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Challenges Facing Korea’s Economy - By Jeon Young Jae

I. Price Hikes

Korea’s economy is beset by rising oil prices and currency appreciation. The
political instability in the Middle East is pushing up the global petroleum prices, raising
the benchmark Dubai oil to US$68.58 per barrel on May 3, 2006.
The Won-dollar exchange rate has fallen to 930 Won after dropping to 960 Won per
dollar on April 5. Later on May 8, it slide below 930 Won per dollar, setting a new low
since October 1997.

If the Won keeps rising at this rate, Korea’s exporters will be hit by worsening
profitability, with some of them being forced to either cut back on manufacturing or
stop their businesses altogether. Further increases of oil prices will undermine
Korea’s economy, and a slow global economy in turn will erode the base of Korea’s
exports.

II. Risk Factors
1. Oil price
The current global oil supply remains tight amid rising demand from China and
the US. Notwithstanding the price hikes, global oil demand in 2006 is likely to grow
2.2% from the previous year. On the supply side, the oil producing countries are unlikely to respond swiftly to the rising demand as they have made no significant
investment in new production facilities since the mid-1980s.

The recent instability in Iran, Nigeria, and the US has contributed to the rise in global
oil prices. In particular, the growing concerns over Iran’s nuclear program have
sent international oil prices higher. Iran, the world’s fourth biggest supplier, poses
the biggest threat to the global oil market. In Nigeria, threats of terrorist attacks by
rebel guerrillas on oil production facilities have raised the specter of protected
supply cutbacks. In the US, the main concern is obsolete refinery facilities that limit
oil supplies to US consumers in the summer season.

Although the price level has been climbing, it is still considered endurable.
The current pattern of price increase differs from the past. During the 1970s and 1980s,
oil prices jumped within a short time frame as unexpected factors wreaked havoc
on the supply side. In recent years, however, oil prices have risen gradually over a
long period, accompanied by an increase in demand stemming from steady global
economic growth. As for the supply shortage, oil prices have skyrocketed rapidly,
while demand increase has been steady and gradual, giving the global economy
enough time to absorb shocks.

Thus, viewed in real, effective terms, the global oil price today is not as high as it
was in the 1970s or 1980s. (A real, effective price refers to nominal oil price
reflecting inflation and global oil demand divided by global GDP, and shows how
seriously oil prices affect the economy.) In the first quarter of 2006, the real effective
price of benchmark Dubai oil was 82.5% of that in the 1970s, and 48.8% of that in the
1980s. During the same period, the real price of the benchmark Dubai surpassed that
of the 1970s, but stood at 76% of that in the 1980s.

How high will oil prices go? The answer depends on both oil supply and demand
as well as on situational development over Iran’s nuclear program. If the geopolitical
risks become protracted and consumer countries respond by releasing their reserves
to counter the supply shortage, then Dubai oil price will remain around US$58-68
per barrel range. However, if Iran’s nuclear standoff aggravates and other producer
countries are crippled either by terrorist attacks or natural disasters, the Dubai prices
will soar to US$68-78. Under the present circumstances, the former scenario appears
more likely.

2. The Won

A steep appreciation of the Korean Won stems mainly from domestic factors.
At the beginning of this year, analysts expected that foreign investors’ demand for
remittance of dividends would increase and the current account surplus will thus fall,
thereby weakening the Won’s value from a three-digit exchange rate figure
to a four-digit rate after March. Yet, such scenario changed as foreign investors,
instead of remitting their dividends, kept strengthening their position on the local bourse
in the form of reinvestment. Record high merchandise exports in March also sent the
exchange rate downward for the Korean Won. Discouraged by the continuous
appreciation of the Korean Won, some investors kept their stock on the market instead
of cashing out, thus accelerating the fall in exchange rate.

Externally, the earlier-than-expected signs of the US ending its interest rate hikes
and continuous pressure from G-7 countries on China to appreciate the Chinese yuan
have further accelerated the falling Won-dollar exchange rate.

Since the Asian financial crisis of 1997, the Won has been undervalued, despite
efforts to prop it up. The recent falls in the exchange rate, however, mean a drop
below the equilibrium. Now, it is overvalued. As of April 2006, the real effective
exchange rate index of the Won stood at 93.1 (the real effective exchange rate below
the benchmark figure of 100 means that Won is overvalued), indicating that the Won is
overvalued by as much as 7%.

