&#91OUTLOOK&#93Economic forecast cloudy for '03

Last year the South Korean economy once again was among the strongest in the world. Although not matching the pace of the glory years before the 1997-98 financial crisis, or the spectacular recovery from that crisis in 1999-2000, real GDP growth in South Korea reached 6 percent last year and was the highest of any significant sized economy, with the exception of China. Buoyant domestic demand (aided by expansionary monetary and fiscal policies), together with a general strengthening of the world economy and of South Korea's exports, provided the impetus for this growth on the demand side. The productivity of South Korea's economy allowed a favorable response on the supply side, with only slight indications of rising inflationary pressures.

Unfortunately, the economic growth prospects for South Korea in 2003 do not look as favorable as the outcome for last year. This is partly because the growth of consumer demand (and of credit incurred by South Korean households) will need to slow somewhat this year; and neither monetary nor fiscal policies will provide a degree of stimulus comparable to last year's. The main reasons to worry that South Korea's real GDP growth might fall substantially, however, relate to three adverse external developments.

First, North Korea's recent decision to withdraw from international commitments concerning its nuclear energy and nuclear weapons policies is a matter of grave concern south of the Demilitarized Zone. If necessary, military action to deal with the problem will obviously pose great danger to South Korea. But such action appears highly unlikely. A diplomatic resolution, backed by all of the main interested parties, is likely to be found eventually. Nevertheless, a prolonged effort to reach such a diplomatic resolution －－while North Korean authorities exploit their penchant for troublemaking －－ could have a significant depressive effect on consumer and business sentiments in South Korea. The magnitude of this potential effect and the possible length of the present crisis are difficult to assess.

Second, among all of the world's significant economies, South Korea's is the most dependent on imported oil for energy needs. Worries about a possible war against Iraq and recent domestic political tensions disrupting oil production in Venezuela have pushed up world oil prices by $8 to $10 per barrel above the level that would probably prevail in the absence of these problems. This costs the South Korean economy about an additional 2 percent of its GDP in imported energy costs, and the bill will escalate substantially if world oil prices spike upward on news of military action in the Persian Gulf.

Third, the global economic recovery, which appeared to be getting off to a good start a year ago, has clearly lost some momentum recently. With the aid of further monetary easing already undertaken by the Federal Reserve, and a possible additional fiscal stimulus, the "soft spot" in the U.S. economy may prove short-lived. Corporate profits and business investments in equipment and software in the United States already show some preliminary signs of recovery. But the reasons for a reacceleration of demand growth in Europe and especially in Japan are far less clear. And higher world oil prices and the uncertainties and worries about the situations in Iraq and North Korea are depressive influences on the pace of global economic advances. In this economic environment, the emerging market countries of Asia may be expected to fare somewhat less well this year than last year.

On the brighter side, the concerns that cloud South Korea's near-term economic prospects could prove short-lived. A rapid diplomatic resolution of problems with North Korea will be feasible －－If North Korean authorities behave responsibly and in their own interests. A war against Iraq might either be avoided or rapidly and successfully concluded, leading to a sharp fall in world oil prices. Perhaps aided by more vigorous, pro-growth policies in Europe and Japan, as well as by lower oil prices, the global economic recovery could gather significant renewed momentum by the second half of 2003.

What can South Korea contribute to help bring about a more favorable outcome? Inside the country, monetary and fiscal policies should remain supportive of reasonable growth of domestic demand －－ but with clear recognition of the limits both to the further stimulus that these policies can prudently supply and to the effects of such stimulus in an inhospitable external environment. South Korea can exert little influence on world oil prices and the general pace of global recovery.

In contrast, South Korea clearly needs to play a central and constructive role in its relations with North Korea. The effort must not be merely to seek a rapid diplomatic solution to the present problem, but to avoid similar problems in the future.

by Michael Mussa

* The writer is a senior fellow at the Institute for International Economics, a former IMF economic counselor and member of the U.S. Council of Economic Advisers in the Reagan administration.