The Korean Economy

THE KOREAN ECONOMYSix Decades of Growth and Development

The Committee for the Sixty-Year History of the Korean EconomyTHE KOREAN ECONOMYSix Decades of Growth and Development

YEARS

THE KOREAN ECONOMYSix Decades of Growth and Development

60

Editors

Il SaKong and Youngsun Koh

THE K

OREAN EC

ONOMY

Six Dec

ades o

f Growth

and Develo

pmen

t

The Committee for the Sixty-Year

History of the Korean Economy

Edito

rsIl SaKong and Youngsun Koh

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60YEARS

THE KOREAN ECONOMYSixDecadesofGrowthandDevelopment

The Korean EconomySix Decades of Growth and Development

Edited by

Il SaKong and Youngsun Koh

The Committee for the Sixty-Year History of the Korean Economy

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2010Korea Development InstituteP.O.Box 113 Hoegiro 49 Dongdaemun-guSeoul, 130-868Koreawww.kdi.re.kr

ISBN 978-89-8063-457-6

The Korean EconomySix Decades of Growth and Development


iiiContents

ForewordA Note on RomanizationAbbreviationsContributors

Chapter 1Introduction 001Il SaKong

Chapter 2The Growth of Korean Economyand the Role of Government 007Youngsun Koh1. Introduction 0092. Liberation and state-building (1948-1959) 0103. Export promotion and government-led

industrialization (1960-1979) 0164. Stabilization and liberalization (1980-1997) 0395. From the economic crisis to the present (1997-2009) 0616. Challenges 0737. Conclusion 074

Chapter 3Koreas Industrial Development 083DoHoon Kim and Youngsun Koh1. Introduction 0852. Structural changes in the Korean economy 0863. Historical development of Korean industry 1024. Conclusion 118

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Contents

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ivTHEKOREAN

ECONOMYSixDecadesofGrowthandDevelopment

Chapter 4International Economic Policy 123Junkyu Lee, Jungho Yoo, Nakgyoon Choi,Jeong Gon Kim, June Dong Kim, Hea-Jung Hyun,Sangkyom Kim, Jinkyo Suh, Deok Ryong Yoon,Hongshik Lee and Yoocheul Song1. Introduction 1252. The early evolution of international economic policy

from the 1950s to 1970s 1253. Expansion of economic liberalization and globalization

from 1980 to the present 1374. Liberalization of foreign direct investment 1455. Economic cooperation 1506. Agricultural import liberalization 1547. Liberalization in the service sector 1618. Financial opening 1679. Conclusion 173

Chapter 5Territorial Development Policy 177Jung Jay Joh, Young-Pyo Kim and Youngsun Koh1. Introduction 1792. Agrarian land reform and post-war reconstruction

from 1948 to the 1950s 1833. Development of industrial parks and population

migration to Seoul in the 1960s 1844. Development corridors and the Saemaul Movement

from 1970 to 1987 1865. The pursuit of a better quality of life and globalization

from 1988 to the 1990s 1956. Promoting regional balance and green growth in the 2000s 2027. An assessment of Koreas territorial policy 2098. Conclusion 223

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Contents

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vContents

Chapter 6Social Policy 227Youngsun Koh, Seung Kwon Kim,Chang Whan Kim, Young Lee, Joo Seop Kim,Sang Young Lee and Young-Ock Kim1. Introduction 2292. Demographic changes 2303. Education system 2344. Developments in the labor market 2475. Social welfare system 2686. Health care services 2867. Womens economic and social participation 2998. Conclusion 306

AppendicesAnnex tables 313Committee members 331Advisory group 331

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List of tables

viTHEKOREAN


Table 2-1. Price inflation 015Table 2-2. Export credit by banks 018Table 2-3. Capacity utilization in manufacturing 025Table 2-4. Tariff rates (1957-1984) 026Table 2-5. Main components of the August 3rd Measure 032Table 2-6. Central bank lending to deposit money banks 035Table 2-7. Contributions to the reserve base growth 036Table 2-8. International comparison of consumer price

inflation 036Table 2-9. Major macroeconomic indicators (1975-1990) 041Table 2-10. Investment coordination and industrial rational-

ization in automobile manufacturing 046Table 2-11. Reform of BOK lending programs (March 14,

1994) 048Table 2-12. Main indicators of the National Health

Insurance (1977-2008) 058Table 2-13. Housing supply ratio (1960-2008) 058Table 2-14. Expansion of transport facilities 059Table 2-15. Major macroeconomic indicators (1991-2000) 061Table 2-16. Average return on assets of the largest 30

chaebol 062Table 2-17. Changes in the number of financial institutions069

Table 3-1. Annual output growth by sector 086Table 3-2. Share in gross value-added by sector 087Table 3-3. Share of the top 10 export items in total exports089Table 3-4. Distribution of employment by sector 090Table 3-5. Sources of growth in major regions (1961-2004) 093Table 3-6. Imports by commodity group 095Table 3-7. Fish exports in the second half of the 1940s 103Table 3-8. Savings and investment 105Table 3-9. Self-sufficiency ratio of grains (1956-2005) 106Table 3-10. Energy consumption by source 108Table 3-11. Growth contribution by ICT industries 113

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viiListoftables

Table 4-1. Foreign aid (1953-1960) 126Table 4-2. The extent of won overvaluation (1955-

1970) 128Table 4-3. Koreas imports and exports (1955-1970)

130Table 4-4. Openness ranking of major countries 141Table 4-5. Koreas current status of the FTAs 144Table 4-6. The utilization rate of preferential tariffs 144Table 4-7. Trends of inward foreign direct investment

by the 10 largest investing countries 147Table 4-8. Contribution by foreign-invested com-

panies in manufacturing production 147Table 4-9. Contribution by foreign-invested

companies in services production 148Table 4-10. Koreas outward direct investment by

region 149Table 4-11. Koreas outward direct investment by

sector 150Table 4-12. Koreas trade surplus (1982-1987) 155Table 4-13. Agricultural import liberalization rate 156Table 4-14. Changes in major indicators of agriculture

in Korea 157Table 4-15. Service sector in Korea (1960-2008) 162Table 4-16. The change in travel expenses (1988-

1992) 163Table 4-17. Level of liberalization in the Mode 3 after

the Uruguay Round 164Table 4-18. The acceptance and reservation rate of

Korea 165Table 4-19. Type of FDI in Korea 166Table 4-20. FDI by industry (1990-2008) 168

Table 5-1. Annual growth rate of population by region182

Table 5-2. Designation of industrial parks (1974-1984)187

Table 5-3. Changes in mining and manufacturingemployment by region 188

Table 5-4. Reclamation projects (1946-2007) 194Table 5-5. Housing stock and housing supply ratio

(1980-2006) 198

Table 5-6. Incheon International Airports ranking inthe ACI evaluation (2009) 207

Table 5-7. Population in the capital region 210Table 5-8. Urbanization trends 210Table 5-9. Annualized growth rate of the price index

for apartment sales 217Table 5-10. GRDP by region 219Table 5-11. Population of Seoul and the capital region

in 1981 and 1991 219Table 5-12. Population growth in regional growth

centers 220Table 5-13. Index for economic and living conditions

222

Table 6-1. Private tutoring in Korea (2007) 245Table 6-2. Employment rates after graduation and

study-job matches of tertiary education 245Table 6-3. Workers by status 251Table 6-4. Employment by sector 256Table 6-5. Employment by occupational group 257Table 6-6. Flexibility and security in the Korean labor

market 264Table 6-7. OECD employment protection index (2008)

266Table 6-8. Development of the social security system

270Table 6-9. Participants in the National Health

Insurance Program 275Table 6-10. Spending for the care and education of

pre-school age children 280Table 6-11. Average personal income tax and social

security contribution rates on gross laborincome (2008) 284

Table 6-12. Main indicators of the National HealthInsurance (1977-2008) 285

Table 6-13. Number of hospitals and clinics byownership (December 2008) 289

Table 6-14. Agreements of the KORUS FTA in thehealth care sector (December 2008) 297

Table 6-15. Womens role in Koreas economic andsocial development 299

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viiiTHEKOREAN


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List of tablesTable 6-16. Advancement rate into tertiary education 302Table 6-17. Employment rates of persons with tertiary

education (2008) 305

Annex Table 1. Major macroeconomic indicators (1953-2009) 313

Annex Table 2. Nominal exchange rate of won to the U.S.dollar (1945-1970) 315

Annex Table 3. Share in gross value-added 317Annex Table 4. Share in total employment 319Annex Table 5. Major trade indicators 321Annex Table 6. Demographic trend 323Annex Table 7. Educational participation and resources

325Annex Table 8. Labor market indicators 326Annex Table 9. Participants in work-related social

insurance programs 328Annex Table 10. Health care indicators 330

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List of figures

ixListoffigures

Figure 2-1. Movement of real exchange rates (1945-2009) 018

Figure 2-2. Exports and imports (1953-2009) 020Figure 2-3. Marginal effective tax rates on corporate

income 022Figure 2-4. Trend in R&D expenditure 023Figure 2-5. Trend in import liberalization (1955-1999)

