Editor

Hae Wang Chung

Associate Editor

Jae- Jung Kwon

English Editor

Lois Rho

Contributors 

Lead Article

Jang Yung Lee

Macroeconomic Developments

Han- Yung Jung and Yong- Sang Shyn

Jae- Ha Park and Jongkyu Park

Financial Market Developments

Imho Kang

Keonbeom Lee

Byung Chul Lim

Jieun Lee

Jaewook Chung

Copyright by

Korea Institute of Finance 

Seoul, Korea

http://www.kif.re.kr

wmaster@kif.re.kr

Printed by Orom System Co.

Ministry of Culture & Public Information

Registration No. Ba -  1891

Registration on April 17, 1993 

KOREAN FINANCIAL

REVIEW

󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏

QUARTERLY ANALYSIS & FORECAST

Vol. 13, No. 1                              Spring 2003

󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏

󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏

CONTENTS 

󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏

Lead Article: Appraisal of the Korean Credit Card Companies:

 Liquidity or Insolvency Crisis󰠜  3

President and Publisher

Macroeconomic Developments  󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜 23

Hae Wang Chung

Current Status and Prospects

Money and Interest Rates 

Financial Market Developments 󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜 85

Banking 

Non- Bank Financial Institutions 

Money and Capital Markets

Insurance 

󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏 

Korean Financial Review: Quarterly Analysis & Forecast is published by the Financial Outlook Team of the Korea Institute of Finance (KIF). The views expressed are those of the authors, and do not necessarily reflect official positions of the KIF.

For subscriptions, please direct requests and inquiries to the Financial Outlook Team, Korea 

Institute of Finance, Seoul, Korea; Telephone (82- 2) 3705- 6272, Fax (82- 2) 3705- 6285.

Lead Article

Appraisal of the Korean Credit Card Companies: 

Liquidity or Insolvency Crisis?*

Jang Yung Lee**

< Abstract > Recently, most Korean credit card companies have been facing serious refinancing risks, which were triggered by the accounting scandal at SK Global and the liquidity crunch at investment trust and management companies (ITMCs). Despite government support measures in early April, the credit card sector of the domestic bond market has yet to show signs of stabilization. Meanwhile, international investors are becoming increasingly concerned about the Korean card companies' insolvency risk, in addition to liquidity risk. This paper analyzes the root causes of the credit card industry's liquidity crisis, evaluates the government support measures, draws attention to the problematic issues, and proposes several supplementary measures to restore investor confidence in regards to the solvency and liquidity of the credit card companies. In conclusion, this paper stresses the need to strengthen the long- term financial position of domestic credit card companies, further improve the risk management system, and accelerate the restructuring of ITMCs.

─────────────────

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

** Research Fellow, Korea Institute of Finance

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I. Introduction

All of a sudden, the Korean credit card companies are facing great difficulties raising funds in the bond market.  This is because investors have become nervous about high- risk borrowers after the SK Global accounting scandal became public in early March, 2003. The liquidity crunch in the bond market further deteriorated as investors rushed to redeem their holdings at the ITMCs (Investment Trust and Management Companies), forcing the ITMCs to dump marginal borrowers' bonds, which include the credit card companies' CPs, bonds and ABS. The prices of card companies' bonds have fallen sharply, and the ITMCs were unable to meet all the redemption requests from the investors. Although the government has stepped in to restore investor confidence by asking the card companies to strengthen their capital base, the financial market turmoil has continued. Then on April 3rd, the government came up with additional support measures, including making commercial banks buy up to 5 trillion KRW (US$4 billion) of the credit card companies' CPs, and ITMCs' bonds. However, the bond market situation has not shown signs of stabilization. Meanwhile, some analysts warn that Korean credit card companies are vulnerable not just in terms of liquidity shortage but in terms of insolvency risk. For instance, in early March, UBS Warburg estimated that, under the worst case scenario, without extra roll- overs, the credit card companies would not be able to survive for more than 2.2 months. The IMF also issued a pessimistic statement that, were the bond market to contract further, many of the credit card companies could collapse by the end of this year.

The purpose of this paper is to assess the validity of such pessimistic views and draw some policy recommendations to restore confidence in the credit card industry‘s solvency. The paper consists of 4 chapters. After the introduction in Chapter I, the structural vulnerability of the credit card industry and the government support measures are examined in Chapter II.  Policy agenda are proposed in Chapter III, and Chapter IV consists of a short concluding remark.

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Ⅱ. The Vulnerability of Credit Card Companies

1. Recent Developments of the Credit Card Industry

The domestic credit card industry has grown rapidly in recent years, boosted by the introduction of tax incentives in 2000 and the consumer boom of the last two years. The total number of credit cards issued has grown to 104 million by the end of 2002, nearly 2.6 times the level at the end of 1999, and the transaction volume of credit cards has increased by more than 7 times, from 90 trillion KRW to 669 trillion KRW during the same period. Despite the remarkable expansion of their assets, the companies have severely compromised the quality of their assets as they began to issue cards to borrowers of doubtful credit worthiness, amid intense competition. Accordingly, the risks of their loan portfolio have increased dramatically by the second quarter of 2002, when the consumer card bubble began to burst and the tightening of prudential regulation on consumer lending has triggered a sharp rise in credit card delinquencies. The authorities took additional measures in October 2002 to curb the excessive household credit growth, which provoked further delinquencies. By the end of 2002, the 30- day delinquency rate on credit card loans had risen to 13%, and at some credit card companies, the delinquency rate has reached over 14% in February 2003 (Table II- 1). If the 30- day delinquency rate is adjusted for re- aged loans as a close approximation of global NPL reporting standards, the delinquency rate could rise as high as 20% at some card companies. Considering the low delinquency rate of 3.8% in early 2002, the recent rise is notably sharp, and represents a serious distress in the credit card industry as the delinquency in Korea is nearly four times the level of other advanced countries such as the US.

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<Table 1>   Financial Position of Major Credit Card Company

(as of end 2002)

(100mil KRW, %)

Notes:   1) Non- current asset ratio of Hyundai Credit Card denotes delinquent credit to total credit ratio

2) Delinquency rate as of the end Feb.'03 is : Kookmin 14.5%, Samsung 9.4%, KEB 12.7%,  Woori 8.0%, Hyundai 18.9%, LG 9.4%

Source:  Association of Credit Institutions 

2. Liquidity Crisis and Policy Response

As delinquency rates on credit cards have risen sharply, the losses suffered by credit card company bondholders have increased substantially, implying a higher funding risk for many of the card companies that had relied heavily on the corporate bond and CP markets. At the same time, market participants' confidence in the ITMCs, the main buyers of the credit card company bonds, was further shaken in mid- March, when the outbreak of SK Global scandal made investors of the funds managed by the ITMCs extremely risk averse and led to a general flight to safety from the risky bond- type funds. There have been strong redemption 

- 6 -

requests at the ITMCs, particularly from the holders of the money market funds (MMFs), who invested heavily in high- risk CPs and the card companies' bonds. Asset quality of the MMFs has deteriorated further as the ITMCs had to liquidate good assets first in the declining market, weakening investor confidence in the remaining assets. In addition, the ability of the credit card companies to service their debts was further inhibited by the humpy maturity structure of the card companies' bonds and CPs: out of 30 trillion KRW (about US$24 billion) worth of bonds and CPs that are due to mature in 2003, more than 58% are coming due in the three month period between April 1st and June 30th (Figure II- 1).

<Figure 1>    Maturing Bonds for Credit Card Companies (by month)

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In an effort to improve market sentiments, the central bank provided liquidity support by injecting 2 trillion KRW (about US$1.7 billion) into the RP market. The government also intervened directly by buying government bonds to ease the pressure on bond yields. However, the financial market turmoil was not subdued, and instead showed signs of becoming a major liquidity crisis for the entire credit card sector. Under the increased systemic risk, the government announced ｢Comprehensive Stabilization Measures｣, which aimed at (i) relieving the liquidity shortages of the credit card companies and ITMCs, and (ii) securing a base for sound management at the credit card companies.  The government involvement in making commercial banks and other financial institutions roll over the maturing card companies' bonds and CPs is one example of the first stabilization measure. Another noteworthy example is the government- initiated launching of a mutual fund to buy 5.5 trillion KRW worth of card companies' maturing bonds and CPs held by the ITMCs. Recommended by the government, all of Korea's commercial banks, securities and insurance companies, regardless of their shareholder relationships with the credit card companies, chose to subscribe to the mutual fund.  Interest rates used for acquiring the card companies' bonds and CPs held by the ITMCs were determined on the basis of average market yields priced by three private bond pricing companies.

The second component of the policy measures was to have the credit card companies raise 4.6 trillion KRW from rights issues (or from subordinate debt issues) to recapitalize their operations by the end of 2003. The original amount planned for recapitalization was 2 trillion KRW, but was later increased to 4.6 trillion KRW. By strengthening the financial position of the card companies, the policy measure was intended to restore investors' confidence in the credit card companies' solvency, and thereby facilitate market absorption of the card companies’ bonds and CPs.

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3. Evaluation of the Policy Measures

Overall, these policy measures appear to sufficiently contain the liquidity risks of the credit card companies, as well as the sharp rises in the bond market yields, in a timely manner. 

However, despite the ｢Comprehensive Stabilization Measures｣, the bond market still seems unnerved. The prices of card companies' bonds, which had fallen sharply since mid- March, still have not returned to pre- crisis levels as of May 9th, 2003. Even bonds with a higher credit rating do not command normal prices, or if they are sold, their market turnover has been too low to provide meaningful yields. The corporate bond market is virtually not functioning as many participants suspect that there is some structural problem with the market. As can be seen from <Figure II- 2> and <Figure II- 3>, market yields of the bonds with credit ratings of AA-  and A+ still hover around 6.5%～9.5%, some 120～420 basis points higher than the pre- crisis levels. 

<Figure 2>         Yield Trend of Credit Card Companies' Bonds

(Credit rating: AA- )  

- 9 -

<Figure 3>       Yield Trend of Credit Card Companies' Bond

(Credit rating: A+)

This implies that, although investors' short- term concerns are quelled, the market still views some of the credit card companies as vulnerable to recurring liquidity risk, or default risks in the mid-  to long- term.

Citing the market's cold verdict, the critics of the government's ｢Comprehensive Stabilization Measures｣ raised the following two concerns: (1) There is a high degree of uncertainty regarding the actual implementation of card companies' proposed recapitalization plan; (2) There is a possibility that, even if the recapitalization plan is implemented fully, the capital position of the card companies may be insufficient to absorb the operational losses associated with high delinquency rates. To assess the validity of the first concern, we need to examine the major shareholders' degree of committment to the proposed recapitalization plan.  Some card companies have foreign shareholders who are opposed to the proposed recapitalization plan, or simply can not afford to raise the 4.55 trillion KRW in capital. 

On the second point of criticism, we need to evaluate whether the card companies will have sufficient internal reserves to meet the rising operational losses. 

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According to an official estimate by the supervisory authorities, the sum of the accumulated loss provisions, capital, and planned rights issues (if the recapitalization plan is implemented) will amount to 14.7 trillion KRW. And the card companies are claiming that even if the delinquency rate goes up to 16%, they will have sufficient internal reserves to absorb the estimated losses of 12.2 trillion KRW (Table II- 2). 

<Table 2>        Loss Absorptive Capacity By Scenario 

(tril KRW, %)

Notes:  1)  This denotes re- aged loans to which interest accrues normally, and it is assumed to increase by 28% in the next 3 months.

2) ( ) : Delinquency rate or Re- aged loan rate of Credit card  company's assets

3) Internal Reserve(Capacity of loss absorption : 14.7 tril KRW)

      = 5.1 tril KRW(existing loss provisions) + 5.0 tril KRW(capital) + 4.6 tril KRW(proposed recapitalization)

   * Excluding pre- provisioning profits (8.2 tril KRW) in 2003

4) Loss is estimated by applying historical loss ratios to the delinquent and re- aged loans

 *  Historical loss ratios = overdue in less than 30 days  3%, 30～90 days 57%, over 90days 90%, re- aged loan 30%

Source: Financial Supervisory Service

However, the card companies' estimations of losses under different scenarios are broadly understated, since they mechanically applied historical loss ratios to the outstanding balances of delinquent loans or re- aged loans. For example, applying a loss ratio of only 30% to the balance of re- aged loans is liable to a significant error as the card companies have aggressively re- aged the delinquent receivables by offering consumer loans with installment principle payments and with interest. The loss rates on re- aged receivables are generally higher than the first- time delinquent 

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receivables. Moreover, the official estimation of losses did not properly consider the deteriorating rate of migration, i.e., the rising loss rates associated with increasing migration of the delinquent receivables from the 1- 30 day delinquent bucket to the 30- 90 day delinquent bucket, and then to the 60- 180 day delinquent bucket. 

Even if the losses are estimated within realistic bounds, there is another problem arising from dangerously low capital base under the pessimistic scenario: when the delinquency rate goes up to 16%, the card companies' capital position will decline from 5.0 trillion KRW to 2.5 trillion KRW and their average capital adequacy ratio will likely fall below the 8% level mandated by the regulatory authority. In other words, unless the card companies swing back to record a large profit in the second half of this year, equity base of the card companies will become dangerously thin and some of the firms will likely be the target of regulators' prompt corrective actions.

