Bank of Korea May Cut as Economic Headwinds Build

Bank of Korea meets Thursday and may begin an easing cycle. However, it’s a tough call and markets are pretty much split. Meanwhile, Japan and Korea are in the midst of a diplomatic spat that risks putting further headwinds on the economy.

POLITICAL OUTLOOK

Last October, the Supreme Court of South Korea ordered Nippon Steel to pay $89,000 each to several plaintiffs suing for damages (see A Brief History Lesson below). When that company refused to pay, the court ordered the seizure of some of its Korean assets. The Supreme Court followed that ruling up with two similar judgments in November against Mitsubishi Heavy Industries. According to reports, there are at least another dozen such cases involving Japanese companies currently pending in the lower courts.

Japan has responded vigorously. It claims that the language in the 1965 treaty (see A Brief History Lesson below) that describes all claims related to the colonial period as “settled completely and finally.”

The situation has deteriorated. Japan recently moved to limit exports of chemicals that are key for South Korean chipmakers. The reason cited was concern about national security, as these chemicals fall under the category of “controlled items” that have potential military use. Yet it seems clear to most observers that this move is retaliation for the fraying of diplomatic ties between the two nations.

South Korea has called on the UN to investigate Japan’s claims. In the meantime, Japanese exporters are now required to apply for licenses to sell to each Korean customer. This process can take up to 90 days, which would potentially damage an export sector that’s already suffering from slowing global growth and trade.

Japan is an important player in the North-South dialogue. As such, a long-lasting solution to Pyongyang’s nuclear ambitions will require greater cooperation between officials in Tokyo and Seoul. Tokyo has given Seoul until Thursday to meet its demand for third-party arbitration over the South Korean court seizures.

Meanwhile, President Moon has warned exporters to prepare for a prolonged fight with Japan. Furthermore, Moon warned Tokyo that these moves would backfire as Korean companies will seek out other suppliers. Polls suggest 67% of Koreans will join the so-called “Boycott Japan” movement. Fitch acknowledged that Japan will most likely end up hurting Japanese companies.

 

A BRIEF HISTORY LESSON

Reparations for the colonial period is just the latest source of tensions between Japan and Korea. The Korean peninsula fell under Japanese control after the Sino-Japanese War of 1894. Those two major Asian powers at that time were fighting for control of the Korean peninsula. Korea had long been a client state of China but its natural resources and proximity to Japan eventually drew interest from its neighbor to the east.

When war was declared in August 1894, many thought China would prevail given its sheer size. However, after the Meiji Restoration, Japan had entered into a period of rapid modernization and industrialization. As a result, the Japanese army was much better equipped and quickly won. The Treaty of Shimonoseki forced China to recognize the independence of Korea and to cede Taiwan, the adjoining Pescadores, and the Liaodong Peninsula in Manchuria.

The Korean Empire became a protectorate of Japan in 1905 and was officially annexed by Japan in 1910. During WWII, a shortage of labor in Japan led to the forced migration of Korean workers. The current dispute between Korea and Japan stems from this, as several plaintiffs have sued Japan’s largest steel maker for compensation for being taken to Japan and forced to work during the period of occupation.

After Japan’s surrender to the US and the USSR to end World War II, Korea was split along the 38th Parallel in 1945. Stalin was reportedly keen to extend Soviet influence in Asia after the war ended, while US officials were concerned that the Soviet Union would eventually occupy the entire Korean peninsula. North Korea was created under Soviet protection while South Korea was created under US protection. When talks to unite the two failed, this partition became permanent in 1948.

All told, an estimated 8 mln Koreans were conscripted as either forced labor or soldiers during the occupation. When diplomatic relations between South Korea and Japan were established in 1965, Japan provided $300 mln in aid and $200 mln in loans to South Korea. However, none of that money went to those workers. Instead, the military government used most of those funds for infrastructure as it pushed to industrialize.