026Figure 2-6. Outstanding stock of external assets and

liabilities (1962-2009) 028Figure 2-7. Debt-to-equity ratio and interest coverage

ratio in the manufacturing sector 029Figure 2-8. Inflows of grants, loans, and FDI 030Figure 2-9. Trends in real interest rates (1954-2009)

034Figure 2-10. Consolidated central government fiscal

balance (1970-2009) 042Figure 2-11. Central government debt (1953-2008) 042Figure 2-12. Sterilization of central bank lending (1950-

2009) 043Figure 2-13. Sterilization of net foreign assets (1966-

2009) 044Figure 2-14. Share of the largest 100 companies in

mining and manufacturing 056Figure 2-15. General and central government spending

(1953-2009) 057Figure 2-16. General government spending by function

(1970-2008) 057Figure 2-17. Enrollment rates and the number of

enrolled students (1965-2009) 060Figure 2-18. Output growth: Comparison of 1997-1999

and 2008-2010 071

Figure 3-1. Share in gross value-added by sector 087Figure 3-2. Share in total employment by sector 088

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List of figuresFigure 3-3. Share in manufacturing value-added by

subsector 088Figure 3-4. Share in exports by sector 089Figure 3-5. Periods of industrialization 091Figure 3-6. Trends of Hoffman ratio across countries

091Figure 3-7. Investment and savings rates 092Figure 3-8. R&D expenditure 094Figure 3-9. Royalties and license fees 095Figure 3-10. Urbanization trend 096Figure 3-11. Labor productivity of the service sector

(1963-2008) 099Figure 3-12. Average wages by firm size in

manufacturing (1980-2008) 100Figure 3-13. Labor compensation per employee (2006)

100Figure 3-14. Employment share in the service sector

101

Figure 4-1. Export composition 131Figure 4-2. Earnings per dollar of exports 132Figure 4-3. Import liberalization 135Figure 4-4. Koreas tariff rates (1978-2007) 138Figure 4-5. Export growth and real effective exchange

rates 142Figure 4-6. Korean outward direct investment (1981-

2008) 148

Figure 5-1. Map of the Republic of Korea 182Figure 5-2. Changes in farm household income (1971-

1982) 192Figure 5-3. Changes in population distribution (1960-

2005) 211Figure 5-4. Infrastructure development (1960-2008) 213

xTHEKOREAN


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Figure 6-1. Population growth and fertility rate(1961-2008) 230

Figure 6-2. Population pyramid in 1955 and 2005231

Figure 6-3. Share of the elderly (65 years and over)in total population (1950-2050) 231

Figure 6-4. Share of foreigners in registeredresidents in Korea 234

Figure 6-5. Number of students 235Figure 6-6. Enrollment rate 235Figure 6-7. Population that has attained tertiary

education (2008) 236Figure 6-8. Investment in educational resources 237Figure 6-9. Advancement rate 237Figure 6-10. Number of high school graduates and

university entrance quota 240Figure 6-11. Fraction of students attending private

institutions (1965-2009) 243Figure 6-12. Inactive youth in the 15-29 age group

with tertiary education (2004) 246Figure 6-13. Unemployment rate 248Figure 6-14. Growth of unit labor costs 249Figure 6-15. Growth of wages and output per work

249Figure 6-16. Number of labor disputes 250Figure 6-17. Labor union participation rate 251Figure 6-18. Share of salaried workers and

regular employees 252Figure 6-19. Employment rate 252Figure 6-20. Wage by workers educational

attainment 253Figure 6-21. Share of temporary employees and

day laborers 254Figure 6-22. Female labor market participation

rate by cohort 255Figure 6-23. Employment rates in OECD countries

(2008) 256Figure 6-24. International comparison of the

employment pattern 258Figure 6-25. Workers by status 259Figure 6-26. Share of the non-salaried workers 259

Figure 6-27. Share of part-time workers in totalemployment 260

Figure 6-28. Incidence of part-time employment(2008) 261

Figure 6-29. Trends in the minimum wage level262

Figure 6-30. The level of minimum wage in OECDcountries (2008) 262

Figure 6-31. Hours worked in Korea 263Figure 6-32. Hours worked in the OECD area

(2008) 264Figure 6-33. Labor union participation rate in

OECD countries (2008) 265Figure 6-34. Growth and distribution of income in

1965-1989 269Figure 6-35. Gini coefficient (1982-2008) 270Figure 6-36. General government welfare

spending 271Figure 6-37. Social expenditure in Korea and other

countries (2005) 272Figure 6-38. Recipients of unemployment benefits

278Figure 6-39. Relative poverty rate 281Figure 6-40. Impact of taxes and transfers in

reducing poverty among the entirepopulation 282

Figure 6-41. Participants in work-related socialinsurance programs 283

Figure 6-42. Trends in tax burden 284Figure 6-43. Health outcomes 287Figure 6-44. Health expenditure in Korea 287Figure 6-45. Out-of-pocket and public health

expenditures 288Figure 6-46. Health expenditures in OECD

countries (2008) 288Figure 6-47. Increases in health care resources

290Figure 6-48. Labor force participation rate 301 xi

Listoffigures

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xiiTHEKOREAN


Foreword

Koreas economic success has often been called amiracle.There has been anongoing debate about the factors behind its success, which has attracted the interestof not only academicians but also policy practitioners. Koreas experience holdsrelevance for other developing countries that want to catch up with advancedeconomies in a short period of time as Korea did. A careful study of Koreaseconomic history is also essential to chart its future path in the face of newchallenges.

Two years ago, a project to compile the sixty-year history of the Koreaneconomy was started to contribute to the discussion. For this purpose, issues weregrouped into five areas(1) general economic policies (macroeconomic, financialmarket, fiscal, taxation and competition policies), (2) industrial growth, (3) externaleconomic relations, (4) territorial development, and (5) social policies. In the lasttwo years, many research institutions and researchers have worked on this projectto highlight Koreas progress in the five areas, examine main issues, and drawlessons. The result was published in five volumes in Korean. This English volumeis a condensed and revised version of the original Korean text.

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xiiiForeword

A Note on Romanization

In romanizing Korean, we have used the guideline set forth by the Koreangovernment in 2000. In romanizing the names of Koreans, we have used theirpreferred romanization. When the information was not available, we havefollowed the above-mentioned guidelines and put a hyphen between the twopersonal names, the second of which has not been capitalized. In ordering theelements of persons names, we have adopted a Western sequence?personalname first and family name last. Exceptions are the names of Presidents of theRepublic of Korea, for whom the use of the family name first seems to beestablished by custom and preference. Korean words in the plural are notfollowed by the letters.

Many people contributed to the publication of this book. Special thanks go toMr. Man-Soo Kang (Senior Economic Adviser to the President and Chairman of thePresidential Council on National Competitiveness) who initiated the project twoyears ago as Minister of Strategy and Finance. The advisory group consisting ofeminent scholarsProfessors Chang Yung Jung (Yonsei University), Kwang SukKim (Kyung Hee University), Heeyhon Song (Asia Development Institute), Jung JayJoh (former Minister of Maritime Affairs and Ficheries), Hacheong Yeon (MyongjiUniversity), and Chong-Hyun Nam (Institute for Global Economics)providedmany valuable suggestions to the authors throughout the two-year period toimprove the book. The Ministry of Strategy and Finance (MOSF) financed andassisted the project under the leadership of Minister Jeung-Hyun Yoon. MessrsCheol-Kyu Park (MOSF) and Sang-Mok Choi (Financial Services Commission) haveplayed a particularly important role in this regard. President Oh-Seok Hyun ofKorea Development Institute organized the work and his staff worked very hard fora successful completion of the project. The participants of the internationalconference held in Seoul on August 30, 2010, including Professor Anne Krueger(Johns Hopkins University), made valuable comments on the original draft. Mr.John Burton served as the English-language editor of the book. The devoted effortsby these people are deeply appreciated.

Il SaKongChairman of the Committee for the Sixty-Year History of the Korean Economy

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xivTHEKOREAN


A Note on Romanization

In romanizing Korean, we have used the guideline set forth by the Koreangovernment in 2000. In romanizing the names of Koreans, we have used theirpreferred romanization. When the information was not available, we havefollowed the above-mentioned guidelines and put a hyphen between the twopersonal names, the second of which has not been capitalized. In ordering theelements of personsnames, we have adopted a Western sequencepersonalname first and family name last. Exceptions are the names of Presidents of theRepublic of Korea, for whom the use of the family name first seems to beestablished by custom and preference. Korean words in the plural are notfollowed by the letters.