The discussion so far suggests that the question of whether or not the current liquidity crisis will further develop into a serious insolvency crisis depends critically on the prospects of card companies' delinquency rate and earnings. To relieve the investors' concern, the government has projected that the high and rising delinquency rate will peak between April～May, 2003, and will go down in the second half of 2003. However, this projection heavily hinges on the two optimistic assumptions on the prospects of early economic recovery and improved institutional environment surrounding the prudential regulation of the card companies. 

In a more recent study by the Korea Institute of Finance (KIF), the general trend of delinquency rate is found to be closely linked to the unemployment rate and the GDP growth rate, which are the two major determinants of household income.  On the basis of this finding, the KIF estimates that if the economy recovers in the 3rd quarter of this year, the delinquency rate will start to fall in the 4th quarter of 2003. If, however, the economic recovery is delayed into the 1st 

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quarter of next year, the delinquency rate will only start to fall in the 2nd quarter of 2004.

<Table 3>         Liabilities of Credit Card Companies

(as of end Feb. 2003)

(tril KRW, %)

A more controversial issue concerning the government support measures is whether the liquidity support for the credit card companies and the ITMCs are properly designed to avoid the moral hazard problems in the financial industry. In particular, many economists criticize the government- initiated bridge loan of 5.5 trillion KRW, which was extended jointly by all of the commercial banks, securities and insurance companies, to buy maturing card companies' bonds and CPs held by the ITMCs regardless of their shareholder relationships with the credit card companies. The main criticism against the support measure is the improper priority set on burden sharing: the heavy burden of providing liquidity support was imposed on all major private financial institutions, although they are just one of the market participants.  In other words, the card companies and the ITMCs should shoulder a heavier burden of adjustment for the failure of their internal control before holding the banks responsible for the lack of investors' prudence in exercising general market discipline. Particularly when the market does not provide sufficient information on the card companies' financial health and true level of delinquencies, the investor group cannot be held responsible before others. Next, the negligent supervisory authorities should also be held accountable, because the official oversight did not prevent the risky operations of the card companies from spilling over to 

- 13 -

other sectors of the financial industry. More recently, the authorities' decision not to provide a full disclosure of the card companies' asset quality to the markets did not help stabilize the markets. In this context, it is not justifiable, especially in regards to minimizing moral- hazards, to force the banking industry to purchase credit card companies' maturing bonds and CPs held in ITMCs.

<Table 4>       Allocation of Bridge Loans

(To support ITMCs' holding of credit card bonds and CPs)

Notes: 1) 64% is the share of banks' financing in the funding structure of the credit card companies (ITMCs are excluded)

As the liquidity support measure transferred the risk exposure from the card companies and ITMCs to the banks, total risk exposure of banking industry has increased by 3.79 trillion KRW, including 2.65 trillion KRW from the monoliner card companies and 1.14 trillion KRW from the subsidiary card companies. More specifically, the credit risk assumed by the banking industry has increased in proportion to the higher- risk bonds and CPs purchased by the banks.  As seen from Table II- 5, of the 21.4 trillion KRW in card companies' maturing bonds and ITMCs‘ CPs, 2.04 trillion KRW(or 9.5%) worth of bonds and CPs were issued by high- risk card companies (i.e. those with credit ratings of A+ and below).  The principle of market mechanism suggests that when the banks buy the card companies' maturing bonds and CPs from the ITMCs, a fair amount of the risk 

- 14 -

premium should be charged on top of the normal bond yields in the secondary market. This would ensure that the ITCs take part of the loss, while also compensating the banks for taking on additional exposure.

In addition, the government support measures severely hampered the operation of the banks' risk management system (especially their industry- specific exposure limits), as the banks were asked to roll over their own existing exposure to the credit card industry, which is one of the closely- managed industries.  Also, the banks face increased difficulties in managing risk exposures to a single borrower group since many of the card companies are affiliated with large conglomerates. Lastly, the government is considering additional support measures, including possibly asking the banks to restructure the card loans from the customers' trust accounts to the banks‘ won accounts. If this measure is implemented, the banks' direct exposure to the credit risks would increase substantially. 

<Table 5>     Maturing Bonds for Credit Card Company (by month)

(mil. KRW, %)

Source: Ministry of Finance and Economy

- 15 -

Ⅲ. Supplementary Measures To Improve Liquidity

1. Strengthen the Long- term Financial Position of Credit Card Companies

A particular concern of those who criticize the government support measures is that the measures would be ineffective in strengthening the mid-  to long- term financial positions of the card companies. The critics are right in that the government's policy measures are effective only when supplemented by other measures, and only in the near term, to restore investor confidence regarding the solvency as well as liquidity of the card companies.

First of all, the proposed recapitalization plan should be implemented by the major shareholders in a timely manner. And if necessary, the size of rights or subordinate debt issuances should be increased sufficiently to absorb the expected losses under a pessimistic scenario. This is the most direct way to restore the credit worthiness of card companies. 

Secondly, in order to enhance the efficiency and profitability of card companies' operations, there is a need to strengthen self- rescue efforts. Steps can be taken to more effectively reduce overhead costs, raise fees and commissions, avoid excessive competition from careless card issuances and offering of overly generous bonuses to captive customers, and strengthen credit screening to prevent the collection of bad debt. 

Thirdly, in case the abovementioned efforts fail to strengthen the financial soundness of the card companies, the government should pursue a more rigorous restructuring strategy through M&As or other methods. This needs to be done before the supervisory authorities start to take corrective actions against the potentially insolvent card companies. 

In response, the supervisory authorities need to step up prudential regulations 

- 16 -

and supervisory standards and enforce them more consistently. This would, in turn, put more pressure on the card companies to make self- rescue and restructuring efforts. For example, enhancing the effectiveness of prompt corrective action rather than granting regulatory forbearance will be critical in accelerating the potentially insolvent card companies' voluntary restructuring efforts. The authorities' rigorous screening of the three criteria for the invocation of prompt corrective action, i.e. the low adjusted capital adequacy ratio, the high delinquency rate, and the operational loss in the previous accounting year, are therefore of great importance. 

Another controversial issue is whether or not the card companies' excessive cash advance business should be regulated by the supervisory authorities. The Financial Supervisory Commission has announced on April 2002 that the authorities will see to it that the share of cash advance business will be gradually reduced below 50% of the card companies' total business volume over two years. Although credit card companies‘ bad debt has originated mainly from cash advances and short- term loans, rather than from sales slip settlement, it is too arbitrary (and against the global standard) to regulate the precise volume of the permissible businesses. A more reasonable solution, in my opinion, is that while properly capitalized card companies should be given full freedom in conducting business activities, the authorities should deal sternly with the companies' financial distress, which is an outcome of mismanagement. 

2. Improve Risk Management System

It is critical that, like any other financial institution, credit card companies properly manage their risk exposure, including credit risk, liquidity risk, and general market risk. As evidenced by the recent liquidity crunch, the Korean credit card companies are exposed, in particular, to refinancing risk or event risk as they rely heavily on bond market financing, and are very sensitive to market risks.  In addressing the risks associated with the extension of credit to customers, the current 

- 17 -

risk management system remains at a rudimentary stage, although some card companies have recently adopted more scientific risk management techniques, such as customer relationship management (CRM). To make this system more effective, all card companies should have access to information concerning delinquent customers, and thereby should be able to assess accurately the creditworthiness of their customers. Currently, however, some card companies (especially those that are recently established) are not allowed to share customer information, and thus cannot screen the migration of delinquent customers from one card company to another. This is the typical problem of adverse selection, arising from information asymmetry between the existing and the new card companies. Since it can also act as a serious barrier to entry, the unfair market practice should be stopped at once. 

3. Restructure the Investment Trust Companies

Despite the progress in financial reform since the 1997 crisis, the ITC sector remains weak, with some companies nearing insolvency. The ITMCs‘ continued low profitability seem to show that the restructuring of the ITC sector is far from complete. In particular, in 1999, the supervisory authorities did not take aggressive actions against the potentially insolvent ITMCs, when the collapse of Daewoo group led to a sharp increase in the ITMCs' impaired assets and thus to an erosion of investor confidence in the ITMCs. The recent liquidity crunch at the credit card companies was also triggered by the ITMCs' poor risk management: in the midst of struggling to survive, the ITMCs continued to recklessly make high- risk, high- return portfolio investments, such as in card companies' bonds and CPs, for their money market funds (MMFs).  Such actions caused many concerned investors to withdraw their money from the MMFs all at once. As the undercapitalized ITMCs had to sell bonds and CPs with higher credit ratings first, investor confidence in the soundness of MMFs was further damaged, leading up to a vicious cycle of fund run.  In particular, some ITMCs, which had illegally incorporated option- CPs into their 

- 18 -

MMFs or agreed through a secret deal to roll over the CPs, could not meet the redemption requests because the payment obligation on the over- the- counter (OTC) derivative instrument reacted sharply to changes in interest rates and credit ratings.

Thus, it is important to press ahead with restructuring the ITMCs, particularly aiming at normalizing the weak but viable companies and reducing excessive competition in the investment trust market through consolidation. In case the weak ITMCs fail to implement the management normalization plan as promised to the supervisory authorities, it would be desirable to induce M&As with healthier companies or seek resolution of distressed companies.

IV. Conclusion

This paper analyzes the root causes of the recent liquidity crisis in the domestic credit card market, evaluates the government's stabilization measures, raises a number of problematic issues, and proposes supplementary measures to restore investor confidence in the corporate bond market as well as the solvency of the credit card companies.

As discussed, the liquidity problems at the card companies and the ITMCs, if unattended, have an element of systemic risk and are likely to affect other sectors of the financial system. The government's active intervention in the credit card market therefore is justified. 

In order to induce market discipline, however, the burden of adjustment should be borne in accordance with each party's contribution to the source problem. In this regard, the card companies and ITMCs, which failed to maintain proper internal control, should shoulder the heaviest burden of adjustment, followed by the supervisory authorities, which were negligent in overseeing the financial soundness of the card companies and ITMCs. Only thereafter, other general market participants 

- 19 -

such as commercial banks, insurance and securities companies should be held responsible. 

In conjunction, the major shareholders of the card companies should truthfully implement the proposed recapitalization plan, and if necessary, the size of rights or subordinate debt issuances should be increased sufficiently to absorb the expected losses under a more pessimistic scenario. In order to fully restore investor confidence, the government support measures need to be supplemented by other measures, including the inducement of operational restructuring and other self- rescue efforts at the card companies and the ITMCs. If the card companies do not swing to a profit and the financial market instability continues in the second half of this year, the government could also resort to the issuance of primary- CBOs. Again, to avoid the moral hazard problem, the CBO's credit enhancement role should be assumed by the major shareholders (i.e., large companies or mother banks) and not by the government or other public entities. 

- 20 -

References

Financial Supervisory Commission (April 2002), ｢Strengthening of Prudential Regulation on the Credit Card Companies｣ policy brief

International Monetary Fund (2003), Korean Credit Card Companies, Global Markets Monitor, March 31, 2003, pp. 7～8

Kim, BD (2002), Improving the Structural Efficiency of the Domestic Credit Card Market, Korea Financial Review, Vol. 12, No. 3, Korea Institute of Finance

Lee, Ji- Eun (March 2003), Financial Unsoundness of the ITMCs and Ways to address the Systemic Risks, manuscript, Korea Institute of Finance

Lee, Myung- Hwal (March 2003), Household Credit Problems and Policy Implications, manuscript, Korea Institute of Finance

Lim, Byung- Chul (February 2003), The Trend and Prospect of the Bad Household Credit, manuscript, Korea Institute of Finance

Ministry of Finance and Economy (April 2003), ｢Resolving the Liquidity Problems at the Credit Card Companies and ITMCs｣, policy brief

UBS Warburg (2003), Liquidity Crunch in the Bond Market, Global Equity Research, March 18, 2003, pp. 1- 2

- 21 -

Macroeconomic Developments

Current Status and Prospects

Economic Growth

1) Review

According to the National Accounts (provisional version) by the Bank of Korea in March, the Korean economy grew by 6.3% YOY in 2002. The growth was attributable to an upbeat trend in exports and private consumption and a steady rise in equipment and construction investments. The high consumption growth was caused by an increase in durable goods spending, including that of automobiles, home electric appliances, etc. and semi- durable goods spending in items such as clothing, books, etc. Exports, particularly of semiconductors, telecommunication apparatus, computers, and automobiles, grew significantly. In the first half of 2002, the Korean economy grew by 6.4% owing to a surge in consumption. Consumption was driven by low interest rates and an expansion in household loans, which fueled a debate over whether the Korean economy was overheated. In the second half of 2002, the GDP is estimated to grow by 6.3% due to an increase in exports and a basis effect. It should be noted that consumption is expected to grow at a slower pace in the second half because of consumption restraint policies, including regulations on household loans.

By sector, private consumption grew by 6.8% YOY in 2002, which was higher than the 4.7% recorded in 2001, supported by a surge in spending on durable goods, semi- durable goods, and services. The contribution of private consumption to the GDP growth rate recorded 3.5% point, which was also higher than that of the previous year <Table 1>. Equipment investments rose by 6.8% in 2002 as 

- 23 -

machinery investment for general industry, construction, and optical industry and transportation investments, including automobiles, increased significantly.

<Table 1>       Trend and Forecast of Economic Growth¹⁾

(%)

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

2) Goods and services.

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

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

<Table 2>      Contributions to the Growth Rate by Factor¹⁾

(%, %p)

Notes: 1) Figures after 2002 are KIF forecasts. 

2) Year- on- year percentage changes. 

