Republic of Korea: Staff Report for the 2002 Article IV Consultation

This 2002 Article IV Consultation highlights that the economic growth of Korea rose to about 6 percent in 2002 from 3 percent in 2001. Buoyant consumption and residential construction spending underpinned the recovery beginning in late 2001. In 2002, exports rebounded strongly in spite of a weaker-than-expected recovery in the global economy. Unemployment has eased to near pre-crisis levels, although wage rises have been matched by productivity growth. In terms of macroeconomic policies, the fiscal surplus was substantially higher than budgeted, resulting in a contractionary fiscal stance in 2002.


This 2002 Article IV Consultation highlights that the economic growth of Korea rose to about 6 percent in 2002 from 3 percent in 2001. Buoyant consumption and residential construction spending underpinned the recovery beginning in late 2001. In 2002, exports rebounded strongly in spite of a weaker-than-expected recovery in the global economy. Unemployment has eased to near pre-crisis levels, although wage rises have been matched by productivity growth. In terms of macroeconomic policies, the fiscal surplus was substantially higher than budgeted, resulting in a contractionary fiscal stance in 2002.

I. Introduction

1. Korea’s excellent economic performance in 2002 reflects the benefits of the far reaching economic reforms implemented since the 1997–98 crisis.1 The rebuilding of the banking system enabled domestic demand to lead the recovery in the face of a sharp decline in external demand in 2001, and to continue to sustain strong growth in 2002. Robust exports in 2002, despite a weaker-than-expected recovery in external demand, also benefited from the substantial restructuring of the corporate sector. Overall, the Korean economy has significantly outperformed other IT-specialized Asian countries in recent years. Medium-term prospects are bright.

2. The central outlook is for economic growth to moderate somewhat in 2003, but to remain relatively strong. There are downside risks from weaker global growth or a sharp rise in oil prices. There was broad agreement between the authorities and the mission team on the policy imperatives for the period ahead, namely:

  • to be prepared to use macroeconomic policies to cushion the impact of weaker external growth or other shocks; and

  • to continue efforts to strengthen the corporate and financial sectors by further entrenching the role of market discipline.

3. At the Board meeting for the 2001 Article IV consultation in February 2002, Executive Directors considered that macroeconomic policies should remain supportive as there were still uncertainties in the near-term outlook. With growth then expected to be a modest 4 percent in 2002, Directors advised that fiscal policy should not be allowed to be tighter than budgeted to avoid a contractionary impulse in 2002. They also urged the authorities to address the problems in budget planning, monitoring, and execution. Directors encouraged the authorities to continue to limit foreign exchange intervention to instances of disorderly trading. They welcomed the announced schedule for the sale of government-held bank shares, along with the authorities’ intention to undertake comprehensive insolvency reform, and encouraged the authorities to continue their gradual approach to the relaxation of chaebol regulations.

4. Korean economic policies have largely been consistent with the Fund’s recent policy recommendations. In the Board meeting for the 2001 Article IV consultation, the authorities expressed their view that the 2002 budget targets were appropriate despite the weak economic outlook, and that the front-loading of expenditures in 2002 would provide sufficient stimulus. As the economy strengthened in early 2002, the staff, in a visit in April 2002, revised its growth projection up to 6 percent and considered that a higher-than-budgeted surplus in 2002 would be warranted. While there has been little recent progress on technical assistance recommendations to improve fiscal management and transparency, the authorities have made progress in developing a medium-term fiscal framework. Other policies have also been consistent with the Fund’s recommendations.

5. Mr. Roll, Moo-hyun of the governing MDP was elected President on December 19, 2002 and will be inaugurated on February 25, 2003. The overall thrust of economic policies is expected to be little changed under the new government, particularly the continuation of corporate and financial sector restructuring, although there maybe more emphasis on strengthening the social safety net. President-elect Roh aims to continue the “sunshine policy” toward the DPRK of outgoing President Kim Dae-jung.

