Value context and insight. lkm@koreatimes.co.kr
Contribution It's not stagflation. It's steady-state expansion
Deyi Tan / Courtesy of Morgan Stanley
By Lee Kyung-min
By Deyi Tan
In 2021, the Korean economy was in what we call a “Goldilocks” phase. In this phase, GDP growth accelerated to being above-trend. Inflation remained benign, and policies were big and easy, with active fiscal policies and loose financial conditions aided by the Bank of Korea's monetary accommodation.
As we approach 2022, markets are debating the likelihood of stagflation, given growth headwinds and upside inflation risks.
Indeed, on the growth front, downside concerns stem from the implications of China's regulatory action and property market deleveraging. More recently, there are also concerns over the Omicron variant and how it may impact the recovery trajectory.
Then there are the supply-side constraints, which have led to fears that this situation could amount to a constraint on growth and continue to lead inflation to surprises on the upside.
Also related to upside inflation risks are how the Bank of Korea and other central banks may respond, especially against the backdrop of a faster Fed taper and whether that could pose an added headwind to growth.
Despite such concerns, we are not in the stagflation camp. We remain optimistic and believe that the growth cycle in Korea is advancing from a Goldilocks phase to a steady-state expansion phase in 2022.
We see three macro trends in this steady-state expansion phase.
First, the percentage of year-on-year GDP growth should be moderate but remain favorable and above-trend, as growth broadens out from exports to domestic demand. Indeed, we see Korea's 2022 GDP growth at 3.4%, year-on-year (versus 4.1%, year-on-year, in 2021). This figure is higher than the consensus' expectation of 3.1% for 2022.
Second, inflation should moderate gradually to an average of 1.9%, year-on-year, in 2022, slightly below the Bank of Korea's inflation target of 2%, after peaking in the fourth quarter of 2021.
Third, we see further policy rate normalization but do not expect that to disrupt the growth cycle.
Indeed, we are optimistic on Korea's growth for the following reasons.
Exports have led the growth recovery in Korea, and there are concerns that the normalization of one-off tech demand, the shift in consumer spending from goods to services and the spillover from China's property market deleveraging could impact Korea's exports.
The year-on-year growth of exports should certainly normalize amidst base effects and as one-off tech demand from COVID-19 peters out. However, we think the underlying growth momentum is likely to remain healthy, and we expect Korea's export growth ― year-on-year ― to moderate to a level that is still above trend in 2022.
This prediction is because secular tech demand for 5G, AI, and cloud computing should stay healthy amidst policymakers' push for automation, digitalization and the smart economy.
China's counter-cyclical policy easing, the U.S.' great inventory rebuild, and excess household savings in the U.S. should also combine to keep global GDP growth at 4.7%, year-on-year, in 2022. This figure is about 1 percentage point higher than the 10- to 20-year historical average seen pre-COVID-19 and should provide a favorable global backdrop for Korea's exports.
Additionally, this export recovery should also broaden out to domestic demand. There have been concerns regarding the macro impact of the Omicron variant. However, our view is, to the extent the Omicron variant is likely more transmissible but less deadly compared to Delta, then any impact from Omicron is likely to be less negative compared to earlier COVID-19 waves.
This expectation is because the vaccination rate is now higher, the private sector has adapted to the new COVID-19 “normal,” and policymakers are likely to adopt a more targeted and nuanced containment approach compared to before.
Moreover, a ramp-up in overall capital expenditures should also help to support domestic demand. Recent chip shortages are leading to a supply-side capacity expansion. Korea's policymakers earlier put in place measures to attract $450 billion in semiconductor capital expenditure by 2030. This figure is sizable at about 27.4% of the 2020 GDP.
Now if all is well on the growth front, what about upside inflation risks?
Inflation has temporarily overshot the Bank of Korea's inflation target range, but we expect it to moderate to below 2% by the second quarter of 2022 for the following reasons.
Global supply constraints have contributed to higher input costs. These constraints have been driven by structural factors (decarbonization, U.S. truck driver shortages), cyclical factors (strong recovery) and temporary factors (weather, COVID-19 production disruptions and capital expenditure delays).
The structural factors are unlikely to go away in a hurry, but temporary factors are fading and helping to alleviate constraints. Indeed, pandemic-related production disruption has normalized, and capital expenditure plans are being rolled out.
To this point, Morgan Stanley's sector analysts' forecasts for commodities and semiconductor prices suggest that peak inflation is mostly behind us, and that the rate of change should start to slow.
Furthermore, the spillover of higher input costs to broader demand-pull price pressure looks manageable. This situation is because Korea's labor market constraints are not as stark as in the U.S., as seen in labor participation and wage data. Besides, the Korean economy is likely to still be in the process of closing a negative output gap in 2022.
Against this backdrop of growth and inflation, we see the Bank of Korea continuing with policy normalization. We expect the Bank of Korea to undertake three more hikes, bringing its policy rate up to 1.75% by the third quarter of 2022.
We see these policy rate moves as a reflection of Korea's continued cyclical recovery. We do not think such moves will amount to an aggressive tightening cycle that will derail growth.
Indeed, based on our projections, after three more rate hikes, Korea's real policy rate would get less negative but still hover close to zero and below what we think is the neutral real policy rate of 0-0.5%.
Moreover, on the fiscal side, Korea's fiscal purse strings will likely remain loose amid an extended election cycle and lingering COVID-19 uncertainties.
Despite the slight narrowing to -4.6% of GDP, Korea's 2022 managed fiscal deficit should still remain materially wider than the usual 1-2% deficit level seen before the pandemic.
Where are the risks? We would watch the following factors.
Growth risks could stem from the COVID-19 pandemic situation and the pace of reopening, potential spillover risks from China's growth slowdown and policy developments after Korea's elections, as well as upside inflation risks in the U.S. and the implications of that for the Fed's tightening path, along with the potential spillover to global demand.
The writer is the Asia Economist at Morgan Stanley.