Bracing for fiscal tightening

The U.S.-led tightening has taken off. The U.S. Federal Reserve delivered a back-to-back increase in the rate target in double the pace of 50 basis points to place the Fed fund range between 0.75 percent and 1 percent, closing on Korea’s benchmark of 1.5 percent. The rate increase by the Fed was in line with expectations from market watchers.

Fed chief Jerome Powell strongly indicated additional half-point increases in the following meetings, which could escalate the U.S. rate’s top target to 2 percent in July. The Bank of Korea’s new governor, Rhee Chang-yong, is scheduled to chair his first rate-setting meeting on May 26. To pre-emptively put the Korean rate ahead of the U.S. rate, another increase after a hike in April is expected.

The trajectory of U.S. rate increases to help contain inflation has often caused tantrums in emerging markets. Capital pulls out of emerging markets to funnel into the U.S. market yielding strong dollar and interest returns. Korea usually bears the brunt.

Foreign selling has already been heavy in Korean capital markets, weakening stock, bond and won value. The three-year government bond yield hovers above 3 percent to eight-year highs and average bank credit loan rate exceeds 5 percent annually.

Swelling household debt from Covid-19 and real estate policy failures pose a grave risk to the Korean economy. Individuals who had sought out debt for stock and property purchases would be alarmed. Rising interest rates would increase debt financing costs to dampen consumption and spur delinquencies in debt obligations.

Household debt in financial institutions reached 1,756 trillion won ($1.4 trillion) by December, surging over 250 trillion won from the pre-Covid-19 period. When loans to the self-employed, small merchants and nonprofit organizations are added, debt load goes up to 2,200 trillion won, overwhelming Korea’s gross domestic product. Household debts are mostly lent on floating rates, which makes them even more vulnerable to rate increases.

The new government under Yoon Suk-yeol’s presidency address the economy with urgency after it launches on May 10. It must do its utmost to stabilize prices and livelihoods as well as containing soaring household debts. Excessive regulations need to be lifted to help normalize the real estate market, but such a move must not trigger a further rise in household debt. The policy imbalance from monetary tightening versus fiscal stimuli should be averted. At the same time, the financial authorities must be more aggressive to strike a currency swap deal with the U.S. to bolster the Korean won. The government must put aside political and ideological interests to protect people’s livelihoods against a wave of external uncertainties.