Global Insight Perspective | |
Significance | The benchmark call rate was raised by 25 basis points to a six-year high of 4.75% following the scheduled monthly meeting of the BoK's monetary policy committee. |
Implications | The increase reflects the BoK's belief that the recovery in domestic demand is entrenching and could result in medium-term inflationary pressure, particularly as liquidity growth remains high. |
Outlook | Global Insight expects the BoK to maintain a gradual tightening stance, with a further 25-basis-point increase expected by year-end. |
Interest Rates Rise to Six-Year High
The Bank of Korea (BoK) today raised the leading rate to a six-year high following a scheduled monthly meeting of its Monetary Policy Committee (MPC). The uncollaterised overnight call rate was increased by 25 basis points to 4.75%, marking the first increase in interest rates since August 2006. The BoK began raising rates in October 2005, implementing five 25-basis-point increments in the period through August 2006. The central bank then paused in its tightening cycle after domestic demand weakened, adopting a pro-growth stance in policy.
Implications and Outlook
Domestic Demand Finally Recovers
The BoK had been expected to raise rates following the recent rebound in domestic demand. Household spending growth has proved sluggish in previous quarters, still suffering from the ramifications of the collapse of a consumer credit bubble in 2002. The overall economy recovered quickly, thanks to surging exports and low interest rates, and government assistance to heavily indebted families. However, consumer spending proved slow to rebound. It fell below 52% of GDP in 2004, as moderately high unemployment and the lingering effect of consumer debt lowered confidence and restrained spending. Household spending has since trended up only gradually, levelling off at around 54% of GDP in 2006. Although consumer debt is no longer a serious deterrent to spending, the slow growth in wages and the increased number of temporary and part-time jobs has restrained consumption.
However, in the first quarter of this year, domestic demand drove growth, which levelled at 4.0% in annual terms. In the three months through March, private consumption rose by 1.3%, boosted by increased spending on durables. Consumer sentiment has been improving job opportunities and rising income levels. Private capital expenditure growth, which has driven this improvement, remained robust in the first quarter, driven by strong profitability and strides by companies to improve productivity. Gross capital formation rose by 2.0% quarter-on-quarter (q/q) and by 7.0% on the year, rebounding from the soft patch experienced in the fourth quarter. Unemployment fell to 3.3% in seasonally adjusted terms in June, providing further justification for the BoK's move.
Inflation Still Muted but Liquidity Pressures Increase
Inflation, as measured by the consumer price index (CPI), remains relatively subdued. Increasing productivity has served to offset rising demand, particularly in the manufacturing sector. Recent rapid appreciation in the won exchange rate has served to contain import price inflation. Finally, declining fuel prices have reduced upward pressure on prices, while formally red-hot appreciation in real estate prices has cooled. However, the BoK's primary concern is over high levels of liquidity, which have fuelled robust credit growth particularly to small and medium-sized enterprises (SMEs) as regulations have crimped mortgage lending. Broad money supply growth has been running at around 10.0%, while loans to SMEs surged by 8.34 trillion won (US$9.1 billion) in June from the previous month, the largest month-on-month (m/m) increase since records began in 2000. The risk also remains that the surge in liquidity could also reignite the property market, which authorities have striven to stabilise in recent months. To clampdown further on liquidity growth, the BoK's liquidity adjustment loans and aggregate credit ceiling were both raised today by 25 basis points to 4.50% and 3.00% respectively.
Exchange Rate Remains a Concern
In deference to the early stage of recovery in domestic demand, however, the BoK is expected to remain ginger towards further rate increases. With inflation set to remain muted, aggressive rate increases are unwarranted and could choke off the upturn in household spending. Moreover, higher interest rates will incite foreign capital inflows that have fuelled liquidity growth and pushed the won exchange rate to multi-year highs. Exports have proved resilient with competitiveness boosted by productivity gains and external demand still strong for leading autos, steel and electronic goods. However, concerns remain that the strong exchange rate, particularly vis-à-vis the weak yen, could undermine exports. The Ministry of Finance today announced reductions in tax rebates for foreign banks borrowing from offshore parent institutions, which has increased dollar flows in the currency market. Subsequently, Global Insight maintains its forecast that the BoK will raise the leading rate by a further 25 basis points by year-end to 5.00%, with inflation forecast to average 2.6% over the year.