Republic of Korea
2003 Article IV Consultation—Staff Report; Staff Statement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for the Republic of Korea

Korea has made a spectacular recovery from the Asian crisis. Executive Directors commended this developments, and stressed the need to implement monetary and fiscal polices. They commended the structural reforms, and emphasized the need to strengthen the asset management sector. They welcomed the approval of a free trade agreement with Chile, and looked forward to further trade-opening steps in the agricultural sector. They welcome the three-year roadmap for corporate reform, which eases regulations on 'chaebol' that improve governance.


Korea has made a spectacular recovery from the Asian crisis. Executive Directors commended this developments, and stressed the need to implement monetary and fiscal polices. They commended the structural reforms, and emphasized the need to strengthen the asset management sector. They welcomed the approval of a free trade agreement with Chile, and looked forward to further trade-opening steps in the agricultural sector. They welcome the three-year roadmap for corporate reform, which eases regulations on 'chaebol' that improve governance.

It has now been six years since the Asian crisis. For most of this period, Korea’s economy has grown rapidly, the result of favorable cyclical developments and deep structural reforms. But in 2003 this ascent was interrupted. The economy contracted during the first half of the year, after financial institutions reined in household credit and some long-standing structural problems re-emerged. While growth has now resumed, the sudden pause was a reminder that, despite the policy progress of the past half-decade, an unfinished reform agenda still remains. This Article IV consultation provides a timely opportunity to take stock, to see what has been accomplished since the crisis and what remains to be done.

I. How Has Korea Changed Since the Asian Crisis?

1. Korea has made a stunning recovery from the Asian crisis. Within one and a half years, output had already regained its pre-crisis level; within five years, the economy was one-quarter larger than before. Meanwhile, international reserves, which were minimal at the depth of the crisis, have been built up to $155 billion as of end-2003, nearly twice the level of short-term external debt on a residual maturity basis. This performance, significantly better than any other Asian crisis country, begs an important question: how did the country do it? Did the recovery merely reflect favorable cyclical developments, or were there deep structural changes, as well? In other words, how has Korea changed?


Real GDP


Citation: IMF Staff Country Reports 2004, 044; 10.5089/9781451822083.002.A001

2. Certainly, cyclical factors played an important role in the recovery. Initially, the economy was buoyed by the worldwide IT boom, which unleashed a torrent of demand for the country’s advanced electronics products: during 1999–2000, exports increased by 18 percentage points of GDP. Then, as the IT boom faded, domestic demand took off, fuelled by a burst of credit to consumers and SMEs, amounting to nearly 50 percent of GDP during 2000–02. A significant part of this rise in household credit came in the form of credit card lending, which proliferated rapidly after 2000, reaching 12 percent of GDP by late 2002.

3. Behind the surge in consumer credit—behind the recovery, more generally—lay deep structural reforms that in a few short years have fundamentally altered Korea’s economic system. Consider the following:

  • The banking system has been transformed. Before the crisis, banks concentrated on lending to the industrial conglomerates (chaebol), making it difficult for consumers and SMEs to secure credit. Afterwards, banks strengthened their commercial orientation, allowing them to refocus their activities on their most profitable lending opportunities. Meanwhile, prudential regulations were tightened, forcing major banks to provision carefully and raise their capital adequacy ratios to around 10 percent. The government has also reprivatized most of the bank equity it acquired during the crisis.1 These changes have had a measurable impact, with the 2003 Financial System Stability Assessment finding that Korean banks are now as sound as those in similar countries (IMF Country Report No. 03/81).

Bank Soundness, 2002

(In percent)

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Sources: FSS, Moody’s, and OECD.

See Chapter VII, Selected Financial Sector Issues, of Korea FSAP Report.

  • Capital markets have been reinvigorated. With banks diversifying their lending, the chaebol have turned to the capital markets for financing, allowing Korea to develop the biggest bond market in Asia outside Japan. The stock market has also grown, largely because it has been opened up to foreigners, who now own 40 percent of the market capitalization, more than in any other Asian country. As this has occurred, financial markets have begun to exercise greater discipline on the chaebol.

  • Corporate finances and governance have improved significantly. Before the crisis, the Korean corporate sector was characterized by high leverage and weak profitability; by 2002, its key financial ratios were comparable to those in other OECD countries. Similarly, while Korea’s corporate governance was once among the poorest in Asia, it is now better than average.2

Manufacturing Sector Financial Ratios

(In percent)

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Source: BOK Financial Statement Analysis.
  • Moreover, the SME sector has developed rapidly, helped by banking reforms that improved the allocation of credit. This sector (defined as firms with less than 300 workers) now accounts for around half of GDP and the bulk of total employment.

