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Capital Market Opinion

Destabilizing Factors in International Financial


Markets and Koreas Economy

Kang, Hyunju

Anxiety in the international financial markets has been mounting due


to destabilizing factors such as Chinas stock market tumble, Greeces
prolonged debt negotiation, and the potential US rate hike. All of those have
been a potential threat to Koreas financial markets and the real economy.
Although optimism prevails on future developments, Korea must prepare for
the possibility that those destabilizing factors will prolong.

On July 9, 2015, the Bank of Korea (BoK) downgraded its outlook on Koreas economic growth
by 0.3 percentage points while the IMF cut the world economic outlook by 0.2 percentage
points. The BoK expected that a MERS outbreak and long drought would slow down the
economy during the second quarter so that Koreas growth would be less than 3% despite a
slight recovery in the second half. Furthermore, the IMFs data imply that external conditions
are not that favorable. Even considering temporary factors such as severe cold and the labor
conflict at US West Coast ports, the first-quarter growth in the US was disappointing at 0.2%.
Meanwhile, the economic slowdown has prolonged in emerging economies including China,
suggesting the absence of growth drivers in the global economy.
Against the backdrop, the international financial markets have been bombarded by a flurry of
destabilizing factors, such as Chinas stock market tumble, the concerns about a Greece default,
rising asset price volatility due to the potential US interest rate hike. This article examines those
external factors, and discusses their implications for the Korean economy.

All opinions expressed in this paper represent the authors personal views and thus should not be interpreted as Korea Capital
Market Institutes official position.
Ph.D., Research Fellow, International Finance Department, Tel: 82-2-3771-0850, E-mail: hjkang326@kcmi.re.kr

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Capital Market Opinion

Chinas stock market plunge


Among others, the most immediate, and direct impact on Koreas financial markets is coming
from Chinas stock market slump. The Shanghai Stock Exchange Composite Index plunged over
30% in July 2015 after surging about 150% from June 2014 to June 2015. Before the plunge,
Chinas stock market had enjoyed rallies as global investments flowed in the market due to the
launch of the Shanghai-Hong Kong Stock Connect and further expectations for capital market
liberalization. Stock prices jumped further as Peoples Bank of China (PBOC) turned to easy
monetary policy to tackle the economic slowdown and resulted in improved liquidity, and
as the contraction in the real estate market pumped liquidity into the stock market. But this
year, the appreciation in stock prices as opposed to the economic slowdown was viewed as a
bubble by some and accordingly, financial regulators have bolstered their supervision on margin
transactions. When stock prices tumbled, so did the value of collateral and consequently the size
of margin transactions, creating a feedback sending the stock market into a downward spiral.
Recently, PBOC acted with another rate cut while financial regulators tentatively suspended
IPOs, all of which are part of efforts to improve the supply and demand imbalance. However,
stock market volatility only rose further due to weak investor confidence.
Going forward, Chinas stock market is expected to face downward adjustments and
subsequent instability, which will inevitably impose a negative impact on Koreas capital markets.
Moreover, there are some other factors that pressure the Chinese economy, for example, Chinese
firms contraction in investments due to IPO suspension, and Chinas bearish stock market that
will cut asset values and thereby curb household consumption. However, the mid- to long-term
impact will be limited because given Chinas bank-oriented financial system the stock market
unrest is unlikely to spread to the whole financial system or international financial markets.

Prolonged Greek debt negotiation


The second destabilizing factor is the prolonged negotiation over debt and further bailouts
between Greece and creditor countries. From the adoption of the euro currency to the global
financial crisis, Greece had grown far higher than the euro zone average and experienced a
boom thanks to domestic demand largely driven by tourism. This led to relatively higher inflation
than other euro zone manufacturers such as Germany and pushed up real effective exchange
rates, weakening the competitiveness of the tourism industry. Before the global financial crisis,

