## cr1840

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### Outlook and projections
- Real GDP growth: 3.2 percent in 2017 and 3.0 percent in 2018.
- Private consumption growth: projected to accelerate, supported by the large minimum wage increase and policies supporting employment and social spending.
- Exports: export volume projected at 5.4 percent (2017) and 3.7 percent (2018).
- Net exports: contribution to growth shifts from negative in 2017 to slightly positive in 2018 as imports of capital goods moderate.
- Headline inflation: projected average 2.0 percent in 2017 and 1.9 percent in 2018; CPI inflation (end of period) 2.1 percent (2017) and 1.9 percent (2018).
- Current account surplus: 5.6 percent of GDP in 2017, edging lower to 5.4 percent of GDP in 2018.
- Nominal GDP (in trillions of won): 1,732 (2017) and 1,805 (2018).
- Unemployment: overall rate around 3.8 percent (seasonally adjusted); youth unemployment 10.0 percent (seasonally adjusted) in September.

### Financial stability and vulnerabilities
- Main financial stability risk: high and rising household debt; household debt exceeds 90 percent of GDP.
- Macroprudential policy: steady tightening is effectively addressing financial stability challenges to date; LTV and DTI limits lowered to 40 percent for financial institutions, with larger reductions to 30 percent for borrowers with multiple mortgages and in regions with speculative buying.
- Macroprudential measures to be implemented:
  - Debt-service ratio limit for all financial institutions in 2018: starting with banks in the middle of 2018 and NBFIs early in 2019.
  - Rapid shift to fixed-rate, amortizing mortgages constitutes 47 percent of total mortgage loans.
- Financial system: sound, but vigilance urged for risks from non-bank financial institutions (NBFIs) and migration of credit risk to NBFIs.
- Selected indicators:
  - Gross international reserves (end of period, billions of U.S. dollars): 366.9 (2017) and 368.5 (2018).
  - Total external debt (end of period, billions of U.S. dollars): 364.9 (2017) and 354.0 (2018).
  - Total external debt (in percent of GDP): 23.8 (2017) and 21.4 (2018).
  - Credit growth (end of period): 6.2 (2017) and 6.1 (2018).
  - M3 growth: 7.9 (2017) and 7.9 (2018).
  - Banks’ capital ratios: 14.8 percent in 2016.
  - Non-performing loan ratio for banks: 1.25 percent.
  - Household credit growth slowed to 7.8 percent year-on-year in October (2017), down from the 12-percent average annual growth rate in 2016.
  - Net international investment position (NIIP): 17 percent of GDP in end-September 2017; gross liabilities totaling 74 percent of GDP, of which 27 percent was gross external debt.

### Structural headwinds and equity issues
- Potential growth: slowed from 7 percent in the early 1990s to below 3 percent; projected to decline steadily until 2058.
- Demographics: working-age population share peaked at 70 percent in 2016 and is projected to drop to 50 percent in 2050.
- Productivity:
  - Total factor productivity slowed and remains about 60 percent of that in the US.
  - Labor productivity in 2012: 65 percent of the frontier in manufacturing and 31 percent in market services.
- Labor market duality:
  - Non-regular workers share: over 20 percent in Korea vs. average 11 percent in OECD economies.
  - Non-regular workers earn on average 66.3 percent of regular workers’ wages.
  - Non-regular workers are less likely to receive social benefits or on-the-job training.
- Income inequality and polarization:
  - Gini coefficient: 0.295 (2015) and 0.304 (2016).
  - Ratio of disposable income of the highest quintile to the lowest quintile: 5.1 (2015) and 5.5 (2016).
  - Old-age poverty and high youth inactivity cited as contributors to worsening inequality.

### Policy recommendations and priorities
- Macroeconomic package: integrated macroeconomic, financial, and structural policies to support recovery, raise potential growth, reduce external imbalances, and preserve financial stability.
- Fiscal policy (short and medium term):
  - Short-term fiscal policy should become significantly more expansionary to support the recovery and rebalance the policy mix.
  - Staff recommends reducing the structural balance toward zero by at least 0.5 percentage point each year during the coming years.
  - Korea has substantial fiscal space to aim for a zero-structural balance in the short and medium run without a risk to debt sustainability.
  - Targeted increases in social spending, sustained over the medium and longer term, to promote rebalancing toward consumption-based growth and lessen inequality.
  - Fiscal spending on childcare and Active Labor Market Policies (ALMP) to boost labor supply.
  - For the longer term, additional revenue mobilization will be necessary to address aging-related fiscal challenges.
- Monetary policy:
  - Should remain accommodative as inflationary pressures are likely to remain subdued.
  - Enhance credibility by strengthening communication of policy intentions and clarifying the Bank of Korea’s policy reaction function.
  - Allow exchange rate to move flexibly, with intervention limited to addressing disorderly market conditions.
- Financial sector:
  - Continue steady tightening of macroprudential policies to contain household debt vulnerabilities.
  - Remain vigilant to risks from non-bank financial institutions and harmonize regulation across institutions.
- Labor market and social protection — adopt “flexicurity”:
  - Three pillars: (i) more flexibility for regular workers; (ii) a strong and inclusive safety net for the unemployed; (iii) Active Labor Market Policies.
  - Strengthen female labor force participation and youth employment; bolster vocational schools, the work-study dual system, and internships.
  - Minimum wage: increase with care going forward; any compensatory subsidy to small- and medium-size enterprises should be temporary.
  - Public sector jobs: scope to expand cautiously and targeted to services not easily provided by the private sector.
- Structural reforms to boost productivity:
  - Ease regulatory burden for firms, especially in the service sector.
  - Government policy towards SMEs should prioritize fostering growth and innovation, rather than shielding weaker firms.
  - Better design and coordinate R&D support.

### Box 1 — Policy initiatives of the new government (selected measures)
- 2017 Supplementary budget: KRW of 11 trillion (0.7 percent of GDP), includes subsidies for job-seeking youth, higher child and unemployment benefits, transfers to the elderly and tax incentives to firms for hiring.
- 16.4 percent increase in the minimum wage beginning in 2018 (from KRW 6,470 ($6.2; PPP terms) per hour to KRW 7,530 ($7.2; PPP terms) per hour).
- Permanent expansion in welfare spending in the 2018 budget.
- Tax revision bill: hike in the income tax rate for the top two brackets by 2 percentage points; increase in corporate tax rate for companies with taxable income exceeding KRW 300 billion ($276 million) from 22 percent to 25 percent.
- Additional initiatives being finalized: five-year employment road map (expansion in public sector jobs; new restrictions on non-regular contracts; 52-hour weekly limit); measures to promote fair competition between conglomerates and smaller firms; plan to support innovation and productivity through regulatory reforms.

### Fiscal policy scenario and modeling (G20MOD/FSGM assumptions and outcomes)
- Scenario assumptions:
  - Permanent increase in targeted transfers by 0.75 percent of GDP to the most vulnerable.
  - Expansion in childcare spending by 0.25 percent of GDP.
  - Increase in ALMP spending by 0.5 percent of GDP.
  - Financing through a combination of higher VAT revenues and lower surplus.
  - In 10 years, implementation of 75 percent of product market and employment protection reforms to converge regulation to frontier average.
  - Shift toward more growth-friendly tax structure: share of consumption and property taxes in total tax revenues increases by 1.1 percentage points.
- Scenario outcomes in 10 years:
  - Output increase of about 6 percent.
  - Consumption increase of about 9 percent.
  - Current account surplus decline of nearly 2.0 percent of GDP.
  - The package would imply an 11-percentage points increase in the debt-to-GDP ratio relative to baseline in 10 years (text notes further increases beyond 10 years).

### Flexicurity, labor-market measures, and quantitative comparisons
- Flexicurity pillars reiterated: (i) flexibility for regular workers; (ii) inclusive safety net; (iii) ALMPs.
- Policy measures to implement flexicurity:
  - Ease restrictions on dismissal of regular workers for performance and economic reasons.
  - Avoid converting temporary workers to permanent status unless regular-contract rigidity is reduced simultaneously.
  - Expand ALMPs toward job training and matching; provide personalized support; target vulnerable groups.
  - Increase unemployment insurance coverage and benefit levels; link benefits to conditionality.
- Quantitative labor-market comparisons and modeling:
  - Net replacement rate (initial phase of unemployment) in Korea: 56 percent (OECD average 63 percent).
  - Maximum duration of unemployment benefits in Korea: 8 month (OECD average 18 month).
  - Spending on ALMP in Korea: around 4900 USD per unemployed (OECD average 7000 USD).
  - Modeling indicates implementing all three pillars together can improve output, equality, and unemployment and raise welfare for all if calibrated appropriately.

