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
Author:
International Monetary Fund
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Publication Date:
25 Feb 2004
eISBN:
9781451822083
Language:
English
Keywords:
ISCR; CR; staff appraisal; Lee Hun-Jai; Merchandise export; authority; labor market; exchange rate; credit card; delinquency ratio; bond market; Corporate governance; Loans; Global
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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.

Abstract

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?

uA01fig01

Real GDP

(1997=100)

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)

article image
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)

article image
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

article image
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.

uA01fig02

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.

uA01fig03

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

article image

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.

uA01fig04

Workers Involved in Industrial Disputes

(Thousands)

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.

article image

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

article image
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

article image
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)

article image
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.

uA01fig05

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.

uA01fig06

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.

uA01fig07

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)

article image
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)

article image

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)

article image
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).

19. While Korea faces little risk of an external crisis, the country’s remaining structural problems nonetheless represent a source of concern. As the events of 2003 demonstrated, these weaknesses have the potential to interrupt growth. They also run the risk of constraining the economy’s medium-term growth, for example, if weak corporate governance leads to sub-optimal investment decisions. Consequently, to ensure that future growth is both rapid and sustained, Korea needs to address the unfinished structural reform agenda.

IV. Report on the Discussions

20. The authorities’ longer-term strategy is to double the country’s per capita income to $20,000, partly by developing Korea into an economic hub for Northeast Asia, providing financial and logistical services to the region. To do this, the authorities and team agreed that the unfinished structural reform agenda would need to be addressed. But the strategy would need to begin with measures to encourage the incipient economic recovery.

A. Supporting the Recovery

21. The staff team shared the government’s view of fiscal policy. Both sides agreed on the importance of maintaining Korea’s long tradition of fiscal prudence to deal with the demands that will be placed on the budget from the rapidly aging population and uncertainties related to North Korea. Accordingly, the fiscal deficit (excluding social security funds) would eventually need to be eliminated and the budget brought back into balance or surplus.

22. The only issue was how quickly this should be done. The original budget plan submitted to the National Assembly aimed to limit the 2004 deficit to 0.4 percent of GDP, which on the staff team’s estimates would have imparted a contractionary fiscal impulse estimated at about 1 percent of GDP. In the team’s view such a rapid adjustment risked undermining the incipient and still-fragile recovery. Accordingly, the team proposed adopting a neutral fiscal stance for 2004, implying a budget deficit of around 1½ percent of GDP. Subsequently, as the recovery takes hold, the budget could be tightened gradually, so as to bring it into balance by 2005.

23. The authorities were somewhat more optimistic about 2004, expecting 6 percent growth, but agreed that there were risks to tightening prematurely. Consequently, after the mission’s departure, the budget was eased somewhat, bringing the 2004 target deficit to 0.6 percent of GDP. The authorities further noted that they would front-load spending into the first half of the year, and were prepared to introduce a supplementary budget, should the recovery fall short of expectations.

24. As for monetary policy, the team judged that the current supportive stance remained appropriate. Under the staff’s baseline scenario, 2004 core inflation is projected to remain close to 3 percent, the midpoint of the central bank’s medium-term target range, partly because the output gap would not be closed until next year.10 It should thus be possible to maintain the current stance for some time, even if the economy recovers as projected.

uA01fig08

Real House Prices

(March 1997=100)

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

25. Some have urged that monetary policy be tightened to counter a potential bubble in housing prices. They point out that since the end of 2000, apartment prices in the southern Seoul area of Kangnam have risen by over 90 percent, greatly outpacing the increase in apartment rents. The team noted, however, that at the national level, the increase has been much more muted, merely bringing real prices back to pre-crisis levels, which in any case were not high by historical standards. Moreover, the pace of national housing price increases has already slowed markedly, falling below 6 percent (y/y) in December 2003.

26. Accordingly, the team concluded that monetary policy was too blunt an instrument to address the housing price problem. Instead, it endorsed the authorities’ strategy of taking targeted measures, including higher capital gains taxes for owners of multiple apartments. At the same time, the central bank should continue to monitor the situation closely; even though average loan-to-value ratios were only about 60 percent, a property market correction might nonetheless put further strain on household and bank balance sheets.

27. On exchange rate policy, the team asked why intervention had increased considerably in 2003. The authorities responded that the exchange rate had actually moved in a wide range last year, with much of the intervention occurring only when market conditions had become disorderly, such as in September 2003. In any case, with others in the region resisting appreciation against the dollar, Korea would have lost considerable competitiveness if they had failed to do likewise, which would have intensified the economic slowdown. Nevertheless, they remained committed to a flexible exchange rate policy, under which intervention would take place only to smooth fluctuations rather than to target the level or trend.

uA01fig09

Exchange Rate Movements

(Dec. 31, 2001=100)

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

28. The team urged the authorities’ to maintain their flexible exchange rate policy, noting that it had served the country well. The policy, adopted after the Asian crisis, had stimulated a rapid development of the foreign exchange market and encouraged firms to hedge; an official survey showed that nearly two-thirds of firms were covering their external exposure as of June 2003. It had also preserved Korea’s competitiveness, with the real effective exchange rate remaining remarkably stable in recent years, facilitating strong export growth and continued current account surpluses.

uA01fig10

Real Exchange Rates

(1995=100)

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

B. Strengthening the Financial Sector

29. Beyond calibrating the macroeconomic settings, restoring sustained growth requires advancing the country’s structural reform agenda. A key task would be to further strengthen the financial sector, not only to address the weaknesses that came to light during 2003, but also to promote the development of Korea’s financial sector.

30. The first step would be to restore the CCCs to financial health. The team noted that KDB’s takeover of LG Card had burdened the development bank, once again, with a difficult restructuring task and a significant potential financial obligation, should the credit losses continue.11 Moreover, this operation had complicated the efforts to resolve the other CCCs, as the companies may now be reluctant to take painful restructuring measures, while consumers may feel less pressure to pay their debts, if they thought they would be bailed out.

31. Accordingly, the government needed to make its policy clear. It should emphasize that LG Card was an exceptional case, due to its size, and demonstrate this point by enforcing prudential regulations strictly. Pressure should be maintained on the other CCCs to recapitalize quickly, with injections sufficient to cover realistic estimates of expected losses. Should existing owners prove reluctant to do this, prompt corrective action should be taken. As for LG Card itself, the company should be sold off swiftly to a suitable buyer, or else be put into court receivership.

