South Korea has had a wild ride in 2008. After the rapid commodity inflation that peaked in July, it saw its usually robust trade surplus sour into an unusual deficit. Then, with the worsening of the financial crisis that began in the West, the Asian tiger suddenly found itself coming up short on the U.S. dollars that its manufacturers and exporters use to finance their operations. Now, as the global economy settles into recession, South Korea is watching its exports slump and production levels fall. Experts are predicting a domestic recession in the first half of 2009.

But the South Korean economy has exhibited remarkable dynamism since World War II and the Korean War that divided it from its peninsular neighbor to the north. Especially since the mid-1980s, South Korea has shown itself to be fleet of foot and highly adaptable to adverse external situations. In all likelihood, through a combination of government investment and competitiveness driven by a peculiar national sensibility, South Korea will wade through the coming global recession without getting washed away.

 

Geography and the Korean Psyche

The Korean psyche has taken shape throughout the centuries in response to its geographical situation. The Korean peninsula hangs precariously between the Japanese archipelago and Manchurian China, and both Chinese and Japanese power have waxed and waned throughout Korea’s history. Ancient Korean kingdoms were often divided because they faced different geopolitical circumstances; the North shares a broad swathe of borderland with greater Asia and fears land-traversing invaders (such as the Mongolians, Chinese and Russians), while the southern Koreans thrive on the coasts and fear seaborne invaders (the Japanese).

Korea often finds itself in the regrettable position of needing to turn to a superior power to defend itself against another superior power. This occurred in the late 16th century, when Japan invaded and China assisted the Joseon Dynasty in driving the Japanese out. The same dynamic played out again in World War II. When the Japanese invaded, they turned Korea into an industrial colony to boost Japan’s imperial war machine. The United States and the Soviet Union freed the peninsula from Japanese domination, but on opposite sides of the 38th parallel they installed separate governments friendly to their rival ideologies. The Korean War resulted, and Chinese influence returned to northern Korea to halt American encroachment. North Korea and South Korea remain divided today as a result of these foreign interventions.

Constantly beset by threats, the Korean national mind has adapted by panicking in reaction to outside events. In the 21st century, the North retreated into itself, exemplifying a paranoid self-reliance that gave ancient Korea the name of the “Hermit Kindgom.” Meanwhile, South Korea adopted an extroverted mercantilist mindset that has made it the third-largest economy in East Asia and the 13th-largest in the world. Seoul’s energetic engagement with the world is equally evidence of panic, the country both dexterously and anxiously tries to anticipate and react to events.

 When South Korea came into existence as a modern state, it was poor and recovering from the wounds of colonization. Lacking notable natural resources, South Korea applied for U.S. financial assistance for developing an industrial base and pursuing economic growth solely by means of a productive export sector, according to the common Asian model of development. From the 1960s to the 1980s, the country’s economy boomed under the leadership of successive military leaders.

The Park Chung Hee government of the 1960s and 1970s relied on using massive government investment and intervention in the economy to ensure economic growth. Specifically, Park focused on harnessing the chaebol, South Korea’s powerful family-run business conglomerates, by directing each of them to a particular field of expertise, such as steelmaking, shipbuilding or automobile manufacture, and providing them with as much subsidized credit as they could absorb, supercharging their growth.

In the 1980s, however, with the accession of Chun Doo Hwan, the economy began to change. As the West sank into recession, South Korea’s government saw the need to grow out of its reliance on Western consumption and adopt a more sustainable growth model. What followed were reforms to tighten credit, cut back on trade protectionism and promote internal development in order to generate domestic consumption. Favoritism for the chaebol was somewhat lessened, forcing them to compete with each other and become more efficient. Toward the end of the decade, South Korea had managed to maintain strong growth by increasing domestic demand and boosting its services sector. Simultaneously the Chun government in Seoul, under domestic pressure, transformed into a constitutional democracy with elections, opening the way for it to join a number of multilateral global institutions and engage fully in global trade. Growth boomed in the 1990s.

The Asian financial crisis of 1997 and 1998 was South Korea’s first serious setback as a major new economy. One of Seoul’s weaknesses stemmed from the legacy of its special treatment of the chaebol. These gigantic businesses had flourished with unhindered access to artificially cheap credit, but this had encouraged massive debt issues. When Thailand’s currency collapsed and financial contagion spread across the region, South Korea’s businesses were unable to find the cash to service their ballooning debt. Investors fled, the stock market sank and the won collapsed. South Korea was forced to appeal to the International Monetary Fund for $67 billion worth of loans.

South Korea came out of the Asian financial crisis with a much-increased national public debt, but its economy resumed rapid growth. Many Asian economies never fully recovered from the dislocations of the 1997 crisis, but the Korean government seized the opportunity to reform its entire banking sector and begin stashing away reserves of foreign cash to shore up its currency in case disaster struck again. The reforms proved successful, and since 1999 South Korea’s economy has generally performed well, with an average growth rate of 3.4 percent. Growth has only slowed twice since 1998, once in 2001, after the dot-com bubble burst and exports sagged, and then in 2003, when household debt dragged domestic consumption down.

 

South Korea and the Current Financial Crisis

This time around, South Korea is entering the global recession with relative strength. Its gross domestic product (GDP) reached $756.8 billion in 2007. It maintains a 3 percent budget surplus, and heavy-but-not-too-heavy external debt at about 30 percent of GDP. While most of the world aches with credit shortages, South Korea has extra cash stored in its $212 billion worth of foreign currency reserves.

