Korea's Optimal Public Debt

Ratio
Korea"s current public debt is low compared with major
advanced economies. Fiscal stimulus during the
financial crisis has accelerated Korea"s public debt
growth to 14.8 percent compared to 4.5 percent in 2007-
8. While current public debt is not problematic, it needs
to be maintained at lower levels to guard against future
risks. Given the high likelihood that government
spending will grow, including possible increases in
insurance costs, the government should be careful to
maintain public debts at a lower level.

MOON Weh-Sol

Korea's Optimal Public Debt Ratio

Moon Weh-Sol

Korea's current public debt is low compared with major advanced

economies. Fiscal stimulus during the financial crisis has
accelerated Korea's public debt growth to 14.8 percent compared to
4.5 percent in 2007–08. While current public debt is not problematic,
it needs to be maintained at lower levels to guard against future
risks. Given the high likelihood that government spending will grow,
including possible increases in insurance costs, the government
should be careful to maintain public debts at a lower level.

The European Union (EU) fiscal crisis triggered by the Greek sovereign debt crisis
proved to be a profound threat to the stability of the global economy. Markets were
already fluctuating greatly in October 2009 as the Greek government massively
revised its forecast fiscal deficit-to-GDP ratio to 12.7 percent, nearly double the
previous government's 6 percent forecast. Moreover, Greece and Italy announced
that their public debts exceeded 100 percent of GDP in 2009. Accordingly, the threat
of sovereign default risk for countries in Mediterranean Europe has grown
increasingly palpable, as the five-year Credit Default Swap (CDS) premium on
government 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, would
fall short of completely relieving market anxieties. As the Greek fiscal crisis started
to spread to other countries in the euro zone, the IMF was compelled to
acknowledge that public debt had become a major stumbling block to any
prospects of a global recovery in the second half.1 In response, the G20 nations set
reduction targets for their budget deficits and public debt during the G20 summit
held in June 2010, under a new consensus that member countries' budget deficits
and public debts had reached uncomfortably risky levels. Their target was to cut
government 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 major
advanced economies. As of 2009, Korea's public debt-to-GDP ratio was 32.6
percent, 21.2 percentage points lower than the average 53.8 percent prevailing in
Organization for Economic Cooperation and Development (OECD) member
countries.3 Korea's public debt-to-GDP ratio was lower than that for Japan (192.9
percent), Greece (125.7 percent), and the US (53.1 percent), ranking 23rd among 31
OECD member countries. Other countries which have relatively small public debt
vis-à-vis GDP include Chile (6.1 percent), Australia (8.1 percent) and Luxembourg
(8.6 percent).
In respect to the sovereign default risk estimated by the CDS premium on
government bonds, Korea on the surface appears to be safe. Korea's average CDS
premium for the first half of 2010, which stood at 102.6 basis points, was below the
average 120.6 basis points of 28 OECD countries.4 Norway and Finland are the
safest 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 CDS
premium rate of 506 basis points.

Nevertheless, relative comparisons alone do not provide sufficient grounds to

conclude that Korea's debt level is in the "safe zone." In fact, Korea's public debt
has swelled at an annual average of 17.6 percent, over the 14-year period of 1997 to
2010. In contrast, in the previous 14-year period from 1983 to 1996 (before the
foreign currency crisis erupted in 1997), Korea's public debt increased by an annual
average 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 percent
of GDP in 2000. In 2009, public debt amounted to ￦359.6 trillion, or 33.8 percent of
GDP.
The main contributor to the rapid increase in public debt was the expansionary
fiscal policy adopted during the 1997 foreign currency crisis and the 2008 global
financial crisis. During the 1997-98 foreign currency crisis, Korea's public debt grew
by an annual average of 35.2 percent. The public debt growth rate reaccelerated to
an annual average of 14.8 percent in 2009 and this year. Before the global financial
crisis erupted, Korea's average public debt growth was 4.5 percent for 2007 and
2008. 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 necessary
to determine the optimal size of public debt, as this can serve as a yardstick for
both 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 an
optimal level of public debt be determined.

