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Currencies
2009 Dollar Outlook December 15, 2008 By Stephen Jen & Spyros Andreopoulos | London Summary and Conclusions In 2009, assuming that the global economy does find a trough by summer, we see the dollar rallying further into the trough, but underperforming most other currencies as the world recovers in 2H. The swings in the global business cycle will likely be the dominant driver for the dollar. (For the ‘Dollar Smile’, the horizontal axis is the US growth premium over the rest of the G7. This means that the world surges higher on the left side of the Dollar Smile only if the US economy underperforms the G7. As the rest of the world catches up to the flattering US economy, however, the world drifts back down into the ‘gutter’ of the Dollar Smile, eroding the safe-haven bid for the dollar. Only successive downward adjustments in US growth could propel the dollar higher.) Other factors such as US government debt sustainability and the US inflation outlook associated with the Fed’s QE (quantitative easing) operations will likely be secondary considerations, mainly because we believe that US Treasuries will likely remain well-supported while a flare-up in inflation is not a probable risk. There is no official change to our forecast, and we continue to look for EUR/USD to dip to 1.10 by 2Q, before recovering to 1.20 by end-2009. USD/JPY will likely exhibit a similar U-shaped trajectory, dropping to 85 by 2Q before rising to 100 by end-2009. Most EM currencies will likely experience intense depreciation pressures vis-à-vis the USD in 1H. Differentiation at the EM country level will likely be unproductive in the sell-off phase. But in the recovery phase, country-specific factors will likely drive a wedge between the currencies of the ‘good’ from the ‘bad’ economies. Resurrecting our ‘Four Seasons’ Framework In thinking about how currencies might be affected by large swings in the global business cycle, it is important to consider both the real side (the real economy) and the financial side (the buoyancy of the global equity markets) factors. In other words, exchange rates are not only functions of the relative economic growth rate, but are also sensitive to general levels of risk appetite, which, in our view, are correlated with the buoyancy of the world’s equity markets. We illustrate a simple framework we have been using for some time (see Currency Implications of a Slowdown in the US, September 6, 2007). On the horizontal axis, we show the relative strength of the global economy. To the right, the global economy is strong. To the left, we have slow global growth. On the vertical axis, we show the buoyancy of global equity markets. Since financial markets tend to be ‘forward-looking’ and anticipatory, when the world plunges into a recession, earnings forecasts are cut and risk-taking curtailed, and equity prices would be likely to fall as a result, ahead of the actual contraction in economic activities. Thus, we have traced out the path A-B-C to convey the notion that equity markets will fall before the global economy reaches its trough. (As the stock market moves faster than the economy, we move along path A-B-C rather than directly from A-C.) Following on from this, as the global economy climbs out of a recession, equity markets could anticipate this outcome and path C-D-A would then be likely. We call this framework the Economic and Financial Life Cycle, or the ‘Four Seasons’ framework for currencies. Through the Economic and Financial Business Cycle, we should see four ‘seasons’ – summer, fall, winter and spring – corresponding to the four quadrants as indicated. Since equities have already declined substantially, yet a synchronous global recession has just begun (in light of the fact that Asian export growth began to falter only in September 2008), we mark where the world is in this stylised chart. We expect to reach point C by 2Q09, with the global equity markets poised to anticipate an economic recovery. To help us think about the implications for currencies, we first calculated the historical correlations between various currencies (vis-à-vis the dollar) relative to economic growth and the equity markets. Different currencies tended to perform best in different ‘seasons’, or ‘comfort zones’. We suggested that high-beta currencies such as many of the AXJ currencies should belong to the top-right (‘summer’) or the top-left (‘spring’) quadrant, while the currencies of large capital-surplus countries, such as JPY and CHF, should be in ‘winter’ or ‘fall’. By and large, simple correlations of exchange rate performances relative to global growth and global financial market buoyancy are consistent with these broad prejudices. (Please see Appendix 1 for more detail on these calculations and how these