Nevertheless, the worldwide economic slowdown is threatening to drag the Northeast Asian economy closer to full-fledged recession than it has been since 1998. The Korean Composite Stock Price Index has dropped by 39 percent since 2007 (losing an estimated $33 billion from foreign investors), the South Korean won has lost about 30 percent of its value year-on-year, and both foreign and domestic demand are falling. In 2009, South Korea could be facing a growth rate as slow as 2.5 percent, down from 5 percent in 2007 and an estimated 4 percent in 2008. Some have predicted a recession in the first half of 2009.

This month, the financial crisis caused Seoul to experience a sudden shortage of U.S. dollars. Most of South Korea’s import and export businesses finance their trade through the dollar, but the credit crunch in the West caused investors to flee in droves along with their capital (and not just from South Korea). The dollar shortage threatened to lock up businesses and banks struggling to pay short-term dollar-denominated debt, raising the specter of a rash of defaults. By mid-October, this now is leading Standard & Poor’s to question the liquidity status of South Korea’s Kookmin bank, as well as that of six other lenders.

Already the financial crisis has taken sizeable chunks out of South Korea’s foreign currency reserves, as the government and central bank have made efforts to boost liquidity for national and regional banks and shore up the currency. Standing at about $264 billion in the beginning of the year, the reserves had fallen to $212 billion by the end of October, registering a massive 11 percent loss ($27 billion) in that month alone.

Though the Bank of Korea (BOK) does not publicize its currency market interventions, it probably dipped into these reserves three times in October to buy up won and bolster its currency, as well as to provide banks with liquidity injections. Meanwhile euros and pounds sterling have depreciated against the dollar, shrinking the reserves’ total dollar value further. With more than $200 billion in reserves remaining, however, Seoul is ultimately confident it can ride out the financial crisis.

But fears persist surrounding the Korean currency. For much of 2008, Seoul has worried about the value of the won, in large part because of commodity inflation. Energy and food saw unprecedented price spikes, oil, which accounts for roughly 20 percent of South Korea’s total import costs, reached nearly $150 per barrel in July. The heightened cost of imports drove the country’s trade balance into the red for the first time since 1998; experts predict an $8 billion trade deficit for 2008, and a current account deficit of $12 billion.

The current account deficit, combined with the worldwide scramble for U.S. dollars and the abandoning of Korean stocks, has driven the won into a downward spiral. So far the currency has lost 27 percent to 30 percent against the dollar since 2007.

Inflation has eased in the second half of the year, though the delayed effects of the earlier price spikes are still driving up consumer prices at a rate faster than 5 percent. With oil prices low in the foreseeable future, South Korea’s trade balance for 2009 is expected to swing to a narrow surplus of $800 million. This in turn could help stabilize the won.

Meanwhile, South Korea’s exports, which account for about 40 percent of GDP, are flagging. The government has recorded a sharp decline in annualized export growth in October, down to 10 percent, from 28 percent in September and 18 percent in August. The business survey index for exporters fell from 82 points in October to 69 points in November, the lowest level since the index began in 2002. The United States, which absorbs 13 percent of Korean exports, and the European Union, which takes in another 15 percent, are in recession. Asian as well as Western markets are buying fewer Korean goods, and though it is not yet clear what China’s imports will do, the effect could be quite significant, as China consumes 21 percent of South Korean exports (much of which is involved in indirect trade with the United States and the European Union).

South Korea’s major manufacturers of steel, cars and electronics are registering the lowest sales so far this year, and its famed shipbuilders have seen orders fall by 38 percent since 2007. The won’s low exchange rate will likely have a mitigating effect, but the overall slowdown will put pressure on Korean exporters, who will see their sales slump.

As South Korea’s exports weaken, domestic demand is showing no sign of picking up the slack. Consumer confidence is turning increasingly gloomy, and debt is growing faster than income. In 2008, household debt rose 3 percent to $511.5 billion, amounting to a full 73 percent of GDP. Household income meanwhile has fallen to its lowest level since 1998, and the combination of heavier debt repayments and less income will further depress domestic demand in the coming months.

 

Rate Cuts, Dollar-Swaps

In the past month, Seoul has moved rapidly to address the global economic downturn, demonstrating yet again its propensity to react forcefully to external circumstances, lest those circumstances become unmanageable. The BOK, like other banks worldwide, has responded to the financial crisis by cutting interest rates. On Oct. 9, the central bank reversed a rate increase of 25 basis points that had been enacted to fight inflation during the summer, bringing the target rate back down to 5 percent. Then, on Oct. 17, the BOK chopped interest rates by a full 75 basis points to 4.25 percent, the largest rate cut in the bank’s history. On Nov. 7, this rate was further reduced to 4 percent. For a country that is paranoid about the devaluation of its currency, these massive rate cuts might seem counterintuitive, but Korea has a history of making sudden changes of direction and defying expectations which now seem to border on panic.

As the dramatic interest rate cuts show, Seoul will probably allow and even encourage further depreciation of the won. A sinking won will make Korean-made goods more attractive compared to those of its competitors. (The Japanese yen is reaching record highs, and the Chinese yuan is effectively pegged to the U.S. dollar, which is also rising.) South Korean President Lee Myung Bak’s government, which came to power in February, is the ideological heir of the old conservative governments that coddled the chaebol. His plan might well be to use budgetary spending to reactivate the policy of feeding subsidized credit to the chaebol, spurring them to take advantage of the weaker positions of some international competitors. The result would be a return to the familiar Korean two-pronged strategy of government investment and export-driven growth, inflation be damned.

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