II. The Current Setting and Prospects

A. Macroeconomic and Market Developments

6. Korea’s economic growth recovered in the second half of 2001 and remained strong in the first half of 2002. Buoyant consumption and residential construction spending underpinned the recovery, supporting 3 percent real GDP growth in 2001 despite a fall in export volumes (Table 1). A rebound in exports in the first half of 2002 consolidated the recovery. Private consumption has been losing steam since the first quarter, and is expected to slow further as consumer confidence has weakened since mid-year. While industrial output growth has been robust, mainly driven by the IT and related sectors, capacity utilization still remains somewhat below average pre-crisis levels, which has been reflected in a modest growth in equipment investment. For the year as a whole, real GDP is estimated to have increased by 6.1 percent. Korea’s growth performance in recent years has compared favorably with OECD and regional economies.

Table 1.

Korea: Macroeconomic Framework, 1998–2003

(in units indicated)

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Sources: Korean authorities; and Fund staff estimates and projections.

Contribution to GDP growth.

Excluding privatization receipts.

Data for 2003 arc as of January 14, 2003.

On a residual maturity basis.

Includes offshore borrowing of domestic financial institutions and debt contracted by their overseas branches.

Debt service on medium- and long-term debt in percent of exports of goods and services.


Real GDP

(q/q percent change, s.a.)

Citation: IMF Staff Country Reports 2003, 079; 10.5089/9781451822076.002.A001


Comparative Real GDP Growth 1999-2002

(in percent)

Citation: IMF Staff Country Reports 2003, 079; 10.5089/9781451822076.002.A001

1/ Hong Kong SAR, Singapore, and Taiwan POC.2/ Indonesia, Malaysia, Philippines, and Thailand.

Economic Indicators

(Percent change, y/y, unless otherwise indicated)

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7. Unemployment has eased to near pre-crisis levels, while wage rises have been matched by productivity growth. Strong employment growth in the service sector has reduced the unemployment rate to 3 percent, although labor force participation remains below pre-crisis peaks. Average monthly earnings rose 10½ percent (y/y) in the first three quarters of 2002, up from a 6 percent (y/y) increase in 2001, but manufacturing labor productivity also accelerated to 9.4 percent (y/y) in the first half of 2002.


Labor Market

Citation: IMF Staff Country Reports 2003, 079; 10.5089/9781451822076.002.A001

8. Core CPI inflation in 2002 was at the center of the 2–4 percent target range. Headline CPI inflation has been volatile, mostly due to weather-related swings in food prices, especially the impact of a major typhoon in August. Core inflation, however, has been relatively stable at 3 percent (y/y), as increases in housing rents were offset by lower public charges and the initial impact of the won’s appreciation against the U.S. dollar.



(y/y percent change)

Citation: IMF Staff Country Reports 2003, 079; 10.5089/9781451822076.002.A001

9. External trade rebounded sharply in 2002. Exports and imports jumped by almost 30 percent (y/y) in December (Table 2). Intra-regional trade, especially with China, was an important contributor to the strong export performance, possibly related to China’s accession to the WTO.2 The deficit in the services account is estimated to have widened further in 2002, due to rising spending by Koreans traveling abroad, transfers for overseas studies, and royalty payments. Overall, the current account surplus is estimated to have declined from 2 percent of GDP in 2001 to 1.4 percent in 2002.

Table 2.

Korea: Balance of Payments, 1998–2003

(in billions of U.S. dollars, unless otherwise indicated)

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Sources: Korean authorities; and Fund staff estimates and projections.

Bonds and notes, money market instruments, and financial derivatives.

These World Bank and ASDB loans were extended as exceptional financing in the 1997-98 crisis.

Merchandise Exports

(Percent change, y/y)

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Source: CEIC.

Exports by commodity and destination are up to November 2002.

10. Foreign borrowing by commercial banks rose sharply in 2002 enabled in part by upgrades of Korea’s credit rating, which almost regained pre-crisis levels. FDI inflows, on a commitments basis, declined by 19.4 percent in 2002, mainly because of reduced mergers and takeovers as corporate restructuring reached an advanced stage. Reflecting redemptions of emerging market funds and profit-taking, net portfolio outflows were US$1 billion in 2002—a sharp turnaround from the large net inflows of 2001. These outflows were offset by increased short-term borrowing by commercial banks to cover foreign exchange hedging by Korean enterprises, which is matched by off-balance sheet assets, and to finance lending in foreign exchange, with yen-denominated short-term debt rising by US$2 billion in the first three quarters of 2002. In response to the latter, the authorities have indicated that measures may be needed to curtail the growth in yen-denominated lending. Upgrades of Korea’s credit rating led to Korea being the first country to graduate from the widely used EMBI+ index for emerging markets, although this exit was accompanied by a small rise in Korea’s sovereign bond spread.


