Seoul: Higher borrowing costs are prompting South Korea to undertake significant economic reforms aimed at boosting productivity and strengthening financial stability. This comes as the era of cheap money, which has prevailed for more than two decades, appears to be coming to an end.
According to Yonhap News Agency, the 10-year US Treasury yield has recently surpassed 5 percent, coinciding with the Federal Reserve's decision to increase its benchmark rate by 25 basis points to a range of 3.75 to 4 percent. This marks the first rate hike since July 2023, signaling a shift in the global financial landscape.
The prolonged period of low capital, energy, and labor costs had previously allowed economies to absorb inefficiencies without incurring significant expenses. However, as these favorable conditions diminish, South Korea must abandon policies that rely on the assumption of perpetually low rates. Long-term yields are now influenced by factors beyond short-term inflation, such as persistent Middle East conflicts driving oil prices above $100 a barrel and substantial investments in artificial intelligence infrastructure competing for global savings.
US fiscal policy also contributes to the strain, with gross public debt exceeding 110 percent of GDP. Investors are demanding higher premiums for holding long-term government bonds, diminishing Treasurys' status as exceptionally liquid and safe assets. While issuing more short-term debt might appear as a solution to avoid locking in elevated long-term yields, it only postpones the issue, leading to costlier refinancing if rates remain high.
South Korea is already experiencing the impact of these shifts, with the 10-year Treasury bond yield climbing above 4.6 percent, the highest since October 2022. This rise in government bond yields is affecting corporate borrowing costs and bank lending rates, putting pressure on businesses and households. Additionally, the Bank of Korea has tightened its policy rate to 3 percent over consecutive meetings in July and August, marking the first back-to-back rate hikes since January 2023. The gap between the Bank of Korea and the Federal Reserve has widened to as much as 1 percentage point, exacerbated by a weaker won and substantial household leverage.
Matching every move by the Federal Reserve would not constitute sound monetary policy for South Korea. The Bank of Korea needs to establish clear conditions for further rate increases, considering domestic inflation, exchange rates, and credit conditions. With household credit exceeding 2,000 trillion won ($1.45 trillion) and corporate debt nearing similar levels, the burden of higher interest expenses will disproportionately affect borrowers with limited financial flexibility. Therefore, financial support should be targeted and selective to avoid concealing losses.
Fiscal policy also faces challenges, as large-scale government borrowing could exert additional upward pressure on market rates, consuming more of the budget on interest payments. South Korea should reduce nonessential spending to maintain primary fiscal stability. In an environment of expensive capital, competitiveness hinges on maximizing output from each unit of investment, necessitating regulatory reforms to lower market entry barriers, enhance labor market flexibility, and strengthen productivity incentives.
While it is uncertain when interest rates will decline, South Korea must prepare for an extended period of elevated capital costs, which could expose overextended finances and unproductive investments. The era of postponing difficult decisions due to cheap money is fading, and South Korea can no longer afford to tolerate low productivity, reckless leverage, or misdirected capital. The current challenge is to ensure that each unit of capital delivers measurable returns to prevent higher borrowing costs from becoming a persistent obstacle to growth.