Reforming the Domestic Credit Card Market*

Byung Duck Kim**

─────────────────

* This thesis contains personal views of the author and does not reflect official views of Korea Institute of Finance.

** Research Fellow, Korea Institute of Finance

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I. Introduction

There have been drastic changes in the domestic credit card industry recently. The transaction volume of domestic credit cards has rocketed since 1999 as the government made several policy arrangements, such as income tax deduction, to promote credit card usages. As the credit card business was regarded to be very lucrative, many banks began to spin off their credit card business units as independent subsidiaries and increasing number of conglomerates tried to enter the market. In addition, excessive competition among credit card companies induced careless card issuances without proper credit screening and illegal collections of bad debt.

In response, the Financial Supervisory Service announced an extensive regulation package for the domestic credit card industry in May 2002. Along with the ever increasing total volume of domestic consumers' borrowing, domestic credit card companies began to experience bad debt problems and their short term business prospects began to deteriorate.

The purpose of this paper is to analyze in- depth the structure of the domestic credit card industry and deliver some reform proposals to address the problematic issues. This paper is composed of 4 chapters. After the introduction in Chapter I, the current status of the domestic credit card industry is explained in Chapter II. Related issues are raised and reform ideas are proposed in Chapter III. Chapter IV consists of a short concluding remark.

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II. The current domestic credit card industry

1. Market Structure

Several economic agents are involved in a series of bilateral transactions for credit cards to be used as a medium of payment. Involved agents are card holders, merchants, card issuers, sales slip acquirers, and VAN(Value Added Network) providers.

Bilateral transactions among involved agents are explained in <Figure 1>. In particular, VAN providers supply card usage authorization services for merchants in return for commission. For cases when domestic card holders use their credit card abroad, abroad sales slip acquirers settle transactions with domestic card issuers via international brand association such as VISA or Master Card. 

<Figure 1>            Domestic Credit Card Market 

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The US Credit card market, considered as one of the most developed markets, has a slightly different structure from that of Korea. In the US, brand associations such as Visa and Master Card are in charge of transaction settlement between cards issuers and sales slip acquirers. Also, their business includes marketing of their brands, transaction rule making for member institutions, and arbitration for any disputes regarding any transactions.

Another striking difference is that, in Korea, card issuers and sales slip acquirers are the same entities, the 25 currently existent card companies, whereas in the US, the markets for issuers and acquirers are very much segregated. For example, the card issuers market in the US is composed of more than 6,000 various entities ranging from commercial banks, credit unions, thrifts, to even department stores, and most of these do not engage in sales slip acquiring business. The segregation of the two markets in the US mainly originates from the differences in the key success factors of the issuing and acquiring businesses. In the issuing market, the key success factors are thought to be competitive marketing power and channel diversification, thereby, engendering many viable small sized niche players. 

<Figure 2>                US Crdit Card Market 

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The key success factor of the acquiring market is the cost effectiveness of automatic data processing, resulting in a very concentrated market structure, that is, the sum of market shares of top 10 companies is about 70%. In the US, several information processors have been acting as the acquirer's processor either as a joint venture or by a long- term business contract. In the Korean market, every credit card company with a business license to cover both issuing and acquiring, actually engages in both. 

2. Credit Card Companies

In the domestic market, 25 financial firms, specifically, 9 credit card companies and 16 banks(7 commercial banks, 6 regional banks, 3 specially licensed banks and 1 foreign bank) engage in the credit card business. 

The size of the domestic credit card market has exploded since 1999. For example, the sales volume, number of card issuances, and number of merchants at the end of 2001 grew 4.88 times, 2.29 times, and 2.04 times, respectively, since 1999. The government's policy arrangement, including income tax deduction for credit card usage and free credit card receipt lottery, was one of many reasons to trigger the rapid growth. As the financial status of the credit card companies improved dramatically with a growing market, credit card businesses began to be regarded as pretty lucrative and there have been numerous efforts by others to enter the market. However, the criteria for entry as set by the Financial Supervisory Committee are somewhat restrictive, causing no brand new entries in the market. Some conglomerates had to take a "detour" to enter the market, by acquiring existing credit card companies. 

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<Table 1>               Credit Card Companies 

(As of 2001.12)

1) Sales volume, number of cards issuance, and number of merchants of credit  card companies include those of affiliated banks

2) Sales volume includes cash advances and short- term loans.

3. Card Holders

As of the end of March 2002, the average number of credit cards per economically active person was about 4.3, which is somewhat higher that of foreign countries. The reasons attributed to multiple card holding per person are not only 

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that some financially distressed card holders use cash advances from multiple credit card companies, but also excessively competitive card issuance by market players produced a substantial volume of unused credit cards.

The age distribution of card holders, as shown in the example of one domestic bank, is as follows; age 20~29: 29%, age 30~39: 35% age 40~49: 21%, age 50~59: 9%, and age 60 and above: 3%. Since the age groups belonging to 40's and 50's are thought to have the largest disposable asset, we can conclude from the age distribution of card holders that there does not exist a close relationship between the asset level and credit card holdings. 

4. Merchants

As of the end of March 2002, the total number of credit card merchants was around 13.2 million, which is about twice as much as that at the end of 1999. Even though a "common merchant network system" was introduced in 1999, most merchants maintained multiple networks with several credit card companies, resulting in more than 5 networks per merchant. This "one merchant -  multiple credit card companies" network is one of the peculiar features of the domestic credit card market.

The current commission fee for merchants ranges from 1.5% to 3.7%, differing for various businesses. The commission fee for merchants is determined by various bargaining factors between merchants and credit card companies, such as the sales volume of the merchant, marketing incentives, and so on. 

<Table 2>           Commission fee for merchants 

source: Federation of NBFIs, end of August, 2002.

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5. VAN(Value Added Network) providers

The KOCES(Korea Credit- card Electronic settlement Service) was established in 1999 to operate the "common merchant network system". Major shareholders of the KOCES are the credit card companies and the Federation of NBFIs. In addition to the KOCES, there are about seven VAN providers, whose main businesses are to provide authorization terminal(CAT terminal) supply and card usage authorization service for merchants.

III. Issue Analysis

1. Bad debt problems of Credit Card Companies

The recent surge of household debt, especially those related to credit cards, invoked much concern among the policy makers and financial community. Credit card debt is not collateralized at all, and its status tends to be heavily affected by the business cycle and fluctuation of household income. An excessively high household credit card debt can be a cause for concern since it may aggravate the unsound financial structure of households. The bad debt ratio of credit card companies has increased sharply since the second half of 2002 and data show that bad debt originate mainly from cash advances and short- term loans, rather than from sales slip settlement. The increased bad debt ratio of credit card companies has started to have negative effects on the credit card companies' earning prospects.

Several factors, such as increased sharing of information among financial institutions, including credit card companies, and reduction of the cash advance limit by credit card companies, are responsible for increasing the bad debt ratio of credit card companies. Since a more active risk management of card companies is under way, the bad debt ratio may increase for the time being, but will gradually be 

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under control as the risk management efforts of credit card companies take effect. 

In May 2002, the Financial Supervisory Services announced a comprehensive package of prudential regulations regarding the credit card market. The main substances of the package were the various consumer protection measures, and gradual reduction of the non- core business ratio of credit card companies to 50% by next year. The regulation over the non- core business ratio of credit companies had been used in the past, but was abolished in the process of financial deregulation. Resorting to this type of direct regulation of business portfolio of financial firms is not desirable and does not conform to international standards. However, the Financial Supervisory Service seems to acknowledge that the current level of lending to households is somewhat dangerous and that there are no other measures than direct regulation to oversee the credit card companies. 

In response, credit card companies have expanded their core- business volume to meet the newly announced non- core business ratio. Since the portion of credit card usage out of total consumer consumption is around 50%, which is somewhat lower than that of other countries, for example 70% in US, there is still room for more credit card usage per consumer. 

2. Entry Policy for Credit Card Industry

The current law regarding the NBFIs(Non- Bank Financial Institutions) specializing in lending specifies strict license requirements for starting a credit card business. In fact, there has not been new entry into the market since 1989 due to the strict requirements. The newly amended entry requirements in July of 2001 are shown in <Table 3>. The minimum paid in capital and IT facility requirements still seem to be very restrictive, actually becoming a systemic entry barrier. 

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<Table 3>       Entry requirement for Credit Card Industry

Due to the current restrictive entry criteria such as the required minimum capital (20 billion won), branches, clients, and cash at hand, applicants with a small capital base, outsourcing some parts of the business such as IT and data processing, cannot enter the market. In contrast, in the US, many small sized financial firms such as thrifts, credit unions, NBFIs, and even data processing firms actively participate in the credit card business. If the structure of the domestic credit card industry gets more competitive by allowing more diversified classes of market players, problems of collusive price setting by the current market players are expected to be more or less resolved. It is presumable that the financial supervisory authority may adjust the entry criteria, the capital size of the applicants or the degree of outsourcing used by the business, so that new entry into the market is made possible. 

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<Table 4>     Business Outsourcing in US Credit Card Market

(Unit : %)

Note:「Group I : Asset level less than 1 million $, Group II : Asset level ranging 1~5 million $,  Group III : Asset level above 5 million $」

Source: American Bankers Association

<Table 5>   Distribution of Top 100 Credit Card Issuers in US (year 2001) 

Source: Nilson Report

Also, the entry policy of the domestic credit card industry should be considered in connection with the current common merchant network system, one of the peculiar features of the domestic market, which will be explored further in the next chapter. 

3. Common Merchant Network

The current common merchant network was introduced in September 1999, in the spirit of promoting the welfare of consumers and merchants and reducing the 

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redundant marketing costs of credit card companies. For settlements via common merchant network, the KOCES has been established, to settle the sales slips of different credit card companies. However, most merchants do not use the common merchant network and rather sign bilateral network contracts with each credit card company.  In fact, the current network system of the domestic market can be described as a type of "one merchant-  multiple credit card companies". This type of multiple network system is driven by the aggressive marketing efforts of credit card companies to secure their own merchant network.

Under the current system, for brand new credit card companies to enter the market, a huge initial joining fee to use the common merchant network is charged. Otherwise, the new credit card companies have to establish their own merchant networks from scratch. In fact, this kind of exclusive merchant network system works as one of the entry barriers to the market, which the existing market players want to exploit to block the new comers. 

It is very doubtful that the current "one merchant-  multiple credit card companies" system is desirable from the social- economic point of view. If every brand new credit card company has to build its own merchant network, namely signing contracts with millions of merchants, the social waste and actual marketing costs will be enormous. The inefficiency of this kind of a merchant network and its social cost will be borne by consumers in the end, directly or indirectly. 

To prevent the current merchant network from acting as an entry barrier, resulting in an inefficient and oligopolic market structure, the financial supervisory authority has to step in the bargaining process of determining the joining fee for the common merchant network. If possible, it is recommended that the FSS be more legally empowered to intervene in the bargaining process.

In the long run, the current "one merchant -  multiple credit card companies" 

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system should be transformed into a "one merchant -  one credit card company" type of a network system. This structural reform of the merchant network system is expected to improve the welfare of the consumers and merchant enormously, and is a prerequisite for the development of a more competitive market structure. 

