South Korea’s central bank last week lowered its policy interest rate by 0.25 percentage points to a record-low 1.5 percent just as Asia’s fourth biggest economy faces a slowdown in both economic growth and price rises. The spread of Middle East Respiratory Syndrome (MERS) in the country threatens to dampen consumer spending. Given the difficult state of the economy, South Korean authorities need to flexibly mobilize fiscal and monetary policy tools.
A preliminary report shows that South Korea’s gross domestic product in the January-March period registered a dismal increase of 0.8 percent in real terms from the previous quarter, marking growth of less than 1 percent for four consecutive quarters. The outbreak of MERS in late May has applied additional pressure on the central bank to reduce the policy rate. The MERS outbreak led some 67,000 foreign tourists to cancel their visits in the first nine days of this month. Department stores and supermarkets have also been hit by declining sales. In April, the Bank of Korea revised downward its 2015 growth estimate from 3.4 percent to 3.1 percent. But the spread of MERS may further lower this year’s growth to a level between 2 percent and 3 percent. This would mean the lowest growth since 2012, when the economy grew only 2.3 percent.
A view is emerging that the South Korean economy is already in the grip of deflation. The consumer price index has been rising at less than 1 percent from a year before for six straight months, with the May figure registering a mere 0.5 percent increase. If the effect of the tobacco price hikes in January is excluded, the index has been in negative territory for four months in a row.
A steep rise in the value of the won against the yen has caused exports, which account for around 45 percent of the nation’s GDP, to dip 10.9 percent in May from a year before, marking a decrease for five consecutive months. This is the biggest factor depressing the economy. Electronics and carmakers suffered losses in their exports to the extent that their Japanese rivals increased their exports. Since South Korean exports to China, including Hong Kong, account for some 30 percent of its total exports, a protracted slowdown of the Chinese economy would take a further toll.
The Bank of Korea’s latest interest rate cut represents the fourth consecutive cut since August. A side effect of the series of interest rate cuts, coupled with deregulation in real estate transactions, is the swelling of housing loans. Household debt has snowballed to top 1,100 trillion won (about ¥120 trillion) — a factor that led to sluggish domestic demand. Clearly the impact of the latest rate cut will be small. But the South Korean government is reluctant to increase fiscal spending to stimulate the economy.
Given the experience of the 1997 financial crisis, the central bank is reportedly cautious toward monetary easing, fearful that aggressive easing could prompt the flight of foreign capital. But given the risk of deflation, additional large-scale monetary easing as well as government spending to underpin the economy appear inevitable as a short-term remedy.
As a medium-term remedy, South Korea should transform its economic structure, which is heavily dependent on exports — particularly shipment to China — into one led more by domestic demand. There are views that South Korea’s current economic situation is similar to the one Japan experienced just before it entered into its prolonged doldrums in the 1990s. Japan cannot be indifferent to a slump of the South Korean economy since it’s the third-largest destination of Japanese exports. Tokyo should readily offer advice based on its experience if Seoul requests it.