By Kim Jae-kyoung
Staff Reporter

The upward spiral in U.S. interest rates is expected to throw cold water on the recovering domestic economy by hurting Korea’s exports to the nation’s largest trade partner, analysts said.



But U.S. credit tightening will not have a significant direct implication on the local financial market in the immediate future, as it has been widely anticipated, they added.

``The most important aspect of the U.S. economy for Korea is U.S. domestic demand, especially for electronics,’’ Barclays Capital senior economist Dominique Dwor-Frecaut told The Korea Times.

``Right now it seems it is slowing down. But the Fed will keep raising rates because U.S. inflation is also rising, which will slow U.S. demand further. That is the overall negative impact of the Fed decisions on the Korean economy,’’ she said.

The Korean economy is still banking on external demand to power its growth, with private spending remaining stagnant. Exports, which account for about two-fifths of the economy, rose 14.2 percent to $24.2 billion in March

On Monday, Fed chairman Alan Greenspan and his colleagues, sticking to a course of gradually raising rates, inched up the federal funds rate by one quarter of a percentage point to 3 percent.

The move, which had been widely expected by financial markets, was the eighth increase in the key rate since Fed began its credit tightening campaign last June.

JP Morgan economist Lim Ji-won also expects that the Fed, caught between rising inflation and slowing economic growth, will continue raising the interest rate that banks charge each other on overnight loans

``Although the U.S. rate hike this time will have little effect on the economy, a further rate cut will have a negative effect on the local economy,’’ she added. JP Morgan expects the U.S. to raise its key rate to 4.25 percent by the end of this year.

However, analysts said that the local financial market, especially the stock market, will not be fluctuated by U.S. rate increases as most of the foreign inflows into Korea are equity portfolio inflows, not bond portfolio or bank deposits.

``Equity portfolio inflows are not directly influenced by the interest rate differential,’’ Dominique said. ``That’s why in practice, the interest rate differential will have little impact on the Korean won.’’

She pointed out that in any event, Korean policymakers would be happy to see an outflow of capital that would weaken the won.

At a press conference in April, Bank of Korea Governor Park Seung dismissed concerns over a possible capital outflow led by U.S. rate hikes.

``Even if the U.S. rate hikes outrun the BOK’s call rate, it will be no problem,’’ he said. ``The problem is how wide the gap between interest rates in the two nations will be.’’ He pointed out that it is time to encourage overseas investment.

The series of rate hikes, however, have placed the Korean central bank in a dilemma as the U.S. credit tightening is putting growing pressure on the BOK to raise interest rates.

``Monetary policymakers are confronted with two challenging factors _ a possible capital outflow on one hand and slowing economic growth on the other,’’ Korea Institute of Finance senior economist Park Jae-ha said.

``Lower interest rates are a defense against a possible capital flight, but higher interest rates make borrowing money more expensive, discouraging some consumers and businesses to spend and invest,’’ he added.

The BOK is scheduled to hold its monthly monetary policy committee meeting to decide on the key interest rate on May 12. Most market analysts expect the central bank will leave the rate unchanged this time.

But if the U.S. keeps hiking the Fed’s rate, greater pressure will be put on the BOK to raise the interest rate because the gap between the rates in the two economies has narrowed, the analysts said.

``The problem is how long the trend of U.S. credit tightening will continue,’’ Lim of JP Morgan said. ``Seven or eight consecutive rate hikes, even if each change is mild, could cause local investors to go abroad.’’

``If a difference between domestic and overseas interest rates is reversed due to continuing U.S. rate hikes, local individual funds, not foreign funds, are likely to leave the country,’’ she added.

The gap between interest rates in the U.S. and Korea has narrowed to 0.25 percentage point this month, compared to a 2.75 percentage point difference during 2003.

The BOK has cut interest rates four times since May 2003 to stimulate domestic demand, most recently in November, but it has maintained the key rate intact since December.

kjk@koreatimes.co.kr