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Asian Development Outlook 2004 : II. Economic Trends and Prospects in Developing Asia : East Asia
Republic of Korea Economic growth slowed in 2003 due to declines in private consumption-as consumer credit dried up-and in business investment. Strong export growth kept the economy expanding. In 2004-2005, a recovery in the world economy will maintain growth in exports, which is likely to stimulate investment. However, the heavy household debt problem needs to be contained so that private consumption growth can resume. Economic Assessment Growth in GDP fell by more than half to 3.1% in 2003 from 7.0% in 2002. Year-on-year growth slowed through the first and second quarters before edging up in the third Gross fixed capital formation increased by 3.6% in 2003, as construction investment remained active throughout the year due to brisk housing construction. However, machinery and equipment investment fell by 1.5% in 2003, in contrast to growth of 6.8% in 2002. On the supply side, despite the strong growth in construction, economic growth was held back by declining output in agricultural production and retail services, and slowing growth in manufacturing. Two consecutive years of agricultural contraction (3.5% in 2002 and 7.1% in 2003) were caused mainly by heavy rains and typhoons. Services sector growth in 2003 was limited to 1.8% as wholesale and retail trade fell, reflecting weak private consumption. Manufacturing increased by 4.8%, supporting the strong export performance. Although poverty is not a major concern, the youth unemployment rate reached a historically high 8.6% at end-2003 because of the economic slowdown and rigidities in the labor market. The overall unemployment rate has also been increasing, reaching 3.9% in February 2004 from an average of 3.1% in 2002. Confrontation between management and labor unions has hindered the labor market, at an estimated cost to the economy of $2.1 billion in lost production in 2003. The budget balance turned to a deficit equivalent to 1.7% of GDP in 2003 from a surplus of 0.4% in 2002. Two supplementary budgets were executed to promote economic recovery. The first was spent mainly on construction and social services while the second was used to repair typhoon damage of W4.2 trillion ($3.5 billion). Central government revenue collection improved slightly to 20.9% of GDP from 20.3% in 2002, mainly supported by growth in income and profit taxes from the tradable sector, and made up for a loss in consumption tax. Expenditures increased faster, to 22.7% from 19.9% of GDP. Central government debt remains manageable at W165.2 trillion ($138.6 billion), or 22.9% of GDP at end-2003, significantly lower than the Organisation for Economic Co-operation and Development (OECD) average and allowing for further fiscal stimulus if necessary.
On the monetary front, core inflation (the CPI excluding agricultural products and oil) of 2.8% in 2003 remained within the targeted range of 2.5-3.5%. Meanwhile, the full CPI increased by 3.6%, up from the previous year’s 2.7%, primarily due to higher oil and agricultural prices. The Bank of Korea maintained an expansionary monetary policy stance throughout 2003 in an attempt to lift private consumption. Long-term interest rates started to rise in October, driven by a surge in treasury bond issuance. Growth in the money supply (M3) slowed to below 5% in January 2004 from 12.4% in the first quarter of 2003 because of a sharp cutback in bank lending to households and a decline in corporate loans. The won’s exchange rate is increasingly market determined, with occasional intervention such as that seen in late 2003. After appreciating in the second and the third quarters of 2003, the won started to depreciate against the dollar in October, mainly driven by robust growth in the US. With this change, it ended 2003 with an appreciation of 4.7% against the dollar. Strong demand in the PRC for raw materials put upward pressure on prices of commodities worldwide. As a result, the import price index rose at a faster rate (year-on-year average of 9.3% in 2003) than the export price index (year-on-year average of 2.5%), leading to a 5.8% worsening of the country’s terms of trade. Export growth accelerated to 20.9% in 2003, and this continued into February this year, marking its highest year-on-year growth at 45.9% since recording 52.6% in August 1988. Exports to the PRC and India surged by about 40% and 72%, respectively. Textile and clothing exports declined, but exports of semiconductors, ships, wireless communication devices, cars, and computers contributed to the strong export growth. Increased demand for inputs from the export sector, together with increased imports of crude oil, capital goods, and consumer goods pushed import growth up to 18.1% in 2003. The deficit in services trade widened, but with a sharp increase in the trade surplus the current account registered a surplus of $12.3 billion in 2003, more than double the previous year’s $5.4 billion and reversing the downward trend seen since 1998. Both approved and actual FDI inflows fell from 2001 through the first half of 2003. Actual FDI turned around in the second half, increasing by 30.6% in 2003 from the 2002 level, to $4.8 billion, but just five mergers or acquisitions accounted for most of this growth. While FDI to developing Asia as a whole is dominated by flows to the PRC, the Republic of Korea (henceforth Korea) attracted around half (about $13 billion) of the other types of capital flows (portfolio