The recent U.S. stock market plunge rattled South Korean financial markets last week. On February 7, the benchmark Korea Composite Stock Price Index or KOSPI fell below the 2,400 mark for the first time in four months, while the won-dollar exchange rate and sovereign bond yields rose. On February 9, the KOSPI tumbled to 2,350 points in the wake of a sharp drop in U.S. stocks, and the won-dollar rate neared 1,100 won against the dollar, indicating the increasingly volatile financial markets in Korea. Here is Kim Jeong-sik, professor of economics at Yonsei University, to discuss what is casting a dark shadow over the local financial markets.

Wages in the U.S. have increased sharply, while the country’s unemployment rate fell to about 4 percent, which is close to full employment. Low unemployment rates would translate to better wages. Rising inflationary pressure from more jobs and higher wages would prompt the Federal Reserve to raise the interest rates. This year, the U.S. Fed is expected to raise its key interest rate at least three times. The latest stock market fall in the U.S. was partly driven by lingering concerns that that the Fed may hike the rate faster than expected.

According to the job data released by the U.S. Department of Labor on February 2, average hourly wages in January rose at the fastest annual pace since June 2009. Following the news, stock prices in the U.S. took a nosedive. On February 5, the Dow Jones industrial average plunged more than 1,100 points, posting its worst decline in seven years since 2011. On February 8, the index again fell more than 1,000 points. The U.S. stock market has been bullish for nearly nine years since March 2009, but it is tumbling now. Behind the shaky market lie fears that the U.S. may raise interest rates at a faster pace than planned due to the better-than-expected employment conditions. Wall Street is predicting that the U.S. will raise the key interest rate four times this year.

Given the fast-recovering U.S. economy, analysts forecast that the U.S. will raise the key interest rate three times this year, by 0.25 percentage point each time. But the rapid pick-up in wages and the fast growth of inflation may push the Fed to lift the interest rate four times. As we know, the U.S. has maintained a monetary-easing policy for the last ten years since the global financial crisis in 2008 to revive the economy by lowering interest rates. As the U.S. economy is showing signs of recovery now, the government has to fight inflation. So it seeks to tighten its monetary policy and raise the interest rate again to absorb easy money floating in the market.

Amid spreading prospects for more interest rate hikes and the stock market volatility, White House Council of Economic Advisers Chairman Kevin Hassett said on February 6 that the U.S. would raise the key interest rate three times this year. But the market has a different opinion. Experts are saying that the equity bull run, on the back of abundant liquidity inundating the market, has come to an end after 10 years. Among 16 major investment banks, six banks, two more than the previous month, have forecast that the rate will be raised four times this year. The Federal Open Market Committee is widely expected to lift the interest rate at a meeting next month. The problem is the potential impact of the U.S. rate increase.

The U.S. is likely to jack up the key rate by 0.25 percentage point in March. If South Korea takes the same measure, there won’t be problems because the base rates in the two countries are at similar levels. But it is uncertain whether Korea will lift its rate right after the U.S. decision, considering the lack of jobs and high unemployment rates. If Korea keeps the benchmark rate unchanged, the U.S. rate will hover above Korea’s to cause a rate gap, and more seriously, a capital outflow from Korea.

Currently, South Korea’s key interest rate stands at 1.5 percent, the same as the upper end of the U.S. policy rate between 1.25 percent and 1.5 percent. But if the U.S. hikes its rate next month in consideration of inflationary pressure, the Korea-U.S. policy rate gap will be reversed. The Bank of Korea will hold its monetary policy committee meeting on February 27. But Korea is unlikely to raise its key rate before the U.S. takes any action, since inflation rates remain low and a rake hike will only add burden on the household debt. Yet, a reversal in the Korea-U.S. rate gap will certainly affect the Korean economy.

A rate gap of 0.25 percent may not lead to an immediate capital outflow from South Korea. But if the trend continues, foreign investors may exit the Korean market to cause local share prices to fall and affect housing prices as well. If the situation deteriorates, Korea may face various crises, including insufficient foreign currency reserves. The movement of capital is influenced by not only the rate gap but foreign exchange rates as well. If the won-dollar rate rises, capital may flow out of the Korean market due to worries about foreign exchange losses. Speaking of a rate hike in the U.S. again, it may lead to foreign capital outflow from South Korea.

As time goes by, the impact of a U.S. rate increase will be stronger. A bigger rate gap between South Korea and the U.S. will pressure the Korean government to raise its interest rate. This will place a heavy burden on the nation’s household debt, which has surpassed 1,400 trillion won or about 1.3 trillion US dollars. It will also influence the real estate market negatively, with falling housing prices in local provinces dampening private consumption. Also, there are concerns over the possibility of foreign investors’ exit from South Korea. On February 6, the Bank of Korea expressed worries about these market uncertainties and raised the need for an additional rate hike. Apparently, the central bank is in a tricky position.

The Bank of Korea is in a dilemma. If it lifts the key rate to follow the U.S. trend, it may prevent foreign capital from flowing out of Korea. On the flip side, though, it will slow the economic recovery. If the bank freezes the rate, it may stimulate the economy but there are worries about capital outflow. In other words, there are disadvantages to both raising the rate and keeping it unchanged. The central bank should closely monitor the won-dollar rate. If the exchange rate falls, the bank may raise the key interest rate rather slowly as the likelihood of an immediate capital outflow is low. If the exchange rate rises too fast, on the other hand, the bank has no other option but to raise the interest rate. But if the hike is too fast, housing and stock prices may plummet to aggravate the economic recession. Therefore, it is necessary to lift the interest rate gradually.

The party of abundant liquidity is over, and markets will inevitably undergo a correction. The recent financial market agitation may signal more serious market turbulence in the future. In consideration of the major impact of a U.S. interest rate hike, South Korea should closely monitor the global financial markets and take proper measures to minimize side effects.