South Korea Outlook: Recovery Gathers Momentum
Korea's economy is picking up thanks to easy fiscal and monetary settings, which are lifting domestic demand.
Exports are strengthening on the back of recoveries in the U.S. and Europe, a trend that will accelerate in 2014.
A stronger economy will lift inflation and prompt the BoK to hike the policy rate in the second half of 2014.
The Fed's taper will put downward pressure on the Korean won and upward pressure on bond yields, while the hit to equities should prove temporary.
Household debt, financial market volatility and geopolitical tension are key downside risks.
Despite a subpar economic performance over the past two years, South Korea enters 2014 in better shape. Real GDP growth has strengthened throughout 2013 and is estimated to have climbed to 4% year-over-year in the fourth quarter, near the economy's trend pace. That rate is expected to be maintained in 2014 and 2015 as fiscal stimulus and easy monetary policy settings lift consumer and business confidence and the labour market, which supports a brighter outlook for consumption and investment.
This year’s continued rise in consumer confidence should filter through to a pickup in consumer spending from sub-2% growth in 2012 and 2013 to 3% in 2014. Consumer fundamentals are positive: Koreans are enjoying the best labour market conditions in more than five years, while the unemployment rate sits at a 16-year low of 2.9%; house prices will be growing in 2014 after declining in 2013; inflation sits around 14-year lows; and wages are rising. Consumption patterns are uneven, however. An aging population and higher living costs are two factors causing consumers to spend more on services than goods, which is capping gains in retail trade.
Korea’s export sector had an up-and-down 2013, though prospects are improving. A surge in smartphone sales boosted export sales earlier in the year, but financial pressures in emerging markets from midyear and a loss of market share to Japan dragged on auto and machinery shipments. Electronics will continue to drive exports in 2014, reflecting robust demand for new smartphones and handheld products as they come on line.
Demand from the U.S., Europe and China kept the export sector afloat this year, and these trends will accelerate next year, supporting a broader recovery in shipments of autos, machinery, and other manufactured wares. The drag from emerging markets and Japan appears to be lessening, which is positive heading into 2014. A number of new trade deals, such as those with Australia and Colombia, should also facilitate greater foreign trade ahead.
Low inflation through 2013 gives the Bank of Korea plenty of scope to keep the benchmark rate lower for longer. Yet the drivers that pulled inflation down to less than 1% year on year in the fourth quarter, including weak commodity prices, government subsidies, a strong currency and subdued domestic demand, are all expected to slowly reverse from 2014.
Rising inflation and interest rates
As demand strengthens, Korea’s negative output gap is expected to shrink, placing upward pressure on prices. There are signs that this shift is already occurring as core inflation, which strips out food and energy prices, is nearer to 2% and on a rising trend. Headline inflation, moreover, is forecast to pick up to more than 2% by the end of 2014 and above 3% the by end of 2015.
This all means that interest rates will head higher, although there are cases for and against pushing them up too soon. Inflation, although rising, will not be overly-concerning as it is forecast stay within the central bank’s 2.5% to 3.5% target in the near term. When the dollar strengthens on the back of tighter Fed monetary policy, the BoK may decide to maintain downward pressure on the won by keeping local rates steady. The more likely outcome is that the BoK will be concerned about leaving rates too low for too long for fear of creating financial imbalances, particularly after the credit and housing binge during the 2000s. A forward-looking central bank should also preemptively hike rates as inflation accelerates to prevent it becoming a bigger problem down the track.
Bond markets signal higher rates in the coming years as the yield on the three-year and 10-year papers have increased in recent months, while consumers’ inflation and interest rate expectations are on the rise. Ultimately, rising rates are the result of a strengthening economy, which is a positive development. We expect the BoK to raise the policy rate by 50 basis points to 3% in the second half of 2014. Yields on the 10-year government bond will rise about 100 basis to 4.5% by the end of 2014, reflecting an increase in local short term rates and tighter U.S. monetary settings.
Fed taper provides clarity
Speculation about whether the Federal Reserve would taper asset purchases created volatility in global financial markets through much of 2013. When the Fed does scale back stimulus, which appears imminent, there should be greater clarity for investors. This may help to limit the impact on financial markets, though the same trends witnessed midyear are expected to play out again.
Capital is flowing out again in anticipation of the Fed's taper, and this trend is expected to continue through early 2014, before recovering once investors focus on Korea’s positive fundamentals.
The Korean won is expected to weaken against the dollar through the first six months of 2014, before recovering through year's end. We expect the won to end 2014 slightly weaker than current levels against the U.S. dollar. The unit will continue to appreciate against the Japanese yen, though not as sharply as it has in the previous 18 months.
Taper speculation led to a 7% fall in Korean equities from June to August, and equities are once again expected to feel the pinch in early 2004 before recovering. We look for the Kospi benchmark to end 2014 slightly above the likely finish in 2013.
Domestic risks...
Downside risks to the outlook outweigh chances for an upside surprise. Household debt, at about 77% of GDP, is still an issue even though it has yet to overwhelm consumers. Rising interest rates in coming years could hurt overstretched borrowers, which makes it the biggest domestic risk to consumption, the wider economy, and the financial system. Despite low inflation currently, rising costs for utilities and rental properties are notable headwinds for consumers moving into 2014.
The Fed’s tapering is an external downside risk should it result in sustained volatility in global financial markets and sharply higher interest rates. The chance of this occurring appears low as the Fed will try to avoid unsettling markets, though it is still noteworthy that Korea wasn't immune to market disruptions earlier this year despite low external debt and strong reserve levels.
...and simmering geopolitical risk
Geopolitical tension between Korea and Japan has been simmering over trade, the weaker yen and the role of military, but at this stage does not cause too much concern. China’s “air defence zone” over disputed islands in the South China Sea has soured relations between China, Japan and Korea and the U.S. To appease the Chinese, Korea recently acknowledged this zone, a strategic and economic move as Korea continues to try and forge a trade deal with China. Regardless, Japan and the U.S. do not acknowledge China's zone and thus geopolitical tensions could still escalate.
Tensions on the Korean peninsula have subsided, though it is always a risk that they could flare up again. Furthermore, Middle East unrest remains an ever present risk to global oil supplies and prices. As Korea is highly reliant on oil to power GDP, a sharp jump in oil prices would push up the import bill and raise the cost of manufacturing, causing a deep contraction in output.
On the positive side, better than expected economic performances and less uncertainty over fiscal and monetary policy in the U.S. and Europe could lead to stronger confidence levels, lifting financial markets and Korea's economy. Reform progress in big emerging markets such as India and Indonesia would also be positive for export demand in Korea.
Matthew Circosta is an Economist at Moody's Analytics.
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