South Korea’s economic outlook is more positive than a year ago. Policymakers should leverage this momentum to push key reforms, especially in labor markets and the SME sector.
South Korea has been in mourning since a ferry disaster left scores of children dead. The tragedy claimed its first political victim recently, when the prime minister resigned in response to popular discontent regarding post-disaster handling. Unless a new cabinet is formed quickly, key economic reforms might be hit. That would be unfortunate as reforms would certainly add strength and sustainability to the current momentum in economic activity. Any delay would also leave the economy vulnerable to key risks such as high household debt, low income mobility, an aging population, and the concentration of economic power in large industrial houses.
Growth speeds up in Q1 2014
The economy expanded 0.9 percent quarter over quarter in Q1 2014, continuing its strong momentum from Q4 2013. Investment was one of the main contributors to growth last quarter; gross fixed capital formation expanded 3.5 percent, the fastest pace in a year. Exports were the other success story in Q1, expanding 1.7 percent. Given that exports amount to about half of GDP, an uptick in the segment over the last two quarters will be encouraging for South Korea’s policymakers.
On the negative side, private consumption growth slowed for the third straight quarter to 0.3 percent, as high household debt offset the benefits of low inflation. Also, a deeper look at the data reveals that investment in facilities—an indicator of private sector investment in plants and machinery—dropped 1.3 percent in Q1 2014. This is another sign that businesses are still uncertain about demand growth—both domestic and external.
Exports on their way up
The strong momentum in exports in Q1 2014 has continued into this quarter. In April exports expanded 9.1 percent year over year, the fastest pace in about 15 months. External demand has been going up, aided by a recovery in the United States and, to a lesser extent, Europe. Rising demand from the West has helped South Korean businesses overcome slowing demand growth from China, the country’s largest export market. For example, in April shipments to the United States grew 19.3 percent, up from 16.9 percent in March; in contrast, exports growth to China fell to 2.4 percent from 4.4 percent during this period. However, the shift in China’s growth momentum might not be bad news for key manufacturing goods exporters such as South Korea in the medium term, especially if the world’s second-largest economy shifts to a more domestic consumption-driven growth model.
Strong won amid emerging market volatility
Interestingly, the current recovery of exports is despite the South Korean won’s strength. In April 2014 the won touched a six-year high against the US dollar. This was after a rise of almost 1 percent in 2013, a stark contrast to sharp losses in major emerging-market currencies. In fact, amid all the anxiety over US Federal Reserve tapering last year, the won emerged as a “safe” currency, given South Korea’s healthy growth prospects, strong external balances, and stable public finances.
Despite the won’s strength, the International Monetary Fund (IMF) believes that the currency is relatively undervalued, given South Korea’s strong external surpluses. The current account surplus was 6.1 percent of GDP in 2013, and the trade balance has been in the black since April 2012. The IMF estimates that the won is undervalued by 2–8 percent, with a bias toward the upper end.1
Low inflation aiding monetary policy
For the central bank, inflation is not a worry, despite rising to an eight-month high of 1.5 percent in April. This figure is way below the Bank of Korea’s (BOK’s) target of 2.5–3.5 percent. A low base and rising prices of key imports (including oil) are likely to push inflation up this year. However, this will be partially offset by a stronger won, keeping inflation below the BOK’s target; the central bank expects average annual inflation to be 2.1 percent in 2014. Low inflation also makes it easier for the BOK to develop a gradual approach to any future monetary tightening. For now, with the economy gaining strength, the BOK appears happy to keep rates on hold; it did so for the 11th straight month in April. The central bank is not likely to embark on a rate-tightening spree before Q4 2014, with a starting hike of not more than 25 basis points.
High household debt is a worry
High household debt—estimated to be 160 percent of disposable income and 77 percent of GDP in 2013—is perhaps the biggest short- to medium-term risk facing policymakers. High indebtedness has been weighing on private consumption growth while creating complications for monetary policy. With close to 80 percent of household debt set to floating rates, any rate hike will likely push up debt-servicing costs and thereby raise risks for commercial banks as well.
To their credit, policymakers are trying to address the problem. They have already set a target of pushing up the share of fixed-rate, amortizing mortgages to 40 percent of total mortgages by 2017. The government has also brought in legislation allowing local banks to issue covered bonds, a source of low-cost, long-term funding. This in turn will enable banks to offer longer-term mortgage loans at fixed rates, thereby protecting borrowers from changing interest rates.
And even though confidence is rising . . .
Consumers seem upbeat despite their high debt burden. For example, consumer sentiment, as measured by the BOK, came in at 108 in April, unchanged from the previous month; a reading above 100 indicates a larger share of optimists in the survey. Optimism is also rising among businesses, albeit slowly, amid improving industry data. In March both industrial production and manufacturing grew 0.9 percent month over month, the first expansion this year. No wonder then that business confidence went up for the third straight month in April. Businesses will benefit more in the coming quarters as export orders go up due to strengthening demand in the West. This, in turn, is likely to aid investment in the second half of 2014 and push growth in the segment up to 3.5–4.0 percent over 2015–16.
. . . There is need for strong reforms
South Korea’s economic outlook is more positive than a year ago. In April the BOK upgraded its GDP growth forecast for 2014 to 4.0 percent, up from an earlier estimate of 3.8 percent and above the 2.8 percent growth last year. Policymakers should leverage this momentum to push key reforms, especially in labor markets as well as the small and medium enterprise (SME) sector. A starting step could be to aid SMEs to enhance productivity. Making compensation in the regular workforce more merit based is another step; so is reducing the size of the irregular workforce. A fourth move could be to encourage greater female participation in the labor force; this will also help offset the impact of an aging population. The country also needs to spruce up social spending, which is about 6 percent of GDP, below levels specified by the Organization for Economic Cooperation and Development.2 While the government has made a start in all the above steps, it is critical that its momentum doesn’t slow, given South Korea’s five-year term limit for a president. Any delay will only create peril for the economy in the medium to long term.
EndnotesView all endnotes
- Reuters, “Korean won undervalued by as much as 8% – IMF,” CNBC, April 2014.
- International Monetary Fund, “Republic of Korea: 2013 Article IV consultation,” April 2014.