Editor

Hae Wang Chung

Associate Editor

Bon Sung Gu

English Editor

Oliver Williamson Jr.

Contributors 

Lead Article

Haesik Park and Woo Jin Kim

Macroeconomic Developments

Jongkyu Park and Yong- Sang Shyn

Jae- Ha Park and Han- Yung Jung

Financial Market Developments

Sang- Il Han

Keonbeom Lee

Jieun Lee

Byung Chul Lim

Bon Sung Gu

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. 3                               Fall 2003

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

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

CONTENTS 

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

Lead Article: Korea's Transformation into a

Northeast Asian Financial Hub

Banking Business Transformation

and IT Strategy 󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜 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- 6364, Fax (82- 2) 3705- 6285.

Korea's Transformation into a Northeast Asian Financial Hub*

―――――――――――――――――――――――

Haesik Park**

While Korea lags behind its main competitors, including Hong Kong and Singapore, in certain respects, it has a potential to become a regional financial center in Northeast Asia if it overcomes the shortcomings with sufficient effort. However, China's rapid economic and financial development means that the window of opportunity for becoming a regional financial center is limited, so Korea must act quickly. A success in establishing itself as a financial center of Northeast Asia depends on whether Korea is able to undertake the tasks required to gain the comparative advantages over its competitors. They include 1) increasing the convertibility of domestic currency, 2) encouraging the entry of foreign financial institutions, 3) reforming the domestic legal system, and 4) fostering financial experts. 

─────────────────

* This article contains the 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

More and more countries are seeking to establish themselves as financial centers as economic globalization, informatization, and financial deregulation proceed apace.  The competition is quite severe.  The field of competitors includes newer upstarts such as Frankfurt, Germany; the State of Delaware in the U.S., and Luxemburg, as well as established financial centers including London, New York, Hong Kong, and Singapore.  London solidified its standing as an international financial center through the Financial Big Bang of 1986, while Frankfurt has become one of the new financial centers as a result of joint cooperation between large- sized banks and privatized stock exchanges.  In 1998, Singapore established a long- term plan to become a financial center in the Asian region, while the state government and commercial banks of the Delaware have jointly pursued the establishment of a bank- centered financial center.

The general rush by various entities to set themselves up as international financial centers is primarily motivated by expectations of substantial benefits thereof.  The establishment of an international financial center would significantly improve the competitiveness of a country's domestic financial industry.  It would also create high value- added employment, broaden the tax base, and reduce the costs of capital, and by means of efficient investment, it would help sustain economic development driven by efficient investment. Any country that could become an international financial center would also find its vulnerability to external shocks like financial crises much reduced and its standing in the global community greatly augmented.

The Korean government recently announced its plan to develop Korea into a financial center of the Northeast Asian region.  Taking into account future 

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changes in the external economic environment, it becomes clear that Korea's development as a Northeast Asian financial hub is key part of its overall long- term strategy.  It is a necessary task if Korea expects to survive and prosper amidst the increasingly heated competition with its neighbors.  Within this context, the paper is organized as follows.  Section Ⅱ seeks to explain why it is imperative for Korea to establish itself as a financial hub of Northeast Asia and what can be expected if it is successful in doing so. Section Ⅲ shows why a regional financial center, instead of an international financial center or an offshore bookkeeping center, is a realistic vision for Korea to pursue.  Section Ⅳ concludes the paper by delineating the future tasks that must be tackled in order for Korea to become such a regional financial center.

Ⅱ. Need and Expected Benefits of a Financial Hub

The rapid economic growth of Northeast Asia has given rise to the need for huge volumes of investment funds.  This has, in turn, increased the need for the development of a financial center to serve as a conduit to facilitate the flow of needed capital into the region.  While it is too early to predict with any certainty given the yet unresolved nuclear issue, North Korea can be expected to actively promote economic development once the tensions on the Korean peninsula subside.  For its part, China is implementing an ambitious master plan to develop its western region, which will require massive investment capital.  A huge volume of investment funds will also be necessary for Korea to remake itself as a logistics hub.  Among the major tasks ahead in this regard is the linkage of the Korean railway system to the Siberian railway system.  The development of a financial center in the region 

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will allow for the provision of capital at lower costs, thus facilitating the implementation of such large- scale investment projects.

The development of a Northeast Asian financial hub will also promote the expansion of high value- added industries.  Korea is currently the world's 13th largest economy in terms of GDP, but high value- added industry accounts for a low percentage of total output relative to Korea's major competitors, not to mention advanced economies.  The financial service sector, for example, accounted for 11 percent of Singapore's GDP in 2002, but only 6.9 percent of Korea's GDP.  In fact, Singapore's financial industry accounted for only 7.0 percent of GDP five years ago.  Its expansion owes much to the Singaporean government's aggressive efforts to develop the country as a financial center.  It has attracted foreign financial firms and taken many other important actions.  Clearly, Singapore's case demonstrates without a doubt that the development of a Northeast Asian financial hub could significantly facilitate the advancement of domestic high value- added industries.

The development of a regional financial hub is also expected to help Korea more efficiently use its pool of highly- skilled labor.  The Korean people at large consider education to be extremely important.  As a result, Korea boasts a huge pool of highly- skilled workers.  Korean industry, however, cannot make use of all of them because it is too heavily concentrated in manufacturing.  The expansion of high value- added industries during the process of developing a regional financial center will provide increased opportunities for highly- skilled workers, thereby preventing high unemployment and the kinds of social instabilities that attend it.

Efforts to develop financial centers are being stepped up in the United States and Europe, and also in Asia, where Korea's direct competitors are located.  China envisions Shanghai as the center of the Chinese economy in 

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the 21st century and also as the financial and trading center for the western half of the Pacific Rim.  Hong Kong is also expanding its investment in order to maintain its current status as an international financial center. Singapore is continuing to improve its economy's business structure, with particular focus on the financial service sector.  Taiwan has formulated a long- term plan to develop itself as a regional business center by 2008.  In other words, all of Korea's neighbors are in a race to become regional financial centers.  If Korea expects to take advantage of this opportunity to reinforce its economy by becoming an economic center of the Northeast Asian region, it should seek to develop itself into both a logistics hub and a financial hub.

It is clear that the Chinese economy is having increasingly greater influence on the global economy.  It has been argued in some circles that the worldwide deflation that began to emerge during the second half of 2002 was triggered by China.  There is also a likelihood that China, with its vast low- cost workforce, will in the very near future threaten the foundations of the Korean economy.  Korea must shift away from manufacturing to services and knowledge- based industries.  The establishment of a Northeast Asian financial hub would provide additional impetus to the overall transformation of Korea's industrial structure by encouraging the development of the domestic financial industry in every respect.

Some observers argue that making Korea a financial hub will impose an undue fiscal burden on the Korean government because the volume of capital investment required is so huge.  However, unlike the development of a logistics hub, the establishment of a financial center can be promoted by offering tax incentives, further improving the legal system, deregulating the business environment, and improving institutional mechanisms, which would 

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partly entail ensuring transparency in regulation.  In this way, substantial results can be realized without incurring significant government expenditures and at minimal cost.

Others have expressed concern that domestic financial institutions will be unable to survive in fierce competition with their foreign counterparts, so that the establishment of a financial center would threaten their existence.  Such concerns are valid.  According to market principles, non- competitive financial institutions will eventually be forced out of the market regardless of whether or not Korea presses ahead with the effort to establish a financial hub.  This is one of the painful lessons that Korea learned from its financial crisis.  The critics, however, fail to realize that the development of a Northeast Asian financial hub should contribute much to the advancement of the domestic financial industry.  As was previously indicated, a financial hub would provide an environment in which domestic and foreign financial institutions can compete aggressively, compelling domestic concerns to make themselves competitive.  Another positive benefit for the domestic financial industry would be the streamlining of the legal and regulatory systems, and deregulation would gain additional momentum.  Moreover, the domestic financial system and environment would tend to more closely conform to international standards.

As the domestic financial industry becomes more competitive during the process of establishing a financial hub, the financial system will naturally become more stable.  It would, therefore, be able to more effectively deal with external shocks.  In addition, the establishment of a financial center would likely encourage a greater volume of direct financing, especially in the capital market.  In other words, the development of a financial hub would provide domestic businesses new opportunities to diversify their capital 

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sources beyond traditional bank lending and more easily obtain investment funds from the capital market over the long term and under better conditions.

The Korean government recently declared its intent to develop Korea into a Northeast Asian logistics hub as an initial step toward making Korea Northeast Asia's economic and business center.  This announcement in part seems to reflect the government's pessimistic outlook on the establishment of a financial hub, but it should be noted that the development of a logistics hub and a financial center is not mutually exclusive.  There could be some synergies in their simultaneous development.  As mentioned above, railways, ports, and other support facilities must be in place in order for Korea to properly function as a logistics center.  And constructing such facilities will require tremendous amounts of capital.  The proposed financial hub, which would promote greater efficiency of the domestic financial market and allow access to numerous different sources of funds, could play an instrumental role in providing low- cost funds for them.  Such a financial center could also promote various financial services required for smooth logistics operations, such as insurance, and also help advance the legal and accounting services sectors, which would in turn encourage more foreign concerns to do business in Korea.

Recent efforts to encourage greater regional financial cooperation in Asia confirm the potential benefits of Korea's becoming a Northeast Asian financial hub.  In the past, discussions on regional financial cooperation were triggered by specific incidents, such as financial crises, so cooperation mostly focused on the prevention of crises or feasible remedies.  More recently, however, new motivations to promote regional financial cooperation have emerged.  ASEAN+3 (ASEAN + Korea, China, and Japan) is seeking to develop a regional bond market in order to ensure that surplus capital is 

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made available to countries of the region.

The development of a Northeast Asian financial hub will provide Korea another opportunity to take the lead in forging financial cooperation in the Asian region.  If surplus capital in the region can be reallocated through a financial hub in Korea, these funds could serve as a liquidity safety net for preventing a regional financial crisis.  In addition, the reinvestment of surplus capital into the region through an efficient financial center could facilitate the operation of a regional financial market and promote balanced economic growth throughout the region.

Ⅲ. Aiming for a Regional Financial Center

According to the International Monetary Fund (IMF), there are three types of financial centers in operation worldwide.  International Financial Centers (IFCs), such as London and New York, are large international full- service centers with advanced settlement and payment systems that support large domestic economies with deep and liquid markets where both the sources and uses of funds are diverse, and where legal and regulatory frameworks are adequate to safeguard the integrity of principal- agent relationships and supervisory functions.  With the support of large- scale domestic economies, IFCs function primarily as funding centers, and their currencies serve as vehicle currencies and/or reserve currencies in the international community.

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<Table 1>      Financial Centers: Types and Characteristics

Regional financial centers (RFCs) differ from IFCs in that they have developed domestic financial markets and infrastructures and handle intermediate funds in and out of the region, but have relatively small domestic economies.  Due to the small size of the real economy, an RFC's main function as a financial center does not lie in the funding center but in the collection center where financial institutions residing in the RFC collect funds from the rest of the world.  In addition, unlike IFCs, RFCs do not provide the full range of financial services, but focus on specialized services. RFCs include Hong Kong, Singapore, Luxemburg, and Dublin.

Offshore Bookkeeping Centers (OBCs) are another type of financial center. Their added value is limited to the bookkeeping of financial transactions occurring in other regions or countries.  Accordingly, in most of OBCs, financial institutions have little or no physical presence, and funds are moved in and out of OBCs generally for such illegal purposes as evading taxes and money laundering.  The Cayman Islands, Labuan in Malaysia, and Burmuda belong to this category.

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Among these three categories of financial centers, Korea should not seek to become an OBC.  By doing so, Korea would not likely to enjoy the benefits mentioned in the previous section because financial transactions do not necessarily take place in OBCs.  Rather, Korea may become a target of international criticism for allowing illegal financial transactions if it became an OBC.  Korea currently does not satisfy all the requirements necessary to become a RFC, not to mention an IFC.  However, once it addresses the shortcomings by improving its fundamental structure and environment, Korea would have the potential to develop at least into an RFC.

There are three criteria that can be used to assess Korea's potential to establish itself as a financial hub: the degree of internationalization of its economy and financial industry, the level of development of its institutional systems, and the quality of its social infrastructure.  Significant tasks remain to be done with respect to internationalization.  Despite the two rounds of foreign exchange liberalization in the post- crisis period, the Korean won is not yet fully convertible.  Additional liberalization is necessary, including measures to allow non- residents to borrow in the Korean won on the domestic financial market.  Also, Korea's networking with the outside world still leaves much to be desired, in spite of recent efforts on the part of the Korean Stock Exchange to strengthen ties with foreign stock exchanges.

The issues of institutional systems concern regulation, taxation, and transparency.  Korea is much more in conformity with international standards as a result of deregulation since the 1997 financial crisis, but Korea's corporate and income tax rates remain higher than those of Hong Kong or Singapore.  Improvements still need to be made in enforcement for transparency of financial transactions and regulatory oversight, although previous financial reforms appear to have established a framework for 

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ensuring transparency in the financial sector.

The social infrastructure includes five major components: transportation, telecommunications, geographical location, human resources, and living conditions.  With regard to transportation, telecommunications, and geographical location, Korea is in a highly advantageous position in that it is in the process of developing itself into a logistics hub for Northeast Asia, boasts a world- class information technology sector, and is located in the center of the Northeast Asian region.  However, there is a serious shortage of financial experts in Korea, and living conditions for foreigners are wanting in several respects, including the lack of educational, housing, and health care facilities, as well as the relatively limited English proficiency of the general population.  These deficiencies may well pose serious obstacles to Korea's efforts to become a regional financial center.

Overall, Korea appears to be lagging behind Hong Kong and Singapore in most basic areas.  This is because Hong Kong and Singapore have long functioned as regional financial centers.  However, Hong Kong's reputation as a regional financial center may be eroded as a result of the difficulties it experiences in its ongoing process of political and economic integration with China.  Singapore is located within the Southeast Asian region, a considerable distance from Northeast Asia, and its economy is rather small.  Therefore, in time, Korea will be able to offset Singapore's current advantages. And while Korea seems to have fallen behind Japan in the development of its social infrastructure, it remains noticeably ahead in such areas as its level of internationalization and institutional systems.  Korea is also ahead of China in most regards, though considering its tremendous economic potential, China's ability to develop into a financial center in Northeast Asia should not be underestimated.

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It therefore seems that although various improvements need to be made, Korea does have the potential to become a regional financial center.  While Korea lags behind its main competitors in certain respects, these shortcomings can be overcome with sufficient effort.  To be sure, China's rapid development means that the window of opportunity is limited, so Korea must act quickly.

