By Kim Tong-hyung
The beast of inflation has escaped its cage, but it needs further watching whether the Bank of Korea (BOK) will attempt to restrain it.
These are extremely challenging times for monetary policy, and the central bank faces a choice between leaving rates at 2.75 percent and risk letting prices get further out of hand or elevate borrowing costs and pray that a double-dip recession can be avoided.
The country’s inflation alarm has been growing louder and more urgent with prices continuing to rise faster than the government’s 3 percent target, and this has put the bank under increasing pressure to retaliate by raising interest rates.
But a rate hike will require massive courage as fears arise over the possibility of an oil-induced recession, triggered by the political unrest in the Middle East and North Africa, decimating world markets and dealing a crushing blow to Korea’s export-dependent economy.
The next meeting for the BOK’s monetary policy committee is scheduled for March 10 and the right course of action has never been more obscure at such a critical moment. Although the spiking energy prices will be hitting regions and countries differently, analysts have Korea among the more badly placed economies for coping with the problem.
``If oil prices continue to soar and tip the global economy into recession, the effect on Korea would be devastating, much worse than what it had to encounter in 2008,’’ said Shin Byeong-ghil, an economist from Solomon Investment and Securities.
``Should political instability in the Arab world and North Africa continue beyond the next two or three months and the price of oil surpass the $150 per barrel level, this could be the point where we begin to see Korea’s economic fundamentals crack. At least during the previous recession, Korea had retained its strength in exports, but now with the price pressure increasing significantly from the manufacturing level and the fear of stagflation growing domestically, the country is very badly positioned to deal with another crisis.’’
The inexorable rise in the cost of black gold is related to the revolt in Libya and concerns that that the unrest could spread to other oil producers.
The worst-case scenario for world economies would be enduring a shock comparable to those caused by the oil embargo of 1973, the Iranian revolution and the Gulf War of the early 1990s.
The price of Dubai crude, which makes up the bulk of Korea’s imported oil, closed at just a hair below $110 per barrel on Thursday (KST), after hovering in the low 90s in January, according to the Korea National Oil Corporation. Brent oil was around $115 a barrel and U.S. crude was above $100 as well, the state-run agency said.
Despite the higher price tags, policymakers aren’t ready to hit the panic button just yet. Prices have mainly been pushed up by the specter of severe supply disruption, not the actual force of it.
Although its low-sulfur crude has been in high demand for diesel and jet fuel, Libya accounts for less than 2 percent of the global crude production. Even when combining Libya’s capacity to those of other politically troubled nations like Algeria, Yemen, Syria and Oman, these countries barely provide 5 percent of the world’s oil supply.
But obviously, all bets are off should the turmoil spread to Saudi Arabia, the region’s kingpin oil producer that has been counted on to make up any shortfalls from elsewhere.
``The unrest in the Middle East is clearly the biggest threat to the Korean economy right now and we are closely monitoring the situation. Of course, all eyes are on Saudi Arabia, and the world economy will be battered severely if they ever get dragged in,’’ said a senior official from the Ministry of Strategy and Finance.
``We are trying to analyze how the geopolitical risks in the Middle East could affect a small, open economy like ours. We are writing contingency plans for every scenario we can come up with.’’
Fuel prices, along with the rocketing prices of other commodities, have reached an extreme-enough level to raise the prospects of distress for the world economy.
A global recession prompted by a surge in oil prices will certainly deteriorate Korea’s export prowess and take the air out of consumer spending. But these aren’t even the biggest concerns for the country, according to Kim Jong-soo, an economist at NH Investment and Securities.
A recession could push the economy firmly into the territory of ``stagflation,’’ the depressing condition of no growth and higher prices, and eventually devour personal wealth.
Korea’s historically high levels of household debt, which at well over 900 trillion won (about $808 billion) is a near-equivalent of an entire year’s gross domestic product (GDP), has been considered as the biggest potential threat to the country’s financial stability. A new recession might push the button to set off this ticking time bomb, Kim said.
The borrowing binge over the past decade has been driven in large by the speculative demand on the real estate market, with low interest rates urging Koreans to buy property at any imaginable price in blind faith that its value will appreciate forever.
Property prices dipped after the downturn of 2008 but have been rebounding recently. The next economic bust could be lethal.
``In the worst case scenario, it will be like the late 1990s Asian financial crisis all over again for Korea. Interest rates will go up dramatically with stagnation taking hold and households, crushed under even larger debts, will be scrambling to sell off their devaluated properties and other assets in a vicious cycle,’’’ Kim said.
``With uncertainties growing, the value of the local currency could skid out of control with investors moving toward safer assets, and this will intensify the price pressure even more.’’
Shinhan’s Shin predicts the BOK will keep the rates on hold for March as policymakers will need more time to monitor the unrest in the Arab world and assess the possible effects on the Korean economy. Kim claims that is exactly why the bank should move to raise borrowing costs.
``Should the situation really get out of hand, interest rates will be at much higher levels than now. The BOK will need to prepare the market for such significant hikes by inching up the rates now,’’ he said.
Korea’s annual rate of inflation rose to 4.5 percent in February, its highest level in more than two years, driven by a dramatic increase in food and energy costs, the government announced earlier this week.
The so-called core inflation, which outstrips the impact of food and energy prices from the cost of living, also rose above the government target at 3.1 percent.
The government, which continues to stick with the 5 percent annual growth target, has been reluctant to clamp down on money supply and has been resorting to price controls instead, such as stemming the increase in utility bills, university fees and other items of consumer spending.
Critics wonder whether such price controls will force prices to bounce more dramatically in the latter part of the year with companies cutting supplies due to the compromised profitability. They also claim that the BOK could risk hurting its own monetary credibility if it fails to display commitment to the inflation target.