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IMF Urges Korea to Shift from Crisis Response to Medium-Term Challenges

A member of Korea’s “Grandma Taekwondo Federation”. Korea’s aging population will be a challenge to future growth. (Kim Jae-Hwan/Newscom)

Economic Health check

IMF Urges Korea to Shift from Crisis Response to Medium-Term Challenges

By Burcu Aydin
IMF Asia and Pacific Department

September 1, 2010

  • Post-crisis, focus on sustainable growth, say IMF economists
  • Fund backs calibrated withdrawal of macroeconomic stimulus
  • Challenges arising from aging population, indebtedness, and slower export growth

Having recovered from the global financial crisis, Korean authorities should now shift their focus from crisis management to paving the way for strong and sustainable growth, say IMF economists.

Korea has rebounded rapidly from the global crisis, backed by supportive macroeconomic and financial policies, and output is expected to expand by 6.1 percent in 2010. In their annual assessment of the country’s economy, the Fund’s economists said the country must now shift its focus to future sustainable growth.

“If Korea is to enjoy robust growth over the medium-term, and reduce its vulnerability to external demand shocks, it will be important to improve the country’s resilience by enhancing macroeconomic and financial policy frameworks, as well as raising productivity in the nontradables sector,” said Subir Lall, the IMF’s mission chief for Korea.

Time to withdraw macroeconomic stimulus

The Korean authorities have already started to plan for the future with the gradual withdrawal of stimulus measures. They have set a target budget deficit (excluding social security) of around 1 percent of GDP—down from 4.1 percent in 2009—and frontloaded budgetary spending in 2010. The benefits from this public sector spending are expected to help smooth the transition to self-sustaining private sector-led growth.

Support for the financial sector is also being withdrawn as financial market conditions have normalized. With the economy expected to reach its potential in the near future, the IMF is recommending continued withdrawal of fiscal support in 2011, along with the sustained normalization of interest rates.

Following discussion of the report, the IMF’s Executive Board backed the call for a “carefully calibrated exit from the supportive macroeconomic policies.”

Learning from the crisis

A key theme of the IMF’s report was the importance of drawing lessons from the recent crisis. The downturn has demonstrated the critical need to have fiscal room to respond to adverse shocks to the economy. Over the medium-term, and given the rapidly aging population, Korea is set to face further pressure on the public purse.

The economists recommended that the authorities take steps to further strengthen their medium-term fiscal framework, including through the introduction of a fiscal rule. This would make fiscal targets more binding and strengthen prioritization of fiscal measures.

The report’s authors also recommended improving the Bank of Korea’s inflation targeting framework by formally incorporating asset prices into the formulation of monetary policy which could help the central bank better manage volatility in output and prices. The benign neglect of asset prices may have led to a build-up of financial imbalances in many countries in the run-up to the global crisis.

The report also commended the Korean authorities’ comprehensive and effective response to the financial stresses that emerged in the wake of the massive global deleveraging and associated capital outflows in late 2008.

To prepare for the post-crisis environment, IMF economists recommended further streamlining and enhancing the institutional framework for safeguarding financial stability, including strengthening coordination among relevant institutions and continued tightening of the supervisory and regulatory framework.

Need to rebalance the drivers of growth

Over the medium-term, the IMF believes that Korea’s growth will be below pre-crisis levels due to three main factors:

• Slower growth in demand for Korea’s exports as advanced economies repair public and private sector balance sheets

• Korea’s highly indebted households and small and medium-sized enterprises

• the rapidly aging population

These trends underscore the need for Korea to build a strong and competitive nontradable sector, which would reduce the country’s reliance on exports as the main engine of growth and make it less susceptible to global demand shocks.

In this context, the report says Korea needs to reform product and labor markets, which would boost productivity of the nontradable sector, while the increased participation of women and the elderly would counter the age-related shrinking of the labor force.