relationships have changed over time.) The distance of these currency cells away from the origin denotes the size of the elasticities. Several modifications will need to be made to this chart. First, we believe that EUR and CHF should underperform the dollar as we enter the ‘winter’ quadrant, due to European and Swiss banks’ exposure to EE. JPY, on the other hand, could be supported by acute repatriation flows as we head into ‘winter’. • Call 1. The dollar to strengthen first, and weaken later. At the turn of each year, there is a temptation for analysts like ourselves to make one call on the dollar for the entire calendar year (i.e., a strong or weak dollar ‘year’). However, more often than not, currencies don’t change trends on January 1 of each year. 2008 is a good example: the dollar did not begin to show strength until May against AXJ currencies and July against the EUR; in the first few months of 2008, the dollar was extraordinarily weak. For 2009, we see the opposite trends: dollar strength in the first months, followed by possible dollar weakness in 2H. We see the world toggling through ‘winter’ and ‘spring’ in 2009, with a risk that ‘winter’ may last longer than 1H, and ‘summer’ may come in 2010 or later. Thus, the point is that we will be buying dollars and JPY into 1H, but with a view to flip our positions some time in 2Q, in anticipation of an economic recovery in the world. • Call 2. EM currencies will be stressed in 1H. The global EM currency ‘moment’ is not over, in our view. In fact, the process is roughly halfway complete. We see weaker Latam currencies in 1H09. Pressures on AXJ currencies will likely persist, as these countries’ exports collapse and their central banks cut interest rates. We believe that even the CNY will be allowed to weaken against the dollar in the coming months (see Changing My Call on the Chinese RMB, December 2, 2008). Finally, EE currencies may come under intense BoP pressures (see The RUB – Eastern Europe – EMU Nexus, November 13, 2008 and EM Currencies: Sell into the Rally, October 30, 2008). While the situation in Russia especially deserves investors’ full attention, the familiar structural fragilities of EE will expose the broad region to possible discrete changes in the RUB, in our view. When the global economy bottoms, we would be keen to buy back KRW, BRL and MXN. Our view on the commodity currencies (AUD, NZD, CAD) is broadly similar to that on the EM currencies. • Call 3. We remain bearish on the EUR in 1H. Though the EUR is no longer over-valued, it is still over-rated and over-owned, in our view. The sell-off from 1.60 to the high-1.20s merely puts EUR/USD closer to its fair value: EUR/USD was massively over-valued at 1.60. The EUR is no longer expensive, but it is not cheap, either. Further, the only reason why the dollar could have rallied so sharply since July was its hegemonic reserve currency status. The fragmentation of the European sovereign bond markets helps preserve the superior reserve currency status of the dollar, in our view. Finally, the negative feedback from possible fractures in EE could cause material damage to the EMU, and weigh on EUR. Two Main Risks to our Dollar View The two key risks to the dollar are inflation and an unsustainable federal debt profile. The Fed’s QE operations need an exit strategy. The latest talk of the Fed issuing its own debt may be one way the Fed could unwind its balance sheet in time to stabilise inflation expectations. The dollar’s performance will be driven by inflation expectations, in our view (see The Fed’s QE Operations and the Dollar, November 26, 2008). Similarly, the super-sized US fiscal deficits will be a risk for the dollar, though our central case view is that US Treasuries are more likely to be a preferred safe-haven asset in a global recession, marginalising other sovereign debt (see US Fiscal Deficits and the Dollar, December 4, 2008). Bottom Line We continue to manage our currency call centred on the ‘Dollar Smile’ and believe that the dollar should head higher in the 1H09, before giving back some of its gains in 2H, assuming that the global economy bottoms next summer. Our ‘Four Seasons’ currency concept may be a useful framework for thinking about the dollar. Appendix 1: Four Seasons Over Three Decades In this Appendix we use our Four Seasons framework to make some observations on how leverage-induced global growth over the last seven years has affected currency performance. For this purpose, we compare the largest span of time for which we have data, 1982-2007, with the 2000-07 period. (The vertical axis measures the correlation between G7 real GDP growth and the return against the USD of the currency in question – the exchange rate expressed as units of currency x that buys one dollar. The horizontal axis measures the correlation between the