Cablegate: Visit of San Francisco Federal Reserve Bank President

Published: Mon 1 Dec 2008 05:23 AM
DE RUEHUL #2289/01 3360523
R 010523Z DEC 08
E.O. 12958: N/A
SUBJECT: Visit of San Francisco Federal Reserve Bank President
Janet Yellen, November 17-19, 2008
1. (U) This cable is sensitive but unclassified and is not/not
intended for internet distribution.
2. (SBU) Summary: President of the San Francisco Federal Reserve
Bank, Janet Yellen, met with a wide range of ROKG financial
authorities, market actors, and economists during her November 17-19
visit to Seoul. Yellen led an open exchange of information and
ideas regarding the impact of global financial turmoil on both
countries. Korean financial authorities and market actors praised
the timing of the Federal Reserve's October 29 announcement of its
USD 30 billion swap arrangement with Korea, crediting the move with
ending panic and bringing stability to Korean financial markets.
The global credit crunch and the continuing selling of Korean
equities by foreign investors were cited as the two biggest factors
in the continuing pressure on the Korean won. Technical factors
such as the gradual unwinding of currency-risk hedging positions
were also cited as contributing to the won's weakness.
3. (SBU) Summary continued: All interlocutors agreed that the
Korean economy has essentially absorbed the shockwave of global
financial turmoil and concern has now shifted to the impacts of the
global economic slowdown and continuing credit crunch on the broader
economy. Given Korea's large trade and financial exposure to the
global economy, the Korean economy is expected to experience lower
growth as exports slow and domestic demand remains weak. All agreed
that deterioration can be expected among weaker SMEs; the financial
authorities noted that they had already begun to encourage
restructuring within the construction and shipbuilding sectors.
Officials pointed to the significant room Korea has for additional
monetary and fiscal stimulation. End Summary.
4. (SBU) During her November 17-19 visit to Seoul, San Francisco
Federal Reserve Bank President Janet Yellen met with a wide range of
ROKG financial authorities, market actors, and economists to discuss
developments in the impact on Korea of global financial turmoil.
Yellen was accompanied by Federal Reserve Board of San Francisco
Group Vice President for Banking Supervision and Regulation Teresa
Curran and Federal Reserve Board of San Francisco Group Vice
President for Economic Research Reuven Glick. Yellen began the
schedule with a call on the Ambassador.
5. (SBU) The financial authority officials that Yellen met included:
Bank of Korea Governor Lee Seong-tae; BOK Monetary Policy Committee
Members Kim Dae-sik, Choi Do-soung, and Kang Myung-hun; Vice
Chairman of the Financial Services Commission Rhee Chang-young; and,
Financial Supervisory Service Governor Kim Jong Chang. The leading
economic and financial sector thinkers included former Prime
Minister Han Duck-soo, Chairman of the National Strategy Institute
Yang Soo-kil, President of the Seoul Financial Forum Kim Kihwan,
Seoul National University professor Min Sang-kee, and Korea
University professor Park Yung-chul. Among the market actors were
President of Kang and Company Kang (Thomas) Chan-soo, Vice President
of Hana Financial Holding Kim Eunice, and JP Morgan Managing
Director Lee Sung-hee. Economists included Lim Jiwon of JP Morgan,
President of the Korea Development Institute Hyun Jung Taik, Moon
Ki-hoon of Good Morning Shinhan Securities, Kwon Goo-hoon of Goldman
Sachs, and Yang Ho-chul of Margan Stanley.
Banking Sector and Currency
6. (SBU) Korean interlocutors described the suddenness and strength
of the dollar liquidity squeeze that hit Korean banks and the
broader economy in September and October following the onset of the
credit freeze in the United States after the collapse of Lehman
Brothers. Most acknowledged that some ROKG and private sector
financial decisions that seemed reasonable at the time actually
exacerbated the vulnerability of Korea's economy to the global
credit crunch. Some of these decisions included the Korean end of
the Japanese yen carry trade, ROKG encouragement of outbound
investment, duration mismatches in currency hedging positions, and
risky or excessive hedging positions. Others factors included
Korea's recent current account deficit and accumulation of
short-term debt, both of which were driven by commodity price
spikes. Professor Min Sang-kee noted that foreign equity investors
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had begun leaving the market and repatriating their hard currencies
two years ago. This was obscured by credit inflows (short-term
debt) that accelerated in the same timeframe.
