Republic of Korea: Staff Report for the 2015 Article IV Consultation

KEY ISSUES Outlook and risks. The outlook remains challenging from both a cyclical and structural standpoint. The hoped-for output recovery has not materialized—domestic demand remains sluggish and inflation low and external uncertainties have increased. More fundamentally, relatively weak non-manufacturing productivity has been accompanied by a heavy, and likely unsustainable, reliance on manufacturing exports for growth while also leaving the economy more exposed to external shocks, and the demographic headwinds from a rapidly aging population are beginning to build. Policy assessment. Building on the authorities’ recent monetary, fiscal, and other policy measures to stimulate demand, efforts should remain focused on shoring up economic momentum where the currently weak outlook could have a lasting impact on Korea’s growth well beyond the near term. Given asymmetric costs of the downside risk of low growth and inflation becoming entrenched the authorities should take additional pre- emptive stimulatory monetary and fiscal policy actions if clear signs of a recovery do not emerge soon. At the same time sustaining longer-term growth and reducing external imbalances call for structural reforms to address low service sector productivity, support a more dynamic corporate and SME sector, and remove barriers that lead to underutilized labor. Maintaining a flexible exchange rate is essential both as a buffer against external shocks and to facilitate adjustment toward domestic sources of growth and thereby reduce external imbalances.

Abstract

KEY ISSUES Outlook and risks. The outlook remains challenging from both a cyclical and structural standpoint. The hoped-for output recovery has not materialized—domestic demand remains sluggish and inflation low and external uncertainties have increased. More fundamentally, relatively weak non-manufacturing productivity has been accompanied by a heavy, and likely unsustainable, reliance on manufacturing exports for growth while also leaving the economy more exposed to external shocks, and the demographic headwinds from a rapidly aging population are beginning to build. Policy assessment. Building on the authorities’ recent monetary, fiscal, and other policy measures to stimulate demand, efforts should remain focused on shoring up economic momentum where the currently weak outlook could have a lasting impact on Korea’s growth well beyond the near term. Given asymmetric costs of the downside risk of low growth and inflation becoming entrenched the authorities should take additional pre- emptive stimulatory monetary and fiscal policy actions if clear signs of a recovery do not emerge soon. At the same time sustaining longer-term growth and reducing external imbalances call for structural reforms to address low service sector productivity, support a more dynamic corporate and SME sector, and remove barriers that lead to underutilized labor. Maintaining a flexible exchange rate is essential both as a buffer against external shocks and to facilitate adjustment toward domestic sources of growth and thereby reduce external imbalances.

Longstanding Growth Challenges

1. Long-run growth trends. Korea’s economic performance has been on a declining trend after decades of robust and sustained growth. Potential output decreased from around 7 percent during 1990–97 to 4¾ percent during 2000-07, and has been running at about 3½–4 percent since then. While this rate still exceeds that of many of Korea’s peers, prosperity has been concentrated within the highly competitive export-oriented conglomerates employing a small share of the population, whereas household income growth and service sector productivity have been sluggish. Going forward population aging will be a major 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 (text figures). Even reaching the staff’s projection for potential growth of 3¾ percent will require total factor productivity playing a larger role than at present.

A01ufig1

Real Output Growth

(In percent)

Citation: IMF Staff Country Reports 2015, 130; 10.5089/9781513555676.002.A001

Sources: CEIC Data Company; and IMF staff estimates.
A01ufig2

Working-Age Population Ratio

(In percent of total Population)

Citation: IMF Staff Country Reports 2015, 130; 10.5089/9781513555676.002.A001

Source: The United Nations World Prospect 2012.Note: Working age is 20-64.

2. Export-led growth. Exports are at the center of these trends, accounting for both the period of rapid growth and the slowdown. Korea’s gross exports have risen steadily since the early 2000s and currently exceed 50 percent of GDP, significantly higher than the OECD average (text figure). This growth was driven in large part by the emergence of Korea’s flagship companies to world-class status and accompanied by a sizeable gain in global market share. It is unlikely however that Korea can continue to rely on this growth model going forward—indeed, Korea’s market share has been at a standstill since 2011 with continued gains in electronics offset by stable or falling shares for other leading export products. Korea’s future prosperity will therefore depend on success in fostering more broad-based productivity growth.

A01ufig3

Share of Export

(In percent of GDP)

Citation: IMF Staff Country Reports 2015, 130; 10.5089/9781513555676.002.A001

Source: OECD.

Financial Soundness and Resilience

3. Overview. Although potential output growth is poised to slow, Korea’s financial fundamentals as proxied by the health of aggregate private and public sector balance sheets and capital and external buffers are relatively sound which limits sources of short-run systemic risk. At the same time vulnerabilities remain and the structure of private debt markets could be strengthened.

4. Financial sector structure and soundness. The resilience of the Korean financial system has increased since 2008 and near-term vulnerabilities are limited.1 Banks remain well capitalized with the capital adequacy ratio at around 15 percent as of June 2014, and their funding and liquidity conditions are stable. The banking sector’s profitability improved somewhat in 2014 driven by lower provisions and impairment losses, although the return on assets is still below the historical average. The aggregate bank non-performing loan (NPL) ratio increased in 2013, albeit from a low level, driven by a rise in NPLs to large companies in the shipbuilding and construction sectors, but since then banks’ asset quality has improved somewhat with the decline in new bad loans and the write-offs and sales of old loans. Growth in the non-bank financial institutions has slowed considerably and their profitability continues to weaken, in part from low interest rates and the strengthening of regulations. Banks’ short-term external debt increased in 2014 although it remains well below the pre-crisis levels, and the sizes of their foreign currency and maturity mismatches continue to decline. However, Korean banks still rely heavily on offshore funding, and a tightening of global financial conditions could lead to funding pressures (text figure).

A01ufig4

Banks’ External Short-term Funding 1/

(Debt ratio to banks’ liabilities in percent)

Citation: IMF Staff Country Reports 2015, 130; 10.5089/9781513555676.002.A001

Sources: CEIC Data Company; and IMF staff estimates.1/ External short-term debt includes domestic banks and foreign banks.
A01ufig5

Korea: Household Debt and Leverage

(percent)

Citation: IMF Staff Country Reports 2015, 130; 10.5089/9781513555676.002.A001

Sources: Bank of Korea; Haver Analytics; and IMF staff estimates.
A01ufig6

Household Debt to Net Worth, OECD Countries

(In percent)

Citation: IMF Staff Country Reports 2015, 130; 10.5089/9781513555676.002.A001

Sources: OCED; Bank of Korea; and IMF staff estimates.Note: Shaded area represents the interquartile range across countries.

5. Household balance sheets. Overall household debt as a share of income has been rising steadily over the last decade but unlike the experience of many other countries leading up to the global financial crisis, this has recently been on the back of relatively stable house prices, with cautious consumer spending keeping household leverage low and stable and the sector’s aggregate net worth comparable to that in many other advanced economies (text figures and Box 1)—rather than reflecting increased borrowing for consumption the rise in debt has been matched by a corresponding increase in household financial assets and may be related to structural factors affecting balance sheet composition, including more retirees and the prevalence of Korea’s unique chonsei rental market. While pockets of vulnerability exist,2 the relatively strong aggregate balance sheet and banks’ solid capital buffers suggest that in the absence of large macroeconomic shocks the rise in household debt does not pose a systemic near-term threat to the financial sector or the macroeconomy.

