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Bracing for the worst

Published: 08 Aug. 2011, 19:10

The United States has endured a downgrade of its sterling credit rating for the first time in history, hammering the long-held faith in U.S. Treasuries as the world’s safest investment. The S&P downgrade comes after Washington’s excruciating political process of addressing its colossal budget deficit. It was a stern warning that the U.S. economy is headed downhill without radical efforts to reduce the deficit. President Barack Obama’s chances for a second term have gotten dimmer with many Americans feeling humiliated by the downgrade.

The global economy must now brace for another whirlwind. We must examine our fences for external shockwaves. The government assures us that our economic fundamentals remain resilient to outside risks. Consumer prices remain high, but the economy has been steadily growing. The current account has been in the black for the last 17 months. Foreign exchange reserves reached $311 billion as of the end of July. Yet the market views things differently. The costs of buying protection against our sovereign debt are rising fast, and investors are jittery about Korean economic prospects.

The large corporate sector is relatively safe, but government and household debts are troubling. Korea recovered comparatively quickly from the last economic crisis thanks to sound budgets and world’s top household savings rates. But the situation is different now. The government spent recklessly for the last decade, and household savings rates are now among the lowest in the OECD. Debt against disposable income is at 146 percent, worse than U.S. households before the subprime mortgage crisis.

Such structural problems cannot be resolved overnight. Authorities must secure against a foreign liquidity crisis. Korea has piled up foreign exchange reserves, but they remain relatively low at 36 percent against the gross domestic product. Foreign capital is mostly from Europe and takes up 31 percent in the equity market. If these capitals suddenly pull out, Korea’s market and economy could be in deep jeopardy.

We have experienced blows many times. Foreign investors quickly lose faith in local markets and Korea’s affordability in debt obligations when the current-account balance sees red. Financial institutions suddenly lose credibility, leading to a financial crisis. Authorities must examine current-account flows and foreign exchange reserves. They also should keep watch whether financial institutions are keeping safe debt-to-saving levels and meeting debt obligations.