Public Information Notice No. 12/110

Public Information Notice: IMF Executive Board Concludes 2012 Article IV Consultation with the Republic of Korea

September 20, 2012

On August 27, 2012, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Korea.¹

Background

After a strong rebound in 2010, the Korean economy slowed in 2011 and into 2012 in line with global economic developments. Weaknesses in the global economy, particularly the intensification of the euro area crisis, have led to a widespread slowing of growth momentum. Domestically, high household debt continues to be a drag on private consumption. Growth is therefore expected to moderate, with a small negative output gap expected to remain for the rest of 2012. The economy is projected to grow at about 3 percent in 2012, rebounding to around 4 percent in 2013. The main short-term risk to the outlook is a further escalation of the euro area crisis, which would have a significant impact on Korea.

Inflation rose and remained elevated at around 4 percent in 2011, about 1 percent above the central inflation target set by the Bank of Korea (BOK). This reflected high commodity prices and other transitory supply-side shocks as well as demand-side pressures from the earlier expansion. More recently, in line with the slowing activity and retreating commodity prices, headline inflation has decelerated to 1.5 percent in July 2012, aided by the introduction of government subsidies for child care services. Inflation expectations, however, have remained elevated at close to 3.5 percent. Headline inflation is expected to pick up in the second half of the year, averaging just below 3 percent for the year as a whole.

The external vulnerability of the Korean financial system has diminished considerably since the global financial crisis due to the concerted efforts of the authorities. This reflects higher foreign reserves relative to short-term debt, a reduction in banks’ short-term debt, the adoption of macroprudential measures designed to curb banks’ reliance on non-core wholesale funding, and the strengthening of the banks’ foreign currency liquidity positions.

Banking system indicators remain strong. Domestic banks are well capitalized, with an average capital adequacy ratio of 14 percent at end-2011. The recently introduced regulatory ceiling on loan-to-deposit ratios (of 100 percent) has been met by all domestic commercial banks.

The current macro policy mix combines an accommodative monetary policy and a broadly neutral fiscal stance. The overall balance (excluding social security funds) is expected to record a deficit of about 0.9 percent of GDP in 2012, compared with the 2011 outturn of a 1.1 percent deficit. In response to data showing a weaker-than-expected economic outlook and lower headline inflation, the Ministry of Strategy and Finance adopted a modest stimulus package in June to support the economy while the BOK cut its policy rate by 25 bps in July 2012 after putting it on hold for the past year.

Executive Board Assessment

The Executive Directors commended the authorities for adjusting macroeconomic policies and strengthening the resilience of the financial system in response to global headwinds and financial stress. Growth has decelerated and is projected to remain below potential for 2012, while inflationary pressures have receded. Directors noted that the near-term challenge is to manage the escalating downside risks to the outlook, particularly those related to a possible further intensification of the euro area crisis and its spillover.

Against this background, Directors considered that the current macroeconomic policy mix is appropriate. They supported the front-loading of budget spending in 2012 and the recent fiscal stimulus package, and welcomed the authorities’ commitment to implement the budget fully while maintaining the medium-term consolidation objectives. Directors also agreed that monetary policy should continue to be accommodative, but stressed that, in light of the elevated inflation expectations, normalization should resume once the economy strengthens and the negative output gap starts to close.

Directors noted that, in the event of a severe downside scenario, Korea has policy space to respond, especially on the fiscal side, including through limited and temporary use of government managed funds and additional discretionary spending. Korea’s flexible exchange rate and ample international reserves would also help cushion against external shocks. Noting that the won is assessed to be moderately undervalued in real effective terms, Directors welcomed the authorities’ intention to limit intervention to smoothing exchange rate fluctuations.

Directors welcomed progress in reducing external vulnerabilities in the financial system—external buffers have been strengthened, short-term debt has declined, and banks have reduced their reliance on wholesale funding. They noted nonetheless that the financial system remains subject to large swings in capital flows and funding risks. This calls for continued vigilance and efforts to enhance the effectiveness of macroprudential policies, including through improved coordination among regulatory agencies.

Noting the still high level of household debt, Directors called on the authorities to follow through with their strategy for a “soft landing,” especially by strengthening asset classification and provisioning rules for non-bank financial institutions. They welcomed the progress in restructuring insolvent mutual savings banks, and encouraged the authorities to monitor remaining balance sheet weaknesses closely. Directors looked forward to a comprehensive assessment of Korea’s financial system in the upcoming FSAP.

Directors underscored the need to address the medium-term challenges of rapid population aging and rising income inequality, and to boost potential growth. They supported the government’s plan for a targeted increase in social spending over time, which will likely require a strengthening of revenue performance, mainly by broadening the tax base. They also encouraged further efforts to improve the oversight and governance of state-owned enterprises. Continued labor market reforms should focus on enhancing workforce and creating a more conducive environment for female participation. Directors also recommended boosting service sector productivity by enhancing competition through deregulation, further SME restructuring, and creating a more level playing field for the tradable and nontaxable sectors.