Federal Reserve Chairman Ben Bernanke mentioned the monetary policy for exit strategy in the end. Korean economic experts expressed their concerns over possible short-term volatility in the financial market while predicting that the recovery of the US economy would act in favor of the export-driven Korean economy down the road. At the same time, some predicted that the global economy could fall into a double dip if the exit strategy went awry due to a failure of communication among market participants, and poor policy timing, etc. It was warned that the interest rate shock could also affect marginal firms and indebted households.
Worse-case Scenario: Double Dip
As of now, the consensus is that the exit strategy has been derived from the predominance of positive prospects for the US economy. The demand side’s picking up to result in increased imports can have a positive effect on Korea’s export to the US market. This can improve the current account balance along with a rise in the exchange rate, which, in turn, can make the Korean economy look more attractive in the second half of this year.
Still, some people are raising concerns that the upward adjustment of the interest rate could exacerbate the problem of household liabilities here. “The rate increase is likely to affect the real economy, households with debt in particular, to cause a decline in spending,” said Jeong Yeong-shik, an analyst at the Samsung Economic Research Institute. He continued, “Furthermore, it will bring about higher financing costs on the part of enterprises and aggravate the liquidity problem in the shipbuilding, shipping, and construction sectors, etc.”
A faster-than-expected pace of tight monetary policy could give rise to simultaneous interest rate hikes around the world and a double dip. This is why local experts are calling upon the government to strengthen its monitoring of the capital market. “The authorities should watch the capital market more closely rather than focusing on regulations for the soundness of the foreign exchange market,” Korea Development Institute researcher Kim Seong-tae explained, adding, “The government will also have to come up with contingency plans in order to provide against sudden capital outflow.”
Financial Companies Expecting Financial Crunch to Be Eased
In the meantime, financial companies are busy calculating pluses and minuses on their part. Both banks and insurers are having trouble these days due to the low interest rate and the drop in profits resulting from it. Significant attention is being paid to whether the Fed’s exit strategy will provide breathing space.
As far as banks are concerned, the lending rate is likely to go up faster than the deposit rate and they will be able to enjoy some profits in the short-term. However, the risks borne by households and corporations could increase at the same time, which means things have to be watched at least for some time. Insurers, meanwhile, are drawing a rosy picture in that their main investment targets include treasury bonds.
Banks Face Risks of Bad Loans
Most local banks raised their conforming loan rates by 0.4 percentage points recently. The move can be a boon to their profits, yet the problem is that the loans have the possibility of becoming insolvent.
“When the interest rate goes up, companies and households have to pay more interest and this could affect the fiscal soundness of banking institutions,” said Dr. Im Jin at the Korea Institute of Finance (KIF), advising financial firms to not simply focus on the loan-deposit spread. Director Park Seong-wook at the KIF’s Macroeconomic & International Finance Division echoed this, saying, “Probably, banks with bonds will face capital losses and tighter foreign currency conditions, making risk management more difficult than it is now.” It appears that what is crucial is the pace of the interest rate change.
Insurers Need to Keep Low Interest Rate Stance
Local life insurance firms’ operating profit rate fell to 3.24% late last year, no less than 0.84 percentage points from a year earlier. The drop was caused by the earnings rate of the asset management division that dipped below 5%. In this vein, the exit strategy can be a favorable factor as it means larger room for asset management.
Nevertheless, some insurers could turn various assets into available-for-sale (AFS) securities subject to the market price valuation method and the interest rate rise could decrease the size of their assets. “The bond rate increase is likely to reduce their reverse margin, but some insurers who convert their securities into AFS will face difficulties,” said Dr. Kim Hae-shik of the Korea Insurance Research Institute. He went on, “With the movement of the interest rate having yet to decide on its direction, they need to maintain the low interest stance at least for a while and a hasty pursuit of larger investment profits will entail high risks.”
Government Working on Financial Market Risk Index for Scenario-specific Response
The government is closely watching the potential aftermath of the policy. “We’ll carry out prepared countermeasures while monitoring the market response,” said Choi Hee-nam, who is heading the International Finance Policy Bureau of the Ministry of Strategy and Finance. Specifically, the ministry will draw up its own financial market risk index based on the exchange rate, treasury bond rate, credit default swap (CDS) premium, foreign currency outflow, and so on, while addressing the situation with phase-by-phase plans. It has already prepared action plans to deal with situations in which the real economy recovers amid foreign currency outflow, and capital outflow if the real economy fails to gain speed, etc. It is also planning to expand currency swaps with the central banks of major economies and shore up the multinational financial safety net, such as the Chiang Mai Initiative.
The authorities believe the current situation is unlikely to result in the perfect storm that was seen during the global financial crisis of 2008. “The implication of the end of the quantitative easing policy shows that the US economy is on a recovery track,” the director explained, adding, “Korea, with its decent economic financials, will take a smaller hit than those countries that are highly dependent on raw material exports or those that have huge current account deficits, that is, a worldwide liquidity crisis is not likely at this time, unlike five years ago.”