Korea
Selected Issues
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This Selected Issues paper on Korea provides background information on economic developments and policies, with particular emphasis on 1995–96. Following two years of rapid expansion, led by buoyant investment and exports, economic growth moderated in late 1995 and the first half of 1996. The moderation was in response to the earlier tightening of monetary conditions and less favorable short-term export prospects. The slowdown was reflected in a sharp deceleration in final domestic demand, whose contribution to growth fell from 9.1 percent in 1995 to 6.6 percent in the first half of 1996.

Abstract

This Selected Issues paper on Korea provides background information on economic developments and policies, with particular emphasis on 1995–96. Following two years of rapid expansion, led by buoyant investment and exports, economic growth moderated in late 1995 and the first half of 1996. The moderation was in response to the earlier tightening of monetary conditions and less favorable short-term export prospects. The slowdown was reflected in a sharp deceleration in final domestic demand, whose contribution to growth fell from 9.1 percent in 1995 to 6.6 percent in the first half of 1996.

I. Recent Economic Developments

This chapter provides background information on recent economic developments and policies, with particular emphasis on 1995-96. It begins with an overview of developments in aggregate demand and prices, followed by a discussion of monetary and fiscal developments. The chapter concludes with an overview of the external sector.

1. Aggregate demand, output, and prices

Following two years of rapid expansion, led by buoyant investment and exports, economic growth moderated in late 1995 and the first half of 1996. The moderation was in response to the earlier tightening of monetary conditions and less favorable short-run export prospects. The slowdown was reflected in a sharp deceleration in final domestic demand, whose contribution to growth fell from 9.1 percent in 1995 to 6.6 percent in the first half of 1996 (see Table I-1). 1/ This was cushioned by a somewhat larger growth contribution from net foreign demand (1.2 percent in the first half of 1996 compared to 0.5 percent in 1995) as export volumes continued to grow rapidly. Total domestic demand behaved in a similar way to final demand, and stockbuilding, a generally volatile demand component, made only a small negative contribution to growth in both 1995 and the first half of this year.

Table I-1.

Korea: Contributions to Growth, 1993-96 1/

(In percent; year on year)

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Sources: Bank of Korea; and staff estimates.

The sum of components may not add to totals due to rounding.

Among the components of domestic demand, investment has shown the biggest deceleration while consumption has remained relatively strong. After growing at double-digit rates in 1994-95, investment slowed in the fourth quarter of 1995 and posted growth of 5.7 percent in the first half of 1996 (Statistical Appendix Table 1). Construction and equipment investment exhibited divergent patterns. Construction investment remained quite strong in 1996, recording growth of 7.2 percent in the first half of the year (against 9.9 percent in 1995), supported by a doubling of the value of construction orders in the public sector. Equipment investment growth slowed from 16.1 percent in 1995 to 3.8 percent in the first half of 1996, reflecting an adjustment to the large capacity buildup in recent years as well as the less favorable export outlook.

Private consumption contributed 4.0 percent to growth in the first half of 1996, broadly similar to 1994-95. Consumption of durable goods and services was especially strong. Public consumption of goods and services picked up in early 1996, but its growth contribution remained small. The contribution of domestic consumption was 4.5 percent in the first six months of 1996, essentially the same as in 1994-95.

Notwithstanding the less favorable external conditions, the growth contribution of net foreign demand in the first half of 1996 exceeded that in the previous year, as export volumes continued to increase more rapidly than GDP and import growth slowed following the deceleration in investment. Exports of goods and nonfactor services recorded 17.4 percent growth in the first half of 1996, only moderately slower than in 1995. Imports of goods and nonfactor services increased by 14 percent (compared to a 22.1 percent growth in 1995), reflecting in part relatively robust private domestic consumption. Imports of consumer goods rose significantly faster than total imports in the first half of 1996.

The saving-investment balance has been characterized in recent years by a pronounced upward trend in investment, with its share in GDP reaching 37 percent in 1995 (see Table I-2 below and Statistical Appendix Table 2). With the saving ratio broadly stable, the higher investment rate led to a widening of the current account deficit. As a result, foreign saving rose to over 5 percent of Korea’s investment in 1995 and, according to staff estimates, increased further to 10 percent in the first half of 1996. The stability in domestic saving in recent years has masked a decline in private saving offset by higher public saving. Reflecting conservative budget policy, the share of public saving in GDP increased steadily from 7.7 percent in 1992 to 10 percent in 1995. Private savings decreased from 27.4 percent to 25.1 percent of GDP over the same period.

Table I-2.

Korea: Investment and Saving, 1990-95

(In percent of GDP)

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Sources: Bank of Korea; and staff estimates.

Adjusted national savings is derived residually to ensure consistency between the domestic savings/investment balance and the current account.

Including public enterprises.

Central and local government and social security funds.

Equivalent to the current account balance (including net transfers).

Slower export growth and cutbacks in investment contributed to weaker industrial output growth in the first half of 1996, notably in manufacturing and construction (Statistical Appendix Table 3). Manufacturing output grew by 7.1 percent in the first half of 1996 compared to 10.7 percent in 1995. Reflecting moderating demand growth, capacity utilization in the manufacturing sector began to ease in the second quarter of 1996. Consistent with recent trends, production capacity continued to decline in labor-intensive light industries in 1996, contributing to a further shift in the composition of manufacturing output away from these industries.

Construction growth decelerated from 9.8 percent in 1995 to 6.9 percent in the first half of this year, reflecting inter alia weak housing demand. According to the Economic Plan for 1993-97, over 1.9 million housing units had been constructed in 1993-95. As of end-June 1996, almost 7 percent of these remained unsold, contributing to a decrease in the number of units under construction in the first half of 1996 compared to the same period a year ago. The continued relatively strong growth of construction output, though at a slower pace than in 1995, reflected mainly public spending on infrastructure projects (Statistical Appendix Table 4).