4. Determination of Interest Rates and Commission

The prudential regulation package announced in last May includes various measures to limit the amount of cash advance commission charged by credit card companies. In principle, commissions levied on consumers and merchants by card companies are prices of financial services, and are better determined by market mechanism. However, market mechanisms often do not work well for a number of reasons. Let us take an example from the US. The US credit card industry, having a much more competitive market structure than the domestic market, experienced resiliently high interest rates while the market interest rates were lowered substantially in the mid 1980s. The US Congress tried in vain to legislate an act to reduce the interest rates of credit cards.  In the end, the interest rates of credit cards in the US market began to decline after many credit card companies adopted the variable rate system in the mid 1990s. 

What will be the solution for the domestic market? It is important for the regulatory authority to prohibit collusive behavior of the card companies. However, it is hard to identify such behavior. A more basic and fundamental approach will be to make the industry structure more competitive, which is largely determined by the entry and exit policy. The more competitive the industry structure becomes, the more elastic consumers' demand of credit card services is. In addition, to amend market incompleteness due to information asymmetry, public disclosure regarding commission and other related service fees should be improved in a more consumer friendly way. 

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5. Consumer Protection

The prudential regulation package of last May also contains a number of consumer protection measures, namely, the prohibition of card issuance without proper income identification, protection from card loses, arbitration for dispute between consumers and card companies, and prohibition of illegal collection of debt and dissemination of cardholders' information by card companies. The current status of consumer protection for credit card usage is at par with the international standards. 

The next task for the regulatory authority is to implement more efficiently the above measures in the context of the domestic market. In addition, it will be desirable to repackage various financial transaction related consumer protection measures that are currently under different acts into one compact consumer protection act.

IV. Conclusion

This paper analyzes the current status of the domestic credit card market, raises several issues, and proposes possible remedies. 

Numerous economic agents, such as card holders, card companies, merchants, and VAN providers, are involved in credit card transactions. In conjunction, conflicts of interest are very much possible in most cases. What should be the philosophy of the regulatory authority as a rule maker, to solve these conflicts of interest? This question coincides with "What will be an objective function or social utility function of the regulator as a social planner?". The author's view is that the social utility function should be "to maximize welfare or utility of consumers subject to resources constraints", not of card companies, or merchants. According to the principle of economics, a competitive equilibrium leads to the utility maximization of consumer

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s. Regulators may keep this proposition in mind whenever they need to solve conflicts of interests.

The history of the domestic credit card market is fairly short and there are not much data accumulated, nor rigorous research works. Additional research that address the issues raised above are expected in the future.

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Reference

Kim, BD(2001), Development of domestic credit card market, manuscript, Korea Institute of Finance,

Kim, BD and Lee, GB(2002), Issues of domestic credit card market, manuscript, Korea Institute of Finance

Kim, BD and Lee, GB(2002), Consumer protection for domestic cardholders, manuscript, Korea Institute of Finance

Kim, SC(1999), Consumer protection for cardholders and related legal issues, Korea Consumer Protection Board

Lewis Mandell(1990), The Credit Card Industry, A History, Twayne Publishers

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Macroeconomic Developments

Current Status and Prospects

Economic Growth

1) Review

According to the National Accounts (provisional version) by the Bank of Korea in August, the Korean economy grew 6.3 percent in the second quarter of 2002 as a result of the upbeat trends in equipment investment and exports, in spite of a slight slowdown in private consumption and construction investment <Table 1>. By sector, private consumption grew by 7.7 percent in the second quarter of 2002, supported by an increase in semi- durable goods spending, such as purchases of books and clothes, and although durable goods spending, including computer and wireless telecommunication apparatus purchases, decreased. The rate of construction investments dropped down to 4.1 percent from 10.1 percent in the first quarter. The drop was attributable to a decrease in investments for social overhead capital, including those for building airports and railroads, in spite of the rise in investments for residential and commercial buildings. Equipment investments increased by 7.7 percent as investments in general and in precision machinery and transportation equipment, including trucks, and vessels, in particular, rose. Total exports rose by 11.8 percent as exports of semiconductors, telecommunication apparatus, and computers increased largely, despite a drop in service exports. Total imports increased by 19.2 percent during the same period, due to the large increase in imports of services, consumption and capital goods.

In the second quarter of 2002, the GDI (gross domestic income), an indicator of the real purchasing power of income from production activities, rose by 6.4 percent, 

- 20 -

surpassing the GDP growth rate for the third consecutive quarter <Table 1>. This was fueled by the improved terms of trade. A decline in the price of major exports,

<Table 1>         Trend and Forecast of Economic Growth¹⁾

(Unit: %)

Notes: 1) Year- on- year percentage changes. Figures after the first quarter of 2002 are KIF forecasts. 

2) Goods and services.

3) GDI (gross domestic income) = GDP + profit and loss of trade due to the change of terms of trade.

4) GNI (gross national income) = GDI + net factor income from the rest of the world. 

Sources: The Bank of Korea, National Accounts, various issues.

<Table 2>             Contribution Ratios by Factor¹⁾

(Unit: %, %p)

Notes: 1) Figures after the first quarter of 2002 are KIF forecasts. 

2) Year- on- year percentage changes. 

Sources: The Bank of Korea, National Accounts, various issues.

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including information communication facilities and semiconductors, was less than that of import goods, including crude oil and machinery. The GNI (gross national income) increased by 6.2 percent, lower than the level of GDP and GDI, due to the decrease of net factor income from the rest of the world and despite an improvement in terms of trade. 

In the third quarter of 2002, Korea's GDP is estimated to grow by 6.5 percent, which is up from the previous quarter. Private consumption and construction investments are forecasted to grow by 7.0 percent and 3.4 percent, respectively, which are relatively slower than the growth rates exhibited in the previous quarter. In the National Accounts, however, total exports are forecasted to grow by 17.2 percent due to an increase in exports of vessel, steel, machinery and IT products, including semiconductors, wireless telecommunication equipment and computer, in conjunction with a worldwide IT industries recovery. Equipment investments are forecasted to increase by 8.3 percent due to an increase in domestic machinery imports and basis effect.

<Figure 1> Service Activities, Service Production and Growth Rate of the GDP 

Note: The peak of the business cycle (P) in August 2000 and the trough (T) in August 2001 are KIF forecast. 

Source: The Bank of Korea, National Statistical Office.

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<Figure 2>                 Industrial Production

Note: The peak of the business cycle (P) in August 2000 and the trough (T) in August 2001 are KIF forecast. 

Source: National Statistical Office.

<Figure 3>        Growth Rate of Producer's Shipment

Note: The peak of the business cycle (P) in August 2000 and the trough (T) in August 2001 are KIF forecast. 

Source: National Statistical Office.

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The estimated 6.5 percent GDP growth rate in the third quarter is based on the  increasing trends of consumption and product activities that were sustained between July and August, as well as the rebound in equipment investments <Table 3>. The industrial production index increased by 8.7 percent in July and 8.5 percent in August, respectively, circumventing the 5.3 percent slump temporarily recorded in June <Figure 2>. Excluding semiconductors, however, the index increased by 2.5 percent and 2.3 percent in July and August, respectively.

Producers' shipments rose by 7.6 percent in the second quarter and by 7.3 and 7.6 percent in July and August, respectively, as the shipments of semiconductors, vehicles, and audio telecommunication apparatus picked up. Following the previous quarter, from July to August, the rate of producers' shipments for exports was higher than that of producers' shipments for domestic use, which declined during the same period <Figure 3>.

Producers' inventory of finished goods continued to decline by 13.6 percent in July and 11.8 percent in August as the inventory of semiconductors and machinery dropped significantly <Figure 4>. The average operation ratio marked 75.3 percent

<Figure 4>                   Inventory Cycle 

Source: National Statistical Office.

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in July, which is lower than the 75.8 percent in the second quarter, but increased to 77.1 percent in August. 

During the third quarter, private consumption is expected to grow by 7.0 percent as expenditures on durable goods, including automobiles and cellular phones, and semi- durable goods, including clothes and books, rise. The 7.0 percent growth is 0.7 percent lower than the 7.7 percent rise experienced in the previous quarter. The wholesale and retail industrial activities grew by 6.3 percent between July and August, only slightly lower than the 6.4 percent recorded in the second quarter, according to the indices, due to the extended sales of vehicles, telecommunication apparatus and machinery for electric use. <Figure 5>. Another consumption indicator, the shipment of consumption goods based on domestic demand, jumped to 8.6 percent between July and August. The growth was due to an increase in demand for automobiles, large- size refrigerators, and televisions, and was much higher than the 4.3 percent growth of the previous quarter. The consumer evaluation index,

<Figure 5>              Consumption

Note: The peak of the business cycle (P) in August 2000 and the trough (T) in August 2001 are KIF forecast. 

Source: National Statistical Office.

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<Figure 6>              Equipment Investment 

Note: The peak of the business cycle (P) in August 2000 and the trough (T) in August 2001 are KIF forecast. 

Source: National Statistical Office.

<Figure 7>              Construction Investment 

Note: The peak of the business cycle (P) in August 2000 and the trough (T) in August 2001 are KIF forecast. 

Source: National Statistical Office.

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which reflects the consumers' evaluation of the current economic and living conditions, however, recorded 103.7 between July and August, down from 107.6 recorded in the second quarter.

Corporate equipment investments in the National Accounts are estimated to increase by 8.3 percent year over year during the third quarter, which is higher than the 7.4 percent of the previous quarter. According to the National Statistical Office, the estimate of equipment investments decreased by 3.3 percent in July, but increased by 1.3 percent in August due to a rise in the investment of vehicles

<Table 3>             Industrial Activities Indices 

(Unit : yoy, %)

Note: 1) End of period.

Sources: National Statistical Office, Monthly Statistics of Industrial Production, various issues.

The Bank of Korea, Money & Banking Statistics, various issues.

- 27 -

and industrial machinery <Figure 6>. Machinery imports also rose by 30.2 percent between July and August, as imports of industrial machinery and motor vehicles rose significantly. However, the domestic shipment of machinery increased by only 2.0 percent between July and August, which was much lower than that recorded in the first and second quarter <Figure 6>, <Table 3>. Domestic machinery orders, a leading indicator for equipment investment, increased by 28.6 percent between July and August due to an increase in shipment of the electric power and public transportation products, wholesale and retail, and construction industry products.

As the private construction orders declined and public orders decreased significantly, the value of completed domestic constructions rose by 2.6 percent between July and August, down from the 3.8 percent increase experienced in the second quarter <Figure 7>, <Table 3>. Domestic construction orders, a leading indicator for construction investment, rose 35.4 percent due to an increase in railroad, and office building construction, which was much higher than the 8.8 percent increase in the previous quarter.

2) Forecast

According to the Bank of Korea's󰡐Business Survey Index During the Third Quarter of 2002󰡑, all BSIs were lower than the basis (100), which means that businesses currently take a pessimistic view of the current economic situation <Figure 8>. The manufacturing industry's BSI fell to 99 in the third quarter, down from 114 in the second quarter. The BSI of equipment investments decreased to 99 in the third quarter, down from 103 in the second quarter. The BSI of profits was reduced to 90 in the third quarter, down from 98 in the second quarter. However, most of BSIs' forecasts for the fourth quarter were higher than the basis (100), although they were lower than those of the previous quarter. The Korean economy is expected to sustain the trend of business recovery in the fourth quarter.

