Reviving faltering private consumption

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Reviving faltering private consumption

Domestic consumption has been in a funk since the 1997 financial crisis, weighing down Korea’s economy. The decline was steady after 1997 but has steepened in the wake of the 2008 global financial crisis. Average actual growth in 2009-11 was 2.1 percent, lower than the trend rate of 2.8 percent. Private consumption in the fourth quarter of 2011 fell by 0.4 percent, its first drop in 11 quarters.

Contraction in private consumption undermines the economy’s growth potential and weakens the buffer role of domestic spending against external shocks to Korea’s export-dependent economy. Private consumption contributed an annual average of 5 percentage points to the GDP growth rate from 1971 to 1990, but fell to 1.5 percentage points from 2009 to 2011.

The main culprits behind the weakness in consumption are climbing inflation and interest on household debt. Inflation reduced real private consumption by an estimated 4.8 trillion won ($4.26 billion) between January and September of 2011. Higher interest costs linked to surging household debt and an increase in bank lending rates cut consumer spending by 1.6 trillion won during the same period.

Meanwhile, the job market has not helped put extra money in wallets. Although more jobs are being added, the quality has not improved much. This has constrained overall income growth. Finally, volatility and uncertainty in the financial markets due to the fallout from the European debt crisis is damaging consumer confidence.

The negative impact of surging household debt on consumption will continue for a considerable time as higher lending rates increase the burden. Moreover, the government, concerned about a further rise in non-performing loans on bank balance sheets, is set to further tighten lending to ensure a soft landing from household debt. Without access to credit, households will be under more pressure to rein in spending.

Deleveraging pressures aside, the main cause for the consumption contraction is consumer inflation. Although the inflation rate should gradually ease, that doesn’t mean the low inflation environment of the mid-2000s will reoccur. Price spikes from international commodities will be a constant due to demand from emerging market economies. Also, because the absolute level of inflation is already high, any slowdown in consumer prices will have a limited effect in boosting households’ spending capacity.

The prevailing conditions make income the pivotal factor in individuals’ decision to spend. Rising income can help overcome the constraining impact of inflation and debt. However, going forward, external and internal factors are not favorable. The global economy faces prolonged slow growth, which will suppress hiring and investment in Korea’s export-led economy. The nation’s rapidly aging population makes it difficult to expect meaningful increases in wages.

In 2010, the average monthly wage of workers aged 60 and older was 1.55 million won, sharply lower than the average of 2.02 million won of all wage earners. Meanwhile, the proportion of people aged 50 and older among the economically active population is expected to increase to 40.7 percent by 2020 from 31.8 percent in 2010.

If consumption recovers fast enough to return to its long-term growth trend, the potential GDP growth rate will drop an estimated 0.2 percentage points by 2020 from 2011. If consumption continues to shrink, potential GDP growth rate would be expected to drop 0.6 percentage points by 2020.

To raise the spending capacity, the government will have to steadily execute price stabilization measures already in place and also take pre-emptive measures against factors that induce structural uncertainties in consumer prices such as housing and education costs.

The government should expand measures for a soft landing from household debt. Service industry productivity should be expanded for quality and quantity job creation.

by Lee Eun-mi

* The writer is a research fellow at the economic policy department at the Samsung Economic Research Institute. For more SERI reports, please visit www.seriworld.org.

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