Abstract

At the turn of the decade, the Korean economy underwent a major crisis, which had its roots in external and domestic shocks that exacerbated the impact of structural imbalances already present in the economy. The main external shocks were the worldwide increase in oil prices and the run-up in international interest rates, which together added the equivalent of 6 percent of GNP to Korea’s external payments during 1979–80. Moreover, the slowdown of economic activity in industrial countries magnified the effect of Korea’s weak external competitiveness. As a result, export growth dropped markedly. On the domestic side, the economy was buffeted by a drought, which sharply reduced agricultural production, and by severe political disturbances. The shortfall in agricultural output accounted for a decline of more than 4 percent in real GNP.

At the turn of the decade, the Korean economy underwent a major crisis, which had its roots in external and domestic shocks that exacerbated the impact of structural imbalances already present in the economy. The main external shocks were the worldwide increase in oil prices and the run-up in international interest rates, which together added the equivalent of 6 percent of GNP to Korea’s external payments during 1979–80. Moreover, the slowdown of economic activity in industrial countries magnified the effect of Korea’s weak external competitiveness. As a result, export growth dropped markedly. On the domestic side, the economy was buffeted by a drought, which sharply reduced agricultural production, and by severe political disturbances. The shortfall in agricultural output accounted for a decline of more than 4 percent in real GNP.

The authorities’ adjustment policies, which were initiated in mid-1978 and strengthened in the subsequent two years, alleviated some of the pressure on the external position. Nevertheless, the magnitude of the external and domestic shocks inevitably led to a pronounced deterioration in economic conditions. Real GNP, which had been rising at an average yearly rate of about 10 percent during the previous two decades, fell by 5 percent in 1980, while inflation surged to 35 percent, and the external current account deficit widened to almost 9 percent of GNP (Chart 12 and Table 3).

Table 3.

Korea: Selected Economic Indicators, 1979–84

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Sources: Korean Ministry of Finance; and Fund staff estimates.

Based on U.S. dollar values.

Balance of payments basis.

Customs basis.

Includes certificates of deposit issued by commercial banks.

Defined as the sum of gross domestic investment and the external current account surplus.

Includes public, publicly guaranteed, and private sector bank and nonbank debt of all maturities.

As percent of exports of goods and services.

Includes interest on short-term debt, and excludes rollover on interoffice bank accounts.

Policies

The increase in international oil prices complicated economic management considerably. In 1979, the authorities allowed domestic oil prices to rise in line with world prices and, in order to contain inflationary pressures, tightened their financial policies by postponing public investment projects and slowing credit expansion. Nevertheless, domestic inflation continued to increase and, with the fixed exchange rate, led to a deterioration in Korea’s external competitiveness. The loss of competitiveness, compounded by slower market growth and greater protectionism abroad, caused export volumes to shrink.

In early 1980, the authorities further strengthened their adjustment effort by formulating a wide-ranging adjustment program which was supported by a one-year stand-by arrangement from the Fund (March 1980-February 1981). The main elements of the program were tight financial policies, a substantial depreciation of the currency, and a comprehensive energy policy designed to reduce Korea’s dependence on imported oil. The authorities eased financial policies somewhat in mid-1980, when they were confronted with a pronounced fall in output and rising unemployment.

Fiscal Policy

The principal objectives of fiscal policy in 1979 were to reduce the public sector deficit and minimize its monetary impact. The public sector deficit fell in relation to GNP from 2.5 percent in 1978 to 1.4 percent in 1979 (Chart 2 and Tables 7 and 8).3 A large share of the adjustment fell on the public enterprise funds whose investment outlays and operating deficits had accounted for a large share of the public sector deficit.4 Prices of most public utilities were adjusted, with price increases ranging from 10 percent for rail fares to 55 percent for electricity rates. As a result, the only enterprise funds that continued to run significant operating deficits in 1979 were the Supply Fund (for stockpiling of critical commodities) and the Grain Management Fund (for stabilizing domestic prices of rice and other food grains).

The overall public sector deficit rose to 3.2 percent in 1980, largely reflecting the impact of the economic downturn. The Government adhered to a tight spending policy in the first half of 1980. The devaluation and the oil price increases resulted in some additional outlays, but they were offset by cutbacks in other expenditures. In addition, subsidies on grain, transportation services, and charcoal briquets rose. In the second half of 1980, however, the Government accelerated its spending to counteract the downturn in economic activity. In line with a policy of selectively stimulating domestic demand, the Government introduced a supplementary budget that provided for increased assistance to low-income households, implementation of a number of investment projects that had been postponed, and higher public sector wages. The supplementary budget and a shortfall in tax receipts raised the public sector deficit by about 2 percentage points of GNP. The increase in the financial requirements of the public sector was financed entirely by the domestic banking system. The result was that net bank claims on the public sector, which had declined slightly in 1979, increased during 1980 by the equivalent of 1 percent of GNP.

