Republic of Korea
Staff Report for the 2012 Article IV Consultation

The Korean economy is slowing in the face of strong global headwinds. It is projected to bottom out during the course of 2012, regaining momentum towards the end of the year, in line with the global recovery. The main short-term risk to the outlook is a further intensification of the euro area crisis and its spillover. Parliamentary elections took place in April and the presidential election is scheduled for December, making 2012 a year of political transition.

Abstract

The Korean economy is slowing in the face of strong global headwinds. It is projected to bottom out during the course of 2012, regaining momentum towards the end of the year, in line with the global recovery. The main short-term risk to the outlook is a further intensification of the euro area crisis and its spillover. Parliamentary elections took place in April and the presidential election is scheduled for December, making 2012 a year of political transition.

Introduction

1. Korea’s rapid recovery in 2010 has stalled in the face of strong headwinds from the global economy. In the near term, the government’s main challenge is to contain the fallout of the euro area crisis. Korea’s impressive growth record in the past has in large part been engendered by its openness to global trade and international finance. However, this close integration has also meant that it is vulnerable to external shocks during periods of sharply slowing global growth and elevated financial stress. In response, the authorities have made concerted efforts to boost the resilience of the financial system and external vulnerabilities have been greatly reduced since 2008.

2. The macroeconomic policy mix encompasses an accommodative monetary policy and a broadly neutral fiscal stance. The government is committed to medium-term fiscal consolidation to create policy space to deal with challenges from an aging population and tail risk events. Fiscal spending was front-loaded in 2012 to support the economy, while maintaining the overall consolidation path. Notwithstanding a decline in headline inflation, inflationary expectations continue to be elevated and monetary policy remains accommodative, particularly with the recent cut in the policy rate. The exchange rate is moderately weaker than warranted by fundamentals. However, this reflects, in part, the risk premium that investors attach to the Korean won in the current environment of heightened uncertainty in international financial markets. Since the last Article IV consultation, the exchange rate has moved flexibly in response to market conditions.

3. Over the medium term, the policy priorities include boosting potential growth and ameliorating income inequality. Policies that lead to higher participation rates will be needed to enhance labor inputs in the face of rapid aging to boost the economy’s productive capacity. As the economy matures further and the sources of growth shift to domestic demand, sustaining growth will also necessitate measures to boost service sector productivity. This should also pave the way for more inclusive growth.

The Economic Context

A. Slowing Growth Amid Heightened Global Uncertainty

4. After a strong rebound in 2010, growth has moderated since 2011 in line with global economic developments. A housing supply overhang and negative base effects from the strong expansion of fixed investment in 2010 served to drag down overall growth in 2011 to 3.6 percent from 6.3 percent in 2010. High household indebtedness and weak wage growth also weighed on private consumption. As the euro area crisis intensified in August–September 2011, growth momentum stalled in Korea. Growth rebounded in the first quarter of 2012 on a sequential basis due to stronger-than-anticipated investment in the information technology sector and the front-loading of the budget. However, this pickup has proved to be short-lived as weaknesses in the global economy have fed into a widespread slowing of growth momentum. As a result, exports and fixed investment have weakened sharply in the second quarter of 2012.

5. Slowing growth and moderating commodity prices have led to a deceleration in inflationary pressure. Inflation had remained elevated around 4 percent in 2011, about 1 percent above the Bank of Korea’s (BOK) central inflation target, reflecting high commodity prices and other transitory supply-side shocks as well as demand-side pressures from the earlier expansion. More recently, in line with the slowing activity and retreating commodity prices, headline inflation has decelerated to 2.2 percent in June 2012, aided by the introduction of government subsidies for child care services.

6. Korea’s export sector is globally competitive and diversifying into new markets. Exports grew by around 25 percent in 2010–11, reflecting strong branding efforts by Korean firms, sustained investment in research and development (R&D), and a relatively favourable exchange rate. However, in line with the global slowdown, exports have also recently slowed. The Free Trade Agreements (FTAs) with the European Union and United States,1 which promote a high degree of trade liberalization and include the comprehensive liberalization of services and investment, should result in further enhanced two-way trade going forward.

A01ufig01

Korea’s Share in Global Export Markets

Citation: IMF Staff Country Reports 2012, 275; 10.5089/9781475510676.002.A001

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

7. Reflecting swings in global risk aversion, capital flows into Korea have been highly volatile. Following the August–September 2011 spike in risk aversion, Korea witnessed a surge in capital outflows of around US$15 billion (including outflows from European banks) in the third quarter. The authorities intervened to cushion the impact, leading to a decline of reserves by US$8 billion; however, the exchange rate still depreciated by about 10 percent. Resurgent risk appetite in the first quarter of 2012 led to a strong resumption of portfolio equity and fixed income inflows, which however reversed in the second quarter with the intensification of the euro area crisis.

8. Banking system soundness indicators remain strong. Domestic banks are well capitalized, with an average capital adequacy ratio of 14 percent at end-2011. Moreover, domestic banks have markedly enhanced their foreign currency liquidity positions since the global financial crisis (GFC). Their foreign currency liquidity ratio2 at end-April 2012 stood at 108 percent, above the guidance ratio of 85 percent. Also, the recently imposed regulatory ceiling on loan-to-deposit ratios (of 100 percent) has been met by all domestic commercial banks. As a result, the growth of bank lending to the household sector has been subdued in 2012. However, lending to households from non-bank financial institutions (NBFIs) has remained brisk. Preparations for Basel III are proceeding smoothly, and related rules and regulations are expected to be ready by end-2012.

9. Housing prices have peaked in Seoul but are rising in the rest of Korea. Following a protracted period of rising prices, housing prices in Seoul have remained weak due to a still large, albeit declining, inventory of unsold homes and limited expectation of price appreciation. The steady rise in housing prices outside Seoul (which have moderated recently) has been supported by contracting supply, a rapid increase in rents, and a rise in demand supported by strong non-bank lending. In response to the weakness in the Seoul housing market, the authorities have relaxed regulations in May 2012, including by raising loan-to-value (LTV) and debt-to-income (DTI) ratios applied to some high-house price districts.

A01ufig02

Apartment Prices Index

(jun. 2011 = 100)

Citation: IMF Staff Country Reports 2012, 275; 10.5089/9781475510676.002.A001

source: CEIC Data company Ltd.

B. Outlook and Risks—Managing External Downside Risks

Staff’s Views

10. Growth is expected to slowly recover in the latter part of 2012, with the negative output gap closing in 2013. Staff’s baseline projections suggest that the economy will bottom out in the second quarter of 2012 and slowly strengthen during the second half of 2012, with a small negative output gap projected for the year. Growth is expected to pick up more strongly in 2013 in line with the projected trajectory of global recovery, closing the output gap. On the domestic demand side, fixed investment is expected to recover in line with exports, as it is largely geared towards the tradable sector. At the same time, private consumption, supported by stronger wage growth and moderating oil prices, should gradually return to trend growth after being held back by the high level of household debt. Real GDP growth is projected at 3 percent in 2012 and around 4 percent in 2013.

