Republic of Korea: Staff Report for the 2013 Article IV Consultation

This 2013 Article IV Consultation highlights that the Republic of Korea has experienced impressive growth since the 1970s, enabling it to escape the middle-income trap. Policies should aim to tackle the weakness of domestic demand and counter forthcoming headwinds to potential growth. Korea is reaping the benefits of prudent macroeconomic management and financial moderation. The economy faces significant medium-term growth and inclusiveness challenges. Slow household income growth hinders stabilization in household debt and weighs on domestic demand, while services sector productivity is very low.


This 2013 Article IV Consultation highlights that the Republic of Korea has experienced impressive growth since the 1970s, enabling it to escape the middle-income trap. Policies should aim to tackle the weakness of domestic demand and counter forthcoming headwinds to potential growth. Korea is reaping the benefits of prudent macroeconomic management and financial moderation. The economy faces significant medium-term growth and inclusiveness challenges. Slow household income growth hinders stabilization in household debt and weighs on domestic demand, while services sector productivity is very low.


1. Korea is reaping the benefits of prudent macroeconomic management and financial moderation. It was affected relatively mildly by the recent global market turmoil, being even dubbed a safe haven: after some short-lived turmoil, bond yields rose only modestly and the exchange rate appreciated (Box 1). This reflected both strong macroeconomic fundamentals and an absence of strong financial tailwinds prior to the turmoil phase, partly due to active macroprudential regulation.


Changes in exchange rate and stock market index

(Percentage change between May 22 and August 30, 2013)

Citation: IMF Staff Country Reports 2014, 101; 10.5089/9781484355619.002.A001

Source: IMF APD Database.

2. However, the economy faces significant medium-term growth and inclusiveness challenges. Slow household income growth hinders stabilization in household debt and weighs on domestic demand, while services sector productivity is very low. These features hamper rebalancing of the economy towards more inclusive and domestically-driven growth, less sensitive to the vagaries of global demand. Separately, absent reforms, rapid population aging will be a drag on growth potential that could stall income convergence with the most advanced economies.

3. To address these challenges, ambitious reforms are needed, as elaborated in the remainder of this report. After discussing the near term macroeconomic context and policies, the report discusses policies to lift domestic demand—by shifting resources away from the prosperous export-oriented corporate sector to households—and to boost potential growth. It then examines in greater depth how to make the fiscal framework and financial sector policies more growth-friendly. As shown in Figure 1, the policies under each heading are mutually reinforcing. Exchange rate appreciation would further help the necessary rebalancing.

Figure 1.
Figure 1.

Korea’s Medium-Term Economic Policy Challenges and Remedies

Citation: IMF Staff Country Reports 2014, 101; 10.5089/9781484355619.002.A001

The Macroeconomic and Financial Context

A. Current Situation

4. After moderating sharply in 2012, GDP growth appears to have bottomed. Facing strong headwinds from the global economy, GDP growth slowed to 2 percent in 2012. Export growth stalled to a mere 0.4 percent, while fixed investment, strongly related to exports, contracted by 1.7 percent. Held back by high household debt, private consumption growth remained tepid. However, activity has bottomed and the economy expanded by 1.1 percent in Q2 and Q3 2013, with exports rebounding strongly and private consumption and construction strengthening, due in part to low base, but also to a pickup in wage growth and policies to reinvigorate the housing market.

5. Inflation has been subdued, due to the absence of demand pressures and moderating commodity prices. Inflation fell from 4.2 percent in 2011 to 1.4 percent in 2012 (end of period), well below the target band of 2½–3½ percent, as the economy weakened and food prices fell. In addition, government subsidies for child care and education costs reduced inflation by around 0.4 percentage point. As a result, headline inflation remained in the 1–1½ percent range during the first half of 2013, falling to 0.7 percent in October, while core inflation was muted, though stable, at around 1½ percent during 2013.

Is Korea A Safer-Haven?1

To assess prospects for the continuation of Korea’s newly-acquired safe haven status, staff estimated a model of capital flows in the presence of unconventional monetary policy (UMP), and including both push and pull factors:1

Key findings:

  • QE operations or announcements were found to have had generally little or no direct influence on capital flows to Korea. The only significant exception was cross-border banking capital flows.

  • While the indirect effects of QE, through financial prices, seem to be significant, impulse responses indicate the existence of an important nonlinear behavior. In particular, bond inflows demonstrate a “safe-haven” behavior (i.e., flows increase with higher VIX), until the risk aversion has reached certain threshold levels. The threshold, which is time-varying, and is now about 40 (about one standard deviation above the median of VIX during the sample period). Bond flows start to decrease with higher VIX, when VIX rises beyond this threshold.

  • Overall, the indirect effects point to a largely positive impact of QE on capital flows through the alleviation of risk aversion (captured by VIX) and global dollar liquidity stress (represented by the LIBOR-OIS spread).


  • A growth-driven smooth QE exit, which leaves long-term U.S. rates anchored and does not hurt U.S. investor confidence, is unlikely to cause capital outflows from Korea, and could even cause inflows to Korean equity and bank debt through positive signaling effects associated with an orderly steepening of the yield curve.

  • However, a disorderly QE exit, that pushes up the VIX and/or the LIBOR- OIS spread would likely cause capital outflows. The negative effects would likely be exacerbated, particularly for bond flows, if the unwinding of bond positions causes dislocation of the onshore dollar funding market. For equities, the impact would be unambiguously negative. But for bonds, the impact of a spike in the VIX could be positive so long as it stays within about one standard deviation from the historical median.

1 The model is estimated as yth=ah+b1hxth+b2hzth+b2h*UMPt+uth, for t=1, …, T (yth: capital flows of type h, from an array comprising portfolio bond, portfolio equity, and bank flows, Xtth:m×1 vector of push factors, Zth:n×1 vector of pull factors, UMPt: n×1 vector of UMP proxy variables). The regression uses weekly data (from January 2008 to June 2013) compiled by the Korea Exchange as the dependent variable for portfolio (equity and bonds) flows. For banking flows, monthly balance of payment data are used. For proxies of UMP, the regression uses the weekly change in the balance sheet of the U.S. Federal Reserve of the amount outstanding of unconventional operational measures. An event dummy variable is also included to capture the impact of QE announcements. For QQME, the BOJ’s monthly balance sheet data are used. A standard set of independent variables, mainly financial market indicators, are used as control variables.

6. Korea’s high interconnectedness exposes it to external shocks. Korea’s trade openness is about twice as high as the OECD average (54 percent of GDP), with main exposures to China, the U.S., the E.U. and Japan and significant value chain links with these and other Asian countries. Financial ties are primarily with the U.S. and U.K. For instance, foreign bank claims on Korea are large and are mostly held by U.K. and U.S. banks, while exposure to euro area banks is relatively limited. Foreign holdings of portfolio capital amount to 40 percent of GDP.


Korean Exports by Partner

(In percent of GDP, 2012)

Citation: IMF Staff Country Reports 2014, 101; 10.5089/9781484355619.002.A001

Sources: OECD; and IMF staff estimates.

7. The current account surplus has widened to a record high, while capital flows remain moderate. Despite fears related to the depreciation of the yen against the won, exports have rebounded in October by 7 percent, after growing 2–2½ percent for most of 2013, reflecting the strong competitiveness of Korea’s world-class electronics, at the same time as much weaker imports. As a result, the current account (CA) surplus is projected to widen to around 5½ percent of GDP in 2013. In the first half of 2013, steady bond inflows were offset by equity outflows. However, the U.S. Federal Reserve’s decision in August to delay QE tapering prompted a sustained pickup in equity inflows. Meanwhile, banks have been repaying external loans and Korean corporates continued to invest overseas, resulting in overall negative net capital flows—not large enough, however, to offset the current account surplus. Thus, the exchange rate has been under upward pressure.



(In billions of U.S. Dollars)

Citation: IMF Staff Country Reports 2014, 101; 10.5089/9781484355619.002.A001

Sources: CEIC Data Company; and IMF staff estimates.

