The Bank of Korea (BoK) has been reactive in its monetary policy and has thus fallen behind the expectation curve. But it does not matter to Korea at this juncture, as rate cuts are not going to help boost growth and asset prices.
So do not expect the BoK to ease aggressively. Solid progress in structural reform is needed to help turn around the current economic deadlock. But political and economic constraints will hamper any significant reform progress.
This will not only hurt investor confidence in the local markets, despite ample liquidity in the system, but will also aggravate the impact of a poor global backdrop on Korea and drag down GDP growth to an expected 4.2% for this year. Short-term downward pressure on the Korean won will remain, and conflicting forces will likely keep the KOSPI range bounded this year.
BoK behind the curve
By insisting on seeing signs of declining inflation and GDP growth before changing its neutral monetary stance, the BoK is following a reactive policy. Such a “behind the curve” stance is normally seen as ineffective and is thus bad for the financial markets. But doesn’t the rise in inflation from a trough of 0.76% year-on-year in September 1999 to 4.2% currently, above the BoK’s 2-4% target range, justify its worry about price pressure?
We see no basis for fear of a sharp rise in inflation, given the moderate pace of wage increases (at less than 6% year-on-year compared to last year’s double digit growth) and high productivity growth (estimated at over 10% year-on-year). While productivity may slow due to the cyclical economic slowdown, so will wage growth. Already, the unemployment rate has risen to 5%, easing labour market pressure.
The cost-push inflation from oil price hikes earlier is fading. Intensifying global deflationary pressure and falling domestic demand will help offset the import price pressure stemming from the 17% decline in the KRW since March 2000. Going forward, growth is the problem, not inflation. The BoK is expected to cut rates in line with the international trend.
Liquidity squeeze, now you don’t see it…
But this begs the question of what rate cuts will achieve? From a structural point of view, easier credit will risk dampening reform resolve, especially when reform fatigue has set in. The current 3% or so real interest rate is not high enough to warrant any imminent and aggressive nominal rate cut.
The system is not short of liquidity either. Major monetary indicators have been growing reasonably fast. Investment grade corporate-Treasury bond yield spread has also come down sharply, after Seoul decided to pump over KRW70 trillion ($54.1 billion) to ease fears about the huge amount of corporate debt due this year.
While investment grade corporates do not have a price-of-credit problem, the rest of the credit system still suffers from a loss of confidence, and hence rising risk aversion. This is evident among banks, which have refused to lend under pressure to repair balance sheet and high credit risk in the corporate sector that has shown insufficient retrenchment. The loan-to-deposit ratio has plunged to a 16-year low, ironically an indicator for rising liquidity.
… now you do
The banks are using most of the liquidity to buy government bonds, or parking it at the BoK as excess reserves. Thus, despite availability of liquidity, investor caution is preventing funds from flowing into the hands of the most needy firms, which are mostly in junk grade. For example, BBB-rated bond yields have remained stubbornly high at over 10%, despite the fall in the high-grade corporate and Treasury bond yields (to below 8% and 6%, respectively).
Domestic equity investors are equally risk averse, squeezing capital market funding for the corporates. This can be seen in their continued sell-off of local stocks since late 1999, depressing prices despite continued buying by foreign investors during the same period. That is why the KOSPI has not been able to sustain any rallies despite ample liquidity.
What will turn the deadlock around?
Korea needs to implement a painful cleansing process to weed out non-viable institutions to regain investor confidence. Financial institutions must also be willing to foreclose on delinquent borrowers, a practice that is still not common because it will damage banks’ balance sheets and because of pressure from the government not to do so.
Unfortunately, economic and political constraints will hamper reform pace in the coming months. First, the authorities are trying to soft-land the economy and have put financial stability before reform. Second, Korean officials have turned cautious in the run-up to local elections, expected in the second quarter next year, and the presidential election in December 2002, so that no major reform moves can be expected.
The recent refinancing package for the Hyundai Group could be another sign for reform inertia. The package, led by the state-run Korea Development Bank, gives Hyundai all the financial support it needs to keep it afloat until the end of this year. While the government said that the creditors would require Hyundai to implement restructuring reform in exchange for the aid, this claim has proven ineffective. It remains to be seen if the Hyundai case will be different. But when the banking sector assumes the insolvency risk of Hyundai, its balance sheet health is being compromised. This cannot escape the perception that Seoul’s too-big-to-fail policy, hence the systemic moral hazard, is still well and alive!
Rate cuts still needed
With the economy and reform in a quagmire, the stabilization task falls on the BoK. Cutting interest rates will be a psychological boost to the markets. Though rate cuts are ineffective to boost growth, because the dysfunctional financial system has impaired the monetary transmission mechanism, they will help sustain the banking sector by lowering the cost of carrying bad debts. As of Q3 last year, the financial sector still had 20% (or KRW145.2 trillion) of loans that were non-performing, accounting for 27% of estimated GDP.
Cutting rates will also allow banks to let companies slide on loan payments, even in a worsening economic environment, rather than forcing them into bankruptcy. The BoK is expected to cut rates by 50bps in the coming months. But this will be far less aggressive than the US Fed because of the BoK’s defence of its “independence”. In fact, its concern about inflation may be an intellectual ploy to fight interference from the government.
Tough markets
Conflicting forces are pulling on Korea’s equity market, making it likely to be a trader’s market this year. Liquidity and rate cuts may propel equity prices higher. But reform disappointment will act as a drag on them. Moral hazard remains, as the chaebol seem to have learned that it’s fine to look earnest about reforms and do nothing real since the government will always come to the rescue. There will be reform progress, but it is not going to be as fast and as thorough as many investors want. Hence, disappointment may ensue, and credit risk will remain a concern.
With reform stuck, the high gearing of Korean corporates means that they are ill-equipped to weather an economic downturn. Rate cuts are expected, but they will not be aggressive. The impaired financial system has rendered monetary easing ineffective in boosting demand. The BoK will thus tolerate a weaker exchange rate, especially on the back of a weakening balance of payments position and Japanese yen, to achieve the desired monetary easing effect. The Korean won will weaken further before recovering in the fourth quarter.
Chi Lo, regional head of research & senior economist (NE Asia), Global Markets, Standard Chartered Bank, Hong Kong.
