US-Korea Interest Rate Inversion 'Imminent'... Possible as Early as July

Looking into past cases
During the second US-Korea interest rate inversion
Foreign stock funds outflow of $26.3 billion

[Asia Economy Reporter Seo So-jeong, Sejong=Reporter Son Seon-hee] As the U.S. Federal Reserve (Fed) has signaled two or three more 'big steps' (0.5 percentage point hikes) following May, concerns are growing that the interest rate differential between South Korea and the U.S. could invert as early as July, potentially triggering large-scale capital outflows. Since the second half of last year, the Bank of Korea (BOK) has proactively responded to the U.S.'s tightening monetary policy by alternating between raising and holding the base interest rate. The decision to raise the base rate last month amid the unprecedented absence of a BOK governor was largely intended to address high inflation and delay the interest rate inversion between South Korea and the U.S. as much as possible.

However, the interest rate inversion between South Korea and the U.S. has become an imminent crisis rather than a future concern. If the BOK's Monetary Policy Committee holds rates steady on the 26th and the Fed raises rates by 0.5 percentage points at the Federal Open Market Committee (FOMC) meeting on June 14-15, the interest rates of South Korea and the U.S. will both stand at 1.50%. This means the interest rate inversion could become a crisis starting as early as July. Market analysts suggest that if the policy interest rates between South Korea and the U.S. invert, the intensity of capital outflows could be stronger than during the period from August 2005 to September 2007, when $26.3 billion was withdrawn from the domestic stock market.

◆ Paying Close Attention to the Second Interest Rate Inversion= According to the BOK on the 6th, there have been three instances of policy interest rate inversion between South Korea and the U.S.: ▲ June 1999 to March 2001 ▲ August 2005 to September 2007 ▲ March 2018 to February 2020.

While the impact of these three interest rate inversion periods on the domestic market was generally limited, experts advise paying close attention to the second case, during which foreign capital outflows from the stock market were significant. From August 2005 to September 2007, foreign investors withdrew $26.34 billion from the domestic stock market. The investment industry attributes this to a global preference for safe assets like the dollar amid U.S. rate hikes, which led to massive foreign capital outflows.

During the third period, foreign capital outflows from the domestic stock market amounted to $8.36 billion. In contrast, during the first period, $20.93 billion of foreign capital flowed into the domestic stock market, which is analyzed as a result of expanded market openness at that time.

Experts express concern about the upcoming fourth interest rate inversion between South Korea and the U.S. Due to the continuous expansion of domestic financial market openness and the much easier inflow and outflow of foreign capital compared to the past, the risk of large-scale foreign capital outflows in a short period has increased.

◆ Won Depreciation Also Heightens Capital Outflow Concerns= Recently, movements in the foreign exchange market have been unusual. Jo Young-moo, a research fellow at LG Economic Research Institute, stated, "Looking at emerging market cases that experienced policy rate inversion in the past, when the inversion deepened and the value of the local currency was expected to decline in the foreign exchange market, the expected investment returns on investments in those countries decreased, leading to increased foreign capital outflows." He added, "If the depreciation outlook of the Korean won spreads in the foreign exchange market, foreign capital outflows could accelerate." The unusually rapid pace of U.S. rate hikes and the sharp depreciation trend of the won, even before the rate inversion has materialized, are factors that increase the possibility of capital flight. If the won-dollar exchange rate continues to rise, foreign capital outflows could expand further, exacerbating stock price declines, rising market interest rates, and additional depreciation of the won.

Of course, there are views that concerns over large-scale capital outflows due to the interest rate inversion between South Korea and the U.S. are excessive. Although temporary outflows of funds from stocks and bonds occurred during the three previous inversion periods, the overall securities investment funds (based on the balance of payments) recorded net inflows of $16.87 billion, $30.45 billion, and $40.34 billion, respectively. Professor Kim Jin-il of Korea University’s Department of Economics said, "What matters more than the inversion itself is how long the inversion lasts," adding, "Capital moves depending on the expected duration of the inversion." BOK Governor Lee Chang-yong also stated at his confirmation hearing, "Capital outflows depend not only on interest rates but also on expectations regarding exchange rate changes, the overall economic fundamentals, and various other factors, so outflows do not necessarily occur immediately." He further noted, "If the interest rate gap widens, the won’s value will depreciate, which could have a more concerning impact on inflation."

The government plans to take immediate action if necessary to respond to uncertainties such as the U.S. policy rate hikes. Lee Eok-won, First Vice Minister of Strategy and Finance, said at a macroeconomic and financial monitoring meeting involving the International Finance Center on the same day, "We will maintain close cooperation and response systems among related agencies while carefully monitoring market conditions and major risk factors with heightened vigilance, and if necessary, we will boldly and swiftly implement market stabilization measures."

There are also expectations that the BOK’s pace of base rate hikes will accelerate beyond current forecasts. Professor Kim said, "Last month, the domestic consumer price inflation rate reached 4.8%, the highest in 13 and a half years since the financial crisis, and inflationary pressure is strong," adding, "Since the upward trend is expected to continue for some time, there is a strong possibility that the Monetary Policy Committee will raise rates in May."

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