Public Information Notice: IMF Concludes Article IV Consultation with Korea

IMF News, December 29, 1999

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Authors: Arrangement. Directors
Published: December 29, 1999

Background

On December 17, 1999, the Executive Board concluded the Article IV consultation with Korea.
In late 1997, Korea experienced a financial crisis characterized by massive capital outflows, a sharp depreciation of the won, and severe distress in the corporate and financial sectors.
Korea agreed to a US$21 billion standby-arrangement with the Fund on December 4, 1997, with main objectives to stabilize the economy and restore sustainable growth through a fundamental restructuring of the economy.
Policies under the program have:
- Restored external stability.
- Rebuilt reserves.
- Initiated reform of the financial and corporate sectors.
The crisis led to Korea's worst recession in over three decades:
- Real GDP contracted by 5.8 percent in 1998.
- Unemployment rate jumped to close to 9 percent in February 1999 from less than 3 percent before the crisis.
After a brief spike in early 1998, inflation has been subdued owing to weak domestic demand and a large output gap; the depreciated won contributed to a sharp swing in the current account to a large surplus in 1998.

Recent economic performance and macroeconomic policy

Once exchange rate stabilization was achieved, policy focus shifted to stimulating growth through easing macroeconomic policies.
- The overnight call rate was progressively reduced, falling to below pre-crisis levels by July 1998.
- The call rate has been kept at about 4¾ percent since April 1999.
Fiscal stance:
- The consolidated central government deficit (including privatization receipts) is projected to be about 4 percent of GDP in 1999.
- Government expenditure on the social safety net is projected to rise to about 2 percent of GDP in 1999, compared to an estimated 1 1/3 percent of GDP in 1998.
1999 turnaround:
- The economy is expected to grow by 9 percent in 1999, with upside potential.
- Growth led by buoyant private consumption, rebound in equipment investment, and slower inventory decumulation.
- Unemployment rate dropped to 4.4 percent in November 1999.
- Inflation has remained low.

External position and capital flows

External strengthening in 1999:
- Current account surplus of $20 billion in the first nine months of 1999.
- Capital inflows increased markedly related to joint ventures and asset sales tied to corporate restructuring, increased weight assigned to Korea in emerging market portfolios, and improved credit ratings for Korean companies.
- Reserves built up to $70 billion at end-November 1999.
- Appreciation of the won in nominal effective terms.
With reserves sufficient to provide cover for external short-term liabilities (on a residual maturity basis), external vulnerability has been significantly reduced.

Financial and corporate sector reforms and remaining vulnerabilities

Financial sector:
- Good strides in restructuring, with tangible progress in consolidating and recapitalizing the banking system via significant injections of public funds.
- Strengthened role and independence of the Financial Supervisory Commission; prudential regulations brought in line with best international practice.
- Divestiture of majority shares in Korea First Bank finalized; privatization of Seoul Bank proceeding more slowly than anticipated.
- In the nonbank financial sector, framework and regulatory structure to deal with insurance industry problems are essentially in place; implementation is now the emphasis.
- Reform of the investment trust industry is a priority.
Corporate sector:
- Major improvements in corporate governance and financial transparency.
- Progress in deleveraging and restructuring of the chaebol has been slow.
- Government stepped up efforts to accelerate and strengthen restructuring; decisive action on Daewoo demonstrated that large conglomerates are not "too big to fail."
- For top-5 chaebol, authorities enforcing implementation of capital structure improvement plans and applying sanctions for noncompliance.
- For the 6-64 chaebol (ranked by asset size), debts are being restructured under a creditor-led debt workout framework, but early evidence suggests restructuring has not gone deep enough; several agreed workouts will need revisiting to reduce debt to a more sustainable level.
- Workout process being strengthened with clearer guidelines for monitoring and enforcement, and improved selection criteria so only viable companies are admitted into the workout program.
Lingering risks:
- Daewoo's collapse and resulting turmoil in financial markets in the second half of 1999 illustrate remaining risks that could impede sustaining rapid medium-term growth.
- Structural reform agenda remains large, especially in financial and corporate sectors.

