Box B: The debt servicing ratio as an early warning indicator

This page contains information on the debt servicing ratio as an early warning indicator from the November 2013 Financial Stability Report.

The debt servicing ratio (DSR) measures the proportion of income that is required to service debt. An elevated aggregate DSR implies that, on average, borrowers have less spare income after debt repayment to absorb unexpected expenses. Under these circumstances, a decline in incomes or rise in interest rates is more likely to lead to a large rise in defaults, as debt becomes more difficult to service. Measured across a group of borrowers, or across the economy as a whole, an elevated DSR can therefore give an indication of increased vulnerability in the financial system.

Reserve Bank estimates suggest that the average DSR within the household and business/agricultural sectors reached stretched levels prior to the GFC (figure B1). The rise in the sectoral DSRs was primarily driven by a rapid increase in debt levels in relation to income, but rising interest rates also contributed towards the end of the financial cycle. By 2006, the increase in the economy-wide DSR was similar in magnitude to the runups that occurred prior to previous financial crises in advanced economies.1

Figure B1: Sectoral DSRs (principal and interest as a share of income)

Figure B1 Sectoral DSRs (principal and interest as a share of income)

Source: Statistics New Zealand, RBNZ SSR, RBNZ calculations.

Note: Where available, the average interest rate paid is used to compute interest payments. Principal repayments are estimated assuming a constant average time to maturity. The data sheet has further details.

In general, the DSR is best suited to forecasting financial stress over relatively short time frames of up to one year.2 During the pre-GFC period, the early warning signal of future financial distress produced by the DSR occurred later than for other early warning indicators monitored by the Reserve Bank. There are, however, some episodes where the DSR can provide different information to other early warning indicators. An example is the rapid rise in the DSR of the business/agricultural sector coinciding with the period of financial stress in the late 1980s. In this case, the rise in the DSR occurred mainly as a consequence of rapid increases in interest rates and the DSR indicated greater vulnerability than other indicators that do not account for the role of interest rates.

Although low interest rates in recent years have reduced the DSR, there are reasons to be cautious. The DSR remains elevated in broader historical context, particularly in the household sector, due to the large amount of debt outstanding. There is also evidence that current low mortgage rates are contributing to the recent increases in house prices and household debt. The decline in mortgage rates over the past 18 months has allowed borrowers to service more debt (figure B2). This, in turn, may have encouraged borrowers to bid more for properties and contributed to the rising share of high-LVR lending and increases in house prices.

Figure B2: DSR for a representative new entrant to the housing market (principal and interest as a share of income)

Figure B2 DSR for a representative new entrant to the housing market (principal and interest as a share of income)

Source: RBNZ, PropertyIQ, Statistics New Zealand.

Note: Forecasts are constructed using the September MPS forecasts for wholesale interest rates, house prices and disposable income. The data sheet has further details.

Combined with the elevated level of outstanding debt, this increased risk taking could make the financial system more vulnerable to a rise in interest rates, particularly if borrowers have not allowed for interest rate increases in their financial planning. Longer-term fixed mortgage rates have already increased in recent months. Based on current market pricing for wholesale interest rates, short-term mortgage rates are set to increase from early next year. Applying typical spreads between mortgage rates observed in recent years, current market pricing implies mortgage rates in the vicinity of 7-8 percent within the next 2-3 years. Rising mortgage rates are likely to affect the household DSR fairly rapidly, as most mortgages remain on floating or relatively short fixed terms of less than one year.

Rising interest rates will reduce the servicing capacity of new entrants to the housing market (figure B2), helping to bring about a reduction in house price pressures. Existing borrowers with stretched debt positions, typically buyers with high LVRs that have entered the market in recent years, will also be disproportionately affected by the rise in mortgage rates. Borrowers faced with elevated DSRs may have a range of options to ease financial pressures, including reducing consumption, lengthening the tenure of loans or temporarily switching to interest-only loans. However, if rising interest rates are combined with a weakening macroeconomic environment and falling household incomes, many of these options could be unavailable and a rise in defaults would be more likely.

 

1 The early warning properties of the economy-wide DSR in predicting financial crises is examined by Drehman, M and M Juselius (2012) “Do debt service costs affect macroeconomic and financial stability?”, BIS Quarterly Review, September 2012. A persistent rise in the DSR above its 15-year trend is found to be a reliable signal of a period of financial stress within the next year.

2 For example, box B of the November 2011 Report shows that a de-trended credit-to-GDP ratio, another prominent early warning indicator, was signalling a significant increase in financial system risk by 2005. A forthcoming Bulletin article will discuss the suite of macro-prudential indicators used by the Reserve Bank.