6. Housing finance. At the same time the structure of household debt could be strengthened. Reflecting Korea’s relatively young and rapidly growing mortgage market (text figure), a large share of houses are financed short-term either in the form of chonsei rental deposits or the rolling over of floating-rate interest-only mortgage loans with short maturities and bullet repayments. One key challenge will be to facilitate the transition by households and financial institutions toward a more stable, long-term structure (paragraph 27).

A01ufig7

Mortgage Outstanding

(In percent of GDP)

Citation: IMF Staff Country Reports 2015, 130; 10.5089/9781513555676.002.A001

Source: UN Habitat’ Housing Finance Mechanisms, 2009 and IMF staff estimates.

7. Corporate balance sheets. While aggregate corporate leverage is relatively modest, many financial soundness indicators have weakened recently and the sector is highly segmented with some growing pockets of vulnerability (Box 2). In particular corporate income and profits have become increasingly concentrated in the top-ranked firms whereas troubled sectors with high leverage and nonviable SMEs requiring public support remain. While capital buffers and adequate provisioning limit direct risks to the banking sector, the need by many firms to shore up their balance sheets is likely to constrain corporate investment.

8. Public finances. Korea’s practice of maintaining a cautious fiscal stance, motivated by the need to preserve investor confidence alongside the country’s open capital account and to deal with uncertain future costs related to demographics and possible reunification with North Korea, has kept government debt below 40 percent of GDP. At the same time the public sector is exposed to contingent liabilities related to loan guarantees estimated at around 10 percent of GDP. SOE gross debt amounts to nearly 30 percent of GDP, but the bulk is held by profitable enterprises and backed by substantial assets.

Household Debt

Household balance sheet developments in Korea over the last decade are unique in several ways. As in many other advanced countries, measures of debt-to-income increased steadily in the pre-crisis period. However, this ratio has continued to increase post-2008, in stark contrast to other countries that experienced a long period of household deleveraging following the sharp decline in house prices. Likewise, measured household leverage in Korea has remained low and stable throughout, whereas other countries saw a sharp buildup of financial (non-housing) leverage and a subsequent fall. In fact, Korean households have accumulated more liquid financial assets than debt since 2002, and household net debt (gross debt minus currency, deposits, and financial security holdings) as a share of income has decreased.

Another unique feature of the rise in household debt is that it has continued despite the recent falloff of house price growth (text figure). Rather than reflecting increased borrowing for consumption, this seems to be related to several structural factors affecting household balance sheet composition.

  • First, Korea’s baby boom generation has begun to retire. As the pension replacement rate remains relatively low, retirees often purchase small businesses, in part financed by bank borrowing, to provide retirement income. The share of household debt held by households in their fifties and older has increased by more than 10 percent in the last decade and may continue to rise as population ages (text figure).

  • Second, Korea’s unique chonsei rental system, in which the tenant loans the deposit (a large share of the property’s value, often borrowed from a bank) interest-free to the landlord and lives rent-free, may also lead to higher gross household debt than would otherwise be the case. Chonsei currently accounts for almost half of Korea’s rental housing market. In recent years its prices have risen sharply against the declining real house prices and chonsei-related loans have almost doubled since 2009 (text figure).

A01ufig8

Household Debt and House Prices

(In percent)

Citation: IMF Staff Country Reports 2015, 130; 10.5089/9781513555676.002.A001

Sources: Haver Analytics; and IMF staff estimates.1/ Real house price series are the nominal price series deflated by the consumer price index.
A01ufig9

Change in Household Debt Distribution

(In percent)

Citation: IMF Staff Country Reports 2015, 130; 10.5089/9781513555676.002.A001

Source: Korea Development Institute.
A01ufig10

Seoul Metropolitan House Sales and Rental

Prices Index (2007. 12=100)

Citation: IMF Staff Country Reports 2015, 130; 10.5089/9781513555676.002.A001

Sources: Kookmin Bank, Statistics of Korea.

Reflecting Korea’s relatively young mortgage market, a large share (about 75 percent) of houses are financed by short term interest only loans, allowing households to accumulate equity in other types of assets instead of paying down mortgage principals. To strengthen the structure of household debt, the government has recently launched a loan conversion program with an aim of increasing the share of fixed-rate and amortizing loans from currently less than 25 percent to 40 percent by 2017. The process of conversion may have the transitory impact of increasing household debt repayment even if it does not affect household net worth.

While the aggregate household balance sheet is relatively stable and rising debt does not pose near-term systemic risks, pockets of vulnerability exist. Previous staff analyses indicate that the share of debt at risk in total household debt is particularly high for certain types of households, namely, older, lower-income and self-employed households. To the extent that these households have relatively higher marginal propensities to consume or are more likely to be liquidity constrained, an increase in household debt service due to higher debt levels and/or higher interest rates may have a negative impact on consumption.

Corporate Balance Sheets and the Implications for Investment

Korea’s growth momentum has weakened since 2010 partly driven by sluggish corporate investment. Although the sector’s aggregate balance sheet does not raise alarms, financial soundness appears to have weakened in the past few years partly due to slowing growth—the growth rate of corporate sales declined from around 17 percent in 2010 to slightly negative in the first half of 2014, the first time corporate sales registered a contraction since the global financial crisis. Corporate income and profits have also become more concentrated in the top-ranked firms.

The decline in corporate growth and rising concentration of income have affected the sector’s financial soundness. For firms with high leverage and low profitability and liquidity, their need to shore up their balance sheets will constrain investment.

A01ufig11

Corporate Profitability and Liquidity Ratios

(In percent)

Citation: IMF Staff Country Reports 2015, 130; 10.5089/9781513555676.002.A001

Source: The Bank of Korea.Note: The cash flow coverage ratio for 2013 is for the first half of the year.
A01ufig12

Corporate Borrowing-to-Total Assets Ratios

(In percent, by company size)

Citation: IMF Staff Country Reports 2015, 130; 10.5089/9781513555676.002.A001

Source: The Bank of Korea Financial Stability Report October 2013.

Compared to some other Asian economies, Korea has a relatively high concentration of corporate debt in firms with high leverage, low profitability, low solvency, and low liquidity—almost 20 percent of corporate debt is owed by firms with negative profitability (the second highest in Asia), about 20 percent by firms with an interest rate coverage ratio less than one (Asia’s highest), and 40 percent by firms with a current ratio below one (fourth highest).1 As such, Korea has a relatively large segment of its corporate sector that is vulnerable to interest and profitability shocks.

Staff analysis using annual firm level data that covers 2,200 Korean firms in 1995–2013 quantifies the link between corporate balance sheets and corporate investment in Korea, with regression results showing that high leverage, low cash flow and low liquidity all have significant negative impacts in this period.

1 IMF Regional Economic Outlook: Asia and Pacific, April 2014.

9. External buffers. Korea has built and maintained substantial external buffers since the global financial crisis which could help limit the impact of renewed financial volatility, including a reduced and now modest level of short-term external debt, a positive and growing net foreign asset position, and a stock of international reserves which—based on measures of adequacy—should be sufficient to buffer against a range of possible external shocks (text figure).

