The Present Status and Future 

Agenda of the Asian Bond Markets^*

Wonchang Jang^**

The development of the Asian bond markets has been discussed in recent years in various international forums as a means of preventing another financial crisis in East Asia. Asian bond market development would help regional governments and businesses which have relied on short- term dollar- denominated bank loans reduce currency and maturity mismatch risk. In addition, it would allow for the channeling of the huge pool of foreign reserves and private savings in Asia back into the region. Therefore, Asian bond market development may help regional economic growth by lowering the cost of capital as well as diversifying investment opportunities.

This paper reviews the present status and the rationale for developing the Asian bond market. After summarizing the current development, we propose future agenda to be discussed.

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Ⅰ. Introduction

The development of Asian bond markets has been widely discussed in various international forums as a means of preventing a financial crisis in East Asia. Development on the demand side involves promoting the pooling of the investor base or the pooling of foreign reserves in Asia, while work revolves around issues of taxation, legal systems and regulation as well as accounting on the supply side.

Asian bonds are issued and offered by regional government, corporation, or financial institution in the on-  and off- shore markets to the international investors. These markets enable the private and public sectors in the region to raise and invest long- term capital without currency and maturity mismatch risks. In addition to providing viable financing alternatives, they also help to strengthen the financial system and support economic growth in the region by fostering capital markets. However, most of Asian bond trading are arranged in Tokyo, Hong Kong, and Singapore which are the regional financial centers, because international investors have largely eschewed the Asian bond markets due to low liquidity and poor credit rating of Asian issuers.

Asian bond markets are expected to develop though a series of evolutionary steps and contribute to regional financial stability. In the first stage, regional entities are encouraged to issue bonds denominated in anchor currencies such as dollar, euro, and yen, while regional foreign reserves and pension funds play a key investors. Hereafter, issuance of local currency- denominated bonds will be encouraged as market develops. This process helps regional governments and businesses which have relied on short- term bank loans in dollars reduce currency and maturity mismatch risks. In addition, the enormous pool of foreign reserves and private savings in Asia can be channelled back into the region and regional capital markets develop through a virtuous circle of regional capital.

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In order to preoccupy regional bond markets with a great potential the Korean government should participate in international forums and propose practical action plans. This paper consists of four chapters. After an introduction in Chapter I, the present status and the rationale for developing the Asian bond markets are described in Chapter II. Current issues and proposals on the Asian bond markets are summarized in Chapter III, and Chapter IV concludes with some details to be discussed in future forums.

Ⅱ. Present Status of Asian Bond Markets

By the end of 2002, the outstanding volume of bonds on the Asian markets was 8,065 billion dollars, which accounted for 18% of world bond market capitalization (see <Figure 1>). 

During the last decade the gap between Asia and the world markets continued to widen on the basis of the outstanding volume, even though the Asian bond markets have grown at the same pace as the world markets. The ratio of the bond markets to regional GDP in Asia is 134%, which is relatively low compared to the US (183%) and the Eurozone (191%), and that of non- Japan Asian markets is just 56%. Eichengreen et al. (2002) found that during 1999∼2001, the volume of bond issuance denominated in major currencies such as the dollar, euro, yen, Swiss franc, or pound amounted for 5.6 trillion dollars out of 5.8 trillion dollars in total issuance. This figure indicates the extreme lack of investor's interest in emerging market currency- denominated bonds. The structure of supply and demand in the international bond markets makes Asian emerging markets' financing vulnerable to external shocks and generates systemic risks that become manifest as corporate fragility to the banking sector.

Japan accounts for 85% of the total bond market capitalization in Asia with 

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6839.7 billion dollars followed by China and Korea with 476.7 billion and 430 billion dollars, respectively (see <Table 1>).

The outstanding volumes of bonds in Hong Kong and Singapore functioning as regional financial centers are 84.7 billion and 70.7 billion dollars, and the ratios of bond market capitalization to GDP are 52% and 81%, respectively, quite below the average of the world markets. The Asian bond markets are also characterized by a low level of globalization because most issuances are of domestic bonds. For this reason, Asian emerging markets have to assume the risk of currency mismatch in financing. Statistical figures show that bond trading tends to be concentrated in New York and London because some critical mass of financial resources is required to facilitate trading activity. For this reason, the Asian dollar bond market is still at the initial stage of development with outstanding volume of only 18.9 billion dollars, despite strategic efforts by the Singaporean government to develop it.

The success of the financial markets largely depends on liquidity and market infrastructure. The massive foreign reserves and insurance/pension funds in Asia as well as growing demand for Asian bonds in the international financial markets indicate that there is great potential for the Asian bond markets on the demand side. However, crucial components of the market infrastructure including credit rating/guarantees agencies and clearing/settlements network remain missing, which is a major obstacle to development on the supply side. Pooling of the investor base and regional foreign reserves must be promoted, and impediments and barriers in the primary and secondary markets must be eliminated. Furthermore, the taxation, legal, and regulatory systems must be improved.

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<Figure 1>Growth of Asian bond Markets

<Table 1>Outstanding Volume of Debt Securities in Asia (2002)

(unit: billon $)

Source: BIS Quarterly Review, June 2003.

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Recently, Asia- Pacific economic cooperative frameworks such as APEC, ASEAN+3 have carried out various plans to establish the Asian Bond Fund and regional guarantees facilities and foster the asset backed securities market. In light of the low globalization of regional currencies and high volatility of regional exchange rates, the development of the Asian bond markets cannot be achieved in a short period of time. Regional cooperation is absolutely necessary to improve the stability of the Asian financial system, for which the development of the capital markets including the bond markets is essential.

The need to develop the Asian bond markets has been apparent since the 1997 Asian financial crisis. At that time, the overhang of short- term debt in the private sector was a major structural problem of the Asian financial system. In the absence of well- developed regional bond markets, a large portion of regional savings was invested into the US dollar or European currency- denominated assets. The bulk of these securities investment was recycled back into East Asia in the form of short- term bank loans denominated in US dollars. In the bank- dominated economies of East Asia, local banks served as the main channel through which foreign banks and non- bank financial institutions lent to local firms. It was this pattern of capital flows that gave rise to maturity and currency mismatch risk to local borrowers. With the rapid increase in non- performing loans and the fear of depreciation, foreign lenders began questioning the ability of local banks to honor their external debts. When over- borrowing and over- investment in the corporate sector resulted in a massive increase in non- performing loans, the local banks were not able to rollover their foreign borrowing and became insolvent, precipitating a major financial crisis. In 1997, the insolvency of the corporate sector eroded the soundness of the financial system, preventing local banks from being able to raise finances in the international markets. Once the crisis broke out, this had devastating effect on the economy and the bank- dependent firms could not find the alternative sources of financing. In view of the fact that international investors consider Asian emerging economies to be homogeneous, a local crisis in Asia easily develops into a regional crisis through the contagion effect. This is why Asian economies have 

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shared a consensus on the development of regional capital markets to solidify the financing structure of the private sector after the crisis.

As an essential component of the infrastructure for regional economic and financial development, the Asian Bond Market is expected to have the following benefits:

First, bond financing alleviates liquidity pressure and stimulates facilities investment by lowering corporate reliance on short- term loans and raising medium/long- term financing. That means the development of the bond markets contributes to stable growth of the national economy by improving the maturity structure of funding and promoting corporate investment.

Second, bond markets enhance the transparency of the corporate sector by upholding market discipline and keeping the financial system secure from corporate insolvency by gearing up structural reforms through debt- equity swaps or securitization. 

Third, the development of regional bond markets reduces the outflow of regional savings such as foreign reserves and promotes fund recycling within the region. As present, Asian countries' foreign reserves total to over 2 trillion dollars and are the most of them are invested in dollar or euro- denominated securities. 

Some essential elements are required for development of the Asian bond markets. First, government bond markets should be facilitated as a benchmark of the corporate bond yield curve. Second, the legal and operational infrastructure needs to be set up to facilitate the capital flows and financial transactions. On the operational side, an efficient clearing/settlement system, financial derivatives for hedging interest rate and exchange rate risks, credit rating agencies, secondary/repo markets must be established or made available. Finally, and most importantly, market participants including issuers, brokerage firms, and investors should do whatever they can to build credibility and expand market liquidity.

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Ⅲ. Current Initiatives on Asian Bond Market Development

Since the end of 2002, initiatives and roadmaps for Asian bond market development have been discussed in the various regional forums (see <Figure 2>). On December 2002, ASEAN+3 endorsed the Asian Bond Market Initiative (ABMI) at the ASEAN+3 Deputies Meeting in Chiang Mai, Thailand, aiming to develop efficient bond markets in Asia. The ABMI emphasizes the need for a joint and comprehensive set of actions by the ASEAN+3 countries in two broad areas, one for facilitating access to the market by a wide variety of issuers and the other for creating an environment conducive to developing bond markets. In February of 2003, working groups on Creating New Securitized Debt Instruments and on Credit Guarantee Mechanisms were established at the ASEAN+3 Informal Session, and followed by a high- level seminar on fostering bond markets in Asia in March. The objective of the ABMI is to prevent the recurrence of currency crisis and stop the outflow of savings from Asian countries through development of the Asian regional bond markets. Since then, ASEAN+3 has discussed a number of initiatives for bond market development such as active issuance of regional sovereign bonds, allowance of cross- border enterprises to issue domestic bonds to finance their foreign direct investments, active development of the market for asset- backed securities, issuance 

<Figure 2>Asian Bond Market Initiatives: Complementarity

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of bonds denominated in local and foreign currencies and currency baskets, effective use of credit guarantees, and development of the bond market infrastructure. 

On June 2003, the Asian Bond Fund (ABF) was launched with US$ 1 billion by 11 members of the Executives' Meeting of East Asia and Pacific Central Banks (EMEAP). The ABF has mandated the Bank for International Settlements (BIS), which has experience in managing fixed income portfolios for central banks for many years, as its fund manager. In principle, the ABF's portfolio will be invested in a basket of liquid US dollar bonds of major Asian economies excluding Australia, Japan, and New Zealand. Asian central banks would authorize an Oversight Committee to review the performance of the fund management on a quarterly basis. 

The Asian Cooperation Dialogue (ACD) meeting on June 2003 supported the Asian Bond Fund Initiative by adopting the Chiang Mai Declaration, and member countries agreed to ensure that the Asian Bond Fund Initiative wins firm political support from Asian countries. It is, therefore, expected that the ACD Financial Cooperation Working Group will have to consider the need to create another ABF for the members of the ACD.

Along with ASEAN+3, Asia Pacific Economic Cooperation (APEC) is working on the development of Asian bond markets. Among the tasks it is addressing the removal of barriers impeding the issuance of bonds both in the regional and domestic contexts. There has been cooperation in setting up the necessary components of the infrastructure for a regional bond market such as credit rating agencies and credit enhancement facilities. As investors have generally stayed away from Asian bonds due to low market liquidity and poor credit rating of issuers, APEC is actively designing instruments that can be traded in these markets through its work on securitization and credit enhancement. On September 2003, the Finance Ministers of the APEC economies recognized the importance of regional efforts to promote sound and efficient financial systems and agreed to work together to 

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achieve well- developed bond markets as effective sources of long- term funds. The APEC Initiatives are intended to promote the development of securitization and credit guarantee markets, which in turn is meant to improve the efficiency of the bond markets. APEC has supported issuances of new products, including long- term, local currency- denominated debt instruments, derivatives, and asset- backed securities.

