Front Matter

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© 2009 International Monetary Fund

August 2009

IMF Country Report No. 09/262

Republic of Korea: 2009 Article IV Consultation—Staff Report; Staff Statement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for the Republic of Korea

Under Article IV of the IMF’s Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. In the context of the 2009 Article IV consultation with the Republic of Korea, the following documents have been released and are included in this package:

  • The staff report for the 2009 Article IV consultation, prepared by a staff team of the IMF, following discussions that ended on July 7, 2009, with the officials of the Republic of Korea on economic developments and policies. Based on information available at the time of these discussions, the staff report was completed on July 23, 2009. The views expressed in the staff report are those of the staff team and do not necessarily reflect the views of the Executive Board of the IMF.

  • A staff statement of August 7, 2009, updating information on recent developments.

  • A Public Information Notice (PIN) summarizing the views of the Executive Board as expressed during its August 7, 2009 discussion of the staff report that concluded the Article IV consultation.

  • A statement by the Executive Director for the Republic of Korea.

The document listed below has been or will be separately released.

Selected Issues Paper

The policy of publication of staff reports and other documents allows for the deletion of market-sensitive information.

Copies of this report are available to the public from

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Staff Report for the 2009 Article IV Consultation

Prepared by Staff Representatives for the 2009 Consultation with Korea

Approved by Mahmood Pradhan and Aasim Husain

July 23, 2009

  • This report is based on discussions held in Seoul during June 25–July 7. The staff team comprised Mr. Lall (Head), Ms. Karasulu, Messrs. Lueth, Eskesen (all APD), and Ariyapruchya (MCM). Mr. Lee (OED) also participated.

  • Counterparts. The mission met with Minister of Strategy and Finance Yoon, Bank of Korea (BOK) Governor Lee, Financial Services Commission Chairman Chin, Financial Supervisory Services Governor Kim, and other senior officials, academics, and private sector representatives.

  • Context of past surveillance. The Fund and the authorities have agreed on the broad policy priorities in recent years. Directors found Korea’s financial system to be healthy, but noted that banks’ reliance on wholesale funding exposes them to elevated liquidity risk. Directors also encouraged upgrading of banks’ risk assessment to address potential risks from lending to SMEs and the real estate and construction sector.

  • Statistical base. Adequate to conduct effective surveillance, but fiscal reporting needs to be improved. Korea subscribes to the SDDS.

  • The exchange rate is freely floating. Korea has accepted the obligations of Article VIII. The exchange system is free of restrictions on the making of payments and transfers for current international transactions. Korea maintains exchange restrictions for security reasons, in accordance with UN Security Council Resolutions, which have been notified to the Fund under the procedures set forth in Executive Board Decision 144-(52/51).


  • Executive Summary Staff Appraisal

  • I. Introduction

  • II. Recent Economic Developments and Outlook

    • A. Recent Economic Developments: Recovering from the Shock

    • B. Outlook and Risks: A Drawn-out Recovery

  • III. Policy Discussions

    • A. Fiscal Policy: Countering the Cycle while Safeguarding Sustainability

    • B. Monetary and Exchange Rate Policies: Appropriate for Now

    • C. Financial Sector Policies: Bracing for Fallout from the Real Economy

    • D. Structural Policies: Laying the Foundations for a Sound Recovery

  • Boxes

  • 1. Downside Risk Scenario: Another Bout of Global Risk Aversion

  • 2. Measures to Ensure Adequate Credit Flow: A Cross-Country Perspective

  • 3. Housing Market—Are Further Losses Looming?

  • Figures

  • 1. The Sudden Stop in Capital Flows

  • 2. The External Demand Shock

  • Tables

  • 1. Selected Economic Indicators, 2005–10

  • 2. Balance of Payments, 2004–09

  • 3. Consolidated Central Government Operations, 2004–09

  • 4. Indicators of Financial and External Vulnerability, 2004–09

  • 5. Financial Soundness Indicators, 2002–08

  • 6. Medium-Term Projections, 2007–14

  • Appendix

  • 1. Debt Sustainability Analysis

Executive Summary and Staff Appraisal

Like other very open economies, Korea was hard hit by the global financial crisis during the last quarter of 2008. Capital left the country at a rate surpassing even that during the Asian crisis, resulting in sharply lower asset prices, dislocations in money markets, and a spike in bank CDS spreads reflecting the sector’s heavy reliance on wholesale funding. This was followed by the largest export slump on record which quickly spilled over into domestic demand. Overall, the Korean economy contracted by 5.1 percent quarter/quarter (q/q) (not annualized) in the last quarter of 2008, among the sharpest contractions worldwide.

The authorities’ speedy and comprehensive response helped stabilize the economy by early 2009. Generous provision of won and dollar liquidity, including by drawing down official reserves, led to a quick recovery in money markets and prevented external defaults. Sizeable monetary and fiscal stimulus boosted confidence and supported economic activity. And the setup of recapitalization and toxic asset funds preempted the risk of prospective loan delinquencies turning into major deleveraging on the part of banks. As a result, activity gathered strength over the course of the first half of 2009.

