Republic of Korea
Economic and Policy Developments

The primary focus of this paper is on economic developments and policies in the period since the outbreak of the financial crisis. Policies adopted under the program successfully restored external stability, rebuilt reserves, and initiated reform of the financial and corporate sectors. Key indicators point to continued economic expansion. Several measures have been implemented to ease the foreign exchange and domestic liquidity constraints putting in place a working social safety net. The paper also discusses financial sector restructuring and corporate sector reforms under way in Korea.


The primary focus of this paper is on economic developments and policies in the period since the outbreak of the financial crisis. Policies adopted under the program successfully restored external stability, rebuilt reserves, and initiated reform of the financial and corporate sectors. Key indicators point to continued economic expansion. Several measures have been implemented to ease the foreign exchange and domestic liquidity constraints putting in place a working social safety net. The paper also discusses financial sector restructuring and corporate sector reforms under way in Korea.

I. Introduction and Summary

1. The past two years have been among the most turbulent in Korea’s recent economic history. During this period, Korea has not only witnessed severe financial turmoil in domestic financial and foreign exchange markets, but also a remarkably rapid stabilization and recovery from the crisis conditions. After a sharp decline in economic activity and employment, both are on the rise and GDP has returned to its pre-crisis levels. Financial market conditions have likewise improved. The stock market, which fell sharply at the onset of the crisis, rose by 33 percent in 1998 and by a further 70 percent through November 1999. After a free fall in early 1998, the exchange rate has strengthened dramatically, although it still remains significantly more depreciated than its pre-crisis level.

2. The primary focus of this paper is on economic developments and policies in the period since the outbreak of the financial crisis. However, to place what follows in context, a thumbnail sketch of pre-crisis economic conditions is presented below. This is followed by a summary of developments since the outbreak of the crisis and an overview of the remainder of the paper.1

A. Pre-Crisis Conditions

3. Korea’s impressive macroeconomic performance up to 1997 served to mask fundamental structural problems, notably a weak financial sector and an over-leveraged corporate sector. Korean conglomerates, known as chaebol, had invested excessively and were focused primarily on gaining market share. The resulting excess capacity depressed the profitability of companies and the financial institutions from which they had borrowed.2

4. Financial institutions traditionally lacked independence and were encouraged by government to channel credit to preferred sectors. Consequently, credit analysis and risk management techniques remained undeveloped. The misallocation of credit was facilitated by a weak system of prudential controls and forbearance by the supervisory authorities. The result was a banking system with little commercial orientation, limited ability to price risk, and excessive exposure to large corporations. Bank financing for large investment projects was made available, even when such investment added to overcapacity. When export prices weakened and a number of chaebol went bankrupt in 1997, there was a commensurate deterioration in the asset quality of financial institutions.

5. By 1997, Korea had also contracted a large amount of short-term foreign debt, which had been favored over longer-term capital flows. This increase in short-term debt increased the vulnerability to crisis. As concerns increased about the health of Korean banks, and falling reserve levels made the willingness of the government to bail out banks less reassuring, international credit lines began to dry up, thus precipitating the foreign exchange crisis (Chart I.1). The situation appears to have been aggravated by the practice of Korean financial institutions making risky investments abroad. When foreign lenders started to recall loans, these assets proved to be illiquid, thereby aggravating the foreign currency crisis.

Chart I.1
Chart I.1

Korea Capital Flows, Reserves and External Liabilities, 1997–1999

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

Sources: Data provided by the Korean authorities.1/ Net position of protfolio investment, foreign direct investment, and other investment. Figure for Q3 1999 is an estimate.

6. Conditions in international markets and the behavior of market participants were also contributing factors. Private investors, attracted by high returns did not carefully assess the risks involved in their investments. Likewise, the impact of adverse external shocks—such as the decline in world semi-conductor prices, the hike in oil prices in 1996, and the impact of a weakening of the yen-dollar exchange rate on competitiveness, net exports and growth—were underestimated.

7. Once market participants began to scrutinize Korea, especially after the foreign exchange crises in Thailand and Indonesia, the structural weaknesses of the Korean economy looked more stark. The lack of transparency further aggravated the situation. Official data provided incomplete disclosure of key variables such as foreign reserves, external debt, forward exposure, and nonperforming loans. Illiquid deposits at offshore Korean banks were included in its foreign reserves, so that the official reserve data tended to understate the true extent of reserve loss. Official debt data were also inadequate, omitting external debt contracted by offshore entities, a practice that appears to have understated true external indebtedness by about a half. Reporting practices by prudential authorities were similarly opaque; markets placed little credibility in official estimates of nonperforming loans, widely regarded as considerable underestimates. In addition, clear assessment of corporate health was precluded by complex systems of cross corporate guarantees and incomplete financial reporting. The lack of transparency served to inflate the fears of international lenders and compounded the severity of the crisis. (Box I.1 provides a selective chronology of the key events that preceded the financial crisis in 1997.)

Korea - Chronology of Main Pre-Crisis Events and Early Policy Responses

1997: Lead up to the foreign exchange crisis

  • Six of the top-30 chaebols declared bankruptcy.

  • The bankruptcies severely weakened the financial system and nonperforming loans rose sharply.

  • After the bankruptcy of Hanbo in January 1997, international credit agencies downgraded the ratings of Korean financial institutions. After the bankruptcy of Kia in July, Korea’s sovereign risk was assigned a negative outlook.

  • In August 1997, the authorities announced that the Korean government will ensure the payment of foreign debt owed by Korean financial institutions.

  • The external financing situation deteriorated markedly following the decline in the Hong Kong stock market on October 23 and a downgrading of Korea’s sovereign risk status by Standard and Poor’s. Substantial difficulties were encountered in rolling over the large stock of short-term debt (about US$100 billion).

  • The BOK’s gross reserves declined sharply, with large amounts used to finance the repayment of short-term debt of Korean commercial banks.

November-December 1997: The government’s response to the crisis

  • On November 20, Korea made a request for IMF assistance. Negotiations on a Stand-By Arrangement (SBA) began in Seoul on November 26.

  • On December 4, the IMF Board approved a US$21 billion Stand-By Arrangement. A total package of US$ 58.4 billion was put together, with pledges of support from the World Bank (US$10 billion) and the Asian Development Bank (US$4 billion), and a second line of defense (US$23.4) pledge from bilateral donors.

  • Money market interest rates rose from 15-19 percent in early December to 25 percent on December 13 as the BOK tightened monetary conditions in line with the program.

  • On December 15, the band on the exchange rate, which limited the daily change to ± 10 percent, was eliminated.

  • The initial market reaction to the program was positive. But market sentiment quickly turned negative, in part, because it became known that Korea had a much lower level of usable foreign exchange reserves and a larger stock of short-term debt than markets had believed to be the case.

  • The won depreciated by about 70 percent during December 5-24 to reach almost W 2000/US$, while the stock market plunged by a further 20 percent during this period.

  • Usable reserves continued their free fall. On December 18, usable reserves were at US$ 4.2 billion, and net of forward commitments they were negative.

  • On December 22, two major international rating agencies downgraded Korean external debt to a speculative grade. The roll-over rate on short-term external debt fell to 10 percent.

  • In late December, in response to the deepening crisis, the Korean authorities strengthened their economic program in order to regain market confidence. The reinforced program called for a tightening of monetary policy and an acceleration of structural reforms (liberalization of capital and money markets, restructuring of financial sector, and trade liberalization) accompanied by a promise for the early activation of the bilateral assistance in the rescue package. (A partial disbursement of US$8 billion from the second line of defense was promised, subject to a debt restructuring agreement with creditors. However, these funds were never activated.) The call rate was increased to 32 percent.

  • On December 30, the Board approved the request by Korea for the modification of the schedule of purchases to frontload part of the purchases. At year-end, usable reserves were US$9.1 billion.

B. Elements of the Adjustment Program

8. The objective of the adjustment program was first and foremost to restore market confidence and stabilize financial markets. To this end the program included a mix of macroeconomic policies and far-reaching structural reforms.

  • Macroeconomic policies included a temporary period of higher interest rates aimed at stabilizing the foreign exchange market and avoiding a depreciation-inflation spiral. Fiscal policy was loosened early in the program to mitigate the impact of the deeper-than-expected slump in activity and to provide a social safety net.

  • Structural reform efforts were focused on financial sector and corporate sector reforms and liberalizing trade and capital account transactions. Financial sector reforms focused on strengthening regulations and the framework for supervisory oversight, restructuring the financial system starting with the weakest segments (namely the commercial banks and the merchant banks), and progressively working up to the rest of the nonbank financial sector. Reforms in the corporate sector initially focused on improvements in governance and competition policies. Subsequently, the authorities’ attention shifted to financial and operational restructuring aimed at reducing debt levels and strengthening the capital structure of Korean corporations. In addition, the liberalization of the capital account was accelerated and labor market flexibility was enhanced.

9. There was early recognition that adequate external financing and debt restructuring would be important complements to the program. To this end, in addition to the resources made available by the Fund (including through accelerated disbursements), the program was supported by other multilateral institutions, especially the World Bank and the Asian Development Bank. In addition, in early 1998, a “second line of defense” was mobilized and an agreement was reached with commercial banks to restructure their loans. Bilateral donors indicated their willingness to provide a supplemental financing package in the context of a voluntary program by bank creditors to maintain credit lines and restructure short-term debt so as to extend the maturity of their existing claims.

C. Economic Recovery, Recent Policy Developments, and the Road Ahead

10. Policies adopted under the program successfully restored external stability, rebuilt reserves, and initiated reform of the financial and corporate sectors. The severe disruption in financial markets and loss of confidence, however, led to Korea’s worst recession in over three decades. Real GDP contracted by nearly 6 percent in 1998 and the unemployment rate jumped to close to 9 percent. After a brief spike in early 1998, inflation has been subdued owing to weak domestic demand and a large output gap. These latter factors, together with the depreciated won, led to a sharp swing in the current account to a large surplus in 1998.

11. Once the task of stabilizing the exchange rate was achieved, the focus of policies shifted to stimulating growth through an easing of macroeconomic policies. The overnight call rate was progressively reduced and has been kept at about 4¾ percent since April 1999. The consolidated central government deficit rose to 4¼ percent of GDP in 1998 and another deficit equivalent to 4¾ percent of GDP is planned for 1999. The fiscal plans ensure that adequate support is allocated to social safety net programs.

12. There has been a sharp turnaround in economic activity in 1999. The economy is expected to grow by 9 percent, with significant upside potential to this forecast. Growth has been led by buoyant private consumption, a rebound in equipment investment, and a slower pace of inventory decumulation. The rapid recovery has also been aided by supportive macroeconomic policies. The strengthening of the economy is reflected in a drop in the unemployment rate to 4.6 percent in October, while inflation has remained low.

13. Korea’s external position has also strengthened considerably. Continued robust export growth has resulted in a sizable current account surplus in the first nine months of 1999. Capital inflows have also increased markedly this year. Consequently, reserves have been built up to $70 billion by end-November 1999. External vulnerability has since been markedly reduced as reserves are sufficient to cover short-term foreign liabilities. Although the won has continued to strengthen in real effective terms, as of November 1999, the won was still about 17½ percent below its pre-crisis level.

14. The sustainability of strong growth is, however, not yet assured and there is still a sizable unfinished agenda of reforms. Indeed, the debt servicing difficulties and subsequent collapse of Daewoo—Korea’s second largest conglomerate—and the resulting turmoil in financial markets in the second half of 1999 illustrate that there are lingering risks that could stand in the way of sustained growth in the medium term. It will therefore be essential to maintain the momentum of reform, especially in the financial and corporate sectors. Specifically:

  • Good strides have been in restructuring the financial sector, but important reforms remain to be implemented. Tangible progress has been made in consolidating and recapitalizing the banking system with significant injections of public funds, strengthening the role and independence of the Financial Supervisory Commission, and bringing prudential regulations in line with best international practice. Looking ahead, priority now needs to be given to: (i) restructuring the fragile investment trust sector; (ii) privatizing the large equity shares acquired in the process of recapitalizing commercial banks; (iii) improving management and business practices, especially to strengthen risk analysis and lending practices; (iv) rehabilitating the insurance sector; and (v) continuing improvements in supervision and prudential regulations.

  • The need to accelerate and strengthen the corporate restructuring process has been clearly demonstrated by the Daewoo group’s failure. By moving decisively to restructure Daewoo, the government has demonstrated that the large conglomerates are not “too big to fail.” For the other top-5 chaebol, the government has moved to enforce implementation of their capital structural improvement plans (CSIPs) and apply sanctions for noncompliance. In the case of the 6-64 chaebol ranked by asset size, debts are being restructured under a creditor-led debt workout framework but early evidence suggests that restructuring has not gone deep enough and several of the agreed workouts will need to be revisited to reduce debt to a more sustainable level. Major steps have also been taken to strengthen market discipline and corporate governance. Looking ahead, the agenda for reform will need to focus on: (i) implementing the restructuring plans for Daewoo in a transparent fashion; (ii) accelerating the restructuring of the other top 5 chaebol; (iii) strengthening the workout process for the 6-64 chaebol and other large corporations; and (iv) continuing to improve corporate governance, especially with regard to disclosure and consolidated financial accounts.