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AbbreviationsALMP active labor market policyAPEC Asia-Pacific Economic CooperationASEAN Association of Southeast Asian NationsASEM Asia-Europe MeetingBOK Bank of KoreaBOP balance of paymentCD certificate of depositCP commercial paperCRIK Civil Relief in KoreaDAC Development Assistance CommitteeDDA Doha Development AgendaDMB deposit money bankECA Economic Cooperation AdministrationEFTA European Free Trade AssociationEIS Employment Insurance SystemEPB Economic Planning BoardEU European UnionFDI foreign direct investmentFSC Financial Supervisory CommissionFTA free trade agreementFTC Fair Trade CommissionGATT General Agreement on Tariffs and TradeGCC Gulf Cooperation CouncilHCI heavy and chemical industryICA International Cooperation AdministrationICT information and communication technologyKDB Korea Development BankKDI Korea Development InstituteKITA Korea International Trade AssociationKOTRA Korea Trade Promotion AgencyL/C letter of creditM&A merger and acquisitionMBC merchant banking corporationMDA Manufacturing Development Act

MFN most favored nationMMA minimum market accessMOF Ministry of FinanceMPC military payments certificateMRFTA Monopoly Regulation and Fair Trade ActMSB Monetary Stabilization BondNAFTA North American Free Trade AgreementNAMA non-agricultural market accessNBFI non-bank financial institutionNBLSP National Basic Livelihood Security ProgramNFA net foreign assetNHI National Health InsuranceNIF National Investment FundNPS National Pension SchemeOBS Office of Bank SupervisionODA Official Development AssistanceODI overseas direct investmentR&D research and developmentRTA regional trade agreementSACU Southern African Customs UnionSITC Standard International Trade ClassificationSME small- and medium-sized enterpriseSOE state-owned enterpriseTFP total factor productivityTRERA Tax Reduction and Exemption Regulation

ActTRQ tariff-rate quotaUNC United Nations CommandUNCTAD United Nations Conference on Trade

and DevelopmentUNKRA United Nations Korean Reconstruction

AgencyUR Uruguay RoundURAA Uruguay Round Agreement on AgricultureWTO World Trade OrganizationZBB zero-based budgeting

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ContributorsNakgyoon Choi

Senior Research Fellow, Korea Institute for International Economic PolicyHea-Jung Hyun

Research Fellow, Korea Institute for International Economic PolicyJung Jay Joh

Former Minister of Maritime Affairs and Fisheries and President of Korea Maritime InstituteChang Whan Kim

Senior Research Fellow, Korean Educational Development InstituteDoHoon Kim

Senior Research Fellow, Korea Institute for Industrial Economics and TradeJeong Gon Kim

Senior Researcher, Korea Institute for International Economic PolicyJoo Seop Kim

Senior Research Fellow, Korea Labor InstituteJune Dong Kim

Senior Research Fellow, Korea Institute for International Economic PolicySangkyom Kim

Senior Research Fellow, Korea Institute for International Economic PolicySeung Kwon Kim

Senior Research Fellow, Korea Institute for Health and Social Affairs

Young-Ock KimSenior Research Fellow, Korean Womens Development Institute

Young-Pyo KimSenior Research Fellow, Korea Research Institute for Human Settlements

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Youngsun KohSenior Research Fellow, Korea Development Institute

Hongshik LeeProfessor of Economics, Korea University

Junkyu LeeResearch Fellow, Korea Institute for International Economic Policy

Sang Young LeeResearch Fellow, Korea Institute for Health and Social Affairs

Young LeeProfessor of Economics, Hanyang University

Il SaKongChairman of the Presidential Committee for the G20 Seoul Summit

Yoocheul SongProfessor of International Business, Dongduk Womens University

Jin Kyo SuhDirector, Department of Planning and Research Coordination, Korea Institute for International Economic Policy

Jungho YooProfessor, Korea Development Institute School of Public Policy and Management

Deok Ryong YoonSenior Research Fellow, Korea Institute for International Economic Policy

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Chapter 1

IntroductionIl SaKong

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In the last six decades, Korea has achieved unparalleled economic growth. Korea wasone of the poorest countries in the world in 1948 when the government was firstestablished. Now it has grown into a global economic player with a solid industrial base.In the meantime, democracy and pluralism have taken firm root in Korean society. It is noexaggeration to say that Korea is one of only a handful of countries that have combinedeconomic success with democratic transition in the post-World War II era.

The transformation of the Korean economy can be summarized in two wordsindustrialization and globalization. The share of the industrial sector (manufacturing,construction and public utilities) in total value-added more than doubled from 17 percentin the 1950s to 38 percent in the 1980s, and has fluctuated around this level ever since. Theservice sector has also increased its share from 41 percent in the 1950s to 60 percent in the2000s. By contrast, the primary sector has experienced a precipitous fall in its share from42 percent to 3 percent in the same period. Along with rapid industrialization, integrationinto the global economy accelerated, as indicated by total trading volume, which rose fromabout 10 percent of GDP in the 1950s to 80-90 percent in recent years. Cross-border capitalflows also increased rapidly in this period.

The industrialization of the Korean economy has been greatly affected by theglobalization trend. International trade offered a vast global market for Korean producers.It also enabled them to import intermediate goods and advanced technologies needed forthe production of export goods. At the beginning, the international division of laborprompted the growth of labor-intensive industries in which Korea had a comparativeadvantage. These industries absorbed surplus labor from rural areas and contributed to anincrease in per capita income and savings rates. Later, as capital accumulation progressed,the comparative advantage shifted from labor-intensive to capital-intensive industries, andthe latter began to dominate industrial production and exports. Per capita incomecontinued to grow rapidly as productivity improved.

In the process of industrialization and globalization, the policy stance of the governmentunderwent a few significant changes. In the aftermath of the Korean War, the governmentfocused on meeting the immediate consumption needs of the population. It was only inthe 1960s that a systematic effort to jump-start the economy was initiated. The governmentactively promoted exports with pecuniary and other incentives given to exporters. Initially,these incentives were non-discriminatory in the sense that all exporters with a good exportperformance were entitled to them regardless of their business sector. In the 1970s,however, as the government came to concentrate its efforts on promoting heavy andchemical industries (HCIs), government intervention in the market became more selectiveand discriminatory. The government also strengthened its control of the financial market to

003Introduction


direct resource allocation in favor of the HCIs.The government-led growth strategy, as exemplified by the HCI drive, produced many

problems, including a serious misallocation of resources, chronic inflation, and greaterincome inequality. In the early 1980s, the government made a radical departure from thepast by emphasizing price stability over economic growth. It also encouraged privateinitiatives and began to liberalize the market. More attention was given to social policies,with a corresponding increase in public spending on health, welfare and education.

Throughout its economic history, Korea has had its fair share of failures as well assuccesses. Financial repression since the 1960s held back the financial sector fromdeveloping into a fully competitive service industry. A number of large businessconglomerates, namely the chaebol, increased their influence on the back of governmentsupport, and the concentration of economic power emerged as an important economicand social issue. In addition, Korea failed to establish sound worker-management relationsuntil disruptive labor movements appeared in the mid-1980s.

Most importantly, the repeated interventions by the government to salvage troubledfirms from bankruptcy strengthened the so-calledtoo-big-to-fail principle. Combinedwith very low interest rates maintained since the 1960s, the risk partnership between thegovernment and private sector encouraged excessive borrowing by the latter. The averagecorporate debt-to-equity ratio hovered between 300 and 400 percent between the 1970sand 1990s. The non-performing loans of banks grew in size, and the financial sectorbecame increasingly vulnerable to external shocks.

The financial crisis of 1997, while inflicting extreme hardship on many Koreans, workedas a catalyst in solving many of these problems. Many chaebol went bankrupt and thepublic-private risk partnership disappeared. Government-led restructuring strengthened thefinancial health of the banking sector significantly. External liberalization, especially theopening of capital markets, accelerated Koreas integration into the global economy. Whilepursuing liberalization, the government also modernized and strengthened prudentialregulation and competition policy. A modern economic system finally came intooperation.

On the other hand, concerns have been raised in the 2000s on the growth potential ofthe Korean economy. Economic growth began to slow in the 1990s with the deceleratinggrowth of the working-age population. Income distribution also started to deteriorate inthe early 1990s, with the expansion of the knowledge-based economy and globalizationleaving low-skilled workers at a disadvantage. At the same time, productivity gapsbetween manufacturing and services, between the HCIs and light industries, and betweenlarge and small companies are widening, and access to quality jobs is becoming more

004THEKOREAN



difficult. Summarized in this way, the economic history of Korea poses many interesting and

important questions. For example, what are the main characteristics that distinguishedKorea from other developing countries that failed to establish an industrial base? What arethe commonalities and disparities between Korea and other East Asian countries thatachieved similar economic success? Were financial repression, the HCI drive, andoppressive labor market policies inevitable choices for Korea? What would have a moreliberal, market-friendly policy achieved? These questions hold relevance not only for Koreabut other countries, and continue to generate discussions in academic and policy circles.

