Baily, Martin N.

Do, Cuong V.

Kim, Yong Sung

Lewis, William W.

Nam, Victoria Lee

Palmade, Vincent

Zitzewitz, Eric

K-Developedia(KDI School) Repository

DEVELOPING MARKETS76 THE McKINSEY QUARTERLY 1998 NUMBER 2WITH PER CAPITA INCOME SWELLING better than Þvefold from 1970to 1995, Korea was on the leading edge of the East Asian miracle.But 1997Õs Þnancial crises brought the miracle to an abrupt end,raising questions about KoreaÕs economic prospects and the underlyingreality of the East Asian boom.To help answer these questions, we studied KoreaÕs current economicperformance and used this knowledge to gauge what its medium- and long-term growth potential might be.* We examined how the regulatoryThe best manufacturing technology did not lead tohigh productivity ¥ Now is the time for deregulation ¥But it must embrace both manufacturing and servicesMartin N. Baily, Cuong V. Do, Yong Sung Kim,William W. Lewis, Victoria Lee Nam, VincentPalmade, and Eric ZitzewitzTHE ROOTS OF KOREAÕSCRISIS› Productivity-led growth for Korea, McKinsey Global Institute, Seoul and Washington, DC, March 1998.THE McKINSEY QUARTERLY 1998 NUMBER 2 77Martin Baily is a principal, Bill Lewis is director, and Vincent Palmade and Eric Zitzewitz areconsultants at the McKinsey Global Institute; Cuong Do and Yong Sung Kim are principalsand Victoria Nam is a consultant in McKinseyÕs Seoul o˜Þce. Copyright ' 1998 McKinsey &Company. All rights reserved.environment has a˜fected Korean companies in four manufacturing industries(automobiles, steel, food processing, and semiconductors) and four serviceindustries (retail banking, general merchandise retailing, housing con-struction, and telecommunications). Our main conclusions are:¥ Overall, the old regulatory environment led to high inputs (especially inmanufacturing), and low productivity (Exhibits 1 and 2).POWERSTOCK/ZEPHYR¥ Despite massive investment in thebest available manufacturing tech-nology, protectionism and poor cor-porate governance prevented Koreancompanies from adopting the bestmanagement practices. As a result,labor and capital productivity inmost manufacturing sectors stands atless than half of US levels.¥ Service sector industries were sys-tematically starved of capital. As a result, companies are well below scale and highly ine˜Þcient. Theirperformance is further hindered byregulations — stringent zoning laws inretailing and product and pricingrestrictions in retail banking — thatdampened competition. ¥ Thorough reform of the economyis the only way to restore high growthand employment. This reform mustinclude removing o˜ten-overlookedservice sector regulations. Our work shows that KoreaÕs old regulatoryenvironment has reached its limit. Even with sustained high investment, the potential for annual GDP per capita growth under the current regula-tory regime could not exceed 3 percent per year for ten years followingTHE ROOTS OF KOREAÕS CRISIS78 THE McKINSEY QUARTERLY 1998 NUMBER 2Exhibit 1GDP per capitaIndex: United States (1993—95 average) = 100*GDP per capitaTotal factor inputs per capitaTotal factor productivityCapital inputs per capitaHours worked per capitaCapital productivityLabor productivity1005080100 9812610051 6310047135100140120100 105601003670United StatesKoreaJapan*	Excludes residential real estateSource: OECD; OÕMahony; Bank of Korea; Korea National Accounts; BEA; EPA; Pilat (1994); United Nations ICP; McKinsey analysisExhibit 2Labor productivity and employment by sector, 1995Index: United States 1995 = 100SteelConstructionSemiconductorsFood processingRetailLabor productivityCumulative employment1001109080706050403020100Average = 53Retail bankingAutomotiveNote: The relative importance of each sector in terms of employment is indicated by its widthTelecomstabilization, and even then the economy would still remain vulnerable tofurther Þnancial crises. By contrast, GDP per capita growth was 6.7 percentper year between 1970 and 1996.If growth in GDP per capita is to return to these levels, across-the-boardeconomic reform is essential. Our previous studies have shown that theservice sector is the engine of job growth in all major economies. Withoutreform, KoreaÕs service sector will not create jobs for the workers displaced asmanufacturing productivity rises. Reform plans that neglect the service sectorand deal only with corporate governance and increasing foreign competitionin the Þnancial and manufacturing sectors are thus especially dangerous inthe short term because they will increase unemployment. Rapid growthKoreaÕs impressive growth over the past 25 years can be explained largelyby the fact that its people worked long hours and saved a great deal, which ledto the rapid accumulation of capital. Coupled with strong exports, this meantthat Korea was able to climb the technology ladder quickly. It began byexporting clothing, which provided the foreign currency to import machineryto build cars. More recently, it has been exporting cars and importingmachinery to make semiconductors. Most of KoreaÕs investment has been directed into manufacturing, givingthe country almost as much manufacturing capital stock per capita as theUnited States. Yet capital prod-uctivity in many manufactur-ing sectors is only half of USlevels (Exhibit 3). This can beexplained by the fact thatalthough Korea has investedin best practice