Introduction

This is the third in a serious of posts in which I develop a consistent “balance sheet framework” for understanding the relationship between the banking sector and the wider economy and apply it to the UK.

I have chosen to focus on households (HH) in this first, “sector-themed” post, to reflect the dominant role that they play in UK economic activity (FCE / GDP) and UK bank lending (the desire to buy properties).

Three key charts

Summary

HHs play a dominant role in the UK economy and in the demand for credit – 65p in every pound of UK GDP is related directly to HH consumption, and 78p in every pound lent is borrowed by HHs.

UK HHs are also important investors in financial and non-financial assets (largely property), with balance sheets skewed towards financial assets. Financial assets, comprising mainly of pensions, deposits and equities, are just over 3x the size of annual GDP. Financial liabilities are, unsurprisingly, mainly mortgage loans. Net financial worth – financial assets minus financial liabilities – hit a new high in 3Q19 and provides support for future consumption and welfare over the medium term.

The HH sector is typically a net saver/net lender in the UK (and other developed economies) but dramatic two-way shifts since the GFC have left financial surpluses well below historic averages (see first key chart above).

• HHs have been funding consumption by slowing their rate of savings and accumulation of net financial assets
• After a period of deleveraging post GFC, HH debt levels have stabilised (around the maximum BIS threshold level) but debt servicing costs remain low, highlighting HHs’ sensitivity /risk to a normalisation in interest rates
• The two periods of declining net financial surpluses – 4Q92-2Q06 and 2Q10-3Q18 – reflect different combined trends in savings and/or HH borrowing

In the immediate future, trends in disposable income and savings are likely to be key factors driving HH consumption and, therefore, GDP growth in the UK. With real growth in disposable income slowing and the savings rate close to historic lows, the risks to UK growth from this analysis appear tilted to the downside, and at odds with the (now out-dated) OBR forecasts and assumptions.

Why start with HHs?

HHs play a dominant role in the UK economy and in the demand for credit. HHs drive GDP growth via consumption (directly), and through government consumption on their behalf (indirectly). In 3Q19, HH consumption accounted for 65% of UK GDP, plus another 17% if government consumption on behalf of HHs is included. In other words, 65p (or 82p) in every pound of UK GDP is related directly (and indirectly) to HH consumption. For comparison, HH consumption accounts for 54% of GDP across the euro area.

The desire to buy properties is also the main driver of UK private sector credit demand. As of November 2019, total HH lending and HH lending for property purchases accounted for 78% and 69% of total UK private sector credit respectively. As can be seen from the graphs above and below, both factors have been enduring features of the UK economy and banking sectors.

HH balance sheets

UK HH are also important investors in financial and non-financial assets, with balance sheets skewed towards financial assets. At the end of 2018, the aggregate, UK HH balance sheet totalled £12.2 trillion, comprising financial assets of £6.5 trillion (54%) and non-financial assets of £5.6 trillion (46%). The breakdown of total assets had shifted from 65%:35% respectively in 1999 to 50%:50% respectively in 2007 before shifting back towards financial assets after the GFC.

Financial assets are comprised mainly of pension assets, deposits and equities. At the end of 3Q 2019, HH financial assets totaled £7.3 trillion, with pensions (insurance and guarantees) of £4.2 trillion (57% total financial assets), deposits of £1.7 trillion (24%) and equities of £1.1 trillion (15%). The breakdown of HH financial assets has been broadly similar over the past two decades albeit with a shift towards deposits and away from equities. Since 2000, HH financial assets have averaged 3x the size of annual GDP. At the end of 3Q19, this ratio had risen above this average to 3.3x GDP.

HH financial liabilities are dominated by mortgage loans, unsurprisingly. Financial liabilities totaled £2.0 trillion at the end of 3Q2019, with mortgage loans accounting for £1.4 trillion out of the total HH loans of £1.8 trillion. Again the breakdown of HH financial liabilities is little changed over the past two decades. Net financial worth – financial assets minus financial liabilities – hit a new high in 3Q2019 providing adequate MT support for future consumption and welfare.

HH sector financial flows

The analysis above has focused on stocks of financial assets and financial liabilities. I turn now to the flows (of income and savings) that accumulate into these stocks. Note that HH accumulation of net financial assets over the course of a year is only possible when spending is less than income over the same period. Put another way:

HH are net savers when savings – income minus consumption minus taxes – are higher than investment.

Note also, one of the key messages from “Everyone has one”, that if one sector is going to run a budget surplus, at least one other sector must run a budget deficit.

The HH sector is typically a net saver/net lender in the UK (and other developed economies) but dramatic two-way shifts since the GFC have left financial surpluses well below historic averages. Since 1989, the UK’s HH sector has run average financial surpluses equivalent to 3.8% of GDP (from a flow perspective). In response to the GFC, however, HHs increases their net savings from 2.6% of GDP in June 2008 to 6.9% of GDP in June 2010, a substantially negative shift equivalent to 4.3% of GDP. Since June 2012, HH have reduced their net surplus from 5.3% of GDP to a recent low of 0.0% in September 2018 and 1.1% currently. This trend reversal represented a substantially positive shift equivalent to 4.2% of GDP, in effect a mirror image of the trends immediately after the GFC.

HHs have been funding recent consumption by slowing their rate of savings/accumulation of net financial assets. Since early 2010, there have been two periods when UK HHs have reduced their savings significantly. The first occurred between March 2010 and March 2013 when HH savings fell from -41% from £37 billion to £22 billion and the second occurred between March 2015 and March 2017 when HH savings fell -61% from £35 billion to £14 billion. Between March 2010 and March 2017 the HH savings ratio fell from 13% to 4%, a thirty year low.

After a period of deleveraging post GFC, HH debt levels have stabilised (around the BIS maximum threshold level) but debt servicing costs remain low highlighting UK HHs’ sensitivity to changes in interest rates. The HH debt ratio is currently 86% of GDP compared with a high of 102% in March 2019. The BIS considers 85% to be the threshold level above which HH debt becomes a constraint on future growth.

While the debt ratio remains high, the HH debt service ratio of 8.9% is below the LT average of 10.1% and the September 2008 high of 12.3%. In other words, the risks associated with UK HH debt relate to the level of the debt rather than its affordability. They are reflected in (real) demand for credit remain very subdued.

The two periods where the accumulation of net financial assets by the HH sector has slowed dramatically have illustrated different drivers. In the first, between 4Q92 and 2Q06, the HH net surplus fell from 8.6% of GDP to –0.1% GDP (HH became slight net borrowers).

Over this period the HH debt ratio rose from 64% of GDP to 92% of GDP (see above) . At the same time, the HH savings ratio fell from 15% to 7% (see below). HH were increasing their borrowing and reducing their saving at the same time.

In the second, between 2Q10 and 3Q18, the HH net surplus fell from 6.9% of GDP to 0% of GDP. However, the HH debt ratio fell from 98% of GDP to 86% of GDP. In this second case, the main driver was the reduction in the HH savings rate from 13% to 6% (with a 3Q17 low of 4.0% described earlier).

Conclusion

In the immediate future, therefore, trends in disposable income and HH savings are likely to be key factors driving GDP growth. UK HHs appear to have little appetite for taking on more borrowing. With real growth in disposable income slowing and savings rate already at/close to historic lows, the risks to UK growth from this analysis appear tilted to the downside. My analysis and data challenges the assumptions in the last (now out-dated) OBS forecasts for the UK economy. I will return to this issue when the OBR updates its assumptions on UK sector balances in 1Q20.

Please note that the summary comments above are abstracts from more detailed analysis that is available separately