South Korea Watch – Moonlight and shadows

by: Arjen van Dijkhuizen

  • Despite North Korea turmoil, South Korean growth jumps to 5-year high
  • Pick-up driven by exports and consumption, confidence has improved
  • We have raised our 2018 growth forecast from 2.5% to 3%.
  • Policies Moon focus on demand side; supply side should not be forgotten
  • Higher inflation, stronger growth and Fed have triggered BoK rate hike
  • While South Korea is resilient, risks from geopolitics, protectionism, high debt levels and tightening financial conditions remain
171220-South-Korea-Watch.pdf (297 KB)

Despite North Korea turmoil, South Korean growth jumps to 5-year high in Q3

Turmoil on the Korean peninsula has flared up this year, as North Korea has stepped up its nuclear and missile programmes. That has alienated the US, but has also put relations between the key powers in the region to the test. Despite all this, the South Korean economy is doing fine. Economic growth jumped to 3.8% yoy in Q3-2017. That was clearly up from the 2.7% yoy growth rate reached in Q2-2017, and equaled the highest pace seen since Q2-2011. Quarterly growth jumped to 1.5% qoq in Q3, the highest level since Q2-2010. The pick-up in growth in Q3 was driven by exports and domestic (public and private) consumption. Growth of exports of goods and services jumped to 5.0% yoy in Q3 (Q2: 0%), reflecting a broad-based pick-up of external demand. Meanwhile, growth of public consumption rose to 4.6% yoy in Q3 (Q2: 3.1%), whereas private consumption – supported by solid consumer confidence – accelerated to 2.6% yoy (Q2: 2.4%). Gross fixed investment slowed to 9.2% yoy in Q3 (1.2% qoq), down from 9.6% yoy (1.8% qoq) in Q2. Construction activity also slowed, to 7.4% yoy in Q3 (Q2: 8.1%).

Confidence indicators improve; long October holiday has distorted latest data

Recent macro data for Q4-2017 show quite a mixed picture. Confidence indicators are on an improving trend, shedding of North Korea related concerns. The manufacturing PMI has trended up in the course of this year, rising by a full point in November to 51.2 (the highest level since April 2013). Other confidence indicators paint a rosy picture as well. The business conditions index has risen throughout 2017 and stabilised around 80, although that is still well below the neutral 100 mark. Consumer confidence has risen to a seven-year high in November. All this reflects the fading of domestic political uncertainty as well as improving economic fundamentals. Still, the latest hard economic data are less impressive. In October, industrial production contracted by 5.9% yoy (down from +8.5% yoy in September). Retail sales cooled to 1.5% yoy in October (September: +9.4% yoy). However, the September and October data are biased by the fact that the national holiday in October was longer this year than in 2016. We expect a normalisation going forward.

Export (and import) growth has recovered sharply

Despite attempts to diversify, the South Korean economy remains heavily export oriented. Hence, the pick-up in global growth and trade has obviously been an important driver of the economic acceleration. Export growth of goods averaged around 16.5% yoy in 2017 (January-November), compared to -6% in 2016 and -8% in 2015. This recovery is broad-based in terms of destination. Exports to China have picked up recently, as bilateral ties have improved under the new president Moon. Relations had been frosty over the past year, reflecting Chinese concerns over a US anti-missile (THAAD, Terminal High Altitude Area Defense) system. These had resulted in Chinese sanctions affecting Korean tourism, cosmetics and entertainment industries. That said, the pace of export growth peaked in September (to 35% yoy), falling back to single digit levels in October and November. While the volatility in the past few months reflects distortions from the long October holiday, some moderation of export growth is likely in 2018.


We have raised our 2018 growth forecast to 3.0%, from 2.5%

A couple of months ago, we raised our 2017 growth forecast from 2.5% to 3% (see our previous South Korea Watch., Growth firms despite North Korea published in July). This upward adjustment was based on the observed acceleration in export growth, the easing of domestic political uncertainty (despite rising external political risks related to North Korea) and the expectation of a bit more stimulative fiscal policy mix. Given our constructive view on the world economy (see our Chief Economist Han de Jong’s Global Macro View for 2018 here), we have raised our 2018 growth forecast for South Korea to 3%, from 2.5%. We expect China’s slowdown to remain gradual and the Fed and other key central banks to remain cautious with monetary policy tightening.

