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p. 9 of 54 BACK | NEXT I. Developing Asia and the World - Economic Developments and Prospects II. Economic Trends and Prospects in Developing Asia Newly Industrialized Economies Hong Kong, China Republic of Korea Singapore Taipei,China Central Asian Republics, Azerbaijan, and Mongolia People’s Republic of China Southeast Asia South Asia The Pacific III. Asia's Globalization Challenge

Asian Development Outlook 2001 : II. Economic Trends and Prospects in Developing Asia : Newly Industrialized Economies

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Republic of Korea

The strong pace of the 1999 economic recovery continued into early 2000. However, the rate of economic growth began to ebb in the second half of the year as optimism about the pace of reforms started to fade and external demand growth slowed. Real GDP grew by an estimated 8.8 percent in 2000, but is expected to slow to 3.9 percent in 2001 before picking up in 2002. Long-term stability depends crucially on continued and steadfast implementation of financial and corporate restructuring.

Recent Trends and Prospects

In 2000, the economy of the Republic of Korea (Korea) continued its impressive recovery from the 1998 recession, led by rapid growth in the value of both total exports and equipment investment. Real GDP expanded by a robust 8.8 percent in 2000, moderating from the very strong 10.9 percent rate of growth in 1999. Yet this strong annual performance masked a significant weakening in the economy in the fourth quarter of 2000. Because of a rapid fall in the expansion of external demand, annual growth in total export value (in dollar terms) fell from 26.6 percent in September to 1.4 percent in December. Changing external conditions, labor strife, and slow corporate restructuring eroded investor and consumer confidence. Annual equipment investment is estimated to have dropped from 38.1 percent growth in August to a contraction of 2.1 percent in December, to give a figure for the year of 29.3 percent. Growth in real final consumption expenditures fell steadily throughout the year, with consumption of durable goods contracting in the fourth quarter.

The industry sector led the economic expansion in 2000. The industrial production index, which tracks manufacturing activity, increased by 16.6 percent, below the 24.2 percent pace of 1999 because of the sharp slowdown in manufacturing growth in the fourth quarter (see Figure 2.1). Construction activity contracted for the third year in a row, though the rate of contraction slowed toward the end of the year. Electricity production rose to 12.0 percent from 9.1 percent in 1999 as industrial and residential demand grew.

Wholesale and retail trade growth moderated throughout the year, matching the slower growth of consumption. The transport and communications sector continued its rapid double-digit expansion in 2000, fueled by the greater popularity of mobile phones and Internet services. Growth of value added in financial, insurance, real estate, and other business services was slower than in 1999 and declined throughout the year.

On the external side, the current account was in surplus for the third year in a row, but narrowing from 12.7 percent of GDP in 1998 to 6.0 percent in 1999 and to 2.4 percent in 2000 as the recovery brought rapid growth of imports in both 1999 and 2000. Merchandise exports grew by 21.1 percent in 2000 but merchandise imports surged by 36.3 percent, cutting the trade surplus to $16.6 billion from $28.4 billion in 1999. Heavy industry products (including chemicals, machinery, electrical and electronic products, semiconductors, and automobiles), which account for over 70 percent of exports, accelerated to over 20 percent growth in 2000 compared with 15 percent in 1999. This, combined with a partial recovery in light industry exports (about 20 percent of exports by value) of about 2.5 percent growth from the previous year’s 8.5 percent contraction, accounted for the surge in exports.

The capital account, which experienced a deficit of $3.2 billion in 1998 as a result of capital outflows, improved to show a surplus of $2 billion in 1999. With sustained high growth, the capital account continued in surplus throughout the first three quarters of 2000 but fell into deficit in the fourth quarter as investor confidence slipped. Overall, the capital account surplus was estimated at $11.7 billion in 2000. As a result of the combined current and capital account surpluses, foreign exchange reserves rose from $74 billion in late 1999 to about $96 billion at end-2000. Reflecting the fourth quarter deterioration, the monthly average exchange rate of the won depreciated against the dollar by 6.5 percent between December 1999 and December 2000. After strengthening to W1,110 per dollar in April, the exchange rate weakened to W1,216 per dollar in December 2000 due to the slowdown in growth, delayed structural reforms, and the rapid increase in world oil prices.

