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(Business Asia Via Thomson Dialog NewsEdge) South Koreas economy is more vulnerable than it appears to a US slowdown
South Koreas relations with the US have been looking increasingly fraught recently, what with differences of opinion over how to handle North Korea, planned changes in military procedures and the difficulties of negotiating a bilateral free-trade agreement. But the prospect of a sharp slowdown in the US economy next year also deserves to be a concern for Seoul, especially since South Korea is in some ways less well equipped to take such an event in its stride than neighbouring Japan, with which it competes directly in many major export sectors.
The Economist Intelligence Unit recently lowered its forecast for US GDP growth in 2007, to 2.1% (from 2.2% in our previous forecast). This will constitute a considerable weakening in US growth compared with our forecast for 2006, when we expect the US economy to expand by an average of 3.4% despite an expected slowdown in the second half of the year.
At first glance, South Korea has little to worry about. In headline terms, the country is becoming less exposed to the US economy. Although the US remains a key market for South Korean exports, it has been overtaken by China and is now only the second-largest buyer of South Korean goods. Over the past five years, the USs share of South Koreas total exports has steadily declined, to 13.6% in mid-2006 from around 21% in 2001. Meanwhile Chinas share has increased, from 12% in 2001 to 21% today. Indeed, perhaps no other countrys export sector has benefited as directly from Chinas rapid GDP growth as has South Koreas. Chinas booming economy, which is generating enormous import demand, therefore insulates South Koreas export sector to some extent from any fluctuations in US demand. As our core forecast scenario envisages China continuing to grow very rapidly next yearby about 10%, after expected growth of almost 11% in 2006there are convincing reasons to believe that South Koreas supposed immunity to a US slowdown ought to continue.
However, the picture is not quite so simple. Although South Korea sells relatively more of its exports to China and less to the US than does Japanand therefore ought to be more resilient to a US slowdownit is fundamentally less able than Japan to withstand any sort of slowdown in external demand, no matter what the source.
There are several reasons for this. The first is that South Korea currently cannot expect domestic demand to take up the slack in the event of a shock to the external sector. For the past three years domestic demand in the country has grown considerably more slowly than GDP, meaning that the economy in essence has relied on exports to make up the difference. This is quite unlike Japan, where the domestic economy is looking more robust than it has done for many years. As a result, the gap between domestic demand growth and GDP growth in Japan is much smaller than in South Korea, implying that exports are less crucial. (Indeed, exports in Japan, though indirectly playing an important role in stimulating the domestic economy, directly account for only around 14% of GDP, compared to well over 40% for South Korea.) In 2007, just as the US slows, Japanese domestic demand is actually forecast to grow slightly more rapidly than headline GDP; thereafter both should grow at almost identical rates until 2010.
SME wobbles
Why does South Koreas domestic sector look more vulnerable than Japans? One of the key reasons is the difference between the small and medium-sized enterprise (SME) sectors in the two countries. Although both countries are better known overseas for high-profile large manufacturers like Hyundai, Samsung Electronics, Toyota and Sony, SMEs play a pivotal role, for example providing the bulk of employment. Yet whereas Japans economic recovery now looks to be filtering through successfully to the SME sector, South Korean SMEs have been less adept at restructuring. For an illustration of the anaemic condition of South Korean SMEs, consider industrial production: in overall terms this has been rising strongly, often at double-digit rates, for the past year, but industrial production by SMEs alone has not matched this performance, with growth generally limping along at 2% year on year or less.
Weakness in the SME sector, in turn, is likely to have a big negative impact on consumer sentimentparticularly given SMEs importance for employment. The latest national consumer sentiment survey, published by the Korea National Statistical Office, shows that confidence declined for the seventh month in a row in August. The uncertain domestic political situation and security fears in the wake of North Koreas missile launches in July are also likely to have damaged sentiment.
Currency divergence
All this would be less worrying if it werent for the fact that there are also clouds over South Koreas export sector. One of the main concerns for South Korean exporters is the decoupling of the won and the yen. South Korea and Japan compete directly in a number of key export sectors, cars and electronics being just two examples. But whereas the two currencies often move somewhat in sync with each other relative to the US dollar, in the past couple of years there has been a divergence in their trajectories, with the won appreciating sharply against the US dollar as the yen has weakened. This, obviously has made it far more difficult for South Korean exporters to compete with their Japanese counterparts on price. So, for example, Hyundai Motor, South Koreas largest carmaker, reported a 37% drop in second-quarter net profit, partly because of strikes that hit production but also because of the stronger won. Japans Toyota, in contrast, reported a 39% rise in net profit.
None of this disastrous just yet, and the severity of South Koreas difficulties should not be overstated. Our core forecast still envisages domestic demand growth of 3.1% next year and GDP growth of just under 4%considerably higher than in Japan, in fact. Moreover, the country is lucky to be able to continue to rely on strong Chinese demand for its exports. However, were China suddenly to experience some economic upheaval that slowed GDP growth sharply and reduced its appetite for imported goods, then the picture would quickly look much gloomier.
Copyright 2006 Economist Intelligence Unit
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