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p. 11 of 81 BACK | NEXT I. Developing Asia and the World II. Economic Trends and Prospects in Developing Asia East Asia People's Republic of China Hong Kong, China Republic of Korea Mongolia Taipei,China Southeast Asia South Asia Central Asian Republics The Pacific III. Preferential Trade Agreements in Asia and the Pacific

Asian Development Outlook 2002 : II. Economic Trends and Prospects in Developing Asia : East Asia

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Republic of Korea

The Republic of Korea performed better than most economies in the region in 2001. This was largely due to the resilience of domestic demand, which arose from significant progress in restructuring the corporate and finance sectors after the Asian financial crisis. More diversified exports also contributed to relatively sustained growth. Strong domestic and external demand is expected to continue over 2002–2003.

Macroeconomic Assessment

The Republic of Korea (Korea), although hit hard by the global economic downturn in terms of a large deceleration in export growth, did not experience as severe a shock as economies that are heavily dependent on exports of information and communications technology (ICT) products. This was because Korea has a more diversified industrial base and because its domestic market, though having significant linkages to the export sector, did not suffer as big a drop in private consumption. As a result, GDP growth decelerated to 3% in 2001 from 9.3% in the previous year (Figure 2.3). This modest expansion was driven mainly by private consumption, in contrast to the broad-based domestic and external demand expansion in 2000. Gross fixed capital formation increased in 2000 by 11.4% but declined in 2001 by 1.7%. Because of the weak earnings outlook in the ICT sector, and sluggish private spending, companies had little incentive to invest in new plant and equipment in 2001. Export growth began to slow in the first quarter of 2000 and continued decelerating through the middle of 2001, bottoming out in the fourth quarter of the year.

Consumption increased in 2001 by 3.7%, a much lower rate than in 2000. This helped support the labor market, and unemployment fell by December 2001 to a seasonally adjusted rate of 3.3%.

One reason for the relative strength of consumption in 2001 was the fact that the corporate sector had, after the financial crisis, generally engaged in significant cost cutting as part of the restructuring process. As a result, firms were not forced to make large-scale layoffs during this downturn. Also, negative wealth effects were weaker due to the solid performance of the stock market (albeit artificially supported by the Government to a degree). In addition, a high level of liquidity in the financial system, along with low loan demand from the corporate sector, led to increased credit availability for consumers in the fourth quarter, part of which was used for buying houses and other real estate. Furthermore, a drop in the savings ratio after 1998, combined with a rising debt-to-asset ratio among households, suggests that the propensity to consume may have risen. These factors may partially explain the pickup in retail sales toward the end of 2001.

On the supply side, manufacturing growth decelerated sharply as a result of weaker orders for ICT products, which account for roughly half the exports of goods and services. As a result, industrial production growth slowed in the first half of 2001. In the second half of the year, external demand led to stronger growth in the automotive sector, helping offset some of the weakness in demand for ICT products. With a substantial depletion of inventories over much of the year and some improvement in domestic demand conditions, industrial production showed an upturn in the second half of 2001. Growth in the construction sector returned, to around 3.5%, from a 3.7% contraction in 2000. This was due to public spending on ports and roads as well as an upswing in residential building construction. Growth in the services sector remained resilient in 2001, although it was slower than in 2000, due to fairly brisk demand for recreational activities, hotel and restaurant services, communications services, and increased trade in construction materials.

Due to a large surplus in the National Pension Fund, the government surplus rose to 1.3% of GDP in 2001. A supplementary budget worth W1.5 trillion was introduced in June, mainly to provide local government subsidies and to improve education facilities. The Government also directed state pension funds worth W2 trillion toward share purchases in the aftermath of the September 11th events. This was done to support equity markets specifically and the economy generally. In November, it announced a reduction of sales taxes on a wide array of luxury goods to boost consumption. With regard to monetary policy, the Bank of Korea had to balance the risks of lowering interest rates to stimulate the economy versus the prospect of sparking inflation through a more accommodative policy stance. Inflation picked up in 2001 due to an escalation in services charges in the form of housing rents. To stimulate economic activity, and recognizing that interest rates were lowered throughout the year in industrial countries, the Bank of Korea cut policy interest rates by 125 basis points in 2001. Real short-term interest rates dropped close to zero. Monetary aggregates rose strongly, as did other indicators, such as the ratio of consumer lending to total bank assets (which underpinned consumer spending) in the second half of the year.