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

- 24 -

Construction investments rose by 3.3% in 2002 which was lower than 5.3% of 2001. This growth was caused by a decrease in investments for social overhead capital and an increase in investments for residential and commercial buildings. In spite of a decline in exports of light industry products and service, total exports increased by 14.9% as exports of heavy industry products, including semiconductors, audio and telecommunication apparatus, computers, and office apparatus shot up significantly. As total imports increased by 16.4%, the contribution of net exports to the economic growth rate recorded 1.9% point in total <Table 2>.

Korea's GDP was estimated to grow by 4.4% in 1Q of 2003 as the economy entered a contraction phase. By sector, construction investment was forecasted to grow by 5.2%, while private consumption and exports were expected to pick up by 3.8% and 4.8%, respectively. The slowdown in private consumption and exports was attributed to the dwindled economic sentiment, which was caused by the breakout of war between U.S. and Iraq, bearish stock market, and a surge in crude oil prices. While total exports were expected to grow by 10.9%, total imports were estimated to increase by 15.9%, marking the contribution of net exports to GDP negative.

The 1Q growth rate was largely affected by sluggish industrial activities between January and February. From January to February, production, consumption, and facilities investment with the exception of construction investment declined from the previous quarter. The cyclical component of the coincident composite index (CI), which indicates the current business movement, recorded the highest level at 100.9 in January but fell to 100.4 in February. The leading CI recorded the highest growth of 11.7% YOY in April of 2002 but continued to decline, recording a 3.3% growth in February of 2003 <Figure 1>. The leading CI usually precedes the current state of the economy by 8 to 13 months. The downturn in February's cyclical component of the coincident index implies that the Korean economy already entered a downward trend since February. In addition, a rise in uncertainties in the global economy due to the breakout of war between the U.S. and Iraq, and the dampened consumption and investment implied that the Korean economy might enter a downward trend.

The growth rate of industrial production slowed in January (3.6%) due to a fall in 

- 25 -

the number of workdays; Lunar New Year fell in February last year while it fell in January this year. However, industrial production growth increased by 10.2% YOY in February due to an increase in the number of workdays. In January, semiconductors and visual/acoustic/telecommunication equipment production increased by 23.4% and 12.9%, respectively. In February, semiconductors, automobile, and machinery equipment production increased by 27.9%, 25.5%, and 19.3%, respectively. The ICT index (Information and Communication Technology) increased by 12.7% in January, which is lower than the 16.3% recorded in December 2002 and 14.5% in February due to a basis effect (17.2% in January of 2002 to 9.9% in February of 2002) <Figure 2>.

In January and February, producers' shipments increased by 5.5%, which is lower than the growth rate of the same period last year. In January, producers' shipments rose by 3.4%; shipments for domestic demand increased by 3.4% due to a rise in demand for petroleum purification, automobiles, and visual/acoustic/telecommunication equipment and producers' shipment for exports rose by 3.8% due to a rise in semiconductor, visual/acoustic/telecommunication equipment and automobiles. In February, producers' shipments rose by 7.8%; producer's shipment for domestic demand increased by 6.6% helped by a rise in automobile and primary metal, producer' shipment for exports increased by 10.3% owing to a rise in semiconductors, visual/acoustic/telecommunication, and machinery apparatus <Figure 3>.

- 26 -

<Figure 1> Changes in the Leading CI and Cyclical Component of the Coincident CI 

Note:     1) 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 2>                 Industrial Production

Note:     1) The peak of the business cycle (P) in August 2000 and the trough (T) in August 2001 are KIF forecast. 

Source: National Statistical Office.

- 27 -

<Figure 3>           Growth Rate of Producer's Shipment

Note:     1) The peak of the business cycle (P) in August 2000 and the trough (T) in August 2001 are KIF forecast. 

Source: National Statistical Office.

Producers' inventory of finished goods increased by 2.1% in January and 7.9% in February as the inventory of autos, semiconductors and visual/acoustic/ telecommunication apparatus picked up <Figure 4>. In January and February, the average operation ratio recorded 77.5% and 77.8%, respectively, the highest level since the 78.1% recorded in April 2002.

<Figure 4>                   Inventory Cycle 

Source: National Statistical Office.

- 28 -

<Figure 5>                    Consumption 

Note:     1) The peak of the business cycle (P) in August 2000 and the trough (T) in August 2001 are KIF forecast. 

Source: National Statistical Office.

During 1Q, private consumption is expected to grow by 3.8% because of consumption restraint policies, including several regulations on household loans, reduced consumption sentiment due to growing uncertainties in the domestic and global economy, and anxiety over economic recession. According to the industrial activities indices, the wholesale and retail sales grew by 4.5% in January; retail sales increased by 8.4% due to extended sales at department store during the Lunar New Year holidays, wholesale sales increased by 1% due to a rise in demand for telecommunication apparatus, machinery for electric use, food, and drink. Despite a 9.4% rise in automobile and fuel sales, however, the wholesale and retail sales decreased by 1.8% in February because Lunar New Year was in January this year while it fell in February last year and consumption sentiment was weaker; wholesale and retail sales decreased by 0.2% and 7.4%, respectively <Figure 5>. Another consumption indicator, the shipment for domestic use of consumption goods grew by 0.9% due to a slowdown in durable and non- durable goods, and it decreased by 2.3% in February as the demand for durable and non- durable goods all declined. 

Equipment investments in the National Accounts are estimated to increase by 

- 29 -

4.0% YOY during 1Q as uncertainties surrounding the global geopolitical environment and fears over economic recession add downward pressure on investor sentiment. This forecast takes into account a 6.9% fall in the estimate of equipment investments between January and February due to the reduced investment on computers, telecommunication, and machinery for industrial use. The domestic shipment of machinery grew at a slower pace since December 2002 and increased by 2.5% in January as the domestic shipment of computers decreased significantly even though machinery apparatus and assembly metal increased. In February, however, the domestic shipment of machinery increased by 16.9% <Figure 6>. Domestic machinery orders, a leading indicator for equipment investment, increased by 2.3% in January, and 9.5% in February, which are slightly lower than those of the previous year, due to an increase in orders for automobiles, wholesale and retail sales, and a boost in the construction industry.

<Figure 6>               Equipment Investment 

Note:     1) The peak of the business cycle (P) in August 2000 and the trough (T) in August 2001 are KIF forecast. 

Source: National Statistical Office.

- 30 -

<Figure 7>                Construction Investment 

Note:     1)  The peak of the business cycle (P) in August 2000 and the trough (T) in August 2001 are KIF forecast. 

Source: National Statistical Office.

During 1Q, construction investments are expected to increase by 5.2%, slightly lower than the 6.0% recorded in the previous quarter. In January, the value of completed domestic constructions rose by 20.9%, boosted by an increase in public and private construction orders. In February, the value of completed domestic constructions increased by 9.0% as the pubic construction orders decreased. Between January and February, however, the value of completed domestic constructions increased by 15%, which was higher than 10.1% of the same period in 2002. Domestic construction orders, a leading indicator for construction investment, rose by 20.9% and 44.0% in January and February, respectively, due to an increase in private construction orders, including residential building, office building, and land developing <Figure 7>, <Table 3>.

- 31 -

<Table 3>               Industrial Activities Indices 

(yoy, %)

Notes:     1) End of period.

2) Period average.

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

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

2) Forecast

During 2Q, the uncertainties in the global economy will not be reduced significantly. Dubai oil prices began to rise from mid- August in 2002 and surged to US$31.3 per barrel before the war between the U.S. and Iraq began, but fell back down to US$24～25 after the outbreak of the war. Oil prices are expected to stabilize to below US$25 per barrel if the war between the U.S. and Iraq ends quickly. After the end of the war in Iraq, the U.S. is expected to take a close look 

- 32 -

at North Korea's nuclear issues, which is likely to heighten the tension in the Korean peninsula, dampening foreign investors' investment sentiment. As North Korea is geo- politically important to its neighbouring countries, including South Korea, China, and Russia, chances are low that the U.S. will launch an attack on North Korea instead of opting a peaceful resolution. 

Notwithstanding that the real estate market will be resilient, the U.S. economy is not expected to rebound in 2Q due to a slowdown in the real sector, including consumption and production, an unstable financial market owing to a bearish stock market, and twin deficits. A decline in federal fund rates will trigger a fall in mortgage rates, which will increase new one- family house total sold and new construction spending, leading to brisk housing businesses. However, the Conference Board, the U.S. based research institute, announced that March's consumer confidence index decreased to 62.5, down 2.3 points from the previous month. This number is the record low in 13 years. The ISM (Institute for Supply Management) announced that March's PMI (Purchasing Management Index) was 46.2. Unemployment rate rose to 5.8%, slightly up from 5.7% in February, while the total number of employed decreased. Stock prices on the Dow and NASDAQ will not be bullish as the real sector is expected to be sluggish. In addition, the expanded fiscal deficit due to a rise in the cost of waging war and the snowballing of current account deficit due to a rise in imports will be a factor to delay the recovery of the U.S. economy.

Korea's GDP in 2Q is forecasted to grow by 4.1%, as uncertainties in the global economy induced by the ongoing war between the U.S. and Iraq dwindle consumption and investment sentiment, boost imports with a surge in oil prices, and cause higher inflation. This forecast is backed by evidence that leading composite index, consumption expectation index, and BSI (Business Survey Index) all are declining <Figure 8>. According to the Bank of Korea's ‘Business Survey Index in February of 2003', the forecasting BSI of the manufacturing industry rose to 89 in March, up from 84 in the previous month. The forecasting BSI of profit was 84 in March, similar to 83 recorded in the previous month. The forecasting BSI of equipment investment execution decreased to 95 in March from 98 in February <Figure 9>.

- 33 -

<Figure 8>            Business Survey Index (BSI) Trends

Note:     1)  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.

<Figure 9>     Trends of Forecasted Business Survey Index (BSI)

Note:       1) The peak of the business cycle (P) in August 2000 and the trough (T) in August 2001 are KIF forecast. 

Sources:  The Bank of Korea, The Korea Development Bank, The Federation of Korean Industries, Korea Chamber of Commerce & Industry

- 34 -

<Table 4>          Trend and Forecast of Economic Growth¹⁾

(%)

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

2) Goods and services. 

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

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

(%, %p)

Notes:   1) Figures after 2002 are KIF forecasts. 

 2) Year- on- year percentage changes. 

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

- 35 -

<Figure 10>   Consumer Expectation and consumer Evaluation Index

Note:     1)  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 11>                Spending Plan CSI

Note:    1) 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.

- 36 -

By sector, private consumption is expected to pick up by 3.9%, which is much lower than that of 2002. The slowdown is attributed to reduced consumption sentiment, a rise in inflation, a rise in the delinquency ratio of household debt, and a bearish stock market. According to a survey by the National Statistical Office, the consumer expectation index, which predicts the consumption pattern of the next six months, reached 96.1 in February, similar to that in the previous month. The consumer survey index (CSI), which is used by the BOK to plan and forecast the level of consumption, reached 103 in 1Q of 2003, which showed a decreasing trend since 1Q of 2002. The stock prices are not expected to drop further, however, positively contributing to consumption <Figure 12>. 

Equipment investments in the National Account are forecasted to increase by 5.3%, as economic recession, North Korea's nuclear issue, SK Global's accounting fraud, and increased risks in bonds issued by credit card companies weaken investment sentiment. This slight rise is supported by a declining BSI for equipment investments, a slow growth in the equipment investments adjustment pressure index, and low average operation ratios. The forecasting BSI for equipment investments execution declined to 95 from 98. The equipment investments adjustment pressure index depicts the difference between the manufacturing production index and manufacturing production capacity index <Figure 13>. Average operation ratios recorded 77.7% between January and February, much lower than that before the economic crisis. Capital imports for domestic use excluding semiconductor and automobile parts increased by 35.0% between January and February, however, implying that equipment investments are expected to fall significantly if economic uncertainties are eased.

Construction investments will increase by 5.9% as orders for construction in the public sector increase due to advanced fiscal spending and construction investments in the private sector rise significantly due to an increase in orders for construction in the private sector between January and February.

- 37 -

<Figure 12>         KOSPI and Private Consumption

Note:       1) The peak of the business cycle (P) in August 2000 and the trough (T) in August 2001 are KIF forecast. 

Sources: The Bank of Korea, Bloomberg.

<Figure 13>          Pressure on Equipment Investment

Note:       1) The peak of the business cycle (P) in August 2000 and the trough (T) in August 2001 are KIF forecast. 

Sources: The Bank of Korea, National Statistical Office.

- 38 -

Price and Wage

1) Review

In January, the consumer price index (CPI) increased by 3.8% YOY and 0.6% month- to- month, recording over 3.0% YOY for three months since November 2002. This rise was affected by a 6.8% rise in agricultural and marine product prices due to seasonal factors, including the biggest cold wave and the Lunar New Year holidays, a gain in manufacturing product prices (4.2% YOY) due to a surge in international oil prices, and a rise in housing prices and rent. In addition, private service prices (2.9% YOY), including health insurance fees and private tutoring prices, attributed to the rise in inflation <Table 6>. In February, CPI continued to rise by 3.9% YOY because agricultural and marine product prices (1.2% month- to- month), housing rent (0.2% month- to- month) and private service prices (0.3% month- to- month) rose and manufacturing product prices continued to rise in conjunction with international oil prices.

<Table 6>            Contribution Ratios by Factor¹⁾

(%)

Notes:    1) Year- on- year percentage changes.

2) Period average. 

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.

