South Korea: Uncertain relations and a new president Asia Pacific Economic Outlook, Q3 2017

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After a period of difficulty, it appears that the South Korean economy is beginning to rebound, with the new president indicating a path of increased fiscal spending. However, South Korea also faces uncertainty around its relations with allies and neighbors.

Temporary rebound

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After a period of difficulty, it appears that the South Korean economy is beginning to rebound. In the first quarter of 2017, real GDP was up a strong 0.9 percent from the prior quarter, fueled by an acceleration in exports and investment.1 Indeed, real exports were up 1.9 percent from the previous quarter, with exports of goods up a staggering 2.6 percent. Export growth continued into the second quarter, with nominal US dollar-denominated exports up more than 24 percent versus a year earlier. This was the strongest such growth in six years. The strength of export demand likely contributed to the revival of business investment. On the other hand, consumer spending continued to grow at a modest pace. Does the strength of growth in the first quarter bode well for the remainder of 2017? It is not yet clear. After all, there are a number of potential headwinds that the South Korean economy faces.

First, consumer spending is likely to be restrained by a high level of household debt, as has been true in the recent past. Moreover, the recent acceleration in inflation is likely to eat into the real purchasing power of consumer incomes. Second, export growth might not stay at the blistering pace recently seen. China is the destination for roughly a quarter of South Korean exports, and its economy shows signs of weakness. If Chinese investment in fixed assets continues to decelerate, it will weigh on the South Korean economy. In addition, China recently banned tour groups from visiting South Korea. This was punishment for the latter government’s decision to accept a missile defense system from the United States. Thus, in March, total tourist arrivals in South Korea were down 11.0 percent from a year earlier, with Chinese arrivals down 40.0 percent. This, too, is likely to dampen growth.

On the other hand, South Korean government and central bank policy might help growth. The government is expected to accelerate fiscal spending in 2017 in order to stimulate demand. The new president has pledged to follow such a policy. With the government’s finances in good shape and with borrowing costs relatively low, there is no reason why this should not happen. In addition, the central bank currently maintains a historically low benchmark interest rate, and it is not likely to boost rates any time soon, despite a recent increase in inflation. Core inflation, which excludes the impact of volatile food and energy prices, remains tame. The recent acceleration in inflation was most likely due to the rebound in global oil prices, something that may actually reverse in the coming year. Thus the central bank needn’t be too worried about inflation. Rather, it will likely be reluctant to boost rates too soon lest the rate change has a deleterious effect on the ability of households to service their large debts.

While it is never possible to predict the future path of exchange rates, an easy monetary policy should, all other things being equal, prevent a significant boost to the value of the South Korean won. Yet South Korea’s currency is at the mercy of what happens in Japan and the United States. If the US dollar weakens amid uncertainty about US fiscal policy, this could mean a stronger won. Naturally, South Korea’s exporters would benefit from a weak won. The weakening of the Japanese yen over the past few years was a source of considerable concern for Korean manufacturers because it boosted the competitiveness of Japanese companies.

Politics

South Korea recently elected a new president following the impeachment of former President Park Geun-hye. The new president is Moon Jae-in, a former human rights attorney. In Korean politics, Moon is on the left side of the political spectrum. He ran on a platform supporting fiscal stimulus through increased government spending. In addition, he indicates a desire to restrain the power of South Korea’s chaebol, the family-run conglomerates that have traditionally dominated much of the economy. Finally, Moon favors a somewhat more conciliatory approach to relations with North Korea, something that could create strains with South Korea’s most important ally, the United States. It is also unclear whether such a policy is likely to bear fruit given recent actions by North Korea. Meanwhile, relations between South Korea and China have become fraught owing to the former’s decision to accept the US missile defense system. Still, the economic relationship between the two countries is substantial and mutually beneficial. It seems unlikely that the spat over missile defense will cause serious deterioration of economic relations.

Finally, one potential source of geopolitical stress for South Korea is its trading relationship with the United States. There is a free-trade agreement between the two countries, and the United States is the destination for roughly 15 percent of South Korean exports. Yet recent news suggests that the United States might choose to withdraw from this agreement,2 sending shockwaves through the Korean economy. Although it seems highly unlikely that the United States will walk away from the agreement, the possibility is worrisome as it could have a serious negative impact on the economy.