The Bank of Korea raised the nation’s key interest rate by a quarter percentage point to 1.5 percent in its Monetary Policy Committee meeting on November 30. The decision signals an end to the record-low key rate that has been maintained since June last year and the beginning of an era of monetary tightening. Here is Kim Jeong-sik, president of The Asia Finance Society and economics professor at Yonsei University, to discuss potential changes from the central bank’s recent rate hike. First, Professor Kim analyzes the background for the measure.
South Korea had maintained low interest rates to revive the economy since 2011, causing the value of money to fall and prompting many people to take out more loans to buy houses. As a result, household debt has spiraled to record levels. To remedy the situation, the government has employed some measures, including tighter restrictions on housing loans and more taxes. Despite the efforts, housing prices as well as household debt have only risen. To ease the pace of household debt growth and stabilize real estate prices more effectively, the government decided to focus more on a macro-oriented policy than on a micro one by lifting the key interest rate.
During the last monetary policy board meeting for this year, six out of seven members chose to lift the interest rate. It is the bank’s first rate hike in six years and five months since June 2011, when it raised the rate to 3.25 percent. The rate had since been frozen or lowered repeatedly. In fact, the recent rate increase was widely expected. South Korea’s gross domestic product, or GDP, in the third quarter grew 1.5 percent compared to the previous quarter, and exports of products, especially semiconductors, have remained strong. Amid clear signs of an economic recovery, the Bank of Korea decided to adjust its monetary-easing policy that had been expanded to cope with low growth and inflation. It also feared that more floating money might flow into the real estate market and household debt will increase even further if the rate is kept at the record-low level for a lengthy period. External factors have also contributed to the bank’s recent decision to raise the rate.
Another reason for Korea’s rate increase is the anticipated hike in the key interest rate in the U.S. amid the nation’s economic recovery. A higher interest rate in the U.S. may cause a sudden outflow of foreign money from the South Korean financial market and even a foreign exchange crisis in Korea. With the U.S. Federal Reserve expected to lift the rate in December, South Korea moved fast to ensure the Korean rate is still high and to dismiss concerns about a possible foreign capital flight from Korea.
As you just heard, the growing possibility of a rate hike in the U.S. also influenced a shift in Korea’s monetary policy. The Federal Open Market Committee in the U.S. is strongly tipped to raise the key interest rate in its meeting on December 12 and 13. If the U.S. lifts its rate with Korea’s benchmark rate still frozen, the interest rate gap between Korea and the U.S. will be reversed to possibly lead to a foreign capital exit from Korea. With these concerns in mind, the Bank of Korea made a preemptive move by lifting its key rate. Similar measures are anticipated next year.
In the U.S., the economy is showing signs of overheating, with real estate prices rising and the unemployment rate declining. Therefore, the nation is expected to raise its key interest rate about three times next year. On a similar note, South Korea may lift its own rate at least twice next year, once in the first half and again in the second, in consideration of the economic recovery and the need to calm housing prices.
The report released by the U.S. Federal Reserve in September shows that the nation is expected to raise the interest rate three times next year. If a report this month shows the same forecast, Korea will also have to lift its rate again to prevent the rate gap between Korea and the U.S. from being reversed. Of course, one of the most important factors that will determine an additional rate increase is the domestic economy. The Korean economy is projected to grow more than 3 percent in 2018, as the Organization for Economic Cooperation and Development, or OECD, has recently revised up its growth forecast for South Korea next year to 3 percent. But if the U.S. continues to raise its key interest rate in 2018, as expected, the Bank of Korea will be in a tricky situation as additional rate hikes in Korea would generate serious side effects.
When the interest rate is raised, borrowers have to pay higher interest rates on their loans. Previously, borrowers were allowed to extend their loans as long as they make only interest payments. But under the new, tighter lending rules, they have to pay both the principal amount and interest, and this will certainly pose a great burden on them when paying back their loans. Now, with a higher interest rate, the burden will be even heavier. Some may end up failing to pay back the interest, much less the principal, to bring about insolvency of household debt. The higher interest rate will also make it more difficult for mortgage borrowers to repay their loans and therefore reduce demand for real estate. If that happens, housing prices may fall drastically. There are concerns about the risk of people defaulting on their loans and a hard landing in the real estate market.
The end of the low interest rate era will increase the burden on those who have to pay more in interest payments. As of the end of September, South Korea’s household debt amounted to 1,419 trillion won, or 1.3 trillion US dollars. The 0.25 percentage point hike in the base rate means that borrowers have to pay 2.3 trillion won, or 2.1 billion dollars, more in interest payments annually. Considering that mortgage loans account for more than half of total loans, a contraction in the real estate market seems inevitable. The market is already faced with the so-called housing “transaction cliff” as a result of strong restrictions on bank lending on households, and it is expected to be frozen further due to the higher interest rate. An increasing interest burden and a slump in the real estate market may lead to a shrink in consumption to hurt domestic spending that has just begun to improve. Also, an interest rate increase may affect the Korean won-U.S. dollar exchange rate. In the past, a higher key interest rate in Korea would make the won stronger against the dollar. The acceleration of the appreciation of the Korean currency might cause local exporters to face a double whammy as they will lose price competitiveness and find it difficult to secure funds as well. Now, the task of the Korean economy is how to minimize the impact of the interest rate hike.
It’s necessary to adjust the interest rate in a moderate manner so as not to increase the burden on borrowers too much and to ensure a soft-landing in the real estate market. The Korean economy is on a recovery track but it’s hard to say that it has made a full recovery. A drastic rate hike could make the economy stagnant again, so it is necessary to raise the interest rate gradually. We cited the risk of a foreign capital exodus as one of the reasons for a rate increase. But the Bank of Korea could prepare against an outflow of foreign money by securing abundant foreign currency liquidity. For instance, South Korea may sign a currency swap deal with Japan and the U.S. If Korea is free from worries about a foreign capital outflow, it may not necessarily have to raise the key rate in line with the move to lift the rate in the U.S. I think the central bank should consider these matters before carrying out its interest rate policy.
Bank of Korea Governor Lee Ju-yeol said that the bank would maintain a monetary easing stance for the time being and decide on an additional rate hike in a prudent manner after carefully examining the trends in growth and inflation. A rate increase, if it is used in a proper way, may help improve the fundamental economic structure. But if used inappropriately, it could pour cold water on the momentum toward economic recovery. It seems more necessary than ever to manage a relevant policy carefully and thoroughly.