- 39 -

New characteristics in inflation pattern are as follows. First, the gap between CPI inflation and core inflation has widened <Figure 14>. Second, private service prices continued to rise, while housing rent grew at a slower pace. Third, public service fees rose rapidly, rebounding strongly from its decreasing trend last year <Figure 15>. 

The producer price index (PPI) rose by 5.1% YOY and continued to rise from August 2002. This was the first time since November 1988 that the PPI recorded a greater than 5.0% growth. This was attributable to a gain in agricultural and marine product prices due to the decreased shipments in the biggest cold wave and a rise in demand from Lunar New Year. In addition, manufacturing product prices increased, particularly for petroleum and chemical products, due to a surge in international oil prices <Table 6>. In February, although agricultural and marine product prices went down due to a slowdown in demand after the Lunar New Year and increase in shipments, PPI increased by 5.2% YOY (0.6% MOM) as the prices of manufacturing product rose due to an increase in international oil prices and public utilities charges, including an increase in electricity, water supply, and city gas.

<Figure 14>                 Trends of Prices

Note:     1) The peak of the business cycle (P) in August 2000 and the trough (T) in August 2001 are KIF forecast.

Source: National Statistical Office

- 40 -

<Figure 15>           Trends of CPI in Service Group

Note:     1) Weight (service = 549.7, housing rent = 131.4, public service = 150.9, personal service = 267.4).

Source: National Statistical Office.

<Figure 16>        Trends of CPI and Dubai Oil Price

Note:      1) The peak of the business cycle (P) in August 2000 and the trough (T) in August 2001 are KIF forecast. 

Sources: National Statistical Office, Bloomberg.

- 41 -

<Figure 17>      Trends of CPI and Won/Dollar Exchange Rate

Note:       1) The peak of the business cycle (P) in August 2000 and the trough (T) in August 2001 are KIF forecast. 

Sources: National Statistical Office, Bloomberg.

<Figure 18>         Consumer and Producer Price Indices

Note:     1) The peak of the business cycle (P) in August 2000 and the trough (T) in August 2001 are KIF forecast. 

Source: National Statistical Office.

- 42 -

Import prices (unit: KRW) increased by 2.5% YOY (0.9% from the previous month) in January because the price of raw materials, including international crude oil, jumped up. Raw material prices were unstable due to the possibility of war between the U.S. and Iraq and labor strike in Venezuela's petroleum sector. Capital and consumption goods imports, however, decreased month- to- month by 1.6% and 0.1% respectively, because of a fall in won/dollar exchange rate and increase in production. In February, import prices rose by 3.5% month- to- month (5.2% YOY) as the prices of raw material, capital and consumption goods increased by 3.9%, 1.0%, 2.9% respectively, due to a surge in international oil prices and a weak won/dollar exchange rate. In January, export prices (unit: KRW) decreased by 0.5% month- to- month(4.3% YOY) due to a fall in won/dollar exchange rate and a decline in demand. In February, however, export prices rose by 2.5% sequentially due to a basis effect as well as a rise in won/dollar exchange rate and international oil prices.

In January, the number of unemployed recorded 789,000, down 58,000 from the same month last year, raising the unemployment rate to 3.5% from 3.1%. The number of unemployed, however, increased 87,000, raising the unemployment rate by 0.4% point. The slight rise in the number of unemployed was due to a seasonal decrease in employment in agricultural and construction industries and the addition of graduating college seniors and students in winter

vacation to the pool of job hunters. In February, the number of unemployed

increased to 822,000, up 33,000 from the previous month and the unemployment rate increased to 3.7% from 3.5% in January. In particular, the number of unemployed in the twenty- something age group increased most significantly. 

- 43 -

<Figure 19>              Trend of Import Prices

Source: National Statistical Office.

<Figure 20>              Trend of Unemployment Rate

Note:     1) The peak of the business cycle (P) in August 2000 and the trough (T) in August 2001 are KIF forecast. 

Source: National Statistical Office.

- 44 -

<Figure 21>            Trend of Wage Growth Rate

Source: Ministry of Labor.

In 2002, the average monthly wage for companies with 5 or more employees increased to 1.95 million KRW, a 11.3% gain YOY. In the real term, it is estimated to be 1.82 million KRW, a 8.2% rise YOY. By quarter, the average monthly wage continued to rise, recording 9.4%, 11.0%, 11.2%, and 13.5%, respectively, in 2002. By industry, the social and private service sector recorded the biggest increase of 12.4% and the manufacturing sector recorded a 11.9% gain <Figure 21>. During 1Q of 2003, the average wage is estimated to rise by 8.0%, which is lower than that of the same period last year. 

2) Forecast

In spite of the economic downturn, CPI inflation during 2Q will mark 4.1% YOY due to cost- push inflationary pressures. Oil prices surged in 1Q of 2003 due to the possibility of war between the U.S. and Iraq, contributing to high inflation in the first quarter. Chances are high that oil prices will rise if the war is prolonged and terrorist attacks reoccur. The value of the won will depreciate due to the 

- 45 -

instability in the domestic and external environment. Cost- push inflationary pressures will be reflected in the rise in public service fees, including transportation and public utility fees such as city gas prices.

The trend of inflation in 2003 will be similar to that in 2001. In 2001, despite a decrease in oil prices, slower economic downturn, a policy regulation on the rise in public utility fees in the second half, a rise in the won/dollar rate and public utility fees boosted the CPI inflation to 4.1%. This year, a surge in crude oil prices will boost the CPI inflation level, even though the won/dollar rate and public utility fees decrease. The Dubai oil price was US$26.2 in 2000, US$22.7 in 2001, and US$23.8 in 2002 on the annual average, while it jumped to US$28.5 during the first quarter of 2003.

In 2Q, the unemployment rate is expected to maintain the 1Q level of 3.5%, as a sluggish economic recession in 2Q and high inflation reduce labor demand. In addition, the aggravated terms of trade will reduce the profitability of exports and a slower increase in exports is expected in 2Q, raising the unemployment rate.

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

(%)

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

2) Period average.

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

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

- 46 -

<Figure 22>         The Trends of the CPI Growth Rate

Source: National Statistical Office.

The Balance of Payments

1) Review

During the first quarter of 2003, the current account is expected to post a US$1.37 billion deficit, recording a deficit for the first time since the third quarter of 1997. The deficit resulted from a rise in crude oil prices due to a possible war in Iraq, which reduced the nation's goods account despite strong performance of exports, and a rise in spending by Korean tourists abroad, which widened the service account deficits.

In January, the goods accounts surplus edged up to US$0.8 billion, which is an improvement of US$0.47 billion from the previous month, as exports increased by 25.9% year- over- year(YOY). On the other hand, in February, the goods account decreased by US$0.59 billion, which was a decline of US$ 0.27 billion from the previous month, as the demand for capital goods, such as machinery, electronics, and semiconductors, 

- 47 -

increased sharply by 31.9% along with raw material imports, centering on crude oil.

During the first quarter, the capital account is expected to maintain its level. This is because the inflow of foreign investment slowed down overall in the quarter as uncertainty in the financial market was aggravated by heightening tensions in the Korean peninsular, particularly with North Korea's nuclear program and SK Global's accounting scandal. In January, the capital account recorded a US$0.9 billion net inflow thanks to foreign stock investments and issuances of development institution's mid-  to long- term bonds. However, in February, the capital accounts recorded a US$0.08 billion net outflow despite an inflow of banks' short- term borrowings. As foreign stock investment recorded an outflow of US$0.6 billion this month as geopolitical tensions, such as North Korea's nuclear issues and the U.S.- Iraq war, were aggravated. Also, domestic institutional investors increased direct investment abroad and purchase of foreign mid-  to long- term bonds. 

In the first quarter of this year, custom- cleared exports (f.o.b) increased 21.0% YOY to US$43.15 billion, rising for the fourth consecutive quarter. The trade account, however, resulted in a US$1.02 billion deficit as custom- cleared imports also increased 30.9% YOY to US$44.24 billion, which was mainly triggered by the rise in crude oil and raw materials prices due to a possible war in Iraq. As for monthly trend, in January, exports increased by 25.8% YOY, recording US$14.3 billion, despite a decrease in the number of business days due to the Lunar New Year holidays. This steep rise in export growth resulted from a favorable trend of major item exports, such as IT products, automobiles and so on, along with a basis effect, caused by the poor performance of exports during the same period last year. In February, exports increased by 21.7% YOY, which has exceeded the 20% growth rate for the fifth consecutive month since October 2002, posting US$15.4 billion, as the amount of daily average exports exceeded US$0.6 billion. In March, exports recorded US$15.4 billion, increasing 16.3% YOY. This is the largest monthly amount, breaking the existing record of US$ 15.3 billion from June 2000. For the quarter, the strong performance of exports was attributable to the increased foreign, especially Chinese, demand for major export items, such as wireless communication equipments, vehicles, machinery, petrochemical products, and steels, along with a basis effect.

- 48 -

<Figure 23>     Exports, Imports, and Balance of Goods Account

Source: The Bank of Korea, Balance of Payment, various issues

<Figure 24>     Foreign Investment and Balance of Capital Account

Source: The Bank of Korea, Balance of Payment, various issues.

- 49 -

As for exports by commodity during the first quarter of this year, semiconductor exports showed strong performance, recording US$4.08 billion, which is up 9.7% YOY. This improvement is mainly attributable to the boost in major companies' production to increase market share and convert to DDR DRAM production line, along with a basis effect due to a poor performance during the same period last year despite a paralysis of world demands for PCs. The wireless communication equipment exports increased 48.0% to US$4.06 billion, as exports to China and the U.S. increased rapidly.

<Figure 25>            Trends in Semi- conductor Prices

Source: Bloomberg.

- 50 -

<Table 8>         Exports and Imports by Item and by Area

($100 mil.)

Note:     1) Parenthesized numbers indicate the ratio of each export item to total exports.

Source: Ministry of Commerce, Industry and Energy, Report of Exports and Imports.

- 51 -

From February and on, wireless communication equipments were the most exported item, exceeding the number of semiconductor exports. Automobile exports showed a continuous upward trend, recording a 18.7% increase YOY, despite the shrinkage of the world automobile market. The increase seemed to be attributable to greater exports, which was caused by the need to replenish a shortage of inventory and to restore the performance of the domestic market. Computer exports recorded US$3.10 billion, up only 1.0%, as the continued rising exports to China and Europe were offset by the sharp decline in exports to the U.S. and ASEAN region. Petrochemical product and steel exports also continued to show a 35.0% and 37.3% increase YOY, respectively, due to the rise in international prices. As for exports by country and region, exports to China (60.8%), East Europe (41.6%), and EU (24.9%) continued to show a rising trend, while exports to the U.S. (2.9%) and Taiwan (- 3.9%) exhibited poor performance. In particular, China became the largest recipient of Korea's exports, overtaking U.S., as exports to China occupied more than 17% of Korea's total exports.

<Figure 26>        Trends of International Crude Oil Price

Source: Bloomberg

- 52 -

In the first quarter of 2003, custom- cleared imports (c.i.f) amounted to US$44.24 billion, up 30.9% YOY. This was mainly due to a rise in international crude oil prices from a possible war in the Middle East region and an increase in exports, which in turn induced a rise in imports of capital goods, such as equipments and intermediate goods, including machinery, electronics, and semiconductors. 

As for the monthly trend of imports, in January, imports recorded US$14.5 billion, increasing 27.8% YOY. A large- scale increase in imports, particularly of energy related products, was caused by the rise in oil prices prior to the U.S.- Iraq war and during Venezuela government enterprise's strike. As high oil prices and the uncertainty of the situation in the Middle East continued in February, imports, centering on capital goods and energy- related items, increased on a large scale and recorded US$13.8 billion, rising 32.1% YOY. In March, imports recorded US$15.9 billion, which is the largest monthly amount in history, exhibiting an increase of 32.8% YOY.

As for import figures by commodity and by use, imports of raw materials recorded US$ 22.95 billion, up 31.5% YOY, as crude oil prices continued to sustain a high level. Capital goods imports continued to show a rising trend, recording a 31.7% growth rate YOY. Imports of consumption goods also increased by 18.3%, recording US$4.93 billon. 

The won/dollar exchange rate declined continuously in January and by the end of the month, it decreased to 1,170.5 KRW, the lowest level since July 2002. The fall was attributed largely to the weakening of the dollar around the world, induced by concerns over U.S.- Iraq war and North Korea's withdrawal from the Non- Proliferation Treaty(NPT). Also, foreign investors' continuous net purchase of stocks seemed to accelerate the fall of the won/dollar exchange rate despite the Korean government's verbal intervention in the foreign exchange markets. During February, the won/dollar exchange rate hovered around 1,170 KRW before it climbed up sharply to 1,207.8 KRW in mid- February, following the decision by Moody's to alter its outlook on Korea's long- term ratings, along with North Korea's nuclear issues. However, at the end of February, the won/dollar exchange rate 

- 53 -

stayed around 1,190 KRW with the weakening of the dollar in the international foreign currency markets due to concerns over the U.S. economy. But as concerns over North Korea's nuclear issues heightened after early March, the exchange rate rose to 1,256.86 KRW on 19 March. Although a government- run bank and BOK have intervened to limit the rising trend of the won/dollar exchange rate in the foreign exchange market after 10 March, the won/dollar exchange rate, on the contrary, continued to rise by virtue of SK Global's accounting scandal and concerns over the insolvency of credit card firms' bonds.

