising over the past few years and at a faster rate
than incomes. And so, too, the prices of non-discretionary items of spending,
such as petrol, electricity, gas and water. This would matter less if incomes
were increasing at a similar rate, but earnings growth has been subdued. It
seems that businesses have been squeezing labour costs as other costs increase
in order to keep prices under control – a practice that is likely to continue.

Debt, however, has now emerged as the single biggest factor affecting the
personal sector. It is generally accepted that we spent and borrowed our way to
healthy growth and record employment levels. Borrowing (secured and unsecured)
soared to 140% of annual earnings and, in cash terms, total consumer debt now
tops £1trillion. Accusing fingers are pointed by lenders at borrowers and vice
versa, but, whatever the source of the problem, the outcome is the same: many
households are struggling to cope.

Rising unemployment is adding fuel to the fire. The numbers claiming benefit
has been edging up (from 819,000 in January 2005 to 962,000 in September this
year – a 17% jump in less than two years). So, too, have the difficulties that
homebuyers are facing. The number of mortgages three to six months in arrears
started to creep up in 2004 after falling for five years. At the end of 2005,
the number (62,920) was 17% higher than 12 months earlier. The rate of increase
was even higher (28%) for the smaller number of homeowners that were six to 12
months and more than 12 months in arrears. The fact that the number of
properties taken into possession is up by 70% in 2005, with the total now back
in five figures, shows the growing fragility of personal sector finances.

Admittedly, the problems are not on the scale of the early 1990s. Arrears are
still a small share of the total mortgage market and repossessions a tiny
proportion of the homeowner population, but they highlight the issue. Even more
emphatic is the dramatic surge in insolvencies. For the eighth successive
quarter, the number of individual insolvencies rose to 27,644. In the first nine
months of this year, the number was a little over 77,000, which is already 15%
higher than the total for the whole of 2005. A figure of 100,000 is widely
predicted for the year.

The surge in insolvencies is largely explained by a step change in the number
of Individual Voluntary Arrangements (IVAs) relative to bankruptcies. From 21%
of total insolvencies in 2003, IVAs’ share has doubled, aided and abetted by the
provisions of the 2002 Enterprise Act (which only came into effect in 2004). It
is claimed that IVAs offer a softer option than bankruptcy for managing debt and
with new IVA rules next year lowering the threshold, there could be further
steep increases.

There are three key effects of this bad debt environment. First, it will
depress consumer activity and impact on GDP. Higher bank rates (as base rate is
once again to be known) will only intensify this pressure. Now at 5% for the
first time in five years, rates are 43% higher than at the trough of 3.5% three
years ago. The rise in debt servicing costs has out-paced the rise in earnings.
Second, banks will be hit by rising bad debts, with possible implications for
future credit supply. And, finally, the new IVA rules could be changing
consumers’ attitudes to debt, since the law appears to help the unlucky and the
irresponsible equally. The law of unintended consequences once again applies. n