Fed rate moves squeeze a key US ally

South Korea's alliance with the U.S. has strengthened during the Biden presidency. But the country's economy has fallen victim to the rapid rise in U.S. interest rates.

Fed rate moves squeeze a key US ally

Since early 2022 the Fed has been on an unprecedented spree of rate increases, in an effort to curb inflation which peaked at 9.1% by mid-last year. Central banks around the world have been following these moves partly to protect their currencies from falling as rising Treasury yields encourage investors to sell overseas assets and purchase U.S. Bonds.

In less than one year and half, Bank of Korea increased interest rates ten times, bringing them up to 3.5% in January. The rise in interest rates in the United States was not the only factor. Korea also had to deal with its own inflation problems and cool down a housing bubble that was at risk two years ago.

The Korean economy is in a shaky state, and the uncertainty surrounding U.S. rates makes it difficult for Korea's central banks to boost the economy while protecting its currency. The Fed's hike cycle is nearing its end, according to most economists. However, it is unclear when the Fed will start to reduce rates and at what level.

Frederic Neumann is a senior economist with HSBC. He said that the Fed had tied the Bank of Korea's hands. The risk is that if the Fed doesn't cut rates for a while, the Korean economy may suffer if it is left high. This could add to the growth drag.

Korea has been an important ally of the United States for many years, but they have become closer since the election of President Biden in the U.S. and President Yoon-Suk Yeol in South Korea. In early this year, the U.S. signed a trilateral pact with Japan and South Korea to protect against North Korea and China. According to estimates made by the Department of Defense in January, there are approximately 28,500 U.S. troops stationed in Korea.

The post-pandemic boom in Korea is over. House prices are down and the economic growth has slowed. According to the International Monetary Fund, Korea's economic growth will be just 1.4% in 2013.

Since the start of the year when the central banks finally stopped raising rates, the Korean won has lost 7% in value against the U.S. Dollar. The Fed raised rates four different times in this year. This has increased the difference between interest rates for Korea and the U.S. by around two percentage points.

Ken Cheung is the chief Asian FX Strategist at Mizuho. He said that Bank of Korea will play catch up with U.S. rate increases in order to maintain stability. He said that the central bank would not do this by increasing rates but rather by waiting until U.S. interest rates drop before cutting rates.

The central bank has been further complicated by the rise in oil costs as a result the Israel-Hamas conflict. After several months of slowing, consumer price inflation reached 3.7% in September. This is well above the central banks' inflation target of 2.5%.

The Bank of Korea kept interest rates at the same level last week.

South Korean policymakers have painful memories about currency depreciation. During the Asian Financial Crisis of the late 1990s - a crisis fueled by massive flight of capital from international investors - the Korean won lost half its value against U.S. dollars. It is deeply embedded in the Korean national memory that during the Asian financial crisis of the late 1990s, the Korean won lost around half its value against the U.S. dollar.

The spiraling debt of Korea's companies and households is a major problem. Nomura estimates that the debt held by both households and companies reached almost 229% in the second quarter. This is the highest level for three decades. The bank reported that interest payments have reached multidecade-highs and that indebted families are using 40% of their income for debt repayment.

Jeong Woo Park is an economist with Nomura. He believes that the Bank of Korea will start cutting interest rates ahead of the Fed due to the financial strain of high debt payments. He expects that the central bank will hold off until April next year, and predicts that the Bank of Korea's interest rate will be cut to 2.5% at the end of the next calendar year.

IMF data show that South Korea's household is at around 105% GDP. This is one of the world's highest levels of debt. The Federation of Korean Industries is a business organization that claims the figure increases to 157% if you include 'jeonse,' large deposits paid by tenants to landlords in order to secure an apartment at a lower or no rent. This system is common in Korea.

Bank of Korea's not the only central bank in the world that is being squeezed due to uncertainty about U.S. rates. Malaysia's central banks said earlier this year that more clarity about Fed policy will support its currency. The ringgit is down almost 8% this year against the U.S. Dollar, making it the worst performing currency in Asia.

Frances Yoon can be reached at EMAIL