Korean Economy Stuck Between Two Whales

By Barry Eichengreen

George C. Pardee and Helen N. Pardee Professor of Economics and Political Science, University of California, Berkeley

The Korean economy is a shrimp swimming amidst two whales, the United States and China. Rather than being bashed by the whales' tails, Korea has always been able to navigate among these humongous creatures. Faced with a difficult situation, it has always been able to make something of it.

In 2008 the shrimp's task will be especially daunting, because the movements of the two whales will be especially violent. The United States is almost certainly headed for recession. While the Fed insists that the jury is still out, it has an incentive to hedge its bets and to avoid disturbing the markets. Independent economists, in contrast, can call it as we see it. And what we see is increasingly depressing. Credit markets are not on the mend; to the contrary, every day brings news that the credit situation is worse than previously thought. Residential construction is at standstill, and commercial construction looks ready to join it. Ultimately the consumer will tell the tale. And here, early returns from retail stores counting on robust holiday sales are not encouraging. 2008 will almost certainly bring a weaker U.S. economy and an even weaker dollar.

China's situation could not be more different. Its economy continues roaring ahead. Extraordinarily high investment rates continue to fuel double-digit growth rates. The authorities' steps to restrain this investment boom, limit the rise in property prices, and put a lid on the Shanghai and Shenzhen stock markets are notable only for their futility. China's export industries continue to motor ahead. And as the dollar falls, the renminbi falls with it, further enhancing Chinese exporters' already admirable competitiveness. In turn this only encourages more frenzied speculation.

What should the shrimp do in this situation? Korea is in the fortunate position that it exports to both the U.S. and China. If the U.S. slows and China accelerates, it can export less to the first and more to the second. Since China is more a purchaser of capital goods and the U.S. of consumer goods, this will be better for Korea's shipbuilding industry than its consumer-electronics industry. But so it goes. Korean policy makers will want to worry more about strengthening trade and investment links with China and less about finalizing the Korea-U.S. FTA. But, again, there would be no grounds for a radical course correction.

While it is hard to imagine that 2008 could turn out better than this, it could turn out worse. Considerably worse would be if China joined the U.S. in recession. The two motors of the world economy would then fail at the same time. And countries like Korea would have no market to which to turn.

An interruption to Chinese growth is by no means certain, but there is a sense in which most economists are underestimating the risks. Worriers have been warning for years of dangerous imbalances in the Chinese economy. China's high investment is admirable, but massive amounts of inefficient investment come back to haunt you ― as Koreans will remember from their own experience in the 1990s. Labor shortages on the coast coexist with labor shortages in the interior. The Chinese economy remains excessively dependent on exports, including exports to a slowing United States.

Particularly worrisome is the country's financial position. China is experiencing massive property-market speculation. The stock market has lost all touch with reality. The banking system is a mess. No one knows exactly how much the banks have lent to real estate and stock market speculators, but the answer is certainly ``too much.''

The most alarming aspect is that the problem will only worsen. Since the renminbi continues to track the dollar, a lower dollar will mean more receipts for Chinese enterprises desperate for somewhere to park their funds. There will be even more credit and liquidity chasing the same investments in real estate and the stock market. Lower Fed interest rates will mean lower Chinese interest rates, where this is the last thing that the economy needs. Unless there is a radical change in China's exchange rate policy, which remains unlikely, the speculative mania will only heighten.

What goes up can, of course, come down. It is hard to say what the trigger might be, but history suggests that there will be one. The United States had a series of investment-led booms and crashes, followed by recessions, when it was a developing country in the 19th century. There is no reason why China should be different.

And a sharp decline in the Shanghai and Shenzhen stock markets could mean a sharp decline in Chinese growth. Property developers would pull in their horns. Banks that had lent to real estate and stock market speculators would have to rebuild their balance sheets, and they would curtail their lending to industrial and commercial borrowers. With less domestic demand, Chinese firms would attempt to export more of what they produced. And the United States would be in no position to buy it.

For an economy like China presently growing a more than 10 percent, a sharp slowdown would mean that growth fell by half, to 5 or 6 percent, until the financial situation normalized. Five or 6 percent growth is not a recession for a typical economy, but it would be a very sharp change in circumstances for China and the world.

If 2008 is a year of U.S. recession, many economists will be able to say ``I told you so.'' While the consequences for the world economy and the Korean economy will not be pretty, the pain will be tolerable. But the real danger is that 2008 may also be a year of Chinese recession. For most economists this would be a surprise. And for the world economy and Korea, it would be a very painful situation.