Borrow to your heart’s content

Economists often say that debt greases the wheels of the economy.  It allows individuals and households to make purchases and investments today on the strength of their future earnings. It could be a car, a house, or going on a holiday. 

Households’ spending makes the economy grow, as home-builders or retail complexes hire more workers to cope with the increased demand. Household debt boosts consumption and GDP growth in the short run, mostly within one year. The multiplier effect of the original spending accentuates the increased demand. 

Of course, debt has to be repaid, except perhaps by irresponsible governments who will borrow to pay off their past borrowings. It follows that for individuals and households, rapid growth in debt can be dangerous. The more rapid the growth, the bigger the cut-back in spending they will have to do later in order to repay their debt.

It is no wonder that an increase in the household debt-to-GDP ratio tends to lower growth in the long run, typically at between three-five years. The negative long-run effects on consumption tend to intensify as the household debt-to-GDP ratio exceeds a certain percentage, something like 60%.

Some studies have estimated that a five percentage-point increase in the ratio of household debt to GDP over a three-year period leads to a 1.25 percentage-point decline in inflation-adjusted growth three years in the future. Higher debt is also associated with significantly higher unemployment up to four years ahead. 

In standard macro-economic models, household debt plays a limited role: although it affects households’ ability to smooth out consumption, it is not by itself a major determinant of consumption. Yet household debt has been at the centre of many recent financial crises and recessions.

There is plenty of evidence that high debt levels are not only a good predictor of financial crisis but also a key determinant of the intensity of the ensuing recession. Household debt servicing costs also play a key role in predicting the future vulnerability of countries to banking system stresses.

US household surveys have shown that the financial exposures of households – hence the distribution of debt and assets ‒ played a central role in depressing US consumption. Some economists have argued that the 2012 recession was aggravated by the high marginal propensity to consume of heavily-indebted US households who cut spending rapidly following a negative house price shock. Besides the negative wealth effects of a drop in property prices, evidence also suggests that highly-leveraged households may deliberately withhold consumption in order to return to more manageable debt levels.

So, managing this trade-off between debt and GDP growth is tricky.  

Given the widespread misery the financial crises of 2008-2013 caused, you might be forgiven if you think people became skittish about borrowing in general. Wrong. It seems that people have very short memories. Surprisingly, since 2008 household debt as a proportion of gross domestic product has grown significantly in as many as 80 countries.

Malta has been no exception.  According to the CBM, household loans last year totalled €6.67bn which, in spite of the Covid pandemic, were 5.2% higher than the previous year. Over a three-year period, loans rose by over 7.3% per annum.

Loans as a percentage of Gross Domestic Product have also increased by almost two percentage points to 57.5% over the three-year period. The increase as a percentage of household disposable income has been even higher, by 5.9 percentage points, to almost 115 percent.

Naturally, households’ ability to incur debt is related to their financial wherewithal. An idea of this can be gleaned from a review of the 2016 Household Finance and Consumption Survey conducted by Silvio Attard, Warren Deguara and Valentina Antonaroli of the Central Bank of Malta.

The median value of Maltese households’ total real assets was estimated at €225,800, compared to €131,000 in the Eurozone (CBM, May 2021). Malta’s median value was close to Ireland’s and Cyprus’s values. The most valuable real asset in the households’ asset portfolio in both Malta and the Eurozone was their main residence, accounting for 54.8% and 60.2% respectively. Other real estate properties were the second most important real asset held by households in both Malta and the Euro area.

If anything, the Maltese are even better off than others in the Eurozone insofar as the median value of total financial assets is concerned. In fact, Maltese households have financial assets valued at €25,000, the third highest in the Euro area, compared to, say, €400 in Latvia. A similar situation occurs with respect to the median value of deposits held by households – €6,100 in the Euro area and €12,600 in Malta.

It is clear that Maltese households are in a better position to incur debt than their European counterparts as they hold more real and financial assets.  The fact that many Maltese own their own home and many repay their mortgage early, means that their ability to borrow money is also better.

The high level and strong growth of household debt relates to the strength of the Maltese economy. Since the housing stock is mostly owned directly by the household sector, so debt financing is owed directly by households. This contrasts with the situation in many other countries where housing is owned by corporations, the government or not-for-profits, so debt financing is owed by other sectors. Falls in nominal interest rates and growth in average incomes can account for much of the rise in household debt in Malta and globally. 

Looking at the balance sheets of Maltese financial institutions, household loans are a relatively high percentage of total bank loans at just under 57%, though they have grown minimally in the last three years. As a percentage of total bank assets, though, household loans have increased their share, from just over 11% four years ago to 16.5% in 2020.

The exposure of the banking sector to an economic contraction due to the COVID pandemic was rather contained, in large part because debt is not concentrated among households with high loan-to-valuation ratios. Though consumption dropped by 6.5% in 2020 during the pandemic, and precautionary savings kicked in, households did not suffer a shock from falling housing prices too. The liquidity measures introduced by the Government also limited the rise in unemployment, which might have tested the resilience of the banks.

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