Research on The Effect of the U.S. Interest Rate on South Korea’s Economy

Master Thesis

Research on The Effect of the U.S. Interest Rate on South Korea’s Economy

: How Is It Related to Households’ Debt on Housing Loans in Korea?

2018

Master of Public Policy Management in International Development (MID)

School of Public Policy Management (SPPM)

Tsinghua University

Table of Contents

I. Introduction

1. Background of Research

2. Research Objectives & Questions

3. Literature Review

4. Research Methodology & Structure

II. Interest Rates in the U.S. and Republic of Korea

1. General Definition of Interest Rates

1.1 Interest and interest Rates

1.2 The different types of interest

1.3 The causes of interest changes

1.4 Impact of Interest change on General Economy

2. Trend of Interest Rate Changes in the U.S. and Republic of Korea since Financial Crisis in 2008

2.1 The U.S. Interest Rates since 2008

2.2 Current Situations in the U.S.

2.3 Republic of Korea Interest Rates since 2008

2.4 Current Situations in Korea

2.5 Relations between the U.S.’ and Korea’s Interest Rates

III. Influence of Interest Rates on Korean Households’ Circumstances

1. Main Different Types of Occupancy in Korea

1.1 Monthly Rental, Key-money Lease and Self-owned

1.2 Analysis on Decision-making on Occupancy Types by Different Income Groups

1.3 Analysis on Decision-making on Occupancy Types by Different Interest Rates

2. The Scale of Korean Households’ Debt on Housing Loans

2.1 Trend of Housing Price Inflation and Interest Rate

2.2 The Scale on Housing Loans and the Burden in Korea

2.3 Analysis on Loan Repayment Size by Occupancy Types, Interest Rates and Income Groups

IV. Summary and Conclusion

1. The Overall Impact of the U.S. Interest Rates on Korea Economy

1.1 The U.S.’ Influence on Korea Interest Rates

1.2 Impact of Korean Interest Rates on Decision-making on Housing Loans

1.3 The Burdens of Households

2. Solutions

3. Limitation

Chapter 1. Introduction

1.1 Background of the Research

The purpose of this research is to explore how the interest changes in the United States influence on Korean citizens’ daily lives and its national economy, regarding the households’ debt and their interest burden. It seems that the relationship between the U.S. interest rates and Korean households’ debt are not quite strong when looking at these two countries’ interests superficially. However, when observing these two nations’ interest rates more deeply, it has been already proven by many economists and statistical reports, that the impact and linkage between the U.S. and South Korea are huge. On March 15th 2017, the U.S. Federal Reserve (FED) announced the increase of its yearly interest from 0.75% to 1%. FED also predicted that they might increase the U.S. interest rate two or three more times within this year. And on May 28th 2017, it is also predicted that “strong U.S. wage growth and a healthy jobs market are expected to pave the way for America’s central bank to raise interest rates for the second time this year (Chan). That is to say, the era of low interest rate has begun to see the end.

Due to the U.S. Federal Reserve’s announcement, the world economy has started to fluctuate. Many countries and multinational corporations that have been in relationship with the U.S. economically and politically, including South Korea, have begun to be affected. One of the main reasons why the U.S. has increased its interest rate and will continually increase is, most importantly, because of the decrease of unemployment rate. According to a statistical report on Trading Economics, the unemployment rate in the U.S. rate has soared to 10% between 2008 and 2010, and the Federal Reserve kept its interest rate low in order to control the inflation. However, from 2010, its unemployment rate started to decrease and went down to below 5% in the last quarter of 2015. Thus, the U.S. assumed that it is on the stage of full-employment status already and decided to raise the interest rates. Simply speaking, citizens in the U.S. are now fully employed and able to earn more income. Consequently, the stronger consuming power of individuals and corporations will result the inflation. In order to prepare for the potential inflation in the near future, Federal Reserve has to raise the interest rate to attract American citizens to deposit money in banks by earning more profit with interest benefits.