Ⅳ. Future Tasks

What does Korea have to do to succeed in its quest to become a financial center?  Korea needs to undertake several tasks with firm determination in order to gain the comparative advantages necessary to establish itself as a financial center of Northeast Asia.

First and foremost, Korea will have to make the Korean won more widely convertible.  Korea must be able to ensure the smooth flow of an enormous volume of domestic financial transactions.  If financial transactions cannot be smoothly conducted, foreign financial concerns will have no interest in doing business here.

Following its financial crisis, Korea pursued far- reaching deregulation of the domestic financial activities, including liberalization of foreign exchange transactions.  As a result, the domestic financial markets are significantly more liquid.  At one point after the financial crisis, the volume of domestic foreign exchange transactions amounted to a daily average of less than US$ 1 billion.  Now that the domestic macroeconomic situation has long since recovered and the liberalization of foreign exchange transactions has induced foreign capital back into the domestic market, the daily average volume of transactions in the domestic foreign exchange market exceeds US$ 3 billion. 

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Moreover, Korea's bond market has become one of the largest in the Asian region, along with those of Japan and Taiwan.  The capitalization of the domestic stock market is equivalent to 46 percent of GDP and is steadily rising.

Various regulations remain in effect that hinder freedom of action for non- residents, such as limits on won- denominated loans, controls on won- denominated transactions, and limitations on the issuance of won- denominated bonds.  In order to accelerate the expansion of domestic financial transactions, these regulations should be relaxed or abolished, thereby assuring the convertibility of capital accounts, eliminating country risks for foreign investors, and making it more convenient to do business in Korea. Foreign investors would be able to more actively participate in the domestic market once the convertibility of the Korean won is increased, and the domestic financial market will become more advanced.  All of this would contribute much to the development of Korea as a competitive financial center in the region.

As a result of the internationalization of financial markets worldwide, financial institutions have been actively pursuing ways to raise their competitiveness, including increasing their economies of scale and entering into a wider range of businesses, for example, through mergers with businesses engaged in similar but complementary activities.  In addition, countries that had traditionally favored segmentation of the financial industry are now lowering the regulatory barriers to encourage the expansion of integrated business activities.  In order to adequately respond to these changes and create a financial environment favorable to foreign financial institutions, it will be necessary to transform the existing financial regulation structure from a sector- based alignment - -  banking, securities, and insurance - -  to a 

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function- based system.

<Table 2>    Future Tasks for Northeast Asian Financial Hub

Korea's laws and regulations on finance are based on a strict division of financial businesses, so Korea is poorly prepared to meet the demands of today's changing financial environment.  Unless the legal system is changed, it especially could create regulatory loopholes and gaps in areas such that the division of financial businesses and products becomes blurred.  In addition, the legal system as it is designed forces the government to enact a new set of laws and regulations whenever new financial services are introduced. Most of these problems could be overcome if the laws and regulations were realigned based on functions, such as market access, asset management, and regulatory oversight.  Furthermore, the establishment of a legal system based on functions could help improve the efficiency and fairness of regulatory 

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oversight.  If regulatory oversight of individual financial institutions in each sector is based on specific laws, treatment is likely to vary in each case due to the application of differing regulatory interpretations in different sectors. Such inconsistency would compromise the proper operation of an advanced financial center and widely discourage participation.

Strengthening cooperative relations with foreign financial institutions and markets could also help boost Korea's competitive edge in the race to become a regional financial center.  Strengthened linkages with foreign markets will afford market participants added convenience, facilitating the flow of foreign capital, and increase the liquidity of the domestic financial market.  It is, therefore, necessary for domestic financial institutions to strengthen their strategic alliances with advanced international financial institutions and to reinforce mutual cooperation and integration between stock exchanges.  The establishment and attraction of joint banks or cooperative financial groups in Korea, involving Korea, Japan, and China, would be beneficial as well.

Government- owned assets, including foreign exchange reserves and public pension funds, can also be used to encourage the entry of foreign financial institutions into Korea.  In Singapore, the government- affiliated institution, named the Government Investment Corporation (GIC), mobilizes some part of the available foreign exchange reserves to attract foreign financial institutions into Singapore.  Recently, the GIC and the Monetary Authority of Singapore jointly raised US$ 36 billion for use as seed money to encourage the entry of small- sized foreign asset management companies.

Finally, in order for Korea to develop into a financial hub of the Northeast Asian region, it would be essential to increase the number of Korean financial experts.  Domestic financial institutions need to strengthen 

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their educational and training programs, and also establish training schools for financial experts.  Another way to foster financial experts would be to allow foreign institutions to compete with domestic training and educational institutions, as this would create an environment in which institutions would have much greater incentive to offer high- quality educational programs. These financial professionals could also be provided by inviting experienced financial experts from abroad to work in Korea.  This would require that Korea establish more favorable living conditions for foreigners.  Among other things, steps would have to be taken to alleviate traffic congestion and reduce air pollution, as well as to ensure the availability of quality educational recreational facilities.  Deregulating immigration control procedures and easing conditions for visa issuance might also be helpful in enabling foreign financial professionals to remain in Korea for extended periods of time.

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References

Ahn, H. and Y. Wang, "Northeast Asian Financial Hub: Its Present and Future," Mimeo, Korea Institute for International Economic Policy, 2003 (in Korean).

International Monetary Fund, "Offshore Financial Centers," IMF Background Paper, 2000.

Korea Institute of Finance, "Establishing a Northeast Asian Financial Hub in Korea," Mimeo, 2003 (in Korean).

Park, H., "International Financial Centers: Types and Korea's Choice," Mimeo, Korea Institute of Finance, 2002 (in Korean).

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Banking Business Transformation and IT Strategy*

―――――――――――――――――――――――

Woojin Kim**

The world's leading financial institutions did a great deal throughout the 1990s to maximize value by diversifying their revenue streams, pursuing mergers and acquisitions, and securitizing their assets.  They indeed managed to realize positive results, but by 2000, their strategy had clearly run its course.  Many claimed that the gains came at the expense of sacrificing customer value.  For this reason, banks need to transform their business models in such a way that they can maintain customer loyalty while still responding flexibly to changes in the market and benefiting from economies of scale.  According to IBM BCS, this calls for the adoption of the Component- based Business Model (CBM).

The new business model simply requires changes in the IT strategy of banks.  This paper discusses efficiency and effectiveness in three areas of IT and points out the implications to the top managements of banks.  They are IT investment, core system transformation, and the IT governance structure. We emphasize the necessity for greater IT outsourcing by banks and the formation of an industry network among financial institutions on the value chain.  The expected gains from implementing a new IT strategy are explained in the later part.  The paper ends with a brief conclusion.

─────────────────

* This article contains the 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. The New Banking Business Architecture

1. Current Business Strategy

Throughout the 1990s, leading international financial institutions managed to create additional value by diversifying their revenue streams, pursuing bold mergers and acquisitions, and securitizing their assets.  Most were able to increase their profits by offering more fee- based products and services, moving away from traditional interest- margin business activities. Their non- interest income of U.S. banks increased by 9.4% annually, and the ratio of non- interest income to total revenue gradually rose. Consolidation and diversification has been achieved among U.S. financial institutions through in- market mergers (for cost savings), inter- state mergers (for market expansion), or inter- company mergers (for cross- selling). Asset securitization has enabled them to reduce risks that are inherent in their business activities.

These financial institutions successfully created additional value in the 1990s, but it could be argued that they have failed to do so since then. The ratio of non- interest income to total revenue peaked at 25.8% in 1999 and has changed little since then. In Korea, the ratio peaked at 25.9% in 1998 and has hovered around 20% since 2000. Not much further improvement in performance through non- interest incomes can be expected. Despite the stagnation in the stock market, a number of M&As among financial institutions has been successfully consummated. However, the question of 

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whether such M&As have really contributed to stockholder value or not has been the subject of hot debate. Some empirical studies show that the sustainable growth of merged institutions depends on effective post- merger integration, not from the M&A itself. The securitization ratio of advanced financial institutions has stabilized since the late 1990s, and this has also happened in Korea, where the restructuring of the banking sector has almost been completed.

The increase in profits in the 1990s at major international banks was, in a sense, nothing more than the result of sacrificing customer values. The banks charged excessive fees to customers for certain products and services, and the quality of services declined as a result in huge reductions in bank tellers through M&A cost cutting strategies. The securtization or sale of assets hindered banks in their efforts to build strong relationships with their customers. In this business environment, banks cannot expect long- term sustainable growth. They clearly need a new strategy to increase value. 

2. A Component- based Business Model

A financial institution must possess several core competencies if it expects to be a leader in the future. More specifically, it must be able to guarantee consistency in that products and services are available to customers across channels with a single view; it must be flexible to the changing market environment, bringing new products to the market with all due speed; and it must also be able to use systems for multiple applications to maximize cost efficiency and prevent needless duplication. Many financial institutions face great difficulties in obtaining such competencies due to the increasing complexity of work flows and the IT infrastructure. They must, therefore, 

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totally transform their business models, dispensing with incrementalism in their thinking with regard to improvement of their systems, processes, and business structures.

The component- based business model (CBM) is an effective means of business transformation to acquire consistency, flexibility, and re- usability. Business functions are grouped into relevant components on the basis of specific considerations such as similarity of activity, user groups, and use of information and technology. A component is defined as a group of cohesive business operations supported by appropriate information systems, processes, organization structure, and performance measures. Each component independently performs a unique role and is responsible for delivering agreed service to other components and collaborating with them within a certain business domain. The traditional business models of financial institutions focus on manufacturing of products. As a result, business functions and systems are largely duplicated around products. The CBM, on the other hand, allows for business flexibility and process optimization and is focused on creating value for the customer.

Business activities can be horizontally divided into three areas, distribution, manufacturing, and operations, according to its value chain. Distribution engenders all customer- contact activities, including those through product and service delivery channels, pricing, cross- selling, and marketing. Every channel needs to have a common infrastructure to create a customer- single view and have a consistent look and feel for the user. Therefore, consistency for customers and across channels is the key for components in this business area. Manufacturing generates and assembles products and services in whatever form to satisfy customer needs. To address the complex and changing customer needs, financial institutions must provide products and services in a timely manner, which is possible when flexibility is maximized. Flexibility is, therefore, the main factor for the 

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success of manufacturing area components. Operations denote the back- office functions, i.e., managerial support (accounting, risk management, etc.) and administrative work (personnel, education, etc.). For a large financial institution, operations are optimized for cost efficiency and economies of scale. This can be achieved when the re- use of back office systems is maximized.

Ⅱ. IT Strategy under CBM

The board of directors sets the vision and strategy of the company, and the top executives manage daily business activities. The IT platform is a system that provides a business tool to manage a company. Consequently, a new business model requires changes in the IT strategy, and the newly established vision and business strategy will not be successfully implemented without adequate backup of the IT platform. IT strategies under a component- based business model entail various issues. In this paper, we will limit our attention to discussion about efficient IT investment, core system transformation, and the establishment of IT governance.

1. Efficient IT Investment: Variable Cost Structure and Network 

The environment of the financial service industry is constantly changing as a result of new competition and technology. Finding new opportunities for development while also responding effectively to changes in the business environment have become key tasks for financial institutions. Considering the 

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trend toward size through consolidation, it is expected that flexible response to change and economies of scale for cost efficiency will be the key factors for success in the financial industry. Recent research by IBM Business Consulting Services indicates that most financial institutions have difficulties achieving flexibility and economies of scale. Figure 1 shows the cost- income ratio and ROE of financial institutions by size and business area. Note that large financial institutions lag behind medium- sized competitors.

<Figure 1>       Profitability of U.S. Financial Institutions

Source: IBM BCS

In response to the increasingly fierce competition, most large financial institutions have expanded into new services and introduced new products and channels. However, they have only been incremental in the addition and alteration of their existing business operations and IT systems. They 

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have failed to find a strategic means of expansion from the enterprise- wide point of view. It is because of their incrementalism that large financial institutions now have inappropriate and overly complex business models characterized by extreme duplication of business functions. As shown in Figure 1, the complexity of business models has led to lower profits and ROEs.

Rigid and complex business structures and IT systems are not conducive to flexible and timely response to changes in customer needs. For example, when banks were permitted to offer bancassurance, most domestic banks established entirely new divisions and IT systems in their business models because their existing systems were not re- usable. This kind of incremental reaction results in more complex business models and slows a bank's response to future changes in the business environment. These problems could have been avoided if financial institutions had adopted a variable- cost structure from the beginning. Under a fixed- cost model, it is very difficult to manage unexpected costs or operational risks. When designing new IT systems that are compatible with CBM, financial institutions need to secure both expandability and flexibility to allow for possible future business transformations that may arise from changes in the business environment.

From the perspective of IT strategy, the transition to a variable cost structure means the investment decision to build a new system should be dictated by the financial institution's core business strategies. Components are to be classified into two groups, competitive and noncompetitive, according to the strategies and competencies of each financial institution. Not every component needs to be developed internally. Resources are reallocated to reinforce competencies of components that are currently or expected to be competitive. The competencies of noncompetitive components are built through collaboration and co- sourcing with third parties or outsourcing.

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<Figure 2>            Global IT Service Outsourcing

Source: Tower Group (2003)

* CAGR: Compound Average Growth Rate

Because each financial institution concentrates only on its core competencies, the outsourcing and networking of companies in the industry is expected to expand rapidly. As illustrated in figure 2, IT service outsourcing has increased at an average annual rate of 9.1% since 2000. Another way to reduce the costs of operations is to move non- core competencies to low wage countries. This has cleary been seen in the financial industry in the last five years. American Express, Citibank, HSBC, and GE Capital, among others, benefited greatly from moving part of their back office functions to low- cost countries. Most back office functions except core competencies can be so transferred. The most routine and labor- intensive operations like the call center can be moved first. Then, more complex and important business operations can follow, depending on wage levels, regulation, language requirements, and human resource availability in the foreign location. However, those operations that can be automated or fulfilled by self- service should not be transferred.

According to the Bank of Korea, about 66.8% of IT staff are outsourced, and 82.0% are in the area of development and maintenance of program software. It seems that most Korean banks have already reached an optimal 

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level of IT investment. However, these outsourcing companies are their own subsidiaries of banks, which implies that they are far different compared to application service providers or other forms of independent outsourcing companies. Therefore, Korean banks should continue constructing the industry network and outsource more IT functions on the value chain. 

<Table 1>            IT Outsourcing by Korean Banks

(person, %)

* Others include staff of data- centers, telecommunication networks, and R&D.

