Headwinds lead to a narrowing of the monetary peloton... In past notes, we have likened the linkages among central bank decisions to the dynamics of riding in a cycling peloton (see "Reining in the Front-Riders", The Global Monetary Analyst, February 3, 2010, and "The Peloton Holds Firm", The Global Monetary Analyst, November 4, 2009). Cyclists cluster together in a peloton to fight wind drag. The positioning and dynamics within these groups are both delicate and highly strategic. Front-riders in these clusters usually have more flexibility in setting the pace, but they also face the brunt of the headwinds. Importantly, the shape of the peloton itself adjusts to the wind drag: the peloton stretches out and narrows when there are headwinds, and widens in order to get the full benefit of a tailwind.
...and sovereign headwinds are stretching this peloton: Thanks to the Great Recession and the synchronised policy response to it, central banks find themselves riding in a monetary peloton. Central banks like the Bank of Israel, the Norges Bank and the RBA that started hiking rates early (the front-riders) faced dual headwinds. First, the widening interest rate differential and abundant liquidity drove their currencies' values higher. Second, higher policy rates failed to translate into tighter financial conditions due to low bond yields and buoyant equity markets in the major economies to which most financial markets around the world remain linked.
Towards the end of 1Q10, that tide seemed to be turning. As global growth surprised to the upside, it seemed to be only a matter of time before the Fed and the ECB drained liquidity from their banking systems and moved towards rate hikes. The events of the past couple of months have undone that route, and have put us firmly back in an environment where major central banks will continue to provide XXL liquidity (see "XXL Liquidity", The Global Monetary Analyst, May 12, 2010) and early hikers will face the discouraging prospect of similar dual headwinds: currency appreciation on the back of hikes in policy rates and low bond yields despite it.
With these renewed headwinds, the monetary peloton has stretched out much more than ever before. When economic recovery in the major economies seemed on track, as many as 13 central banks were expected to raise rates in 3Q10 alone. That number has now fallen to six. More importantly, the Fed and the ECB have now moved further to the back of the peloton, so that everyone raising rates before them feels some of the headwinds of a front-rider.
What a difference a couple of months makes: Just a few months ago, most central banks were likely deciding how soon they would have to begin their hiking process. It was too early then for most G10 central banks to start raising rates (with the notable exceptions of Norges Bank and the RBA) but markets mostly saw risks that would tempt monetary policymakers to hike sooner rather than later. That was then. Now, the risk of a spillover of euro area problems into global growth and commodity prices and a subsequent dampening of inflation expectations have shifted risks the other way.
XXL liquidity: Our US and euro area teams have pushed back the first rate hikes from the Fed and the ECB to 1Q11 and 3Q11, respectively. In addition, the ECB's asset purchase programme (and, to a much lesser extent, the reinitiating of FX swap lines between the Fed and major central banks) has been a step in a direction directly opposite to an exit from QE. In other G10 economies too, central bank statements show increasing concerns about global growth and funding market stress. But perhaps the most important consequence of the euro area problems has been a recent dampening of inflation expectations. Breakeven inflation rates have fallen some 50bp in the US in the last few weeks, and talk of deflation that had all but disappeared has now resurfaced. Keeping interest rates ultra-low and the liquidity spigot on full is possible in no mean measure due to these dampened inflation expectations.
And the story isn't very different for EM central banks: In a previous note, we highlighted that emerging markets (with the notable exception of China) are insulated from a global slowdown or contagion to varying degrees (see The Unwelcome Trinity for Emerging Markets, May 13, 2010). Policymakers in the emerging economies are undoubtedly paying close attention to their access to funding as well as any spillover from sovereign credit concerns to growth. With a moderation of inflation expectations, a less sure outlook for growth and weaker commodity prices, central banks in emerging markets (and particularly in the AXJ region) seem to be keeping one eye on their domestic economies and the other on the global picture. AXJ central banks, for all the outperformance in their region, were conspicuous by their absence from the top of our ranking for monetary tightening (see EM Tightening: Think Locally, Rank Globally, May 5, 2010). Instead, it is the CEEMEA and Latam central banks which are deemed most likely to tighten more aggressively over the next 6-12 months. Central banks in the AXJ region (with the exception of India and, to a lesser extent, Indonesia) were all too willing to delay raising rates, given a benign inflation backdrop. With inflation expectations dampened and commodity prices weaker, that backdrop has undoubtedly become more supportive of the wait-and-see strategy.
