The Bank of Korea's ability to maneuver its monetary policy is increasingly constrained. While lowering the benchmark interest rate seems difficult due to inflation, exchange rates, and household debt, the burden of raising rates is also significant given that household debt has surpassed 2,000 trillion won, particularly affecting vulnerable borrowers such as small business owners. Even if the benchmark rate is held steady, the rise in global long-term interest rates could keep domestic market rates elevated, effectively continuing the tightening effect.
On July 16, the Bank of Korea raised the benchmark interest rate from 2.50% to 2.75%, marking a 0.25 percentage point increase. This decision was made amid strengthening growth driven by exports and investment, but with inflation remaining above target levels and ongoing financial stability risks. However, since the rate hike, market interest rates have not aligned with the Bank's expectations.
On August 18, the yield on 30-year government bonds reached a record high of 4.751%. In contrast to the immediate aftermath of the rate hike, the yield on the 3-year bonds, which are sensitive to monetary policy, actually fell by 5 basis points, while the 10-year and 30-year bonds rose by 5 and 23 basis points, respectively. Short-term rates are heavily influenced by future rate expectations, but long-term rates are affected by global rates, inflation forecasts, and the supply and demand for government bonds. Thus, there is no guarantee that changes in the policy rate will lead to similar movements in long-term market rates.
Lowering the benchmark rate again is not straightforward. The Bank of Korea cited inflation above target levels and threats to financial stability as reasons for the previous rate hike. With ongoing uncertainties in inflation due to geopolitical tensions in the Middle East and rising energy prices, hastily lowering rates could exacerbate the depreciation of the won and increase import price pressures. There is also the risk of reigniting the growth of housing prices and household debt.
Conversely, raising rates further poses challenges. As of the end of the second quarter, household credit reached 1,979.8 trillion won, exceeding 2,000 trillion won for the first time. Given the increased debt levels, any additional rate hikes could significantly impact borrowers' principal and interest burdens and consumer spending.
Vulnerable borrowers, such as small business owners and those with multiple debts, are particularly at risk. According to data submitted by the Bank of Korea to the National Assembly, a 0.25 percentage point increase in loan rates would raise the annual interest burden for small business owners by 1.8 trillion won. For small business owners with multiple debts, this figure would increase by 1.1 trillion won. The average interest burden per small business owner is estimated to rise by approximately 560,000 won.
Repayment capacity is already deteriorating. As of the end of the first quarter, the amount of overdue loans for small business owners reached a record high of 22.3 trillion won, with a delinquency rate of 2.04%, the highest since the second quarter of 2015. The delinquency rate for loans to individual business owners from savings banks reached 12.79%. If further rate hikes occur, the risk of delinquencies and defaults among borrowers already struggling to repay their debts is likely to increase.
The issue is that not raising the benchmark rate does not automatically ease financial conditions. If long-term interest rates in major countries like the United States remain high, domestic government bond and bank loan rates may not easily decline. Even if the Bank of Korea lowers the benchmark rate in the future, if long-term market rates do not decrease sufficiently, the reduction in mortgage or corporate borrowing rates will also be limited. This means that attempts to support the economy through rate cuts may not yield the expected results.
Ultimately, the Bank of Korea faces a dilemma: while tightening is necessary to control inflation, exchange rates, and household debt, increasing tightening could exacerbate the financial distress of vulnerable borrowers and domestic consumption burdens. Additionally, as global long-term interest rates rise beyond the Bank's control, the options for policy action have narrowed. Whether to raise or lower rates presents a burden, and the independent movement of market rates complicates the monetary policy challenges currently facing the South Korean economy.
* This article has been translated by AI.
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