Wealth Effect versus Debt Effect on Consumption — how they interact?

Some economists found that house owners would spend more when housing price goes up (wealth effect on consumption [1][2]), but some economists found that house owners would spend less when their debt piles up (debt effect on consumption [3][4][5][6]). These two theories may not be contradicting, but when house price goes up, new house buyers’ mortgage debts would normally be higher, then how would these households decide to spend?

There were very few previous studies answering this question until The Reserve Bank of New Zealand (2019) [8] and the Reserve Bank of Australia (2019) [9] studied on both effects to identify the difference in consumption pattern during housing booms and busts for households of different indebtedness.

New Zealand’s results seem to confirm both theories. as they found that “household leverage reinforces the housing wealth effect in a housing bust, but dampens the housing wealth effect in a boom.” But Australia’s results seem to contradict the two, as they found that “households reduce their spending when the gross value of both their debt and assets increases.” There are no consistent results yet.

This article is a casual observations of the two effects in Hong Kong situation. According to the latest July figures released by the Census and Statistics Department, the total retail sales of Hong Kong is HK$34.428 billion, which is an average retail consumption per person of about $4,500 per month. Although the figures reflect consumption amount fell by 11.4% year-on-year, indeed it has been falling for six consecutive months, and the decline in February was also 10.2%. It reflects that the recent decline was due to the decline in consumer confidence brought about by the global economic recession and rising household debt.

However, the recent decline in total retail sales has been slightly less than the decline in 2016. Figure 1 below shows the total retail sales index and its annual rate of change over the past decade. The yoy drop in consumption in Feb 2016 was up to 20.6%, and the down cycle lasted for more than two years. In contrast, the rise in the total retail sales value was longer in time and in magnitude. In 2010–2014, the market rose with a peak of more than 30% and last for five years. In addition, the 2017-2018 rise in the market has also seen a 30% increase.

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Figure 1 Hong Kong retail sales volume index and its annual changes. Source: Hong Kong Census and Statistics Department (2019) https://www.censtatd.gov.hk/hkstat/sub/sp320_tc.jsp?tableID=089&ID=0&productType=8

If compared with the peak, the total retail sales value index in Hong Kong has actually dropped slightly from the recent peak in January 2014 (index of 135.3, value of $54.30 billion) (Blue line in Figure 1). If the value of retail sales is compared with the 2014 peak, it has dropped 36.9%. In other words, the average amount of consumption has decreased by about 40% compared with 2014. Of course, this average does not count the number of visitors.

In fact, many international studies have found a strong correlation between property price changes and consumption power (studies on wealth effect — [1] [2]), so the cyclical changes in consumption are found to be similar to changes in the housing market cycle. This association is mostly a psychological factor. Even if a household with only one self-owned housing, the household consumption will still increase or decrease when the property price rises or falls. This theory reasonably explained the two retail sale declines in 2016 and 2019.

However, another set of theories is about the impact of household debt on consumption power. Many studies have found that when household debt rises, their consumption power will drop significantly (studies on Debt Effect — [3–5]). The logic is clear and easy to understand, when most of the household income has been spent on debt repayment, they would not have much money to spend. However, in recent years, Hong Kong’s household debt has exceeded 70% of GDP, breaking through a record high (Figure 2), nearly half of which is mortgage debt (Figure 3), which is closely related to high property prices in recent years, but it seems that household consumption is not affected, does it refute the theory?

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Figure 2 Household debt as a percentage of GDP. Source: Trading Economics
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Figure 3 The classification of household debt as a percentage of GDP. Source: HKMA (2018)

Combining the above two theories, can we make the following predictions? When property prices continue to rise, the wealth effect will increase household consumption. Even if some of their debts are high, it is psychologically felt that future growth can be consumed first, and in reality, the homeowners can raise funds by refinancing. In other words, the wealth effect offsets the debt effect.

However, once property prices fall, debt entanglement will naturally reduce consumption power. If property price is expected to drop further, then it would affect consumer confidence, and refinancing from the mortgage stops. Under these double blows of the negative wealth effect and debt effect, consumption power would rapidly decline.

The decline in consumption power is often a vicious circle. When consumption is reduced, but the rent has not yet fallen, some entrepreneurs would choose to close down their businesses, leading to rising unemployment. Unemployment further makes consumption power fall and it becomes a vicious circle.

References:
[1] Campbell, John Y. and Joao F. Cocco. 2007. How do house prices affect consumption? Evidence from micro data. Journal of Monetary Economics 54(3): 591–621. http://dx.doi.org/10.1016/j.jmoneco.2005.10.016

[2] Yerer Coskun, Burak Sencer Atasoy, Giacomo Morri and Esra Alp (2018) Wealth Effects on Household Final Consumption: Stock and Housing Market Channels, International Journal of Financial Studies 6, 57; doi:10.3390/ijfs6020057

[3] Reuven Glick and Kevin J. Lansing (2010) Global Household Leverage, House Prices and Consumption, Federal Reserve Bank of San Francisco Economic Letter, Jan 11. — “the authors find a strong correlation between household-debt growth before the downturn and the decline in consumption during the Great Recession.”[7]

[4] IMF (2012) Dealing with Household Debt, in Ch. 3, World Economic Outlook: Growth Resuming, Dangers Remain, Apr. — “Their findings confirm that growth in household debt is one of the best predictors of the decline in household spending during the recession.”[7]

[5] Oscar Jorda, Moritz Schularick and Alan M. Taylor (2011) When Credit Bites Back: Leverage, Business Cycles and Crisis, Working Paper №7621, NBER. — “Economic disasters are almost always preceded by a large increase in household debt.”[7]

[6] Kan Ji, Rutger Teulings and Bram Wouterse (2019) Disentangling the effect of household debt on consumption, CPB Discussion Paper, Netherlands Bureau for Economic Policy Analysis, Apr. https://www.cpb.nl/sites/default/files/omnidownload/cpb-discussion-paper-395-disentangling-the-effect-of-household-debt-on-consumption.pdf

[7] Atif Mian and Amir Sufi (2015) House of Debt: How they (and you) caused the Great Recession, and how we can prevent it from happening again, Chicago: The University of Chicago Press.

[8] Mairead de Roiste, Apostolos Fasianos, Robert Kirkby and Fang Yao (2019) Household Leverage and Asymmetric Housing Effects — Evidence from New Zealand, Reserve Bank of New Zealand, DP2019/01, Apr. https://www.rbnz.govt.nz/-/media/ReserveBank/Files/Publications/Discussion%20papers/2019/DP2019-01.pdf

[9] Fiona Price, Benjamin Beckers and Gianni La Cava (2019) The Effect of Mortgage Debt on Consumer Spending: Evidence of Household-level Data, Research Discussion Paper 2019–06, Economic Research Department, Reserve Bank of Australia, July. https://www.rba.gov.au/publications/rdp/2019/pdf/rdp2019-06.pdf

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ecyY is the Founder of Real Estate Development and Building Research & Information Centre REDBRIC

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