Current Account Imbalances In Korea

2.1 Current account trends

Korea's current account changed dramatically after the 1997–1998 Asian financial crisis. Between 1980 and 1996, the current account had an average deficit amounting to 0.32% of GDP, with a standard deviation of 1.82 (using quarterly data). Between 1999 and 2009, however, the current account shifted to an average surplus amounting to 1.99% of GDP, with a standard deviation of 2.17 (Table 1 [ PDF 13KB | 1 page ]). There was greater volatility in the post-crisis period, particularly if data for 1997 and 1998 are included.

Given such volatility, it is difficult to tell if the recent surplus in the current account will be permanent. Indeed, Korea's current account surplus began narrowing in 1999, when the foreign exchange crisis ended, and continued to do so until 2007. There was even a brief return to a current account deficit in the first three quarters of 2008.

The drastic depreciation in the Korean won and the rapid contraction in domestic demand following the 2008 global financial crisis put the current account back into surplus by the fourth quarter of 2008. Estimates for 2009 suggest a vast surplus amounting to 5.3% of GDP, due to large surpluses in the goods and services accounts. The massive slowdown in exports was outweighed by an even sharper deceleration in imports, as Korean firms and consumers cut back on spending.

Nonetheless, if we look at the 5-year moving average of the current account balance as a percentage of GDP and smooth out the annual volatilities, it would be premature to say that this dramatic widening in the surplus signals a departure from the overall narrowing trend (Figure 3 [ PDF 25.3KB | 1 page ]). It may well be that the 2009 surplus is temporary, and merely repeating trends in the immediate years after the Asian financial crisis.

2.2 Determinants of Korea's current account

Korea's current account seems to be correlated with major economic variables such as exchange rates, national GDP, and world GDP. To determine the exact magnitude of the effects of these variables, we conducted econometric analyses using dynamic ordinary least squares method.

Specifically, we set up the following models for exports and imports. Equation (1) is for exports, where the real effective exchange rate and world GDP are the determinants. Equation (2) is for imports, where the real effective exchange rate and Korea's GDP are the main determinants.

Here, ex is export volumes, im is import volumes, reer is real effective exchange rate, wgdp is world GDP, and gdp is Korea's GDP. All variables are in natural logs and use quarterly data from various sources.¹ Equations (1) and (2) are estimated with p = 2.

The results for Equation (1) are summarized in Table 2 [ PDF 15.6KB | 1 page ]. Column (1) is the specification for Equation (1) with the full sample. The results show that Korea's exports are significantly correlated with exchange rates and world GDP, as predicted by economic theory. However, the coefficient of the exchange rate, or the exchange rate elasticity of exports, is much smaller (-0.16) than that of world GDP (3.44). This means that a one percent depreciation in the real effective exchange rate will increase Korea's exports by 0.16%², whereas a one percent increase in world GDP will increase Korea's exports by 3.44%

Overall, these results may have been influenced by drastic changes in the variables during the 1997–1998 Asian financial crisis and the 2008–2009 global financial crisis. If one considers a stable period, the same econometric model would give a totally different picture. Column (2) in Table 2 shows the results for Equation (1) for the non-crisis period covering 2000Q4–2007Q2. For this sample, the effect of the exchange rate on exports has virtually no significance, while world GDP has a strong effect.³ During this non-crisis period, the Korean won appreciated without reducing the pace of export growth.

Table 3 [ PDF 20.2KB | 1 page ] shows similar results for imports: while the real effective exchange rate and GDP are generally important determinants, the exchange rate elasticity is much smaller than the income elasticity. Column (1) corresponds to Equation (2) with the full sample. The results show that a one percent appreciation in Korea's real effective exchange rate raises imports by 0.59%, while a one percent increase in Korea's GDP raises imports by 1.55%. Moreover, as seen in Column (2), the effect of the exchange rate again becomes insignificant if one considers the non-crisis period.⁴ During the non-crisis period, exchange rate appreciation did not increase domestic demand; the share of private consumption declined continuously, regardless of the direction of the won's value (Figure 4 [ PDF 20.2KB | 1 page ]).

These results suggest that exchange rates may not have a significantly meaningful impact on exports and imports in Korea; however, immense shocks such as financial crises do affect net exports. Moreover, the magnitude of the exchange rate elasticity is smaller compared to variables such as world GDP or Korea's own GDP. These results are consistent with the findings of other research. For example, Choi and Choi (2009) have shown that the effect of exchange rate changes on exports and imports has diminished since 2000. This is partly due to a significant weakening in the exchange rate pass-through effect for export products, as more intermediate goods are outsourced globally. Kim and Kwark (2009) have likewise shown that the effect of exchange rates on exports and investment has weakened significantly since the Asian financial crisis.

2.3 Behind the current account trends: Dollar recycling mechanism through the services account deficit

It remains unclear if Korea's current account imbalance should be regarded as something serious; on average, the imbalance has only amounted to a small percentage of GDP (Table 1), and had in fact been narrowing until the global financial crisis hit in 2008. However, merely focusing on the magnitude of the current account would be missing the structural problems which have caused the imbalance in the first place.

Figure 5 [ PDF 25KB | 1 page ] shows that there has been a clear shift in the composition of the current account balance. Before 1997–1998, the goods and services accounts moved in the same direction. Shortly after the Asian financial crisis, however, the services account started moving in the opposite direction of the goods account. From 1999 to 2009, the accumulated goods account had a surplus of US$283.8 billion, while the services account had a deficit of US$117.3 billion. In other words, 41.34% of the goods account surplus has been offset by the services account deficit.

This can be regarded as a kind of dollar recycling mechanism, and could partly explain why the appreciation in the won did not reach levels where net exports would disappear. This mechanism works as follows: the goods account surplus pushes up the value of the won, inducing Korean firms and households to buy more foreign services; this widens the services account deficit, and keeps the value of the won from appreciating as much. Granger causality tests (Table 4 [ PDF 18.6KB | 1 page ]) confirm that the services account deficit follows the goods account surplus, and not the other way around.

What kind of services brought about the deficit in the services account? Figure 6 [ PDF 18.6KB | 1 page ] shows that travel and other business services account for most of the deficit. Travel includes not just tourism but also the money that goes to Koreans studying overseas. Other business services consist of merchant and other trade-related services; advertising; legal, accounting, and consulting services; and services between related enterprises.

The correlation between the goods account surplus and services account deficit may reflect a basic structural problem in the Korean economy: the weakness of the services sector, such as education and business services. If the services sector had been strong enough, domestic demand as a percentage of GDP would have been larger, and Korea would not have had to rely so much on the external sector. The services account deficit would have been smaller, while the goods account surplus would not have been so large.

This points to another kind of imbalance in the economy: the imbalance between the goods sector and the services sector. This imbalance is reflected not only in the external accounts but also in the internal imbalance in domestic industries, as will be discussed in section 5.

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