KDI

Ⅰ. Current Economic Conditions

□	The Korean economy is continuing a moderate recovery on improving exports despite weak domestic demand resulting from the COVID-19 spread and global supply disruptions.

• It maintains a moderate recovery nearing the existing growth path, even as the seasonally adjusted GDP grew at a slower pace of 0.7% in Q1 than the previous quarter (1.2%).

□	By expenditure item, domestic demand slowed on the rapid spread of COVID-19 and strained global supply chains, but exports continued high growth, led by semiconductors.

• The recovery in private consumption was limited by the coronavirus spread, while equipment and construction investment plunged on lingering instability in global supply for auto parts and construction materials.
• Exports grew fast on continued improvements in semiconductors despite the contraction in automobiles caused by global supply chain disruptions.
• As the supply-side price pressure, coupled with the recovery in domestic demand, rippled through the economy, the expected inflation increased, and headline and core inflation far exceeded the target range.
• Employment remained solid, with huge growth mainly in non-face-to-face businesses and industries closely tied to the government’s job projects.

□	Given the overall internal and external factors at play, the Korean economy is likely to continue a modest recovery led by private consumption despite external risk factors.

• Domestic inflation is under strong upward pressure from persistent high energy and food prices amid deteriorating export and investment from supply chain disruptions and economic slowdown worldwide.
• However, the service industry will fuel a gradual recovery to continue as private consumption returns from suppressed spending during the pandemic.
• After the COVID-19 crisis, Korea is expected to see a gradual slowdown in exports, with private consumption emerging as a new growth engine to bolster the economic recovery.

□	Macroeconomic policy needs to gradually normalize its accommodative stance in light of the pace of recovery and, simultaneously, tame high inflation and ballooning debt.

• Monetary policy should slowly raise the base rate to keep the expected inflation within the target range.
• While retaining policy support for the vulnerable groups, fiscal policy should refrain from stimulus measures considering the recovery pace and high inflation.
• Financial policy needs to prepare for effective risk response while maintaining a tough stance on macro-prudential regulations.

□	New political and economic challenges meet the Korean economy coming out of the COVID-19 crisis, and they require special attention to medium- to long-term structural reform of the economy.

• Korea is confronted with multiple structural problems demanding immediate action, including demographic changes, polarization, global value chain reconstruction, and the climate crisis.
• Since those structural issues involve a conflict of interest between stakeholders, their resolution requires leadership to bring out cooperation and understanding among economic actors.
• At the same time, efforts for international cooperation should continue to work on structural problems facing the globe.

Ⅱ. Domestic Economic Outlook for 2022~2023

1. Assumptions on Internal and External Conditions

□	The global economy is assumed to rapidly decelerate in 2022~2023.

• The IMF recently forecasts global economic growth at a much slower pace of 3.6% in 2022 than 6.1% in 2021 due to the Russia-Ukraine war, and the growth will be moderate(3.6%) in 2023.

□	Crude oil prices (Dubai) will remain high at $105 per barrel in 2022 and slide a little to $92 in 2023.

□	In terms of the real effective exchange rate, the Korean won is assumed to depreciate by about 4% in 2022 and remain little changed in 2023.

□	It is assumed that the second supplementary budget bill currently under discussion will be executed as planned in the government’s draft.

2. Domestic Economic Activity Outlook

□	The Korean economy is forecast to grow 2.8% in 2022 on shrinking investment and rebounding private consumption but 2.3% in 2023 on slower exports.

• Private consumption is expected to maintain a solid recovery in 2023 after rebounding mainly in service consumption in 2022, owing to the lifting of social distancing rules and the effect of financial support.
• Equipment investment is expected to recede in 2022 as the semiconductor-driven surge enters an adjustment phase, followed by moderate growth in 2023.
• Construction investment is expected to contract in 2022 due to rising construction costs, followed by a gradual moderation in 2023 as supply conditions for construction materials improve.
• Exports and imports are expected to slow in growth, mainly in the goods sector, due to worsening external conditions. However, the service sector will improve as the cross-border movement of people gradually restarts.

