Korea Confronts Global Headwinds with Strong Fiscal Position

Uncertain global economy—including escalation of euro crisis—threatens Korean growth

Korea’s strong fiscal position will help it meet challenges to growth

Despite strengthened financial sector, Korea still vulnerable to capital outflows

Despite weathering the global financial crisis robustly, strong headwinds from the global economy are dampening Korea’s growth momentum, say the IMF experts in their regular report on the state of the country’s economy.

Korea is expected to grow by 3 percent this year—below its growth potential— and then around 4 percent in 2013, although continued weakness in the global economy may make this difficult to achieve, suggests the report. And despite significantly slower exports, the country’s current account is projected to remain in surplus this year.

Managing risks, preserving macroeconomic soundness

If the global economy deteriorates, the authors of the report say Korea has sufficient space to respond, particularly on the fiscal side. In the event of a severe financial contagion, similar to that of 2008–09 when capital poured out of the region, the authorities should be prepared to use their ample foreign reserves to maintain orderly market conditions, they added.

The Korean authorities have already announced a modest fiscal stimulus package, and cut the monetary policy rate to support the economy in response to a weaker-than-expected growth outlook.

“We believe this step is appropriate given global weakness and heightened uncertainties, but a normalization of monetary policy stance will be needed in 2013 if the economy returns to trend growth as projected” said Hoe Ee Khor, IMF mission chief for Korea.

Less vulnerability in the financial sector

The report suggests that the Korean financial system has become less vulnerable since 2008 due to the concerted efforts of the authorities. External buffers have been strengthened, with higher foreign reserves and bilateral swap lines, while short-term debt has been reduced.

Regulators have also taken a number of macroprudential measures to strengthen the resilience of the banks to liquidity shocks. These steps included a cap on foreign exchange derivatives positions and a financial stability levy.

The foreign investor base in the government bond market has also become more diverse, and now includes regional central banks, but Korea still remains vulnerable to shocks from volatile capital flows, warns the report.

IMF...