Editor

Hae Wang Chung

Associate Editor

Haesik Park

English Editor

Emily Adler

Contributors 

Lead Article

Bon- Sung Gu

Macroeconomic Developments

Gongpil Choi

Sang Whan Kim and Han- Yung Jung 

Financial Market Developments

JaeYoun Lee

Byung Duck Kim

Sunho Kim

Bon- Sung Gu

Copyright by

Korea Institute of Finance 

Seoul, Korea

Printed by Orom System Co.

Ministry of Culture & Public Information

Registration No. Ba -  1891

Registration on April 17, 1993 

KOREAN FINANCIAL

REVIEW

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

QUARTERLY ANALYSIS & FORECAST

Vol. 8, No. 4                                 Winter 1998

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

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

CONTENTS 

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

Lead Article: Enhancing Solvency Margins of Life Insurance Companies 󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜

President and Publisher

Macroeconomic Developments 󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜󰠜 

Hae Wang Chung

Current Status and Prospects

Money and Interest Rates 

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

Banking 

Non- Bank Financial Institutions 

Money and Capital Markets

Insurance 

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

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

For subscriptions, please direct requests and inquiries to the Financial Outlook Team, Korea Institute of Finance, Seoul, Korea; Telephone, (82- 2) 3705- 6278, Fax, (82- 2) 3705- 6285. 

Enhancing Solvency Margins of Life 

Insurance Companies

Bon- sung Gu*

Ⅰ. Introduction

The financial soundness of life insurance companies is based primarily on their solvency margin. The solvency margin represents the capability of life insurers to satisfy their future liabilities, i.e. paying policyholder claims. The solvency margin may seem similar to capital regulations at banks and security companies, but some modifications are necessary to account for specific risks of life insurers, such as variable liabilities. For instance, most policyholder's reserve is calculated using actuarial methods whose distribution is ex- ante fixed but ex- post variable. If the solvency margin only takes into account the effect of asset risks, a margin requirement would cause life insurers to fail when the size of claims rose sharply due to unexpected contingencies. Taking into account such effects, the solvency margin requirements most countries use can be classified into two categories. One is the risk- based capital requirement adopted by the US and Japan, and the other is the minimum solvency margin that hinges on the ratio of liabilities over the volume of total assets.

In Korea, the solvency margin requirement for life insurance companies 

introduced in 1994 required 10 billion won for each life insurer, and was revised to 1 percent of policyholder reserve after 1996. Until quite recently, the regulatory authorities had been very passive in enforcing the solvency margin requirement for those life insurance companies that did not satisfy the minimum standard. Last August, 

󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏󰠏

*Research Fellow, Korea Institute of Finance. The author is grateful to Sang- Uck Nam and Young- Mi Chu for their able research and secretarial assistance.

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however, the Insurance Supervisory Board implemented managerial improvement measures for life insurance companies based on the level of solvency margin requirements. In addition, the government and the IMF have agreed to strengthen the solvency margin requirements for insurance companies by 2000. Domestic life insurance companies are therefore faced with an urgent need to enhance their solvency margins.

Against this background, this paper intends to analyze the strategies of domestic life insurers to improve their solvency margins. The margin is determined by various factors such as the level of capital, the composition of invested assets, and the underwriting strategy, but many small-  and medium- sized life insurers are constrained by size. Since many are either subject to insufficient minimum solvency levels or weak financial soundness, they will need to rely heavily on the cash flows generated from ordinary business activities such as underwriting and asset management, rather than relying on recapitalization or seasoned offerings. This paper therefore uses the cashflow model of a life insurance company in order to identify strategies for improving the solvency margin. The cash flow model has been widely used in the risk and asset- liability management by Coutts and Devitts (1989) and Ji (1995). This paper also focuses on the effect of cash flow determinants on the solvency margin, and tries to find the best strategy for improving the solvency margin in the short term or, if applicable, in the long term. To end, the paper also empirically tests the adequacy of asset sizes held by small-  and medium- sized life insurers in Korea.

The results of this study can be summarized as follows. First, the solvency margin based on the cash flow from underwriting and investment activities is mainly determined by changes in premium income, paid claims, and the investment income. Second, improvement in the solvency margin over time is conditional on the rate of growth of total assets being strictly higher than the rate of growth of liabilities, the later being mostly reserves for policyholders. In addition, solvency margin improvement is more likely for life insurers with a relatively high return on assets. Third, empirical work shows that the size of assets of most small-  and medium- sized life insurers in Korea seems to be inadequate for improving solvency margins over 

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time. Those domestic life insurers which are joint ventures with foreign insurance companies, however, do seem to have sufficient assets. In this sense there is no clear- cut criteria for choosing between consolidation and specialization as a way for domestic small-  and medium- sized life insurers to improve their solvency margins. Nonetheless, improvement of solvency margins in the short and long term require that small-  and medium- sized life insurers either consolidate or specialize, develop new products with flexible premium payments, extend marketing efforts for single premium policies, and facilitate longer holdings of savings- oriented policies. These conclusions are borne out by both theoretical and empirical investigation.

Chapter II presents a cash flow model of life insurers and finds the theoretical conditions under which life insurers can improve their solvency margins. Chapter III empirically tests for the required minimum size of assets to guarantee the improvement of solvency margins over time, by simplifying the theoretical model in chapter II. In Chapter IV some strategic implications of enhancing the solvency margin are discussed. A short conclusion follows.

Ⅱ. Life Insurer's Solvency: Cash Flow Effect 

This chapter presents the financial structure model of a life insurance company in terms of cash flows from underwriting and investing activities. Cash flows of life insurers are simplified into three elements: premium income, investment income and claims. 

1. Model

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<Table 1>Cash Flows of a Life Insurer

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To analyze the effects that premium income, the lapse ratio, and rate of return on assets have on the solvency margin, the following assumptions are also necessary.

Assumption 2 :

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2. Analysis: Conditions for Higher Solvency Margin

From equation (2) in section II- 1 it is easy to derive the condition that the solvency margin of a life insurer at the end of the period improves from the beginning of period as follows:

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Result 1: Conditions for a better solvency margin are given by the following:

or

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As previously mentioned, the product mix of a life insurer can change the solvency margin. Result 4 shows that one venue for this effect to occur is if product mix affects the ratio of policyholder liabilities at the end of the period.

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Ⅲ.Empirical Analysis: Adequacy of Asset Size

In this chapter the required minimum asset size for small-  and medium- sized life insurers in Korea is estimated. The required minimum asset size is the volume of assets allowing premium income, claims paid and investment income to enhance the solvency margin. The model presented in chapter II is simplified here for empirical estimation.

1. Simple Model

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2.Estimation of Minimum Asset Size: the Case of Small-  and Medium-  sized Life Insurers in Korea

In this section, the required asset size for small-  and medium- sized life insurers in Korea, employing the actual data set is empirically estimated. The estimation is done very simply by inserting actual data on initial total assets, premium income, expenses and claims paid during the sample period into result 5.

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On the other hand, the three insurers which are joint ventures with foreign life insurers (SS, YP, KP) and a regional life insurer (HI) did have sufficient assets for the improvement of the solvency margin. Thus it appears that joint ventures could be a viable alternative to consolidation in order to improve the solvency margin of small life insurers in Korea. It is also noticeable that the four life insurers closed last August fell far short of the required minimum asset sizes, indicating the existence of short- term scale economy effects. These closings should be an impetus to other small and medium- sized life insurers to increase their asset sizes through mergers or acquisitions to improve their solvency margins.

Ⅳ. Strategic Implications

The theoretical and empirical analyses in chapters II and III clearly show that improving solvency margins through generating cash flows is possible either by holding minimum required assets or changing liability structures such as product mix. Asset size can be directly related to consolidation or specialization, and reorganizing the liability structure is concerned with recapitalization efforts and various business strategies. This chapter therefore concerns itself with improving the solvency margin of small-  and medium- sized life insurers through consolidation, specialization, asset management, and distribution channels.

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<Table 2>                Inadequate Level of Assets

(0.1 billion won)

Notes: 1) At the end of March 1998, △ denotes the deficiency size.

×claims paid+ excess expenses.

  5) * denotes 4 suspended life insurers in August.

Source: Insurance Monthly Review.

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1. Consolidation

The first priority for domestic small-  and medium- sized life insurers is to expand their business until they can reach the required minimum asset size. To this end, the consolidation of domestic life insurers through mergers and acquisitions should be facilitated. Consolidation between financially weak life insurers might deteriorate their solvency margin in the very short term, but the higher level of managed assets can improve the solvency margin more quickly than through individually generating cash flows. The expansion of managed assets can also allow greater risk diversification and liquidity management. In particular, consolidation through a merger could be a good strategic option for the purpose of enhancing scale economies and expanding regional market shares.

2. Specialization

Specialization is recommended for lines of business allowing small-  and medium- sized insurers to accumulate assets. For instance, the market for pensions allows the quick accumulation of assets, and risks are stable. On the other hand, such products may increase the size of future liabilities proportional to present assets, so specialization in this market may not improve the solvency margin as quickly as expected. In addition, if the market demand for liquid assets remains high, it may threaten the long- term profitability of asset management due to early and unexpected surrenders. Specialization in the pension market should therefore be undertaken cautiously. 

