Republic of Korea: Staff Report for the 2004 Article IV Consultation
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International Monetary Fund
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Publication Date:
11 Feb 2005
eISBN:
9781451822182
Language:
English
Keywords:
ISCR; CR; service industry output; staff appraisal; report; key interest rate; IMF staff representative; delinquency ratio; labor market; operating income; private sector; exchange rate; Global
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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.

Abstract

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.

uA01fig01

Delinquent individuals

(millions)

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

uA01fig02

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.

uA01fig03

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)

article image
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

article image
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.

uA01fig04

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)

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, 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

article image
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).

uA01fig05

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.

uA01fig06

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

article image
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.

uA01fig07

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
uA01fig08

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.

uA01fig09

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, and staff projects that it will continue to fall, as output remains below potential.8 For all these reasons, the team suggested there was scope for further reductions in interest rates to provide support to the real economy. And, indeed, after the mission’s departure the central bank cut its policy rate, noting it would monitor the economy closely to see if a further easing were necessary.

uA01fig10

CPI Inflation

(y/y percent change)

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

Source: National Statistical Office and staff calculations

18. Regarding the exchange rate, the mission commended the authorities for allowing the won to appreciate, consistent with their flexible exchange rate policy. It noted that this policy, adopted at the time of the Asian crisis, had served the country well, encouraging firms to hedge their foreign exchange exposures while simultaneously ensuring that exports remained competitive. Such a policy was also consistent with efforts to resolve the problem of global current account imbalances.

uA01fig11

Exchange Rates, period average

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

Source: Information Notice System

19. The authorities stated that they remained committed to allowing the won’s external value to reflect market fundamentals. At the same time, they would continue to intervene to smooth the currency’s path when it came under speculative pressure, as had occurred on a number of occasions during 2003-04. During the most recent episode, starting in mid-October, the pressure had been so intense that, merely by trying to smooth the sharp appreciation, they had accumulated considerable additional reserves.

uA01fig12

Exchange Market Pressure Index

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

Source: Staff calculationsDefined as the sum of the change in the dollar/won rate in percent (a positive value implies appreciation) and the ratio of the change in gross reserves over reserve money in percent.

B. Reviving Household Spending

20. While macroeconomic stimulus can provide a spark for the economy, achieving sustained strong growth will require addressing the underlying structural difficulties. This will require, first and foremost, addressing the household delinquency problem.

21. The staff team strongly endorsed the government’s basic policy approach toward debt delinquencies. It commended the decision to stand firm against calls for an interventionist approach, noting that a mandated debt amnesty scheme would only generate moral hazard, make financial institutions more reluctant to lend to households in the future, and trigger calls for government bail-outs in other sectors. Instead, government efforts have appropriately focused on establishing a market-friendly framework within which debtors and creditors can work to resolve their problems (Box 3). Already, a number of programs have been created for different groups of debtors, allowing one-sixth of the delinquencies to be resolved in the short period since many of the schemes were established.

22. Even so, the bulk of delinquencies remains to be resolved, including many of the most difficult cases. In other countries, those debtors who have little chance of repaying their debts in full would seek refuge in the bankruptcy courts. But such a course is less likely in Korea because a strong social stigma is attached to being bankrupt, exemplified by provisions in over 100 laws mandating discrimination against such persons. In addition, the terms of bankruptcy are relatively onerous, with debtors having to live on minimum incomes for 8 years, compared to 3-5 years in the United States and Japan. As a consequence, very few debtors apply for bankruptcy, while creditors are extremely reluctant to exercise their legal rights: there are only 18 recorded cases of creditor-initiated bankruptcy proceedings. In such circumstances, the team noted, the personal bankruptcy system is not only failing to serve those unable to pay, it is failing to serve as a standard that would motivate others to enter the various out-of-court schemes.

23. For these reasons, the team strongly supported the personal bankruptcy reforms submitted to the National Assembly in November 2004. These reforms would expand asset exemptions, increase minimum living incomes, and raise the debt ceiling for use of a simplified bankruptcy process 2½ times to W500 million (around $500,000). Over time, the mission considered, these measures should be extended, notably by shortening the repayment period and reducing official discrimination against bankrupt persons.

How Much Progress is Being Made in Resolving Credit Card Debts?

