Jon Pareliussen

Yoonyoung Yang

The Korean economy relies heavily on goods exports. Korea’s concentration in the manufacture of semiconductors was an important driver of growth as the world invested in home offices and home entertainment equipment during the time of social distancing, leading to growth of 4.6% in 2021. However, global overcapacity in semiconductor supply emerged in 2022. At the same time Russia embarked on a war of aggression against Ukraine. The ensuing energy crisis pushed up inflation across the world, accentuated by post-COVID frictions in global value chains. Relatively low direct reliance on Russia and Ukraine, together with early monetary tightening already from August 2021 dampened the inflation shock in Korea compared to most OECD peers. Nonetheless, inflation, high household debt, increasing interest rates and falling housing prices have held back private consumption after the initial post-pandemic catch-up and continue to do so, even though excess savings and a resilient labour market have prevented an outright contraction of domestic demand (Figure 2.1). Fiscal policy also turned from highly expansionary during and immediately after the pandemic to contractionary in 2023 as pandemic-related spending was discontinued.

The labour market has held up well, with net job creation every month since March 2021 (Figure 2.2, Panel A) and labour underutilisation steadily falling since the start of the pandemic. The employment to population rate (ages 15-64) increased from 66.5% in 2021 to 69.2% in 2023. The unemployment rate hovered around historical lows of around 2.5% during most of 2023 before it edged up to 2.8% in early 2024, and labour force participation expanded to record-high levels (Panel B). Job growth since the start of the pandemic has been concentrated in health care and public services. Employment in the accommodation and restaurants sector is back to its previous level after the pandemic-induced slump. Employment in manufacturing and in construction has hovered around pre-pandemic levels, while employment has fallen in wholesale and retail trade (Panel C). Job quality has improved with a reform capping the work week at 52 hours fully implemented in 2021, and with the share of regular employees on the rise until mid-2023 and stabilising thereafter (Panel D). Nominal wage growth has moderated, particularly in manufacturing, where shrinking bonuses during the tech downcycle have helped alleviate inflationary pressures.

Real GDP growth picked up in spring 2023 following a weak spell in late 2022 and early 2023, mainly driven by exports. Global trade volumes have picked up, semiconductor export volumes and prices are recovering, the sentiment of exporters has bottomed out, the real effective exchange rate has stabilised (Figure 2.3) and the current account is back into solid surplus. The first quarter of 2024 saw a sharp and broad-based acceleration, with real GDP up by 1.3%. While some of the factors driving private consumption and construction investment may have reversed in the second quarter, domestic demand momentum may have reached a turning point. Consumer sentiment has improved, even though the labour market has shown signs of weakening. Inflation continues to trend towards target: after inching above 3% in February and March 2024, headline fell to 2.4% in June, while core continued to decline, reaching 2.2% in June. The Bank of Korea has kept the policy rate at 3.5% since January 2023 after a cumulative tightening of 3 percentage points. Falling real-estate prices have led to some financial stress in construction-related project finance, but incidents so far have been contained (Box 2.2 further down).

Against this background, real GDP growth is projected to strengthen from 1.4% in 2023 to 2.6% in 2024 and 2.2% in 2025. Exports are set to keep improving with robust semiconductor demand. Elevated debt servicing burdens and accumulated inflation will continue to weigh on private consumption and investment in the short term, but domestic demand should strengthen from the second half of 2024. Inflation is on course to gradually moderate and reach the target in late 2024. The policy rate is expected to remain at the current level until late 2024, before being cut gradually to 2.5% by mid-2025. The budget for 2024 rests on an expected increase in tax revenue, which has so far not materialised, and contained expenditure growth. The projected contractionary fiscal stance in 2025 is in line with the government’s consolidation plan (Table 2.1).

There are risks to this growth scenario. Trade restrictions, especially between the United States and China, have already started shaping Korean companies’ value chains, albeit to a limited extent and in an orderly fashion so far. Supply chain dependencies on critical inputs have materialised as shortages occasionally arose but only as individual cases that have been solved with limited consequences, and the government is implementing measures to reduce the risk of shortages of critical inputs, as discussed below. More abrupt decoupling has a low probability but would come at a considerable cost to the Korean economy. Other low-probability risks are related to household debt and real estate. Nominal housing prices fell by about 9% from their post-pandemic peak before stabilising, but could fall further. Related to this, project finance for real estate investments has turned out to be a particularly vulnerable segment of the financial market (see below). A large fall in property prices could expose weaknesses on a larger scale and trigger a loss of confidence with potentially serious consequences depending on the policy response (Table 2.2). Another and longstanding source of tail risk relates to North Korea. North Korea’s economy, North-South cooperation and related risks to South Korea’s economy are discussed in more detail in Annex A.