15. The remainder of the paper is organized as follows: Chapter II contains a description of the developments in economic activity, labor markets and prices; Chapter III presents developments in the current and capital accounts of the balance of payments and describes recent reforms to liberalize capital and trade flows; Chapters IV and V outline the monetary and fiscal policy response to the outbreak of the crisis and the evolution in the stance of macroeconomic policies to date; and Chapters VI and VII sketch the major structural reforms that were implemented since the outbreak of the crisis to restructure and strengthen the financial system and the corporate sector.

II. Developments in Economic Activity 1

A. Introduction

1. By most criteria, Korea had sound macroeconomic fundamentals prior to the financial crisis that struck in late 1997, including rapid economic growth, high investment rates, moderate inflation, small current account deficits, and balanced government budgets. In retrospect, however, the strong macroeconomic performance masked structural weaknesses that made the country vulnerable to shocks (Chapter I).

2. The crisis resulted in Korea’s worst growth performance since the Korean War. Real GDP fell by 5.8 percent in 1998, in contrast to a 2¾ percent decline during the recession in 1980. The crisis brought about a severe disruption in the normal functioning of markets, a sharp decline in confidence, and a collapse of private demand. Corporations reacted by slashing inventories, scaling back investment plans, and lowering wages, thus exacerbating the impact of the crisis on the real sector. For their part, households reacted by raising precautionary savings to unprecedented levels in the face of large uncertainties, thus depressing private consumption. The severity of the recession was misjudged by most observers (including the IMF) at the onset of the crisis. 2

3. The output decline bottomed out in the third quarter of 1998 and a strong recovery has been underway since then. Although the recession was relatively shortlived, its consequences—in terms of severely depressed consumption, record number of bankruptcies, large-scale layoffs, and increased incidence of poverty—have been widespread. The rest of this chapter is organized as follows. Section A discusses the recession of 1998; Section B outlines key aspects of the recovery; Section C discusses price developments since the crisis; Section D examines the impact of the recession on the labor market; and Section E briefly discusses the economic outlook.

B. The Recession of 1998: A Decomposition

4. The slowdown in economic activity that had already started in 1997 became full blown in early 1998. Equipment investment fell significantly in the third quarter of 1997 and industrial production started decelerating in the fourth quarter of the same year (Table II.1 and Chart II.1). By January 1998, the average daily number of corporate insolvencies had more than doubled to over 30, and the weakening of the real economy accelerated in early 1998. On a year-on-year basis, industrial production fell sharply in January 1998 for the first time since late 1992, and this decline continued for the next nine months. With the exception of electronic goods, output of all major industrial products fell during this period. The index of wholesale and retail sales started declining in December 1997 and continued to decline through end-1998.

Table II.1.

Korea: Key Indicators of Economic Activity, 1998-99

article image
Sources: Korea, National Statistical Office.

Weighted average of 10 indicators, including index of producer shipment for intermediate goods; industrial production index for intermediate and construction goods; machinery orders; total liquidity; export letters of credit; and imports of raw material for reexports.

Weighted average of 10 indicators, including index of total industrial production; index producer shipment for all goods; electric power consumption; amount of labor, wholesale and retail sales index; cement consumption; and real exports and imports.

Not seasonally adjusted data.

Rate of capacity utilization.

Rate of unemployment.

Chart II.1
Chart II.1

Korea Real Sector Activity, 1997-99

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

Sources: National Statistical Office; and the Korean authorities.

5. The crisis resulted in a collapse in investment spending. Construction and equipment investment fell by 10 percent and 38½ percent respectively in 1998 due to the uncertain outlook, weak corporate balance sheets, and reluctance of banks to make loans owing to impaired capital adequacy ratios giving rise to a credit crunch (Chapter IV for a discussion of credit developments). By mid-1998, overall capacity utilization rates had fallen to about 66 percent, a decline of about 14 percentage points from the level a year earlier.

Chart II.2:
Chart II.2:

Real GDP and Demand Components, 1997-99

(4-quarterly percent change; unless otherwise indicated)

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

6. Private consumption fell by 9½ percent in 1998, reflecting declining income and wealth, as well as depressed confidence levels. According to a survey of urban households, income fell by about 11 percent in real terms in 1998 owing to a sharp increase in layoffs and cuts in nominal wages. In addition, household wealth was reduced by the fall in stock prices, and also land and housing prices. Furthermore, consumer confidence was adversely affected by rising unemployment and the record number of bankruptcies. Increased government spending on social safety net in 1998 helped mitigate the steep decline in private consumption (Chapter V).

7. The sharp decline in private consumption was mirrored by a rise in the private saving-investment balance. This reflected in part an increase in precautionary saving in view of the uncertainty brought about by the deterioration in labor market conditions. Private saving rose to a record 34 percent of GDP in the second quarter of 1998. Together with the fall in private sector investment, the private saving-investment balance swung from a deficit of 5½ percent of GDP in 1997 to a surplus of 10½ percent of GDP in 1998. The government saving-investment balance worsened by 1½ percentage points of GDP over the same period.

8. Inventory destocking—including the one-off exports of recycled gold jewelry and used machinery—played an important role in the decline in economic activity. The scale of inventory reduction in 1998 was unprecedented and depressed real GDP growth by about 6 percentage points. By end-1998, the inventory-to-shipment ratio was at its lowest level since 1993 (Chart II.1). The rapid pace of inventory destocking that occurred in the first three quarters of 1998 is explained by the high cost of holding stocks due to high interest rates, the need by cash-strapped firms to raise cash owing to difficulty in obtaining new bank loans, and the compression of output by firms, arising from the unexpectedly steep decline in demand.

9. The only component that made a positive contribution to GDP in 1998 was the net foreign balance. Imports of goods and services were severely compressed—owing to the depreciated won and the sharp contraction of output and consumption—declining in volume terms by 22 percent in 1998. (See Chapter III for a more detailed description of external sector developments.) Exports of goods and services, however, rose in volume terms by more than 13 percent, helped by the improved external competitiveness and the government’s export drive. As a result, the net foreign balance contributed about 12 percentage points to GDP growth in 1998.

C. The Recovery in 1999

10. The economic upturn, which started in the last quarter of 1998, has been much faster and stronger than expected, giving the path of GDP growth a distinct “V” shape. On a year-on-year basis, real GDP grew by 4.6 percent in the first quarter of 1999 for the first time since the crisis. Real GDP growth has accelerated since then to 9.8 percent (y/y) and 12.3 percent in the second and third quarters of 1999 respectively. Real GDP thus grew by 9 percent in the first three quarters of 1999, in sharp contrast with a decline of about 6 percent during the same period last year. Indeed, the Korean economic recovery has been faster and stronger than in other countries that suffered similar financial crises (Box II.1).

11. The contribution of net exports to GDP growth in 1999 has moderated considerably, in sharp contrast with 1998. Owing to the fast pace of recovery in imports (reflecting strong economic activity and an unwinding of the severe import compression in 1998), the contribution of net external balance to GDP growth was slightly negative in the three quarters of 1999, a trend which is expected to continue for the rest of 1999.

Comparison of Korea’s Recovery with Other Crisis Countries

A comparison of Korea’s recovery with those of Sweden, Finland and Mexico - which experienced similar financial crises during the 1990s marked by severe external shock, exchange-rate depreciation and a banking crisis - reveals some striking differences that may explain why Korea has been able to adjust as quickly as it has.

The Korean economy’s turnaround has been quicker, stronger and broader based than in Finland, Mexico, and Sweden. The economy bottomed by the fourth quarter of 1998, roughly one year after the onset of the crisis. Although initially externally driven—with net exports contributing 12 percent to GDP growth in 1998—the recovery has broadened to private consumption and investment thanks to improved sentiment, corporate profitability and a regional recovery.

Sweden and Finland entered deep and prolonged recessions well before the financial crises struck in 1992 when the currency peg was abandoned. Their recessions were triggered by a combination of adverse factors, including the bursting of an asset price bubble and an overvalued exchange rate. Finland’s recession was more severe mainly because of the collapse of trade with the former Soviet Union and a terms of trade shock. Starting in early 1990, their recessions lasted three full years. Sweden’s real GDP contracted by a cumulative 5 percent, Finland’s by almost 9.5 percent. The initial recoveries were narrow and externally driven. Domestic demand began strengthening only in late 1994.


Real GDP


Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

Mexico went into a severe recession in 1995 following the financial crisis in late 1994. Real GDP contracted by 7 percent in 1995. Similar to Korea, Mexico’s economy rebounded swiftly. The recovery ensued within six months of the financial crisis and was driven chiefly by booming exports, benefiting from market-opening trade reforms, strong partner country growth and an improvement in terms of trade.

In all countries, the external sector led the recovery and contributed to a sharp turnaround in the current account. But the nature of the external adjustment differed. While in Finland, Mexico and Sweden, strong exports led the recovery and current account swing, in Korea, import compression rather than a burst in exports led the initial current-account swing. However, since mid-1998, robust export growth, benefiting from a competitive exchange rate, the regional recovery and rising semiconductor prices, has also contributed.


Current Account Balance

(As percent of GDP)

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

Korea enjoyed several advantages in the pre-crisis period—a fiscal surplus; high household savings; and a relatively balanced pre-recession real estate market—which helped the country come out of the recession relatively quickly.

Governments’ ability to respond with fiscal and monetary policy differed. Korea entered its recession and financial crisis with very low public debt and fiscal surplus, allowing greater latitude in countercyclical policies and in absorbing bank restructuring costs. In Sweden and Finland, public finances deteriorated rapidly with the recession, and were at the core of the crises, leaving less room for fiscal accommodation. The downturn in Sweden and Finland was also prolonged by the authorities’ tight monetary policy stance used to defend an overvalued currency. In Mexico, the government sought a fiscal surplus to offset foreign capital outflows and the effects of higher external debt service and bank restructuring costs, dampening its recovery.


Real Private Consumption


Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

Korea’s private consumption rebounded very fast, despite high unemployment and a real-wage decline, due to Korea’s exceptionally high household saving ratio (23 percent average between 1995-1997) and low debt burden. A revival of private consumption in Finland and Sweden, but also Mexico, by contrast, was slow to come. Households were heavily indebted going into the recession, forcing a sharp retrenchment when interest rates rose and credit contracted. This sparked a major increase in household savings, effectively precluding any swift revival of private consumption and prolonging the recession.

Investment recovery has been swifter in Korea. There is a strong technical element to the rebound, however. Companies faced a severe liquidity squeeze as sales collapsed and banks were reluctant to finance working capital. This forced companies to rapidly destock to free up cash and reduce costs. A large share of these inventories also were exported in the first quarter of 1999 in response to the depreciated currency. With the rebound in domestic demand and easing of liquidity pressures, restocking to desired levels is contributing to the recovery (4 percentage points to growth in 1999).


Stock Building

(As contribution to GDP Growth)


Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

Fixed investment has responded surprisingly fast in Korea, after a severe collapse in 1998. There were some concerns that the capacity overhang in several heavy industries and excessive corporate indebtedness would act as drag on investment. Yet, there are signs of recovery. Capacity utilization rates have returned to their pre-crisis levels. Capital expenditure plans that were cancelled during the crisis are being executed because of improvements in corporate profitability and outlook. In addition, new emerging growth industries—such as IT, telecommunications and high-tech startups—are investing strongly in new equipment and upgrades. The recovery in fixed investment could also be faster in Korea than in other countries because the construction sector, where excess supply takes longer to absorb, was not overheated. The construction sector boom of the late 1980s had already unwound when the 1997 crisis hit. By contrast, fixed investment in Sweden and Finland only began to recover three full years after the recession began, reflecting largely the overhang that resulted from the construction sector boom of the late 1980s.


Real Fixed Investment


Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

12. From the supply side, industrial production began to recover during the last quarter of 1998, and the upturn is becoming more broad-based. The growth rate (year-on-year) of overall industrial production turned around in October 1998, and has been trending upwards since then. A closer look at the major components of total manufacturing output shows that the recovery has been primarily driven by the consistent strong growth of electronics since 1997. More recently, there has been a sharp pick-up in the production of motor vehicles. The output of other sectors, especially those producing nondurable consumption goods has remained fairly stable since January 1997.

Chart II.3:
Chart II.3:

Manufacturing Output in Selected Sectors, 1997–99

(12-monthty percent change)

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

13. The recovery has been helped by the supportive macroeconomic policy stance since mid 1998, the temporary measures implemented to alleviate the credit crunch, and progress made in implementing structural reforms. With the strengthening of the won starting in early 1998, the call market rate was progressively lowered to below 5 percent by end March 1999. The easier monetary policy stance lowered borrowing costs by firms and interest rates across the maturity spectrum (Chapter IV). In addition, the recovery has been helped by the implementation of expansionary fiscal policy, especially since the second half of 1998 (Chapter V). The restoration of confidence (through the stabilization of the won in early 1998, build up of external reserves, and upgrade of Korea’s sovereign rating) has also been instrumental in the recovery process.