change in the market cap to nominal GDP ratio for the G7 and the return against the dollar.) Both exhibits show some broad patterns which we have already pointed out above: currencies of export-driven economies, namely the commodity currencies (CAD, AUD) and AXJ currencies (THB, KRW, TWD), are ‘high-beta’; meanwhile, CHF and EUR are more defensive in nature, outperforming when stock markets are bearish and growth is weak. In addition, in the long run, GBP is a ‘spring currency’, outperforming once stock markets begin pricing in a recovery while the real economy is still weak. We believe that this is due to the breadth and depth of the UK’s capital markets, relative to its real economy. Thus, in ‘spring’, capital inflows to the UK markets could be so large that GBP could be buoyed even before the global economy recovers. When comparing the two exhibits, a dominant theme emerges. The recent period of strong global growth has accentuated the performance characteristics of most currencies. Specifically, we make the following observations: • Compared to the full sample, the ‘high-beta’ currencies have moved further to the right; these were the main beneficiaries of the rapid expansion in the global economy recently. • EUR and CHF have become more obviously ‘defensive’ in this fast-growth environment by moving (further) into ‘winter’ territory. • GBP, while being a ‘spring currency’ in the long run, turned outright ‘high-beta’ over 2000-07. This suggests that recent sterling buoyancy is in no small part due to leveraged global growth. These observations carry clear implications for currency performance going forward: in a period of more muted global growth, with a prospective compression of US C/A deficits, commodity currencies and AXJ should show a less stellar performance. The EUR should also be less strong as we enter the ‘winter’ quadrant. Appendix 2: A Look Back at 2008 There are many lessons we should have learned from 2008. Here are some lessons from the currency markets. • Lesson 1. The dollar is the undisputed reserve currency in the world. There have been persistent doubts, in recent years, about the dollar’s reserve currency status. But when push came to shove, the currency of the epicentre of the global financial crisis rallied, by about 20% against many majors and 30% against the minors. It is important to distinguish between three roles of international currencies: medium of exchange, unit of account and store of value. The dollar, in our view, has proven itself to be the dominant medium of exchange and unit of account. In times of stress, investors ‘bring money home’. 75% of hedge funds in the world are dollar-based, and most investors from EM are dollar-centred. The ‘home’ currency to hedge funds and EM investors is the dollar. The reserve currency characteristics are only revealed in stressful times. In this particular cycle, the dollar’s reserve currency status, in our opinion, has been a powerful factor supporting the ‘Dollar Smile.’ • Lesson 2. Central banks need to reconsider the adequacy of their USD holdings. Despite the widely held view – one that we had endorsed – that many EM economies had more than adequate official reserve holdings, experiences with interventions this year show that some central banks may not have had adequate reserve holdings in the sole intervention currency – the USD. Over the years, as official reserves rose in size, the objective of reserve managers around the world drifted from maximising liquidity to maximising investment returns. Currency and asset diversification was an established trend for reserve managers. But this year, some central banks may have discovered that the capital outflows were so strong that they may not have had enough dollar holdings in the right asset, i.e., in the most liquid US Treasuries. The IMF’s COFER data suggest that 62.5% of the world’s official reserves were held in dollars, as of 2Q08, down from 65.1% in 1Q07. (A total of US$7 trillion of reserves are covered in the IMF COFER survey. Some US$3.6 trillion of reserves are not covered as some countries do not participate in the IMF’s surveys.) It will be interesting to see if this downtrend stabilises or even reverses in the years ahead. • Lesson 3. The EUR’s status as a global reserve currency is questioned, while its regional status may have been enhanced. The lack of a federal fiscal system in Euroland, coupled with intense pressures on the banking systems and on the economies, has led to widening spreads among the sovereign bond markets in the EMU. This fragmentation of bond markets undermines the EUR as a global reserve currency because it reduces the effective liquidity of the underlying bond market. The US Treasury market, on the other hand, is monolithic. At US$5.7 trillion, the US Treasury market is significantly larger than the