[Financial Planning for the 100-Year Life] Interest Rates Will Remain Stable Despite Government Bond Issuance

Domestic economic activity is contracting due to sluggish consumption and investment, increasing the government's role. Recently, discussions have even emerged about drafting a supplementary budget. In such a case, there is a possibility of increased government bond issuance and rising market interest rates. However, considering the economic conditions that determine interest rates, market interest rates are more likely to decline further.

In South Korea, household and corporate debt levels are high, while government debt is low. According to the Bank for International Settlements, in the first quarter of last year, South Korea's household debt accounted for 92.0% of its Gross Domestic Product (GDP), significantly higher than the 61.1% average of the Group of Twenty (G20) countries. The corporate debt-to-GDP ratio in Korea was also higher at 112.2%, compared to the G20 average of 90.4%.

However, the government debt-to-GDP ratio in South Korea stands at 45.4%, which is lower than the G20 average of 93.2%. With high household and corporate debt, it is difficult for consumption and investment to increase. The government is thus compelled to spend. This is why discussions about drafting a supplementary budget have arisen.

To finance the supplementary budget, the government will likely need to issue treasury bonds. This would increase supply in the bond market, causing bond prices to fall and interest rates to rise. However, despite continuous increases in government bond issuance, market interest rates have declined in the medium to long term.

The outstanding amount of treasury bonds, which was 50.919 trillion won at the end of 2001, surged to 1,062.175 trillion won by October 2024. Yet, the yield on 3-year treasury bonds fell from 5.93% (monthly average) in December 2001 to 2.59% in December 2024.

There are three main reasons for the decline in market interest rates. First, the decrease in economic growth rates and inflation rates that determine interest rates. The market interest rate observed is a nominal rate, which is the sum of the real interest rate and the inflation rate. Real GDP growth rate is used as a proxy for the real interest rate. South Korea’s potential growth rate, estimated at around 5.7% in 2000, has recently fallen to around 2%.

In December last year, the Bank of Korea estimated the potential growth rate for the next five years (2025?29) at 1.8%. It further projected that the potential growth rate will continue to decline, entering the zero percent range after 2040. This suggests that interest rates will continue to fall.

Second, from a national economic perspective, the supply of money exceeds demand. In a country’s economy, savings represent the supply of money, and investment represents the demand for money. Before the 1997 Asian financial crisis, the domestic gross investment rate was higher than the total savings rate. Demand for money exceeded supply, resulting in a high-interest-rate economy. However, after experiencing the financial crisis, Korean companies realized that excessive investment could lead to their disappearance from the market.

Since then, the investment rate has been lower than the savings rate. From 1998 to 2023, the average savings rate was 34.7%, surpassing the investment rate of 31.7%, creating a surplus capital economy. This trend is expected to continue, leading to further declines in market interest rates.

Third, as banks purchase bonds, market interest rates are expected to fall further. When banks receive funds, they either lend to households or companies or invest in securities. Households are surplus fund holders with savings exceeding loans, while companies are fund-deficient entities. In Japan’s case, from 1998, companies shifted to being surplus fund holders. With both households and companies saving, loans decreased, and banks had no choice but to increase investments in securities, especially bonds.

The proportion of bonds in banks’ assets increased from 12.6% in 1998 to 32.4% in 2011. During Japan’s deflationary period, the government significantly increased treasury bond issuance to stimulate the economy, and banks purchased these bonds, pushing interest rates down to the zero percent range.

A similar phenomenon is highly likely to occur in South Korea. As of September last year, Korean companies held 923 trillion won in cash-equivalent assets. Large corporations holding substantial cash are expected to borrow less from banks, prompting banks to increase bond investments. Considering these conditions that determine interest rates, even if the South Korean government increases treasury bond issuance, market interest rates are likely to decline in the medium to long term.