Explaining Korea's policy mix

By Park Chong-hoon

"Fiscal and monetary policies should complement each other, depending on the economic situation." This quote was made jointly by the Economy and Finance Minister Hong Nam-ki and the Bank of Korea (BOK) Governor Lee Ju-yeol after their breakfast meeting July 2.

This can be taken to mean that the BOK and the government will each do their part to support growth and financial stability through differing but complementary policies. The government will continue to expand fiscal policy to support the economy, while the BOK will reduce liquidity to counter the risk of an asset price bubble.

The BOK's hawkish stance is currently the biggest concern in Korea's financial markets. The BOK has strongly indicated that it plans to hike its base rate before the end of the year amid asset-bubble and inflation concerns.

This hawkish stance is in stark contrast to the government's current focus on revitalizing the economy ― the government has announced an extra budget of 33 trillion won ($28.8 billion) to support the economy, including handouts of national disaster funds to households. At the same time, Korea imposed strict social distancing measures for two weeks starting July 12 as COVID-19 cases continue to increase while a vaccine shortage slows the vaccination rate.

Interestingly, Hong, concurrently deputy prime minister, has been supportive of the BOK's expected rate hike. Government economic policy makers, tasked with supporting growth, typically dislike rate hikes because they can hamper growth and jobs.

Hong said that monetary policy and government policy may take different paths, depending on economic conditions, but can still complement each other. So while rate hikes and fiscal expansion may appear to be in conflict, they are two parts of the same policy mix aimed at containing risks to financial stability while supporting growth.

To understand this seemingly contradictory policy mix, it is important to understand Korea's political economy, going beyond a purely economic approach. Politics and economics are inter-connected and inevitably influence each other. It is natural for the government to seek an economic solution that will position it well with voters, particularly with elections coming up.

A significant economic phenomenon brought about by the pandemic has been widening inequality. Liquidity provision has raised asset prices, exacerbating the wealth gap between those who own assets and those who do not.

In addition, some industries are rapidly returning to normal or even growing faster than pre-COVID levels, while others continue to struggle with the impact of the pandemic; this is leading to a "K shaped," or imbalanced, recovery.

From the political economy perspective, government policy needs to address the widening wealth gap through income redistribution policies. The recently announced extra budget of 33 trillion KRW, which will channel funds to lower-income households and pandemic-affected sectors, is one such policy.

On the other hand, asset prices ― especially real-estate prices ― have risen recently, and household debt has increased, posing risks to financial stability. While a BOK rate hike should reduce this risk, it will also place an economic burden on small and medium-sized enterprises (SMEs) that have borrowed heavily to survive during the pandemic.

A rate hike will increase interest payments and suppress consumption, to the detriment of SMEs. While government fiscal policies will provide support, a rate hike will have the macroeconomic impact of slowing the rebound. So, from a political economy perspective, it may be difficult to justify in that sense. This is why offsetting fiscal expansion is needed.

At the same time, a rate hike may be politically expedient considering the negative impact of rising real-estate prices on Korea's younger generation ― who are expected to be the decisive voting bloc in next year's elections.

The older generation, who tend to own real estate, want asset prices to rise to support their retirement. However, rising prices are an economic burden for younger Koreans seeking to buy their first homes or upgrade as their children grow. According to the Korea Real Estate Board, housing prices have risen for 22 consecutive months, while rents have increased for 21 consecutive months.

The key reason why the ruling party lost the recent Seoul and Busan by-elections is that younger voters swung toward the opposition party due to the perception of the current government's failed real-estate policy. While the government has implemented more than 20 real-estate measures aimed at containing price rises, they have not worked so far. A rate hike may be the only effective tool to stem the increase.

At the BOK's Monetary Policy Committee meeting July 15, rates were kept on hold, but there was a dissenting vote for a rate hike ― despite the current wave of the virus. We believe the BOK wanted to signal that it will hike rates soon. As Lee mentioned, it is time to pay more attention to financial imbalances than to growth itself.

Park Chong-hoon (ChongHoon.Park@sc.com) currently heads the Korea Research Team at Standard Chartered Korea. Before joining the bank, he worked as a senior research fellow and head of telecommunication policy at the Korea Information Society Development Institute (KISDI).