Public Information Notice No. 01/8

Public Information Notice: IMF Concludes Article IV Consultation with Korea

February 1, 2001

On January 31, 2001, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Korea.¹

Background

Korea's three-year standby arrangement with the IMF expired on December 3, 2000. Substantial progress was made during the program. First, macroeconomic fundamentals have improved sharply, and Korea's economy has become more resilient to external shocks. Second, a wide range of structural reforms have made the economy more open, competitive, and market driven. Despite these accomplishments, both domestic and foreign sentiment about Korea have deteriorated in recent months. The decline in confidence is largely related to the perception of a lack of tangible results in corporate and financial sector restructuring, combined with a worsening of the external environment.

In 2000, full-year growth is estimated to have been around 9½ percent, with continuing healthy growth in domestic demand and a substantial contribution from net exports. Unemployment continued to fall, averaging 4.0 percent in 2000. Supply shocks and higher public service charges pushed up headline CPI inflation to 2¼ percent, but average core inflation remained well within the Bank of Korea's target of 2.5 ± 1 percent. The external position remained healthy. Higher oil prices and strong import demand were offset by booming export volumes and steady prices for most exports. The current account surplus is estimated to have been $10½ billion (2¼ percent of GDP) in 2000, down from $25 billion (6 percent of GDP) in 1999.

Fiscal consolidation in 2000 proceeded much more rapidly than expected, with the consolidated central government balance switching from a deficit of 3.8 percent of GDP in 1999 to a surplus of around 1 percent of GDP in 2000 (under comparable definitions). The overnight call rate, after being increased twice in 2000, has been kept steady since October, at 5¼ percent.

The economy's rapid expansion has slowed substantially in recent months due to a less favorable external environment and weaker consumer confidence. Over the medium term, growth is projected to settle at about 6 percent, in line with potential output growth. Achieving this growth rate depends critically on further progress in implementing structural reforms.

Substantial progress has been made in stabilizing the financial system, addressing corporate distress, strengthening the institutional framework for corporate governance and financial supervision, liberalizing capital markets and foreign investment, fostering transparency, and enhancing the role of market discipline. The institutional framework for restructuring is largely in place and major strides have been made in addressing the deep-seated problems of enterprises and financial institutions. However, several structural weaknesses remain, which have dented market confidence.

In the corporate sector, financial disclosure and corporate governance are improving. Some corporate divestitures and other operational restructuring have occurred, notably by less-distressed chaebol acting voluntarily outside formal workout programs. The ability of creditors to force a number of large chaebol into receivership and to take control of Daewoo should help deter imprudent corporate investments in the future. Nevertheless, Korea's corporate sector remains highly leveraged and continues to suffer from low profitability. The ongoing liquidity pressures in the corporate bond market are a further sign of the need for corporate restructuring.

Significant steps have been taken to strengthen the financial system, and the problems that remain largely stem from continuing weaknesses in the corporate sector. Progress has been most notable in consolidating and recapitalizing the banking system, operational restructuring, and strengthening prudential regulations and supervisory oversight. The restructuring has been aided by a large injection of public funds. To spur restructuring, partial deposit insurance was reintroduced on January 1, 2001 and the blanket guarantee was removed. The market, however, remains nervous about the health of the banking system largely because significant asset quality problems remain. The problems in the investment trust sector and merchant banks continue to hamper financial intermediation, but are no longer seen as systemic threat.

Executive Board Assessment

Executive Directors commended the authorities on the considerable achievements under the three-year stand-by arrangement that expired in December 2000. Directors noted that Korea's recent economic performance has been impressive with high growth, low inflation, a fall in unemployment, and a marked strengthening of the external position that has resulted in a sizable current account surplus and substantial build-up of international reserves, while short-term external debt was contained to reasonable levels. Furthermore, structural reforms have made Korea's economy more open, competitive, and market oriented; these reforms will continue to yield benefits for many years to come. Directors also welcomed the authorities' intention to make early repurchases of Fund credit and to repay the outstanding amount by August 2001.

Directors noted that the external environment has recently become less favorable, and with domestic demand also weakening, growth in 2001 is expected to fall to about half the level seen in 2000. They pointed out, however, that Korea has substantial upside potential waiting to be harnessed. In particular, Directors noted that the continued weakness of the corporate and financial sectors is imposing an increasing drag on the economy. Directors, therefore, stressed that it will be critical to deepen and accelerate restructuring to ensure sustainable high growth in the medium term.

Directors welcomed the authorities' focus on fiscal consolidation and noted that the budget had returned to surplus in 2000, four years ahead of schedule. Some Directors considered, however, that this rapid pace of consolidation may have unduly contributed to the recent weakening of the recovery and, taking note of the projected growth slowdown, were in favor of more fiscal stimulus, while stressing the need to avoid a stop-go pattern of fiscal policy. They noted that there is scope to expand spending on the social safety net, especially if the economy slows more sharply than expected or if restructuring leads to a marked rise in unemployment. Directors encouraged the authorities to explore how to improve the accuracy of intra-year budget monitoring in order to ensure against inadvertent fiscal tightening. They also encouraged the authorities to prepare a plan to address the shortcomings identified in the fiscal transparency report, and welcomed the authorities' intention to publish that report.