Economic policy under president Moon shifts to the demand side

Since May of this year, South Korea is governed by President Moon Jae-in from the centre-left Democratic Party (Minjoo). He succeeded Ms. Park Geun-hye, who was formally impeached in March, following a scandal that resulted in the largest protests in the country since the end of dictatorship in 1987. This marked the end of a decade of conservative rule. As expected, the focus of government policy is shifting under the new leadership. Under previous centre-right governments, policy was supply-side oriented and aimed at diversifying Korea’s growth model away from exports. However, the current policy mix is more demand-oriented, with an emphasis on ‘income-led growth’. These policies are aimed at reducing income inequality and improve employment prospects, with youth unemployment in South Korea relatively high at around 10% currently.


Raise of minimum wage should boost consumption, but there are limits to this

The government aims to raise the minimum wage by more than 16% in 2018, the strongest rise in almost twenty years. That should be followed by further increases in subsequent years, so that the minimum wage will rise by more than 50% by 2020. According to OECD data, in 2015 Korea ranked 14th among OECD member countries in terms of minimum wage (below the US and Japan and the core eurozone countries, but also below Slovenia). Although these measures will underpin consumption growth, there are also downsides to this approach as it may negatively affect external competitiveness over time. That would come on top of the  strong real effective appreciation of the Korean won over the past years compared to currencies like the Japanese yen, the euro, the US dollar and the Chinese yuan (partly reflecting the country’s large external surpluses).

Higher inflation, stronger economy and the Fed have triggered BoK rate hike

Inflation has been quite volatile over the past year. After having reached a multi-year low in July 2016, CPI inflation has risen to 2.6% yoy in August. Over the past few months, inflation has fallen again to 1.3% yoy in November, driven by falling food price inflation. We expect headline inflation to average 2% this year, in line with the target of the Bank of Korea (BoK). For 2018, we expect also an average inflation of 2%. Meanwhile, core inflation remains quite subdued, at around 1.5%. With the real policy rate having turned negative this year (except for November),  the economy accelerating and the US Fed on its way for another rate hike in its December meeting, the BoK was the first regional central bank to raise its policy rate on 30 November. It was the first policy rate move since the 25 bp cut in June 2016, to a record low of 1.25%. The BoK is traditionally quite cautious in moving rates too aggressively, also given Korea’s high (household) indebtedness. With inflation getting back to 2%, the economy growing nicely and the Fed anticipated to hike rates further (we expect two hikes next year), we have penciled in one more 25bp rate hike by the BoK for 2018.

Although South Korea is resilient amongst EMs, risks remain

We are quite positive about recent economic developments in South Korea. We are also quite positive about the country’s creditworthiness, given the country’s high GDP/capita, diversified economic base, generally adequate macro economic policies, strong institutions, large external surpluses and ample foreign reserves (covering 7 months of imports and three times short-term external debt). That is also reflected in the country’s strong sovereign ratings (Moody’s Aa2, S&P AA, Fitch AA-), which have not been adjusted after the flaring-up of tensions with North Korea. Despite the country’s resilience, we see a couple of risks that could cloud the outlook:

Tensions on the Korean peninsula. We are still of the view that, although North and South Korea are technically at war, a full-scale interstate conflict is not very likely, because both sides are aware of the high cost. However, the risks of escalation and miscalculation have risen.

High debt levels and tightening financial conditions. South Korea’s overall debt levels are relatively high, particularly household debt. Recently, measures were announced to tighten mortgage rules to curb the further rise of household debt. In any case, these high debt levels make the country vulnerable for interest rate and currency shocks and that could be particularly relevant in times of monetary tightening by the Fed and other key central banks. A rise of inflation in the US and other advanced economies could trigger a faster than expected tightening cycle, possibly affecting capital flows to EMs and triggering a tightening of financial conditions. We should add that foreign debt is relatively low, while we expect the won to depreciate only mildly versus the US dollar in 2018.

Moderation global trade growth and protectionism. Despite diversification attempts, South Korea is still more dependent on the global business cycle than its large Asian peers (China, Japan, India, Indonesia). Hence, the country is more sensitive to a deterioration in external competitiveness (e.g. triggered by ongoing real effective won appreciation cq rising wages) and to more protectionist policies, for instance from the US (together with China, Japan, Germany and Switerzland, South Korea is still on the US Treasury’s Watchlist regarding possible currency manipulation).