Prospects for the Korea's economy in the second half of 2007

Summary

There is plenty to lift the mood over the economy. Exports remain robust. Consumer demand and corporate investment is recovering. A US-Korea free trade agreement is on the table for ratification and progress has been made on North Korea denuclearization. All of this has lifted consumer and business sentiment and sent stocks into record territory.

SERI's 2007 economic forecast is now 4.5%, up from 4.3%. For the year, we see double-digit export growth; private consumption rising 4.2%; fixed investment at 4.3%, up from 3.2% in 2006; unemployment at 3.4%, and interest rates slightly higher.

Concerns and risks are not far away. Manufacturing is lackluster. The strong won is pushing all-important major exporters toward price hikes, which would protect profitability but bruise cost competitiveness and weigh on the overall economy. Household debt and short-term lending also could become more problematic. Externally, lofty commodity prices are an omnipresent threat and the global liquidity splashing around capital markets gives pause.

In the second half, macroeconomic policy should focus on sustaining the current recovery trend to provide momentum going into 2008. Appropriate foreign exchange market intervention also is in order to prevent the won value from rising too much compared to the nation's economic capacity.

1. Overall Trends

Prospects for the Korean economy in 2007 are more positive than at the end of 2006. Consumer and business sentiment are rising despite numerous risks, including unwinding of the yen-carry trade and extreme volatility in global financial markets. April's consumer sentiment index tallied by the Korea National Statistical Office exceeded 100 for the first time in a year thanks to completion of a Korea-US free trade agreement and progress on the North Korean nuclear issue. In addition, the KOSPI has been setting all-time highs; on May 28 it topped 1,650.

Despite all the upbeat factors, irrefutable evidence of a recovery in the supply side of the economy is missing. First-quarter economic growth was 4.0%, matching the fourth quarter in 2006. Manufacturing, a traditional growth engine, has remained lackluster with industrial production growth declining to 3.3% in the first quarter this year from 5.2% in the fourth quarter of 2006.

Although supply has been sluggish, demand is showing signs of revival. In the first quarter, consumption of durable goods such as air-conditioners and computers rose 4 percentage points from the previous quarter. Fixed investment grew 7.0% in the first quarter, the biggest gain since the fourth quarter of 2002. Robust demand side growth was largely due to increased facility investment by financial institutions, which needed new automated teller machines for newly designed banknotes.

The appreciating won is still in a precarious position due to a weaker US dollar and Japanese yen, similar to March. The won's value against the dollar was approximately 930-940 won until this April, but fell to around 920-930 won in May. Meanwhile, the won-yen exchange rate fell to 766.0 won per 100 yen as of May 28. Worse, speculative financial transactions have occurred, increasing short-term foreign debt to $126.3 billion in late March, up $12.7 billion from last year.

2. Economic Growth

The global economy is expected to maintain its current growth trajectory in the second half. The US economy's growth, one of the major risk factors in the world economy, is forecast to decelerate due to a sluggish housing market. The slowdown, however, is not expected to severely dent consumption levels. Overall, the US economy is expected to grow 2.6% in 2007. The European Union and Japan, both experiencing an economic revival, should post strong growth on the back of robust exports and recovering consumption. The Chinese economy is also forecast to maintain its roaring growth despite belt-tightening measures.

SERI has raised its 2007 growth rate for the Korean economy to 4.5% from 4.3%, accounting for better than expected private consumption and investment. We expect the economy will grow 4.2% in the first half and accelerate to 4.7% in the second half. Overall, the manufacturing sector's operating profit to sales ratio showed signs of recovery in the first quarter despite sluggish performances of larger businesses. Near completion of inventory adjustment, including reductions totaling 1.3 trillion won, and a widening gap between short and long-term interest rates add more potential for economic growth.

Balanced economic growth on the strength of both exports and domestic consumption is expected. Exports will likely maintain double-digit growth in the second half as the global economy continues to expand. However, substantial downside risks imperil this forecast. At the forefront is the robust won. After notable won appreciation in 2006, manufacturers have the unenviable task of either subsisting on razor-thin profit margins or raising prices. With corporate profitability progressively worsening, they may opt for price increases, which would crimp export growth and weigh on the trade-dependent Korean economy. In addition, the economy faces numerous risks abroad i.e. runaway commodity prices and a hard landing in the US. Finally, domestic risks such as a spike in household debt or short-term lending could stunt growth.