### Youth employment, female labor participation, and public employment guidance
- Youth employment: rate about 10 percentage points below the OECD average; share of youth neither in employment nor in education or training: 18 percent.
- Recommended youth measures: strengthen Meister schools, work-study dual system, internships; increase business ownership; ensure quality of placements.
- Female labor force participation:
  - Korea’s female participation one of the lowest in the OECD—20 percentage points below best performers.
  - Share of women in regular jobs: 40 percent.
  - Women’s average pay gap: women paid on average about 37 percent less than men.
  - Share of women in senior management positions: 2 percent (OECD average 20 percent).
  - Recommended policies: quality and affordability of childcare; shared parental leave; neutral tax treatment for second earners; corporate benchmarks for women’s employment and leadership.
- Public employment:
  - Government plans: create 514,000 new jobs in government and public corporations; convert 300,00 public sector workers into regular employment.
  - Current public employment: around 8 percent of total (OECD average 21 percent).
  - Staff guidance: scope to increase public employment in civil and social services, but avoid using public employment as a general job-creation tool.

### Minimum wage observations and cautions
- 2018 minimum wage increase: 16.4 percent (to KRW 7,530 ($7.2; PPP terms) per hour).
- Current minimum wage (prior to 2018): KRW 6,470 ($6.2; PPP terms) per hour.
- Government medium-term objective: raise minimum wage to KRW 10,000 per hour.
- Impacts and risks:
  - Boosts incomes and consumption; around 7 percent of workers receive the minimum wage.
  - Some low-skilled jobs may be lost; further sharp increases could erode competitiveness and price low-skilled workers and youth out of the market.
  - Government compensation to small businesses estimated at KRW 3 trillion (0.2 percent of GDP) for 2018; subsidies should be temporary.

### External sector, exchange rate, and reserves
- Current account dynamics:
  - CA was 7.0 percent of GDP in 2016; first three quarters of 2017 CA surplus was 5.7 percent of GDP (seasonally adjusted).
  - Preliminary EBA-based estimates: 2017 cyclically adjusted CA surplus 4.8 percent of GDP; EBA CA norm 1.8 percent of GDP; staff CA gap midpoint 2.3 percent of GDP; CA gap range 0.3–4.3 percent of GDP.
  - CA surplus projected to decline to around 5.6 percent of GDP in 2017 and edge lower to 5.4 percent of GDP in 2018.
- Exchange rate and REER:
  - Average REER Jan–Nov 2017: 2.7 percent above the 2016 average.
  - Nominal effective exchange rate appreciated by 2.4 percent over this period.
  - Won appreciated against the dollar by 11.7 percent in 2017 (another authority figure reports 12.8 percent for the whole year).
  - Staff assessment: REER is 1 to 12 percent below the level consistent with fundamentals and desired policies (high uncertainty).
- Capital flows and reserves:
  - Net non-FDI capital inflows increased by $10 billion compared to first three quarters of previous year.
  - Non-resident portfolio inflows surged US$16.6 billion.
  - Foreign ownership in domestic stock market rose to more than 34 percent in September.
  - Foreign exchange reserves reached US$384 billion (25 percent of GDP) in October, increasing by 3.6 percent year-to-date; reserves around 120 percent of IMF composite reserve adequacy metric at end-November 2017.

### Risks and Risk Assessment Matrix (selected)
- External downside risks: geopolitical tensions (North Korea), tighter global financial conditions, renegotiation of KORUS.
- Domestic risks: high household debt and a house price correction.
- Upside risks: stronger-than-projected exports and higher-than-expected consumption reflecting new income support measures.
- Selected RAM entries (likelihood / potential impact / policy response):
  - Retreat from cross-border integration: Medium / High / Accommodative fiscal and monetary policies, flexible exchange rate, structural policies.
  - Tighter global financial conditions: High / Medium / Flexible exchange rate; macroprudential policies.
  - Significant China slowdown: Medium / High / Accommodative policies; diversify exports.
  - Increase in geopolitical risks (North Korea): High / High / Flexible exchange rate; macroprudential policies; fiscal expansion if tail risks materialize.
  - Excessive household debt weakening consumption and financial stability: Medium / Medium / Expansionary fiscal and accommodative monetary policy while using macroprudential policies.

### Debt sustainability and long-term fiscal challenges
- Nominal gross central government debt (percent of GDP): 30.0 (2015), 35.6 (2016), 36.1 (2017), 35.4 (2018), 35.0 (2019), 34.8 (2020), 34.6 (2021), 34.5 (2022).
- Gross financing needs (percent of GDP): 5.5 (2015), 6.8 (2016), 5.7 (2017), 1.3 (2018), 1.5 (2019), 2.2 (2020), 2.2 (2021), 2.7 (2022).
- Real GDP growth projections (percent): 3.7 (2015), 2.8 (2016), 2.8 (2017), 3.2 (2018), 3.0 (2019), 2.9 (2020), 2.8 (2021), 2.7 (2022).
- Long-term aging fiscal pressures:
  - Outlays for pensions and healthcare set to rise by 10-16 percent of GDP by 2060.
  - With unchanged revenues, debt-to-GDP ratio projected to climb above 100 percent of GDP by 2050.
  - Staff indicates revenue increases and borrowing combinations could stabilize debt-to-GDP well below 85 percent.
- Policy options to raise revenues: broaden tax base, eliminate deductions, reduce number of corporate income tax rates to one, greater neutrality in taxation of capital income, broaden VAT base (VAT currently 10 percent).

### Key statistics (selected exact figures)
- Real GDP (percent change): 3.3 (2014), 2.8 (2015), 2.8 (2016), 3.2 (2017), 3.0 (2018).
- Total domestic demand: 3.1 (2014), 4.0 (2015), 3.7 (2016), 5.0 (2017), 3.0 (2018).
- Consumption: 2.0 (2014), 2.4 (2015), 2.9 (2016), 2.8 (2017), 3.3 (2018).
- Gross fixed investment: 3.4 (2014), 5.1 (2015), 5.2 (2016), 9.0 (2017), 2.3 (2018).
- Current account balance (in percent of GDP): 6.0 (2014), 7.7 (2015), 7.0 (2016), 5.6 (2017), 5.4 (2018).
- CPI inflation (average): 1.3 (2014), 0.7 (2015), 1.0 (2016), 2.0 (2017), 1.9 (2018).
- Gross national saving (in percent of GDP): 34.5 (2014), 35.6 (2015), 35.7 (2016), 36.6 (2017), 36.0 (2018).
- Gross domestic investment (in percent of GDP): 29.3 (2014), 28.9 (2015), 29.2 (2016), 31.0 (2017), 30.7 (2018).
- Consolidated central government overall balance (authorities, in percent of GDP): 0.6 (2014), 0.0 (2015), 1.0 (2016), 0.8 (2017), 1.0 (2018).
- General government debt: 35.9 (2014), 37.8 (2015), 38.3 (2016), 37.6 (2017), 37.3 (2018).
- Exports, f.o.b. (billions of U.S. dollars): 613.0 (2014), 542.9 (2015), 511.9 (2016), 569.1 (2017), 603.3 (2018).
- Imports, f.o.b. (billions of U.S. dollars): 524.1 (2014), 420.6 (2015), 393.1 (2016), 446.6 (2017), 476.9 (2018).

*Source: IMF staff report for the 2017 Article IV Consultation (Republic of Korea).*

### 3.0 percent, with private consumption growth benefitting from the large minimum wage increase

### 3.0 percent, with private consumption growth benefitting from the large minimum wage increase

### Outlook and projections
- Real GDP growth: 3.2 percent in 2017 and 3.0 percent in 2018.
- Private consumption growth: projected to accelerate, supported by the large minimum wage increase and policies supporting employment and social spending.
- Exports: expected to benefit from stronger global trade; export volume projected at 5.4 percent (2017) and 3.7 percent (2018).
- Net exports: contribution to growth shifts from negative in 2017 to slightly positive in 2018 as imports of capital goods moderate.
- Headline inflation: projected average 2.0 percent in 2017 and 1.9 percent in 2018; CPI inflation (end of period) 2.1 percent (2017) and 1.9 percent (2018).
- Current account surplus: 5.6 percent of GDP in 2017, edging lower to 5.4 percent of GDP in 2018.
- Nominal GDP (in trillions of won): 1,732 (2017) and 1,805 (2018).
- Unemployment: overall rate around 3.8 percent (seasonally adjusted); youth unemployment 10.0 percent (seasonally adjusted) in September.

