- As fundamental drivers return to the forefront, we should see the won steadily appreciate as several factors point to a widening real interest rate advantage versus the U.S. dollar.
- The Brent crude oil price crash should see Korea’s annual oil import bill fall by roughly USD20-30bn, equating to as much as 2% of GDP.
- Korea’s relatively low public debt load will not pose an obstacle to future rate hikes in contrast to the U.S., which risks triggering a surge in government interest payments.
With the Fed’s swap lines in place, we do not expect to see a repeat of the dollar liquidity crunch that saw USDKW spike to ~1,300 in mid-March. As fundamental drivers return to the forefront, we should see the won steadily appreciate as several factors point to a widening real interest rate advantage versus the U.S. dollar.
Liquidity Shortage-Driven Selloff Unlikely To Be Repeated
USDKRW has stabilized since the introduction of U.S. dollar swap lines on March 19, with the pair ~5% from its intraday peak. The Bank of Korea has so far tapped the swap lines for USD16.2bn of dollar liquidity, which pales in comparison to the size of its foreign reserves, which stand at USD400bn. With short-term funding pressure no longer the main driver of USDKRW, we expect Korea’s superior fundamentals to drive steady won gains. Specifically, Korea’s already-high real interest rate advantage should grow wider thanks to improving terms of trade, lower levels of government debt, and an improving net income account picture.
Real Rate Picture Highly Won Supportive
From a fundamental perspective, real interest rates drive currency performance and the widening spread between Korean and U.S. real rates should provide support to the won. The relatively strong performance of the Korean economy has allowed the BOK to refrain from reducing interest rates to near zero as has been the case in the rest of the developed world. After cutting by 50bps in March, the BOK held off from further easing measures at its April meeting, keeping the base rate at 75bps.
This relatively high base rate contrasts with the fact that long-term inflation expectations in Korea are the lowest of any country globally with the exception of Japan. Among the world’s major economies, Korea boasts the highest real interest rate based on the spread between the base rate and long-term break-even inflation expectations.
Overnight Rate Minus 10-Year Break-Even Inflation Expectations for Korea, Australia, Japan, Eurozone, U.S., U.K.
Oil Price Collapse To Add Further Support To Real Rate Spreads
The collapse in oil prices should provide further support to Korean real interest rates by supporting real GDP growth (both of which are intimately related). As a major oil-importing economy, the fall in global oil prices is a gift to Korea. The country imported 84mn barrels of crude oil in March meaning that with Brent crude oil prices halving since then, it should see its annual oil import bill fall by roughly USD20-30bn, equating to as much as 2% of GDP.
As explained in ‘3 Reasons Low Oil Prices Are Dollar Negative‘, this should be highly supportive for Korea’s economic recovery, particularly relative to the U.S. which is now a marginal oil exporter. The difference in the terms of trade between the two countries can be seen below, with the Citi terms of trade index for Korea back at 2003 levels.
Korea Vs U.S. Terms of Trade
Source: Bloomberg, Citi
Korea’s Fiscal Position Is No Obstacle To Eventual Rate Hikes
Another supportive factor for the won is Korea’s far superior fiscal positions. While the COVID-19 stimulus package continues to rise and could be as high as USD200bn, Korea has the fiscal room to shoulder such an increase given its modest fiscal deficits in recent years. In fact, while the U.S. saw its public debt-to-GDP ratio rise 107% of GDP in 2019, Korea’s debt ratio has fallen over recent years, coming in at just 37% of GDP in 2019. This suggests that once economic recovery takes place, the BOK will face few fiscal restraints preventing rate hikes. In contrast, the U.S.’s high debt load and high degree of foreign ownership will make it very difficult to hike rates even if inflation pressures begin to emerge as it will put upside pressure on interest payments.
Korea’s International Credit Status An Additional Benefit
Since the Global Financial Crisis in 2008, Korea has gone from being a modest net international debtor to a sizeable net international creditor, with a net surplus equivalent to 30% of GDP at the end of 2019. Persistent current account surpluses as a result of Korea’s high savings rates have allowed Korea’s external assets to soar. The beneficial impact on the won from this is twofold.
Firstly, it limits risk to the won arising from rising global risk aversion by creating potential for domestic residents and the central bank to repatriate overseas assets. In the case of Japan, the country’s huge net external asset position is a major reason why the currency acts as a safe haven during times of global risk aversion. Secondly, Korea’s large NIIP surplus acts as a long-term disinflationary force as income receipts from overseas assets exceed income payments on liabilities. As dividend and coupon payments on these net assets flow back into Korea, it helps to put downside pressure on inflation, supporting real interest rates. Japan’s low inflation rate is at least partly the result of this persistent demand for yen arising from the returns on its external asset hoard.