Korea’s economy depends heavily on goods exports. Exports, notably of semiconductors, drove growth coming out of the COVID-19 crisis, dampened growth in 2023, and are again driving growth in the current juncture. The United States and China are its main export destinations, with exports to the United States surpassing those to China in December 2023 for the first time since 2005, even though China remained the biggest export destination for the full year (Figure 2.4). This shift reflects the relatively weak state of Chinese demand in 2023 and stronger competition from domestic Chinese producers, but it is likely also affected by trade restrictions, since a considerable share of Korean exports to China consists of semiconductors as inputs to Chinese products. China remains the largest country of origin for Korean imports and a key partner in Korean companies’ value chains. Approximately 21% of imported items for the material, parts and equipment industries depended more than 50% on supply from China in 2022, according to the Ministry of Industry, Trade and Energy (MOTIE, 2023a). Korea’s geographical concentration of trade with the United States and China and rising tensions between the two create vulnerabilities, accentuated by the fact that Korea’s trade with China and the United States is to a large extent centred on strategic high-tech sectors.

Supply chains have started to shift in response to geopolitical rivalries and protectionist policies, notably with Korean multinationals investing in new overseas production facilities to diversify their supply chains. However, the pace of change has been moderate and clear negative consequences for Korean firms in aggregate have so far not materialised (Box 2.1). Korea has also experienced an increase in inward direct investment as foreign multinationals seek to diversify their own supply chains (MOTIE, 2024).

The importance of supply chain dependencies for critical inputs has come to the fore on several occasions in recent years. China limited exports of urea, a key input for the chemical, transport, fertiliser, and car production industries in November 2021, causing prices to spike and some disturbances to production (OECD, 2022a). Dependency on China for urea dropped to about 70% after this incident but bounced back to 90% due to China’s cost competitiveness by December 2023, when China again restricted urea exports. Another manifestation of vulnerabilities came at the start of Russia’s invasion of Ukraine, as Korea relied heavily on Russia and Ukraine for raw materials to produce semiconductors. China tightened export controls on gallium, germanium and graphite in 2023, in what appears to be tit-for-tat responses to announcements by the United States, the European Union, and the Netherlands to restrict certain advanced semiconductor sales to China (Blakemore, 2023). Korean companies, in cooperation with the government, have so far managed these disruptions by a combination of sourcing from alternative suppliers, increasing stockpiling and establishing own production.

Korean value chains are more exposed to disruptions in foreign inputs and foreign markets than the OECD average. Korea’s reliance on inputs from non-OECD countries is the highest in the OECD and the reliance on non-OECD markets is the second highest in the OECD, reflecting to an extent its close value chain integration with China (Figure 2.5). The 2022 OECD Economic Survey of Korea argued that it is largely private companies’ responsibility to reduce their supply chain dependencies according to their own business interest. The main ways to reduce such dependencies include diversification by introducing redundancies in supply chains, increasing stockpiling, and vertical integration combined with moving production to the home country or another location seen as less risky. All these options have a cost. In some cases, the societal cost of supply chain dependencies is higher than the private cost to companies, justifying a role for the government, especially when supply is concentrated in a small number of countries and firms, or of strategic importance, such as for energy (Schwellnus et al., 2023).

Government action can help identify risks and coordinate measures to improve resilience by clarifying the scope of strategically important products, collecting and disseminating information on the concentration of supply and stress-testing to identify potential supply chain bottlenecks. Based on such stress tests, countries can require private suppliers of essential goods to implement contingency plans to avoid or mitigate supply chain disruptions. Governments can facilitate stockpiling of essential goods based on risk assessments and cost/benefit analyses of investing in stockpiles. Committing to regular purchases of a minimum quantity from a supplier at a set price in exchange for a commitment by the latter to stand ready to temporarily scale up production in the case of an emergency surge in demand can be considered. Governments can also support the development of domestic production capacity with due consideration of costs involved, including the opportunity costs of public funds and possible costs of introducing other distortions into markets (OECD, 2022a; Schwellnus et al., 2023).

In December 2023, to strengthen supply chains of critical raw materials and equipment, the government (MOTIE) identified 185 “supply chain stabilisation items” among imported material, parts and equipment items based on import dependence and economic importance, and unveiled the Industrial Supply Chain 3050 Strategy, which aims to reduce the dependence on these items from specific countries from an average of 70% in 2022 to 50% or less by 2030. For designated items the government can support technology development and mergers and acquisitions, apply regulatory exemptions, support the relocation of overseas plants to other overseas destinations (dubbed “P-turns”), recommend to companies to expand their inventories based on national economic needs and support them in covering the associated cost. In an emergency, the government can order companies to home-shore production (MOTIE, 2023a).

Korea's Framework Act on Supporting Supply Chain Stabilisation for Economic Security took effect in June 2024, encompassing all imported core items and services such as logistics. According to the law, the Ministry of Economy and Finance (MOEF) designated 300 “economic security items” in June 2024 to extend support for their stable introduction, production, and stock management. It also operates an early warning system for economic security items and prepares crisis management manuals. A supply chain stabilisation committee consisting of ministers and private experts acts as a pan-governmental control tower for the national-level supply chain resilience policy master plan. This plan will be updated every three years, with corresponding implementation plans under each ministry. A supply chain stabilisation fund operated by the Export-Import Bank will be launched to support private firms in reinforcing their supply chains, including by diversifying their imports by country of origin, expanding domestic and foreign production, developing technology, and expanding stockpiles (MOEF, 2024).