D. Impact on Prices

14. Consumer price inflation jumped sharply in the immediate aftermath of the crisis, but has remained subdued since then. However, the CPI- and PPI-based inflation rates reacted differently to the depreciation of the won at the onset of the crisis:

  • The CPI-based inflation rate peaked at 9½ percent (y/y) in February 1998. The pass-through of the large exchange rate depreciation to consumer prices was only partial, reflecting primarily the collapse of imports of consumer goods and the decline of import prices.

  • The PPI-based inflation rate peaked at 15 percent (y/y) in February 1998. The larger pass-through of the exchange rate depreciation to PPI-based inflation can be explained by the large share of imported raw materials and capital goods used in manufacturing, coupled with continued increase in production for exports.

Chart II.4
Chart II.4

Korea Price Developments, 1996–99

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

Source: Bank of Korea, Monthly Statistical Bulletin.

15. Both the CPI- and PPI-based inflation rates have decelerated since early 1998. The price level has remained broadly unchanged since February 1998 although the CPI has edged up in recent months. The recent increase in the CPI-based inflation—to 1.2 percent (y/y) in November 1999—is explained by higher energy and agricultural prices. Nevertheless, core CPI inflation remains very low, and producer price inflation remains negative on a year-on-year basis. The subdued inflation rates reflect the continued output gap, the appreciation of the won since the beginning of 1999, and the decline in import prices.

E. Labor Market Developments

16. The financial crisis took a heavy toll on the labor market.3 Faced with the collapse in demand in the wake of the crisis, firms slashed both employment and wages. Layoffs were concentrated in small and medium-size enterprises where the highest rate of bankruptcies were recorded, as well as in the financial sector. By contrast, with few exceptions, chaebol did not undertake large-scale layoffs, although many reduced employment through voluntary separation and early retirement packages.

17. An important policy initiative aimed at building consensus on greater labor market flexibility was the formation of the Tripatrite Commission in January 1998. This Commission, with representation from government, business and labor, came to agreements on layoffs, payouts, reductions in overtime and bonuses. Labor laws were also changed in February 1998 to allow layoffs of redundant workers in cases of “urgent managerial need,” including mergers and acquisitions.

18. Nevertheless, firms contemplating shedding workers are required to follow strict guidelines aimed at minimizing actual layoffs. Prior to making a final decision on layoffs, firms are encouraged to maximize efforts to avoid dismissals, including through wage cuts, reductions in working hours, freezing of new recruitment, reduction of the number of temporary workers, early retirement, and temporary shutdown. In addition, the Ministry of Labor has to be notified of layoff plans and firms must provide severance payments. Moreover, the government provides various temporary wage subsidies to firms that retain redundant workers. The government has also put in place a social safety net program in order to assist the unemployed via public works programs, unemployment insurance, vocational training, and job placement (Chapter V).

19. Unemployment, which averaged about 2½ percent during 1990-97, rose sharply following the crisis to peak at 8.7 percent in February 1999. Total employment fell by more than 5 percent (y/y) in 1998, representing a total of 1.1 million people. Unlike the past when unemployment was concentrated mainly among the young, the rate of joblessness in the 30–50 age group rose substantially. The unemployment increase in this age group, including a tripling of unemployment among heads of family in 1998, amplified the hardship caused by the crisis. The unemployment problem was moderated by a significant decline in the labor force participation rate, mainly as a result of postponement of job search by younger workers and a substantial withdrawal from the labor force by discouraged female workers.

Chart II.5:
Chart II.5:

Labor Market Developments, 1997–99

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

20. Nominal wages fell by an average of 2½ percent in 1998, or by 9 percent in real terms. The decline in nominal wages was the first since 1970. The flexibility of wages reflected mainly adjustments of overtime payments and bonuses, which account for about ⅓ of total pay. Bonuses fell by about 17 percent in 1998, and due to the large decline in production and work hours overtime pay fell by 15 percent. In addition, during the 1998 wage negotiations, many workers had agreed to wage cuts and freezes in an effort to limit employment reduction.

21. The labor market situation has been improving since the second quarter of 1999. The unemployment rate has declined to 4.6 percent in October owing to the pick up in economic activity, the impact of public works program, and expanding part-time and temporary employment. Wages have also been rising steadily since the beginning of the year, reflecting the pick up in economic activity and rising demand by workers for increased pay to recover lost ground in 1998. Average wages per full-time worker have increased by about 5½ percent in the first eight months of 1999 (y/y).

22. However, the quality of job creation may not be as strong as suggested by the headline numbers. Given the significant decline in the labor force participation rate, the unemployment problem was actually more pronounced than indicated by official statistics. In addition, if international standards are used, the unemployment rate would be higher—in Korea, only those who have looked for work during the previous 1 week are counted as unemployed, while the ILO and OECD definitions include those who have looked for work in the preceding 2 weeks and 4 weeks, respectively. Moreover, many of the newly created jobs are for temporary and part-time employment.

F. Economic Outlook

23. Key indicators point to continued economic expansion in the period immediately ahead. The rise in the aggregate index of leading economic indicators continued to be robust in the third quarter of 1999. In addition, the Bank of Korea’s Business Survey Index (for all industries) increased from 66 in the first quarter to 99 in the third quarter of 1999.

24. The staff’s projection for growth in 1999 has been raised to 9 percent (from 6½ percent at the time of the last World Economic Outlook). Even this forecast has considerable upside potential. Growth is projected to slow to about 6 percent in 2000, reflecting the tapering off of the technical rebound registered in 1999 (e.g., a smaller contribution to growth from stockbuilding) and the shift of macroeconomic policies to neutral as the output gap narrows. Sustaining strong growth in 2000 and beyond will depend critically on progress made in the implementation of reforms in the financial and corporate sectors. With these reforms, Korea can lay the foundation for a growth path based on higher value-added production and strong productivity growth.

III. External Sector Developments 1

1. Since the crisis, Korea has made considerable progress in reducing its vulnerability to external shocks. Following the March 1998 debt restructuring agreement with commercial banks, Korea’s short-term external liabilities have come down significantly from their excessive pre-crisis level. Government measures to further open Korean capital markets have also helped to attract foreign capital and reduce corporation’s reliance on short-term debt and bank financing. Strong inflows in the current account, the return of foreign investors, and foreign direct investment inflows related to corporate restructuring, have helped Korea to rebuild quickly its international reserves. The rest of this chapter is organized as follows: Section A describes the evolution of the major components of the current account; Section B outlines capital and financial account developments; and Section C presents details of the liberalization of the current and capital accounts.

A. Developments in the Current Account

2. A remarkable feature of Korea’s economic performance following the crisis has been the large turnaround in the current account balance. This turnaround has played a major role in helping Korea to rebuild quickly its international reserves and restore investor confidence in Korea. Specifically, the current account moved from a deficit of 1.7 percent of GDP in 1997 ($8 billion) to a large surplus of 12½ percent in 1998 ($40 billion)—a turnaround of almost $50 billion. While much of the turnaround was due to the sharp reversal of capital flows and the collapse of imports associated with the severe recession, other factors, including the national export drive, the significant real depreciation, the strong inflows of transfers from Korean living overseas, and the impact of the inventory decumulation were also important.

3. The switch to a current account surplus was mainly due to a sharp improvement in the trade account. Korea’s current account deficit averaged around 2½-3 percent of GDP during 1995-1997, and in the three months prior to the crisis, amounted $2½ billion (Chart III.1 and Table III.1). Starting in Q4 1997 (November), however, the current account switched to a surplus reaching a peak of $10.9 billion in Q2 1998. The trade balance jumped from almost zero in Q3 1997 to a surplus of $4 billion in Q4. Imports in all commodity groups fell sharply while exports remained fairly steady during the early part of 1998. The nontrade current account (services, income, and transfers) also showed strong improvement moving from a deficit of $2 billion in Q3 1997 to a surplus of $1 billion in Q1 1998. As Chart ELI shows, the current account surplus began to shrink after the first half of 1998.

Chart III.1.
Chart III.1.

Korea: Current Account Balance, 1997 Q3–1999 Q3

(in billions of USS)

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

Source: Korean authorities and staff estimates.
Table III.1.

Korea: Developments in the Current Account, 1997–1999

(In billions of U.S. dollars)

article image
Sources: Korean authorities, and staff estimates.

Exchange rate developments

4. The crisis also led to a sharp real depreciation of the won. In real effective terms, the won depreciated by an average of 26 percent in 1998 (Chart III.2). 2 Following its sharp fall in late 1997 and early 1998, the won began to recover steadily such that by the end of 1998 it was about 20 percent below its pre-crisis level. 3 The currency came under significant upward pressure in the first half of 1999 due to a sharp increase in capital inflows and the continued large current account surplus. In addition to keeping interest rates low, the authorities have intervened in the foreign exchange market to smooth the appreciation of the currency and to rebuild international reserves. There has, however, also been considerable exchange rate flexibility under the managed float. The won appreciated by 11 percent in nominal effective terms during the first half of the year, but it depreciated in the third quarter because of Daewoo-related market jitters. Upward pressure resumed in November with the return of foreign portfolio investment following the announcement of the workouts for Daewoo affiliates. Taking into account these fluctuations, and in view of the strengthening of the Japanese yen against the U.S. dollar in the second half of 1999, there has been little movement in the real effective exchange rate during 1999. Specifically, as of end-November 1999, the real effective exchange rate for the won still remains some 17½ percent below its level in June 1997.

Chart III.2.
Chart III.2.

Korea: Real Effective Exchange Rate, 1995–1999 1995 = 100

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

Source: IMF Information Notice System.

Export performance and the response to the real depreciation

5. Despite the competitiveness gains from the large real depreciation and government led efforts to boost exports, export growth slowed in 1998. Chart III.3 shows that annual export volume growth remained on a declining trend through 1998 before showing signs of recovery in early 1999. After the onset of the crisis, the growth rate of Korean exports fell in volume terms from an average of 24 percent in 1995-1997 to 14½ percent in 1998.

Chart III.3.
Chart III.3.

Korea: Export Volume Growth, 1997 Q3 - 1999 Q2

(Year-on-Year percent change)

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

Source: Korean authorities and staff estimates.

6. To help meet the urgent need for foreign exchange, a national drive to export second-hand goods and recycled gold jewelry was initiated in early 1998. Financial institutions collected gold products (jewelry, coins, etc.), refined and exported them, and then sold the foreign exchange proceeds to the Bank of Korea. The drive had widespread national support, and is estimated to have contributed about $4.2 billion to total exports in 1998. Chart III.3 shows that the national drive also played an important role in sustaining the export growth in the first half of 1998. Excluding exports of gold and second-hand goods, export volume growth in 1998 is estimated to have been about 4 percentage points lower.

7. In 1998, Korean exports responded slowly to the large real depreciation of the won and were hampered by several factors including: (i) weak world demand; (ii) a collapse in trade financing associated with external creditors reducing their exposure to Korean firms and banks; (iii) continued declining export prices; and (iv) the high import content of Korean exports.

8. External demand, particularly in Asia, remained weak in 1998 and hampered the response of Korean exports to the real depreciation. Reflecting the disparity in economic conditions between regions, exports to China, Japan, and Southeast Asia in 1998 fell by 17 percent in value terms, while exports to the U.S. and the EU rose by 6½ percent. As a share of the total, exports to China, Japan, and Southeast Asia fell from 48 percent to 41 percent in 1998, while exports to the U.S. and EU increased from 28 percent to 31 percent (see Chart III.4).

Chart III.4.
Chart III.4.

Korea: Share in Total Exports by Area of Destination 1997 Q3 - 1999 Q2

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

Source: Korean authorities.

9. The strong U.S. economy was a significant source of growth for Korean exports during this period, in particular for both light and heavy industrial products. A closer examination reveals that much of the decline in exports of industrial products to Japan (mainly in electronic and metal goods) were being redirected to the U.S. and to a less extent to the EU. 4

10. Exports immediately after the crisis were also constrained by the collapse in available trade financing as external creditors reduced their exposure to Korean firms and banks. While larger firms were able to utilize credit lines from foreign banks, smaller firms faced difficulties in opening new letters of credit. In response, during the first half of 1998 the Korean government initiated a number of programs to help address the difficulties experienced by small- and medium-sized enterprises (SMEs) including:

  • Establishing a $300 million facility for the rediscount of export bills in the BOK.

  • Increasing the capital of the Korean Credit Guarantee Fund (KCGF) and the Korean Technology Credit Guarantee Fund (KOTEC) whose objectives were to provide credit guarantee services to viable enterprises that lacked tangible collateral.

  • Creating a $3 billion import financing scheme for SMEs supported by the World Bank Structural Adjustment Loan (SAL) and by the reserves of the BOK.5

11. The use of the trade financing scheme, however, got off to a slow start as commercial banks remained cautious in assuming additional risk in lending to SMEs, while SMEs themselves relied upon their traditional links to large conglomerates for purchasing needed raw material imports. Although the program was later expanded to include larger non-chaebol companies, through mid-July, only $0.7 billion out of the available $3 billion in the trade financing scheme and only $25 million of the available $300 million in the BOK facility for the rediscount of export bills was utilized.