US$1.5 trillion German Bund market. The combined sovereign bond markets in EMU are US$6.5 trillion. But bond market liquidity will remain an issue for the EMU until some of the structural ambiguities are resolved. Having said the above, while the EUR’s global reserve currency status may have been impaired somewhat, its regional reserve currency status may have improved this year. In other words, the relative reserve currency status of GBP and CHF has deteriorated even more than that of the EUR, making it possible for the EUR to actually gain market share among the official reserve managers. We would not be surprised if the world’s reserve holdings of GBP and CHF start to decline from here, with the EUR being a beneficiary of this prospective new trend. • Lesson 4. Emerging markets (EM) are largely a leveraged play on the developed markets (DM). At the start of the year, we were proponents of the ‘decoupling thesis’, built on the view that the US economy would not fall into an outright recession. However, we made a U-turn on this call in May when we realised that the US economy was heading towards an outright recession. (In Dollar Smirks in Asia (May 1, 2008), we explicitly abandoned a two-year-old call for AXJ currency strength, and warned that the tide had turned against AXJ currencies in favour of the dollar. Subsequently, we argued for dramatically weaker Latam and EE currencies.) While EM had enough positive ‘alphas’ to offset mild mid-cycle recessionary forces from the US, its negative ‘betas’ were too large if the US were to fall into an outright recession. What we have witnessed since May is precisely evidence supporting the view that much of EM is a leveraged play on the US. Our bearish call on EM currencies was one of the strongest out-of-consensus calls this year, attracting a surprising amount of hostile reactions from investors. Our view is that, while investors may now have accepted that EM could suffer from the negative cyclical forces, some may still have the view that EM’s structural outlook is as bright as in recent years – a view we do not endorse. • Lesson 5. C/A surplus countries could be just as vulnerable as C/A deficit countries. In contrast to the notion that capital-deficit countries (e.g., the US, UK, Australia) should suffer more than capital-surplus countries (like Japan, Germany and China), what we have witnessed is that the cyclical pains are at least as great in the latter as in the former. Appendix 3: The Gutter of the Dollar Smile While most regular readers of our work understand the basic implications of the Dollar Smile, we thought that it is important to point out one particular feature that will be crucial in the period ahead. In the Dollar Smile framework, the horizontal axis is the growth differential between the US and the rest of the world (RoW). Technically, when we did the econometric calculations to come up with this convex relationship, we used the US-minus-G7 growth as the x-axis, not just the growth rate of the US economy. The fact that it is the growth differential rather than the absolute level of growth of the US is important. When the US led the world into a recession, (i.e., the US economy underperforming the RoW), the world was high on the left side of the Dollar Smile (i.e., at point A). But as the RoW caught up to the faltering US, the growth differential actually shrank. In other words, the more synchronous is the global economic slowdown, the more we will drift back down into the ‘gutter’. Every round of downward growth revision in the US will trigger a temporary slide up the left side of the Dollar Smile, followed by a drift back down into the ‘gutter’. One could consider this a ‘decay’ process. There are many factors that drive currencies, including the Dollar Smile. Our view is that, when the global business cycle turns sharply, the Dollar Smile should give the best description of how currencies ought to trade. However, as long as the world is in the ‘gutter’, i.e., growth differentials are not large in size, while the dollar should not necessarily weaken, factors other than the world’s business cycle should become more important drivers of currencies. Being in the ‘gutter’ allows other factors – such as general worries about US fiscal sustainability and the Fed’s QE operations – to become important drivers of the dollar. Further, in the final trading days of the year, general reduction of risk-aversion (consistent with stable-to-buoyant equity markets) and unwinding of existing FX positions are also possible explanations for the weakness in the dollar this week, we think. Some have the view that we might see a FIFO (first-in first-out) scenario whereby the US leads the world out of the global recession, in light of the early and aggressive financial stimulus the US has deployed. If that scenario