To secure resources, the government also plans to gradually expand its stockpiles of 20 key minerals and 35 items to an average of 100 days supply, expand the supply chain overseas development assistance that links resources from key mineral-producing countries with Korean technology, and actively participate in multilateral cooperation platforms (MOTIE, 2023a). Korea has participated in the Indo-Pacific Economic Framework (IPEF), a key multilateral channel for responding to supply chain disruptions, and signed its Supply Chain Agreement in November 2023, creating a joint response system among Indo-Pacific countries (MOTIE, 2023b). IPEF also agreed to launch a “Critical Minerals Dialogue” (The White House, 2023).

Korea’s proactiveness in dealing with supply-chain risks is at the outset a strength and a necessity, but careful cost-benefit analyses are needed to prevent unnecessary and costly interventions. This is especially important in the case of homeshoring of production which may enjoy popular support but should generally be a last resort to boost supply chain resilience due to its high cost. It is natural and sensible to address risks to Korea’s key exporting industries, but resources channelled to incumbent industries inevitably raise hurdles for emerging ones competing for labour and capital but lacking lobbying power.

The Bank of Korea (BoK) embarked on a tightening cycle already in August 2021, partially motivated by an ambition to dampen household credit growth (OECD, 2022a). CPI inflation peaked in July 2022 at 6.3% (y-o-y), following Russia’s war of aggression against Ukraine and the ensuing energy price shock. Since then, both headline and core inflation have trended down towards the 2% target in line with expectations, as discussed above (Figure 2.6). Following cumulative hikes of 300 basis points, the BoK has held the policy rate at 3.5% since January 2023 (Figure 2.7, Panel A), while signalling that the policy stance will likely remain restrictive for some time.

Long-term inflation expectations remain solidly anchored. Consumer inflation expectations one year ahead stood at 3.0% in mid-2024 after having peaked at 4.7% in July 2022, while professionals’ year-ahead expectations were down to 2.5% in the second quarter of 2024. Professionals’ five-year expectations remained within a decimal point of the 2% target since the beginning of 2022 before dropping to 1.8% in the second quarter of 2024 (Figure 2.7, Panel B), indicating that trust in BoK’s monetary policy execution is solid.

The government has embarked on fiscal consolidation after fiscal policy supported demand and reduced poverty during the pandemic. A record fiscal deficit in 2020 was followed by a strengthened fiscal balance in 2021 which largely reflected unexpectedly high tax revenue. The largest emergency budget amendment in Korea’s history (2.9% of GDP) was enacted in the summer of 2022 at a time when the post-pandemic recovery was already solidly underway. The budget deficit was contained at 1.7% of GDP, however, as tax revenues continued to exceed forecasts on strong business profits (Figure 2.8, Panel A). In a reversal of fortunes from the two preceding years tax revenues fell 13% from 2022 to 2023 and ended up 14% below original estimates (Panel B). The falling revenue largely reflects a shrinking tax base, notably weak corporate incomes and the weak property market reducing transaction taxes, although tax relief also contributed. The government funded spending without additional bond issuance, in part by withdrawing government deposits and funds, including from the foreign exchange stabilisation fund, and in part by reducing transfers to local governments.

When annual budgets are approved by the National Assembly before the start of the year, taxes and other fiscal revenues are by definition estimates, as is the case for some rules-based expenditure items (for example needs-based minimum income support). It is challenging to correctly project revenues from year to year, as they fluctuate over the economic cycle in ways that are not fully predictable. It would nonetheless be natural to re-examine the tax revenue projection methodology in light of the large shortfall, and explore if cyclicality could be taken into account more accurately.

The role of the legislature in public debt management varies considerably across countries. Best practice is when parliaments establish the broad framework through legislation and delegate borrowing authority to the executive, while using the budget process for oversight and accountability. Legislatures have roles that go well beyond this in a number of countries, ranging from approving every transaction in Austria and Czechia to hard debt limits in the United States, although in many of these cases the role of the legislature is seen as a formality (Awadzi, 2015). Within the limits set by the National Assembly in regular budgets on expenditures and rules and rates for taxes and rules-based expenditure, borrowing should be allowed to balance the books between regular budget events. Borrowing limits are redundant and can undermine fiscal policy’s countercyclical role, if for example spending is kept lower than budgeted because negotiating to increase the borrowing limit would mean re-opening discussions about the already approved budget. Borrowing limits could be warranted if revenue and expenditure estimates were systematically biased, but this is not the case in Korea. Korea should therefore consider abolishing borrowing limits, while continuing to use the regular budget process and annual accounting and auditing for oversight and accountability. If deemed necessary as part of such reform, the National Assembly Budget Office (NABO), Korea’s fiscal watchdog, could be explicitly tasked with evaluating whether fiscal projections suffer from any systematic biases.

