News in Charts: Falling star?

Four decades ago, South Korea was identified as one of the star performers of the global economy. Its stellar performance was a consequence of the Korean government’s drive to promote export-led growth. It escaped the ‘middle-income trap’, which has ensnared so many, close to a decade ago. It provided perhaps the most successful model of all time for emerging markets to follow. But, now the process of rapid industrialisation has run its course, the economy has begun to slow. And the current response of ultra-loose monetary policy is doing more harm than good in South Korea, as across the developed world. Productivity growth has stagnated and real wage growth turned negative earlier this year. Moon Jae-in’s victory in the May presidential election, along with a pickup in global demand, gives grounds for optimism in the short term. But, ultimately, for its economy to return to a higher trend rate of growth, South Korea will need to shift to a new growth model, a feat that has eluded Japan these 25 years. It would mean focusing on promoting ‘fair competition’, stepping up existing corporate restructuring plans, and moving away from ultra-low interest rates, in order to tackle weak productivity.

Today, South Korea’s economy is almost ten times the size it was in 1980. Labelled one of the star performers of the global economy during this time, it moved up the World Bank’s income-classification ladder to achieve ‘high-income’ status by 1995, joining advanced economies such as the US and Japan. In 2016, South Korea’s GDP per capita, measured in purchasing-power-parity terms, was just shy of Japan and 75% of that of the US. On this metric, South Korea escaped the middle-income trap (MIT) a decade ago.

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This surge in growth came as a consequence of the Korean government’s drive to promote export-led growth. Tax credits introduced to incentivise efficiency and investment in favoured industries encouraged expenditure on R&D and boosted productivity growth. Until a few years ago this strategy worked. Real unit labour costs — the average cost of labour per unit of output — fell by almost a third between 1980 and 2010. The textbook for developed economies would see this as a constant in the long run, with labour income growing in line with productivity. Falls on the scale achieved by South Korea are only really achievable by countries engaged in rapid industrialisation — the transfer of labour from low-productivity (typically rural) occupations to higher productivity (typically industrial) occupations. Falling real unit labour costs, combined with a significant depreciation in the South Korean won against a basket of currencies, dramatically improved the Asian economy’s international competitiveness by over 50% during this period.

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However, since 2011, the gains in South Korea’s competitiveness have ceased, and GDP growth has slowed considerably as a result. Average annual GDP growth was 3% between 2011 and 2016, less than half the average pace achieved during the preceding thirty years.

Growth has slowed, and so, more recently, has inflation. Between 2010 and 2013, the Bank of Korea (BoK) headline inflation target was 3%, with a tolerance range of plus/minus 1%. In July 2012 headline inflation dipped below this range with a reading of 1.5%. In response, between July 2012 and June 2016, the BoK gradually cut its base rate from 3.25% to 1.25%. But, with the base rate at a record low (and negative in real terms for eleven months), the ability to use this policy tool to boost the economy has been exhausted.

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Ultra-low interest rates progressively undermine the supply side of the economy because unprofitable firms with weak or non-existent productivity growth are kept alive. In that sense, the BoK’s policy stance — attempting to stimulate growth by making credit cheap — may even be counterproductive at this stage…South Korea’s labour productivity has stagnated in both the manufacturing and service sectors since the beginning of the loosening cycle. Last June, the government announced some measures to address this problem, including the first stage of its corporate restructuring plan, in which it identified the shipbuilding industry as its first target. In August 2016, Hanjin Shipping, South Korea’s number one shipping company by capacity, was allowed to fail, as the state refused to restructure its loans. Although this represents a step in the right direction, there is still a long way to go. Productivity growth drives wage growth. Average real wage growth — measured per hour — turned negative in the first quarter of this year. South Korea is in the same boat as the rest of the developed world, with high debt, low interest rates, weak productivity growth and correspondingly weak real wage growth.

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The leadership of the South Korean government changed this year — Moon Jae-in was elected President in May, following the impeachment of his predecessor, Park Geun-hye. By July, he had passed a KRW 11.2 trillion supplementary stimulus package. Since then, he has proposed a record $380 billion expenditure budget for 2018, which, if passed, will be the largest on record. The stimulative impact on the economy is limited, as both of these are largely funded out of higher tax revenues. These policy measures provide our first insight into whether President Moon will succeed in boosting productivity growth: the jury is still out. On the one hand, a KRW 300 billion fund to help businesses retry after failing risks selectively breeding those firms which are least productive, and creating adverse incentives for profitable businesses too: potentially a profoundly damaging policy. On the other hand, promoting competition in sectors currently dominated by chaebols, large family-run conglomerates, is a step in the right direction. However, it should be noted that President Moon’s Democratic Party does not hold a majority in Parliament and that therefore he may need to fight to get his budget passed.

The short-term outlook for the South Korean economy will no doubt be highly affected by political developments and international relations, not only with its neighbour to the North, but with the major global powers, too. However, focusing solely on the domestic economy, there are reasons for optimism. President Moon’s actions to date suggest he is willing to support the economy through fiscal expansion. Since government debt is just 40% of GDP, 60 percentage points below the OECD average, he has the fiscal space to ramp up government expenditure without offsetting this by tax increases. Meanwhile, annual export growth of around 20% achieved so far this year looks set to continue for now. The average survey respondents’ assessment of ‘foreign trade volumes over the next six months’, according to the IMF World Economic Survey, reached a three-year high in Q3 this year, with an average answer of 32.6.

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However, to return the South Korean economy to its higher trend rate of growth beyond the short term, President Moon will need to win enough votes in parliament to pass those policies aimed at tackling weak productivity growth, and those policies will need to work. Moreover, the corporate restructuring plan needs to be stepped up to allow those unproductive firms who, to date, have relied on state backing and low interest rates, to fail. Until then, negative real wage growth, rising debt, low interest rates and slowing potential growth will prevail — in South Korea as in the rest of the developed world.

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