Policy Agenda: Rebalancing Growth

The preceding discussions have highlighted the internal factors that influence Korea's external imbalances. However, the degree of influence varies across the different factors. In terms of the saving-investment imbalance, evidence of either underinvestment or oversaving remains inconclusive; the lower savings and investment rates may even be the new equilibrium levels based on the economy's fundamentals and income level. What is certain is that the declining gap between savings and investment contributed to the narrowing of Korea's current account imbalances, prior to the global financial crisis of 2008.

The adoption of export-oriented policies does not seem to have strongly influenced Korea's external imbalances, since the exchange rate is flexible and adjusts to prevailing market conditions. Nevertheless, export-promotion policies have created domestic distortions. In particular, export-promotion policies have encouraged more investment in manufacturing relative to services, creating an imbalance between the two sectors. Productivity and the quality and quantity of investment in services are low. As a result, Korea is heavily reliant on services imports.

Given these challenges, what policy measures should Korea adopt to ensure balanced and sustained growth for its economy?

6.1 The potential role of the exchange rate

Korea's external imbalance does not seem to be persistent. An artificial adjustment in the exchange rate may not be necessary, since the exchange rate is fairly flexible (Figure 22 [ PDF 322.9KB | 1 page ]) and is likely to remain so, given that the government has not intervened to influence the exchange rate since the Asian financial crisis. Although some policymakers may want to manipulate the value of the won, such efforts are bound to fail since Korea's capital market is almost perfectly open to foreign investors.

Figure 23 [ PDF 17.3KB | 1 page ] shows a marked shift in Korea's capital account after the Asian financial crisis. On occasion, the capital account has tended to move together with the current account. This movement amplifies the behavior of exchange rates: when the exchange rate depreciates, it tends to go too far, and when it appreciates, it tends to move too fast. Moreover, the sheer magnitude of the capital account imbalance sometimes increases the volatility of the exchange rate. For example, in the fourth quarter of 2008, the capital account deficit reached about 25% of GDP, leading to a rapid depreciation in the won.

Under the current circumstances, manipulating the won is virtually impossible. The results of the empirical analyses have further shown that the effect of exchange rates on net exports is limited. In addition, the real exchange rate that decides the current account balance is an endogenously-determined relative price that adjusts to clear markets in response to shocks (Eichengreen 2010).

6.2 Intra-regional integration

Korea must enhance its resilience to external shocks by broadening the scope and structure of its openness, and fostering intra-regional trade, investment, and financial transactions. Fostering trade within the region will be necessary to reduce over-reliance on extra-regional demand. Although Korea's trade with the rest of developing Asia has been rising, its share in total trade has increased at a relatively slower pace in recent years (Figure 24 [ PDF 80KB | 1 page ]). Between 1990 and 1997, Korea's exports to the rest of the region more than doubled, increasing from 16.7% to 37.3% of total exports. By 2008, however, intra-regional exports had risen to just 44.7% of total exports. The slight uptick registered in the first half of 2009, to 46.7% of total exports, may just be a temporary effect of the global financial crisis.

Strengthening intra-regional relationships can be mutually advantageous to Korea and its neighbors. Asia has a large savings pool that can be tapped for intra-regional investment. Considering that its investment has been stagnating, Korea could benefit from the increased availability of funding sources. The flipside of this is that Korea would also have wider options for investment.

6.3 Fostering service sector productivity and domestic demand

Corporate savings have been rising in Korea. Reducing corporate savings and raising the corporate investment rate, particularly in the services industry, may help reduce internal imbalances if these foster restructuring within the services sector and raise the sector's productivity. Although the services sector's share in the total economy has been gradually diminishing in real terms, it still remains the largest sector in the economy.

Nevertheless, the country remains heavily reliant on services imports. Since records started in 1980, surpluses in the services account have only been recorded during 1982–1989, and in 1998. Business services other than transportation and financial services account for the bulk of the deficits in the last few years.

Korea needs to further develop its services sector in order to shift to a domestically-supported growth strategy. This issue is more complex than it seems, since the low productivity of the services industry is closely related to massive hidden unemployment created by economic restructuring after the Asian financial crisis. Moreover, raising the demand for traditional services will require improvements in the share of household income. Since 88% of workers were employed by SMEs as of 2005, promoting investment in SMEs will be critical.

In order to raise investment rates, the productivity of investment will have to be improved. Raising the productivity of SME investment, particularly in the services industry where about 70% of workers are employed, will be important to rebalancing the Korean economy both internally and externally. This will require a reduction in widespread entry barriers in knowledge services, and reforms to address the inefficient structure of traditional services. Investments in knowledge services such as education and business services should focus more on how to cope with growing global competition, while investments in traditional services should focus primarily on industry restructuring, as well as reallocating excess workers to productive sectors.

The emergence of a large and rapidly growing urban middle class will be crucial to increase domestic demand. The expansion of the middle class will hinge on the dynamism of enterprises, especially SMEs. Increasing investment by SMEs will help reduce the internal imbalance between savings and investment.

Further improvements in the investment climate are necessary to encourage greater investment and boost domestic demand. The upgrade in Korea's Doing Business (World Bank 2010) ranking for 2010 is largely due to improvements in business startup procedures. Specifically, the number of procedures and number of days required to start a business have been reduced. The minimum capital requirement and cost of starting a business have likewise been cut. The effects of these changes are expected to positively affect investment in the near-term.

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