Utilities remained buoyant in 1996. The growth of value added in this sector was 10.3 percent in the first six months (year-on-year), practically unchanged from 1995. Growth in the service sector slowed, but outstripped overall economic growth in the first half of 1996. The structure of production within this sector has been gradually changing over time. Certain services, such as industrial infrastructure (transportation and. communication), supported in part by government-financed projects, posted double-digit growth in the first half of 1996, as in 1994-95. On the other hand, financial services, which for the decade prior to 1994 exhibited high growth, have been recovering from the short-term negative effects associated with the introduction of the “real name” system in 1993, and grew by 7.3 percent in the first half of 1996. Agricultural output in the first half of 1996 was only a shade above the level a year ago, reflecting mainly adverse weather conditions.

Consumer price inflation edged up in the first half of 1996 to 5.0 percent (year-on-year) from 4.5 percent in 1995 (Statistical Appendix Table 5). Prices of manufactured consumer goods picked up the most (from 2.6 percent in 1995 to 4.1 percent in the first half of 1996), reflecting the delayed pass-through effect of earlier increases in producer prices. The rate of growth of the services component of the CPI also edged up (from 6.8 percent in 1995 to 7.4 percent in the first half of 1996), in part due to increases in government-administered prices. The CPI was influenced by less favorable agricultural price developments. Producer price inflation, which had accelerated to 4.7 percent in 1995 as a result of the pass-through of import-price increases, slowed to 2.4 percent in the first half of 1996.

Land prices, which declined in 1993-94 following the adoption of measures to discourage land speculation, stabilized in 1995 and edged up in the first quarter of 1996 (Statistical Appendix Table 6). However, average residential, commercial and industrial land prices are still lower than in 1991. Housing prices also stabilized in 1995 and posted a 0.3 percent increase in the first six months of 1996, mainly due to an increase in prices in rural areas. Unlike land and housing prices, rental costs continued increasing between 1994 and 1995, on average by 3 1/2 percent a year. Average rental costs further increased in the first six months of 1996 by 4.4 percent.

In line with the slowdown in growth, gains in employment slipped to 1.8 percent in the first half of 1996, after posting 2.7-3.0 percent annual rates of growth in the previous two years (Statistical Appendix Table 7). At the end of 1994-95, the labor market was very tight with vacancies accounting for 3.7 percent of jobs available and the unemployment rate at 2 percent. In the first half of 1996, overall unemployment edged up to 2.1 percent with some decline in the participation rate partially offsetting the slowing of employment gains.

Employment growth during the expansion was unevenly spread across industries. Employment in construction, and services and public utilities increased twice as fast as overall employment (by 5-6 percent a year), while that in manufacturing expanded moderately. Employment in the agricultural sector has continued to decline in recent years in line with longer-term trends. In the first half of 1996, manufacturing employment contracted by 2 percent, primarily in traditional labor-intensive industries. The loss was, however, more than outweighed by job creation in construction, services and utilities.

Despite increasing tightness in the labor market, wage increases (in nominal and real terms) have been relatively moderate in recent years. Wage growth in the nonagricultural sector in 1995 declined to 11.2 percent, down from 12.7 percent in the preceding year. The moderation was uneven among the industries: wage growth in manufacturing and construction slowed to 9.9 percent and 9.0 percent, respectively, while in services (except for social and personal) wage increases accelerated, with increases ranging from 12.1 percent to 14.6 percent. In 1994-95, wage increases exceeded productivity gains, though the gap was narrowing compared to previous years, while actual earnings continued to surpass negotiated wage settlements by a substantial margin. The share of nonwage benefits has recently been increasing with the nonwage component of total labor costs rising from 18.3 percent in 1990 to 24.6 percent in 1994 (the last year for which data are available). The growth of wages edged up somewhat early in 1996, reflecting in part the carryover of bonus payments from the previous year.

2. Monetary policy and developments

Monetary policy in Korea is implemented within the framework of annual target ranges for the M2 aggregate on a December-over-December basis. Policy has been handled flexibly during the course of the year in order to accommodate shifts in money demand. The end-year targets, however, have generally been met, adding credibility to the monetary policy framework.

Monetary developments in 1995-96 have been broadly consistent with the government’s objectives to lower underlying inflation and achieve a soft landing. Growth of the broad monetary aggregate M2 in 1995, although relatively high at the beginning of the year, slowed steadily to 13.7 percent by end-December, well within the target range of 12-16 percent (Chart I-1 and Statistical Appendix Table 8). 1/ Other monetary aggregates, such as MCT (an augmented version of M2) and M3 showed a similar trend. 2/ Specifically, MCT growth declined from 23.7 percent in January 1995 to 21.6 percent in December 1995, while M3 growth declined from 24.7 percent at end-1994 to 19.1 percent at end-1995 (Chart I-2). 3/

CHART I-1
CHART I-1

KOREA: M2 GROWTH AND TARGET RANGES, 1991-96

(12-month percentage change) 1/

Citation: IMF Staff Country Reports 1996, 136; 10.5089/9781451822021.002.A001

Source: Bank of Korea; and staff calculations.1/ Monthly averages.
CHART I-2
CHART I-2

KOREA: DEVELOPMENTS OF MAJOR MONETARY AGGREGATES, 1991-96

(Percentage change, 12-month basis)

Citation: IMF Staff Country Reports 1996, 136; 10.5089/9781451822021.002.A001

Source: Bank of Korea.

Growth in the narrow monetary aggregate M1 has been slower than in the broader monetary aggregates in recent years. After reaching 12.7 percent at end-1995, Ml growth slowed to 8.9 percent in July 1996. Growth in reserve money, after peaking in 1993, declined to 11.3 percent by end-1995 and to 8.9 percent in April 1996. In April, the Bank of Korea (BOK) reduced the average reserve requirement ratio from 9.4 percentage points to 7.4 percentage points. The reduction was sterilized and reserve money recorded negative 12-month growth in May (Statistical Appendix Table 10).

