34_Asia Special Report - Korea- Housing Recovery Set to Accelerate

Please see Appendix A-1 for analyst certifications, important disclosures and the status of non-US analysts.

25 March 2014

Principal authors Asia Economics

Young Sun Kwon - NIHK [email protected]

+852 2536 7430

Asia FX strategy

Craig Chan - NSL

[email protected]

+65 6433 6106

Asia rates strategy

Wee Khoon Chong - NSL

[email protected]

+65 6433 6547

Korea equity strategy Michael Na - NIFK

[email protected]

+82 2 3783 2334

Michael Na - NIFK [email protected]

+82 2 3783 2334

Korea: Housing recovery set to accelerate

Since housing inventory adjustments over the last four years are close to an end, we expect the nascent property market recovery to gain momentum in 2014-15.

This should raise both GDP growth (from 2.8% in 2013 to 4.0% in 2014) and CPI inflation (from 1.3% to 2.3%), while reducing the current account surplus (from 5.8% of GDP to 4.1%), paving the way for a 25bp policy rate hike to 2.75% in December 2014.

If the Jeonse system Koreas unique housing lease contract system is abolished in an orderly manner, it should lift Koreas potential GDP growth as a large amount of Jeonse deposits could be released for more productive investments.

FX strategy: A housing recovery and a robust current account surplus should keep KRW among the regional outperformers in 2014, amid broad-based USD strength. China-related concerns, possible FX intervention and a sharp JPY depreciation remain the key risks to our view.

Rates strategy: The recovery in growth and rising inflation favours a paying bias for KRW IRS in the 5yr area. Our view of a stable BOK for most the year is likely to keep the front end relatively anchored. We would suggest investors look to pay KRW 5yr IRS, position long inflation breakevens and range trade the 2y-5y part of the curve.

Equity strategy: The abolition of Jeonse should have a positive impact on Korean bank asset growth, but our top pick is Hyundai Development on the housing market recovery.

Global Markets Research

Asia Special Report

Nomura | Asia Special Report 25 March 2014

2

Contents

Executive summary 3

Economics: A looming housing recovery 4

The housing recovery is key to our bullish 2014 economic outlook 4

Housing market developments and outlook 4

Box 1: High household debt does not suggest a housing bubble in Korea 8

Housing markets and macroeconomy dynamics 9

Box 2: Housing wealth effects, household debt and asymmetric policy responses 10

Abolition of Jeonse could be a game changer to boost potential GDP 16

Eroding effectiveness of the Jeonse system 16

Box 3: Jeonse banking without banks in Korea 17

Government policy to reform Jeonse system 19

FX strategy: KRW outperformance in the region on improving macro fundamentals 21

Robust current account surplus and housing recovery support for KRW 21

Foreign portfolio flows to remain KRW supportive 21

Risks to KRW 22

Rates strategy: Pay bias on KRW IRS and position long breakeven inflation 24

Equity strategy: Abolition of Jeonse positive for banks; Buy Hyundai Development 25

Appendix 1: Korean government housing policies 27

Recent Asia Special Reports 28


3

Executive summary

Koreas house prices after a four-year slump associated with housing inventory

adjustments are at a turning point. We expect house prices to increase by 3.0% in

2014 and by a further 5.0% in 2015 following a 0.4% fall in 2013. This should be

supported by an improved export outlook, government policies to boost property

markets, increasing room for mortgage financing, improving housing affordability and

higher Jeonse (Koreas unique housing rental) prices.

As pent-up domestic demand should materialise, we expect the Korean economy to be

more balanced in 2014 than in 2013, with GDP growth improving (to 4.0% in 2014 from

2.8% in 2013), CPI inflation rising (to 2.3% from 1.3%) and the current account surplus

narrowing (to 4.1% from 5.8% of GDP).

As this suggests that equilibrium interest rates should rise, we expect the Bank of Korea

(BOK) to hike its policy rate by 25bp to 2.75% in December. We do not view this as a

tightening of policy, but rather a reduction of an accommodative policy stance, given that

2.75% is still below our estimated so-called neutral policy rate of 4.0%.

Also, during the rapid urbanisation and industrialisation of the 1960s-90s, the Jeonse

housing rental contract system played an important role in supporting Koreas economic

growth by channelling finances between savers (tenant/lenders) and investors

(landlord/entrepreneurs) without the use of banks.

However, the Jeonse system no longer supports economic growth. First, most landlords

of Jeonse are now no longer entrepreneurs who have access to investment projects with

high return. Second, a mismatch between demand and supply of Jeonse, when not used

for capital raising purposes for investment, has resulted in higher Jeonse prices. Third,

the economic efficiency of Jeonse (eliminating agency costs by excluding the banks) has

eroded as bank loans for Jeonse rose to KRW64trn (5% of GDP) in 2013.

An orderly abolition of Jeonse would likely increase Koreas potential GDP growth

because the inefficiently large security deposits (KTW430trn or 34% of GDP in 2012)

could be released for more productive investments or reduced debt. As a result, demand

for Jeonse would be converted into either house purchases (which should increase

construction investment) or monthly rental (which should reduce household leverage).

If the household debt-to-GDP ratio fell by 5 percentage points (pp) (i.e., loans for Jeonse

would be reduced to zero), we estimate the household net savings rate would increase

by 1pp permanently and potential GDP growth would rise by 0.2pp.

An orderly abolishment of Jeonse would have many other benefits: 1) It would increase

the supply of monthly rentals and lower the yield to somewhere between the bank

deposit rate and lending rate. This should eventually lower the financial burden on

tenants; 2) Financial intermediation on housing would increasingly be through banks,

which should boost jobs and service output in the banking sector; 3) It should limit

financial system risks, as the credit risks associated with Jeonse deposits would cease to

exist; and 4) It could increase tax revenues as the taxable income base (via monthly

rental markets) should expand.

FX strategy: A housing recovery and a robust current account surplus should keep KRW

among the regional outperformers in 2014, amid broad-based USD strength. China-

related concerns, possible FX intervention and a sharp JPY depreciation remain the key

risks to our view.

Rates strategy: A recovery in growth and rising inflation favours a paying bias for KRW

IRS in the 5yr area. A stable BOK for most the year is likely to keep the front end

relatively anchored. We suggest investors look to pay KRW 5yr IRS, position long

inflation breakevens and range trade the 2y-5y part of the curve.

Equity strategy: An abolition of Jeonse should have a positive impact on Korean banks

asset growth. However, given the structural issues with Korean banks (structurally lower

ROA and declining leverage), we believe upside potential from a housing market

recovery is unlikely to cause any significant improvements in Korean bank valuations.

Therefore, our top pick is Hyundai Development on the housing market recovery.


4

Asia Economics

Young Sun Kwon - NIHK [email protected] +852 2536 7430

Economics: A looming housing recovery

The housing recovery is key to our bullish 2014 economic outlook

Housing market developments and outlook

House prices are at a turning point

Since the 2008 global crisis, low interest rates and sizable fiscal stimulus have fuelled

property market booms in several Asian countries. If we overlay residential property

prices in the US (indexed to 100 in 2000) on residential property prices in Asian

countries or cities (indexed to 100 in 2008), it is striking that prices in many Asian

property markets are tracking above those during the US housing bubble (Figure1). The

notable exception is Korea, where house prices have gained only 11% from December

2008 levels, compared to Hong Kong (134%), India (104%), China (94%), Taiwan (85%),

Malaysia (68%) and Singapore (32%).

International experience suggests that changes in house prices have important

implications for the macroeconomy and stability of the financial system. This is because

housing has a pervasive impact on the economy: it is the most important form of savings

for many households; mortgage loans are often the primary business for banks; many

upstream industries are dependent on housing investment; changes in property prices

and rents influence CPI inflation; and property taxes are an important source of

government revenue. The relationship between the property market and the wider

economy is particularly important for Korea now as house prices after a four-year

slump are at a turning point.

Indeed, there are increasing signs that Korea's housing markets are turning around. The

Korea Appraisal Board's (KAB) real-time transaction-based apartment price index

which is a good indicator to gauge market sentiment gained 3.6% y-o-y in November

2013, exceeding its previous peak in 2011 (Figure 2).

Fig. 1: House prices in Asia and the US

Note: Wherever possible, official property price measures have been used. Data are either monthly or quarterly, while t=number of years from the start date (January 2000 for the US and December 2008 for Asia). Chinas index is the average of Shanghai, Beijing, Shenzhen, Guangzhou and Tianjin; Indias is the average of all major cities; Malaysia is for capital city Kuala Lumpur; the US index covers 898 counties. Source: CEIC, Centa Property, US CoreLogic and Nomura Global Economics.

Fig. 2: Koreas nation-wide apartment price indexes

Note: The Korea Appraisal Board (KAB) publishes two types of apartment price index. KAB house prices (purchase) is compiled under the Jevon index (unweighted), and KAB house prices (transaction) is compiled under the repeated sales-based weighted prices index. Kookmin Bank (KB) also publishes a house price index, which is compiled using a Laspeyres methodology. Source: KAB, KB, CEIC and Nomura Global Economics.