Since March, the co- movements between the won- dollar rate and the yen- dollar rate, which became evident since the end of 2001, weakened. Since early March, the won- yen rate has moved away from the limits of 1000±20 won per 100 yen, which it had maintained for the past year, and traded around the 1,050 KRW range at the end of March.

<Figure 27>   The Won/Dollar and Yen/Dollar Exchange Rate Trends

Source: Bloomberg

- 54 -

<Figure 28>       Banks' Maturity Amount on Foreign Borrowings¹⁾

Note: 1) Maturity amount of banks' foreign borrowing is estimated to about US$ 3～3.5 billion, including short- term borrowings. 

<Figure 29>Trends of the Korea 10 year Foreign Exchange Stabilization Bond Spread 

Note:     1)  The spread of the Korean government's ten- year foreign exchange stabilization bond over the ten- year U.S. treasury note

Source: Korea Center for International Finance

- 55 -

Additional interest rate to commercial banks' foreign borrowings exhibited a steep rise as uncertainties concerning the opening of the U.S.- Iraq war was aggravated along with the accounting scandal at SK Global and Moody's downgrading of Korea's long- term ratings, on the basis of North Korea's nuclear issues. Therefore, additional interest rate to short- term foreign borrowings, which is due in three months, is estimated to increase to 0.15% in March compared to the previous month. Additionally, entering March, the spread of the Korean government's ten- year foreign exchange stabilization bond over that of the ten- year U.S. treasury note also widened notably and thus, increasing by 1.95% on 12 March. Besides, there is a possibility that commercial banks' supply demand situation for foreign funds may worsen as maturity amount of short and mid- term foreign borrowings is expected to reach to US$9～10 billion during the second quarter. However, although foreign financial institutions reduce the credit line on domestic commercial banks in parts, along with increasing foreign borrowings interest rate, it does not seem to be a big problem for domestic banks to convert issues. 

<Table 9>    Trends of Additional Interest Rate on Foreign Borrowings¹⁾

(%)

Note: 1) The spread over LIBOR(London Interbank Offered Rates)

- 56 -

2) Forecasts

In the second quarter of 2003, the current account is forecasted to record a US$ 0.54 billion deficit. This is expected to be induced by a sharp increase in imports, following the rising trend of exports, and the large services account deficits. Despite the expected decrease in foreign travels by virtue of Severe Acute Respiratory Syndrome (SARS), service account will record a US$1.74 billion deficit due to a rise in the payments for royalty and business services. In the second quarter, the trade account will show a US$0.93 billion surplus. This forecast is based on a continuous increase in international demand for major export items, along with the expected surge in the export market due to the end of the U.S.- Iraq war. 

During the second quarter of 2003, exports (f.o.b) are expected to increase 10.7% YOY to US$44.54 billion, showing a continuous rising trend. This favorable trend of exports results from the view that foreign demand for domestic major export items will improve in conjunction with foreign consumer psychology, which will be positively affected by the early ending of the U.S.- Iraq war, as well as the sustained strong growth of the Chinese economy. 

As for exports by commodity, semiconductor exports will decrease significantly in the second quarter as the PC market is expected to continue to be depressed and a fall in semiconductor chip prices, due to an oversupply of DRAM, is expected to last throughout the next quarter. Moreover, semiconductor exports are expected to deteriorate significantly as the U.S. government has decided to preliminarily impose countervailing duties, at the high rate of 57.7%, on Hynix semiconductor, and EU also seems to have decided on imposing high tariffs at the end of April, at rate of 30% or so. Computer exports, including LCD monitors, are expected to slowdown in growth in the second quarter as computer assembly plants continue to move abroad and as foreign demand for computers decline with the delay in corporate IT investments in the midst of a global economic slump. Automobile export growth will be sustained throughout the second quarter because a high- demand season is drawing near and export price competitiveness is expected to improve with a 

- 57 -

weakening trend of the won in the second quarter. Besides, in case the U.S.- Iraq war ends quickly, consumer psychology in leading economies will recover, along with a fall in crude oil prices, and this will accelerate the growth rate of computer exports. Wireless communication equipment exports, centering on cellular phones, are forecasted to help increase the growth rate of overall exports as they are expected to exhibit a sharp rising trend in EU and the U.S., as well as China.

<Table 10>            Forecasts for Exports and Imports

($100 mil. %)

Note:    1) KIF Estimates

Source: Ministry of Commerce, Industry and Energy

Imports (c.i.f) are expected to rise by 17.3% YOY, exceeding the export growth rate, to US$43.61 billion in the second quarter of 2003. Imports of crude oil and items related to petroleum will be reduced in the next quarter thanks to the expected fall in import prices of oil, affected by the early ending of the U.S.- Iraq war. However, an increase in domestic demand for machinery, machine parts and components, and semiconductors due to the buoyancy of exports will induce a relatively high growth of imports. 

The won/dollar exchange rate is expected to fluctuate within the band of 1200～1220 KRW in the second quarter of 2003. The decline in the exchange rate will be led by expectations for a peaceful resolution of the North Korea nuclear issue, driven by talks between North Korea and the U.S., although the dollar is expected to exhibit a strong trend overall in the international foreign exchange market after 

- 58 -

the U.S.- Iraq war. If North Korea's nuclear issues were brought to early resolution by talks between the U.S. and North Korea, there is a possibility that the won/dollar exchange rate would decline sharply to the level of 1100 KRW. At the same time, the movement of the won and the yen will be synchronized again. Meanwhile, if the talks among related countries proceed with difficulty and as a result, tensions related to the North Korea nuclear is further escalated, the won/dollar exchange rate may rise by over 1,300 KRW within a short period.

<Table 11>       Trends and Forecasts for the Current Account

($100 mil., %)

Note:     1) KIF Estimates

Source:  The Bank of Korea, Balance of Payment, various issues.

- 59 -

Money and Interest Rates

Money

1) Review

During the first quarter of 2003, the slowdown in the Korean economy became more pronounced as consumer and investor confidence deteriorated in response to heightened geopolitical risks, particularly relating to the war between the U.S. and Iraq and the North Korea's nuclear weapons issues. The rise in Inflation also accelerated with a sharp rise in crude oil prices. The weakening of market sentiments due to prevailing uncertainties in the domestic and overseas markets was shown in the decline in both stock prices and long- term interest rates. Reflecting the widespread uncertainties, the liquidity in the market was concentrated mostly on short- term deposits, centering on MMFs at Investment Trust Management Companies (ITMCs). 

Entering March, the domestic market became highly unstable as a huge flow of funds was drawn from MMFs following the news of SK Global's accounting scandal and the financial weakness of credit card companies. Taking into account such fragile financial market conditions, the Bank of Korea (BOK) flexibly supplied liquidity through the issuance of Monetary Stabilization Bonds (MSBs) and RP operations, while maintaining its benchmark overnight call rate at its current level of 4.25%.

The BOK has also decided to publish new monetary aggregate indicators, the so called new M1 and M2, from this year to accurately inform market participants of the market liquidity conditions, and the statistics have already been published for the first quarter.

The Korean economy entered a downward phase from early this year, as consumption and investment decreased significantly, following heightened domestic 

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and overseas geo- political uncertainties.  However, exports grew at a solid pace, recording 25.9% and 22.5% in January and February, respectively. However, the pace of consumption growth slowed down significantly owing to the contraction in consumer confidence, which was affected by the government measures for restraining household loans, as well as by widespread market uncertainties. Equipment investment and industrial activities indices also exhibited weaknesses entering this year. For example, the estimation index of equipment investment declined sharply from 2.4% in December 2002 to - 7.7% in January 2003. The industrial production growth rate significantly declined to 3.0% YOY in January from 9.7% last December. The contraction in consumption and investment mainly stemmed from the geopolitical risks relating to the possibility of war between U.S. and Iraq and the North Korea's nuclear weapons issues. When the war started, it was widely believed that the war would not last long, and as such, the domestic and world economies were positively affected by the perception of reduced uncertainties. As the war advanced, however, some began to doubt the possibility of a quick war. 

<Table 12>             Trends of Major Sentiment Index

Notes: 1)The Korea National Statistical Office (NSO)

2)  The Consumer Survey Index (CSI) represents how consumers feel about the economy over the next six months.

3) The Federation of Korean Industries (FKI)

4)  The business survey index (BSI) represents how enterprises feel about the business condition by industry over the next month.

Concerns over the impact that a delayed U.S.- Iraq war would have on the Korean economy became widespread. It was also doubtful whether advanced economies would recover rapidly even after the end of the war. The Korean economy, in particular, was faced with another serious geopolitical risk, i.e. North 

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Korea's nuclear weapons issues.

Notwithstanding the downward trend of economic growth, consumer price index rose in January and February, registering 3.8% and 3.9%, respectively. These inflationary pressures stemmed from the increase in industrial product prices, following a rise in oil and agricultural product prices due to seasonal factors. In contrast to consumer price index, core inflation remained stable at around the 3% level during the first quarter. During the same period, international oil prices rose sharply due to the prospect of a war between the U.S. and Iraq, and the strike at a state- run oil company in Venezuela. Because of the heightened possibility of a war between the U.S. and Iraq, prices of Dubai skyrocketed to $30.89 per barrel as of March 10, from $17.91 per barrel as of the end of January. The hike in oil prices have added instability in the financial markets by adding inflationary pressures as well as the aggravating the current accounts. After the outbreak of the war in Iraq, however, oil prices shifted to a sharp declining trend, reflecting expectations for a quick war. Consequently, prices of Dubai registered $24.78 per barrel as of the end of March.

Negatively affected by the geopolitical risks and economic uncertainties, investors became seriously risk averse during the first quarter. And as a result, the stock market continued to be bearish. Despite the unstable financial market conditions, the corporate sector did not face difficulties  raising funds. This was mainly due to the low demand for funds by corporations as they delayed facilities investments. Depositors and investors showed strong preferences for short- term financial products typically centering on MMFs at ITMCs, in response to the narrowing of spreads between long- term and short- term interest rates and growing uncertainties in the domestic and overseas economic conditions. After the outbreak of SK Global's accounting scandal in mid- March, however, a large flow of funds started to shift from MMFs to the banking sector, centering on MMDA. In addition, concerns over the deteriorating asset quality of credit card companies accelerated such shift of funds.

As aforementioned, during the first quarter, the BOK has stopped publishing 

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existing monetary aggregates, such as M1 and M2, and began to use new monetary aggregates instead. The compilation of previous monetary aggregates was based on the legal status of financial institutions rather than the liquidity of financial instruments. Accordingly, monetary aggregates were not able to accurately reflect the actual liquidity level of the domestic economy. 

<Table 13>     Components of New Monetary Aggregate Indicators

The new M1 includes all the instant access accounts of the banking and non- banking sectors, in addition to the current M1. The new M2 is composed of the new M1, short- term marketable deposits, time and savings deposits, money in trust, beneficiary certificates and debentures of less than 2 years. The new monetary aggregates clarified the structure of and movement between long and short- term liquidity. According to BOK's analysis, the new monetary aggregates are expected to provide a more detailed explanation about the macroeconomic variables, although they do take a month longer to publish than what was required for the original monetary aggregates. 

Throughout the first quarter, the Monetary Policy Committee of the BOK 

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decided to maintain the benchmark overnight call rate at its current level of 4.25%. The BOK absorbed 4.8 trillion KRW of short- term excess liquidity through open market operations in January. The BOK evaluated that the market had been supplied with too much liquidity as the funds withdrawn at the end of last year were returned back to the financial institutions and short- term speculative funds were increased due to growing concerns over various economic uncertainties. As financial institutions preferred to invest in long- term, safe assets regardless of the low rates of return, long- term interest rates declined rapidly. In response to this, the BOK decided to absorb 1.3 trillion KRW of excessive market liquidity through RP operations and the net issuance of MSBs in order to moderate the decline in long- term interest rates. The BOK continued to absorb the excess liquidity through RP operations until mid- March. However, when SK Global's accounting scandal and credit card companies' financial troubles triggered huge withdrawals from MMFs, the BOK quickly supplied liquidity through RP operations to stabilize the financial markets. Overall, during the first quarter, the BOK absorbed excessive liquidity through net issuance of MSBs and controlled short- term liquidity through RP operations, in accordance to prevailing financial market conditions. 

The most significant characteristic of deposits and investments during the first quarter was a sharp increase in short- term deposits, centering on MMFs of the ITMCs from January and February, and the sudden reversal from ITMCs to deposit money banks (DMBs) after mid- March when SK Global's accounting scandal was made public. In January, deposits centering on MMFs and short- term bond- type beneficiary certificates at ITMCs surged, while those of DMBs decreased by 4.3 trillion KRW as those funds placed in demand deposits at the end of previous year were moved into ITMCs. Savings deposits also decreased due to interest rate cuts on deposits. In February, deposits in the DMBs increased by 1.1 trillion KRW due to an influx of funds which were supplied just before the Lunar New Year. Deposits at ITMCs increased by 16.5 trillion KRW in January and February, and the sale of MMFs increased by KRW 10.6 trillion. Such shift of funds from DMBs into ITMCs continued until mid- March. The direction of fund flows, however, was 

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reversed after SK Global's accounting scandal. Deposit- taking by ITMCs fell sharply in March due to the redemption of MMFs following the SK Global's accounting scandal and as concerns over credit card companies' financial troubles heightened. As a result, ITMCs' total deposit- taking during March declined 24.7 trillion KRW, while MMF fell 20.3 trillion KRW. In contrast, deposit- taking by DMBs, centering on MMDA, increased sharply in March, which attracted a major part of the funds withdrawn from ITMCs. Most funds withdrawn from ITMCs rushed to MMDA at DMBs, recording an increase of 13.7 trillion KRW from March 12 to 20. And deposits at securities firms also increased sharply as money withdrawn from ITMCs' fixed income funds and MMFs rushed into the stock market with expectations for a market rebound.

