Credit Highlights

The Korean tier-one local government system remains mature and operates under strict oversight by the central government (CG). S&P Global Ratings expects the fiscal setups of local and regional governments (LRG) to remain highly predictable. That's despite recent political drama, which includes the temporary imposition of martial law that then led to the impeachment of President Yoon Suk Yeol.

Our base case is that such turmoil won't overturn the prudential law-based framework set by the CG, which would remain in place thanks to the institutional checks and balances. Furthermore, LRG budgets are approved by the local councils, which are typically comprised of multiple parties exercising scrutiny over each other.

The swift revocation of the martial law order and the return to relative normalcy without serious violence showed that checks and balances in the institutional setup are functioning. The announcement of government support for Korean financial markets, and subsequent measures introduced by the Bank of Korea, have quelled jitters in government bond prices, and reflects the CG's capacity to provide exceptional support in the face of a negative shock. That said, it could take a while see the potential effects, if any, on economic, financial and fiscal credit metrics of LRGs.

The Korean CG, and tier-one LRGs, place fiscal sustainability as a top policy priority. Budget laws requires that Korean LRGs base their spending decisions primarily on revenue availability, leading to overall very strong fiscal positions. Major spending responsibilities such as social welfare are mostly subsidized by the CG. LRGs' discretionary spending, such as capital investments, are budgeted based on available funding. In times of revenue shortfall, tier-one LRGs often delay corresponding expenditures to maintain a sound fiscal balance.

In addition, tier-one LRGs tend to adopt conservative projections in their budgeting process, leading to frequent surplus fiscal positions. More specifically, they tend to conservatively project revenues, and base the expenditure budgets on these conservative revenue projections. As a result, revenue settlements often outperform revenue budgets, while expenditure settlement must underperform budgets by law.

We believe CG's enhanced governance over LRGs' guarantees after delayed payments by Gangwon-do on defaulted guaranteed debt in October 2022 testifies to the system's commitments to honoring the government's promised obligations. It also demonstrates low tolerance for mishaps that could cause disruptions to the financial markets and investor confidence.

The Ministry of Interior and Safety guidelines ("Standards for Establishing Municipal Bond Issuance Plans") now requires LRGs' decisions to take on guarantees must undergo a central investment review by the CG. LRG projects with large guarantee that can potentially affect financial markets are monitored quarterly (currently 28 big relevant projects nationwide). The status of LRG debt (including guarantees) is monitored by the CG. Furthermore, on Oct. 27, 2022, governors of all provinces and municipalities made a joint announcement pledging that local governments would fulfil all payment guarantee obligations.

Trend: Stable

We view the institutional framework for Korean tier-one LRGs as stable and one that is characterized by key features such as being a mature intergovernmental system and having prudent fiscal framework in place. This institutional setting has led to strong budgetary outcomes, especially with the help of strong CG support.

The current high interest environment may impact certain sectors and bring some persistent revenue pressure for tier-one LRGs. Nonetheless, we expect their fiscal position to remain strong, and a gradual fiscal consolidation through their effective spending management.

We do not anticipate an overhaul to the current system going forward as the system values continuity, and the current intergovernmental system has performed well over different economic and political cycles. Instead, we expect any changes to the system to be incremental and move towards more balanced development among regions.

The current LRG framework is based on a two-tier system whereby LRGs are divided into high-level and low-level LRGs. At present, there are 17 high-level, or tier-one governments and 226 lower-level (tier-two) governments. Tier-two governments are allowed to borrow although there is typically no debt at that level, reflecting management principles of the higher tiers.

Predictability Of The Framework

Mature fiscal management framework with changes debated and planned well in advance

The Korean LRG fiscal framework is mature and characterized by strong predictability. The framework is defined in the constitution and codified by law.

The institutional setup is predictable with little fundamental change since its establishment.   The legal framework defining the current Korean fiscal system is the National Finance Act (initiated in 2006) for the CG and the Local Finance Act (LFA) for LRGs. They set out principles for the finances and accounting of the general government. The current LRG framework was established in 1988 through the 'Local Autonomy Act' (LAA) which enabled LRGs to hold local council elections from 1991 onwards, and define the basic principles for LRGs is to promote the convenience and welfare of residents in performing affairs.

