Summary:KEY ISSUES Overview. Korea has experienced impressive growth since the 1970s, enabling it to escape the middle-income trap. However, this prosperity has been concentrated lately within the highly competitive export-oriented conglomerates, whereas household income growth and service sector productivity have been sluggish. Moreover the population is aging rapidly. To sustain income convergence with the most advanced countries and enhance stability and inclusiveness, Korea needs ambitious reforms to its fiscal framework (including to create space for higher social spending), labor market, and services sector. Such reforms would be mutually reinforcing. Near-term Outlook and Risks. The economy is recovering gradually, helped by supportive monetary and fiscal policies and strong exports, and it emerged as a “safer” haven in last summer’s market turmoil. Growth should strengthen further in 2014, although risks are on the downside. The main near-term risks are external: sharply slower growth in Korea’s main trading partners or severe market stress. Given significant private debt overhang, key domestic risks are weak domestic demand and, over time, lower potential growth if structural reforms fail to offset the drag from rapid aging. Policy Recommendations. Policies should aim to tackle the weakness of domestic demand and counter forthcoming headwinds to potential growth. • Fiscal Policy. Keep supporting demand in 2014, which may require a supplementary budget. Increase countercyclicality through higher automatic stabilizers and a structural balance fiscal rule. Create fiscal space to boost household incomes and the growth potential by allowing a temporary structural decline in government savings and broadening the narrow tax base. • Structural Policies. Continue to focus on labor market reforms to enhance participation and reduce duality and, as the social safety net expands, accelerate services sector deregulation and SME consolidation. • Monetary Policy. The current accommodative stance is appropriate given the lack of inflation or financial stability concerns. Normalization should not start until there is confidence that the output gap will close soon. • Exchange Rate Policy. The exchange rate should continue to be market-determined and intervention limited to smoothing disorderly market conditions. FX reserves are ample and there is no need for further accumulation. • Financial Sector. As the FSAP found no imminent stability risks, focus on closely monitoring vulnerabilities such as household and corporate debt to further enhance resilience; and supporting growth, including by reducing government intervention.