The decision by the U.S. Federal Reserve on interest rate raise put Bank of Korea (BOK) into a serious dilemma whether it has to follow the interest rate trend of the U.S. or not. In order to support this thesis statement, this research explores three phenomena, including historical and theoretical data. First phenomenon shows South Korea has followed the trend of the U.S.’ interest rate changes since 2008. Second phenomenon displays Korea has been setting its interest rate a little higher than the U.S. These two phenomena will be further analyzed and be supporting evidence for the cause of the third phenomenon that Korean citizens’ purchasing power and their interest burden will be severely affected, influencing the whole economy in South Korea.

1.2 Research Objectives

Based on these three phenomena, this research analyzes the direct and indirect influence on individual level and national level from interest burden and housing price changes to the integrated consumer expenditure variation and South Korea’s overall economy. The objective is to suggest better, alternative solutions in order for Korea to be better prepared for the future possibility of interest rate rise in the U.S.

1.3 Research Questions

In order to achieve the final objectives on this research, this paper suggests five critical research questions, regarding the three phenomena presented above.

· How much have people borrowed from bank from 2008 to the present? (By year & different income groups)

· What percentages have they spent the bank loans on housing? (By year & different income groups)

· Korea has three main types of housing (Owning, Key-money lease, and monthly rental). How much more percent of income will be spent on paying interests when interest rate increased? (By yearly wage raise & income groups)

· By interest burden and its changes, how will private consumption expenditure be changed? (By yearly based expenditure & income groups)

· What do all of these data mean for Korea overall economy?

Before explaining the reasons why this research proposes these research questions, it will be necessary to give more detailed explanation on the phenomena.

Phenomenon #1

Figure 1: The U.S. Interest Rate Trend

Figure 2: South Korea Interest Rate Trend

These two charts show the interest rate trends of the U.S. and South Korea since 2008. Both are used in order to put more emphasized evidence that Korea has been following the U.S.’ interest rate trend even though there are some differences, which needs further research. Ever since 2008, the U.S. lowered its interest rate due to the decrease of unemployment rate and kept it below 1%. Likewise, in few months, South Korea also lowered its rate after the U.S. and kept it low.

Phenomenon #2

Figure 3: Combined Graphs of the U.S. & Republic of Korea

The chart above demonstrates a combination of the two previous figures in Phenomenon #1 to ease the observation of the two states’ * United States and Republic of Korea) interest rate trends. In Figure 3, Korea has been keeping its interest rate a little higher than the U.S. since 2008. Since the U.S. Federal Reserve expressed the high possibility of raising its interest rates several more times in 2017, South Korea is put in a critical dilemma, whether it has to keep its interest rate low or has to raise it, following the U.S. interest trend.

For the first case, if South Korea decided to maintain its previous rate, the U.S.’ interest rate will be higher than Korea’s, and Korea will experience its capital outflow. In other words, the rich and multinational corporations in Korea will move their tremendous amount of assets to the U.S. banks in order to gain income benefits from interests. According to the Korean Broadcasting System (KBS), it states, “since the US lowered its benchmark interest rate to buoy its sagging economy, investors turned their eyes to the world to search for higher rates. For the past 5 years, 6.2 trillion dollars have been invested in 25 developing countries including Korea and China. These funds could flow back to the US at any time” (March, 2017). That is to say, in order to prevent capital outflow from Korea to the U.S., it will be essential for Korea to set the interest rate higher than America. However, this is not an easy decision to make due to the dramatically increasing households’ debt in Korea, which will be further explained in subsequent chapters.

Phenomenon #3

Figure 4: Trend of Household Debts in the Republic of Korea

Phenomenon #3 takes a look at the effects apparent when the interest rates remain steady. Korea has been maintaining low interests rate, hence the reason why many households have borrowed loans from the bank. The total amount of households’ debt will be enormously soared and people will suffer from paying debt and interest. KBS News has also reported that, “As of the end of last year, Korea's household debt amounted to 1,344 trillion 30 billion won, which is 82.9% of the GDP. Korea is burdened with debt as it is, but with just a 1% increase in the interest rate, the debt increases by 9 trillion won. An interest rate increase is bad news for the real estate market” (March, 2017). So the increase of interest rates will influence on Koreans’ private consumption and purchasing power, reported as “the country’s household debt stands at more than 160 per cent of household incomes” (Mundy, 2016).

