Press Release No. 14/20

IMF Executive Board Concludes 2013 Article IV Consultation with the Republic of Korea

January 22, 2014

On January 10, 2013, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation¹ with the Republic of Korea.

GDP growth has bottomed in 2013 after slowing sharply in 2012. The economy expanded by 1.1 percent in Q2 and Q3 2013, with exports rebounding and private consumption and construction strengthening. Real GDP growth is projected to reach 2.8 percent in 2013. Reflecting stronger exports and muted domestic demand, the current account surplus widened and is expected to reach around 5¾ percent of GDP. Inflation has fallen from 4.2 percent in 2011 to 0.9 percent in October 2013, well below the target band of 2½–3½ percent, in the absence of demand pressures and falling food prices.

The economy is expected to strengthen further and growth to rise to 3.7 percent in 2014. Domestic demand is expected to strengthen as consumption and investment recover supported by higher wages and stronger exports respectively, as well as a bounce back from the low base. However, risks are on the downside. The main near-term risks are external: sharply slower growth in Korea’s main trading partners or severe market stress. With a significant private debt overhang, key domestic risks are weak domestic demand and, over time, lower potential growth if structural reforms fail to offset the drag from rapid aging.

To support the economy, a supplementary budget of 1¼ percent of GDP was adopted in May 2013 to authorize borrowing to make up for a large revenue shortfall and finance a spending increase of around ½ percent of GDP. The government also postponed to 2017 the deadline for broadly restoring balance. The proposed 2014 budget keeps the overall deficit unchanged from the 2013 supplementary budget (at 1.8 in percent of GDP). To maximize policy effectiveness, the Bank of Korea cut its policy rate to 2.5 percent in May 2013, amid the uncertain global outlook, the continued negative output gap, and subdued inflation.

The resilience of the Korean financial system has increased since 2008 as a result of concerted policy efforts. Banks’ liquidity profiles have improved markedly due to well designed macroprudential measures, as reflected in lower external debt and foreign exchange liquidity mismatches. Banks are highly capitalized, with an average capital adequacy ratio of 14.3 percent during Q3 2013, and have low nonperforming loans ratios, reflecting active disposal. However, low net interest margin and non-interest income have led to weak profits. Depository institutions’ lending growth to the household sector has continued to decline, increasing by 3.2 percent as of end-June 2013, down from double-digits prior to the crisis. However, lending by non-depository institutions continues to be brisk, up 11 percent annually over the same period.

Executive Board Assessment²

Executive Directors commended the Korean authorities for their skillful policymaking, which allowed the economy to fare well in the recent crisis and position itself to gain from the global recovery. They stressed the need for continued structural reforms to rebalance the economy toward domestic demand, promote inclusive growth, and continue lifting living standards.

Directors noted that, while a modest recovery is underway, domestic demand remains relatively weak and the output gap is expected to remain negative through 2014. They considered it important to ensure that the monetary and fiscal stances remain supportive of the recovery until it is firmly entrenched. Directors agreed that risks to the growth outlook are on the downside, both in the near and longer term. These include, on the external side, adverse global growth surprises and severe market stress. On the domestic demand side, Directors saw as key risks high private sector indebtedness and ensuing deleveraging needs, weak household income growth, and population aging.

Directors commended the authorities for their fiscal prudence, which has provided Korea with ample fiscal room to maneuver. They agreed that priority should be placed on enhancing automatic stabilizers and increasing social safety nets, while broadening the tax base. Most Directors supported the authorities’ current medium term fiscal path to restore a balanced budget, given rapid population aging, contingent liabilities, and geopolitical risks. Others saw scope for somewhat higher deficit targets—implemented prudently—in support of social needs and rebalancing growth toward domestic demand. Directors generally felt that a structural fiscal framework deserves further consideration, although a few did not see a strong case for it given Korea’s track record of fiscal discipline. Directors welcomed the authorities’ ongoing efforts to enhance fiscal transparency, including on contingent government liabilities.

Directors noted the widening of Korea’s external imbalance and the increased pressure on the exchange rate, which the staff assessed as being moderately undervalued in real effective terms. A number of Directors expressed the need for caution in interpreting the results of model based assessments. Directors were of the view that the won should continue to be market determined, with intervention limited to smoothing disorderly market conditions. In this context, many Directors considered that increased transparency in interventions would help enhance the credibility of the authorities’ exchange rate policy. Structural policies to bolster domestic demand and continued flexibility of the won in line with fundamentals would facilitate economic rebalancing. Some Directors considered that the current level of reserves is adequate and does not warrant further accumulation, while a few others, noting the proven benefits of building a strong buffer in past crises, cautioned against prejudging the case.

Directors supported the authorities’ reform agenda aimed at increasing labor force participation and reducing labor market duality. They saw the merits of deregulation, including in network industries, reducing government intervention, and promoting competition in the service sector. Directors encouraged further efforts to boost service sector productivity and strengthen the competitiveness of small and medium sized enterprises, including by phasing out the prolonged use of loan guarantees.

Directors agreed that the financial sector is sound overall. They nevertheless encouraged the authorities to monitor risks closely, particularly weak bank profits, debt owed by fragile households and corporations, and activities in nonfinancial depository institutions. Directors underscored the importance of further improving the supervisory structure, including by strengthening operational independence, group wide supervision, and institutional coordination.