<Table 14>        Recent Deposit Changes at Financial Institutions¹⁾

(billion won)

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

Source: The Bank of Korea, Money and Banking Statistics (various issues), Trends of Daily Financial Market, Trends of Financial Market in March.

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Another feature of the financial market during the first quarter was the shortened maturity structure of the deposits in financial institutions. The ratio of short- term deposits to total deposits at financial institutions remained high, reaching the top level of 42.15% as of February from 41.49% as of the end of the previous year. The high ratio was caused mainly by the inflow of funds into MMFs, as investors began to favor short- term financial assets. Those factors that caused a sharp increase in short- term investments included the overall economic uncertainties, the continued low interest rates, bearish stock markets and government's enforcement of measures restraining speculative real estate investments. Too much concentration of funds into the short- term products always have the possibility of causing large scale shifts in other products, which may result in disturbing the overall financial market. In mid- March, this concern was realized as the financial markets were 

<Figure 30>     Short- term Deposit at Major Financial Institutions¹⁾²⁾

Notes: 1)Short- term deposits = Demand deposit + Instant access accounts + Short- term marketable deposits (CD+RP+Cover bills) + Short- term bond- type beneficiary securities + MMFs + Deposits at Merchant banking corporations

2) Long- term deposits are the sum of deposits at Deposit money banks, Investment trust management companies, Trust accounts of banks, and Stock accounts, but exclude short- term deposits. 

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<Figure 31>       Outstanding Deposit Bank Loans by Type and 

Ratio of Households to Total Loans

<Table 15>                   Trends in Bank Loans¹⁾²⁾

(Trillion KRW)

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

2)Includes trust accounts.

3)Excludes trust accounts, and includes loans for housing purchase.

Source: The Bank of Korea, Trends of Financial Market in March.

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temporarily thrown into turmoil due to the exodus of money from MMFs, in response to SK Global's accounting scandal and growing concerns over the deterioration of financial soundness in credit card companies. Although the sudden exodus of money from MMFs gradually slowed down with the help of government measures, there still exists latent factors which could send the financial market into turmoil again.

In terms of corporate financing, bank loans to the corporate sector expanded sharply by 16.4 trillion KRW during the first quarter. The increase in bank loans was mainly due to seasonal factors, such as the payment of value added taxes and the Lunar New Year, etc. Bank loans to the household sector decreased by 0.3 trillion KRW in January, the first decrease since January 2001. Mortgage- based loans increased only slightly, reflecting the effects of government policy in restraining household loans for real estate investment. Bank lending to the household sector in February, however, shifted to a 2.5 trillion KRW increase. This was mainly caused by a sharp increase in lending to overdraft accounts holders for paying school tuition fees. 

Reflecting all these economic movements, M3 growth rate recorded 13.1% during January, a decrease from the previous month's 13.3% due to the decline in credit to the private sector, including lending to households. M3 growth continued to decline in February, registering 12.6%, owing to the decline in household loans and payment of value added tax of approximately 7.2 trillion KRW. M3 growth is estimated to have declined to around 12% level in March. New M1 growth rate decreased to 13.7% in January, down from the previous month's 15.2%, and again decreased to 9.5% in February. This decreasing trend mostly stemmed from the slowing rate of increase in demand deposits and cash due to the economic slowdown and dampened consumer sentiments. The new M1 growth rate is estimated to have reached a 7% level during March. New M2 growth recorded 13.9% during January, slightly lower than the previous month's 14.1%. It further decreased to 13.3% in February. 

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<Table 16>             Trends in Monetary Growth Rates¹⁾

(%)

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

2) Preliminary values

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

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

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

5)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.)

Source: The Bank of Korea, Money and Banking Statistics (various issues), Trends of Financial Market in March.

<Figure 32>        Trends in Major Monetary Growth Rates¹⁾

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2) Forecast

During the second quarter of 2003, the Korean economy is expected to slowdown further due to contractions in consumption and investment, uncertainties remain over the domestic and overseas economic conditions. Although the geopolitical risks surrounding the Iraq war are diminished, there are deep doubts over whether the global economy would recover from its long depression in the near future. While North Korea's nuclear weapons issues will be the most important determinant for the direction of  Korean economy, the negative effects of SARS on the Asian countries and the Korean economy may become increasingly visible, which may also lower the forecast for this year's growth rate. 

Considering these uncertainties, the BOK is expected to supply sufficient amount of liquidity. The current problems in bond markets, including concerns over deteriorating asset quality of credit card companies following an exodus of MMFs caused by the SK Global crisis, are seen to be somewhat eased by the government's prompt bailout plans. However, considering that the major cause of the current problems in bond markets is a credit quality issue rather than a temporary liquidity problem, government intervention did not provide the fundamental solution. Thus, it is thought that there are still latent aggravating factors in the financial market.

Growth rates of major monetary aggregates are forecasted to be slightly lower than the previous quarter due to a slowdown in the growth of private loans and a decrease in money supply through the foreign sectors. For the time being, it is difficult to expect that deposit- taking by ITMCs would recover the level prior to the exposure of the SK Global's accounting scandal. Corporations' demand for bank loans will increase due to the contraction of other funding channels, such as CPs and corporate bonds. However, the amount of loans to corporate sectors is expected to increase only slightly, compared to the previous quarter, due to continued contraction in demand for equipment investment, improved cash flows of large corporations and banks' cautious attitude toward lending. Money supply through private loans will not increase significantly as banks take a conservative stance in 

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extending household credit. Money supply through foreign sectors is expected to decline as capital accounts also post a decrease. As a result, the new M2 growth rate is forecasted to record around 12.9% in the second quarter, which is lower than that of the previous quarter. The M3 growth rate is expected to be around 12.5%, which is also slightly lower than that of the previous quarter.

<Table 17>           Monetary Growth Rate and Forecasts¹⁾

(%)

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

2)Preliminary values.

3)M2 is New M2.

Source:  The Bank of Korea, Monthly Bulletin, various issues, Money and Banking Statistics, Trends of Financial Market in March.

- 71 -

- 72 -

Interest Rates

1) Review

The demand for bonds continued to exceed the supply in the first quarter of 2003. The abundant market liquidity was translated into a strong demand for long- term bonds, while the supply of new bonds was very low due to the discouraged corporate demand for financing. Furthermore, geopolitical affairs of the middle east region and the Korean peninsula both had an extremely unfavorable impact on the Korean economy. Therefore, long- term and short- term rates declined gradually from the beginning of 2003. Although the long- term and short- term bond rates shot up with the revelation of the accounting irregularities at SK Global Co. in mid- March, they have now recovered to their pre- crisis levels. The War in Iraq finally began on March 20, triggering an immediate drop in crude oil prices. Ironically, the outbreak of the war itself was thought to be helpful in removing some of the geopolitical uncertainties, which had for many months added downward pressure on investor and consumer sentiment. Furthermore, the concerns related to the war in Iraq are expected to be soon overshadowed by those regarding North Korea's nuclear crisis.

<Table 18>        Quarterly Movement of Major Interest Rates¹⁾

Note:     1) Period averages.

Source: Bank of Korea, Fn- Guide.

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Despite high increase in exports, the Korean economy has started to slow down, due to the sluggishness in domestic demand since February 2003. During the first quarter of 2003, exports(F.O.B.) drastically increased to 21.5% YOY in spite of the global depression. However, the level of imports rose by 30.7% YOY due to a hike in international oil prices, war in Iraq and labor strikes in Venezuela. Therefore the balance of goods account(F.O.B.) recorded a US$8.4 billion loss during the first quarter of this year, which is the first time since the financial crisis.

The Bank of Korea has set the inflation target for the year to 3.0±1.0%, based on the annual rate of increase in core inflation. The consumer price inflation(CPI) increased to 3.8% and 3.9% YOY, respectively, from January to February, and rose sharply to 4.5% YOY in May, which is the largest YOY percentage increase in 19- months. This was not attributed to inflationary pressure from the demand side, but increase in international oil prices.

The Monetary Policy Committee of the Bank of Korea was set to maintain the call rate at 4.25% on January 9, due to concerns over economic uncertainty generated by North Korea's Nuclear crisis and potential war on Iraq. The BOK remarked that the monetary policy would be flexibly managed to accomodate the rapidly changing economic environment.

<Figure 33>              Major Long- term Interest Rates

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In January, deposit- taking at banks decreased by 6.9 trillion KRW, due to seasonal factors, such as payments of value added tax and the demand for funds before the Lunar New Year. However, deposit- taking, particularly in MMFs, which increased to a historical 60.4 trillion KRW, surged in ITMCs. This stemmed from re- inflows of funds withdrawn at the end of last year, the relatively higher profitability of short term financial products of ITMCs due to the decrease in bank deposit rates, the growing uncertainties about the economic conditions and a slowdown in the rise in housing prices.

Investors' demand for safe assets grew sharply in response to the overwhelming economic and geopolitical uncertainties. However, the supply of government bonds was far short of the growing demand. The amount of net issue of government bonds was 0.7 trillion KRW and the amount of corporate bond redemptions was 1.07 trillion KRW in February. The BOK absorbed 4.86 trillion KRW in long and short- term funds via Repos and Monetary Stabilization Bonds in January, which was not enough. 

<Figure 34>             Major Short- term Interest Rates

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Entering 2003, long- term interest rates maintained a downward trend. The government bond yield and corporate bond yield went down to 4.77% and 5.29%, respectively, in January.

Short- term interest rates, including those of CDs and CPs, dropped sharply in mid- January, while long- term interest rates declined gradually during January. The yield on CDs recorded 4.55%, a 0.35% decrease from beginning of January, and that of CPs decreased to 4.63%, a 0.34% fall from the beginning of January. Banks reduced their volume of CD issuances as household loans decreased. In return, ITMCs' demand for short term bonds, such as CDs and CPs, increased, thereby lowering the short- term interest rates in January. But it is difficult to explain why the short- term interest rate was suddenly adjusted downward by simply looking at the macro economic condition and the demand and supply of short- term bonds.

Banks began to lower their average- deposit rates to a historically low level of 3.88% in January. The decline was estimated to have been caused by a continuous downturn in household loans and imposition of added deposit insurance fee by the Korea Deposit Insurance Corp. Therefore, the real deposit rates at banks fell below zero in January and demand deposits decreased. 

<Figure 35> Spread between Lending     <Figure 36> Real After- tax Deposit

 and Deposit Rates at Banks                Rates at Banks¹⁾

Note : 1) Average- Deposit Rate at Bank -  CPI -  Tax(16.5%)

- 76 -

On the other hand, the lending rate at banks fell to the lowest level of 6.51% in January. Owing to the expanded lending to medium and small firms, the ratio of loan to deposits at commercial banks rose significantly in January. Furthermore, the interest rate on loans to households was also reduced as lending rates for collateral residence buildings started to decline.

Uncertainty in the external environment had mounted due to the possibility of a war between U.S. and Iraq and as tensions over North Korea's nuclear program heightened.  Consequently, the market interest rates sharply declined in January. Although some expected a reduction in call rates, the Monetary Policy Committee(MPC) froze the target call rate at 4.25% on February 6. The decision was based on the fact that economic recovery seemed to be continuing, as evidenced by the rapid growth of exports despite weaker consumer and investor confidence. The BOK's growth rate forecast was adjusted downward from 5.7% to 5.5% in February. But the BOK maintained their expectations of a global economic recovery to take place in the second half of this year, when geopolitical uncertainties are significantly eased.

<Figure 37>     Growth Rate of Loans to the Household Sector

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Entering February, the net issuance of government bonds amounted to 0.6 trillion KRW. Instead of issuing new bonds, corporations paid back their existing bonds in the amount of 4.39 trillion KRW. The net issuance of bank debentures amounted to a mere 1.5 trillion KRW, as bank deposits began to recover and the demand for household and corporate loans began to decline.

In February, long- term rates declined moderately, while the volatility of movement in long- term interest rates increased. Moody's cut its ratings outlook for Korea by two notches to "negative" from "positive" on February 11, reflecting the risk of military confrontation in the Korean peninsula. From mid- march and onward, the won per dollar exchange rate and long- term interest rates started to increase. Along with a decline in stock prices, government bond yield and corporate bond yield fell by 17bp and 16bp, respectively, at the end of February. The yield on CDs and CPs declined by 2bp and 4bp, respectively, from January to February.

The credit risk in the corporate sector was mitigated and the corporate bond yield spread gradually narrowed from February 2002. In particular, the interest rate spread between corporate bonds ranked BBB and AA-  went down to 2.19% and interest rate spread between corporate bonds ranked BBB-  and AA-  decreased to 3.31% in February.

<Figure 38> Net Issuance of Principal    <Figure 37> Net issuance of Corporate

Government Bonds¹⁾                             Bonds²⁾

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

2) On the basis of amounts of total corporate bonds

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Deposit- taking by deposit money banks increased by 2.7 trillion KRW, while that of ITMCs increased by 5.7 trillion KRW in February.  Although bank reserves shrunk owing to tax payments in the beginning of February, they maintained a good condition due to a sizable government expenditure and increase in bank deposits after mid- February. 