LAA requires that the budget bills (including supplementary budgets), and settlement of accounts are submitted to the local councils for approval, and budget approvals must involve procedures such as hearings, reviews and plenary session votes.

Since the development of these frameworks, incremental reforms to the system have fine-tuned the division of responsibilities and revenues with the ultimate aim of providing more autonomy to LRGs.   This continuous reform effort reflects the ongoing recognition that the CG still holds the final decision power on too many local affairs.

Notable efforts include the establishment of the 'Presidential Commission for Decentralization' which enacted the 'Special Act on the Promotion of Decentralization' in 2004, which subsequently led to growing revenue sharing to LRGs in the past decade. Korea concluded the scheduled central-local financial decentralization in 2023.

We expect future institutional reforms to also be incremental and slow, with a focus toward more balanced regional development for LRGs.   Although this has been indicated for many years, we believe a more balanced regional development among the LRGs will still take a long time and be stridently negotiated/debated before execution, given it would shift the balance of power.

The predictability and visibility of tier-one LRG finances are generally quite strong, with incremental changes to enhance their revenue and autonomy in recent years.   Changes to the division of revenues or expenditures between CG and LRGs will be largely minimal and done with consultation between the different layers of governments involved and to be passed through the relevant legislature.

We believe Korean tier-one LRGs produce reliable medium-term fiscal plans, which are adjusted every year on a rolling basis, providing good visibility over its mid-to-long term commitments.   These fiscal plans are based around a five-year cycle, accompanied with an annual budgeting process, which combine to ensure that LRGs have good visibility. The visibility on capital expenditure plans is even stronger given the long project lifecycles involved and the fact that investments over a specific size require approval from the relevant upper-level governments.

Tier-one LRGs exert influence over CG decisions through MOIS, legislature procedures, etc.

Korean tier-one LRGs do not have a hard veto to oppose unwanted changes but they do have the ability to influence any possible legislature through the National Assembly and the legislative branch of government. LRGs can also exert influence over CG decisions through forming associations and make public proposals or private lobbying efforts. The Ministry of the Interior and Safety (MOIS), which is responsible for promoting local autonomy and decentralization would also have a voice and seek to represent the LRG sector as a whole.

Revenue/Expenditure Balance

Overall adequate revenues to cover expenditures needs, aided by strong CG transfers.

Korean tier-one LRGs' performances reflect fiscal management rules, which require spending decisions be budgeted according to resources to cover their essential service and infrastructure needs.   This is evident by the fact that the overall sector runs well-balanced budgets and a low level of debt burden compared to most international peers. No local council may increase the amount of each expenditure category in the budget or establish new expense categories without approval from the head of an LRG. After approval of settlement, the head of the LRG shall report it to the upper-level government (the Ministry of the Interior and Safety in the case of tier-one LRGs).

Nonetheless, we believe Korean LRGs have enough resources to finance their essential services, aided by very strong central government support and robust fiscal generation abilities of their own.

Around half of Korean tier-one LRGs' adjusted operating revenues are from transfers which reflects the strong vertical fiscal equalization framework in place.  Transfers consists of Local Allocation Tax (LAT), i.e. 19.24% of national tax income to supplement LRGs' financial resources as well as other subsidies or grants given to LRGs by the CG. The contribution of transfers toward operating revenues has been stable based on data we have dating back to 2011, reflecting no major changes to the fiscal equalization system during this period. State subsidies peaked at 45% of tier-one LRGs' adjusted operating revenues in 2020, before coming down gradually in the years after, reflecting the extra support from CG during the height of the COVID-19 lockdowns (see chart 2).

This transfer distribution varies depending on the economic and fiscal profiles of the LRG, with the transfers making up less than 20% of Seoul Metropolitan Government's operating revenues, while the share may range typically from 30%-50% for urban LRGs to more than 70% in the rural areas.   The main tax items for Korean LRGs are (i) acquisition tax--a levy on all purchases of property, vehicles or capital equipment; (ii) local income tax (10% of national income tax); (iii) local consumption tax (25.3% of national VAT as of end 2023); and (iv) property tax. These four tax items combined account for close to 80% of total tax revenues as of end 2022.

