Abstract

At the outset of 1981, the economic environment was characterized by relatively high unemployment, high levels of inventories, and excess capacity. The Government continued with its adjustment effort during 1981–82, but relaxed financial policies to counter the severe economic recession. Economic conditions improved significantly during this period as output rose by an annual average of about 6 percent, while the rate of inflation fell gradually to below 5 percent and the current account deficit to below 4 percent of GNP. Nevertheless, the adjustment process was by no means completed by the end of 1982. The economy still operated well below full capacity and the external financing requirements remained large—a particularly serious problem in light of the emerging international debt crisis.

At the outset of 1981, the economic environment was characterized by relatively high unemployment, high levels of inventories, and excess capacity. The Government continued with its adjustment effort during 1981–82, but relaxed financial policies to counter the severe economic recession. Economic conditions improved significantly during this period as output rose by an annual average of about 6 percent, while the rate of inflation fell gradually to below 5 percent and the current account deficit to below 4 percent of GNP. Nevertheless, the adjustment process was by no means completed by the end of 1982. The economy still operated well below full capacity and the external financing requirements remained large—a particularly serious problem in light of the emerging international debt crisis.

Policies

The adjustment program for 1981–82 was designed to restore economic growth, while reducing domestic inflation and the external imbalance. This program continued to be supported with a stand-by arrangement with the Fund (March 1981-February 1982) and a structural adjustment loan from the World Bank. The authorities adopted a more stimulative financial policy to revive the economy. The public sector deficit rose to over 4 percent of GNP, while domestic credit expansion slowed only moderately despite a sharp decline in inflation. Exchange rate policy was managed flexibly, although the real effective exchange rate appreciated somewhat and contributed to a weakening of exports. The Government’s structural policies focused on the public investment program, tax reform, and trade liberalization.

Fiscal Policy

Fiscal policy was used to stimulate aggregate demand in 1981. The budgetary impulse became expansionary as public sector expenditures were raised and taxes cut (Table 8).5 Largely as a result of expenditure increases, the consolidated public sector deficit rose from 3.2 percent of GNP in 1980 to 4.6 percent in 1981. Increased expenditures resulted from higher central government spending, greater purchases of rice by the Grain Management Fund to replenish stocks used after the 1980 crop failure, and extraordinarily large capital outlays in telecommunications.

Expenditure policy focused initially on increasing the tempo of public spending on rural projects so as to cushion the loss in agricultural incomes. Outlays for low-income housing and social overhead capital also were increased, partly to repair typhoon damage. Thus, the structure of expenditure shifted toward public capital formation and housing, and much of the fiscal stimulus was provided through net lending operations. Several temporary tax changes reinforced these expenditure measures. Income taxes for low-income workers were cut and special excise duties for selected consumer durables were reduced. A temporary investment tax credit was extended, as was the scheme to encourage additional investment by certain smaller firms. The larger overall deficit in 1981 resulted in significant increases in both foreign and domestic financing. The ratio of domestic financing to GNP rose from 2.3 percent in 1980 to 3.4 percent in 1981, largely reflecting an increase in bank financing (Table 7).

With the strengthening of the economy in 1982, fiscal policy was reined in so as to help correct the external imbalance and improve the price performance. Faced with large shortfalls in revenues, central government expenditure was cut to a level below the budgetary target—a step which was instrumental in reducing the public sector deficit to 4.3 percent of GNP.6 Expenditure restraint held central government outlays roughly unchanged as a proportion of GNP (22.5 percent). The tax to GNP ratio increased marginally as a result of the positive effects of a new education surtax and the underlying high elasticity of the tax system. The ratio of domestic financing to GNP declined from 3.4 percent in 1981 to 3 percent in 1982. Within domestic financing, bank financing was limited to 0.6 percent of GNP in 1982—compared with 2 percent in 1981—while nonbank financing rose by 1 percentage point to 2.4 percent of GNP. The ratio of foreign financing to GNP increased slightly to 1.3 percent in 1982.

Monetary Policy

The objective of monetary policy in 1981 was to support economic growth while securing a reduction in inflation and further external adjustment. Monetary policy accommodated increased bank borrowing by the public sector, which was associated with the stimulative stance of fiscal policy. Nevertheless, overall credit was sufficiently tight to help bring about a further reduction in domestically generated inflation and a decline in the current account deficit. The growth of domestic credit decelerated from 41 percent in 1980 to 31 percent in 1981. Credit to the public sector accounted for 19 percent of the overall increase in domestic credit, compared with 8 percent in 1980. With a substantial decline in net foreign assets, the growth of broad money slowed from 27 percent to 25 percent. However, as the rate of inflation fell sharply, the real stock of broad money rose by 12 percent in 1981, compared with a decline of 6 percent in 1980. The income velocity of money, which had risen in 1980 following three years of steady decline, fell slightly in 1981 in line with the deceleration in the rate of inflation. (The close association between the behavior of velocity and the real yield on deposits in Korea is shown in Chart 4.)

