Korea’s stars tell of an economy saddled with a real neutral rate (r-star) that has declined significantly in recent decades and is currently below zero. This reflects a significant decline in trend growth, and two large financial crises that triggered significant shifts in the saving-investment balance. Larger fiscal deficits and frothy financial conditions since 2012 have helped offset rising demand for safer assets, preventing the neutral rate from falling further. Nonetheless, the fall in the neutral rate, coupled with its effects on asset returns, has complicated the task of monetary policy stabilization. Korea’s neutral rate is likely to remain low over the medium-term and could fall further, reflecting a structural savings-investment imbalance owing to declining productivity and a rotation in demographics increasing the demand for precautionary saving and convenience yield, and widening the capital risk premia. The COVID pandemic risks magnifying these trends.
Mr. Gee Hee Hong, Anne Oeking, Mr. Kenneth H Kang, and Changyong Rhee
Asian countries have high demand for U.S. dollars and are sensitive to U.S. dollar funding costs. An important, but often overlooked, component of these costs is the basis spread in the cross-currency swap market that emerges when there are deviations from covered interest parity (CIP). CIP deviations mean that investors need to pay a premium to borrow U.S. dollars or other currencies on a hedged basis via cross-currency swap markets. These deviations can be explained by regulatory changes since the global financial crisis, which have limited arbitrage opportunities and country-specific factors that contribute to a mismatch in the demand and supply of U.S. dollars. We find that an increase in the basis spread tightens financial conditions in net debtor countries, while easing financial conditions in net creditor countries. The main reason is that net debtor countries are, in general, unable to substitute smoothly to other domestic funding channels. Policies that promote reliable alternative funding sources, such as long-term corporate bond market or stable long-term investors, including a “hedging counterpart of last resort,” can help stabilize financial intermediation when U.S. dollar funding markets come under stress.