[OUTLOOK]From sneezes to pneumoniaOn my first visit to Korea more than ten years ago, I was told by a Korean economist, “When the United States sneezes, Korea catches a cold.” This came as a surprise to me; Although not a medical doctor, I believed that nations could not transmit rhinovirus infections to one another. However, it was then explained me that this expression was metaphorical: The Korean economy was so dependent on exports to the United States that even a minor setback in the U.S. economy could create significant economic woes in Korea.
Of course, only about three years later, we all learned that Korea could “catch a cold” even without a “sneeze” from the United States: The contagion that developed into the financial crisis of 1997-98 came not from North America but from Thailand. To be sure, and as Korean analysts agree, the financial crisis was rooted in weaknesses within the domestic Korean economy, especially the financial sector. But, even so, contagion played some role.
And is there once again the danger of an external setback? In particular, is Korea vulnerable to a setback in China?
In fact, one result of the rise of China is that China now surpasses the United States as the largest immediate destination for Korean exports. I say “largest immediate destination” because some Korean exports to China are intermediate products that are re-exported to other locations, including the United States. Taking this into account, the United States might still be the largest final market for Korean exports. Even so, a large and growing percentage of Korean exports to China are for the domestic Chinese market and not for re-export. Moreover, during the past year, economic growth in Korea has been dependent upon exports. Indeed, of the main components of gross domestic product, only exports have shown significant growth. In contrast, consumption growth has been negative. So, if Korea’s largest export market “sneezes,” it is possible that Korea will “catch a cold.”
The main worry thus is that the Chinese economy might finally have reached a point of “overheating” that could be followed by recession. The signs of overheating are, in fact, many. They include a very high rate of investment (almost 45 percent of Chinese gross domestic product) that might not all be productive and soaring prices of real estate in some large cities such as Shanghai, creating a fear that there might be a “property bubble” similar to those in Japan during the late 1980s and in Southeast Asia during the mid-1990s.
Moreover, there is a growing problem of inflation in the rural sector in China, spurred in part by measures taken in September 2003 to redistribute income to farmers. The overheating has not apparently responded to efforts made by the Central Bank of China to “apply the brakes” in September 2003 and March 2004.
Fears of overheating are intermixed with fears of instability within the Chinese banking system, which holds large portfolios of loans to state-owned enterprises that are effectively non-performing. During the past year, in spite of efforts to bolster the capitalization of the four main banks, no one has been convinced that these banks are anything but fragile. Further efforts to “cool” the overheating in China, e.g., by further curtailing bank lending and forcing interest rate rises, could increase the fragility of these very large banks.
Given all of this, does Korea have to worry about a growing risk of “catching a cold”? My best guess is that Korea should worry, but not to the point of becoming a hypochondriac. The good news in this regard is that the Chinese authorities are well aware that overheating is occurring in the Chinese economy. The bad news is that measures taken to date have largely been ineffective to cool the economy down. Korea’s best hope is that further actions will now be taken by the Chinese authorities to create a minor “growth recession” there; that is, to bring the rate of growth down to a sustainable 8 percent a year from the current and unsustainable rate of nearly 10 percent a year.
Even this could create some difficulties for some Koreans. For example, if major infrastructure projects in China were to be slowed down, it might adversely affect Korea’s booming steel exports to China. But it would be better than the alternative, that overheating in China gets out of hand, creating out-of-control inflation and necessitating draconian measures by the government to restore balance there.
The big danger to Korea thus might not be that China “sneezes” but rather that this very important country “catches pneumonia because it failed to sneeze.”
* The writer is a senior fellow at the Institute for International Economics in Washington.
by Edward M. Graham