Credit Ratings Local currency A-/Positive/A-2 Foreign currency BBB-/Positive/A-3 Rating History Foreign currency ratings upgraded to BBB-/Positive/A-3;local currency ratings upgraded to A-/Positive/A-2 January 25, 1999 Outlook revised to positive from stable January 4, 1999 Foreign currency ratings upgraded to BB+/Stable/B; local currency ratings upgraded to BBB+/Stable/A-2 Feb. 17, 1998 All ratings place on CW Developing Jan. 16, 1998 Foreign currency ratings downgraded to B+/CW Neg/C; local currency ratings downgraded to BBB-/CW Neg/A-3 Dec. 22, 1997 Default History Since 1975 None Basic Data Year 1999 Population 46.9 million Per capita GDP US$7,800 Current Government President Kim Dae-jung is head of state. Election Schedule Presidential Last    December 1997 Next    December 2002 Legislative Last    April 1996 Next    2000 ______________________________ Analysts John Chambers, CFA, New York (1) 212-208-8941 Takahira Ogawa, Singapore (65) 239

Sovereign Ratings
Service

Analysis
Korea (Republic of)

RATIONALE

The restoration of the Republic of Korea's (South Korea, herein referred to as Korea) investment-grade rating reflects the government's progress to date in corporate and financial sector restructuring, as well as its restored external position. Korea's largest corporations have agreed to cut their leverage ratios in half, to 200% over one to three years, the banking sector has been rationalized, supervision tightened, and nationalized banks have begun to be returned to private ownership.

Korea's sovereign ratings are supported by:

· Decisive government responses to the crisis on several fronts. The NCNP-ULD coalition has been effective in passing key legislation to open the Korean market to foreign investment, to consolidate financial sector supervision, to make labor more flexible, and to expand the social safety net. The government, since mid-1998, has adopted an aggressive fiscal stance to boost demand, with general government deficits estimated at 5.3% for 1998 and forecast at 5.6% in 1999. Throughout the year, the Bank of Korea has cut rates steadily without weakening the won or engendering inflation, to the point that real rates are less than 3%.

· Broad support of the population. Korea's external position was materially improved by the efforts of ordinary citizens, who sold their gold and family heirlooms to the government to generate foreign exchange and curtailed overseas studies, as well as those of the larger community of Koreans who remitted unprecedented sums. Although these exceptional measures will not be repeated in 1999, Standard & Poor's still expects Korea to post a current account surplus of US$15 billion, as exporters still benefit from a real effective exchange rate roughly 20% lower than its 1997 level.

· A developed economic base compared with similarly rated countries. Korea's human development indicators of health, education, and per capita income are among the best in the 'BBB' category. Its exports are diversified, with a higher value-added component than most other countries in this category.

· A restored external position with fewer vulnerabilities. Korea's current account surplus, increased foreign direct and equity portfolio investment, and reduced external borrowing requirements should cut its net external debt to 23% of exports in 1999 from 38% in 1998. Similarly, short-term external debt to reserves has been cut to 78% at year-end 1998 from 768% the previous year.

Korea's sovereign ratings are constrained by:

· A still-hobbled banking sector. On Aug. 6, 1997, Standard & Poor's estimated that the cost of recapitalizing Korea's troubled financial system could cost the government 20% of 1997 GDP (Korean won (W) 84 trillion). The government has allocated W41 trillion to date to purchase bad loans from banks and to recapitalize them. Standard & Poor's now raises its government cost estimate for rescuing Korea's ailing financial sector to W120 trillion to enable Korean banks to resume normal intermediation. Current loan loss provisioning is less than half of reported nonperforming assets. At 170% of GDP, private sector credit is high, indicating that even after aggressive government assistance, the financial sector will remain a large contingent liability to the sovereign. Notwithstanding these concerns, Standard & Poor's believes that the rated Korean banks participating in the US$21.8 billion Extended Debt Agreement of March 31, 1998, will be able either to roll over their external debt or repay it once the government guarantee expires.

· Uncertain viability of many major chaebol. Almost all of Korea's 64 chaebol are highly leveraged with weak earnings power and reliant on favorable external conditions to remain solvent. Standard & Poor's expects several of the medium-sized chaebol to approach their banks for debt forgiveness or rescheduling. Some will enter liquidation. The ensuing loan losses are included in Standard & Poor's estimates of further needed government assistance for the banks. The upgrade, however, assumes that individual chaebol difficulties will not translate into renewed material capital outflows.

