1. The Korean economy, one of the economies leading the recovery from the financial turmoil, has recorded rapid economic growth along with relatively stable employment and price stability. The Korean authorities are now implementing a well-calibrated and gradual exit strategy, while aiming to achieve strong and sustainable long-term economic growth.
2. Our Korean authorities appreciate the staff’s constructive policy dialogue and will give due consideration to the staffs recommendations. This paper, a pilot initiative as part of innovative reform of staff papers, is successful in streamlining the report and providing a summary of major issues with regard to the Korean economy.
Economic Outlook and Risks
3. A faster-than-projected recovery is expected. GDP growth rate in the first half of 2010 picked up to 7.6 % y-o-y, recording the highest growth rate in the past decade and thus raising the Ministry of Strategy and Finance (MOSF)’s growth outlook in 2010 to 5.8%, which is slightly lower than staff’s outlook of 6.1%. This recovery was underpinned by the timely and decisive policy response of the authorities, and supported by solid growth of private consumption and investment spurred by the strong rebound of exports. Employment is expected to pick up more rapidly than expected. Inflation is expected to remain well within the inflation target range, while the current account is likely to record a surplus of over USD 15 billion in 2010. Financial market conditions have also stabilized. The Korean stock market gained more than 70 percent in value, while the nominal exchange rate appreciated approximately 35 percent against the U.S. dollar from their lows of March 2009. Foreign exchange reserves have risen to USD 286 billion as of end-July 2010, surpassing pre-crisis levels. Consumer confidence has rebounded and reached a seven-year high by end-2009, while business confidence has also strengthened.
4. Against the backdrop of this robust recovery, a calibrated exit from accommodative macroeconomic policies is being implemented in a very cautious manner. The fiscal deficit will be gradually reduced and will be eliminated between 2013 and 2014. Small and Medium Enterprise (SME)-support measures are being gradually unwound. Liquidity support injected into financial markets has been gradually reversed as well.
5. Being an open economy, however, Korea remains vulnerable to external shocks. Its large exposure to global trade and international capital markets always poses key risk to the Korean economy. Accordingly, despite its small exposure to southern Europe, our authorities have been closely monitoring and preparing for any negative spillovers from the European financial crisis. Any adverse spillovers from the impact of major economies’ exit strategy as well as a possible increase of global commodity prices will receive due and vigilant attention.
Fiscal Soundness and Consolidation
6. The recent European crisis demonstrates the importance of fiscal soundness. For ensuring fiscal soundness, the Korean government has developed the National Fiscal Management Plan (NFMP) and the National Debt Management Plan (NDMP), the objectives of which can be adjusted to accommodate economic and fiscal circumstances on a rolling basis. With fiscal stimulus being gradually reduced, the fiscal deficit, which rose to 4.1% of GDP during the crisis in 2009, is projected to drop to 2.7% in 2010 and will be eliminated between 2013 and 2014, while the public debt to GDP ratio will stabilize at mid-30 percent levels.
7. Fiscal soundness will greatly help secure appropriate policy ammunition against any future crises. To this end, the authorities will broaden the tax base by eliminating some tax deductions/exemptions and will enhance expenditure efficiency by curtailing excessive or overlapping expenditures. On the fiscal framework, the fiscal soundness management system will be improved by periodic analysis of fiscal risks and reorganization of the fiscal statistics infrastructure. The authorities are developing a new NFMP covering 2011-2015, which will specify detailed measures for medium-term fiscal consolidation. In this context, a fiscal rule recommended by staff will be introduced, if necessary.
8. The recent debt increase of public enterprises is not likely to create fiscal burden on the Korean economy. In the history of the Korean economy, public enterprises have contributed to its dramatic economic growth by undertaking large scale infrastructure investments. As of the end of 2009, public enterprises debt has increased by KRW 114 trillion from end-2005. However, their assets recorded an increase by KRW 137 trillion during the same period, 20% higher than the debt increase. Given such large asset growth and continued net annual profit of KRW 3.3 trillion on average since 2005, the recent debt increase is not likely to create fiscal burden. Nevertheless, our authorities will closely monitor the development of public enterprises’ debt levels, review their medium and long term investment plans, and prepare for tailored debt management plans.
Monetary Policy Coordination and Objective
9. Inflation has remained subdued despite the accommodative monetary policy. Core inflation has continued to remain below 2 percent since February 2010. Headline inflation, 2.6 percent in July 2010, remains comfortably within the inflation target of 3±1 percent. Against this backdrop, the Monetary Policy Committee (MPC) had maintained the policy interest rate at 2 percent since February 2009. However, in July 2010, the MPC raised the policy rate to 2.25 percent, reflecting the recent economic recovery.
10. The MPC, as an independent policy-rates setter, determines the rate with comprehensive consideration of economic circumstances, price pressure, and financial market developments. The revision of the BOK Act in 1997 has served as the momentum to significantly strengthen the independence of the Committee. For example, the Governor of the Bank of Korea has been designated as the Chairman of the Committee. The Act ensured the guaranteed term of the Committee members and also improved the independence of budget and personnel affairs of the BOK. Given the need for continued policy coordination with the government, the BOK Act still entitled the MOSF (Vice Minister) to attend the MPC meeting and voice its view. Since January 2010, such attendance has resumed, after consultation with the MPC, to meet the need for policy coordination among authorities. It reflects the lessons from the crisis that cooperation between the government and central bank is critical to cope with crisis. Some advanced countries like UK and Japan are also implementing similar practice.
