"Economic Growth Hampered by Politics...Active Fiscal Expansion Needed" [Issue Interview]

Interview with Kwak Noh-sun, President of the Korean Finance Association (Professor, Sogang University Department of Economics)
South Korea Lacks Political Power Ahead of Trump’s Second Term, Politics Hampering Economy
Continued Political Turmoil Delays Timely Economic Policy Response
Active Fiscal Policy Crucial in First Half of This Year... Limitations of Interest Rate Cuts

Gwak Nosen, President of the Korean Finance Association, is being interviewed by Asia Economy in the Economics Department office at Sogang University, Mapo-gu, Seoul. Photo by Park Jaehyun

Since the '12.3 Martial Law' incident, the impeachment political turmoil has prolonged, increasing anxiety surrounding the South Korean economy. As political risks spread, the KOSPI fell below the 2400 mark, and the won-dollar exchange rate rose to the high 1400 won range, levels seen during the financial crisis. Consumer sentiment has also frozen, with year-end and New Year gatherings canceled and events postponed.

If Donald Trump's second administration takes office in the U.S., it will be difficult for South Korea, a country with a trade surplus with the U.S., to avoid tariff hikes. There are many predictions that exports, which have been the backbone of our economy this year, will be shaken, and economic growth will slump to the 1% range. Concerns are emerging that the combination of Trump's policies and the impeachment turmoil could plunge our economy into a slump this year.

Political Interference Hampering Economy, Quick Solutions Needed

Kwack Noh-sun, President of the Korean Finance Association and Professor of Economics at Sogang University, expressed in a New Year's interview with Asia Economy that political uncertainty continues under the acting presidential system, saying, "Since the ultimate decision-maker is the acting president, there are inevitably limitations in decision-making," and "It may delay having a clear direction and responding at the right timing regarding economic policies."

Meeting Professor Kwack in his Sogang University office in Mapo-gu, Seoul, he expressed great regret over the current situation where domestic political power is not being exerted ahead of the Trump administration's second term. As a macroeconomics and finance expert, he said, "Trump's political style is close to a top-down approach, but there is no representative who can network directly with him," and "There is no channel to exert political power during the implementation of the economic policies Trump promised." This means politics is not helping the economy but rather hindering it.

He evaluated that the negative impact of the high exchange rate on our economy has increased compared to the past, as the won-dollar exchange rate remains at a high level around 1470 won. Professor Kwack said, "Our economy is heavily influenced by the global value chain, so the positive effects such as recording a trade surplus due to exchange rate increases have diminished compared to the past," and "Recently, the exchange rate has risen significantly due to political instability, so it is important to send a message that consistent economic policies will be pursued through political leadership."

He emphasized the need for active fiscal spending in the first half of this year to stabilize the economy. "Currently, due to the high exchange rate, it is difficult to stimulate consumption through monetary policy such as interest rate cuts," he said, adding, "If there is a shortage, the budget should be supplemented accordingly, and active fiscal roles such as supplementary budgets in the first half of this year should be discussed."

In the mid to long term, he stressed the need to invest fiscal resources in innovation sectors. Professor Kwack said, "It is not the level of fiscal spending that matters, but where it is spent," and "We should be cautious about spending on welfare expenditures or subsidies that are fixed costs, but fiscal spending should be directed toward improving the environment in new innovation sectors that help economic growth."

He added, "In the U.S., new artificial intelligence (AI) technologies and information and communication technology (IT) ecosystems are being established and gradually growing, but South Korea is not reaching that level. Rather than simply providing money, evaluation and screening procedures are necessary," and "The most important thing is to build an ecosystem where private sector equity investments lead growth rather than government intervention."

Kwack Noh-sun, President of the Korean Finance Association (Professor of Economics at Sogang University), is being interviewed by Asia Economy at his research office in Sogang University, Mapo-gu, Seoul. Photo by Jae-hyun Park

Long-Term Measures Needed to Prevent Decline in Potential Growth Rate

He suggested focusing on policies to prevent the decline of the potential growth rate to avoid our economy falling into a low-growth trap in the future. Professor Kwack said, "There may be expectations that the two consecutive interest rate cuts by the Bank of Korea could somewhat alleviate economic contraction, but more important are long-term policies that can prevent the decline of the potential growth rate," emphasizing, "Policies to improve potential growth rate are absolutely necessary, distinct from short-term fiscal expansion policies."