12. Exports were also constrained by the decline in export prices, led mainly by the price of semiconductors, which continued to fall throughout 1998 and 1999 (see Chart III.5). After having fallen by a cumulative 27 percent from 1995 to 1997, export unit values declined by a further 17 percent in 1998. The price of electronic products, which make up roughly 26 percent of total exports, fell by almost 80 percent from 1995 to 1998 (by 32 percent alone in 1998). Light industrial exports, which make up roughly 25 percent of total exports, fell in price by 20 percent over the same 3-year period. The terms of trade, however, improved slightly in 1998 (by 2 percent) as import prices fell by more than export prices in 1998. Nevertheless, the terms of trade still remained some 22 percent below its level in 1995.

Chart III.5.
Chart III.5.

Korea: Export Unit Values, 1993 - 1999 H1

(Year-on-Year percent change)

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

13. Finally, the large import content of Korean exports limited the competitiveness gains from the large real depreciation. In 1997, the share of imports used for export production was around 37 percent, implying that the gains from the large real depreciation of the won were partially offset by higher import prices for inputs to production. In 1999, this increased to around 39 percent, reflecting to some degree the restocking of inventories.

14. Exports continued their strong growth in 1999, led by electronics, semiconductors, and automobiles. Export volume growth during the first three quarters of 1999 is estimated to be around 12 percent (year-on-year). Exports of crude materials and light industrial products were stagnant, while exports of electronic products and automobile, particularly to the U.S. and Japan, remained strong. Export prices, after declining about 9 percent during the same period, also showed signs of a turn-around starting in Q3 1999, largely as a result of the recovery in world electronic prices.

Import compression and substitution

15. The large turnaround in the current account was also due to the sharp compression of imports following the onset of the crisis. In value terms, imports in 1998 were some $50 billion below their level in 1997. As Table III.2 shows, imports across all major commodity groups, except for cereals, fell sharply in volume terms in 1998. In particular, capital goods which make up roughly 40 percent of imports in 1998, fell by 21 percent in real terms.

Table III.2.

Korea: Volume Growth of Imports, by Selected Groups, 1995–99

(Year-on-Year percent change)

article image
Sources: Korean authorities; staff estimates.

16. In addition to the slowdown in overall economic activity, the drawdown of inventories and the effects of the real depreciation also contributed to the collapse in imports. In the face of higher domestic cost of importing, producers moved away from importing towards drawing down existing inventories for their production inputs. Chart III.6 shows that the ratios of imports for overall industrial and export production declined starting in early 1998. In particular, the ratio of imports of industrial raw materials, fuels, and capital goods to industrial production dropped from 35 percent in Q1 1998 to 24 percent in Q4 1998 before recovering.

Chart III.6.
Chart III.6.

Korea: Import Ratios for Export and Industrial Use 1997 Q3–1999 Q1

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

Source: Korean authorities, and staff estimates.1/ Ratio of imports of industrial materials, fuels, and capital goods to industrial production.

17. Also, despite the continued decline in international prices for oil and agricultural commodities, import prices expressed in domestic currencies increased significantly as a result of the real depreciation. From November 1997 to March 1998, import prices denominated in won rose 38 percent before stabilizing. On a period average basis, import prices rose by 28 percent from 1997 to 1998.

18. Imports in 1999 showed signs of a significant rebound, reflecting the unwinding of last year’s import compression and the rapid speed of the economic recovery. Imports surged by 27 percent in volume terms during the first three quarters of the year (year-on-year). Consumer goods, particularly non-cereal items, and capital goods led the rebound, growing in volume terms by 31 percent and 36 percent respectively during this period. Import unit values also began to rise in early 1999, driven mainly by the recovery in oil prices.

Developments in the nontrade current account

19. The sharp turnaround in the current account was also helped by one-time factors affecting the service and transfer accounts, which are estimated to have added some $4.5 billion to the current account surplus in 1998 (Chart III.7). These included: (i) a deferment of interest payments from 1998 to 1999 granted under the debt restructuring program (about $1 billion, see Box III.1); (ii) inflows of private transfers from Koreans living overseas ($2.5 billion); and (iii) sharply curtailed travel and study abroad ($1 billion). In particular, net private transfers increased from close to zero in 1995, to almost ¾ billion in 1997 (with nearly all of this coming in December), and then to $3.3 billion in 1998. Net transfers have started to decline from their record levels starting in end-1998 but still remain a significant source of foreign exchange inflows in 1999.

Chart III.7.
Chart III.7.

Korea: Net Private Transfers from Overseas, 1997 Q1 - 1999 Q2

(in billions of US$)

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

Korea: Debt Restructuring Agreement with Commercial Banks

On January 28, 1998, the Korean authorities and a group of 13 foreign banks reached an agreement in principle on a voluntary rescheduling of the short-term debt of 33 commercial and specialized Korean banks (including their overseas branches) and certain merchant banks.

On March 31, 1998, the debt restructuring agreement was signed, in which $21.8 billion (96 percent of eligible debt) was tendered from 134 creditor banks in 32 countries. The debt covered interbank deposit obligations as well as short-term loans owed to foreign banks and financial institutions that matured during calendar year 1998. It excluded: (i) trade related debt; (ii) bonds and publicly traded securities (i.e. commercial paper); (iii) overnight deposits and lines of credit; (iv) obligations arising from derivatives; (v) off-balance sheet obligations; and (vi) foreign exchange contracts.

The original deposits and loans were converted into new loans in the form of “transferable loan certificates” which could be transferred to other financial institution and carried an explicit guarantee by the Government of Korea. Creditor banks chose from a menu of three options in restructuring their original claims, all of them with bullet amortization and semi-annual interest payments: (i) a 1-year rescheduling at an interest of 225 basis points above 6-month LIBOR ($3.8 billion), (ii) a 2-year rescheduling at an interest rate 250 basis points above 6-month LIBOR ($ 9.8 billion); and (iii) a 3-year rescheduling at an interest rate of 275 basis points above 6-month LIBOR ($8.3 billion). Individual creditors were not permitted to choose more than 20 percent of their exposure for the 1-year rescheduling option.

The new loans were denominated in U.S. dollars except for those loans that originally were issued in yen or deutsche marks. Korean banks reserved the option to prepay the new loans having final maturities of two or three years, in part or in full, on any interest payment date, without premium or penalty, but no earlier than the first 6-months after the completion of the operation. A number of Korean banks have availed of this prepayment option.

B. Capital and Financial Account Developments

20. Movements in the capital and financial account have also been very sharp. Immediately following the onset of the crisis, the capital and financial accounts switched from a surplus to a deficit as a result of the large outflow of portfolio investment and curtailment of short-term capital, and remained in deficit through 1998. Starting in the first quarter of 1999, the capital and financial accounts registered a surplus led by strong inflows of portfolio and foreign direct investment, a decline in overseas investment by Korean companies, and a slight pickup in short-term trade financing related to the economic recovery (Chart III.8).

Chart III.8.
Chart III.8.

Korea: Capital and Financial Account Balance, 1998 Q1–1999 Q3

(in billions of US$)

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

Source: Korean authorities and staff estimates.

Foreign direct and portfolio investment

21. After the crisis, foreign direct investment into Korea picked up sharply in 1998 as companies began to rely increasingly on foreign capital to finance their corporate restructuring efforts (Chart III.9). Gross foreign direct investment in Korea (on a disbursement basis) grew from $2.8 billion in 1997 to $5.1 billion in 1998; for 1999, the figure is projected to be even higher. 6

Chart III.9.
Chart III.9.

Korea: Foreign Direct Investment, 1997 Q3–1999 Q2

(in billions of USS)

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

Source: Korean authorities and staff estimates.

22. Recently, there has also been a marked shift in FDI flows away from manufacturing to the service sector. For the first four months of 1999, the share of FDI commitments to the service sector rose from 33 percent in 1998 to 67 percent in 1999. The leading recipients in the service sector industries were telecommunications, finance, trade and hotel business.

23. In an effort to raise capital, Korean companies have also increasingly relied upon overseas issuances of depository receipts (DRs). In the first three quarters of 1999, Korea issued about $8 billion in global DRs, compared to only $495 million in 1998 and $630 million in 1997. The largest issuance of depository receipts so far was for Korea Telecom which raised $2.5 billion in May 1999, followed by Pohang Iron and Steel ($1.5 billion) and Hanvit Bank and SK Telecom (about $1 billion each).

24. Korean investment overseas fell sharply starting in mid-1998. Specifically, faced with a tighter financing constraint and the need to reduce debt-equity ratios, Korean companies significantly scaled back their overseas investment plans. Of the investment overseas by Korean companies in 1998, about 85 percent was directed to help overseas affiliates and subsidiaries meet their debt service obligations. With the improvement in Korea’s credit ratings in the second half of 1998 and early 1999, overseas affiliates and subsidiaries were able to roll-over existing debt or obtain new financing, and no longer required emergency financing from headquarters. As a result, overseas investment by Korean companies fell from an average of $1.2 billion per quarter in 1998 to roughly half that in 1999.

25. With regards to portfolio investment, Chart III.10 shows that private equity flows rebounded sharply from the large withdrawal during the Q4 1997. Partially in response to the early liberalization measures, private equity flows began to return to Korean starting in 1998. Portfolio inflows picked up markedly in the first half of 1999 after international credit rating agencies raised Korea’s sovereign rating to investment grade. Financial market jitters because of Daewoo’s debt servicing problems, however, led to outflows in the third quarter. The share of Korean stocks held by foreigners rose from 14½ percent in 1997 to 18½ percent in 1998; in August 1999, the share stood at 21 percent (Chart III.11). The amount of Korean bonds held by foreigners also increased from W 209 billion in 1997 to W 968 billion in 1998.

Chart III.10.
Chart III.10.

Korea: Net Equity Inflows, 1997 Q3 - 1999 Q3

(in billions of USS)

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

Chart III.11.
Chart III.11.

Korea: Shareholding by Foreign Investors, 1993–1999

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

Source: Korean Stock Exchange (KSE)

26. After a period of extreme volatility, the spread on international bond yields have come down to near pre-crisis levels (Chart III.12). Following the devaluation in December 1997, international bond spreads jumped from around 80-90 basis points to a peak of 850 basis points before declining.7 In early April 1998, the Korean government issued $3 billion in 10-year global bonds (priced at 355 basis points above U.S. treasuries) and $1 billion in 5-year bonds (priced at 345 basis points over U.S. treasuries). With the crisis in Brazil and Russia and international investors again retreating from emerging markets, international bond spreads in Korea widened again, to as high as 1000 basis points. By June 1999, international spreads had come down to as low as 150 basis points.

Chart III.12.
Chart III.12.

Yield Spreads on Korean Sovereign Bond Issues July 1997–November 1999, in basis points

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

Source Korean authorities. Bloomberg; and staff estimates

External liabilities

27. Since the crisis, Korea has managed to significantly improve the structure of its external debt. Prior to the crisis at end-September 1997, Korea’s total external liabilities stood at $180 billion, of which $98 billion (54 percent of the total) was short-term debt. Within two year (by end-September 1999), Korea had managed to reduce its total external liabilities to $141 billion, with short-term debt ($35 billion) now accounting for only 25 percent of the total (see Table III. 3).

Table III.3.

Korea: Stock of External Liabilities, 1996-99 1/

(In billions of U.S. dollars)

article image
Sources: Korean authorities; and staff estimates.

Excluding nonresident holdings of domestic bonds, estimated at US$0.8 billion at end-December 1998.

Includes commercial banks, specialized banks, merchant banks, and development institutions.

Includes commercial paper, call money, refinance, and term loans.

Domestic finanicial institutions’ offshore borrowing, excluding interoffice accounts.

Domestic financial institutions’ overseas branches and subsidiares, excluding interoffice accounts. The data in the table exclude the nonresident deposits in the overseas branches and subsidiaries of domestic financial institutions.

Includes nonresidents’ deposits, call money, refinance, term-loan, and interoffice account borrowings.

Includes trade credit, loans for oil imports, and advance receipts of export.

In line with international standards, these data exclude nonresident subsidiaries of Korean corporations.

Including structural adjustment lending beginning December 1997.

28. Short-term liabilities of domestic financial institutions fell by over 50 percent from September 1997 to March 1998, as a result of actions taken by foreign creditors to cut off new lending and limit the rollover rates of existing lines of credit to Korean financial institutions at end-1997 (Chart III.13). Following the March 1998 agreement to reschedule some $22 million of short-term liabilities into maturities of 1-3 years, short-term debt was reduced further to $34 billion by end-June 1998 (Box III.1).

Chart III.13.
Chart III.13.

Korea: Rollover Rates on External Borrowing of Domestic Financial Institutions, 6/97–9/99

(survey of 13 major banks, in percent)

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

Source: Korean authorities.

29. Short-term financing began to recover starting in the second half of 1998, reflecting the improved credit ratings of Korean companies and increased availability of trade financing. The rollover rates on domestic financial institutions’ external debt increased from an average of 30-35 percent in December 1997 to over 95 percent in March 1998 reflecting the agreement reached with foreign creditors to voluntarily rollover short-term debt. Roll-over rates on short-term debt remained above 90 percent through July 1998 before dipping temporarily as conditions in emerging markets deteriorated with the crisis in Russia and Brazil. By January 1999, rollover rates had recovered and exceeded 100 percent mainly due to increased trade financing associated with the economic recovery.

