Start of Rate Hikes Won't Derail Recovery

Summary and Conclusions

After the central bank in Australia hiked rates by 25bp on October 6, we believe that Korea is very likely to be the next in the region to hike. We do not expect a rate change at the BoK's monetary policy meeting on October 9, but we do expect to see stronger language from the BoK towards a rate hike. As an advocator of a coordinated effort on exit strategy, it is now easier for the BoK to justify a rate hike, as Korea will not be seen as an outlier now that Australia has taken action.

In our base case scenario, we forecast that the BoK's first rate hike (by 25bp) will come in January 2010, while the market is split between 4Q09 and 1Q10. We now see a rising probability of a rate hike in December or even November. The 91-day CD yield has already risen 21bp since September (or 37bp since the trough). No matter what, rate hikes are almost certain to come - in our view, it does not matter whether the rate hike comes next month or next quarter, because in any case it will not derail the economic recovery.

We believe that the market's concern over tightening in Korea is unjustified.

In fact, there is a long way to go for interest rates to get back to normal levels; we see more benefits for an early but gradual rate hike path. As long as the shift in policy is guided and anticipated, it should actually be positive for sentiment, as it clears uncertainties. Most important, even if the central bank were to shift its policy stance, we believe that the government will continue to support the economy through fiscal measures and reforms in the long run.

Korea is not growing on liquidity anyway, so this policy mix between the central bank and the government is not necessarily as contradictory as the market thinks, because the two have different functions, with the former focusing on pre-empting inflation risk, while the latter focuses on growth potential.

No Urge for Imminent Rate Hike, but it Could Come as a Symbolic Move

Without inflationary pressure, there is no rush for Korea to raise interest rates. The latest inflation figure, at 2.2% in September, is still below the BoK's target of 2.5-3.5%. Although the high base effect from last year is fading out, we expect Korea's CPI growth to pick up only moderately as the stronger currency offsets higher import prices, while the domestic economy, with a utilization rate below 80%, is not strong enough to trigger any significant price reflation. Although the economy is performing better than expected, it is far from overheating. As a result, we do not see any urgency for the BoK to raise interest rates imminently.

What about asset prices?

After all, the BoK's main concern is about asset price inflation, which is not reflected much, or with a lag, in CPI data. We do not believe that Korea is facing an asset bubble, and we also think that monetary policy will not be effective in tackling the property market problems in Korea, which have seen different developments in and outside Seoul. The micro policies implemented by the government, such as the LTV and DTI restrictions, are more useful to avoid a bubble in the making and to ensure the asset quality of mortgage loans, in our view.

Then why should the BoK raise interest rates at all?

As a central bank, the BoK is doing its job to properly anchor inflation expectations and to prevent problems that can arise from interest rates staying too low for too long. The current interest rate level, at a historical low of 2%, was set to boost the economy under a crisis scenario. Not only did the Korean economy not have a crisis, but it even avoided a recession this time.

So indeed, the interest rate level does need to be adjusted to be more in line with the growth outlook. Since it will take a long process for interest rates to return to normal levels, it makes sense for the central bank to start early rather than late in order to pre-empt inflationary threats, which can often come very fast. Nevertheless, the coming rate hikes will have to be gradual, given the lingering uncertainties in the global economy.

Even if a Rate Hike Is Imminent, So What?

First, interest rate movements are a function of economic growth.

Rate hikes confirm that the recovery in Korea has been fast and strong. The 3Q09 GDP data, due to be released on October 23, will likely post positive year-on-year growth in both real and nominal terms, meaning that it has taken the Korean economy only three quarters to get back to pre-downturn levels. The market should not be worried by the start of rate hikes, which simply reflect stronger economic growth. This is evidenced in the historical positive correlation between the KOSPI and real interest rate movements.

Second, interest rates are way below neutral, and it will take a long time before they approach or go above neutral.

Before this happens, monetary conditions will still be considered accommodative. We expect rate hikes to total 100-150bp by end-2010, depending on the timing of the first rate hike. Thus, the policy rate could go up from the current 2% to 3-3.5% by end-2010, which would still be low, as we forecast GDP growth of 5% in real terms and 8% in nominal terms in 2010. Also, considering next year's average inflation forecast of 3.3%, it means that the real interest rate level could be negative, or hover close to 0%, throughout most of 2010.

