Korea outperforms rivals in post-crisis era

By Stephen S. Roach and Sharon Lam

There can be no mistaking the extraordinary resilience of the South Korean economy. On the heels of a 7.8 percent surge in real GDP in the first quarter of 2010, Moody's has just upgraded the sovereign bond ratings of Korean government debt. With good reason: Notwithstanding its high degree of dependence on exports and external demand, Korea sailed through the devastating 2008-09 financial crisis with remarkable aplomb. Moreover, it is now extending that impressive record in a still fragile post-crisis climate.

This performance stands in sharp contrast with that of other economies in the region - all of which were hit extremely hard by the collapse in global trade. Not only did the Korean economy register just one quarter of sequential decline in real GDP during the Great Recession - thereby technically avoiding full-fledged recession - but the quality of its subsequent recovery is increasingly compelling.

Significantly, South Korea's economic resilience is not just an outgrowth of the emergency policy actions that were put in place during the recent crisis. Instead, it is more a natural by-product of the nation's long standing commitment to a strategic development strategy. For an economy with exports running at about 35 percent of GDP in the four years heading into the crisis, that turned out to be key in the Great Recession.

While the depreciation of the won in 2008 certainly played a supportive role in sustaining exports during the global downturn, it was hardly the decisive factor. In particular, Korean corporates were early in shifting their export focus to emerging markets - enabling them to temper the impacts of the crisis-related shortfall in the developed world.

Emerging markets accounted for 45 percent of total Korean exports during 2000-05 and fully 54 percent in 2006-07. When the crisis led to a collapse in external demand from the developed world, the emerging markets share of Korean exports soared to 59 percent in 2008-09. In retrospect, this pre-emptive shift in the mix of Korean exports may well have been the most important factor behind the economy's remarkable resilience during the recent crisis.

Turning crisis into opportunity

Moreover, South Korean producers' ability to thrive amid crisis reflects a relentless focus on improving product design and quality, as well as savvy and aggressive marketing efforts to enhance the global image and acceptance of South Korean brands. For example, less than a decade ago, Samsung Electronics had a reputation as a maker of lower-end consumer electronics, barely noticeable in global markets. But then the company figured out how to move up the value chain by building a strong brand image through product innovation. Those efforts have paid off handsomely: In 2009, Samsung ranked 19th on Inter-brand's Best Global Brands list - marking the sharpest improvement of any of the top 100 brands over the past decade. Moreover, Hyundai Motor and LG Electronics have made similar dramatic progress on the brand recognition front.

This focus on product quality and design must be maintained if Korea is to sustain this strategic advantage in the years ahead. That raises several critical questions: Does South Korea have the right model to withstand the inevitable next round of shocks to the global economy? Can the nation grapple with other problems that threaten long-term growth? Can it find a comfort zone sandwiched between an advanced Japan and a rising China? Does it have the strategic vision to take advantage of major changes likely to unfold elsewhere in the word economy?

In addressing these questions, one thing seems clear: Any attempt to compete with China on cost or scale in legacy manufacturing businesses is bound to fail. Instead, South Korea's best hope is to migrate up the value chain. Capital investment must play a critical role in that ascent. Korean firms have a solid record of investing in state-of-the-art productive capacity. Moreover, Korea's spending on research and development is among the highest in the world relative to national income. This is a strength the nation must preserve at all costs.

South Korea's recently announced decision to expand tax deductions for business investments in research and development should be helpful in sustaining such a strategy. But these incentives need to be forward looking, targeting investments in new and future growth areas such as alternative energy, green technologies, and biotechnology. Korea's comparative advantage lies in technology and design, not in resource-intensive heavy-manufacturing industries. The latter will inevitably lose market share to competitors in China whereas the former could keep Korea well ahead of the competitive curve.

It is equally important that export-led Korea be forward looking at anticipating future shifts in the demands of its major trading partners. That is especially the case with respect to China - who in the past decade has replaced the United States and Japan as Korea's largest export market. However, with a pro-consumption tilt likely in the Chinese development model in the years immediately ahead, Korea must be well positioned to take advantage of what could well be Asia's most decisive transition. Specifically, that offers Korean exporters enormous China-centric opportunities in the areas of consumer products, alternative energy, and clean technologies. In those cases, Korea's export capabilities fit very well with the seismic changes about to unfold in the structure of Chinese economic growth.

Reform on economic structure

At the same time, South Korea must face up to a critical strategic challenge to the basic character of its own growth model: It must begin to wean itself from a manufacturing-led macro structure. In part, that's because productivity recipes in technology-intensive manufacturing industries are largely premised on the substitution of capital for labor. And these labor-saving strategies ultimately sow the seeds of future imbalances - they are inherently biased away from job creation, labor income generation, and autonomous growth in private consumer purchasing power.

If Korea is to achieve balanced, sustainable growth, it must place greater emphasis on the employment and income-generating potential of large-scale services industries such as finance, distribution, professional services, and communications. Only 66 percent of South Korea's workforce was employed in services in 2008 - less than the 70 percent portion in Japan and far short of the 85 percent reading in the United States. Moreover, the services portion of Korea's workforce probably overstates its true economic potential. Indeed, Korea's 30 percent self-employment rate - among the highest of any nation in the OECD - is largely an outgrowth of a fragmented, over-regulated services sector, which is dominated by inefficient low-valued added "mom and pop" proprietors.

For a nation long steeped in the culture and values of manufacturing, services-led growth doesn't come easy. Korea's surest solutions to its shortfall in higher-value added services sector activity must entail liberalization and greater openness to foreign competition. At the same time, the nation must increase infrastructure investments in medical care, tourism, and education. Over time, such efforts will pay enormous macro dividends of balance and diversification.

South Korea also must also focus on the mix of its income distribution - specifically on narrowing the gap between rich and poor. Critical in this respect is that growth must be distributed more equitably between urban and rural areas. Currently, Seoul and its adjacent cities generate nearly half of South Korea's GDP. The government has used the crisis and its aftermath as an opportunity to accelerate regional infrastructure spending.

It should now move to complement that effort with investment policies aimed at encouraging the creation of regional economic clusters outside the vast Seoul metropolitan complex. The recent announcement of a US$22 billion development program in Korea's southern coastal area as a new center for distribution and tourism is especially encouraging in that regard.

It is always tempting to try and predict the future by extrapolating trends from the recent past. In the case of South Korea, that would be a serious mistake. Yes, the nation's trend growth in real GDP, which averaged 6.3 percent in the 1990s, declined to 5.2 percent during 2000-07 before plunging to just 1.2 percent in 2008-09 in the midst of the global crisis. Not surprisingly, this recent downtrend has prompted some to warn that South Korea's potential growth rate over the coming decade could slip further to as low as 3 percent.

We believe such an assessment is too pessimistic and that South Korea can sustain an average growth rate of 4 percent or better. Such an outcome is conditional on the hope that public policy, in conjunction with forward-looking private-sector strategies, focuses on the three fundamentals stressed above: continued investment in R&D, services sector reform, and regional development. Should, as we suspect, South Korea take decisive actions in these areas, it can only build on its recent success as one of Asia's most resilient and forward-looking economies.

Roach is the chairman of Morgan Stanley Asia and the author of The Next Asia. Lam is a vice president in Morgan Stanley's global economics team.