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On the face of it, the Korean economy is not performing too badly against its advanced industrial peers. Its gross domestic product (GDP) growth rate of 2.7 percent for the fourth quarter of 2014 was slightly better than the U.S. (2.4 percent) and Canada (2.6 percent) and much better than Japan, Germany, France or Italy. Korea compared well even with the British economy, which at 3 percent was the best-performing among the major European countries.
Nonetheless, there are reasons for increased gloom about Korea's economic prospects going forward. Although the government this month predicted that GDP for 2015 will expand by 3.1 percent, economists are privately warning that growth may slow to as low as 2 percent, half of the growth target of 4 percent that President Park Geun-hye said it would be the goal of her administration.
To understand why the economy is turning sour, one needs to examines the four factors ― net exports, corporate investment, consumer spending and government expenditures ― that make up economic growth.
Start with exports, which are vital to Korea's trade-dependent economy. Exports stumbled in March when they fell by 4.2 percent from a year earlier, the biggest drop since February 2013. This was due to weak demand from China and particularly Europe. The figure would have been even more dismal if it was not for strong demand from the recovering U.S. economy, with Korean exports rising there to 17 percent.
Although some have blamed the weakness of the Japanese yen in undercutting Korean exports, the real problem is soft global demand and a slowing economy in China, Korea's biggest trade partner.
Companies are feeling the impact of weak export growth and are cutting back investment as output falls. Domestic consumer spending might take up the slack except for the fact that wages have barely grown in real terms over the past decade. Excessive debt levels among households, among the highest in the rich world, are further curbing spending.
Government spending could make up some of the shortfall in domestic demand, but it too is facing fiscal constraints as expenditures are already outpacing tax revenues. In the interim, the government is bringing forward 3 trillion won of spending planned for later in the year.
As a result, the government is resorting to a strategy adopted elsewhere of issuing cheap and plentiful money through interest rate cuts to keep the economy afloat. The Bank of Korea in March cut interest rates to 1.75 percent, a historic low, and most analysts believe it will drop to 1.5 percent this year.
A loose monetary policy is meant to stimulate consumer spending by increasing inflation, the theory being that people will spend more to avoid inflation eroding the value of their money if they wait to purchase a product. The central bank wants an inflation rate of at least 2.5 percent.
Unfortunately, the lower interest rate policy is having little effect. Prices are actually falling due to weak demand, which encourages people to hold off on spending since they believe they will pay less for an item later.
This disinflationary trend is affecting other countries as well, including Japan and Germany. The biggest threat posed by disinflation is that it makes any debt burden more difficult to pay off despite lower interest rates while increasing the chances of debt defaults, a particularly worrying development for Korean households.
Another worrying development is that household debt levels increased rapidly in the fourth quarter of 2014 as the government eased rules on bank lending to revive the stagnant property market.
Officials are still hoping that lower oil prices will give more discretionary spending power to consumers.
The government also introduced a new tax on excess corporate cash reserves to force companies to increase investment spending or raise wages, but this has also been met with mixed results.
Officials appear to be running out of ideas for new stimulus measures. Structural reforms appear to be off the agenda, while policy responses are mainly reactive and short-term. There is an increased reliance on fiscal and monetary policy measures to achieve growth. Some are arguing that further rate cuts will be counterproductive since it will only encourage households to borrow more.
Adding to the difficulties is that the Park administration is becoming increasingly preoccupied with corruption allegations affecting the President's inner circle. With no signs of global trade picking up, Korea faces a challenging economic environment.
Even if Korea manages to maneuver through the current economic problems, the long-term challenge for sustained growth remains formidable. Like its troubled Eurozone and Japanese counterparts, Korea faces a daunting list of negative developments, including excessive debt, low productivity growth, an aging population and the threat of deflation.
John Burton, a former Korea correspondent for the Financial Times, is now a Seoul-based independent journalist and media consultant. He can be reached at john. burton@insightcomms.com.
