The increase of the key interest rate had largely been anticipated, but that does not mean that all economic players are well prepared for the long-awaited end to monetary easing that lasted more than six years.
The Bank of Korea’s decision to increase the base rate to 1.5 percent from a record low of 1.25 percent, which ended a 16-month freeze, reflects the central bank’s positive assessment of the economy.
Gross domestic product is forecast to expand by more than 3 percent this year, buoyed by exports which increased 17.3 percent in the first 10 months of the year from a year ago. The BOK said the Korean economy expanded a higher-than-expected 3.6 percent on-year in the third quarter.
Besides the domestic recovery, the BOK needed to keep up with the US’ normalization of monetary policy. Most of all, it needed to prevent the Korean key rate from becoming lower than the US rate, as the US Fed, which raised its benchmark rate twice this year, is anticipated to raise it again by 25 basis points in December.
In the case of Korea, an increase of 0.25 percentage point from a record low 1.25 percent is not a radical one, but it nonetheless signifies a shift in the central bank’s monetary policy.
All the economic players -- especially households and businesses that had been used to live with low-interest debt -- now should prepare for a different situation.
In fact, it still is too early to say that the Korean economy is in good shape. Major industries, except the semiconductor and petrochemical sectors, are still struggling with a slump. Household income has dropped for two consecutive years. Unemployment continues to remain a big problem.
Against this backdrop, households must bear the brunt of the new economic environment as they already hold a record-high debt of 1,419 trillion won ($1.3 billion), with the average per-household borrowing standing at nearly 73 million won. The latest increase of 25 basis points will force the households to take up 2.3 trillion won in additional interest payments.
Another problem is that about 50 percent of the household debt came from second-tier lenders like savings banks that charge higher rates than commercial banks.
Higher interest rates would also impose heavier burdens on businesses too. It should not be underestimated that even now the operating profits of 3 out of 10 companies fall short of their interest payments. Moreover, a push up of interest rates strengthens the won, which would threaten the bottom line of exporters. Then add the hike in the oil prices to the list of imminent challenges.
The real estate market is another area of deep concern. Mortgages account for much of the household debt and high interest rates coupled with government loan regulations could prompt a steep fall in house prices. That is exactly what we witnessed in Japan’s lost decades.
All in all, everyone needs to leave behind the comfort of cheap and easy borrowing and embrace deleveraging. The government’s efforts to rein in mortgages is part of such endeavors, but more measures are needed to reduce its total size.
One realistic way to cope with interest rate increases would be helping businesses and households build up financial health so they can repay debt or not to rely on new loans. Efforts to free businesses from regulations, helping them find new growth engines, create jobs and raise household income are important in that regard.