[Viewpoint] Debt growth portends worrisome future

Household loans are rising at a rapid pace despite the ongoing economic downturn. In the first seven months this year, outstanding home equity loans increased by 22.6 trillion won ($18 billion), 8.6 trillion won more than in the same period in 2006, when the country was at the peak of a property boom.

The high household debt level may seem slightly counterintuitive in a country still in an economic slump. In industrialized countries like the United States, the recession has put the brakes on climbing household debt. Indeed, many express concern that rising household debt in Korea could destabilize the economy in the long run.

Contributing to the debt trend are the robust measures taken by financial authorities to prevent the economy from declining further. Although Korea was not a direct participant in igniting the global financial crisis, aggressive responses have been adopted to weather the storm, including record rate cutting, massive injections of liquidity, and the easing of real estate regulations.

Another factor is the soundness of domestic financial institutions, which contrasts with bankruptcies and reduced business among peers in developed nations. Since the global financial crisis erupted, authorities have initiated policies including strict stewardship of financial institutions’ balance sheets and capital injections into banks.

A third factor is the rising household demand for money. Korea has seen housing prices rebound steadily since they plunged immediately after the 1997 currency crisis. With that experience in mind and ample liquidity available, they are now borrowing on the expectation that housing prices will continue to rise. Smaller companies and self-employed people have also increasingly taken out home equity loans to secure funds for their businesses.

Any further increase in household debt risks additional bad loans at financial institutions and undermined economic growth potential. This, therefore, requires an in-depth assessment of the sustainability and risk of household debt. The Samsung Economic Research Institute analyzed the potential danger by using its proprietary “household credit risk index” and making comparisons to industrialized countries. The index in the first quarter this year was 0.33, which did not indicate a risk. This was thanks to falling household loan rates and increasing financial assets of households on the back of rising stock prices.

To predict future developments, SERI created two scenarios - soaring household debt and gradually rising debt. In the first scenario, household loans rise by 9 percent. In this case, the household credit risk index would rise to 1.56, more than twice the 0.59 of the second quarter. This assumes that lending rates will ratchet up and household debt will swell faster than disposable income and financial assets.

In scenario two, household loans rise 5 to 6 percent year-on-year. If this takes place, the index will rise modestly for the rest of the year and end 2009 at 0.99. That level would still be tolerable, posing no significant risk. However, even if household debt increases at a stable pace, it could be problematic if lending rates exceed the expected 6 percent.

We at SERI compared the data with those of industrialized countries to examine whether household debt will continue to rise, and concluded that household debt in Korea is worrisome in both its growth rate and level. In 2008, the ratio of household debt to GDP rose 2.1 percentage points from a year ago to 78.3 percent, while in the U.S. the figure declined 3.2 percentage points to 98.7 percent during the same period. Moreover, the ratio of household debt to disposable income, which measures the pace in which household debt rises, was 139.9 percent in 2008, exceeding the United States’ 133.9 percent.

Another concern surrounds the loan rate structure. Korea has a higher share of floating-rate loans and shorter maturity compared with other developed nations. More than 90 percent of mortgages have a floating rate, far higher than the U.S. and France (both 30 percent) and Germany (16 percent). Industrialized countries’ mortgages typically have a maturity of 20 to 30 years, but in Korea, 56 percent of mortgages are for less than 10 years and 36 percent are less than three years.

On the other hand, our loanto-house value ratio is lower and less securitization of mortgages than those of our developed peers reduce the possibility of household debt worsening. A lower LTV ratio means that Korea can better cope with the reduced debt-servicing capability that results from a decline in the value of collateral. Moreover, even as household debt poses a threat, the securitization rates of home equity loans is low, meaning less spillover of mortgage defaults.

In short, current household debt in Korea is not at a worrisome level. The problem lies in the future trajectory. If household debt rises quickly or interest rates rise, household debt will indeed pose problems for the economy. In this regard, financial authorities need to take pre-emptive measures to manage debt.

While strengthening the current loan-to-value and debt-to-income rules to prevent further defaults at financial institutions, we must also institute a flexible application of risk weights on home equity loans. A more effective credit rating evaluation system needs to be developed to help steer more money into companies. For households, fixed lending rates and longer maturity are crucial to ease their repayment burden.

*The writer is a research fellow at Samsung Economic Research Institute.

by Jeong Young-sik