Source: Bank of Korea (2003)

2. Core System Transformation

In defining their core businesses, the focus of the financial industry has recently shifted away from specific functions toward customer contact. For this reason, the areas of the core system are classified according to the customer contact point. That is, the "core business" in a financial institution engenders all activities that are undertaken through various customer contact points, including those for information management, deposits, loans, insurance, securities, commodities, foreign exchange, card processing, and business operations, etc. In short, the core system implies the application system that supports the operations of the core business that occurs at every customer contact point. It also interchanges with other financial and non- financial institutions. The core system, therefore, engenders the back 

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office infrastructure of financial institutions, storage of source data on the core business transactions.

As described above, the core system is the critical element that forms the foundation of the technology infrastructure of financial institutions. Hence, the reconciliation of the financial business process with the IT strategy is essential to constructing a new core system that will increase efficiency and profitability. Today, the core system provides products and services that better serve customers' needs, facilitates the product development process, provides multi- dimensional information to improve the intelligence of the organization, and simplifies and standardizes business knowledge and channel interfaces. Not surprisingly, it is seen as the key competitive element that maximizes the overall capacity of financial institutions.

As mentioned in the previous section, the major business strategies of leading financial institutions to create value in the 1990s were revenue stream diversification, M&As, and asset securitization. These strategies were indeed successful toward generating stable streams of profits, but they also had negative side- effects. The complexity of business models increased as financial institutions expanded their organizations, entered new areas of business, widened their product lines, and began offering products and services through more and more channels. This led to redundancies in investment and discord between the business functions and the core systems. Serious inefficiencies were inevitable.

In order to ensure continuity and consistency, banks must be able to offer products and services through all channels, even if a customer prefers a specific channel. For example, a customer may call into the call center to learn more about a specific product. The content of the call should first be recorded in the call center and then saved in the central customer information management system. Then, the bank can provide services to the same customer without having to repeat the information collection process over and over again simply by connecting to the central customer 

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information management system, even if the customer initiates contact through other channels. Since channels are not integrated in most financial institutions, they must repeat the business process from the beginning every time customers make contact with them.

Financial institutions should also be able to bring new products to market quickly, and they must be able to effectively develop products in cooperation with outside partners. At the present time, the IT systems of financial institutions are still not yet adequately developed to allow this. Outdated legacy systems are too cumbersome and lack the functionality needed to develop new products and cannot be readily linked to systems of other financial institutions. One new IT solution after another is implemented, but with no real benefit. As a result, the system becomes more complex with each new product roll- out, and administration expenses increase due to overlapping functions.

In operations management, it is necessary to achieve economies of scale by outsourcing or by sharing the system with other financial institutions. However, the present system is structured such that back office operations are performed independently by product or business division. Subsequent functional redundancy of the system and the insufficient linkage with other financial institutions militate against economies of scale. Worse yet, the legacy system lacks flexibility and incurs high maintenance costs because it is mostly designed with past technology. Therefore, the core system cannot provide much multi- dimensional business information and be used to properly manage the risks of the constantly changing financial environment. In such a case, it cannot really be considered a core system.

In the era of service- on- demand, businesses should evolve from product and organization silos and the traditional linear value chain and adopt a business model that utilizes the industry value network, focusing on customer leading competencies. The core system that supports the component- based business model must play the central role of business 

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optimization and construction of the value chain of financial institutions. For these purposes, changes in the infrastructure mind- set is essential. That is, the core system should evolve toward a common customer- centric infrastructure and away from the individual infrastructure that supports each application and channel separately, which adds to the complexity of the system.

Banks can build a common customer- centric infrastructure by routing out overlapping product and organization silos and by horizontally integrating themselves in such a way that processing, profitability, and control of each product is still feasible (See figure 3). The IT infrastructure must support a mind- set shift to this customer centric model, allow for collaboration and re- usability of applications, and be designed in such a way that the customers and data can be handled consistently enterprise- wide.

There are two approaches that can be taken to build up the core system. The so- called Big Bang approach entails executing at once a series of business processes into one integrated system, while the phased approach means implementing modules one- by- one until the entire new system is constituted.

The Big Bang approach involves short- term simultaneous execution of process/system/organization. This naturally requires strong leadership and support from the management. It also requires high quality support from solution providers, system gap analysis at an early stage of development, preparation of an appropriate contingency plan, and early and adequate training. Although such short- term yet sweeping implementation saves much time and expense, the risk of confusion throughout the enterprise is very high. The phased approach involves long- term, step- by- step execution of various changes. This permits the execution of different operations independently without attachment to other departments. Such a method may lower the operating risk and be more smoothly executed. However, it requires more drive to develop interim inter- phase reform plans and in most 

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case takes more time to complete.

<Fig. 3> Common Infrastructure that Supports All Applications/Channels

Source: IBM BCS

The best solution may differ from one institution to another. Each institution is engaged in different areas of business and possesses a different level of IT technology and manpower. Financial institutions need to analyze their own business processes through BPI (Business Process Integration). Then, the to- be model should be constructed, and the appropriate package for the model should be selected. In doing so, the so- called gap analysis should be followed by necessary customization of the to- be model. 

3. Establishing IT Governance

The IT infrastructure itself is one of the core competencies that constitutes the component- based business model. And IT competency, which supports the future business strategy, can be developed through the execution of the 

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process, human resources, and organization. This is called IT governance. In other words, IT governance determines how, where, and by whom the IT- related decisions are made by carefully considering the organization structure, process, human resource management, and rules/guidelines of the IT business unit. In this respect, the IT infrastructure of Korean banks has inherent problems today as follows:

First, most Korean banks have very inefficient IT organizational structures. The IT planning department cannot fulfill its main role of planning and budgeting due to lack of competency. For example, we know that an effective post- merger integration heavily depends on success in IT integration of the two different organizations. In most cases, however, the choice of IT platform is determined not by the IT planning department but by the strategic planning department. This means that the IT strategy is not implemented in a consistent manner and that company resources may be wasted. This is also true with regard to integrated revenue management or customer relationship management. Although these are essential to improving the profitability of banks, maximum effectiveness will not be achieved without a proper IT strategy.

Second, empowering the IT business unit is not sufficient for banks to have a competitive advantage. After the financial crisis in 1997, most banks established IT service units as separate entities or independent business units. That is, most Korean banks adopted a centralized IT organizational model in which IT services, under the guidance of the CIO, are provided to other business units. However, there is still a limit to supporting the users of IT services because of the lack of communication channels between the IT department and users. The job descriptions for IT staff are rather ambiguous, so performance and evaluation criteria connected with IT business goals are not well developed. As illustrated in figure 4, the number of IT staff has not decreased much even during the restructuring period due to the nature of IT tasks. In fact, it has increased steadily in recent years, but the skill levels of 

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IT staff in Korean banks lag behind those of IT staff at IBP banks because of the absence of career development programs and inadequate skill set management.

<Figure 4>              IT Business Unit Staffing

Source: Bank of Korea (2003)

Finally, the business process is not systematic, and the applicable rules and guidelines are not well defined. Users, therefore, have no idea whom or how to make contact to handle problems that arise during the course of their daily transactions. IT investments are not rigorously analyzed because there is no concrete methodology by which to review the investment decisions. Guidelines for the security system do not exist yet, and integrated internal IT regulations are not well developed.

We propose that the future IT governance model should be built with the objective of making it a specialized and standardized organization system that is user- friendly, and its performance should be based the operations of 

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human resources. In terms of organizational structure, the IT business unit should be responsible for the full range of IT activities from planning to staffing. Then, the IT business unit should develop its own business areas and maintain specialized competency. In addition, well- defined job descriptions should be drawn up to improve the efficiency and effectiveness of IT business operations. A performance- based evaluation and compensation scheme should be developed to empower IT staff, and a proper system should be designed to rigorously evaluate the effectiveness of IT investment, development, and outsourcing tasks. Finally, the introduction of so- called help desks or relationship managers for various business units should be considered so as to make the whole process user- friendly.

4. Expected Gains from the Transformation

We have found that the component- based business model requires far- reaching IT transformation. In the short term, IT system integration as envisioned by the CBM may be more costly, but this should not be the case in the long term. The costs of establishing the integrated solution may actually be less than the maintenance costs of the existing legacy system.

Improvement of the current system is a logical point of phased investment since the Big Bang once- and- for- all approach of building the new system may be far too costly. However, the merits of the new system should never be underestimated. A bank must be flexible in choosing one of several options even at the initial stage of investment. It must decide whether to improve the current legacy system, purchase and establish an entirely new system, or develop a new system in- house. Note that the final goal of investment is a system that allows for the seamless functioning of CBM. If total replacement of the legacy system, for example, is unavoidable for this end, the once- and- for- all approach may be the best.

With the business transformation, banks are now able to provide products 

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and services that best satisfy customer needs. Customer needs vary across customer segments, so it is necessary to categorize customers into segments based on age, income level, and expenditure patterns, and determine the typical lifestyle of each segment. Furthermore, adequate products and services at proper prices should be selected, and they should be offered through the most appropriate channels depending on the customers' needs. The CBM and its IT platform guarantees a consistent approach toward customers (customer single view) in all business areas and at all customer contact points.

From the point of view of manufacturing and product development, banks now can easily develop compound products and products in alliance with other institutions through the establishment of a product management group as a component. The group oversees the whole process of development, launching, evaluation, revision, and termination of products. It controls the development process of all products within the organization. It also monitors the sales of products and makes decisions on revision and termination of products. A new technology infrastructure such as the "product factory" is required to support this integrated management of the product life- cycle. This makes it possible to develop a new product and change an existing product by combining attributes of products in much the same way that children play with Legos.

Needless to say, the CBM improves the system flexibility of the organization. Banks can now respond in a timely way to the changes in the constantly shifting business environment. The meaning of so- called "speed- to- market" to meet the customer needs is embedded in the system.

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III. Conclusion 

Throughout the 1990s, leading financial institutions were able to increase their value by diversifying their revenue streams, pursuing mergers and acquisitions, and securitizing their assets for risk diversification. However, their strategy seems have run its course, and its benefits ares seen by many as nothing more than the result of sacrificing customer value. Clearly, banks need to transform their business models in such a way that customer loyalty, economies of scale, and business flexibility are well preserved.

The new business model simply requires changes in the IT strategy of banks. In this regard, this paper discussed efficiency and effectiveness in three IT areas and suggested implications to the top managements of banks. The three areas are IT investment, core system transformation, and the IT governance structure. Specially, we emphasized the necessity for more extensive IT outsourcing by banks and the formation of an industry network among financial institutions on the value chain.

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References

Bank of Korea (2003) The Assessment of Financial Informatization Promotion in 2002, Financial Informatization Promotion Committee (in Korean).

IBM Business Consulting Services (2003) mimeo.

Sang- il Kim (2000) Strategic Guidelines for IT Investment, LG Business Weekly, pp. 37- 43 (in Korean).

Woojin Kim (2003) Re- building Banking Business Architecture, Weekly Korean Financial Review, Korea Institute of Finance (in Korean).

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Macroeconomic Developments

Current Status and Prospects

Economic Growth

1) Review

1. The domestic economy contracted further in the second quarter.  Real private consumption had led the economic expansion in 2002, but it plummeted abruptly in the first quarter of 2003 and was down 2.2% y.o.y. in the second quarter.  The real growth rate of equipment investment turned negative in the second quarter.  Exports and construction investment again posted fairly strong growth, but this growth was mainly offset by the very weak private consumption and equipment investment (<Table 1>).

<Table 1>                  Economic Growth¹⁾

(unit : %)

Note: 1) Figures after the second quarter of 2003 are Bank of Korea estimates.

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2. The main culprit of the current recession is indeed the abrupt contraction in private consumption.  This becomes obvious when examining industrial production data.  Entering 2003, declines in the wholesale, retail, restaurant, and hotel industries were especially marked.  Together, they contracted △1.4% and △4.5% in the first two quarters (see <Figure 1>).  The output of the mining industry declined during the first half of this year, but it accounts for only 0.3% of GDP.  Agricultural production declined during the second quarter due to the unfavorable weather conditions. 

3. The wholesale, retail, restaurant, and hotel industries account for the largest combined share of total employment <Figure 2>).  In 2002, that share was 27.1%. These industries were hit hardest by the contraction in private consumption.  Since they retain so many employees, the current recession has had greater impact compared to other episodes of economic recession, which had been driven by contractions in investment or declines in exports.

<Figure 1>          Industrial Real GDP Growth Rates (1)

- 41 -

4. There is not yet solid evidence of an aborning economic recovery, though the advanced economies are picking up only slowly.  Presumably, the Korean economy will begin to benefit from the impetus of their gathering strength. 

5. Some indications of an imminent economic upturn can be gleaned by analysing the business cycle indices.  The coincident composite index is still declining on a y.o.y. basis, but the leading composite index (LCI) is showing signs of turning around.  The rate of decline in the LCI has been slowing, from △1.2% in May, to △0.6% in June, and △0.5% in July (see <Figure 3>). 

6. An estimation of an economic turning point also suggests that the next economic upturn will begin before the end of the year.  The estimation procedure calculates the probability of an economic turning point conditional upon the observed rate of increase in the LCI.  When we plug in the LCI data up to July into the estimation procedure, the result predicts that the economy will start to expand by November 2003 with a probability higher than 50%.  Since the LCI for August has 

<Figure 2>         Industrial Real GDP Growth Rates (2)

- 42 -

not yet been published, we wrote up three different scenarios for the August LCI data.  The pessimistic scenario assumes that the rate of increase in the LCI will be less than 0.23% m.o.m. in August.  The probability of this scenario is 30.3%.  The probability of an economic upturn prior to March 2004 is estimated to be less than 50%, implying that the economic recovery is not actually likely this year.  The neutral scenario assumes that the m.o.m. rate of increase of the LCI will be in between 0.23% and 0.79% in August.  This scenario has a probability of 42.4%, and it predicts an economic upturn prior to November 2003, implying that we can expect an economic recovery in the fourth quarter of this year.  The optimistic scenario has a probability of 27.0% and assumes the m.o.m. rate of increase of the LCI to be higher than 0.79% in August.  It predicts that the economy will start to expand by October 2003 (see <Figure 4>). 

7. The estimation results suggest that if we don't have to be pessimistic about future course of economic fluctuations, the economy will pass through a cyclical trough and start to recover by October or November this year.  Although a consensus forecast as of today excludes any possibility of economic recovery in this 

<Figure 3>  Changes in the Leading CI and the Coincident CI

- 43 -

year, we don't have to be too pessimistic about the economic performance in the fourth quarter, unless specific unforeseen economic shocks occur.

8. The real GDP growth rate slowed sharply from 3.7% y.o.y. in the first quarter to 1.9% y.o.y. in the second quarter.  Private consumption and equipment investment recorded were down significantly, but a steep increase in construction investment and exports prevented real GDP growth from becoming negative.  Out of the 1.9% real GDP growth in the second quarter, 2.8% and 1.0% are attributable to net exports and construction (see <Table 2> and <Figure 5>).

