Troubled Seoul

Wednesday, October 8

Seoul is worried about a continuing slide in the currency that has brought it to levels last seen in the late 1990s, when Asia was in financial crisis. Capital has been flowing out of the country as foreign investors look to offset the liquidity squeeze that has come with an international financial crisis to which South Korea is also exposed.

President Lee Myung-bak's government faced serious economic challenges even before the landmark failure of Lehman Brothers in the United States last month, which deepened the international credit crisis:

• Weakening domestic demand has constrained growth and policy responses have been limited by the need to keep interest rates high enough to combat inflation.

• A slowing world economy, with consumers burdened by higher prices, has weakened demand for South Korean exports, limiting the competitiveness gains arising from won weakness this year.

• The government has faced political difficulties and policy problems implementing plans to reform and streamline the bureaucracy and privatise companies, including financial institutions that were rescued with public funds in the 1997-98 crisis.

Weak investor confidence ebbed further following Lehman's failure, and foreign investors have withdrawn capital from South Korea at an accelerating pace.  The flight of capital has been further encouraged by the emergence of a current account deficit of 12.6 billion dollars (January-August), chiefly the result of a falling trade surplus because of high raw materials prices.

In South Korea, fixed rate mortgages now cost up to 10% per year; the yield on three-month certificate of deposits reached nearly 6% at the end of September. Rates might go higher. Banks appear reluctant to lend to small and medium-sized enterprises (SMEs), having focused on expanding lending to this sector over the last two years.

However, bank balance sheets are far more robust than during the financial crisis in Asia ten years ago, although several have taken losses from exposure to the US markets. No substantial bank failure is anticipated, and the state, which has a large share in the sector, would anyway not allow it. Yet, despite this underlying robustness, South Korean banks are regarded as vulnerable:

• Their liquidity is being dented by slow deposit growth -- loan-to-deposit ratios rose to 150-180% in the second quarter.

• Indebted households and SMEs account for a substantial share of their loans. The latter are particularly vulnerable to a slowing economy and higher input prices; the former are suffering from higher interest rates, inflation and labour market weaknesses.

 

Prospects in the real economy have deteriorated because of the turmoil on world financial markets. Higher interest rates would dampen domestic demand further as will the impact on domestic purchasing power of declines in the terms of trade. Expectations for growth have dropped to below 4% for this year.

The outlook for external demand is worsening as world demand falls. While there may be some offsetting strength in demand from Asia, Russia and the Middle East, exports to OECD economies are likely to slow. There may be some underpinning for the won from a possible improvement in the trade and current account position as a result of lower oil prices in the fourth quarter.

The outlook for the economy is deteriorating. The government faces a stiff test bolstering growth over coming months given internal weaknesses and pressure from the financial crisis abroad. The policy interest rate is likely to come down and a fiscal stimulus to be provided in the budget for next year. The government is pledged to be more flexible and business-friendly, but risks reverting to an earlier dirigisme as it seeks to defend South Korea against the current crisis.