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Korea’s Finance Gurus Battle the Global Economic Storm

Tuesday, November 22nd, 2011

South Korea’s top financial policy-makers see Korea weathering the storm of financial upheaval on world markets but acknowledge that continuing to do so won’t be easy. “A short-term effect is inevitable due to the increase of volatility from overseas uncertainties such as the debt crises in the US and Europe,” Finance Minister Bahk Jaewan told a forum staged by The Economist in Seoul in September.

Nor was Bahk sure if it would be possible to bring the economy to pre-downturn conditions. “According to an old Korean proverb, it is very difficult to restore broken bone china to its original condition,” said Bahk. “The same is true for fiscal soundness. Once it weakens, greater effort is needed for a full recovery.”

Bahk said, however, that Korea’s “economic fundamentals and financial soundness” have both improved since the 2008 financial crisis, “so the country is expected to be able to stand shocks to a certain extent.” Buttressing his argument, Bahk noted that Korea by now has foreign reserves of more than $300 billion, the world’s seventh largest, and is a net creditor with foreign bond holdings exceeding its debt by US$89.5 billion. Short-term debt, he said, accounts for 37.6 percent of the total external debt, “significantly less” than the 51.9 percent in 2008.

At the same time, Bahk said, “the country is also maintaining a relatively strong fiscal situation” with the ratio of gross domestic product to debt hovering around 33 percent, much lower figure than the OECD average of 97.6 percent.

In addition, said Bahk, “the relative stability of the bond and foreign exchange markets compared to the stock market proves that there is confidence in the Korean economy’s fundamentals and ability to respond to changes. “ Thus, he said, “the impact on the country’s real economy is limited.”

Employment, he went on, has grown for the past 10 months, with over 300,000 jobs created each month since October 2010.” Overall, he concluded, “The recovery of the economy is continuing as capacity utilization remains at a high level and industrial production continues to grow.”

Exports, meanwhile, have been increasing, up by 27 percent in August when the current global crisis started, from August of last year. “Korea’s export market is highly diversified with emerging economies accounting for over 70 percent of the total,” said Bahk, yet the delayed recovery of advanced economies like the United States will have a limited effect on overseas shipments.” Nonetheless, he warned, “if the global economic recovery continues to falter and unease remains in international financial markets, there will be a negative effect on the Korean economy.”

Kim Seok-dong, chairman of the financial supervisory commission, spoke frankly of just that danger. “My take on the ongoing uncertainty in the global markets is that it is very much an aftereffect of the 2008 global financial crisis,” he said at the same forum. “This time, however, he noted “considerable differences in the nature of the uncertainty and our capacity to deal with it.” In 2008, “in the face of a looming market collapse, policy makers around the world set a clear common goal of safeguarding the financial system and closely cooperated to achieve the goal,” said Kim, speaking at the same Economist forum. “By contrast, the uncertainty we are facing now stems from the ‘real sector’ that remains sluggish even after sustained stimulus policies for the past few years.”

The FSC chairman warned against wishful thinking. “We are not likely to see yet another round of forceful, globally unified action to tackle sluggish growth,” he said.” In fact, the reality this time may well be that the extended post-crisis expansionary policies have significantly diminished our capacity to further stimulate the economy.” He based this assessment on a hard look “at the reality of the global economy,” beginning with the euro zone sovereign debt crisis.

“Loss of autonomous exchange rate and interest rate policies more or less forced several euro-zone economies to rely too much on their fiscal options,” said Kim. “They must now grapple with a mounting debt crisis. The absence of exchange rate and interest rate flexibility also means no effective risk adjustment or cost-sharing through the market. So uncertainty persists on how long it will take for the euro-zone to make a remarkable turnaround for their economic stability.”

Kim was pessimistic about the capability of the United States to recover quickly. “For the United States, with its substantial twin deficits, it seems also difficult to restore momentum for a robust pace of recovery,” he said. “With limited fiscal options and policy rates already near zero, it is doubtful whether additional monetary easing will in fact improve the performance of the economy in any meaningful fashion. Moreover, any sudden shift in the US dollar policy aimed at spurring export growth is probably not feasible in the near term, as it will upset the existing global trade relations.”

Nor was the financial supervisory commission chairman optimistic about the outlook for Japan – or even China. “In Japan, the aftermath of the March earthquake, on top of an already underperforming economy, has heightened the likelihood of prolonged sluggishness,” he said. And China, which he described as having “served as the world’s factory and market,” was “expected to continue monetary tightening to fight inflation.” The result, he said, would “inevitably lead to a further contraction of a global demand.”

Kim summarized this view by citing the outlook expressed by World Bank President Robert Zoellick at a forum of finance ministers and regulators. While “risks to the global economy are intensifying,” said Kim, quoting Zoellick, “we have fewer options to deal with them.” It was “unlikely that the global economy will encounter a sudden and unexpected outbreak of major crisis like the one we had back in 2008,” he said, but he predicted “the economic turmoil we are facing will last for quite a long time.”

