South Korea Emerges as Top Asian Tiger
South Korea has long operated under the threat of Pyongyang’s nuclear weapons program. But the threat hasn’t stopped the South’s rapid emergence into the world’s fifteenth largest economy, and an elite member of the Asian Tigers, along with Hong Kong, Singapore, and Taiwan. In 1980, South Korea’s economic output per capita was $2,300. Since then, its GDP per capita has grown to $30,000, almost thirteen times larger than thirty-years ago. Likewise, South Korea’s economic output has increased from $88-billion to $1.46-trillion during the same time span.
Deprived of natural resources, South Korea adapted an export-oriented strategy to fuel its economy. It’s evolved into the world’s eighth largest exporter and tenth largest importer. Finished products such as computer chips, LCD monitors, electronics, textiles, ships, automobiles, phones, and steel, are among its most important exports. Seoul has designed a roadmap, aiming its next goal of $1-trillion in foreign trade, including exports of over $500-billion per year, by 2012.
Yet across the demilitarized zone in North Korea, the national economic output is a scant $26-billion per year, or $1,900 per capita. A complete socialization of the North Korean economy was instituted in 1958, when private ownership of the means of production, land, and commercial enterprises was replaced by state control or collective ownership. The North’s top economic asset is a mine in the Hamgyong province that contains 2.2-billion tons of iron-ore, - the biggest reserve of iron-ore in Asia outside Australia. Roughly 1,800-tons of iron ore are shipped through Nanping to China’s state-owned Yanbian Tianchi Industry & Trade each day.
China’s voracious demand for iron ore is one of the economic realities that stand in the way of United Nations sanctions to choke off income to North Korea to block its nuclear weapons program. For Pyongyang, the iron-ore trade is a crucial source of foreign exchange for the country’s cash-strapped regime. With most of the supply of iron-ore controlled by BHP Billiton, Rio Tinto, and Brazil’s VALE, shipments from North Korea helps to fuel China’s steel industry. On the other hand, North Korea is heavily dependent upon China, for 95% of its crude oil imports.
While South Korean economy’s high growth rate is attracting legions of foreign investors, traders must deal with periodic shock waves to the Kospi stock market, due to the belligerence of Pyongyang, which threatens military crises, with either long-range missile firings towards Japan, sinking South Korean warships, and on Nov 24th, shooting artillery on Yeonpyeong Island. Yet perhaps, the biggest shock to the Kospi Index and the Korean won was Pyongyang’s bold decision to detonate a nuclear bomb on October 9, 2006.
In a knee-jerk reaction to the nuclear blast, the Korean Kospi Index tumbled 50-points or 3.7% to an intra-day low of 1,300. The US-dollar jumped 2% higher to 965-Korean won. Yet the intra-day shakeout was simply a better buying opportunity for Korean equity bulls, and a better spot to short-sell the US-dollar vs the won. Five weeks later, in November 2006, the Kospi Index was climbing towards the 1,425-level, and the US-dollar tumbled to 930-won. When it comes to investing in South Korea, traders have simply learned to live with geopolitical risk, and adopted the ability to look past events such as a nuclear test. Thus, the firing of artillery shells on a South Korean village, barely caused a hiccup in the Kospi Index.
However, a senior Seoul presidential aide Kim Tae-Hyo, warned on October 6th, that Pyongyang’s nuclear program has reached a “very alarming level and could cause havoc in South Korea,” if Pyongyang develops smaller mobile weapons. “North Korea’s nuclear threat has progressed at a rapid pace and reached a very alarming level, while the nuclear programs are evolving even now,” Tae-Hyo warned.
He said Pyongyang was believed to be operating all its nuclear programs, including the Yongbyon nuclear reactor which produces weapons-grade plutonium, and a separate highly-enriched uranium project to make bombs. “If the nuclear warheads are made compact and deployed to the field, they could wreak immense havoc on South Korea regardless of their precision level,” Tae-Hyo added. The North’s current plutonium stockpile is estimated to be enough for six to eight bombs. It tested atomic weapons in October 2006 and May 2009.
Despite the nuclear threat from the North, the Korean Kospi Index has recouped its post Lehman Brothers’ meltdown losses, suffered in the second half of 2008. The Kospi Index has rebounded in a V-shaped parabolic rally, to as high as 1,950 this month, fueled by booming exports to China and the emerging world. Share prices in the top automakers, Hyundai Motor and Kia Motors, soared to record highs. Korean exports hit a record $44.1-billion in October, up +30% from a year ago, while imports were $37.2-billion, and netting a record trade surplus of $6.9-billion.
