October 12, 2017 / 2:43 AM / a year ago

Fitch Affirms Korea at 'AA-'; Outlook Stable

(The following statement was released by the rating agency) HONG KONG, October 11 (Fitch) Fitch Ratings has affirmed Korea's Long-Term Foreign-Currency Issuer Default Rating (IDR) at 'AA-' with a Stable Outlook. A full list of rating actions is at the end of this rating action commentary. KEY RATING DRIVERS Fitch's affirmation of Korea's sovereign ratings with a Stable Outlook balances robust external finances and a strong macroeconomic performance with geopolitical risk related to the tense relationship with North Korea and longer-run challenges of rapid population ageing and low productivity. Geopolitical risk resulting from the longstanding standoff on the Korean peninsula continues to weigh on the rating. The heightened tensions over North Korea's nuclear weapons program and the escalated rhetoric from both North Korea and the US imply an increased risk that confrontation could be triggered by an unexpected event or miscalculation. Even in the absence of outright conflict, the tensions also have the potential to negatively affect the South Korean economy if currently strong business and consumer sentiment start to worsen or if exports weaken as a result of a deterioration in trade relations between the US and Korea's main trade partner, China. Affirmation of the ratings, nonetheless, is in line with Fitch's belief that an outright war on the Korean peninsula will be averted. While the current level of tensions is high, strains on the Korean peninsula are not new, and have followed a familiar pattern of rise-and-fall cycles in the past. In Fitch's view, it remains important to differentiate between the recent escalation of missile testing and aggressive rhetoric on the one hand, and the likelihood of war on the other. The geopolitical risk to South Korea's sovereign balance sheet relates not only to the potential for conflict, but to a long-term scenario of reunification as well. An assessment of the potential impact of reunification would depend heavily on the assumptions made, for instance about the policy measures taken to rein in spending, and possible foreign financial contributions. Reunification would not be only a cost for the sovereign but would also provide opportunities in terms of political stability and relatively cheap labour during a transition period of integration for manufacturing export-led growth. Korea's macro performance continues to be strong compared with many of its peers. Fitch expects GDP growth to be close to potential at 2.7% for 2017, 2.8% for 2018 and 2.6% for 2019. Exports of Korean semiconductors support economic activity, even though the high import component of this sector limits the net contribution to growth. However, exports in other sectors, such as the car industry, continue to lag. Domestic demand is expected to support growth after a long period of political uncertainty ended with the election of President Moon Jae-in in May 2017. The new administration's economic policy focus on job creation and income-led growth is likely to strengthen demand. The government is planning new supply-side policies to strengthen innovation and create a better level-playing field between the large conglomerates (chaebol) and SMEs. However, the extent to which these measures will improve Korea's relatively low productivity depends on the details, which are in the process of being developed. Some measures, eg an increase in government jobs and subsidies to SMEs, do not necessarily point to enhanced productivity. Reforms to increase transparency and encourage greater separation between the government and the corporate sector could improve governance standards, and hence support Korea's credit profile. Broad public support for change in this regard suggests good prospects for progress. In the meantime, the close ties between business and politics that became apparent in the recent political crisis that culminated in the removal from office of former President Park Geun-hye in March 2017 illustrate Korea's relatively weak governance standards compared with its peers, as well as a weaker score (72nd percentile) for the World Bank's governance indicator than the 'AA' median (80th). Korea's robust external finances form a clear rating strength and are indicated by persistent current-account surpluses since 1998, foreign exchange reserves at 7.3 months of current-account receipts (versus a median of 3.5 months for sovereigns rated in the 'AA' category) and a net external creditor position, even though net external assets of 29.4% of GDP are slightly lower than the 'AA' median of 32.1%. The government's targeted slight fiscal easing in the coming few years does not significantly alter the neutral impact of the fiscal finances on Korea's credit