Korea EMPI

Citation: IMF Staff Country Reports 2014, 101; 10.5089/9781484355619.002.A001

Sources: APD Core Database; and IMF estimates.

8. The external sector position is substantially stronger than implied by medium-term fundamentals and desirable policies and external imbalances have widened. The 2013 External Sector Report (ESR) assessed Korea’s 2012 CA balance to be 1–4 percent of GDP above the level implied by fundamentals and desirable policies (“norm”). Refinements in the staff estimate of the norm (in particular updated estimate of the social spending norm) and actual developments have contributed to an updated EBA estimate of a CA gap of around 4 percent reflecting in part fiscal policies in the rest of the world1. Given that Korea’s terms of trade changes may not be fully captured in the exercise, staff assesses that the CA is now around 3–4 percent above the norm. An updated EBA estimate for Korea finds that the REER is 8 percent below equilibrium, relative to 11 percent in the June 2013 EBA. While the exchange rate has appreciated recently, updates to the social spending norm have led to a higher norm, indicating continued undervaluation. Staff therefore continues to assess that the exchange rate remains moderately undervalued in the range of 2–8 percent, with the upper end of the range seeming more plausible in light of the recent widening of the current account surplus.2 Also the lower end of the range is derived as the deviation from historical average, which is not necessarily a valid equilibrium benchmark. Reserves rose to US$343 billion in October 2013 (US$ 16 billion above end-2012), broadly unchanged at 130 percent of the IMF’s adequacy metric. The BOK’s forward position has risen by US$ 7 billion since end-2012, which may have further mitigated appreciation pressures (see Box 1). Korea’s international investment position is modest at around -9 percent of GDP, and has been improving in line with CA surpluses.

9. As noted in the Financial System Stability Assessment, Korea’s financial system is sound though household and corporate debt levels are high. Domestic banks are well capitalized, with an average capital adequacy ratio of 14.3 percent during Q3 2013, and have markedly enhanced their foreign currency liquidity positions since the global financial crisis. Depository institutions’ lending growth to the household sector has continued to decline, increasing by 3.2 percent annually as of end-June 2013, down from a double-digit peak prior to the crisis. However, lending by non-depository institutions continues to be brisk, up 13 percent annually over the same period. Overall, household and corporate debt levels (based on OECD data, which includes private and state-owned enterprises) reached 76 percent and 164 percent of GDP as of end-2012, respectively.

10. Housing prices in Seoul continue to decline, but have leveled off in the rest of Korea. These developments reflect a large inventory of unsold homes and limited expectations of price appreciation. The authorities introduced various temporary measures—including tax breaks—to revive housing transactions, but volumes have remained low after a spike in mid-2013, when these measures expired.


Korea: Apartment Price and Rent (Jeonse) Indices (Jan 2011=100)

Citation: IMF Staff Country Reports 2014, 101; 10.5089/9781484355619.002.A001

Source: CEIC.

B. Outlook and Risks

Staff Views

11. The economy appears set for a modest recovery while inflation is expected to remain muted. Real GDP growth is projected to reach 2.8 percent in 2013 and strengthen further to 3.7 percent in 2014. In 2014, domestic demand is expected to strengthen as consumption and investment recover supported by higher wages and stronger exports respectively, as well as a bounce back from the low base. In line with the authorities, staff expects a negative output gap to persist in 2014, with inflation returning to the target band only in late 2014, assuming that the one-off effect of government subsidies on inflation disappears.

12. Risks to the near-term outlook are to the downside. The main risks to the short-term outlook are external given Korea’s openness to global trade and finance. The key ones include a disorderly exit from quantitative easing in the U.S., re-emergence of financial stress in the euro area, and deeper-than-expected slowdown in emerging markets, especially China (see Appendix 1). While Korea is unlikely to be much affected by mild turmoil from U.S. monetary policy normalization, more severe turmoil would have considerable knock-on effects.3 The main near-term domestic risk is protracted sluggish demand reflecting notably high household and corporate debt and uncertainty about the outlook and policies4, which will weigh on both consumption and investment. In the longer run, weak household income growth, deleveraging needs, and conservative fiscal plans mean that demand is likely to remain highly dependent on net exports. On the supply side, the structural reforms implemented may be insufficient to stem the further fall in growth potential implied by rapid population aging.

Authorities’ Views

13. The authorities’ broadly concurred with staff on the near-term outlook and risks. They expect that growth will rise back to potential in 2014 (3.9 percent) as a result of the more favorable world economic outlook, lagged effect of the stimulative policies of 2013, and reduced uncertainty as the government enters the second year of its term. They viewed possible disruptive QE tapering as the key external risk. While they agreed that Korea has become more resilient to external shocks, they noted that its “safer haven” status still has to be tested.

C. Near-Term Policies

Staff Views

14. A supplementary budget rendered the 2013 fiscal stance slightly expansionary and the 2014 budget proposal, if approved, would be less expansionary than the 2013 budget. The supplementary budget of 1¼ percent of GDP was adopted in May to authorize borrowing to make up for a large revenue shortfall and finance a spending increase of around ½ percent of GDP. The government also postponed to 2017 the deadline for broadly restoring balance. The proposed 2014 budget keeps the overall deficit unchanged from the 2013 supplementary budget (at 1.8 in percent of GDP). However, revenues have slipped further, likely leading to a larger-than-budgeted deficit (2.1 percent of GDP) in 2013. Thus, without a supplementary budget, the 2014 budget would entail a slight withdrawal of fiscal impulse, and automatic spending cuts on top if there are further revenue short falls. This could unhelpfully dampen the recovery.

15. The current accommodative monetary policy stance is appropriate and provides significant space for countercyclical use in both directions. The Bank of Korea cut its policy rate to 2.5 percent in May 2013, amid the uncertain global outlook, the continued negative output gap, and subdued inflation. However, looking ahead, growth is expected to strengthen over the next 6 quarters, and the previous loosening still has to fully work through the economy, suggesting little need for further cuts. This will also avoid fueling further household indebtedness. With inflationary pressures muted, monetary policy normalization should start only when the recovery is firmly established and there is confidence that the output gap will close soon.

16. Exchange rate policy has entailed active intervention at times, in both directions, but asymmetrically. Staff analysis, based on estimates of the rise in reserves unexplained by interest income and spikes in the FX forward positions around periods of appreciation, suggests that intervention has tended to be more active in the face of appreciation (Box 2). The won should continue to be market determined, and intervention (either in spot or forward markets) limited to smoothing excessive volatility in the event of disorderly market conditions and not to influence the pace of appreciation toward the equilibrium level. Reserves are adequate and there is no need for further accumulation relative to the range of metrics. Any additional accumulation should be carried out by the BOK rather than by increasing government borrowing. Over the medium term, greater exchange rate appreciation would encourage reallocation of resources to the non-tradables sector, thereby further supporting rebalancing.

17. Korea has strong buffers and should use its ample policy space to deal with large shocks. In the event of a sharp external downside scenario, it can deploy supportive monetary and fiscal policies. In addition, in case of sharp capital outflows, it can use its large foreign exchange reserves buffer, allow exchange rate depreciation—the authorities appropriately used both responses in the aftermath of May 22 and could do the same as needed—and deploy crisis response tools used in 2008 such as the BOK’s foreign exchange swap with domestic banks, and even government guarantee on banks’ short-term external debt. If the domestic risk of the vicious cycle between weak domestic demand, tepid household income and high household indebtedness materializes and leads to sub-potential growth, the authorities could deploy supportive fiscal policy, as well as monetary loosening, and accelerate structural reforms.

Authorities’ Views

18. The main near-term policy challenge, in the authorities’ view, is to support the recovery while moving to a medium-term fiscal consolidation path. On the one hand, they aim to continue supporting the recovery in the near term, including by proposing the same deficit in the 2014 budget as in 2013 budget. On the other hand, the government intends to resume fiscal consolidation over the medium term, citing the need for fiscal prudence and their expectation that private demand will revive next year, allowing for gradual withdrawal of fiscal impulse.