9. Industrial output increased by only 3.0% in the second quarter and 0.7% in July, indicating a sharp slowdown in industrial production activities.  In addition to the overall economic sluggishness, a series of strikes at the automakers led to a suspension of production of more than one month.  This alone caused manufacturing output in July to fall off sharply (see <Table 3>).

<Figure 4>   Scenarios for Probable Time Frame of Economic Recovery

- 44 -

10. The average manufacturing operating ratio dropped to 73.8% in July from 77.1% during the second quarter.  The decline in domestic shipments accelerated that same month, falling at a △3.4% rate as compared to only △0.8% during the second quarter (see <Figure 6>).  Thankfully, exports rose strongly by 10.7% y.o.y. 

<Table 2>            Contributions to the Growth Rate¹⁾

(unit: %, %p)

<Figure 5>         Contributing Factors to Economic Growth

- 45 -

in July.  Producer's inventories rose at a slightly slower rate of 9.1% y.o.y. as compared to 9.9% y.o.y. in the second quarter (see <Figure 7>).

11.  Private consumption declined by △2.2% y.o.y. in the second quarter, the first decline since the fourth quarter of 1998.  The was partly due to a technicality 

<Table 3>                 Industrial Activity¹⁾²⁾

(unit : %)

Note: 1) Percent change from previous year (Except avg. operating ratio, unemployment rates, bill default ratio)

2) End of period.

3) Period average.

4) Adjusted to reflect electronic settlement. 

Sources: National Statistical Office,『Industrial Activity Review』, various issues, The Bank of Korea,『Trend of Financial Market』, various issues.

- 46 -

as real private consumption growth had increased at an incredible rate of 8.4% y.o.y. in the first half of 2002.  More fundamentally, however, the ongoing stagnation in private consumption should be understood as part of an adjustment process, i.e., a return to the mean. 

<Figure 6>      Change in Industrial Production and Shipments

<Figure 7>                   Inventory Index

12. The index of wholesale and retail sales declined by 1.7% and 1.8% y.o.y. 

- 47 -

during the second quarter and July, respectively.  Domestic shipments of consumer goods declined by 3.6% in July, a slower rate of decline than in the second quarter (see <Figure 8>). 

13. It should be noted that poor consumer sentiment is not the only reason for the long- term low consumption.  The domestic economy has been adversely affected by the global recession since the second half of 2000.  It is now widely believed that an economic recovery of advanced countries is prerequisite for a domestic economic recovery.  However, the domestic economy remains mired in a deep recession even despite the fact that a solid recovery is already underway in the global economy and exports have consistently been up over 10% y.o.y. since the second half of 2002. 

14. Household debt in Korea has grown at an alarming rate since 2000.  The cumulative volume of household debt today is staggering(see <Figure 10>). Numerous consumers are hard- pressed to service their debts.  This is the major

<Figure 8>                    Consumption

reason domestic demand has failed to revive, even in the face of strong export 

- 48 -

growth.  We forecast private consumption to remain weak until households manage to pay down their debt burden sufficiently (see <Figure 9>).  Allowing forbearance in financial supervision to ease consumers' liquidity situation would not be advisable. Low private consumption is the salient feature of the current recession,

<Figure 9>  Business Cycle and Rate of Change in Private Consumption

<Figure 10>      Real Growth in Outstanding Household Debt

but the fundamental problem of the Korean economy is the prolonged stagnation in 

- 49 -

investment.  If investment rebounds to normal levels, consumers will more easily be able to reduce their debts as they will realize higher incomes (see <Figure 10>).

15. In the second quarter, total fixed capital formation increased by only 3.5% y.o.y., much more slowly than last year's annual average rate of 4.8%.  While the real growth of construction investment was fairly strong at 7.2% y.o.y., real equipment investment declined by 0.8% y.o.y.  Although real interest rates have been at record low levels and exports have been strong, equipment investment has been depressed because of the anemic domestic demand, excessive inventories, violent labor disputes, and so forth.

16. According to a Korea National Statistics Office(NSO) estimate, equipment investment contracted by 3.7% y.o.y. during the second quarter, and it decreased by 11.0% y.o.y. in July (see <Figure 11>).  Total domestic machinery shipments were hurt in July by a sharp decrease in shipments of communications equipment and motor vehicles.  Domestic machinery shipments increase only 0.1% y.o.y. during the second quarter but then plummeted by △9.4% y.o.y. in July. Domestic machinery 

<Figure 11>            Equipment Investment Indices

orders fell by 4.8% y.o.y. during the second quarter.  In July alone, they were 

- 50 -

down 13.1% y.o.y. 

17. According to the Bank of Korea's financial statement analysis, manufacturers' ordinary income to sales in the first half of 2003 improved by 1.7%p, while their sales rose 6.2% y.o.y.  The manufacturing sector's debt ratio fell from 105.8% at the end of 2002 to 101.6% by the end of June 2003.  This is much lower than the corresponding figures for Japan (162.5% as of end 2001) and the U.S. (167.3% as of end 2002).  The interest coverage ratio rose dramatically to 456.4% by the first half of 2003 from 355.4% in the first half of the previous year. 

18. This vast improvement in corporate profits and financial soundness has not yet led to a rebound in investment.  Economic and other uncertainties are impacting future cash flows and are seen as the major reason for the reluctance to invest. Instead of identifying and doing what they can to eliminate the uncertainties, however, corporations are calling for government intervention to stimulate the economy.  At this point of time, policymakers need to ensure that the domestic economy is structurally sound.  The government should, therefore, focus on resolving unsettled policy issues rather than intervening in the market. 

19. In contrast with equipment investment, construction investment continues to rise strongly.  Domestic construction rose by 17.4% in July y.o.y., after increasing by 16.0% and 15.8% y.o.y. during the first two quarters of this year.  Domestic construction orders are a leading indicator of construction investment, and they increased by an astonishing 80.3% y.o.y. in July, even much higher than the second quarter's performance, 56.3%.  While orders from the public sector decreased slightly, construction orders for residences from the private sector increased explosively (see <Figure 12>). 

20. Because the stock market has performed so poorly, the extremely low interest rates induced an enormous amount of liquidity into the realestate market, where 

- 51 -

returns to investment have consistently been high through the years.  The low interest rates fueled demand for housing because they naturally made housing more affordable, and this led to increased construction activity to meet the sharply rising demand.

21. Strong export growth has been maintained.  During the second quarter, exports of goods and services on the national account increased by 10.3% y.o.y (see <Figure 4>). Exports of wireless communications equipment, semiconductors, computers, and ships increased markedly.  Exports to China soared 48.1% y.o.y. during the first eight months of 2003.  As of the end of August 2003, China accounted for 17.5% of Korea's total exports, up from 14.6% of last year.  Exports to the U.S. have not yet fully recovered, and the U.S. share of total exports had fallen from 20.2% last year to 17.6% during the first eight months of this year.

<Figure 12>           Construction Investment Indices

- 52 -

2) Forecasts

1. As mentioned early on, there are no clear indications of a full fledged economic recovery.  However, we predict that the economy will bottom out no later than the fourth quarter of this year.  <Table 4> and <Table 5> presents our economic forecasts for this year.  Various economic forecasting techniques, including a large- scale macroeconomic model, were employed to produce the forecasting results presented in the tables.

2. The tables show that we predict the real GDP growth rate to pick up significantly in the fourth quarter of this year.  During the third quarter, real private consumption will contract again, though not as sharply as in the previous quarter. Equipment investment will decline at a more rapid rate in the third quarter, and the rate of increase in construction investment will flatten out.  The rate of increase in total fixed capital formation will decline.

<Table 4>          Forecasts for Economic Growth of 2003¹⁾

(unit: %)

Note:  1) Percent Change from the previous year.  Figures after the third quarter of 2003 are KIF forecasts.

- 53 -

3. In the fourth quarter, equipment investment will finally bottom out, but the growth rate of total fixed capital formation will improve only slightly because the of the slowdown in the growth in construction investment.  Private consumption will also start to recover, and domestic demand will pick up slowly.  The real GDP growth rate in the fourth quarter is forecast at 4.2%, and the annual real growth rate this year is seen at 3.0%. 

4. Economic research institutes at home and abroad have recently revised downward their economic forecasts for growth to mid 2% for this year and mid 4% for next year.  If their pessimistic forecasts are realized, it would imply that the Korean economy is entering the mature, low- growth phase of development.  The Korean economy indeed has various structural and institutional problems that compromise its economic vitality, but these are not so serious that they will reduce real GDP growth in the near future. 

<Table 5>         Contributions to Economic Growth¹⁾

(unit: %, %p)

 2) Year- on- year percent changes and figures after the third quarter of 2003 are KIF 

forecasts.

- 54 -

Prices and Wages

1) Review

1. The CPI rose 4.1% during the first half and then decelerated in July and August, rising 3.2% and 3.0% y.o.y., respectively.  Prices for agricultural products were up 3.4% y.o.y. in July because of an usually long spell of heavy rain that damaged the crops of fruits and vegetables and greatly reduced the hours of sunlight.  The heavy rain continued in August, but the inflation rate on agricultural products declined to 2.1% because the rainfall in August last year was much worse (see <Table 6, Figure 13>).

2. Inflation on manufactured products has declined since the end of the second quarter (see <Table 6>.  Prices for large- sized passenger cars, light oil, and liquified petroleum gas (LPG) for automobiles rose sharply during the period, but 

<Table 6>                      Prices and Wages¹⁾

(unit : %) 

Notes: 1) Year- on- year percent changes

2) The weight of CPI (Total = 1000, Agricultural & Marine = 107.4, 

Manufacturing = 342.9, Services = 549.7)

3) Period average.

Sources: National Statistical Office,『Consumer Price Indices』, various issues.

The Bank of Korea,『Producer Price Indices』, various issues.

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

- 55 -

prices of mobile phones declined, helping to hold overall prices for manufactured products steady.  Although the housing rent index has been stabilizing recently (see <Figure 14>), public utility charges such as hospital fees, bus fares, and municipal gas charges rose significantly and pulled up the inflation rate in the service sector to around 4% in July and August.

<Figure 13>                     CPI and PPI

Source: National Statistical Office.

<Figure 14>        Housing Rent Index in the CPI

Source: National Statistical Office.

- 56 -

3. Entering the third quarter of 2003, the PPI inflation rate rose from the very low level of 1.3% of the second quarter (see <Table 6>).  In July, prices of manufacturing products rose by only 0.8% y.o.y. owing to the on- going and the sizable exchange rate appreciation.  Prices of agricultural products increased by 4.0% due to the heavy rainfall.  The overall PPI was up 1.6% y.o.y. in July.  In August, the PPI rate rose to 1.9% y.o.y. as prices of agricultural products increased by 4.1% y.o.y. and prices of crude oil and raw materials climbed.  Considering the economic recovery in advanced economies, the prices of crude oil and raw materials are likely to increase steadily for a while, pushing the PPI up further (see <Figure 13>). 

4. The rate of increase in import prices declined to 2.6% y.o.y. in August from 3.2% in July.  During this period, the Korean won appreciated substantially, and the prices of capital goods stabilized.  However, the effect of the sharp increases in prices for crude oil and raw materials was overwhelming.  While the inflation rate of the import price index was relatively high, the export price index 

<Figure 15>             Import and Export Prices

Source: National Statistical Office.

- 57 -

barely moved at all.  The export price index rose 0.5% in July and then fell △0.1% in August.  The appreciation of the Korean won, decline in agricultural products exports, and heated competition with Chinese products all served to stabilize unit export prices (see <Figure 15>). 

5. During the first half of this year, the terms of trade deteriorated severely owing to the sharp increase in the unit price index of imports.  The terms of trade plummeted by 15.1% y.o.y. in the first quarter, but it rebounded to some degree in the second quarter to △6.9% y.o.y.  Since the mid- 1990's, the terms of trade has declined repeatedly.  In order to maintain international competitiveness, Korea must determine why the unit prices of export goods have not risen at the same rate (see <Figure 16>).

6. The wholesale price index (WPI) in the U.S. jumped dramatically by 7.1% in the first quarter, and the Japanese WPI, aggregated in terms of Japanese yen, shot up by a remarkable 10.4%.  In addition to a technical rebound effect, the sharp rise in the WPIs of these countries was primarily a result of their economic 

- 58 -

recoveries.  The unit price of export goods will increase modestly as the economic recovery of advanced economies gains momentum, and it will extend its positive influence to domestic private consumption by improving gross national income (GNI) in the future.

7. In July, students' participation in the labor market increased significantly as summer vacation began.  As a result, the unemployment rate rose 0.2%p to 3.4%. This was 0.6%p higher than that of the same month of the last year.  The number of unemployed increased 18.5% y.o.y. to 781,000.  The number of unemployed rose in all age groups except the eldest age group.  The number of unemployed workers younger than 30 years of age totaled 385,000, representing an unemployment rate of 7.5%, and the number of unemployed workers in their forties was 132 thousand.  In August, the total number of unemployed was up 9.4% y.o.y. to 756,000, and the unemployment rate was 3.3%, slightly below the rate reported in July.  Since the 1990s' the unemployment rate of the third quarter has historically been lower than that of the second quarter.  Considering the unemployment rates of July and 

<Figure 17>               Unemployment Rate

Source: National Statistical Office.

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August, however, the unemployment rate of the third quarter of this year will be exceptionally high (see <Figure 17>).

<Figure 18>      Average Industry and Manufacturing Wages

Source: Ministry of Labor『Report on Monthly Labor Survey』, various issues.

<Figure 19> Real Wage Rate Net of Labor Productivity Improvement Rate

Source: Ministry of Labor『Report on Monthly Labor Survey』, various issues.

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8. The nominal non- farm industry wage rose 13.2% y.o.y. during the first quarter of this year, but it was only up 8.4% y.o.y. in the second quarter.  Extra allowances such as special bonuses increased sharply.  In April alone, they were up 23.5% y.o.y., and they contributed to the steady increase in nominal wages.  The rate of increase in real wages was 4.4%, 5.8%, and 5.1% during the three months of the second quarter (see <Figure 18>).  Last year and in the first quarter of this year, the rate of increase in real wages was well above the rate of increase in labor productivity improvement, but entering the second quarter, the gap narrowed significantly (see <Figure 19>).  Keeping the real wage increase rate within that of labor productivity is crucial with regard to maintaining strong macroeconomic fundamentals.

