Economy Faces Stronger Headwinds Ahead

South Korea’s economy posted a growth of over 5 percent both in the second and third quarters. Whether it will sustain its solid growth in coming quarters depends on how it will weather external negatives such as high oil prices and subprime credit woes.

By Na Jeong-ju and Lee Hyo-sik
Staff Reporters

The country's economy has posted impressive growth for the past several quarters, boosted by strong exports. Policymakers and the central bank say the country's economy is in good shape and will fare well going forward, but some economists caution that there are a number of external uncertainties that could threaten its health.

At the center of their worries are surging oil prices, high household debt, a stronger won and sluggish corporate investment.

In the third quarter, the gross domestic product, the total output of goods and services produced in a country, expanded 5.2 percent from a year ago on robust household spending and exports growth. But investment growth slowed further, suggesting that high interest rates are starting to bite as exports begin to slow.

``We look for economic growth in South Korea to cool over the next several quarters, reflecting rising oil prices and high household debt,'' according to Frederic Neumann, an HSBC economist.

The Bank of Korea remained confident that economic growth will continue, but cautioned that higher oil prices and the slowing U.S. economy could negatively affect it.

``GDP data showed strong growth again in the third quarter. Still, it's a bit hard to predict the fourth-quarter growth due to some negative external factors, like rising oil prices and the slowing U.S. economy,'' said Choi Chun-sin, director of the BOK's economic statistics department.

In October, the central bank raised its annual growth forecast for 2007 to the 4.5-5 percent range, compared with its previous estimate of 4.5 percent, citing strong exports and a recovery of private consumption.

The Ministry of Finance and Economy also recently forecast the economy would grow at the high end of the 4-5 percent range in 2007, up from its initial forecast of 4.6 percent.

In the third quarter, headline growth accelerated to 5.2 percent year-on-year, a touch above the consensus and up from the previous 5 percent. Importantly, the recovery in private consumption is gathering speed, with household spending rising 5 percent from a year ago compared to 4.2 percent during the previous quarter, reflecting the bounce in consumer confidence that has gripped the country.

Meanwhile, net exports continued to be supportive _ although export growth slowed to 9.2 percent from 10.6 percent in the second quarter, in part due to the delayed effects of the won's rapid appreciation, import growth decelerated faster to 7.1 percent year-on-year from 12.3 percent.

Altogether, the Korean economy put in an impressive performance in the third quarter, registering its 35th consecutive quarter of growth.

Fading Momentum

But, a closer look at the data shows the negative side of the recovery, according to analysts. They say the going will get a little tougher, with growth likely to cool off over the next several quarters. In some respects, this is already apparent in today's headline numbers _ while GDP expanded at an impressive pace compared to last year, output growth slowed to 1.4 percent in the third quarter from 1.8 percent quarter-on-quarter growth.

``Altogether, these are still respectable numbers, but, evidently, momentum is fading,'' said Neumann.

Lim Kyung-mook, a research fellow at the Korea Development Institute forecast the country will record over 5 percent economic growth in the fourth quarter, but cautioned the country faces growing uncertainties.

``There are some external factors that can hamper economic growth, but it remains to be seen whether the country will be able to overcome them to continue strong growth,'' Lim said.

``There are encouraging signs of economic recovery everywhere, but there are also wake-up calls,'' said Ha Joon-hyung from the Korea Institute Finance, citing surging oil prices and the possibility of a global credit crunch.

More specifically, there are a number of factors that suggest that the economy will face stronger headwinds.

Take investment, while most of the components of today's GDP release were fairly solid, the real surprise was the sudden slowdown in capital outlays by private businesses. After growing at double-digit rates during the first half of the year, spending on facilities expansion slowed to 2 percent year-on-year. Overall investment fared little better as construction activity continues to languish _ gross fixed capital formation rose a mere 1.8 percent year-on-year, down from 6.7 percent previously and the slowest pace in five quarters.

Of course, the slowdown in investment spending partly reflects payback from the rapid rise seen in previous quarters.

But, suspicions linger that something more fundamental is going on as well.

Even if growth rebounded over the last two quarters in Korea, businesses are likely to remain cautious regarding the prospects for a continued acceleration of growth, putting on hold their more ambitious capital expenditure plans. Clearly, the operating environment is getting tougher for many of Korea's companies _ the Bank of Korea hiked interest rates twice over the summer and maintains a firm tightening bias. The real policy rate lingers near its highest level in years, with market rates higher still due to the global credit jitters that have left Korea's financial market not entirely unaffected.

Mighty Won

Equally important, the rapid appreciation of the won is beginning to take its toll. To be sure, export growth remains remarkably robust, but anecdotal evidence suggests that Korean companies have allowed their profit margins to absorb most of the blow from the adverse exchange rate movement.

There is, moreover, a structural factor at work here, too. Following the Asian financial crisis, Korean exporters benefited from domestic deflationary forces, which kept operating costs under control.

In addition, the massive depreciation of the won provided a boost to profitability, which only wore off over time as the currency began its steady climb against the dollar. As a result, the period of extraordinary profit growth is coming to an end _ for the last two years, the ratio of operating profits to GDP for non-financial firms, as measured by national accounts, has declined.

While profits remain high by historical standards, the fading dividend of low operating costs and the won's recent rise against the dollar suggest that the going is likely to get tougher. Profits as a share of national output, in fact, will have to fall further if they are to revert to their pre-crisis level.

The won has gained its pre-crisis level already and is expected to gain further.