19. The authorities viewed the current monetary policy stance as accommodative, and argued that the won is in line with fundamentals. Given the level of the policy rate, they viewed the room to cut more limited than in large open or closed economies, given Korea’s exposure to capital flows volatility. They did not view high household debt as a significant constraint on monetary policy for now, in either direction. They disagreed with staff’s assessment that the won is moderately undervalued, noting its appreciation since 2012. They stressed that smoothing operations are restricted to alleviating excessive exchange rate volatility in the face of market herding.

Tackling the Weakness of Domestic Demand

For a sustained and inclusive recovery, policies need to break the nexus among weak household income generation, suppressed domestic demand, and high indebtedness. This entails redirecting savings from the corporate sector and government to boost households’ incomes, as well as labor market reforms.

Exchange Rate Intervention1

The marked rise in FX reserves since the onset of the crisis, and spikes in the BOK FX forward position and FX market flows are indicative of asymmetric intervention to slow the pace of appreciation.

  • While subject to uncertainty, estimates of the degree of intervention—approximated by the change in FX reserves not attributable to FX valuation changes or interest income gains/losses—suggest considerable intervention activity. Most frequently, interventions appear to involve dollar purchases.

  • Periods of appreciation appear to have been accompanied by spikes in the BOK FX forward position. Most recently, between October 2012 and May 2013, the forward position shot up by 82 percent at a time of appreciation. The forward position also increased fivefold between July 2009 and May 2011 at a time of won appreciation. It is unclear that such increases are linked to financial market pressures. Apart from November 2008, when the authorities used the forwards to inject FX liquidity, increases in forward positions did not occur in periods of rising VIX or deeply negative basis swap spreads.

  • Discussions with multiple international banks and hedge funds also suggest that the authorities intervene assymetrically to curb appreciation pressures, effectively “leaning against the wind”. Recent statements by the authorities also point to the use of this approach.

  • FX interventions are not idiosyncratic to Korea. Across Asia, appreciation pressures have gone hand in hand with the accumulation of FX reserves. On average, most (76 to 94 percent) of the monthly rise in the exchange market pressure index (EMPI) is related to FX reserves accumulation. However, the correlation of the REER of the Korean won with the FX forward position is relatively high compared to other Asian countries.

  • High FX reserve accumulation entails costs related to the negative differential between the interest received on reserves and that paid on instruments issued to finance or sterilize the reserves. A potentially far larger cost relates to forgone spending in the domestic economy and possible FX valuation losses due to the policy of “leaning against the wind.” The current gross costs from the interest differential alone are estimated to amount to 0.6 percent of GDP a year (KRW7.3 trillion), or about 2 times the envisaged FY14 budget support for childcare.2,3

  • Under its medium-term debt management plan, the MOSF plans to issue up to KRW16 trillion a year in bonds for its Foreign Exchange Stabilization Fund (FESF) over 2014-17, of which about half is to meet interest payments on existing FESF bonds (about a half of total reserves).


Korea: Estimated Intervention

(In billions of U.S. dollars, += dollar purchases)

Citation: IMF Staff Country Reports 2014, 101; 10.5089/9781484355619.002.A001

Sources: CEIC and IMF staff estimates.Note: The estimation assumes FX reserves holdings in U.S. dollar, the Euro and the Japanese yen, based on relative allocations (updated annually) from the BOK Annual Report.

Korea: Long FX Forward Position and NEER

Citation: IMF Staff Country Reports 2014, 101; 10.5089/9781484355619.002.A001

Sources: CEIC Data Company and IMF staff estimates.

Asian Economies: Exchange Rate Appreciation and Contribution of FX Reserve Accumulation to the EMPI 1/

(In percent; average month-on-month changes)

Citation: IMF Staff Country Reports 2014, 101; 10.5089/9781484355619.002.A001

Source: IMF staff estimates; and IMF, IFS.1/ Reserves accumulation during periods of appreciation of the domestic exchange rate. Only countries with current account surpluses.

Korea: Cost of Reserves

(In percent of GDP)

Citation: IMF Staff Country Reports 2014, 101; 10.5089/9781484355619.002.A001

Source: IMF staff estimates based on data from CEIC and Bloomberg.Note: The estimates assume interest costs of 1-year Monetary Stabilization Bonds (in line with average remaining maturity of 0.9 years), and 2-year Treasury bonds (in line with longer average maturity of the constituent Foreign Exchange Stabilization (FESF) Bonds). Interest income is assumed to derive from 5-year U.S., Japanese and German bonds, broadly in line with average maturities of these bonds. Weights reflect currency composition of reserves (USD, JPY, and Euro) provided by the BOK.

Asian Economies: Correlation of REER and Change in FX Forward Positions

Citation: IMF Staff Country Reports 2014, 101; 10.5089/9781484355619.002.A001

Sources: CEIC; and IMF staff estimates.
1 Prepared by Silvia Iorgova, Sonali Jain-Chandra and Anuk Serechetapongse.2 The estimates assume interest costs of 1-year Monetary Sterilization Bonds and 2-year Treasury bonds. Interest income is based on 5-year U.S., Japanese and German bonds.3 See the government’s budget proposal sent to National Assembly on October 1, 2013 (“Explanatory Annex on Program Level Expenditure and Revenue Budget”; Book IV page 148). The childcare budget includes both benefits to families and supports for socially provided childcare services.

A. Background

20. Sluggish domestic demand has rendered Korea highly dependent on, and susceptible to, fluctuations in global demand. Since 2005, domestic demand, like household disposable income, has grown by about 1 percentage point less than real GDP on average, primarily due to weak private consumption growth. As a result, the economy is heavily reliant on external demand, which explains about 60 percent of the quarterly variation in growth since 2003. Rebalancing the engine of growth toward domestic demand would deliver both higher living standards and lower sensitivity to global cycles.


Drivers of the Decline in Households Income Share (In percent of GNI)

Citation: IMF Staff Country Reports 2014, 101; 10.5089/9781484355619.002.A001

Sources: Bank of Korea ECOS system; and IMF staff estimates.Note: Adjusted for changes in the proportion of self-employed in the employed.

Real GDP, GNI, and Private Consumption

(In 2005 won, 2000=100)

Citation: IMF Staff Country Reports 2014, 101; 10.5089/9781484355619.002.A001

Sources: CEIC Data Company; and IMF staff estimates.

Distribution of Equity Ownership Across Income Groups (2012)

Citation: IMF Staff Country Reports 2014, 101; 10.5089/9781484355619.002.A001

Sources: Survey of Household Finances … Living Conditions; and IMF staff estimates.

21. This sluggishness has multiple causes:

  1. Falling share of disposable income. Households’ share of gross disposable income (GDI) fell by 5.5 percentage points during 2000–12. This is driven primarily by the weak financial condition of the self-employed, but salaried workers’ share of GDI has fallen too. Meanwhile, the share of corporates’ disposable income increased by 4.5 percentage points; however investment has been broadly stable as a share of GDP, cyclical fluctuations aside.

  2. Worsening terms of trade. Driven mainly by the secular rise of global oil prices, Korea’s net barter terms of trade index has fallen by about 56 percent since 1995. As a result, GDI grew by about 1 percentage point less than real GDP on average since 2000.

  3. Stagnant household real wealth. The recent moderation of real estate prices hurt households’ net worth, given that real estate accounts for 75 percent of household wealth. Despite overall buoyancy of the financial market since 2000, the benefit has not spread widely, given the skewed distribution of financial assets across households.

22. Households have responded to their muted disposable income growth by reducing savings and compressing consumption. Private consumption growth has averaged 3.7 percent on average since 2000, about ½ percentage point below real GDP growth. During the same period, the household saving rate fell to 4.7 percent, well below the OECD average of 5.9 percent. The squeeze on consumption and savings has been disproportionately intense for lower income households, amid rising inequality. With household debt now reaching 136 percent of disposable income, many households’ ability to consume is getting constrained.