We expect house prices to rise further in 2014-15

We expect house prices (as measured by Kookim Banks nationwide housing purchase

index) to gain by 3.0% in 2014 and further 5.0% in 2015 after a 0.4% fall in 2013.

Given that Korean house prices have moved largely in line with GDP growth (i.e., along

with other parts of the economy, they can be affected by common shocks such as

external demand), we expect improved GDP to support house prices (Figure 3). Despite

80

100

120

140

160

180

200

220

240

t t+1 t+2 t+3 t+4 t+5 t+6 t+7

IndexChina, Dec-08 HK, Dec-08

India, Dec-08 Malaysia, Dec-08

Singapore, Dec-08 US, Jan-00

Taiwan, Dec-08 Korea, Dec-08

100

105

110

115

120

125

130

135

140

145

Jan-06 Jan-08 Jan-10 Jan-12 Jan-14

KAB house prices (purchase)

KAB house prices (transaction)

KB house prices (purchase)

2006=100

Lehman crisis


5

the recent weaker macro data from China, we believe global growth will continue to

recover gradually. Koreas high-value added exports to advanced economies should

therefore improve, more than offsetting weaker low-value added exports to China and

other emerging economies (Figure 4 and see Korea: Impact from a China slowdown and

Ukraine-Russia developments, 17 March 2014).

Fig. 3: Koreas GDP growth and house prices

Source: CEIC and Nomura Global Economics.

Fig. 4: Koreas GDP growth and exports


Domestically, the governments comprehensive measures to support the property

markets have started to pay off. Throughout 2013, the government cut acquisition tax

rates by 1 percentage point (pp) permanently, introduced revenue or profit-sharing type

mortgage loans and reduced annual public housing supply from 200,000 to 140,000 until

2017 (see Appendix 1: Korean governments housing policies).

As a result, the total number of unsold houses, which had surged to 165,641 in March

2009, has been reduced to 58,576 in January 2014 lower than the historical average of

73,000. In particular, the number of bad housing inventory (unsold houses that have

already completed) fell from the peak of 54,141 in May 2009 to 20,566 in January 2014

lower than the historical average of 22,000 (Figure 5). Improved household confidence

resulted in higher housing transaction volume growth, although there was payback in the

latest data from a strong rebound over the last 12 months (Figure 6).

Fig. 5: Koreas unsold houses and house prices


Fig. 6: Koreas housing transaction and confidence index

Source: KAB and Nomura Global Economics.

Also, we see room for banks to increase mortgage financing. The growth rate of

residential mortgage loans bottomed out in mid-2013 (Figure 7). Koreas household debt-

to-GDP ratio rose to 86.3% in 2013, but importantly the rate of increase has slowed

-15

-10

-5

0

5

10

15

20

25

Mar-88 Mar-93 Mar-98 Mar-03 Mar-08 Mar-13

GDP

House prices

% y-o-y

Asian crisis Global crisis

-20

-10

0

10

20

30

40

-10

-5

0

5

10

15

20


GDP, lhs

exports, rhs

% y-o-y % y-o-y


-5

0

5

10

15

20

0

20

40

60

80

100

120

140

160

180

Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-14

Unsold houses, lhs

Unsold houses (completed), lhs

House prices, rhs

Thousand % y-o-y

100

105

110

115

120

125

130

135

140

-60

-40

-20

0

20

40

60

80

Dec-07 Dec-09 Dec-11 Dec-13

Housing transaction volume

Housing confidence index

% y-o-y, 6mma DI=100


6

markedly. This can be gleaned from the "credit gap" the deviation of the ratio of

household debt to GDP from a slow-moving long-term trend which, on a five-year

rolling rate of change, has declined from 16.2pp in 2009 to 7.6pp in 2013. As the

government plans to cut the household debt to disposable income ratio by 5pp by 2017,

banks can be expected to increase mortgages more than other loans to households

(Figure 8; see Box 1: High household debt does not suggest a housing bubble in Korea).

Fig. 7: Koreas residential mortgage loans


Fig. 8: Koreas household debt-to-GDP ratio


Another positive sign is improving housing affordability. The KABs Home Affordability

Index (HAI = median income/necessary income for mortgage payment x 100) rose to

191 in Q3 2013 from 158 in Q1 2012. As this historical series is only available from 2012,

we calculate our own more timely measure of home affordability the average home

price to household income ratio using housing finance survey data from 2009-13 and

construct historical back data from 1988 to 2008. Our measure of housing affordability

continues to steadily decline, from 17.1 in 1988 to a record low 4.5 in 2013, which is now

relatively low in a global comparison (Figures 9 and 10, and again, Box 1).

Fig. 9: Home price-to-income ratio in Korea, Taiwan, the US

Note: We construct back data for household income and home prices from 1988 to 2008 using an income and house price index. Source: Housing Finance Survey, CEIC and Nomura Global Economics estimates.

Fig. 10: Home price-to-income ratio across countries

Note: Korea is Nomura estimate. All household income and home prices are median values, except Japan (average value). Source: Demographia and Nomura Global Economics.

In addition to improved affordability, higher Jeonse (Koreas unique two-year lump sum

security deposit for housing rental) prices will likely force some tenants who feel that the

credit risks of Jeonse are too large, to decide instead to buy their first-time homes (for

details about the Jeonse system, see the next section in this report Abolition of Jeonse

could be a game changer to boost potential GDP).

-5

0

5

10

15

20

25

Dec-03 Dec-05 Dec-07 Dec-09 Dec-11 Dec-13

Banks

Non-banks financial institutions

Nominal GDP

% y-o-y

-5

0

5

10

15

20

25

0

10

20

30

40

50

60

70

80

90

100

1983 1988 1993 1998 2003 2008 2013

Household debt to GDP ratio, lhs

5 year changes of the ratio, rhs

% of GDP %p

0

5

10

15

20

1988 1993 1998 2003 2008 2013

Korea

US

Taiwan

(multiple)

3.5

3.7

4.0

4.5

4.5

4.7

5.1

6.3

8.0

8.5

14.9

0 3 6 9 12 15

US

Ireland

Japan

Korea

Canada

UK

Singapore

Australia

NZ

Taiwan

Hong Kong

(multiple)


7

Since the 2008 crisis, Jeonse prices have been rising much faster than house purchase

prices for two reasons. First, there were wide-spread expectations for house prices to

fall, which delayed house purchases and instead increased demand for Jeonse. Second,

lower interest rates were also attributable as landlords tried to offset a smaller amount of

interest earned on bank deposits by raising Jeonse prices.

As a result, the Jeonse price-to-house purchase price ratio rose to 67.7% in February

2014 close to the historical high of 69.5% in October 2001 (Figure 11). The Bank of

Korea (BOK) estimated the Jeonse loan-to-value (LTV) ratio (Jeonse owners' mortgage

plus Jeonse security deposit) at 75.7% in June 2013, which was higher than the owners

LTV (48.4%) (Figure12).

That said, tenants would lose part of their security deposits if the premises were

auctioned off at lower than 75% of house values when landlords cannot pay back

mortgage loans and tenants do not have the senior lien on the premises (Figure 12).

Even if tenants come before other creditors, a prolonged auction process would likely

mean sizable opportunity costs to the tenants.

Fig. 11: Koreas apartment Jeonse and purchase prices


Fig. 12: Koreas LTV ratios

Source: Bank of Korea and Nomura Global Economics.

0

20

40

60

80

-10

0

10

20

30

Jan-00 Jan-04 Jan-08 Jan-12

Apartment purchase prices, lhs

Apartment Jeonse prices, lhs

Jeonse-to-purchase value ratio, rhs

% y-o-y %

48.4 49.9 49.4

75.7

49.9

58.7

0

20

40

60

80

Jeonse Owner Total

LTV

Adjusted LTV

%


8

Box 1: High household debt does not suggest a housing bubble in Korea

Koreas household debt is at a record high relative to disposable income (157% in 2012; latest data available), putting it among the highest in Asia. In the Organization for Economic Co-operation and Development (OECD),

only five countries out of 18 (Denmark 302%, Netherlands 281%, Ireland 226%, Norway 201% and Sweden

168% in 2011) had higher household debt-to-income ratios (Figure 13).

This is worrisome to some observers, given that many countries with high household indebtedness have

experienced house price bubbles. They argue that Koreas high household-debt-to-income ratio suggests that house prices are either too high relative to income, or indeed already in a bubble.

However, the OECDs house price valuation measures suggest that Koreas house prices in 2012 were actually undervalued relative to long-term averages (Figure 14). If the price-to-rent ratio (a measure of the profitability of

owning a house) and the price-to-income ratio (a measure of affordability) are above their long-term averages,

house prices are said to be over-valued, and vice versa. As of Q4 2012, Koreas price-to-rent ratio was 6% higher than its long-term averages, but the price-to-income ratio was 38% lower (which is in line with the falling

home price-to-income ratio shown in Figure 9). The average of the two ratios in Korea was 16% lower than its

long-term averages. This is stark contrast to the UK, for example, where the household debt-to-income ratio is

almost the same as in Korea but house prices are said to be over-valued by about 27%.

In our Asia Special Report South Korea household debt: Myths and reality (8 September 2009), we argued that

official statistics overstated the true level of household debt and understated the true level of household income.