Finance Minister Bahk promised three specific steps that he said his government would take “to stabilize the financial market, recover fiscal soundness, reinforce the structure of the economy and ensure continued growth.”

For starters, he noted “the Korean economy’s high level of exposure” raised the risk of “sudden excessive movement of capital to financial markets and macroeconomic management.” In order “to facilitate close monitoring and quick responses,” Bahk said, his ministry, along with the Financial Services Commission, the Bank of Korea and other institutions “are jointly operating a monitoring system on a daily basis.”

Bakh cited three main measures that the government, anxious “to prevent sudden changes in the flow of foreign capital,” was implementing. It had “lowered the ceiling on banks’ foreign exchange forward position, revived a tax on capital gains from bonds held by foreigners, and placed a macro-prudential levy on banks for non-deposit foreign currency liabilities.” At the same time, he said the government had “introduced a tax to reduce improper use of domestically-issued foreign currency bonds,” known as kimchi bonds, in tax revisions set for next year.

Korea’s second step to deal with the crisis, said Bahk, was to “increase midand long-term efforts to recover fiscal soundness.” Rather than wait for another crisis, he said, “the government needs to enhance the country’s fiscal capability, as Korea is vulnerable to external shocks due to the small scale and large exposure of its economy.” Recovery, he added, would “make it possible to take good care of ordinary citizens, who are the first ones to suffer when there are economic difficulties.”

Setting 2013 as the goal for “achieving a fiscal balance,” he said, the government would “push for an early recovery of fiscal soundness” and carry out tight fiscal management, such as maintaining the yearly average of the expenditure increase at three percentage points lower than the revenue increase.” The government, he went on, would “also expand the tax base by modifying tax exemption and reduction systems, and manage the country more frugally by cutting expenditures on under-performing state projects.”

As for the third step, Bahk said the government would “reinforce the structure of the economy and act preemptively in response to potential risks such as household debts and savings bank insolvency to ensure that the economy will not be shaken by external shocks.” Although “the level of household debts is high compared with the level of disposable income,” he said, “the soundness of household loans and ability of repayment is at a good level, as the delinquency rate on household loans of banks is low and the high income class holds about 70 percent of the total household debt.”

However, Bahk warned, “the ability to repay debt could be hindered if economic conditions change, such as by an increase of the interest rate or stagnancy of the real estate market. Thus, he said, “there is concern that household debt could be a risk to the economy.” The government, said Bahk, had to “tightly manage the total amount of household debt so its increase will not exceed the speed of growth of the real economy.” And, in a foretaste of the closure of a number of saving banks found to be insolvent, Bahk said the government would “push for restructuring of the banks and make them prevent any recurrence of insolvency by increasing supervision and improving governance systems.”

Bahk worried, however, about “Korea’s vulnerability to external shocks.” The country “needs to set up a strong economic structure that can weather external shocks,” he said. “To this end, the government will abolish entry barriers to high value-added sectors such as medical care, education, culture and content, and push for restructuring of the service industry.” He also stressed the importance of encouraging small and medium-sized enterprises. “An economy can resist external shocks when SMEs, a basis of industries, are sound,” he said, promising a reduction in taxes on SMEs from 22 to 20 percent beginning next year.”

FSC Chairman Kim Seok-dong said, “Overall bank soundness has significantly improved” while the “the loan-to-deposit ratio, which used to hover around 120 percent, has remained stable at below 100 percent with a BIS capital ratio above 14 percent.” He stressed, meanwhile, “steps to deal with household debt and the troubled mutual savings banks.“

For household debt, “we have implemented a number of measures to bring it under control,” said Kim. As for “the distressed mutual savings banks, he said, “restructuring will pick up the pace going forward, and no systemic risk will arise from them.” In order “to make sure that the financial industry continues to thrive and advance,” he went on, “we are undertaking new efforts to promote home-grown investment banks and introduce hedge funds.”

A program to “reform our capital market system,” said Kim, would “improve market efficiency and transparency,” while revision of the Capital Markets Act would “pave the way for Korea’s financial market to be more transparent and predictable so that it can equally compete with any other financial markets.” Kim promised “more effective checks and balances on the management” and “tighter oversight on the banks’ risktaking activities.” And, he said, “We will be looking to revamp the financial consumer protection structure as key part of our push for the advancement of the financial system.

Kim wound up with a reminder of the origin of the word “crisis,” from the Greek word “krinein,” a medical term meaning the turning point of a disease, for better or worse. “In the East, the word ‘crisis’ similarly denotes the duality of risk and opportunity,” he said. “In many ways, Korea’s success over the decades—the Miracle of the Han River—has been made possible by turning risk into opportunity to renew, reinvigorate, and regenerate.” In that spirit, said Kim, “We will continue to look for new opportunities to sustain the dynamic growth of the Korean economy.”

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