Chart 1

Chart 2

The bulk of operating expenditures are directed toward social welfare-related spending  (see chart 3). This is in line with the principle that the LRGs are mandated to handle affairs relating to livelihoods of local residents. However, 77% of operating expenditures for social welfare are subsidized by the CG, which effectively relieves tier-one LRGs from the most burdensome part of their duties.

Chart 3

The overall fiscal health among Korean tier-one LRG sector is robust.   With performance averaging substantial operating surpluses and a well-balanced performance after capital accounts (see chart 4).

We expect performances after capital accounts to improve from a low point in 2023, as the Korean economy and tax revenues recover.   In 2023, tier-one LRGs' performances were negatively affected as they share a percentage of national taxes, which declined. This was a result of subdued economic performance in 2023 due from high inflation, interest rates and weak exports from weak global demand. Much of these factors have improved since.

Chart 4

Reflecting the prudent fiscal management framework and a commitment to fiscal sustainability, overall direct debt taken on by tier-one LRGs has also been low by international standards.   Moreover, we expect LRGs to embark on mild deleveraging through reducing the stock of direct debt over the next two to three years, which will help cap the direct debt burden at below 20%.

Direct debt as a percentage of operating revenues has trended lower for the last decade or so, starting from a peak in 2010 due to borrowings related to stimulus post the global financial crisis. The stock of direct debt reduced gradually in absolute terms until 2018 before edging up, mostly from post-pandemic investments; it began stabilizing in 2022-2023. Debt burden as a percentage of adjusted operating revenues edged higher to above 20% by 2023 due to revenue challenges, which we expect to reverse in 2024 and beyond.

Chart 5

Chart 6

Korean tier-one LRGs operate within a fiscal policy framework set and heavily scrutinized by the CG, which puts fiscal sustainability as a top priority.

We believe tier-one LRGs have a strong and prudent fiscal policy framework, governed by the CG.   Korean CG and LRGs place fiscal sustainability as a top policy priority. As a result, the tier-one LRGs base their spending decisions primarily on revenue availability, leading to overall very strong fiscal positions. Major spending responsibilities such as social welfare are mostly subsidized by the CG. Tier-one LRGs' discretionary spending, such as capital investments, are budgeted based on available funding. In times of revenue shortfall, they often delay corresponding expenditures to maintain a sound fiscal balance.

In addition, Korean tier-one LRGs tend to adopt conservative projections in their budgeting process, leading to frequent surplus fiscal positions.   More specifically, they tend to conservatively project revenues, and base the expenditure budgets on these conservative revenue projections. As a result, revenue settlements often outperform revenue budgets, while expenditure settlement must underperform budgets by law.

The CG has multiple limits and checks on the LRG to ensure the prudency gets implemented.  These are:

Budget checks by CG. The CG's framework of managing LRG's finances and debt is centered on the 'National Fiscal Management Plan' set by Ministry of Economic and Finance (MOEF). The Plan requires tier-one LRGs to submit their five-year fiscal plan to the MOEF at the start of the calendar year for approval, to ensure spending priorities are in line with national priorities, with budgets being approved by the local council. MOEF is Korea's finance ministry managing the national fiscal affairs. Its role in managing LRGs focuses on ensuring fiscal alignment of CG and LRG, through national subsidies and sharing of national taxes with LRGs.

Debt limits by CG. Every year, the MOIS establishes plans for LRG bond issuance limits, standards and procedures, and target projects. These criterion allow LRGs to issue bonds in the domestic market by going through local council but without needing approval of the CG. MOIS is Korea's ministry for overseeing LRGs' financial soundness on an ongoing basis. It oversees LRG budgeting, execution and settlement processes. It also has the agenda of enhancing fiscal autonomy for LRGs, and working toward a more balanced regional development.

It also ensures fiscal prudency on LRGs and the alignment of LRGs with CG directions. MOIS also performs investment screening for LRGs and supervises local taxes. MOIS is a spokesperson for LRGs when dealing with relevant matters with MOEF.

The ministry also establishes limits on LRG total debt, based on risk groups. LRGs that are deemed as having higher financial risks will be constrained in growing new debt.

Monitoring of LRG fiscal conditions and government-related entity (GRE) for stress alert. The Local financial crisis management system evaluates key fiscal metrics for early warning signs. Those who fail to meet certain criteria are designated as "precautionary" or "in-crisis" organizations by MOIS. The "in-crisis" organizations are required to submit a "Fiscal Improvement Plan". Notably, this system includes monitoring the debt ratio of LRGs' GRE sector as well as individual GREs.