materialises, then the world might be pushed up on the left side of the Dollar Smile in the recovery. But this process is also likely to be temporary, because as the RoW catches up to the US, the world drifts back down into the ‘gutter’. Uncertainty towards the global economic outlook is also positive for the dollar – a direct result of the convex curvature of the Dollar Smile relationship. Assume that there are only two views of the global economy: good (B) and bad (A). The average USD value of scenarios A and B (point D) is higher than the USD value corresponding to the average growth forecasts (point C). Now that decoupling is no longer a debate, the spread of opinions on global growth has narrowed, in turn eroding the ‘uncertainty premium’ of the dollar, according to the Dollar Smile Framework.
ASEAN
Setting the Context and Calibrating the Risks December 15, 2008 By Chetan Ahya & Deyi Tan | Singapore; Shweta Singh | Mumbai Cutting Our Baseline Further Spillover effects from the credit crunch, trade and asset market linkages continue to exert their impact on the real economy. Recent macro data in developed economies suggest that the trajectory of the downtick is likely to be sharper than what has already been penciled into our models. Reflecting that, latest ASEAN exports data, which have so far been supported by EM demand, nosedived and declined 2.5%Y (October 2008) after showing strong growth of 29.8%Y in July 2008. Our macro team has downgraded the global growth forecast to 0.9%Y from 1.7% for 2009, making this the second-weakest global growth outlook in the post-war period and similar to the slowdown in the 1982-83 downturn (see Risks to the Global Outlook: The Good, the Bad and the Ugly, December 9, 2008). Similarly, we are marking to market our ASEAN GDP growth forecasts to 1.3%Y in 2009 and 4.0%Y in 2010, from 2.0%Y and 4.4%Y previously. Assessing ASEAN Vulnerability Indeed, we continue to view ASEAN’s vulnerability to the spillover via a two-fold transmission mechanism, as well as the respective country’s propensity for and the extent of policy responses (both fiscal and monetary). Our downgrades for Indonesia, Malaysia and Singapore reflect a combination of these factors. For Thailand, where macro remains relatively less sensitive to tightening credit conditions and weakening trade, a fourth idiosyncratic factor of political conditions comes into play. We reiterate our vulnerability framework as follows: 1) Who is most addicted to risk-capital liquidity? Overall, ASEAN balance sheets are less overstretched compared to 1997-98. However, those economies that have, at the margin, been most dependent on leverage as a fuel of economic growth would be most affected as liquidity becomes more costly in this develeraging cycle. The source of credit funding is also critical. In an environment of risk-aversion, economies that had been running a credit cycle alongside current-account deficits are likely to see the most disruptive tightening of liquidity conditions. By these measures, we believe that Indonesia is most vulnerable, followed by Singapore, Thailand and then Malaysia, as credit growth in the latter two remained relatively subdued. 2) Who is most exposed to global trade and asset markets? Economies with a smaller domestic demand base and a higher trade and asset market linkage will be more susceptible to a bigger growth deceleration in the coming global slowdown. Moreover, we note that for economies such as Singapore and Malaysia, dependence on external demand is weakened further by the relative underperformance of its exporters. Indeed, Malaysia exporters of integrated circuits and telecommunications equipment have seen declining market shares since the early 2000s. In this regard, we believe that Singapore remains most vulnerable, followed by Malaysia, Thailand and then Indonesia. 3) Who has the ability and wherewithal to undertake policy responses? The ability to cushion the downcycle would depend on the authorities’ propensity for and the extent of policy responses. However, widening spreads, a change in pricing of risk and tighter lending standards have rendered the monetary policy easing less effective than usual. In fact, the monetary policy rate has already ceased to be an effective signaling tool in Indonesia, as the market takes charge of automatic tightening. Nonetheless, economies where the central banks are sitting on reasonable liquidity (i.e., Malaysia) and have not seen a strong credit cycle (i.e., Malaysia and Thailand) – and hence have a lesser possibility of bad lending – will likely experience a higher degree of success in terms of monetary easing. Fiscal expansion is likely to be constrained by a higher cost of fiscal financing, particularly for Indonesia. On the other hand, Thailand’s fiscal pump-priming could face execution difficulties due to its political conditions. For Malaysia, the already significant budget deficit suggests that the room for additional delta in terms of discretionary stimulus could be more limited. Comparatively, the Singapore government has the most gunpowder, given its history of fiscal surpluses. Our ranking in terms of policy responses is Singapore (more effective), Malaysia, Thailand and then Indonesia (less effective). 