### Financial stability and vulnerabilities
- Main financial stability risk: high and rising household debt.
- Macroprudential policy: steady tightening is effectively addressing financial stability challenges to date, allowing monetary policy to focus on inflation.
- Financial system: described as sound, but Directors encouraged vigilance to emerging risks, especially from non-bank financial institutions.
- Selected indicators:
  - Gross international reserves (end of period, billions of U.S. dollars): 366.9 (2017) and 368.5 (2018).
  - Total external debt (end of period, billions of U.S. dollars): 364.9 (2017) and 354.0 (2018).
  - Total external debt (in percent of GDP): 23.8 (2017) and 21.4 (2018).
  - Credit growth (end of period): 6.2 (2017) and 6.1 (2018).
  - M3 growth: 7.9 (2017) and 7.9 (2018).

### Structural headwinds and equity issues
- Potential growth: has slowed from 7 percent in the early 1990s to below 3 percent; projected to decline steadily until 2058.
- Demographics: working-age population share peaked at 70 percent in 2016 and is projected to drop to 50 percent in 2050.
- Productivity: total factor productivity slowed and remains about 60 percent of that in the US; labor productivity in 2012 was 65 percent of the frontier in manufacturing and 31 percent in market services.
- Labor market duality:
  - Non-regular workers share: over 20 percent in Korea vs. average 11 percent in OECD economies.
  - Non-regular workers earn on average 66.3 percent of regular workers’ wages.
  - Non-regular workers are less likely to receive social benefits or on-the-job training.
- Income inequality and polarization:
  - Gini coefficient increased from 0.295 (2015) to 0.304 (2016).
  - Ratio of disposable income of the highest quintile to the lowest quintile: increased from 5.1 (2015) to 5.5 (2016).
  - Old-age poverty and high youth inactivity contribute to worsening inequality.

### Policy recommendations and priorities
- Macroeconomic policy package: integrated macroeconomic, financial, and structural policies to support recovery, raise potential growth, reduce external imbalances, and preserve financial stability.
- Fiscal policy:
  - Short-term fiscal policy should become significantly more expansionary to support the recovery and rebalance the policy mix.
  - Korea has substantial fiscal space to aim for a zero-structural balance in the short and medium run without a risk to debt sustainability.
  - Targeted increases in social spending, sustained over the medium and longer term, to promote rebalancing toward consumption-based growth and lessen inequality.
  - Fiscal spending on childcare and Active Labor Market Policies to boost labor supply.
  - For the longer term, additional revenue mobilization will be necessary to address aging-related fiscal challenges.
- Monetary policy:
  - Should remain accommodative as inflationary pressures are likely to remain subdued.
  - Enhance monetary policy credibility by strengthening communication of policy intentions and clarifying the Bank of Korea’s policy reaction function.
  - Exchange rate: allow to move flexibly, with intervention limited to addressing disorderly market conditions; a few Directors encouraged publication of intervention data.
- Financial sector:
  - Continue steady tightening of macroprudential policies to contain household debt vulnerabilities.
  - Remain vigilant to risks from non-bank financial institutions.
- Labor market and social protection:
  - Adopt “flexicurity”: (i) more flexibility for regular workers; (ii) a strong and inclusive safety net for the unemployed; and (iii) Active Labor Market Policies.
  - Strengthen female labor force participation and youth employment; bolster vocational schools, the work-study dual system, and internships.
  - Minimum wage: increase with care going forward; any compensatory subsidy to small- and medium-size enterprises should be temporary.
  - Public sector jobs: scope to expand cautiously; government should be careful in expanding public employment to create jobs.
- Structural reforms to boost productivity:
  - Ease regulatory burden for firms, especially in the service sector.
  - Government policy towards SMEs should prioritize fostering growth and innovation, rather than shielding weaker firms.
  - Better design and coordinate R&D support.

### Key statistics (selected exact figures)
- Real GDP (percent change): 3.3 (2014), 2.8 (2015), 2.8 (2016), 3.2 (2017), 3.0 (2018).
- Total domestic demand: 3.1 (2014), 4.0 (2015), 3.7 (2016), 5.0 (2017), 3.0 (2018).
- Consumption: 2.0 (2014), 2.4 (2015), 2.9 (2016), 2.8 (2017), 3.3 (2018).
- Gross fixed investment: 3.4 (2014), 5.1 (2015), 5.2 (2016), 9.0 (2017), 2.3 (2018).
- Current account balance (in percent of GDP): 6.0 (2014), 7.7 (2015), 7.0 (2016), 5.6 (2017), 5.4 (2018).
- CPI inflation (average): 1.3 (2014), 0.7 (2015), 1.0 (2016), 2.0 (2017), 1.9 (2018).
- Gross national saving (in percent of GDP): 34.5 (2014), 35.6 (2015), 35.7 (2016), 36.6 (2017), 36.0 (2018).
- Gross domestic investment (in percent of GDP): 29.3 (2014), 28.9 (2015), 29.2 (2016), 31.0 (2017), 30.7 (2018).
- Consolidated central government overall balance (authorities, in percent of GDP): 0.6 (2014), 0.0 (2015), 1.0 (2016), 0.8 (2017), 1.0 (2018).
- General government debt: 35.9 (2014), 37.8 (2015), 38.3 (2016), 37.6 (2017), 37.3 (2018).
- Exports, f.o.b. (billions of U.S. dollars): 613.0 (2014), 542.9 (2015), 511.9 (2016), 569.1 (2017), 603.3 (2018).
- Imports, f.o.b. (billions of U.S. dollars): 524.1 (2014), 420.6 (2015), 393.1 (2016), 446.6 (2017), 476.9 (2018).

*Source: IMF staff report for the 2017 Article IV Consultation (Republic of Korea).*

### Box 1. Policy Initiatives of the New Government

### Box 1. Policy Initiatives of the New Government

### Policy measures approved or imminent
- 2017 Supplementary budget of KRW of 11 trillion (0.7 percent of GDP), which includes subsidies for job-seeking youth, higher child and unemployment benefits, transfers to the elderly and tax incentives to firms for hiring.
- 16.4 percent increase in the minimum wage beginning in 2018.
- Permanent expansion in welfare spending in the 2018 budget.
- Tax revision bill envisaging measures to make the tax system more progressive, including:
  - a hike in the income tax rate for the top two brackets by 2 percentage points;
  - an increase in the corporate tax rate for companies whose taxable income exceeds KRW 300 billion ($276 million) from 22 percent to 25 percent.

### Additional initiatives being finalized
- A five-year employment road map: expansion in public sector jobs; new restrictions on the use of non-regular employment contracts; enhancements in the wage system; a 52-hour limit on weekly working hours.
- Measures to promote fair competition between conglomerates and smaller firms.
- A plan to support innovation and foster productivity growth: upgrading technology, providing an environment that promotes creative research, and far-reaching regulatory reforms to foster private-sector-driven growth.

### Macroeconomic outlook and inflation
- GDP growth projections:
  - 2017: projected at 3.2 percent.
  - 2018: forecast at around 3 percent.
  - Output gap: projected to remain negative in 2017 and 2018; estimate of around 0.6 percent of GDP in 2017 is subject to high uncertainty.
- Inflation:
  - Headline inflation temporarily rose above the Bank of Korea’s two-percent target during 2017; in November headline inflation slowed to 1.3 percent year-on-year.
  - Core inflation stood at 1.4 percent in November.
  - Headline inflation is projected to remain around 2 percent in 2017 and 2018.
  - Core inflation is likely to remain below 2 percent in 2018.
- Monetary policy:
  - Policy interest rate was raised 25 basis points in November 2017 to 1.5 percent (later referenced as current interest rate of 1.25 percent in context of risks from accumulated financial imbalances).
  - BOK expected to take a measured approach to adjusting the accommodative stance; at least one more rate hike expected by financial markets in 2018.
- Fiscal stance:
  - Structural fiscal surplus is likely to remain sizable, at 1.4 percent of GDP in 2017.
  - Baseline policy mix in 2018: a tight fiscal and an accommodative monetary stance.
  - Structural fiscal balance projected to increase to 1.5 percent of GDP based on the 2018 budget.

