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

This 2009 Article IV Consultation highlights that like other open economies, Korea was hard hit by the global financial crisis during the last quarter of 2008. The authorities responded with a timely and comprehensive set of financial market and macrostabilization measures. Executive Directors have commended the authorities for their speedy and comprehensive measures, which have successfully stabilized the economy and the financial system. Directors have also supported the sizable and frontloaded fiscal stimulus package and the intention to maintain fiscal stimulus in 2010 given the uncertain outlook.

Abstract

This 2009 Article IV Consultation highlights that like other open economies, Korea was hard hit by the global financial crisis during the last quarter of 2008. The authorities responded with a timely and comprehensive set of financial market and macrostabilization measures. Executive Directors have commended the authorities for their speedy and comprehensive measures, which have successfully stabilized the economy and the financial system. Directors have also supported the sizable and frontloaded fiscal stimulus package and the intention to maintain fiscal stimulus in 2010 given the uncertain outlook.

I. Introduction

1. Korea is facing its biggest economic challenge since the 1997–98 crisis. Korea’s openness to trade and financial flows—the foundation of its enviable growth record and rapid recovery after the Asian crisis—left it particularly exposed to the tightening of global financial conditions and the sharp decline in trade that followed. The authorities have responded forcefully to the dual onslaught of massive capital outflows and collapsing exports and, thereby, avoided major tail events so far. However, the downturn is expected to be protracted.

2. The current environment also presents an opportunity for Korea to prepare for a different post-crisis global environment. Few view the current global recession as a typical cyclical downturn. Following a substantial accumulation of debt, households in key export destinations will likely need to shore up balance sheets over an extended period, which could suppress Asian export growth long after the global recovery has taken hold. Similarly, a more stringent regulatory regime at the global level could lead to a higher cost and lower volume of credit long after financial institutions’ balance sheets have been restored to health. These possibilities need to be taken into account when designing the strategy for a strong and durable economic recovery in Korea, and preparing for the challenges of a rapidly aging population.

II. Recent Economic Developments and Outlook

A. Recent Economic Developments: Recovering from the Shock

3. In the aftermath of the collapse of Lehman Brothers, Korea experienced the dual onslaught of a sudden stop in capital flows and collapsing exports.

  • With the seizure of international money markets in September 2008, Korean domestic banks and foreign bank branches faced a sharp reduction in their credit lines, and rollover rates on short-term external bank debt dropped to around 40 percent. As a result, the capital account deteriorated by over 6 percentage points of GDP, compared to 5½ percentage points of GDP during the Asian crisis. Both the won and equity markets declined around 30 percent, severe dollar shortage spilled over into domestic money markets, and the perceived default risk of Korean banks, which rely heavily on wholesale funding, increased by more than anywhere else in the region.

  • Shortly thereafter, Korea suffered its greatest export slump on record. At the low point in January, exports were down 35 percent year/year (y/y), compared to a fall of 22 percent y/y when the dotcom bubble burst in 2001. Given its openness to trade, the external shock quickly spilled over to domestic demand: real investment contracted by 6½ percent q/q and private consumption fell by a striking 4½ percent q/q. Overall, the Korean economy contracted by 5.1 percent q/q (not annualized) in the last quarter of 2008, among the sharpest contractions worldwide.

4. The authorities responded with a timely and comprehensive set of financial market and macro-stabilization measures. The authorities set aside $55 billion in foreign exchange reserves to provide as swaps or loans to banks and trade-related businesses, effectively substituting for loans previously provided by foreign creditors. They administered major monetary and fiscal stimulus to arrest a further slide in confidence and sustain the real economy. Finally, they set up a bank recapitalization fund and a toxic asset fund to shield the banking sector from the downturn and prevent major deleveraging.

A01ufig01

Balance of Payments

(percent of annual GDP)

Citation: IMF Staff Country Reports 2009, 262; 10.5089/9781451822250.002.A001

Source: CEIC data Company, Ltd.

5. The steep exchange rate depreciation helped fend off deflationary pressures. The BOK intervened only exceptionally, confined spot market intervention to smoothing operations, and secured swap lines from other central banks totaling $90 billion.1 The weak won redirected domestic demand from imports to domestic production and, in combination with falling oil prices, turned the current account from a deficit of 3¾ percent of GDP in the third quarter of 2008 to a surplus of 4½ percent of GDP in the first quarter of this year. As a result, reserves fell by just $38 billion in the last quarter of 2008 to $200 billion and have since risen to $232 billion. Moreover, the weak won has sustained core inflation, at 3.5 percent in June, while headline inflation has declined to 2 percent on the back of softer commodity prices, slightly below the target range of the BOK.

6. Defaults on banks’ external obligations and a credit crunch have been avoided and economic activity stabilized in the first quarter of 2009. Bank credit continues to grow—at 8 percent y/y—and domestic bond issuance in the first five months of 2009 (relative to GDP) is close to an all-time high. In the first quarter of 2009, government consumption and construction investment rose by 3¾ and 5¼ percent q/q, respectively, as a direct result of the fiscal stimulus, and private consumption recorded a mild recovery of 0.4 percent q/q. As a result, the economy expanded by 0.1 percent q/q in the first quarter, thereby avoiding a technical recession. Economic activity continues to improve with exports, industrial production, and service sector activity well above their end-2008 lows and business and consumer confidence back in expansionary territory.

Figure 1.
Figure 1.

