Consumer spending remains sluggish under high interest rates, with South Korea's Q2 economy unexpectedly contracting by 0.2%

According to Zhitong Finance APP, in the last quarter, the South Korean economy experienced a reversal after exceeding expectations at the beginning of the year, posing a challenge for policymakers as they strive to stimulate investment and consumption.

The Bank of Korea stated on Thursday that the country's Gross Domestic Product (GDP) shrank by 0.2% in the three months ending in June compared to the previous quarter, which is lower than the 0.1% growth widely expected by economists.

This unexpected contraction may increase calls for the Bank of Korea to cut interest rates, but immediate action is unlikely. The rapid growth in the economy in the previous quarter exacerbated this weakness, and currently, the focus of the Bank of Korea is to ensure that no signal of short-term policy easing is sent, inadvertently stimulating further household debt increase.

The South Korean government and the central bank have raised their growth forecast for 2024, indicating that they see the results of the second quarter more as a deceleration on the path to sustained expansion rather than a warning sign of a trend reversal.

Nevertheless, the report still highlights the weakness in domestic demand. Private consumption decreased by 0.2% compared to the previous quarter, while government spending increased by 0.7%. Real exports grew by 0.9%, and facility investment decreased by 2.1%.

Kwon Young-Sun, Chief Economist at Woori Finance Research Institute, stated, "What is truly worrying is the contraction in investment, which indicates a deterioration in the long-term growth potential." He pointed out that if businesses wait until after the U.S. presidential election in November, investment plans may be further delayed.

The Bank of Korea stated in its announcement that machinery equipment, including chip manufacturing equipment, led to the decrease in investment. Construction investment contracted by 1.1% after an unexpected growth of 3.3% in the previous quarter.

The continued weakness in consumer spending indicates that strong external demand has not driven overall economic strength.

The global trend of artificial intelligence development has propelled South Korea's growth, with the country being home to Samsung Electronics (SSNLF.US) and SK Hynix, the world's two largest semiconductor manufacturers. In particular, memory chips have led the growth in South Korea's exports, driving the country's economic growth in the first quarter by 1.3%, more than double what economists had predicted.

Trade data shows that the export rebound led by technology continued from April to June and may persist into this quarter. Semiconductor shipments in the first 20 days of July grew by over 50% year-on-year, supporting the central bank's expectation that the chip rebound may continue into the first half of next year Bloomberg Economics' model shows that South Korea needs to grow by about 0.8% in the second half of this year to achieve its mid-term target of around 2.5% in 2024.

Consumption is key to the economy in the second half of this year, as private spending remains subdued amid rising interest rates and persistent consumer inflation.

Economists are divided on whether the Bank of Korea will cut interest rates in August or October. The authorities have maintained the policy rate at a restrictive level of 3.5% for a year and a half. The weakness of the South Korean won against the US dollar is a factor that makes the central bank cautious about cutting rates prematurely, as further currency weakness would increase the costs of food and energy imports.

The stronger-than-expected economic momentum at the beginning of this year has given the Bank of Korea another reason to be cautious in adjusting its policies, as the authorities gain confidence from the semiconductor boom. South Korea is increasingly relying on semiconductors to navigate through economic challenges, including the COVID-19 pandemic.

Kelvin Lam, a researcher at Pantheon Economics, stated in a report before the GDP release, "Meanwhile, strong export growth driven by artificial intelligence should support economic growth and give the central bank more room to take a more cautious approach in policy shifts."

As South Korea's birth rate continues to hit record lows, the country finds itself facing another long-term economic vitality risk. With an expected average of 0.72 children per woman, South Korea is facing the prospect of the fastest shrinking labor force in the world, prompting the country to more actively turn to automation and artificial intelligence to mitigate the impact of an aging population.

Economists from Bank of America, including Benson Wu, stated in a report, "We believe that artificial intelligence can continue to drive South Korea's long-term growth without harming the existing labor market. The overall productivity growth brought about by the development of artificial intelligence may be a potential driver of South Korea's economic growth in the coming years."

In the short term, South Korea needs to address ongoing concerns about credit risks, as these risks cast a shadow over the construction industry, a key component of South Korea's GDP. Apart from rising raw material costs, developers are struggling to repay debts due to persistently high interest rates.

After a warm winter encouraged investment, the industry saw unexpected growth in output in the first quarter. Chong Hoon Park, an economist at Standard Chartered Bank Korea Limited, stated that the situation may not continue in the next few quarters, predicting a quarter-on-quarter contraction in the second quarter.

Hyosung Kwon, an economist at Bloomberg Economics, said, "GDP data clearly indicate growth risks both domestically and abroad. There is significant uncertainty about how restructuring will play out in the troubled real estate market." At the same time, the cooling of the US economy may slow down the demand for computer chips, which we once saw as a major growth driver for South Korea this year."