As a consequence, our China economics team is now expecting only one hike in the policy rate from the PBoC sometime in 2H10. In Korea, our economists continue to expect a 3Q10 start to policy rate hikes but expect much less tightening in 2010 now. In the CEEMEA region, the central bank of the Czech Republic recently delivered a 25bp cut that was in line with Pasquale Diana's expectations, but he has pushed out the expected timing of the first rate hike to 2Q11. The Bank of Israel recently delivered another on-hold decision and our Israel economist Tevfik Aksoy believes that the ‘normalisation' of rates has likely been postponed in part due to global concerns. He also expects the Central Bank of Turkey to deliver rate hikes this year, but thinks that these will only start in 4Q10. Finally, the Latam region has so far been the exception to the worldwide rule. Brazil's larger 75bp rate hike on April 28 and Peru's 25bp rate hike on May 7 caught many by surprise. Inflation never really fell in this region like it did in AXJ and central banks are wary of the inflation risks from strong domestic demand and a rapid economic recovery. Given the region's strong links to the US, however, the risks to US growth will almost certainly translate into similar risks for the Latam region, and central banks there are undoubtedly watching such developments keenly
The silver lining: Global monetary policy is clearly designed at the moment to provide downside protection to growth. Should material effects from euro area developments be felt in other parts of the world or in global growth, central bankers will be quite willing to push policy rates lower. Where such room is not available, the path of quantitative easing is quite a familiar one at this juncture. On the other hand, if the euro area is successful in tempering the fallout from recent events there, then this easing of the global monetary policy stance would mean stronger growth and higher asset prices first, but perhaps also monetary policy catch-up and a higher risk of inflation afterwards. Our US team expects that a scenario similar to this one will play out there thanks to a delayed start to rate hikes. Growth projections for 2010 and 2011 are now higher, but the Fed is expected to raise rates faster later on in the tightening cycle (see Sovereign Credit Risk Means a Lower Path for US Rates, May 10, 2010). A similar story could easily show up on screens in different economic theatres around the world.
Summary and Conclusions
The stigma of having had a crisis before is difficult to shed... Korea has gone through two major crises in the last 12 years; a balance-of-payments crisis in 1998 and a credit card crisis in 2002. The market expected that Korea would experience a crisis again in 2008 due to external vulnerability, but it did not. Not only did it not collapse, the Korean economy even avoided a recession amid the global crisis in 2008-09. However, the stigma remains. Some investors typically point to Korea whenever concerns over global demand and financial health surface.
...but we have been arguing that the Korean economy is much more defensive than the market thinks: If European demand slows, or even if a global double-dip occurs, Korea's exports will almost certainly be affected. However, we think it will be affected less than other exporters due to its strong competitiveness. At the same time, Korea has rebuilt its foreign reserves, reduced its short-term external debt, and is running a current account surplus, all of which help make it much less externally vulnerable than in 2008. There are also fewer problems in the domestic economy now than in 2008, as there is no inflation threat this time and liquidity has become more abundant.
Given that Korea survived the 2008 global credit crunch, it is only in a stronger position today to defend against any external crisis. Meanwhile, the government still has room to implement stimulus measures if needed, given its solid fiscal position.
