IV The Years of Recovery (1981-82)
At the outset of 1981, the economic environment
was characterized by relatively high unemployment,
high levels of inventories, and excess capacity. The
Government continued with its adjustment effort dur-
ing 1981-82, but relaxed financial policies to counter
the severe economic recession. Economic conditions
improved significantly during this period as output
rose by an annual average of about 6 percent, while
the rate of inflation fell gradually to below 5 percent
and the current account deficit to below 4 percent of
GNP. Nevertheless, the adjustment process was by
no means completed by the end of 1982. The economy
still operated well below full capacity and the external
financing requirements remained large—a particularly
serious problem in light of the emerging international
debt crisis.
Policies
The adjustment program for 1981-82 was designed
to restore economic growth, while reducing domestic
inflation and the external imbalance. This program
continued to be supported with a stand-by arrangement
with the Fund (March 1981-February 1982) and a
structural adjustment loan from the World Bank. The
authorities adopted a more stimulative financial policy
to revive the economy. The public sector deficit rose
to over 4 percent of GNP, while domestic credit
expansion slowed only moderately despite a sharp
decline in inflation. Exchange rate policy was managed
flexibly, although the real effective exchange rate
appreciated somewhat and contributed to a weakening
of exports. The Government's structural policies fo-
cused on the public investment program, tax reform,
and trade liberalization.
Fiscal Policy
Fiscal policy was used to stimulate aggregate demand
in 1981. The budgetary impulse became expansionary
as public sector expenditures were raised and taxes
10
©International Monetary Fund. Not for Redistribution
cut (Table 8).5 Largely as a result of expenditure
increases, the consolidated public sector deficit rose
from 3.2 percent of GNP in 1980 to 4.6 percent in
1981. Increased expenditures resulted from higher
central government spending, greater purchases of rice
by the Grain Management Fund to replenish stocks
used after the 1980 crop failure, and extraordinarily
large capital outlays in telecommunications.
Expenditure policy focused initially on increasing
the tempo of public spending on rural projects so as
to cushion the loss in agricultural incomes. Outlays
for low-income housing and social overhead capital
also were increased, partly to repair typhoon damage.
Thus, the structure of expenditure shifted toward
public capital formation and housing, and much of the
fiscal stimulus was provided through net lending op-
erations. Several temporary tax changes reinforced
these expenditure measures. Income taxes for low-
income workers were cut and special excise duties for
selected consumer durables were reduced. A tempo-
rary investment tax credit was extended, as was the
scheme to encourage additional investment by certain
smaller firms. The larger overall deficit in 1981 resulted
in significant increases in both foreign and domestic
financing. The ratio of domestic financing to GNP rose
from 2.3 percent in 1980 to 3.4 percent in 1981, largely
reflecting an increase in bank financing (Table 7).
With the strengthening of the economy in 1982, fiscal
policy was reined in so as to help correct the external
imbalance and improve the price performance. Faced
with large shortfalls in revenues, central government
expenditure was cut to a level below the budgetary
target—a step which was instrumental in reducing the
public sector deficit to 4.3 percent of GNP.6 Expend-
5
The stance and impulse of fiscal policy have been measured on
the basis of public sector revenues and expenditures, but very
similar qualitative results are obtained on the basis of central
government expenditures and revenues.
6
The removal of the Korea Telecommunications Authority (KTA)
from the public sector accounts in January 1982 also contributed to
the improvement in the public sector position. In 1981, telecom-
munications operations accounted for 0.6 percentage point of the
public sector deficit of 5 percent of GNP. The 1982 public sector
deficit was 4.6 percent of GNP, of which 0.5 percentage point
represented net lending to the KTA. Therefore, of the 0.4 percentage

iture restraint held central government outlays roughly
unchanged as a proportion of GNP (22.5 percent). The
tax to GNP ratio increased marginally as a result of
the positive effects of a new education surtax and the
underlying high elasticity of the tax system. The ratio
of domesticfinancingto GNP declined from 3.4 percent
in 1981 to 3 percent in 1982. Within domestic financing,
bank financing was limited to 0.6 percent of GNP in
1982—compared with 2 percent in 1981—while non-
bankfinancingrose by 1 percentage point to 2.4 percent
of GNP. The ratio of foreign financing to GNP in-
creased slightly to 1.3 percent in 1982.
