The household debt-service risk index rose to 6.68 in the third quarter 2012 from 6.63 in the second quarter‚ its fifth consecutive quarterly increase and remains well-above the long term (32 year) average level of 5.3‚ John Loos‚ FNB’s household and property sector strategist said on Thursday.

The index is compiled from three variables - the debt-to-disposable income ratio of the household sector‚ the trend in the debt-to-disposable income ratio‚ and the level of interest rates relative to long term average (5- year average) consumer price inflation.

The higher the debt-to-disposable income ratio‚ the more vulnerable the household sector becomes to unwanted “shocks” such as interest rate hikes or downward pressure on disposable income.

An upward trend in the debt-to disposable income ratio contributes negatively to the overall risk index.

Then‚ the nearer prime rate gets to the “structural” inflation rate‚ the lower this estimate of real interest rates becomes‚ the more vulnerable the household sector becomes - the reasoning being that the nearer we may be getting to the bottom of the interest rate cycle and the end of rate cutting relief‚ and the more the risk of the next rate move being upward becomes‚ or at least the less the chance becomes of cuts.

In addition‚ Loos said that households tend to make poorer borrowing decisions‚ on average‚ when money is cheap‚ and far better ones when interest rates are relatively high.

“That’s a common human weakness‚ and hence an additional part of the logic of viewing low interest rate periods as higher risk ones‚ especially when rates are ’abnormally low’ by a country’s standards‚ as is currently the case. At current high levels it would be preferable to be seeing a declining trend in the index‚” he added.

The index peaked at 7.45 in 2006 prior to the National Credit Act setting rules on “reckless lending”‚ which became effective in June 2007.

The previous peak before that was during the gold boom years of 1980 and 1981‚ when the index was 7.22 in the fourth quarter 1980 and first quarter 1981.

The index fell below 3 in 1998 after the prime rate rose to a record high of 25.5% compared with the current level of 8.5%.

“Driving the index higher was a higher debt-to-disposable income ratio of 76% in the second and third quarters‚ up from late-2011‚ while abnormally low interest rate levels have also helped to sustain high risk levels. The high level of household vulnerability has introduced a key policy dilemma. Arguably the most effective way to curb overall household borrowing growth is to hike interest rates. However‚ given the high level of household indebtedness‚ the initial effect of rising interest rates is to exert severe pressure on many of those households with high levels of debt‚ not an attractive policy option in a time when the economy is battling and unemployment is a real problem‚” Loos noted.

“A key challenge is thus to find a way to reduce the household sector’s propensity to borrow‚ and increase its desire to save‚ preferably without having to have painfully high interest rates such as those experienced at certain times in the 1990s. Expect this debate‚ and increasing focus on the ’how to achieve it’ to be a key theme in 2013‚” Loos concluded. - I-Net Bridge