The market for protection- oriented products is an alternative area for specialization. First, it can improve the short- term solvency margin faster than savings- oriented products. Second, the lapse ratio and early surrenders are relatively lower than that of savings- oriented products. In the long term, the expansion of asset size may diversify 

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insured risks more fully, enhancing the dynamic solvency margin.

3. Asset Management

Asset management can be just as important for the improvement of the solvency margin as liability structure or the composition of products. Suppose that the managed assets can be either safe or risky. If a life insurer is specializing in the market for protection- oriented policies, then increasing the ratio of risky assets to total assets can better hedge the risk of claims, since the net premium for protection- oriented products is composed mostly of risk premiums on mortalities or other risks. On other hand, life insurers heavily exposed to interest rate risk, for example those selling long- term pensions or long- term endowment policies, should increase their investment in safe assets offering long- term fixed returns. This sort of asset management can reduce the risk of a deteriorating dynamic solvency margin and also minimize any term mismatch between asset and liabilities.

4. Product Mix 

It has already been shown that a change in the lapse ratio can affect the solvency margin of life insurers. For instance, a surging lapse ratio can shrink the size of managed assets and limit stable long- term asset management. In particular, a rise in early surrenders of saving- oriented policies can bring about a sharp fall in managed assets, deteriorating the solvency margin. From this perspective, small-  and medium- sized life insurers should try to reduce the lapse ratio of savings- oriented policies to keep the solvency margin sound. Early surrenders can be reduced by developing new products that offer intermittent cash to policyholders, for example, through loans within the cash value of policies- in- force. 

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Life insurers can also improve the solvency margin by changing their method of collecting premiums. In instances where the lapse ratio or number of long- term policies remain relatively low, the solvency margin could be improved by increasing the ratio of initial or early premiums to total premiums. In this sense, single- premium or decreasing- premium policies could improve the solvency margin more quickly. 

5. Marketing Channel

As previously mentioned, lower lapse and early surrender ratios significantly improve an insurer's solvency margin. A recommended strategy would be to extend marketing efforts for single premium policies, such as policies for groups and high- income families. In particular, these efforts should be made through the main office rather than through agencies or individual solicitors. This strategy would also allow life insurers to reduce premiums, since commissions would be lower. For low- income families or individuals with higher tendencies to surrender their policies early, life insurers could choose to sell short- term rather than long- term policies so as to stabilize the solvency margin.

Ⅴ. Concluding Remarks

This paper has presented several strategies for improving both the short- term and long- term solvency margin of life insurers by analyzing cash flow patterns generated from underwriting and investment activities. It also examined the required minimum asset size, considering the lapse ratio and expense ratio for small-  and medium- sized life insurers in Korea. Empirical analysis shows that most domestic small-  and medium- sized life insurers fall far short of the estimated minimum asset size, indicating a need for those insurers to expand their scope of business through consolidation.

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The paper's main focus, however, is on the short- term effects of asset size on the solvency margin. The dynamic effects of changes in asset size is a topic for future research. The approach used in this paper could be easily extended to other financial institutions needing to enhance their financial soundness through ordinary business activities.

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References

BarNiv, R., and J. Hathon (1997), “The Merger or Insolvency Alternative in the Insurance Industry,” Journal of Risk and Insurance, 64, 89- 113.

Bustic, R. P. (1997), “Optimal Funding of Long- Term Liabilities,” Paper presented in the Fifth International Conference on Insurance Solvency and Finance, London.

Canadian Institute of Actuaries (1997), Dynamic Capital Adequacy Testing Life Insurance: Education Note, Committee on Solvency Standards for Financial Institutions, Canadian Institute of Actuaries.

Cummins, J. D., S. Tennyson and M. A. Weiss (1998), “Consolidation and Efficiency in the U.S. Life Insurance Industry,” Working Paper 98- 08- B, The Wharton Financial Institutions Center, University of Pennsylvania.

Coutts, S. M. and R. Devitt (1989), “The Assessment of the Financial Strength of Insurance Companies by a Generalized Cash Flow Model,” in Financial Models of Insurance Solvency, edited by Cummins, J. D. and R. A. Derrig, Kluwer Academic.

Ji, B. H. (1995), “Management of Life Insurance Companies and Solvency Margin,” Insurance Development Study, 14, 86- 108 (in Korean).

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Macroeconomic Developments

Current Status and Prospects

Economic Growth 

In 1998, economic growth in Korea is estimated to decline 6.0 percent over the previous year, due to the ongoing recession and lingering uncertainty in the financial sector. Restructuring in the financial system has led to a serious contraction of consumption and investment. Internationally, the Asian financial crises spread through Russia to Latin America, and financial instability has become a worldwide phenomena. Under these worsening internal and external conditions, consumer expectations have become more pessimistic, leading to further demand contraction and investment reduction. 

The severity of the recession in 1998 was unprecedented. In particular, sluggish domestic demand greatly hurt the manufacturing industry, reducing activity in all

<Table 1>                     Economic Growth

(percent)

Notes:1) Figures in parentheses are percentage changes from the previous year.

2) Figures for the first half of 1998 are estimates and those for the second half of 1998 are forecasts. 

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

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sectors but telecommunications and shipbuilding. Industrial production recorded a negative 8.1 percent growth rate during the third quarter, following a minus 10.1 percent growth rate in the first half, mainly due to severe cuts in the production of automobiles and trailers, machinery & equipment, and metal products. The industrial activity index for small-  and medium- sized firms shrank 20 percent in the first half, and continued to decrease at an alarming rate of about 35 percent in the third quarter.

<Table 2>                 Industrial Activity index 

(percent)

Notes:1) End of period. 

2) Period total.

Sources: National Statistical Office, Industrial Activity Review, various issues. 

The Bank of Korea, Ratio of dishonored Bills, various issues. 

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In the second half, the operating ratio of the manufacturing industry continued to hover around 60 percent, mainly due to sluggish domestic demand and labor strikes in the automobile industry, as well as such secular factors as excess capacity in some major industries from the previous expansionary phase. Investment continued to decrease rapidly because of major restructuring efforts in the financial and corporate sectors. For example, imports of machinery and the domestic value of machinery, both leading investment indices, fell by 55.2 percent and 22.5 percent, respectively. Domestic construction orders and building construction permits also fell by 45.0 percent and 63.6 percent, respectively.

Although figures are not yet available for the second half, no discernible changes in the economic environment means that inventories and shipments are expected to decrease rapidly, possibly causing a long term economic recession. In addition, because reductions in shipments are greater than reductions in inventory, inventory cutbacks will be prolonged. Categorized by sector, textiles, non- metallic products and motor vehicles are among those which have inordinately high levels of inventory.

<Figure 1>            Manufacturing Industrial Production

Source: National Statistical Office, Industrial Activity Review, various issues.

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<Figure 2>   Growth Rates of Producer Shipments and Production Capacity 

Source: National Statistical Office, Industrial Activity Review, various issues.

<Figure 3>              Inventories and Shipments 

Note: 3 month moving average.

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One of the most striking features of the current economic contraction is the unprecedented decline in consumption spending. Due to reduced real income, increased unemployment, and deflated asset value, the purchasing power of most consumers fell precipitously. Moreover, the lack of consumer confidence contributed to the severity of the consumption scaledown. The wholesale & retail consumption and the shipment of consumer goods decreased 15.3 percent and 23.4 percent, respectively. Also, the monthly average consumption expenditure of a typical urban labor household decreased by 13.2 percent compared with the same period last year to 1225.6 thousand won. Real income and disposable income decreased 19.7 percent and 6.5 percent, respectively, during the second quarter. 

Average propensity to consume decreased 5.1 percentage points compared to the same period last year, standing at 66.1 percent. As a result, the gross saving rate is

<Table 3>        Inventories and Shipments Indices by Type (1990=100)

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estimated at 37.8 percent, the highest level since the early 80s. In particular, since 

consumers reduced expenditures on non- necessary durable and imported goods after the fourth quarter of 1997, the growth rate on those goods declined 38.5 percent and 51.3 percent, respectively, during the first quarter. Overall private consumption for the year is projected to have declined 12.4 percent.

<Figure4>       Growth Rates of Real Income and Real Consumption 

Source: National Statistical Office, National Survey of Family Income and Expenditure, various issues.

<Table 4> Composition of Final Consumption Expenditure of Households by Type 

(yoy, percent)

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

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According to the KIF's analysis of consumption contraction in Korea, the wealth effect is estimated to be about 16 percent (3.4 percent in U.S.). This implies that changes in asset values have a large effect on private consumption in Korea. In addition to cyclical factors, including reductions in disposable income, other factors such as liquidity constraints and higher interest rates have also contributed to the dramatic decline in private consumption. Therefore, without a recovery in the stock and real estate markets, consumption is likely to decline further next year. 

The so- called Katona effect states that inflation volatility contracts consumption through an increase in precautionary savings. When applied to the Korean case, the

Katona effect is present in all periods but in 1991~1995, when the wealth effect

<Table 5>                   The Savings Rate in Korea

(billion won)

Note: Figures for '98 and '99 are estimated assuming growth rates for 1998 and 1999 to be - 5.7 and 2.3 percent, respectively, and assuming final consumption growth rates as - 11.6 and 0.6 percent. 

