- Growth drops to post global crisis low in Q1, driven by weaker investment
- Exports and imports have slowed on weaker global trade and protectionism
- High frequency data suggest slowdown may be behind us
- We leave our growth forecasts for 2019 and 2020 unchanged at 2.5% so far …,
- … although structural challenges remain
- We cut our inflation forecasts and expect the BoK to stay ‘on hold’ in 2019-20
- Global trade tensions form biggest risk, but also create opportunities
Growth drops to post global crisis low in Q1, driven by weaker investment
South Korea’s economic growth for Q1-19 came in weaker than expected, at 1.8% yoy (consensus expectation: 2.4%), down from 3.1% in Q4-18. This marked the lowest annual growth rate since the global financial crisis (Q3-09: 0.9%). On a quarterly basis, economic growth was even negative, at -0.3% qoq (consensus expectation: +0.3%). The growth slowdown was primarily driven by a further weakening of fixed investment. Capital expenditure contracted by 8.4% yoy (Q4-18: -3.8%), mainly driven by declines in machinery and transport equipment and construction investment. The slowdown of investment partly reflects payback from strong growth levels in preceding years, but also relates to the rise of global trade tensions affecting export prospects (see below) as well as rising operational costs due to the minimum wage increase.
Exports and imports have slowed on weaker global trade and protectionism
In our previous South Korea Watch, Trade conflict biggest risk to growth, we stated that – while South Korea’s strong fundamentals had shielded it from market turbulence – global trade tensions form the key downside risk for this highly export oriented global bellwether. Despite attempts to reform the country’s growth model, South Korea is still highly export oriented and depending on global supply chains, with China (25% in 2017) and the US (12%) as the two most important export destinations. And indeed, this risk has manifested itself as illustrated by recent foreign trade developments. Export volume growth weakened in Q1, to a mere 0.2% yoy (Q4-18: 7.2%), but as import volume growth contracted by 5.4% the annual growth contribution from net exports remained positive. On a quarterly basis, exports shrank by 2.6% qoq (Q4-18: -1.5%), while imports fell by 3.3% qoq. The slowdown in export and import growth for South Korea is in line with the collapse in world trade growth in late 2018, which partly reflects the impact from the escalation of US-China trade tensions last year including payback from previous frontloading.
High-frequency data suggest slowdown may be behind us
Although South Korea’s growth performance weakened more than expected in Q1, high-frequency activity indicators suggest that the slowdown may be behind us. In February 2019 (the month of China’s long Lunar New Year holiday break), the manufacturing PMI dropped to a 3.5 year low of 47.2, but this index gained three points in the two subsequent months climbing back to above the neutral 50 mark in April (50.2). This improvement was broad based. The volatile export subindex jumped by more than three points in April, reaching a ten-month high of 52.2 (March: 49.0). The new order index rose by 1.7 point to 49.5, remaining just below the neutral 50 mark. Export and import growth data for April point to a bottoming out as well. The latest numbers for industrial production, construction activity and consumer and business confidence also indicate some improvement.
We have left our growth forecasts for 2019 and 2020 unchanged at 2.5% so far
The weaker than expected GDP print in Q1 highlights downside risks to our 2019 growth forecast of 2.5%, which is slightly down from 2.7% in 2018 and just below Bank of Korea (BoK)’s forecast. That said, with high-frequency indicators pointing to an improving momentum in Q2, we keep our 2019 growth forecast unchanged for now. A stabilising China should be beneficial for South Korea, and we expect more policy support. Still, an expected slowdown in the US, sub-trend growth in the eurozone and a flaring up of trade tensions (not impossible, as Trump just surprised financial markets by dropping new tariff threats versus China) pose downside risks.
