STRATEGY
Overview and Prospects for the South Korean Economy
November 14, 2005
James McCormack, Fitch Ratings

During the 30-year period from 1970 to 2000, real (inflation-adjusted) economic growth in South Korea slipped below 4 per cent only twice, in 1980 and 1998. Excluding these two years, the economy expanded by an average of more than 8 per cent, and South Koreans became accustomed to rapidly rising incomes and living standards.

Given this strong growth record, it is no wonder there has been public disappointment with the economic performance of more recent years. Growth has been less than 4 per cent twice since 2000, and may struggle to reach that mark again this year. So what has gone wrong and what, if anything, should policy makers be doing about it?

While it is notoriously difficult to get economists to agree, most concur that economic growth depends on expansion of a country's capital stock and technological progress that allows for improvements in labor productivity. In this context, South Korea has some distinct advantages. The domestic savings rate is high by international standards, thus providing the financing for domestic investment, which is also high compared with other countries. Nevertheless, while South Korean savings and investment ratios are high, they both peaked more than 10 years ago and have subsequently trended lower.

In Fitch's opinion, reductions in South Korea's savings and investment ratios are not the cause of the recent slowdown in economic growth and should not be an issue of particular policy concern. Since 1990, the economy has been driven more by consumption, which is to be expected with a fall in savings. Moreover, it is not at all clear whether the fall in the investment ratio has diminished medium-term growth prospects. The ratio is in fact still high, at 30 per cent in 2004, and there is little evidence of a decline in labor productivity, which is growing by about 8 per cent annually.

If it is not the fall in savings and investment that explains South Korea's recent economic performance, then what might it be? This is not an easy question, since economic growth responds to a myriad of international and domestic factors that change continuously and relate to each other differently over time. In considering the recent slowdown in South Korea, we will explore only two factors, both of which have implications for policy makers.

Household Debt

The first factor that may be holding back economic growth is the household debt overhang resulting from a surge in borrowing that financed the 2001-2002 consumption boom. The increase in debt and consumption was a direct consequence of a government initiative to encourage the use of credit cards, in part to raise tax revenue by bringing more transactions into the formal - and taxable - economy.

While the authorities' motives were understandable, especially as financial institutions struggled to find new lending opportunities in the aftermath of the 1997-1998 crisis, official economic initiatives are best undertaken with the policy tools at hand. These include fiscal and monetary policies as well as the establishment and maintenance of prudent supervisory and regulatory regimes. Policy makers need to be careful about instead putting in place specific measures that distort incentives and behaviors that are otherwise guided by market-based principles. Often times, such measures are accompanied by unintended side effects that may require offsetting measures, and the policy environment then becomes focused on correcting a problem that was brought on by previous policies, however well-intended.

Recent developments in real estate policy need to be considered in this context. It is critical that a proper balance is struck so as to discourage real estate speculation that could lead to a price bubble, while still allowing the property market to clear in response to market-based pricing. Wealth generated through real estate investment is a delicate social issue in South Korea, but as home ownership expands so too does household wealth held in property. Policies that restrict property value increases - as recent policies are intended to do - may also restrict consumption.

Disparities in the Labor Market

The second factor to consider in South Korea's recent growth performance is disparities in the labor market that have lingered since the 1997-1998 crisis. Workers earning a salary - as opposed to unpaid workers that are either self-employed or employed in the home - are divided into regular and temporary employees. Regular employees enjoy all the standard benefits of employment in a developed economy, including job protection, while temporary employees have few benefits and little job protection.

The number of regular employees reached a low of 6.1 million in early 1999, having peaked before the crisis at 7.5 million in 1996. It took nearly eight years for regular employment to return to its pre-crisis peak, and as of mid-2005, regular employees numbered 7.9 million. The labor market was expectedly weak in the post-crises period on account of businesses cutting costs, but it was especially weak for regular employees. Businesses have relied increasingly on temporary employees, whose numbers have grown steadily to about 5.2 million in mid-2005.

With temporary workers now accounting for nearly one-quarter of those employed compared to about 18 per cent a decade ago, economy-wide job security has declined. This encourages households to build precautionary savings where possible and adds to the adjustment borne by labor during an economic downturn. It also raises issues of social equity, as labor adjustments will not be shared equally by regular and temporary workers. In its March 2005 Economic Policy Reforms, the OECD advised the South Korean government to ease the employment protection enjoyed by regular workers to address these issues, though there has been no obvious policy response to date.

In South Korea, as in any country, there are no quick-fixes for restoring strong economic growth and certainly no guarantees that policies that worked once will work again, or that policies that worked elsewhere will work here. And even if South Korean policy makers agree to the points above and are careful to avoid interfering with market-based principles while improving the structure of the labor market, there may be other unforeseen developments to contend with. From the perspective of fostering growth, however, these are ideas worth considering.

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