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Asian Development Outlook 2005 : II. Economic trends and prospects in developing Asia : East Asia
Republic of KoreaThe economy is on a gradual economic rebound from the 2003 slump induced by a household debt hangover, although the modest pace of recovery in private consumption will likely limit the speed and magnitude of near-term growth. To underpin the nascent recovery in domestic demand, the Government needs to address underlying structural weaknesses. Successful completion of comprehensive structural reforms remains key to achieving sustainable high growth. Macroeconomic assessment of 2004A robust recovery in early 2004--boosted mainly by strong exports--stands on shaky ground, as the usual knock-on effects of exports on investment and consumption spending failed to materialize. The economy grew by 4.6% in 2004, up from 3.1% in 2003, but its momentum weakened with year-on-year growth easing to 4.7% and 3.3% in the third and fourth quarters, respectively, from 5.4% in the first half. A 31% surge in merchandise exports proved insufficient to resuscitate private consumption, which fell by 0.5%, following a contraction of 1.2% in the previous year. Lingering effects of a household debt hangover, combined with underlying structural problems in the labor market and financial system, largely explain the weakness in consumption spending. Despite considerable progress in debt restructuring since the credit card crisis in 2003, households remain reluctant to spend, with limited income growth and a continuing debt burden (Figure 2.3). Household debt stood at 73.8% of GDP at end-2004, with debt outstanding increasing by 5.7% from the prior year's level. More important, household disposable income (the amount of net income after tax and social security contribution that is available for household consumption or saving) has grown by an annual average of about 5.0% since the 1997 crisis, which is not enough to allow for both debt repayments and an increase in consumption spending.
Gross fixed capital formation rose by 1.9% in 2004 from a year earlier, on account of a pickup in export-led machinery and equipment investment, which grew by 3.8% in 2004 after a contraction of 1.2% in 2003. However, a continuing erosion of labor market competitiveness has deterred firms in the Republic of Korea (henceforth Korea) from investing domestically, limiting the investment gains. The absence of attractive domestic opportunities, compounded by sluggish demand, has induced corporations to use increased export earnings to lower their debts or divert their investment abroad.
The sharp contrast between external and domestic demand was further evident on the supply side. Manufacturing output rose by 11.4% in 2004, driven mainly by major export items such as information and communications technology products and motor vehicles, while services sector gains were limited to 1.3% over the year. Wholesale and retail trade continued to contract, by 0.5%, reflecting sluggish consumption. Real estate services also stagnated, as the property market cooled. Despite a mildly improving trend through the year, financial services contracted by 1.2% in 2004 in the aftermath of the credit card crisis.
Industrial production expanded by 9% on the back of robust exports. Shipments of manufactured goods rose by 9.1%, with those going overseas dominating with a 20.0% increase. The average operating ratio in manufacturing reached 80.3% in 2004.
The divergence between large and small firms widened. Behind this disparity lies unfinished business in reform efforts since the Asian financial crisis of 1997-98. Whereas large firms, or chaebol, have been subject to restructuring and refocused their businesses on globally competitive manufacturing or the high-tech sector, SMEs remain largely sheltered from the reform process. As a result of their substantial restructuring efforts, the large export-oriented companies enhanced their operational efficiency and financial stability. However, a prolonged slump in private consumption has eroded profitability of SMEs, most of which cater to domestic services markets. This has a damping effect on the overall economy since SMEs account for such a high proportion of total employment (Box 2.2).
The unemployment rate averaged 3.5% in 2004, rising marginally from an average of 3.4% in 2003. Although about 382,700 new jobs were created in 2004, a steady increase in the share of temporary workers due to structural rigidities in the labor market lessened job security, delaying a consumption recovery despite a gradual upturn in wage income. A considerable gap between permanent and temporary workers in terms of job security and overall compensation remains a problem for sustainable improvement in the labor market. Following years of militant labor action, permanent employees have gained strong legal protection for job security, improved working conditions, and significant wage increases. However, such protection has made firms reluctant to hire for permanent positions, limiting both job market improvement and increases in household income during the expansion period.
The consolidated budget balance, excluding social security contributions and repayments of the public fund for financial sector restructuring, resulted in a deficit of W3.6 trillion in 2004, from a surplus of W1.0 trillion in 2003, providing a mild fiscal stimulus. However, in the second half of the year when the economy sharply slowed, the fiscal balance even turned into a slight surplus. Total expenditures and net lending amounted to W173.2 trillion in 2004, increasing by 5.5% year on year. On the revenue side, tax collection increased by 2.7% to W117.8 trillion. Property, inheritance, and gift taxes continued to account for a substantial share of tax revenues, while collection of personal income tax strengthened, which compensated for a continuing shortfall in VAT and excise tax. Total revenue collection reached W178.8 trillion over the same period.
