The Peninsula

IMF Article IV Consultations Suggest Korea’s Economy is Well Poised for the Challenges Ahead

By Seongjin James Ahn

In light of all the recent and mixed reports attempting to evaluate Korea’s economic outlook for the remainder of 2012 and beyond, many analysts have been wondering what truly lies ahead for Korea’s economy.  Is the country bound for leaner times, or will things turn around?  What will a potential economic bounce-back look like, and what key policies are in place to facilitate it?  And is Korea’s economy as resilient as they say it is?

Last Thursday during a presentation at the Korea Economic Institute (KEI), senior IMF economist Dr. Jack Ree provided some assurance to fellow analysts and economists that Korea – although not yet out of deep waters – is pointed in the right direction.  The insights he provided were carefully worded and, most importantly, grounded in his recent Article IV consultations with the government of Korea.

Although Dr. Ree’s presentation had some restrictions (due to the fact that the full report is not yet available in the public domain), his otherwise detailed analyses showed that in spite of the current economic challenges, Korea’s economy retains an amount of resilience.  By the end of his presentation there was a sense of reserved optimism that permeated through the room leaving analysts cautiously hopeful about the future of Korea’s economy.

The following is a summary/analysis of a few of Dr. Ree’s main points regarding the resilience of Korea’s economy and its outlook into 2013.

Light at the End of the Tunnel

Depending on how one looks at it, the fact that the IMF projects the world economy to bottom out in 2013 can either be a good or disappointing thing. It can be good because it means there is an end in sight; or it can be disappointing since it also means that there is further decline ahead.

After disappointing economic figures for Korea in Q2, many analysts have downwardly revised Korea’s economic projections for the remainder of 2012.  However, Dr. Ree commented that once the global economy turns around, Korea’s economy will most likely follow suit.  Since 2008, Korea’s path of real GDP growth has closely matched up with the rest of the world, affirming Korea’s interconnectedness with the global economy.  Korea is an export driven economy, it has open capital markets, maintains many financial linkages, etc. Once the global economy picks up, Dr. Ree suggested that Korea is likely to benefit from an increase in exports, especially given the country’s specialty in pro-cyclical IT products and facilities investments in IT research and development.

It is important to note, however, that Dr. Ree also qualified his statements by saying that a recovery was likely going to be slow, weary, and lengthy. While this was not the most reassuring point in his presentation, he moved on to explain what measures the government and other authorities in Korea have taken to safeguard Korea’s economy in light of the road ahead.

Patching Up Vulnerabilities

A part of Korea’s continued economic resilience is owed to the fact that authorities are determined and committed to patching up key vulnerabilities that undermine the economy.  For instance, since the global financial crisis Korea has made noticeable progress in fixing two main external weaknesses: the banking sector’s high level of short term debt and volatile capital flows.

The banking sector’s high short term debt, once blamed for the volatility occurring in Korea’s financial markets, is now better managed due to the strengthening of currency liquidity positions and a significant buildup of foreign reserves.  An analysis of VIX, an index that captures the level of global risk aversion, indicates that the measure of volatility in the face of external shocks has markedly decreased since 2010.

Korea’s vulnerability in volatile capital flows is also being addressed.  There has been a move towards a diversification of foreign investors in government bonds, thus mitigating the amount of money that flees from the country in times of crises.  Net capital flows – although still volatile – have shown relative signs of stabilization since the first half 2010 in comparison to the period leading up to the crisis.

Equally threatening to Korea’s economy are internal vulnerabilities, such as the expansion of household debt, which rose above 160 percent last year. However, according to Dr. Ree authorities in Korea have a credible plan to address this problem as well.  In June of 2012, plans were made to a) tighten regulations on non-banking financial institutions in order to restrict imprudent lending to vulnerable households, and b) improve the structure of mortgage lending, which at the moment only accommodates for floating interest rates which are susceptible to volatility in the market.  Additional plans were made as well.

Whether or not this strategy is sufficient to tame household debt in Korea remains to be seen, but it is an issue that authorities in Korea are not idle on.

Policy Prudence and Flexibility

In his presentation, Dr. Ree mentioned that the government of Korea has had a commendable record of fiscal prudence in recent years.  He highlighted the fact that the government has consistently maintained an overall operating balance of about -1 percent of GDP, with the exception of 2009 wherein it made a large fiscal injection to boost the economy.

In 2012, in order to maintain this operating balance and remain fiscally neutral (i.e. not withdrawing or injecting) the government took up a strategy of frontloading the budget in the first half of the year: shifting spending and investments towards early in the year, but without changing the actual size of the budget.  Although small fiscal packages were eventually delivered later on in the year (i.e. June 28, Sept. 10), this shows that the government has carefully worked to maneuver fiscal policies around economic hurdles, while avoiding actions with potentially dramatic consequences.

In addition to policy prudence, Korea, unlike other economies of the world, also has ample flexibility to further adjust fiscal and monetary policies.  In terms of short term fiscal policy, Korea is in a safe position to increase spending given that its debt was only 34 percent of GDP in 2011.  Korea’s level of debt – even in comparison to Germany, a country known for fiscal prudence that had a debt to GDP ratio of above 80 percent in 2011 – is very low. However, long term fiscal policy in Korea should bear in mind the country’s aging population and anticipate large amounts of spending on social security needs in the future.

In terms of monetary policy, Korea is again in a position to do more if necessary.  In the EU, the benchmark interest rate has remained around 1 percent since the latter half of 2009 and recently dipped below 1 percent. In the United States and Japan, rates have hovered around 0 percent since 2009.  In contrast, Korea’s key interest rate currently stands at 3 percent, which was recently lowered from around 3.25 percent.  While this rate is already accommodative, Korea’s central bank can make additional interest rate cuts if necessary, whereas the EU, United States, and Japan do not have much room to do so.

In light of Dr. Ree’s presentation it is clear that his consultations with the government of Korea show that authorities are taking an active role in carefully steering its economy through the current period by taking measures to improve its overall position and fortify any weaknesses.  If the global economy improves, Korea will hopefully see its policies and improvements pay off; but if the economy does not, then at least Korea has room to increase the role of fiscal and monetary policies.

Seongjin James Ahn is a Visiting Fellow with the Korea Economic Institute. The views expressed here are his own.