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A Nordic chill

5 September 2014 By Andy Mukherjee

South Korea’s finance minister has warned that the economy is entering “an early stage of deflation”. His admonition should stir the country’s central bank from slumber.

Since March 2012, the Korean inflation rate has been below the midpoint of the Bank of Korea’s 2.5-to-3.5 percent target. Yet the monetary authority has been reluctant to cut interest rates for fear that lower borrowing costs could swell the ageing society’s large household debt pile.

This cautious approach mimics the now-abandoned strategy of Sweden’s Riksbank. Korea’s household debt was 164 percent of disposable income in 2012 – similar to Sweden’s 172 percent.

But failing to conjure up inflation has backfired. Finance Minister Choi Kyung-hwan said on Aug. 29 that “the economy could get mired in a protracted slump”. He is right. The Korean won’s real exchange rate in the past six months has been 7 percent higher than in the first half of 2013.

If the central bank slashed its policy rate – currently at 2.25 percent – the won could depreciate, boosting exports and investment. But Bank of Korea has cut borrowing costs by just 1 percentage point since mid-2012, including a quarter-point cut in August. This has not been enough to weaken the currency or lift local prices.

That failure is actually aggravating consumer debt. If the Bank of Korea had achieved its goal of 3 percent annual inflation, the real value of a Korean loan taken out in September 2008 would have fallen by 19 percent. But with inflation below target, the debt load has only shrunk by 14 percent. The 5 percentage point gap is effectively a tax on borrowers. No wonder Korean consumers are depressed.

In Sweden, Riksbank’s Deputy Governor Lars Svensson quit last year after failing to persuade his colleagues that higher-than-warranted interest rates were worsening the consumer debt overhang. In July this year, policymakers finally overruled the governor, slashed rates and pledged not to raise them until late in 2015.

Korea is not yet in deflation: prices rose 1.4 percent last month. But the monetary authority needs to stop repeating the Riksbank’s mistake. Choi is right to raise the deflation alarm. Now the central bank needs to wake up.




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