11. Inflation, which has moderated recently, will likely pick up as the economy strengthens in 2013. Staff estimates suggest that in the absence of recent administrative measures, such as subsidies for child care, headline inflation would be higher by about ½ percentage point. With the dissipation of the favorable base effects underpinning the recent decline, inflation is projected to rise to around 2.8 percent, slightly below the BOK’s central inflation target, by the end of 2012. Some inflation risks remain, as reflected in elevated inflationary expectations (3.7 percent in June) and the possibility of an upward adjustment in utility tariffs.

12. Risks to the near-term outlook are tilted sharply to the downside primarily due to the fragilities in the global economy. The most immediate risk is still that delayed or insufficient policy action will further escalate the euro area crisis. As noted in the June 2012 World Economic Outlook Update, the situation in the euro area will likely remain precarious until all policy action needed for a resolution of the crisis has been taken. While the direct exposure to Europe is not high, if weaknesses in Europe spill over to the United States and China, the impact on Korea can be substantial. Although oil prices have recently declined along with global weakness, an oil price increase stemming from geopolitical concerns in the Middle East cannot be ruled out. Given that China is Korea’s largest trading partner, a more substantial slowing of China’s growth would have a considerable impact. The 2012 Spillover Report estimates that a 1 percentage point reduction in investment growth in China would lead to a 0.6 percentage point decline in Korea’s growth. Another tail risk arises from the longstanding uncertainty associated with North Korea (see the Risk Assessment Matrix).

13. Over the medium term, GDP growth is projected at 4 percent, below the pre-crisis average (of around 5 percent). This moderation reflects mainly rapid aging and declining working age population growth. The authorities are pursuing the rebalancing of the sources of growth toward domestic demand to ensure more sustainable and inclusive growth. This could lead to weaker potential growth as productivity in the non-tradable sector tends to be lower. Boosting service sector productivity will need sustained structural reforms, the gains from which will take time to materialize.

The Authorities’ Views

14. The authorities broadly agreed with the staff’s assessment of the near-term outlook. They also expected the economy to remain weak for most of the year due to elevated global uncertainties, and foresaw a gradual strengthening of the economy only in the latter part of the year. They expected the economy to grow at a moderate pace, led by domestic demand, with private consumption underpinned by continued job growth, wage increases, and lower oil prices. Investment is expected to maintain its relatively strong growth, despite weak exports, led by forward-looking, globally competitive, and cash-rich companies, which are positioning to garner market share. However, in view of a worsening global outlook, the Ministry of Strategy and Finance (MOSF) revised down its growth forecast in June to 3.3 percent for 2012 and 4.3 percent in 2013. More recently, with weaker-than-expected growth in the second quarter, in July, the BOK revised down its growth forecast to 3 percent in 2012 and 3.8 percent in 2013.

15. The authorities also expressed concerns about the elevated downside risks. In line with staff views, they considered the most pressing downside risk to be a further intensification of the euro area crisis. They argued that this could have a serious impact on Korea; in addition to the direct trade exposure to Europe, the indirect exposure via sizeable Chinese exports to the European Union rendered Korea vulnerable. They also viewed a possible increase in oil prices following from an escalation of geopolitical tensions as another risk.

Managing the Risks to Growth While Preserving Macroeconomic Soundness

The near-term challenge is to manage the risks to growth in an uncertain external environment. While continuing to pursue medium-term consolidation objectives, fiscal policy should support growth within the confines of the current budget. Monetary policy is accommodative and normalization should resume once the economy strengthens. The exchange rate should remain flexible with intervention limited to smoothing excessive volatility.

Background

16. The current macro policy mix combines an accommodative monetary policy and a broadly neutral fiscal stance. Somewhat weaker economic growth is likely to limit the ability to exceed the revenue forecast in the 2012 budget, as typically occurs. Therefore, the overall balance (excluding social security funds) is expected to record a deficit of about 0.9 percent of GDP, compared with the 2011 outturn of a 1.1 percent deficit. After putting the policy rate on hold for a year, the BOK reduced it by 25 bps in July 2012, in response to the weakening economic outlook, lower inflation, and elevated global uncertainty. Hence, monetary policy continues to be accommodative. During the global financial crisis, international reserves declined sharply and were subsequently rebuilt during 2009–11. Since the 2011 Article IV consultation, the exchange rate has moved freely and the real effective rate (REER) is estimated to be moderately undervalued (see Box 1).

Staff’s Views

17. For fiscal policy, the near-term challenge is to support growth while maintaining medium-term efforts to create fiscal space. Staff views the 2012 budget targets as appropriate under the baseline scenario and supports the government’s commitment to medium-term consolidation. The government’s effort to resist pressures for populist spending in the current political cycle is welcome and helps avoid introducing spending programs that could prove difficult to unwind and risk compromising consolidation plans going forward. Reflecting global weakness, the authorities responded by front-loading 60 percent of the spending to the first half of the year, even though this would imply a slight fiscal drag in the second half as they had expected the economy to strengthen by then. However, given that the economy is likely to remain weak for longer than anticipated, ensuring that the budget is fully implemented would be appropriate (in contrast to the typical experience of underspending by 3–5 percent). Staff also recognized that there was scope to provide some additional support through the temporary and cautious use of government-managed funds in selected areas. This should help reduce any near-term fiscal drag in 2012, while still preserving consolidation objectives.3

External Sector Assessment1

Staff assesses that the current account position is stronger than implied by medium-term fundamentals and appropriate policies (including in partner countries). Also, the Korean won is estimated to be moderately undervalued. This assessment is based on various empirical methodologies and broader considerations, which are outlined below.

Consultative Group on Exchange Rate Assessment (CGER): The CGER methodologies suggest that the exchange rate is moderately undervalued using an average of the three methodologies. These estimates are broadly in line with those suggested by the CGER during the 2011 Article IV consultation.

External Balance Assessment (EBA): The EBA is a new methodology that is being developed in the context of the Pilot External Sector Report, to build on the base of the CGER with some enhancements.2 It comprises three methods, based on its corresponding CGER predecessor. The real exchange rate method finds moderate undervaluation. The successor to the macrobalances approach is based on a current account (CA) regression that produces CA gaps, which include the sum of the estimated contributions of policy gaps and the regression residual. The estimates suggest that the CA is some 1 percent of GDP above that suggested by fundamentals and appropriate policies, reflecting in part the need for fiscal adjustment in major advanced economies and limited social protection in Korea.

A01bx01ufig01

Korea: Current Account Balance

(as a percent of GDP)

Citation: IMF Staff Country Reports 2012, 275; 10.5089/9781475510676.002.A001

Sources: CEIC Data Company Ltd.; IMF staff estimates.

