August 18, 2014

The government’s new economic team announced a breakthrough stimulus package on 24 July in an effort to address the slowdown in the South Korean economy. President Park Geun-hye’s aim is that the team, led by Head of the Ministry of Strategy and Finance (MOSF) Choi Kyoung-hwan, can revive the tempered economy. Economic growth decelerated in the second quarter of the year and more recent data indicate that the economy is still losing momentum. The Sewol-ho ferry disaster in mid-April accentuated the weakness; businesses and consumers cut spending as they mourned the accident, which has negatively impacted private consumption. Moreover, although exports have been rising, growth is moderate, mainly due to the strong appreciation of the Korean won. Against this backdrop, Choi Kyoung-hwan’s economic policy is focused mainly on stimulating domestic demand.



The stimulus entails three components: macro easing in fiscal, financial and exchange rate policies; a boost to the housing market; and encouraging firms to spend cash on investments and wages. The fiscal and financial package totals KRW 40.7 trillion (USD 40 billion) or nearly 3.0% of GDP and breaks down into KRW 11.7 trillion for additional fiscal spending and KRW 29.0 trillion to provide financial support mostly to small- and medium-sized businesses. The measures are expected to be implemented as early as August and to continue into 2015. Regarding exchange rates, the measures underline the importance of stability in the currency market in the wake of swift changes in other economies’ monetary policies, particularly in developed economies. The measures include the relaxation of regulations for outbound financial flows, the creation of a new Korean won and Chinese renminbi market, as well as the tightening of macroprudential measures.



In an effort to boost the housing market, the government has introduced measures that relax rules on mortgage lending, thus allowing for higher debt-to-income and loan-to-property value ratios. Although these adjustments are expected to improve the state of the housing market, they are likely to increase pressure on ballooning household debt, which has already reached over KRW 1,000 trillion in 2013 (USD 998 billion). This measure took effect on 1 August.



Meanwhile, investors are especially interested in the changes the government will implement to encourage businesses to spend more of their cash on investments and wages. President Park Geun-hye’s administration plans to overhaul the tax code in the form of tax benefits to encourage businesses to increase wages; a new tax on corporate cash holdings in order to incentivize corporations to deploy savings for investments, dividends and wage hikes; and a tax cut on revenues from dividends. The proposed new tax system is imposed upon large corporations and conglomerates, whose wage growth, dividends and investments fall short of a 60–80% share of net profits. The exact amount of the share, however, may change. The government will submit the new tax scheme to the National Assembly on 23 September and the revised scheme is expected to become effective on 1 January 2015. Young Sun Kwon, analyst for Nomura, commented:



We expect the National Assembly to pass these tax revision bills with minor modifications given the ruling party possesses a majority and the opposition party seems to agree with the rationale for these tax revisions. Any economic impact should occur more in 2015 than 2H 2014, depending on the behavioural changes of corporate and household sectors. That said, the success of the stimulus measures (including new tax scheme) hinges on whether economic agents change their behaviours (i.e., deep parameters). For example, if firms and households believe that making use of the new tax scheme (e.g., increasing wages and dividends) will improve their utility or welfare, they would do so and the new tax scheme would work. However, if economic agents are not swayed by the stimulus measures (including the new tax scheme) or feel the government might at some point in the future deviate from its currently announced policies, the government might lose its credibility.



The government hopes that the stimulus package will boost economic growth by 0.1 percentage points this year and by another 0.1 percentage points in 2015. Currently, the government expects the economy to expand 3.7% this year and 4.0% in 2015. However, as fiscal expenditure will be large, the upsurge in government disbursements may put the plan to balance the budget in 2017 at risk. Moreover, the entire economic impact of the stimulus remains uncertain.