Monetary Policy

The authorities tightened credit policy in 1979 in order to offset the impact of the oil price shock (which was passed through to domestic oil prices) on other domestic prices and the balance of payments. The Government reduced its debt with the banking system and restrained the expansion of bank credit to the private sector by lowering credit ceilings for each bank. As a result, the rate of growth of bank credit declined from 45 percent in 1978 to 36 percent in 1979 (Chart 3 and Table 9). The rate of growth of broad money decelerated even faster than credit—from 35 percent to 25 percent—reflecting a substantial decline in net foreign assets. Broad money in real terms rose by only 3 percent, and velocity increased. The rise in velocity was partly attributable to a decline in real interest rates that took place because domestic inflation rose, while nominal rates remained fixed at the level of June 1978.

The authorities maintained tight credit policy through mid-1980. However, in the face of a severe economic recession, they relaxed credit policy in the latter half of 1980. Net bank credit to the Government increased substantially to finance fiscal expenditures, and the expansion of bank credit to the private sector accelerated. The rate of growth of domestic credit rose from 37 percent (seasonally adjusted annual rate) in the first half of the year to 44 percent in the second half. Nevertheless, given the surge in inflation induced by the rise in energy prices and the devaluation of the won, credit conditions remained tight and contributed to the slowdown of domestic demand and the decline in output.

The growth of broad money accelerated to 27 percent in 1980, but the real stock of money declined by almost 6 percent. The contraction in real money balances during 1980 can be attributed largely to the behavior of real income (which fell sharply during this period) and to the sizable decline in the real yield of bank deposits. Net foreign assets of the banking system fell further, by the equivalent of 8 percent of broad money, as the commercial banks increased sharply their short-term foreign liabilities.

The relative scarcity of bank credit during 1979–80 led firms to increase their borrowing from nonbank financial intermediaries and from the money and securities markets—a shift which was partly encouraged by the authorities. The Bank of Korea allowed banks to guarantee commercial bills with a maturity of 90 days or less, which the issuing enterprises could negotiate in the money market. The Government also lifted the ceiling on issuance of bonds of listed corporations, raised the maximum interest rates payable on debentures, simplified the regulations affecting bonds with repurchase agreements, allowed the introduction of bonds with floating interest rates, and introduced a workers’ securities saving plan to boost the demand for securities.

Interest rates in the domestic banking system were initially raised in January 1980 (by 4–6 percentage points), but subsequently were reduced by an equivalent amount in order to shore up the financial position of the business sector (Chart 4). The interest rate reduction, together with an acceleration of consumer price inflation, sharply lowered real interest rates (relative to the rate of increase in consumer prices over the previous year). For example, the real interest rate on one-year time deposits fell from near zero in 1979 to negative 14 percent in the last quarter of 1980.

Exchange Rate Policy

During 1979, the authorities continued to peg the won to the U.S. dollar. This exchange rate regime, which had been in effect since December 1974, resulted in a loss of external competitiveness. During 1975–78, the effective exchange rate depreciated by 15 percent, in line with the movements of the dollar, but appreciated by 13 percent in real terms because prices rose faster in Korea than in its partner countries. In 1979, the divergence in price developments was compounded by a substantial appreciation of the dollar. As a result, the real effective exchange rate further appreciated by 18 percent (Chart 5 and Table 10).

In order to restore external competitiveness, the authorities devalued the won by 17 percent in January 1980 and simultaneously introduced a more flexible exchange rate regime. Under the new regime, the exchange rate of the won vis-à-vis the U.S. dollar was to be determined on the basis of movements of a currency basket and other factors affecting Korea’s external position. Because of a surge in inflation, the won depreciated by only 8 percent in real effective terms in the first quarter of 1980. During the course of the year, the won declined further in relation to the U.S. dollar. Between the first and fourth quarters of 1980, the effective value of the won declined by 18 percent in nominal terms and by 7 percent in real terms.

