[Contribution] What G2 growth divergence means for Korea

Stephen Lee is a chief economist at Meritz Securities Korea in Seoul. Courtesy of Meritz Securities Korea

By Stephen Lee

Despite concerns about a property-driven downturn in growth in China, Korean exports are likely to improve thanks to a manufacturing recovery in both the U.S. and China. In the medium term, Korean trade is likely to be influenced greatly by the U.S.

G-2 divergence

Early this year, forecast consensus concerning U.S. and Chinese 2023 GDP growth was at 0.5 percent and 5.1 percent respectively. Investors thought that the U.S. economy would run into a recession while China would benefit from reopening.

Now, the estimates for the U.S. and China have changed to 2.0 percent and 5.0 percent respectively. The U.S. has shown resilience in consumption with a surprise rebound due to investment. While in China, the impact of reopening was short-lived, with concerns rising due to the property industry along with credit risks caused by overly zealous developers.

What will be the implication for the Korean economy? Should we be expecting problems from our neighbor, as we are more dependent on China than the U.S. in terms of trade? Alternatively, should we be looking at some positives due to U.S. investment recovery?

Investment recovering in US

While consumption is showing resilience, growth is set to slow down as the labor market finally starts to cool down. On the other hand, the investment cycle has started to pick up despite the banking sector's lending attitude worsening further ― limiting bank credit availability.

The recent recovery in private fixed investment looks unusual because investment tends to contract when credit is less available for firms. Previous cases when banks tightened lending saw a surge in credit spreads for corporate bonds, causing hardships for firms' funding.

Today's case, however, is different. Corporate bond markets have stabilized; hence, firms with investment-grade ratings can easily issue investment bonds. Here is one example. IBM, Micron, Intel, and Texas Instruments ― the four Big-Tech companies that are heavily into structured investments ― have issued a combined $19.5 billion in corporate bonds from January to July this year, compared to $13.9 billion for the full year of 2022.

Manufacturing activities are also set for a recovery it appears. Surveys of purchasing managers from the Institute for Supply Management (ISM) serve as a good early indicator. Starting in June, customers of manufacturers started to use up their existing inventories and put in new orders. This has led to a rise in production and order backlogs. With signs of investment demand recovering in the U.S., the manufacturing industry has likely bottomed out.

In recent months, the labor market has cooled down, causing consumption growth to slow and the deflationary trend to be prolonged. Job openings-to-unemployment ― a measure of labor market tightness ― came down to 1.53 in July and is estimated to have fallen more to 1.38 as of August, close to the pre-COVID-19 equilibrium of 1.24.

Wage growth is slowing and quitting rates are coming down as well, which serve as drivers for service sector inflation cooling further. Additional rate hikes seem unnecessary at the moment.

China entering long-term downward trend

Concerns about the Chinese economy are centered on the property sector. Real estate accounts for roughly 25 percent of the nation's fixed investment and employment, and 60 percent of urban household assets ― hence the impact of the real estate downturn on the overall Chinese macro level is not trivial.

Real estate investment itself is likely to shrink over the next few years, as housing and new construction start to decline fast. The former has decreased by 26 percent year-to-date, and the latter 22 percent. A declining population and elevated housing inventories are structural reasons behind this, which is certainly a drag on economic growth over the medium term.

Recent policies aimed at invigorating housing transactions have focused on stabilizing the market rather than boosting property and have them be the growth driver. Restoring confidence in the property sector seems to be the key, as households refrain from buying homes. Home prices are no longer rising steeply, and people are less confident as to whether they can live in the property they bought.

A cash shortfall from developers may be prolonged unless property sales recover, as the government restrained lending ― over the past three years ― and developers used up their cash to operate. Lack of transactions is leading to credit defaults from major developers, which can cause housing projects to be delayed and further restrain the ability of new projects to get off the ground.

Implications for Korean exports

What does all this mean for Korea? Despite the huge headwind, surrounding China, the Korean economy, which is based on exports, is more likely to recover next year. This is because of the following characteristics.

First, the property debacle in China certainly weighs on construction and services, which are non-tradable sectors. Manufacturing, on the other hand, has been on a gradual upward trend since May as the country struggles to enhance productivity and continue to support high-tech industries. Moreover, China still serves as a major production base for multinational firms. This will be the factor affecting Korean exports.

Second, Korean exports are centered on business-to-business (B2B) related products, rather than business-to-customers (B2C). Major B2B products among Korean exports are tech (mostly semiconductors), machinery, petrochemicals and oil refining. This shows that Korean exports are more sensitive to the global investment cycle.

Moreover, semiconductors account for one-third of Korean exports to China, which is a function of China's tech exports. China's tech exports are determined by the U.S.' manufacturing cycle, which has just started to recover.

Third, the importance of the U.S.-bound trade may be increasing if we look at Balance of Payments (BoP) statistics. Among BoP-based exports, which include activities from overseas affiliates of Korean companies, the U.S. accounted for 20.2 percent, topping China at 17.9 percent, for the first time since 2004. The transformation of the global supply chain may further increase the influence of the U.S., offsetting the negative impacts of China's growth slowdown.

The writer is the chief economist at Meritz Securities, Seoul.