Korea's Growth Performance: Past and Future

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  • Koreas Growth Performance:Past and Future

    Marcus NOLANDPeterson Institute for International Economics and the East-West Center

    South Korea is arguably the premier development success story of the last half century. Rapid growth

    coincided with extensive state interventions in the economy, and considerable controversy exists as

    to how much this performance should be credited to the countrys state-led development strategy

    and to what extent the lessons from that experience might be portable or applied elsewhere. The

    salience of this issue has grown as South Korea has become a more important provider of develop-

    ment assistance and advice. Now the country faces challenges in maintaining its superior economic

    performance, notably interrelated problems revolving around the countrys demographics, long-

    term fiscal position, and lagging productivity in the services sector domestically, and a taxing

    environment externally. Finally, the country confronts scenarios involving potential instability,

    collapse, and/or absorption of its neighbor, North Korea.

    Key words: convergence, growth, institution, Korea, unification

    JEL codes: H11, O43, N15, P30

    1. Introduction

    South Korea is arguably the premier development success story of the last half century. For47 years starting in 1963, the economy averaged 7% real growth annually, and experiencedonly 2 years of economic contraction: 1980 after the second oil shock and the assassina-tion of President Park Chung-hee, and 1998 at the nadir of the Asian financial crisis(Figure 1). At the start of that period, South Korea had a per capita income lower than thatof Mozambique or Bolivia; today it is richer than Spain or New Zealand, and was the firstAsian and first non-G-7 country to host a summit of the G-20, the unofficial steeringcommittee of the world economy.

    The South Korean case is of interest for a variety of reasons. Rapid growth coincidedwith extensive state interventions in the economy, and considerable controversy exists asto how much this performance should be credited to the countrys state-led developmentstrategy and to what extent the lessons from that experience might be portable or appliedelsewhere. The salience of this issue has grown as South Korea has become a moreimportant provider of development assistance and advice. Now the country faces chal-lenges in maintaining its superior economic performance in the face of an aging

    I would like to thank Alex Melton for research assistance, and Lee Jong-Wha, Mohamed Ariff, and

    other conference participants for helpful comments on an earlier draft.

    Correspondence: Marcus Noland, Peterson Institute for International Economics and the East-

    West Center, 1750 Massachusetts Avenue NW, Washington, DC 20036, USA. Email: mnoland@

    piie.com

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    doi: 10.1111/j.1748-3131.2012.01212.x Asian Economic Policy Review (2012) 7, 2042

    2012 The Author

    Asian Economic Policy Review 2012 Japan Center for Economic Research20

  • population domestically and a taxing external environment. Finally, the country confrontsscenarios involving potential instability, collapse, and/or absorption of its neighbor, NorthKorea.

    2. Historical Context

    Annexed by Japan in 1910, in the context of the Second World War, the Koreans werepromised their independence in due course by the Allied Powers. The war ended beforethe victorious powers could reach agreement on a trusteeship formula, however, and theUSA and USSR hastily agreed to assume responsibility for accepting the surrender ofJapanese forces and temporarily occupying the country, dividing responsibility in accor-dance with an American proposal at the 38th parallel, which had been previouslyidentified as a possible boundary of Russian and Japanese spheres of influence in 1896 and1905.

    The starting point was not auspicious: agricultural and industrial productions werewell below pre-war levels, and much of the physical plant and equipment was barelyfunctioning. Inflation hit triple digits. The ranks of the unemployed were swelled by thereturn of 500,000 refugees from other parts of the Japanese empire. Crime and gangactivity surged. Levels of human capital and per capita income were higher in the North,which predominated in industry, mining, and power generation, as compared to the Southwhich was largely agricultural.

    In 1948, with the Soviets blocking proposals for peninsula-wide elections, indepen-dent states staking claim to the whole peninsula were declared in the US and Soviet zonesof occupation.

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    Figure 1 South Korea GDP growth rate.Sources: Kim (2009); World Development Indicators (20082010), and authors calculation.

    Marcus Noland Korean Growth Performance

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  • On June 25, 1950, North Korea invaded South Korea. Most of the capital stock wasdestroyed as armies from both sides twice traversed nearly the entire length of the pen-insula. There was considerable population movement as well, mostly from the North tothe South, and it is impossible to ascertain the capacities of the two countries whenhostilities ended in 1953 with the original borders more or less reestablished.

    At the end of the Second World War, the Korean nationalist movement reflected awide ideological spectrum and was geographically dispersed: Rhee Syngman, the studentof Woodrow Wilson who would eventually lead South Korea, had been in exile in theUSA for 30 years; Kim Il-sung and other Korean communists had fled to the SovietUnion; there was a provisional government in exile in Shanghai; there were nationalistswho had remained underground in the peninsula. After the division of the peninsula in1948, both Rhee and Kim confronted the same formal problem, namely how to mobilizepolitical support and create institutions through which to govern. Specifically, the formerexiles faced a lack of institutional capacity (and hence had to rely, at least initially, ontheir respective patrons) as well as a basis for political loyalty, which could be inspired,compelled via repression, or bought through the creation and distribution of economicrents.

    The expropriation of Japanese assets both land and industrial was one source ofpotential rents that could be channeled to political supporters. Another was tocreate them via policy intervention. South Korea inherited an economic legacy of stateintervention from the Yi dynasty, through the Japanese colonial occupation (19101945)that carried into the period of independence, reflecting the dirigiste character ofJapanese administration and the continuation of extensive controls by the US militaryauthorities in the immediate post-war period. An interventionist strategy that wouldpermit the dispensation of political favors would amount to a continuation of pastpractices.

    At the end of the Second World War, approximately 94% of the industrial assetsin Korea were in the hands of the colonial government or Japanese citizens. Startingin 1947, US administrators began a process of selling or giving away formerly Japanese-owned businesses, but the divestiture of assets really accelerated once Rhee tookpower.

