How to explain the differences between Korea and Japan in USD funding cost: Their monetary policy outlook

The cross-currency (XCCY) swap spreads for the JPY and the KRW have converged since early June 2018 (Chart 1). As the tightening expectations for the Bank of Korea (BoK) receded, the KRW XCCY swap spread has reduced after spiking before June, in line with the market rate hike expectations (Chart 2). Before the summer, the BoK was expected to hike by 50 basis points by year end and the related government bond selloff have pushed 10 year yield to 2.8%. However, as the BoK trimmed its GDP outlook for 2018, rate hike expectation was further delayed. As the risk of capital loss declined, foreign investors were attracted back into Korean bonds. On the back of these developments, the XCCY swap spread in Korea narrowed.

Going forward, the XCCY swap spread against the USD could expand once again when the Korean economy gains momentum. However, we do not think this is likely to happen in the immediate future given the headwinds on the economy. That said, trade war and lackluster investment environment may delay the BoK again, defeating the current market expectations for hikes in 2019. In any event, a positive surprise in Korea would widen the difference in the KRW and the JPY XCCY swap spreads. The key reason is that it seems even more unlikely that the BoJ will move out of its qualitative quantitative easing (QQE) as there is no expectation that it reaches its 2% inflation target.

Still, should the XCCY swap spread expand, Japan and Korea have considerable disparity in their policy tools to cope with the increasing USD funding cost. On the one hand, the BoJ has two swap lines in place to help Japanese banks through the Growth Program and the USD-JPY swap agreement with the Fed, under which banks can borrow USD up to 3 months. As for Korea, after the USD liquidity swap line with the Fed expired in 2010, the BoK’s arsenal has been rather limited. With this background, the BoK has been eager to arrange swap agreements with overseas central banks. But it only managed to arrange swap lines with Switzerland and Canada, and also a swap line with China for another three years. Nevertheless, with a rather limited policy tool to supply USD, the XCCY swap spread for the KRW is arguably more structurally vulnerable to expand against the USD rather than the JPY.

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