Republic of Korea: Staff Report for the 2004 Article IV Consultation

This 2004 Article IV Consultation highlights that from 1999 to 2002, Korea’s economy grew rapidly, by an average of 7¼ percent per year. But starting in 2003, the economy has begun to sputter. Growth suddenly stopped in the first half of the year, leapt ahead in the second half as exports boomed, but then slowed again to an anemic 2¾ percent annualized rate during January–September 2004 as exports decelerated. The authorities have been countering this slowdown by easing macroeconomic policies. The fiscal policy stance has been shifted from neutral to mildly expansionary.


This 2004 Article IV Consultation highlights that from 1999 to 2002, Korea’s economy grew rapidly, by an average of 7¼ percent per year. But starting in 2003, the economy has begun to sputter. Growth suddenly stopped in the first half of the year, leapt ahead in the second half as exports boomed, but then slowed again to an anemic 2¾ percent annualized rate during January–September 2004 as exports decelerated. The authorities have been countering this slowdown by easing macroeconomic policies. The fiscal policy stance has been shifted from neutral to mildly expansionary.

I. Introduction

1. From 1999 to 2002, Korea’s economy grew rapidly, by an average of 7¼ percent per annum. But starting in 2003, the economy began to sputter. Growth suddenly stopped in the first half of the year, leapt ahead in the second half as exports boomed, but then slowed again to an anemic 2¾ percent annualized rate during January-September 2004 as exports decelerated. What explains this pattern of stop-and-go growth? And what can be done to put the economy back on the path of sustained, rapid, expansion? These are the key policy questions facing the Korean economy.

2. In some sense, the answer to the first question is straightforward. Growth has slowed because the economy has been dealing with the after-effects of a 2001–02 credit boom, which damaged the balance sheets of households and firms, causing them to slow their spending. But in another sense the issue is deeper. The origins of the credit boom, and the impediments to renewed growth, lie partly in government intervention into the economy, the legacy of decades of a state-directed development strategy. The Article IV consultation discussions consequently focused on ways to overcome this legacy and complete the shift to a market-based framework needed for sustained growth.

II. The Ubiquitous Hand

3. Since the Asian crisis, Korea has accelerated its shift towards a market-oriented development strategy. Directed credit has been abolished, protectionist barriers largely eliminated, the exchange rate floated. The bulk of the banking system has been placed in private hands, while the chaebol have been restructured and their leverage reduced to U.S. levels. As a result, Korea now has one of the more open and liberal economies in the emerging market universe. Foreign investors, for example, now hold 43 percent of equity market capitalization, the 4th highest share in the world.

4. Nonetheless, since the crisis Korean governments have continued to intervene in the economy, and the after-effects of these interventions are now holding back a recovery.1 The key areas where past interventions have had unintended costs are:

  • The household debt problem. Since 2002 the number of people in default on their debts has risen sharply, peaking at 3¾ million, one-tenth of the adult population. Delinquencies on credit cards are the main factor, following a more than five-fold expansion in credit card debts during 2000-02. The primary impetus for this expansion came from the credit card companies themselves, which marketed their product aggressively. But according to an official investigation by the Bureau of Audit and Inspection, the government also contributed to the boom by introducing tax deductions and lotteries for credit card users, as part of a strategy to develop domestic demand and expand the formal economy.2 Moreover, lax supervision allowed card companies to issue cards without requiring basic information needed to assess credit risk, such as income. There were 31 million cards issued in 2001 alone—in a country with a total population of 48 million.

  • The financial difficulties of SMEs. To contain the decline in bank loans to SMEs immediately after the Asian crisis, the government sharply expanded its credit guarantees. These emergency guarantees, however, have not been unwound over time. Instead, they have been repeatedly rolled over, contributing to a boom in bank lending to SMEs in 2001–03. As a result, this vital sector—which accounts for 85 percent of employment—is now plagued by over-capacity and poor profitability (Box 1)

  • The reluctance of larger corporations to invest. In contrast with smaller firms, the position of the larger corporations is generally strong. But they have preferred to use their profits to repay debts, repurchase stock, or invest in China, rather than to expand their domestic investments. One reason is that they are discouraged by the highly regulated domestic labor market: workers with regular contracts in Korea continue to benefit from some of the strictest job protection in the OECD, the legacy of government attempts from the 1960s through the 1980s to provide the security of lifetime employment.