technology, ithas failed to adopt best prac-tice management techniques.In semiconductor manufac-turing, for example, Koreancompanies use machinessimilar to those employed byUS companies, but produce low-value DRAM chips instead of more complexmicroprocessors. Within the DRAM industry, Micron, the largest USmanufacturer, boasts capital productivity 50 percent higher than that of theaverage Korean maker. Similarly, KoreaÕs failure to implement leanmanufacturing in the automotive industry means its car makers produce onlyhalf as many vehicles as their Japanese counterparts in a similar plant. THE ROOTS OF KOREAÕS CRISISTHE McKINSEY QUARTERLY 1998 NUMBER 2 79Exhibit 3Capital allocation and capital productivity, 1995Index: United States 1995 = 100*	Excludes utilities 	Excludes construction and agricultureSource: OECD; Bank of Korea; McKinsey analysisCapital stock per capitaManufacturing*Services Capital productivity in manufacturingSteelAutomotiveSemiconductorsConfectioneryTelecom115803048543958By contrast, the service sector has been starved of capital, leading to subscaleand ine˜Þcient operations. Korea has almost no modern retailing formats,for example; family-run stores account for 70 percent of retail employment,compared with less than 20 percent in the United States.Then the slowdownIf existing regulations remained, they would slow KoreaÕs recovery from itspresent crisis and possibly expose it to future di˜Þculties. They would alsodepress growth in GDP per capita, for three reasons:¥ Growth can no longer be fueled by increases in the proportion of thepopulation that is of working age, and by the migration of workers away fromagriculture. These two e˜fects accounted for two percentage points of the 7 percent annual GDP per capita growth of the past ten years.¥ Growth through new investment in manufacturing would decline. Thefailure to raise capital productivity and the negligible scope for technologicalimprovement are leading to rapidly falling marginal returns on manufacturinginvestment (Exhibit 4). Capital productivity must be improved by theadoption of best management practices or Korea will remain vulnerable toÞnancial crises that could jeopardize its growth. But capital productivity will not improve much if Korea continues to Þnanceuneconomic investments and resist the pressures of imports and foreign directinvestment. In the past, it was relatively easy for Korean companies to gain anadvantage in ÒsimpleÓ sectors such as clothing, because labor costs were low.Even in the more complicated integrated steel industry, government-imposedprice pressures and Japanese assistance helped companies achieve bestpractice. But in the far more complex automobile and semiconductorindustries, Korea is struggling to learn and catch up with ever-advancingcompetitors. Among car makers, for example, productivity growth is lowerthan it was in Japan at the same stage of development.¥ Growth in services will remain slow as long as regulations restrictinvestment and productivity gains. Substantial barriers to growth exist inTHE ROOTS OF KOREAÕS CRISIS80 THE McKINSEY QUARTERLY 1998 NUMBER 2Exhibit 4Capital productivity and return on capital investments, 1995Index: United States 1995 = 100*	Capital inputs per labor hour 	Production rate of return = capital productivity x (PPP output Ö PPP investment goods) x share of capital in value addedSemiconductorsAutomotiveConfectioneryCapitalintensity*CapitalproductivityRate of return oncapital investments 6454112100964842 5057each of the four service sectors we studied. In retailing, strict zoning lawsand bureaucracy are blocking the development of larger, more productivestores in the suburbs. In housing construction, zoning laws and price ceilingsfavor standardized apartments. This prevents single-family homes andcustomized condominiums — the most e˜Þcient way to provide housing on alarge scale, and the model for 70 percent of new housing in the United Statesand 60 percent in the land-starved Netherlands — from being built.Similarly, in retail banking, restrictions on products and pricing limitcompetition between banks and lead to overpriced, mediocre products andunderused, oversta˜fed branches. In telecommunications, pricing regulationslimit growth in call volume and new services. If telecom companies wereallowed to price local calls at near-zero marginal cost, network use wouldincrease and service quality improve in many other industries.Steps in the right directionReform plans currently under discussion cover the supervision andgovernance of the Þnancial sector and the lowering of barriers to importsand foreign direct investment. Liberalization in these areas could reduce therisk of further Þnancial setbacks, since companies would be forced by acombination of increased competition, better bank lending, and moredemanding shareholders to adopt better management practices and improvereturns on investment. In addition, higher manufacturing productivity growth should enable percapita GDP to grow by 4 percent a year on average, more than could beachieved without reform. In e˜fect, higher manufacturing productivity andlower import barriers would bring down prices and higher capital produc-tivity would reduce the need for imported machinery, enabling domesticconsumption to increase without raising the trade deÞcit or external