Korea Economic Forum: where are we heading for?

Despite a robust performance and upbeat outlooks for the Korean economy, uncertainties among investors and market participants are growing larger than ever due to a myriad of external challenges surrounding Asia’s fourth largest economy, such as soaring oil prices, a slowdown in China’s growth and lingering debt woes in Europe.

Against this backdrop, we, the BusinessFocus team, have conducted in-depth interviews with five global economists ― HSBC senior economist Frederic Neumann, Moody’s vice president Tom Byrne, Wharton School professor of management Mauro Guillen, ING Group senior economist Tim Condon and Morgan Stanley economist Sharon Lam ― to examine the current state of the economy and predict its future course. The following round-table discussion has been reconstituted based on separate interviews, which were conducted through email and phone calls from April 11 to 19. ― ED.

By BusinessFocus team

Growth and inflation
Q: The International Monetary Fund (IMF) is maintaining Korea’s GDP growth outlook of 4.5 percent for this year. But it recently raised its inflation forecast to 4.5 percent from 3.4 percent, which is higher than the policy target of the Bank of Korea (BOK). What’s your take on these figures?

Tom Byrne: I agree with those figures. Although inflation forecast will likely average 4.5 percent for the year as a whole, I see the possibility of it trending down by year-end to 4.0 percent.

Sharon Lam: The IMF GDP forecast is reasonable. I expect Korea’s GDP growth to normalize in 2011 after a robust post-crisis recovery in 2010. Meanwhile, I think domestic consumption will moderate faster this year as inflation is hurting consumers’ real purchasing power.

Frederic Neumann: The challenge will be tomaintain price stability. My inflation forecast for 2011 is at the upper end of what the IMF is predicting, which implies that for the full year headline inflation may be above Bank of Korea’s target range.

Lam: For me, the IMF’s inflation forecast seems to be more to the higher end. I expect consumer price index (CPI) growth to be highest in the second quarter and peak around June and July this year as food prices are easing after the winter months and the containment of foot-and-mouth disease. However, oil price is the swing factor and may delay the peaking of CPI growth.

Q: What do you think are the main obstacles to Korea’s economic growth?

Neumann: The number one risk facing Korea currently is the rise of oil prices. The Korean economy is heavily dependent on imports of crude and still highly oil intensive. Moreover, Korea is quite dependent on export growth and high oil prices could slow demand elsewhere in the world, thus dampening Korea’s surging export performance.

Lam: Yes, highflying oil prices can slow down the global economy. In this scenario, Korea’s current account will quickly turn into a deficit. If the Korean won depreciates, it will only exacerbate the inflation problem, causing further downside to domestic demand.

A shrinking current account surplus and hot money flows will also lead to volatility in the currency. It can cause large swings in exporters’ profitability and can also complicate inflation outlook.

It will also attract speculation in the currency market which will increase the risk of foreign exchange losses in the private sector, at banks and even the central bank.

Mauro Guillen: I would say that the uncertainty about China’s economic growth and inflation outlook, and uncertainty about the economic recovery in Europe and the U.S., which are South Korea’s biggest markets, are the most significant sources. Uncertainty about energy prices is also important.

Neumann: A second big risk facing Korea is that low interest rates may over time encourage another rise in household debt. So far, of course, consumers have not raised their debt levels too aggressively, partly thanks to the government’s prudent mortgage guidelines. But, as long as interest rates remain low, further debt build-up always remains a risk.

Q: By what degree will high inflation and high oil price undermine growth?

Byrne: The rise in oil prices is a headwind to Korea’s economic growth. Should the oil price rise about $120 a barrel and remain there for a sustained period, the effects will be more severe.

Guillen: A high oil price is a tough problem for an importer from the dollar area, like Korea. If it stays high, it will slow down growth, maybe by 1 percentage point. Note that this problem also affects Korea’s export markets in Europe and the U.S.

Neumann: Exactly. At these levels, oil prices can harm economic growth globally, and especially in the West. If this occurs, the real risk from high oil prices is not so much inflation but slump in growth. That’s why it is so challenging for policymakers to react to rising crude prices.

Inflation, meanwhile, is driven primarily by food costs and rising pressure at the core level, and it is this that a central bank needs to address.

Lam: Inflation is harmful to consumption in Korea because Korean households’ savings rate is very low at roughly 3 percent. This means Korean consumers do not have enough savings to buffer against price increase.

Inflation therefore quickly eats into consumer sentiment and real purchasing power in Korea. High oil price is not only bringing inflation to Korea, but it can also bring trade deficits which can compress profit margins, deplete nominal national income, and also weaken the currency.

Q: Following the global financial crisis, Korea’s economic growth potential has been weakening further. The BOK says that the growth potential has fallen to 4 to 4.5 percent from 5 to 6 percent. What’s your opinion on this?

