MNI ANALYSIS: Potential For Korean Won To Outperform Yen

--Rate Divergence With Japan To Widen In Favour Of KRW

By Stuart Allsopp

     SINGAPORE (MNI) - As the Bank of Korea continues on its interest rate

hiking cycle, the won should remain strong against the dollar, supported by

highly positive real interest rates amid a still-depressed inflation rate.

     There is also strong potential for the won to rally against the Japanese

yen as the Bank of Japan is forced to maintain its ultra-loose monetary policy

due to the country's deteriorating public finances.

     Near neighbours, the economies of South Korea and Japan share many

similarities such as key export industries, reliance on energy imports, weak but

improving corporate governance, and deteriorating demographics.

     However, South Korea's superior fiscal accounts mean that the BOK faces far

fewer obstacles to hiking interest rates than the BOJ as a rise in the cost of

government borrowing would only negligibly increase public sector debt servicing

costs.

     --BOK TO STAY AHEAD OF CURVE

     As inflation pressures pick up, in line with rising energy import costs,

the BOK is likely to stay firmly ahead of the curve, and money markets may even

be underestimating the extent to which the bank could hike over the coming

months. Two more 25bps hikes are looking increasingly likely, as Governor Lee

Ju-yeol will continue to guide policy for another term, after becoming the first

governor to be reappointed since the 1970s.

     While the continued rise in household debt is a significant obstacle to the

BOK given the inevitable rise in debt servicing costs as rates rise, nominal GDP

and household income growth are likely to continue rising faster than nominal

interest rates, preventing a surge in the debt service ratio. Furthermore, the

BOK will be mindful of keeping rates at current low levels and encouraging a

further build-up in debt as it has seen in recent years.

     --DEFLATIONARY HOUSEHOLD DEBT

     A key point to note is that private sector debt is more deflationary than

government debt as there is far greater potential for private sector

deleveraging to reduce the money supply, whereas the government can rely on debt

monetisation by the central bank. Japan's low inflation rate over the past two

decades has been driven largely by private sector debt deleveraging, in spite of

the huge rise in government debt.

     The implication is that Korea's higher level of private debt and lower

level of public debt are likely to keep inflationary pressures subdued relative

to Japan, even as price pressures pick up, supporting real interest rate

differentials and long-term won outperformance.

     The won is also undervalued in purchasing power parity terms relative to

both the dollar and the yen. With these factors in mind it wouldn't be

surprising to see Korea overtake Japan in terms of GDP per capita over the next

five years or so.

     --TRADE WAR RISK

     The three main risks facing the won come from a renewed spike in tensions

between the US and North Korea, a ramp up in Keynesian-style fiscal spending by

Moon Jae-in, and a further rise in global protectionism. Of these, rising global

protectionism poses the main risk. As a very open export-driven economy, a

global trade war would be very damaging to the Korean economy.

     Exports represent around 40% of GDP compared to just 16% in Japan. The fact

that Japan has a far superior external balance sheet also suggests that any rise

in global risk aversion would benefit the yen, which remains a safe haven due to

the corporate sector's tendency to repatriate large overseas liquid financial

assets at times of heightened uncertainty.

--MNI Singapore Bureau; +65 8233 2326; email: Asia-Editor@marketnews.com

[TOPICS: M$A$$$]