Public Information Notice No. 99/115

Public Information Notice: IMF Concludes Article IV Consultation with Korea

December 29, 1999

On December 17, 1999, the Executive Board concluded the Article IV consultation with Korea.¹

Background

In late 1997, Korea was hit by a financial crisis marked by massive capital outflows, a sharp depreciation of the won, and severe distress in the corporate and financial sectors. To restore confidence and replenish reserves which had been almost depleted, Korea agreed to a US$21 billion standby-arrangement with the Fund on December 4, 1997. The main objectives of the program were to stabilize the economy and restore sustainable growth through a fundamental restructuring of the economy.

Policies adopted under the program have successfully restored external stability, rebuilt reserves, and initiated reform of the financial and corporate sectors. The severe disruption and loss of confidence because of the crisis, however, led to Korea's worst recession in over three decades. Real GDP contracted by 5.8 percent in 1998 and the unemployment rate jumped to close to 9 percent in February 1999 from less than 3 percent before the crisis. After a brief spike in early 1998, inflation has been subdued owing to weak domestic demand and a large output gap. These factors, together with the depreciated won, led to a sharp swing in the current account to a large surplus in 1998.

Once the task of stabilizing the exchange rate was achieved, the focus of policies shifted to stimulating growth through an easing of macroeconomic policies. The overnight call rate was progressively reduced, falling to below pre-crisis levels by July 1998; the call rate has been kept at about 4¾ percent since April 1999. The consolidated central government deficit (including privatization receipts) is projected to be about 4 percent of GDP in 1999, providing considerable stimulus to the economy. The fiscal plans also ensure that adequate support is allocated to social safety net programs. Government expenditure on the social safety net is projected to rise to about 2 percent of GDP in 1999, compared to an estimated 1 1/3 percent of GDP in 1998.

There has been an unexpectedly sharp turnaround in economic activity in 1999. The economy is expected to grow by 9 percent in 1999, with upside potential to this forecast. Growth has been led by a buoyant private consumption, a rebound in equipment investment, and a slower pace of inventory decumulation. The rapid recovery has also been aided by supportive macroeconomic policies. The strengthening of the economy is reflected in a drop in the unemployment rate to 4.4 percent in November. Meanwhile, inflation has remained low.

Korea's external position has also strengthened considerably. Despite a pick-up in imports, continued strong export growth has resulted in a sizable current account surplus of $20 billion in the first nine months of 1999. Capital inflows have also increased markedly this year, related to joint ventures and asset sales related to corporate restructuring, an increase in the weight assigned to Korea in emerging market portfolios, and improved credit ratings for Korean companies. The inflows, together with the large current account surplus, have resulted both in a build-up of reserves to $70 billion at end-November as well as an appreciation of the won in nominal effective terms. With reserves now sufficient to provide cover for external short-term liabilities (on a residual maturity basis), external vulnerability has been significantly reduced.

The sustainability of strong growth is, however, not yet assured. Indeed, the collapse of Korea's second largest conglomerate--Daewoo--and the resulting turmoil in financial markets in the second half of 1999 illustrates that there are lingering risks that could stand in the way of sustaining rapid growth in the medium-term. Thus, despite the major progress made in the area of structural reforms there is still a large unfinished agenda, especially in the financial and corporate sectors. The key recent developments in these two sectors are as follows:

• Good strides have been made in restructuring the financial sector, but important reforms remain to be implemented. Progress has been most tangible in consolidating and recapitalizing the banking system with a significant injections of public funds; strengthening the role and independence of the Financial Supervisory Commission; and bringing prudential regulations in line with best international practice. The divestiture of majority shares in Korea First Bank has recently been finalized, but the privatization of Seoul Bank has run into a variety of problems and is proceeding more slowly than anticipated. In the nonbank financial sector, the framework and regulatory structure to deal with the insurance industry's problems are essentially in place, and the emphasis now turns to implementation. In addition, reform of the investment trust industry is now the priority issue in the financial sector.

• Major improvements have been made in corporate governance and financial transparency. Progress in deleveraging and restructuring of the chaebol has, however, been slow. The government has stepped up efforts to encourage corporations to accelerate and strengthen the restructuring process. By moving decisively to restructure Daewoo, the government has also demonstrated that the large conglomerates are not "too big to fail." For the other top-5 chaebol, the government has moved to enforce implementation of their capital structure improvement plans and apply sanctions for noncompliance. In the case of the 6-64 chaebol ranked by asset size, debts are being restructured under a creditor-led debt workout framework but early evidence suggests that restructuring has not gone deep enough and several of the agreed workouts will need to be revisited to reduce debt to a more sustainable level. The workout process is being strengthened, especially with regard to establishing clear guidelines for the monitoring and enforcement of agreed workouts, and improving selection criteria so that only viable companies are admitted into the workout program.