and bank lending), or as much as the PRC, India, Indonesia, Malaysia, Philippines, and Thailand combined. This contributed to the KOSPI stock index gain of 29.2% during 2003. Meanwhile, direct investment abroad fell by 12.4% to $5.4 billion in 2003, due to investor hesitation resulting from increased uncertainty from SARS and the Iraq conflict in the first half of the year, as well as a general sluggishness in Korean investment activity. The PRC continued to be the largest external destination for investment, followed by the US and Viet Nam. Overall, the capital account surplus rose from 1.1% to 2.2% of GDP. By end-2003, total external liabilities amounted to $160.7 billion, or 26.6% of GDP, about half of which are short term. However, the short-term external liabilities were more than adequately covered by $155.4 billion of foreign exchange reserves-the fourth-largest in the world after Japan; PRC; and Taipei,China-which increased by $34.0 billion, partly due to intervention in the foreign exchange market to maintain the won’s competitiveness in the fourth quarter of 2003. Policy Developments Economic policies for 2004 focus on domestic issues, primarily the need to assist the recovery of machinery and equipment investment, private consumption, and employment. These issues are being addressed largely by the Ministry of Finance and Economy’s new tax package, which came into effect at the beginning of the year. While the impact on tax revenues is expected to be minimal, a more business-friendly tax environment will be achieved through measures such as a reduction of the minimum tax rate from 12% to 10% for small and medium enterprises. Furthermore, to promote more equitable taxation, the Government will revise the tax code to cover all transactions resulting in property being inherited or gifted. Other provisions include (i) an increase in the capital gains tax for short-term holdings (of less than 1 year) of land and buildings from 36% to 50% and from 9-36% to 40% on holdings of 1-2 years; (ii) greater support for low- and middle-income families through extension of the eligibility period for the Special Tax for Rural Development until June 2009; and (iii) an increase in the maximum tax credit for university tuition from W5 million to W7 million per student. Excise tax rates for cars, air conditioners, and other luxury goods have been reduced until end-2004 in an effort to increase domestic consumption. The budget in 2004 will provide a mild fiscal stimulus and will focus on economic recovery through front-loading 54.8% of expenditures in the first half of the year. It will also provide support to investment that increases the country’s competitiveness-in research and development (R&D), education, and information technology. Several measures were initiated in 2003 to address the credit problems, including a system whereby personal debts could be rescheduled and partly written off. More substantial reforms are beginning in 2004. For example, the Government will establish a “bad bank” in May to help reschedule overdue consumer debt by providing consumer debtors with fresh loans of up to 8 years. The new bank will also acquire consumer NPLs from existing lenders, helping clean up their balance sheets. The Korea Housing Finance Corporation began operations in March 2004 to deal with the household debt issue in the medium to longer term. This government-led initiative aims to make mortgage money available to people in need and to help refinance short-term mortgage loans to reduce the risk of default. To improve the labor situation, a tripartite commission representing workers, employers, and the Government reached agreement on the Social Pact for Job Creation in February 2004. Under this pact, labor unions will cooperate to stabilize general wage levels. The pact aims to reduce confrontation between management and workers in an attempt to encourage firms to increase investment and create new jobs. The Bank of Korea has kept its core inflation target range for 2004-2006 at the 2003 level. It intends to maintain the benchmark call interest rate at a historical low of 3.75% in the first half of 2004, until the economic recovery is firmly on track. However, the effectiveness of monetary policy hinges on reducing the high household debt because demand for liquidity is weak. Although state ownership remains an important feature of the financial system, privatization has led to foreign ownership increasing in the banking sector, from below 10% of total issued share capital at the end of 1998 to 30% in 2003. Reforms of other financial institutions (e.g., specialized banks and nonbank financial institutions) are less advanced. An accounting fraud at SK Global in early 2003, which triggered a collapse in the market for bonds issued by credit card companies, showed that corporate reform is incomplete, entailing significant costs. Free economic zones (FEZs) continue to be central to the Government’s objective of turning the country into the business hub of northeast Asia. In addition to Incheon international airport area, two more areas (Busan/Jinhae and Gwangyang Bay) were designated as FEZs in 2003. Cash grants to refund part of the cost of investment and eased requirements for tax relief are the two main incentives to attract foreign investors to the FEZs. The success of this approach will depend on how the Government addresses various weaknesses-including a tightly controlled financial system, still difficult labor relations, and an underdeveloped regulatory system-to better compete as a