We expect the BoK to stay ‘on hold’, but fiscal support to be stepped up
Headline inflation has dropped back to around 0.5% yoy over the past months, far below the Bank of Korea’s inflation target of 2%. These low inflation levels do not only reflect weaker domestic demand and lower growth, but also the impact from lower energy prices and government price controls. Core inflation is also still at subdued levels (0.9% yoy in March/April). We have lowered our annual inflation forecasts for 2019 and 2020 to 1.0% and 1.5%, respectively (from 1.5% and 2.0%). With the BoK policy rate stuck at 1.75% since November 2018, the ‘real policy rate’ has risen to over 1% over the past few months. Given the subdued inflation picture and the fact that the global monetary stance has turned more dovish (we do not expect further Fed hikes), we now expect the BoK to remain on hold in 2019-20. We do not expect rate cuts, as the BoK is looking through the temporary factors surpressing inflation and also given still elevated household debt levels. support will come from the fiscal side in our view. The government has sufficient fiscal space: it runs surpluses, while public debt is manageable at 40-45% GDP. Against that background, the South Korean government typically works with additional budgets to support the economy, if circumstances ask for that.
Structural challenges remain
We just visited Seoul and spoke with delegates from relevant financial institutions, academics and politicians. Besides the cyclical issues we discussed a couple of key structural challenges for South Korea: duality and income inequality, inflexible labour laws and high youth unemployment, chaebol dominance and innovation, ageing population, high household debts and last but not least North Korea related risks.
Duality and inequality
Income inequality between people working in the high-productivity, global competitive export-oriented sector dominated by large conglomerates (chaebol) and the low-productivity domestic oriented (services) sectors is high. Already for years, policies are directed at making Korea’s growth model less export-reliant and more focussed on domestic consumption and innovation. The centre-left government aims to support growth by job creation, boosting consumption and improving the welfare system. President Moon has promised to raise the minimum hourly wage with more than 50% by 2020.
Chaebol dominance, SMEs/start-ups and innovation
In the past, chaebols have been active in using their market power to take over relevant companies, increasing their pricing power. That has stifled entrepeneurship and innovation. The government is now putting an end to these practices. The strategy is not to split up existing chaebols, but rather to take measures to ensure fair competition and improve prospects for new start-ups to safeguard innovation and long-term economic growth. A special Ministry for SMEs and Start-ups has been established.
External competitiveness and trade tensions
Within the export-oriented industry, shipbuilding and construction are the problem childs and more capital injections and a further consolidation is needed. However, the government takes a soft approach, given the potential effects on employment. Some sectors are vulnerable to the US-China trade conflict, such as semi-conductors and electronics. That said, the tech battle between US and China also creates opportunities for South Korea, with for instance Samsung profiting from international measures vis-à-vis China’s Huawei. Over the longer-term, China is a strategic competitor for South-Korea. China has stronger economics of scale and a government that has more room and less constraints to support export-related industries.
Tail risks from North Korea
In Seoul, we have intensively discussed North Korea related risks for the South Korean economy with various stakeholders and we have visited the easternmost part of the Demilitarized Zone. Our conclusion is that the risk of a sudden, disruptive conflict remains low, as none of the stakeholders seem for the time being willing to enter into a war. Also, we found that a serious spill-over of North Korea related tensions to the South Korean economy is remote. During the escalation of tensions in 2017, there was hardly any impact on South Korean FX, CDS and equity markets. At the very long term, unification of the Koreas would probably be the best option for the peninsula, but that will remain a very complex affair as it could form an extreme threat for North Korea’s leadership. Moreover, there are quite some challenges to ensure an ‘orderly unification’.
Under centre-right governments in South Korea, the stick is typically used more than the carrot, while under centre-left governments the opposite is true. Hence, an easing of tensions under the centre-left Moon administration was to be expected. The inter-Korean summits in 2018 set a welcome change in tone on the peninsula. Meanwhile in North Korea, we have seen some improvements under the leadership of Kim Jong-un, particularly in the Pyongyang area. However, as the implementation of sanctions became stricter following the rise of tensions with the US in 2017, the economy deteriorated. So, it was also of crucial importance for the North Korean administration to improve ties with the US and South Korea from 2018 onwards. Still, the failure of the Trump-Kim summit in Hanoi once more illustrated that North Korea’s refusal to completely halt its nuclear and missile programmes will keep regional tensions brewing in the long term.