Risk-Averse Policies Threaten Recovery
The 1997-1998 crisis was a painful one for Korea. The business sector, which had become hugely overleveraged, got crushed. Over the course of a year, corporate cash flow fell by 10 percent (profits even more), investment was slashed and many firms went bankrupt. Consumers also faced troubling times, as failing firms could no longer afford to pay their workers. A collapsing housing market only added to their woes.
However, the pain did not last long. Within a couple of years, the economy had regained much of the ground lost during the crisis. The government rightly followed IMF advice and focussed on sorting out the banking system. The corporate sector restructured vigorously. Balance sheets improved dramatically, profit growth picked up and debt servicing costs plummeted. Households were even quicker off the mark, as rising confidence and house price gains boosted consumption.
But the party was soon over. By 2002, the authorities were once again panicking as consumer credit growth ballooned. In their attempts to engineer a soft landing, their mistaken use of credit controls rather than interest rates cost them dear. A credit crunch ensued, causing huge increases in personal bankruptcies and repossessions, which stifled consumer spending for the next two years.
Since then output growth has accelerated, most prominently in the externally-orientated sectors. The household sector has been slow to get going, although recent rapid gains in house prices have offered a helping hand. Money and credit growth have increased, rising to levels not seen since the peak of the credit card bubble.
As a result, at each of its last two meetings the central bank, led by Governor Lee Seong-tae, decided to raise interest rates by 25 basis points, bringing them to 5 percent, their highest level since 2001. At the same time, the Bank of Korea (BOK) has also pushed up its discounted lending rates to small businesses, while continuing to stress its concerns over excess liquidity.
So is rampant liquidity growth really a threat to the Korean economy and medium-term inflation? One way to measure liquidity is to look at broad money aggregates that include cash, bank deposits and other highly liquid assets. According to recent data, broad money grew by 10.3 percent in the year to June, high by recent standards but consistent with the central bank hitting its inflation target. In the medium-term, money balances should grow at roughly the same rate as trend nominal GDP. Some allowance must also be made for the fact that over time people and firms choose to hold less money because of changing liquidity preference.
In Korea trend real GDP is approximately 5 percent; the central bank inflation target is currently 3 percent; and estimates suggest that historically money has grown about 2 percent faster than nominal GDP. Broad money should therefore be growing at around 10 percent to meet the needs of the economy and to keep inflation at its target. By this metric, the central bank need not be concerned.
Another important factor the Bank should be looking at is lending by the banking sector. In the twelve months to June, borrowing by the private sector increased by 13.8 percent, considerably higher than rates seen over the last three years. As a result, policymakers are spooked. Concerned that credit growth is getting out of hand, the central bank has signalled its intent not to allow the formation of another consumer lending bubble. However, there are two important issues here: on the one hand, should it be worried by this recent surge in borrowing? On the other, isn't the ultimate purpose of monetary policy to ensure price stability over the medium-term?
On the former, the central bank's worries seem overblown. For one thing it is clear that credit growth is slowing fast, in particular new mortgage borrowing, which has effectively ground to a halt. Secondly, it is important to recognise that a crucial factor in the recent lending surge has been the considerable mortgage market liberalisation since 2004, which should have only transitory effects on lending growth. Finally, while lending to businesses has been growing strongly this year, corporate balance sheets seem in good shape to absorb increased borrowing.
In short, monetary conditions are at best neutral and probably restrictive given that the won has risen close to its highest level in a decade on a trade-weighted basis. On these grounds rate hikes do not seem justified if the BOK is solely concerned with hitting its inflation target. Other indicators have also argued against any monetary tightening: house price growth is softening, there is spare capacity in the overall economy, and inflation remains at the bottom of its target range (it was 2.5 percent in July).
Therefore the rise in the short-term call rate to 5 percent looks distinctly unwise, especially when put into a slightly larger perspective. In the summer of 2004, real interest rates had slipped into negative territory. Since then, they have climbed back up to 2.5 percent. Given the long lag between changes in monetary policy and their ultimate effect on firms' and households' spending, this suggests that there is still a fair amount of policy tightening yet to take effect.
The central bank's actions seem increasingly puzzling. Inflation is evidently not a problem. Money growth appears consistent with steady growth and stable prices. There are no apparent capacity problems within firms and fiscal policy is exerting a strong deflationary force on the economy, with the government surplus at 2 percent of GDP. The nascent Korean recovery is therefore under threat, not just from global developments but also from the wrong balance of domestic economic policies.