Exchange Rate Movements

(Sept. 1, 2001=100)

Citation: IMF Staff Country Reports 2003, 079; 10.5089/9781451822076.002.A001

11. The exchange rate fluctuated largely in line with the yen in 2002. The won appreciated sharply against the U.S. dollar in April–July, but fell back somewhat in the fall, before strengthening again in recent months. Although the won appreciated some 10 percent against the U.S. dollar in 2002, it was quite stable against the yen, and appreciated only 2½ percent on a nominal effective basis and 4½ percent on a real effective basis. Official reserves continued to rise, reaching US$121.4 billion by end-2002, mainly reflecting interest earnings, valuation gains, loan repayments by banks, and privatization receipts.3

12. Concerns about the global growth outlook since the second quarter have driven capital market developments, although domestic corporate financing conditions have improved. Korean equity markets largely moved with regional markets, as the KOSPI rose significantly in the first quarter of 2002 but fell back thereafter. Yields on long-term government bonds moved in a similar fashion. The DPRK’s announcement that it had withdrawn from the Treaty on the Non-Proliferation of Nuclear Weapons in mid-January dented equity markets modestly and put further downward pressure on domestic bond yields, but had a negligible effect on sovereign spreads. Nonetheless, spreads on corporate bonds have remained at the low levels reached earlier in 2002. Official support for the corporate bond market has been virtually eliminated, as the authorities introduced a penalty fee on rollovers of more than 50 percent of maturing PCBOs.4 Together with the improved financing conditions, this resulted in a sharp drop in PCBO rollovers to only 7.3 percent of maturing PCBOs in the first three quarters of 2002; PCBOs were less than 6 percent of outstanding corporate bonds in September 2002.


Stock market Index and Business Confidence

Citation: IMF Staff Country Reports 2003, 079; 10.5089/9781451822076.002.A001

B. Monetary and Fiscal Policies

13. The fiscal surplus for 2002 is expected to be 2 percent of GDP higher than in the original budget (Table 3). Total revenues are likely to exceed budget projections by 0.3 percent of GDP reflecting the buoyant economy and higher-than-expected transfers from the BOK. Consistent with Korea’s conservative budget management practices, current expenditures are anticipated to be 1 percent of GDP lower than budgeted. The shortfall of 0.6 percent of GDP in non-interest current spending would have been larger were it not for the supplementary budget of W 4.1 trillion (0.7 percent of GDP) approved in September to finance typhoon-related reconstruction.5

Table 3.

Korea: Consolidated Central Government Operations, 2000–03

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Sources: Ministry of Planning and Budget; and Fund staff estimates.

Including supplementary budgets.

From 2003 onward, interest payments on W50 trillion of KDIC/KAMCO bonds will no longer be included in the consolidated budget, amounting to 0.5 percent of GDP in 2003.

14. Monetary policy has been on hold since a 25 basis point tightening in May. In its May decision the BOK anticipated upward pressure on inflation from oil prices and demand-side pressures, and noted concern about the rapid rise in household lending. But further rate hikes were put on hold due to the instability in international financial markets that emerged around mid-year and the associated uncertainty about external demand prospects, coupled with the appreciation of the won and the continued stability of core CPI inflation.


Interest Rates

(Percent per annum)

Citation: IMF Staff Country Reports 2003, 079; 10.5089/9781451822076.002.A001

15. The rise in household lending and housing prices has slowed since the introduction of prudential measures in October 2002, casing concerns about a possible real estate bubble and reducing the urgency to tighten monetary policy (Box 1):

  • Bank lending to households increased 50.4 percent (y/y) in September 2002 (Table 4), and then fell to about one-third of that pace in November–December.

  • Overall house price inflation has been running at 16–18 percent (y/y) since March 2002, led by apartment prices in the southern Seoul area of Gangnam, which rose 43.4 percent (y/y) in September. In October–November, however, the national house price index slowed more than would be expected due to seasonal factors, and price falls were recorded in Seoul, especially in areas like Gangnam. From a longer-term perspective, the level of real housing prices remains relatively low (Figure 5).

Table 4.

