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Economics Weekly: Is UK economic recovery at risk from rising defaults?

UK recovery threatened by debt defaults?
One of the key questions about economic recovery in the UK economy is whether or not the rising level of personal and company defaults will constrain consumer and investment spending. Can investment spending - critical to any rebalancing of economic growth away from consumer spending towards the corporate sector - rise if company failure rates are increasing? We look at some recent trends in these variables in this week’s briefing, concluding that higher interest rates and the level of debt are a bigger risk to consumer spending than to company investment spending but that this will actually encourage the economy to rebalance.

More individuals than ever are being declared bankrupt as company defaults though rising remain low…
An interesting divergence is beginning to appear in the pattern of defaults (bankruptcies and company liquidations) in the UK. Although chart a shows that the trend of defaults by individuals and companies is worsening, it is rising particularly sharply for individuals. Why is this? One reason appears to be due to a change in the bankruptcy law in 2004. This effectively made it easier to be discharged as a bankrupt. In Q1 2006, there were 3,439 company liquidations, a rise of 17% on the year before. But the number of companies going into liquidations remains very low (as shown in chart a) - a ratio of just 0.7% of the total number of companies on the active register in the 12 months to Q1 2006. This ratio represents the cyclical low reached in Q3 2004 and is exactly half, or 50%, of the average of 1.4% recorded since the series was first calculated in 1987.

For individuals, however, there has been a sharp rise in the numbers defaulting as well as a massive rise in percentage terms, see chart b. Note, however, that the increase in bankruptcies was occurring before the change in the law in 2004, though it seems to have subsequently boosted this trend. Overall, this illustrates that the law change has naturally impacted individuals more than companies. But also that other factors have been at work to increase the level of household defaults in the UK. Chart b shows the sharp rise in 1989/ 90 bankruptcies was associated with recession; the spike in 2004/5 was accompanied by solid growth.

...and this may put economic recovery at risk though help the economy rebalance
Chart b illustrates that economic growth plays a big role in determining default rates, as one would expect. As economic growth falls, more individuals and companies default; as growth improves it eventually reduces default rates. Since our forecast shows the economy recovering this year and next, one would expect defaults rates to decline, with a lag. In the short term, however, even as the economy recovers, defaults may continue to deteriorate a little further. But the economic relationship so far discussed is at a macro level – we have to delve deeper in order to get a feel for more specific, micro, drivers of default rates.

Chart c illustrates that interest rate changes impact both sectors' default rate, but affects individuals more than companies. Why is this? The answer may be that companies can borrow at lower, wholesale, interest rates, restructure their debt and borrow in financial markets, via equity and bonds issuance for larger entities, so a rise in rates has a bigger impact on households. Greater borrowing also has an impact, see charts d and e, but again is exerting more of a negative impact on individuals than on companies. The reason for this may be seen in charts f and g, where company profit growth has been faster than that of disposable income growth for individuals, so helping more to reduce the burden of debt payments for companies compared with households. Moreover, the background to this is that in the last few years companies have been reducing debt ratios whereas individuals have increased theirs, measured as a share of income. This is one reason why continued fast household borrowing, particularly on unsecured debt, is pushing up bankruptcies, especially as unemployment has also been rising in the past 12 months.

...though continued economic growth should help the rate of bankruptcy to fall back
In conclusion, as interest rate rise with the economic recovery, we look for insolvencies to fall as faster growth pushes up profits and company borrowing stays relatively modest. For individuals, the risk is that a rise in interest rates, which will be a negative for debt payments, if not offset by faster growth in disposable income and a reduction in borrowing (there are signs that this is happening), may keep defaults high. However, this should not prevent consumer spending from recovering. As economic growth picks up in 2007, we expect the rate of growth of bankruptcies to fall back, even if the numbers themselves remain large for some time, boosted by the change in the bankruptcy law. Paradoxically, the rising trend of defaults analysed here makes a rebalancing of economic growth away from consumers towards the corporate sector even more likely.

Trevor Williams, Chief Economist
trevor.williams@lloydstsb.co.uk
www.lloydstsbfinancialmarkets.com
Lloyds TSB Bank,
Financial Markets
Division,
Faryners House,
25 Monument,
London EC3R 8BQ
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