Are Things About to Get Worse for South Korea?

South Korea suffered a double whammy of weak exports, which plunged the most in nearly three years, and manufacturing activity that continues to shrink, and economists tell CNBC that the worst is not over for the export-dependent economy.

An employee works on the assembly line of the Hyundai Motor Co. Ulsan factory in Ulsan, South Korea.
Bloomberg | Getty Images
An employee works on the assembly line of the Hyundai Motor Co. Ulsan factory in Ulsan, South Korea.

Exports in July fell 8.8 percent from a year earlier, the government said on Wednesday, much worse than a consensus of a 3.7 percent decline and a 1.3 percent increase in June. The HSBC Purchasing Managers’ Index also declined, to 47.2 for the month from 49.4 in June, the sharpest contraction this year.

All these data point to a “very weak” second half for Korea, according to Robert Prior-Wandesforde, Director of Non-Japan Asia Economics with Credit Suisse.

“GDP could be flat or even slightly negative on a quarter-on-quarter basis, especially if Western demand continues to be weak and domestic leverage remains high. This will crimp consumption,” he told CNBC.

Exports, which account for around 50 percent of the country’s GDP are at risk of falling further in the coming months, according to economists. A particular weakness is electronics, which make up 21 percent of Korean exports, said Ronald Man, Economist with HSBC.

“Our Asian electronics lead index signal a downturn in the electronics cycle over the third quarter,” Man said. “This is important because the manufacturing sector is among the largest in Korea when compared against other Asian countries, amounting to roughly 30 percent of GDP on a value-added basis.”

He said his forecast of 3.1 percent expansion in Korea’s GDP looks at risk after Wednesday’s data.

Rate Cuts May Not Help

Last month, in order to boost growth, the Bank of Korea unexpectedly cut its base rate for the first time in more than three years. The following day, it sharply lowered its view for 2012 GDP the next day, fuelling speculation that another rate cut was on the table. The Bank of Korea next reviews policy on Aug. 9.

But Prior-Wandesforde of Credit Suisse said another rate cut, while almost necessary, may not stem the country’s weakness for the rest of the year.

“The Bank of Korea has already eased but effects won’t be quick enough or big enough to have much impact in the second half,” he said. “Interest rates usually take 8-12 months to take effect.”

He expects one more rate cut of 25 basis points by the Bank of Korea, bringing the base rate to 2.75 percent, in line with what other economists are forecasting.

Tim Condon, Head of Research for Asia with ING, said he agrees with that forecast but does not think “the BOK will ease sufficiently to boost nominal GDP growth.”

Barclays’ Economist Wai Ho Leong is less pessimistic about Korea’s prospects and sees bright spots in Wednesday’s data.

“We are probably close to starting to turn around. In fact, for exports, July may be a bottom for export momentum,” Leong said. The technology industry continues to recover, expanding 1.6 percent in July after declining 1.6 percent in June and 2.7 percent in May. Car exports also continue to do well, climbing 6.9 percent in July after increasing 1.8 percent in June, he said.

“If U.S. consumer sentiment and activity indicators continue to improve, more export orders, not less, will be headed for Asian exporters.”

He expects Korea to expand 0.9 percent in both the third and fourth quarters, after growing 0.9 percent and 0.4 percent in the first two quarters of the year. That works out to be 2.7 percent growth for 2012.

- By CNBC's Jean Chua.