Korea's Economy Comes Full Circle: From Domestic Demand Back to Exports

By Caroline Cooper, Director of Congressional Affairs and Trade Policy at the Korea Economic Institute (KEI) in Washington

Visitors to Korea over the past year have witnessed a new phenomenon there - a surge in domestic demand. Domestic demand, rather than exports, sustained the Korean economy during the worst of the global economic downturn last year and for the first half of this year. But that trend is now changing. A recent Bank of Korea report shows that domestic demand as a portion of gross domestic product (GDP) decreased from 50.7% in the second quarter to 28.7% in the third quarter. Exports as a percentage of GDP increased from 49.3% in the second quarter to 71.3% in the third quarter. The return of exports as the primary driver of Korea's economic growth brings with it new challenges and opportunities. If trade is to sustain Korea's growth over the long-term, new emphasis must be placed on importing and diversifying Korea's export base.

Once Considered Bad, Consumption Proved Good for a Time

Despite the global economic downturn and a 6%+ drop in real GDP growth from 2000 to 2001, Korea managed to experience positive growth in 2001 and through much of this year. This was due in part to pro-growth policies of the government and a surge in household spending. The latter was the most surprising.

The Korean economy, which developed from a sustained high household savings rate, saw that rate plummet as consumer spending and credit card usage increased. The Korean government encouraged credit card use, in part according to the Ministry of Finance and Economy, "to bring the taxable income of the high-income self-employed more into the open."

The plan worked and brought with it a new credit culture in Korea. The majority of banks shifted their credit provision policy away from corporations to households. Koreans - both young and old - easily obtained credit cards and began spending. The results were at first positive - private consumption rose to never before seen levels, facilities investment increased, as did domestic production. The negative result, most evident in the past two months, read across the headlines of major global newspapers from The Wall Street Journal to Korean dailies such as the Chosun Ilbo: "Credit Card Usage Out of Control."Koreans, some not yet debt-ridden, were reported as taking on personal debt to bail out friends in severe financial turmoil - a sign that individualistic spending habits had taken a firm hold in Korea. According to the Chosun Ilbo, the average credit card default ratio rose to a record 7.3% in the third quarter.

The Financial Supervisory Service has stepped in to curb defaults, imposing caps on cash advance limits and raising the reserve ratio for credit provision at lending institutions. But these efforts coincide with a sharp decline in consumption, sparking fears among analysts that trends will worsen as the government continues its efforts to reign in spiraling household debt. A recent Bank of Korea report shows that the consumer goods sales index (measured year on year) declined by 25% from the first quarter of this year to the third quarter. According to the Samsung Economic Research Institute, the consumer expectation index and consumer evaluation index - leading indicators of consumer attitudes in Korea - each declined for the fourth straight month in October.

Imports and Exports are Both Good

Korea has long been fearful of an increase in imports, and that attitude does not appear to have changed. Higher consumption over the past year resulted in an increase in imports - both of consumer goods and capital goods. This precipitated a rise in import prices and fears among experts that a further increase in imports could threaten Korea's current account balance. According to the Bank of Korea, this reached a surplus of $459.7 billion in September.

A primary concern has been a worsening of Korea's terms of trade. While exports - now totaling $117 billion - continue to outpace imports, the latter grew at a faster rate than exports from the second quarter to the third quarter. Bank of Korea data also shows that import prices increased at a faster rate than export prices during the first three quarters of this year.

Analysts need not be worried. An increase in imports is positive and normal as an economy's shift becomes more fully developed, and production focuses more on services than manufacturing. Indeed, the government thinks that imports are positive. In a recent op-ed piece, Commerce, Industry, and Energy Minister Shin Kook-hwan wrote:

Proof that Korea's economy is changing in the right direction can be seen in the data. Increases in imports of capital goods and raw materials are indicative of investment by manufacturing companies. Minister Shin argues that "cheap, but good quality, raw materials and machinery component imports contribute to international competitiveness." The biggest percentage changes in imports from the second to third quarter were seen in raw materials such as iron and steel and chemicals (35% and 77% increase month to month), and in capital goods (43% increase), not consumer goods.

Another positive sign that Korea's economy is changing is that services now account for a larger percentage of Korea's GDP than manufacturing. According to the Bank of Korea, services as a percentage of GDP increased from 55.8% in the second quarter to 64.3% in the third quarter. Manufacturing as a percentage of GDP now accounts for only 38.7%.

Diversification Also Includes Services

In balancing its trade strategy, Korea needs to consider diversifying its export base - common advice given by experts. Korea's top exports are information technology goods (i.e., computers, semiconductors, and wireless telephony) and old favorites - heavy industry goods (i.e., autos, ships, steel, and chemicals). Diversifying this export base should mean that Korea puts priority on increasing production of more advanced IT goods and on opening IT service markets.

As has traditionally been the case in Korea, technology is first developed and tested in the home market before being exported. As the first country to commercialize Qualcomm's CDMA (code division multiple access technology) in 1996, Korea used its domestic market to capitalize on producing wireless handsets. These are now its top export item. Companies such as Samsung Electronics and LG Electronics have become world-class producers of CDMA handsets.

Korean's fascination with the Internet and limited landmass provided it with a logical testing ground to also develop a competitive wireless communications service industry. Capitalizing on technology already in place from fixed line broadband, Korean wireless service providers such as SK Telecom have developed wireless broadband products for export. But they are not looking to develop new opportunities in the United States, recognizing that the market there is not ripe for investment and that the economy is still in a downturn.

SK and other Korean fixed line and wireless telecommunications service providers are heading to China - now Korea's largest export market (including Hong Kong) - for business opportunities. They are smart to do so, especially as the domestic market becomes more saturated with service options, and demand in China's nascent wireless telecommunications industry keeps growing. Other Korean services industries would do well to follow suit, especially finance and retail, which could profit from increased e-commerce made available through advanced telecommunications service delivery in China.

Caroline Cooper is the Director of Congressional Affairs and Trade Policy at the Korea Economic Institute (KEI) in Washington. The views expressed here are those of the author and not KEI.