Reducing risks from the reversed rate gap

The U.S. raised the policy rate by a quarter percentage point from 5 to 5.25 percent, the highest since 2007. The U.S. central bank still found the need to control inflation despite the economic and banking strains from relentless tightening. The additional rate increase has caused a gap of record 175 basis points between the U.S. and Korean base rates.

As interest rate reflects financial risks, it is supposed to go down when the risk is smaller. That’s why commercial banks offer lower deposit rates than savings banks. The Fed’s interest rate is generally lower than Korea’s for the same reason, as the dollar is a key currency.

When the interest rate of the Korean won is lower than that of the U.S. dollar, capital would chase U.S. assets for higher returns. In that case, the Korean won’s value against the U.S. dollar falls, causing jitters across the capital market in Korea.

Of course, foreign capital does not move entirely on rate terms. Other macroeconomic factors — such as growth outlook, expected exchange rate, profit incentives and volatility in the global market — also affect the movement. The Bank of Korea (BOK) also does not see a specific impact of the rate gap on the behaviors of foreign investors in Korea.

In fact, foreign investment has not sharply declined during past inverse periods. For instance, foreign investments in the Korean capital market rather increased when the U.S. rates were higher than Korea’s up to 150 basis points from June 1996 to March 2001; up to 100 basis points from August 2005 to September 2007; up to 85 basis points from March 2018 to February 2020, and up to 175 basis points from July last year to the present. Actually, foreign investment in Korean stocks and bonds recorded a net inflow of $16.8 billion during the first episode, $30.5 billion in the second and $40.5 billion in the third.

Still, past behavior cannot be a source of comfort. The latest gap is the biggest, while the macroeconomic conditions for Korea are not good. The International Monetary Fund downgraded this year’s growth outlook for Korea to 1.5 percent, which is below the BOK’s estimate of 1.6 percent. The average outlook from major investment banks is lower at 1.1 percent.

That’s not all. Korea’s current account balance has been in the red for the second consecutive month for the first time in 11 years. The trade balance is also running a deficit steak for the 14th straight month.

Financial authorities vowed “extraordinary vigilance” against uncertainties in the financial and foreign exchange market during an emergency meeting. The pledge must not end in rhetoric. The authorities must demonstrate their presence to investors at home and abroad during volatile times.