Korea: The Sudden Stop in Capital Flows

Citation: IMF Staff Country Reports 2009, 262; 10.5089/9781451822250.002.A001

Figure 2.
Figure 2.

Korea: The External Demand Shock

Citation: IMF Staff Country Reports 2009, 262; 10.5089/9781451822250.002.A001

B. Outlook and Risks: A Drawn-Out Recovery

7. The recent pickup in economic activity is likely to moderate and lead to a drawn-out recovery. The rebound is to a considerable extent driven by the weak won and the front-loaded fiscal stimulus. The won has begun to strengthen, while the sequential impact of the stimulus will peter out over successive quarters. With economic conditions in the United States and Europe projected to remain weak through 2010, maintaining growth momentum will be challenging. Bleak export prospects should continue to depress facility investment, while the record stock of unsold homes will weigh on construction investment. Unemployment is expected to peak only in the third quarter of 2009 and weigh on consumption for an extended period of time. Moreover, deleveraging by financial institutions is expected to constrain credit growth. As a result, the economy is projected to contract by 1¾ percent in 2009 and grow by 2.5 percent in 2010, while inflation is projected to fall to 1½ percent in late 2009, and recover thereafter.

A01ufig02

Korea’s Share in Global Export Markets

Citation: IMF Staff Country Reports 2009, 262; 10.5089/9781451822250.002.A001

Sources: IMF, Direction of Trade, and Information Notice System.

8. Risks to the outlook are broadly balanced with the upside from massive stimulus measures offset by various downside risks.

  • The greatest upside risk stems from the impact of monetary and fiscal stimulus. The outturn for the first quarter of 2009 suggests that stimulus measures, implemented expeditiously, may be more effective than anticipated. Stimulus measures abroad could also prove more effective than anticipated.

  • Over the short-term, the greatest downside risk facing the economy is another sudden reversal in capital flows, triggered, for example, by heightened risk aversion among Western European banks (see Box 1). While it is unlikely that Korean borrowers would be forced into large-scale defaults on external liabilities under such circumstances, the resulting tightening of financial conditions and a further delay in the European recovery would reduce growth significantly.

  • Over the short to medium term, the greatest downside risk is a negative feedback loop from the real economy to the financial sector, or a spike in oil prices. Fueled by capital inflows and low interest rates, private credit grew from 120 percent of GDP in mid-2002 to 160 percent of GDP by end-2008, and is now close to the all time high reached during the Asian crisis. Depending on the state of corporate and household balance sheets, bank deleveraging could be substantial and protracted. While lackluster global activity should keep oil prices in check, geopolitical events or speculation could raise prices markedly.

  • Over the next decade, the global environment will arguably be less conducive to growth than it was over the past decade. It is likely that the time of abundant global liquidity has come to an end, as the trend in financial deregulation is being revisited and few continue to believe that asset prices should be ignored in the conduct of monetary policy. Similarly, there may be much less support for the global economy from Western consumers over the long term as house and stock prices return to more sustainable levels.

A01ufig03

Korea GDP Growth

(Central forecast (line) and 50, 70, and 90 percent confidence intervals (areas); in percent)

Citation: IMF Staff Country Reports 2009, 262; 10.5089/9781451822250.002.A001

Sources: IMF staff estimates.
A01ufig04

Korea: Risk Factors

(Contribution to balance of short-term risks for growth forecast)

Citation: IMF Staff Country Reports 2009, 262; 10.5089/9781451822250.002.A001

Sources: IMF staff estimates.

Downside Risk Scenario: Another Bout of Global Risk Aversion

While financial market volatility has come down markedly from the heights of the Lehman collapse, another sudden stop in capital flows remains a possibility. Excess liquidity has been a global phenomenon and asset bubbles have built up well beyond the U.S. sub-prime mortgage market. Some of these imbalances may still unravel and impact the global financial system. One case in point is overextension in Eastern Europe, where any defaults could quickly spill over to Korea through the common link of Western European banks. The latter account for 31 percent of Korea’s total external debt according to BIS data as of end-December.

In the event of a large scale reversal of capital flows, Korea would probably avoid the tail event of external defaults.

  • Current reserves of $232 billion exceed 2009 and 2010 external financing needs of $201 billion, defined as external debt amortization net of the current account surplus. Hence, even if roll-over rates of external debt were to fall to very low levels, reserves would be sufficient to cover debt payments throughout 2010. As a comparison, during the Asian crisis roll-over rates of short-term external debt fell to 50 percent.

  • The default risk of domestic banks seems manageable, despite their reliance on wholesale financing. Offshore wholesale financing of domestic banks at short maturities amounted to only $45 billion at end-December, which amounts to an estimated 4 percent of their total funding or 20 percent of official reserves. Moreover, Korea has very strict bank regulations in terms of maturity and currency mismatches and so the ratio of short-term foreign exchange assets to liabilities (due in three months or less) was 104 percent at end-June.

  • It is unlikely that steep exchange rate devaluation would trigger defaults. Although foreign currency open positions by sector are not available, data on external debt and external assets (as defined by the residency principle) suggests that only foreign bank branches have significant exchange rate exposure in the short term, while positions beyond the short-term would be covered by BOK reserves.

Net Open Positions, End-2008 1/

(In billions of U.S. dollars)

article image

External assets minus external debt.

However, Korea would still experience a severe tightening of financial conditions with a knock-on effect on growth.

  • Faced with falling roll-over rates on their external debt, banks would have to obtain foreign currency by liquidating assets—denominated both in foreign currency and in won. This would affect credit growth and could lead to an outright credit contraction.

