The Korean economy is maintaining moderate growth with continued improvements in the service sector despite a sluggish construction industry.
Manufacturing is showing slightly higher growth from last quarter in terms of the value-added in the national accounts, although output has stalled according to the Index of Industrial Production (IIP).
Domestic demand is continuing the high growth trend as strong consumption significantly offset the slowdown in investment growth.
Growth in construction investment is slowing mostly in residential housing. Meanwhile, facilities investment posted a moderating growth influenced by the base effect from last year’s spike in semiconductor manufacturing equipment.
Private consumption has expanded sharply, exceeding the income growth rate as net overseas consumption sustained a relatively high contribution rate and non-profit organizations temporarily boosted spending.
Conditions in consumption-related services have yet to exhibit a full-scale recovery despite the high growth in consumption, resulting in a low inflation rate.
Improvements in consumption-related services have been hindered by the increase in overseas consumption and decrease in tourists although consumption growth was strong.
Export growth is slowing on sluggishness in several items despite the robust growth in semiconductors and some other items, and therefore the improvement trend in domestic manufacturing activities is undergoing an adjustment.
Domestic production and export shipments have descended and the utilization rate continues to contract―except for a few items including semiconductors―as external demand for traditional manufacturing products shrinks.
Employment growth has contracted slightly on weakening improvements in manufacturing and a delayed recovery in consumption-related services, which has a high employment inducement effect, even when temporary factors are considered.
A recovery in employment will not be easy as the restructuring efforts in motors vehicles and shipbuilding continue to restrict the improvement of employment conditions in the manufacturing industry and because the rebound in the services industry is deemed weak.
Meanwhile, the global economy is still expected to restore its growth momentum despite the slowing growth in industrial production and dips in sentiment indices, implying that a rapid decline in exports is unlikely.
The manufacturing sentiment index and OECD leading indicators point to a gradual weakening of the global recovery. However, global industrial production remains on a high growth trajectory.
Despite the domestic financial market seeing a rise in the long-term interest rate due the US rate hike, FX soundness remains relatively favorable and any impact from the rate hike appears limited, implying that, for Korea, overall conditions remain positive for implementing autonomous monetary policies for the time being.
Under the circumstances both at home and abroad, Korea‘s macroeconomic policies require an accommodative stance for the time being as the current economic recovery still lacks a virtuous cycle e.g. inflationary pressure and strong employment.
Fiscal policies must be flexibly managed in response to changing economic conditions and monetary policies should remain accommodative for now.
Financial policies need to consider the possibility of higher volatility in the global financial markets as a result of the US rate hike and instability in emerging markets while reinforcing macroprudential countermeasures against capital flow volatility.
In the mid-term, restructuring efforts must continue to resolve pending challenges such as unbalanced growth between different industries and weak job-creation capacity.
Without consistent restructuring efforts to accurately diagnose and tackle problems, the Korean economy will not be able to avoid losing its economic competitiveness and dynamism.
Thus, an objective assessment should be conducted on the global competitiveness of key export industries to confirm the urgency of restructuring not only key industries sectors but also the overall economy.
In addition, policy discussions on the balanced growth of manufacturing and services and strengthening the competitiveness of the service sector need to be held in earnest to increase the likelihood of creating a virtuous cycle in which higher domestic demand leads to more value added.
Ⅱ. Domestic Economic Outlook for 2018-2019
1. External Conditions
The global economy will continue to grow in 2018-2019 at a similar rate to 2017.
The IMF foresees that the global economy will grow 3.9% in 2018-2019, an inch up from 2017 (3.8%) as major advanced economies exceed their potential grwoth rates and emerging markets recover.
Crude oil prices will climb by an average of 26% YoY to around $67 per barrel in 2018 and by 1% YoY to around $68 per barrel in 2019.
The value of the Korean won, in terms of the real effective exchange rate, will ascend by 4% in 2018 and rise by an additional 1% in 2019.
2.Outlook for the Domestic Economy
Korea is projected to grow 2.9% in 2018 and 2.7% in 2019 as exports continue on the upward trend and domestic demand slows.
With the global economy continuing to grow steadily, Korea will likely see a slight increase in export growth and improvements in consumption, but its growth rate is expected to post 2.9% in 2018 on shrinking investments.
However, 2019 is expected to mark a slightly lower growth rate due to a decline in private consumption and overall investment despite the similar upswing in exports.
Private consumption will see a steep growth in 2018 thanks to rising asset prices, increased transfer payments and job policies, but this will slow gradually in 2019.
Facilities investment will exhibit a relatively fast decline in growth influenced by a moderation in last year’s exceptionally high growth in semiconductor investment.
