© YONHAP News

On December 19, the U.S. Federal Reserve raised its benchmark interest rate for the fourth time this year by a quarter percentage point, widening the rate difference between the U.S. and Korea to 0.75 percentage point. But the U.S. central bank also hinted that it may slow down the pace of rate increases next year, lowering 2019 hike projections from three down to two.

Here is Oh Jung-geun(오정근), professor of IT and Finance at Konkuk University, to examine the effects of the latest U.S. rate decision and how Korea may respond. First, Professor Oh explains the backdrop for the Fed hike. 

The U.S. economy is in good shape. It expanded at a strong 4.2 percent annual growth rate in the second quarter of this year and 3.5 percent in the third quarter. The Federal Reserve forecasts that the local economy will grow 3.0 percent overall this year, with the potential growth rate estimated at 2.4 to 2.5 percent. Simply put, the economy is doing very well, with the average per capita income in the nation surpassing 60-thousand dollars recently.

Moreover, the unemployment rate of 3.7 percent goes beyond the 5 percent minimum unemployment rate many predicted the U.S. could not go below. 

However, the inflation rate is about half a percentage point higher than is considered healthy. At 2.5 percent, there are growing concerns of an economic bubble. These factors combined motivated the Fed to raise its policy rate, despite President Donald Trump’s repeated requests not to do so. 

In regards to the December rate hike, the Fed noted that the U.S. economy has been growing fast and the job market has improved. Unemployment, in particular, has dropped to the lowest rate in nearly 50 years. Wary of the possibility of an overheated economy, the Fed decided to raise rates. 

Back in the 1980s, the U.S. raised the rate to as high as 20 percent to fight inflation. When the economy entered a recession in the wake of the 2008 global financial crisis, the rate remained in the zero percent range. But the Fed began to normalize rates in December 2015 when the economy showed clear signs of recovery. From next year, though, the U.S. is expected to slow the pace of its monetary tightening. 

The Fed was expected to lift the rate four times this year and three times next year. But many members of the Federal Open Market Committee seem to have agreed on two increases for next year. This decision reflects a growing belief that the U.S. economy may begin to slow.

The Federal Open Market Committee has reduced the number of projected rate increases for next year from three to two, due partly to growing uncertainties about the U.S. economy. Indeed, the U.S. central bank lowered its forecasts for the nation’s GDP growth this year to 3 percent from 3.1 percent, and from 2.5 percent to 2.3 percent for 2019.If the Fed raises the base rate only twice next year, Korea will be given room to operate its monetary policy in a more flexible way. But it means only a little less pressure on Korea to raise its own rate to catch up with the U.S. The Korea-U.S. interest rate reverse as a result of the Fed’s continuing rate hikes has some fearing an outflow of foreign capital from the Korean financial market. 

The Bank of Korea is caught between a rock and a hard place now. The domestic economy continues to decline, while Korea’s overall household debt has reached a staggering 1,500 trillion won, or roughly 1.3 trillion US dollars. 

There are more than 1.2 million “marginal households,” which refer to those with a debt service ratio or DSR above 40 percent of their income or those whose debt exceeds their assets. DSR is the ratio of a family’s total debt payments—principal and interest—to its annual income. Also, the combined debt of self-employed individuals amounts to 600 trillion won or about 540 billion US dollars. Among the self-employed with debt, 150-thousand are considered extremely high risk. There are also so-called “marginal firms” that are unable to earn enough operating income to pay interest and principal on their borrowing. 

Judging from this economic situation alone, the Bank of Korea has to lower the interest rate. But the bank should also consider the possibility of foreign funds exiting the market. So it is stuck in the middle of a domestic slump and pressure to raise the interest rate. One thing for sure is that the Asian foreign exchange crisis in the late 1990s should never happen again. So I imagine the central bank will have to lift the rate anyway. 

A wider rate spread between Korea and the U.S., along with a global economic slowdown, may lead to foreign capital outflow. On a more serious note, however, rate hikes will place a heavier burden on the already struggling individuals and companies in debt and dampen the local Korean economy further. Lastly, Korea’s exports may also be affected by the U.S. rate increases. 

Rising interest rates in the U.S. have led to a strong dollar trend, which means a weaker Korean won against the dollar. But the problem is that the Japanese yen is weakening even faster. 

Unlike Korea, Japan doesn’t feel the need to raise its interest rate to prevent a capital outflow. The yen itself is one of the world’s key currencies, and Japan has an unlimited currency swap arrangement with the U.S. Federal Reserve. Japan has near-zero possibility of being hit by a foreign currency crisis. So the country maintains a money-easing policy or a weaker yen trend. This makes the Korean won stronger against the yen, and the decline in the won-yen exchange rate will hurt Korea’s exports. 

Depreciation of the Korean won will boost exports and help revive the local economy. But the value of the Japanese yen is falling more sharply, raising concerns that Korea may lose its export competitiveness in a global market where the two countries are competing. 

Most of all, the recent U.S. rate increase may slow down economic growth of the U.S. and bring about contraction in demand overall. This could fuel a general preference for safe assets and avoidance of risky assets to accelerate an outflow of capital from emerging economies. This bodes ill for emerging markets, where Korea is trying to expand its exports to.   Thus, policymakers in Seoul must craft proper measures to address these factors.

Foreign investors may choose to leave the Korean market in order to leverage foreign-exchange rates amidst a strong dollar. But if the Korean economy performs well enough to cause stock prices to rise, investment may stay rooted in the local financial market. It is thus important to improve the business environment to help Korean companies make more investment and earn better profits so foreign investors are reassured that Korean shares will keep rising despite the dollar’s appreciation. 

A slower rate hike by the U.S. may ease global economic sluggishness and reduce volatility. For Korea, the rising value of the dollar triggered by the U.S. interest rate hike may give a price-competitive edge to Korean goods in the international market. 

So, in a sense, the U.S. rate increases could influence the Korean economy in a positive way. Households, companies and the government in Korea must use the situation as an opportunity to strengthen their fundamentals and raise economic vitality.