  • Falling stock prices would depress private consumption and investment. With foreign participation in the stock market amounting to about 30 percent, stock prices would fall in response to a global shock. With Korean households holding 15 percent of their financial assets in stocks, consumption is bound to fall. Companies would issue fewer shares—indeed, companies issued 70 percent fewer shares in 2008 than in 2007—and cut down on investment.

  • Rising interest rates would further dampen investment and demand for durable goods. It is estimated that foreigners (both nonresidents and resident branches of foreign banks) account for 27 percent of all holdings of outstanding treasury and central bank bonds, which could lead to a spike in interest rates should external debt flows reverse.

A01ufig05

Private Credit 1/

(Percent of GDP)

Citation: IMF Staff Country Reports 2009, 262; 10.5089/9781451822250.002.A001

Source: CEIC data Company, Ltd.1/ Private credit for nonfinancial corporations and individuals from the BOK’s depository corporations survey.
A01ufig06

U.S. Consumption: Cyclical or Structural Correction?

(Percent of GDP)

Citation: IMF Staff Country Reports 2009, 262; 10.5089/9781451822250.002.A001

Source: CEIC data Company, Ltd. and Schiller, Robert J, “Irrational Exuberance,”http://www.irrationalexuberance.com.

Authorities’ views

9. The authorities were somewhat more upbeat about growth prospects in the second half, and expect the economy to contract by 1.5 percent in 2009. They maintained that the growth impact of front-loaded fiscal spending did not necessarily translate into a subsequent petering out of fiscal stimulus due to the lag between budgetary execution and final demand, particularly for transfers and capital expenditure. While the recent won recovery was likely to have a dampening effect on growth, in their view it was also reflective of improved sentiment and would support domestic investment by lowering the cost of imported capital goods. The authorities also felt that the lagged effect of unemployment was likely to be cushioned by public works programs introduced as part of the fiscal stimulus package.

10. In 2010, the authorities expect growth to rise to 4 percent, but acknowledged downside risks from lackluster growth in the G3 countries. The authorities were in broad agreement with staff’s global growth assumptions, but indicated that Korea was well placed to profit from solid growth in China and other emerging markets, given its specialization in advanced manufacturing. Risks from weak demand in the United States and Europe were acknowledged, but they noted a shift of Korean exports towards the vast pool of consumers in emerging markets.

III. Policy Discussions

A. Fiscal Policy: Countering the Cycle While Safeguarding Sustainability

Background

11. Conventional fiscal stimulus has been a crucial line of defense during the current downturn. The government introduced two fiscal stimulus packages for 2009: the first package in the original budget amounted to about 2 percent of GDP, while the second, passed in April, amounted to 1.7 percent of GDP.

Announced Fiscal Stimulus Packages

(Percent of GDP)

article image

12. The authorities have also undertaken extensive quasi-fiscal measures to boost bank lending to SMEs, which account for 80-90 percent of employment. They expanded the available amount of SME loan guarantees, announced automatic rollovers of guarantees expiring in 2009, and increased the guarantee coverage per loan. In addition, the authorities injected capital into policy banks, encouraged commercial banks to roll over all SME loans falling due in 2009 (16 percent of GDP), and established targets for SME loan growth.2

Staff views

13. The size and composition of the 2009 fiscal stimulus have been appropriate. The fiscal stimulus, defined as the change in the structural deficit (including social security), is projected at 2¾ percentage points of GDP and exceeds the G20 target of 2 percent of GDP by a significant margin. It also aptly focuses on spending measures such as infrastructure outlays and targeted transfers for liquidity constrained households, which typically have the highest immediate growth impact. The tax cuts are not expected to have a significant short-term impact on growth, but could support the recovery once it is under way. Based on model-generated multipliers, staff estimates that discretionary measures could lift growth by 1-1½ percentage points in 2009.3

Composition of Fiscal Stimulus in 2009

(In percent)

article image
A01ufig07

Korea: Fiscal Multipliers With Monetary Accommodation

(Impact on GDP growth from 1% of GDP Stimulus)

Citation: IMF Staff Country Reports 2009, 262; 10.5089/9781451822250.002.A001

Note: The multipliers are derived from simulations using IMF’s Global Integrated Monetary and Fiscal Model.

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

Korea’s support measures for SMEs have been among the most generous in the world after Japan, owing to the sector’s large share in employment. Public capital injections into banks have been modest by international standards reflecting Korea’s peripheral role in the current crisis. By the same token, toxic asset programs have been set up as a contingency measure, and no public money has been spent so far.

SME credit facilitation

Korea’s expansion of SME financial support facilities, already among the most generous in the world prior to the crisis, is only rivaled by Japan. Credit guarantee schemes for SMEs have been expanded by 1.8 percent of GDP, compared to 5.9 percent of GDP in Japan, 0.8 percent of GDP in the United Kingdom, and 0.4 percent of GDP in Mexico. Maximum guarantee coverage per loan has been expanded to 100 percent in both Korea and Japan, compared to 90 percent in Taiwan Province of China, 85 percent in India, 75 percent in the United Kingdom, and 50 percent in Mexico. Fees for these guarantees are comparable to other countries—1.2 percent of the outstanding guarantee, compared to 0.5 percent in Taiwan Province of China, and 2 percent in Mexico and the United Kingdom. Similarly, the expansion of subsidized lending facilities for SMEs has matched those of other countries—0.2 percent of GDP, compared to 0.2 percent of GDP in India and Germany, and 2 percent of GDP in Japan.

