Looking Ahead
South Korea has achieved an annual growth rate of 5½ per cent during the past five years, thanks in part to progress in restructuring its economy and strong external demand, particularly from China. What does the future hold? Infomag takes a look at the various economic forecasts, as the country struggles to recover from quite a long recession.
Expert Zone
By Rambabu Garikipati
In what has become an annual event, the EUCCK organized a special seminar on the “Korean Economy: Forecast for 2006” on November 24th, with noted economic experts and businessmen deliberating on the future growth strategies.
Deep-seated worries have existed about whether the Korean economy could regain its pre- 1997- crisis vibrancy and growth potential.
Capital spending, too much of which was viewed as evidence of reckless corporate expansion in the pre-crisis period has slowed drastically in recent years. Lack of new capital formation, in turn, has meant lower growth potential. This new trend is due to a significant change in corporate behavior since the 1997 crisis. The corporate sector, ever the workhorse of South Korea’s rapid growth, has been made the key culprit for the 1997 crisis by the government and has been placed on an intrusive probation for past wrongdoings, both real and imaginary.
Naturally, businesses are now being too careful. The overall trend in employment conditions has also ratcheted down. Given such developments, it may be natural that consumers have an uneasy feeling about the future.
These two factors should greatly influence the tone and tenor of South Korea’s economic outlook in 2006.
There is widespread consensus, for example, that growth in external demand will slow down compared with previous years. Consequently, this year’s growth will depend largely on the expected recovery in domestic spending. An improvement in consumer sentiment could help consumption, which has contracted since 2003.
Given this overall sentiment, the EUCCK organized a special seminar focusing on the economic forecasts for the next year.
Before the seminar, the EUCCK also organized a luncheon meeting, and Mr. Kyung Kim, Acting President, Korea Development Institute (KDI) was the keynote speaker.
In the aftermath of the Asian “financial crises,” a number of factors have been identified as the culprits in leading to them and intensifying their severity. Among them, “crony capitalism,” the “weakness of the banking system pre-crisis,” financial liberalization and opening of the capital account, and the nominal exchange rate regime have all been singled out. While all these factors obviously contributed, their relative importance quantitatively, and the interactions between them, are little understood.
It is in this context that Mr.Kim, gave an overview of the economic crisis and structural changes in the economy.
In his opening remarks, Mr. Frans Hampsink, EUCCK President, dwelt on the economic forecasts for 2005, expectations for next year, and highlighted some factors, that the government could do well to address, if it wants the economy to gather steam.
“Now that the year is drawing to a close, almost everyone, including the Finance Ministry, which had projected a 5 percent growth rate in 2005, now realizes that the country's growth rate will hover around 3.8 to 3.9 percent, he said.
“To realize a 4 percent growth rate for the full year, the economy needs to grow by 5.6 percent during the fourth quarter. Since the target is considered to be unapproachable at the moment, I would project this year's growth rate to stand at around 3.8 percent.”
For 2006, the majority of think tanks have projected the economy to grow by 4.5 to 5 percent. These estimates are based on the expectation that private spending is expected to enter a full recovery track next year.
“Clearly, future growth hinges primarily on healthy household and consumer spending. Nonetheless, there have also been voices of concerns that the Korean consumers may not pick up as widely expected,” Mr. Hampsink said.
In this context he said that the policy makers and economists should worry more the alarming rate at which household purchasing power is losing its steam, with household disposable income sinking to the lowest in the third quarter this year on year-on-year real basis.
“I also feel that the oil price hike, new real estate property measures, and anti-corporation sentiment, in addition to external factors like sluggish demand from Chinese market and the burst of the U.S. real estate bubble may dampen the economic growth,” he said.
The government should maintain macroeconomic stability and sound public finances in the face of spending pressures stemming from exceptionally rapid population ageing/. It should develop a social safety net and the potential cost of future economic integration with North Korea.
Persistent remaining weaknesses in the corporate and financial sectors should be resolved. In sum, it is essential to complete the transformation of the economic framework that was launched in the wake of the 1997 crisis, while addressing emerging challenges, in order to sustain high growth, he said.
Economic Experts: Dr. Kim Kyeong-won, Director, Samsung Economic Research Institute, predicted that GDP is expected to grow 4.6 percent in the second half, up from 3.0percent in the first six months of this year.
Export continues solid growth. Exports rose 15.8 percent in the third quarter, up from 9.0 percent in previous quarter. This was despite unfavorable external conditions such as surging oil prices. Export growth in the second half is expected to be 15 percent, up from 10.8 percent in the previous six months.
