Features : Country Report: South Korea - Global Finance Magazine

South Korea Leans on Domestic Economy

South Korea is showing the potential for strengthening economic growth, but old burdens and new threats loom.

That the South Korean economy is export driven is undisputed even now as it faces the challenge of a possible weakening of demand in its major markets. Consumer demand in China is increasingly coming under a cloud as that country works with a stronger currency that might hurt its export earnings over time and thus affect its imports from South Korea. Demand from the United States, another major market for South Korean companies, is also weakening. However, despite these concerns, the export growth rate of 18.8% for August this year is the highest the economy has seen in the past nine months.

As a result of the strong export numbers, the KOSPI stock index climbed to an all-time high in early September of 1,153.63 points, driven largely by electronics companies Samsung and LG Electronics. Samsung is South Koreas most important exporter, accounting for 10% of the countrys export volume.

Despite obvious export success in electronics, shipping and automobiles, the South Korean government is leaning toward the view that reviving domestic demand is the answer to generating sustained GDP growth, especially for the latter part of 2005 and for 2006.

The finance ministry has said that it expects GDP growth to pick up in the second half but, given the uncertainty in both the external and domestic sectors, has reduced the GDP growth it expects for the full year to 4% from 5%. The IMF in a recent statement acknowledged that 2005 growth would hover around 4% but predicted that the economy would raise growth rates to 5% in 2006.

The South Korean central bank is also unclear about whether it should be using monetary policy to promote the external sector or to stimulate domestic demandespecially as the country faces the possibility of an increase in interest rates. Its biggest worry is the threat of inflation, prompted by both the rising cost of crude oil and the continuing acceleration of growth in Asias third-largest economy. The central banks of the neighboring economies of Indonesia and Thailand have already raised interest rates as they try to minimize the risk of inflation.

The worries are beginning to pile up as the Korean won continues to depreciate against the US dollar, and this will begin to exacerbate the impact of the increase in the cost of crude, prices of which have increased by 70% in the past few months.

But while tinkering with interest rates may be necessary to protect the external sector and reduce the threat of inflation, it puts the economy in a dilemma. Higher interest rates could dampen the nascent strengthening of the domestic economy, particularly as there are already signs of uncertain consumer confidence levels. Recent surveys have shown that consumer confidence in August is the lowest it has been all yearprimarily as a result of rising energy costs, worries over interest rates and issues over job security as pressure mounts on politicians to end the high level of protection that Korean workers enjoy.

Consumers Hold the Key

The financial flexibility of Korean households is the key to domestic economic growth. However, despite an improvement in the macro fundamentals of Korean households, there is no perceptible improvement in consumer confidence, and retail sales are still sluggish. The key factor is that with the high level of indebtedness of Korean households any increase in interest rates will hurt the recovery in consumer confidence given the fact that a fair share of family incomes goes toward interest payments. But the current level of indebtedness does reflect an easing over previous periods, which could become a factor in pushing domestic growth. Economists expect that with reduced indebtedness and despite current sluggishness the domestic economy is in a better position to push growth in 2006. The fear is that any change in interest rates could derail budding domestic demand.

The countrys central bank had been following an expansionist monetary policy where it cut interest rates twice in 2004 following the consumer credit crisis in 2003. In order to stimulate consumer spending and GDP growth, the government had introduced tax incentives to use charge cards (which functioned like a deferred debit card) a few years ago. Their ease of useand aggressive marketing by banksled to an explosion in family debt that, at the peak of the consumer bubble, reached 14% of GDP. Ultimately, overuse of the cards triggered the collapse of LG Card, the countrys largest credit card company, when a large portion of debtors could not pay up, forcing the government to mount a $4.5 billion bailout. When the crisis broke, one in 10 Koreans had debts outstanding for more than three months. According to the state-owned Korea Development Bank, this figure had improved to one in 13 of the countrys 48 million people by the end of 2004, but it remains a major concern.

But in contrast to the prevailing consumer sentiment, which is limping back to some form of normality, South Korean industry in general appears to be upbeat and confident. The argument for strengthening the domestic sector is further buoyed by reports of increased investment activity in the countrys construction sector, which accounts for 17% of GDP. The sector is being supported by huge increases in public investment in construction in the second half of 2005 as part of a package to stimulate domestic consumption.

In a statement released in early September by the Federation of Korean Industries, the largest South Korean companies plan to increase investment in plant and machinery by 25% in the second half of 2005 to $35 billion. In a strong endorsement of business confidence in the country, the federation has cited results of a survey of the countrys top 600 companies ranked by sales, where companies are the most confident that they have been in the past five months.

Aaron Chaze