In sum, EMEAP with ABF has played a catalytic role on the demand side by initially making investments in both Asian sovereign and quasi- sovereign bonds and to encourage a higher level of trading activity in the Asian bond markets. On the supply side, ASEAN+3 and APEC are studying new debt instrument offerings, debt instrument rating and enhancements, market infrastructure improvement, etc. The ACD will perform an important function by employing technical work and securing political support to carry forward momentum. 

1. ACD: Asian Bond Market Development Initiative

The Asian Cooperation Dialogue (ACD) was established in 2002 with a membership of 17 countries in the Asian region to enhance regional cooperation with other forums such as EMEAP, APEC, and ASEAN+3. The mandate of the ACD is to improve public awareness of the various initiatives and to secure political support from Asian leaders. Furthermore, the ACD helps to provide the missing links between each economic setting and brings in those key countries, such as India, Bahrain, and Qatar, which do not belong to any of the above- mentioned frameworks, to participate in Asia- wide financial cooperation. The first meeting of the Working Group on Financial Cooperation of the ACD was held on May 2003 to review the status of Asian bond market initiatives and make a draft on Asian bond market development. The Chiang Mai Declaration was released 

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after the second meeting on June 2003 to extend full support for further exploration of the Asian bond market initiatives undertaken by relevant forums through market demand, supply, and infrastructure development. At that time, 18 ACD countries supported the ABF Initiative and the roadmap for Asian bond market development, while Taiwan, Brunei, and India agreed to contribute to the additional ABF. By the Chiang Mai Declaration, it is envisioned that the Asian Bond Fund will act as a catalyst to spur private sector investors within and outside the region to invest in the Asian bond markets. Recognizing the importance of efficient bond markets to intermediate between the high level of savings and demand for long- term investments in Asia and as one of the fundamental foundations of a strong and resilient financial system in the region, the Declaration encourages a wide range of issuers including international organizations and government agencies in the region to issue bonds denominated in local currency to contribute to the stability of the financial markets. It also encouraged efforts to better coordinate and strengthen regional cooperation in the areas of taxation, legal systems, accounting, credit guarantees and ratings, clearing and settlement, and regulatory supervision to promote the development of Asian bond markets. It was agreed that cooperation would be pursued on a voluntary, mutually beneficial, and step- by- step basis to build the necessary political support as a foundation for sustainable development of the bond markets in Asia, while improving domestic laws and policies, along with the development of the domestic bond markets.

2. APEC: Regional Bond Market Initiative

Asia Pacific Economic Cooperation (APEC) began to discuss the development of the regional bond markets at the APEC Finance Ministers' meeting on September 2002, where Hong Kong, Korea, and Thailand proposed the “Securitization and Credit Guarantees Market Development Initiative.” APEC's favorable response to the Asian Bond Market is significant because it reaffirmed the effort to disseminate the 

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best international practices for key financial policies to all economies.

The first policy dialogue was held on April 2003 to discuss securitization at both the domestic and regional levels. Four member countries, China, Thailand, the Philippines, and Mexico, have volunteered to participate in the initiative by receiving expert advice to assist them in identifying and removing impediments to development of securitization and credit guarantee markets. Korea proposed a regional bond market development plan focused on vitalizing the ABS (Asset- backed securities) market. APEC supported dialogues with the APEC Financiers' Group (AFG), APEC Business Advisory Council (ABAC), and Pacific Economic Cooperation Council (PECC) Finance Forum on ways to strengthen the financial systems and promote regional cooperation. The dialogues should benefit the private sector by providing valuable insights and supporting the work under the APEC Finance Ministers' Meeting.

APEC's study on Asian bond market development gained momentum after the ASEM Summit Meeting discussed the issues on regional bond market initiative and launched a working group on how to link the Asian and euro bond markets. The fifth ASEM Finance Ministers' Meeting was held in Indonesia, and the participants highly praised the progress in the ACD's Asian bond market initiative as well as the Chiang Mai Initiative. The participants fully expected the ABF to play an important role in the development of the Asian capital markets. In the meantime, the Finance Ministers of China, Japan, and Korea agreed to thrust forward with a long- term plan and vision on regional bond market development and continue to build up the market infrastructure. Japan stressed the need for regional cooperation for regional market development, and China proposed the development of domestic bond markets as a prerequisite.

At the PECC meeting on July 2003, Takatoshi Ito proposed that the fiscal authorities of Japan, Korea, and Thailand, and any other willing Asian countries, should jointly establish the Asian Bond Corporation (ABC) in an offshore market 

14 KOREANFINANCIALREVIEW / Winter2003

(Tokyo, Hong Kong, or Singapore). According to his proposal, the ABC would initially purchase sovereign bonds of the participating countries, issued in the respective local market and denominated in yen, won, and baht. This would later be followed up by investments in corporate bonds and asset backed securities of the participating countries. The ABC's assets would be a basket of bonds in different currency denominations at different coupon rates. This scheme would help to directly channel regional savings, which are currently in the form of foreign reserves and invested in dollar or euro- denominated bonds, to borrowers in the region and encourage regional circulation of funds. In addition, Park and Park (2003) suggested that the first step toward developing regional bond markets should begin with domestic financial reform focusing on removing impediments to issuing domestic bonds and building the market infrastructure.

At the tenth APEC Finance Ministers' Meeting on September 2003 under the policy theme of “Local/Regional Link, Global Reach: A New APEC Financial Cooperation,” the importance of regional efforts to promote sound and efficient financial systems was recognized, and the Regional Bond Market Development Initiative was proposed. Under this Initiative, the APEC members are to work together to establish well- developed bond markets that would be effective sources of long- term funds, both domestically and within the region.

APEC's Regional Bond Market Development Initiative engenders (1) a comprehensive approach to systematically developing sound and sustainable regional bond markets, (2) an initiative on development of securitization and credit guarantee markets, and (3) an initiative to develop new products. Component 1 is being undertaken by Thailand with the World Bank and the Asian Development Bank providing technical assistance. Component 2 is being handled by the three co- chairs (Hong Kong/China, Korea, Thailand) through panels of experts. Component 3 is meant to develop new products that would not only increase the supply of regional bonds in the market but also promote further financial cooperation, including the for development of long- term, local currency- denominated debt instruments, derivatives, and asset- backed securities.

15 KOREANFINANCIALREVIEW / Winter2003

3. ASEAN+3: Asian Bond Market Initiative

At the ASEAN+3 Finance Minister Deputies' Meeting held in Tokyo on November 2002, Korea proposed the "Asian Bond Market Development Scheme" as a major agenda on regional financial cooperation. The participants agreed to set up working groups to study the issues and develop action plans for such matters as issuance of regional currency- denominated bonds via securitization, establishment of regional credit guarantee facilities, deregulation on foreign exchange settlements, and establishment of regional credit rating agencies, etc.

The Asian Bond Market Initiative (ABMI) was endorsed at the ASEAN+3 Deputies Meeting in Chiang Mai on December 2002. Its objective is to develop efficient bond markets in Asia so that the private and public sectors could raise and invest long- term capital without currency and maturity risks. The ABMI stresses the need for a joint and comprehensive set of actions by the ASEAN+3 countries in two broad areas: (1) facilitating access to the market by a wide variety of issuers and (2) creating an environment conducive to developing the bond markets. 

At the ASEAN+3 Informal Session on February 2003, the working group on Creating New Securitized Debt Instruments (chaired by Thailand) and the working group on Credit Guarantee Mechanisms (chaired by Korea) were established. The High- Level Seminar on “Fostering Bond Markets in Asia” was held on March 2003, during which the governments were encouraged to issue sovereign bonds more actively and regularly in order to complement corporate bond placements in terms of volume as well as duration. In addition, the seminar participants urged the governments and government agencies to issue bonds in place of private companies that currently do not have access to the bond markets and to on- lend the proceeds to such companies. In order to allow small and medium- sized enterprises access the bond markets, the participants agreed to develop asset- backed securities (ABS), which are packages of loans extended to companies as well as debentures issued by corporations. To avoid currency mismatches in funding, they recommended that markets be developed using local currencies as the denominations of issuance. As a 

16 KOREANFINANCIALREVIEW / Winter2003

first step, multilateral financial institutions such as the ADB and the IBRD/IFC, as well as government agencies in the region, should be encouraged to issue local currency- denominated bonds. From the standpoint of international investors and multinational enterprises, bonds denominated in a currency basket consisting of regional currencies would help reduce the exchange risk. ASEAN+3 pointed out that the provision of guarantees would prove effective as a transition measure to overcome the gap in risk perception between issuers and investors. Given that existing credit guarantee facilities are subject to some operational constraints, the establishment of an international organization such as the “Asian Regional Guarantee Facility” would help regional corporations achieve a high credit rating. To this end, the Facility should be given a solid legal foundation by basing it on an regional treaty, and the regional governments might subscribe to the shares of the Facility. The Facility could also offer currency swaps to facilitate fund procurement by private corporations without inviting currency mismatch, and it could help international investors avoid foreign exchange risk. Further progress in the establishment of the Facility will be discussed within the framework of ASEAN+3. Furthermore, it was agreed that developing the necessary infrastructure is a key requirement toward fostering the bond markets in Asia. Elements of such an infrastructure include accounting standards, disclosure rules, settlement systems, rating agencies, and rules and regulations concerning transactions. For this purpose, it is important for countries of the region to provide mutual technical assistance under the ASEAN+3 framework.

On April 2003, the first joint meeting of the working groups was held in Seoul, Korea. It was agreed to launch three more working groups, on foreign exchange transactions and settlement systems (chaired by Malaysia), issuance of bonds denominated in local currencies by multilateral development banks (chaired by China), and local and regional rating agencies (chaired by Singapore with Japan). It was also agreed that the technical assistance coordination group (chaired by Indonesia with the Philippines and Malaysia) should also be launched (See <Table 2>).

17 KOREANFINANCIALREVIEW / Winter2003

The ASEAN+3 Finance Ministers' Meeting on August 2003 discussed regional financial system enhancement by minimizing maturity and currency mismatch risks and facilitating regional savings. They agreed to continue to work on securitization, credit guarantees, regional currency- denominated bond issuance, credit rating, foreign exchange transactions, and the settlement system to develop the regional bond markets and domestic markets. In addition, ASEAN+3 urged regional governments to focus on improving the bond market infrastructure, and it suggested that multilateral development banks, government agencies, insurance companies, and other market participants should continue to cooperate with the working groups.

<Table 2>Working Groups Under ASEAN+3

4. EMEAP: Asian Bond Fund Initiative

The Executives' Meeting of East Asia Pacific Central Banks (EMEAP) is a forum of central banks and monetary authorities in the East Asia and Pacific region set up to encourage greater cooperation among its members. Three EMEAP working groups, on payment systems, financial market development, and banking supervision, were established. The Financial Market Development Working Group has organized the technical work in support of the actual launch of the Asian Bond Fund (ABF). 

