Ju-yeol Lee, the governor of the
Bank of Korea, recently sent a
strong message that the central bank
might raise its base rate soon. At the
Bank’s October monetary board meeting
last week, he said that “the current economic conditions and inflation trend have
been, to some degree, ripe to pare down an
accommodative monetary stance.”
Governor Lee mentioned that exports and
domestic consumption are improving and
inflation is nearing the central bank’s target of 2 percent. Despite the risks of
China’s retaliation over THAAD deployment and further provocations from North
Korea, he was confident about the Korean
economy as facilities investment and consumption have been quite active, improving amid geopolitical challenges.
Of course Lee didn’t explicitly mention a rate hike like Federal Reserve Chairwomen Janet Yellen did several times this year. He only mentioned or hinted the ripeness of the environment to lessen the accommodative monetary policy. Also, he reiterated with some caution that more time is needed to assess whether the current economic situation is permanent or temporary. But this was a clear enough sign that the bank is serious about the rate hike. It is very clear that the bank’s conviction about changing the accommodative monetary policy rests on the belief of overall upturn in economic conditions. Indeed, the bank readjusted its outlook for economic growth for 2017 to 3 percent from 2.8 percent last July. In addition, the rate has been sitting idle for too long. The current rate of 1.25 percent stayed for as long as 16 months since June 2016—one of the two longest lapses in time since the bank adopted the rate policy in 1999. Therefore, it is not surprising that there was a dissenting vote among the board members, urging a quicker rate hike. The immediate response in the market was a general rise in the market yields of the government bonds.
Such an action caused the household
debt burden to react the quickest.
According to research, the interest burden
of annual household debt is expected to
increase from KRW 3.08 million to KRW
4.76 million following a 1 percent hike in
the benchmark rate. And this will put
315,000 households—about 2 percent of
the total—in danger of bankruptcy. Also, a
14.4 percent additional debt service burden clearly puts a dent on consumption.
With household consumption standing at
KRW 800 trillion, KRW 14.4 trillion in
interest burden will take away about 1.8
percent from consumption.
Nonetheless, a 1 percent point increase in the interest rate would not thrust Korea’s entire banking industry into jeopardy. Even in the worst case scenario, only 7 percent of bank assets will become nonperforming and this magnitude is well under the realm of control either by the bank prudence measure or by the central bank. A slight dampening effect in growth after stagnant consumption may well be compensated by increased earnings of banks and deposit holders.
A higher rate is not always riddled with anomalies. It sometimes could work as a blessing. A higher rate allows higher income to depositors. In Korea, aggregate deposits of the banking industry amounts to almost KRW 2.3 quadrillion, and 1 percent point increase in the deposit rate means KRW 23 trillion of extra interest income to the depositors, equaling 2.9 percent of KRW 800 trillion in private consumption. Therefore, an increase in the deposit interest rate could work as a strong stimulant for private consumption. Also, a higher rate would enable banks to create more credit by encouraging more deposits to the banking system. In other words, a higher rate could speed up money supply by the credit creation process. It may sound odd, but it’s true. Under the low rate regime in the past, bank savings have been severly discouraged. Consequently, the credit creation process of the bank has been critically hampered, rendering the
growth of money supply to slow down.
This is manifested by the gradual fall in
the money multiplier. The money multiplier—the ratio of bank savings to the base
money—was 25 in 2000, but shrunk to
16.3 in August 2017. A higher rate environment would also make financial industries more lucrative as it would allow a
higher net interest margin. In addition, this
environment would make financial industries more balanced by channeling funds
from stock markets to other fields such as
bonds, direct investments and various
funds. Under an extremely low rate environment, security markets have been so
overheated as to arouse a bubble-burst in
the market. A higher rate would work for
the balanced development of financial
Now, considering the KRW 1.4 quadrillion in household debt burdens and the possible sluggish construction industry, the bank would like to postpone the rate hike. But then, the rate in Korea will fall short of the US rate. It would cause serious capital outflow from Korea, rendering a substantial exchange rate fluctuation. But the bank can’t let the rate be fixed indefinitely. Persistent capital outflow and following exchange rate volatility becomes even greater. A better solution would be to practice the ‘leaning with the wind’ policy; let the bank follow where the global interest rates and exchange rates go. The market is always afraid lest the government properly readjusts in time. Now, the bank believes that the Korean economy is sound and strong enough. That means a rate hike is imminent, and almost all parties are ready to accept it.