Public Information Notice No. 98/39

Press Information Notice: IMF Concludes Article IV Consultation with Korea

June 19, 1998

On May 29, 1998, the Executive Board concluded the Article IV consultation with Korea¹.

Background

Until the financial crisis in late 1997, Korea had experienced a long period of rapid growth, low inflation, and a sustained improvement in the standard of living. Prudent macroeconomic policies and high domestic savings and investment contributed to the rapid transformation of Korea into an advanced industrial economy in four decades. The government had begun an economic reform program—which gained momentum in 1993-96— to gradually liberalize financial markets and the capital account.

Capital account liberalization, however, was not well sequenced nor accompanied by the necessary reforms and strong prudential supervision of the financial system. The vulnerabilities of the economy to external events stemming from weaknesses in the corporate and financial sectors were not fully recognized. Controls on short-term external borrowing by banks were eased, but controls on medium- and long-term capital remained in place. In 1994-96, Korean conglomerates undertook an aggressive investment drive financed by large increases in borrowing from domestic banks, which, in turn, sharply increased short-term external borrowing. During 1997, an unprecedented number of highly leveraged conglomerates went into bankruptcy as the buildup in capacity proved unviable owing to the depreciation of the yen, a sharply adverse movement in Korea’s terms of trade, and the slowing of domestic demand in 1996. The bankruptcies resulted in a severe deterioration in the balance sheets of Korean financial institutions.

The onset of the crisis in Thailand in mid-1997 brought Korea’s financial and corporate sector problems into sharper focus and increased the concerns of foreign creditors about the soundness of Korea’s financial system. With markets already apprehensive, the correction of the Hong Kong stock market in late October 1997 triggered a massive and sudden loss of market confidence. In the weeks that followed, credit lines to Korean banks were cut back severely and usable reserves fell to critically low levels as the Bank of Korea provided emergency foreign exchange support to Korean banks to avoid default. Korea entered into a Stand-By Arrangement with the IMF on December 4, 1997.

The program supported by the Stand-by Arrangement has two main objectives: the restoration of confidence in the basic soundness of the Korean economy; and the fundamental restructuring of the financial and corporate sectors supported by far-reaching market opening to lay the basis for recovery and growth. In the immediate period of the crisis, monetary conditions were tightened in support of the stabilization of the foreign exchange market. With the stabilization of the foreign exchange market, interest rates have fallen substantially in recent months. Fiscal policy has been flexible so as not to aggravate the downturn in economic activity. The program for 1998 envisaged a fiscal deficit of 1.7 percent of GDP, close to the estimated cyclically neutral deficit, and allowed for increased social safety net expenditures. The social safety net has been improved through a widening of the coverage and extension of benefits. Structural reforms have been accelerated. In the financial sector, an autonomous consolidated supervisory agency has been established; the merchant banking sector has been rationalized with the closing of about half the original number of banks and approval of recapitalization plans of the others; and 12 undercapitalized commercial banks have been asked to submit recapitalization plans by end-June. With regard to corporate restructuring, large conglomerates have been required to publish combined financial statements by next year; shareholder rights have been strengthened; and bankruptcy procedures improved. Restrictions on foreign investment in domestic equity, bond, and money markets have been eliminated and foreign direct investment substantially liberalized. In addition, legislation has been passed to increase labor market flexibility.

Substantial progress has been made in overcoming the immediate external financial crisis, and the won has appreciated and stabilized. A debt restructuring agreement with foreign banks was finalized at end-March and in early April, the government issued $4 billion in a global bond issue. The current account balance has turned into a substantial surplus (some $14½ billion in the first four months of 1998) and there have also been significant inflows of portfolio capital. Usable reserves have been rebuilt to exceed pre-crisis level—reaching $34½ billion by end-May.

The impact of the crisis on the real economy, however, has been severe. After growing at 5.5 percent in 1997, real GDP contracted by 3.8 percent in the first quarter of 1998, as the decline in consumption and domestic investment outweighed the strong positive stimulus to growth from net external demand. The unemployment rate reached 6.7 percent in April 1998 (compared with 2.5 percent in 1997). In spite of the won depreciation, inflation has been subdued, reflecting falling domestic demand and the absence of wage pressures.