profile. The general government debt of 39.2% of GDP, as forecast by Fitch for 2017, is marginally below the 'AA' median of 42.3%. In the absence of policy measures, a fiscal deterioration could be expected in the longer run as a result of the challenging demographics. In this light, parliament will discuss draft legislation aiming to set out clear fiscal policy rules, including ceilings for the deficit (3% of GDP, excluding social security funds) and the debt burden (45% of GDP). Implicit contingent liabilities are significant, as the debt of state-owned enterprises amounts to 21% of GDP (excluding debt owed to the government), although it has gradually declined from 24.8% in 2012. Inflation reached a five-year high in August, at 2.6% yoy, largely driven by increased prices of fresh vegetables and electricity. These effects proved temporary, and inflation fell back to close to the Bank of Korea's 2% inflation target in September. Core inflation, a better gauge of demand-pull pressures in the economy, remains quite muted at around 1.5%, which should allow the Bank of Korea to retain an accommodative bias. We expect the central bank to start tightening cautiously before the end of 2018. The Bank of Korea may decide to hike earlier in case of strong capital outflows, for instance related to stronger Fed tightening than expected by the market or an increase in geopolitical risk. Household debt is high (96.5% of the rolling four-quarter GDP in 2Q17) and rising fast (11.4pp of GDP in just three years). This dampens households' propensity to consume and increases Korea's vulnerability to shocks, although household assets are also relatively high, which mitigates the risk to financial stability and the economy. Korea's expected per capita income at USD29,050 in 2017 is one of the lowest in the 'AA' category and well below the 'AA' median of USD41,375. However, its broader level of development is higher than income levels would suggest and its business environment is generally strong, as indicated by its fifth position out of 190 countries in the World Bank's ranking for Ease of Doing Business. SOVEREIGN RATING MODEL (SRM) and QUALITATIVE OVERLAY (QO) Fitch's proprietary SRM assigns Korea a score equivalent to a rating of 'AA' on the Long-Term Foreign-Currency (LT FC) IDR scale. Fitch's sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to rated peers, as follows: - Structural Features: -1 notch, to reflect ongoing geopolitical risk related to the tense relationship with North Korea. Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables based on three-year centred averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM. RATING SENSITIVITIES The main factors that, individually or collectively, could trigger negative rating action are: - Significant escalation of tensions on the Korean peninsula that would severely worsen Korea's economic metrics or the level of security - An unexpected large rise in the public-sector debt burden caused by a deviation from the current prudent fiscal-policy framework or crystallisation of contingent liabilities - Evidence that medium-term GDP growth will be structurally lower than expected, potentially reflecting challenges for Korea's economic model The main factors that, individually or collectively, could trigger positive rating action are: - A structural easing of geopolitical risk to levels more in line with rating peers - Implementation of a convincing strategy to improve overall debt dynamics for the government and state-linked enterprises - Evidence that the economy can grow at a relatively high rate over time without deterioration in the aggregate household balance sheet, for instance resulting from enhanced governance standards or successful reform implementation that would spur productivity growth KEY ASSUMPTIONS The global economy performs broadly in line with Fitch's Global Economic Outlook (September 2017). The full list of rating actions is as follows: Long-Term Foreign-Currency IDR affirmed at 'AA-'; Outlook Stable Long-Term Local-Currency IDR affirmed at 'AA-'; Outlook Stable Short-Term Foreign-Currency IDR affirmed at 'F1+' Short-Term Local-Currency IDR affirmed at 'F1+' Country Ceiling affirmed at 'AA+' Issue ratings on long-term senior unsecured foreign-currency bonds affirmed at 'AA-' Issue ratings on long-term senior unsecured local-currency bonds affirmed at 'AA-' Contact: Primary Analyst Thomas Rookmaaker Director +852 2263 9891 Fitch (Hong Kong) Limited 19/F Man Yee Building 68 Des Voeux Road Central Hong Kong Secondary Analyst Andrew Fennell Director +852 2263 9925 Committee Chairperson Tony Stringer Managing Director +44 20 3530 1219 Media Relations: Wai-Lun Wan, Hong Kong, Tel: +852 2263 9935, Email: wailun.wan@fitchratings.com. 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