Korea as a Dynamic Hub - An Economic Overview

Korea as a Dynamic Hub – An Economic Overview

A Presentation Given by Dr. Scott B. MacDonald
Co-Head of Research and Senior Managing Director
Aladdin Capital Management, LLC
At the Busan-North American Investment Forum
On June 14, 2005 in New York City

Good morning. It is a pleasure to be here today to talk to you about the Korean economy.

I have called my presentation – Korea as a Dynamic Hub – An Economic Overview. Although there is some discussion that the Korean model has run out of gas and the economy runs the risk of stagnation like that which gripped Japan during the 1990s, I still observe a dynamic economy in the process of dramatic change.

By almost any measure, Korea is one of the great economic success stories of the 20th century. Although it faces tough challenges today, the past success of the Korean people suggest they remain capable of being one of the great success stories in the 21st century as well.

Let us put this in a historical perspective:

1. In 1960, South Korea had an average per capita income of $80, putting it roughly at the same level of as Ghana and Sudan and a bit behind India;

2. Natural resources were scarce and the national infrastructure was still recovering from the Korean War (1950-53);

3. Private cars were a novelty;

4. Electricity and running water were still luxuries;

5. At the time, the World Bank’s Asian up-and-comers were Burma and the Philippines;

6. Indeed the World Bank was not optimistic about South Korea’s prospects, noting of the government’s 1961 Development Plan which emphasized export growth: “There can be no doubt that this development program by far exceeds the potential of the Korean economy…It is inconceivable that exports will rise as much as projected.”

7. All of this led one observer to gloomily note: “South Korea seemed destined to remain a perennial mendicant.”

It would appear the World Bank and other development experts were wrong…

From 1965-1980, Korea’s real GDP averaged 9.9%
From 1980-1990, Korea’s real GDP averaged 9.7%

Throughout the post-1960 period, South Korea’s economic peer group became what has been called Asia’s “Tiger” economies – Singapore, Taiwan and Hong Kong. Burma and the Philippines, the World Bank’s former up-and-comers, were left far behind in the development dust.

What helped propel Korea forward was the successful implementation of an export-driven growth model, founded on cheap, but increasingly well-skilled labor. In addition, there was a close working relationship between government, the banks, and big business in the form of large conglomerates known as chaebols. The government also promoted the import of raw materials and technology at the expense of consumer goods and encouraged savings and investment over consumption.

A symbolic reflection that Korea has “made it” as an industrialized country came on December 12, 1996, when it became only the second Asian country to become a member of the Organization for Economic Cooperation and Development. The other Asian country was Japan.

However, Korea’s economic success has not occurred without disruption. The rapid development of the post-war era led to dramatically higher living standards and business costs. In addition, the Korean economic model, which was instrumental in driving the nation’s development as an Asian Tiger, became increasingly unsuitable to meeting the needs of a larger, advanced industrial economy. This resulted in the emergence of structural weaknesses including weak corporate governance, high levels of short-term debt and inefficiencies in the corporate sector, and problems in the banking sector – all of which came to the surface in full view, shocking the nation as well as outside observers, during the 1997-98 Asian or as it is known in Korea, the “IMF” economic crisis.

Despite the troubles of 1997-98, Korea quickly made an economic comeback, implementing numerous painful structural reforms. The results were positive: the banking sector has regained its health, the corporate sector has undergone considerable restructuring, and foreign exchange reserves have been greatly augmented (at $206 billion as of April 2005).

What has not come back, however, is the dynamic pace of growth that marked the 1965-1996 period. Real GDP growth in 2003 was 3.1% and in 2004, 4.6%. This year, it appears that the economy is struggling to grow over 4%.

The major challenge for Korea comes from its neighbors in the form of cheap, yet increasingly skilled labor in China, India and Southeast Asia. South Korea’s labor, though highly skilled, has simply become too expensive for the old model of export growth to work – at least in the same way.

As a result, Korea has reached a new crossroads in terms of defining what kind of economy it will have, how competitive that economy will be, and what kind of lifestyle it will generate for its citizens. The last includes the long-term challenge of doubling per capita income to converge with the average level within the OECD and to deal with pressures from rapid population aging.

Korea has two options:

Option one – Korea can seek to regain its cost competitiveness. This would likely entail either an erosion of present day living standards or reunification to take advantage of the North’s cheap labor, natural resources and location.

As we can see in the reaction to outsourcing and pressure on wages from foreign competitors in the United States, this type of adjustment is not easy and no nation is eager to give back its hard-earned advances and voluntarily lower its living standards.

Reunification would seem to offer a better solution. However, while there is reason for optimism over the long term, this is also problematic. The complexity and unpredictability of the reunification process – as well as the potential costs of reunification – which, depending upon the speed and how it takes place – could be quite large and strain the country’s social net and financial resources.

Alternatively…

Option two – Korea can accentuate its efforts to move up the economic food chain and to tap its proven industrial and technological competitiveness in pursuit of innovation and high valued added industries. This implies a greater emphasis on service industries and a move toward what Koreans term the “dynamic hub” concept.

Option two would provide Korea the ability to more fully act on its current advantages. These are:

1. A strong and fairly diversified export sector;
2. A well-educated and skilled work force (98% literacy rate);
3. Prudent fiscal and public sector debt policies (Public debt is equal to 21.3% of GDP in 2004, one of the lowest levels in the OECD);
4. An ongoing liberalization of its foreign investment regime;
5. A cadre of highly competitive multinational corporations;
6. External debt maintained at a moderate level;
7. A more efficient and open financial sector;
8. Improvement of corporate governance/better transparency and disclosure since 1997;
9. National standard of living is relatively high and improving – only 4% of the population live below the poverty line & per capita income is around $14,000;
10. Korea still has a great strategic location.