Delinquent individuals


Citation: IMF Staff Country Reports 2005, 049; 10.5089/9781451822182.002.A001

Source: Korea Federation of Banks

III. An Economy Flying on Just One Engine

5. With the household and SME sectors facing financial difficulties, and many corporations reluctant to invest, most of Korea’s engines of growth have shut down. Domestic demand has stagnated since early 2003, with private consumption in particular contracting in 5 out of the past 7 quarters as households have focused on paring down their debt burdens, while incomes have been eroded by the sharp rise in world oil prices.3


Economic Growth

(Seasonally Adjusted Annualized Rate, Percent)

Citation: IMF Staff Country Reports 2005, 049; 10.5089/9781451822182.002.A001

Source: Bank of Korea

Are SMEs the Next Credit Card-Style Problem?

As large enterprises in Korea engaged in financial deleveraging after the crisis, banks turned to SMEs as a new lending opportunity. Starting in 2001, SME loans and housing mortgages surged, with the former substantially collateralized by real estate as well. Lending to SMEs seemed justified at the time by their relative profitability and financial stability, and was certainly aided by a 23 percent increase in government SME credit guarantee provisions.1 Not all SMEs benefited equally from this credit boom however, with the largest increases concentrated in services sectors.


Bank Credit

(percent change, y/y)

Citation: IMF Staff Country Reports 2005, 049; 10.5089/9781451822182.002.A001

But weak domestic demand is hurting the SMEs’ bottom line. The proportion of loss-making SMEs increased from 17.7 percent in 2002 to 21.3 percent in 2003.2 Tougher business conditions are also unmasking lingering structural deficiencies in the sector, with many nonviable SMEs reliant on the credit guarantees and other forms of government support. These guarantees account for more than 6 percent of GDP, a much larger share than in comparable economies like Taiwan Province of China.

With SME finances weakened after a period of strong credit growth, some analysts have questioned whether SMEs will be Korea’s next mass defaulters. SME loans now constitute more than 40 percent of banks’ credit portfolio, and amount to over 30 percent of GDP. A wave of SME defaults would put further pressure on the financial system which is recovering from a credit card boom-bust cycle.

The underlying degree of financial distress remains unclear. SME delinquency ratios have risen little from 2.1 percent in December 2003 to 3 percent in August 2004, but this may partly reflect “evergreening” by banks.3 Certainly, these ratios appear too low if, as shown by some studies, 6 percent of SMEs have failed to generate enough operating income to cover interest charges for the last three consecutive years.

Relative to credit card loans, potential losses on SME loans are limited by two key factors. First, the combination of real estate collateral and government guarantees secure some 70 percent of SME credit. Even in a pessimistic scenario where all SMEs with an interest coverage ratio below one in 2003 default on their debts, private sector analysts have estimated the unsecured portion of the defaulted debt at slightly more than one year of banks’ pre-provisioning profits and less than a fifth of the banks’ book value. Second, most SMEs deal with one or two creditor banks, making any restructuring easier than in the case of households with multiple credit cards.

However, there is no room for complacency. Restructuring of the sector needs to begin soon if SMEs are to resume investment and growth.

1 Including SME collateralized bond obligations.2 These figures are for manufacturing SMEs only. The services sector may be facing even deeper problems.3 Note that credit card delinquency ratios are much higher at 12.5 percent.

6. Accordingly, the economy has been forced to rely on merchandise exports. These boomed in the second half of 2003 as the global electronics industry recovered, propelling GDP growth to an annualized rate of 9 percent. But in early 2004 this growth engine began to falter. Exports slowed as the electronics expansion matured, reducing GDP growth in the first three quarters to just 2¾ percent (q/q annualized, Table 1).

