[Contribution] COVID-19 recovery in Korea: short-term strength, long-term weakness

Park Cyn-young / Courtesy of Asian Development Bank

By Park Cyn-young

Korea's economy has fared relatively well during the COVID-19 pandemic, thanks to exceptional crisis management. After the first confirmed case was reported in January 2020, the country managed to contain several waves of infections without complete border closures or local lockdowns.

This helped ensure the continuity of essential social and economic activities. The economy contracted 0.9 percent last year, which was one of the best performances among major economies worldwide.

The Korean economy is projected to grow 4 percent this year and 3.1 percent next year. Strong exports and investments have driven the recovery since the second half of 2020.

And expansionary macroeconomic policy bolstered consumer spending starting in early 2021. A new flare-up in infections led to tightening of social distancing measures and a sharp drop in domestic demand in the third quarter. However, the near-term outlook remains bright.

Global demand for Korea's major exports, including semiconductor chips, electronics, automobiles and ships, will likely benefit from the broadening global recovery. Rapid digitization is also a boon to the semiconductor and information and communication technology sectors, boosting exports and investments.

Despite a resurgence of infections, the government appears set to progressively ease social distancing measures as nearly 80 percent of the adult population is fully vaccinated. This also bodes well for consumption growth.

However, the country faces considerable cyclical headwinds as it navigates the path to an inclusive and sustainable recovery.

First, record-low interest rates in response to the pandemic have pushed household debt to over 100 percent of GDP. It is now the highest in Asia. Financial asset and housing prices also soared amid increased market liquidity and credit growth. Inflation has picked up significantly, with higher prices for food, energy and housing rentals. Debt-laden households are vulnerable to higher interest rates as the Bank of Korea (BOK) has begun lifting its policy rates. Should higher inflation force the BOK to raise interest rates faster, rising debt servicing burdens and potential asset price corrections could put households under financial strain, threatening the consumption recovery.

Second, inflation is a concern around the world and for Korea. The release of pent-up demand following lockdowns is raising prices particularly for services, while persistent supply chain bottlenecks and surging energy prices are pushing up manufacturing costs. High inflation could also force the U.S. Federal Reserve to accelerate its tapering of asset purchases and start interest rate hikes earlier and faster than expected. U.S. interest rate hikes and a tightening of global financial conditions have proved disruptive to emerging markets in the past, as global investors pulled funds from riskier emerging market assets. This scenario led to the so-called "taper tantrum" in 2013.

Third, fiscal spending has pushed government debt in Korea to an estimated 51.3 percent of GDP this year, from 41.2 percent in 2019. Although the government's extraordinary fiscal measures were warranted during the pandemic, the debt should be aggressively managed in the medium to long term to ensure its sustainability. The need will continue for increased spending associated with an aging population and necessary structural adjustments to meet growing demand for welfare as well as disaster and climate resilience.

Structural challenges are bigger problem

An aging population, labor market rigidities and widening inequality are casting a shadow over the economy's long-term growth potential. Short-term macroeconomic stimuli seem to have cushioned the economy from the pandemic, but they are unlikely to reverse the long-term trend of declining potential growth.

A recent International Monetary Fund study estimated Korea's long-term growth potential will fall below 2 percent by 2030, mainly due to population aging.

Korea is among the world's fastest-aging economies. People aged 65 and older account for 16.5 percent of its population, and by 2030 the proportion is expected to reach 25 percent.

The fertility rate is 0.84 children per woman, the lowest in the world, while longevity is up thanks to a comprehensive and affordable national healthcare system. Combined with structural rigidity in the labor market that's lowering labor force participation and dampening investment, the aging population is crimping productivity and long-term growth potential.

Social inequality is also a concern, as more than 40 percent of citizens over 65 live in relative poverty (defined as earning 50 percent or less of median household income), according to a recent Organization for Economic Cooperation and Development survey. This is the highest level among the 39 OECD member countries.

Inequality, entrenched by economic and social stratification, can also lead to a loss of momentum and dynamism. Recent reforms have taken aggressive steps to address rising inequality, by driving up minimum wages, increasing property and wealth taxes, and strengthening health insurance and social safety nets.

Despite some potential long-term benefits of these reforms, there has been criticism that they add regulatory obstacles to already rigid markets and pose challenges to long-term debt sustainability.

As the pandemic recedes, government policy needs to transition from "crisis response" to a new phase of "economic recovery." For example, it needs to reorient fiscal spending to promote long-term growth potential that also meets social and environmental objectives.

There is ample scope to raise productivity, especially in the services sector, where regulatory restrictions have limited entries and competition.

The country's goal of achieving carbon neutrality by 2050 can also create new opportunities in the clean energy, battery, and automobile industries. Post-pandemic reforms should clearly promote economic efficiency and productivity by addressing market rigidities, reducing red tape, improving the rule of law and enhancing transparency and predictability in policy making.

The writer is director of the Regional Cooperation and Integration Division in the Economics Research and Regional Cooperation Department of the Asian Development Bank.