It is very hard to forecast the economic trend at this point in time because the whole world is under increased uncertainty, caused by the delay of the U.S. 

- 28 -

economic recovery and the possibility of war between the U.S. and Iraq. Consumption, investment, and exports will inevitably be affected greatly by the future development of the war in the Middle East region. Although there was much talk about the recovery of the U.S. economy based on various macroeconomic indicators, the tension between the U.S. and Iraq might push the time of recovery further into the second half of next year. Furthermore, if the instability of international crude oil price and exchange rate due to a war between the U.S. and Iraq induce a world economic recession, exports will not be the leading force to pull the Korean economy out of recession in the fourth quarter. Although the Korean economy has achieved a relatively high growth rate, unlike its competitors in East Asia, Korea also depends heavily on the strength of the U.S. market, as well as other Asian countries for exports. In addition, if the U.S. economy experiences a deflation, it might lead to a world economic recession.

<Figure 8>   Trends of Forecasted Business Survey Index (BSI)

Note: The peak of the business cycle (P) in August 2000 and the trough (T) in August 2001 are KIF forecast. 

Source: The Bank of Korea.

- 29 -

The cyclical component of the coincident index, an indicator of current economic trends, decreased to 99.6 in July and 99.1 in August, down from 100.1 in June. This downturn was caused by the decreased number of workdays during the World Cup and summer holidays in July, and the labor disputes in the automobile industry. In this respect, the downturn in the third quarter seemed to be temporal and is not expected to continue during the fourth quarter. The leading composite index recorded a 6.0 percent increase year- on- year, down 0.6 percent from the 6.6 percent year- on- year increase recorded in July, showing a generally decreasing trend. However, the economic condition is not expected to enter the contraction phase in the fourth quarter, because the leading composite index is ahead of the actual economic performance by 8～13 months.

During the fourth quarter, the Korean economy is expected to exhibit stable growth. The growth will be aided by a rise in exports, especially in semiconductors, along with the increase in semiconductor prices, and a basis effect due to the low- base of last year. Whether the Korean economy will continue to 

<Figure 9> Changes in the Leading CI and Cyclical Component of the Coincident CI 

Note: The peak of the business cycle (P) in August 2000 and the trough (T) in August 2001 are KIF forecast. Shade on the figure indicates economic slump in U.S.

Source: National Statistical Office. 

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grow resiliently or not, will depend on the prospect of the U.S. economy. Futhermore, the concern over an outbreak of a war between the U.S. and Iraq will dampen investment and consumption sentiments in Korea. The forecast is based on the leading economic indicators and business sentiment indexes, including the consumer expectation index and BIS. In the fourth quarter, the GDP is expected to grow by 6.3 percent, as consumption will grow at a slower pace. On the other hand, equipment investment and exports will rebound because of the basis effects for this period <Table 4>.

By Sector, private consumption is expected to record a 6.6 percent growth, which is slower than that of the third quarter as well as that of the second half of this year. This slowdown is attributed to the volatile performance of the stock market, governmental efforts to deter a rise in consumer lending, and a downward trend in GNI growth, which denotes a decrease in the real purchasing power of income. Two leading indicators presented below, namely, the Consumer Expectation Index and the Consumer Evaluation Index, predict a decrease in private consumption. According to a survey by the National Statistical Office, the consumer expectation index, which predicts the consumption pattern of the next six months, sharply decreased to 103.9

<Figure 10>          Trends of Dow Jones and KOSPI

Source: Bloomberg.

- 31 -

<Figure 11>                  Trends of GDP

Note: The peak of the business cycle (P) in August 2000 and the trough (T) in August 2001 are KIF forecast. Shade on the figure indicates economic slump in U.S.

Source: The Bank of Korea, Bloomberg.

<Table 4>          Trend and Forecast of Economic Growth¹⁾

(Unit: %)

Notes: 1) Year- on- year percentage changes. Figures after the first quarter of 2002 are KIF forecasts.

2) Goods and services 

Sources: The Bank of Korea, National Accounts, various issues.

- 32 -

<Table 5>      Contributions to the Growth Rate by Factor¹⁾

(Unit: %, %p)

Notes: 1) Figures after the first quarter of 2002 are KIF forecasts. 

2) Year- on- year percentage changes. 

Sources: The Bank of Korea, National Accounts, various issues.

<Figure 12>  Consumer Expectation and Consumer Evaluation Index

Note: The peak of the business cycle (P) in August 2000 and the trough (T) in August 2001 are KIF forecast. 

Sources: National Statistical Office, Monthly Statistics of Industrial Production, various issues. 

- 33 -

in September from 110.6 in June <Figure 12>. The consumer evaluation index, which measures the consumers' outlook on the growth of the economy and in spending for the next six months, sharply decreased to 97.2 in September, the lowest value since December last year, from 102.1 in August. The BOK's spending plan, as indicated by the consumer survey index (CSI), which is used to plan and forecast the level of consumption, tells a similar story. The CSI went down to 116 in the third quarter from 120 in the previous quarter <Table 13>. These three figures signal a slowdown in consumption sentiment and negative expectation for future economy. In the circumstance that equity prices can greatly affect the level of consumption, if stock prices do not rebound from the current bearish phase, private consumption might decrease in addition by the negative wealth effect <Figure 14>.

Equipment investments in the National Account are forecasted to increase by 7.7 percent in the fourth quarter, which is lower than the 8.3 percent increase in the third quarter of this year, due to a possible slowdown in the economy and exports. The possibility of a reduction in investments still lingers as firms may continue to be

<Figure 13>                Spending Plan CSI

Note: The peak of the business cycle (P) in August 2000 and the trough (T) in August 2001 are KIF forecast. 

Source: The Bank of Korea.

- 34 -

reluctant to expand facilities due to the uncertainties in the domestic and global economies. The Korea Development Bank announced that the trend of forecasted Business Survey Index (BSI) continued to increase since the third quarter of 2001, while the BOK and KCCI announced that it would be higher than the basis (100) but lower than that of the third quarter <Figure 15>. 

During the first half of this year, construction investments increased significantly, due to the expectation of economic recovery, low interest rates, and the increase in mortgages. Construction investment is expected to grow by 2.9 percent year- on- year in the fourth quarter, which is lower than the 3.4 percent increase in the previous quarter. The downturn will be attributed to the uncertainties in the domestic economy and the instability in the real estate market. Although completed domestic construction increased significantly between June and july, centering around the construction of residential buildings, it is expected to exhibit a downward trend because of a slower increase in housing prices and the tighter regulation on rebuilding of old apartments. However, construction orders increased significantly between July and August, possibly leading the future construction investments in a positive direction.

Exports are expected to rise by 16.2 percent year- on- year in the fourth quarter, which is lower than a 17.2 percent rise experienced in the third quarter. This will be supported by a rebound in the IT industries, a rise in exports, including automobile and home electric appliance exports, and a basis effect due to a low- base in the second half of last year. However, the possibility for a weak export market may persist, due to the strong won and rising uncertainties in the world economy. Imports are expected to rise by 15.4 percent in the fourth quarter, which is lower than the 18.1 percent increase in the third quarter of this year, due to a decrease in imports of raw materials such as crude oil. 

- 35 -

<Figure 14>           KOSPI and Private Consumption

Note: The peak of the business cycle (P) in August 2000 and the trough (T) in August 2001 are KIF forecast. 

Source: The Bank of Korea, Bloomberg.

<Figure 15>          KOSPI and Private Consumption

- 36 -

Price and Wage

1) Review

During the third quarter of 2002, the consumer price index (CPI) increased by 2.6 percent year- on- year, and by 0.5 percent sequentially <Table 6>. Although agricultural product prices, housing rent, and private service fares jumped significantly, the CPI maintained its level from the previous quarter (2.7 percent), as the prices of public services declined concurrently. As for CPI by commodity and service group, agricultural and marine product prices increased by 4.6 percent year- on- year as the shipment volume was reduced by a localized torrential downpour in August and a typhoon at the beginning of September. Moreover, housing rent and personal service prices continued to increase and recorded a 5.7 percent and 3.9 percent growth year- on- year, respectively. However, a fall in public utility prices and a stable trend in industrial product prices helped to maintain the CPI at a stable level this quarter. 

As for the monthly CPI figures, in July, the CPI decreased by 0.3 percent sequentially, but increased by 2.1 percent year- on- year. The CPI's decline since last month was mainly attributable to a fall in agricultural prices such as vegetables and fruits and prices of industrial products, such as gasoline, despite a

<Table 6>                Trends for Prices

(Unit: %)

Note: Percentage changes from the previous year.

Sources: National Statistical Office, Consumer Price Index, various issues.

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continuous rise in housing rent and personal service prices, such as hotel charges and domestic aviation service fees. On the other hand, the 2.1 percent year- on- year rise in CPI recorded in July was mainly due to a 5.7 percent rise in housing rent with a 3.9 percent rise in personal service prices, as compared to the same period last year. In August, agricultural and marine products prices increased by 3.2 percent year- on- year under the influence of a torrential rain. Service prices rose 2.8 percent year- on- year as the rising trend in housing rent prices was maintained and personal service prices rose with a tuition increase in private universities. Therefore, the CPI in August rose to 0.7 percent month- on- month, and 2.4 percent year- on- year. In September, agricultural and marine product prices grew by 8.6 percent year- on- year due to the seasonal increase in demand and a lack of shipments, as a result of a typhoon. The prices of industrial products also increased by 1.9 percent year- on- year as the prices of automobiles rose with the restoration of special excise tax. Housing rent prices continued to rise and recorded a 5.8 percent increase year- on- year. Consequently, the CPI, in September, was up 3.1 percent year- on- year. 

During the third quarter of 2002, the producer price index (PPI) rose by 1.6 percent year- on- year <Figure 16>. The PPI had continued to decline for two 

<Figure 16>         Consumer and Producer Price Indices

Source: National Statistical Office and the Bank of Korea.

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months from June to July. From that time on, however, the rise in factors such as the prices of raw material and international crude oil, along with a lack of shipments, damaged by a typhoon and torrential rain, led an increase in the PPI, which also overlapped the seasonal increase in demand for agricultural goods. By month, the PPI in July decreased by 0.2 percent month- on- month, affected by the increased shipments of agricultural and marine products, and a strong won. In August, the PPI showed a reversing trend due to the large month- on- month increase (2.5 percent) in agricultural products prices, which was up 0.3 percent month- on- month. In September, the PPI rose by 0.4 percent month- on- month because of a rise in prices of vegetables and cereals due to the typhoon and real estate.

During the third quarter in 2002, export prices declined by 3.9 percent sequentially. Export prices recorded a decline for the fourth consecutive month since April 2002, and went up by 1.2 percent and 1.5 percent month- on- month in August and September, respectively. In July, the weakening foreign demand for exports in conjunction with the sluggish world economic conditions, the appreciation of the won/dollar exchange rate, and heightened price competition

<Figure 17>              Growth Rate of Wage 

Note: Three- months moving average.

Source: National Statistical Office.

