[Insight & Opinion] Korea's Sluggish Domestic Demand and the Challenge of Interest Rate Cuts

Structural Changes Such as Aging Slow Domestic Demand Recovery
Despite Growth Rate Rebound
Cautious Monetary Policy Amid Inflation and Household Debt Concerns

The bottom seems to have been in the second quarter of last year. Our economy now appears to have entered a recovery phase. The preliminary figure for real Gross Domestic Product (GDP) growth rate in the first quarter of this year was recorded at 1.3%, the same as the flash estimate. This is the highest quarterly growth rate in two years and three months since the fourth quarter of 2021. The biggest contributor to the recovery in growth was exports.

The domestic demand situation is somewhat different. Although the government recently assessed that the domestic economy is also recovering, the rebound is not that clear. Compared to exports, the pace of recovery is definitely slower. Retail sales in April decreased by 2.6% compared to the same month last year. In fact, retail sales compared to the same period last year have been declining every month except February this year since July last year. This is not surprising. As prices soar, self-employed business owners raise prices to match the skyrocketing material costs and public utility charges, while ordinary people, shocked by soaring prices, close their wallets. It is a vicious cycle.

The situation for small-scale self-employed businesses is actually approaching the worst now. The closure rate of self-employed businesses, which was 9.5% last year, remains unchanged this year. Over the past year, the number of one-person self-employed businesses decreased by 114,000. In particular, the closure rate of dining establishments exceeded 21% last year. There is also a record that nearly 6,000 restaurants closed in Seoul in the first quarter of this year. As business fails, debt increases and repayment becomes difficult. The 1,112 trillion won in loans to self-employed individuals has increased by 51% compared to just before the COVID-19 outbreak in 2019, and the delinquency rate on personal business loans in the banking sector is the highest since November 2014.

The sluggish domestic demand and the worst self-employed business conditions are the background for calls for interest rate cuts. Coincidentally, major countries are lowering interest rates and shifting their monetary policies. Emerging countries in South America as well as advanced countries such as those in Europe and Canada have started to cut their benchmark interest rates. The Korea Development Institute (KDI) also argues that interest rates should be lowered preemptively regardless of the US interest rate cuts.

However, realistically, the possibility of the Bank of Korea cutting interest rates ahead of the US is not very high. First, the countries that have cut or are showing signs of cutting interest rates are in different circumstances from us. Those countries generally have appreciated exchange rates or smaller depreciation compared to other countries. They are also countries likely to settle within their inflation targets within the year. South Korea is not one of them. The Korean won is one of the currencies that has depreciated the most this year, and although South Korea’s inflation rate is lower than that of the US, the rate of decline is gradual. Concerns about capital outflows and rising import prices cannot be ignored.

The burden of household debt is also significant. Household loans in the financial sector have surged by nearly 10 trillion won in just the past two months. While a cut in the benchmark interest rate would improve the real estate project financing (PF) market, household loans could surge. Raising the economic growth forecast for this year from 2.1% to 2.5% and then cutting interest rates does not make sense. Fundamentally, the problem is that our current sluggish domestic demand is not easily revitalized by slightly lowering interest rates.

Besides economic factors, structural changes in our society are also affecting the current sluggish domestic demand. Rapid aging has led to increased savings and reduced consumption, while employment conditions for the main consumer demographic are not very good. Non-consumption expenditures such as housing and education costs have increased significantly, reducing the capacity to increase consumption.

Changes in conditions such as reduced working hours are also altering consumption patterns, and there is a shift in consumption habits from offline to online. Of course, the low-price competition from Chinese platform companies adds to the difficulties. The expected timing of the US Federal Reserve’s policy rate cuts is being delayed. The Bank of Korea’s benchmark interest rate cut is unlikely before the fourth quarter. It will not be easy to find a way out for the sluggish domestic demand.

Kim Sang-cheol, Economic Commentator