KDI - Korea Development Institute - RESEARCH - Economic Outlook

Summary

KDI Economic Outlook 2023-1st Half Semiconductor Market Trends and Macroeconomic Implications

■ Korea's semiconductor exports have been heavily concentrated in the highly volatile memory sector, making the industry more vulnerable to downturns.

- As of 2022, the proportion of the highly volatile memory semiconductor sector within Korea's semiconductor market was more than twice that of the global market. This discrepancy may have contributed to the 9.5%p decline in semiconductor exports during Q1.

- Despite the growing investment in non-memory semiconductors since 2018, Korea's semiconductor industry continues to exhibit a significant reliance on the memory sector, leading to persistently high levels of volatility in semiconductor exports.

■ The trajectory of the semiconductor industry is shrouded in uncertainty, but certain indicators suggest a potential trough might occur between Q2 and Q3.

- The latest replacement cycles of semiconductor-related products, coupled with the trends in production and inventory cycles, hint that the semiconductor industry may be approaching a trough.

- A deceleration in the semiconductor economy is likely to exert a negative impact not only on exports but also on domestic demand via income channels. This slowdown may lead to deteriorating tax revenue conditions in 2023-2024.

- However, given the relatively modest employment multiplier effect of the semiconductor industry, the repercussions on the labor market are expected to be minimal.

■ Elevating the share of the non-memory sector could contribute to reducing economic fluctuations. In addition, concerted efforts are needed to mitigate the spillover effect of intensifying geopolitical risks in recent times.

- Acknowledging the growing macroeconomic significance of the semiconductor industry, the recent diversification towards increasing the investment in the non-memory sector can be viewed positively from a standpoint of economic stability.

- Conversely, the semiconductor industry's high susceptibility to geopolitical risks, particularly in the context of the escalating US-China conflict, underscores the critical need to strengthen industrial, trade, and diplomatic leadership strategies to mitigate uncertainties in associated sectors.

Summary

KDI Economic Outlook 2023-1st Half Recent Fluctuations in Current Account: Factors and Implications

■ The analysis results show that the recent decline in the current account balance was driven by a sustained increase in expenditure despite a decline in income due to deteriorating external conditions.

- The decline in the current account in 2H 2022 was largely due to a decrease in income caused by the decline in the terms of trade, with some contribution from domestic demand.

- In 2023, the current account surplus is expected to narrow to 1.0% of GDP as domestic demand maintains a relatively high increase amid the persistent global economic slowdown.

■ Given the current status of external soundness of the Korean economy, a sharp contraction in the foreign exchange market due to a decline in the current account is unlikely to occur.
- Currently, Korea’s foreign exchange reserves and net foreign assets are significantly different in size from those of countries that have experienced foreign exchange crises in the past, and even if the current account decline persists for one or two years, the likelihood of a foreign exchange crisis due to a decline in net foreign assets appears to be low.

■ Therefore, it is advised that the macroeconomic policy stance should not be sensitive to short-term fluctuations in the current account.

- It is important to note that the narrowing of the recent trade deficit may not guarantee macroeconomic stability.

- Consequently, when assessing the current situation and setting a policy framework, it is necessary to pay close attention to indicators closely related to macroeconomic conditions, such as prices, economic activity, and employment, rather than short-term fluctuations in the current account.

Summary

KDI Economic Outlook 2023-1st Half The Impact of Rising Interest Rates on Housing Construction and Outlook

■ The rate hike has contributed to the reduction in housing prices and starts and is anticipated to result in a decline in future housing construction, ultimately weakening economic growth.

- The analysis found that the decline in housing starts, due to high interest rates, is projected to hinder economic growth by 0.3%p in 2023 and 0.4%p to 0.5%p in 2024.

■ Recent rate hikes are intentionally designed to control inflation by managing economic growth at a slower pace, with the decline in the housing economy being understood as part of that process.

- The current tight monetary policy stance aims to stabilize inflation despite the broader economic slowdown.

- With low-interest rates in 2020 and 2021, real transaction prices of apartments soared by 16.7% and 18.1%, respectively, and are now entering a correction period.

- With the recent timing of rate hikes, the housing market encountered credit crunches centered on real estate PFs, exacerbating the challenges faced by construction companies. However, the need for policy response is not urgent unless the risk of a financial system crisis escalates.