18 KOREANFINANCIALREVIEW / Winter2003

On June 2003, the EMEAP announced the launch of the ABF, which has initial funding of US$ 1 billion contributed by 11 member countries: Australia, China, Hong Kong, Indonesia, Japan, Korea, Malaysia, New Zealand, the Philippines, Singapore, and Thailand. Among these countries, Thailand provided US$ 120 million, while Korea agreed to invest more than US$ 100 million, and Japan, Singapore, and the Philippines each provided US$ 100 million. Australia and Indonesia provided US$ 50 million each, and New Zealand offered US$ 25 million.

In principle, the ABF has mandated the Bank for International Settlements (BIS) as its fund manager, and its portfolio will be invested in a basket of liquid US dollar- denominated bonds of Asian economies excluding Australia, Japan, and New Zealand. Asian central banks will authorize an oversight committee to review the Fund's management performance on a quarterly basis. The Fund envisions each participating central bank allocating a fraction of its foreign reserves to be placed in an investment pool. It aims to bring back Asian reserves that traditionally have been invested in Europe or the US to be used in the Asian bond markets, and the Fund itself will act as a channel of finance intermediation that turns savings into investment. In the next step, the Asian Bond Fund will extend the investment into the various local bonds markets in local currencies to encourage private investors to participate in the Asian markets. This will increase liquidity and improve lending terms for Asian governments and corporations.

Ⅳ. Future Agenda

Development of the Asian bond markets essentially entails stimulating cross- border trading of regional bonds and globalizing regional markets by facilitating offshore trading followed by onshore demand. So far, the Asian bond markets are based on domestic issues; the portion of international bonds is low because of the low credit ratings of Asian corporations, which greatly discourages direct funding from overseas. To solve this problem, the corporate governance 

19 KOREANFINANCIALREVIEW / Winter2003

structure should be reformed, and governments should improve the market infrastructure and regulations to attract foreign investors as well. Some Asian countries still impose restrictions on nonresident's bond issuance in local currencies and offshore trading of local currencies because they are concerned over possible disturbances by foreign speculative capitals. However, the policymakers should face the facts that excessive regulation on capital account transactions is an impediment to the development of local financial markets and eventually prevents the regional circulation of Asian savings.

Another task for Asian bond market development is how to deal with the exchange risk clearing system attendant upon local currency- denominated bond issuance and clearing systems upon default. To hedge or eliminate exchange risk, we can employ the following schemes. First, regional liquidity facilities should be set up to prevent a currency crisis within the regional economies. Along these lines, the ASEAN+3 central banks agreed to include bilateral currency swap arrangements as a part of the Chiang Mai Initiative after the 1997 Asian financial crisis. However, judging by the size of swap contracts and conditionality, these arrangements will have only limited effectiveness toward preventing another crisis. Therefore, the bilateral support scheme should focus on multilateral contracts, and the swap line should be expanded. Conditionality tightly linked with IMF facilities should be switched to an independent scheme as well. Second, a standing institution for coping with the regional exchange rate system needs to be established. Institution building helps to build up the infrastructure for the regional bond market by promoting monetary cooperation for regional financial stability. The EU members have successfully carried out action plans for regional exchange rate stabilization centering around the European Monetary Institute, so their progress can serve as a good benchmark. Third, the idea of a regional common currency is worth developing as a notational currency in the regional bond market. We could, for example, construct a currency basket composed of weighted regional currencies. According to the European experience, regional governments have cooperated for 

20 KOREANFINANCIALREVIEW / Winter2003

encouraging ECU (European Currency Unit) denominated bond issuance, which has spontaneously activated the private ECU bond markets.

In sum, it is clear that the development of the domestic bond markets should proceed the development of the regional bond markets in Asia. Fierce competition to become a dominant player in the regional bond market between leading financial centers reflects the promising growth potential of the Asian bond market. Hong Kong and Singapore approach the bond markets with a strategic viewpoint and have concentrated all their energies toward improving them. In consideration of these circumstances, the Korean government should pursue financial deregulation on capital account transactions and build a well- organized clearing and settlement system for cross- border securities transactions to make Korea a regional hub of bond trading.

References

Chiang Mai Declaration on Asian Bond Market Development (2003), The 2nd ACD Meeting.

Eichengreen, Barry, Richard Hausmann and Ugo Panizza (2002), “Original Sin: The Pain, the Mystery, and the Road to Redemption,” paper presented at the conference “Currency and Maturity Mismatching: Redemption Debt from Original Sin,” Inter- American Development Bank, Washington, D.C. 

Richard Yan Ki Ho and Chak Sham Michael Wong (2003), “Road Map for Building the Institutional Foundation for Regional Bond Market in East Asia,” The 2nd Annual Conference of PECC Finance Forum.

Takatoshi Ito (2003), “The ABC of Asian Bonds,” The 2nd Annual Conference of PECC Finance Forum.

Yung- Chul Park and Daekeun Park (2003), “Creating Regional Bond Markets in East Asia: Rationale and Strategy,” The 2nd Annual Conference of PECC Finance Forum.

21 KOREANFINANCIALREVIEW / Winter2003

Macroeconomic Developments

Current Status and Prospects

Economic Growth

1) Review

1. The Korean Economy began to experience difficulties as soon as 2003 began. Among these were the geopolitical uncertainties stemming from the North Korean nuclear threat, rise in international oil prices, and poor consumer and investment sentiment as a result of the war in Iraq. The domestic economy slipped into a recession in February and struggled for the rest of the year. 

2. Before 2000, the historical average duration of economic expansions was 32.7 months, with a maximum 44 months from June 1975 to February 1979 and a minimum 24 months from August 1998 to August 2000. The duration of the last cyclical expansion, however, was just 17 months (see <Table 1>). The last economic expansion came to an end primarily as a result of the sudden and sharp contraction in private consumption. 

<Table 1>Business Cycle since the 1970s

Note: KIF estimation after August 1998.

23 KOREANFINANCIALREVIEW / Winter2003

3. Because the current recession was brought about by the contraction in private consumption, the industries that were naturally hit hardest were the wholesale, retail, restaurant, and hotel industries (see <Figure 1>). The combined output of these industries declined by 1.4% and 4.5% y.o.y. during the first and second quarters of this year. The output of mining industry declined by 0.4% and 8.7% during the same periods, and during the second quarter, the output of the agricultural industry and the community, social, and personal services industry contracted by 1.4% and 0.4% respectively. The latter industry includes personal education, entertainment, healthcare, broadcasting, laundry, and other such services.

4. The wholesale, retail, restaurant, and hotel industries employ the largest share of total wage workers. As of 2002, these industries employed 27.1% of total employees nationwide, while the manufacturing sector employed 19.4%. For reference, the respective shares for other industries are 12.2% for government services, 11.0% for finance, insurance, real estate, and business services, 9.5% for agriculture, forestry, and fisheries, 8.0% for construction, 6.3% for transportation, storage, and communications, 6.0% for community, social, and personal services, 0.2% for electricity, gas, and water, and 0.1% for mining and quarrying. Because the industry that retains the largest share of wage workers was hit hardest, the current recession has had greater adverse impact on the public than past recessions.

<Figure 1>Real GDP by Type of Economic Activity

24 KOREANFINANCIALREVIEW / Winter2003

5. Since February, consumer and investment sentiment was extremely poor due to the war in Iraq, SK Global accounting scandal, near- default on bonds by credit card companies, and the spread of SARS. Real economic growth was only 3.7% and 1.9% during the first two quarters (see <Table 2>).

6. Net exports propped up the economy during the first half, preventing the recession from becoming much more severe. Imports were naturally weak, but export growth was strong because of the recovery in advanced economies. Construction investment also remained strong during the first half due to the surge in real estate prices. 

7. In 2002, the increase in real private consumption was 6.8%, higher than the real GDP growth rate of 6.3%. In the first quarter of 2003, the real consumption growth rate plunged to 0.7% y.o.y. and then to △2.2% in the second quarter. Traditional macroeconomic variables related with private consumption, such as disposable income, real wages, unemployment rate, household lending, and asset prices etc., cannot fully explain such an abrupt contraction in private consumption (see <Table 2> and <Table 3>).

<Table 2>Expenditures and Gross Domestic Product¹⁾

(unit: %)

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

25 KOREANFINANCIALREVIEW / Winter2003

8. Household debt had grown at an alarming rate since 2000, and it financed a significant portion of the consumption boom of last year. However, the increase in household lending, which had also been explosive since 2000, started to reached a staggering volume by the third quarter of 2002 and then began to fall sharply in the fourth quarter (see <Figure 2>). The stagnation in private should therefore be 

<Table 3>       Contributions to Growth Rate¹⁾

(units: %, %p)

<Figure 2>Real Growth in Outstanding Household Loans

26 KOREANFINANCIALREVIEW / Winter2003

understood as a positive adjustment process during which private consumption is mean reverting after a grossly excessive expansion in 2002. The fact that consumption is much more stagnant than can be explained by macroeconomic variables implies that the adjustment is proceeding very rapidly. The more rapid the adjustment process is, the sooner it will come to a conclusion. 

9. In September, the consumer present situation index and the consumer expectation index hit 59.9 and 90.4, respectively, which are the worst readings since the end of 1998 (see <Figure 3>). The consumer present situation index has a fairly strong correlation with real private consumption on the national account. We predict, therefore, that real private consumption in the third quarter will decline as much it did during the second quarter. The consumer expectation index, which represents consumers' predictions of their spending six months ahead, has a low correlation (correlation coefficient: 0.260) with actual real private consumption on the National Account six months ahead. for this reason, we believe that the index merely indicates consumers' psychological state and has little practical use in forecasting future private consumption.

<Figure 3> Consumer Expectation and Consumer Present Situation Indices

27 KOREANFINANCIALREVIEW / Winter2003

10. The indices related to private consumption continued to decline all during the year, and the pace of decline accelerated. During the first quarter, the wholesale and retail index rose 1.5% y.o.y. before dropping 1.7%, and 2.6% y.o.y. in the second and third quarters. The index of shipments of consumer goods showed declines of 1.6%, 7.4%, and 6.4% y.o.y. (see <Table 2> and <Table 3>). 

11. In our own judgement, numerous consumers are under a sort of liquidity constraint owing to the huge buildup of financial debt. Under this situation, consumption expenditures can only increase after a sizable portion of the debt burden borne by consumers is paid off or when consumers' incomes grow faster than their interest payments. In other words, private consumption is bound to the cyclical economic fluctuations and cannot serve as a leading economic indicator. 

12. Although public attention had been focused on the weak private consumption until recently, consumption will return to normal levels only when the domestic economic recovery fully gathers strength. Any effort to inflate consumption in order to hasten a recovery will prove ineffective. 

13. Although the poor private consumption is a salient feature of the current recession, a more serious problem is the prolonged stagnation in corporate investment. After rising 6.8% in 2002, equipment investment increased only 1.6% y.o.y. during the first quarter of 2003 and then declined by 0.8% y.o.y. in the second quarter. The domestic machinery shipment index fell decelerated to 3.3% and then 0.1% y.o.y. during the first two quarters of the year from 12.4% in 2002. In the third quarter, it declined by 3.3% y.o.y. Also during the first three quarters, estimated quarterly equipment investment contracted by 3.4%, 3.7%, and 7.0% after rising 1.6% last year (see <Figure 5> and <Table 4>).

