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INTERVIEWKorea to tighten monetary policy further: Fitch

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This article is the last in a three-part series of interviews with chief economists covering the Korean economy for the Big Three credit rating agencies to analyze the state of Asia's fourth-largest economy amid rising interest rates and high inflation. _ ED.

Top credit rating agency expects BOK to end credit tightening next year

By Kim Yoo-chul

Consumer inflation in South Korea continues to rise at a rapid pace, raising the odds that the country's central bank ― the Bank of Korea (BOK) ― will deliver another 50-basis-point rate hike at its August policy meeting. The top-tier global credit rating agency, Fitch, is ready to revise higher its rate forecast for the BOK.

The country's consumer inflation soared to the highest level in 24 years in July, according to Statistics Korea. This journey is interpreted as a major factor in strengthening the market's view for additional rate increases by the country's central bank.

Inflation is one of the key challenges confronting the Yoon Suk-yeol administration's economic policy team, and the administration already appears to be struggling to handle escalating labor disputes due to rising costs of living, a recent torrential rain and flooding disaster and the current major COVID-19 surge.

Jeremy Zook, director of Asia-Pacific Sovereigns, Fitch Ratings
Jeremy Zook, director of Asia-Pacific Sovereigns, Fitch Ratings
"We will be revising higher our policy rate forecast for the BOK when we next review our economic outlook for South Korea. Higher than expected inflation and faster than expected tightening by the U.S. Fed have added additional pressure on the BOK to tighten relative to our expectations in early June," Jeremy Zook, the director of Asia-Pacific Sovereigns at Fitch Ratings, said in a recent interview. The BOK's key rate as of July this year is 2.25 percent.

In a news conference after delivering a historic half-point interest rate hike in July, a move seen by many economists as a signal to control soaring inflation, BOK Governor Rhee Chang-yong said he viewed the market forecast that sees the country's benchmark policy rate reaching between 2.75 percent and 3 percent by this year as "reasonable."

Assuming that the inflation trajectory will continue, Rhee said he would take "gradual steps" in terms of increasing the key rate by 25 basis points each time "for a while." The point is that economists have been expecting the country's inflation to rise past 5 percent by the end of this year. South Korea saw inflation soar to 7.5 percent at the end of 1998, when the country was hit extremely hard by the Asian financial crisis.

"There is a growing likelihood that we could see additional rate hikes beyond our expectations this year, particularly as the U.S. Fed has become more aggressive in its rate hike cycle, and inflation is proving a bit higher than we previously expected. Much of the rise in inflation has been driven by supply side factors, over which the BOK has limited control, but core inflation is also rising," Zook said. "There are some clear upsides to this inflation outlook, as inflation is rising a bit faster than we expected, and particularly if inflation expectations continue to become entrenched in wage negotiations."

Despite the continued moves by the U.S. Fed and the BOK to hike interest rates, it looks like Fitch Ratings' long-term optimism on the growth potential of the South Korean economy and inflation remain unchanged. Also, Wall Street analysts and economists project price pressures could possibly swing from inflationary to deflationary by the end of next year, owing to the easing of price spikes earlier caused by supply chain mismatches in durable goods, energy and chips.

The mainstream perception is that such a situation could make the U.S. Fed and the BOK's work of curbing inflation much easier. Within that context, Fitch expects the BOK to pivot to easing monetary policy next year because inflation could fall back below 2 percent, and the need to lift economic growth will likely become a top policy consideration.

Bank of Korea Governor Rhee Chang-yong closes his eyes to take a brief pause before responding to questions from reporters after the country's central bank raised its benchmark rate by 50 basis points in July this year at the bank's headquarters in downtown Seoul. Yonhap
Bank of Korea Governor Rhee Chang-yong closes his eyes to take a brief pause before responding to questions from reporters after the country's central bank raised its benchmark rate by 50 basis points in July this year at the bank's headquarters in downtown Seoul. Yonhap

"Our expectation for easing inflationary pressures in South Korea in 2023 will relieve pressure on the BOK to further tighten monetary policy. Further, growth concerns in the global economy could prompt a more cautious approach by the BOK. We expect inflation to begin to decline toward the end of the year to 4.2 percent," Zook, also a Fitch's lead analyst for South Korea, responded.