Both the consumer and producer price indexes rose in 2004, by 3.6% and 6.1%, respectively. Nevertheless, inflationary pressure abated somewhat in the fourth quarter of 2004, thanks to stabilizing global oil prices and a strengthening Korean won. Prices of agricultural products subsided following a favorable harvest, significantly contributing to the price stabilization. The subdued inflationary pressure allowed the Bank of Korea to lower its policy rate from 3.50% to 3.25% in October, following a quarter-point cut in August. Long-term interest rates fell to low levels, flattening the yield curve after the rate cuts in the latter half of 2004. Money supply crept up, reflecting the mild improvement in investment demand. Picking up from 5.4% in the first half, growth in M3 averaged about 6.3% in the second half of 2004, although lower than the 2003 average of 8.8%.
The KOSPI index of share prices rose by 10.5% in 2004. A resilient export performance in the last quarter of the year, despite concerns about slowing global demand and the rising won, underpinned the market's rebound from a retreat in the May-July period when US interest rates began climbing. Overall, corporations raised more than W58.7 trillion in 2004 through equities and bonds, a decrease of 19.4% from 2003's level. On the back of a revamped financial situation since the credit card crisis, financial institutions resumed lending, though low investment demand restrained credit expansion. A trend of financial deleveraging accelerated due to increased export profits. Reflecting the voluntary repayment of debt by medium-sized export companies, bank credits to corporations fell significantly from W30.5 trillion to W3.8 trillion in 2004.
The won substantially strengthened against the US dollar, to W1,035/$1 at end-2004 from W1,193/$1 at the previous year-end. A robust position on the balance of payments, as well as the global trend of dollar depreciation, were the main factors. The balance of payments was again in surplus; $38.7 billion was added to foreign exchange reserves in 2004. Bolstered by a record rise in merchandise exports, the current account surplus reached $27.6 billion. The capital account turned to a surplus of $8.3 billion, as foreign investors returned to the Korean stock market in the second half of the year. FDI was buoyant, with a net inflow of $3.4 billion in 2004. Portfolio investment remained a popular choice among foreign investors, with equity and bond purchases generating net capital inflows of $9.3 billion. On the other hand, Koreans also increased FDI abroad, amounting to $12.3 billion, with the majority directed to the PRC.
Macroeconomic policy developments
The lackluster growth performance in the second half of 2004 provided a political backdrop for bringing economic and development policies to the fore. In line with a firmer political consensus, the priority of economic policy is to create quality jobs and revive robust growth. To enhance growth fundamentals, the Government is emphasizing strengthening SMEs and the overall services sector, which remain labor intensive, thus having good potential to create jobs. The policy is also to create an investment-friendly environment and to reinforce the social safety net. Efforts will center on improving the competitiveness and productivity of SMEs by encouraging new entrants, nurturing technological innovation, and facilitating effective restructuring. Opening the services sector to international competition and related deregulation will bring about restructuring in services firms, thus heightening productivity. Meanwhile, a stronger social safety net will be put in place as increased competition causes some firms to reduce staff.
Macroeconomic policies will remain supportive of an emerging recovery at least in the first half of 2005. The consolidated central government budget has been expanded to W167.3 trillion for the full year, a 3.8% increase from W161.3 trillion in 2004. About 59% of the budget will be allocated during the first half to provide an immediate stimulus, while a planned public investment strategy--the Comprehensive Investment Initiative--will reinforce an investment revival in the second half. The initiative is expected to encourage private efforts and market incentives in public sector investment such as education, roads, energy, and other social overhead capital. However, the scope of the initiative remains vague, casting doubt on its effectiveness in boosting domestic demand in the near term, when the stimulus is required. There also is some concern that the initiative may mask fiscal liabilities that could stem from government guarantees to induce private investment in desired areas.
While a near-term fiscal stimulus is warranted to bolster weak investment demand, equally important is the establishment of an effective fiscal management system that is tightly anchored to long-term fiscal sustainability. The lack of comprehensive budget controls, together with inadequate fiscal management, often results in unintended fiscal tightening and repeated use of supplementary budgets, as seen in 2003 and 2004, which makes tax cuts a better choice than expansionary fiscal spending for short-term stimulus. Against this background, more comprehensive fiscal reforms should follow the near-term fiscal stimulus to maximize the role of automatic stabilizers by increasing efficiency and transparency of expenditures and by minimizing distortionary effects of the tax system within a longer-term budget framework. To this end, the revenue structure should be streamlined through rationalization of different tax treatments of various income sources and the removal of earmarked and quasi-taxes with specific purposes (such as education, transportation, and a special tax for rural development), alongside a broadening of the tax base through limiting the use of allowances and personal income tax credits.
