How Can We Stabilize Prices Amid High Oil Prices and a Weak Won?

According to Opinet of the Korea National Oil Corporation, the spot price of Dubai crude, the benchmark for crude oil imported into Korea, stood at $98.33 per barrel on July 15, up 36.13% from $72.23 a year earlier, while the futures price of U.S. West Texas Intermediate (WTI) was recorded at $97.59 per barrel on the same day, up 36.20% from $71.65 a year earlier.

The biggest reason for the rise in international oil prices is the Russia-Ukraine war, which began in late February, and international oil prices are climbing steeply further due to the European Union’s embargo on Russian crude oil. Since Korea depends entirely on imports for its crude oil, it cannot help but be highly sensitive to fluctuations in global oil prices.

In addition, according to the Bank of Korea’s Economic Statistics System, the won-dollar exchange rate (opening price) exceeded 1,300 won on June 24 and stood at 1,318 won as of July 15, up 15.11% from 1,145 won a year earlier.

After the U.S. Federal Reserve, the central bank of the key currency country, took a “big step” on May 4 by raising its benchmark interest rate by 0.5 percentage points for the first time in 22 years under a strong monetary tightening policy, the won-dollar exchange rate has been rising.

Meanwhile, under its zero-COVID policy, China has continued to maintain strict lockdown measures in response to the resurgence of COVID-19 within the country, and as a result the global supply chain has deteriorated further.

The zero-COVID policy is a high-intensity quarantine measure aimed at ensuring that not even a single COVID-19 case occurs among China’s 1.4 billion people; areas where cases appear are locked down, and the lockdown is lifted only when no confirmed cases remain.

Since March, China has locked down dozens of cities, including Shanghai and Beijing, where the Omicron variant spread, and the resulting disruptions to the global supply chain have continued.

Need to Reduce Aggregate Demand Through Fiscal Tightening and Increase Aggregate Supply Through Regulatory Reform

In Korea’s macroeconomy, there are growing concerns about stagflation, in which prices rise while output falls, as production costs increase due to high oil prices and a strong dollar caused by the Russia-Ukraine war and the United States’ aggressive monetary tightening, and as aggregate supply declines because global supply chains have broken down due to China’s lockdown measures.

In June, the consumer price inflation rate reached 6% year-on-year, the highest level in 24 years. In addition, the current inflation fundamentally stems from increases in the money supply intended to boost aggregate demand in response to the 2008 global financial crisis and the 2020 COVID-19 outbreak for the purpose of economic stimulus.

Therefore, going forward, it is important for Korea to pursue measures that restrain aggregate demand while simultaneously increasing aggregate supply in order to stabilize prices. Aggregate demand needs to be curbed through contractionary monetary policy, such as benchmark interest rate hikes, and contractionary fiscal policy, such as reducing government spending, while aggregate supply needs to be expanded through tax cuts, restraint in raising the minimum wage, and regulatory reform.

First, in order to stabilize inflation, which has surged into the 6% range, the money supply in the market must be reduced through benchmark interest rate hikes. Following 0.25 percentage point increases in April and May, the Bank of Korea took its first-ever big step (a 0.5 percentage point increase) since the benchmark interest rate system was introduced in 1999 on July 13, raising the benchmark interest rate for the third consecutive time to 2.25% annually, the highest level in eight years.

Although the Bank of Korea is rapidly raising the benchmark interest rate, an important issue going forward is how to rein in soaring prices while avoiding a deeper economic downturn under stagflationary conditions.

To stabilize prices by curbing aggregate demand, government spending must be reduced alongside benchmark interest rate hikes. The 2022 budget submitted to the National Assembly increased at an average annual rate of 8.6% over the five years under the previous administration, reaching 604.4 trillion won, and the consolidated fiscal balance ran deficits for three consecutive years beginning in 2019.

Fiscal spending surged as expansionary fiscal operations continued in response to COVID-19, and fiscal expenditure is expected to continue rising due to growing demand for welfare spending amid low birth rates and population aging. Therefore, caution must be exercised in designing welfare policy, indiscriminate welfare spending should be avoided, and the sharp structural increase in fiscal expenditure should be restrained.

In addition, tax cut policies are needed to stabilize prices by increasing aggregate supply. Tax cuts can stimulate aggregate demand, but they also increase aggregate supply by expanding production. Fundamentally, tax cuts enhance households’ willingness to work and firms’ willingness to invest, increasing the supply of labor and capital and thereby raising production.

Under the previous administration, the corporate tax burden on Korean companies increased. Korea’s top corporate tax rate was raised by 3 percentage points at the end of 2017 to 25%, above the OECD average of 21.1%, and corporate tax revenue as a share of GDP, at 4.3%, also ranks among the highest among OECD countries.

If rising corporate tax burdens weaken international competitiveness, Korean firms may increase overseas direct investment and foreign firms may reduce domestic investment, shifting capital from Korea to overseas and further deepening constraints on domestic production.

In addition, it is desirable to refrain from raising the minimum wage, thereby increasing aggregate supply through lower production costs and stabilizing prices. The minimum wage rose 41.58% between 2017 (6,470 won) and 2022 (9,160 won), and the Minimum Wage Commission decided on next year’s minimum wage at 9,620 won, a 5.0% increase from this year.

Under these circumstances, increases in production costs for companies and small business owners are expected to be unavoidable, raising concerns that they may further stimulate inflation.

Lastly, in order to achieve price stability by expanding aggregate supply, improving productivity through regulatory reform is more important than anything else. This is the time for bold regulatory reform that can enhance corporate vitality through technological innovation and the development of high value-added industries.

Korea must do its utmost to pursue regulatory reform based on standards consistent with global standards so that the competitiveness of Korean companies can be strengthened. At a time when rising prices are compounded by rising interest rates, I have higher expectations than ever for this administration’s regulatory reform as a breakthrough to revitalize the market.

Sanghyun Hwang, Professor, Division of Economics and Finance, Sangmyung University

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Original title: 고유가·고환율 물가 안정은 어떻게?

Author: Sang-hyeon Hwang

Date: 2022-07-27

Source: https://www.cfe.org/bbs/bbsDetail.php?cid=press&idx=24867