OUTLOOK

The positive outlook indicates that Korea's credit standing could continue to improve in a one- to three-year time horizon if private sector restructuring continues apace. Deepening of reforms will require that the current cooperation between the coalition and the opposition not be derailed by vendettas or political infighting and that labor relations continue to be constructive, even should unemployment approach 10% in the first half of 1999. Unanticipated events could also delay improvements to Korea's credit standing, such as a confrontation over the nuclear program of the Democratic People's Republic of Korea (North Korea), a material depreciation of the currencies of Korea's Asian trading partners, or the collapse of one of the top five chaebol.

Comparative Analysis

· Korea's political stability can usefully be compared with several Latin American countries that underwent military rule and have since developed mature and resilient democracies.

· The country's fiscal flexibility has been diminished by the crisis, but it still compares favorably with several similarly rated countries.

Korea's low-investment-grade rating balances the fiscal costs of its recent economic crisis and the imbalances in its private sector with the resilience of its external position and the ability of policymakers to implement a robust program to address structural problems.

Korea's political stability can usefully be compared with several Latin American countries that underwent military rule and have since developed mature and resilient democracies, such as the countries of the Southern Cone. The amount of time under democratic rule is comparable and power has alternated between main parties. Like Chile (A-), Uruguay (BBB-), and Argentina (BB), there is a solid consensus on economic policy among the government and the opposition. Although Korea faces a serious external threat from North Korea, this threat is not materially more dangerous than that faced by Israel (A-) or Cyprus (A+).

Korea's income and economic structure presents a mixed picture. Its forecast 1999 per capita GDP will be twice that of the 'BBB' median. In "The Global Competitiveness Report 1998," Korea ranks 19 out of 53 countries, behind Malaysia (BBB-) and Chile, but ahead of many Western European countries. Korea scores 30 out of 168 on the UNDP's Human Development Index, ahead of most 'BBB' countries. Among the 64 countries classified as "High Human Development," Korea scores above the average on adult literacy rate (98%), combined first-, second-, and third-level gross enrollment ratio (83%), and infant mortality rate (6‰). Since 1960, its Human Development Index has increased from 0.398 to 0.894, more than that of any country except Malaysia. However, its economic structure is hurt by its weak banking sector and high domestic corporate indebtedness. Although not as bad as the banking sector crises in Indonesia (CCC+) or Thailand (BBB-), the cost of its bailout will be one the larger ones of the post-War World II period.

Korea's long-term growth prospects (in per capita dollar terms) are above average, given the level of human capital and the state of the country's infrastructure. Although an 11 percentage point swing in GDP from 1997 to 1998 might belie this statement, the swing was in part occasioned by a combination of egregious policy mistakes in 1997 (in bank external funding and central bank reserve management) and external financial panic. Once the chaebol delever and the banks resume normal intermediation, Korea's growth prospects should exceed the OECD average.

Korea's fiscal flexibility has been diminished by the crisis, but it still compares favorably with several similarly rated countries, such as Qatar (BBB), Greece (BBB), and Hungary (BBB). Nevertheless, the expense of bailing out its financial system and the cost of jump starting the economy with 2.5% and 1.3% primary budget deficits in 1998 and 1999, have raised Korea's debt burden above the 'BBB' median, both in terms of stock and in terms of interest to revenues.

Except for 1998, inflation has been below the 'BBB' median over the past five years and is projected to be again in 1999. Regarding its external position, a swing in the current account from a 2% of GDP deficit to a 13% surplus one year later epitomizes balance of payment flexibility. The reserve position has rebounded nicely to 84% of debt service, the won has appreciated by 40% from its nadir in December 1997, and export volume has continued to grow, at 16% in 1998. Debt service ratios are now comparable with the 'BBB' median. Korea's rapidly improving net narrow external debt-to-exports ratio should exceed the 'BBB' median by year-end 1999.

Political Environment

· The government and the opposition form a strong consensus on economic policy.

· The principal risk to the government's completing its legislative agenda is that congressional attention could be diverted either by a premature sense of victory over the country's economic problems or deteriorating relations between the opposition and the government.

· The government's policy toward North Korea has been successful in easing tensions, but the underlying danger remains.

