Ahearn, Raymond J.

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Sources of information include various reports of the International Monetary Fund, the1Korean Economic Institute of America, and the Economist Intelligence Unit Country Reports.Congressional Research Service  The Library of CongressCRS Report for CongressReceived through the CRS WebOrder Code RS20041February 1, 1999South Korea’s Economic ProspectsRaymond J. AhearnSpecialist in Trade RelationsForeign Affairs and National DefenseSummaryAs South Korea has completed a full year of restructuring under an Inter ationalMonetary Fund (IMF) imposed program, the prospects for a sustained economicrecovery are mixed.  While the financial crisis that broke out in October 1997 has beenalleviated, the contraction of South Korea’s  economy intensified in 1998. A significantdrop in Gross National Product, as well as a rapid increase in unemployment, hasprecipitated  Seoul’s  most serious economic and social crisis sin e the end of the KoreanWar. To return the economy to a healthy growth trajectory, the government isattempting to reform the financial and corporate sectors, as well as to create moreflexibility in labor markets. Analysts now predict that the South Korean economy mightresume growth in the last quarter of 1999.  South Korea’s economic crisis, in turn, ishaving both short and long term consequences for U.S. economic interests. Short term,the United Sta es is  experiencing a rising trade deficit with South Korea, as well asincreased conflict on a number of sectoral trade issues.  Longer term, however, thereforms that Seoul is implementing have the potential to make it a much  more open,important, and stable trade partner. This report will be updated periodically.  A relatedCRS report is Korea: U.S.-South Korean Relations--Issues for Congress, CRS IssueBrief 98045.Background1By the close of 1997, South Korea was in the midst of a serious inancial crisis.   Duein large part to a sharp increase in repayments required on short-t rm external debt, thecountry’s foreign currency reserves dropped precipitously to  a precariously low $4 billionlevel.  This  undermined investor confidence and capital fle  the country.  The Korean wonlost half its value, going from 800 won to 1,600 won to the dollar, within a few days. Atthe same time, some major industrial conglomerates (cha bol) declared bankruptcy, andthe value of the Korean stock market  plummeted.  To deal with the crisis, the governmentagreed in late Dcember 1997 to the terms of a $57 billion support package put togetherCRS-2For background, see Nanto, Dick K. and Vivian C. Jones, “South Korea’s Economy and21997 Financial Crisis,” CRS Report 98-13 E, December 29, 1997, 29 p.WuDunn, Sheryl.  “South Korea’s Mood Swings From Bleak to Bullish,” New York Times,3January 24, 1999, p. A 3.by the International Monetary Fund (IMF), and engaged in a U.S.-backed negotiation ondebt-payment moratorium and rescheduling.  2As a quid pro quo for the IMF emergency loa s, South Korea agreed to pursue tightmonetary and fiscal policies, to refinance  and restructure the banking system throughdirect government assistance, and to enact wider policy refo ms aimed primarily at makinglarge conglomerates and labor markets more efficient.  Buttressed by laws passed in early1998  to toughen financial oversight and agreement by international banks to rescheduleforeign debts, Korea’s financial crisis began to stabilize.  By year-end 1998, Korea wasexperiencing major improvements in its financial position with foreign exchange reservesapproaching $50 billion and with an annualized current account surplus of about $40billion. In January 1999, Korea began paying back its IMF loan, and  international creditagencies began upgrading its sovereign risk rating from junk bond to  investment gradestatus.3Despite the improvement in Korea’s fin ncial position,  its real economy continuesto suffer. The overall economy contracted by 6% and unemployment rose to about 8% in1998.  No growth is predicted until the last quarter of 1999, and unemployment isexpected to continue to rise as thousands of small and medium sized companies  gobankrupt every month. Behind these numbers are painful adjustments for millions ofordinary Koreans, particularly in terms of job losses and a dramatic decline in livingstandards.Restoring Economic GrowthRestoration of economic growth depends on both improvements in the globaleconomy and implementation of  internal reforms.  Improvements in the health of theglobal economy, particularly the Asian economy, would do much to boost Korean growth.Nearly 50% of Korean exports now go to Asia, and the export sector has been hard hit byeconomic declines there.While South Korea has limited influence on improving the global economy, it canwork to restore its own economic growth by enacting structural reforms more vigorously.According to a number of analysts, the fundamental cause of Korea’s economic plight isthat capital and labor productivity in most industries are  less than 50% of levels in theUnited States and Japan. Low capital productivity resulted from  a banking system thatprovided the chaebol with easy credit for basically undisciplined capacity expansion in agrowing number of industries.  Not needing to worry about profitability, the top chaebolcreated considerable overcapacity in industries such as cars, petrochemicals,semiconductors, and steel. At the same time, under political pressure to avoid labortroubles, the chaebol over the past decade awarded labor a five-f ld increase in wages thatwas not matched by increases in productivity.CRS-3Lee, Kyung-Tae.  “Korea’s Economic Transition: A New Growth Paradigm,” Korea4Economic Institute of America Economic Update, Volume 9, Number 4, November 1998, p. 2.The IMF program provides external pressure to assure that productivity-enhancingreforms of the banking, corporate, and labor sectors take place.  