### External sector and exchange rate
- Capital flows and reserves:
  - Net non-FDI capital inflows increased by $10 billion compared to the first three quarters of the previous year.
  - Non-resident portfolio inflows surged US$16.6 billion.
  - Foreign ownership in the domestic stock market rose to more than 34 percent in September.
  - Foreign exchange reserves reached US$384 billion (25 percent of GDP) in October, increasing by 3.6 percent year-to-date, mostly owing to valuation effects.
- Exchange rates and REER:
  - Average REER from January to November 2017 was 2.7 percent above the 2016 average.
  - Nominal effective exchange rate appreciated by 2.4 percent over this period.
  - Won appreciated against the dollar by 11.7 percent in 2017.
  - Foreign exchange intervention appears limited based on staff estimates with available data.
- Current account:
  - First three quarters of 2017: surplus was 5.7 percent of GDP (seasonally adjusted), compared to 7 percent of GDP in 2016.
  - Surplus for the whole year projected at 5.6 percent of GDP.
  - Current account surplus projected to edge lower to around 5.4 percent of GDP in 2018.
  - Narrowing driven by surge in imports of capital goods, narrower service balance, smaller income balance, and rising commodity prices.
- Assessment:
  - A preliminary assessment finds the 2017 current account surplus to be “stronger than warranted by medium-term fundamentals and desirable policies.”
  - About two-thirds of the “current account gap” is attributed to a “policy gap,” primarily a tighter-than-warranted fiscal stance and social spending being below the desirable level.
  - The REER is assessed to be weaker than the level consistent with fundamentals and desirable policies.

### Financial sector, household debt, and corporate sector
- Household debt:
  - Household debt exceeds 90 percent of GDP.
  - Household credit growth slowed to 7.8 percent year-on-year in October, down from the 12-percent average annual growth rate in 2016, following macroprudential tightening.
- Housing prices:
  - National increase in house prices slowed to about 1 percent year-over-year; in Seoul apartment prices still rising at a nearly 5-percent annual rate.
  - Staff analysis: overall housing prices level is in line with fundamentals; risk of price correction remains in the region around Seoul.
- Corporate sector:
  - Aggregate debt-to-equity ratio was 79.6 percent at the end of 2016—just 1 percentage point up from the previous year.
  - Profitability and interest coverage ratio improved overall, but liquidity and profitability are weaker for SMEs than for large firms.
  - Profitability, solvency, liquidity and leverage positions are poorer among the conglomerates excluding the largest four compared to the top four conglomerates and other large companies.
- Corporate restructuring:
  - Debt-to-equity ratios in the shipbuilding and shipping industries fell dramatically in 2016 (by 155 and 147 percentage points, respectively, compared to 2015) owing to debt restructuring and capital injections.
  - State-owned policy banks EXIM and KDB increased their capital by KRW 2.2 trillion and KRW 3 trillion, respectively, in 2016-17.
  - The Policy Bank Recapitalization Fund set up last year, and partly financed by a BOK loan, has not been tapped yet.

### Risks to the outlook
- External downside risks:
  - Geopolitical tensions related to North Korea could adversely impact financial markets and investment.
  - Tighter global financial conditions could trigger capital flow volatility.
  - Renegotiation of KORUS expected to take time and is unlikely to have a sizeable short-term impact.
- Domestic risks:
  - High household debt and a house price correction.
- Upside risks:
  - Stronger than projected exports, especially if the recent U.S. tax reforms boost global demand.
  - Higher than expected consumption reflecting the government’s new income support measures.

### Policy recommendations to support recovery and mitigate risks
- Fiscal policy:
  - Reduce the structural balance toward zero by at least 0.5 percentage point each year during the coming years.
  - Achieve the fiscal adjustment largely through higher expenditures on social policies and structural reforms, including targeted transfers to the most vulnerable, increased spending on childcare and Active Labor Market Policies (ALMP).
  - The recommended fiscal expansion would increase growth by nearly 0.2 percentage point each year.
  - Preferably frontload the expansion provided it does not significantly hinder the efficiency of public expenditures.
  - Aim for a zero-structural balance in the short and medium run while maintaining debt sustainability and allowing the pension fund to accumulate additional assets.
- Monetary policy:
  - BOK should maintain its accommodative monetary stance while monitoring inflationary pressures.
  - If the output gap closes earlier than anticipated and inflationary pressures emerge, tighten monetary policy faster while allowing fiscal policy to continue supporting long-term growth and rebalancing.
- Monetary policy framework and communication:
  - Continue to strengthen the credibility of the revised point inflation target of 2 percent.
  - Enhance communications by more specifically characterizing policy rate intentions and the central bank “policy reaction function,” building on elements of inflation-forecast targeting (IFT) to clarify how policy would respond to shocks impacting the inflation forecast.

*International Monetary Fund staff summary based on the source content.*

### 29.      In the context of the strong commitment to exchange rate flexibility, policymakers

### 29. In the context of the strong commitment to exchange rate flexibility, policymakers

### Exchange rate policy and intervention
- Policy should clarify foreign exchange intervention policy to respond to “excessive volatility” resulting from disorderly market conditions (DMCs).
- Clarification could address how excess volatility is triggered by DMCs, which typically result from some form of market dysfunction or illiquidity (e.g. a buildup of very large speculative positions).
- Authorities clarified that intervention policy in foreign exchange market was limited to episodes of disorderly market conditions and that exchange rate flexibility would continue; this was the meaning of intervention in “periods of excessive volatility”.

### Banking system resilience and regulatory reforms
- Banks’ capital ratios were 14.8 percent in 2016.
- A Basel III capital surcharge on five domestic systemically important banks and a counter-cyclical capital buffer (CCB) were put in place in 2016 and will be phased-in gradually.
  - The surcharge will rise to one percent in 2019.
  - The CCB has not been activated yet; its maximum size is of 2½ percent of RWA, but it is likely to remain low owing to the slowdown in credit growth.
- Loan-to-deposit ratio was 119 percent and expected to edge lower with moderation in loan growth.
- Non-performing loan ratio for banks was 1.25 percent.
- NBFIs’ indicators of financial soundness are strong, although NPL ratios tend to be higher than for banks.
- Part of the increase in capital ratios in 2016 was due to lower risk weights as low interest rates contributed to an improvement in borrowers’ credit ratings; this can reverse as future interest rates increases push up risk weights.
- Supervisory authorities are tightening and harmonizing regulation across different types of financial institutions to contain migration of credit risk from banks to NBFIs.

### Interest rate risk and stress testing
- Rising interest rates could pose a risk to asset quality because low interest rates have contributed to low NPLs by making repayment easier.
- Stress tests are essential; supervisory authorities conduct a range of bottom-up and top-down stress tests for banks at an annual or quarterly frequency.
  - Tests show that even a large interest rate increase of 300 basis points has a manageable impact on bank asset quality.
- Top-down stress testing will be extended to NBFIs next year; bottom-up stress tests are already applied to individual NBFIs and generally show high resilience.

### Macroprudential measures and household debt
- Macroprudential policies are being used to contain risks from high household debt.
- Loan-to-value (LTV) and debt-to-income (DTI) limits have been lowered to 40 percent for financial institutions; with larger reductions, to 30 percent, for borrowers with multiple mortgages and in regions with speculative buying.
- In 2018, a debt-service ratio limit will be implemented for all financial institutions:
  - Starting with banks in the middle of 2018 and NBFIs early in 2019.
- Rapid shift from floating rate to fixed rate, amortizing mortgage—constituting 47 percent of total mortgage loans—increases households’ resilience to interest rate shocks.
- Credit growth has been higher for NBFIs, indicating some migration of risk from banks to NBFIs, but harmonized tightening of micro- and macro-prudential policies should contain this.