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between domestic and foreign companies in the leading export markets, led a fall in export prices. However, in August and September, export prices turned around with the depeciation of the won and the rise in manufactured goods and international oil prices. Import prices dropped by 2.7 percent sequentially in the third quarter. From July to September, the continued appreciation of the won/dollar exchange rate and strong prices of oil and other raw materials were the main factors to trigger a fall in import prices. 

In July, the nominal average monthly wage in companies with five or more employees rose by 9.9 percent year- on- year <Figure 17>. By industry, the social and personal service sector recorded the biggest increase of 11.4 percent. The wholesale, retail, hotel, and restaurants sector was next with a 10.7 percent increase. In August, wages rose by 10.2 percent year- on- year, and similar to July, wages in the social and personal services sector recorded the highest increase, up 11.5 percent year- on- year. The next highest increase was led by the wholesale, retail, hotel, and restaurants sector, up 11.2 percent year- on- year. 

In the third quarter of 2002, the unemployment rate recorded 2.7 percent, down 0.2 percent form the previous quarter. This is largely attributable to a reduction in job hunting by students who returned to school after summer vacation and an increase in the number of employed by seasonal factor such as the Korean Thanksgiving Day. 

2) Forecast

In the fourth quarter of 2002, the inflation rate in terms of the consumer price index is expected to go up to 3.3 percent year- on- year, leading to a 2.8 percent average growth for 2002 <Table 7>. This stable trend is expected to continue, as the rising trend of housing rent, which had caused a rise in the CPI throughout this year, is expected to dampen since governmental measures to control the housing market were announced on September 4th. Also, a stable trend of inflation in the main trade partner countries is expected to contribute to the stabilization of domestic inflation. The inflationary pressure on the demand side is not expected 

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to be severe due to the uncertainty surrounding the domestic and foreign economy and a reduction in private consumption. However, in the fourth quarter, the CPI will be stimulated by the presidential election, and excess liquidity. 

There is a possibility that import prices will increase in the fourth quarter because of the concerns surrounding the U.S. attack on Iraq, the unstable international oil prices due to seasonal demands, and the weak won due to the Japanese government's support for a weak yen along with the stagnation of the Japanese economy in the fourth quarter. 

The employment level can be negatively affected by interest groups who will look to take advantage of a lame duck president expecting to be replaced during the presidential election in December 2002, also during which, the worker will ask for wage hikes. The five- day work week will not hoist wages significantly as compensation is expected to be confined to keep the current wage level.

<Table 7>       Trends and Forecasts for Prices and Wages¹⁾

(Unit: %)

Notes: 1) Percentage changes from the previous year.

2) Figures after the fourth quarter of 2002 are forecasts.

Sources: National Statistical Office, Consumer Price Index, various issues.

The Bank of Korea, Monthly Bulletin, various issues.

Ministry of Labor, Report on Monthly Labor Survey, various issues.

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The Balance of Payments

1) Review

In the third quarter of 2002, the current account surplus is expected to decrease to $1.2 billion from $1.8 billion sequentially <Table 8>. This is because the service account deficits erased out a large portion of the goods account surplus. In July, the current account recorded a $0.01 billion deficit, which was the first monthly deficit since April 2002. In August, however, the current account turned around to record a $0.2 billion surplus as the goods account improved despite the service account deficit. In September, the current account surplus is expected to record $0.5 billion, reflecting the contraction of the service account deficits and sequential improvement of the goods account surplus. 

During the third quarter of this year, the total exports and imports continued to increase. The rise in consumer goods imports and capital goods imports were triggered by the improvement in exports. Hence, the goods account recorded a $3.0 billion surplus, which is about the same as $2.9 billion surplus recorded in the same period last year. On the other hand, the service account recorded a $2.5 

<Table 8>              Trends in the Current Account

(Unit: $100 Mil., %)

Notes: 1) KIF estimates

2) Period average

Sources: The Bank of Korea, Balance of Payments, various issues

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billion deficit, which is the greatest quarterly deficit in history, in the same period. This was mainly attributable to an increase in travelling abroad during the summer vacation season and rising royalty payments. 

During the third quarter of 2002, the capital account recorded a $2.5 billion inflow <Figure 18>. In July, an introduction of trade credit and a collection of 

<Figure 18>   Foreign Investment and Balance of Capital Account 

Sources: The Bank of Korea, Balance of Payments, various issues.

<Figure 19>     Exports, Imports, and Balance of Goods Account

Sources: The Bank of Korea, Balance of Payments, various issues.

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external investment by domestic investors led to a $2.9 billion inflow, which was the greatest inflow since March 2000. In August, the capital account recorded $0.7 billion due to the inflow of money from the sale of the domestic corporations' Depository Receipts (DR) and short- term borrowing from the international market by banks, despite the flight of foreign investment funds in the capital market. In September, the capital account, however, recorded a $0.1 billion outflow due to the net outflow of foreign stock investment and the redemption of public loan.

Exports on a custom- cleared basis (f.o.b) amounted to $41.5 billion in the third quarter of 2002, recording a 16.5 percent growth year- on- year, which is the first two digit growth rate recorded since the third quarter of 2000 <Figure 19>. In July, exports increased 19.0 percent to $13.5 billion. In August, exports increased 18.9 percent to $14.0 billion. This rising trend of exports may be attributable to the stabilized external demand due to a stable foreign economic recovery, along with a basis effect during this period. Particularly, the increased demand for main export items such as IT products, petrochemicals and steel led the growth of exports. 

<Figure 20>   OECD Leading Indicator and Exports Growth Trend

Note: 3- months moving average.

Sources: Ministry of Commerce, Industry and Energy, OECD.

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In September, exports recorded $14.0 billion, rising merely 12.3 percent. This slowdown of export growth was attributable to the reduction of workdays due to the Korean Thanksgiving Holiday: Because the holiday is based on the lunar calendar, the date of the holiday changes year by year on the solar calendar. But daily average exports in September recorded $0.6 billion, which was the largest amount to have been exported since 2001.

As for exports by commodity, the semiconductor exports showed improved performance in the third quarter of this year, recording $4.2 billion, which was up 53.6 percent year- on- year. This was in part attributable to increased system IC exports and also to a basis effect as the semiconductor exports performed poorly due to the fall in the price of DRAM during the same period last year. Exports of computers recorded $0.3 billion, up 26.8 percent, as the export of computer related substitute items, such as LCD monitors, continued to show a rising trend and exports to China and other Asian countries continued to increase. The export growth of automobiles showed a continuous upward trend. The normalization of large- scale auto plant operations and increased exports to the U.S. throughout the third quarter of this year led to a 5.4 percent increase year- on- year although there were negative

<Figure 21>          Trends in Semi- conductor Prices

Note: 128M(16×8) DRAM (PC133).

Source: Bloomberg.

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factors such as a shrinkage of the world automobile market and a reduction of workdays in September. The wireless communication equipment exports increased 35.7 percent to $0.3 billion in the third quarter of 2002, as exports to China and europe recorded 376.4 percent and 72.6 percent increases, respectively, from July to August. The petrochemical and steel exports also continued to show 14.3 percent and 9.0 percent increases, respectively, year- on- year, due to the rise in the international prices in the third quarter of this year. 

Imports on a custom- cleared basis (c.i.f) amounted to $38.8 billion in the third quarter, up 13.7 percent year- on- year <Figure 19>. In July, imports recorded $12.9 billion, a 16.5 percent increase year- on- year. As for monthly import figures by commodity and by use, imports of raw materials recorded $0.6 billion, up 9.7 percent year- on- year, as import volume of crude oil increased. The imports of capital goods, which were effected largely by an increase in exports during this month, increased sharply, recording a 22.2 percent increase as compared to same period last year, despite the depressed investments in the domestic equipment market. Consumer goods imports also increased by 28.2 percent and led a 

<Figure 22> Consumer Expectation Index and Consumer Goods Imports Trends

Source: National Statistics Office.

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rising trend of total imports this month. In August, raw material imports continued to show a rising trend, recording a 6.5 percent increase year- on- year. The capital goods imports increased largely and recorded $4.8 billion, up 18.2 percent during this month. This is mainly due to an induced import by exports improvement and an increase in equipment investment of machinery and electronics. The consumer goods imports also increased sharply, by 28.8 percent, in August, boosted by the optimistic consumer sentiments. Hence, the total imports in August recorded $12.9 billion, up 13.5 percent year- on- year. In September, although crude oil imports decreased due to the reduction of overall oil imports, the imports of raw materials for industrial use increased by 4.2 percent year- on- year with a rising manufacturing operation ratio, caused by efforts to secure inventory to prepare for seasonal demands.

During the third quarter of 2002, the terms of trade index deteriorated by 1.3 percent year- on- year, recording 91.6 <Table 9>. The fall in the import unit price far surpassed that of the export unit price, due to a drop in the export price of semiconductors and a rise in the international market price of crude oil and caused the deterioration in the terms of trade index.

The won/dollar exchange rate was at 1,202 won during July of the third quarter. However, the instability of the U.S. financial markets continued to weaken the dollar in the international foreign exchange market, and pushed the won/dollar exchange rate lower to 1,160 won by the 23rd of July. The instability of the U.S.

<Table 9>        Net Barter Terms of Trade Trends

(Unit: 2000=100)

Source: The Bank of Korea.

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economy had stemmed from the loss of confidence in U.S. corporations, compounded by the tumbling of stock prices amid the growing current account deficit in the U.S. 

Thereafter, the won/dollar exchange rate fluctuated substantially around 1,200 won during August and increased to 1,225.5 won at the end of September. In conjunction with the weak yen in the international foreign exchange market, the won has also been weakening since September. The reason for the relatively strong dollar in September is because the U.S. dollar was perceived as the safest asset in an unstable international financial market. Also, the suspicion against the Japanese government's financial and economic reform efforts, which was reflected in the lack of subscription for Japanese public bonds, accelerated the weakening of the yen. With the synchronization of the Korean won and Japanese yen, domestic factors such as the shrinkage of the current account and foreign investors' net selling of Korean stocks might induce a weak won during September <Figure 23>.

<Figure 23>       Won/Dollar and Yen/Dollar Exchange Rate

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2) Forecast

In the fourth quarter of 2002, the current account is forecasted to record only a $0.6 billion surplus, despite a continuously rising trend in exports, as a large service account deficit is expected in the quarter. Therefore, the current account this year is expected to record a $4.8 billion surplus, a $4.2 billion reduction from $8.6 billion recorded last year. The goods account is forecasted to record a $2.7 billion surplus and the service account is forecasted to record a $1.8 billion deficit in the same period <Table 8>.

Exports (f.o.b) are expected to increase by 17.3 percent to $42.7 billion as it is anticipated that exports of electronic products will continue to increase with a basis effect. Therefore, yearly exports are forecasted to record $160.1 billion, up 6.4 percent year- on- year. As for exports by commodity, semiconductors are expected to lead the export growth next quarter as a rise in DRAM prices, caused by a continuous increase in the loading rate of DDR on PC, and reduction of DRAM supplies is expected. Computers and TFT- LCD monitors are also expected to continue to show a rising trend faced with a high- demand season, such as Thanksgiving Day and Christmas, and with an anticipation for increased exports to Asia in the fourth quarter. On the other hand, the direction of crude oil prices, contingent upon the possible outbreak of a war between the U.S. and Iraq, and a possibility of a slowdown in economic recovery of the U.S., may be the major variables to affect the exports market in the fourth quarter of 2002.