Monetary conditions in 1982 were dominated by a financial scandal in the unorganized money market (the curb market) in May, which forced two large corporations into default and threatened other firms with insolvency. Dishonored checks rose sharply; their value during May reached almost 8 percent of demand deposits. Confidence in nonbank financial intermediaries was shaken and the public withdrew large amounts of funds from nonbank financial markets. As a result, the ratio of bank deposits to currency rose by 11 percent in May 1982. Lending activities in nonbank markets were curtailed, creating severe liquidity problems for enterprises that depended heavily on these sources of finance.

To offset the contraction in nonbank lending and to avoid a generalized financial crisis, the Bank of Korea permitted a rapid expansion of bank credit and supported this expansion by sharply increasing reserve money. During the period May-September 1982, domestic credit expanded at an annual rate of 30 percent (seasonally adjusted); and reserve money grew at an annual rate of 48 percent (adjusted for seasonal factors and a change in reserve requirements). As the turmoil in financial markets subsided in the fourth quarter of 1982, expansion of domestic credit slowed to an annual rate of 18 percent (Table 4).

Table 4.

Korea: Selected Monetary Aggregates, 1982

(Percentage change)1

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Quarterly change at seasonally adjusted annual rates.

Adjusted for increase in reserve requirements.

Reflecting the less expansionary fiscal policy in 1982, credit to the public sector accounted for only 8 percent of the total increase in domestic credit, compared with 19 percent in 1981. The reduced borrowing requirements of the public sector in 1982 considerably eased the burden of reserve money management. In 1982, about 50 percent of the credit needs of the public sector was satisfied by the Bank of Korea in 1982, compared with about 85 percent in 1981. Credit to the private sector in 1982 grew at virtually the same rate as in 1981 (about 25 percent). The growth of broad money also accelerated in the second and third quarters, but slowed to 4 percent (annual rate) in the fourth quarter because of the sharp slowdown in the growth of net domestic assets, the large balance of payments deficit, and some reflow of funds to nonbank financial markets. For 1982 alone, broad money rose by 27 percent—slightly faster than the average rate of expansion for the period 1980–81. Income velocity of broad money fell by about 11 percent (compared with an average annual decline of about 3 percent during 1978–81), reflecting the increase in bank deposits after the curb market incident,7 higher real interest rates, and lower inflationary expectations (Table 5).

Table 5.

Korea: Velocity of Money, 1978–82

(Percentage change)

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Sources: Korean authorities; and Fund staff estimates.

Bank interest rates, which are under government control, were reduced during 1981–82, but these reductions were held to less than the decline in inflation so that real interest rates would become positive. The nominal interest rate on one-year time deposits was gradually reduced from 19.5 percent in early 1981 to 8 percent in the second half of 1982. After the sharp drop in inflation in 1981, real interest rates turned positive in the fourth quarter of 1981 and remained positive throughout 1982, averaging about 3 percent. Lending rates, which ranged from 12 percent to 17.5 percent in early 1981, were also reduced gradually to a uniform rate of 10 percent in mid-1982. The adjustment of interest rates was aimed at spurring investment by lowering interest costs of firms, while still maintaining a positive level of real interest rates. The lowering of domestic interest rates was faster and sharper than the decline in international interest rates, and a differential was opened in favor of foreign assets in 1982. This differential narrowed late in the year as foreign rates declined.

Preferential interest rates for priority sectors were eliminated in 1982, but directed loans remained an important feature of Korea’s financial system. A substantial part of directed lending continued to be channeled through the deposit money banks as well as the Korea Development Bank and other development institutions. In carrying out directed lending activity, banks either use their own funds, supported by rediscounting of eligible bills by the Bank of Korea, or act as a conduit for government lending funds. As part of an effort to improve the allocation of financial resources, the authorities reduced the share of directed loans in total loans from 20 percent in 1980 to 16 percent in 1982.

The monetary authorities, in early 1982, changed the instruments by which they conduct monetary policy. The Bank of Korea replaced direct credit control, exercised through ceilings on individual banks, with indirect control exercised through the instruments of reserve requirements, open market operations, and the rediscount mechanism. The system of preferential lending rates of commercial banks was eliminated in June 1982, and the rediscount rates of the Bank of Korea were unified. In addition, to permit banks more flexibility in their lending operations, the maximum loan period for working funds was extended from one year to ten years.

