Selected Issues

Abstract

Selected Issues

Are Financial Conditions at Risk?

Tightening global financial conditions coupled with a slowing domestic economy and rising household leverage potential poses significant risks to the Korean economy. This chapter looks at the forecasting of risks to financial conditions based on current domestic and global macro and financial conditions. Financial conditions are expected to remain neutral in 2019, while tail risk financial condition outcomes in Korea have remain contained over the past year.

A. Introduction

1. External financial risks remain due to vulnerabilities, including rising corporate debt, house price misalignments and sovereign-banking sector links in some EU countries, domestically rising financial risks arise from higher household and corporate leverage. This chapter examines current domestic and global macro and financial conditions and links them to a distribution of possible financial condition outcomes in Korea. An important advantage of this approach is that it allows an assessment as to whether slower domestic growth/higher household leverage and/or a tightening in global financial conditions is net financial-critical and puts financial stability at risk in Korea.

B. Construction of Financial Conditions in Korea

2. To capture aggregate financial conditions a dynamic factor model is estimated.

[y1,ty2,t....y16,t]=[1λ1,tλ2,t...λ16,t][ytft1]+ξt(1)

3. The model contains 16 variables, including bank and NBFC credit, bond spread, equity prices, broad and narrow money, credit developments based on BOK Loan Officer Survey, and measures of leverage including corporate bond issuance and household and corporate debt. This framework purges changes in the real cycle from financial conditions by including CPI inflation and a measure of economic activity, based on a mixed frequency coincident indicator containing real GDP (quarterly) and industrial production, a services index and retail sales (all monthly). The model also controls for financial conditions driven by changes in monetary policy by including a measure of reserve money.

4. The model assumes that the weights of each variable in the factor i,t) can vary over time according to the following AR specification

λi,t=λi,t1+ϑt(2)

5. This assumption helps account for structural breaks and non-linearities in the dynamics between the financial variables. Time-varying loadings can be thought of as an approach to network connectedness measurement.

Figure 1.
Figure 1.

Korea: Financial Conditions Index

Citation: IMF Staff Country Reports 2019, 133; 10.5089/9781498314824.002.A002

Source:Authorities’ data and IMF staff calculations.Note: The financial conditions index is constructed using credit growth from deposit money banks and non‐bank financial corporates, house prices, the equity price, the spread between corporate and government debt at a 3 year horizon, household and corporate debt. The index is estimated using a factor model that allows for time‐varying factor loadings.

C. Estimation Tail-Risks to Financial Conditions in Korea

6. The idea follows work done on growth risks in Tobias, Boyarchenko, and Giannone (2016), The estimation here, however, focuses on Korean financial conditions. The forecast of the distribution of financial conditions is constructed using quantile projections:

FCt=ap,qhPt+βa,qhAggt+γy,qhyt+θf,qhft+et(3)

where FCt is the measure of financial conditions in Korea (as charted in the policy note), and in which p, Agg, y and f correspond to the principal components of the price of risk (asset prices and risk spreads), financial leverage (household and corporate debt-to-GDP ratio, corporate bond issuance, NPLs, bank risk-weighted assets), domestic real economic conditions (real GDP growth, exports, IP), and global or foreign variables (global growth and financial risk sentiment). This approach disentangles the contribution of changes in the price of risk from evolving financial leverage (a concern in Korea) and shocks to the external environment when it comes to forecasting risks to overall financial conditions in Korea. It thereby provides insight into which variables signal tail risks to financial conditions in Korea.

D. Risk to Financial Conditions

7. Distribution of Financial Risks in Korea. Based on current domestic macro and financial conditions and the global risk environment as of the 3rd quarter of 2018, the median projection and high probability outcome suggests that financial conditions in Korea over the next 4 quarters will remain quite neutral, implying no real tightening in the ability of firms and households to obtain new financing. The distribution of outcomes reports a median FCI estimate of around 0. In an extreme event with tail-risks materializing, financial conditions in Korea would expect to tighten considerably, with the FCI falling from its current level of 0 to -2. This would have significant repercussions for the real sector.

Figure 2.
Figure 2.

Financial Conditions-at-Risk

(2018.Q3: 4-qtr horizon)

Citation: IMF Staff Country Reports 2019, 133; 10.5089/9781498314824.002.A002

8. Tail-risk financial outcomes remain contained in Korea. Rising financial stress risks in Korea would be associated with a more negatively skewed distribution and a fatter negative tail (higher kurtosis). Figure 3 illustrates rolling estimates of the tail of the distribution (the 5th quantile) of financial conditions since 2010 based on the quantile regression equation (1). The estimate shows that since 2010 financial stability tail-risks have not substantially risen; the tail of the distribution has not become fatter or more skewed, which would signify greater financial risks.

Figure 3.
Figure 3.

Financial Conditions Tail Risk (5%)

(Index)

Citation: IMF Staff Country Reports 2019, 133; 10.5089/9781498314824.002.A002

9. The materialization of tail-risk outcomes to financial conditions in Korea is susceptible to external financial conditions. Figure 4 shows that should external financial conditions tightening (as proxied here by a standard deviation shock in the VIX) financial conditions in Korea would tighten, and the probability of tail-risk outcomes in the financial sector would grow considerably. This is perhaps unsurprising given high household debt, much of which is linked to floating rates.

Figure 4.
Figure 4.

Financial Conditions-at-Risk to VIX Shock

(2018.Q3: 4-qtr horizon forecast)

Citation: IMF Staff Country Reports 2019, 133; 10.5089/9781498314824.002.A002

10. Link to authorities’ views. The finding that financial risks remain contained in 2018 are in line with the BOKs own financial stability index published in the December 2018 Financial Stability Report.

E. Policy Implications

11. Tail risk financial condition outcomes in Korea from recently evolving domestic and external real and financial condition have not grown over the past year. Should tail-risks materialize financial conditions are expected to tighten considerably, with significant repercussions for the real sector. The analysis underscores the importance of policymakers maintaining heightened vigilance regarding risks to financial conditions during periods of benign macro conditions that may provide a fertile breeding ground for the accumulation of financial vulnerabilities. Changes in the domestic price of external risk is a potent signal of imminent threats to financial conditions in Korea, and can be useful for the swift deployment of monetary easing and macro prudential policy actions.

Reference

Tobias, A., N. Boyarchenko,and D. Giannone (2016), ‘Vulnerable Growth’, Federal Reserve Bank of New York Staff Report 794.

Republic of Korea: Selected Issues
Author: International Monetary Fund. Asia and Pacific Dept