asem Korea Needs to Watch Out for Global Market Risks

By Jeong Bu-kyun

President of Korea Center for International Finance

Recently Ben Bernanke said in a monetary policy conference, ``We are attentive to the implications of change in the value of the dollar for inflation and inflation expectation. The U.S. central bank and the Treasury were continuing to carefully monitor currency market developments.''

This comment by Bernanke surprised the market because it is unusual for a Federal Reserve chairman to speak openly and substantively about the dollar. The financial market took his relatively rare comments as a warning on the dollar-driven inflation and placed weight on an interest rate hike within the year.

Hence, the vicious circle of a weak dollar leading to higher oil prices and again to a weak dollar seemed to have come to an end.

However, the FED chief's signal that he will stop cutting interest rates will not solve the complex problems confronting international financial markets.

It may stabilize the dollar in the short run but it is highly unlikely that the weak dollar trend, which has continued for the past six years on the grounds of U.S. twin deficits (of the balance of trade and budget), economic slowdown and low interest rates, would change directions.

Paradox of Credit Crisis

In a worst-case scenario, an interest rate hike to curb inflation would stunt economic growth and cause stagflation. In fact, the U.S. economy showed less than a mere 1 percent growth in the first quarter and U.S. troubled housing market, the root of the subprime crisis, is showing no sign of recovery.

Rising oil and commodity prices in advanced nations and even emerging countries are causing a jump in import prices, reducing purchasing power and dragging world economic growth down.

Subprime losses for global banks reached $386.2 billion as of May 2008; with U.S. financial institutions incurring $165.6 billion (with $147.7 billion of capital raised) and European financial institutions incurring $199.2 billion (with $125.5 billion of capital raised).

European banks have suffered considerably more losses but raised less capital to compensate for the losses. Adding to the problem, Morgan Stanley, Merrill Lynch and Lehman Brothers had their ratings lowered by Standard & Poor's on expectations the investment banks will be forced to write down the value of their assets.

Possibility of further losses related to subprime mortgages triggered worries over the deterioration of the credit market.

Overall, the value of money is falling on the international finance market and liquidity isn't supplied to where it is needed, thereby fueling inflation and worsening credit market conditions at the same time. This is the paradox that we are now facing.

More Time Needed

Currently there are two main problems threatening the international financial market; rising inflationary pressures and a credit crunch caused by the subprime crisis.

Both problems need considerable time to solve. It is true that speculation is a significant factor in the current spike in oil and commodity prices, but many believe the primary cause is an imbalance between supply and demand.

There is not enough to keep pace with the world's thirst for oil with emergence of countries like China and India, and insufficient facility investment is stagnating production.

Another reason to blame for is institutional investors like pension funds; increased participation of investment institutions in the oil and commodities markets during recent years is likely to continue for a while. This demand excessive structure upholds the view that commodity prices will not decline within a short period.

Furthermore to solve the credit crunch problem, U.S. housing prices, the root cause of subprime crisis, should stabilize and faith must be restored to banks. Major investment banks are now selling assets to offset subprime losses but they need to raise more capital in order to restore market confidence.

Therefore, it is difficult to expect the financial market and economy to recover in a short span of time.

Impact on Korean Financial Market

Considering the situation in the international market, there is the high possibility that financial instability will continue to linger for some time and the Korean financial market is no exception to the global woes.

Last year, whenever the crisis was heightened there was a massive sell-off of Korean stocks by foreign investors, reducing foreign investor holdings from 44 percent in year 2004 to 31 percent in June 2008. Foreign investors trying to avoid risk also led to a sell- off of the most liquid currency in the NDF market, the Korean won.

Current account deficit owing to a rise in import prices is also a reason for the weak currency but the situation is particularly acute in India and Korea among Asian countries.

Unlike the stock and FX market, foreign investors are buying massive Korean treasury bonds and monetary stabilization bonds since last year. However, foreign investment in the fixed income market is due to ``arbitrage opportunity" and not because they prefer Korean won assets.

Instead arbitrage trading is responsible for the rise of Korea's short-term foreign debt, which has become a big concern to the government.

Monitor Market Developments

Despite the gloomy market conditions, the subprime crisis seems to have slowed due to aggressive government measures, and investors are dimly grasping hold of the whole credit crunch picture.

IMF chairman Strauss Kahn recently warned that tight global credit conditions may go on and the impact on the broader economy will drag on until 2009, but also underscored that there are good reasons to believe the worst is behind us. Some market participants are hoping the U.S. economy will recover as soon as the second half of this year.

For now, it is unlikely that the international market will show a fast recovery and Korea will increasingly become further exposed to external shocks.

In times when external factors have greater impact on the economy, extreme optimism or pessimism is the least thing you need. Korea should be attentive to global market risks and continue to carefully monitor financial market developments.