Koreas self-employed accounted for 23% of total employment in 2012, higher than the OECD average (13% in 2010). These households running their own small business were thus more likely to be leveraged than those

households in which members are employed by others. Many small business owners use their own houses as

collateral and, by definition, bank loans to self-employed businesses are recorded as household, not corporate loans, although much of this borrowing is for business-related, not housing, purposes. Furthermore, many self-employed under-report or withhold their business income, mainly as there is little or no third-party

cross-checking.

In Korea, mortgages make up a relatively small component of overall household debt. Korea boasts relatively

tight prudential regulation of mortgages, reflected in its low average loan-to-value (LTV) ratio of 49% (or 59% if

we include Jeonse-associated double leverage) well below the 80% global average. Mortgage securitization, a key facilitator of mortgage borrowing, has not really taken off in Korea. The share of securitized housing loans

in total personal debt is very low just 4% compared with over 50% in the US. This is mainly because Korean banks (which account for 70% of mortgages, compared with 37% in the US) prefer to hold credit on their

balance sheets to increase their asset base. Institutional investor demand for mortgaged-backed securities has

also been weak, due to difficulties in pricing given the lack of a reliable system of credit risk evaluation.

All in all, in contrast to other countries with high household debt, Korea has not recently experienced the usual

symptoms of a house price bubble such as a private consumption boom or a large current account deficit.

Fig. 13: Household debt across the OECD

Source: OECD and Nomura Global Economics.

Fig. 14: House prices across the OECD

Note: Figures are average of two indicators (price-to-rent and price-to-income ratio) in 2012, percentage to the long-term averages from 1980 Source: OECD and Nomura Global Economics.

- 100 200 300

Czech

Italy

Germany

Austria

Greece

France

Finland

US

Japan

Spain

Portugal

UK

Korea

Sweden

Norway

Ireland

Netherlan

Denmark

% of disposable income

-40

-30

-20

-10

0

10

20

30

40

50

No

rwa

y

Fra

nc

e

Sw

ed

en

UK

Fin

lan

d

Ne

the

rla

nd

s

Sp

ain

De

nm

ark

Ita

ly

Au

str

ia

Gre

ec

e

US

Cze

ch

Po

rtu

ga

l

Ire

lan

d

Ko

rea

Ge

rma

ny

Ja

pa

n

Over-valuation

Under-valuation

% over- or under-valuation relative to long-term averages


9

Housing markets and macroeconomy dynamics

Pent-up demand for consumption to materialize

There is a positive long-term relationship between house prices and private consumption

due to the associated wealth effects (Figure 15). In the short term, however, the

relationship may not be so clear. For example, Korean house prices gained strongly in

2011, but retail sales growth slowed and real estate service activity declined (Figure 16).

The household debt overhang was certainly a factor (see Box 2: Housing wealth effects,

household debt and asymmetric policy responses), but we believe that weaker

consumption in 2011 was also largely attributable to concerns at the time over the

European debt crisis and the US fiscal cliff.

Fig. 15: Korea's house prices and private consumption


Fig. 16: Koreas house prices and consumption data


Despite disposable income increasing by 11% in 2010-12, consumption growth was flat

(Figure 17). The 2013 housing finance survey data reconcile the discrepancy, showing

that Korean households increased net savings by 38% in 2010-12. Flow of fund data

also show that the net financial surplus of households rose to 7.7% of GDP in Q3 2013,

close to the previous peak (9.1%) in Q3 2009, due to the increase in net savings (Figure

18).

Although we remain cautious on structural consumption due to an ageing population and

the household debt overhang, we believe pent-up demand for consumption will likely

materialise in 2014-15, supported by the government measures to increase social

welfare spending and boost the property market. Lagged spill-over income flows from

exporters should also help further support domestic demand.

Fig. 17: Korea household finance survey data

Source: Korea Housing Finance Survey and Nomura Global Economics.

Fig. 18: Koreas net financial surplus


-15

-10

-5

0

5

10

15

20

25


Private consumption

House prices

% y-o-y % y-o-y


-30

-20

-10

0

10

20

30


KAB house prices (transaction)

Retail sales volume

Real estate service activity

% y-o-y

0

5

10

15

20

25

30

35

40

Disposable income Consumption Net savings

2010 2011 2012KRWmn

+11%

+38%

0%

-8

-6

-4

-2

0

2

4

6

8

10

Mar-04 Mar-07 Mar-10 Mar-13

Government Public corporates

Private corporates Households

Rest of the world

% of GDP


10

Box 2: Housing wealth effects, household debt and asymmetric policy responses

Household balance sheets on a macro and micro level

The Korean household sector, at both the individual or aggregated level, holds a larger share of its wealth in the

form of real assets (e.g., houses). On a macro level, Statistics Korea estimated the household sectors net asset value (total assets less depreciation) at KRW3,472trn (273% of GDP) in 2012. The BOK estimated the household

sectors total financial assets and liabilities at KRW2,550trn (200% of GDP) and KRW1,182trn (93%), respectively, in 2012. Combined, we estimate net real assets accounted for 58% of the total household wealth (Figure 19).

Meanwhile, housing survey data show that real assets accounted for 73% of total assets in 2013 for the

average household. Depreciation may explain the different share of real assets in total wealth between the

aggregated macro level (58%) and micro survey data (73%). Compared to other OECD countries, Korean

households have a relatively higher share of wealth as non-financial assets, and a relative lower share of

financial assets compared to liabilities (Figure 20). From a distribution perspective, 61% of Korean households

(65% of US households) owned homes in 2010, while only 25% of Korean households (50% of US households)

held stocks, including stocks held indirectly through mutual funds.

Koreas lower share of financial assets to non-financial assets or financial liabilities can be explained by societys age structure and pension system. Financial wealth is hump-shaped over the life-cycle, peaking after retirement. If an economy is already aged like Japan, its households have a higher share of financial wealth

than recently ageing economies like Korea. Also, Koreas national pension system started only in 1988, much later than other OECD countries.

The role of household debt in the wealth effect

The wealth effects from housing may be smaller than those felt from the equity market, because when home

prices rise by more than incomes, renters must reduce their consumption of non-housing goods to offset the

higher cost of housing for a given amount of income and debt. Also, if homeowners are unwilling to downsize

their housing stock (due to a capital gains tax burden), they cannot fully realize those same capital gains for

consumption purposes.

Wealth effects are typically viewed from the asset side, but debt also matters. Debt does not exert an

independent influence on consumption as it represents a way to finance spending. Debt-constrained homeowners

can also increase their spending when home prices increase and can monetize the equity in their homes.

However, a high level of debt-to-income could limit these wealth effects. For example, if house prices rise due to

a positive economic shock, positive wealth effects would be limited because highly-leverage households may be

concerned about higher future housing costs (e.g., property tax, higher rent prices or debt-servicing costs due to

higher interest rates). If house prices fall due to a negative economic shock, highly leveraged households are

likely to cut their consumption to pay down debt as high debt ratios prevent them from obtaining additional credit

they need to finance their desired spending.

All in all, because the household sector is still highly leveraged in Korea, there are asymmetric wealth effects

associated with it. This implies that policymakers should be more concerned about house price falls, than gains.

Fig. 19: Household assets and liabilities, OECD

Note: Net real assets are estimated by National Statistics, and financial assets/liabilities are estimated by the Bank of Korea. Source: Statistics Korea, Bank of Korea and Nomura Global Economics estimates.

Fig. 20: Household assets and liabilities, OECD

Note: Figures are based on housing survey. Korea is for 2013 and other countries are for 2011. Source: OECD and Nomura Global Economics.

200 93

273 380

0

50

100

150

200

250

300

350

400

450

500

Assets Liabilities

% of GDP

Financial assets

Net real assets

Financial liabilities

Assets less liabilities

(58% of total assets)

(42% of total assets) 2.0

2.5

3.0

3.5

4.0

4.5

20 30 40 50 60 70 80

(Financial assets/liabilities, multiple)

(Non-financial assets/total assets, %)

Korea

US

Japan Italy

Germany

France

Canada

UK


11

Building investment is rebounding

Koreas residential building investment, which fell in the three years 2010-12, started to

rebound in late 2013 (Figure 21). As higher house prices are boosting residential building

orders, we expect housing construction to increase further in 2014 (Figure 22).

Besides residential buildings, we also expect to see non-residential (e.g., hotels) and

other type of construction investment (e.g., nuclear power plants) to continue to increase

in 2014. For example, five nuclear reactors are presently under construction, with

construction to on another two in September.

Fig. 21: Koreas construction investment (nominal)


Fig. 22: Koreas house prices and construction orders

Source: KAB and Nomura Global Economics.

The economy is up and running

Since the credit card crisis in 2003, Koreas GDP growth generally moved in line with

global GDP growth. But 2012 was an exceptional year in that Koreas GDP growth

(2.0%) was much lower than the global average (3.1%), because domestic demand was

extremely weak due to housing market adjustments and negative sentiment from the

European debt crisis and fears of the US fiscal cliff.

