Bank of Korea rate cut, what is direction to exchange rate?

1. the Bank of Korea's rate cut

1)  Bank of Korea's rate cut 

On October 11, the Bank of Korea finally lowered its base interest rate by 0.25% after 38 months. 

This rate cut by the Bank of Korea is considered as desperate measure. The European Central Bank, Canada, and others have preemptively taken advantage of inflation being under control to lower interest rates. 

In the case of the United States, which was uncertain about its own economic situation, the Federal Reserve acted swiftly with a significant 0.5% rate cut as inflation entered the 2% range and new unemployment claims rose to about 250,000, raising concerns about a higher unemployment rate.

 While this decision was made in consideration of the U.S. domestic economy, it has a significant impact on other countries like Korea. As a result, the gap in base interest rates between Korea and the U.S. is now narrowing. 

2) interest rate gap will narrow

With the U.S. setting its interest rate at 5%, if Korea maintains its existing 3.5% base rate, the interest rate gap will narrow, raising concerns about the potential outflow of foreign investment from Korea’s stock market and other sectors. 

Inflation, which is the condition for maintaining high interest rates, has already fallen below 2% in Korea, creating sufficient room for a rate cut. 

However, one of the key reasons why the Bank of Korea has been cautious about lowering interest rates is Korea's exceptionally high household debt levels.

 Lowering rates could reduce financing costs for real estate and other sectors, leading to a potential increase in household debt.

Korea's domestic economy has already cooled, with many small businesses closing down, raising concerns that the country could face a prolonged period of deflation similar to Japan’s 30-year slump. 

In this context, there is a growing need to stimulate the economy. The Bank of Korea, acknowledging the risk of rising household debt, nevertheless decided to lower the base interest rate by 0.25% in an effort to revitalize the economy.

2. The direction of the exchange rate after an interest rate cut

1) the Bank of Korea rate cut's impact

When the Bank of Korea cuts interest rates, it inevitably impacts the exchange rate, a critical factor in trade for Korea, which has a high dependence on exports. 

The key question is how the rate cut will affect the exchange rate between the Korean won and the U.S. dollar—whether the exchange rate will rise or fall. 

The exchange rate, like any other economic commodity, follows a simple price determination structure: if there is an abundance of U.S. dollars in supply, the exchange rate falls; if the supply decreases, the rate rises. 

Whether the exchange rate rises or falls depends on whether the supply of U.S. dollars increases following the rate cut, which in turn depends on Korea’s economic situation. 

2) The volatility of the exchange rate

Fundamentally, by lowering the interest rate despite the risk of increasing household debt, the Bank of Korea is aiming to revitalize the sluggish domestic economy and stimulate overall economic growth. If the monetary policy direction focuses on stimulating the economy, then investment efforts will primarily target revitalizing domestic demand.

If foreign investors share optimism about the economic stimulus, foreign capital will flow into Korea, increasing the supply of U.S. dollars and leading to a lower exchange rate.

 However, if foreign investors remain uncertain or pessimistic about Korea's economic outlook despite the Bank of Korea's rate cut, capital may flow out of the country, causing the exchange rate to rise.

The key to understanding the volatility of the exchange rate after the Bank of Korea’s rate cut is not merely that the rate cut was made to boost domestic demand, but rather how the Korean economy evolves following the rate cut.