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.

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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