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IMFSurvey Magazine: Countries & Regions

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Korea Confronts Global Headwinds with Strong Fiscal Position

Customer uses automated teller machine in Seoul. Korea’s financial sector has become more robust due to concerted efforts by authorities (photo: Jo Yong-Hak/Corbis)

ECONOMIC HEALTH CHECK

Korea Confronts Global Headwinds with Strong Fiscal Position

IMF Survey online

September 19, 2012

  • Uncertain global economy—including escalation of euro crisis—threatens Korean growth
  • Korea’s strong fiscal position will help it meet challenges to growth
  • Despite strengthened financial sector, Korea still vulnerable to capital outflows

Korea must guard against risks to its economic growth, particularly those posed by a possible escalation of the European debt crisis. But its strong fiscal position—including its relatively small public debt—and a robust institutional framework leave it well placed to tackle threats to growth, say IMF economists.

Despite weathering the global financial crisis robustly, strong headwinds from the global economy are dampening Korea’s growth momentum, say the IMF experts in their regular report on the state of the country’s economy.

Korea is expected to grow by 3 percent this year—below its growth potential— and then around 4 percent in 2013, although continued weakness in the global economy may make this difficult to achieve, suggests the report. And despite significantly slower exports, the country’s current account is projected to remain in surplus this year.

Managing risks, preserving macroeconomic soundness

If the global economy deteriorates, the authors of the report say Korea has sufficient space to respond, particularly on the fiscal side. In the event of a severe financial contagion, similar to that of 2008–09 when capital poured out of the region, the authorities should be prepared to use their ample foreign reserves to maintain orderly market conditions, they added.

The Korean authorities have already announced a modest fiscal stimulus package, and cut the monetary policy rate to support the economy in response to a weaker-than-expected growth outlook.

“We believe this step is appropriate given global weakness and heightened uncertainties, but a normalization of monetary policy stance will be needed in 2013 if the economy returns to trend growth as projected” said Hoe Ee Khor, IMF mission chief for Korea.

Less vulnerability in the financial sector

The report suggests that the Korean financial system has become less vulnerable since 2008 due to the concerted efforts of the authorities. External buffers have been strengthened, with higher foreign reserves and bilateral swap lines, while short-term debt has been reduced.

Regulators have also taken a number of macroprudential measures to strengthen the resilience of the banks to liquidity shocks. These steps included a cap on foreign exchange derivatives positions and a financial stability levy.

The foreign investor base in the government bond market has also become more diverse, and now includes regional central banks, but Korea still remains vulnerable to shocks from volatile capital flows, warns the report.

IMF economists say that an escalation of the euro area crisis could still cause Korean banks to experience difficulties rolling over their debt, despite their reduced dependence on wholesale funding. The IMF stressed the importance of monthly stress tests undertaken by Korean financial authorities on the foreign currency liquidity positions of domestic banks, and said the vulnerability of foreign bank branches, resulting from their reliance on parent funding, needs to be monitored closely.

The IMF welcomed the establishment of the inter-agency Foreign Exchange Market Stabilization Committee and its efforts in monitoring and responding to market developments.

Domestically, the high level of household debt remains a concern, but the authorities are addressing the problems in an appropriate manner, says the report.

Enhancing inclusiveness and sustainability

In the report, the IMF economists say that Korea’s fiscal prudence can help the country address the future challenge of increasing inclusiveness and dealing with an aging population.

The economists welcomed plans to raise the country’s social spending—which is relatively low by the standards of an industrialized economy—to improve income inequality and the welfare of poorer groups in society, while preserving medium-term fiscal consolidation objectives.

Khor said that the increase in social spending would probably require further broadening the tax base and perhaps raising tax rates in some areas, although there may also be some scope for expenditure reprioritization.

The IMF economists also stressed the need for labor market reform and enhancing service sector productivity. They said the labor force participation rate also needed to be improved, with greater numbers of women joining the workforce to boost potential growth.