The Korean economy grew moderately as investment improved but private consumption weakened.
4Q 2016 GDP recorded 2.4% YoY, lower than a quarter ago (2.6%) and QoQ growth exhibited a low growth of 2.0% on an annualized basis.
By industry, construction remained favorable and manufacturing showed less sluggishness in a few sectors. But, services slowed gradually, limiting improvements in economic activities.
Domestic demand exhibited a slow recovery as investment stayed relatively positive but private consumption turned sluggish.
Despite the high growth rates in both construction and facilities investments, the improving trend was limited to only a few sectors including building construction and semiconductors.
Meanwhile, private consumption exhibited slowing growth on falling income growth and weaker consumer sentiment due to persistent uncertainties at home and abroad.
Exports improved slowly on a gradually recovering global economy, while the current account exhibited a reduced surplus influenced by rising oil prices.
As overseas demand increased steadily and the semiconductors industry continued to boom, export volume expanded moderately, and the import and export amount surged on rising oil prices.
The current account exhibited a reduced surplus in a few sectors influenced by rising import prices, particularly oil, but the surplus itself stayed high on tepid improvements in domestic demand.
The domestic financial market saw a gradual rise in long-term interest rates influenced by the US rate hike, while FX soundness remained favorable.
CPI inflation moved up to 2% mainly due to supply factors while the expected inflation stayed low at the 1%-range.
Employment growth slowed among wage workers, mostly in manufacturing, while advancing among the self-employed, pointing to deteriorating employment quality. Also, the rate of unemployment stayed high mainly among the young population.
Despite some positive signs of a global recovery, it is expected to be limited due to lingering risks.
The global trade volume and industrial production rose at a modest pace with leading economic indicators nearing the baseline (100), indicating a moderation in the global economic slowdown.
However, the recovery pace is expected to be limited by numerous risks such as US trade policies, China’s overinvestment, Brexit negotiations and political uncertainties in the Eurozone.
In particular, the rise of trade protectionism led by the US is expected to take a heavy toll on the highly trade-dependent Korean economy.
The US will likely seek an aggressive stance in trade using diverse policy measures, and trade disputes between major countries may erode the growth of the overall global economy.
In such a case, the Chinese economy burdened by overinvested and over-indebted corporate sector may suddenly collapse due to rapid debt restructuring and capital outflow.
Under the circumstances, Korea’s households and businesses have become increasingly vulnerable to external shocks while potential growth rate has retreated fast.
Korea’s working age population is likely to recede since peaking in 2016 as population aging progresses. And with productivity failing to improve, growth potential is on a rapid decline.
Household debt, mostly from non-banking sectors, has risen fast, and corporate restructuring has stalled, adding to the increasing number of marginal companies－a sign of accumulating insolvency in the Korean economy.
Accordingly, economic policies should step up the monitoring of risks at home and abroad while concentrating on reforming the overall economic structure.
Although the Korean economy has grown at a modest pace recently, there are also lingering downside risks, implying that fiscal and monetary policies need to be managed with the short-term focus on macroeconomic stability.
There are limitations in managing demand through macroeconomic policies. Therefore, active actions are necessary for regulatory reform and corporate restructuring, which could enhance growth potential.
An engine for structural reform must be secured via inclusive policies on building social consensus and establishing social safety nets that include vocational training and unemployment measures to help lessen the short-term impact of reform, among others.
Ⅱ. Domestic Economic Outlook for 2017-2018
1. Assumptions about External Environment
The global economy will grow at a modest rate in 2017 and 2018, led by the US and emerging markets.
The IMF projected a modest recovery of the global economy in 2017 and 2018 led by the US and emerging markets with growth picking up to a mid-3%, slightly up from 2016 (3.1%).
Crude oil prices will jump by 32% to around $54 per barrel in 2017 and by 7% to around $58 per barrel in 2018 on an average YoY basis.
The value of the Korean won, in terms of the real effective exchange rate, will edge up by 4% in 2017 and change little in 2018.
2. Outlook for Domestic Economy
The Korean economy is projected to grow 2.6% in 2017 and 2.5% in 2018 as exports recover gradually and domestic demand slows.
Korea’s export growth is expected to improve in 2017 on advancements in a few sectors amid a moderate recovery of the global economy. But, GDP growth will fall from 2016, as domestic demand, particularly private consumption, moderates.
Korea’s exports and private consumption are expected to maintain a moderate growth in 2018 while GDP growth falls again from 2017 as overall investment growth decelerates.
