Outlook and Risks

External uncertainties such as US-China trade tensions and a global slowdown in the tech cycle, especially for semi-conductors which account for about 21 percent (customs clearance basis in 2018) of Korea’s exports, has dampened both exports and facility investment. Along these trends, compounded by base effects in government investment, growth in Q1 of 2019 unexpectedly dipped 0.3 percent (Q on Q). The temporary drop in government investment was mainly driven by slow budget execution in Q1 this year due to delays in bidding and contracting, compared to the large increase in government spending in Q4 of 2018¹ following last year’s supplementary budget.

The Korean authorities still see this year’s growth target of 2.6–2.7 percent as achievable. While private consumption remains solid, they expect a steady rise in export volumes from the second half of this year. Policy efforts are also being made to boost the economy including through expansionary fiscal spending and multi-pronged investment stimulus measures. Furthermore, they have committed to closely monitoring economic conditions and taking additional actions as necessary.

Fiscal Policy

Fiscal policy will remain expansionary in accordance with staff’s recommendation. The increase in expenditure of 9.5 percent in the 2019 budget is at the highest level since the global financial crisis. Furthermore, the government has frontloaded spending, committing 61 percent of the budget in the first half of this year. To improve spending efficiency, budget execution is being thoroughly monitored and assessed to feed into the budget adjustment in the following year.

A supplementary budget bill of KRW 6.7 trillion or 0.4 percent of GDP was also submitted to the National Assembly last month. The size of this supplementary budget could seem smaller than those in past years, but if it is combined with grants already disbursed to local governments² in early April (10.5 trillion KRW), the additional fiscal support beyond the original budget would amount to around 0.9 percent of GDP. This extra budget will support measures to ensure public safety against fine dust pollution and disasters. It will also prevent downside risks from materializing in the early stages by propping up exports and investments, job creation and strengthening the social safety net.

The authorities are of the view that fiscal sustainability could be strengthened with additional revenue mobilization, mainly by broadening tax bases. On staff’s suggestion to increase the neutrality of corporate income taxation to enhance resource allocation, the authorities take a cautious position, in that it should be reviewed across the whole tax system more holistically, taking country-specific circumstances into account.

Monetary Policy and Financial Sector

The authorities consider the current policy rate supportive and accommodative. The Bank of Korea (BOK) has conjectured that the output gap has been slightly negative. The difference between the output gaps estimated by the BOK and the IMF is attributable to the IMF’s overestimation of potential GDP for 2010. The BOK plans to closely monitor any changes to financial and economic conditions at home and abroad and take a data-dependent approach in managing monetary policy.

Korea’s financial system has performed well with the subsequent implementation of the Basel III framework and regular stress tests for the financial market. The BOK and the Financial Supervisory Services have implemented regular stress tests to monitor the loss-absorbing capacity of the financial system against potential risk factors given financial institutions’ interconnectedness.

Efforts are being made to contain the rapid growth of household debt utilizing diverse macroprudential measures (MPMs). The BOK underscored that, while the MPMs are effective in specific markets, using a mix of the MPMs and monetary policy would be much more effective in addressing overall financial stability risks. Key policy goals include managing household debt growth, supporting vulnerable borrowers, and improving household loan structures from floating-rate interest-only to fixed-rate amortizing payment. The authorities intend to maintain household debt growth at around the rate of nominal GDP growth over the mid-to-longer term. On top of the loan-to-value and debt-to-income ratios, they have introduced the debt service ratio as a controlling indicator for the banking sector, and it is also expected to be applied to non-banking sectors in June 2019.

The authorities also remain vigilant to monitor property prices linked to the financial market. While overall housing market risks are currently being contained with tightened MPMs, the government will continue its policy efforts to maintain market stability—focusing on suppressing the speculative demand, supporting occupiers for purchasing their own house, and implementing targeted measures by region.

External Sector

The current account surplus is expected to decline gradually. The authorities note staff’s assessment that Korea’s external position in 2018 is moderately stronger than warranted by medium term fundamentals and desirable policy setting. They expect staff to keep refining the model and reflect country specific factors such as rapid population aging and potential reunification costs in assessing the external position. They also have concerns over staff’s view on FX macroprudential measures. A levy on non-deposit foreign currency liabilities and a leverage cap on FX derivatives have helped prevent excessive build-up of short-term debt and lengthen the maturity structure of debt. These measures are not residence-based and were never intended to limit capital flows, rather to reduce systemic risks in the financial market. In this context, they clearly need to be classified as MPMs under the Fund’s Institutional View.

From March this year, Korea has begun to disclose FX market intervention data to enhance the transparency of its foreign exchange policy. The data for the second half of last year were posted on the website of the BOK in end-March this year and the BOK will keep up these postings going forward.³

Structural Policies

One of Korea’s key policies is promoting innovation to boost productivity. The authorities implemented a law on a regulatory sandbox that is pre-permissive and post-regulatory. They expect to make many successful cases from the regulatory sandbox starting this year. The authorities have also focused on supporting finance, taxation, and regulatory changes in four major service sectors such as tourism; healthcare; smart-logistics; arts and entertainment contents (i.e. K-contents). In addition, R&D investment, particularly in driverless cars and artificial intelligence, has increased in preparation for the fourth industrial revolution. Tax benefits will also be given on private fifth-generation (5G) network investments. The Korean government launched a task force for innovative growth in April. Moreover, the authorities support the restructuring of insolvent companies promptly, with three major principles— holding large shareholders responsible, sharing the burden among stakeholders, and ensuring companies make tough decisions to survive on their own.

Korea continues to promote labor market stability and flexibility through social dialogue and compromise. The authorities support transforming irregular workers into regular ones, while strengthening the social safety net through measures such as unemployment benefits and further improving active labor market policies—including public employment services and vocational training—which is also emphasized in the selected issue paper. They encourage adopting a performance-based payment system over seniority-based salaries. In addition, they also concur with staff that 52 working-hours per week would be beneficial in terms of workers’ well-being, productivity, female labor supply, and fertility.

The Korean government is putting in every effort to ensure the smooth implementation of the minimum wage policy. Since there is a relatively high portion of low-wage workers (receiving less than two-thirds of median income) in Korea, with comparably lower social expenditures, the minimum wage plays an important role in correcting inequality and boosting domestic consumption. In the meantime, the authorities are trying to cushion the adverse impact on production by providing temporary financial support to the self-employed and to SMEs that may experience difficulties from the minimum wage increase. A bill to introduce a new minimum wage setting mechanism with two sub-committees (i.e. the range-setting committee and the decision-making committee) is currently being discussed at the National Assembly. The former will consist of experts who will set the upper and lower bands of the minimum wage, based on objective indicators. The latter will make the final decision within the range, enhancing the objectivity and rationality of the minimum wage and encouraging wider social acceptance.

Expanding public sector jobs is necessary to provide quality public services in an aging society. The share of public employment in Korea is lower than half of the OECD average. The authorities plan to increase public employment particularly in understaffed areas like security and welfare, where the private sector cannot replace it easily.

Tackling low fertility and aging is one of the top policy priorities. The authorities have laid out a basic plan for addressing the low birth rate and aging society, which is renewed every five years. In February, the authorities released the third basic plan with a variety of policy measures. Coverage of maternity benefits and a subsidy for shortening working hours for childcare have been expanded. They plan to increase paid parental-leave days for spouses at the time of childbirth and establish more daycare centers in the workplace to further facilitate female labor force participation. In addition, a new governmental task force will investigate the impact of the demographic change on employment, budget, welfare, education, and industrial structure in order to enhance the adjustability of the economy and prepare comprehensive policy responses for the future.