To contribute to this debate, the following chapters describe the growth of the Koreaneconomy from various perspectives. Chapter 2 chronicles the various market interventionsmade by the Korean government, including export promotion, the HCI drive, financialrepression, the bail-out of private companies, and price controls. Some of theinterventions, notably export promotion and investment in infrastructure and education,successfully addressed market failures and contributed to economic growth. But manyothers did more harm than good to the long-term growth and stability of the Koreaneconomy. The author concludes that the government can and should play an importantrole in a countrys economic growth, but try to avoid the errors made by the Koreangovernment.

Chapter 3 documents Koreas industrialization process, and offers an explanation on itsstructural changes in the growth accounting framework. The rapid capital accumulationbased on Koreas high savings rate accounts for a large part of output growth as has beennoted in the existing literature. No less important, however, has been the rapid increase intotal factor productivity (TFP). Among other factors, international trade has made aparticularly important contribution to TFP growth by stimulating innovation andtechnological progress and by encouraging the reallocation of resources from less to moreproductive sectors. The authors point out that a critical task for the Korean government isto maintain dynamism in the private sector, rather than designating certain industries as

strategic and providing them with subsidies in the name of industrial policy.Chapter 4 explains the development of external economic policies in various areas

trade, foreign direct investment, economic cooperation, agriculture, services and financialmarkets. According to the authors, three rounds of devaluation in 1960 and 1961 prompteda sudden jump in exports in the early 1960s and led to a policy switch in the mid-1960sfrom import-substitution industrialization to export promotion. Various export-promotionmeasures neutralized the depressing effects of the protectionist policy on exports andcleared roadblocks to allow the growth of Korean exports in the global market. In this

005Introduction


respect, a major contribution by the Korean government to export growth in the 1960s andthereafter lay in eliminating market distortions created by overvaluation and protectionism.Building on past success, future efforts should be directed at pursuing externalliberalization consistently in all areas and strengthening market mechanisms.

Chapter 5 reviews Koreas territorial development over the last sixty years. In Korea,territorial policy has been assigned three main responsibilities: (1) supplying physicalinfrastructure for economic growth, (2) stabilizing real estate prices, and (3) promotingbalanced regional growth. The first of these has achieved tremendous success thanks toheavy government investment, while the other two goals have fallen short. Variousmeasures to reduce speculative real estate demand often increased price instability in themarket. More successful in curbing property prices were the measures to increase thehousing supply, such as the construction program adopted at the turn of the 1990s. TheKorean government has also made recurrent efforts to promote balanced regional growth,but the population has continued to be concentrated in the capital region. A more market-friendly approach to regional development is called for that focuses on buildingsoftinfrastructure in regional communities while allowing the dynamic reallocation of resourcesacross the country.

Chapter 6 examines Koreas social development with a focus on education, the labormarket, welfare and health care policies. Up to the early 1990s, Korea could maintainrelatively equitable income distribution due to several factors, including the explosive paceof economic growth and the rapid creation of jobs; the promotion of mass education bythe government; and a labor market that functioned smoothly in most areas. But Koreacurrently faces many new challenges. It needs to upgrade the quality of education bydecentralizing the education system and giving more power to parents and students. Thesharp contrast in the labor market between core and periphery workers should bemitigated by relaxing legal employment protection provisions on the one hand andstrengthening social welfare and active labor market programs on the other. Welfarepolicies achieved great progress, especially after the 1997 financial crisis, but further effortsare required to improve their effectiveness, minimize their adverse impact on workincentives, enhance long-term financial sustainability, and give a greater role to the privatesector in the provision of services.

To summarize, Korea has achieved not only tremendous economic growth but alsobroad-based social development in the last sixty years. Government policies have beenbroadly in line with market principles, in particular in regard to exchange rate and tradepolicies. Many challenges remain, but as long as Korea maintains its economic and socialdynamism, the future will favor Korea.

006THEKOREAN



60YEARS

THEKOREANECONOMYSixDecadesofGrowthandDevelopment

Chapter 2

The Growth ofKorean Economy

and the Role ofGovernment

Youngsun Koh


1. Introduction

Korea has achieved rapid economic growth and social development in the last fivedecades. Per capita income grew from 1,342 dollars1 in 1960 to 19,227 dollars in 2008. Inthe same period, life expectancy rose from 52.4 years to 79.6 years and infant mortalitydeclined from 70 deaths per 1,000 births2 to 3.4 deaths. The political structure alsoswitched from an authoritarian one to a fully functioning democracy.

In the 20th century, such sustained growth over decades can be found in only a handfulof developing economies, including Korea and other East Asian countries. Their socio-economic achievements have often been described as amiracle. Various interpretationshave been offered for the role that governments played in leading or supporting theseachievements (Aoki, Kim and Okuno-Fujiwara, 1997).

According to the market-friendly view, the rapid growth was made possible by thegovernment maintaining macroeconomic stability and heavy investments in human capital.On the other hand, the selective promotion of particular industries by government waseither ineffective or counter-productive to overall growth since it hampered an efficientallocation of resources. This view, as represented by the World Bank (1993), Noland andPack (2003), Jungho Yoo (2004) and others, emphasizes the primary role of government inhelping the market mechanism to function properly.

At the opposite end of the spectrum is the development-state view, which claims thatprevalent market failures in the early years necessitated government intervention to correctthem. East Asian countries purposefully distorted relative prices (getting the priceswrong, Amsden, 1989) and boosted investment in particular sectors, attaining rapidindustrialization that would have been otherwise impossible.

In the case of Korea, the truth may lie somewhere in between these two extreme views.Government intervention appears to have been more extensive than the World Bank(1993) admits. The promotion of exports in the 1960s and heavy and chemical industries(HCIs) in the 1970s was based on severe financial repression. The period up to the 1980swas characterized by high import barriers, restrictions on capital flows, widespread pricecontrols, and repressive labor practices. On the other hand, a relatively stablemacroeconomic environment, well-established private property rights, and large publicspending on education (particularly primary education) and infrastructure investment weremarket-friendly aspects of government policy often ignored by proponents of the

1 In 2008 constant won converted into dollars using the exchange rate in 2008.2 This figure is for 1960-1965.

TheGrowthofKoreanEconomyandtheRoleofGovernment009


development-state view.Some authors have noted that Asian countries did not take the same road to growth

(Perkins, 1994). Hong Kong and Singapore adopted laissez-faire attitudes from thebeginning, whereas Japan, Korea and Taiwan took more dirigiste approaches in varyingdegrees. Late industrializers like Malaysia, Indonesia and Thailand, with their abundantnatural resources, relied heavily on foreign direct investment. China and India weredistinctive in their eagerness not only to invite foreign direct investment but also to goabroad to acquire foreign firms. It would therefore be inappropriate to treat all Asiancountries in the same manner.

At any rate, few would argue that government intervention should continue in managingthe Korean economy. Past interventions produced various problems, including anunderdeveloped financial sector, excessive corporate reliance on debt financing, theaccumulation of non-performing loans by banks, the concentration of economic power inthe hands of a few large business conglomerates (the chaebol), chronic inflation, and weakdemocracy. Recognizing these problems, the government began efforts in the 1980s toliberalize the market and redefine its role. These efforts were not always successful,however, and full-scale liberalization was postponed until after the economic crisis of 1997.

This chapter discusses the history of the Korean economy during the last six decades.The central questions are whether various government interventions promoted or retardedeconomic growth, and what kind of policy lessons we can now draw for Korea and otherdeveloping countries. Of course, we should expect no definitive answers to such grandquestions, but only meaningful insights that may guide further research.

2. Liberation and state-building (1948-1959)

The liberation from Japanese colonial rule in 1945 left Korea in economic chaos. Thecomplementary economic structure between the northern and southern parts of thepeninsula was lost. Most of the Japanese businessmen, managers and technicians returnedto Japan, leaving many firms bereft of management or technical expertise. The closely-knitties with the Japanese economy, a vast market for Korean goods, were broken. Astupendous growth in money supply around the time of the liberation period generatedhyperinflation. Amid these difficulties, the newly independent Korean government wasinstalled in 1948, and it immediately embarked on rebuilding the nation. Any serious effort,however, was delayed by the Korean War (1950-1953).

010THEKOREAN



011

2.1 Establishing a market economy based on private property ownershipThe American military government which was in charge of South Korea between 1945

and 1948 tried to introduce a modern market economy system.3 It outlawed the so-calledworkersself-management of factories abandoned by Japanese owners and barredworkers from interfering with managerial responsibilities (Yong-deok Jeon, 1997a). Themilitary government also began to sell confiscated Japanese-owned property despite callsfor nationalization from both right- and left-wing political groups. The realized sales ofcompanies and farmland during the three-year U.S. military rule were not large in size, butthis was an important first step toward establishing a market economy based on privateproperty ownership.