14. Like exports, construction spending has been fairly strong recently. It rose 8.1% and 7.2% y.o.y. in the first and second quarters. Domestic construction orders 

28 KOREANFINANCIALREVIEW / Winter2003

in the third quarter soared 52.3% (public: 32.9%, private: 63.5%), after an even more impressive gain of 56.3% (public: 29.3%, private: 58.5%) in the second quarter (see <Figure 6>). Because the stock market has been bearish, the extremely low interest rates induced an enormous volume of liquidity into the real estate market, where profits have historically been strong. The low interest rates encouraged demand for housing in that they reduced the costs of it, and construction spending increased in order to meet the soaring demand. 

<Table 4>Industrial Activity¹⁾²⁾

(unit: %)

Notes: 1) Percent change of previous year (Except average operating ratio, unemployment rates, bill default ratio)

2) End of period.

3) Period average.

4) Adjusted to reflect electronic settlement. 

Sources: National Statistic Office, ꡔIndustrial Activity Reviewꡕ, various issues, The Bank of Korea, ꡔTrend of Financial Marketꡕ, various issues.

29 KOREANFINANCIALREVIEW / Winter2003

15. Despite the strong increases in construction spending, total fixed capital formation rose no more than 4.8% and 3.5% y.o.y. during the first two quarters owing to the weak equipment investment. During the crisis year, 1998, total equipment investment plummeted 21.2%. In the next year, it rebounded 3.7% and then surged 11.4% in 2000. In 2001, it retreated slightly by 1.8% and then resumed

<Figure 4>Consumption

<Figure 5>Equipment Investment Indices

30 KOREANFINANCIALREVIEW / Winter2003

its advance in 2002, rising 4.8% (see <Figure 7>). Prior to the economic crisis, especially the period from 1989 to 1997, over- investment was rampant in the Korean economy, leading to the accumulation of a gigantic volume of corporate debt. This situation came to an end once and for all during the ensuing economic crisis. In the six consecutive years since then, total investment has been far below the optimal level.

<Figure 6>Construction Investment Indices

<Figure 7>Total Investment Rate and Return on Investment

31 KOREANFINANCIALREVIEW / Winter2003

16. Even though total fixed capital formation increased by 26 trillion won in 2002 on a nominal basis, the total investment ratio did not rise above the rate of return to total investment, preserving dynamic efficiency in investment. If investment could increased by the amount needed to close the gap, we believe that most of Korea's present macroeconomic problems would be resolved. The government's should, therefore, focus on identifying and addressing the causes of the low equipment investment. 

2) Forecasts

1. In as much as the current recession turned out to be much more severe than anticipated, the public has been fixated on the next economic rebound. As of the end of May 2003, the domestic economy was still slowing down, and the prospects for an economic recovery in the foreseeable future were bleak. An estimation of an economic turning point conditional upon observed data of the leading composite index (LCI) suggested that a recovery before the end of 2003 was unlikely. Taking a pessimistic view, it was forecast that an economic recovery would not in all probability occur even before the end of 2004. In a neutral scenario, an economic upturn was seen to begin at the end of May 2004. 

2. However, as soon as LCI of June was added to the data set, an economic turning point before the end of 2003 did not seem out of the question. The probability that an economic expansion would begin before October approached 60% in the neural scenario. In the pessimistic scenario, the probability of an economic upturn prior to March 2004 was estimated at more than 50% (see <Figure 8- 1>～<Figure 8- 4>). Affirmative signals that an economic recovery was approaching appeared in July and August. The pessimistic scenario turning point estimate was advanced to January 2004 at the latest.

3. As of November 2003, our assessment was that a rebound was likely already 

32 KOREANFINANCIALREVIEW / Winter2003

underway. If our assessment is correct, further estimation of an economic turning point would be meaningless for a while until the economy is about to fall into a recessionary phase. 

4. We can indeed cite some evidence that the economy might have already begun to expand. Industrial production in September rose by 6.6% y.o.y., the highest increase in over a year, and the average manufacturing operating ratio rose 2.2%p to 78.7%. In September, the producers' shipment index rose 5.1% y.o.y., and 

<Figure 8- 1> Average of All Cases     <Figure 8- 2>  Neutral Case

<Figure 8- 3> Optimistic Case         <Figure 8- 4> Pessimistic Case

33 KOREANFINANCIALREVIEW / Winter2003

the equipment investment estimate index fell only 2.3% y.o.y. as compared to 11.1% y.o.y. in July (see <Figure 5> and <Table 4>). The growth rate of commodities exports (f.o.b.) increased beyond expectations by a remarkable 23.4% y.o.y. in September. Considering the appalling aftermath of Typhoon Maemi, which ravaged southern Korea in early September, the Korean economy's performance in September is extremely encouraging. Recent business survey indexes published by four different organizations (The Bank of Korea, Korea Development Bank, The Federation of Korean Industries, and Korea Chamber of Commerce and Industry) show weak but nevertheless consistent signs of improvement in the business environment (see <Figure 9>).

5. Consumer sentiment is still depressed, as indicated by the increasingly steep decline in the consumer evaluation index. We estimate that private consumption decelerated as much in the third quarter as it did in the previous quarter.

6. While export growth is very strong, equipment investment has contracted more rapidly in recent months. Although the economic recovery is approaching, the domestic recession is still getting worse, implying that the coming recovery will be led by exports.

7. Since the economic crisis, the share of exports out of the national account has increased dramatically. Evaluated on a constant- price basis, the share amounted to 59.0% of GDP during the first half of 2003, a 22.6%p increase compared to 36.4% in 1997. The share of imports out of total GDP rose to 40.0% in the first half of this year from 33.3% in 1997 (see <Figure 10>). The increased share of exports means that the global economic recovery will be of more benefit to the Korean economy than it had been in the past.

34 KOREANFINANCIALREVIEW / Winter2003

8. According to recent world economic outlooks published by international organizations and leading investment banks such as the IMF, J.P. Morgan, Morgan Stanley, and Deutsche Bank, the GDP growth rates of all of Korea's fifteen largest 

<Figure 9>Forecast Business Survey Indexes

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

<Figure 10>Imports to GDP and Exports to GDP Ratios

35 KOREANFINANCIALREVIEW / Winter2003

trade partners will be significantly higher next year or at least equal to this year's performance with only one exception, Japan. Those countries will also see their currencies appreciate against the U.S. dollar more rapidly than the Korean won. The increases in trade partners' growth rates and exchange rates should add an estimated 1.64%p to domestic real GDP growth next year (see <Table 5>).

9. Economic research institutes at home and abroad have recently revised downward their economic forecasts for growth next year to the mid 4% range. If Korea's real GDP grows no more rapidly than this rate next year even while most of Korea's major trade partners show strong growth, the implication would be that the Korean economy remains beset by very serious structural problems.

10. The Korean economy indeed has various structural and other problems. Some of these include an aging population, excessive household debt, expanding real estate bubble, widespread labor unrest, rapid de- industrialization, inconsistent government policy, incomplete financial and corporate sector reform, geopolitical uncertainties, and lack of preparation to face the Chinese challenge. We do not expect the real estate bubble to burst next year, and de- industrialization has not yet reached such an extent that the real GDP growth rate will be significantly reduced. The aging of the population is not yet a pressing macroeconomic risk factor either. Therefore, the recent forecasts of only mid 4% growth for the Korean economy next year seem overly pessimistic. The prospects for recovery next year are very bright because exports account for a very large share of total GDP and the economies of Korea's major trade partners are strongly recovering. 

11. Our forecast for the real GDP growth rate next year is considerably higher than recent pessimistic forecasts. Our estimate of annual real GDP economic growth for 2003 is 2.9%, and our forecast for 2004 is 5.8%. Real private consumption 

36 KOREANFINANCIALREVIEW / Winter2003

growth was down by an estimated 2.3% and 0.6% in the third and fourth quarters of 2003. We must wait until the first quarter of 2004 to see real private consumption show positive growth. In the second half of 2004, private consumption should rebound at an annual rate of more than 5% (see <Table 6> and <Table 7). Our forecast that private consumption will not fully recovered during the next two quarters reflects the difficulties that consumers are suffering due to the burden of their financial debt. In the second half of 2004, however, consumers will finally be able to increase their expenditures because they will have greater income.

12. Real equipment investment may begin to increase in the first quarter of 2004. In the third and fourth quarters of 2003, it fell 9.8% and then increased 0.7%(see <Table 8> and <Table 9>). Like private consumption, a full recovery in equipment investment will not likely occur until the second half of 2004. We forecast a sharp rise in real equipment investment in the fourth quarter.

<Table 5> Effects of Expenditures and Global Economic Conditions 

on GDP Growth¹⁾

(unit: %p)

Note: 1) Differences between GDP forecasts for 2004 assuming stronger global economic growth and present conditions.

37 KOREANFINANCIALREVIEW / Winter2003

<Table 6>2003 GDP Growth¹⁾

(unit: %)

Notes: 1)Percent changes from previous year.

2) Figures after the third quarter of 2003 are KIF forecasts.

3) Exports and imports of goods and services.

<Table 7>Contributions to Economic Growth in 2003¹⁾²⁾

(units: %, %p)

2) Year- on- year percent change.

3) Figures after the third quarter of 2003 are KIF forecasts.

38 KOREANFINANCIALREVIEW / Winter2003

13. The contraction of the domestic economy will be less severe during the first half of 2004. The output of the wholesale, retail, restaurant, and hotel industries, for example, will start to increase in the first quarter. Manufacturing output will fall until the end of the third quarter notwithstanding the strong export growth. It will then increase at an accelerating rate through the end of the year. Overall employment will turn around and begin rising as the second half approaches.

14. Economic growth in 2004 will be fueled entirely by net exports. The contribution of net exports to economic growth in 2003 was about 3.3%p, higher than the real GDP growth rate of 2.9%. This implies that domestic demand had a lead the economy until the first quarter of 2004. By that time, net export's contribution to economic growth will reach 3.4%, accounting for nearly three- quarters of the forecast economic growth of 4.8%. The contribution of net exports to real economic growth will begin to decline in the second quarter and 

<Table 8>2004 GDP Growth Forecast¹⁾

(unit: %)

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

2) Figures after the third quarter of 2003 are KIF forecasts.

3) Exports and imports of goods and services.

39 KOREANFINANCIALREVIEW / Winter2003

that of private consumption and equipment investment will increase gradually.

15. Our economic forecast for next year seems optimistic compared with other research institutes' economic outlooks. It is indeed fortunate that the economy can fully benefit from the recoveries in major trade partners. However, the fact that the share of exports in total GDP has reached around 60% may not be desirable for the sake of economic stability over the long term because the economy may be overly vulnerable to economic shocks from abroad.

16. Based on our economic outlook, we do not consider further macroeconomic stimulus to be necessary. Nevertheless, policy efforts to encourage corporate investment are indispensible not only for short- term economic recovery but also for long- term sustainable growth. 

<Table 9>Forecast Contributions to Growth Rate in 2004¹⁾

(units: %, %p)

2) Year- on- year percent change.

40 KOREANFINANCIALREVIEW / Winter2003

Prices and Wages

1) Review

1. Import prices rose sharply by 3.5% y.o.y. during the first quarter of 2003. Much of the rise was due to exchange rate depreciation and uncertainties surrounding the war in Iraq. Other major factors included the increase in international oil prices, which was exacerbated by labor strikes at Venezuelan oil companies, and oil production cut- backs by OPEC. Import prices declined in the second quarter when it became clear that coalition forces were going to handily win the war in Iraq and the domestic recession became more serious. In the third quarter, a global increase in raw materials prices more than offset the rise of the Korean won, pushing import prices up 1.4% y.o.y. (see <Figure 11>).

