[Debt Dilemma] ③ Will Raising the Base Interest Rate Reduce Household Debt? "Effective vs Already Too Late"

Lee Chang-yong "If Household Debt Isn't Controlled, Interest Rate Hike"
Need for Rate Response as DSR Effect Is Limited
Some Say No Need as Market Interest Rates Rise
Unified Voice on Real Estate, Main Cause of Debt: "Must Manage"

Concerns are mounting that South Korea's household debt has reached a dangerous level, leading to increasing calls for a response through raising the base interest rate. Since existing loan regulations such as the Debt Service Ratio (DSR) have limitations, there are suggestions that if the household debt continues to rise, it is necessary to mitigate the shock of interest rate hikes. However, some analyses argue that raising the base interest rate could burden not only household debt but also consumption, investment, and finance across the economy, and since market interest rates are already rising independently of the base rate, the Bank of Korea (BOK) may not need to raise rates.

According to the Bank of Korea and the government on the 2nd, household debt, especially mortgage loans, has recently surged again, creating a cooperative policy atmosphere aimed at lowering the household debt-to-GDP ratio. Although loan regulations fall under government agencies such as the Financial Services Commission, the BOK is also proactive in reducing household debt as part of its macroeconomic management role. Lee Chang-yong, Governor of the Bank of Korea, stated at the BOK’s parliamentary audit on the 23rd of last month that "if household debt is not controlled, we will seriously consider raising interest rates."

Lee Chang-yong, Governor of the Bank of Korea, is speaking at a press conference on the interest rate decision of the October Monetary Policy Committee held at the Bank of Korea in Jung-gu, Seoul, on the 19th of last month.
[Photo by Yonhap News]

Accommodative Monetary and Financial Policies... Could Cause a 'Debt Trap'

The fact that the BOK mentioned it might raise the base interest rate not because of inflation but due to household debt indicates the level of concern over the rising household debt. Professors Atif Mian of Princeton University, Ludwig Straub of Harvard University, and Amir Sufi of the University of Chicago pointed out in their January 2021 paper (Indebted Demand) that "expansionary policies such as accommodative monetary policy create a short-term boom financed by debt at the expense of future debt demand," and "in such cases, the economy can become trapped in a liquidity trap caused by debt."

Increasing debt can stimulate demand in the short term, but this can worsen income inequality and increase savings among high-income earners, which lowers the natural interest rate and leads to a vicious cycle where debt rises again, especially among low-income groups. The paper also noted that "stimulus through debt can exacerbate future recessions."

DSR Also Insufficient... "Raising Base Rate Needed to Control Household Debt"

Kang Kyung-hoon, professor of business administration at Dongguk University, said, "To resolve the household debt problem, the BOK needs to raise the base interest rate at least once more," adding, "Currently, the BOK only talks about the possibility of raising rates, but it needs to actually raise rates to send a clear signal to the market." Professor Kang explained, "Strengthening regulations like the DSR only suppress new loans but do not reduce existing loans. Deleveraging must include adjustments to existing debt, so ultimately, raising interest rates is necessary."

Joo Byung-ki, professor of economics at Seoul National University, also said, "I think interest rates need to be raised to some extent," adding, "If policy measures are used together to prevent excessive burdens on vulnerable groups such as self-employed people, the shock may not be severe." Furthermore, since high-income groups in South Korea take out more real estate-related loans than low-income groups, it is analyzed that even if deleveraging is pursued through interest rate hikes and housing price adjustments, the economic shock on consumption and other areas will be less severe compared to other countries.

However, some argue that since domestic loan interest rates are already under upward pressure due to the recent high U.S. interest rates, there is no need to raise the base interest rate solely because of household debt. The U.S. 10-year Treasury yield, a global bond market benchmark, remains high at 4.9% due to expectations of prolonged high rates by the U.S. Federal Reserve (Fed) and large-scale U.S. government bond issuance. This trend raises South Korea’s government bond, bank bond, and loan interest rates in succession.

Considering Economic and Market Interest Rates... "Raising Rates Is Not the Right Answer"

Han Jae-jun, professor of global finance at Inha University, said, "The BOK needs to raise rates by about 0.25 percentage points due to international oil prices and inflation instability, but household debt does not require a response through the base rate since loan interest rates at commercial banks are already rising due to recent increases in funding costs," adding, "Instead, the government should not block rising market interest rates and should reduce exceptions to DSR regulations, such as 50-year maturity loan products, to prevent further increases in household debt."

Especially since raising the base interest rate affects not only household loans but the entire economy, it is a difficult choice when consumption, investment, and exports are struggling as they are recently. It could be like burning down the thatched roof while trying to catch a flea. Governor Lee also pointed out at a press conference after last month’s Monetary Policy Committee meeting that "interest rates can theoretically adjust household debt, but it would require raising or lowering rates significantly," which could incur substantial costs.

Shin Yong-sang, senior researcher at the Korea Institute of Finance, explained, "The most effective way to reduce household debt is to raise interest rates, but given the current economic situation with mixed upward and downward factors, it is not easy," adding, "Since vulnerable borrowers and real estate project financing (PF) issues could arise, the BOK governor seems to favor starting with micro-level measures and gradually adjusting household debt from a mid- to long-term perspective."

Consensus on the Need for "Management" of Real Estate, the Main Culprit of Household Debt

Instead, experts agree on the need to manage the real estate market, the main cause of household debt expansion. Senior researcher Shin Yong-sang emphasized, "The fundamental solution is to curb expectations of rising real estate prices," adding, "The reason people borrow to buy homes in a high-interest-rate environment is due to expectations of housing price increases, and the government needs to manage these expectations." He explained that the government’s easing of loan regulations this year has created a perception in the market that "the government is propping up housing prices," which should be avoided.

Professor Joo Byung-ki explained, "It is necessary to clean up bad loans in the problematic real estate project financing (PF) sector and allow the real estate market’s self-correcting function to bring out listings and create momentum for price declines." Professor Han Jae-jun also said, "South Korea has many factors that increase the household debt ratio, such as the apartment pre-sale system, DSR exceptions, and the real estate PF market," adding, "These real estate-related systems need to be comprehensively reformed."