    The system was rife with favoritism and corruption. Chung (2007) estimates that thepurchase prices for formerly Japanese-owned assets were on average less than half theirtrue value, and payments in nominal terms would be further eroded by inflation.

    In principle, the disposal of these assets was to occur through public auctions, but inreality, it appears that these procedures were routinely ignored. The majority of thebeneficiaries of the divestiture program were individuals who had some prior connectionto the asset. On one level this makes sense it is precisely the former employees of theseenterprises who would have the best understanding of the underlying worth of the assetand have the requisite knowledge to operate the plant and equipment. But it also had theeffect of channeling economic bounties toward collaborationists. In other cases, localinvestors simply paid a repatriation cost to the Japanese owner to secure the title, claimownership, and circumvent the divestiture program altogether. Some of todays chaebol, or

    Korean Growth Performance Marcus Noland

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  • family-run conglomerates, can trace their origins (or at least significant expansions) to theasset divestiture program. The potential for building a political machine through suchmechanisms is obvious.

    Economic policy under Rhee also reflected the urban bias that was typical in devel-oping countries of the period, signaling both the greater affinity of the governing eliteswith urban residents, as well as their fear that urban discontent, particularly in thenational capital, could be politically destabilizing. The goal was maximizing the value ofAmerican aid (Cho, 1994) which facilitated politicized rent distribution, financed most ofthe capital accumulation and, at its peak in the late 1950s, roughly 80% of imports(Figure 2). South Korean policy could be summarized as the three lows: maintenance ofa low price for grain (courting urban residents who could most easily challenge theregime); a low, that is, an overvalued, exchange rate; and low interest rates. The latter twoconditions create excess demand for foreign exchange and bank loans, respectively, whichthen creates political opportunities for distributing rents (as well as incentives for corrup-tion). The low interest rate policy had the further consequence of discouraging saving andcapital accumulation.

    3. High-Growth Performance Period

    Rhee was eventually driven from power by urban discontent with poor economic perfor-mance, repression, and corruption, and was followed for a brief period by a weak

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    Figure 2 Foreign aid to South Korea 19531973.Sources: Collins and Park (1989); World Banks World Development Indicators; Bank of Korea.

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  • government led by Premier Chang Myon. A military government led by General ParkChung-hee took control in 1961. He sought legitimacy through his ability to defend thecountry against Northern aggression and economic development.1 When Park seizedpower, gross domestic saving net of aid was derisory (Figure 3). Gross investment,financed mostly by aid, stood at a bit more than 10% of gross domestic product (GDP),and the current account was in rough balance. After 2 years of poor economic perfor-mance, the military government unified the existing multiple exchange rate system,devalued the currency, raised the real interest rate, and initiated a series of wide-rangingreforms. Domestic saving net of aid began rising rapidly (Figure 3). Domestic investmentbegan rising even faster.

    While in some ways Parks reform package marked a fundamental departure from pastpractices (with respect to trade policy, for example), it retained an important role for thestate in the development process. Pervasive regulatory entry barriers (and thus protectionfrom competition for incumbents), and Parks penchant for sole-sourcing importantinfrastructural and other large-scale government supported projects, in effect socializedrisk and created opportunities for cross subsidization across different business ventures,encouraging the chaebol to diversify into otherwise unrelated lines of business. By the1980s, the top 10 chaebol accounted for more than 20% of national income (SaKong, 1993table A.20).

    The countrys exposure to international trade grew enormously (Figure 4). Not onlydid South Korea benefit from the conventional gains from trade, performance in the

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    Figure 3 South Korean savings and investment, 19602009.Sources: Bank of Korea, Economic Statistics System; World Bank World Development Indicators.

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  • international arena was used as a neutral standard, free of domestic distortions, on whichto benchmark the relative competitiveness of firms receiving industrial policy support which was terminated to laggards.

    The accumulation of capital contributed to rapid technological upgrading and astunning transformation of the composition of output. In 1963, nonfuel primary prod-ucts accounted for more than half of South Koreas exports, and human hair wigs was thethird leading item. A decade later, South Koreas exports were dominated by manufacturessuch as textiles, electrical products, and iron and steel; only one primary product category,fish, made the top 10. Today, South Koreas merchandise exports are concentrated inmotor vehicles and telecommunications equipment, and the country generates increasingservice exports, much of it entertainment related.

    As seen in Figure 3, capital accumulation was financed primarily by growing domes-tic savings, augmented by a significant inflow of savings from abroad, nearly reaching10% of GDP in 1971, and actually breaching this threshold in 1974 after the first oilshock. These inflows predominately took the form of long-term loans and trade creditsfrom private lenders and public institutions (including the multilateral developmentbanks). Portfolio inflows and inward foreign direct investments were negligible duringthis period. A substantial academic literature exists (e.g. Westphal et al., 1981, 1985;Kim, 1997) that attempts to understand the sources of South Korean industrial com-petence and that documents the varied forms of technological transfer and interactionbetween South Korean and foreign firms. Whatever the origins of South Korean tech-nical mastery, much of the foreign capital arrived in the form of technologicallydisembodied loans.

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    Figure 4 South Korea exports and imports as share of GDP.Source: World Development Indicators.

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  • In 1972, Park initiated the intensive promotion of heavy industry through what cameto be known as the heavy and chemical industry (HCI) policy. Modest financial sectorliberalizations that had been undertaken in the late 1960s were reversed in 1972, wheninterest rates were lowered and direct government control of the banking system wasincreased in order to channel capital to preferred sectors, projects, or firms. In order tofinance large-scale projects, special public financial institutions were established, andprivate commercial banks were instructed to make loans to strategic projects on a pre-fere...

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