2011 Economic Outlook

This year, the government will put more focus on curbing inflation rather than promoting economic expansion as concerns on the rise of consumer prices are growing.

President Lee Myung-bak said at his first cabinet meeting this year, “If we cannot keep inflation rate at 3 percent level this year, we should realize that it will directly affect low-income households,” pledging a “war” against inflation. He added he has been trying to curb inflation which will protect low-income families. as part of his campaign for a fair society.

Also at a recent meeting with business leaders, President Lee told that the goal is to stabilize inflation at 3 percent while achieving an economic growth rate of 5 percent.

The Ministry of Strategy and Finance put in a helping word by saying, “The administration will take steps in all directions to limit inflation expectations.”

The Fair Trade Commission’s new chairman, Kim Dong-soo, also said his main mission will be to take measures to fight inflation, and he ordered a shake up of the agency’s top officials, saying, “I will replace anybody who does not understand fighting inflation is one of the antitrust agency’s main roles.”

In a lecture hosted by the Korea Institute of Finance, Governor Kim also said that Korea is facing a difficult situation in taming inflation, as the economic recovery and rising raw material prices are exerting upward pressure on consumer prices,” which could lead to a hike in the benchmark interest rate sooner than expected. He added, “As for the central bank, inflationary pressures are a bigger concern than growth.” He went on to say, “Korea’s actual economic growth exceeded potential output in the second half of last year, and the gross domestic product gap is expected to gradually widen, pointing to growing inflationary pressure.”

These remarks of the central bank head are in contrast to last year, when the central bank kept monetary policy loose to help the economy recover from the global financial crisis. Attention is now focused on whether the central bank will raise the key interest rate from the 2.5 percent level it set in November. The benchmark interest rate is below the inflation rate of 3.5 percent in December. The central bank earlier set an inflation target of 2 percent to 4 percent for 2010 through 2012.

Inflation Tops BOK’s Target

The price of fresh produce, closely associated with ordinary citizens’ standard of living, soared 21.3 percent last year, marking its highest on-year increase in 16 years. In December alone, fresh produce prices were 33.8 percent higher compared with a year ago, driven by skyrocketing prices of fresh fruit and vegetables. The outbreak of foot-and-mouth disease and record-low temperature across the country are also expected to raise food prices until the spring.

Meanwhile, import prices in December rose by 12.7 percent from a year ago, marking the highest increase in 22 months, while producer prices rose by 5.3 percent, the biggest gain in two years. Both were driven by climbing international raw material costs, including oil prices. Prices for raw materials, including crude oil, have increased. Every time the international oil price goes up 10 percent in the international market, consumer prices increased by around 0.2 percentage points.

Excess liquidity overseas, the economic recovery in the U.S. and climbing wages in China are also putting upward pressure on prices of Korean goods and services.

In regard to the price stability target, the central bank stated that this year’s consumer prices will be on an upward trend, hovering above the median inflation target of 3 percent.

“We will manage the benchmark rate in a way that price stability is made firmer while our economy maintains robust growth,” the BOK said in its 2011 monetary policy report.

“If inflationary pressures continue to mount, the benchmark interest rate will likely be raised four times this year,” said a researcher at a securities company. He added, “There is a high possibility that the inflation rate could reach 4 percent level by the end of the year” because of the European debt crisis and increased raw materials costs.”

In the aftermath of the Bank of Korea’s surprise interest rate hike in the previous week, financial observers said the central bank chief’s stronger statements against inflation could signal a more rapid series of price control measures than previously expected.

Some observers predict that the central bank will wait for a rate hike until next month. An analyst in the industry said that the central bank usually raises rates at the beginning or the end of the year, but instead is likely to signal a rate hike sometime in the first quarter this time around.

However, some local think tanks and academics have criticized the central bank for making a hasty assessment. A professor at Korea University’s economics department said, “It is difficult to confirm that the GDP gap has entered positive territory. The BOK has made a mistake by raising the benchmark rate under the misjudgment that there are inflationary pressures in terms of demand. In a situation where investments and consumption have not yet fully recovered, a rate hike may result in depressing demand.” He argued there is a possible stagflation risk under which inflation can’t be controlled while the economy becomes stagnant.

A research institute estimated that this year’s inflation rate will be 3.1 percent, or 0.1 percentage point higher than the government target, while other institutions believe it will be between 3.0 percent and 3.5 percent. However, many analysts say that if the won appreciates against the dollar, it would dampen inflationary pressure since it would mean the cost of imported products would be cheaper. The currency has appreciated 8.8 percent in the past six months, the second-biggest climb in Asia.

The Central Bank Raises Growth Forecast to 5%

Meanwhile, the Bank of Korea is likely to raise its growth forecast for this year from 4.5 percent to 5 percent, matching the government’s target rate. The central bank is also expected to raise its estimate for inflation and the current account surplus this year to 3.5 percent and US$18 billion, respectively.

“The economy is expanding at a faster rate than expected so the initial forecast of 4.5 percent growth would be adjusted upward,” said a BOK official, adding, “It means that our economy is expanding at a faster pace than initially expected,” which is partly due to the United States’ projection to post over 3 percent growth, or 0.6 percentage points higher than earlier forecasts.

Previously, BOK Governor Kim said that a potential upgrade to the U.S. economic forecast to 3 percent growth may prompt Korea to raise its growth estimate as well. If the U.S. economy recovers at a rapid pace, it will eventually lead to rising Korean exports.

Export and China Risk

The leading indicator for exports in the first three months of the year came in at 52.7, only slightly down from 52.8 for the previous quarter, when Korea was expected to have enjoyed record quarterly growth in exports, according to the Korea Trade-Investment Promotion Agency (Kotra).

The indicator is based on a survey of 1,993 foreign buyers of Korean products jointly conducted by Kotra and a private think tank Samsung Economic Research Institute. A reading above 50 means more than a majority said they see improving conditions for Korean exports. A reading below 50 means pessimists outnumber optimists. “When considering the leading indicator for exports is still well above 50 and that it’s only slightly down from the figure for the fourth quarter of 2010, when the country’s exports are expected to have marked a new quarterly record, exports in the first quarter of the year will likely show positive growth,” Kotra said.

Contrary to such optimistic forecast, Korea’s biggest buyer China could turn out to be a source of risk for the Korean economy this year, which would be the reverse of the previous situation when Korea was able to make a rapid economic recovery from the global financial crisis because of the strong demand in China that was fueled by its loose monetary policy.

China is also raising interest rates to curb a rapid rise in consumer prices, though so far the moves appear to have been ineffective. As a result, there are concerns that Chinese inflation could be exported to the rest of the global economy, reflecting the increased cost of Chinese exports. China’s recent tightening of its monetary policy and measures to curb auto sales are another source of concern for Korea’s exports. Korea has been enjoying a boom in car exports to China.