Table 1.

Korea: Selected Indicators, 2000-05

(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 2005.

Excluding privatization receipts and rollover of KDIC/KAMCO bonds.

Change in the cyclically adjusted overall balance (excluding net lending in 2003). A negative impulse implies a contractionary stance.

Data for 2004 are as of September 21, 2004.

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

7. The authorities have tried to counter this slowdown by easing macroeconomic policies. In particular:

  • The fiscal stance was shifted from neutral to mildly expansionary. As concerns about growth mounted, the government initially frontloaded expenditures into the first half of the year, then adopted a supplementary budget of ½ percent of GDP (Table 2).

  • The monetary policy mix was shifted to favor domestic demand. The Bank of Korea cut its policy rate by 25 basis points in both August and November, to an historic low of 3¼percent, easing the burden on domestic debtors (Table 3). Meanwhile, the won was allowed to appreciate, cushioning the impact of higher world commodity prices and helping to sustain household real disposable incomes. Over the course of 2004, the currency climbed by 14½ percent against the U.S. dollar, a 12 percent gain in nominal effective terms—the sharpest rise among Asian currencies. While smoothing this ascent, the authorities accumulated $37 billion in reserves, bringing the total to $196 billion (Table 4).

Table 2.

Korea: Consolidated Central Government Operations, 2001-05

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

Original budget, excluding supplementary budgets.

The conversion of KDIC and KAMCO bonds is excluded, amounting to W13 trillion in 2003, and W12 trillion annually thereafter.

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 (including net lending).

Table 3.

Korea: Monetary and Financial Indicators, 2001–04

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Source: Bank of Korea.

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

Table 4.

Korea: Balance of Payments, 2000–05

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

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

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


Local Currency per U.S. Dollar

(Change in percent since Dec. 2003)

Citation: IMF Staff Country Reports 2005, 049; 10.5089/9781451822182.002.A001

Source: IMF, International Financial Statistics, Bloomberg.Based on monthly end of period exchange rates through December 29, 2004. A positive value implies appreciation.

8. On the structural side, the progress of Fund-supported measures was slow for much of the year, partly because the National Assembly was preoccupied by legislative elections.4 Now that the President’s party has secured a slim majority, however, some of these measures have been advancing. A major corporate governance bill, aimed at discouraging cross-shareholdings and strengthening the firewalls between industrial and financial firms, was approved in December 2004. In addition, the government has sold one of the three large investment trust companies that it controlled at end-2003, and is in the process of selling the other two.

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IV. What Lies Ahead?

9. Staff expects that domestic demand will finally begin to recover in 2005. Experience from other countries that have gone through similar credit boom-and-busts suggests that consumption could revive as the process of household balance sheet adjustment advances into its third year (Box 2).5 Moreover, high capacity utilization ratios and strong manufacturing profitability should ultimately prompt a recovery in facility investment, offsetting a slowdown in construction. With appropriate polices (as described in the following section), growth could gradually accelerate to 4 percent in 2005 and 5½ percent by 2007, before settling down over the medium term to its potential rate of around 5 percent (Table 5).6

Table 5.

Korea: Medium-term Projections, 2002-09

(In units indicated)

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

Contribution to GDP.

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

During 2003-06, W49 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.

Gross Domestic Product, 2003-06

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Source: Bank of Korea and staff calculations.

When Will Private Consumption Recover?

A revival in private consumption is the key to a broader economic recovery. But when will this occur? The question is impossible to answer with certainty, but analysis suggests that a revival may begin in 2005.

Growth in private consumption averaged 6½ percent during 2000–02 before becoming negative in 5 out of the 7 past quarters. The persistent weakness in private consumption has resulted, to a large extent, from the bursting of the consumer credit bubble in 2003, especially the “plastic bubble” (the consumer credit bubble associated with credit cards), leaving many households with crushing debts and high delinquency rates. Credit card debt grew from less than 2½ percent of GDP in early 1999 to about 9 percent by the third quarter of 2002 before declining to less than 4¼ percent by mid-2004. Similarly, total household debt increased from 37 percent of GDP in early 1999 to 62½ percent by the last quarter of 2002 before falling to 59 percent in mid-2004.