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

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dominated savings and consumption decisions. In addition to the Katona effect, the increase in unemployment, lower real income and economic uncertainties since the financial crisis have significantly contributed to demand contraction. In particular, the increase in the dependency ratio arising from higher unemployment caused domestic demand to contract sharply, suggesting a prolonged decline in consumption.

In addition, expectations of further decline in permanent income will play a major role in dampening future consumption. According to permanent income variance estimates, permanent income decreased sharply after the first quarter of 1998. In sum, the current reduction in consumption is most affected by the rapid fall in permanent income, increased domestic and foreign debt accumulation, and an increasing dependency ratio.

To stimulate domestic demand and provide more job opportunities, the government must increase its investment in social overhead capital and social safety net system

<Figure 5>        Uncertainty in Consumptionand Degree of Aversion

Notes:1) Uncertainty in consumption = estimated consumption growth rate -  real consumption growth rate.

2) Degree of consumption aversion = estimated wholesale and retail turnover growth rate -  real wholesale and retail turnover growth rate.

3) A degree of consumption over 0 implies that consumption fell rapidly.

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immediately. For best results, an expansionary fiscal policy mix of tax reductions and expenditure increases need to be implemented as well.

Another feature of the current economic contraction is the growing income gap between the rich and the poor, which is currently approaching pre- 1980 levels. Income and consumption growth rates for the lower income class have decreased 12.5 percent and 9.5 percent, respectively, while income and consumption growth rates for the middle income class have decreased 6.8 percent and 7.5 percent, respectively. By contrast, the income growth rate for the upper income class increased 0.4 percent while consumption expenditure dropped by 9.7 percent. The excessive sensitivity of consumption in the upper income class also contributed to the falling incomes of the middle and lower income classes.

Equipment investment is expected to decline 44.9 percent in 1998, reflecting the widening supply- demand gap. Construction investment is expected to decrease 11.4 percent, due to sluggish social overhead capital investment and falling domestic construction orders from a slump in the real estate market. 

<Figure 6>        Dependency Ratio Corrected for Unemployment

Notes:1) Total dependency ratio corrected for unemployment 

= (population under 14+population over 65+unemployed)/(population between 15 

and 64 -  unemployed)×100.

2) Elderly dependency ratio corrected for unemployment

= (population over 65 + unemployed)/(population between 15～64－unemployed)×100. 

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<Figure 7>           Katona Effect and Consumption in Korea

<Figure 8>       Total Debt to GDP Ratio and Consumption Growth Rate

Source: KOSIS

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<Figure 9>        Permanent Income (Variance) Trends

(percent)

<Table 6>                 Trends of Coefficients

Note: 1) Kalman filter analysis based on estimates between the first quarter of 1992 and the fourth quarter of 1996.

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<Figure 10>    Income and Consumption Growth Rate by Income Group 

Note: Lower is the bottom thirty percent; middle is the fourth to seventh decile group, while upper is the eighth to tenth decile group.

Source: National Statistical Office, Family Income and Expenditure Survey, various issues.

<Figure 11>          Income Distribution of Urban Households

Note: Lower is the bottom thirty percent; middle is the fourth to seventh decile group, while upper is the eighth to tenth decile group.

Source: National Statistical Office, Family Income and Expenditure Survey, various issues.

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<Figure 12>            Production Capacity Growth Rate  

Note: The four major industries are chemicals, basic metals, Radio, TV & communication equipment, and motor vehicles. 

Source: National Statistical Office, Industrial Activity Review, various issues.

<Figure 13>   Contribution to the Potential Growth Rate 

<Figure 14>          Unit Labor Costs and Labor Productivity

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Source: National Statistical Office.

This alarming trend of investment decline raises the concern of overadjustment, since it will hurt Korea's long- term growth potential. According to the relative contribution analysis of potential growth rates, this year's drastic input decline, both in labor and capital, contributed to the lower potential growth rate for 1999 by about 3 percent. It should be acknowledged, though, that this model emphasizes inputs rather than productivity enhancement as the main factor in determining economic growth.

Exports are expected to rise by 17.5 percent, due to the worldwide recession, yen appreciation, labor strikes and declining export unit prices, while imports are expected to fall 23.3 percent, due to the sharp contraction of domestic demand.  The financial crises in Asia and Latin America and an international credit crunch will further injure Korea's exports.

The CPI, which rose 9.0 percent in the first quarter of 1998, is estimated to record a yearly level of about 7.6 percent. Inflation- reducing measures were aided by the quick recovery of the won/dollar exchange rate after the crisis in November 1997, as well as the contraction of private consumption that significantly weakened the pressures for demand pull inflation. 

Decreased wages and real estate prices also weakened cost- push inflation. The 

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price of manufacturing products rose just 11.4 percent, despite rising gasoline prices, while agricultural product prices rose just 4.7 percent in spite of heavy rain and flooding last summer. Service sector prices rose just 5.5 percent, mainly due to low housing rental prices and educational services. The PPI, which rose 16.5 percent in the first quarter, is expected to rise only 14.3 percent for the year, because of the special excise tax cut, an appreciation of the won, and stable world commodity prices. Wages will continue to decline by 4.3 percent, however, mainly due to the increase in unemployment. 

The current and goods accounts are expected to record surpluses of 40.9 billion dollars and 39.4 billion dollars, respectively, in 1998. Exports are expected to decrease 4.4 percent compared to the same period last year using a customs clearance basis, mainly owing to the recession in Asian countries and decreased export unit prices. Exports either declined or slowed to all Asian countries including Japan. 

<Table 7>       Potential Growth Rate and Productivity Growth Rate 

(percent)

<Figure 15>        CPI and Sources of Inflation 

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

<Figure 16>               Export Growth Rate by Region

Source: The Bank of Korea, Monthly Balance of Payments, various issues. 

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Export unit prices, which decreased 19.7 percent in the first half, stabilized somewhat in the second half, despite the won's appreciation and increased competition from other Asian countries. This factor will help support exports in the fourth quarter, when export volume growth, which rose 29 percent in the first half, begins to show signs of decline. Externally, because Asian countries, including Japan, recorded a trade surplus about 200 billion dollars in the first half, advanced countries may strengthen their import regulations. Internally, labor strikes and contraction of trade credit could lead to lower industrial production. Both of these factors can bring about a reduction in trade, a sector that already suffers from sluggish domestic demand, a decline in import L/C openings and an unstabile financial system. 

Owing to the sizable current account surplus and a continued increase in foreign currency deposits, the won/dollar exchange rate is forecast to register a yearly average of 1,415 won/dollar, with a stronger won performance toward year- end. In the third quarter, Russia's debt moratorium and the crisis in Latin America weakened the won temporarily. Foreign debt redemption by corporations and financial institutions also played a role in weakening the won in the third quarter. The won/dollar exchange rate will continue to decline (appreciate) toward year- end, mainly due to the coordinated interest rate cut among G- 7 nations and a stronger yen.

<Table 8>                     Inflation and Wages¹⁾ 

(percent)

Notes:1) Percentage changes from the previous year.

2) Figures after the third quarter of 1998 are forecasts.

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

The Bank of Korea, Monthly Bulletin, various issues.

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

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<Figure 17>        Growth Rate of Unit Export Prices and Volume 

Source: The Bank of Korea, Monthly Balance of Payments, various issues. 

<Table 9>                    Balance of Payments¹⁾ 

(100 million dollars)

Notes:1) Figures for the first half of 1998 are estimates and those for the second half of 1998 are forecasts.

2) Period average.

Source: The Bank of Korea, Monthly Balance of Payments, various issues.

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<Table 10> Trends of Official Foreign Reserves and Deposits in Foreign Currency 

(100 million dollar)

Note: End of period.

Source: The Bank of Korea, Official Foreign Reserves, various issues.

<Figure 18>     Won/Dollar Exchange Rate and Yen/Dollar Exchange rate 

Forecast

In 1999, both advanced and developing countries are forecast to register lower economic growth rates. Even with a strong third quarter performance and a surprisingly stable labor market, the U.S. economy is already showing some signs of contraction due to crises in Russia and Latin America and recession in East Asia. 

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The Japanese economy, in particular, is unlikely to recover soon, even with an ambitious stimulus package and the Miyazawa plan. Non- performing loans (NPLs) at financial institutions topping 1 trillion dollars in 1998 will be a drag on any efforts to end the recession. For similar reasons, most Asian countries, including non- crisis countries, will continue to experience difficulties next year. If advanced countries are successful in implementing economic stimulus packages that include deep interest rate cuts, however, countries such as Korea and Thailand are expected to recover rapidly, thanks to earnest structural reforms.

With interest rate cuts and declining profitability at U.S. corporations, together with increasing concern about credit shortages, the dollar is forecast to weaken next year while the euro, scheduled to launch in January, is expected to strengthen. The yen/dollar exchange rate, however, will remain between 125 yen and 140 yen as a result of continued economic recession in Japan and lingering instability in the world financial market. International interest rates will maintain a downward trend through the first half of 1999, largely due to a slower growth rate in the world economy and the possibility of further interest rate cuts in advanced countries attempting to isolate themselves from contractionary market trends.

