Swimming against strong currents: Korea treads cautiously

Korea has seen better days – exports are languishing in double digits due to weakness of global demand, the downturn of the tech cycle, and escalated US-China tensions. Meanwhile, domestic demand is weakening further, weighed down by contracting investment for the fourth consecutive quarter and slowing private consumption. To make matters worse, President Moon’s minimum wage hike raised labor input costs and caused SMEs to reduce headcount demand. To cope with the erosion of profitability, large conglomerates have accelerated offshoring to expand growth market and arbitrage higher costs at home. In 2018, Korea allocated most of its capital to the US and Europe; FDI to China and ASEAN also increased. Within ASEAN, Vietnam was a key destination, as more Korean firms expand their footprint for Vietnam’s cheap wages and growing domestic market. This strategy also helps de-risk from escalated tensions between the US and China. While large firms can arbitrage wage costs and diversify risks, even if it is geopolitical in nature, most Koreans cannot as they work in non-tradeable sectors and operate in an economic environment where the outlook is murky at best. Whether it is consumer or business confidence, the mood is sobering. And this does not bode well for future spending and investment. To help with worsening external environment, the Bank of Korea has let the KRW depreciat e versus the USD by 9.1% in one year. That has helped ease monetary conditions by lowering the real effective exchange rate, supporting export competitiveness. That said, our Natixis Monetary Condition Index (NXMCI) shows that monetary policy is still too tight, particularly on the real interest rate (RIR). Given the BOK raised the policy rate by 25bps in November 2018 to 1.75%, we believe that there is room to loosen the policy rate. At the current juncture, the central bank is wary of the KRW sliding too rapidly. Moreover, it had just raised rates in November 2018. As such, we believe the BOK will hold rates for now but will take a dovish tone to pave way for a cut in H2 2019.