Korea: Monetary and Financial Indicators, 2000–02

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Source: Bank of Korea.

Covers credit from banks, savings institutions, and insurance, credit card, finance, and merchandise companies.

Adjusted for the sale of nonperforming assets to KAMCO.

Figure 1.
Figure 1.

Korea: Activity and Prices

Citation: IMF Staff Country Reports 2003, 079; 10.5089/9781451822076.002.A001

Sources: Korean authorities, CEIC database; and Fund staff calculations
Figure 2.
Figure 2.

Korea: External Developments

Citation: IMF Staff Country Reports 2003, 079; 10.5089/9781451822076.002.A001

Sources: Korean authorities, CEIC database, Bloomberg; and Fund staff calculations
Figure 3.
Figure 3.

Korea: Financial Market Indicators

Citation: IMF Staff Country Reports 2003, 079; 10.5089/9781451822076.002.A001

Sources: Korean authorities, CEIC database; and Fund staff calculations1/ Countries include China, Hungary and Poland.
Figure 4.
Figure 4.

Korea: Corporate and Financial Sector Soundness

Citation: IMF Staff Country Reports 2003, 079; 10.5089/9781451822076.002.A001

Source: Bank of Korea and Financial Supervisory Service.1/ Current assests divided by current liabilities.2/ Operating profits divided by interest payments.
Figure 5.
Figure 5.

Korea: Housing Price Developments, 1986-2002

Citation: IMF Staff Country Reports 2003, 079; 10.5089/9781451822076.002.A001

Sources: CEIC database and IMF staff calculations.

Bank Lending to Households (net)

(in billions of won)

Citation: IMF Staff Country Reports 2003, 079; 10.5089/9781451822076.002.A001

Developments in Household Credit

High growth in credit to Korean households in recent years has partly reflected a shift in bank lending practices that had previously focused largely on the corporate sector. Household credit rose at an annual rate of 33 percent in the first three quarters of 2002, following high growth in 2000–01. Banking reforms, including the end of directed lending after the 1997–98 crisis, have allowed the banks to increase the share of household loans from 35 percent of total won loans in 1997 to over 50 percent in June 2002, similar to that in other advanced economies. Household lending has contributed to the improved profitability of Korean banks, and banks with the lowest initial household exposure have been the most aggressive in competing for new customers. Growth in credit card debt was especially rapid after the introduction of a tax deduction and other measures designed to encourage credit card use and thereby broaden the tax base.

Household Credit Developments

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Source: BOK and FSS.

The risks of large financial sector losses or of a sharp retrenchment in household spending do not appear to be substantial. Credit to income ratios have risen to levels comparable to other advanced economies, while the increase over the past decade is close to that in Australia.1 Despite rising debt levels, the interest payment burden has been stable and household net financial wealth remains above pre-crisis levels. Delinquency rates remain relatively low and stable on household loans. Although there has been a rise in credit card delinquency, credit card debt is only one-sixth of household credit. Most household lending has been to purchase housing, with almost two-thirds of bank loans collateralized. Loan-to-value ratios are modest on average, with most banks close to the revised official guideline of 60 percent.

The authorities adopted a range of measures in 2002 to strengthen prudential supervision of household lending, including a wide range of credit card regulations and on-site examinations of banks’ risk management practices for household credit, with agreements on the implementation of planned improvements. Further measures were adopted in October: (i) increases in minimum mandatory loan loss provisioning on household loans, especially credit card debt; (ii) an increased BIS risk-weight on new household loans that are overdue more than 30 days and/or are more than 250 percent of the borrower’s income; and (iii) a reduction in the loan-to-value ratio guidelines on housing loans from 70–80 percent to 60 percent, and reductions over time in loan-to-value ratios by those banks that have above average ratios. The authorities have also sought to reduce real estate speculation through a variety of measures, some targeted at the districts of Seoul with the highest house price rises, such as making greater use of market rather than official prices in capital gains taxation, effectively increasing the tax rate in these areas.

The effects of these measures are being monitored closely by the authorities. While data for October-December 2002 suggest some slowdown in the pace of household credit expansion and in house price inflation, the next “moving season” around the turn of the year will be a key test of the effectiveness of these measures.

1Chapter IV of the Selected Issues paper provides further analysis of developments in household debt.

