Economics Group Special Commentary Tim Quinlan, Senior Economist tim.quinlan@wellsfargo.com (704) 410-3283 Nick Bennenbroek, Currency Strategist nicholas.bennenbroek@wellsfargo.com (212) 214-5636 Shannon Seery, Economic Analyst shannon.seery@wellsfargo.com (704) 410-1681 South Korean Economic Outlook The Bank of Korea (BoK) has kept its target lending rate on hold since June 2016, but there has been growing speculation that a rate hike could soon be in store. At its October policy meeting one member of the BoK s rate-setting committee dissented with a preference to raise rates. Then last week third quarter GDP came in at the fastest pace in three years. While we admit that third quarter growth was better than we were expecting, we do not think that rate hikes are imminent in South Korea. High levels of household debt imply headwinds for consumer spending, and a shrinking labor force diminishes the country s productive capacity. Those factors, combined with a mostly benign inflation backdrop, suggest to us that any rate hike will have to wait until 2018. In the meantime, a low base for inventory investment and an improving global economy represent the potential bright spots that may eventually compel the BoK to raise rates. Such bright spots will likely factor into the Korean won gradually appreciating against the U.S. dollar over the medium term. Figure 1 Figure 2 South Korean Official Bank Rate Percent 1 South Korean Real GDP Bars = Compound Annual Rate Line = Yr/Yr % Change 1 We do not think that rate hikes are imminent in South Korea. 1 1 - - -1-1 Official Bank Rate: Oct @ 1.2 2000 2002 2004 2006 2008 2010 2012 2014 2016-1 Compound Annual Growth: Q3 @ 5.8% Year-over-Year Percent Change: Q3 @ 3. -2 2001 2003 2005 2007 2009 2011 2013 2015 2017-1 -2 Source: Bloomberg LP, IHS Global Insight and Wells Fargo Securities As the old saying goes, a rising tide lifts all ships. That is an apt phrase to characterize the backdrop for a number of export-dependent economies. In figure 3 on the next page, we look at one common metric used to size up trade dependence which is exports as a share of overall GDP. A number of these more export-oriented countries have been posting improving GDP growth figures in recent quarters. In Malaysia, Thailand and South Korea, for example, the most recently published GDP report revealed an increase in the year-over-year rate of GDP growth relative to the prior quarter. Greater foreign exposure has contributed to faster rates of growth. Greater foreign exposure has contributed to faster rates of growth. This report is available on wellsfargo.com/economics and on Bloomberg WFRE.
Third quarter GDP in South Korea was particularly strong. Solid Q3 GDP in South Korea Third quarter GDP growth in South Korea was particularly strong. The annualized growth rate during the period was a torrid 5.8 percent with contributions from every major category except inventories, which exerted a drag of 2.8 percentage points. On a sequential basis, it was the fastest growth rate in seven years. On a year-ago basis, the 3.6 percent growth rate was the strongest since the first quarter of 2014. Because real exports of goods and services add up to 42 percent of GDP, growth in the rest of the world is particularly important for the South Korean economy. China is South Korea s most important export market; it receives roughly one quarter of all Korean exports. In that regard, the economic moderation of China since the beginning of the decade had exerted a slowing effect on the South Korean economy. However, growth in China has stabilized more recently and the global growth backdrop is improving and Korean exports are again on the rise. Figure 3 Figure 4 10 8 Export Dependence Merchandise Exports as a Percentage of GDP Exports/GDP: 2012 Exports/GDP: 2016 *Japan's most recent data is 2015 10 8 South Korean Consumer Prices Year-over-Year Percent Change 6 6 4 4 2 2 CPI: Oct @ 1.8% Core CPI: Oct @ 1. 