The Fund’s support has been pivotal in building public consensus for continued reform

Our authorities would like to record their deep appreciation to staff for a very productive Article IV consultation process. The team’s policy recommendations for the Korean economy, which have been articulated in a well-written report, are very relevant. Importantly, they were formulated through a constructive dialogue between the mission team and the authorities. The manner in which this dialogue was conducted was greatly appreciated by the authorities, the highlight of which was staffs seminar at the conclusion of the mission. The seminar was well attended by officials from various ministries and was instrumental in reaching a common understanding on the policy needs of Korea and the way forward.

Our authorities also appreciate the team’s effective communication with the press during their visit. As rightly noted in the report, Korea’s policy environment is not currently ideal, with the governing party having only a minority in the National Assembly and a general election is scheduled for April. An example of those difficulties was the recent passage of the ratification of the FTA with Chile. The ratification was only passed after three failed attempts due to strong resistance from congressmen from rural constituencies. Notwithstanding these difficulties, the authorities have managed to advance some important reform bills, as well as strengthen the accommodative stance of the 2004 budget (most of these developments taking place after the team’s departure). They are also appreciative of the team’s contribution to enhancing public awareness of this process.

Looking ahead, the authorities strongly believe that building public consensus is the best way to push ahead with necessary reforms and, as was the case during the fast recovery after the crisis, the Fund will continue to be a crucial ally in this effort. In this regard, they would like to convey their gratitude to the Managing Director who has agreed to visit Korea shortly after the Article IV Board discussion.

Given that the report reflects the common views of the authorities and staff regarding Korea’s policy needs, we will focus on providing some background information on the macroeconomic policy mix, labor market developments, and some comments on “legacy issues” in relation to financial and corporate restructuring.

Policy mix remains accommodative

While the impact of the bursting of the credit card boom still remains, there are signs that economic activity has started to strengthen. The leading composite index has continued to rise since the second half of 2003 and industrial production growth has also gained pace. Although a full recovery in domestic consumption (which accounts for around 60 per cent of GDP) will take some time due to high household indebtedness and the problems associated with credit card debt, investment is expected to rise as production moves closer to full capacity. (The latest average capacity utilization ratio is 81.2 per cent - the highest level since April 1997.) With the pick-up in domestic demand, economic growth is expected to draw closer to its potential by year’s-end.

Like staff, the authorities are of the view that the macroeconomic policy mix needs to remain accommodative in order to support the economic recovery. The deficit target for the 2004 budget has already been moderated and the authorities plan to front-load expenditure, as they did last year. The recently-announced budget disbursement plan envisages that 54 per cent of budgeted expenditure will be spent during the first half of the year, surpassing last year’s record of 53 per cent. The authorities remain vigilant to ensure that the economic recovery progresses and will monitor the need for a supplementary budget.

Following the adoption of targeted tax measures last November, price rises in one segment of the real estate sector have now been brought under control. Given that core inflation remains comfortably within the target range, the Monetary Policy Commission (MPC) has not adjusted the policy interest rate.

Since the last Board discussion on Korea, there has been a further improvement in the inflation targeting regime, along the lines recommended by staff. The medium-target is now fully incorporated into law and the independence of the MPC has been further strengthened, with the Bank of Korea being represented by more members in the nine-member monetary policy decision-making body.

Reflecting the better-than-expected performance in the external sector, the won appreciated substantially last year, however, pressure is expected to dissipate as imports rise with the recovery in domestic demand. That said, it is clear that much of the recent appreciation in the currency has reflected capital transactions. While the authorities are committed to the maintenance of a flexible exchange rate, they are also very mindful of the damaging consequences of excessive volatility in the exchange rate and the fact that Korea still has a very shallow foreign exchange market. Hence, as noted by the staff, intervention in the foreign exchange rate occurred when market conditions became disorderly.

While the authorities found the staff’s description of the foreign exchange rate policy broadly fair, they are concerned about the explicit reference to currency appreciation due to market sensitivities.

Labor sector issues are the key to the continued success of the Korean economy

The labor sector poses a number of inter-related challenges for the Korean economy. The economy is more vulnerable to industrial disputes than implied by the low union participation ratio (currently 11.6 per cent and continuing to decline from 15.6 per cent of ten years ago). Unionization is concentrated in upstream, assembly industries. As a result, the impact from any sustained industrial action in those industries can easily spill over to the downstream, parts industries. Business confidence is often affected by disputes in the labor market and foreign investors tend to single-out labor militancy as one of the major inhibitors to investment.

Another challenge comes from the increasing duality of the labor market (as analyzed in Box 3 of the staff report). So far, there is little evidence that the increase in the non-regular labor sector has impacted on productivity. To the contrary, it has brought remarkable flexibility to the labor market and contributed to a moderation in unit labor costs since the 1997 crisis. As indicated in the divergence between CPI-based REER and ULC-based REER (text figure on page 15 of the staff report), the increase in unit labor costs has been lower than inflation. However, regular sector wages have grown faster than productivity gains in recent years. The authorities are very mindful that the continuation of this trend would undermine productivity gains and are determined to rectify this trend.

