IMF Executive Board Concludes 2006 Article IV Consultation with Korea

Public Information Notice (PIN) No. 06/111
October 11, 2006

Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.

On September 29, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Korea.1


For most of the period since early 2005, Korea has enjoyed the benefits of strong growth and low inflation. Output growth reached 6 percent, propelled by double digit export growth on the back of an upswing in the global electronics sector. Consumption also rose rapidly as households, which had been heavily overindebted following a credit card boom, advanced in repairing their balance sheets, helped along by a sharp rise in the local stock market and a pick up in housing prices.

These favorable conditions encouraged large capital inflows and the won strengthened considerably. This was only partially tempered by a shrinking current account balance, which has essentially vanished this year as the oil bill increased and domestic demand improved. The substantial won appreciation and falling regional food prices lowered inflation throughout 2005 and much of 2006, bringing inflation to the bottom of the Bank of Korea's 2½-3½ percent target band. Nonetheless, with output growing rapidly, the central bank gradually raised benchmark interest rates by 125 basis points starting in October 2005 to counter inflationary pressures pre-emptively, and to respond to mounting upward pressures on asset prices.

However, recent signs show that the period of high growth is coming to an end. The economy is slowing as the consumption recovery is maturing, while the export boom—notably in electronics—may abate as the U.S. economy slows.

Staff anticipates a soft landing, with GDP growth easing from 5 percent in 2006 to 4¼ in 2007, while inflation remains low. This baseline scenario has risks however, which are tilted to the downside. In particular, the U.S. economy could experience a sharper than expected slowdown. This would have a major impact on Korea, given that exports account for 40 percent of GDP and the United States is Korea's second largest export market after China. Also, while ample reserves and healthy financial and corporate balance sheets would help cushion Korea, should global risk aversion increase, the associated increase in lending rates would hurt Korean households and small and medium enterprises given their high leverage.

While the performance of the Korean economy over the last year and a half has been encouraging, daunting challenges loom on the horizon. In particular, the population is aging rapidly, capital accumulation is decelerating, and overall productivity growth is falling. If these trends continue, potential output growth will slow substantially by mid-century, and strong fiscal pressures will emerge.

Executive Board Assessment

Executive Directors lauded the remarkable progress Korea has made since its first consultation with the IMF 50 years ago: over this span, the country has developed from a poor, agrarian society into a prosperous advanced economy. By integrating the manufacturing sector into the global economy, while maintaining prudent macroeconomic policies, Korea has been able to enjoy a prolonged period of strong growth and low inflation, which offers lessons for other countries. Looking ahead, Directors were confident that the Korean authorities would succeed in tackling the underlying long-term issues related to an aging population, decelerating capital accumulation, and falling productivity growth.

Directors noted that the Korean authorities have been tightening macroeconomic policies as a pre-emptive action against inflation. In recent months, the economy has begun to decelerate, and while a soft landing is expected, prospects could weaken if the slowdown in the United States proves sharper than expected, oil prices rebound, or global financial conditions tighten further. Meanwhile, inflation should remain subdued. In this environment, Directors considered that it would be appropriate to maintain a neutral fiscal stance. Similarly, they believed that any further monetary policy tightening should be data-dependent, based on signs of inflation. Directors endorsed the Bank of Korea's decision to shift to targeting headline inflation, a step that would improve transparency because this index is the one used and understood by the public.

Directors commended the authorities for adhering to their flexible exchange rate policy and allowing the won's value to be determined in the foreign exchange market, while limiting intervention to smoothing operations. They considered that overall competitiveness remains appropriate, as reflected in the sustained increase of Korea's share in global export markets.

With respect to financial stability, Directors noted the strengthening of Korea's banking system in recent years. However, they cautioned that mutual savings banks have been expanding loans rapidly, a situation that requires careful monitoring and steps to subject them to the same prudential regulations as banks. Directors endorsed the authorities' close monitoring of domestic foreign exchange lending, which has also been expanding rapidly. In addition, they recommended improving the flow of information to credit bureaus to help lenders respond to risks in a more timely and accurate fashion.

