Korea must guard against risks to its economic growth, particularly those posed by a possible escalation of the European debt crisis. But its strong fiscal position—including its relatively small public debt—and a robust institutional framework leave it well placed to tackle threats to growth, say International Monetary Fund (IMF) economists.
Despite weathering the global financial crisis robustly, strong headwinds from the global economy are dampening Korea’s growth momentum, say the IMF experts in their regular report on the state of the country’s economy.
Korea is expected to grow by 3 percent this year—below its growth potential— and then around 4 percent in 2013, although continued weakness in the global economy may make this difficult to achieve, suggests the report. And despite significantly slower exports, the country’s current account is projected to remain in surplus this year.
If the global economy deteriorates, the report says Korea has sufficient space to respond, particularly on the fiscal side. In a severe financial contagion, similar to that of 2008–09 when capital poured out of the region, the authorities should be prepared to use their ample foreign reserves to maintain orderly market conditions, it adds.
The Korean authorities have already announced a modest fiscal stimulus package, and cut the monetary policy rate to support the economy in response to a weaker-than-expected growth outlook.
“We believe this step is appropriate given global weakness and heightened uncertainties, but a normalization of monetary policy stance will be needed in 2013 if the economy returns to trend growth as projected,” said Hoe Ee Khor, IMF mission chief for Korea.
The report suggests that the Korean financial system has become less vulnerable since 2008 due to the concerted efforts of the authorities. External buffers have been strengthened, with higher foreign reserves and bilateral swap lines, while short-term debt has been reduced.
Regulators have also taken a number of macroprudential measures to strengthen the resilience of the banks to liquidity shocks. These steps included a cap on foreign exchange derivatives positions and a financial stability levy.
The foreign investor base in the government bond market has also become more diverse, and now includes regional central banks, but Korea still remains vulnerable to shocks from volatile capital flows, warns the report.
IMF economists say that an escalation of the euro area crisis could still cause Korean banks to experience difficulties rolling over their debt, despite their reduced dependence on wholesale funding. They stress the importance of monthly stress tests undertaken by Korean financial authorities on the foreign currency liquidity positions of domestic banks, and say the vulnerability of foreign bank branches, resulting from their reliance on parent funding, needs to be monitored closely.
Korea’s fiscal prudence can help the country address the future challenge of increasing inclusiveness and dealing with an aging population.
The economists welcomed plans to raise the country’s social spending—which is relatively low by the standards of an industrialized economy—to improve income inequality and the welfare of poorer groups in society, while preserving medium-term fiscal consolidation objectives.
They also stress the need for labor market reform and enhancing service sector productivity. They say the labor force participation rate also needs to be improved, with greater numbers of women joining the workforce to boost potential growth.
Photo: Arthur Chapman
