Is the South Korean economy headed for a recession?

Around the region, rates are being cut. Malaysia, Philippines, India, New Zealand and Australia have all cut rates, and more are likely to be on the way now that the US Federal Reserve seems to have shifted to an easing bias.

The Korean economy may actually be in a recession right now, we're simply waiting for the data to confirm it

Compared to most of these economies, the argument for some easing from the Bank of Korea is considerably more compelling and is exacerbated by the rate hike in November 2018 which we never felt was justified by the Korean macroeconomic situation. Moreover, since we last wrote about this economy at length, economic conditions have deteriorated further with the escalation of the trade war and the morphing of the global technology slump into a tech war of its own.

The best you can say about the Korean economy right now is that year-on-year comparisons will be less unhelpful in 2019. But this is an economy that may actually be in a recession right now, we're simply waiting for the data to confirm it. Forecasting an imminent upturn is a difficult thought-experiment.

Korea is an export power-house, punching well above its place of the 11th biggest global economy by GDP to rank fifth by export share. But what ought to be a sign of strength is a serious handicap against the backdrop of slowing global trade growth. The World Trade Organisation (WTO) forecast for global trade growth this year is only 2.6%, which is slower than global GDP growth (3.3%), so the headwinds for Korea's external sector are very severe indeed. This is more than a little temporary external weakness (as the BoK initially suggested as a reason not to respond with more accommodative policy).

Though the decline in Korea's exports is predominantly a semiconductor phenomenon, it's not as if Korea's other major export sectors are looking like they'll make up for this

Though the decline in Korea's exports is still, predominantly, a semiconductor phenomenon, it is not as if Korea's other major export sectors are looking like they'll make up for this. Indeed, the more traditional sectors of steel, autos, petrol etc. are also looking a bit subdued, probably reflecting a more general slowdown in global demand.

In the semiconductor industry itself, the Bank of Korea asserts that volume exports are picking up. That may well be the case, but producer price series for semi-conductors still show prices declining at anything between 11%YoY for semiconductors themselves, to 23% YoY for integrated circuits. It will take more than a slight uptick in volumes to offset that.

By destination, more than 50% of Korean exports are destined for other parts of Asia, with North Asia - China (41%), Hong Kong (11%), Japan (10%) and Taiwan (5%) taking the lion's share.

Within South East Asia, Vietnam is the standout recipient at 13.5%, dwarfing the Korean export receipts of most other Southeast Asian economies, even some many times its size. The 2015 Free Trade Agreement has probably helped this, with Vietnam reducing its tariffs by 89% and South Korea reducing its tariffs by 95%. Today, about 40% of Samsung handphones are reportedly made in Vietnam, so electronic imports for assembly and then re-export make up a significant amount of this intra-regional trade.

The other standout country in Asia, though for the wrong reasons, is the Philippines. The Philippines is seeing the strongest decline in growth of exports from Korea when compared to any Asian country. A database of trade shows that electronics goods, mainly integrated circuits, make up about a third of all South Korean exports to the Philippines - far more than any other category. While most reports cite exports from the Philippines to Korea being mainly agricultural produce (bananas and pineapples) as well as copper, the Observatory of Economic Complexity (OEC) of MIT shows electrical and electronic goods making up more than half Philippine - Korean exports. There is clearly a strong degree of interlinkage in this sector.

The Philippines is seeing the strongest decline in growth of exports from Korea of any Asian country

With a free trade deal between Korea and the Philippines due in November, some firms may be holding back exports until after that deal is signed. But the global tech slump may also be playing its role here by weighing on intra-regional exports.

While the external economy is struggling, and the best that can be said of it is that it may be showing signs of reaching a floor, the domestic economy looks slightly better. Inventory to shipments ratios are now falling (see charts below, where inventory ratios are inverted) and together with rising production in the quarters ahead, they also point to rising investment and capacity building.

Retail sales volumes have been slowing on a trend basis, but overall, sales volumes are still holding up reasonably well. And though the unemployment rate has been heading the other direction (higher) it has been doing so at a very gradual pace. However, that hasn't propped up inflation, which at 0.7%, is too far from the Bank of Korea's inflation target for it to be ignored further, and together with weakness elsewhere, make the case for rate cuts almost overwhelming.

The central bank governor, Lee Ju-yeol admitted at the BoK's semi-annual briefing recently that Korean inflation would likely miss the Bank's 1.1% forecast from April. He also suggested that there was a rising chance that the semiconductor recovery would be delayed. These and other comments seem to be warming the market up for a rate cut, perhaps as early as this month when they next meet (18 July).

While Governor Lee has indicated that there is not much room for monetary policy easing, we believe there is certainly room for at least two 25bp rate cuts

Downward revisions to both growth and inflation forecasts in the BoK's quarterly Economic outlook for July look highly probable, which should further increase the chances of a rate cut at that meeting. The last BoK meeting already had one dissenter to the no-change policy, and that too could be a precursor to a broader change of mind within the Bank.

