Bank of Korea on Hold While Political Risks Remain High

Korea reported lower than expected inflation and weak trade data for June, supporting steady rates for the time being.  In the political sphere, North-South relations have improved but intelligence reports suggest that Pyongyang continues to develop its weapons program despite pledges it made at its summit with the US last month. 

POLITICAL OUTLOOK

President Moon Jae-In was elected President in 2017 to replace impeached former President Park Geun-Hye.  He was the runner-up in the 2012 election, and will serve a single five-year term.  Moon was elected on a platform of engagement with the North, and he has certainly delivered.  Polls show Moon enjoying very high levels of popularity after the North-South summit in April and the US-North Korea summit in June.

Parliamentary elections are scheduled for April 2020.  Moon’s Democratic Party won 130 seats in the 300-seat National Assembly in the last elections in 2016.  If Moon’s high popularity is sustained, we expect his Democratic Party to pick up enough seats to have a working majority.

Yet the US-North Korea summit in Singapore yielded little of substance.  While President Trump touted that Pyongyang was no longer a nuclear threat, North Korea President Kim Jong-Un did not make any specific pledges or timelines.  Secretary of State Mike Pompeo travels to Pyongyang this week to work on a detail disarmament plan.  There are also press reports that another US-North Korea summit is possible in New York City this September, though there has been no firm commitment.

Recent reports suggest North Korea is continuing with its weapons program.  The Wall Street Journal reports that Pyongyang has accelerated a major expansion of the main manufacturing facility for its missiles.  Recent satellite images also suggest rapid development of infrastructure at North Korea’s Yongbyon Nuclear Scientific Research Center.  Lastly, US intelligence has reportedly found evidence that Pyongyang increased its production of enriched uranium for weapons use.  

A BRIEF HISTORY LESSON

Korea was annexed by Japan in 1910.  Kim Il-sung and his family were reportedly active in the fight against Japanese occupation.  Kim became heavily influence by communist ideology, and joined the Communist Party of China in 1931.  He and many nationalists practiced guerrilla warfare against the occupying Japanese forces, both before and during World War II.

Kim and what remained of his guerrilla army crossed into the Soviet Union in 1940 to escape advancing Japanese troops.  They were sent to a camp in the eastern part of the Soviet Union, where the Soviets retrained them.  Kim became a Major in the Soviet Red Army and served until the war ended.  This was the heyday of Stalinism, and it appears that Kim quickly took to Stalin’s methods of rule.

The Russo-Japanese war of 1904-1905 over their respective ambitions in Manchuria and Korea has been well-documented.  However, what’s less known is that Russia and Japan later clashed in 1939, fighting a brutal conflict along the Mongolia-Manchuria border that ended with a defeat for Japan.  The two then signed a neutrality pact that basically kept the Soviet Union out of the Pacific for most of World War II.

At the Yalta conference of February 1945, Josef Stalin promised to join the Allies in the Pacific War.  That August, the Soviet Union declared war on Japan and Soviet troops massed in Manchuria in preparation for an invasion of Japan.  Operation August Storm was launched just as the US was dropping an atomic bomb on Nagasaki, and Soviet troops quickly advanced to within spitting distance of Japan’s main northern island of Hokkaido.  Some historians believe the Soviet entry into the Pacific War played a much bigger part in Japan’s surrender than is generally given credit.

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.  Success in repelling the North were nullified when China forces entered the war in October 1950.  The war ended in 1953 with an armistice.  However, a formal peace treaty was never signed.

President Kim Il-Sung ruled from 1948 until his death in 1994.  From the start, he established a cult of personality akin to Josef Stalin’s and was known as Great Leader.  He groomed his son Kim Jong-Il to be his heir.  Kim Jong-Il ruled from 1994 until his death in 2011, and continued the cult of personality as Dear Leader.

Kim Jong-Il had three sons, and is was not apparent who would take the reins after his death.  The eldest Kim Jong-Nam was believed to have been the favorite but he fell out of favor after being arrested at Narita Airport in 2001 for trying to enter Japan on a fake passport (reportedly to visit Tokyo Disneyland).  In June 2009, youngest son Kim Jong-Un was designated as the next leader, and became known as Brilliant Comrade.

