This report consists of two independent and interrelated studies pertaining to the debt of state-owned enterprises (SOE).

Chapter 1 analyzes the impact of SOE debt on the financial soundness of the government. First of all, we review the current status of public sector debt by examining data and previous studies on various categories such as local government, public institutions (including SOEs), financial institutions, etc. The results reveal that Korea’s relative size of non-financial SOE debt to GDP is much higher than that of major foreign countries, and the ratio of SOE debt to sovereign debt is also very high, indicating that the role of SOEs in Korea’s public sector is significant. On the other hand, we conclude that regulations on the financial status of SOEs is relatively insufficient. Therefore, the regulating system needs to be improved for future public debt management and control of public institutions.

Based on these findings, we develop a general equilibrium model that explicitly considers SOE debt for analyzing its effects on fiscal soundness and the macroeconomy. The results vary depending on whether the debt growth of SOEs is a temporary shock or is accompanied by the economic inefficiency of SOEs. If the debt shock is merely temporary while the efficiency of SOEs is maintained, the fiscal sustainability is hardly affected. Government subsidies increase slightly, but it has little impact on the economy's fiscal soundness and macroeconomic variables. However, if both debt growth and economic inefficiency occur simultaneously, it can shrink the economy’s fiscal space and reduce private consumption and the growth rate, thereby worsening social welfare. Accordingly, it is necessary to improve management and supervision functions on debt growth and efficiency of SOEs to the extent of the regulations on the debt of central and local governments.

Taking into consideration the distinctive traits of public enterprises, Chapter 2 (Should this be Chapter 2) analyzes the problem of 'moral hazard' (in terms of economically inefficient behavior rather than illegal action) arising from the government's tacit guarantees on their debt. In general, Korean public enterprises become financially indebted through the issuance of bonds. These bonds are recognized as safe assets in the market because participants share a strong but implicit belief that when a debt defaults, the government will repay it on their behalf. In the banking sector, it has become a well-known fact since the global financial crisis that moral hazard occurs when the discrepancy between management fundamentals and funding conditions widens. However, unlike banks, public enterprises’ decisions on large-scale investments are determined not by their management executives but by the government, meaning that moral hazards may differ.

Chapter 2 examines the effect of moral hazard in implicit guarantees, using a theoretical model that takes into account situations in which the government assigns policy projects to public enterprises for operation. The analysis shows that implicit guarantees by the government on public enterprise-issued bonds incur moral hazard not only for the public enterprises themselves, but also for the government―which, in turn, boomerangs back to the public enterprises as a larger moral hazard. Once a policy project is assigned, the employees of the public enterprise are guaranteed a salary under the payment guarantee (salary guarantee effect), even when they fail. There is even less incentive to work harder as public enterprises can issue bonds at an interest rate similar to that of government bonds (low cost financing effect) without making any special efforts towards the success of the project.

Additionally, the government will be unable to meet the participation constraints of employees in public enterprises if it ignores profitability when assigning projects in order to maximize political interests. However, with implicit guarantees, the aforementioned effects of a basic salary guarantee and low-rate procurement serve to increase the utility of employees and, thereby, relax the participation constraints, resultantly making it easier for the government to force public enterprises to take on political-oriented policy projects―this is a moral hazard on the government side. Also, such a ‘forced’ policy project could damage the business environment in public enterprises, thus exacerbate the moral hazard of employees. This double moral hazard may diminish the social welfare of the general public.

Based on the analysis, this study suggests the following policy directions for the government's implicit guarantees. First, guarantees should not be provided in general situations. Second, guarantees should only provided in exceptional cases wherein sufficient funds cannot be raised from the bond market while the project is needed for its considerable social contribution.

Preface
Executive Summary

Chapter 1 Public Sector Debt and Fiscal Soundness in Korea (Jinwook Hur)
　Section 1 Introduction
　Section 2 Importance of Fiscal Soundness and State-Owned Enterprises (SOE) Debt Management
　Section 3 Literature Review
　Section 4 General Equilibrium Model Analysis
　Section 5 Conclusion and Policy Implications
　References
　Appendix

Chapter 2 Government Guarantees for SOEs and the Issue of Double Moral Hazard (Sunjoo Hwang)
　Section 1 Introduction
　Section 2 Case Study on Fiscal Soundness and Policy Project Implementation
　Section 3 Theoretical Model: Implicit Guarantees and Moral Hazard
　Section 4 Extensions
　Section 5 Conclusion
　References
　Appendix

ABSTRACT