Why Korea must uphold fiscal integrity
Kim Woo-cheol
The author is a professor of tax affairs at the University of Seoul.
As an expert on public finance, there is one regular question I get. People ask why the government and scholars are timid towards increasing fiscal spending to bolster welfare or the economy, although the country’s debt to GDP ratio hovers below the average of major economies like Europe, the U.S. and Japan. More than half of Korean politicians insists on drawing up a supplementary budget even if it means an additional issuance of national bonds to assist the deteriorating macro and micro economic conditions hardening public lives.
Since fiscal policy exists entirely for the people, the argument has a point. But increased spending requires a condition — the sustainability of fiscal health. Aggressive fiscal policy or an appropriate level of increased spending is only possible when fiscal integrity can be sustained for this and next year as well as beyond. Just as a state and government are permanent, fiscal integrity also must be the same.
All dynasties squandering fiscal resources were short-lived
Fiscal integrity is important because a government that failed in policymaking can be forgiven, but one that could not maintain fiscal soundness cannot. History shows that all dynasties that pursued reckless military quests or wasted public coffers for ambitious construction projects were short-lived. Maintaining fiscal health over the mid-to-long term is not an option but the first-priority for any governments.
In this sense, the national duty to defend the country as laid out in the Constitution is not restricted to defense. It also requires the preservation of fiscal integrity. An individual or a company without the ability to meet debt obligation can be bailed out by financial or public institutions. But there is little option left for a nation if it faces insolvency. It would have to put some of its valuable assets in a fire sale or seek an international bailout by sacrificing its economic sovereignty. That’s why fiscal policy comes as the final resort.
Fiscal integrity a must for a small open economy
As the Korean economy — open and relatively small in size with heavy dependence on trade — is particularly susceptible to external shocks, it must uphold two pillars — sufficient foreign exchange reserve and sound fiscal condition — to ensure stable economic growth.
COL-A
The national default crisis and the consequential bailout led by the International Monetary Fund (IMF) in 1997 should be a sober reminder of the dire consequences from a lack of reserve currencies in case of emergency. Owing to the costly lesson, we regard the FX reserve of more than 530 trillion won ($409 billion) stocked at the Bank of Korea not just as an extra reserve set aside for contingency, but as the last resort.
Some Koreans attribute the financial crisis to a temporary shortage of dollar liquidity. But the fundamental reason was the government’s poor management of sovereign credit rating. At that time, Korea could not borrow money from the international market by selling foreign denominated national bonds. If Korea had had sound sovereign credit rating in the international financial market, it could have easily borrowed dollars to overcome its short-term liquidity crisis. Fiscal integrity is a crucial factor in determining a country’s sovereign credit rating. A small-scale open economy like Korea’s with security risks from North Korea must have a solid fiscal foundation to secure trust from the international community. The government must recognize that managing sound fiscal health requires more than simply making a policy decision on budget increase if it really wants to join the first-tier country rank.
Fiscal weakness can cause bank bankruptcies
Fiscal integrity has significant economic ramifications beyond sovereign credit rating. The health of the financial sector largely depends on fiscal soundness. The risk premium on bonds issued by commercial banks hinges on the sovereign bond yield. As the risk premium on sovereign bonds of a government of relatively poor fiscal conditions goes up, it push up borrowing costs for the private sector to hurt profitability of financial institutions and corporations. The toll can affect a country’s international competitiveness.
Fiscal weakness can shake the financial sector and cause unexpected bankruptcies. A number of pension funds had to be rescued last September by the Bank of England after bond prices crashed from the government’s disastrous “mini-budget” scheme. A tax-cut scheme by new Prime Minister Liz Truss despite heavy debt from the massive pandemic spending sent British bonds and pound nose-diving. The consequences were bloody. As government bonds known as “gilts” crumbled, it pushed a number of pension funds and banks to the brink of insolvency upon the sharp depreciation of the liability-driven funds invested in long-dated gilts. The Bank of England had to abruptly reverse from the tightening policy to offer emergency liquidity to solve the crisis. The prime minister had to resign after just 45 days into office. The U.K. is still grappling with the highest inflation among advanced economies partly due to the disruption in the central bank’s policy to tame prices.
The fiscal crisis of southern European countries also underscores the grave consequences if a government neglects excessive debt piling despite lack of funds. If fiscal ammunitions are not sufficient, a government cannot quickly respond to bank troubles to invite a serious financial crisis. Empirical studies are ample, showing greater adverse impact on the financial sector from fiscal weakness for countries like Korea, which lacks an internationally-trading currency and has a high private debt ratio against the GDP.
Fiscal health helped overcome the financial crisis
It is a pity that Korea discredits the importance of fiscal integrity despite its experience of having overcome a financial crisis through the power of fiscal integrity. Korea was able to swiftly carry out restructuring the ailing financial institutions and restore stability in the financial and FX markets quicker than expected, all thanks to public funds of 168 trillion won which came out of the government coffers. At the time, Korea’s fiscal debt-to-GDP ratio hovered slightly above 10 percent.
Having learned a hard lesson in 1997, Korea has become overly defensive of FX reserves. But what should be more prized is fiscal health that has helped the country combat the financial crisis. National debt-to-GDP ratio has ballooned more than five times from the level of 25 years ago, shrinking fiscal affordability. Yet proponents for fiscal expansion steadfastly point to Korea’s lower national debt-to-GDP ratio than the OECD average to claim fiscal affordability. Fiscal deficit added 100 trillion won on average each year over the past three years under the pandemic, and yet there is no effort to fill the yawning rift. Instead, debt goes on stretching through repeated supplementary budgets and one-time welfare spending.
The government has a duty to care for public livelihoods during economic hardship. But it is hard to understand why the legislature — which should have deliberated hard where and how the 640-trillion-won annual budget should be spent — talks about raising the budget by another 5 percent only a few months later.
Fiscal debt to hit 145-161 percent of GDP by 2060
Major economies struggled in fiscal management due to rising debt from fast aging and a surge in welfare cost from the early 2000s. Aging is happening in an unprecedented pace for Korea. The increase in its welfare spending from 2000 has been the fastest among OECD countries.
The worst is yet to come. According to the Social Security Committee’s welfare expenditure outlook in 2020, the cost would reach 20.1 percent of the GDP by 2040 even without any changes in the current welfare system. In other words, the entire tax revenue would have to go to welfare. According to long-term estimates by the Korea Development Institute and the National Assembly Budget Office, the country’s national liability ratio would hit 145 to 161 percent of its GDP by 2060. Skepticism is brewing in the international community on how Korea can endure such a fiscal burden when seniors’ share in the population will be the highest among OECD countries from 2050.
Global sovereign credit rating agencies and institutions like the OECD and the World Bank have raised doubts about the long-term sustainability of Korea’s fiscal integrity due to its rapid aging. We must raise vigilance before it is too late. An inclusive body must be set up to discuss fiscal reforms, fiscal guidelines and long-term means to bolster our tax revenue.
Translation by the Korea JoongAng Daily staff.
with the Korea JoongAng Daily
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