Korea’s economy has expanded at a 4.3% annual rate since 2002, lifting per capita income to two-thirds of the OECD average. Despite a stronger currency, growth has been primarily driven by external demand, thanks in part to the continuing development of Korea’s information and communication technology sector and strong demand from China. In contrast, domestic demand has been relatively sluggish, growing at an annual rate of 2% since 2002, reflecting the collapse of the credit card bubble and a deterioration in the terms of trade. Subdued domestic demand and the appreciation of the currency have kept inflation somewhat below the Bank of Korea’s medium-term target of 2.5% to 3.5% since mid-2005, despite higher oil prices.

Economic growth in Korea remains one of the highest in the OECD area, led by buoyant exports. Sluggish domestic demand in recent years, though, suggests the need to address structural weaknesses in order to continue the convergence to income levels in the high-income countries. This chapter looks at five key challenges: i) implementing appropriate monetary policy in the context of upward pressure on the exchange rate and real estate prices; ii) coping with rising house prices in the capital region while addressing the government’s priority of balanced regional development; iii) maintaining a sound fiscal policy in the face of upward pressure on spending and weaknesses in the tax system; iv) coping with pressure for increased public social spending and addressing the issue of low fertility in the context of rapid population ageing, while limiting the increase in the tax burden; and v) increasing productivity growth by enhancing Korea’s integration in the world economy.

Economic growth slowed to less than a 4% annual rate in the second half of 2006, largely due to weak private consumption and a decline in housing construction. The economy is projected to pick up gradually, with growth of about 4¼ per cent in 2007. Korea should pursue a flexible exchange rate policy by limiting intervention in foreign exchange markets. The liberalisation of controls on capital outflows should aim at improving long-run efficiency rather than moderating upward pressure on the won in the short run. The Bank of Korea should focus on achieving its new medium-term target for overall CPI inflation and avoid using monetary policy as a tool to stabilise real estate prices in some parts of the capital region, as further hikes in the short-term interest rate would have a negative impact on the increasingly indebted household and small and medium-sized enterprise sectors.

The government has introduced five policy packages since August 2005 to stabilise house prices, mainly due to concerns about possible spill-overs from the capital region to other parts of the country, even though the increase on a nation-wide basis has been modest compared to other OECD countries. The planned expansion in housing construction in the capital region will reduce upward pressure on house prices. However, other policies aimed at reducing “speculative” demand and lowering house prices, such as the price ceiling on new houses, are likely to constrain supply and result in stronger price pressures in the longer term. The government should shift its focus from short-term price fluctuations in house prices to creating an efficient housing market, relying more on private-sector supply. Concern about increasing concentration in the capital region should be dealt with through economic instruments to address externalities, such as pollution and congestion, while phasing out the restrictions on construction in the capital region.

Korea currently has a sound fiscal position and a relatively low level of public spending. Given the impact of rapid population ageing on public expenditures in the long run and the potential cost of economic integration with North Korea, it is important to maintain a strong financial position. Slowing the growth of public outlays from its 9% pace since 2002 would help achieve the target of a balanced budget in the medium term. Reforming the tax system is necessary to generate additional revenue and to remove the cost of distortions as tax rates rise to cope with spending pressure. The personal income tax system should be improved by reducing generous exemptions and allowances that exclude more than half of wage income from the tax system. In addition, the corporate income tax base should be broadened by eliminating incentives that distort the allocation of investment and complicate tax administration.

Faced with exceptionally rapid population ageing, Korea should address obstacles that lower fertility rates while encouraging higher labour force participation, particularly among women. While public social spending is currently very low, there is pressure for increased outlays on pensions, healthcare, long-term care and social assistance. The government should be cautious in expanding spending, taking into account the impact on economic growth. Outlays should be limited by shifting from direct provision of social services, notably childcare and long-term care, in favour of providing vouchers to consumers. Given the limited coverage of the public pension system, the new means-tested benefit for the elderly will be useful in reducing poverty. It is important to increase transparency about self-employed income to ensure fairness in the financing of social insurance systems, including the new longterm care insurance. The rise in inequality and relative poverty should be reversed by reducing labour market dualism.

Globalisation through foreign direct investment (FDI), international trade and international movements of labour is a key force driving economic growth. Although Korea has become more integrated in the world economy over the past decade, it still ranks low in terms of import penetration, the stock of inward FDI relative to GDP and foreign workers as a share of the labour force. A number of policy reforms would help Korea make greater use of goods, services, capital and human resources from abroad: i) reducing barriers to FDI, including foreign ownership limits in some sectors; ii) focusing on attracting FDI by improving the business and living environment rather than through special zone schemes; iii) reducing import barriers, particularly in agriculture, through multilateral trade negotiations and WTO-consistent regional trade agreements; iv) relaxing product market regulations, notably in services; and v) easing controls on and facilitating the inflow of both low and high-skilled workers.