The Bank of Korea raised its benchmark interest rate by 50 basis points to 3 percent on Wednesday. The eighth hike since August last year sent the rate to the 3 percent range for the first time in 10 years.
The so-called “big-step” rate increase came as the central bank had few other alternatives in the face of stubbornly high inflation and the local currency’s slide against the US dollar that could put extra upward pressure on import prices.
South Korea’s consumer prices -- a key barometer of inflation -- rose 5.6 percent last month from a year earlier, and is expected to rise or remain at a high level due to external factors, particularly high energy prices following last week’s decision by OPEC+ to slash oil production output.
The BOK’s latest move reveals a couple of notable changes in its policy stance. First, it held a view in favor of a 25-basis point increase to tame inflation in August. But such position proved untenable as the US Federal Reserve took a third straight “giant step” rate hike of 75 basis points last month, widening the gap in benchmark interest rates between the two countries.
The US rate, now between 3 and 3.25 percent, is forecast to reach 4.5 percent or a higher level by the end of this year, while the Bank of Korea is likely to settle for 3.5 percent through another 50 basis point hike when it holds this year’s last rate-setting meeting in November.
Second, the central bank used to downplay the possibility of a capital outflow stemming from the interest rate gap. In a clear sign of changed stance, BOK Gov. Rhee Chang-yong admitted that high expectations for the weakening of the local currency could add to the outflow of capital and distort the local foreign exchange market, leading to financial instability.
Along with other weakening currencies around the world, the Korean won has lost its value by some 20 percent this year against the greenback, hovering around a 13-year low. This is a big concern for Korean policymakers as it could fan the flames of inflationary pressure further by sending import prices higher.
The BOK’s move to raise borrowing costs seems inevitable in consideration of dire financial conditions. But there are tricky problems linked to the continued hike of interest rates, as it could hurt the nascent economic recovery and bring in a much-dreaded economic slowdown.
The outlook looks far from positive. The International Monetary Fund, for instance, trimmed the country’s growth forecast for next year to 2 percent this week, down from 2.1 percent it forecast three months ago.
The Korea Development Institute said in a report Tuesday that the country’s business survey index, or BIS, for the manufacturing sector dropped to 73 this month, down from 82 in September.
In May, South Korea’s major conglomerates pledged to invest a combined total of 1,000 trillion won ($700 billion) during the Yoon Suk-yeol administration. But they are delaying their large-scale investment projects to next year, signaling tough conditions ahead for employment and business activities.
Another worry for policymakers is debt owed by households and small- and medium-sized companies. As of June, the total household debt is estimated at 1,869 trillion won, a record-high level that is equivalent to 137 million won in debt per household that took out loans.
The interest rates of housing loans at banks have nearly tripled to near 8 percent in a year, posing a serious threat to households who are struggling to service rising interest payments. At the same time, a rate hike of 50 basis points by the central bank is expected to push up the interest owed by companies by close to 4 trillion won, according to the Korea Chamber of Commerce and Industry.
Given that the BOK is expected to keep raising rates until it brings inflation under control, economic policymakers should lose no time in mapping out more comprehensive measures to help soften the side effects of higher borrowing costs on households and companies.