The optimal level of public debt is the sustainable level of debt that can maximize
the social welfare of the entire economy. Here, "sustainable debt" means repayable
debt. 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 be

considered are the nation's economic conditions and benefits and the costs of
government spending. Since there is considerable variation across countries in
terms of public debt-to-GDP ratio, it is not practical to apply the same optimal debt
ratio across them uniformly, as circumstances for each nation vary widely. For
example, Japan's public debt-to-GDP ratio was 193 percent in 2009, three times
higher than the 53 percent found in the US.6 A similar case can be made for the EU's
Stability and Growth Pact (SGP). The EU asked member states to keep their fiscal
deficits below 3 percent of GDP and public debts below 60 percent of their GDP
under this pact. However, the ceiling of 60 percent of GDP for public debt does not
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 by
claiming these ceilings do not reflect the unique economic conditions of member
countries, and the need for modest widening of fiscal deficits as needed.

Therefore, when discussing the optimal debt level for Korea, the distinctive
characteristics of the Korean economy, along with the benefits of government
spending (e.g., economic stabilization and an increase in social well-being) must be
considered.

Benefits and Costs of Public Debt

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 during
economic crises, when total demand plummets, expansionary government
spending can help push the economy towards recovery.

For example, the G20 countries' stimulus packages during the global financial crisis
were estimated to increase their GDP growth by an average of 0.4–1.3 percentage
points. Korea's stimulus packages in 2009 raised GDP by an estimated 0.5–1.3
percentage points. In this manner, public debt can contribute to growth.

Second, an increase in public debt can boost household consumption in the short
run as it provides "consumption smoothing"7 by easing household liquidity
constraints. Since the government has relatively lower risk compared to households
and 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 bonds
can boost potential growth. In the case of the OECD countries, the 1 percent
increase in SOC investment was estimated to increase GDP per capita by an
average 0.3-0.5 percent. For Korea, a 1 percent increase in transportation-related
SOC 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 boosting
the entire financial market. In Korea's case, corporate bond issuance has been low
despite continued demand for long-term bonds. Thus, if the government increases
long-term government bonds, it will not only ease the supply shortage but also
enlarge the bond market. On top of this, government bonds with various maturities
will provide different benchmark rates in the bond market, which will serve as base
rates to assess bonds with various maturity dates and risks.
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 or
increased 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, consequently
hurting aggregate output. In the case of 27 OECD countries, the correlation
coefficient 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 negative
relationship, with one rising as the other sinks.

Second, a surge in public debt can erode sovereign credit ratings, causing a rapid
capital outflow, which can evolve into a financial crisis. As shown in the recent
global 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-GDP
ratio rose by one percentage point, it was estimated that the five-year CDS premium
for government bonds increased by an average of 4.7 to 6.2 basis points. Also, the
budget deficit ratio turned out to have a positive relation to the CDS premium on
government bonds (coefficient: 0.34).

Third, the tax increases required to eventually repay the country's public debt can
dampen economic sentiment. It is inevitable that the government will raise taxes in
order to repay increased public debt. Tax increases, however, can shrink
investment, and dampen the labor supply while eroding purchasing power, thereby
distorting economic activities.

Estimating the Optimal Piblic Debt Ratio

The optimal public debt ratio is estimated quantitatively by weighing benefits
against 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 social
welfare for the entire economy this paper used an economic model8 which reflected
differences in labor productivity and asset holdings among households. In
measuring the gap between expected and optimal public debt ratios from 2010 to
2050, projections of public 8 Aiyagari, R. & McGrattan, E. (1998). "The Optimum
Quantity of Debt." Journal of Monetary Economics, 42(3), 447-469.9 It was assumed
that the growth rate of GDP per capita would decline gradually by 2050 and the
consolidated government spending-to-GDP ratio would increase for the same
period. More specifically, based on the average growth rate of GDP per capita from
2000 to 2009 at 2.74 percent, it was assumed that the growth rate of GDP per capita
would be 2.51 percent for 2020, 1.73 percent for 2030, 0.93 percent for 2040 and 0.5
percent for 2050. debt ratios were calculated by using consolidated central
government spending as future government expenditures.9

The results of our analysis showed that projected public debt-to-GDP ratio is likely
to stand at 52.8 percent in 2020. This will likely rise to 67.8 percent in 2030 and
further increase to 113.3 percent in 2050. These estimates reflected a likely increase
in government spending in areas of health insurance and national basic livelihood
security, and the four major public pensions, where expenditures are expected to
increase due to demographic changes.
To analyze optimal public debt ratio, economic conditions in 2010 were used as a
benchmark; including the public debt-to-GDP ratio (33.8 percent), projected
consolidated government spending- to-GDP ratio (23.5 percent), depreciation rate of
capital 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 the
external dependence of the Korean economy, it was assumed that foreigners held
part of the public debt. At the end of May 2010 foreign investors represented 12.7
percent of the outstanding balance of government bond issuance (￦39.881 trillion).
However, in this economic model the foreign positions in government bonds were
set higher at 30 percent because there is high potential that foreign investors will
increase their positions in the government bond market. Lastly, spreads on
government bonds held by foreigners were assumed to increase 6.2 basis points
when 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 what
mechanism does each factor influence the optimal public debt ratio? First, the
higher international sovereign credit rating lowers national default risk, thereby
raising the optimal public debt ratio. Second, higher potential productivity enhances
the government's ability to service debts, consequently raising the optimal public
debt ratio. Third, increased government bond issuances provide a savings
instrument to households, pushing up the optimal public debt ratio.