7. (SBU) Bankers and market actors uniformly stressed the decisive
impact the October 29 Fed-BOK currency swap arrangement has had in
stabilizing Korean financial markets by eliminating fear. Bankers
and officials described the overall health of the Korean banking
sector as good. While banks are engaged in corporate lending and a
full range of other financial services, bankers pointed out that the
banks' biggest assets are loans to households -- both mortgage and
credit card debt. They noted that even though real estate prices
are declining, conservative loan-to-value ratio rules (40-60
percent) would prevent the emergence of a Korean version of the U.S.
sub-prime loan problem. Short-term (3-year) housing loans are
gradually being extended to longer durations and the ROKG is working
to prevent variable interest rates from climbing too high.
Nonetheless, there was broad agreement that banks will focus on
strengthening capital as some assets on their balance sheets sour.
8. (SBU) JP Morgan economist Jiwon Lim argued that relatively few
banks are currently overexposed to bad loans. Lim, who had been the
first economist to call the won overvalued in 2008, said she does
not see a second wave of currency crisis hitting the banking sector
or the economy. Dollar supply will remain tight and keep the won
under pressure, but banks are seeing increases in deposits of both
won and dollars (unlike the situation in many other markets). The
continuing unwinding of earlier hedging positions will keep dollar
demand strong for many months. Foreign banks have reduced dollar
lending as home offices now strictly enforce stiffer collateral
requirements. Many banks have been hesitant to sign up for ROKG
foreign debt guarantees because of the conditions in the
government-required MOUs, e.g., reducing executive compensation.
The won-dollar exchange rate should begin to reset with a
strengthening of the won as the global credit crunch begins to ease,
according to Lim. Another factor in favor of a stronger won will be
the movement of the current account balance into the black and
growing net export revenues over the coming months.
Impact on the Broader Economy
9. (SBU) Korean firms, particularly larger exporters and chaebols,
had learned the lessons of the Asian Financial Crisis and are not
overleveraged, according to financial authorities. Corporate
leverage routinely reached 400 percent in 1997 but was currently
less than 100 percent on average. Despite this careful positioning,
many of these firms are being affected by the credit crunch by
scarcity of dollar lending, falling equity values and a very thin
bond market. Market actors suggested that one problem is the
mismatch between Korea's well developed export industries and its
still developing financial markets.
10. (SBU) Economists continue to worry that despite considerable
diversification by region and product, Korean exports may be hit
hard if global growth falls as much as some analysts have predicted.
Korea's economy is heavily exposed to international demand both
through exports and imports. The shipbuilding industry will be
watched especially carefully because of its huge hard currency
earnings in recent years. Some interlocutors suggested that in the
longer term the substantial depreciation of the Korean won will have
a payoff in export earnings as Korean exports become more
competitive vis-`-vis China, and particularly Japan. One banker
noted that the won was down by approximately 50 percent versus the
yen in the last few months. Others worried that this
competitiveness could produce an increase in market share for Korean
vehicles in the U.S. market at a time when U.S. deliberations on
possible ratification of the KORUS Free Trade Agreement were most
sensitive to such a development. Still others argued that in the
short term, trade adjustments will tend to come with respect to
imports (through the price mechanism) rather than exports, which
take longer to respond to new price and other market conditions.
11. (SBU) Economists pointed to the Korean construction sector as a
continuing source of weakness in a generally sluggish environment
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for domestic demand. The earlier excess housing construction needs
to be worked through -- one expert estimated total lending to
construction firms at over USD 100 billion -- and there is unlikely
to be significant new demand for construction domestically before
the ROKG's stimulus package is implemented in 2009. There was also
broad agreement that many SMEs will need restructuring -- in
construction and even in the lower tiers of the shipbuilding
industry. FSS Governor Kim Jong Chang noted that the delinquency
rate on SME loans was still only 1.5 percent, but he acknowledged
that the rate was still rising.
Economic Policy/Regulatory Actions
12. (SBU) Former Prime Minister Han Duck-soo described the Federal
Reserve's October 29 action to extend the USD 30 billion swap line
to Korea as "very crucial" and noted that this action had eliminated
the sense of panic that had pervaded Korean markets until that
point. He noted that the ROKG had faced a psychological barrier, a
fear of actually using the considerable (USD 212 billion as of
October 31) foreign exchange reserves to protect the financial
system. He ascribed this to the extreme nature of the current
financial turmoil and the worry about how much foreign currency
reserves were enough. Korea's experience in the Asian Financial
Crisis 11 years ago -- running out of foreign exchange reserves and
requiring an IMF program to prevent sovereign default -- also made
financial authorities cautious about using the foreign exchange
reserves. Professor Min pined that if the credit crunch continued
over a sufficiently long term, Korea would not have sufficient
foreign exchange reserves to weather the global financial storm.