■ Nevertheless, if housing construction stays contracted for a significant period of time in the future due to the recent decline in housing prices, a shortage of housing supply may arise, necessitating ongoing efforts to enhance housing supply resilience to demand changes.

- Housing supply takes considerable time, and mismatches between supply and demand often occur. It is essential to create conditions that can support housing supply, such as through public residential sites preparation, when housing demand begins to recover.

- Simultaneously, due to rising construction costs, construction companies and homeowners' associations frequently engage in conflicts, causing delays in construction. Relevant systems must be overhauled for improvement to ensure construction projects are executed as planned.

Summary

KDI Economic Outlook 2023-1st Half The Impact of Rate Hikes on Young Adults’ Debt and Consumption: Implications for Policy

■ Rising interest rates disproportionately lowered consumption among young adults compared to middle-aged and older adults, with larger decreases observed for young adults with higher levels of debt, lower income, or weaker credit ratings.

- Those in their 20s reduced their consumption by approx. 299,000 won (1.3%), which is 8.4 times larger than the decrease of 36,000 won (0.2%) among older adults in their 60s.

- Young adults with debt in the top half experienced a consumption decrease (264,000 won, 1.1%) that was about 11 times greater than that of those without debt (24,000 won, 0.1%).

- Among the top 50% of debt-burdened young adults, those with low credit scores (700 and below) reduced their consumption by a noteworthy 539,000 won (2.2%) per year for a 1% increase in the base rate.

■ Policy makers should continue their efforts to assist younger borrowers in managing their debts at sustainable levels.

- Loan regulations, such as DSR, should account for the current and future income of young adults, considering their potential income growth over the life cycle.

- Since a considerable share (around 85%) of young adults’ debt is tied to housing, concurrent policy efforts to stabilize housing costs are crucial for managing their debt in a sustainable manner.

■ It is essential to offer young borrowers in marginal situations additional opportunities to refinance their existing debt into longer-term amortizing loans. This can help alleviate their debt burden, enabling them to gradually repay their obligations over an extended period of time.

- Given the lengthy remaining work period of young adults, facilitating debt repayment over an extended period could mitigate the risk of a sudden deterioration in debt structure. This approach would help prevent precarious financial behaviors, such as engaging in a ‘rob Peter to pay Paul’ strategy.

Summary

KDI Economic Outlook 2022-2nd Half Long-term Economic Growth: Projection and Implications

■ According to the analysis, the declining growth rate of the Korean economy since the global financial crisis was mainly attributable to the slowdown in productivity improvement.

- During 2001~10, the slowdown in capital supply growth was the main driver of falling economic growth.

- In comparison, the contribution of labor supply to growth remained relatively steady in 1991~2019.

■ It is projected that the economic growth rate of Korea will slump to 0.5% in 2050 as the growth starts to slow gradually from the 2020s due to demographic changes like population decline and rapid population aging.

- In 2050, the per capita GDP growth rate is expected to stand at 1.3% due to the accelerating pace of population aging, which causes decreasing working-age population and an increasing share of the elderly with low labor force participation.

- This long-term growth projection is based on the premise that Korea’s productivity will maintain a 1% growth after a partial rebound from its lowest (0.7%) in 2011~19.

- Meanwhile, the potential growth rate of the Korean economy will reach a 2.0% level over the next five years (2023~27).

■ The Korean economy needs to mitigate the negative impacts of demographic changes by actively pushing for structural reforms to enhance productivity.

- Institutional reforms in trade openness and regulatory rationalization aiming to boost Korea’s economic vibrancy are necessary to achieve higher productivity.

- Employment conditions should improve to facilitate the active participation of women who, despite high productivity, typically stay out of the labor force due to childbirth and rearing, as well as elderly citizens whose share is rapidly increasing. Also, a reduction in labor supply needs to be countered by actively accepting foreign workers.

- At the same time, continued policy efforts are needed, with a particular focus on improving the qualitative capability of human capital through educational reforms.

■ Furthermore, the stance of macroeconomic policy needs to reflect the slowing pace of the long-term economic growth.

- While efforts to strengthen the growth potential are of reasonable necessity, the government should not be myopic and focus only on short-term stimulus in seeking a goal that greatly exceeds its growth potential.