business hub with other sites in northeast Asia. These efforts, together with continually upgrading the skills of the labor force, will also determine whether the economy can, on a sustained basis, return to its long-run potential rate of growth (currently estimated at about 5% annually), and perhaps even raise that potential. One aim of the FEZ plan is to build on the fact that services created jobs in 2003 and manufacturing shed them, by attracting more services sector industries, such as financial services and R&D, which will create well-paid jobs. Outlook for 2004-2005 Supported by strong growth in exports and accommodative monetary and fiscal policies to lift domestic demand, GDP growth is expected to recover to just below 5% in 2004 and to increase further in 2005. Early containment of the credit card and household debt problems is the key for recovery in private consumption. While several measures have already been taken, there are few positive signs of recovery so far. The Consumer Sentiment Index improved for a fourth consecutive month in January 2004, but then declined in February and March. Growth in private consumption might resume only in the second half of 2004, after further progress has been made in reducing consumer NPLs. This would imply weak consumption growth for 2004 as a whole, before it strengthens in 2005. Investment demand is expected to recover in 2004, bolstered by fiscal policy, although its timing and magnitude may be subject to rising uncertainty over developments in the north of the peninsula, the presidential impeachment, and National Assembly elections in April. Robust export growth is expected to raise demand for new investment, as has been observed in past export-led economic recoveries. However, the increasing trend in FDI flows to countries such as the PRC suggests possibly weaker spillover effects from export growth this time. Also, growth in construction will be slower because of government measures to cool a buoyant real estate market. Nonetheless, there are positive signs for investment, such as increasing capacity utilization and large retained earnings in the export sector, which might result in growth in machinery and equipment investment. Hence, investment growth will likely turn positive during the first half of 2004, but remain low, before firming up in 2005. As the 2004 growth projection is slightly lower than assumed in the Government’s budget, a wider than planned fiscal deficit may result. Nonetheless, relatively low central government debt (22.0% of GDP) allows room for fiscal policy to be more expansionary if necessary. The 2004 budget was designed to support the full turnaround of domestic demand, particularly by supporting investment. Running a planned deficit (0.5% of GDP) will continue the fiscal stimulus, with a more balanced budget likely to be targeted in 2005. As for monetary policy, the expansionary stance is projected to continue through the first half of 2004, before the stance tightens in the second half of the year and in 2005 when economic growth accelerates. The trend of slower money supply growth may continue during the first half of 2004, until the demand for liquidity picks up in late 2004 and in 2005. Careful attention is required to ensure adequate liquidity, especially in the small and medium enterprise and household sectors. Recovery of these sectors, along with continued expansion by larger exporting firms, is the key to resuming balanced, strong growth. Core inflation appears under control and is expected to remain within the target range in 2004-2005. Strong export growth will steer the economy along the recovery path. Although the country has a diversified export base in terms of products and markets, any weakness in demand from the PRC and US would set back its export performance, as would an appreciation of the won. However, merchandise export growth is expected to continue in 2004 at about 21%, before slowing to around 19% in 2005. The increase in import prices needs to be monitored. The high demand for inputs to the export sector as well as higher oil prices are expected to lead to faster merchandise import growth in 2004 of an estimated 22%. Thus, the contribution to growth of net exports will decline slightly to 2.5 percentage points in 2004. Risks to the outlook could arise from domestic or external sources and would mostly affect investment or exports. Prolonged or violent disputes between labor and management, or heightened tensions across the northern border could deter investment. Weaker global expansion, and particularly any sharp deceleration of growth in the PRC, could also reduce the important contribution of net exports to growth.
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and picking up strongly in the fourth. Net exports posted robust growth of 90.6% and contributed 2.8 percentage points to GDP growth, but private consumption declined by 1.4%. After posting 4 years of steady growth, private consumption was hit by credit difficulties: household debt increased to exceed 70% of GDP and about 3.8 million people, or 8% of the population, were delinquent on credit card payments by January 2004. The defaults shook consumer confidence and prompted credit card companies to cut credit lines. Although consumption of nondurables showed resilience in the first half of the year and government consumption grew modestly, all categories of private consumption declined in the second half, restricting GDP growth for the year (Figure 2.3).
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