Currency Wars, Gangnam-Style
(Corrects amount of South Korean exports in description of second chart.)
The U.S. Treasury on Friday issued a warning to Japanese policymakers "to refrain from competitive devaluation and targeting its exchange rate for competitive purposes." The warning was prompted by the Bank of Japan's commitment to a new inflation target and a much larger balance sheet. My colleague Caroline Baum has already noted the strangeness of the U.S. statement, given that the Japanese government is merely doing what U.S. academics have been recommending for more than 15 years.
Talk is cheap, however. The reaction in South Korea may prove far more consequential. Early today, Bloomberg News reported that the government in Seoul is planning to spend trillions of won (about 2 percent of gross domestic product) to create jobs and support exporters. A fiscal booster shot makes sense, even if the plan's specifics are imperfect. The government has little debt, Korean consumers are overstretched, the Chinese economy is slowing, and the cheapening yen threatens the profits of industrial giants like Samsung, Hyundai and LG. Today's announcement may not be the last.
Korea weathered the financial crisis relatively well compared with other rich countries. Korean real gross domestic product has grown at an annualized average rate of 2.4 percent since the summer of 2008, which includes the economic crisis. For comparison, the U.S. economy has only grown at an average annualized rate of 0.5 percent since its pre-crisis peak (the end of 2007), while Japan and the euro area have yet to surpass their previous highs from five years ago. Korea's outperformance can be partly explained by the remarkable devaluation of the won against the yen since the crisis began building in the summer of 2007.
For a variety of reasons, the won, which had previously been worth about 0.13 yen, fell to about 0.07 yen -- a decline of more than 45 percent. Korean and Japanese firms compete head-to-head in many third markets selling cars, consumer electronics, and advanced manufacturing tools, among other things. The dramatic change in their relative terms of trade was a boon to Korean exporters, at the expense of their Japanese rivals.
Despite the overall slowdown in global trade since the downturn, Korea's nominal export earnings soared by about 90 percent from the summer of 2007 through the middle of 2011. Exports accounted for about 40 percent of Korea's economy in the 2003 to 2007 period -- a share that has since increased to more than 50 percent. By contrast, Japanese nominal export earnings are still about 25 percent below their 2007 levels. Exports have shrunk as a share of the Japanese economy to about 15 percent, from about 18 percent in 2007.
Export earnings have been stagnant since the middle of 2011, however, thanks in part to the ongoing depression in the euro area and the slowdown in China. The recent cheapening of the Japanese yen is therefore occurring at an inopportune time for South Korea. Korea's total economy only grew by about 2 percent in 2012, compared to 3.7 percent in 2011. Korean households are highly indebted, with personal debt worth about 160 percent of disposable income. For perspective, household debt is currently worth about 125 percent of disposable income in the U.S. The surge in exports almost certainly helped the Korean household sector avoid retrenching to the extent seen in other highly indebted countries. It's hard to see how Korean domestic demand could offset the coming hit to exports without an assist from the fiscal authorities.
Fortunately, the government in Seoul has a lot of room for expansion. Right now, public debt is only worth about 35 percent of national income. That gives Korea plenty of room for fiscal stimulus. Done right, the government could help the private sector adjust to an environment in which exports play a less important role.
It's also possible that the Bank of Korea may start intervening in the currency markets to preserve the won's competitiveness. We shouldn't be surprised if Japan's biggest commercial rival fights back against the reflationary policies emanating from Tokyo.
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