Since his inauguration on Feb. 25, 1998, President Kim Dae-jung has consolidated his coalition's power in the National Assembly. Initially, his National Congress for New Politics (NCNP) and its junior partner, United Liberal Democrats (ULD), governed as minority in the legislature. With several members of the Grand National Party (GNP) crossing the aisle this summer, the coalition now holds 157 of the 299 legislative seats, although the GNP still holds the most seats by a single party with 136. The government and the opposition form a strong consensus on economic policy. This is due, in part to recognition that the severity of the 1998 recession (GDP fell 11 percentage points in real terms from 1997) requires bipartisanship and also to the fact that the coalition moderated the more populist elements of its campaign platform, such as Kim Dae-jung's initial disavowal of the IMF program, once in power.

Beginning with the transition period, from the Dec. 18, 1997, election to the inauguration, and throughout Kim Dae-jung's first year in office, the administration's success in passing needed legislation for economic reform has been impressive. It includes bills on opening sectors to FDI, eliminating cross-guarantees among conglomerate groups, permitting redundancies due to mergers or acquisitions, reducing taxes for restructuring firms, ending (in 2000) the deductibility of interest for highly leveraged firms, and permitting single minority shareholder stakes up to 33% without board approval. The government also announced plans to fully or partially privatize Pohang Iron & Steel, Korea Gas Corp., Korea Telecom, and Korea Tobacco & Ginseng Corp. Equally important, the septuagenarian president has staked his credibility on corporate sector reform, most visibly evidenced in December 1998, when he obtained consent from the chairmen of Korea's five-largest conglomerates to reduce their consolidated leverage to 200% by specific target dates from December 1999 to December 2002. His approval ratings have been consistently high throughout his first year in office, according to the Gallup Poll, with his latest approval rating topping 60%.

Differences on economic policy between the coalition and the opposition center more on tactics, with the GNP-evidently newly converted to the faith of laissez-faire-accusing the government of being too interventionist in handling corporate reform. The GNP also accuses the government of using its state apparatus for political surveillance, again a practice not new to Korean politics. Most of the needed legislation has been passed, but some measures remain regarding campaign finance, reduction of red tape, raising Korean business standards to international norms, and granting full autonomy for the Financial Supervisory Service (FSS). The principal risk to the government's completing its legislative agenda is that congressional attention could be diverted either by a premature sense of victory over the country's economic problems or deteriorating relations between the opposition and the government. The latter could rise from a government inquiry into the causes of the crisis should it turn into a political vendetta.

The question of constitutionally changing Korea's government to a parliamentary system from a presidential one remains an open issue. Although the change appears to have little support among either the public or the NCNP, the NCNP had promised the ULD that it would push for the change in exchange for its support during the 1997 presidential campaign, which proved crucial for its victory. The ULD may press for a constitutional amendment to be debated this year in the National Assembly, although the ULD is unlikely to withdraw from the coalition if the debate is delayed, given that it holds six of 16 cabinet seats, principally on economic matters, and the prime minister's office. Regardless of the status of the coalition, President Kim's term runs until 2003.

In addition to economic reforms, Kim Dae-jung has embarked on a shift of government policy toward North Korea, known as the "Sunshine Policy." This policy calls for increased economic exchange and a more conciliatory stance toward North Korea's frequent bellicose provocations. The policy has been successful in easing tensions, but the underlying danger remains from North Korea's artillery units along the demilitarized zone (well within reach of Seoul) and from its more advanced weapons.

North Korea's dissatisfaction stems from delays in completing a US$5.12 billion project to build a light water reactor and a related deal for the U.S. to provide fuel oil to the North. The project (which South Korea, the U.S., and Japan agreed in 1994 to finance and build in exchange for North Korea's halting development of a nuclear facility at Yongbyon with verification from International Atomic Energy Agency (IAEA) inspectors) and the oil deliveries have been slowed by allied concerns over a new facility at Kumchang-ri, where nuclear capacity may also be under development. These concerns were heightened when North Korea launched a Taepo-dong missile over Japanese air space in August 1998. Although Yongbyon remains mothballed under the watchful eyes of the IAEA, North Korea, so far, has refused inspections of Kumchang-ri. Should Yongbyon return to operation, North Korea could have the capacity to produce nuclear weapons within a few months. On the other hand, it will take North Korea several years to produce nuclear weapons (should it so desire) at Kumchang-ri.

At another level, North Korea's provocations are a means of focusing its population's attention on an imagined threat from the south to draw it away from the government's own failings to deliver public services. An autarkic renegade state, it operates a repressive regime that has rendered its population poor and malnourished. Should it collapse under its own mismanagement or under revolt, the cost of unification with South Korea could reach 300% of GDP spread over several years.