“Recovery of domestic demand apparently picks up speed entering the second half. Pace of consumption recovery is accelerating. Sales of durable goods rose 6.4percent in 3Q. Rising real wage seems to boost consumer spending. Real wage grew 4.2percent in the first half from a year ago,” he said.
Mr. Kim also noted that non-manufacturing sector’s investment is expected to increase. Leading investment indicators of non-manufacturing companies reversed upwards in 3Q 2005. Housing supply will fall due to government’s tough real estate market stabilization measures announced on August 31 Increase in public sector investment will make up for the shortfall in the private sector Public works will increase 12.1percent from 44.5 trillion won of 2005 to 49.9 trillion won in 2006. Construction projects in the form of Build-Transfer-lease (BTL) schemes will start in earnest. Exports in 2006 will slow to 9.2percent from 13.0 percent projected for 2005.
He predicted that the won will gain value against the US dollar, and the global economy will slow down. Export conditions will be unfavorable in 2H, falling to a single-digit growth. The won-dollar exchange rates will fall to the 1,000 won level in 2H. US and major industrialized countries’ rate hikes will slow their imports. Current account surplus will decrease to $9.0 billion as imports increase faster than exports.
Economic growth rate will decline 1.3 percentage points if external conditions worsen. Economic growth rate will fall 0.9 percentage point if domestic conditions deteriorate. As an effect of the government’s real estate policy on Aug 31st , economic growth rate will drop 0.6 percent due to aggravated consumers’ sentiment and slump in real estate market.
“There will be pressure and criticism from society against companies. Economic growth rate will drop 0.3percent due to companies’ careful move on investment. Economic growth rate will decline 1.9 percentage points if both external and domestic conditions worsen,” he said.
Mr. Sunny Yi, Partner, Bain & Company Korea, spoke on the “Korean Job Market & Related Macro Economic Overview” while Mr. David Richardson, President of TNS Korea gave a presentation on “Domestic Consumption Attitude & Forecast 2006.”
In his address, Dr. Kenneth H. Kang, Resident Representative, IMF Korea, discussed the near-term economic outlook for Korea, its strengths and risks, and the policies being pursued to promote the recovery. He then turned specifically to some structural areas that are crucial for ensuring that this recovery is rapid and sustainable.
“As we predicted last year, the economic recovery is underway in South Korea. Strikingly, this recovery has been led by private consumption, which has revived after remaining dormant for almost two years. One important reason behind the recovery is the progress that households have made in restructuring their delinquent debt. Here, the government has done a good job of putting together a framework for resolving household delinquents, either through the personal bankruptcy system or through the out-of-court workouts, such as the bad bank and the Credit Counseling Recovery Service,” he said.
The number of credit delinquents who have had their delinquencies resolved and their debts restructured through the CCRS has increased very rapidly, from around 50,000 at the beginning of last year to over 400,000 this year. This is a positive development as it will help to clear out the back log of credit delinquents, particularly for those who have little capacity to repay their debts. This debt rescheduling has helped create room, particularly for these lower-income credit delinquents to spend again.
“As a result, after two years of negative growth, private consumption has expanded now for 5 consecutive quarters, reaching an annualized rate of around 5 percent in the 3rd quarter of this year. This has helped to revive domestic demand as an engine for growth in the economy,” Dr. Kang said.
At the same time, exports have also been accelerating. Starting in the middle of this year, overseas demand for Korean exports, especially for high-technology products, has gathered renewed momentum. Electronic exports account for nearly one-third of Korean exports, and have helped to drive the recovery in Korean exports this year, growing by nearly 25 percent. And the outlook for exports remains favorable. Recent data on U.S. computer and electronics orders have picked up strongly in the 2nd half of this year, suggesting that the momentum in the IT industry will continue forward, helping to lift Korean exports.
“We anticipate that these encouraging trends will continue into next year. As a result, we forecast that growth will accelerate from 3.8 percent this year to 5 percent in 2006. We have not changed our forecasts from our earlier September World Economic Outlook figures. Underlying this forecast is a gradual but accelerating recovery, driven both by domestic demand and net exports. However, there are some risks to the outlook that could cause growth to be lower than expected.”
First, investment still remains sluggish, and it is unclear when it will revive. Second, consumption could be constrained by heavy household debt and slow income growth. Lastly, there are some possible external risks, e.g. oil prices, Avian flu, etc. that could lower demand for Korean exports.
With exports accounting for nearly half of GDP, the projected recovery could be undermined if growth in the industrial countries slows sharply or if there is a significant downturn in the electronics sector.
After a strong performance in the 2nd quarter, facility investment in the most recent 3rd quarter actually declined compared to the previous quarter on a seasonally adjusted basis. Part of the reason is because SMEs, the small and medium-size enterprise sector in South Korea, continues to suffer from excess capacity and thus are not in a financial position to invest. In addition, although large corporations are earning record profits and are investing, their willingness to invest has declined.