Obviously, addressing the duality of the labor market involves narrowing the gap in employment protection between regular and non-regular labor sectors. The Spanish model suggested in the selected issues paper has merit but, as explained in the staff report, it could raise legal issues in Korea. Strengthening the social safety net would certainly be helpful in generating consensus, but the authorities are cognizant of the fact that the generosity of severance payments in the regular sector is well above the OECD average.¹

The authorities prefer a more direct approach. Their agenda includes reducing the mandatory notification period for lay-offs from 60 days to 30 days and a further relaxation of the lay-off procedures for those firms under insolvency filing, while providing more protection for non-regular workers. But, as noted in the staff report, it is not an easy process and is politically contentious given that regular workers, who are unionized, tend to take their existing employment rights for granted. The process could result in further serious industrial relations strains, at least in the short term.

The authorities are a making concerted effort to achieve social consensus in addressing the adverse impacts of the duality of the labor market. Currently, the reform agenda is being discussed in the context of the Employee-Employer-Government Tripartite Commission. Thus far, progress has been encouraging as evidenced by the recent agreement that the three parties will cooperate in advancing job creation. According to the agreement, the unions will refrain from illegal strikes and will moderate their wage demands, management will make efforts to avoid unnecessary job cuts, and the government will provide better protection for non-regular workers. The authorities expect that consensus will emerge by June, which would allow the new National Assembly to incorporate the agreement into law.

The chaebol “legacy” and financial/corporate restructuring

The staff report tends to present the LG Card case as a government-sponsored bail-out. This is based on the fact that the Korea Development Bank (KDB), which is government-owned, would become the largest shareholder of the company once the proposed restructuring plan is implemented. We would like to note that this is a fair resolution, with more burden-sharing by shareholders in the chaebol affiliate for management’s failures, apart from the systemic risk that the company’s abrupt resolution would imply. (LG Card is the largest credit card company, accounting for about 25 per cent of assets in the credit card sector and KDB is one of LG Card’s largest creditors.)

According to the absolute priority principle under the corporate insolvency scheme, a shareholder’s legal responsibility ends once the share value is given-up when a company is in bankruptcy. It then becomes the responsibility of creditors to decide the fate of the company. In the case of LG Card, the LG Group has already agreed to give-up its equity in the company. However, the reality of corporate governance in Korean chaebols is that families exercise far more control than indicated by their ownership in the groups (as shown in Box 2 of the staff report). Conversely, creditors insist that families be more accountable for their management’s failure in ailing affiliates than is reflected by their shareholding. Creditors also know that this approach can not be achieved through bankruptcy filing. Hence, creditors prefer out-of-court settlements where families are pressed to bear greater losses for management’s failure than simply giving-up their equity in the company.

This was the case with LG Card. Creditors, led by the largest creditor (KDB), struck a loss-sharing arrangement with the LG family. In addition to giving-up its and the group’s equity in LG Card, the family agreed to surrender another non-bank financial company (LG Investment Securities), whose sale proceeds would be injected into LG Card, in return for a creditors’ debt-equity swap plan. The family also agreed to take over 70 per cent of any additional losses should they materialize during the restructuring of LG Card, by offering its equities in other affiliates of the group as collateral.

Obviously, the deal is only enforceable when creditors collectively agree to take-up the remaining 30 per cent of the additional losses. Faced with reluctance from other creditor banks, which are now managed under ever-increasing foreign ownership, the KDB (as the largest creditor) agreed to the risks involved for the resolution of LG Card.² Such an outcome between creditors and the shareholder family may go beyond the provisions of the law but, given the persistence of the “legacy” of the Korean chaebols’ governance structure, it can be argued that it is much closer to a fair burden-sharing arrangement than would likely emerge under insolvency procedures.³

The chaebols’ legacy is dying. Previous corporate reform measures have already brought enormous market pressure upon the Korean chaebols’ complicated ownership structure. Families’ minor ownership positions have been challenged in a number of recent hostile take-over bids. The chaebols now realize that cross-shareholding among affiliates of their group can be at their own peril, rather than insurance, as it can be an easy route for a successful take-over of one affiliate to spread into other affiliates in the group.

The “Korea discount” referred to in the staff report is a painful phenomenon, but it is now well recognized in business circles. In the case of the chaebols, the pain is even more acute because their affiliates are increasingly being treated with a “chaebol discount” in local capital markets, rather than a “chaebol premium”, which they enjoyed before the crisis.

Facing ever-fierce market pressures, big conglomerates have begun to streamline their ownership. A number of chaebols have already broken their groups into smaller operations by adopting the holding company structure. The authorities’ plan to relax some stringent qualifications for establishing holding companies is expected to speed-up this process further.

Finally on the Korean Investment Corporation (KIC) issue, we wish to confirm that the authorities do not have any disagreement with the staff’s suggestion. In fact, they are now preparing a draft bill which will accommodate the staff’s views. We hope that the staff’s concern, as recorded in the staff report, will not be interpreted as a negative stance by the Fund on this issue.