Economic Prospects

· Prospects for growth depend on the resumption of normal bank intermediation, restored consumer confidence, and the replenishment of normal working capital.

· To achieve the objective of a 200% debt-to-equity ratio, the chaebol will have to pursue an aggressive program of asset sales, public offerings, and management buyouts, coupled with (for the weaker entities) debt relief.

Korea's economy contracted by an estimated 5.5% of GDP in 1998, after having grown 5.5% in 1997. The contraction was Korea's first recession since 1980 and the 11 percentage point swing was greater than that experienced by Mexico in 1995. The contraction was deeper than initially anticipated because banks sharply curtailed extending credit (due to their own distressed financial straits, institutional paralysis as several months elapsed before plans were drawn to consolidate the industry, and their need to repay costly emergency advances to the Bank of Korea), households raised their savings rate in the face of job uncertainties, and companies had substantial room to reduce inventories. Accordingly, prospects for growth depend critically on the resumption of normal bank intermediation, restored consumer confidence, and the replenishment of normal working capital. The Bank of Korea projects 3.2% growth for the year, with positive growth beginning in the first quarter of 1999. The IMF, in its November staff appraisal, forecast a 1% contraction.

The Korean government has taken several steps to strengthen its banking sector. It created the FSS to consolidate supervision. It also guaranteed US$21.8 billion of nontrade, short-term external interbank debt of its solvent commercial and merchant (specialized finance) banks. It nationalized Hanil Bank and Commercial Bank of Korea (and merged them to form Hanvit Bank), and helped arrange the acquisitions of Daedong, Dongnam, Donghwa, Kyungki, and Chung Chong banks by stronger banks. It closed 16 of 30 merchant banks, 10 of 25 leasing companies, two of 36 securities firms, 31 of 230 mutual savings and finance companies, and 50 of 1,653 credit unions. It intervened in two of the largest commercial banks (Korea First Bank and Seoul Bank), wrote down their equity, cleaned up their portfolios, and is expected to sell them to foreign hands. In addition to its role with Commercial Bank and Hanil Bank, the authorities forced several other bank mergers, including Hana Bank and Borum Bank; Kookmin Bank and Korea Long-Term Credit Bank; and Cho Hung Bank with Kangwon Bank and Hyundai International. Through the Bank of Korea, it subscribed the equivalent of 1.1% of 1998 GDP of 10-year subordinated debt of 28 commercial banks and made emergency won and dollar advances (discussed below). Through the Korea Deposit Insurance Corporation (KDIC), the government made direct capital injections into 13 banks totaling 1.5% of GDP; paid nine banks and insurance companies 1.6% of GDP to compensate for losses on arranged acquisitions; paid depositors of 16 closed merchant banks, 17 mutual savings and finance companies, and 39 credit unions 3.4% of GDP; and lent four merchant banks, 10 mutual savings and finance companies, and 23 credit unions 0.14% of GDP. It also established Kamco to acquire nonperforming loans at a discount from virtually every bank in the system. The amount of bad loans bought by Kamco at year-end 1998 totaled W44 trillion (roughly 7% of the system's total loans, for which it exchanged notes equal to W19.9 trillion, or 4.7% of GDP). After these measures, reported nonperforming loans on a (recently tightened) 90-day past-due basis totaled W64 trillion at September 1998 (10.4% of total loans), and precautionary loans a further W71 trillion. Standard & Poor's expects nonperforming loans (including loans sold to Kamco) to peak at 25%-30% of total credit, based on individual bank surveys conducted by Standard & Poor's. Given the existing loan loss provisions of roughly 4% of total loans and guarantees, and reduced core bank system profitability, the W64 trillion allocated to Kamco, even accounting for proceeds from the future disposal of assets (which have yet to begin in earnest), is unlikely to be enough to enable the banks to resume normal lending.

Calculating the cost of bailing out a troubled financial system involves many uncertainties and requires several assumptions. As a starting point, Standard & Poor's uses a simple framework to estimate the contingent liability that a financial system poses its sovereign. This framework is based on domestic credit to the private sector and nonfinancial public enterprises (NFPEs).