South Korea like other emerging market economies has experienced huge capital inflows. The profit-seeking activities and diversification of risks by foreign traders are the main contributors to increased cross-border capital flows. At it peak, foreign investors accounted for nearly half of ownership in the main local bourse in 2004 and 2005. Foreign ownership of Korean stocks fell to less than 30%, during the crash in the second half of 2008, knocking the Kospi Index to the 1,000-area. However, ultra-low interest rates in the so-called advanced economies and quantitative easing by the Bank of England, the Bank of Japan, and the Federal Reserve has encouraged investors to snap up emerging markets’ assets, such as Kospi blue-chips.
South Korea’s economy is on track to grow 6% this year, thanks to resilient exports, said Bank of Korea chief Kim Choong-soo, on October 29th. “As economic conditions have improved, the growth rate is likely to reach 6-percent. Next year, the economy is likely to grow at the mid-4 percent rate,” Kim said. South Korea’s state debt vis-a-vis its growth domestic product has fallen to 32.6%, the third lowest after Australia and New Zealand, according to the IMF.
Strong demand for Korean government bonds, and the Fed’s telegraphing of QE-2 helped to knock the US-dollar to 1,100-won in late October. Foreign holdings accounted for 4.3% of the total Korean T-bond market at the end of 2008, but now their portion has increased to 7.1-percent. In order to dampen foreign capital inflows, the government decided on November 19th, to scrap the special tax exemption on foreign investment in government bonds. The decision led to the revival of a 14% tax on interest income and 20% on capital gains.
The yield on Korea’s three-year T-bonds has jumped to 3.60% this week, from 3.25% at the end of October, as investors began to lighten-up on T-bonds, fearing the tax measures. Usually, higher interest rates increases demand for the local currency. However, with the capital control measures on the table, the government and central banks aim to put a floor under the US-dollar at 1,100-won. Thus, the Bank of Korea (BoK) can start to focus on tackling inflation by lifting short-term interest rates, and not fear a renewed slide of the US-dollar. On Nov 16th, the BoK hiked its 7-day repo rate to 2.50%, following a quarter-point hike in July. But the BoK is still far behind the inflation curve.
The BoK has lagged its regional peers, such as Australia and India, in lifting rates back to pre-crisis levels, partly due to the slide of the US-dollar to 1,100-won. Consequently, its repo rate has stayed below the inflation rate for the past year. From June thru October, the BoK was intervening in the currency markets, injected roughly $23-billion worth of Korean won into the banking network, in order to slow the US-dollar’s descent. Much of the added liquidity eventually found its way into the Korean stock market, helping to artificially inflate an asset bubble.
South Korea’s consumer and producer inflation hit two-year highs in October, with consumer prices rising to +4.1% from a year ago, slightly above the upper end of the BoK’s 2-4% target range. Producer prices were up +5.3%, and threatening to go even higher, elevated by a wave of soaring commodity prices. The radical QE policies of England, Japan, and the United States is fueling commodity inflation worldwide, and the burden of countering the inflation threat, has fallen upon the shoulders of central banks situated in the fastest growing economies, in Australia, Brazil, China, Chile, India, and belatedly Korea.
If inflationary psychology becomes deeply entrenched, central banks of the emerging countries would have to ratchet interest rates much higher. On Nov 24th, a top deputy of the People’s Bank of China, Hu Xiaolian, warned it will use all the policy tools at its disposal to steer money and credit growth back to normal. “Strengthening liquidity management is the priority for monetary policy, and a key aspect of bringing monetary conditions back to normal. We will continue to make full use of various monetary policy tools, quantitative and price tools, as a way of maintaining reasonable liquidity levels in the banking system,” she warned.
Her remarks were a clear warning that Chinese interest rates could be headed much higher to keep a lid on inflation, which reached a 25-month high of 4.4% in October. Hu said the G-5’s easy-money policies shared some of the blame for the unwanted tide of cash washing up in China. “Major developed countries have continued to implement quantitative easing policies, which are exacerbating excess liquidity on a global scale. As expectations of yuan appreciation grow, global liquidity is flowing into China continuously, intensifying upward pressure on inflation and on asset prices and making it harder for China to manage liquidity,” she said.
Big Chinese banks must now hold a record 18.5% of their deposits in reserve instead of lending them out. But the ratio might need to steadily increase to 22%, to slow down lending and credit creation. Over the past decade, Korea’s economy has increasingly relied upon China, the European Union, and other emerging economies for growth. Korea exported 24% of its outbound shipments to China in 2009, and in October, exports hit an all-time high of $10.4-billion to its big neighbor.
In recent weeks, the PBoC has begun to guide China’s long-term bond yields higher, and the key benchmark 7-year yield reached 3.85% this week, up 1% from a month ago. Traders in Korea’s Kospi Index are more focused on China’s economy, and its monetary policy, and less concerned about artillery shells from the North. If Beijing decides to take stern action to fight the commodity inflation, and jacks-up interest rates and T-bond yields above the highs of 2008, the Korean Kospi Index could find stiff resistance at the 2,050-level, in the weeks ahead.
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