Imports are expected to increase in conjunction with an increase in exports in the fourth quarter of 2002. For imports by commodity and by use, consumer goods imports are expected to record around a 20 percent increase, which is less than that in the third quarter, as the consumers' optimism is expected to subside at the end of this year. The net value of imports of raw materials is expected to increase along with a rise in oil prices due to the unsettled conflicts in the Middle East region and an increase of oil imports, triggered by the seasonal factor. Capital goods imports for domestic demands are expected to slow down as domestic corporations are expected 

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to maintain a conservative pattern of equipment investment with the increasing uncertainty surrounding the domestic and foreign economy. The imported capital goods for the purposes of exports are, however, expected to continue to increase with a rising trend in exports. Therefore, the total amount of imports in the fourth quarter of 2002 is forecasted to record $40.2, up 17.2 percent, and annual imports are forecasted to record $149.9, a 6.2 percent increase year- on- year <Table 10>.

<Figure 24>       U.S. Goods Imports and Korea Exports 

Sources: U.S. Department of Commerce, Conference Board, Ministry of Commerce, Industry and Energy.

<Figure 25>   U.S. Consumer Confidence Index and Korea Exports

Sources: U.S. Department of Commerce, Conference Board, Ministry of Commerce, Industry and Energy.

- 50 -

The won/dollar exchange rate rose to 1,263.5 won on October 14th, after exhibiting large fluctuations due to a swift outflow of foreign stock investment and shrinkage of domestic stock market at the beginning of October. But the trend of a strong dollar is not expected to last long, and the average won/dollar exchange rate in the fourth quarter is expected to fluctuate substantially around 1,240 won.

<Figure 26> Capital Goods Imports for Domestic Demand and Equipment Investment

Sources: KOTIS, National Statistics Office.

<Table 10>        Forecasts for the Exports and Imports

(Unit: US$100 mil., yoy)

Note: 1) Estimates.

Sources: Ministry of Commerce, Industry and Energy, Report of Exports and Imports, various issues.

- 51 -

This is because in the fourth quarter, the won/dollar exchange rate is expected to be largely affected by weakening factors such as the growing U.S. current account and fiscal account deficit, the possibility of a rise in oil prices with a U.S. attack on Iraq, and the delay of U.S. economic recovery. In conjunction, the won/dollar exchange rate in the fourth quarter is expected to be continuously affected by the factors that cause the movement of the yen/dollar exchange rate and its synchronization with the yen/dollar exchange rate is expected to re- strengthen after the middle of October. 

- 52 -

Money and Interest Rates

Money

1) Review

During the third quarter of 2002, the Korean economy maintained its growth rate as exports and consumption continued to rise and as manufacturing and industrial production maintained dynamism. However, the possibility for economic recovery remained uncertain due to the unstable economic and geo- political environment abroad, including the overall economic depression in major advanced countries, reduced confidence in the international financial markets and a possible war between the U.S. and Iraq. Notwithstanding the worsened situations aforementioned, the current account recorded a surplus as exports made a steady recovery. Also, consumer prices remained relatively stable during the third quarter. Despite the potential destabilizing factors, such as a rise in the housing and oil prices, and an increase in agricultural product prices from the typhoon in the third quarter, the consumer prices increased only 2.6 percent on a year- on- year basis (<Figure 27>). In the financial markets, the stock prices and long- term interest rates continued to decline due to the mounting economic uncertainties in the U.S. and international financial markets, reflecting retarded world economic recovery. Overall, liquidity was sufficiently supplied during the third quarter, even though short- term liquidity was relatively tight as the government absorbed liquidity through the collection of taxes on July and the demand for money increased by the Chou- Suk holidays (Korean equivalent to the U.S. Thanksgiving Day) in September.

Notwithstanding the growing inflationary pressures, the excessive market liquidity, and the need for housing price stability, the Bank of Korea (BOK) maintained its benchmark overnight call rate at its current level of 4.25 percent, considering the aggravated external environment. But the BOK revealed its intention to squeeze the excessive liquidity by keeping the average call rate at 4.27 percent (4.17～4.37%) and by reducing the credit line from 11.6 trillion won to 9.6 trillion won. In September, it was expected that the BOK would raise the call rate target preemptively in order to counteract the inflationary pressures, rising housing prices and household loans.  However, the BOK decided not to raise the call rate target, considering the worsened external situation, including the delayed economic recovery in the U.S., a possible U.S.- Iraq war, and the abrupt decrease in stock prices.

During the third quarter of 2002, the growth rates for major monetary aggregates declined compared to the previous quarters as the government collected taxes in July and household credits decreased in August. But, in September, the growth rates of major monetary aggregates reversed to an increasing trend due to the rapidly increasing household 

- 53 -

loans.

<Figure 27>          Inflation Target and CPI Inflation

<Table 11>            Trends in Monetary Growth Rates¹⁾

(Unit: %)

Notes: 1) Year- on- year growth rates of the average balance

 2) Preliminary values

 3) Reserve Money = bank notes + reserves of deposit money banks

- 54 -

 4) M1 = currency + demand deposits

 5) M2 = M1 + savings deposits + foreign currency deposits

      6) MCT = M2 + CDs + money- in- trusts

 7) M3 = M2 + deposits in non- bank financial institutions + debentures issued + commercial bills sold + CDs + RPs

 8) New M1 = currency + demand deposits & savings deposits with transferability at depository corporations*

* Financial instruments with a maturity of more than two years are excluded

 9) New M2 = New M1 + periodical deposits & installment savings + marketable instruments (CD, RP, cover bills, etc.) + yield- based dividend instruments (Money in trust, beneficial certificates, etc.) + financial debentures + others (securities investment savings at Investment Trust Companies, bills issued by Merchant Banking Corporations, etc.) 

Sources: The Bank of Korea, Money and Banking Statistics (various issues), Trends of Financial Market in September

In particular, the M2 growth rate decreased to 12.1 percent from 14.7 percent sequentially. It decreased to 12.3 percent in July mainly due to the tax receipts by the government, and further decreased to 11.8 percent in August in conjunction with the decrease in the resident foreign exchange account. However, it bounced back to 12.1 percent in September due to the expansion in household loan and small- medium business loan during the Chou- Suk holidays.

The growth rates of the new M1, the recently employed measure of monetary aggregate reflecting the condition of overall short- term market liquidity, decreased to 22.6 percent and 20.3 percent in July and August, respectively. Despite the increase in demand deposits, a large margin of taxes and withholding income tax were absorbed by the government sector in July and August. In addition, the MCT growth rate during the third quarter decreased to 11.2 percent. The decrease was led by a decline in the M2 growth rate, as well as deposit taking by the money trust, and limited increase of only 1.6 trillion won in the net issue of CDs.

<Table 12>               Multipliers and Velocities¹⁾²⁾

(Unit: Times)

- 55 -

Notes: 1) Money Multipliers are the ratios of each monetary aggregate to the volume of the reserve money. The velocities of money represent the ratios of seasonally adjusted nominal GDP of each seasonally adjusted monetary aggregate. 

 2) Figures in parentheses represent year- on- year growth rates of the velocity.

Sources: The Bank of Korea, Money and Banking Statistics (various issues), Trends of Financial Market in September

The growth rate of M3, the broadest measure of monetary aggregate, exceeded the BOK's monitoring rage (8~12%), recording 13.0 percent and 12.4 percent in July and August, respectively. In July, the M3 growth rate decreased to 13.0 percent from 13.6 percent in the second quarter. This was mainly attributable to the decrease in the extension of private credit and foreign investors' selling of domestic stocks that caused an outflow of funds. 

In the meantime, the divergence between major monetary growth rates has diminished in the second quarter(<Table 11>, <Table 12>). The discrepancy between M2 and M3 growth rates is estimated to be narrower than that of the previous quarter. Moreover, the divergence between the M2 and MCT growth rates has continued to decline after hitting 2.8 percent in March and only 0.7 percent in the third quarter. The diminishing divergence among growth rates of monetary aggregates implies that monetary aggregates are reflecting market liquidity conditions more accurately(<Figure 28>).

During the third quarter, deposit- taking by financial institutions showed clear differences 

- 56 -

between ITMCs on one hand and merchant banks and money- in- trust on the

<Figure 28>       Discrepancies between Monetary Growth Rates

other. Deposits in deposit money banks (DMBs) jumped by 10 trillion won, much larger than the increase of 6.3 trillion won in the previous quarter. This resulted from the sufficient liquidity supply during the Chou- Suk holidays. Also, deposits at ITMCs showed a reversing trend from a decrease of 3.5 trillion won in the previous quarter to a 5 trillion won increase this quarter. There was a sharp increase in Money Market Funds (MMFs) as investors began to favor short- term financial assets. The insecure financial markets, bearish stock market, and government's announcement to implement restraining measures toward speculative investment in real estate have fueled the flight to quality. On the other hand, deposits in merchant banks and money- in- trusts experienced a 1 trillion won and 1.8 trillion won decrease, respectively. In particular, deposits in merchant banks decreased as CP sales sharply dropped. (<Table 13>, <Table 14>).

<Table 13>                 Trends in Bank Loans¹⁾

(Unit: billion won)

- 57 -

Notes: 1) End of period. Changes from the previous period

 2) Excluding CP discounts

Source: The Bank of Korea, Trends of Financial Market in September

Another feature of the financial market during the third quarter was the reduction in the structure of deposits in financial institutions due to the continuing low interest rate policy and depositors' concern over a possible economic slump in the second half of the year. The ratio of short- term deposits to total deposit- takings by financial institutions still remained high, registering 40.2 percent, slightly higher than the 39.4 percent recorded in the previous quarter. It resulted mainly from short- term deposits and the inflow of funds into MMF in the banking sector(<Table 14>). 

<Table 14>      Recent Deposit Changes at Financial Institutions¹⁾

(Unit: billion won)

- 58 -

Note: 1) End of period. Changes from the previous period

Sources: The Bank of Korea, Money and Banking Statistics (various issues), Trends of  Daily Financial Market, Trends of Financial Market in September

<Table 15>    Trends in Credit to Households by Financial Sectors¹⁾

(Unit: trillion won)

Notes: 1) End of period. Changes from the previous period

- 59 -

 2) General loans to households and loans for housing of deposit money banks

 3) Comprises advance services and card loan

Sources: The Bank of Korea, Monthly Bulletin (various issues), Trends of Credit to Households in the second quarter of 2002

The overall financing condition in the corporate sector continued to improve in the third quarter. The supply of funds greatly exceeded the demand as the demand for facility investment funds was low. Corporations delayed making new investments in the midst of uncertain economic conditions. Bank loans to the corporate sector and the issuance of stocks were increased, while the issuance of commercial papers and corporate bonds were depressed. The net issuance of corporate bonds decreased as the high- quality large corporations maintained comfortable levels of internally generated cash flows and delayed making new investments. The net issuance of commercial papers increased by 2.7 trillion won and 1.2 trillion won in July and August, respectively, supported by the increase in deposits at ITMCs. However, the net issuance of CPs decreased by 0.7 trillion won in September as deposits at MMFs declined. Issuance of stocks by corporations was inactive until August due to the bearish stock markets, but jumped sharply in September as some companies such as LG EI issued stocks(<Table 16>).

