Public Information Notice No. 11/109

Public Information Notice: IMF Executive Board Concludes 2011 Article IV Consultation with the Republic of Korea

August 4, 2011

On July 29, 2011 the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Korea.¹

Background

Following a rapid recovery from the global financial crisis, growth in 2010 reached an impressive 6.2 percent, led by exports and domestic demand. Momentum eased in the first half of 2011, reflecting the maturing of the expansion, the adjustment in global inventories, and the weaknesses in the construction sector. Growth in 2011 is projected above potential at 4½ percent, led by exports and firming domestic demand, before easing to 4.2 percent next year. Risks to the outlook are broadly balanced.

Aggregate demand pressures, compounded by the rise in food and fuel prices, have led inflation to remain above the Bank of Korea’s (BOK) inflation target of 3 ± 1 percent thus far this year. Headline CPI inflation, after having eased to 4.1 percent in May, returned to its year-to-date peak of 4.7 percent in July. Core inflation has continuously risen since December 2010. Wage pressures are not yet apparent due to lagged wage negotiations, even though employment growth and the unemployment rate have reverted to pre-crisis levels.

Exports have been strong, primarily to China and other fast growing emerging markets, but with rising fuel prices and increasing domestic demand for imports, the current account surplus has narrowed relative to last year. Korea is now the world’s seventh largest holder of international reserves, which have risen to US$304 billion. The real effective exchange rate has appreciated 2.1 percent from end-2010 through June 2011, but still remains below the pre-crisis levels and its 2000–07 average.

Against the background of ample global liquidity, Korea’s strong growth and a perceived one-way bet on the currency have led to large portfolio inflows, boosting equity prices to near all-time highs. The external short-term debt of Korean banks has been maintained below pre-crisis peaks, although these flows have strengthened recently.

Despite subdued credit growth from commercial banks, overall credit to households continues to be robust, driven primarily by nonbank financial institutions. As a result, household debt remains high at 125 percent of household disposable income. Corporate funding conditions are favorable, except for medium-sized enterprises (SMEs), reflecting the weaknesses in the construction and real estate sector and the expiration of guidance to roll over SME loans. National house prices are now 8.4 percent above their post-crisis lows.

The commercial banking system’s capital adequacy ratio stood at 14.3 percent, while the nonperforming loan ratio remains low at 1.3 percent. Commercial banks have also reduced their reliance on wholesale funding, with loan-to-deposit ratios declining to 96½ percent. However, the large exposure of Mutual Saving Banks (MSB) to the weak construction and real estate sector has led to deposit runs on eight MSBs, which have been suspended.

The authorities moved decisively toward fiscal policy consolidation since last year. The budget deficit, excluding social security funds, is projected to decline to 0.6 percent of GDP in 2011, from 1.1 percent of GDP in 2010, driven by expenditure restraint and efforts to broaden the tax bases. This implies a broadly neutral fiscal stance in 2011. The BOK has raised the policy rate by a cumulative 125 basis points—from an all-time low of 2 percent—since July 2010. However, monetary policy remains accommodative with real policy rate at -1 percent. The authorities have implemented several administrative price stabilization measures to address rising inflation. They also introduced several measures to address capital flow volatility, including by limiting banks’ foreign currency derivative positions and reinstating the withholding tax on foreign holdings of Treasury and Monetary Stabilization Bonds. They have also adjusted various elements of their housing market policies over the cycle to support the sector.

Executive Board Assessment

Executive Directors welcomed the solid, broad-based recovery of the economy from the global financial crisis, buttressed by the authorities’ skillful economic management. Growth is expected to continue robustly above its potential this year, and the medium-term outlook remains favorable. Directors noted the buildup of inflationary pressures and near-term risks linked to uncertainties in the global economy and financial markets. They agreed that the immediate policy priority is to ensure a soft landing and safeguard financial stability—through proactive monetary tightening, greater exchange rate flexibility, and ongoing fiscal consolidation, complemented by macroprudential policies.

Directors supported the broadly neutral stance of fiscal policy, and welcomed the plan to balance the central government budget by 2013–14. They encouraged the authorities to save revenue overperformance and stand ready to accelerate consolidation in 2012 should aggregate demand pressures persist. Directors stressed the need to continue strengthening the medium-term fiscal framework, particularly by introducing a structural fiscal rule linking future liabilities—including those related to population aging and public enterprise debt—to annual budgets. Broadening the tax base, streamlining subsidies, and reforming entitlement programs are also essential to ensure long-term fiscal sustainability.

Directors welcomed the resilience of Korea’s overall financial system, with well-capitalized banks and low nonperforming loans. While noting that problems in some mutual savings banks do not pose a systemic risk, they recommended a restructuring of the industry, including through strengthening its risk management and governance. Directors welcomed recent steps toward that end and plans for further improving the supervisory framework more broadly.

Directors underlined the importance of enhancing the macrofinancial policy framework. They generally saw merit in further integrating macroeconomic and financial policies into a coherent framework, allowing policymakers to capture cross-sectoral linkages and detect vulnerabilities early on. In this context, Directors agreed that overall price stability should remain the central bank’s primary objective, and most Directors saw scope for making interest rate policy more responsive to financial stability considerations. Directors encouraged the authorities to gradually phase out administrative price stabilization measures.

Directors considered macroprudential tools a useful complement to macroeconomic policies in addressing financial stability concerns arising from capital inflows. They saw the benefits of greater exchange rate flexibility in managing capital flows and absorbing external shocks. Directors also noted a role for market-based housing policies in containing leverage among households.

Directors underscored the need to rebalance the sources of growth, reducing Korea’s vulnerability to shocks and promoting inclusive growth. This requires comprehensive reforms aimed at enhancing productivity and competition in the nontradables sector—creating a level playing field with the manufacturing sector while also reducing household indebtedness and social disparities. Further efforts are needed to deregulate the service sector and expedite a bank-led restructuring of small- and medium-sized enterprises. Directors supported labor market policies to increase formal employment opportunities for women and the elderly, while expanding the coverage of the social safety net to address dualities in the labor market.