2. Export prices continued to decline throughout most of the year. Korean exporters had very little pricing power in the face of the prolonged economic recession and heated price competition from major export rivals. Export prices declined by 3.9% and 4.4% y.o.y. during the first two quarters. In the third quarter, 

<Figure 11>Import and Export Prices

41 KOREANFINANCIALREVIEW / Winter2003

they fell only 0.7% y.o.y. At that time, the export prices of agricultural products rose sharply because bad weather conditions led to a poor harvest (see <Figure 11>).

3. As explained above, import prices rose sharply early in 2003. The unit value of imports jumped, but the unit value of exports was practically pegged. During the first two quarters, the former rose by 20.2% and 7.1% y.o.y., while the latter increased by 2.1% and then fell 0.2% y.o.y. Consequently, the terms of trade plummeted 15.1% y.o.y. during the first quarter and fell another 6.9% y.o.y. in the second quarter (see <Figure 12>).

4. The PPI rose 3.0% y.o.y. during the first quarter, mainly because of seasonal factors in agricultural products and the rise in crude oil prices. As the shipments of agricultural products increased and prices of crude oil and raw materials subsided, the PPI rate declined to 1.3% y.o.y. in the second quarter. Exchange rate appreciation and the deepening domestic recession also served to discourage price increases. The PPI rose by 1.9% in the third quarter, led by prices for agricultural 

<Figure 12>Unit Costs of Imports and Exports

42 KOREANFINANCIALREVIEW / Winter2003

products and manufactured products. Agricultural prices were up because of the poor weather conditions for the crops, and manufacturing prices climbed due to the rise in international raw material prices (see <Figure 13>).

5. The CPI in 2003 changed roughly in tandem with the PPI. Notwithstanding the domestic recession, the CPI rose at a higher rate of 4.1% y.o.y. in the first quarter, owing to the high increases in prices for agricultural and manufactured products. In the second and third quarters, the CPI rose at more modest rates of 3.4% and 3.2% y.o.y. due to the recession and stabilization of crude oil prices, among other factors (see <Table 10>). 

6. Until the end of the third quarter, the unemployment rate had not increased significantly despite the domestic recession: it was recorded at 3.6%, 3.3%, and 3.3% during the first three quarters, which compared with 3.7%, 3.0% and 2.8% during the same quarters of the previous year. However, job creation practically stalled in 2003. After increasing by 3.8% last year, the number of workers increased by only 0.6% and the declined by 0.5% during the first two quarters of 

<Figure 13>CPI and PPI

43 KOREANFINANCIALREVIEW / Winter2003

this year. The recession naturally discouraged labor force participation in the job market. The labor force grew by a meager 0.5% y.o.y. in the first quarter and contracted 0.3% y.o.y. in the second quarter, whereas it had expanded 2.1% in 2002 (see <Table 10>).

7. The employment situation for young workers deteriorated in 2003. The unemployment rate among workers aged 15 to 29 rose 1.0%p from 6.6% in 2002 to 7.6% during the first three quarters of 2003. In contrast, the unemployment rate among workers aged 30 to 59 rose by only 0.3%p during the same period. The unemployment rate among the oldest workers actually declined by 0.2%p. Labor market rigidity remains a serious problem, and employers are still very reluctant to hire new employees. 

8. The all- industry average nominal wage rose 13.2% y.o.y. during the first quarter, far exceeding the rate of labor productivity growth. In January, the all- industry average rose by 35.3% y.o.y., and the nominal wage in the manufacturing 

<Table 10>Prices and Wages¹⁾

(unit: %)

Notes: 1) Year- on- year percent change.

2) Weight of CPI (Total=1000, Agricultural & Marine=107.4, Manufacturing=342.9, Services=549.7)

Sources: National Statistical Office, ꡔConsumer Price Indicesꡕ, various issues.

The Bank of Korea, ꡔProducer Price Indicesꡕ, various issues.

Ministry of Labor, ꡔReport on Monthly Labor Surveyꡕ, various issues.

44 KOREANFINANCIALREVIEW / Winter2003

sector jumped was up by an even more staggering 41.4% y.o.y. These enormous increases are in large part explained by the fact that the lunar new year's day was in January. The special bonuses given to workers contributed to the sharp increase in nominal wage in January. However, the increase was still exceptional in light of the fact that there were declines of 7.6% and 12.8% y.o.y. in the all- industry nominal wage and manufacturing sector nominal wage during the same month of 2002 (see <Figure 14>).

9. The gap between the real wage growth rate and the labor productivity growth rate, which had been very wide in 2002 and the first quarter of 2003, narrowed significantly to 1.84%p in the second quarter (see <Figure 15>). In 2002, the gap was 6.1%p, the widest since 1989 and, if we set aside 1989, the widest in 25 years since 1978. Because of the extreme rigidities of the labor market, real wages rose at high rates of 3.7% and 9.8% y.o.y. in July and August in spite of the recession.

<Figure 14>  Average All- industry and Manufacturing Sector Wages

45 KOREANFINANCIALREVIEW / Winter2003

<Figure 15>  Real Wage Growth Rate -  Labor Productivity Growth Rate, 

Annually

2) Forecast

1. The annual CPI inflation rate will fall to 2.7% from 3.5% in 2003 (see <Table 11>). Although the real GDP growth rate will be higher, prices will be stable because the domestic recession will just begin to have effect on prices. There will also be little inflationary pressure from abroad because of price stability in major trade partners.

2. Based on inflation forecasts for our trade partners in 2004, we predict that the unit value of imports will change less than the unit value of exports, which means that there will be an improvement in the terms of trade. The stabilization of the unit value of imports will eventually help contain any increase in the domestic CPI. Increases in both import prices and producer prices will be contained. Even if the BOK lowers its target inflation rate, it should be able to achieve it without difficulty. 

46 KOREANFINANCIALREVIEW / Winter2003

3. The annual unemployment rate is forecast at 3.2% in 2004. In the first quarter, it is seen at 3.9%, higher than in this year, but it will decrease gradually as the domestic recovery gains strength and employment increases in the second half. Nominal wages will rise more than 10% the second quarter and onwards after rising 3.1% in the first quarter because of a technical rebound effect (see <Table 11>). Consequently, the real wage growth rate next year will again exceed the labor productivity growth rate by a wide margin, pointing to the urgent need for much greater labor market flexibility.

<Table 11>Forecasts for Prices and Wages in 2004¹⁾²⁾

(unit: %)

Notes: 1) Percent change from previous year.

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

Sources: National Statistical Office, ꡔConsumer Price Indicesꡕ, various issues.

The Bank of Korea, ꡔProducer Price Indicesꡕ, various issues.

Ministry of Labor, ꡔReport on Monthly Labor Surveyꡕ, various issues.

47 KOREANFINANCIALREVIEW / Winter2003

The Balance of Payments

1) Review

Korea recorded a US$4.97 billion current account surplus from January through September, slightly higher than during the same period of 2002. The goods account surplus increased sharply to US$14.1 billion, more than offsetting increases of US$1.54 billion in the service account deficit and US$1.43 billion in the current transfer account deficit. Exports of major products such as automobiles and steel were strong, and imports of capital goods and consumer goods were down significantly. The service account deficit during this period was US$6.86 billion. Much of the shortfall was attributable to the increased deficits of the general travel account deficit and the business service account deficit. The general travel account deficit totaled US$2.57 billion. Fewer Koreans traveled overseas, but the number of foreign passengers declined even more sharply - -  by 14.5% y.o.y. - -  because of the SARS epidemic. The service account deficits widened further as payments of royalties and license fees increased due to an increase in business service payments (e.g. overseas advertising and market research services). 

<Table 12>Current Account

(unit: $100 million)

Notes: 1) Preliminary, 2) Estimates.

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

48 KOREANFINANCIALREVIEW / Winter2003

The capital account, from January through September, saw a US$8.0 billion inflow. Increases in short- term external borrowing by deposit banks and capital inflows for equity investment more than offset increased external lending by domestic financial institutions. The total net inflow for stock purchases by foreign investors was especially high, US$6.62 billion. Foreign investors were not dissuaded by the weakness of the domestic economy as the semiconductor industry showed signs of rebounding, and their liquidity had been increasing as a result of an inflow into stock- type beneficiary certificates encouraged by the rise in stock prices in the U.S. stock market. Short- term external borrowing by deposit banks increased because of a sharp rise in interest rates on foreign exchange stabilization bonds in March in reaction to the rising tensions over the North Korean nuclear issue. This caused the mid and long- term external borrowing condition of deposit banks to deteriorate. After July, deposit banks refrained from mid and long- term external borrowing because of the higher uncertainty as to which direction bond rates would go amid the sudden rise in U.S. government bond rates. They instead increased their short- term borrowing.

<Figure 16>Foreign Investment and Capital Account Balance

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

49 KOREANFINANCIALREVIEW / Winter2003

The trade balance through September was a US$8.29 billion surplus, US$0.99 billion higher y.o.y. The trade balance had been in a deficit condition until March. Despite strong exports at the beginning of this year, soaring raw materials prices, expecially for oil, caused imports to rise at an even more rapid rate. In April, the trade balance reverted to a surplus on continued strength in exports and slowing imports. Korea's strong trade performance was impressive in light of the seemingly difficult export conditions such as the rising Korean won, the SARS effect, and labor union strikes. The trade balance with the U.S. through September was a surplus of US$5.78 billion, a decline of US$0.84 billion from the same period of the previous year. The surplus with China more than doubled by US$4.69 billion to US$8.76 billion y.o.y. Wireless communications products led the advance. The trade 

<Figure 17>Exports and Imports, Balance of Goods Account 

<Table 13>Trends in Daily Average Exports 

(unit: 100$ million)

Source: Ministry of Commerce, Industry and Energy.

50 KOREANFINANCIALREVIEW / Winter2003

surplus with the EU increased by US$1.19 billion to US$4.01 billion y.o.y. Korean products were more price competitive in the Eurozone because the euro appreciated much more against the dollar than the won. Meanwhile, the trade account with Japan remained in a deficit condition. The deficit totaled US$13.6 billion, which exceeded the combined trade surpluses with China and the U.S. and was the largest 

<Figure 18>Semiconductor Price 

Source: Bloomberg.

<Figure 19>Semiconductor Sales

Source: Bloomberg.

51 KOREANFINANCIALREVIEW / Winter2003

deficit during the same period except in September. Imports of capital goods from Japan such as machinery and machine parts increased in tandem with the rise in Korea's exports.

Exports on a custom- cleared basis (f.o.b) from January to September continued to rise strongly, surpassing a daily average of US$0.6 billion throughout the year. In early September, daily average exports reached US$0.79 billion, rising above US$0.7 billion for the first time. 

Exports through September were up a strong 17.0% y.o.y. to US$137.1 billion. Early in the year, exports were relatively weak, but they rebounded throughout the remainder of the year. Korea's export performance in 2003 is impressive when taking into account the economic slowdown in major trade partners and the deteriorating price competitiveness due to the appreciation of the Korean won. The 

<Table 14>Export Growth by Commodity

(units: %, y.o.y.)

