Abstract
During the period 2012–2017, Korea’s inflation slipped to a very low level, notwithstanding the accommodative monetary policy. Focusing on the transmission channel of lower interest rates on house rents, this study argues that the official consumer price index (CPI) in Korea understated the true inflation rate because Korea has a unique rental system, known as the chonsei contract. Under this contract, the tenant pays the landlord a large, lump-sum, upfront deposit without a periodic rent payment, and the landlord derives his returns from the interest accrued on the deposit. Thus, a cut in interest rates induces the landlord to offset the loss on his returns by charging the tenant a larger upfront deposit, which should have raised the CPI inflation. However, this effect was not properly captured owing to the growing prevalence of a hybrid chonsei contract, under which the tenant makes a periodic monthly payment as well as the upfront deposit. Thus, a low interest rate converts the upfront deposit paid under the hybrid chonsei into lower interest flows, significantly under-estimating the rent and CPI. An examination of the official CPI figures alone will in all likelihood misguide monetary policy.
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Notes
- 1.
In particular, see Dias and Duarte (2016) for a positive correlation between interest rate and rent in the US.
- 2.
Given that this study focuses on the transmission of the monetary policy through rent, we do not account for the traditional impact of low interest rates on aggregate demand. For the traditional transmission issues, see Bank of Korea’s Inflation Report (2016b).
- 3.
According to the survey conducted by the private KB bank, the average chonsei deposit in the Seoul area was 293 million Korean won at the end of 2014 and increased to 420 million Korean won at the end of 2016.
- 4.
It was thought that the CS system could no longer survive if interest rates continued to drop. However, given that monthly rental contracts are mostly HCS rather than MRO, the uniqueness of the Korean private rental market under the CS system remains strong.
- 5.
Notably the reaction of the landlord with respect to the interest rate change is asymmetric. For instance, if the interest rate rises, the landlord has no reason to lower the upfront deposit amount. Thus, the positive relation between the interest rate and the conversion rate is obtained only when there is a long-term trend of lowering interest rates.
- 6.
In Korea, the upfront deposit has rarely been financed through bank loans. According to Korea’s Ministry of Land, Infrastructure and Transportation (2016), more than 70% of chonsei tenants rely only on their private savings to fund the deposit. Thus, if the deposit paid to the landlord increases, the tenant alone has to bear the increasing financial burden for the housing.
- 7.
It may seem strange that Korea Statistical Office uses two different criteria for calculating the monthly rent for the CS and HCS contracts. However, this difference did not attract any attention until recently.
- 8.
There are two institutions in Korea that calculate the conversion rate: the Korea Statistical Office (KSO) and the Korea Appraisal Board (KAB). Although the KSO uses survey data on the CS deposit and the deposit and monthly rent of the HCS for the same type of houses and calculates the conversion rate based upon the above formula, it does not make it public. Independent of the KSO, the KAB conducts a survey on household housing conditions and publishes data on the yield on deposit. However, as the collection of the consistent data started only in 2011, a long series of data were not available, let alone the difference in sampling. Once the conversion rate is obtained, it can be used to convert the deposit for both CS and HCS contracts into the corresponding monthly interest income streams, which can be compared with the monthly rent under the MRO.
- 9.
There may be two main reasons why increase in the CS deposit is considered as the growth in rental cost. First, tenants relied mostly on self-financing as they were rarely accessible to bank borrowing. More importantly, when tenants could borrow from banks, they paid fixed interest rates for their CS deposit borrowed. Thus, a decrease in interest rates did not help reduce the interest cost of tenants for their outstanding loans. Although rents rose consequent to lower interest and conversion rates, their debt cost did not fall. Second, the impact of conversion rate on the CS contract varies depending on the conversion rate level. Basically, the CS contract was the output of the high interest and high conversion rate period. When the conversion rate remained high, for instance, at 10%, a 1% drop in the conversion rate rarely affected the CS deposit. When the conversion rate is very low, say at 2%, then a 1% drop will have an extremely important impact.
- 10.
Due to the increasing concern about the US interest hike, this cut had little impact on market interest rates and conversion rate and thus prevented rent inflation from further accelerating.
- 11.
The CPIH is not yet universally adopted as the most appropriate measure of the cost of living of households but the consensus is that the OER should be incorporated into the CPI despite the differences in the approaches to estimate the OER ranging from rent equivalent method to user cost approach or expenditure approach. Thus, many countries such as the US and Japan were already reflecting the OER into the compilation of the CPI. Some countries which did not do it have just decided to publish it (e.g., the UK) or are planning to do so (e.g., the EU). In the case of the US, the share of housing expenditure is 32.10% whereas the share of rent is 7.32%. In Japan, the share of housing expenditure is 18.65% whereas the share of rent proper is just 3.07%. Similarly, in the UK where the CPIH is published separately from the CPI, the share of housing expenditure is 23.8% whereas the share of rent is limited to 6% (Consumer Prices Advisory Committee 2010).
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Moon, W. (2023). Low Inflation in Korea During the Accommodation Policy Period 2012–2017: Unravelling the Mystery. In: Rövekamp, F., Bälz, M., Hilpert, H.G., Sohn, W. (eds) Inflation and Deflation in East Asia. Financial and Monetary Policy Studies, vol 54. Springer, Cham. https://doi.org/10.1007/978-3-031-27949-2_3
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