C. Financial and Corporate Sector Developments

16. The health of the banking system in Korea has continued to improve. The share of commercial bank loans classified as substandard or below fell to 2.5 percent in September 2002, from 3.3 percent at end-2001 and 8.9 percent at end-2000, while the average capital adequacy ratio of the banking system stood at 10½ percent. Profitability has also improved, with the banking system earning a profit (net of provisions) in 2001 for the first time since 1997; operating income also grew strongly in 2002, although increased provisioning on household loans and credit card receivables, as well as on loans to ailing firms including Hynix, dampened the growth in net profits. With the banks’ return to profitability, reprivatization has begun in earnest (Box 2).

17. In contrast to the banking sector, progress in restructuring the NBFIs has been relatively slow. Most insurance companies and a number of ITCs remain under capitalized, and there are concerns about the financial strength of nonbank deposit-taking institutions. As a group, credit unions have sustained losses for three consecutive years and close to 30 percent were insolvent as of end-June 2002. To begin addressing this problem, the FSC/FSS suspended operations of 125 credit unions in late 2002 and announced in early 2003 that 107 of them would be liquidated.

18. The recovery of public funds injected for financial sector restructuring has continued, partly due to renewed momentum in reprivatizing commercial banks. One-third of the public funds has been recovered, and the government estimates it will collect a total of 56 percent, which compares favorably with the experience of other countries (Box 3). The government has also made progress in privatizing nonfinancial corporations, completing the privatization of Korea Telecom and Korea Tobacco & Ginseng, and opening bidding for one of KEPCO’s power generation units.

19. In the corporate sector, debt-equity ratios have fallen to levels below the United States and Japan, although debt remains high relative to sales. The recent reduction in debt-equity ratios has partly reflected debt-equity swaps and debt forgiveness for the former Daewoo group companies, along with debt repayments by large healthy companies. Overall, three-quarters of the fall in the debt-equity ratio since the end of 1997 has reflected increased equity financing, with debt reduction accounting for only one-quarter of the fall in the ratio. Operating profitability has improved from 2001, due mainly to lower material prices and higher semiconductor prices. The strongest improvement in profitability was in larger firms, exporters, and firms in the IT sector.

Reprivatization of Financial Institutions

The restructuring of the Korean financial sector in the aftermath of the 1997–98 financial crisis resulted in a significant increase in government ownership of banks. Recapitalization with public funds raised average government ownership in commercial banks, weighted by banks’ assets, from 17 percent at end-1996 to 58 percent at end-1998.

As part of the effort to recover public funds, and mindful of the inefficiencies associated with public ownership, the government started in 1999 a process of reprivatizing several commercial banks that it acquired fully or partly when it recapitalized the banks during the crisis. As a result, average government ownership in commercial banks declined to 34 percent at end-2001, and average foreign ownership in commercial banks increased from below 10 percent at end-1998 to more than 30 percent at end-2001.

An updated plan for bank privatization was announced in January 2002 that aimed to complete the privatization process over the next three to four years, seek a balance between domestic and foreign investors, and employ diverse sale methods to minimize the effects on financial markets. The primary target of the plan was to reduce government-held stakes to less than 50 percent in Seoul Bank, Chohung Bank, and Woori Bank by the end of 2003:

  • In April 2002, 51 percent of Cheju Bank, a small regional bank, was sold to Shinhan FHC for W 22.8 billion.

  • In June 2002, 11.8 percent of Woori (W 600 billion) was floated via an initial public offering, followed by Woori’s listing on the Korea Stock Exchange. The group also sold convertible bonds to Lehman Brothers, which can be converted into equity stake.

  • Seoul Bank was sold to Hana Bank in September 2002 in exchange for shares whose value Hana guaranteed for W 1.1 trillion over the next 18 months. As a result, the government now has a 31 percent stake in the merged bank, Agreement has reportedly been reached on the timing and method for sale of 60 percent of the remaining government shares in the merged bank; the other 40 percent will also be sold within the 18-month price-guarantee period.

  • Shinhan FHC was chosen in January 2003 as the preferred bidder to purchase most or all of the government’s share in Chohung Bank, although negotiations have not been completed.

