Country Report South Korea
South Korea’s banking sector remains vulnerable to external liquidity risks, although these have been reduced somewhat, and rising household debt. Supported by government measures, real GDP growth has been accelerating. Meanwhile, tensions with North Korea have eased, for now.
Strengths (+) and weaknesses (-)
(+) Well developed and diversified economy
South Korea’s economy is the 15th-largest in the World with a relatively high GDP per capita. It has a strong, diversified and internationally highly competitive industrial and manufacturing base.
(+) Strong democratic institutions
Underpinned by a mature and stable democratic system, South Korea has strong institutions. Especially the rule of law, regulatory quality and government effectiveness are solid.
(-) Export dependency
South Korea’s economy is very open (import + exports amount to 114% of GDP) and heavily dependent on exports. As a result, it is vulnerable to external shocks.
(-) Relations with North Korea
The Korean War ended in 1953 without a formal peace-treaty and the countries are thus still officially at war. As a result of highly erratic and at times aggressive behavior of North Korea, tensions flare up from time to time.
1. Banking sector risks remain, although external liquidity risk has fallen somewhat
South Korea’s banking system’s dependency on offshore funding, makes it vulnerable to external developments and adverse changes of investor sentiment towards South Korea or emerging markets in general. In the past years, this risk has been reduced compared to 2008. South Korean bank’s foreign liabilities have reduced since end-2008, with net foreign liabilities decreasing by 33% between end-2008 and end-2012 (figure 1). Moreover, the share of short-term external borrowing to total foreign debt has fallen as well and the sources of funding have been somewhat more diversified, which has lowered the dependency on funding from Europe while more funding is sourced from Asia and the US. The reduced vulnerability somewhat helped South Korea to cope with the recent global market turmoil - the result of the anticipated ending of quantitative easing measures in the US that has led to a strong outflow of capital from emerging markets. Even so, despite a 25bps cut of the Bank of Korea’s Base Rate to 2.5%, domestic interest rates came under upward pressure. This indicates that although external vulnerabilities of the banking sector have reduced, they continue to constitute an important risk. Fearing that the corporate sector would face a credit squeeze as a result of the higher interest rates, the government implemented a KRW 6.4trn (USD5.5bn) corporate bond refinancing program to lower interest rates, as it did in response to the global financial turmoil in 2008. High and rising household debt is another risk factor to the banking sector. Compared to end-2009, total household debt has increased by 25% to a record KRW 927trn. With household debt at roughly 73% of nominal GDP (2012) and expected to rise further, the situation may prove unsustainable. Moreover, falling real estate prices may aggravate the problems as declining property values could lead to mortgage repayment problems. Fixing the household debt problem will be difficult and South Korean authorities will have to carefully manage the situation.
2. Growth performance boosted by government measures
On the back of weak external demand, which also led to a contraction of investment, South Korea’s export-dependent economy grew by a mere 2% in 2012. In 2013, external demand remained weak. Growth in China slowed and the yen weakened on the back of strong monetary easing implemented in Japan. In response, the government passed a supplementary budget, which will raise government expenditure growth to 5.5%. Furthermore, tax measures were implemented to support private consumption growth while stimulus measures helped push up investment growth. As a result, real GDP growth accelerated to 4.4% year-on-year in the second quarter of this year. In the second half of 2013, the stimulus measures that were implemented earlier in the year are expected to continue to have a positive effect on growth. Furthermore, export growth, which was stronger than expected in July at 2.7% year-on-year, will likely benefit from (temporary) stronger growth in China – as a result of stimulus measures implemented there – and increased strength of the US economy. However, exports to Japan will continue to suffer from the weakness of the yen. For the whole of 2013, real GDP growth is estimated at 2.8%. Inflation, meanwhile, has remained well below the 2.5-3.5% central bank target. In July, consumer prices rose by 1.4% year-on-year. The government’s stimulus measures will likely have an upward effect on inflation but oil prices, a major factor, remain difficult to forecast. Increased tensions in the Middle East have led to upward pressure recently. Therefore, it is likely that average inflation in 2013 will be higher than the 1.7% currently estimated.
3. Tensions with North Korea have eased again, for now
Late 2012, North Korea successfully carried out a long-range missile test. The UN intensified sanctions against North Korea in January this year in response. In turn, North Korea performed a third nuclear test on February 12th. Tensions between North Korea and South Korea flared up strongly as a result. All forms of direct communication between the two countries were cut off, the joint industrial complex (Kaesong) was closed and the North threatened with a nuclear war against its Southern neighbour. After a period of extremely high tensions, a lack of provocations from North Korea quieted down the situation. Recently, developments have become more positive. The hotline between the two Korea’s was opened again and talks between the countries have eventually led to an agreement on the re-opening of the Kaesong industrial complex. South Korea’s government has been positive about these attempts to re-establish a degree of trust between the countries. As a result, tensions on the Korean peninsula are likely to continue to ease in the coming months. However, North Korea’s regime is known to act highly erratic and at times aggressive towards South Korea. Aside from badly needed foreign exchange earnings from the Kaesong complex, there is no real pressure for the North Korean government to maintain improved relations with South Korea. The role of China, which desires stability in the region, is also important in this regard, as this is the only country that is still able to effectively influence the North Korean regime. Its influence, however, seems to have diminished compared to a few years back. The situation, therefore, remains highly volatile and tension might flare up again unexpectedly.
South Korea is a high-income country with a strong industrial base. South Korea is the 15th largest economy in the world and a member of the G20 and the OECD. Since South Korea has adopted an outward-looking strategy in the second-half of the 20th century, in which growth and development were supported by labor-intensive manufactured exports, the country industrialized rapidly. The industrial sector still remains the backbone of the South Korean economy. From the 1990s onwards, South Korea’s manufacturing sector expanded into other, more high-tech areas such as microelectronics and microbiology. The importance of the export sector to the South Korean economy does, however, increase the country’s vulnerability to external developments. As a result of continued focus on business friendly policies, the country is ranked 8th out of 183 countries on the ease of doing business index.
A constitutional change in 1987 laid the foundation for the current stable multi-party democracy. South Korea’s political and business environment is dominated by close personal relationships and a strong influence of cheabols (large business conglomerates). The downside of this is economic nationalism and corruption. Since fighting between North and South Korea ceased in 1953 without a formal peace-treaty, the tense and uneasy relationship between the two nations remains an important downside risk. Tensions flare up from time to time, usually due to provocations initiated by the North Korean regime.