While some critics haveargued that Seoul has not moved fast enough, the government has maintained that muchis being done, particularly given the wider economic and social repercussions that have tobe considered in the implementation process. All agree, however, that the domesticreforms are indispensable for economic recovery.Banking Reforms.  A key component of Korea’s reform program is a comprehensiverestructuring and recapitalization of the banking system.  Korea’s banks are burdened bya high level of non-performing loans and an eroded capital base. One estimate is that 20%of all bank loans are to some extent non-performing and that half of those will have to bewritten off. The first step the government took to deal with this problem early in 1998 was toestablish an independent, finacial supervisory institution called the Financial SupervisoryCommission.  Next a total of 94 financial institutions, including 16 merchant banks, twosecurities firms, and one investment trust, were closed.  Remaining banks have beenordered to clean up the number of non-performing loans to meet international capitaladequacy standards. The government has also announced, and partially funded, a 64trillion won ($54 billion) fund to purchase non-performing loans and to fund bankrestructuring.4The government has decided to deal with the six biggest and most troubled banksthrough mergers or sales to foreign investors.  The hope is that “super” banks will haveenough leverage over the c aebol to begin allocating credit efficiently.  In return for aninfusion of new capital into the troubled banks, the government is demanding costreductions through deep cuts in branches and staff or other efficiency measures. Some fear that this plan could prolong the financial crisis by forcing strong banks totake on the problems of weaker bans. In June 1998, for example, the government closedfive commercial banks, but had healthier banks take over the assets.  While the mergedbanks are under orders to restructure and cut costs, no plans have been announced.Corporate Reforms.  Efforts to restructure Korea’s banking sector are alsointertwined with corporate sector reforms. The main proble s deal with an incredibly highcorporate debt level and weaknesses in corporate governance, especially in the dominantchaebol.Large Korean companies rely on debt as their main source of financing withextraordinarily high debt levels. The level of corporate debt in Korea has been estimatedby the IMF to be between $500-$600 billion, of which $60 billion is external debt.  Shortterm liabilities accounted for half the total, making Korean companies vulnerable toeconomic downturns, changes in interest rates, and changes in creditor perceptions. The vulnerability of Korean companies to cyclical downturns is intensified by th irownership and financial structures. A non-transparent structure, combining a large numberCRS-4Lee, Charles S. “Chaebols Again Promise Kim They Will Reform,” Far Eastern Economic5Review, p. 52.of affiliates with cross shareholding and debt payment guarantees, makes the failure of oneor two companies a threat to the viability of  the entire chaebol.Top priority is being given to the reform of the five largest chaebol (Hyundai,Samsung, Daewoo, Lucky-Goldstar, and Sunkyung), given the huge role they play in theoverall Korean economy.  In what is called  the “Big Deal,” the government is pressuringthe chaebol to swap businesses.  For example, Samsung has agreed to hand over its carmanufacturing affiliate to Daewoo in return for Daewoo’s electronics unit.  Also in aneffort to eliminate duplication and become more specialized, the haebol leaders haveagreed  to cut the number of their subsidiaries nearly in half.  The proceeds from the sale(an estimated 20 trillion won or $16 billion) of  these non-core companies will be used toreduce corporate debt.  The c aebol leaders have also reaffirmed deadlines set forpreparing consolidated financial statements in 1999 and for unraveling their cross-subsidiary loan guarantees by March 2000. 5While President Kim Dae Jung has been taking a leading role in pushing the c aebolleaders to implement substantial reforms, many analysts caution that underlying problemsof overcapacity and politically directed cdit need to be addressed.  Under this view, truerestructuring involves shutting down money-losing enterprises.  The closing of plants andreduction of excess capacity, of course, is vehemently resisted by both corporate captainsand organized labor. Labor Reforms.  The government’s efforts to liberalize the labor market by passingnew labor laws or strictly enforcing labor laws with regard to strikes have facedconsiderable  resistance. The labor market has been very rigid because of the tradition oflifetime employment. While trade unions appeared to accept an end to life ime employmentguarantees in  February 1998 based on the promise that chaebol owners would give upsome of their economic power and make themselves more accountable, efforts to pushthrough reform have been hampered by political stalemate and the lack or inadequacy ofstate unemployment benefits. The opposition Grand National Party,  with close links to bigbusiness, has attempted to weaken a number of labor reform proposals. In order to maintain social stability during the reform process, the government hasbeen broadening unemployment benefits. As of October 1, 1998, unemployment insurancewas expanded from coverage of only those displaced workers who lost their jobs at largecorporations to coverage of all displaced workers. In addition, the government hasbudgeted an excess of 10 trillion won ($8.5 billion) for social welfare purposes. If thechaebol begin shutting inefficient plants and laying off workers on a significant scale,demand for social services and unemployment benefits could soar.U.S. Economic InterestsSouth Korea’s economic crisis will have both short term and long term consequencesfor U.S. economic interests.  