Public Information Notices
Republic of Korea and the IMF
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On February, 20, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Korea.1
For most of the period after the Asian financial crisis Korea's economy has grown rapidly, the result of favorable cyclical developments and deep structural reforms. But in 2003, this ascent was interrupted. The economy contracted during the first half of the year, after a household credit boom came to an end and some long-standing structural problems re-emerged. Although growth has now resumed, the recovery relies heavily on surging exports, while domestic demand remains subdued.
For 2003 as a whole, economic growth fell to an estimated 2.9 percent from 6.3 percent in 2002. The main factor was a decline in domestic demand. Private consumption fell, as a sharp rise in credit card delinquencies forced financial institutions to rein in household credit. Meanwhile, an increase in labor tensions and a corporate governance scandal (SK Global) took a toll on bond markets and investment, including foreign direct investment intentions, which declined by 29 percent.
As growth slowed, the authorities used macroeconomic policies to support the economy. Monetary policy was eased, with the policy rate being cut to an historic low of 3.75 percent, facilitated by a reduction in inflation below the 3 percent mid-point of the authorities' target band. The fiscal stance was also relaxed, by front-loading expenditures and adopting two supplementary budgets, thereby avoiding the traditional underspending of the budget, which would have imparted a significant contractionary impulse.
In addition, the authorities resisted pressures for an exchange rate appreciation. With portfolio inflows exceptionally large, they stepped up their foreign exchange purchases, contributing to a US$34 billion increase in reserves to US$155 billion. These actions limited the won's appreciation against a weakening dollar, keeping the average nominal effective exchange rate for the year essentially unchanged.
At the same time, the authorities were able to advance their structural reform agenda. To spur further improvements in corporate governance, new accounting and auditing bills were passed, which will increase the amount of information provided to investors and help ensure that this information is accurate. At the same time, to ensure that investors can enforce their legal rights in cases where the information does prove misleading, class action lawsuits were legalized in cases of securities violations.
Further progress was also made during 2003 in financial sector privatization. The government sold stakes in three large banks, leaving its 87 percent stake in the Woori Group as its sole sizeable holding remaining—and even in this case, it initiated procedures to sell down its shares. The government also arranged to sell the largest investment trust company, Hyundai ITC, to a foreign securities firm, facilitated by a large injection of public funds.
As for 2004, the IMF is expecting a moderate recovery, with growth of around 5½ percent, propelled by a continued rapid growth in exports. There is even some upside potential to this forecast, as the export performance may flow through rapidly into domestic demand. But there are also downside risks, especially since consumption could continue to be weighed down by heavy household indebtedness, while investment could be dampened if firms continue to take a "wait and see" attitude, pending improvements in the labor situation or April's National Assembly elections.
Executive Board Assessment
Executive Directors commended the authorities for Korea's impressive recovery from the Asian crisis. During most of the past six years economic growth has been rapid, raising output far above its pre-crisis level, while economic resiliency has also improved. Korea today is a prosperous economy, with strong medium-term prospects, based on its well-educated workforce and expertise in advanced technology. This remarkable achievement is a tribute to deep structural reforms, which have created a more competitive and transparent economic system, guided predominantly by market signals.
Notwithstanding this considerable progress, Directors noted that the structural reform agenda remains unfinished. The end of a credit card boom has left households saddled with high levels of debt and loan delinquencies, and the credit card companies themselves in financial difficulties. Other nonbank financial institutions also suffer weaknesses, corporate governance practices should still be further improved, and the labor market remains dualistic. In 2003, these problems combined to derail the economic expansion. While a recovery is now underway, propelled by surging exports, domestic demand remains weak. Directors therefore agreed that decisive action will be needed to strengthen the foundations for broad-based and sustained rapid growth, in line with the authorities' long-term objective of doubling Korea's per capita income. Accordingly, they were encouraged by the authorities' continued readiness to learn from experience, and their plans to address the remaining structural weaknesses.
