ⓒ YONHAP News

On October 18, the Bank of Korea’s monetary policy board froze the benchmark interest rate at 1.5 percent for the eleventh straight month, and downgraded its 2018 growth outlook to 2.7 percent, much lower than a previous projection it made early this year. Here’s Dr. Kim Wang-jung(김완중) at the Hana Institute of Finance to discuss why the central bank decided to keep the rate unchanged and how its financial policy may evolve. 

The Bank of Korea or BOK maintained its policy rate for the eleventh consecutive month after lifting it in November last year. Inflation pressure is one of the major factors the bank takes into account when raising the interest rate. An increase in private consumption and investment will fuel inflation pressure. But Korea’s consumer price index has remained in the mid-1 percent range this year, lower than the central bank’s 2 percent target. 

Moreover, economic indicators have worsened due to unfavorable external factors, including the trade dispute between the U.S. and China and financial uncertainties in emerging economies partially due to a continuous rise in interest rates in the U.S.  In this situation, the BOK probably found it difficult to raise the key interest rate. 

The BOK’s decision to hold the interest rate untouched was influenced by rising economic uncertainties in the global economy as well as worsening economic data in South Korea. Dr. Kim explains that a rate hike under these circumstances might worsen the economic downturn. 

In an economic slowdown, household and corporate income decreases. A decline in their income will worsen their fiscal health and increase insolvency risks. Financial institutions will then charge higher interest rates on those households and companies, reflecting their credit risk. A rate increase in this situation will dampen consumer and investor sentiment quickly. Households will cut their spending and companies will tend to conserve cash rather than make investment. That will slow the overall pace of economic growth. 

In brief, money-tightening rake hike actions in the economic downturn may cause a deterioration or protraction of the slump as side effects. That’s why the central bank usually refrains from raising the key interest rate in the recession. 

The Korean economy continues its sluggishness. Consumer price growth hovers around 1.6 percent to stay below the BOK’s target inflation of 2 percent. Poor employment numbers have also led the bank to leave the interest rate unchanged. The bank expects that 90-thousand new jobs will be created for the entirety of 2018. The number is only half of the previous estimate announced in July, and this number isn’t expected to improve much next year. 

A rate increase in this current situation will put a damper on consumption, while a prolonged recession will worsen employment conditions even further. These concerns are reflected not only the BOK’s decision to freeze the rate but in the downward adjustment of its growth forecast. 

The BOK lowered its 2018 growth outlook for South Korea to 2.7 percent from 2.9 percent, against the backdrop of waning growth momentum. Export conditions have worsened due in part to intensifying global trade protectionism and the deepening Sino-U.S. trade war, while the local construction industry has been hit by the government’s strong real estate regulations. With demand for semiconductors – a major Korean export – expected to weaken in the coming years, facility investment will also likely decline. 

Concerned by the poorer-than-expected economic data in the second quarter, the central bank revised down its growth forecast by 0.2 percentage points. On an even more serious note, the bank could make additional downward revisions of growth projections for next year. Amid the rising possibility of a drawn-out trade war between the U.S. and China, South Korean exports to China are feared to face significant obstacles. This is an alarming situation because the Korean economy depends heavily on exports to China. 

Early this year, the BOK predicted that the Korean economy would grow at 3 percent this year. But in July, it marked down the growth forecast to 2.9 percent. And only three months later, the bank again downgraded it to 2.7 percent. This is lower than the market projection of 2.8 percent and the lowest annual growth for the nation since 2012 when exports decreased due to the financial crisis in Europe. 

The bank also adjusted down its 2019 growth outlook to 2.7 percent, 0.1 percentage points lower than an earlier prediction in July, casting a negative outlook for the local economy next year. However, the bank cannot keep the rate unchanged forever. 

The U.S. Fed is set to raise its key interest rate again in December this year and carry out three more rate hikes next year. South Korea, on the other hand, has frozen its own rate for eleven straight months, causing the U.S.-Korea rate difference to increase to 75 base points. The rate gap could reach as much as 100 base points or even higher, stoking concerns over a possible outflow of foreign capital from South Korea. 

But the rate difference is not the only factor that foreign investors take into consideration. They also examine the soundness of the foreign exchange market, the amount of foreign reserve holdings and various other factors. So, I don’t expect a massive outflow of foreign investment from South Korea. 

Still, the 2019 growth outlook for South Korea is not bright, while the Fed is expected to conduct more rate hikes. In that situation, the BOK cannot continue to freeze its key rate.

This year, the U.S. Federal Reserve lifted its base rate in March, June and September. As a result, the rate gap between South Korea and the U.S. has widened to point-75 percentage points. Another rate hike by the U.S. in December may broaden the rate spread with South Korea to 1 percentage point if the BOK does not keep pace with the U.S. in terms of rate adjustments. This raises concerns that foreign capital may flow out of South Korean financial markets. 

Uncertainties in the local financial and real estate markets are placing more pressure on the BOK to hike the interest rate. In fact, two members of the seven-member monetary policy board of the bank stressed the need for a rate hike. Analysts predict that the bank will lift the rate in November at its last monetary policy meeting of the year. 

Given the BOK’s growth projections of 2.7 percent for both this year and next year, there is a strong possibility that the bank will raise the interest rate in its next monetary policy meeting on November 30. If not for some reason, it will lift the rate in January next year. As the U.S. Fed is set to make another rate hike in December, the BOK’s rate increase next month will convince the public that it is preemptively responding to the widening Korea-U.S. rate gap. So, the BOK is highly likely to raise the interest rate in November. 

The BOK made a difficult decision to maintain its policy rate last week, out of concerns over an economic downturn. We’ll keep our eyes on what decision it will make next month—whether it will actually lift the rate, as it has suggested.