Korean economy: at a crossroads

Short-term outlook remains brisk but structural issues question sustainable growth

By Kim Jae-kyoung

The Korean economy is now at a crossroads, as its gross domestic product (GDP) growth is getting back on track but its growth potential is destined to head south in the future.

Briefly put, the economy is expected to undergo robust growth in the short-term but it is unclear whether the expansion will be sustainable for the next decade due to structural problems, such as an aging population and deepening economic polarization.

In particular, it is getting more and more difficult for policymakers to steer the economy as a broad range of economic data are delivering mixed messages on the future course of Asia’s fourth largest economy.

While economists and market analysts are predicting a stronger economic performance, Korean consumers are far from convinced with confidence levels declining due to rising household debt coupled with falling income.

Robust exports are firing up parts of the economy but inflation is emerging as a major threat to a full economic recovery. Large firms are enjoying huge profits, while many smaller firms are facing a forced exit from the market.

The task of steering the economy through this intersection is made all the more difficult by a myriad of challenges abroad, such as soaring oil prices, a slowdown in China’s growth and lingering debt woes in Europe, which play havoc with economic growth and retail figures.

Upbeat but cautious

Despite worries over external headwinds, the outlook for the Korean economy and financial market remains quite strong. Global economists are issuing an upbeat outlook, saying that robust exports will continue to support a healthy rebound in line with a recovery in advanced economies.

Indeed, the upside risk on inflation, currently, is much larger than the downside risk on growth, with inflationary pressure building up fast due to the protracted low interest rate and soaring costs of oil.

In early April, the International Monetary Fund (IMF) released a report that maintained Korea’s GDP growth outlook of 4.5 percent for this year. But it raised the inflation forecast from 3.4 percent to 4.5 percent.

“Korea’s economy will have another year of solid expansion in 2011, and we are even more optimistic for 2012 when we expect the Korean economy to expand at 5.2 percent,” Frederic Neumann, managing director and co-head of Asian Economics at HSBC, told BusinessFocus.

“The challenge, however, will be to maintain price stability. Our 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 the Bank of Korea (BOK)’s target range,” he added. “In general, we are more optimistic than the IMF on growth, but see therefore a bigger challenge on the inflation front as well.”

Two-track world

Korea has successfully recovered from the global financial crisis but the turmoil has begotten a two-track world, a new economic trend both at home and abroad, which brings both opportunities and threats.

On the domestic side, the crisis has created a two-track economy by impairing the transmission mechanism between the manufacturing and services sectors. As a result, the manufacturing industry showed a robust performance while the services sector is still struggling.

“The economy became a two-track economy during 2010. The manufacturing sector, helped by the significant real exchange rate depreciation during the Lehman crash, performed very well. However, something prevented the transmission of the strong manufacturing-led recovery to the services sector,” ING Group senior economist Tim Condon said.

“I think it was the weakness of the housing market. A more buoyant services economy requires a more buoyant housing market. It seems the authorities are gradually loosening restrictions on the property market, which I think would be a good thing,” he added.

On the overseas front, a similar trend, known as “a two-speed recovery,” seems to be taking hold. On one side are red-hot developing nations like China and India. Then you have the United States, Europe and other developed regions, facing a sluggish economic recovery.

“The scenario of a two-speed global recovery is materializing, under which advanced countries continue their accommodative monetary policy to cope with only a modest rise in activity and sovereign debt overhang, while emerging market economies run the risk of high inflation and asset price bubbles,” BOK Deputy Governor Kim Jae-chun said in his recent contribution BusinessFocus.

Two-pronged approach

This new trend implies that the Korean economy is at a critical juncture in its transition to an advanced economy. A two-speed global recovery has created opportunities for Korea to capitalize on China’s strong performance. Internally, the crisis has highlighted long-term issues that the country needs to deal with.

Depending on how it copes, China can provide a valuable opportunity for Korea to shape up for the winning platform for the future. To make the transition successful, Korea should adopt a two-pronged approach _ short-term and long-term.

In the short-term, the government needs to focus on addressing pending issues, such as soaring household debts, rising inflation and sluggish real estate markets. To that end, a more sophisticated policy mix to tackle slowing growth and rising inflation is essential.

In the long-term, it is important for policymakers to come up with strategies to create a winning platform by developing competitive sources or future industries for the post-crisis era when China’s importance will become much bigger.

“The main focus of the government, at this stage, is not so much the development of defenses against external shocks, or the creation of an even faster recovery. Rather, with growth robust and external vulnerabilities well contained, the priority needs to shift to long-term development goals,” Neumann said.

“For example, what will Korea’s future industries be once competitors, such as China, have caught up? How can productivity gains be maintained as the population ages and output shifts more to services away from manufacturing?” he added.

Now is the time for Korea to get down to doing its homework, which could only be pursued in economically-difficult periods by liberalizing the services sector and developing futures industries which will carry 10 years of continued success.