korea's optimal public debt ratio

8/8/2019 Korea's Optimal Public Debt Ratio

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Korea's Optimal Public DebtRatioKorea"s current public debt is low compared with majoradvanced economies. Fiscal stimulus during thefinancial crisis has accelerated Korea"s public debtgrowth to 14.8 percent compared to 4.5 percent in 2007-8. While current public debt is not problematic, it needsto be maintained at lower levels to guard against futurerisks. Given the high likelihood that governmentspending will grow, including possible increases ininsurance costs, the government should be careful tomaintain public debts at a lower level.MOON Weh-Sol

Korea's Optimal Public Debt RatioMoon Weh-Sol

Korea's current public debt is low compared with major advancedeconomies. Fiscal stimulus during the financial crisis hasaccelerated Korea's public debt growth to 14.8 percent compared to4.5 percent in 200708. While current public debt is not problematic,

it needs to be maintained at lower levels to guard against futurerisks. Given the high likelihood that government spending will grow,including possible increases in insurance costs, the governmentshould be careful to maintain public debts at a lower level.

The European Union (EU) fiscal crisis triggered by the Greek sovereign debt crisisproved to be a profound threat to the stability of the global economy. Markets werealready fluctuating greatly in October 2009 as the Greek government massively

revised its forecast fiscal deficit-to-GDP ratio to 12.7 percent, nearly double theprevious government's 6 percent forecast. Moreover, Greece and Italy announcedthat their public debts exceeded 100 percent of GDP in 2009. Accordingly, the threatof sovereign default risk for countries in Mediterranean Europe has grownincreasingly palpable, as the five-year Credit Default Swap (CDS) premium ongovernment bonds from southern Europe has soared.

Under these circumstances, the EU and the International Monetary Fund (IMF)devised a joint bailout fund worth 750 billion in May 2010. This too, however, wouldfall short of completely relieving market anxieties. As the Greek fiscal crisis startedto spread to other countries in the euro zone, the IMF was compelled to

acknowledge that public debt had become a major stumbling block to anyprospects of a global recovery in the second half.1 In response, the G20 nations set


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reduction targets for their budget deficits and public debt during the G20 summitheld in June 2010, under a new consensus that member countries' budget deficitsand public debts had reached uncomfortably risky levels. Their target was to cutgovernment deficits in half by 2013 and to stabilize the recent rapid growth in the

public debt-to-gross domestic product (GDP) ratio by 2016.2

In comparison, Korea's current public debt is relatively low compared with majoradvanced economies. As of 2009, Korea's public debt-to-GDP ratio was 32.6percent, 21.2 percentage points lower than the average 53.8 percent prevailing inOrganization for Economic Cooperation and Development (OECD) membercountries.3Korea's public debt-to-GDP ratio was lower than that for Japan (192.9percent), Greece (125.7 percent), and the US (53.1 percent), ranking 23rd among 31OECD member countries. Other countries which have relatively small public debtvis--vis GDP include Chile (6.1 percent), Australia (8.1 percent) and Luxembourg(8.6 percent).


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In respect to the sovereign default risk estimated by the CDS premium ongovernment bonds, Korea on the surface appears to be safe. Korea's average CDSpremium for the first half of 2010, which stood at 102.6 basis points, was below theaverage 120.6 basis points of 28 OECD countries.4Norway and Finland are thesafest countries with CDS premiums at 19.5 and 28.7 basis points, respectively.Greece, on the other hand, is at the greatest risk of national default with a CDSpremium rate of 506 basis points.

Nevertheless, relative comparisons alone do not provide sufficient grounds toconclude that Korea's debt level is in the "safe zone." In fact, Korea's public debthas swelled at an annual average of 17.6 percent, over the 14-year period of 1997 to2010. In contrast, in the previous 14-year period from 1983 to 1996 (before theforeign currency crisis erupted in 1997), Korea's public debt increased by an annualaverage of 8.5 percent. More specifically, Korea's public debt, which was once

60.3 trillion or 12.3 percent of GDP in 1997, rose to 111.4 trillion or 18.5 percentof GDP in 2000. In 2009, public debt amounted to 359.6 trillion, or 33.8 percent ofGDP.