Staff econometric analysis finds that Korean households are quite sensitive to the health of their balance sheet. Faced with a negative shock to their net wealth, they will reduce their consumption. An increase in household gearing ratio—the ratio of household liabilities to household assets—by one percentage point will reduce consumption by 2¾ percent (see chapter II of the Selected Issues).


Household debt

(Percent of GDP)

Citation: IMF Staff Country Reports 2005, 049; 10.5089/9781451822182.002.A001

1/ Data on credit from NBFls is used as a proxy for credit card debit

Therefore, achieving sustainable growth in private consumption will depend crucially on the amount of adjustment needed by households to repair their balance sheets. This will depend on the degree to which the substantial increase in households’ gearing ratio has been excessive and needs to be unwound, and the extent to which it has reflected fundamental factors, such as financial innovation and low interest rate environment. Prior to the Asian crisis the gearing ratio had been relatively stable around 46 percent. If the gearing ratio were to revert to its mean, significant adjustment remains ahead.


Household Liabilities/Assets

(4-quarter moving average)

Citation: IMF Staff Country Reports 2005, 049; 10.5089/9781451822182.002.A001

Some clues on how long this adjustment might take can be found in other emerging and industrial economies which went through boom-bust episodes. A recent WEO study (Chapter IV, April 2004) finds that the average duration of a boom, fueled by rapid credit growth, is 2 years followed by a bust of 1½ years during which private consumption declines by about 12 percent. In Korea, econometric evidence shows that, on average, it takes 6 to 8 quarters for consumption to adjust to a negative shock unrelated to household balance sheets, while it takes about 3½ years to fully adjust to a negative shock to household balance sheets. Since the adjustment started in late 2002, this suggests that consumption could begin to revive in 2005.

The adjustment of households’ balance sheet is unlikely to be uniform across households as the most rapid debt growth has been registered at the lowest and highest income levels. While the latter seem to have borrowed heavily to invest in real estate, low income households did so for consumption, which has increased their gearing ratio significantly, reducing substantially their capacity to service their debt as demonstrated by the significant increase in delinquency rates in 2003.

Household Debt Growth Rate by Income Level

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Source: Authorities and staff calculations

10. There are both upside and downside risks to this baseline projection:

  • The recovery in domestic demand could be much more vigorous than projected, especially as Korean recoveries have often been swift and sharp.

  • On the other hand, the external environment could prove harsher than expected. With exports accounting for nearly half of GDP, the projected recovery could be undermined if OECD growth falters or there is a significant downturn in the volatile electronics sector, which alone accounts for one-third of Korean exports. Moreover, with the country dependent on imported oil for the bulk of its energy needs, growth in 2005 could be cut significantly if oil prices prove higher than the WEO assumption of $43 per barrel, since the central bank estimates that GDP falls by 0.2 percentage points for every 10 percent increase in oil prices.

  • Balance sheet adjustments could prove more protracted than expected, especially if flagging confidence fails to recover.

  • Which brings us to the most critical assumption: that government policies will be sufficiently strong to restore confidence and restart the economy.


Average Growth Between Turning Points in Four Most Recent Business Cycles

(s.a. q/q growth at annualized rate, in percent)

Citation: IMF Staff Country Reports 2005, 049; 10.5089/9781451822182.002.A001

Source: Staff calculations

Consumer Expectation Indicator

(Seasonally adjusted)

Citation: IMF Staff Country Reports 2005, 049; 10.5089/9781451822182.002.A001

Source: National Statistical Office

11. Under any scenario, however, Korea’s vulnerability to crisis is very low. The fundamental pillars of the economy are solid: the balance sheets of the chaebol are healthy on average, while banks remain well capitalized despite their recent losses (Table 6). Moreover, the cushions are considerable, with external reserves now exceeding external debt and government debt amounting to only 30 percent of GDP (Table 7). As a result, vulnerability analysis shows that the economy is robust even to severe shocks (Annex I).

