What euro crisis and China's sliding mean to Korea
Since the second half of last year, worsening global risk factors including the eurozone’s fiscal crisis had led to a severe slump in the Korean economy. With an unfavorable global environment such as this, sluggish exports combined with weak domestic consumption and investment brought 3.3 percent economic growth in the fourth quarter, which was surprisingly lower than expected. Early this year, however, as global conditions improved and domestic economic sentiment indicators showed signs of turning positive, optimistic views on economic recovery had temporarily come to the fore.
But with the possibility of Spain requesting a bailout growing recently and the second general elections coming up in Greece, the eurozone’s fiscal crisis has once again come into central focus. In addition, a pessimistic view on the possibility of a hard landing in China has been gaining support. As a result, the Korean economy in the second half may be mostly affected by these two global events: the eurozone’s fiscal crisis and the economic recovery in China.
There are three scenarios that we may forecast in relation to Greece. The first scenario is one where the incumbent party forms a government and continues with the retrenchment policy or partially re-negotiates it. The result is unlikely to have a big impact on the Korean economy.
The second scenario is where the opposition Syriza party comes to power and totally resists the current retrenchment policy but still finds Greece remaining in the eurozone. This is the scenario that may very well pose a significant threat to the world economy for a long time.
The last scenario is one that would find Greece resisting the current retrenchment policy and exits the eurozone. If, under this scenario, the crisis spreads to Spain, Italy and other European countries, the impact may be worse than the Lehman Brothers collapse as witnessed in 2008.
At this point, the first scenario seems most probable, but neither should we ignore the possibility of the second or third scenarios either. If we assume the first scenario and the Chinese economy grows by 8 percent, the Korean economy should see 3.4 percent economic growth this year.
However, if we assume the second scenario and China’s economy grows by only 7 percent, Korea’s economy is likely to grow under 3 percent for the year. The Korean economy may be affected most severely under the third scenario and where economic growth in China falls below 7 percent. Here we cannot exclude the possibility of minus economic growth in the second half.
It is probable that these unfavorable global conditions, when they are taken into consideration together with diminishing fiscal policy breathing room in the second half, have underpinned the calls for the Bank of Korea to cut the policy interest rate preemptively to boost the economy.
But considering the household debt problem and the negative effects that it may have on consumer prices, lowering the interest rate may not be as easy as it sounds.
On the other hand, with inflation falling recently, raising the interest rate may not actually be necessary in the short-term. However, with real interest rates hovering near zero, incrementally increasing the interest rate may be what is needed for the mid-to-long-term.
Consequently, for the first scenario, the policy interest rate should stay in and about where it is now for the time being. It is only when the Korean economy is on the right track towards recovery that the stalled efforts from the second half of last year to normalize the interest rate resume once again.
For the second scenarios, lowering the policy interest rate is needed to shield from unstable financial markets and a contracting economy. If we come to face the third scenario and there is a hard landing in China, we would need to pay particular care to the possibility of having to lower the interest rate to where it was during the 2008 global financial crisis.