Public Information Notice No. 08/117

Public Information Notice: IMF Executive Board Concludes 2008 Article IV Consultation with the Republic of Korea

September 12, 2008

On September 8, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Korea.¹

Background

Difficult global conditions have made this a challenging year for Korea. First, against the backdrop of a global slowdown, economic activity in Korea is moderating. Second, surging global commodity prices and a weakening of the won are contributing to rising domestic inflation. Finally, while the Korean financial system remains in good health, increased global volatility has raised near-term risks, and ongoing structural changes to the financial sector present opportunities but also challenges to financial oversight.

After reaching 5 percent in 2007, growth is expected to moderate to 4.1 percent this year, before recovering to 4.3 percent in 2009. Headline inflation reached 5.6 percent in August, exceeding the Bank of Korea's target of 2½−3½ percent for a tenth consecutive month. However, slowing domestic demand and moderating food and fuel price inflation should help bring headline inflation down early next year. Reflecting a sharp deterioration in Korea's terms of trade, a current account deficit of 1¼ percent of GDP is expected this year, declining to about 1 percent in 2009. This outlook is subject to substantial uncertainty, with the possibility remaining of a deeper global slowdown, further volatility in global financial conditions, or still higher oil prices.

After a one-year pause, monetary policy was tightened in August, with the Bank of Korea raising its policy rate by 25 basis points to 5¼ percent, citing concerns about liquidity growth and the need to anchor inflation expectations. This year's fiscal stance provides an expansionary impulse of about 1½ percent of GDP, including about 1 percent of GDP in measures adopted after the budget, to address higher fuel prices. Despite the recent sharp depreciation, the exchange rate remains broadly in line with fundamentals. Intervention has been stepped up since June to smooth volatility and support the won.

The direct impact of the global financial crisis has been small, owing to limited exposure to subprime assets, but Korea has not escaped the turmoil unscathed: stock prices have declined; volatility has increased; and spreads on external debt have widened. Some concerns have also arisen regarding the financial sector. In particular, the heavy reliance of Korean banks on wholesale financing, has led supervisors to focus efforts on containing liquidity risk. In addition, while overall bank loan quality is strong, an economic slowdown could reveal some vulnerabilities, particularly in small- and medium-sized enterprise (SME) lending. Short-term external debt has risen sharply in recent years, as a counterpart to hedging activity, and more recently, with foreign purchases of sovereign bonds. This debt should be monitored, but its sources and uses are very different from those a decade ago, and risks remain moderate.

Looking ahead, structural changes to the financial sector will present both challenges and opportunities. Increased financial sector competition, in light of the Capital Market Consolidation Act taking effect in 2009, should contribute to growth, but will also require enhanced financial oversight to meet new regulatory challenges, including from more complex institutions and products. Korea also faces longer-term challenges to its impressive record of economic growth from population aging, the erosion of its low-skilled manufacturing base and lagging service sector productivity. The government aims to address these with a wide-ranging set of reforms, including through deregulation, privatization, and tax cuts.

Executive Board Assessment

Executive Directors commended the authorities for their continued skillful economic management, which has contributed to the resilience of the Korean economy in the face of challenging global circumstances. Korea's growth momentum has been supported by strong exports. The overall health of the financial sector and limited direct subprime exposures have contained the direct impact of the global financial turbulence. Nevertheless, growth has softened, equity prices and the won have weakened, and high oil prices have contributed to higher inflation. While baseline projections point to only a modest slowing of growth and a return of inflation to the Bank of Korea's target band during 2009, risks are skewed to the downside.

Directors supported the authorities' macroeconomic policy mix for addressing the difficult challenges facing Korea, in particular the priority being given to controlling inflation. Noting the recent indications of second round effects of commodity price increases, they emphasized that keeping expectations well-anchored is crucial to avoid more forceful, and more damaging, tightening later. Directors therefore welcomed the August policy rate hike. Going forward, some Directors suggested that the balance of risks may call for further tightening, while some others saw merit in proceeding cautiously. Directors also highlighted the importance of effective communication regarding monetary policy and inflation developments in keeping inflation expectations well-anchored. They noted that a more accommodative monetary policy could be envisaged if inflation eases and growth remains soft.

Directors agreed that the won remains broadly appropriately valued, despite the recent depreciation. They considered that Korea's flexible exchange rate regime continues to be appropriate, and generally supported the view that foreign exchange intervention should remain limited to smoothing excessive volatility. Directors stressed that Korea's inflation targeting framework remains the most effective policy tool for addressing inflation. At the same time, some Directors suggested that exchange rate management could also have a role in containing inflation.

Directors saw the slightly expansionary fiscal stance in 2008 as broadly appropriate. They underscored, however, that the scope for further fiscal stimulus is limited given the inflation pressures and the medium-term fiscal challenges facing Korea. Any further transfers to protect the vulnerable against high oil prices should be temporary, timely, and well targeted.

Directors noted that Korea's financial system remains healthy, although the ongoing financial turbulence has raised vulnerabilities. Global credit market stresses have highlighted that banks reliant on wholesale funding are subject to elevated liquidity risk. In that context, Directors agreed that the strengthening of liquidity risk management by banks and regulators in line with emerging best practices is a priority. Short-term external debt has increased in recent years and warrants close monitoring, although risks remain moderate. While loan quality is strong, Directors encouraged continued upgrading of banks' risk assessment, in line with the introduction of Basel II, noting that this would help address potential risks from lending exposures to SMEs and the real estate and construction sectors during a downturn.

Directors welcomed the Capital Market Consolidation Act, taking effect early next year, as an important step to develop Korea's financial sector and support long-term growth by increasing competition and the scope for innovation. They agreed that enhanced financial oversight will be needed to meet new regulatory challenges, including those associated with more complex financial institutions and products. Directors therefore welcomed the authorities' efforts to strengthen risk monitoring and enhance regulatory and supervisory capacity ahead of domestic market growth and innovation. Directors also welcomed the authorities' intention to privatize remaining state-owned banks, while emphasizing that any loosening of constraints on bank ownership by nonfinancial corporates should not threaten hard-won progress on corporate governance.

Directors commended the authorities' reform efforts to address long-term challenges to Korea's impressive growth record. They supported the plans to boost investment and growth through privatization and deregulation. Directors encouraged the authorities to meet head-on the longer-term implications of an aging society. They underscored, in this context, that proposals for reducing taxes should be part of a broader reform plan to address longer-run fiscal challenges.