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SERIEconomic Outlook

SERI Economic Outlook for 2010

September 24, 2009

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1. Recent Trend

The Korean economy has been showing signs of recovery faster than other countries.Bolstered by improved sentiment among consumers and businesses and fiscal stimulus,economic growth rate in the second quarter of 2009 increased 2.6% from the firstquarter, sharply up from 0.1% in the first quarter. Given an easing in the global financialcrisis and heightening expectations of economic recovery, financial markets have alsostabilized. With the help of foreign investment, the KOSPI increased by 45.4 percentsince the beginning of the year to 1,634.91 as of September 14, and the won/dollarexchange rate stabilized to levels prior to the bankruptcy of Lehman Brothers at around1,200 won per dollar in the third quarter of 2009. With the help of foreign investment,by September 14th, the KOSPI had increased by 45.4% since the beginning of the yearto 1,634.91 and the won/dollar exchange rate stabilized to levels prior to the bankruptcyof Lehman Brothers to 1,225. The number of jobs is continuously decreasing, whileexports continue to remain in negative territory at about 20%. In addition, with liquiditypouring into the real estate market, concerns about a surge in real estate price are rising.

2. Global Economy

The global economy, which began to recover in the second half of 2009, is expected tomaintain growth momentum in 2010 as the effects of expansionary fiscal policies in2010 become more visible and global trade gradually revives led by emerging markets.However, job insecurity resulting from high unemployment and households need toreduce debt dash hopes of a consumption rebound in the near term. At the same time,weak corporate earnings rebound and idle facilities due to demand/supply gap aredelaying a recovery in corporate investment. Taking these factors into account, theglobal economy is forecast to grow a modest 2.3% in 2010.

The growth rate in emerging economies will remain substantially higher than in theadvanced economies. GDP of advanced countries such as the US, EU and Japan, whoseeconomies were hard hit by the global financial crisis, are forecast to growapproximately 1 percent. On the other hand, GDP of emerging economies will likelygrow at around 5 percent, largely due to a fast recovery in domestic demand and anincrease in resource prices.

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3. Domestic Economy

Korean economy is expected to grow by 3.9% in 2010. Both domestic demand andexports will drive economic recovery with the former posting mid-3% growth and thelatter recording double-digit growth. On the back of plus growth and a strong won, percapita GDP for 2010 should be in the US$20,000 range for the first time in three years.Due to weak dollar, current account surplus and inflow of foreign investment, the won-dollar exchange rate will likely stabilize downward to an annual average of 1,130 won.Despite expected recovery in 2010, it will take quite a while for the Korean economy,which derailed from long-term growth trajectory, to get back to its original upwardslope. Even if it achieves near 4% growth rate, real GDP is estimated to be 38 trillionwon less than potential GDP. The protracted time needed for the global economy toescape financial turmoil will also delay Koreas turnaround.

4. Private Consumption

Private consumption is showing signs of recovery thanks to government stimulusmeasures. Particularly, consumption of durable goods rose sharply in the second quarterthanks to tax incentives for car purchases. The contribution of consumption to growthwas the highest among domestic demand categories. This recovery trend inconsumption will likely continue, with the consumption growth rate estimated at 3.1%in 2010, up from -0.3% estimated for 2009. One catalyst is the income effect. As theemployment market, which usually lags behind the economy, improves gradually,consumers affordability will recover steadily. Furthermore, financial and real estatevalues, which were roiled by the erupting global financial crisis in 2008, are recovering,spurring positive "wealth effect" in the high-income class. Still, structural weaknesscontinues to be a major hurdle to consumption, which has been sluggish since the 1997

currency crisis. Rising household debt and interest rate hikes will also be burden on therecovery of private consumption.

5. Fixed Investments

Backed by the gradual recovery of the world economy, facilities investment will likelyrecover in 2010 from the severe slump in 2009, posting an 8.2% year-on-year growth.An increase in export demand thanks to global economic recovery is likely to spur

facilities investment, centering on the manufacturing industry, while imports of capital

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goods by domestic manufacturers are expected to increase on declining won/dollarexchange rate. Other factors contributing to an increase in facilities investment include

inventory adjustment completed in the first half, declining pressure on facilitiesinvestment adjustment, and the base effect stemming from the 2009 plunge ininvestment. However, deteriorating investor sentiment due to lingering uncertainty athome and abroad and curtailment of investment incentives such as temporary taxdeductions on investments will likely exert a negative effect on facilities investment.According to a survey of 500 listed companies about their investment plan in 2010,41.6% of companies surveyed said that they will maintain the current investment leveland only 28.4% said that they will increase investment by 1% to 10%.

Construction investment is likely to grow by 1.9% in 2010, a slight decrease from 2009,due to possible scaling down of government social infrastructure investment and modestrecovery of the housing market. Government spending on social infrastructure willlikely continue centering on major projects such as four river renovation projects, butthere won't be a sharp increase in spending like the one seen last year. The scale of budget for social infrastructure (based on main budget) will be earmarked at about 26.2trillion won in 2010, a mere 1.4 trillion won increase from a year ago, with the growthrate slowing to 5.7%. Construction in the private sector, particularly residential and non-residential buildings is likely to improve along with reviving domestic demand. Theexpansion of construction investment in the private sector, however, will be limited dueto huge backlog of unsold newly-built apartments, which has risen sharply since 2008.The number of unsold homes stood at 140,000 at of the end of July 2009. In particular,the number of completed-but-unsold homes, the malignant problem of the housingmarket, stood at 52,000, up 11.4% compared to late 2008.