4) Who is most affected by idiosyncratic factors? Political conditions continue to be wildcards in the case of Thailand and Malaysia. Specifically in Thailand, the recent unfolding of political events and the continuous lack of visibility in terms of a political endgame will serve to further weaken already weak macro momentum, specifically through the conduit of tourism and FDI. In Malaysia, the transition process from a single-party government to a two-party government could also potentially hinder the momentum in the public sector economy. On the other hand, Indonesia is heading into elections in April 2009. Recent regulation changes that raised the level of Parliamentary seats and votes (from 3% and 5% to 20% and 25%, respectively) a party or coalition needs to have in order to nominate the presidential candidate introduce a degree of uncertainty as President SBY’s Democratic Party won only 10% of the seats and 7.5% of the votes in the 2004 elections. Comparatively, the short-term risks in terms of political stability remain relatively lower in Singapore. Our ranking in terms of the potential downside risks from political conditions is Thailand, Malaysia, Indonesia and then Singapore. Inflation, Disinflation or Deflation? We are also cutting our ASEAN inflation forecasts to 4.6%Y for 2009 and 4.7%Y for 2010 from 5.1%Y and 5.2%Y, respectively. Slower growth and hence lesser demand-pull price pressures would come into play for 2009 inflation. For several of the ASEAN economies, high commodity prices in 2008 have led to inflation going beyond the comfort zone for some of the central banks. In the reversal, the decline in commodity prices will now also reduce cost-push pressures. For Malaysia, Thailand and Singapore, where retail fuel prices would be adjusted in line with market prices, direct fuel weights constitute about 7.3%, 5.3% and 2.4% of the CPI basket, respectively, and the decline in fuel prices since July 2008 would be a significant disinflationary force. Indeed, for most of ASEAN generally, disinflation (a slower pace of inflation) rather than outright deflation would generally characterize the inflation outlook for 2009. However, we highlight that Singapore and Indonesia lie at the two extreme ends of the inflation spectrum. The open nature of Singapore’s economy makes it most vulnerable to a build-up of slack, and hence lower pricing power. Moreover, the correction in the real estate cycle is likely to show up in CPI, as rental contracts reset with a lag. In the 1998 and 2001 recessions, when GDP growth was -1.4% and -2.4%, respectively, there were three to four quarters of deflation. We expect negative inflation toward 2H09. For Indonesia, currency vulnerability remains a key risk to import-led inflation. With a small current account buffer and continued capital outflows, we expect the currency to weaken to a peak of 13,000. Every 1% depreciation in the currency will add 0.13 pp to headline CPI. In this regard, we expect Indonesia to see the least degree of disinflation. Calibrating the Risks to Our Outlook Our GDP base case reflects our view of the most likely scenario in a distribution of outcomes. However, we believe that the distribution of outcomes is still skewed towards more downside. We quote our global economists in Risks to the Global Outlook: The Good, The Bad and the Ugly (December 9, 2008) on some of the risks that dominate, which are more pertinent for ASEAN. First, the extent of the develeraging by leveraged lenders remains uncertain, and further write-downs and provisions will intensify the credit crunch in developed economies. Risk capital and risky assets are unlikely to recover until credit markets begin to function again. Moreover, the extent of further declines in asset values, especially in real estate, will deepen those risks, especially for US consumers. This will have implications for ASEAN economies that are dependent on risk capital and global trade. Second, central banks and policymakers have eased monetary policy aggressively and quantitatively, but it remains unclear whether and when such policies will get traction in reviving growth and avoiding deflation. This will have bigger spillover implications for the ASEAN economies where the effectiveness and wherewithal for monetary and fiscal policy responses are lower. Third, the extent of swings in currency and commodity prices matter in terms of