Korea’s Rising Household Debt Poses Downside Risks to Economic Growth
Last Tuesday, the Bank of Korea reported that household debt at the end of 2016 had reached KRW1.3 quadrillion, or 82.9% of GDP, a KRW141.2 trillion increase from the year before and an increase of more than 20 percentage points since 2006. The increase is credit negative for Korea (Aa2 stable) because households’ high leverage raises their vulnerability to falling incomes or rising interest rates and poses downside risks to consumption and growth.
Household credit growth has accelerated since 2014 (see Exhibit 1), propelled by mortgage debt. However, there has been no corresponding rapid increase in property prices. Rather, higher levels of household debt partly reflect rising home-ownership rates amid low interest rates.
To address these risks, the government has introduced macro-prudential measures to shift household loans to fixed and amortizing structures. In 2015, for instance, the government introduced a one-off mortgage refinancing scheme, under which about 10% of system-wide bank mortgages were switched to longer-term, fixed-rate amortizing mortgages in place of short-term floating-rate and non-amortizing loans. The total amount of loans converted under the program equaled 3.7% of outstanding household debt, or 2.7% of GDP.
The shift to amortizing loans from bullet loans is positive and reduces financial stability risk. However, the shift to fixed-rate loans, although positive for households, is not necessarily positive for the financial system because it shifts interest rate risk to the banks. Nonetheless, most banks are shielded from the interest rate asset-liability mismatch risk because they transfer their fixed-rate mortgages to the government-backed Korea Housing Finance Corporation (Aa2 stable). This systemically important entity has nearly doubled in size since 2013 to almost 6% of GDP. The systemic risk associated with the increased concentration of mortgage loans on its balance sheet is mitigated somewhat by the low loan-to-value ratio of its mortgage loan portfolio and by strengthened prudential measures.
Sovereign risks are therefore primarily linked to the real economy. Income or interest rate shocks that undermine households’ debt-servicing capacity would likely weigh on consumption. Because household consumption has historically been an important growth driver (see Exhibit 2), this would dampen domestic demand and overall economic activity, and could cycle through to higher unemployment. Higher unemployment would take a toll on household income, further hitting the ability to service debt.
In addition to income levels, asset price fluctuations can affect consumption behavior when consumers own real estate or financial assets. These wealth effects are statistically significant in Korea, and could add additional downside risks to consumption and economic growth should a shock trim financial asset valuations. In such a scenario, policymakers have fiscal and monetary policy means to buffer such a shock and absorb contingent liabilities. However, should indebted households retrench consumption significantly, the spillover effects on the broader economy, and thereby the sovereign and banks, would be more material.