Consumption is recovering, but household debt, which leapt in 2005 and 2006, is expected to drag on growth. Facility investment is forecast to continue to grow due to expectations for economic recovery and increased investment pressure.

3. Private Consumption

We expect private consumption to achieve a 4.2% growth in 2007, the same level as that in 2006. First-half private consumption should rise 4.0%, 0.2 percentage point higher than the second half of 2006. In the second half, private consumption should grow 4.4%.

Private consumption growth, which had slowed down since the first quarter of 2006, has re-accelerated from the first quarter of this year. This is due to the increase in real wages and disposable income, which had slowed in 2006. Ratification of the Korea-US FTA and more record highs in the KOSPI are additional boosters.

Meanwhile, higher growth in private consumption in the second half than the first half will be led by an improved labor market. The growth rate of real Gross Domestic Income (GDI) is catching up with that of real GDP. Additionally, while job growth is stagnant, there are more regular employees, who are assured of a stable stream of income, at the expense of temporary employees who have become more numerous in recent years.

4. Fixed Investment

In 2007, fixed investment is anticipated to expand at 4.3%, above the 3.2% growth rate in 2006 due to increased construction investment. Facility investment will likely post an annualized growth rate of 7.1% in 2007, backed by continued economic growth momentum. The repeated short-term boom-bust cycle after the 1997 financial crisis is yielding to a normal economic cycle, relieving public concern over economic volatility. Progress in resolving the North Korean nuclear crisis (the February 13 agreement for dismantling North Korea's nuclear program) and the Korea-US FTA conclusion are expected to boost business confidence as well. Moreover, manufacturing facilities are run at a similar utilization rate to that of the 1990s.

Manufacturing investment will likely increase in the first half of the year as exports continue their robust growth; service investment will expand in the second half with private consumption also recovering.

We expect to see construction investment grow at an annualized rate of 2.0% in 2007, owing to more public construction projects. More specifically, the government's budget frontloading should lead to a significant jump in construction investment in the first half and then a probable slowdown in the second half. We do not see residential and non-residential (such as shopping centers and office buildings) construction, usually led by the private sector, rebounding this year. This is because of the government's efforts to curb real-estate speculation with a stronger taxation system, regulations on mortgages, and a substantial inventory of unsold houses outside of metropolitan Seoul. In the second half, the outlook is expected to improve. Before the December presidential election, the government will likely relax real estate regulations in non-metropolitan areas, which would stimulate residential construction. Meanwhile, non-residential construction looks to recover slightly as vac ancies decline and unsold buildings are purchased.

5. Trade

We expect double-digit export growth to continue in the second half to continue for 10.6% growth year-on-year. The world economy's stable growth will be one of the major contributors. Still, the won-dollar exchange rate is pushing exporters toward price hikes. That would help maintain profitability but undermine their price competitiveness.

We also anticipate a 12.8% import growth year on year, backed by rising oil prices and recovering domestic demand. International oil prices ( Korea relies on Dubai crude) will increase by US$ 3-4 per barrel from the same period in 2006. Capital good and consumer product imports are likely to rise quicker due to increased facility investment and consumption.

In the second half, the trade surplus is expected to expand US$1.3 billion to US$7.6 billion from the first half. This will help the current account from the first-half US$2.6 billion deficit to US$1.5 billion surplus.

6. Price Levels

Prices noticeably rose in early 2007 as higher oil prices and slower won appreciation sent producer prices and import prices higher. Public utility charges have also increased, contributing to a steady rise in services costs. Considering cost and demand going forward, we believe inflationary pressure will be contained. On the cost side, real wages have not increased significantly. Foreign exchange rates are predicted to bring down prices, albeit to a smaller extent, compared to 2006. Without a sharp increase in oil prices, this year's prices will likely rise 2.5%.

7. Employment

This year's job market is expected to add 270,000 employees with hiring picking up in the second half. This will keep the recent job creation level (between 250,000 and 300,000) from 2005. By industry, in the second half, we see hiring in the services sector (construction, electricity, transportation, finance, enterprises, private and public service providers) and less hiring in agriculture, forestry and fishery, manufacturing and traditional services (wholesale and retail, lodging and restaurant businesses).

