As widely expected, the US has raised its interest rate. On March 15 local time, the US Federal Reserve raised the benchmark interest rate by 0.25% to a range of 0.75 to 1%. The move signaling the beginning of efforts to normalize the rate came as the global economic crisis seems to be coming under control. How will the decision affect the Korean economy? We'll take a closer look at how this decision will affect the Korean economy with Professor Kim Kwang-suk (김광석) of the Graduate School of International Studies at Hanyang University. Let's first take a look at the US decision to raise the benchmark interest rate.
The US raised the interest rate in December 2015 and again in December 2016. It has only been three months since the last rate increase. The Fed raised the rate by 0.25% this time after seeing positive signs in various reports for jobs, inflation and economic growth. So, it seems that the Federal Reserve policymakers are shifting over to interest rate normalization rather than sticking with quantitative easing. Fed chair Janet Yellen has said that a total of three rate increases are expected this year, followed by three each year for 2018 and 2019. This is why the US economy is forecast to be well on its way towards recovery.
The US decision to raise its interest rate shows its confidence. The unemployment rate dipped to 4.7% which effectually signifies full employment, while the inflation rate is nearing the Fed's 2% goal. As the US economy is showing signs of recovery, the Fed has put an end to its low-interest rate policy that it has been maintaining for the past 8 years. The US will raise the interest rate three times each year for the next three years to make the interest rate reach the 3% range by 2019 in what's called the "3.3.3 plan". As such, Korea is paying attention to foreign investors and what they will do next.
While the US interest rate has been raised, Korea's interest rate remains steady so the value gap has widened between the Korean won and US dollar. This can lead to a relative capital outflow. This trend will be more noticeable in emerging economies that have a wider gap between their currency and the dollar. Korea's amount of foreign exchange reserves, the ratio of short term loans out of the total foreign loans and other indices, show that a capital outflow-induced economic crisis is not probable. However, we do need to note that the Korean economy relies heavily on exports to emerging economies. If emerging economies suffer a foreign exchange crisis, this could negatively impact Korea's exports and create a hurdle in economic recovery.
Since the US lowered its benchmark interest rate to buoy its sagging economy, investors turned their eyes to the world to search for higher rates. For the past 5 years, 6.2 trillion dollars have been invested in 25 developing countries including Korea and China. These funds could flow back to the US at any time. Fortunately, foreign buyers continued to buy Korean stocks even after the Fed announcement, helping the benchmark KOSPI to break through the 2,150 mark for the first time in 23 months on the following day. However, it is unclear whether this stability will last. If the US interest rate surpasses the Korean interest rate, foreign capital that is currently in the Korean market can rapidly flow out. But raising Korea's interest rate is not an option that the Bank of Korea can think about lightly.
Korea is stuck in a situation where it can't raise or lower the interest rate. When considering the concerns about capital outflow, we should raise our benchmark rate. However, Korea's economy has been stagnant for a long time and it must be supported through measures such as keeping the interest rate low. If the US keeps on raising its interest rate, there could come a time when Korea has no choice but to raise its rate. However, just because the US raises its rate, it doesn't necessarily mean that Korea must also raise its rate. In Korea's case, it might even need to lower its benchmark rate further as economic recovery will be key due to the unstable political situation and other domestic factors.
Korea's benchmark rate has remained at 1.25% for the past eight months. If the US raises its interest rate according to plan, after two sessions it will surpass Korea's rate. In the end, the Bank of Korea will inevitably have to raise Korea's rate. But, the big problem is household debt which has reached 1.3 trillion won, and its influence in stagnating the real estate market.
If the interest rate goes up, the real estate market will inevitably face a slump. Until now, real estate investors relied heavily on household debt for funding. But, if the real estate market is undergoing a price adjustment and your housing price goes down, it could cause big damages especially if you’ve borrowed a lot of money to buy the house. The situation worsens when the interest rate goes up because people who borrowed money on a floating rate will have a higher interest. That could increase the burden in paying back the principle. This becomes a vicious cycle as the real estate market will become further stagnated as the asset value depreciates.
As of the end of last year, Korea's household debt amounted to 1,344 trillion 30 billion won, which is 82.9% of the GDP. Korea is burdened with debt as it is, but with just a 1% increase in the interest rate, the debt increases by 9 trillion won. An interest rate increase is bad news for the real estate market. As households burdened with higher debt start to sell off their property at low prices, it will lead to a real estate price depreciation that will further stagnate the already sagging economy. As you can see, the US interest rate increase is affecting many different corners of the Korean economy. So, how can Korea adjust to the changes coming ahead?
The speed of US rate increase and other factors could lead to financial insecurity. As such, the government must keep close watch on macroeconomic indices and give that data to small and medium enterprises. Large corporations already have the ability to monitor the situation, but SMEs do not. That is why the government must strengthen its role as a monitor and let them know what to be wary of, or advise them on countermeasures such as using FOREX Hedge. That will be the only way to prepare for the times coming up ahead, which is full of uncertainty.
The Korean government has been holding meetings to establish countermeasures to minimize the damage. The key would be to devise measures to cushion the shock from the US rate increase. As the US rate increase is no longer an assumption but reality, we must do our best to eliminate uncertainties in the market.