The last point needs to be emphasized, as it plays a major role in developing option two – climbing up the value added chain. Korea has a great location for being a regional hub for trade and finance.

Consider the following:

There are 700 million people within a 1,200 kilometer radius of Seoul;
There are 43 cities with a population of around 1 million that can be reached within a three-hour flight from Incheon airport.

Korea’s ability to act on deepening the value added side of economic development is also helped by excellent infrastructure:

Busan is the world’s third largest transshipment container port;
The capacity of Incheon airport is to be increased to 100 million a year by 2020;
The country has excellent roads and rails, which at some point could be linked to North Korea’s transportation nexus, which would only augment Korea’s overall interconnectiveness;
And, equally important, Korea is a major high tech nation, leading the world in broadband penetration and boosting of its own cadre of high tech companies (large as well as small).

Foreign firms and investors are coming to recognize Korea’s attractions. Foreign direct investment in Korea accelerated in 2004 to roughly $13 billion, twice the prior year’s total. One notable acquisition was Citigroup’s purchase of KorAm Bank, the nation’s seventh largest lender, for 3.18 trillion won.

The American Chamber of Commerce in Korea now represents over 1,000 member companies. It is organized into 31 active standing committees, divided by industry, in order to promote their corporate interests in Korea. This includes numerous Fortune 500 companies as well as many mid-sized and smaller enterprises.

The FEZs

To provide foreign firms with cost incentives, as well as a more comfortable living environment, the Republic of Korea has recently launched three Free Economic Zones or FEZ’s in Busan, Incheon and Gwangyang. These FEZs are offering a laboratory in which foreign firms can operate and from which local and foreign companies can establish joint ventures and to take advantage of the region’s access to enhance their international competitiveness.

The FEZs by nature mean a greater reliance on cross-border relationships and interactions. This includes the marketing of exports as well as deepening the process of technology transfer, design, product development and the flow of intellectual capital. It also means the development of attractive living conditions – schools, health facilities and other elements that make the FEZs nice places to live. In Busan – which possesses Korea’s largest port – handling 80% of total container volume – an added development is the annual Busan International Film Festival, which last year attracted some 166,000 people.

Remaining Challenges

While Korea has made considerable progress on the economic front, there are still challenges. The world remains a highly competitive place and some of the remaining weaknesses in the Korean economy still need to be addressed. These include:

1. The debate over the role of foreign investment has a tendency to he heated within government circles, sometimes resulting in a public airing of policy. Although such debate is necessary, especially in a democratic setting, it probably could be better managed. As the American Chamber of Commerce in Seoul recently noted, there is a need for Korean authorities to have one voice on foreign investment.
2. Labor markets still tend to be rigid. There could be greater latitude for companies (both Korean and foreign) to adjust the level of their work force to reflect changing market conditions.
3. Continue to upgrade human capital, promoting R&D and innovation. This also includes upgrading health care.
4. Despite the development of hydro and other resources, Korea remains dependent on outside sources of energy.

When one compares the labor environment in Korea today, however, to that which existed before the Asian financial crisis, when the militancy of Korean labor unions was seen as a real obstacle by both Korean and foreign firms, it is fair to say substantial progress has been achieved. If for no other reason than to respond to the increasing pressures of globalization, there is reason to believe this will continue moving forward.

Political Risk

One last issue remains in discussing the Korean economy and that is political risk. While the ups and downs of democratic government have an impact on a country’s economic performance and certainly are an influence on foreign investment decisions, the main political risk facing the South Korean economy is North Korea.

Most analysts agree the North does represent a political/military threat – it has a large army, nuclear weapons (at least it says it does and other countries think so), and an opaque political leadership, more than willing to make threats vis-à-vis perceived enemies (usually the United States and Japan).

Despite the deterioration of North Korea’s relations with the United States and Japan over the past few years, the situation has proven manageable. This is not to suggest that conditions are ideal. War remains a threat; and the implosion of Kim Jong-il’s government (along the lines of Romania’s Cseaceau’s) continues as an ongoing worry.

Yet, ultimately the likelihood of conflict on the Korean peninsula is not high. At the end of the day, it is to no one’s advantage for a nuclear meltdown or a shooting war to occur. That was the logic that pulled all the key players back in 1994 and it is likely to remain the same today.

Conclusion

Despite a more challenging world, Korea remains one of the more dynamic countries on the economic front. And, while Korea is at the crossroads of moving down a path toward developing a higher-value added and service-oriented economy, it would appear that in terms of actions, it is already on the path to achieving real progress.

The road is going to be bumpy, but the Korean people in the past have demonstrated an ability to adapt, improvise and overcome. They are likely to do the same today.

What is new today, however, is a realization by Korean government and corporate decision makers that sustainable change, and the drive to accelerate the forces of innovation and move toward greater reliance on services – all of which are essential to deliver economic growth moving forward – will require a greater involvement by foreign companies and investors. Consequently, Korea is more open to foreign participation than ever before.

The advent of the FEZs is one key element of the strategy to position the nation as the “Dynamic Hub of Northeast Asia” and today we will hear in detail about the many opportunities that U.S. firms and investors can find in Busan – Korea’s leading transportation, logistics and industrial center.

Thank you.