Based on these three phenomena, this research will throw out deep and detailed explanation on how the interest rate changes in the U.S. are related to many different corners of Korean economy. So the purpose of the five research questions, mentioned above will observe how much loans Korean households have borrowed from the bank and where they have spent or invested on by different income groups and yearly base. Moreover, among many other main areas where debtors have spent loans, this research will concentrate especially on structural change in the rental housing market according to three main different types of housing; privately owned, key-money lease (Chonsei deposit), and monthly rental. Also, as the interest burden becomes severe, “how the private consumption expenditure will be changed” and “how it will affect the overall Korean economy” are to be more deeply analyzed.

1.4 Literature Review

Many scholars and critics have written, regarding the various influence of the U.S. interest rate changes on its domestic and international level. The U.S.’ interest rate obviously has a huge impact on every side of the international economy. According to an Institute for International Trade (IIT) report, it analyzes how the U.S.’ interest changes in the past negatively affected Korean economy, especially on import and export. The chief researcher of IIT states, “looking to the past examples of the U.S. interest changes, it negatively influenced on South Korea’s export, followed by international financial market instability, decrease of oil price, and developing nations’ economic stagnation” (Kim, 2016). On this imminent point of time when U.S. Federal Reserve is planning to raise interest rate for the second time this year, Korean corporations will have many negative impacts on exports to the developing nations. Fortunately, Kim also asserts that, “even though corporations that export to Latin America, Southeast Asia, and Middle East will have negative impacts, but corporations that export to the U.S will relatively have positive impact” (Kim, 2016). However, he also concerns that South Korea’s economy is heavily depended on export to developing nations, it will be necessary to concentrate on the negative impacts, because Korean multinational corporations’ financial stability will directly influence on its employees, regarding incomes, lay-off, unemployment, and finally their household consumption expenditure.

Furthermore, because Korean households’ debt has been enormously increasing, the raise of interest rate in Korea, following the U.S.’ trend this year is already seriously influencing households and their housing structures. According to a research on Department of Consumer & Child Studies from Incheon National University, Sung compares the expenditure patterns among Korean households living in monthly rental, key-money lease (Chonsei or Jeonse), and privately owned means. In terms of Key-Money Lease, it refers to “a real estate term which is unique to Korea where a lump sum deposit is given the landlord without monthly rent and same amount of deposit should be returned to the tenant when the rental contract completes” (Sung, 2015).

According to her research (Sung, 2015), Korean bank had been setting its interest rate low for last several years until the first quarter of 2017. So those landlords who used to lend houses by key-money lease now put their houses on monthly rental basis. The deposit received on key-money lease is usually put in the banks by house owners, but if the interest rates are too low, it is meaning less to put the deposit in the banks to gain interest income. So according to Sung’s report, among total households, 53.6% of them live in privately owned houses, and 46.4% are included in monthly rent and key-money lease types of housing. Before 2012, among 46.4%, key-money lease type was higher than the monthly rental, but after 2012, key-money lease type (55.0%) became less than monthly rental (45%), indicating that monthly rental ratio became 5.1% higher since 2006. If monthly rental ratio continuously raises, households will have to spend more part of their monthly income to pay the monthly rental (17.3% of salary in 2014).

However, if Korean interest rate goes up, following the U.S. interest policy, the interest income will be more beneficial to landlords and the conversion rate for Jeonsei-to Monthly rent will be higher. So many households will have to borrow more loans from the bank to pay the deposit for key-money lease and their interest burden will also increase. Then, households’ consumption will again decrease in order to pay off the debt and interest, affecting the overall Korean economy.

1.5 Research Methodology & Structure

The purpose of this research is to evaluate the influence of the U.S. interest increase on the overall Korean economy. The demographics of research will be different income groups, types of housing (Privately-owned, Key-money lease, Monthly rental) and amount of households’ debt. Setting the increase and decrease of interest rate changes as independent variables, this research will run hypothesis tests on the four dependent variables; interest burden variation, conversion rate of Key-money lease to monthly rent vice versa, households’ expenditure ratio variation, spent on paying interest and debt from income, and Korea overall debt percentage to GDP.

Chapter 2. Interest Rates in the U.S. and Republic of Korea

2.1 General Definition of Interest Rates