2) Forecasts

1. In the first half, and especially in the first quarter of this year, crude oil prices rose sharply as a result of the war in Iraq.  Producer prices soared in the U.S. and in European countries.  In dollar terms, Japanese producer prices were up sharply as the yen appreciated substantially against the dollar.  Raw materials prices rose at a double- digit rate in the first half.  All of these developments pulled the unit price of imports up by 13.8% in the first half, raising domestic import prices, producer prices, and consumer prices, directly and indirectly.

2. In the second half of this year, inflation will be considerably moderated.  In the second half, the unit price of imports will be stable, and the recession in the domestic economy will begin to have a deflationary effect on prices.

3. The annual CPI and PPI inflation rates for the year are forecast at 3.5% and 2.0%.  Notwithstanding the domestic recession, both of these rates are higher than last year's rates of 2.7% for the CPI and △0.3% for the PPI.  This anomaly was 

- 61 -

due to the sharp increase in the unit prices of imports that occurred during the first half of this year.  Last year, the unit prices of imports decreased by 3.8%, but they will increase by 9.9% this year; a spectacular 13.7%p reversal in one year.

4. This year's unemployment rate is forecast at 3.3%, only 0.2%p higher than in the last year, despite the current recession.  The recession reduced the number of employed, but it also discouraged labor participation and, therefore, any increase in the labor supply.  The number of workers increased by 3.8% in 2002, but then remained nearly unchanged during the first half of this year.  On the other hand, the workforce, i.e. the number of people participating in the labor market, increased by 2.5% last year, but it did not increase at all during the first half of this year. Because the supply of and demand for labor have moved in tandem, the number of unemployed has not changed appreciably this year (see <Table 7>).

<Table 7>            Forecasts for Prices and Wages¹⁾

(unit : %)

Notes:  1) Percent changes from the previous year.

2) The figures for the CPI and PPI after the fourth quarter of 2003 are KIF forecasts, and figures for the unemployment rate and average industry wage after the third quarter of 2003 are KIF forecasts.

Sources:  National Statistical Office,『Consumer Price Indices』, various issues.

The Bank of Korea,『Producer Price Indices』, various issues.

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

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The Balance of Payments

1) Review

The current account surplus fell by US$1.28 billion to only US$0.43 billion, but this was the third consecutive month during which the current account was in the black.  The goods account surplus narrowed by US$1.18 billion to US$1.57 billion. The reduction in the goods account surplus was mainly due to a sharp decline in automobile exports stemming from a labor union strike.  Exports of other major products such as wireless handsets, semiconductors, and machinery were actually up for the month.  Imports of raw materials rose as oil refiners increased their oil imports despite a reduction in domestic equipment investment and a contraction in consumer sentiment.  As a result, the surplus in the goods account fell even more sharply.  The deficit in the service account was US$1.09 billion.  The travel account deficit increased to US$0.69 billion in July as a result of a decline in the number of foreigners entering Korea and an increase in the number of Korean

<Table 1>                  Current Account

(Unit: $100 mil.)

Notes: 1) Preliminary, 2) Estimates.

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

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nationals traveling abroad.  The deficits in the other components of the service account such as payments for business services like advertising and marketing continued to increase, and the balance of royalties and license fees showed another deficit. 

In August, the current account rebounded by US$0.97 billion to US$1.39 billion. Most of the increase came in the goods account, which rose to US$2.37 billion. The deficit in the service account narrowed to US$0.99 billion from the previous month's US$1.09 billion.  Exports, comprised mainly of heavy & chemical industry products, increased sharply, and imports rose at a slower rate than in July.  The service account narrowed because of a decline in the travel account as an increased number of foreign visitors came to Korea.  The deficits of the other components of the service account also narrowed due to a decreased in payments for business services. 

The capital and financial account in July registered a net outflow of US$0.13 billion.  This was due primarily to the increased redemption of short- term

<Figure 1>   Foreign Investment and Balance of the Capital Account

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

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borrowing and lending by financial institutions, which more than offset a large net inflow of foreign equity investment capital of US$2.76 billion, the highest figure since March.  Financial institutions redeemed US$2.24 billion in short- term loans, adversely impacting the financial account. 

The capital and financial account in August saw a US$3.73 billion net inflow, partly as result of a net inflow of foreign portfolio funds.  The net inflow of foreign stock investment was US$1.61 billion, and private firms issued depositary receipts (DRs) in stock markets overseas.  It was also partly due to an increase in the short- term borrowings by financial institutions and the withdrawal of trade related loans.

The trade balance in July and August totaled US$2.50 billion surplus; US$0.60 billion surplus in July and US$1.90 billion surplus in August.  The improvement was mainly due to a rebound in exports to China after the passing of SARS. Exports of electronic products such as like wireless communications equipment continued to rise.  Imports decelerated as a result of the declining consumer sentiment and weak demand for capital equipment in the corporate sector. 

Exports on a custom- cleared basis (f.o.b) totaled US$30.9 billion in July and August, up 12.0% y.o.y.  August marked a third consecutive month of double- digit growth.  It seems that companies aggressively sought to increase exports, and global demand for IT products remained strong even in the face of a deteriorating export environment characterized by an appreciation of the Korean won and labor- management instability in Korea.  The truck drivers' union and automobile labor union strikes had especially negative impact on exports, making Korea's overall export performance all the more impressive.

Exports in July were up 15.3% y.o.y. to US$15.5, and daily average exports reached US$0.63 billion, the eleventh consecutive month above US$0.6 billion.  This strong performance was attributable primarily to high demand for IT products to China.  Automobile exports were actually down 20.5% y.o.y. because of the labor strike.  After factoring out automobiles, total exports were up an impressive 17.6% y.o.y.  Semiconductor exports were up 13.5% y.o.y.  In August, exports rose 10.4% 

- 65 -

y.o.y. to US$15.4 billion, even though the automobile workers strike was still on- going and export conditions were not very favorable in other respects. 

It should also be noted that there were fewer business days than during the same month of the previous year.  Exports of IT products like wireless communications equipment more than made up for the declines in other products.  Exports of semiconductors also remained strong, rising 20.0% y.o.y.  Exports to advanced countries in July were up only 3.3% y.o.y. as a result of general economic stagnation and the disruption in automobile exports, but exports to developing countries surged 29.2% y.o.y.  Demand from China was especially strong as the effects of SARS began to fade. 

<Figure 2>       Exports and Imports, Balance of Goods Account 

<Table 2>                  Daily Average Exports 

(Unit: 100$ mil.)

Source: Ministry of Commerce, Industry and Energy.

- 66 -

Despite the weak global sales of PCs, demand for semiconductors increased substantially due to an increase in demand for memory chips.  Exports were helped by the rise in DRAM prices.  Demand for new products like the DDR400 continued to rise. 

In July and August, there were concerns about excessive inventories of wireless communications equipment and the sluggish global economy, but demand in developed countries continued steadily upward while demand in China surged 126.0% y.o.y. Wireless communications equipment exports rose 55.6% y.o.y. in July and by 43.9% y.o.y. in August.  Exports of computers increased 31.9% y.o.y. in July and 23.2% in August as prices continued to rise, and demand for TFT- LCDs was strong because of expansion of production of notebook computers.  The labor walkouts at the automobile manufacturers laster more than forty days, causing automobile exports to fall by 19.9% y.o.y. in July and by 8.9% y.o.y. in August. 

Exports to the U.S. declined 7.7% y.o.y. in July and by 5.7% y.o.y. in August. Most of the decline came in automobiles.  Exports of electronic parts and petrochemicals to China increased as the SARS threat had clearly faded and China needed intermediate goods from Korea for its own export products.  Exports of IT products such as wireless communications equipments and computers also helped to 

<Figure 3>  Semiconductor Price           <Figure 4> Semiconductor Sales

Sources: Bloomberg, Datastream. 

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raise the overall exports to China.  In July, exports to China, were up 47.6% y.o.y., and in August, they were up 51.7% y.o.y.  Exports to the EU increased slightly by 11.7% y.o.y. in July and by 0.3% y.o.y. in August.  Exports of major items like computers, semiconductors, and mobile phones were up substantially.  The U.S. accounted for 17.6% of total exports, the largest share of any country.  It was followed closely by China, which accounted for 17.5% of total exports.  Considering China's rapid growth, China will certainly become Korea's largest export market very soon. 

Imports during July and August on a custom- cleared basis (c.i.f) increased by 9.5% y.o.y.  Imports of capital goods and consumer goods rose, but at a slower rate than previously because of the weakness of the domestic market.  In July, imports rose 14.0% to US$14.9 billion.  Much of this growth was due to a spike in imports of raw materials.  Oil companies rushed to increase their stocks of crude oil ahead of the resumption of the petroleum tax.  Like exports, daily 

<Table 3>             Exports Growth by Commodity

(Unit: %, y.o.y.)

Note: 1) From Jul. 1 to Aug. 31.

Source: Korea International Trade Association, KOTIS.

- 68 -

average imports also surpassed US$0.6 billion in July, but in August, imports of raw materials decreased as oil companies reached their storage capacity and imports capital goods and consumer goods rose at a slower pace.  As a result, daily average imports fell back below US$0.6 billion.  Imports in August were up by 5.1% y.o.y. to US$13.5 billion. 

Imports of raw materials, crude oil imports were up sharply by 32.1% y.o.y. in July, whereas they were only up 10.9% y.o.y. in the second quarter.  Petroleum

<Table 4>                Export Growth by Region

(Unit: %, y.o.y.)

Source: Korea International Trade Association, KOTIS.

<Table 5>           Import Growth by Region and by Use

(Unit: %, y.o.y.)

Note: 1) From Jan. 1 to Aug. 31. 

Source: Korea International Trade Association, KOTIS.

- 69 -

product imports rose by 26.8% y.o.y. due to an increase in imports of products for oil refining.  Imports of LNG soared 77.1% y.o.y. as demand from power plants and needs for urban gas increased.  The spike in demand for energy products pushed up overall raw materials imports up 20.1% y.o.y. in July to US$7.4 billion. In August the rate of increase in raw materials was a much lower 3.9% y.o.y.  The rates of increase in imports of equipment for manufacturing memory chips, machinery, and parts for automobiles were all down sharply because of the slowdown in domestic equipment investment and the poor automobile exports Overall imports rose 8.9% y.o.y. in July and 7.0% y.o.y. in August, much lower rates than the 14.0% y.o.y. recorded in the second quarter.  Consumption goods imports continued to decline throughout this period due to the poor consumer sentiment, rising only 7.0% y.o.y. in July and 3.5% y.o.y. in August.  Most adversely affected were alcoholic beverages, automobiles, and tobacco products.

The terms of trade during the second quarter deteriorated by 6.9% y.o.y.  The rise in the unit price of imports surpassed that of exports.  The unit price of exports actually decreased by 0.2% y.o.y.  The unit price of semiconductors was down steeply by 39.8%, but it was partly offset by a 17.9% y.o.y. increase in the unit export prices of petrochemical products and a 5.9% y.o.y. increase in the unit prices of steel products.  The unit price of imports rose by 7.1% y.o.y. as the unit prices of raw materials increased.  Real Gross National Income (GNI) during this period increased by only 0.2% y.o.y., while real GDP showed an increase of 1.9% y.o.y., indicating that the real purchasing power of income fell off and the sentiment in the business environment remained low.

The won/dollar exchange rate began the third quarter at 1,190 won and then gradually dropped to lows of 1,170 won by early September.  The won was being influenced by the rise of the yen, underlined by the expectations for an improvement in the Japanese economy, and net foreign stock investment inflows. The government intervened in the foreign exchange market to stem the won's rise throughout the quarter, but the communique issued by the G7 economies on September 20 triggered a substantial dip in won/dollar exchanger rate.  On 

- 70 -

September 22, the won/dollar exchange rate was 1,151.2 won.

<Figure 5>              International Crude Oil Prices

Source: Bloomberg.

<Figure 6>                 Terms of Trade Index

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

- 71 -

Taking a closer look at the monthly trend, in July, the won/dollar rate fell from 1,180.0 won in early July to 1,176.3 by July 14 as a result of the appreciatory pressure from June's trade surplus and the net flows of foreign capital into the Korean stock market.  The authorities intervened continually in the foreign exchange market in an effort to prevent a significant decline in the won/dollar exchange rate. The U.S. dollar traded around 1,180 won in early August, but declined to the 1,170 won level by mid- August.  On August 22, the won/dollar exchange rate dropped by 1,169.5 won due to further net stock purchases by foreigners despite the government's announcement of an additional issuance of foreign exchange stabilization bonds and its continued intervention in the foreign exchange market. The bombing of the UN office in Bagdad and the fall of the yen/dollar exchange rate, helped by the announcement of the better- than- expected second quarter growth of the Japanese economy, caused the won/dollar exchange rate to decline still more. However, after August 27, the won/dollar exchange rate rebounded to around 1,170 won as a result of market participants' concerns over further intervention in the foreign exchange market by the authorities.  In early September, the won/dollar exchange rate began to fall again.  It started off at 1,175.3 won and then 

<Figure 7>             Won/Dollar Exchange Rate

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gradually dropped to a low of about 1,170 won by mid- September due to continued buying by foreign investors in the domestic stock market.  On September 20, the G- 7 finance ministers called for "more flexible" exchange rates at their Dubai meeting to resolve global economic imbalances, which investors interpreted as a warning against persistent intervention in the foreign exchange markets by Asian countries to keep their currencies weak.  As a result, the won/dollar exchange rate plunged to 1,151.2 won, the lowest level of the year.  The G- 7 statement did not name names, but it was widely considered a slap at the authorities in Japan and China for maintaining currency pegs against the U.S. dollar.  The G- 7 seems to be concerned that the Japanese government has intervened excessively in the foreign exchange market, in addition to talking down the yen down throughout the year. Moreover, the intervention seems less justifiable in light of the recent strength in the Japanese economy.  As a result, a general dispute that there is an imbalance in the Asian foreign exchange markets has begun to emerge.  The G- 7 is also concerned about the U.S. current account deficit.  It is now running at an annual rate of US$550 billion, about 5% of U.S. GDP.  The net foreign debt of the

<Figure 8>  Overall U.S. Trade Balance and Trade Balance with China

Source: Datastream.

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United States is now approaching US$3 trillion and is rising by about 20% annually.  The United States must import US$4 billion in foreign capital every working day to finance the current account deficit and its own outward foreign investments.  Under these conditions, the ballooning deficit, especially with China, has seemingly prodded the U.S. to change its external policy stance on the dollar. Finally, with the next presidential election about one year away, the Bush administration is under political pressure to let the dollar decline in order to relieve pressure on U.S. manufacturers.  For this reason alone, the U.S. is likely to adhere to its weak dollar policy to aid the economic recovery for a while.  The won/dollar exchange rate will likely remain low for some time because the yen is expected to continue to appreciate with the recovery in the Japanese economy.  However, considering Korea's geopolitical problems, such as the North Korean nuclear issue and the dispatch issue of troops to Iraq, as well as the on- going weakness in the Korean economy, the Korean won seems to be too strong.  If the won moves beyond the proper range, the authorities should intervene in the foreign exchange market to restore stability, taking into account the fact that there was no binding obligation in the G- 7 statement.