While deposits with the deposit money banks (DMBs) continued to grow during 1995-96, in part due to the subdued real estate and stock market, there have been large portfolio shifts between these deposits and bank trust accounts (Chart I-3). These were particularly large in 1996 following an increase in the minimum maturity of bank trust account deposits. 4/ Time and savings deposits, historically the largest components of deposits, increased by 14 percent by end-1995, 6 percentage points lower than in 1994 but their growth started to pick up after March 1996. On the other hand, deposits in banks’ trust accounts, after increasing substantially in 1995, were relatively flat after March this year.

CHART I-3
CHART I-3

KOREA: BANK DEPOSITS, 1992-96

(12-month percent change; end of period)

Citation: IMF Staff Country Reports 1996, 136; 10.5089/9781451822021.002.A001

Sources: Bank of Korea; and staff estimates.

Monetary policy in 1996 has been complicated by these large portfolio shifts from trust accounts into other assets, including deposits in the DMBs. 5/ M2 growth averaged 14 percent in the first four months of 1996--well within the target range--but picked up after May, rising to 16.3 percent in June and further to 17.1 percent in July. The magnitude of the portfolio shifts by the end of July is estimated to have been about 2.5 percent of M2. 1/ Broader monetary aggregates such as MCT and M3 do not appear to have been much affected by these portfolio shifts. MCT growth rose only slightly to 22.6 percent in June from 21.6 percent in December 1995, while M3 growth was 19.4 percent in May compared to 19.1 percent at end-1995.

The velocities of the major monetary aggregates have been declining as the result of the continuing process of financial deepening. The income velocities of broader monetary aggregates such as MCT and M3 have showed sharper declines compared with those of Ml and M2 (Table I-3). Moreover, portfolio shifts between various money assets have resulted in sharp fluctuations in the short-term velocity of these aggregates. Since 1994, while the velocities of MCT and M3 continued to decline sharply, the decline in M2 velocity was below trend. The velocity of Ml increased, however, as a result of the shifts of funds out of M2 into M3 assets such as CDs and money in trust.

Table I-3.

Korea: Trends in Velocities of Major Monetary Aggregates, 1992-96 1/

(Twelve-month percent change)

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Sources: Bank of Korea; and staff estimates.

Velocities are calculated using the GDP deflator to measure the growth of prices. In Chapter II below, alternative measures of velocity are calculated using the CPI, but in general these behave quite similarly.

With regard to the sources of reserve money growth, increases in the net foreign assets (NFA) of the BOK continued to be the main contributor during 1995-96, partly offset by a continued fall in net domestic assets. Reserve money growth (12-month average basis) slowed to 11.3 percent in December 1995 from 13.6 percent in December 1994. In the first seven months of 1996, despite large increases in the BOK’s NFA, reserve money growth fell sharply following the sterilization of the April reduction in average reserve requirements. This reduction was intended to improve banks’ profitability and competitiveness vis-à-vis nonbank financial institutions. According to estimates, the lower reserve requirement added additional liquidity of about W 2,700 billion to the banking sector. This was sterilized by the issuance of monetary stabilization bonds (MSBs) (Table I-4).

Table I-4.

Korea: Factors Affecting Reserve Money Growth, 1992-96

(Year-on-year percent change in initial stock of reserve money)

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Sources: Bank of Korea; and staff estimates.

The sources of broad money (M2) growth changed during 1995-96 (Table I-5). While domestic credit continued to be the main contributor, accounting for 90 percent of the increase in M2, the contribution of NFA increased. In the first five months of 1996, NFA accounted for almost 60 percent of the growth in M2, mainly due to the surge in capital inflows in the first half of the year, related to the April increase in the ceiling for nonresidents holdings of domestic equities. 1/ These inflows were in part sterilized by the issuance of monetary stabilization bonds (MSBs). The money multiplier, while remaining stable during the period 1993-95, increased sharply in 1996, as both the reserve requirement ratio and the currency deposit ratio declined.

Table I-5.

Korea: Contributions to Broad Money Growth, 1992-96

(Year-on-year percent change in initial stock of broad money)

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Sources: Bank of Korea; and staff estimates.

Domestic credit growth has tended to moderate in line with the slowing in economic activity. In particular, domestic credit growth slowed from 18.5 percent in 1994 to 14.1 percent in 1995, followed by a slight pickup to 16.5 percent in June 1996. Growth in credit to the private sector, after peaking in 1994, fell to 16.3 percent in 1995 and moderated a little further in the first half of 1996 (see Statistical Appendix Table 8).

The slowdown in economic activity has been accompanied by downward movements in market-determined interest rates (Statistical Appendix Tables 11 and 12). The yield on three-year corporate bonds has declined since the beginning of 1995 and at end-April 1996 was at the same level as at the beginning of the current business expansion (Chart I-4). Money market interest rates showed a similar pattern, albeit with greater volatility. Movements in the yield on 90-day CDs have closely followed movements in the yield on three-year corporate bonds. Overnight call market rates dropped by almost 6 percentage points between January 1995 and April 1996. In addition to slower economic growth, capital inflows due to capital market liberalization may have contributed to the fall in interest rates, although the evidence for such a link is weak (see Chapter IV below). While yields on three-year corporate bonds have remained relatively flat since April 1996, short-term interest rates (such as the call market rate and the 90-day CD rate) rose sharply in May and June. Short-term money market rates increased by more than 2 percentage points in that period, reflecting tighter liquidity as companies were affected by lower profitability due to weaker export sales.

CHART I-4
CHART I-4

KOREA: SELECTED MARKET-DETERMINED INTEREST RATES, 1991-96

Citation: IMF Staff Country Reports 1996, 136; 10.5089/9781451822021.002.A001

Source: Bank of Korea.

