MNI ANALYSIS: S Korea GDP Contraction Belies Economic Strength

--BOK Likely To Maintain Tightening Bias

By Stuart Allsopp

     SINGAPORE (MNI) - The contraction in the Korean economy in Q417 is likely

to prove temporary and should not prevent the Bank of Korea from continuing to

tighten monetary policy or the won from outperforming its peers.

     The 0.2% Q/Q contraction was entirely driven by a drop in net exports which

subtracted 1.4 percentage points from headline growth. The domestic-focused

sectors of the economy continued to grow strongly. Gross capital formation and

private consumption both expanded, with the latter rising at its fastest pace in

two years. The trend real GDP growth rate remains around 3%, significantly above

the current BOK real interest rate of 0.1% (benchmark interest rate at 1.5% and

headline inflation at 1.4%).

     Korean won bears point to three main areas of weakness in the Korean

economy; an overarching reliance on external demand, high levels of household

debt, and poor corporate governance which undermines productivity. In our view,

these three weaknesses are manageable and do not pose major risks to the

economy.

     --TRADE WAR WORRIES

     With exports representing over 50% of GDP, headline real GDP growth will

continue to be heavily influenced by external factors, and a global trade war

would certainly be very negative for Korea, as we saw during the Global

Financial Crisis when export demand dried up. However, the country's external

health is much stronger today than it was 10 years ago.

     External debt levels have fallen significantly and the economy is now a net

international creditor as a result of years of current account surpluses

following the crisis. Not only is the level of external debt lower but the

composition of the debt is also much more stable. The high level of short-term

external debt was the key driver of the collapse in the won in 2008 as global

funding options dried up.

     --HOUSEHOLD DEBT FEARS OVERBLOWN

     While the continued rise in household debt, currently at 95% of GDP,

suggests that excessive lending to the household sector has occurred and a

reduction in debt may act as a shock to domestic-focused business, there is

little danger of a systemic crisis. 

     The banking sector is relatively well capitalized and debt repayment ratios

are manageable given that interest rates remain far below income growth. The low

level of public debt also means that the government could absorb some of the

burden of the household sector in the event that rising interest rates posed a

systemic risk.

     --CORPORATE GOVERNANCE REFORM

     The longstanding issue of poor corporate governance has been one factor

undermining productivity growth in South Korea, but this is slowly being

addressed. Hyundai Motor Group announced yesterday that it will streamline its

complex ownership structure, as it responds to calls from the government and

investors to reform the country's family-controlled conglomerates or chaebol. 

     The company's leadership is looking to resolve the group's circular

shareholdings, which give too much power to Hyundai's controlling Chung family

at the expense of shareholders. We expect to see the Korean government

increasingly apply pressure to conglomerates to reform their ownership

structures and unlock productivity.

     With a strong business environment, low levels of government debt, and

prospects of improved corporate governance, real GDP growth should remain strong

absent any major external shock. This should allow the BOK the room to continue

hiking interest rates should inflation pressures rise, keeping the won firm

relative to its trading partners. 

     While the Korean won may struggle to continue rallying against the

greenback given the growing real interest rate differential in the U.S.'s

favour, prospects are bright relative to the euro and the Japanese yen given the

inability or unwillingness of the BOJ and ECB to hike rates.

--MNI Singapore Bureau; +65 8233 2326; email: Asia-Editor@marketnews.com

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