Divesture continued under the newly established Korean government, and sales reacheda peak in 1951-1953. As a result, most of the Japanese-owned properties were convertedinto private ownership by 1958. They accounted for a large portion of the total nationaleconomy; for example, among the companies with 300 or more employees, the share ofprivatized ones was roughly 40 percent in the 1950s. This achievement is notable given thepredisposition toward socialism even among right-wing politicians at the time.4

2.2 Agricultural land reformLand surveys and registration conducted by the colonial government in the 1910s

established the first modern system of property rights in Korea and reduced landtransaction costs significantly. But it was not accompanied by measures to protect smallfarmers, and led to a wide disparity in agricultural land holdings (Seok-gon Cho, 2001).The Korean government responded to the increasing demand for agricultural land reformby enacting the Farmland Reform Act of 1949 and revising it in 1950. The reform wasbased on the principle ofcompensated forfeiture and non-free distribution, whereby thegovernment bought farmland from landlords at forced prices and sold it to farmers atbelow-market rates.

The reform had many elements that ran counter to private property rights. Thecompensation to landlords was less than the market price, leading to big losses for thelandlords (Yong-deok Jeon, 1997b).5 The Farmland Reform Act also banned farmland

TheGrowthofKoreanEconomyandtheRoleofGovernment

3 The North was occupied by Soviet Union until a separate government was established in 1948.4 In fact, the first Constitution of 1948 mandated companies of major importance to be nationalized or controlled by the government.Following this mandate, the government designated 50 companies as state-owned enterprises in 1951. The Constitution, however,was revised in 1954 as agreed by the Korean and American governments, and divestures gained speed to encompass allindustries except a few strategic ones.


ownership by non-farmers, stipulated the maximum amount of landholdings per farmer,and prohibited tenant farming. Nevertheless, from the perspective of private propertyrights, compensated forfeiture and non-free distribution was a better option than

uncompensated forfeiture and free distribution as espoused by left-wing groups andcompensated forfeiture and free distribution by centrist groups. The most pressing taskat the time was state-building, based on the support of farmers who constituted by far thelargest part of the Korean population, even if this meant some infringements on the privateproperty rights of landlords.

Agricultural land reform contributed not only to state-building, but also to redistributingwealth and reducing income inequalities. Everyone was now placed on a more or lessequal footing, and individual effort and ability rather than family wealth became the mostimportant determinant for individual success. Many believe that the Koreanscharacteristicdiligence and their emphasis on education were motivated by this perception of equalopportunity. On the negative side, however, restrictions on farmland holdings hamperedthe growth of large-scale farming and contributed to the low productivity growth of theagricultural sector in later years.

2.3 Economic reconstruction plans and foreign aidRhee Syngman, the first president of the young republic, strived to rebuild the economy

with a series of reconstruction plans.6 These plans aimed to expand the economicinfrastructure, build key industries (cement, steel, etc.) and increase the productivecapacity of manufacturing (Sang-oh Choi, 2005, pp.358-359).

Rhees desire to construct a self-sufficient Korean economy with these plans was indirect conflict with the American governments intention to rebuild an East Asian economicbloc with an industrialized Japan at its center. America urged Korea to liberalize its market,stabilize the value of the Korean currency, and expand cooperation with Japan. To Rhee,however, this implied nothing but the revival of the Greater East Asian Co-ProsperitySphere and the re-colonialization of the Korean economy. Rhee made full use of Koreasgeopolitical value to frustrate Americas effort while promoting import-substitutionindustries through reconstruction plans.7

5 The forced prices were well below market prices. In addition, the delay in payments due to the war, combined with high inflation,significantly eroded the real value of land compensation securitiesthat had been given to landlords in exchange for their lands.

6 The Five-Year Industrial Reconstruction Plan (1949), Reconstruction Plan (1951), Comprehensive Reconstruction Plan (1954),Five-Year Economic Reconstruction Plan (1956), and Three-Year Economic Development Plan (1960). These kinds of development planscould be found not only in socialist economies, but also in capitalist ones such as France after the Second World War (Yergin andStanislaw, 1998).

7 The Taiwanese government was much more cooperative than Korea was with the Americans (Jung-en Woo, 1991, p.52).

012THEKOREAN



013The Korean government also differed with the Americans on what kind of foreign aid it

would receive. There were two types, one being project assistance and the other non-project assistance. The former was to be used for reconstruction, while the latter was to bedistributed to private enterprises for civilian use. Korea received a large amount of foreignaid from the United Nations and the U.S. in the 1950s and 1960s.8 The Korean governmentpreferred project assistance, while the American government preferred non-projectassistance. In the end, the American preference prevailed; under ICA (InternationalCooperation Administration) aid, for example, project assistance made up 27 percent of thetotal and non-project assistance 73 percent.

In any event, various reconstruction plans prepared by Rhees administration failed tospark economic growth in Korea. They remained just thatplans.

2.4 Exchange rate and trade policiesThroughout the 1950s, the Korean government maintained a complicated multiple

exchange rate system (Frank, Kim and Westphal, 1975). In addition to the official rate,there were separate rates applied to the counterpart fund9 and to military paymentscertificates (MPCs).10 The overvaluation of the Korean won under these rates eitherreduced the governments burden (as in the case of the counterpart fund rate) or increasedits revenues (as in the case of the MPC rate). The government reluctantly adjustedexchange rates from time to time when it could no longer withstand pressure fromAmerica.

An overvalued exchange rate discouraged imports. Imports were further discouraged byquantitative restrictions that the Korean government employed to promote import-substitution industrialization. Trade Programs, which were published semi-annually by theMinistry of Commerce and Industry, listed three types of goods: (1) freely-imported items,(2) restricted items whose import required prior approval from relevant ministries, and (3)banned items (Sang-cheol Lee, 2001, p.459). Banned items referred to those that wereproduced domestically in sufficient quantity to meet all domestic demand. Restricted items


8 The amount of aid as a proportion to GDP corresponded to a low of 11 percent in 1954 and a high of 23 percent in 1957 (Sang-ohChoi, 2005, p.362).

9 The foreign aid often took the form of the right to import from America or other countries a certain amount of goods in dollarterms. A private importer or a government agency that was allocated these rights had to deposit Korean currencies in thecounterpart fund held by the Bank of Korea. The low won/dollar value of the counterpart fund rate meant a smaller burden forthe importer or the government agency (Younghoon Rhee, 2007, pp.302-303).

10 During the war, American and other military forces needed a means of payment for local goods and services they purchased. Tofacilitate this, the Korean government turned over to the United Nations Command a large amount of won in advance with theunderstanding that the terms of repayment in dollars would be negotiated later. In the negotiations, the Korean government triedto keep the won/dollar exchange rate at low levels to maximize its dollar receipts (Krueger, 1977).


were those whose domestic production could not meet all demand.The tariff system was also geared to protecting domestic industry. From 1945 to 1949, a

single tariff rate of 10 percent was levied on all items except for foreign aid goods. In 1950,the government enacted the Tariff Act that imposed different rates depending on whetherthe item was produced domestically or not, and whether the item was a finished good ornot. Tariff rates were generally high, ranging between 27.4 and 66.5 percent in the latterhalf of the 1950s.

Export promotion was also pursued, but the focus was not on actively promotingexports but on mitigating the impediments to exports. An example is the ForeignExchange Deposit System, which allowed exporters to deposit foreign currencies earnedfrom exports at the Bank of Korea (BOK) and to use them to pay for imports or sell theforeign currencies to other importers at market rates. However, direct subsidies for exportswere minimal.

2.5 Financial market policiesAccording to Jung-en Woo (1991, p.60), Korea in the 1950s exhibited a textbook

example of financial repression. The official lending rate by banks was capped at 20percent when the curb market rate was well above that.11 In addition, the credit priorityregulation and the credit ceiling regulation enabled the government to control banklending directly (Pyung-joo Kim, 1995, p.188).

In January 1954, the Korea Development Bank (KDB) was launched as a solelygovernment-owned bank. Its mission was to provide long-term credits to key industries. Itfinanced over 70 percent of total equipment loans and over 10 percent of total workingcapital loans made by financial institutions (Joon-kyung Kim, 1993). It raised funds byborrowing from the government fiscal loan program (50 percent of the funds in the 1950s)and issuing bonds (37 percent).

The real interest rate remained negative most of the time due to low official rates andhigh inflation, discouraging savings and increasing demand for credit. Credit demandalways surpassed savings despite the regulations mentioned above, and commercial bankshad to rely on the central bank rediscount facility to fill the gap. Before 1957, about half ofbank lending was financed by the central bank in this way (Jung-en Woo, 1991, p.62).

The excessive reliance on the central bank rediscount facility inevitably generated highinflation. Money supply was increased further by central bank lending to the government

11 The curb market rate was 48-120 percent according to Sang-cheol Lee (2001, p.463) and 150-240 percent according to Jung-enWoo (1991, p.61).

014THEKOREAN



015to finance essential public services, such as defense and the police. Annual inflationfluctuated between 20 and 400 percent between 1946 and 1957 (Table 2-1). The root causeof high inflation lay in the lack of operational independence of the central bank. ArthurBloomfield, an economist at the New York Fed, recommended the establishment of anindependent central bank resembling the Federal Reserve Bank. Following his advice, theBank of Korea Act and the Banking Act were enacted in May 1950. The Bank of Korea Act,however, failed to bestow full independence on the central bank.