Energy Policy

The main structural problem facing the Korean authorities in this period was the dependence on petroleum, which was Korea’s major source of energy. In 1979, oil accounted for 63 percent of domestic energy consumption, coal for 27 percent, and firewood for 7 percent. Nuclear power, hydroelectricity, and natural gas were minor sources. All the oil consumed in Korea and about 10 per cent of coal consumed were imported.

The authorities reacted to the rise in world oil prices during 1979–80 by taking prompt action to encourage energy conservation. The Government raised domestic energy prices in lockstep with increases in world oil prices and changes in the exchange rate. Domestic oil prices were raised by about 230 percent during 1979–80, electricity rates by 110 percent, and coal prices by 80 percent. Restrictions were set on the use of air conditioners, elevators, and street lights. Operating hours of gasoline stations and entertainment businesses also were regulated. In order to improve energy efficiency in the industrial sector, a fund was created to help replace industrial boilers with new energy-efficient models. Reflecting these measures and the economic recession, domestic consumption of petroleum products actually fell by 1 percent in 1980, after rising by around 13 percent a year in the previous decade.

Furthermore, a long-term energy program was adopted with the objective of cutting the share of oil in energy consumption to 42 percent by 1991. The program called for greater use of nuclear power, coal and natural gas, as well as further progress in the conservation and efficient use of energy. The Government embarked on the construction of nuclear power plants—there was only one in operation—while placing a moratorium on new oil-fueled power plants.

Economic Developments

The period 1979–80 was characterized by a severe weakening of economic activity. The growth of real GNP slowed from over 10 percent a year during 1977-78 to 6.5 percent in 1979 largely because of a decline in exports. In 1980, exports recovered somewhat, but agricultural output dropped precipitously, and domestic demand contracted sharply because of a steep decline in the terms of trade, the poor harvest, and tight financial policies. Domestic output fell for the first time in modern Korean history. Adding the loss of income associated with a sizable increase in interest payments abroad, real GNP declined by over 5 percent (Tables 11 and 12).

In 1979, real exports of goods and services, which had increased by an average of 20 percent a year during the previous two years, declined by 4 percent, owing to sluggish economic growth abroad and the marked erosion of Korea’s competitiveness. The impact on economic activity of unfavorable export performance was compounded by a slowdown in the growth of real domestic demand; a substantial weakening of fixed investment canceled out the effect of robust private consumption and a large accumulation of inventories. The retrenchment of demand had a sharp impact on manufacturing output. Although the recessionary impact of weak domestic demand was partly absorbed through a large accumulation of inventories, the rate of growth of manufacturing output was more than halved to 10 percent. The growth of construction, which had accounted for almost 2 percentage points of the growth of real GNP in 1978, came to a halt in 1979 in response to government measures that were taken in the previous year to discourage residential building. Even later, when some of those measures were repealed, construction continued to stagnate because of weak demand.

The sharp decline of output in 1980, to a large extent, was a result of a disastrous harvest, a further weakening of manufacturing, and the continued slump in construction. Agricultural output fell by 22 percent (the equivalent of 4 percent of GNP), while nonagricultural output remained stagnant. On the demand side, the rate of growth of exports recovered to 11 percent, largely as a result of improved competitiveness and export promotion efforts. The export recovery, however, was more than offset by the weakening of domestic demand. Real domestic demand dropped by 8 percent, as fixed investment declined markedly, private consumption edged down, and inventories were depleted rapidly.

The rate of increase in consumer prices rose from 16 percent in 1978 to 21 percent in 1979, reaching 35 percent in 1980. The two main factors affecting price developments were the oil price increases of 1979–80 and the depreciation of the won in 1980. Less important factors were the Government’s relaxation of price controls in 1979—which gave vent to suppressed inflation—and the poor agricultural harvest of 1980. The economic slowdown of 1979–80 softened the labor market and reversed the trend of real wage increases in excess of productivity gains that had taken hold during the boom years of 1976–78. Total employment grew by only 1 percent a year during 1979–80. Mean-while the labor force expanded by over 2 percent, causing the unemployment rate to rise from 3.2 percent in 1978 to 5.3 percent (770,000 persons) in 1980. The increase in the unemployment rate was accompanied by a considerable slowdown in real wage increases. The growth of real wages was reduced by half to 9 percent in 1979, and real wages actually declined by 4 percent during 1980.

