Korea-US Rate Gap Set to Hit Record High... Bigger Variables Than Foreign Capital Outflows [Why&Next]

Side Effects of the Korea-US Rate Gap: Capital Outflows and Won Weakness...
"A Comprehensive Assessment Is Needed"
Future Burden If US Holds Rates and Pressures for Won Appreciation

Expectations are growing that the Bank of Korea will cut its base rate this month, increasing the likelihood that the Korea-US interest rate gap will once again reach a record high. A further widening of the Korea-US rate differential is a factor that raises concerns about capital outflows by foreign investors from Korea and a weakening of the Korean won. Market participants pointed out that, in addition to the interest rate gap between Korea and the US, a variety of other factors have a complex impact on both domestic and global economic and financial conditions, so the immediate effects of a wider rate differential are expected to be limited. However, they also noted that the ongoing pause in US policy rates is likely to become a burden for future rate decisions. The recently intensified Korea-US currency negotiations are also expected to act as a variable.

Side Effects of the Korea-US Rate Gap: Capital Outflows and Won Weakness... "A Comprehensive Assessment Is Needed"

The Bank of Korea's Monetary Policy Board will decide the base rate on the 29th of this month, alongside the release of its revised economic outlook. The market expects that Korea's economic growth forecast for this year will be revised down sharply to around 1%. The dominant expectation is also for a 0.25 percentage point rate cut. If the base rate is lowered by 0.25 percentage points from 2.75% to 2.50% per annum, the Korea-US rate differential will widen to 2.00 percentage points, based on the upper end of the US policy rate. This would mark a return to the record-high gap seen between July 2023 and August 2024.

The negative effects of a widening Korea-US rate gap include outflows of foreign investment capital and a weakening of the Korean won. Because capital tends to move toward countries with higher interest rates (yields), a larger gap between Korea and US rates increases concerns about capital outflows. At the same time, currencies of countries with lower interest rates face depreciation pressure. This also increases the burden of a falling won. However, capital flows and exchange rate fluctuations are influenced not only by the Korea-US rate gap but also by a complex mix of domestic and global economic and financial conditions. Therefore, when making this rate decision, it is difficult to assess the impact based solely on the numerical size of the Korea-US rate differential, and it is necessary to check market conditions. Lee Changyong, Governor of the Bank of Korea, has also repeatedly stated, "We do not make rate decisions mechanically; we look at Korea's economic conditions at the time," and "If the gap becomes too wide, it could have a technical impact, so we consider it along with other factors."

In fact, even during periods when the Korea-US rate gap widened to 2 percentage points, there was no significant outflow of foreign investment capital. In 2023 and 2024, net inflows of foreign securities investment amounted to $18.87 billion and $20.77 billion, respectively. This year as well, despite expectations for a further widening of the rate gap, there was a continued net inflow of foreign capital, mainly into bonds, totaling $3.63 billion through March, so the burden remains limited. The ongoing net outflow from the stock market for nine consecutive months has been attributed mainly to concerns over corporate earnings and economic conditions in key domestic industries such as semiconductors, rather than to the Korea-US rate gap. Strategic currency hedging by the National Pension Service and inflows of World Government Bond Index (WGBI) funds are also factors limiting the impact of the rate gap. Anxiety over the won-dollar exchange rate level has also eased. The rate, which once threatened to surpass 1,500 won per dollar, has recently been fluctuating around the 1,400 won level.

Lee Changyong, Governor of the Bank of Korea, is striking the gavel to declare the opening of the Monetary Policy Committee meeting held on the 17th of last month at the Bank of Korea headquarters in Jung-gu, Seoul. Photo by Joint Press Corps

Future Burden If US Holds Rates and Pressures for Won Appreciation

The key issue is what happens after May. There is a growing view that the recent US policy of holding rates steady will become a burden if Korea, currently in a rate-cutting cycle, seeks further cuts in the future. The US Federal Reserve (Fed) has held its policy rate steady at 4.25-4.50% for three consecutive meetings this year, signaling a cautious stance that rules out the possibility of rate cuts for the time being. The Fed has also stated that it will continue to monitor the situation, as the impact of tariff hikes on the economy and inflation is not yet clear. The market expects the Fed to maintain its hold through June. If the timing is pushed back to September this year due to the effects of future tariff policy easing, it is expected to place even greater pressure on the Bank of Korea's decision to cut rates further.

Another variable is the fact that working-level consultations between Korea and the US on exchange rates, which are included in the bilateral trade negotiation agenda, have begun in earnest. If the US pushes for appreciation of the won in order to address its trade deficit by raising the value of its trading partners' currencies, this could become a burden for future rate cuts. Even if there is no direct pressure for appreciation, there are concerns that the exchange rate could be used as leverage in trade negotiations. During the "2+2" meeting held in Washington, D.C. on April 24 (local time), the two countries agreed to address the exchange rate issue as a separate agenda item, and since then, working-level officials from the finance ministries of both countries have been holding ongoing discussions. On May 5 (local time) in Milan, Italy, Choi Jiyeong, Deputy Minister of Strategy and Finance, and Robert Kapros, Deputy Assistant Secretary of the US Treasury, met to share mutual understanding on principles for managing the foreign exchange market and agreed to continue discussions going forward. News that these face-to-face consultations have begun and related discussions are ongoing caused the won-dollar exchange rate to fall below 1,400 won during after-hours trading on May 14, increasing volatility.