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The main contributor to the rapid increase in public debt was the expansionaryfiscal policy adopted during the 1997 foreign currency crisis and the 2008 globalfinancial crisis. During the 1997-98 foreign currency crisis, Korea's public debt grewby an annual average of 35.2 percent. The public debt growth rate reaccelerated toan annual average of 14.8 percent in 2009 and this year. Before the global financialcrisis erupted, Korea's average public debt growth was 4.5 percent for 2007 and2008. Thus, even if Korea's debt levels are lower than average, Korea's rapidly

growing debt levels cannot be described as "safe."5

For a more accurate assessment of Korea's national default risk, it is first necessaryto determine the optimal size of public debt, as this can serve as a yardstick forboth the current pace of debt growth, and for future fiscal management.Considering the recent rapid growth of Korea's public debt, it is critical that anoptimal level of public debt be determined.

The optimal level of public debt is the sustainable level of debt that can maximizethe social welfare of the entire economy. Here, "sustainable debt" means repayabledebt. If the public debt level is sustainable, a country can service debt at this level

with tax revenue and the public debt-to-GDP ratio can be maintained.

When determining the optimal level of public debt, important factors to beconsidered are the nation's economic conditions and benefits and the costs ofgovernment spending. Since there is considerable variation across countries interms of public debt-to-GDP ratio, it is not practical to apply the same optimal debtratio across them uniformly, as circumstances for each nation vary widely. Forexample, Japan's public debt-to-GDP ratio was 193 percent in 2009, three timeshigher than the 53 percent found in the US.6A similar case can be made for the EU'sStability and Growth Pact (SGP). The EU asked member states to keep their fiscaldeficits below 3 percent of GDP and public debts below 60 percent of their GDPunder this pact. However, the ceiling of 60 percent of GDP for public debt does not


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fit all member countries, as it was simply the average of member states' public debt-to-GDP ratios when the pact was drafted. Accordingly, SGP has been criticized byclaiming these ceilings do not reflect the unique economic conditions of membercountries, and the need for modest widening of fiscal deficits as needed.

Therefore, when discussing the optimal debt level for Korea, the distinctivecharacteristics of the Korean economy, along with the benefits of governmentspending (e.g., economic stabilization and an increase in social well-being) must beconsidered.

Benefits and Costs of Public Debt


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What are the costs and benefits of public debt? Let's look at the benefits first.

First, increased public debt expands total demand in the short run, raising GDP.Especially when wages and prices are not flexible enough, increased total demand

can induce more employment and investment spending. Particularly duringeconomic crises, when total demand plummets, expansionary governmentspending can help push the economy towards recovery.

For example, the G20 countries' stimulus packages during the global financial crisiswere estimated to increase their GDP growth by an average of 0.41.3 percentagepoints. Korea's stimulus packages in 2009 raised GDP by an estimated 0.51.3percentage points. In this manner, public debt can contribute to growth.

Second, an increase in public debt can boost household consumption in the shortrun as it provides "consumption smoothing"7by easing household liquidityconstraints. Since the government has relatively lower risk compared to householdsand can raise capital more easily, if the government borrows more and transfers the

capital to households, they suffer fewer liquidity constraints.

Third, an increase in government spending for Social Overhead Capital (SOC) (i.e.,infrastructure) investment with funding secured by issuing more government bondscan boost potential growth. In the case of the OECD countries, the 1 percentincrease in SOC investment was estimated to increase GDP per capita by anaverage 0.3-0.5 percent. For Korea, a 1 percent increase in transportation-relatedSOC investment was estimated to increase GDP per capita by 0.17-1.06 percent.

Fourth, an increase in public debt can expand the bond market, thereby boostingthe entire financial market. In Korea's case, corporate bond issuance has been low

despite continued demand for long-term bonds. Thus, if the government increaseslong-term government bonds, it will not only ease the supply shortage but alsoenlarge the bond market. On top of this, government bonds with various maturitieswill provide different benchmark rates in the bond market, which will serve as baserates to assess bonds with various maturity dates and risks.


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Of course, increased public debt provides economic costs as well as benefits. First,growth in public debt crowds out private investment and lowers labor productivity,consequently retarding GDP growth over the long term. Declining tax revenue orincreased fiscal spending, which increases public debt, lead to interest rate hikes.Higher interest rates raise financing costs, thereby dampening private investment.Over the long term, higher interest rates will reduce capital stocks, consequentlyhurting aggregate output. In the case of 27 OECD countries, the correlationcoefficient of the central government's debt-to-GDP ratio on economic growth was -0.24. This means that public debt and economic growth have a negativerelationship, with one rising as the other sinks.

