South Korea: Positive signs Asia Pacific Economic Outlook, Q1 2016

With China’s slowdown and Japan’s currency appreciation affecting exports, South Korea’s hope for a revival in growth lies in domestic demand. The government's attempts to boost demand by temporarily reducing taxes on automobiles and durable consumer goods resulted in a surge in real GDP growth in Q3.

South Korea’s economy continues to suffer the consequences of China’s slowdown and Japan’s currency appreciation. Thus, the main hope for a revival of growth comes from domestic demand. The government has attempted to boost demand by temporarily reducing taxes on automobiles and durable consumer goods. The result was a surge in the growth of real GDP in the third quarter. The economy grew 1.2 percent from the second to the third quarter, the fastest rate of growth in five years. Was this a one-off event due to a temporary shift in policy, or does it suggest the start of a rebound?

If oil remains largely subdued, which now seems likely, this will not only boost domestic demand in Korea, it will also boost demand for non-oil imports in Korea’s leading export markets such as the United States and Europe.

The evidence is not conclusive, but there are some favorable signs. First, consumer confidence was up in October to the highest level in 2015. This, combined with strong employment growth, bodes well for increased consumer spending. Second, while dollar revenues from exports continue to decline, export volume is increasing. Moreover, although exports to China (Korea’s largest export market) are weak, the revival of the US and European economies has been helpful to exports. These two are the second and third largest export markets for Korea respectively. Plus, the Korean won has declined in value in the past year, setting the stage for greater export competitiveness. Third, the strong growth in the third quarter included a sizable surge in business investment. This bodes well for further increases in production. Also, given low inflation and the likelihood of an interest rate increase on the part of the US Federal Reserve, there is widespread expectation that Korea’s central bank will leave interest rates unchanged, essentially continuing a relatively easy monetary policy. This should be helpful to the economy as well. Finally, given that the budget is roughly in balance, there remains considerable room for the government to engage in further fiscal stimulation (beyond the tax cuts), if the need should arise.

Another factor that is likely to be helpful to the South Korean economy is the very low price of oil. If oil remains largely subdued, which now seems likely, this will not only boost domestic demand in Korea, it will also boost demand for non-oil imports in Korea’s leading export markets such as the United States and Europe. Hence, the path that oil follows could make a big difference for Korea.

Short-term challenges

Although South Korea’s economy appears to be on the mend, problems remain. The most notable is the slowdown in China. If this worsens, it could have a significant negative impact on Korea, given the tight integration of the two countries’ supply chain in electronics manufacturing. Another problem is the large amount of external debt held by Korean businesses.

Longer-term challenges

In the past decade, South Korea’s economy grew at an annual rate of about 3.6 percent. Yet, economic growth is expected to be less than 3 percent for the remainder of this decade and less than 2 percent in the first half of the next decade. Why the deceleration? The main reason is demographics. Due to an unusually low fertility rate, the working-age population is expected to stabilize in the next few years and start to decline early in the next decade. Even if we assume that labor force participation expands, and even if we assume that labor productivity accelerates, economic growth is still likely to decelerate, given the big impact of demographics. Moreover, Korea’s population is set to rapidly age, increasing the ratio of retirees to workers and potentially creating headaches in terms of supporting the elderly population.

Thus, an important question concerns the extent to which productivity growth can be boosted. If it can, then the negative impact of demographics can be offset. Korea’s manufacturing sector has made huge strides, fueling Korea’s emergence as a world class economy. Yet, the services sector has not made much progress, with productivity being low compared to other OECD countries. And, as the economy becomes more affluent and more goods production moves offshore, the fate of the services sector will be critical. If Korea is to be in the same ranks as the United States, Japan, and Western Europe, it will need to boost the efficiency of its services sector.

There is plenty of low-hanging fruit in services. The service areas that have especially low productivity are business services, wholesale trade, and transportation. Among the possible explanations are low investment in these sectors, government regulations that protect inefficient players, and barriers to global trade in these sectors. The latter problem could be partly resolved if South Korea were to join the Trans-Pacific Partnership (TPP), the new free trade and investment agreement between 12 Pacific Rim nations. Indeed the South Korean government has sought membership, fearful that it will otherwise fall behind Japan, Malaysia, and Singapore in terms of competitiveness. Freer trade and capital movements for South Korea would likely go a long way toward boosting services productivity and competitiveness.