- Limit could go lower if global economy falters, economists say
- Central bank is forecast to hold key rate at 1.25% this week
A steady series of interest-rate cuts over the past four years has taken borrowing costs in South Korea to unprecedented levels, raising the question of where the lower limit lies for the central bank’s key policy tool.
With slowing global trade and weak demand at home crimping growth and inflation, the Bank of Korea last month cut the benchmark seven-day repurchase rate to 1.25 percent. As Governor Lee Ju Yeol and his board prepare to meet again on Thursday, a Bloomberg survey of economists indicates that the BOK’s so-called lower bound is very close.
Lee said after the cut to 1.25 percent that as a non-key currency nation, Korea should have higher interest rates than major developed economies. He added that the BOK is getting closer to the lower bound, without specifying the level. Of ten economists estimates compiled by Bloomberg, nine put the lower bound at 1 percent for now, while one suggested 0.75 percent. None expect a cut in interest rates on Thursday.
Policy makers are mindful that taking rates too low could spark a massive outflow of capital from Korea, or create a liquidity trap whereby loose monetary policy no longer provides any meaningful boost to the economy. The closing of the gap between yields for 10-year Korea government bonds and U.S. Treasuries is already causing some concern, having gone from about 200 basis points in 2011 to a small reversal this year.
“I think Korea’s key rate should be about 50 basis points higher than the U.S. to prevent rapid outflows, which would put the lower limit at 1 percent,” said Kim Wan Joong, a Seoul-based research fellow at Hana Institute of Finance. “If U.S. jobs data improve and the Federal Reserve raises interest rates for policy consistency, then Korea would have less policy room.”
There could come a point when Korea has to look at options other than further rate cuts. These could include a bigger dose of fiscal stimulus from the government or even some form of quantitative and qualitative easing. The idea of bond purchases was raised by some lawmakers earlier this year before falling from favor.
Also available to Lee and his board are cheap loan programs, especially for smaller companies, and adjustments to reserve ratio requirements for financial institutions.
Central bank board member Hahm Joon Ho said in a June interview that Korea has room for “rate adjustment” as countries like Japan and Europe are adopting negative rates. Korea’s ten-year government bonds yielded 1.41 percent as of 10 a.m. in Seoul, compared with minus 0.26 percent for similar maturity Japanese bonds and minus 0.03 percent for German debt, according to data compiled by Bloomberg.
The won appreciated 2.5 percent in the past month to 1,144.45 per dollar, posting one of the biggest gains among Asian currencies.
DBS Group Holdings sees the lower bound at 0.75 percent. With Korea’s one-year time-deposit rate expected at about 1.5 percent and inflation at 0.8 percent in June, Ma Tieying, an economist for DBS in Singapore, said two more cuts by the BOK are possible before real interest rates would drop into negative territory.
Goldman Sachs Group Inc. estimated an “interim lower bound” of 1 percent in Korea, Taiwan, and Thailand in a report this month. It cited volatility in capital flows, financial stability concerns from higher household debt and the Federal Reserve’s tightening stance.
Most economists said the limit isn’t fixed and may fall further if the global economy deteriorates and other countries ease more. Oh Suk Tae of SG Securities Co. in Seoul said the BOK’ key rate could touch 0.5 percent in 2019 if the U.S. went into recession.
The idea of the 1 percent lower bound “does not account for any deterioration in global growth conditions, which may yet come through on account of the UK’s vote to exit to the EU affecting consumer and business confidence,” said Vaninder Singh, a Singapore-based economist for Royal Bank of Scotland Plc. “These effects will not become clear until several months from now. For this reason also I think the BOK will preserve policy space, in case more may be required next year.”