Korea is dealing with an unprecedented rise in household loan delinquency following an unchecked expansion of credit card lending in 2000–2002. Some 3.7 million persons, or 10 percent of the adult population, are classified as being delinquent, up from about 2 million prior to the credit card boom. Most delinquents are younger people, typically with lower incomes—half are under 40 and almost 20 percent are under 30.

Financial institutions and the government have established a number of channels for resolving household debts. These channels offer varying terms depending on the size of debts and whether the debts are to single or multiple creditors.

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So far, about 15 percent of the total number of delinquent borrowers have resolved their debts. For the many deeply insolvent debtors with multiple debts rescheduling is not sufficient to achieve resolution, while the sanctions under personal bankruptcy are considered overly harsh. Thus, rather than participating in these resolution channels, many delinquents appear to be waiting for some kind of debt amnesty.

Creditors lack the information and sanctions that would be needed to prevent such delays by debtors. For example, credit card companies indicate that up to 40 percent of their delinquent borrowers have not provided current addresses or phone numbers. Moreover, creditors are reluctant to use bankruptcy, as is done in other countries, due to the strong social stigma that is attached to it in Korea.

Number of Rescheduled Cases

(September 2004)

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As of October 22, 2004.

24. In addition, the team supported efforts to streamline the new Personal Debt Rehabilitation Program (PDRP), which allows court-supervised debt restructuring outside of bankruptcy. The Supreme Court has already begun to simplify the PDRP, reducing the documentation requirements and shortening the standard repayment period to 3-5 years. But further efforts may be needed: a possible model is the Individual Voluntary Arrangements system, an informal but court-supervised mechanism, which has proved a helpful way to deal with consumer debt problems in the United Kingdom and Hong Kong SAR.9

25. At the same time as efforts are made to accelerate debt resolution, it would also be important to lay the groundwork for households to regain access to credit. This would require building up positive credit bureaus. Currently, financial institutions do not widely share positive credit information (i.e., information about loans that have been serviced on time, as opposed to delinquencies) with credit bureaus, making it difficult for lenders to obtain a complete picture of their loan applicants’ credit standing. If this situation were changed, the team stressed, credit bureaus would be able to provide comprehensive reports whenever financial institutions need them. These institutions could then begin to tailor their lending to their applicants’ credit standing, enabling those with less-than-perfect records to still get access to funds, provided they are willing to pay higher interest rates—just as occurs in other advanced countries.

uA01fig13

Household Consumption and Credit

(Percent change, q/q)

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

Source: Bank of Korea

26. Building such an efficient system of positive credit bureaus will take time, and will require a supportive regulatory framework. Based on Mexico’s experience, the team considered that two basic regulations were needed.10 First, financial institutions submitting information to credit bureaus should be required to submit the same information, at the same fee, to all other licensed credit bureaus. Second, financial institutions should be encouraged to obtain credit reports, for example, by requiring them to provision more heavily on loans for which reports were not obtained.

27. Beyond restoring access to credit, it will also be important to address problems on the asset side of households’ balance sheets. This will involve housing policy. The government’s anti-speculative measures of October 2003 have succeeded in engineering a “soft landing”, with national housing prices declining by a modest 2½ percent in the subsequent year.11 However, the impact on transactions has been profound, with nationwide housing turnover falling by 31 percent y/y in the first 9 months of 2004, especially in the areas designated as “speculative zones” that cover over half of Seoul. As a result, the main asset of households—accounting for more than 80 percent of their wealth—has been rendered less liquid, giving them further reasons to build up their precautionary savings, rather than consume. One way to address this problem, the team suggested, would be to rebalance the tax burden on property by reducing transactions and capital gains taxes when the new wealth tax on property is introduced in 2005.

28. The authorities welcomed the team’s recommendations. They appreciated the suggestions for streamlining the debt resolution programs and agreed that the credit information system needed to be improved, expressing hope that a new entrant, sponsored by the largest banks and credit card companies, could provide a catalyst for change. As for the housing market, they noted that the proposed law introducing a comprehensive real estate holding tax would reduce the total tax rate on property transactions. In addition, they announced that seven more areas in Seoul would be removed from the list of “speculative zones” in November, following the removal of eight areas in August.