<Table 16>           Trends in Firms' Direct Financing¹⁾

(Unit: billion won)

Notes: 1) End of period. Changes from the previous period

 2) On the basis of CP discounts of securities companies and merchant banks

 3) Figures in parentheses exclude Primary CBO, Korea Development Bank's Prompt Bond Underwriting and debt restructuring related CBs. Figures in brackets exclude Primary CBO and Korea Development Bank's Prompt Bond Underwriting. 

 4) During September 1~25

Sources: The Bank of Korea, Trends of Financial Market in September

- 60 -

Financial Supervisory Service, Monthly Financial Statistics Bulletin, various issues

<Figure 29>     Outstanding Deposit Bank Loans by Type and 

Ratio of Households to Total Loans

- 61 -

2) Forecast

In the fourth quarter of 2002, the BOK is expected to maintain the current policy stance as the economy is confronted with a more complex domestic and external economic environment. The Korean economy is expected to be on the track to recovery, aided by the solid growth in consumption, exports and production. A steep rise in agricultural product prices as well as unstable international oil prices are forecasted to add inflationary pressure. In particular, concern for excessive liquidity in the market will be very serious as the household loans are still at a high level. Taking into account all of the above factors, strong arguments for raising the call rate target, in order to maintain a stable growth pattern, will persist.

On the other hand, the external environment surrounding the Korean economy is likely to be highly uncertain and unstable. Signs of economic recovery in the major economies, including those in the U.S., Japan and Europe, are not clearly seen yet and concerns for a sharp rise in oil prices are stronger due to the growing possibility of an outbreak of a war between the U.S. and Iraq. In addition, the situation could worsen if consumer confidence wanes as a result of the insecure and unstable economic situations. Therefore, there are also cautionary arguments against BOK's raising of the call rate. This is a policy dilemma also confronting many other countries at this time. 

The M3 growth rate is forecasted to be slightly lower than that of the previous quarter as the GDP is likely to maintain sequential growth. The household loan is expected to decrease as the BOK's concern over the excessive household debt problem will cause an absorption of excess liquidity. The M2 growth rate, however, is expected to be slightly higher than that of the previous quarter, reflecting the shift of funds into bank deposits, which are considered relatively safe compared to other financial products(<Table 17>).

<Table 17>                 Monetary Growth Rate¹⁾

(Unit: %)

Notes: 1) Year- on- year growth rate of the average balance.

 2) M2 is a preliminary value, and M3 is a forecast.

Sources: The Bank of Korea, Monthly Bulletin (various issues), Money and Banking 

- 62 -

Statistics, Trends of Financial Market in September.

Interest Rates

1) Review

1. While the domestic economy continued a solid recovery, long- term interest rates declined further in the third quarter due to prospects of increased economic uncertainties. In this period, interest rates on government bonds and corporate bonds(AA- ) declined by 73bp and 70bp  on average since the previous quarter, recording 5.49%, and 6.31%, respectively(<Figure 30>). 

2. The target call rate had been fixed at 4.25% during the third quarter, and other short- term interest rates also showed little change: interest rates on CD and CP were 4.84% and 4.94%, respectively, on average, which were not different from 4.82% and 4.94% recorded in the second quarter(<Figure 31>).

3. Consequently, the marked decline in long- term interest rates and the generally fixed short- term rates were the distinguishing feature of the interest rate movements during the third quarter.

4. When the long- term interest rate is set equal to the sum of the real economic growth rate and the rate of inflation expectation, as suggested by a number of textbook theories, a 8～9% long- term interest rate would be deemed normal, considering the 6.5% real GDP growth rate and 2.6% CPI inflation rate recorded during the third quarter. However, the actual long- term interest rate was just 6.3%, much lower than the "normal" level. We can find several explanations for the much lower long- term rate by taking a look at various macroeconomic indices. 

5. First, the supply of long- term bonds was cut back remarkably this year. The trend of low interest rates, which had been set since 2001, dramatically alleviated the interest payment burden of private companies, improving their profitability. On the other hand, the economic outlook of advanced countries, including the U.S., has never been optimistic this year, and therefore, the outlook of the Korean economy was also very bleak, discouraging corporate business investments. As the demand for mobilizing external funds shrank, companies tried to pay back their loans and maturing bonds.

- 63 -

<Figure 30>              Long- term Interest Rates

<Figure 31>           Short- term Interest Rates

6. Second, as the financial sector reform progressed, additional fund raising was no longer needed, and the Deposit Insurance Bond was no longer issued from 2002. Furthermore, the balance of the central government budget continued a large scale surplus in 2002. Not only did the off- budget balance, including the National Pension Fund and other social security related 

- 64 -

public funds, exhibit a huge surplus, but on- budget deficit was also significantly reduced(<Figure 32>). Therefore, the volume of the new government bond to finance this year's on- budget deficit turned out to be much smaller than anticipated. In this manner, the supply of long- term bonds such as government bonds, the Deposit Insurance Bond, and corporate bonds declined drastically. On the other hand, the demand for long- term bonds remained strong this year. 

Throughout this year, record breaking low interest rates brought about overly abundant liquidity, which fueled the demand for long- term bonds. The sustained excess demand in the long- term bond market kept the long- term interest rates below the "normal" level implied by macroeconomic indices, such as the real growth rate and inflation rate. 

<Figure 32> Consolidated Balance of Budget of the Central Government 

7. At the end of April, long- term interest rates started to decline along with stock prices and won/dollar exchange rate. In particular, the co- movement of long- term interest rates and stock price index was remarkably conspicuous and lasted until the end of the third quarter(<Figure 33>). The possibility of an outbreak of a war between the U.S. and Iraq had mounted, aggravating the domestic and world economic outlook. As the linkage between the domestic and U.S. stock price indexes strengthened, the domestic market consequently exhibited a bearish performance during the third quarter, and the long- term interest rates also continued to decline. It looked as if the long- term interest rates were determined by the domestic stock market performance and the performance of the domestic stock market was determined by the performance of the U.S. stock market.

- 65 -

8. At the beginning of July, the decreasing trend of long- term interest rates reversed temporarily by a revived expectation of a solid domestic economic recovery. The Bank of Korea revised upward its economic growth forecast from 5.7% to 6.5% for this year, and estimated that export growth would be strong enough to lead a full- scale economic expansion this year. The KOSPI also recovered rapidly, reaching 800 points on July 9 from 701.9 points at the end of June. Influenced by the revived market expectations, the interest rate on government bonds sharply rose to 5.93% on July 9, which was 30bp higher than that recorded at the end of June. 

9. However, in mid- July, the long- term interest rates started to decline again. As the economic performances of the U.S. turned out to be disappointing and a series of accounting scandals surrounding the U.S. companies, including WorldCom, persisted, the U.S. stock prices plummeted and the U.S. dollar began to depreciate from mid- July. As a result, the won per dollar exchange rate declined significantly, to the extent that such a strong currency value might be harmful for future export growth. The KOSPI index dropped by more than 100 points in less than two weeks and long- term interest rates reversed from temporarily rising to decline again.

10. The domestic economic indices sustained a similar performance in August, but the long- term interest rates dropped further. The prospect for domestic economic

<Figure 33>          KOSPI and Corporate Bond Yields 

expansion was severely blurred with the weakened economic developments in the U.S., and the excessive demand for long- term bonds became more evident. In August, the interest 

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rates on government bonds and corporate bonds fell down to 5.37% and 6.23% from 5.70% and 6.49% of the previous month, respectively.

11. In early August, it was published that the U.S. real GDP grew by 1.1% per annum in the second quarter. It was a dramatic drop from 6.1% of the first quarter, and the speed of economic slowdown was a lot faster than expected. Moreover, when the ISM(Institute for Supply Management) index precipitated also in August, the possibility of a double- dip recession regained public attention and additional cuts in federal funds rate was called for in order to prevent the seemingly impending economic double- dip. All of these developments contributed to keeping the domestic long- term interest rates low.

12. At the end of August, long- term interest rates temporarily rose again as the KOSPI index rebounded and prices of crude oil and agricultural products soared, triggering inflationary expectations. However, entering September, when the U.S. government confirmed its resolution to unilaterally take military action against Iraq, if and when necessary, the domestic long- term interest rates declined again.

13. During the third quarter, the domestic private consumption slowed down moderately, but its rate of increase was still maintained at a relatively high level. Also, manufacturing productions and equipment investments increased steadily. Export of commodities (F.O.B.) increased by 18.7% y.o.y. in August, and the BOK and government revised their economic forecasts of GDP growth rate for this year up to 6.5% per annum. However, all of those indications were not deemed strong enough to influence market participants to ascertain domestic economic expansion. The 18.7% export growth in August was not so impressive when taking into consideration the - 20.4% export contraction in August of last year.

14. Historically, the real growth rate of Korea exceeded 7% whenever the economy picked up(<Table 18>). Therefore, the 6% economic growth rate this year might have been regarded as somewhat stagnant. Setting aside the economic expansion from September 1998 to July 2000 because it was basically a technical rebound from the severe economic downturn during the economic crisis, and considering the structural changes that took place in the Korean economy after the economic crisis, the 6% of growth cannot simply be considered a stagnant recovery.

15. As long- term interest rates declined in the third quarter, the volume of bond trading increased to 582 trillion won from 482 trillion won in the previous quarter. 

16. Meanwhile, an additional increase in the target call rate was strongly demanded in August in order to control the real estate bubble and to cool down the lending boom. From November 1998 to December 2000, the rate of increase of the all- city apartment price index rose 

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by 9.0%, which was just slightly higher than the average nominal GDP growth rate of 8.4%, in the same period. But in 2001, the apartment price 

<Table 18>     Real GDP Growth Rate in Each Business Cycle

<Figure 34>       Residential Real Estate Price Index

Total                                   Detached House

Tenement House                           Apartment

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<Table 19>   Rate of Increase of Housing Price and Chon- se Price 

index jumped up by 14.5% per annum, almost twice as much as the nominal growth rate in that year of 8.1%. In 2002, from January to August, the index skyrocketed by an astonishing 26.3%, or equivalently 39.5% per annum(<Figure 34>). The abnormally sharp rise in residential real estate prices was not confined to the southern area of Seoul but was sprawling rapidly to the northern part of Seoul, the metropolitan capital, and even to large and small local cities(<Figure 35>). It was quite evident by August that the real estate bubble had already emerged and was vigorously expanding all over the country.

17. More specifically, the rate of increase of Chon- se price was alarming. During the 45 months from November 1998 to August 2002, the Chon- se prices for apartments rose by 93.5%, approaching 102.4%, the rate of increase during the period from July 1987 to April 1991 when an enormous real estate bubble had reached a historical peak(<Table 19>). Furthermore, rents for office buildings started to increase recently. Prior to the economic crisis, dollar denominated average rental price of office buildings in the Seoul area ranked 4th or 5th 

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among cities all over the world.

<Figure 35>   Rate of Increase of Residential Real Estate Prices

The rent prices declined significantly and the won per dollar exchange rate depreciated by 50% as the economy went through the economic crisis. Consequently, the ranking of dollar denominated rent prices in the Seoul area also had been declining to 7th, 11th, 13th, and 20th as of July 2000, January 2001, July 2001, January 2002, respectively. However, reflecting the recent real estate bubble, the ranking rose to 19th as of July 2002(<Table 20>).

