Tag Archive | "household 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.

Posted in Economics, slider, South KoreaComments (0)


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