Beyond these immediate challenges, Directors emphasized the need to tackle longer-term problems. On current trends, potential growth will slow considerably, largely because the population is aging rapidly, while productivity growth has proved disappointing, especially in the services sector. The authorities' strategy to deal with this challenge is to open the services sector to more domestic and external competition, which Directors strongly supported.

Directors welcomed in particular the plans to develop the financial sector by integrating it further into the global and regional economy. They supported the planned deregulation of capital markets, noting that this measure will spur competition and innovation. Directors stressed, however, that this reform will need to be accompanied by measures to contain the accompanying risks, notably by imposing stronger sanctions against conflict-of-interest violations, and continuing to prevent industrial groups from owning banks. Many Directors favored maintaining a legal separation between investment banks and asset managers.

Directors also welcomed the plans to open up and deregulate the nonfinancial services sector. They emphasized the importance of multilateral trade liberalization in these efforts, urging the authorities to take a proactive role in advancing the Doha Development Round. Directors stressed that as Korea opens up its services sector, labor market flexibility will become increasingly important. They noted that the lack of flexibility in the regular labor market has led firms to replace permanent employees with fixed-term staff, which has exacerbated income inequality and social polarization. Directors therefore strongly recommended a renewal of efforts to secure a social consensus to ease conditions of regular employment, while continuing to strengthen the social safety net.

As a final longer-term challenge, Directors cautioned that Korea's traditionally strong fiscal position will gradually come under pressure from the aging of its population. Expenditure pressures will grow as health care costs climb, while pension costs will rise and eventually deplete the assets of the pension system under current parameters. Directors strongly endorsed the authorities' plans to keep the debt-to-GDP ratio low by creating fiscal space, putting the pension system back on a sustainable track, and containing health care expenditures. However, they stressed that the key to success was prompt action, especially on pensions, for the longer corrective actions are delayed, the more painful the measures would ultimately need to be.

Korea: Selected Economic Indicators


2002 2003 2004 2005

IMF Staff

IMF Staff

Real GDP (percent change)

7.0 3.1 4.7 4.0 5.0 4.3


7.6 -0.3 0.4 3.4 4.5 3.8

Gross fixed investment

6.6 4.0 2.1 2.3 1.8 4.0

Net foreign balance 1/

-0.2 2.5 3.3 1.4 1.4 1.0

Prices (percent change)


Consumer prices (end of period)

3.7 3.4 3.0 2.6 3.0 2.7

GDP deflator

2.8 2.7 2.7 -0.4 -1.6 1.7

Labor market (in percent)


Unemployment rate

3.3 3.6 3.7 3.7 ... ...

Wage growth, manufacturing

12.0 8.7 10.0 7.8 ... ...

Consolidated central government (In percent of GDP)


Revenues 2/

23.2 23.7 22.9 23.7 25.3 25.7


20.9 21.0 20.7 21.6 22.9 23.2

Balance 2/

2.3 2.7 2.3 2.1 2.4 2.5

Money and interest rates (In percent)


Overnight call rate

4.3 3.8 3.3 3.7 4.5 ...

M3 growth

13.6 4.7 7.1 7.4 7.7 ...

Yield on corporate bonds

5.9 5.6 3.7 5.5 5.1 ...

Balance of payments


Current account balance (In billions of U.S. dollar)

5.4 11.9 28.2 16.6 3.3 2.9

Current account balance (In percent of GDP)

1.0 2.0 4.1 2.1 0.4 0.3

Won per U.S. dollar (Period average)

1,252 1,192 1,146 1,024 ... ...

Sources: Data provided by the Korean authorities; and IMF staff estimates and projections.

1/ Contribution to GDP Growth.

2/ Excluding privatization receipts and rollover of KDIC/KAMCO bonds.

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.


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