South Korean Won outlook : RBC

RBC Capital Markets notes:

1-3 Month Outlook - Door to cuts remains open

KRW was one of the worst performing AXJ currencies in May, falling by 3.2% against the USD. Cyclical data and JPY price action have returned focus on KRW's overvaluation. The June Business Survey showed increasingly negative sentiment.

Manufacturers' business confidence falls to 77 for June from 82 for May and the Confidence index for non-manufacturers declined to 76 for June from 78 for May. Weak domestic demand and an uncertain economic outlook were cited as major difficulties facing businesses.

Meanwhile trade data was very disappointing. Annual export growth contracted further from -8.0%y/y to - 10.9%y/y, the lowest since September 2009 and annual import growth remained in deeply negative territory (- 15.3%y/y). With USD/JPY trading to a new 12 ½ year high, we expect increased jawboning on the KRW from government officials.

Annual CPI inflation increased for first time in 7 months in May. Headline inflation rose 0.5%y/y (cons: 0.4%, previous: 0.4%). Core CPI rose 2.1%y/y (previous: 2.0%). Despite the slightly better than expected readings, the outturns remain below the BoK's annual inflation 0.9%.

We think the door remains open for further monetary easing of 25bps. Consensus expects only 10bps of cuts this year and rate hikes in early 2016. With the negative output gap continuing for longer than had been anticipated, we think those expectations seem too optimistic and KRW outperformance looks unsustainable.

6 - 12 Month Outlook - Debt sustainability issues

Longer-term, we worry about the sustainability of Korean leverage. Household mortgage loans rose 15.2%y/y in April to KRW383trn, marking a new record and adds to concerns about the risks from high household debt, which rose by a record 10.8%y/y in April to a record KRW535.6trn.

Even though the IMF emphasised that the Korean banking system is considerably more sound today compared to late 2008 and stress test results show that Korean banks can absorb shocks bigger than in the 1997 Asian financial crisis, leverage is unsustainable and something has to give.

KRW is one of the biggest potential losers from continued JPY and CNY weakness, which we expect (USD/JPY end 2015 target of 132; USD/CNY end 2015 target of 6.70). South Korea has the highest export correlation and lowest export complementarity with Japan and China.