Table 2-1.Price inflation (Unit: %)

Source: Bank of Korea (2005a).

The implementation of the Banking Act was postponed until August 1954 due to thedelay in the privatization and recapitalization of banks. From 1954, the governmentattempted five times to sell its shares in banks, but failed. It could finalize the sales inFebruary 1957 only after relaxing the eligibility conditions for bids. In the end, each majorchaebol came to own a bank, which accelerated the concentration of economic power(Pyung-joo Kim, 1995, p.190). The military government re-nationalized the banks in 1961shortly after seizing power.

2.6 Performance of economic policies in the 1950sThroughout the 1950s, the Korean government maintained an overvalued exchange

rate, restricted imports, regulated interest rates and bank lending, and undermined centralbank independence. These market interventions created economic rents, which amountedto 16-19 percent of GNP according to Nak-nyeon Kim (1999). Of these, the rents resultingfrom exchange controls amounted to 11-15 percent of GNP and those resulting fromfinancial repression 3-8 percent of GNP.

The question is how much of these rents were utilized in productive activities. Sang-ohChoi (2005) observes that rents were distributed mostly to those who put them toproductive use, and stimulated economic reconstruction at the time. He cites the case ofthe cotton spinning industry, which lost 66 percent of its facilities during the war, butrecovered soon after and even encountered over-capacity in the latter half of 1956.Younghoon Rhee (2007) also claims that the government maintained a certain degree of


1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959

Producer price 385.4 73.9 62.9 36.7 - - - 25.3 28.2 81.1 31.6 16.2 -6.2 2.6

Consumer price 280.4 78.9 58.4 24.9 167.5 390.5 86.6 52.5 37.1 68.3 23.0 23.1 -3.5 3.2


consistency and ethical standards in distributing dollars obtained from foreign aid andmilitary payment advances to civilians. In fact, real output grew by 3.8 percent annually in1953-1960. This is about half the rate witnessed in the 1960s and afterwards, but it canhardly be calledstagnation.

Contrary to these views, some authors believe that the government policies at the timeencouraged zero-sum rent-seeking activities rather than positive-sum productive ones,leading to the underperformance of the Korean economy far below its growth potential.Jones and SaKong (1980, pp.270-274) describe the rapid growth of the chaebol after theliberation, and declare that the major sources of accumulation were (1) non-competitiveallocation of import quotas and import licenses, (2) the bargain price acquisition of formerJapanese properties, (3) the selective allocation of aid funds and materials, (4) privilegedaccess to cheap bank loans, and (5) the non-competitive award of government and U.S.military contracts for reconstruction activities. To be successful as an entrepreneur, one hadto build close ties with politicians and return their favors with cash (Jung-en Woo, 1991,pp.65-69).

However plausible each of these contrasting views is, it is not possible to make anyquantitative judgment on this issue. We will conclude this section by looking at policychanges taken in 1957. In the mid-1950s, the view gained wide support within Americathat the best way to win the war against communism lay in promoting the economicgrowth of its allies. The American government subsequently separated military andeconomic aid, and began to reduce the former while increasing the latter. In addition, itreduced unrequited transfers and introduced the Development Loan Fund in its place.American aid to Korea peaked in 1957 and declined rapidly thereafter. At the same time,the American government pressed the Koreans to adopt the Financial Stabilization Program(1957-1960) to eliminate large budget deficits and curb rapid monetary expansion. Unlikeprevious efforts, stabilization under the Program relied on a systematic frameworkcomprising annual targets for M1 growth and quarterly and monthly implementation plans.This provided the first opportunity for Korean officials to learn the techniques ofcontrolling money supply (Pyung-joo Kim, 1995, p.187).

3. Export promotion and government-led industrialization(1960-1979)

Park Chung-hee, who came into power in 1961 through a military coup, adopted agovernment-led growth strategy to build an industrial base for Korea. The strategy restedon promoting exports and heavy and chemical industries (HCIs). For this purpose,

016THEKOREAN



financial repression was continued and imports were restricted. Below we will explorevarious aspects of the growth strategy in the 1960s and 1970s.

3.1 Export promotionAs the new president, Park proclaimed that economic development would be the central

agenda of his administration (Soon Cho, 1991, pp.175-177). He and his aides understoodthe importance of economic success in legitimizing their forceful seizure of power. Theirideological orientation was far from a free market economic model and they made manymistakes.12 Still, they managed to adopt active export promotion and this later turned outto be the most important reason for their success.

Initially, export promotion was pursued in response to the rapid depletion of foreignexchange reserves (Sang-cheol Lee, 2005, p.394). The reserves began to decline in March1962 due to the large repayment of short-term commercial loans raised in 1961 and 1962 tofinance the first Five-Year Economic Development Plan (1962-1966).13 Faced with thespecter of a foreign exchange crisis, the government introduced various measures. InJanuary 1963, the export-import link system was introduced to give exporters the right toimport foreign goods equal to the full amount of exports.

In the meantime, exports began to grow rapidly following the two rounds ofdevaluation in February and October of 1960.14 Starting with a 66 percent growth in 1960,exports increased by 43 percent a year up to 1964. Bolstered by the success, thegovernment started more serious efforts to promote exports in 1964-1965. First, a newexchange rate regime was announced in May 1964. Multiple fixed rates were consolidatedinto a single variable rate, and the won was devalued by almost half from 130 to 255 wonper dollar. The real exchange rate has maintained a competitive and stable level sincethen. Figure 2-1 shows the won/dollar real exchange rate and the wons real effectiveexchange rate over the past decades, and compares them to the dollars performance.

At the same time, the government phased out various ad hoc export subsidies and theexport-import link system, and established a comprehensive and consistent exportincentive mechanism (Kwang Suk Kim, 1994, p.322; Choong Yong Ahn and Joo-HoonKim 1995, p.324). Key measures were (1) export credits that were automatically extended

12 They abandoned the Financial Stabilization Program and adopted expansionary fiscal and monetary policies in the first two yearsof the first Five-Year Economic Development Plan (1962-1966). They carried out a currency reform in May 1962 to mobilize idledomestic capital held by households, but it failed to disgorge the funds. The new administration also attempted unrealistic andwasteful investments in the domestic production of cars and color TV sets, but abandoned the projects shortly thereafter.

13 The reserve fell by half (from 205 to 107 million dollars) in nine months between December 1961 and September 1962.14 The Korean government reluctantly accepted these devaluations in accordance with the agreement with the U.S. government.

See Chapter 4 for further discussion on export promotion policies in the 1960s.



to exporters who turned in letters of credit and (2) tariff exemptions on imports ofintermediate inputs.15 Of particular importance were the export credits, whose share intotal bank credit rose from 4.5 percent in 1961-1965 to 7.6 percent in 1966-1972 and thento 13.3 percent in 1973-1981 (Table 2-2). The interest rate on export credits was kept atlow levels, and the gap with the general interest rate reached 17 percentage points duringthe high-interest rate period of 1966-1972.

Figure 2-1. Movement of real exchange rates (1945-2009)

Note: A rise in exchange rate indicates a decline in the value of domestic currency. Source: OECD (http://stats.oecd.org); Bank of Korea (2005a).

Table 2-2. Export credit by banks (Unit: %)

Source: Joon-kyung Kim (1993), Table 4-3; Bank of Korea (http://ecos.bok.or.kr).

These incentives were augmented by administrative measures. First, a target was set for018THEKOREAN


1961-1965 1966-1972 1973-1981 1982-1986 1987-1991 1992-2001 2002-2008

Share of export credit in total bank credit 4.5 7.6 13.3 10.2 3.1 2.0 1.5

Interest rate on export credit (A)General interest rate (B)(B-A)

9.318.28.9

6.123.217.1

9.717.37.6

10.010-11.5

0-1.5

10-1110-130-2.0

15 Other measures for export promotion included (3) indirect tax exemptions on intermediate inputs and exports, (4) direct taxexemptions on exporters (abolished in 1973), (5) wastage allowance for imports of raw materials, (6) registration as an importerconditional on export performance, (7) tariff and indirect tax exemptions granted to domestic suppliers of exporters, and (8)accelerated depreciation of fixed assets in major export industries.


019each years total exports by adding up the export forecasts of individual firms. This practicewas often calledexport targeting. Second, Monthly Export Promotion Meetings wereheld, where government officials and business representatives gathered to monitor exportperformance, compared it to export targets, identified problems, and sought solutions. Thepresident himself chaired the meetings. Third, the Korea Traders Association and the KoreaTrade Promotion Agency (KOTRA) were launched. KOTRA took charge of building overseasnetworks, helped the marketing activities of domestic firms, and collected market information.