A01ufig13

Reserve and Reserve Metric

(In billions of USD)

Citation: IMF Staff Country Reports 2015, 130; 10.5089/9781513555676.002.A001

Sources: CEIC Data Company; and IMF staff estimates.

Recent Developments

10. Output growth. The growth momentum that had been building since early 2013 has stalled reflecting a continued high savings rate and low investment on the back of sluggish wage growth and falling performance in some major manufacturing industries, and closing the output gap remains elusive. A key turning point was the April 2014 Sewol ferry accident which had a surprisingly large and persistent impact on consumer and investor sentiment as it led to protracted political turmoil more broadly. Recent external developments may have also played an indirect role, with news of slowdowns in China, Japan, and the EU weighing on sentiment. Reflecting this, GDP growth in 2014, although positive at 3¼ percent, fell below potential for the third straight year.

11. Inflation. Headline inflation has fallen to about ½ percent, well below the Bank of Korea’s (BOK) target range, in part because of lower oil prices (text figures). The BOK has cut the policy rate several times since August 2014—with the most recent move in March bringing the rate to an historic low of 1¾ percent—citing concerns of a larger-than-expected output gap, low inflation pressure, fragile sentiment, and more recently the need to take pre-emptive action against downside risks. Nominal wage growth data are volatile but show a generally declining trend.

A01ufig14

Inflation

(In percent)

Citation: IMF Staff Country Reports 2015, 130; 10.5089/9781513555676.002.A001

Source: CEIC Data Company Ltd.
A01ufig15

Policy Interest Rate

(In percent)

Citation: IMF Staff Country Reports 2015, 130; 10.5089/9781513555676.002.A001

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

12. Exchange rate. The won has been on a gradual, appreciating trending since 2012 on a measured, trade-weighted basis, although this masks important movements in cross rates—in particular, the won continues its climb against the yen, Japan being Korea’s main export market competitor, but has weakened against the U.S. dollar in the last several months (text figures). Nevertheless, we continue to assess the exchange rate as being undervalued. After increasing in the first half of 2014, official foreign exchange reserves (including the BOK’s forward position) have declined modestly in U.S. dollar terms reflecting valuation losses related to shifts in the relative exchange rates of the major reserve currencies (paragraph 33).

A01ufig16

Korea Won: Measured Real Effective

(2010=100)

Citation: IMF Staff Country Reports 2015, 130; 10.5089/9781513555676.002.A001

Source: IMF INS Database.
A01ufig17

Korean Won: Cross Rates

Citation: IMF Staff Country Reports 2015, 130; 10.5089/9781513555676.002.A001

Sources: CEIC Data Company, Haver Analytics; and IMF staff estimates.
A01ufig18

Current Account

(In Percent of GDP)

Citation: IMF Staff Country Reports 2015, 130; 10.5089/9781513555676.002.A001

Sources: Korean authorities; and IMF staff estimates.
A01ufig19

Change in CA/GDP: Contibution Analysis

(2011-14, in percentage points)

Citation: IMF Staff Country Reports 2015, 130; 10.5089/9781513555676.002.A001

Sources: CEIC Data Company; and IMF staff estimates.

13. Balance of payments. Despite the real appreciation the current account surplus has increased sharply since 2011, reaching 6¼ percent of GDP in 2014, on the back of lower global oil prices and weak domestic demand (text figures). Oil imports alone fell from 8½ percent of GDP in 2011 to 6¾ percent last year, although the net windfall from lower oil prices is estimated to be somewhat lower as many of Korea’s export prices (for petroleum products, shipbuilding, and others) tend to move in tandem.3 Substantially lower domestic investment which generally has a high import component has also played an important role. The counterpart to the higher surplus has mainly been an increase in corporate retained earnings held abroad. Other capital account developments including portfolio flows have been broadly stable.

14. Recent policy initiatives. Recognizing the challenging growth environment, the authorities put in place a number of measures to spur economic recovery in addition to loosening the monetary policy stance. These include:

  • Direct budget stimulus—about ½ percent of GDP in additional spending in 2014 focused on financial support for home buyers and renters. This was followed by the 2015 budget which allowed for a more broad-based increase including for social spending.

  • Increased support for policy-based lending—this includes a capital injection to the Korean Development Bank to support new growth source projects, including those centered on intellectual property, through lending as well as diverse forms of hybrid captial.

  • Ad hoc tax measures to incentivize firms to allocate idle cash to wages, dividends, or investments.

  • Measures to try to revive a housing market that has been in a multi-year slump including legislation to unwind major regulatory roadblocks for housing reconstruction projects which had been previously introduced to curb house price inflation and speculative demand. In the wake of these measures, together with some unwinding of the earlier tightening of mortgage lending restrictions (paragraph 26), there have been some preliminary signs of a pickup in house prices and transactions volumes.

The policy reorientation also entails stronger expenditure growth over the medium term with the timing of the planned deficit reduction pushed back relative to last year’s budget (text figure). This will lift the projected public debt profile only modestly, with debt now expected to peak at 37 percent of GDP. In addition the authorities have put in place or aim to launch a number of initiatives to address structural challenges (paragraphs 37 and 39).

A01ufig20

Medium-term Fiscal Management Plan: 2013 vs. 2014 versions

(In percent of GDP)

Citation: IMF Staff Country Reports 2015, 130; 10.5089/9781513555676.002.A001

Source: Korean authorities.

Outlook and Risks

15. Outlook. The Korean economy is at crossroads where macroeconomic trends over the coming quarters could have implications well beyond the near term. We currently project output growth for 2015 in a range centered at around 3 percent, where exceeding this midpoint will require a rebound in aggregate demand this year.4 Recent policy initiatives may succeed in bringing this about although it is still too early to gauge their full impact. A rebound in the construction sector, while not yet apparent, could be a possible contributing factor to domestic demand. Inflation is projected to be in the 1–1½ percent range, depending on the one-off impacts of lower oil prices and the recent increase in administered tobacco prices. An increase in underlying inflation, currently hovering around 1 percent, would likely require higher wage growth or a nominal depreciation of the won.

16. Near-term risks and uncertainties. The outlook will depend on a number of uncertain factors (Appendix I). Domestically, households’ concerns about future house price and wage growth could continue to weigh on consumption, and business sentiment will remain closely linked to how firms view the external environment, the prospects for a rebound in private consumption, and the future growth potential of the economy. Externally, Korea’s highly open economy exposes it to both positive and negative global cross-currents. Specifically:

  • Partner country growth—although growth momentum in the U.S. may be building, the outlooks for China (Korea’s main export market), the EU, and Japan remain a concern (text figure).

  • A persistently weak yen—Korean export volumes have held up so far, but signs suggest weakening prospects, with Korean market share beginning to decline in some industries. Profits and stock prices for the key exporting firms have taken a protracted hit, resulting in downward price pressure on input-providing domestic SMEs (text figure). The recent shift in market expectations that the yen will remain weak for some time could eventually lead to more off-shoring, lower investment in domestic capacity and R&D, and reduced export proceeds. The ultimate effect on Korea’s growth outlook is difficult to quantify, as staff analysis suggests that the weak export volume response the short run could mask a more fundamental shift in relative competitiveness which would take some time to materialize (Box 3). At the same time, the strong dollar could provide some buffer.

