[Insight & Opinion] Preventing the Spread of Financial Distress by Stimulating Domestic Demand

The government predicted a "lower in the first half, higher in the second half" economic pattern for this year. While a recession was expected in the first half, a recovery was anticipated in the second half. This optimism was based on the belief that exports would increase due to China's reopening (resumption of economic activities) starting in the second half. Consequently, fiscal spending was accelerated in the first half. However, contrary to expectations, exports to China are not projected to rise significantly even in the second half, raising concerns about a hard landing of the economy. In fact, the Bank of Korea recently downgraded its growth forecast for this year from 1.6% to 1.4%, and other forecasting institutions, including the International Monetary Fund (IMF), have also lowered their growth projections.

The reasons for the stagnation in our exports include the global economic downturn, falling semiconductor prices, and reduced exports to China. Another underlying factor is the narrowing technological gap with China, which has weakened our export price competitiveness. This is evident not only in the recent decline of exports to China but also in the decrease of exports to Southeast Asia, with China filling that gap. The problem is that if export sluggishness deepens the recession in the second half, corporate bankruptcies and financial insolvencies could expand. Due to the prolonged high-interest rate policy, households, self-employed individuals, and small and medium-sized enterprises are increasingly unable to bear the heavy interest burdens.

Delinquency rates in banks and other secondary financial institutions are rising, and there are concerns that this will worsen as the second half progresses. Additionally, if public utility charges, including electricity rates, and international crude oil prices rise after the second half, the exchange rate may increase, potentially driving inflation higher again. If prices rise, the Bank of Korea will have no choice but to raise interest rates, which could further deepen the recession and financial insolvencies. It is urgent for policymakers to devise measures to help the Korean economy escape the risk of financial distress.

First, if exports do not increase, efforts should focus on stimulating domestic demand. While lowering interest rates is a way to reduce the risk of financial distress, considering capital outflows and inflation, it is unlikely to happen before the United States lowers its rates. Given that most financial distress and crises stem from hard landings, policymakers need to stimulate domestic demand. Priority should be given to reviving the construction industry. Even advanced countries use construction to counter domestic demand slumps. The construction sector has strong linkages with other industries, effectively boosting domestic demand, and can increase employment for unskilled workers, thereby creating jobs for low-income groups. Additionally, excessive regulations on real estate should be eased, including reforming the abnormal tax structure on housing to revitalize the housing market.

Increasing fiscal spending to expand infrastructure investment in low-income residential areas is also necessary. Infrastructure investment in local regions has increased significantly so far. However, investments in transportation, distribution, and educational infrastructure in low-income residential areas on the outskirts of cities or in the metropolitan area have been insufficient. Policymakers should allocate fiscal resources to build infrastructure in these areas to alleviate economic inequality and stimulate domestic demand. If the recession worsens, supplementary budgets will also be needed. While fiscal soundness is important, avoiding a financial crisis is more urgent.

The Korean economy faces growing crisis risks as the trade deficit widens and the exchange rate stabilizes in the 1,300 won range. Past cases show that 1 to 2 years after interest rate hikes, financial distress expanded due to export declines and recessions, leading to crises. This is because interest rate hikes affect the economy with a time lag. Due to the risk of financial distress, the U.S. Federal Reserve is expected to end interest rate hikes soon. However, from the second half of this year, the side effects of previous rate hikes must be carefully monitored. The economic team must make every effort to increase exports to prevent a hard landing, but if exports do not rise, preemptive measures should be prepared to stimulate domestic demand and prevent the spread of financial distress.

Kim Jeong-sik (Emeritus Professor, Department of Economics, Yonsei University)