The market is pricing similar amounts of monetary policy tightening across developed economies over the next couple of years — despite countries facing very different issues. Some small, open economies — notably Norway, Sweden, Canada, New Zealand and Australia — are potentially more vulnerable to higher interest rates due to high levels of household debt and slowing wage growth. This could limit the interest-rate hikes that these countries can bear.
The five countries mentioned have one major factor in common — their central banks cut rates aggressively over the past decade, adopting emergency monetary policy despite not being at the epicentre of either the global financial or eurozone sovereign crises. With no brakes to slow the flow of credit, household debt has risen sharply in response to low rates at a time when other developed markets consumers have been deleveraging. As a result, real property prices have risen by more in these economies since the global financial crisis, and housing valuations are more elevated relative to income and rents, than anywhere else in the OECD.
Because households in these countries borrowed a lot more in the decade since the financial crisis, their debt service ratios (interest and capital payments on debt as a percentage of income) have not fallen much below their pre-crisis highs, despite some of the lowest policy rates on record. The implication is that rates would not have to rise by much to lift debt service ratios back to their pre-crisis highs.
Moreover, looking just at the ability of households to service their debt understates how sensitive consumers in these countries are likely to be to interest-rate rises because it does not take into account the slowdown in wage growth since the financial crisis. Rising incomes make debt more manageable over time, so the fall in wage growth since 2008 means a higher average debt service ratio over the life of a mortgage (we look at mortgages since they represent the vast majority of household debt in these economies).
Wages have decelerated particularly sharply in commodity-producing countries such as Australia, Canada and Norway, where a negative terms-of-trade shock in recent years has impacted national income and weighed further on salaries.
Taking that into account, it would take an even smaller increase in rates to lift average debt ratios back to the highs reached before 2008. In some cases, wages have fallen and household debt has increased so much since 2008 that the average debt service ratio over the life of a 20-year mortgage is already above previous peaks.
In contrast, in countries where households have been deleveraging, such as the US, there is scope for rates to rise further before reaching those highs.
The implications of these countries’ vulnerability to higher rates include:
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