Now, we expect pent-up demand for private consumption and construction investment to

materialize through 2014-15, supported by the housing market recovery. As a result, we

expect domestic demands contribution to GDP growth to catch up with exports (Figure

23). We also expect GDP growth to rise from 2.8% in 2013 to 4.0% in 2014 and 2015,

exceeding the global average (3.4% in 2014 and 3.7% in 2015; Figure 24).

Korea, as a small open economy, is naturally vulnerable to global economic and financial

market conditions. A key risk to the global economy remains the global financial system,

which is not yet comfortably stable and where a number of challenges remain. A hasty

unwinding of prolonged quantitative easing in advanced economies could put the global

(particularly EM) economy in a difficult spot, while over-use of ultra-low interest rates

may well create adverse side effects, such as excessive risk-taking, high leverage and

asset bubbles. Another risk is a hard landing for Chinas economy, which could have

contagion across EM and result in a synchronized global growth downturn. While

acknowledging these risks, our base case is that growth in the advanced economies will

pick up in H2 and that China experiences a long landing (i.e. a multi-year gradual

growth slowdown) as opposed to a hard landing, in which case we see upside risks to

our already above-consensus 4% GDP growth forecast for Korea, influenced also by a

weaker KRW which should help underpin exports (see Asia Special Report: Alive in the

bitter sea, 5 February 2013).

0

20

40

60

80

100

1983 1993 2003 2013

Residential building

Non-residential building

Others

KRWtrn (4 quarter rolling sum)

-80

-60

-40

-20

0

20

40

60

80

100

-10

0

10

20

30


KAB house prices (transaction), lhs

Housing constuction orders, rhs

% y-o-y % y-o-y


12

Fig. 23: Contributions to Koreas GDP growth

Source: CEIC and Nomura Global Economics estimates.

Fig. 24: Global and Korea GDP growth

Source: IMF, CEIC and Nomura Global Economics estimates.

We see a steeper CPI inflation projection from a low base

Koreas CPI inflation fell to 1.0% y-o-y in February much lower than the BOKs 2.5-

3.5% target largely due to cost-side disinflationary factors (e.g., lower prices for

agricultural and energy products, and free schooling) that we judge to be temporary.

We expect a steeper CPI inflation projection from here, forecasting 2.3% for full-year

2014 and 3.3% in 2015 (Figure 25). Strong job creation, rising unit labour costs and

higher housing rents are all indicative of inflationary pressures. The government is set to

hike public service and utility prices to help manage public debt, and we expect growth

rates of agricultural and energy prices to mean-revert (see Korea: We expect a steeper

inflation projection, 4 March 2014).

Housing rents account for 9.3% of the CPI basket in Korea, which is much lower than in

the US (31.7%), Hong Kong (29.1%), Japan (18.6%) and Taiwan (18.2%). This is

because Korea does not include owners equivalent rent (OER) the implicit rent that

owner-occupants would have to pay if there were renting their homes in the CPI. If

OER was included in the CPI basket, we estimate adjusted CPI inflation in 2013 would

be 0.3pp higher than the actual 1.3% (Figure 26).

Fig. 25: Koreas housing rent and CPI inflation


Fig. 26: Koreas CPI including owners equivalent rent

Source: Statistics Korea and Nomura Global Economics.

-4

-2

0

2

4

6

8

10

12

2000 2002 2004 2006 2008 2010 2012 2014

Domestic final demand

Exports (goods & services)

Percentage point y-o-y

F

-8

-6

-4

-2

0

2

4

6

8

10

12

1985 1990 1995 2000 2005 2010 2015

South Korea

Global

% y-o-y

F

Credit card crisis in

2003

-10

-5

0

5

10

15

20

25

-1

0

1

2

3

4

5

6

7

Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-14

Headline CPI inflaton, lhs

Housing rent in CPI, lhs

House rent(Jeonse) price, rhs

% y-o-y % y-o-y

F

1.3

1.6

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

2005 2006 2007 2008 2009 2010 2011 2012 2013

CPI inflation

CPI inflation, including OER% y-o-y


13

The current account surplus should narrow

Theoretically, increased demand for housing reduces the current account balance.

Housing must be locally produced; if households preference for housing increases

strongly, countries import tradable goods during periods when more domestic labour is

devoted to producing housing (non-tradable goods) to smooth consumption between

tradables and non-tradables.

Empirically, there is a negative correlation between changes in house prices and the

current account as a percentage of GDP. The correlation was -0.55 in the G7 countries

in 2001-07. Several Asian countries also showed a negative correlation in 2000-13: -0.97

in India, -0.59 in Malaysia, -0.52 in Indonesia and -0.58 in Korea (Figure 27).

Mainly due to pent-up demand for private consumption and construction investments, we

expect the current account surplus to narrow from a record USD71bn (5.8% of GDP) in

2013 to USD55bn (4.1%) in 2014 (Figure 28). Indeed, reflecting improved domestic

demand, capital and consumer goods imports gained 12.6% y-o-y and 12.1%,

respectively, in February. As a result, the trade account surplus narrowed to USD1.7bn

in January and February combined, 25% smaller than the USD2.3bn recorded in the

same period last year.

Fig. 27: Koreas house prices and current account

Note: Figures are annual data from 2000 to 2013. Source: CEIC and Nomura Global Economics.

Fig. 28: Koreas balance of payments


We expect the BOK to start to reduce its accommodative stance in December 2014

While we expect domestic demand to improve, we also believe domestic credit risks will

remain manageable. The delinquency ratio for mortgage loans fell to 0.6% in January,

from a post-2008 high of 1.0% in February 2013 (Figure 29). The delinquency ratio of

bank loans to small and medium-sized enterprises (SMEs) fell to 1.2% in January, close

to the post-Asian crisis historical low of 1.0% in December 2007.

We expect the Korean economy to be more balanced in 2014 than in 2013, with GDP

growth improving (to 4.0% from 2.8% in 2013), CPI inflation rising (to 2.3% from 1.3%)

and the current account surplus narrowing (to 4.1% from 5.8% of GDP). This suggests

that equilibrium interest rates should rise, and we therefore expect the BOK to hike its

policy rate by 25bp to 2.75% in December (Figure 30). Rather than a tightening of policy

we view this as a reduction of an accommodative policy stance, given that 2.75% is still

below our estimated so-called neutral policy rate of 4.0% a rate that neither

stimulates or restraints economic growth when the output gap is zero and inflation is

anchored at target.

y = -0.1767x + 3.4619R = 0.3414

0

1

2

3

4

5

6

-5 0 5 10 15 20House prices, % y-o-y

Current account, % of GDP

-8

-4

0

4

8

12

-80

-60

-40

-20

0

20

40

60

80

1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Net capital flows, lhs

Current account, lhs

BOP % of GDP, rhs

USDbn %

F


14

Fig. 29: Koreas bank loan delinquency ratio


Fig. 30: Koreas macro variables and BOK policy rate

Note: Current account is percentage of GDP and BOK policy rate is end-period. Source: Nomura Global Economics estimates.

Risks to our call for a 25bp rate hike in December 2014

Although not our base, should global growth slow sharply, reducing Korean GDP growth,

we would expect the BOK to cut policy rates. Historically, the BOK has tended to cut

rates when GDP growth (sa, q-o-q) slows sharply (Figure 31).

Fig. 31: Koreas GDP growth and BOK policy rate changes


Fig. 32: Policy rates: Global, DM, EM and Korea


We believe the BOK takes the global monetary policy stance into account in assessing

its own stance. BOK policy rates have moved in a 10~80bp range below global rates

since 2008 (Figure 32). Given that policy rates in developed markets should remain near

rock-bottom (at 0.31% in 2014, on Nomuras estimates), any move in emerging market

policy rates are likely to pull up the level of global rates with them. Nomuras Global

Economics team expects higher EM policy rates at 6.63% in 2014, from 6.23% in 2013,

due to inflation risks. Although not our base case, should EM inflation slow sharply, we

believe this would provide the BOK with room to cut rates.

On the other hand, we judge that political risks for a rate cut have abated for three

reasons. First, President Park Geun Hye has nominated Mr. Lee Ju-Yeol to become the

next BOK governor after Governor Kim Choongsoos four-year term ends on 31 March

(Figure 33). Mr Lee is a former BOK senior deputy governor and MPC member, with 35

years of monetary policy experience, suggesting to us that President Park appreciates

0

2

4

6

8

10

12

0.0

0.5

1.0

1.5

2.0

2.5

3.0

Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-14

SMEs, lhs

Mortgage on residential property, lhs

Credit card over 1 month, rhs

% %

4.0

2.3

4.1

2.75

GDP growth

CPI inflation

Current account

BOK policy rate

2013

2014 F

-250

-200

-150

-100

-50

0

50

100

150

200

-5

-4

-3

-2

-1

0

1

2

3

4

BOK policy rate changes, rhs

GDP (seasonally adjusted), lhs

% q-o-q bp

F

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

2008 2009 2010 2011 2012 2013 2014 2015

Global

Developed markets

Emerging markets

Korea

%

F


15

central bank independence (see Korea: We expect BOK policy continuity from new

governor, 3 March 2014).