  • The government has indicated that it will sell its minority stakes in other banks at opportune times, after its stake in Chohung Bank and Woori Bank has been reduced to less than 50 percent. The 2003 budget envisages the sale of its 9.6 percent stake in Kookmin Bank for W 1.6 trillion.

Government Shareholdings in Major Commercial Banks

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Sources: FSS; and Fund staff estimates.

As of end-June 2002.

Held by the Bank of Korea (10.7 percent) and the Export-Import Bank of Korea (32.5 percent).

In addition to banks, the government sold 51 percent of Korea Life to a consortium led by the Hanwha Group for W 824 billion in October 2002. The government has been actively seeking a buyer for two Hyundai Group financial units, Hyundai Investment Trust & Securities and Hyundai Investment Trust & Management. The Korean Development Bank has also announced plans to sell its 39 percent stake in Daewoo Securities in 2003.

Recovery of Public Funds for Financial Sector Restructuring

The Korean government has used public funds of W 157 trillion (32 percent of average GDP in 1998–2000) for financial sector restructuring. Of this total amount, about W 60 trillion was used to recapitalize financial institutions, W 39 trillion was used to purchase nonperforming assets, W 26 trillion was used to pay off depositors of closed institutions, and W 32 trillion was used to facilitate purchase and assumption transactions. The bulk of the funds were financed by the issuance of W 104 trillion of government-guaranteed bonds by KDIC and KAMCO.

Good progress has been made in recovering public funds through sale of acquired government shareholdings, collection of NPLs, and sale of assets. The authorities had recovered 32 percent (W 50 trillion) of the total by the end of June 2002, which compares well with the experience of other countries. The government estimates that it will recover a total of 56 percent (W 87 trillion), with W 37 trillion to be realized in the medium term.

For the unrecoverable residual of W 69 trillion, a burden sharing plan has been adopted: 70 percent of the unrecoverable amount will be explicitly recognized as government obligations, with the remaining 30 percent covered by a 0.1 percentage point surcharge in the deposit insurance premium, which went into effect in early 2003 and will be maintained for 25 years.

To implement the plan, W 49 trillion of the KDIC and KAMCO bonds maturing in the next four years will be converted into treasury bonds, and the remaining outstanding KDIC and KAMCO bonds of W 50 trillion will be serviced by increases in the deposit insurance premium and future recoveries of public funds. The budget will no longer provide subsidies to KDIC and KAMCO for interest payments on their bonds. The conversion of KDIC/KAMCO bonds into treasury bonds will raise explicit government debt by 8 percentage points of GDP.

Fiscal Costs of Selected Banking Crises

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Source: Fund staff estimates.

Excludes a 40 trillion rupiah allocation to the deposit guarantee fund in September 2001.

Losses implied by the merger of two state owned banks (Bank Bumiputra and Bank Simc) with private banks are excluded.

Refers only to the Savings and Loans crisis.

As of end–1998.

Indicators of Financial Stability and Profitability in Manufacturing, 1997–2002

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Source: Bank of Korea, Financial Statement Analysis.

Operating income to gross interest payments.

20. However, the proportion of firms in poor health rose and their performance deteriorated, with almost 10 percent of companies exhibiting persistent weaknesses, pointing to the need for restructuring. The share of companies with operating profits less than interest payments (i.e., with an ICR below 100 percent) rose to 34 percent for the first three quarters of 2002 from 32 percent in same period of 2001, driven by a sharp 5 percentage point rise in the share of companies making operating losses. While the average ICR rose significantly, the ICR of the weakest quarter of firms fell 44 percentage points to only 8 percent. The FSAP mission found that almost 10 percent of companies had an ICR less than 150 percent in each year from 1999–2001; excluding companies under some form of restructuring, this group accounts for about 15 percent of total corporate debt.

21. A number of steps to strengthen corporate governance and regulation were taken in 2002:

  • A draft insolvency law was circulated for public comment in November, and most observers expect the law to be approved by the National Assembly in 2003. While the draft law represents an improvement on the current legal framework, bolder reforms along the lines of staff recommendations could have established an insolvency regime better suited to the needs of the Korean economy (Box 4). Nonetheless, full use of the new law should help resolve the problem of persistently weak companies.