B. Staff Views

23. While maintaining a supportive macro-policy mix until the output gap closes is essential, the problem is primarily structural. Policies to address the weakness in domestic demand could include:

  • Redirecting corporate savings by boosting incentives to pay dividends and own shares. Various elements of the tax code favor earnings retention over dividend payouts and discourage share ownership. Removing distortions and raising Korea’s dividend payout ratio of around 30 percent to the G-7 ex-Japan average of 46 percent—undoubtedly a tall order—would redirect around 4 percent of GDI from corporates to households. In addition, encouraging households to hold a larger share of their wealth in shares would help them benefit from the prosperity generated by Korean corporates and would boost domestic demand. Efforts to reduce the tax disincentives to hold shares should continue. The government has proposed tax incentives for long-term investment in equities, similar to the Japan Individual Savings Account.


    Non-Financial Corporations: Dividend Payout

    (In percent of net profit)

    Citation: IMF Staff Country Reports 2014, 101; 10.5089/9781484355619.002.A001

    Sources: Haver Analytics; OECD; and IMF staff calculations.

  • Advancing labor market policies that raise the share of salaried wage income and the number of wage earners in each household. There is no evidence that wages of regular workers are low by international standards; however regular workers account for a low share of the working population. Policies that reduce the duality of the labor market and foster higher female participation would raise household disposable income. The former could also further contribute to redirect corporate savings to households (see next section).

  • Increasing government transfers. Korea’s social spending is low by international standards: staff estimates a gap of about 6 percent of GDP between Korea and its OECD peers5. There is adequate fiscal space to narrow the gap (see below), through a combination of a lower government savings and higher tax revenues. Better targeting of existing transfers to lower-income households, who have a high propensity to consume, would also help. Such transfers would not only boost income but also possibly reduce precautionary saving.

C. Authorities’ Views

24. The authorities argued that the lingering weakness of domestic demand is primarily cyclical, but also saw structural factors. They expect the cyclical drag to subside once policy uncertainty diminishes and the new government’s growth-supporting measures take effect, and when exports durably pickup. They noted they have an extensive agenda to combat the structural drag, including ramping up social transfers and labor market reforms to improve the wages and social protection of non-regular workers. They acknowledged that financing higher social spending amid the medium-term consolidation plans is a challenge. The authorities agreed that the current taxation of capital income is non-neutral and that the exemptions on capital gains tax coupled with partial double-taxation of dividends may be a disincentive to dividend payouts. The government’s Medium-to-Long term Tax Policy includes a higher capital gains tax on equity as a possible avenue for revenue raising.

Arresting the Decline of Growth Potential

Given rapid population aging, only a comprehensive package of reforms to preserve the size of the workforce and boost service sector productivity could maintain potential growth at around 3½ to 4 percent during the next 10 years, and strengthen its inclusiveness.

A. Background

25. Korea’s growth has been on a declining trend after decades of robust and sustained growth. Staff estimates that Korea’s potential growth decreased from around 7 percent during 1990-97 to 4¾ percent during 2000-07 and further to 3¼-3½ percent in 2011–12, with a slight increase in contributions of total factor productivity and labor inputs outstripped by a decline in the contribution of physical capital.

26. Going forward, population aging will be a major further drag on potential growth. On current trends, the working age population is projected to peak in 2016, and Korea is expected to become one of the oldest countries in the OECD by 2050, with the dependency ratio increasing rapidly. As a result, without offsetting policies, Korea’s potential growth would decrease to around 2–2½ percent by 2025 and its per capita GDP would cease to converge and instead plateau at the present rate (about 65 percent of the U.S. level).


Korea: Employment Rates

(In percent, 2012)

Citation: IMF Staff Country Reports 2014, 101; 10.5089/9781484355619.002.A001

Source: OECD.

27. Labor market duality and low employment of segments of the population are key impediments to higher and more inclusive growth. Korea’s employment rate is below the OECD average, particularly for women—their participation rate was around 60 percent in 2012 compared to 70-80 percent in the most advanced countries—and for young males, due to high enrollment in tertiary education, mandatory military service and a widening skills mismatch. Moreover, there is a very high share of temporary, self employed and part-time workers (together over half of the labor force). This dualism stems from high protection for regular workers, which leads firms to favor hiring less costly non-regular workers. The latter receive little training, which negatively impacts productivity. Moreover, because of high wage costs due to a seniority–based wage system, firms tend to push workers to retire before the mandatory retirement age (which averaged 57 years in 2010). Given the low pension replacement rates, such workers then tend to become non-regular workers or self-employed in the services sector with much lower productivity.

28. Another drag on potential growth results from low productivity in the services sector. Korea has a world-class manufacturing sector, but services sector productivity is just around half that of manufacturing (against an OECD average of 87 percent), and investment in services has consistently lagged behind the manufacturing sector. This reflects a combination of longstanding, albeit declining, de facto preferential tax treatment for the manufacturing sector, high regulation in parts of the services sector leading to limited competition, excessive reliance on government guarantees to SMEs, and other distortions that effectively constitute incentives for SMEs to remain small and inefficient. It also reflects the role of the services sector as de facto social safety net.


Facilities Investment in Manufacturing and Services (Scaled by Gross Value Added)

Citation: IMF Staff Country Reports 2014, 101; 10.5089/9781484355619.002.A001

Sources: Bank of Korea, ECOS System and IMF staff estimates.

B. Staff Views

29. Reforms to increase labor force participation are key to boosting potential growth. Further increasing investment in public childcare and childcare benefits, facilitating part-time work, and building on substantial progress to achieve full tax neutrality for second wage earners could boost female participation enough to critically support potential growth. Further efforts to reduce skill mismatches including through vocational training, improving youth access to information on career opportunities and including job-search techniques in school curricula would boost youth participation in the workforce.

30. Efforts to reduce labor market duality should be stepped up. Broadening the access to training opportunities and improving social coverage for non-regular workers would raise productivity and reduce precautionary saving. To preserve overall employment, some changes in regular workers’ contracts may be needed, including moving to performance rather than seniority-based wage, reducing the relatively high degree of employment protection, and accelerating the shift from mandatory retirement allowance to corporate pension schemes with defined contributions or defined benefits. An important step in this direction was taken in May 2013, when the Federation of Korean Trade Unions, Korea Employers Federation, and the government signed a grand bargain (Tripartite Jobs Pact to Achieve 70 percent Employment Rate). This called for employers to adopt a legally protected minimum retirement age and for unions to accept performance-based wage. However, with implementation of the wage reform left to be negotiated at firm level, there is a risk that in many cases only the increase in minimum retirement age would become binding. This could place an unsustainable burden on some firms, leading them to shut down or cut jobs to survive.

31. Boosting services sector productivity is also imperative but will take politically and socially difficult steps.

  • Considerable productivity gains could be achieved by deregulating health, education, and legal and other protected professions, and network services (such as rail and utilities). Promoting greater competition in intra-group service provision within the chaebols would also help. Together, these steps would attract investment to these sectors, create jobs, and foster greater efficiency, which would filter through to the rest of the economy.

  • The services sector also comprises a myriad of small and unprofitable SMEs that depend on government guarantees, subsidies, and protections for their survival. Such features that prolong the life of unviable enterprises impair productivity. Loan guarantees should thus expire after a few years, and banks be encouraged to develop risk management practices that allow them to provide non-guaranteed funding to viable SMEs. Reducing information asymmetries, e.g., via credit bureaus, would be essential to this process. Until then, policy banks should refocus their lending toward SMEs. As well, efforts are needed to revive access of SMEs to capital markets. An expansion of the social safety net would be a prerequisite to the acceptability of these reforms.

  • Additionally, tax breaks and financial support that disproportionally benefit manufacturing should be eliminated over time.

32. The benefits of comprehensive structural reforms are likely considerable, though the reform agenda should be carefully sequenced. Staff simulations suggest that a comprehensive package may enable Korea to continue with a potential growth of 3½ to 4 percent over the next 10 years. However, in order to do so the government has to fully implement current plans (to boost labor force participation, reduce duality and deregulate certain services) and further intensify reform efforts6. This could enable Korea to reach per capita GDP of US$48,000 by 2025 (71 percent of the projected U.S. level).

