Course Notes: Korean Economic Development

Korean Economic Development

1945: Korea gains independence from Japan.

Unfavorable initial conditions:

• Underdeveloped, low income
• Poor endowment of natural resources
• Agrarian society trapped in vicious cycle of poverty
• Division of the Korean peninsula
• 1948 level of production was only 16% of the 1939 level

Achievement 1: Rapid Growth of Income

Escaped the MIT (Middle Income Trap)

• 1980: Half of Mexico's GDP per Capita
• 1985: Caught up to Mexico
• 1990: Double Mexico's GDP
• 2014: 3x GDP compared to Mexico

Achievement 2: Growth with Equity

• Gini Coefficient (2000-2010)
  Sweden: .25
  Korea: .3
  US: .4
  Colombia: .55
• Industrial Structure:

1950-1953: The Korean War

Major economic achievements: 

1. Neoclassical growth model.
2. Institutional approach to emphasize the role of the government

2014 Status of Korea

• GDP Rank: 12th ($1,410Bn.)
• Per Capita GDP Rank: 29th, $27,970
• HDI Ranking: 15th
• Merchandise Trade Ranking: 7th Exporter, 9th Importer

Achievement 3: Democracy

"Once you achieve economic freedom, you tend to demand political freedom too"

1987 a turning point for massive demonstration for democracy and Korea was pressured into changing the constitution.

Intro II: How do explain the success of the Korean economy?

• Neoclassical Model: Y(t) = A(t) * F[L(t), K(t)]
• Human Capital (Education)
• Macroeconomic Stability: Low inflation, budget balance
• Small Open Economy
• Policies Summarized in Washington Consensus (1990)

1965: Economy starts to go up. Korea educational level is close to Chile whose income was 7x larger. 

Gross Savings

Technology. After 80s and 90s invested in tech. In 1990-2013, average growth rates of TFP & GDP were 5.1 GDP / 2.03 TFP. Chile has 5.0 GDP bu -1.01 TFP. Large portion of Korea's goals came from technological progress. What made this possible in Korea? Human capital, R&D increasing rapidly, government initiated the technical development, private sector followed, competitive and open economy. 

World Bank 2008: 5 Resemblances among SHG Countries

• Global economy (open economy)
• Macroeconomic stability (low inflation)
• Future orientation (save money)
• Market allocation (market sells the price, not government)
• Leadership and governance (government has to be credible, committed, and capable)

Korea was one of the sustainable high growth countries with average of 7% growth rate over 25 years.

Medium to long-term challenges of Korea:

• SMB, increase competition
• Fiscal discipline, there is more and more demand for welfare
• Aging population
• North Korea and unification, may bear the burden of leveling up NK

From Independence to War

Unfavorable initial conditions. Division of the peninsula was bad news. Many industrial facilities were located in NK, and they were cut off. For example, 90% of electricity was generated in NK.

Upon independence, 1M Japanese leave. Most of them were managers and directors. Korea dependent on Japan for trade as well. Korea had a more serious loss of output because they also had to deal with the split of the peninsula. 

1945 - 1950

One of the biggest challenges was inflation. Before the independence, there have been too much money supply. Korea has to address this fast and reduce money supply. They also created the "Land Reform" 

Land Reform:

• First Reform: A lot of land that was owned by Japan needed to be redistributed to the Korean population. US played a big part in this redistribution.
• Second Reform: Conducted by Korean gov (not US). It was aimed at rich local Korean land lords. Korean government wanted to redistribute the land to small farmers. The plan involved Government giving Land Owners a Government Bond for their land. Then, selling that land to Small Farmers for a generous price. Small Farmers paid back over 5 years. Before this, 50% of small farmers were tenants. 
• Rural Breakdown:
  1945 ––
  Extra: 35.6
  Independent Farmer: 14.2
  Tenant: 50%
  1951 ––
  Extra: 15.4
  Independent Farmer: 80.7
  Tenant: 3.92
• As a result, income distribution improved. Productivity increase. Owning land gives more incentive. 
• Government expected the large landowners (rich people who sold land) to use that money to invest in the industrial sector. It was only partially successful because the war broke out.

