04/10/2014 12:59 pm ET Updated Jun 10, 2014

Reflections from South Korea

Recently, I visited South Korea and Mongolia along with a group of McGill University undergraduates and alumni. This trip was part of the Hot Cities of the World Tour organized by Professor Karl Moore of the Desautels Faculty of Management at McGill University. Frankly, South Korea was an incredible place to visit; especially from an economic perspective. South Korea is the world's 12th largest economy, as well as a global leader in the manufacture of automobiles and electronics. Despite these successes however, South Korea's economy does face key issues.

Specifically, South Korea's financial services sector is surprisingly underdeveloped when compared to OECD peers, both with regards to productivity and employment share. South Korean home loans act as an excellent example which demonstrates precisely how the Korean financial sector is underdeveloped. Typically, Korean home loans have short durations of 10 years, compared to durations of 15 years or 30 years found in North American home loans. Additionally, South Korean home loans require high loan-to-value ratios, typically amounting to 51 percent of the underlying home value. Keep in mind that in North America, loan-to-value ratios typically stand at 20 percent. Moreover, before the Great Recession of 2008, loan-to-value ratios often stood at zero percent. Granted, the effects of these liberal lending policies were problematic as they led to the subprime lending crisis which triggered the Great Recession of 2008.

Korea purposely imposes these high loan-to-value ratios in an attempt to ensure that housing bubbles do not form, effectively mitigating problems in the financial sector. It seems as if these policies may have paid off for South Korea. Not only did South Korean real estate prices decline to a lesser extent during the 2008, they also recovered at a quicker rate and more robustly than North American real estate did in 2009. Many of those gains were erased in 2011 however, while North American real estate prices continued to appreciate at a moderate pace. However, in 2012 and 2013, Korean real estate prices increased dramatically, recovering any losses from 2011 and far exceeding returns found in North America. Since the Great Recession occurred in 2008, South Korean real estate prices have outperformed North American real estate prices by nearly three times!

Another significant difference is that South Korean home loans are typically issued with floating rates, as opposed to fixed rates. In many cases, South Koreans are often forced to take loans from second tier banks. Naturally, these loans have incredibly high spreads; making borrowing very costly as high interest payments are required to service the loan. As South Korean household borrowing grows by an average rate of seven percent per year, the need for financing has been filled by second tier banks and non-banking institutions. This overwhelming demand for funds is precisely the reason why South Koreans are forced to pay high loan-to-value ratios, as well as high spreads on interest rates. This issue is exacerbated by the fact that Korean housing prices are much higher, with respect to local incomes (7.7x), than those found in the United Kingdom (6.1x) or Australia (6.1x), and especially those found in the United States (3.5x) and Canada (3.4x).

Overall, home ownership is far less attainable in South Korea. High interest rates and a low pool of savings, caused by large down payment requirements, lead to a state of affairs where investment is crowded out of the South Korean economy. Therefore, it would be quite beneficial for the South Korean government to examine reforms which would make housing more affordable and more accessible such that more South Koreans could enjoy the benefits entailed within.