Developments in bank interest rates during 1995-96 are to be viewed against the background of continuing financial sector deregulation. Since 1993, progress has been made with the implementation of a comprehensive albeit gradual program of financial sector reform. The formal deregulation of most lending and deposit rates--the core of the reform program--is almost complete, regulations concerning banks’ lending portfolios and restrictions on short-term financial instruments have been eased, policy-based lending has been scaled back, and reliance on market-based instruments of monetary control has increased. 1/ Interest rates on general loans and long-term deposits were deregulated in November 1993, and most interest rates on short-term deposits, the main exception being those on demand deposits, were deregulated in 1995. 2/

Despite the recent interest rate liberalization, deposit and lending rates of banks have remained relatively sticky. These rates, except those on overdrafts, have not displayed a close relationship with movements in the money supply or key market-determined interest rates (Chart I-5). The apparent stickiness of these interest rates after liberalization has raised concerns about the extent to which the reforms introduced so far have effectively taken hold.

CHART I-5
CHART I-5

KOREA: SELECTED INTEREST RATES ON BANKS’ DEPOSITS AND LOANS, 1991-96

(x denotes the date when the rate was deregulated)

Citation: IMF Staff Country Reports 1996, 136; 10.5089/9781451822021.002.A001

Source: Bank of Korea.

3. Fiscal policy and developments

The fiscal situation in Korea is sound as a result of a long tradition of fiscal conservatism. Over the years, fiscal expenditure, which is relatively low by international standards, has been kept broadly in line with revenue, resulting in relatively low levels of government debt and high government saving. Taking into account its financial assets, the government has been a net creditor in recent years.

The general government and nonfinancial public enterprises constitute the nonfinancial public sector in Korea. The general government consists of the consolidated central government and local governments. The central government finances comprise the general account and several special accounts and funds; those of the consolidated central government include in addition four public-enterprise special accounts (Statistical Appendix Table 13). 3/ The budgetary approval process involves the consolidated central government excluding the special budgetary funds. 4/ Local governments have limited fiscal autonomy, with the center playing an important role in their budgetary process. The operations of nonfinancial public enterprises are financially independent of the budget, which includes only transfers to and from these enterprises, notably through the above-mentioned public-enterprise special accounts.

Fiscal developments in recent years have continued to be favorable. The budget balance of the consolidated central government has been in small surplus since 1993, and the financial balance averaged a surplus of 2 percent of GDP during 1992-95. 1/ The primary balance has been slightly smaller than the budget balance, averaging a 1/4 percent of GDP during 1992-95. 2/ Despite the increase over the years in the number of tasks assigned to the budget, the ratio of total budgetary expenditure (including net lending) to GDP remains low by international standards (20 1/2 percent). A modest rise in the expenditure ratio has been financed by a parallel rise in revenues. 3/ Central government saving, high to begin with, has risen markedly: from 3 1/2 percent of GDP in the 1980s to 6 percent by 1995. 4/ Gross debt of the central government has fallen by half since the 1980s, to 7 percent of GDP (Statistical Appendix Table 14). 5/ At end-1995, the nominal interest rate on government bonds was just over 10 percent per year (the average corporate bond rate was just under 12 percent).

During 1995 and 1996, fiscal policy has been broadly neutral. In 1995, the overall balance was roughly unchanged from 1994, and somewhat higher than envisaged in the budget (Table I-6). An even stronger outcome was preempted by additional expenditure (equivalent to 1/4 percent of GDP), half of which was related to disaster relief, in a supplementary budget late in the year. The fiscal and structural impulses--measuring the change in the fiscal stance and the change in the fiscal stance adjusted for cyclical effects, respectively--were quite small at 0.3 percent of GDP. The 1996 budget envisaged a small deficit, but preliminary indications suggest that revenue and expenditure are likely to be in approximate balance.

Table I-6.

Korea: Operations of the Central Government and Consolidated Central Government, 1992-96 1/

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Source: Data provided by the Ministry of Finance and Economy.

The central government comprises the General Account, Special Accounts, and Special Budgetary Funds. The consolidated central government comprises the central government and Public Enterprise Special Accounts.

Figures for the 1995 and 1996 budgets are relative to the budget for the previous year.

Central government revenues in Korea consist primarily of tax receipts (86 percent), with small contributions from nontax and capital revenues (Statistical Appendix Table 15). Tax revenues comprise, in order of importance, taxes on goods and services (indirect taxes), taxes on corporate and individual income (direct taxes), social security contributions, trade taxes, and several smaller taxes.

In recent years, the share of revenue in GDP has increased steadily. During the period 1992-95, the revenue ratio increased by 2 1/2 percentage points to 20 1/2 percent, mainly reflecting an increase in the tax ratio. Revenue from income-related taxes was markedly higher, as a result of a rise in social-security contributions and in individual income-tax revenue (despite the relatively high threshold and wide lower brackets of the individual income tax). Taxes on goods and services accounted for a smaller part of the increase in the tax ratio. The 1996 budget envisaged a further small rise in the revenue and tax ratios, notwithstanding a small negative impact expected from the ongoing medium-term tax-reform program (discussed below). Preliminary indications suggest that revenues may turn out slightly stronger than envisaged, in part because of higher customs duties and value-added tax (VAT) revenue due to the exchange rate being lower than the budget anticipated.

The multiyear tax reform program, originally intended for the period 1993-97, is currently being implemented and will continue into the medium term. The main objectives are to gradually increase reliance on direct taxes, and to increase efficiency and horizontal equity, by broadening the tax base while reducing tax rates. Since the program was initiated, the share of income taxes in total taxes has, however, stayed roughly constant (at 36 percent) and the share of indirect taxes has declined slightly (to 37 percent). Initial measures have focused on reducing tax rates--but the broadening of the tax base has been limited, partly as a result of the continued prevalence of a variety of tax exemptions--entailing a slightly negative impact on revenues.