Korean War: 1950 - 1953. Really messed things up and slowed down progress.

Japan's industry was revitalized due to the Korean war. They provided supplies, manufacturers of equipment, etc. Kick started a high growth era in Japan.

1950s: Import Substitution Policy

Many countries follow from inflation after wars. Because they print too much money during the war.

• 1953, Korea introduced Currency Reform. They changed the unit of currency. They removed two zeros. 101 = 1.
• Money supply was restricted. 
• Keep Government Budget Balanced
• Increased Supply of Consumer Goods. This helped bring prices down.

IS Policy

Background

• Chronic trade deficit and balanced of payment problem
• Experience of early-industrialized countries

Goal

• To reduce the Ratio of foreign import/domestic consumption by producing industrial product domestically. They relied on import too much.
• Achieve industrialization and growth

Policy tools of IS

• Protect domestic industry through quantitative import restriction
• Subsidize: Bank lending at low interest rate
• Monopolistic competition
• Overvalued currency intentionally. It discourages export and encourage domestic production. Local companies will not have cost advantages.

First Korean-Made Products. 3-Whites. Consumer goods.

• Sugar
• Flour
• Cotton
• By 1950s they were self-sufficient.
• 1956 cement
• 1959 radio
• 1960 electric fan
• As they increased production, they still needed to import equipment and materials. Lack of exports (no competitiveness) caused chronic deficit that lasted to 70s.

1950s: The Role of Foreign Aid

Major sources: USA and UN.

• Major source for investment in infrastructure, transportation system, education.
• Anti-inflationary. Supplies and goods were given to the market. 
• Financed trade deficit
• Source of Government Revenue. Could spend money without running into deficit and avoid inflation.

Even though it helped Korea, ODA (Official Development Assistance) does not always help to raise developing countries income level. 

History of ODA to Korea. One of the few countries that changed itself form recipient to the donor of the aid in such a short amount of time.

• 1950-53: heavy reliance on ODA
• late 50s: grant reduced, loan increased
• 67: Join the USAID project
• 2010: Join the OECD/DAC

1960s: Promotion Policy

Transition to EP: Korea received a constant warning that aid would reduce. Growth was lagging during the political transition. Reliance on import persisted. New government could not provide meaningful changes.

Export Promotion

• E unified and currency depreciated
• Export and Import link. If you export a lot, you can import.
• policy loans
• tax incentives
• tariff reduction

Export was led by manufacturing sector. Initially thought it was going to be food. Government didn't realize that would be the case. Korea had abundant labor forces.

Evolution of Development Strategy

• East Asia: 1st Import Substitution → Export Promotion → 2nd Import Subs
• Latin America: 1st Import Substitution → 2nd Import Subs → Export Promotion

Saemaul Undog (New Community Movement). Towns were given free cement. Only towns that showed potential were given more cement.

5 year development plan supervised by the president of Korea

• Establish of Economic Planning Board
• Top-down economic decision making

Mobilization of Capital

Domestically

• Commercial banks under gov control
• 1962 currency reform
• 1965 interest rate reform to increase saving

External

• Diplomatic normalization with Japan and Colonial era compensation fund (1965): $800M in 7 years.
• Sending laborers to Germany (1962-76): Max $50M a year. Mainly nurses and miners. They saved wages and sent to Korea.
• Sending soldiers to Vietnam (1964-73): $1B in 10 years. 300,000 soldiers sent. When Koreans moved to Vietnam, Korean companies could export more to Vietnam.
• Foreign loan increased since the mid-1960s

Compensation used for highway and skilled industry POSCO (iron and steel company). Mainly investing in long-term plans.

Remittance is bigger than ODA.

1970s: Heavy and Chemical Industry

Invested in steel industry.