Korea’s external current account deficit rose from $1.1 billion (2.2 percent of GNP) in 1978 to $4.2 billion in 1979 (6.4 percent of GNP) (Chart 6 and Table 13). Although the volume of merchandise exports fell by 1 percent, export receipts increased by 16 percent because of price increases. Since 1977, export growth had weakened markedly, reflecting a gradual erosion of external competitiveness, as well as a deceleration of the growth of export markets and intensified protectionism. Furthermore, investment policies during this period had neglected the traditional light industries, making it difficult for these industries to face increased competition from other developing countries. Demand for imports decelerated throughout the year as restrictive financial policies took hold. Nevertheless, the value of non-oil imports rose by about 27 percent, reflecting equal increases in volume and prices. The oil import bill rose by 45 percent, owing almost entirely to price increases, and reached $3.1 billion (equivalent to 16 percent of total imports). The external terms of trade remained relatively stable.

With a sharp deterioration in the external terms of trade in 1980, the current account deficit widened to $5.3 billion (8.7 percent of GNP). Although the volume of exports rose by 12 percent, export receipts rose only slightly faster than in 1979 (17 percent) because the rate of increase in export prices decelerated from 17 percent to 5 percent. Owing to restrictive demand management policies, the volume of non-oil imports contracted by about 16 percent and offset an increase in prices of about equal magnitude. However, the oil import bill rose by over 80 percent to $5.6 billion, owing entirely to a doubling of oil prices. The volume of oil imports, responding to policy measures and to the economic downturn, rose by less than 1 percent. The balance on invisibles payments (including transfers) swung from a small surplus in 1979 to a deficit of about $1 billion because of the rise in international interest rates.

Viewed from the investment-savings perspective, the worsening of the current account balance in 1979 largely reflected the sharp increase in the ratio of investment to GNP (from about 31 percent in 1978 to about 36 percent in 1979), which was associated with substantial accumulation of inventories. Gross national savings remained constant at 29 percent of GNP despite a moderate drop in the terms of trade and a slowdown in output growth. In 1980, the ratio of investment to GNP fell back to 31 percent, mainly because of a rapid drawdown of inventories; however, the ratio of savings to GNP fell even more steeply (to 23 percent) because of the substantial drop in the terms of trade and in real GNP, leading to the further deterioration in the current account position.

The widening of the current account deficit was accompanied by a sharp increase in external borrowing during 1979–80. Net capital inflows (of which a minimal part were direct investment inflows) rose from $2.1 billion in 1978 to $5.3 billion in 1979 and to $6 billion in 1980. In particular, net short-term inflows jumped from a negligible amount in 1978 to over $2 billion in 1979 and $4 billion in 1980 (Chart 7 and Table 14). As a result, Korea’s external debt rose by 80 percent during 1979–80 to almost $27 billion (42 percent of GNP), and the maturity structure of the debt shortened significantly. The sharp increase in short-term borrowing was partly the consequence of a relaxation of measures relating to short-term import credits with the purpose of helping to finance the sudden increase in the current account deficit. Also, the civil disturbances of mid1980 led to a postponement of medium and long-term borrowing. The gap that this postponement created was financed through short-term inflows, particularly by the banking system. In spite of the increase in external debt, gross international reserves rose only moderately during 1979–80. The ratio of reserves to imports fell from the equivalent of 3.2 months in 1978 to less than 3 months in 1979 and 1980, and the reserve cover of short-term debt fell from close to 140 percent in 1978 to about 70 percent in 1980.

Situation at the End of 1980

The period 1979–80 was a difficult one for Korea. A number of supply shocks buffeted the economy at a time when there was an urgent need to restore price stability and external competitiveness. The rise in world oil prices and the subsequent devaluation of the won contributed to a sharp acceleration of domestic inflation. At the same time the measures taken by the authorities to contain pressures on prices and the balance of payments depressed domestic demand. The contraction of domestic demand and the impact of supply shocks resulted in a decline in domestic output for the first time in Korea’s modern history. Still, the external current account deficit rose to a record level.

At the end of 1980, the Government faced difficult economic problems: an unsustainable external imbalance, rapidly rising external debt, a weak economy, and entrenched inflationary expectations. The external environment contained distinctly adverse elements: high and rising interest rates, weak demand, and intensifying protectionism. However, the policy actions taken during 1979–80 favorably positioned Korea to launch a successful stabilization effort. In particular, the adjustment of domestic oil prices to the new level of international prices had been accomplished and external competitiveness had been restored. Financial restraint, although contributing to the weakness of the economy, had helped to contain inflationary pressures and reversed the gap between increases in real wages and gains in productivity. Therefore, the situation at the end of 1980 presented important policy achievements, which were to be of great value in the period ahead as the authorities moved to close Korea’s external imbalance and restore growth and price stability.