### External financing and macroprudential framework overhaul
- Post-GFC measures included a leverage cap on banks’ foreign exchange derivatives positions and a levy on foreign exchange funding; these were assessed as capital flow management measures as well as macroprudential measures (CFM/MPM).
- Authorities maintained preemptive CFM/MPMs for about seven years and adjusted settings on three occasions as risks diminished; in July 2015, the levy was substantially restructured, including a shift from contractual to residual maturity.
- In January 2017, reforms targeting external risks included:
  - Introduction of a currency-differentiated liquidity-coverage-ratio (FX-LCR) — an MPM permitted under Basel III.
  - Abolishing five existing measures that overlapped with the FX-LCR (the seven-day, one-month and three-month maturity mismatch ratios on banks’ net foreign currency assets; the reserves requirement on high-quality foreign currency-denominated assets; and a non-mandatory foreign currency cash-equivalent ratio).
  - Retaining two pre-existing measures (leverage cap on FX derivatives positions and levy on FX funding) as preemptive MPMs to complement the FX-LCR.
- A standard Basel III NSFR is being implemented; making it currency differentiated was considered unnecessary given low currency mismatch risks.
- Rationale: preemptively and directly target buildup of specific short-term FX risk on banks’ liabilities; FX-LCR targets asset side to ensure sufficient high quality liquid foreign currency assets to cover potential net outflows for 30-days in a stress scenario.

### Corporate restructuring and policy banks
- Rapid implementation of financial and operational restructuring of distressed firms is critical to reallocate resources to more productive sectors.
- Recent recapitalization of policy banks EXIM and KDB was important to safeguard financial stability and allow them to fulfill policy functions, including corporate restructuring.
- Social spending should cushion impact of firm restructuring on affected workers and help reallocate them.
- Involvement of policy banks in shipbuilding and shipping firms should be reviewed as excess capacity narrows and outlook improves with rebound in global trade.

### Authorities’ views (selected)
- Authorities regarded fiscal policy in 2018 as expansionary; government spending was expected to increase by 7.1 percent in nominal terms—the largest increase since 2010, and higher than nominal GDP growth. Revenues were projected to rise at a similar rate.
- BOK agreed monetary policy should remain accommodative; with the output gap narrowing and inflation close to target the process of monetary policy normalization should begin; markets were expecting at least one rate increase in 2018, but monetary policy would remain accommodative even if policy rates rose moderately.
- BOK believed inflation expectations were well anchored and recognized merits of “inflation forecast targeting,” while cautioning implementation risks.
- Authorities closely monitored risks from high household debt, noting supervisory stress tests and that recently announced macroprudential tightening would reduce risks; capital flow volatility from Fed and ECB normalization was not seen as a major concern.
- Authorities adhere to principle that the exchange rate is determined by the market and clarified intervention is limited to disorderly market conditions.

### Addressing long-term challenges and fiscal policy
- Current growth momentum is an opportunity to implement reforms to reinvigorate long-term growth and foster inclusion; priority is to boost labor supply and productivity growth given adverse demographics and labor productivity at about 50 percent of that in the U.S.
- Fiscal policy should be used to foster social protection and growth-enhancing structural reforms:
  - Public social spending at 10 percent of GDP in Korea is less than half the OECD average.
  - Strategy involves higher targeted transfers for the most vulnerable and increasing share of spending toward social welfare, accompanied by reduction in fiscal surplus.
  - Increase spending on ALMP and childcare to bolster labor supply.
- Staff analysis example: additional spending of 1.5 percent of GDP on targeted transfers, childcare, and ALMP, accompanied by labor and product market reforms and a shift in the tax structure toward consumption taxes would:
  - Boost output permanently by more than 6 percent in 10 years.
  - Boost consumption permanently by more than 9 percent in 10 years.
  - Reduce the current account surplus by nearly 2 percent of GDP in 10 years.
- Korea has substantial fiscal space:
  - Central government debt below 40 percent of GDP (below 45 percent of GDP including non-market non-profit institutions’ debt).
  - Average consolidated central government surplus of 1.2 percent of GDP since 2010.
  - Debt-to-GDP ratio is expected to remain below 40 percent until at least 2032, with an average deficit of 0.7 percent of GDP, taking into account increase in pension- and health-related public spending and assuming no change in the revenue-to-GDP ratio.
- Longer-term fiscal challenges from aging:
  - Outlays for pensions and healthcare are set to rise by 10-16 percent of GDP by 2060.
  - With unchanged revenues, debt-to-GDP ratio projected to climb above 100 percent of GDP by 2050.
  - Staff indicates revenue increases and borrowing combinations could stabilize debt-to-GDP well below 85 percent; scenarios exist where, with revenue increases and additional spending on social safety nets, childcare benefits and ALMP, government debt-to-GDP could be stabilized well below 85 percent.
- Higher revenues could be achieved by broadening the tax base:
  - Korea’s tax revenue-to-GDP ratio is one of the lowest in the OECD.
  - Options include gradually eliminating deductions, reducing the number of corporate income tax rates to one, greater neutrality in taxation of capital income, broadening the VAT base to cover all new real estate supplies (including the value of land) and fee-based financial services.
  - VAT is relatively low at only 10 percent; depending on comprehensiveness of base-broadening, it may still be necessary to raise some tax rates, notably the VAT.

### Fiscal policy scenario and Box 3 simulation
- Scenario assumptions (G20MOD/FSGM):
  - Permanent increase in targeted transfers by 0.75 percent of GDP to the most vulnerable.
  - Expansion in childcare spending by 0.25 percent of GDP.
  - Increase in ALMP spending by 0.5 percent of GDP.
  - Financing through a combination of higher VAT revenues and lower surplus.
  - In 10 years, implementation of 75 percent of product market and employment protection reforms to converge regulation to frontier average.
  - Shift toward a more growth-friendly tax structure: share of consumption and property taxes in total tax revenues increases by 1.1 percentage points, accompanied by a decline in share of labor income tax.
- Scenario outcomes:
  - Output increase of about 6 percent in 10 years.
  - Consumption increase of about 9 percent in 10 years.
  - Current account surplus decline of nearly 2.0 percent of GDP in 10 years.
  - The package would imply an 11-percentage points increase in the debt-to-GDP ratio relative to baseline in 10 years and a 30 percentage points increase beyond (text truncated in source).

*IMF staff report excerpt (Republic of Korea).*

### 2100. The fiscal surplus would decline permanently by about 1.6 percentage points of GDP relative to the

### cr1840 - 2100. The fiscal surplus would decline permanently by about 1.6 percentage points of GDP relative to the

### Fiscal impact and key projections
- The fiscal surplus would decline permanently by about 1.6 percentage points of GDP relative to the baseline.
- Staff recommends that the government reduce the structural balance toward zero by at least 0.5 percentage point each year during the coming years.
- Korea has substantial fiscal space to aim for a zero-structural balance in the short and medium run without a risk to debt sustainability, but longer-term aging-related fiscal challenges will require greater revenue mobilization.
- Staff estimates: if the regulatory burden (as measured by the OECD Product Market Regulation index) were lowered to close the gap with the OECD frontier in 10 years, potential output could increase by 3.5 percent in the long run, and yearly potential growth could rise by more than 0.3 percentage points for ten years.

### Labor market policy — Flexicurity framework (findings and recommended pillars)
- Objective: adopt “flexicurity” to address duality and boost job creation; protect workers rather than jobs.
- Three pillars:
  - (i) More flexibility for regular workers.
  - (ii) A strong and inclusive safety net for the unemployed.
  - (iii) Active Labor Market Policies (ALMPs).
- Expected outcomes:
  - Better adaptation to technological and structural change.
  - Increased productivity via improved resource allocation and training.
  - Higher labor force participation through stronger work incentives.
  - Enhanced equity by reducing duality and protecting the vulnerable.
- Implementation caveat: implementing all three pillars is critical; partial implementation (for example, expanding unemployment insurance alone) could increase unemployment.

### Policy measures to implement flexicurity (specific recommendations)
- Flexibility:
  - Ease restrictions on dismissal of regular workers for performance and other economic reasons.
  - Avoid lowering overall labor-market flexibility through policies that convert temporary workers to permanent status unless regular-contract rigidity is reduced simultaneously.
- Active Labor Market Policies (ALMPs):
  - Expand ALMPs and shift composition from direct job creation toward enhanced job training and matching.
  - Provide personalized support to job seekers, target vulnerable groups (women, youth), and coordinate ALMPs with passive policies (unemployment insurance, social assistance).
  - Continuously evaluate and adjust programs to ensure effectiveness and adequacy.
- Unemployment insurance:
  - Increase coverage and benefit levels, and link benefits to conditionality (training, job search).