32. Measures should also be put in place to ensure these problems do not recur. In particular, the authorities need to ensure that the CCCs shift to a more sophisticated risk management systems, which will require developing the credit information bureaus so that they can provide comprehensive information on cardholders’ obligations and payment histories. There may also need to be a need to strengthen the supervisory framework itself, especially by shifting away from a regulatory approach, which focuses on compliance with rules, toward a more risk-based approach, as recommended in the FSAP (IMF Country Report No. 03/81).

33. Meanwhile, steps should be taken to ensure that problems in the CCCs do not spread to the banking sector.12 So far, bank nonperforming loans have remained low, but the very large increase in household and SME debt suggests that it would be prudent to take precautionary measures. The team therefore urged the authorities to intensify supervision and tighten consumer credit standards pre-emptively, most notably by requiring that financial institutions start to take income as well as assets into account when granting loans.

34. As a further step, the team proposed reversing the recent decision reducing the minimum CAR needed to qualify as a “first class” bank from 10 percent to 9 percent.13 This measure was designed as a temporary expedient to promote additional bank lending, after the SK Global crisis impaired the bond market. The reduction, however, had sent an unintended signal that the health of the banks was being subordinated to the credit needs of the corporate sector. With the economy improving, it should be possible to allow this measure to expire earlier than the planned date of end-2004.

35. The next step would be to reform the ITC sector. For Korea to exploit its comparative advantage of a large domestic bond market, a strong asset management sector would be crucial. For this reason, the team welcomed the government’s plans to recapitalize and privatize the major ITCs. Now that Hyundai ITC has been sold, the government has announced a market-driven strategy for selling the other two ITCs by the end of 2004, under which the precise nature of the transaction would be determined by the demand from potential investors.

36. As a further spur to the asset management sector, the government is planning to establish a Korean Investment Corporation (KIC). Initially, $20 billion will be transferred from the Bank of Korea and outsourced to reputable international asset management firms for investment in marketable securities. In the authorities’ view, this move could help jump start the plans for a regional financial hub, by attracting asset management firms to the country. The authorities stressed that the KIC would be independent, and it would not be used as a vehicle for intervention in financial markets, or as a substitute for exchange rate flexibility.

37. The team nonetheless expressed concerns about this proposal, noting in particular the risk that outside pressures may be brought to bear on investment decisions. To contain this risk, strong safeguards will need to be put in place. The agency’s operational independence, investment guidelines, and rules for any future transfer of reserves should be inscribed in law, while its accounts should be regularly and fully disclosed to the public. Moreover, until the new agency’s credibility is firmly established, its funds should not be invested in domestic assets.

38. Beyond strengthening the asset management sector, measures need to be taken to improve the efficiency of the bond market itself. One of the by-products of the LG Card rescue was that holders of the company’s bonds were bailed out, potentially signaling to investors a return to the pre-crisis approach of “too big to fail.” Certainly, the persistent rating of LG Card bonds as investment grade, even as the company teetered, as well as the narrow corporate spreads on domestic bonds (compared with spreads in other countries), suggest that markets perceive little default risk in large-company bonds.

39. The team emphasized that perceptions of implicit guarantees are costly. They distort the allocation of capital away from smaller firms. They encourage short-term finance, since investors will assume that such guarantees will eventually need to be abandoned. Moreover, by reducing the rewards to careful corporate analysis, they discourage the entry of world-class investment managers, undermining the objective of creating a financial hub. In short, guarantees do not stimulate bond market development—they stifle it.

40. Consequently, the team recommended that the government make clear it is not providing implicit guarantees, and encourage investors to sharpen their risk assessments. For this reason, the team welcomed recent government measures to improve the accuracy of bond ratings, including a requirement for ratings agencies to publish the information underlying their assessments. To complement these steps, the team suggested spurring competition by encouraging foreign firms to enter the industry without joint venture partners. At the same time, to ensure orderly work-outs in cases where firms do fail, the team supported the plans to rationalize the bankruptcy system by clearing up the welter of partly contradictory laws. The government submitted a bill to this effect in early 2003, but it has been languishing in the National Assembly.

41. The authorities responded that they broadly agreed with the team’s recommendations. In particular, LG Card would be sold off as soon as possible, in a sale (like that of the ITCs and other financial firms) open to all qualified investors, foreign or domestic.14 The KIC’s independence would be enshrined in law, and no government officials would be allowed to work for the new agency.

42. As for the bond market, the government remained firmly committed to the principle that bondholders must bear the risk of investing. LG Card, however, was a special case, because it posed systemic risks. If LG Card had failed, this would have set off a wave of downgradings, triggering repayment clauses and possibly liquidity crises at the other CCCs, and causing the bond market to freeze. All this could have jeopardized the still fragile recovery. Still, moral hazard was a concern; to minimize it, the authorities had ensured that shareholders were written down, bank creditors have converted much of their debt into equity, and the management has been replaced.

C. Ending the Korea Discount

43. Another key task is to improve corporate governance. Despite the considerable progress achieved since the Asian crisis, the market has a lingering distrust of local companies, made manifest in the “Korea discount,” which reduces the price/earnings ratio of local firms below that of their regional competitors. If this distrust could be dispelled, Korean firms could enjoy lower-cost equity capita, relaxing the financing constraints on the economy’s longer-term growth rate. Moreover, the economy would be less subject to credit events that can lead to financial market break-downs, interrupting growth.

uA01fig11

Price Earnings Ratio, August 2003

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

Source: Center for Corporate Competitiveness, Seoul National University

44. But how can the Korea discount be eliminated? A growing body of research finds that Korea’s corporate governance problems are rooted in the wide divergence between the effective control that key shareholders wield over the chaebol and their actual ownership stakes, which are often quite small (Box 2). This divergence is facilitated by the practice of cross-shareholdings, in which members of a chaebol hold stakes in the other members of the group, thereby grossing-up capital and creating voting rights that the key shareholders can control.

