On September 20, the U.S. Federal Reserve announced that it would start reducing its asset holdings, signaling an end to quantitative easing. The U.S. central bank’s decision to trim its balance sheet is expected to bring about a change to the Korean economy as well. Here is Professor Kim Gwang-seok at the Graduate School of International Studies at Hanyang University to analyze the potential ripple effects of the U.S.’ fiscal tightening. First, Professor Kim explains what the Federal Reserve announced after a two-day meeting of its policymakers.

The Federal Open Market Committee kept its key interest rates unchanged at the range between 1 and 1.25 percent. More importantly, the Fed said that it would begin scaling back the size of its 4.5 trillion dollars in assets from next month. It has increased asset holdings to take quantitative easing steps since the 2008 global financial crisis to boost the economy. The Fed’s recent decision to cut its asset holdings shows its confidence that the U.S. economy has shown a sound recovery and will continue to maintain this trend down the road. Amid keen interest in the future of the U.S. economy, the Fed’s announcement is drawing special attention.

A reduction in assets is the opposite of the “quantitative easing” that the U.S. has supported since the 2008 global financial crisis. In an effort to ease a serious financial crunch and economic recession triggered by the crisis, the Fed has maintained abundant liquidity in the market by purchasing bonds, including maturing Treasury bonds. As a result, its asset holdings have grown to 4.5 trillion dollars, which the Fed now wants to reduce. Starting with a monthly cut of 10 billion dollars from October, it plans to gradually shrink its asset holdings in the next few years.

The U.S. is seeing a steady recovery in its economy, with the recovery phase lasting nearly 98 months in a row. The unemployment rate was pegged at as low as 4.3 percent as of August. In a word, the U.S. economy is in a highly stable situation. Much of the credit should go to active quantitative easing, which means the government has pumped money into the economy. The so-called “policy bullets” have been used to purchase real estate or stocks to fuel the economic recovery. Now, it’s time to retrieve the bullets. The Fed is confident that the recovery phase will be maintained even though the asset size and key interest rates may return to a normal level. That’s the backdrop for its decision on asset reductions.

The Fed believes that the U.S. economy is on a solid recovery path, with the economy forecast to grow 2.4 percent this year. It has raised key interest rates four times over the last two years, and it is ready to pare back its balance sheet. That is to say, the Fed will now stop taking the emergency measure aimed at propping up the collapsing economy and begin implementing a normal fiscal policy instead. The end to the U.S.’ experiment of quantitative easing is something that the global economy has never experienced before, and attention is being paid to the potential effects of the unprecedented move on the market.

For now, the U.S. Federal Reserve’s plan is unlikely to affect the global financial markets in a big way. While the U.S. will reduce its asset holdings, other major economies such as the European Union and Japan have yet to normalize their fiscal policies. In other words, the U.S. is the only country to unwind the balance sheet, and other countries will still maintain their quantitative easing programs. Therefore, the impact will only be limited. But in the future, the EU and Japan may adopt a policy similar to that of the U.S. If that happens, it will have a major impact on the global economy. For instance, increased volatility in financial markets could lead to a prompt outflow of funds from emerging markets, which may subsequently face a foreign currency crisis.

The global financial markets remained relatively calm following the news of the U.S. Federal Reserve’s plan. But the backlash might start soon. As the Fed’s policy has switched over to asset reductions, central banks in other countries are expected to seek to find an exit from their existing monetary easing and pump-priming policies aimed at reviving their economies. The Bank of Korea is also concerned about the situation. If banks in major countries, including the U.S., introduce belt-tightening policies, the central bank in Korea will also be pressured to raise its key interest rate. But an interest rate hike in Korea will place further pressure on debt borrowers, with household debt amounting to 1,388 trillion won, which is about 1.26 trillion US dollars, as of the end of June. Yet, it is also difficult to leave the interest rate unchanged. With the Bank of Korea’s key interest rate set at 1.25 percent, another rate hike by the U.S. in December, as it has suggested, will inevitably reverse the interest rate gap between Korea and the U.S.

The higher rate in the U.S. may lead to a capital outflow from Korea and also influence the won-dollar exchange rate. In 2013, then-Fed Chair Ben Bernanke hinted at the possibility of tapering quantitative easing, causing a massive outflow of foreign capital from emerging economies as well as Korea, and drastic currency devaluation. At the time, Korea’s composite stock price index KOSPI plummeted 11 percent. The U.S. balance sheet drawdown will narrow the interest rate gap between Korea and the U.S. and reduce foreigners’ bond investment. Local financial companies in Korea will prefer overseas investment that may ensure more profits, and this will result in the rise in the won-dollar exchange rate. Overall, the tightening move from the U.S. could greatly influence the South Korean capital, financial and foreign exchange markets.

Foreign capital has already been flowing out of the South Korean market due to North Korean nuclear risks. Fiscal austerity of the U.S. may accelerate this trend, making the Korean financial market and the economy overall suffer from a major setback. But the U.S.’ asset reduction plan was highly anticipated, and it will be carried out gradually in consideration of its potential impact on the market. South Korea is able to overcome the crisis, if it formulates well-thought-out measures.

The Fed’s plan may not have a major impact on the Korean economy, but it’s still necessary to prepare against various uncertainties. First, Korea needs to keep pace with a possible global trend to lift key interest rates, based on the assumption that Korea’s economic recovery remains robust. Secondly, the government should constantly monitor economic uncertainties and indexes as well as the possibility of a financial crisis in emerging economies, as the U.S.’ move to normalize its fiscal policy may heighten financial instability in Korea. It should continue to inform small-and mid-sized firms of the results of the monitoring and send them warning messages when necessary, so the companies can swiftly respond to any crisis.

Now that the U.S. has begun to take a step back from quantitative easing that has been unleashed since the global financial crisis, the global fiscal policy will change once again. Given its high-level of capital market openness, Korea should watch the situation carefully, analyze its impact on the local financial market and consider the possibility of an interest rate hike at an appropriate time.