Structural Adjustment Policy in Korea’s Transition to Economic Maturity
1. Introduction
Recent loan defaults and the resulting failures of several major business groups, together with a worsening balance of payments in Korea, have generated a deep sense of anxiety, if not of crisis. These developments also raise a question about whether or not Korea’s success story has come to an end. How should we interpret these developments? Is it a birth pain, as Deputy Prime Minster Mr. Kang alluded to earlier, or are these developments simply an unfortunate sequence of events resulting either from cyclical downturn or from changes in external conditions in the world economy? If the former, it has the potential of delivering a new economy equipped to continue to grow in the future. My view is that these seemingly separate developments are actually the symptoms of structural adjustment of Korea’s economy, changing from high growth to a slower and steadier and, hopefully, sustainable growth path. Knowing this helps us to understand the need for a new approach in the formulation and implementation of economic policy.
But I do not think many business leaders or the general public understand that it is necessary to carry out the new economic policy now. A case in point is the comment offered by the head of a major business organization at a recent breakfast meeting with President Kim. His comment was that "80.7 percent of businesses surveyed in the organization agreed with the need for structural adjustment, but now is not the right time to bring about structural change because there are many defaults on loans and international credit rating agencies downgraded the ratings of several banks". What he does not realize is that the right time will probably never come unless major structural adjustment policy is first carried out right now.
A review of Korea’s past economic growth history over the last two and half decades will convince us that it achieved its success, not necessarily because Korea got its policy right, but did so despite many mistakes and distortions. As is well known, the Korean economy built a solid foundation for growth during 1962-71 by focusing on the development of export-oriented light industry. As light industry exports began to sag, government then focused on the development of heavy and chemical industries during the 1972-79 period. Korea’s economy achieved a remarkable growth rate of more than ten percent during this period. When inflationary pressures started to build in 1979, largely as a result of high economic growth and the heavy investment boom, the main thrust of economic policy then switched from growth to stabilization. The stabilization effort was successful in substantially reducing the rate of inflation. At the same time, the Korean economy recovered its competitiveness and productivity gains.
From 1986 to 1989, the Korean economy grew at an excessively high growth rate of over twelve percent a year, largely due to a weak dollar, low oil prices and low global interest rates. In 1987 new democracy was suddenly introduced to the Korean society. The economy growing rapidly at near full employment and the sudden introduction of democracy emboldened workers to demand and receive higher wages and protective labor clauses. About this time, land prices started to soar in part due to higher living standards and to land speculation. These developments set the stage for higher wages and land prices, resulting in a significant reduction of the competitiveness of the Korean economy.
As long as the economy was able to grow at a fast pace, as it did during 1986-89 period, problems like low competitiveness, high debt ratios of Korean business, weakness in the banking sector and overall inefficiency did not surface to become major policy issues. But once the growth rate started to slow down, as it did in the early 1990s, all these inherent problems emerged. The most recent three developments in late 1996 and 1997, namely the poorly-managed governmental attempt to reform labor laws, the well-publicized failure of the Hanbo Steel Company and the related political scandal, and a series of failures and pending failures of conglomerates, made already bad transition problems only worse.
Viewing these current problems in perspective helps one to understand that they are essentially related symptoms attendant to the slowdown in economic growth, which actually started in the early 1990s, if not earlier. It is also important to realize that Korea is not unique in experiencing similar transition pains. Japan went through the same experience, starting in 1973-74 through 1985. In the United Kingdom, the Thatcher government, facing the British economy’s structural problems in May 1979, implemented an economic policy, "Thatcherism’, to resolve these problems. And closer to home, other East Asian tigers, Taiwan, Hong Kong, and Singapore, are also going through essentially similar experiences. The Korean economy is not in a crisis; it is in the process of transition.
The current transition is likely to be much more difficult to bear than the early 1980s for several reasons. First, the external condition is not as favorable. The world economy is more competitive than before and, as many Koreans often say, we are now in an "era of limitless competition". Secondly, the demand for opening up the Korean economy is fierce, as Korea’s position in the world improves as a member of OECD, WTO, and APEC. Third, and finally, Korea’s former driving forces of fast economic growth, namely her cheap and abundant and highly trained work force and easily available technology, are no longer available.
Facing these difficulties, it is tempting to call for a quick fix by resorting to monetary and fiscal stimuli to regain high growth rates. But this ill-conceived policy option ignores the fact that the current economic slowdown and its attendant problems is not caused by a cyclical downturn, but by structural factors. Therefore, any temptations to delay necessary reforms in the labor and financial markets and other adjustment policies should be resisted. These policies are necessary to restore the competitiveness again in the world market. History tells us that unattended distortions and resulting inefficiency come back to haunt nations and exact a bigger price in the long run.
