South Korea: Inflation test

Monday July 28

The South Korean economy is facing important challenges this year, testing policymakers in Seoul.  Growth is slowing, but with the economy particularly vulnerable to high commodity prices, the administration of President Lee Myung-bak is also worried about inflation.

Slower GDP growth. As the economic environment has deteriorated, growth projections for the year have been revised down.  The Bank of Korea (BoK) has adjusted its forecast to 4.6%, a far cry from the 7.0% (subsequently dropped to 6.0%) that the incoming government had pledged to pursue.

Policy problems. South Korea has a widening current account deficit, pushed by soaring oil imports and a loss of foreign investor confidence.  This has produced a significant weakening of the won this year.  Under different circumstances a decline in the won would have been welcomed by the corporate sector, which has been bemoaning won strength for years. However, the rising cost of imports of raw materials and energy is combining with won weakness to erode profits. The government has intervened to supply dollars to the market, but the causes of the declining won are structural, and real interest rates are barely positive. Indeed, with the rate held at 5.0% for nearly a year now, the next move in the policy rate is likely to be upwards, to curb inflation.

Energy dependency. South Korea is noticeably concerned about its high dependence on imported carbons energy and other resources. Unlike other advanced economies, it has actually become more energy intensive since the last oil shock -- its energy consumption per 1,000 dollars worth of GDP rose from 0.28 tons of oil equivalent to 0.31 between 1980 and 2001, according to the International Energy Agency. This compares with a fall from 0.11 to 0.09 in Japan.

In the difficult current climate, President Lee Myung-bak's pledges to push forward privatisation plans and to remove many of the restrictions on the activities of large corporations will take second place to managing the problems caused by oil and commodity price rises.