Debt deflation refers to a phenomenon where consumers reduce spending due to excessive debts, which results in shrinking domestic consumption and economic growth engines being turned off. Irving Fisher, an American economist, laid out this concept for the first time when he explained the 1930’s Great Depression.
Signs of Debt Deflation
For the last 2 to 3 years, many experts have pointed out that there are warning signs about household debt. However, chances are growing that households will face entirely different hard times this year. The reason is that households have become mired in a situation where they can no longer rob Peter to pay Paul, which means borrowing money to pay debt, and with household income on the decline, the ability to pay debts is reaching breaking point.
Last year’s portion of principal and interest repayments to disposable income was 18.3 percent, up 2.2 percent from 2010. This means that out of 10 million won, households have spent 1.83 million won repaying debts. The ratio is estimated to reach around 20 percent this year. The ratio was 18.6 percent in 2007, just before the US subprime mortgage crisis. This indicates that debt burden on households this year will become worse than in the US where a chain of household bankruptcies occurred.
Beginning this year, the government has banned 7 million people whose credit ratings are below grade 7 from applying for new credit cards. The number of individuals filing for bankruptcy is highly likely to rise sharply because individuals with poor credit ratings can no longer rob Peter to pay Paul. In addition, the expiration dates of the housing mortgage loan, which is very likely in default, are concentrated on this year. According to The Bank of Korea (BOK), among the loans offered to those who repay only interest for their loans and have debts 4 times larger than their income or whose loans against collateral value exceed 40 to 50 percent, the ones expiring in 2012 account for 21.2 percent, larger than 15.0 percent in 2013 and 15.4 percent in 2014.
Gross domestic income (GNI) grew only 0.8 percent year-on-year in Q3 last year, which is less than one tenth of the growth rate (9 percent) of household debt. The monthly average real income of employees decreased 3.5 percent from January to September last year, compared to the same period a year earlier due to inflation. Meanwhile, the monthly average interest payment on household loans was a historic low of 93,000 won as of Q3 last year.
“Household Debt Reaching Breaking Point”
Korean households have so far maintained their spending by increasing debt, but they are being driven into a situation where they have no choice but to reduce spending because they cannot increase debt any further.
The signs of shrinking spending are already being witnessed. The Retail Business Survey Index (RBSI) released by the Korea of Commerce & Industry (KCCI) was 125 in Q2 last year but decreased for three consecutive quarters. As a result, the forecast for Q1 this year fell to 101. The main reason for this is consumers not opening their wallets, and as result, department store sales during the New Year holidays fell sharply.
Choi Gong-pil, a senior counselor at the Korea Institute of Finance, said, “Unless a large number of people do no make dramatic changes to their current patterns of spending based on debt, debt inflation is unavoidable.” “At present, household debt has reached breaking point, with our economy unable to prop up household debt any further,” he added. Park Chang-gyun, a professor from the Business Administration Department at Chung-Ang University said, “Deleveraging (reducing the amount of debt) will spread across the globe from Europe, which is suffering from financial trouble. When households get down to the work of reducing debt, debt inflation will likely hit the nation.”
However, there is an opposing argument that even though household debt is now very serious, debt inflation is less likely to take place. Lee Seok-joon, a member of the standing committee at the Financial Services Commission (FSC), said, “It is premature to mention debt inflation because our nation is in the process of growing. As long as a sharp decline in property prices does not occur, a chain of household bankruptcies will not take place.”
Government authorities are mired in dilemma. They should reduce household debt, but need to adjust the speed of reducing debt because a fast drop in household debt can trigger debt inflation. However, authorities do not have proper measures. Some experts point out that policies to reduce the spending burden of households are necessary to prevent the possibility of debt inflation occurring. Yu Kyung-won, a professor from the Finance Economics Department at Sang Myung University said, “Recently, the number of low-income households applying for loans to maintain their living standards has soared, which promotes default. The government should implement policies to reduce costs for education, transportation, and communication in order to mitigate the spending burden of low-income households.”