Considering all the factors, the economic growth rate in Korea is forecast to register 2.3 percent in 1999. While the contribution of exports to economic growth will decrease slightly, recovery of inventory investment will contribute to the creation of a positive growth rate next year. Unfortunately, domestic demand will not recover quickly in 1999, and is instead forecast to decrease 5.7 percent in the first half, mainly due to the increase in unemployment and reduced permanent income. By the fourth quarter, however, the consumption growth rate is expected to record a positive 1.1 percent, thanks to stimulus measures like cutting the special excise tax, widening consumer credit, and easing liquidity constraints.

Equipment investment, which fell more than 40 percent in 1998, will continue to remain sluggish, dropping a further 14.9 percent in 1999. Despite an easing of the credit crunch and a slight recovery in investment, past overinvestment by major industries will lead to continued downsizing of their investment plans. 

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<Table 11>             Major Indicator Forecasts for 1999¹⁾²⁾

(percent, 100 million dollars)

Notes:1) Major indicators in the national accounts and CPI are percentage changes from the previous year.

2) KIF Estimates for 1998 and 1999. 

3) Custom clearance basis.

4) Period average.

5) End of period. 

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Exports, measured on a customs clearance basis, are expected to fall 0.9 percent owing to sluggish growth in advanced countries and persistent recession in Asian countries. Imports, on the other hand, are expected to rise 1.1 percent in the first half and 21.0 percent in the second half, also on a customs clearance basis. As a result, the current account surplus will reach 29 billion dollars in 1999, making next year the second consecutive year of surplus since the financial crisis in 1997.

Unemployment is expected to reach 9.1 percent at the end of the first quarter, then improve slightly to 8.6 percent by the end of year. These figures do not represent those who have given up searching for a job, however, and the size of the economically active population has already decreased significantly. This decline, if not stopped in the immediate future, could potentially lead to a breakdown of the industrial base and growth potential.

With respect to inflation, the CPI is expected to rise just 3.8 percent in the first half, but will shoot up to 5.7 percent in the second half, as a result of the government's pursuit of an expansionary monetary and fiscal policy in the second half of 1998 and a slight recovery in domestic demand. An expansionary monetary policy will also have a positive effect of increasing consumption, alleviating concerns of deflation. 

<Figure 19>            Contributions to Economic Growth

- 43 -

The won/dollar exchange rate is expected to remain stable around 1,200～1,300 won in the first half, mainly due to the trade surplus and increased foreign reserves. It will then continue to decrease toward 1,200 won after the first half, owing to reduced uncertainty and continued inflows of foreign capital. Two semi- uncertain events in 1999 are the advent of the euro in January and the scheduled liberalization of foreign exchange transactions in April. Depending on the progress made in structural reform efforts, sizable inflows of foreign capital are likely, and could cause a long- term appreciation of the exchange rate. Hopefully most foreign investment will be in the form of direct investment, since other forms of foreign capital can increase the burden on authorities to manage market liquidity, especially in a recovery period. The exchange market pressure index indicates that the current year- end exchange rate has already reached an optimal level, and that further appreciation below the 1,200 won level could jeopardize exports and delay economic recovery. In practice, cutting short- term interest rates such as RPs toward the 5 percent level will help reduce uncertainty in the foreign exchange market by preventing an overvaluation of the exchange rate. Combined with coordinated interest rate cuts by G- 7 nations, the destabilizing effect of lowering domestic interest rates will be minimized. 

<Figure 20>      Exchange Rate Pressure in Major Asian Countries 

- 44 -

Both the internal restructuring process and external environmental changes will affect economic growth in Korea. An unstable external environment could have a relatively large effect on short- term growth prospects, while mid-  to long- term growth prospects depend on the success of restructuring. Considering the persistent credit shortage and sluggish exports, however, the economy will not recover rapidly. Recovery in 1999 will therefore depend almost exclusively on inflows of foreign capital, and successful restructuring leading to a revival in domestic demand. In the worst case scenario, failure of restructuring could lead to a negative growth rate through major disruptions in foreign capital inflows and increased vulnerability to contagion effects from foreign crises. In particular, deepening international financial uncertainty, combined with a weakening yen and a full- fledged recession in the U.S., could worsen the current account to the extent that recovery would be almost impossible before 2000. A more likely scenario, however, is that a stable external

environment will combine with restructuring in corporate and financial sectors and a governmental stimulus package to place Korea firmly on the path to recovery in 1999.

<Figure 21>  Fundamental Factors + Exchange Market Pressure on Asian Currencies and Changes in the Won/Dollar Exchange Rate

Note: Weighted average of fundamental factor and exchange market pressure in Asian currencies(contagion effect).

- 45 -

<Figure 22>          Exchange Rate Forecasts for 1999

<Table 12>       Won/Dollar Exchange Rate Forecasts (End of period)

Notes:1) Forecasts.

2) Based on the Bayesian VAR model and the Hooper- Morton (1982) model.

Source: Morgan- Stanley.

- 46 -

Money and Interest Rates

1. Money

1) Review

The Bank of Korea (BOK) pursued two very different monetary policies in 1998; contractionary in the first half and accomodative in the second half. In the beginning of 1998, the Korean government focused on stabilizing the foreign exchange market, which was on the verge of collapse due to an abrupt outflow of foreign currency. In coordination with the IMF, the government implemented a contractionary monetary and fiscal policy to curb domestic demand and increase the current account surplus. This strategy met with partial success; the foreign exchange market regained stability with the successful issuance of 4 billion dollars of foreign exchange stabilization bonds on April 8th, and the current account surplus reached 21.8 billion dollars in the first half. On the other hand, business activities were harshly hit by the sharp cutback in domestic consumption and facility investment, causing the GDP growth rate to plunge to - 5.4 percent in the first half. 

<Table 13>        Monetary Targets in 1998 under IMF Agreement¹⁾

(billion won, percent)

Notes:1)End of period. Target growth rates from the same period last year in ( ). Realized value in [ ].

2) Indicative floor. 

3) Usable Reserves = Total International Reserve (TIR) -  Deposits in foreign branches. 

Sources: Ministry of Finance and Economy, Letter of Intent and Agreement (98.7.22). 

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

- 47 -

As worries over the sluggish economy grew, the central bank turned to an accomodative monetary stance to keep the economy from shrinking further. The BOK lowed the RP rate 2 percentage points to 7.1 percent on September 30. To help small-  and medium- sized enterprises (SMEs), the BOK's rediscount facility was expanded from 5.6 trillion won to 7.6 trillion won, and its discount rate was lowered from 5 percent to 3 percent on September 1. Another important monetary policy measure was to expand the consumer credit facility system so as to boost demand for housing and consumer durables. The IMF came to share Korea's worries of a full- fledged recession in the second half, and therefore agreed to the implementation of flexible monetary and fiscal policies. For example, ceilings on the money supply were lifted in the fourth- quarter policy consultation.

The reserve base (RB) continued to decrease through late September. Thanks to a high savings rate, bank deposit accounts became highly liquid. Banks then used their new- found liquidity to purchase monetary stabilization bonds (MSB) and repurchase 

<Table 14>             Trends in Monetary Growth Rates¹⁾

(percent)

Notes:1)Year- on- year average period percentage changes. September and October 1998 figures are preliminary. 

2) Reserve Base = bank notes + reserves of deposit money banks. 

3) M1 = currency + demand deposits. 

4) M2 = M1 + savings deposits + foreign currency deposits. 

5) MCT = M2 + CDs + money- in- trusts. 

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

7) Preliminary. 

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

The Bank of Korea, Monetary Movements during the Second Quarter of 1998. 

- 48 -

agreements (RP) from the BOK. Liquidity thus flowed out of the market into the

BOK.

With the government's injection of 21 trillion won of public funds to recapitalize ailing commercial banks and purchase non- performing loans, the RB shot up to 22.3 trillion won in the last week of September, an increase of 3.8 trillion won over the end of August. The M2 growth rate surged from 14.5 percent in the first quarter and 15.3 percent in the second quarter to 27.3 percent in October. Meanwhile, the MCT (M2+CD+money trusts) growth rate, which had climbed up to 14.7 percent in December 1997, dropped gradually to 10.8 percent in the first quarter, 8.6 percent in the second quarter, and 6.7 percent in October. The striking contrast between the behavior of M2 and MCT comes from a portfolio shift between financial products. Savings funds became more sensitive to interest rates, as high market interest rates prevailed until September and reduced savings compensation came into effect last July. Thus, sluggish MCT growth reflects a shift from bank money trusts into short- term non- bank financial products bearing higher interest rates. The contrastingly sharp increase in the M2 growth rate is due to the shift from money trusts, CDs and RPs into time deposits, a component of M2. The growth rate of M3, indicating overall liquidity conditions, decreased to 14 percent, down slightly from last year's 15～16 percent. The slow growth of M3 reflects the persistent credit crunch in current financial markets.

Even after the first round of financial restructuring measures, the Financial Supervisory Commission (FSC) continued to make efforts to reform Korea's financial system, ruthlessly abolishing old financial conventions. Significant progress was made in strengthening loan classification and provisioning requirements. Previously, loans overdue more than 6 months were classified as substandard, whereas now the threshold has been lowered to three months. Moreover, effective as of next year, a forward looking measurement will be introduced as an official loan classification criterion. In addition, financial institutions' accounting, auditing, and reporting systems have been upgraded to international standards.

