The weakness of the South Korean won and the rising financial risks restrict the space for stimulus policies. South Korea's economy unexpectedly contracted in the fourth quarter.

Due to a comprehensive decline in demand, the South Korean economy contracted in the last quarter of 2025, highlighting the challenges faced by authorities in stimulating economic growth, with its policy space constrained by the weakening Korean won and rising financial risks. The Bank of Korea said on Thursday that the country's Gross Domestic Product (GDP) shrank by 0.3% in the three months ending in December. This was a significant slowdown from the revised 1.3% growth in the previous quarter and lower than analysts' expectations of 0.2% growth; for the whole year of 2025, the South Korean economy grew by 1%, in line with market expectations. Data shows that the forces driving economic growth at the beginning of 2025 - expansionary fiscal policy, net exports, and consumption recovery - have weakened, as South Korean authorities are working to manage risks related to the continued boom in the real estate market, high household debt, and a persistently weak Korean won. The Bank of Korea maintained its policy unchanged last week, but effectively shifted to a neutral stance, removing references to potential interest rate cuts in its policy statement. At the same time, these data are unlikely to prompt a shift in the Bank of Korea's stance. The economy grew by 1.3% quarter-on-quarter in the third quarter of last year, higher than the official estimate of potential economic growth, making a slowdown towards the end of the year almost inevitable. Additionally, some data may have been exaggerated in the statistical compilation process. Net exports in the fourth quarter fell by 2.1% quarter-on-quarter, reversing the 2.1% growth in the third quarter. This quarter's results may reflect the impact of adjusting nominal data to real data, and the depreciation of the Korean won may have inflated import costs in the statistics. However, these data also highlight the imbalance of the recovery, reflecting signs of "K-shaped growth" - export-oriented industries related to semiconductors continue to outperform, while the construction industry and interest-sensitive households and small businesses are still struggling to recover. This trend raises concerns that overall growth data may mask deeper structural imbalances. This differentiation is becoming increasingly evident in the financial markets. Following a 76% surge in 2025, the South Korean benchmark Kospi index has been rising almost every trading day this year and briefly exceeded the symbolic 5000-point mark on Thursday - an important milestone long advocated by South Korean President Lee Jae-myung. During the presidential campaign, Lee Jae-myung promised to roughly double the Kospi index and sees capital market reform as a core to revitalizing growth. Since taking office last year, his government has established a committee responsible for deepening market access, improving corporate governance, and attracting foreign investment. The rise in the South Korean stock market has also been echoed in the real estate market, especially in high-end residential areas in Seoul. According to data from the Korean Real Estate Institution, as of January 12, Seoul apartment prices have been rising for the 50th consecutive week, ignoring the government's efforts to cool the real estate market. This upward trend has policymakers cautious about easing policies, fearing that doing so could increase household debt levels and amplify financial instability risks. With the diminishing effects of fiscal stimulus, consumption has slowed down. However, the recent decline to some extent has been exaggerated by the strong performance in the previous quarter. Private consumption growth in the fourth quarter slowed from 1.3% in the third quarter to 0.3%; government spending increased by only 0.6%. Construction investment and equipment investment decreased by 3.9% and 1.8% respectively. Economist Hyosung Kwon said, "South Korea's unexpected contraction in GDP in the fourth quarter is a technical backlash from the exceptionally strong expansion in the third quarter of 2025, not a major setback for the economy. Growth has been affected by the 'cliff effect' in fiscal spending being front-loaded in the third quarter. The drag from net exports is not a concern - nominal shipments remain strong." These pressures are exacerbated by the ongoing depreciation of the currency. Since late June last year, influenced by capital outflows, global interest rate differentials, and trade policy uncertainties, the Korean won has depreciated by over 8%. A weaker currency makes it more difficult for the Bank of Korea to ease monetary policy, as rate cuts could accelerate the depreciation trend. Officials have warned that further depreciation could exacerbate financial instability and push up inflation. Imbalanced growth Despite a weakening of momentum at the end of the year, exports continued to support South Korea's external balance for most of last year. With semiconductor prices rebounding and energy costs declining, improved trade conditions helped South Korea achieve a current account surplus of around $118 billion last year. The government expects this surplus to expand to $135 billion in 2026. However, this resilience masks increasing external vulnerabilities. For the whole of 2025, exports to the United States declined by 3.8%, and uncertainties remain about the implementation of South Korea's commitment to invest $350 billion in the US - part of an agreement reached last year that set the US tariff cap on Korean products at 15%. According to a source familiar with the matter, given the pressure on the currency, Seoul has indicated that it may delay fulfilling its commitment to invest up to $200 billion in the US this year. Beneath the surface of the rising stock market, gains are still concentrated in a small number of stocks led by Samsung Electronics and SK Hynix. A similar pattern is also seen in exports, with semiconductor shipments growing by about 22%, while most other industries, including automobiles and steel, lag behind. This high degree of concentration exacerbates South Korea's exposure risk to changes in US trade and industrial policies, which are specifically targeting the chip industry. US Commerce Secretary Lutnick has warned that South Korea and Taiwan, China's storage chip manufacturers may face tariffs of up to 100% unless they commit to expanding manufacturing capacity on American soil. The White House has stated that President Trump may announce new tariffs in the near future and introduce offsetting plans to encourage domestic manufacturing. Jin-Wook Kim, an economist at Citigroup, said that considering the structural financial risks and the prolonged upturn in the semiconductor cycle, a weak currency and rising house prices may keep monetary policy on hold until 2027. The Bank of Korea raised its economic growth forecast for 2026 to 1.8% in November and revised its 2025 growth forecast to 1%, while raising its inflation forecast for next year to 2.1%. The government, on the other hand, is more optimistic, projecting economic growth of 2% this year, driven by more stable consumption and stronger exports. Officials have pledged to continue strict monitoring of household debt, consider setting up a dedicated real estate regulatory agency, and extend onshore foreign exchange trading to a 24-hour system as part of broader efforts to attract foreign investment and enhance productivity. Currently, South Korea continues to grow in the new year, but its foundation is increasingly fragile. On one hand, buoyed by chip exports and asset markets, on the other hand, constrained by a weak currency, policy constraints, and rising risks in foreign trade policies. Once growth momentum further weakens, the available policy "levers" are becoming increasingly limited.