However, the recent growth momentum is likely to moderate and the recovery will be drawn out. As the impulse from the front-loaded fiscal stimulus and export gains from the steep depreciation of the won in early 2009 fade, the pickup in growth is unlikely to be sustained. Combined with a sluggish recovery in demand from trading partners, and highly leveraged households and small- and medium-sized enterprises (SMEs), Korean growth is projected at -1¾ percent in 2009 and 2.5 percent in 2010. There is a distinct possibility that weak global exports will weigh on Korean growth well beyond 2010, as Western consumers permanently increase their savings rates. Other risks to the outlook are another bout of global risk aversion, rising oil prices, or—on the upside—a stronger than anticipated impact from stimulus measures in Korea and abroad.

Fiscal policy

The authorities are to be commended for their expansionary fiscal stance, which they should maintain through 2010. The structural deficit in 2009 is expected to expand by 2¾ percentage points of GDP, well above the G20 average. Stimulus measures are also appropriately weighted towards the expenditure side, including public investment and targeted transfers, which should maximize its growth impact, estimated at 1-1½ percentage points of GDP. Given Korea’s ample fiscal space and little evidence of funding pressures, the fiscal stance should be maintained in 2010, until a self-sustained recovery takes hold.

However, with abrupt deleveraging avoided and the economy stabilized, a roll back of the quasi-fiscal support measures targeted at SMES could be initiated, given their distortionary character. The authorities raised the amount of available SME credit guarantees, increased the guarantee coverage to 95 percent for most loans, and 100 percent for some, and guided banks to roll over all SME loans falling due in 2009. These measures may have had their merits in the early stages of the crisis, but rolling them back would help ensure that banks have incentives to move ahead with restructuring SMEs, while conventional fiscal and monetary policies can be relied upon to stabilize output.

Announcement of a medium-term fiscal consolidation plan would assure investors and boost the impact of the current stimulus. The authorities’ plan to balance the budget (excluding social security) over the medium term is appropriate and should be underpinned by revenue raising measures and a streamlining of non-age related expenditures, and further pension reform. This adjustment would also leave sufficient room to allow for contingent liabilities associated with recent financial market measures, which should be transparently reported in the budget.

Monetary and exchange rate policies

Monetary policy accommodation should be maintained for now, while concerns about asset price appreciation are best addressed through prudential regulation. Given the absence of inflationary pressures and a large projected output gap, the current accommodative policy stance is appropriate. While asset prices are rightfully on the authorities’ radar screen, they do not seem out of line with regional trends.

Foreign exchange intervention in the spot market should remain confined to smoothing operations. The exchange rate has undershot most estimates of its medium-term equilibrium level, but is likely to return to equilibrium as capital inflows continue to gather strength.

Financial sector policies

Banks are likely to withstand a deterioration in asset quality and schemes to support their balance sheets could be more unambiguously linked to restructuring efforts. Given highly leveraged SMEs and households, nonperforming loans are bound to increase in the current weak economic environment. However, banks are in a position to absorb these losses, especially after recent capital raising efforts. In this context, access to the recapitalization fund should no longer be linked to credit extension to SMEs, but be made clearly conditional on banks’ efforts to restructure SMEs.

While the crisis response framework has performed relatively well during the recent crisis, there may be scope for further improvement. A more formal framework such as a Financial Stability Council could help improve financial policy coordination between the government, the regulator, and the central bank. It would also ensure that the BOK has sufficient real-time information to better fulfill its lender-of-last-resort mandate.

In light of recent financial sector stresses, the authorities may want to consider some upgrades to bank supervision and regulation. In the short term, there is scope to improve stress testing within banks and by the regulator. Over the medium term, the authorities may also want to consider prudential regulation with respect to banks’ wholesale funding, as is currently being contemplated in Australia and New Zealand, counter-cyclical capital requirements, and other lessons from the crisis currently being discussed in international fora. These issues will be further explored during the FSAP update scheduled for 2010-11.

Given the scale of the downturn, the authorities should also take a fresh look at the bankruptcy regime. In particular, a decriminalization of the personal bankruptcy regime would ensure that entrepreneurs do not procrastinate on needed restructuring.

Structural policies

The weakness of demand by Western consumers, possibly for years to come, has given added urgency to a recalibration of Korea’s export-led growth model. As a matter of priority, tax incentives that favor the export-oriented manufacturing sector over the service sector should be removed. Moreover, opening up the service sector to competition, including from abroad, and moving expeditiously on the restructuring of SMEs would narrow the productivity gap between the tradables and nontradables sector. Finally, reducing employment protection for regular workers would facilitate a reallocation of labor towards the nontradables sector. Higher labor participation rates in turn would counter the fall in total factor productivity associated with the shift of economic activity towards the less productive nontradables sector.

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Staff Report for the 2009 Article IV Consultation—Informational Annex

Prepared by the Asia and Pacific Department

July 23, 2009


  • I. Fund Relations

  • II. Statistical Issues

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Public Information Notice (PIN) No. 09/103


August 9, 2009

International Monetary Fund

700 19th Street, NW

Washington, D. C. 20431 USA

IMF Executive Board Concludes 2009 Article IV Consultation with the Republic of Korea

On August 7, 2009, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV Consultation with the Republic of Korea.1

Washington, D. C. 20431 • Telephone 202-623-7100 • Fax 202-623-6772 •