KDI

Ⅰ. Current Economic Conditions

□	The Korean economy is recovering modestly, with its momentum diminished in Q3 on the resurgence of COVID-19 and global supply chain disruptions.

• The seasonally adjusted GDP grew at a slower pace of 0.3% (QoQ) in Q3, moving slightly further away from the existing growth path.

□	The recovery in exports and investment has been limited by the weakening global recovery, rising raw material prices, and logistics disruptions, but private consumption is showing a recovery trend, centering on the face-to-face service industry after September.

• Exports posted reduced growth led by goods on receding exports of automobiles in a global parts shortage, despite the sharp increase in semiconductor exports.
• Equipment investment growth is decelerating, mainly in transport equipment, owing to the lack of automobile production capacity, while construction investment remains stagnant on soaring construction expenses.
• Private consumption slid in Q3 as quarantine rules tightened, but due to increasing vaccination uptakes since September, resuming economic activities, and improving consumer sentiments, private consumption is signaling recovery.
• Employment is picking up led by the service industry as the face-to-face service industry rebounded in September.
• Headline inflation stood above the 2% level, but this high inflation phase will not last long given the current level of core inflation and inflation expectations.

□	Given the overall external and internal economic conditions, the Korean economy is projected to recover led by the service industry, notwithstanding expanding external risks in the manufacturing industry.

• The manufacturing industry has led the economic recovery since the onset of the COVID-19 crisis. But, its momentum may be challenged for the time being as the global supply chains continue to struggle.
• However, private consumption will likely make a quick rebound led by the face-to-face service industry as the COVID-19 measures shift to 'phased return to normal life' backed by broad vaccine uptake.

□	In the short term, coronavirus contingency policies under implementation need a gradual normalization, considering the Korean economy is rebounding out of the pandemic.

• The fiscal policy needs to slowly downsize stimulus programs and concentrate more on the vulnerable hit hard by the crisis.
• Both monetary and financial policies need to gradually adjust the accommodative stance to reduce the financial instability brought by mounting debts in the private sector.
• However, since a rapid rate hike may dampen the upward trend and the financial market is at risk of confusion when tightening the rules on household loans without sufficient prior notice on the way forward, the pace of policy normalization needs fine-tuning.

□	In the mid- to long-term, policy reform must continue to heal the losses and trauma from the pandemic and smoothly adapt to the emerging economic and social environment after COVID-19.

• Policy efforts should focus on enhancing social inclusiveness, given the probable deepening of inequality and polarization among economic agents during the crisis.
• Additional programs are needed to support further adaptation to the economic transformation caused by the COVID-19 crisis.

Ⅱ. Domestic Economic Outlook for 2020-2021

1. Expected External Conditions

□	The global economy is assumed to continue recovery in 2022 but at a slower growth pace compared to 2022.

• The IMF projected that the global economy will grow 4.9% in 2022, maintaining the positive momentum seen in 2021 (5.9%).

□	Crude oil prices (Dubai) are assumed to mark around $70 per barrel in 2022, similar to 2021.

□	The Korean won, in terms of the real effective exchange rate, is assumed to depreciate by about mid-2% in 2022.

2. Outlook for Domestic Economic Activity

□	The Korean economy is projected to grow 4.0% in 2021, led by exports and equipment investment, and 3.0% in 2022 as the recovery in private consumption continues on full steam.

• Private consumption will likely exhibit a steady recovery, mainly in services, thanks to the vaccine supply.
• Equipment investment is expected to sustain solid growth owing to the continued favorable conditions in the semiconductor market.
• The contraction in construction investment will likely ease housing construction and mark a reversal to up.
• Exports are expected to see a gradual decline in the rapid increase in goods exports but a fast recovery in services exports as the pace of global recovery moderates.

□	The current account surplus is projected to recede in 2022 from the previous year as amid the terms of trade deteriorating, the import demand increases on the recovery in domestic demand.

□	Headline inflation is projected to mark 1.7% in 2022, down from 2021 (2.3%), as the effect of rising oil and raw material prices wanes gradually after mid-2022.

□	The number of employed persons is expected to rise about 300,000 as the service industry slowly picks up from a slump.

3. Risks

□	Externally, the Korean economy may face a delayed recovery if the imbalance in raw material supply and demand and the logistics disruptions prolong, or if the global economy slows down led by China..

• If global supply chains strain and soaring raw material prices continue to delay the production process even after the second half of 2022, it will weigh down on exports and equipment investment, leading to a slowdown led by manufacturing.
• If the recent supply shortage challenges, including urea water, are not resolved soon, they will likely exert a significant downward pressure on the overall Korean economy.
• Meanwhile, if the Chinese economy faces more difficulties from power shortage and corporate liquidity crises, this could also have a negative impact on the Korean economy that heavily relies on exports to China.