Part of the reason is that corporations are now investing more overseas to take advantage of low-cost labor but also to produce closer to their main markets. In addition, labor market rigidities in South Korea have raised the cost of risky investment and discourage large enterprises from investing in the domestic economy. Partly because investment still remains weak, the benefits from large corporations’ record profits have not spread yet to the household sector.
“Growth in real household income--that is household incomes after adjusting for inflation--has remained steady for the past year, at less than 2 percent per year. Real incomes are now growing less than household spending. Slow growth in incomes combined with the household sector’s heavy debt burden could slow the recovery in consumption looking ahead. Household debt as a percent of GDP remains near its peak in 2002 of around 60 percent. Without a sustained improvement in household incomes and employment, it is possible that households may wish to—or be forced to—increase their saving further in order to pay down their debts.”
On the external side, with South Korea depending on imported oil for much of its energy needs, higher sustained oil prices could lower overall growth. South Korea compared to other economies in the region is more dependent upon oil. It is the world’s 4th largest importer of oil, with oil imports accounting for 4.5 percent of GDP. However, oil prices have recently stabilized, and the futures market for oil indicate that oil prices could decline further over the medium-term.
On the ways to promote the recovery, he said that macroeconomic policies will need to continue supporting the economy. Strong government policies can play an important role in boosting confidence and safeguarding against the risks to the recovery. In addition, structural reforms also needed to help ensure the recovery matures into rapid and sustainable growth.
“In 2005, fiscal policy turned expansionary with cuts in income and excise taxes, strong frontloading of government spending, and a supplementary budget. For 2006, we agree that the government should aim for a neutral fiscal stance, targeting another small deficit in the budget (excluding social security funds) next year. This will ensure that fiscal policy remains supportive of the recovery in 2006.”
Turning to monetary policy, real interest rates in South Korea are still low by historical standards, helping to provide support to the recovery. But the main goal of monetary policy is price stability, and despite the run-up in oil and raw material prices, inflation pressures remain weak. Despite higher oil prices, headline CPI inflation (red line) fell in October to 2.5 percent (y/y). Core inflation which is the target for the BOK (blue line) also fell to [1.9] percent and is now well below the lower bound of the BOK’s target range of 2.5 – 3.5 percent. Since inflation pressures remain subdued, there is room for the Bank of Korea to maintain a “wait and see” attitude on interest rates until the recovery is more firmly established, he said.
The first critical area for reform is revitalizing the SME sector. First, it is useful to keep in mind that SMEs are an important part of the economy. SMEs account for 85 percent of employment; 50 percent of manufacturing output; 40 percent of exports. There is no typical SME since they cover such a wide range of sectors, ranging from retail and real estate to IT. Many SMEs have been hit hard by the weak domestic economy. According to some estimates, around 1/5 of manufacturing SMEs are incurring losses, with more than 1/3 unable to generate sufficient operating income to cover their interest expense.
However, the sector also faces some severe structural problems. SME reforms are needed because this key sector continues to lag behind the rest of the economy, as many of its enterprises are overburdened by debt and threatened by overseas competition.
To address this problem, a two-pronged strategy needs to be put in place. First, some restructuring will be necessary. Currently, restructuring is being hindered by the extensive system of credit guarantees, which provide subsidized credit to certain firms, helping them to survive but making it harder for others to compete with them.
Finally, South Korea’s financial sector has already advanced considerably over the past few years, and it has considerable potential to develop further. Particularly since demand for financial products will grow rapidly as the population ages and workers save for their retirement. Over the medium-term, this represents an important source of potential growth for the Korean economy! Further developing the financial sector will not only raise overall productivity in the service sector, but also help lay the foundation for a shift to a more knowledge-based, advanced technology economy. But for this potential to be realized, the sector needs to be deregulated further, to encourage competition and innovation.
At the same time, it will be necessary to upgrade financial supervision to keep pace with these changes, most notably by ensuring that all sales of financial products are supervised in the same way, no matter which firms are selling them, thereby ensuring a “level playing field” for all financial institutions. In addition, there is a need to enhance the flexibility of the labor market to ensure that South Korea remains an attractive place to invest, both for domestic and foreign companies.
“Overall, the IMF remains fundamentally optimistic about South Korea’s economic prospects. One important reason is that government is putting in place measures to sustain the recovery which gives us reason for being optimistic. Another is that the fundamentals of the Korean economy remain sound. Looking ahead, the key challenge for policies will be to ensure that this recovery is rapid and sustainable,” he said.
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