C. Revitalizing the Small and Medium Enterprises

29. In addition to addressing the difficulties of households, Korea also needs to resolve a growing problem in the SME sector, which accounts for half of manufacturing output. Around one-fifth of manufacturing SMEs are now incurring losses, with more than one-third failing to generate enough operating income to cover their interest expenses. Indeed, these figures likely understate the extent of the sector’s problems because the bulk of SMEs are in services, where firms’ financial difficulties are apparently worse. In response, banks have been slowing their credit to SMEs, even as delinquency rates on these loans remain modest.

uA01fig14

Profitability of Korean businesses

(Operating profits/assets; in percent)

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

Source: Korea Development Institute

30. To a certain extent, the sector’s problems are cyclical. Many firms have been hit hard by the slowdown in domestic demand, and as demand recovers, so too will their financial position. But the problems go beyond mere cyclical difficulties: there are profound structural problems, as well. While profitability of SMEs improved during the early 1990s, it has been declining steadily since the 1998 crisis, in marked contrast to the experience of large firms. Part of the reason is that SMEs have made much less progress than large firms in operational restructuring, as can be seen from their lagging productivity growth.

uA01fig15

Total Factor Productivity in Manufacturing

(Average yearly growth rate)

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

Source: Korea Development Institute

31. A telling contrast can be found in Taiwan Province of China. There, as in Korea, the SME sector plays a very important role, and is also highly exposed to growing foreign competition. Yet profitability has remained strong. The main reason is that this sector is considerably more dynamic, with entry and exit rates much higher than in Korea.12

uA01fig16

SME Credit Guarantees

(In percent of GDP)

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

Sources: Korea Credit Guarantee Fund and Korea Technology Credit Guaranteee Fund

32. What explains this difference? A key factor is government loan guarantees. In Taiwan Province of China, guarantees amount to only 1½ percent of GDP, compared with 6¼ percent in Korea. As a result, Taiwanese banks cannot rely on them to guide their lending: they instead need to evaluate credit themselves, and take risks accordingly. In contrast, in Korea resources tend to flow to the SMEs that can secure guarantees, which are overwhelmingly well-established firms. Moreover, the average length of KCGF guarantees is now around five years, implying that most of the firms benefiting from this program are the ones originally selected in 1998 when guarantees were expanded in the wake of the crisis. In this way, the program has been preserving existing firms and raising barriers to entry, thereby limiting the dynamism of the sector.

33. The government has recognized this problem, and in July 2004 formulated a plan to deal with it. Under this plan, guarantees would be directed away from well-established firms toward start-ups and new technology companies. In addition, a government-run credit bureau for SMEs will be established, to provide banks with the information they need to undertake risk-based—rather than guarantee-based—lending.

34. The team welcomed these steps, but recommended that the government go further in this direction. To encourage banks to do more credit analysis, the loan coverage of guarantees could gradually be reduced from the current typical level of 85 percent to around 50 percent, which is more consistent with international practice. And to limit the risk of firms “monopolizing” guarantees, the fee structure could be altered to impose higher rates on firms rolling over loans; currently, these rates only rise by 5 basis points for each rollover.

35. Fundamentally, though, what is needed is a new framework for the sector, in which the private sector plays a dominant role in allocating capital. This will require winding back the levels of the guarantees. The reduction could be gradual, perhaps by 1 percent of GDP per year for the next five years. It could also be preannounced, to give time for banks and enterprises to adjust. But it should also start now, the team stressed, because postponing the necessary task of restructuring will only increase the eventual costs.

36. At the same time, measures could be taken to provide direct help to SMEs, especially start-ups. The team recommended relaxing Korea’s strict rules on venture capital firms; amending the Civil Code to allow for the registration of property rights and security interests on a wide range of assets, to make it easier for SMEs to borrow on the basis of their receivables and other intangible collateral; reducing the minimum capital requirement for incorporation; and providing a more efficient way for SMEs to reorganize or exit by approving the long-awaited unified insolvency bill.

37. The authorities agreed with the team’s proposals, but were concerned that changing the SME framework at the current juncture could trigger a credit crunch that would worsen the macroeconomic situation. The team, however, considered such risks to be small, primarily because any unwinding of guarantees would be gradual. More to the point, the team considered that the risks of inaction were greater. Currently, SMEs are not investing because they are not in a financial position to do so. Thus, SME investment will not revive until creditors force them to accelerate—or begin—the process of restructuring.