C. Authorities’ Views

33. The authorities shared staff’s views that addressing labor market duality and low participation is essential to sustained and inclusive growth. Indeed, the government has a broad reform agenda to tackle labor market duality and boost the employment rate to 70 percent by 2017 (from 64 percent). The “70 percent Roadmap” shifts the focus of job creation from current male, manufacturing and conglomerates toward female, services and SMEs. It also focuses on increasing youth and aged employment and improving work-life balance by cutting long working hours. Regarding duality, they considered the existence of different work modalities a natural outcome in the labor market. Their priority is to expand social insurance, including through subsidizing low-income employees of SMEs, eliminate discrimination for non-regular workers, and increase mobility between regular and non-regular workers.

34. The authorities welcomed staff’s recommendation to boost services sector productivity. They also concurred that further deregulation and competition is needed, as well as higher investment in this sector. They noted that FTAs with the U.S. and E.U. will help in this regard, particularly in markets for legal services and accounting. The authorities stressed that deregulation should be sequenced along with strengthening the social safety net. They viewed boosting service sector productivity as the key pillar, along with fostering venture capitalism, in the government’s creative economy initiative. Both deregulation and convergence of services with information and communication technology would be necessary to achieve this.

35. The authorities argued that despite imperfections, SME guarantees should be provided for the time being. They view the credit guarantee system as important in that it enables financial access to SMEs which lack collateral and corrects information asymmetry and limitations pertaining to banks’ credit scoring systems. However, the government is continuously making efforts to contain moral hazard by reducing long-term guarantees.

A More Growth-Friendly Fiscal Framework

There is a strong case for cautious recalibration of the fiscal framework to make it more supportive of growth, in two ways: enhanced countercyclicality (via higher automatic stabilizers and a structural balance rule), and more fiscal space (via lower medium-term government saving and a broader tax base), to help address structurally weak domestic demand and large social spending needs. This can be done while fully providing for rising aging costs.

A. Background

36. Korea’s long record of fiscal prudence has been an anchor of macroeconomic stability but the framework that delivers it could be more efficient. Fiscal discipline relies primarily on strict borrowing and asset sale constraints on the central government set in annual budgets, and indicative medium-term fiscal plans that aim to gradually eliminate the overall fiscal deficit (excluding social security) and eventually reduce public debt to about 30 percent of GDP. Automatic stabilizers are weak by advanced economies standards, reflecting a low taxes-low transfers system that provides little cushion during downturns. As a result, Korea has relied mostly on politically contentious supplementary budgets to provide stimulus during slowdowns. Otherwise, revenue shortfalls naturally occurring in downturns have to be offset by spending cuts. The tax base is also very narrow.7

37. Korea enjoys low gross debt and large assets, implying an impressive net creditor position. Korea’s net debt was -38 percent of GDP by end-2012, excluding non-financial assets, which are deemed large. Of this, 31 percent corresponds to the assets of the National Pension Fund that can fully meet its pension obligations through 20608. The government views the large asset position as a means to ensure credibility and to cushion against aging costs and geopolitical risks. At the same time large scale quasi-fiscal activities by state-owned enterprises and banks imply contingent liabilities, which are also not well understood, albeit initial inquiries by staff suggest they are manageable. While financial analysts are sanguine about the strength of Korea’s fiscal policy and generally think Korea has fiscal space to do more, lack of clarity about the overall public debt position and implicit liabilities has reportedly contributed to Korea’s lower sovereign ratings than countries with similar fundamentals.


General Government Net Financial Liabilities

(percent of GDP)

Citation: IMF Staff Country Reports 2014, 101; 10.5089/9781484355619.002.A001

Source: OECD Economic Outlook No. 93

B. Staff Views

A More Countercyclical, Rules-Based Fiscal Framework

38. The fiscal framework should aim to strike a balance between short- and medium-term flexibility and long-term prudence.

  • Short-run: the existing annual financing constraints allow for only limited scope for countercyclical policies that risk being less timely and targeted than automatic stabilizers. There is room to enhance the degree of counter-cyclicality of fiscal policy in Korea.9

  • Medium-term: the indicative fiscal plans imply an overly contractionary fiscal policy stance that would exacerbate existing external macroeconomic imbalances and provide insufficient support for domestic demand. In particular, without tax reform to boost revenues, they would hinder enhancing social spending needed to kick start structural reforms. The government has a record of flexibly adjusting these medium-term plans, but this approach creates policy uncertainty.

  • Long-term: the fiscal framework should ensure sustainability in the face of population aging. Budget spending on health, old age pension supplement and other pension schemes outside the national Pension Fund, is expected to increase by about 3.4 and 6.8 percent of GDP in net present value terms through 2030 and 2050, respectively. To ensure the long term sustainability of public finances, reforms that enhance labor force participation and boost potential growth are critical, albeit they have fiscal costs.

39. Moving towards a structural rule-based fiscal framework would ensure time-consistency in policy objectives. A structural budget balance rule for the general government would allow timely counter-cyclical policies and reduce uncertainties over medium-term policy objectives. Such rules are being adopted by a growing number of countries, including by most of the EMU countries, the United Kingdom and Colombia. A key element of such a rule is a structural balance target, underpinned by a prudent level of debt, and accounting for the expected increase in spending due to demographics. The structural balance target should be revised every 3–5 years to reflect updated actuarial projections of pension schemes as well as health spending, long-term debt sustainability assessment as well as risk-based assessment of contingent liabilities. Within these constraints, the target can be calibrated to allow space to boost productive social spending and address macroeconomic imbalances.

40. Well-designed complementary mechanisms would ensure credibility and support the implementation of such a rule. An automatic mechanism to correct for past deviations from the balance rule would provide a medium-term anchor. Escape clauses would ensure needed flexibility in the face of low automatic stabilizers to address large adverse shocks. A politically independent fiscal council with mandate and expertise to analyze policy proposals, could monitor the implementation of numerical rules, and propose revisions to the structural target would be essential for credibility.

Fiscal Space

41. Staff analysis suggests that it would be helpful, and safe, for general government savings to be reduced, in structural terms. Considering debt-stabilizing conditions, a prudent level of debt and projected aging costs and their current financing schemes, a medium-term consolidated government deficit of up to 1¼ percent of GDP excluding the National Pension Fund (compared to the zero balance targeted by the current indicative rule) would still allow the debt to GDP ratio to decline for a prolonged period of time. This would leave ample time for reforms to rebalance the economy and contain long-term aging costs (see Box 3). This fiscal space can be used to finance the reforms discussed previously to support domestic demand and boost the growth potential (see Box 3). Once the economy rebalances, the structural balance target can be recalibrated.

42. Additional fiscal space could be generated through revenue measures concentrating on gradually broadening tax bases. There is considerable scope for both efficiency and equity gains (Box 4). The average effective personal income tax rate is one of the lowest in OECD, and for the median wage earner is close to zero. The base should be broadened by gradually eliminating the wage and other deductions while providing targeted support through social spending. VAT should be extended, notably to all new real state supplies, including the value of land, insurance and financial services, and suppliers to exporters. The corporate income tax is a source of multiple distortions that could usefully be streamlined, in particular there is a need to move toward neutrality in taxing various sources of capital income.


43. The government has ample financial assets to contain fiscal risks stemming from medium-term structural loosening. As noted above the government has a large net creditor position, even after ring-fencing the assets of the national pension system.

Towards a Rules-Based Fiscal Framework1/

A structural balance target would enhance counter-cyclicality and ensure time-consistency between policy objectives. A structural balance rule—such as the one mandated by the 2012 EU Fiscal Governance Reform—allows the budget balance target to be adjusted every year for the output gap, therefore enabling the free operation of automatic stabilizers The balance target should be regarded as the lower bound for fiscal policy and set in such a way that it ensures convergence of the debt-to-GDP ratio towards a prudent level while incorporating projected ageing costs.

The debt ceiling on which to anchor the rule should not exceed the lower bound of a safe range of public debt levels. Following Debrun et al. (forthcoming)* the safe level of public debt can be defined as the maximum stock of gross financial liabilities the government can stabilize under highly adverse interest rate-growth conditions while generating the highest plausible primary surpluses. As such, the safe level of debt ensures sustainability even in case of large adverse shocks. The safe level of debt for Korea is estimated to be around 65–70 percent of GDP, with robustness tests pointing to a prudent lower bound at about 55 percent of GDP.