### Modeling exercise and quantitative labor-market comparisons
- Net replacement rate for the initial phase of unemployment in Korea: 56 percent (below the OECD average of 63 percent).
- Maximum duration of unemployment benefits in Korea: 8 month (compared to an OECD average of 18 month).
- Spending on ALMP in Korea: around 4900 USD per unemployed (compared to the OECD average of 7000 USD).
- Modeling (search-and-matching model based on Dolado et al. (2017), calibrated to Korea) suggests:
  - Introducing only one pillar creates trade-offs between output, inequality, and unemployment and across population groups.
  - Reducing dismissal costs can narrow the wage gap between permanent and temporary workers and reduce the “revolving-door effect,” but may lower welfare of permanent workers without accompanying safety nets.
  - ALMPs that raise training or improve matching increase output and lower unemployment but can exacerbate duality if not combined with other reforms.
  - Implementing all three pillars together can improve output, equality, and unemployment and raise welfare for all if calibrated appropriately.

### Youth employment
- Korea’s youth employment rate has fallen significantly over the past decade and is now about 10 percentage points below the OECD average.
- Share of youth neither in employment nor in education or training: 18 percent (compared to less than 10 percent in many OECD economies).
- Recommended measures:
  - Strengthen Meister schools, work-study dual system, and internships — increase business ownership and ensure quality of placements to build on-the-job skills.
  - Implement a comprehensive policy framework for coordination and continuous program evaluation.
  - Consider preemptive measures (e.g., education plans in lower secondary education) to build realistic individual education and career plans.
  - Raise SMEs’ productivity and reduce labor market duality to increase availability of quality employment.

### Public employment
- Government plans: create 514,000 new jobs in the government and public corporations, and convert 300,00 public sector workers into regular employment.
- Current public employment: around 8 percent of total (well below the OECD average of 21 percent).
- Staff guidance:
  - There is scope to increase public employment in civil and social services (police, firefighters), but public employment should not be used as a general job-creation tool.
  - Public employment expansion should be linked to services that cannot be adequately provided by the private sector.
  - Risks: crowding out private employment and low effectiveness of public employment programs in boosting youth employment due to weak skill transferability to the private sector.

### Minimum wage — observations and cautions
- 2018 minimum wage increase: 16.4 percent (to KRW 7,530 ($7.2; PPP terms) per hour).
- Current minimum wage (prior to 2018): KRW 6,470 ($6.2; PPP terms) per hour.
- Government medium-term objective under income-led growth: raise minimum wage to KRW 10,000 per hour.
- Impacts and risks:
  - The 16.4 percent hike will boost incomes of low-wage earners and overall consumption; low-wage earners have higher propensity to consume.
  - Around 7 percent of workers receive the minimum wage; ratio of minimum to average wage remains close to the OECD average.
  - Some low-skilled jobs may be lost, especially where producers cannot pass on higher costs.
  - Further sharp increases that move the minimum closer to the average wage could erode competitiveness and risk pricing low-skilled workers and youth out of the market (historical reference: France).
  - To partially compensate small businesses, government plans to pay part of the additional burden, estimated at KRW 3 trillion (0.2 percent of GDP) for 2018; subsidies to SMEs should be temporary.

### Female labor force participation and gender gaps
- Korea’s female labor force participation is one of the lowest in the OECD—20 percentage points below the best performers.
- Share of women in regular jobs: 40 percent.
- Women’s average pay gap: women are paid on average about 37 percent less than men.
- Share of women in senior management positions: 2 percent (compared to the OECD average of 20 percent).
- Recommended policy mix to boost female participation:
  - Strengthen quality and affordability of childcare services.
  - Promote shared parental leave.
  - Make tax treatment of second earners more neutral.
  - Introduce corporate benchmarks for employment and leadership of women.
  - Broader measures: reduce working hours, mitigate labor market duality.
  - Government plans: enhance assistance for women’s reemployment; reduce gender wage gaps; raise paternity leave allowance; expand government childcare support.
- Expected benefits: reduce gender income inequality and raise potential growth by boosting labor supply; adding a second earner may reduce demand for job security among regular workers.

### Product market reforms and innovation policy
- Government plans: build ecosystem and infrastructure for innovation; reduce regulatory cost; expand capital provision and safety net for start-ups; establish a national innovation cluster; foster SMEs and cooperative SMEs.
- Competition policy: reduce monopsony power of large firms over smaller suppliers and enhance corporate governance.
- Regulatory burden:
  - Korea’s product market regulation is one of the fourth-most stringent in the OECD, partly due to network industry regulation (electricity, gas, rail).
  - Further deregulation, especially in services, is needed.
- R&D and innovation incentives:
  - Shift size-based subsidies and tax incentives to target young firms to encourage growth.
  - Invigorate research in higher education via expanded international collaboration and competition.
  - Ensure R&D incentives do not discriminate against service industries and are tailored to young firms (e.g., carry-over provisions).
  - Coordinate R&D support with objective selection and continuous evaluation.
  - For SMEs, prioritize fostering growth and innovation rather than shielding weak firms.

### Authorities’ views (summary of points made by authorities)
- Authorities agreed revenues need to increase in the longer term to preserve fiscal sustainability and planned gradual tax base broadening; noted that increasing the VAT rate may face opposition and that reducing the number of corporate tax rates might burden SMEs.
- On labor market reform, authorities emphasized achieving “security” for workers before increasing flexibility and agreed safety nets are lower than in other OECD countries; stressed need to build trust among social partners.
- On public employment expansion, authorities view planned expansion as enhancing public services and converting permanent-continuous work into regular contracts; they do not see risk of crowding out private employment due to a focus on services the private sector cannot provide adequately.
- Authorities agreed on the need to ease regulatory burdens and plan to introduce a “regulatory sandbox” as part of broader reforms in human resources, innovation, and the job market.

### Staff appraisal (summary conclusions)
- A cyclical recovery is underway despite geopolitical tensions, but potential growth has slowed due to adverse demographics and slowing productivity driven by structural weaknesses.
- Income inequality and polarization are worsening, partly reflecting inadequate social protection and labor and product market duality.
- Korea’s external position is stronger than warranted by medium-term fundamentals and desirable policies.
- Policy recommendation highlight: fiscal policy should become significantly more expansionary to support growth and reduce excessive external imbalances; labor and product market reforms (including flexicurity and regulatory liberalization) are key to raising potential growth and inclusiveness.

*International Monetary Fund — Staff analysis and recommendations as presented in the sourced chapter.*

### 64.      Monetary policy should remain accommodative as inflationary pressures are likely to

### Monetary policy should remain accommodative as inflationary pressures are likely to

### Monetary policy and exchange rate
- Monetary policy should remain accommodative as inflationary pressures are likely to remain subdued.
- Early and decisive action to ease the fiscal stance would facilitate a rebalancing of the policy mix.
- Monetary policy credibility could be enhanced by strengthening communication of policy intentions:
  - Clarify the BOK’s “policy reaction function” that describes the conditions under which it will adjust policy rates in the future.
- The exchange rate should continue to be allowed to move flexibly, with intervention limited to addressing disorderly market conditions.

### Macroprudential and financial stability
- Macroprudential policies are effectively addressing financial stability challenges.
- Macroprudential measures remain necessary to contain risks from high household debt.
- Corporate restructuring has to proceed expeditiously.

### Fiscal policy and social spending
- Fiscal policy should be used to enhance social safety nets and support long-term growth.
- A targeted expansion in social spending would:
  - Mitigate income inequality,
  - Promote consumption-led growth,
  - Support economic rebalancing.
- Staff supports the government’s intention to increase the share of spending towards social welfare.
- This increase in social spending needs to be accompanied by a reduction in the fiscal surplus to maximize the impact on growth.
- Public spending on ALMP and childcare should increase to boost labor supply and potential output.

### Labor market, duality, and job creation
- To mitigate duality and support job creation, Korea should adopt “flexicurity” with three pillars:
  - (i) more flexibility for regular workers;
  - (ii) a strong and inclusive safety net for the unemployed;
  - (iii) Active Labor Market Policies.
- Implementing all three pillars is critical.
- There is scope to expand public sector jobs, but the government should be cautious in expanding public employment to create jobs.
- The minimum wage should be increased cautiously going forward and any compensatory subsidy to SMEs should be temporary.
- To support youth employment, existing measures such as Meister schools, the work-study dual system, and internships could be strengthened.
- Policies should also focus on strengthening female labor force participation and leadership.

