[Viewpoint] Low Likelihood of Interest Rate Increases Due to the Crowding-Out Effect

Recently, market interest rates have risen relatively sharply amid expectations of a crowding-out effect. The essence of the crowding-out effect is that when the government issues national bonds to finance economic stimulus rather than increasing tax revenue, interest rates rise, eventually reducing consumption and investment. However, it seems highly likely that market interest rates will actually fall as financial institutions purchase the government-issued bonds.

According to the Ministry of Economy and Finance's "2020?2024 National Fiscal Management Plan," government revenues are expected to decrease relatively compared to expenditures, leading to an expansion of fiscal deficits and national debt. The Ministry projected that the managed fiscal balance deficit, estimated at 111.5 trillion won this year, will increase to 127.5 trillion won by 2024. Additionally, the ratio of national debt to gross domestic product (GDP) is expected to rise from 43.5% to 58.3% during the same period.

To cover the fiscal deficit, the government has no choice but to increase bond issuance. In fact, the outstanding amount of national bonds has been steadily increasing, from 280.9 trillion won at the end of 2009 to 611.5 trillion won at the end of 2019. By July of this year, it had risen to 691.9 trillion won, with the pace of increase accelerating. All else being equal, bond issuance increases supply in the bond market, lowering prices and raising interest rates.

However, the crowding-out effect has not appeared in our economy and is unlikely to do so in the future. Statistical analysis from January 2001 to July this year shows a very high negative correlation coefficient of -0.89 between the outstanding amount of national bonds and bond yields. This means that even as the government increased bond issuance, market interest rates actually fell. Other factors besides bond issuance have influenced interest rates. First, market interest rates incorporate expected real economic growth rates and inflation rates, both of which have been steadily declining. Additionally, the total savings rate continues to exceed the domestic investment rate. From a macroeconomic perspective, this indicates that the supply of funds exceeds demand, resulting in excess liquidity.

Moreover, as financial institutions, especially banks, purchase bonds, the pace of interest rate decline may accelerate. When banks receive funds, they either lend to households or businesses or invest in securities such as stocks and bonds. Although household financial debt is high, individuals remain net savers. In the first quarter of this year, the net funds surplus (difference between operation and procurement) in the personal sector was 67 trillion won, significantly higher than 28 trillion won in the same period last year. Corporations are net borrowers, with borrowed funds exceeding savings, but the scale of this deficit is shrinking. For example, the corporate funding shortfall, which was 8.7% of GDP (four-quarter moving average) in 2008, decreased to 3.9% in the first quarter of this year. If this trend continues, corporations may become net savers within two to three years.

If corporations, following households, become net savers with more funds deposited in financial institutions than borrowed, financial institutions will significantly increase their investments in securities, especially bonds, with the surplus funds. This has already occurred in Japan. When Japanese corporations became net savers in 1998, there was a major shift in bank asset management. The loan portion of bank assets, which was 62.9% in 1998, decreased to 41.0% by 2011, while the bond portion increased from 12.6% to 32.4% during the same period. From the end of 2011, Japan's government bond yields entered the zero percent range, with banks' expanded bond purchases greatly contributing to the decline in interest rates. During this period, Japan's government debt to GDP ratio rose from 100% to 198%, reflecting increased bond issuance?all of which was purchased by financial institutions.

As of the end of March, the loan portion of Korean bank assets is 62.7%, and the bond portion is 15.0%, similar to Japan's situation in 1998. Going forward, the government will increase spending to stimulate the economy and cover fiscal deficits through bond issuance. However, as financial institutions such as banks purchase more government bonds, market interest rates are likely to fall further.

Kim Young-ik, Adjunct Professor, Graduate School of Economics, Sogang University

This content was produced with the assistance of AI translation services.