Reflecting high economic growth, unemployment dropped from an annual average of 6.3 percent in 1999 to 4.1 percent in 2000. However, much of this improvement took place in the fourth quarter of 1999, in which the seasonally adjusted annual GDP growth rate peaked at 14 percent. On a seasonally adjusted basis, the unemployment rate stood at 4.4 percent in January 2000, bottomed out at 3.7 percent in June, and rose back to 4.0 percent in December. The growth rate of nominal wages slowed to the high single digits in 2000 compared with a 12.1 percent increase in 1999. In contrast, annual average consumer price inflation, at about 5.5 percent during 1994–1998, rose from a low of 0.8 percent in 1999 to 2.3 percent in 2000. This was a result of the combination of the external influence of rising oil prices and the internal influence of rising agricultural prices reflecting poor, weather-affected harvests.

Monetary policy was generally tight in 2000. With an inflation target of 2.5 percent, the Bank of Korea raised short-term interest rates in February and October 2000 to lower the spread between short- and long-term rates in an effort to reduce the concentration of funds at the short end of the market. This was done despite concerns about liquidity problems faced by large corporations. The Bank of Korea was concerned about signs of a rising core inflation rate (i.e., excluding oil and food). The overnight call rate was raised from 4.74 percent a year in January to 5.31 percent in December, while the three-year treasury bond rate fell from 9.3 percent to 7.16 percent. Although the supply of broad money (M2) grew at a fairly rapid pace of about 26 percent through the year, M3, which includes various financial market instruments, expanded by 5.5 percent, much slower than the rate of economic growth.

Fiscal policy tightened in the second year of high growth as the consolidated government budget recorded a surplus for the first time since 1996, at 1.1 percent of GDP. This was achieved through a 23.7 percent increase in total revenues, while the growth of total expenditures plus net lending was contained at 5.8 percent. In particular, income, profit, and capital gains tax collection showed a 40.3 percent gain in 2000, as corporate income tax payments surged with the economic revival and the resulting increase in corporate income. On the other side of the account, current expenditures increased more rapidly than capital expenditures due to a 9.4 percent increase in transfers to local governments, nonprofit institutions, and households. Current expenditure represented about 65 percent of the current budget.

Real GDP growth is forecast to fall sharply to about 4  percent in 2001, before recovering to perhaps 5.5 percent in 2002. Private consumption is projected to experience low single-digit growth in 2001 as a result of lower consumer confidence, higher unemployment, and negative wealth effect of a weaker stock market (in which average prices fell by about 9 percent in 2000). Equipment investment is expected to contract in 2001. However, net exports will be relatively strong in 2001, since the won is still undervalued in terms of its real effective exchange rate and foreign demand is likely to remain fairly buoyant despite the anticipated slowdown in the US. The Bank of Korea’s inflation target is 3.0 percent for 2001 to allow for an accommodative monetary policy. Fiscal policy is expected to be expansionary in 2001.

Issues in Economic Management

The Government is currently implementing a coordinated, two-pronged reform program that aims to restructure the financial and corporate sectors simultaneously. The financial sector program was designed in two phases to strengthen enforcement of prudential regulations and capital adequacy requirements in the financial sector, so that financial institutions will in turn put pressure on firms to accomplish debt-reduction and business-restructuring measures. In the first phase, which began after the 1997 Asian financial crisis, the Government initiated and implemented measures designed to (i) restructure the financial industry, (ii) liberalize and augment the capital market, and (iii) strengthen prudential regulation and supervision. Through this program, the number of banks has fallen from 33 to 22 through mergers, closures, and nationalization. In addition, with W100 trillion in public funds, the Government has raised capital adequacy ratios to above 8 percent and reduced their nonperforming loan ratios. However, weak loan classification standards may be masking the real extent of the problem.