The sense of crisis actually offers an unprecedented opportunity to carry out boldly the required reforms and policy adjustments. Though it may be difficult for those who are adversely impacted, policy makers must develop a mindset of taking advantage of this opportunity. Since there will be short-run costs in the form of higher unemployment, the government needs to develop programs for job retraining and a clearing house for job opportunities to help those in need. To carry out successfully this unpleasant but necessary task of adjustment, it will take an extra dose of political will and skill to build and maintain "winners" from the necessary policy reform. True political leadership lies in the ability to convince the public, business, and workers of the necessity of such structural reform and to create and maintain "winners" from the reform to sustain it.
What follows centers around three related issues. First, I will review the structural adjustment experience of Japan to learn from it how Japan restored vigor and vitality in her economy during her transition period. Secondly, I also review the structural adjustment policy in the Korea’s Seventh Five-Year Plan for the1992-96 period and its implementation. Third, and finally, I turn to the discussion of a set of policy guidelines for the future.
2. Structural Adjustment Policies of Japan
After growing at an average annual rate of 12 percent a year during the 1950s and 1960s, Japan experienced the first slowdown in economic growth and also suffered rapidly rising inflation during 1973-74 period. Real GNP growth slowed to 7.5% in the 1970-73 period and slowed further to 3.8% during the 1974-85 period. The Japanese balance of payments also underwent a major shift from a small deficit in 1973 to a large surplus of $49.2 billion in 1985.
The slowdown in the Japan’s economic growth brought about both macreconomic and microeconomic changes. First, the slowdown in the economic growth caused a surplus in the private sector. During the high growth period, surplus household savings were absorbed by financing high investment in the private sector. But when households continued to save as much as they did in earlier period but domestic demand for investment declined, the Japanese economy started to stagnate and might possibly have gone into recession without government action. The principal macroeconomic adjustment policy during 1975-79 period came in the form of fiscal expansion with the government’s deficit absorbing surplus private savings. In the following years of 1980-85 period, the yen depreciated against the U.S. dollar and the resulting fast increase in Japan’s exports provided an external stimuli. Since the slack was picked up by soaring U.S. federal deficits and balance of payments deficits, Japan’s fiscal deficit was allowed to fall steadily over this period.
What were the microeconomic policy adjustments? There were four such changes: financial deregulation, industrial restructuring, and competition policies and administrative reform. I will briefly discuss these changes in order.
During the 1950 and 1960s, the banking and financial system was highly regulated and virtually all interest rates were controlled by the government. This regulation reduced risk and directed funds toward the targeted industries chosen to be fostered. The slow economic growth in the early 1970s made corporations less dependent on bank loans and the government found selling bonds to finance rapidly increasing fiscal deficits difficult with controlled interest rates. Simultaneously, the soaring balance of payments surplus added further pressure to deregulate international transactions to allow the surplus to be recycled abroad.
During the transition period of 1973-85, the service sector expanded its share of economic activity while the manufacturing sector became relatively less important. The latter development was largely caused by large increases in energy costs and wages. As is well known, Japan relies heavily on imported oil and when crude oil prices quadrupled, this adversely affected energy-intensive industries. Also at this time, light and labor-intensive industries such as textile experienced a significant decline because they could not compete with low-wage producers in the East Asia. In the midst of restructuring of industries, the Japanese labor market also went through major changes. First, the rate of increase in real wages dropped from 6.6 percent in the earlier high growth period to a bare 1.6 percent. Furthermore, life-time employment gave way as a result of declining labor demand in many industries and labor unions became more conciliatory on wage demands.
The changes in competition policies and administrative reform are also worthy of comment. During the earlier high growth period before the early 1970s, the Ministry of International Trade and Industry pursued policies that reduced competition in some industries through legalized cartels and the promotion of mergers. In early 1970s, however, as the public outcry and mistrust of big business groups, called keiretsu, increased, the Japan Fair Trade Commission pursued many antitrust cases and expanded antitrust legislation was passed in 1977. In the 1980s the government exercised less control over industry than it had earlier. Finally, toward the end of 1970s, an administrative reform movement was continued, but with little impact on the economy.
3. Structural Adjustment Policy in the Korea’s Seventh Five-Year Plan
A good starting point to discuss the current structural adjustment policy is to restate the strategies and policy goals of the Seventh Five-Year Plan (1992-96). Planners, having recognized the need for structural adjustment in the early 1990s, have already highlighted three major strategies and specific tasks (or policy goals) to accomplish them. They are 1) strengthening the competitiveness of industry, 2) enhancing equity and balanced development, and finally 3) pursuing internationalization and liberalization.
