0% base rate ends in S. Korea

Bank of Korea’s Monetary Policy Board raised the base rate to one percent on Wednesday, ending the 20-month period of zero percent base rate since last March. Bank of Korea is expected to raise the base rate twice next year and the U.S. is likely to move up the date to raise its base rate from the current zero percent. Central banks’ expansionary monetary policies that have been continuing since the outbreak of COVID-19 are transitioning to austerity.

The South Korean central bank believes that low-interest rates and excessive liquidity are driving up inflation and leading to the risky level of household and corporate debts. The inflation of consumer prices rose over three percent last month, which was the first time in nine years and nine months and well above the two percent target to stabilize prices. Despite the financial authorities’ restrictions on the overall amount, real estate loans have increased and household credits outstanding reached 1844.9 trillion won at the end of September, exceeding South Korea’s GDP last year. The country has the highest household credits outstanding to GDP ratio at 104.2 percent among 37 major countries. The loans taken from five major banks by small and medium-sized businesses and the self-employed whose businesses struggled due to COVID-19 also rose 10 percent compared to a year ago.

In order to restrict sharply rising prices and prevent the growing bubble of asset prices, such as real estate and stocks, the base rate rise was inevitable. As Governor of the Bank of Korea Lee Ju-yeol indicated a possibility to further raise interest rates at the beginning of next year, excessive borrowing to buy a house or stocks will become risky. There are already many households tightening their budget to repay a mortgage with an annual interest rate of six percent. If the base rate rises 0.25 percentage points, households in South Korea will take an additional interest burden of 2.9 trillion won per year. Small and medium-sized businesses and the self-employed with excessive debts will struggle furthermore.

What’s worrisome, however, is that the recent inflation has been caused by not only excessive liquidity but also foreign structural factors, including the bottleneck effect of the global supply chain, countries’ transition to environment-friendly policies, and U.S.-China economic conflicts. Inflation may continue to rise, deepening the interest burden on households and companies, despite the base rate increase. If the gradual recovery of normal lives faces suspension due to the sharp increase of COVID-19 patients, the economy may freeze quickly.

Bank of Korea should be careful when determining the speed of base rate increase, examining the movement of the real economy. The government should also refrain from unnecessary spending and spare some financial capabilities in preparation for the shock of an interest rate increase on vulnerable groups and businesses.