IMF Executive Board Concludes 2009 Article IV Consultation with the Republic of KoreaPublic Information Notice (PIN) No. 09/103
August 9, 2009
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 August 7, 2009, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV Consultation with the Republic of Korea.1
Like other very open economies, Korea was hit hard by the global financial crisis towards the last quarter of 2008. Capital left the country at a faster pace than during the 1997-98 crisis, resulting in sharply lower asset prices, dislocations in money markets, and a spike in bank CDS spreads reflecting the sector’s heavy reliance on wholesale funding. This was followed by the largest export slump on record, which quickly spilled over into domestic demand. Overall, the Korean economy contracted by 5.1 percent quarter/quarter (not annualized) in the last quarter of 2008, among the sharpest contractions worldwide.
The authorities responded with a timely and comprehensive set of financial market and macro-stabilization measures. The authorities set aside US$55 billion in foreign exchange reserves to provide swaps or loans to banks and trade-related businesses, effectively substituting for loans previously provided by foreign creditors. The Bank of Korea (BOK) cut interest rates by a cumulative 325 basis points between October and February and relaxed conditions for its repo operations. On the fiscal front, the authorities enacted a 2009 fiscal stimulus package equivalent to 3.6 percent of GDP and provided generous quasi-fiscal support for ailing small and medium-sized enterprises (SMEs), mostly in the form of credit guarantees. Finally, they set up a bank recapitalization fund and a toxic asset fund to shield the banking sector from the downturn and prevent major deleveraging.
The steep exchange rate devaluation helped fend off deflationary pressures. The BOK intervened only exceptionally, confined spot market intervention to smoothing operations and secured swap lines from other central banks totaling US$90 billion. The weak won redirected domestic demand from imports to domestic production and, in combination with falling oil prices, turned the current account into a solid surplus in the first quarter of this year. Reserves declined by US$38 billion in the last quarter of 2008 to US$200 billion and have since recovered. Moreover, the weak won has sustained core inflation, at 3.5 percent in June, while headline inflation has declined to 2 percent on the back of softer commodity prices.
External defaults and a credit crunch have been avoided and economic activity stabilized in the first quarter of 2009. Bank credit continues to grow at a healthy pace and domestic bond issuance in the first five months of 2009 (relative to GDP) is close to an all-time high. In the first quarter of 2009, government consumption, construction investment, and private consumption rose as a direct result of the fiscal stimulus, and the economy expanded by 0.1 percent q/q. Economic activity continues to improve with exports, industrial production, and service sector activity well above their end-2008 lows and business and consumer confidence back in expansionary territory.
Going forward, the recent growth momentum is likely to moderate during the second half of 2009 and be followed by a drawn-out recovery. As the impulse from the front-loaded fiscal stimulus and export gains from the steep depreciation of the won in early 2009 fade, the pickup in growth is unlikely to be sustained at the same pace. Faced with a sluggish recovery in demand from trading partners, and highly leveraged households and SMEs, Korean growth is projected at -1¾ percent in 2009 and 2.5 percent in 2010. There is a distinct possibility that weak global exports will weigh on Korean growth well beyond 2010, as Western consumers permanently increase their savings rates. Other risks to the outlook are another bout of global risk aversion, rising oil prices, or—on the upside—a stronger impact from stimulus measures in Korea and abroad.
Executive Board Assessment
Executive Directors noted that, despite strong macroeconomic policies and limited direct financial sector exposure to subprime assets, Korea was hard hit by the global financial crisis. The sudden withdrawal of capital and the collapse of external and domestic demand had led to a sharp contraction in output in late 2008. Directors commended the authorities for their speedy and comprehensive measures, which have successfully stabilized the economy and the financial system.
Directors observed that, as domestic demand is constrained by highly leveraged households and small- and medium-size enterprises (SMEs), Korea’s recovery hinges critically on external demand and global financial conditions. While a moderate recovery is likely to take hold next year, in line with global growth prospects, the possibility of another bout of global risk aversion poses a downside risk. Accordingly, Directors agreed that macroeconomic policies should continue to focus on supporting growth until a self-sustained recovery is firmly established.
Directors supported the sizeable and frontloaded fiscal stimulus package and the intention to maintain fiscal stimulus in 2010 given the uncertain outlook. Noting the distortionary nature of quasi-fiscal measures to support SMEs, they welcomed the authorities’ plan to withdraw such support gradually as conditions permit. Directors looked forward to the announcement of a medium-term fiscal consolidation plan with concrete revenue and expenditure measures.
Directors agreed that the current accommodative monetary policy stance is appropriate. While vigilant monitoring of monetary conditions continues to be necessary, with their impact on asset prices taken into account in monetary policy deliberations, concerns about rising house prices are best addressed through prudential regulations, pending housing market reforms.
Directors took note of the staff’s assessment that the won is undervalued relative to its medium-term equilibrium level, and expected this trend to be reversed as capital inflows regain momentum. They endorsed Korea’s free floating exchange rate regime, and emphasized that foreign exchange intervention should remain limited to smoothing volatility. Some Directors acknowledged that Korea’s large reserve buffers had helped provide liquidity and confidence to markets in times of crisis, while a few others pointed to the potential costs of holding excessive reserves, including from the global perspective.
Directors agreed that the financial system is well-positioned to withstand deterioration in asset quality associated with the economic downturn. They were encouraged by the success of preemptive bank recapitalization in preventing a credit crunch, and welcomed the establishment of a fund to purchase impaired assets. Directors underscored the importance of linking future capital injections more clearly to progress on bank-led restructuring of SMEs. Given banks’ increased reliance on wholesale funding, consideration should be given to introducing prudential regulations limiting banks’ wholesale financing, and improving stress testing by banks and regulators.
Directors observed that the crisis response framework has worked well. They encouraged the authorities to consider a more formal approach to coordinating financial policies and sharing information among the government, the financial regulators, and the central bank. They also recommended further improvements to the insolvency regime, including through decriminalizing personal bankruptcies.
Directors noted that the current global crisis has highlighted the urgency of rebalancing Korea’s growth toward the nontradable sector, and welcomed the authorities’ renewed efforts to address structural weaknesses. This would require, as a matter of priority, eliminating the preferential tax treatment of the manufacturing sector, deregulating the service sector, and expediting SME restructuring. Reducing employment protection for regular workers and expanding social protection for nonregular workers would help improve labor market flexibility.