Global Economy
Nature of Recent Economic Distress in South Korea

Jahyeong Koo examines causes for declining economic growth in Korea.

After showing over-par growth of 6.3 percent last year, the South Korean economy started to lose its growth momentum. Korea’s robust growth in 2002 had been sustained by the overall resiliency of domestic demand, even as worldwide economic conditions deteriorated and Korean exports fell. However, this engine of Korean growth has weakened recently, as evidenced by the decline of retail sales and household expenditures in fourth quarter 2002. Equipment investment dropped 11 percent year over year in January, and business sentiment has worsened for the past six months.

Korea's Economy Slows
The Korean economy is heavily dependent on oil imports and semiconductor exports—Korea’s share of the world D-RAM market is 45 percent. Recent oil price hikes and falling D-RAM prices, due to the delayed expansion of U.S. capital expenditure, have weakened Korea’s terms of trade. For the first time in three years, Korea’s economy showed a trade deficit in January and February (Chart 1). However, the current deceleration of the Korean economy was more abrupt than changing international economic conditions would predict. Geopolitical and political factors have also influenced consumer and investor decisions in Korea. The war in Iraq, the nuclear threat from North Korea and the politically oriented expansion of Korean domestic credit in 2001 and 2002 have all contributed to the break in Korea’s consumption spree.

Chart 1

Korea's Sensitivity to Foreign-Demand Shocks
Geopolitical uncertainly in Iraq and fear of an oil price shock have stalled the world economy. As a heavily trade-dependent economy (Korea’s trade–GDP ratio is 76 percent, whereas the United States' and Japan's are 21 percent and 17 percent, respectively), Korea is particularly sensitive to foreign-demand shocks. Among East Asian nations, an oil price shock would have the most negative impact on Korea because the country’s economy is the most energy intensive. Korean equity markets, which co-move with their foreign counterparts, have fallen to historically low levels. The Korean stock market index, Kospi, is at a 16-month low, and Kosdaq, the Korean counterpart of Nasdaq, is the lowest since it opened in 1996 (Chart 2).

Chart 2

Effects of the Region's Worsening Political Climate
Recently North Korea withdrew from the Nuclear Nonproliferation Treaty and threatened to reprocess plutonium if the U.S. government did not renew its promise to supply oil and begin discussions of establishing diplomatic relations with the isolated country. The current political situation has worsened. North Korea launched a test missile and interrupted a U.S. Air Force intelligence operation. Also, the new South Korean president has publicly announced that he strongly opposes any aggressive measure by the United States against North Korea under any circumstances.

Markets and consumer sentiments are highly susceptible to the risk of possible military action in the Korean peninsula. In response to this region-specific risk, the Korean won has fallen against the dollar—even as the dollar weakened against the euro and the yen because of uncertainty caused by the war in Iraq (Chart 3). The markets’ nervousness is also reflected in the higher risk premium of Korean government bonds, which reached 1.9 percent in mid-March.

Chart 3

Consumption Boom Turns to Bust
It is not only foreign shocks and the geopolitical uncertainty that have chilled Korean consumers’ instinct to buy. Last year’s strong demand was upheld by a credit-expansion policy, which was politically motivated prior to December’s presidential election. Loosening regulation on household loans by commercial banks launched a household loan and real estate boom. Household loans have increased 65 percent over the past two years, currently reaching 76 percent of the country’s GDP (Chart 4). The deregulation of credit card companies also drove the consumption boom. This breakneck credit expansion continued until last fall, when spikes in apartment housing prices caused political problems. As the Korean government tightened the regulations on household loans, the consumption boom turned into a bust. Credit card delinquencies increased dramatically, rising to 11.2 percent in January—far higher than the 5 percent delinquency rate in the United States. The Korean government tends to favor regulatory changes instead of using monetary and fiscal policy to manipulate the boom-and-bust cycle of credit markets. Most of the time, this use of regulatory change is more politically motivated than in Western countries.

Chart 4

Outlook
Economic distress is being felt sharply in Korean daily life. Some observers hope that an early end to the war in Iraq and peaceful settlement of the North Korean nuclear problem will return the economy back to robust growth. However, consumer spending may not bounce back as strongly as hoped, even if geopolitical uncertainty is resolved. The hangover of last year’s consumption binge will carry on for a while.

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