Accumulation of international reserves

30. As a result of the strong inflows in the current and capital account, and aided by the disbursements from the AsDB, IMF, and World Bank, Korea was able to quickly rebuild its international reserve position. After having fallen to a low of $9 billion at end-1997 (2.7 months of imports of goods and services), gross usable reserves increased steadily reaching $48.5 billion by end-1998. At end-November 1999, gross usable reserves stood at nearly $70 billion. The ratio of gross usable reserves to short-term debt has increased from 14 percent at end-1997 to 181 percent by end-November 1999. In terms of short-term debt on a residual maturity basis, the coverage ratio rises from 12 percent to 101 percent over the same period. The accumulation of reserves by the BOK also reflects (i) direct foreign exchange interventions by BOK; (ii) repayments to the BOK of both emergency and non-emergency support by commercial banks, and (iii) operational income from the sizable reserve accumulation.

31. Korea has made ten purchases totaling $20 billion under the 36-month stand-by arrangement approved on December 4, 1997. Of this amount, $13.75 billion was purchased under the Supplemental Reserve Facility (SRF). With the strengthening of the reserve position, Korea accelerated repayments under the SRF and by September 1999 had repaid the entire amount 9 months ahead of schedule.

C. Further Liberalization of the Current and Capital Accounts

32. From the outset, the Korean program emphasized structural reforms aimed at further opening Korea’s economy and addressing the problems which led to the financial crisis. As described in Chapter I, the external financing crisis had its roots in structural weaknesses in the financial sector which left domestic financial institutions lacking in market discipline and highly vulnerable to destabilizing external shocks. These weaknesses, to some extent, were a result of government actions to regulate overseas borrowing by Korean corporations and the legacy of government control of the financial system.

33. In 1993, the Korean government had expanded the scope for short-term overseas borrowing by removing controls on short-term borrowing by banks, while maintaining tight restrictions on medium- and long-term capital. 8 As a result, short-term debt increased dramatically and a maturity mismatch was created, as Korean financial institutions borrowed short-term overseas in order to help finance Korean company long-term investment projects. In addition, foreign borrowing was intermediated mainly through domestic financial institutions while direct corporate borrowing from capital markets was limited, leaving domestic financial institutions highly vulnerable to external shocks. Finally, a long history of government control had left the financial system in a weakened state and lacking in market discipline, as evidenced by problems of moral hazard, inadequate expertise in credit and risk analysis, and lack of transparency in financial operations.

34. In order to address these problems, the structural reforms in the external sector had four main objectives:

  • Open up the capital account to allow Korean companies direct access to foreign capital markets and to expand the range and amounts of financial instruments available to foreign investors. This would not only help provide Korean companies with a wider menu of financing options and lower borrowing costs, but also help shift corporate financing away from an excessive reliance on debt. Allowing Korean companies direct access to capital markets would also reduce the exposure of Korean domestic financial institutions to sudden changes in external market conditions.

  • Increase foreign participation in the Korean economy by allowing for greater foreign investment and ownership of Korean companies and financial institutions. By allowing for mergers and acquisitions and imposing the threat of hostile takeovers, the opening of the market to foreigners would strengthen market discipline on managers and owners of domestic companies and help with corporate restructuring.

  • Create a simple and transparent framework of rules governing the use of foreign exchange in both current and capital account transactions.

  • Eliminate distortions in the trade regime and liberalize the service account in order to enhance the competitiveness of Korean companies.

Program for liberalization of the capital account: access to foreign market and corporate control

35. From the beginning, the opening of the capital account was a major focus of the program and can be roughly divided into two stages. In the first stage, the government moved quickly to liberalize the equity, bond, and money markets and removed the restrictions on direct corporate borrowing in order to attract much needed foreign capital and reduce the excessive amount of short-term debt. In the second stage, the controls on foreign takeovers of nonstrategic Korean companies and restrictions on foreign ownership of corporations were liberalized to promote greater foreign direct investment and to impose greater market discipline on corporations.

First stage: opening of the capital markets

36. In the first stage, the government took early action to open the bond and equity markets to foreign investors. Measures undertaken by the end of December 1997 included: (i) raising the ceiling on aggregate foreign ownership of listed Korean shares from 26 percent to 50 percent and the individual ceiling from 7 percent to 50 percent; (ii) increasing the aggregate ceiling on foreign investment in Korean equities to 55 percent, and (iii) eliminating all foreign investment ceilings for the government, special, and corporate bond markets, including for maturities of less than 3 years. In May 1998, some 7 months ahead of schedule, the aggregate ceiling on foreign investment in Korean equities was eliminated.

37. Given the authorities’ concern about short-term inflows, the government next moved to liberalize the domestic money market in two steps. First, the government allowed for unlimited foreign investment in domestic money market instruments starting with nonfinancial institutions in February 1998 and then with all financial institutions in May 1998. 9 The government also deepened the treasury bill market by issuing more than W 1 trillion in government notes.

38. The government also took steps to facilitate direct overseas borrowing by corporations. In December 1997, the government lifted the restriction on foreign borrowing of over 3 years maturity and initiated a review of the remaining restrictions on borrowing of 1–3 year maturities as part of its overhaul of the Foreign Exchange Law. In February 1998, venture companies were allowed to borrow in excess of $2 million.

39. As discussed above, these liberalization measures contributed to strong portfolio and foreign direct inflows, starting as early as the first quarter of 1998. Furthermore, in response to the lifting of the restrictions on overseas borrowing, long-term external liabilities of domestic corporations rose from $25 billion at end-1997 to $30 billion by end-June 1999, while short-term borrowings by domestic financial institutions was reduced from $63 billion to $31 billion over the same period.

Second stage: liberalizing controls on corporate ownership

40. In the second stage of capital account liberalization, the focus shifted towards removing the controls on corporate ownership to allow for greater foreign participation through mergers and acquisitions and direct foreign investment. In order to promote corporate restructuring, foreign investors were allowed for the first time to undertake hostile takeovers. In April 1998, the amended Foreign Direct Investment Act was put into effect which (i) permitted the takeover of nonstrategic Korean corporations by foreign investors without government approval, and (ii) raised the ceiling on the amount of stock foreigners can acquire in nonstrategic companies without approval by the company’s board of directors from 10 percent to 331/3 percent. In May 1998, restrictions on foreign ownership of land and real estate properties on the basis of national treatment were abolished, and in July 1998, the government allowed equity investment in nonlisted companies.

Chart III.14.
Chart III.14.

Korea: Gross Foreign Direct Investment In Korea, 1993–1998

(in billions of US$)

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

Source: Korean authorities.

41. The government also pushed for greater foreign participation in the restructuring of state-owned enterprises by relaxing restrictions on foreign ownership and control. In May 1998, the permitted share of equity ownership by foreigners of Korean telephone service providers was increased from 33 percent to 49 percent. Other public utility sectors are also being considered for further privatization with greater foreign involvement.

Streamlining the administrative procedures on the use of foreign exchange

42. The opening of the capital account was also accompanied by further liberalization of the rules governing the use of foreign exchange. The objective was to replace the cumbersome set of laws and restriction on foreign exchange transactions with a simple and transparent framework. In April 1999, the first stage of the new Foreign Exchange Transaction Act was put into effect. The first stage streamlined the various procedures of current account transactions by corporations and financial institutions and moved from a Positive List System to a Negative List System for capital account transactions. Out of concern over speculative activity by non-residents, the limits on Korean won denominated borrowing by non-residents was maintained, and overseas short-term borrowing by unsound corporations are still restricted. The second stage, scheduled to go into effect by the end of 2000, will remove the remaining restrictions on capital account transactions and relax further the guidelines on current account transactions, except those related to national security. 10

D. Trade Reform and Liberalization of the Services Account

43. Korea had a relatively open trade regime before the crisis, characterized by low tariff rates and dispersion. The average tariff rate was 8 percent in 1997, including an average rate of 6 percent for manufacturing and 17 percent for agricultural products.

44. Steps taken early in the program to eliminate remaining distortions in the trade regime included:

  • Elimination of trade-related subsidies. The government in January 1998 abolished the assistance program for domestically produced mini-computers, and in March 1998, eliminated the subsidies related to the reserves for export losses, the reserves for overseas market development, and the import content of the tax credit for investment in facilities.

  • The phasing out of the import diversification program. In the first stage, the government liberalized 25 items from the Import Diversification Program in December 1998, and the remaining 40 items in June 1999.

  • Tariff reductions. The number of items subject to adjustment tariffs was reduced from 62 to 38 on January 1, 1998.

  • Import certification procedures. In August 1998, a plan to streamline import certification procedures and bring them closer to international practices was implemented.

45. Following an announcement in January 1998 that Korea would liberalize financial services as agreed with the OECD, a new offer was submitted to the WTO in January 1999. The bindings made in this offer are broadly consistent with the financial services liberalization measures agreed earlier with the OECD, although they fall short in the area of cross-border services. Starting in April 1998, the government also allowed foreigners for the first time to engage in security dealings, insurance, leasing, and other property-related businesses.

IV. Monetary and exchange Rate Policy and Developments 1

1. The monetary policy response to the Asian financial crisis has drawn considerable attention, with the discussion surrounding themes such as whether and by how much interest rates should have been raised, when they should have been lowered, the effect of the change in interest rates on exchange rates and credit markets as well as the causes and appropriate response to tight credit conditions—”credit crunches.” This section examines some of these issues and is organized as follows. Section A describes the framework used for the conduct of monetary policy prior to the crisis and outlines key monetary policy developments during that period. Section B describes the key policy responses to the financial turmoil, and key outcomes with respect to interest rates, exchange rates and monetary and credit aggregates. Section C outlines the changes in the monetary policy framework since the outbreak of the crisis and key developments thus far in 1999.

A. Pre-Crisis Monetary Policy Framework and Key Developments

2. Prior to the crisis, monetary policy was aimed at the dual objectives of maintaining the stability of the value of the won and ensuring the soundness of the financial system.2 In practice, this translated to the government pursuing both external objectives (the exchange rate) and domestic objectives (growth/inflation) as conditions required. The Bank of Korea (BOK) sets monetary targets to achieve its objectives. Reserve money was the key operational target for day-to-day implementation of monetary operations and M2 was adopted as the intermediate target. (Box IV.1 contains definitions of key monetary aggregates.) In the 1990s, financial sector liberalization caused significant portfolio shifts which gave rise to an unstable demand for bank deposits. In particular, the restructuring of the money-in-trust system in May 1996, to clearly distinguish between money-in-trust products with time and savings deposits, triggered large portfolio reallocations. As a result, in early 1997, the BOK adopted MCT in place of M2 as the intermediate target. However, continued liberalization in the financial sector led to further large portfolio shifts between bank and nonbank financial institutions. Finally in late 1997, the BOK chose to target M3.

Definition of Monetary Aggregates

M2 is defined as Ml (currency in circulation + demand deposits at deposit money banks) plus quasi money (time and savings deposits + residents’ foreign currency deposits at deposit money banks. MCT is defined as M2 plus certificates of deposits plus money in trust. M3 is defined as MCT plus deposits at other financial institutions plus financial debentures issued plus commercial bills sold plus reverse repurchase agreements plus cover bills.

3. During most of the 1990s, the exchange rate regime was essentially a tightly managed float, with the won/dollar rate moving in a very narrow range. In March 1990, the Korean authorities introduced the market average exchange rate system (MAR) to replace the previous multicurrency basket. Under this system, the won/US dollar rate in the foreign exchange market was allowed to float within a range centered around the previous day’s weighted average spot rate. The daily exchange rate band was initially set at ± 0.2 percent. The authorities would intervene as necessary to keep the exchange rate within the daily band and would suspend foreign exchange market trading if pressures proved too great. Between 1990 and 1996, the won depreciated by 2 percent on average per year against the U.S. dollar (Chart IV.1). The intervention to maintain stability of the won was partly sterilized. In the first five years of the MAR system, the BOK issued W 10 trillion (50 percent of reserve money) in new Monetary Stabilization Bonds (MSBs) to absorb liquidity. 3

Chart IV.1:
Chart IV.1:

Exchange Rate and Stock Market Index, 1990 - 1997

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

4. As Korea embarked on the process of opening up its financial and capital markets during the early 1990s, the focus of monetary and exchange rate policy was to ensure a smooth transition to the more liberalized markets. In addition, by July 1997, most interest rates had been deregulated. 4 With greater freedom in the movement of capital flows and the deregulation of interest rates, developments in the exchange rate were likely to be influenced to a greater extent by short-term interest rates than in the past. It was important therefore to fully integrate the interactions between money supply, interest rates and the exchange rate into a consistent monetary framework. To this end:

  • First, the BOK started to pay more attention to movements in short-term interest rates and increased the use of market-based auctions to allocate MSBs as well as the use of repurchase operations to fine tune liquidity on a day-to-day basis.

  • Second, in the face of increased capital flows, greater flexibility of the exchange rate was allowed. In fact, the permitted daily fluctuation margin had been steadily increased since 1990. By 1996, the daily exchange rate band had been widened to ± 2.25 percent. (In November 1997, it was widened to ± 10 percent, before finally being abandoned in mid-December 1997.)

