Need to cut interest rates
By John Burton
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North Korea and Japan are likely dominating the thinking of Bank of Korea Governor Kim Choong-soo on whether to cut interest rates when the central bank meets today for its monthly monetary policy deliberations.
The two neighbors have delivered twin blows to Korea’s economy. North Korea’s recent bellicose threats are starting to panic foreign investors, who are pulling money out of the stock market and causing the value of the won to fall against the U.S. dollar as a result.
A prolonged nuclear crisis could also affect foreign direct investment in South Korea. General Motors suggested last week it might be forced to move production from its car plants in South Korea if the nuclear stand-off continues.
Ironically, the currency weakness may come as good news to Seoul, which has been worried recently about Japan’s monetary easing because it is making the yen cheaper and consequently improves Japan’s export competitiveness against Korea.
Currency fluctuations between the two countries are important to their overall economies since they compete globally in many of the same industries from cars and electronics to machinery and shipbuilding.
The strong export performance of Korea since the global financial crisis of 2008 has largely been due to a weak won. But that advantage is now being eroded by the switch in Japan’s monetary policy under its new Bank of Japan Governor Haruhiko Kuroda. Last week he announced an unprecedented and aggressive easing of Japan’s monetary policy to stimulate the comatose economy.
The combined worries over a weakening Japanese currency and North Korean threats have already had an impact on the Seoul stock market, which has underperformed most Asian bourses this year.
These developments obviously pose a major risk for Korea, which has already reduced its economic forecast for this year from 3 percent to 2.3 percent. While Korean exporters already complain about the rise of the won against the yen, the pain could get much worse. The won is still nearly 40 percent below its high against the yen reached in July 2007.
The easiest way to keep the won weak is to cut interest rates. That is the strategy being urged by the Park Geun-hye administration and the ruling party.
But BOK Governor Kim and the majority of the monetary policy committee members have been skeptical about this approach. They argue that the current key interest rate of 2.75 percent is already low by historical standards on a nominal basis.
The central bank has refused to embrace the unconventional monetary policy of printing money to stimulate the economy that has been adopted by the U.S., the U.K. and now Japan. Instead the BOK prefers to stick to its traditional method of intervening in the foreign exchange markets to put a lid on won’s rise.
There are several reasons for BOK’s reluctance to cut interest rates. One is the fear that a lower rate would lead to a bout of renewed inflation, stoked by the availability of cheap money.
Another is the suspicion that rate cuts would encourage increased borrowing and add to the excessively high ratio of household debt to disposable income, which stood at 155 percent at the end of 2012.
But such concerns are puzzling, at least in the near term. The household debt burden is crushing domestic consumer demand and consequently keeping inflation in check. Moreover, lower interest rates would make it easier for households to pay off their mortgages and reduce their debt burden, similar to the deleveraging that has taken place in the U.S. This would set the stage for a recovery in domestic demand later.
The Bank of Korea has also argued that it sees no need to prop up the economy with an interest rate cut because it believes the export-orientated economy will rebound as a result of a global synchronized recovery this year.
There are signs that optimism may be misplaced, however. Europe is facing continuing headwinds in solving its financial crisis as shown by the recent banking problems in Cyprus. The economic recoveries in the U.S. and China appear to be weaker than what was predicted at the beginning of the year. The growth in Korean exports in January and February was tepid.
Adding to the hesitation of the BOK to cut rates is its desire not to be seen to be bowing to government pressure to ease monetary policy. The issue of maintaining the appearance of central bank independence is a strong motivating factor for Governor Kim and the BOK employees. Nonetheless, the BOJ’s radical change in monetary policy may provide a face-saving pretext for the BOK to go ahead with the interest rate cut today.
Governor Kim may be right about the long-term inflationary impact of global monetary easing, a concern shared by many economists. But an interest rate cut now is the correct course for Korea’s near-term recovery.
John Burton, a former Korea correspondent for the Financial Times, is now a Seoul-based independent journalist and media consultant. He can be reached at johnburtonft@yahoo.com.