Exchange Rate Policy

The authorities pursued a flexible exchange rate policy during 1981–82 to preserve the external competitiveness of Korean producers. The effective exchange rate remained relatively stable as the won was allowed to depreciate by about 13 percent against the U.S. dollar. However, because domestic inflation exceeded foreign inflation, the real effective exchange rate appreciated by about 6 percent, contributing to the weak performance of exports in 1982.

Structural Policies

During 1981–82, structural policies were aimed at increasing the productivity and efficiency of the economy. These policies encompassed public sector investment, a comprehensive tax reform, and trade liberalization. The investment program was designed to support an increasingly urban and industrial economy. An important objective of the investment plan was to reduce dependency on imported petroleum by expanding domestic coal production and constructing electricity-generating plants powered by coal, liquefied natural gas, and nuclear fuel. To reinforce energy conservation, the Government passed through to domestic consumers only 30 percent of the $5 per barrel reduction in world oil prices in 1982. About 40 percent of the savings from the decline in world oil prices were earmarked for a special multipurpose fund to finance projects primarily in the energy sector. The remainder of the savings was absorbed by an import duty. Because basic needs for clothing and food had been largely met, housing became the centerpiece of the Government’s social development efforts. Housing construction was promoted by a combination of financial incentives to private investors and direct public sector investment.

Significant reforms of the tax system were introduced in 1981 as part of the overall policy of structural adjustment. These reforms included an increase in the separate tax for interest and dividend income, a simplification of the corporate tax structure, and an extension of the value-added tax. The 1982 tax changes were more sweeping and were aimed at both making the system more neutral with respect to resource allocation and increasing the tax effort. The new tax measures changed the tax status of corporations, modified certain deductions and tax incentives to favor small and medium-size firms, introduced tax credits to promote development of technology, reduced the number of industries that received tax advantages, and introduced a minimum tax on public corporations. In addition, individual income tax rates were reduced, and deductions for wage and salary earners and spouses were increased. The implementation of these measures was facilitated by the high elasticity of the taxes with respect to GNP (about 1.2), which ensured that adequate revenues were available for financing the Government’s development effort.

With the improved economic situation during 1981–82, the import liberalization drive was resumed following its lapse during the previous two years. This drive was aimed at improving the structure of industry by enhancing competition, stabilizing prices by increasing supplies, and facilitating trade negotiations with trading partners which restricted imports from Korea. At the same time, to avoid major disruptions in domestic production, selective use was made of import tariffs. Import restrictions were lifted on a large number of items during 1981–82, raising the ratio of unrestricted imports to total from 69 percent to 77 percent.

Economic Developments

Economic growth resumed in 1981, as real GNP rose by 6 percent. The recovery of agriculture and rapid expansion of exports dominated developments in aggregate output during 1981. Following the disastrous harvest of 1980, agricultural production rose by 22 percent in 1981, returning to the 1979 level. The volume of exports rose by 17 percent in response to both the devaluation of the won in 1980 and buoyant foreign markets. Domestic demand revived on the basis of an upturn in consumption and stimulative financial policies, but accounted for only one third of the overall growth in aggregate demand. Investment remained weak. Fixed investment in real terms declined for the second consecutive year, owing to the still fragile business confidence, depressed profits, and persistence of excess capacity, particularly in the heavy industry sector. Shipbuilding, automobiles, fertilizer, and cement industries were particularly affected. The recovery of aggregate demand and the shortage of grain supplies (arising from the crop failure of 1980) led to an increase of 6 percent in the volume of non-oil imports. The volume of oil imports, on the other hand, fell by 2 percent as a result of strong conservation and oil-substitution efforts.

During 1982, external demand weakened considerably as traditional export industries—textiles, shoes, wood, paper—suffered under the impact of the global recession and restrictive trade policies in the industrial countries, as well as some loss of external competitiveness. Nevertheless, the growth of real GNP remained at about 6 percent as domestic demand continued to exp and in response to stimulative financial policies. Fixed capital formation grew in real terms (by 13 percent) for the first time since 1979. The major factors contributing to this outcome were: (a) faster growth in the nonagriculture sector; (b) a cut in domestic interest rates; and (c) a decline in prices of imported raw materials and oil. Also, a brisk recovery in construction activity began in early 1982 because of government efforts to stimulate housing. These efforts included lowering the capital gains tax on houses, increasing the supply of housing sites, constructing low-income housing units, and expanding housing loans. Consumption continued to rise by about 4 percent in real terms as an acceleration in public consumption offset a slowdown in private consumption. With the return of agricultural output to normal levels, food grain imports were drastically reduced. The volume of non-oil imports rose by 6 percent, while the volume of oil imports declined by 1 percent, reflecting continued success of energy conservation policies.