Importance of Small- and Medium-Sized Enterprises

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Source; Small and Medium Business Administration.

Post-crisis year is 2001.

1998 instead of 1997.

In sum, the Korean economy has changed in profound and important ways. At the same time, some long-standing structural problems remain. In particular:

  • Key nonbank financial institutions remain financially weak and vulnerable to shocks, especially the major investment trust companies (ITCs) and, more recently, some credit card companies.

  • Markets remain wary of Korean corporate governance. In part, this is because there is a large gap between the ownership and control of conglomerates, with most chaebol still being run by founding families, despite their generally small ownership stakes.

  • Meanwhile, the labor market remains sharply divided. Two-thirds of employees benefit from some of the strongest employment protection in the OECD, but the remaining workers face job insecurity and a limited social safety net.

II. Why Was Korea’s Growth Interrupted in 2003?

5. In early 2003, the long post-crisis expansion suddenly stalled. In the first two quarters of the year, GDP shifted into reverse, falling by a cumulative 1 percent, as both private consumption and fixed investment declined (Table 1).3 Part of the problem was that export growth slowed, while in March there was a brief flare up of geopolitical tensions with North Korea. But the bulk of the problem was domestic.

Table 1.

Korea: Selected Indicators, 1999–2004

(In units indicated)

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

Contribution to GDP growth.

Refer to budget plan for 2004.

Excluding privatization receipts and rollover of KDIC/KAMCO bonds.

Change in the cyclically adjusted overall balance (excluding net lending). A negative impulse implyies a contractionary stance.

Data for 2003 are as of December 31, 2003.

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


Economic Activity and Consumer Spending

(Dec. 2000 = 100)

Citation: IMF Staff Country Reports 2004, 044; 10.5089/9781451822083.002.A001

6. To begin with, the long household credit boom finally came to an end, depressing consumption. During the course of 2002, the authorities had become increasingly concerned about the rapid growth of household lending, especially by the aggressively expanding credit card companies (CCCs, Box 1). By the end of the year, with household lending growth rates approaching 30 percent (y/y) and delinquency rates beginning to rise, they decided to clamp down, tightening provisioning and other prudential regulations. In response, the CCCs began cutting credit lines, pulling down private consumption by a cumulative 3½ percent in the first half of 2003.

7. Meanwhile, Korea’s unresolved structural problems took their toll on investment. During the year, a corporate governance scandal exposed weakness in the financial sector, labor unrest increased, and the political situation became increasingly difficult. All of this undermined business confidence, causing machinery and equipment investment to fall by 9 percent in the first three quarters of the year, while foreign direct investment commitments declined by 29 percent for the year as a whole.

8. The problems started in March, when prosecutors announced that SK Global—an affiliate of SK Group, the third-largest chaebol—had hidden debts, implying that its net equity was actually negative. Bond fund investors reacted by seeking redemptions from the Investment Trust Companies, which held SK Global paper as part of their investment portfolios. The ITCs, in turn, attempted to meet this run by selling bonds issued by the CCCs, but the rapid rise in credit card delinquencies made this paper illiquid. Calm was soon restored to the market, after the CCCs agreed to inject additional capital. Nonetheless, for the remainder of the year, risk aversion toward corporate bonds remained high, especially for lesser-rated companies, constraining investment.


Monthly Change in Bond Funds Including MMF

(In trillions of won)

Citation: IMF Staff Country Reports 2004, 044; 10.5089/9781451822083.002.A001

9. Moreover, the underlying problems at the CCCs proved far worse than initially expected. Despite energetic efforts by the companies, impaired assets (including rescheduled loans) rose during the year to 34 percent, equivalent to around 3 percent of GDP. As a result, by January 2004, the largest CCC, LG Card—which had issued credit cards to one-third of the population—stood on the brink of collapse. After creditors balked at assuming control, the authorities, worried about the effect that a failure would have on other CCCs and the capital markets, cleared the way for the government-owned Korea Development Bank to take over the company.4

The Credit Card Boom and Bust

  • Korea’s credit card industry expanded rapidly from 1999 to 2002, driven by aggressive marketing and official support through tax deductions.1 Over this short period, the number of cards issued by credit card companies (CCCs) more than doubled to over 100 million, an average of four cards for every Korean adult. These cards were used intensively: annual usage increased six-fold to 114 percent of GDP.

  • The CCCs tried to contain risks by requiring holders to settle their balance in full every month. However, as consumers began to acquire multiple cards, they were able to create de facto revolving credit by shifting debts between cards. It has been estimated that close to one million card holders have been “kiting” their payments from one company to another. Nonetheless, the CCCs remained confident, since profits were high and estimated future defaults (based on past experience) were low. Supervisors, lacking experience with CCCs, also underestimated the risks, especially as the companies appeared well capitalized.

