[Opinion] The COVID-19 Crisis and the Effects of Monetary Policy

Seo Ji-yong, Professor, Department of Business Administration, Sangmyung University

Recently, due to the spread of the novel coronavirus infection (COVID-19), normal social and economic activities seem to have come to a halt. In particular, the damage to small business owners and small and medium-sized enterprises (SMEs) is considerable. Above all, since there is no end in sight to the COVID-19 crisis, public anxiety appears to be growing. To minimize the damage caused by the COVID-19 crisis, the government announced a supplementary budget plan. A super supplementary budget of 11.7 trillion won was prepared, including a budget of 2.4 trillion won to support SMEs and small business owners. Among this, there are plans for emergency management fund loans at lower interest rates than bank loans, showing the government's strong will to actively implement fiscal policies.

Meanwhile, the Financial Monetary Policy Committee (FOMC), which is responsible for monetary policy, also decisively cut the base interest rate by 0.5 percentage points on the 16th, following the U.S. Federal Reserve's (Fed) large-scale rate cuts (a total of 1.5 percentage points reduction in two rounds from March 3 to March 15). This is aimed at overcoming the economic recession caused by the COVID-19 crisis. With the Fed's large-scale rate cuts, the U.S. is currently at a zero interest rate. The widening base interest rate gap between Korea and the U.S. seems to have been reflected in the FOMC's significant rate cut. Then, is it really possible to support low-interest liquidity funds for small business owners and SMEs as expected through the base interest rate cut? This depends on the response of commercial banks to the base interest rate cut.

Unfortunately, the possibility of an increase in low-interest loan supply through the base interest rate cut is not high. After the FOMC's decision to freeze the base interest rate at the end of February, commercial banks lowered deposit and loan interest rates by about 0.2 percentage points. Banks have preemptively reflected the possibility of future base rate cuts in their deposit and loan interest rates. The base interest rate no longer functions as a benchmark rate for commercial banks' deposit-loan rate spreads. Therefore, it is difficult to expect further declines in deposit-loan interest rates despite the March base rate cut. The transmission channel of monetary policy is not operating smoothly.

The main reason is that the base interest rate level itself is already too low, and it is difficult for banks to further lower interest rates. For commercial banks, so-called low-cost deposits, such as demand deposits, account for about 20-40% of total deposits. When loan interest rates are lowered due to a base rate cut, deposit interest rates should also be lowered proportionally, but there is no room to further reduce the demand deposit interest rate, which is around 0.1%. If only loan interest rates are lowered, it could reduce the net interest margin (NIM), which is the banks' profit base.

Moreover, accommodative monetary policy may lead commercial banks to reduce the supply of SME loans, which are considered risky loans. Domestic and international studies published in 2015 (Valencia, 2014; Seo, 2016) have shown that a low interest rate environment set by central banks reduces risk premiums, causing banks to reduce SME loan supply. To support numerous small business owners and SMEs financially, policy funds alone have limitations, and voluntary loan expansion by the private sector commercial banks is necessary. The FOMC's base interest rate cut is neither effective nor desirable in this regard.

Rather, the base interest rate cut may accelerate the depreciation of the Korean won. With the recent continuous net selling by foreigners and the ongoing decline in stock prices, there is a possibility of foreign investment funds currently staying in the domestic financial market leaving overseas. The U.S. has experience overcoming the 2008 global financial crisis through quantitative easing policies and is expected to focus on economic stimulus through active liquidity supply in the future. Then, can Korea further cut the base interest rate to implement a zero interest rate policy like the U.S.? In conclusion, it seems unlikely. Thus, the 0.5 percentage point base interest rate cut is judged to have exhausted the FOMC's monetary policy capacity. Going forward, it is necessary to further increase market liquidity through the central bank's repurchase agreement (RP) purchases. Additionally, to prepare for the rapid rise of the won-dollar exchange rate, efforts should be focused on concluding and expanding the scale of won-dollar currency swap agreements with the U.S.

[Seo Ji-yong, Professor, Department of Business Administration, Sangmyung University]

This content was produced with the assistance of AI translation services.