Executive Board Assessment

Executive Directors commended the authorities for their steadfast implementation of their wide-ranging stabilization and reform program. This had contributed to a rapid rebuilding of usable reserves, the strengthening and stabilization of the won, and Korea’s successful re-entry into international capital markets. Directors stressed that international confidence in the authorities’ commitment to reforms had been a key factor contributing to these achievements. Nevertheless, they cautioned that confidence remained fragile—as indicated by the more recent weaknesses in the equity market—particularly given the severe downturn in economic activity and the difficult challenges that were widely recognized to remain ahead. Several Directors noted that the weakening of the yen and adverse developments elsewhere in the region were also likely to make Korea’s situation more difficult. Directors urged the authorities to persevere with the determined implementation of the reform program, especially as the contraction in output will be sharper than originally anticipated, with unemployment expected to continue rising. Directors stressed the importance for the successful implementation of the program of continued efforts by the authorities to maintain social consensus and stability. In this context, they emphasized the need for an adequate social safety net to protect vulnerable groups in the economy that are adversely affected by the restructuring process. Directors welcomed the initiation of the second-round tripartite committee.

To lay the basis for recovery, Directors urged the authorities to continue to pursue policies to safeguard the gains in confidence, preserve social stability, and decisively address weaknesses in the financial and corporate sectors. In particular, Directors advised the authorities to continue to focus monetary policy on maintaining exchange market stability. Directors saw scope for further gradual reductions in interest rates, provided the exchange market remained stable.

Directors viewed fiscal policy as prudent, and many supported a further widening of the deficit through the operation of automatic stabilizers, should the economic downturn prove to be worse than currently expected. Indeed, in light of the severity of the downturn, many Directors observed that additional social expenditures were desirable to help preserve social consensus, and supported a modest further widening of the fiscal deficit to allow additional social safety net expenditures.

Directors considered decisive action to strengthen the financial system to be imperative in the period ahead. They welcomed the progress made in rationalizing the merchant banks, and emphasized that focus should now shift to creating a sound and more efficient commercial banking sector. In this context, Directors were encouraged by steps taken to prepare two major intervened banks for privatization. They emphasized that the decisions expected shortly on the recapitalization plans of undercapitalized banks should be made with the benefit of a rigorous review of the magnitude of the nonperforming loan problem.

Directors welcomed the authorities’ recent efforts to make public a more realistic assessment of the size of the nonperforming loan problem and the commitment of public resources to support financial sector restructuring. They underscored the importance of setting clear conditions on the use of public resources for bank recapitalization. Systemic importance and clear market indications of viability, as signaled by the willingness of private parties to inject new capital, should be criteria in the provision of such assistance. In this regard, several Directors cautioned against the provision of public funds for nonviable banks. Directors welcomed the authorities’ plans to bring Korea’s prudential regulations and supervision closer to international best practices. They regarded the proposed regulations relating to short-term external borrowing and foreign exchange exposure as especially important, particularly in view of the liberalization of the capital account. Development of the capital market was also seen as a key element in corporate restructuring and in mobilizing the high level of domestic saving more efficiently.

Directors saw corporate restructuring as a further key challenge facing Korea, emphasizing that delays would only serve to postpone economic recovery and undermine the credibility of the reform effort. Directors noted that the important steps taken to improve corporate governance and strengthen market discipline needed to be complemented by actions to deal decisively with corporate overindebtedness. In this regard, Directors pointed to the need to put in place a framework for corporate debt workouts by June. Some Directors expressed concerns that the making of "rescue loans" could impair banks’ balance sheets and represent a return to former modes of lending; others regarded such loans as a temporary necessity pending a more coordinated corporate restructuring. As next steps in this regard, Directors identified the creation of debt workout units in commercial banks with the help of external audits, the formation of voluntary creditor committees, and improved disclosure to creditors by the large conglomerates. Directors underscored that corporate restructuring would also be spurred by the development of capital markets, the phasing out of cross-corporate payment guarantees, further opening up of the economy to foreign investment, and the strengthening of prudential regulations and supervision of banks.

Directors noted that, in view of the continuing difficulties experienced by small and medium-sized enterprises in obtaining trade financing, the provision of temporary credit support was necessary. They stressed, however, that trade financing and trade credit guarantee schemes should be time bound, provided on commercial terms, and not directed toward specific industries.