Fiscal policy tightened in 2023, with the cyclically-adjusted primary balance narrowing from -1.4% of potential GDP to -0.2%. The fiscal stance is set to be broadly neutral in 2024 with contained expenditure growth. The increased revenues which underpinned the 2024 budget on the expectation that some of the drivers of the tax shortfall in 2023 are likely to reverse as exports recover and property prices stabilise have so far failed to materialise, with nominal tax revenues down by almost 6% in the first five months of 2024 compared to a year earlier. A minimum corporate tax of 15% for multinationals has taken effect from 2024 and may bring additional revenues as Korea implements Pillar two of the OECD Base Erosion and Profit Shifting agreement. The Government has also announced a number of tax incentives varying by company size and sector to boost emerging industries.

All in all, fiscal policy tightening has supported monetary policy in keeping inflation expectations anchored since late 2022. Fiscal measures have also been put in place to directly steer inflation. Tariff reductions enacted on key foodstuffs and other goods can reduce prices permanently if kept in place, while boosting productivity and welfare. Direct price interventions are on the other hand distortive. A temporary fuel tax reduction was put in place early 2022. In the context of high and volatile global oil prices, the measure has since been extended a number of times and remains in place. The government continues to clearly communicate that the measure will eventually be allowed to expire, has shortened the intervals of reviewing the tax cut from every six months to every two months, and has reduced the discount from July 2024. This tax subsidy should be abolished altogether, as it is costlier than alternative policies to help households struggling with energy bills, benefits high-income households disproportionately, leads to overconsumption in the long term and runs counter to climate targets (OECD, 2022a). The government has also sought to avoid price hikes for utilities, transport and other public services which have faced increasing input prices to alleviate burdens on households and businesses. These measures contributed to flatten the peak of inflation in the summer of 2022, but they distort prices at least temporarily and accumulate contingent liabilities for central and local governments. The most visible example of these imbalances relates to artificially low electricity prices, which have ballooned Korea Electric Power Corporation’s (KEPCO) debt to roughly 10% of GDP (Chapter 4). Korea Railroad Corporation (KORAIL) has also run deficits for the past decade, with its debt close to 1% of GDP. The government raised electricity prices by a cumulative 44% in 2023, the first substantial increases since 2012. This welcome and necessary move returned KEPCO to running surpluses since the third quarter of 2023. The current environment of inflation close to target and trending down provides an excellent window of opportunity to allow prices in general to align with fundamentals.

Korea needs an improved fiscal framework to better align fiscal policy in the near term to long-term ageing challenges (Chapter 5), while allowing sufficient room for short-term stabilisation. Public debt remains low compared to most other OECD countries (Figure 2.9, Panel A), but rapid ageing is set to increase fiscal pressures going forward. In October 2022, the government tabled a bill enshrining a fiscal rule in law that would limit the managed budget deficit (excluding social security) to 3% of GDP, reduced to 2% if debt exceeds 60% of GDP, but with an escape clause for major shocks. The bill has not been passed, however, and the rule is set to be broken in 2024, when the managed budget deficit is projected by the Ministry of Economy and Finance to reach 3.9%. The government has committed to abide by the rule by 2025 at the latest. Without action to strengthen public finances, public debt is set to increase rapidly going forward and exceed 150% of GDP by 2060. Adherence to the rule would strengthen public finances considerably in the long term. However, upholding the rule in the absence of additional reform to boost employment of the elderly, women and youth as well as increasing immigration, as discussed in Chapter 5, would be challenging. In this case, spending pressures from ageing, including pensions, health care and long-term care, would have to be met by a combination of higher taxes and reduced spending (Panel B).

Mounting fiscal spending needs related to population ageing could lead to pressures to raise taxes, against the backdrop of low government revenue as a share of GDP compared to the OECD average (Figure 2.10, Panel A). The 2018 OECD Economic Survey of Korea (OECD, 2018) noted that the 10% VAT standard rate in Korea is barely over half of the OECD average standard rate (which was 19.2% in 2022), pointing to one possible avenue for meeting ageing-related social spending pressures. Even so, supplementing the deficit rule with multi-annual expenditure ceilings could be helpful to ensure a balance between tax and expenditure measures (Manescu and Bova, 2020). There is also room to improve the expenditure structure, and thereby create fiscal space to meet fiscal pressures from ageing and fund structural reforms. For example, social security benefit expenditure is low compared to other OECD countries (Panel B), while SME supports are very high and have increased over time with likely negative effects on productivity, as discussed in Chapter 3. Reversing half of the increase of state support to SMEs from 2017 to 2023, fully reversing the fuel tax cut, as planned, and increasing auctioning in the next phase of Korea’s emissions trading scheme taken together could more than fully finance the recommendations in this Survey to fill gaps in employment insurance, maternity- paternity- and parental leaves. (Table 2.3).

