Ongoing reform under the new administration

The rapid recovery of the Korean economy from the brink of bankruptcy to one of the fastest growing economies in the world continues to surpass most expectations, including even those of Koreans themselves. The sweeping changes go beyond macroeconomic indicators or various performance indices of the corporate and financial sectors. The factor-intensive growth strategy, which often led to over-investment in the past, is no longer pursued. Consumer credit, which was previously discouraged so that the country’s high saving could be pipelined into industry, has now become the main input to private consumption that has, in turn, become a key source of growth. Even the five-day-a-week work system, which would have been unthinkable in the past, is now being publicly discussed and, in fact, is starting to be introduced within the government. This is the outcome of five years of reform and restructuring, with the assistance of the Fund, and was recently described in The Economist as “the clearest example of how quickly reforms can produce results”. The new administration of President Roh, Moo-Hyun, who was inaugurated on February 25, fully recognizes these hard-won lessons and has made it clear that there will be no stoppage or complacency in carrying forward economic reforms.

The new administration has underscored that its economic policies, including its “East Asia Hub” vision, will be fully embedded in fair and transparent market principles. In particular, the painstaking efforts of enhancing the soundness of the financial sector and improving corporate governance will continue.

This year’s Article IV consultation has provided a valuable input to the economic strategy for the new administration at the start of its five-year term. Our authorities would like to thank the Article IV team for their excellent work. In addition, they would like to thank the FSAP team’s two-year-long comprehensive effort which was instrumental in identifying the remaining reform agenda in the financial and corporate sectors, including valuable advice in coping with the new challenges arising from ever-being sophisticated market practices. Our authorities would also like to thank the First Deputy Managing Director for her recent visit to Korea, which was very timely and provided the opportunity for discussions with key policy makers, including then President elect Roh, Moo-Hyun.

Macroeconomic Outlook and Policy Responses

Our authorities broadly agree with the staffs outlook for the economy. Economic growth in 2003 will be a little slower than last year, in the range of 5 percent and broadly in line with the economy’s potential growth. This easing in growth has a lot to do with the slower-than-expected recovery in the world economy but it also reflects a slowing in private consumption growth, which was a major driving force behind the very strong economic growth last year.

The main downside risks come from weaker external conditions, as indicated in the staff’s worst case scenario. As the staff note, Korea is more sensitive to external shocks than other countries in the region given its dependence on imported oil and exposure to international financial flows. Nevertheless, Korea’s vulnerability should be weighed against its demonstrated resilience to adverse external conditions which reflects in part the ever-increasing diversity of its exports, both in terms of destination and product composition.

That said, our authorities are prepared to take the necessary policy actions if the downside risks eventuate. On the fiscal front, the response would include the front-loading of fiscal spending with the target of overall fiscal balance. Given relatively weak automatic stabilizers, modulation on the speed of spending has been the major fiscal policy, coupled with a timely supplementary budget.

Last year about 60 percent of the budget was allocated for expenditure in the first half of the year but implementation was soon slowed as the economy revealed early signs of faster-than expected growth. As the staff acknowledge, this was an appropriate adjustment.

The authorities’ target this year is to spend 51.6 percent (62 percent on the budget allocation basis) of the budget in the first half of the year, as compared with the out-turn of 47.2 percent last year. Staff note that non-interest current spending, which was under-spent last year, is budgeted to rise by 16 percent this year. Non-interest current spending is, however, the appropriate expenditure for the discretionary operation of fiscal policy. Furthermore, while the authorities do not see any need for a supplementary budget at this stage, it remains a policy option.

As for interest rates, the Bank of Korea (BOK) has maintained an accommodative stance. With core inflation comfortably within the target range and the beneficial impact of the appreciation in the exchange rate still to come, there is no immediate need for a policy change. Nevertheless, the authorities are mindful of staff’s advice about the objective of monetary policy moving to a neutral stance.

The free-floating exchange regime, introduced in 1977, has now been entrenched and still serves the economy well, although the shallowness in the foreign exchange market has to be overcome. Exchange rate intervention has remained minimal, as noted by the staff.

Longer-term policy issues

The authorities are determined to formally introduce a medium-term fiscal strategy under the auspices of a special law on fiscal soundness, which is currently pending before the National Assembly. This is not a new concept, a notable example being the Medium-Term Fiscal Plan which was announced with the first budget after the 1997 crisis. However, the formalization of a medium-term budgetary framework, including fiscal targets, is expected to be the main channel of communication by the authorities with the National Assembly on a yearly-rolling basis. Other policy recommendations in the 2001 FAD technical assistance report require substantial changes in budget-related laws and the possibility of revisions to these laws will continue to be studied.

