Strong export growth kept Korea's economy
afloat in 2003 and 2004 despite very weak domestic
demand. But export growth has slowed sharply this
year. Domestic demand, meanwhile, has picked up
modestly, raising expectations of improved
economic performance in 2005. But weakening
external demand and renewed deterioration in
domestic demand will slow GDP growth to 3% in 2005
and below 2% in 2006. Accordingly, Korea's stock
market and exchange rate are also expected to
wilt.
In 2003, South Korea's net exports
accounted for 2.6 percentage points of GDP growth,
which amounted to 3.1%. In 2004, net exports
contributed four percentage points to the GDP
growth of 4.6%. In other words, without the
enormous contribution of net
exports, GDP growth in Korea
would have been less than 1% in both 2003 and
2004. The strength of Korea's exports has in
effect papered over structural political, social
and economic problems that have strongly
undermined domestic demand, especially private
investment and consumption.
The Asian
liquidity crisis of 1997 and Korea's subsequent
economic collapse and exchange rate devaluation
produced long-term changes in the investment
practices of Korea's chaebols. These changes were
born from greater regulation of chaebols, which,
among other things, required these massive
conglomerates to sharply reduce their debt levels.
Improved regulation of the chaebols immediately
pushed private investment growth lower. Investment
growth never recovered its pre-crisis level, which
was typically at double-digit rates in the late
1980s through the mid-1990s. Between 1998 and
2004, the real average growth rate of investment
amounted to only 1.4% annually.
In
contrast to investment, private consumption growth
boomed from 1999. This boom, fueled by readily
available personal credit, lasted until 2002, when
Korea's credit card bubble burst. In 2003 and
2004, real consumption expenditure growth was
-0.3% and 0.2% respectively. Scarce credit and
slowing income growth contained the growth of real
consumption expenditure.
Economic
engine misfiring In 2004, exports soared
31%. But in the first half of 2005, export growth
slowed to 11%. After increasing by nearly 42% in
2004, Korea's exports to China, the country's
largest export market, increased by only 24% in
the first half of 2005. Exports to the US, Korea's
second largest export market, which increased by
25% in 2004, contracted slightly in the first half
of 2005.
The slump in exports in the first
half of 2005 was led by slowing shipments of
computers, wireless telephones and semiconductors.
In addition to the relocation of some export
manufacturing plants overseas, very strong price
competition for Korea's electronics exports from
China has slowed export growth this year. The
relocation of export manufacturing plants overseas
is inspiring the flight of manufacturing capacity
from Korea. Overseas investment by Korean
companies between 2001 and 2004 was equivalent to
$13 billion. This investment is expected to reach
$5 billion in 2005 and $6.5 billion in 2006.
Export growth is expected to continue
slowing in the second half of 2005. The relentless
rise of international oil prices will undermine
external demand for Korea's exports. The ongoing
flight of manufacturing capacity to China will
also push exports lower. In addition, increasing
financial pressure on Korea's small and
medium-sized enterprises will also slow export
growth. Financial pressure arising from Korea's
over-valued exchange rate and high wages will
reduce the activity of these enterprises.
Private consumption In the first
half of 2005, total consumption expenditure
increased at an annual rate of 2.4%. This growth
was comprised of a 2% annualized increase in
private consumption and a 3.7% annualized increase
in government consumption. Investment growth
continued to weaken in the first half of 2005,
advancing at an annualized rate of just 1%. But
strong growth of public sector investment offset
contracting private investment.
The modest
rebound of private consumption expenditure in the
first half of 2005 has prompted hopes for
broad-based, accelerated economic growth this year
and in 2006. Unfortunately, the recovery of
private consumption will be short-lived. Like
exports, private consumption growth will weaken in
the second half of 2005, continuing into 2006.
In the first half of 2005, declining
inflation and the reduction of import taxes on
automobiles and luxury goods helped spur private
consumption growth. Rapidly rising energy prices
will push inflation higher in the second half of
2005 while excise tax cuts are due to expire at
year-end. The potential for additional fiscal
stimulus to private consumption is limited by the
Roh government's legislative minority and
increasing political instability.
More
troubling for private consumption growth will be
rising unemployment, the continued slowing of
income growth and increasing social instability.
The average unemployment rate increased in the
first half of 2005 to 3.9% from 3.7% in 2004.
Unemployment is expected to continue rising in the
second half of 2005 and in 2006. Weakness in the
export sector and the broader manufacturing sector
will push unemployment higher, as will the
accelerating flight of manufacturing capacity.
Slowing income growth has accompanied
rising unemployment. Though industrial action has
helped to increase manufacturing wages, wages in
the service sector, which account for the majority
of employment, have been rising at a much slower
pace. In the second quarter of 2005 the income of
all urban salary earners expanded by only 3.5% in
nominal terms, its slowest rate of growth since
1999. Nominal income growth is likely to slow
further in the months ahead.
Growing
social instability, driven by increasingly
widespread labor strikes, will also weigh on
private consumption. Worryingly, these strikes
have become unusually politically motivated in
seeking changes in both government and industrial
policy. Increasingly, frequent labor strikes are
being fueled by deteriorating governance - a
product of growing political instability.
No legs left to stand on In
addition to pushing private consumption lower,
political and social instability are key factors
preventing the recovery of private investment in
Korea. Political instability is preventing the Roh
government from formulating coherent economic
policies. Social instability is pushing production
costs higher and profits lower. Both of these
factors are encouraging Korean companies to
accelerate overseas investments at the expense of
domestic investment.
Geopolitical
instability could produce a knock-out blow to
Korea's economy in the months ahead. This
instability is being driven by the North Korean
nuclear crisis. Though the Roh government has made
a series of mostly unreciprocated concessions to
Pyongyang, these efforts will amount to little
unless the fourth round of the six-party talks
comes to some kind of successful conclusion.
Unfortunately, more probable will be the failure
of the talks and escalation of the crisis. Any
escalation could trigger a nuclear test by North
Korea as early as the end of 2005, which could
dramatically alter the security situation in Asia,
especially in Korea.
The increasing threat
of military confrontation will add to downward
pressure on private consumption and investment.
Renewed weakness of domestic demand will hold real
GDP growth to about 3% in 2005 and below 2% in
2006. Increasing geopolitical, political, social
and economic instability will push the value of
Korean assets and the exchange rate of the won
sharply lower in the months ahead.
Jephraim P Gundzik is president
of Condor Advisers Inc,
which provides emerging markets investment risk
analysis to individuals and institutions
globally.
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