Korea-US Interest Rate Gap Hits Record High... Concerns Rise Over Currency Surge Due to Capital Outflow

"Real Trend May Stimulate Inflation Again"
"Long-term Exchange Rate Stability Expected," Counterarguments Also Raised

The U.S. Federal Reserve (Fed) raised its benchmark interest rate by 0.25 percentage points on the 3rd (local time), widening the interest rate gap between South Korea and the U.S. to a record high of 1.75 percentage points. Concerns over foreign capital outflows are growing, deepening the Bank of Korea's dilemma ahead of its interest rate decision scheduled for the 25th.

On the morning of the 4th, at an emergency macroeconomic and financial meeting, Deputy Prime Minister and Minister of Economy and Finance Choo Kyung-ho, Bank of Korea Governor Lee Chang-yong, Financial Services Commission Chairman Kim Ju-hyun, and Financial Supervisory Service Governor Lee Bok-hyun stated, "Due to the Fed's interest rate hike, there is a possibility of increased uncertainty in the financial and foreign exchange markets."

Deputy Prime Minister Choo and Governor Lee, attending the Asian Development Bank (ADB) Annual Meeting held in Songdo, Incheon, held an in-person meeting that day, while Chairman Kim and Governor Lee participated remotely. The government and the Bank of Korea emphasized, "Given the expanded interest rate differential between domestic and foreign rates, there is a persistent risk of increased volatility caused by market disruption and herd behavior, necessitating heightened vigilance and a careful response to the current situation."

In particular, the Bank of Korea noted that Fed Chair Jerome Powell indicated that future rate decisions would depend on economic indicators and denied the possibility of rate cuts within the year. Bank of Korea Deputy Governor Lee Seung-heon said, "The Fed's decision to raise the benchmark interest rate was as expected by the market," adding, "This decision suggests that the Fed's rate hike cycle is approaching its final stage." Going forward, the Bank plans to closely monitor market conditions as volatility in domestic and international financial markets may increase depending on changes in expectations regarding monetary policies of major central banks such as the Fed and the European Central Bank (ECB), as well as developments in financial stability.

In the market, concerns are growing as the Fed's rate hike has expanded the benchmark interest rate gap between the U.S. (5.00?5.25%) and South Korea (3.50%) to 1.75 percentage points at the upper limit, forming the largest ever Korea-U.S. interest rate inversion. Recently, the won-dollar exchange rate surpassed 1,340 won, showing a soaring trend, raising fears that foreign investor capital outflows could accelerate due to the Korea-U.S. interest rate gap. The largest previous interest rate inversion was 1.5 percentage points recorded in October 2000, so the current 1.75 percentage points is an unprecedented gap, which is also a cause for concern. From the perspective of the won, which is not a key currency (the basic currency for international settlement and financial transactions) like the dollar, a wider interest rate gap with the U.S. could lead to foreign capital outflows and a sharp rise in the won-dollar exchange rate.

Kim Jung-sik, Professor Emeritus of Economics at Yonsei University, said, "If the won depreciates, the won-denominated price of imported products will rise, potentially reigniting inflation that has just begun to stabilize," adding, "Since exchange rate increases affect import prices and domestic stock market declines, the exchange rate trend must be closely watched." Choi Jae-young, former head of the International Finance Center, said, "The interest rate differential between domestic and foreign rates is one of the key variables in determining monetary policy," and predicted, "If the won-dollar exchange rate rises to 1,340?1,350 won and foreign capital outflows intensify, the Bank of Korea cannot completely rule out the possibility of raising the benchmark interest rate at this month's Monetary Policy Committee meeting."

On the other hand, there is a considerable counterargument that the recent won-dollar exchange rate rise was driven by caution ahead of the U.S. interest rate decision and that, in the long term, it will show a downward stabilization trend. Kim Chan-hee, a researcher at Shinhan Investment Corp., said, "The sharp rise in the exchange rate at the end of last month was due to the market's anticipation of further Fed tightening," adding, "Seasonal dividend repatriation demand also contributed to the exchange rate increase." Korean companies mainly pay dividends in April, and foreign investors actively convert the dividends received into dollars and remit them back to their home countries, which has driven up the exchange rate. Additionally, concerns over fundamentals have grown, causing the won to show relatively weaker performance compared to major currencies. Kim predicted, "Although there may be temporary spikes, the won-dollar exchange rate is expected to gradually stabilize downward."

The Bank of Korea also positively evaluated the Fed's deletion of the phrase "additional policy tightening is expected to be appropriate" from its rate policy statement, signaling a possible pause in rate hikes. The Bank stated, "The Fed's indication of a 'conditional pause in rate hikes' is a positive factor for our financial and foreign exchange markets," and assessed, "Despite recent global banking sector instability, our financial markets have remained relatively stable, supported by net foreign purchases, and the corporate bond and short-term money markets are generally in good condition." In fact, on that day, the won-dollar exchange rate opened at 1,335.0 won, down 3.2 won from the previous day, and has been moving in the low to mid-1,330 won range.

Experts expect the Bank of Korea to keep the benchmark interest rate unchanged on the 25th if there are no significant changes in the exchange rate and foreign capital trends. Joo Won, head of economic research at Hyundai Research Institute, predicted, "At this month's Monetary Policy Committee meeting, the Bank of Korea will likely maintain rates while assessing the impact of its ongoing tightening measures and monitoring global financial instability following the U.S. Silicon Valley Bank (SVB) incident." Professor Ha Joon-kyung of Hanyang University's Department of Economics added, "The current account deficit recorded for two consecutive months for the first time in 11 years in January and February, and the trade balance based on customs clearance has been in deficit for 14 consecutive months through April, making the future current account trend a key variable in monetary policy decisions," adding, "Although the April consumer price inflation rate has fallen to the 3% range, core inflation remains sticky, so the Bank of Korea cannot afford to relax its vigilance."

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