Ronald Man
HSBC economist
High-beta economies are being hit by sluggish trade. Korea is no exception — exports amount to half the size of its GDP, a global slowdown will have a proportionately larger impact on the country. Weak overseas demand for goods lower production, prompting firms to cut jobs, which decreases domestic demand.
Korean exports contracted sharply in July, showing that persistent weakness in the global economy is being felt in the local economy. The outlook, too, remains dim.
Our Asian electronics lead indicator points toward a quarterly contraction in the region’s electronics cycle. This means electronics exports and, in turn, production, are set to moderate further through September. As the electronics industry makes up almost half of Korean manufacturing production, sustaining growth in Korea will become increasingly difficult.
We recently downgraded our Korea 2012 GDP growth forecast to 2.6 percent. While lower trade contributed to the downward revision, the real driver is domestic demand. Household consumption growth is slowing, while firms are pushing back investment. Most worryingly, there are signs of weakening in Korea’s labor market, which may make repayment of household debt increasingly difficult.
Already, the Bank of Korea has responded by cutting its policy rate. Lower rates will reduce the burden of interest repayment on household debt, given that 88 percent of bank loans to households are tied to variable rates. This increases the disposable income of Korean households, which may be used to support consumption growth.
One potential drawback is that the interest rates on bank loans have become less responsive to policy rates.
A sharper rate cut by the Bank of Korea is required to deliver an equivalent reduction in interest rates charged on banks loans. Monetary policy is now a less efficient tool to stimulate the economy.
Policymakers are likely to see through this and keep as much of their powder dry as possible. Barring a sharp external shock, a return of policy rates at 2 percent following the 2008 global financial crisis is unlikely. Greater pressure will be placed on the government to use fiscal stimulus.
Recently, the South Korean government announced plans to raise the minimum corporate tax from 14 percent to 15 percent. Higher tax revenue will fund more welfare spending while keeping the government on track for its targeted fiscal balance in 2013. This, however, will probably be implemented next year. With the eagerly awaited Chinese recovery proving slower than expected, Korean policymakers may need to act sooner.
So far, government expenditure has been kept in line with the 2012 budget. Around 60 percent of planned spending came through in the first half of this year. Note, however, that the current budget was initially built on the assumption of a strong recovery in the second half of the year that would have brought this year’s growth to 3.7 percent.
In June, the Ministry of Strategy and Finance downgraded its growth forecasts to 3.3 percent. Now, even this appears too optimistic. Calls for a supplementary budget will become louder.
Indeed, fiscal stimulus will be a more efficient tool to support growth for three key reasons: First, unlike monetary policy, the lag for it to have its maximum effect on the economy is shorter. Second, spending can be targeted at the most vulnerable groups — think of the 8.5 trillion won economic support measures rolled out at the end of June to low-income earners and small businesses.
Third, the government is in a strong fiscal position to spend more. Korea’s government debt-to-GDP ratio and expected fiscal deficit in 2012 are among the lowest across OECD countries.
A responsible increase in spending to support growth over a particularly tough economic period is unlikely to threaten the country’s hard-earned reputation for fiscal prudence.
In all, do not expect an aggressive monetary easing cycle from the Bank of Korea. A balanced mix of monetary and fiscal policy will likely be used to keep Korea’s engine running. Look out for more fiscal spending.