Corporate Insolvency Law Reforms

Corporate insolvency law reforms are essential to enhance the efficient allocation of resources within the Korean corporate sector. Although the health of the Korean corporate sector has improved in recent years, a significant proportion of corporations display persistently weak capacity to service their debts. Weak insolvency procedures allow these “zombie” corporations to continue to operate, impairing overall corporate performance by using capital and labor less productively. Weaknesses in Korea’s corporate insolvency framework, and in related procedures on foreclosure of collateral, also adversely affect the financial system by restricting creditor rights and distorting lending practices.1

The Korean authorities have moved forward with insolvency reform by drafting a single law to replace three overlapping laws. To assist the reform process, Fund staff provided technical assistance through participation in a February 2002 workshop on the design of an effective corporate insolvency framework. Subsequently, the Korean authorities prepared a draft Bankruptcy Act covering both corporate and personal insolvency procedures. When enacted, the draft Bankruptcy Act is likely to improve the efficiency and predictability of insolvency processes.

However, Fund staff considers that the draft Bankruptcy Act does not deal adequately with some key issues. In particular, it suffers from the following shortcomings:

  • inconsistencies between the equivalent criteria in liquidation and rehabilitation proceedings, which contribute to the length and complexity of the law and also present opportunities for strategic behavior by debtors and creditors;

  • inordinate deference to shareholders and inattention to insider creditor claims, which controvert the basic assumption of corporate finance that shareholders are subordinated in insolvency proceedings, and dilute the accountability of shareholders and insiders;

  • cram-down procedures overriding dissenting classes of creditors arc consistent with relative priority rather than absolute priority, which reduces the likelihood of approving equitable rehabilitation plans;

  • incoherent treatment of secured creditor claims, which diminishes the value of secured credit and thereby constrains the extension of credit; and

  • unwarranted opportunities for judicial discretion, which create unpredictability and inefficiency in proceedings that should be based on commercial judgments.

Bolder reforms would have taken fuller advantage of the opportunity to establish an insolvency regime to better serve the current and prospective needs of the Korean economy. Fund staff recognizes that any reform of corporate insolvency law reflects compromises among many interested parties. The dynamics of compromise can result in a tendency to sequence reforms over a number of years, which may also happen in Korea.

1 The problems with Korea’s insolvency system are discussed in Republic of Korea—Selected Issues, IMF Country Report No. 02/20.
  • The coverage of chaebol regulations constraining equity investment in other companies was narrowed to the 12 largest private-sector business groups in the spring of 2002, reflecting corporate sector restructuring.6 The FTC penalized nine groups that had exceeded the limits by prohibiting the exercise of voting rights.

  • The SFC stepped up enforcement of accounting and disclosure standards in 2002, and has drafted an accounting reform bill, including a requirement that the CEO and CFO certify the accuracy of financial statements. Other reforms include a requirement for board approval and public disclosure of loans made to major shareholders or executives; firewalls between consulting and auditing services within accounting firms; and enhanced supervision of the accounting industry by the SFC and FSS.

  • Aiming to enhance minority shareholder rights, the government had submitted a bill to allow class action lawsuits in the case of violations of securities laws by large corporations. Although this bill was not approved in 2002, the incoming President has indicated that the new government will aim to enact it in 2003.

  • The resolution of major distressed companies has advanced. Daewoo Motors was taken over by GM in April 2002. In the same month, however, a takeover offer for Hynix Semiconductor from Micron Technology was rejected by the Hynix Board. Since June, creditors have taken control of Hynix. A further restructuring was approved by creditors in December 2002, including a debt-equity swap of W 1.9 trillion, rescheduling of W 3 trillion in debt, and the sale of assets.

D. Outlook and Assessment of Risks

22. The outlook is for a moderate slowing of economic growth in 2003 followed by continued robust growth in the medium term. The projections assume that the global economy recovers in 2003. In the team’s baseline scenario:

  • Real GDP growth is projected to slow to 5½ percent in 2003, mainly on account of weaker domestic demand. This compares with the 6 percent growth assumed in the 2003 budget and the projections of Korean research institutes ranging from 5¼–5¾ percent. In the medium term, growth is expected to average 5½ percent, in line with potential. This estimate assumes somewhat higher growth in total factor productivity than before the

  • crisis, reflecting the benefits of structural reforms and the increased outward orientation of the economy, which is partly offset by a lower rate of physical capital accumulation (Table 5).7

  • Increases in domestic demand slow in 2003 mainly due to weaker private consumption growth, which has already begun to taper off as the household savings rate has fallen to historic lows. Measures taken to moderate the rise in household credit may also slow consumption and residential construction. The current account surplus is projected to decline slightly to 1 percent of GDP in 2003, and to near balance in the medium term.