Guillen: The key here is to continue increasing productivity. Also, the Korean economy is increasingly a service economy. Therefore, the government needs to liberalize services.

Lam: I think a 4.5 percent potential growth rate for an economy at an income level like Korea is not low. A slow transition from a manufacturing-based economy to a service-based one is causing a mismatch in the supply and demand in the labor market demand.
The question is not about how to boost growth potential but how to maintain the current growth rate. I suggest the government maintains its emphasis on R&D not just for existing industries but also to find new growth industries; develop regional economies outside of Seoul; and accelerate the development of the service sector.

Neumann: I agree that potential growth of 4.5 percent is a very respectable rate given Korea’s high income level. Raising this level further will be quite challenging, especially given the headwinds of an ageing population.

The government may need to strengthen productivity growth in the economy by putting further emphasis on research and development, and especially, improving productivity in the service and retail sectors of the economy, which lags the impressive manufacturing sector. Policies here include not only subsidies and targeted tax breaks, but also encouragement of competition among firms as well as liberalization.

Q: Is household debt a serious problem? Can it be tamed?

Guillen: I do not think it is as big a problem in Korea as it is in other countries. Also, Korean households have a high savings rate.

Condon: I agree with Guillen. I do not think the high level of household credit is a problem. Korean people, like Americans, appear to be more risk-loving than others. They operate with more leverage and there is no reason to think they are incapable of determining for themselves what the right amount for them.

Lam: Korea’s debt level is often compared to that of the U.S. The major difference between the two is credit quality, in my view. It has taken Korea a lot of prudent measures to achieve the strong credit quality of its household loans today.

It needs to avoid going down the road of the U.S. which opened too much lending facility to all sorts of income groups regardless of debt paying ability.

Byrne: Household debt is not an immediate threat to Korea’s economy. Most of the debt is in the housing market, which in Korea’s case seems to be holding up.

Many mature, advanced economies have elevated household debt. This seems to be a function of well developed financial and capital markets. As long as monetary policy remains prudent and financial regulators remain vigilant, and as long as incomes are rising and unemployment remains low, this should not pose a threat to the economy.

Lam: The increase in household debt in the past few years was mainly caused by mortgages. Mortgage borrowing is skewed to the higher income group because of the stringent anti-speculation measures imposed on the property market, including the debt-to-income and loan-to-value restrictions. The higher income groups are backed by strong asset support, and their asset to liability ratio is much higher. As a result, Korean banks’ household loan delinquency ratio was still below 1 percent even during the global financial crisis in 2008-09.

However, we do see risks that credit quality can deteriorate if not carefully monitored. First, credit card issuance has recently exceeded the peak of the credit card crisis in 2002. In face of higher inflation and low savings rate, Korean consumers could be tempted to maintain their spending power by resorting to plastic, and they are only more tempted when given more cards.
Second, the government’s policy focus on helping the low income groups can lead to an increase in loans available to those in this bracket. We agree that financial assistance needs to be given to the low income groups especially as interest rate is rising, but the authorities need to be careful of not lending excessively to the groups which are less capable of paying off their debt.

Financial market and capital flow
Q: Is Korea vulnerable to volatile cross-border capital movement? Does it need more capital control measures?

Byrne: Volatile capital flows are most threatening under a set of circumstances that are not present in Korea: Low international FX reserves, current account deficits, inflexible exchange rate policy, and wide fiscal deficits or an overhang of government debt that is largely held by external creditors regardless of the currency in which the government debt is denominated.

Neumann: Korea has already instituted a number of policies to reduce the volatility of capital flows. These appear to be working. While the country remains a big recipient of capital inflows, these are now of a less volatile nature. Still, further work may be necessary. For example, Korea still receives little foreign direct investment when compared to China, for example. Encouraging more foreign direct investment would likely enhance the stability of capital flows into Korea.

At this stage, it appears that Korea is not at risk of capital flow volatility. Capital controls, if any, should therefore be applied only gently and prudently to encourage the gradual development of Korea’s financial markets.

Lam: Korea has seen a capital inflow of $48 billion into its equity market from 2009 to 2010. There is a risk on its financial markets if there is a sudden outflow of this capital. However, I believe such risk is not high as Korea has demonstrated robust resilience during the global financial crisis that is attractive to foreign investors.

Also, domestic investors have stepped up in the equity market. Foreign ownership in KOSPI is now at 36.3 percent which is much lower than the peak of 47.6 percent in September 2004, thereby reducing the impact of foreign capital movements in its stock market.

Q: Will money keep flowing into Korea for the rest of the year, boosting the local equity market? What is the prospect of rate changes in the U.S. and Europe?

