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To: 16yearcycle who wrote (25594)	10/21/1998 10:01:00 PM
From: Fred Levine	Read Replies (1) \| Respond to of 70976

To all-- Good news about Korea Korea: Low Real Interest Rates: First Stage of Economic Recovery Tim Condon (Hong Kong) Key Points: Real and nominal interest rates in Korea have plunged since July and now are below their pre-crisis levels. This has occurred despite tight monetary policy settings by the Bank of Korea. A behavioral shift in consumers resulted in a deposit windfall for banks that created the conditions for the plunge in domestic interest rates. One of the conditions that caused the behavioral shift now has reversed, and the impact of the other has diminished, in our view. While we believe there is little further downward scope for nominal interest rates, we expect low real interest rates to persist and halt the sharp contraction in consumer demand seen in the first three quarters of 1998. As consumption stabilizes, we expect a gradual pickup in inflation with the result that real interest rates would remain at about current levels. We maintain our view that the economy will bottom out in the first quarter of 1999 and post positive real growth in the second quarter. The implications for the currency depend on what happens to net private capital inflows. This, in turn, depends on the speed at which Korean corporates de-leverage. We favor a middle position between the two extremes of a large-scale sell-out to foreigners -- high capital inflows, strong won scenario -- and a return to business as usual by the chaebols -- low capital inflows, weak won scenario. We expect private capital inflows to rise but not sufficiently to offset a narrowing trade surplus, with the result that we forecast the won will weaken in 1999. Details: Interest rates in Korea have plunged. At 11.1% in September, the monthly average three-year corporate bond yield was at a historical low. Having reached single digits during the second week of October, the three-year won-denominated corporate bond yield was less than that for US dollar-denominated Korean sovereigns. Nominal interest rates are at record lows. The plunge in nominal interest rates has translated into low real interest rates as well. And we're referring not only to nominal rates deflated by year-over-year price inflation. We believe this is not an accurate measure of inflationary expectations because virtually all of Korea's inflation occurred in the first three months of the year. Since then there has been little inflation. Even when monthly inflation (seasonally adjusted annual rate) is used, real interest rates are below their pre-crisis levels. Falling interest rates usually mean monetary policy is expansionary. Yet throughout the first half of 1998 monetary policy was tight. The Bank of Korea (BOK) purchased foreign exchange but did not allow the inflows to expand the money supply (reserve base money, as it is called in Korea, comprising cash plus commercial bank deposits with the BOK). Instead, the central bank issued Monetary Stabilization Bonds or MSBs, which caused reserve base money to contract (Table 1). Inflows continued in July, and reserve base money contracted further. Falling reserve base money is evidence of contractionary monetary policy. Table 1 Bank of Korea, Summary Balance Sheet --------------------------------------------------------- Changes (Won Trillion) 1H98 July 98 --------------------------------------------------------- Assets Net Foreign Assets 18.8 2.8 Liabilities Monetary Stabilization Bonds 18.9 -1.5 Reserve Base Money -1.7 -1.0 Residual 1.8 5.3 Sources: CEIC and Morgan Stanley Dean Witter Research The explanation for the decline in interest rates despite a contractionary monetary policy lies, we believe, in the private sector's response to the unprecedented shock from the balance of payments crisis in December and January. The huge devaluation and the extremely high interest rates that resulted had two effects. First, the crisis led to an increase in the savings rate. And second, high interest rates made it uneconomic to hold cash. These behavioral changes explain the shift out of cash into more remunerative forms of saving that underlies the huge jump in the money multiplier. The behavioral shift created a deposit windfall for banks. They used the windfall to invest (mainly) in top 5 chaebol bonds (the row labeled Debentures in Table 2) and recapitalize themselves. The crisis also affected banks' behavior as seen in their reduction of risk exposures. Banks clawed back loans from the private sector and sold their holdings of securities. Table 2 Financial System Sources and Uses of Funds (YTD, Won Trillion) --------------------------------------------------------------- July 1998 --------------------------------------------------------------- Sources of funds 56.7 M3 62.8 of which: M2 25.3 OFI Time and Savings Deposits 18.7 Beneficial Certificates 40.1 Money in Trust -19.2 Foreign liabilities -6.1 Uses of funds 45.6 Loans to private sector -14.0 Stocks -11.4 Debentures 27.2 Foreign Assets 23.1 Capital Account 20.7 Residual 11.1 Source: CEIC, Morgan Stanley Dean Witter Research One of the conditions that caused the behavioral shift now has reversed. The fall in real interest rates has reduced the reward to economizing on cash balances, and consumers are likely to restore a more normal level of transactions balances. As they shift out of time deposits and other forms of saving into cash and demand deposits, the rate of growth of reserve base money will pick up. As that occurs, inflation also will pick up. We also believe that the dramatic fall in interest rates will cause some of the anxiety that produced the jump in the savings rate to dissipate. The world is quite different from what it was in the first half of 1998. US monetary policy has moved from a bias toward tightening to outright easing, with more interest rate cuts to come, according to Morgan Stanley Dean Witter's chief economist, Stephen Roach. The shift to expansionary monetary policy has had the predictable effect on the US dollar, which has further bolstered sentiment by removing, at least for now, the prospect of a dramatic weakening of the Japanese yen. The likely response to these changes is that consumers will now begin to be coaxed into actually consuming. The economy then will be close to bottoming out. As consumption demand stabilizes, the deposit windfall of the first half of 1998 will end. The stabilization of consumption also will mean that the severe import compression in evidence so far this year will begin to unwind. As that occurs, the trade surplus will narrow. For these reasons we believe there is little further downward scope for interest rates and, going forward, the behavioral shifts we forecast are likely to mean nominal interest rates rise somewhat (our end-year forecast for the three-year corporate bond yield is 11%). Beyond the very near term, inflation will pick up slightly as consumers shift back into transactions balances, though the pickup in inflation will lag the pickup in reserve money growth by about a half year, in our view (our end-1999 inflation forecast is 10%). Whether or not these changes put pressure on the currency depends on what happens to the capital account of the balance of payments. If corporate Korea begins to de-leverage aggressively through debt:equity swaps and asset sales to foreigners, capital inflows will result in an appreciating currency despite the narrowing of the trade surplus. However, if net private capital inflows remain slight, as they have for the first seven months of 1998 (Table 3), the narrower trade surplus will translate into reserve outflows and the exchange rate will depreciate. Our view is that reality is likely to fall somewhere in between. We forecast a slight weakening of the won in 1999 (our end-1999 won/US dollar forecast is W1,550). Table 3 Korea: Balance of Payments (US$ Bil) ---------------------------------------------------------------------- 1Q98 2Q98 July 98 Aug 98 ---------------------------------------------------------------------- Current Account Bal 10.7 11.6 3.6 2.3 Trade Balance 9.6 11.6 3.9 2.9 Capital & Financial Acc. -0.6 2.1 -0.9 0.4 Financial Account -0.5 1.7 -0.9 0.4 Direct Invest. -0.4 0.1 0.7 -0.2 Portfolio Invest. 4.2 0.5 -0.8 -1.1 Other Invest. -4.4 1.1 -0.8 1.7 Changes in Reserves (a) -9.4 11.3 -2.1 -1.9 Errors and Omissions -0.7 -2.4 -0.6 -0.7 (a) A negative sign indicates a reserve accumulation. Source: CEIC, Morgan Stanley Dean Witter Research