Exports as a proportion of GDP rose from 5 percent in 1963 to 28 percent in 1973(Figure 2-2). International trade is known to produce multiple benefits.16 The question iswhether various schemes introduced in the mid-1960s were really helpful in promotingexports. Kwang Suk Kim (1994, p.326) notes that they did not raise financial gains forexporters much. Even before the exchange rate reform, exporters could convert theirforeign currency earnings into domestic currencies at market rates through the foreignexchange deposit system. Devaluation of the won therefore did not suddenly increaseexportersprofits. The total amount of various subsidies to individual exporters was alsosimilar in the 1950s and 1960s. Jones and SaKong (1980, p.96) propose other reasons forthe rapid growth of exports. According to them, the most important cause for the changewas probably the reduction of alternative higher-yielding sources of entrepreneurialincome. If you can make 100 percent in a few months with little risk, through privilegedaccess to foreign exchange, there is little point in devoting effort to the difficult andcomplicated task of exploring export markets and putting together internationallycompetitive productive combinations. The exchange rate reform closed out the zero-sumsources of rent, reduced opportunity costs, and drove rent-seekers into productive positive-sum activity. They also note that other factors such as the decline in exchange ratevariability and the commitment to growth by a politically stable government must haveplayed an important role in creating a favorable business climate.


16 First, international trade enhances the division of labor as countries specialize in their areas of comparative advantage.Second,integrated markets enable producers and consumers to reap the full benefits of economies of scale. Third, stronger competitivepressure prompts producers to reduce inefficiencies and invest in productivity-enhancing capital goods and innovation (OECD,2007, pp.6-7). In addition, exporters from developing countries can gain knowledge of product development,manufacturing,marketing, and other modern practices in advanced countries (Je-min Lee, 2001, pp.493-495). The knowledge gained issubsequently disseminated to other parts of the economy, leaving positive externalities.


Figure 2-2. Exports and imports (1953-2009)

Source: Bank of Korea (http://ecos.bok.or.kr).

3.2 Government-led industrializationIndustrialization was the central theme of the Five-Year Economic Plans that started in

1962. The initial version of the first Plan (1962-1966) assigned 34 percent of grossinvestment to mining and manufacturing (Eun-bok Lee, 1986, pp.777-778). The revisedversion (1964) declared the Korean governments ambition to modernize the industrialsector and enhance its international competitiveness by rapidly expanding key industries(cement, fertilizer, industrial machinery, oil refinery and others), fostering related industries,and promoting new export and import-substitution industries.

The second Plan (1967-1971) placed emphasis on HCIs, including steel, machinery andpetrochemical industries. In case of steel industry, the Steel Industry Promotion Act wasenacted in 1969 to support the construction of a large-scale integrated iron and steel milland other kinds of mills by granting tax exemptions to them (Ki-jun Lee, 1986, p.786). Inother industries, similar lawsthe Machinery Industry Promotion Act (1967), theShipbuilding Industry Promotion Act (1967), the Textile Industry Modernization Act (1967),the Electronics Industry Promotion Act (1969), the Petrochemical Industry Promotion Act(1970), the Nonferrous Metal Producing Business Act (1971)were introduced to providefinancial and tax incentives to these industries (Kwang Suk Kim and Joon-kyung Kim,1995, p.49). Of particular importance to the government was the construction of apetrochemical complex and an integrated iron and steel mill. Both projects had to rely

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021almost entirely on foreign technology and capital, and they encountered many difficultiesat the beginning. Construction began in 1969 and 1970, respectively, after several years ofstruggle.

The government also made considerable efforts to alleviate shortages in economicinfrastructure. Electric power development projects were carried out from 1962 and thesupply of electric power came to exceed demand in the mid-1960s. Road construction alsosucceeded in easing transport difficulties with the completion of major expressways. TheSeoul-Incheon, Seoul-Busan and Honam Expressways were opened in 1968, 1970 and1973, respectively.

A full-scale drive toward HCIs began in 1973. On January 1st, Park Chung-hee stated inhis New Years press conference thatthe government is announcing the HCI project topromote HCIs. To achieve a 10 billion dollar target of annual exports by the early 1980s,the share of HCIs in total exports should be raised to well over 50 percent. From now on,the government will accelerate the promotion of HCIs such as steel, shipbuilding andpetrochemical industries, and thereby increase their exports (Yeong-koo Park, 2005,p.406). The HCI Drive Committee was organized shortly after, and the Committeepresented the HCI Drive Plan in June. Targets were set to achieve per capita income of1,000 dollars and annual exports of 10 billion dollars. Through industrial deepening andexport mix upgrading, the share of HCIs in total industrial production was to be raisedfrom 35 to 51 percent between 1972 and 1981, and their share in total exports from 27 to65 percent. For this purpose, six strategic industriessteel, nonferrous metal, machinery,shipbuilding, electronics, and chemical engineeringwere selected. The Plan was revisedslightly in the fourth Five-Year Economic Plan (1977-1981) prepared after the first oilshock, but in most part, it was pursued with great consistency until the ComprehensiveEconomic Stabilization Program was introduced in April 1979.

Various reasons have been suggested for the adoption of the HCI drive (Choong YongAhn and Joo-Hoon Kim, 1995, p.329). First, the government felt the urgent need tostrengthen its self-defense capacity by building a defense industry. Concerns about nationalsecurity grew as North Koreas military provocations increased in frequency toward theend of the 1960s. Furthermore, the American government announced in 1968 that itsground troops would be gradually pulled out of Korea in 1971-1975. Second, it wasconsidered necessary to upgrade the industrial structure and find new export industries tomaintain a safe lead over newly industrializing countries. Policymakers thought that HCIswould provide new sources of growth.

Government support to HCIs took various forms; (1) providing long-term credits and taxincentives to selected industries; (2) establishing and expanding vocational schools and



training centers to supply skilled manpower; and (3) creating government-funded researchinstitutions to carry out R&D activities as a public good (Kwang Suk Kim, 1994, pp.347-348; Choong Yong Ahn and Joo-Hoon Kim, 1995, p.330).

Perhaps the most important of these were the credit programs. By controlling thefinancial sector, the government could supply vast amount of directed credits with lowinterest rates and share investment risk with private enterprises. The National InvestmentFund (NIF), established in 1974, played an important role in this regard. Banks, insurancecompanies and public funds were required to lend a certain portion of their funds to NIF.17The NIF lent these funds in turn to financial institutions at low interest rates (5 percentagepoints below the rates on general long-term bank credits on average before 1982) for verylong periods (8-10 years in some cases). In 1974-1991, 80 percent of the lending wasassigned to specialized banks (including development banks), 17 percent to commercialbanks, and 3 percent to regional banks. In 1974-1981, 62 percent of NIF lending wasassigned to KDB, and the NIF accounted for 57 percent of total equipment loans byfinancial institutions. This share reached 70 percent in the late 1970s, when big industrialcomplexes were being built around the country.18

Figure 2-3. Marginal effective tax rates on corporate income

Source: Tae-won Kwack (1985). Recited from Jungho Yoo (1991).

022THEKOREAN


17 To lend to NIF, banks set aside 10-30 percent of the increase in deposits, insurance companies 40-50 percent of total premiumcollection, and public funds (such as pension funds for teachers and civil servants) 90 percent of their idle cash. In 1974-1979,these sources accounted for 74, 14 and 12 percent, respectively, of NIF funding (Joon-kyung Kim, 1993, pp.162-163).

18 In 1982, interest subsidies on policy loans were abolished. At the same time, the share of KDB in NIF re-lending began to declinewhile those of the Export and Import Bank and other specialized banks began to rise.


023On top of directed credits, various tax incentives were offered to HCIs. Tae-won Kwack

(1985) estimated the marginal effective tax rates of HCIs to be 30-35 percentage pointslower than those of light industries during the height of the HCI drive (Figure 2-3).

Also notable were public-sector R&D activities. The total of public and private R&Dspending remained below 0.5 percent of GDP throughout the 1970s, far below the currentlevel of around 3 percent (Figure 2-4). The public sector played a leading role in thoseyears, accounting for 50-70 percent of total R&D spending. The government launchedmany research institutions whose mission was to import advanced foreign technologies,modify them to suit local needs, and disseminate the results.

Figure 2-4. Trend in R&D expenditure

Source: National Statistical Office (http://www.kosis.kr).

Yeong-koo Park (2005) summarizes the characteristics of the HCI drive in the followingway. First, it had a clear export orientation, going beyond import-substitutionindustrialization. Its primary goal, as stated by President Park in his New Years pressconference, was to increase total annual exports to 10 billion dollars. Such exportorientation exposed domestic firms to international competition, forcing them to constantlyimprove productivity.

Second, the government led the drive but left actual implementation to the privatesector. In most cases, the government confined its role to providing financial and taxincentives to large private enterprises such as Samsung and Hyundai, and refrained fromdirect participation in industrial production. This distinguished Koreas strategy from those



of other developing countries at the time.19Third, the HCI drive took demand conditions and government budget constraints into

full consideration. Priority was given to finished goods production, and then wentupstream to intermediate inputs and raw materials. Even in the case of the defenseindustry, 80 percent of the capacity was allocated to the production of civilian goods inorder to maximize capacity utilization. The HCI Drive Plan specified funding requirementsfor each project, and care was taken not to exceed the budget ceiling.

