By Kim Jae-kyoung
Staff Reporter

As interest rate hikes loom larger than ever, a noted global economist has warned that Korea has become vulnerable to a massive property bubble as a result of growing stagflationary pressure.

``Korea may be experiencing a massive property bubble funded by debt,'' Andy Xie, an independent economist and former Morgan Stanley chief economist overseeing the Korean economy, said in an e-mail interview with The Korea Times.

He said that Korea is now on the course toward stagflation, with a slowing property market coinciding with high international oil prices. He emphasized that since there is no remedy for this situation, the country should focus on carrying out structural reform.

``There is no obvious macro response. A decline of asset values and the rise of the consumer price index (CPI) are a deadly combination,'' he said.

``Only structural reforms can alleviate the situation. Let's look at deregulation and tax reforms,'' he added. ``I think there is quite a bit of an upside there that can offset the cyclical downturn.''

Of late, the deadly cocktail of asset deflation and rising inflation have haunted the world's 13th largest economy, creating a big headache for the government. The central bank is poised to raise interest rates to control rising inflation, but this will, in turn, deal a blow to asset values.

According to Real Estate 114, a real estate services provider, prices of apartments in Seoul fell 0.04 percent for the first week of July, continuing a losing streak for the third week in a row.

Stock prices also took a heavy beating, with the KOSPI falling to a yearly low of 1,533.47 on July 8, down nearly 25 percent from the yearly high of 1,888.88 on May 16. In addition, the net asset value of domestic funds under management came to 48.32 trillion won on July 9, down from 70.85 trillion won on Oct. 31, 2007, according to Zeroin, a fund evaluation firm.

On the other hand, interest rates on mortgages have jumped by more than 0.25 percentage points since April. Home mortgages reached 229 trillion won in June, up 35.5 percent from 169 trillion won at the end of 2004.

Xie, who received Ph.D. from MIT, pointed out that stagflation is a global phenomenon, as most major economies are reporting surging inflation and slowing GDP.

``This is due to excessive monetary expansion in the past during low inflation. The low inflation came from globalization. As the global economy hits constraints in the supply of basic inputs, inflation surges everywhere together,'' he said.

``At the same time, asset values are declining, because they rose too much in the past, which slows economic growth. This is the stagflationary dynamic we are seeing around the world,'' he added.

Regarding the recent sharp fall in the Korea's foreign direct investment (FDI), Xie said that the nation's anti-foreign capital sentiment is the key culprit behind falling inbound investment.

``Korea has become less friendly to foreign investment in the past five years as it recovered from the financial crisis,'' he said.

He explained that Korea's development model is based on developing indigenous firms to conquer foreign markets, very similar to the Japanese model.

``The opening to FDI during and after the crisis was out of necessity. Korea was down and needed the money,'' he added. ``When Korea recovered, it changed back. Korean people may disagree but this view is widely shared in the international community.''

He pointed out that when the property bubble deflates, Korea may become friendly to foreign investment again but that may prove temporary again.

``Korea may never become a truly open economy. An open economy is a matter of choice,'' he said.

``Its foundation is to treat all businesses, foreign or local, the same. The mere fact that people always talk about foreign versus local means that the economy cannot be truly open,'' he added.

He pointed out that Korea may not be willing to make the changes to attract FDI as it takes a major crisis to change attitudes.

According to the Organization for Economic Cooperation and Development (OECD), the nation's FDI ranking nose-dived to 29th in 2007, down from 16th in 2004. In particular, the country has become the only OECD member whose efforts to induce more FDI were dealt a severe setback three years in a row.

The volume of net FDI ― FDI inflow minus outflow ― in the first quarter fell to minus $670 million for the first time since the third quarter of 2006, according to the Bank of Korea.

Inbound investment had increased sharply since 1998 when the currency crisis hit the nation, with net FDI soaring to $9.33 billion in 1999 and $9.28 billion in 2000 from $5.41 billion in 1998.

However, after recording $9.25 billion in 2004, the net FDI steadily decreased to $6.31 billion in 2005, $3.59 billion in 2006 and $1.58 billion in 2007, turning negative in the first quarter of this year.

kjk@koreatimes.co.kr