4 Economic Challenges South Korea Faces in 2016

South Korea has exhibited impressive economic expansion over the past 50 years, becoming one of the wealthiest nations in the world. The outlook continues to be mostly positive for the Asian nation, with GDP growth expected to accelerate to 3% amid improving domestic consumption. Nonetheless, 2016 presents some challenges for South Korea, mainly in the form of threats to export competition.

South Korea's economy is heavily dependent on international trade, with exports totaling close to 50% of GDP in 2014. Exchange rates with currencies in nearby countries are therefore important to Korea's outlook. Because China and Japan are two of South Korea's closest trading partners, depreciation of the yuan and yen could have a deflationary impact, as imported goods and services will become cheaper and exports more expensive in end markets. This places domestic producers at a clear disadvantage to competitors in neighboring countries.

China and Japan are also major competitors of Korea in global markets. Inflation in these currencies could erode South Korea's price competitiveness, as the same goods are cheaper if sourced from China or Japan, all other factors being equal. South Korea has faced this precise challenge since 2012, when Japan took measures to depreciate certain electronics and metals prices. Exports have been absolutely central to South Korea's booming economic development from the 1960s to 2015, and any serious threats to the country's competitive position could have serious ramifications for growth potential.

South Korea's economy is massively exposed to China, with the Chinese being the largest importer of South Korean goods. Aggregate demand in China is therefore an important driver of economic growth in South Korea, and China's well-publicized GDP growth deceleration appears to be causing some stagnation in Korea's export growth. Many Chinese companies are struggling to maintain their levels of operating profits, and an increasing number of Chinese bonds are also reaching maturity, which could create liquidity issues. A narrowing trade surplus could create a significant drag on the Korean economy and destabilize exchange rates. Other than using monetary policy to minimize any exchange rate fluctuations, there is little South Korea can do to stoke demand in China for imports.

The U.S. Federal Reserve reversed its long-term expansionary monetary policy, raising interest rates 0.25% in December 2015. Most economists expect the United States to raise rates further in 2016, which can create issues for other global economies that are still engaged in expansionary monetary policy. Capital will flow disproportionately to the United States as investors seek higher returns on debt. While short-term factors make South Korea more likely to continue cutting rates, the country's finance ministers have to monitor capital flows relative to the United States to ensure Korean companies can still comfortably access global capital markets. Growth in exports to the United States will help South Korea benefit from the Fed's rate hike, reducing the necessity to chase rising rates abroad.

Among South Korea's most prominent exported goods categories are semiconductors and other electronic equipment, automobiles and refined petroleum products. All of these categories have faced significant pricing pressure globally, creating a number of issues for industry in South Korea. Pricing pressure decreases the total revenue available to these industries at a given production volume. This also squeezes profits at productive firms, which leads to consolidation and cost cutting. Typically, industry consolidation and cost-efficiency campaigns lead to job losses and downward pressure on wages. As these industries mature, small- and medium-sized enterprises operate at an increasing disadvantage to large incumbents, which can also stifle job creation.

Maturing economies with rising wages often struggle to maintain export competitiveness in comparison to countries with cheaper labor, especially if the mature economy previously relied on relatively labor-intensive manufacturing. In many cases, service sector employment becomes more prominent in maturing economies. Productivity growth in the service sector is frequently slower than in industrial sectors, often because service providers are disproportionately smaller businesses and are less likely to benefit from global value chains, thus limiting wage growth.