The US Federal Reserve System raised interest rates on June 14th local time for the second time this year. With the rate hike, there are fears that the move will worsen Korea’s household debt situation and cause foreign funds to flow out from the nation. We’ll take a closer look at the situation with economic analyst Jung Cheol-jin. First, let’s look at the US decision.
As expected, the US raised the short-term interest rate range from between 0.75 and 1 percent to between 1 and 1.25 percent. Before the announcement, there were questions on the Federal Reserve’s plan to reduce assets, whether it will mention the plans, and how specific the plans are in terms of the timescale and method. Thankfully, Fed officials just mentioned that they intend to begin reducing assets, but that was pretty much it, so it wasn’t the worst scenario. Although US jobs, prices, and other economic indices are not great, officials still need to pull back on quantitative easing. Looking at Janet Yellen’s comments, it seems the Fed will continue to raise interest rates in the second half of the year unless they see major contractions in the US economy. So, we might expect another hike in September or December this year.
Last month, the US unemployment rate fell to its lowest point in 16 years as the economy continues to recover. Reflecting the positive signs in the economy, Fed officials raised interest rates for a second time by 0.25 percentage points. Along with the interest rate hike, they also announced that they intend to reduce $4.5 trillion in Treasury and mortgage securities and other assets the central bank currently holds in an attempt to stimulate the economy. They also hinted at another possible rate hike this year, which will affect the flow of foreign funds invested in emerging markets such as Korea.
Korea’s interest rate is 1.25 percent, which is the same as it is in the US. If the Fed carries out another rate hike this year to 1.5 percent, it would have a higher interest rate than Korea. We call this an “interest rate reversal.” Historically, there were only a few times that the US rate was higher than Korea’s interest rate. There was the summer of 1999 until 2001 and August 2005 to August 2007. In principle, if the US interest rate is higher than Korea’s interest rate, foreign investors think “the US interest rate is relatively higher” and start pulling out of the market. This is worrisome because when the dollar pulls out of Korea’s stock market, real estate market, asset market, and bond market, it could lead to a collapse of our investment market.
With the US Federal Reserve raising the interest rate last week, it became the same as Korea’s interest rate for the first time in 12 years. With Korea’s interest rate currently frozen, and the US rate set to be raised once more in the second half of this year, the US key rate will become higher than Korea’s benchmark rate for the first time in 10 years. If this interest rate reversal occurs, there is the possibility that global investment funds searching for higher interest rates will flow out of emerging markets. A case in point is the two years from August 2005 when the US’s interest rate was higher than Korea’s. Over 19.7 trillion won worth of foreign investment poured out of the Korean stock market. Of course, Korea’s economic situation is different from 2005 with foreign-invested bonds more established than in the past and Korea’s external soundness much improved. However, there are voices being raised that Korea’s benchmark rate should also be raised to prevent an outflow of funds. Bank of Korea Governor Lee Ju-yeol also mentioned the possibility of a rate hike.
On June 12th, Bank of Korea governor Lee said a rate hike was possible but he has also hinted that monetary tightening is a possibility on recovery. What he said before was that at this point the need for a rate cut has decreased. However, recently he said “we may need to adjust our monetary easing stance”, which means the Bank Of Korea can not only cut the interest rate but also freeze or raise it. Why did he make this comment? He was conscious of the US. He was hinting that if the Fed raises the interest rate, the Bank of Korea has no choice but to keep pace with it.
Since becoming the chief of the BOK in 2014, Lee Ju-yeol cut the benchmark rate five times. But, for the first time in three years, Lee pulled out the monetary tightening card. However, it will be difficult for Korea to raise the benchmark rate immediately. Unlike the US, Korea’s economic growth still remains in the low 2 percent range. Also, an interest rate adjustment will negatively affect President Moon Jae-in’s “J-nomics”, which aims to tackle household debt and create more jobs by releasing the state’s coffers.
It’s a difficult situation. One may ask why we can’t let the bond rates, loan interest rates, and so on go up through the US rate hikes. It’s because it will cause the nation’s household debt, which has snowballed to over 1,350 trillion won, to explode, especially when 60-65 percent of the debt is tied to real estate as mortgage loans. President Moon Jae-in’s “J-nomics” aims to pursue income-led growth through household and domestic consumption. But, if the Bank of Korea raises interest rates due to bad news from the US and the commercial rates increase, it will shake up household debt, making the real estate market collapse. This would be a real crisis.
If the Bank of Korea raises the interest rate, the effects of monetary tightening would show up in the market, limiting the effects of the government’s pump priming measures. It would probably worsen the nation’s household debt situation which has snowballed to 1,360 trillion won as of the end of March this year. Korea is now at a crossroads having to choose between reviving the economy or stopping the outflow of foreign investment.
Now, we need policies that are not focused on a single issue such as real estate or the interest rate, but something that can work with everything. All of these issues are interconnected, which is why we need constant communication when making policies. Most importantly, we need to see what kind of impact the US interest rate hike has on the market in the long run, and think of countermeasures.
The Moon administration has been tasked with addressing the US interest rate hike and how it will affect the Korean economy. As it will have to contemplate the timing of Korea’s interest rate hike and the household debt situation at the same time, we look forward to the innovative policies it will come up with to tackle these pressing issues.