Standard & Poor's rates most of the large private and public sector banks in Korea. Based on discussions with management, we estimate that nonperforming loans will reach 25%-30% of total remaining loans (i.e., those not yet put to Kamco). Then, taking an estimated loss content of 50% (slightly less than the current discount rate applied to loans put to Kamco) and 75%, subtracting existing provisions, and adding the loans already purchased by Kamco, we obtain a range of possible amounts that will be needed to recapitalize the banking system. These amounts will be borne by the financial institutions' shareholders and the government. The amounts range from 23%-40% of 1999 GDP. Standard & Poor's has added 27% of 1999 GDP to the government debt stocks to estimate the government's share of this future potential cost. Although the figure is our base-case scenario, the estimate could be high. Nonperforming loans may peak at lower levels. The loss content may be significantly less than the prevailing Kamco discount rate. Kamco may be able to recover substantial portions of its assets. Bank shareholders may be able to recapitalize themselves without so much government assistance. (See calculations below.)

However, in Standard & Poor's view, the medium-term prospects for the Korean banking sector one year into the crisis are brighter than those of the Mexican banking system in January 1996 for the following reasons:

· The Kamco bonds tendered in payment for the NPLs pay cash interest at market rates and are negotiable;

· Kamco has imposed losses of 55% (on average) on the banks that put loans to the resolution trust;

· Korea has opened the retail banking sector to foreign competition; and

· No one suspects the bailout to be contrived to protect the country's elite.

The health of the banking system, of course, reflects the soundness of the corporate sector. Both the IMF ("Republic of Korea: Selected Issues," August 1998,) and the World Bank ("Korea's Corporate Crisis: Its Origins and a Strategy for Financial Restructuring," Liberman and Mako, October 1998) have written about the perilous state of Korea's conglomerates. The 64 largest chaebol are deeply indebted (the top 30 had debt-to-equity ratios of more than 500% at year-end 1997), have weak earnings power, and unwieldy corporate structures. They are burdened with overcapacity, and their fortunes are tied to favorable exchange rates. That they could continue expanding for so many years before the crisis speaks to the government's past influence on the financial sector, the financial sector's own weak credit skills (which still need strengthening), the opaque nature of chaebol nonconsolidated accounts, and the fillip provided by a weak dollar-yen exchange rate through 1995.

Standard & Poor's has low issuer credit ratings on four of the top five chaebol-those generally considered the more creditworthy: Daewoo Corp. (B/CreditWatch Negative/-), Hyundai Motor Co. and Hyundai Semiconductor America, Inc. (B/CreditWatch Negative /-), LG Group (not rated), Samsung Electronics Co., Ltd. (BB-/Negative /-), SK Telecom Co. Ltd. (BB+/positive/-). These ratings reflect the firms' weak capital structures and dismal near-term operating environment.

More generally, to achieve the objective of a 200% debt-to-equity ratio, the 64 chaebol will have to pursue an aggressive program of asset sales, public offerings, and management buyouts, coupled with (for the weaker entities) debt forgiveness, debt-for-equity swaps, or concessional loans. (The possibility exists that part of the debt reduction will be met by asset revaluations and swaps at inflated prices, although the FSS and other regulatory watchdogs are on the outlook for such accounting tricks.) The prospect that part of the chaebol deleveraging will be achieved through default is included in Standard & Poor's estimated costs of cleaning up the Korean banking system.

With the exception of a month-long strike at Hyundai, 1998 was free of major labor strife. The recession has weakened the power of the two largest unions (the Federation of Korean Trade Unions and the Korean Confederation of Trade Unions), notwithstanding their victory in allowing teachers to organize. However, as unemployment rises from 8% currently to perhaps closer to 10% with additional layoffs from the chaebol and the public sector, both organized labor strikes and unorganized street demonstrations could increase, hurting industrial output and affecting investor confidence.

Fiscal Flexibility

· After running a modest deficit of 1.1% of GDP in 1997 (originating at the local government level), the Korean government attempted to counteract some of the effects of the recession through higher fiscal deficits, most of which were realized in the second semester of 1998.

· General government debt increased to 45% of GDP at year-end 1998 from 28% in 1997 and is expected to rise further to 66% at year-end 1999.

Korea's consolidated central government figures comprise the General Account (which includes social security), the Fiscal Financing Special Account (FFSA), four Enterprise Special Accounts, and 17 other Special Accounts. The structure is similar to the Japanese budget system. The General Account represents slightly more than half of the consolidated central government budget, somewhat less than Japan's. In addition to the consolidated central government, the general government is composed of 16 provinces and large cities, 232 other cities, counties, and districts. Roughly two-thirds of its revenue comes from its own sources. In addition to the general government, the public sector includes more than 30 public enterprises. Some of these public enterprises are not majority owned by the government. Standard & Poor's expects the central government to trim its ownership of industrial companies and banks obtained in the course of rescue operations through privatization during the remainder of the current administration.