Third, Korea has not recovered on liquidity this time; And thus the reversal in liquidity conditions should have a less-than-proportional impact on the recovery path.

Unlike during the 2001 export downcycle, when the government engineered a credit card bubble to support the economy that later led to a bubble burst, the Korean government is not using any artificial measures to support the economy this time.

The government has guaranteed SME loans as a defensive strategy, but it has not encouraged excessive lending. In fact, loan growth has slowed significantly this year. During January-August 2009, new bank loans made to the private sector (corporates and households) amounted to only W36 trillion (roughly 5% of GDP), down from W82.6 trillion (12%) during the same period in 2008 and W62.2 trillion (10%) during the same period in 2007.

The loans created year to date represented only 3.9% of total outstanding bank loans. This means that only a very small portion of the economy has entered into new loans when interest rates were at a historical low. The segment that has taken the greatest advantage of low interest rates is the household sector, as mortgage loans are the only lending that has picked up in 2009.

Mortgage loans accounted for 126% of incremental household loan creation during January-August 2009, since non-mortgage household loans have declined. However, due to the strict loan-to-value ratio, which is set at 40% in some areas in Seoul, it is clear that only high-income groups have been able to afford property, and such groups are much less sensitive to rate hikes.

Fourth, the argument that Korea is highly leveraged and thus rate hikes will hurt the economy is also not entirely correct.

It is debatable whether Korea is highly leveraged.

We need to be careful in interpreting some of the debt statistics. Korea's loan-to-deposit (including CDs) ratio in the banking system is about 100%, but a significant portion of deposits are actually with non-bank financial institutions, such as asset management and insurance.

The loan-to-deposit ratio in the entire financial system is only 70%. What also matters is the asset side of the balance sheet, especially for individuals. As of 2Q09, Korean individuals held 2.1x financial assets than their liabilities. Even during the cyclical trough of asset valuation in 4Q08, the financial asset/liability ratio for individuals was still a solid 1.96x.

Korea's ratio of household debt to GDP also has distorted data when it comes to measuring the debt service burden. Again, due to the strict loan-to-value ratio, mortgage loans are taken by high-income groups, who buy high-value properties.

The household loan value is therefore inflated when it is compared to the whole national income level - it includes low- and middle-income groups, which are less active in mortgage borrowing and, as a result, the leverage ratio of Korean households is distorted. The impact of interest rate hikes on the economy, in our view, is therefore much less than what the market thinks based on the over-simplified statistics.

In Fact, Pre-Emptive Measures by the BoK Reduce Downside Risk to the Economy

One of the biggest downside risks to the economy is the risk of a double dip in the global economy, which is not in the BoK's control. If this happens, the central bank can always stop raising rates, or even revert back to rate cuts, for a short period of time. However, equally risky, in our view, is asset price inflation getting out of control if interest rates stay too low for too long. When inflation expectations are built up, a longer time and more aggressive measures are required to combat inflation, and thus pre-emptive measures are warranted. Asset price inflation happening at a time when average income growth remains sluggish creates social problems as well, which will indirectly complicate government policy. When complaining about rate hikes, we should not forget about the consequences of not raising interest rates. If mild and gradual rate hikes will not derail the economic recovery, as we have argued here, we think it is actually positive to see the central bank act early in order to pre-empt inflationary pressures or any bubble in the making. And without an asset bubble, Korea is less vulnerable to any shock in asset prices.

We have all learned from this global turmoil that mopping up the aftermath from a bubble burst is not an easy task and requires a lot of resources.

If anything, we should praise the Korean authorities, from the central bank to the government, for having put in the effort, from monetary policy to property market regulations to monitoring loan growth, in order to avoid the unwanted consequences of a possible bubble. Korea today is more defensive than its own historical trend and market expectations, in our view. If a shift in policy is inevitable, we believe that it will be better to take a more gradual approach than make a sudden, aggressive change once it is too late