For South Korea, the colossus across the Yellow Sea provides both opportunity and great uncertainty. China’s proximity coupled with its growth has provided a massive market for ROK goods; China has long-since been South Korea’s top trade partner, besting the United States by wider margins each year. There is also great potential for deepening of economic ties, especially in financial markets.
Yet Koreans remain apprehensive about embracing the pull, given the increasingly important relationship and, indeed, dependence on a partner that most believe does not consider their country’s interest, supports the North Korean regime, and engages in less-than-benign territorial disputes with neighboring countries. There is also a strong working relationship with the United States to consider: while President Park, like previous administrations, has attempted to pursue bilateral relations with the two countries “cooperatively but independently” in principle, China’s increasing importance to Korea may prove this strategy untenable.
In the first installment of a two-part post, we seek to quantify South Korea’s expanding economic relationship with China in terms of bilateral trade and financial integration; we will see, with a few caveats, that China is an increasingly vital partner for the ROK with a great deal of room to grow. Tomorrow, we attempt to shed light on South Korea’s possible trade-off between economic growth and closer bilateral ties with China on the one hand, and potential domestic malcontent and loss of strategic independence on the other.
The Trade Channel
Bilateral merchandise trade provides the most visible impact of China’s growth on South Korea. Since the early 2000s, China has been South Korea’s top trade partner in terms of total goods value and share, taking a commanding lead ahead over other major countries (Exhibit 1). In 2013, South Korea’s total trade with China – $83 billion in imports and $146 billion in exports – was more than trade with the United States and Japan combined for the fifth year in a row.
Another way to think about this is the relative importance China trade has on South Korea’s overall economy. Even compared to other countries, international trade is an integral part of the ROK’s economic vitality. Total merchandise trade as a percent of GDP has risen from 52% in 2000 to 95% in 2012; out of 202 counties that the World Bank lists, Korea is in the top 83th percentile in terms of this rough measure of trade penetration. Taken at face value, the volume of trade with China alone would be equivalent to one-fifth of South Korea’s total GDP in 2012.
But before we conclude that China has pulled far ahead of the pack, two caveats. First, while only a fraction of the value of merchandise trade, South Korea’s trade in services look somewhat different; as of 2011, the Unites States still held a commanding share (22%) of the ROK’s total service trade compared to China (13%). Secondly, as opposed to US-South Korea trade, which traffics primarily in final goods such as automobiles and cellular handsets, Korea-China trade incorporates a non-trivial amount of intermediate inputs, resulting in re-imports and re-exports and leading to overstatement in the real value of their bilateral trade.
A clearer way to understand the true nature of economic dependency then, is the OECD-WTO’s Trade in Value Added database, which rather unfortunately reports 2009 as its latest year. As Exhibit 2 shows, China-South Korea trade in value added (as % of GDP) terms is now not as dominant, overtaking Japan-Korea but lagging behind US-Korea in every year shown.
Despite these qualifiers, China’s role in South Korea’s economy, the intensity of bilateral flows of goods across borders, and the direction of future trends towards trade dominance is evident by almost any measure one looks at.
The Investment and Financial Channel
But there is far more to economic integration than simply lobbing goods back and forth over the Bohai. Complex supply chains, service and financial needs, and infrastructure to facilitate this trade must exist – all of which require significant investment in physical and human capital. As shown in exhibit 3, the direct investment (large, usually fixed investment; see here for exhaustive definition) flow has indeed increased over the last decade or so, but it has primarily been from South Korea to China. The stocks of portfolio and other investment (financial investment and primarily banking assets, respectively) increased markedly as well.
However, China clearly has a much smaller presence in South Korea in the financial and investment space than the US, EU, or even Japan. This should not come at a surprise given China’s financial sector is still overwhelmingly domestically-focused and unsophisticated, and domestic investors face tight restrictions on investing overseas (Exhibit 4). Furthermore, given restrictions on investment flows in and out of China, South Korea’s portfolio holdings in China are very small and China’s holdings in South Korea are similarly limited and dominated by official sources. At base, China footprint in the financial and investment space does not match that of trade.
That said, there are strong signals that South Korea-China financial integration will expand, in turn fostering future trade and general economic ties.
The minutes (page 9) of a recent Bank of Korea Monetary Policy Committee meeting revealed a member showing strong interest in the possibilities of China’s financial liberalization and renminbi internationalization efforts, and advocating potentially opening up a RMB offshore market in South Korea (dubbed CNK). This is not a new notion: there are now offshore renminbi centers in Hong Kong, Singapore, Taiwan, London, New York, Frankfurt and others, where individuals and firms can get access to RMB deposits and even invest in RMB-denominated products. There are several advantages afforded by these markets, principally that it allows domestic (or domestically domiciled) firms to fund operations in China via offshore RMB bond and equity offerings or maintain RMB deposits to transact (implicitly subsidized by the PBoC; see Garber 2011) with parties in Mainland China. However, until the financial liberalization program allows for sufficient two-way capital movement, many South Korean businesses will likely be reticent to hold RMB for liquidity reasons alone.
There are many reasons why policymakers in Korea should pursue this initiative. As China gradually loosens restrictions on domestic residents’ international investment portfolios, portfolio diversification pressures will push pent-up capital abroad, and one natural destination for this wall of capital would be South Korea. There is a considerable literature on why and how investors allocate their international portfolios – common trade and cultural ties being non-trivial factors thereof –which would suggest the ROK as a prime target. Having adequate financial infrastructure in place in this eventuality will be immensely important for making this development beneficial for South Korea’s economy.
Summarily put, China’s continued opening up of both its industrial base as well as its heretofore pent-up capital markets will likely result in a self-reinforcing cycle of deepening economic integration, the likes of which are being experienced in Hong Kong and, more controversially, Taiwan. But for South Korea, a similarly small, open economy in relative terms, the question remains: on whose terms will the future relationship be tempered?
In tomorrow’s posting, we will qualify the warming of economic relations with the general apprehension in South Korean diplomatic and public opinion regarding China’s growing influence, and whether there are other analogous situations being faced by other neighboring countries around China’s periphery.