Bank recapitalization

Public capital injections into Korean banks have been modest by international standards. The government has injected W 4 trillion into public financial institutions, while commercial banks have drawn W 4 trillion from the W 20 trillion recapitalization fund. The Korean government’s W 8 trillion, or $6 billion capital injections, account for less than 1.5 percent of the $470 billion in public capital injections worldwide. Not surprisingly, Korea’s capital injections pale against the more than $230 billion provided in the United States or the more than $50 billion made available in the United Kingdom. However, Korean capital injections also compare favorably to those of China or Russia (each around $20 billion), which like Korea have been at the periphery of the current crisis. This is due to Korean banks’ solid capital adequacy ratios at the outset of the crisis—12.3 percent at end-2007—and the relative ease of raising private capital ($15 billion) after the onset of the crisis.

Toxic asset management

With the W 40 trillion Restructuring Fund—W 462 billion drawn so far—Korea is one of a few countries worldwide that have established a program to purchase toxic bank assets. Reflecting the difficulties in valuing toxic assets, Germany and the United States are among the few G20 countries that have committed public funds to purchases of risky assets. The United States has redesigned its program midway, seeking to solve the valuation problem through private sector participation. Other countries, such as Spain, Italy, and the United Kingdom have capped bank losses by issuing guarantees on existing or new bank lending. Korea is confident that it can handle the valuation problem, given the expertise acquired during the Asian crisis: to date, Korea’s Asset Management Corporation has recovered 110 percent on the toxic assets it bought in the wake of the Asian crisis.

14. Weighing Korea’s fiscal space against the current economic outlook, it seems too early to withdraw fiscal stimulus in 2010. This implies that the structural deficit in 2010 should be at least as large as in 2009. Under current policies, government debt (including government guaranteed debt) would rise to a manageable 40 percent of GDP by end-2009; and although the yield curve has steepened somewhat in response to the government’s increased funding needs, this has not offset the effect of lower policy rates.4 Hence, crowding out of private spending or a Ricardian increase in private saving is not a major policy concern at this stage.

15. However, with a credit crunch averted consideration needs to be given to an exit strategy from distortionary SME support measures. Given the magnitude of the shock and the risk of abrupt deleveraging, some of the credit facilitation measures for SMEs may have had their merits. However, credit guarantees that were extended in response to severe downturns in the past—for example, in 1998 and 2001—persisted long after the downturns ended, and have been partly blamed for the structural financial problems the SME sector is facing today. As a high priority, the maximum loan guarantee coverage should be reduced to the customary 60-80 percent, from 100 percent currently. Moreover, the guidance to commercial banks to roll over maturing SME debt should not be renewed in 2010. Finally, the authorities may want to consider committing to a time-bound path for a significant reduction of SME credit guarantees (and subsidized loans provided by BOK through commercial banks).

16. A medium-term fiscal consolidation plan would bolster the effectiveness of the current stimulus and assure investors about the authorities’ intention to guard against policy imbalances, especially in the face of looming demographic pressures. Aiming for a balanced budget (excluding social security) over the medium-term—the authorities’ goal prior to the current crisis—still seems appropriate and would require discretionary measures of 3¾ percentage points of GDP. This adjustment path would lead public debt to peak at 47 percent of GDP in 2011 and also leave sufficient room for fiscal contingencies related to recent financial sector support measures, which should be transparently reported in the budget (see DSA Appendix). On the revenue side, the adjustment could be brought about by broadening the base for personal and corporate income taxes (by eliminating extensive allowances and incentives, including the temporary investment tax credit), as well as increases in the VAT rate and social security contributions. On the expenditure side, there is scope for streamlining non-age-related outlays and further pension reform, which would help provide room for a needed expansion of the social safety net.

Contingent Liabilities Associated with Crisis Measures 1/

(In trillions of won, unless otherwise specified)

article image

Dates in parenthesis indicate when measure was announced.

Authorities’ views

17. The authorities agreed with staff that it was too early to exit from conventional fiscal stimulus measures, and were mindful of medium-term fiscal pressures. Despite a more optimistic growth outlook for 2010, the authorities agreed that there were downside risks and, consequently, planned not to withdraw fiscal stimulus until a self-sustained recovery was firmly established. The authorities plan to announce a fiscal consolidation plan in October, which will aim for a balanced budget (excluding social security contributions) over the medium term. However, the detailed measures underlying the medium-term consolidation strategy are still being worked out.

18. The authorities are well aware of the disincentives associated with SME financial support policies and have started to reverse some of the measures introduced at the height of the crisis. Given the speed of deleveraging in late 2008, generous SME support was seen as necessary to avert a credit crunch that would have left viable firms without access to financing. With liquidity conditions back to normal, the authorities acknowledged that the focus needed to shift towards addressing the structural weaknesses of the sector. As a first step, they have relaxed the targets for SME loan growth and indicated that the guidance to roll-over all SME bank loans would be withdrawn in 2010. However, a rollback of SME support measures to pre-crisis levels was seen as politically difficult at present.

B. Monetary and Exchange Rate Policies: Appropriate for Now

Background

19. The BOK undertook a wide range of policy measures to ensure the adequate flow of credit and support the rapidly deteriorating economy. It cut interest rates by a cumulative 325 basis points between October and February to 2 percent. BOK also broadened the list of eligible counterparties and collateral in its repo operations and relaxed banks’ liquidity requirements. BOK further set aside W 5 trillion ($4 billion) to assist financial institutions to purchase corporate bonds and commercial paper, and increased its ceiling for subsidized SME lending by W 3½ trillion to W 10 trillion ($8 billion).

