Contribution How will economy respond to 'Living with COVID-19'?

By Lloyd Chan

Lloyd Chan, economist at Oxford Economics

Despite a surge in Delta-driven COVID-19 cases, Korea's economy continues to recover and should enter 2022 on a firm economic footing. Output returned to pre-coronavirus levels in the first quarter of the year and by the second quarter was 1.4 percent higher. We currently forecast a 4-percent expansion for 2021 to be followed by 3.5-percent growth in 2022. And while peak growth is behind us, the recovery across all major economies will continue to support Korean exports.

But next year we think consumption will be the engine for growth, particularly as coronavirus restrictions are lifted. Indeed, the government is considering how to transition into a new normal of “Living with COVID-19,” and the shift to fewer social-distancing measures may come as soon as November, according to reports. While a resurgence of COVID-19 could be a risk, a majority of the population is now fully vaccinated, reducing the chances of serious illness from the virus.

Living with a new normal

The shift to relaxing restrictive measures will catalyse the recovery in domestic consumption. Once mobility constraints are lifted, we think consumers will refocus their spending on services, with local businesses poised to be the first to gain. Since the start of the year, visible gains have been seen in accommodation and food services, and online sales of travel and transportation services. True, the recovery momentum in retail sales of goods has tapered off somewhat, but this reflects the shift to services as pent-up consumption demand is unleashed.

Recent encouraging trends support our view that consumption will strengthen in 2022. Employment returned to growth in March and continues to rise. And since March, the consumer sentiment survey has also indicated confidence in the domestic economy. Although optimism dipped in July and August amid a resurgence in COVID-19, sentiment improved in September even though restrictions were still in place, suggesting that people are adjusting to a new normal. And if, as is possible, households unwind their large stocks of household savings faster than expected, consumer spending could exceed our forecast.

Risks lurk in background

One potential risk is that the reopening of Korea's economy will trigger a rise in daily COVID-19 cases, a scenario that played out in other highly-vaccinated countries, such as the UK and Israel. But if the experiences of the United Kingdom and Israel are any guide, COVID-19 cases should ebb at some point.

While we think export performance in 2022 will be less impressive than this year as we move past peak growth, our forward-looking indicators of world trade bode well for Korean exports. What's more, the manufacturing purchasing managers' index has remained positive for twelve months, and in September was above 50 (indicating expansion) on the back of output and orders growth.

The recent strength of semiconductor exports, which account for about one-fifth of Korean outbound shipments, and sales of semiconductor manufacturing equipment suggest that the electronics sector has potential to grow even more. The persisting global shortage of chips and increased digital transformation across the world will generally be a positive for chip exports.

Central bank will stay the course

Barring a sharp deterioration in health conditions derailing growth as the country pivots to living with COVID-19, the durability of the economic recovery should sway the Bank of Korea (BOK) to stay the course on rate normalization and maintain its focus on curbing the risk of growing financial imbalances.

We estimate that household debt as a share of disposable income will rise to 178 percent in the third quarter, from 175 percent in the second quarter. House price growth has also accelerated, while the consumer price index inflation has surpassed the central bank's 2 percent inflation target. Improving domestic demand and elevated energy prices look set to keep inflation above 2 percent through the first half of 2022.

Given elevated household debt levels, we think policymakers will proceed with rate normalization carefully to avoid causing a disorderly adjustment to the household sector.

Accordingly, we expect one 25 basis point rate hike at the BOK's last monetary meeting of this year on Nov. 25. After that, we believe monetary policy normalization will remain gradual and we maintain our expectation for only one 25 basis point rate hike in 2022 to lift the policy rate back to the pre-pandemic level of 1.25 percent.

Overall, we expect consumption to continue to rotate into services as the country pivots toward living with COVID-19. Consumers are optimistic about domestic growth prospects, and the gains in employment and a faster unwinding of accumulated household savings will support stronger spending.

The writer is an economist at Oxford Economics.