Summary

KDI Economic Outlook 2022-2nd Half Increase in the Number of Employed Persons: Assessment and Projection

■ Unprecedented gains in the recent job market can be mainly attributable to the higher labor demand related to non-face-to-face services and the digital economy resulting from responses and adaptations to the pandemic crisis.

- The COVID-19 pandemic dealt a severe blow to employment in face-to-face services but expedited the transition into a non-face-to-face economy and the Fourth Industrial Revolution, creating jobs in the related sectors.

■ While the labor market will remain robust into 2023, the growth of the number of employed persons will decline sharply to 84,000 in 2023 from 791,000 in 2022 as shifting population structures cut down the employment number, and the base effect kicks in.

- The number of employed persons is likely to significantly narrow its gain in 2023 owing to the base effect. Still, the employment rate, which reflects the change in employment conditions, is expected to keep favorable contributions at about 102,000.

- However, structural changes in demographics, such as the share of the working-age population and age distribution, are expected to bring down the number of employed persons (-18,000) with more explicit negative impacts on labor supply.

- The percentage of the prime-age population (30~59) will continue to fall, and the share of the working-age population (15+) will shift to decrease. Accordingly, such a structural change in the population is expected to be the leading cause of the slowdown in the number of employed persons.

■ Since a fall in labor input risks a decline in Korea's economic growth, policy efforts are required to boost the labor supply.

- In parallel with enhancing the use of an underutilized workforce of women, young seniors, and foreigners, policy efforts should aim to raise the birth rate in the longer term.

- On top of expanding the quantity of labor supply, there should be a human capital development system that can improve labor productivity and promptly respond to rapidly changing labor demand.

Summary

KDI Economic Outlook 2022-2nd Half Impacts of Currency Fluctuations on Exports and Imports and the Trade Balance

■ This study finds that the weakening of the Korean won reduces import value temporarily and, in the mid-term, expands export value, narrowing the trade deficit.

- Since the US dollar is the usual choice for payment in international trade, the depreciating won has little impact on export volume in the short term. In contrast, import volume plunges due to the rising import value (in terms of the Korean won).

- In the medium term, as product prices are gradually adjusted, the weaker Korean won has a growing impact on the volume of imports.

■ While the recent rise of the dollar has caused a short-term increase in the trade deficit, the analysis shows that the rising rate of won/dollar has partially offset the deficit.

- The dollar rally in Q2 and Q3 this year brought about a contraction in overall trade, expanding Korea’s trade deficit by $6 billion for the said period.

- On the other hand, the rising won/dollar rate is estimated to offset the trade deficit by $2 billion during that period.

- Price adjustment via increasing the won/dollar rate progresses gradually, and the recent strength of the dollar is estimated to reduce the trade deficit by $6.8 billion in the next two years.

■ Fluctuating exchange rates can affect the economy through various channels, and this study reaffirms that currency fluctuations function to mitigate trade imbalance.

- Monetary policies appropriate for the macroeconomic conditions of each country cause exchange rates to move, alleviating imbalances between countries.

- Accordingly, the currency rate should be allowed to float in line with the supply and demand of the foreign exchange market as long as it operates smoothly and stably.

■ In addition to macroeconomic stability, policy efforts should also seek to protect vulnerable people in economic hardship due to soaring import prices in the dollar rally.

- With persistent high inflation, rising prices of items like petroleum products, electricity, and gas, closely tied to import prices, may put further pressure on the vulnerable.

- As sweeping policy support for the vulnerable risks conflicts of interest with the policy effort to tame high inflation, policy protection for vulnerable groups should look for ways to provide selective assistance.

■ To enhance the macroeconomic stabilization of foreign exchange rates in the longer term, an environment conducive to wider use of Korean won in international transactions in goods should be promoted.

- When international transactions are settled mostly in dollars, the short-term effect of currency fluctuations on exports is insignificant, thus limiting the adjustment of trade imbalance.

- In the medium to long run, the government should work to lay the ground for the Korean won to serve as a settlement currency in international trade by strengthening its macro-prudentiality and enhancing the financial and foreign exchange market systems.

