End of expansion?

Economy passing a peak point; set to slide into contraction

By Kim Jae-kyoung

For policymakers, it is extremely important to correctly analyze and assess the state of the economy as a wrong diagnosis results in the wrong prescription, which could cause significant consequences for the country, such as a prolonged contraction and high inflation.

In this regard, policymakers and investors are always paying close attention to the so-called business cycle, which shows where the economy is heading. The cycle tends to exhibit a pattern — an expansion, a peak, a contraction and a trough.

Depending on which phase the economy stays in, the financial authorities shift the focus of their policies. Correct analysis of economic developments makes it possible for them to take policy actions in a preemptive manner so that unwanted shocks can be prevented.

The business cycle has emerged as one of the hottest topics here after the Bank of Korea (BOK) released on Nov. 29 the minutes of its October monetary policy committee meeting where a couple of members voiced concerns over Asia’s fourth largest economy ending its expansion phase and entering a contraction.

“The economy has already been in an expansion phase for more than 30 months and has lost growth momentum. It is probable that the economy is now passing the point of a peak and that (entering a contraction stage) is imminent,” the note quotes one committee member as saying. Statistics Korea has assumed that the economy bottomed out in February, 2009

According to the minutes, another member expects the Korean economy will contract in the first quarter of next year, citing the sluggish U.S. economy, which many economists believe will shrink in the fourth quarter of this year.

The problem is that these concerns seem quite plausible assumptions. Several indicators showing signs of such an economic situation, including employment, personal income and industrial production, all point to a downward trend. Indicators such as manufacturing and trade also remain gloomy.

“The signs in the global economy right now are not very good. I think it is the correct assumption (the economy is approaching a contraction stage),” Mauro F. Guillen, director of the Lauder Institute at the Wharton School, told Business Focus.

“Right now a threat to the global recovery, and Korea’s own growth, is the priority over inflation, which is not as big a problem as some think,” he added.

HSBC Asian Economics Research economist Ronald Man echoed the view, saying, “the Korean economy will probably remain on a growth trajectory but it is set to enter, if not already, a period of prolonged slowdown.”

Where are we?

The business cycle generally repeats, though not in a regular manner. Contraction is followed by periods of expansion. Governments can opt for various policies to narrow the cycle to reduce the harshness of recessions.

Expansion is a speedup in the pace of economic activity, while contraction is a slowdown in such activity. At the point of peak, the upper turning of a business cycle, expansion turns into contraction.

In the past, the gross domestic product (GDP), the total value of goods and services produced within a country in a given period, was considered the most popular indicator of the business cycle because it is related to aggregate economic activity. Technically, a recession refers to two consecutive quarters of falling GDP growth.

However, with business environments more complicated and changing faster, the GDP has become less popular as a primary business cycle indicator. The GDP, the broadest measure of economic performance, is revised frequently and reported only on a quarterly basis, while the business cycle is normally tracked on a monthly basis.

For such reasons, policymakers and investors are nowadays looking at more specific data, such as employment, personal income, industrial production and trade, to figure out where the economy is heading.

If you look at only the GDP side, the Korean economy is still in an expansion phase. According to the BOK, the GDP growth slowed to a moderate pace in the third quarter but it is expected to show a better performance in the fourth quarter.

The nation’s GDP grew 0.7 percent quarter-on-quarter between July and September, slowing from a 0.9 percent expansion in the second quarter. The GDP rose 3.4 percent last quarter from a year ago.

The central bank’s official view is that the economy is confronting several downside risks but is likely to stay on track for expansion.

“In the fourth quarter, the growth number is forecast to be better than the third-quarter, bolstered by exports,” Kim Young-bae, director general of the BOK’s economic statistics division, said at a press conference in late October.

However, most other indicators of the business cycle speak a different story.

According to Statistic Korea Wednesday, industrial output declined 0.7 percent (seasonally adjusted) month-on-month in October after a 1.2 percent gain in September, while business investment fell 12.1 percent. The growth rate of the leading economic index fell for a third consecutive month to 1 percent year-on-year from 1.4 percent a month ago.

Both export and domestic shipments are also losing steam. On a year-on-year basis, export shipments, both to the euro area and the U.S., suffered back-to-back declines in October and November 2011, the first back-to-back setback since September and October 2009. Korea’s export growth to China has slowed further.

“We believe that Korea’s still solid exports to emerging economies will fade soon as these economies are negatively affected by weaker growth from the euro area, the U.S. and China,” Nomura International economist Kwon Young-sun wrote in its latest research paper Thursday.

However, producer inventory increased by 3.2 percent month-on-month in October. As a result, the inventory/shipment ratio surged to 109.5 in October.

“This (the inventory/shipment ratio) was the highest reading since February 2009 (110.1) and suggests that manufacturers will likely cut production in the coming months to reduce inventory given the bleak demand outlook,” Kwon said.

“There are increasing signs of weaker growth for the Korean economy,” he added, forecasting the GDP growth will slow to 0.4 percent in the fourth quarter from the previous quarter’s 0.7 percent.

Employment figures are showing signs of slow improvement but if the real situation in the labor market is factored in, the outlook still remains bleak. The jobless rate fell in October and job creation accelerated at the fastest pace in 17 months,

However, the current unemployment data did not include a large number of people who are preparing for jobs and remain economically inactive. Besides, the unemployment rate among those aged 15 to 29 was 6.7 percent in October, up from the prior month’s 6.3 percent.

Implications for policymakers

Taking all things into consideration, it is obvious that the Korean economy is losing steam in many aspects of economic activities. Lingering woes in Europe are likely to accelerate this trend by dampening exports, which supports the views that the economy is at the entrance of a contraction stage in the business cycle.

The fact that such pessimistic views, although they are not yet majority, are gaining ground at the monetary policy committee indicate that the central bank will unlikely normalize monetary policy in the foreseeable future by raising its key rates despite high inflationary pressure. The BOK froze the key rate at 3.25 percent for the fourth straight month in October.

The BOK will face one of its toughest decisions of the year at the December monetary policy committee meeting on Thursday. Domestic demand is weak enough to warrant a rate reduction, but headline CPI has breached the 4 percent ceiling again in October, even with the new basket in force.

“Current conditions do not merit a rate cut by the Bank of Korea. External risks continue to loom large, highlighting the need for policymakers to sustain demand. But, given economic activity has not fallen off a cliff, the BOK should save some of its monetary firepower as insurance against a significant external shock,” Man of HSBC said.

“Elevated inflation and high household debt, too, will hold back the central bank from cutting rates. In particular, limiting further leverage of households is critical for dampening the contractionary effect when rates restart their normalization process,” he added.

Since inflationary pressure has been stoked mainly by the central bank’s credit-easing policies, additional monetary easing will not be efficient in injecting a new vigor into economy. In this regard, the government is advised to resort to fiscal stimulus.

“Growth will lean increasingly on government expenditure for support. Unlike many OECD countries, Korea’s sound fiscal position allows it to finance expansionary policy,” Man said.

“In particular, SMEs may require support from the government to weather both domestic and external headwinds, especially as access to credit begins to tighten.”