Other considerations:

Behavior of the real exchange rate: The REER remains around 7 percent below its historical average and about 20 percent below the average level during 2005–08, a period of slower reserve accumulation. The REER has appreciated by around 13 percent since the fall of 2008, when it came under strong depreciation pressure.

Behavior of the current account: The current account has been on a downward path in recent years and is in moderate surplus (2.4 percent of GDP in 2011). It is projected to continue to narrow as domestic demand growth is projected to increase over the medium term.

A01bx01ufig02

Korea - Real Effective Exchange Rate and Reserves

Citation: IMF Staff Country Reports 2012, 275; 10.5089/9781475510676.002.A001

Sources: CEIC Data Company Ltd.; and IMF staff estimates.

International reserves and their adequacy: While the BOK has intervened after the global financial crisis, the resulting reserve accumulation was to rebuild reserves back to the pre-crisis trend. Current reserve levels remain in line with standard adequacy indicators. Using the most widely used metric for emerging market economies, reserves are 160 percent of short-term debt. The Fund’s composite reserve metric is constructed to reflect four possible drains on the balance of payments during periods of exchange market pressure, namely, short-term debt outflow, broad money loss, decline in exports, and other portfolio liabilities outflows. Korea’s FX reserves are around 130 percent of this combined metric, within the range of 100–150 percent, which is considered adequate. In light of this, there is no need for further reserve accumulation beyond what would be needed to keep pace with rising foreign liabilities over time.

1 Prepared by Sonali Jain-Chandra.2 The estimates of exchange rate and current account assessments are based on staff’s analysis in the Pilot External Sector Report and are thus preliminary.

18. There is a need to improve the monitoring of state-owned enterprises (SOEs) to guard against the risk of contingent liabilities. Aggregate debt of the seven largest SOEs increased to W 313 trillion (25 percent of GDP) at end-2011 from W 276 trillion (24 percent of GDP) a year before, with the Korea Land & Housing Corporation accounting for about 40 percent of the debt. The bulk of SOE debt is held by profitable and well-capitalized enterprises, and is used for the acquisition of fixed assets for investment purposes, rather than financing of current operations. It thus appears to raise limited concerns on debt sustainability so far, although given the large size of the debt, the authorities should monitor SOE finances closely. Moreover, administrative intervention in public utility pricing is worsening the finances of some SOEs, distorting efficiency and hampering their operations on a commercial basis. Preparing a comprehensive statement of fiscal risks to be included with budget documents (in line with recommendations of the 2001 fiscal ROSC) would improve the monitoring of contingent fiscal liabilities.

19. On the monetary policy side, rate hikes should resume when the economy strengthens and the negative output gap starts to close. Notwithstanding the recent decline in headline inflation, the monetary stance is still accommodative, as the policy rate remains below its historical average in real terms and inflation expectations continue to be elevated. The recent cut in the policy rate has eased the monetary stance further and hence, normalizing policy in a timely manner would also help rebuild policy space and enhance credibility. Under the staff’s baseline, a gradual normalization of the policy rate starting in the first half of 2013 would lead to inflation stabilizing at around 3 percent, in line with the current inflation target, at the end of the year.

A01ufig03

Real Policy Rate

(Percent)

Citation: IMF Staff Country Reports 2012, 275; 10.5089/9781475510676.002.A001

Sources: CEIC Data Company Ltd.; and IMf staff estimates.

20. In the event of a significant downside scenario, Korea has scope to respond, especially on the fiscal side. If the global economy were to deteriorate substantially with knock-on effects on the domestic economy, more support would be warranted from the fiscal side, given the ample fiscal space. In this scenario, support would have to go beyond automatic stabilizers and likely involve higher-than-budgeted discretionary spending, similar to what was done effectively in 2009.4 On the monetary policy side, in such a downside scenario, the BOK has room to cut rates further as it did in 2008–09.

21. International reserves are in line with the Fund’s standard indicative metrics. Using the Fund’s reserve adequacy metric, reserves are at 130 percent of the benchmark level, within the 100-150 range deemed adequate. Including the forward positions provides some additional comfort. Also, the authorities have augmented the reserves buffer by securing bilateral swap lines with Japan and China. Therefore, there is no need for further reserve accumulation beyond what would be needed to keep pace with rising foreign liabilities over time. In the event of an escalation in the euro area crisis, if financial contagion were severe enough to cause Korean banks to face difficulties in obtaining wholesale funding or to trigger large capital outflows, the authorities should stand ready to use their reserves to provide liquidity and maintain orderly market conditions.

22. The exchange rate is estimated to be moderately undervalued (see Box 1). In part, this could reflect the risk premium that investors attached to the Korean won in the current environment of heightened uncertainty in financial markets, given its past susceptibility to volatility spikes. Since the 2011 Article IV Consultation, when staff underscored the need for greater two-way flexibility, the exchange rate has moved flexibly in response to market conditions. Beyond the near term, as risk appetite recovers and capital inflows resume, and policy gaps (entailing faster fiscal consolidation in the rest of the world and increased social spending in Korea) start to close, the exchange rate is likely to be subject to appreciating pressure. In view of the overall competitiveness of the export sector and the already comfortable level of reserves, the exchange rate should continue to move flexibly in accordance with market conditions, with intervention limited to smoothing excessive volatility.

A01ufig04

Korea: Reserves and Forward Position

(In billions of U.S. dollars)

Citation: IMF Staff Country Reports 2012, 275; 10.5089/9781475510676.002.A001

Source: CEIC Data Company Ltd.

The Authorities’ Views

23. The authorities concurred with staff that the current conjuncture calls for moderate adjustment of macroeconomic policy rather than deploying a strong countercyclical response.

  • On fiscal policy, they expressed a strong commitment to their fiscal consolidation objectives, including the achievement of overall budget balance (excluding the Social Security Fund) in 2013. They recently announced that budgeted expenditures will be more fully executed compared to previous years given growth headwinds. To further support the economy in the second half of 2012, they have adopted a stimulus package of 0.3 percentage point consisting of increased spending by government-managed funds (W 2.3 trillion) and public investment through SOEs and public–private partnerships (W 1.7 trillion).

  • On monetary policy, the BOK cut the policy rate by 25 basis points in July 2012 after pausing for a year. The easing of policy is based on the assessment that economic weakness and a negative output gap is expected to persist for a considerable period. The recent decline in inflation and a benign inflation outlook, along with the boost to household incomes from lower debt service burdens, were also important considerations.