Note: 1) From Jul. 1 to Sep. 30.

Source: Korea International Trade Association, KOTIS.

52 KOREANFINANCIALREVIEW / Winter2003

situation was further exacerbated by the truck drivers' union and autoworkers' union strikes. What is more, shipment of export products was interrupted as a result of heavy damage to industrial facilities by Typhoon Maemi.

Much of the strength in exports was a result of strong demand from China. Exports to China in the first nine months actually surpassed those to the U.S., totaling US$24.3 billion. For the first time, China accounted for the largest share of Korea's exports - -  17.7%, up from 14.6% in 2002. Much of the increase in exports to China was due to the rise in China's own exports. A huge 87.4% share of Korea's exports to China were raw materials and capital goods, and the bulk of these went to Chinese exporters engaged in processing trade.

A considerable part of the increase in exports was led by digital electronic equipment such as a digital electric home appliances, including IT products. Exports of information and communications equipment such as wireless communications equipment and computers rose 23.7% through September y.o.y., and semiconductors, which account for the largest share of exports, also showed double- digit growth.

Korea's strong export performance was also due to the efforts of exporters 

<Table 15>Export Growth by Region

(units: %, y.o.y.)

Source: Korea International Trade Association, KOTIS.

53 KOREANFINANCIALREVIEW / Winter2003

themselves to promote their products overseas. In the face of flagging domestic demand, they turned aggressively to the export market to make up the shortfall.

Semiconductor exports rose 12.7% y.o.y. to US$13.5 billion as exports of products using memory chips soared and the international price for memory chips increased. The prices of flash memory and DRAM chips rose steadily all during the year. Flash memory prices were pushed up by rising demand for information equipment such as digital cameras, MP3 players, and USB storage equipment, and DRAM chip prices rose as a result of the introduction of new products like DDR400 and a sustained decline in inventories. Exports of wireless communications equipment through September were up by 41.4% y.o.y., reaching US$12.9 billion and overtaking automobiles for the second largest share of total exports. Wireless communications exports to the U.S., the largest market for such products, were up 35.2% y.o.y. Wireless communications exports to China surged 114.2% y.o.y. despite a contraction in new subscribers due to the Chinese government's discontinuation of its subsidy for mobile phone users and the SARS effect. Automobile exports also rose strongly. The automakers redoubled their efforts to increase exports to make up for the weak domestic demand, and the average unit price rose as they upgraded their models. In July and August, automobile exports declined because of the partial strike at Kia Motors and general strike at Hyundai Motor. In September, automobile exports resumed their upward path. Through September, automobile exports were up 8.6% y.o.y. to US$12.6 billion. Exports of electric and electronic goods increased 16.5% y.o.y. as firms endeavored to offset their poor domestic sales on the international market. They also benefited from Korea's rising global brand awareness brought about by their improvements in quality. The demand for computers was slack, but that for portable computers, especially in China, was very strong. Overall exports of computers increased by 8.6% y.o.y. through September to US$10.5 billion. 

Exports to China soared 48.6% y.o.y., surpassing the last year's 30.6% rate. Exports of computer and wireless communication equipment to China totaled 

54 KOREANFINANCIALREVIEW / Winter2003

US$2.1 billion and US$2.0 billion respectively, accounting for the first and second largest shares of all exports to China. Automobile and wireless communications equipment exports to the U.S. rose 14.9% y.o.y. and 35.9% y.o.y., respectively. This was impressive in light of the U.S. economic slowdown. However, exports to the U.S. were up only 1.9% y.o.y. through September as exports of PCs and PC components such as semiconductors were off sharply. Exports to ASEAN during the same period were up 6.0% y.o.y to US$14.6 billion. Semiconductors accounted for about 18.0% of total exports to ASEAN and led the overall growth. Wireless communications equipment exports rose 23.2% y.o.y., also contributing greatly to the rise. Exports of petrochemicals and ships to ASEAN were down. The price competitiveness of Korean products in the E.U. was bolstered by the relative depreciation of the won against other currencies. For this reason, automobile exports to the EU through September soared 52.7% y.o.y. Exports of computers and wireless communications equipment also continued their upward trend, rising 16.3% y.o.y.

<Figure 20>International Crude Oil Prices

Source: Bloomberg.

55 KOREANFINANCIALREVIEW / Winter2003

Imports on a custom- cleared basis (c.i.f) through September rose 17.2% y.o.y. to US$128.8 billion. Major factors in the increase were the rise in international oil prices early in the year and the increase in import products needed for production of export products. Imports of capital goods and consumer goods rose only slightly due to the poor performance of the domestic economy. 

Raw material imports were up 31.5% y.o.y. during the first quarter of 2003 as the unit price of oil rose by 52.8% y.o.y. between January and February owing to the threat of war in Iraq and the general oil industry strike in Venezuela. Afterwards, however, international oil prices stabilized, and domestic demand for oil declined. As a result, the rise in raw materials imports slowed slightly. Total raw materials imports were up 17.4% y.o.y. through September, reaching US$64.8 billion. Weak imports of capital goods pulled down the growth rate of total imports. Facilities investment sentiment was poor because of the slack domestic economy. Only those

<Table 16>Import Growth by Region and by Use

(units: %, y.o.y.)

Note: 1) From Jan. 1 to Sep. 30. 

Source: Korea International Trade Association, KOTIS.

56 KOREANFINANCIALREVIEW / Winter2003

capital goods needed by Korean exporters increased significantly. Total capital goods imports for the period increased by 17.9% y.o.y. In the meantime, imports of consumer goods rose 11.9% y.o.y. to US$15.2 billion for the period. This was a much lower rate compared to the last year and was due to the contraction in consumer sentiment. 

During the first quarter of 2003, the terms of trade deteriorated by 11.0% y.o.y. The rise in the unit price of imports surpassed that of exports. The unit price of exports actually decreased by 0.8% y.o.y. during the first quarter, excluding IT equipment and semiconductors, which showed an increase of 8.7% y.o.y. The unit price of imports rose 13.4% y.o.y. through September, and excluding oil prices, it showed a rise of 9.1% y.o.y. Real Gross National Income (GNI) increased only by 0.8% y.o.y., while real GDP showed an increase of 2.7% y.o.y. These figures indicate that the real purchasing power of income fell off and that business sentiment was poor.

<Figure 21>Terms of Trade Index

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

57 KOREANFINANCIALREVIEW / Winter2003

The won/dollar exchange rate, during 2003, gradually declined and had reached 1,174 won by October 21. The annual average rate was 1,193 won. The won was affected by the movement of the yen and intervention in the foreign exchange market by the authorities as the dollar steadily weakened. Nearly every currency has been under appreciatory pressure against the dollar. The weakness of the dollar seems mainly attributable to the U.S. economy's fragile fundamentals, widening current account and budget deficits, and concerns over deflation stemming from flagging U.S. demand. Concern over the U.S. engagement in Iraq served to hasten the dollar's decline at the beginning of the year. The won, however, came under depreciatory pressure during much of the year because of national security threats such as the North Korean nuclear issue. The North Korean nuclear issue came to the fore with North Korea's withdrawal from the NPT (Nuclear Nonproliferation Treaty) in January. Moody's reacted by downgrading Korea's long term ratings. As a result, the nuclear issue gave rise to greater exchange rate volatility with the won fluctuating over a wider range all during the year. Korea's trade surplus and heavy buying of Korean equities by foreign investors also served to make the won/dollar 

<Figure 22> Overall U.S. Trade Balance and Trade Balance with China

Source: Datastream.

58 KOREANFINANCIALREVIEW / Winter2003

exchange rate fluctuate throughout the year. Early in the year, the trade account was in a deficit condition, and there was a heavy net- ouflow of capital by foreign investors. At that time, these factors exerted depreciatory pressure on the won. In March, the trade account reverted to a surplus, and the capital inflows for stock purchases by foreigner investors resumed in April, creating appreciatory pressure on the won. From May to mid- October, the net inflows of capital totaled 11.4 trillion won. The government continued to intervene in the foreign exchange market all during the year to prevent the won/dollar exchange rate from falling too rapidly or rising suddenly. At the beginning of the year, market jitters stemming from the North Korean nuclear issue and the SK Global accounting scandal caused the won/dollar exchange rate to rise suddenly, and the government moved fast to stem the won's depreciation. By the end of March, however, expectations for a peaceful resolution to the North Korean nuclear issue and worries about a prolonged U.S. economic recession and the U.S. current account and budget deficits served to weaken the dollar. Conversely, the won came under strong appreciatory pressure. At this time, the government intervened to prevent the won from strengthening too quickly. The won came under even greater appreciatory pressure when Korea began to experience huge inflows of foreign capital for equity investment, U.S. Treasury Secretary John Snow stated that the U.S. would tolerate a weak dollar, and the FRB lowered the federal funds rate. The government partially stemmed the won's rise through direct intervention. It, later, intervened actively to stabilize the market when the won/dollar exchange rate moved below 1,150 and when it plummeted after the statement issued by the G- 7 economic ministers' meeting in Dubai on September 20 calling for more flexibility in the currency markets.

The won/dollar exchange rate dropped from 1,192.9 at the very beginning of 2003 to 1,170.5 won by the end of January. The fall was attributed largely to the worldwide weakening of the dollar brought about by concerns over the threat of war in Iraq and a net inflow of foreign stock investment into the domestic equity market. The won/dollar exchange rate rose sharply to 1,207.8 won in mid- February 

59 KOREANFINANCIALREVIEW / Winter2003

following the decision by Moody's to alter its outlook on Korea's long- term ratings from positive to negative, but as the concerns over the U.S. economy's fragile fundamentals spread, the won/dollar exchange rate fell again under the effect of a relative strengthening of the yen against the dollar. After March, the tone for the won was decidedly toward weakness. Various factors such as the trade deficit, withdrawals of foreign stock investment from the domestic equity market, and the North Korean nuclear issue caused the won/dollar exchange rate to rise to 1,258 won by April 4, the highest level of the year, despite intervention by the authorities in the foreign exchange market. However, from that time on, the won again showed strength against the dollar as foreign investors returned en masse to the domestic stock market, the North Korean nuclear situation eased, and concern began to mount about the condition of the U.S. economy. The dollar was also affected by the FRB's decision to lower federal fund rates and U.S. Treasury Secretary John Snow's suggestive statement that the U.S. would tolerate a weak dollar. Consequently, the won/dollar exchange rate declined to 1,184.8 won on June 19, and government intervened in the foreign exchange market in order to prevent 

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

Sources: The Bank of Korea, Bloomberg.

60 KOREANFINANCIALREVIEW / Winter2003

the won from appreciating suddenly as well as to reduce the exchange volatility. After July, the inflows of foreign capital into the Korea stock market were the main factor behind the strengthening of the won against the dollar. It was also being pulled up by the decline of the yen/dollar exchange rate as the Japanese economy began to show signs of recovery. The won/dollar exchange rate declined to 1,169.5 by August 22 and then traded within a relatively narrow range around 1,170 won. On September 20, the G- 7 finance ministers called for "more flexible" exchange rates at the Dubai meeting to resolve the 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. The yen and the won both rose against the dollar in reaction to the news; the won/dollar exchange rate plunged and hit 1,147.2 on October 13, the lowest level of the year. Despite the controversy over excessive intervention, the government responded by intervening heavily in the foreign exchange market with the determination of preventing the won/dollar exchange rate from staying below 1150. The effort was successful and the won/dollar exchange rate rebounded 19.2 won the next day (October 14) to 1,166.4 won, and by October 22, it had reached 1,181.3. 

