Taiwan & Korea: how low can rates go?

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Stuart Dixon
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7% in Korea In the event of a sharp downturn, these central banks would allow domestic rates to fall to nearly zero Extraordinary measures outright asset purchases and negative interest rates seem

1 Economics Taiwan & Korea: how low can rates go? DBS Group Research 7 July 216 Taiwan s and Korea s central banks have both cut rates by 2bps this year. Further cuts are possible given a sluggish growth outlook and Brexit-related uncertainties For now, the lower bound of the benchmark rate is seen at % in Taiwan and.7% in Korea In the event of a sharp downturn, these central banks would allow domestic rates to fall to nearly zero Extraordinary measures outright asset purchases and negative interest rates seem unlikely Including the last move on 3th June, Taiwan s central bank (CBC) has cut rates by a total of 2bps this year, bringing the benchmark discount rate to 1.37%. The Bank of Korea (BOK) has also cut rates by 2bps this year (9th June), pushing down the benchmark repo rate to 1.2%. Market expectations remain that these two central banks will ease in 2H16. The growth outlook is sluggish as both economies are experiencing the worst slump in exports since the global financial crisis (GFC). Meanwhile, Brexit-related uncertainties have emerged. This could further weigh on Taiwan s and Korea s exports, depending on how the ripple effects play out. How low can interest rates go in Taiwan and Korea? Taiwan: close to the GFC bottom Rates are already at ultra-low levels in Taiwan. The benchmark discount rate, which refers to the interest rate that banks are charged to borrow funds from the central bank, now stands at 1.37%. But this rate is symbolic, as banks have sufficient funds to tap in the interbank market and don t need to borrow from the CBC. Short-term interbank rates are notably lower than the discount rate. The overnight call loans rate, for instance, is only marginally positive at.18% at present. This is close to the GFC bottom of.1%. To estimate the lower bound of interest rates, one way is to look at the inflation-adjusted real rates. During normal times, central banks should be reluctant to push real rates to negative levels, which would result in asset bubbles, household/corporate overleverage and other problems. The CBC has closely followed this rule, keeping the 1-year real deposit rate in the positive territory during most of the past 1 years (except 28, Chart 1). Note that core CPI is used to calculate real deposit rates as headline CPI in Taiwan is susceptible to fresh food prices and is highly volatile. Today, the 1Y real deposit rate is at.24%. If the CBC wants to avoid negative real rates, it could cut the discount rate by a maximum 37.bps from the cur- Ma Tieying (6) matieying@dbs.com 1

2 Chart 1: Taiwan: deposit rates vs. inflation % pa, % YoY - Real deposit rate 1Y deposit rate Core CPI - Chart 2: Taiwan: TWD interbank call rate vs. FFTR % pa Rate gap - - O/N TWD interbank call rate FFTR - rent levels (every 12.bps decline in the discount rate leads to 7-8bps decline in the 1Y nominal deposit rate). This means a pause in the discount rate at %. The Federal Funds Target Rate (FFTR) also offers a perspective. A negative rate gap with the FFTR should be considered carefully by the central banks in emerging markets. Such could trigger capital outflows and put depreciation pressures on currencies. For the case of Taiwan, the FFTR doesn t seem to be a binding constraint on the CBC s policy, however. The O/N TWD call rate had stayed below the FFTR for a long time in the 2s, until the Fed slashed rates to zero during the GFC (Chart 2). This didn t hammer the TWD. The financial account deficit caused by negative TWD-USD yield spreads was offset by Taiwan s strong current account surplus (Chart 3). The overall balance of payments remained in healthy position. During the ongoing cycle, it is also clear that the CBC is willing to accept negative yield spreads and capital outflows as the country s current account remains robust. The CBC started to cut rates steadily from Sep1, notwithstanding the Fed s rate hike in Dec1. The O/N TWD rate has fallen below the FFTR since the beginning of this year and remained so as of today (also Chart 2). Chart 3: Taiwan: balance of payments Current account Financial account USD/TWD (RHS) -2 1Q 1Q3 1Q6 1Q9 1Q12 1Q Chart 4: Korea: KRW call rate vs. FFTR % pa Rate gap O/N KRW call rate FFTR - 2