5. Following a period of rapid monetary and credit growth in the mid-1990s, the authorities began to tighten monetary conditions during the second half of 1996. During the economic boom in 1994–96, broad monetary aggregates expanded and credit to the private sector grew at an average annual rate of 20 percent. As concern mounted about the inflationary impact of the sustained economic expansion, the authorities attempted to achieve a soft landing by raising short-term interest rates. Inflation was gradually brought down and contained at 4-5 percent annually through 1997. In line with the tighter policy stance, growth in broad monetary aggregates and reserve money declined (Chart IV.2).

Chart IV.2:
Chart IV.2:

Money Developments, 1990–97

(Year-on-year percent change; end-of-period)

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

6. Prior to the crisis, there was little evidence that monetary and exchange rate policies were out of line with fundamentals. The current account deficit averaged 2½-3 percent of GDP in the mid-1990s and the external position was considered sustainable. In real effective terms, the exchange rate had appreciated by about 5 percent between 1994 and 1996, and was not believed to be overvalued. 5 There was some concern over the continued expansion of credit to the private sector at double digit rates but the rate of expansion was not considered excessive compared to regional rates (Table IV.1). Moreover, credit growth had been brought down from over 25 percent in 1994. Nevertheless, to the extent that there was a preference for short-term foreign borrowing, and because of the inflexible exchange rate regime which encouraged a one-way bet on the won, there was an increase in vulnerability of the Korean economy to sudden shifts in market sentiment and a reversal in short-term capital inflows.

Table IV.1:

A Regional Comparison of Growth in Private Sector Credit

(year-on-year, in percent, end of period)

article image
Source: IFS (Monetary Survey).

As of end-1996. For Korea, figures in brackets include credit extended by nonbank financial institutions.

7. Following the decline in the Hong Kong stock market in late October 1997, and the downgrading of Korea’s sovereign risk, financial markets in Korea came under increasingly severe pressure. The early policy responses to this pressure included intervention to support the value of the won, assurances from the Korean government that foreign debt liabilities of financial institutions would be serviced, and a short-lived increase in interest rates by 100-200 basis points in mid-November. These measures failed to calm markets and the won depreciated by about 22 percent between late October and December 3. Furthermore, the intervention to support the won, together with the fact that an increasing portion of gross official reserves had become unusable as they had been deposited at overseas branches of domestic banks, resulted in the virtual depletion of usable foreign exchange reserves.

B. Policy Responses Following the Crisis and Key Developments in 1998

Stabilizing the exchange rate

8. The design of monetary policy in the midst of a crisis of confidence is difficult, requiring a determination of which is likely to be the least costly in terms of foregone output—a rapidly depreciating exchange rate reflecting massive capital outflows, or temporarily higher interest rates. In Korea, as in the other Asian crisis countries, with reserves essentially depleted the choice was made to raise interest rates to restore market confidence and stabilize the exchange market. Monetary tightening to stabilize a currency under severe pressure is generally necessary for the following reasons:

  • higher interest rates tend to slow capital outflows by raising the nominal return to investors from assets denominated in the currency, that is, by paying the higher risk premium demanded by investors;

  • higher interest rates makes speculation more expensive by raising the cost of going short on the currency;

  • tighter monetary policy reduces expectations of future inflation and therefore of future currency depreciation;

  • monetary tightening—by lowering expectations of currency depreciation—reduces default risk for those with unhedged foreign currency debt exposure.

9. Of course, higher interest rates raise the burden on borrowers with a large amount of domestic debt and may, by raising the default risk on domestic debt, result in a further weakening of the currency. 6 Indeed, it was recognized that in Korea corporations had incurred high levels of domestic debt at variable interest rates, making their “bottom lines” dependent on the level of interest rates. At the same time, however, the high degree of exposure of banks and corporations to unhedged short-term foreign currency borrowing and the increase in financial obligations arising from a depreciation of the currency made it critical to arrest the sharp decline in the exchange rate. Therefore, despite the drawbacks and limitations of monetary tightening, the first priority was to secure exchange market stability and prevent a pervasive loss of confidence. The view taken was that a temporary but forceful increase in interest rates would demonstrate the authorities’ determination to maintain monetary discipline and hence be least costly in terms of foregone output.

10. Interest rates were raised sharply during December 1997. The legal ceiling on interest rates was raised from 25 percent to 40 percent and subsequently removed in January 1998. The overnight call rate rose from around 12 percent in early December 1997 to 32 percent on December 26. Other market interest rates also increased sharply during this period. In particular, the average bank lending and deposit rates climbed from 12 percent before the crisis to 18 percent and the overdraft lending rate jumped 13 percentage points to 37 percent.

11. It was recognized that for an interest rate defense to be successful, additional policy measures would be needed. Toward this end, key measures included: (1) obtaining agreement with external creditors on restructuring short-term debt; (2) provision of liquidity support by the BOK and accelerating the program of capital account liberalization; and (3) structural reforms to address the weaknesses in the financial sector and the high degree of indebtedness in the corporate sector (Chapters VI and VII).

12. Concerted efforts were made to persuade foreign creditors to roll-over short-term external debt in late 1997. A formal debt restructuring agreement was signed in early 1998. The agreement to reschedule short-term debts under an explicit guarantee provided by the government was key to easing the foreign exchange constraint by allowing indebted companies breathing space to restructure their operations and to service their foreign debt obligations. In addition, as discussed in Chapter III, the authorities liberalized the policy regime for capital inflows. The conclusion of the debt agreement facilitated an upgrade in sovereign credit ratings by international credit rating agencies, and Korea’s return to the international capital market. In early April 1998, the government placed two sovereign global bond issue totaling $4 billion. 7 The bond offerings were well received and demonstrated a turnaround in investor confidence in the economy. The elimination of restrictions on foreign investment in domestic bonds and other capital account liberalization measures also contributed to a pick-up in portfolio inflows from the first quarter of 1998.

13. Several measures were implemented to ease the foreign exchange and domestic liquidity constraints. All restrictions on foreign investment in domestic bonds were eliminated and in 1998, the aggregate ceiling on foreign portfolio investment in Korean equities was lifted. The BOK extended emergency liquidity support to distressed financial institutions, comprising W10 trillion in special loans to domestic financial institutions facing liquidity problems and $23.3 billion of foreign currency support to enable domestic financial institutions to meet their foreign currency obligations. The BOK also placed substantial foreign currency deposits at domestic banks and their branches abroad. The liquidity injection was later absorbed through open market operations.

14. This multi-pronged approach successfully restored external stability and allowed reserves to be rebuilt. By mid-1998, the foreign exchange market had stabilized and the exchange rate, while still far below the pre-crisis value, had appreciated quite significantly from the lows recorded in early January (Chart IV.3). By June 1998, the won had appreciated to about W1300-1400 to the dollar, up from the trough of close to W2000 to the dollar in late 1997, and remained broadly stable from about that time. The overnight call rate had begun to be lowered from early 1998 and by mid-1998, interest rates had been brought down to below pre-crisis levels.

Chart IV.3:
Chart IV.3:

Stabilizing the Foreign Exchange Market, 1997-99

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

15. Once the task of stabilizing the exchange market was accomplished in early 1998, the stance of monetary policy was progressively eased. A key question in this regard concerned the pace of the reduction in interest rates. Critics contended that although interest rates may have had to be increased initially, they were kept high for too long, plunging the economy into a vicious cycle of declining output, increasing bankruptcies, and further weakening of the financial sector—all of which served to weaken rather than shore-up investor confidence. 8 Several points are noteworthy in this context:

  • First, there is little evidence that Korea’s monetary policy response was unusual. The degree of tightening of monetary policy in Korea—measured by the number of months during which interest rates were maintained above the average level prevailing during the two years prior to the crisis—was not unusual compared to recent experience in other countries facing exchange rate crises (Table IV.2).

  • Second, as discussed below, growth rates of money and credit did slow sharply, but it is difficult to disentangle demand and supply factors contributing to the slowdown. Moreover, studies of the impact of the decline in money and credit growth on economic activity suggest that the deceleration in real money accounted for less than ¼ of the swing in GDP growth rates between 1997 and 1998.9

  • Third, interest rates began to be cautiously lowered in May 1998. Although the debt restructuring agreement had been signed by late March, continued caution was warranted especially in view of the unsettled global financial markets as well as the uncertain impact of the debt restructuring agreement on investor confidence in Korea. However, by June 1998, interest rates had been brought down to below the level prevailing before the crisis.

Korea: Credit Slowdown or Credit Crunch?

In the aftermath of Korea’s economic crisis, there was substantial anecdotal evidence that Korean firms were finding it difficult to obtain credit. Figure 5 confirms that a credit slowdown occurred over the period 1997-98. A credit slowdown, however, is a fairly general phenomenon that can be expected to occur during an economic downturn. As firms’ confidence decreases and their investment outlays are cut back, the demand for credit would fall. In contrast, a credit crunch refers in particular to (a) a reduction in the available supply of credit and/or (b) nonprice allocation of credit (i.e., rationing). A credit crunch can arise through one or more of the following channels:

  • The balance sheet channel focuses on the negative impact of a downturn on borrowers’ financial position, which would raise the external finance premium they face, or make it more difficult for them to obtain credit at all. Even without a downturn, monetary tightening could weaken borrowers’ balance sheets by increasing their interest expenses or shrinking the value of their collateral, also making them less creditworthy. Small and medium-sized enteprises (SMEs) could be hit especially hard, since they usually have little access to the commercial paper market.

  • The bank lending channel emphasizes reductions in the supply of credit occasioned by monetary tightening or capital build-ups by banks (due to requirements to meet capital adequacy targets; especially relevant in the Korean context). As monetary tightening increases interest rates, depositors shift their funds toward other assets offered by nonbank financial institutions and banks lose deposits. It may not be so easy for banks to replace deposits with, say, new equity issues, or to win back deposits with higher deposit rates (due to the need to hold unremunerated reserves). Furthermore, if banks prefer to hold government securities (which are very liquid and may be regarded as risk-free) rather than loans, they would accommodate the reduction in their liabilities by contracting credit. Since SMEs typically do not have as much clout as the chaebols, would be likely to be penalized as well.

  • Alternatively, banks may respond not only by reducing credit in general, but also by engaging in a flight to quality. That is, they could become more selective regarding their borrowers. This mechanism may in turn trigger a vicious circle (the “financial accelerator”): a downturn leads to tighter credit; tighter credit worsens the downturn; etc.

Several studies have concluded that one or more of the above mechanisms did indeed operate in Korea. Specifically, Domac and Ferri (1998) find that interest rate spreads capturing credit channel effects are significant for predicting real economic activity, and that SMEs suffer more than other businesses do from the adverse effects of credit contraction. Similarly, Ferri and Kang (1999) find that capital-constrained banks experience a more marked slowdown in loan expansion and disproportionately raise their lending rates.

However, identifying the existence of a credit crunch in a given period is difficult, since it requires (a) disentangling the supply from demand effects, and (b) identifying credit rationing. Ghosh and Ghosh (1999) estimate credit supply and demand functions for January 1992-June 1998 to determine whether, in any period, it is the supply or demand for credit which is the constraining factor. They conclude that supply was the constraining factor in Korea during the first half of 1997 (before the crisis broke), and that credit supply was not the constraining factor since then. In contrast, Kim (1999), who also estimates supply and demand functions (using slightly different specifications), concludes that there was excess demand for credit starting in 1997, increasing sharply during the crisis, and continuing through May 1998 (the end of his sample).

Ding et al (1998) use an indirect approach to study the crisis period. They point to the following: the increase in the spread between corporate and government bond yields, as evidence for the balance sheet channel (i.e., a contraction in loan supply to risky borrowers); the increase in the spread between the overdraft lending rate and the yield on corporate bonds, as evidence for the penalty faced by bank-dependent borrowers; and the increase in banks’ holdings of government securities as a proportion of their total assets, as evidence for the flight to quality.

On balance, the available evidence on whether Korea experienced a credit crunch in 1997-98, is inconclusive, although it is clear that credit shortages were more pronounced for SMEs. As the recovery proceeds and balance sheets improve, the “financial accelerator” should turn into a virtuous circle.

Table IV.2:

A Comparison of Real Interest Rates During Crises Period 1/2/

(In percent unless otherwise indicated)

article image

Based on average monthly data of overnight interbank/call rate.

The 12-month period for Korea is defined as Dec-97 to Nov-98; for Brazil Sept-98 to Aug-99; for Thailand July 97-Jun-98; for Sweden Sept-92 to Aug-93; for Mexico Jan-95 to Dec-95.

The threshold real interest rate is defined as the average real interest rate during the 24 months preceding the crisis period.

Year-on-year inflation.

16. In sum, the policies to stabilize the exchange rate were highly successful. This hard-won stability, together with the replenishment of international reserves with support of the international community, was instrumental in restoring confidence in the Korean economy. Together with the easing of macroeconomic policies to support demand and growth, the improved sentiment has been a major contributor to the quick recovery from the recession in 1998.

