End of low inflation-interest rate period could affect Korean economy

International oil prices and interest rates have turned upwards, and the prolonged low inflation and low interest rate period may be coming to an end. Rising inflation and interest rates hold positive since they are the natural outcome of economic recovery. However, there are concerns that they could put a damper on the Korean economy that is showing signs of rebound, albeit very modestly.

Of particular concern is that rising oil prices could put a brake on the current account surplus spree that have been propping up Korea`s economy. According to Korea National Oil Corporation on Sunday, average Dubai crude prices stood at 109.15 U.S. dollars per barrel between September 1 and 20, up 2 percent from August. The prices of Brent Crude and West Texas Intermediate also went up 1.7 percent and 1 percent, respectively, over this period.

Global oil prices have been surging since late last month due to political instability in the Middle East stemming from the Syrian crisis, thus raising concerns of cutbacks in oil supply. West Texas Intermediate prices soared to 110.1 dollars per barrel when the U.S. said it could attack Syria on August 28, the highest level in two years and three months.

The U.S. and Russia on September 14 agreed to destroy Syrian chemical weapons, raising hopes for a diplomatic resolution to the Syrian incident, but experts do not expect oil prices to fall much.

Crude oil demand is rising on the back of economic recovery in the U.S. and China, but unstable political situations in the Middle East will likely hamper oil production. As of Wednesday last week, U.S. crude oil inventories fell 16.4 million barrels in just two months to a record low since March last year.

International raw materials prices are also rising. Oil is necessary to produce and transport raw materials, and thus oil is a preceding indicator for raw material prices. According to London Metal Exchange on Monday, copper prices surged 3.5 percent, aluminum prices 2.1 percent, and zinc 1.8 percent last week.

Crude oil is Korea`s biggest import product, and a rise in its prices will inevitably hamper current account balance. At its economic outlook in July, Bank of Korea forecast oil prices to hover around 99 dollars per barrel in the second half of this year. But average Dubai crude prices in July-September already have topped 106 dollars per barrel.

Accordingly, prices are showing signs of rising. Import prices (in dollar terms) in August turned upwards in six months.

Interest rates have also reversed upwards, and the low interest rate policy is showing signs of a change. As the U.S. said it would start exit strategy, leading to rising U.S. Treasury bond yields, Korean bond yields are taking the cue. The Bank of Korea said household lending rates (based on new loans) stood at 4.31 percent in July, up 0.2 percentage points from the previous month and posting the first rise this year.

Rising interest rates increase the debt-servicing burden of households and companies, which contracts consumer sentiment while leading to rising bad loans at vulnerable industries such as shipbuilding and marine sectors.

The Korea Center of International Finance at its report on "Assessing the Five Years after the Lehman Brothers` Collapse and Prospects" said if interest rates rise in major countries, Korea`s household debt problem could worsen, and the domestic financial market could face foreign capital outflow and currency volatility.