Sino-Korea divergence?

At first glance, the recent GDP data was a surprise, while growth in 2013 decelerated in China it picked up in Korea. As China is Korea’s largest trading partner, buying almost a quarter of Korean exports, this apparent contradiction may suggest that the two economies are diverging structurally. If not, does the slowdown in the world’s second largest economy mean that Korea’s export-led recovery is not sustainable?

We don’t think either scenario is likely. The latest numbers still show Korea remains on track for an export-led recovery, and we believe the divergence between the latest headline growth figures in China and Korea will likely prove temporary.

So far this year, Korea’s export growth continued to be supported by strong Chinese purchases even as the headline growth in China moderated. The resilience of the Chinese economy, at least in absolute terms, is clear. China is Korea’s only important export market where shipments rose year-on-year in the first quarter (they were up 7 percent), while the value of exports to the US, Europe, Japan and Hong Kong all fell.

Looking deeper into the numbers, China bought more machinery equipment and chemicals from Korea. These are needed to fuel infrastructure growth, consistent with our house view that China’s recovery will be driven by greater spending on roads, rail, subways and other industrial projects. With rising domestic demand providing the fuel for growth, our China economists expect growth on the mainland to accelerate from 7.7 percent in the first quarter of the year to 8.5 percent by the fourth quarter. Given that the correlation between growth in the two countries has strengthened in the past decade, greater economic activity in China should provide a healthy boost to Korea’s GDP throughout the year.

Meanwhile there is the yen. No doubt, a weaker yen relative to the won will pose problems for Korea’s exporters. But what is more important for Korea’s economic recovery is global growth. We find that Korea’s export growth has been increasingly correlated with global production, while its correlation with the strength of the won has become more muted since the 2008 global financial crisis. Therefore, what Korea needs is for the size of the pie to increase, which places more emphasis on a global recovery that, in turn, is likely to be driven by emerging markets such as China.

Even if the yen is weaker, the recent visit of Japanese lawmakers to the Yasukuni Shrine may bolster trade between China and Korea. Past tensions have benefited Korea’s trade: during the three months after Japan nationalized the Senkaku Islands (Diaoyu Islands in China) in September, China’s imports from Korea rose 10 percent over the same period the previous year, while those from Japan fell by 15 percent.

Korea’s economic outlook is likely to be at its most precarious in the second quarter. For one, global economic activity has not yet picked up enough steam to get Korea’s trade back to full speed. Given the connection between exports and Korea’s private sector, this will put a cap on private consumption and investment growth. For another, the additional boost from the government’s recent fiscal stimulus package will likely be skewed towards the second half of the year. We can expect more government spending in the second half of the year as 70 percent of the original budget was frontloaded into the first six months. Taken together, we expect Korea’s economic growth to be a touch weaker this quarter.

For the Bank of Korea, a potentially weaker second quarter should not warrant a rate cut. Monetary policy takes at least three months to filter through to the economy. Should global economic activity pick up in the second half, as we expect, further policy rate cuts may overstimulate the economy later.

The recent fiscal stimulus package will also take pressure off the central bank to deliver more easing, by providing support for domestic demand before external conditions fully recover. In all, we believe the monetary easing cycle in Korea is over and we now put Korea’s likely GDP growth at 3% in 2013, having revised it down from 3.8% to account for a slower-than-expected recovery in China.