11. Price stability has still been the primary and sole objective of the BOK. In the wake of recent crisis, a revision to the BOK Act, making it pay attention to financial stability, is being discussed in the National Assembly. Including financial stability as the central bank’s additional policy goal is still contentious. As we recall, during the Board meeting on “Central Banking Lessons from the Crisis” in June, it was highlighted that “assigning only one policy instrument- the policy interest rate- to more than one objective would confront monetary policy with sharp trade-offs and could well lead to a failure to achieve either objective”. Since this is one of the highly controversial issues up until now, more careful and in-depth review will be made before a final decision is reached.
Safeguarding Financial Sector Stability
12. The two episodes of crisis experienced by Korea were mainly triggered by capital flow volatility. A huge capital inflow during the economic boom and rapid capital outflow in the subsequent downturn adversely affected the financial system and collapsed its economy. Korea’s flexible exchange rate has thus far played the role of a shock absorber very well. But more needs to be done. Against this backdrop, our authorities introduced strengthened macro-prudential regulations in June 2010, such as limiting banks’ foreign currency forward positions and tightening regulations for domestic foreign currency lending. This aims to address the banks’ wholesale funding problem and to reduce currency and maturity mismatches. The design and the degree of regulations will be revisited later following the review of outcomes.
13. Establishing the Financial System Stability Council (FSSC) was recommended by staff. In Korea, however, there are various policy coordination channels among relevant authorities and, in practice, policy coordination and information sharing among them including BOK has been very successful, as was evidenced by its fast recovery from the crisis. Moreover, Financial Services Commission (FSC) is very similar with the FSSC in many aspects. All the relevant bodies (MOSF, BOK, Financial Supervisory Service (FSS), and Korea Deposit Insurance Corporation (KDIC)) participate in the FSC as a commissioner, and each body has analyzed systemic risks from its own perspective. As a result, Korean authorities’ policies have been well-designed and successfully implemented in a coordinated manner. More consideration to country-specific circumstance could have enhanced the credibility of the staff’s recommendations.
14. A cautious approach for so-called “Mega bank” is appropriate. Currently, regulating the size of individual financial institution is being discussed by some advanced countries. Country-specific circumstance, such as differences in terms of size of financial agencies, the development stage of financial industry, and supervisory and regulation system, should be carefully considered. Going forward, the Korean authorities will take a balanced and cautious approach along with sufficient comparative analysis, with the main focus being placed on enhancing the financial industry competitiveness as well as preventing systemic risks.
15. Productivity-driven and balanced growth will be pursued. The policy focus is shifting from overcoming crisis to preparing for the next challenge. “New Policy Goals beyond the Crisis” was recently announced in this context. This elaborates mid- to long-term comprehensive development strategies to achieve strong and sustainable long term growth. To this end, revitalizing and increasing the competition in the non-tradable sector including the service industry will be prioritized. In May 2009, our authorities launched a major initiative to develop the service industry and selected nine service sectors based on their growth potential and job creation as well as value added and trade deficit reduction. Up to date, this initiative has been continuously implemented.
16. Continued increase of household debt, in particular of mortgage debt, has seized our authorities’ attention. Household debt remains higher than the average level of OECD countries. Nevertheless, the majority of debt belongs to high-income households with a large amount of financial assets. The delinquency rate on household loans remains very low, recording 0.54% as of March 2010. Given the sufficient accumulation of provisions for bad debts, banks remain resilient against shocks. However, as the rapid rise in household debt and de-leveraging may dampen the economy’s growth potential, our authorities will remain vigilant. Macro and micro prudential regulations such as Loan-to-Deposit ratio, Loan to Value (LTV), and Debt to Income (DTI) will be continued. In addition, financial assistance measures including micro-finance projects will reduce the financial burden of low income families.
17. Unlike the household, SMEs have sound balance sheet. Their financial soundness was greatly improved since the financial crisis in 1997. The debt to equity ratio decreased from 418% in 1997 to 137% in 2009, while equity to asset ratio rose from 19% in 1997 to 42% in 2009. Comparison with major economies also shows that financial soundness indices of Korean SMEs are similar to or better than those of companies in major economies. However, bank-led restructuring of troubled SMEs will be expedited, and the process of restructuring will be continuously monitored. Most SMEs-support measures are being normalized. The financial support measures, which are being maintained to sustain market confidence and establish a safety net, will also be gradually unwound with due consideration to market conditions.
18. Improving the labor markets flexibility has been one of the key priorities, the importance of which we cannot over-emphasize. To make labor markets more flexible, employment protection for regular workers will be reduced while social protection for non regular workers will be expanded. A great deal of efforts have been made to enhance the flexibility of wages and working hours, such as creating jobs with reduced working hours as well as expanding the Wage Peak. At the same time, the social safety net will be expanded to facilitate employment stability, by enriching job training, upgrading employment support service, and expanding coverage of employment insurance.
19. The rapidly ageing population is one of the key challenges confronting Korea. It has the lowest fertility rate among OECD member countries, which stands at 1.15 children per woman in 2009. Its population over age of 65 is projected to increase from 11% in 2010 to 38.2% in 2050. In light of this, a five-year “Master Plan preparing for Ageing Society (2011-2015)” is being envisaged as a comprehensive response. This Plan will focus on boosting fertility rate by creating “work and family friendly” environment. Measures supporting employment and turnover of older population will be strengthened, and promoting public awareness on the importance of higher fertility rate will be enhanced.
20. Finally, our Korean authorities wish to express their utmost appreciation to the Fund and its staff for their policy advices in addressing the risks facing the country. They also extend their deepest gratitude to the mission chief and his team, for their hard work as well as frank advices in supporting the Korean economy.