2) Forecast

The current account for all of 2003 is expected to be a US$9.97 billion surplus. In 2004, the current account surplus is expected to decline by US$3.4 billion to US$6.53 billion. Although exports are forecast to rise at a double- digit rate again in 2004, imports will likely increase at a more rapid rate. Imports of capital goods and consumer goods are expected to be strong as a result of the economic recovery and appreciation of the won. The service account is forecast to show a deficit of US$14.8 billion. It is expected to increase even much more than in 2003 and more than offset the goods account surplus.

61 KOREANFINANCIALREVIEW / Winter2003

<Figure 24>Service Account 

Source: The Bank of Korea.

<Figure 25>  Changes in OECD Leading Composite Index and Exports

Source: OECD.

62 KOREANFINANCIALREVIEW / Winter2003

The chronic deficit in the service account will likely be the main factor holding down the surplus in the current account. The on- going deficits in the travel account and business service accounts have caused the overall service account deficit to rise at an accelerating rate. The service account has been in a deficit condition since 1998. That year, Korea was mired in the economic crisis and realized a surplus because of the greatly diminished number of Koreans traveling abroad. In 2002, the travel account deficit reached a record US$3.8 billion, and the deficit for 2003 will almost certainly be higher. Through September, it was already US$5.2 billion. This huge rise in the travel account deficit is primarily attributable to the number of Koreans traveling abroad rising more quickly than the number of foreign visitors to Korea. The other service account in 2002 had a recorded US$6.1 billion deficit, surpassing the previous year's travel account deficit, and it totaled US$4.7 billion through August 2003. The chronic and growing deficit of the other service account was mainly due to increased payments in foreign financial services and royalties. The service account deficit is forecast to widen more and more because payments by manufacturers for services, such as fees for research and development and legal services, are expected to increase. In 2003, the service account is expected to exceed the previous year's deficit by a wide margin and total US$9.5 billion. There is no reason to believe that the service account deficit may come down in 2004 because the service trade structure cannot be changed in a short space time. The expected economic recovery and opening of the service sector at the end of next year, by which time the DDA (Doha Development Agenda) negotiations will be finished, will almost certainly accelerate the rise in the deficit throughout 2004. 

During the fourth quarter of 2003, exports are believed to have continued rising at a double- digit rate on strong economic growth in the U.S., Japan, and the EU and strong exports to China. These factors likely outweighed the technical effects of the strong performance in the same period of the previous year. Total exports for the fourth quarter are estimated at US$55.8 billion, up 23.1% y.o.y., and total annual exports are estimated at US$192.9 billion, up 18.7%. In 2004, exports are 

63 KOREANFINANCIALREVIEW / Winter2003

expected to top US$200 billion for the first time. They are forecast to rise 18.8% to US$229.1. Demand for Korean products will increase as the advanced countries' economies rebound. The largest bottleneck to exporters in 2003 was the economic slowdown in major export markets. The expected recovery of advanced countries' economies in 2004, especially the U.S. and Germany and other EU countries, will be the major driver of exports. However, the expected appreciation of the won against the dollar might affect exports negatively in that exporters' payability could be adversely impacted. This, in turn, could lead to a rise in unit export prices, weakening their price competitiveness. Even though the currencies of competitor 

<Figure 26>Changes in Various Currencies against the Dollar

Note: Changes as of October 20 in 2003 from the beginning of 2002.

Source: Bloomberg.

<Table 17>Korea's Market Share in U.S.

(units: $billion, %)

Source: KOTIS.

64 KOREANFINANCIALREVIEW / Winter2003

export countries such as Japan and Taiwan would also appreciate, a deterioration in exporting firm's payability would be a significant burden to them. On the other hand, appreciation of the yuan and yen and increased volatility in other currencies in 2004 would serve to restore some of Korea's export competitiveness. Furthermore, exports of IT products such as semiconductors are expected to continue rising throughout the next year. Semiconductors are forecast to register double- digit growth on strong demand for PCs and flash memory chips. Wireless communications equipment exports are forecast to rise steadily as the change in inventories comes to an end sometime in the first half of the year and the mobile terminal market is forecast to expand about 9%, roughly the same rate as in 2003. However, the rise in exports to China and the U.S. will be restrained in percentage terms because of the very strong performance in 2003 and tougher competition by Chinese manufacturers and other foreign exporters. If the yuan should appreciate in 2004, there is a possibility that the decline in Chinese exports will lead to an increase in Korea's exports to China. 

<Figure 27> Relationship between Facilities Investment and Capital Goods Imports

Source: Korea National Statistical Office.

65 KOREANFINANCIALREVIEW / Winter2003

During the fourth quarter of 2003, imports on a custom- cleared basis are estimated to have risen 18.6% y.o.y. to US$50.1 billion, and imports for the entire year as seen to have risen 17.6% to an estimated US$178.9 billion. Imports of raw materials were up more than 10% y.o.y. as imports of crude oil increased due to seasonal effects and the price of oil likely rose slightly in the fourth quarter due to cutbacks in production by OPEC. However, the decline in capital goods imports held total imports down. In 2004, imports are forecast to increase by 20.4% to US$215.5 billion. This forecast assumes an expansion in equipment investment and private consumption due to an economic recovery. In light of the high correlation of 0.86 between facilities investment and imports of capital goods, a increase in facilities investment should lead to an increase in capital goods imports. The growth rate of consumer goods imports is also expected to rise thanks to an improvement in consumer sentiment. There is virtually no possibility of a sudden increase in raw material imports even if there is a rise in international crude oil prices in 2004. It is true that seasonal demand for oil after the fourth quarter of 

<Table 18>U.S. Trade Balance with Major Countries

(units: $billion, %)

Source: KOTIS.

66 KOREANFINANCIALREVIEW / Winter2003

2003 and demand stemming from the recovery of the worldwide economy might increase gradually, pushing the price of crude oil up temporarily, but concerns over the supply of oil should dissipate when Iraqi oil facilities come back online. Crude oil should trade around US$30 (based on WTI) at the beginning of 2004 and decline to around US$27 afterwards. 

During the fourth quarter, the won/dollar exchange rate was determined largely by the extent of the authorities' intervention and the direction of the yen/dollar exchange rate, and this is expected to be the case for all of the 2004.

The call by the G- 7 for Asian countries such as China and Japan to let their currencies float seems to be tied to the Bush administration's political interests ahead of the presidential election in November and the fragility of the U.S. economy. With 45% of the U.S. current account deficit concentrated on China, Japan, Taiwan, Korea, and other East Asian countries, an improvement of the current account and budget deficits would boost President Bush's chances of reelection. For this reason, the yen and the yuan will face appreciatory pressure until at least the U.S. presidential election. The yen is also under appreciatory pressure in the international currency market because of the Japanese economy's slow but steady recovery. The won has shown a strong correlation with the yen and may also, therefore, come under upward pressure for the time being. However, considering the on- going weakness of the domestic economy, the won should not appreciate very much or very quickly in the mid and long- term. The won has little room to move up during the next year in light of the reduction of the current account surplus and domestic economic recovery, but especially because there won't likely be such a large net inflow of foreign stock investment as in 2003. The average won/dollar exchange rate is expected in the range of 1155 to 1165 won in the fourth quarter, 1130 to 1150 won during the first half of 2004, and 1090 to 1110 during the second half of 2004. For all of 2004, the average won/dollar exchange rate is forecast between 1115 and 1125. 

67 KOREANFINANCIALREVIEW / Winter2003

<Figure 28>   U.S. Trade Account and Growth Rate of U.S Exports 

Source: Bloomberg.

<Table 19>Current Account¹⁾

(units: $100million, %)

Note: 1) Period Averages.

68 KOREANFINANCIALREVIEW / Winter2003

Money and Interest Rates

Money

1) Review

The Korean economy slowed significantly in 2003 as both private consumption and facilities investment declined sharply. Both consumer and business sentiment soured as a result of the steep increase in credit delinquencies, soaring household debt, the North Korean nuclear issue, and other negative developments. Moreover, the already weak economic conditions were exacerbated by serious instability in the domestic financial market following the accounting scandal at SK Global and the liquidity problems at numerous credit card companies. The Bank of Korea (BOK) lowered its target for the overnight call rate by a quarter of a point in May and reduced it again by the same amount in July in a bid to stimulate the faltering economy. Nevertheless, fears of a more prolonged economic slump rose again in September due to the widespread typhoon damage, hike in oil prices, and increasing volatility of the won/dollar exchange rate.

<Figure 29>Inflation Target and CPI Inflation

69 KOREANFINANCIALREVIEW / Winter2003

The BOK kept interest rates very low during the entire year, but it decided in February to freeze its target rate at 4.25 percent despite the bleak economic outlook as international oil prices continued to rise amid fears that supplies might be jeopardized by the month- long oil industry strike in Venezuela and possible U.S. military action in Iraq. However, entering May, the BOK again decided to respond to the economic situation by lowering the overnight call rate target by 25 bps to 4.0 percent and formally shifting to a stimulative monetary policy, even at the risk of a further rise in real estate prices. However, the economic slowdown continued, and the economy did not show any indication of picking up. The BOK, therefore, decided to further lower its target for the overnight call rate from 4.0 percent to 3.75 percent on July 10 in an attempt to prevent an excessive contraction in economic activity. Simultaneously, the government increased its fiscal expenditures through such means as the supplementary budget or accelerated budget spending. 

Market liquidity remained extremely high as a result of low corporate demand for funds. The BOK continued to absorb excess liquidity by issuing Monetary Stabilization Bonds (MSBs) and by RP operations throughout 2003. The BOK on one occasion even sold MSBs at windows directly in order to stem the decline in long- term interest rates. The yield on long- term treasury bonds fell to around 4.0 percent in June, driven by deepening fears of an economic downturn. Fears were being fueled by a number of factors. In March, news broke of the SK Global accounting scandal, and concern over the financial conditions of credit card companies increased. Amidst these signs of worsening conditions in the money market, redemption calls on money market funds (MMFs) with exposure to SK Group's and credit card companies' bonds surged during the month. The BOK pumped funds into the market through RP operations to restore stability. After May, as the exodus of funds from MMFs at ITMCs ceased and the liquidity situation at credit card companies showed signs of improvement, the BOK absorbed market liquidity through issuance of MBSs and RP operations. After its call rate cut on May 13, expectations for further call rate cuts and the on- going flight to quality 

70 KOREANFINANCIALREVIEW / Winter2003

led to a sharp decline in the treasury bond yields to their lowest levels ever. For this reason, the BOK even announced plans to increase the issuance of long- term MSBs to counterbalance the sharp decline in treasury bond yields stemming from the shortage in the supply of long- term bonds. Entering the second half, the need to issue MSBs to counterbalance the earlier plunge in long- term interest rates greatly diminished, as the long- term interest rates began to rise. However, the net issuance of MSBs continued as money streamed in from the external sector as a result of increased inflows of foreign stock investment funds. By the end of October, 

<Table 20>Issuance of Monetary Stabilization Bonds

(unit: billion won)

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

Korea Investors Service, KIS- LINE

<Table 21>Stock Investment by Foreigner Investors

Notes: 1) Units are 100 million dollars.