Korea’s proposed fiscal rule is a useful tool to help achieve responsible fiscal outcomes, but its successful implementation depends on political commitment and solid institutions. Political commitment is brought about by building consensus around the rule and the general fiscal framework, by ensuring transparency, and abiding by the framework over time. Independent fiscal councils can help build trust and ensure transparency. Overly rigid fiscal rules tend to undermine commitment, as they either lose relevance and break when economic shocks hit, as has repeatedly happened in the European Union, or force countries to follow a sub-optimal fiscal policy as happened in Germany where the fiscal rule was enshrined in the constitution (OECD, 2023). With too much flexibility and too frequent adjustments, as has been the case for example in the United Kingdom (OECD, 2022b), fiscal frameworks can lose their function as a guideline and anchor for fiscal policy. As a middle way, an organised process for infrequent adjustments can help build commitment by ensuring that fiscal frameworks remain relevant over time. Sweden, a country with strong fiscal discipline, has for example a set process to evaluate its budget surplus target every eight years. Korea has some way to go in building consensus supporting the rule. It has not yet been approved by the National Assembly even though the rule is relatively similar to a rule proposed by the opposition while they were in power. The country has strong institutions to build a fiscal framework on, notably the Ministry of Economy and Finance, a trusted civil service in charge of fiscal policy. In addition, the National Assembly Budget Office (NABO), established in 2003, provides projections of economic growth and tax revenue and analyses national fiscal management, including the annual budget proposed by the President. It also evaluates government spending programmes and estimates the cost of legislation proposed in the National Assembly. An independent fiscal council could further strengthen the fiscal framework (OECD, 2022a) but for now, the priority should be to pass the fiscal rule as proposed.

Private consumption picked up in the first quarter of 2024 after having moved sideways since late 2022, reflecting a combination of forces. On the one hand, households’ purchasing power was hit by falling real wages and rising debt servicing burdens. On the other, a strong labour market with historically high employment has supported incomes. Furthermore, excess savings of 4.7%-6% of GDP amassed during the pandemic are largely held in liquid assets and likely have contributed to limiting the toll on consumption compared with past crisis episodes (BoK, 2023b).

Despite the moderating effect of excess savings (BoK, 2023b), housing prices declined by almost 15% in real terms from their peak in Q4 2021 until Q1 2024 (Figure 2.11, Panel A). Nominal prices remain above pre-pandemic levels after a fall of approximately 9% from June 2022 to June 2023 and stabilising thereafter. Throughout 2022, housing transactions plunged, inventories of unsold properties surged, and mortgage lending slowed. This correction was among the most pronounced in the OECD despite the policy rate only increasing by three percentage points, reflecting high household debt compared to other OECD countries (Panel B). 68% of bank loans carried a floating rate in April 2024, even as the share of fixed rate loans has increased (Panel C). A considerable share of outstanding debt remains unsecured, even though credit tightening has led unsecured lending to contract (Panel D). The average debtor spent just over 40% of their disposable income servicing debt as of end-March 2023 (BoK, 2023c).

Relatively tight borrower-based macroprudential measures have limited the financial stability risk associated with household debt. The loan-to-value limit for housing loans ranges between 30% and 70%, depending on the region, the purpose of buying and the number of properties the lender owns. The loan-to-value limit for first-time buyers is 80%. Two different measures are in place to limit households’ debt servicing burden. The debt servicing -to-income limit (DSR) applies to amortisation of housing debt plus interest payments on non-housing debt. It ranges between 40% and 60% depending on the region, except for non-metropolitan areas while it is 60% for first-time buyers. The debt servicing limit stipulates that amortisation of household debt (housing and non-housing) totalling KRW 100 million or more should not exceed 40% of the borrower's annual income. The “Stress DSR”, a debt servicing limit considering possible future interest rate rises, is being rolled out in 2024. The rate of non-performing loans is on the rise but remains low by historical standards (BoK, 2024), banks’ capital to risk-weighted assets are below the OECD average, while the ratio of capital to unweighted assets is just above (Figure 2.12). The main direct risk from high household debt remains the macroeconomic risk that indebted households hold back consumption as interest rates increase and property values fall. This scenario is already realised, as discussed above, but could intensify especially if sentiment is hit.