2000 2002 2004 2006 2008 2010 2012 2014 2016 Source: IHS Global Insight, The World Bank and Wells Fargo Securities That firming in the broader global economy manifested itself in a pronounced way in the third quarter GDP report. Looking at the GDP components on a quarter-over-quarter, nonannualized basis, net exports contributed substantially to headline growth. Exports increased 6.1 percent and imports were up a lesser 4.5 percent on the quarter, with both exports and imports reversing declines from the prior quarter. It would be an oversimplification, however, to characterize Korea s stronger growth in the third quarter as nothing more than an improving global economy. Consumer spending picked up for the sixth straight quarter rising 0.8 percent, non-annualized. Business fixed investment spending notched its seventh straight pick-up, though the pace of growth at just 1.1 percent perhaps reflects a bit of caution on the part of businesses. As mentioned earlier, a retrenchment in inventories weighed on Korean growth in the period. An argument could be made that inventories are now poised to be supportive of growth in the coming quarters. Businesses have drawn down stockpiles in six out of the past seven quarters which sets up a low base for this component to be additive to topline GDP in the near future. Even a slower pace of inventory correction would be additive to growth in the final quarter of the year. Are Objects in the Rearview Mirror Better Then They Appear? The most-recent move from the BoK was in cutting its primary lending rate a quarter of a percentage point to 1.25 percent. In the 17 months since, financial markets have attempted to dial-in precisely where the BoK is on the scale of neutrality, favoring a cut or an increase as the next move. Even prior to the recent GDP release, financial markets were beginning to price in the possibility that the BoK s policy bias was more hawkish than it was neutral. However, even with the surge in economic growth reported in the third quarter, fundamentals suggest lingering headwinds for the Korean economy, which underpins our expectation that the BoK will wait to raise its target lending rate until 2018. 2
Inflation, measured by the Consumer Price Index (CPI), continues to linger around the BoK s target rate of 2 percent. The core measurement of CPI, which excludes the volatile components of groceries and energy, has moderately decreased, currently standing at just 1.3 percent. The stillsubdued inflation figures add to our doubts of an imminent rate hike, though we do expect inflation to gradually pick up throughout our forecast period. Despite heightened geopolitical risks, consumer confidence remains elevated, which should sustain modest gains in personal consumption. The threat, however, is that household debt in South Korea has doubled since 2008. Against those rising debt obligations and the associated financing cost, we remain cautious on the outlook for the consumer. High levels of household borrowing could constrain future consumption if individuals take on too much debt to finance with future wages and salaries a key consideration for the BoK as it balances the low interest rate environment to stimulate growth, without encouraging an excessive rise in consumer borrowing. In this regard, policymakers at the BoK have a similar problem to their counterparts at the Reserve Bank of Australia. Figure 5 Figure 6 18 16 South Korean Household Debt Total Household Debt as a Percentage of Disposable Income Household Debt/Disposable Income: 2016 @ 153. 18 16 7 South Korean Working Age Population Population Aged 15-64 as a Percentage of Total Population 7 Household debt in South Korea has doubled since 2008. 14 14 12 12 7 7 10 10 8 8 6 6 7 7 4 4 2 03 04 05 06 07 08 09 10 11 12 13 14 15 16 2 Working-Age Population/Total Population: 2016 @ 71. 69% 69% 99 01 03 05 07 09 11 13 15 17 Source: Bloomberg LP, IHS Global Insight and Wells Fargo Securities South Korea has also experienced a slowing in its productive capacity as growth in its working-age population has slowed in recent years. The pace of population aging in South Korea is projected to be one of the fastest among its international counterparts, highlighting potential risks to the productivity of its labor force moving forward. As the elderly population grows as a percentage of total population, the labor market becomes constrained due to disproportions, hindering the availability of qualified workers. Although the unemployment rate hit a seven-year high of 4.0 percent earlier this year, it has been trending lower in recent months and currently stands at 3.7 percent through