By Lee Myong-hwal

2012 is the Year of the Black Dragon. Coming once every 60 years in the lunar calendar, the year of the Black Dragon is remembered special in Korean history. The 1592 Japanese invasion into Korea is one example.

In 2011, the Korean economy experienced a slump market, mainly from global risk factors such as the eurozone’s fiscal crisis, downgrade of the U.S. credit rating and a delay in its economic recovery. Unfortunately, the outlook for the Korean economy isn’t any better in 2012. The eurozone’s fiscal crisis will continue to slow Korean exports, and excessive household debts will weigh on domestic demand as would North Korea-related geopolitical risk. These factors will produce an economic growth rate of only 3.7 percent in 2012, lower than that of 2011.

Korea’s consumer price index (CPI) is expected to fall about 3.1 percent as international oil and other commodity prices stabilize and global and domestic economies are slow to recover. But due to the ‘transition effect’ of high oil prices in 2011 that is still keeping Korea’s underlying rate of inflation high, CPI is expected to be higher in the first half than in the second. Korea’s current account surplus is also expected to be down to about $12.8 billion from last year as export growth slows along with the global economy.

Entering 2012 the continued flight-to-quality will most likely keep the value of the Korean won low against the U.S. dollar, but a steady reversal in global risk appetite and an economic recovery in the second half will raise the annual average exchange rate to around 1,100 won for dollar.

Several global and domestic risk factors could bog down the Korean economy in 2012. The eurozone’s fiscal crisis poses a global risk that looks like it won’t be going away anytime soon, which may cause instability in the financial markets and a subsequent contraction in the real economy. A protracted U.S. economic recovery can also weigh on the Korean economy, and so does the possibility of a hard landing in China. With international restrictions on Iran, higher oil prices cannot be ruled out as it has the potential to fuel instability in the Middle East.

Domestically, the excessive level of household debt has the potential to deepen the economic slowdown by discouraging consumption and this could raise unemployment and hold down income growth, lowering the ability of households to service debt. If this vicious cycle continues, Korea’s household debt problem can spin out of control. And since the sharp rise in household debt is largely concentrated in the non-banking sector, precautionary measures should be taken especially against any further deterioration of household debt by multiple, heavy borrowers.

In regards to foreign exchange risks, the eurozone fiscal crisis could trigger another liquidity shortage and fan risk aversion in the global financial markets. With European banks having to recapitalize until June 2012, Korean banks could face foreign exchange liquidity challenges if European banks either deleverage or repatriate funds from emerging markets. Korea’s foreign exchange market will likely see heightened volatility as the exchange rate responds sensitively to any geopolitical developments coming out of North Korea.

For the longer term, issues surrounding Korea’s fiscal soundness will likely come into force due to growing pressures to increase fiscal expenditures for social welfare program. In addition, Korea’s low birth rate and an aging society are long-term economic headwinds that are holding back Korea’s potential growth and employment rates.