D. Unleashing Corporate Investment

38. In addition to reviving the household and SME sectors, Korea also needs to unleash corporate investment. The decline in investment is not just cyclical: facility investment has been declining for more than a decade, from a peak of 14 percent in 1995 to a projected 9½ percent of GDP in 2004. In part, this decline has been a natural consequence of moving from a government-directed system that encouraged over-investment toward one that places more emphasis on economic returns. But another reason why so few investments are now profitable is that structural problems are raising the cost of capital, and the projects themselves. These problems—including a relatively rigid regular labor market, lingering problems with corporate governance, and an underdeveloped bond market—have become particularly pressing in recent years, as Korea’s economy has begun to integrate with that of China, forcing firms to consider carefully what production should take place domestically, and what should be outsourced.

39. As with the other structural challenges, making Korea an attractive place to invest will require a further reduction in government regulation and intervention. Most important would be a modernization of the labor market.

uA01fig17

Labor Disputes

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

Source: Korea Labor Institute

40. The team welcomed the progress in improving industrial relations. In 2004, the government’s stance of refraining from intervention in disputes, apart from enforcing labor laws, has had notable success. Strikes, though still numerous, are being settled relatively quickly, with less disruption to the overall economy.

41. But the fundamental labor market problem, the team noted, remains: the strict employment protection for regular workers. 13 With the legal criteria for dismissal being difficult to satisfy, firms must often offer high voluntary severance payments to those workers they wish to dismiss. Larger companies, for example, typically offer 2¼ months of salary for each year of employment, twice as high as in other advanced countries. Such high costs of adjusting the labor force deter risky investments. They have also led employers to hire a growing number of nonregular workers—now accounting for half of the nonself-employed labor force—who face large gaps relative to regular workers in wages, conditions, and job security.

uA01fig18

Severance Payments

(Weeks of Salary, for 20 years service)

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

Source: World Bank, Doing Business in 2004

42. Seeking to narrow these gaps, the government has proposed two bills to protect nonregular workers by prohibiting “unreasonable discrimination.” The team recognized this objective, but warned that the law would need to be designed carefully, to ensure that it does not further reduce labor market flexibility.

43. The case of Spain, first raised during the previous Article IV consultation, was a pertinent example, the team noted. During the 1990s, Spain initially tried to increase protection to nonregular workers, but employers responded by reducing their hiring of all workers, and unemployment increased. Subsequently, the country tried the opposite approach: it introduced a new type of employment contract with less job protection, reducing opposition by “grandfathering” existing contracts for regular workers. This new contract has proved highly successful in generating jobs and helping unify the labor market.

44. For this reason, the team welcomed the Tripartite Commission’s consideration of the example of Spain’s labor market reform strategy, among others, to see if it can be applied to Korea. The team also proposed exploring whether more flexible contracts for regular workers can be adopted in certain firms or industries, and then expanded if successful. Furthermore, the mission endorsed the government’s plans to lay the groundwork for increased labor market flexibility by expanding the social safety net, especially eligibility for unemployment insurance and basic livelihood protection.

45. Even as labor market flexibility is increased, it would also be important, the team emphasized, to improve corporate governance. This remains a priority because, for all the progress that has occurred in recent years, there remains a “Korea discount” on share prices, increasing the cost of equity capital.14 For this reason, the team supported the Fair Trade Commission’s bill (approved after the mission) to strengthen corporate governance. This bill provides incentives for chaebol to bring their governance up to adequate levels, by granting exemptions to the cross-shareholding limits to those which improve their internal checks and balances or adopt more transparent vertical holding company structures. At the same time, the bill strengthens the firewalls between industrial and financial firms.15

46. To supplement these measures, the team suggested developing more market-based mechanisms for enforcing corporate discipline. The government has already taken a welcome step in this direction, by allowing class action lawsuits for securities violations, starting in 2005. In addition, the team again recommended that the government encourage the Korea Stock Exchange to adopt a “comply or explain” regulation for its Code of Best Practices in Corporate Governance, which would set out a short list of good governance practices and ask listed companies to comply with the individual measures or explain why they haven’t done so.

