Sunday, January 23, 2011

Korea's Tenuous FX/Interest Rate/Inflation Situation (Update 1)

Korea Declares A "War" on Inflation:  Too Late, It's Here
This past week, President Lee Myung-bak declared a "war on inflation."  Official statistics reflect what every day Koreans have already know:  inflation is a problem at home.  The Seoul Gyopo Guide has pointed out here, months ago, that the KOR-US Free Trade Agreement needed passing immediately in order to reduce the cost of any imports that come from any country.  Later this year, a Korea-EU Free Trade Agreement should also be in place.  These agreements are important, but they are not the dominant factors affecting everyday Korean life. This post describes some of the issues that face the Korean economy, and potential effects on the Korean population.

Korean Inflation Has Been Rising and Looks Like It Will Continue
After the fact, it has been reported that Korea's inflation rate has risen to 2 1/2-year highs.  To working-class Koreans, this is not news.  As a country that is highly dependent upon foreign sources of energy, the rise in the price of oil to nearly USD 90/barrel is an unwelcome development.  In addition, the price of commodities such as metals and food have also risen dramatically.  Given that Korea is a net importer of each of these, inflationary pressure is set to rise for the foreseeable future, as companies will attempt to increase prices of final goods.

Korean Interest Rates Are Going Up
This past week, the Bank of Korea increased interest rates, to the surprise of many.  The reason that interest rates are used to curb inflation is because higher interest rates will create additional demand for the Korean Won relative to other currencies.  In addition, people may choose to save instead of spend which will gradually reduce demand.

Rises in Interest Rates Could Hurt Korean Competitiveness
The other side of this balance is that stronger demand for the Korean Won relative to other currencies will make Korean-made exports less profitable for Korean corporations, or reduce demand for Korean-made products.  Since the beginning of the financial crisis beginning in 2007, Korea has benefited a great deal from the relative cheapness of the Korean Won.  This point has been made by the Seoul Gyopo Guide a number of times.  In fact, one reason that Japan's economy continues to lag is because competitive Korean-made products are cheaper than their Japanese competitors' products.   Conversely, if the Korean Won strengthens compared to other foreign currencies, particularly versus the USD, EUR and JPY, Korean products may suffer on the international marketplace.  This would be a major source of concern for all Koreans.
(Update 1)In the English version of Dong-A Ilbo, this article was written to reflect the same opinions already posted here on the Seoul Gyopo Guide.  The downgrade of Japan's debt rating by Moody's may have contributed to a slight depreciation in the Japanese Yen against the U.S. dollar last week.  Whether or not this is coupled with Korean Won strength or weakness is yet to be seen.

Rises in Interest Rates Will Hurt Domestic Real Estate
In addition to the challenge that a rising Korean Won would create on the international marketplace, the domestic Korean real estate market will continue to struggle.  The single biggest factor in the value of real estate is the level of interest rates.  Higher interest rates make it more expensive to borrow to buy an apartment, even in Gangnam-gu.  If the Bank of Korea continues to raise interest rates, then the value of domestic real estate cannot rise dramatically.  There are other factors influencing the price of Korean real estate.  For example, the aging population will reduce demand, over time, for apartments in the busiest parts of Seoul.  That will translate to lower prices over time.
In addition, greater transparency and greater belief in the laws governing Korean corporations will reduce the percentage of household wealth used for real estate.  Why is that?  It is because there are other assets, such as stocks and bonds, which may be more promising.  Those investments have been hampered by the fact that Koreans themselves are very wary of the largest chaebol, the government, and the legal structure that keeps corporate misuse of funds in check.  As the Korean economy and regulations mature, native Koreans may re-allocate their wealth from real estate to other areas.
The problem with lower real estate prices is that people will feel less secure, and may be unwilling to spend.  This has happened in the United States, where the plunge in real estate prices has depressed consumer spending.  It is not a heroic prediction to suggest that if Korean real estate prices decline, then Koreans that own their apartments are going to spend less money for food, movies, entertainment, and mobile phones.  (Well, maybe not for mobile phones, but you get the idea.)
The other problem with lower real estate prices is that there are lower amounts of real estate taxes that will be collected by the government.  Why is this bad?  It is bad because then the government would have less money to spend, if further economic stimulus is needed.  Korea has spent a great deal of money during the financial crisis by bringing forward infrastructure projects, as well as compensating construction companies who built large apartment complexes outside of central Seoul, and that remain unoccupied, even today.

A Few Potential Solutions
The Seoul Gyopo Guide has pointed out that the government and companies and society face difficult choices.  That is what is called a conundrum.   There are no easy solutions.  However, here are a few, some of which have been proposed in earlier posts.   
First, Korean companies need to hedge their exposure to the possible appreciation of the Korean Won.  This point has been made by the Seoul Gyopo Guide months ago.  If the Korean Won rises, and Korean products are less competitive, then the only way that Korean companies' profitability will be sustained is if there are measures to counteract a stronger Korean Won.  That is fundamentally different from recommending that Korean corporations should speculate on the KRW/JPY rate.  If there is a decline in global demand, or an appreciation of the KRW relative to other currencies, then Korean corporate performance will suffer, almost regardless of the quality of Korean-made products.  In short, the relative strength of the KRW is to Korean corporations can be compared to jet fuel prices to airlines.  The best-run airlines partially hedge their exposure, and so should Korean corporations.  Korean corporations need to do this without taking excessive risks; the knock-in, knock-out (KIKO) options debacle was a situation where Korean corporations misused derivatives (with the help of securities dealers) can be avoided by using simpler, more straight-forward strategies.
Second, Korean companies' investments in technology to create the most sophisticated, leading-edge products must be accelerated.  Korean companies have made huge market gains, even since the beginning of the financial crisis.  The hard-won profits and market share must be deployed to make sure that Korean-made products are the best from both a quality and features standpoint.  The Seoul Gyopo Guide has pointed out that China has overtaken Korea in shipbuilding during 2010.  Korea must reclaim its lead by offering superior products, and Hyundai Heavy, Samsung Heavy, et al seem to have responded. Samsung Electronics, Hyundai-Kia Motors, and other leaders must do the same.   
Third, the Korean economy must support small and medium-sized enterprises.  There needs to be a better way for the highly-educated Korean population to create wealth other than via speculation or working for a large chaebol.  This includes, but is not limited to, tax incentives for new businesses.  Small businesses employ the largest number of Americans, and while that is an unrealistic goal for Korea, there is little doubt about the fact that Korea has a well-educated, creative population which can create new ideas/products, and thus, companies. 
Admittedly, this is only a partial list of suggestions.  There will need to be changes in every aspect of Korean life, and perhaps even the way of thinking, in order for these suggestions to be taken seriously.  However, the benefit would be that Korea would become more independent in determining its own economic course.  That has limits, certainly, because of Korea's lack of natural resources, small population, and small geographic size.  Nevertheless, moving forward in this way will reduce the burden on the government which has to tread carefully.  Currently, if there were policy errors of any sort, then the consequences would be devastating.  The time to address these issues is now, while Korea's economy is in relatively good shape compared to its global counterparts, not when there is an emergency situation.

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