Second, a surge in public debt can erode sovereign credit ratings, causing a rapidcapital outflow, which can evolve into a financial crisis. As shown in the recentglobal financial crisis, a surge in the public debt led to an increase in the CDS

premium on government bonds. From 2008 to 2009, when the public debt-to-GDPratio rose by one percentage point, it was estimated that the five-year CDS premium


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for government bonds increased by an average of 4.7 to 6.2 basis points. Also, thebudget deficit ratio turned out to have a positive relation to the CDS premium ongovernment bonds (coefficient: 0.34).

Third, the tax increases required to eventually repay the country's public debt candampen economic sentiment. It is inevitable that the government will raise taxes inorder to repay increased public debt. Tax increases, however, can shrinkinvestment, and dampen the labor supply while eroding purchasing power, therebydistorting economic activities.

Estimating the Optimal Piblic Debt Ratio

The optimal public debt ratio is estimated quantitatively by weighing benefitsagainst costs of public debt. Here, the optimal public debt level is defined as the

level that maximizes social welfare for the entire economy. To measure socialwelfare for the entire economy this paper used an economic model8which reflecteddifferences in labor productivity and asset holdings among households. Inmeasuring the gap between expected and optimal public debt ratios from 2010 to2050, projections of public 8 Aiyagari, R. & McGrattan, E. (1998). "The OptimumQuantity of Debt." Journal of Monetary Economics, 42(3), 447-469.9 It was assumedthat the growth rate of GDP per capita would decline gradually by 2050 and theconsolidated government spending-to-GDP ratio would increase for the sameperiod. More specifically, based on the average growth rate of GDP per capita from2000 to 2009 at 2.74 percent, it was assumed that the growth rate of GDP per capitawould be 2.51 percent for 2020, 1.73 percent for 2030, 0.93 percent for 2040 and 0.5percent for 2050. debt ratios were calculated by using consolidated centralgovernment spending as future government expenditures.9

The results of our analysis showed that projected public debt-to-GDP ratio is likelyto stand at 52.8 percent in 2020. This will likely rise to 67.8 percent in 2030 andfurther increase to 113.3 percent in 2050. These estimates reflected a likely increasein government spending in areas of health insurance and national basic livelihoodsecurity, and the four major public pensions, where expenditures are expected toincrease due to demographic changes.


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To analyze optimal public debt ratio, economic conditions in 2010 were used as abenchmark; including the public debt-to-GDP ratio (33.8 percent), projectedconsolidated government spending- to-GDP ratio (23.5 percent), depreciation rate ofcapital stock (10 percent), contribution of capital stock to output growth (30 percent)and the ceiling for household credit loans (two thirds of wages). To reflect theexternal dependence of the Korean economy, it was assumed that foreigners heldpart of the public debt. At the end of May 2010 foreign investors represented 12.7percent of the outstanding balance of government bond issuance (39.881 trillion).However, in this economic model the foreign positions in government bonds wereset higher at 30 percent because there is high potential that foreign investors willincrease their positions in the government bond market. Lastly, spreads ongovernment bonds held by foreigners were assumed to increase 6.2 basis pointswhen the public debt-to-GDP ratio increases by 1 percent.

In this economic model, factors influencing the optimal public debt ratio are the

sovereign credit rating, potential growth rate, and liquidity constraints. By whatmechanism does each factor influence the optimal public debt ratio? First, thehigher international sovereign credit rating lowers national default risk, therebyraising the optimal public debt ratio. Second, higher potential productivity enhancesthe government's ability to service debts, consequently raising the optimal publicdebt ratio. Third, increased government bond issuances provide a savingsinstrument to households, pushing up the optimal public debt ratio.

The results of analysis showed that the optimal public debt ratio for 2010 is 62percent in terms of GDP. If the public debt ratio rises due to more issuance ofgovernment bonds, this will have the same effect as if it provided assets to the

financial markets. Increased assets in the financial markets offer more savingsinstruments to households with "precautionary saving motives" whichconsequently increases social welfare. However, the government will also have toraise the income tax rate in order to pay interest rates on already issuedgovernment bonds and rising spreads to foreign bondholders. If the distortionaryincome tax rate is raised, it will reduce labor supplies, lower income levels, andshrink consumption,10which will decrease social welfare for all economic agents.Considering all these factors, the optimal public debt ratio for Korea is 62 percentas a percentage of GDP. At this level of public debt, the social welfare of the Koreaneconomy is maximized.