The effects from improvements in real income on private consumption are expected to wane due to rising oil prices, and growth will likely decrease as the impact from consumption stimulus measures in 2016 dissipates.
The recent favorable trend in facilities investment is not expected to last long despite the modest improvement in export growth as the manufacturing capacity utilization rate remains at a low level.
A gradual slowing of the recent high growth in construction investment is expected, mainly in building construction.
Exports are projected to grow at a faster rate than GDP despite the sluggish growth in certain items as the global economy picks up at a moderate pace.
The current account is projected to run a reduced but still a large surplus, as the terms of trade deteriorate.
The CPI is expected to increase by a high 1% on rising oil prices, but the pace will slow gradually as the expected inflation remains low and the economy grows at a moderate rate.
Employment growth is projected to diminish on a changing demographic structure and corporate restructuring while the unemployment rate is likely to rise slightly YoY.
The Korean economy may weaken faster than anticipated if trade protectionism gains momentum led by advanced economies, including the US, or if surrounding geopolitical uncertainties worsen.
The rise of trade protectionism will increase tariff and non-tariff barriers and erode the modest recovery of world trade, eventually having a negative impact on the highly trade-dependent Korean economy.
Meanwhile, mounting geopolitical uncertainties will not only unsettle the financial market but also weaken consumer and investor sentiments, which could limit growth, particularly in domestic demand.
If marginal households and firms with weak debt repayment ability rapidly fall into default, the negative repercussions arising from outside shocks may be amplified further.
Ⅲ. Policy Recommendations
1. Fiscal Policy
Fiscal policy must be flexibly managed in response to changing economic conditions while the potential fiscal burdens of a new administration is reflected gradually in the subsequent year’s budget via a carefully developed plan.
The initial 2017 budget must be executed as planned, allowing for flexibility in adapting to changing economic conditions later.
Meanwhile, fiscal expenditure in the new administration’s agenda need to be reflected in the subsequent year’s budgets, only after being carefully planned and systematically reinforced.
Also, in order to secure fiscal soundness, fiscal rules need to be applied while the short- to mid-term budget should embrace fiscal reform agendas as implied in the long-term fiscal projection.
Adopting fiscal rules are expected to help reduce fiscal deficits, if fiscal disciplines at an aggregate level are clarified and the connection between mandatory expenditure and refinancing measures are further reinforced.
Additionally, the short- to mid-term budget must consider the fiscal reforms necessary to adapt to the rapidly increasing expenditure needs in certain sectors while maintaining a more realistic long-term projection.
The mid- to long-term direction should be steered toward developing rational financing measures, for instance by combining policies with adjustments of major tax items under the premise of a strong restructuring of tax expenditure.
Government expenditure in welfare sectors is expected to rise exponentially, implying a growing need for tax hikes.
To build social consensus on a tax hike, fiscal efficiency should be enhanced beforehand by reducing unnecessary expenditures through a strong restructuring of tax expenditures.
If the burden from a tax hike is unavoidable, the tax burden must be dispersed via inclusive measures to rationalize the tax system, such as reducing tax expenditures and expanding tax bases for multiple items.
2. Monetary Policy
Monetary policy should remain accommodative until the inflationary target is met.
The inflation rate recently neared its target, but core inflation remained stagnant at a mid-1%, implying that inflation may dip again.
Economic conditions at home and abroad have improved but the negative aggregate demand pressure accrued so far cannot be resolved soon and the downside risks run still high.
The US rate hikes are expected at a relatively moderate pace, and hence, limited negative impact is expected on the Korean economy even if Korea’s monetary policy remains accommodative for the time being.
3. Financial Policy
Financial policy should maintain the current regulations on non-banking loans to households while curbing the fast rise in household credit by strengthening macroprudential policies.
The rapid increase in household credit could become a potential risk to the financial market.
The rise in non-banking loans to households should be curtailed while complementary measures must be developed to prevent heavy debtors, such as financially vulnerable borrowers, from falling into default.
Financial institutions should be required to strengthen the risk management of loans to households to curb the increase in household credit, while reserving additional capital buffer or allowances on rising default risks.
Corporate restructuring should be implemented in a way that the interested parties bear the losses and not the taxpayers. To do so, shareholders need to hold enough loss-absorbing capacity during normal times.
It is important to comply with the principle that the interested parties should bear the losses, since bailouts of large firms invoke critical problems regarding unfair treatment of taxpayers, moral hazard and deterioration of fiscal soundness.
Firms whose economic importance is large in the national economy must be required to hold more loss-absorbing capacity during normal times so that public funding will not be injected to rehabilitate or reorganize when they fall into default.