<Table 20>      Ranking of Rent Price of Office Building

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Note: 1) Dollar per Square Feet.

Sources: CB Richard Ellis Global Research and Consulting, Global Market Rents, various issues. 

18. When real estate prices go up, private consumption tends to rise in the short- run due to the wealth effect. But if the prices increase so much that a real estate bubble emerges, a vicious cycle of 'high cost structure' can be created. The high cost structure, which indicates a chain reaction of increases in wages, inflation, nominal interest rates, land prices and rent, had swept over the Korean economy in the 1990's, seriously damaging the country's economic competitiveness. The high cost structure erodes the profitability of businesses in the long- run and increases the non- performing loans of financial intermediaries. Therefore, suppressing the real estate bubble is an indispensible policy agenda to maintain sound economic fundamentals that in turn can secure sustainable long- run economic growth. The current rate of increase in Chon- se prices seems to be high enough to lead workers to demand higher real wages than their level of productivity, in 

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order to finance their housing expenses. In such a case, a long lasting, runaway inflation may incur.

19. The volume of consumer loans is literally exploding due to the record low level of recent interest rates. The volume of consumer loans made by commercial banks increased by 47.3% y.o.y. in the third quarter, which was slightly lower than the 52.1% recorded in the previous quarter, but still obviously explosive(<Figure 36>). According to the Bank of Korea, more than half of these consumer loans

<Figure 36>        Rate of Increase of Loan to Households 

were used to finance the recent real estate bubble. 

20. A moderate yet repeated increases in interest rates is strongly required to breakdown the linkage between the exploding consumer loans and expanding real estate bubble. However, the Monetary Policy Committee froze the target call rate at 4.25% in September, citing the bearish stock market and the increasingly uncertain world economic outlook due to the possible war between the U.S. and Iraq as the reasons.

21. Entering September, as stock prices plummeted and the economic outlook became more uncertain, a huge amount of financial capital flew into the bond market as investors turned to safer assets. The interest rate on government bonds, followed by other long- term interest rates, declined again. The net issuance of government bonds was just 191 billion won(<Figure 37>), and this limited supply of government bonds, given the excessive demand for safe assets, accelerated the downward trend in their interest rates.

<Figure 37> Net Issuance of<Figure 38>   Net Issuance of

Principal Government Bonds¹⁾Corporate Bonds²⁾

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Notes: 1) Sum of treasury bonds, foreign exchange stability fund bonds, national housing bond type 1 and type 2, and grain securities, billion won

2) On the basis of amounts of total corporate bonds, billion won

22. The positive effects of the interest rate decline were translated to corporate profitability from 2002. In the first quarter of 2002, the ordinary income of manufacturing firms amounted to 8.0% of their total sales, which was an unprecedented record since the quarterly data on Financial Statement Analysis was first collected(<Table 21>). As a result, the quarter- over- quarter incremental free cash flow in the corporate sector rapidly increased from 7.9 trillion won in the fourth quarter of 2001, to 15.9 trillion won and 12.6 trillion won in the first and second quarter of 2002, respectively. Without ambitious investment projects, the corporate sector accumulated its internal reserves while paying back maturing corporate bonds(<Figure 38>).

23. The net issue of debentures declined to 6.2 trillion won in the third quarter from 11.6 trillion won in the previous quarter. Although the need to raise funds was alleviated due to a steady inflow into deposit accounts during the third quarter, the increase in deposit was attributable mostly to the increase in short- term deposits.

<Table 21>   Profitability Indicators of Firms in Manufacturing Sector¹⁾

(Unit: compared with sales, %)

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Notes: 1) Listed companies, and enterprises registered at the Korea Securities Dealers Automated Quotation (KOSDAQ) and the Financial Supervisory Commission (FSC) in the manufacturing sector. Figures in parentheses are the results of the financial statement analysis, conducted on the entire manufacturing sector.

24. The spread between lending and borrowing rates of banks was slightly reduced to 2.71% in August from 2.73% in June(<Figure 39>).

25. As the profitability of firms improved significantly, the credit risk in the corporate sector was mitigated and the corporate bond yield spread gradually narrowed in the third quarter. The corporate bond premium, i.e. the interest rate spread between government bonds and corporate bonds rated AA- , went down to 0.70% in September from 0.93% in June(<Table 22>). 

<Figure 39>   Spreads Between lending and Deposit Rates at Banks 

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2) Forecast

1. In the fourth quarter, the long- term interest rates will be determined mostly by the future course of stock prices and world economic outlook, while short- term rates will be influenced by the call rate. The domestic stock market is going to pick up slightly in the fourth quarter. The uncertainty of the future economic outlook, which originated from the impending war between the U.S. and Iraq or the escalation of hostilities in the Middle East etc. is also expected to be relieved gradually in the fourth quarter. Various economic forecasts are currently predicting higher growth rates for developed countries in 2003 than in 2002. Therefore, stock prices of those countries may pick up preemptively in the fourth quarter of this year before the actual business cycle approaches an expansionary phase. In that case, the domestic long- term interest rates will moderately rise, following the stock prices.

<Table 22>     Corporate Bond Yield Spread by Credit Rating¹⁾

(Unit : %, %p)

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Notes: 1) End of Period

2) Spreads between Government bond(3yrs.) and Benchmark high grade issues(AA- )

3) Spreads over benchmark high grade issues(AA- )

Source : The Korea Securities Dealers Association

2. Even if the BOK increases the target call rate some time in the fourth quarter, unless it is surprisingly drastic, the long- term interest rates will not be affected significantly as the demand for long- term bonds will continue to dominate the supply. A call rate increase will have a more direct impact on short- term rates.

3. As of October, while there are competing views on the desirable policy reaction to the expanding real estate bubble and the exploding consumer loans, the target call rate has been maintained at a fixed rate of 4.25% since last May. Recently, apartment prices in the Gang- nam area stopped increasing after the anti- speculation policy package was announced on October 11. The rate of increase of consumer loans has also started to slow down recently. These current developments are actually loosening the pressure on the BOK to increase the call rate.  Recalling how difficult it was to raise the target call rate in May, it seems, therefore, doubtful as to whether the BOK can keep its commitment to increase the call rate once more by the end of this year.

4. A rapid increase in business investments in the fourth quarter does not seem very plausible. Therefore, the supply of new corporate bonds will not be large enough to meet the abundant demand. However, the gap between the supply of and demand for long- term bonds will shrink gradually in the fourth quarter. 

5. As aforementioned, the current long- term interest rates are much lower than the level implied by the real growth rate and inflation rate. This suggests that, depending on the future course of stock prices, the amount of excess liquidity, and geopolitical uncertainty in the Middle East etc., the long- term interest rates can increase by at least 2.0% in no time. For instance, if the Bank of Korea increases the target call rate and if bond market participants interpret it as a signal that there remains only interest rate hike in the future, the long- term interest rate may jump up sharply in the fourth quarter, as it did at the end of last year.

6. Considering the excess demand for long- term bonds, however, it seems that a small increase in the call rate cannot trigger a sudden jump of long- term interest rates. Therefore, in the fourth quarter, interest rates on government bonds and corporate bonds will be about 5.5% and 6.2% respectively. 

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<Table 23>             Interest Rate Forecasts¹⁾

(Unit: %)

Notes: 1) Interest rates are period averages and others are percentage change from the previous year. 

2) CPI, M2 and Corporate bond yields are reported figures, and GDP growth rates  are preliminary. 

3) Forecasts

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Financial Market Developments

Banking

The total volume of bank deposits, loans, and trust accounts increased by 1.5%, 5.8% and 0.2%, respectively, in the third quarter of 2002. However, these growth rates show a drop of 1.3%, 1.7% and 1.5%, respectively, from the last quarter.  The reduction of market liquidity under the BOK's controls has led to the lower growth in deposit volume. The falling growth in loans was caused by a 2.7% decrease in household loans and a 2.0% decrease in corporate loans. The reduced volume of Money in Trust accounts was caused by the outflow of funds during the quarter's bearish stock market conditions. The interest rates of deposits and loans decreased slightly, as a result of the fierce competition among the banks. 

<Figure 1>  The growth rate trend of deposits, loans and trust accounts

<Figure 2>     The interest rates of deposits, loans and trust accounts

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Deposit Market

1) Review

In the third quarter of 2002, the total volume of bank deposits held by depository banks recorded 549.1 trillion won, up 1.5% compared to last quarter.  The decrease in the growth rate of deposits is due to the reduction of market liquidity and the remarkable decrease both in the growth rate of marketable financial products and the level of foreign currency deposits. Considering the M2 and MCT+ as indicators for market liquidity, the growth rate of M2 and MCT+ decreased by 2.6%p and 1.8%p, respectively, from the last quarter, which was partially caused by the open market operation of the Bank of Korea and the outflow of foreign stock funds. 

As shown in <Table 1>, demand deposits grew by 3.9% in the third quarter, totaling 42 trillion won. The declining growth rate of demand deposits reflected the reduction of market liquidity and the shift of funds to alternative investment opportunities. 

<Table 1>                     Bank Deposits¹⁾

(unit: billion won, %)

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Notes: 1) End- of- quarter basis. The figures in the parentheses represent percentage change from the previous quarter.

 2) Measurement

 3) Excludes BOK trust funds

Sources: The Bank of Korea, Money & Banking Statistics (various issues) and Daily Trend of the Financial Market.

In the third quarter of 2002, the volume of time and savings deposits rose by 2.0%, totaling 441.8 trillion won. Time and savings deposits with a term exceeding 1 year increased by 6.8 trillion won, while frequent- deposit- and- withdrawing accounts, under 6 months, rose to just 560 billion won.  The reasons for the slight increase in frequent- deposit- and- withdrawing accounts included seasonal factors such as tax- payments, and funds demanded for Chou- Suk (the Korean Thanks- giving day).  There were a few contributing factors for the increase in time and savings deposits with a term over 1 year. For starters, floating funds seeking alternative investment opportunities were invested in time and savings deposits with a term over 1 year, mainly due to the bearish stock market and the newly implemented policies for stabilizing the real estate market. Second, because of their flexibility and stability, the rotary (revolving) savings deposits remarkably increased in volume since last quarter. Third, banks raised interest rates of time and savings deposits with a greater than 1 year term to attract funds in early third quarter to control the liquidity ratio.  Fourth, a significant portion of corporations' surplus income flowed into time and savings deposits with a greater than 1 year term instead of being used for facilities- investment, under the expectations for uncertain economic conditions.  Finally, 

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banks made an effort to attract time and savings deposits compared to short- term deposits, in order to moderate shortness of deposit structure. 

The volume of marketable financial products slightly increased, up 0.6%, totaling 53.2 trillion won. Its growth rate this quarter substantially decreased compared to that of the last quarter. The decline in growth rate of marketable financial products was mainly due to the following factors.  First, corporations that had preferred CDs for controlling and securing operational funds last quarter demanded CDs less because they repaid loans with surplus income instead, as expectations for possibly worsened economic conditions prevailed. Second, banks have reduced their efforts to attract short- term marketable deposits as they have already satisfied the liquidity ratio level imposed by the FSS(Financial Supervisory Services). 