Annual local financial analysis for structural prudency in local fiscal management. This check is exercised every year from August–December. Targeted LRGs will perform primary analysis first and MOIS will further perform cross-checks. The tool evaluates a range of 13 different fiscal metrics to provide an overall scorecard. LRGs which fall below standard are required to devise recovery plans in consultation with the MOIS, with ongoing performance evaluations thereafter.

This overall fiscal framework therefore allows for strong management of LRGs' direct budgetary and borrowing activities. Areas that are less defined include the management of GRE borrowings, though policy attention is increasing for such debt. Management guidelines for LRG non-debt liabilities, including guarantees, are also less clear but have also been improving.

Expected strong exceptional support from the CG when in need.

We expect the CG to provide extraordinary support in case of substantial dislocation in tier-one LRGs' finances or debt. The CG has a track record of stepping in during financial turmoil, including by purchasing Korean won 1 trillion in LRG bonds in the aftermath of the Asian financial crisis. This move provided financing to LRGs to enact various stimulus measures and helped revive the municipal bond market.

In the height of COVID-19 outbreak, the CG has also provided timely and targeted support to those LRGs most affected by the pandemic. See chart 2 for CG increasing subsidies to LRGs over time, especially in 2020 to combat COVID.

Other examples include instances of natural catastrophes or human hazards whereby the CG has provided financial support to all affected LRGs. More specifically, over the years, legislation and administrative capabilities have been strengthened to shift more of the fiscal burden of disaster recovery to the CG from the LRG. The Emergency and Safety Management Basic Act passed in 2004 and the establishment of the Ministry of Public Safety and Security in 2014 as an overarching ministry responsible for disaster relief are two examples of such initiatives. The 2022 torrential rain and Itaewon stampede in Seoul show central government financial supports in times of social stress.

Transparency And Accountability

Approach to budget setting and maintaining accountability.

We see a relatively clear delineation of roles and responsibilities between the elected officials and the tier-one LRG's administration. Local elections for officials, namely the mayor and council members, occur every four years, with a three-term limit for mayors and no term limits for council members. The mayor is responsible for setting policy priorities and annual budgets which in turn must be agreed on by a majority of the elected council. These policies are then administered by staff belonging to the LRG, which are separate from the electoral cycle, with many administrative staff serving across multiple political cycles. Administrative staff are in general well qualified professionals for their roles and staff turnover is generally low though rotation among divisions is common to enhance well-rounded expertise within a field. This helps to support management continuity.

Disclosure and accounting standards.

Disclosure and accounting standards have improved in recent years. LRGs adopted an accrual-based double-entry book-keeping system from 2011 onwards. Their annual financial statements are audited by qualified experts appointed by local council, and are submitted to the National Assembly before publishing. Disclosure requirements are stipulated by the LFA which sets out rules for transparency and soundness in local finances.

There has been much improved disclosure of public institutions (including GREs) under the government's push for higher transparency.

Control and reliability of information.

All tier-one LRGs provide five-year plans as a medium-term anchor to their annual fiscal budgets, which are adjusted every year, thus are relatively credible. As challenges associated with an aging population gain increasing awareness, some LRGs have produced long-term reports on the associated fiscal impact and possible remedial policy actions. Annual budgets are generally published on the respective LRGs' public websites as well as being accessible via MOIS, which also provides a local public finance database. Some LRGs also have real-time revenue and expenditures tracked on their public websites.

Related Criteria

• Criteria | Governments | International Public Finance: Methodology For Rating Local And Regional Governments Outside Of The U.S., July 15, 2019

Related Research

• Bulletin: Effects Of Korea's Brush With Martial Law May Linger, Dec. 4, 2024
• Institutional Framework Assessments For Local And Regional Governments Outside Of The U.S., Dec. 12, 2024
• Full Analysis: Korea (Republic of), Oct. 28, 2024
• Full Analysis: Seoul Metropolitan Government, Oct. 24, 2024
• Institutional Framework Assessment: Korea Special Metropolitan Cities And Provinces, Oct. 11, 2022