Bank of Korea Meets as Downside Risks Grow

Bank of Korea meets Friday and may resume its tightening cycle. However, it’s a tough call and we see risks of a dovish surprise as the economy struggles with growing headwinds. Political risk remains high too as North-South relations are in a sort of limbo.

POLITICAL OUTLOOK

President Moon Jae-in has seen his popularity fall due to the sluggish economy. Moon is prevented from serving beyond one 5-year term, which began in 2017. Parliamentary elections are scheduled for April 2020. Moon’s Democratic (Minjoo) Party won 130 seats in the 300-seat National Assembly in the last elections in 2016. Minjoo swept local elections back in June, which bodes well for the 2020 vote.

President Moon Jae-in recently sacked Finance Minister Kim Dong-yeon. He was replaced by Hong Nam-ki, who has embarked on an effort to promote what Moon calls his “inclusive growth” model. It is meant to boost local incomes and spending rather than rely on export-led growth. Moon’s decision to sharply hike the minimum wage has boosted unemployment, however, which rose to 3.8% in Q3. Youth unemployment of 9.4% is the highest since 1999.

North Korean leader Kim Jong-un is scheduled to visit South Korea next month. However, recent press reports suggest that the visit will not take place until 2019. If and when it happens, it would be the first visit to the South by a North Korean leader. In a sense, it would bookend President Moon’s September visit to Pyongyang, the first by a South Korean leader in over a decade.

US Secretary of State Mike Pompeo visited Pyongyang last month but was unable to jump-start a dialogue. High level talks had been scheduled for November 8 but were postponed. No new date has been set yet but it’s clear that some sort of impasse is shaping up.

Meanwhile, reports suggest Pyongyang continues to develop its nuclear and ballistic missile programs. Satellite images show several ballistic missile bases still being developed, despite claims otherwise from US President Trump. Missile tests have been halted for over a year, but other reports suggest Pyongyang continues to produce nuclear material that can be used for weapons.

 

A BRIEF HISTORY LESSON

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.

Kim Il-Sung became the leader of North Korea and quickly sought Stalin’s support for an invasion of the South. US troops had been withdrawn from Korea in June 1949, emboldening Kim to attempt to unify the peninsula under Communist rule by force. Initially, Stalin resisted as the Chinese civil war was still ongoing. Once Mao prevailed in October 1949, it appears Stalin gave Kim permission to invade the South under the condition that China would send reinforcements as needed.

In June 1950, the Korean War began as North Korean leader Kim Il-Sung invaded the South. The Soviet Union sent generals with combat experience to advise the North as well as arms, but otherwise was not directly involved in the fighting. On the other hand, the UN sent soldiers to support the South, with 90% of those forces coming from the US. Initial success in repelling the North was nullified when China forces entered the war in October 1950. The war ended in July 1953 with an armistice. However, a formal peace treaty was never signed.

North Korea’s nuclear program began in earnest after the end of the Korean War. Kim feared a nuclear attack from the US and sought to deter such action by building his own nuclear arsenal on the Korean peninsula. Stalin died in March 1953 but his successor Nikita Khrushchev (after a brief 6-month rule by Georgy Malenkov) was only too happy to help this client state, training North Korean scientists and engineers to get a rudimentary nuclear program off the ground.

 

ECONOMIC OUTLOOK

Growth is slowing. GDP growth is forecast by the OECD at 2.7% in 2018 and 2.8% in 2019 vs. 3.1% in 2017. GDP rose only 2.0% y/y in Q3, down from the 3.8% peak in Q3 2017 and the weakest since Q3 2009. As such, we see downside risks to the forecasts. Indeed, the BOK cut its 2018 growth forecast last month from 3.1% to 2.7%.

Price pressures have risen. CPI rose 2.0% y/y in October, the highest since September 2017 and right at the BOK’s target. However, core CPI   Furthermore, PPI eased to 2.2% y/y in October from the 3.1% peak in August. As such, price pressures are likely to ease in the coming months.

The Bank of Korea (BOK) has kept rates steady since the first and only 25 hike of this cycle back in November 2017. It has been on hold since as that 2017 hike basically took back the emergency 25 bp cut in June 2016, when the Brexit vote roiled global markets.

Next policy meeting will be held this Friday November 30. Of the 18 analysts polled by Bloomberg, 4 see no hike and 14 see a 25 bp hike to 1.75%. Governor Lee said last month that a November hike would be considered if conditions remain stable. At the October meeting, 2 dissented in favor of a hike vs. 1 dissent the previous meeting. Given the weaker growth outlook that has developed, we see risks of a dovish surprise.

The fiscal outlook is solid. The budget has been kept in surplus since the Asian Crisis. The OECD forecasts the surplus to come in at 2.7% of GDP in 2018 and 2.1% in 2019 vs. 2.8% in 2017. This gives the government leeway to use fiscal stimulus as needed to boost growth.

The external accounts are likely to remain strong. The current account surplus was 5.1% of GDP in 2017, and the IMF expects the surplus to narrow slightly to 5.0% this year and 4.7% in 2019. Export growth has slowed noticeably this year, leading the trade surplus to narrow modestly.

Foreign reserves remain near record highs. At $402.8 bln in October, they are just below the September record of $403 bln. They cover over 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) remains positive at nearly 20% of GDP. As such, Korea’s external vulnerabilities remain very low.

 

INVESTMENT OUTLOOK

The won is still outperforming after a stellar 2017. In 2017, KRW rose 13% vs. USD and was the best EM performer, followed by MYR (11%) and THB (10%). So far in 2018, KRW is -5% and is behind only the best performers THB (-1.5%), SGD (-3%), MYR (-3.5%), TWD (-3.5%), MXN (-4%), PEN (-4.25%), and PHP (-5%). Our EM FX model shows the won to have STRONG fundamentals, and so we expect this outperformance to continue.

USD/KRW has traded in the 1100-1150 range since June. The pair has retraced about half of the 2016-2018 drop. A break above 1152 is needed to set up a test of the December 2016 high near 1212. The key JPY/KRW cross has gyrated on either side of the key 10 level for much of this year.

Korean equities continue to underperform. In 2017, MSCI Korea was up 29% vs. 34% for MSCI EM. So far this year, MSCI Korea is -16% YTD and compares to -15% 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 outperformed this year. The yield on 10-year local currency government bonds is -32 bp YTD. This is behind only the best performer China (-49 bp). With price pressures likely to remain low, we think Korean bonds will continue to outperform even if the BOK hikes this week as any tightening cycle will likely be very shallow.

Our own sovereign ratings model shows Korea’s implied rating was steady at AA/Aa2/AA. S&P’s AA and Moody’s Aa2 ratings appear to be on target, while Fitch’s AA- appears to have some upgrade potential.