How dangerous Is Singapore's soaring household debt?

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The wealthy Southeast Asian nation Singapore has seen soaring household debt levels in recent years as low interest rates have led to a borrowing spree, prompting the government to step in to curb demand.

This island state, which is an important financial hub, has among the highest level of household borrowing relative to gross domestic product (GDP) in Asia at 77 percent, rising from around 64 percent in 2007. Home loans, which account for around three quarters of household debt, have grown rapidly in recent years together with a booming property market.

Now with bond yields beginning to climb – the 10-year Singapore government bond yield has risen to 2.5 percent from 1.4 percent in May – concerns are growing over whether there is a debt bubble in the making.

"The buildup in leverage starts becoming a risk when short term rates – which are linked to mortgage rates - start to move higher," said Taimur Baig, economist at Deutsche Bank, noting that this could take place as early as 2014 if the U.S. Federal Reserve decides to hike interest rates. The benchmark Singapore interbank overnight rate (SIBOR), used to price housing loans, tracks rates in the U.S.

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"It's definitely a concern, any country that has household debt at a high level will face problems when interest rates go up," said Baig. "While there may not be bankruptcies, there will be a transition that entails some pain."

Within Asia, Singapore ranks just behind South Korea and Malaysia whose household debt levels stand at 88 percent and 80.5 percent of GDP, respectively.

Economists, however, note that the healthy growth in financial assets in Singapore will temper the blow from higher interest rates.

"While, rising household debt is a concern, it should also be viewed in context with the asset side of the balance sheet. If needed, they [borrowers] could draw down on deposits," said Michael Wan, economist at Credit Suisse.

"It is a popular theory with owners of real estate that there is holding power, people have the wealth. That argument has some merit," added Baig.

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Household financial assets – which include currency, bank deposits, shares and securities – have risen to 86 percent of GDP from 72 percent in 2007.

"I think household sector balance sheets are strong – so it's not a concern around solvency," said Wan. "When interest rates do rise, households will have to pay higher monthly mortgage payments as portion of income - not just for housing but to service car loans. This could crimp private consumption – I think that's where the risk is, " he said. Private consumption makes up around 40 percent of the country's GDP.

In the recent months, the Monetary Authority of Singapore (MAS), the country's de facto central bank, has introduced new measures to limit consumer debt.

Most recently at the end of June the MAS announced a new framework which requires financial institutions to take into account borrowers' other outstanding debt obligations when granting a property loan. The rule ensures that the property buyer's monthly loan payments do not exceed 60 percent of his income.

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This framework used for approving home loans, may be extended to other types of loans as well, including car and student loans, the Straits Times reported on Friday.

"We believe these measures are prudent and will limit systemic risk in the event of an economic deterioration," David Mann, head of regional research, Asia at Standard Chartered wrote in a report called "Asia Leverage Uncovered" earlier this month.

While debt levels seem manageable, the rise in leverage should be monitored as pockets of over-leverage are inevitable, he added.

By CNBC's Ansuya Harjani