HCI Development:

• Background 
• Big Push Policy
• Results

Background

Security Issues

• Nixon Doctrine (1969) – USA said they will not provide protection in perpetuity. 

Economic issues

• EP in labor-intensive industry almost completed
• Rising labor cost
• Protectionism from Advanced Countries
• Slowed Growth in the Early 70s
• Linkage effects of HCI

HCI Drive: The Big-Push

• In order for the dev. country to catch up, they need to promote the development of very big industries at the same time. Those industries were chemical industries.
• Arguments of big-push: Why? Criticism?
• Policies: Protection, NIF, Loans, Tax Incentives Including Tax Holidays, Tariff Incentives
• Six Target Industries: Steel, Nonferrous Metal, Electronics, Chemical, Machinery (including automobile), Shipbuilding

HCI Policies: Easy Loan to HCI

• Bank loans - national investment fund introduced (NIF) to help economic development. Exclusively for HCI. 
• Case Study: Shipbuilding industry. in the early 1970s when the Chairman of Hyundai, Mr. Chung Ju-yung, was assigned to develop shipbuilding industry. They went to UK to figure out how to build ships because they had no experience. UK refused. Went to Ecuador Company. "Look this is the ship we produced 400 years ago" and that was the beginning of the ship building industry. Today Hyundai are world famous ship builders.
• During 1980s HCI has accounted for about 50% of total export.

Difference from 1960 Policies...

• More aggressive, direct, bigger size
• industry (firm) specific
• role of foreign loans
• contribution to export

HCI of Japan in the 30s

• Japan also promoted HCI heavily and was accounting for more than half of the manufacturing sector by late 1930s

Side-effects of HCI and Oil Shocks

Oil shock and middle east construction

• Dispatched workers to middle east and stimulate economic growth

2nd Oil Shock, recovered easily

Background

• Rising current account deficit financed by foreign loan
• Deteriorating income distribution. Income inequality widened.
• Emergence of conglomerates and disparity between large firms and SME. Huge gap in between these as well.
• Negative real interest rate, misallocated capital, under-utilized capacities. Increase demand for skilled labor.
• Inflation

1st Oil Shock

• Effort to secure oil supply. Went to Kuwait 
• Current account deficit and inflation.
• It was during this time that Korea had initiated this strategy for fast growth. With the oil shortage, Japan accepted slow growth. Korea stuck to plan investment on HCI. 
• One good news: Middle East countries decided to use the money to rebuild infrastructure. Korean construction companies took advantage of this chance. Won bids for contracts.

1980s: Crisis Management, Structural Reform, and Trade Liberalization

Contents

• Crisis Management
• Structural Reform
• Trade Liberalization

Crisis Management

• Multi-policy and fiscal policy is tightened. 
• Mid 1980s the savings ratio is bigger than investment ratio.

Structural Reform: Industrial Rationalization Policy

• Over-investment on HCI and need to restructure
• 1979 Management stabilization measure
• 1979-1980 HCI Investment adjustment Measure
• 1981 Fertilizer Industry
• 1982 Shipping Industry
• 1986 Automobile Industry
• 1987 Power Generation Industry
• 1988 Coal Industry
• 1989 Shipbuilding Industry

What does this translate to? Korean government would not allow new entry or investment into existing HCI. Then, M&A were encouraged. 

After rationalization policies in Korea Automobile companies profit improved.

Trade Liberalization

• Two year import liberalization plan 84-85 and three year import liberalization plan (1986-88)
• Changed philosophy from infant-industry protection to liberalization. Protecting domestic industry cannot go on forever. Too much protection reduces competitiveness. 
• Comprehensive and profound. Almost every industry was open.
• Voluntary and unilateral. Voluntary important to increase productivity. 
• Out of 7,915 importable items, 369 remained restricted in 1989 and of those only 32 were manufactured products.

Three Lows and Economic Boom of the 80s

Three Lows

• 3 Lows: Low dollar, low oil prices, low interest rates
• Low $ (High Yen)
• Current account surplus from 1986–1989

Economic Boom

• Won/Yen Exchange rate. The biggest economic boom since 5000 years ago.