He also mentioned that selective immigration policies should be considered to prevent population decline from hindering economic development. He said, "Birth rate policies have limitations because even if implemented now, effects will only be seen 20 years later," and "As the economically active population decreases, our economy's dynamism will certainly decline, so selective and minimal foreign immigration should be considered to secure labor supply." As an example, he noted that Europe accepted immigrants, which helped recover birth rates and improve population issues, whereas Japan did not accept immigrants, resulting in its current population structure.

Regarding household debt, a risk factor for our economy, he said it is more important to prevent qualitative deterioration than to impose quantitative regulations. He said, "If the Debt Service Ratio (DSR) is steadily applied, housing demand will not be as high as before, naturally stabilizing household debt," adding, "If DSR is uniformly applied, household debt problems will not be significant, so more focus should be on project financing (PF) loans and small business issues."

Below is a Q&A with Professor Kwack.

- Political uncertainty has not been resolved since the declaration of martial law. What impact does political uncertainty have on the economy?

▲ With Choi Sang-mok, Deputy Prime Minister and Minister of Strategy and Finance, also acting as the president and prime minister, it has become difficult to maintain consistency in economic decision-making. Since the ultimate decision-maker is an interim president, there are inevitably limitations in decision-making. There is a possibility of delays in South Korea's external economic positions or stances. It may be late to respond with a clear direction and at the right timing.

- The Trump administration's second term is about to begin amid unresolved domestic political issues.

▲ Since there is no South Korean representative who can communicate with the new economic officials of the Trump administration, it is difficult to respond proactively and appropriately. Trump's political style is closer to a top-down approach rather than a bottom-up approach that involves contact with working-level staff. This means a representative who can network directly with Trump is important. However, South Korea currently lacks such a representative, reducing avenues for assistance. While some economic policies Trump promised will apply to all countries, others will not be uniformly applied. Political power should be exercised in such cases, but there is no channel to attempt this. Politics is not helping but rather hindering the economy.

- The exchange rate has recently remained at a high level around 1470 won.

▲ In the past, exchange rate increases contributed to South Korea's trade surplus, but now this effect has diminished. This is because the economy is much more influenced by the global value chain than before. Under the global value chain, intermediate goods must be imported during the manufacturing of finished products, so when the exchange rate rises, margins may shrink compared to the past, limiting profits. On the other hand, import prices rise, raising inflation concerns. The positive effects of exchange rate increases have decreased, while negative effects remain.

Recently, the strong dollar has played a role, but political instability has also significantly driven up the exchange rate. Currently, foreign investors, especially institutional investors, are responding conservatively to the Korean market. If political uncertainty shows signs of resolution, they may reconsider, but until then, they will remain cautious. Since the demand base has weakened considerably, political leadership is most needed now. It is important to send a message that economic policies will be pursued consistently. Although efforts are being made to stabilize the market through F4 meetings, from the perspective of foreign investors, South Korea's national prestige has regressed 40 years. It may appear like Southeast Asian countries prone to coups.

- How much damage could Trump's second-term policies inflict on our economy in the current situation?

▲ The situation in the U.S. is the same, but the problem lies with South Korea. Even if not negotiations, having political connections would be much more effective. According to the Federal Open Market Committee (FOMC) regular meeting in December, the U.S. revised its dot plot to show only about two interest rate cuts this year. Since then, U.S. long-term bond yields have risen due to two factors: first, the prediction that U.S. interest rates will fall less than expected, and second, the realization of U.S. fiscal deficit concerns leading to a strong dollar. While the U.S. needs a weak dollar to reduce trade deficits, Trump's policies tend toward a strong dollar. Although there are discrepancies, most predict a strong dollar. Consequently, the won's value against the dollar has fallen. South Korea's currency has fluctuated more than major countries due to the impeachment turmoil.

- Domestic demand appears to be in prolonged stagnation.

▲ Consumption seems to have sharply declined due to the Jeju Air passenger plane accident at Muan International Airport. Data shows many year-end parties have been scaled down. The national mourning period is also expected to affect consumption. This incident may shrink the travel industry, especially affecting low-cost carriers. After the 2000s U.S. terror attacks, the airline industry experienced a recession. In the short term, South Korea is expected to travel less than before, with reduced dining out and canceled year-end parties, leading to decreased consumption.

