Insolvencies likely to follow rate rises
July 16, 2007
By Ethel Hazelhurst
Johannesburg - A sustained rise of 100 basis points in the prime overdraft rate is likely lead to a 10.5 percent increase in the number of insolvencies within 11 quarters, according to Johan van den Heever, the head of the Reserve Bank's research department.
His calculation appears in a report on household debt, interest rates and insolvencies, published in the July edition of the Irving Fisher Committee on Central Bank Statistics Bulletin, along with reports from a range of other countries on the topic "measuring the financial position of the household sector".
The bank has raised its key repo rate by a total of 250 basis points in a series of five moves, starting in June last year. Given the time frame suggested by the research, the full impact of the moves so far will not be measurable for several years.
"High interest rates may be expected to lead to more insolvencies through at least two channels," said Van den Heever.
The first is the rising cost of debt. Heavily indebted borrowers find that the cost of servicing debt escalates as interest rates rise, reducing their cash flow and their ability to service the debt.
Some eventually reach the point where they are declared insolvent.
The term "household" applies to partnerships and one-person businesses, such as farmers, as well as to individuals. For these unincorporated businesses, the situation is aggravated by the fact that higher interest rates may reduce demand for their products, cutting cash flows and pushing the most vulnerable closer to insolvency.
Van den Heever said the number of insolvencies of South African individuals and partnerships is small relative to the population: generally only a few hundred per quarter in a country with a total population that exceeds 47 million.
"Insolvency is not a popular outcome from the point of view of creditors," he said.
"With insolvency, creditors typically collect a fairly small amount relative to the debtor's outstanding debt, and thereafter can no longer claim any further amounts...
"By contrast, less dramatic court orders, such as judgments for debt, leave creditors in a position where they retain the option to claim payment from the debtor's future income."
Despite this trend, he said, "insolvency is usually a demonstration of severe financial distress and a worthwhile economic indicator to watch closely".
The research into debt is based on creditor data, in the absence of a regular census of household finances.
"In total, the banking sector was responsible for more than 90 percent of total household debt at the end of March 2006," said Van den Heever.
For the rest, stores, vehicle finance companies, insurers and pension funds, microlenders and the like grant loans.
Van den Heever outlined the history of the debt ratio: the ratio of households' stock of outstanding debt to their annual after-tax income.
The debt ratio was moderated by the imposition of credit ceilings for certain periods during the 1960s and 1970.
In 1980 the debt ratio rose sharply when credit ceilings were abolished and borrowing was fuelled by the gold boom, rising levels of employment and income, and low interest rates. It was subsequently supported by the development of innovative financial products, such as flexible mortgages, as well as by the repeal of legislation that prevented black South Africans from owning businesses and property in certain areas.
The generally upward move in the debt ratio thereafter was reined in sharply on two occasions.
The first was in 1984/85, when the prime overdraft rate hit 25 percent and financial sanctions were imposed on South Africa. These sanctions damaged economic prospects and caused the debt ratio to decline significantly.
The second such occasion was in 1998, following the east Asian crisis, when prime hit 25.5 percent, which reduced borrowing and spending.
The debt ratio recovered in 2003, reaching successive record highs each year.
In the first quarter of this year, the debt ratio was nearly 76 percent. It will be a while before it falls, because it takes time for markets to fully respond to interest rate increases.
Though interest rate increases first inflict pain on the economy and individuals, they promote price stability by ensuring that money is appropriately priced. After the pain comes the gain.
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