Table 6.

Korea: Financial Soundness Indicators, 1997-2004

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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).

Table 7.

Korea: Indicators of External Vulnerability, 1999-2004

(In percent of GDP, unless otherwise indicated)

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

Including government guaranteed restructuring bonds issued by KDIC and KAMCO.

Short-term debt measured on a residual maturity basis.

12. There are, nonetheless, problems in particular sectors. As already noted, households and SMEs are over-indebted. Moreover, while credit card companies have rebuilt their capital adequacy ratios, a substantial fraction of rescheduled delinquent loans has fallen into arrears again, suggesting that further losses are yet to be recognized. Also, failures among the 226 mutual savings banks are eroding the reserves of the KDIC, a symptom of the fact that one-fifth of their loans are overdue.7 Finally, without corrective action, the National Pension Fund is likely to slip into a substantial deficit over the longer-term.

V. How Can Korea Start the Stalled Engines of Growth?

Reviving the economy will require restarting the stalled domestic engines of growth—spending by households, SMEs, and larger corporations. But how can this be done? The first step would be to provide a macroeconomic spark, by implementing stimulatory fiscal and monetary policies. But the heart of the strategy would need to involve addressing the structural problems: the household debt overhang, the SMEs’ financial difficulties, and the reluctance of corporations to invest. In all of these areas, the challenge will be to find ways of developing market-friendly frameworks that reduce the need for heavy-handed government interventions. It is this policy challenge that formed the crux of the mission’s discussions with the authorities.

A. Providing a Macroeconomic Spark

13. The mission and authorities agreed that some macroeconomic stimulus was necessary to spark the awaited recovery. The 2005 budget submitted to the National Assembly contains some expansionary measures, including reductions in income tax rates, increases in tax deductions for SMEs, and the abolition of excise taxes on a range of luxury items. There are also plans to again front-load spending, as was done in 2003 and 2004. Nevertheless, the budget as a whole is essentially economically neutral, since the deficit target (excluding social security funds) of 1 percent of GDP is close to the projected deficit in 2004. The reason is institutional: Korea has a strong tradition of fiscal conservatism, starting as far back as the 1970s oil shocks and maintained in recent years to ensure the country can cope with rising demographic pressures and the potential costs of reunification.


Fiscal impulse

(In percent of GDP)

Citation: IMF Staff Country Reports 2005, 049; 10.5089/9781451822182.002.A001

Source: Staff calculations

14. Accordingly, the authorities intend to supplement the budgeted spending with a “General Investment Plan for Economic Revitalization.” At the time of the mission, the package was still being finalized, but the initial plan involved new spending of around 1 percent of GDP, targeted on infrastructure projects and involving private sector participation in combination with funding from the National Pension Fund and other nonbudget sources.

15. While welcoming the plan for additional fiscal stimulus, the mission noted that it faced a number of challenges. To begin with, maintaining fiscal transparency might be difficult, as the public sector outlays involved would need to be identified and added to the consolidated central government accounts. It will also be a challenge to make these projects as commercial as possible, ensuring that the entities providing financing receive an adequate cash rate of return while simultaneously containing the extent of contingent fiscal liabilities. For this reason, the projects may take time to materialize.

16. There is consequently a risk that fiscal policy could fall short in providing the needed stimulus. Accordingly, the team strongly supported the plans to front-load fiscal spending, and recommended the adoption of a supplementary budget, with additional social spending. The authorities responded that they would evaluate the need for a supplementary budget in mid-2005.

17. In the meantime, the mission noted, the task of macroeconomic management would fall mainly on monetary policy. In mid-2004, the sharp increase in international commodity prices caused headline inflation to increase. But core inflation has remained within the 2½ to 3½ percent target range, while longer-term interest rates have fallen to unusually low levels, suggesting that inflationary expectations remain firmly under control. Already, headline inflation has receded below 3½ percent,