Monetary Policy
The objective of monetary policy in 1981 was to
support economic growth while securing a reduction
in inflation and further external adjustment. Monetary
policy accommodated increased bank borrowing by
the public sector, which was associated with the
stimulative stance of fiscal policy. Nevertheless, over-
all credit was sufficiently tight to help bring about a
further reduction in domestically generated inflation
and a decline in the current account deficit. The growth
of domestic credit decelerated from 41 percent in 1980
to 31 percent in 1981. Credit to the public sector
accounted for 19 percent of the overall increase in
domestic credit, compared with 8 percent in 1980.
With a substantial decline in net foreign assets, the
growth of broad money slowed from 27 percent to 25
percent. However, as the rate of inflation fell sharply,
the real stock of broad money rose by 12 percent in
1981, compared with a decline of 6 percent in 1980.
The income velocity of money, which had risen in
1980 following three years of steady decline, fell
slightly in 1981 in line with the deceleration in the rate
of inflation. (The close association between the be-
havior of velocity and the real yield on deposits in
Korea is shown in Chart 4.)
Monetary conditions in 1982 were dominated by a
financial scandal in the unorganized money market
(the curb market) in May, which forced two large
corporations into default and threatened other firms
with insolvency. Dishonored checks rose sharply; their
value during May reached almost 8 percent of demand
deposits. Confidence in nonbank financial intermedi-
aries was shaken and the public withdrew large amounts
point reduction in the public sector deficit to GNP in 1982, only 0.1
percentage point was due to telecommunications operations (i.e.,
the deficit without telecommunications was reduced from 4.4 percent
of GNP in 1981 to 4.1 percent in 1982).
©International Monetary Fund. Not for Redistribution
Policies
Table 4. Korea: Selected Monetary Aggregates,
1982
(Percentage change)1
March June September December
Domestic
credit 21.0 31.6 30.0 18.1
Broad money 27.5 41.0 38.3 4.2
Reserve
money 2 -1.2 2.9 45.4 -5.8
Quarterly change at seasonally adjusted annual rates.
Adjusted for increase in reserve requirements.
of funds from nonbank financial markets. As a result,
the ratio of bank deposits to currency rose by 11
percent in May 1982. Lending activities in nonbank
markets were curtailed, creating severe liquidity prob-
lems for enterprises that depended heavily on these
sources of finance.
To offset the contraction in nonbank lending and to
avoid a generalized financial crisis, the Bank of Korea
permitted a rapid expansion of bank credit and sup-
ported this expansion by sharply increasing reserve
money. During the period May-September 1982, do-
mestic credit expanded at an annual rate of 30 percent
(seasonally adjusted); and reserve money grew at an
annual rate of 48 percent (adjusted for seasonal factors
and a change in reserve requirements). As the turmoil
in financial markets subsided in the fourth quarter of
1982, expansion of domestic credit slowed to an annual
rate of 18 percent (Table 4).
Reflecting the less expansionary fiscal policy in 1982,
credit to the public sector accounted for only 8 percent
of the total increase in domestic credit, compared with
19 percent in 1981. The reduced borrowing require-
ments of the public sector in 1982 considerably eased
the burden of reserve money management. In 1982,
about 50 percent of the credit needs of the public
sector was satisfied by the Bank of Korea in 1982,
compared with about 85 percent in 1981. Credit to the
private sector in 1982 grew at virtually the same rate
as in 1981 (about 25 percent). The growth of broad
money also accelerated in the second and third quar-
ters, but slowed to 4 percent (annual rate) in the fourth
quarter because of the sharp slowdown in the growth
of net domestic assets, the large balance of payments
deficit, and some reflow of funds to nonbank financial
markets. For 1982 alone, broad money rose by 27
percent—slightly faster than the average rate of ex-
pansion for the period 1980-81. Income velocity of
broad money fell by about 11 percent (compared with
an average annual decline of about 3 percent during
1978-81), reflecting the increase in bank deposits after
11
IV • THE YEARS OF RECOVERY
the curb market incident,7 higher real interest rates,
and lower inflationary expectations (Table 5).