their implications for ASEAN domestic demand. Fundamentals have improved since the 1997/98 crisis. However, ASEAN currencies, such as the rupiah, still risk further overshooting on the weak side, amid dislocated asset market, further declining commodity prices and relatively open capital accounts. Indeed, growth risks are asymmetrical. In our global bear case scenario, global activity contracts 0.8% in 2009 and recovers to 1.3% in 2010, as economic headwinds dominate policy stimulus, making this the most severe recession in the post-war period. The global bull scenario involves growth of 2.3% in 2009 and 4.4% in 2010, as a comprehensive and massive range of policy actions overwhelm the downturn. Our ASEAN bull-bear profile is similarly skewed to the downside with the bull case growth trajectory at 2.6%Y for 2009 and 5.2%Y for 2010 and the bear-case growth trajectory at -1.0%Y for 2009 and 2.1%Y for 2010. The bull-bear growth variance surrounding the base case is also of a larger delta to reflect the high-beta nature of the ASEAN economies. For additional charts and details of the bull-bear case, please see ASEAN Economics: Setting the Context and Calibrating the Risks, December 11, 2008.
Korea/Taiwan
In a Mad Race to ZIRP? December 15, 2008 By Sharon Lam | Hong Kong Summary and Conclusions Both Korea and Taiwan cut interest rates more than expected this week. The Bank of Korea (BoK) cut its policy rate by 100bp, reducing the base rate to 3%, the lowest level in its rate-setting history. The Central Bank of China, Taiwan (CBC) cut 75bp, taking its rediscount rate down to 2%, its lowest level since mid-2005. Within the last two weeks, China cut 108bp in one go, India cut 100bp in one go and Korea did 100bp this week. It appears that three-digit rate cuts are in fashion, and anything less will be deemed too ‘stingy’. The question is how much more ‘generous’ can they be when their economies have low interest rates to begin with. If Korea and Taiwan both continue with rate cuts of 50-100bp each, there are not many bullets left. Will they end up having a zero interest rate policy (ZIRP)? Possibly, but that is not our base case projection. We believe that the central banks are attempting to front-load the rate cuts to reduce the private sector’s debt obligations during the toughest times, hopefully to get their economies out of recession soon. Most importantly, rate cuts are not the only weapons. The governments can also inject capital to restore financial market stability and fiscal stimulus to boost growth. All measures work with a time lag and the impact should be more visible starting in 2Q09, and should then reduce the need for aggressive rate cuts. We forecast that the BoK will cut another 200bp to bring the base rate down to 1% and the CBC will cut 150bp more to 0.5% by 2Q09. Korea: Rate Cuts Are Essential and Have Bigger Impact Since September, the BoK has slashed interest rates four times, including this week, for a total of 225bp, with one being an inter-meeting move. Bigger rate cuts are indeed much-needed in Korea since the economy is troubled by higher leverage, and the heavy debt burden needs to be reduced during these tough times when income and wealth are both contracting. Therefore, we applaud the BoK for acting aggressively. However, rate cuts alone cannot turn around the economy, and Korea’s market rates are not yet moving in proportion to policy rate changes because of the current tight liquidity. The 91-day CD yield, a benchmark for lending rates, has only dropped 74bp from the peak. A direct liquidity injection is more effective in bringing market rates down than interest rate policy. The BoK is doing both and so far being more aggressive on cutting policy rates, but the positive news is that the BoK is stepping up efforts on both. Although market rates are moving slower, we believe that they will eventually drop more in line with policy rates. After all, in Korea’s rate history, market rates have always moved more than the policy rate in both directions. If the BoK lowers the base rate to 1%, as we expect, we believe that the market rate can also eventually decline another 200bp from the current level or even more. We estimate that this can reduce the private sector’s debt service burden, a saving that is equivalent to at least 2.8% of GDP, which is rather significant. However, one can argue that the calculation should not be that straightforward since certain parts of the economy – namely the interest earners – will lose from rate cuts. The market has the misperception that Korea has more loans than deposits. This is only true when looking at the banks with a loan/deposit ratio at 140% as of September 2008. It is not true for the economy as a whole, as the loan/deposit ratio for non-bank financial corporations (including asset management, merchant