To prevent excessive price falls, the authorities eased macroprudential regulations, reduced housing-related taxes, relaxed regulations including for zoning and reconstruction, and introduced a policy lending programme (Bogeumjari), including for young, newlyweds and borrowers with new-born children. These policies helped shore up demand, and housing prices bottomed out in mid-2023 in nominal terms before stabilising, although in real terms they continued to edge down throughout the year. However, rising housing prices and transactions in certain locations also contributed to a renewed rise in already high household debt. More recently, the focus of prudential measures has again shifted from supporting the housing market to containing the increase in household debt, with several measures announced to tighten mortgage lending. Even so, the government introduced a new policy lending programme for families with newborns in January 2024: the "Newborn Special Loan" offers lending significantly below market rates to households with young children and annual incomes below KRW 130 million (approximately $98,000). The 2022 Economic Survey of Korea pointed out that frequent changes in housing-related taxes and macroprudential policies should be avoided (OECD, 2022a). Frequent policy changes increase volatility, and new policies may not have the intended effect if households expect them to be temporary. Making sure housing supply is well-functioning should be the top priority to secure that housing is affordable, and thereby dampen household indebtedness, as further discussed in Chapter 5.

In the Korean leasehold deposit market (jeonse), renters transfer a large interest-free deposit (often around 50-70% of the house value) to the landlord instead of monthly rent. The deposits landlords can expect to receive from a new leaseholder have fallen in tandem with housing prices, which has increased the risk that landlords cannot return the deposit in full. A sizeable share of jeonse deposits are guaranteed, but not all. Jeonse deposit default rates increased considerably in 2023. The housing market stabilisation should help mitigate repayment risks along with temporarily eased lending-related regulations for jeonse landlords. Overall, BoK stress tests indicate that systemic risks from households and jeonse debt remain contained, even though the loss absorption capacity of some financial institutions needs to be strengthened (BoK, 2023c; BoK, 2024).

Even though the direct risks from household debt seem contained, the weak housing market is spilling over to project financing in the construction sector. Project finance has been central to three recent events of financial market volatility (Box 2.2).

MG Community Credit Cooperatives (MGCCC) is a special case due to its history and unique governance by the Ministry of Interior and Safety, but it is not the only non-bank financial institution to escape the full scrutiny of regulated banks. Non-bank financial institutions have increased their market share since the global financial crisis, holding over 60% of total assets in the financial system in 2023. While banks reduced their exposure to real estate project finance as a share of own capital over the past decade, non-bank financial institutions including insurance companies, consumer credit companies, savings banks and securities companies all increased their exposure considerably (Figure 2.13, Panel A). Delinquency rates remain relatively low, even though they have risen rapidly among mutual savings banks and mutual credit cooperatives (Panel B). The financial sector is relatively well-capitalised, and stress tests indicate that systemic risks related to real estate project finance loans remain relatively limited (BoK, 2023c).

Swiftly announced and implemented policy measures were instrumental in containing recent incidents, stabilizing financial and housing markets and preventing more widespread losses of confidence. These measures were coordinated in regular meetings between the heads of the Ministry of Economy and Finance, the Financial Services Commission, the Financial Supervisory Service, and the Bank of Korea. Important measures put in place under the auspices of this coordination since October 2022 include liquidity provision, asset purchases, postponing the implementation of planned prudential measures, providing new credit guarantees and reaffirming regional governments’ commitments to existing ones (IMF, 2023).

The crisis response was all in all necessary and appropriate, but will create expectations that similar rescue operations will be carried out in the future, thereby leading financial markets to not price in the full range of risks. Systemic change is needed to prevent such moral hazard and to correct the structural weaknesses uncovered. The Financial Supervisory Service has appropriately instructed financial institutions to clean up their balance sheets by conservatively raising provisions related to project financing in stages, and writing off unviable bridge loans used to secure property for projects that could not be converted to regular project finance by the end of 2023. Furthermore, the government is working to improve institutions, and is commissioning research on these issues to specialized agencies such as Korea Development Institute. The government should review regulations of community credit cooperatives, gradually align regulatory requirements with those of other non-bank financial institutions and narrow regulatory gaps between non-banks and banks. It should also consider how credit cooperatives could be brought into the fold of the Financial Supervisory Service to increase the transparency and system-wide overview of the regulator while continuing to foster local economies through credit intermediation. Finally, even though Korea’s financial authorities have made institutional efforts to improve gender diversity in the board of directors of financial firms, further steps should be taken to increase diversity of management in the financial sector, notably by improving the gender balance. Women accounted for only 9% out of 899 executives at 23 domestic financial companies, including the five major commercial banks, major insurance companies and credit card companies, as of mid-2023. Excluding state-run, foreign banks or cooperatives, there had never been a female CEO at a domestic commercial bank until an internet bank (Toss Bank) appointed a female CEO from March 2024. When management is skewed toward a specific gender, this increases the risk of groupthink and biased decision-making.