Executive Board Assessment

Executive Directors noted that the remarkable speed and strength of Korea's economic recovery and the marked reduction in external vulnerability provided clear evidence that the policies adopted by the authorities in response to the crisis were the right ones and were working. They commended the authorities for their sound management of macroeconomic policies and for the substantial progress that has been made in structural reforms, and welcomed their intention to withhold making further drawings under the Stand-By Arrangement. Directors observed that these achievements have made Korea a more open, competitive, and market-driven economy, and have contributed to significant improvements in market confidence.

Directors stressed, however, that the sustainability of strong growth is not yet assured, and that it will be essential to maintain the momentum of reform and to tackle the remaining structural weaknesses in the financial and corporate sectors. They saw the current strength of the economic situation as providing an excellent opportunity to push ahead with these reforms.

Directors emphasized that, with the narrowing output gap and continuing large external inflows, macroeconomic policies need to shift to a more neutral stance and the mix of policies needs to be rebalanced. The major focus of macroeconomic adjustment should be on fiscal consolidation. In this context, Directors strongly welcomed the authorities' intention to begin the process of consolidation with the 2000 budget, and for bringing forward the goal of achieving a balanced budget to 2004, especially given the potential high budgetary costs of financial restructuring. They noted that if growth next year is stronger than expected, automatic stabilizers should be allowed to work.

Given the absence of inflation pressures, Directors considered that monetary policy should remain accommodative. However, they noted that in view of the rapid pace of growth, the monetary authorities would need to exercise vigilance and stand ready to adjust monetary policy before inflation pressures arise. Directors also noted that the trend toward strengthening of the won was appropriate in light of the large depreciation following the crisis, and was helping to dampen inflation pressures. This trend was also consistent with achieving a more balanced and sustainable current account position in the medium term. In addition, Directors stressed that intervention in the foreign exchange market and the accumulation of reserves should take place in line with the principle that the exchange rate should be determined by market forces. A number of Directors considered that inflation targeting could provide a useful framework for guiding monetary policy, and urged the authorities to establish a reliable framework for forecasting inflation so as to facilitate a move to inflation targeting; some others suggested, however, that the authorities take more time to weigh the advantages and disadvantages of such a move.

Directors considered forceful action to further strengthen the financial system as a high priority for the structural reform effort in the period ahead. They noted that, although the authorities have managed to contain the fallout on the financial system from Daewoo's collapse and to stabilize the situation in the investment trust sector, this has been achieved at the cost of introducing new distortions in financial markets. The most immediate financial sector issue is the needed reform of the investment trust industry. Directors urged the authorities to implement fundamental reforms in this sector without delay, and they welcomed the authorities' plan to increase the use of market valuation principles in the industry. In addition, they noted that special attention will need to be given to improving supervision and strengthening governance in this sector, especially to ensure that managers and trustees honor their fiduciary responsibilities. Moreover, public funds should be used only to provide a partial safety net for small investors. Directors suggested that these reforms, as well as the ongoing reforms of the insurance sector, will be critical for deepening capital markets in Korea.

Directors commended the authorities for the substantial achievements in improving the health of the banking system over the last two years. They noted, however, that the process of building a sound banking system is far from over. They welcomed the introduction of stricter loan classification guidelines and strengthened supervisory oversight, but observed that the ongoing process of corporate restructuring was likely to expose additional losses and require greater efforts to strengthen banks' capital. Directors welcomed the recent progress made in the privatization of Korea First Bank. They urged the authorities to also move expeditiously to privatize Seoul Bank so as to demonstrate the authorities' commitment to introducing international management practices and greater competition into the Korean financial system.

Directors noted that, although favorable economic conditions and a strong stock market have helped improve corporate liquidity, Daewoo's failure clearly shows that it is not possible simply to grow out of structural problems. Directors therefore stressed the need to accelerate and strengthen the corporate restructuring process to ensure that more fundamental and meaningful operational restructuring is undertaken. Directors made the following specific points:

Regarding Daewoo, they commended the authorities for the speed with which they have drawn up the framework for the complex restructuring of the conglomerate, and for demonstrating that no company in Korea is "too big to fail." They welcomed the authorities' willingness to place Daewoo affiliates in workout arrangements with their creditors. Directors noted that it is critical for the government to ensure that the final workout plans go beyond financial restructuring to operational restructuring through asset sales, liquidation of nonviable companies, and other forms of business restructuring, and that the workout agreements are fair and transparent with equal treatment of domestic and foreign creditors.

With regard to other large conglomerates, Directors welcomed the authorities' intention to make greater use of regulatory powers and sanctions to ensure that they continue to restructure.

As regards mid-sized conglomerates, Directors underscored the importance of deeper restructuring to enhance their viability, and noted this could be achieved through their creditor banks applying stricter sanctions for noncompliance with stated restructuring plans.

Directors strongly supported the authorities' plans to adapt the social safety net system away from the emergency measures designed as a response to the crisis toward a more strategic medium-term approach. They also advised the authorities to continue to strengthen the administrative framework necessary to respond promptly to potential future shocks to employment.

Directors commended the authorities for the progress that has been made since the crisis in improving the coverage, periodicity and timeliness of key economic data. Directors urged the authorities to continue making improvements in data coverage, especially with respect to government operations, and financing.