20. As a result, disruptions to the monetary transmission mechanism were short lived. Short-term interest spreads, which shot up in the immediate aftermath of the Lehman collapse, returned to pre-crisis levels in late-2008, and lending rates are now at an all time low. Similarly, bond spreads of high grade issuers have returned to pre-crisis levels, although they remain elevated for lower rated corporates. By international standards, the monetary transmission mechanism seems to be working fairly well: Among a set of comparator countries, Korea is placed in the middle of the field. Moreover, some of the countries exhibiting a greater responsiveness of lending rates to policy rates started the easing cycle earlier, giving the monetary transmission process more time to run its course.

A01ufig08

Monetary Transmission Mechanism 1/

Percentage points

Citation: IMF Staff Country Reports 2009, 262; 10.5089/9781451822250.002.A001

Sources: Bloomberg LP; and IMF, International Financial Statistics, and staff calculations.1/ The dates behind country labels indicate the start of the easing cycle.

Staff views

21. The BoK should maintain its accommodative stance for now and address potential asset price inflation with prudential regulation. With the output gap projected at -6¼ percent a year from now, the current stance should be maintained for now. While there are signs of excess liquidity, stock market valuations and house prices remain well in line with global peers (see Box 3) and do not warrant an immediate monetary policy response. If pressures on asset prices intensify, the first line of defense should be prudential regulations, especially on mortgage lending.

A01ufig09

Short-Term Liquidity

(In trillions of won)

Citation: IMF Staff Country Reports 2009, 262; 10.5089/9781451822250.002.A001

Source: CEIC Data Company Ltd.

Korea: Housing Market—Are Further Losses Looming?

Korea’s housing market has trended up since the Asian crisis. House prices have increased by around 25 percent in real terms since 1999. This is slower than the average for Asia Pacific of around 31 percent, but above the 17 percent average excluding fast appreciating countries such as India, Australia, and New Zealand. The run-up in real prices in Korea has largely been driven by higher prices in Seoul, up by more than 60 percent since 1999. This is well-above the price increases seen for other metropolitan areas, including Singapore and Hong Kong. In particular the southern districts of Seoul have experienced rapid real price increases since the Asian crisis, up by close to 100 percent at the 2006 peak. Since the onset of the current global economic crisis, however, real prices have waned across Asia, including in Korea (-3.5 percent in April). In Korea, prices even started to flatten in early 2007 in response to policy measures to cool the market, including tax measures, selected price controls, and prudential measures.

uA01bx03fig01

Asia: Real House Price Increases since 1999

(In percent)

Citation: IMF Staff Country Reports 2009, 262; 10.5089/9781451822250.002.A001

Despite the fast run-up in house prices since the Asian crisis, home valuations in Korea do not on average appear to be significantly out of line with fundamentals. To get a sense of house price alignment with fundamentals, house price growth was modeled as a function of an affordability index, growth in disposable income, short- and long-term interest rates, credit and equity price growth, and changes in the working-age population.1 The results of this exercise suggest that house prices in Korea are on average broadly in line with fundamentals. Moreover, a look at house prices relative to income over a longer time period shows that they are still more affordable compared to the early 1990s, even for the faster growing districts of Seoul. That being said, the current economic slowdown is restraining prices as incomes shrink and banks tighten credit standards. The spillovers from the current slowdown are also showing up in a significant jump (19 percent y/y in May) in the stock of unsold homes and steep declines in construction and construction permits.

uA01bx03fig02

Price Increase Above Level Suggested by Fundamentals

Citation: IMF Staff Country Reports 2009, 262; 10.5089/9781451822250.002.A001

The authorities introduced a number of measures at the height of the crisis to reduce downside risks to the housing market, but have recently scaled some of these back. The initial response was broadly appropriate given the heightened level of uncertainty at the time. Back then, the government announced that public institutions would buy unsold houses and land from construction companies. Loan-to-value and debt-to-income limits for certain areas were relaxed and the number of speculative zones with stricter prudential regulations was reduced. Moreover, tax relief was provided for purchases of multiple houses and on the proceeds of new houses bought until February 11, 2010 (except in Seoul) and sold within the next five years. Finally, the period after which purchase rights to apartments in the metropolitan area could be resold was shortened from 5-10 years to 1-5 years. To address a potential re-emergence of upward price pressures in selected Seoul neighborhoods, the authorities recently lowered the required loan-to-value ratios for these areas. This selective approach is appropriate given the absence of nationwide pressures in the housing market, and could be pursued further if house prices continue to rise in specific areas.

uA01bx03fig03

Korea: Housing Affordability Index

(House prices to incomes, Q1 1990 = 100)

Citation: IMF Staff Country Reports 2009, 262; 10.5089/9781451822250.002.A001

1 See Asia and Pacific, Regional Economic Outlook, May 2009

22. The impact of unconventional monetary policy on BOK’s balance sheet has been limited and should be easy to unwind. The expansion of domestic assets was largely offset by a decline in foreign assets, limiting the overall expansion of the balance sheet. Some of this asset swap was automatic and the direct consequence of BOK’s decision to substitute for foreign capital flows by lending out of its foreign currency reserves. With the policy rate well above zero and global as well as domestic funding conditions easing, a gradual unwinding of these measures, as is under way, should continue.