45. This is why the authorities’ three-year Roadmap for Market Reform aims squarely at reducing the gap between ownership and control. Under the Roadmap, the gap would be narrowed in one of two main ways. The chaebol could improve internal checks and balances, for example by adopting cumulative voting for the selection of independent directors and creating committees of independent directors to monitor related-party transactions.15 Or they could adopt vertical holding company structures, so that all the group’s equity investments are held by one company, as is common in other OECD countries. Such a move would eliminate cross-shareholdings, improve transparency, and perhaps also strengthen the chaebol’s profit orientation, since holding companies rely for their income on dividends from subsidiaries.

46. The team strongly endorsed these reforms, but noted that the chaebol may not have enough incentive to adopt them. Under the Roadmap, the main incentive offered is a relaxation in existing regulations: firms which reform would be exempted from the limits on their equity investments.16 But these benefits may not be enough to compensate controlling shareholders for the potential reduction in their control or for the cost of equity injections that moving to a holding company structure would entail. Accordingly, the team recommended introducing reinforcing measures.

Control versus Ownership in the Corporate Sector

  • Korean corporate governance has improved. Since the Asian crisis, Korea’s standing in international measures of corporate governance has risen, reflecting measures to strengthen creditor and minority shareholder rights, improve accounting standards, and tighten regulations.

  • Nonetheless, there are still signs of continuing problems. The financial accounts of chaebol have been found to be suspect, and not only because of recurring scandals such as SK Global. Research has shown that earnings and book value have less explanatory power for stock price variations in chaebol-affiliated firms, with this power declining as cross-equity ownership rises.1 Moreover, controlling families have been found to expropriate minority shareholders in various ways including: transferring profits to affiliates in which they have higher stakes; shifting their ownership from less to more profitable companies at favorable prices; and transferring wealth via mergers.2 Consequently, chaebol stocks trade at a “Korea discount”, a relatively low P/E ratio compared to similar enterprises in other Asian countries.

  • The root of these governance failures seems to lie in the high degree of control exercised by the family “owners” relative to their actual ownership. Research indicates that Korean companies that have high disparities between the ownership and control have lower profitability, higher leverage, and lower P/E ratios.3

  • The key means of amplifying control relative to ownership are crossshareholdings among chaebol affiliates. If company A invests in B, which in turn invests in C (under family control), which then invests back in A, the family has increased its control over A without actually providing any new equity. In this way, families—relatives and management—have been able to maintain their control of the top-10 chaebol even as their direct ownership shares fell from 9½ percent to less than 4 percent. Expanding crossshareholdings has also created “phantom” capital, which has flattered firms’ debt/equity ratios without creating a real cushion against losses.

Control of Top 10 Chaebol

(In percent)

article image
Source: Fair Trade Commission.
1 Bae Kee-Hong and Jeong Seok-Woo, 2003, “The Value Relevance of Accounting Information, Ownership Structure, and Business Group Affiliation: Evidence from Korean Business Groups,” Asian Institute of Corporate Governance, Working Paper 2003-6. 2 Chang Sea-Jin, 2001, “Ownership Structure, Expropriation, and Performance of Group-Affiliated Companies in Korea”, Korea University, December. 3 Black, Jang, and Kim, 2002, “Does Corporate Governance Affect Firm Value? Evidence from Korea,” Stanford law School Working Paper No. 237. Sung Wook-Joh, 2001, “Korean Economic Crisis and the Corporate Governance System,” Korea Development Institute, October.

47. In particular, the team recommended strengthening market-based mechanisms for exerting discipline on the corporate sector. Currently, Korea is forced to rely on direct controls (such as equity investment limits and firewalls between the corporate and financial sector) because financial markets still do not have adequate tools to influence companies’ behavior. In particular, despite considerable improvements in recent years, investors remain concerned about the quality of information provided, while minority shareholders have found it difficult to enforce their rights.

48. For these reasons, the team welcomed the recent laws to improve accounting and auditing practices. These laws, which are similar to those in the American Sarbanes-Oxley Act, will do much to improve the accuracy and timeliness of the information provided to the market.17 As a next step, the team recommended adopting a “comply or explain” system for the existing Code of Best Practices in Corporate Governance, as other OECD countries have done. If firms were required either to comply with the code or explain on an article-by-article basis why they are not complying, then investors would be better able to identify and reward the companies that have been making strides in improving their governance.

49. The team also welcomed progress in re-enforcing the legal rights of minority shareholders. In particular, the team considered the new law allowing class action lawsuits in cases of securities violations in large companies as a major step forward, since it will substantially reduce the cost of legal actions for minority shareholders. As experience with these suits develops, the team noted, the law’s coverage could be expanded to all listed companies, as well as other types of violations, such as breaches of duty by directors, managers, and auditors. In addition, the use of derivative lawsuits, which are suits by shareholders on behalf of the company whose shares they own, could also be expanded. For example, it would be helpful to allow “multiple derivative” lawsuits, so that shareholders can sue affiliated companies that have harmed the financial interests of the company in which they hold shares.

50. The authorities broadly shared the team’s views, stating that they would examine its recommendations carefully. They stressed, in particular, that the scope for intensifying direct controls on the chaebol was nearly exhausted; a more effective and sustainable approach was needed. Consequently, the government would be moving toward market-based mechanisms, which is why, for example, passing the class action lawsuit and accounting/auditing bills had been a priority.

D. Modernizing the Labor Market

51. In addition to financial markets and corporate governance, the third key item on the structural agenda is labor market reform. Labor reform has become an increasingly important issue, not just because there was an increase in strikes during 2003, but because some fundamental trends are at work. The Korean economy has been changing, shifting from an economy based on manufacturing standard goods to one based on producing advanced products.18 At the same time, there has been a significant expansion of the service sector. Both trends require a more flexible labor force, so that employers can shift their output as demand and technology change.

52. The core segment of Korea’s labor market, however, is relatively inflexible (Box 3). Regular workers benefit from strict employment protection, with dismissals being more difficult than in Japan or Germany according to OECD indicators. Employers must show there was “just cause” or “urgent managerial reasons” to justify dismissals or redundancies, which is difficult in practice. In addition, employers found not to have followed the complex dismissal rules properly are potentially subject to criminal charges.

53. The high cost of firing workers has encouraged employers to turn increasingly to nonregular workers. In recent years, the bulk of new hires have been nonregular workers, such as those hired on one-year contracts, to the point where they now account for around one-third of total employees, one of the highest ratios in the OECD. As this has occurred, overall job insecurity has increased, fanning labor tensions and leading regular workers to insist on employment protection.

