South Korea’s housing policy legacy

South Korea has been badly hurt by the world’s financial troubles, which have engulfed its debt-laden companies and banks. At the same time, Korea’s housing market is heading down.

House prices rose 4.4% to the end of the 2nd quarter of 2008 from a year earlier, a marginal drop in inflation-adjusted terms (-0.4%) but a significant deceleration from the 12% y-o-y price rise to end-Q1-2007 (a 9.8% rise in real terms).

Property prices rose 9.1% in 2007 (6.4% in real terms), up from 6% in 2006 (3.8% in real terms), and 0.8% in 2005 (-1.9% in real terms).

The housing market may fall much more, as a result of two factors:

• The global financial and economic crisis
• Misguided housing policies

The global financial and economic crisis hits Korea

South Korea started 2008 on a note of optimism with the inauguration of President Lee Myung-bak’s administration in February. The former Hyundai Construction CEO and mayor of Seoul was expected to bring economic and administrative competence, which his predecessor lacked. Lee ran on a platform of “Economy, First!”, in sharp contrast to the erratic policies of left-of-centre former president Roh-Moo-hyun.

However, President Lee’s first few months in office were wasted dealing with the unpopular US beef imports trade agreement. The outcry reduced his political capital, making it difficult to enact tough reforms and deregulation.

Then the international financial crisis hit. The South Korean won (KRW) has depreciated by over 40% this year, from KRW935=1US dollar to KRW1,400=1US$. Investors, alarmed by Korean corporations’ leverage levels, have dumped more than US$33 billion worth of South Korean stocks over the past 12 months.

Finance for Korean banks has been drying up fast.

When short-term loans mature, banks find it difficult to refinance foreign currency loans, partly because bank loan-to-deposit ratios have risen to almost 140 to end-Q2 2008, according to Bank of Korea figures, and much of this has been financed by foreign currency loans.

Global demand for Korea’s electronic goods, semiconductors and automobiles has also slowed, adding to pressure on the Won.

Misguided housing policies

President Lee also has to face the disastrous legacy of the housing policies of former presidents Roh Moo-hyun (2003-2008) and Kim Dae-jung (1998-2003).

The left-of-center Roh felt that average house prices were beyond the reach of average Koreans. In Seoul's most popular neighborhoods, three-bedroom apartments can now cost $2 million, about 100 times the average national income.

Yet ironically, the real risk facing South Korea’s housing market is not over-high prices. South Korea faces an alarming glut of new housing over the next 5 years. This is because to bring down prices, the government gave tax-breaks for the construction of hundreds of thousands of apartment units, including many low-income rental units.

In 2002, the government announced a plan to build five million housing units within ten years or around 500,000 units per year. It’s roughly on target, with an average of 507,800 units constructed annually. But the country's construction industry is grappling with a large number of unsold apartments. Potential homebuyers have taken a wait-and-see attitude since early last year.

The number of unsold apartments is now the highest in 11 years, with 129,858 unsold apartments in August 2008, according to the Ministry of Land, Transport and Maritime Affairs.

Bank lending woes

Bank lending has expanded rapidly over the past five years, rising by 29% in 2002, 9.9% in 2005, 14% in 2006 and 15% in 2007. Outstanding loans have risen much faster than the deposit base, with the deficit financed by overseas borrowing by banks. Loan-to-deposit ratios have risen to almost 140 to end-Q2 2008, according to Bank of Korea figures.

Outstanding mortgage loans have risen by an average of 12.5% annually from 2004 to 2006. However, lending to households for housing drastically slowed in 2007, rising only 2%. Outstanding mortgage credits rose from 21% of GDP in 2003 to 25.6% of GDP in 2006, before falling to 24.6% in 2007.

Interest rates

The rapid expansion of bank loans in recent years was fueled by low interest rates. From an Asian Crisis peak of more than 15%, interest rates for loans to households dropped to below 6% during most of the period 2004 to 2006. Interest rates for housing loans were also below 6% from June 2004 to December 2006.