A01ufig21

Exports by Trading Partners

(In percent of GDP)

Citation: IMF Staff Country Reports 2015, 130; 10.5089/9781513555676.002.A001

Sources: OCED; CEIC; and IMF estimates.
A01ufig22

Hyundai and Toyota Stock Prices

(2015M5 = 100)

Citation: IMF Staff Country Reports 2015, 130; 10.5089/9781513555676.002.A001

Source: Bloomberg.

Impact of the Weaker Yen on Korea’s Exports

Following the Bank of Japan’s launch of its asset purchase program (QQE) in August 2011 the yen has depreciated against the U.S. dollar by over 35 percent and by about 40 percent against the won. More than prices and volumes, the effect has been largely felt in the profit margins of Korean and Japanese exporters. This is in line with historical episodes and econometric analysis which shows a long lag before exports respond to shifts in won-yen cross rates.

Price pass-through. The pass-through of the weaker yen and won to export prices has been timid so far—both Korea and Japan have decreased export prices modestly but this is likely to reflect factors other than exchange rate movements, including the drop in oil prices and the continued trend decline in global prices of electronic products. Price cuts by Japan’s exporters have been somewhat higher than Korea’s in key sectors where product similarity is high (metal, electronics, and transportation equipment).

Volume response. Export volumes have also been slow to respond. Japan’s real export volumes continued to decline until late 2012 before a sharp rebound since late 2014 helped recoup the bulk of the loss. Korea’s real exports have largely traced a trend similar to the one before the global financial crisis.

Profit margins. With the limited volume and price response, exchange rate movements have been mostly reflected in higher profits for Japanese exporters and lower for Korean firms. One striking example is the behavior of profit ratios of car makers—since the first quarter of 2012 Hyundai Motors’ operating margin decreased by around 20 percent while Toyota’s increased by over 60 percent (figures).

A01ufig23

Hyundai

Citation: IMF Staff Country Reports 2015, 130; 10.5089/9781513555676.002.A001

A01ufig24

Market share. After rising significantly, Korean exporters’ market share has stalled since 2011 with continued gains in three leading export destinations—China, ASEAN, and the United States—offset by broad-based slippages elsewhere. At the same time Japan endured sharp losses across all markets. In terms of product space, Korea has continued to expand its market share in electronics offsetting flat or declining shares in other leading export items, while Japan’s market share declined across a broad range of products (figures, next page).

Short- and long-run export responsiveness. The limited price pass-through and high correlation between profit margin and exchange rate movements are in line with exporters’ historical behavior where they are slow to change prices in the short-run but do so over time as exchange rate shocks become locked in. This may be related to a range of structural factors for both countries’ key export industries (such as electronics and automobiles) including the importance of branding, product cycles, global supply chains, and offshoring of production. In these industries the impact of persistent exchange rate movements is likely to be felt through lagged adjustment in pricing as well as non-pricing decisions such as where to invest new capacity, the level of R&D investment, and others. This is supported by staff’s econometric analysis, which finds a low short-run exchange rate elasticity for both countries and across products, with the elasticities increasing over the longer-run.1 All of this suggests that the muted price and volume response so far to the sustained weakness of the yen may mask a more fundamental shift in the relative competitiveness of Japanese and Korean exporters.

1 “Should Korea Worry about a Permanently Weak Yen?” by Jack Ree, Gee Hee Hong, Seoeun (Thelma) Choi, IMF Working Paper, forthcoming.
  • Lower oil prices—as one of the world’s largest importers of oil products Korea is clearly benefiting from lower prices, but it may take some time before this translates into growth. The most significant channel would be through an increase in global purchasing power and corresponding demand for Korean exports, which could in turn lead to firms to invest in new capacity, while the impact on domestic consumption is likely to be relatively modest. At the same time persistently lower prices could reduce already low inflation expectations.

  • Exposure to global financial risks—Korea has been less affected than many emerging markets to financial turmoil over the last two years and its relatively strong fundamentals and solid external buffers have led markets to view the country as a “bounded safe haven” where minor shocks to global markets, possibly related to an unwinding of U.S. quantitative easing, could lead to capital inflows. At the same time an open capital account exposes it to the risk of a sudden reversal of capital flows which would likely be accompanied by a fall in asset prices affecting business sentiment and lead to tighter financial conditions for corporates and banks. Allowing the won to respond flexibly would provide a key buffer.

17. Risks of a downside growth and inflation scenario. In this environment there is a risk that a self-reinforcing downside dynamic could take hold where falling inflation expectations keep consumer spending suppressed, which coupled with perceived weak external prospects, leads firms to withhold investments and decrease hiring (Appendix I). Ultimately these expectations could become self-fulfilling and result in significantly slower nominal and real growth relative to the recovery assumed in the baseline scenario. The growth consequences of a downside scenario could be protracted. As seen in many other economies, the expectation of low or negative inflation once entrenched can be very difficult to break and can have long-lasting negative effects on household, corporate, and public sector balance sheets. Many of the reforms needed to shore up potential output over the longer term could be more costly and difficult to implement in an environment of weak economic growth. The likelihood of this scenario may not be high but the costs could be significant.

18. Authorities’ views. The authorities agreed with staff that the near-term outlook was subject to uncertainties and risks. Although they recognize that the recovery in domestic demand has yet to take hold, they expected growth to pick up from the second quarter of this year as a result of the lagged effect of the stimulus policies put in place so far including the series of policy rate cuts and the expected dividend from lower oil prices. They remain mindful of the possibility that a weaker-than-expected global environment and continued household and investor pessimism could lead to stagnating or falling nominal and real growth, but at the time of the mission they considered the likelihood of this scenario to be low. Regarding external risks, they viewed capital flows related to an orderly tightening by the U.S. Fed as manageable but remained mindful of the risk that there may be bouts of disruptive financial market volatility. At the same time they recognized that Korea’s strong fundamentals—positive growth, current account surpluses, low debt, and solid reserve buffers—make it more resilient to these risks than many other countries with open capital accounts, and viewed the flexible exchange rate as a key shock absorber.

Policies to Boost Growth Momentum

19. Overview. Going forward macroeconomic policy decisions will need to be taken before it becomes clear how effective the measures to stimulate demand already in place prove to be, and whether the stalled growth momentum and weak inflation has shifted or become entrenched. If the global outlook improves, for example, or the housing market gains momentum, it may turn out that the monetary, fiscal, and other policy measures already taken prove more than sufficient. But if consumer or investor caution is allowed to deepen, then additional measures at the margin might not have much power to change the psychology from pessimistic to optimistic. While recognizing that the current uncertainties make policy fine-tuning very challenging, staff argued that the high costs if the downside scenario materializes warrant a more pro-active use of available policy tools than would be called for in a normal cyclical environment, and that the risks of doing too little too late outweigh the risks of doing too much. The lack of clear signs of a recovery of domestic demand would call for additional use of the authorities’ fiscal and monetary space. The primary aim would be to send a signal strong enough to shift confidence, which would be aided by a broad-based set of policy actions that are bold rather than incremental.

20. Measures already taken. While the full impact remains to be seen, the measures have not had a material impact on confidence suggesting they may fall short of what is needed. Prospects for recent policy rate cuts to stimulate demand will depend in part on whether they spur households and firms to take on more leverage to consume and invest, and together with steps to deregulate housing investment, lead to a recovery in the housing market sufficient to change savings behavior. While there have been pockets of increased housing market activity recently, the decline in expectations of future price and wage growth may blunt the impact of recent cuts on real interest rates. The budget measures to stimulate demand are relatively modest and the impact of the steps aimed at unlocking idle corporate cash is difficult to predict.

