A Korean proverb says that “when whales fight, the shrimp’s back is broken.” It’s emblematic of how South Koreans may be feeling about the country’s two most important relationships—with China (their main trading partner) and the United States (guarantor of their national security). Trapped between economic and safety concerns, South Korea finds itself in a difficult spot.  

 

Yet despite increasing geopolitical tensions along the Korean peninsula and recent turmoil in local politics, the South Korean economy is staging a mild, cyclical recovery on the back of improving global growth and domestic economic policies.

The country’s new president is pushing for a paradigm shift for inclusive economic growth through higher minimum wages and social spending to boost consumption while reducing income inequality. We have yet to see whether these policies will bear a lasting effect on the country’s long-term structural problems that are pushing potential growth down.

South Korea remains a tactical play in our portfolio. We expect its yield curve to steepen. We also anticipate its currency (the won) to remain supported by the country’s large current account surplus and its desire to avoid being labeled a “currency manipulator.” Yet the headline risk associated with North Korea could keep the won more volatile.

From Political Turmoil—to Economic Recovery

Just a few months ago, South Korea was embroiled in its biggest political crisis with the impeachment of its then-president on corruption charges—an unprecedented event in the history of this young democracy. But the peaceful and speedy transition of power to a newly elected president in June clearly showed how mature its governing institutions are.

Still, the timing could not have been worse. The geopolitical tensions on the peninsula have increased with North Korea’s almost regular missile tests. South Korea’s response to these increased threats—deploying a U.S.-supplied missile shield—was met by informal economic sanctions from its largest trading partner, China. At the same time, its bilateral trade surplus with the U.S.1 has drawn criticism from the latter. South Korea dreads the prospect of being labeled a “currency manipulator” by the U.S. Treasury, especially since the U.S.-Korean free trade agreement is back on the table.

Nonetheless, with domestic political uncertainty out of the way and continued strong exports, consumer sentiment is improving. Consumption is likely to follow suit, with support from a minimum-wage increase of more than 16%, which will affect a third of the country’s workforce. However, more restrictive housing market policies and higher corporate taxes could curb investment appetite. Yet, on balance, gross domestic product (GDP) growth could rise slightly to 2.9%–3% in 2017 from 2.8% last year.

With core inflation at around 1.8% and a still-negative output gap, we do not see demand-driven inflationary pressures yet. However, if wage increases are implemented fully, they could change this outlook in 2018.

A Closer Look at the Government’s Policy to Boost Growth

Redistributive fiscal policy is a key element of the government’s strategy to stimulate economic growth. The government plans to increase social spending and public employment by increasing taxation on high-income earners and large corporations. This is an important departure from the past, when demand-side policies were geared toward supporting investment, rather than consumption. These redistributive policies could start a virtuous cycle, shifting growth to be led by domestic consumption. The hope is that these policies would also help shrink the large current account surplus, and that less intervention by the government in controlling the exchange rate will help South Korea avoid a “currency manipulator” designation by the U.S. Treasury.

On the supply side, the government’s policies are not as clear for now. It wants to promote the fairness of transactions between chaebols (i.e., large business conglomerates) and small and medium-sized enterprises (SMEs), and it seeks to reduce irregular and unprotected workers’ share of the economy (see below). But will these measures be enough to address the long-term issues that are reducing potential growth? We think it’s a good start, but more needs to be done.

The Structural Issues that Ail South Korea

1. An aging society and inefficient education system

The first and foremost structural challenge facing South Korea’s economy is the rapid aging of its society. The labor force started declining in 2017, mostly because of low fertility rates. The overall population is expected to start declining after 2025, with negative implications for domestic demand. At 1.26 children per woman, South Korea's fertility rate is one of the lowest among countries in the Organization for Economic Cooperation and Development (OECD).

 

And can you blame South Korean women for this? The country’s education system, which provided social mobility after the Korean War, is now one of the least efficient ones, considering how expensive it is. In the OECD, South Korea tops the charts when it comes to the cost of education to households.2 Hence, less is more when it comes to having children.

Add to that the grueling social pressures of being a working mother in South Korea, and you also get a labor-participation rate for women below the OECD average—particularly among women aged 35-44. Considering that women in South Korea earn 36% less than men on average (twice the average wage gap in the OECD), they may feel that it just doesn’t pay off to work.

The International Monetary Fund (IMF) estimates that South Korea’s potential growth rate has fallen from about 4.75% during 2000−2007 to roughly 3.25% – 3.5% by 2011−2012. Absent reforms, this rate is projected to fall further to about 2% by 2025, primarily because of the declining working-age population.

2. A dual labor market and social divisions

South Korea’s second challenge is the dual nature of its labor market, which is divided as its  production sector: Chaebols employ the bulk of regular, unionized workers with benefits and social protection—whereas the SMEs that constitute their supply chain employ mostly irregular workers without benefits or social protection.  Chaebols’ monopsonist power over SMEs leaves little room for them to innovate and grow. The government’s support system for the SMEs is based on firm size and further undermines incentives to grow. The result is a divided labor market, lower productivity growth and increasing social divisions. Within the OECD, South Korea has the greatest share of temporary contract workers, at 22% of the workforce.

 

With seniority still a key determinant of pay, lucky South Koreans who find themselves among the regular workers may receive better compensation but tend to be pushed out at a much earlier age than in other industrialized nations in order to make room for the younger and cheaper ones. This leaves them with insufficient savings to support longer non-working years, and drives many of them to pursue second careers in small mom-and-pop shops in the services sector.

 

The government’s new employment policies push companies to convert irregular employers to regular ones. Along with the higher minimum wages, this policy could backfire for the SMEs, especially those in the services sector. So far, no one wants to talk about reducing employee overprotection and changing the compensation system for regular employment. Such measures, in our view, need to be the next step toward unifying the country’s labor market.

 

South Korea also has one of the lowest social spending rates among the OECD countries. The social contract of low taxation and low social spending might have served the country well when it was enjoying its demographic dividend during its industrialization period, but now it is leaving older-age cohorts behind. OECD data (“Pensions at a Glance,” 2015) shows that 49.5% of South Korean seniors are below the poverty line defined as half the median household income. This statistic should not be lost on a nation that reveres its elderly. The government’s plan to increase social spending is a good starting point, and with recent tax policies it could become sustainable, rather than one-off.

What About the Threat from North Korea?

 

The North Korean threat has been there all along in the so-called “Korea premium,” which is a catch-all term for the added risk on South Korean assets. Saber rattling between North and South Korea regularly makes headlines, causes volatility in South Korean assets, and then dies off, as no one imagines that the status quo could change. But for South Koreans, it’s more personal. Over my two years living in Seoul, I found that the idea of Korean