Staff have recommended legislative changes to the inflationary targeting system. However, the medium-term target approach has already been formally in operation in Korea. The BOK regularly announces medium-term targets in parallel with annual targets following the decision of the Monetary Policy Committee. While there may be some concern as to confusion over the link between an annual and a medium-term target in Korea, the public is accustomed to yearly economic plans. In fact, the public may still require an annual target in order to fully grasp a medium-term objective of price stability.

To ensure consistency between annual and medium-term targets, the BOK sets the annual target such that the mid-point is within the range of the medium-term target. Currently, the annual target for 2003 is 3±1 percent, while the medium-term target is 2.5-3.5 percent. Importantly, the current BOK Act which stipulates the inflation target, was a very difficult compromise over the jurisdiction of related agencies in terms of monetary policy and financial supervision. Against this background the benefit of revising the inflation targeting arrangement needs to be offset against the political cost of reopening this whole issue.

Pension reform is another high priority area for the new administration. The authorities are well aware that the initial round of reform did not ensure long-term sustainability of the National Pension System (NPS), as well as other occupational pensions in the public sector. Under the law, the public pension system is under policy review every five years and for almost a year an independent panel has been preparing the first review which will be completed this year. While there are some other studies on this matter which tend to be less pessimistic than staff’s diagnosis on the long-term prospects of the NPS, the authorities appreciate the staff’s efforts which will provide valuable input to the forthcoming policy debate.

Sources of Growth

The authorities’ estimate for the economy’s potential growth rate is in the range of 5 percent. Maintaining high growth is not easy as an economy matures. In particular, demographic change is taking place in Korea and it may soon move from an “aging society” to an “aged society”. Nevertheless, the new administration is confident that Korea will be able to not only maintain its current potential growth rate, but will enhance it. The envisaged sources of growth include the following.

• The most importance source will be efficiency gains from structural reform. The better functioning of the financial market should improve efficiency in resource allocation, which to date has contributed to the expansion of a creative and flexible SMEs sector after the crisis. In fact, a large share of the 1 million jobs created since the crisis are attributed to SMEs.

• The authorities are well aware of the importance of technical progress in enhancing the country’s growth potential. In the pursuit of technical development, they have put a high emphasis on ways to make the most of Korea’s existing strength as an information- and knowledge-based society.

• Foreign direct investment has been a major contributor to the rapid growth achieved since the crisis. The total amount of FDI inflows over the past five years is around eight times the accumulated total since Korea opened itself to FDIs from 1962 till 1997. Inflow did fall last year but this was against the background of a global downturn in FDI.

• While there is a limit to labor force growth, there still remains an under-utilized sector of the workforce; namely, females. The new administration is determined to encourage greater female participation in the workforce.

The authorities are mindful of foreign investors’ concern over uncertainty in the area of industrial relations. But Korea’s labor market has proved to be much more flexible than might have been perceived given the attention that some militant labor unions have attracted. However, the union movement is below 10 percent of the workforce and even the unions have accepted the necessity for lay-offs in the face of business difficulties. The administration is confident that encouraging dialogue between employers and employees, supported by fair and speedy mediation through the Tripartite Committee that is composed of labor, management and government representatives, will ensure even sounder labor-management relations.

Financial Sector

The new administration will continue the task of restructuring or “normalizing” the financial sector. In this respect, “reprivatization” of commercial banks that were nationalized as part of overcoming the crisis is expected to gain speed. Currently, the sale of the government’s share of Chohung Bank has priority. It was hoped that negotiations with the preferred bidder would have been completed by the previous administration. However, with the task now being handed over to the new administration, it is recognized that progress on this front will be a litmus test for the new economic team.

Another milestone decision by the previous administration was the financing of the unrecoverable public funds used for financial restructuring. As Box 3 in the staff paper summarizes, 70 percent of the unrecoverable residual of 69 trillion won will be borne by the budget eventually, after converting previous KDIC and KAMCO bonds, which mature in the next few years, into Treasury bonds, and 30 percent will be repaid by the financial sector collectively. The government has set up a special fund for this purpose in order to ensure transparency and accountability.

This decision puts to rest uncertainty regarding the government’s contingent liability associated with the use of the sovereign guarantee in underwriting financial sector restructuring. The decision will also facilitate the development of the domestic bond market, since the new bond will have a maturity of more than five years which has been rare to date.

The authorities’ response to the FSSA report is self-explanatory but we would highlight the following points.

• The expansion of consumer loans requires continuous careful monitoring, although this does not pose a serious threat to the financial system. Moreover, prompt actions by the authorities, both in terms of prudential regulation and targeted taxation measures, has brought the expansion of consumer credit under control.

• The authorities are mindful of problems in the insurance sector. On top of the asset price fall suffered by most insurance companies worldwide, Korean insurance companies are struggling with a mismatch of liabilities with a long maturity and a short maturity asset portfolio. This mismatch may cause credit difficulties, but it is not likely to provoke a liquidity crisis. Furthermore, the introduction of a sovereign bond with long-term maturity, as mentioned previously, will contribute to the resolution of this problem by offering insurance companies an efficient way of re-balancing their asset portfolio.