Second, President Park is focused on boosting potential GDP growth, not just short-term

growth, as she recognises rightly, in our view that structural reforms are key to

creating investment opportunities and jobs. This reduces the risk of political pressure on

the BOK to cut rates because a prolonged period of monetary easing is likely to reduce

the private sectors desire for structural reform (see Korea: Deregulation is key economic

agenda, 21 March 2014).

Last, if the BOK cuts rates only because of political considerations, this could erode the

governments efforts to increase fixed-rate mortgages as people are likely to prefer

floating-rate mortgages. Also, lower interest rates may encourage landlords to increase

Jeonse security deposits to offset a smaller amount of interest earned on deposits.

Fig. 33: Nomuras BOK doves/hawks chart

Note: Date in [ ] is each MPC members expired term. Mr. Lee Ju-Yeol will replace Mr. Kim Choongsoo on 1 April 2014.

Source: BOK and Nomura Global Economics.

Balancing the external and domestic political factors, overall we believe the biggest risk

is that the timing of the first rate hike happens earlier than our forecast of December

2014. Higher US yields due to an FOMC that is less dovish than earlier perceived

should increase capital outflows from emerging economies (including Korea) and

increase depreciation pressures on KRW (see Korea: We now see a risk of earlier BOK

rate hike, 20 March 2014). If Koreas GDP growth improves faster than our 4.0% forecast

due to a weaker KRW (on hawkish FOMC and better US demand) and Korean

government deregulation, we would expect the BOK to deliver a 25bp rate hike in

September 2014, one quarter before our base-line call.

Voted against rate cuts in May 2013

Doves Hawks

Kim , Choongsoo

[31 March 2014]

(Governor)

Lim, Seoungtae

[14 April 2014]

Chung, Hae-Bang

[20 April 2016]

Ha, Sung Keun

[20 April 2016]

Chung, Soon Won

[20 April 2016]

Moon, Woosik

[20 April 2016]

Park, Won Shik

[7 April 2015]

(Senior Deputy Governor)

Voted against rate cuts in July and October 2012

Voted against rates on hold in January-April 2013

Voted against rates on hold in April 2013

Voted against rates on hold in April 2013


16

Abolition of Jeonse could be a game changer to boost potential GDP

Eroding effectiveness of the Jeonse system

Jeonse supported Koreas rapid economic growth in the 1960s-90s

During the rapid urbanization and industrialization of the 1960s-90s, the Jeonse housing

rental contract system played an important role in supporting economic growth by

channelling finance between savers (tenant/lenders) and investors

(landlord/entrepreneurs) without using the banks (see Box 3: Jeonse banking without

banks in Korea).

Kim and Shin (2011) argue that the landlords of Jeonse were typically small business

owners who had access to investment projects with high returns during the rapid

industrialization period of the 1960s-90s1. Jeonse played an important role in providing

housing finance because mortgage financing had not yet developed given that the

government at the time had long directed banks to concentrate their credit extension on

corporate loans (especially large Chaebol), instead of consumer loans. As lenders loans

(i.e., Jeonse security deposits) were secured by living in the collateral asset (dwelling),

the Jeonse system lowered the cost of capital and increased credit.

As Koreas rapid economic growth in the 1960s-90s resulted in fast-growing house

prices, home owners preferred to lease their house though Jeonse rather than selling, to

enjoy large future capital gains. In the absence of housing finance at least until the late

1990s, those who did not have enough to pay full house prices resorted to Jeonse, which

cost about 40-60% of house prices.

but it is no longer supportive of economic growth

We estimate the total amount of Jeonse security deposits in 2012 at KRW430trn (34% of

GDP) and total financial institution loans for Jeonse at KRW64trn (4.8%) in 2013

(Figures 34 and 35).

Since the 2008 global crisis, the ratios of loans for Jeonse and Jeonse security deposits-

to-GDP have not been positively associated with economic growth, suggesting that there

could be credit allocation problems in the Jeonse system. For example, the BOK (2011)

estimated that a 1% increase in real Jeonse prices would reduce real private

consumption by 0.4pp2. This is because higher Jeonse reduces the purchasing power of

the tenants, whose marginal propensity to consume is higher than that of landlords.

Fig. 34: Jeonse security deposits

Note: We estimate total Jeonse deposit by multiplying average Jeonse (including quasi-Jeonse) deposit with total number of Jeonse households. Source: Nomura Global Economics estimates.

Fig. 35: Loans for Jeonse and GDP growth

Note: 2013 is Nomuras forecast. Source: Bank of Korea and Nomura Global Economics estimates.

1) Se-Jik Kim and Hyun Song Shin (2011), Financing Growth without Banks: Korean Housing Repo Contract

2) The Bank of Korea (2011), Impact of Jeonse on consumption (in Korean), Monthly Bulletin

0

100

200

300

400

500

0

10

20

30

40

50

60

70

1985 1990 1995 2000 2005 2010 2012

Jeonse security deposits, rhs

Jeonse security deposits to GDP, lhs

% of GDP KRWtrn

0

1

2

3

4

5

6

7

0

10

20

30

40

50

60

70

2009 2010 2011 2012 2013

Loans for Jeonse, lhs

Loans for Jeonse to GDP, rhs

Real GDP growth, rhs

KRWtrn %


17

Box 3: Jeonse banking without banks in Korea3

The Jeonse system was already in operation over 100 years ago. It was first mentioned in a Social Customs

Report in 1910: "Jeonse is the most popular housing rental contract in Chosun (the last dynasty of Korean

history)".

From a finance point of view, the Jeonse contract is essentially a repurchase agreement in which the landlord

borrows money from the tenant, using the house as collateral. The landlord grants the tenant the right of

occupation without monthly rental. At the termination date, the tenant returns the house and the landlord repays

the exact amount of the security deposit, without interest. In the interim period, no cash payments are made by

both parties.

The share of Jeonse to all dwellings rose to a high of 30% in 1995, in line with rapid industrialization and

urbanization in the 1960-90s when there were fewer houses than the number of households. The incidence of

the Jeonse has waned in recent years, but still accounted for 22% of all dwellings in 2010 (Figure 36). Very

recently, much of the Jeonse contract has been changed to quasi-Jeonse (where the tenant pays 30-70% of the

full Jeonse deposit at the contracting date and a substantially reduced amount of monthly rent). As of 2010,

quasi-Jenson accounted for 18% of all dwellings and pure monthly rent (without security deposit) accounted for

only 2% of the total. Interestingly, 22% of Jeonse tenants own houses elsewhere.

Jeonse played an important role to providing housing finance before mortgage financing was developed in

Korea (mortgages were only introduced in 2004). Prior to the Asian crisis in 1997, Koreas spectacular growth performance was part of what had been described as the East Asian Miracle. Until late 1990s, the government effectively controlled the banking sector, allocating scarce financial resources to the export-oriented heavy and

chemical industries (dominated by the chaebol, family owned business conglomerates). As a result, bank loans

to households had been lower than those to corporates until the early 2000s (Figure 37).

Jeonse is de facto banking without banks. By sitting on the collateral, the creditors (tenant) cost of managing the collateral is minimized, and by cutting out the middle man (the bank), agency costs are eliminated. As the

two implicit cash flows (interest payment and rent) are designed to net out, the hold-up problems associated

with delinquent tenants who are late on their rent is also eliminated. That said, the landlord does not need to

collect monthly rent from the tenant, nor the tenant collect interest from the landlord.

The legal underpinnings governing Jeonse have been developed, with many-layered legal safeguards for the

smooth working of the contract, since the National Assembly established the Housing Lease Protection Act in 1981. For example, if a landlord declares bankruptcy, the tenant has the senior lien on the house and comes

before other creditors. Also, the term of housing lease is deemed to be two years. In return, the landlords legal claim to the house at the end of the contract is protected.

Fig. 36: Korea's urbanization, ownership and Jeonse ratios

Note: Jeonse ratio means the percentage of Jeoonse to all dwellings. Source: Statistics Korea, CIEC and Nomura Global Economics.

Fig. 37: Koreas bank loans-to-GDP ratio and savings rate


3) Most of this box is drawn from Se-Jin Kim and Hyun Song Shin (2011), Financing Growth without Banks:

Korean Housing Repo Contract

16

18

20

22

24

26

28

30

32

30

40

50

60

70

80

90

100

110

1970 1975 1980 1985 1990 1995 2000 2005 2010

Urbanization ratio, lhs

Home ownership ratio, lhs

Number of houses/number of households, lhsJeonse ratio, rhs

% %

0

5

10

15

20

25

30

0

10

20

30

40

50

60

70

1970 1976 1982 1988 1994 2000 2006 2012

Bank loans to corporates, lhs

Bank loans to households, lhs

Household net saving rate, rhs

% of GDP %


18

We see several structural factors why the Jeonse system no longer supports economic

growth in Korea.

First, most landlords of Jeonse are now no longer entrepreneurs who have access to

investment projects with high return. In the past, Jeonse security deposits were used to

build additional houses, or increase business investment (i.e. capital stock) where the

ratio of number of houses to households was below 100%. However, the ratio exceeded

100% in 2008, meaning that any additional increase in Jeonse deposits did not increase

the capital stock by as much as in the 1960s-90s.