3 Chart : Korea & Taiwan: currency volatility 1M implied volatility 8 7 USD/KRW USD/TWD Chart 6: Korea: external position External assets External debt Foreign reserves Short-term external debt 1Q1 1Q3 1Q 1Q7 1Q9 1Q11 1Q13 1Q1 Korea: a lower new bottom In Korea, the benchmark 7-day repo rate set by the BOK is a good guide for short-term market rates. The O/N call rate now stays close to the 7D repo rate of 1.2%. This is a record low in Korea. During the GFC, the BOK didn t take rates below %. The KRW was hit hard at that time due to mounting foreign debt repayments amid the global shortage of USD liquidity. The BOK maintained local rates above the FFTR, in order to retain foreign investors interest in the KRW assets and to support the currency (Chart 4). But KRW volatility has decreased during the post-gfc period, thanks to the reduction of Korea s foreign debt exposure and the strengthening of its external asset position (Chart -6). This has provided flexibility for monetary policy. The BOK further trimmed rates starting from 212, allowing the KRW-USD rate spreads to narrow and tolerating the gradual increase in capital outflows (Chart 4 and 7). Whether the FFTR remains a lower bound considered by the BOK for setting rates is unclear. What about the real rates? Like in Taiwan, the BOK kept real rates positive during most of the past 1 years (except 1H9, Chart 8). At present, the 1Y real deposit rate adjusted by core CPI has fallen to cross zero. But headline CPI stays well below core CPI in Korea due to low oil prices and stable food prices. Chart 7: Korea: balance of payments Current account Financial account USD/KRW (RHS) 1, 1,4 1,3 1,2 1,1 1, Jan- Jan-4 Jan-8 Jan-12 Jan-16 Chart 8: Korea: deposit rates vs. inflation % pa, % YoY Real deposit rate 1Y deposit rate Core CPI (tax adjusted) - 3

4 Adjusted by headline inflation, the 1Y real deposit rate is now positive at.7%. Should oil prices remain low and continue to suppress headline CPI inflation, there would be the leeway for the BOK to justify further cuts lowering the repo rate by another bps to.7%. Zero interest rates and beyond? If macro conditions continue to worsen, we see the possibility that the CBC and the BOK could take domestic rates to almost zero. Inflation would decline if GDP growth slowed further. Negative real rates may not be a worry anymore as asset prices will come down and deleveraging would commence. The economic malaise in Taiwan and Korea originates from external factors the slowdown in global growth and contraction in global trade. Inflation falls in tandem with slower GDP growth, not only due to the excessiveness of domestic capacity but also due to the decline in international commodity prices. Domestic-foreign rate differences are not a large concern against the backdrop of a synchronized global slowdown, because major central banks would ease monetary policy in a concerted fashion. The Fed has showed the tendency to delay rate hikes when downside risks in the overseas economies increased (e.g., China hard landing risks, Brexit). In the event of a severe global downturn, the Fed could reverse course and lower rates. Beyond zero interest rates, extraordinary measures like outright asset purchases and negative rates would prove difficult to implement in Taiwan and Korea. Neither the TWD nor the KRW is a reserve currency that is commonly used in international transactions. Despite the soundness of Taiwan s and Korea s sovereign credit ratings (AA- for both, S&P), the TWD and the KRW are not viewed by all the investors as safe haven assets. The CBC and the BOK would be cautious about the side-effects of unconventional easing, including a loss in investor confidence about their currencies, excessive capital outflows and disorderly exchange rate movements. Also note that Taiwan s and Korea s central banks have issued large amounts of certificates of deposits / bonds during the economic expansion cycles to sterilize their FX interventions. As opposed to purchasing assets from banks and other financial institutions, the CBC and the BOK could allow the short-term debt on their balance sheets to mature. This will be equivalent to injecting liquidity into the financial system and easing monetary policy in a quantitative way. Sources: All data are sourced from CEIC, Bloomberg; Transformations and forecasts are DBS Group Research. 4

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