- Should fiscal spending be actively expanded to prevent economic recession?

▲ It is necessary to proactively implement fiscal policies to stabilize the economy. Due to the high exchange rate, lowering interest rates is difficult. While the Bank of Korea's Monetary Policy Committee may cut rates in January, that alone cannot stimulate consumption. If there is a shortage, the budget should be supplemented, and supplementary budgets should be discussed. Active fiscal roles in the first half of this year will be important.

- How should the direction of fiscal policy be set in the mid to long term?

▲ While agreeing that fiscal expansion is needed to stimulate the economy, attention must be paid to chronic fiscal deficits. It is not the level but where the money is spent that matters. If spent where needed and helpful to economic growth, it is acceptable, but more caution is needed regarding fixed welfare expenditures. Pension fund deficits will increase social welfare spending in the future, raising national debt even without additional spending. Currently, social security accounts are in surplus, meaning the national pension is in surplus. However, excluding social security, fiscal deficits are large. If social security turns to deficit, it will be a significant future burden. Fiscal spending decisions must carefully consider the future and focus on areas that improve the environment for new innovation sectors. Subsidies tend to become fixed costs with only temporary effects.

- What do you mean by new innovation sectors?

▲ Software and IT sectors. New AI technologies and IT ecosystems are gradually growing, but South Korea is not at the level of the U.S. There are changes like startups, so supporting these areas is good. However, simply providing money is not enough; continuous evaluation and screening procedures are necessary. Projects that do not work should be terminated. The U.S. has established such an ecosystem. The most important thing is to build it through private equity investments rather than government intervention. Currently, there is heavy reliance on government funding. This may waste fiscal resources without effectively helping. I hope a financial ecosystem is built where private equity investments occur autonomously.

- There are also opinions that monetary policy such as interest rate cuts has limited capacity to stimulate the economy.

▲ Interest rate cuts have positive aspects. Reduced interest burdens can increase consumption capacity, and lower interest rates can help investment. It is not yet time to confirm whether monetary policy can stimulate the economy. More important is the need for long-term policies to prevent the decline of potential growth rate. This should be distinguished from short-term expansionary fiscal policies. Long-term policies to improve potential growth rate are absolutely necessary, not just short-term economic stimulus.

- There are concerns that domestic demand will stagnate long-term due to low birth rates and aging population.

▲ It seems South Korea's new growth engines have disappeared over time. This has become entrenched, leading to domestic demand stagnation. The biggest concern is the economy losing vitality. Inflation is low at around 1%. However, prices have already risen significantly, so consumers may be reducing spending compared to 2-3 years ago. Consequently, small business owners and self-employed people are struggling, and many sectors are in recession. Overall, some sectors are doing well, but the gap between thriving and struggling sectors has widened.

- How can population decline hindering economic development be prevented?

▲ Selective and minimal foreign immigration should be considered to secure labor supply. One cause of difficulties in the service sector is rising labor costs. Having replacement labor can help control price increases. Immigration should be considered from this perspective. Low birth rate policies take 20 years to show effects, so they alone are insufficient. Effective birth policies are needed, with housing being the biggest issue. Providing residential environments for young generations would be beneficial.

Low birth rates and aging will certainly reduce our economy's dynamism. It may follow a path similar to Japan. Europe experienced this long ago but recovered birth rates. The difference lies in immigration policies. Europe accepted many immigrants, while Japan did not. Despite conflicts, Europe improved population issues by recovering birth rates. Japan did not, resulting in its current population structure. South Korea may face a similar fate as Japan.

- Is there a risk that the interest rate cut trend could cause household debt to surge?

▲ It is more important to prevent qualitative deterioration than to impose quantitative regulations on household debt. The core of deterioration is a housing price crash or declining household creditworthiness, but since the loan-to-value ratio (LTV) is low at 40-50%, concerns about housing price crashes are less than in the U.S. If the Debt Service Ratio (DSR) is steadily applied, domestic demand will not rise as before. This will curb housing demand and naturally stabilize household debt. Focus should be on project financing (PF) loans and small business issues. South Korea's household debt-to-GDP ratio is high compared to other countries due to the special characteristic of expensive housing relative to income. Considering net assets, there is no problem, but looking only at debt, there is an issue. Instead of obsessing over quantitative indicators, qualitative indicators should be monitored to assess the risk of household debt deterioration.