Korea’s self-defence

Korea’s heavy reliance on exports, which account for half of its economy, and the openness of its capital markets make it particularly vulnerable to external factors. In addition, structural weaknesses could threaten the resilience of domestic demand and attitudes, which President Lee Myungbak has recognised.

“When it comes to the economy, the psychology of the people also matters.

Indeed some people refer to the recent crisis as a crisis of confidence. In order to overcome this crisis of confidence, we need to have confidence in ourselves,” Lee told his audience in a bi-weekly radio address to the nation on October 3.

The government has already lowered its growth projections for this preelection year from 5% to 4.5%, while in August the International Monetary Fund cut its growth forecast for Korea to 4% from 4.5%. Local private think-tanks are more pessimistic. Samsung Economic Research Institute and LG Economic Research Institute reduced their forecasts to 3.6%, citing a likely slowdown in exports as well as mounting household debt that could weaken economic activity.

Industrial production fell 1.9% month-on-month in August, and the decline was for the second consecutive month. This hasn’t happened since 2008, and according to Tkuji Okubo, Korea analyst at Societe Generale, this could be a symptom of a serious crack in the country’s domestic economic activity. At a minimum, he called it “quite concerning”, and might indicate a future weakening in a still resilient external sector.

Declining trade surplus
At first glance the September figures shouldn’t cause too much concern.

Exports rose 19.6% year-on-year, driven by a 40% surge in vehicle sales, apparently helped by an increase in the share of the US market. Oil and steel shipments were also strong, and electrical and electronics exports ­ which normally make up 30%-to-35% of the total ­ stabilised. As Wai Ho Leong, economist at Barclays Capital pointed out, export momentum turned positive in September after three consecutive negative months.

However, part of the strength is attributable to the rise of export unit prices due to higher oil prices, as well as increased exports to Japan and other Asian countries due to Japan’s reduced production and export capacity, noted Citi’s Korea economist Jaechul Chang.

And “a decline in Korea’s export growth looks unavoidable with fiscal drags in advanced countries,” despite exports to emerging markets now making up 73% of the total compared with 51% a decade ago.

The country’s trade surplus is still a healthy $22.4 billion year-to-date, but Leong is sceptical about whether the full year target of $29 billion will be achieved. The recent trend has been a narrowing of the surplus.

Indeed, the finance ministry said in a statement last month that “the trade surplus is unlikely to widen as export conditions weaken from a global economic slowdown while imports are expected to continue growing due to high oil prices.”

Nevertheless, a 30.5% rise in imports in September provided evidence of continued robust domestic demand, although the effect of a 9.5% fall in the value of the won against the US dollar on commodity prices can’t be ignored.

But inevitably a weaker won and a dependency on commodity imports, including food, is fuelling inflation.

And as Leong noted, “inflation remains a top political issue in Korea”.

The Seoul mayoral elections will be held on October 26, and “anti-inflation rhetoric is likely to pick up in the mainstream media”.

Headline inflation jumped to 5.3% year-on-year in August, from 4.7% in July and has shown an upward trend for most of the year.

Yet, most analysts now expect the central bank to take a tentative stance, given what’s happening in Europe and the US. In fact, recently, the Bank of Korea said that it will not aim to pursue its 4% at the expense of economic growth.

Citi’s Chang believes that it will keep the policy rate on hold at 3.25% until the end of the year, “given that fiscal drags in advanced economies will continue to pose downside risks to the country’s growth via moderation of production and exports”.

Against a threatening external backdrop, it is important that Korea should have sufficient defences and ammunition to face-off challenges from nervous investors.

Vulnerable markets
Markets have reacted nervously, to say the least. Overseas investors have fled the equity market, causing a sharp fall in the Kospi index and a drop in the value of the won against the dollar. The won is the second worst-performing emerging Asian currency this year after the Indian rupee, approaching a one-year low against the dollar, and plunging 9% in September alone.

Foreigners’ net sales of Korean equities during the first three weeks of September amounted to W1.9 trillion ($1.58 billion), sending the Kospi down to below 1,700 compared with 1,880 at the end of August.

Certainly, those withdrawals have been part of widespread risk aversion or general fear among funds. But, the earnings outlook for corporate Korea also looks tepid.

Brokerages have downgraded 2012 operating profits for some of Korea’s biggest companies significantly during the past two months. These include Hanjin Shipping, whose projected operating profit was slashed by 45%, LG Display by 37%, and Hynix Semiconductor by 30%, according to local financial information provider FnGuide, whose figures are based on the average of at least three securities firms’ forecasts.

Debt market indicators are also worrying. The credit default swap premium on Korea’s five-year foreign currency bonds, which reflects the cost of hedging credit risks on sovereign debt, closed at 219 basis points at the end of September, up 91bp from a month earlier. That was the highest level since May 1, 2009, and the largest one-month jump since October 2008 following the collapse of the Lehman Brothers, according to the Korea Centre for International Finance.

But, these market fears seem overdone. Korea’s defences look mostly — although not entirely — solid.

According to the Strategy and Finance Ministry, the country’s national debt is estimated to reach W448.2 trillion next year, up W25.5 trillion from an estimated W422.7 trillion in 2011. But, that only represents 33% of Koreas’ gross domestic product, which is about a third of the average 98% of the members of the Organization of the Economic Cooperation and Development (OECD).

The country’s foreign exchange reserves have increased from $20 billion at the end of 1997 to $300 billion today, and are the world’s seventh-largest. The central bank certainly has the firepower to fight back against speculative attacks on Korea’s currency or sudden outflows from its local bond market.

Exposed flank
However, there is one major weakness: the country’s mountain of household debt that now amounts to a year’s entire GDP. Korea’s household debt grew by nearly W10 trillion in July and August, despite measures by the country’s financial regulator to rein in consumer borrowing in June. Tighter loan-todeposit ratios for mortgages and other restrictions have had little effect: individuals and families can’t stop borrowing.

Household debt increased an average 13% each year between 1999 and 2010, nearly double the 7.3% nominal growth in GDP over the same period, according to government data, and is now 1.5 times the average annual disposable income.

Only households in the UK among OECD countries are more profligate.

The obvious danger is that declines in industrial production caused by slower demand for exports might lead to job losses in the manufacturing sector, reduced incomes and a wave of debt defaults. Fortunately, Korea’s unemployment rate at 3% is low and less than the historical average of 3.75%.

But the country’s politicians are anything but complacent, particularly with presidential and national assembly elections looming next year.

President Lee activated an “emergency economic system” of regular industry and government consultations at the end of September.

Substantive measures will be introduced if there are signs that Koreans’ self-confidence slides and their psychology weakens.