### Business regulation, SMEs, and R&D
- The regulatory burden for firms should be eased especially in the service sector.
- Government policy towards SMEs should prioritize fostering growth and innovation, rather than shielding weaker firms.
- There is scope to better design and coordinate R&D support.

### External sector assessment and policy responses
- Net international investment position (NIIP) reached 17 percent of GDP in end-September 2017, with gross liabilities totaling 74 percent of GDP, of which 27 percent was gross external debt.
- The external position in 2017 is projected to be stronger than warranted by medium-term fundamentals and desirable policies, reflecting excess saving and relatively weak private investment.
- Developments as of December 2017 point to a decline in the current account (CA) surplus this year to around 5.6 percent of GDP, although it is expected to remain large in the absence of strong fiscal support and well-targeted structural measures.
- Current account background: the CA surplus in the first three quarters of 2017 was 5.7 percent of GDP (seasonally adjusted).
- Potential policy responses:
  - Significantly more expansionary fiscal policy to boost domestic demand in the short and longer run, given available fiscal space.
  - Structural policies to facilitate rebalancing toward services and boost domestic demand growth, including strengthening the social safety net to lessen incentives for precautionary savings and addressing bottlenecks to investment.
  - Maintain a market-determined exchange rate, with intervention limited to addressing disorderly market conditions.

### Other procedural recommendation
- Staff recommend that the next Article IV consultation be held on the standard 12-month cycle.

*REPUBLIC OF KOREA — INTERNATIONAL MONETARY FUND (excerpt).*

### 7.0 percent of GDP in 2016. The large CA surplus reflects increased savings as well as a decline in the share of investm

### cr1840 - 7.0 percent of GDP in 2016. The large CA surplus reflects increased savings as well as a decline in the share of investm

### Current account (CA) — background and assessment
- CA was 7.0 percent of GDP in 2016.
- The large CA surplus reflects increased savings and a decline in the share of investment in GDP, possibly due to firms shifting investment abroad and Korea’s recent integration into the global value chain.
- The CA surplus has been falling since mid-2015 owing to:
  - challenges in the corporate sector (particularly shipping services and shipbuilding),
  - an increase in commodity prices,
  - a decline in tourism from China,
  - a boom in construction and a recent strong recovery in facilities investment (machinery and equipment), which raised imports despite a tight fiscal stance.
- Projection: the CA surplus is projected to decline further next year but remain large in the absence of strong fiscal support and well-targeted structural measures.

Assessment (EBA model and staff estimates)
- Preliminary EBA model estimates the 2017 cyclically adjusted CA surplus to be 4.8 percent of GDP.
- The cyclically adjusted EBA CA norm is 1.8 percent of GDP.
- Net retained earnings on equity investments are estimated to unduly increase the CA gap by about 0.7 percent of GDP; this adjustment is included in staff estimates.
- Including this adjustment, staff estimates:
  - CA gap midpoint: 2.3 percent of GDP.
  - CA gap range: 0.3–4.3 percent of GDP (based on the EBA standard deviation).
- The CA gap is described as in the stronger-than-warranted range of 2 to 4 percent.
- Key contributors to the policy gap:
  - tighter-than-desired fiscal policy,
  - relatively low social spending and a smaller social safety net compared to other EBA countries, increasing precautionary savings and the CA surplus.
- Policy implication: to durably reduce the CA surplus, significant policy adjustment is required; the fiscal stance is tighter than warranted and a significantly more expansionary policy is needed to exploit Korea’s substantial fiscal space.

### Real exchange rate (REER)
Background
- REER appreciated gradually since 2013 until 2016, when the REER depreciated by 2.3 percent relative to its 2015 average on a trade-weighted basis.
- REER appreciated by 2.7 percent in 2017 (first three quarters average vs. 2016 average).

Assessment
- EBA REER regressions suggest a wide range of estimated gaps:
  - EBA Level REER model gap: –15.3 percent.
  - EBA Index REER model gap: +0.9 percent.
- The CA regression direct approach implies a gap of 6 ½ percent (used as the midpoint).
- Overall assessment for 2017: REER is 1 to 12 percent below the level consistent with fundamentals and desired policies (range reflects high uncertainty).

### Capital and financial accounts — flows and policy measures
Background and recent developments
- Net capital outflows were relatively stable over the medium term but composition shifted.
- First three quarters of 2017: net capital outflows decreased to 5.6 percent of GDP from 7 percent of GDP in 2016.
- Compared to the first three quarters of last year, net non-FDI capital inflows increased by $10 billion.
- Non-resident portfolio inflows surged US$16.6 billion as foreigners sharply expanded purchases of debt securities.
- Equity inflows were strong; the share of foreign ownership in the domestic stock market rose to more than 34 percent in September, contributing to an all-time high in stock prices.

Assessment
- The present configuration of net and gross capital flows appears sustainable over the medium term.
- Korea has demonstrated capacity to absorb short-term capital-flow volatility of magnitudes observed over the last few years.

### FX intervention and reserves level
Background
- Korea has a floating exchange rate.
- FX intervention appears to have been two-sided since early 2015 (based on staff estimates).
- Reserves increased steadily from 2009 through mid-2014, then remained broadly stable.
- Until November 2017, reserves increased by $16 billion year-to-date and stood at 24.7 percent of GDP, with around $12 billion estimated to stem from valuation changes and interest income.
- The forward position increased by $0.6 billion until October 2017 (0.   04 percent of GDP).

Assessment
- Intervention appears to have been limited to address disorderly market conditions since 2015.
- Foreign exchange reserves were around 120 percent of the IMF’s composite reserve adequacy metric at end November 2017, providing a sufficient buffer against a wide range of possible external shocks.

### Risks (Risk Assessment Matrix) — selected entries
- Retreat from cross-border integration
  - Likelihood: Medium
  - Potential impact: High
  - Policy response: Accommodative fiscal and monetary policies, flexible exchange rate, continue multilateral efforts on trade agreements, implement policies to boost sustainable domestic demand.
- Tighter global financial conditions
  - Likelihood: High
  - Potential impact: Medium
  - Policy response: Rely on a flexible exchange rate; use macro-prudential policies to limit spillovers.
- Significant China slowdown and its spillovers
  - Likelihood: Medium
  - Potential impact: High
  - Policy response: Accommodative fiscal and monetary policies, flexible exchange rate; diversify export markets and manufacturing base through structural policies.
- Structurally weak growth in key advanced economies
  - Likelihood: High
  - Potential impact: High
  - Policy response: Expansionary monetary and fiscal policies plus structural reforms; maintain appropriate macroprudential policies.
- Increase in geopolitical risks (North Korea)
  - Likelihood: High
  - Potential impact: High
  - Policy response: Maintain flexible exchange rate and active macro-prudential policies; fiscal expansion would likely be warranted if tail risks materialize.
- Excessive household debt weakening consumption and financial stability
  - Likelihood: Medium
  - Potential impact: Medium
  - Policy response: Implement expansionary fiscal policy and accommodative monetary policy to support recovery, while using macroprudential policies to limit banking-system risks.
- Note on RAM: “low” indicates probability below 10 percent, “medium” between 10 and 30 percent, and “high” between 30 and 50 percent; short term and medium term indicate within 1 year and 3 years, respectively.