A specific policy goal in strengthening the competitiveness of industry which has direct implications for the structural adjustment policy in industrial sector is to raise the efficiency of business management and the industrial structure by dispersing the ownership of conglomerates and establishing a professional management. The Plan also sets a goal of strengthening the competitiveness of small and medium enterprises.
Evidently Korean policy makers believed that business efficiency can be enhanced by dispersing the ownership of large business groups, called the chaebol, and by establishing a professional management system. It is interesting to note that while dispersing chaebol ownership is a stated policy goal, the Plan itself does not address the issue of reducing high concentrations by chaebol. Strengthening the competitiveness of small & medium enterprises is obviously a worthy goal, and much effort has been devoted to it. But small & medium enterprises as a whole are still playing only a minor role in Korean economy, especially in the manufacturing sector.
As is well known, this imbalance is the direct result of past industrialization policy. While an industrial targeting policy was discarded long ago and the Monopoly Regulation and Fair Trade Act (MRFTA) (initially enacted in 1980 and amended in 1986) to regulate monopolistic practices and to promote competition is in force, little has been achieved in correcting structural imbalance and reducing economic concentration by conglomerates. In fact, Korea’s economic concentration is higher than that in Japan or Taiwan, and chaebol ‘s influence in the Korean economy seems to have increased in recent years. According to a most recent study by Lee (1997), the relative share of chaebol in economic activity actually has increased in recent years, whether measured by the relative share of value added in GNP, the relative share of sales, or by employment
. For instance, the relative share of value added to GNP by top thirty business groups has steadily increased from 12.5% in 1985, to 13.5% in 1992, and to 16.2% in 1995; and the top thirty chaebol ‘s relative share of sales in the manufacturing sector increased from 35% in 1990 to 39.6% in 1993. Why might this have happened? One reason is that the Monopoly Regulation and Fair Trade Act has too many exceptions. For instance, when a provision of the law conflicts with the goal of promoting competitiveness, a waiver is given. More fundamentally, policy targets of growth first and export first are basically contradictory to goals of limiting concentration of wealth and to the fostering social justice and equity; the legal institutions are in place but the government does not enforce the law. A tighter and more consistent application of the existing legal framework is necessary to check the further growth of chaebols.This increasing concentration and relative size of big business groups in Korea makes an interesting contrast with Japan’s experience. In Japan, the relative size of keiretsu do not presently seem to be gaining strength. In fact, industrial concentration in Japan has recently fallen as investment and output rose rapidly as a result of technological innovations in industries and companies that are not part of keiretsu, leading to sizable new entry and fast growth of small firms.
While imbalance between chaebols and small and medium enterprises is serious, an equally or even more serious imbalance exists between the real and financial sectors of the economy. The industrial and manufacturing sector is reasonably well developed and strong. In contrast, the financial sector is undeveloped and weak. This imbalance results directly from the past industrialization policy pursued by Korean government. As is well known, this imbalance was created in the mid-1980s when the government targeted heavy and chemical industries
(in iron and steel, shipbuilding, electronics, and petrochemicals) as growth industries, and funds were channeled at very low or even negative real interest rates into big investment projects. The motive behind this industrialization was to build upstream industries, and heavy investment in large projects was partly justified by economies of scale. Starting in the early 1980s, wastes and distortions in resource use, increasing inflationary pressure, and the emergence of giant conglomerates with their dominant economic positions became major policy issues. Consequently, policy emphasis was reoriented away from the heavy and chemical industries to price stabilization, to the restructuring of industries and to liberalization. In the process, industrial targeting was dropped and industrial restructuring by the promotion of small and medium enterprise was pursued. During this period, banks were privatized and liberalization in trade and investment were also pursued.An important reason why banks and financial sector was undeveloped was because they were mainly distributing funds to conglomerates to add capacity. Since conglomerates as a group are very successful under government protection, bank lending to such proven and highly successful business groups was easy with no risk of default. As a result, Korean banks did not have any real experience with risk management. Indeed, in all the East Asian tigers, except for Hong Kong and Singapore, the financial sector has lagged the real sector. When an economy grows rapidly, weaknesses in the financial sector are not readily apparent. But once economic slowdown occurs, the latent weaknesses in the financial sector surface as witnessed by large amount of bad loans due to poor lending practices, compounded by sub-standard auditing practices and inadequate disclosure rules and standards.