Domestic inflation fell from a peak of 35 percent in 1980, to 13 percent in 1981, and 5 percent in 1982. The principal reasons for this fall were lower inflation abroad and a stable effective exchange rate. Prudent demand management, improved food supplies, wage moderation, and productivity gains also contributed to lower inflation. Price controls were eliminated in 1981 and replaced by a price monitoring system under which selected enterprises are required to report price increases to the Government.

With the decline in inflation, the growth of nominal wages decelerated from 23 percent in 1980, to 20 percent in 1981, and 15 percent in 1982. Real wages actually fell by 1 percent in 1981, while labor productivity increased by 18 percent. The unusually large growth of labor productivity reflected the fact that in the initial phase of economic recovery, firms increased production mainly by lowering excess capacity, rather than by increasing employment. The unemployment rate declined moderately from 5.4 percent in 1980 to 4.5 percent in 1981 because of a rapid increase in employment in services and in agriculture. Employment in manufacturing, however, continued to decline because of excess capacity. Real wages rose by 7 percent in 1982, about the same as labor productivity. The unemployment rate fell slightly in 1982, reflecting a more rapid expansion of nonagricultural output and a rise in domestic investment; manufacturing employment rose significantly.

The external position improved steadily during 1981–82. The current account deficit declined to $4.6 billion (6.9 percent of GNP) in 1981, as the vigorous expansion of exports (20 percent) more than offset the increase in imports (12 percent), the continued growth in interest payments, and a small deterioration in the external terms of trade. The moderate growth of imports represented a significant adjustment effort in view of the exceptionally large rice imports (equivalent to 1 percent of GNP) that were necessitated by the 1980 crop failure. In 1982, the current account deficit was almost halved to $2.6 billion (3.7 percent of GNP), despite stagnating exports. The main factors contributing to the improvement in the current account were a sharp decline in import prices (8 percent) and a further slowing of the volume growth of imports. The narrowing of the current account imbalance during 1981–82 reflected a gradual decline in the ratio of gross domestic investment to GNP. The ratio of gross national savings to GNP remained relatively stable.

With the gradual decline in external financing requirements, the growth in Korea’s external debt, which had averaged about 35 percent per annum during 1979–80, slowed to about 16 percent during 1981–82. Nevertheless, outstanding external debt rose by close to $10 billion, reaching $37 billion (52 percent of GNP) at the end of 1982; the associated debt service ratio rose from 20 percent to 21 percent. Short-term debt rose by 15 percent per annum during 1980–82; its share in total debt remained at around 34 percent. A large portion of the increase in short-term debt was trade-related, including such obligations as trade credit and oil bills. Reflecting the elimination of advance deposits on deferred-payment imports, the share of trade-related credit in total short-term debt rose from 30 percent in 1980 to 38 percent in 1982. A significant portion of the increase in short-term debt was in the form of interoffice accounts of local branches of foreign banks and credit lines of domestic banks with foreign banks. This development reflected both reduced nonbank capital inflows due to lower domestic interest rates and limited availability of medium and long-term loans during 1982, as Korea’s access to the international capital market was hindered by the global debt crisis. Gross international reserves rose by about $0.8 billion and stood at $7.7 billion by the end of 1982; in terms of imports, gross reserves remained stable at around 2.9 months. The ratio of reserves to short-term debt declined from 73 percent in 1980 to 58 percent in 1982.

Situation at the End of 1982

By the end of 1982, the Korean economy had made substantial headway in overcoming the economic crisis of 1980. The progress in reducing the rate of inflation and the current account deficit was particularly noteworthy. Korea’s growth outcome of about 6 percent a year was satisfactory in comparison with the growth rates in other developing countries, but fell well below Korea’s historical performance. The gradual weakening of the export sector was of particular concern in view of Korea’s large external debt and the emerging crisis in the international capital market.

Notwithstanding the significant reduction in the current account deficit, Korea’s borrowing during 1980–82 was substantial. Although Korea’s debt-servicing obligations remained consistent with its capacity to earn foreign exchange, the level of its outstanding debt was high in an international context. Commercial banks became increasingly reluctant to raise their exposure limits, mainly because of the fallout from the financial crisis in Latin America as well as in Asia. In this environment, the high level of short-term debt, particularly in relation to international reserves, became an increasing source of concern.