In 1995-96, several tax measures were implemented as part of the reform program. 1/ Key among them were the following. The individual income tax base was expanded to include all financial income and its tax brackets were widened. Interest and dividend earnings, which were previously taxed according to a separate schedule, were incorporated into the global income-tax base in 1996. 2/ The income-tax brackets were widened by raising the upper limit of each of the main brackets--the threshold for the maximum rate (40 percent), for example, was raised from W 60 million to W 80 million. The corporate income tax rate was reduced by 2 percentage points in both 1995 and 1996. The exemption limit for the VAT was doubled to W 24 million (annual turnover), and the compliance costs for small businesses were reduced. The number of special excise taxes was reduced from six to three, and the top rate reduced from 60 percent to 25 percent.

A key medium-term fiscal objective is to raise the tax ratio. The intention is for the general-government tax ratio (excluding social security contributions) to rise from 20 3/4 percent in 1995 to 23 1/2 percent by early next decade. The increase is to be achieved partly through the eventual broadening of tax bases in the context of the tax-reform program, reductions in tax exemptions, and strengthening tax administration.

Fiscal expenditure in Korea focuses largely on traditional state activities--provision of public goods and social and economic services--and less on income transfers and (given the government’s strong financial position) debt service (Statistical Appendix Table 16). The provision of general public and economic services (including general administration, transportation and communications infrastructure, and maintaining law and order), defense, and education account for nearly 70 percent of fiscal expenditure. Social expenditures have a much smaller share--social security and housing, for example, account for less than 10 percent each of total expenditure, and health services for less than 1 percent--and interest payments (gross) are small. 1/ In terms of the economic classification of expenditures: current and capital expenditure together account for nearly 90 percent of total expenditure, and net lending for just over 10 percent (Statistical Appendix Table 17).

The ratio of total expenditure to GDP has increased moderately in recent years. This has reflected the increasing number of tasks assigned to the budget and the government’s program to increase by a significant margin spending on “social-overhead capital” (SOC), including infrastructure investment and education spending. During 1992-95, total expenditure increased by 1 1/2 percentage points of GDP; this change was the net result of a rise in education and public and economic services (including infrastructure investment) spending of 2 1/2 percentage points of GDP, a reduction in defense spending of 1/2 percentage point of GDP, and a combined reduction in other spending of 1/2 percentage point of GDP. In economic terms, the rise in the expenditure ratio essentially reflected an increase in capital expenditure, as an increase in net lending was almost totally offset by a reduction in current expenditure.

The 1996 budget envisaged a marginal rise in the expenditure ratio, reflecting mainly an increase in spending on economic services, along with some increase in education spending, a further small reduction in defense expenditure, and a reduction in other expenditure. The rise in the expenditure ratio was intended to entail slight increases in the shares in GDP of capital and current expenditure and unchanged net lending.

The national pension fund, the largest of the four pension funds in Korea, was established in 1988. 1/ Initially the pension fund covered all workers in firms that employ five or more people; in 1995, it was expanded to include, on a compulsory basis, the rural self-employed and farmers, and, on a voluntary basis, the urban self-employed and workers in firms that employ fewer than five people. The total contribution rate (by both employer and employee) was initially 3 percent of salary; in 1993 it was raised to 6 percent. 2/ The scheme requires participants to make a minimum of 15 years of contributions in order to qualify for pension payments; after 40 years of contributions, the benefit amounts to 80 percent of the reference salary. 3/ Given the 15-year minimum period, and the lack of retroactivity, pension payments will not be made before 2003.

In the interim, the fund has been running surpluses, which, while small initially, have averaged 1 1/4 percent of GDP annually in recent years (Statistical Appendix Table 18). 4/ The surpluses have gone toward government investment in priority areas and purchases of financial securities. In 1995, the surplus of the fund was equivalent to 1 3/4 percent of GDP, and was put to three uses: nearly three-fourths was invested in the public sector, and nearly one-fourth in the financial (“banking”) sector, with a very small share invested in welfare projects. Investment in the public sector was partly (two-thirds) done via the Fiscal Investment and Financing Special Account (FIFSA), whence it went mainly toward SOC investment, and partly via direct purchases of public-sector (public-enterprise and government) securities. The remainder of the surplus (one-fourth of the total) was used for buying corporate bonds and equities. The average rate of return to the pension fund was about 12 percent (nominal terms), close to the market rate. 5/

Local government consists of three tiers: provinces and autonomous cities, counties or cities in the provinces and districts in the autonomous cities, and towns or villages. The local government finances are sound, although data limitations hinder timely analysis of this sector. 6/ During 1991-94, local government revenue and expenditure both amounted to about 12 percent of GDP and the fiscal position of local governments was in approximate balance. 1/ The fiscal balance recorded a deficit in 1992-93, before rising strongly into surplus in 1994 reflecting a rise in nontax revenue (and, to a smaller extent, in tax revenue) as well as a reduction in expenditure (Statistical Appendix Table 19). 2/ Given positive, albeit small, local-government net lending, the financial balance was higher than the budget balance.

Local governments are assigned a prominent role in national expenditure in two key areas: public administration and social and economic services. They are responsible for nearly half of general government spending on public administration; for nearly 90 percent and over 70 percent of spending on education and social security, respectively; for 55 percent of spending on housing and community development; and for over half of spending on economic services.