A01ufig10

Central Banks Total Assets

(August 2007=100)

Citation: IMF Staff Country Reports 2009, 262; 10.5089/9781451822250.002.A001

Sources: Haver Analytics; and CEIC Data Company Ltd.

23. Foreign exchange intervention in the smoothing operations. As a result of massive capital outflows, the exchange rate has moved considerably below most estimates of its long-term equilibrium level. However, as evidenced by the recent pickup in capital inflows, this should be a temporary phenomenon. Intervention should remain confined to smoothing operations, given the reasonable reserve coverage and the questionable effectiveness of intervention in the current volatile environment.

Exchange Rate Misalignment According to Spring CGER Exercise

(In percent)

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A positive number denotes an overvaluation. The reference period is February 25 to March 25, 2009.

Authorities’ views

24. The authorities agreed with the need for an accommodative monetary stance, but remained concerned about its effect on asset prices. The authorities felt that the monetary stance was appropriate for now, but in line with their more upbeat assessment of economic prospects they remained attuned to signs of excess liquidity. Moreover, they took little comfort from the fact that house prices had fallen until recently, given the upturn in mortgage-related lending and rising house prices in some localized markets. They agreed that prudential regulation should be the first line of defense against frothy asset markets, as evidenced by a recent tightening of loan-to-value ratios in selected Seoul neighborhoods. However, the authorities did not rule out interest rate hikes should more generalized asset price rises become a concern.

25. The authorities reiterated their commitment to a freely floating exchange rate. Prior to 2009, intervention was confined to smoothing operations. So far in 2009, the authorities abstained completely from exchange market intervention, as evidenced by the won’s volatility and appreciation since early March. The unwinding of dollar liquidity provision has accounted for the recent increase in official reserves.

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

Background

26. corporate and household vulnerabilities are bound to erode banks’ relatively strong capital positions.

  • While the corporate sector as a whole entered the current crisis in a relatively strong position, there are pockets of significant vulnerability, particularly in the SME sector. Based on balance sheet information and asset price volatility of listed companies, it is estimated that creditor losses could reach 4.1 percent of GDP, with losses for banks amounting to 3.1 percent of total loans.5

  • Household debt as a percent of disposable income has been on an upward trend since the Asian crisis and is higher than in the United States and Japan. Moreover, at 50 percent of GDP, non-mortgage household debt is much higher than in comparator countries. As stock market valuations tumbled, debt relative to financial assets has spiked recently, and while well below 100 percent, exceeds the ratio in other countries by a wide margin.

A01ufig11

Corporate Leverage, 2008 1/

(In percent)

Citation: IMF Staff Country Reports 2009, 262; 10.5089/9781451822250.002.A001

Source: IMF, Corporate Vulnerability Utility.1/ Debt in percent of assets.2/ Data refers to 2007.
A01ufig12

Household Indebtedness 1/

(In percent of nominal GDP)

Citation: IMF Staff Country Reports 2009, 262; 10.5089/9781451822250.002.A001

Source: Korea, Ministry of Strategy and Finance.1/ As of the end of 2007.

27. In anticipation of a substantial rise in banks’ NPLs, the authorities are pursuing a strategy that includes capital injections and purchases of impaired assets. Banks have since late-2008, under guidance from the supervisor, raised their capital adequacy ratios (CARs) to 12.9 percent. The authorities have also established a W 20 trillion bank recapitalization fund (1.6 percent of risk weighted assets) and in the first quarter of 2009, eight banks drew a total of W 4 trillion from the fund. In addition, the Korea Asset Management Corporation (KAMCO) stands ready to issue government-guaranteed bonds totaling W 40 trillion ($30 billion) mainly to purchase NPLs and troubled assets from financial institutions.6

Staff views

28. Banks are well positioned to withstand a significant deterioration in asset quality. According to staff estimates, the NPL ratio could reach 6.4 percent under the baseline, which would reduce banks’ capital adequacy ratio to 10 percent. Only under a very extreme scenario—G7 growth of minus 7.8 percent—would the CAR fall below the regulatory minimum of 8 percent.7

29. There may be a need to link capital injections and purchases of nonperforming loans more clearly to progress on bank-led restructuring of SMEs. While less disruptive than an after-the-fact recapitalization, the current strategy may weaken banks’ incentives to actively pursue company restructuring. In fact, access to the recapitalization fund has been explicitly linked to the provision of SME credit and, hence, undermines restructuring efforts. Similarly, given the time and expertise required to restructure debtor companies, it may be easier for banks to sell impaired assets to KAMCO rather than engage in costly restructuring. In this context, capital support to banks and purchases of impaired assets could be more clearly linked to restructuring efforts.

30. While the crisis response framework has performed relatively well during the recent crisis, there may be scope for further improvement. The global liquidity crisis and the new emphasis on macro-prudential oversight have highlighted the interconnectedness of financial supervision, monetary policy, and lender-of-last-resort policies. Following the examples of Australia, New Zealand, and Hong Kong SAR, a more formal framework such as a Financial Stability Council could help improve financial policy coordination and information sharing between supervisors, the central bank, and the government.

31. In light of recent financial sector stresses, the authorities may want to consider some upgrades to bank supervision and regulation. As pointed out during last year’s Article IV consultation, there is scope to improve stress testing within banks and the regulator and the FSAP update envisaged for late 2010 will follow up further on this issue. The authorities may also want to consider additional prudential regulation with respect to banks’ wholesale financing, given its macro stability implications. Counter-cyclical capital requirements and other lessons from the global financial crisis could also be explored in line with the evolving international debate.