The volume of foreign currency deposits fell by 14.6% in the third quarter, totaling 12.9 trillion won, as illustrated in <Table 1>. A substantial decrease in the growth rate of foreign currency deposits was due to the devaluation of the won, repayment of foreign loans and settlement for import products. 

In the third quarter, the average interest rates on deposits, except installment savings, fell slightly. The interest rates continued to remain low and the reasons are as follows. First, banks decreased short- term interest rates such as those for demand deposits since the short- term funds were not profitable to banks. Second, as the market interest rates have slightly fallen this quarter, the interest rates of marketable financial products, which are based on the market rates, kept falling, except for those of RPs. Third, the prime interest rates of time and savings deposits with a term exceeding 1 year were raised to attract lump- sum funds deposits so as to increase the liquidity ratio. As the banks' liquidity ratio exceeded the level imposed by the FSS near the end of this quarter, banks decreased the prime rates, which resulted in low interest rates for the time and saving deposits. 

<Table 2>           Interest Rates on Selected Bank Deposits¹⁾

(unit: % per annum)

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Notes: 1) End- of- quarter basis. Weighted average interest rates

 2) Include MMDA

Sources: The Bank of Korea, Money & Statistics (various issues) and Daily Trend of the Financial Market.

2) Forecast

The growth rate of the total volume of deposits is expected to increase somewhat in the fourth quarter of 2002 for the following reasons. Firstly, although the Bank of Korea has controlled market liquidity prudently, plentiful market liquidity that continues from last year will increase deposits. Secondly, the funds in deposit accounts seeking alternative investments are not likely to flow into stock and bond markets under the uncertain market conditions. Flight- to- quality will induce the funds to stay in deposit accounts. Thirdly, some funds that have been invested in the real estate market may flow into demand deposits as an alternative, due to the implementation of governmental policies to stabilize the real estate market.  However, as some still expect the real estate market to remain strong, the influx volume into demand deposits is not likely to be very large. Lastly, for the purpose of settling accounts at year- end, the preference for short- term deposits, such as for marketable financial products and demand deposits, will increase temporarily. The influx volume into short- term deposits will not be very big because of the year- end tax payments and repayment of loans.

The total volume of marketable financial products is likely to increase with the rising growth rate, as compared to the last quarter. Two factors will contribute to this increase. First, corporations and investors will look to manage funds with short- term marketable products in order to keep alternative opportunities alive. So, the shortness of deposit structure will be more pronounced in fund markets.  Second, the volume of CDs will 

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continue to expand since banks have satisfied the liquidity ratio required by the FSS. However, the volume of RPs and Cover bills is likely to decrease slightly, because banks' need for liquidity has been reduced somewhat as corporations' demand for loan has decreased. 

The volume of foreign currency deposits is expected to decrease in the fourth quarter of 2002, but the growth rate will not be as low as last quarter's. The demand for foreign currency deposits will be low because exchange rates are expected to be volatile as a result of the prevailing uncertainties in the world economy. The decrease in foreign currency deposits will come from the settlement of import products and the repayment of foreign loan in the fourth quarter of 2002.  However, the growth rate will not be as low as that of the third quarter as the continually expanding export financing will flow into foreign currency deposits in order to make year- end settlement. 

The average interest rates on deposits are expected to remain the same in the fourth quarter of 2002 as the third quarter. Banks do not have much incentive to increase interest rates on deposits because investors who are making a flight- to- quality continue to flow into deposit accounts and banks have difficulty managing assets from deposits.

Loan Market

1) Review

In the third quarter of 2002, the total volume of loans reached 441 trillion won, a 5.8% increase compared to the last quarter. The growth rates of loans to households and small and medium sized firms declined throughout this quarter and loans to major companies also decreased. Several factors have contributed to this increase in volume of loans and decrease in growth rate. First, although the expansion of the domestic economy was disturbed somewhat by external economic conditions, the demand for capital, especially by small and medium sized firms, was still high with sound industrial production and expansion of exports. Second, low interest rates on loans since last year also stimulated corporations' demand for loans. Small and medium sized companies were able to easily access loans as the competition among banks to win their business became fierce. Third, funds for Chou- suk, the Korean thanks- giving day, funds for the mortgage market and funds for recovering flood damage boosted the volume of loans substantially at the end of this quarter. Finally, despite the rise in reserve rates for provisions for loans since the second quarter of 2002 and the expectations for household loan rates to rise next quarter, the total volume of household loans still increased by 15.6 trillion won, albeit at a lower growth rate than the last quarter. 

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Loans to small and medium sized firms rose by 8.6 trillion won in the third quarter of 2002. This increase, up 8.1%, was due to the following factors. For starters, as banks have difficulty managing assets and the growth rate of household loans decreased, banks intended to increase loans to small and medium sized firms. Second, small and medium sized firms demanded a considerable amount of funds for Chou- suk (Korean Thanks- giving day). However, the growth rate of small and medium sized firms slowed compared to that of the last quarter as the internal and external economic conditions have become more unstable. Moreover, the demand for facilities investment loans by small and medium sized firms decreased substantially compared to last quarter. Loans to major companies decreased about 0.3 trillion won in the third quarter because of the decreasing debt ratio and the repayment of loans from banks. 

Household loans increased by about 15.7 trillion won compared to last quarter, while its growth rate has decreased since the fourth quarter of 2001, as illustrated in <Figure 3>. Although the minimum reserve rate of provisions for household loans was adjusted upwards and FLC for mortgage- backed loans were strengthened, the following factors contributed to the increase in the volume of household loans. Firstly, as expectations for rising real estate prices remained in spite of the newly implemented policies for stabilizing the real estate market, the volume of household loans expanded. Secondly, demand for household loans rose as banks tended to decrease interest rates on household loans, which were considered a good

<Table 3>                      Bank Loans¹⁾

(unit: billion won, %)

Notes: 1) End- of- quarter basis. The figures in parentheses represent percentage changes from 

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the previous quarter.

 2) Measurement 

Sources: The Bank of Korea, Money & Banking Statistics (various issues)

opportunity from the banks' asset management perspective. Even banks that have concentrated on corporate loans began to extend household loans. Competition for loans among banks resulted in preventing a rise in household loan interest rates.  Finally, demand for household loans during this particular period was remarkably high because the policies to reduce the ratio of loan to value (LTV) are to be implemented in the fourth quarter of 2002. 

<Table 4>      The Sector trend of increase and decrease in Loans¹⁾

(unit: billion won, %)

Notes: 1) End- of- quarter basis. The increase and decrease during the quarter

Source: The Bank of Korea, Money & Banking Statistics (various issues)

<Figure 3>        The trend of the growth rate of loans sector

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As illustrated in <Table 5>, the average interest rate on loans fell slightly compared to the last quarter. The decline in loan interest rates was mainly due to the following factors. First, banks had no incentive to increase interest rates on loans because of the inflow of deposits and the decrease in market rates. Also limited opportunities to manage assets under low market rates along with the bearish stock market prevented loan interest rates from being raised accordingly. Second, banks still competed for loans to small and medium sized firms, which kept the loan rates low. Moreover, corporations' need for loans declined this quarter in accordance with the expectations for weakening of the economy, contributing to low loan rates. Third, as CD yields, on which interest rates of household loans were based, fell, interest rates on loans decreased this quarter. 

<Table 5>          Interest Rates on Selected Bank Loans¹⁾

(unit: % per annum)

Source: The Bank of Korea, Money & Banking Statistics, Monthly Bulletin and Trend of Interest Rates Offered by Banks and Non- Bank Financial Institutions (various issues)

2) Forecasts

The total volume of loans, in won, in the fourth quarter is expected to increase with a 

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lower growth rate as compared to the third quarter. Although the growth rate of loans to corporations is likely to stay at a level similar to that of the third quarter, the overall growth rate is expected to decrease because the growth rate of household loans is expected to decrease considerably. The reasons behind this expectation are as follows. First, companies are expected to increase their demand for loans in the fourth quarter due to seasonal factors such as tax payments and accounting settlements at year- end. Second, the low level of interest rates on loans will be sustained by the competition among banks, which will increase the volume of loans. However, the growth rate of loans is forecasted to slow down with loan repayments, withholding of surplus cash in vault and a decrease in loans for facilities investment, in accordance with the uncertain economic conditions. Third, the strict government policies against rising credit risks in consumer loans, relatively stable real estate market and expectation for rising interest rates will make the overall growth rate lower than that of the third quarter. 

Loans in foreign currencies are expected to rise in a similar manner as that experienced in the third quarter. Corporations may need loans in foreign currencies in order to repay loans in foreign currencies and settle for import products at year- end. Also, the necessity for reducing open positions by banks may increase foreign currency loans as foreign currency deposits increase relative to the third quarter.

The average interest rates on loans will increase slightly compared to that of the third quarter. The factors that will contribute to the rise in interest rates for loans are as follows. First, the interest rates of household loans may be raised because of supply- side factors such as rising credit risks and strict governmental policies. The breadth of increase will be small because of the stable real estate market, bearish stock market and decreasing consumption. Second, corporations' need for loans will not be as high as before since corporations will manage themselves conservatively with the prevailing uncertainty in the economy. 

Bank Trust Market

1) Review

As illustrated in <Table 6>, the total volume of deposits in the bank's trust accounts increased by 0.2%, totaling 116.3 trillion won in the third quarter of 2002. The volume of Money in Trust decreased by 2.5%, continuing its downward trend from the last quarter. The decreasing trend is due to the fact that the fund in trust products invested in stock decreased significantly as the stock market became increasingly bearish. The growth rate of the balance of Property in Trusts was 5.2% this quarter, which was lower than last 

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quarter's 21%.  The increase in Property in Trust was led by Trust bond products. 

The final balance of Money in Trust amounted to 73.5 trillion won in the third quarter, a 2.5% drop from the end of last quarter. The reasons for the decrease are as follows. First, the flight- to- quality, bearish stock market and concerns about uncertain economic conditions caused an outflow of money from Money in Trust into deposit accounts and short- term bond markets. The outflow of funds from

<Table 6>                 Bank Trust Accounts¹⁾

(unit: 100 million won, %)

Notes: 1) End- of- quarter basis. The figures in parentheses represent percentage changes from the previous quarter.

Source: Individual Bank Data

performance- based trust products was more notable than that from principal- based products. Second, the volume of Unit Trusts and High- Risk-  High- Return products, which were mainly based on stock investment, decreased by about 50% due to the  bearish stock market this quarter. Third, as expectations for a prolonged bearish stock market and unstable economic conditions continued, corporations tended to secure cash from trust products even while incurring losses by doing so. Finally, the breadth of decrease in Money in Trust widened as New Installment Products reached maturity. Some trust products still continued to sell since the last quarter, however. The balance of specific trust products increased substantially since the third quarter of 2001, which are advantageous in managing duration of investment assets, matching asset maturities with financial plan, and providing higher yield than time and savings deposits. Also, the Real Estate Trust continued to rise, owing to the demand for funds by mortgage developers. 

The portfolio composition of trust accounts, as shown in <Table 7>, reveals that loans funded by bank trusts increased, whereas those of investments in securities decreased. 

<Table 7>   Loans Funded by Bank Trusts and Investment in Securities¹⁾

(unit: 100 million won, %)

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