2) Forecast

The current account in the fourth quarter is expected to record a US$1.7 billion surplus.  The goods account surplus will decline, and the service account will show another deficit.  The current account surplus for all of 2003 is forecast at US$6.4 billion surplus, up US$0.3 billion from the previous year's US$6.1 billion.  Export growth will be relatively flat in the fourth quarter as a result of appreciation of the won and technical effects of the strong performance of the same period of the previous year.  Import growth is expected to surpass export growth because of the rise in crude oil prices and an increase in oil imports.

The service account deficit during the fourth quarter is forecast to narrow slightly to US$2.4 billion.  The chronic deficit in the service account has been a major 

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factor restraining the surplus of the current account.  The deficit in the travel account and other business service accounts has caused the overall service account deficit to balloon.  It has been in a deficit status since 1998, when the economic crisis discouraged many Koreans from travelling abroad.  During the previous year, the service account deficit was a record US$3.8 billion, and another record will almost certainly be set in 2003 as the deficit through August was already US$3.6 billion.  The number of foreign visitors to Korea is not increasing as rapidly as the number of Koreans travelling abroad.  As a result, the travel account is a major factor in the total service account deficit.  In 2002, the other service account deficit totaled US$6.1 billion, surpassing the previous year's deficit, and in 2003, it was already up to US$4.7 billion through August.  The chronic deficit in this service account was mainly due to increased payments for foreign financial services and royalties.  Moreover, the overall service account deficit is forecast to continue ratcheting up as payments for manufacturing industry business services, such as research charges and development and legal service fees, increase.  The service account for all of 2003 is expected to exceed the previous year's deficit and total US$9.5 billion.  It also seems that the service account will continue to increase over the next year.  Given the structural nature of the deficit, it can be expected to persist for some time.  The expected economic recovery and opening of the service sector at the end of next year, at which time the DDA (Doha Development Agenda) negotiations will be finished, will likely serve to deepen the deficit in the service account throughout 2004. 

Exports in the fourth quarter are expected to continue rising, helped by stronger economic growth in the U.S., Japan, and the EU region and the on- going boom in exports to China.  The y.o.y. growth will not be spectacular because of the strong performance of the same period last year and the Korean won's appreciation. 

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<Figure 9>                   Service Account 

Source: The Bank of Korea.

<Figure 10>             Visitors and Travellers Abroad 

Source: Korea National Tourism Organization.

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Exports will be up only about 8.7% y.o.y., but for the entire year, they will be up 14.8% to about US$186.6 billion.  Korea's exports are benefitting from strong economic performances of major trade partners.  The Japanese economy expanded more than 2% in the second quarter, China's economic growth rate is expected to continue to grow at a rate of over 7% annually, and the U.S. economy should expand more than 4% in the fourth quarter and perform well in 2004.  The economic recovery of the U.S. is especially important because the U.S. is the most important export market for all of Asia.  Not only does Korea stand to benefit by exporting more products directly to the U.S., it will realize higher exports to other Asian countries as inputs for their increased exports to the U.S.  China's booming economy is also important.  Exports to China will continue to rise sharply as the Chinese purchase huge volumes of Korean- made IT products such as computers and wireless communications equipment.  The appreciation of the won may reduce 

<Figure 11>           Other Business Service Accounts

Source: The Bank of Korea.

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<Figure 12>    Share of Asia Countries' Exports to U.S. in 2002 

Source: Korea International Trade Association, KOTIS.

<Figure 13>      Share of Exports to China by Items in 2003

Source: Korea International Trade Association, KOTIS.

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the price competitiveness of Korean products in the fourth quarter, but considering that more than 70% of Korea's exports to China are raw materials and capital goods for China's exports, the rise in the value of the Korean won may actually cause exports to China to rise.  There is also the possibility that exporters might not charge higher prices abroad for their products even if the Korean won appreciates against the dollar in order to maintain their price competitiveness.  This would serve to limit any reduction in exports in the fourth quarter stemming from the Korean won's appreciation. 

Imports of raw materials in the fourth quarter are expected to rise more than 10% y.o.y.  Imports of crude oil are expected to increase due to seasonal effects, and the price of oil is forecast to rise slightly due to OPEC's decision to decrease production.  However, the reduction in capital goods imports for production of export products and the stagnation in equipment investment should cause total imports to rise at a slower rate.  Imports of consumer goods are forecast to decline further.  Total imports for the fourth quarter are expected to rise to US$46.2 billion, up only 9.2% y.o.y., and imports for all of 2003 should reach US$175.1 billion, up 15.1%. 

The won/dollar exchange rate in the fourth quarter will be determined by the extent to which the monetary authorities intervene in the foreign exchange market and the direction of the yen/dollar exchange rate, which itself is expected to rise. Because both the U.S. and EU are publicly calling for adoption of flexible exchange rate systems in Asia, the monetary authorities' ability to intervene in the foreign exchange market will be limited for some time.  Also, as the expectations for a Japanese economy recovery increase, the authorities' actions would create upward pressure on the Japanese yen.  Much of the appreciatory pressure on the yen also seems to be due the political considerations of the Bush administration in the U.S. as it is naturally concerned about American manufacturers during the run- up to the presidential election.  However, considering the geopolitical risks such as the North Korean nuclear issue and disputes over the potential dispatch of troops to Iraq as well as the doubts over the domestic economy recovery, the Korean won may 

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appreciate against the dollar only slightly.  This could lead to an imbalance in the foreign exchange market because foreign investors are making smaller net purchases on the domestic stock market and may even begin to record a net outflow.  It may, therefore, be necessary for the authorities to intervene to discourage exchange rate speculation in the foreign exchange market and the excessive appreciation of the Korean won against the U.S. dollar.  All told, the won/dollar exchange rate is forecast to move in a band of 1,135～1,145 won on average in the fourth quarter. For the year, the won/dollar exchange rate is forecast to record an average of 1,180～1,185 won. 

<Figure 14>                Foreign Stock Investment

Note: 1) The figure for September is through the 16th.

Source: National Computerization Agency.

<Table 6>                     Current Account¹⁾

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(Unit: $100 mil., %)

Notes: 1) After the third quarter of 2003, KIF Estimates.

2) Period Average.

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

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Money and Interest Rates

Money

1) Review

The Korean economy slowed significantly during the first half of 2003 as both private consumption and facilities investment became very sluggish. Sentiment was grim because of the unrelenting global economic slump and the North Korean nuclear issue.  Households were burdened by heavy debt. The already weak economic conditions were exacerbated by serious instability in the domestic financial market following the accounting scandal at SK Global and the financial problems at numerous credit card companies. As the economy continued to slow down, the Bank of Korea (BOK) lowered its target for the overnight call rate by 25 basis points to 3.75 percent on July 10, the lowest level ever, in a bid to stimulate the faltering economy. Considering the longer than expected economic slowdown, the BOK also downwardly revised its outlook for economic growth in 2003 to 

<Figure II- 1>         Inflation Target and CPI Inflation

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3.1 percent from its April forecast of 4.1 percent.  Contrary to the BOK's forecast, expectations for a mid- term recovery actually began to rise during the third quarter as the economic recovery in advanced countries including the U.S. became more apparent.  However, many domestic market participants remained doubtful of the domestic economic recovery because there were no signs of improvement in the domestic economic fundamentals. In September, fears of a more prolonged economic slump rose again due to the widespread typhoon damage, hike in oil prices, and rise in the won/dollar exchange rate.

The movement of funds during the third quarter was interesting in several respects, and the various monetary aggregate growth rates moved in different directions depending on the changes in long-  and short- term liquidity.  Interest rates were kept low, and market liquidity was high. Funds rushed into bank deposits because the flight- to- quality that had been on- going previously had begun to ease, and a large volume of money shuttled between banks and Investment Trust Management Companies (ITMCs).  In the first half, funds for the most part had rushed into safe havens such as bank deposits.  In the third quarter, however, funds pursued higher yields in addition to safety and shifted between financial institutions again.  As much of the market funds were directed into investments in short- term financial assets rather than the capital markets, the funds at financial institutions generally became more concentrated in shorter- term deposits.  This increase in short- term investments was attributable to the economic slump and the persistence of the low interest rates.  There was, in fact, very little movement of funds into the capital markets.  Long- term interest rates rose sharply with expectations of the mid- term economic recovery, causing demand for bonds to fall off steadily.  Despite the strength of the stock market, many participants decided to take profits, and the bulk of these proceeds also went into short- term financial assets.  Both corporate 

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and household demand for long- term funds was weak.  Corporations did not have much need for funds except for operating purposes, and households had already become heavily burdened with debt.  There was an increase in bank lending to households, mainly in the form of mortgages, but this was seen as a seasonal phenomenon. 

Considering these economic conditions, the BOK continued to hold interest rates at low levels throughout the third quarter.  On July 10, the BOK slashed its target for the overnight call rate by 25 basis points to 3.75 percent as the economic downturn became more pronounced than previously expected.  However, the low interest rates did little to increase corporate demand for funds, so market liquidity remained extremely high.  Roughly 11.3 trillion KRW in liquidity was pumped into the market through net fiscal spending in July and August, and the BOK absorbed it by issuing Monetary Stabilization Bonds (MSBs) and by RP operations.  The net issuance of MSBs was 270 billion KRW in July, and the volume of RP operations totaled 4.36 trillion KRW.  In August, the BOK absorbed 4.98 trillion KRW of the market liquidity through 3.7 trillion in RP operations and a net issuance of 1.28 trillion in MSBs.  Because the long- term interest rates began to rise in June, the need to issue MSBs to counterbalance the 

<Table II- 1>            Issuance of Monetary Stabilization Bonds

(Unit: Billion won)

Sources: The Bank of Korea, Monthly Bulletin, various issues. 

Korea Investors Service,  KIS- LINE

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earlier plunge in long- term interest rates had greatly diminished, which explains why the BOK increasingly engaged in RP operations (See <Table II- 1>). 

After news broke of the SK Global accounting scandal in mid- March, funds seeking safe assets moved into deposits at banks, and the flow was accelerated by concerns over deteriorating asset quality at the credit card companies.  The bulk of funds withdrawn from MMFs at ITMCs moved into bank deposits, especially money market deposit accounts (MMDAs).  As the liquidity crunch at credit card companies gradually began to ease, the uneasiness in the financial market dissipated.  Expectations for a mid- term economic recovery then spread home and abroad.  Yet another shift in funds between the banking and non- banking sectors occurred as investors became less risk averse and actively sought high yields.  The rush of funds into bank deposits showed signs of trailing off, and a large volume of funds shuttled between various financial institutions. 

Deposits at ITMCs increased sharply in July.  Most of the new funds went into MMFs.  Funds that had been temporarily withdrawn prior to the semi- annual closing of books at the end of June were redeposited, and banks cut their deposits rates on MMDAs.  Deposits at Deposit Money Banks (DMBs) fell sharply by 115 billion KRW.  Deposits into instant access accounts, such as MMDAs, especially declined owing to cuts in the short- term deposit rates and also the end- of- month value- added tax payments.  The DMBs lowered their deposit rates after the BOK reduced the call rate in July.  Therefore, the yields on MMFs became comparatively higher than the deposit rates on MMDAs.  A huge flow of funds naturally shifted to MMFs from MMDAs, pushing total deposits in MMFs up by 9.3 trillion KRW in July alone.  Deposits at DMBs increased sharply by 5.5 trillion KRW in August, with 2.1 trillion KRW going into MMDAs.  Deposits 

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at ITMCs soared by 7.2 trillion won in July but inched up only 0.1 trillion KRW in August.  Whereas the flow of funds into their MMFs had increased sharply in July, it tapered off markedly in August.  The inflow of funds into stock- type and bond- type beneficiary certificates marked a declining

<Table II- 2>         Deposits at Financial Institutions¹⁾

(Unit: billion won)

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

2)As of September 1 ~ September 17

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

- 86 -

trend.  The slowdown in deposit- taking at ITMCs was mainly attributable to the drop in short- term market rates, which in turn caused the yields on MMFs to decline.  From September 1 to 17, deposits- taking by DMBs decreased by 1.3 trillion KRW, while that by ITMCs increased by 0.4 trillion KRW.  Most of the increase in deposits at ITMCs was in MMFs, as banks cut their deposit rates on MMDAs (See <Table II- 2>). 

Short- termism seemed to a major defining characteristic of financial assets in the third quarter.  Funds seeking favorable investment opportunities rushed into short- term deposits with maturities of less than six months, including the MMDAs at DMBs and MMFs at ITMCs.  The share of short- term products out of total deposits at major financial institutions (banks, bank trust accounts, ITMCs, merchant banking corporations) stood at a high level of 40 percent.  As the flight- to- quality gained momentum in the process of the economic slowdown, market funds were shifted into those MMDAs and MMFs that specifically invest mainly in government and public bonds.  The increasing volume of floating funds could disturb the financial markets at any time if there is a mass shift.  In mid- March, the financial markets actually were temporarily thrown into turmoil due to the exodus of funds from MMFs in response to the SK Global accounting scandal and growing concerns over the deteriorating soundness of credit card companies. However, as most of funds withdrawn from MMFs flowed into short- term deposits at DMBs, mainly into MMDAs, the relative volume of short- term deposits at financial institutions decreased very slightly to 46.9 percent in March from the previous month's 47.3 percent.  However, as the exodus of money from MMFs gradually slowed down and market interest rates fell sharply following the BOK's reduction of the call rate in May, financial assets became more short- term.  The average deposit rate dropped to a record- low following the BOK's additional call rate cut in July, which chipped away at the incentive to save.  Partly for this reason and the 

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uncertain outlook for the domestic economic recovery, investors have increasingly preferred short- term investments to long- term ones.  In the stock market, domestic investors withdrew their investment funds from stock holdings after taking gains off the table, taking advantage of foreign investors' active net purchasing.  Much of the funds withdrawn from the stock market were used as stand- by funds in search of high- yield investments, and these funds stayed in short- term deposits at financial institutions, including MMFs.  As a result, the share of short- term deposits increased to 48.7 percent in August, the highest level since the first quarter of 2002 (See <Figure II- 2> and <Figure II- 3>). 

Such unusual patterns in the circulation of money made the financial markets vulnerable to external shock and reduced corporate competitiveness. 