24. While agreeing with the overall assessment of the current account and the exchange rate, the authorities underscored that the exchange rate is freely determined in the market, with intervention limited to smoothing operations to counter any large fluctuations. They pointed out that the Korean won has appreciated 3 percent this year against the U.S. dollar, but noted that the exchange rate had been under downward pressure because of high global risk aversion. On reserves, they emphasized that recent changes in reserves were the result of interest income from investments or valuation effects, with intervention limited to smoothing operations. With regard to the forward positions, the authorities argued that they should not be included in foreign reserves as they comprise mostly swaps that were used to provide foreign currency liquidity to the domestic banks during the global financial crisis to alleviate the funding squeeze. They noted that the BOK had been unwinding the swaps as they matured, and that they are not liquid assets that can be called upon during a crisis. While welcoming the staff’s efforts to improve the analytical framework for external sector assessment, they viewed the EBA as a work-in-progress, which has inherited some of the limitations of the CGER (e.g., large margins of error and omission of key country-specific factors) while adding additional complications (e.g., endogeneity of policy variables and difficulties in calibrating policy norms).

25. The authorities shared staff concerns regarding SOEs, and are increasing efforts to improve their oversight and governance. Comprehensive data on the financial position of SOEs are reported on the MOSF website. Moreover, preliminary feasibility studies will be required for all large projects undertaken by SOEs, and the 41 largest SOEs will be required to submit five-year financial plans to parliament beginning in 2012. The authorities believe that these initiatives will further strengthen the monitoring of SOE finances.

Safeguarding Financial Stability

A stronger external position, combined with the use of macroprudential measures, has helped to increase the resilience of the financial system to external shocks. As a result, external vulnerability is markedly lower than it was during 2008. However, policy makers should remain vigilant as banks are still dependent on external wholesale funding and the equity and bond markets are highly exposed to volatile capital flows. In addition, there are domestic financial concerns, namely the high level of household indebtedness and the rapid increase in lending by nonbanks, which warrant close monitoring.

Background

26. Korean banks’ large external short-term debt and dependence on wholesale funding were key vulnerabilities prior to the global financial crisis. In the aftermath of the crisis, claims by Bank for International Settlements (BIS) reporting banks on Korea fell by more than US$70 billion. This constituted a sudden stop as banks were unable to rollover their short-term debt, prompting the BOK to provide about US$65 billion of reserves to cushion the liquidity squeeze on banks and the economy. Even so, the Korean won fell by 32 percent, from the pre-crisis peak to trough, while stock prices declined by 35 percent. The liquidity squeeze led to a slowdown in credit growth with adverse effects on the economy.5 To address these vulnerabilities and to boost the financial sector’s resilience to shocks, the authorities have strengthened their foreign reserves position and put in place an array of macroprudential measures (see Box 2).

27. The high level of household indebtedness and the rising share of lending by non-bank financial institutions (NBFIs) remain of serious concern. The household debt-to-disposable income ratio is high at 135 percent at end-2011, larger than in most OECD countries. Measures aimed at limiting household borrowing—including caps on LTV and DTI ratios—have led to a slowdown of household lending by banks. However, household lending by the less regulated non-bank sector has continued to expand at a rapid pace, with their share in household credit rising by roughly 5 percentage points since 2008, to 29 percent as of April 2012. Moreover, the growth in household lending is increasingly being driven by low-income borrowers with weaker credit scores. In addition, a large share of mortgage loans has floating rate and/or bullet structures, exacerbating potential interest rate and rollover risks.

A01ufig05

Household Debt to Disposable Income

(in percent, as of 2010)

Citation: IMF Staff Country Reports 2012, 275; 10.5089/9781475510676.002.A001

Sources: Canada: Statistics Canada; France: INSEE; Germany: Deutsche Bundesbank, Federal Statistical Office (Destatis); Italy: Banca d’Italia; Japan: Economic Planning Agency; United Kingdom: Office for National Statistics; United States: Federal Reserve; and Korea: CEIC Data Company Ltd.

Macroprudential Policies1

Initial conditions

The onset of the global financial crisis (GFC) revealed three key areas of financial risks in Korea that the authorities have sought to address via macroprudential measures. Firstly, Korean banks are vulnerable to FX funding risk. Prior to the GFC, domestic banks had grown increasingly dependent on short-term FX funding, both directly through external borrowing and indirectly through FX swaps with foreign bank branches. This dependence was driven in part by robust demand for hedging via FX forwards by the export sector—mostly ship-building companies—and by asset management companies, accounting for FX maturity mismatches on banks’ books and high FX liquidity risks. Secondly, household debt is very high by OECD standards at 69 percent of GDP and 135 percent of disposable income as of end-March 2012. Third, Korea has one of the largest and most open capital markets and is highly vulnerable to capital flow volatility from “risk on-risk off” dynamics in global markets.

The measures

The Korean authorities have introduced a broad mix of macroprudential measures in an effort to curb these risks to financial stability.

  • To curb excessive borrowing by households and limit housing price volatility, the authorities have followed a policy of periodic relaxation and tightening of loan-to-value (LTV) and debt-to-income (DTI) limits on bank mortgage lending. Since their inception in September 2002 and August 2005, LTVs and DTIs have been tightened six and five times respectively, and loosened three times, most recently in May 2012.

  • To reduce banks’ reliance on wholesale funding, other measures include a maximum loan-to-deposit ratio of 100 percent for domestic banks, expected to be enforced by end-2013.

  • To curb capital flow volatility and vulnerabilities related to potential capital flow reversals, the authorities have also re-introduced a withholding tax on foreign purchases of treasury and monetary stabilization bonds in January 2011 (in line with the tax on domestic residents), and a macroprudential stability levy on banks’ non-deposit FX liabilities in August 2011.2 The macroprudential stability levy is meant to curb excessive dependence on non-core FX funding by subjecting banks’ shorter-term (based on contract maturity) non-deposit liabilities to higher charges.3 It allows for a countercyclical macroprudential response, granting regulators discretion in adjusting the levy and imposing a surcharge of up to 50 basis points at times of high capital inflows.

  • To rein in the level of foreign currency lending, macroprudential measures introduced in July 2011 prohibit financial companies from obtaining kimchi bonds—foreign currency-denominated bonds issued in the local market—if the issuer intends to swap the proceeds into won. In addition, a measure introduced in September 2011 (to take effect at the beginning of 2012) would expand the taxation of interest income on kimchi bonds from domestic banks to foreign bank branches.

A01bx02ufig01

Housing Prices and GDP Growth

(In percent, yoy growth)

Citation: IMF Staff Country Reports 2012, 275; 10.5089/9781475510676.002.A001

Source: CEIC Data Company Ltd.

Effectiveness

The adopted measures have been reasonably effective in curbing banks’ reliance on short-term FX funding. Banks’ external funding profiles have improved considerably, particularly for foreign bank branches for which the short-term portion of total external debt declined steadily from more than 80 percent of total funding during the GFC peak to roughly 60 percent at end-2011. Overall, foreign banks no longer play a pivotal role in providing short-term FX funding to domestic banks. Their share in aggregate short-term FX funding decreased to 52 percent at end-2011 from 64 percent in 2009. More broadly, rollover risks for domestic banks have contracted as residual maturities of their external debt have increased. Now domestic banks meet comfortably the regulatory requirement of matching long-term FX lending with long-term FX borrowing, with the ratio of borrowing to lending at 162 percent as of end-March 2012.4 However, as the residual maturities of FX borrowings shorten, Korean banks may be subject to certain liquidity risks, raising the need for close monitoring. For example, the ratio of long-term FX borrowing (with residual maturity of over one year) to FX lending was down to 82 percent as of end- 2011 from 87 percent at end-2010.

