Korea-US interest gap widens to record high after Fed rate hike

Top financial officials, from left, Bank of Korea (BOK) Governor Rhee Chang-yong, Finance Minister Choo Kyung-ho, Financial Services Commission (FSC) Chairman Kim Joo-hyun and Financial Supervisory Service (FSS) Governor Lee Bok-hyun, attend an emergency economic and financial policy meeting in central Seoul, Thursday. Yonhap

Experts say solid fundamentals prevent major capital outflow

By Anna J. Park

The interest rate gap between Korea and the U.S. has widened to an all-time high of two percentage points, following the U.S. Federal Reserve's interest rate hike of a quarter of a percentage point overnight, triggering concerns of a possible capital exodus from Korea in pursuit of higher returns.

The U.S. Federal Open Market Committee (FOMC) approved the interest rate hike to a target range of 5.25 to 5.5 percent, Wednesday, U.S. time. The U.S.' benchmark borrowing cost has not only reached the highest level in 22 years, but the interest rate gap between the two countries has also widened to an all-time high, as the Bank of Korea (BOK) has kept the base rate frozen at 3.5 percent since January.

Finance Minister Choo Kyung-ho stressed that the economic situation in Korea as well as foreign exchange market conditions remain stable, despite concerns over increased uncertainties stemming from the unprecedented interest rate gap between the two countries.

"There has been a net influx of more than 22 trillion won ($17 billion) from foreign investment funds this year alone, while the foreign exchange rates are also showing a stable trend," the finance minister said during an emergency economic and financial policy meeting held on Thursday in Seoul.

"Matters of capital inflows, outflows and foreign exchange rate fluctuations are influenced by a combination of factors, including the interest rate differential between countries, as well as domestic and international economic and financial conditions," Choo added.

The meeting was held to discuss the impact of the U.S. FOMC meeting results and policy directions to counter the situation. Bank of Korea (BOK) Governor Rhee Chang-yong, Financial Services Commission (FSC) Chairman Kim Joo-hyun and Financial Supervisory Service (FSS) Governor Lee Bok-hyun also attended the meeting.

"The International Monetary Fund (IMF) also stated that Korea's foreign exchange reserves are at a sufficient level to cope with external uncertainties, and it is expected that the size of the current account surplus is to gradually expand in the future," Choo said, adding that the government will make every effort to strengthen external soundness, while closely monitoring key risk factors.

Experts view that a major capital outflow is not highly likely, as the U.S. Fed's interest rate hike in July was highly anticipated and concomitant risks have already been factored into the market.

"Risk factors still exist for sure. However, what is certain is that the U.S. Fed's interest rate hike peak has already or almost passed, and that has a calming effect on the markets," Park Sang-hyun, economist at HI Investment & Securities told The Korea Times, Thursday.

"As seen in the past, a capital exodus could worsen when economic conditions are unstable. Yet, the Korean economy is at a point of recovery, heading for improvement during the second half. Thus, economic fundamentals are preventing a major capital outflow from the economy," he added.

The economist also explained that demand originally intended for Chinese bonds are currently flowing into Korea, contributing further to the stable situation of the economy.

However, some economists are urging the government to become more vigilant and focus on beefing up the foreign exchange reserve in case of an emergency.

"Given that about 22 countries are experiencing foreign exchange crises, including Sri Lanka, Argentina, and Egypt, the government should not be complacent. Korea has the world's second highest dependence rate on global trade, yet it only has about 20 percent of its GDP level in foreign exchange reserves," Kim Dae-jong, professor at Sejong University, stressed in a phone interview on Thursday.

The professor added that about 30 percent of the Korean stock markets' market capitalization is held by foreign investors, meaning that they could be facing a higher incentive to take the capital out of Korea if the interest gap persists. Thus, he stressed the need to defend the country's foreign exchange reserves.

"It is understandable that the BOK has frozen the key interest rate four consecutive times since January, considering the debt burden on the economy. However, the central bank should take a more sophisticated and closer examination of its interest rate action in the coming months," Kim said.

Faced with a policy dilemma of discouraging capital outflows and lowering the debt burden on households and corporations, the next BOK meeting will be held on August 24. The U.S. Fed, meanwhile, is expected to maintain the current rate until the end of this year, according to market analysts.

"The U.S. Fed said it will make the future interest rate decision based on data. Data on inflation in the service and employment sectors show that overheated inflation from an imbalance between supply and demand is now showing signs of normalization," Im Jey-hyuk, analyst at Meritz Securities Korea, told The Korea Times.

"Amid the overall expectation that inflation is going to stabilize during the second half, the U.S. Fed will check on inflation twice during the month of September. And [we are] forecasting that July's hike will be the last increase for this year, followed by a decrease by early next year," the analyst explained.

Market indices appeared unfazed on Thursday. The main benchmark KOSPI ended at 2,603.81 points, up 0.44 percent from the previous session, while the secondary Kosdaq fell 1.87 percent, ending at 883.79 points. The won-dollar exchange rate ended at 1,277.7 won, a 3.2 won increase from the previous session.