54. One reason why protection is demanded, the team noted, is that the social safety net is relatively limited. While employment insurance benefits are similar to other countries, less than one-fifth of the unemployed actually receive benefits, as most nonregular workers are not covered. Those without employment insurance must rely on the social assistance program, but the strict eligibility criteria mean that only half of the poor receive these benefits.

55. Recognizing the need for change, the government has released a “Reform Proposal for Industrial Relations.” The aim of this plan is to create a new framework for industrial relations that would allow the government to step back from individual labor disputes, narrow the divide between regular and other workers, and make labor relations less confrontational. In particular, flexibility would be improved by shortening the notification period for dismissal from the current 60 days and easing conditions of dismissal for companies undertaking bankruptcy proceedings. Meanwhile, the social safety net would be strengthened, by expanding the coverage of the employment insurance system and the industrial accident compensation system.

Korea’s Dual Labor Market

  • Korea’s rapid recovery from the Asian crisis was facilitated by labor market reforms. Emergency legislation allowed dismissal of workers for “urgent managerial reasons” as well as the use of temporary workers; and the social safety net was strengthened by expanding coverage of unemployment insurance and the “productive welfare” system through the National Basic Livelihood Security Law (NBLS). These steps facilitated economic restructuring, and supported the quick return to low unemployment rates, at 3½ percent recently.

  • The Korean labor market has a high degree of duality. About two-third of employees are “regular” workers, while the remainder are “temporary” or “daily” workers, whose numbers can be more easily adjusted in line with changing economic conditions. Moreover, the proportion of nonregular workers has been increasing, with 70 percent of new hires in 2002 being nonregular workers, because they are paid 20 percent less on average and also have much lower firing costs, both administratively and in monetary terms.

uA01fig12

Share of Regular Employees in OECD Countries

(In percent)

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

Sources: Ministry of Labor, and OECD (2000).Pushing Ahead with Reform in Korea.
uA01fig13

OECD Index of Strictness of Protection Against Dismissals

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

Source: OECD Employment Outlook 1999.

  • Regular workers benefit from one of the strongest employment protection in the OECD. Lay-offs, including for “managerial reasons” in case of business transfer or mergers and acquisitions, are difficult as they have to meet criteria including: (1) the employer must make every effort to avoid dismissals; (2) the selection of employees to be dismissed must be based on fair and reasonable criteria; (3) the employer must consult sincerely with trade unions as to the measures to avoid dismissals and selection of dismissed workers; and (4) employee representatives or unions must be notified at least 60 days in advance of lay-offs. In addition, the definition of unfair dismissals is vague, allowing collective bargaining and precedent to set a high standard for what constitutes a “just cause.” High minimum severance payments, and criminal sanctions in case of unfair dismissals, also raise firing costs significantly.

  • The still-limited social safety net in Korea underpins demand for strong employment protection. Only one-fifth of the unemployed receive unemployment benefits as some nonregular employees do not meet eligibility requirements and some employers, especially in SMEs, do not comply with social contributions. In addition, benefit entitlement under the NBLS is subject to unusually strict income criteria, based on the income capacity (and not actual income) of the extended family. These problems leave many Koreans little means of making ends meet once they are out of a job.

  • This labor market structure undermined the Korean economy in 2003, and may limit future growth. First, the wide gap in employment protection between regular and nonregular workers tends to make industrial relations confrontational. Second, this rigidity in the formal labor market reduces Korea’s attractiveness for FDI and may also promote greater FDI outflows. Third, job precariousness among nonregular workers discourages vocational training, undermining innovation and productivity growth. Fourth, youth unemployment is high at over 8 percent because nonregular jobs are viewed as traps.

56. The team welcomed the Reform Proposal, noting that it constitutes a significant first step toward overhauling the current labor market framework. Nevertheless, it considered that more reforms would be needed to increase flexibility in the core segment of the labor market, while simultaneously expanding this core by creating incentives for employers to hire regular workers. In considering how this might be done, the team suggested that the experiences of other OECD countries might offer useful lessons. In particular, Spain’s experiment in introducing a new type of regular employment contract, with lower layoff costs, might be worth examining, although the authorities would need to tailor any measures to be consistent with Korea’s own traditions and legal framework.19

57. The authorities emphasized that they were committed to modernizing the labor market. But they noted that achieving social consensus on this issue would be difficult, pointing out that even the steps in the Roadmap were politically very contentious, and had still not been fully agreed by the employers and trade unions. As for Spain’s experiment, they agreed that it might be worth considering, but pointed out that introducing a such a contract would be very difficult, since the Labor Standards Act would need to be modified, and there might be constitutional challenges to the creation of two different types of treatment for regular workers.

E. Other Issues

58. The authorities stressed that they were committed to the success of the Doha round of trade negotiations. In particular, they are paving the way for a gradual opening up of its agricultural sector by offering to provide income support to those farmers who will be most affected by the liberalization. Even so, steps toward liberalization have encountered stiff domestic resistance: Korea’s first Free Trade Agreement, with Chile, agreed in 2002, has still not been ratified by the National Assembly, even though a number of agricultural safeguards have been included. Moreover, trade in rice will continue to be restricted; the government will be negotiating an extension of its quantitative restrictions beyond the end-2004 terminal date agreed under the WTO.

59. Korea has continued to upgrade its statistical system, but improved fiscal transparency is needed (Annex II). In particular, monthly data on the consolidated central government should provide a more comprehensive breakdown of revenues and expenditures, and data on the general government should also be published.

V. Staff Appraisal

60. Korea has made a spectacular recovery from the Asian crisis. Economic growth has been rapid, raising GDP far above its pre-crisis level. Economic resiliency has also improved, as international reserves have been built up to ample levels, while debt ratios have been maintained in a comfortable range. Korea today is a prosperous economy, with strong medium-term prospects, based on its well-educated workforce and expertise in advanced technology.

61. This remarkable achievement is tribute to the deep structural reforms of the past six years. By opening up and deregulating the economy, the financial sector has been transformed, freed to allocate capital to its highest returns. This change, in turn, has put pressure on the chaebol, forcing them to become more transparent and focus more on earning profits. In short, the reforms have created a more competitive system, guided much more by market signals and far less by government directives.