The current level of public debt is 33.8 percent against GDP, 30 percentage points


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lower than the estimated optimal public debt ratio. If there are no future shocks fromthe current account balance or foreign exchange rates, the current level of short-term public debt will not cause a serious problem. However, if the potential growthrate falls and subsequent future income growth drops, households will increase

their labor supply and save more money. Moreover, if the nation's aging populationrequires more government spending, the government will raise tax rates, which willnegatively affect income and consumption. Not only that, lower potential growthrates weaken the government's ability to repay debt, which makes tax hikesinevitable. Tax hikes shrink private consumption and lower the social welfare ofeconomic agents. If both potential growth rates fall and government fiscal spendingincreases, the optimal public debt ratio will drop gradually.

From this analysis, the optimal public debt ratio will likely remain at the 50% levelfrom 2020 to 2050. Compared with projected public debt ratios, the public debt levelwill exceed the optimal public debt ratio in 2030. A rapid increase in the public debtratio stemming from rising government spending going forward will likely threatenfiscal soundness, eroding sovereign credit ratings. Accordingly, it is critical to

maintain the public debt ratio at an optimal level. To do so, the pace of increases ingovernment spending needs to be contained.

Implications

Public debt should be limited to the optimal public debt ratio of 60%. In the mid- tolong-term, to enhance fiscal soundness, fiscal discipline should be stepped up.Specific targets related to fiscal indicators - such as public debt and the budgetbalance - should be set as standing rules to avoid arbitrary and ad hoc fiscalmanagement.

On the other hand, it is important to raise the optimal public debt ratio. Once the

optimal public debt ratio increases, the government will have more fiscal leeway,thereby gaining more time to bolster fiscal soundness. To raise the optimal publicdebt ratio, potential growth rates and sovereign credit ratings should be raised tostrengthen debt repayment ability. For example, the US and Japan have lowsovereign default risk thanks to high sovereign credit ratings, even though theirlevel of public debt is high.

In addition, the government should increase government assets to lower the ratio ofnet public debt and raise the share of long-term government bonds. If governmentbond interest rates are higher than economic growth rates, the public debt ratiostands to rise. Accordingly, ways to stabilize government bond interest rates should


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also be explored.

Furthermore, the government should effectively brace for expected mid- and long-term fiscal demands through increased government-sector productivity and higher

efficiency in utilizing tax revenue sources.

Keywordspublic debt, CDS (Credit Default Swap), government deficits, optimal public debtratio, stimulus packages

Note

1. IMF (Apr. 2010). World Economic Outlook - "Rebalancing Growth."

2. "World Leaders Agree on Timetable for Cutting Deficits." (June 27, 2010). NewYork Times.

3. The OECD method to define "public debt" differs from that used by the IMF, whichthe Ministry of Strategy and Finance has adopted. Accordingly, the public debt-to-GDP ratio for Korea in 2009 according to the OECD definition is 1.2 percentagepoints lower than the ratio calculated by the Ministry of Strategy and Finance.

4. Due to lack of data, Canada, Luxembourg and Sweden were excluded.

5. In "Ketchup Economics," Larry Summers, director of the National EconomicCouncil (NEC) criticized economists for relying more on relative evaluation ratherthan absolute evaluation. He used a parable about "ketchup economists" who "haveshown that two-quart bottles of ketchup invariably sell for exactly twice as much asone-quart bottles of ketchup," and then concluding from this that the ketchup

market is perfectly efficient without questioning whether the ketchup price isappropriate. (Summers, L. (1985). "On Economics and Finance." Journal of Finance,


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40(3), 633-635.)

6. Based on the IMF's assessment method, the public debt-to-GDP ratios for the USand Japan was 88.8% and 217.4%, respectively in 2009.Horton, M., Kumar, M. &

Mauro, P. (2009). The State of Public Finances: A Cross-Country Fiscal Monitor(SPN/09/21). IMF.

7. "Household liquidity constraints" mean that households have constraints inborrowing money from financial institutions. If there are liquidity constraints, it isimpossible to "smooth consumption." "Consumption smoothing" refers tobalancing out of consumption levels by acquiring loans when future income levelsare higher than current levels.

8. Aiyagari, R. & McGrattan, E. (1998). "The Optimum Quantity of Debt." Journal ofMonetary Economics, 42(3), 447-469.

9. It was assumed that the growth rate of GDP per capita would decline gradually by2050 and the consolidated government spending-to-GDP ratio would increase forthe same period. More specifically, based on the average growth rate of GDP percapita from 2000 to 2009 at 2.74 percent, it was assumed that the growth rate of GDPper capita would be 2.51 percent for 2020, 1.73 percent for 2030, 0.93 percent for2040 and 0.5 percent for 2050.

10. Generally, wages tend to increase if the labor supply declines, but tax increasesare more effective in reducing the labor supply rather than increasing wages.

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