South Korea: Interest Rate Cut: What It Means For Household Debt

British Embassy Seoul

July 2012

Summary

The Bank of Korea (BOK) unexpectedly cut rates by 25bp to 3% on 12 July, for the first time in more than 3 years. The main reasons were a pre-emptive response to downside risks to growth stemming from the Eurozone debt crisis and concern over the current cost of servicing household debt, which at 81% of GDP is well above the OECD average (75%).

Detail

What does yesterday’s interest rate cut mean for Korea’s household debt problem? Our assessment below.

Monetary policy in Korea plays a particularly important role in the housing market as 95% of the household debt are loans at variable rates. Korea’s household debt to disposable income ratio jumped to 156% in 2011 - very high by international standards. Household debt increased by £1.7 billion to £508 billion in March from the previous month. The average Korean household has a bigger debt burden than those in the UK and US. Banks’ loan delinquency rates on domestic banks’ won-denominated loans also increased to the highest level since Oct 2006 (1.37%) in May.

On the demand-side, stagnating real income growth has been the fundamental driver of increasing household debt. In order to keep up with inflation and bridge the income gap, households had to borrow in order to invest in property or their own businesses. Given that Korea does not yet have a well-established social safety net, retired workers often had little choice but to set up their own businesses (known locally as “Mom and Pop” shops, ubiquitous in Korea). Public and private benefit spending stands at about 1.7% of GDP, much lower than the OECD average (8.4%).

3. On the supply side, monetary easing and financial innovation boosted asset prices over the past ten years. Households’ financial assets (mutual fund or stocks) rose sharply from 51% in 2001 to 100% in 2011, whereas the size of household deposits rose only slightly from 83% of GDP to 86% over the same period. This suggests that higher asset price increases in 2001-07, and the associated build-up of household financial wealth were major contributing factors to the surge in household debt. As higher household loan demand was met by an increase in the money supply, keeping the cost of credit low over the past had a self-fulfilling effect – in effect, lifting asset prices further.

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