47. Enhancing the functioning of Korea’s corporate bond market can also facilitate investment.16 While Korea has the second largest corporate bond market in Asia after Japan, the market lacks liquidity and credit spreads are compressed. To overcome these problems and develop the market as a ready source of capital for a larger group of domestic firms, the team recommended that the government break with the tradition of rescuing of bond investors when companies incur financial difficulties.17 Instead, the team suggested, the government should facilitate market-led debt work outs by passing corporate insolvency reforms, thereby giving market participants incentives to do proper risk management.

48. The government agreed that the team’s proposals would help improve the investment climate, and noted that steps would be taken in all of these areas. Labor market reform would take place gradually, once agreement had been reached with all parties involved, including unions. Meanwhile, the bill to improve conditions for nonregular workers, the authorities clarified, was not intended to require equal pay or working conditions for nonregular workers. (The team encouraged them to make this intention clear to the courts.) In relation to the revised insolvency law, they hope to have this approved shortly, while they were still considering the “comply or explain” proposal.

E. Other Issues

49. The team also discussed a number of other important issues:

  • Korean Investment Corporation (KIC). The bill to establish the KIC, which will be charged with investing a portion (initially $20 billion) of the country’s reserves, has now been introduced to the National Assembly. The team commented that the bill should provide the agency with more specific objectives, stronger independence, and greater transparency, to ensure that public funds are managed efficiently and are not used to bolster specific firms or markets. The authorities responded that some of these issues would be addressed in the Presidential Decree, while the risks of market distortion would be limited since the KIC would invest its foreign assets offshore. They also noted that the assets entrusted by the Bank of Korea would be invested in liquid assets and remain readily available to the central bank, so they could continue to be considered as reserves.

  • Financial supervision. In the 2002 FSAP, the Fund recommended a unified and independent supervisor. And an official investigation has recently concluded that the overlapping responsibilities of the three agencies involved in financial supervision (the FSC, the FSS, and MOFE) had indeed contributed to the credit card crisis. However, the authorities see a major impediment to unification, since they believe that a private body such as the FSS could not have the legal authority to impose sanctions. Accordingly, they are instead planning to clarify each agency’s responsibilities.

  • Population aging. Korea’s population is aging rapidly, a process which could propel the National Pension System into sizeable deficit by 2030.18 The team therefore encouraged the authorities to press ahead with long-standing plans to increase contribution rates and reduce income replacement rates over time.

  • Trade. Korea’s trade barriers remain high by OECD standards, especially in the agricultural sector. Out-of-quota tariffs for agricultural products averaged 50 percent in 2003; agricultural support is almost double the OECD average; and domestic rice prices are more than three times the world level. Accordingly, the team argued that the government can demonstrate leadership—internationally, as well as domestically—by further opening up its agricultural sector. The authorities responded that they are planning to do this, but gradually. In particular, they are considering doubling the rice import quota from its current level of 4 percent of consumption and allowing foreign rice to be sold for the first time directly from retail outlets, provided partners agree to extend the 10-year WTO exemption from tariffication of rice that expires at end-2004. Also, in November, Korea signed its second FTA, with Singapore—a relatively comprehensive agreement that includes financial services, investment, and government procurement.

  • Data. Korea’s provision of data is broadly satisfactory for surveillance purposes. A vast array of high-quality statistics is published, with short time lags, providing a strong base for policy assessment. The team welcomed the authorities’ plans to build on this base by developing more comprehensive data on the financial and fiscal sectors.

VI. Staff Appraisal

50. After a long post-crisis boom, Korea’s economy has begun to sputter. One by one over the past two years, the domestic engines of growth have shut down. Spending by households and SMEs have slowed sharply because they accumulated too much debt during the boom years, while corporations have become reluctant to invest. As this has occurred, the economy has been forced to rely on merchandise exports, which boomed in late 2003, but have now slowed, reducing Korea’s growth to low levels.

51. Reviving the economy will consequently require restarting the domestic engines of growth. To a certain extent, they are ready to restart on their own. Experience from other countries that have experienced credit boom-and-busts suggests that consumption should begin to revive in 2005. Moreover, the high rate of capacity utilization suggests that ultimately investment will recover, as well.