Indeed, most landlords now want to increase Jeonse deposits, not for new investments

but to offset the smaller amount of interest earned on bank deposits. The BOK (2013)

estimated that the total return on Jeonse (assuming that the landlord borrows a

mortgage at 60% LTV) turned negative in H2 2012 (Figure 38).4

Second, a mismatch between demand and supply of Jeonse, when not used for capital

raising purposes for investment, has resulted in higher Jeonse prices. The cost of

Jeonse is cheaper for tenants than monthly rental, suggesting that demand for Jeonse

will rise. From the landlords perspective, however, the return on Jeonse is lower than a

monthly rental yield, suggesting that supply for Jeonse will fall. The yield gap between

monthly rentals and Jeonse has been narrowing, but still remains large (Figure 39).

This is because the supply of Jeonse (or the number of available Jeonse contracts) is

inelastic to Jeonse prices because if the Jeonse-to-purchase value ratio breaches a

certain threshold (70%), those houses would not be suitable for Jeonse due to credit

risks. The transition from Jeonse to monthly rental has faced many frictions (e.g.,

different tax treatments, information mismatch and deep-rooted habits). As a result,

quasi-Jeonse (where a tenant pays 30-70% of the full Jeonse deposit at the contracting

date and a substantially reduced amount of monthly rent) has recently increased.

Third, the economic efficiency of Jeonse (eliminating agency costs by excluding the

banks) has eroded as bank loans for Jeonse rose to KRW64trn (4.8% of GDP) in 2013.

With the development of the financial system, many of the imperfections that made the

Jeonse advantageous have been eroded. Also, the total amount of Jeonse security

deposits (KRW430trn, or 34% of GDP in 2012) is unnecessarily large to ensure

counterparty risks. For example, the Jeonse deposit is equivalent to more than 10 years

monthly rent, compared to a more standard on or two months in many countries. The

government recently announced measures to solve this structural problem.

Fig. 38: Total return on Jeonse

Note: Total return on Jeonse = Changes in owned house prices + Interests earned from Jeonse deposits - interest payments on mortgages. It assumes that landlords borrow mortgage at 60% of house value. Tax and other transaction costs are excluded. Source: Bank of Korea estimates.

Fig. 39: Return on Jeonse and monthly rental

Note: Return on Jeonse = Interests earned from Jeonse deposits - interest payments on mortgages. It assumes that landlords borrow mortgage at 60% of house value. Tax and other transaction costs are excluded. Source: Bank of Korea estimates.

4) The Bank of Korea (2013), Financial Stability Report.

-5

0

5

10

15

20

25

30

Jan-05 Jan-07 Jan-09 Jan-11 Jan-13

%

0

1

2

3

4

5

6

Jun-10 Jun-11 Jun-12 Jun-13

Monthly rental

Jeonse

Bank deposit rates (2 years)

Bank lending rate for mortgage

%


19

Government policy to reform Jeonse system

Goal is to increase home ownership and reduce Jeonse

On 26 February 2014, the government announced housing lease-related measures to: 1)

increase public monthly rental housing; 2) provide tax benefits on monthly rental

payments; 3) increase financial support for first-time homebuyers; and 4) decrease the

public guarantee for Jeonse (see Appendix 1: Korean governments housing policies). As

of 2010, monthly rentals (including quasi-Jeonse) accounted for 21.4% of all dwellings

(Figure 40).

On 27 February, the government also announced household debt-related measures to

increase the share of fixed interest rate or amortization-type mortgages to 40% of total

mortgages by 2017 (Figure 41). For this, the government plans to develop Mortgage

Backed Securities (MBS) markets by adding MBS to the eligible securities for BOK open

market operations. The government will also increase tax benefits on fixed interest rate,

long-term, amortization-type mortgages.

Fig. 40: Types of dwellings in Korea

Source: Statistics Korea and Nomura Global Economics.

Fig. 41: Korean banks mortgage lending structure

Note: 2017 is the governments target. Source: Korean government and Nomura Global Economics.

Orderly abolition of Jeonse could boost potential GDP growth

We see government policy as moving in the right direction. As the Jeonse system has

been the dominant rental contract in Korea for the last six decades, it is not easy to

abolish the system via market forces. Nonetheless, an orderly abolition of Jeonse would

increase Koreas potential GDP growth because inefficiently large security deposits

could be released for more productive investments, or to reduce debt. As a result,

demand for Jeonse would be converted into either house purchases (which should

increase construction investment) or monthly rentals (which should reduce household

leverage). If the household debt-to-GDP ratio fell by 5pp (i.e., loans for Jeonse would be

reduced to zero), we would estimate the household net savings rate could increase by

1pp permanently and boost potential GDP growth by 0.2pp (Figure 42).

It may not be feasible in the near future, but if the National Assembly amends the

Housing Lease Protection Act by limiting the amount of security deposits to two months

rent (a global standard), the Jeonse system would effectively be abolished by the law5.

An orderly abolishment of Jeonse would have many benefits:

It would increase the supply of monthly rentals and lower the yield to somewhere

between the bank deposit rate and lending rate. This could eventually reduce the

financial burden on tenants.

Financial intermediation on housing would increasingly be through banks, which should

boost jobs and service output in the banking sector. Koreas financial sector output to

GDP ratio was 6.0% in 2012, lower than most other advanced economies (Figure 43)

5) The Housing Lease Protection Act was amended in 1989 to set the minimum lease contract at two years.

49.9 53.3 54.2 55.6 54.2

27.8 29.7 28.2 22.4 21.7

19.1 14.5 14.8 19.0 21.4

0

20

40

60

80

100

1990 1995 2000 2005 2010

Others Monthly rental Jeonse Owner-occupied

% of total

16

19

7

40 40

15

0

5

10

15

20

25

30

35

40

45

Fixed interest rates Amortized Fixed Interest rates and amortized

2013

2017

% of total mortgage


20

It should limit financial system risks as the credit risks associated with Jeonse deposits

would cease to exist.

It could increase tax revenues as the taxable income base (via monthly rental markets)

should be broadened if under-reported monthly rental incomes are reported and taxed

properly.

Fig. 42: Koreas household savings rate and GDP growth

Note: From 1975 to 2012, excluding 1997 and 2008 recession. Source: CEIC and Nomura Global Economics.

Fig. 43: Financial sector output to GDP across countries


Fig. 44: Korea's economic outlook

% y-o-y growth unless otherwise stated 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14 2013 2014 2015

Real GDP (sa, % q-o-q, annualized) 3.3 4.5 4.2 3.7 3.6 4.4 4.0 3.6

Real GDP (sa, % q-o-q) 0.8 1.1 1.1 0.9 0.9 1.1 1.0 0.9

Real GDP 1.5 2.3 3.3 3.9 4.1 4.0 4.0 4.0 2.8 4.0 4.0

Private consumption 1.5 1.8 2.2 2.2 3.4 3.4 2.9 2.8 1.9 3.1 3.2

Government consumption 1.3 3.8 3.1 3.6 3.5 2.1 3.0 4.1 3.2 3.2 3.4

Business investment -11.9 -4.6 1.8 9.9 8.3 9.6 10.7 5.1 -1.8 8.4 4.6

Construction investment 2.4 7.2 8.0 8.1 3.8 1.3 -0.9 4.1 6.1 2.0 4.1

Exports (goods & services) 3.4 5.7 2.9 5.5 3.5 3.6 6.6 6.7 4.4 5.1 6.7

Imports (goods & services) 1.8 4.7 2.9 5.2 3.7 4.6 6.8 6.7 3.3 5.4 6.8

Contributions to GDP growth (% points)

Domestic final sales 0.1 2.0 3.1 3.7 3.9 3.6 2.8 2.6 2.2 3.6 3.4

Inventories 0.3 -0.7 0.0 -0.5 -0.1 0.1 0.2 0.6 -0.2 0.1 0.0

Net trade (goods & services) 1.0 1.0 0.3 0.7 0.5 0.3 0.9 0.7 0.9 0.4 0.6

Unemployment rate (sa, %) 3.2 3.2 3.2 3.0 2.9 2.9 3.0 2.9 3.1 2.9 3.0

Consumer prices 1.6 1.2 1.4 1.1 1.2 2.2 2.7 3.2 1.3 2.3 3.3

Current account balance (% of GDP) 5.8 4.1 2.8

Fiscal balance (% of GDP) 0.0 1.0 0.5

Fiscal balance ex-social security (% of GDP) -1.8 -1.8 -0.5

BOK official base rate (%) 2.75 2.50 2.50 2.50 2.50 2.50 2.50 2.75 2.50 2.75 3.25

3-year T-bond yield (%) 2.55 2.88 2.82 2.86 2.90 3.00 3.00 3.10 2.86 3.10 3.40

5-year T-bond yield (%) 2.58 3.14 3.05 3.23 3.20 3.30 3.35 3.40 3.23 3.40 3.55

10-year T-bond yield (%) 2.91 3.31 3.53 3.60 3.60 3.75 3.80 3.90 3.60 3.90 4.00

Exchange rate (KRW/USD) 1,111 1,142 1,076 1,055 1070 1075 1080 1085 1,055 1,085 1,100

Notes: Numbers in bold are actual values; others forecast. Interest rate and currency forecasts are end of period; other measures are period average. All forecasts are modal forecasts (i.e., the single most likely outcome). Table reflects data as of 24 March 2014. Source: Bank of Korea, CEIC and Nomura Global Economics.

y = 0.2685x + 4.0974R = 0.375

0

2

4

6

8

10

12

14

16

0 5 10 15 20 25 30

Real GDP growth, %

Household net savings rate, %

0

2

4

6

8

10

12

14

16

18

20

1963 1973 1983 1993 2003 2013

Japan

Korea

Taiwan

Hong Kong

Singapore

USA

% of GDP


21

Asia FX Strategy

Craig Chan - NSL [email protected] +65 6433 6106

Prateek Gupta - NSL [email protected] +65 6433 6197

Wee Choon Teo - NSL [email protected] +65 6433 6107

FX strategy: KRW outperformance in the region on improving macro fundamentals

We expect KRW to be among the regional outperformers in 2014 amid broad-based

USD strength. Our view is supported by an expected recovery in domestic demand and

strong exports resulting in higher economic growth. The growth recovery is also likely to

prop up foreign equity inflows, while structural demand for local government bonds from

central banks and sovereign wealth funds should cushion any negative impact of rising

US yields on bond-related flows. The risks to our view stem from China growth and/or

credit related concerns, BOK FX intervention and sharp JPY depreciation. Overall, we

continue to expect limited KRW weakness versus USD and forecast USD/KRW at 1,085

by year-end.