The use of DTI and LTV ratios as tools for curbing excessive household leverage and housing price volatility have had mixed results. Both measures have been loosened and tightened periodically in the current cycle and appear to have helped dampen housing price volatility. However, household debt has continued to climb, and reached 135 percent of disposable income at end-2011 up from 122 percent at end-2007, driven mostly by rapidly expanding non-bank credit. While the growth of bank credit to households declined to less than 5 percent per year as of end-2011, non-bank credit has continued to expand briskly at 13 percent per year as of end-February 2012 well above GDP growth. Staff has previously cautioned against the tendency to use macroprudential policies to support housing prices when somewhat greater reliance on market-induced price corrections would help prevent excessive leverage.

The measures adopted to curb capital flow volatility also had a somewhat positive impact. The coefficient of variation of debt inflows has declined from roughly 2.5 percent in the 15 months before the introduction of a withholding tax to 1 percent in the 15 months afterwards.5 However, the effectiveness of this regulation may have been limited by the extensive use of double taxation treaties. A more detailed assessment of the effectiveness of these measures would require a longer time horizon, and will be carried out under the upcoming FSAP.

1 Prepared by Silvia Iorgova.2 The reinstated tax includes a 14 percent withholding tax, coupled with a 20 percent capital gains tax.3 The levy is set in the range of 2 to 20 basis points, based on the remaining maturity of non-core liabilities. Shorter-term non-core liabilities are subject to higher charges, with adjustments to the levy during periods of high capital inflows. In case of an acceleration of the net capital inflows, the authorities have discretion to impose a surcharge of up to 50 basis points based on the scale of the inflows. The overall levy cannot exceed 100 basis points, and the surcharge cannot be extended for more than six months.4 The ratio of long-term borrowing to long-term lending is a measure of liquidity risk as it measures the ability of banks to cover less liquid longer-term loans with debt that is not subject to high rollover risks. “Long-term” refers to maturity of over one year.5 The coefficient of variation is measured as the ratio of the standard deviation to average flows in a given time period.

28. The authorities have moved to decisively contain the problem in the Mutual Saving Bank (MSB) sector by restructuring insolvent MSBs. In particular, the authorities closed down 20 MSBs in 2011–12. However, the remaining MSBs are still exposed to the risk of defaults on project financing loans to the real estate sector (the delinquency rate was around 20 percent at the end of the first quarter of 2012). These defaults have led to the persistent deterioration of MSB balance sheets and prompted the need for higher loan-loss provisions. However, MSBs account for only 2 percent of financial system assets.

Staff’s Views

29. The external vulnerability of the Korean financial system has diminished considerably since 2008 due to the concerted efforts of the authorities. This reflects a reduction in banks’ short-term debt, the diversification of the foreign investor base in the government bond market to include regional central banks, the adoption of macroprudential measures designed to curb banks’ reliance on short-term and non-core FX funding, the strengthening of the banks’ foreign currency liquidity positions, and the buildup of higher foreign reserves. In particular, the banking system’s exposure to FX liquidity risks has decreased sharply since 2008. Because of these changes, Korea’s exchange rate volatility, which tended to surge during past crises, has become less sensitive to global risk factors.6 The reduced funding risk is also reflected in cross currency swap spreads which have remained relatively low and stable despite the recent increase in global risk aversion.

Indicators of External Vulnerability

article image

Short-term debt measured on a residual maturity basis.

Includes commercial and specialized banks.

Commercial banks only; including foreign currency loans and deposits.

30. Despite this progress, Korea is subject to substantial capital flow volatility given the large size and openness of its capital markets. Even though the banking system vulnerabilities have diminished since 2008, it is important to remain vigilant as Korea’s exposure to foreign banks on the funding side is among the highest in Asia (see Box 3). Looking ahead, the possibility of rollover difficulties resulting from an intensification of the euro area crisis cannot be ruled out. A potential deterioration of conditions in parent banks’ jurisdictions may create funding difficulties in foreign bank branches, which will need to be monitored closely.

The Impact of European Bank Deleveraging 1

Korean liabilities to foreign banks are sizeable, in absolute terms and compared with other countries in the region. The consolidated claims of foreign banks on Korea were around US$300 billion at end-March 2012, of which claims of euro area banks on Korea were only around US$38 billion, while claims of United States and United Kingdom banks stood at around US$95 billion each. These claims include both cross-border lending and credit extended by the local subsidiaries and branches of foreign banks. Compared with other countries in the region, Korea still relies heavily on foreign banks, along with Australia, Malaysia, and Taiwan Province of China. The Korean banking sector is reliant on wholesale funding, including from abroad, as around 25 percent of foreign claims outstanding is vis-à-vis the banks. Foreign credit is also extended directly to the Korean non-bank private sector to the tune of US$160 billion.

A01bx03ufig01

Korea: Stock of Consolidated Foreign Claims to Euro Area, UK, U.S., and Japan Banks

(USD, billions)

Citation: IMF Staff Country Reports 2012, 275; 10.5089/9781475510676.002.A001

Sources: Bank for International Settlements (BIS); and IMF staff calculations.

During the 2008 global financial crisis, the large exposures resulted in the Korean banking system facing a severe shock to external funding. Cross border claims on Korea fell by more than US$70 billion between 2008 Q2 and Q1 2009. This figure exceeds US$85 billion once local claims by foreign banks are factored in. This constituted a “sudden stop” as banks were unable to rollover their short-term debt, putting severe stress on the FX market, which was also transmitted to the equity market. Moreover, the bulk of this retrenchment was attributable to deleveraging by European banks, despite the fact that Europe was not the epicenter of the 2008 crisis. This demonstrates that when there is a large enough global shock, the retrenchment can be indiscriminate regardless of the source country. The intensification of the euro area crisis in August 2011 has led to further pullback by European banks, with claims on Korea falling by around 15 percent and 7 percent in the third and fourth quarter of 2011, respectively. The retrenchment was the sharpest by French banks, which reduced claims by half, followed by Italian and Spanish banks (though the amounts outstanding are much smaller than for French banks). This episode of deleveraging was not limited to European banks as non-European banks, including U.S. banks, also retrenched. However, other Asian banks, in particular Japanese banks, stepped in to fill the gap and increased their market share. The European Central Bank’s Long Term Refinancing Operations (LTRO) led to a temporary easing in funding strains and resulted in foreign banks (including European banks) re-leveraging in the first quarter of 2012.