52. The key policy challenge facing the authorities, then, is ensuring that this recovery will be strong and sustainable. How can this be done? The first step would be to provide a macroeconomic spark, by implementing stimulative fiscal and monetary policies. In the staff’s assessment, the 2005 budget submitted to the National Assembly as a whole is economically neutral. Moreover, while there are plans for additional investment spending, these involve private-public partnerships which may take some time to materialize. (But when they do, the public sector outlays should be recorded transparently in the fiscal accounts.) Consequently, staff supports the authorities’ plans to front-load budgetary spending, and urges the adoption of a supplementary budget, with additional social safety net spending.

53. In the meantime, the task of macroeconomic management will fall mainly on monetary policy. With core inflation remaining within the target range and inflation expectations under control, the staff believes there is scope for the central bank to provide support to the real economy. It consequently supports the recent reduction in interest rates, as well as Bank of Korea’s plan to stand ready in case further reductions are required. Staff also commends the authorities’ decision to allow the won to respond to market forces, noting that Korea’s flexible exchange rate policy has served the country well, encouraging financial market development while maintaining external competitiveness.

54. While macroeconomic stimulus can provide a spark for the economy, achieving sustained strong growth will require addressing the underlying structural difficulties. This will require, first and foremost, addressing the household delinquency problem. The staff strongly supports the government’s decision to stand firm against calls for a mandated debt reduction scheme, and instead establish a market-friendly framework within which debtors and creditors can work together to resolve their problems.

55. The linchpin of such a framework, however, needs to be a working bankruptcy system, to provide a final resolution for those who cannot repay their debts and a standard for others, so as to encourage them to settle out of court. For this reason, the staff endorses the plans to make bankruptcy a viable option, and suggests that the government go further in this direction by shortening the repayment period and reducing official discrimination against bankrupt persons. Staff also endorses the efforts to streamline the Personal Debt Rehabilitation Program. Most importantly, these reforms should be enacted speedily, for accelerating the pace of debt restructuring is critical for hastening the advent of the recovery. Meanwhile, to restore households’ access to lending, staff recommends that the authorities promote the information sharing needed for an efficient system of competing credit bureaus.

56. The second engine that needs to be restarted belongs to the SMEs. For too long, resources flowing to these firms have tended to be allocated on the basis of government guarantees, mainly to businesses first identified in 1998. This has stifled the dynamism of the sector, taking a severe toll on its overall financial health.

57. In the staff’s view, reviving the SMEs requires a fundamental reform: the current government-led framework needs to be replaced by one where the private sector allocates resources, funding the firms with the most promising futures. To do this, the amount of guarantees should be unwound in the medium-term, while the share of each loan covered by guarantees should be reduced, and the cost of rollovers increased. At the same time, to help SMEs grow, staff recommends measures to broaden the range of security for loans, expand the availability of venture capital, reduce start-up costs, and improve the efficiency of exits—the last, by passing the long-awaited unified insolvency law.

58. Restarting the third engine of growth—spending by larger corporations—requires improving the investment environment. And the key to doing this is modernizing the labor market. Staff welcomes the recent improvement in industrial relations, but this still leaves a fundamental problem: strict employment protection for regular workers, which deters risky investments and has prompted a growing use of nonregular workers. These problems can only be resolved in one way, by reducing employment protection for regular workers. Accordingly, staff welcomes the plans to consider Spain’s reform of introducing a new regular labor contract, with less protection. It also encourages trials of more flexible contracts in particular firms or industries. Meanwhile, the staff welcomes the plans to lay the groundwork for increased flexibility by expanding the coverage of the social safety net.

59. Promoting investment also requires improving corporate governance and developing the bond market, so as to encourage markets to provide more financing, to more firms, at lower costs. Accordingly, the staff welcomes the amendments to the Fair Trade Act, aimed at encouraging the chaebol to improve their governance. It also welcomes the introduction of class action lawsuits for securities law violations and encourages additional steps to reinforce market discipline on corporate governance, such as adopting a “comply or explain” system for the Code of Best Practices in Corporate Governance. In the bond market, what is needed most is for the government to refrain from bailing out investors, which has distorted the balance between reward and risk, stifling market development.

60. Two final points. First, the staff urges the government to play a leadership role in advancing global trade liberalization, including by further opening up Korea’s heavily protected agricultural sector. Second, to build the credibility of the proposed Korea Investment Corporation, its objectives should be clarified, to ensure they are based on sound economic principles. These objectives should be supported by well-defined governance, transparency and accountability arrangements, to allow the public to confirm that the organization’s activities are indeed consistent with its mandate.