While Governor Lee has indicated that there is not much room for monetary policy easing, we believe there is certainly room for at least two 25bp rate cuts. One to reverse last November's unnecessary hike and another to deliver some genuine easing. If we get a July cut, then we may not have to wait too much longer until the next.

Some slight won (KRW) appreciation since May, driven by Federal Reserve rate cut expectations, makes it easier for the BoK to move, though it is difficult to come up with a cogent set of explanations as to why the BoK previously felt that the currency's weakness made it harder for them to act. Nonetheless, to the extent that they felt this was a constraint before, now they should be slightly more relaxed.

One other factor that prompted the rate hike in late 2018 was housing. This was never a convincing story back then, when house price growth was modest, and largely confined to the Seoul Metropolitan area, which still remains one of the strongest regions nationally for house price growth, but even there, house prices are barely keeping pace with wages, and in other parts of the country, is either very weak or falling.

National house price growth is now less than 2%YoY. We expect it to fall further and even register some negative year-on-year comparisons in the quarters ahead. Easier monetary policy would provide some insurance against a harder and more painful decline in house prices, though we don't think there is a bubble on the verge of bursting. House price growth has never been that strong.

Despite the likelihood of some policy easing from the central bank, the main drivers for the currency are:

1. Global financial market risk appetite, in particular, sentiment about the trade war
2. Korea's trade balance
3. The US dollar

Recent swings in the Korean won are down to almost exclusively non-domestic factors: the growing expectation of Fed easing, ever-declining US Treasury yields, and some sense of relief following the G20 meeting which averted even greater tariff rates on China or retaliation. But looking ahead, we are a bit concerned that Fed easing, and subsequent dollar weakness that has helped the KRW swing from 1180 to break 1150, is overdone and could flip back. To some extent, this has already happened with the KRW already now at 1180. Higher still, is of course possible.

Our forecast of a gradual appreciation of the KRW is centred on an expectation of a gradually improving global outlook as we reach the end of the year

A catalyst for this is hard to predict in advance, though could include anything that undermined the easier Fed view – More evidence of strength on the labour market will remain key, but also stronger activity, wages and inflation data. If the US really is slowing now, then this probably won't be a problem, but if recent softer data flows are more a result of inherent noise rather than genuine signal, then it can't be ruled out.

Our forecast of a gradual appreciation of the KRW is centred on an expectation of a gradually improving global outlook as we reach the end of the year and as the commencement of the US Presidential race-proper limits further trade aggression, if only for 2019.

Korea's Treasury bonds rallied on the weak Korean story before they were pushed even lower by the US Treasury story. We have been surprised at just how far US Treasury yields have fallen, and remain suspicious that current levels are sustainable especially if the US is simply showing signs of slowdown, not hurtling into recession, consequently, for both Korean Treasury bonds and the KRW, we have some reversal of recent moves, though the conviction on the timing and extent of this is very low.

President Moon Jae-in's government continues to focus on measures to provide peace and reconciliation on the Korean peninsula, and in that respect, although there has been no breakthrough on North Korea, the support of US President Trump and recent revitalisation of talks is proof of some progress.

We don't think the government should abandon its reform goals of making the economy less reliant on a few big family-run conglomerates

But on the economy, the approach of tax and spend has been somewhat less successful, though it is hard to draw firm conclusions given the hostile global environment, and the counterfactual of what might have happened in the absence of a trade war or tech slump would probably have been considerably better. Active industrial policy is not the direction this current government follows, though in April a supplementary budget was crafted, amongst other things, to provide economic support.

The overall size of the budget was KRW 6.7 trillion, about 0.3-0.4% GDP, though arguably on the low side given the scale of the external problem and also the fact that about one-third of that total was related to health and safety, not economic support.

Korea has low rates of public debt to GDP. Consequently, given the uniquely difficult state of the external and domestic environment, one can make a very good argument for further targeted support, especially bearing in mind that the BoK's room for manoeuvre is limited.

We don't, however, think the government should abandon its reform goals of making the economy less reliant on a few big family-run conglomerates, known as chaebol. A more competitive market structure would be positive for Korean growth, even if it meant giving up some of its market share of global exports. In the current environment that doesn't seem like a bad trade-off.

The government seems to see more promise in the services sector, where it feels it lags behind the most developed world economies. Policies to push Korea to a more developed services future include:

• Providing the same level of support to services that has been extended to manufacturing firms
• Invest in basic infrastructure, including national statistics
• Promote convergence between the manufacturing and service sectors
• Build a regulatory foundation
• Relax regulations on promising service sectors, including healthcare and tourism
• Improve the logistics agency

These are of course very long run ambitions, but consistent with a modern developed economy. Though it brings with it a number of problems, including slower economic productivity growth, and in turn slower wages growth across both manufacturing and service sectors. One could argue that in trying to rid itself of some of its current problems, this policy direction will simply swap them for problems being suffered by most G-7 economies, and for which there seem few obvious remedies.