Money and credit developments, 1998

17. Monetary developments after the crisis were marked by significant portfolio adjustment. The uncertainty induced by the crisis combined with high interest rates triggered a rise in precautionary savings and a corresponding increase in holdings of financial assets. The lack of private spending reduced cash demand and thus had an impact on reserve money. Although reserve money declined, broad monetary aggregates continued to expand as there was a shift from currency to deposits. On a year-on-year basis, reserve money fell by 8 percent in December 1998; M2 growth surged to 27 percent; while M3 grew at a steady rate of some 13 percent—driven largely by growth in net foreign assets and credit to the public sector. The divergent behavior of the monetary aggregates have implied a significant increase in the money multiplier and sharp declines in velocity in 1998 (Charts IV.4 and IV.5).

Chart IV.4:
Chart IV.4:

Money Developments, 1997-99

(Year-on-year percent change; end-of-period)

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

Chart IV.5:
Chart IV.5:

Money Multiplier and Changes in Velocity, 1997-1999

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

18. There was also a sharp reduction in the growth of bank credit. After years of double digit growth, the pace of private sector credit expansion was reduced to single digits in the second half of 1998. 10 At end-1998, growth in private credit was 1 percent, down from 21 percent a year ago. In real terms, private credit contracted by nearly 3 percent (Chart IV.6). Several factors contributed to this decline.

  • As bank lending rates rose, firms scaled back investment plans and demand for loans fell. A survey conducted by the Korea Institute for Industrial Economics (KIIE) and the World Bank during 1998 of 850 firms in key manufacturing sectors found high interest rates an important factor in raising the cost of loan repayments. This is not surprising given that the corporate sector in Korea has high debt-equity ratios and, indeed, at end-1997 had the highest in the region on average (Table IV.3). In addition, the share of domestic corporate debt to total corporate debt at 73 percent was comparatively high. Assuming the level of debt stays constant, the debt service burden in Korea would have intensified as the average lending rate rose during 1998 (Chart IV.7).

  • At the same time, banks were reluctant to extend new loans in light of the greater risk of default and as a result of the deterioration in the capital base.11 Borrowers who were dependent on bank credit had to pay increasingly higher premiums for their financing relative to firms that could issue debt on the market. The cost of bank borrowing rose as the spread between the average bank lending rate and the yield on commercial paper widened (Chart IV.8). The KIIE survey found that firms encountered difficulty in obtaining bank credit. According to the survey, the share of firms whose loan applications were rejected by financial institutions rose from 14 percent in the first half of 1997 to 38 percent in the first half of 1998. Box IV.2 contains a summary of the evidence on whether there was a credit crunch in Korea.

  • Small- and medium-sized enterprises (SMEs) were hit harder by the effects of the credit squeeze compared to larger firms. Not only were SMEs operating at lower capacity utilization and experienced significantly steeper drop-off in production than larger firms, they were also more dependent on bank credit financing. SMEs accounted for 73 percent of the total corporate financing by domestic money banks while large firms accounted for only 27 percent. By contrast, large chaebols enjoyed better access to alternative forms of credit that were easily substitutable for bank loans. In fact, gross issuance of bonds by large firms increased 22 percent between 1997 and 1998, with large firms capturing almost 100 percent of the market. Moreover, of the W12.9 trillion in outstanding listed corporate bonds in the local market, the top 5 chaebols accounted for some 60 percent. The major buyer of corporate bonds were investment trust companies, which increased their holdings of corporate bonds by 200 percent in 1998 before the restriction on the single group corporate bond holdings by financial institutions imposed later in the year dampened demand somewhat. As a result, by the end of 1998, the top 5 chaebols increased their total debt by 6 percent, with much of the increase concentrated in Daewoo and Hyundai.

Chart IV.6:
Chart IV.6:

Real Private Sector Credit, 1997-1999

(Year-on-year percent change)

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

Table IV. 3.

Composition of Corporate Debt in Selected Countries

(In billions of U.S. dollars, as of end-1997)

article image

Claessens at al (1998); for Philippines, debt-equity ratio is for top 5000 corporations, excluding banks (Philippine Stock Exchange Investment Guide).

World Bank and IMF staff estimates.

For Korea, includes nonresident Korean corporations’ borrowing overseas and resident corporations’ borrowing denominated in foreign currency. Data for Philippines also includes loans to resident corporations denominated in foreign currency.

Chart IV.7:
Chart IV.7:

Corporate Debt Servicing Burden, 1997–1999

(In billions of U.S. dollars)

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

Chart IV.8:
Chart IV.8:

Interest Rate Spreads, 1997–1999

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

19. The authorities took a number of steps to ease the financing constraint for SMEs. In order to increase the guarantee capacity of the credit guarantee funds, the government, with support from the World Bank and AsDB, injected some W7.5 trillion of capital into these institutions. A short-term trade financing facility of $3.3 billion for SMEs and larger enterprises not affiliated with the top five chaebols was established and the BOK provided short-term financing to temporarily illiquid financial institutions through a liquidity support facility with interest charged at the average call rate. Box IV.3 contains a summary of the measures taken to support SMEs. Additionally, the government imposed restrictions on the single group corporate bond holdings by financial institutions in order to encourage financial institutions to hold bonds issued by smaller firms; this raised the share of bonds issued by smaller firms from 1 percent in the first quarter of 1998 to 9 percent in the fourth quarter. Finally, banks were allowed to phased-in over a period of two years the more stringent capital adequacy ratio requirements.

Support to Small- and Medium-Sized Enterprises (SMEs)1

Following the onset of Korea’s financial crisis in late 1997, SMEs suffered a sharp contraction in bank and trade credit because of higher perceived risk. Starting in early 1998, the authorities initiated a number of schemes to address the credit crunch problems of the SMEs.

  • In early 1998, the BOK increased its rediscount facility for SMEs by W 1 trillion to W 5.6 trillion. Rediscounts were given in connection with the discount of commercial bills, foreign trade financing, and working capital loans to SMEs.

  • BOK established a one-year nonsector-specific US$ 300 million export financing facility under which it rediscounted SME export bills from selected commercial banks. The BOK also deferred by one year $1 billion of refinancing falling due in 1998 from long-term commercial bank foreign currency loans to SMEs.

  • In April 1998, the BOK initiated a $1 billion nonsector-specific temporary import financing facility for SMEs. Under the scheme (financed by the World Bank SAL, KDB and KEXIM) credit lines were provided to selected domestic banks to open usance LCs of up to 180 days for raw material imports. The maximum credit to a single company was limited to $10 million.

  • In early May 1998, the Banking Supervisory Authorities (BSA) urged banks to roll-over SMEs loans until the end of December 1998 and conduct a “triage” analysis of SMEs with over W 1 billion in outstanding bank credit in order to separate sound companies from those needing restructuring. In early July, banks began to extend financial support to sound SMEs in form of extensions of loan maturities, new money at favorable rates (2 percent above the prime rate), debt-equity swaps and trade financing. In total, between July and end-September, banks rolled over 88 percent of loans and extended W 10.8 trillion in new money to SMEs. The BSA raised the target in new lending to be provided to SMEs by the end of 1998 from W 12.8 trillion to W 14.8 trillion.

  • In July 1998, the BOK supplemented the $1 billion import financing scheme operated via KDB/KEXIM with $2 billion from official reserves, and expanded the coverage to include larger firms not affiliated with the top 5 chaebol. Of these additional funds, $1 billion is reserved for SMEs.

  • In September, the guarantee ceiling of the credit guarantee funds was raised by W 1 trillion through a capital increase funded by the budget. The government plans to allocate $1 billion in capital from World Bank SAL II to the guarantee funds implying a further W 26 trillion increase in the guarantee ceiling. Default ratios of the guarantee funds have risen to about 20 percent from some 5 percent before the crisis.

  • Credit guarantees provided by the two publicly supported credit guarantee agencies (the Korea Credit Guarantee Fund and the Korea Technology Guarantee Fund) had been increased sharply to help ease the impact of the recession on the corporate sector. The objective of these funds was to provide credit guarantee services to viable enterprises that lack tangible collateral.

  • With a view to reducing the moral hazard inherent in a guarantee system which provides full insurance, the authorities have moved away from the system of full guarantees to one of partial guarantees. Some effort has already been made toward this objective: of the total new guarantees issued in 1998,2.1 percent were partial guarantees, where the lending institutions took up to 20 percent of the risk. Beginning July 1, 1999 at least 20 percent of the new guarantees, including rollovers, issued by KCGF and KOTEC will cover only 80-90 percent of the value of guaranteed obligations depending on the credit rating of the firm.

1 SMEs are defined as enterprises employing less than 300 workers in the manufacturing sector and 20 workers in the service sector.

C. Key Monetary Developments, 1999

20. In April 1998, the Bank of Korea Act was revised to allow for greater independence of the BOK as well as to transfer the supervisory powers of the BOK to the newly established Financial Supervisory Commission. The revised Act re-defined the primary objective of monetary policy as promoting price stability and strengthened the role of the Monetary Board, the policymaking body of the BOK. The Board is now a seven-member body, comprising the Governor, three members recommended by government bodies (the BOK, the MOFE and the FSC, respectively) and three members from the private sector. The Governor serves as the chairman of the Board, a position previously held by the Minister of Finance. The independence of the central bank has been further enhanced with the reduction in the number of monetary board members—from five to one—appointed by government ministries. All members of the Board serve on a full-time basis.

21. Since late-1998, monetary policy has been focused on stimulating and supporting economic recovery. After a period of sustained reductions in the overnight call rate, which brought down other interest rates across the maturity spectrum, the BOK has kept the call rate essentially unchanged at close to 4.7 percent since May 1999. At the end of June, the 3-year corporate bond rate was 8 percent and the average bank lending rate was 9 percent, down from the highs of around 25 percent in January 1998 (Chart IV.9). As of end-June 1999, the total credit extended by the financial sector increased by close to 4 percent. The increase in bank lending has benefited SMEs to a greater extent than large corporations. Reserve money is also showing signs of recovery following the contraction in 1998. In particular, the transactions demand for cash has strengthened along with the pick up in private consumption. In recent months, reserve money growth has also reflected the shift in deposits from the investment trust sector to commercial banks following the Daewoo crisis. In addition, robust broad money growth combined with the rapid recovery in the economy has moderated the decline in velocity following the sharp fall in 1998.

Chart IV.9:
Chart IV.9:

Domestic Interest Rates

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

22. The policy response to the sharp increase in capital inflows from early 1999 involved a combination of reserve accumulation and exchange rate appreciation. Given the cyclical position of the economy in 1999, when the recovery from the recession was just beginning to take hold, the authorities chose to respond to the inflows by keeping interest rates low, allowing the exchange rate to appreciate and intervening in the foreign exchange market to reduce external vulnerability by accumulating reserves and to moderate the pace of appreciation of the exchange rate.12 The won appreciated by more than 10 percent in real effective terms during the first half of 1999. The pace of appreciation was somewhat slower during the second half of 1999, owing partly to Daewoo-related market jitters and the resultant portfolio outflows, as well as the appreciation of the yen and the euro against the dollar. Through the end of November 1999, the won appreciated by some 5 percent in real effective terms. Usable reserves rose from $48.5 billion at end-1998 to nearly $70 billion at end-November 1999, providing close to full cover for short-term foreign liabilities on a residual maturity basis.

23. Maintaining stability in financial markets became an additional consideration in the conduct of monetary policy during the third quarter of 1999. Specifically, following the collapse of the second largest conglomerate in Korea—Daewoo—there was a sharp jump in the 3-year corporate bond rate by about 300 basis points. The increase in bond yields was triggered by investors—nervous about the ability of Daewoo to meet its debt obligations—seeking early redemption of the beneficial certificates issued by investment trust companies. These companies were forced to sell their assets, including bond holdings, to satisfy requests thus pushing up bond yields. 13 The authorities’ response to the rise in corporate bond rates was two-pronged. First, the BOK reiterated its intention to provide sufficient liquidity into the system to keep the overnight call rate at around 4¾ percent. Second, the authorities established a Bond Market Stabilization Fund (BMSF), funded with contributions from banks and insurance companies, to support bond prices and push down bond yields. Chapter VI contains a more detailed description of the impact of the BMSF.

V. The Fiscal Policy Response to the Crisis 1

1. In the last two years, there has been a major shift in the way the state interacts with the private sector in Korea. In the area of fiscal policy, this change is manifested in the increased use of an activist fiscal policy to support economic activity during the severe economic downturn; the greater role of the state in providing income security for those who have lost their jobs or are in need of social support; and the provision of significant public resources to restore stability in the Korean financial sector. This chapter describes these developments. Section A provides a general overview of the evolution of fiscal policy following the financial crisis. Section B and C then highlight two particular aspects of this policy that deserve separate mention—the tax policy response to the crisis, and the reform of the social safety net to lessen the adverse distributional effects of the ensuing economic downturn. The issues relating to the costs and design of financial sector restructuring are dealt with in Chapter VI.

