Can household debt be tackled?

This is the first in a series of articles prognosticating on the challenges facing the Korean economy this year. — ED.

By Kim Tong-hyung

For over a decade, the government has encouraged homeowners to borrow and spend like there was no tomorrow, claiming it has eliminated the boom and bust in property and stock prices.

That tomorrow that was not supposed to come is arriving, making this year a crucial juncture in an effort to defuse the time bomb of household debt and for the nation’s economy in general.

The household problem is being compounded by other equally serious factors such as the eurozone debt crisis and the slumping American economy.

Of course the options are limited, but the consequences could be dire.

With the recent recession leaving millions struggling with crippling debt, policymakers seem at a loss as what to do with one of the highest levels of household debt among industrialized nations.

At over one quadrillion won, the amount families have borrowed has now overtaken the size of Korea’s entire economic output. And unlike the economy, the massive debt mountain shows no sign of slowing.

Families here are facing a growing squeeze in living standards and a report by the Bank of Korea (BOK), Monday. showed how banks are twisting the knife in them by increasing profit margins on loans and lowering savings interest rates.

As of November last year, lenders were charging interest rates of 16.5 percent for personal credit loans, a significant rise from the average of 7.1 percent at the end of December in 2010.

Mortgage rates moved more modestly from 4.67 percent to 5.01 percent during the same period, which suggests that banks are competing hard to secure home-backed loans while dramatically upping the borrowing costs for the financially precarious, confirming how the bad economy is biting low-income earners harder.

The difference between banks’ interest rates on customer deposits and loans was measured at 2.14 percentage points for November, representing the widest gap in 10 months. The poorest 20 percent of Korean households spent 2.5 percent of their income on debt interest payments, the highest level since the central bank began keeping data in 2003.

It’s plain as a pikestaff that banks will tag higher interest rates on money lent to people with risky credit, a trend that becomes more profound when the economic climate takes a turn for the worse.

Still, policymakers can ill-afford to dismiss lower-end borrowers and the increasing difficulties they face in servicing their debt when they could very well prove to be the match that lights Korea’s consumer debt bomb.

Further illustrating the bleak financial situation facing households are the alarming skid in savings rates, which proves that millions are failing to get any real return on their money once taxes, debt and inflation are taken into account.

“In tough economic times, banks will raise their interest rates on credit loans or small-sum borrowing. Since these types of loans are used mainly by low-income earners to support their costs of living, the hardship on these households has probably increased,” said Ahn Seun-kwon of the Korea Economic Research Institute.

“This will continue to be a trend as the economy is expected to take a further dip in the New Year, although a full-blown recession may force the central bank to lower its policy rates, which will push down the rates on loans.”

The government and central bank have been accused frequently of being too complacent about combating the historically high levels of household debt despite the serious threat posed to financial stability.

While key policymakers, such as BOK Governor Kim Choong-soo, continue to maintain that the country’s household debt is broadly manageable, it’s hard to deny that the problems created by personal indebtedness have made consumers and the wider economy more sensitive to shocks.

Critics have accused the BOK of pouring fuel on fire by keeping borrowing costs low, which encouraged households to maintain their borrow-to-spend habits. However, with the eurozone debt problems threatening to derail the country’s recovery, it’s likely that the central banks will cut interest rates before lifting them.

Besides, with exports showing signs of tumbling and corporate investment subduing significantly, this is expected to be an economy that relies even more on households’ ability to take on even more debt.

Korean household debt has been growing by an average of 13 percent annually since the financial crisis in the late 1990s, almost twice as fast as gross domestic product as families reel from a lengthy binge on property, stocks and credit cards.

Attempting to tackle personal indebtedness, the Financial Services Commission (FSC), the country’s financial regulator, has been tightening lending at commercial banks. However, the move appears to be backfiring by streaming more people toward non-banking sources of credit and their crippling interest rates.

Just six years after breaching the 500-trillon-won mark for the first time, the mountain of debt amassed by consumers on mortgages, personal loans and credit cards reached 892.5 trillion won as of September last year.

When combining borrowing by the self-employed and non-profit organizations as well as non-interest paying debt, the consumer debt measurement has long exceeded one quadrillion won, the size of Korea’s GDP for 2010.

Providing a gloomy update on the state of the economy, the strategy and finance ministry last month dramatically cut the growth forecast for this year and emphasized threats posed by the eurozone debt crisis. The ministry now expects the economy to grow 3.7 percent in 2012, shaving its previous prediction of 4.5 percent growth.