21. Monetary policy. There is scope for monetary policy to take pre-emptive action against downside risks. In an environment where households and firms hold excess cash and postpone spending on the self-reinforcing expectation that wages, prices, and house price growth may continue to be weak, policy rate cuts can help shift incentives away from cash hoarding toward more consumption and investment. The longer expectations become entrenched however, the more policy rates would need to be cut to break this dynamic. With the space to cut limited by the zero lower bound, waiting to see if additional rate cuts are called for runs the risk of reducing their effectiveness if ultimately needed. Concerns about their short run impact on household debt ratios may be counterproductive if withholding monetary stimulus results in weaker nominal income growth, and are better addressed by the government’s macro-prudential policy tools for mortgage lending standards (paragraph 26).

22. Fiscal policy. The government’s expansionary fiscal policy in the 2015 budget is a step in the right direction for supporting aggregate demand in the near term, and the revised medium-term deficit path is consistent with utilizing fiscal space when needed while preserving longer-term fiscal sustainability. Relatively modest public debt allows the authorities the flexibility to take additional measures if needed to ensure the budget’s planned spending program is carried out in the event that weaker-than-expected nominal GDP growth results in revenue falling short of this year’s target. Budget support should be broadened where there is scope for temporary measures to boost employment and household incomes in a way that does not run counter to needed structural reforms and longer run fiscal sustainability. The government’s efforts to expand policy-based lending with budget support would be most cost-effective for both stimulating demand and increasing productivity if priority is given to the most commercially viable enterprises, including by refocusing public support for SMEs, and in a way that preserves the financial sector’s profitability and capital buffers.

23. Structural reforms. The reforms discussed in paragraphs 36–38 should be undertaken as quickly as feasible independent of the near-term macroeconomic outlook. But while most of the reforms will take some time to yield direct growth benefits, maintaining their momentum could have benefits in the near term by shoring up confidence in the economy’s long run potential.

24. Authorities’ views. The authorities viewed revitalizing the economy as a key near term priority and stood ready to take additional policy actions when needed if growth momentum does not show signs of picking up soon. At the same time Korea’s strong dependence on global economic developments and its underlying structural factors make this task more challenging. In particular:

  • The BOK recognized that there is still space for further monetary easing if needed, but highlighted a number of considerations. Headline inflation has been pushed down in part by supply side factors including low oil prices, and with survey data showing inflation expectations anchored in the mid-2 percent range it would not be prudent to over-react to inflation falling below target. Also, they argued that many of the factors driving weak demand—low wage growth, consumer and investor caution—reflect not so much cyclical factors as structural rigidities which will need to be addressed through longer-run reforms and will limit the effectiveness of monetary easing on its own. Overall, monetary policy would need to strike a balance between growth and stability, and the bank would need to remain mindful of the possible impact of monetary easing on household debt.

  • The Ministry of Strategy and Finance emphasized the role that fiscal policy has been and will continue to play in supporting demand within the boundaries of maintaining fiscal soundness, including through direct budget spending and expanded and refocused policy lending efforts. Unlike many countries with sizeable infrastructure needs, Korea has no clear areas where there is broad-based support for ramping up public spending in the short run. They highlighted slower than initially-projected nominal output growth as a key reason for the budget revenue shortfalls over the last several years, and that achieving the nominal growth target will be important for meeting the revenue target and addressing the increased social spending needs.

  • The authorities agreed with staff’s assessment that household debt does not pose imminent risks and would like to see debt levels stabilize gradually while avoiding a forced deleveraging which could have adverse impact on growth. The authorities were in broad-based agreement that concerns about household debt would be better addressed through the government’s existing tools for setting mortgage lending standards, and that a coordinated approach to monetary and macro-prudential policy would be needed.

Financial Stability and Macro-Financial Risks

25. Financial sector reforms. The 2013 FSAP found the near-term vulnerabilities of the Korean financial sector to be limited (paragraph 4), and while banks’ vulnerabilities to corporate and household exposures appear contained in the near term, further economic weakness could impair the soundness of both sectors. Staff urged progress in addressing the high priority recommendations of the FSAP to further strengthen financial stability analysis and supervision, develop financial market infrastructure, and reform the institutional framework to separate macroprudential policy making from crisis management with the aim of increasing transparency and accountability among the various agencies responsible for economic and financial market policies and ensuring greater political independence (Appendix III). Although the authorities have initiated a number of measures in line with these recommendations, they were reluctant to adopt those requiring more fundamental institutional changes.

26. Macroprudential tools and capital flow management measures. The Korean authorities have a number of tools which they have used with the aim of containing the build-up of systemic vulnerabilities. These include:

  • Limits on mortgage lending, including loan-to-value (LTV) and debt-to-income (DTI) ratios, which were introduced in the last decade in response to sharp increases in house price growth. These have been adjusted several times since then as financial stability risks related to housing market conditions change but are currently significantly tighter than when introduced. In line with this policy, the authorities in mid-2014 took a modest step toward unwinding the earlier tightening of these ratios given banks’ strong balance sheet position. This step may have also contributed to the recent slowdown in housing-related lending growth by non-bank financial institutions.

  • Measures to contain liquidity and foreign exchange vulnerabilities which were introduced when the Lehman collapse exposed the volatile funding structure of the Korean banking system. These include a ceiling on banks’ loan-to-deposit ratio, a leverage cap on banks’ foreign exchange derivatives positions, and a levy on foreign exchange funding.5 The FSAP determined that together these measures succeeded in increasing financial sector resilience by reducing exposure to liquidity shocks, reducing maturity mismatches caused by short-term foreign exchange borrowing to finance derivatives purchases, and more generally lengthening the maturity of the financial sector’s foreign exchange borrowing, and we continue to assess these measures as appropriately aimed at addressing systemic financial sector stability.6

27. Mortgage financing. To facilitate the transition toward a more stable, long-term structure the government recently launched a loan conversion program with the aim of increasing the share of fixed-rate and amortizing loans from currently less than 25 percent to 40 percent by 2017. Staff emphasized that this is best accomplished by further developing the market and regulatory infrastructure that would, through market-based incentives, encourage households and banks to move in this direction. The program involves the provision of new long-term fixed-rate loans funded by the Korea Housing Finance Corporation (KHFC) through their issuing mortgage-backed securities (MBS).7 The KHFC securitizes all loans brought to its balance sheet before the close of the same day which should limit its exposure to credit risks of the long-term amortizing products. Securities are generally purchased by pension funds looking to match their long-term liabilities. While the program is in its early stages, it is important that its execution be tightly focused on the objective of deepening the market for long-term mortgages and increasing the resilience of housing finance.