32. The scale of the downturn gives added urgency to further improvements in Korea’s corporate and personal bankruptcy regime. In 2006, Korea enacted a new unified insolvency law, which has greatly reduced uncertainties and streamlined court procedures. However, there is scope for further improvement, including by introducing an automatic stay on assets and removing the requirement for prior court approval when submitting a restructuring plan. Moreover, decriminalizing personal bankruptcies—loan defaults are treated as a criminal offense—and extending exemptions for personal assets may induce entrepreneurs to declare bankruptcy early on.

Authorities’ views

33. The authorities underscored that the recapitalization fund and KAMCO restructuring fund had fulfilled important functions in the early phase of the crisis, but acknowledged that there was scope to revisit some of these functions. The funds had been set up as a contingency measure and were meant to assure investors that the government was aware of the risks to the banking system. This strategy was seen to have succeeded, as several banks have been able to tap international capital markets in recent months without recourse to the government’s guarantee on external debt. The funds had also helped support the real economy by preempting an excessive degree of deleveraging. With economic conditions stabilizing, the authorities agreed that the modalities of accessing the recapitalization fund needed to be more clearly aligned with the broader restructuring strategy. On the other hand, they did not share the concern that banks would overuse the KAMCO fund instead of engaging in time consuming restructuring. Recent plans by banks to set up their own asset purchase vehicle is seen as evidence that KAMCO’s pricing of impaired assets is perceived as conservative.

34. The authorities recognize the need for greater coordination among the central bank and government agencies, but value a clear delineation of supervisory responsibilities in maintaining the BOK’s independence in the context of the inflation targeting framework. They acknowledged that BOK needed better access to information to act as a lender of last resort in times of crisis and noted that a formal agreement to this effect is being considered. The authorities also saw an increased role for macro-prudential regulation in line with international consensus on this issue. They pointed out that BOK has established financial stability as an important policy objective in the conduct of monetary policy.

35. Regulators saw scope for improved stress testing and are following with interest the international dialogue on wholesale funding regulation. The authorities want to develop stress testing to a stage where it can be used as a basis for regulatory action and are allocating more resources for this purpose. With respect to banks’ wholesale financing, they pointed out that Korea has one of the strictest regulations in terms of foreign exchange maturity mismatches, while domestic funding pressures could be addressed through BOK’s liquidity facilities. Notwithstanding, they were closely following the deliberations of the Financial Stability Board and the Basel Committee on Banking Supervision with respect to wholesale funding regulation and other lessons from the crisis.

D. Structural Policies: Laying the Foundations For A Sound Recovery

Background

36. Korea’s growth relies heavily on the tradables sector, and increasingly so. During 2001-08, net exports and investment—which is heavily geared towards the tradables sector—accounted for 55 percent of growth, up from 27 percent in the 1990s. This bias towards the tradables sector is mirrored on the production side. Labor productivity growth in the services sector has been about 1.2 percent since 2000, down from 2.6 percent in the 1980s, and significantly lower than the 6.7 percent for the manufacturing sector. To a large extent, low service sector productivity reflects the poor state of the SME sector, which accounts for 80 percent of the sector’s output. According to BOK, the ratio of listed SMEs with interest burdens in excess of operating income reached 44 percent in 2007.

uA0101fig13

Export-Led Growth Model

(In percent)

Citation: IMF Staff Country Reports 2009, 262; 10.5089/9781451822250.002.A001

Source: CEIC Data Company Ltd.1/ Ten year moving average.

Staff views

37. Putting the SME sector on a sound footing and rebalancing growth towards the nontradables sector seems key for a lasting recovery. Rebalancing growth will require removing the bias towards exports and increase service sector productivity. This would support potential growth in the post-crisis environment when external demand and capital inflows from advanced countries may prove permanently lower. The three major avenues to attain these goals are SME restructuring, service sector deregulation, and labor market reform.

38. The authorities have launched important initiatives in each of these fields, but progress remains uneven. The authorities recently stepped up a bank-led restructuring program begun in 2004, and of 861 SMEs screened since June 2009, 77 have been found to be in need of restructuring and 36 have been diagnosed unviable. The free-trade agreement with the United States, whose ratification is pending in both legislatures, takes steps to open up the service sector in areas such as law, accounting, and finance, but not health and education. The government has also undertaken some important labor market reforms, but employment protection of regular workers remains high by international standards.

39. Progress on SME restructuring is contingent on the right incentive structure and mechanism to address the social adjustment costs. The bank-led approach to SME restructuring seems appropriate, in principle, given limited court capacity to deal with a large number of SMEs and the banks’ information advantage. However, extensive loan guarantees and mandated loan roll-overs have created disincentives on the part of banks and borrowers, respectively. There are also a large number of small SMEs where the cost of restructuring outweighs the benefits. Given the underlying structural problems, debt relief or maturity extension in these cases does not seem a compelling option. Instead, public transfer programs may be a more effective use of public funds.

40. Raising service sector productivity through deregulation should support potential growth and strengthen domestic demand. The historic bias towards an export-led growth strategy could be reduced by eliminating the preferential tax treatment for the manufacturing sector. Moreover, the service sector could be opened up to more competition, including from abroad. According to a recent OECD study, a third of service business lines impose entry barriers, and restrictions on services imports and FDI remain high by industrialized country standards.

