Korea offers dollar rates with a yen-like currency

Those signing America’s Declaration of Independence pledged “our lives, our fortunes, and our sacred honour”. Many of their descendants are still willing to pledge lives and sacred honour, at least those volunteers in the US armed forces, but every day fewer dollar-based investors are prepared to pledge all their fortunes to their native currency.

In recent months the chart line of confidence in the Bush administration has crossed the line of funds flowing into metals and overseas investments going in the opposite direction. A lot of that money has been trying to squeeze into markets too small to accommodate it, such as copper, silver and oil futures. As has been noted in this space, the commodities funds and institutional investors have been chasing their own tails for some months. Also the equity markets look as though they’re getting tired.

Asia’s bond markets are a good place to go. The undervaluation of the currencies in which they pay principal and interest is the other side of US overconsumption and the overvaluation of the dollar. For years conventional wisdom held that Asia’s economies could not stand the competitive disadvantage of stronger currencies. And governments were still traumatised by the 1997 current account crises, when they were caught with inadequate foreign exchange reserves.

By now, forex reserves have reached Himalayan levels, and even with the dollar’s decline are continuing to rise. Growth through exports is no longer as important as it was, with domestic consumption and investment having taken the lead. Tighter money supplies, higher interest rates and stronger currencies are seen by Asian governments as necessary to deflate asset bubbles and lower the cost of imported materials.

But which Asian currency bonds are best? The Korean won is increasingly correlated with other regional currencies, in particular the yen and the renminbi. The three-year maturity seems a good point on the curve to me.

The won may also have good news coming to its assistance, which could, in turn, lead to a ratings upgrade for its debt. The US is apparently backing off its hard line towards North Korea and considering peace talks that could lead to a treaty. Also, Bruce Klingner of the Eurasia Group in Washington, who follows Korean affairs, says the South and North Koreans may hold a summit later this year. If an inter-Korean summit were to upset the White House, that would probably be a domestic plus for South Korea’s governing party.

As Mr Klingner points out: “One of the reasons given by ratings agencies for keeping a discount on ratings for South Korean debt is the threat from North Korea. If that were to go away, or be reduced, then its bonds could more easily be upgraded. The South Koreans, the Russians, and the Chinese believe the real threat is not a Northern attack but a Northern collapse.” More lightly conditioned aid from the South could be exchanged for less belligerence from the North.

There are also technical monetary policy reasons for South Korea to allow the won to appreciate, and with it the value of bonds bought by dollar-based investors. The Bank of Korea has been buying dollars for years to keep down the price of the won (and support Korea’s exporters). The won created by that policy have to be soaked up through short-term won bonds issued by the BOK, and longer term bonds issued by the ministry of finance and economy. (You’d be buying some of those.)

This is a money-losing proposition, because the bank earns less interest on its dollars deposited with the Federal Reserve than it pays on the won bonds. Also, as the won has appreciated, the BOK’s dollar reserves get marked down in value. The result is the gradual decapitalisation of the Bank of Korea. By next year, it could have a negative net worth.

It could be argued that this doesn’t mean much, because Seoul would support the bank with its taxing and borrowing power. But it means a lot to the BOK, which has tried to become more of an independent central bank. Having no balance sheet of its own would put it entirely at the service of government policy and raise the spectre of inflation.

The BOK is also aware that the lower policy rate it maintains to keep down the value of the won is probably creating asset bubbles in high-end real estate and the Korean equity market. It would probably like to be more proactive than the Federal Reserve has been in letting the air out. Higher short term rates and a stronger won would help achieve that. (That’s why I suggested not going out longer than three years on the curve.)

Reasonable people will point out that the yen may very well have more upside as a currency than the won. Desmond Lachman, a monetary economist and senior fellow at the American Enterprise Institute think-tank in Washington, says: “When you invest in a foreign currency bond, you need to look at the currency, the coupon, and the appreciation on the bond through a fall in interest rates. The potential for the yen to rise is greater than for the won. Besides, the won has already had an upward move.”

Mr Lachman makes a good point, but at 8.55 the won is not at an extremely high value in relation to the yen. And the three-year yen bonds yield about 0.96 per cent, while the three-year won governments yield about 4.8 per cent. That means the won could devalue by more than 10 per cent against the yen and you would still be ahead, but I would not bet on that happening.

With the three-year Korean government bonds, you’re getting dollar interest rates with a yen-like currency.