South Korea Between China and Japan

When Japanese Prime Minister Shinzo Abe came to power in December of 2012, promising to reinvigorate the long-moribund Japanese economy, he famously proposed an economic strategy composed of what he called "three arrows."

One of those arrows appears to have made a direct hit on the economy of South Korea, which depends for half of its gross domestic product on exports. According to the Seoul-based Samsung Economic Research Institute, 49 of the top 100 Korean and Japanese exports overlapped in 2012, creating a pricing advantage that will be paid by South Korean exporters. Indeed, growth in South Koran exports slowed sharply, from 3.5 percent in the first quarter to 1.5 percent in the second.

The yen/dollar exchange rate climbed to a high of 103.21 May 17 from 77.6 at the end of last September, representing a nearly 25 percent depreciation of the yen against the dollar. That has alerted the entire region to the possibility of a competitive devaluation as mercantile nations attempt to beggar their neighbors by reducing the value of their currency against the US dollar - an unappetizing prospect to the Americans, who are attempting to keep their own currency low enough to stimulate exports for their flagging economy.

Remarkably, despite the relative appreciation of the won against the yen, South Korea's economy so far has suffered little. That is partly because President Park Guen-hye added ₩17.3 trillion (US$173.41 billion) in supplementary spending to the fiscal budget and the Bank of Korea, the country's central bank, cut interest rates a quarter of a percentage point to 2.5 percent.

On Thursday, the Bank of Korea government announced that the country's economy grew at its fastest pace in two years in the second quarter as government stimulus and rising consumer spending drove up gross domestic product by 2.3 percent, up from .5 percent in the first quarter.

But it is questionable how long that can keep up. Corporate profitability is falling and companies have been experiencing free cash outflows for two years. Companies are overleveraged and still have a long way to go in cutting debt. Facilities investment continues to decline and with both corporate and households already carrying too much debt there is little appetite to borrow, according to an analysis of the economy by Sharmila Whelan, deputy chief economist for the independent Hong Kong-based Asianomics financial analysis firm.

Despite making the government phenomenally popular in Japan, as the recent upper house election showed, Abenomics so far hasn't had the effect most economists expected. Japan exports aren't doing as well as anticipated. While they show an adjusted 11 percent annual increase when denominated in yen, they show a 7.5 percent decrease in US dollar terms.

Nonetheless, according to an analysis by the Seoul-based Samsung Economic Research Institute, "Due to the yen's steep slide, Japan's major export industries, including automobiles and electronics, have already seen improvements in their operating profits, while (Japanese) stock prices for exporters have surged." The Nikkei index skyrocketed by to 15,627 on May 22, up 76 percent since the yen depreciation began on September 28, 2012, allowing Japanese carmakers and electronics companies to repair their balance sheets.

And, while Korea's economy may be perking along now, if the yen depreciates faster and the yen falls to as low as¥118:US$1while the won/dollar rate plunges to ₩930:US$1, "there would be a 3.8 percentage point drop in economic growth and a US$254.5 billion loss in the current account," SERI said in a report released last week, which is available only by subscription. "In terms of export industries, machinery would be hit the hardest, followed by automobiles and electronics."

While to the west South Korean industry is looking with dread on the Japanese devaluation, to the east, the Chinese government has identified seven strategic industries in its 12thh Five-Year Economic Development Plan (2011-2015), including solar energy, wind power, fuel cells, next-generation IT and bio-pharmaceutical industries, all of which overlap with Korea's next-generation flagship industries.

The Chinese government is expected to invest 10 trillion yuan over five years in these industries and provide other active support, including corporate tax cuts for science and technology firms. It is also likely that government-run banks like the Industrial and Commercial Bank of China and China Construction Bank will play a supporting role, aggressively acquiring promising overseas companies to secure technologies needed for development of next-generation industries.

Accordingly, SERI says, "China's technological advance will accelerate to new highs, intensifying competition with Korea. It appears likely that China will not only catch up to Korea in many promising industries, but will outpace it."

Certainly, the effect of the weakened yen on Korea can't be overestimated. "Hence, the pricing advantage that Japanese exporters can derive from a weak yen can swing the competition in their favor and undermine Korea's economic ambitions," the SERI report noted. "In terms of export industries, machinery would be hit the hardest, followed by automobiles and electronics."

Source: SERI

President Park Geun-Hye has proposed a "creative economy" to promote growth, referring to the generation of new economic value "through a combination of innovation and creation driven by new ideas, creative knowledge and imagination."

That may take a lot of new ideas, creative knowledge and imagination. While the 2.3 percent growth rate recorded so far for the first half of 2013 is heartening, it is less than half of the 8 percent the Korean economy recorded during the heady years of the 1980s and 1990s. The country has one of the fastest-aging populations in the world, and one of the lowest birth rates.

A combination of factors "has steadily widened income gaps, pushing more and more households out of the middle Class," SERI notes. "Korea's Gini coefficient rose from 0.256 in 1990 to 0.311 in 2011, while the share for its middle class fell from 75.4 percent to 67.7 percent during the same period.

The question since Abenomics began is whether it would trigger the competitive devaluation. So far, it hasn't. The Chinese yuan - literally the elephant in the room - has remained at around the 6.150 level, up or down slightly since May, and so far the Chinese authorities have shown little sign they intend to take on the Japanese at this point.

Clyde Prestowitz, a onetime trade counselor to the Reagan administration and the founder and current President of the Washington, DC-based Economic Strategy Institute, is a hawk on Japanese currency manipulation and a critic of the US government in not taking on Tokyo for its mercantilist policies.

At the official level, he says, "the U.S. Treasury, the White House, and the State Department all maintain that…there is no currency manipulation going on in China or Japan. Indeed, for the past four years, the Secretary of the Treasury has carefully and steadfastly refrained from making any finding of currency manipulation by anybody even when countries have been accumulating enormous dollar reserves as a result of dollar buying in the global currency markets." He calls for an aggressive currency intervention policy by the South Korean government to force Japan, China and others to "talk seriously about currency policy in the context of free trade."

So far, that hasn't happened. The Park Geun-Hye administration has devised a fiscal budget of ￦79.3 trillion to be spent on welfare for the next five years. With Korean exports accounting for 50 percent of GDP, the new government will continue to promote overseas advancements to ensure uninterrupted revenue for social welfare programs.

"Accordingly, future competition for exports is expected to heat up further in Northeast Asia, the SERI report says. It remains to be seen if the other shoe will drop and competitive devaluation becomes a reality.