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Thu, December 12, 2019 | 06:00
John Burton
Korea's debt trap
Posted : 2014-06-04 17:04
Updated : 2014-06-04 17:04
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By John Burton

Korean industry may be bemoaning the strengthening of the won because it hurts exports, but the country should see it as a sign of foreign confidence in the economy.

Korea has many advantages that are attracting capital from overseas, which is increasing the value of the won against the U.S. dollar and other currencies.

These favorable factors include a growing current account surplus, a low government budget deficit, a stable yield curve and moderate bank lending. All of these suggest that Korea is maintaining a healthy financial system, unlike many countries in the West.

But what has worried economic policymakers in Seoul is Tokyo's aggressive monetary easing, which has driven down the value of the yen and boosted Japanese exports, such as cars and electronics, which compete directly with those from Korea.

The easiest way to deal with this challenge would be to cut interest rates, which would weaken the currency and make the won more competitive against the yen.

But the Bank of Korea under its new governor, Lee Ju-yeol, sees little reason to do so and is maintaining a conservative approach. At its monthly policy meeting in May, the BOK maintained the benchmark interest rate at 2.5 percent, where it has been for the past year.

Some believe that the BOK's stance is appropriate. Won appreciation has not hurt export growth so far. Although inflation remains low, the BOK expects it to increase by the end of 2014 despite the fact that its previous forecasts over the past two years of rising inflation have proved to be false. There are expectations that the BOK will begin raising interest rates for the first time since June 2011 later this year.

But there are also both short-term and long-term reasons for why the BOK should ease interest rates instead. The near-term argument is that lower interest rates would boost domestic consumption, which has been depressed following the Sewol ferry disaster.

The long-term argument is that Korean exports may yet be adversely affected if the Bank of Japan continues with monetary easing. The loss of a competitive currency advantage against Japan could force Korea to adopt similar loose monetary policies.

More importantly, the BOK could come under political pressure from the government of Park Geun-hye to lower, or at least keep steady, current interest rates to prevent the administration's popularity from falling further.

The big problem with raising interest rates from the Park administration's point of view is that it is likely to worsen the household debt problem, which has reached an estimated $1 trillion. With debt expanding faster than economic growth, increased interest rates could threaten bankruptcy for many since the average household debt in Korea amounts to 160 percent of annual disposable income, one of the highest rates among advanced economies.

A wave of personal loan defaults could devastate parts of the financial industry, including credit card companies, mutual savings groups and insurers who have become the biggest creditors to households after banks learned their lesson from the 1997 Asian financial crisis and curbed excessive lending.

An interest rate increase would particularly affect mortgages, which account for about half of all household debt. Around 85 percent of all mortgages in Korea are based on floating rates, which means that households have to pay more to the banks as interest rates increase. Banks have encouraged borrowers to accept floating rate mortgages rather than fixed rate ones because the banks do not want to see their profits on mortgage loans reduced by inflation.

The trouble is that many middle-class families are already struggling to keep up with their mortgage payments despite the current benign conditions of what is supposed to be a low interest rate environment.

Household debt is climbing because families are turning to non-bank financial institutions, where loans carry much higher interest rates, to service their mortgage payments since income growth has stagnated.

Mortgage payments are also the reason why Korea's savings rate has fallen sharply as families scramble to meet their debt obligations by raiding their savings accounts. This means that many people will have little money to support themselves once they retire since pensions and welfare benefits are seen as inadequate.

A rise in interest rates could thus prove disastrous when it is considered that debt payments already consume a quarter of many family incomes and half of households are estimated to be having problems keeping up with the payments. The continued weakness in housing prices also means that it is proving difficult for many families to escape the debt burden by selling their homes to raise cash.

Koreans appear to be caught in a tightening debt trap and the Bank of Korea may have little alternative but to keep interest rates low to avoid a financial implosion.

John Burton, a former Korea correspondent for the Financial Times, is now a Seoul-based independent journalist and media consultant. He can be reached at john. burton@insightcomms. com.









 
 
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