Bank interest rates, which are under government
control, were reduced during 1981-82, but these re-
ductions were held to less than the decline in inflation
so that real interest rates would become positive. The
nominal interest rate on one-year time deposits was
gradually reduced from 19.5 percent in early 1981 to
8 percent in the second half of 1982. After the sharp
drop in inflation in 1981, real interest rates turned
positive in the fourth quarter of 1981 and remained
positive throughout 1982, averaging about 3 percent.
Lending rates, which ranged from 12 percent to 17.5
percent in early 1981, were also reduced gradually to
a uniform rate of 10 percent in mid-1982. The adjust-
ment of interest rates was aimed at spurring investment
by lowering interest costs of firms, while still main-
taining a positive level of real interest rates. The
lowering of domestic interest rates was faster and
sharper than the decline in international interest rates,
and a differential was opened in favor of foreign assets
in 1982. This differential narrowed late in the year as
foreign rates declined.
Preferential interest rates for priority sectors were
eliminated in 1982, but directed loans remained an
important feature of Korea's financial system. A sub-
stantial part of directed lending continued to be chan-
neled through the deposit money banks as well as the
Korea Development Bank and other development
institutions. In carrying out directed lending activity,
banks either use their own funds, supported by redis-
counting of eligible bills by the Bank of Korea, or act
as a conduit for government lending funds. As part of
an effort to improve the allocation of financial re-
sources, the authorities reduced the share of directed
loans in total loans from 20 percent in 1980 to 16
percent in 1982.
The monetary authorities, in early 1982, changed
the instruments by which they conduct monetary
policy. The Bank of Korea replaced direct credit
control, exercised through ceilings on individual banks,
with indirect control exercised through the instruments
of reserve requirements, open market operations, and
the rediscount mechanism. The system of preferential
lending rates of commercial banks was eliminated in
June 1982, and the rediscount rates of the Bank of
Korea were unified. In addition, to permit banks more
flexibility in their lending operations, the maximum
loan period for working funds was extended from one
year to ten years.
7
An econometric analysis indicates that there was an upward
shift in the demand for broad money following the curb market
incident. Aside from this shift, the demand function remained a
stable function of real income, interest rates, and expected inflation.
12
©International Monetary Fund. Not for Redistribution
Table 5. Korea: Velocity of Money, 1978-82
(Percentage change)
Period averages 1978 1979 1980 1981 1982
Nominal GNP 34.6 26.9 18.1 23.5 13.8
Broad money 39.3 26.8 25.8 27.4 28.1
Velocity -3.4 — -6.1 -3.1 -11.1
Sources: Korean authorities; and Fund staff estimates.
Exchange Rate Policy
The authorities pursued a flexible exchange rate
policy during 1981-82 to preserve the external com-
petitiveness of Korean producers. The effective ex-
change rate remained relatively stable as the won was
allowed to depreciate by about 13 percent against the
U.S. dollar. However, because domestic inflation ex-
ceeded foreign inflation, the real effective exchange
rate appreciated by about 6 percent, contributing to
the weak performance of exports in 1982.
Structural Policies
During 1981-82, structural policies were aimed at
increasing the productivity and efficiency of the econ-
omy. These policies encompassed public sector in-
vestment, a comprehensive tax reform, and trade
liberalization. The investment program was designed
to support an increasingly urban and industrial econ-
omy. An important objective of the investment plan
was to reduce dependency on imported petroleum by
expanding domestic coal production and constructing
electricity-generating plants powered by coal, liquefied
natural gas, and nuclear fuel. To reinforce energy
conservation, the Government passed through to do-
mestic consumers only 30 percent of the $5 per barrel
reduction in world oil prices in 1982. About 40 percent
of the savings from the decline in world oil prices were
earmarked for a special multipurpose fund to finance
projects primarily in the energy sector. The remainder
of the savings was absorbed by an import duty. Because
basic needs for clothing and food had been largely
met, housing became the centerpiece of the Govern-
ment's social development efforts. Housing construc-
tion was promoted by a combination of financial
incentives to private investors and direct public sector
investment.