debt. Importance of service reform However, these reforms are insu˜Þcient. The experience of developed econ-omies shows that the performance of service industries becomes increasinglyimportant for output and employment growth as incomes rise. Deregulatingits service sector would enable Korea not only to employ the labor sloughedby more e˜Þcient manufacturers, but also to boost manufacturing output.Per capita GDP growth could return to 6 percent a year.Relaxing zoning laws for retailers, for example, would allow the constructionof large modern retail formats that provide new jobs and better service. Whilebuilding high-productivity shopping malls would consume some additionalland, the loss of green space would be small. If Korea raised its labor prod-uctivity in retailing to 69 percent of the US level, only an additional 4 percentTHE ROOTS OF KOREAÕS CRISISTHE McKINSEY QUARTERLY 1998 NUMBER 2 81of existing commercial land or 0.1 of undeveloped but usable land would be needed. Moreover, building malls would generate jobs in construction. Inbanking, the removal of restrictions on investment products would lead tothe creation of jobs in the design, marketing, and selling of products.The rapid development of new services would bring beneÞts for manu-facturing too. Modern independent retailers would force manufacturers toreduce prices and increase productivity. They would also stimulate demandwith better marketing. Greater competitive pressure in retailing and retailbanking would in turn force more companies to invest in informationtechnology (service companies are the biggest users of IT), creating jobsamong IT providers. The people who Þll these jobs would then be likely toconsume more manufactured goods.If all these measures were introduced, we estimate that with investmentequivalent to 30 percent of GDP (realistic by Korean standards), the econ-omy could grow by 6 percent a year, taking it to 90 percent of the UnitedStatesÕ current per capita GDP by 2010. Productivity-led growth of this kindwould be faster and more sustainable than the current Japanese-style input-driven variety.Social problemsOnly total reform will reduce KoreaÕs susceptibility to future Þnancial andsocial difÞculties. Anything less would mean lower growth and could createserious employment problems.Policy changes directed atmanufacturers alone, such asthe li˜ting of import barriersand the reform of the Þnan-cial sector, would cause em-ployment to fall in theseareas because productivitywould rise faster than output(Exhibit 5). This is a trendthat has been observed in alldeveloped economies. Unfor-tunately, job creation inservice industries would belimited because present regu-lations inhibit the growth ofnew high-value services. Laid-o˜f manufacturing workersand young people reachingTHE ROOTS OF KOREAÕS CRISIS82 THE McKINSEY QUARTERLY 1998 NUMBER 2Exhibit 5Policy reforms and future wage distributionPercent of hours worked in 2010 at different hourly wage rates*	At purchasing power parity$2—$5 $5—$9 >$9No reformsAfter reforms 	in financial and manufacturing sectorsAfter additional reforms in service sectorWages and employment in manufacturing protected by barriers to imports and foreign direct investmentNo attractive reemployment opportunities in services for redundant manufacturing workersStrong job creation in high-value services506070352020152010Hourly wage rates*Underemployment or unemploymentworking age would be forced into low-value service jobs or, if the minimumwage were raised, unemployment. Assuming that Korea imposed minimum wage and unemployment beneÞts atUS levels, we estimate that a reform program that neglected the service sectorcould lead to unemployment of 12 percent. Reform that included the servicesector, on the other hand, would lead to rapid growth in good service jobsand reduce the expected level of unemployment to 5 percent, even if the USminimum wage were set.Implications While a comprehensive reform program will take time and resources, there isno economic or social reason to delay. Korea should not fear the period ofadjustment. On the contrary, a completely reformed economy would attractforeign investment and create jobs immediately, when they are most needed.Important value-creation opportunities were present in almost all theindustries we studied. In manufacturing, openings lie in making better use ofexisting machinery. In underdeveloped service industries, developing newmarkets is the key. Korean companies seeking to beneÞt from theseopportunities must act quickly to reform their corporate governance, refocustheir portfolios, and seek out partnerships with leading multinationalcompanies in order to learn best management practices. KoreaÕs current crisis represents a unique opportunity for its government. Itis a chance to embark on far-reaching changes that would enable the economyto return to rapid but balanced growth based on higher productivity inmanufacturing and increased investment in services. Miss the chance, andthe country could, like Latin America in the 1980s and Japan in the 1990s,lapse into a prolonged period of stagnation.THE ROOTS OF KOREAÕS CRISISTHE McKINSEY QUARTERLY 1998 NUMBER 2 83

The roots of Korea's crisis

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The roots of Korea's crisis

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