The results of analysis showed that the optimal public debt ratio for 2010 is 62
percent in terms of GDP. If the public debt ratio rises due to more issuance of
government bonds, this will have the same effect as if it provided assets to the
financial markets. Increased assets in the financial markets offer more savings
instruments to households with "precautionary saving motives" which
consequently increases social welfare. However, the government will also have to
raise the income tax rate in order to pay interest rates on already issued
government bonds and rising spreads to foreign bondholders. If the distortionary
income tax rate is raised, it will reduce labor supplies, lower income levels, and
shrink consumption,10 which will decrease social welfare for all economic agents.
Considering all these factors, the optimal public debt ratio for Korea is 62 percent
as a percentage of GDP. At this level of public debt, the social welfare of the Korean
economy is maximized.

The current level of public debt is 33.8 percent against GDP, 30 percentage points
lower than the estimated optimal public debt ratio. If there are no future shocks from
the 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 growth
rate falls and subsequent future income growth drops, households will increase
their labor supply and save more money. Moreover, if the nation's aging population
requires more government spending, the government will raise tax rates, which will
negatively affect income and consumption. Not only that, lower potential growth
rates weaken the government's ability to repay debt, which makes tax hikes
inevitable. Tax hikes shrink private consumption and lower the social welfare of
economic agents. If both potential growth rates fall and government fiscal spending
increases, the optimal public debt ratio will drop gradually.

From this analysis, the optimal public debt ratio will likely remain at the 50% level
from 2020 to 2050. Compared with projected public debt ratios, the public debt level
will exceed the optimal public debt ratio in 2030. A rapid increase in the public debt
ratio stemming from rising government spending going forward will likely threaten
fiscal 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 in
government spending needs to be contained.
Implications
Public debt should be limited to the optimal public debt ratio of 60%. In the mid- to
long-term, to enhance fiscal soundness, fiscal discipline should be stepped up.
Specific targets related to fiscal indicators - such as public debt and the budget
balance - should be set as standing rules to avoid arbitrary and ad hoc fiscal
management.

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 public
debt ratio, potential growth rates and sovereign credit ratings should be raised to
strengthen debt repayment ability. For example, the US and Japan have low
sovereign default risk thanks to high sovereign credit ratings, even though their
level of public debt is high.

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

Keywords
public debt, CDS (Credit Default Swap), government deficits, optimal public debt
ratio, stimulus packages

Note

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

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

3. The OECD method to define "public debt" differs from that used by the IMF, which
the 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 percentage
points 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 Economic

Council (NEC) criticized economists for relying more on relative evaluation rather
than absolute evaluation. He used a parable about "ketchup economists" who "have
shown that two-quart bottles of ketchup invariably sell for exactly twice as much as
one-quart bottles of ketchup," and then concluding from this that the ketchup
market is perfectly efficient without questioning whether the ketchup price is
appropriate. (Summers, L. (1985). "On Economics and Finance." Journal of Finance,
40(3), 633-635.)

6. Based on the IMF's assessment method, the public debt-to-GDP ratios for the US
and 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 in

borrowing money from financial institutions. If there are liquidity constraints, it is
impossible to "smooth consumption." "Consumption smoothing" refers to
balancing out of consumption levels by acquiring loans when future income levels
are higher than current levels.

8. Aiyagari, R. & McGrattan, E. (1998). "The Optimum Quantity of Debt." Journal of

Monetary Economics, 42(3), 447-469.

9. It was assumed that the growth rate of GDP per capita would decline gradually by
2050 and the consolidated government spending-to-GDP ratio would increase for
the same period. More specifically, based on the average growth rate of GDP per
capita from 2000 to 2009 at 2.74 percent, it was assumed that the growth rate of GDP
per capita would be 2.51 percent for 2020, 1.73 percent for 2030, 0.93 percent for
2040 and 0.5 percent for 2050.

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