Korea’s recovery in 2002, which boosted output growth to 6 per cent despite a sluggish world economy, reflects both the success of the economic restructuring programme initiated in the wake of the 1997 crisis and the underlying dynamism of the economy. Reform efforts have strengthened the mechanisms for resource allocation through market forces and significantly altered the legal and institutional settings to improve governance. They have also created positive synergies with macroeconomic policies. In particular, the restoration of healthy bank balance sheets has strengthened the transmission of monetary easing to the economy, as slowing credit growth to the enterprises in the wake of corporate restructuring has been more than offset by buoyant lending to households, in part through credit cards. At the same time, tax reform measures to encourage credit-card use and thereby increase tax compliance have broadened the tax base and helped to keep the government budget in surplus. These developments laid the foundation for a rebound from the 2001 downturn led by private consumption and housing investment. However, the recovery has been accompanied by a sharp increase in household debt, rising inflationary pressures and a steep rise in real estate prices, prompting the government to take numerous measures to stabilise the housing market. Even though private consumption and housing investment are likely to moderate, output growth in the 5½ to 6 per cent range is projected for 2003 and 2004, assuming that there is a pick up in the world economy that results in a recovery in external demand. The challenge for Korea is to maintain its high growth potential by overcoming remaining structural weaknesses through further reforms, while keeping inflationary pressures under control and containing potential financial imbalances through appropriate macroeconomic policies.

Economic growth decelerated from 9 per cent in 2000 to 3 per cent in 2001 in the context of a marked slowdown in the world economy (Figure 1). However, Korea’s first downturn since the 1997 financial crisis was short-lived, thanks to robust private consumption and a rebound in construction investment, which led to a recovery beginning in the final quarter of 2001. The strong growth in these two components was driven by buoyant bank lending, reflecting success in overcoming credit-crunch conditions through a comprehensive financial-sector restructuring programme. In addition, supportive macroeconomic policies played an important role in Korea’s early recovery (see Chapter II). Economic growth accelerated to 6 per cent (year-on-year) in the first three quarters of 2002, despite weak investment in machinery and equipment and exports in the early part of the year. However, by mid-2002, exports had also rebounded, led by the information and communications technology (ICT) sector.

The relaxation of monetary policy helped to attenuate the impact of the world economic slowdown in 2001 on Korea and lay the foundation for the recovery that began in the final quarter of that year. At the same time, inflation has been kept within the annual target zone. Fiscal policy, meanwhile, played a mildly supportive role with increased government spending focused on the priority of expanding the social safety net. With economic growth picking up to 6 per cent in the first three quarters of 2002, macroeconomic policy has shifted to a more neutral stance. Indeed, the Bank of Korea, which had a medium-term inflation target of 2.5 per cent, increased the policy interest rate in May 2002 (Figure 13), in the context of double-digit wage hikes and a surge in housing prices. However, there has been no further tightening of monetary policy since then in the context of the uncertain world economic outlook and the sharp appreciation of the won in the second quarter of 2002. Meanwhile, fiscal consolidation has become a priority, given the cost of financial-sector restructuring. This chapter begins by examining monetary policy and exchange rate developments, and then discusses fiscal policy issues.

Korea has a history of fiscal prudence, reflected in relatively small budget deficits and low public debt. In gross terms, public debt is around 22 per cent of GDP, ranking well below the average of 74 per cent in the OECD area. Korea also has one of the lowest ratios of government spending to GDP (Figure 23). The level of public spending also reflects the immaturity of the social welfare system as well as the relatively low level of public services. However, Korea’s public finances are facing serious pressures for increased spending. First, population ageing is projected to be exceptionally rapid in Korea, boosting the demand for greater spending on pensions and health. Second, the state-provided social safety net will expand as Korea moves away from traditional family-provided social protection. Third, Korea needs to prepare for the cost of co-operation with the North and eventual reunification. Meeting these challenges will require dealing with structural shortcomings of the budgeting and public expenditure management system. While the public expenditure system has been successful in maintaining aggregate fiscal discipline, it is not geared toward attaining efficient allocation of resources and maximising value for money. Furthermore, maintaining fiscal discipline through the traditional budgetary tools will be increasingly difficult, given the spending pressures that will significantly increase the share of non-discretionary spending in the government budget.

Rapid growth beginning in the 1960s transformed Korea from one of the poorest countries in the world to an industrialised nation with a per capita income more than half of the OECD average (Figure 31). However, certain aspects of Korea’s economic framework left it vulnerable to contagion from the crisis that began in Southeast Asia in mid-1997. In the wake of the crisis, Korea launched a major restructuring programme to create a more market-based economy. Progress in implementing these reforms, which has been examined in the past four OECD Economic Surveys of Korea, laid a foundation for strong growth and allowed the convergence to income levels in the advanced countries to resume, after having been temporarily reversed by the crisis. Measures taken since the 2001 Survey are summarised in Box 8.