European slowdown, U.S. subprime crisis will slow ’08 economy

Korea’s economic expansion is near its peak, in our view. Our forecast for the GDP in 2008 is 4.1 percent and 4.2 percent in 2009. Developments in the international economy, the domestic economy and policy all favor more moderate growth on the horizon.
First, manufacturing momentum has reached a level that normally marks the peak even without an analytical case for slower growth. Domestic leading indicators for Korea have flattened out, then picked up and are not yet showing convincing signs that a downturn in industrial production is coming.
But the analytical case for a slowdown from these levels is strong, given signals from the international economy to which production is linked.
This is especially true when we take Europe into consideration. One reason industrial production has done well this year is exports to Europe. The euro has been strong in conjunction with accelerating European economic growth up until August. That has helped exports post respectable growth this year.
China has helped too, but Europe has been the principal source of acceleration. That is changing. The European outlook is deteriorating rapidly, and UBS European economist Stephane Deo is forecasting that Europe will slow from 2.6 percent in 2007 to 1.6 percent in 2008, although his forecast is below consensus.
Remember that Europe absorbs 15 percent of Korea’s exports versus 13 percent for the United States. The drop in European leading indicators likely means that the best of this manufacturing/export expansion is near, in our view.
Second, Korean financial policy makers are tightening. The goal is to slow credit growth, and we believe they will succeed in the next quarter or two. Note that private sector debt hit 166.3 percent of GDP as of the second quarter of 2007, and total debt or non-financial sector debt is 210 percent of GDP. These levels are similar to the United States.
It would be highly unusual for a policy aimed at reducing credit growth not to slow domestic demand. Korea’s credit boom has funded consumption and investment. Yet forecasters so far give little or no weight to the fact that Korean exports will probably slow, just as tightening credit policies reduce the flow of credit to the domestic economy.
It is interesting to note that the three-month CD rate has been allowed to rise to around 5.6 percent (versus the overnight policy rate of 5 percent) and bond yields have risen to over 6 percent in the last few weeks. In our view, the rise in market rates is the result of changes in regulations over the last six months to hinder offshore funding by local banks along with declining U.S. dollar liquidity globally due to rising concerns about credit risk.
Over the past year, banks have been funding incremental asset growth by borrowing foreign currency, given that loan-to-deposit ratios far exceed 100 percent. Slowing external borrowing is thus a big part of the effort to slow credit growth. The sharp rise in three-month CD rates should translate into higher debt payments for households as most loans are floating rate and use CDs as their benchmark.
It is interesting to note that domestic auto sales surprised on the downside in November and that consumer confidence has turned down and looks suspiciously like it has rolled over.
At any rate, the central bank has made it clear that it has no intention of taking actions to bring these rates down. So while they did not raise rates this month, market rates have risen by far more than the 25 basis points we warned investors to watch out for.
Recall that we were forecasting the Bank of Korea to hike one more time before the end of 2007 and then reduce rates sometime in the third quarter of 2008. This is predicated on the view that the pickup in inflation we forecast for the last quarter of 2007 and the first quarter of 2008 begins to taper off by the second quarter of 2008, and assumes that the credit and money supplies are firmly slowing by then, along with the economy, something that just hasn’t happened yet. We believe that this will translate into a stronger exchange rate in the months ahead followed by weakness in the second half of 2008.
None of this means Korea is facing a meltdown or crisis as the United States and the global economy slow. However, in our opinion all of these risks need to be factored into one’s forecast for 2008 and 2009. Overall the economy continues to be strong and so do forecasts for this year’s GDP.
However, the balance of risks is clearly on the side of weaker than expected economic growth for Korea, and we prefer not to project the current macro-momentum into 2008 and beyond.

By Duncan Wooldridge Economist at UBS [Duncan.Wooldridge@ubs.com]