41. Labor market reform would also support growth both from the supply and demand side. Past staff advice to reduce employment protection for regular workers and expand social protection of non-regular workers is still appropriate. More labor market flexibility would facilitate a reallocation of labor from the tradables to the nontradables sector, while better social protection would strengthen domestic demand by reducing precautionary savings. Moreover, increasing labor market participation of women, the old, and the young would help offset the projected fall in total factor productivity associated with a shift of economic activity to the less productive nontradables sector.

Authorities’ views

42. The authorities recognize the need to rebalance growth towards the nontradables sector and have already taken several initiatives to this effect. The next phase of the restructuring process, scheduled from July to November 2009, will explicitly target SMEs, which make up the lion’s share of the service sector. The government announced further plans to develop the service industry on May 8: Nine service industries have been chosen on the basis of potential for job creation, value added, and growth and will be nurtured through streamlined regulation and increased competition. The government has also signaled its intention to equalize tax treatment between the manufacturing sector and these service sectors, although by extending preferential tax treatment to selected services. In the area of labor reform, the government is considering ways to facilitate part time employment, as it should help to raise the share of women, students, and elderly in the labor force.

Table 1

Korea: Selected Economic Indicators, 2005–10

Nominal GDP (2008): $930.7 billion

Main exports (percent of total, 2008): Electronics (26), vessels (10), and road vehicles (8).

GDP per capita (2008): $19, 148

Unemployment rate (2008): 3.2 percent

FDI (2008): $2.2 billion

Public debt (2008): 33.6 percent of GDP

Foreign public debt (2008): 3.6 percent of total public debt

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

Contribution to GDP growth.

Data for 2009 are as of July 13.

Data for 2009 are as of May.

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

Table 2.

Korea: Balance of Payments, 2004–09

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

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

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

Table 3.

Korea: Consolidated Central Government Operations, 2004–09

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Sources: Ministry of Planning and Budget; and IMF staff estimates and projections.

The conversion of KDIC and KAMCO bonds is excluded, amounting to W 13 trillion in 2003, and W 12 trillion annually until 2006.

Table 4.

Korea: Indicators of Financial and External Vulnerability, 2004–09

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Sources: Korean authorities; private market sources; and IMF staff estimates and projections.

Including government guaranteed restructuring bonds issued by KDIC and KAMCO.

Short-term debt measured on a residual maturity basis.

Table 5.

Korea: Financial Soundness Indicators, 2002–08

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Sources: Bank of Korea; Financial Supervisory Service; and CEIC Data Company Ltd.

Includes nationwide commercial banks, regional banks, and specialized banks.

Includes nonfinancial corporations.

Operating income to gross interest payments. Operating income treats depreciation as an expense, so this ratio is lower than calculations using earnings before interest, taxes, and depreciation allowance (EBITDA).

Over 1 month.

Table 6.

Korea: Medium-Term Projections, 2007–14

(In units indicated)

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

Potential growth is assumed to be around 3 percent over the projection period, compared to 4.6 percent prior to the crisis.

Contribution to GDP.

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

During 2003-06, W 49 trillion in government guaranteed KDIC/KAMCO bonds have been 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.

Appendix: Debt Sustainability Analysis

Korea’s government debt is sustainable predicated on a resumption of medium-term fiscal consolidation. In the baseline scenario, the authorities are assumed to resume fiscal consolidation plans over the medium term, targeting a balanced budget (excluding the surplus of social security funds) by 2015. To achieve this, staff assumes that the authorities take measures on the revenue side (CIT and PIT base broadening and, possibly, a hike in VAT rates) and expenditure side (pension reform and streamlining of non-aging related expenditures. In this scenario, it is further assumed that the Korean Asset Management Company (KAMCO) will issue W 30 trillion (around 3 percent of GDP) in government guaranteed bonds to buy up bad loans and other impaired assets of financial institutions over a period of two years (partly repaying these through re-sale of assets), which is counted towards the broader debt measure considered in this exercise. Under these assumptions, government debt will initially increase quite steeply, mostly due the widening of the primary deficit (excluding social security funds) led by the discretionary fiscal loosening in response to the crisis and the cyclical revenue losses during current economic downturn. It will peak at around 47 percent in 2011, before declining to 41 percent at the end of the forecast horizon as the structural primary balance flips to a surplus as the consolidation measures kick in, underscoring their importance. While the debt dynamics are broadly favorable, they remain vulnerable to shocks, especially a macroeconomic shock or the realization of contingent liabilities (i.e., if KAMCO has to issue more guaranteed bonds or if contingent liabilities related to guarantees of SME loans and bank’s external debt are realized). However, even if it is assumed that 50 percent of the guarantees issued in response to the crisis are called, the debt dynamics do not become adverse.

Figure A1.
Figure A1.

Korea: Public Debt Sustainability: Bound Tests 1/

(Public debt in percent of GDP)

Citation: IMF Staff Country Reports 2009, 262; 10.5089/9781451822250.002.A001

Sources: International Monetary Fund, Korea desk data; and staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ Permanent ¼ standard deviation shocks applied to real interest rate, growth rate, and primary balance.3/ One-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occur in 2009, with real depreciation defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).
Table A1.

Korea: Public Sector Debt Sustainability Framework, 2004–2014

(In percent of GDP, unless otherwise indicated)

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Gross debt of central government and guaranteed debt issued by the Korea Asset Management Company (KAMCO) and Korean Deposit Insurance Corporation (KDIC).

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.

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

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

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

Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.