Korea: is optimism justified?

29 March 2017

Economics

Korea: is optimism justified?

DBS Group Research 29 March 2017

• Korea’s financial markets have stayed resilient despite political turmoil

since late last year. Optimism is now on the rise thanks to Park’s im-
peachment and the confirmation of an early election
• Fiscal stimulus can be expected after a new government takes office. But
don’t expect too much
• Reforms to reduce economic disparities and boost industrial competi-
tiveness could also be anticipated. But progress will be gradual
• Monetary easing remains unlikely
• Positive surprises may come from exports instead, despite the ongoing
Korea-China tensions and the risk of US protectionism

Korea’s financial markets have stayed resilient despite the political turmoil since
late last year. The KOSPI fell initially as former President Park Geun-hye’s corrup-
tion scandal unfolded in October 2016. But it rebounded strongly after parliament
voted to impeach Park on 9 December 2016. The KOSPI has crept even higher re-
cently, with the constitutional court’s decision to uphold the impeachment on 10
March 2017 (Chart 1).
On the FX front, the KRW depreciated against the USD initially in 4Q16, in line
with the dollar’s rally following Trump’s election. But the correlation between the
USD/KRW and the DXY index weakened in 1Q17 (Chart 2). Despite the dollar’s
volatility during this period, the KRW stayed firm and appreciated some 7.5%
against the USD.

Chart 1: Stock market performance Chart 2 : USD/KRW vs. the dollar index
USD mn
2200 800 1230 USD/KRW 104
Foreign equity inflows (RHS)
KOSPI DXY (RHS) 103
1210
2150 600
102
1190
400 101
2100 1170 100
200
2050 1150 99
0 98
1130
2000 97
-200 1110
96
1950 -400 1090 95

1900 -600 1070 94

Jul-16 Sep-16 Nov-16 Jan-17 Mar-17 Jul-16 Sep-16 Nov-16 Jan-17 Mar-17

Ma Tieying • (65) 6878-2408 • matieying@dbs.com

Refer to important disclosures at the end of this report. 1

Korea: is optimism justified? 29 March 2017

Chart 3: Fiscal balance deteriorated Chart 4: Government debt on the rise

KRW bn % central govt debt, % of GDP
50
40000 4.0
45
30000 3.0 40
35
20000 2.0
30

10000 1.0 25
20
0 0.0 15
Primary deficit: 2% of GDP per year
Fiscal balanc e 10
-10000 (consolidated) -1.0 2.5%
5 3%
% of GDP (RHS)
-20000 -2.0 0
2000 2004 2008 2012 2000 2004 2008 2012 2016F 2020F

Optimism is now on the rise. The country needs to pick Park’s successor within 60
days. An election will be held on 9 May, much earlier than originally expected.
An early election bodes well for the economy, as it should further ease political
uncertainties and policy paralysis.

Fiscal stimulus is possible, but don’t expect too much about the scale
Indeed, fiscal stimulus could be expected in the later part of this year. In order to
revive public confidence, the upcoming new government should have the incen-
tives to increase supports on employment, social benefits and public livelihood.
Note that Park’s administration had pursued an expansionary fiscal policy via sup-
plementary budgets during the past four years – KRW 17trn in 2013, KRW 12trn in
2015 and KRW 11trn in 2016. It is reasonable to expect a supplementary budget
worth up to KRW 10trn (0.6% of GDP) from the new government.
But don’t expect too much. The public fiscal position has already deteriorated.
The consolidated fiscal balance slipped into deficit in 2015 for the first time since
2009 (Chart 3). Excluding social security funds, the net fiscal deficit has widened
from 1.5% of GDP in 2013 to 2.4% in 2015. The central government’s outstanding
debt, albeit still moderate, has risen to a record high equivalent to 36.9% of GDP
as of Sep16 (Chart 4). In order to avoid a steeper rise in public debt and negative
responses from rating agencies, it would be appropriate for the government to
keep the deficit at less than 3%. This would require it to cap the 2017 supplemen-
tary budget at KRW 20trn (1.2% of GDP).

Structural reforms in focus, but progress would be gradual

Structural reforms will also be a post-election focus. Public aspirations for reforms
are strong. The outgoing government undertook some steps in recent years to
reduce economic disparities, encourage innovation, promote the development of
services industries and expand free trade [1]. The Gini coefficient, albeit down
from the 2009 peak, has remained well above the levels prior to the 1997/98 Asian
financial crisis (Chart 5, next page). Large companies still control some 70% of the
total financial assets in the corporate sector.
Boosting industrial competitiveness is also important. Samsung’s product failure
and Hanjin’s bankruptcy last year serve suggests Korea may be beginning to lose
competitiveness. In China’s import markets, the share of Korea-made electronics
products declined in 2016 for the first time in nine years. The share of Korea’s au-
tomobile products in the US market also fell for the first time in six years in 2016
(Chart 6, next page). External competition has been on the rise, largely due to the