A01bx03ufig02

Korea: Quarterly Change in Exchange Rate Adjusted Locational Cross Border Claims of BIS Reporting Banks

(USD, billions)

Citation: IMF Staff Country Reports 2012, 275; 10.5089/9781475510676.002.A001

Source: Bank for International Settlements (BIS).

Even barring a global financial shock, some deleveraging is likely to take place. Some deleveraging is structural in nature and is likely under the baseline as European banks strive to meet EBA capital requirements. Indeed, the April 2012 Global Financial Stability Report estimates that European banks could pare back their balance sheets by an additional 2 trillion euros, or 7 percent of total assets, by the end of 2013.

Korea now appears better prepared to handle such shocks relative to 2008, as a result of the higher reserves buffer and improved FX liquidity management. Also, macroprudential measures appear to have preemptively moderated the short-term debt of banks. However, Korea remains vulnerable to contagion from an escalation of the euro area crisis, as the outstanding claims of European (including United Kingdom) banks vis-à-vis Korea still remain sizeable. Furthermore, a worsening of the crisis and the accompanying deleveraging is unlikely to be confined to European banks and will likely spillover to other global banks as a result of financial market stress.

1 Prepared by Sonali Jain-Chandra.

31. The still high exposure of Korean banks to FX funding continues to be a key external vulnerability. Accordingly, the authorities have taken steps to mitigate risks arising from banks’ FX funding profiles, including the conduct of monthly stress tests on the foreign currency liquidity positions of domestic banks and regular reviews of maturity mismatches. The authorities need to be mindful of the liquidity risks deriving from the shortening in residual maturities of domestic banks’ foreign currency debt over time. For example, at end-2011, the ratio of long-term FX borrowing (with residual maturity of over one year) to FX lending at domestic banks declined to 82 percent from over 87 percent at end-2010.

32. On balance, macroprudential measures appear to have yielded positive results. These measures have curbed banks’ external funding vulnerabilities by limiting their short-term external debt and reducing foreign currency maturity mismatches. However, they appear to have been less effective in containing overall capital flow volatility. Given that many of these measures have been in place for only a short period of time, a more thorough analysis of their effectiveness will be undertaken during the upcoming Financial Sector Assessment Program (FSAP).

33. The establishment of a formal institutional set-up for the design and implementation of macroprudential policies would help ensure consistency of the measures and close loopholes. Further strengthening the macroprudential organizational framework could enhance existing coordination among responsible regulatory agencies—including the MOSF, the BOK, the Financial Services Commission (FSC) and the Financial Supervisory Service (FSS). It would clarify of roles and accountability for policy responses. This organizational issue is expected to be reviewed more comprehensively in the context of the forthcoming FSAP.

34. High household debt remains a source of vulnerability despite relatively stable housing prices, favorable net asset positions, and low loan-to-value ratios. The overall financial position of households remains strong, with net financial assets accounting for roughly 100 percent of GDP. However, the level of household debt remains very high, in part due to the authorities’ housing market policies which had engendered expectations of steady nominal house price appreciation. Moreover, a severe downturn in the economy or a sharp increase in interest rates, while not likely, could raise the household delinquency rate significantly and impair banks’ balance sheets. Overall, household debt remains exposed to interest rate and rollover risks, given the still high share of floating rate and bullet structures for mortgage loans. Moreover, the rapid expansion of lending to households by the NBFIs warrants close monitoring, particularly given their significant size. The authorities are gradually tightening asset classification and provisioning requirements for NBFIs to curb their lending to households and secure a soft landing for household debt, while being mindful of their weak provisioning capacity. The mutual savings banks, while not systemically important given their small size, are still experiencing weaknesses in their balance sheets and need to be closely monitored.

The Authorities’ Views

35. The authorities expressed confidence that FX liquidity risks are contained. They emphasized that banks’ short-term FX liquidity positions are sound, monitored on a daily basis, and have improved considerably since the GFC. In particular, the banks have sufficient foreign currency liquidity to withstand a shutdown of the funding market for three months. The authorities noted that, even though banks have sufficient capital buffers, they have imposed a regulatory limit on the ratio of long-term FX borrowing to long-term FX assets to prevent the potential risk of maturity mismatches in banks’ foreign currency balance sheets. They also indicated that the residual maturities of bank liabilities are already taken into account in the stress testing of domestic banks.

36. The authorities emphasized that they had established an institutional framework for management of foreign currency liquidity risks. They noted that the Foreign Exchange Market Stabilization Committee, established at the vice-ministerial level by the MOSF, BOK, FSC, and FSS in 2010, meets regularly to exchange information, analyze and discuss developments in financial markets, and agree on and coordinate policy responses.

37. The authorities concurred with the need for a soft landing of household debt. They indicated that the current level of household debt is high by international standards and needs to be curbed. They emphasized that they were strengthening micro-finance-based safety nets to provide protection for low-income borrowers before tightening enforcement of prudential regulations on NBFIs. In addition, they are encouraging banks to shift the structure of new housing loans to fixed interest rate installment payments in order to mitigate the interest rate and rollover risk.7 Overall, the authorities expressed a cautious view that a soft landing was in sight.

38. The authorities view the process of restructuring of the MSBs as completed. They suggested that most remaining MSBs are basically sound, with capital adequacy ratios exceeding 10 percent and that outstanding issues should be viewed as a social—rather than a financial stability—problem, given that these institutions largely served low-income customers.

Enhancing Inclusiveness and Sustainability

Korea faces two closely related challenges going forward. The first is to sustain economic growth against the backdrop of a rapidly aging population, and the second is to reduce income inequality. In this context, increased and well-designed social spending can foster more sustainable and inclusive growth, but it needs to be consistent with the envisaged medium-term fiscal consolidation plan. In particular, social spending should be raised gradually, and supported by strengthened revenue performance over the medium term.

Background

39. Going forward, Korea faces the challenge of a rapidly aging population. While currently one of the youngest countries in the Organization for Economic Co-operation and Development (OECD), Korea is projected to shift rapidly to the second oldest by mid-century, given its low fertility rate and gains in longevity. According to the OECD, the working age population is projected to peak in 2016 and then decline by a quarter by 2050. Although pressures will not show in the near term, age-related spending will begin to appear in the medium term and accelerate from 2020 with the rapid aging of the population.

40. Another challenge confronting Korea is addressing income inequality and economic polarization. Despite stabilizing in recent years, during 2002–09, income inequality rose to the average OECD level, in part reflecting labor market dualism between regular and non-regular workers. The cost of employment protection for regular workers is a key factor why companies have been shifting most new jobs to non-regular workers. As a result, the share of non-regular workers is significantly higher than the OECD average, and they are paid about 40 percent less, although some of this difference can be attributed to factors such as gender, education or experience. Low labor productivity in the service sector also reinforces income inequality and acts as a drag on potential growth.