61. While this structural reform agenda is ambitious, staff remains fundamentally optimistic about Korea’s economic prospects. Time and again, the Korean authorities have demonstrated the willingness and ability to take decisive measures to address the economy’s problems. In particular, ever since the Asian crisis, they have been dismantling the state-directed economic framework at an accelerated pace. By enacting this reform agenda, the authorities will go a long way toward completing this task, the task of building the comprehensive market-based framework that is the sine qua non for a return to sustained and rapid growth.

62. 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 2005, 049; 10.5089/9781451822182.002.A001

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

Korea: External Developments

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

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

Korea: Financial Market Indicators

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

Sources: Korean authorities, CEIC database; and Fund staff calculations
Figure 4.
Figure 4.

Korea: Corporate and Financial Sector Soundness

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

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

Korea: Housing Price Developments

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

Source: CEIC database and IMF staff calculations.
1

The history of government intervention in Korea and its role in Korea’s current structural problems is discussed in Zebregs, “The Ubiquitous Hand: Government Intervention in Korea,”, in the forthcoming Selected Issues.

2

The overall strategy of stimulating domestic demand was welcomed at the time by the IMF.

3

Domestic petroleum prices are market-determined.

4

Another factor is that the governing party has been focusing on four major social issues repealing the anti-communist National Security Law, regulating media monopolies, reforming private schools, and investigating collaboration during Japan’s 1910–45 colonial rule of Korea.

5

See Senhadji, “Balance Sheet Effects on Household Consumption,” Selected Issues, forthcoming.

6

On an annual basis, however, growth would slow, because output in 2004 was boosted by the export-driven growth spurt at the end of 2003.

7

Chapter IV of IMF Country Report 04/45 discusses the health of the NBFIs in more detail.

8

These inflation projections are based on the models in Chapter II of IMF Country Report 04/45.

9

Under the Individual Voluntary Arrangements, debtors and creditors submit their debt restructuring proposals to arbitrators, usually accountants experienced in insolvency issues, who decide what plans would be appropriate. Then, to give the plans legal status and afford creditors some protection against any relapses into delinquency, they are ratified by the courts. Thus, those debtors who subsequently default could be sent into bankruptcy for a final resolution.

10

See Frydl, “Digging Out From Under the Credit Card Collapse”, forthcoming Selected Issues.

11

The measures included increasing tax rates on property holding and capital gains, especially for owners of multiple properties. In “speculative zones”, the cost of transactions and capital gains taxes have risen substantially, the result of shifting the tax base to actual market values.

12

See Kang and Miniane, “Too Small To Fail? Revitalizing the SME Sector in Korea”, Selected Issues, forthcoming.

13

See Chapter III of IMF Country Report 04/45 for a more detailed discussion.

14

The price/earnings ratio for Korean shares averaged 7.6 in 2003, compared to 14.6 in Taiwan Province of China and 18.8 in Japan. Even Thailand had a higher price/earnings ratio at 9.7.

15

Specifically, the measure tightens restrictions on the voting rights of chaebol’s financial affiliates in related industrial firms.

16

See Soueid and Zebregs, “Development of the Corporate Bond Market in Korea,” and Kang, Kim, and Rhee, “Developing the Government Bond Market in Korea: History and Challenges,” forthcoming Selected Issues.

17

For example, when LG Card was rescued in 2003, bond holders were made whole, while other creditors were required to convert debt into equity. As a result, LG Card is still rated as investment grade despite having negative capital.

18

Chapter I of IMF Country Report No. 03/80 provides projected pension balances.

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 25¾ percent in 2004 and the central government debt/GDP ratio at 23 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 household and SME sectors expose it to a domestic demand shock. SME failures could trigger a decline in property prices, reducing consumption and investment, which would further reduce SME profitability.