The second phase of financial sector restructuring began in late 2000 with the creation of financial holding companies and the decision to inject an additional W40 trillion into the banking sector. The Government is also encouraging mergers among the better run banks that have had no injection of public money to enlarge bank size and strengthen their competitiveness.

To ensure that public money is efficiently used, the Special Law on the Management of Public Money was promulgated on 20 December 2000. However, improving efficiency of the banking system will be difficult since it requires strong independent management expertise in a banking system that is accustomed to accommodating government policy directives. To sustain balance sheet gains following financial restructuring, banks will have to improve business practices, particularly with respect to evaluating potential borrowers and analyzing risk. The Government’s large equity holdings should eventually be replaced by private sector equity, including that from abroad.

The second plank of the economic reform program—corporate sector restructuring—also started right after the financial crisis began. It focused on three aspects: (i) improving management transparency and corporate governance structure, (ii) allowing financial institutions to assume the lead role in corporate sector restructuring, and (iii) restructuring the chaebol (conglomerates). The introduction of “forward-looking criteria” as an element in asset classification put banks’ potential nonperforming loans on their balance sheets. Consequently, banks’ credit monitoring has been strengthened, and some of their troubled debtor companies were forced to close in 2000. Also, based on a credit inspection of companies conducted in November 2000, the Government has made specific plans for 52 firms on the brink of bankruptcy, including liquidation, court receivership, and sale of the firms.

However, the restructuring of larger companies has been difficult and the corporate sector remains weak. The failure of the planned acquisition of Daewoo Motor had a large negative impact on the stock market. Also, Hyundai Construction has continued to receive new credit despite concerns that the company is financially weak. Debt-equity ratios in the corporate sector are still high, profitability is low, and the level of nonperforming loans remains high. Thus, the corporate sector is particularly vulnerable to the slowing of the economy and the associated reduction in profit growth.

Policy and Development Issues

In the longer term, the Government recognizes that it must take on the task of redefining its role in promoting economic growth. Recent events indicate that, in the financial and corporate sectors, the Government is finding this task difficult. Around the time of the financial crisis in 1997/98, a large number of corporate bonds were issued and most of them will mature in 2001. To prevent them from paralyzing the bond market when corporations attempt to roll them over, the Government provided investment trust companies with credit guarantees to ensure that the maturing bonds are purchased. The Korean Industrial Bank was directed to purchase a significant portion of the bonds. However, this policy has drawn criticism because six of the initial companies to receive support from the Korean Industrial Bank in January 2001 consisted of four Hyundai subsidiaries, and two cement companies. Two of the subsidiaries and the two cement companies are in a weak financial condition. This raised the specter of moral hazard created by using public money to support failing companies.

While it attempts to disengage from the financial and corporate sectors, the Government has been promoting information and communications technology (ICT). Korea is already one of the world’s largest producers of ICT products for export. At the same time, the Government has been encouraging the development of the domestic market. The dramatic increase of Internet access has largely been the result of government initiatives, such as sponsoring research and development on ICT, strengthening infrastructure by laying more high-speed telecommunications lines, encouraging foreign investment in ICT, deregulating telecommunications, and simplifying procedures for Internet startup firms.

The proportion of Internet users in Korea is estimated now to be about 35 percent of the population, one of the highest rates in the world. As demand for Internet services has surged, the number of Internet service providers has also soared, from about 23 in 1998 to more than 80 in 2000. Because the industry is relatively new, turnover is still high among the small and medium-sized Internet service and content providers, reducing consumer confidence. Moreover, ICT firms tend to be concentrated in Seoul. To help balance ICT development geographically, the Government intends to set up what it calls “information technology towns”. A super high-speed telecommunications network will link the information technology towns.

To further develop its ICT infrastructure, the Government plans to expand its ICT-related investments from the current 1.2 percent of GDP to 3.0 percent over the next five years in an attempt to raise national competitiveness to the level of the industrial countries. This is part of its overall aim to weave the use of the Internet into many areas of the economy so as to spur national competitiveness. However, the Government should plan these investments with care given the recently demonstrated volatility of the global ICT market.

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