62. Despite this considerable progress, structural problems remain, which in 2003 helped derail the economic expansion. In particular, weaknesses in the credit card and investment trust companies made them vulnerable to liquidity pressures following an accounting scandal in one of the chaebol. One effect was to intensify a household credit squeeze already underway, further constraining consumption. Another was to impair the market for corporate bonds, which coupled with rising labor strife and political uncertainties, reduced investment. As a result, for two quarters, the economy actually contracted.

63. Economic recovery is now underway, but the rebound is highly uneven. Exports are booming and the global upswing—including vigorous growth in China, Korea’s largest trading partner—implies that they will remain strong for some time. But domestic demand will continue to be held back by high levels of household debt and loan delinquency, along with the risk of continuing labor strife and political uncertainties. A broad-based recovery may therefore not occur until 2005, when the process of household balance sheet adjustment should be more complete.

64. Accordingly, macroeconomic policies in 2004 will need to remain supportive of the recovery. In particular, the staff recommends maintaining a broadly neutral fiscal stance this year. It therefore welcomes the authorities’ steps to amend the original budget proposal to bring it closer in line with this objective, as well as their plans to front-load spending and introduce a supplementary budget, if necessary. Subsequently, as the recovery develops, the staff agrees that it would be prudent to restore fiscal balance gradually, to prepare for the budgetary challenges of an aging population and for uncertainties related to North Korea.

65. Similarly, there is scope to maintain the current monetary stance for some time. Forward-looking indicators such as the output gap suggest that inflation should remain subdued this year. And while housing prices have risen in certain areas of the country, this should not constrain policy, unless a nation-wide problem emerges.

66. At the same time, the staff urges the authorities to scale back their foreign exchange purchases and allow the exchange rate to be determined essentially in the market. Korea’s flexible exchange rate policy, adopted in the wake of the Asian crisis, has served the country well, encouraging financial market development, while maintaining external competitiveness. Moreover, with exports surging and the economy recovering, there would seem to be scope for greater exchange rate flexibility, which would also contribute to an orderly adjustment of global current account imbalances.

67. Meanwhile, the key remaining structural problems will need to be addressed. The authorities have set the appropriately ambitious objective of doubling Korean per capita incomes over the longer-term. To help realize this goal, they have developed reform roadmaps for the corporate sector and the labor market, while accelerating ongoing reforms of the financial sector.

68. With respect to financial markets, the staff agrees that the main priority should be to strengthen the non-bank institutions. The first task will be to resolve the credit card companies. The government should make it clear that the rescue of LG Card was an exceptional case, and that other card companies will be required to recapitalize quickly, with injections sufficient to cover realistic estimates of expected losses. Should existing owners prove reluctant to do this, prompt corrective action should be taken, including possible court receivership. As for LG Card itself, the company should be sold swiftly to investors with the needed financial strength and management skills. Meanwhile, to prevent similar problems in the banking system, supervisory authorities should encourage lenders to assess the adequacy of borrowers’ incomes, as well as their assets. There may also need to be a need to strengthen the supervisory framework itself, especially by shifting away toward a more risk-based approach, as recommended in the FSAP.

69. The next task will be to strengthen the asset management sector. Accordingly, the staff welcomes plans to sell the remaining two government-controlled investment trust companies to financially strong and capable buyers, foreign or domestic. With respect to establishing a Korean Investment Corporation, the staff recognizes that the aim is to spur the development of the asset management sector, rather than to provide a a mechanism to intervene in the market or a substitute for exchange rate flexibility. However, it believes that strong safeguards are necessary to guard against the risks involved. The agency’s law should guarantee its operational independence, investment guidelines, and rules for any future transfer of reserves. Moreover, the KIC’s accounts should be regularly and fully disclosed to the public, and it should refrain from investing domestically, at least until its credibility is established.

70. To develop the bond market further, the government will need to dispel notions that large companies are “too big to fail.” It should make clear that it is not providing implicit guarantees, and instead encourage investors to sharpen their risk assessments. Accordingly, the staff welcomes the plans to improve the accuracy of bond ratings by requiring agencies to publish information underlying their assessments and recommends that foreign firms be encouraged to enter the credit rating industry, thereby spurring competition. Moreover, once bondholders have used this information to take risks, they should bear the consequences of their decisions. The unified bankruptcy bill currently before the National Assembly could facilitate this, by promoting orderly workouts in problem cases.

71. The staff welcomes the three-year roadmap for corporate reform, which eases regulations on chaebol that improve their governance. The staff agrees that direct controls (including strict firewalls between corporations and financial institutions) need to be maintained or even enhanced for the time being. But they should be wound back as market discipline on chaebol improves. Particularly important in this endeavor is providing accurate and timely information to investors. Accordingly, the staff welcomes the National Assembly’s approval of the long-awaited accounting and auditing reforms, and recommends the adoption of a “comply or explain” system for the Code of Best Practices in Corporate Governance. Since investors must also be able to act on information that suggests their rights have been violated, the staff welcomes the new law allowing class action lawsuits for securities violations, and suggests that this be followed by permitting other kinds of legal action, including multiple derivative lawsuits.

72. The final item on the structural reform agenda is labor market reform. As the economy has advanced into the rapidly changing IT sector, and as the importance of services have grown, the need for employment flexibility has increased. The government has proposed a balanced approach of easing employment protection while at the same time expanding the coverage of the social safety net. Nonetheless, employment adjustment costs for regular workers would remain relatively high, so the share of nonregular workers may continue to rise. Other OECD countries have faced similar challenges, and Korea may be able to draw useful lessons for its own reform efforts.

73. Implementing this ambitious reform agenda will be challenging. Nonetheless, there is widespread recognition that the key structural problems will need to be addressed for Korea to achieve its target of doubling per capita incomes. Moreover, Korea has already demonstrated a substantial capacity to implement difficult reforms after the Asian crisis. Given Korea’s strong drive to advance its economy, staff expects the authorities will find the way forward.

74. It is recommended that the next Article IV consultation take place on the standard 12-month cycle.

Figure 1.
Figure 1.