Executive Board Assessment — findings and policy recommendations

Directors' appraisal:
- The speed and strength of Korea's recovery and reduced external vulnerability indicate that the policies adopted in response to the crisis were right and are working.
- Commended authorities for sound macroeconomic management and substantial progress in structural reforms; welcomed authorities' intention to withhold further drawings under the Stand-By Arrangement.
- Noted Korea is now more open, competitive, and market-driven, contributing to improved market confidence.
Risks and reform momentum:
- Sustainability of strong growth not yet assured; essential to maintain reform momentum and tackle remaining structural weaknesses in financial and corporate sectors.
- Current strength provides an excellent opportunity to push ahead with reforms.
Macroeconomic stance:
- With a narrowing output gap and continuing large external inflows, policies need to shift to a more neutral stance and the policy mix needs rebalancing.
- Major focus should be on fiscal consolidation.
- Strongly welcomed authorities' intention to begin consolidation with the 2000 budget and to bring forward the goal of achieving a balanced budget to 2004, given potential high budgetary costs of financial restructuring.
- Noted that if growth next year is stronger than expected, automatic stabilizers should be allowed to work.
- Monetary policy:
- Given absence of inflation pressures, monetary policy should remain accommodative.
- Monetary authorities should be vigilant and ready to adjust policy before inflationary pressures arise.
- Trend toward strengthening of the won is appropriate and helps dampen inflation pressures; consistent with more balanced and sustainable current account in the medium term.
- Intervention in foreign exchange markets and reserve accumulation should follow the principle that the exchange rate be determined by market forces.
- Some Directors considered inflation targeting could provide a useful framework and urged establishment of a reliable framework for forecasting inflation; others suggested taking more time to weigh advantages and disadvantages.
Financial sector priorities:
- Forceful action to further strengthen the financial system is a high priority.
- Immediate issue: reform of the investment trust industry — Directors urged implementation of fundamental reforms without delay and welcomed plans to increase use of market valuation principles.
- Improve supervision and strengthen governance in the investment trust sector; ensure managers and trustees honor fiduciary responsibilities.
- Public funds should be used only to provide a partial safety net for small investors.
- Reforms in the investment trust and insurance sectors are critical for deepening capital markets.
Banking sector:
- Commended progress in improving banking system health over the last two years.
- Process of building a sound banking system is far from over; corporate restructuring may expose additional losses and require greater efforts to strengthen banks' capital.
- Welcomed privatization progress of Korea First Bank; urged expeditious privatization of Seoul Bank to introduce international management practices and greater competition.
Corporate restructuring specifics:
- Daewoo:
- Commended authorities for speed in formulating complex restructuring framework and for demonstrating no company is "too big to fail."
- Welcomed willingness to place Daewoo affiliates in workout arrangements with creditors.
- Critical that final workout plans go beyond financial restructuring to operational restructuring via asset sales, liquidation of nonviable companies, and other business restructuring.
- Workout agreements should be fair and transparent with equal treatment of domestic and foreign creditors.
- Other large conglomerates:
- Welcomed intention to make greater use of regulatory powers and sanctions to ensure continued restructuring.
- Mid-sized conglomerates:
- Underscored importance of deeper restructuring to enhance viability; creditor banks should apply stricter sanctions for noncompliance.
Social safety net and data:
- Strong support for adapting social safety net away from emergency crisis measures toward a more strategic medium-term approach.
- Advised to continue strengthening administrative framework to respond promptly to future employment shocks.
- Commended progress in improving coverage, periodicity, and timeliness of key economic data; urged continued improvements in data coverage, especially government operations and financing.

Korea: Selected Economic Indicators (percent changes, unless otherwise noted)

Real GDP: 1995 8.9; 1996 6.8; 1997 5.0; 1998 -5.8; 1999 9.0
Private consumption: 1995 9.6; 1996 7.1; 1997 3.5; 1998 -9.6; 1999 10.0
Public consumption: 1995 0.8; 1996 8.2; 1997 1.5; 1998 -0.1; 1999 -1.1
Gross fixed investment: 1995 11.9; 1996 7.3; 1997 -2.2; 1998 -21.1; 1999 3.7
Stockbuilding 1/: 1995 0.6; 1996 -2.0; 1997 -5.6; 1998 4.0
Net foreign balance 1/: 1995 0.2; 1996 5.7; 1997 12.2; 1998 -0.6
Exports: 1995 24.6; 1996 11.2; 1997 21.4; 1998 13.3; 1999 18.1
Imports: 1995 22.4; 1996 14.2; 1997 3.2; 1998 -22.0; 1999 31.0
Inflation — GDP deflator: 1995 3.9; 1996 3.1; 1997 5.3; 1998 0.9
Inflation — CPI (period average): 1995 4.5; 1996 4.9; 1997 4.4; 1998 7.5
Unemployment rate (period average): 1995 2.0; 1996 2.6; 1997 6.6 2/
Industrial production (period average): 1995 8.7; 1996 -7.3; 1997 21.7 2/
Current account balance (Billions of U.S. dollars): 1995 -8.5; 1996 -23.0; 1997 -8.2; 1998 40.0; 1999 25.2
Current account balance (Percent of GDP): 1995 -1.7; 1996 -4.4; 1997 12.5; 1998 6.1
Consolidated central government (percent of GDP) — Revenues 3/: 1995 19.3; 1996 20.4; 1997 20.6; 1998 21.5
Consolidated central government (percent of GDP) — Expenditure: 1995 19.0; 1996 22.3; 1997 25.7; 1998 26.1
Consolidated central government (percent of GDP) — Balance (excluding privatization revenues): 1995 0.3; 1996 0.0; 1997 -4.2; 1998 -4.6
Money and interest rates — M3: 1995 19.1; 1996 16.7; 1997 13.9; 1998 11.0
Yield on corporate bonds (period average): 1995 13.8; 1996 13.4; 1997 15.1; 1998 8.9 4/
Exchange rate (period average) — Won/dollar rate: 1995 771; 1996 804; 1997 951; 1998 1,402; 1999 1,190 5/

1/ Contribution to GDP growth. 2/ Average for January-October 1999. 3/ Excluding privatization receipts. 4/ Average for January 25-December 21, 1999. 5/ Average for January 4-December 21, 1999.

Public Information Notice: IMF Concludes Article IV Consultation with Korea — December 29, 1999, IMF EXTERNAL RELATIONS DEPARTMENT.