Tag Archive | "debt"

The Federal Reserve Challenge for Korea

 By Kyle Ferrier

The Federal Reserve’s move to increase its benchmark interest rate hardly came as a surprise. Though the March 15 rate increase is only the third since the Global Financial Crisis of 2008, it is the second in three months and we are likely to see at least two more incremental rises this year. Janet Yellen and company’s decision to cool a strengthening economy and the expectation that they will continue to do so this year will certainly irk President Trump. Higher interest rates will dampen the effectiveness of his promised stimulus package and, vis-à-vis a stronger dollar, make U.S. exports more expensive. While the latter will further complicate Korea’s relationship with Trump over the bilateral balance of trade, the biggest challenge to Korea stemming from the Fed rate rises will hit closer to home.

As the Fed’s key interest rate converges with the Bank of Korea’s (BOK) we should expect to see a weaker won, or at the very least constraints on its appreciation. Though the won strengthened immediately in response to the Fed’s rate increase, this can largely be attributed to the less hawkish wording in the Fed’s decision than anticipated. Currency volatility aside, a weaker won encompasses several benefits to a struggling South Korean economy. A cheaper won makes domestic consumption less expensive—aiding fiscal stimulus measures, though tempered by higher import costs—and helps struggling export-oriented companies. However, if the Fed does follow through on the additional two interest rate increases, it could force the BOK to raise its benchmark rate sooner than it might be ready to, exposing critical risks in the economy. The most concerning of which is household debt.

In 2015, Korea ranked 9th out of the 35 OECD countries in household debt. Korean household debt has continued to reach new heights since then, with the most recent statistic of $1.15 trillion up 11.7 percent from last year and representing nearly 90 percent of GDP. Though other advanced economies rank ahead of Korea—a group that is led by Denmark, the Netherlands, and Norway—which households own how much of the debt is of particular concern for Korea.

Earlier this month the Financial Supervisory Service (FSS), Korea’s top financial watchdog, stated it has entered an “emergency response mode” after revealing the growth in household debt is primarily originating from nonbank lenders. These institutions tend to issue loans with higher rates to homes with lower incomes and credit, i.e. those which are more likely to default once interest rates rise. Only about 8 percent of households are considered marginalized—meaning at least 40 percent of disposable income is used to pay off loans—yet they hold an outsized 32.7 percent of the total debt. A one percent increase in the interest rate would add on around $22 billion in debt to these marginalized homes as well as create an additional 69,000 marginalized households. Government efforts to encourage less risky amortized loans, requiring monthly principal and interest payments as opposed to amortized loans which are interest only, have had limited success. Sixty percent of mortgages are non-amortizing and another sixty percent utilize floating rates, both of which are not mutually exclusive.

The danger to the Korean economy from household debt has hardly come out of left field. Oversized debt is not only a risk, it is a drag on sluggish domestic demand plaguing the economy. Seoul seems to recognize tackling the issue would kill two birds with one stone, but past efforts to curb household debt have been derailed in favor of short-term gains. President Park’s attempts to curtail debt growth early in her administration were undercut by a series of rate reductions starting in August 2014 and seemed to take a back seat to short-term growth thereafter. Perhaps the most notable example is the government disregarding IMF suggestions to cap debt in favor of safeguarding growth in the construction industry, essentially kicking the can down the road. With interest rates on the rise in the U.S., Seoul may now be running out of pavement much faster than it was expecting.

The benchmark U.S. and Korean interest rates will be the same by the end of the year if the Fed raises rates two more times by 0.25% and the BOK holds at its current rate. The prospect of this parity alone would be too distressing for the BOK to tolerate, but market forces in the interim should force their hand well in advance. If the Fed stays on course, all signs point to at least one BOK rate increase this year, though more would not be surprising to maintain some distance ahead of the U.S. The new Korean administration will inherit an economic dilemma that creative solutions alone cannot resolve. Past presidents may have sacrificed long-term stability for short-term gains, but the winner of the election in May must realize they will not have such an option.

Kyle Ferrier is the Director of Academic Affairs and Research at the Korea Economic Institute of America. The views expressed here are the author’s alone.

Photo from Ervins Strauhmanis’s photostream on flickr Creative Commons.

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Why Korea is Hesitant to Accommodate the IMF’s Suggestion on Household Debt

By Jaeho Jeon

South Korea faces a household debt crisis. Household debt reached more than 1,257 trillion won ($1.1 trillion) in the second quarter of this year, up 125.7 trillion won and 11.1 percent from a year ago. This marks the highest level for household debt since the government began compiling related data in 2002. As a result, South Korea’s household debt stands at 163 percent of disposable income, or the amount of money that a household can actually spend after paying taxes or other welfare contributions. It’s also 26 percentage points higher than the OECD average of 137 percent.

Household debt in South Korea has been increasing mostly because of real estate. Apartment prices in Seoul rose about 3 percent from January to September this year. As apartment prices went up, more people rushed to borrow money to buy houses. Another driver of rising household debt has been increasing chonsei rental prices.

High levels of household debt also have significant implications for the wider Korean economy and have been widely dubbed the ‘detonator of the Korean economy.’ If household debt is increased, the disposable income of a household will be decreased. This can adversely affect domestic demand. If interest rates rise, borrowers’ debt-servicing burden will be escalated and consumption capability will be diminished. Most household debt is mortgage based, so if housing prices go down Korea could face its own version of the sub-prime crisis that hit the United States.

Many experts have suggested that the government should more strictly manage the levels of household debt. Even the IMF recently pointed out that level of household debt in Korea is high and the DTI, debt to income, cap of 60 percent should gradually be tightened toward a range 30 to 50 percent.

The IMF also suggested last August that the DTI cap should be extended to apply to other types of household debt including so-called group loans which are taken by a group of prospective apartment buyers and guaranteed by developers and public credit guarantee corporations. The IMF believes that these measures should reduce financial risks and also help consumption and growth by reducing household debt.

The Korean government has implemented a set of policies aimed at curbing rising household debt. But the latest measure did not include anything regarding DTI. Why did the government not implement strong measures like tightening the DTI cap? If we look at the statistics, we can understand the concerns of the government.

In the first half of this year, construction investment in South Korea has grown by 10.3 percent compared to the same period last year to 104 trillion won. In contrast, when compared to the first half Korea’s exports fell 10 percent in the first half. Private consumption, on the other hand, only increased by 2.8 percent in the first half.

Amid sluggish exports, the Korean economy is increasingly dependent on the construction sector for growth. GDP growth recorded 2.8 percent increase in the first quarter from the same period in the previous year and 3.3 percent increase in the second quarter.

But these figures drop to 1.6 percent each, when construction investments are excluded. Construction investment contributed to 51.5 percent of the Korean economic growth achieved in the second quarter. In contrast, they contributed to only 5.3 percent of economic growth from 2000 to 2014 on average.

Taking into account the circumstance that the Korean economy heavily relies on construction and the real estate market, the government will not likely tighten DTI as part of efforts to tackle the soaring household debt in the foreseeable future. Tightening DTI might result in a real estate market slump and failure to achieve the government’s goal for economic growth. Especially considering the South Korean presidential election next year, it is likely that the government would be reluctant to take significant measures which could reduce economic growth.

Jaeho Jeon is a reporter at ChosunBiz and a visiting fellow at the Korea Economic Institute of America. The views expressed here are the author’s alone.

Image from Francisco Anzola’s photostream on flickr Creative Commons.

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