Staff’s Views

41. Social spending remains below desired levels and should be raised gradually over time while preserving medium-term fiscal consolidation objectives. Compared with other OECD countries, Korea has the second-lowest level of public social spending. Even after controlling for Korea’s lower income level, currently younger population, and low unemployment rate, staff estimates point to a gap of about 3½ percent of GDP between Korea and OECD peers (see Box 4).

42. A sustainable increase in social spending requires greater attention to a longer-term fiscal framework, which is under development. Korea’s public debt-to-GDP ratio is currently very favorable. However, the rapid pace of population aging, the trajectory of current public entitlements, and the relatively low tax revenue-to-GDP ratio (reflecting both narrow bases and low rates) imply that efforts will be needed to maintain long-term fiscal sustainability. Potential contingency costs of reunification further limit the long-term fiscal space. Meeting all of these objectives will likely require strengthening revenue performance over the medium term, mainly by reducing tax expenditures and broadening the tax base. If that is not sufficient, it may be necessary to increase tax rates in some areas. There may also be some scope for expenditure reprioritization. In this light, there is a need to integrate long-term issues more systematically into the fiscal policy framework.

Social Spending and Inclusive Growth 1

Looking ahead, Korea faces two intertwined fundamental challenges: sustaining economic growth in the face of the most rapid population ageing in the OECD area, and ameliorating the effects of income inequality. Regarding the former, according to the OECD (2012), Korea’s estimated potential growth decreased from 7 percent in 1995 to 4 percent in 2010. The latter challenge relates to the fact that, despite Korea’s relatively high real GDP growth rates, income inequality had been trending upward over the last decade, indicating deteriorating socio-economic conditions. More recently, however, there are indications of some improvement in these trends. Moreover, after spiking in the late 1990s, the unemployment rate in Korea has come back down, and remains at a low level, in contrast to many other advanced economies. Nevertheless, the slowdown in economic growth, the relatively high share of lower paid non-regular workers, and holes in the social safety net (especially for the elderly), among other factors, have resulted in political pressure to increase social spending.

Social spending can foster more sustainable and inclusive growth in Korea. In most general terms, social spending is related to a broad range of social welfare programs pertaining to healthcare, education, and social safety nets. Specific social spending policies can nurture growth in several dimensions. For example, given low investment in pre-primary care in Korea, expanding early childhood education and childcare programs would not only lay the foundation for future productivity gains, but would also encourage greater female labor market participation. In addition, expanded vocational training would enhance the skill sets of non-regular workers (predominantly in the lower-productivity services sector) and facilitate their transition to regular status. Lower worker turnover, combined with increased firm-based training would raise productivity over the medium term. Therefore, a combination of targeted social spending policies would not only reduce income inequality and improve the welfare of lower-income groups, it would also boost potential growth over the longer term by raising productivity and labor force participation rates (especially by females).

A01bx04ufig01

Korea: Unemployment and Relative Poverty Rates

(In percent)

Citation: IMF Staff Country Reports 2012, 275; 10.5089/9781475510676.002.A001

Source: OECD.

Increases in social spending would need to fit within the confines of the envisaged fiscal consolidation plan, and will require strengthened revenue performance over the medium term. Despite tripling its share of GDP since 1990 to 7.6 percent in 2007, social spending in Korea is still low relative to the OECD average of 19 percent, implying a sizeable gap. However, among OECD economies, Korea has one of the lowest unemployment rates, below-average per capita income, and currently has a younger population. When these characteristics are taken into consideration, regression analysis suggests that the social spending gap between Korea and its OECD peers narrows to about 3.5 percent of GDP. Nonetheless, the medium-term fiscal consolidation plans will limit available resources to fund major expansions in social spending programs. While there may be room for expenditure reallocation, increased social spending will likely need to be accompanied by broadening the tax base and improving revenue collection over the medium term.

1 Prepared by Selim Elekdag.

43. Labor market reform should continue to be given priority to boost potential growth and ameliorate income inequality. To support potential growth in the face of declining labor inputs resulting from the impending decline in the working age population, higher participation rates of women, the youth and the elderly will be needed. The participation rate for women, which is lower than the OECD average, should be boosted by reforms that focus on enhancing labor market flexibility and creating a more enabling environment. As part of the authorities’ commitments under the G20 Mutual Assessment Process (MAP), legislation was revised in 2011 to allow parents with young children to request shorter working hours and a bill was introduced to promote the employment of part-time workers and encourage flextime. Reforms to address the duality in the labor market between regular and non-regular workers, which partly contributes to income inequality, should also be continued. Reducing labor market duality would entail relaxing employment protection for regular workers, to reduce the incentives for firms to hire non-regular workers. The government announced initiatives to strengthen the social safety net (for example, by subsidizing SME contributions to social insurance systems to encourage greater coverage of non-regular workers) and improve employment conditions for non-regular workers.

A01ufig06

Female Labor Force Participation Rates

(In percent, females between ages 25-54)

Citation: IMF Staff Country Reports 2012, 275; 10.5089/9781475510676.002.A001

Source: OECD.

44. Efforts towards continued reform in the service sector are also key to lifting potential growth. To enhance service sector productivity, efforts could continue to focus on: (i) enhancing competition in the legal, accounting, education and health sectors by lowering the barriers to entry; (ii) continuing the restructuring of SMEs, most of which are in the services sector; (iii) expanding industry training programs for workers and self-employed; (iv) providing R&D and other services to the SMEs; and (v) leveling the playing field between the tradable and non-tradable sectors (which is still biased towards the former) in terms of tax incentives and other supporting policies. Deregulation measures being implemented under the FTAs with the European Union and the United States should also lead to increased competition and thereby help support service sector productivity.

The Authorities’ Views

45. The authorities agreed that social spending should be increased gradually over the medium term in line with the rising demand for social services. Indeed, the 2012 budget envisages a 20 percent nominal increase in social welfare spending. They stated that social welfare programs should be well targeted and tailored to the differentiated needs of the recipients, and designed to incentivize work (for example, by focusing on the expansion of the earned-income tax credits). The Direction for the Preparation of the 2013 Budget, which was recently approved, also maintains workfare and sustainable growth as core themes.

46. The authorities also concurred with the need to enhance revenues over the medium term to finance increased social spending. They stressed that their priority was to increase revenues by continuing to broaden the tax base, building on the revenue agencies’ track record of capturing more of the informal economy. They expected a government plan on tax reform to be published in August, which would aim to further increase the coverage of the informal economy and rationalize tax exemptions.

47. The authorities have been closely tracking their medium-term fiscal plans. The government’s National Fiscal Management Plan for 2011–15 also lays out several areas to increase revenues. Moreover, plans for a longer-term fiscal framework covering the years up to 2060 are underway.

