IMF Executive Board Concludes 2010 Article IV Consultation with the Republic of KoreaPublic Information Notice (PIN) No. 10/120
September 1, 2010
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. The staff report (use the free Adobe Acrobat Reader to view this pdf file) for the 2010 Article IV Consultation with Korea is also available.
On August 25, 2010, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Korea.1
Growth has rebounded impressively since the recession in the second half of 2008. Following the collapse in economic activity in the fourth quarter of 2008 (-16.8 percent quarter-on-quarter seasonally adjusted annualized rate (SAAR)), the subsequent recovery has solidified with GDP growth at 7.4 percent (q/q SAAR) in the first half of 2010. The rebound owes primarily to supportive macroeconomic and financial sector policies. Exchange rate flexibility, the normalization of international trade, and capital inflows have also supported the relatively quick recovery. Growth is projected at 6.1 percent in 2010, led by fixed investment and restocking before easing to 4½ percent next year. Risks to the outlook are broadly balanced.
Despite the recovery and strong capital inflows, inflation pressures and asset valuations remain contained. There are no signs yet of inflation pressures and inflation expectations remain well anchored as reflected in consensus forecasts. However, both headline and core inflation have trended up in recent months to 2.6 and 1.7 percent, respectively, from 2.3 and 1.5, respectively, in March. With Korea and other Asian economies leading the global economic recovery, capital inflows have rebounded. Renewed investor risk appetite and ample liquidity in the advanced economies have amplified this trend. In Korea, capital inflows have mainly been concentrated in portfolio investments, boosting equity prices. Housing prices are above their lows in early 2009, but the momentum in the housing market has slowed in recent months.
Korean banks entered the 2008 crisis well capitalized and with low nonperforming loans, although their reliance on wholesale funding proved to be a vulnerability. Since the crisis, banks have raised their average capital adequacy ratio (CAR) to 14.6 percent, 2 percentage points above pre-crisis levels. Moreover, nonperforming loan (NPL) ratios have remained low on average, partly due to significant write-offs, but NPLs remain high for savings banks exposed to ailing construction companies.
Exports have been buoyant, especially to China, but the rebound in imports associated with the recovery in domestic demand has led to a narrowing of the surplus relative to last year. Foreign exchange reserves have risen by close to US$75 billion since their lows during the crisis, currently standing at US$274 billion. The real effective exchange rate has appreciated by 22 percent since its weak point in March 2009, but still remains below pre-crisis levels.
Korea has embarked on exiting from the supportive macroeconomic and financial sector policies introduced during the crisis. The 2010 deficit is projected to decline to 1½ percent of GDP (excluding social security funds) following a deficit of 4.1 percent of GDP in 2009, primarily driven by the nonrenewal of most stimulus measures. This implies a negative fiscal impulse of close to 2 percent of GDP. Having kept the policy rate unchanged at 2 percent since February 2009, the Bank of Korea in July raised the policy rate by 25 basis points. However, monetary policy still remains highly accommodative. Most measures in support of small- and medium-sized enterprises (SMEs) are being gradually unwound, while many facilities in support of the financial sector remain in place, although utilization has been limited.
Executive Board Assessment
Executive Directors commended the Korean authorities for their swift and decisive policy response, which has contributed to an impressive economic recovery since early 2009. Growth is expected to be strong in 2010, increasingly led by private sector demand, and the economy is likely already at, or close to, its potential level. The outlook is nevertheless subject to downside risks related to a global economic weakening and heightened global financial strains, especially in advanced economies.
Against this background, Directors agreed that a carefully calibrated exit from supportive macroeconomic policies is appropriate. This comprises a measured fiscal withdrawal in 2011, a gradual normalization of policy rates given the current accommodative monetary stance, and a further unwinding of support to the financial sector and SMEs. Directors also called for preserving exchange rate flexibility as a key element of the exit strategy. At the same time, it would be important that the authorities stand ready to adjust their policy stance in the event that downside risks to growth materialize.
Directors welcomed the plan to balance the central government budget (excluding social security funds) by 2013–14, in light of the rapidly aging population and the need to retain room for counter-cyclical policies. Directors saw scope for broadening the tax base and for raising social security contributions. A further formalization of the medium-term fiscal framework, including through the introduction of a binding fiscal rule, would provide an additional anchor for fiscal policy. Directors considered it prudent to monitor public enterprises’ debt and to review their investment plans.
Directors agreed that overall price stability should remain the central bank’s over-riding objective. Some Directors saw merit in broadening the monetary policy framework to allow for policy responses to emerging pressures in asset markets or the excessive buildup of leverage.
Directors underscored the need to better incorporate macro-financial linkages into the policymaking process. Most Directors noted that, while taking into account country-specific circumstances, consideration could be given to further strengthening the coordination process among the relevant agencies charged with financial stability. Directors welcomed the authorities’ pre-emptive steps to tighten prudential regulations, as well as their readiness to adopt new measures to upgrade the supervisory and regulatory frameworks as they emerge from international consensus. They looked forward to the forthcoming Financial Sector Assessment Program (FSAP) update.
Directors considered that strengthening domestic sources of growth would reduce Korea’s vulnerability to economic downturns elsewhere in the world. They encouraged the authorities to introduce bolder reforms to raise productivity in the nontradable sector, including expediting a bank-led restructuring of troubled SMEs and opening up for competition in the service sector. Increased labor market flexibility and social protection would also help facilitate the rebalancing of the economy.