How South Korea Can Cope With Volatility in Global Bond Markets

Yields on long-term government bonds have risen significantly in major economies during the past year. The increase in long-term yields is driven by several factors, notably inflation, fiscal burdens, and bond supply-demand dynamics. The war against Iran has driven up oil prices and inflation, while large government budget deficits and debt have raised concerns about fiscal sustainability. As these factors have made government bonds less attractive, investors demand higher returns (Figure 1). Ten-year government bond yields in the United States topped 5 percent for the first time since 2023, while in Japan, they climbed to their highest point since 1996. French and German bond yields have risen to levels not seen since 2008 and 2011, respectively.

Korea’s bond market is sensitive to global macroeconomic shocks and has seen a significant rise in yields. When U.S. bond yields rise, domestic yields in Korea also tend to increase to limit capital outflows and a weaker won. Korea’s ten-year government bond yield rose from 2.8 percent to 4.5 percent (171 basis points) during the past year, exceeding all Group of Seven (G7) countries (See Figure 2). In addition, yields on thirty-year government bonds, introduced in 2021, reached a record high level in August. Prolonged high government bond yields would raise interest costs when the government refinances maturing bonds or issues new ones.

Policies to Promote Stability in Korea’s Government Bond Market

Interest rate hikes push short-term yields up, but they can bring long-term yields down if investors believe that the central bank’s action will slow inflation. With inflation around 3 percent, well above the 2 percent target, the Bank of Korea (BOK) raised its base rate by 25 basis points in July and again in August—the first hikes in more than three years—bringing it to 3 percent. The central bank said that it will decide the timing and pace of further increases to the base rate based on economic conditions.

Tighter monetary policy should be paired with measures to address growing concerns about fiscal discipline, rising national debt, and reliance on deficit bonds. Two supplementary budgets, totaling around 1 percent of GDP, boosted the government budget deficit from 1.5 percent in 2024 to 2.5 percent in 2025 (on a general government basis).

The Korean government expects strong GDP growth of 3.0 percent in 2026, aided by another supplementary budget of about 1 percent of GDP to cushion the impact of higher energy prices. Tax revenue during the first seven months of 2026 increased 17.8 percent year-on-year, led by corporate income tax revenue. The OECD projects that strong growth will help reduce the government budget deficit from 2.5 percent in 2025 to 2.1 percent in 2026. However, the fiscal stance is essentially neutral, as the structural government budget deficit (on a cyclically-adjusted primary basis) is projected to remain constant at 2.1 percent of GDP in 2025, 2026, and 2027 under current policies (Figure 3). The structural balance, which strips away the temporary effects of economic booms and recessions, has been in deficit since 2020.    

Korea should aim for a structural budget balance. The OECD advises that “increased spending when the economy is weak, be it from automatic stabilizers or supplementary budgets, needs to be balanced by savings when the economy is strong.” Korean economist Cho Dong-chul recently argued that additional tax revenue generated by the semiconductor and AI boom should be used to reduce government debt. If government spending rises with additional tax revenue, the economy will overheat, putting further upward pressure on inflation, and government bond yields will continue to increase.

Achieving Fiscal Sustainability

Korea’s government debt is relatively low at 48 percent of GDP, but its public social spending is projected to nearly double by 2060 as the country ages faster than any other. While there is scope to cut government spending in some areas, additional revenue is needed to reduce government budget deficits and ensure long-term fiscal sustainability. Korea’s total tax revenue amounted to 25.3 percent of GDP in 2024, well below the OECD average of 34.1 percent (Table 1). Most of that gap is primarily due to personal income tax and taxes on goods and services, notably the value-added tax (VAT).

At 5.1 percent of GDP (Table 1), Korea’s personal income tax (PIT) revenue is relatively low, reflecting its narrow base. Although the share of tax-exempt wage earners has fallen significantly during the past decade, it remains high at one-third in 2024 (Figure 4). The share of tax-exempt workers is 27 percent for those earning more than the median wage (Figure 5).

The tax code provides numerous deductions, including those for personal exemptions, insurance premiums, housing funds, credit card expenses, medical costs, and education fees. Broadening the tax base would raise significant revenue while reducing inequities in the tax burden. A 2024 National Assembly Budget Office report stated that “a high rate of tax exemptions exacerbates inequities in the tax burden and weakens income tax’s role in redistribution.”

Korea’s taxes on goods and services, often referred to as consumption taxes, consist primarily of the VAT, which applies to all goods and services. Since its introduction in 1977, the VAT rate has remained at 10 percent, about half of the OECD average.

Consequently, VAT revenue has remained steady at only 4 percent of GDP (Figure 6). Consumption taxes have many advantages compared to other types of taxes. For a fixed amount of tax revenue, relying more on indirect taxes (notably the VAT) and less on direct taxes (income taxes on individuals and companies) has a positive impact on GDP, as it imposes fewer distortions on employment and investment. In addition, consumption taxes are less affected by economic fluctuations, making them a relatively stable revenue source. Another advantage of the VAT is that it is relatively simple to enforce and difficult to evade. However, given the VAT’s adverse implications for income distribution, a higher VAT rate should be balanced by a greater role for personal income tax, as noted above.

Conclusion

Rising yields on Korea’s long-term government bonds are largely due to global macroeconomic shocks. However, Korea’s above-target inflation rate and persistent government budget deficits also contribute to higher yields.

Monetary policy focused on bringing inflation down to 2 percent may help stabilize bond markets. In addition, fiscal measures to bring the budget back into balance are a priority. Ensuring long-term fiscal sustainability will likely require increased government revenue, notably by broadening the personal income tax and gradually raising the VAT.  

Randall Jones is a Nonresident Distinguished Fellow at the Korea Economic Institute of America (KEI). The views expressed here are the author’s alone.

This material is distributed by KEI on behalf of the Korea Institute for International Economic Policy. Additional information is available at the Department of Justice, Washington, DC.