Can Korea solve household debt woes?

Korea remains one of the best-performing advanced industrial economies this year despite the eurozone debt crisis and economic slowdowns in the U.S. and China. Its weak currency is preventing exports from falling further than they probably should have as demand dries up in Europe, the U.S. and China. Consumer spending remains firm because of a low unemployment rate, while wage growth is outpacing inflation. The country’s strong financial reserves have bolstered confidence that the Korean government has the money to kick start the local economy if the global economy deteriorates further.

But the current global uncertainties should provide a warning to Korea that its traditional export-dependent economic model is becoming stale, while a shift to a domestic-demand society could prove difficult.

Economists have long argued that Korea and other Asian economies such as China need to do more to rely on domestic demand for future economic growth. As part of the market reforms he introduced after becoming president in 1998, Kim Dae-jung took this advice to heart. He encouraged consumer spending by easing controls on the issuance of credit cards and other forms of debt.

The result was an orgy of consumer spending that ended in tears with the “credit card debt” crisis that shook the Korean financial industry in 2003. At the same time, the easy availability of credit led to a speculative housing bubble. Although it has not ended in the same kind of bust as seen in the U.S., it has left homeowners struggling to pay off big mortgages.

It is this legacy of the heavy household debt built up from a decade or more ago that is proving to be the biggest brake in switching to a domestic demand economy. How can people spend more when they are already mired in debt? Meanwhile, banks are becoming more reluctant to issue loans when they are worrying about increased defaults.

This is the challenge that will face the next administration since the eurozone is likely to hit the local economy harder in coming months as it squeezes the earnings of Korean companies. Household debt is huge, amounting to 857.8 trillion won at the end of March. The average Korean household has a bigger debt burden than those in the U.S. and the U.K.

The debt problem has so far not posed a great danger to the banking industry. The delinquency rate of loans extended to households rose to 0.97 percent in May, the highest rate since October 2006. But it is still way below that in other countries such as the U.S., where the delinquency rate is 9 percent because of permissive bankruptcy laws there.

The current government has so far taken a “band aid” approach to dealing with the debt situation by discouraging credit card usage and trying to ease interest conditions for low-credit borrowers.

But these measures have failed to deal with the core of the debt problem, which is that most of the household loans have been used to buy homes. Many families bought homes in the belief that housing prices would continue to rise, providing enough money to both pay off their mortgages and allow them to build up a retirement nest egg.

However, the property market, particularly in Seoul, has been in a slump since the 2008 global financial crisis. Unless housing sales revive, the chances increase of more defaults down the road. Although most Koreans have managed to keep up with interest payments on their mortgages, they will have difficulty in paying back the principal unless they sell their homes. But few want to sell their homes in a stagnant property market, which means that it will likely stay stagnant.

The household debt problem is in many ways a more difficult one to solve than dealing with the corporate debt defaults that triggered the 1997 financial crisis in Korea. Then, the government was able to take over corporate assets as part of their nationalization of troubled banks. Industrial assets are relatively easy to sell compared to homes as the U.S. is now finding as it tries to clear its property market after the housing bust. If mortgage defaults rise in Korea, it may be difficult to clear the backlog of these homes since demand is already weakening due to demographic changes as the population becomes older.

So what should the government do? One way is to encourage banks to expand the use of so-called pre-workout programs, which offers potential defaulters lower interest rates and a longer period of up to 20 or 30 years to pay back their mortgages.

A longer-term solution may lie in a willingness by the normally conservative Bank of Korea to cut interest rates and accept higher inflation. Debtors benefit in an inflationary environment, while rising prices would stimulate the housing market and make it easier for borrowers to sell their homes and repay their mortgages. The ultimate result would be to ease the debt burden that is blocking Korea’s shift to a domestic demand economy. <The Korea Times/John Button>

news@theasian.asia