  • Core CPI inflation is projected to increase modestly to 3¼ percent in 2003, largely reflecting pressure on rents and more typical increases in public service charges. With a negligible output gap, inflation is expected to remain subdued in the medium term.

Table 5.

Korea: Medium-Term Projections, 2000–07

(in units indicated)

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Sources: Korean authorities; and Fund staff estimates and projections.

Contribution to GDP.

Excluding privatization receipts. from 2003 onward, interest rate payments on W 50 trillion of KD1C/KAMCO bonds will no longer be included in the consolidated budget, amounting to 0.5 percent of GDP in 2003.

During 2003–06, W 49 trillion of the outstanding government guaranteed KDlC/KAMCO bonds issued for financial sector restructuring will be converted into treasury bonds.

Customs clearance basis.

Includes IMF and offshore borrowing of domestic financial institutions and debt contracted by their overseas brunches.

Debt service on medium- and long-term debt in percent of exports of goods and services.

23. Risks to the outlook come mainly from the external front and are predominantly on the downside. International financial market volatility suggests an increased risk of a weaker-than-expected global economic recovery, which could be combined with a spike in oil prices. The impact of weaker external demand on Korean growth would likely be exacerbated by reduced confidence and a cutback in investment. And although a sharp retrenchment of consumption appears unlikely, the rise in household debt levels may magnify the usual response to slower income growth. An intensification of tensions with the DPRK would impair confidence and roil financial markets, likely delaying investment including FDI inflows, but experience suggests that a protracted standoff may not have large adverse effects on domestic demand.

24. The Korean economy may be more sensitive to these downside risks than other countries in the region due to the combination of Korea’s dependence on oil imports, high level of exports, and relatively strong linkage to international equity price fluctuations, partly reflecting large foreign participation in Korean equity markets.8 To illustrate the potential significance of these risks, two scenarios are presented: the first assumes that the world price of crude oil rises to US$40 per barrel in the first half of 2003 then returns to the WEO baseline of US$25 per barrel; the second is a worst case scenario where the oil shock is combined with slower global growth and sharp falls in equity markets and confidence.9

  • The oil price shock, in isolation, has a modest impact, with real GDP reduced by ½ percentage point.

  • In the worst case scenario, Korean real GDP could be reduced by as much as 2½ percentage points, pushing growth to as low as 3 percent in 2003.10 This exceeds the estimated impacts of 1¼–1¾ percent in other economies in the region. The impact on inflation is small because the oil shock is assumed to be temporary, with the inflation impact largely offset by weaker demand.


Estimated Impact on Real GDP Growth in 2003

(in percent)

Citation: IMF Staff Country Reports 2003, 079; 10.5089/9781451822076.002.A001

1/ Hong Kong SAR, Singapore, and Taiwan POC.2/ Indonesia, Malaysia, Philippines, and Thailand.3/ Japan, Australia, and New Zealand

25. These scenarios suggest that even in the worst case Korea’s external vulnerability is limited (Table 6). The external current account balance could shift from a surplus of US$5 billion to a deficit of up to US$2 billion in the worst case scenario, but Korea’s ample reserves would more than cover this deterioration. In addition, Korea’s public and external debt ratios are relatively low and are projected to decline in the medium term, making it unlikely that problems associated with debt sustainability would become important, except in the case of an extreme shock such as the collapse of the DPRK government and a rapid unification of the Korean peninsula.

Table 6.

Korea: Indicators of External Vulnerability, 1998–2003

(in percent of GDP, unless otherwise indicated)

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Sources: Korean authorities, private market sources; and Fund staff estimates.

Including government guaranteed restructuring bonds issued by KDIC and KAMCO.

The latest estimates are from customs clearance data.

Excluding IMF repurchase obligations. Reported in the reserves template, which was initiated in May, 2000, as “Predetermined short-term net drains on foreign currency assets.” According to the template, the Bank of Korea does not engage in derivatives transactions.

Short-term debt measured on a residual maturity basis.