□	Domestically, the growth path that Korea will face greatly depends on how smoothly it can manage out of the crisis with quarantine measures and economic policy normalization.

• If the plan for a phased return to normal life proves successful and people can move more freely to other countries in the near future, the Korean economy will likely rebound rapidly, mainly in the face-to-face service industry.
• If the market is impacted from rushed decisions regarding a rate hike and tighter financial regulations, this would pose a downward pressure on the economy.

Ⅲ. Policy Recommendations

1. Fiscal Policy

□	The 2022 budget bill remains expansionary, although the stance appears moderate compared to the previous year’s.

• The budget deficit is expected to be slightly reduced but intended to risk a high fiscal deficit to support the economic recovery and have more growth engines.
• It is recommended that considering the continued vaccinations and eased quarantine rules, the fiscal policy for 2022 should focus more on selective support for the affected classes and economic structure transformation than economic stimulus programs.

□	In the mid- to long-term, active efforts must be on containing the rapid increase in national debt so that public finance could properly respond to structural demands.

• The government recently raised its fiscal revenue forecast to reflect the possibility of economic recovery, and accordingly, the fiscal deficit and national debt growth in the mid-term fiscal management plan were slightly revised down.
• However, the steep rise in national debt is expected to continue since the gap between total expenditure and revenue remains wide.
• It is recommended that the government should lay out the plans for fiscal soundness management so as to strengthen the trust in the government's capability for sustainable fiscal management. nbsp;

2. Monetary Policy

□	The monetary policy needs to start normalizing the accommodative stance considering the pace of the economic recovery and rising inflation while managing a steep rate hike not to hamper the recovery trend.

• The economy is forecast to exhibit a gradual acceleration in the inflationary trend as the recovery starts to pick up led by private consumption.
• Accordingly, it is recommended that the accommodative monetary stance adopted in the COVID-19 crisis should be gradually normalized in accordance with inflation.
• However, since the pace of recovery is not robust enough due to the COVID-19 spread and the global supply chain strain, the pace of rate hike needs to be managed in light of potential negatives on the economy.

□	Regarding the recent expansion in inflation driven by supply-side factors, policy response may be required only when the expected inflation rate continues to stay above the target.

• If a temporary inflation spike caused by supply factors is dealt with monetary tightening, the economy may face additional downward pressure.
• Policy efforts should be accelerated to stabilize inflation expectations only if high inflation continues and the mid- to long-term inflation expectations rise above the target.
• The expected inflation rate has so far remained below the target, suggesting that there is no urgent need for policy measures in response to the rising inflation driven by temporary supply-side factors.

3. Financial Policy

□	Given the recent rapid growth of the private sector debt both in size and pace to the point of risking financial instability, policy efforts need to downsize the debt risks.

• Private credit growth recorded 216.2% of GDP in Q1 of 2021, higher than the average of advanced countries (179.9%) and the G20 (174.9%).
• The private credit has risen by 18.5%p in recent years, compared to the long-term trend, and according to the Bank for International Settlements (BIS), if the increase relative to the trend in the preceding year is 10%p or more, this can be seen as a 'warning' condition akin to a credit crisis.
• It is recommended that the financial authorities take actions to reduce the risk of household credit growth in order to enhance financial soundness.

□	Instead of reducing total household loans as much and fast as possible, the policy focus should be on a gradual and continuous stabilization of household loans by laying out a mid- to long-term debt management roadmap and strengthening capital regulations.

• The financial authorities recently announced a plan to control the increase in household loans by limiting them to 5-6% in 2021 and 4-5% in 2022, which appear to be much lower than the actual rates. Moreover, the plan was not fully discussed with the public leading to the announcement, raising concern over likely damages to some consumers.
• A reduction in aggregate household debt should be gradually carried out according to the mid- to long-term debt management plan, instead of slashing the debt drastically.
• Instead of imposing direct regulations regarding the aggregate debt, the policy needs to induce financial institutions to adjust their liabilities by strengthening their crisis response capabilities, such as through more loans and additional capital accumulation.

□	As corporate loans may be as risky as household loans, their growth needs to be managed in a rational way while exceptional measures such as interest payment deferral should be normalized.

• Corporate credit is larger than household credit, and it has risen rapidly (10%p of GDP) since the COVID-19 outbreak with poorer credit quality.
• Financial instability may occur in corporate credit, not just in household credit. Accordingly, it is necessary to gradually and consistently reduce the size of the entire private credit through tighter capital regulations while normalizing the relaxed regulatory measures such as interest payment deferral for corporate loans.