Republic of Korea

Briefing Notes for the Launch in Seoul, April 2007

Growth performance

• Although the Republic of Korea grew faster at 5.2%, economic confidence wavered in 2006 as a result of political tensions with the Democratic People's Republic of Korea, higher oil prices and interest rates and industrial disputes.
• Domestic demand, while growing at a reasonable pace, remains fragile. Consumption grew at 5% in the first quarter (year-on- year), but declined to a more modest 4.4% in the third quarter after industrial disputes in July and the nuclear test conducted by the Democratic People's Republic of Korea.
• Similarly, after growing at 3.8% year-on-year in the first quarter gross fixed capital formation dipped to 0.8% in the second quarter due to a collapse in construction. However, plant and equipment investment growth showed remarkable resilience and accelerated to 10.1% in the third quarter, laying the foundation for a rebound in gross fixed capital formation to 4%.

Inflation

• Inflation is generally low, but credit growth is proving to be a problem.
• Inflation in the Republic of Korea remained within the central bank's target range, but housing prices appeared to accelerate late in the year. Apartment prices in Seoul rose by more than 24% in 2006, and house prices rose nationally by more than 11%. The higher prices partly reflect supply constraints, but the rapid price increase has raised the spectre of a bubble, which could threaten economic and financial stability.
• The Bank of Korea increased interest rates, allowed the won to appreciate and raised the reserve ratio on deposits. Its policy rate reached 4.5% in August before leveling off. The won appreciated by about 8% for the year.
• Despite the appreciation, foreign reserves still rose by more than $21 billion ($9 billion in November and December), thereby expanding liquidity. The central bank did not want to raise interest rates further, which could dampen investment growth and stimulate additional financial inflows, or to allow a further appreciation, which could harm exports. So it took the unusual measure of increasing the required reserve ratio on demand and foreign currency deposits from 5% to 7%, the first time it had resorted to such measures since February 1990.

Current and capital account

• The current account of the Republic of Korea reached a modest $1.6 billion by the end of October, a much smaller amount than the $15 billion surplus recorded in the same period the year before. One of the reasons was the strong won, which encouraged imports and foreign travel; the other reason was higher oil prices.
• Financial flows generated an overall financial and capital account surplus of $12.7 billion in the first 10 months (compared with $4.8 billion for the same period in 2005). The substantial inflow was largely due to short-term foreign currency borrowing, reflecting speculation that the won would appreciate.

Medium-term prospects

• GDP growth is expected to decrease to 4.8% in 2007. Inflation in 2007 is expected to remain steady.
• With growth widely supported by external demand, slowdown in the United States economy continues to be a major concern for growth. A sharp slowdown in the United States would have a double impact as it is a principal export market, and the Republic of Korea is also producing intermediate inputs for final assembly by China to supply the United States market. Countries in the Asia-Pacific region accounted for 66% of China's imports in 2006.
• If external demand does not weaken, the Republic of Korea will have to deal with the ever-growing liquidity and inflation risks associated with its balance-of-payments surplus. Policymakers have a limited number of options. First, they could increase interest rates further. But doing so would probably be ineffective as higher interest rates would attract short-term capital inflows and add to excess liquidity. Raising rates could also threaten the already fragile investment climate, something the central bank would prefer to avoid.
• Continuing appreciation is the main alternative. However, investment demand is already weakened by geopolitical tensions, and export growth remains the foundation for economic growth in the country. The authorities will be reluctant to see the won appreciate too fast -- as it is already weakening profits in some exporting sectors.

 

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