Korea: Activity and Prices

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

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

Korea: External Developments

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

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

Korea: Financial Market Indicators

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

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

Korea: Corporate and Financial Sector Soundness

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

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

Korea: Housing Price Developments

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

Source: CEIC database and IMF staff calculations.

ANNEX I Debt Sustainability Analysis

Korea has relatively low public and external debt, and its debt dynamics are robust to most shocks, although population aging casts a cloud over the longer-run fiscal outlook. Korea’s external debt/GDP ratio is estimated at 30 percent in 2003 and the public debt/GDP ratio at 23½ percent. This annex outlines the main assumptions and results of an analysis of Korea’s public and external debt sustainability.

Korea’s remaining structural problems in the corporate and financial sectors expose it to a domestic demand shock. The failure of a major corporation or credit card company could lead to renewed runs on ITCs, a rise in corporate bond spreads and reduction in bond issues, bank losses and falling equity values, which would slow consumption and investment.

The country-specific scenario used in the sustainability analysis includes such a domestic demand shock. Korean growth has a high standard deviation in the last 10 years at 4.9 percent, so a shock of one standard deviation would imply no growth in real GDP in 2004. The scenario also assumes that the exchange rate depreciates by 5 percent. The primary fiscal balance would fall as revenues decline while primary spending is unchanged in real terms, but the current account surplus would rise as imports decline.

Public debt remains below 60 percent of GDP even in the face of extreme shocks (Annex I, Table 1). In the baseline, public debt remains stable as a ratio to GDP, as the central government budget returns to balance (excluding the accumulation of social security funds) in the medium-term, and as GDP growth offsets the increase in debt due to the planned rollover of guaranteed bonds into treasury bonds amounting to 8 percent of GDP (Box 3, SM/03/58). The shock to real GDP (B2) has the greatest impact, lifting public debt to 53 percent of GDP by 2008, but the shock is extreme, with GDP falling 18 percent and the primary deficit rising by almost 5 percentage points of GDP. Public debt rises to 40 percent of GDP with variables at their historical average (Al), but this is because the social security surplus was small in the past and because of the impact of the 1997–98 crisis on the fiscal balance. Under the above country-specific scenario, public debt rises modestly, to 27 percent of GDP.

Table 1.

Korea: Public Sector Debt Sustainability Framework, 1998–2008

(In percent of GDP, unless otherwise indicated)

article image

Central government debt. Includes projected conversion of publicly guaranteed debt of KDIC and KAMCO into treasury bonds, see Box 3 of SM/03/58.

Derived as [(r - π(1+g) - g + αε (1+r)]/(l+g+π+gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; α = share of foreign-currency denominated debt; and e – nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

The real interest rate contribution is derived from the denominator in footnote 2/ as r - π (1+g) and the real growth contribution as -g.

The exchange rate contribution is derived from the numerator in footnote 2/ as αε(1+r).

Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.

Derived as nominal interest expenditure divided by previous period debt stock.

The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP.

The implied change in other key variables under this scenario is discussed in the text.

Real depreciation is defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).

Assumes that key variables (real GDP growth, real interest rate, and primary balance) remain at the level in percent of GDP/growth rate of the last projection year.

External debt is most sensitive to exchange rate shocks, but shocks of the assumed magnitude appear very unlikely (Annex I, Table 2). Korean external debt is projected to remain about 30 percent of GDP in the baseline, as the current account surplus declines toward balance and as net nondebt creating inflows decline from the high levels after the crisis. Most shocks have a relatively modest impact on the external debt path, but the two exchange rate shocks have a substantial impact:

Table 2.

Korea: External Debt Sustainability Framework, 1998–2008

(In percent of GDP, unless otherwise indicated)

article image

Derived as [r - g - ρ(1+g) + εα(1+r)]/(1+g+ρ+g+gρ) times previous period debt stock, with r = nominal effective interest rate on external debt; ρ = change in domestic GDP deflator in U.S. dollar terms. g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-ρ(1+g) + εα(1+r)]/((1+g+ρ+gρ) times previous period debt stock, ρ increases with an appreciating domestic currency (ε>0) and rising inflation (based on GDP deflator).

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and nondebt inflows in percent of GDP.

The implied change in other key variables under this scenario is discussed in the text.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and both non-interest current account and nondebt inflows in percent of GDP) remain at their levels of the last projection year.

  • a 30 percent exchange rate depreciation (B6) lifts the external debt ratio to 46 percent

  • a two standard deviation shock (B3) lifts the external debt ratio to 64 percent—the exchange rate falls by 49 percent given the 13.2 percent standard deviation of the exchange rate due to the volatility in 1997–98.

Such large permanent shocks to the real exchange rate seem highly unlikely for a manufactured goods exporting country like Korea.

In the longer-run, Korea faces a rapid aging of its population, presenting a major risk to fiscal sustainability. The National Pension System is projected to swing into deficits of as much as 8 percent of GDP after 2030.1 The authorities have proposed to phase in reforms over time, including lowering the income replacement rate to 50 percent by 2008 from the current 60 percent, and raising the contribution rate to 16 percent by 2030 from the current 9 percent. The authorities estimate that the proposed reforms will avoid exhaustion of the NPF, which would otherwise occur by 2047. However, National Assembly approval of these reforms is uncertain.

ANNEX II Statistical Issues

Korea’s macroeconomic statistics and statistical base are adequate to conduct effective surveillance and the country subscribes to the Special Data Dissemination Standard (SDDS). Nevertheless, the April 2001 data ROSC mission identified shortcomings in some statistical practices that have the potential for detracting from the accurate and timely analysis of economic and financial developments and the formulation of appropriate policies.

Real Sector

  • The overall structure of the national accounts mainly follows the 1968 System of National Accounts (1968 SNA). The delineation of the economy, the valuation rules, and the production and asset boundaries are in line with the 1968 SNA. However, the classifications used are broadly in accordance with those recommended in the 1993 SNA. The existing data collection program is not being fully used to compile the national accounts and new measures have yet to be implemented to improve those surveys perceived as being unfit. One omission from the accounts is the informal activity in the unrecorded economy, the size of which is not known. Informal activities, including some illicit activities, are expected to be reflected in the next revision of the national accounts. Although GDP data are produced in accordance with international practice, the national accounts could be improved by shifting to the 1993 SNA. The BOK plans to implement the shift at the time of the next rebasing to take effect during 2003–04. Also, the commodity flow technique could be improved by moving to the Supply and Use Table framework. The BOK intends to produce such a framework in 2004, but there are currently difficulties with obtaining the basic data required.