6. Trade

Exports are expected to post double-digit growth of 12.2% in 2010 helped by the globaleconomic recovery and strong performance of main export items. Particularly exports of ships are expected to increase 34.6% from 2009 to US$70 billion. In addition, exportsof semiconductors, whose unit export prices are on the rise, and displays, which areexpanding market share, are expected to increase more than 10% year-on-year.Meanwhile, imports are expected to rise 17.8% year-on-year thanks to export growth,recovery of domestic demand, and rising international commodity prices. Accordingly,

trade surplus will likely decline to US$15.9 billion from US$30.8 billion expected in

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2009 as import growth outweighs that of exports. The current account surplus is alsoexpected to decline to US$15.9 billion from US$35.5 billion from 2009 as service

account deficits will likely rise to US$16.5 billion on economic recovery and wonappreciation.

7. Prices

Consumer prices are expected to register an annual growth rate of 3.0% as upwardpressure grows on the side of cost rather than on the side of aggregate demand. Increasein demand is expected with an economic growth rate of 3.9%, but it is expected thatinflationary pressure is low as actual real GDP is short of 38 trillion won compared withpotential real GDP, affected by the negative economic growth in 2009. However, interms of cost, inflationary pressure stemming from rising raw materials prices isprojected to increase as the global economic recovery, which materialized in the latterhalf of 2009 will continue in 2010. Nominal wage, which continued a downward trendin 2009 with a sluggish labor market, will reverse direction in 2010, increasinginflationary pressure.

8. Employment

The number of the employed decreased by 131,000 from January to July in 2009compared with the same period of last year. However, thanks to various policy measures,subsidies for retaining employment, unemployment benefit, the condition of the labormarket proved to be better than expected. In 2010, the unemployment rate is expected tomark 3.5%. With the expected economic growth rate of nearly 4% in 2010, the economyis forecast to create about 150,000 to 200,000 jobs with its job creation capability likelyto improve. However, the participation of the non-economically active population in the

labor market amid expectations of economic recovery will help keep the unemploymentrate in check. Meanwhile, as job creation through the budget input is expected to bereduced in 2010, creation of temporary jobs will decline, and most of the job creationwill arise in regular work.

9. Interest rate

The market interest rate, in terms of AA- corporate bond yield, is expected to inch up to

6.4% in 2010. Economic recovery, an expansion of inflation, and the expected increase

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in the issuance of monetary stabilization bonds by financial authorities to absorb marketliquidity will act as a driving factor to increase interest rate. However, as credit risk

ebbed along with less anxiety in the financial market, the interest rate gap betweengovernment bonds and corporate bonds is expected to narrow, helping stabilize theinterest rate of corporate bonds. Meanwhile, as credit risk spread on risky assets shrinks,and restructuring on small- and medium-sized enterprises (SMEs) begins in earnest,polarization of funding among firms will decline. It is expected that the issuance of lower credit rating bonds will increase with less burden from credit risk. As credituncertainty is eliminated in part with economic recovery, money supply by financialinstitutions will expand, and liquidity for blue-chip SMEs that pass a credit stress test isexpected to be facilitated.

10. Foreign Exchange Rate

The won/dollar exchange rate is forecast to be 1,130 in 2010, down from 1,281 in 2009.The dollar will likely face weakness due to eased preference for safe assets resultingfrom the recovery of the world economy, the US fiscal deficits, and growing debate overthe replacement of the key international currency. Apart from such dollar-weakeningfactors, dollar supply will outweigh demand domestically, serving as a factor thatstrengthens the won's value. In particular, the order receipts of the shipbuilding industry,a major source of dollar supply, although not included in export statistics, are likely toimprove in 2010. Another factor contributing to the strength of the won include the factthat the financial authorities withdrew most of the foreign currency liquidity theysupplied when coping with the outbreak of the financial crisis in 2008. That suggeststhat the government's withdrawal of foreign currency liquidity reached the final phase,along with the fact that the won is now undervalued from the perspective of foreignexchange balance.

11. Implications

Although economic environment both at home and abroad is likely to improve in 2010,it is too early to be optimistic about the economic recovery. The pace of economicrecovery of industrialized countries remains weak and the risk factor of the globalfinancial market remains latent. Hence, the current economic stimulus stance should bemaintained until the recovery of the world economy is visualized. When it comes to

fiscal policy, the current expansionary fiscal policy should be maintained in 2010. The

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fiscal condition of Korea whose fiscal deficits are likely to stand at a level equivalent to2% of GDP in 2010, is relatively favorable. Accordingly, it is necessary for Korea to

tolerate a certain level of fiscal deficits in the short term, while placing its mid-termtarget at achieving fiscal balance. Financial policies should flexibly respond to theeconomic situations of major countries. Interest rate hikes should be implemented on agradual basis, keeping abreast with the speed of economic recovery and the interest ratetrends of major countries.