[Editorial] Caught in debt trap

By Yu Kun-ha
  • Published : Apr 25, 2012 - 19:24
  • Updated : Apr 25, 2012 - 19:24
The Bank of Korea has released a report highlighting the negative impact of the sustained growth of household and government debt on the economy. One of the report’s main points is that the Korean economy is already caught in a debt trap.

The bank does not see the household debt bomb detonating any time soon to trigger a fresh financial crisis. Yet it urges concerted government efforts to defuse it because it has begun to undermine the fundamentals of the languishing national economy,

The nation’s household indebtedness reached 912.9 trillion won as of December, up 7.8 percent from a year ago. Since 2005, household debt increased 9 percent a year on average.

Household borrowing, if maintained at a low level, can boost consumption, setting in motion a virtuous circle of output growth, job creation, household income gains and debt repayment.

But when indebtedness exceeds a certain point, the high cost of servicing debt has the opposite effect ― interest payments reduce disposable income, weakening demand for goods. This in turn causes a drop in output, stunts economic growth and reduces household income.

The authors of the report have found that the consumption-boosting effect of household borrowing disappears when interest expenses as a percentage of disposable income exceed 2.51 percent. Once this critical line is passed, the researchers say, a 1 percent increase in household debt reduces consumption by 0.16 percent.

Currently, the figure is at 2.72 percent. According to the researchers, the percentage has remained above the critical point since the third quarter of 2009. No wonder then that the level of domestic consumption has remained below the long-term trend in recent years.

The report also warns that if household debt continues to grow down the road, it would not only shrink consumption but weaken the fundamentals of the economy by amplifying the volatility of asset prices and business cycles.

Furthermore, runaway debt growth would increase the likelihood of the economy being dragged into a drawn-out recession, such as the one Japan experienced in the 1990s, in the event of a negative external shock.

The report also puts a spotlight on the worsening quality of household debt. In recent years, nonbanking financial institutions have been brisk in lending to low-income households.

Since these households are more likely to default on their debt, the institutions that have extended loans to them should have been prepared to manage their increased risks. But in reality, nonbank institutions are not as sophisticated as banks in risk management. As a result, these institutions have not only exposed themselves to risks but ratcheted up the overall risk of the financial system.

One way to prevent the economy from falling further into the debt trap may be to transfer some of the household debt to the public sector. But the public sector has little room to take over private debt.

According to the central bank report, the nation’s public debt could surpass 100 percent of its GDP in 2030, if the current growth pace is maintained. It forecasts that the increase in social security spending due to population aging alone would push the government debt to GDP ratio above 70 percent by 2030.

Add to it housing support and the inevitable government absorption of huge losses at state-run enterprises, such as LH Corp., then the ratio would easily top 100 percent in 2030, according to the paper.

Hence to defuse the household debt bomb, the government needs to implement a well-conceived debt restructuring program in cooperation with financial institutions. For this, financial regulators and the central bank need to be well informed of the indebtedness and repayment capacity of each household and tailor the restructuring program accordingly.

More importantly, the government needs to create jobs for people who have to take out a loan simply to get by. Job creation is the best remedy for the household debt problem.

At the same time, the government should take steps to stabilize real estate prices. Recently, some economists have claimed that the Korean economy has been experiencing a modest debt deflation, a situation where debt increases amid falling asset prices. If apartment prices fall further from the current levels, the debt deflation would become more virulent, ruining households, financial institutions and the national economy.