South Korea’s outlook is foggy, but will ‘stopping the car’ help?

Among the biggest vulnerabilities in the world economy are overheated real estate markets, the threat of a full-blown recession and the heightened risk of policy mistake by central banks
No other nation is having to contend with them as intensely as South Korea

Nicholas Spiro

Published: 3:45pm, 2 Mar 2023

Why you can trust SCMP

Spare a thought for Rhee Chang-yong, South Korea’s central bank governor. Just weeks after he assumed office in April last year, the US Federal Reserve embarked on its aggressive interest rate-hiking campaign, putting an end to a decades-old regime of low inflation and low borrowing costs.

At the time, South Korea – an open, export-driven economy long seen as a bellwether for global trade – appeared to be ahead of the curve, having been the first major Asian economy to raise rates in August 2021 in response to concerns about the surge in household debt and property prices during the Covid-19 pandemic.

Yet, almost one year on, the challenges facing Asia’s fourth-largest economy and the world’s seventh-largest exporter are more acute. At first glance, this reflects the dramatic shift in market expectations of how much further global borrowing costs are likely to rise.

Over the past month, investors have ramped up their bets on US benchmark rates peaking at a significantly higher level than what was priced in January, causing a sharp sell-off in stocks and bonds.

On closer inspection, however, it is clear South Korea’s problems extend beyond US monetary policy. Among the biggest vulnerabilities in the world economy are overheated real estate markets, the threat of a full-blown recession and the heightened risk of policy mistake by central banks.

Many leading economies are grappling with all three challenges simultaneously. However, no other nation is having to contend with them as intensely as South Korea.

The logo of chip maker SK Hynix is seen at Korea Electronics Show in Seoul on October 8, 2019. South Korea logged its biggest monthly trade deficit ever, at US$12.7 billion in January, as exports of computer chips and other hi-tech items sank and the costs of importing oil and gas surged, the trade ministry said on February 1. Photo: AP

With exports responsible for more than 40 per cent of the country’s gross domestic product – China alone accounts for nearly a quarter of them – two of the nation’s chipmaking giants dominating the global supply of computer memory, and household debt as a share of disposable income among the highest in the world, South Korea is highly sensitive to financial and economic trends.

Since Rhee took the reins of the Bank of Korea (BOK), policymakers have raised rates by a further 25 basis points to 3.5 per cent, a 14-year high. Although headline inflation has come down, the core rate – which strips out volatile food and energy prices – continues to rise and currently stands at 5.2 per cent, suggesting further rate increases may be needed.

Yet, the tightening campaign has already exacerbated a sharp downturn in the economy. In the property sector, prices of flats in Seoul – one of the world’s frothiest housing markets – have plunged 24 per cent since their peak in October 2021, fanning fears about a financial crisis in the construction and real estate market. The high share of variable-rate mortgages, and a peculiar rental system that amplifies risks, have made matters worse.

South Korea has also been hit hard by the slowdown in global trade, particularly the plunge in demand for technology products. Data released on Wednesday showed that exports contracted 16 per cent year on year last month, with shipments of semiconductors – the largest contributor to exports – down a whopping 42.5 per cent. The steep decline in trade, particularly with China, was the main reason the economy shrank last quarter for the first time since the pandemic erupted.

This presents the BOK with an acute policy dilemma: raise rates further and risk compounding financial instability and economic weakness, or end the tightening campaign – and even start cutting rates – and risk rekindling inflationary pressures just when the won is under renewed strain due to expectations of a more hawkish Federal Reserve.

Currency exchange shop signs are seen at the Myeongdong shopping area in Seoul, South Korea, on November 24, 2022. Photo: Xinhua

In a report published on February 23, JPMorgan noted that the “conviction level” of the BOK about the outlook for inflation, growth and the property market is “not very high”, attesting to the uncertainty pervading South Korea’s economy.

Rhee, an experienced policymaker whose previous jobs included senior roles at multilateral institutions, is trying to play it safe by adopting a wait-and-see stance. In an interview last week, he said that “when the situation is very foggy, it is better to stop the car”.

This seems like a sensible approach. The problem is that the car is already damaged while the fog is unlikely to lift any time soon. Although the deteriorating growth outlook and the disorderly decline in house prices pose a bigger threat than high inflation, the sudden repricing of US rate expectations and China’s abrupt reopening could force the BOK’s hand.

The renewed rise in the US dollar and surge in Treasury yields are putting pressure on emerging market assets just as speculation intensifies about the inflationary impulse of China’s reopening. Even keeping rates on hold, never mind cutting them, will prove increasingly difficult for the BOK.

If there is any consolation for Rhee, it is that his counterparts around the world are also struggling to square a number of circles. Yet given that South Korea began tightening policy earlier than its peers, it might have hoped to be in a better position by now. That its challenges are even more daunting is deeply worrying.

Nicholas Spiro is a partner at Lauressa Advisory

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