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JEONG Young-Sik

Is Rising Household Debt Manageable?

JEONG Young-Sik

Aug. 28, 2009

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

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

One major factor lubricating the debt trend is 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 contagion, including aggressive rate cutting, massive injections of liquidity supply, and 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, financial authorities have initiated policies, including strict stewardship of financial institutions' balance sheet and capital injection into banks.

A third factor is heightening household demand for money. Households have seen housing prices rebound steadily after they plunged immediately after the 1997 currency crisis. With that experience in mind and ample liquidity available, they are now borrowing on expectations 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 business.

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. Samsung Economic Research Institute (SERI) 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. The first scenario: household loans rising by 9%. In this case, the household credit risk index would rise to 1.56, more than two-fold the 0.59 of the second quarter. This assumes that lending rates ratchet up and household debt swells faster than disposable income and financial assets.

Scenario two: household loans rising 5-6% year-on-year. The index, in this case, would rise modestly the rest of the year and end 2009 at 0.99. That level would still be tolerable, posing no significant risk. However, even as household debt increases at a stable pace, it could be problematic if lending rates exceed the expected 6%.

We compared with industrialized countries to examine whether household debt will continue to rise. The result was that household debt in Korea is at a worrisome level in both its pace and level. In 2008, the ratio of household debt to GDP, which measures households' debt level, rose 2.1 percentage points from a year ago to 78.3%, while in the US the figure declined 3.2 percentage points to 98.7% 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% in 2008, exceeding the US ' 133.9%.

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

Meanwhile, lower loan-to house value ratio is lower and less securitization of mortgages than those of developed peers are factors that reduce the possibility of household debt going sour. A lower LTV ratio means that Korea can better cope with reduced debt-servicing capability that results from the decline in the value of collateral. Moreover, even as household debt problem poses a threat, the securitization rates of home equity loans is low, meaning less spill over of home equity debt defaults.

n short, the current household debt in Korea is not at a worrisome level, but the problem lies on the future trajectory. If household debt rises fast or interest rates rise, household debt will indeed pose problems to the economy. In this regard, financial authorities need to take preemptive measures to soundly manage debt. While strengthening the current LTV of DTI rules to prevent further rise in defaults at financial institutions, a flexible application of risk weights on home equity loans is also necessary. Moreover, a more effective credit rating evaluation system needs to be addressed to help steer more money into companies. For households, fixed lending rates and longer maturity are crucial to ease households' repayment burden.

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