After running a modest deficit of 1.1% of GDP in 1997 (originating at the local government level), the Korean general government attempted to counteract some of the effects of the recession through higher fiscal deficits, most of which were realized in the second semester of 1998 after a second supplementary budget was passed. The result was an estimated 5.3% of GDP general government deficit in 1998, excluding privatization receipts. Total general government revenues actually increased to 36% of GDP in 1998 from 35% in 1997, as the effects of the downturn were mostly felt in lower receipts from the value-added tax, while income tax and social security contributions were surprisingly robust compared with the previous year. (However, compared with the initial 1998 budget, central government revenues were off 10%.)

The increased general government deficit was the result of higher central government spending. (Local government expenditures actually declined.) Increases came from extending unemployment insurance to firms with more than five employees from those with more than 30, thus covering 70% of the workforce, while raising minimum benefit levels and easing eligibility requirements. Increases also came from a higher interest bill, due not only to higher interest rates but also higher debt stocks stemming from the bank assistance measures. The government also pursued an aggressive public works program, that included highway building, airport improvements, and the construction of a high-speed train connecting Korea's major cities. Spending increases also resulted from special assistance programs for small and medium-size companies. These higher expenses were partly offset by a reduction in civil service salaries. Federal and local governments laid off 9.5% of their 453,000 employees in 1998, with another 13.7% expected to be cut by 2002.

The 1999 general government budget, excluding privatization receipts, calls for a deficit of 5.7%. Discretionary spending will be front-loaded to maximize the stimulus on the recovering economy. The initiatives to sustain employment and raise economic activity begun in 1998 will be maintained. Welfare programs will be increased a further 36%, to 2% of GDP. In addition, the higher interest costs associated with financial sector assistance will push the entire interest bill to 12% of revenues in 1999.

General government debt-including disbursed assistance through Kamco and KDIC, and monetary stabilization bonds issued by the Bank of Korea-increased to 45% of GDP at year-end 1998 from 28% in 1997, and is expected to rise further to 66% at year-end 1999. The increases represent the heavy cost imposed on Korean taxpayers by poor corporate and bank management. This is the most visible sign of the impairment of sovereign credit standing brought about by the 1997 crisis. If guarantees are added to the general government debt, the 1998 figure would rise to 54% of GDP. The debt of public sector financial enterprises (KDB, Kexim, and IBK) would add a further 8%.

At the consolidated public sector level, operating balances of public enterprises have consistently been positive, but from 1994 through 1997, they represented a 2%-3% of GDP net borrowing requirement because of their large investment programs. As operating balances have improved-to 3.3% of GDP in 1998 from 1.0% in 1994-these investments appear to have been well made.

Monetary Policy

· The government's interest rate cut could prove premature, given that the won appreciation depended, in part, on a favorable dollar-yen rate and that there could be political pressure not to raise rates during a recession should the won falter.

· A 3% CPI outturn in 1999 is expected, given the prospects of rising unemployment during the first half of the year, an only modest increase in private consumption, and low inflation expectations conditioned by past prudent monetary policy.

Since Dec. 16, 1997, the Korean won has floated. Since a week thereafter, the Bank of Korea has husbanded reserves. These two steps mark important policy changes.

At Dec. 16, 1997, the won traded at 1,669 to the dollar. At Jan. 21, 1999 (the time of writing this report), it traded at 1,172, a 30% nominal improvement. At Dec. 21, 1997, usable reserves were almost exhausted. At Jan. 15, 1999, they stood at US$49 billion, or 155% of short-term debt and 4.4 months of imports and services coverage.

The appreciation of the won is due to several factors:

· A weakened dollar against the yen;

· An estimated US$40 billion current account surplus in 1998;

· A US$9.1 billion (567%) increase of 1998 net FDI over 1997; and

· Improved investor sentiment, evidenced by US$4.7 billion of net portfolio flows.

The currency depreciation can also be explained by real interest rates. The real overnight rate approached zero from November 1997 to January 1998 and lending rates were negative.

