Kim Jung-sik
The author is an emeritus professor of economics at Yonsei University.
Korea’s economy is facing the shock of “four highs”: high oil prices; a weak won, as reflected in a high dollar exchange rate; high inflation; and high interest rates. Despite the possibility of a cease-fire in the Middle East conflict, tensions between Israel and Iran are expected to continue, making a return to prewar oil prices unlikely. The dollar-won exchange rate is also expected to hover in the mid- to upper-1,400 won range, and inflationary pressure from high oil prices and a weak currency is likely to rise with a lag.
Tankers are anchored in the Strait of Hormuz off the coast of Qeshm Island, Iran, on April 18 in this AP photo. [AP/YONHAP]
Increased fiscal spending has led to higher government bond issuance, and borrowing costs in the market are already trending upward amid persistent inflation. U.S. interest rates are also expected to rise. Before the conflict, expectations leaned toward rate cuts following stable oil prices and the U.S. midterm elections in November. However, concerns about inflation have grown as global supply chains shift after the war, raising the likelihood of policy tightening. Additionally, the Middle East conflict is expected to increase U.S. national debt, pushing up yields through expanded Treasury issuance.
The combination of the four highs and rising U.S. rates poses a significant risk to Korea’s economy. A deeper slowdown and expanding financial instability are key concerns. High inflation and borrowing costs tend to weaken domestic demand by reducing consumption and investment while increasing loan delinquencies. Exports are also likely to decline amid a global slowdown. At the same time, higher U.S. rates could accelerate capital outflows, further weakening the won.
To respond, policymakers have introduced fuel tax cuts and price caps to counter high oil prices and expanded fiscal spending through supplementary budgets to support domestic demand. However, challenges remain in addressing financial instability, capital outflows, inflation and exchange rate volatility.
First, macroprudential supervision must be strengthened. Unlike microprudential regulation, which focuses on individual financial institutions such as capital adequacy requirements under the Bank for International Settlements framework, macroprudential policy aims to maintain financial system stability in response to broader financial conditions. This approach draws on the “global financial cycle” theory proposed by Helene Rey, a professor at the London Business School.
According to the theory, global bank credit flows linked to cross-border capital movements are closely associated with the CBOE Volatility Index (VIX), which is influenced by U.S. interest rates. When U.S. rates rise, the VIX increases, prompting global banks to reduce lending due to heightened risk aversion. This leads to capital outflows from emerging markets. A stronger dollar also increases the debt burden of firms in those economies by depreciating local currencies.
Consequently, raising domestic interest rates alone is insufficient to prevent capital outflows. Instead, stronger macroprudential measures are needed to prevent financial crises and systemic instability. The theory also challenges the traditional “trilemma” of international finance and suggests a “dilemma” in which countries with open capital markets cannot fully maintain independent monetary policy.
Korea has previously stabilized exchange rates by imposing levies on excessive foreign currency borrowing by banks. However, the current situation differs. Capital outflows are increasing due to rising U.S. rates and growing overseas stock investments by Korean residents. This suggests the need to strengthen macroprudential oversight of securities firms, not just banks. Authorities are considering reforms to exchange-traded fund systems and tighter supervision of overseas operations by securities firms.
A gradual increase in interest rates is another policy option. While the global financial cycle limits the effectiveness of rate hikes in preventing capital outflows, higher rates can still reduce lending, contain financial risks and help stabilize inflation. However, sharp increases could deepen the domestic downturn and worsen financial stress. A measured approach is needed to absorb excess liquidity, stabilize housing prices and guide household debt toward a soft landing.
At the same time, policymakers must guard against “fiscal inflation” driven by expansionary fiscal policy. Increased government spending aimed at boosting domestic demand and supporting low-income groups can widen fiscal deficits, increase liquidity and push up inflation and exchange rates. Such policies may also conflict with monetary tightening efforts. As a result, fiscal spending must be used efficiently and should prevent excessive liquidity growth.
Exchange rate stability is another key priority. The global financial cycle framework places greater emphasis on foreign currency liquidity than on exchange rate levels. Korea’s strong current account surplus and net external creditor position suggest that foreign currency liquidity remains sufficient. However, a weaker won can still trigger capital outflows and raise import prices, making the exchange rate a critical vulnerability.
Most external assets are held by the private sector, complicating efforts to attract inflows during depreciation. While a currency swap with the United States could provide stable liquidity, such arrangements are difficult to secure for nonreserve currencies like the won.
Fuel prices for gasoline and diesel are displayed at a gas station in Seoul on April 22. According to the Bank of Korea’s preliminary Producer Price Index for March released that day, the index stood at 125.24, up 1.6 percent from the previous month and 4.1 percent from a year earlier. Coal and petroleum products surged 31.9 percent due to rising global oil prices linked to the conflict in the Middle East, and chemical products rose 6.7 percent. [NEWS1]
Korea posted a record current account surplus of $123 billion last year, but outbound investment has surged. Overseas securities investment by residents reached $140.2 billion, and combined with direct investment abroad, upward pressure on the exchange rate is likely to remain. Without policy intervention, a cycle of capital outflows and currency depreciation could intensify.
Finally, household debt must be managed carefully. Strict lending regulations aimed at stabilizing housing prices can reduce excessive debt but may also increase financial distress. Many financial crises have been triggered by abrupt credit tightening. Authorities should ensure that debt reduction occurs gradually to maintain financial stability.
The postwar global economy is expected to undergo structural changes, with cost-push inflation driven by supply chain shifts and rising liquidity. Unlike in the past, when central banks led liquidity expansion through low rates and quantitative easing, governments are now playing a larger role through fiscal expansion, increasing the risk of fiscal inflation.
Korea now faces a dilemma between supporting domestic demand and stabilizing inflation and the exchange rate, and policy tools are still constrained. The Bank of Korea has held its benchmark rate steady multiple times since last July, reflecting these limits. A cautious and well-coordinated macroeconomic policy mix is more necessary than ever.
This article was originally written in Korean and translated by a bilingual reporter with the help of generative AI tools. It was then edited by a native English-speaking editor. All AI-assisted translations are reviewed and refined by our newsroom.
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