A. A Chronology of Fiscal Developments


2. Before the financial crisis, fiscal policy in Korea had been dominated by a culture of fiscal prudence with the financial position of the consolidated central government remaining in balance since 1993. 2 Indeed, it has long been a common practice in Korea not to undertake spending commitments until the revenues that finance them have been received. During the 1990’s the government has consistently reduced its sovereign indebtedness with the central government debt falling to a low of 9 percent of GDP by 1996. As a result, responding to the unprecedented economic downturn of 1998 required a major change of focus and attitude in fiscal policy. Instead of a fiscal policy directed towards budget balance in a time of high growth, the government has had to shift to a more supportive stance that would provide temporary demand stimulus to a worsening economic downturn.

Table V.1.

Korea: Consolidated Central Government Key Aggregates, 1995-99

article image
Sources: Ministry of Finance and Economy; and staff estimates.

3. When the financial crisis hit, there was initially a general belief that the policy of fiscal conservatism should be continued. The reasons were three-fold: First, the authorities believed that a worsening fiscal position would have placed a greater burden on monetary policy in the overall macroeconomic adjustment. Second, the expected contingent liabilities from the costs of financial sector restructuring would require an offsetting policy response in other components of the fiscal balance. Third, a tight fiscal policy would provide a positive signal to financial markets and foster a return of confidence. However, as discussed in greater detail below, the fiscal stance was adjusted in early 1998 to take account of the weaker growth outlook and the need to strengthen the social safety net.

Fiscal policy in 1998

4. In the initial stages of the crisis, the government’s priority for fiscal policy was to avoid a worsening of the fiscal position as a result of the economic downturn. The original 1998 budget, passed on November 17, 1997 before the crisis became full blown, was predicated on real growth of 6 percent and targeted a budget surplus of ¼ percent of GDP. By early December 1997, however, growth estimates had been downgraded to 3 percent (Chart V.2). Under this revised macroeconomic outlook, the overall balance was expected to worsen to a deficit of around ½ percent of GDP. In addition, the interest costs of financial sector restructuring were projected to add a further ¾ percent of GDP to the deficit. Faced with the prospects of a significant turnaround in the overall deficit the authorities decided to undertake offsetting policies aimed at restoring fiscal balance. Measures were introduced in late 1997 to increase excise and oil taxation, expand tax bases, freeze civil service salaries, and reduce current expenditures. In addition, the government also prepared contingency measures to increase consumption taxes and further cut discretionary expenditure should the fiscal position continue to worsen.

Chart V.2:
Chart V.2:

Growth Forecasts and Budget Plans, 1996

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

5. By the end of December 1997 the extent of the crisis was becoming more clear, including its implications for activity. This led to a reconsideration of the appropriateness of the initial fiscal policy response. In late December, the government’s economic program adopted a more flexible position. Rather than trying to maintain fiscal balance the revised program focused on allowing the automatic stabilizers to operate and tolerating a deficit in the short-term. It was likely that even this policy stance would have provided only a modest stimulus to the economy as the effect of the automatic stabilizers was likely to have been weak given the high proportion of indirect taxes in revenue and the meager social safety net. As Chart V.2 shows, as the extent of the crisis slowly became apparent, greater fiscal support for the economy was programmed.

6. By spring of 1998, the government changed the goals of its fiscal policy putting greater emphasis on providing fiscal stimulus and lessening the consequences of the crisis on the poor and the unemployed. On February 5, 1998 the government concluded an agreement, as a part of the Tripartite Accord, that increased unemployment-related spending by about ½ percent of GDP. This effort, as well as other increases in safety net spending included in the March 1998 supplementary budget, resulted in an increase in the deficit to a projected 1½ percent of GDP. This change in fiscal stance provided a needed temporary fiscal stimulus to the ailing economy, and also, in the context of the Tripartite agreement, helped maintain social consensus and support for the government’s economic program in the face of social and economic hardships that were already becoming increasingly apparent.

7. Despite the deeper than expected economic downturn and the shift in the official position on fiscal policy, the first quarter actual budgetary outturn was one of fiscal balance. Both current and capital outlays were well below projections. In part, this slow disbursement of budgetary funds reflected difficulties in executing several of the newly implemented social safety net programs and bottlenecks in capital projects that were to be implemented by local governments. However, the balanced budget also reflected the traditional reliance on securing revenues prior to making expenditures; it soon became clear that this past practice would need to be quickly abandoned.

8. By July 1998, the sharp drop in economic activity and an increase in social pressures led the authorities to dramatically shifting gears with the introduction of a second supplementary budget (which was passed in September). This budget aimed to support economic recovery by further increasing spending on social safety nets by W 3.8 trillion and W 3.4 trillion in assistance to SME’s through guarantees and net lending. This additional spending was partially offset by reductions in the size and salaries of the civil service and by savings from lower than expected costs of financial restructuring. 3 At the same time a package of revenue measures was introduced that increased the tax on interest income and oil products, while reducing taxes on consumer durables and automobiles. Although the thrust of the budget was appropriate, increasing the stimulus at a time of a collapse in domestic demand, some elements of the package were questionable. Specifically the introduction of higher tax rates was perhaps unnecessary at a time when economic prospects were far from certain. In addition, the initiatives on spending could have been better directed towards consumption-generating programs and the further development of the social safety net rather than the package of net lending.

9. By the third quarter of 1998, the economic downturn had moderated and, following the approval of the supplementary budget, government expenditures began to pick-up. Safety net programs in particular were rapidly disbursed with funds being shifted away from programs with low take-up (e.g. wage subsidy programs to prevent layoffs and subsidized lending to the unemployed) and towards faster-disbursing programs. In addition, public works programs were redesigned and, as a result, became more popular among the unemployed. By the end of the year expenditure had risen from 22 percent to almost 26 percent of GDP and the fiscal deficit reached 4.2 percent of GDP which, although less than the budgeted level, still provided considerable fiscal stimulus to the economy. As Chart V.3 shows, although the economic downturn would, in the absence of offsetting policy action, have resulted in the budget moving into a deficit about 1½ percent of GDP, the actual deficit was much larger. The fiscal impulse provided in 1998 is estimated to be 0.6 percent of GDP. 4

Chart V.3.
Chart V.3.

Actual and Cyclically Neutral Budget Balance 1/

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

1/ Deficit measured excluding privatization receipts.

Fiscal policy in 1999

10. In 1999, the government intended to continue the expansionary fiscal stance instituted in 1998. Initially a fiscal deficit, including privatization receipts, of around 5 percent of GDP was targeted. This involved increased spending on the social safety net, greater support for SME’s, and additional interest payments associated with bonds issued for financial sector restructuring. At the same time spending on public sector employment was reduced and other categories of spending were depressed moderately in real terms. The intention was to front-load capital expenditures into the first half of the year in order to offset the usual seasonality of the budget and to provide the greatest demand stimulus when it was most needed. Facing a rapidly rising level of unemployment at the start of 1999, the authorities introduced in March a supplementary budget aimed at reinforcing measures for job creation and protection for the unemployed. The supplement planned an increase in spending of around 1 percent of GDP that was offset by lower than expected interest expenditures and increased revenues from the Bank of Korea profits. The net effect on the budget was an increase in the deficit (and also of stimulus) of 0.4 percent of GDP.

11. By mid-1999, it was clear that the automatic stabilizers associated with the rapid economic recovery were going to result in a budget deficit that was well below the level targeted at the start of the year. In June, the government decided to announce a second supplementary budget which added ¾ percent of GDP to the deficit. This supplementary budget was aimed in part at shoring up political support for the reform process. Measures included increased deductions and allowances for the personal income tax, corporate tax incentives and preferences, spending to encourage business start-ups, increased funding for subsidized lending and the credit guarantee fund, and expanded programs of free food provision to the needy. In the wake of Typhoon Olga, the National Assembly also approved additional spending of W 1.5 trillion (¼ percent of GDP) to assist victims of flood-related disasters. The net effect of the improved economic outlook, together with the supplementary budget, imply a deficit of 4.6 percent of GDP. The fiscal impulse in 1999 is estimated to be 1½ percent of GDP.

The outlook for the 2000 budget

12. In 2000, with a strong economic recovery under way, the Korean authorities intend to redirect fiscal policy towards the process of medium-term fiscal consolidation. Given the increased debt burden implied by the financial sector restructuring (see Chart V.l) as well as demographic factors, the authorities believe that the focus now should be one of reducing the stock of public debt and achieving fiscal balance by 2004. To achieve this medium-term goal the government plans to restrain the growth of nominal spending to 2 percent below that of nominal GDP. However, it is likely that expenditure restraint alone will prove insufficient to achieve the government’s medium-term goals. Hence, efforts will also be required on the revenue side, such as phasing out tax exemptions and expanding the tax bases, as well as improving tax administration particularly for the self-employed.

Chart V.l.
Chart V.l.

Central Government Debt-GDP

Citation: IMF Staff Country Reports 2000, 011; 10.5089/9781451822175.002.A001

13. The 2000 Budget targets a deficit for the consolidated central government of 3¾ percent of GDP. Public salaries are to be increased by an average of 9.6 percent during the year while public employment will be reduced by 1.7 percent. In addition, budgetary allocations to local governments will be increased from 13 to 15 percent of national tax revenues. To accommodate these higher expenditures while remaining on a path of fiscal consolidation, the government plans to limit the increase in Social Overhead Capital (i.e., infrastructure) spending to 5 percent, to reduce net lending programs to SMEs and the unemployed, and to dramatically reduce expenditure on publics works programs.

B. The Tax Policy Response to the Crisis

14. In the wake of the financial crisis the government implemented a number of tax measures with multiple, and often competing, aims such as to encourage corporate and financial restructuring, to encourage inward investment, to support regionally balanced economic development, to broaden the tax base and raise revenues, and to provide fiscal stimulus.

  • To encourage restructuring, profits from the revaluation of assets following mergers or acquisitions received corporate tax deferrals; capital gains tax was deferred for gains accruing from restructuring; and capital gains accruing on assets that were sold to repay debts were exempt from taxation. In addition, the tax treatment of loan loss provisioning for banks was made consistent with financial accounting rules prescribed in prudential regulations. 5

  • In an effort to attract investment, a number of tax preferences and incentives were introduced or expanded, including various tax holidays and exemptions for import duties on capital goods. Preferential tax treatment was also introduced for performance-related pay schemes such as employee stock options, and investment tax credits were expanded to encourage various forms of corporate behavior (such as investing in machinery or relocating companies to outside of the capital).

  • Although some tax rates were reduced during mid-1998—such as the excise on automobiles and the tax on capital gains—steps were also taken to protect budget revenue and broaden the tax bases. Specifically, tax rates on cigarettes, alcohol, petroleum products, and some luxury goods were increased; VAT exemptions for professional services were eliminated; and a withholding tax on interest income was introduced (initially at 22 percent and later increased to 24.2 percent).

  • To provide fiscal stimulus and encourage private consumption, the second supplementary budget for 1999 introduces a number of further changes to the tax law. These include an increase in personal income tax deductions and allowances; the introduction of a new deduction for credit card purchases;6 an expansion in the eligibility for tax-free savings; and further increases in preferential tax treatment for newly established SMEs, for investment in venture enterprises, for SMEs that relocate outside of the capital, for the acquisition of new homes, and for investment in machinery.

15. Overall, the immediate response to the unfolding crisis these tax measures provided a necessary reduction of the tax burden and removed many tax disincentives to corporate and financial restructuring. However, in many cases the tax policy efforts, while often appearing appropriate individually to mitigate the effects of the financial crisis, have lead to a complication of the tax system, an increase in the number of tax exemptions, and, ultimately, a loss of revenue. What is now needed, given the current more stable environment, is a comprehensive review of the tax system that would aim to simplify and expand the tax bases, reduce distortions, lower rates, and ultimately improve the simplicity, efficiency, and fairness of the tax system. Looking forward, some of the areas for tax reform that could be considered include a repeal of the Asset Revaluation Tax, simplifying the VAT regime for small businesses, improvements in the current system of capital income taxation, unification of the corporate income tax at a common rate, simplifying the schedule of income tax deductions, allowances, and credits, and limits on the number of tax incentives and tax preferences.

16. In the 2000 budget the government plans to take the first few steps towards streamlining the Korean tax system. The VAT system for small businesses will be simplified, the special excise tax will be eliminated from a number of goods, and the withholding rates on capital income will be unified at a common 20 percent. In addition, the system of tax concessions on special savings accounts will be simplified and the system of inheritance and gift taxation will be made more progressive and its administration will be tightened.

C. The Expansion of the Social Safety Net

17. In the aftermath of the crisis, one of the most dramatic changes in Korea’s fiscal policy was the concerted effort directed at putting in place a working social safety net. It became clear early on that the needed financial and corporate sector restructuring was likely to lead to a major increase in unemployment and a deterioration in income distribution. Indeed, unemployment rose to 8½ percent by early 1999, labor force participation fell, and real incomes declined. The government’s efforts at instituting a safety net focused on two aspects. First, providing support for those that had been made redundant and facilitating their rapid return to the workforce. Second, providing a minimum level of income for the most needy in society including the aged, children of the unemployed, and those unable to work. As a result, expenditure priorities have changed substantially in the last two years as shown in Table V.2.

Table V.2.

Korea: Current Expenditure 1997–99

(in percent of GDP)

article image