The HCI drive, however, was not always planned and implemented with care. YungBong Kim (2003) observes thatgiven the haste with which the HCI Drive Plan wasprepared, it is extremely unlikely that economic benefits of individual investment projectswere carefully evaluated. In implementing the Plan, the detailed targets and modes ofindividual projects were often determined through bargains between politicians,bureaucrats and businessmen, with bureaucrats selecting the firms to benefit from theprojects. If this observation was true, there must have occurred no small degree ofinefficiencies in implementing the Plan.

Different authors have expressed different views on the success or failure of the HCIdrive. On one side are those who believe that it was mostly a failure. Indeed, the HCI driveproduced excess capacity. In 1975-1980, capacity utilization in machinery, electricalinstruments and transportation equipment was around 50 percent, well below the averagecapacity utilization of over 70 percent in total manufacturing (Table 2-3). This indicates theexistence of inefficiencies in resource allocation. Jungho Yoo (1991) shows that HCIsexhibited a very low capital efficiency compared to light industries, and claims that the HCIdrive retarded overall output growth. Jong-Wha Lee (1996) finds no correlation betweenindustrial policies, such as tax incentives and subsidized credit, and total factor productivitygrowth in the promoted sectors. He further shows that trade protection reduced growthrates of labor productivity and total factor productivity.

The HCI drive has also been criticized for its negative impact on other aspects of thenational economy. Large amounts of policy lending led to the unhealthy accumulation ofdebts by enterprises. Acting as vehicles for the HCI drive, the chaebol further increasedtheir economic power. Excessive monetary expansion produced chronic inflation. Mostimportantly, financial repression obstructed the development of a competitive financialsector and increased the inefficiency in financial intermediation.

024THEKOREAN


19 Since 1973, the Taiwanese government also stressed the promotion of three HCIssteel, petrochemical and shipbuildingindustries. Unlike in Korea, however, state-owned enterprises played the main role in implementation.


025Table 2-3. Capacity utilization in manufacturing

(Unit: %)

Source: Young-Sun Lee (1986).

On the other hand, some authors argue the HCI drive should be evaluated from theperspective of a dynamic comparative advantage.20 According to them, Korea could makefull use of thethree lows21 in the mid-1980s because of the industrial base built duringthe HCI drive, which provided an opportunity to deepen industrial structures and upgradethe export mix.

It is difficult to assess the impact of HCI drive on Koreas growth path because of ourlimited ability to construct counterfactuals. International comparisons, however, providesome clues. Radelet, Sachs and Lee (1997), after reviewing the different paths taken by Eastand Southeast Asian countries (Korea, Taiwan, Hong Kong, Singapore, Thailand, Malaysia,China and Indonesia), concluded thatwhile the promotion of heavy industry may havebeen beneficial in some identifiable cases, it surely was not the common denominator thataccounts for the rapid growth across East and Southeast Asia. Instead, the commondenominator was manufactured exports, supported by a regime best characterized as freetrade for exporters. The varied experiences of the countries of East and Southeast Asiaindicate that both an open market and a more interventionist approach that offsets otherdistortions can be made to work, as long as manufacturers face the acid test of operatingon world markets, both for imported inputs and exports. East Asias successful industrialpolicy strategy was to support labor-intensive manufactured exports, not capital-intensiveheavy industries (emphases by the original authors).

From this perspective, Koreas favorable growth performance was due to its exportorientation taken since the 1960s rather than the HCI drive itself. Of course, without


20 See Pack and Saggi (2006) for the discussion on dynamic comparative advantage and their criticism of this concept.21 The three lowsrefer to low oil prices, low international interest rates, and the low value of the dollar (with which the won

moved closely) against the Japanese yen.

1975 1977 1979 1980

Total manufacturingSteelNonferrous metalMachineryElectrical instrumentsTransportation equipmentTextileWood and wood productsPaper and printing

70.167.167.152.262.642.070.874.784.7

81.580.285.066.971.837.658.994.396.5

81.981.169.660.169.435.382.884.393.2

71.874.862.042.358.644.079.152.657.2


definite proof for or against the effectiveness of the HCI drive, the debate will continue.

3.3 Import liberalizationThe government promoted exports but maintained restrictions on imports to contain

current account deficits and protect domestic industries. Tariff rates began to decline slowlyin the early 1970s, but their levels remained very high until the early 1980s (Table 2-4).

Table 2-4. Tariff rates (1957-1984) (Unit: %)

Note: 1) Simple average of statutory tariff rates.Note: 2) Weighted average of statutory tariff rates with 1975 production as weights.Note: 3) General tariff plus special tariff and foreign exchange tax.Note: 4) = 1 / (1 + total tariff). Note: 5) Shaded areas indicate the periods when the tariff rates rose.

Source: Kwang Suk Kim (1998), Tables 1 and 5.

Figure 2-5. Trend in import liberalization (1955-1999)

Note: Tariff liberalizationrefers to the inverse of total tariff as defined in Table 2-4. Liberalization of quantitativerestrictionsrefers to the number of freely-imported items divided by the number of total items.Totalimport liberalizationis the average of these two ratios. Quantitative restrictions include those imposed notonly by the Ministry of Commerce and Industry but also by other ministries.

Source: Kwang Suk Kim (1988), Table 5; Kwang Suk Kim (2001), Table -1.

026THEKOREAN


1957 1962 1968 1973 1977 1979 1984

Simple average tariff1) 30.2 39.9 39.1 31.5 29.7 24.8 21.9

General tariff2) 35.4 49.5 56.7 48.1 41.3 34.4 26.7

Total tariff3) 35.4 49.6 58.9 48.2 41.3 34.4 26.7

Inverse of total tariff4) 73.9 66.8 62.9 67.5 70.8 74.4 78.9


On the other hand, quantitative restrictions were reduced significantly. The previouspositive list system whereby the Ministry of Commerce and Industry designated freelyimported, restricted and banned items was turned into a negative list system in July 1967.In the new system, only restricted and banned items were identified, and all other itemscould be imported without restriction. In Figure 2-5,liberalization of quantitativerestrictionsis defined as the number of freely-imported items divided by the number oftotal items. This ratio jumped from 9.3 percent in 1966 to 52.4 percent in 1967.

Between 1968 and 1977, however, quantitative restrictions were strengthened, and totalimport liberalization remained at around 55 percent. Compared to Japan and Taiwan,which had already raised the liberalization ratio above 90 percent in the mid-1960s andmid-1970s, respectively, liberalization proceeded very slowly in Korea (Young-Sun Lee,1986, p.812). Quantitative restrictions were aimed mainly at protecting the domestic HCIand agricultural sectors (Jungho Yoo, 1991, p.70). It was almost impossible to import theitems in these protected sectors.

Import liberalization made a fresh start in 1978 with the announcement of three separateliberalization schedules. It was put off again due to the second oil shock that occurred in1979, but continued after 1980. It gained full momentum in 1984 as the external balancewas restored.

3.4 Large increase in foreign borrowingCapital account opening was also pursued. In so far as its goal was to encourage foreign

capital inflow to fill the gap in domestic savings, however, liberalization remained selectiveand partial. In January 1960, the Foreign Capital Inflow Inducement Act was enacted butdid not succeed in attracting much inflow. In July 1962, the new administration introducedthe Foreign Borrowing Repayment Guarantee Act to provide guarantees not only to publicbut also private borrowing. These two laws were merged into the Foreign Capital InflowAct in August 1966 (Pyung-joo Kim 1995, p.199). At the same time, the government agreedwith Japan to normalize their diplomatic relationship in return for reparation payments of 500million dollars22 and commercial loans of 300 million dollars (Jung-en Woo, 1991, pp.85-87).

All these efforts led to the heady growth of foreign borrowing. Access to stateguarantees was considered a privilege, and all private enterprises wanted to get a shareregardless of the viability of their business plans. The large gap between domestic and

22 Reparation was for the Japanese colonial occupation, and the payments comprised 300 million dollars in grants and 200 milliondollars in government loans.



foreign interest rates due to the interest rate reform in 1965 also encouraged foreignborrowing. Figure 2-6 shows that the outstanding stock of external liabilities, rising from 4percent of GDP in 1962, hovered at around 40 percent in the 1970s, and rose further to 50-60percent in the early 1980s. This ratio went down to close to 20 percent only after the currentaccount experienced large surpluses in the latter half of the 1980s due to thethree lows.23

Figure 2-6. Outstanding stock of external assets and liabilities (1962-2009)

Source: 1) Debt liability for 1962 is from Joon-kyung Kim (1993), Table 4-14, and those for 1963-1969 are fromJung-en Woo (1991), Table 4-8. Foreign direct investment for 1962-1969 was obtained by accumulatingannual foreign direct investment from Figure 2-8. Total external liability in this period is the sum of debtliability and FDI.

Source: 2) Figures for 1970-2004 are from Lane and Milesi-Ferretti (2006). Figures for 2005 and after are f

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The Korean Economy