  • This boom has now come to an abrupt end. Already in 2002, delinquency rates had begun to rise, while credit bureaus began accumulating information about the debts of clients to multiple CCCs. As the worrisome signs multiplied toward the end of the year, the authorities tightened prudential regulations and the CCCs began cutting credit lines and selling impaired assets.

  • The industry’s problems were further aggravated in March 2003, when the SK Global scandal triggered a collapse of the market for CCC bonds. The immediate problem was resolved when the industry convinced creditors to roll-over their exposures, by promising to secure new capital. Nonetheless, bond market access remained tenuous, because the nonperforming asset problem continued to deteriorate. By November 2003, total impaired assets, including rescheduled loans, reached 34 percent, and 2.3 million card borrowers were delinquent, representing 6 percent of the population aged 15 or more.

  • In December, the largest company, LG Card, lost access to the capital market, creating a liquidity crisis. Creditors responded by requesting an audit, which found that liabilities exceeded assets, leading them to balk at assuming control of the company. In the end, the government-owned Korean Development Bank (also a major creditor) stepped in to rescue the company, averting the threat of bankruptcy, which, owing to the practice of “kiting,” could have cascaded through the entire sector. The authorities were also concerned that a failure could have resulted in ratings downgrades for the other firms, triggering early repayment clauses on their bonds.

  • The industry is now facing formidable challenges. Some CCCs are being absorbed by their well-capitalized parent banks, but stand-alone companies (such as LG Card) need to secure additional equity to cushion them against continuing defaults. All firms need to develop their capacity to recover loans. Moreover, all firms need to improve their risk management practices by relating credit card lines to borrowers’ income, and ensuring that credit management bureaus provide complete information on borrowers’ debts.

Credit Card Delinquencies1

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CCCs excluding Kookmin Card.

1 More information on the credit card boom is presented in Chapter IV of the 2003 Selected Issues paper (IMF Country Report No. 03/80).

10. Meanwhile, labor strife intensified. When the new government of President Roh Moo-Hyun assumed office in early 2003, it announced a policy of “dialogue and compromise.” But strike activity nonetheless increased by nearly 50 percent (as measured by the number of workers involved) as unions pressed key economic sectors for wage increases, greater employment protection, and a shorter working week.


Workers Involved in Industrial Disputes


Citation: IMF Staff Country Reports 2004, 044; 10.5089/9781451822083.002.A001

11. At the same time, the political situation grew increasingly complex. In September, President Roh’s party split, leaving his forces in a small minority in a National Assembly that had from the start been controlled by the opposition. Around the turn of the year, political attention focused on an investigation into political fund-raising practices, which encompassed the main political parties as well as a number of chaebol. And as 2004 progressed, the April legislative elections began to loom large.

12. Despite these obstacles, the government was able to advance its structural reform agenda, in line with Fund recommendations. Indeed, many of the priorities identified in last year’s staff report were acted upon in 2003. In particular, to spur further improvements in corporate governance, new accounting and auditing bills were passed, which will increase the amount of information provided to investors, and help ensure that this information is accurate. At the same time, to ensure that investors can enforce their legal rights in cases where the information does prove misleading, class action lawsuits were legalized in cases of securities violations.

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13. In addition, further progress was made in financial sector privatization. During 2003, the government sold stakes in three large banks, leaving its 87 percent stake in the Woori Group as its only sizeable holding remaining—and even in this case, it initiated procedures to sell down its shares. The government also arranged to sell the largest investment trust company, Hyundai ITC, to a foreign securities firm, facilitated by a large injection of public funds.

14. Furthermore, the government used macroeconomic policies to support the economy:

  • Monetary policy was eased. With core inflation gradually receding below the 3 percent mid-point of the authorities’ target range, the policy rate was cut to an historic low of 3.75 percent (Table 2).

  • The fiscal stance was also eased. As the economy slowed, the authorities front-loaded spending and adopted two supplementary budgets, thereby averting the traditional underspending of the budget targets, which would have imparted a significant contractionary impulse (Table 3).5

  • The authorities resisted pressures for an exchange rate appreciation. With portfolio inflows exceptionally large, they stepped up their foreign exchange purchases, contributing to a $34 billion increase in reserves (Table 4).6 These actions limited the won’s appreciation against a weakening dollar; the average won/dollar exchange rate during 2003 was 4.5 percent higher than in 2002, keeping the average nominal effective rate essentially unchanged.7

Table 2.