Staff Appraisal

48. The Korean economy is slowing in line with global economic developments. Reflecting weakness in global economic prospects, the economy is expected to continue experiencing moderate growth with a small negative output gap projected to remain for the rest of 2012. Staff projects GDP growth for 2012 at 3 percent and around 4 percent for 2013 in line with the expected recovery in the global economy. Declining growth, moderating commodity prices, and government subsidies have led to falling inflation, with headline inflation projected at slightly below 3 percent, the BOK’s inflation target.

49. The current macro policy mix combines an accommodative monetary policy and a broadly neutral fiscal stance. Staff supports the government’s intention to consolidate the fiscal position to restore policy space and prepare for the challenges of the future. The front-loading of budget spending in 2012 to support the weak economy in the first half of the year was an appropriate response to global developments. In addition, the government’s determination to resist populist spending in this dual election year is also welcome, avoiding spending programs that could compromise consolidation plans going forward. In response to weaker-than-expected growth in the second half of the year, plans to ensure that the budget is more fully implemented are welcome. While government-managed funds can provide some additional support, their use should be limited and temporary with a view to maintaining fiscal transparency. Monetary policy continues to be accommodative, particularly with the recent cut in the policy rate, but a normalization of policy will be needed in 2013 if the economy strengthens. For now, maintaining the currently accommodative monetary policy stance is appropriate given global weakness and heightened uncertainties.

50. Near-term risks to the baseline are sharply tilted to the downside, with the main risk being a further intensification of the euro area crisis. In the event of the materialization of a severe downside scenario, Korea has sufficient policy space to respond, especially on the fiscal side. In such a scenario, consideration should be given for additional discretionary spending beyond the current approved budget. If financial contagion were so severe as to cause difficulties for Korean banks in obtaining wholesale funding or to trigger large capital outflows, the authorities should stand ready to use their ample foreign reserves to provide FX liquidity and maintain orderly market conditions.

51. The external vulnerability of the Korean financial system has diminished considerably since 2008 due to the concerted efforts of the authorities. A series of macroprudential measures have been adopted, and external buffers have also been strengthened, in the form of higher foreign reserves and bilateral swap lines. Another welcome development is the diversification of the foreign investor base in the government bond market to include regional central banks.

52. Despite this progress, Korea is subject to capital flow volatility and therefore needs to remain vigilant. A key external vulnerability in the past was the high exposure of Korean banks to rollover risk from their dependence on wholesale funding. A potential intensification of the euro area crisis could lead to funding difficulties. Therefore, the conduct of monthly stress tests on the foreign currency liquidity positions of domestic banks to ensure that they have sufficient funding for three months is an important exercise. Moreover, the vulnerability of foreign bank branches resulting from their reliance on parent funding will need to be monitored closely. In this context, staff welcomes the establishment of the inter-agency Foreign Exchange Market Stabilization Committee and its efforts in monitoring and responding to market developments.

53. On the domestic side, the high level of household debt and rapid expansion of non-bank credit to vulnerable households are key concerns. It is important that the authorities follow through with the plan for a “soft landing” of household debt, including by strengthening of asset classification and provisioning rules for NBFIs, and increasing the share of fixed-rate installment mortgages. The weaknesses in the mutual savings banks have been alleviated by the authorities’ move to restructure the insolvent MSBs. However, there are weaknesses remaining in the balance sheets that warrant close monitoring.

54. International reserves have increased to a comfortable level and the exchange rate is estimated to be moderately undervalued. Reserves are in line with reserve adequacy indicators, and the authorities have augmented the external buffer by securing bilateral swap lines. Therefore, there is no need for further reserve accumulation beyond what would be needed to keep pace with rising external liabilities over time. Given the strong competitiveness of its export sector, the exchange rate should continue to move flexibly, with intervention limited to smoothing excessive volatility.

55. Staff supports the authorities’ long-established and continued commitment to fiscal prudence. This provides a good starting point for addressing a number of fiscal challenges in the future including a need for higher social spending, as well as the large medium- to long-term budgetary implications of an aging population (including pension liabilities). Staff welcomes the authorities’ plan to raise social spending over time, and recommends that this be carried out while maintaining the overall fiscal consolidation path. While there may be scope for expenditure reprioritization in some areas, this will likely require strengthening revenue performance over the medium term, mainly by base broadening, although adjusting tax rates in some areas may be necessary. A sustainable increase in social spending and rapid population aging requires greater attention to a longer-term fiscal framework, which is under development. The rising debt levels of SOEs warrant careful monitoring, and efforts should be made to increase their commercial orientation, including by refraining from administrative intervention in public utility pricing.

56. Labor market reform and enhancing service sector productivity should continue to be given priority to boost potential growth and ameliorate income inequality. Staff welcomes steps in this direction and encourages greater efforts to secure more sustainable and inclusive growth. Higher participation rates will support potential growth, and reforms that focus on enhancing labor market flexibility and creating a more enabling environment for female participation will also help. Boosting service sector productivity will require a multi-pronged approach, focusing on enhancing competition by deregulation, continuing with SME restructuring and moving towards a more level playing field for the tradable and non-tradable sectors.

57. It is recommended that the next Article IV Consultation takes place on the standard 12-month cycle.

Figure 1.
Figure 1.

The Real Economy

Citation: IMF Staff Country Reports 2012, 275; 10.5089/9781475510676.002.A001

Figure 2.
Figure 2.

The Banking System

Citation: IMF Staff Country Reports 2012, 275; 10.5089/9781475510676.002.A001

Figure 3.
Figure 3.

Financial Markets

Citation: IMF Staff Country Reports 2012, 275; 10.5089/9781475510676.002.A001

Table 1.

Korea: Selected Economic Indicators, 2008–13

Nominal GDP (2011): $1,116 billion

Main exports (percent of total, 2011): Vessel (10), Petroleum products(9), Semi-conductor (9), Automobile (7), LCD device (5)

GDP per capita (2011): $21,728

Central government debt (2011): 32.6 percent of GDP

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

Contribution to GDP growth.

Data for 2012 are as of July 26, 2012.

Data for 2012 are as of May.

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

Data for 2012 are as of May.

Table 2.

Korea: Balance of Payments, 2008–14

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

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

Includes financial derivatives, net.

Table 3.1.

Korea: Statement of Central Government Operations, 2008–14

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Sources: Ministry of Strategy and Finance; and IMF staff estimates and projections.
Table 3.2.

Korea: Integrated Balance Sheet - Consolidated General Government, 2008–11

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Source: Haver Analytics.
Table 4.

Korea: Medium-Term Projections, 2011–17

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

Contribution to GDP growth.

Customs clearance basis.

Includes 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.

Table 5.

Korea: Financial Soundness Indicators, 2005–11

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

Includes commercial and specialized banks.

Includes commercial banks only.

Includes non-financial corporations.

Operating income to gross interest payments.

Over one month.

Table 6.

Korea: Indicators of Financial and External Vulnerability, 2007–12

(In percent of GDP, unless otherwise indicated)

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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.

Values for the trading day in each year corresponding to the reference date in the right most column.