ECONOMIC OUTLOOK

The economy is slowing down.  GDP growth is forecast by the IMF at 3.0% in 2018 and 2.9% in 2019, down slightly from 3.1% in 2017.  GDP rose 2.8% y/y in Q1, and monthly data so far suggest the slowdown is carrying over into Q2.  The BOK has warned that trade tensions post a big risk to the Korean economy, and we concur.

Price pressures remain modest, with CPI inflation reported at 1.5% y/y in June.  This was lower than expected and well below the 2% target.  Core inflation was 1.4% y/y in June, near the cycle low of 1.1% y/y in January.  PPI inflation picked up to 2.2% y/y in June, and bears watching.  Overall, however, we believe the subdued inflation outlook argues for steady to modestly tighter monetary policy ahead.

The central bank meets July 12 and is expected to keep rates steady at 1.5%.  The bank’s first (and last) hike in this cycle was a 25 bp hike in November.  Since then, officials have stressed that the cycle would be gradual and modest, and so far, the BOK has stuck to its guns.  Bloomberg consensus sees one 25 bp hike to 1.75% in H2 and then one more to 2.0% in H1 2019.  We concur.

The fiscal outlook remains solid.  The budget surplus widened to 2.8% of GDP in 2017, but the OECD expects it to narrow to 2.1% in 2018 and 1.9% in 2019.  This gives the government a lot of leeway to use fiscal stimulus if the economy slows too much.

The external accounts remain strong.  The current account surplus was an estimated 5.1% of GDP in 2017.  The IMF expects the surplus to widen to 5.5% of GDP in 2018 and 5.9% in 2019.  We see some downside risks, however.  Korea reported weaker than expected June trade data.  Exports contracted -0.1% y/y vs. +2.2% expected, while imports rose 10.7% y/y vs. 12.5% expected.  Note that exports slowed significantly in Q2, so it’s not just a one-off reading.

Foreign reserves have risen to record highs.  Gross reserves were $399 bln in May, an all-time high.  They cover over 8 months of imports and are about 3.5 times the stock of short-term external debt.  As such, external vulnerabilities are extremely low.

INVESTMENT OUTLOOK

The won is in the middle of the EM pack after outperforming in 2017.  In 2017, KRW rose 13% vs. USD and was the top EM performer.  The next best last year were RON (+11%), MYR (+11%), and THB (+10%).  So far in 2018, KRW is -4.5% and compares to the best performers COP (+3%) and MYR (+0.75%) as well as the worst performers ARS (-33%) and TRY (-19%).  Our EM FX model shows the won to have VERY STRONG fundamentals, and so outperformance should pick up a bit.

USD/KRW is trading near its highest level since October.  The pair is on track to first test the September high near 1150 and then the July 2017 high near 1158.  Looking further out, USD/KRW needs to break above 1133 and then 1152 to set up a test of the December 2016 high near 1212.  Note that the key JPY/KRW cross rate has moved above the key 10 level, and is on track to test the 2017 high near 10.5675.

Korean equities are performing with the rest of EM, similar to 2017.  In 2017, MSCI Korea was up 29% vs.  34% for MSCI EM.  So far this year, MSCI Korea is –8.5% YTD and compares to -8.0% YTD for MSCI EM.  Outperformance should pick up, as our EM Equity model has Korea at a VERY OVERWEIGHT position.

Korean bonds have outperformed this year.  The yield on 10-year local currency government bonds is +10 bp YTD.  This is behind only the best performers Poland (-1 bp), Taiwan (-3 bp), Mexico (-4 bp), and China (-41 bp).  With inflation likely to remain low and the central bank still in a very modest tightening cycle, we think Korean bonds will continue to outperform.

Our own sovereign ratings model shows Korea’s implied rating rising a notch to AA/Aa2/AA.  As such, S&P’s AA and Moody’s Aa2 ratings now appear to be on target, while Fitch’s AA- appears to have some upgrade potential.