IMF Concludes Article IV Consultation With Rep. Of Korea

by Mary Swire, Tax-News.com, Hong Kong

11 August 2009

On August 7, 2009, the Executive Board of the International Monetary Fund concluded its Article IV Consultation with the Republic of Korea.

Like other very open economies, Korea was hit hard by the global financial crisis towards the last quarter of 2008, noted the IMF. Capital left the country at a faster pace than during the 1997-98 crisis, resulting in sharply lower asset prices, dislocations in money markets, and a spike in bank CDS spreads reflecting the sector’s heavy reliance on wholesale funding. This was followed by the largest export slump on record, which quickly spilled over into domestic demand. Overall, the Korean economy contracted by 5.1% quarter/quarter (not annualized) in the last quarter of 2008, among the sharpest contractions worldwide.

The authorities responded with a timely and comprehensive set of financial market and macro-stabilization measures. The authorities set aside USD55bn in foreign exchange reserves to provide swaps or loans to banks and trade-related businesses, effectively substituting for loans previously provided by foreign creditors. The Bank of Korea (BOK) cut interest rates by a cumulative 325 basis points between October and February and relaxed conditions for its repo operations. On the fiscal front, the authorities enacted a 2009 fiscal stimulus package equivalent to 3.6% of GDP and provided generous quasi-fiscal support for ailing small and medium-sized enterprises (SMEs), mostly in the form of credit guarantees. Finally, they set up a bank recapitalization fund and a toxic asset fund to shield the banking sector from the downturn and prevent major deleveraging.

In the first quarter of 2009, government consumption, construction investment, and private consumption rose as a direct result of the fiscal stimulus, and the economy expanded by 0.1% quarter/quarter. Economic activity continues to improve with exports, industrial production, and service sector activity well above their end-2008 lows and business and consumer confidence back in expansionary territory.

According to the IMF, the recent growth momentum is likely to moderate during the second half of 2009 and be followed by a drawn-out recovery. As the impulse from the front-loaded fiscal stimulus and export gains from the steep depreciation of the won in early 2009 fade, the pickup in growth is unlikely to be sustained at the same pace, the IMF further notes. Faced with a sluggish recovery in demand from trading partners, and highly leveraged households and SMEs, the IMF estimates that Korean growth will be 1.75% in percent in 2009 and 2.5% in 2010. There is a distinct possibility that weak global exports will weigh on Korean growth well beyond 2010, as Western consumers permanently increase their savings rates, warns the IMF.

In its recommendations, the IMF commended the sizeable and frontloaded fiscal stimulus package and the intention to maintain fiscal stimulus in 2010 given the uncertain outlook. Noting the distortionary nature of quasi-fiscal measures to support SMEs, the IMF welcomed the authorities’ plan to withdraw such support gradually as conditions permit. The IMF welcomed the authorities’ plan to introduce a medium-term fiscal consolidation plan, advocating that it put in place concrete revenue and expenditure measures.

The IMF noted that the current global crisis has highlighted the urgency of rebalancing Korea’s growth toward the nontradable sector, and welcomed the authorities’ renewed efforts to address structural weaknesses. The IMF concluded by recommending that Korea, as a matter of priority, eliminate its preferential tax treatment of the manufacturing sector, deregulate its services sector, expedite SME restructuring, and reduce employment protection for regular workers in favor of expanding social protection for nonregular workers to improve labor market flexibility.

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