<Figure II- 2>     Short- term Deposits at Major Financial Institutions¹⁾²⁾

Notes:1)Short- term deposits = Demand deposit + Instant access accounts + Short- term marketable deposits (CD+RP+Cover bills) + Time deposits (less than 6 months) + Additional money in trust + 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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This increase in short- term investments was attributable to the overall economic uncertainties, the low interest rates, bearishness in the stock market, and the government's efforts to restrain real estate speculation.  It may gave rise to wide and sharp movements in short- term floating money, as previously experienced, which could lead to monetary tightening, a liquidity crisis at financial institutions, and a bubble in the real estate market.  It may also cause SMEs, which depend on bank loans for most of their borrowing needs, to experience difficulties raising long- term funds because financial institutions will naturally tend to manage their funds on a shorter time horizon following an increase in short- term deposits.  On the other hand, banks rushed to lower their deposit rates, especially short- term rates, in order to guarantee an interest margin in response to the decline in loan rates.  As a result, the average rate on savings deposits at banks fell to 4.15 percent by June, a drop of 55 basis points during the first half.  The general lowering of deposit rates was accelerated after the call rate cut in July.  Financial institutions, including ITMCs, have experienced difficulties in management of their increased short- term deposits because of the very low yields on short- term financial assets. 

<Table II- 3>            Deposits at Financial Institutions¹⁾²⁾

(Unit: Trillion won, %)

Notes: 1) End of period.

2)Short- term deposits = Demand deposits + Instant access accounts + Short- term marketable deposits (CD+RP+Cover bills) + Time deposits (less than 6 months) + Additional money in trusts + Short- term bond- type beneficiary securities + MMFs + Deposits at Merchant Banking Corporations

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The outflow of funds from bond- type beneficiary certificates at ITMCs continued unabated.  Investors were concerned about a possible decline in bond prices following a rise in market interest rates, so they were increasingly disinclined to invest in long- term bonds.  Deposits at money- in- trusts also continued to decline.  Investment in short- term bond- type beneficiary certificates at ITMCs began to decline in August. Meanwhile, funds for stock investments have decreased despite the rise in stock prices.  In May, funds withdrawn from MMFs following the SK Global accounting scandal flowed into the stock market even though stock prices were declining at the time.  Since July, many investors decided to take profits on their stock investments.  The stock market continued to rise, however, seemingly because foreign investors continued to buy stocks heavily, though their purchases were not justified by improvements in economic fundamentals. 

Demand for funds in every sector of the economy was low during the third quarter.  The low interest rates and abundant market liquidity were not enough to overcome the economic slowdown.  In July, there was a net issuance of corporate bonds of 1.3 trillion KRW, followed by a net redemption of 1.0 trillion KRW in August respectively as corporations were not interested in making heavy investments and were relatively flush with cash.  In July and August, there were net redemptions of commercial paper (CP) of 0.9 trillion KRW and 1.0 trillion KRW, respectively.  Credit card companies continued to redeem their CP as demand from institutional investors, including ITMCs and bank trusts, declined.  Corporations also did not issue much equity, except during a short interval in August to complete M&As between several banks.  Bank lending to large corporations increased in July due to seasonal factors such as the roll- over of loans withdrawn prior to the semi- annual closing, and it decreased again by 0.2 trillion KRW in August.  Bank loans to small and medium sized enterprises (SMEs) in July 

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increased by 4.0 trillion KRW, an even larger increase than the previous month's 2.2 trillion KRW increase.  The bulk of these funds were used for operating purposes in addition to seasonal purposes such as paying value- added taxes.  In August, lendig to SMEs increased only by 1.9 trillion KRW because of low seasonal demand for funds during the summer vacation period and other such factors, as well increased caution on the part of banks in management of their loans to the service sector, which had previously been expanding rapidly for some time (See <Table II- 4>).  As banks have become increasingly conservative in their lending to counter the rising delinquency rates, SMEs with low credit ratings have experienced greater difficulties raising funds.  Demand for funds for investment shrank because of the contraction in domestic consumption.  In a recent BOK survey of 65 large companies listed on the Korea Stock Exchange, 42.2 percent of the respondents answered that they plan to delay or reduce investment during the period of September through December.  Only 7.8 percent of the respondents said they will increase investment for the remainder of this year.  Both the supply of and demand for corporate funds in the direct finance market, which includes corporate bonds and CP, continued to shrink. 

<Table II- 4>           Corporate Direct Financing

(Unit: Trillion won, Changes)

Notes:1)Korea Stock Exchange (KSE) + KOSDAQ 

2) Based on bonds issued by general companies (including guaranteed bonds)

3)The figure is the amount of investment converted from the liabilities of four companies, including Hynix. 

Sources: The Bank of Korea, Trends of Financial Market in August. 

Financial Supervisory Service, Monthly Financial Statistics Bulletin, various issues.

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Bank lending to households increased by only 2.3 trillion KRW month- on- month in July, a significantly lower rate of increase from the previous month's rise of 2.7 trillion KRW.  There was a deceleration in the extension of mortgages as housing prices stabilized and seasonal demand for housing was low.  Overdraft accounts increased by a mere 1.0 trillion KRW due to the contraction in consumer spending.  In August, bank lending to households increased by 3.2 trillion KRW (See <Table II- 5> and <Figure II- 3>).  Most of the mortgage lending was used to cover moving expenses because numerous households needed to move ahead of the fall school semester.  A greater volume of loans was taken out by overdraft account holders to pay tuition fees.  The increase in bank lending to households was mostly due to temporary seasonal demand.  With the exception of loans collateralized by advance ownership rights on apartments yet to be built, the overall demand for household funds was low.  Many households are overburdened with debt.  The number of credit delinquents increased to 3.22 million by the end of June, and the outstanding balance of credit per household was over 29 million KRW. 

<Table II- 5>                   Bank Loans¹⁾

(Unit: Trillion won)

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

2)Excludes trust accounts

3)Includes loans for home purchases

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

- 92 -

<Figure II- 3>       Outstanding Deposit Bank Loans by Type and 

Ratio of Household Loans to Total Loans

Reflecting all of these developments in the flow of funds, both the M3 growth rate and New M2 growth rate continued to decline in the third quarter, but the New M1 growth rate actually rebounded.  The combination of high short- term liquidity and low demand for longer- term funds meant that each of the monetary aggregates moved differently.  The New M1 growth rate represents the short- term market liquidity condition and, therefore, began to rise as a huge volume of short- term floating money shifted back and forth between financial institutions.  The M3 growth rate and New M2 growth rate continued to decline due to the shrinking demand for long- and mid- term funds following the economic slump.  The New M1 growth rose at a 6.2 percent rate in July, slightly more quickly than the previous month's 5.9 percent rate owing to an increase in funds in MMFs at the ITMCs.  In August, the New M1 money supply is estimated to have grown at a still slightly higher rate in the mid- 6 percent range, buoyed by an increase in instant access accounts.  The growth of the M3 money supply slowed to 8.7 percent in July, down from 9.1 percent in June.  In August, 

- 93 -

the M3 growth rate is estimated to have declined to around the lower- 8 percent level.  This slowdown was mainly due to the banks' extending less credit to the private sector, including households, compared to the previous year (See <Table II- 6> and <Figure II- 4>). 

<Table II- 6>              Monetary Growth Rates¹⁾

(Unit: %)

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

2) Preliminary estimates

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 maturities 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.) 

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

<Figure II- 4>           Major Monetary Growth Rates

- 94 -

2) Forecast

Exports remained strong in the third quarter, and expectations of a mid- term economic turnaround both at home and abroad spread, but the Korean economy remained relatively weak due to the continuing sluggishness in domestic demand.  The on- going economic weakness, typhoon damage, labor strikes, and appreciation of the won all served to discourage spending and investment by households and corporations.  A huge volume of funds rushed into short- term investments because of a lack of high- yield long- term investments, causing the long and short- term monetary aggregates to move in separate directions.  These patterns in market liquidity will likely persist for the time being.  However, the rapid flow of short- term floating money is expected to slow as expectations of a gradual economic recovery begin to increase. 

In the financial market during the fourth quarter, the liquidity is likely to remain abundant because interest rates will be kept at their low levels. Although the economic recovery in advanced countries including the U.S. has become more apparent, there is still some doubt as to whether the improvement in the U.S. economy can be sustained, mainly because there is no sign of an improvement in the labor market.  There are also concerns that exports will no longer be able to prop up the Korean economy because of the sharp appreciation of the Korean won.  For this reason, some believe that there will be another call rate cut in a move to rev up the economic recovery.  However, there is widespread controversy over the effectiveness of keeping interest rates at such low levels, which suggests that there will not actually be another cut in the call rate.  Rather, the BOK is expected to absorb the market liquidity, given that fiscal stimulus is being implemented and the money supply from abroad is increasing. 

Assets will likely continue to become more short- term for the time being. 

- 95 -

Even if the Korean economic turnaround begins in the fourth quarter, the pace of the economic recovery is not expected to be high, considering the relatively poor consumer sentiment and low facilities investment.  As a result, investors can be expected to make the most use of short- term financial assets, though their interest in short- term investments should begin to gradually decline. 

Taking into account all these factors, the New M1 growth is forecast at roughly the same level as in the previous quarter or slightly higher, and the M3 growth rate is forecast to decline much more.  There will be increases to the money supply through fiscal spending and from abroad, but these increases will be partly offset by a contraction in private credit, including bank loans.  The New M1 growth rate is expected to rise somewhat as market funds are forecast to continue flowing primarily into short- term deposits like MMFs at ITMCs and MMDAs at DMBs, though the rise in short- term deposits should begin to flatten out.  The New M1 growth rate during the fourth quarter is forecast at around 6.8 percent, a slightly higher rate than during the previous quarter. 

<Table II- 7>           Monetary Growth Rates and Forecasts¹⁾

(unit: %)

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

2)Preliminary estimates.

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

- 96 -

Interest Rates

1) Review

The long- term and short- term interest rates moved in different directions during the third quarter.  The Monetary Policy Committee at the Bank of Korea decided to reduce the target call rate to 3.75% on July 10, causing the short- term interest rates including those on CDs and CPs to decline.  The long- term interest rates increased sharply as expectations of the long- awaited Korean economic recovery grew in response to the improvement in macroeconomic indicators in the U.S. and the expansionary policies by the Korean government, such as the cut in the overnight call rates.  In August, the short- term interest rates were steadily pushed down as many institutional investors, expecting a rise in interest rates, rushed to purchase short- term assets.  The long- term interest rates rose at a relatively slower rate through the middle of the month and then declined toward the end of the month as the Korean economic recovery then seemed less certain and concerns increased over the volume of national bonds and a rapid rise in interest rates. 

<Table 1>       Quarterly Movements of Major Interest Rates¹⁾

(Unit: %)

Notes: 1) Period averages.

2) Average from the 1st to 16th of September.

Source: The Bank of Korea, FnGuide.

- 97 -

Entering September, the short- term interest rates actually continued to move down owing to the high market liquidity.  The long- term interest rates fell rapidly as fears persisted that the Korean economy would not recover as soon as previously believed.  Sentiment was clearly hurt by the extensive typhoon damage in Korea, the weakness of the labor market in the U.S., and the huge volume of KDIC bonds that was coming due at the end of the month (See <Table 1>). 

Inflation, as measured by the CPI, was expected to stabilize because the prices of agricultural products decreased and the oil price fell.  Despite a rise in  exports, weakness in domestic consumption and investment caused the Korean economy to remain sluggish.  The Monetary Policy Committee at the Bank of Korea responded by reducing the target call rate to 3.75% on July 10, and revised its forecast for the 2003 GDP growth rate downward from 4.1% in April to 3.1%. In August, the Monetary Policy Committee decided to keep the target call rate at 3.75% because of the improvement of the industrial activity indexes in June, the rise in the long- term interest rates, and abundant market liquidity.  In September, the target call rate was kept unchanged on account of the slack domestic consumption, despite rising exports and increases in the CPI and housing prices. 

The treasury bond yield (3 years) and corporate bond yield (3 years, AA- ) were recorded at 4.37% and 5.65% in July, up 30 bps and 37 bps from June, respectively (See <Table 1>, <Figure 1>).  The rise in long- term interest rates in July was a result of high expectations of imminent economic recovery, which were fueled by the improvement in the U.S. economic indexes and Korea's industrial activity indexes in June and a sharp increase in the U.S. treasury bond yield. Entering August, the treasury bond yields and corporate bond yields were fairly stable, but then plummeted at the end of month.  The macroeconomic indicators in the Korean economy were not in line with the improvement of the U.S. indicators. This gave rise to debate over a decoupling effect between the U.S. and Korean economy.  Evidence of this was the narrowing in the spread between the Korean 

- 98 -

<Figure 1>              Major Long- term Interest Rates

Source: FnGuide.

<Figure 2>  Treasury Bonds Yield and U.S. Treasury Notes Yield

Source: FnGuide, Bloomberg.

- 99 -

treasury bond yield (3 years) and the U.S. treasury note yield (10 years) to 21bps in August, a narrowing of 51bps from 72bps in the second quarter.  The Korean treasury bond yield rose more slowly than the U.S. treasury bond yield due to the overall uncertainty in the Korean economy (See <Figure 2>).  Entering September, the interest rates declined at an increasingly rapid rate as the issuance of national bonds planned for September was less than expected.  The treasury bond yield and corporate bond yield were recorded at 4.37% and 5.41%, respectively, reflecting fears of continued economic stagnation due to the typhoon damage and the huge volume of bonds coming due at the end of the month. 

In July, the yields on CDs and CPs fell 13 bps and 15 bps, respectively, to 4.15% and 4.49% as the Bank of Korea reduced the target call rate and the volume of short- term deposits at financial institutions increased (See <Table 1>, <Figure 3>).  The downward trend in short- term interest rates continued into August and September.  The yields on CDs and CPs fell to  3.90% and 4.22% in August and then to 3.84% and 4.08% in September (average from 1st through the 19th), respectively.  In absolute terms, the yield on  CP fell by 27bps and then 14 

<Figure 3>            Major Short- term Interest Rates

Source: FnGuide.

- 100 -

14 bps August and September, and the yields on CDs decreased by 25 bps and 6 bps, respectively.  Activity in the the CP market was thin in the first half as a result of the accounting fraud at SK Global and the deteriorating profits at the credit card companies.  Since July, the volume of net redemptions has decreased significantly.

