Low interest rates prompt switch from deposit-based rentals in South Korea

For a country trying to avoid the menace of deflation, South Korea is receiving timely help from unusual quarters - landlords and their tenants.

Interest rates at historic lows have wrought a change in traditional rental contracts that could gradually unleash billions of dollars for more productive uses such as consumption and home-buying.

Landlords have for decades operated the jeonse rental system, whereby tenants pay a deposit that can be more than half the home's value instead of having to pay a monthly rent.

There is a huge pool of funds being underused. Nomura estimates that US$400 billion was tied up in jeonse deposits in 2012, equal to a third of the country's annual economic output.

But the jeonse system appears to be going out of fashion, as most landlords cannot make high enough returns from stashing the money in bank deposits paying just 2.5 per cent - they will go down again after the central bank lowered its policy rate last week.

Using the funds as leverage to further invest in the real estate market holds little attraction for landlords either. Prices have been flat.

Jeonse accounted for slightly more than half of rentals early this year, sharply down from nearly 70 per cent in early 2011, land ministry data showed.

"The sharp drop in interest rates is the most important factor behind this phenomenon as homeowners want to make up for the shrinking income as much as possible," said Kim Eun-kyung, a consultant at Samsung Securities.

"The jeonse deposit money has mostly been illiquid, but the declining jeonse contracts will turn the money more liquid, more ready to spend on consumption or paying back loans, although this will happen very gradually."

Korea's ageing population - the number of working-age people between 15 and 64 will begin shrinking from 2017 - also heralds lower demand for rentals, as typically demand comes from younger people.

Landlords have responded to the changing market environment by either charging a monthly rental, or asking for a substantially higher jeonse deposit, which should further reduce demand for such rentals.

Either way, the prospect of less money locked up in the jeonse system, and more becoming available for people to spend, invest, or buy their own homes should be a boon for the economy.

Kwon Young-sun, an economist at Nomura in Hong Kong and a former official with the Korean central bank, estimated that renters had borrowed 64 trillion won (HK$467 billion) to fund jeonse deposits.

The trend away from jeonse rentals comes at a good time for Finance Minister Choi Kyung-hwan, who fears Asia's fourth-largest economy could go the way of Japan and slip into deflation.

The extra money coming into circulation will help his strategy to lift asset prices as a way to boost consumption.

Lee Yeon-hee, an office worker in her 20s, had rented through a jeonse contract with a deposit of 80 million won, until her landlord demanded an extra 15 million won increase. At the same time, with the economy slowing, her father's small-scale machine assembly business failed.

"I couldn't accept the demand for an increased jeonse," Lee said.

She now pays a monthly rent of 400,000 won, and has used the returned deposit to pay off a loan and support her parents.

As jeonse rentals have fallen and the benefits of Choi's policies come through, analysts see clear signs that people are using money for more productive purposes, like home-buying.

Home prices have risen for 13 consecutive months and, according to data from Kookmin Bank, have gained 1.41 per cent so far this year, following a 0.37 per cent gain last year and a fall of 0.03 per cent in 2012.

The jeonse system developed decades ago, when banks' lending was focused on financing Korea's rapid industrialisation, and the mortgage lending market was underdeveloped in a country emerging from the ravages of post-war poverty.

The country passed through a long phase of high economic growth, which fuelled inflation, high interest rates and rising property prices, all of which sustained the jeonse system.

"When the country was short of capital and proper retail banking service, the jeonse system contributed a lot to economic development, but times have changed and much of the money does little for economic growth," Kwon said.

If just 5 per cent of money now tied up in jeonse deposits flowed back into consumer spending, it would amount to 20 trillion won, equivalent to 3 per cent of annual private consumption, according to calculations based on central bank data.

While the government has not said it wants to abolish jeonse, some officials say in private that waning popularity of the system was good for the country over the long term.

"The country should abolish it, and as long as it is done in an orderly manner, it will make a big contribution to the economy," Kwon said.