On May 8, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation¹ with the Republic of Korea.

Growth momentum that had been building since early 2013 has stalled. Average quarterly growth rate declined to about 0.5 percent in the last three quarters of 2014 from about 1 percent in the previous four quarters. A turning point was the April 2014 Sewol ferry accident which had a surprisingly large and persistent impact on consumer and investor sentiment. Headline inflation has fallen to below 1 percent, well below the Bank of Korea’s target band of 2½–3½ percent. Despite some real appreciation the current account surplus remains at around 6¼ percent of GDP, on the back of lower global oil prices and weak domestic demand.

Growth is projected to be in a range centered around 3 percent in 2015, where exceeding the midpoint would require a rebound in aggregate demand during the year, possibly from the lagged effect of the stimulus policies put in place so far and the dividend from lower oil prices. The main external risks include slower-than-expected growth in Korea’s main trading partners, the impact of a persistently weak Japanese yen on Korean export industries and side-effects from the global financial conditions.

Recognizing the challenging growth environment the authorities put in place a number of measures to spur economic recovery. The Bank of Korea lowered its policy interest rate by 75 basis points since last August to 1.75 percent. The government implemented about 0.5 percent of GDP in additional spending in 2014, followed by another increase in the 2015 budget. Other stimulus measures include increased support for policy-based lending and measures to revive the housing market.

The resilience of the Korean financial system has increased since 2008 and near-term vulnerabilities are limited. Overall household debt has been rising, but it has been matched by a corresponding increase in household financial assets rather than reflecting an increase in borrowing to finance consumption. Some of the corporate sector financial soundness indicators have weakened recently and the sector is highly segmented with growing pockets of vulnerability.

Executive Board Assessment²

Executive Directors welcomed Korea’s ongoing recovery, but noted that the economic outlook hinges on the authorities’ success in tackling remaining cyclical and structural vulnerabilities. In particular, sluggish domestic demand is holding back the pace of activity and a rebalancing away from export-led growth, while relatively low productivity in the service sector and a rapidly aging society sap potential output growth. Against this background, Directors generally saw merit in pro-active policies to shore up growth momentum in the near term, together with structural reforms to sustain it over the longer run.

Directors welcomed recent monetary, fiscal, and other policy changes to reinvigorate domestic demand. If clear signs of restored growth momentum from this counter-cyclical support do not emerge soon, additional stimulative policies should be considered to forestall an adverse feedback loop of low or negative inflation and depressed aggregate demand. In particular, Directors agreed that there remains room for further monetary easing, if needed, and that Korea’s low public indebtedness provides ample room for additional fiscal stimulus and reinforced social safety nets without prejudice to debt sustainability.

Directors commended the authorities for progress in implementing the recommendations under the 2013 Financial Sector Assessment Program and agreed that Korea’s sound financial fundamentals limit sources of short-run systemic risk. Nonetheless, they noted that the structure of household debt could be strengthened through additional steps to facilitate the transition of the mortgage market toward more stable, longer-term lending.

Directors emphasized that the country’s ability to continue growing through a heavy reliance on gaining export market share is increasingly limited. They concurred that achieving a more balanced growth path depends critically on addressing long-standing barriers to higher productivity in the non-traded goods and services sectors. Accordingly, Directors welcomed the authorities’ plans to boost Korea’s growth potential through a variety of reforms including initiatives to address labor market rigidities, support commercially viable small- and medium-sized enterprises, and foster competition.

Directors took note of the staff’s assessment that the won appears to be weaker than the level consistent with fundamentals and desired policies, but underscored that methodological shortcomings amplify the uncertainty surrounding such an assessment. In this regard, a few Directors called for more in-depth analysis of Korea’s external position and its policy implications. Directors stressed that maintaining a flexible exchange rate is essential to facilitate Korea’s adjustment toward domestic sources of growth. Accordingly, they concurred that official foreign exchange interventions should be limited to smoothing excessive exchange rate volatility and not prevent needed exchange rate adjustment.