While the autonomy of local governments has increased in recent years, this has related more to administrative than to economic autonomy, and not to a loosening of central control over local budgets. 3/ As noted above, central transfers are a significant part of local revenues; in addition, while local budgets need to be approved only by local councils, local borrowing plans need to be approved by the Ministry of Home Affairs and, de facto, by the Ministry of Finance and Economy. Moreover, for the few taxes that are designated as local taxes, the base rates are determined by the center and are uniform throughout the country. 4/

Nonfinancial public enterprises in Korea can be divided into four categories, based on the degree of independence and government ownership in each. 5/ “Government enterprises” are wholly owned by the government, and their finances are unified with the budget through the above-mentioned public-enterprise special accounts. 1/ Enterprises in the remaining three categories operate on a commercial basis outside the budget, principally in the public utilities, manufacturing, and transport, storage, and communications sectors. “Government-invested enterprises” (GIEs) and “government-funded enterprises” are those in which the government holds at least 50 percent and less than 50 percent of the outstanding equity, respectively. Finally, subsidiary companies of GIEs are also considered to be public enterprises. The largest category is the GIEs: there are currently 18 of them; 2/ in 1995, their sales amounted to around 10 percent of GDP and their investment to 10 percent of gross domestic fixed investment (Statistical Appendix Table 20). 3/

The past ten years have seen the formulation and partial implementation of two public-enterprise privatization programs. In 1987, the government introduced a privatization plan which envisaged full privatization of those enterprises that had fulfilled the objectives for which they had been established, and partial privatization of several other enterprises. The objectives of the plan were partially met, but the number of companies completely privatized was small. In December 1993, a new privatization program was announced, which envisaged that 58 among 133 public enterprises would be privatized during the period 1994-98. As of mid-1996, 16 had been privatized and 6 were in the process of being privatized. It is intended for the program to continue into the medium term.

4. External developments

The major recent external development has been the sharp widening of Korea’s current account deficit, initially in tandem with the rapidly growing economy, but more recently mainly as a result of adverse developments in the terms of trade. The positive response of capital inflows to the further relaxation of controls has nevertheless implied that the current account deficit has been comfortably financed.

The external current account deficit doubled in size in 1995 to 2.0 percent of GDP (Table I-7), primarily on account of a less favorable invisible trade and transfers balance, but the trade deficit also widened. Exports surged in 1995, recording U.S. dollar growth of over 30 percent (Statistical Appendix Table 23), albeit exaggerated by the weakness of that currency during the year. Nevertheless, stimulated by the favorable won/yen exchange rate, export volumes increased by 24 percent over 1995 and Korea continued to increase its share in world markets (Table I-8). Due to a boom in domestic equipment investment, import volumes also grew strongly in 1995, and given a terms of trade loss of 4 1/2 percent, the trade balance deteriorated slightly to a deficit of 1 percent of GDP. The decline in the balance on services and transfers in 1995 was more significant (Statistical Appendix Table 24); contributing factors included payments for transportation, royalty payments, and overseas remittances.

Table I-7.

Korea: Balance of Payments, 1993-96

(In millions of U.S. dollars)

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Sources: Bank of Korea, Monthly Balance of Payments; and IMF, International Financial Statistics.

Including gold; end of period.

Table I-8.

Korea: Export Market Shares, 1980-95

(In percent of total imports by region or country)

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Sources: IMF, Direction of Trade Statistics.

In the first six months of 1996, the current account deficit widened further. Export volumes continued to grow robustly but sharp falls in unit values of key exports, primarily semiconductors, and also chemical and steel products after April, began to depress export earnings. The effect on the trade balance of the declining terms of trade, 7 percent on average in the first half of 1996, 1/ was partly offset by lower import volume growth associated with the slowing economy. Meanwhile, increased travel by Koreans abroad, as well as further rises in royalty payments and private transfers, led to an increasing deficit on the services and transfers components of the current account. The current account deficit reached 1.9 percent of GDP through June, compared to 1.3 percent of GDP in the comparable period in 1995.

The boom in export volumes in 1995 was driven by rapidly expanding heavy industry exports, notably machinery and equipment, electronic products (including semiconductors) and motor vehicles. In volume terms, heavy industry exports increased by 31 percent over 1994, while exports from formerly dominant industries such as textiles and footwear, grew considerably more slowly; this switch from light to heavy industry has been ongoing since 1980 (Statistical Appendix Table 25). A secular change has also been evident in the destination of Korea’s exports since 1990, whereby the share going to industrial countries has decreased markedly, primarily as a result of burgeoning exports to developing countries in Asia (Statistical Appendix Table 26). In the first half of 1996, export volumes continued to grow at an annual rate exceeding 20 percent, again led by heavy industry products. 2/

Import volume growth in 1995 also exceeded 20 percent. Capital goods imports grew fastest--24 percent in volume terms, following growth of 29 percent in 1994--but raw materials imports also grew briskly. The strength of capital goods imports contributed to a partial reversal of the recent decline in the share of imports procured from industrial countries. (Statistical Appendix Table 27). In the first six months of 1996, import volumes grew at half the 1995 rate, with the growth of capital goods volumes down sharply. However, while imports of capital goods and raw materials have tended to grow procyclically, imports of consumer goods appear to be trending up; the share of consumer goods in total imports for domestic use has edged up from 12 percent in the first half of 1990 to 15 percent in the first half of 1996 (Statistical Appendix Table 28).

The surplus on the capital account in 1995 rose to $16 billion, sufficient to finance the higher current account deficit and to allow official international reserves to increase and maintain import cover (Statistical Appendix Table 29). The increase in the capital account surplus in 1995 was associated with a number of important steps to liberalize the capital account. The loosening of restrictions on the ability of foreign investors to buy domestic equities generated large inflows of portfolio investment, 1/ which were supplemented by the effects of relaxing the limits on the access of Korean firms to trade credit. 2/ More liberal capital controls also led to a surge in international placements of syndicated loans and bond issues, with Korean banks particularly active in the international bond market. A similar pattern of capital flows was witnessed in the first six months of 1996, when net inflows of a further $14 billion were recorded. Further liberalization of the restrictions on foreign equity investment and on access to trade financing again led to large inflows of portfolio investment and trade credits. 3/ International reserves increased by $2.3 billion through July 1996.