Restructuring in the self-employed segment will likely continue in the second half. This will lead to fewer self-employed and unpaid family workers. In contrast, the number of paid workers is forecast to increase. As the economy improves, employers should be more open to contract hires on at least a one-year basis.

For the year, the unemployment rate will likely reach 3.4%, nudging down from 3.5% in 2006. More specifically, the first half will see unemployment at 3.5% and the second half at 3.3%. In the second half, the total number of the newly employed will not expand greatly. Worse yet, an increasing number of youth will likely give up seeking work as the demands of job seekers and employers do not match, adding to the economically non-active population.

8. Interest Rates

Market rates have steadily moved upward since March. The AA- corporate bond yield surged 24 basis points to 5.54% in May from 5.3% in January. The interest rate on certificate of deposit, the benchmark rate for loans extended by financial institutions, rose 20 basis points to 5.07% in May from 4.87% in January.

The rise in markets rates is attributed to a stronger real economy. Domestic demand has started to recover with facility investment and private consumption rising. Closer central bank monitoring of banks' short-term foreign borrowing is also pushing up interest rates.

Interest rates are likely to rise slightly in the second half of 2007 compared to first half. Monetary authorities will continue to remove excess liquidity from the markets which will put rates higher. Another factor contributing to the upward trend is investors' perception of higher inflation. Producer prices grew 2.5% in April after 1.8% growth in the first quarter. Nevertheless, the pace of rate increases will be moderate due to an increased inflow of foreign capital, which will boost liquidity in the markets.

9. Foreign Exchange Rate

From the end of February to early March, a sharp correction in China's stock markets and defaults in the US sub-prime mortgage market strengthened the US dollar and weakened the Korean won. In April, stock markets in emerging economies rebounded, the US mortgage market stabilized, and yen carry-trade resumed, following the Bank of Japan freeze on its benchmark interest rate. This pushed up the value of the won against the US dollar. Robust exports, more foreign borrowing by banks, and net stock buying by foreign investors also were catalysts to the won appreciation. Meanwhile, the won-yen decoupling deepened. The won-yen exchange rate fell to 766.0 won per 100 yen on May 28, the lowest figure since the 1997 financial crisis.

In the second half of the year, the won will likely appreciate mildly. Concerns of US economic slowdown will heighten anticipation of a Federal Reserve rate cut, thus weakening the dollar and strengthening the won. In addition, the won will strengthen only slightly as the current account deficit increases, and financial authorities strengthen their monitoring of banks' foreign borrowing.

The interest rate gap between the US and Japan is anticipated to narrow, while emerging economies will promote monetary tightening measures, slowing the yen- carry trade. The yen will likely resume strength as a result. Meanwhile, the Chinese yuan will continue to strengthen on pressure from the US for yuan appreciation and the Chinese government's efforts to slow the overheating economy.

10. Conclusion

Economic policy for the second half of 2007 should focus on sustaining the current recovery trend to provide momentum going into 2008 and contingency measures should be taken to manage internal or external shocks.

Fiscal and monetary policies must remain neutral. In addition, appropriate intervention must be made in the foreign exchange market to maintain export competitiveness. Today, the value of the won against major currencies has appreciated by 14.7% in terms of the real effective exchange rate (as of 1993.) In order to prevent the won value from rising too much compared to the nation's economic capacity, proper intervention in the foreign exchange market is necessary to curb the rise in the value of the won against the dollar.

Second, crisis management programs should be set up to closely monitor external and internal economic conditions, thus enabling the nation to quickly respond to any worst-case scenarios. Externally, a hard US economic landing and oil price hikes are potential threats. Domestically, soaring inflow of external borrowings and households debt problem are concerns. Both domestic and overseas stock prices, interest rates, exchange rates and related capital flow require closer monitoring. A soft landing in the domestic real estate market must be encouraged so that falling housing prices do not threaten the economy. If an upward trend in interest rates, fuelled by too much focus on stabilization of the real estate market continues, side effects such as increase in non-performing household loans could occur. Therefore, financial austerity measures must be properly adjusted to market conditions.