Two-Way Risk in KRW May Rise But Fundamentals Remain Strong by BBH

Korean officials warned that it will take stern steps to prevent one-sided currency moves.  Concerns about won strength come just as Korea and the US start trade talks and tensions ease on the Korean peninsula.

POLITICAL OUTLOOK

The United Nations Security Council approved a new round of sanctions on North Korea late last month by a unanimous 15-0 vote.  China and Russia voted with the majority after the US agreed to soften some provisions.  Imports of refined petroleum products will be cut drastically and North Korean laborers in other countries will be expelled within two years.  This round of sanctions follows two others in August and September.

In his New Year’s Day speech, North Korean President Kim Jong Un surprised everyone by calling for direct bilateral talks with South Korea.  He expressed a desire to discuss sending a North Korean delegation to the Winter Olympic Games next month.  This opens up a new phase of relations on the Korean Peninsula even as the tougher UN sanctions will bite Pyongyang.

At first blush, one might surmise that these latest sanctions forced North Korea to the negotiating table.  On the other hand, some believe that Pyongyang is seeking to drive a bigger wedge between the US and South Korea.   Relations between Presidents Moon and Trump have worsened in recent months over how to deal with North Korea.  South Korean President Moon favors a conciliatory approach, while President Trump favors a confrontational one.

South Korea responded to the overture positively and proposed talks this week at the border village of Panmunjom.  It also invited a North Korean delegation to attend the Olympics.  Pyongyang accepted both offers, with talks to be held this Tuesday.  These developments seem to lower the odds that it will do something to disrupt the Olympics.  The games will be held in Pyeongchang, which is only 50 miles from the border with North Korea.

What is the end game?  North Korea is clearly hoping to get sanctions lifted.  However, the UN and the US are unlikely to loosen them without getting significant, tangible concessions from Pyongyang.  Eliminating its nuclear program is a deal-breaker, so perhaps the best that can be hoped for is a verifiable freeze at current levels.

Pyongyang has long demanded that joint US-South Korean military exercises be halted.  This could be one concession from the US, as the joint exercises seem more for show than anything else.  If developments warrant, then sanctions could be eased in stages.  We think these could all lead to a significant de-escalation of tensions going forward.

South Korean assets typically shrug off any negative news regarding North Korean tensions.  However, we think that improved relations between the two could remove potential headwinds to South Korean equities and the won.

The US and South Korea just started talks to amend the existing bilateral free trade agreement (Korus).  Both sides acknowledge that a deal will be difficult.  Because of these talks, South Korea faces some constraints on influencing the won.  Since the government is in the midst of delicate trade talks, any whiff of potential currency manipulation could be used as leverage by the US.

ECONOMIC OUTLOOK

The economy picked up in 2017, but there are some warning signs.  GDP growth is forecast by the IMF to have accelerated modestly to 3.0% in 2017 from 2.8% in 2016, but is seen staying at 3% in 2018.  GDP rose 3.8% y/y in Q3, the strongest rate since Q1 2014.  Monthly data so far in Q4 suggest some slowing should be expected.  Furthermore, the manufacturing PMI fell to 49.9 in December, the first time below the 50 boom/bust level since August.

Price pressures remain low, with CPI rising 1.5% y/y in December.  Inflation has remained below the 2% target for three straight months.  PPI has slowed two straight months to 3.0% y/y in November, the lowest since July.  The strong won should add to the disinflationary forces, since it acts like monetary tightening.

The Bank of Korea started the tightening cycle in November with a 25 bp hike to 1.5%.  However, officials have stressed that the tightening cycle will be very gradual.  Next policy meeting is January 18, no change is expected then.  Bloomberg consensus sees a 25 bp hike in Q3 followed by another one by mid-2019.

Fiscal policy has remained prudent.  The budget surplus was an estimated 0.8% of GDP in 2017, and the OECD expects it to widen to around 1.5% in both 2018 and 2019.  Persistent surpluses give the government leeway to use fiscal stimulus if the economy slows more than expected.

The external accounts are in very good shape.  Export growth has remained strong but this bears watching in light of continued won gains.  The current account surplus was an estimated 5.5% of GDP in 2017, and is expected by the OECD to widen to 5.7% in 2018 and 6% in 2019.

Foreign reserves have risen to record highs.  At $389.3 bln in December, they cover 8 months of import and are over 3 times larger than the stock of short-term external debt.  The increase of $18 bln for 2017 was larger than the $3 bln gain in 2016, but falls well short of the US threshold that suggests currency manipulation.

Note that in its latest report from October, the US Treasury kept South Korea on its currency monitoring list.  Recall that the criteria for possible manipulation are 1) bilateral trade surplus with the US above $20 bln, 2) current account surplus over 3% of GDP, and 3) foreign currency purchases totaling 2% of GDP over the course of a year.  The Treasury estimated then that Korea had reduced its net FX purchases to about 0.3% of GDP in the four quarters ended June 2017, but called on officials to increase the transparency of its intervention.  The next Treasury report is due out in April.

INVESTMENT OUTLOOK

The won did much better in 2017 after a “so so” 2016.  In 2016, KRW fell -3% vs. USD and was in the middle of the EM pack.  The worst performers were ARS (-19%) and TRY (-17%), while the best were RUB (+22%) and BRL (+22%).  In 2017, KRW was the top EM performer (+13%), followed by ZAR (+11%) and MYR (+11%).  Our EM FX model shows the won to have VERY STRONG fundamentals, so last year’s outperformance is likely to continue.

USD/KRW made new lows for this move today just below 1060, trading at levels not seen since October 2014 before reversing higher on the official comments.  Charts suggest that the pair will eventually test the July 2014 low near 1008.  That said, we think 1060 will provide some support near-term as markets may not be prepared to test the BOK just yet.

With the won outperforming the yen, the key JPY/KRW is also made new lows for this move and trading at levels not seen since November 2015.  Charts suggest this pair is on track to test the June 2015 low near 8.83.  As a point of reference, it’s thought that Korean exporters prefer this cross to be above 10.

Korean equities underperformed in 2017 after outperforming in 2016.  In 2016, MSCI Korea rose 10% vs. 7% for MSCI EM.  In 2017, MSCI Korea was up 29% and compares to 34% for MSCI EM.  This modest underperformance should ebb, as our EM Equity model has Korea at a VERY OVERWEIGHT position.

Korean bonds underperformed in 2017.  The yield on 10-year local currency government bonds rose 45 bp.  This was amongst the worst performers, behind only Czech Republic (+123 bp), India (+98 bp), and China (+88 bp).  With inflation likely to remain subdued and the central bank likely to tighten at a very slow pace, we think Korean bonds will start outperforming more.

Our own sovereign ratings model showed Korea’s implied rating steady at AA-/Aa3/AA-.  Korea still faces some very modest downgrade risks to S&P’s AA and Moody’s Aa2 ratings, while Fitch’s AA- appears to be on target.

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