Directors commended the Bank of Korea on progress achieved with the implementation of the inflation targeting framework, but agreed that further efforts to enhance accountability and transparency are needed. They noted that the inflation target for 2001 has been set slightly above the medium-term target of 2.5 percent to accommodate the inflationary impact of recent oil price increases. Several Directors advised the authorities to keep monetary policy oriented to achieving the medium-term inflation target, but considered that the recent weakening in the growth outlook might justify a temporary loosening in monetary policy. Directors also welcomed the greater exchange rate flexibility that has been achieved in recent months, but reiterated that intervention should be limited to instances where trading is exceptionally disorderly.

Directors noted with concern that, despite commendable progress, a large portion of the corporate sector continues to suffer from serious weaknesses, with repercussions for financial sector stability. They therefore strongly welcomed the authorities' renewed commitment to further reform in these areas and encouraged them to proceed without delay. Directors noted that the improved social safety net should help the economy absorb the temporary dislocations that may result from the process of restructuring. They also emphasized the critical importance of developing a sufficient social consensus in favor of the needed shift from preserving old jobs in sunset industries to creating new jobs in vibrant growing industries.

Directors expressed concern that the corporate sector remains highly leveraged and that its profitability is still low. They referred to the continuing decay and loss of value in Daewoo affiliates and the ongoing problems of some Hyundai affiliates. Directors agreed that, for viable companies, management and creditors need to focus on de-leveraging, the sale of non-core assets, and on operational restructuring to allow these companies to return to profitability. For nonviable companies, banks should be more forceful in pushing for liquidation before values decline further. In view of the mixed record of out-of-court workouts, Directors suggested that greater reliance be put on court-supervised insolvency to accelerate the restructuring of distressed companies. In this context, further insolvency reform and the introduction of prepackaged bankruptcies are essential to enhance the capacity of courts to handle insolvency cases. Directors also urged the authorities to refrain from pushing creditors into bailing out troubled companies, and to maintain an open attitude to foreign involvement (including purchases of assets) in the restructuring process. Over the longer term, stronger corporate governance practices will be crucial to allow markets to drive the process of corporate restructuring.

Commenting on the increased use of collateralized bond obligations and the establishment of bond market funds, Directors noted that some government intervention may have been justified, given the bunching of maturities and the current weak demand for bonds. Nevertheless, Directors cautioned the authorities to ensure that these measures are transitory, keep distortions to a minimum, are limited to viable firms with temporary financing problems, and avoid the perception that some companies are "too big to fail." Directors stressed that a durable solution to the problems in the bond market will require restructuring efforts aimed at reducing leverage in the corporate sector.

Directors noted that the overall condition of the financial sector continues to improve, but the viability of several banks remains unclear. They welcomed the approval of additional public funds for financial sector restructuring and, in particular, the government's commitment to a greater degree of transparency and disclosure in the use of such funds. To minimize moral hazard, ensure effective use of the funds, and contain future claims on the budget, Directors stressed that all injections should be tied to restructuring and permanent solutions to financial sector problems. They also welcomed the reintroduction of partial deposit insurance as part of the shift to market discipline.

On financial consolidation, Directors cautioned against the establishment of financial conglomerates in the absence of an adequate governance and regulatory infrastructure and before the banks, which will be at the center of such conglomerates, are themselves financially strong and well managed. While welcoming a number of steps toward establishing such an infrastructure, they urged the authorities to ensure that the current plan to merge smaller banks with a large bank into a financial holding company, be implemented without compromising the health or restructuring of larger, systemically important banks. With regard to non-bank financial institutions, Directors welcomed the recent legislation to strengthen the fiduciary responsibility of managers and trustees, and looked forward to its implementation. More generally, they stressed that it will be critical for supervisory authorities to resist pressures for forbearance and to ensure that supervisors and managers shift from focusing on rules-based observance of standards to pro-active risk management.

Directors noted that the basic framework for restructuring is in place and the key issue remains implementation and ensuring a stronger role for markets to drive the process. In this regard, they noted that Korea is a mature economy and that it will now be important for the government to step back from intervening in the operation of markets and economic decision making, and instead rely in the future on markets in imposing discipline.

Directors welcomed Korea's continuing close cooperation with the Fund, including through post-program monitoring and Korea's participation in the forthcoming Financial Sector Assessment Program (FSAP).

Noting that Korea's statistical base is adequate to conduct effective surveillance, Directors encouraged the authorities to continue to make progress in improving the coverage, periodicity, and timeliness of data.