By Kim Tae-gyu
The interest rate gap between Korea and the United States will likely narrow this week as the former is expected to freeze its rate at 1.25 percent and the latter is moving to raise its to 0.5-0.75 percent, observers said Monday.
This puts the Bank of Korea (BOK) in a quandary over its interest rate policy for next year when the country’s economy might struggle due to a slowdown in consumption and political uncertainties regarding President Park Geun-hye’s impeachment.
“For the time being, the BOK is expected to maintain the benchmark interest rate at 1.25 percent and it will reevaluate its position if the U.S. raises its rate this week,” said Shinhan Investment Corp. analyst Lee Sun-yup.
“It would be difficult to slash the rate if the U.S. phases in an upward trend. On the other hand, it would be difficult to lift the rate in consideration of the economic slump. Chances are the BOK will keep the rate at 1.25 percent for the time being although there are requests to decrease it further.”
The Korea Development Institute recently urged the BOK to cut the policy rate to invigorate the weak economy even though the central bank has maintained the historic low rate of 1.25 percent for over half a year.
After making a downward adjustment of its expectations for next year’s growth from 2.7 percent to 2.4 percent, the state-backed think tank suggested the government bolster its financial policies.
Societe Generale Securities Korea economist Oh Suk-tae predicted that the BOK would cut the base rate twice to 0.75 percent next year in desperate bids to underpin the economy.
“It is likely that the government will not be able to bring about proactive financial measures to boost the economy while the President is impeached,” Oh said. “There remains only one tool ― a monetary approach.”
Recently, the head of a local commercial bank also told The Korea Times that the BOK will not raise the interest rate next year.
“The central bank will only raise the key rate next year in the face of big inflationary pressure, which is highly unlikely,” he said.
However, observers point out that such an analysis works only for a closed economy. For an open economy such as Korea, external factors including overseas investors and foreign exchange rates should be considered. Foreign capital accounts make up around a third of the country’s main bourse.
“The market consensus is that the Federal Reserve will raise its benchmark rate two or three times next year and the number might increase if incoming President Donald Trump’s pump-priming measures result in inflationary pressures,” said Prof. Kim Sang-jo at Hansung University.
“How can we afford a situation where our interest rate is lower than that of the U.S., which would wreak havoc on our economy.”
His concerns are that investors in Korean bonds will sell them if the rates of U.S. bonds, which carry less risk, stay the same and Korea trims its interest rate too much. Plus, Korean investors could purchase more dollar-denominated bonds.
If that happens, the Korean won would depreciate, thus prompting international investors on the Seoul bourse to leave for fear of foreign exchange losses; the classic case of capital flight.
BOK Governor Lee Ju-yeol also pointed out, “Our interest rate cannot be lower than that of the U.S., which issues a key currency.”
By contrast, Societe Generale economist Oh countered that such negative effects would be limited.
Another big woe of policymakers is the ever-rising household debt, which is estimated to have topped 1,300 trillion won as of the end of this November. The debt is expected to approach 1,500 trillion won next year.
In this climate, IBK Securities research head Lee Jong-woo said that the BOK would freeze the interest rate at 1.25 percent over a long time.
“If the interest rate goes up, many households would be in trouble. The underwater homeowners would pose a serious threat to the whole economy,” he said.
“If the interest rate goes down, household debt would further soar to pose a long-term but bigger threat to the economy. Against this backdrop, the BOK would keep the rate unchanged next year.”