Export-Led Growth And External Imbalances

The roots of Korea's export orientation predate the Asian financial crisis. In the early 1960s, the country shifted its economic policy from import-substitution to export-orientation to support growth. Although the import-substitution policy was not completely abandoned, the government began providing incentives to exporting firms based on their export performance. The exposure to international export markets compelled industries to become more efficient, and spurred significantly faster economic growth.

In the early 1970s, government policy reverted to import-substitution, favoring conglomerates to build up heavy and chemical industries. This policy shifted again with a change in regime in the 1980s, following the deregulation of the trade and financial sectors. Capital account liberalization followed in the 1990s, giving firms easy access to short-term foreign debt that raised their leverage to unsustainable levels and eventually contributed to the 1997–1998 financial crisis.

As the crisis ensued, domestic demand languished, prompting even greater emphasis on export promotion. Since then, Korea has increasingly relied on external demand to drive growth. Exports accounted for 27.7% of GDP in 1996, but this share had increased rapidly to 52.9% by 2008 (Figure 17 [ PDF 82.8KB | 1 page ]). Similarly, imports shot up from 30.4% of GDP to 54.1% during the same period. Preliminary figures for 2009 suggest that these trade shares have declined somewhat, although they remain substantial: for the first nine months of 2009, exports accounted for 50.4% of GDP, while imports amounted to 45.8%. These developments make the Korean economy even more vulnerable to the global business cycle.

Increased reliance on external demand was abetted by the sharp devaluation in the won following the Asian financial crisis. From an average of W804/US$1 in 1996, the exchange rate depreciated by 42.7% to W1,403/US$1 in 1998. Although the won has appreciated since, it has not returned to the nominal levels registered in 1996. However, the real effective exchange rate recovered to its pre-crisis level in 2005 and surpassed this level until 2008, when the won depreciated again in the face of the global financial crisis (Figure 18 [ PDF 82.8KB | 1 page ]).

The weaker won may have encouraged exports to some extent. In general, exports increase as the value of the real effective exchange rate falls (Figure 19 [ PDF 85.1KB | 1 page ]). The empirical analysis in Section 2 confirms this relationship, although the magnitude of the impact of the exchange rate becomes unclear if the two crisis periods are excluded.

Along with the depreciation of the won, growth in the global economy further bolstered Korean exports, allowing the accumulation of massive foreign exchange reserves. These reserves ballooned to US$265.2 billion by the end of 2009, from just US$32.4 billion at the end of 1996 (see Figure 2). As a proportion of GDP, Korea's foreign exchange holdings swelled from 5.7% to 32.8% during the same period.

Despite the rapid build up in foreign exchange reserves, some economists in Korea continue to argue for a further build up in reserves, to perhaps a minimum of US$300 billion. For example, Kim, Lee, and Lim (2010) have argued that Korea's reserves should have been somewhere between US$232.3 billion and US$326.9 billion in March 2009, when actual reserves were only US$206.3 billion. This thinking may reflect Korea's recent experience with the foreign exchange crisis that followed the global financial crisis. Indeed, the won depreciated by 38.8% in wake of the crisis, from around W939/US$1 on 1 March 2008 to W1,534/US$1 by 1 March 2009.

Massive foreign exchange reserves, however, entail some costs. A specific cost of keeping excess reserves is the forgone return from holding them in low-yielding, safe, and liquid assets such as US government bonds, rather than in higher-yielding assets (ADB 2009). While large foreign exchange holdings may help countries recover quickly from currency crises, they cannot insulate countries from such crises in the future. Moreover, the opportunity costs of holding excess foreign reserves in low-yielding, safe, and liquid assets are significant.⁷

Perhaps the more important issue is whether Korea should change its export-oriented growth strategy. The economy's current industry structure seems to require sustained export orientation; the semiconductor, motor vehicle, shipbuilding, electronics, and steel industries require ever-growing foreign markets. These sectors managed to expand even after the Asian financial crisis. The domestic economy's inability to fully absorb the increasing outputs of these sectors has necessitated the exploration of larger export markets. Stagnating global demand, however, cannot assure a continued market for Korea's export products. This issue takes on greater urgency in the current global environment, where recovery remains fragile, and demand from industrial countries cannot be relied on. Another key challenge is competition from the PRC's manufacturing sector, which is gradually shifting to higher value added goods that directly compete with Korea's exports.

The export sector's expansion has tended to overwhelm domestic sectors and small- and medium-sized enterprises (SMEs) in the post-Asian financial crisis period. Moreover, with the trend toward globalization, big firms in the export sector are increasingly relying on foreign intermediate goods and services to exact efficiency gains. This shift has been unfavorable to SMEs, which now face increasing global competition. The profitability of SMEs has been eroded by their weak market power.

Overall, Korea's export-oriented growth strategy allowed it to recover swiftly from the Asian crisis, and facilitated its transformation into a surplus economy, or a net capital exporter from 1998 through 2007. However, the very same strategy made the country very vulnerable to the 2008–2009 global crisis. Over-reliance on external demand made Korea susceptible to a sharp fall in the industrial countries' appetite for imported goods. As a result, Korea's economic growth began declining in the first quarter of 2008, and bottomed out in the first quarter of 2009. The large declines in Korea's exports resulted in three quarters of economic contraction that finally ended in the second quarter of 2009.

These developments highlight the need for Korea to reduce its dependence on export- driven growth. A rebalancing of the economy toward more diversified sources of growth needs to be prioritized.

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