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The Korean Economy: Still Powering Along

By Jonathan Lemco

The Korean economy continues to demonstrate strength as we enter the mid-year point. This growth is driven by an increase in exports, primarily to the United States, but also is the result of a series of prudent fiscal measures. In fact, it is likely that of all of the post-1997 stricken Asian economies, South Korea has done the most to help itself and to emerge as strong as ever. The major credit ratings agencies have been champions of this Korean reform effort and have steadily upgraded the credit to A3 (Moody's) and BBB+ (Standard and Poor's). We think that they will upgrade the Korean credit again by one notch before year-end 2002. Wall Street investment banks have bought the Korea story and recommend Korea to their investor base. In April, Barclays Capital went so far as to suggest that Korea and Japan (AA1/AA) might enjoy the same rating by year-end 2003. Their presumption is that the Japanese credit would continue to falter as Korea's improved.

We would not go so far as Barclays to suggest that the two Asian sovereigns would have the same rating in the next year. But we would stress that Korea has made tremendous progress. Investors worldwide have been paying attention, and Korean interest rate spreads are trading at their tightest levels since the economic crisis four years ago.

Why are we confident about Korea's prospects? First, Korea has been registering solid economic growth since the 1997-98 crisis and we expect it to be the strongest growth engine in Asia (ex-China) in 2002. GDP grew 5% in 2001 and we think that it will increase to 5-6% in 2002 and 6% in 2003. This growth has been driven by strong domestic consumption and increased export volume. Specifically, as the third largest exporter of electronic goods in the world (U.S. $58.7 billion in 2000), Korea stands to gain dramatically as the global recovery drives a resurgence in technology spending. DRAM prices are finally rising and the semiconductor book-to-bill ratio-a leading indicator of export growth-shows that demand is rebounding after considerable weakness in 2001. In addition, Korean consumer confidence has risen to near post-crisis highs, and is reflective of low unemployment (2.9% seasonally adjusted) and the wealth effect from increasing asset prices.

Also, the Korean sovereign's net external debt has fallen of late as foreign exchange reserves have risen dramatically and political progress is made on the reform agenda. External liabilities totaled U.S. $122 billion in January 2002, well below the end-1997 level of U.S. $159 billion. The debt/export ratio has fallen from a high of 94% in 1997 to an estimated 63% in 2002. Further, the nation's foreign exchange reserves were an impressive $106 billion in March 2002. This testifies to Korea's ability to withstand future external economic shocks. In turn, this has encouraged investor confidence in Korea's external position and its stable currency.

Korea's position as the world's largest manufacturer of computer memory chips, a staple component for computer systems, made the country's exports particularly sensitive to the slowdown in sales of personal computers in 2001. But the U.S. consumer has resumed its appetite for high tech products. This is contributing to Korea's GDP growth. The reform effort is evident in the banking sector as small and unprofitable banks are allowed to fail or are being merged into larger and more productive entities.

We think that the Korean reform effort has been a model for all of Asia. For example, six of eleven public enterprises slated for privatization had been privatized by the end of 2000, and the rest face 2002 deadlines. Corporate restructuring has been slower, but progress has been made here as well.

Korea has a diverse economy and varied manufacturing base. The country's labor force has shown that it could adapt to the massive changes brought about by the financial crisis by taking nominal wage cuts with minimal labor strife.

With its foreign exchange reserves rebuilt ($ 100 billion and rising) and burgeoning strength in domestic demand, the major hazard to continued improvement in the Korean economy may come from outside the country's borders. Japan's ongoing economic slide continues to be potentially destabilizing to Korea's exchange rate. This is because Japan is a destination for much of Korea's exported goods, and because Korean and Japanese industrial concerns compete in third markets. In the near term however, Japanese policymakers support a generally stable exchange rate.

Rising oil prices could pose another problem for Korea, which imports U.S. $18.6 billion (4.4% of GDP) worth of petroleum products annually. According to Lehman Brothers, a $10/bbl increase in oil prices would reduce Korea's real GDP growth rate by 1.1% and increase CPI by 2.0%. But although oil prices are high now by historical standards, they are far from a point at which they would be debilitating for Korea.

It should also be acknowledged that the process of private sector restructuring remains incomplete. The government has strengthened minority shareholder and creditor rights, improved accounting standards, and opened the economy to foreign investment. But there remains much to do. The government remains the owner of most of the banking sector. Many of the Chaebol (large conglomerates) remain inefficient. This being said, Korea has made far more progress in addressing these issues since the financial crisis than any of its neighbors.

Finally, the enormous issue of peninsular integration remains unsettled. North and South Korea remain in a technical state of war. Both entities devote tremendous resources to sustaining large armed forces that might be better spent in developing economically viable enterprises or improved public and private sector infrastructure and services.

Notwithstanding these problems, the fact remains that the Korean economy is growing, Korean industry seems to be thriving, and the quality of life for many Koreans in now on an upward trajectory. From a Korean bondholders perspective, Korean paper has realized tremendous gains this year. From an equity holders perspective, the Korean stock market has rallied 22% in 2002. International investors are increasingly likely to see Korea as a profitable and safe haven in north Asia.