Fears of liquidity crisis amid tightening

The quick pace of monetary tightening in the United States and Europe will likely trigger a liquidity crisis in Korea as higher yields on overseas assets could attract portfolio capital invested in Korea, a private think tank said in a report Sunday.

The Korea Economic Research Institute warned that a rate increase by the Federal Reserve in particular could translate to an economic crisis in emerging markets based on recent trends and called for more foreign capital reserves to be used in emergencies.

“After the United States started raising rates in 1994, the Asian financial crisis took place in 1997,” the report said, “and four years after the Fed raised rates in 2004 came a liquidity crisis in emerging markets.”

The institute estimated that Korea might need around $120 billion in foreign reserves to hedge against any potential headwinds.

In terms of exchange rates, the think tank argued that a stronger dollar resulting from a rate hike would hardly help Korean exports given that a weak yen under Abenomics will keep the won from depreciating.

Oh Jeong-geun, one of the authors of the report, called on the government to foster better trade ties with the United States to minimize the effect of heftier tariffs on major export items from Korea.

“Korea should be able to have more flexibility in monetary policies and currency directions by restoring trust with the United States,” Oh said.

Still, he warned against unrestrained rate increases by the Bank of Korea because of the risks associated with fast tightening.

“Rate hikes that are too frequent could result in financial distress for corporations and burden households with debt,” he said. “An additional rate hike should take place with much discussion and through monitoring of capital flows while the Korean government should make efforts to prevent capital exodus and stabilize the economy.”

The sobering report contrasts optimism from the central bank that the Korean economy will not face a capital flight or any substantial negative impact from the wave of tightening occurring at other central banks.

Last month, at a meeting where the central bank held its key rate at 1.5 percent, Gov. Lee Ju-yeol dismissed concerns surrounding the much-anticipated rate hike by the Fed in March.

The Fed is expected to raise rates to the upper range of 1.75 percent during the next Federal Open Market Committee meeting this month.

The Bank of Korea’s rate freeze in February means that Korea could potentially offer lower rates than the U.S. Fed for the first time in over 10 years.

BY PARK EUN-JEE [park.eunjee@joongang.co.kr]