By Ronald Man

Korea is in good shape to weather further fallout from the economic turmoil in Europe. For example foreign currency reserves here are greater now than in 2008, strengthening the country’s defenses against short-term liquidity pressure. Banks have also reduced their reliance on wholesale funding, making them far less vulnerable to any spike in risk aversion. Not least of all, Korea continues to be highly competitive, gaining market share year after year in everything from electronics to cars. Still, it’s worth asking whether or not Korea’s relatively high household debt poses a risk. In the short-term, probably not; but deliberate policies can help mitigate any potential upsets.

Current household debt levels have reached a historical high, amounting to more than 150 percent of disposable income and pose two particular risks to Korea’s economic recovery. First, high interest repayments limit the scope of consumption to compensate for sluggish exports. Second, default levels may rise if employment decreases on the back of a bumpy growth period, sapping household spending. So far, policymakers successfully managed to moderate new lending by tightening loan guidelines and imposing caps on the loan-to-deposit ratio of both the banking and non-banking sectors. But additional steps may be needed. Focusing solely on limiting new credit could be insufficient if the global economy heads towards another slump.

High household debt is not necessarily a concern because the outstanding amount has increased in recent years. Rather, the distribution of debt is shifting. More debt has been recently taken out by low-income borrowers. These households tend to be composed more of irregular workers who are generally less skilled, have lower job-security and are older than regular workers. With few signs of irregular workers’ wages picking up amid the weakening global economy, these workers may be prompted to take on even more debt.

Tighter credit access, especially from banks, increases the risk of household debt. Indeed, there is evidence of a rise in multiple loans as more households are forced to tap new credit from non-banking financial institutions. This may not be sustainable. Should the economy experience weaker-than-expected growth over the coming quarters, employment may take a hit and further squeeze households with high levels of debt, which in turn would weigh on local consumer spending at a time when exports are slow.

Further credit tightening alone is not therefore a sustainable solution.

Some complementary policies may be helpful. While overall employment has risen over the past year, this has been driven solely by services. That means that construction jobs, which contain a disproportional number of irregular workers, have fallen. Korea is in an enviable fiscal position. Government debt is among the lowest among OECD countries. Korean policymakers can use this strong financial position to support the country's labor market, for example by increasing public construction projects. Some may point at potential threats to the sovereign credit rating assigned by Moody’s in April, changing it from “stable” to “positive”. However, the ratings agency recently confirmed that Korea’s positive outlook remains because “nothing fundamental has changed” since the upgrade. A responsible stimulus package to support the labor market is unlikely to tarnish Korea’s hard-earned reputation for fiscal prudence. Stimulus is one thing. Structural reforms in Korea’s labor market are another. While spending can provide a short-term solution to create jobs, fundamental reforms must be introduced to make irregular workers more competitive. One solution is for the government to provide training for irregular workers. Currently, employers have little incentive to train irregular workers because according to a law they cannot be retained for over two years without gaining regular worker status. Equipped with more skills, irregular workers will be in a stronger position to compete for higher-paid regular jobs, which reduces their dependency on everything from borrowing to fuel consumption.

Mitigating the risks of high household debt, therefore, requires a two-pronged strategy. Lowering credit growth is, of course, a necessary strategy and has been successfully applied. In addition, fiscal support for jobs reduces the need for poorer households to resort to further debt increases.