28. Authorities’ views. The authorities viewed the financial sector as currently sound with banks and non-bank financial institutions having maintained improved asset quality and satisfactory capital adequacy. They expect that the recently launched mortgage loan conversion program will enhance the structure of the mortgage market, and given the already high demand of the program, are confident that they will meet the government’s target for increasing the share of fixed-rate and amortizing loans. The authorities acknowledged that the low corporate profitability in some ailing sectors could affect financial institutions’ balance sheets, but noted that recent progress in debt restructuring and lower oil prices have brought about improvements in their leverage ratios and operating balances, and the authorities will push for further progress in restructuring going forward. With respect to the 2013 FSAP key recommendations the authorities have implemented various measures to further strengthen financial stability analysis and supervision and financial market infrastructure. They emphasized the important role their macro-prudential policy framework plays in containing systemic risks to financial stability, and viewed the regulatory limits on the financial sector’s foreign exchange exposure as a key source of Korea’s increased resilience to external market volatility. However, they do not see the need to establish, as recommended by the FSAP, two distinct committees with separate mandates on macroprudential policy and crisis management, viewing the current institutional framework adequate for safeguarding financial stability.

Assessing External Stability

29. Overview. While Korea has built up large external buffers and does not currently face external sustainability issues, the country’s ability to continue growing through a heavy reliance on gaining export market share is increasingly limited while also leaving the economy more exposed to external shocks. This means achieving more balanced, sustainable long-run growth depends on success in closing the large productivity gaps in the non-traded sector, which would be accompanied by a reduced role for net exports as a source of demand-side growth.

30. The current account. The current account in part reflects where Korea is in that process and where it needs to go. In this regard Korea’s underlying current account surplus—even after allowing for the transitory effects of the windfall from lower oil prices which is expected to continue to put upward pressure on the surplus in the near term—is larger than would be consistent with the country’s economic and policy fundamentals. This gap reflects a number of factors including precautionary savings related to a relatively weak social safety net (Box 4).

31. Policies to address imbalances. An active policy approach to boost near-term aggregate demand and longer-run productivity will also help reduce external imbalances, reinforcing their importance in bringing about a more stable, resilient, and durable structure to the economy. In particular:

  • Structural policies. Staff scenario analysis suggests that a 0.3 percentage point increase in non-traded sector productivity would increase long-run potential output growth by 0.2 percentage points, and for a given real exchange rate would result in a reduction in the current account surplus of around 1 percent of GDP.

  • Fiscal policy. The government’s more expansionary fiscal policy stance, both this year and over the medium term, could help narrow imbalances, all the more so if coupled with an expanded social safety net that reduces the need for precautionary savings.

  • Exchange rate flexibility. Even with some closing of the productivity gap, won appreciation over time will likely be needed to bring about a reduction in external imbalances to levels consistent with Korea’s fundamentals.

32. Medium-term current account prospects. Korea faces a number of trends that will affect the current account and how it responds to price changes in uncertain ways, making it difficult to pin down the size of Korea’s external gap. Korea’s unique demographics trends where the expected rapid transition from a relatively young to an old society will take place against the background of what has been a substantial increase in life expectancy might produce a pattern of higher aggregate household savings now that unwinds over time. Whether the oil dividend is saved or spent will depend on how durable households and firms perceive it to be. How the current account will respond to past and future exchange rate movements, including the relationship between the won and yen, is a key uncertainty—staff analysis suggests that Korean export volumes have become highly inelastic to exchange rate movements in the short run, pushing the adjustment into the longer term where forecasting is particularly difficult (Box 3). The longer-run export prospects will also be affected by a number of uncertain structural developments such as product innovation and evolution and entry into the market by newer competitors in China and elsewhere.

33. Exchange rate and foreign exchange reserve policies. Maintaining a flexible exchange rate is essential both as a buffer against external shocks and to facilitate adjustment toward domestic sources of growth and thereby reduce external imbalances, and the won should remain market determined with intervention limited to smoothing excess volatility. The quantity of reserves has increased steadily since the sharp decline in 2008 but has been broadly stable (at around 130 percent) as a share of the IMF’s composite reserve adequacy metric during most of this period. Lacking published data, foreign exchange intervention proxies based on changes in stocks or balance of payments data point to periods of net purchases, albeit at levels below those in the first half of 2014, although these proxies should be treated as suggestive given their high degree of uncertainty.8

External Stability Assessment

Foreign asset and liability position and trajectory. Korea’s net international investment position (NIIP) increased from -2.9 percent of GDP in 2013 to 5.8 percent in 2014. This position is expected to strengthen further as the current account is in strong surplus. The net external debt position was -16.7 percent of GDP in 2014. Banks’ short term external debt remains below the pre-crisis levels, and the risks of currency mismatch are limited as the bulk of the short term external debt is matched with forward hedging activities mainly by exporters. The NIIP position and dynamics present little risk to external sustainability.

Current account. Drawing on various approaches including the IMF’s model-based External Balance Assessment (EBA) regression exercise (after adjusting the results to account for various Korea-specific factors), staff assesses the cyclically-adjusted current account surplus in 2014 to be in the range of 2½ to 5 percent above the level consistent with fundamentals and desirable policies. A part of this gap could be accounted for by relatively low public social spending in Korea and the fiscal policy gaps of other countries.1

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Real exchange rate. Based on the assessed current account gap and considering other EBA-related regression estimates, the measured, trade weighted real exchange rate (REER) for 2014 is assessed as weaker than the level consistent with fundamentals and desired policies. By precisely how much is subject to uncertainty, particularly given both the difficulty in predicting when and by how much Korea’s exports will respond to exchange rate movements (paragraph 32 and Box 3), as well as the diversity of estimates produced by the EBA’s exchange rate regression models. Applying a plausible range of elasticities to the current account gap produces a range for the exchange rate gap of 5–13 percent.2

Capital and financial accounts: flows and policy measures. With an increase in net portfolio outflows and a decrease in net banking outflows (about 1¾ percent of GDP for both) offsetting each other, the overall net capital flow deficit remained at 5 percent of GDP. A proposed technical change to an existing bank levy, predicted to take effect later in 2015, does not substantially alter the macroprudential policy setting. Overall, Korea’s net and gross flows appear sustainable.

FX intervention and reserves level. Korea has a floating exchange rate. The quantity of reserves has been broadly stable as a share of the IMF’s composite reserve adequacy metric during most of period since 2008.3 Intervention should be limited to smoothing excessive volatility. The stock of reserves should be sufficient to buffer against a range of possible external shocks.

Based on the above information staff assesses that Korea’s external position in 2014 was substantially stronger than that implied by medium-term fundamentals and desirable policies. Developments as of March, 2015, point to a somewhat stronger external position in 2015.

1 Staff’s assessment is based on an EBA model which has recently been modified to incorporate changes in the treatment of demographic explanatory variables, which relative to the previous model results in an increase in Korea’s estimated current account gap through a corresponding increase in the unexplained residual. Staff interprets this as indicative of the existence of important country specific factors that are not fully captured by the model’s variables and cyclical adjustments. After adjusting for these factors, the recent methodological changes to the EBA model do not materially alter staff’s assessment of the current account gap.2 Staff used the assessed current account gap and applied a range elasticities, both EBA-based and staff’s own calculations, as well as information on the REER gap itself coming from the EBA’s exchange rate models. EBA exchange rate estimates vary widely, with the “index model” showing a positive gap of 0.1 percent and the “level model” a negative gap of 13.8 percent.3 Staff assessment is based on the IMF’s framework for assessing reserve adequacy, and accounts for Korea’s deepening financial markets.

