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How South Korea rides out emerging-markets turmoil

by A. Gary Shilling

Bloomberg

South Korea is one of the few emerging markets to weather the recent storms. This stability is the legacy of 60 years of forced industrialization imposed by authoritarian governments and tightly controlled monetary and fiscal policies.

South Korea’s growth has been fueled by exports, which accounted for 58.7 percent of nominal gross domestic product in 2012. This expansion propelled the economy — with $22,600 GDP per capita in 2012 — to its intermediate status position between the BRIC nations (Brazil, Russia, India, China), where GDP per capita ranges from $1,500 in India to $11,300 in Brazil, and the older industrialized countries, where GDP per capita ranges from $33,000 in Italy to $46,700 in Japan and $50,000 in the U.S.

Dependence on exports, however, has left South Korea vulnerable to global volatility, as was evident from the nose dives in real GDP caused by the 1997-1998 Asian crisis and the 2008-2009 global crisis and its aftermath.

The relatively low level of consumer spending, 53.5 percent of GDP in 2012, was inadequate to offset the collapse in exports. Among industrialized and BRIC nations, only China’s, at 35.7 percent, was lower.

South Korea rebounded from the most recent recession as exports leaped. Growth has subsided, however, and will probably be held back by the slow recovery in Europe, the slowdown of growth in China, the competitive devaluation of the Japanese yen and a tepid U.S. economy.

Industrial production is barely rising. Business conditions continue to be subdued, and the consumer sentiment index has been little changed in the past year. In December, confidence in the economy stood at 84 and the evaluation of the future was 96, both below the 100 level at which there is an equal number of optimists and pessimists.

South Korea depends on energy imports, and the volatility of global oil prices has affected wholesale and consumer prices. Nevertheless, wholesale prices fell 0.1 percent year-over-year in November and the index (excluding food and energy) dropped 1 percent. Also, the consumer price index is well below the Bank of Korea’s target range of 3 percent to 4 percent, with the total index up 1.2 percent in November from a year earlier and the index excluding food and energy was up 1.7 percent.

The competitive devaluation of the yen is a considerable threat to South Korea’s export machine because it competes with Japan in many export industries, including automobiles. Competition is also fierce in electronics, especially parts and components and machine tools.

Adding to the pressure of recent cost increases and the strong won is the lack of innovation in South Korean manufacturing. Samsung Electronics Co.’s smartphones accounted for 29 percent of world demand in 2012, but the mobile phone industry is reaching saturation, with new demand centered on low-priced models in developing countries.

Japan’s competitive devaluation comes at a critical time for South Korea. Despite huge monetary and fiscal stimulus, most economies around the world are experiencing slow growth. The obvious alternative to domestic-led economic growth is export expansion, but the question is, to whom?

For decades, the U.S. has absorbed the world’s excess goods and services. Slower growth in real wages and incomes means Americans are no longer able to occupy that role. Indeed, U.S. trade and current account deficits are shrinking. These trends will probably persist as the rising consumer saving rate continues to damp demand.

So promoting exports requires making them cheaper to gain market share from other exporting countries. Yet when countries resort to tit-for-tat competitive devaluations, no one wins. Trade is disrupted and economic growth is slower.

Currency protectionism can take the form of reducing wages, as has happened to U.S. real wages in recent years as businesses rigorously cut costs. Furthermore, declining real wages reduce domestic demand, putting more pressure on export promotion to encourage economic growth.

Then there’s out and out currency manipulation. Prime Minister Shinzo Abe is determined to end that nation’s two decades of deflationary depression. So, emulating the Federal Reserve and the European Central Bank, the Bank of Japan is flooding markets with money by doubling its purchases of Japanese government bonds.

Abe has also targeted a return to a 2 percent inflation rate. The result has been a decline by the yen along with a leap in Japanese stocks as the surge in money promotes domestic spending and exports due to the cheaper yen.

Japan’s deliberate efforts to devalue the yen will probably induce retaliation by other nations. South Korea, which competes with Japan in many export markets and has a history of currency manipulation, may be the next to competitively devalue, given the recent strength of the won.

The heavy exposure to global volatility and South Korea’s disciplined culture are probably most responsible for the government’s conservative fiscal policies. Chronic trade and current-account surpluses have made the country the eighth-largest holder of foreign reserves, with $345 billion.

Government revenue has tended to exceed expectations in recent years: Except for a deficit in 2009, South Korea has recorded surpluses every year since 2000. Rather than using public funds, the authorities prefer private pensions to cover old-age poverty. They also plan privatization of public enterprises.

Nevertheless, to promote growth, the government announced a $15.3 billion stimulus package in May to fund more public-sector jobs, finance business startups and infrastructure, extend trade financing for small exporters pressed by the weakening yen, and ease credit for small and medium enterprises.

