Economies grow over time when more people are employed or there is an increase in the number of machines, factories and supporting infrastructure used by workers.

Output also increases when capital and labour are combined in smarter ways. Growth in output increases income for workers, businesses and government (via taxes), and this income is either spent or saved.

By far the largest portion of spending in all economies is household consumption.

In South Africa, household consumption makes up 60% of gross domestic product (GDP). In most developed countries it is more than this. In China it is less important, because fixed investment in China is more than double that of South Africa. In our case, fixed investment in plant and machinery is third, following government spending.

Household spending is usually quite stable, because households tend not to change their consumption patterns in the short term. Most households wish to consume more than they do, but are limited by what they earn. Households may consume less than they earn, saving some of their income. They can only consume more than they earn by drawing on past savings or by borrowing.

In recent decades, households in South Africa and much of the developed world ceased saving and instead borrowed to fund consumption greater than their incomes. In our case this has been happening every year since 2006. As a result, household spending has outstripped domestic income, the difference being funded by bank credit. When households buy locally produced goods, rising household spending becomes a principal driver of our growth in output. But some of what households purchase is imported, driving imports up as a share of GDP and causing problems for our balance of payments.

Continuous recourse to credit to maintain such spending leads to much higher levels of debt. South Africa’s household debt rose from 52% of after-tax income in 2002 to 83% in 2008. It has since fallen to 75%, but remains higher than at any other time in history.

With rising indebtedness comes the burden of increasing interest payments.

The average South African household spent 12.5% of its after-tax income servicing its debt in 2008. In other words, for every R100 left after tax, R12.50 had to go to meeting interest payments on contractual borrowings. This is without any repayments of debt itself. Because interest rates have since fallen to very much lower levels, the cost of servicing debt has fallen to 7.7% of after-tax income.

However, this does not mean that households have cut back on borrowing. Many households have even higher levels of debt than this. At the time of the Marikana shootings reports revealed that large proportions of miners’ pay were used just to repay debt.

Much household debt is mortgage borrowing to buy houses. But a growing proportion was incurred to fund consumption. According to the latest Reserve Bank Quarterly Bulletin, the proportion of non-mortgage debt rose from 39% in 2007 to 46% last year. Borrowings to fund consumption attract higher interest rates than mortgages because the borrowing is unsecured and the risk to lenders greater.

Many families are trapped in a vicious circle. They have borrowed to enjoy higher consumption previously and to maintain these levels they have to borrow even more. Growth in consumption spending therefore inevitably slows and indeed becomes a brake on future economic growth. When households try to reduce their debt by cutting consumption spending below what it was in the past, the short-term effect on growth is more severe.

High debt also means household spending is vulnerable to a future rise in interest rates. If the prime overdraft rate were to rise just four percentage points — a relatively modest increase by historical standards — the cost of servicing existing debt will increase to about 12% of after-tax income, further squeezing the proportion left for consumption spending. Households and banks seem aware of this risk and so borrowing to fund consumption in excess of income has reduced. As a consequence, household spending has also slowed markedly, contributing to the current sharp slowdown in economic growth.

Household debt still needs to fall much more if it is to approach historical norms. This can be achieved only if debt is reduced or after-tax income grows. Repaying debt is difficult, requiring considerable belt-tightening at a time when electricity and fuel costs are surging. Income is unlikely to grow while economic growth is slowing and employment is stagnant. The 2.2% rise in household real after-tax income so far this year is the slowest increase since the 2008 recession.

Growth in consumer spending will therefore remain weak for some time. Stronger economic growth can now occur only if fixed investment by firms and government increases or there is a sustained rise in exports. Should we succeed in improving our growth it is important that households use the proceeds to reduce debt and so limit exposure to the higher interest rates that are inevitable once local economic performance recovers.

By Gavin Keeton

Keeton is with the economics department at Rhodes University.

Article Source: Business Day