Public Information Notice No. 02/09

Public Information Notice: IMF Concludes 2001 Article IV Consultation with Korea

February 12, 2002

On February 11, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Korea.¹

Background

The completion of early repayments to the Fund in August 2001 symbolizes how much Korea has achieved since the crisis that erupted in late 1997. Reserves are now at a level that provides substantial insulation against shocks. A wide range of reforms has also helped to address the weaknesses that precipitated the crisis and foster an environment where market discipline is beginning to play a more important role. In November 2001, Korea's sovereign credit rating was upgraded, driven in large part by its record on structural reform. Yet major challenges remain for Korean policymakers as the country now faces the risky combination of a weak global economy and continued weakness in the corporate and financial sectors.

In 2001, growth is estimated to have slowed to 2.9 percent down from 9 percent in the previous year. Although Korea was hit hard by the global downturn in information technology and slower growth in major trading partners, its economy has suffered less than other export-dependent Asian countries, largely on account of its relatively diversified export structure and steady consumer spending. After peaking in May, headline CPI inflation has fallen steadily reaching 3.2 percent (y/y) in December. Although core inflation in 2001 exceeded by a small margin the upper bound of the 2-4 percent (period average) target range set by the Bank of Korea (BOK), it is projected to decline further this year as a result of subdued wage and demand pressures and the large output gap. The external position remains healthy. The current account surplus is estimated at $10½ billion (2½ percent of GDP) in 2001, unchanged from the previous year, with the impact of slower export volume growth and sharply lower semiconductor prices offset by lower import volumes and oil prices.

In an effort to support domestic demand, macroeconomic policy has shifted to a more expansionary stance. The BOK cut its overnight call rate target by a total of 100 basis points in the third quarter of 2001 to a historic low of 4 percent, including a 50 basis points on September 19 in its first ever inter-meeting cut. Fiscal policy, however, provided no stimulus, with an estimated consolidated central government surplus of 1.7 percent of GDP in 2001, up from a surplus of 1 percent of GDP in 2000.

Latest macroeconomic indicators point to an upward revision of the staff's projection for Korea's growth rate to 4 percent, up from the 3¼ percent forecast in the IMF's latest World Economic Outlook. Domestic demand, mainly private consumption and construction investment, is projected to offset a smaller contribution from net exports. Over the medium-term, growth is projected to return to 5½ percent, in line with potential output growth. Productivity increases needed to reach this growth rate will depend critically on further progress in implementing structural reforms.

Progress in corporate restructuring continued in 2001. A number of companies in formal workout programs were either rehabilitated, sold, or liquidated. Debt-equity ratios also continue to fall. Nevertheless, the corporate sector remains weak and vulnerable. Although average profitability has improved, a large proportion of companies still are unable to generate sufficient cash flow to meet their interest payments. Needed restructuring and asset sales have been hampered by disagreement between creditors over loss-sharing and weak insolvency procedures, and creditors' reluctance to write down losses has prolonged the liquidation of unviable companies. A Corporate Restructuring Promotion Law was passed in September 2001 with the aim of addressing some of these impediments.

Strides were also made in strengthening the financial system in 2001. Commercial banks have reduced their impaired loans as a share of total bank loans to 3.4 percent at end-December, from 9 percent at end-2000, and profitability, loan-loss provisioning, and capital positions have improved for most banks. Consolidation also continued with the launch of a private financial holding company and the creation of the largest commercial bank in Korea through private merger. However, progress has been slow in rehabilitating and privatizing the nationalized financial institutions.

Executive Board Assessment

Executive Directors noted that the sustained implementation of structural reforms aimed at enhancing market discipline, together with strong macroeconomic fundamentals, have greatly improved the resilience of the Korean economy. Korea has weathered the current global downturn better than many other economies and growth is picking up, its external position is strong, and reserves have been built to a comfortable level. Directors commended the authorities on repaying the Fund ahead of schedule, which symbolizes Korea's considerable achievements since the 1997 financial crisis.

Directors considered that macroeconomic policies should remain supportive in the period ahead, as there are still uncertainties in the near-term outlook, and as low inflation and strong government finances provide welcome scope to support activity if needed. On the structural front, further strengthening of the corporate and financial sectors is needed to put the economy on a sustained growth path driven by competition and productivity. Although implementing these reforms will be an ongoing multi-year process, Directors noted the importance of maintaining the momentum during this election year through appropriately prioritized measures to sustain confidence and ensure that the role of market discipline becomes more firmly entrenched.

