1998.3.7

Korea is demonstrating signs of gradually escaping its foreign currency crisis. The roadshow of a group of bankers traveling to the home countries of creditors to sign binding agreements based on guidelines reached in New York was widely successful. The roadshow’s success has brightened the prospects that Korea can overcome its current difficulties. The massive amount of cash inflow in stock market is also helping to stabilize foreign exchange market. S&P upgraded Korea's sovereign rating by three notches from B+ to BB+. All of these factors are auspicious for a recovery of the domestic financial system.

However, many obstacles remain. We are closely monitoring the following factors, each of which holds the potential of preventing stabilization of interest rates:

The biggest current influence on interest rates is the foreign exchange rate. Recently, the foreign exchange rate has demonstrated close correlation with interest rate fluctuation. The IMF announced that an essential prerequisite of decreasing interest rates is the stabilization of the won. Meanwhile, the huge and abrupt depreciation of the won is fanning inflation fears.

Consumer prices rose 1.7% MoM in February, compared with a 2.4% rise in January and a 2.5% rise in December. However, on a year-on-year basis, prices rose 9.5% in February, the highest such gain since a 9.7% rise in prices in November, 1991. Though inflation pressure is weakening in line with reduced fluctuation of the won, expectation of soaring inflation remain widespread.

The other factor to watch when forecasting interest rates is the flow of funds. Most firms are currently facing acute difficulties in securing sufficient funds to continue operations. The most severe damage to the Korean economy is likely to come from the effects of the foreign currency crisis and the continued high insolvency rate of manufacturers and financial institutions. Though cash flow between financial institutions has improved following the additional shutdown of two merchant banks at the end of February, we expect that most manufacturers will continue to face difficulties in accessing sufficient funds.

The BoK has tightened the money supply as per the agreement with the IMF. However, money market conditions are improving, especially the inter-banks call market. Excluding merchant banks and trust accounts of banks, financial institution liquidity is increasing due to the increasing creditability of financial institutions, declining corporate sector facility investment and an improved current balance. Especially, bank liquidity has begun to rise in line with increased deposits.

However, contracting manufacturer liquidity will continue. 14 out of Korea’s 26 banks failed to satisfy the minimum BIS capital adequacy requirement ratio of 8% at the end of last year. The banks’ capital adequacy ratio will be a crucial criteria when the government evaluates management and decides whether a bank should survive. Thus, both banks and merchant banks will remain reluctant to extend new loans, making the attainment of sufficient funds to maintain operations difficult for manufacturers. Fears resulting from the high insolvency rate is another factor behind the tight purse strings of the financial sector. Restoration of mutual trust between the financial and manufacturing sector is essential to reaching stabilization of the domestic financial system. Such trust between the two sectors can largely be realized by continued restructuring and increased foreign capital inflow boosting efficient management and financial structure.

The new Kim Dae-jung administration is promising greater freedom of economic activities under market-driven principles. Such an approach will see the new government making a strong push for economic recovery through reforms in the financial sector and also of the large conglomerates. The new administration plans to push for enhancing transparency of corporate management, an end to the practice of mutual loan guarantees among subsidiaries, and a stress the creation of a healthier overall financial structure. However, many fear conglomerate resistance to such reforms. We are closely watching for signs of the approach the new government takes towards restructuring the failing financial sector and large conglomerates.

We believe the major determinants of interest rates are the won exchange rate, inflation expectations and cash flow. The won/dollar rate should fluctuate at around 1,550 in March. The massive amount of foreign capital that has recently flowed into the stock market and the successful worldwide roadshow brightens the prospects for solving foreign debt crisis. We expect the foreign currency market to further stabilize. Furthermore, the short-term cash flow of banks is improving.

However, high inflation expectation and the difficulties manufacturers face in raising sufficient funds will continue. Furthermore, many uncertain factors remain, any of which could bring a quick return of financial market instability. Such factors include resistance by conglomerates to the new administration’s economic policy, a decrease in export growth, an increase in foreign lenders’ repayment demand to the domestic firms and increasing insolvency rate of manufacturers. Thus, we maintain our position that long-term bond yields will continue to fluctuate widely in a range of between 17% to 21%. And we expect short-term rates to hover around 22%. In addition, the wide interest rates spreads between relatively healthy and unhealthy individual manufacturers will continue.

C.H. Hur