An important lesson to learn from the experiences of Japan and Korea is that high growth should not mislead one to believe that necessary reforms in the financial sector can be delayed. When these financial woes have to be attended to the throes of a financial crisis, it will be much more painful to correct them, particularly when the economy slows down.4. Policy Guidelines for Future Growth and Industrialization Policy:
My suggested guidelines for structural adjustment policy are:
1) Fostering long-term and sustained economic growth, rather than the promotion of short-run economic growth. A growth rate of 6 to 8 percent a year is in line with this policy guideline. This policy goal entails a major shift in growth policy from the "quantitative growth" of pursuing maximum market share to one of "qualitative growth" in the pursuit of maximum profits and the development of the necessary institutions for a more competitive market system.
2). Adopting a market-oriented industrial policy. Government should attempt to encourage rather than to pick winners individually to compete in world markets. The marketplace will then become the ultimate referee as to whether or not continued support of an industry is justified.
In the past, the government chose "winners" based on a policy of development strategy, and support was given largely to firms according to their success in world markets. One of the main problems of a government policy of picking winners, instead of relying on market forces, was that the government took over the job of handling business failures. This policy effort has proved to be very costly, as support for seventy-eight bankrupt companies in the mid-1980s required the write-off or rescheduling of billions of dollars of loans. This policy also resulted in a small number of conglomerates, which have monopsonistic access to the best human and financial resources, and their economic power is so dominant that it has become a major social issue.With this general market-driven policy guideline in mind, what is the right policy toward the chaebols? Personally, a realistic and reasonable policy is to leave them to themselves. To many, this may sound irresponsible in light of all the known problems with the Chaebols. But one major implication of this policy is to let the principle of "creative destruction" guide responses to recent bankruptcies and business failures of several Chaebols. The market-driven economic policy implies that it is primarily the responsibility of creditors and stockholders of bankrupted businesses, not government, to decide what to do with the failed businesses. They have to decide either to sell out or to merge with other business. "Leaving them to themselves" also means that entrepreneurs will rely on their own initiatives to develop their business potential and to venture out.
Cases in point are the current Sam Sung’s expansion of auto plants in the face of a glut of production capacity and Daewoo’s investment in emerging countries. Should government intervene in their decision to carry out these business ventures abroad? Some may argue that these overseas investments are made without adequate preparation in technology and marketing savvy and thus they should be discouraged. "Leaving them to themselves" also means that it is entirely up to the individual conglomerate in deciding whether or not to invest in auto plants in the East European countries or elsewhere. But "leaving them to themselves" does not mean a hands-off policy. Government should carry out a tighter and more consistent application of existing Monopoly Regulation and Fair Trade Act by making sure that entry and exit are guaranteed. It would be a desirable goal to pursue a more balanced industrial structure by encouraging specialization of chaebol in producing final goods and of small and medium enterprises in producing parts and intermediate goods.3) Restoring Competitiveness
Korea’s ranking in recent survey of competitiveness by the World Economic Forum is 24th in 1995 and 20th in 1996 out of 49 countries. Korea trails all of her neighbors in terms of competitiveness. The first challenge Korea faces in her transition is to restore competitiveness through a more active competition policy and to resists undue wage increase. The active competition policy consists of reducing industrial concentration, thus reducing potential for oligopolistic behavior in the domestic market, and by dismantling and abolishing regulations and practices that restrict business activities. Even though deregulation has been a stated policy goal of the current government, it has not been forcefully pursued, mainly because the task of deregulation was given to entrenched regulators. There is, evidently, a moral hazard of regulators not having incentives to carry out deregulation forcefully and while many minor rules and regulations have been abolished during the past two and half years, most key provisions for regulations are still intact. Along the same line, liberalization in trade and investment and deregulation of the service industries, including banking, need to be more forcefully pursued.
Fortunately the rate of wage increase finally seem to have slowed down to less then 10 percent for the first time since 1987. As mentioned earlier, the real wage in the manufacturing sector in 1989 increased at the unparalleled rate of 18.3%, far exceeding any increase in labor productivity. This resulted in a significant reduction of the competitivenss of the Korean economy, In the short run, it is reasonable to restrain the increase in the real wage rates within limits set by the increase in labor productivity. The long-term labor policy is to develop human resources to improve labor productivity in all industries.
4) Maintaining Steady Macroeconomic Fundamentals
With fostering long-term and sustained growth potential as main goal of the structural adjustment policy and with the marketplace as the mechanism to carry out this policy, continuous liberalization and deregulation is obviously necessary to make sure the market mechanism functions smoothly.
Carrying out these policies cited cannot succeed without a stable marcoeconomic environment by pursuing stable monetary and fiscal policy. In the absence of stable macroeconomic fundamentals, inflation rates will be too high and volatile, and the resulting uncertainty will undermine all attempts to carry out structural adjustment policy. Therefore, it is imperative as of now to resist the temptation to use fiscal stimuli motivated by political and/or noneconomic factors in face of huge amount of bailout funds for banks released in the economy.