The following OECD assessment and recommendations summarise Chapter 2 of the Economic Survey of Korea 2005 published on 5 October 2005.
With the rebound in domestic demand still hesitant…
Structural factors have contributed to the weakness of domestic demand since the 2003 recession. Households have reduced consumption following the run-up in debt during the credit card bubble of 2001 and 2002, while the corporate sector has been reluctant to expand investment despite a high level of profits. The acceleration of real export growth to a historical high of 20% supported output growth of 4.6% in 2004. However, with exports slowing significantly in the first half of 2005, due in part to weaker demand from China, output growth will fall short of the government’s goal of 5% for the year. Although there are some signs of a pick-up in domestic demand, output growth may slow to around 4% for the year, with faster growth in 2006 as domestic demand strengthens.
…the Bank of Korea should keep short-term interest rates low, while limiting intervention in the currency market …
The central bank should maintain low interest rates until aggregate demand is on a sustained recovery track in the context of the medium-term inflation targeting framework introduced in 2004. The Bank has supported demand by keeping the short-term policy rate at a record low of 3¼ per cent since November 2004. With the core consumer price index rising almost 3% year-on-year in the first half of 2005 – near the midpoint of the inflation target of 2½ to 3½ per cent the real short-term rate is close to zero. The impact of low interest rates has been partially offset by the rising exchange rate, which gained 12% on a trade-weighted basis between the first quarters of 2004 and 2005. This appreciation occurred despite significant foreign exchange market intervention, which boosted reserves to $205 billion by early 2005, the fourth-highest in the world. With reserves now more than three times larger than Korea’s short-term foreign debt, there is little rationale for further reserve accumulation. The apparent scaling back of intervention since the beginning of 2005 should thus continue. Moreover, a stronger won has the positive effect of re-balancing the composition of growth from exports to domestic demand. It is important to carefully monitor the new schemes created to manage foreign exchange resources -- such as the Korea Investment Corporation -- so as to avoid losses.
… despite increases in real estate prices in some areas
The Bank of Korea is under pressure to raise interest rates to stabilise the upward trend in real estate prices in some parts of the country. Prices of apartments in certain districts of Seoul rose 10% in the first half of the year, although on a nation-wide basis, prices are up less than 4%. However, interest rate hikes are a blunt instrument for influencing real estate prices and would be harmful to the nascent recovery in domestic demand. The economic impact of rising real estate prices in specific regions is likely to be limited, although it may raise equity issues about the distribution of wealth. Such concerns should be addressed by targeted measures, such as ensuring that the capital gains tax is adequate to achieve the desired level of redistribution. Policies to deal with real estate prices should be market-friendly. In particular, the authorities should end the stop-and-go pattern of imposing regulatory measures aimed at stabilising prices, and then periodically removing such measures to boost the construction sector.
Housing price trends
Source: Kookmin Bank.
Additional fiscal stimulus appears to be unnecessary…
The easing of monetary policy has been accompanied by a mildly expansionary fiscal policy stance in 2004 and 2005. The consolidated central government deficit – excluding the social security surplus and the cost of financial restructuring – is projected to rise in 2005 from ½ to 1% of GDP. This reflects a 1 percentage point cut in income tax rates and the elimination of special excise taxes on some luxury items. In addition, nearly 60% of expenditures were frontloaded in the first half of 2005, which may result in a decline in government outlays in the second half of the year in the absence of a supplementary budget. However, spending by state-owned enterprises and private-sector investment in infrastructure will increase in the latter half of the year. Given the recent upturn in domestic demand, additional fiscal stimulus appears unnecessary. The priority should be to achieve the medium-term framework’s objective of a balanced budget, excluding the social security surplus, by 2009.
…and public-private partnerships should be pursued with care to limit contingent liabilities
To boost fixed investment, the government recently launched a public-private partnership plan, which aims at attracting private-sector participation in the provision of infrastructure under a “build-transfer-lease” approach. The government and private sector are expected to agree on total spending of 6 trillion won (0.8% of GDP) in 2005 and a cumulative 24 trillion won by 2007. The private sector is projected to spend 0.5 trillion won on these projects in 2005. Given that these projects will take up to four years to complete, the programme should not be pursued as a countercyclical policy. Instead, joint public-private projects should be selected on the basis of their long-term economic benefits and the programme should be anchored in the medium-term framework. Moreover, contracts with firms need to be carefully crafted to control the government’s expenses and contingent liabilities. Limiting increases in public debt should be a top priority, given the spending pressures, particularly for population ageing. Indeed, Korea’s elderly dependency ratio, the third-lowest in the OECD area in 2000, is projected to be the third-highest by 2050.
Systemic reform of the public pension system is an urgent task
Given the rapid ageing, fundamental reform of the public pension system is urgent. Under the current parameters -- a contribution rate of 9% and a benefit replacement rate of 60% -- the National Pension Scheme (NPS) would run deficits by 2036 and its Fund would be exhausted by 2047. Ensuring the sustainability of the NPS would require a contribution rate of around 20%, which would likely have a negative impact on the labour market. Korea needs a more systemic reform of the pension system to ensure its sustainability, while providing adequate coverage. In 2004, 12.4 million persons -- a little more than half of the labour force -- paid contributions to the NPS. In addition, there appears to be a considerable under-reporting of income by the self-employed. The authorities should immediately adjust the parameters of the earnings-related public pension to sustainable levels, which implies lower benefit rates. Furthermore, the tax-financed means-tested social programme, which currently has limited coverage, should be gradually transformed into a universal basic pension, with a relatively low flat rate. The scope of such a two-tier system depends on the availability of fiscal resources and may require measures to reduce the basic pension benefit to the wealthy. Given the small number of persons currently receiving public pensions, it is essential that the means-tested programme be adequate to lower the relatively high incidence of poverty among the current elderly population as well as those entering retirement before the introduction of the basic pension.
The National Pension Scheme is not sustainable
1. Including investment earnings.
2. Including administrative costs.
Source: National Pension Research Institute.
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