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Korea: Statement at the Conclusion of the 2012 Article IV Consultation Mission

An International Monetary Fund (IMF) mission, led by Mr. Hoe Ee Khor, visited Seoul during May 30 – June 12 to conduct the 2012 Article IV consultation discussions. At the conclusion of the mission, the team issued the following statement:

“After a strong rebound in 2010, the Korean economy moderated in 2011 and into 2012 in line with global developments. Reflecting the weakening global economic outlook, Korea’s growth is likely to be weaker than the 3.5 percent in our baseline forecast and we expect growth for this year to be reduced by about ¼ percentage point. Activity in the second half of 2012 is expected to expand at a moderate pace supported by Korea’s competitive export sector and the recently concluded EU and US free-trade agreements. On the domestic side, facilities investment is expected to recover, while consumption should be boosted by stronger wage growth.

“The outlook is, however, subject to substantial uncertainty. The main downside risk relates to the intensification of the crisis in Europe. While the direct exposure to Europe is not high, if weaknesses there were to spill over to the United States and China, the impact on Korea can be substantial.

“The baseline for 2012 envisages the full implementation of the budget. The government’s determination to resist spending pressure in an election year and to continue to consolidate the fiscal position is commendable. However, given its fiscal strength, in the event of a significant worsening of the global economy, there is room for the government to take additional fiscal measures to support the economy, if necessary.

“We commend Korea’s longstanding commitment to fiscal prudence, which creates space for a strong fiscal response when needed. In this regard, we welcome the plan to achieve a balanced budget (excluding the social security fund balance) in 2013. Looking ahead, higher social spending, rapid population ageing, and potential costs related to geopolitical events, all suggest that integrating long-term issues more systematically into the fiscal policy framework remains an important priority.

“Korea’s intention to increase social spending is also laudable, particularly to improve the welfare of the lower income groups. Despite a significant rise over the last two decades, there is still scope for social spending to increase at a measured pace. Ideally, this spending increase should be carried out while maintaining the overall fiscal consolidation path, which could be achieved through a combination of reducing spending in some lower priority areas, and strengthening revenue performance.

“With respect to monetary policy, maintaining the policy rate at the current level is an appropriate response to global economic weakness and uncertainties. However, the monetary policy stance is still accommodative, and when growth strengthens from its current moderation, some increase in the policy rate may be needed in early 2013 to ensure that inflation remains within the target range. If the economy were to weaken significantly more than expected, the Bank of Korea still has room to cut rates as it did effectively in 2008-09.

“The external vulnerability of the Korean financial system has diminished considerably since 2008. This reflects higher international reserves relative to short-term debt, lower reliance on external funding for the banks, and the adoption of a series of macroprudential measures. International reserves are currently at a strong level and have been augmented by the bilateral swap lines with China and Japan. The exchange rate should continue to be market determined with intervention limited to smoothing excessive volatility. If the Euro area crisis intensifies, international reserves should be deployed to support foreign exchange liquidity and maintain orderly market conditions.

“Despite substantial progress in strengthening the financial system, some potential vulnerabilities remain. Korea is one of the most open economies in Asia and is highly exposed to volatile capital flows and foreign currency funding risks. We would therefore encourage the authorities to enhance its contingency planning for tail risks. The high level of household debt has been a concern for some time and the government has taken measures to address it. Recently, lending by nonbank financial institutions to households has grown rapidly and this also needs to be monitored closely with corrective actions taken if necessary.

“Korea is now an advanced industrial economy. Maintaining high potential growth will become more challenging over time and will require improved labor markets and higher productivity, especially in the services sector. Higher labor force participation rates—particularly by females—will support higher growth. Improving competition in the education and health sectors, and expediting the bank-led restructuring of small- and medium-sized enterprises will enhance service sector productivity, as will deregulation measures being implemented under the free-trade agreements with the US and EU.”