 

ECONOMIC OUTLOOK

Growth is sluggish. GDP growth is forecast by the IMF at 2.6% in 2019 and 2.8% in 2020 vs. 2.7% in 2018. GDP rose only 1.7% y/y in Q1, the weakest since Q3 2009. Monthly data so far in Q2 suggest further deceleration, and so we see downside risks to the forecasts.

Price pressures remain low. CPI rose 0.7% y/y in June. While above the 0.4% y/y trough in March, inflation remains well below the BOK’s 2% target. Furthermore, PPI rose only 0.4% y/y in May and so price pressures are likely to remain low in the coming months.

The Bank of Korea (BOK) has kept rates steady since the second 25 bp hike of this cycle back in November. Next policy meeting will be held this Thursday. Of the 24 analysts polled by Bloomberg, 14 see no move and 10 see a 25 bp cut to 1.50%. It’s a close call but we lean towards a cut. However, if it stands pat, a move at the next meeting August 30 seems very likely.

The fiscal outlook is solid but deteriorating modestly. The budget has been kept in surplus since the Asian Crisis. The OECD forecasts the surplus to come in at 1.1% of GDP in 2019 and 0.6% in 2020 vs. 2.5% in 2018. This gives the government less leeway to use fiscal stimulus if needed to boost growth.

The external accounts are also solid but deteriorating modestly. The current account surplus was 4.5% of GDP in 2018, and the IMF expects the surplus to narrow slightly to 4.6% this year and 4.5% in 2020. The 12-month trade and current account surpluses are at multi-year lows and so there are downside risks to the forecasts.

Exports have been contracting y/y since December as Korea is one of the many regional casualties of the US-China trade war. Imports have also started to contract y/y, perhaps limiting the deterioration of the trade surplus. Trade data for the first 20 days of July will be reported early next week and are likely to show continued weakness.

Foreign reserves remain near record highs. At $403.1 bln in June, they are just below the March record of $405.3 bln. They cover nearly 8 months of imports and are nearly 4 times greater than the stock of short-term external debt. Korea’s Net International Investment Position (NIIP) has risen to an all-time high of around 26.5% of GDP. As such, Korea’s external vulnerabilities remain very low.

 

INVESTMENT OUTLOOK

The won is underperforming after a stellar 2018. In 2018, KRW was -4% vs. USD and was behind only the best EM performers THB (+0.1%), MXN (flat), SGD (-2%), MYR (-2.1%), TWD (-3%), and PEN (-4%). So far in 2019, KRW is -5.4% and is ahead of only the worst performers ARS (-11%) and TRY (-7.5%). Our EM FX model shows the won to have VERY STRONG fundamentals, and so we expect this underperformance to ebb.

USD/KRW traded at its highest level since October 2017 near 1197 in late May. The pair has since traded largely in the 1150-1200 range but appears likely to retest that high. Break above 1200 would target the December 2016 high near 1212. After that is the March 2016 high near 1245 and then the May 2010 high near 1278. The 200-day MA comes in near 1142 currently.  The key JPY/KRW cross has hovered near 11 for several weeks, well above the key 10 level for Korean exporters.

Korean equities continue to underperform. In 2018, MSCI Korea was -19.8% vs. -17.4% for MSCI EM. So far this year, MSCI Korea is up 5.7% YTD and compares to 11% YTD for MSCI EM. Our EM Equity Allocation Model puts Korea at VERY OVERWEIGHT, and so we expect Korean equities to start outperforming more.

Korean bonds have underperformed this year. The yield on 10-year local currency government bonds is -38 bp YTD. This is ahead of only the worst EM performers Argentina (+491 bp), Turkey (+68 bp), Pakistan (+65 bp), China (-2 bp), Singapore (-9 bp), and Taiwan (-19 bp). With price pressures likely to remain low, we think Korean bonds will start to outperform. Even if the BOK stands pat this week, a rate cut is likely in the coming weeks.

Our own sovereign ratings model shows Korea’s implied rating was steady at AA-/Aa3/AA-. S&P’s AA and Moody’s Aa2 ratings are vulnerable to downgrades, while Fitch’s AA- appears to be on target.