2
Korea: is optimism justified? 29 March 2017

Chart 5: Gini coefficient still relatively high Chart 6: Korea's market shares declined
%
0.34 % in China's imports of electronics
20
% in US's im ports of automobiles
0.32 18
16
0.30 14
12
0.28 10
8
0.26
6
4
0.24
2
0.22 0
1990 1995 2000 2005 2010 2015 2008 2010 2012 2014 2016

narrowing of technology gap between Korean manufacturers and their emerging

market counterparts [2]. Reforms are needed to cut overcapacity in uncompeti-
tive sectors and to encourage innovation and technological advancement in new
industries.
Alas, progress will likely remain gradual. While reforms are believed to create
long-term gains for the economy on the whole, some measures may bring short-
term pain and encounter resistance. Curbing chaebols’ power, for instance, would
directly depress investment among the large companies, before creating new
business opportunities for the SMEs. Industrial restructuring would also mean
company closures and worker layoffs in the unproductive sectors in the short
term. Given these varied results, the authorities would find it necessary to adopt
a gradual approach to reform. A framework of supporting measures will need to
be established first to address the concerns about the potential adverse impacts.

Monetary easing remains unlikely

Monetary easing remains unlikely. The Bank of Korea has cut rates by a total of
200bps over the past 4 years. Given that the benchmark repo rate has fallen to an
all-time low of 1.25%, room for further reductions is nearly nil. Pursuing extraor-
dinary easing like QE and zero/negative interest rates would prove controversial
and possibly counter-productive for an emerging market like Korea.
Importantly, as a result of the extremely low interest rates and the relaxation of
property market controls, household debt has expanded [3]. As a percentage of
GDP, household debt has risen to a record 94% in Sep16. Total debt, including the
household, corporate and public sectors, is now equivalent to 3 times GDP (Chart
7). Such rising debt probably requires the BOK to tighten monetary policy rather
than loosen it.
Moreover, the period of ultra-low inflation may have come to an end. CPI growth
fell to 1% and PPI plunged to negative in 2013-16 thanks to the sharp downturn in
global commodities prices [4]. With commodities prices now bottoming, PPI infla-
tion has returned to positive territory and CPI inflation has risen to the BOK’s 2%
target (Chart 8). Plainly, this augurs against easing as well.

Positive surprises may come from exports

Positive surprises may come from exports this year. Externally, the Chinese econo-
my is bottoming, the US growth is picking up and even the Eurozone and Japan
now look less sickly. A cyclical upswing would certainly help Korea.

3
Korea: is optimism justified? 29 March 2017

Chart 7: Household debt expanded Chart 8: Inflation on the rise

% of GDP % YoY % YoY
6.0 CPI 14
320
PPI (RHS) 12
280 5.0
Government 10
240 8
4.0
200 6

160 Corporate 3.0 4

2
120 2.0
0
80
-2
1.0
40 Household -4

0 0.0 -6
Mar-09 Mar-11 Mar-13 Mar-15 Jan-08 Jan-10 Jan-12 Jan-14 Jan-16

The impact of ongoing Korea-China tensions may not be as severe as feared. Due
to the THAAD-related disputes, China has cut trade ties with Korea, such as tight-
ening the approvals for importing films/music/TV contents from Korea, banning
the travel agencies from selling group tours to Korea, and boycotting the Korean
conglomerate Lotte. These retaliation measures will likely hit Korea’s cultural,
tourism and some other exports like food and cosmetics. But Korea’s major ex-
ports to China are electronics, chemicals, machinery and automobiles. These seg-
ments would remain unscathed and even benefit from China’s cyclical recovery, as
long as the anti-Korean movement in China doesn’t escalate.
The risk of US trade protectionism shouldn’t be overestimated either. It is true that
Trump has threatened to renegotiate the US-Korea free trade agreement. The US
Treasury has also put Korea on the watch list for unfair currency practices, togeth-
er with China, Japan and Taiwan. In reality, however, the US must tread carefully
with Asia given the US’s growing dependence on Asia over the past decade [5].
Barring an immediate and serious trade dispute, Asia including Korea should see
a rise in exports to the US this year as recovery there continues.

Sources:
All data are sourced from CEIC, Bloomberg. Transformations and forecasts are
from DBS Group Research.
Notes:
[1] Korea: decoding “474”, April 2014
Korea: unleashing services, July 2014
[2] Korea: wither export competitiveness? March 2015
[3] Korea: housing recovery, August 2014
[4] Korea: explaining low inflation, January 2015
[5] Asia: Trump and the state of US-Asia trade, March 2017

4
Korea: is optimism justified? 29 March 2017

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SG: upgraded 20 Feb 17 TW: diversifying into Southeast Asia 21 Oct 16

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improvement
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