On the external front, ICT exports slumped in 2001, after double-digit expansion in 2000, due to the contraction in the ICT sector worldwide. This caused overall merchandise exports to fall by 14%, compared with 21.2% growth in 2000. Imports also contracted, by 13.3%, due to softer demand for oil, capital goods, and intermediate materials. As a result, the merchandise trade surplus declined to $13.4 billion in 2001. This combined with worsening deficits in travel and other areas of the services sector to narrow the current account surplus to $8.6 billion. The external debt position improved due to the early repayment of an IMF program loan and to a buyout by domestic creditors of Daewoo Motor’s $55 billion debt from foreign creditors at a 60% discount. As a result, official reserves increased to over $100 billion at the end of the year from $96 billion at the end of 2000. The debt service ratio was around 14.1%.

Policy Developments

The Government’s traditional focus on supporting exports and investment may shift toward consumption in the medium term. Manufacturing is now highly export oriented as well as cyclical in nature, and most investment is concentrated in this subsector. As a result, the past decade has been marked by increased volatility in both the finance and real sectors.

In response, and for the first time, the Government has begun to utilize tax policy to stabilize consumption. Less dependence on export industries and on investment in plant and equipment will have an impact not only on the composition of GDP but also on the volatility of the equity market. Since the early 1990s, there has been a significant increase in listings of capital-intensive companies with an export orientation, and these companies tend to be cyclically volatile. A move toward domestic demand would help reduce this volatility and indeed, the tax cuts in 2001 could be the first steps in implementing such a longer-term policy of diversifying the economy into domestic demand-related activities.

Korea’s high savings ratio is partially grounded in the country’s inadequate social welfare and pension systems, although benefits and national pension coverage have increased since early 1998. A corporate pension scheme may be introduced soon, possibly resulting in some of these savings being used for consumption. In addition, the Government may make more funds available to shore up the National Pension Fund, which is expected to face insolvency issues within the next 2 decades due to large benefit payouts resulting from changing demographic profiles. One proposal to address this concern is limiting the Fund’s benefits at current levels or reducing them and introducing corporate pensions to cover some of the living costs of retirees. Since 2002 is an election year, any government impetus in this direction will likely be seen only in 2003.

Outlook for 2002-2003

On a quarter-on-quarter seasonally adjusted basis, private consumption and gross fixed capital formation seem to have bottomed out in the fourth quarter of 2001. Private consumption growth is expected to be stronger in 2002–2003 since liquidity conditions are forecast to remain favorable, consumer and business sentiment should improve, and tax cuts will have multiplier effects on consumption and income. Fixed investment is expected to improve moderately. Given that a significant inventory correction took place in 2001, inventory investment is likely to gain momentum in the first half of 2002 and continue to do so for the rest of the year.

On the supply side, industrial production rose strongly in the second half of 2001, and, under the influence of restocking and improving domestic demand conditions, it should continue its recovery in 2002–2003. Furthermore, Korea is well placed to benefit from a recovery in the world economy since it has a diversified economy, a sound structural base (after significant postcrisis restructuring), and a low level of nonperforming loans. These factors suggest that economic growth will accelerate in the next 2 years.

There are, however, two concerns. The first is whether domestic demand will remain resilient, given the uncertainty of the timing of a strong recovery in export growth, as well as the absence both of strong social welfare and pension systems and of other automatic stabilizers. The second is how rapidly the global economy will recover and how this will impact on the demand for Korean exports. On the first point, the shift in emphasis toward an expansionary fiscal policy that began in 2001 is likely to continue, although at a somewhat subdued pace, and this should help support consumption demand. On the second, since Korean exports and US imports of ICT products are closely correlated and since US new ICT orders appear to have stopped declining in the fourth quarter of 2001, prospects are for a gradually strengthening rebound in ICT exports in 2002. On this basis, GDP growth is forecast at 4.8% in 2002 and 6% in 2003. Inflation should remain at about 4%. As economic activity improves, the current account surplus will rise slightly to about $8.8 billion in 2002 but fall to about $4 billion in 2003. As GDP growth picks up in 2002–2003 and as government revenues rise with an expanding tax base, the fiscal surplus is projected to increase to 1.5% and 1.6% of GDP, respectively.

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