Uncertainty surrounding North Korea and the potential impact of European contagion could linger for longer, and the KRW may remain weak for a while. However, we think that Korea's stock market and currency are strong enough to allow it to face the current economic crisis, given its solid fundamentals. KRW depreciation of the magnitude seen in 2008 is unlikely to recur this time, in our view. Having said that, under our base case scenario - no double-dip and recovery continues, albeit at a mild pace - the KRW is not likely to appreciate too much even when all the uncertainties clear. This is because in a recovery scenario, its current account surplus will normalize from an exceptionally high level last year; thus KRW should be stable this year. As a result, KRW is still highly competitive at current levels, and its exporters' market share gain story can continue for longer.
Korea Is Less Vulnerable Externally than in 2008
First, Korea is running a current account surplus due to strong export competitiveness: This is in contrast to 2008 when it suffered from a deficit due to soaring oil prices. In 1Q-3Q08 (prior to the Lehman Brothers collapse, which marked the beginning of the global credit crunch), Korea was running a current account deficit of US$13.6 billion (-1.8% of GDP). Last year Korea's current account surplus totaled US$43 billion (5.1%), as exports held up well. Although we expect the current account surplus to normalize this year on higher imports, it is tracking at 2% of GDP, which would be higher than the three-year average of a 1% surplus prior to 2008. A slowdown in global demand would certainly hurt Korean exports, but it would also help bring down oil prices. Judging from the experience in 2009, Korea's current account surplus could actually expand in a global slowdown scenario, as the country's competitiveness helps it defend exports, while at the same time enjoying cheaper commodity prices.
Second, Korea is less reliant on foreign capital inflows today than in 2008. This is due in part to a higher current account surplus, which brought in foreign currency inflows, as well as a peak in ship orders that resulted in much less FX hedging and foreign currency loans. Prior to the global economic downturn in September 2008, Korea took in US$35 billion in short-term (ST) foreign loans in 2007, and US$23 billion during 1Q-3Q08. These loans were mainly due to shipbuilders' hedging positions but also became a source of liquidity for Korean banks. The global credit crunch in 2008 then caused massive capital outflows of US$55 billion in 4Q08-1Q09, as foreign banks could not roll over Korea's loans. From 2Q09 to 1Q10, Korea saw an inflow of only US$15.5 billion of short-term foreign loans. Thus, the scale of potential capital outflows, if any, should be much less than in 2008. The total amount of outstanding short-term external debt also fell from a peak of US$190 billion in 3Q08 to US$154 billion in 1Q10.
Third, Korea has been able to rebuild its foreign reserves and reduce its external vulnerability: Korea's foreign reserves stand at a record high of US$274 billion as of April. Most important, its foreign reserves now cover 1.8x of short-term external debt, compared to only 1.3x in 3Q08. Meanwhile, details of the short-term external debt holding also show a healthier picture. Korean banks now account for 28% of short-term external debt holding compared to 35% in 3Q08, while foreign banks remain the biggest holder at 48% versus 50% in 3Q08. The central bank saw an increase in foreign loan holdings from 6% in 3Q08 to 9% now. Korea is also now back to being an external creditor with more foreign assets than debt - it was a debtor in 3Q08.
Domestic Liquidity and Balance Sheet Also Better than in 2008
While Korea is less externally vulnerable than it was in 2008, its domestic economy is also healthier. The fast and strong recovery in 2009 helped restore soundness in overall liquidity conditions and private sector balance sheets that will help to buffer external shocks.
One major difference between today and 2008 is the lack of inflation risk: Korea suffered from high inflation in 2008 when Dubai oil prices soared to a peak of nearly US$140/barrel in the middle of the year, and CPI jumped to more than 5%. The inflationary pressure presented the central bank with a policy dilemma then, as it was forced to raise interest rates when the economy was already faced with uncertainties and declining profitability. When inflation came together with concerns over external vulnerability, it became a vicious cycle - currency depreciation exacerbates inflation.
Today, inflation in Korea is under control with latest CPI growth at 2.6%, well within the BoK's target range of 2-4%. Falling oil prices due to external uncertainty are helping to keep inflationary pressure at bay, at least for this year. As such, even if KRW depreciates further on external concerns, inflation is much less likely to get out of control this time.