In July, the spread between the treasury bond yield (3 years) and call rate (1 day) was 54 bps.  In the previous month, the spread was only 8 bps.  The spread between the corporate bond yield (AA- , 3 years) and call rate (1 day) was 182 bps, up 54 bps from 128 bps in June (See <Figure 4>).  This was due to a sharp decline of the short- term interest rates after the BOK's cut of the target call rate and an increase in the rates offered by MMFs.  The long- term interest rates skyrocketed as the U.S. treasury bond yield went up and expectations of a Korean economic recovery increased.  In spite of the stability in the call rate, the spread between the treasury bond yield and call rate in August was a wide 89 bps, and the spread between the corporate bond yield and call rate was 214 bps.

<Figure 4>      Long- term and Short- term Interest Rate Spreads 

and Risk Premium

Source: FnGuide.

- 101 -

The spread widened is response to the overall economic uncertainties and abundant market liquidity.  The spread between the long- term and short- term interest rates narrowed considerably in September when the interest rates began to decline again. The risk premium rose after news broke of the accounting scandal at SK Global. It peaked in August and then began to slowly decline.  It declined sharply in September, implying that the credit risks at firms were easing. 

The interest rate yield curve in the third quarter became steeper.  The short- term interest rates such as those on CDs declined, while the long- term interest rates such as the treasury bond yield (3 years) increased.  In the second quarter, the treasury bond yield (3 years) was lower than the CD yield (91 days) and the yield on debentures (1 year), but it began to rise in July, nearing the debenture yield. Entering August, the treasury bond yield continued to rise, and it exceeded the debenture yield.  Both the long- term and short- term interest rates declined in September.  The yields on long- term bonds including those of treasury bonds (3 years) and national housing bonds (5 years) posted greater absolute declines than those on short- term bonds (See <Figure 5>).

<Figure 5>                      Yield Curve

Source: FnGuide.

- 102 -

Issuance of corporate bonds during the first half was down 32.5% y.o.y. to 8.5 trillion KRW (See <Table 2>).  The volume of corporate bonds issued by large- sized enterprises and small & medium- sized enterprises (SMEs) decreased by 31.6% and 74.1% y.o.y., respectively.  The issuance of corporate bonds for equipment loans decreased by 76.7%.  In fact, no corporate bonds for equipment loans were issued in either May or June.  The total volume of corporate bonds issued in July fell 35.8% from June to only 0.7 trillion KRW, mainly due to the low equipment investment and a significant decrease in the issuance of corporate bonds with A or better credit ratings stemming from the rise of interest rates and the lack of demand for funds.  In August, the issuance of corporate bonds rebounded to 1.4 trillion KRW, up 52.9% month- on- month.  The issuance conditions for corporate bonds improved due to the decline in the corporate bond yield, and the issuance of corporate bonds with BBB or lower credit ratings rose significantly owing to debt- equity swaps at firms under work- out programs. 

During the first half, the issuance of credit card bonds plummeted 52.0% y.o.y to 5.4 trillion KRW due to a rise in credit risks.  Issuance rose 54.5% month- on- month in July to 2.2 trillion KRW after the financial market stabilization plan was announced.  It then fell 60.4% month- on- month in August to 0.9 trillion KRW as the credit card companies raised some money in July, lowered the limits on credit card spending, and raised the commission rates for cash advances.

<Table 2>     Net Issuance of Corporate and Credit Card Company Bonds

(Unit: Billion KRW)

Note: 1) Excludes finance debentures and ABS.

Source: Financial Supervisory Service.

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The weighted average of interest rates on deposits at deposit money banks (DMBs) has fallen since October 2002 (See <Table 3>).  DMBs became awash in idle funds because of the low demand for funds from large- sized enterprises, the government's actions to restrain consumption, the imposition of special premiums on deposits by the Korea Deposit Insurance Corporation, and the downward adjustment of target call rate by the Bank of Korea.  The weighted average of interest rates on loans at DMBs has also decreased since the second half of 2002, due to the reduction in corporate lending and the downward trend in market interest rates. The interest rates on loans to SMEs, in particular, declined significantly.  In July, the DMBs' weighted average of interest rates on deposits was 4.09%, 0.06%p less than 4.15% during the previous month.  The interest rates on deposits were reduced by the DMBs in response to the cut in the target call rate.  The DMBs' weighted average of interest rates on loans was 6.2%, which was 0.04%p less than 6.24% in June.  The spread between the weighted average of interest rates loans and deposits at DMBs widened to 2.11%p in July.

<Table 3>      Weighted Averages of Interest Rates on Deposits and

New Loans at DMBs and Spread

(Unit: In percent per annum, %p)

Notes:1)Interest rates on time & savings deposits except savings deposits with transferability, and marketable instruments issued by DMBs.

2)Excludes overdrafts and other revolving loans ‘minus loans' (Other revolving loans have been excluded since Sep. 2001).

Source: The Bank of Korea.

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Interest rate futures and interest rate futures options for treasury bonds (5 years) at the Korean Futures Exchange were approved by the Financial Supervisory Commission in June and were listed and began to trade on August 22.  Trading of interest rate futures for CDs (91 days), monetary stabilization bonds (1 year), and treasury bonds (3 years) is permitted so far.  The listing of the interest rate futures for treasury bonds (5 years) will lead to the introduction of long- term interest rate futures.  The introduction of the interest rate futures for treasury bonds (5 years) will encourage the development of the long- term bond market because investors will be able to manage market risks for long- term bonds of more than 3 years at lower costs, including the 5- year treasury bonds, and the long- term interest rates are likely to stabilize.

2) Forecast

Economic indicators in the U.S. and Japan suggest an economic recovery in the global economy.  Several factors, including appreciatory pressure on advanced countries' currencies, volatility in oil prices, and global excess manufacturing capacity due to overinvestment are likely to sway the global economy, however.  In the U.S., consumption and facilities investment are improving, and the ISM manufacturing index and consumer confidence index are showing positive signs.  In Japan, exports are continuing to grow, the GDP growth rate in the second quarter was higher than expected, and the yields on treasury bonds are rising.  These indicators imply that the Japanese economy is likely to rebound, but there are many factors which point to uncertainty in the advanced countries.  In the U.S., the labor market has not yet begun to improve; the unemployment rate has remained at the 6% level, and payrolls continue to fall.  Snowballing fiscal and current account deficits, overinvestment, and fears concerning deflation hang over the U.S. economy as ominous threats to long- term growth.  The U.S., Japan, and European countries are all seeking to keep their currencies relatively weak, thereby increasing overall exchange rate volatility.

- 105 -

In the fourth quarter, the market interest rates in Korea will be determined more so by the expectations for an economic recovery rather than the inflation rate.  In spite of a slight increase in oil prices, inflation will be held in check by the importation of cheap products made in China and appreciation in the won/dollar exchange rate.  The economic recovery remains uncertain, however.  The leading CI bottomed out and continued to rise at a slower pace between June and July.  In light of the fact that the economy usually lags the leading CI by 8 to 13 months, the economy is likely to rebound in the fourth quarter.  However, the Business Survey Index (BSI) and the Consumer Survey Index (CSI) have shown little change for the better.  These indicators cast some doubts over the economic rebound. What is more, the won/dollar rate has been under appreciatory pressure since the G7 finance ministers meeting in mid- September 2003.  If this pressure continues, the profits and price competitiveness of Korea's exports will decline, delaying the economic recovery.

The issuance of treasury bonds should increase, but the net issuance will not be great because public funds will be redeemed.  There will be a net issuance of the monetary stabilization bonds to siphon off excessive liquidity from the inflow of foreign portfolio funds and fiscal spending.  The primary market for corporate bonds will likely become active if expectations of an economic recovery increase.  A recovery would both mitigate the credit risks at firms and increase the demand for money, though the money demand for facilities investment is not likely to rise significantly and market liquidity will remain high. 

Notwithstanding the high market liquidity and appreciatory pressure on the won/dollar exchange rate, the market interest rates are forecast to move upward in the fourth quarter in response to indications of economic recovery in the U.S., the possibility of an economic rebound in Korea, the continuation of the same monetary policies, and a rise in bond issuance.  The yields on CDs and CPs are forecast at 3.9% and 4.1%, respectively, and the treasury bond yield is forecast at 4.5% (See <Table 4>).

- 106 -

<Table 4>                Interest Rate Forecasts¹⁾

(Unit: %)

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

2)Figures for the GDP growth rate after the second quarter of 2003 are forecasts, and others are forecasts after the third quarter. 

Source: The Bank of Korea, National Statistical Office, FnGuide.

- 107 -

Financial Market Developments

Banking

The total volume of bank deposits and loans increased by 1.9% and 2.9% respectively, in the third quarter.  Trust accounts decreased by 4.3%.  Deposits increased in July despite the facts that businesses had to remit their value- added taxes to the government and interest rates on deposits remained low.  Evidently, substantial liquidity had built up in the business sector as the long- awaited economic recovery still failed to materialize, but the banks' liquidity began to decline.  Banks have taken extra precautions as household bankruptcies have increased and small and medium- sized firms have performed poorly.  They were more careful in their risk management and issued fewer loans than in the previous quarter.  The contraction in money- in- trust accounts was spurred on by the general decline in stock prices in the third quarter as well as concerns over the SK Global accounting scandal and financial woes of the credit card companies.

<Figure I- 1>           Deposits, Loans, and Trust Accounts

- 91 -

1. Deposit Market

1) Review

The total volume of bank deposits held by depository banks rose 1.9% from the second quarter to 617,313 trillion won.  This represents a slowdown in the rate of increase of 0.3%p and 1.5%p from the 2.2% rate of the first quarter and the 3.4% rate of the second quarter.  The flow of funds in July and August indicates that there was an increase and then a decrease in bank deposits, implying that there were higher than usual flows of funds between different segments of the financial industry.  The slowdown in the growth of deposits was due to a 0.2%p slowdown in growth of savings deposits and a substantial 7.6%p slowdown in growth of marketable financial products.  The M2 growth rate declined by 7- 8%p in the first and the second quarter because of weak lending to households and an insufficient money supply within the secondary financial sector.  This suggests that businesses are refusing to invest in risky assets due to the economic slowdown and the unstable financial market.

<Figure I- 2> Interest Rates on Deposits, Loans, and Trust Accounts

- 92 -

As shown in <Table I- 1>, demand deposits fell by 2.0% in the third quarter to 42.8 trillion won.  The growth in demand deposits decelerated sharply by 10.9%p from last quarter, reflecting the shift in floating funds to alternative investment opportunities in the stock market and marketable deposits.

The volume of time and savings deposits increased by 1.8% to 488.8 trillion won.  Time and savings deposits with a term exceeding one year declined slightly from the previous quarter, while frequent- deposit- and- withdrawal accounts picked up, especially in August.  The number of large savings accounts, 

<Table Ⅰ- 1>                   Bank Deposits¹⁾

(unit : billion won, %)

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

 2) KIF Estimates

 3) Excludes BOK trust funds

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

- 93 -

especially that of time deposits, has increased because banks have attempted to segment their customers as high net- worth, legal persons, or corporations, and provide them service accordingly. 

The volume of long- term deposits of a year or longer increased for a number of reasons.  In addition to the stock market being range bound, the decline in stock prices, not surprisingly, discouraged a great deal of investment in stock.  This, in addition to government policy meant to stabilize the real estate market, led to the movement of a huge volume of cash into time and savings deposits with terms over one year.  Second, the volume of revolving savings deposits, stock index funds, time and savings deposits increased markedly in the third quarter.  Third, Korean exports were strong, and a significant portion of large corporations' export earnings flowed into time and savings deposits instead of being used for facilities- investment because corporations remained uncertain about future economic conditions, both in Korea and overseas. 

<Table Ⅰ- 2>          Interest Rates on Selected Bank Deposits¹⁾

(unit: % per annum)

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

2) Includes MMDAs

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

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The total volume of marketable financial products increased in the third quarter because funds were shifted away from trust accounts and capital gains from the stock market were directed into marketable accounts.  As seen in Table I- 1, the volume of marketable financial products increased by 4.3% by the end of the quarter to 67.57 trillion won.  This was a much slower growth rate than the rate of 11.9% in the second quarter, indicating that investors were much less inclined to deposit their funds in marketable financial products at banks.  The net amount of CDs issued increased by 3.5 trillion won, but this represented an increase of only 14.2%, 18.1%p less than the growth rate of the previous quarter.  With marketable financial products increasing by approximately 2.8 trillion won, the total of deposits including cover bills and RPs decreased by around 0.7 trillion won. 

5. As Table I- 1 shows, foreign currency deposits within the deposit money banks rose 4.2% to 18 trillion won in the third quarter.  This is in fact the largest recorded quarterly increase ever, and it appears that it was mainly due to strong exports in the shipbuilding industry, increased availability of funds from the issuance of bonds in foreign currencies, and a higher inflow of foreign investment capital. The trade surplus has persisted, and exporters seem to be retaining their dollars because they are concerned about the economy in general, not because the value of the won has increased.

6. The average interest rate on deposits in the third quarter decreased in line with the downward adjustment of the target call rate (July 10).  Since June, the yield curve became inverted because the return on Korea Treasury Bonds (KTBs) with three year maturities was only 3%, less than the call rate.  However, the return on KTBs in July seems to have rebounded as the U.S. economy has shown increasing strength and the government's efforts to stimulate the economy have led to widespread confidence that the domestic economy has seen the worst.  In contrast, the short- term market interest rates such as the rate of return of CDs and CPs (three- month) decreased substantially, mainly because of the reduction in the 

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target call rate and the reversion to a normal yield curve.  As the monetary authorities have continued to adhere to their easy money policy, banks have kept interest rates low on loans in order to preserve their deposit margin. 

2) Forecast

1. The fourth quarter should see a further increase in the total volume of loans, but the rate of increase will be lower than in the third quarter.  As before, demand for funds will be fueled by uncertainty in both domestic and international economic conditions.  The performance of the stock market has not been strong enough to lure funds away from the real estate market.  This situation will not likely change as long as expectations remain high in the real estate market.  Furthermore, seasonal factors such as the settlement of accounts at year- end have led to increased demand for financial products with short maturities of around a three months, which suggests that pass- book deposits including marketable savings will likely increase. However, this increase will not be considerable because firms will require funds for tax payments and to settle accounts at year- end.  Finally, given the active movement of funds in the financial sector, a flow of the funds out of marketable savings can be expected if the stock market continues to move up in the fourth quarter. 

2. The total volume of marketable financial products is likely to increase. Corporations and investors will look to manage funds by means of short- term marketable products so that they can quickly take advantage of the any alternative opportunities that may emerge.  For this reason, short- termism will be more pronounced in the money markets.  Also, the volume of CDs will continue to rise since banks have satisfied the liquidity ratio required by the FSS.  However, the volume of RPs and cover bills is likely to decrease slightly because banks do not have as much need for liquidity due to the low corporate demand for funds. 

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