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Previous Surveys have discussed the North Korean Economy as a contingent liability to the South, focusing mainly on the fiscal cost in the case of a future unification through a gradual and peaceful rapprochement to which both countries were legally committed. However, absent a decisive change of direction in the relationship between the two countries, unification through gradual rapprochement now seems unrealistic. The two countries are still formally at war after the 1953 ceasefire agreement ended hostilities. With ups and downs, the two Koreas were gradually increasing economic cooperation from the late 1980s. Industrial cooperation in the Kaesong Industrial Zone, which started construction in 2003, was the most tangible symbol of such cooperation. South Korea withdrew from the cooperation in 2016 in response to North Korean’s accelerated nuclear weapons development. Efforts to re-open culminated in 2018 with the opening of the Inter Korea Liaison Office and the restoration of water supply from the South. However, cooperation took a turn for the worse following the breakdown of the 2019 North Korea-United States Summit in Hanoi. South Korea and North Korea jointly decided to close the liaison office temporarily at the start of the COVID-19 pandemic. North Korea blew up the office in June 2020 in response to defectors sending leaflets and flash drives into North Korea. The frequency of hostile actions, including missile launches, has increased since. In December 2023, Kim Jung Un stated that North-South relations had shifted from being compatriots to entering a hostile state of war between the two countries. In January 2024, he designated South Korea as the North’s “principal enemy”, requested the deletion of text in the constitution promoting peaceful unification and ordered officials to close state agencies dedicated to unification and inter-Korean tourism. Along with the gradual deterioration in the relationship between the two countries, North Korea’s changed policy towards the South increases the risk of incidents happening and escalating, with economic consequences for the South. South Korea remains constitutionally committed to peaceful reunification and it could still happen, for example if the regime in the North were to collapse. It would have considerable macroeconomic consequences, the most certain of which is that it would require considerable fiscal resources to bring infrastructure up to date and increase living standards in the North.

When the COVID-19 pandemic hit in early 2020, the North Korean economy had experienced a brief rebound by an estimated 0.4% in 2019, after severely contracting in 2017 and 2018 as a result of tightened international sanctions. Drastic measures were put in place to curb the COVID-19 virus, blocking human and material exchanges across the border and restricting domestic movement, at considerable economic cost (OECD, 2022). GDP fell by an estimated 4.5% in 2020 and 0.1% in 2021 (Annex Figure A 1, Panel A). North Korean authorities declared victory over COVID-19 in August 2022, but only partially opened their borders. Trade with China resumed but only slowly (Annex Figure A.1, Panel B). GDP declined further by an estimated 0.2% in 2022, with a rebound in light industry and services offset by a large drop in heavy industry and contracting agricultural output.

The economy seems to have recovered somewhat, driven by increased trade and food production. In 2023, trade with China more than doubled from 2022 to USD 2.3 billion, recovering to 83% of 2019 levels. Exports rose to USD 0.3 billion, exceeding 2019 exports, led by false eyelashes, wigs and false beards. Imports grew to USD 2.0 billion, driven by hair, soybean oil, textiles, and chemical fertilisers, but only recovered to 78% of 2019 levels (China Customs). External trade is expected to increase further, as trade between Dandong and Sinuiju by truck, which accounted for a large share of North Korea-China trade, appears to have resumed since late 2023 (Nikkei, 2023). Trade between North Korea and Russia is also suspected to have expanded since the North Korea - Russia summit in September 2023. North Korea is believed to supply arms for Russia’s war in Ukraine and supplies such as oil were shipped from Russia into North Korea (AP News, 2023; UN, 2024). In February 2023, Russia allowed North Koreans to stay in the country visa-free for up to six months, which could lead to an increase in labour migration (Kim, 2023). However, some COVID-related bottlenecks remain. For example, tourism, which is not targeted by UN sanctions and was North Korea’s most important source of foreign currency before the pandemic, is still largely closed with exceptions for selected small Russian groups (Reuters, 2024a).

North Korea is thought to have suffered severe food shortages from 2020 to 2022 due to border closures and failing crops. The estimated number of undernourished North Koreans increased from 8.3 million between 2004 and 2006 to 11.8 million between 2020 and 2022, representing 45.5% of the population (FAO et al., 2023b). Increased imports of fertiliser, mobilisation of military factories to produce agricultural equipment and favourable weather conditions are estimated to have raised the 2023 harvest to 4.8 million tonnes, its highest level since 2017 (Kim, 2024; Rural Development Administration, 2023). Grain imports from China also grew to 0.28 million tonnes in 2023, doubling from 2022 (China Customs). Nevertheless, food shortages remain, and the UN's Food and Agriculture Organisation (FAO) declared in 2023, for the 17th consecutive year, that North Korea requires external food assistance (FAO, 2023a).

UN sanctions had already pushed North Korea's economy towards self-subsistence before the pandemic, and a clear rebound seems unlikely as long as sanctions remain in place. Progress on denuclearisation, which could lead to the loosening of sanctions and renewed growth, is not expected to happen in the near future (KINU, 2024). Sanctions on imports of metals and machinery will hold back investment. A South Korean survey of North Korean defectors found that state-owned enterprises in the mining and manufacturing sectors are running at shorter hours due to intensifying power shortages and difficulties in securing raw materials (MOU, 2024). Productivity in the battered economy is therefore set to take a further hit over time (Lee, 2023). The informal market economy and services which had been growing before the pandemic is also challenged, as North Korean authorities tightened state control over markets and external trade during the pandemic and seem determined to maintain control going forward. Deteriorating public services and diminishing public food distribution are nonetheless increasingly driving up inequalities of living standards (MOU, 2024; Jung, 2024).

