From The Economist Intelligence Unit
South Korea's economy was among those in Asia most exposed to the global financial crisis. The country's commercial banks were heavily reliant on short-term external debt financing, the loss of access to which would have had potentially severe implications for both the financial sector and the real economy. The government responded with a broad package of measures aimed at both supporting domestic demand and shoring up confidence in the banking system. Although it is hard to quantify the impact of the government's measures, policy stimulus certainly seems to have contributed both to the stabilisation of the economy and to the start of a robust recovery.
Headline Measures
South Korea responded early to the crisis. In September 2008 the government announced its first significant fiscal stimulus package, worth 6.9% of GDP and covering the period 2008-12, with W33.9trn (US$30bn) to be spent on tax cuts and a further W33.2trn allocated to government spending. Personal and corporate tax rates were cut in 2009 and will be cut further in 2010. The government also increased guarantee coverage on most categories of loan from 95% to 100% for small and medium-sized enterprises (SMEs).
In addition, the freezing up of credit markets after the collapse of Lehman Brothers, a US investment bank, in September 2008 prompted the Bank of Korea (BOK, the central bank) to initiate a number of support measures for the financial sector. It provided US$55bn in foreign-exchange reserves (in the form of swaps or loans) to banks and other domestic financial institutions involved in trade financing. Domestic banks needing to roll over external borrowings taken out before July 2009 received guarantees on these loans for up to three years, with up to US$100bn allocated for this purpose. The BOK also provided won and US-dollar liquidity to domestic financial institutions in an effort to offset the loss of funding from external sources. Other measures included the establishment of a W40trn bank-recapitalisation fund and a W40trn fund to purchase toxic assets. In early 2009, in an effort to shore up the capital bases of banks, the BOK started to use public funds to buy banks' preferred stock and subordinated debt. The BOK has also loosened monetary policy significantly, cutting its key policy interest rate, the base rate, by 325 basis points between October 2008 and February 2009. The base rate remains at a record low of 2%.
What do these mean?
The fiscal element of the stimulus measures focused on several aims: stabilising the livelihoods of low-income households (eg, via welfare payments); supporting the labour market through funding for retraining (with a budget of W2.8trn); aiding SMEs, exporters and the self-employed (with a budget of W4.5trn); providing funds to local governments (at a potential cost of W3.5trn); and boosting environment-friendly economic growth (with a budget of W2.3trn). However, there is likely to have been considerable double-counting, with supplementary budgets announced as new spending when some of the measures they contained probably relied on earlier funding redirected from other sources.
The fact that the budget moved from a surplus of 1.2% of GDP in 2008 to an estimated deficit of 4% of GDP in 2009, according to the Economist Intelligence Unit's calculations, suggests that most of the promised stimulus funds did translate into real additional spending. Government revenue fell by an estimated 3.9% in 2009, while expenditure rose by 18.7%. That said, many of the fiscal measures can be considered part of a broader restructuring package over four years, and these specific funding commitments may be withdrawn if the domestic economic recovery continues.
Macroeconomic Impact
Much of the fiscal stimulus spending budgeted for 2009 was front-loaded into the first half of the year in an effort to boost domestic demand during what was considered the worst phase of the crisis. South Korea managed to avoid a technical recession (defined as two consecutive periods of quarter-on-quarter decline): having contracted by over 5% in the fourth quarter of 2008, real GDP grew 0.1% in the first three months of 2009. Growth in the first quarter was driven in part by government consumption and construction investment, although the headline GDP figure also reflected a sharp contraction in imports of goods and services.
It is clear that fiscal stimulus boosted the economy during 2009 as a whole--we estimate that government consumption grew by a healthy 6.1% during the year, and while fixed investment contracted by 2.8%, most of this reflected a sharp drop in non-construction activity (a segment dominated by the private sector). In contrast, buoyed by public spending on infrastructure, investment in construction is estimated to have grown by 2.5% in 2009, the highest annual rate since 2003.
