[Financial Planning for the 100-Year Life] Will Market Interest Rates Fall Despite Increased Government Fiscal Spending?

According to the 2026 budget proposal and the 2025-2029 National Fiscal Management Plan approved by the government at the Cabinet meeting on August 29, both the fiscal deficit and national debt are set to increase. This will lead to an increase in government bond issuance, which is expected to act as a factor pushing up market interest rates. However, considering the underlying factors in the Korean economy, there is a high probability that interest rates will decline over the medium to long term.

The government has decided to increase next year's fiscal expenditure to 728 trillion won, up 8.1% from this year. There is significant interest in how this expansionary fiscal policy will affect interest rates. Most notably, to cover the managed fiscal deficit, which amounts to 4% of gross domestic product (GDP), the government will inevitably have to increase the issuance of government bonds. If the net issuance of government bonds rises by tens of trillions of won each year, the bond market will face supply pressure, which may lead to a fall in bond prices (and a rise in interest rates).

Large-scale fiscal spending can support economic recovery in the short term, but it also stimulates inflationary pressures. In this case, the Bank of Korea will likely adopt a tighter monetary policy to achieve its inflation target.

The rising trend in the national debt ratio is also expected to weigh on the bond market. The government projects that the national debt ratio will reach 51.6% in 2026 and aims to manage it in the upper 50% range through 2029. While this is still only a mid-level figure by Organisation for Economic Co-operation and Development (OECD) standards, Korea's government debt ratio has risen by nearly 20 percentage points in just over a decade. What matters more than the absolute level is the pace of increase and its sustainability. International credit rating agencies and foreign investors are closely monitoring this, and if the outlook for Korea's credit rating turns negative in the future, interest rates could rise further.

However, when considering the structural factors of the Korean economy, there is a high probability that market interest rates will continue to decline. This can be explained from three perspectives. First, both economic growth rates and inflation rates, which determine interest rates, are falling. The market interest rate we observe is the nominal rate, which is the sum of the real interest rate and the inflation rate. The real GDP growth rate is used as a proxy for the real interest rate. Korea's potential growth rate, which was estimated at about 10% in the 1980s, has recently dropped to around 2%. The Bank of Korea estimates the potential growth rate for the next five years (2025-2029) to be 1.8%. After that, the potential growth rate is expected to continue declining, entering the 0% range after 2040. As the economic growth rate falls, so do interest rates.

Second, from the perspective of the entire national economy, the supply of money exceeds demand. In a country's economy, savings represent the supply of money, while investment represents the demand. Before the 1997 foreign exchange crisis, the gross domestic investment rate was higher than the gross savings rate in Korea, resulting in a high-interest-rate economy due to demand outpacing supply. However, after the crisis, Korean companies made more rational investments, and the investment rate fell below the savings rate. From 1998 to 2024, the average savings rate was 34.6%, surpassing the investment rate of 31.6%, making Korea a capital surplus economy. This trend is expected to continue, leading to further declines in market interest rates.

Third, as banks purchase more bonds, market interest rates are expected to fall further. When banks receive deposits, they either lend to households or companies or invest in securities. Households, with more savings than loans, are net suppliers of funds, while companies are typically net demanders. However, in Japan, since 1998, companies have also become net suppliers of funds. With both households and companies saving, lending decreased, and banks inevitably increased their investments in securities, particularly bonds. The proportion of bonds in Japanese banks' assets rose from 12.6% in 1998 to 32.4% in 2011. During this period, as Japan's economy fell into deflation, the government dramatically increased government bond issuance to stimulate the economy, and banks bought these bonds, driving interest rates down to the 0% range. There is a high probability that similar dynamics will occur in Korea. According to the Bank of Korea's flow of funds data, as of March this year, Korean companies held 944 trillion won in cash and cash equivalents. Since large corporations with ample cash will borrow less, banks are expected to further increase their bond investments.

With expectations of a widening fiscal deficit and increased government bond issuance, market interest rates, especially long-term rates, are rising. Looking further ahead, it may be a good time to increase bond investments.

Kim Youngik, Advisor, The J Asset Management

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