In 1995 and 1996, attempts were made to improve the climate for inward foreign direct investment (including in the financial services sector): the approvals process was simplified and there were further reductions in the number of business sectors closed to foreign investors (Statistical Appendix Tables 30 and 31). Under a new schedule announced in May 1996, only 19 of 1,148 sectors are to remain closed by 2000. At the same time, however, the authorities have also been easing restrictions on outward direct investment, and, with Korean companies increasingly seeking profitable opportunities overseas, the balance on the foreign direct investment account became more negative in 1995 and in the first half of 1996.

With regard to future steps to liberalize the capital account, the authorities intend to remove all remaining restrictions over time. The ceiling on foreign ownership of Korean stocks was raised again in October 1996 (to 20 percent) and further increases are expected in 1997 and in subsequent years. By the end of 1999, it is expected that limits on access to trade credit and quantitative ceilings on the amount of foreign borrowing will be abolished. However, while foreign investors are gradually gaining access to the domestic bond market, no firm timetable has been set for the removal of the remaining restrictions.

Korea’s external debt increased from 14.7 percent of GDP at end-1994 to 17.2 percent at end-1995 (Statistical Appendix Table 32) and by a further $6.5 billion (1.3 percent of GDP) in the first quarter of 1996. Short-term debt grew fastest in 1995, partly reflecting a jump in trade credit associated with the expansion of trade and the liberalizing steps described above. Similarly, interest on short-term debt increased sharply in 1995, but at 5 1/2 percent of exports, the overall debt-service ratio remained moderate (Statistical Appendix Table 33). The increase in the debt stock in 1995, however, overstates Korea’s debtor status, since foreign assets were also accumulated during the year: net debt, defined as gross debt less the foreign assets of the banking system, rose from 2.6 percent of GDP at end-1994 to 4.1 percent of GDP at end-1995. The share of public debt in the debt stock declined to 4 percent at end-1995, compared to 13 percent as recently as 1992.

The market average exchange rate system (MAR), in which the won/U.S. dollar exchange rate in the interbank market floats within a range centered around the previous day’s weighted average spot rate, has been in effect since March 1990. The daily exchange rate fluctuation band has been widened on five occasions, most recently in December 1995, when it was increased to +/- 2 1/4 percent. However, on a day-to-day basis, the won has tended to vary rather little within the band. 1/ The authorities have announced plans to open a won/yen exchange market in the second half of 1996. Foreign exchange banks are permitted to enter into forward exchange contracts with their customers providing that there is a bona fide underlying commercial transaction. Cover in the forward market tends to be of no more than seven-day duration and is limited to won/U.S. dollar transactions, although a won/yen forward market is to be opened in the latter half of 1996.

In the period since late 1994, the nominal effective exchange rate of the Korean won has been broadly unchanged, notwithstanding large fluctuations over the same period in key currency exchange rates. Given the inflation differential with Korea’s trading partners, constancy of the nominal effective exchange rate has implied a slight reduction in Korea’s competitiveness as measured by the CPI-based real effective exchange rate. OECD estimates using cost-based measures of competitiveness show essentially the same picture of there having been little stimulus to exports from cost conditions in 1994-95. 1/

Since 1994, the authorities have been progressively dismantling import barriers and cutting tariffs in accordance with undertakings made in the context of the Uruguay Round. With the exception of a small number of products with potentially adverse health or security effects, import licensing is now automatic. The number of import items subject to quantitative restrictions has been reduced and the schedule announced by the authorities implies that import liberalization will largely be completed by 1997 (Statistical Appendix Table 34).

Both the average tariff rates and the dispersion in rates have been lowered in recent years, continuing a process which began in the 1980s (Statistical Appendix Table 35). Average tariff rates are currently 6.2 percent for manufactured goods, 16.6 percent for agricultural goods, and 7.9 percent overall. WTO tariff bindings apply to more than 90 percent of product lines, 2/ and average bound rates are to be reduced from 20 percent for manufactured and marine products to 8.2 percent for manufactured goods and 13.6 percent for marine products, and from 68 percent to 62.8 percent for agricultural goods. Korea’s developing country status under the WTO allows it ten years to fully implement its WTO commitments.

Adjustment tariffs and special safeguard duties are levied on a small number of products. Adjustment tariff rates may be up to 100 percent, but are applied within the WTO bindings. Tariff quotas, which apply to 11 percent of imports by value, were introduced in 1995 to replace import quotas in agriculture, but also apply to crude oil. An import diversification scheme, whereby restrictions are placed on import items from countries with which Korea has a large bilateral trade deficit, continues to exist, but is expected to be phased out by 1999. Korean exporters continue to report instances of nontariff barriers in industrial-country markets (Statistical Appendix Table 36).

1/

The term “country,” as used in the paper, does not in all cases refer to a territorial entity that is a state as understood by international law and practices; the term also covers some territorial entities that are not states, but for which statistical data are maintained and provided internationally on a separate and independent basis.

1/

Unless noted otherwise, growth rates refer to year-over-year changes.

1/

All growth rates are on a 12-month average basis, unless otherwise noted.

2/

MCT covers, in addition to the assets in M2, certificates of deposits and trust accounts. M3, a broader aggregate, includes MCT, other deposits of nonbank financial institutions, debentures, commercial and cover bills, as well as RPs.

3/

The growth rate of M3 is on a 12-month, end-of-period basis.

4/

Specifically, these changes include (i) an increase in the minimum maturity for deposits in money-in-trust from 1 year to 1 1/2 years in May; and (ii) a reduction in tax incentive of holding trust funds. For example, trust funds with a maturity of less than five years are now subject to the global tax (this regulation was introduced on July 1, 1996), which is higher than the 15 percent flat withholding tax they were subject to before.

5/

The target range for M2 was lowered from 12-16 percent in 1995 to 11.5-15.5 percent for 1996.

1/

According to the official estimates, the 12-month growth of M2 through June, controlled for such portfolio shifts, would have been about 14.8 percent. As a result of these portfolio shifts, the 12-month growth in M2 by the end of 1996 may be above the upper bound of the target range of 11.5-15.5 percent.