The current exchange rate lies below the breakeven point for Korea’s
manufacturers exporting overseas, so regardless of their export volume, they would
still lose money. (The current breakeven point for exporters is 953 Won per US dollar.)
For every 100 Won drop in the Won-dollar exchange rate, Korean manufacturers lose
11.1 trillion Won in their overseas operating profit. That means a drastic erosion of their
corporate profitability.

The value of the US dollar against the Korean Won is expected to slide further as the
US Federal Reserve Board halts its cycle of interest rate hikes. For a long time, the
US dollar was able to maintain its strength due to its interest rate hikes. After a round
of 16 rate hikes, the US appears likely for a pause in the first half of this year, as the
target rate has almost reached its optimal value, at which the economy can grow
without inflationary or deflationary pressure. The US housing market is also showing
signs of calming.

As Europe and Japan raise their target rates, the narrowing interest rate gaps
between the US and its major trading partners will pose an obstacle to a strong dollar.
Further erosion of the dollar’s strength fuels the international community’s concern
over global imbalances and their efforts to resolve them. Reinforcing the possibility
of a weaker dollar, the US government and Congress are expected to strengthen
pressure on surplus-generating trade partners to appreciate their currency.

The future of the US dollar depends on a number of factors such as the US interest
rate policy, economic growth, push for a second Plaza Accord arrangement,
and appreciation of the Chinese yuan. Given the present conditions, the dollar is
expected to weaken slightly, resulting in the Won-dollar exchange rate hovering at
about 960 Won per dollar. On the other hand, one should not rule out the possibility
of a drastic weakening of the American currency.

III. Recommendations

Under the weight of an overvalued Won, Korea’s economic performance will
critically depend on the oil price movement. The soaring energy costs will likely
affect Korea’s exports. However, the oil prices have so far failed to dent consumer
prices. In 2005, consumer prices rose a mere 2.7% despite a 46% jump in oil prices.

This is not the first time that Korea’s growth has come under threat of rising energy
prices. In 2000, the oil price increase dragged down the global economy,
undermining Korea’s growth. With the per-barrel price of Dubai crude jumping 52%
from US$17 in 1999 to US$26 in 2000, Korea’s terms of trade aggravated 12.4% in 2000.

At that time, the US initiated a series of rate hikes in order to keep consumer prices
in check. The rate policy, however, let to a burst of the info-tech bubble and
global economic slump. Under the impact of the sagging global economy,
Korea’s economic growth rate also fell by 4.7 percentage points from 8.5% in 2000
to 3.8% in 2001.

As the current oil prices remain within an endurable level, Korea’s economy
can expect to grow at a faster pace this year, unless the energy front shakes again.

If the Won-dollar exchange rate is stabilized at 960 Won per dollar and price of
Dubai crude is kept to below US$68 per barrel, Korea’s economy can expect to
grow 4.8% in 2006, which is higher than 4.0% growth of 2005. Here, the key
assumption is that oil price increase weakens purchasing power, but the rising Won
strengthens purchasing power. In the event of steep fall in the exchange rate,
Korea’s economy would grow 4.0% as it did last year. If the price of Dubai oil stays
within US$58-US$68 per barrel, while the Won-dollar exchange rate falls drastically
to 900 Won per dollar, Korea’s growth will still record 4%. Considering the fat that the
first quarter growth rate has already surpassed 6%, the projected annual growth of 4%
in 2006 will lead to a slower expansion in the second half. If the scenario of 4%
growth materializes, Korea will be facing its first current account deficits since the
financial crisis in 1997.

An oil price exceeding US$78 per barrel will prove as a serious challenge for
Korea’s economy. A combination of high oil prices and overvalued Won will
undermine Korea’s growth. In such scenario, if the Won-dollar exchange rate stood
at 960 Won per dollar, Korea’s growth will show a new low since 2000. If the exchange
rate falls below that, Korea’s economy will be seriously damaged.

Therefore, Korean firms should prepare for additional oil price increase and further
appreciation of the Won. Korea also needs to establish a risk management program
in order to deal with changes in oil prices and exchange rate. The government
should increase its efforts to ensure that current growth, and set up effective policies
protecting corporate profitability and consumers’ confidence.