Gradual policy rate increases needed

By Ronald Man

Household debt in Korea has climbed to a historic high. In 2013, it was equivalent to 164 percent of disposable income, up from 161 percent the previous year. To address the problem, the Bank of Korea needs to strike a delicate balance.

On the one hand, loose monetary policy supports household consumption and economic growth. On the other, tighter monetary policy reduces credit availability and leverage. Some expect the central bank to raise its policy rate from 2.5 percent in 2015. But even from the household debt perspective, there are three reasons why we think the Bank of Korea can afford to increase its policy rate sooner.

First, the wealthiest households account for the majority of debt. The top quintile of households owed 47 percent of total household debt in 2013 and, in turn, the most interest payments.

Wealthy households have more assets, especially financial, which increase their capacity to withstand higher interest repayments. This puts a floor under the delinquency rate of bank loans to households, which has stabilized below 1 percent of total loans outstanding.

It’s not all about the rich. Debt growth in less-wealthy households last year was driven by higher secured loans, such as mortgages. Secured loans limit risks of potential defaults and this reduces systemic risks for Korea’s banking system in a higher interest rate environment.

Second, household consumption has become more dependent on debt. Over the past three years, household debt grew at a stronger rate than private consumption. That means Korean households need to borrow more to sustain the same increase in consumption.

This trend fuels more household leverage, which may cause Korea’s medium-term economic fundamentals to deteriorate. Tighter monetary conditions will help discourage private consumption from being reliant on debt.

The Bank of Korea’s quarterly survey of lending practices also noted the excessive demand for household loans over the past year. At the same time, Korean banks expected risks on household loans to stay elevated, which dampens their enthusiasm for lending to households. When demand for household loans exceeds supply, interest rates on bank loans need to rise.

Third, the interest rate on household loans continued to trend downward, lowering the cost of leverage for households. The weighted average interest rate of outstanding bank loans to households fell to 4.49 percent in February 2014, a record low. Low interest rates on household loans will raise disposable income by limiting interest payments, thereby supporting private consumption.

We expect the Bank of Korea to keep its policy rate unchanged through the first half of 2014 and, in turn, this should provide enough room for private consumption to pick up sufficient momentum in the second half of the year.

Furthermore, the share of household loans on fixed interest rates has stabilized above 20 percent, from around 6 percent recorded more than five years ago.

Meanwhile, the government aims to raise the share of fixed rate and installment-type lending to 40 percent by 2017. As more household loans are fixed to a low interest rate environment, increases in the policy rate by the Bank of Korea will hurt households less than before. Therefore, the drag on private consumption of policy rate increases will be lower.

Taken together, we believe the Bank of Korea can gradually raise its policy rate without derailing the recovery in household consumption as monetary conditions will still be very accommodative.

Reducing the high dependency of growth on debt is important. To strike a balance between supporting the recovery and tackling high household leverage, we expect the Bank of Korea to start raising its policy rate gradually before the end of the year.