I’m currently managing director of Content and Business Planning at The Korea Times. Before I took the current position in early 2024, I served as managing editor in charge of both paper and online for over three and a half years. In 2015-2018, I worked as Singapore correspondent covering ASEAN nations.
Is Economy in Liquidity Trap?
Lee Seong-tae Bank of Korea Governor
By Kim Jae-kyoung
By Kim Jae-kyoung
Staff Reporter
The Bank of Korea (BOK) is facing a dilemma in determining the course of its monetary policy at an interest rate meeting Thursday as risk of a liquidity trap is looming larger amid the deepening economic downturn.
While further rate cuts seem inevitable as the economy is contracting at an unexpectedly fast pace, aggressive credit easing could drive Asia's fourth largest economy into a liquidity trap that Japan experienced a decade ago.
A liquidity trap is a situation in which the nominal interest rate has been lowered to nearly zero to avoid a recession, but the liquidity created by lower rates does not stimulate the economy. In these situations, consumers and firms start to hoard money rather than spend it, making a recession even more severe.
Despite a combined 2.75 percentage point rate cut since last October, the economy has shown no signs of bottoming out. Gross domestic product shrank 5.6 percent quarter-on-quarter in the fourth quarter of last year, the worst performance in 11 years due to slumping domestic demand.
Market analysts forecast that the central bank will slash its policy rate by 50 basis points to a record low 2 percent tomorrow but chances are that aggressive rate reductions will stop there to avoid the liquidity trap.
They added that the central bank's credit easing cycle should continue, but more in terms of micro level action to direct liquidity to credit products than through policy rate cuts.
``We maintain our view that the central bank will reduce its policy rate to 2 percent by the end of March,'' Goldman Sachs Korea economist Kwon Goo-hoon said.
``Thereafter, we expect the central bank to pause before further rate cuts, given the start of fiscal stimulus in the first quarter of 2009, the risk of a liquidity trap, and a still weak balance of international payments,'' he added.
A zero rate policy is considered worrisome, as it will narrow interest rate gap with the U.S. and other advanced countries, which will make the local bond market less attractive and drive more foreign capital out of the country.
However, some argue that the BOK's monetary policy should be heading toward this policy to prevent a recession from turning into a depression.
``The BOK may need to cut rates aggressively in order to stay in line with other countries, avoid an appreciation of the won, and ease debtors' positions,'' Mauro F. Guillen, director of the Lauder Institute at the Wharton School of Business, told The Korea Times.
Most major central banks around the world have already adopted zero rate policies. The U.S. Fed lowered the target on the funds rate to a range of zero to 0.25 percent, the lowest level in history, while the Bank of England cut its key rate to a record low of 1 percent last Thursday.
David Mann, head of Korea Research at Standard Chartered Bank, said, ``The fact that lower interest rates are not having as much of a positive effect on the economy as they would have done a few years ago does not justify stopping the easing cycle.'' He forecast a 50 basis point reduction tomorrow.
``The lesson from Japan is that policymakers should act quickly and aggressively to prevent a liquidity trap from emerging. Delaying or not going ahead with rate cuts does not therefore make sense,'' he added.
ING Group forecast that the severity of the trade shock and falling inflation will lead the BOK to cut by cumulative 150 basis points, including this week's forecast 50 basis points.
If a series of rate cuts fail to improve a credit squeeze, the central bank should consider employing ``quantitative easing'' like the U.S. Fed by purchasing commercial papers. Experts remain very cautious about direct purchase of commercial papers.
``I believe that in general Korea should follow the pattern established by larger economies ― cutting rates, injecting liquidity, providing fiscal stimulus, and ensuring that the banking system is reasonably stable,'' Guillen said.
``However, the government should not play a major role unless companies cannot find funding for their short-term needs. It is very important to try first to revive the market through other means, like injecting liquidity, before purchasing paper,'' he added.