Democratization

• 1987: Lee Han Yol was shot dead by the riot police and caused a turning point which made millions of South Korea civilians to join demonstration for democracy. 
• Labor movement. First sector to get stimulated by democracy was labor.
• Wage labor increased rapidly in the late 1980s.
• Rising government spending on Welfare

1990s

• End of High Growth Era
• High cost, low efficient economy
• Omen of the crisis

End of High Growth Era

• Japan and Korea had 20+ years of high growth
• Diminishing Marginal Productivity of capital. Loss of demographic dividend, benefit from your population being young. Depletion of 'advantage of backwardness' (reach a certain level of income, it gets difficult to grow)
• Eichengreen (2011) High growth ends when per-capita GDP reaches $17,000
• Have to change economic structure to cope with it.
• 1993 New 5-year plan. 

High cost, Low efficiency

• Three high costs: labor costs (wages), logistics costs, financial cost (burden of interest payment)
• Korean companies depended too much from borrowing from Japan
• Low efficiency: labor productivity, inefficient investment, decreasing profitability

Omen of the Crisis

• Large companies collapsed and caused many other small/medium companies to struggle.

1997: OECD and IMF

Korea recognized that it had to restructure policies and industries and did that aggressively. Foreign exchange reserves in 1997 was 3.9B in 2001 99B (5th highest in the world). Korea paid the loan 3 years ahead of the deadline.

1997 Asian Financial Crisis

Outbreak of the crisis

• Financial sector: mounting NPL
• Corporate sector: Losing credibility, excessive investment, poor corporate governance system
• External Sector: Current account deficit and mounting foreign debt, unprecedented financial market liberalization, contagious effect of southeast asian crisis

Four Major Reforms: Corporate sector, Financial sector, Labor market, Government

Financial

• Increase IF ratio of Korean commercial sector. Government had to inject 118 trillion won.
• 761 financial institutions disappeared

Corporate

• Had borrowed too much money.
• Provided 5 guidelines
• IMF and Korea gov. tried to lower companies debt to equity ratio from 400% to 200%.
• Debt/equity ratio dropped. Cross-debt guarantee removed.

Labor

• Almost 2M unemployed people instantly
• Had to setup social safety-net system
• Was necessary to make labor market more flexible

Government

• Privatized 6 public enterprises and planned to privatize 5 more.
• Decreased number of regulations
• Total number of civil servants decreased

Controversial issues and side-effects

• Was it caused by structural domestic problems? By a liquidity problem?
• High interest policy. To attract foreign capital to Korea. Big trade-off, many companies went bankrupt. 
• Tight fiscal policy. 
• Fire sales and local assets to foreigners (at a low price)
• Inflow of short term speculative fund

Side effects

• Investment behavior changes. Less investment and Focus more on profit now. 
• Unbalanced growth between export and domestic demand
• Unstable labor market. After crisis, less full-time jobs were created. 
• Credit bubble. Household debt problem
• Gini coefficient. Income inequality was huge problem.
• Set back of reforms in labor market and government

2000s

• Automobile industry is a powerful engine for economic growth
• Semiconductor industry - world's third ranked producer.
• IT – Korea is one of the early countries to use the internet and has a strong history of innovation in technology

2008: Global financial crisis and beyond

Causes of 2008 financial crisis in USA

• Primary reason: Subprime loan + low interest rate (housing market)
• Second reason: Financial derivatives. MBS, CDO, CDS. Chain reaction.
• Structural reason: Pursuit of Short term profit, High risk, Right return.
• Foreign investors withdrew money from Korea
• Export to the emerging market saved Korea
• Korea National Assembly stimulus package helped them recover fast

Differences between 1997 and 2008

• Causes: Internal vs, External
• Loss in financial derivatices
• abundant foreign exchange reserve in 2008
• Healthier corporate sector and financial sector

