Growth has strengthened after a soft patch, largely reflecting the fortunes of semiconductor exports. Monetary policy loosening is on the horizon, while fiscal restraint is needed to prepare for ageing.

Trade is a key driver of growth but creates dependencies. Exports, of semiconductors in particular, have accounted for much of the cyclical ups and downs since the exit from the COVID-19 crisis, with GDP growth projected to recover to 2.6% in 2024 and 2.2% in 2025. Trade tensions between Korea’s main trading partners, the United States and China, are felt but with limited economic fallout so far. High supply chain dependencies on individual countries for some critical inputs are key risks to hedge.

Private consumption has been weak, pulled down by high interest rates and weak real wage growth but shored up by strong employment and pandemic-era excess savings. With disinflation, interest rates having peaked and housing prices stabilising, consumption is expected to gradually pick up going forward.

The government has started to consolidate public finances, after fiscal policy supported demand and reduced poverty during the pandemic. A proposed fiscal rule can help meet spending pressures from rapid ageing, while a tax revenue shortfall in 2023 points to room for improving fiscal and debt management frameworks.

Inflation expectations have remained well anchored. The policy rate has been kept at 3.5% since early 2023 after a cumulative tightening of 3 percentage points. Inflation has trended down since July 2022, and is in the process of reverting to target (Figure 1).

A weak property market caused financial turbulence. Housing prices fell around 9% in nominal terms during the year to June 2023, after which they stabilised. Macroprudential easing and policy lending contributed to nominal stabilisation, and macroprudential regulations have limited the risk of widespread defaults on household debt. The combination of tight financial conditions and a weak property market has uncovered vulnerabilities in non-bank financial institutions, centred on construction project finance, but systemic risk remains low.

Productivity growth has declined in Korea, reflecting the global trend and less scope for catch-up growth as Korea has reached the OECD average per capita GDP. Past GDP growth resulted largely from increasing employment and heavily investing in capital and education. Going forward, considerable scope remains to raise SME productivity towards that of large companies by means of pro-competition reforms levelling the playing field in the domestic market.

A “red light” reform to consolidate state support could help break a vicious cycle. Central government spending on SME subsidies is high and increasing. A total of 1646 programmes were in place in 2023 to support SMEs, 530 run by 18 ministries and central government agencies and 1116 by the 17 regions (Figure 2). SMEs also enjoy special treatment in public procurement, lower taxes, size thresholds in regulations and other benefits. Consolidation of support and protection in various forms could reduce the risk that these policies lock resources in low-productive uses and thereby hold back overall productivity.

A “green light” reform removing regulatory hurdles could foster private enterprise. Korea has streamlined regulations over time, and overall product market regulations are around the OECD average. Greater foreign competition could be particularly beneficial in domestic markets requiring scale to compete, such as those dominated by the large Korean conglomerates and network sectors. Competition reforms in sectors with heavy state involvement would help provide services more cost-effectively and correct relative price distortions, notably for electricity and rail. Korea has a well-developed system of regulatory sandboxes and “Regulation free zones” which allow trialling new technologies and business models. Many projects are coming to the end of their sandbox period which makes it a priority to speed up the related regulatory overhaul.

Korea has pledged to reduce greenhouse gas emissions by 40% in 2030 and become carbon neutral in 2050 (Figure 3). Proper calibration of allocations to Korea’s emissions trading scheme can ensure that the targets are reached.

Emissions peaked in 2018 and the policy framework is moving forward. Approximately three quarters of Korea’s greenhouse gas emissions are capped by the emissions trading scheme. Setting its 2026-30 emissions limit in line with the 2030 target is necessary to inspire confidence in Korea’s overall target achievement.

Korea’s economy is very energy intensive. Decarbonising sectors such as petrochemicals, iron and steel will require additional clean electricity and energy savings. In the current system, the carbon price from the emissions trading scheme is not fully reflected in electricity generation. The government has raised electricity prices considerably to better reflect the true cost of energy, but they remain regulated and vary across categories of end users.

Koreans support action on climate, but concrete policy instruments are unpopular. Support for necessary but unpopular policies could be built by means of dialogue, place-based measures and by bundling climate policy with policies supporting structural change, reducing inequalities and boosting incomes.

The Korean fertility rate has fallen to the lowest in the world (Figure 4). As a result, the population is set to halve over the next six decades and the old-age dependency ratio is projected to surge rapidly, putting considerable strain on labour supply and public finances. Supporting people to have the number of children they desire would dampen the projected population decline, while lengthening working lives and welcoming more foreign workers would counteract the adverse effects of ageing.

Improving the work-life balance could help reverse the decline in the fertility rate while boosting female employment. Spending on childcare has significantly increased, but the current childcare system does not fully meet the needs of working parents, partly reflecting scarcity of quality childcare and short opening hours. Despite improvements, Korean parents underutilise paid parental leave due to stringent eligibility criteria, low benefits, and a fear of adverse career consequences reflecting the cost on employers.

The weak financial position of youth holds back family formation. Addressing labour market dualism by a combination of streamlining employment protection and strengthening social insurance would help. Alleviating the burden of high housing cost and reducing the need to pay for expensive private tutoring would also strengthen the economic position of parents.

Korea must prepare for and adapt to the inevitable challenges of ageing. The old-age dependency ratio will surge even more than elsewhere (Figure 5). Combined reforms to increase immigration, employment and fertility can dampen a dramatic increase in the number of elderly to be supported by each person employed.

Careers are shortened by the seniority-based wage system which renders older workers less appealing to firms when the wage rises above productivity. Company-specific mandatory retirement ages below the legal pension age and the practice to encourage older employees to voluntarily leave even before reaching this mandatory retirement age also contribute to premature retirements from their main job.

The potential to increase immigration and make better use of foreign labour is considerable. Current low-skill work immigration policies allow low-productivity firms to overly rely on migrant workers on temporary work visas and making these workers dependent on their employers. Meanwhile, high-skill immigration is held back by various visa hurdles. Foreign students find it difficult to stay after graduation and start-up visa issuance remains low, despite growing interest.