banks, credit unions and life insurance) was only 38%, and therefore the economy’s overall loan/deposit ratio was 77%. As a result, there could be more loss in interest income than savings in interest payments. However, there is apparently a more urgent need to save the borrowers than the savers at this time. Taiwan: Liquidity Is Not a Problem, So Rate Cuts Have Smaller Impact This week was the fifth time that the CBC has cut interest rates since September, with the policy rate coming down 162.5bp from the peak. Three of those cuts were inter-meeting moves. This makes the CBC the most aggressive central bank in the region, not only in terms of frequency but also in terms of magnitude, since Taiwan started with a lower rate level. Is Taiwan desperately in need of rate cuts? We do not think so. It has one of the strongest liquidity conditions in the region and lower leverage. Meanwhile, Taiwan’s market rates have been lower than the policy rate since mid-2006, and so the impact of interest rate policy on actual market rates will be smaller, not to mention that there is not much room to cut, given that its interest rate is low to begin with. If the CBC cuts another 150bp as we predict and market rates move in proportion from here, we estimate that such a move can save the private sector 1.7% of GDP on interest payments. Why is the CBC so eager to stay ahead of the curve? We believe that it is because Taiwan has a confidence problem, and it requires the authorities to show their commitment to support sentiment. Practically, however, rate cuts will only give limited support to the economy, in our view. Meanwhile, we worry about asset quality in Taiwan. Taiwan is much more export-oriented than Korea, but it is rapidly losing competitiveness on the exchange rate and is experiencing a more severe export slowdown; therefore, it is possible that more exporters could go bankrupt in Taiwan. Unfortunately, rate cuts will not solve much of the asset quality issues, although they should help to reduce the debt burden and let the fitter ones survive. ZIRP Is Not Optimal As indicated in our forecasts, we believe that neither Korea nor Taiwan will adopt ZIRP, although we see a higher chance of ZIRP happening in Taiwan, simply because it does not have many bullets left with its policy rate down to 2% now. Yet, in contrast, we see a bigger disadvantage for Taiwan to run ZIRP than Korea. Given the high savings and wealth accumulated in Taiwan, a zero interest rate could cause another round of capital outflows, similar to what happened in the past few years. Since the beginning of this year, Taiwan just managed to have a positive interest rate gap against USD rates for the first time since 2004, and this has indeed helped to attract capital to flow back, with the financial accounts within the balance of payments posting a surplus in 1H08. Since we have argued that there aren’t many pros for lower rates in Taiwan but the con is capital outflows, we think that ZIRP is not optimal for this economy. In Korea’s case, the risk of moving towards ZIRP is inflation, since its currency depreciation is causing inflation to moderate at a much slower pace than other economies in the region. However, this may not be as bad as it seems now, since deflation is not desirable either. Although we see fewer disadvantages for Korea to have a zero interest rate, we do not see the necessity for the BoK to give up its flexibility on the interest rate policy; we believe that a further 200bp cut will be sufficient. NTD to Depreciate Slightly Against KRW, but Not Enough to Turn Around the Competitive Landscape As we have long argued, the KRW movement in the past few months has gone beyond fundamentals, and so we are not surprised that it is reversing part of the undershoot now. We expect KRW to remain stable while the NTD depreciates in the next six months. Although on an absolute level Korea’s current account surplus is far smaller than Taiwan’s, the momentum is going in the other direction, as Korea is swinging back from a deficit to surplus while Taiwan is seeing a declining surplus. This is because: 1) the decline in Korea’s exports is relatively milder due to stronger competitiveness; 2) the drop in Korea’s imports is bigger since it needs to adjust for over-consumption and more expensive import prices; and 3) Korea’s services’ net exports are expanding due to the rise in inbound tourists and rapid cut in outbound travel due to the weaker exchange rate. As a result, we believe that NTD will depreciate against KRW in the next six months, but only marginally, because the lingering concerns over ship cancellations in Korea and their subsequent impact on external debt repayment will limit the KRW appreciation. We expect KRW/USD and NTD/USD to average 1,250 and 34, respectively, in the next six months. |