1/

The ceiling on foreign ownership of domestic equities was raised from 15 percent to 18 percent in April 1996 (see Section I.4 below).

1/

The financial sector reform plan and its implementation are discussed in the background papers prepared for the 1995 Article IV consultation (SM/95/264, 10/10/95).

2/

Interest rates liberalized since 1995 include those on (i) time deposits with maturity of six month to one year on July 24, 1995; (ii) time deposits with maturity less than six months; and (iii) saving deposits with a maturity of less than three months.

3/

The four public-enterprise accounts are small, together accounting for 1 percent of total revenue and expenditure. See “Korea--Background Papers,” (SM/95/264, 10/10/95), Chapter I, for a discussion of the various components of government finances.

4/

The special budgetary funds together account for about 12 1/2 percent of consolidated central government revenue and expenditure.

1/

The financial balance is defined here as the budget balance excluding net lending (that is, as budgetary revenue less current and capital expenditure).

2/

Interest receipts are larger than payments, mainly reflecting the net creditor position of the government, so the budget balance is smaller if net interest is excluded.

3/

The buoyancy of fiscal revenue, which was less than 1.0 on average during the 1980s, is estimated at 1.3 on average during the period 1990-95.

4/

Data on the primary and financial balances and government saving are provided in the main paper.

5/

Of this, just over a fifth is foreign-currency debt, most of it of medium-term maturity.

1/

A number of other, less significant tax measures were also introduced; these measures mainly involved taxes whose revenues were earmarked for priority expenditures. This year, for example, marked the introduction of a new transportation tax to finance infrastructure investment, and of a tax on cigarettes and petroleum products to finance education spending.

2/

The initial effect on the tax base may be limited, however, since under the new system interest and dividend earnings are given a high threshold--W 40 million--below which they are not taxed. In addition, partly with a view to not discouraging saving, interest earnings on saving deposits with a maturity of five years and longer are not included in the global income tax base.

1/

In 1995, interest payments (gross) accounted for 3 percent of total expenditure, or about 1/2 percent of GDP.

1/

The three other funds relate to military personnel, national schoolteachers, and government workers, respectively.

2/

A further increase to 9 percent is planned in 1998.

3/

The reference salary is an average of the participant’s own salary and average national earnings. Since contributions are related to only one’s own salary, the scheme involves a redistributive element.

4/

As of end-1995, the stock of the pension fund’s assets was over 4 1/2 percent of GDP.

5/

FIFSA is compensated by the general account of the budget for the interest-costs it incurs in paying the pension fund a near-market rate while using the resources for SOC investment.

6/

Data on local government finances are available only with a considerable lag. The last year for which data are available on the annual outcome is 1994.

1/

About one-fourth of local revenue comprised grants and subsidies from the central government.

2/

The main source of local government revenue is nontax revenue, followed by local tax revenue, and transfers (grants and subsidies) from the center. In 1994, their shares in local revenue were 44 percent, 32 percent, and 23 percent, respectively. (The official data prepared by the local authorities, on which these calculations are based, exclude center-state education transfers--which are about three-fourths the size of recorded transfers--from both transfers and total local revenue.)

3/

In 1991, a major step toward local autonomy was taken with local assemblies (but not their leaders) being elected for the first time. In 1995, local leaders were elected for the first time.

4/

Local governments are allowed to determine the actual rate within a small band around the base rate.

5/

Nonfinancial public enterprises are productive entities in which the government owns at least 10 percent of the outstanding equity either directly or indirectly through other public entities.

1/

The two major enterprises in this category (there are four in all) are the post office and the railways. As noted at the beginning of this section, the public-enterprise accounts are relatively small in size.

2/

Of these, however, only 16 are in the nonfinancial sector.

3/

The GIEs, taking into account both their debts and their financial assets, have a net creditor position amounting to about 11 percent of GDP.

1/

Export unit values for electronic products in the first seven months of 1996 were 27 percent lower than in the first seven months of 1995.

2/

An exception was metal goods (including steel products), where the volume of exports declined sharply.

1/

The limit on foreign ownership of Korean stocks was increased from 10 percent to 12 percent in December 1994, but the impact on the capital account was pushed into 1995 by the Mexican crisis. The ownership limit was raised further to 15 percent in July 1995.

2/

In 1995, the maximum period for deferring payment for imports was extended, with the length of the extension depending on the size of the firm and the source and type of import; for large firms importing from outside the region for domestic use, the deferred payment period was extended from 60 days to 90 days. At the same time, the ceiling on export advances was eliminated for small firms and doubled to 10 percent of the previous year’s exports for large firms.

3/

The ceiling on foreign equity ownership was increased from 15 percent to 18 percent in April 1996 (and the limit on ownership by a single individual was raised from 3 percent to 4 percent). With regard to trade credit, the ceiling on export advances was raised from 10 percent to 15 percent for large enterprises.

1/

The daily change in the won/dollar exchange rate has exceeded 1 percent of its previous day’s value on only five occasions since January 1994.

1/

Economic Survey of Korea, OECD, Paris, March 1996, page 26. It is possible that these measures of competitiveness understate gains in competitiveness in third markets.

2/

Excluding marine products.

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Korea: Selected Issues
Author:
International Monetary Fund
  • CHART I-1

    KOREA: M2 GROWTH AND TARGET RANGES, 1991-96

    (12-month percentage change) 1/

  • CHART I-2

    KOREA: DEVELOPMENTS OF MAJOR MONETARY AGGREGATES, 1991-96

    (Percentage change, 12-month basis)

  • CHART I-3

    KOREA: BANK DEPOSITS, 1992-96

    (12-month percent change; end of period)

  • CHART I-4

    KOREA: SELECTED MARKET-DETERMINED INTEREST RATES, 1991-96

  • CHART I-5

    KOREA: SELECTED INTEREST RATES ON BANKS’ DEPOSITS AND LOANS, 1991-96

    (x denotes the date when the rate was deregulated)