Economy to Maintain Growth Momentum in 2008
By Lim Ji-won
JPMorgan Vice President and Senior Economist in South Korea
Korea's economic activity stayed relatively firm this year, with solid exports and improving consumption. We expect Korea's real gross domestic product (GDP) growth to stay around its potential in 2008, with the gap between exports and domestic demand down slightly further.
Still, it should be noted that the global growth environment will remain fluid for now, with progress in the US subprime mortgage problems and global oil price movements as key risks to watch.
Internally, the outcome of the presidential and the legislative elections and the ensuing changes in policy will matter, notably for business investment decisions. Meanwhile, consumer inflation is expected to see a gradual acceleration, with the balance of payments more likely to deteriorate. We expect the Bank of Korea to keep interest rates on hold at 5.0% in 2008.
Real GDP growth moderated in the third quarter, but still outperformed its potential. Some of this slowdown was well expected, with the gain in the second quarter on the early bounce of global manufacturing upturns.
Korea's growth is expected to slow slightly further for now, with the US subprime mortgage problems pressuring the U.S. and European economies.
Still, unless the global liquidity crunch worsens further from here, Korea's growth should be stable around its potential next year, albeit through quarterly volatility. We expect real GDP to rise 4.9 percent in 2008, following a 4.7 percent rise in 2007.
The exports outlook is less bright, but the composition of exports offer some comfort. Traditionally, Korea's exports have a strong correlation with the global business cycle. According to a commonly used rule of thumb, Korean exports decline about 4 percent when global GDP slows by 1 percent.
Still, it should be noted that Korea's exports have become more diversified than before, and are less sensitive to country-specific and sector-specific shocks. Given that much of the prospective global slowdown is expected to concentrate in the U.S. and Western Europe, any direct impact on Korea exports should be less serious than some years ago.
Another potential cushion is the large backlog of orders currently being filled by Korea's shipbuilding industry. Export orders for vessels have surged since 2004, but it takes about two to three years to complete a vessel. Therefore, export shipments resulting from the surge started only in late 2006, and will likely continue for a couple more years
Private consumption has steadily improved, with the movement in equity prices creating a positive wealth effect due to the continued shift of the household sector portfolio from bank deposits to stock investments.
According to the Bank of Korea's fund flow data, about 21 percent of individuals' financial assets are in the form of stock holding this year, up from 14 percent in 2003.
Such a portfolio shift, accompanied by equity market rallies, has so far worked in favor of the household sector's balance sheet, dropping the overall debt ratio to financial asset values from 49 percent in 2003 to 45 percent in 2007. Consumer sentiment too has stayed at elevated levels, not much affected by global financial market tensions in recent quarters.
That said, caution is warranted for several reasons. First, labor market reports and anecdotal evidence of collective wage negotiations suggest that household income conditions will not improve much.
Second, the debt-servicing burden is likely to rise further. Loan maturity structures have been shifting, with three-year bullet loan mortgages now comprising less than 30 percent of the total, down from 60 percent in 2004.
Given a constructive change in long-term efficiency, this suggests that household sector's debt-servicing burden will rise, as long-term maturity loans require installment payment of principal, albeit with a two- to three-year grace period.
Such a burden would be more painful if interest rates move upward, with about 80-85 percent of housing loans still with floating-interest rates. Finally, domestic pass-through of global energy price hikes will also matter, especially if accompanied by food price inflation.
Rising corporate facility investment
Fixed investment fell sharply in the third quarter, with a decline in business equipment and construction investment. Still, much of the fall in equipment investment is due to the technical payback for previous quarters' strength when investment was flattered by one-off factor that financial institutions replace cash machines following the introduction of a smaller size of paper money.
Based on a solid rebound in domestic machinery orders, favorable inventory condition and relatively positive business confidence, we believe that equipment investment would improve in the coming quarters.
However, construction investments will likely stay soft, with the gain in public sector activity mostly offset by continued adjustment in residential construction.
Neutral monetary policy
The Bank of Korea's policy stance appears balanced, hinting at few rate actions in the foreseeable future. Economic activity has stayed firm, but still accompanied by rising expectations of a global slowdown.
Meanwhile, the inflation environment is also turning less favorable, with global commodity prices on the rise while the output gap seems to have almost closed by now.
Of course, headline consumer prices are unlikely to overshoot the Bank of Korea's target band of 2.5 to 3.5 percent anytime soon, but still edging up steadily to move in the upper range of the target band in 2008.
Accordingly, the BOK is more likely to resume a tightening bias in the middle of next year although this forecast still requires the condition that the global economy be stabilized by then.
Key risks to watch
Our 2008 growth forecast assumes that global growth would decelerate but not turn into a serious downturn. Indeed, the 2008 outlook seems to be less exposed to local risks, but more global ones, such as the progress of U.S. subprime mortgage problems and movements in oil prices.
The global growth environment is extremely fluid, with the U.S. subprime mortgage problems still persisting. Relative diversification of Korea's export composition could insulate exports from the U.S.-led global slowdown to some extent, but not completely.
If the U.S. slowdown is serious enough to affect Korea's other trading partners' economies, exports would eventually slow.
We also assume global oil prices will decline, stabilizing below the current level.
An energy price rise will dampen households' purchasing power, but we also note that such an effect could still be moderated by the adjustment of tax rates on oil product prices.
However, the export sector will also eventually reflect the second order impact, through a slowdown of global demand. According to a simple regression model, an increase of about 10 percent in global oil prices reduces Korea's GDP by 0.16 percentage points.
Also, exports have stayed relatively firm, weathering the appreciation of the won. However, such an outcome is at the cost of corporate sector profits, which appear to have peaked in 2004.
A strong positive correlation between the won's strengthening and small and mid-sized companies' (SMEs) share in Korea's exports confirmed that SMEs are the hardest hit from strength in the currency.
JPMorgan maintains the view that the won appreciation has almost run its course, especially in trade-weighted terms.
Meanwhile, Korea will vote in a presidential election on December 19 and legislative elections in April 2008. Based on previous history, various types of coalitions among candidates and parties could occur in the coming months, keeping the political landscape uncertain.
The outcome of the election would also be important, especially for long-term issues such as service sector deregulation and public sector reforms. In the very near term, the real estate and construction sector outlook would be most sensitive to progress in the political environment.