SK: planning for the eurozone fallout

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South Korean officials are painfully aware that the country’s financial markets could be hit again by sudden capital outflows amid growing concerns that Greece could exit from the eurozone. The concern is that foreign investors could suddenly withdraw money from Asia’s fourth-largest economy if Europe’s debt crisis worsens. Korea’s export-driven economy is particularly vulnerable to external shocks.

Such fear has sharply increased in recent weeks as foreign investors offloaded a net Won3.6tn ($3bn) worth of Korean stocks in their 16-day selling streak, pushing the Kospi composite index 8.7 per cent lower to 1,808.62. The Korean won, which is one of the most volatile currencies in Asia, has also fallen 3.8 per cent against the dollar so far this month, prompting intervention by the government. On Wednesday, it fell 0.8 per cent to Won1,172.9 per dollar, near a five-month low.

Finance minister Bahk Jae-won has cited risks such as Greece and sanctions against Iran as increasing market uncertainty. However, government officials stress that the country has enough foreign reserves to cope with the Greek crisis and will take prompt action if needed.

Indeed, South Korea has strengthened its defences against a potential credit crunch since the country was hit by destabilising capital outflows during the global financial crisis in 2008. The country’s external debt rose to a record high of $510.9bn in the first quarter but the ratio of short-term debt to the country’s foreign exchange reserves fell to 43.1 per cent, the lowest nearly six years. In an effort to curb capital inflows into the country, Seoul has introduced a series of capital control measures in recent years, such as limiting banks’ forex forward positions, imposing a bank levy on foreign-currency debt and reimposing a withholding tax on foreign investors’ earnings from government bonds.

However, the country still faces risks of the recurrence of sudden capital outflows as long as it remains a “small open” economy with heavy dependence on exports. Plus any export slowdown is not good for the country’s economic outlook. Economic growth has slowed to 2.8 per cent in the first quarter from a year earlier, the weakest level in two and a half years. The Organisation for Economic Cooperation and Development forecast the country’s growth to slow to 3.3 per cent this year from 3.6 per cent last year before it recovers to 4 per cent next year.

Chang Jae-chul, economist at Citibank, said in a report: “Expected narrowing of the current-account surplus and a larger proportion of mobile capital will remain as the main vulnerability factors amid recurring risk aversion along with external headwinds”.

However, government officials are preparing contingency measures in case of Greece’s exit from the eurozone and a massive global credit crunch. Kwon Young-sun, economist at Nomura, said Seoul would take whatever steps to defend the local currency in such extreme case, utilising currency swap pacts with China and Japan. The Bank of Korea, which has left interest rates unchanged at 3.25 per cent for the past 11 consecutive months, could cut interest rates to 2.5 per cent in the second half to support the economy and the national assembly could form Won12tn of supplementary budget, he predicted.

“We believe the initial shock from a Greek exit would be hugely negative but the Korean economy would eventually recover strongly, led by exports benefiting from a weaker won,” said Kwon. The country recovered fast from the 2008 global financial crisis on the back of the won’s weakness. A repeat performance may be needed.

Related reading:
South Korea: An economy divided
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South Korean growth slips to 2.8%
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Eurozone fears continue to damp Asia
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