    2) Units are billions or dollars.

Sources: The Korea Stock Exchange, Monthly Bulletin, various issues.

h t t p://www.kosdaq.co.kr

71 KOREANFINANCIALREVIEW / Winter2003

105.3 trillion KRW in MSBs were outstanding.

During the first quarter of 2003, demand deposits at Deposit Money Banks (DMBs) fell sharply by 0.54 billion KRW from the end of last year as funds placed in demand deposits for settlement at the previous year- end were moved into ITMCs. The decline was also attributed to the decline in bank deposit interest rates together with seasonal factors such as payments of value- added taxes and demand for funds before the lunar new year. As a result, deposits at DMBs, mainly in time & savings deposits, declined until the beginning of March. After the SK Global accounting scandal was reported in mid- March, however, a huge volume of funds seeking safe havens moved into bank deposits, especially money market deposit accounts (MMDAs). In the first quarter alone, 11.2 trillion KRW was pumped into time & savings deposits. During the second quarter, the volume of deposits at banks also continued to rise due to the on- going flight to quality in the financial market, although the volume fluctuated as funds were being withdrawn to make tax payments. Also, as the revolving time & savings deposits, which banks had introduced in order to meet the liquidity ratio ahead of semi- annual settlements, showed a favorable performance, total time & savings deposits increased sharply. In the third quarter, deposits in revolving time & savings accounts continued to increase, but instant access account deposits at banks fell due to tax payments, the redemption of Deposit Insurance Fund Bonds (DIFBs) and Non- performing Claim Resolution Fund Bonds (NCRFBs), and the decline in the short- term yield.

Throughout the entire year, the volume of deposits received by Investment Trust Management Companies (ITMCs) was largely determined by the rate of outflow from the MMFs. Bond- type beneficiary certificate investments at ITMCs did not perform well, and the volume of equity- type beneficiary certificate investments continued to decline. From January to February, ITMC receipts increased sharply, led by a surge in MMFs. A decline in interest rates at this time made the profit margins on short- term ITMC financial products more attractive in comparison with bank deposit rates. However, in March, deposit- taking by ITMCs fell as investors 

72 KOREANFINANCIALREVIEW / Winter2003

redeemed their MMFs en masse when news of the SK Global accounting scandal became public and concerns increased about the liquidity crunch at credit card companies. Total ITMC deposit- taking declined by 24.7 trillion won that month, and MMF deposits fell 20.3 trillion won. In the latter half of March, the volume of redemptions from MMFs declined, but deposit- taking by ITMCs remained flat until the end of April. Deposits at ITMCs began to increase slightly in May. 

<Table 22>Deposits at Financial Institutions¹⁾

(unit: billion won)

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

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

73 KOREANFINANCIALREVIEW / Winter2003

Most of the new funds were directed into MMFs, which invest mainly in safe assets such as government and public bonds. In June deposits continued to rise even despite the redemptions of Deposit Insurance Fund Bonds (DIFBs) and Non- performing Claim Resolution Fund Bonds (NCRFBs). Entering the third quarter, market participants sought out higher yields as well as safety, and funds shifted frequently between financial institutions depending on the yields. Short- term market funds moved back and forth between banks' MMDAs and ITMCs' MMFs.

More than anything else, the market fund flows in 2003 were characterized by short- termism. Funds were concentrated in short- term financial products. From the beginning of this year, depositors and investors began to show a strong preference for short- term financial products, especially MMFs. The ratio of short- term deposits to total deposits at major financial institutions (banks, bank trust accounts, ITMCs, merchant banking corporations) reached 47.3 percent at the end of February in response to increasing concerns over the domestic economic slowdown and the narrowing spreads between long- term and short- term interest rates. Entering March, notwithstanding the sharp decline in deposit- taking by ITMCs, the overall share of short- term deposits to total deposits at major financial institutions remained at a high level of 46.9 percent. Most of the funds withdrawn from ITMCs rushed into MMDA at DMBs. As the turmoil in the financial market gradually dissipated and market interest rates plummeted after mid- April, the short- termism became pronounced again. Furthermore, in the third quarter, as uncertainties over the domestic economy increased and the average deposit rate dropped to a record- low, funds seeking favorable investment opportunities rushed into short- term deposits with maturities of less than six months. In the stock market, domestic investors withdrew their investment funds after taking gains off the table, taking advantage of the heavy buying by foreign investors. 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. 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. 

74 KOREANFINANCIALREVIEW / Winter2003

<Figure 30>    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. 

<Table 23>       Deposits at Financial Institutions¹⁾²⁾

(units: 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

75 KOREANFINANCIALREVIEW / Winter2003

Another feature of the fund flows was the extreme volatility in movements of short- term floating money between financial institutions in search of both safety and good yields. At the beginning of this year, market participants tended to concentrate their funds in MMFs at ITMCs rather than bank deposits owing to the low interest rates on the latter. However, after March, the market uncertainties caused them to shift the bulk of their funds into bank deposits in the interests of safety. Most of the funds withdrawn from MMFs at ITMCs rushed into MMDAs at banks. After May, the financial markets regained their stability as the exodus of funds from MMFs came to an end and concerns about the credit card companies' financial conditions lessened. Nevertheless, a high level of risk- averseness persisted; many depositors continued to deposit funds in banks and new funds. Most of the deposits at ITMCs went into government and public bond- oriented MMFs, which investors perceived as a safe type of asset. Since the second half of 2003, market funds shifted frequently between financial institutions in search of the best relative yields between banks and ITMCs. As a large volume of short- term funds flowed into banks during the second quarter, banks quickly lowered their short- term rates in order to guarantee an interest margin. As a result, after July, short- term market funds flowed into MMFs at ITMCs, which had higher effective yields than banks deposits. However, ITMCs had also begun to experience difficulties in management of their increased short- term deposits, so they also lowered their yields on MMFs. In consequence, funds in August streamed into instant access accounts at banks again. The increase in short- term floating money in 2003 was attributable to the overall economic uncertainties, the low interest rates, and poor performance of the stock market during much of the year. 

The flow of funds in the market was also marked by a continued slowdown in the inflow of funds into bond- type beneficiary certificates at ITMCs. Investors were concerned about a possible decline in bond prices following a rise in market interest rates. As a result, they were increasingly disinclined to invest in long- term bonds. 

Demand for funds in every sector of the economy was low during 2003. Corporate demand for funds was extremely low because of declining corporate 

76 KOREANFINANCIALREVIEW / Winter2003

facility investment. There was actually a net redemption of 5.1 trillion KRW in corporate bonds from January to September because ITMCs' buying power was reduced as a result of the concentration of market funds into short- term deposits. In addition, the credit card companies continued to redeem their commercial paper (CP), and demand for CP by institutional investors, including ITMCs and bank trusts, declined. There was a net redemption of CP of 14 trillion KRW during this period. Corporations also did not issue much equity, except to complete M&As between banks. Through September, the volume of bank loans to large corporations only rose 0.9 trillion KRW, but bank loans to small and medium- sized enterprises (SMEs) jumped 33.9 trillion KRW during the same period. This resulted from the increased demand for SMEs' operational funds in a tight financing market. However, SMEs with low credit ratings still experienced difficulties raising funds, and their cash flows worsened. Declining margins and soaring delinquency ratios led banks to lend only to corporations with higher credit ratings. 

Bank lending to households slowed during the year as the government sought to rein in real estate speculation. Lending had increased by 61.6 trillion KRW in 2002 but was up only by 22.6 trillion KRW through September 2003. The volume of 

<Table 24>Corporate Direct Financing

(units: trillion won, changes)

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

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

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

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

77 KOREANFINANCIALREVIEW / Winter2003

mortgages had increased by 45.8 trillion KRW last year and was up only by 13.9 trillion KRW through September. With the exception of loans collateralized by advance ownership rights on apartments yet to be built, the overall new demand

<Table 25>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 September.

<Figure 31>Outstanding Deposit Bank Loans by Type and 

Ratio of Household Loans to Total Loans

78 KOREANFINANCIALREVIEW / Winter2003

for household funds seems to have been lower. As a result, the share of loans to households out of total bank lending decreased from 48.3 percent at the end of 2002 to 47.1 percent as of the end of June. The volume of outstanding household debt at the end of June was 439.1 trillion KRW, up 2.1 times since the end of 1997. By the aftereffect of this huge increase in household debt, 3.5 million people had become listed as credit delinquents as of the end of September, accounting for 15.2 percent of the economically active population. 

The increase rates of major monetary aggregates, including M3, showed a declining trend throughout 2003, mainly due to weak economy and the decline in credit to the private sector, including households. The growth in M1, which represents the short- term market liquidity condition, slowed to 10.3% in the first quarter and 5.5% in the second quarter. This slowdown was mostly a result of falling demand for cash and demand deposits. Technical effects seemed to be behind the slower growth rate in new M1, considering that it had increased more than 20% during the first half of 2002 last year as a result of the increase in stand- by funds and the general rise in real estate prices. However, in the second half of 2003, the new M1 growth rate began to rise as a huge volume of short- term floating money shifted back and forth between financial institutions. It 

<Figure 32>Household Debt

79 KOREANFINANCIALREVIEW / Winter2003

is believed to have reached the mid 6% level in the third quarter. Meanwhile, M3 growth, which was 12.4 percent in the first quarter, continued to decline due to the contracting demand for long and mid- term funds following the economic slump and the decline in bank credit to the private sector. M3 grew at an estimated 8 percent rate in October.

The growth in the M3 money supply from the private sector slowed down as the volume of loans to households decreased sharply. The amount of funds through ITMCs also lessened as corporations raised few funds in the direct financing market. As a result, the private sector contributed only 37.4 trillion KRW to the growth in M3 during the first half, half the rate of compared to the same period of 2002. The contribution to the M3 money supply from the public sector was an increase of 1.5 trillion KRW in the first half, as compared to a contraction of 3.7 

<Table 26>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 September.

80 KOREANFINANCIALREVIEW / Winter2003

trillion KRW in the first half of 2002. The external sector served to absorb liquidity in the first quarter; there was a current account deficit and a net outflow of foreign direct investment. Since the second quarter, however, it played a major role in pumping up the M3 supply as the current account reverted to a surplus with a huge inflow of foreign capital. 

<Figure 33>Major Monetary Growth Rates

<Table 27>M3 Money Supply by Sector¹⁾

(unit: billion won)

Notes: 1) End of period changes from the previous period

2) Government and local government- invested corporations

Source: The Bank of Korea, Money and Banking Statistics, various issues

81 KOREANFINANCIALREVIEW / Winter2003

The money multipliers of major monetary aggregates slightly increased in 2003. The growth in reserve money declined sharply compared to other major monetary aggregates, such as the new M1 and M3. The reserve money growth rate was only 7.4% in the first half of 2003, barely half the previous year's average of 14.3%. Considering that most of the increase in payment reserves had occurred in the first half of last year and that there was a sudden increase in short- term stand- by funds, the deceleration in growth of reserve money would seem to be technical in nature. The velocity of major monetary aggregates has continued to slow down since 1995, mainly because of efforts to stimulate the economy by increasing the money supply. 

<Table 28>Changes in Velocities and Multiplier 

of Major Money Aggregates¹⁾

(units: times, %)