When global interest rates started rising during late 2006 and 2007, South Korea followed suit. Interest rates on housing loans rose to 7.08% in January 2008, declined slightly before inching up to 7.16% in Aug 2008 (the latest data available).

In line with the global effort to increase liquidity, the Bank of Korea (the central bank) reduced its base rate by 25 basis points to 5.0% in September 2008. It is still unclear how this will affect housing loan rates.

Firm government response to the crisis

To address the crisis, the government has provided US$100 billion to guarantee the banking system’s foreign-currency debt. The three-year guarantee covers all new foreign debt secured by domestic banks between Oct 20 2008 and June 30, 2009. The government will also inject US$30 billion worth of liquidity into the banking system.

Although the Bank of Korea has US$239.7 billion foreign exchange reserves, the private sector is holding onto their foreign currencies, expecting the won to depreciate further.

The government has also offered exemption from the dividends tax for long-term investments in bonds and equity.

In September this year, the government adjusted real estate taxes for houses in an effort to boost the construction sector. The minimum tax base for homes subject to the real estate holding tax was raised, from KRW600 million (US$456,600) to KRW900 million (US$684,900).

Tax rates were also lowered to 0.5% - 1% from 1% - 3%. Senior citizens (aged 60 or more) will get an additional 10% to 30% tax cut if they own only one house.

The government also said that it will buy up to KRW2 trillion (US$1.5 billion) worth of unsold homes from builders, through the Korea Housing Guarantee Co., under a repurchase agreement.

In September, the government also announced plans to merge the National Housing Corp. and the Korea Land Corp. in 2009. This is part of a more general plan to merge, privatize or restructure 41 state-owned or controlled companies.

Housing intervention

South Korea has a very long history of interventions in the housing market to deter speculation or lower house prices, often with disastrous results. Transaction costs in South Korea are among the highest in Asia and developed countries. A myriad of housing-related agencies, from government regulatory bureaus to government-owned corporations, distort the allocation of resources and often discourage private-sector participation.

For instance, former president Roh introduced a number of measures to slow price gains, among the most powerful of which was raising capital gains taxes by as much as 60%, and limiting the size of some bank loans so that monthly payments do not exceed 40% of a borrower's monthly income.

As a result, the country's construction industry is grappling with a large number of unsold apartments. The ratio of housing units to households has increased from 72.4% in 1990 to 107.1% in 2006 and is expected to reach 116.7% in 2012.

Potential homebuyers have taken a wait-and-see attitude since early last year. As the financial market crisis continues, more households are likely to delay their house purchase.

The number of unsold apartments is now the highest in 11 years, with 129,858 unsold apartments in August 2008, according to the Ministry of Land, Transport and Maritime Affairs. An official at the Construction Association of Korea, a lobby group, has warned that the number continues to pile up, more than 200 builders will be out of business by the year's end.

Weakening economy

South Korea’s economy quickly recovered after the 1997 Asian Crisis with an average 9% rate of economic growth from 1998 to 1999. This was followed by economic growth averaging 4.8% from 2002 to 2006. In 2007, the economy expanded by almost 5%.

However, the current financial crisis has dragged economic growth down to 4.3% y-o-y to the second quarter of 2008. GDP growth is expected to be around 4.3% in 2008 and 4% in 2009.

Inflation, tame compared to other Asian countries, eased to 5.1% in Sept 2008 from 5.9% in June 2008, the highest rate since 1998. Over-all inflation for 2008 is expected to be around 4%, above the government’s target of 2.5% – 3.5%.

The fate of South Korea’s housing market hangs in a balance as the global financial meltdown continues.

If President Lee is as passionate about reviving the housing market, as his predecessor were about pushing house prices down, then, the government should start dismantling all the complex, archaic and cumbersome rules, restrictions and penalties targeted the housing market.

The government’s plan to buy unsold and unfinished houses from developers is another way of distorting the housing market. Cutting real estate taxes and transaction costs will lead to better results, both in the short run and in the long run.