Summary

KDI Economic Outlook 2022-1st Half US Rate Hikes and Korea’s Policy Response

■ The US is raising base interest rates in keeping with rising inflation and solid economic recovery. The analysis finds that its macroeconomic impacts on Korea vary depending on the causes of the US rate hikes and the monetary policy responses of Korea.

- The US and Korea responded by raising interest rates to the US positive demand shock since an increase in demand puts upward pressure on prices and economic conditions in both countries.

- When Korea follows the US and raises interest rates after the US rate hike shock, an economic downturn in the US spills over into the Korean economy as is. On the contrary, monetary independence serves as a buffer against substantial effects of the shock but temporary inflation.

- The analysis shows that independent policy in line with domestic price levels and other economic conditions yields greater utility than the interest rate synchronization system from the viewpoint of social welfare.

■ Korea’s monetary policy should tolerate capital flows and exchange rate fluctuations and operate congruently with domestic inflationary and economic conditions.

- Korea’s inflation has remained elevated, far above the target rate, and this situation calls for raising the base rate to achieve price stability.

- However, the policy rate gap between the US and Korea should be allowed, which may arise from the difference in their inflation levels and economic conditions.

- Meanwhile, considering that currency volatility serves as a mechanism to adjust the imbalances between countries and absorb external shocks, the policy needs to tolerate the fluctuations in exchange rates and refrain from intervening in the forex market in line with the purpose of the floating exchange rate system.

- Furthermore, since macroeconomic soundness is essential to cushioning external economic shocks, the existing strong macro-prudential policy stance needs to be sustained for the time being in this phase of recovery from the COVID-19 crisis.

Summary

KDI Economic Outlook 2022-1st Half Impact of External Uncertainty on Exchange Rate and Capital Flow

■ Rising external uncertainty increases the capital outflows and depreciates exchange rates, but the magnitude has decreased after 2014.

- We have shown that, after Korea transitioned to a net creditor position in 2014, the extent of the exchange rate depreciation and capital outflows decreased.

- This change can be attributed to positive feedback from foreign investors on Korea’s business competitiveness and macro-policy management.

- The total Korean government bonds held by other countries as foreign exchange reserves are approximately $81 billion as of the end-2020. The magnitude is higher than other currencies except for the US dollar and the euro.

■ In the short term, we suggest that the financial market be closely monitored and prepare for sudden market disruption.

- Ongoing global uncertainty expansion could possibly be very devastating; with sudden outlfows being realized, proactive policy measures, including foreign exchange prudential regulations, should be called for.

■ In the mid-to-long term, consistent efforts should be made for stable inflation, and the overall level of the public debt needs to be managed. Also, improvement in access to the forex market is highly recommended.

- Policies to rein in recent high inflation and burgeoning sovereign debt are at the core of macroeconomic stability and maintaining external debt soundness.

- For business competitiveness, it is necessary to upgrade Korea’s macroeconomic fundamentals, the basis of the won currency, by enhancing economic dynamics through regulatory system reforms and infrastructure investment.

- At the same time, mid-to-long-term efforts should continue to strengthen the status of the won currency.

Summary

KDI Economic Outlook 2022-1st Half External Uncertainty: Impacts on Korea’s Real Economy

■ This study finds that an increase in external uncertainty per se poses a downside risk to the overall real domestic economy, with exports harder hit than domestic demand.

- According to the analysis, prolonging the recently intensified uncertainties puts sizable downward pressure on the economy, lowering the growth in all industry production by 1.4%p. Even reducing uncertainty in the short run still stunts the growth and brings down its rate by 0.3%p, weighing down the real economy.

- It shows that uncertainties about US monetary policy and Russia’s geopolitical risk hit Korea’s exports harder than its domestic demand.

- Korea’s major industries tightly linked to investment, including computers, electronics, and optical devices, are the most influenced.

■ Since external uncertainty has a considerable impact on the real domestic economy, it is crucial to closely monitor main uncertainties and improve transparency by collecting and sharing relevant information. At the same time, consistent effort is necessary for building and utilizing a response mechanism to safeguard against global supply disruption.

- Providing sufficient information on external risk factors can help mitigate the excessive contraction of economic confidence.

- In addition, there should be ongoing efforts to stabilize the supply and demand for key raw materials and parts while setting up a response mechanism that can achieve a soft landing of shocks and repercussions once downside risks come true.

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