Korea's economy is forecast to expand 5.6% in 2004, accelerating from 3.1% in 2003, and then pick up further to 5.9% in 2005.
But the outlook is burdened by sluggish domestic consumption which is pressured by weak consumer confidence, the OECD said in a comprehensive economic survey on Korea released recently.
"...there is uncertainty about private consumption, given the still weak level of household confidence. With their debt still at a high level, there is a risk that households will raise their saving rate in order to improve their financial position.
"A second risk is a slowdown in export demand, particularly in China, which has been the major factor driving the growth of exports," it said.
Exports have been the sole driver of the economy, making up for the gap in domestic consumption which had been depressed by a rise in household debt and a surge in delinquency ratio, led by credit card debt.
"The conflicting signals given by buoyant export growth and sluggish domestic demand make it exceptionally difficult to project the path of the economy. Nevertheless, robust export growth should stimulate sluggish business investment and private consumption," said the OECD.
With the economy gaining momentum, monetary policy should contribute to macroeconomic stability by focusing on the medium-term inflation target introduced this year, it said.
The OECD also suggested that short-term interest rates may rise as the economy accelerates. But by the same token, given the surge in household debt recently, higher interest rates are likely to burden a recovery in private consumption.
"The extent of the rise in interest rates needed to keep inflation in the medium-term target zone depends to some extent on exchange rate developments," it said.
By the end of 2003, the Korean won had fallen six percent from a year earlier against currencies of Korea's major trading partners.
"This may have contributed to the acceleration of exports, though possibly weakening domestic demand by reducing the purchasing power of Korean households and firms," said the OECD.
The organization noted that the decline in the won occurred against the backdrop of a large accumulation of foreign exchange reserves which totaled $155 billion in 2003.
"Therefore, now that Korea's reserves are almost three times larger than its total short-term foreign debt, there is no need for continued foreign exchange accumulation," said the OECD.
On fiscal policy, it pointed out that the frequent use of supplementary budgets could lead to higher expenditures although an economic recovery during the year may forestall the need to allocate an extra budget.
"The authorities should aim to keep the consolidated government budget (excluding the social security surplus) in balance over the business cycle once the process of bringing the costs of financial sector restructuring into the budget is completed in 2006," it said.
Greater reforms needed for medium-term growth
To sustain rapid growth over the medium term, Korea must make greater progress in structural reform, particularly in the labor market and in the corporate and financial sectors, the OECD said.
As a part of this process, the country needs a comprehensive reform package to increase employment flexibility and improve industrial relations.
"Relaxing employment protection for regular workers and improving the coverage of the social safety net, especially for non-regular workers who account for about a quarter of all employees, would enhance flexibility...Active labor market policies should be improved while limiting deadweight costs," the OECD said.
It stressed the importance of continued privatization of commercial banks and promptly resolving problems in the non-ban
