Analysis - South Korea needs to step on economic gas pedal

An office worker goes up the stairs at an underground passageway in central Seoul September 7, 2011.

SEOUL (Reuters) - South Korea cannot afford to keep its economic policy on auto pilot and will need more than just a weak won to avert a possible recession as exports slide and domestic demand crumbles.

While the economy grew in the fourth quarter thanks to a huge build in inventories, which hit a three-year high as a proportion of shipments, exports have dropped sharply and indebted consumers are focused on paying off their loans rather then spending.

The Bank of Korea, which held interest rates steady for the eighth successive month on Thursday, lost the fight against inflation in 2011 and has little room to support Asia's fourth-largest economy.

That leaves an unpopular and divided government, in the last year of its mandate ahead of parliamentary and presidential polls this year, as the only source of much-needed stimulus.

Signs are that it, too, is fixated on inflation, with President Lee Myung-bak recently reiterating that the battle against rising prices take precedence over growth.

"Korea has consistently missed the right time in policy implementation, and (policymakers) are now talking about inflation when they should be worried about growth," said Young Sun Kwon, economist at Nomura International in Hong Kong.

MORE SPENDING NEEDED?

When Lee took office in 2009, he was credited with helping Korea become the first major industrial economy to emerge from the 2008 financial crisis. He implemented a huge spending package, coupled with rapid interest rate cuts from the Bank of Korea that saw the benchmark drop to 2.00 percent by February 2009 from the cycle peak of 5.25 percent.

It has since raised rates to 3.25 percent in five 25 basis point moves, yet inflation climbed to more than 4 percent, the top of its target range, during much of 2011. Economists argue the central bank was too timid to anchor inflation expectations.

Although the government has front-loaded 60 percent of its budget spending to the first half of the year, Nomura's Kwon says that to achieve even 3 percent growth this year, it will need to pump in an extra 12 trillion won ($10.71 billion), equivalent to 1 percent of annual gross domestic product (GDP).

The government's official forecast is for 3.7 percent growth in 2012 and it has repeatedly said there are no plans for an extra budget, something that would be unlikely ahead of elections given the wrangling over existing spending plans that passed at the last moment in parliament.

"Domestic demand has been lower overall and growth has been stifled due to a decrease in exports. However, more jobs have been created," Bank of Korea Governor Kim Choong-soo told a news conference after the rate decision on Thursday.

"Downside risks to South Korea's growth will remain for now due to external factors, but the economy will heal in the long term," he said, adding that he did not expect a trade deficit for the first quarter of this year.

INVENTORIES PILING UP, EXPORTS FALLING OFF CLIFF

South Korea last saw a quarterly economic contraction three years ago at the peak of the 2008-2009 financial meltdown, but it only barely managed to avert one in the final quarter of 2011, thanks to a surprise inventories build-up that helped it record 0.4 percent growth in the period.

The ratio of inventories to shipments hit a three-year high of 117 percent in December, according to official data, up from a trough of 90 percent in January last year. Unless demand picks up, those accumulated inventories will weigh on output.

Annual factory output growth slid to a two-year low of 2.8 percent in December, falling for the third consecutive month. On a month-on-month basis it dropped 0.9 percent.

"Inventories and exports have been the real drivers of growth over the past 12 months, so if they both switch off then growth can really slow down from here," said Jonathan Cavenagh, a foreign exchange strategist for Westpac in Singapore.

Exports in January posted a shock 6.6 percent decline from a year earlier as deliveries of ships and electronics exports plunged and demand from crisis-stricken Europe collapsed.

New ship orders during 2008 plummeted 43 percent as the global credit crunch took hold and by a further 75 percent in 2009. Those cutbacks are now showing up in export numbers because it takes three to four years to build a ship.

Electronics and ships account for 40 percent of South Korea's exports. Even though firms such as Samsung Electronics reported bumper earnings thanks to sales of new smartphones, the rest of the sector is hurting.

Exports of information and communications products dived 12.8 percent in January from a year earlier, the worst since May 2009.

"The electronics sector was hit hard except for the smartphone sector -- semiconductors, PCs and LCDs are having a tough year. These are discretionary items, and when economies are not doing well, you can't see this kind of consumption coming back," said Kevin Lai, economist at Daiwa Capital Markets in Hong Kong.

CONSUMERS REPAYING DEBTS, GOVERNMENT UNDER PRESSURE

While exports have always been key to Korea Inc's success, private consumption still accounts for half of GDP and it shrank in the final quarter of 2011 for the first time in nearly three years.

Official data shows households in the bottom two income brackets spent 22 percent of their disposable income paying back loans in 2011, up from 14 percent in 2010, as their debt grew to 230 percent of income in 2011 from 181 percent in 2010.

Overall, South Korean household debt levels amount to nearly 160 percent of their disposable income, among the heaviest in the world and higher than the level seen in the United States before its 2008 financial crisis.

At the same time as consumers are paying back loans, there is a growing threat to big business from a more strident left-wing opposition that wants to regulate it more tightly and to spend 33 trillion won on welfare changes, to be funded from unspecified changes to taxes.

With parliamentary and presidential elections being held in the same year for the first time in 20 years, the political debate has become bruising, forcing the ruling conservatives to change their name and embrace more welfare spending.

This could add another twist to any downward spiral in South Korea as businesses are likely to hold off investment decisions while they ponder the outcome of the April parliamentary polls and the more important presidential polls in December.

"What the companies hate most is uncertainty, and now the situation is going in that way," said Nomura's Kwon.

(Editing by David Chance)