The Consequences of UK Household Debt

Daniyal is a researcher volunteering for Positive Money through the summer. He is working on the impact of the current banking system on debt and poverty.

The financial sector is an effective tool that can contribute to the economic development of the country. It can help in the expansion of business, assist in the expansion of the productive sector of the economy that contribute more to GDP growth and reduce poverty in the economy. Banks are important part of the financial sector that can have a significant influence on the economic growth. Over the last two decades banking sector grew phenomenally and accounted for an increased share of GDP, of corporate profits, and of stock market capitalization.

In theory, banks are the channel through which savings are channeled into the productive activities that are crucial for growth and general welfare. Households and firms provide their savings to the banks and banks act as intermediaries to supply funds from lenders to the ultimate borrowers which are mainly firms, governments and households. If the banks are making productive investments it will lead to sustainable growth of the economy. But since last decade banks have been making speculative and non-productive investments that led us to the financial crisis.

Average private borrowing by banks from 2003 till 2010 increased at 11.2 percent of GDP but it decreased to £16 billion in 2008-09 from £114 billion in 2007-08 due to the financial crisis. This had a significant impact on the economic growth since the eight largest economic sectors of the UK are dependent upon borrowing.

Household debt was one of the major concerns during the financial crisis. During the last decade banks lending to households in the form of secured (mortgage) and unsecured (credit cards, overdrafts etc) increased more than 50 percent. The households’ debt stood at over £1.4 trillion at the end of 2010. Out of total debt of £1.4 trillion in 2010, £1.24 trillion (85 percent) accounted for secured debt (mortgages) and £216 billion (15 percent) accounted for unsecured debt.

The average house price grew from £40,000 in 1987 to over £170,000 in 2006. The increase in housing prices increased the consumption of households’ as they borrowed against the increase in home equity due to the easy availability of credit. During 2007 the consumption fell sharply due to credit crunch. Total household resources and household final consumption expenditure was negative in Q3 of 2008 and Q1 of 2009.

This decrease in household consumption affected the GDP growth of UK as private consumption is an important contributing factor in the GDP growth of the economy. In the UK 60 percent of consumption is by the household sector. The household sector alone has a direct impact on the economic growth of UK. As long as households were able to obtain debt finance their consumption could grow but as soon as banks stopped lending, their consumption decreased and so did economic growth.

High household debt accumulation decreased the purchasing power of the households. Bank of England estimates that 13 percent of households spend more than 35 percent of their income on debt repayments and 18 percent of households with unsecured debt spend more than one-fifth of their income servicing unsecured debt payments.  One fifth of the households with mortgages spend 20 percent of their gross income on mortgage repayments, 13 percent are spend more than 35 percent on debt repayment cost and 6 percent of households have debt repayment ratio greater than 50 percent.

Monthly average budget (income receipts minus expenditures) position of the low income group households declined from £51 in 2005 to -£450 in 2010.Many households are breakeven and even a slight increase in their expenditure will tip them into indebtedness unless they have any other source of saving. This means that households will have to borrow more in order to maintain their consumption levels which will further decrease their purchasing power as they will allocate large proportion of their disposable income for repayment of debt, leading to further decrease in their monthly budget position.

Saving ratio (proportion of disposable income not contributed for final consumption) also declined during the last decade due to increase in final consumption. The saving ratio declined to -0.7 percent in 2008. It increased to 8.4 percent in 2009 due to households response to uncertain economic conditions and holding of liquid assets. The large difference between property income receipts and property income payments also contributed to increase in saving ratio as many homeowners exploited the financing  by banks by obtaining ‘buy to let’ mortgages.

Office for Budget Responsibility (OBR) projected that debt will rise to 175 percent of household income by 2015 compared with 160 percent in 2010. OBR estimated that households debt will rise over £1,700 billion by 2012 and £2,100 billion by 2015.  This will have a drag on households personal finances and their ability to save for future that will lead to financial vulnerability.

Currently 29 percent of households with no savings have debt to income ratio of more than 60 percent. If this level of debt is made available in the economy by the banks, this means further increase in credit in the economy, asset prices boom and another financial crisis.

If UK banks continue to lend to make speculative and non- productive investments, particularly mortgages, we will be facing another crisis in near future because UK economy needs more debt to sustain growth and prevent a depression. More debt means more interest and more interest payments means less purchasing power. This means that we need more debt to service and this cycle continues until we enter into another recession when this cycle breaks down.