September. Effects of South Korea s shrinking labor force have the potential to produce downside risks of a secular like stagnation. The changing labor force paired with an uptick in personal consumption needs to be matched with a rise in personal income in order to keep an encouraging pace of growth. This is no easy task. With the slowing of the working-age population impacting the productive capacity of the economy, there is little room for growth concerning wages and salaries. Without an increase in output, it will be difficult to see any translation to an increase in income. Further, without an increase in income, personal consumption is likely to slow; if it does not, household debt will continue to soar. There has been discussion for policy reform to aid the high levels of debt that South Korea is experiencing. Talks concerning an increase in the minimum wage produce the potential to uplift a portion of wages in the hopes of spurring further personal consumption. But, again, an increase in output, or production, is needed to see a robust increase in income. The pace of population aging in South Korea is projected to be one of the fastest among its international counterparts. 3
An improving global growth environment should be an overall positive force on the won. Moderate Gains in the Won We expect moderate gains in the Korean won over time. An improving global growth environment should be an overall positive force for the won. However, even with the recent firming in Korean economic growth and an overall bias to tighten monetary policy, actual BoK rate hikes still appear to be some way off. Geopolitical tensions on the Korean peninsula may at times influence the value of the won, although in the absence of a significant escalation we doubt those tensions will have a lasting impact on the Korean currency. Finally we would note, that for two of Korea s key trading partners China and Japan we are also expecting only moderate gains in those currencies, a factor we believe argues for moderate gains in the Korean won as well. Figure 7 1,000 South Korean Exchange Rate KRW per USD (Inverted Axis) KRW per USD: Oct @ 1,124.8 1,000 1,050 1,050 1,100 1,100 1,150 1,150 1,200 1,200 1,250 1,250 1,300 2010 2011 2012 2013 2014 2015 2016 2017 1,300 Source: Bloomberg LP and Wells Fargo Securities On Hold for Now We expect the BoK to leave its target lending rate unchanged at its November policy meeting. Despite the solid GDP report for the third quarter and notwithstanding the dissent at the October meeting, we do not think conditions currently warrant a rate hike. The headwinds of elevated consumer debt and a fast-aging population are not going away any time soon. That said, continued firming in the global economy, as well as a rebuilding of inventories should push the South Korean economy to continue to grow. If that proves sustainable, the BoK may eventually adopt a more hawkish bias in 2018. On that basis, we see scope for modest improvements in the Korean won over the next 12 months. 4
Wells Fargo Securities Economics Group Diane Schumaker-Krieg Global Head of Research, Economics & Strategy (704) 410-1801 (212) 214-5070 diane.schumaker@wellsfargo.com John E. Silvia, Ph.D. Chief Economist (704) 410-3275 john.silvia@wellsfargo.com Mark Vitner Senior Economist (704) 410-3277 mark.vitner@wellsfargo.com Jay H. Bryson, Ph.D. Global Economist (704) 410-3274 jay.bryson@wellsfargo.com Sam Bullard Senior Economist (704) 410-3280 sam.bullard@wellsfargo.com Nick Bennenbroek Currency Strategist (212) 214-5636 nicholas.bennenbroek@wellsfargo.com Eugenio J. Alemán, Ph.D. Senior Economist (704) 410-3273 eugenio.j.aleman@wellsfargo.com Azhar Iqbal Econometrician (704) 410-3270 azhar.iqbal@wellsfargo.com Tim Quinlan Senior Economist (704) 410-3283 tim.quinlan@wellsfargo.com Eric Viloria, CFA Currency Strategist (212) 214-5637 eric.viloria@wellsfargo.com Sarah House Economist (704) 410-3282 sarah.house@wellsfargo.com Michael A. Brown Economist (704) 410-3278 michael.a.brown@wellsfargo.com Jamie Feik Economist (704) 410-3291 jamie.feik@wellsfargo.com Erik Nelson Currency Strategist (212) 214-5652 erik.f.nelson@wellsfargo.com Michael Pugliese Economic Analyst (704) 410-3156 michael.d.pugliese@wellsfargo.com E. 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