[Why&Next] Household Debt and Middle East Instability... Will the Bank of Korea’s Interest Rate Dilemma Deepen?

Korea's Household Debt-to-Income Ratio at 174%, Ranks 6th Among OECD Countries
Household Loans Rise Led by Mortgages... Home Price Increases and Rate Cut Expectations Drive Demand
International Oil Prices in Focus Amid Middle East Instability... Rate Cut Burden Grows if Inflation Threatens

As the recent surge in housing prices continues to spread, concerns over household debt are mounting. At the same time, international oil prices are fluctuating due to the military conflict between Israel and Iran, raising questions about whether previously subdued inflation concerns will resurface. The Bank of Korea, which has announced it will maintain its current stance on lowering the base interest rate for the time being due to strong downward economic pressures, is also expected to face even greater challenges in determining the timing and scale of future rate cuts.

Korea’s Household Debt-to-Income Ratio at 174.7%... Constraining Private Consumption, Leading to Weak Domestic Demand and Slower Growth

Last month, household loans from financial institutions increased by 6 trillion won, mainly driven by mortgage loans. This is the largest monthly increase in seven months, since October of last year. The rise in home prices and increased borrowing were triggered by the temporary lifting of the land transaction permit system in Seoul in February, which led to more transactions, especially in the Gangnam area. There was also a rush in demand to secure loans before the implementation of the third phase of the stricter Debt Service Ratio (DSR) regulations next month, which will reduce borrowing limits. As of June 12, household loans from the five major banks (KB Kookmin, Shinhan, Hana, Woori, and NH Nonghyup) increased by about 2 trillion won (1.998 trillion won) compared to the end of May, bringing the total balance to over 750.0792 trillion won. Although financial authorities are attempting to address the issue through emergency inspections of the banking sector, the problem is that expectations of interest rate cuts and further increases in home prices persist. Recently, the upward trend in home prices has been spreading to the outskirts of Seoul and some areas in the greater metropolitan region.

The household debt-to-income ratio in Korea is high compared to other major countries. According to data submitted by Representative Cha Kyugeun of the Innovation Party to the National Assembly’s Strategy and Finance Committee, as of the end of last year, the ratio of financial liabilities (2,370.1 trillion won) to disposable income (1,356.5 trillion won) for Korean households and nonprofit organizations was 174.7%. This figure rose from 182.9% at the end of 2020 to 194.4% at the end of 2021, then gradually declined to 191.5% at the end of 2022, 180.2% at the end of 2023, and 174.7% at the end of last year. Nevertheless, it remains the sixth highest among OECD member countries. According to OECD statistics, Korea’s household debt-to-income ratio at the end of 2023 was 186.5% (provisional), following Switzerland (224.4%), the Netherlands (220.3%), Australia (216.7%), Denmark (212.5%), and Luxembourg (204.4%) out of 32 countries.

The Bank of Korea has cut the base interest rate four times since October of last year and plans to maintain a rate-cutting stance for the time being. However, it remains cautious about the timing and scale of further cuts, with the burden of household debt being one of the main reasons. The household debt burden constrains private consumption, leading to weak domestic demand and slower economic growth. The recent real estate boom and increase in household debt are further complicating the Bank of Korea’s interest rate decisions. If the central bank continues to lower rates without prioritizing these concerns, it may end up fueling further increases in real estate prices rather than supporting a recovery in the real economy. This is why Bank of Korea Governor Rhee Changyong has emphasized, “We must break away from the past practice of encouraging excessive investment in real estate as an easy way to boost the economy.”

International Oil Prices Volatile Amid Middle East Instability... Watching for Threats to Expected Downward Stabilization of Inflation

The instability in the Middle East resulting from the Israel-Iran conflict has caused international oil prices to fluctuate, introducing an unexpected variable. This could threaten the Bank of Korea’s top monetary policy goal of price stability, and if the conflict escalates into a full-scale war or becomes prolonged, it may put pressure on the current stance of lowering the base interest rate.

On May 29, the Bank of Korea maintained its forecast for this year’s consumer price inflation at 1.9% in its revised economic outlook. The expectation that inflation would remain stable at the Bank’s target level of 2.0% was based on the downward trend in international oil prices. The forecast assumed that falling oil prices and low demand pressure would offset increases in the prices of processed foods and some services. In fact, the month-on-month consumer price inflation rate, which had hovered in the low 2% range from January to April this year, dropped to 1.9% last month due to falling oil prices, entering the 1% range for the first time in five months.

Experts caution against excessive concern at this stage but point out that, depending on how the military conflict between Israel and Iran unfolds, a sharp rise in oil and other commodity prices could impact global inflation and negatively affect the real global economy. Hwang Sunghyun, a researcher at Eugene Investment & Securities, noted, “Last year, Iran produced about 3% of the world’s oil supply. The actual impact of its exports on oil inventories is about 1%. If the war drags on, monthly oil inventories could decrease by about 30 million barrels. Compared to past statistics, this would contribute to a $6 per barrel increase in international oil prices.” He added, “The biggest risk is whether the Strait of Hormuz will be blocked. If it is, oil prices could exceed $100 per barrel.” Amid growing tensions both domestically and internationally, the Bank of Korea plans to hold a briefing on June 18, presided over by Governor Rhee, to review the status of its inflation targeting operations.

Meanwhile, due to years of accumulated inflation, the public’s “perceived inflation” remains high. When adjusted for real purchasing power, Korea’s food and beverage prices are the second highest among OECD countries, after Switzerland. Dining-out prices, which have a significant impact on perceived inflation, have also risen sharply over the past five years, with items such as Gimbap and hamburgers increasing by 24.6%, outpacing the consumer price inflation rate of 16% over the same period. While the government is working to ease the burden of perceived inflation, the Bank of Korea has stated that it must address structural issues such as low productivity and limited imports in food, beverages, and clothing?where prices are much higher than the OECD average?as well as high distribution costs.