Robust current account surplus and housing recovery support for KRW

As discussed earlier, we expect Koreas GDP growth to pick up in 2014 to 4.0% from

2.8% in 2013, supported by the housing sector recovery and exports. The expected

recovery in the housing sector is likely to put some pressure on the current account

surplus through higher import demand, with some early signs of this already in the

February trade data. February capital and consumer goods imports rose 12.6% y-o-y

and 12.1% y-o-y respectively. That said, we still expect a robust USD55bn (4.1% of

GDP) current account surplus in 2014, led by a recovery in exports (Figure 45). We

expect this to be supported by rising demand from the US and euro area, which should

offset relatively weak demand from China and other emerging markets (Figure 46).

Fig. 45: Current account to be supported by exports growth

Source: CEIC and Nomura. Note: Based on BoP data.

Fig. 46: Exports contribution to GDP growth


Foreign portfolio flows to remain KRW supportive

With the recovery in both the global and local economy, foreign portfolio inflows are likely

to be another source of support for KRW. In particular, we expect foreign equity inflows

to pick up in line with the global recovery (Figure 47). Indeed, our equity strategists

continue to hold an Overweight recommendation on Korea (see Asia ex-Japan: The

Matrix, 26 February 2014). We expect positive sentiment surrounding the local economy

and housing recovery, plus growing confidence in a developed market-led global trade

recovery, to support equity inflows this year after relatively lacklustre USD4.9bn of net

equity inflows in 2013.

-2

0

2

4

6

8

10

45

48

51

54

57

60

63

Mar-12 Jun-12 Sep-12Dec-12Mar-13 Jun-13 Sep-13Dec-13

C/A ($bn, RHS) Exports ($bn)

Imports ($bn) Exports (trend)

Imports (trend)

-4

-2

0

2

4

6

8

10

12

2000 2002 2004 2006 2008 2010 2012 2014

Domestic final demand

Exports (goods & services)

Percentage point y-o-y

F


22

Fig. 47: Foreign equity inflows vs global manufacturing PMI

Source: Bloomberg and Nomura.

Fig. 48: Korea topped 2013 bond inflows, USD bn

Source: Bloomberg, CEIC and Nomura.

Although there is some risk to bond outflows as the global recovery and rise in US

Treasury yields continue, we believe that this is unlikely to have a significant negative

impact on overall net portfolio inflows into Korea. In recent years, Korean government

bonds have benefitted from structural demand from the global central banks and

sovereign wealth funds (CBs/SWFs) because of stable macro fundamentals, relatively

attractive yields and an investment grade sovereign credit rating. Indeed, Korea was the

only Asian economy (Figure 48) that attracted net bond inflows of USD4.6bn in 2013,

despite a backdrop of rising global yields. In addition, demand from CBs/SWFs seems to

have continued against the backdrop of rising global yields. Based on our discussions

with local authorities, we believe CBs/SWFs accounted for about 40% of foreign bond

holdings as of end-2013. This suggests that more than 50% (USD2.4bn) of the inflows

came on the back of foreign official demand (Figure 49).

Fig. 49: Structural demand from foreign CBs/SWFs persists

Note: Based on monthly net investments by foreign investors in local listed bonds. Source: CEIC, FSS and Nomura.

Risks to KRW

There are a few risks that we see to our baseline view of KRW outperformance in the

region, including the slowdown in China, BoK and/or MoF FX intervention, and JPY

depreciation. Nomuras projection of USD/JPY rising to 112 by end-2014 (see FX

Insights - Forecast Update, 13 March 2014) is unlikely to have a similar negative impact

on KRW as that seen in early 2013 given the view of gradual JPY depreciation (Figure

50). We also expect any official FX intervention to be an exercise in leaning on rather

than trying to stem outright KRW appreciation. However, given the continued narrowing

of KRW undervaluation (Figure 51), we believe that USD buying FX intervention will

remain intact over the medium-term (Figure 52).

The biggest risk to KRW is likely to be from a China economic hard landing and negative

credit events. Trade with China accounted for 29.0% (as of February 2014) of Koreas

-5

-4

-3

-2

-1

0

1

2

3

4

30

35

40

45

50

55

60

65

Jan-07 Feb-08 Mar-09 Apr-10 May-11 Jun-12 Jul-13

Global manufacturing PMI

Korea: Foreign equity flows, 12m rolling avg ($bn, rhs)

$bn KR MY ID IN TH Total

Jan-13 0.6 1.1 0.2 0.6 2.7 5.2

Feb-13 3.2 -4.6 1.0 0.8 0.9 1.3

Mar-13 1.4 1.9 -0.2 0.9 1.8 5.7

Apr-13 2.0 5.0 1.8 1.3 1.0 11.0

May-13 1.3 1.6 0.2 0.5 -2.0 1.6

Jun-13 2.3 -6.6 -2.4 -5.4 -2.6 -14.6

Jul-13 1.5 -5.2 -0.7 -2.1 0.4 -6.1

Aug-13 -1.9 -2.5 -1.8 -1.4 -3.3 -11.0

Sep-13 -2.2 5.3 -0.7 -1.3 2.1 3.2

Oct-13 -2.3 4.0 3.0 -2.1 0.8 3.4

Nov-13 -0.9 -1.7 -1.2 -0.8 -2.2 -6.9

Dec-13 -0.3 -0.7 -0.5 0.9 -0.9 -1.6

Total 4.6 -2.4 -1.4 -8.0 -1.4 -8.6

Asia - Foreign bond flows

14.4 14.6 6.4 6.6 4.63.1 7.2 11.8 6.1 2.411.4 7.4

-5.4

0.4 2.2

12.3%

20.5%

34.1%

38.7% 40.0%

-10%

0%

10%

20%

30%

40%

50%

-5

0

5

10

15

20

2009 2010 2011 2012 2013

Net Foreign bond investments - Total (USD bn, lhs)by CBs/SWFsby Private SectorCBs/SWFs holding % of Total Foreign Holding (%, rhs)


23

total trade over the previous 12-months, which is the largest in the region. We also note

that there is a risk to the Korean equity market from a China slowdown given the revenue

exposure to China of Koreas top 10 companies by market cap (at 10.7% of total revenue

in 2012). However, there is a near-term risk of China providing stimulus to its economy,

which could further boost Koreas near-term growth/equity prospects.

Fig. 50: Risk from sharp JPY weakening


Fig. 51: Narrowing KRW undervaluation

Note: KRW has appreciated about 0.4% against its NEER basket since end-January. See Asia Insights - Opportunities from shifting FX valuations, 14 February 2014. Source: Bloomberg, CEIC and Nomura.

Fig. 52: Korea FX intervention, including FX forwards

Source: Bloomberg, CEIC and Nomura.

-40%

-20%

0%

20%

Nov-12 Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14

USD/KRW and USD/JPY 120d rolling correlation

76

84

92

100

108

1040

1080

1120

1160

Nov-12 Feb-13 May-13 Aug-13 Nov-13 Feb-14

USD/KRW

USD/JPY (rhs)

REER valuation PPP valuation

Apr-13 Jan-14 (Apr-13

to Jan-14)

(Apr-13 to

Jan-14)

(Apr-13 to

Jan-14)

INR 26.6% 13.5% -13.0% -9.7% -10.7%

IDR 5.3% -7.2% -12.5% -15.9% -18.0%

PHP -4.8% -14.7% -9.8% -9.6% -8.0%

THB 3.7% -5.6% -9.3% -13.0% -13.1%

MYR -0.1% -4.5% -4.4% -6.2% -7.8%

TWD -29.0% -29.8% -0.8% 0.0% -2.1%

CNY -3.2% -3.0% 0.2% 1.4% 4.1%

SGD -18.5% -18.2% 0.3% 0.5% -1.8%

KRW -4.7% -2.5% 2.2% 3.4% 2.4%

HKD 3.9% 6.4% 2.4% 3.7% 1.9%

Filtered FEER valuation

-25

-20

-15

-10

-5

0

5

10

15

20

25

Jan-08 Oct-08 Jul-09 Apr-10 Jan-11 Oct-11 Jul-12 Apr-13 Jan-14

Latest 3 months intervention (ex-Fwds)Dec-13: USD0.7bn

Jan-14: USD3.0bnFeb-14: USD0.8bn

Korea monthly intervention (including forwards), $bn


24

Asia Rates Strategy

Wee Khoon Chong - NSL [email protected] +65 6433 6547

Rates strategy: Pay bias on KRW IRS and position long breakeven inflation Given the backdrop of an anticipated strong domestic recovery in South Korea and rising

inflationary pressure (see earlier sections), we believe higher KRW rates are likely. This

in turn would exert relative widening pressure on KRW rates against USD rates and

some rates in parts of EM Asia, especially against Thailand and China the laggard

countries with weak growth outlooks and /or poor or deteriorating fundamentals (see

Asia Economic Monthly Variety is the spice of life, 6 March 2014).