Korea's liquidity conditions have also improved significantly: Excess liquidity has rebounded from the low in 2008. Without any aggressive monetary tightening, Korea's excess liquidity is unlikely to ease in the near term. Deposit growth of commercial banks has been rising at double-digits since 3Q08, with the latest growth rate reported at +15.3%Y in March, on top of an already high base from a year ago. Despite a low interest rate environment, bank deposits have grown as corporate earnings have been strong and risk-averse investors return to banks. Meanwhile, loan growth slowed significantly from mid-double-digits to only 3%Y, according to the latest available data. Consequently, Korea's loan-to-deposit (including CDs) ratio at the commercial banks has eased below 100% now.
Although any contagion impact from Europe will likely affect Korea's banking system, Korean banks' liquidity conditions are less tight than in 2008. As they weathered the storm in 2008, we believe that they are in an even stronger position now.
Most important, liquidity in the whole financial system, including the non-bank financial corporations, remains healthy at 70%; thus the whole economy does not face any liquidity problem. Korean banks are also less reliant on foreign currency funding, according to our bank analyst, Joon Seok; the proportion of foreign currency funding is down from 1Q09 peak levels of 12% to 9% now.
Household balance sheets are also healthier, with their financial asset/liability ratio improving since 1Q09: If the equity market correction continues, this would certainly eat into household financial assets. However, Korean households now have a higher asset/liability ratio of 220% compared to 200% in 3Q08. As a result, they have a higher buffer to cushion any financial market shock than in 2008. In fact, when assets cover 200% of liabilities, it was not a problem even in 2008. Meanwhile, corporates' net debt/equity has declined to 40% from 50% at the start of 2009. Yet again, it was not a problem even at 50%.
In fact, we have been arguing that Korea's asset quality is strong, and this is evident in the low NPL ratio of only 1.2% even though the economy went through a difficult period in 2009. If Korea's corporate and household balance sheets were not a problem in 2008, they are even less likely to be a problem today, even if faced with another asset market correction.
Government Still Has Room for Stimulus if Needed
Although the government implemented a generous stimulus package last year that partly helped Korea to avoid a recession, it did not create any artificial growth through wasteful spending. This is different from 2001-02, when the tech bubble burst and the government engineered a credit card bubble to boost domestic consumption. That resulted in three years of subpar growth in 2003-05 as the economy had to adjust for overconsumption.
The stimulus measures this time focused on spending in segments where there is the need for longer-term growth: Regional infrastructure is an example. There were also measures to smooth out short-term fluctuations through job creation and SME support, but corporate restructuring was also pursued at the same time. The Korean government did not encourage using lending to boost growth this time, so there is virtually no rising risk of bad loans as a result of the stimulus. Without overconsumption and overinvestment in this cycle, Korea should not see any major correction in its domestic economy. Korea's recovery this time is mainly driven by its strong export competitiveness; thus, this appears to be a genuine self-recovery that is more sustainable.
If a severe double-dip occurs, the Korean government still has room to support growth; it is in a solid fiscal position: Even though government debt has risen due to extra spending in 2009, the debt level projected at 36.9% of GDP this year is still rather low, especially versus other OECD countries. From 2001 to 2008, Korea recorded annual consolidated fiscal surpluses. The deficit that Korea is seeing after 2009 is a cyclical rather than a structural deficit problem. The consolidated fiscal deficit this year is expected to be only -0.4%.
Such a solid fiscal position is supported by its recent sovereign credit rating upgrade: This is particularly meaningful at a time when certain parts of the world face downgrade risks due to budget problems.
A check of Korea's external vulnerability, domestic liquidity and balance sheets, and government fiscal position leads us to conclude that Korea's fundamentals are solid. Today it is even more resilient than in 2008. Given its ability to weather the 2008 crisis, Korea looks even more capable this time round. Given that fundamentals are not deteriorating, Korea's asset prices and currency are not likely to correct more than its peers, in our view.
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