<Figure 38>            KOSPI and Corporate Bond Yields

Sources : Korea Stock Exchange, Bank of Korea.

<Table 19>        Corporate Bond Yield Spread by credit Rating¹⁾

(%, %p)

Notes : 1) End of Period

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

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Early February, deposits at commercial banks declined as the after- tax real deposit rate turned negative and regular tax payments became due. The BOK supplied the needed short- term funds to commercial banks via RP promptly and sufficiently on February 6. The volume of BOK's purchase of RPs reached a historical 9.5 trillion KRW. Soon after commercial banks came out of financial difficulty, the BOK quickly absorbed 1.3 trillion KRW via issuance of 2.8 trillion KRW in Monetary Stabilization Bonds. It seems that the monetary authority supplied short- term liquidity, while absorbing long- term funds, in order to alleviate the declining trend in long- term interest rates. 

Entering February, as bank deposits increased sharply, a number of commercial banks decreased their deposit rates and increased their lending rates. It can be interpreted that the commercial banks attempted to revive their profitability by widening the spread between the deposit rate and the loan rate. Mortgage lending rates and credit loan rates were raised by 0.1%p and 1.0%p~2.0%p, respectively. And deposit rates were lowered by 0.1%p～0.5%p. 

<Figure 39>                   Repo Operating 

Source : Bank of Korea.

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The MPC decided to leave the overnight call rate unchanged at 4.25% on March 6, based on expectations for export growth rate to continue to rise despite contracting consumption and flagging business investment.

The MMF deposits reached a historical 62 trillion KRW on March 10. On March 11, however, when the SK Global accounting scandal was made public, investors rushed to withdraw their MMF deposits, which were invested in SK group's corporate bonds. The investors withdrew about 19 trillion KRW in 10 days. The ITMCs quickly sold a huge amount of government and high- grade corporate bonds from their portfolio in order to raise enough money to meet the 'fund run'. 

<Figure 40>       Daily Trend of AUM(Asset Under Management)

On March 13, the BOK pumped up short- term and long- term liquidity in the market. The BOK purchased 2 trillion KRW of RP and 0.5 trillion KRW of government bonds and repurchased 1.5 trillion KRW of Monetary Stabilization Bonds. Following the BOK's prompt actions, interest rates dropped quickly. It was embarrassing, however, for the BOK that the call rate reached 3.71% on March 21, as a huge amount of short- term funds shifted out of MMFs and into the banking sector during this turbulent adjustment period. From March 18 to March 21, the BOK tried to absorb the excess liquidity by selling 4.6 trillion KRW of RP per day, and the call rate resumed its target rate of 4.25% by March 27. 

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During May, bank deposits surged by 19.9 trillion KRW, while ITMC deposits decreased by 24.7 trillion KRW owing to a massive redemption of MMFs.

Long- term interest rates rose immediately after the outbreak of SK Global's accounting scandal. Government bond yields and corporate bond yields jumped up by 51bp and 60bp, respectively, on March 12. However, the BOK quickly supplied short- term funds in the market, after which, those rates declined by 70bp and 51bp, respectively.

The CD rate jumped up by 53bp on March 12 and 13, and slowly declined thereafter. However, the interest rate movement of CPs was different from the movement of other long- term and short- term interest rates during this period. The CP rate alone did not return to its pre- crisis level. The CP rate jumped by 0.62% during March 12 and 13. The rise in CP rate was caused by a drastic reduction in demand for CPs in the bond market after the SK's accounting scandal.

After mid- May, long-  and short- term fund flows were limited even with abundant short- term liquidity. This was due to deteriorated confidence in the bond market after the revelation of SK Global's accounting fraud and credit card companies' liquidity problems. Consequently, mid-  and large- sized firms attempted to raise funds through bank loans instead of through corporate bonds and CPs.

<Figure 41>         Trend of Won's Synchronization with Yen

Source : Bloomberg.

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2) Forecast

During the first quarter of 2003, domestic and overseas financial and capital markets were not completely free from recession, which was mostly caused by oil price hikes in expectations for a long- run war in Iraq. Therefore, while domestic economic condition weakened, long-  and short- term interest rates decreased, and abundant market liquidity and low interest rates continued in the first quarter.

In the first quarter, the U.S. led war in Iraq and North Korea's nuclear threats influenced domestic financial market and real economic activities, compounding the weak economic situation under the accumulation of household debts and liquidity problems in the credit card industry. However, it was estimated that uncertainties from the war in Iraq affected financial markets before March and North Korea's nuclear problems affected the markets after the beginning of March.

Moody's has adjusted downward its rating on the outlook of the Korean economy by two notches. Consequently, the won to dollar exchange rate and market interest rates jumped up, while stock prices showed no significant reaction. However, the won to dollar exchange rate started to deviate from its co- movement with the yen to dollar exchange rate, which had lasted for over a year, after mid- March. In addition, it is estimated that North Korea's nuclear problems had not affected the Korean economy till the beginning of March.

The long expected U.S. attack on Iraq finally began on March 20, and the uncertainties surrounding the war were somewhat alleviated. It seems highly likely that the war would be brought to an end in the second quarter of this year and as a result, the interest rates are expected rise and the condition of the Korean economy is expected to improve in the second half of 2003.

If the uncertainties related to the U.S.- Iraq war and the North Korean nuclear program are resolved, then the long-  and short- term interest rates will rise and the demand for money by consumers and corporation will recover.  Therefore, we cautiously predict a moderate pickup in long- term interest rates from the second quarter and onwards. The rate of increase, however, will not be as impressive due 

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to the currently abundant market liquidity and the BOK may want to maintain a slightly expansionary monetary policy stance in order to prop up the economy until a full- fledged economic recovery is secured.

Another important factor in determining market interest rates is the status of Korea's sovereign credit rating after April. If the credit rating is maintained at the current level, then the market rates will rise. However, if Moody's sovereign credit rating is downgraded from 'positive' to 'negative', then that determination would affect stock prices as well as the exchange rate. 

<Table 20>                  Interest Rate Forecasts¹⁾

(%)

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

4) M2 is New M2.

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Financial Market Developments

Banking

The total volume of bank deposits and loans increased by 1.7% and 4.6%, respectively, while the total volume of trust accounts decreased by 0.9% in the first quarter of 2003. Generally, the growth rate of deposits and loans continued to keep a downward trend since the first quarter of 2002 when they were 7.8% and 13.3%, respectively. The growth rates of deposits and trust accounts in the second quarter of 2003 are expected to maintain a similar level as those of the last quarter, but the growth rate of loans is expected to decrease slightly. In addition, while the interest rates on deposits are expected to decrease a little, the interest rates on loans are expected to increase slightly.

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

- 85 -

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

Deposit Market

1) Review

In the first quarter of 2003, the total volume of deposits held by depository banks recorded 583.4 trillion KRW, up 1.7% compared to last quarter. During this period, deposits were very sensitive to yields on investment alternatives while flight to quality became an increasing concern. The rise in deposit volume this quarter was due to the influx of repurchased MMF from Investment Trust Companies(ITCs), the flight to quality over geopolitical risks related to North Korea's nuclear issues and Iraq war, and the increased volume of foreign currency deposits. On the other hand, the growth rate of demand deposits decreased by 11.9% sequentially, due to seasonal demands during the Lunar New year and tax payments. 

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<Table 1>                     Bank Deposits¹⁾

(billion KRW, %)

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 first quarter of 2003, the volume of time and savings deposits rose by 2.4%, totaling 468.2 trillion KRW. The reasons for this increase were the following: First, before SK Global's accounting fraud was made public in March, funds in time and savings deposits flowed into MMF accounts in ITCs as deposit interest rates declined. However, the outflow of funds from time and savings accounts suddenly converted to an inflow of funds into MMDA deposits from MMF accounts since the outbreak of the SK Global accounting scandal. In particular, the influx of funds into pass- book deposit marked about 10.2 trillion KRW(729 billion KRW per day) from the occurrence of SK Global accounting fraud to the end of quarter. 

- 87 -

Second, flight to quality concerns caused a slight increase in the volume of time and savings deposits. Flight to quality concerns originated from the expansion of geopolitical risks related to North Korea's nuclear issues and the Iraq war. Finally, the equity linked deposits(ELDs) remarkably increased in volume since the end of last year, because of optimistic expectations for the stock market and the favorable ELD yields. 

The volume of marketable financial products slightly increased, up 4.8%, totaling 57.8 trillion KRW, along with an increase in the volume of RPs and Cover bills. The volume of CDs decreased by 3.7%, totaling 18.9 trillion KRW, as they were repurchased from ITC accounts to secure liquidity after the announcement of the SK Global accounting fraud and as banks' need to secure short- term liquidity through marketable financial products declined as banks possessed plenty of liquid assets. On the other hand, the volume of Cover bills and RPs rose 9.5%. This increase was due to the higher demand for RPs based on government bonds, which were preferred with the flight to quality concerns over the SK Global accounting fraud, North Korea nuclear issues and Iraq war. 

The volume of foreign currency deposits rose by 10.1% in the first quarter, totaling 17.2 trillion KRW, as illustrated in <Table 1>. In particular, it marked US$13.7 billion as of March 2003, which is the highest level in history. A substantial increase in the growth rate of foreign currency was due to the depreciation of the won against the dollar and the increased demand for dollar, affected by the North Korea nuclear issues and the war in Iraq. 

The issuance of bank bonds raised 7.3 trillion KRW in the first quarter, which is 77% of the amount raised in the same period last year. The decline in bank bond issuances this quarter was mainly due to the following factors. First, in terms of asset management, issuing bank bonds imposed a heavy burden on banks' asset management because banks already had plenty of assets. Second, in terms of fund raising, the continuously increasing deposits were less expensive than issuing bank bonds. Third, ITCs lost their capacity for buying the issued bank bonds, because the outflow of funds from ITCs since the SK Global accounting fraud and 

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under- liquidity of credit card corporations had a serious impact on the financial market. 

In the first quarter of 2003, the average interest rates on deposits fell slightly. The interest rates have continued to remain low and the reasons are as follows. First, banks tended to bring interest rates down in consideration of high administrative fees, especially of pass book deposits. Second, the decline in overall market rates led a decline in interest rates of deposits. Finally, as banks' profitability has gotten worse, banks have tried to widen the spread between interest rates of deposits and loans by bringing interest rates of deposits down. 

<Table 2>           Interest Rates on Selected Bank Deposits¹⁾

(% per annum)

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

2) As of the end of February

3) Include MMDA

4) On the basis of account balance

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

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2) Forecast

The growth rate of the volume of deposits in won is expected to remain at a similar level in the second quarter of 2003 as in the first quarter for the following reasons. For starters, the increase in deposits is not likely to be very large, considering the interest rates of deposits, although plenty of market liquidity since last year has been sustained in the second quarter of 2003. Funds, which are sensitive to interest rate changes, are likely to move into alternative investment products, which provide more yields than deposits such as beneficiary certificates, MMF and ELS (equity linked securities). Second, if the financial market, which has been disturbed by the SK Global accounting fraud, becomes stabilized in the second quarter, the factors that caused the funds to move from ITCs to MMDA accounts last quarter will be less influential, and as a result, the increase in MMDA will not be as much as last quarter's. Third, the funds in deposit accounts may flow out gradually under an optimistic outlook of the stock market, a reduction in flight to quality concerns, a quick war in Iraq and the stabilization of North Korea's nuclear issues. Fourth, securities and ITCs will sell equity linked financial products actively in the second quarter of 2003, which will contribute to the decrease in deposits accounts. Lastly, there are seasonal factors, including tax- payments, which can cause a shift in deposit account funds. 

The total volume of marketable financial products is likely to slightly increase sequentially with the rising growth rate. Two factors will contribute to this increase. First, the volume of marketable financial products will increase slightly, because banks' need for liquidity will be greater as they would need the funds for buying credit card bonds. Second, the issuing volume of CPs or corporate bonds is expected to be more than last quarter's, if the financial market overcomes the affects of the SK Global accounting fraud in the second quarter. As the issuing volume of CPs or corporate bonds increases, the volume of marketable financial products will increase slightly based on the underlying assets. Third, corporations that preferred short- term financial products for controlling operational funds will demand the marketable financial products more because corporations tend to manage 

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operational funds raised by loans earlier, in preparation for possibly worsened economic conditions. 

The volume of foreign currency deposits is likely to decrease slightly compared to last quarter's. If the Iraq war is finished in the second quarter of 2003, demands for dollar in foreign currency deposits will decrease somewhat as geopolitical risks are reduced. The other expected factor is the deficit of trade account. During last year, the increase in foreign currency liquidity made the volume of foreign currency deposits to increase as exports grew. As the growth rate of exports has decreased slightly since 2003, however, the volume of foreign currency deposits actually will go down from the second quarter of 2003. 

The issuing volume of bank bonds is expected to sustain its level into the second quarter of 2003. Banks' need for raising capital by issuing bonds will decrease slightly because banks are facing difficulty managing their plentiful assets, which have grown by the decline in household loans, and risks from unstable corporate loans and uncertain financial markets. 

The average interest rates on deposits are expected to decline in the second quarter of 2003 compared to the first quarter. Banks do not have any incentive to increase interest rates on deposits because investors with flight to quality concerns continue to flow into deposit accounts and banks have difficulty managing assets from deposits. And, in expectations for worsened profitability, banks tend to secure their profitability by widening the spread between interest rate on deposits and loans. 