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 4.8 percent, so a shock of one standard deviation would imply a 0.8 percent decline in real GDP in 2005. 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 50 percent of GDP even in the face of extreme shocks (Annex I, Table A1). In the baseline, public debt remains broadly stable as a ratio to GDP, as the central government budget returns to balance (excluding the accumulation of social security funds) in 2008 in line with the government’s medium-term fiscal plan, 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, IMF Country Report 03/79). The shock to real GDP (B2) has the greatest impact, lifting public debt to 46 percent of GDP by 2009, but the shock is extreme, with a permanent GDP fall of 18 percent below its historical average, and the primary deficit rising by 4 percentage points of GDP. Public debt rises to 34¾ percent of GDP with variables at their historical average (A1), 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 25¾ percent of GDP.

Table A1.

Korea: Public Sector Debt Sustainability Framework, 1999-2009

(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 IMF Country Report 03/79.

Derived as [(r - π(1+g) - g + αε(1+r)]/(1+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 ε = 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).

For projections, this line includes exchange rate changes. The large residual is due to asset accumulation of the National Pension Fund.

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 A2). Korean external debt is projected to remain about 25 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:

  • a 30 percent exchange rate depreciation (B6) lifts the external debt ratio to 42¾ percent;

  • a two standard deviation shock (B3) lifts the external debt ratio to 62½ percent—the exchange rate falls by 55 percent given the 13.5 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 In 2003 the authorities 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, the National Assembly has not approved these reforms, largely due to union resistance to these additional measures on top of the reforms that were adopted in 1998. The opposition party has drafted an alternative plan and a Presidential committee is working on another alternative plan, so the nature and timing of pension reforms is currently unclear.

Table A2.

Korea: External Debt Sustainability Framework, 1999-2009

(In percent of GDP, unless otherwise indicated)

article image

Derived as [r - g - p(1+g) + sa(1+r)]/(1+g+p+gp) times previous period debt stock, with r = nominal effective interest rate on external debt; p = change in domestic GDP deflator in US 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 [-p(1+g) + sa(1+r)]/(1+g+p+gp) times previous period debt stock, p increases with an appreciating domestic currency (s 0) and rising inflation (based on GDP deflator).

For projection, line includes the impact of price and exchange rate changes.

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 non-debt 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 non-debt inflows in percent of GDP) remain at their levels of the last projection year.

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 gradually over time. Also, the commodity flow technique could be improved by moving to the Supply and Use Table framework, 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 (GFSM1986). 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 payment

  • 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, 2002 and 2003.

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

Korea: Survey of Reporting of Main Statistical Indicators 1/

(As of November 19, 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 - monthly, 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 October 31,2004)

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. Latest Financial Arrangements:

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VI. Projected Obligations to the Fund (SDR million; based on existing use of resources and present holdings of SDR’s):

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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 December 29, 2004, the exchange rate was W1,041=US$1.

VIII. Last Article IV Consultation:

Korea is on a 12-month consultation cycle. Staff discussions for the 2003 Article IV consultation were conducted on a mission to Seoul during November 5-18, 2003. The Article IV consultation was concluded by the Executive Board on February 20, 2004. In addition, a Staff Visit took place during May 18-25, 2004.

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

Same Series

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Cover IMF Staff Country Reports
Republic of Korea: Staff Report for the 2004 Article IV Consultation
Author:
International Monetary Fund
Volume/Issue:
Volume 2005: Issue 049
Publisher:
International Monetary Fund
ISBN:
9781451822182
ISSN:
1934-7685
Pages:
54
DOI:
https://doi.org/10.5089/9781451822182.002

Delinquent individuals

(millions)

Economic Growth

(Seasonally Adjusted Annualized Rate, Percent)

Bank Credit

(percent change, y/y)

Local Currency per U.S. Dollar

(Change in percent since Dec. 2003)

Household debt

(Percent of GDP)

Household Liabilities/Assets

(4-quarter moving average)

Average Growth Between Turning Points in Four Most Recent Business Cycles

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

Consumer Expectation Indicator

(Seasonally adjusted)

Fiscal impulse

(In percent of GDP)

CPI Inflation

(y/y percent change)

Exchange Rates, period average

Exchange Market Pressure Index

Household Consumption and Credit

(Percent change, q/q)

Profitability of Korean businesses

(Operating profits/assets; in percent)

Total Factor Productivity in Manufacturing

(Average yearly growth rate)

SME Credit Guarantees

(In percent of GDP)

Labor Disputes

Severance Payments

(Weeks of Salary, for 20 years service)
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