Korea faces rapid population ageing, transforming the country from the third-youngest currently to the second-oldest in OECD by 2050. Unless mitigated by policy actions, this trend will have profound effects not only on health and pension spending but also on potential per capita growth, which matters for debt sustainability.

  • The actuarial deficit of the National Pension Fund through 2060 is estimated to amount to about 30 percent of GDP but is fully covered by accumulated assets. The means-tested basic old-age benefit is expected to increase by at least 1.5 percent of GDP by 2050.

  • Health spending is projected to increase by about 3 percent of GDP by 2030, reaching close to 8 percent of GDP by 2050.

Simulations suggest that, under current policies, Korea can safely allow for a modest structural loosening in the medium term. The simulations are based on the authorities’ current policies and staff’s medium-term projections, assuming slight deterioration in the long-run interest-growth differential once the economy converges. While the National Pension Fund is ring-fenced (i.e., higher spending is not debt-creating), other pension spending is fully passed through to the costs. Following current policies 80 percent of the increase in health spending is assumed to be covered by annual increases in health premiums. The accompanying chart shows the debt dynamics under two scenarios. First, keeping the medium-term structural target (excl. SSF) at -1¼ percent of GDP up to 2020 and subsequently allowing the deficit to increase in line with health costs would raise the debt to about 55 percent of GDP by 2050. Second, keeping the -1¼ percent of GDP target (excl. SSF) until 2028 would allow to fully cover the cumulative net present value of ageing costs up to 2050 while raising the debt to just below 45 percent of GDP. In both cases, the interest-growth differential is sufficient to allow the debt to decline for a prolonged period of time.


Debt Simulations

(In percent of GDP)

Citation: IMF Staff Country Reports 2014, 101; 10.5089/9781484355619.002.A001

Source: IMF staff calculations.
* Debrun, X., Jarmuzek, M. and A. Shabunina (forthcoming), “Public Debt: Where Is The Safe Harbor?”1 Prepared by Alvar Kangur.

Tax Policy Priorities in Korea

Korea stands out as a lightly taxed economy with a revenue structure that is heavily tilted towards corporate income taxation and excises.



Citation: IMF Staff Country Reports 2014, 101; 10.5089/9781484355619.002.A001

Sources: OECD Revenue Statistics.


Citation: IMF Staff Country Reports 2014, 101; 10.5089/9781484355619.002.A001

Sources: OECD Revenue Statistics.

Reforms should be geared towards optimizing the tax structure to alleviate macroeconomic imbalances.

  • Property taxation. Despite recent reductions, it is still tilted towards taxing transactions, potentially weighing on the functioning of the real estate market. Shifting to recurrent taxes on property would enhance efficiency.

  • Employment. Current policies to use CIT exemptions to create employment opportunities can be counterproductive. Since CIT is a tax on profits (the return to investment), CIT exemptions induce corporations to substitute away from labor towards capital. In this manner current exemptions can contribute to capital intensive manufacturing and low-skilled intensive services.

  • Income distortions. The taxation of capital income should aim to achieve the greatest possible degree of neutrality, to avoid various distortions in the economy and incentives to artificially transform one type of capital income into another. Deductibility of interest expense leads to a bias towards debt financing. Exemptions for many categories of taxpayers on capital gains could incentivize excess accumulation of retained earnings. Similarly, there is no clear rationale for even partial double taxation of dividends; this deters households from diversifying their portfolios towards ownership of shares.

  • Inequality. The wide range of deduction and exemptions under PIT are considerably dampening progressivity. High deductions benefit disproportionately more well-off taxpayers as poorer do not have sufficient income to benefit from deductions. Attempts to curtail personal income tax exemptions should move in tandem with efforts to close self-employed tax loopholes.

1 Prepared by Alvar Kangur.

44. There is scope to contain long-term aging costs. Increasing the retirement ages in both the private and public sectors would enhance sustainability in the face of increasing longevity. Boosting participation and reducing labor market duality will reduce the costs linked to the basic pension scheme. Payroll contribution rates in Korea are currently very low and it should be possible to raise them with limited impact on participation given the highly credible link between current contributions and future pensions, and low participation tax rates. Korea’s rapid excess cost growth in health10 suggests ample scope to curtail future health costs growth, including with policies to reduce expenditure on pharmaceutical drugs, eliminate incentives for a high number of visits, and reduce hospitals’ role in providing long-term care.

45. Greater transparency on fiscal risks would be desirable particularly, but not only, in the event of the new rules-based framework. While fiscal risks arising from direct credit guarantees are manageable,11 state-owned-enterprise debt, some of which reflects quasi-fiscal activities, is high (estimated at 38.8 percent of GDP as of end-2012 with incomplete coverage, albeit their net debt is -19 percent of GDP), and policy banks own about a quarter of the system-wide loan book, exposing the public sector to contingent liabilities. The government’s plans to expand the monitoring system to cover assets and liabilities of the whole public sector are welcome; the budget should include a comprehensive assessment of established fiscal risks.

C. Authorities’ Views

46. While the recommendation to adopt a structural balance rule was received with interest, the authorities do not plan to loosen fiscal policy in the medium term. The authorities recognized that a structural balance rule would be desirable on macroeconomic stabilization grounds. However, it was considered hard to implement and potentially hostage to political difficulties. Instead, the authorities intend to proceed with the adoption of a “PAYGO” scheme on a central government level that requires fiscal neutrality of any new policy changes, thus favoring stronger fiscal discipline to any loss in cyclical stabilization. In a similar vein, against the background of high exposure to external shocks, looming aging costs and potential geopolitical risks arising from North Korea, the authorities did not view structural fiscal loosening in the medium-term as prudent and aim, for now, to follow the planned consolidation path12.

47. The authorities intend to gradually increase social spending financed by broadening the tax base. To achieve both an expanded welfare state and the medium-term consolidation objectives, the authorities plan to broaden the revenue base and reallocate spending, rather than increase debt. They plan to reduce tax expenditures, strictly apply sunset clauses and tackle tax evasion. Although preferential treatment of specific industries has decreased over time, wide tax exemptions to invest in new technologies, attract FDI, and support SMEs remain a part of the authorities’ strategy to create employment. A high level commission has been set up by the President to consider the pros and cons of moving over time to a higher welfare-higher taxes system.

Towards A More Growth-Enhancing and Stable Financial System

The 2013 FSAP found the near-term vulnerabilities of the Korean financial sector limited, but exposures to household and corporate debt warrant close monitoring. Over the medium term, the financial system should play a greater role in supporting growth, including by reducing government intervention. A more formalized macroprudential institutional setup, with a stronger role for BOK, would be beneficial.

A. Background

48. The resilience of the Korean financial system has increased since 2008 as a result of concerted policy efforts. Banks’ liquidity profiles have improved markedly due to well designed macroprudential requirements, as reflected in lower external debt and FX liquidity mismatches. Owing in part to preemptive capital injections by the public sector, banks’ capital adequacy is sound. In addition, nonperforming loans (NPLs) are below 1 percent, reflecting, in part, active disposal of bad assets.

49. Banks’ profitability has continued to decline. Since 2008, profitability has been hampered by low interest rates and elevated credit costs, as well as informal guidance on banks’ pricing. The return on assets of commercial banks in 2012 was only ½ percent, compared to 1–1¼ percent in 2005–07, lower than in most peer countries.13 The share of non-interest income since the onset of the 2008 crisis has remained low, at 17 percent on average of total income between 2008–11. This reflects the growth slowdown and limited offering of high value-added financial services to households and corporations, due to regulatory reasons. Low profitability has reportedly been an important driver of foreign banks’ recent retrenchment of their operations in Korea.


Banks’ Non-Interest Income

(In percent of total Income; average 2008-2011)

Citation: IMF Staff Country Reports 2014, 101; 10.5089/9781484355619.002.A001

Source: World Bank.

