Korea well-placed for recovery

With the steep downturn in the economy expected to continue through the first half of 2009, Korea’s government will have a critical role to play in efforts to repair the country’s ailing economy. It will have to make up for the absence of support which would normally be provided by exports, Korea’s main driver of growth, private investment and consumption.

Last year the government announced a 51.3trn won fiscal expenditure package to be rolled out between 2009 and 2012, in a bid to boost the economy. The plan increased the 2009 budget by 16trn won and included a 35.3trn won package to cut income tax and corporate tax.

There were high expectations for these efforts, and also for the impact of measures set to be introduced by the Obama Government in the US. However, it always takes time for the benefits of government-led projects to materialise, given they are typically designed with a view to the long-term.

With the outlook for the global economy still resolutely gloomy, a Korean recession in 2009 is now virtually unavoidable due to collapsing global demand, Korea’s high debt levels, and high dependence on external demand as well as financing.  It is too early to mention an economic recovery right now.

On a lighter note, the external environment surrounding the Korean economy has stabilised somewhat since last October and the global credit crunch seems to have passed its worst phase. Even with the negative forecasts for the economy and the decidedly downbeat picture in the stock market, we believe any material weaknesses in the stock market are likely to be a good investment opportunity in the long term. There is a disagreement on the timing of the recovery, but, when the global economic situation improves, the Korean market is in a position to be one of the first to recover.

The pullback of the domestic equity market can be a good buying opportunity for long-term investors. The National Pension Fund, the nation’s biggest investor with 225trn won in assets, has bought the domestic market aggressively for the last few years. Its investment holding in domestic stocks has grown from 2.96trn won in 2000 to 27.6trn won as of October last year. Among its investments last year, domestic stocks accounted for 12% of its total assets and it plans to increase the ratio to 17% this year.

The pension fund will consistently support the market when it needs to. Its purchase of Korean stocks last year helped trim the benchmark KOSPI index’s declines after overseas investors sold shares worth a net 33.8trn won. It was among the net buyers of 9.3trn won in KOSPI index shares in 2008 and it will purchase an additional 17trn won this year according to the plan.

In the long run, the implementation of Korea’s new retirement system, which was introduced in 2005, will have a positive impact on the domestic stock market. It is still in the early stages of adoption and will continue to be gradually implemented until 2010. Its potential market is over 150trn won (as of last September). So far only 4.6trn won is in the retirement pension fund, of which the equity portion is only 0.5%.

The Korean government has taken further steps to revive the economy through the recent appointment of financial experts to its economic team. Four new ministerial officials have been nominated to the Strategy and Finance Ministry, the Financial Service Commission, the Ministry of Unification and the Prime Minister’s Office. In a step to gain market confidence, the government also nominated former top financial regulator, Yoon Jeung-Hyun as the new finance minister early this year to replace the widely discredited Kang Man-Soo.

Other measures, such as guarantees, recapitalisation funds for banks, and the completion of corporate restructuring, have reduced the likelihood of a vicious cycle between the economy and the financial sector. Yet uncertainties still linger as the economy is deteriorating at a faster pace than expected.

This decline should prompt policymakers to be more aggressive about stimulating economic growth. Possible measures include cutting the base rate further from its current 2% (cut from 5.25% last August), direct liquidity support for the corporate sector and additional budget allocation.

2008 was a particularly difficult year in which the won depreciated by 25.68% against the US dollar, CPI climbed to 5.6%, oil prices peaked at $140 per barrel, and Korea’s foreign reserve dropped to around US$200bn. The KOSPI index had a roller-coaster year, falling to 938 in October; its lowest level since 2004.

November was a month of records; manufacturing output fell by a staggering 14.8% year-on-year, the largest fall on record, business sentiment nosedived to its lowest level ever and the factory utilisation ratio fell to 68%, its lowest point since 1998.

Net sell-offs by foreign investors amounted to 38trn won in 2008. As a result, foreign ownership of the market sank to 28% by the end of the year, the lowest level since 2004. However, foreign investors did return to buy up Korean shares in December and continued to do so in January. They made purchases worth 824bn won in December and 651bn won in January. Considering that they sold more than 38trn won last year, the purchases made during these two months is quite positive news. However, it is too early to say how long this will continue in the future.

Exports maintained resilient growth through most of 2008 thanks to the weaker won, diversified export destinations and products, and exports to oil-rich countries. However, growth was negative in November and December and is unlikely to recover anytime soon, considering the global economic situation.

An upside to the savage competition underway in the export sector is that the competitiveness of big Korean companies will be comparatively strengthened. For instance, Qimonda, a German manufacturer of DRAM memory chips, filed for bankruptcy recently. Its DRAM market share was 10% at the end of Q3 08 and it has plunged since then. Korean DRAM makers are expected to reap the benefits as they produce graphics DRAM chips; an area Qimonda was strong in.

The KOSPI has recovered since last October, reaching 1220 in early February. We could see some fluctuations after this short-term rally, but, investors also need to pay attention to the decreasing interest rate and undershot Korean Won right now. Even though the short term outlook for the Korean stock market is not good, there are some structurally positive factors in the long run, such as the retirement pension system adoption, an increasing equity portion of The National Pension Fund, and potentially, the need for an individual private pension system.

We don’t expect fast recovery of the market, however; we believe that long term investors will find good investment opportunities some time later this year.