34. Authorities’ views. While agreeing that a narrowing of the current account surplus from its current level would be desirable, and expected as the economy recovers and temporary factors recede, the authorities emphasized that the surplus appears unrelated to a weak exchange rate boosting export competitiveness—indeed, the increase has taken place despite the substantial appreciation of the won in real terms since 2012 and appeared to be driven mostly by the sharp fall in oil prices, weak domestic demand, and changes in demographics. They continue to view the IMF’s econometric approaches used in informing the staff’s external sector assessment as suffering from a number of methodological and data shortcomings which prevent them from fully capturing key country specific factors such as past experiences of foreign exchange liquidity crises, the speed of population aging, and trade elasticities. While they did not view the exchange rate as undervalued, they agreed that a flexible exchange rate could play a role in reducing external imbalances, but put more emphasis on the role of boosting near-term growth and productivity-enhancing structural reforms in bringing about this transition. In this context they reiterated their policy of allowing the exchange rate to be freely determined in the market with intervention limited to smoothing operations to counter any large fluctuations in flows.

Addressing Longer-Run Growth Challenges

35. Key structural challenges. The Korean economy faces many well-diagnosed impediments to productivity growth, particularly in the non-traded sectors. These include:

  • Low service sector productivity—the ratio of service-to-manufacturing sector productivity in Korea is very low compared to its peers and investment in services has been consistently lagging. There are many reasons for this gap, including regulatory barriers in the sector that impede competition.

  • An un-dynamic SME sector—low service sector productivity is closely tied to SMEs as they provide the bulk of services and employ around 90 percent of the workforce. The sector is highly heterogeneous, but includes a myriad of unprofitable firms which, given the de facto social safety net role they play, are kept on life support through government guarantees, subsidies, and protections. This ties up labor, capital, and budgetary resources in low productivity activities and stifles innovation.

  • Labor market rigidities and distortions—a number of these lead to underutilization of productive resources. Female labor force participation is low and dips sharply for women aged 30–40 years, an age-linked compensation system encourages firms to push older and more skilled workers into early retirement, and labor market duality—the large and growing gap between the high protection for regular workers, particularly in large manufacturing firms, and over half of the labor force who are self-employed and non-regular workers—leads to higher turnover and lower firm-based training, and hampers the employment prospects of market entrants, largely young people.

36. Structural policy priorities. We see several key priority areas where actions are clearly needed and have the potential to yield the highest long run growth payoff.9 Many are overlapping and mutually reinforcing, and will contribute to higher productivity while at the same time reducing income inequality (Box 5):

  • Increasing service sector productivity. Considerable productivity gains could be achieved by promoting competition in health, education, and other protected professions, and by removing regulatory impediments to investment.

  • Making firms more dynamic. Phasing out government support that sustains unviable SMEs and further progress on restructuring ailing enterprises would free up resources for more productive activities.

  • Reducing labor market rigidities. This entails addressing gaps in legal protection for regular and non-regular workers, moving to performance- rather than seniority-based wages, reducing incentives for forcing early retirement, and improving unemployment insurance.

  • Increasing female labor force participation. Options include improving public support for childcare, facilitating part-time work, and enhancing job search and training support.

More generally, strengthening the government’s role in providing a social safety net would add to the effectiveness of many of these reforms and make them more politically and socially viable.

37. Government initiatives. The government largely shares these priorities, but as its growth strategy recognizes, tackling these challenges will require far-reaching reforms which should begin now as they may take some time to bear fruit. Particularly important is the government’s efforts to support labor market reform momentum following on the May, 2013, tripartite agreement between unions, employers, and the government. Discussions have covered a wide range of areas which have impeded productivity and wage growth, including workforce duality, low labor participation rates, low unemployment and employment-related public support, retirement, and the age-dependent compensation structure. But progress toward bringing about the desired changes will require a process of consensus-building among the stakeholders which will take time and require overcoming significant political and economic hurdles.

38. Tax reform. Korea’s relatively low public debt affords it the flexibility—unlike in many other countries—to undertake needed structural reforms that may have short-run fiscal costs, particularly since achieving higher growth potential will have a lasting fiscal payoff down the road. At the same time revenue in Korea is low relative to countries at similar levels of development in part reflecting weak compliance and high levels of exemptions (Box 6). Tax reform focused on broadening the base could generate meaningful revenue gains, helping address future fiscal needs consistent with the government’s emphasis on fiscal prudence, and in a way that would reduce rather than increase policy distortions and improve economic productivity.

Income Inequality in Korea

Korea’s standard, composite metrics of inequality such as Gini coefficients are near the average for OECD countries, but underlying these are trends pointing to increasing polarization.

Social mobility. Korea has traditionally been an egalitarian society. Since industrialization began social mobility—including through educational attainments and entrepreneurship—has buttressed Korea’s economic success. As Korea’s catch up process has matured, however, societal standing has become more entrenched. Studies find that Korea’s social mobility is relatively high but falling. They also show that the intergenerational correlations for educational attainment and socioeconomic status have increased in the last decade or so.

Middle class. Perceptions of middle class attainment have changed. Before the 1997 crisis the shared social belief was that a college degree would through a decent job allow anyone to rise to the middle class. In part as the result of Korea’s economic transformation after the 1997 crisis (e.g., corporate and bank restructuring), there is now a perception of two extremes in opportunity—lucrative jobs that require exceptional qualifications and mediocre jobs with no easy way to transition from the latter to the former.

A01ufig26

Relative Poverty Rates by Age Group 1/

Citation: IMF Staff Country Reports 2015, 130; 10.5089/9781513555676.002.A001

1/ The figure shows the poverty rate for each age group using an index, with the rate for the entire population set at 100. The poverty threshold is set at 50% of median income of the entire population. The OECD average includes 18 member countries.

Elderly poverty. Korea’s elderly poverty problem, worst among the OECD, is largely a consequence of (i) an immature social insurance system; (ii) rapid changes in social norms, (iii) shortfalls in retirement savings; and (iv) a substantial increase in life expectancy.

Gender occupational inequality. A combination of weak corporate management support for maternity for working women, a shortage of childcare availability, and increasing competition for forerunning cohorts in early childhood education, result in a sizeable drop in labor force participation for women in the childbearing age group.

Policy remedy? The challenge of rebuilding social mobility and maintaining the middle class is complex and requires coordinated actions in multiple fronts, including structural reforms in the labor market, the educational system, the SME sector, the services sector, and conglomerates. Consideration could be given to role of fiscal policy, where measures of fiscal redistribution are among the lowest in the OECD.

A01ufig27

Resdistributive Effect of Fiscal Policy

(Advanced Economies, mid-2000s)

Citation: IMF Staff Country Reports 2015, 130; 10.5089/9781513555676.002.A001

Note: The bar denotes absolute Gini reductions from transfers and taxes.Source: IMF (2014).

Tax Revenues in Korea

Korea’s tax revenue is low compared with most OECD countries, reflecting a number of factors and with implications that are broad-based.

Total revenue. Total revenue (including social contributions and local governments) reached 24.3 percent of GDP in 2013. This relatively low level is explained by narrow tax bases, lower tax rates, and potential compliance issues. Using a stochastic frontier tax analysis, staff found that Korea has considerable fiscal space given its relative high level of potential theoretical tax capacity but also importantly due to the low level of tax revenues currently collected.1

A01ufig28

Tax Revenue for OECD Countries

(In percent of GDP)

Citation: IMF Staff Country Reports 2015, 130; 10.5089/9781513555676.002.A001

Sources: OECD; IMF staff calculations.