13. (SBU) Economists and strategists shared largely similar views
regarding a slow start to the ROKG response to the crisis. Many saw
the government as responding strongly since mid-October (and
implicitly not so strongly before) with a broad array of measures.
They called for the government to take additional bold measures to
encourage restructuring in weak industries. While fiscal stimulus
could buy time for this restructuring, it cannot put it off
indefinitely. Former PM Han noted that SMEs account for around 80
percent of employment and that the government will need to expand
the targeted lending that it has initiated through the state policy
banks such as the Industrial Bank of Korea.
Government Policy Perspectives
14. (SBU) ROKG financial authorities were quick to explain that with
Bank of Korea lending rates set at 4 percent, a budget surplus, and
over USD 200 billion in foreign exchange reserves, the ROKG still
has significant room for additional monetary and fiscal stimulation
of the economy. Most dismissed the possibility of negative
repercussions for the current account balance from fiscal
stimulation. The choice to stimulate the construction sector
generates a low marginal propensity to import. The more-or-less
universal choice by governments around the globe to undertake
economic stimulation measures should neutralize to some extent
effects on imports and exports.
15. (SBU) FSC Vice Chairman Rhee described the now-familiar ROKG
view of ways in which the foreign media got the situation in Korea
wrong -- misunderstanding the actual status of short-term loans (a
large proportion of which reflect borrowing by foreign banks), a
sudden panic regarding exports (which are diversified by region and
sector), and an unfair downgrading of Korean banks (which generally
remain in good shape). He also cited changes made by successive ROK
governments had made changes that that strengthened government and
financial institutions and left the country much better prepared for
times of economic uncertainty. That said, he acknowledged something
of what he called the "stigma effect," in which people automatically
tend to view the Korean economy through the prism of what happened
in 1997/98.
16. (SBU) Rhee continued that the government has reviewed the health
of SMEs burdened with the especially pernicious Knock-in Knock-out
(KIKO) currency hedging contracts and that fewer than 20 are in deep
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trouble. He stressed that Korean banks are safe and are still
receiving a strong deposit flow from Korean citizens who seek the
safety of guaranteed deposits. Rhee estimated that foreign
investors had pulled USD 30-40 billion out of Korea but claimed the
rate of withdrawal was decelerating. He also noted that banks were
beginning to issue subordinate debt to raise capital and ensure they
remained within the 10 percent BIS end-of-year ratio. Rhee closed
by noting the utility of credit guarantee agencies during the
recovery from the Asian Financial Crisis and the ROKG's current use
of them.
17. (SBU) FSS Governor Kim stated that banks did not currently have
sufficient capital to absorb the expected souring of assets. He too
noted that the banks are working to issue subordinated debt but
believed that more would be necessary. He anticipated that ROKG
financial authorities would develop a method to inject capital
directly into banks. A specific method had not yet been selected
and would likely wait for an evaluation of banks' own efforts to
raise capital. Asked about the impact of government encouragement
of bank lending to SMEs on the quality of bank assets, Governor Kim
said the ROKG asks the banks to support only those SMEs that are
sound with temporary liquidity problems and leaves the determination
of soundness to the banks.
18. (SBU) Several experts asked Yellen how financial prudential
regulations for banks and other financial institutions could be
expected to withstand the current extremes of the current global
financial turmoil. Yellen stressed that in modeling scenarios, U.S.
financial authorities had never projected out conditions as bad
those currently prevailing.
Expectations for 2009
19. (SBU) Most of the economists still anticipate Korean GDP growth
in 2009 will be between 3 and 4 percent, reflecting the positive
impact of the ROKG's substantial 2009 stimulus plan. A few economic
forecasts, however, have suggested growth could be one percent or
even less. Most non-ROKG interlocutors suggested that the
government should work harder to lower expectations for future
growth (and to formally abandon the campaign goal set a year ago by
then Presidential candidate Lee Myung-bak of GDP growth of 7
20. (SBU) Regarding global steps to address the financial
turbulence, most interlocutors agreed that the G20 was a good choice
of forum - not least because of Korea's participation -- and that
the gathering went as far as possible under the circumstances. All
agreed that global cooperation had been very strong so far and
remains important in ensuring that countries maintain a positive
policy response (and eschew unproductive or beggar-thy-neighbor
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