Loan Market

1) Review

In the first quarter of 2003, the total volume of loans reached 493.3 trillion KRW, a 4.6% increase compared to the last quarter. The characteristics of loans in this quarter could be summarized as the following three; the effect of SK Global accounting fraud, the decline in demand for household loans and the expectation of 

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weakening economic condition. Several factors have contributed to the increase in loan volume. First, the growth rate of household loans decreased substantially owing to the strengthened policies of the government against household loans. The increase of household loans in same period of last year and last quarter were 17.4 and 10.4 trillion KRW, respectively, but it rose to 4.9 trillion KRW this quarter. Second, the worsened economic outlook, the abrupt rise in oil prices and the decline in consumer consumption caused a decline in loan demands on the first half of this quarter. Also, corporations' avoidance of facilities investment decreased demands for loans on the first half of this quarter. However, corporate loans showed a sudden increase in volume since March of 2003, although they were less than the level in the same period of last year on January and February. A sudden increase in corporate loans was mainly due to demands for preoccupied operational funds with the consideration of expecting of possible worsening of cash flow. 

<Table 3>                         Bank Loans¹⁾

(billion KRW, %)

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

2) Measurement 

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

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As illustrated in <Table 4>, loans to small and medium sized firms rose by 14.7 trillion KRW in the first quarter of 2003. This rise 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, tax- payments, funds for Lunar New Year and refunds for year- end settlement increased loans to small and medium sized firms temporarily. Third, small and medium sized firms showed the tendency of securing operational funds in advance because interest rates on loans were still low and credit lines would be tightened to small and medium sized firms with the consideration of corporation's credit risk and insolvency. 

Loans to major companies increased by about 2 trillion KRW in March, although they decreased by about 0.3 trillion KRW from January to February. Several factors contributed to the increase of loans to major companies. In January and February, major companies had substantially less demand for loans, due to a reduction in facilities investment in the midst of prevailing geopolitical risks, such as the Iraq war, North Korea's nuclear issues and a sudden increase in oil prices. In March, however, loans to major companies increased unexpectedly by about 2 trillion KRW because other options for financing were not available. Economic shocks, including the SK Global accounting fraud and the possible insolvency of credit card bonds, rendered major companies with difficulties finding financing through corporate bond issuances. Also, major companies tended to borrow operational funds in advance, in consideration of the expectation for worsened economic conditions, as small and medium sized firms did in the quarter. 

Household loans increased by about 4.9 trillion KRW sequentially, after having shown a declining trend since the second quarter of 2002, as illustrated in <Figure 3>. The reasons for the continued decline in household loans are the following. One was the influence of government policies to constrain the substantial increase in household loans last year. Such measures to contain the surge in household loans and stabilize real estate prices have decreased the demand for household loans remarkably. The other reason was due to seasonal factors. The repayment of 

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household loans decreased the growth of household loan volume temporarily in the first quarter of 2003. A year- end bonus and special bonus for the Lunar New Year contributed to the repayment of household loans.

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

(billion KRW, %)

Note:      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, which have been kept low since the fourth quarter of 2001, fell slightly compared to the last quarter. The decline in loan interest rates was mainly caused by the following factors. First, banks had no incentives to raise interest rates on loans because of the inflow of deposits and the decrease in market rates. Also, limited opportunities to lend loans to corporations as the corporations avoided facilities investments, along with a worsened economic outlook, prevented the loan interest rates from rising. Second, banks have still been competing for opportunities in extending loans to small and medium sized firms with relatively good financial structure. Third, interest rates on household loans decreased this quarter, as CD yields, on which interest rates on household loans were based, fell. 

<Table 5>           Interest Rates on Selected Bank Loans¹⁾

(% per annum)

Notes:   1) End- of- quarter basis. Weighted average of interest rates on selected bank loans

   2) As of February 28, 2003

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)

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2) Forecasts

The total volume of loans in won in the second quarter is expected to increase with a lower growth rate than that of the first quarter. Although the growth rate of loans to households is likely to increase slightly compared to that of the first quarter, the growth rate of total loans is expected to decrease because the growth rate of corporate loans is expected to decrease considerably. The reasons behind this expectation are as follows. For starters, the demand for loans to corporations will not be stimulated sufficiently, owing to the avoidance of facilities investment and the uncertain economic conditions. Although the Iraq war may end in the second quarter, North Korea's nuclear issues, a decline in consumer consumption and potential insolvency of credit card corporations are expected to discourage corporate investments. Second, the sudden increase in loans to corporations was caused by the unstable market for financing after SK Global's accounting fraud was made known in the first quarter. Therefore, if the financial market is stable, a sudden increase in loans to corporations will not occur in the second quarter. Third, although banks regard loans to small and medium sized firms as one the profit- centers of asset management, they would reduce extending their credit lines to corporations considerably due to concerns over possible insolvency. Therefore, loans to corporations are not expected to go up again as was the case in the first quarter. Fourth, corporations are forecasted to exhibit a seasonal demand for funds, for the purposes of making a mid- year settlement. Fifth, as assets of banks have increased considerably, resulting from the continuous increase in deposits, banks are expected to have difficulty managing their abundant assets and finding another loan market except the market for household loans. Last, the strict government policies against rising credit risk in household loans, such as by keeping interest rates on household loans low, will have the overall growth rate just slightly lower than that of the first quarter.

The average interest rates on loans will increase slightly compared to that of the first quarter. The factors that will contribute to the rise in interest rates for loans are as follows. First, the interest rates on loans may rise because of the widening 

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spread between interest rates on deposit and loans, as SK Global accounting fraud affected banks' profitability negatively. Second, interest rates on loans are expected to rise due to supply- side factors such as the strengthened credit review and strict government policies to prevent a rise in credit risk for household loans. However, there are some factors that will limit the increase in loan interest rates. 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 banks' trust accounts increased by 1.2%, totaling 132.6 trillion KRW in the first quarter of 2003. The volume of Money in Trust decreased by 0.9%, continuing its downward trend since the last year. And the volume of Property in Trust increased by 3.9%, which was lower than last quarter's 33.6%. 

The final balance of Money in Trust amounted to 73 trillion KRW in the first quarter, which is a 0.9% drop from the end of last quarter. The reasons for the decrease are as follows. First, geopolitical risks, bearish stock market and concerns about uncertain economic conditions caused an outflow of money from investment focused products. Moreover, 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. The outflow of funds from performance- based trust products was more notable than that from principal- based products. Second, banks tended to sell ELDs or securities instead of inducing money in the products of Money in Trust. Third, SK Global accounting fraud also influenced the outflow of funds from Money in Trust account, about 1.9 trillion KRW. Moreover, the growth rate of Specific products in Money in Trust account, 

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which hold credit card bonds, decreased remarkably to 4.1%, which is lower than that of the last quarter, owing to the insolvency of credit card companies. 

The final balance of Property in Trust reached to 59.5 trillion KRW in the first quarter, a 3.9% increase compared to last quarter. The increase in Property in Trust was led by asset consignment Trust products, which marked a rise of 21% compared to last quarter. 

<Table 6>                   Bank Trust Accounts¹⁾

(100 million KRW, %)

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

Source: Individual Bank Data

The portfolio composition of trust accounts, as shown in <Table 7>, reveals that investment in securities increased slightly, whereas loans funded by bank trusts decreased compared to those of the last quarter. 

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

(100 million KRW, %)

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

2)  Total amount of investment in securities less amount of securities in investment trusts

Source: Individual Bank data

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2) Forecast

In the second quarter of 2003, the final balance of bank trust accounts is expected to increase a little, but at a lower growth rate, reflecting the continuous decrease in Money in Trust and the slowdown in the growth rate of Property in Trust accounts. First, funds in Money in Trust are forecasted to outflow in the second quarter due to expectation that equity linked financial products, such as ELF and other alternatives, will be sold well. Second, Specific trust products will not sell as well in the second quarter if banks are not perceived to be as  attractive to investors, who are faced with unstable market conditions. Accordingly, poor performance in performance- based trust products is expected, which will cause funds to flow out into alternative investments, which produce bigger yields. 

The growth rate of Property in Trusts will decrease slightly due to the reduced demand for asset consignment. And the volume of Property in Trust will not increase to the extent of last year because consigned trust bond products will not increase much under unstable financial markets. Also, the magnitude of stocks consigned will decrease owing to the bearish stock market. 

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<Table 8>                   Money in Trust Accounts¹⁾

(100 million KRW, %)

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

Source: Individual Banks

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Non- bank Financial Institutions

Overview

In the first quarter of 2003, deposits at non- bank financial institutions (NBFIs) decreased by 1.0% from the previous quarter. Deposit at Investment and trust management companies (ITCs), which hold the highest ratio among NBFIs, led the overall decrease in NBFIs, even though most NBFIs showed an increase in deposits. The main reason for the decrease in deposits at ITCs was the rush to redeem money, mainly MMFs, due to the uncertainties in the financial market with the revelation of SK Global's accounting fraud and the credit card industry's liquidity crisis. The increase of deposits at merchant banking corporations (MBCs) was led by the inflow of deposits into Cash Management Account (CMA). Deposits at mutual savings banks (MSBs) also increased as MSBs exhibited good performance in the second half of 2002 and maintained competitive interest rates, along with the downward trend in interest rates in commercial banks. Deposit at credit unions (CUs) showed a negative growth rate because of a loss of market confidence, which stemmed from the expectation for a liquidation of 109 ailing CUs. Mutual credits (MCs), community credit cooperatives (CCCs), and postal savings (PSs) showed positive growth in deposits as they kept competitive interest rates like MSBs'.

During the first quarter of 2003, the total level of credit at NBFIs increased by 2.8% from the previous quarter. The increase was mainly due to the expansion of household loans in MSBs, MCs, and CCCs and the increase in commercial paper discounts as a result of MBCs' aggressive stance. However, the level of credit and deposit at CUs decreased because of the anxiety over the liquidation of over 100 ailing CUs.

In the second quarter of 2003, deposits at NBFIs are expected to increase by 1.9% from the previous quarter. MMF balance is likely to be recovered, owing to government plans to enhance market stability and the self- rescue efforts of credit

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<Table 9>                Deposits and Credits at NBFIs¹⁾

(billion KRW, %)

Notes:     1)  End of period. The figures in parentheses are percentage changes from the previous quarter, and the figures in brackets are percentage changes from the previous year.

2)  Deposits at non- bank financial institutions = Merchant Banking Corporations (issuance of their own paper + CMAs + sales of bills) + Investment and Trust Companies (beneficiary certificates + equity savings) + Mutual Savings Banks (deposits) + Mutual Credits (deposits) + Postal Savings (deposits + RP).

3)  Credits at non- bank financial institutions = Merchant Banking Corporations (paper discounted) + Mutual Savings Banks (loans + paper discounted) + Mutual Credits (loans) + Credit Unions (loans) + Community Credit Cooperatives (loans).

4)  Including Merchant Banking Corporations account of Cho Hung Bank and Korea Exchange Bank since the fourth quarter of 2002

5)  Estimates.

6)  KIF Forecasts.

Sources: The Bank of Korea, The Association of Merchant Banking Corporations, The Korea Federation of Mutual Savings Banks, The Association of Credit Unions.

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card companies. Deposits in equity and hybrid type funds are also expected to increase as an early end to the war in Iraq is likely to remove the uncertainties surrounding the world economy, and thereby induce a bullish stock market. Deposits at MBCs are expected to increase, especially sales of bills and CMA, due to the short- term liquidity in the market and competitive interest rates. MSBs are also expected to increase by enhancing their services, with the permission to increase the number of branches and develop integrated financial information services through Federation of Savings Banks.

The total level of credit at NBFIs is expected to show a 2.2% increase in the second quarter of 2003. Credit at MSBs is expected to show an increase because of the service expansion and the development of various financial products. However, the fierce competition in the consumer credit market, with the full- scale entry of sub- prime credit lenders, will reduce the credit growth level. Credit at MBCs is expected to rise within narrow limits due to the uncertainty of economic recovery.

Investment and Trust Management Companies

During the first quarter of 2003, the total balance of deposits at ITCs decreased by 4.3% from the previous quarter. The balance of MMFs has sharply declined in March because a large volume of MMFs was redeemed for fear of value loss due to the revelation of SK Global's accounting fraud and credit card industry's liquidity crisis. Until the middle of 1Q, the increase in short term floating funds and the return of the outflow of funds at the end of 2002 increased the total balance of MMF by 9 trillion KRW from the end of 2002. However, the accounting irregularities at SK Global and credit card companies' liquidity problems increased doubts on the quality of MMF, triggering a rapid redemption of MMFs by depositors at ITCs. Therefore, the balance of MMFs decreased by about 22 trillion KRW in just 20 days. Long- term bond and hybrid type funds also decreased due to the drop in long- term interest rates, although, deposits in equity type funds increased 

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by 13.4% due to expectations for a quick war in Iraq.

During the first quarter of 2003, ITCs' investments have not been active due to the decrease of deposits at ITCs. In particular, the net purchase of bonds recorded a sharp decrease due to a large scale redemption of MMFs after the revelation of SK Global's accounting fraud and the worsening credit card debt problem. ITCs also decreased their holdings of stocks because of the uncertainties in financial markets, partly caused by North Korea's nuclear problems.

<Table 10>                  Deposits at ITCs¹⁾

(billion KRW,%)

Notes:    1) End of period. The figures in brackets are percentage changes from the previous year, and the figures in parentheses are percentage changes from the previous quarter.

2) Forecasts. 

Source: The Korea Investment and Trust Companies Association.