Catalog

	Table of Contents
p. 13 of 68 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 Asia The Pacific III. Competitiveness in Developing Asia Statistical Appendix

Asian Development Outlook 2003 : II. Economic Trends and Prospects in Developing Asia : East Asia

---

Republic of Korea

The economy performed strongly in 2002, led by vigorous expansion in exports of goods and services, particularly in the second half of the year. As private consumption decelerated from the second through fourth quarters, equipment investment and exports took up the slack, resulting in steady and high growth. Keeping fiscal and monetary policy supportive of moderate yet sustainable economic performance, the Government passed regulations restricting consumer loans and housing mortgages. Optimism for the future based on domestic factors is tempered by regional and global political uncertainties.

Macroeconomic Assessment

The Republic of Korea (Korea) continued its brisk recovery in 2002, with GDP expanding by 6.3%. On the demand side, private consumption made the strongest contribution to growth in the first half of the year thanks to robust income growth, the wealth effect of rising property (and hence loan collateral) values, low interest rates, and tax incentives. Consumption growth slowed in the second half, reflecting unusually bad weather, the relatively high level of accumulated debt, the end of a temporary tax exemption on certain durable goods, and stricter regulation of consumer credit. An increase in exports offset the slowdown in consumer spending and construction investment, the latter of which decelerated noticeably following completion of projects for the World Cup and Asian Games sports events.

The gross savings ratio was 29.2% while the gross domestic investment ratio was 26.1%, both slightly lower than in 2001. The increased opportunities to acquire and use consumer loans and credit cards, which boosted consumption, led to the savings rate reaching a 20-year low of 26% in the third quarter of the year (Box 2.3). The investment ratio declined amid rising global uncertainties over prospects for the world economy and continuing corporate efforts to lower debt-equity ratios.

Box 2.3 Consumer Credit Growth in Korea

Koreans have traditionally preferred to pay for their purchases in cash, but after the Asian financial crisis, aggressive marketing efforts by financial institutions were directed toward consumers. Firms, in their efforts to rehabilitate and reduce their debt-equity ratios, resorted to equity financing instead of borrowing from banks. As a result, some banks found themselves with a lot of cash but no borrowers. They then began to tap a new market for their loan products the household. With renewed consumer confidence in the economy, it was quite easy for financial institutions to encourage households to adopt their loan products.

While consumer borrowing remains heavily oriented toward housing, credit card use has expanded rapidly in recent years. New credit cardholders were often signed up at sidewalk stands without even a home address required. In the second half of 1999, the Government granted incentives to credit card users, including taxable income deductions for payments made via credit card and introduction of a credit card lottery service, to lift consumer spending and improve tax collection. This further fueled the credit card boom. The result was a large expansion in credit card use, effectively reducing transactions in the underground economy and boosting VAT revenues.

As the credit card industry grew and credit card use soared, adverse impacts from their reckless use began to appear. A large proportion of credit card transactions involve the cash advance facility for which cardholders can avail of non-collaterized loans from automatic teller machines. Cardholders began to use advances from one credit card to pay off debts falling due on another credit card. As a result, the debt was simply rolled over but never actually repaid. However, since cardholders can only have as many credit cards as the number of card issuers, the supply of new credit cards eventually became tight and cardholders faced the prospect of defaulting on their loans. As could be expected, the number of delinquent cardholders began to rise, with most delinquents having debts well in excess of their annual income. From only 7.3% at the end of 2001, default rates on bank-issued credit cards rose to 12.2% by end-November 2002 (Box Figure). Credit card companies also saw their rates of overdue payments double to 11.7% from only 5.8% over the same period.

This has raised concern about the bursting of the consumption credit bubble and impending mass bankruptcies of households. According to the Bank of Korea, household debt surged to three quarters of GDP as at end-2002, from less than half in 1999. In absolute terms, household credit more than doubled to W439 trillion by the end of 2002 from only W214 trillion at the end of 1999. Even as increased household spending was fuelling inflation, the Government remained wary of increasing interest rates as this could trigger new financial turmoil, just as mounting corporate debt contributed to the 1997 financial crisis. While rising interest rates could have reined in consumer spending, they would have led to even higher loan default rates, particularly at a time when household debt had reached very high levels.

In their desire to stem the excessive use of credit cards, card issuers are now educating cardholders on personal credit management. The Government, for its part, has put pressure on banks and credit card companies to lower fees, reduce the cash advance limit for cardholders, and increase loan-loss provisions. In particular, the Government has ordered credit card issuers to set aside capital equivalent to 8.0% of outstanding loans to cover potential defaults, write off debts older than 6 months, and use a stricter yardstick to judge the creditworthiness of applicants.

The Government and credit card companies also agreed to cancel 2.1 million "dormant" cards (i.e., cards not used for 1 year) in 2003. While this will benefit card companies by freeing up the required 1.0% of the cash advance limit they have set aside for every card issued, stricter rules on credit card operations put a strain on their profitability in the second half of 2002.