In addition to financial restructuring, the government has focused on corporate restructuring, particularly for the top five chaebols. The government considers the top 

- 49 -

five conglomerates to have the ability to pursue restructuring efforts on their own, while workout plans are a key element of reform for the remaining 59 conglomerates. With this aim, foreign advisory groups were hired utilizing an IBRD technical assistance loan (TAL). The lack of determination toward reform from the top five chaebols, however, has prompted the government to increase pressure on the conglomerates to take concrete steps to reduce their debt- equity ratio and liquidate nonviable subsidiaries. The IMF has also urged state- run banks to pursue a stricter lending policy to large conglomerates, following the example of commercial banks. In addition, the IMF is asking three major state- invested banks to regularly report

<Table 15>           Trends in the BOK's RP Operations

(100 million won)

Source: Korea Investors Service, INC., KIS- LINE. 

<Table 16>          Monetary Stabilization Bonds Issued

(billion won)

Note: 1) Preliminary figures. 

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

The Bank of Korea, Monetary Trends, Second Quarter 1998. 

- 50 -

<Table 17>      Recent Deposit Changes at Financial Institutions¹⁾

(billion won)

Notes: 1) Average period changes. 

Sources: The Bank of Korea, Current Monetary Statistics, various issues. 

The Bank of Korea, Monetary Trends, Second Quarter 1998. 

<Table 18>             MCT Money Supply by Sector¹⁾ 

(billion won)

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

2) Preliminary. 

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

The Bank of Korea, Monetary Movements during the second quarter of 1998. 

- 51 -

their capital adequacy ratios as required by the Bank for International Settlement, thus restricting banks' lending policies. These three major state banks are the Korea Development Bank, the Export- Import Bank and the Industrial Bank of Korea.

The financial market did not fulfill its function of distributing funds to productive businesses in 1998, even though the market was slowly regaining its energy in the fourth quarter. The credit crunch was worst in the first half; the decline in loans was noticeably greater than is typical during a recession. For example, in the second quarter, total lending by commercial banks decreased by 4.8 trillion won. Market interest rates increased to above 20 percent, cutting off all but a few extremely

<Table 19>      Trend of Residents' Foreign Currency Deposits¹⁾

(billion US dollars)

Note : End of period.

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

<Table 20>          Non- performing Loans and Bad Loans

(billion won)

Notes:1)Credits classified as 'doubtful' or 'estimated loss'.

2) bad loans + substandard.

sound firms from access to credit. SMEs, usually bank- dependent borrowers, were hit 

- 52 -

more severely by the credit crunch than were large firms. In the second half, even repeated announcements of an accommodative stance by the BOK could not ease the credit shortage. Although market interest rates dipped to the single- digit level, uncertainties in the financial market were still very high. With the decline in the willingness and capacity of banks to lend, monetary policy actions that increased bank reserves did not translate into additional bank lending. As the government became stricter on bank loans to conglomerates, the top five chaebols have had to raise funds through issuing bonds, in the amount of 33.9 trillion dollars between January 1 and September 30, or about 99 percent of total corporate bonds issued in the same period. In other words, SMEs were also unable to obtain financing through issuing bonds.

2) Forecast

The BOK will continue its accommodative stance in 1999 to prevent excessive economic contraction. Let us now briefly overview main indicators such as monetary policy, domestic business levels, the foreign exchange market and inflation. First, the value of the Korean won will stabilize in the coming year. This is because the current account will continue to record a surplus of around 28 billion dollars, slightly less than this year's estimated 39 billion dollars. The continued net inflow of foreign direct and indirect investment will also contribute to the stability of the foreign exchange market. Korean financial markets have become much more vulnerable to external shocks since the currency crisis in December 1997, and currently carry an external debt burden of 150 billion dollars. Therefore, uncertainties in the international financial markets are hazardous to the Korean market. 

Second, consumer price inflation is expected to fall below 5 percent, lower than the estimated 7.6 percent in 1998. Since the Korean won is forecast to appreciate 9.7 precent relative to dollar next year, the cost- push pressure from import price inflation will be minimal. Lackluster domestic demand will also keep inflation in check. The stable exchange rate and inflation will therefore provide ample room for an increasing money supply to boost business activities. In the second half of 1999, when the economy bottoms out and the earnings of nonfinancial companies rebound, the credit 

- 53 -

crunch will be significantly eased. 

Next year's monetary policy will focus on manipulating the interest rate through open market RP adjustments rather than the aggregate money supply. On the recommendation of the IMF, Korea's capital market system and institutions have been modified to conform to international standards. Significant improvements include the issuance of long- term bearer bonds, expansion of the range of bond credit ratings, the elimination of the issuance limit on corporate bonds, and the removal of restrictions on bond investments by foreigners. With the new bond market system and the increase in state bond issuance, bond trading has become more active and the trading volume has increased. The highly active bond market provides the BOK with an additional venue for implementing its monetary policy through open market transactions.

Financial market speculations of an imminent RP rate cut by the BOK are growing. The three consecutive cuts in US interest rates by the US Federal Reserve and coordinated interest rate cuts in other G7 countries make a 1～2 percent point drop of RP rate more likely. The loose monetary stance of G7 countries will help keep the foreign exchange market stable even with lower domestic interest rates.

<Table 21>                 Inflow of Foreign Capital

Sources: 1) Ministry of Finance and Economy, Foreign Investment Trends, 98. 1～10. 

2) Korea Securities Supervisory Board, Foreign Investment Trends, various issues.

Monetary growth rates will be similar to those in 1998. The M2 growth rate will 

- 54 -

be about 14～15 percent and M3 growth rate about 13～14 percent. Such a monetary injection should keep the market sufficiently liquid, considering the low inflation rate of 4.8 percent and a weakened demand for financing due to sluggish economic growth of just 2.3 percent. In terms of money supply by sector, money will be supplied mainly through the government and foreign sectors, while increases from the private sector will be modest. Money will actually be absorbed by the other sector. Although the money supply in the private sector will turn from negative to positive thanks to an expansionary monetary policy, the recovery will be modest since commercial banks will continue to be cautious in extending loans, and low levels of facilities investment will

keep demand modest. Money supply in the government sector is likely to increase significantly since constructing a social safety net and stimulating sluggish business activities will sharply increase expenditures while tax revenues keep falling. The current account surplus and the continuing inflow of foreign capital will again lead to a positive contribution to money supply from the foreign sector.

Despite the substantial liquidity injection from the BOK, persisting uncertainties and

high default risks will force banks to be cautious in extending new loans, thereby

<Table 22>            Monetary Growth Rate and Forecasts¹⁾²⁾³⁾

(percent)

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

2) GDP rates and monetary rates are preliminary values.

3) KIF forecasts.

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

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

The Bank of Korea, Monetary Movements during the Second Quarter of 1998.

continuing the credit crunch in the first half. The credit shortage problem will improve 

- 55 -

in the second half as recovering domestic demand improves the balance sheet of nonfinancial companies. Large conglomerates may not benefit from the eased credit environment, since they are being forced to repay bank debt and to cut their debt- equity ratio down to 200 percent by the end of 1999. SMEs, however, will see their financing situation improve considerably with falling market interest rates. Commercial banks will be forced to seek out SMEs for lending since the large conglomerates are prohibited from borrowing any further funds.

2. Interest Rates

1) Review

During 1998, market interest rates were most influenced by the BOK's open market operations. In the first quarter of 1998, market interest rates soared to the 20 percent levels, for two main reasons. One is that the BOK raised its market intervention rates, RP selling rates, up to 35 percent in a bid to stabilize the foreign exchange rate in accordance with the IMF agreement. The other reason is that risk premiums rose unprecedentedly high as the market's concerns about additional corporate bankruptcies became serious. Interest rates, however, have fallen gradually as the foreign exchange market stabilizes. The stable foreign exchange market was in turn facilitated by the remarkable improvement in the current account balance, massive overseas borrowing including a successful roll- over of the bank's short- term external debt in New York in late January, and the upgrade of Korea's credit rating by S&P in February. In response to these developments, the BOK began to decrease the RP

selling rates in the second quarter, leading to a sharp reduction in market interest rates. The RP selling rates were lowered from 23.0 percent at the end of March to 14.5 percent at the end of June, and again to 7.1 percent at the end of September. 

Following RP rates, market rates have continued to decrease since the second quarter of 1998. The IMF condoned this move in a second quarter agreement with the Korean government in order to stimulate the flagging domestic economy. Market interest rates did fluctuate periodically, however, due to both external and internal 

- 56 -

factors. External factors included the possibility of another round of financial crises among Southeast Asian countries, Japanese banks' withdrawal of overseas lending, and Russia's declaration of a debt moratorium on August 17. On the other hand, internal 

<Figure 23>      Won/Dollar Exchange Rates and Corporate Bond Yields 

<Figure 24>                 Major Long- term Interest Rates 

factors included the uncertainty surrounding the restructuring of financial institutions. 