Next year, Fitch expects South Korea's inflation rate to ease further to 1.5 percent by year-end based on a decline in oil prices from an average of $105 per barrel to $85 per barrel, and "base effects" from the high inflation rate this year.

Rising debt servicing costs from higher interest rates, along with high inflation, will dampen household spending. Some slowing of demand would be consistent with the central bank's objective of reducing the rate of inflation and ease pressure for further rate hikes. "However, if supply side shocks prove persistent, the BOK could be faced with a more difficult tradeoff between tackling inflation and supporting growth," according to him.

Regarding the metrics behind its decision to make a downward revision of its 2022 growth forecast for the South Korean economy, which is Asia's fourth-largest, Zook said its 2.4-percent growth target for the country's economy is based on deteriorating external conditions from China's slowing growth and risks to the global economy from the global commodity price shock and global monetary policy tightening.

"China remains committed to its zero-COVID policy, which could imply further lockdowns and further economic headwinds in the second half of 2022. The risk of a shut-off of gas supplies in Europe, is also a key risk for South Korea's external demand," he said. However, he expects domestic consumption to support growth this year as COVID-19-related restrictions have largely been removed and households still hold precautionary savings, which they can run down to use to support growth.

U.S. Senate Majority Leader Chuck Schumer speaks to the media after the
U.S. Senate Majority Leader Chuck Schumer speaks to the media after the "Inflation Reduction Act of 2022" passed in a 51-50 vote on Capitol Hill in Washington, D.C., Aug. 7. Reuters-Yonhap

"High inflation and rising interest rates may start to erode household purchasing power in the later part of the year, but we believe consumption should hold up well in 2022. A key question for South Korea's economic outlook over the next year will be whether the recovery of domestic consumption will be sufficient to offset the external headwinds," the Fitch official responded.

As long as the BOK is allowed to shift to monetary easing from next year, the GDP should continue trending upward and then could accelerate further in both 2024 and 2025, said economists. Regarding the housing issue, probably the most interest-rate-sensitive component of the South Korean economy's GDP, Fitch Ratings didn't elaborate, though lower rates to be seen over the next few years are necessary to improve housing accessibility and thereby resuscitate demand in the volatile local housing market.

North Korea's limited impact on sovereign ratings

Washington and Seoul officials have warned many times that North Korea is fully ready to conduct what will be its seventh nuclear test, a move that the United States vowed to counter with a forceful response. The geopolitical tensions are rising on the Korean Peninsula as Pyongyang has test-fired its most advanced intercontinental ballistic missiles (ICBMs) at full range for the first time since 2017.

North Korean leader, Kim Jong-un, recently told his military lieutenants that his regime is "ready to mobilize" its nuclear deterrent in future military conflict with the United States and South Korea.

Fitch Ratings said that while another nuclear test by North Korea would raise tensions on the peninsula, a test itself would not be enough to affect the rating, unless it has a severe impact on the South Korean economy and outlook.

"Our rating already captures the potential for a high degree of geopolitical tensions with North Korea. Our primary concern would be a potential geopolitical event that would have a large and prolonged negative impact on the South Korean economy, but this is not close to being our baseline expectation," Zook explained.

Currently, Fitch already accounts for geopolitical risks related to the North in its sovereign rating by having lowered South Korea's rating to AA- from the country's AA score in its sovereign rating model. "This downward notch has been in place for quite some time and encompasses a high degree of volatility in the relationship with North Korea," he added.

In 2017, when tensions with North Korea were highly elevated as the North conducted its sixth nuclear test, Fitch did not adjust its rating on South Korea.

Kim Yoo-chul

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