In addition, financial sector shares in the stock market, which include banking shares, lost about 20% of their value between September and December 2002. Overall, the initial impact on credit card companies may be unfavorable, but the timely response of the Government to mounting household credit may be just what the industry needs to ensure its long-run viability.

In terms of supply, services made the strongest contribution to growth, followed by manufacturing (Figure 2.3). The services sector grew by 7.4% overall, and by 5.8% excluding finance and insurance services. Particularly noteworthy is the information technology industry, which has been the fastest growing industry sector in recent years, accounting for some 10% of GDP and 30% of total exports in 2002.

Industrial production increased by 6.1%, led by export subsectors such as semiconductors, telecommunications devices, and machinery; manufacturing's capacity utilization rate increased to 76.7%. Since the 1997-98 Asian financial crisis, the country's largest conglomerates (chaebol) have reduced debt and cross shareholdings, and improved corporate governance. By September 2002, the debt-equity ratio of manufacturing firms had been reduced to 131% from 398% in 1998. However, several chaebol continue to dominate the corporate environment, with the top 30 of them accounting for about 40% of manufacturing output and 50% of exports.

The unemployment rate has declined each year since 1998, reaching just 3.0% in 2002 as employment in the services sector particularly (especially wholesale, retail, housing, and food services) expanded and as the economy continued its rapid recovery from the financial crisis, generally benefiting from its diverse economic structure, improved governance, financial sector rehabilitation, and enhanced flexibility. Manufacturing employment declined marginally in 2002 but manufacturing wages continued to rise as labor productivity grew by more than 10% over the year.

Central government revenues reached 26.6% of GDP and the consolidated fiscal surplus amounted to 3.9% of GDP, boosted by proceeds from the sale of the Government's stake in Korea Telecom, greater revenues from value-added tax (VAT), transferred profits from the Bank of Korea, and contributions from the National Pension Fund, as well as restraint in expenditures. Repeated budgetary surpluses since 2000 have contributed to one of the lowest ratios of public debt to GDP (42%) in the OECD and leave room for further fiscal stimulus if necessary.

The CPI edged up by 2.7% in 2002 (3.0% excluding agricultural products and oil), but producer prices rose by just 1.6%. Long-term interest rates declined throughout most of the year. After a protracted rise in response to a shift in banking behavior from lending to firms to greater lending to households, housing prices appear to have stabilized, reflecting stricter regulation of consumer credit and toughened taxation of real estate and capital gains. The positive wealth effect from higher housing values contributed to the growth in general consumption while the expansion of home ownership boosted sales of consumer durables in particular.

Credit card delinquencies rose to a record 12.2% in November 2002, and as a result, lending to households is slowing. However, the overall ratio of NPLs to total loans in the banking sector is down to 2.4% from a peak of over 16% in 1998. Banks are again placing their emphasis on corporate lending, which the Government is hoping will be increasingly directed to SMEs.

Equity market volumes continued to grow in 2002, with the values of stocks and bonds traded increasing by 51% and 232%, respectively. The KOSPI stock price index declined by 9.5%, reflecting a general weakness in equity markets in the region.

Despite a 10.5% appreciation of the won against the dollar during the year, exports increased by 7.5% as export prices on a won basis declined by 4.8%. The strong export performance reflected a 20.1% increase in shipments of ICT products, such as wireless communications devices, semiconductors, and computers, and a 3.9% increase in non-ICT exports. Korea has benefited from both more diversified export markets and a broader export base than some other developing Asian economies.

The PRC (including Hong Kong, China) has replaced the US as Korea's largest export market, taking 20.9% of exports, as well as being the favored destination for investment outflows. Direct investments in the PRC also stimulated exports of equipment and components to supply the factories associated with those investments. However, export expansion lagged the import growth rate of 7.7%. With over 50% import content in exports, robust import growth is likely to underpin continued strong export performance. Meanwhile, the current account surplus has declined steadily each year since its approximately $40 billion peak in 1998 following the onset of the financial crisis, but at around $6 billion in 2002 continued to boost the country's net creditor position (Korea has been a net creditor since 1999).

Reversing a trend of positive capital inflows, net outflows of $703 million of direct investment by foreigners and inflows of $183 million of portfolio investment were recorded. Gross FDI inflows in 2002 fell by 44.1% to $2.0 billion, as foreign investors bought only five Korean companies under major restructuring, compared with 18 in 1999, partly reflecting the previous success in postcrisis recovery. However, foreign investors' interest remains strong, particularly in finance and telecommunications, as seen in the 35.4% of Korean Stock Exchange market capitalization held by foreigners as of end-February 2003. At the same time, outward investment by Koreans has been increasing.

By the end of December 2002, total external liabilities amounted to $131.0 billion, or about 27.5% of GDP. Short-term foreign liabilities, driven mostly by external borrowing by local branches of foreign banks, were about 40% of total foreign liabilities. However, they were more than adequately covered by $121.4 billion of foreign exchange and gold reserves. Foreign exchange reserves increased in dollar terms primarily through interest revenue earned on the stock of reserves and an increase in the value of yen- and euro-denominated assets when converted into dollars. Total external assets increased to a record $185.3 billion by end-2002.

