Geopolitics weighs heavily on Korea's economy

While events in the Middle East are leading to higher geopolitical risk in many countries, much greater risk is being cultivated, by the same US policies, in Korea. Geopolitical risk is being amplified by increasing domestic political risk.

These risks, which are almost completely disregarded by investors globally, have weakened private consumption and investment, contributing to slowing economic growth in Korea this year. Geopolitical and political risks are expected to remain high over the next 12 months, perpetuating economic weakness. The Korean won will become vulnerable to depreciation as numerous events could trigger sudden and substantial domestic and foreign capital flight.

Unilateralism has increasingly characterized the Bush administration's foreign policy. On diverse issues ranging from trade to global warming, the US has eschewed multilateralism in favor of pursuing its own agenda. Unilateralism was strengthened by military action in, and the subsequent occupation of Iraq, which have circumvented the United Nations.

Unilateralism is also integral to the Bush administration's 'doctrine of prior action' most notably applied within the narrow confines of the 'road map' to peace between Israelis and Palestinians. The 'doctrine of prior action' has also become an enormous obstacle to resolving the intensifying conflict between the US and North Korea.

Insisting that North Korea abandon its nuclear weapons program prior to receiving any security assurances eliminates diplomacy, forestalling resolution of the conflict. The longer it takes to resolve the conflict with North Korea the greater the probability that the North will demonstrate its nuclear capability.

Strong governance in South Korea could help to ameliorate this unstable geopolitical environment but the political environment has also become unstable. President Roh Moo Hyun has repeatedly questioned his own ability to lead the country amid rapidly declining public and parliamentary support. Economic weakness, corruption scandals, and indecisiveness in foreign and social policies have all undermined support for President Roh. Governance is being further weakened by electoral politics in advance of next April's general elections and social unrest.

Lacking parliamentary support and fighting for his political life, President Roh has become unable to advance any policy that would enhance security on the Korean peninsula. Geopolitical, political and social instability could intensify in 2004. It is unlikely that any party will gain a parliamentary majority in next April's elections.

It is even less likely that President Roh's Uri party will significantly improve its weak parliamentary position. Increasing opposition pressure to depose the Roh government will characterize the political environment during the second half of next year. Weak governance will continue to feed both geopolitical and social instability.

Geopolitical, political and social instability have been the primary factors that have contained economic growth in Korea this year. This instability has weakened private consumption despite strong real wage growth and low unemployment. After expanding by 4.3 percent, year-on-year in the fourth quarter of 2002, private consumption growth slowed to 0.7 percent in the first quarter of 2003.

In the second quarter of this year, private consumption growth contracted by 2.2 percent year-on-year. Private consumption has declined in concert with real wage growth that is expected to exceed 10 percent this year and unemployment of only 3.5 percent. Falling private consumption has weakened private investment.

After growing by five percent in 2002, gross fixed capital formation growth slowed to about two percent in the first half of this year. Investment in equipment and machinery has been nearly flat. Persistent geopolitical, political and social instability next year implies, at best, continued weak economic growth.

Instability heightens investment risk. This risk is further compounded by the potential for substantial domestic and foreign capital flight.

Korea's foreign exchange reserves are expected to reach about $140 billion at the end of this year. However, reserves have become increasingly offset by growing net foreign liabilities of Korean corporations and banks which stand around $65 billion. Hidden foreign liabilities of corporations probably add another $20 billion to net foreign liabilities, pushing the total toward $85 billion. Most of these liabilities are unhedged.

Similarly, only a small amount of the accumulated foreign portfolio investment in Korea, which approaches $30 billion, is hedged. Unexpected geopolitical, political, social or economic events could trigger capital flight. The risk that such an event occurs is increasing.