□	The current account surplus is expected to narrow sharply in 2022 from the previous year due to deteriorating terms of trade amid slowing exports and imports in volume terms. In 2023, it will rebound slightly as service imports will increase significantly despite the terms of trade improving.

□	Headline inflation is expected to rise fast in 2022 led by gradual economic recovery and soaring oil prices and moderate in 2023 as oil prices stabilize.

□	The number of employed persons is expected to increase significantly by about 600,000 in 2022 as face-to-face services are back. The favorable growth will continue into 2023 with a reduced increase to 120,000 due to the base effect.

• The unemployment rate is expected at 3.3% in 2023 after recording 3.1% in 2022, sharply down from the previous year (3.7%).

3. Risks

□	In case raw material supply shortage and global supply chain disruptions drag out long-term, or the Chinese economy takes a nosedive, the Korean

• The unemployment rate is expected at 3.3% in 2023 after recording 3.1% in 2022, sharply down from the previous year (3.7%).

□	economic growth may take a hit, especially on exports.

• Amid the prolonged war in Ukraine, assuming the tension between Russia and the West escalates further, driving up raw material prices with global supply chain disruption extended, it may constrain Korea’s exports and investment to the point of economic contraction, mainly in the manufacturing industry.
• If China extends extreme COVID lockdowns, the Korean economy may be exposed to considerable downside risk, such as export contraction due to waning demand from China and supply disruptions for intermediate goods procured from China.

□	In case the US interest rate hike accelerates and the global economic recovery is limited, especially in emerging countries with weak economic fundamentals, it is likely to have a negative impact on the recovery of the Korean economy.

• Moreover, if the US rate hike leads to pushing up the domestic market interest rate, it may limit the capacity of private consumption and corporate investment.

Ⅲ. Policy Recommendations

1. Fiscal Policy

□	Fiscal policy should gradually normalize the sharp widening of the fiscal deficit and the surge of sovereign debt during the COVID-19 crisis.

• Since the COVID-19 spread is coming under control and the Korean economy is gearing up for recovery, the fiscal stance should gradually move toward normalization from the current expansionary measures.
• The need for fiscal stimulus to support the economy is not strong for the time being, and putting an additional fiscal burden calls for careful consideration and weighing on recent inflation dynamics and fiscal conditions.

□	Compensating damages resulting from COVID-19 measures is unavoidable, but the demand for public spending should dictate government expenditure rather than short-run government revenue fluctuations for fiscal sustainability.

• The second supplementary budget for 2022 contains fiscal expenditure earmarked to compensate for damages to small businesses and reinforce public safety measures, which are of great need.
• Deciding on the size of fiscal spending based on the needs and priorities is desirable in ensuring fiscal sustainability and counter-cyclicality.
• In addition, authorities should improve fiscal soundness and legitimacy of government expenditure by reforming systems for local grants and education subsidies, in which tax revenues determine their budgets.

2. Monetary Policy

□	Monetary policy should gradually increase the base interest rate for stable expected inflation.

• As inflation remains persistently elevated in the overall economy, monetary policy action is needed to stabilize inflation.
• While maintaining the stance to raise the base rate for the time being, flexibility is required to respond effectively to changes in economic and inflation dynamics.

□	Korea’s monetary policy should put more emphasis on domestic inflation and economic conditions as compared to US monetary policy.

• Instead of following suit with aggressive rate hikes in the US, how domestic inflation and economic conditions affect the changing economic landscape, both internal and external, including the impact of US monetary policy, should be considered in managing monetary policy.
• Given its economic fundamentals, a rate hike in a major country is not likely to lead to a massive capital flight in Korea.

3. Financial Policy

□	Since the surge in private loans in the aftermath of COVID-19 can threaten financial instability, financial policy should maintain its tough stance on macro-prudential regulations and prepare for effective risk responses.

• Private debt has shot up since 2020, and domestic banks are expected to relax their lending attitudes from Q2 2022.
• The current trend of rate hikes amid the rapid growth in loan volume suggests higher credit risks in the foreseeable future.
• To avoid a future crisis and secure the capacity to respond, the financial policy needs to gradually tighten the regulations on banks’ financial soundness and to keep a strong debt service ratio (DSR).