South Korea: Headwinds, and a policy response Asia Pacific Economic Outlook, Q3 2016
Two factors are driving economic weakness in South Korea: declining exports and a weakening of domestic demand. The central bank has cut the benchmark interest rate for the first time in a year, in the hope that it will suppress the value of the Korean won, thus lifting exports.
The South Korean economy has recently faced headwinds, culminating in a central bank decision on June 9 to cut the benchmark interest rate for the first time in a year. This comes at a time when the government is also engaged in a modest fiscal expansion aimed at stimulating growth. The economic weakness comes from two factors: poor export performance and a weakening of domestic demand. Let’s consider both.
The recent cut in South Korea’s benchmark interest rate should have the effect of suppressing the value of the currency. If this persists, it could help effect a rebound in exports.
First, exports have lately been declining. This is important given that exports of goods account for roughly half of economic activity, while exports of services account for another 10 percent of GDP. The Korean won has appreciated against the Japanese yen due to Japan’s policy of quantitative easing, which resulted in a sharp drop in the yen. Although the yen has risen lately, its value against the won remains low compared to the past. The effect has been to hurt the competitiveness of Korean manufactured goods versus Japanese goods. The recent cut in South Korea’s benchmark interest rate should have the effect of suppressing the value of the currency. If this persists, it could help effect a rebound in exports.
South Korea’s largest export markets are China and the United States, and in both markets its manufactured goods compete with goods from Japan. In addition, Korean exports to China, which are about 25 percent of Korean exports, have likely been hurt by the weakness of the Chinese economy where domestic demand has been poor. Moreover, Korea produces goods that are used as inputs in final products that are assembled in China for export to the rest of the world. These inputs account for about 80 percent of Korea’s exports to China, according to the Export-Import Bank of Korea. Yet Chinese exports have lately been declining, owing to an overvalued currency and weak global demand. Thus, Korea’s external sector has faced negative factors that are largely beyond its own control.
The weakness of exports has contributed to a deceleration in the growth of the industrial side of the economy. However, this has been offset by continued strong growth of the services sector. This is not surprising as Korea, like other developed economies before, transitions away from dependence on industry toward greater growth from services. Moreover, there is considerable room for improvement in the productivity of the services sector.
Korean domestic demand has been growing modestly. Consumer spending has been restrained by the high level of consumer debt. Indeed throughout the past decade, consumer spending has grown more slowly than the overall economy. On the other hand, business investment has lately accelerated, providing a boost to economic growth. In addition, the government’s fiscal stimulus has played a role in maintaining growth at a moderate level.
On the positive side, inflation remains subdued, the result of declining oil prices and the strength of the currency. This has given the central bank room to engage in a more expansive monetary policy. However, as oil prices rise and as the currency depreciates in the coming year, inflation will ultimately accelerate. Still, it will take a long time before this happens, especially as producer prices continue to fall. Thus, monetary policy could remain expansive for some time to come. As for fiscal policy, the good news is that government debt as a share of GDP remains low at about 35 percent. Thus, there is plenty of room for fiscal stimulus without concerns about excessive debt. On the other hand, the government has generally run a relatively tight fiscal policy, if only to be in a position to handle the cost of reunification should North Korea implode. That remains a concern, especially given the increasing aggressiveness of North Korea.
Going forward, the economy is likely to accelerate somewhat in the coming year given the mixture of monetary and fiscal stimulus. However, in the longer term, it is clear that South Korea is becoming a more mature economy and, therefore, can expect more modest growth. In addition, demographic trends suggest slower growth absent an expansion of productivity. The greatest opportunity for productivity growth is in the increasingly important services sector.
The biggest risk to the South Korean economy remains China. Given the country’s considerable dependence on exports to China, the future path of Asia’s behemoth will make a big difference for South Korea. If Chinese growth decelerates more than anticipated, or if its currency depreciates more than currently expected, it will have an onerous impact on South Korea.