  • The Consumer Price Index (CPI) is based on internationally endorsed standards and uses classifications compatible with internationally recommended systems. Concepts and definitions used for the compilation of the CPI are in line with the recommendations of the International Labor Organization (ILO). The scope of the CPI covers urban areas, but excludes single person, farm and fishing households. The CPI is compiled using sound procedures and methods which, however, could be improved by also including single-person households, and by having the prices of missing seasonal items imputed by similar items within their group. The coverage gaps can be a potential problem with the level of the indices, while the absence of good imputation procedures can potentially introduce a bias in short-term price trends and affect inflation monitoring. New weights and a new market basket using the 2000 Household Income and Expenditure Survey were introduced in the CPI for January 2002.

  • The Producer Price Index (PPI) is also based on internationally endorsed standards and recommendations. Concepts and definitions used for the compilation of the PPI are in line with the 1993 SNA. The scope of the PPI covers all domestic industrial activities and a large segment of service activity, as well as free trade zones and bonded warehouses. The PPI is compiled using sound procedures and methods but could be improved by imputing missing prices from other similar commodities, rather than being simply carried forward using the last reported price.

Fiscal Sector

  • Consolidated statistics on the general government aligned with internationally recognized standards are not compiled. Statistics following these standards only cover the central government, which accounts for about 75 percent of total general government. National concepts and definitions differ from those internationally recognized. Therefore, two sets of government finance statistics are compiled for the central government, using national definitions and using internationally recognized standards. Concepts and definitions used in the latter set of central government finance statistics generally follow the recommendations of the 1986 Government Finance Statistics Manual (GFSM 1986). The data cover the budgetary units of the central government (including social security funds owned and/or managed by the government) and the extra-budgetary funds owned or managed by these units.

  • Central government statistics aligned with internationally recognized standards are produced from the National Financial Information System (NAFIS), which integrates the preparation of budget data, accounting reports, and the generation of fiscal statistics on a monthly basis. The NAFIS provides for automatic crosschecks at different levels of the compilation process.

Monetary Sector

  • The overall quality of Korea’s monetary statistics is generally sufficient for informing the policy process. The data ROSC mission to Korea identified several areas that are not in line with international guidelines. The revised monetary aggregates, which have been compiled since early 2002, address many of the identified data issues and now almost fully comply with the Monetary and Financial Statistical Manual (MFSM 2000).

  • The analytical usefulness of data relating to foreign assets and foreign liabilities is affected by the BOK valuing its financial assets and financial liabilities at book value (rather than at market value) and revaluing its foreign currency denominated assets and liabilities twice yearly (rather than on a monthly basis). Also, some banks are using nationality rather than residency to distinguish between resident and nonresident individual and household accounts, affecting the accurate measurement of net foreign assets of the banking sector.

Balance of Payments

  • The overall quality of balance of payments data is good. The Bank of Korea implemented the fifth edition of the IMF’s Balance of Payments Manual (BPM5) in early 1998, but some deviations remain in the classification and sectorization of balance of payments transactions.

  • Following liberalization, the coverage of the balance of payments statistics has become less comprehensive, as residents were permitted to conduct transactions via accounts with banks abroad. There is also incomplete coverage of transactions via intercompany accounts, via nonresident won-denominated accounts with domestic banks, and noncash transactions. The BOK is preparing to implement new collections to improve coverage. The BOK has developed an array of statistical techniques and collections to improve the coverage, classification, and timeliness of source data, including timing and valuation adjustments to trade statistics compiled from customs documents, grossing of certain services transactions, and recording long-term construction contracts under direct investment.

  • The quality of external debt statistics has greatly improved since the financial crisis. However, until September 2003, the statistics were not compiled on a residency basis, and certain external liabilities are excluded from the disseminated data. Hence, the external debt statistics were not comparable with the balance of payments statistics, nor with external debt data disseminated by other countries. In September 2003, the BOK started to release external debt statistics on a residency basis according to the SDDS specifications; a debt service schedule, an encouraged item in the SDDS, is not disseminated. The BOK has also released data on Korea’s International Investment Position (IIP) for 2001 and 2002.

  • Data dissemination on international reserves, foreign currency liquidity, and external debt generally meets the SDDS specifications for periodicity, timeliness, and advance release calendars.

Korea: Survey of Reporting of Main Statistical Indicators 1/

(As of January 20, 2004)

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The codes are explained below.

Frequency of data: D – daily, M – monthly, Q – quarterly. Frequency of reporting: D – daily, M – monlhly, BM - Bi-Monthly, Q – quarterly, P – periodically (upon request). Source of data: A – direct reporting by authorities, N – official publications and websites. Mode of reporting: E – electronic data transfer, M – mail F – fax, R – press report. Confidentiality: C – unrestricted use, D – embargoed for a specific period, and for unrestricted use thereafter.

ANNEX III Fund Relations

(As of November 30, 2003)

I. Membership Status: Joined August 26, 1955; Article VIII

II. General Resources Account:

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III. SDR Department:

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IV. Outstanding Purchases and Loans: None

V. Financial Arrangements:

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VI. Projected Obligations to the Fund: None

VII. Exchange Rate Arrangement:

Korea’s exchange rate system is classified as “independently floating.” Previously, the exchange rate against the U.S. dollar was allowed to float only within specified margins around the previous day’s weighted average exchange rate in the interbank market. The margins were widened five times between March 1990 and November 1997 (most recently to +/-10 percent), and on December 16, 1997 were eliminated altogether. On January 15, 2004, the exchange rate was W 1,180.2=US$l.

VIII. Last Article IV Consultation:

Korea is on a 12-month consultation cycle. Staff discussions for the 2002 Article IV consultation were conducted on a mission to Seoul during October 16–29, 2002. The Article IV consultation was concluded by the Executive Board on March 3, 2003. In addition, a Staff Visit took place during April 22–April 30, 2003.

