Weakening export demand and excessive consumer debt may put the brakes on economic growth. In the long term, South Korea may need to move away from manufacturing toward a service-based economy.
The world today knows Korea not only for its smartphones but also for “Gangnam Style,” the recent pop single by rapper Psy that holds a Guinness World Record for being the “most liked video in YouTube history.” The music video is shot in the affluent Gangnam district of Seoul, which benefited from Seoul’s rapid economic development and planned expansion of in the 1970s. The video’s humorous compilation of unusual dance moves can be perceived as a social satire of the materialistic lifestyle of Gangnam’s elite residents. It also depicts two fundamental characteristics of the Korean economy: conspicuous consumption and rising income inequality.
Consumption has long been the main driver of the Korean economy. Historically, rapid industrialization from the 1960s to 1980s resulted in double-digit growth rates, which set the trend for robust private consumption in future decades. Today, private consumption accounts for almost half of Korea’s GDP. However, similar to many developed economies, rising levels of affluence have led to a consistent increase in conspicuous consumption as Korean households strive to achieve a higher social status. One of the immediate consequences has been the rise in household indebtedness; Korean household debt stands as high as 160 percent of disposable income, which is even higher than the rate in the United States right before the subprime crisis.
Rising household debt
Korean consumer debt is equivalent to over 80 percent of Korea’s GDP and has expanded by an average of almost 9 percent per year since 2005. Data from the Central Bank of Korea shows that at the end of the first quarter of 2012, outstanding loans by the depository and other financial corporations stood as high as $757 billion—the highest level in the seven years for which data is available. What is worrisome is the fact that household indebtedness is rising in a sluggish economy with stagnant income growth and declining property prices.
Rising real estate mortgages, especially at a time when external headwinds are having an adverse impact on the domestic economy, present a growing risk to the banking sector. Recent statistics from the central bank show that around 70 percent of outstanding loans in the banking sector are in the form of real estate mortgages, exposing the sector to fluctuations in property prices. Real estate prices in Seoul have already begun to contract; after negligible growth in 2011, property prices have already dropped 1.2 percent since the beginning of this year. Further softening of the housing market could lower the value of household borrowers’ collateral and further amplify indebtedness.
Another concern stems from the growing involvement of the nonbanking sector (credit card companies and mutual savings banks) in household debt. With looser regulations than those imposed on the regular banking sector, these institutions typically enforce less stringent qualifying conditions on loan applicants but charge a higher rate of interest. Moreover, around 90 percent of household loans are subject to floating interest rates, leaving borrowers vulnerable to a rise in interest rates. While the central bank has kept interest rates low, expected economic recovery in the next few years could tighten policy rates and push up variable mortgage rates.
Record-high household debt levels have prompted policy action from the government. So far, the government has adopted a loose monetary policy stance to relieve pressure on borrowers; on the other hand, it has tightened measures for lending institutions to keep a check on household debt. The government faces an additional task of reviving private consumption, which has been declining as overstretched households are tightening their purse strings. Growth in private consumption, which is the main driver of growth after exports, is slowing down as well. After registering a growth rate of 4.4 percent in 2010, private consumption growth almost halved to 2.3 percent in 2011 and is forecasted to slow down to 1.9 percent this year. Underlining weaker consumer sentiment, retail sales have also experienced steady declines over the past few months. Policy makers are thus faced with the dilemma of reviving consumption while ensuring the stability of household debt.
The eggs and the export basket
Korea’s growth engine is losing steam primarily due to decelerating domestic consumption, declining investment, and weaker export growth. The export sector contributes to about half of Korea’s GDP, leaving the economy vulnerable to external headwinds. Korea’s exports, which mainly consist of electronics and semiconductors, suffered a quarter-over-quarter contraction of 1.4 percent during the second quarter of 2012. In the month of August alone, exports declined by 6.2 percent year-over-year, the sixth month this year in which exports have fallen. Exports to its main markets—China, Japan, the United States and the EU—all contracted. The outcome of the Eurozone debt crisis is uncertain, but depressed demand conditions are likely to persist for a few years and are expected to weigh down Korean manufactured exports.
Korea’s export reliance is a result of an outward-looking strategy adopted in the 1960s. The strategy envisaged economic growth through labor-intensive manufactured exports, giving Korea a competitive advantage over countries with limited human resources. The government greatly encouraged foreign direct investment (FDI) in the manufacturing sector, which made up for the shortage of domestic savings. This strategy served Korea well for the next few decades, leading to rampant industrialization and a rapidly expanding export sector.
However, in recent years, this outward-looking strategy and the openness of the economy have exposed it to external economic conditions including trade demand, currency fluctuation, and volatile capital inflows. While macro prudential measures taken by authorities and the resilience of the economy itself has cushioned the landing so far, manufacturing—Korea’s export-oriented growth engine—has lost its magic in the wake of major global economic and geopolitical events.
Soul searching in Seoul
This is perhaps a wake-up call for the South Korean policy makers to identify a new growth engine that will catapult the economy back to a growth trajectory. Korea’s historic success as a manufacturing champion came at the expense of the country’s service sector, which was starved of capital and innovation that was directed toward manufacturing.
However, the recent export slowdown and its negative impact on the manufacturing industry have highlighted the need to diversify away from both exports and manufacturing while striving for a more balanced and sustainable growth model. Although the government has taken some steps to expand its service sector, it has become imperative to design more focused policies to improve the service sector’s efficiency and productivity. The service sector has traditionally been protected by several regulations that should be loosened in order to attract more competition and encourage investment in vocational training for employees. This strategy would also empower highly skilled professionals to drive innovation and reduce income disparities and migration of highly skilled professionals to foreign countries.
Moreover, a healthy and vibrant service sector can exert positive externalities on the manufacturing sector. In short, there is a room for the services sector to increase its share to the GDP and provide immunity to external shocks. Indeed Korea’s large conglomerates, chaebols, can also play an important role in the development of the service sector; currently only about 4 out of Korea’s large enterprises are operating in the service sector as compared with 12 out of 30 large enterprises in the United States.
There is also a need to alter the export-led strategy in order to move up the value chain. There are opportunities in newer technology areas; nanotechnology, pharmaceuticals, and energy offer employment to its skilled workforce and encouraging entrepreneurship. Diversification to high-value exports will provide some immunity to strong competition from its neighbors that produce low-cost manufactured goods. Perhaps geographical diversification to emerging trading hubs in the Middle East and Africa could also reduce dependence on its current trade partners.
The South Korean economy is at a tipping point to explore new growth engines instead of trying to stoke engines that are beset with fatigue. South Korean policy makers need to design forward-looking policies that include expansion of the service sector, export diversification, and regional development while also being mindful of the trade-offs. It is indeed time for soul searching in Seoul.