Korea: Monetary and Financial Indicators, 2001–03

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Sources: Bank of Korea, and Fund staff estimates and projections.

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

Table 3.

Korea: Consolidated Central Government Operations, 2001–04

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

Original budget, excluding supplementary budgets.

The conversion of KDIC and KAMCO bonds is excluded, amounting to W 13 trillion in 2003 and W 12 trillion in 2004.

From 2003 onward, interest payments on W49 trillion of KDIC/KAMCO bonds will no longer be included in the consolidated budget, amounting to 0.6 percent of GDP in 2003 and 0.4 percent of GDP in 2004.

Excludes privatization receipts.

Change in cyclically adjusted fiscal balance (excluding net lending).

Table 4.

Korea: Balance of Payments, 2000–04

(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.


Interest Rates

(percent per annum)

Citation: IMF Staff Country Reports 2004, 044; 10.5089/9781451822083.002.A001

III. What Lies Ahead?

15. Despite the difficulties encountered during 2003, the economy started to revive toward the end of the year. The reason was soaring overseas demand. Exports increased by 11 percent (q/q) in the third quarter, and by a further 10 percent (q/q, estimated) in the fourth, boosting annualized GDP growth to around 3½ percent by the fourth quarter. Moreover, leading indicators suggest this trend is likely to continue well into 2004. Export orders are climbing rapidly, as the global IT industry is accelerating again, while China—now Korea’s largest trading partner—is continuing to boom.


Exports and OECD Leading Indicator

(Annualized 6 month percent change)

Citation: IMF Staff Country Reports 2004, 044; 10.5089/9781451822083.002.A001

16. Typically, such export rebounds have produced very quick and strong recoveries. With exports accounting for some 42 percent of GDP, rising overseas shipments have normally flowed through rapidly into new investment and growing consumption. But this time, domestic demand is likely to remain weak. In particular:

  • Consumption could be weighed down by heavy household indebtedness, which now exceeds 70 percent of GDP. Households may wish to—or be forced to—increase their saving further to pay down their debts, especially as the recovery proceeds and interest rates begin to rise, aggravating debt service burdens.8 This risk is particularly great if the CCCs’ financial difficulties persist for a prolonged period, risk aversion by banks grows, or there is a correction in property prices, all of which could constrain household credit.

  • Investment could be dampened if firms continue to take a “wait and see” attitude, pending improvements in the labor or political situation. Moreover, risk aversion in the bond market may persist, impairing the ability of lower-grade firms to secure bond financing.


Household Debt

(In percent of GDP)

Citation: IMF Staff Country Reports 2004, 044; 10.5089/9781451822083.002.A001

17. On balance, the staff expects a moderate recovery. Under current projections, GDP growth would rise to around 5½ percent this year, which is relatively modest for the first year of a Korean recovery. Subsequently, growth would remain around the potential rate of 5–5½ percent, as domestic demand gradually revives while exports slow to a more sustainable pace (Table 5). There is some upside potential to the 2004 forecast, as export performance may continue to be exceptionally strong, and may flow through more strongly into domestic demand. But there are also downside risks, in particular if structural reforms fail to gain momentum after the elections and the needed adjustments, especially to household balance sheets, prove to be more prolonged than expected.

Table 5.

Korea: Medium-Term Projections, 2001–08

(In units indicated)

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

Contribution to GDP.

Excluding privatization receipts and conversion of KDIC/KAMCO bonds into treasury bonds.

During 2003–06, W 49 trillion in government guaranteed KDIC/KAMCO bonds will be converted into treasury bonds.

Customs clearance basis.

Includes IMF and 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.

Components of GDP

(In percent)

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Contribution to GDP growth.

18. Over the medium term, Korea’s economy is robust to the standard sustainability analysis (Annex I). Short-term external debt has increased significantly in recent years, to around $60 billion (12 percent of GDP), but this presents little risk, since it is more than covered by reserves. (Table 6). A further cushion is provided by the low level of public debt, at just over 20 percent of GDP, and by the moderate levels of corporate debt (Table 7). This combination of low debt and high reserves allowed Korean borrowers to continue rolling over their obligations at modest spreads through 2003, even at the height of the SK Global scandal.9

Table 6.

Korea: Indicators of External Vulnerability, 2000–03

(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.”

Short-term debt measured on a residual maturity basis.

Table 7.

Korea: Financial Soundness Indicators, 1997–2003

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Sources: BOK, FSS, Korean Federation of Banks, Kookmin Bank.

Operating income to gross interest payments. Operating income treats depreciation as a expense, so this ratio is lower than calculations using earnings before interest, taxes, and depreciation allowance (EBITDA).