IX. FSAP and ROSC Participation:

MFD: The final FSAP mission was conducted during October 2002. The mission completed the FSAP by assessing the short-term vulnerability of the financial sector to macroeconomic and sectoral shocks and analyzing overall financial sector soundness and developmental challenges, including issues arising from the draft standards assessments. A follow-up technical assistance mission on the supervision of derivatives markets was held in Seoul during January 9–20, 2003. The Financial System Stability Assessment report has been published (country report No. 03/81) and is available on the web through the following link: http://www.imf.org/external/np/fsap/fsap.asp

FAD: Discussions on fiscal transparency were held in Seoul during June 2000, and a report was drafted and finalized in November 2000, with input from APD staff. The report has been published (SM/01/22) and is available on the web through the following link: http://www.imf.org/external/np/rosc/kor/fiscal.htm

STA: Discussions on Korea’s data dissemination practices against the IMF’s Special Data Dissemination Standard (SDDS) were held in Seoul during April 2001, and a report was drafted and finalized on November 28, 2001. The report has been published and is available on the web through the link: http://wwwjmf.org/external/pubs/ft/scr/2003/cr03127.pdf

X. Technical Assistance:

FAD: A technical assistance mission visited Seoul during January 8–19, 2001 to evaluate current practices in budgeting and public expenditure management and to provide advice on setting up a medium-term fiscal framework.

MFD: A mission conducted a high-level technical seminar during May 16–22, 2000 on the development of the foreign exchange market. Jointly with the authorities and market participants, the mission analyzed the current state of the foreign exchange market and identified possible areas for improvement. The seminar covered issues in supervision, market monitoring, derivatives instruments, and market microstructure.

STA: A technical assistance mission visited Seoul during March 29-April 12, 2000 to provide advice on balance of payments and external debt statistics, with a view toward improving the recording of financial derivatives and developing an international investment position statement.

XI. Resident Representative:

The resident representative office in Seoul was opened in March 1998. Mr. Kenneth Kang has been the Resident Representative since September 2003.
1

See, for example, Chungwon Kang, “From the Front Lines at Seoul Bank: Restructuring and Privatization,” IMF Working Paper 03/235, December 2003.

2

The widely-used index from Crédit Lyonnais Securities Asia indicates that Korea’s corporate governance rating has improved to 71 in 2003, compared with an average of 62 in the major Asian emerging markets.

3

All quarterly figures in this report are seasonally adjusted, but not annualized.

4

CCC debt accounts for about one-fifth of Korea’s outstanding commercial paper.

5

These expenditure shortfalls are discussed by He, 2003, “Budget Formulation and Implementation in Korea: A Macroeconomic Perspective,” Selected Issues, IMF Country Report No. 03/80. See also Chapter I of the forthcoming Selected Issues paper.

6

The foreign exchange purchases were sterilized, in accordance with the authorities’ objective of using interest rates as their policy tool, allowing broad money growth to slow to 8 percent in 2003.

7

In January 2004, as a further step to moderate upward pressure on the won, the authorities limited the size of the positions that domestic financial institutions could take in the nondeliverable forward market, the offshore market frequently used by foreign investors to take positions on the Korean currency.

8

Around 1 in 10 Koreans over the age of 15 had delinquent loans in November 2003.

9

Despite the domestic difficulties, the government successfully placed a $1 billion 10-year global bond in May, with a spread of just 92 basis points over U.S. treasuries. The inclusion of collective action clauses had no noticeable effect on the pricing.

10

Estimates of the Korean Phillips curve are presented in Chapter II of the forthcoming Selected Issues paper.

11

The KDB has been used in the past as a vehicle for intervention in the financial markets, most notably to underwrite corporate bonds issued by troubled conglomerates during 2001 in the wake of the Daewoo crisis.

12

Despite write-offs from SK Global and other cases during 2003, CARs of the major commercial banks remained a robust 11.3 percent as of September 2003. The subsequent losses from LG Card are estimated by Standard and Poor’s to reduce the CAR of the nine creditor banks involved by about 0.4 percentage points on average.

13

A first class bank is subject to standard supervision procedures while other banks have more intensive supervision.

14

In December, a central bank research paper proposed developing domestic-based alternatives to foreign investment. The authorities have explained, however, that the proposal aims at developing domestic markets, and has no implications for their asset sales policy.

15

Cumulative voting means that investors could vote all of their shares for one director, rather than be required to split their votes among all the chairs up for election.

16

The regulation limits investment in affiliated companies to no more than 25 percent of net assets of the acquiring company, and applies to 17 large business groups.

17

The reforms require: the CEO and CFO to certify the accuracy of financial statements; the board to approve and publicly disclose loans to major shareholders and executives; and firewalls between consultancy and auditing services within accounting firms. A six-year limit on auditing relationships was added after the SK Global scandal.

18

Two facts illustrate the point: Korea has the highest rate of broadband penetration in the world; and Samsung Electronics is now Asia’s largest electronics company measured by market capitalization.

19

Chapter III of the Selected Issues paper provides background information on labor market institutions in Korea and analyzes options of reforms.

1

See Gruenwald, 2003, “Options for Pension System Sustainability in Korea,” Selected Issues, IMF Country Report No. 03/80.

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Cover IMF Staff Country Reports
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
Author:
International Monetary Fund
Volume/Issue:
Volume 2004: Issue 044
Publisher:
International Monetary Fund
ISBN:
9781451822083
ISSN:
1934-7685
Pages:
62
DOI:
https://doi.org/10.5089/9781451822083.002

Real GDP

(1997=100)

Economic Activity and Consumer Spending

(Dec. 2000 = 100)

Monthly Change in Bond Funds Including MMF

(In trillions of won)

Workers Involved in Industrial Disputes

(Thousands)

Interest Rates

(percent per annum)

Exports and OECD Leading Indicator

(Annualized 6 month percent change)

Household Debt

(In percent of GDP)

Real House Prices

(March 1997=100)

Exchange Rate Movements

(Dec. 31, 2001=100)

Real Exchange Rates

(1995=100)

Price Earnings Ratio, August 2003

Share of Regular Employees in OECD Countries

(In percent)

OECD Index of Strictness of Protection Against Dismissals
Figure 1.

Korea: Activity and Prices
Figure 2.

Korea: External Developments
Figure 3.

Korea: Financial Market Indicators
Figure 4.

Korea: Corporate and Financial Sector Soundness
Figure 5.

Korea: Housing Price Developments