By Lee Myong-hwal

With unfavorable economic conditions at home and abroad, the Korean economy has recently performed poorly in terms of both exports and domestic demand.

The Korean economy seems to be locked in a downward spiral — its real GDP grew a mere 2.4 percent in the second quarter, down 0.4 percent from the previous one. It is now even questionable whether the economy will achieve three percent economic growth rate this year.

Externally, the global economy is in a deep trouble with the drawn-out debt woes in the Eurozone, the slow recovery of the US economy and a growing fear over a hard landing of the Chinese economy. There is a mounting concern that all the major axes of the global economy are losing growth momentum, sliding into a great recession.

The situation is worsened by sluggish exports and economic downturn in the emerging markets, which used to prop up the global economy in the wake of the 2008 financial crisis. Combined together, these are likely to propel the downfall of the global economy for the time being.

On the domestic front, potential risks abound — household debts reaching nearly 1 quadrillion, the possibility of a further decline in housing prices, little improvement in polarization and youth unemployment — that deters consumer spending and stunts economic growth.

So far, the Korean government has been hesitant about conducting strong measures to revitalize the economy. It tried to alleviate the economic slowdown with fine-tuning efforts, while saving room to maneuver monetary and fiscal policy for more aggravated situations.

However, the government seems to be now changing its policy stance. The BOK recently cut the key interest rate and significantly lowered growth forecast, elevating the fear of a steep decline in the economy. The grave fiscal crisis in the Euro-zone, including a growing possibility of a bailout for Spain, prompted the Korean government to reassess the current economic situation.

Specifically, the focus of the fiscal policy stance seems to be shifting from maintaining a fiscal soundness to avoiding a sharp drop in the broad economy. As of 2011, Korea’s sovereign debt-to-GDP ratio was 33.3 percent substantially lower than the OECD average of 101.6 percent. Given this, the government is likely to seek measures that will boost the economy by injecting a supplementary budget without severely eroding fiscal soundness.

As for the interest rate policy, the effects of the BOK lowering rates are limited under the current recession. Even if the BOK further cuts the interest rate, the boost effect will not be powerful enough to compensate for the falling exports and domestic demands caused by the global recession.

Considering the massive size of household debts and uncertainties abroad, it is highly probable that lowering the interest rate will only have limited effects on consumption and investment as well. The past experiences with the BOK’s monetary policy also suggest that, while a rate hike can be effective in cooling the overheating economy, a rate cut is often not as effective in stimulating the market.

With the excessive household debts and a chill in the property market, a lower interest rate is not likely to lead to rapid increase in
household debt.

Nevertheless, as the prospect of achieving three percent annual growth fades, further rate cuts would be positively considered in order to alleviate the burden of repaying household debts and relieving the economic downfall. Furthermore, the additional rate cuts would help normalize the bond market, which is currently experiencing reversed interest rates between short and long-term bonds.

It is likely to have positive effects in the financial markets as well. All these factors make it highly probable that the BOK would further cut the policy interest rate during the second half.