Dr. P.V. Viswanath

pviswanath@pace.edu

High tech, low growth

Jun 9th 2005 | SEOUL, From The Economist print edition

WHILE the country's scientists and engineers churn out astonishing discoveries and devices, its economic policies look out of date. South Korean researchers have found new ways to clone human stem cells; the cars in Hyundai Motor's new Alabama plant are flipped this way and that while being painted. Economic officials, meanwhile, are still cloning mercantilist foreign-exchange policies from the 1970s, while the central bank does somersaults in an effort to explain its currency and interest-rate policies.

South Korea's economy is slowing sharply. Seasonally adjusted, industrial production was 1.7% lower in April than in March. Private consumption is only slowly recovering from a burst credit-card bubble in 2002-03. The government's consumer-expectation index for May, published on June 9th, showed a second consecutive monthly fall. The finance minister now says that this year's GDP growth target of 5% looks “impossible”. Poor stuff, for an economy next door to booming China.

The core problem is that South Korea, despite its skilled workforce and large middle class, has not yet developed a strong and diverse local economy. Instead, policies have been skewed towards boosting exports, which benefit a few giant conglomerates, in ways that stifle domestic demand. So as the won has risen by 15% over the past year (see chart), partly in anticipation of a revaluation of the Chinese yuan, and as demand for electronics and other exports has waned, the economy has had little else to fall back on.

The central bank has been slow to correct the problem. The Bank of Korea (BoK) has been preoccupied with slowing the appreciation of the won, by intervening heavily last year in currency markets. Intervention is understandable, given South Korea's dependence on exports. Yet the central bank has also worked furiously to offset the effects of this policy at home, by vacuuming up the extra currency it has printed in order to prop up interest rates.

A policy puzzle
This is odd, given the need to boost domestic demand. The core inflation rate (ie, excluding food and energy prices), at 2.5%, is at the bottom of the BoK's target range. So with demand and confidence still weak, further cuts in official interest rates, now 3.25%, would make sense. But the central bank is holding rates—as it did on June 9th, for the seventh month running. Many onlookers think it will keep rates steady while it pursues two other objectives that have little to do with economic stability.

One of these concerns capital flight. The country still maintains controls on capital outflows, requiring South Koreans to get permission for most transfers greater than 10m won ($10,000). Many have been flouting these rules, for example by snapping up property in America and passing off the investment as educational expenses for children studying abroad. Some control-dodgers may be trying to escape potential taxes under the populist president, Roh Moo-hyun. Others are simply unimpressed by Mr Roh's other economic policies. The central bank seems to be propping up interest rates in the hope of stemming outflows.

But why try to restrict these outflows so much? The country hardly seems at risk of a currency crisis. Its banking system has recovered nicely from the 1997-98 Asian meltdown. The central bank has more than $200 billion in foreign-currency reserves, the fourth-largest stockpile in the world and enough to pay for nearly a year's-worth of imports. Nor is the economy burdened with a load of short-term debt denominated in foreign currency, which caused so much trouble for Asian countries in 1997-98. So there seems to be little reason to stop South Koreans investing some of their savings abroad.

No such restrictions apply to the state. It has set up a new unit, modelled on Singapore's Government Investment Corporation, to invest some of its huge reserves in higher-yielding foreign assets. Instead of maintaining overly high interest rates, hoarding foreign exchange and investing it abroad, it would seem far more sensible to loosen monetary policy and boost domestic demand—and let South Koreans invest directly in foreign assets if they wish.

The central bank's other fear is that cutting interest rates will spur property-price inflation. This also seems at odds with the state of the economy. Domestic demand could use a boost—in particular, consumers are still understandably reluctant to take on fresh debt. If lower interest rates did manage to boost home prices, people might feel richer and spend more.

Some economists believe that the central bankers are afraid to let home prices rise because it is inconsistent with South Korea's egalitarian bent. “It is almost as if the Bank of Korea is part of the Roh administration,” says one private-sector economist. Others point out that economic officials in Seoul, as elsewhere in Asia, are preoccupied with exercising control. “Look at [the Bank of Korea's] currency interventions and foreign-exchange reserves,” says an analyst in Seoul, “and you can clearly see the obsession.”

Questions:

1. Is this an example of sterilized or unsterilized intervention? Do you think it will work?