- 57 -

Corporate bond rates (guaranteed by banks), which recorded 28.98 percent in the beginning of the first quarter, hovered around the 20 percent level during the January to February period. High rates were caused by the prolonged instability in the financial market, due to the nationalization of the two worst- performing commercial banks, the shutdown and suspension of several merchant banks, and worries over additional corporate bankruptcies. As the won/dollar exchange rate stabilized in March and market sentiment began to improve, market rates started a steady fall, recording 17.7 percent at the end of April.  In May, however, rates periodically rose above 18 percent, either because of the downgrading of domestic banks' credit ratings by Moody's, or because of the Southeast Asian countries' ongoing economic crises. After the government and the IMF agreed to lower interest rates, however, rates resumed a downward trend. Aided by abundant market liquidity, market rates fell to 10 percent at the end of October. The rates of financial debenture, typically considered safe assets, increased to 19.56 percent in the first quarter, swept along by the overall upward trend in interest rates. Rates fell to 11.94 percent in the third quarter, however, reflecting the overall downward trend of interest rates and abundant market liquidity. 

Call rates stayed above 20 percent throughout the first quarter, as the monetary authorities sold a large amount of RPs and some of financial institutions that determine call rates were revealed to be unhealthy. In particular, call rates between banks and merchant banks surged to 40 percent after the shutdown of 12 merchant banks in late January and early February. But coupled with a continuous decrease in the BOK's RP ratio, call rates decreased after the middle of the second quarter, finally falling to 14.6 percent by the end of June.  Rates plummeted to the one digit level at the beginning of August and fell to the 7 percent level by the end of September, the lowest since the establishment of call markets in Korea. This sharp fall was attributed to abundant liquidity at healthy banks and investment and trust companies (ITCs), as well as the government's willingness to lower market rates.

Notwithstanding that commercial paper (CP) discount activities were allowed in bank trust accounts, CP rates hovered above 30 percent in the beginning of the first

<Figure 25>             Major Short- term Interest Rates

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<Table 23>              Major Interest Rates by Quarter¹⁾

(percent)

Notes:1)Period averages.

2) End of month figures for RPs with short term maturities.

3)Guaranteed by banks until the first quarter of 1998, guaranteed by credit guarantee firms during April 1998 to August 1998 period, non- guaranteed since September 1998.

Source: Korea Investors Service, INC., KIS- LINE.

The Bank of Korea.

quarter, reflecting the possibility of bankruptcies among large firms. After mid- quarter, 

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CP rates fell to the 20 percent level and decreased further to 16 percent in the second quarter. This decrease was affected by both the CP maturity extension agreement among merchant banks, and the government's financial market stabilization package. During the third quarter, the rates decreased further, reaching 10 percent at the end of the quarter. This additional decrease was the result of the downward trend of interest rates and increased deposits at merchant banks.

The most remarkable feature of financial market development in 1998 has been the widespread credit crunch and the distorted flow of funds. This situation resulted from the restructuring of financial institutions and fierce competition among these institutions for customers' deposits. A credit crunch is defined as a reduction in credit availability and a failure of market mechanisms such as interest rates to alleviate the

<Table 24>       Bank Deposits and Loans and Interest Rate Spread¹⁾

(100 million won, percent)

Notes:1)Average of period changes. Reported values until June and preliminary values from July.

2)Deposits include demand deposits, time and savings deposits, and net CD issuances.

3)Excludes CP discounted.

4)Interest rate spread = average bank loan rate -  average bank deposit rate.

Source: The Bank of Korea.

shortage. Under such a circumstance, the lender is reluctant to extend any sort of 

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loan at any interest rate, neutralizing any attempts by the BOK to increase liquidity. In the third quarter, even the sharp reduction in both market interest rates and risk premiums failed to ease the credit crunch. Financial institutions continued their restrictive loan policy, in some cases even calling in loans early, and were particularly reluctant to lower lending rates to firms and households. Therefore, while the big five conglomerates with less credit risk had little difficulty in borrowing new money, other firms with higher credit risks experienced great difficulty in floating bonds and borrowing money. Financial institutions also exacerbated the situation by using their liquidity to purchase only short- term financial products with high returns, blocking a lending channel to firms and households. 

Another remarkable feature of financial markets in 1998 was the excessive fluctuations in flows of funds. As market liquidity flocked to short- term financial products with high returns in the first quarter, total deposits at banks decreased 9,400

<Table 25>               Determinants of Interest Rates

(percent, billion won)

Notes:1)Annualized growth rates.

2)CPI inflation is a realized value and other figures are preliminary. 

Sources: The Securities Supervisory Board, Monthly Bulletin, various issues.

      Korea Investors Service, INC., KIS- LINE.

billion won, while time deposits with maturities less than one year increased by 21,791 

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billion won. Moreover, deposits in money trusts decreased 9,500 billion won from the end of the last year, whereas deposits in new installment trusts at banks, a short- term financial product, increased by 21,100 billion won. At ITCs, deposits in short term bonds increased 14,799 billion won, accounting for 77.6 percent of the total increase in deposits at those companies. 

In the second quarter, more money moved to healthy financial institutions and those short- term financial products with a fully guaranteed principal. This movement was facilitated by the enforcement of the depositor protection system and the shutdown of nonviable banks. Therefore, while the share of time deposits with maturities less than one year grew 15.4 percentage points at the end of June 1998 from 33.5 percent at the end of 1997, the share of time deposits with maturities more than two years decreased 18.4 percent points from 28.4 percent to 10.0 percent over the same period. In particular, in the third quarter, increases in short- term deposits at ITCs accounted for 81.6 percent of the 44.2 billion won increase in total deposits at ITCs.  This surge was due to large shifts of funds from bank trust accounts to ITCs, as the government opted not to guarantee the full principal and interest at bank- trust accounts. 

The ratio of dishonored bills in 1998 grew past pre- crisis levels, spurred by flagging business due to the economic recession, the financial institutions' reluctance to lend to firms with increased credit risks, and the excessive cost of loans with such high interest rates. Examining the trend shows that after the ratio hit its peak at the end of the last year, it slowly decreased and returned to 1997 levels in August. On the positive side, the number of corporate bankruptcies has declined since the first quarter.

The term structure of interest rates in the first quarter showed that three year bond rates exceeded one year bond rates until the middle of the first quarter. This was caused by a sharp rise in corporate bond yields reflecting the high risk of bankruptcies. The term structure reverted to its typical high short- term and low long- term pattern by the end of the quarter and into the second quarter, since three year corporate bond rates fell significantly against one year bank debenture rates. A relatively smaller decrease in bank debenture rates during this period was attributable to an increase in foreigners' purchase of several debentures from the Korea Development Bank and others. Since the 

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third quarter, however, a fall in short- term interest rates caused the term structure of interest rates to return to the low short- term and high long- term pattern.

<Table 26>                  Rate of Dishonored Bills

(percent, number)

Note:Dishonored bill- ratio reflects adjustment for electronic settlements.

Source: The Bank of Korea, Ratio of Dishonored- Bills in September.

<Figure 26>                 Dishonored Bill Ratios

The volatility of interest rates decreased in the first quarter from the last quarter of 

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1997, with the exception of call rates. The increased volatility of call rates was due to the suspension of unsound financial institutions and the BOK's monetary retrenchment, which caused rates to shoot up early in the quarter. Call rates then dropped rapidly after mid- quarter with the help of the stable foreign exchange market and a decrease in RP rates. In the second quarter, the overall volatility of interest rates decreased 

<Figure 27>              Yield Curves by Quarter in 1998

significantly as the foreign exchange market regained its stability and the trade volume 

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in the capital market rose. In particular, the volatility of corporate bond rates and CD rates approached their pre- crisis levels. On the other hand, the volatility of interest rates varied widely during the third quarter. Call rates became less volatile and the volatility of financial debenture rates change little from the previous quarter. The volatility of both corporate bonds and CD rates increased, because corporate bonds previously guaranteed by the five suspended banks lost protection, and corporate bonds guaranteed by credit firms were excluded from the Depositor Protection Law.

There were several institutional changes in the financial market in 1998. First, the ceiling on foreign investment in listed bonds was completely abolished as of January 1, and the CP market was entirely opened to foreign investors as of February 16. Also, short- term financial products such as CDs and RPs were fully opened to foreign investors as of May 25. These moves were made in an effort to alleviate shortages of funds for firms and to solidify financial conditions in preparation for an additional reduction in interest rates. Unfortunately, the newly available financial commodities attracted little notice from foreign investors, who still regard Korea's sovereign credit rating as ‘unsound’. Many foreign investors anticipated difficulties in recovering the principal of their investments in financial institutions undergoing extensive restructuring,

<Table 27>             Daily Absolute Change in Interest Rates¹⁾

(percent point)

Notes:1)Period Averages.

2)Guaranteed by banks until the first quarter of 1998, guaranteed by credit guarantee firms from April 1998 to August 1998, non- guaranteed after September 1998.

Source: Korea Investors Service, INC., KIS- LINE.

despite a governmental guarantee. As a result of this skepticism, foreign capital 

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concentrated in purchases of risk- free monetary stabilization bonds and financial debentures issued by the Korea Development Bank.

Another remarkable institutional change in 1998 is that the benchmark bond used to price the corporate bond rate was changed twice. On March 16, the benchmark bond was changed from the corporate bond guaranteed by banks to that guaranteed by credit guarantee firms. The percentage of corporate bonds guaranteed by banks recorded over 25 percent at the end of the first half of 1997, but fell sharply in the fourth quarter of 1997, recording only two percent in the first quarter of 1998. Banks needed to improve their BIS capital adequacy ratios, and were therefore reluctant to guarantee high- risk corporate bonds. Subsequently, corporate bonds guaranteed by credit guarantee firms were excluded from protection under the Depositor Protection Law, starting on August 1. Therefore, the percentage of non- guaranteed bonds reached 97.3 percent in August, up 60.7 percent points from July. Therefore as of September 1, the non- guaranteed corporate bond became the benchmark.