``The U.S. central bank's decision to lower a key interest rate to 4.75 percent from 5.25 percent in September accelerated the dollar's weakness against the won and other currencies,'' said Cho Hyun-seok, a currency dealer at the Korea Exchange Bank (KEB). ``Currency dealers and companies are betting that the U.S. will further cut the rate to boost its economy amid growing signs that the subprime mortgage defaults are spreading to the broader economy.''

He also said currency traders and central banks across the globe are increasingly trying to reduce their dollar holdings and are staying away from dollar-denominated assets, further weakening the greenback.

``The dollar will remain weak at least throughout the year and possibly for the next two years as the U.S. economy is forecast to slow down. Unless the U.S. finds ways of curtailing huge fiscal and trade deficits, it is unlikely that the greenback will gain upward momentum because increasing U.S. deficits will continue to flood the global currency market with dollars,'' Cho said.

Bubbly China

Another external risk for Korea is rapidly rising Chinese consumer prices. China has played the role of a global factory, churning out various products at lower costs.

But rising inflationary pressure in the world's fastest growing economy could make its products more expensive, forcing consumers in Korea and other countries to pay more for Chinese-made goods. At the same time, the Chinese central bank is tightening its monetary policy to keep its economy and stock market from overheating further.

``Inflationary pressure has built up in the Chinese economy for months mainly because of surging food prices. High consumer prices could discourage Chinese consumers from spending, reducing Chinese demand for Korean made products,'' said Song Tae-Jung, a senior economist at LG Economic Research Institute.

The Chinese central bank will likely raise its key interest rate to rein in inflation, which will negatively affect consumer spending, dealing a blow to Korean exporters

Consumer prices in China increased 6.2 percent in September from a year earlier, far higher than the government target of 3 percent, due to hikes in prices of pork and other food items.

Song also said high consumer prices will lead to a wage hike and will negatively affect Korean companies operating in China.

Costlier Energy

Apart from such structural factors, there are other things to fret over.

Take oil prices for example, the steady climb of the cost of crude on world markets in recent weeks is causing particular head-scratching among Korean officials and executives _ the economy is among the most energy intensive in the world, with the country being the fifth largest net importer of crude oil. So far, a rising exchange rate has taken much of the punch out of higher dollar prices for oil, but it is only a matter of time until higher energy costs squeeze margins and fan inflation.

``International oil prices have increased more than 52 percent this year as the demand from China and other developing countries continues to rise, while the oil supply has remained unchanged across the globe. Also, speculative forces have recently come onto the market, further pushing up prices. The dollar lost its strength following the U.S. rate cut and international funds started rushing to the oil and raw material markets,'' said Song.

He said strong oil demand indicates the global economy is growing, which is positive for local exporters. ``But high oil prices make products more expensive, worsening profitability of local companies and forcing local consumers to spend less.''

Slowing Overseas Demand

Apart from energy, Korean boardrooms also keep a wary eye on the state of the US economy _ despite all the noise about Asian de-coupling, the country remains particularly exposed to demand conditions across the Asia Pacific region.

Shin Min-yong, a senior economist at the LG Economic Research Institute, said the U.S. economy will slow for the remainder of the year and beyond, affected by the stagnant housing market and the unstable credit market.

``The sluggish U.S. housing market will likely continue for the foreseeable future, weighing down on the overall U.S. economy. If the U.S. financial market jitters carry on and its economic slowdown is substantial, worsening conditions will prompt U.S. consumers to save more and spend less, purchasing fewer products from South Korea and other emerging economies,'' Shin said.

Altogether, then, with financing costs rising at a time of falling profit margins and an increasingly uncertain global demand outlook, better keep those ambitious investment plans on the shelf.

Does subdued investment growth mean that GDP growth is about to fall off a cliff? Not quite. One remarkable development this year has been the rebound in household spending.

At a time when the outlook for exports is becoming more uncertain, strengthening domestic demand growth will serve as a welcome buffer. But, some caveats are in order here. High household indebtedness, while not derailing the recovery in consumer spending, will certainly serve to restrain it.

Therefore, any significant upside to private consumption growth is likely to be limited for the time being.

To be sure, a booming stock market is providing a bit of a drive to personal spending, helping to push up sales of consumer durables such as cars.

But, such wealth effects can evaporate as quickly as they appear _ for a sustainable rise in private consumption, higher real wage growth remains the most important driver. Unfortunately, so far, there is little evidence that incomes are rising more rapidly, leaving consumers to struggle with burgeoning financing costs for their considerable debt.

What, then, is the bottom line? By and large, the third quarter GDP numbers are fairly reassuring.

However, economic growth may have already peaked _ not only do firms appear cautious about raising capital expenditure aggressively, perhaps sensing that the cycle is about to turn, but the outlook for exports is beginning to sour at a time when households continue to grapple with record indebtedness.

None of this is to say that growth in Korea will collapse. HSBC predicts South Korea will record 4.5 percent GDP growth for 2008, which represents a slight cooling from an estimated growth rate of 4.8 percent this year.

The Korea Development Institute raised its forecast for 2007 growth to 4.9 percent from the previously estimated 4.4 percent, adding the economy is projected to expand 5 percent next year. Also, Samsung Economic Research Institute (SERI) and LG Economic Research Institute expect the economy to grow at a faster pace in 2008, putting the next year's growth rate at 5 percent.

And the Bank of Korea? With risks to economic growth mounting, despite a reassuring headline figures for the third quarter, the central bank is likely to become cautious about its rate policy at least until the first quarter of 2008 when oil prices start to make themselves felt in elevated inflation readings.

jj@koreatimes.co.kr
leehs@koreatimes.co.kr