Significant reforms of the tax system were introduced
in 1981 as part of the overall policy of structural
adjustment. These reforms included an increase in the
separate tax for interest and dividend income, a sim-
plification of the corporate tax structure, and an ex-

tension of the value-added tax. The 1982 tax changes
were more sweeping and were aimed at both making
the system more neutral with respect to resource
allocation and increasing the tax effort. The new tax
measures changed the tax status of corporations,
modified certain deductions and tax incentives to favor
small- and medium-size firms, introduced tax credits
to promote development of technology, reduced the
number of industries that received tax advantages, and
introduced a minimum tax on public corporations. In
addition, individual income tax rates were reduced,
and deductions for wage and salary earners and spouses
were increased. The implementation of these measures
was facilitated by the high elasticity of the taxes with
respect to GNP (about 1.2), which ensured that ade-
quate revenues were available for financing the Gov-
ernment's development effort.
With the improved economic situation during
1981-82, the import liberalization drive was resumed
following its lapse during the previous two years. This
drive was aimed at improving the structure of industry
by enhancing competition, stabilizing prices by in-
creasing supplies, and facilitating trade negotiations
with trading partners which restricted imports from
Korea. At the same time, to avoid major disruptions
in domestic production, selective use was made of
import tariffs. Import restrictions were lifted on a large
number of items during 1981-82, raising the ratio of
unrestricted imports to total from 69 percent to 77
percent.
Economic Developments
Economic growth resumed in 1981, as real GNP
rose by 6 percent. The recovery of agriculture and
rapid expansion of exports dominated developments
in aggregate output during 1981. Following the disas-
trous harvest of 1980, agricultural production rose by
22 percent in 1981, returning to the 1979 level. The
volume of exports rose by 17 percent in response to
both the devaluation of the won in 1980 and buoyant
foreign markets. Domestic demand revived on the
basis of an upturn in consumption and stimulative
financial policies, but accounted for only one third of
the overall growth in aggregate demand. Investment
remained weak. Fixed investment in real terms de-
clined for the second consecutive year, owing to the
still fragile business confidence, depressed profits, and
persistence of excess capacity, particularly in the
heavy industry sector. Shipbuilding, automobiles, fer-
tilizer, and cement industries were particularly af-
fected. The recovery of aggregate demand and the
shortage of grain supplies (arising from the crop failure
of 1980) led to an increase of 6 percent in the volume
of non-oil imports. The volume of oil imports, on the
©International Monetary Fund. Not for Redistribution
Economic Developments
other hand, fell by 2 percent as a result of strong
conservation and oil-substitution efforts.
During 1982, external demand weakened consider-
ably as traditional export industries—textiles, shoes,
wood, paper—suffered under the impact of the global
recession and restrictive trade policies in the industrial
countries, as well as some loss of external competi-
tiveness. Nevertheless, the growth of real GNP re-
mained at about 6 percent as domestic demand con-
tinued to expand in response to stimulative financial
policies. Fixed capital formation grew in real terms
(by 13 percent) for the first time since 1979. The major
factors contributing to this outcome were: (a) faster
growth in the nonagriculture sector; (b) a cut in
domestic interest rates; and (c) a decline in prices of
imported raw materials and oil. Also, a brisk recovery
in construction activity began in early 1982 because
of government efforts to stimulate housing. These
efforts included lowering the capital gains tax on
houses, increasing the supply of housing sites, con-
structing low-income housing units, and expanding
housing loans. Consumption continued to rise by about
4 percent in real terms as an acceleration in public
consumption offset a slowdown in private consump-
tion. With the return of agricultural output to normal
levels, food grain imports were drastically reduced.
The volume of non-oil imports rose by 6 percent, while
the volume of oil imports declined by 1 percent,
reflecting continued success of energy conservation
policies.
Domestic inflation fell from a peak of 35 percent in
1980, to 13 percent in 1981, and 5 percent in 1982. The
principal reasons for this fall were lower inflation
abroad and a stable effective exchange rate. Prudent
demand management, improved food supplies, wage
moderation, and productivity gains also contributed
to lower inflation. Price controls were eliminated in
1981 and replaced by a price monitoring system under
which selected enterprises are required to report price
increases to the Government.
