An International Monetary Fund (IMF) mission, led by Ms. Isabelle Mateos y Lago, visited Seoul during October 21-November 1 to conduct the 2013 Article IV consultation discussions. The mission met with Deputy Prime Minister and Finance Minister Hyun Oh-seok, Governor of the Bank of Korea Kim Choongsoo, as well as other senior officials, civil society and think tank representatives, and private sector analysts. The concluding meetings with the authorities also covered Korea's assessment under the IMF Financial Sector Assessment Program, conducted over April to July 2013 by a team led by Mr. Ghiath Shabsigh. At the conclusion of the mission, the team issued the following statement:
The Korean economy has fared well in the recent turmoil and is well-positioned to benefit from the global recovery, reflecting strong fundamentals and skilled policy-making. However, it will need to rebalance its economic structure to continue lifting the living standards of its population, in an inclusive way, ever closer to that of the richest advanced economies. Many of the reforms needed, and identified below are already in train or planned. Steadfast implementation across these areas will be needed.
Taking stock: modest recovery with sound fundamentals
Korea's GDP growth is expected to rebound to 2.8 percent in 2013, and inflation is subdued. Despite a supplementary budget in the spring and a cut in the Bank of Korea's policy rate to 2.5 percent, domestic demand remains relatively weak. In contrast, exports are projected to grow at 5.5 percent, and as a result, the current account is expected to reach a record 5 percent of GDP.
The financial sector is sound overall. Banks' vulnerability to external liquidity shocks has declined, as macro-prudential regulations have reduced markedly banks' short-term external debt. Banks are highly capitalized and have low nonperforming loans (NPLs) ratios. However, bank profits remain low. Low loan-to-value ratios on mortgage loans and large household asset buffers limit risks from high household debt. However, weak repayment capacity of some households could further erode profits. Similarly with parts of the corporate sector—construction, transportation, and shipbuilding—where a prolonged cyclical downturn has increased risks to banks relative to their prudential buffers.
Korea has emerged as a safe haven of sorts in the summer's market turmoil. Low inflation, a strong fiscal position, and ample foreign reserves have strengthened Korea's attractiveness to risk-averse investors, including many central banks and sovereign wealth funds. However, the robustness of this new safe haven status has not been tested.
Growth outlook: recovery to gather pace, but risks are on the downside
Growth is expected to strengthen further to 3.7 percent in 2014. However, in the near term, absent reforms, private domestic demand momentum is expected to remain relatively weak, reflecting the debt overhang in parts of the household and corporate sectors. Meanwhile the global environment is full of risks. Korea is unlikely to be much affected by further mild turmoil from the U.S. monetary policy normalization, but adverse growth surprises in any of its main export markets—China, the U.S., and the EU—or more severe market stress would significantly damage its outlook. In the longer run, weak household income growth, deleveraging needs, and conservative fiscal plans mean that demand is likely to remain highly dependent on net exports. On the supply side, rapid population aging will be a drag on the growth potential.
Key policy priority: support domestic demand, notably households' income
Policy support should not be withdrawn too soon, and should be enhanced if the outlook deteriorates, given the uncertain momentum of private demand and ample policy space.
Fiscal policy has an essential role to play. While the 2014 budget appears well-calibrated, a more countercyclical fiscal framework would be desirable including by adopting a structural balance target, which would allow automatic fiscal support in downturns. A debt rule anchored at a prudent level would ensure continued fiscal soundness. Beyond 2014, the central government balance could be safely reduced for a while, even after accounting for projected large aging costs. This would free up resources to finance growth-enhancing social spending and help rebalance the economy towards domestic demand. There is also scope to finance further additional spending by broadening the tax base and removing distortions.
Contingent government liabilities need close and transparent monitoring, and the government's plans in this regard are much welcome. Encouraging broader ownership of shares by households would also help reconnect the prosperity of Korea's successful firms and that of the population at large.
Labor market: higher participation and lower duality would further support households' income growth and raise the growth potential and inclusiveness
Increasing public spending on childcare and creating more part-time work opportunities could boost female participation enough to critically support potential growth. Further efforts to reduce skill mismatches including through vocational training and improved youth access to information on career opportunities and job-search techniques would boost youth participation in the workforce.
Reducing the gap in training and social protection between non-regular and self-employed workers—over half of the work force—and regular ones would raise productivity and reduce precautionary saving. To preserve competitiveness, some changes in regular workers' contracts would likely be needed, including moving to performance-based wage, turning the mandatory retirement allowance into a defined contribution/defined benefits system, and reducing hurdles to individual dismissal of regular workers.
Service sector: deregulation, restructuring and greater market-based pricing are needed to boost productivity throughout the economy
As the social safety net expands, incentives that discourage SME growth and allow non-viable ones to survive should be phased out. Loan guarantees should expire after a few years, and banks be encouraged to develop risk management and pricing practices that allow them to provide non-guaranteed funding to viable SMEs. Policy banks should be encouraged to refocus on SMEs. Considerable productivity gains could be achieved by deregulating network services, health, education, and professions (e.g., lawyers) and by promoting competition in service provision to and by conglomerates. Allowing market-base pricing for utilities would also be desirable for overall efficiency.
Exchange rate appreciation in response to balance of payment surpluses would encourage reallocation of resources to the nontradables sector, thereby enhancing its vitality and further supporting rebalancing.
Financial sector: active monitoring of risks, adjustments in incentives, and streamlined and more structured institutional frameworks would further support stability
Corporate sector risks warrant close monitoring. Banks' foreign exchange liquidity positions should continue to be monitored closely with a view to ensuring that banks are able to meet their liquidity needs autonomously. Pressures on banks' pricing behavior should be minimized and the authorities should seek to curb potential moral hazard in debt workout programs. The current supervisory structure would benefit from enhanced independence, greater focus on the core supervisory mandate, and institutional streamlining. Its effectiveness would be enhanced by supervision of financial activities on a group-wide basis, and a dedicated macro-prudential council and a fully formalized committee on crisis management.