Korea: To Survive the Slowdown in 2007

Sharon Lam | Hong Kong

The Korean economic cycle is often perceived as volatile, and as a result it is common to see overly optimistic growth projections during an upturn and overly pessimistic ones during a downturn, in my view. The resulting adjustment to miscalculated forecasts will therefore often cause unnecessary disappointment, (which happened in mid-2006) or false excitement (which is happening now).

The Korean economy rebounded in 3Q as we had predicted, bringing positive surprise to the market, which led to more pundits looking for further acceleration of the economy. I believe, however, it is too late to look for further rebound in the economy. The export sector and liquidity conditions are turning less favorable, which will only weaken the economy.

We forecast GDP growth to slow from an estimated 5.1% in 2006 to 4.3% in 2007. We are sticking to this 4.3% forecast we set a year ago, and we think it still looks realistic, while throughout the year the market consensus has revised down its 2007 outlook from 4.8% in the beginning to 4.4%, meaning our view has become a consensus. We predict GDP to slow to 3.6% in 1H07 but to pick up to 4.2% in 2H07. We expect the recovery to continue into most of 2008 when we predict growth to be at 4.8%, i.e., slightly above trend.

Meanwhile, we expect inflation to tick up next year on the back of higher housing rent and an increase in service sector charges. The upside in inflation, however, will be offset by a strong currency and therefore we only foresee a moderate pickup in inflation from an estimated 2.3% in 2006 to 2.6% in 2007.

Export slowdown on the way. Exports have been the major growth driver throughout most of 2006. The rosy export picture, however, is likely to be reversed. Korea’s two most important markets, China and US, are both slowing down although it is expected to be a soft-landing in both countries.

Adding to the pressure is KRW appreciation, which is largely narrowing the price discount between Korean and Japanese products. KRW appreciation against other Asian currencies has got to a point that will begin to hurt Korea’s competitiveness, in our view, as Korea’s export prices in USD terms have already been rising faster than Japan’s and Taiwan’s. Korean products that compete directly against the Japanese and Taiwanese will be in trouble, in our view.

Apart from its impact on competitiveness, exporters’ earnings are also directly affected by KRW/USD, as most export items are priced in USD terms, thus leading to earnings lost after conversion into local currency. This was not a problem when export volume was good, but now volume is likely to turn down, and as a result, we believe Korean exporters will be facing double pressure on both volume and price.

Yet consumption may relatively outperform. Consumption generally cannot escape an economic slowdown. However, we believe the slowdown in consumption will be much milder than that in exports this time, implying consumption will relatively outperform next year.

First of all, Korean consumers did not overspend during the consumption recovery in 2005–06. The wealth multiplier on consumption is declining because the extra wealth is now saved for a longer life expectancy, lack of social security and higher property prices, in our view. Nevertheless, the good news is that a more conservative spending pattern has helped Korea to avoid overspending during the boom, and consequently there is no need for correction during the downturn. We expect consumption to remain stable going forward.

At the same time we do not see forces pulling down consumption next year. First, the wealth effect is still slightly positive as we believe property prices will be upheld next year. Second, wage growth and the labor market are stable. Third, there is no overheating in household credit cycle.

We forecast private consumption to slow only marginally from to 4% in 2007 from 4.2% in 2006, which is much milder than the slowdown in exports and overall economy.

And the government will strive to keep sentiment buoyant. There has been a lot of speculation about extra spending from the government to spur the economy before the presidential election at end of next year. If policymakers’ attention becomes merely election-focused next year, then Korea may see a U-turn in housing market regulations, i.e., from restricting to relaxing. This would be the most bullish case for 2007 outlook, yet it will at the same time increase chances of a hard-landing in 2008. Our core assumption is that the government will continue to keep the property market in check, yet instead of using tax measures we expected it to adopt what we see as a “win-win strategy” — increasing housing supply.

We believe property prices will remain strong next year as there is still a housing supply shortage. Meanwhile, new satellite town development will also prop up prices in the short term due to anticipation of a better living environment. We only see prices declining when more new housing is completed, which will be from 2008 onward. With housing prices staying strong next year, if not increasing, consumption growth will not deteriorate.

Whether the government delivers real supportive measures does not matter, in our view. What matters is there will be continuous supportive talk from the government to keep up market expectations. This will help consumer confidence to defy a slowing economy in the first half of next year.

However, do not hope for monetary easing. Cutting interest rates is another way to stimulate the economy next year, yet the property market issue has complicated an interest rates decision. If property market crashes when interest rates are too low to begin with, then the central bank will be left with no policy option to save the economy and a Japan-like recession could happen. We believe the Bank of Korea will keep interest rates unchanged in the next six months. We see chances of further interest rate hikes in 2H07 to cool down property prices.

2008 outlook — recovery to continue but rising risks of property market deterioration. We expect the economy to start recovering in 2H07 and into 2008 on the back of (i) pickup in construction activities as government pledges to increase home supply; (ii) stable consumption as we believe the government will strive to keep sentiment intact; and (iii) exports improving as the Beijing Olympic Games approaches, which will drive more demand for Korean-made chips, consumer electronics and automobiles.

However, we also see an increasing chance of property market deterioration in 2008 when more new housing construction is completed, exceeding demand. Careful control of the housing market to avoid excessive price increases should top the policy agenda in 2007.