South Korea worries over interest rate hike

Following from a recent news about South Korea’s exchange rate and its record high appreciation since 2008, I want to talk about the general threat that Korea may face in the near future.

According to South Korea Finance Minister Hyun Oh Seok, interest rate rise might pose great threat at home. South Korea have generally fared well despite 2008 financial crisis and Euro zone debt crisis. Just to see few data on inflation control and interest rate;

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We see that there was a huge drop in nominal interest rate from above 5% down to 2%, and at the same time inflation dropped at about the same rate. As a result, the real interest had little influence. This abled Korea to control capital in/outflow and thusly export. Because of lack of much natural resource endowments, Korea is quite dependent on its exports. one of the characteristics that Korean economy shows is that many exports are highly value added items with high technology. To name a few, cell phones, TV’s, naval engineering goods and automobiles.

As a result, in order for South Korea to be really stay on its competitive edge requires favorable financial conditions, especially those regarding exchange rates and interest rates. So, what happened to Korea in the past few months? There has been a huge appreciation in Korean currency Won and many worry that this will be a head wind against its growth.

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Another big concern for Korea right now is climbing household debt level reaching its record high (see graph below) at a wrong time. The Fed is continuing to taper quantitative easing programs, and the talk of whether interest rate will increase sooner than anticipated will also play a role in markets other than that of US. Why Korea should really be worried is that most of household debt is tied to mortgage in floating interest rate. Consequently, if interest rate hike around the world could bring back up the interest rate in Korea, burden on household could cause a series of default.

High debt level and high interest rate are something that Korea is not so fond of with harsh memory of defaulting less than two decades ago. There has been government measures to mitigate mortgage loan by directly bailing out some of highly distressed households, but this has not been so popular for many people on the ground of moral hazard. These kind of approach is also very costly in political games.  Although current level of debt is of course not as bad as the level during the Asian financial crisis in 1996, but it is something to keep in mind over time.

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Another thing I would like to point out briefly is the recent low level of inflation. With target band between 2.5% and 3.5%, the 1.3% Korea has right now may be not so satisfying. Yes, Korea have endured quite well the recent financial crises around the world, but with inflation rate going down, monetary policy instrument may be eroding its power, at least less than it could fully have. I don’t think it is at a worrisome level just yet at nominal interest rate still at 2.5%, but this is another side that Korea should really keep in mind for the next few years.

Although Korea is number four economy in its geographical region of East Asia, it should be still considered as a “small economy.” Yes, it experienced very high growth and despite hardships in the past had came out of its crises at a record speed, the economy is still very vulnerable to financial market around the world. After having such a bitter experience in 1996, Korea’s financial market is one of the most heavily regulated market in East Asia. However, I think in order for Korea to truly grow, it should allow financial sector to grow organically.