ⓒ YONHAP News

The Bank of Korea has frozen its key interest rate again and lowered its growth outlook for the second half of this year. In a monetary policy meeting on July 12, the central bank left its benchmark interest rate unchanged at 1.5 percent, holding the rate for the fifth consecutive time since a 0.25 percentage point increase in November last year. It also revised down this year’s economic growth forecast to 2.9 percent from the previous projection of 3 percent. Here is Choi Bae-geun, economics professor at Konkuk University, to examine the reasoning behind this decision. 

The interest rate has remained unchanged, as anticipated, amid the worse-than-expected growth forecast in the first half of the year and rising uncertainties at home and abroad. The Bank of Korea’s revised growth projection was released after it froze its policy rate. The bank downgraded its growth outlook for this year from 3 percent to 2.9 percent. For next year, it also slashed its growth estimate by 0.2 percentage point to 2.8 percent from its earlier forecast of 3 percent. This shows that the central bank’s economic outlook is not very bright. 

In a press conference after the monetary policy meeting, Bank of Korea Governor Lee Ju-yeol cited sluggish employment as the reason for the rate freeze. The monthly number of newly added jobs in Korea only remained around 100-thousand for the fifth straight month in June—the longest job stagnation since the 2008 global financial crisis. The manufacturing sector, in particular, has shed jobs over the last three months, due to a series of restructuring in the shipbuilding and auto industries as well as a contraction in the construction industry as a result of a decreasing number of housing orders. Worse yet, the escalating trade war between the U.S. and China is affecting South Korea’s exports negatively, forcing the Bank of Korea to lower its growth forecast for the second half of the year. 

Consumption, investment and exports are all worse than expected, contributing to a downgrade in growth projections. Moreover, the intensifying trade dispute between the G2 will not be settled easily. The U.S. wants to bring China to its knees in their trade war. Otherwise, the U.S. will have to admit that it is on an equal footing with China. China, for its part, thinks that if it retreats now, the U.S. will keep trying to tame it and China will be stuck in second place forever. That’s why both sides refuse to budge. The two nations account for about 40 percent of South Korea’s total exports. That means South Korea will take a direct hit from their trade conflict. 

It seems an all-out trade war has begun between the world’s two largest economies. The U.S. imposed 25-percent tariffs on 34 billion dollars worth of Chinese goods, starting July 6. On the same day, China struck back with tariffs on American imported cars. And on July 11, the U.S. said that it would slap 10 percent tariffs on imported products from China worth 200 billion dollars. Their intense tug-of-war is expected to deal a blow to South Korea, which exports a large amount of intermediary goods that are shipped to China via the U.S. or vice versa. In an even more serious scenario, the ongoing friction between the U.S. and China might escalate into a global trade war. 

If the U.S., China and the EU each raise tariffs by 10 percentage points, it is estimated that global trade will shrink by 6 percent and South Korea’s exports will decrease by 36.7 billion dollars. Falling exports and the shaky financial market amid sluggish employment will put the Korean economy in danger. With these concerns in mind, some raise the need for a rate hike. But the Bank of Korea remains circumspect. 

One of the seven members of the Monetary Policy Board held a minority opinion for an interest rate increase. The opinion shows that South Korea needs to find an exit from the prolonged low interest rate trend. Amid the gloomy projection of a recession in the global economy next year, some experts are calling for the Bank of Korea to push up the key interest rate so it can lower it again later when the economy deteriorates. As the bank is reluctant to raise the interest rate, concerns are rising over possible capital outflows and uncertainties are growing in the foreign exchange market. In this regard, a rate hike seems to be necessary. But the bank finds it difficult to make the move due to the slowing economy. 

The central bank refrains from lifting the key rate due to slow economic recovery. In a monthly economic evaluation, the Korea Development Institute said that growth in domestic demand and the pace of economic improvement have slowed considerably. A rate increase in this situation may lead to weak private consumption and a higher insolvency risk of massive household debt. However, the bank cannot freeze the rate forever. The U.S. raised its benchmark interest rate by 0.25 percentage point in March, reversing the interest rate gap between Korea and the U.S. for the first time in ten years and seven months. Another rate hike in the U.S. in June widened the gap to 0.5 percentage point. And additional rate increases are anticipated in the U.S. in the second half of the year. 

The Federal Reserve Board of Governors in the U.S. plans to raise the key interest rate two more times this year, possibly in September and December, and the rate gap between Korea and the U.S. could widen further to 1 percentage point. That might cause rapid capital outflows from Korea. Moreover, Japan and the EU are showing signs of ending their easy-money policy this year and shifting to money-tightening next year to keep pace with the U.S. In that situation, South Korea will also have to increase its key rate. So it should prepare for the expected rate hike. I think Korea should lift the rate in August, as the monetary policy meeting will be held in October and November, not in September. The U.S. Fed is likely to raise its rate in September and December. If the U.S. raises it in September, and Korea doesn’t lift the rate in August, the rate gap will be widened even further. 

The U.S. is expected to lift its interest rate soon, while central banks in Japan and Europe are likely to move toward monetary tightening. Rate hikes in the U.S. have added financial jitters to emerging economies, including Argentina and Turkey. The situation is placing a burden on the Bank of Korea, which has held its interest rate unchanged since last November. The bank should also fend off risks from the trade conflict between the U.S. and China. 

China is the largest holder of U.S. bonds worth 1.1 trillion dollars. If China sells the U.S. bonds, the bond prices will plummet, causing their yields to go up because bond yields move in the opposite direction of prices. It will push up market interest rates sharply and stock markets will plunge. In this worst-case scenario, financial markets and foreign exchange markets will also be unstable, resulting in a recession in the global economy. Of course, we hope this scenario will not become a reality. But we still have to prepare against it. 

Economic indicators, including investment, consumption and employment, are looking bad, while the U.S. and China is engaging in a fierce trade war, adding to the difficulty of the South Korean economy for the second half of the year. 

That’s why the government needs to come up with comprehensive countermeasures. The Bank of Korea will convene its monetary policy meeting in August, October and November. We’ll have to wait and see what decision it will make to overcome the crisis.