### Debt sustainability (Annex III) — key indicators and projections (selected)
- Nominal gross central government debt (percent of GDP):
  - 2015: 30.0
  - 2016: 35.6
  - 2017: 36.1
  - 2018: 35.4
  - 2019: 35.0
  - 2020: 34.8
  - 2021: 34.6
  - 2022: 34.5
  - (2022 repeated as 34.4 in one row)
- Gross financing needs (percent of GDP):
  - 2015: 5.5
  - 2016: 6.8
  - 2017: 5.7
  - 2018: 1.3
  - 2019: 1.5
  - 2020: 2.2
  - 2021: 2.2
  - 2022: 2.7
  - 2023: 2.7 (table continues projections)
- Real GDP growth (percent):
  - 2015: 3.7
  - 2016: 2.8
  - 2017: 2.8
  - 2018: 3.2
  - 2019: 3.0
  - 2020: 2.9
  - 2021: 2.8
  - 2022: 2.7
- Inflation (GDP deflator, percent):
  - 2015: 1.8
  - 2016: 2.4
  - 2017: 1.8
  - 2018: 2.4
  - 2019: 1.5
  - 2020: 2.0
  - 2021: 2.2
  - 2022: 2.1
- Effective interest rate (percent):
  - 2015: 4.0
  - 2016: 2.8
  - 2017: 2.5
  - 2018: 2.5
  - 2019: 3.1
  - 2020: 3.1
  - 2021: 3.4
  - 2022: 3.6
  - 2023: 3.9
- Primary balance (percent of GDP) — baseline projections:
  - 2017: -0.7
  - 2018: -0.4
  - 2019: -0.6
  - 2020: -0.7
  - 2021: -0.6
  - 2022: -0.5
- Change in gross central government debt (cumulative, percent of GDP): -0.3 (debt-stabilizing primary balance indicated)
- Composition of public debt and alternative scenarios: projections show gross nominal public debt rising from 34 (2015) to 37 (2022) in some scenarios; public gross financing needs and by-maturity and by-currency charts are provided in the source.

### Main recommendations from the 2016 Article IV consultation (Annex IV)
- Use fiscal support, given low public debt, to incentivize structural reforms, cushion adverse effects, and support growth; support a carefully targeted expansion of social expenditure over the medium term while safeguarding long-run fiscal sustainability.
- Continue corporate restructuring; implement timely assistance for distressed firms; recapitalize policy banks with sufficient budgetary resources and unwind Bank of Korea bridge financing.
- Undertake labor market reforms to address segmentation and boost female labor force participation; promote competition in the service sector and among small and medium enterprises to raise productivity.
- Maintain supportive fiscal and monetary policies given weak conjuncture and downside risks, while recognizing some Directors’ caution about additional stimulus.
- Tighten and harmonize macroprudential standards across banks and nonbanks to contain risks from rising household debt.
- For the external sector, some Directors recommended a more explicit focus on reducing the current account surplus and stressed allowing the exchange rate to move flexibly to facilitate rebalancing and shock adjustment.

*Source: IMF staff.*

### 9.     The authorities have put in place measures to safeguard financial stability and reduce income

### 9.     The authorities have put in place measures to safeguard financial stability and reduce income inequality. 

### Macroprudential measures and housing
- A variety of macroprudential measures were tightened to slow lending to households and house price increases.
- LTVs and DTIs have been lowered to 40 percent for financial institutions; with larger reductions for borrowers with multiple mortgages and in regions where speculative buying is driving up prices.

### Corporate restructuring and financial sector support
- Corporate restructuring progressed in the shipbuilding and shipping industries.
- In these sectors leverage fell dramatically owing to debt restructuring and capital injections.
- The state-owned policy banks, which are the main creditors of some of the firms in the vulnerable sectors, were recapitalized.

### Fiscal and social measures to reduce inequality
- A supplementary budget of KRW of 11 trillion (0.7 percent of GDP) was approved in July 2017.
  - It included additional transfers to the most vulnerable (e.g., elderly, unemployed) as well as additional spending on childcare benefits.
- Welfare spending was expanded in the 2018 budget.
- A tax revision bill with measures to make the tax system more progressive was approved.

*Source: cr1840 - 9.     The authorities have put in place measures to safeguard financial stability and reduce income inequality.*

### 7.1 percent. This exceeded the growth rate of last year, the largest increase since 2010 and was

### cr1840 - 7.1 percent. This exceeded the growth rate of last year, the largest increase since 2010 and was

### Fiscal policy and budget composition
- 7.1 percent. This exceeded the growth rate of last year, the largest increase since 2010 and was significantly higher than the nominal GDP growth projection of 4.8 percent.
- In terms of composition, the budgets for education, health, welfare and labor were prominent with more than 11 percent of growth, which support the priorities of the new government's economic policy.
- Taxation policy adjustments to support job creation:
  - Tax incentive to promote employment is introduced to expand tax credit when employing youth as regular workers.
  - Start-ups and SMEs launched by the youth are exempted from corporate income tax for 5 years.
- Views on fiscal stance:
  - Korea's fiscal balance is assessed as surplus according to the IMF criteria.
  - Once social security funds—including national pension savings, which take up a significant portion of the surplus (around 2.5 percent of GDP) and are subject to disbursement in the future, are factored out, overall fiscal balance has been negative for decades.
  - The nascent stage of social security funds: pension receipts far exceed disbursement.
  - Need for careful management to prevent a public debt spiral given aging population and future welfare needs.
  - The Korean government is carrying out fiscal reform plans for fiscal sustainability while implementing more proactive fiscal policies.

### Monetary policy and financial sector
- Authorities have maintained an accommodative monetary policy stance in line with staff’s recommendation.
- Inflationary pressures are not projected to be significant; monetary policy of 2018 is likely to be accommodative.
- The Bank of Korea raised the base rate by 0.25 percent point to 1.5 percent at the end of last November as a preemptive measure considering domestic household and corporate debt burden due to normalization of the global interest rate.
- Financial system assessment:
  - Overall financial system remains sound.
  - Household debt remains high but is being managed through macro-prudential measures including lower loan-to-value (LTV) and debt-to-income (DTI) ratios and housing market stabilization measures.
  - With these measures, household debt growth is expected to slow down gradually in 2018.

### External sector
- Current account surplus continued a downward trend and shrunk in 2017 mostly due to rising commodity prices and a decrease in foreign tourists.
- Authorities predicted the current account surplus would continue to decline in 2018 with the recovery in consumption and solid investment, combined with rising oil prices.
- Exchange rate and REER movements:
  - According to the BIS’s statistics, the average REER from January to November was appreciated by 2.9 percent above the 2016 average, and by 2.6 percent in nominal terms.
  - Appreciation of the won against the dollar by 12.8 percent during the whole of last year.
- Authorities’ reservations on external sector assessment:
  - Preliminary assessment of 2017 does not adequately reflect changes made throughout the year.
  - EBA methodology should be refined, measurement issues addressed, and country specific factors sufficiently incorporated.
  - Korea-specific considerations highlighted:
    - Fastest population aging; OECD predicts Korea will be the most aged country in the world in 2075.
    - Need to prepare for possible future reunification, which could require large resources.
    - Rapid integration into global value chains accounted for a significant portion of the current account surplus.
    - Temporary effect of the super cycle in semiconductor exports.
    - Merchanting, global processing, and mandatory pension savings should be considered as country specific factors in External Sector Assessments.
  - Anticipation that planned revamping of the external assessment would lead to more rigorous, even-handed, and candid assessments in the future.
- Macro-prudential measures debate:
  - Staff recommended classification issues around a levy on non-deposit foreign currency liabilities and a leverage cap on FX derivatives.
  - Authorities view these prudential regulations as preventing excessive build-up of short-term debt and lengthening debt maturity structure.
  - Measures were not residence-based and were not intended to limit capital flows, but to reduce systemic risks; authorities assert they should be classified as MPM under the Fund’s Institutional View.
  - Authorities reiterated importance of appropriate application of the Fund’s policy framework and urged staff to take a more even-handed approach.

### Labor market and long-term challenges
- Authorities broadly shared staff views on labor market policies and plan to actively support expansion of youth employment and women's participation from a mid- to long-term perspective to address demographic pressures.
- Short-term labor market dynamics:
  - Next five years see the “echo-generation” (children of the baby boomers) entering the labor market, tightening labor market for new entrants.
  - Expansion of employment in the public sector could act as a buffer to resolve youth unemployment.
  - Public employment in much needed areas (police force, firefighters) does not crowd out private sector jobs, given Korea’s public employment accounts only for 8 percent of total, well below the OECD average of 21 percent.
  - Public employment could help prevent hysteretic phenomenon of labor—productivity decline as youth unemployment persists.
- Minimum wage:
  - Authorities welcomed a positive assessment of 2018 minimum wage increase.
  - Expectation that the rise in minimum wage will start a virtuous cycle: increased income leads to higher consumption and production.
  - Minimum wage adjustment at the current price level is expected to help address income polarization without incurring inflation pressure.

*Source: cr1840 — 2017 Article IV consultation (IMF).*

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_Source: https://www.imf.org/-/media/files/publications/cr/2018/cr1840.pdf_