South Korea: still going strong
Government stimulus helps South Korea’s economy hold ground against domestic and external headwinds. Tensions with North Korea have picked up, but are unlikely to have severe consequences.
Strengths (+) and weaknesses (-)
(+) Well developed and diversified economy
South Korea’s economy is the 13th-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 relatively strong institutions. Especially the rule of law, regulatory quality and government effectiveness are solid.
(-) Strained relations with North Korea
The Korean War ended in 1953 without a formal peace-treaty and the countries are still officially at war. Highly erratic and at times aggressive behaviour of North Korea flares up tensions occasionally. A collapse of North Korea could result in very high re-unification costs for South Korea.
(-) High household debt
Korea’s household debt to GDP ratio has increased rapidly in recent years, from 72.3% in 2007 to 85.6% in 2015, which is similar to the most indebted advanced economies in the world.
1. Stimulus helps economic growth weather headwinds
South Korea’s economy slowed down from 3.3% in 2014 to 2.5% in 2015, with weak external demand dragging down on growth for the first time since 2010 and a MERS outbreak hurting activity. Domestic demand found support in policy stimulus, both on the monetary and fiscal front and strengthened in 15H2. The Bank of Korea cut policy rates by 1ppt between June 2014 and June 2015 to their lowest level on record of 1.5% (figure 2). The government’s expansionary fiscal stance, including several stimulus packages and cuts in consumption taxes, reduced the budget balance by 1ppt to a deficit of 0.4% of GDP (figure 3). Looking forward, economic growth is expected to remain just below 3%. Exports should benefit from new free trade agreements with China, Vietnam and New Zealand adopted in late 2015. Monetary policy is expected to remain accommodative, though high private sector debt will contain further easing. Consequently, South Korea will use the room given by low public debt (36% of GDP in 2016) to stimulate the economy.
2. External position strengthens
The external position of South Korea has continued to improve, thereby reducing one of the country’s past vulnerabilities. Structural current account surpluses (at record levels in 2015, 7.2% of GDP) pushed the external balances into positive territory in 2014. The net international investment position has strengthened ever since to 13.7% of GDP in 15Q3. On top of that, South Korea has improved the maturity profile of its debt. In 2015 short term debt is estimated at around 30% of foreign debt, down from 40% in 2011. Banks are also reported to have reduced their short term borrowings to less than 50% of external bank debt, down from more than 70% before the great financial crisis. Besides, they also have little currency mismatches as the lion share of short term external debt is matched by hedging activities by exporters. South Korea’s vulnerability to a sudden stop of foreign finance, which caused the 1997 crisis and led to some financial markets tension in 2008 again, has thus fallen firmly. However, the banking sector still relies strongly on external financing and is thus vulnerable to a tightening of international capital markets conditions.
3. Household debt is high but not yet problematic
South Korean households picked up the pace of borrowing in the past two years. In terms of GDP, household debt increased by roughly 4ppts between 14Q2 and 15Q2 to 85.7%. More importantly, at 165% in 15Q1, debt to disposable income is higher than the OECD average of 133%. Debt service was just 11.5% of disposable income in 15Q2, but could pick up rapidly if interest rates increase given the high share of flexible interest rate debt. On a positive note, the lion share of household debt is mortgage debt, partially related to the country’s peculiar house rental system which requires the tenants to deposit a large share of the real estate value with the property owners; an amount which most South Koreans need to borrow. Also positive is the strong net asset position of households and concentration of mortgage debt amongst high income households. Nevertheless, household debt could become problematic in the longer term, when monetary policy tightens again. Therefore, it is positive that the government has implemented a package of measures in June 2015 to increase the share of fixed-rate and amortizing loans from 33% at the time, and thus reduce this risk. The measures are also likely to constrain further leverage as they shift the check of creditworthiness from the collateral to the payment capacity of the borrower.
4. Another episode of the North Korea saga
Tensions between South and North Korea flared up twice in the past year. The first incident, the injury of two South Korean soldiers in the demilitarized zone in August 2015, led to the first exchange of artillery fire since the end of the Korean War in 1953. South Korea also retaliated by resuming cross-border loudspeaker broadcasting for the first time since 2004. Tensions were eased by an agreement reached on August 24, but increased again in January 2016 when North Korea announced it had tested a “hydrogen bomb”. These skirmishes increase tensions and might trigger economic retaliation against North Korea, but are not expected to precipitate a violent conflict.
South Korea is a high-income country with a strong industrial base. South Korea is the 13th largest economy in the world and a member of the G20 and the OECD. After South Korea adopted an outward-looking strategy in the second-half of the 20th century, in which growth and development were supported by labour-intensive manufactured exports, the country industrialised 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 185 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 chaebols (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.