50. Credit risks at some non-bank financial institutions have increased. Stricter bank regulations led to a shift of household borrowing to this sector, which accounted for 47 percent of household credit at end-2012. The share of delinquent loans in some of these institutions is now relatively high, and stress tests suggest that some have relatively thin buffers against credit shocks.

51. While household debt is high, it is covered by household assets to a large extent, mitigating near-term financial sector risks. At 136 percent of disposable income as of end-2012, household debt is high compared with OECD peers, and has been rising. Debt owed by households with low debt servicing capacity (debt service-to-income ratio over 40 percent) reached 33 percent at end-2012. However, household debt deemed to be at risk accounts for only 0.7 percent of total debt, once the high asset buffers (mostly real estate) are accounted for. It is estimated to increase to 0.9 percent in the event of a 300 bps rise in interest rates. In the near term, short of a sizable housing price shock, financial stability risks appear limited to certain household segments—including low-income, older and self-employed.

52. Corporate sector vulnerabilities show a marked duality. Corporate sector leverage is high and concentrated and corporate debt (based on OECD data, which includes private and state-owned enterprises) was at 127 percent of equity at end-2012, above OECD average (see Box 5). Importantly, risks of corporates other than the largest and most profitable chaebols have increased, pointing to a marked duality among corporates. Profitability pressures, liquidity risks and high leverage are concentrated in a few vulnerable industries, including construction, shipbuilding and transportation. Debt of these vulnerable sectors accounted for 33 percent of aggregate corporate debt at end-2012.


OECD Countries: Corporate Sector Leverage

(Debt-to-equity ratio; in percent)

Citation: IMF Staff Country Reports 2014, 101; 10.5089/9781484355619.002.A001

Sources: OECD, Bank of Korea; and IMF estimates.Note: Shaded area represents the interquantile range across countries; 2012 leverage for Israel, Japan and Switzerland is as of end-2011.

B. Staff Views

53. Impediments to the financial sector contributing more to growth should be removed. As noted above, SME financing needs an overhaul. The drivers of weak banking sector profitability should also be addressed. These include curbing pressures on banks to cut interest rates and fees which may depress bank profits and limit the availability of credit for higher risk borrowers. In this regard, a balance needs to be found between consumer protection and banks’ soundness; and in removing disincentives for banks to engage in more extensive risk-taking and innovation, thus enhancing their ability to support growth. Caution is warranted with regard to the policy to encourage banks to expand overseas, given potential stability risks. Policies to this end should be complemented by more robust cross-border framework for bank regulation and supervision to mitigate possible negative spillovers.

54. FSAP stress tests suggest that the Korean banking system appears sound. Banks remain solvent under extreme growth shocks or a protracted economic slowdown. Their foreign currency liquidity positions are robust, with a small but manageable liquidity shortage emerging only under an extreme scenario.

Corporate Sector Risks12

There is an increasing duality between large export-driven corporations, whose profitability has improved, and other smaller corporates, who have seen a downward drag in profitability. The return on assets (ROA) of Korea’s champion exporters—Samsung Electronics, Hyundai Motors, Hyundai Heavy Industries and Kia Motors—continued to rise, reaching 10.5 percent at end-2012, up from 9.6 percent in 2010. This presented a stark contrast to the rest of the corporate sector, where the ROA of all listed companies, excluding the top 100 by assets, slumped from 4.2 to 3.3 percent in this period (Figure). Altogether, at end-2012, the four “national champions” accounted for a staggering share–about 30 percent—of the aggregate retained earnings of Korean listed companies.


Korea: Return on Assets of Corporate Sector 1/

(In percent)

Citation: IMF Staff Country Reports 2014, 101; 10.5089/9781484355619.002.A001

Source: IMF staff estimates based on Worldscope.1/ A weighted average based on assets.

Weaker profitability has impaired the ability of corporates to deleverage further and to meet interest expenses. The aggregate debt at risk of the corporate sector—i.e. the debt of financially distressed corporates whose earnings before interest and taxes (EBIT) cannot cover their interest expenses—stood at 29 percent of corporate debt at end-2012, only marginally lower than the 31 percent at end-2008 (Figure). The share of financially distressed companies has also edged up since 2010, but remains lower than in 2008, suggesting that now risks are concentrated in somewhat larger companies.


Korea: Corporate Debt at Risk 1/

(In percent of corporate debt)

Citation: IMF Staff Country Reports 2014, 101; 10.5089/9781484355619.002.A001

Source: Bank of Korea.1/ Companies are financially distressed if their interest coverage ratio is below 1. Debt of financially distressed companies is considered at risk.

Vulnerabilities are concentrated in certain sectors—construction, cross-border transportation and shipbuilding—that have been impacted particularly negatively by the growth slowdown and the sluggish property sector. Cross-border transportation and construction are considerably more leveraged than other industries, and both sectors had negative profitability in 2011 and 2012. All three sectors have debt at risk that has been higher than for other corporates, over 40 percent of corporate debt in the cross-border transportation and shipbuilding sectors. The shipbuilding industry, while still profitable, remains vulnerable to the shift towards lower upfront installments in the global shipbuilding industry and more limited bank funding. Their impact on aggregate corporate sector risks is non-trivial, as they collectively accounted for 26 percent of corporate assets at end-2012.

1 Prepared by Silvia Iorgova.2 The analysis of the corporate sector is based on Worldscope data which includes listed companies, some of which are majority state-owned.

55. While near-term risks of high household and corporate sector debt appear muted, they warrant continued close monitoring. Given the sensitivity of asset quality to adverse interest rate or growth shocks, close monitoring of exposure risks and associated provisioning should continue. Separately, it is important to minimize moral hazard in household and corporate debt workout programs. The authorities’ intention to strengthen monitoring of commercial real estate lending and lending to the self-employed are welcome14.

56. While the current supervisory framework has been reasonably effective, it should be enhanced further. Banks’ supervisory structure needs to be strengthened by minimizing the perception of political influence, and eliminating complex processes and overlap of responsibilities across multiple agencies. As the recently completed FSAP pointed out, key recommended improvements to financial supervision include15: (i) a more risk-sensitive approach; (ii) extension of Basel II to financial holding companies (which came into effect on December 1, 2013); (iii) expansion of supervisory activities on a group-wide basis; and (iv) better assessment of banks’ corporate governance. Also, regulation of large non bank depositary institutions should be aligned with that for banks, with stricter supervision and higher capital and provisioning requirements16.

57. While the current institutional framework for macroprudential policy and crisis management has worked well, it can be enhanced. There would be benefits to establishing two distinct committees with separate mandates on macroprudential policy and crisis management. Such an arrangement should focus on enhancing transparency and accountability, ensuring a greater degree of independence from the political process, and clarifying and strengthening the financial stability role of the BOK.

C. Authorities’ Views

58. The authorities viewed the depressed bank profitability as cyclical rather than structural. They noted that banks are suffering due to the low growth and interest rate environment, but foresaw this unwinding as the business cycle turns around. However, the authorities are encouraging banks to expand overseas to boost profitability, targeting areas compatible with Korean banks’ limited expertise and balance sheet power, such as bad assets disposal.

59. The authorities argued that they have successfully implemented measures to reduce household debt, and that they do not view corporate debt levels as excessive. They emphasized that the growth of household debt has slowed and that banks’ exposures to low income households are low, and do not present risks to banks’ profitability. The authorities concurred that boosting household incomes is a viable way to grow out of debt. They also considered banks’ exposure to large distressed conglomerates to be limited as they have encouraged banks to proactively restructure. They stressed that the bulk of the expected losses have already been provisioned for. The authorities viewed the current level of banks’ prudential buffer sufficiently large to absorb adverse shocks on the corporate balance sheets.

60. The authorities acknowledged that there is close supervisory monitoring of banks’ risk pricing behavior. They pointed out that they monitor voluntary guidelines on banks’ risk pricing, and emphasized that these are motivated by the need to ensure sufficient consumer protection. They stressed that the guidelines are entirely voluntary and there are no sanctions for non-compliance. More broadly, they stressed that ensuring sufficient consumer protection is a global trend, and an area that requires sufficient policy focus.