Construction investment will turn to a decrease as the civil engineering sector continues to be sluggish and the building construction sector rapidly slows particularly in residential housing.
Export growth will continue to exceed GDP growth influenced by continued steady increases in the global economic growth rate and trade volume, although some high-growth items will contract.
The current account is projected to run a significantly reduced surplus in 2018 as exports increase but the terms of trade deteriorate. However, the surplus will expand slightly in 2019.
The CPI is expected to increase to a mid- to high 1% influenced mostly by oil price hikes.
Employment growth is projected to retreat from last year on demographic changes and industrial restructuring while the unemployment rate is likely to remain similar to 2017.
Externally, falling unit prices of major export items and weakening global competitiveness will become downside risks to growth projections. But, the accelerating growth in global trade volume will be an upside risk.
The Korean economy will likely grow at a slower pace than expected if semiconductor prices tumble or flagship export items lose their competitive edge due to China.
On the other hand, the Korean economy will likely grow faster than expected if the global trade volume expands quicker than expected influenced by the rapid recovery of emerging markets.
Internally, soaring market interest rates and falling asset prices could pose downside risks and rising consumption driven by government policies will serve as an upside risk.
A plunge in asset prices amid a spike in market rates will rapidly undermine marginal households’ repayment ability which could lead to a sudden setback in economic growth, particularly domestic demand.
Meanwhile, the Korean economy is likely to see a swift increase in private consumption and higher-than-expected growth if government policies to raise household income promptly create tangible outcomes.
Ⅲ. Policy Recommendations
1. Fiscal Policy
Fiscal policies need to maintain flexibility in response to changing economic conditions while consistently adjusting the pace of spending growth and reinforcing expenditure restructuring in consideration of fiscal risk factors.
Korea is experiencing a modest recovery driven by private consumption and exports. However, fiscal policies should remain as the buffer for the time being against risk factors related to internal and external uncertainties and structural issues.
With thorough monitoring of future economic situations and mid- to long-term fiscal demand, the government needs to keep the pace of expenditure at an appropriate level and implement fiscal restructuring through which expenditure efficiency is heightened and fiscal space is secured.
Tax revenue is projected to again exceed the yearly budget, making it necessary to explore ways to utilize the additional gains.
Surplus tax revenue acquired due to stochastic factors could be best spent on reducing government bond holdings.
2. Monetary Policy
Monetary policies should maintain the current accommodative stance for the time being in consideration of the recovery trend which is not yet steady enough to lead to a full recovery in employment or to inflationary pressure.
The headline and core CPI recently marked a low to mid-1%, far below the inflationary target.
Despite the recent favorable trend in consumption, there have been set backs in the recovery of the service sector due to increases in net overseas consumption as well as slow investment growth, implying that the economy has not yet become so overheated as to require any monetary-policy action to control the overall aggregate demand.
A prompt shift towards a tightening stance in the near future is highly unlikely given Korea’s moderate growth and unbalanced recovery of different sectors and industries.
Concerns are mounting over the external environment due to fears over additional US rate hikes and the high volatility in emerging markets. However, overall conditions remain positive enough for Korea to autonomously implement its monetary policies which are based on current inflationary and economic situations.
But, in order to ease market concerns over the widening gap in the base rate between the US and Korea, efforts must to made to prevent the unnecessary increase in the volatility of market variables (e.g. interest rates and foreign exchange rate) by clearly and sufficiently communicating with the financial markets.
3. Financial Policy
Efforts must be made to allocate funds to sectors with a high productivity-to-risk ratio as SME loans are expected to increase influenced by productive financial policies.
The policy goal of injecting stable and long-term funds to sectors that will likely achieve high productivity growth and strong innovation is most desirable.
Credit loans, long-term loans and equity investments are needed to enhance the effectiveness of productive finance. However, these pose a higher risk than mortgages and guarantee loans.
The revised capital regulations in favor of corporate loans will likely provide more loan support for SMEs. Thus, relevant indicators must be developed and support systems for relationship banking should be strengthened to enable funds to flow into sectors with high productivity-to-risk ratios.
A few emerging markets are seeing increasing capital outflow, indicating that the global financial markets may become more volatile. Accordingly, Korea needs to strengthen the monitoring of its foreign exchange soundness.
If the US increases its rate faster-than-expected, global financial markets will likely experience a liquidity decline and emerging financial markets will become more volatile. Therefore, the government should strengthen the monitoring of such cases and consider reinforcing macroprudential policy to respond to the volatility in capital flow e.g. lowering the rates for macroprudential stability levies if a sudden outflow of foreign capital occurs.