Public Information Notice No. 05/13

Public Information Notice: IMF Executive Board Concludes  2004 Article IV Consultation with Korea

February 4, 2005

On January, 21, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Korea.¹

Background

From 1999 to 2002, Korea's economy grew rapidly, by an average of 7¼ percent per annum. But starting in 2003, the economy has begun to sputter. Growth suddenly stopped in the first half of the year, leapt ahead in the second half as exports boomed, but then slowed again to an anemic 2¾ percent annualized rate during January-September 2004 as exports decelerated.

In effect, for the past two years, the economy has been dependent on export growth, because the domestic engines of growth have shut down. Households and SMEs have been unable to spend, as they are repairing their balance sheets following a long credit boom. Meanwhile, corporations have become reluctant to invest, in large part because they are discouraged by the highly regulated domestic labor market.

The authorities have been countering this slowdown by easing macroeconomic policies. The fiscal policy stance has been shifted from neutral to mildly expansionary. At the same time, the monetary policy mix has been shifted to favor domestic demand. The policy interest rate has been reduced to an historic low of 3¼ percent, easing the burden on debtors, while the won has been allowed to appreciate, cutting the cost of imports and thereby boosting real household incomes. Over the course of 2004, the won climbed by 14½  percent against the U.S. dollar, a 12½  percent gain in nominal effective terms. While smoothing this rise, the authorities accumulated $44 billion in reserves, bringing the total to $199 billion.

Staff expects that domestic demand will finally begin to revive in early 2005, supporting yearly growth of 4 percent. Experience from other countries that have gone through similar booms and busts suggests that consumption could revive as the process of balance sheet adjustment advances into its third year. Moreover, high capacity utilization ratios and strong manufacturing profitability should ultimately prompt a recovery in facility investment, offsetting a slowdown in construction.

There are both upside and downside risks to this baseline projection. On the upside, the recovery in domestic demand could be much more vigorous than projected, especially as Korean recoveries have often been swift and sharp. On the downside, the projected recovery could be undermined if OECD growth falters or there is a significant downturn in the volatile electronics sector. Moreover, with the country highly dependent on imported oil, growth could be cut significantly if oil prices rise significantly from current levels. Most importantly, the strength and sustainability of the recovery will depend heavily on government policies, especially in tackling the ongoing structural difficulties.

Despite these challenges, Korea's vulnerability to crisis remains very low. The fundamental pillars of the economy are strong: the balance sheets of the chaebol are healthy on average, and banks have preserved their capital strength despite recent loan losses. Moreover, the cushions against shocks are ample: the external position is more than comfortable, with reserves now exceeding the level of gross external debt, while government debt is only 30 percent of GDP.

Executive Board Assessment

Executive Directors agreed with the thrust of the staff appraisal. They welcomed the Korean authorities' basic policy approach, especially the accelerated dismantling of the state-directed economic framework, in recent years. These efforts, Directors considered, have paid handsome dividends, creating a relatively open and liberal economy and touching off a long economic boom.

More recently, however, Directors noted, the Korean economy has begun to slow down. While noting that this has occurred because the economy has been dealing with the after-effects of a 200l-02 credit boom, Directors emphasized that the more fundamental problem is the remaining legacy of a state-directed development strategy. Accordingly, they stressed that completing the shift to a market-based framework would be the key to restoring sustained and rapid growth.

Directors agreed that stimulative fiscal and monetary policies would be appropriate to provide a macroeconomic spark. Directors welcomed the authorities' plans to adopt a pro-active approach by front-loading budgetary spending, and urged the adoption of a supplementary budget with additional social safety net spending. They also welcomed the Comprehensive Investment Plan, which aims to stimulate additional investment spending through public-private partnerships, but noted that these projects may take some time to materialize, and will need to be recorded transparently in the fiscal accounts when they do.

Directors believed that, with core inflation remaining within the target range and inflation expectations under control, there is scope for the central bank to provide support to the real economy. They consequently supported the reduction in interest rates in November, as well as Bank of Korea's plan to stand ready in case further reductions are required. Directors commended the authorities' decision to allow the won to respond to market forces, noting that Korea's flexible exchange rate policy has served the country well, encouraging financial market development while maintaining external competitiveness.

Directors emphasized that achieving sustained strong growth will require addressing the underlying structural difficulties. This will require, first and foremost, addressing the household delinquency problem. Directors strongly supported the government's decision to stand firm against calls for a mandated debt reduction scheme and instead establish a market-friendly framework within which debtors and creditors can work to resolve their problems. Directors stressed that the linchpin of such a framework, however, needs to be a working bankruptcy system, to provide a final resolution for those who cannot repay their debts and a standard for others, so as to encourage them to settle out of court. For this reason, they endorsed the plans to make bankruptcy a viable option, and suggested that the government go further in this direction by shortening the repayment period and reducing official discrimination against bankrupt persons. Most importantly, these reforms should be enacted speedily, as accelerating the pace of debt restructuring is critical to hastening the advent of the recovery. Meanwhile, to restore households' access to lending, Directors recommended that the authorities promote the information-sharing needed for an efficient system of competing credit bureaus.

Reviving the SMEs is another important priority. Directors noted that resources flowing to these firms have tended to be allocated on the basis of government guarantees, mainly to businesses first identified during the Asian crisis. This has distorted competition and stifled the dynamism of the sector, taking a severe toll on its overall financial health. Fundamental reforms are consequently needed: the current government-led framework needs to be replaced by one where the private sector allocates resources, funding the firms with the most promising futures. Directors recommended that the amount of guarantees be scaled back over the medium term, while the share of each loan covered by guarantees should be reduced, and the cost of rollovers increased. At the same time, to help SMEs grow, Directors recommended measures to broaden the range of security for loans, expand the availability of venture capital, reduce start-up costs, and improve the efficiency of exits.

Directors considered that improving the investment environment would require modernizing the labor market. They welcomed the recent improvement in industrial relations, but noted that a fundamental problem still remains: the strict employment protection for regular workers, which deters risky investments and has prompted a growing use of nonregular workers. The only way to resolve these problems, Directors considered, would be by reducing employment protection for regular workers. Accordingly, they welcomed the authorities' plans to consider introducing regular labor contracts with less protection, while simultaneously expanding the social safety net.

Promoting investment also requires improving corporate governance and developing the bond market, so as to encourage markets to provide more financing, to more firms, at lower cost. For this reason, Directors welcomed the amendments to the Fair Trade Act, aimed at encouraging the chaebol to improve their governance. They also welcomed the introduction of class action lawsuits for securities law violations, and encouraged additional steps to reinforce market discipline on corporate governance, such as adopting a "comply or explain" system for the Code of Best Practices in Corporate Governance. In the bond market, Directors recommended that the government refrain from bailing out investors, which has distorted the balance between reward and risk, stifling market development.

Directors urged the government to play a leadership role in advancing global trade liberalization, including by further opening up Korea's heavily protected agricultural sector. On the proposed Korea Investment Corporation, Directors urged that its objectives be supported by well-defined governance, transparency, and accountability arrangements.

While recognizing that the structural reform agenda is ambitious, Directors remained fundamentally optimistic about rekindling the dynamism of the Korean economy. The Korean authorities have time and again demonstrated the willingness and ability to take decisive measures to address the economy's problems. Moreover, by enacting the reform agenda, Korea will advance considerably toward achieving a comprehensive market-based framework that is needed for a return to sustained rapid growth.

It is expected that the next Article IV consultation with Korea will take place on the standard 12-month cycle.