Against the backdrop of a still uneven recovery, Directors encouraged the authorities to continue to ensure that macroeconomic policies in 2004 remain supportive. They welcomed the steps towards maintaining a broadly neutral fiscal stance, including the plans to front-load spending and adopt a supplementary budget if necessary. As the recovery takes hold, it will, however, be important to restore fiscal balance to prepare for the budgetary challenges of an aging population and uncertainties related to North Korea.
Directors endorsed the continuation of a supportive monetary policy given the subdued level of inflation and the remaining output gap. The rise in housing prices in certain areas of the country will require continued vigilant monitoring, suggesting that the authorities should continue to pursue targeted measures, which are better suited to deal with this issue than monetary policy actions.
Directors observed that Korea's flexible exchange rate policy, adopted in the wake of the Asian crisis, has served the country well, supporting financial market development, while maintaining external competitiveness. To preserve these gains, they urged the authorities to allow the exchange rate to be determined essentially by market forces by scaling back their foreign exchange purchases, which should be limited to smoothing excessive volatility. Going forward, and with surging exports, Directors considered that greater exchange rate flexibility would help achieve more balanced growth domestically, while also contributing to cooperative efforts towards an orderly adjustment of global current account imbalances.
Directors were encouraged by the authorities' plans to address the remaining structural problems in the financial sector, corporate governance, and the labor market. The most pressing priority will be to strengthen the credit card companies. Directors emphasized the importance of making it clear that the rescue of LG Card was an exceptional case, and that other card companies will be required to recapitalize at an early date. It will also be important to sell LG Card quickly to investors with strong financial and managerial credentials. To prevent similar problems in the banking system, Directors recommended that the authorities tighten household lending standards and strengthen the supervisory framework by shifting toward a more risk-based approach, as recommended in the Financial Sector Assessment Program (FSAP).
In the asset management sector, Directors welcomed plans to sell the remaining two government-controlled investment trust companies to financially strong and capable buyers. They also welcomed the authorities' declaration that the planned Korean Investment Corporation will be independent and will not be used as a vehicle for intervention in financial markets, and their intention to enshrine these principles in the agency's law. To ensure a high level of transparency, the agency's accounts should be disclosed fully and on a regular basis.
In the bond market, Directors urged the authorities to dispel notions that large companies are "too big to fail". To encourage investors to sharpen their risk assessments, they supported the plan to improve the accuracy of bond ratings. They also looked forward to an early approval of the unified bankruptcy bill currently before the National Assembly.
Directors strongly encouraged the authorities to press ahead with measures to further improve corporate governance. They supported the authorities' three-year roadmap for corporate reform, aimed at easing regulations on chaebol that improve their governance. Also welcome are the new accounting and auditing reforms, which will contribute to more accurate and timely information to investors. As a further step, Directors encouraged the authorities to explore the scope for further enhancements. They suggested requiring firms to comply with the Code of Best Practices in Corporate Governance, or, at least, explain why they are not doing so. They welcomed the new law allowing class action lawsuits for securities violations, and encouraged further steps to improve investors' legal protection.
Directors underscored the importance of a sustained effort to reform Korea's labor market, especially since greater employment flexibility will be needed to help face the challenges of an economy increasingly specialized in high technology and services. Directors consequently welcomed the plans to ease employment protection, while at the same time expanding the coverage of the social safety net, and encouraged the authorities to continue to build the required consensus to move forward in this area. Since even with these reforms the share of nonregular workers may continue to rise, Directors encouraged the authorities to envisage further efforts to increase flexibility in the regular labor market, noting that Korea could draw useful lessons from the experiences of other OECD countries in this area.
Directors welcomed the recent approval by the Korean parliament of a free trade agreement with Chile, and looked forward to further trade opening steps, including in the agricultural sector.
Directors recognized that implementing this ambitious reform agenda will be challenging. They were, nevertheless, confident that the authorities will find the way forward, building on their demonstrated capacity to implement difficult reforms and the widespread awareness that tackling the remaining challenges will be key to substantially lift per capita incomes.
Sources: Data provided by the Korean authorities; and IMF staff estimates and projections.
1/ Contribution to GDP growth.
2/ Excluding privatization receipts.
3/ Latest available data for 2003.
1 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.
IMF EXTERNAL RELATIONS DEPARTMENT