Two credit guarantee firms experienced liquidity shortages, with accumulated capital losses reaching 2,587 billion won at the end of May, and 5,046 billion won of non- performing loans over the past three years. These losses resulted from the failure of the two firms to secure collateral for their losses.  The value of loans and bonds guaranteed by those two firms stood at 149 trillion won at the end of July. When the firms merged on November 25, small-  and medium- sized firms had even more difficulty in borrowing new money. In response, the Financial Supervisory Commission (FSC) decided to provide 1,100 billion won to the Asset Management Corporation to purchase the nonperforming loans of small-  and medium- sized firms by April 1999. This action narrowly managed to stave off the expected shortage of liquidity.

2) Forecast

In 1999, market interest rates are expected to be affected significantly by the following four factors; the direction of the current business cycle, the extent of financial and corporate restructuring, foreign exchange market trends, and price movements. RP selling rates, which decreased rapidly in 1998, will be lowered further, but they will not significantly affect market interest rates. Also, the issuance of 

- 66 -

government bonds is not expected to be important in determining market interest rates.

The most important factor that will affect market interest rates in 1999 is the performance of the real economy, in particular, the timing and the speed of recovery. As is well known, if the business cycle enters an expansion period, firms' demand for money increases, immediately raising short- term interest rates and eventually long- term interest rates. Restructuring will be completed by the end of the first half of 1999 at the latest, and the government will likely undertake expansionary polices at that time. Thus far, the recession has lasted more than 36 months, hitting its last peak in the 6th business cycle around the third quarter of 1995. Also, the economy will be likely to enter an expansionary period with the completion of restructuring accompanied by the `three lows': low interest rates, a weak dollar, and cheap raw material prices.

The relationship between the business cycle and nominal interest rates was not strong during the third and fourth business cycles, though it strengthened at the start of the fifth business cycle until the foreign exchange crisis broke out. The peaks and bottoms of interest rate trends follow the peaks and bottoms of the business cycles. In other words, interest rates go down at the beginning of expansionary periods and go up at the beginning of contractionary periods. Market interest rates are likely to show a downward trend for the entire year of 1999, assuming that the 6th business cycle hits its bottom in the first half of 1999. But we cannot exclude the possibility that market interest rates will turn upward before the economy enters a full- scale expansionary period, given the government's strong economic stimulation package and the `three lows'.

The foreign exchange market, the primary factor in determining market interest rates in the post foreign- exchange crisis period, will be stable throughout the first half of 1999, reflecting the weak dollar. Accordingly, the won/dollar exchange rate will hover at the 1,300 won level, as agreed between the government and the IMF. If the foreign exchange market becomes unstable, however, it will immediately put upward pressure on market interest rates, since market interest rates typically follow the exchange rate after the crisis. This is not a serious problem in Korea's case, since the 

<Figure 28>       The Business Cycle and Corporate Bonds Yields

- 67 -

Note: The peak of the 6th business cycle is an estimated point of time. 

<Figure 29>       Spreads of Corporate Bonds, Call, and CD Rates

Note: The peak of the 6th business cycle is an estimated point of time. 

correlation is weak enough that a 1 percentage point increase in the won/dollar 

- 68 -

exchange rate raises domestic interest rates by just 0.07 percentage points. On the other hand, unstable factors remain in Southeast Asia, Russia, and Latin America, balanced by a coordinated policy among G- 7 countries to cut key interest rates. Overall, overseas unstable factors will not significantly affect domestic market interest rates. The greatest danger would be if Korea's trade balance worsened and China devaluated its currency to maintain their target level of economic growth.

Capital movements have been highly responsive to interest rate and foreign exchange rate volatility, particularly since the crisis. Before the crisis, capital movements were insensitive to trends in domestic interest rates and exchange rates because the capital market was not sufficiently open. But significant capital market liberalization since the crisis means that a bigger spread between foreign and domestic interest rates or the anticipation of future exchange rates have a greater impact on 

arbitrage effect of international interest rates, increased initially following the crisis, but 

- 69 -

later decreased as the foreign exchange market stabilized and capital movements were liberalized, resulting in a significant increase in capital flows. On the other hand, government intervention has caused market interest rates to follow movements in exchange rates, causing rates to fall when exchange rates are stable.

RP selling rates are not expected to decrease further in 1999. RP selling rates, which stood at 7.02 percent at the end of October, are already similar to international interest rates such as the US Federal Fund Rate, which was 5.0 percent as of October 15, 1998. Additional reductions might destabilize the foreign exchange market by reducing both foreign and domestic investors' interest in the Korean bond market.

It is also noteworthy that the five year global bond rates have been higher than the National Housing Bond (type 1) rates since September 1998. Another reason to doubt additional cut in RP rates is the worry that the government would be left without alternative policy options if an additional cut in RP rates failed to have the desired effect on the economy. In addition, further cuts in RP selling rates would lead to rapid monetary expansion, giving rise to high inflation. It is therefore highly unlikely that the BOK will cut RP rates further in 1999.

An increase in reserve money will have the effect of lowering interest rates. If banks use the additional reserve to purchase government bonds rather than corporate bonds, the effect of an increase in reserve money on interest rates will not be significant. As shown in table 29, an increase in the real money balance lowers interest rates by 0.04 percent points in the long run, while an increase in real government bonds raises interest rates by 0.03 percent points, largely neutralizing the money supply effect.

The ongoing issuance of government bonds will boost interest rates. In developed countries, outstanding government bonds do not affect market interest rates, because capital markets function more perfectly. In developing countries, however, a tax cut financed by the government bonds pushes up interest rates. One reason is that the 

the typical individual has myopic expectations about the future. The other reason is that most people experience liquidity constrains due to the imperfect capital market. As 

shown in table 29, the crowding- out effect does take place in the Korean bond market,

- 70 -

as a 1 billion won increase in government bond issuance raises interest rates by 0.00034 percentage points.

In 1999, the economy- wide credit crunch is not expected to disappear. Market players will pursue short- term gains, and while healthy financial institutions and firms will have ample access to credit, others will not. As is well known, the high interest rate policy that brought about the credit crunch has already been alleviated, but the restructuring program that has also exacerbated the credit problem will not be completed until mid- 1999. In reality, it is unlikely that the credit crunch will be alleviated until the economy begins to recover. 

<Table 28> Foreign Exchange Stabilization Fund Bonds and National Housing Bond  Rates¹⁾

(percent)

Notes: 1) Period averages. 

2)Spreads = Foreign Exchange Stabilization Fund Bond (5 yrs maturity) -  Treasury Bill (5 yrs maturity).

Source: Korean Investors INC., KIS- LINE.

Bloomberg.

<Table 29>        Crowding- out Effect of Government Bond Issuance

Notes:CBR=corporate bond yield (3 years), DGE=change in government expenditure, DGB= change in government bonds and monetary stabilization bonds, DM2=change in M2. EquationⅠuses real values. Equation Ⅱ uses nominal values. The figures in parentheses are the values of t- statistics.

Although Korea's external debt is significant, it will not destabilize the foreign 

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exchange market in 1999. The total redemption of external debt in 1999 is estimated to be 26.4 billion dollars, including 17.8 billion dollars for financial institutions plus 8.6 billion dollars for the government. And since the trade surplus will reach 26.0 billion dollars, Korea should not have difficulty paying back its external debt. The capital market may experience slight difficulties in March 1999, however, when 2.4 billion dollars of one year external debt comes due. This debt was previously due in March 1998, but was rescheduled according to the New York maturity extension program. 

Korea's debt maturity structure is improving. As of July 1998, short- term debt with maturities of less than one year accounted for 25.2 percent of the 152.3 billion dollars of external liabilities. This is a significant improvement from 63.5 percent at the end of 1996 or 44.3 percent at the end of 1997. Also, overseas financing by the 30 largest conglomerates was only 39.07 billion dollars at the end of June 1998, down 5.94 billion dollars from the end of 1997.

Prices are also expected to depress interest rates. Domestic demand remains very low; wage rates will not increase, and in the international market, raw materials prices and foreign exchange rates will be stable. The consumer price index is expected to fall

<Figure 31>  Contraction of Credit Supply     Contraction of Credit Demand 

below the government target level of 5 percent. In sum, the Fisher effect of inflation pushing up interest rates is not expected to play a role.

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Considering these factors, the average non- guaranteed corporate bond rates are expected to hover around 10.1 percent in 1999, remaining stable until the middle of the first quarter, then fluctuating somewhat toward the end of March when the aforementioned short- term external debt falls due. The capital market will stabilize again in the second quarter, when restructuring is completed and the government focuses on measures to boost the economy. 

<Table 30>            Interest Rate Forecasts by Quarter in 1999¹⁾

(percent)

Notes: 1) Corporate bond yields (3 year), period averages.

2) Interest rate forecasts for ScenarioⅠare estimated using a linear model and those for scenarios Ⅱ～Ⅴ are estimated with a non- linear model.