Meanwhile the largest component of the economy, private consumption, grew by an estimated 0.4% in 2009. This is much better than we were forecasting at the start of last year, and suggests that policies to support the labour market (such as employment opportunities in government projects) have shored up consumer confidence. Unemployment peaked at just 4% in March 2009 and has since been on a broadly declining trend. Private consumption also benefited from the successful stabilisation of the banking system, ensuring continued access to credit. Domestic credit rose by an estimated 7.5% in 2009, thus enabling highly indebted South Korean households to take advantage of a continued supply of loans even as record low official interest rates helped to contain their debt-servicing costs.
Business and Sectoral Impact
The banking system has benefited from the emergency measures, though mainly through their impact on confidence as a number of special facilities have not been heavily used. Concerns over liquidity shortfalls prompted the BOK to reduce policy interest rates and provide won and US-dollar swaps and loans. The establishment of the W40trn recapitalisation fund helped to address concerns over the health of domestic banks' balance sheets--though less than half of this fund has been used, largely because global financial markets have been recovering since April 2009 (institutions have therefore been able to access private investment in order to boost their capital). The toxic-asset fund has also been largely unused, as South Korean banks did not invest heavily in US sub-prime loans. Similarly, the US$100bn fund aimed at ensuring local banks retained access to foreign borrowing has turned out to have a mainly precautionary value: by August 2009 only US$8.5bn had been used.
It is difficult to assess the impact of the government's policies on the external sector, as South Korean exporters benefited from healthy demand in China for much of 2009. It is clear, though, that programmes to improve the functioning of domestic financial markets, along with government support for export credits, have been helpful in allowing local companies to continue overseas trading (without such financing they would have been unable to import components for re-export). Tax incentives, credits and grants have largely targeted manufacturing exporters, for whom the weak won has also proven beneficial. A significant proportion of South Korea's export revenue is generated by the chaebol (conglomerates), which would have benefited from access to the broader corporate restructuring fund as well as to export incentives.
Increased public-sector infrastructure spending has aided construction companies in parts of the country where projects are taking place. More generally, domestic SMEs are being helped through loan guarantees--this sector has maintained access to funding owing to these guarantees, even as the SME sector has suffered in other major OECD economies because of banks' concerns over the ability of small companies to repay their debts.
Exit Strategy
South Korea enjoys healthy fiscal resources--the budget deficit estimated for 2009 will be the first since 1982--but the country is mindful of the need for fiscal health, given the likelihood that it will one day have to absorb North Korea. Indeed, since signs that the financial system and the domestic economy have stabilised became evident in mid-2009, the authorities have been outlining plans to scale back emergency measures. On the fiscal front, welfare benefits for workers and emergency loan-support measures for SMEs will be withdrawn when the economic recovery is seen as fully sustainable. To limit waste, supplementary spending is likely to be phased out, with investment focusing on existing projects. New projects are likely to face stricter approval criteria than was the case in late 2008 and in 2009. Planned personal and corporate tax cuts are likely to remain in place, although the government is likely to remove emergency tax breaks for exporters and other companies in 2010. Nevertheless, the authorities will remain committed to using public finances if there is a further deterioration in the domestic economy.
On the financial front, the need for intervention in the foreign-exchange market has already waned, with the won now viewed as being at a level that has improved the competitiveness of domestic exporters vis-à-vis their Asian rivals. Many of the funds established in an effort to boost confidence in the financial sector remain in place. As the bulk of the funds are yet to be used, it is likely that these mechanisms will be closed only once the authorities are sure that global credit markets have normalised, with one signal being the rates and spreads that local financial institutions face when accessing these markets.
Signs of the property market growing too strongly in 2009 prompted the BOK to lower the loan-to-value ratio for customers taking out mortgages on properties in certain parts of the country. The government and the BOK are mindful of the fact that excessive liquidity played a major role in causing the housing bubble in the US and the sub-prime crisis there. Fears of excess liquidity prompting asset-price bubbles suggest that the emergency liquidity measures introduced by the BOK in late 2008 and in 2009 will be withdrawn, as long as risk aversion in global capital markets continues to decline. Monetary policy is likely to be tightened in 2010, but only cautiously. There are still concerns over the fragile state of the finances of SMEs and households, both of which remain highly leveraged.
