Lift from fiscal stimulus, surprise rate cut

By Matthew Circosta

South Korea’s annual growth rate has been stuck at 1.5 percent for the past nine months, well below the economy’s trend pace of about 4 percent. Stubbornly weak growth has prompted fiscal policymakers to act. The government recently unveiled a supplementary budget worth 17 trillion won ($15.4 billion), or 1.3 percent of GDP, which is expected to lift growth and create 40,000 jobs. Tax breaks and easier lending standards will support the flagging housing market.

Some fiscal spending may have been brought forward because the government contributed 0.2 percentage point to the first quarter’s 0.9 percent quarterly growth rate. Fiscal stimulus will increase the government’s contribution to GDP growth in coming quarters. The supplementary budget is the largest since the 1998 Asian financial crisis, and the government estimates it will lift GDP growth by 0.3 percent in 2013 and support jobs at small-and medium-sized businesses.

Korea’s government can afford to provide further stimulus, as debt levels remain low. The government projects the budget deficit for 2013 will come in higher at 1.8 percent of GDP, while the debt-to-GDP ratio will rise to 36.2 percent, which compares well against those of highly indebted economies such as the U.S., Europe and Japan.

Investment has been sluggish since mid-2012, but there are tentative signs that it is stabilizing. The first quarter expansion showed a much-needed rise in construction and machinery and equipment spending. Companies such as Samsung are reportedly increasing spending on new technology to take advantage of the strong expansion in the handheld device market. This trend is expected to see investment shift from a drag to a minor support for GDP growth in the second half of 2013 and into 2014.

High household debt, the end of tax cuts on car purchases, and slower employment growth restrained private consumption. These challenges remain, but rising consumer confidence suggests households will still contribute to growth in coming quarters. The government’s measures to create jobs and lift the housing market out of the doldrums will help consumer spending recover. Low inflation is also supporting solid growth in real wages.

Net exports helped the economy expand strongly in the opening quarter, but a more modest contribution is expected in coming quarters. A better global recovery will support gains in exports, but that will be partly offset by improving imports as domestic demand recovers. Fiscal problems in the U.S. will dissipate as the year progresses, and European policymakers are starting to favor growth over austerity. Upbeat forecasts for Chinese investment spending and energy consumption also point to a near-term pickup in demand from South Korea’s largest export market. Emerging markets such as China and other Asian nations are the key source of demand for Korean handheld devices, which sets the stage for better export growth in the second half of the year.

A strong first quarter means the economy is carrying solid momentum, but this came broadly as expected and has not prompted any change to our outlook: Slow and steady growth describes the first half of the year, before fiscal stimulus and a stronger global economy help the economy expand faster. Overall, the economy is forecast to grow at a middling 2.5 percent in 2013, only slightly better than last year’s return. Growth is not expected to reach a trend pace of 4 percent until about mid-2014.

Recent inflation data show price pressures are weaker than previously thought. Below-trend growth, government subsidies for child care and education, and the rising won are all restraining inflation. The Bank of Korea has followed the government’s cue and provided additional monetary support. The BOK lowered its key policy rate by a further 25 basis points to 2.5 percent in May to boost growth, just like other global central banks such as Australia have done recently. An easing bias remains because a negative output gap allows the central bank to keep rates lower for longer.

The BOK is often unpredictable, which means that rate cuts have never been a certainty. Governor Kim Choong-soo had recently signaled a reluctance to continue lowering rates for fear it could fuel a new credit expansion. Korean households are saddled with household debt equal to more than 75 percent of GDP. Consumer confidence is rising, and the new fiscal stimulus will help create jobs and jump-start growth.

Inflation will become a bigger issue later in the year and into 2014, which will prompt the BOK to grow hawkish. Consumers expect the inflation rate to be 3.1 percent in the coming year, threatening the upper band of the BOK’s 3.5 percent target. Rate hikes will come into view as the output gap starts closing, which appears unlikely before mid-2014, suggesting a long period of steady rates ahead. We expect the policy rate to remain on hold at 2.5 percent in coming months.

Export challenges

The external sector still faces challenges, which makes the forecast susceptible to heavy downside risk. Chief among those concerns is the falling Japanese yen.

In particular, a quickly depreciating currency and stagnant wage growth are boosting Japan’s competitiveness while growing wages and a rising won are working against South Korea. Unit labor costs in Korea are outpacing Japan’s, which suggests Korean manufacturers are losing some of their long-held price advantage.

Questions also remain about a coming tech upswing. Solid export gains in smartphones and tablets are being offset by weaker demand for personal computers, televisions, and other consumer electronics. The rising SEMI book-to-bill ratio offers hope that electronics production will pick up, but the same signals in 2012 proved to be a false dawn. Lower than expected global tech demand could keep Korean production and exports weaker for longer.

Domestic risks

Domestic obstacles also persist. House prices have been contracting on a year-ago basis for six months, down more than 2 percent nationwide. If government measures fail to work, further declines could make consumers nervous about spending.

Tension on the Korean peninsula remains high and could flare again. South Korea recently pulled 53,000 workers from a jointly run factory in the North Korean town of Kaesong, which signals relations between the two Korean nations are deteriorating.