The debt dilemma
The Bank of Korea is poised to lower the benchmark interest rate further after President Park Geun-hye in a New Year’s address made her wishes clear. If it does, the key interest rate could enter an unprecedented 1 percent range. This may be an inevitable move, considering deepening troubles in the domestic economy, worsening corporate profitability and a worsening employment situation amid a prolonged slowdown in domestic demand. Ultra-low interest rates are necessary to buy time for structural reforms to kick in. But there is an uncomfortable downside risk to the move - its effect on household debt.
A rate cut is the central bank’s plea to consumers and companies to spend. It aims to encourage companies to invest, start new ventures and develop real estate. The problem is that individuals - not companies - are the ones who respond to lower interest rates, which means cheaper loans. Bank loans that increased by 1.4 trillion won ($1.29 million) on average per month in the first half of 2014 jumped to a monthly average of 5 trillion won in the latter half. Borrowings snowballed after the central bank cut rates in August and October and the government eased mortgage-related loan regulations to perk up the real estate market.
It’s a smart move for consumers to borrow and purchase new homes or invest when interest rates are low because the investments can return bigger profits in the future. What’s not smart is borrowing when one cannot afford to repay. There are many who fit in this category. Individuals are seeking loans and using their homes as collateral to make up for losses in their mom-and-pop business ventures. A survey by the Financial Supervisory Service showed that just 45 percent of the increase in house-backed loans were actually used for property purchases.
What happens if a loan of up to 70 percent of the value of a property is all spent? That person could lose their home to the bank and then have to move into a rental apartment. That is the most irresponsible use of a family’s main asset. The debt could be manageable when interest rates are low - and could go even lower. But interest rates will go up and loans might not be rolled over. Home values could plummet due to some kind of external shock. People will rush to sell their homes and the real estate market could be wrecked. This could translate into a serious economic crisis.
The danger with debt is widely recognized. The Japanese asset bubble’s bursting in 1990, the Asian financial crisis in 1998 and the U.S.-sparked global financial meltdown in 2008 were all caused by overblown debt levels. Korea’s household debts are unquestionably at danger levels. The debt ratio has reached 165 percent against disposable household assets. The rate is the highest level among the members of the Organization for Economic Cooperation and Development, whose average is 133 percent. The debt-to-assets ratio in the United States, which shot up to 127 percent in 2007, has been deleveraged to 115 percent. Japan also brought down its level to 120 percent.
The best solution is to revive the economy and improve households’ incomes. Or inflation could be sparked to a manageable level to depreciate the debt’s value. Both measures are easier said than done. There is more practical and workable solution. We could consider extending household debt maturity to 20 or 30 years as in the United States and change the floating interest rates to fixed terms. In this way, individuals would be able to muddle along even when their home values fall or interest rates move higher. The loans after a certain grace period should have to be repaid in both principal and interest so that households won’t borrow recklessly. Banks advertise that 30 percent of their home-related loans are at fixed rates. But this is not true, as lending rates shift to variable terms after three to five years. Banks also should share the burden if loans turn bad. Korean banks are authorized to seize homes as well other assets including monthly salaries if the debtor fails to repay home-backed loans. But many advanced nations like the United States ban such right of recourse beyond the home collateral. They make the lenders share part of the moral risk.
Korean banks do business too easily with loans with short maturity, floating rates and the right of recourse. That is why they are happy to lend to home owners - the risk is entirely on the borrower. Banks would become more cautious if their rights were limited and loan rates fixed. Then the growth in household debt will naturally slow.
JoongAng Ilbo, Jan. 22, Page 28
The author is the head of the Economist, a weekly business new magazine published by the JoongAng Ilbo, and the Korean edition of Forbes.
by Kim Kwang-ki