<Table 31>     Interest Rate Regression Equation(Non- linear Model)

Note:The figures in parentheses are the values of t- statistics.

During the second half of 1999, money demand will increase in anticipation of economic recovery, and the BOK will begin to gravitate back toward a conservative monetary policy to curb inflationary pressures, raising interest rates slightly. Interest 

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rates will also rise slightly when 4 trillion won worth of one year government bonds fall due between September and November 1999. In sum, three year corporate bond rates are expected to be 10.6 percent in the first quarter and 9.9 percent in the second quarter. During the third quarter, the rate will decrease further to 9.7 percent, and then rebound to 10.1 percent in the fourth quarter. Call rates and CD rates are expected to be stable at the 7～8 percent level, reflecting the high level of liquidity in the capital market.

The yield curve generally shows a low short- term and high long- term pattern at the beginning of a recovery stage, flattening out as the recovery progresses, and finally returning to a high short- term and low long- term pattern in the expansionary period. The initial low short- term and high long- term pattern is expected to persist through 1999. First of all, there is no reason for the BOK to raise RP rates and exacerbate the credit shortage. Second, the abundant market liquidity will be invested in short- term bonds, lowering short- term interest rates. Third, long- term corporate bonds will be traded at higher rates, reflecting the credit risk of firms. On the other hand, the slope of the term structure will become flatter, since long- term interest rates will decrease in the first half and money demand will increase during the second half, causing short- term rates to decrease.

In 1999, it is expected that the market evaluation system introduced in November 1998 for new funds at bank trust accounts and ITCs will have an effect on capital movements. Under the market evaluation system, investors will acquire capital when the bond price goes up, and lose money otherwise. If the new system is well established, a loss and gain shift between original accounts and trust accounts will be automatically equalized, and individuals will come to consider ITCs and bank trusts as investment rather than savings institutions. In addition, the new system will create incentives for more bond trading, thus helping the secondary bond market to be more active. 

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Financial Market Developments

Banking

Deposit Market

The total volume of bank deposits held by deposit money banks, including deposits in won, sales of marketable financial products, and foreign currency deposits, rose by 20.4 percent in 1998, ending the year at 281.5 trillion won. The growth of bank deposits this year was faster than in 1997, mainly due to the large transfer of funds from accounts not covered by deposit insurance protection to time and savings deposits subject to deposit insurance protection. In the first half of the year, large amounts of funds moved into short- term financial products, as short- term interest rates on bank deposits became higher than long- term ones. In the second half of the year, time and savings deposits, especially short- term ones, increased sharply in the face of economic uncertainty. Another reason for the popularity of time and saving deposits was investors' increasing preference for safety over high returns after the passage of the Financial Restructuring and Revision of Deposit Protection Act. In addition, as sound banks were distinguished from ailing banks by the supervisory office, the sound banks naturally attracted large amounts of funds and became excessively liquid, lowering interest rates. Bank deposits also became more popular as depositors reduced consumption faster than income and consequently increased savings. Finally, residents increased their holdings of foreign currency, both for future need and expected profit from exchange rate fluctuation.

The volume of time and savings deposits is estimated to have risen 31.5 percent to 214.1 trillion won by the end of 1998. Most of this increase came from time deposits, which increased by 156.9 percent at the end of 1998 to 121.7 trillion won. Money Market Deposit Accounts (MMDAs) decreased in the first half of the year due to the shortage of working funds, but later rebounded as other financial institutions looking for safe investments transferred their funds to MMDAs in the second half of the year. The volume of other products in the time and savings 

- 75 -

deposit category decreased due to the recession and the reduction of household income.

<Table 1>                      Bank Deposits¹⁾

(billion won, percent)

Notes:1)End of period. Excludes inter- bank deposits. The figures in ( ) are percentage changes from the previous quarter. The figures in < > are percentage changes from the previous year.

2) Estimates.

3) Excludes the trust money of the BOK.

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

The volume of marketable financial products, such as certificates of deposit (CDs), 

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repurchase agreements (RPs), and cover bills, is estimated to have fallen by 36.5 percent, reaching 27.7 trillion won by the end of 1998, mainly due to falling rates of return. Since the second quarter, the supply of CDs has fallen, since banks had

<Table 2>                   Time and Savings Deposits¹⁾

(billion won, percent)

Notes:1) End of period. The figures in ( ) are percentage changes from the previous quarter. The figures in < > are percentage changes from the previous year.

2) Estimates.

3) Permitted from July.

4) Includes household preferential installment savings deposits.

5) Includes mutual installment savings, housing installments savings, workmen's long- term savings, and workmen's property formation deposits.

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

excess funds that they could not properly employ. Sales of cover bills declined 

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continuously due to the recession- induced shortage of underlying assets, such as commercial and trade bills, despite deposit insurance protection. The volume of RP sales decreased because of the exclusion of RPs from deposit insurance protection, as well as the shortage of original bonds.

The balance of foreign currency deposits is estimated to have risen by 200.3 percent, reaching 19.9 trillion won at the end of 1998, largely due to the great increase in residents' holdings of foreign deposits. Firms also retained foreign currency obtained from exports and asset sell- offs in foreign deposit accounts, in anticipation that the Korean won would depreciate in the face of international economic instability. Furthermore, the revision of the Foreign Exchange Transaction Act in July allowed firms and households to purchase foreign currency more easily and retain it in foreign deposit accounts.

<Table 3>           Interest Rates on Selected Bank Deposits¹⁾

(percent)

Notes:1) End of period. Weighted average interest rates.

2) Estimates.

Source: The Bank of Korea.

The volume of demand deposits is estimated to have fallen by 4.1 percent, 

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reaching 19.8 trillion won by the end of 1998. This move reflects the reduction in financial transactions during the recession as well as depositors' efforts to avoid non- interest bearing products.

High interest rates on deposits, especially short- term ones, were maintained during the first quarter in order to stabilize the plunging currency value following the IMF bailout loan package. After the second quarter, both deposit and market interest rates decreased following an agreement between the Korean government and the IMF to avoid an economic collapse caused by high interest rates. The inverted yield curve of high short- term interest rates and low long- term interest rates was corrected in July as severe competition among banks lessened and short- term deposit interest rates fell faster than long- term ones.

In 1999, the total volume of bank deposits is forecast to rise 15.5 percent to 325 trillion won, a somewhat lower rate of increase than that in 1998. This forecast is based on observing the continuous flow of funds into bank deposits under deposit insurance protection during 1998, and noting several factors that could cause this flow to decrease somewhat in 1999. Following the first round of financial industry reorganization, banks will compete with each other by offering services rather than high interest rates to attract depositors. Depositors are also likely to prefer financial products at sound banks subject to deposit insurance protection, since financial market instability will continue into next year. Competition among financial institutions will also increase in those business areas recently opened to them by deregulation. Financial institutions are also likely to develop many new products covered by deposit insurance protection, and decrease deposit interest rates to offset losses arising from lower loan interest rates. 

The volume of time and saving deposits will grow by 18.1 percent, reaching 252.8 trillion won at the end of 1999. Short- term time deposits, in particular, will increase, in expectation of rising interest rates. The volume of marketable financial products is expected to contract by 11.8 percent, as lessening competition between banks leads to lower interest rates. Growth of foreign currency deposits will decline, since large amounts of foreign debt are scheduled to be redeemed. In addition, 

- 79 -

demand for foreign currency accounts will decrease as the foreign exchange rate stabilizes, even though large inflows of foreign currency are expected from the sell- off of assets to foreign investors and the continuous current account surplus. 

Loan Market

The total volume of bank credits offered by deposit money banks, including loans in won and foreign currency, and loan guarantees and acceptances, is estimated to have fallen by 12.4 percent to 270.5 trillion won in 1998, for several reasons. First, banks not only ceased new loans but also withdrew existing loans to troubled firms in order to raise their BIS capital adequacy ratios. Simultaneously, firms and households decreased their demand for loans as loan interest rates increased. Second, available bank credit was concentrated in loans to a few credible firms, while the other firms with low credit had no chance to receive funding. Third, more stringent asset classification criteria implemented in July made banks conservative in their credit management. Fourth, the volume of bank credits decreased because banks sold non- performing assets to the Korea Asset Management Corporation in late September, and swapped loans for deposits in November. All these factors prolonged the credit shortage and increased the circulation of funds between financial institutions looking for safe fund employment. Most funds were invested in safe government and public bonds, investment and trust company (ITC) beneficiary certificates, or RPs from the Bank of Korea. One desirable development is that loans to large- sized firms decreased, while loans to credible small- and medium- sized firms increased. In particular, the five conglomerates (chaebols) decreased demand for new loans and redeemed existing high interest loans with funds obtained from issuing large amounts of commercial bonds.

Increased credit to viable small-  and medium- sized firms and trade- oriented firms was provided by increasing policy loans to banks that actively lend to small-  and medium sized firms, which has lowered interest costs of small-  and medium- sized firms and encouraged trade finance.

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The volume of loans from banking funds decreased in 1998 due to a large reduction in discounted bills, despite increased general loans. The volume of discounted bills in the fourth quarter is expected to rebound from its consecutive decline in the preceding quarters, owing to various policies to support small-  and medium- sized firms. Nontheless, this rebound will not be sufficient enough to offset

<Table 4>                       Bank Loans¹⁾

(billion won, percent)