The appreciation of the won (in roughly a steady manner throughout the year) helped keep price increases in check and enabled the Bank of Korea to ease its monetary stance. After the first quarter (when much of the inflationary impact of a won depreciation was felt), consumer prices barely rose and producer prices actually declined slightly. Inflation was subdued also by weak demand, a 3% cut in wages, falling housing rents, and stable or declining commodity prices. As a result, the Bank of Korea cut overnight rates. Real rates, which peaked at more than 20% in April 1998, stood under 3% by year end. In the eyes of some observers, the interest rate cut was a moxie move, given that the won appreciation depended, in part, on the exogenous factor of a favorable dollar-yen rate and that there would be political pressure not to raise rates during a recession should the won falter for any reason.

The Bank of Korea has also taken steps to clean up its own balance sheet. After extending US$23.4 billion (14% of 1997 exports) to troubled banks mostly in the fourth quarter of 1997 (at the expense of its own creditworthiness), the Bank of Korea has collected US$19.7 billion of the advances, the balance of which is expected to be repaid by year-end 1999. (An additional US$6 billion made earlier in 1997 to help banks carry the bad debts of Hanbo and Kia Motors is hoped to be recovered by year-end 2000.) In addition, the central bank lent financial institutions W11.3 trillion (2.7% of 1997 GDP) in emergency advances, of which W6.2 trillion is now outstanding. Amounts that cannot be repaid by the banks will be assumed by the KDIC to preserve the integrity of the Bank of Korea's asset base. The Bank of Korea expects to report a modest profit in 1998.

Real lending rates have been slower to respond than the Bank of Korea's overnight deposit rate. They peaked later than the overnight rate, in June at 20%, and stabilized during the fourth quarter at 10%, provoking criticism from some political quarters that the banks were choking off corporate recovery in an effort to restore their own earnings power.

At the time of the writing of this report, the immediate concern of policymakers was the unexpected strength of the won resulting from capital flows. To preserve the competitive advantage of a real effective exchange rate depreciation in the order of 20% since the fourth quarter of 1997, authorities were planning to pay down public sector external debt and to encourage public enterprises to fund themselves domestically in 1999. Thus, Korea's balance of payments flexibility translates into exchange rate flexibility. Other policy levers, however, are more limited. In a recession, it would be difficult for the Bank of Korea to raise interest rates, should the won weaken due to shocks. The Bank of Korea also has little additional room to ease bank liquidity conditions through reserve requirements, which now average 3%, although it is well within its agreed ceiling with the IMF for gross domestic assets.

As for inflation, the government target of (1%)-3% CPI change in 1999 appears realistic, given the prospects of rising unemployment during the first half of the year, an only modest increase in private consumption, and low inflation expectations conditioned by past prudent monetary policy.

External Finances

· The current account should reach the government's forecast, given continued weak internal demand and the benefits of a won that is still well below its 1997 levels.

· Korea's balance of payments flexibility is enhanced by its expected current account surplus, the prospects for continued robust FDI, and a recently negotiated US$5 billion bilateral swap line with Japan.

Korea's external position improved remarkably in 1998 and should improve further in 1999. In 1998, Korea is estimated to have posted a trade surplus of US$41 billion (3.4% of GDP), compared with a trade deficit of US$3 billion in 1997. A more modest trade surplus of US$26 billion is forecast by the government for 1999. The improvement is due to sharply lower imports, which declined 35% in dollar terms in 1998, as exporters ran down inventories, companies slashed investments, and consumers cut back on purchases of foreign merchandise. Exports declined 3% in dollar terms, but increased 17% in volume terms, as exporters cut prices in dollar terms to gain market share. Demand for Korean footwear, textiles, automobiles, and general machinery dipped as a result of weakened Asian economies, to which Korea exported 40% of its goods in 1998. Excluding the US$4.2 billion of exports of gold and second-hand jewelry from the government's successful campaign of raising reserves from its citizenry, the decline in exports would have been 6%.

Korea's current account also swung into a surplus of US$40 billion in 1998 from a deficit of US$8 billion in 1997 and is expected to post a surplus of US$15 billion-US$20 billion in 1999. In 1998, the surplus was helped by additional exceptional factors, such as US$2.5 billion in foreign remittances and the rolling forward of interest payments on the extended interbank debt guaranteed by the government. Notwithstanding the absence of these one-off measures and the need for exporters to replenish their stocks, the current account should reach the government's forecast, given continued weak internal demand and the benefits of a won that is still well below its 1997 levels.

