Korea needs to diversify supply chains

By Trinh Nguyen

The novel coronavirus is spreading across Asia ― infecting first China's labor force and economic activity and now South Korean's output.

Analysts had not finished counting the costs of China's deceleration in demand and supply chain disruption on the Korean economy when confirmed cases on the peninsula begun to surge.

Even before the coronavirus struck China and South Korea, the peninsula's economy was already being dragged down by a double digit decline in exports and a sharp fall in investment. The government tried to offset this with more social spending, but weak labor market conditions and subdued expectations of future economic growth did not lift private consumption.

With the virus dampening risk appetite and Koreans' willingness to gather in larger crowds, economic momentum will further sag. Given that private consumption is the largest contributor to GDP at 47 percent, the lack of it will negatively impact the Korean economy.

But it isn't just consumption, which the government will try to offset with more spending, although that won't be enough, investment and external sectors such as exports and tourism will also be impacted.

An analysis by Natixis of 500 publicly listed Korea firms showed that these companies were already suffering the worst in terms of earnings in the first half of 2019 and reduced their investment as a result. Even their usually healthy balance sheet was taking a hit as the ability to repay debt worsened, although still significantly better than Chinese, Singaporean and Taiwanese firms.

With domestic demand infected by the virus, the external environment is not much better. South Korea's tradable sectors are its key comparative advantage and punch above its services sectors in terms of productivity.

That said, the tradable sectors were hit by the downturn in the electronics sector, the slowing down of China's demand, and also the U.S.-China trade war alongside a mini trade war with Japan. All hope for a cyclical rebound was dashed by the virus spread from China to the rest of the world.

Travel curbs and fear of crowded places dragging on Korea's tourism sector ― which is 1.6 percent of GDP, of which 0.5 percent is exposed to China ― will mean that sectors such as transport, retail sales and hospitality will stagnate as the virus goes global.

Beyond the tourism channel, Korea is exposed to Chinese demand for its goods, which is above 10 percent of GDP. Already, February export data show double digit contractions in exports to China, a trend that is likely to continue into the rest of 2020 to an even lesser degree due to the deceleration of Chinese demand.

But it is not just China ― Japan, Southeast Asia and the rest of the world will also have slower demand as well, hurting Korea's tradable sectors.

On the supply side, Korean firms are exposed in three areas: through their mainland investment in China, which is still sizeable despite moving production to Southeast Asia; their reliance on Chinese input for production in Southeast Asian sites; and finally the disruption of imported goods.

Beyond the supply chain impact, increasingly there is a chance that production inside Korea will be disrupted given the rise of infections. For example, SK hynix's headquarters is quarantined although its factory is not yet impacted, and Hyundai Motor shut down part of its operations in Ulsan due to an infected worker.

Vietnam, Hong Kong and Singapore will likely be the most affected on items such as optical instruments, electronic parts and semiconductors. The effects will reverberate across most of the electronics supply chain.

Both external and domestic shocks will bring growth downward to 1.1 percent in 2020 from an already low point of 2 percent in 2019. Such a low performance will require fiscal and monetary support.

The BOK is therefore likely to cut rates and ponder an unconventional policy in 2020 ― rates will likely be cut below the present level of 1.25 percent. On the fiscal side, a legislative election and a raging economic storm will require President Moon Jae-in to do more to help put a floor to growth.

Beyond short-term support, South Korean firms need to accelerate their diversification strategy, following Samsung Electronics' lead to move its manufacturing to Vietnam. Already, foreign direct investment (FDI) to ASEAN has exceeded China and this trend will likely accelerate.

Beyond having relative cheap input costs such as labor and electricity, Vietnam has what few Asian nations have ― a free trade agreement with the largest economic bloc in the world ― the European Union, which gives it a huge advantage. Moreover, it will also accelerate the trend of moving production closer to final markets ― such as the U.S. or the EU.

Trinh Nguyen is a senior economist for emerging Asia at Natixis.