Aftermath of the crisis. Global competitiveness of economy today

• Boost domestic demand (which is more stable): Consumption and investment have to be maintained. Household financial debt is a problem. 
• Threat of deflation. which discourages consumption
• Fluctuation of the exchange rate
• End of QE and US interest rate policy
• Slow down of the Chinese growth

Competitiveness index to improve:

• Institutions, ranked 69 behind India
• Labor market efficiency, ranked 83 behind Philippines
• Financial market development, ranked 87 behind Uganda and Nigeria
• There is a wide gap between General economic ranking (GCI) and financial market ranking.
• Corruption Perceptions Index. Pretty low after the crisis (higher corruption)
• Hard to hire new laborers because it's hard to lay off existing laborers

The Economist 2016-07-02

• South Korea’s exports have fallen every month year-on-year since January 2015

Final Review:

What would be the most important factors behind the success of the Korean economy?

I cannot attribute the success of the Korean economy to only one factor. The reason I started this course was because I wanted to answer this exact same question for myself. How did Korea grow to be the economic and technological power it is today in such a short amount of time? 

After taking this course, one factor that needs to be attributed to the success has to be the resilience and drive of the Korean people as a collective. I was impressed by their ability to rally together and make hard decisions like investing towards the future. Particularly during the 60s when huge investments when into education. 

It was also fascinating to learn about how Korea transitioned to becoming an independent country. We have many other examples where countries are not able to succeed after declaring independence. There are a few things that come to mind that maybe contributed in the subconsciousness of the people. One has to be the fact that their neighbor has taken an entirely different stance on governance and economics. There has to be a taxing element in the back of their heads in having to prove themselves as superior but also knowing that at some point they will have to pick up the pieces. Another thought that comes to mind is that poverty and wealth disparities are glaringly visible everyday. This ties to the size of a country, visible change and visible failure are amplifiers for motivation.

These are not exactly covered in this class but I would be very interested in learning about the social and cultural aspects of South Korea. Regardless, in 1950s Korea switches to a Neoclassical growth model and an institutional approach emphasized the role of the government during this period. As mentioned earlier, an important factor was investing heavily in human capital (education). They purposely managed to keep inflation low and budget balance. They implemented a small and open economy. Finally, I should mention the genius and willingness of construction companies that took advantage of the Oil Shock in the middle east and dispatched workers there to stimulate economic growth by sending money back home.

Which aspects of the Korean economic development can be copied by the other developing countries? Also, which aspects would not be able to be copied by the other developing countries?

Starting with the second question, I am always interested in the real-world obstacles aside from economic strategy. For instance, culture, geography, the effect of neighboring countries, corruption, and colonial historical background. I believe it will be easier for countries that are similarly composed to achieve the same kind of economic development, but many countries will not fit this template. In a way, Korea got a fresh start in 1945 and they took and ran with it without ever looking back, which is inspiring.

In terms of things that can be copied I would say: Investment in human capital, small open markets, the involvement of the government being democratic and transparent. I was impressed by the land redistribution policies of the late 1940s where the government bought land from the wealthy Japanese and sold it to small Korean farmers.

Explain briefly about the most important policies of 1950s, 60s, 70s, and 80s.

Okay.

1950s: Import Substitution Policy with the goal of reducing the ratio of foreign import and domestic consumption. The approach was to produce industrial products domestically because they were relying on import too much. With this, they would achieve industrialization and growth.

1960s: Promotion Policy with the goal of promoting exports by reforming currency, creating tax incentives, and reducing tariffs. During this time mainly started investing in long-term plans for highways and skilled industry.

1970s: HCI Policies.  After realizing the potential of Heavy and Chemical industries, those types of industries were given exclusive bank loans, they received protection, tax incentives, etc. This time, the policies were more aggressive, direct, bigger in size, and industry specific.

1980s: Industrial Rationalization Policy. The government stops allowing new entry or investment into existing industries of HCI and encourages mergers and acquisitions. This resulted in improved profits for automobile companies.