[INTERVIEW] Geopolitical risk burdens S. Korea's credit profile: Moody's

This article is the second in a three-part series of interviews with chief economists covering the Korean economy for the Big Three credit rating agencies to analyze the state of Asia's fourth-largest economy amid rising interest rates and high inflation. _ ED.

Top credit rating agency asks Seoul to specify 'well-defined path toward peace settlement' with Pyongyang

By Kim Yoo-chul

As Washington and Seoul are preparing for expanded summertime joint military drills, Pyongyang is ratcheting up tensions by claiming that the two allies could face "undesirable consequences" if they don't stop their "military confrontation."

In a recent media briefing, White House National Security Council (NSC) spokesperson John Kirby told reporters that Washington has been very clear that North Korea could be ready to conduct a nuclear test. "I won't speculate about the timing here, or what that can look like. We are obviously going to watch this very, very closely for any possibility of a nuclear test," Kirby said.

It was in September 2017, at its Punggye-ri test site, that North Korea last conducted a nuclear test, which was by far its largest to date.

Investors' primary focus is how conflicts between Seoul and Pyongyang will affect the South Korean financial markets and credit profile.

So far this year, Pyongyang has conducted 31 missile tests, including one that it insists was its first intercontinental ballistic missile (ICBM) launch since 2017. While it is less likely that North Korea will escalate a series of major provocative tests into a full-scale war, a senior credit officer at Moody's Investors Service warned about the geopolitical risk remaining significant for the country's credit profile.

Moody's Investors Service Vice President Anushka Shah

"Notwithstanding strong credit fundamentals, South Korea's credit profile remains constrained by its exposure to event risk, driven by the low-probability ― but high-impact ― risk of a military confrontation with North Korea. We have for long highlighted a heightening of geopolitical risks to be a key trigger for rating action," Moody's Vice President Anushka Shah said in a recent interview.

Thoughts are that because earlier military provocations by the North have only had a short-lived effect on the market, with investors concerned more about the deepening conflict between China and the United States, the effects of North Korea's seventh nuclear test will be detrimental but not massive.

Simply put, the presence of a nuclear North Korea just across the border has been viewed as another risk, albeit one that's less of a peril than it used to be.

But investor sentiment remains fragile, because of rising inflation, renewed supply chain disruptions, surging commodity prices and weakening fiscal strength both in developed and emerging economies. When downside pressure outweighs upside potential, investors react more sensitively to even simple factors.

While it's fair to say that the decades-long tension between the two Koreas has not materially impacted the South's economy, the functioning of its government or its finances or the country's payments, Shah said an escalation of tensions would elevate the risk of a military conflict.

"And it could threaten South Korea's economic growth or its strong fiscal position. Since the start of this year, North Korea has carried out a spate of missile tests. Weapons testing indicates that recurring tensions will remain a distinctive feature of our geopolitical risk assessment in the absence of a well-defined path toward a permanent peace settlement," Shah said.

South Korean President Yoon Suk-yeol, right, listens to a policy briefing by Unification Minister Kwon Young-se at the presidential office in Seoul, July 22. AP-Yonhap

Moody's maintains a "stable" rating for South Korea ― Aa2 ― because the country is underpinned by strong policy effectiveness and a highly diverse and competitive economy. The New York-based credit rating agency stated that a material and irreversible reduction in geopolitical risk ― in particular, a lowering of the threat of warfare on the peninsula ― is one of the key factors that could drive a sovereign rating upgrade.

Downward pressure outweighs upside potential

Unsurprisingly, Shah expects the Bank of Korea (BOK), the country's central bank, to keep its benchmark rate higher regardless of how much economic growth weakens. It's been widely expected that the BOK will increase the benchmark rate to up to 3 percent this year. A lot of policymakers say the bank will then review the possibility of cutting the rate amid slowing economic growth in China and a high level of household debt.

"We expect central banks to keep interest rates higher regardless of how much growth weakens, and that swiftly tightening credit conditions will help curtail demand enough to reduce any demand-side pressure on inflation. This will be the case for South Korea as well. As a result, we forecast that global monetary and financial conditions will be quite tight by the end of this year and in 2023 and that inflation rates will moderate," Moody's vice president said.

Shah went on to say that the impact of China's economic slowdown was mainly affecting supply chains.

"While disruptions can hurt trade and investment, producers ― particularly in the electronics supply chain ― can also fill the gap created by China, which may benefit," according to the executive, adding that Moody's expects the Chinese economy will record 4.5 percent real GDP growth by this year, followed by 5.3 percent in 2023.

Continued aggressive rate hikes are making it costly and difficult for leading Korean businesses to get financing at a time when it is already tough, which would in turn cut business enthusiasm for active employment. Shah said because advanced and emerging markets' central banks are raising interest rates and draining liquidity, aggregate spending should fall in the coming quarters due primarily to higher borrowing costs for household purchases and increased costs for companies.

"Slower growth will also reduce labor demand and prevent excessive real wage growth pressures," according to the agency's senior credit officer.

Currency traders watch monitors at the foreign exchange dealing room of KEB Hana Bank headquarters in Seoul, July 21. AP-Yonhap

Regarding the rating agency's thoughts on South Korea's inflation, which marked a 13-year high recently, and what it would look like throughout next year, the vice president said, "Our forecasts incorporate the year-end consumer price index (CPI) easing from current levels as monetary tightening takes effect, although average annual inflation may be higher given the increase in prices over the first half of this year."

Referring to a series of government-initiated measures such as an expansion of fuel tax cuts and Seoul's efforts to keep prices of metals and foods under control, the executive said some of these measures will have a "fiscal impact." She didn't elaborate further.

Moody's said it would observe higher-frequency data, including export growth, consumption and investment trends to gauge the evolving impact of these factors on the South Korean economy.

"Still, we generally expect global growth to slow, dragging down the South Korean economy as well. Global credit conditions have deteriorated and will tighten for the rest of the year amid rising borrowing costs, a potentially protracted military conflict between Russia and Ukraine and materially slower global growth. As such, downside pressure outweighs upside potential."