Summary

While exports continue to suffer from the global economic slowdown, the Korean economy is supported by resilient domestic demand. Recent retail sales numbers indicate consumption is holding up well. Capital investment seems to be bottoming. But the outlook for domestic demand is somewhat mixed. Consumer expectation is still on an upward trend, but business sentiment has dipped again following a strong 1H rebound. Easing inflation pressure will enable the Bank of Korea to loosen its monetary stance in the coming months, which can further stimulate growth. We expect the economy to grow by 3.1% in 2001.

Decline in exports to continue

Export performance worsened in Q2. Total exports dropped 10.5% yoy, against the 2.1% growth in Q1. Electronics and IT exports, down more than 20% in April-May, continued to drag down total exports. Fortunately, exports of transportation equipment have been quite strong so far, rising 17% yoy in the January-May period. Meanwhile, the decline in Q2 imports was 13.5% yoy, again larger than the 2.0% drop in Q1. This was due largely to the plunge of capital goods imports, semiconductor and IT equipment in particular. With imports falling more than exports, the trade balance in Q2, at US$ 4.4 billion, was higher than the US$ 3.6 billion posted in the year-ago period.

The decline in exports is set to continue in the short-term. Recent US economic indicators have dashed the hope for a rebound in H2. The more likely scenario seems to be an L-shaped recovery. This may mean sub-par growth for both the US and the world for 2001 and 2002, which certainly is not good news to Asia's export-oriented economies. As to the technology sector, there have been no signs of bottoming out. The book-to-bill ratio for semiconductor equipment in the US, a leading indicator for Asia's tech exports, remains below 1. Although the ratio has risen for 2 consecutive months, the absolute amount of orders is still declining. This suggests the dawn for the hi-tech sector is yet to come. Moreover, the message from the recent company reporting season in the US is that the outlook for the hi-tech sector remains gloomy in Q3.

Production data show no signs of bottoming

Industrial production growth slowed to 1.7% yoy in Q2 from Q1's 5.0%. On a seasonally adjusted basis, production has declined for 3 consecutive months. Latest indicators point to more weakness in production. Producers' inventories have not yet shown a substantial reduction and shipments are still on a downward trend. This is especially true for the telecommunications equipment sector. In contrast to countries like Taiwan, Korea still posts positive growth (albeit slowing) in telecom equipment production. Falling external demand for these products means there is a surge in inventories (up some 70% year-to-date). The piled-up inventories have to be drawn down some time later, which does not bode well for future production.

Domestic demand holding up well

As to domestic demand, consumer spending is holding up well. Korean consumers, like their US counterparts, are still spending despite the economic slowdown. Retail sales volume grew 2.2% yoy in Q2. After seasonal adjustment, it was up 1.9% qoq in Q2, reversing the declines in the December and March quarters. Improvement in the labour market surely helped boost consumer sentiment. The unemployment rate (seasonally adjusted) dropped from 4.2% in February and March to 3.6% in June.

Capital investment continued to post negative growth in Q2, but the decline was less steep. Equipment investment dropped 4.2% yoy in Q2, against Q1's 6.2% decline. Private domestic machinery orders were down 5.4% yoy in the April-May period, compared to the 13% plunge in Q1.

The outlook for domestic demand is mixed. On the one hand, consumer expectation has risen for 6 months. On the other hand, recent business sentiment surveys conducted by the Federation of Korean Industries have shown waning optimism after a strong H1 rebound. The August reading went below the neutral level of 100, the first in 6 months. This probably reflected the concerns over the prospect of the export sector, as it has become clear that there is little chance of a Q3 rebound in the US.

The downside risk to domestic demand is that consumer spending may not be sustained. While consumer expectation has been rising, the pace has slowed. With business sentiment starting to dip again, it cannot be ruled out that consumer sentiment will follow. Besides, consumer goods imports for May posted the first yoy decline in 2001, which may be the first sign that consumer demand has begun weakening.

External position comfortable

Despite declining exports and slowing economic activity, Korea's external position remains healthy. The current account balance reached US$ 6.9 billion in H1, boosted by increased net goods balance as imports fell faster than exports. As to the capital account, inflows dropped in Q1 compared to the highs in 1999 and 2000, but have rebounded. In Q2, inward foreign direct investment and portfolio inflows rose to US$ 1.5 billion (US$ 0.8 billion in Q1) and US$ 3.2 billion (US$ 2.0 billion in Q1) respectively. Nevertheless, the overall balance of payments surplus shrank to US$ 0.3 billion in Q2 (US$ 0.6 billion in Q1), as there were capital outflows related to the repayment of foreign loans.

Outstanding external liabilities stood at US$ 128.7 billion as at end-May, down from the end-2000 level of US$ 136.3 billion. The external debt-to-GDP ratio has been reduced from over 40% in 1998 to around 30% currently. More importantly, short-term external debt is less a problem now as the level of foreign reserves is more than twice outstanding short-term external debt.

More expansionary policies to come

As of July, the BoK has only cut the overnight call rate by 50 bps this year, as the inflation rate, averaging 4.8% yoy in H1, was above target. Rising inflation was a result of the price increase in energy items (up 16% yoy in H1), and in public services (eg, medical service prices jumped 21% yoy in H1). The depreciation of the won has also pushed up consumer prices. Price pressure, nevertheless, is expected to ease in H2, as the effect of last year's rise in oil prices and medical service charges is to fade later this year. This leaves the BoK more room to cut rates.

That said, further depreciation of the won may prevent the BoK from cutting rates aggressively. The risk is that the yen may depreciate substantially in response to the short-term pain brought about by Koizumi's structural reform measures. Since Korea and Japan are keen competitors in electronics and telecom exports, it is unlikely to see Korea let the won/yen cross rate appreciate. This means if the yen falls, the won will probably follow. Actually, this was what happened in the past year.

On the fiscal policy front, a 10 trillion won package was approved in early August to stimulate the economy. Measures were also put forward to boost exports and facility investment. Officials estimated that the additional fiscal package would increase GDP growth by 0.7-0.9 percentage points.

The pace of restructuring slowed

There has been little progress in corporate and financial restructuring in the past year. The debt-to-equity ratio of chaebols was over 250% as at end-2000, well above the government's target of 200%. The slowdown of the reform process is due not only to deteriorating economic conditions, but also to mounting pressure from labour unions. The next wave of reform measures is not likely to come before 2003, as the presidential election in December 2002 means the government will probably ease the pace of reform, so as not to lose the support of the labour unions.