The Impact of the US-China Trade War on South Korea

Similar to a stone nonchalantly tossed into the water that unexpectedly splashes those passing by, the Trump administration’s use of tariffs to pressure China to undertake economic reforms has had unintended consequences. In a globalized economy where goods and capital easily flow across borders, and countries form parts of production chains, the blunt use of tariffs by the Trump administration has rippled beyond their intended target to negatively impact other countries.

South Korea is one of the countries most exposed to a trade war between the United States and China.

If the current pause for negotiations is unsuccessful in reaching a solution, the United States and China could enter into a protracted trade war. For the global economy, a prolonged trade war would likely only have a modest impact. In recent years, trade as a percentage of GDP globally has been declining and most states trade primarily with other countries in their region. This is the case for Asia, where 60 percent of trade is intraregional, and where a more significant impact could be felt, especially in countries such as South Korea.

If the global economy is largely insulated, South Korea’s exposure to a trade war between the United States and China is greater than most. South Korea’s economy is more dependent on trade for economic growth than most major economies, while also being reliant on export markets in China and the United States. Overall exports are equal to more than 40 percent of South Korea’s GDP. In contrast, the two protagonists in the burgeoning trade war are less exposed. Chinese exports are less than 20 percent of GDP and U.S. exposure is only around 12 percent of GDP.

As South Korea’s two largest trading partners, China accounted for just under 25 percent of South Korean exports in 2017, with the United States at 12 percent. Declining demand in either market would exhibit a drag on South Korean economic growth. A shift of 1 percent in China’s economic growth is estimated to cause a 0.3 percent shift in South Korea, with an equivalent change in U.S. economic growth estimated to impact South Korean growth by 0.1 percent.

Despite this dependence, South Korea has largely weathered the trade conflict between China and the United States so far. Earlier this year, OCBC Bank Singapore estimated that U.S. tariffs on $250 billion worth of Chinese exports to the United States could reduce South Korean GDP growth by 0.3 percent, while DBS Bank (Singapore) estimated that in a worst case scenario South Korea could see GDP growth decline by 0.6 percent. Overall economic growth in South Korea has slowed, with the Bank of Korea and the OECD having cut estimates for the year by around 0.3 percent. While some of the cut is due to uncertainty surrounding trade, sluggish investment and job growth are also weighing on an economy that has seen exports to China and the United States rise so far this year.

If South Korea has been able to manage the short-term effects of a U.S.-China trade conflict, the medium to long term presents a more challenging picture. Much of South Korea’s trade with China is processing trade. South Korean parts are shipped to China for assembly into goods that make their way to markets around the world. South Korea’s direct exposure to U.S. tariffs on Chinese goods is limited. Only 5 percent of its trade with China is for the assembly of goods that are destined for the United States. However, as demand for Chinese imports more generally declines, South Korea will see a decrease in demand for intermediate goods and finished products in China.

The last few months may have been the beginning of that decline. Vehicle sales have slowed significantly in China over the last three months, meaning South Korean automakers Hyundai and Kia will likely face slimmer prospects in China. Slower growth in China is also decreasing demand for South Korean intermediate products such as semiconductors. Exports of semiconductors account for over 20 percent of South Korea’s exports globally and more than 25 percent of its exports to China. With China’s economy slowing, shipments of semiconductors to China have been declining since October.

Even if the United States and China reach an agreement to end their trade war, South Korea could still be negatively impacted. If part of a deal included China purchasing more semiconductors from the United States, the Korea International Trade Association estimates it could result in a $4 billion loss for South Korea.

All of this comes as South Korean firms still face the hangover of China’s informal retaliation against the deployment of the U.S. Terminal High Altitude Area Defense (THAAD) missile defense system last year. Lotte, which provided the golf course where THAAD is deployed, is in the process of selling off its supermarkets in China, while the loss of Chinese tourism has cost South Korea over $13 billion.

South Korea also finds itself under pressure in the U.S. market. While the majority of tariffs on Chinese exports to the United States are a result of the Section 301 investigation into Chinese theft of U.S. intellectual property, the Trump administration initially turned to the blunter tool of Section 232 national security investigations to address U.S. concerns over Chinese steel and aluminum overcapacity. This investigation resulted in tariffs on all steel imported by the United States. South Korea was the first country to negotiate quotas to avoid being hit by U.S. tariffs, agreeing to limit its exports of steel to the United States to 70 percent of its average exports over the last three years.

Steel, however, is not the only Section 232 case the Trump administration has used. A decision is still pending on automobiles and automotive parts. Despite having ratified the changes to the Korea-U.S. free trade agreement (KORUS), South Korea remains the only major automotive exporter not to receive a specific exemption from the automobile Section 232 case. There is also the prospect that the Trump administration could initiate a new Section 232 case focused on semiconductors, another major South Korean export.

In response, the South Korean government and private sector are refocusing their attention on Southeast Asia to reduce their exposure to China and the United States. Economic growth in the region has made it more attractive to South Korean firms, but the current tariff conflict and the South Korean experience with THAAD is also pushing firms to increasingly diversify production away China. As a result, South Korean investment for the year in Vietnam currently exceeds investment in China. The government is expanding its New Southern Policy to increase outreach to the region to complement these efforts.

Seoul has also been working to resolve its trade issues with Washington. Earlier this year, South Korea reached an agreement on revising the KORUS FTA and the National Assembly has recently approved the changes. The hope in Seoul is that this will normalize economic relations with Washington.

While diversifying away from China and smoothing tensions with the United States are a sound strategy, a prolonged trade war between the United States and China will undoubtedly affect South Korea as well. As Chinese growth slows, South Korea will face declining demand for its own exports to China, while the United States has yet to show a willingness to exempt South Korea from national security tariffs that directly and indirectly target China in key export areas. If these trade irritants are not reversed, they would dim South Korea’s economic prospects going forward.