• Non-performing loans of non-bank deposit taking institutions remains a problem. The authorities took prompt corrective action last year and continue to be watchful of this sector. That said, non-bank deposit institutions play only a minor role in the country’s financial system. Furthermore, there are some early signs that things are improving. The credit union group is estimated to have recorded a surplus after three consecutive years of losses. Smaller scale mutual savings banks also recorded profits in the first half of 2002.

• Derivative transactions are a fast growing business. Korea was number one in 2001 in terms of the number of derivative contracts largely as a result of its state-of-the-art internet transaction system. Nevertheless, as noted by the recent Fund mission in this area, the risks remain controllable in terms of the amount of exposure.

Corporate Sector

An important conclusion of the staff’s stress test on the banking sector’s exposure to the corporate sector is that it is now under control. Staff highlight the substantial improvements in debt-equity ratios and in corporate governance. The market reaction to these developments is important. Stock prices are reflecting good corporate governance and there appears to be a “chaebol discount” rather than “chaebol premium” in that the share price of chaebol affiliates tends to be lower than if they were not associated with a chaebol.

That said, our authorities fully recognize that there is no place for complacency. In fact, the new administration has emphasized that it will be pushing even harder in pursuit of good governance in the corporate sector, including the passage of a number of new laws proposed by the previous administration, such as the law regarding class action lawsuits. These laws remain on the top of the corporate law reform agenda.

The authorities also share the staff’s emphasis on advancing corporate insolvency law reform. The government’s proposal for a unified corporate insolvency system (equivalent to combining Chapter 7 and 11 in the US insolvency system) is now ready for debate in the National Assembly. While there is still scope for improvements to this bill, as noted by staff in Box 4, it does reflect the most comprehensive attempt to reform corporate insolvency and is a significant advance over the four revisions of the same laws in the past five years and will strengthen the incentive for creditors to take the initiative in corporate restructuring.

As regards the references in the staff report to the interest coverage ratios (ICR) of Korean firms, we would emphasize the following:

• the ICR of the corporate sector has improved substantially and there is an ever-increasing gap between “good” and “bad” companies;

• the figures quoted for companies with ICRs below 100 percent are based on the number of companies, not on the size of their debts, and their recent increase is mainly due to difficulties in small-scale firms, particularly those producing electronic parts;

• the reference to unsatisfactory performance of ICRs of lower-end firms should not be seen as questioning the soundness of prudential standards within the banking sector. ICR is one factor for individual banks to consider in their loan classification under the country’s forward-looking criteria (FLC) system, but there are many others.

Other issues

On trade issues, Korea participated actively in the opening of the Doha Round and will continue to be active in forthcoming DDA negotiations. While Korea has been categorized by the OECD as maintaining higher producer support for agricultural products, this is mainly due to price protection in the politically sensitive area of rice. The authorities are prepared to discuss the further opening of the agricultural market and will consider replacing price subsidies with more market-neutral direct compensation to rice farmers.

Korea intends to pursue FTAs with other countries, building on the momentum generated by the recent signing of the FTA with Chile. Regarding the EU’s request for consultation in the context of the WTO’s dispute settlement mechanism of alleged government subsidies to Korean trade shipbuilders, we would note that the staff made a statement at the WTO’s Working Group on Trade, Debt and Finance to the effect that: (i) the use of public funds was the key element in Korea’s implementation of conditionality under the Fund-supported program; (ii) under this program, the Korean government committed to avoid direct lending; and (iii) the injection of public funds into banks did not include targeted financial assistance to any specific sector. (See attachment to EB/CWTO/03/1.)

On statistical issues, the BOK applied for the late submission of the International Investment Position under the SDDS. Two test compilations for 1999 and 2000 were completed and the BOK is checking their consistency. The BOK is determined to keep the deadline on this matter and plans to publish IIP as of the end-2001 by end March this year and IIP data for 2002 by end June. In addition, the BOK has agreed to publish the ROSC on data module, having addressed the technical problems noted in the report.

To conclude, we would add our observation to the staff’s description of recent developments in the DPRK. In our view, the introduction of “market” prices is the most significant economic reform that DPRK has made and the implications of this development should not be taken lightly, for it cultivates the sense of “money” in the economy. There are signs that people are responding to this development, although not all of them are encouraging. For example:

“Salaries have not increased in line with price changes (…). This is bound to make for some unhappy labor campers, especially given reports that many companies are unable to pay the salaries. Farmers were reportedly content with the changes as it meant more side income for produce raised on allotments.”¹

As people’s experience with money and the concept of the market develops, their sense of ownership and involvement in the economy will intensify. Accordingly, it would be very difficult to reverse the process since, as one analyst has observed, “the bus has left the station”.