Directors commended Korea's tradition of fiscal conservatism, but they considered that a more supportive fiscal stance in 2001 would have been preferable and still consistent with maintaining sound public finances over the medium term. While the current policy mix appears to be broadly appropriate in view of the expected upturn in economic activity, Directors stressed that in order to avoid imparting an unduly contractionary impulse in 2002, fiscal policy should not be allowed to overperform as it has in recent years. They welcomed the planned front-loading of expenditure in the first half of the year, which should provide stimulatory impulse when most useful. Looking ahead, Directors urged the authorities to address the persistent problems in the implementation of fiscal policy by improving budget planning, monitoring, and execution in line with the Fund's technical assistance recommendations. As a first step in this regard, they welcomed the authorities' intention to introduce in 2002 monthly reports on budget execution by ministries, as well as a formal midyear budget review. This could be an opportunity to consider additional supportive measures if needed.

Directors commended the Bank of Korea (BOK) for appropriately cutting interest rates in the second half of 2001, and for successfully balancing the need to cement the credibility of the inflation targeting framework and the need to support the weak economy. Although the easing cycle may have reached its end, Directors noted that, with subdued inflation and a negative output gap, monetary policy still has room for maneuver in the event of renewed weakness in the economy. In this regard, they welcomed the BOK's decision to maintain last year's inflation target range for 2002, pending the switch as soon as feasible to only a medium-term inflation target. Directors also welcomed the greater flexibility in the exchange rate, and encouraged the authorities to continue to limit intervention in the foreign exchange market to instances of exceptionally disorderly trading and to avoid any attempt to hold the won exchange rate constant against any single currency.

Directors noted that, despite progress, the corporate sector remains beleaguered by the continued operation of loss-making companies. They stressed that the orderly exit of nonviable companies should be accelerated, and that state-owned banks, in particular, need to accept reductions on their claims, including by allowing a company to be liquidated if losses become unmanageable. Furthermore, many companies need to undertake deeper operational restructuring, close loss-making operations, and sell noncore assets to improve profitability and resolve debt levels. While noting that these are complex transactions, Directors expressed concern that asset sales in the case of some large troubled companies and financial institutions have slowed.

Directors noted that further reforms of the insolvency laws will be crucial to facilitate corporate restructuring, and they welcomed the authorities' intention to undertake a comprehensive reform of the bankruptcy framework within the next year. They stressed that a number of complex issues will need to be addressed, including harmonizing the different bankruptcy codes, encouraging greater participation in reorganization plans by both debtors and creditors, and addressing the problem of dissenting creditors.

Directors agreed that the direct regulations imposed on the chaebol after the financial crisis will need to be removed over time, but they cautioned that this should be done only to the extent that market-based mechanisms ensuring sound corporate governance are fully in place. Meanwhile, the authorities should continue their gradual and prudent approach to the relaxation of chaebol regulations. Looking ahead, Directors encouraged the authorities to accelerate the development of market-based mechanisms to control the risk that companies engage in renewed overexpansion without regard to profitability. The need for further steps to enhance the accountability of management—such as improved auditing and disclosure practices and new laws that permit class action lawsuits—was also highlighted.

Directors commended the substantial progress with financial sector reform, and encouraged the authorities to continue their efforts to strengthen the soundness of the financial system. They welcomed Korea's participation in the Financial Sector Assessment Program, which will provide a comprehensive analysis of the priorities for reform and restructuring. Directors also welcomed the recent announcement by the authorities to advance the sales of government-held shares in several banks, as private ownership will help these banks run more efficiently and dispel the notion that the government is interfering in bank lending decisions. In addition, Directors highlighted the importance of strengthening supervision, especially conducting proper risk assessment and pressing creditors to acknowledge the true health of debtors. In view of the proposal to relax the limit on domestic ownership of banks, tighter safeguards on connected lending will also be important to prevent the potential for exploitation by major shareholders. Directors welcomed the withdrawal of the Korea Development Bank bond underwriting scheme, and encouraged the authorities to continue their efforts to improve the efficiency of the capital market. They also welcomed the authorities' efforts to combat money laundering and the issuing of blocking orders to freeze the assets of terrorists.

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, particularly fiscal data.