Lam: Currently, KOSPI is breaking historical highs thanks to strong export growth and investors' speculation of Korea gaining more market share from substituting Japan's supply disruption. Capital will shift back from developed markets to emerging markets once inflation peaks in emerging markets. We believe Korea will benefit from such trend when it happens.

Neumann: From a macroeconomic perspective, capital inflows will likely remain robust. In the United States we still do not expect a rate hike until the middle of 2012 and even in Europe, where the European Central Bank has already hiked rates, the scope for aggressive tightening appears limited.

Guillen: The Eurozone will continue to raise rates. At some point the Fed will need to follow suit. This will attract more money to those areas, but I don’t think the effects on Korea will be significant.

One risk, as mentioned, is that the high oil prices, as well as other commodity prices, start to erode margins, which could hurt corporate profitability. But, generally, the outlook for the Korean market is still encouraging.

Lam: If oil prices continue to surge at the current pace and inflation starts to dampen consumption more significantly, there could be downside risks

Q: What is your outlook for the course of the Korean won and its bond market?

Condon: I think I am in the consensus in expecting the won-dollar exchange rate to go lower. The break of 1,100 was important and this raises the uncomfortable question for the BOK and the finance ministry _ “how low can it go?” My six-month forecast is 1050.

Lam: My opinion is that it will be difficult for the Korean won to outperform this year. First, Korea's current account is shrinking on high oil prices and could even turn into a deficit if oil price surges higher.

Second, the Korean government is unlikely to relax on the macro-prudent measures it has put on restricting external leverage and thus capital inflow in the form of external debt will be limited.

Neumann: I expect only limited appreciation over the course of this year to roughly 1,070 against the U.S. dollar. In recent weeks, the currency has rallied strongly, and in the short-term this may continue. However, we believe that over the second half of the year the exchange rate may drift up again towards our year-end target.

Condon: Korea's economy is doing fine. The BOK is near the end of its normalization. But bond yields, which collapsed during the Lehman crash, have not retraced to their pre-Lehman crash levels.

I think this is because they are linked, via Korea's exchange rate policy, to the U.S. Treasury yields. The 10-year U.S. Treasury bond yield moved from 4 to 5 percent before the Lehman crash to 3 to 4 percent after, where I expect it to stay into the medium term. So KTB yields also will stay structurally lower than before, which is interesting. All of these lead me to expect that 2011 will be an excellent year for KOSPI.

Q: Some believe that high inflation has made countries appreciate their currencies, thus defusing the so-called "currency war." 

Neumann: Only partly. At the margin, policymakers may be more open to allow for appreciation, especially when oil prices climb. However, it is not clear that appreciation alone is an effective tool against inflation.

Sustained appreciation can draw in more capital into an economy thus raising, rather than lowering, inflationary pressures. The overall theme in FX markets has been the weak dollar in recent weeks and months.

This is a broad trend that will likely continue as long as the Fed is seen as reluctant to raise rates. As long as the dollar weakens against all currencies, the so-called currency war remains suspended.

But, greater differentiation may set in at some point, when some emerging market currencies are clearly preferred over others, which, in turn, may again spark a more forceful response by officials concerned.

Lam: High inflation is making some countries raise interest rates faster and therefore their currencies may also appreciate faster.
However, I believe most Asian central banks will still be reluctant to raise interest rates too aggressively because many of these countries are rebalancing their economies with an increasing focus on domestic demand. Aggressive rate hikes will dampen domestic demand.

Monetary Policy
Q: Is the Bank of Korea doing well? Do you think it needs to be more independent from the government?

Lam: I think the BOK should have raised the interest rate more last year to anchor inflationary expectation and to control inflation.
However, it is not too late to catch up yet and I think the BOK has been doing the right thing by raising rate every other month since November. Any central bank's policy will have to be forward-looking.

Condon: The only way to judge a central bank's performance, especially an inflation-targeting central bank like the BOK, is its performance on inflation.

Korea has been hit by food and oil shocks and there is some evidence that these have had second-round effects on core inflation. But the BOK has been slowly but steadily normalizing the base interest rate and so far the higher core inflation has not shown up in treasury bond yields, which is the ultimate test of its performance.

The authorities demonstrated impressive institutional depth in responding to the Lehman crash. Their performance warrants optimism in their ability to respond to future shocks.

Byrne: The BOK is facing more inflationary pressures from the supply side (global commodity prices and foot-and-mouth disease in Korea) than the demand side (positive output gap in 2010), probably greater than the Bank may have anticipated.

But the fact is, the BOK has a very good track record on managing inflationary expectations and second round effects of supply shocks. Korea has had a long period of price stability since the effects of the Asian Financial Crisis abated.

Neumann: The BOK is already one of the most independent central banks in Asia. It has an established track record in maintaining price stability and we continue to expect the central bank to pursue its mandate vigorously. In my view, the policy-framework of the Bank of Korea is among the best Asia has on offer