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the use of the euro currency gave Greece opportunities to finance at rates equivalent to those of
Germany, so that Greece largely turned to foreign capital to finance its current account deficits
that had widened since the inception of the euro. However, the global financial crisis began to
push up financing costs and the subsequent fiscal crisis greatly increased the borrowing rates,
which made debt repayment even more onerous. As a result, Greece had to receive two bailouts
worth 240 billion from the ECB (European Central Bank), the European Stability Mechanism
(ESM), and the IMF in exchange for its promise to implement structural reforms. The pursuit of
fiscal austerity dramatically improved Greeces conditions, cutting its fiscal deficits (against GDP)
from 10.2% in 2011 to 3.5% in 2014. Moreover, wage cuts lowered down labor costs by 15%
from 2009 to 2014. But involuntary reforms in the post-crisis period and resultant economic
recession gave rise to recession fatigue and anti-reform sentiment among Greeks. Under the
circumstances, the left-wing Syriza government took office and a hard line stance toward creditor
countries bailout plans that call for additional reforms. This eventually led to failed negotiations
with creditor countries at the end of June 2015. Consequently, Greece defaulted on the IMF
loans, rejected credit countries bailout plans through a referendum, and presented its own plan,
all of which made the negotiation process extremely difficult. Alongside Greeces strong stance,
divergent interests across creditor countries have delayed the process to resolve the Greek crisis.
Germany and Northern European countries such as Finland are uncooperative with any further
debt relief for Greece due to moral hazard concerns, whereas the IMF, the US and some euro
zone counties including France and Italy agree upon the inevitable nature of debt relief.
Although Greece and creditor countries reached an agreement, many obstacles still remain
before settling down the debt crisis of Greece. It is relieving to find the euro exchange rates
remain stable despite the prolonged Greek debt crisis, implying optimism in the international
financial markets. Behind the optimism are several factors, including Greeces small economy and
its little clout over the global economy, and the view that the market price has already reflected
the crisis that had been somewhat anticipated. Above all, the euro zones past experience that
had effectively tackled down the EUs exchange rate mechanism crisis of 1992 prior to the single
currency regime bolsters market confidence about the robustness of the euro currency. In the
Asian foreign exchange market, the Greek debt crisis has less influence compared to Chinas
stock market unrest. Rather, the relative, albeit slight, strength of the yen due to the flight to safe
assets can be favorable to Korea and other Asian emerging countries directly competing with
Japan for exports. But if the Greek debt crisis results in a catastrophe and a Grexit in the end, this,

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according to some studies, would offset the economic stimulus effect from the ECBs quantitative
easing program. Also worrying is the chain reaction where Southern European countries that
have been pushing forward reforms in exchange for bailouts may follow Greeces footsteps. This
may involve greater market unrest and raise concerns about another global-scale crisis.

A potential US interest rate hike


Last, it is worth paying attention to the US interest rate hike. After tapering its asset purchases
to end quantitative easing in 2014, the Fed is likely to normalize its monetary policy this year by
increasing its policy rate for the first time after the crisis. Despite improvements in employment
data, the wage increase rate hovers around the mid 2% range and inflation is far lower than the
2% Fed target. On top of this, there are external factors such as the Greek debt crisis. The IMF
recommended the US to delay a rate hike until next year, which is also supported by Chicago
Federal Reserve President Charles Evans and some of the high-ranking Fed officials. However,
Fed Chair Janet Yellen publicly stated a rate hike starting later this year in June and again in
July. Although the Fed said the process would be data dependent, it has clearly and precisely
conveyed its intention for a rate hike this year in order to induce economic entities in the US
and participants in the international financial markets to prepare themselves for a future rate
hike. Furthermore, her remarks on a gradual pace given the lukewarm economic recovery rather
than baby steps taken by former Fed Chair Alan Greenspan are expected to significantly address
uncertainties around the future rate hike path.
Hence, if the Fed is actively engaged in communications with market participants to minimize
potential shocks during the rate hike process, the effects of a rate hike will be limited in most
emerging countries except for susceptible economies running large current account deficits such
as Brazil and Turkey. In fact, a study published by Fed Economist Ozge Akinci in 20131) found that
emerging economies were more swayed by uncertainty in international financial markets than
shocks from the US interest rate hike.
Recently, it is observed that numerous disturbing factors in the international financial markets
tend to be reflected only limitedly in financial market prices such as stock prices, interest rates,
and foreign exchange rates. The primary reason behind this is because market participants

1) Akinci, Ozge, 2013, Global financial conditions, country spreads and macroeconomic fluctuations in emerging countries, Journal of
International Economics, vol. 91, no. 2, pp. 358-371.

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amid sufficient liquidity in general remain optimistic about how those factors pan out in the
future. Hence, the impact on Koreas financial markets and the real economy is expected to
be insignificant. It is still hard to rule out the possibility that the destabilizing issues mentioned
above will extend over a long period: Chinas stock market tumble, if met with a slowdown in
Chinas real economy, may lead to long-term price adjustments while Greeces debt negotiation
may reach a deadlock due to tangled interests among the countries involved. This may reinforce
risk aversion in the international financial markets, increase exchange rate volatility of the
Korean won, exacerbate already weak exports, and affect the real economy. Hence, it is wise
to prepare for the possibility that those destabilizing factors will prolong. Although a gradual
pace of the US rate hike has a limited impact, this is not a one-off event. During the rate hike
path, Korea must thoroughly monitor the continuous and cumulative impacts of rate hikes on
emerging economies and financial markets.

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