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Global Economic Outlook
South Korea: 2011 Outlook
By Arpitha Bykere
- Exports, industrial production and investment will revive by Q2 2011 due to improved U.S. consumption and global demand for South Korea’s competitive consumer and business electronics.
- Markets, sovereign ratings and debt inflows will continue to price in high-alert status or military action on the peninsula.
- The central bank will need to hike rates in H1 2011 to stay on the curve and curb inflation; further capital controls on banks and the debt market will address external-sector risks but not currency appreciation and volatility.
Growth Dynamics: The Fragile Pillars of Domestic Demand and Exports
The sequential slowdown in GDP growth in H2 2010 will continue in Q1 2011, as exports and industrial production (IP) suffer from subpar U.S. and Chinese growth. Already, exports of parts and components to Asia, particularly China, are slowing, which portends a lull in Korean and Asian exports to the U.S. Investment and consumption, which are structurally tied to exports, have weakened since late Q3 2010, suggesting domestic demand will be unable to compensate for export weakness.
However, improved U.S. and Chinese consumption and global business investment in new productivity-enhancing technologies should revive demand for Korean electronics and semiconductors in Q2 2011. Meanwhile, strong Asian consumption and investment, global demand for new consumer electronics (like smart phones), Korean companies' technological edge and Korea's export competitiveness vis-à-vis Japan will support these trends. Together with inventory adjustment and improvements in domestic consumption and investment, these dynamics will raise GDP growth starting in Q2 2011. Hence, the "Year of Two Halves"—with seasonally adjusted annual rates (SAARs) of 7.3% q/q in H1 2010 and 2.4% q/q in H2—will reverse in 2011, to SAARs of 4.9% q/q in H1 and 5.9% q/q in H2.
However, close to 30% of Korean exports are destined for the U.S. and Europe, where consumers are deleveraging. Of the exports directed to Asia—more than 50% of the total, with China absorbing over 20% of total exports and Southeast Asia 11%—more than half are meant for re-export outside of the region. As Korean exports to emerging markets fail to offset weaker U.S. and EU demand in the near term and Korean households face a high debt burden (153% of income), consumption (4.3%), exports (10%) and GDP (4.3%) will grow below their 2006-07 peaks in 2011.
Figure 1: Competitiveness Cannot Avert Export and Investment Slowdowns
Inventories, especially in the electronics sector, have increased since Q3 2010, pushing the inventory-to-shipment ratio above trend. IP could remain under pressure until Q1 2011 as firms continue reducing inventories, leading to a negative contribution to growth, but improved demand in the U.S. and China thereafter should encourage firms to begin restocking inventories in Q2. The trade contribution to growth should turn marginally positive in Q1 2011, as imports slow more than exports, before turning slightly negative thereafter as consumer and capital goods imports accelerate.
Figure 2: Industrial Sector Headwinds Will Keep Blowing in Early 2011
Source: Bloomberg, RGE estimates
The improvement in consumer spending in Q3 2010 has begun to ease as slowing exports, high food prices and tighter credit access, including for mortgages, hurt consumer sentiment. Amid a weak export outlook and high inventories, fixed-asset investment has slowed since late Q3 2010, when pent-up demand from H2 2009 and H1 2010 was released. Consumption will slow marginally while investment will weaken in Q4 2010 and Q1 2011 before these become key contributors to GDP growth starting in Q2 2011. However, rate hikes and a slower-than-expected real estate recovery could constrain debt-burdened consumers. The contribution of government spending to 2011 GDP growth will be miniscule due to fiscal cutbacks following large fiscal stimulus in 2009-10.
Risks: Pricing in Global and Cross-Border Risks
Given the high-beta nature of Korean markets, a wave of risk aversion from a eurozone debt crisis or an escalation of Korean peninsula tensions would be likely to trigger capital outflows from Korean equities and bonds (which respectively attracted US$16 billion and US$36 billion in foreign investment in January-November 2010). Moreover, foreign investors' shares had increased to 30% of the Korean stock market's capitalization, 13% of treasury bonds and 19% of monetary stabilization bonds as of November 2010. And though Korea’s external debt position has improved since 2008, its short-term external debt (50% of FX reserves, down from 75% in 2008) and banking and private sector external debt (64% and 51%, respectively, down from 84% and 77% in 2008) remain vulnerable to market volatility, posing downside risks to the Korean won.
So far, the economic impact of cross-border tensions has been mild and temporary as investors have priced in one-off events. However, continued cross-border artillery exchanges and/or verbal threats are likely to weigh on investment decisions—affecting debt inflows and FDI in particular—and trade. The resulting downward pressure on the Korean won could be somewhat mitigated by global liquidity and boosts to export competitiveness, depending on upside surprises regarding tensions. Bilateral tensions from China’s continued support for the North could put South Korean trade and investment under pressure, since China is South Korea’s largest export destination and a key source of FDI. Chinese investment in South Korean bonds (which has increased recently due to China’s FX reserve diversification strategy) could also suffer. But this is a worst-case scenario, since China-South Korea trade relations are vital for the Asian supply chain. South Korean policy makers are likely to respond to any dire situation by injecting liquidity into the banking system and intervening in the FX market to defend the currency. Moreover, large FX reserves and access to the Chiang Mai Initiative's multilateral FX reserve pool and central bank swap agreements will protect the economy.
Policy Implications: Inflation Risks Cannot Be Ignored for the Sake of Growth
Delayed monetary tightening has not reduced capital inflows and currency challenges; instead, it has put Korea behind the curve in preventing rises in food and commodity prices and wages from feeding into core inflation. Though food prices may ease somewhat, downward pressure on the Korean won (due to global risk aversion or geopolitical risks) could raise imported inflation. Annual inflation will remain comfortably within the central bank’s target of 2-4% in 2011, but firms’ rising pricing power will keep monthly inflation close to the upper end of the target through early Q3 2011. We envision the central bank hiking rates by 25 basis points in both Q1 and Q2 2011 and by 50 basis points in Q3 2011. Stronger-than-expected domestic and global recovery and high commodity prices (due to global liquidity) could expedite rate hikes in Q2 2011. However, increased cross-border tensions or risk aversion due to a eurozone crisis could delay rate hikes and FX intervention.
Figure 3: Negative Real Rates Raise Inflation Expectations
As sterilization costs and capital inflows' impact on liquidity rise, policy makers could tighten the FX derivative and short-term loan positions of banks further, especially foreign banks, or tax banks’ short-term and foreign currency liabilities. After reinstating the withholding and capital gains taxes on government bonds in November, policy makers could impose a new tax on short-end government bonds. However, a Tobin tax on cross-border capital flows is unlikely due to the risk of a global backlash. Over time, these prudential measures will improve the maturity and composition of Korea’s external debt and reduce banks’ systemic and FX liquidity risks. Yet, rising interest rate and exchange rate arbitrage and ample global liquidity could continue to drive up capital inflows, making currency appreciation and market volatility ongoing challenges.