As a consequence of stagnation in the North, economic gaps with South Korea have widened further in recent years. Gross national income per capita was about 30 times higher in South Korea than in the North in 2022, up from 22 times in 2016. South Korea’s recorded foreign trade was 892 times higher than North Korea’s (Annex Table A.1). In tandem with deteriorating relations, North-South Korea trade has plummeted since 2019, with no trade in 2023 (Korea Customs Service).

The change in North Korea's policy towards the South has been interpreted as a reflection of its desperate economic situation (Lee, 2024), while it increases the country’s isolation and worsens its economic plight. Only 10% of North Korean defectors say the economy has improved under Kim Jong Un. Negative views of Kim and the legitimacy of the succession have become increasingly common over time and access to foreign cultural content has increased, while the regime has responded with tighter ideological control (MOU, 2024). As North Korea's economic stagnation and exhaustion grow, and the lack of a solution is increasingly perceived as a regime crisis, it is not inconceivable that the regime will attempt to step up military provocations (Lee, 2024). However, US and South Korean authorities say there are no signs that North Korea is preparing for war (Reuters, 2024b; VOA, 2024), and the likelihood of a large-scale armed conflict remains very low (Seiler, 2024; Jang, 2024 ).

The risk of border clashes and other incidents could increase volatility and risk premia in South Korea. North Korea-related events have caused some volatility in South Korea's stock markets in the past, but the effects were short-lived and their impact on the real economy was negligible. For example, when Kim Jong-il died in December 2011, the stock market fell 3.4% that day but recovered within two days. The impacts of the past six nuclear tests hit the stock market for only a few days, except for the fourth test (Annex Figure A.2). This limited reaction suggests that financial markets have not perceived North Korea's past provocations as a systemic risk as tensions have escalated and eased repeatedly (Kim, 2017). South Korea's Kospi index fell 1.1% and 2.5% on the day and the day after Mr. Kim's hostile rhetoric in January 2024, but reversed course one day later (KRX, 2024).

South Korea remains committed to peaceful and gradual reunification, but regime collapse or other events in the North could abruptly trigger rapprochement. This scenario remains unlikely, but would have considerable impacts on the economy and fiscal sustainability. In the case of the peaceful but abrupt reunification of Germany in 1990, net transfers from West Germany to the East amounted to around DM 120-140 billion per year, or around 4.5% of West Germany's GDP between 1991 and 1999, for social assistance and infrastructure investments (Bibow, 2001; Lee and Mckibbin, 2018). Following tax hikes and spending cuts to reduce the pressure of mounting public debt, GDP growth, which had been 5% in 1991, averaged only 1.5% for the rest of the 1990s. Within the first 15 years of reunification, almost 10% of the East German population moved to the West in search of better opportunities (Lee and McKibbin, 2018). Considering that the economic gap between North and South Korea is far greater than that between East and West Germany at the time of reunification, fiscal burdens to secure a minimum income for North Koreans and to fill infrastructure gaps could be much higher. Depending on assumptions about how quickly and to what extent the gap would close, the National Assembly Budget Office (NABO, 2014) estimated it at an average of 3.9% of the unified Korea's GDP per year for 45 years after reunification, while Ahn (2011) estimated it between 1.3% and 7.6% of South Korean GDP per year in the first decade after the reunification, based on different scenarios. This fiscal burden, coupled with South Korea's ageing population, could seriously jeopardise South Korea's fiscal sustainability (Chapters 2 and 5). Ageing is less serious in North Korea than in the South and the fertility rate remains higher, even though there is some reason to believe that the United Nations fertility rate estimate for North Korea is too high (Lee and Kim, 2023). North Korea has also seen a shift in gender norms, with women's increased economic activity and participation in the market economy leading to later marriages, more divorces, and lower fertility (MOU, 2024). South Korea’s population is set to age and shrink faster than North Korea’s, but it is uncertain to what extent reunification would alleviate future labour shortages, as the skills of the population in the North might not match employment opportunities (Annex Figure A.3).

Ahn (2011), Research on Financing Options for Korean Reunification, The Korean Association of Public Finance (in Korean).

AP News (2023), “US says North Korea delivered 1,000 containers of equipment and munitions to Russia for Ukraine War“, 13 October.

Bibow, J. (2001), “The economic consequences of German unification: The impact of misguided macroeconomic policies”, Levy Institute Public Policy Brief No. 67.

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FAO (2023a), Crop Prospects and Food Situation, No. 03/2023, Food and Agriculture Organisation.

FAO et al. (2023b), The State of Food Security and Nutrition in the World (SOFI) 2023, Food and Agriculture Organisation, International Fund for Agricultural Development, UNICEF, World Food Program and World Health Organisation.

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