the reserve bank therefore welcome the fact that the household debt ratio has flattened out in recent years and, as glenn stevens remarked last week, there would be benefits in that stability continuing. foreign debt let me now turn to the question of australia ’ s foreign debt. following the floating of the exchange rate and the removal of capital controls in the early 1980s, both foreign investment in australia and australian investment abroad increased sharply as the australian economy became more integrated into the global financial system ( graph 7 ). in net terms, capital inflows increased from around 2 per cent of gdp to around 4 per cent, and, in the latest decade, to an average of almost 5 per cent of gdp. the current account deficit widened correspondingly, since with a floating exchange rate the current account and capital account balances must be equal and offsetting, both being determined simultaneously through the interaction of a wide range of economic and financial forces. the pick - up in net capital inflow meant that the ratio of net foreign liabilities to gdp rose. from around 20 per cent in 1980, it rose to around 50 per cent by 1995. it then flattened out for a decade, but in recent years the further increase in net capital inflow has seen the foreign debt ratio rise again ( graph 8 ). expressing foreign liabilities relative to gdp is, perhaps, the most common way in which people analyse them. for emerging markets, this measure has been shown to have some association with vulnerability to balance of payments crises. this is because emerging market economies often have a fixed or managed exchange rate and their foreign liabilities tend to be denominated in foreign currency, rather than domestic currency. in such instances a rise in the ratio of foreign liabilities to gdp does indicate increased vulnerability as it signals an increase in the country ’ s foreign exchange risk and liquidity risk. for a developed economy that can borrow overseas in its own currency, and which has a floating exchange rate, the significance of a rise in the ratio of foreign liabilities to gdp is less clear. it also needs to be kept in mind that, as economies develop, most financial variables rise relative to gdp. this seems to be a consequence of financial deepening. expressing net foreign liabilities as a percentage of the total financing in the economy is, perhaps, more relevant, since it gives some indication of the proportion of the economy ’ s funding that is coming from offshore. in australia, this ratio has remained relatively steady since the late 1980s, at a

– 65 year olds with debt increased significantly through to 2008, as households have been more inclined to trade up to bigger or better located houses, and to buy investment properties. households under 35 years of age ( i. e. the group that would typically encompass first - home owners ), in contrast, have seen a fall in the proportion with debt ( graph 5 ). another factor that has contributed to the resilience of household finances is that, by and large, the debt has not been used to increase consumption. apart from some brief periods, household consumption has not been unusually elevated during this period of rising debt. rather, the debt has mainly been used to acquire assets. perhaps the best, and most direct, indicator of households ’ capacity to support the increase in debt is the arrears rates on loans. this remains very low in australia. the current arrears rate is around 0. 7 per cent. this is one of the lowest rates among developed economies ( graph 6 ). other data also suggest that households ’ aggregate debt - servicing capacity is quite strong : in recent years more than half of owner - occupiers have been ahead of schedule on the repayments on the loan they took out to buy their property. within this relatively benign aggregate figure, pockets of stress have emerged from time to time. we saw this clearly in the south - western suburbs of sydney following the sharp run - up in sydney house prices over 2002 and 2003. more recently there are some signs of increased housing stress in south - east queensland and western australia, again following sharp rises in house prices in these areas. another segment of the market that will bear close watching is first - home owners. they have accounted for an unusually high proportion of housing purchases over the past couple of years – around 40 per cent. this has reflected the incentives created by various first - home owner concessions. most of these purchases have been funded by floating rate mortgages, and the average loan to valuation ratio is relatively high, at around 90 per cent. clearly, this group will be very sensitive to changes in interest rates. in summary, if we look at the way the increase in household debt has been distributed, what households have done with the money, and the arrears rates on loans, it is reasonable to conclude that the household sector has the capacity to support the current level of debt. having said that, the higher the level of debt the more vulnerable households are to shocks that might affect the economy. we at