For 2014, the government plans a 2.5 percent increase in spending and a 2.8 percent increase in government receipts, along with a fiscal deficit of 1.8 percent of GDP, the same as was planned for 2013.

Government debt, at 35 percent of GDP in 2012, is small compared with Group of Seven countries. Even with the additional stimulus, the Finance Ministry projects government debt will remain below 37 percent of GDP. South Korean sovereign debt is rated A+ by Standard & Poor’s, better than many developing countries and European nations.

South Korea also espouses a conservative monetary policy. The Bank of Korea cut its policy rate during the global financial crisis, to 2 percent in February 2009 from 5.25 percent in August 2008.

As the recovery took hold, the rate was raised to 3.25 percent. Subsequently, it was reduced to 2.5 percent as a way to aid mortgagors, but also to slow the won’s rise against the yen and to accelerate inflation, which is at a 14-year low of 1 percent, well below the central bank’s 2.5 percent to 3.5 percent target range. The current policy rate of 2.5 percent is distinctly positive in real terms, and therefore contractionary, with 0.84 percent year-over-year inflation. The central bank emphasizes price stability over financial stability.

M2 money-supply growth has dropped considerably along with inflation. Still, it is a bit faster than nominal GDP, suggesting that the central bank, with a target of 3 percent to 4 percent, is trying to raise inflation rates, as are the Fed and the Bank of Japan. Yet the Bank of Korea foresees only a 1.7 percent increase in prices this year.

The family-run conglomerates known as chaebol are very powerful, with annual revenue equivalent to the nation’s GDP. They were central to the efforts of Park Chung Hee, the military ruler from 1962 until his assassination in 1979, to propel the nation from war to prosperity in one generation. The chaebol were granted tremendous economic power and near-monopoly control in autos, electronics and other industries.

Ironically Park’s daughter, who is now president herself, was elected in part on her pledge to restrain and clean up the chaebol. So far, she has little to show for her efforts: Last year, sales of the largest 30 conglomerates accounted for 82 percent of GDP, up from 53 percent in 2002.

Worries about their size and power have been exacerbated by a recent increase in failures among second-tier conglomerates involved in cyclically weak industries such as shipbuilding, shipping and construction. Many had been supported by the government in response to the global recession. The bankruptcies have caused a jump in bad loans, especially by government-controlled banks such as the Korea Development Bank. Still, bank exposure is limited, and no systematic risk is expected.

A larger challenge in South Korea is the huge income disparity and the difficulty in boosting output:

• According to the Organization for Economic Cooperation and Development, 45 percent of old people live in poverty, three times the average of wealthy nations, and the social safety net is one of the weakest. The chaebol are widely blamed for doing very little for the underclass.

• South Korea is essentially divided between members of the upper class who are involved with the chaebol and are politically well-connected, and the rest who earn relatively low incomes and operate small businesses, largely in the service sector.

• South Korea doesn’t have a lot of unemployed people who can be put to work to increase output. The jobless rate remains low, and the labor force participation rate has been rising recently despite the aging of the population, as is the case with many advanced countries except the U.S. and Canada.

• As with other highly industrialized lands, South Korea’s population growth has slowed to almost zero.

Meanwhile, the South Koreans’ legendary work ethic and zeal to get ahead continue to be apparent in the emphasis on education. The goal is to get into prestigious universities that lead to jobs in chaebol. Parents incur huge debts to pay for cram courses for their children’s entrance exams.

These efforts seem to pay off. With the exception of China, South Korea ranks highest in reading and math, and is behind only Finland and Japan in science.

Nevertheless, with seven of every 10 high school graduates attending a university, there is a surplus of educated people. Estimates show that there are 50,000 more college graduates each year than the labor market needs, but there is a shortfall of 30,000 people for jobs requiring just a high school degree.

Estimates are that 40 percent of college graduates are redundant.

South Korean youths pursuing an education are delaying raising families, contributing to the low fertility rate of 1.2 per woman and to low population growth. This compares with 1.4 in Japan and Germany, 1.6 in Canada and 2.1 in the U.S. Excluding immigration, a 2.1 fertility rate is needed merely to replace the population.

Also, because they are delaying their entry into the labor force while attending a university, young people’s contribution to GDP has been negative since 2009. They added about 2 percent a year from 1970 to 1990.

South Korea has well-developed roads, railways and port facilities, which fuel the export sector. In health care, however, the World Health Organization ranks South Korea only 58th globally. This, in part, is because that country spends comparatively little on health care, only 6.9 percent of GDP in 2010, or about a third of the U.S. percentage.

A. Gary Shilling is a Bloomberg View columnist and president of A. Gary Shilling & Co. He is the author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” Email: insight@agaryshilling.com.