Overnight, South Korea became the first major Asian economy to raise interest rates since the start of the pandemic, as record household debt and soaring housing prices outweighed fears over Seoul’s struggle to contain the Delta coronavirus variant. In the closely watched decision on Thursday, the Bank of Korea raised its benchmark rate by 25bps to 0.75%, increasing the seven-day repurchase rate 25 basis points from a record low of 0.50% with a majority vote. One member cast a dissenting vote calling for an on-hold decision. The MPC statement kept the door open for further policy rate hikes, on the back of stable growth outlook and an upward revision to the headline inflation forecast.
The hike marked the country’s first rate rise since September 2018, while interest rates have remained unchanged since the BoK cut them by 50 basis points in May last year. A minority, or 9 out of 20 economists, were expecting a hike in today's meeting and as such the decision was a surprise to consensus and was only ~40% priced in. The unusual level of uncertainty stemmed from a months-long resurgence of coronavirus cases, which has forced South Korea into its toughest social-distancing controls since the start of the pandemic. Last week, New Zealand scrapped its plans for an imminent rate hike after the country entered a lockdown after just one covid case.
The governor kept a hawkish stance, noting that today’s hike is just the first step for policy normalization and overall monetary policy remains accommodative even with the 25bp policy rate hike. He explained that real interest is in negative territory and overall liquidity remains ample considering robust private sector credit growth. In his view, the 25bp policy rate normalization would not deter the recovery trend in private consumption or robust private sector investments but would still be helpful in restraining demand for excessive borrowing from households. While the governor did not provide a direct answer to his view on the neutral rate for Korea, he responded that the current level of policy rate remained well below the neutral level.
“Despite today’s hike, financial conditions remain accommodative,” said Lee Ju-yeol, BoK governor. “We are seeing some side effects from the unusually loose conditions of the past year-and-a-half, so we will normalize interest rates in accordance with the economic recovery.”
The statement kept a broadly positive tone on the macro outlook, noting that the Korean economy has "continued its sound recovery" notwithstanding a slowdown in private consumption due to the coronavirus resurgence. The statement noted that GDP growth for this year will likely be around the central bank's May forecast, while pointing to upside risks to headline inflation. During the press conference, the governor clarified that 2021 GDP growth forecast was unchanged at 4.0% and headline inflation forecast was raised 30bp to 2.1%, broadly in line with our forecast (GDP growth: 4.1%, headline inflation: 2.1%).
While South Korea is on track for gross domestic product growth of 4% this year as the export-led economy has benefited from robust demand for electronics products including computer chips and smartphones, as well as recovering markets for Korean-made ships and cars, economic planners in Seoul have grown increasingly concerned that chronic problems in the domestic economy have been masked by the booming export recovery, which helped rescue the country from the depths of a pandemic-induced recession last year
The forward-looking section of the MPC statement kept the door open for further policy rate adjustments. It added the wording that MPC will "gradually adjust the degree of monetary policy accommodation..." and decide "when to further adjust the degree" based on assessment of various macro risk factors, including growth, inflation and financial imbalance, as well as developments in coronavirus situations and changes in monetary policies in major economies.
Alex Holmes, an economist with Capital Economics, expected the BoK to tighten its monetary policy further to rein in financial risks.
“The financial stability issues troubling the BoK continue to build,” he said. “House prices rose by 14.3 per cent year on year in July, the most since 2002. Recent data show that household debt was up by 10.3 per cent year on year in [the second quarter], after posting its largest ever gain in the April to June period.”
There are also signs that many self-employed workers in Asia’s fourth-largest economy, who make up almost one-third of the labour force, were under mounting financial pressure after coronavirus restrictions sharply reduced their incomes.
Some more observations on the BOK decision from Goldman:
- For future policy rate decisions, the governor explained that the largest risk factor was remaining uncertainties surrounding the global pandemic. Regarding the ongoing 4th wave of coronavirus infections, the governor's overall assessment did not change meaningfully from the previous meeting. While stricter social distancing measures would undeniably have a temporary negative impact on private consumption, it remains unlikely to have meaningful impact on the broader economic recovery trend. Furthermore, high frequency data (such as credit card usage and mobility) suggest that the impact was also likely to be smaller than previous waves, consistent with our assessment. Going forward, the BOK will continue to closely watch coronavirus developments, especially changes to the government's social distancing measures and their economic impact, rather than simply focusing on levels of new infections. For now, the central bank takes the government's expectations as its base case assumption, which entails elevated new cases until September and some moderation in October which would allow for relaxation of social distancing measures.
- On the macro outlook, the governor expected the temporary slip in private consumption to be offset by robust exports and investment and an upcoming fiscal boost. For inflation, the governor mentioned that even with the upward revision to the forecast for 2021, headline inflation was not at excessively high levels (2.4% for 2H) and is still expected to moderate in 2022. That said, the central bank remains mindful of upside risks of inflation staying at elevated levels for a longer-than-expected period, on the back of a broadening demand-side pressure in inflation and a pick-up in inflation expectations (2.4% based on BOK's August survey, which is the highest since November 2018).
- On potential growth, the governor mentioned that the central bank's latest estimate for 2021-2022 was around 2%, which is meaningfully lower than the central bank's previous estimate of 2.5%. The decline in potential growth reflects demographic changes, employment conditions and lowered service sector productivity following the global pandemic. The governor added that potential growth could recover in the short term by minimizing the scarring effects from the pandemic and improving investment conditions. He added that lower potential growth could, in principle, imply lower normal levels of interest rates.
- On financial imbalances, he reiterated many of his previous views in the context of acceleration in household debt growth for July and continued rapid and broad increase in housing prices. He noted that tightening in macroprudential measures, the first line of defense, have not been successful in reigning in household debt growth, perhaps due to expectations for a sustained period of low interest rates. Hence, he noted that most MPC members think that now is the time monetary policy normalization, in addition to tight prudential measures, would be needed to reduce financial instability risks.
As the FT notes, the BoK’s move also sparked debate over whether central banks in Asia might soon follow suit earlier than expected. TD Securities strategist Mitul Kotecha said that while further easing in monetary policy in the region was “unlikely”, most Asian central banks were set to “maintain accommodative bias”.
“Perhaps only India is at risk of hiking in the region in the months ahead, though we think this will only take place in [the first quarter] next year. In contrast, we think the [People’s Bank of China] could cut its RRR in the weeks ahead,” he said, referring to the central bank’s reserve requirement ratio, or the amount of cash Chinese banks must hold as reserves.
Goldman kept its baseline scenario that the BOK will follow up with another 25bp rate hike on November 25, assuming that the coronavirus situation continues to stabilize. Key events and indicators to watch, other than regular activity, leverage and inflation data, include the pace of vaccination till end-October (full vaccination of 70% of population) and the pace and timing of Fed tapering.