Public Debt and Monetary Policy in Korea

Abstract

This note reviews Korea’s fiscal policy and public debt management, and discusses some of the constraints that bind the Bank of Korea in its conduct of monetary policy. Fiscal prudence and low public debt in Korea have allowed monetary policymakers to focus on inflation control without worrying about public debt dynamics. Such fiscal prudence is mainly attributable to the strong and long-standing commitment to a balanced budget. However, recently, fiscal policy has been managed in a more countercyclical manner within the framework of medium-term fiscal planning. During the recent global financial crisis, Korea implemented large-scale countercyclical fiscal policies to counteract the contractionary effect of the crisis.

Meanwhile, the Korean government bond (TB) market has grown rapidly. Such a development can potentially be helpful for implementing countercyclical fiscal policy against crises, by acting as a low-cost funding source during crises. The Korean government has made various efforts to develop an efficient bond market, such as introducing a system of fungible issuance and opening the market to foreign investors. A recent phenomenon is the increase of official investment in TB by Asian countries, including China and Thailand. The opening-up of the financial market, however, has also complicated the implementation of monetary policy because capital flow also affects market liquidity and the exchange rate. A recent study on the transmission channel shows that the bank lending channel is the most effective one, while the scope for other channels to operate (eg through the yield curve) is limited. This result indicates that monetary policy may have been constrained in reacting to inflationary pressure after the global crisis.

While it is true that public debt sustainability is currently not an issue in Korea, it is also true that sovereign debt management could face significant challenges arising from population ageing and ballooning social welfare expenditures. Other risk factors for public debt dynamics are unfunded government liabilities, public agency or state-owned enterprise debt that is not counted as sovereign debt, and the cost of unification.

Full publication: Fiscal Policy, Public Debt and Monetary Policy in Emerging Market Economies

Keywords: Fiscal policy, public debt management, capital inflow, monetary policy

JEL Classification: E61, E62, H60