Composition of revenue. VAT is the main source of revenue, followed by taxes on income. VAT collections reached 4.3 percent of GDP and accounted for 24 percent of tax revenues (excluding social contributions). Personal Income Tax (PIT) generated 3.7 percent of GDP and Corporate Income Tax (CIT) 3.4 percent. Customs duties represent around 0.8 percent of GDP.

Income inequality. The PIT features a high level of deductions and credits which diminish the progressivity of the tax. The government has recently attempted to curtail personal income tax exemptions, namely by replacing them with tax credits which are less regressive.

Income shifting. The large difference between PIT rates, CIT rates, and rates on capital gains might facilitate avoidance and increase the returns to shifting income artificially across categories. Moreover, the taxation of capital income should aim to achieve the greatest possible degree of neutrality, with the goal of minimizing distortions in the economy. The complexity of the CIT - comprised of three rate levels (10, 20 and 22 percent) depending on the tax base - complicates monitoring and control.

Property taxation. Despite recent reductions, it is still tilted towards taxing transactions, which might create an additional bottleneck to the recovery of the real estate market. Shifting to recurrent taxes on immovable property would also enhance tax efficiency.

With Korea’s low revenue and high level of exemptions, there is a case for reforms that broaden the tax base both to increase the efficiency of the tax system while also reducing economic distortions. Staff estimates show that even without changing rates the potential revenue yield could be substantial across a range of tax areas.2

1 “Understanding Countries’ Tax Effort” by R. Fenochietto and C. Pessino, IMF WP/13/244.2 “Understanding the Korean Tax Capacity” by Byung Mok Jeon and Ricardo Fenochietto, IMF Working Paper (forthcoming).

39. Authorities’ views. The authorities shared staff’s views that addressing impediments to productivity growth is essential to supporting Korea’s long run potential growth. The government’s Three-Year Plan for Economic Innovation for 2015 is led by reforms in four major areas: labor market, finance, public sector, and education. The government is committed to tripartite discussions with unions and employers to advance comprehensive labor market reform and bring about a more flexible and stable labor market, better working conditions for irregular employees, and a more comprehensive social safety net. At the same time, they recognized that building consensus in these areas will take time before leading to the changes in laws, regulations, guidelines, and labor and business practices that affect the structure of Korea’s labor market. Other reforms include those aimed at boosting financial sector dynamism by promoting finance-IT convergence, invigorating venture capital, and fostering an economic “ecosystem” where creative ideas can thrive. They also noted that progress has been made in refocusing SME financing and building public-private partnerships for infrastructure investment.

Staff Appraisal

40. The outlook for Korea remains challenging from both a cyclical and structural standpoint. Growth momentum has stalled reflecting sluggish domestic demand, inflation is low, and external uncertainties have increased. From a longer run perspective, relatively weak non-manufacturing productivity has been accompanied by a heavy, and likely unsustainable, reliance on manufacturing exports for growth while also leaving the economy more exposed to external shocks, and the demographic headwinds from a rapidly aging population are beginning to build.

41. The near-term growth outlook is subject to a number of uncertainties and risks. With a highly open economy, Korea faces global cross-currents. Korea will clearly benefit from lower oil prices, although it may take some time before this translates into growth through higher investment and consumption, while the growth outlook for Korea’s trading partners is mixed and the prolonged weakness of the yen has been a challenge to some Korean export industries.

42. There is a growing risk of a self-reinforcing downside scenario where the expectation of falling price and wage growth keeps consumer spending suppressed, and coupled with perceived weak external prospects leads firms to withhold investments and decrease hiring. Ultimately these expectations could become self-fulfilling. The growth consequences of such a downside scenario could be protracted, as the expectation of low or negative inflation once entrenched can be very difficult to break, and can have long-lasting negative effects on household, corporate, and public sector balance sheets.

43. Policies should remain focused on shoring up economic momentum. The authorities’ recent measures to spur economic recovery including monetary easing and fiscal policy initiatives are steps in the right direction, although it is still too early to gauge their full impact. The cost of getting stuck in a low growth, low inflation trap warrants a more pre-emptive use of available policy tools than would be called for in a normal cyclical environment, and additional steps should be taken if clear signs of a recovery do not emerge soon. There is room for further monetary policy easing if needed and relatively modest public debt allows the authorities the flexibility to broaden public support for the economic recovery while still preserving longer run fiscal sustainability.

44. Korea has built external buffers which enhance the economy’s resilience to shocks, and together with exchange rate flexibility, would help limit the impact of any renewed global financial volatility. At the same time Korea’s external position is substantially stronger than that implied by medium-term fundamentals and desirable policies. Building growth momentum could have some impact on reducing this imbalance but a more durable reduction will require shifting away from Korea’s heavy reliance on manufacturing exports for growth, aided by structural reforms to boost productivity growth in the non-traded sector. This reinforces the need for the authorities to maintain an active policy approach to support the economic recovery and address longer-run challenges, which will help improve the economy’s resilience to shifts in the external growth environment. Real exchange rate appreciation over time should also play a role. In this regard, the won should remain market determined with intervention limited to smoothing excess volatility.

45. Korea’s financial fundamentals are relatively sound which limits sources of short-run systemic risk. The financial system is broadly stable with solid capital buffers. Overall household debt has been rising but this has been matched by a corresponding increase in household financial assets rather than reflecting an increase in borrowing to finance consumption, and although there are pockets of vulnerabilities, we do not see debt levels as a near term threat to financial stability and the macroeconomy. At the same time, the structure of household debt could be strengthened, and one key challenge will be to facilitate the transition of mortgage market towards a more stable, long-term structure, in line with the government’s objective of increasing the share of fixed rate, longer-maturity amortizing mortgages.

46. The government’s focus on boosting Korea’s future growth potential is welcome and recent initiatives to begin addressing labor market and other rigidities are steps forward on a long road of policy actions that will be needed, and should begin now as they may take some time to bear fruit. Korea’s relatively low public debt affords it the flexibility—unlike in many other countries—to undertake needed structural reforms that may have short-run fiscal costs, particularly since achieving higher growth potential will have a lasting fiscal payoff down the road.

47. Staff recommends that the next Article IV consultation be held on the standard 12-month cycle.

Figure 1.
Figure 1.

The Real Economy

Citation: IMF Staff Country Reports 2015, 130; 10.5089/9781513555676.002.A001

Figure 2.
Figure 2.

Monetary and Financial Sector

Citation: IMF Staff Country Reports 2015, 130; 10.5089/9781513555676.002.A001

Figure 3.
Figure 3.

External Sector

Citation: IMF Staff Country Reports 2015, 130; 10.5089/9781513555676.002.A001

Table 1.

Korea: Selected Economic Indicators, 2012-16

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

Contribution to GDP growth.

Excludes gold.

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

Table 2.

Korea: Balance of Payments, 2012–16

(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, 2012–16

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Sources: CEIC; and IMF staff estimates and projections.
Table 3.b.

Korea: Integrated Balance Sheet - Consolidated General Government, 2011–14

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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, 2013–20

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Sources: Korean authorities; CEIC; 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, 2009–14

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Sources: Bank of Korea; Financial Supervisory Service; 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.

Manufacturing only.

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

Over one month.