Staff Appraisal

61. Korea’s economy is experiencing a modest recovery, helped by supportive monetary and fiscal policies and buoyant exports. Korea’s GDP growth is expected to rebound to 2.8 percent in 2013 (from 2 percent in 2012), and inflation is subdued. Despite a supplementary budget in the spring and an accompanying cut in the policy rate, domestic demand remains relatively weak, growing at only 2 percent. Growth is expected to strengthen to 3.7 percent in 2014, in view of the projected global recovery and the gradual pickup in domestic demand. Despite this, the output gap is expected to remain negative through 2014. In view of the fragile recovery, macroeconomic policies should remain supportive. The expansionary fiscal and accommodative monetary stances should be maintained until there is confidence that the output gap will close soon.

62. Korea has emerged as a safe haven of sorts in the summer’s market turmoil. A strong fiscal position, large CA surplus and ample FX reserves have further strengthened Korea’s attractiveness to risk-averse investors, including many central banks and sovereign wealth funds. However, the robustness of this new safe haven status has yet to be tested.

63. The external sector position is substantially stronger than implied by medium-term fundamentals and desirable policies, and the won moderately undervalued. Policies are needed to bolster domestic demand and bring rebalancing back on track. The won should continue to be market determined, with intervention (either in spot or forward markets) limited to smoothing excessive volatility in the event of disorderly market conditions and not to influence the pace of appreciation. Reserves are adequate and there is no need for further accumulation relative to the range of the metrics. Any additional accumulation should be carried out by the BOK rather than by increasing government borrowing. Further won appreciation would facilitate the overall rebalancing of the economy towards households and domestic demand.

64. Risks are on the downside, both in the near and longer term. While, Korea would likely not be very affected by further mild turmoil from US monetary policy normalization, adverse growth surprises in any of its main export markets—China, U.S., and the EU—or more severe market stress would significantly damage its outlook. On the domestic demand side, absent reforms considered in the baseline, momentum will be muted, reflecting the debt overhang in parts of the household and corporate sectors, which will weigh further on both consumption and investment. In the longer run, weak household income growth, deleveraging needs, and conservative fiscal policy mean that demand is likely to remain highly dependent on net exports. On the supply side, rapid population aging implies a further significant fall in the growth potential. In turn, continued weakness in domestic growth would likely worsen the debt problems of households and corporates. These risks to growth call for a comprehensive and ambitious set of reforms that will be mutually reinforcing across a number of areas, including to the fiscal framework, the labor market and services sector.

65. Fiscal policy has an essential role to play to support domestic demand, boost growth potential and reduce inequality. Fiscal policy should be more countercyclical to allow automatic fiscal support in downturns. Specifically, the borrowing ceiling should become non binding and the balance target a structural one. The central government balance could be safely reduced to a deficit of 1¼ percent of GDP over the medium term, even accounting for projected large aging costs. This would free up resources to finance higher social spending and help rebalance the sources of growth toward domestic demand. A debt rule anchored at a prudent level that could be significantly higher than the present one, would ensure continued fiscal prudence. There is also sizable scope to finance additional spending by broadening the currently narrow tax base. Contingent government liabilities arising from credit guarantees and quasi-fiscal operations of state-owned firms and banks need close and transparent monitoring. The government’s plans in this regard are much welcome.

66. Continued reforms to increase labor force participation and reduce labor market duality would further support households’ income growth and raise the growth potential. Higher public spending on childcare and creating more part-time work opportunities could boost female participation enough to critically support potential growth. Further efforts to reduce skill mismatches would boost youth participation in the workforce. Reducing the gap in training and social protection between non-regular and self-employed workers and regular workers would raise productivity and reduce precautionary saving. While the Tripartite Jobs Pact is a step in the right direction, skillful policy making would be required to tackle considerable implementation challenges, and more has to be done to combat dualism, including reducing the relatively high degree of employment protection for regular workers.

67. Deregulation, restructuring and reduction in government intervention are needed to boost value-added in services and productivity throughout the economy. As the social safety net expands, incentives that discourage SME growth and allow non-profitable ones to survive should be phased out. Loan guarantees should expire after a few years, and banks be encouraged to develop risk management and pricing practices that allow them to provide non-guaranteed funding to a broader range of viable SMEs. Policy banks should refocus their lending on SMEs. Initiatives to expand SME access to capital markets should continue. Also, considerable productivity gains could be garnered by deregulating network services, health, education, and other professions and by promoting competition in service provision to and by chaebols.

68. The FSAP found the financial sector sound overall, though risks warrant close monitoring. Banks are highly capitalized and have low nonperforming loans ratios, reflecting active disposal guidance. The associated write-offs, along with low net interest margin and non-interest income, have contributed to continued weak profits. Low loan-to-value ratios on mortgage loans and large household asset buffers limit risks from potential further deterioration in household debt. However, weak debt repayment capacity and buffers among low income households could further erode profits. Similarly, in certain parts of the corporate sector—construction, transportation, and shipbuilding—a prolonged cyclical downturn had raised risks. Despite these risks, banks’ vulnerability to external liquidity shocks has declined, as macro-prudential regulations have reduced markedly their short-term debt. Non-bank depositary institutions are vulnerable to asset quality shocks, but they are individually small and largely not interconnected. Overall, systemic risk appears limited.

69. Despite this, financial stability would be further supported by active monitoring of risks, adjustments in incentives, and streamlined, more structured institutional frameworks. Pressures on banks’ pricing behavior should be minimized and the authorities should seek to curb potential moral hazard in debt workout programs. The current supervisory structure would benefit from enhanced independence, greater focus on the core supervisory mandate, and institutional streamlining so as to improve coordination. Overall effectiveness would be enhanced by supervision of financial activities on a group-wide basis, and establishment of a dedicated macro-prudential council and a fully formalized committee on crisis management.

70. In sum, the Korean economy has fared well in the recent turmoil and is well positioned to benefit from the global recovery, reflecting skilled policy-making. However, it will need deep changes in its economic structure to continue lifting the living standard of its population, in an inclusive way, closer to that of the richest advanced economies. Many of the reforms needed, and identified above, are already in train or planned. Steadfast implementation across these areas will be needed to meet this challenge.

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

Figure 2.
Figure 2.

The Real Economy

Citation: IMF Staff Country Reports 2014, 101; 10.5089/9781484355619.002.A001

Figure 3.
Figure 3.

Credit and the Banking Sector

Citation: IMF Staff Country Reports 2014, 101; 10.5089/9781484355619.002.A001

Figure 4.
Figure 4.

Financial Markets

Citation: IMF Staff Country Reports 2014, 101; 10.5089/9781484355619.002.A001

Table 1.

Korea: Selected Economic Indicators, 2009–15

Nominal GDP (2012): $1,130 billion

Main exports (percent of total, 2012): Petroleum products(13), Semi-conductor (12), Automobile (11), Machinery (10)

GDP per capita (2012): $22,589

Central government debt (2012): 33.4 percent of GDP

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

Contribution to GDP growth.

Data for 2013 are as of November 4, 2013.

Data for 2013 are as of August.

Excludes gold.

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

Table 2.

Korea: Balance of Payments, 2009–15

(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.a.

Korea: Statement of Central Government Operations, 2009–15

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Sources: Ministry of Strategy and Finance; and IMF staff estimates and projections.
Table 3.b.

Korea: Integrated Balance Sheet - Consolidated General Government, 2009-12

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Source: Haver Analytics.

As of 2012, the asset of the National Pension Fund stood at 393 trillion (295 trillion won excluding government bond holding).

As of 2012, state-owned enterprises (SOEs) in 2012 held 731.2 trillion won of assets and 493.4 trillion won of liabilities.

Table 4.

Korea: Medium-Term Projections, 2012–18

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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, 2009–13

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

Includes merchant banking corp, asset management corp, trust accounts of banks, mutual savings banks, credit unions, mutual credits, community credit cooperatives, and life insurance corp.

Includes commercial and specialized banks.

Includes commercial banks only.

Includes non-financial corporations.

Operating income to gross interest payments.

Includes listed companies only.

all metrics for houehold sector refer to households, including Non-profit institutions serving households (NPISH).