With the decline in inflation, the growth of nominal
wages decelerated from 23 percent in 1980, to 20
percent in 1981, and 15 percent in 1982. Real wages
actually fell by 1 percent in 1981, while labor produc-
tivity increased by 18 percent. The unusually large
growth of labor productivity reflected the fact that in
the initial phase of economic recovery, firms increased
production mainly by lowering excess capacity, rather
than by increasing employment. The unemployment
rate declined moderately from 5.4 percent in 1980 to
4.5 percent in 1981 because of a rapid increase in
employment in services and in agriculture. Employ-
ment in manufacturing, however, continued to decline
because of excess capacity. Real wages rose by 7
percent in 1982, about the same as labor productivity.
13
IV • THE YEARS OF RECOVERY
The unemployment rate fell slightly in 1982, reflecting
a more rapid expansion of nonagricultural output and
a rise in domestic investment; manufacturing employ-
ment rose significantly.
The external position improved steadily during
1981-82. The current account deficit declined to
$4.6 billion (6.9 percent of GNP) in 1981, as the
vigorous expansion of exports (20 percent) more than
offset the increase in imports (12 percent), the contin-
ued growth in interest payments, and a small deteri-
oration in the external terms of trade. The moderate
growth of imports represented a significant adjustment
effort in view of the exceptionally large rice imports
(equivalent to 1 percent of GNP) that were necessitated
by the 1980 crop failure. In 1982, the current account
deficit was almost halved to $2.6 billion (3.7 percent
of GNP), despite stagnating exports. The main factors
contributing to the improvement in the current account
were a sharp decline in import prices (8 percent) and
a further slowing of the volume growth of imports.
The narrowing of the current account imbalance during
1981-82 reflected a gradual decline in the ratio of gross
domestic investment to GNP. The ratio of gross
national savings to GNP remained relatively stable.
With the gradual decline in external financing re-
quirements, the growth in Korea's external debt, which
had averaged about 35 percent per annum during
1979-80, slowed to about 16 percent during 1981-82.
Nevertheless, outstanding external debt rose by close
to $10 billion, reaching $37 billion (52 percent of GNP)
at the end of 1982; the associated debt service ratio
rose from 20 percent to 21 percent. Short-term debt
rose by 15 percent per annum during 1980-82; its share
in total debt remained at around 34 percent. A large
portion of the increase in short-term debt was trade-
related, including such obligations as trade credit and
oil bills. Reflecting the elimination of advance deposits
on deferred-payment imports, the share of trade-
related credit in total short-term debt rose from 30
percent in 1980 to 38 percent in 1982. A significant
portion of the increase in short-term debt was in the
14
©International Monetary Fund. Not for Redistribution
form of interoffice accounts of local branches of foreign
banks and credit lines of domestic banks with
foreign banks. This development reflected both re-
duced nonbank capital inflows due to lower domestic
interest rates and limited availability of medium- and
long-term loans during 1982, as Korea's access to the
international capital market was hindered by the global
debt crisis. Gross international reserves rose by about
$0.8 billion and stood at $7.7 billion by the end of
1982; in terms of imports, gross reserves remained
stable at around 2.9 months. The ratio of reserves to
short-term debt declined from 73 percent in 1980 to 58
percent in 1982.
Situation at the End of 1982
By the end of 1982, the Korean economy had made
substantial headway in overcoming the economic crisis
of 1980. The progress in reducing the rate of inflation
and the current account deficit was particularly note-
worthy. Korea's growth outcome of about 6 percent
a year was satisfactory in comparison with the growth
rates in other developing countries, but fell well below
Korea's historical performance. The gradual weak-
ening of the export sector was of particular concern
in view of Korea's large external debt and the emerging
crisis in the international capital market.
Notwithstanding the significant reduction in the
current account deficit, Korea's borrowing during
1980-82 was substantial. Although Korea's debt-
servicing obligations remained consistent with its ca-
pacity to earn foreign exchange, the level of its out-
standing debt was high in an international context.
Commercial banks became increasingly reluctant to
raise their exposure limits, mainly because of the
fallout from the financial crisis in Latin America as
well as in Asia. In this environment, the high level of
short-term debt, particularly in relation to international
reserves, became an increasing source of concern.