The nomination of Mr Lee Ju-Yeol as the new BOK governor considered to be a

relatively neutral candidate (see First Insights - Korea: We expect BOK policy continuity

from new governor, 3 March 2104) has removed residual market expectations for a

rate cut to counter a relatively strong KRW. This was reflected in the 5bp lift across the

KRW IRS curve after the announcement. This gives us more conviction on our view to

maintain a pay bias in Korea rates (see Asia Insights - Korea: Maintain a paying bias, 24

February 2014).

Given our view that the BOK will keep rates unchanged at 2.50% through November

before hiking by 25bp to 2.75% in December, the overall tightening of liquidity in the

region is likely to overshadow any short-term carry and roll down tactical trades. In other

words, we do not expect to see a repeat of the Q1 2010-Q2 2011 period in which a QE-

related search for yield kept 5yr KRW IRS relatively depressed amid higher inflation in a

rate hiking environment (Figure 53).

On the curve, we believe KRW 2-5yr IRS is likely to drift within a broad 20-40bp trading

range, led by the belly of the curve with a well anchored front end. In other words, a

steep curve is likely to attract receiving interest in the belly for yield, while a flat curve is

unlikely to be sustainable given rising inflation outlook, resulting into a range bound KRW

2-5yr IRS profile.

A more interesting trade, in our view, would be to go long breakeven inflation (BEI)

spreads. Inflation breakeven spreads in Korea has risen from multi-year lows for the 3, 5

and 10yr segments. We believe there is ample room for breakeven widening if our

projected rising inflation rate materialises (Figure 54).

As for the longer end, the 15yr part of the curve has recently underperformed due to a

reduction in structured product flows. This has caused 10s15s20s KRW IRS to move

from a -10/-12bp range since mid-August 2013 to early January, to +5/-5bp last week.

We expect demand for duration by insurers and lifers to return in coming months,

eventually pushing 15yr KRW IRS back to its lows.

Fig. 53: Outright KRW IRS to rise with higher inflation

KRW IRS no longer enjoys the QE-related receiving seen in 2010-11.

Source: CEIC, Bloomberg and Nomura Economics.

Fig. 54: Korean breakeven inflation at lows

We expect breakeven inflation to rise in the coming months.


0

1

2

3

4

5

6

Feb08 Feb09 Feb10 Feb11 Feb12 Feb13 Feb14

%

CPI KRW 5yr IRS

BoK forecast

50

100

150

200

250

300

Mar12 Sep12 Mar13 Sep13 Mar14

bp

KTBi2017 KTBi2020

KTBi2021 KTBi2023

Breakeven inflation


25

Korea Strategy

Michael Na - NFIK [email protected] +82 2 3783 2334

Equity strategy: Abolition of Jeonse positive for banks; Buy Hyundai Development It seems that the government is getting ready for the structural migration from the Jeonse

system to a monthly rent system, in our view, with the government already saying that,

as of April 2014, it will no longer provide guarantees on Jeonse loans on Jeonse

deposits exceeding KRW300m. The government also announced that it plans to levy tax

on Jeonse deposits starting in 2016, according to Maeil Economics (6 March). Already

there have been more landlords converting Jeonse properties into monthly rental

properties in recent years, largely because they no longer expect meaningful capital

gains from their property investment, while the Jeonse to monthly rent conversion ratio

remains very attractive at around 6%. In addition, the government is making monthly rent

more attractive by providing tax credits (although this is still subject to parliamentary

approval) in the amount of 10% of rent paid, up to KRW750,000 (roughly US$710), to

renters living in monthly rent properties, starting with the 2014 tax return,. We believe

that the move by the government could accelerate the change.

If we assume that households living in Jeonse properties eventually either buy a home or

move into monthly rental properties, this would 1) further increase home prices as home-

buying demand increases; 2) monthly rental prices could fall as supply increases; and 3)

result in an increase in bank deposits and loans.

Home prices have been rising in Seoul and the metropolitan area in recent months.

Obviously, if Jeonse renters are forced into buying a home, then home prices should rise

further from the increase in home-buying demand. Statistically, based on Kookmin Bank

research, it takes roughly 10 years for married couples to buy their first house after living

in a Jeonse property. On this basis, we expect home-buying demand to increase from

2014 through 2018 given the number of marriages increased from 2004 through 2008. If

Jeonse properties become scarce, then we believe that already rising home-buying

demand could see further upside.

Fig. 55: Yearly number of married couples in Korea (10Y forwarded)

Source: Korea Statistical Information Service and Nomura.

Landlords have been effectively borrowing money using the Jeonse system and forgoing

monthly rent in lieu of interest payments. The market has been focused on the high level

of Korean household debt, but we also note that Korean household financial assets

actually amount to 215% of household debt, partly buoyed by Jeonse deposits. Koreans

who does not own a home have long been putting their savings into Jeonse deposits. If

we assume that 50% of renters who live in Jeonse properties move into monthly rental

properties, and the other 50% buy homes, then theoretically 50% of Jeonse deposits

could flow into the banking system and then lent out as mortgage. Based on Nomura

Economics estimates, Jeonse security deposits total about KRW430trn (34% of GDP). If

50% of this is turned into bank deposits and lent out immediately, then we would see a

23% increase in bank loans (excluding policy banks).

-10

-8

-6

-4

-2

0

2

4

6

8

10

250

270

290

310

330

350

370

390

20

09

2010

2011

2012

20

13

20

14

2015

2016

2017

20

18

20

19

2020

2021

2022

20

23

(%)(1,000 couples) Yearly number of married couples (10Y forwarded)

Chg (YoY)


26

Fig. 56: Korea banks: Total loans vs. total deposits (2001-2012)

Source: Financial Statistics Information System and Nomura.

We also note that the structural migration to a monthly rental system is already in

progress. In 1995, the proportion of households living in monthly rental properties was

11.9%, rising to 20.1% as of year-end 2012. During the same period, the Jeonse

proportion decreased by 8 percentage points (pp) and the self-owned proportion

increased by 1pp. As landlords continue to convert Jeonse properties to monthly rental

properties, we believe that homeownership will increase given that the mortgage rate is

currently lower than the monthly rental yield.

We think that Jeonse is a cheaper substitute than owning a home from a utility

perspective, only given that one would enjoy the same utility at roughly 65% of the

purchase price using Jeonse. Hence, without any expectation for capital gains one would

always chose to live in a Jeonse property instead of buying a home. If the Jeonse

system is completely abolished, then a renter may be forced into buying a home until

monthly rental property supply increases enough to drive the rental yield down below the

mortgage rate.

Fig. 57: Korea housing: Jeonse-to-price ratio by size

Source: Budongsan 114 and Nomura.

As we expect the recovery in the housing market to continue, we like Hyundai

Development (012630KS, Buy). Also, a pick-up in mortgage lending should have a

positive impact on banking system asset growth. However, given the structural issues

with Korean banks (structurally lower ROA and declining leverage, see Korea banks:

One for opportunistic investors, 19 February 2014), we believe upside potential from a

housing market recovery is unlikely to cause any significant improvements in Korean

banks valuations, in our view.

300

400

500

600

700

800

900

1,000

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

LoanDeposits

(KRWtn)

70.272.1

35

40

45

50

55

60

65

70

75

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

Total Small Medium Large(%)


27

Appendix 1: Korean government housing policies

Source: Korean government and Nomura.

August 28, 2014Category Policy Details Commencement date Current status (as of 10 Dec)

Promote sw itch from

Jeonse to purchases

Low er acquisition tax 1% for house priced below KRW600mn, 2% for KRW600-900mn, 3% for

KRW900mn+. Abolish discriminate taxation on multi-home ow ners.

(low ered from 2% for house below KRW900, 4% for KRW900mn+)

August 2013 Bill passed (10 Dec). New tax applied

retroactively for purchases since 28

Aug. Discriminate taxation related bill

still pending.

Expa

Date post:	15-Oct-2015
Category:	Documents
Upload:	girishrajs
View:	65 times
Download:	0 times

34_Asia Special Report - Korea- Housing Recovery Set to Accelerate

Documents