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SINGAPORE, April 4, 2023 – The Korean economy has recovered strongly from the pandemic, led by robust export growth and a strong rebound in private consumption. However, inflation remains elevated and the economic outlook in the near term has deteriorated amid tighter financial conditions and weakening external demand. As risks to the economic outlook remain significant, the authorities need to be ready to recalibrate the monetary and fiscal policies flexibly and prudently to contain inflation and support the economy.

These policy recommendations are highlighted in the 2022 Annual Consultation Report on Korea published by the ASEAN+3 Macroeconomic Research Office (AMRO) today. The report is based on AMRO’s Annual Consultation Visit to Korea which was completed on December 9, 2022, and information available up to March 7, 2023.

Recent developments and outlook

Real GDP grew strongly by 2.6 percent in 2022, driving the output gap into positive territory for the first time since 2020. However, the economic recovery from the pandemic remains uneven across sectors. While manufacturing activities rebounded quickly, services recovered only gradually.

The economic outlook in the near term has deteriorated. Private consumption and exports are expected to decelerate, and facility investments to remain weak amid tighter financial conditions and weakening external demand. The economy is forecast to moderate to 1.7 percent in 2023.

With energy and food prices likely to continue falling, headline inflation should gradually decline to an average of 3.3 percent in 2023 from 5.1 percent in 2022. Short-term inflation expectations have risen, while long-term expectations, based on market pricing, remain well-anchored.

Monetary policy stance has become restrictive. The Bank of Korea (BOK) has raised the Base Rate ten times since August 2021, from 0.50 to 3.50 percent, to tame the rapid and broad-based increase in inflation. Despite a sharp rise in risk aversion and heightened market volatility, the external sector, supported by ample foreign reserves, has been resilient.

The budget for 2023 and the National Fiscal Management Plan (NFMP) 2022–2026 envisage a shift in fiscal policy stance from expansionary to consolidation. The fiscal deficit, excluding social security funds (SSFs), is budgeted to decline sharply to 2.6 percent of GDP in 2023, mainly due to the spending cut by 6.0 percent. Over the medium term, the NFMP 2022–2026 aims to maintain the fiscal deficit, excluding SSFs, at mid-2 percent of GDP and the government debt at below mid-50 percent of GDP.

Risks, vulnerabilities, and challenges

Risks to the economic outlook are significant. Short-term risks include renewed commodity price hikes, increase in supply chain disruptions, more aggressive policy rate hikes by the Fed, a sharper economic slowdown in advanced economies, and a weaker-than-expected recovery in China.

Over the medium term, although household and corporate debts are generally sound, a rising interest burden and a weaker economy could lead to distress for vulnerable families and businesses. Vulnerabilities could also arise among some land developers and small securities companies. In the long term, rapid population aging will aggravate the fiscal burden and weigh on the economic potential.

Policy recommendations

As headwinds have mounted and uncertainties remain elevated, the authorities need to be ready to recalibrate the monetary and fiscal policy stance flexibly and prudently to contain inflation, support growth, and preserve financial stability.

Expediting fiscal consolidation is warranted and should be supported by an effective and credible fiscal rule. The government should continue to provide targeted support for vulnerable sectors and groups affected by high inflation and strengthen social safety nets which serve as automatic stabilizers. Once the growth momentum is back on track, it would be prudent to reduce the primary deficit target to a level that will at least stabilize the debt-to-GDP ratio in the medium term, to provide fiscal buffers for future shocks.

The current restrictive monetary policy stance is appropriate as inflation is expected to remain above the BOK’s target for some time. However, the BOK needs to consider the economic downside risks and financial stability risks and be ready to recalibrate policy to support the economy.

Banks should maintain their capital and liquidity buffers at the current high levels, while riskier non-bank financial institutions should strengthen their financial buffers. Concerted efforts by government agencies and private financial institutions have stabilized investor sentiment in the aftermath of the default of the Legoland developer in Korea, thus averting a liquidity crunch.

The authorities should continue to pursue structural reforms and bolster economic potential by developing and promoting digital technology to enhance productivity, and implementing their commitment to reducing carbon emissions while managing the adverse impact during the transition.

About AMRO

The ASEAN+3 Macroeconomic Research Office (AMRO) is an international organization established to contribute towards securing macroeconomic and financial stability of the ASEAN+3 region, comprising 10 members of the Association of Southeast Asian Nations (ASEAN) and China; Hong Kong, China; Japan; and Korea. AMRO’s mandate is to conduct macroeconomic surveillance, support the implementation of the regional financial arrangement, the Chiang Mai Initiative Multilateralisation (CMIM), and provide technical assistance to the members.

About AMRO’s Annual Consultation Report

The Annual Consultation Report was prepared in fulfillment of AMRO’s mandate. AMRO is committed to monitoring, analyzing and reporting to its members on their macroeconomic status and financial soundness. AMRO also helps identify relevant risks and vulnerabilities, and assists members, if requested, in the timely formulation of policy recommendations to mitigate such risks.