Although the change in the current account can be attributed to the 11 percentage point swing in GDP and to broadly favorable won-yen exchange rate movements, several points should be underlined that speak to the resilience of Korea's economy. In the first instance, unlike Indonesia, exporters were able to maintain access to credit. Credit scarcity for importers was immediately addressed by a line of credit extended by Kexim and funded by lines totaling US$4.7 billion from export banks of Japan and the U.S. Therefore, exporters reduced stocks more because of the cost of carry due to high interest rates, rather than the unavailability of credit. Second, Korean corporations were able to slash investment. Korea's investment rate fell to 26% of GDP in 1998 from 35% the previous year. The investment rate is still high and suggests that a reduction was overdue. (Korea's Investment Capital Output Ratio (ICOR) has only averaged 0.10 the past five years.) Third, Korea's households increased savings rather than reduced them. In a year of fiscal deficits and poor corporate profitability, Korea's saving rate increased to 40% of GDP in 1998 from 33% in 1997. On the one hand, individuals save more when social assistance is limited and uncertainty is high; on the other hand, Koreans were able to adjust their personal finances, despite falling wages and rising unemployment. Fourth, there is great solidarity among the populace: Koreans at home contributed gold and family heirlooms; Koreans abroad remitted funds and curtailed overseas studies.

In the capital account, the most marked improvement in fundamentals entailed a sharp increase in net FDI, which rose from a US$1.6 billion outflow in 1997 to a US$7.5 billion inflow in 1998 and is projected to reach a similar amount in 1999. Korea has traditionally had more outward FDI than inward FDI, due to its unwelcome stance toward foreign competition. The Korean market now is much more open. FDI commitments soared at the end of 1998, partly due to the Nov. 17, 1998, passage of the Foreign Investment Promotion Act. FDI was also generated by generous tax holidays, a new bureau for foreign investors to help cut through red tape, and the forced restructuring of the chaebol. The latter accounts for much of the 1999 forecast for higher FDI, as much of the 1998 FDI came from foreigners buying out joint-venture partners.

Korea's external position was also enhanced by equity portfolio flows. Foreign ownership of the Korean stock market is estimated to have risen from 18% at the beginning of the year to roughly 20% by year end. Net portfolio investment of US$4.7 billion (which was mostly equity) helped fuel an appreciation of the Korea Composite Stock Price Index (Kospi), whose market capitalization increased by 94% in won terms during 1998. In addition to responding to the country's improved macroeconomic prospects, investors were encouraged by tighter protection for minority shareholders and the government's plan to float part of its holdings in Korea Telecom and other parastatals.

Including guarantees of interbank debt (of which a third corresponds to the public sector financial entities of KDB, Kexim, and the Industrial Bank of Korea, for which there are already government indirect capital replenishment commitments), gross public sector external debt increased to US$94.7 billion (57% of BOP exports) at year-end 1998 from US$62.4 billion at year-end 1997. In addition to the guarantees, the public sector external debt stock increased because of scheduled disbursements under the IMF Stand-by and SRF agreements and the Republic's US$4 billion global bond issue.

In 1998, financial institutions (including the debt of Korean banks offshore and guaranteed debt) reduced their external liabilities by US$22 billion by using the proceeds from contracting dollar-denominated loans and, to a lesser extent, liquidating cross-border interbank assets. Due to the extended debt program, the maturity profile of the financial system has been extended so that 76% of the debt has maturities of more than one year from 54% the year before. Private sector corporations also reduced their external indebtedness modestly, to US$8 billion (estimated at year-end 1998, excluding the debt of offshore subsidiaries and affiliates) and similarly reduced short-term debt to 32% of its total.

Therefore, the current portion of long-term external debt plus short-term external debt equaled US$57 billion, or 118% of reserves, at year-end 1998, compared with 897% only 12 months earlier and a near infinite amount 53 weeks before that. Korea's balance of payments flexibility is enhanced by its expected current account surplus, the terms of its stand-by arrangement that would allow a one-year postponement of the US$9.7 billion repurchase due in 1999, the prospects for continued robust FDI, and a recently negotiated US$5 billion bilateral swap line with Japan. Its vulnerabilities stem from foreign investment in the stock market and the banking sector. Investor sentiment could be hurt by endogenous events such as prolonged labor strife, a chaebol default, or a military confrontation; or by exogenous events such as a renminbi devaluation, a recession in the U.S., or a sharp sell-off of the yen. Regarding the banking sector, Standard & Poor's believes that the rated commercial banks will be able to roll over or retire their external indebtedness to their 134 creditor banks as the government guarantees expire.