Policy Developments

The fiscal policy stance was basically neutral and remains constrained over the medium term by the need to cover costs already incurred for financial sector restructuring and precautions with regard to geopolitical uncertainties. Income tax rates were trimmed to boost household disposable income and preferential tax treatment equivalent to a 10% deduction for corporate capital investments was extended until June 2003 to help offset the tightening of consumer credit.

In the second half of 2002, the Government intervened to reduce the likelihood or magnitude of a bubble in the property and consumer credit markets. The Financial Supervisory Commission is continuing to closely monitor loans to households to prevent the higher consumer debt from disrupting the financial sector, and the ceiling for new mortgages was lowered from 80% to 60% of the value of the property. Credit card companies are being required to maintain a capital-adequacy ratio of 8%, will have to write off loans that are unpaid for more than 6 months, and will have to classify risky loans more strictly.

Despite falling international interest rates, the Monetary Policy Committee of the Bank of Korea kept its key call-rate target steady at 4.25% for the last 8 months of the year to balance the tensions between brisk economic growth and external uncertainties. Although neighboring countries are experiencing deflation and the current nominal interest rate is relatively high, the Bank of Korea has not seen the need to loosen monetary policy significantly. To protect against currency volatility, the foreign exchange equalization bond ceiling was raised from W5 trillion to W8 trillion in 2002. Increased overseas confidence in the economy was reflected in the low spreads between Korean sovereign bonds and US treasury bonds, which fell to just 95 basis points by end-November 2002.

Privatization in the banking sector continues. Banks and brokerage firms will be permitted to sell casualty and life insurance products targeted at households beginning in August 2003, with a goal of full market liberalization by 2007, including government withdrawal from the financial sector.

Risks of disruptions to oil supplies due to conflict or political disturbances in oil-producing regions have been mitigated by the stockpiling of emergency reserves in excess of 100 days' consumption. In addition, major Korean airlines have been entering into forward contracts as defensive measures against potential oil supply disruptions.

Free economic zones (FEZs) are at the center of the Government's plans, unveiled in April 2002, to turn the country into the business hub of Northeast Asia. Five FEZs are to be set up by July 2003, offering tax incentives, one-stop shop investment facilities, and other amenities to attract foreign investors. The strategy aims to develop a state-of-the-art transportation and logistics network, capitalize on the nation's advanced communications infrastructure, and create a world class business environment for foreign firms.

The policy direction under the new Government appears to aim both at continuing corporate reforms (since a significant number of companies still have weak balance sheets), and at improving efficiency of the product distribution system. Corporate reforms for the chaebol are to be pursued on a voluntary and gradual basis, raising some concerns about the speed and effectiveness of their implementation. Among other plans are expansion of employee shareholding schemes, distribution of profits between management and workers, and introduction of class-action lawsuits to increase accountability of owners and managers. Indications that the privatization program may be put under review have cast doubts on the proposed sale of gas and rail systems.

Outlook for 2002-2003

With strong real wage growth and high employment levels, GDP growth is expected to remain firm, though declining to 4.0% in 2003 before rising somewhat to 5.3% in 2004. The slowdown in consumer spending growth arising from tighter consumer credit and mortgage terms will be largely offset by rising exports to growing world markets, the end of the global manufacturing downturn, and a moderate revival of savings and business investment. There is, however, a downside risk stemming from rising uncertainty over developments in the north of the peninsula and the aftermath of the conflict in Iraq.

Planned capital investment by the 200 largest corporations is forecast to increase in the second half of 2003, according to the Ministry of Commerce, Industry and Energy, when global markets are expected to pick up and corporate debt-equity levels will have declined to even more comfortable levels. Automobile, machinery, and petroleum companies are expected to be the most aggressive in their investment spending. The slowdown in consumer spending is likely to cause unemployment to edge up marginally.

Exports are expected to rise by 8.0% and imports by 9.0% in both 2003 and 2004. The change in trade patterns favoring higher exports to the PRC and Hong Kong, China should help export performance weather any slowdown in the US or EU. Nevertheless, the current account is expected to slip back into the red as the services account deficit and recovery-driven imports increase.

Domestically, the successful promotion of broadband Internet usage will continue to spur the development of higher value-added sectors and to maintain competitiveness. Slowing domestic consumption is expected to feed into growth of only 1.7% for the industry sector. Government efforts to expand the housing supply and spending on social infrastructure projects will continue to support construction investment, while support for SMEs is aimed to counter the consumption slowdown.

With housing prices stabilized and growth in consumer debt slowing, inflation is expected to remain within but near the top of the Bank of Korea's target range of 2-4%. To contain inflation, the Government plans to minimize increases in charges for public services. In the financial sector, the interest rate spread between loans and deposits is expected to widen slightly as stricter lending guidelines and greater credit risks push up loan rates while ample liquidity keeps deposit rates subdued.

Back Hong Kong, China	Next Mongolia