Bank of Korea between a rock and a hard place

Finance

Published: 31 Oct. 2022, 18:03 Updated: 31 Oct. 2022, 19:09

Bank of Korea between a rock and a hard place

A view of Legola Korea Resort on Oct. 24. [YONHAP]

The Bank of Korea risks destabilizing the economy as it fights inflation, and like many central banks, it's struggling to get the balance right.

A default of bonds related to Legoland Korea Resort, falling housing prices and strapped consumers limit what the central bank can do and has left it contemplating creative measures to provide targeted support as it tightens monetary policy.

It's in uncharted waters, and so far, the central bank has chosen not to push the panic button and initiate desperate measures.

“There’s no need for excessive medicine at first,” Gov. Rhee Chang-yong told the National Assembly on Oct. 24.

The Bank of Korea has been aggressively increasing rates since August last year, taking them up a full 2.5 percentage points since then. Another increase is projected for November.

Facing high inflation — which hit 6.3 percent in July — and a weak currency, the central bank has little choice but to increase rates.

The downside of tight money can already be felt, most dramatically in the default of a company used to finance the construction of Korea Legoland Resort and the shudders in the bond market following the default.

On Oct. 4, Iwon Jeil Cha, a special purpose company established to fund the construction of the Legoland resort in Gangwon, was listed as bankrupt. It had failed to repay 205 billion won ($144 million) in asset-backed commercial paper.

The bond market responded almost immediately.

Three-year government bond yields hit 4.495 percent on Oct. 21, up from 1.8 percent a year earlier.

AAA-rated Korea Electric Power Corporation, the state-owned power supplier, tried to sell 400 billion won of bonds on Oct. 17 at 5.9 percent, but was only able to sell 280 billion won worth.

Bank of Korea Gov. Rhee Chang-yong announces a 50 basis point rate increase in the Monetary Policy Board meeting held on Oct. 12. [YONHAP]

The central bank steeped in to support the market.

On Oct. 27, the Bank of Korea announced plans to expand the types of bonds it takes in as collateral. Currently, only debt with the highest credit ratings are accepted.

The central bank also announced the activation of 6 trillion won in repurchase agreements, a form of short-term borrowings for dealers in government securities, through Jan. 31. Brokerage firms will be able to raise much-needed cash with these facilities.

“The Bank of Korea reacted more aggressively than was expected,” said Ahn Jae-kyun, a fixed income strategist at Shinhan Securities. The market “did not expect the bank to bring out the repurchase agreement measure because its stance on the matter was unclear before the announcement.”

In a meeting on Oct. 18, Na Jae-cheol, chairman of the Korea Financial Investment Association, requested Rhee to reactivate a special purpose vehicle (SPV) that buys subprime corporate debt, according to local media reports. Financial Services Commission (FSC) Chairman Kim Joo-hyun told the National Assembly on Oct. 24 that he “believes the Bank of Korea will take all measures possible at this point."

Activation of an SPV, which increases liquidity in the market, is seen as the ultimate step the central bank can take to stabilize the market.

“An SPV could be reactivated later, but it isn’t an appropriate policy at this point,” Rhee said, adding that banks currently don’t have difficulties financing their operations.

The current financial upheaval was the "result of the accumulated stress from the interest rate increases, and the Legoland Korea incident just fueled the market distress,” Ahn added. The activation of an “SPV is the ultimate card the central bank seems to be saving for later as it still has to raise the interest rate by one or two more times.”

The current market instability “was not caused by the lack of liquidity, but because the flow of liquidity suddenly halted as people grew very cautious” following the Legoland Resort incident, said Kim Ja-bonn, a senior research fellow at the Korea Institute of Finance. “So reflowing that liquidity will be enough to reactivate the market.”

Critics say the activation of SPV could raise concern about policy imbalance in Korea. The loss of credibility could lead to confusion in the market, much as what happened in the UK following tax cut plans that conflicted with the Bank of England’s monetary tightening.

The British pound fell to a new low following a tax cut announcement in September.

Rhee expressed concerns about how the “overseas market accepts this policy."

The last time an SPV was used was in July 2020.

Kim said the situations in Korea and the UK are different.

“The problem in the UK was caused by the distrust in the prime minister and her overall economic policy, while the situation in Korea was ignited by the Legoland incident. Comparing it with the UK isn’t appropriate,” Kim said.

The Bank of Korea is expected to continue raising the rate next month.

“The central bank will have to raise the rate because of the continued inflation and falling won,” said Lee Jeong-hwan, an associate professor at College of Economics and Finance at Hanyang University.

If won falls, the value of debt banks hold in dollars increases, which will require banks to issue bonds to meet capital requirements.

“Bank bonds have triple A ratings, and if banks issue bonds, it will become difficult for corporations with lower credit ratings to issue bonds, further aggravating the bond market,” Lee added.

The Bank of Korea’s Monetary Policy Board is scheduled to hold the meeting on Nov. 24, three weeks after the Federal Open Market Committee finishes its two-day meeting on Nov. 2.

The vote by the seven-member Monetary Policy Board on Oct. 12 was five in favor and two against, with the dissenters calling for a quarter point increase.

BY JIN MIN-JI [jin.minji@joongang.co.kr]