On the monetary front, an accommodative stance will prevail at least through 2005 given the below-potential economic performance. Although negative real interest rates limit the effectiveness of monetary policy, extended weakness in the financial position of households and SMEs will further weigh on policy decisions. While the mitigation of inflationary pressure late in 2004 provides a benign context, the Bank of Korea needs to monitor money and credit conditions to avoid any asset price booms arising from monetary easing and structural weaknesses in the financial system. Over the medium term, maintaining price stability should be the primary objective of the Bank of Korea. With the recovery likely to gain momentum later this year, monetary policy needs to gradually return to a neutral stance by adhering to the inflation target.
Alongside its strengthening of the financial system, the Government is continuing to facilitate restructuring of household debt, through rehabilitation of individual credit delinquents by court orders to reschedule debt payments, private debt workouts by financial institutions for defaulters, and the establishment in 2004 of a so-called "bad bank" that acquired distressed assets from banks and credit card companies. The credit card delinquency ratio of households fell to 9.6% in October 2004 from 10.5% in December 2003. The rate of overdue (1 month or longer) payments on credit cards also edged down to 7.3% from 7.8% over the same period.
In order to buttress a stable consumption recovery without a credit crisis recurring, further reforms need to ensure more efficient but prudent banking practices, including encouraging banks to diversify their lending services and to enhance their risk management through credit derivatives and hedging products.
Outlook for 2005-2007 and medium-term trendsThe near-term outlook remains weak, with GDP growth projected to slow to 4.1% in 2005. Various adverse external factors, such as sustained high oil prices, softening global demand for high-tech products, and a likely moderation in the global recovery will weigh on export growth, not least because of the exceptional export performance in 2004. Meanwhile, consumption is picking up, but at a sluggish rate because of the weakness of household balance sheets and structural weakness in the labor market.
Still, evidence points to the end of the prolonged consumption slump that has dogged the economy since the credit card crisis. Household debts and the delinquency ratio on credit card loans have stabilized, although at a higher level than before that crisis, as a result of debt-restructuring efforts. A trend of financial deepening in the household balance structure based on increasing access to household credits and more assertive credit behavior by households also suggests that households should be able to manage debts more efficiently and soon resume spending. Meanwhile, expansionary macroeconomic policies and significant improvements in corporate balance sheets provide a favorable backdrop for investment. On the basis of a stronger recovery in domestic demand with lagged effects of policy stimuli, economic growth is projected to move up to 5.1% in 2006 and 4.9% in 2007.
While growth in merchandise exports will slow to an estimated 12% in 2005 from 31% in 2004, external demand will continue to provide a gentle push to growth. Trade and industrial production data in the last quarter of 2004 were surprisingly upbeat, which reflects the global competitiveness of many of Korea's exporting companies. Such resilience will help sustain industrial production and business spending, providing a firm foothold for an economic recovery.
The investment outlook is brighter than the immediate outlook for consumption, as many firms that retained substantial export earnings and improved their financial status throughout 2004 appear to be in a promising position. Following years of conservative spending, exporters are also in need of aggressive business investment to maintain their global competitiveness. Operational and financial difficulties faced by the SME sector should gradually ease, as business spending driven by large firms will have an effect on overall domestic demand later in 2005.
A slowdown in the real estate market poses a significant near-term risk to a recovery in domestic demand. Policy measures to curb speculative activity in the housing market have started to have an impact. Amid uncertainty surrounding the implementation of new tax laws, real estate transactions have crumbled and housing prices have fallen, in turn helping weaken consumer sentiment and driving the near-term consumer expectation index down to a historical low at end-2004. Adding to the concern, construction investment growth fell sharply to 1.1% in 2004 from 7.9% in 2003. With its significant share (about 58%) in gross fixed capital formation and effects on overall economic activity, a further slowdown in such investment could impede a nascent recovery in domestic demand.
More important, unbalanced growth between the external and the domestic sector, manufacturing and services, and large and small firms--which highlights the disparities in competitiveness and productivity between these areas--remains a medium- and longer-term risk to sustainable high growth. To tackle this, the Government needs to focus urgently on linking the supply-side performance to domestic demand by creating a favorable investment climate to unlock domestic opportunities.
Over the long run, structural reforms to promote economic efficiency and competition across all sectors are key to sustaining stronger growth. The pace of comprehensive postcrisis reforms, which enhanced overall economic efficiency by promoting competition, has slowed in the past few years as the reform agenda moved into politically sensitive areas, such as labor markets, tax policy, and restructuring of social services. However, the economy's ability to sustain high growth will depend on the successful completion of comprehensive structural reforms that entail enhancing competition in SMEs and services, closing the gap between permanent and temporary workers, minimizing tax distortions, reducing inefficient regulatory interventions, and further strengthening governance in the corporate sector and risk management in the financial sector.
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2.6% in September 2004. Such financial problems are particularly severe in the services sector. 
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