On bala ce, the effects are likely to be mostly adverse in theshort term, but more favorable over time.CRS-5Burton John. “Koreans Cut Stel Exports To Stave Off Clash With US,” Financial Times,6January 12, 1999, p. 7.Korea’s economic crisis will have the most immediate effect on U.S. exports andimports.  Contraction of the Korean economy and depreciation of the won reducddemand for U.S. exports in the first 10 months of 1998 by 41%, dropping U.S. exportsfrom $21.6 billion in 1997 to $12.6 billion in 1998.  All major U.S. export sectors - capitalgoods, consumer goods, and agricultural products - were affected.  South Korea droppedfrom being the fifth largest country market for U.S. exports in 1997 to being the 10thlargest market in 1998.At the same time, U.S. imports from South Korea  continued at 1997 levels ($19.7billion in exports through the first 10 months of 1998 compared to $19.3 billion during thesame period of 1997).  U.S. imports from South Korea are concentrated in steel,computers, cars, and video equipment.  Among these sectors, steel imports surged bymore than 125% over 1997 levels.As a result mostly of the steep drop in U.S. exports to South Korea, the U.S. tradesurplus with Korea, which totaled $1.9 billion in 1997,  moved to a deficit position ofabout $7 billion in 1998.  This reversal came after a sustained upward trend over the pastfew years.  South Korea’s trade surplus with the United States can be xpected to grow in 1999.On the one hand, Korean demand for U.S. exports of machinery and industrial inputs islikely to remain depressed as the Korean economy remains in recession for most of theyear. On the other hand, U.S. demand for Korean goods is likely to grow due to continuedU.S. economic growth and the increased price competitiveness of Korean exports.  Therising trade deficit, in turn,  is likely to lead to increased political pressures to limit Koreanexport surges in particular sectors, as well efforts to  improve market access for U.S.exports to Korea.Political pressures to limit Korean exports are being felt in the steel sector.  A numberof U.S. steelmakers and unions are pressing the Clinton Administration to impose quotasof steel imports, which grew overall by 30% in the first 10 months of 1998.  Koreanexports have been singled out by U.S. steel interests due to their 86% increase in 1998 andlong-standing allegations that Korean steel producers have benefitted from low-interestloans and subsidies from the Korean government.6U.S. steelmakers and workers  have also alleged that unfair subsidies were providedto Hanbo Steel,  Korea’s second largest steel producer. According to industry sources,Hanbo’s  access to credit on preferential terms enabl d it to undertake construction of oneof the largest integrated steel mills in the world .  Hanbo collapsed in January 1997, butthe South Korean government allegedly continued to provide grants so that Hanbo couldcontinue its operations. The U.S. steel industry and congressional steel caucuses havrepeatedly pressed the Clinton Administration to address these concerns of unfaircompetition. In the omnibus spending bill passed in October 1998 (P.L. 105-277),Congress directed (section 621) that the Office of the United States Trade Representativereport to Congress within 60 days on the K rean government’s support for Hanbo and itssteel industry.CRS-6Lee, Charles S. and Michael Vatkiotis, “South Korea Warms Towards Foreign Investors,”7Far Eastern Economic Review, December 24, 1998, p. 51.Administration trade officials historically try to deflect pressures to limit importpenetration i  key sectors by increasing efforts to open up markets to U.S. exports. Better market access conditions for U.S. exports  is viewed as a way of minimizing thepolitical fal-out from a rising bilateral trade deficit.  Efforts along these lines in certainsectors, particularly automobiles, could prove difficult.  Even though the Koreangovernment has recently pledged to lower tariffs, and eliminate other discriminatorybarriers, the drop in projected demand for automobiles in Korea means that trade in thissector will remain sensitive.  In 1997, for example, U.S. automobile exports to Koreatotaled $83 million, while Korean automobile exports to the United States totaled $1.9billion, for a $1.8 billion deficit.Longer term, assuming  Korea  returns to a position of sustained growth, U.S.economic interests should be substantially enhanced. A major  reason is that the kinds ofchanges that Korea is being required to undertake under the IMF program are basicallycongruent with longstanding U.S. trade and investment liberalization objectives.  Theseentail a much more open market, including elimination of trade-related subsidies, andrestrictive import licenses.  They also include greater transparency in both Koreancorporate and governmental decision-making, wider participation by U.S. companies inthe Korean economy, and less policy-driven bank lending which in the past had given riseto overcapacity in industries such as steel, utomobiles, semiconductors, and shipbuilding.Perhaps the most promising changes have occurred in the area of foreign directinvestment. In an effort to attract more foreign direct investment as a way of fuelingKorea’s economic recovery, the Kim Administration has enacted sweeping changes in itsforeign direct investment regime. Buttressed by an “attract foreign capital” motto, alllimits on foreign investment in the local bond and money markets have been lifted, and theceiling on foreign investment in the stock market has been eliminated.  Foreign banks andsecurities companies have gained the right to establish local subsidiaries.  In June 1998,the Korean government allowed hostile takeovers of K r an corporations by foreignersto take place without any reservations. Restrictions on foreig  ow ership of land have alsobeen eliminated. 7Combined with cheaper asset prices, the liberalized environment contributed to arecord amount of foreign direct investment in 1998.  The nearly $9 billion invested byforeigners in Korea during 1998 was more than one-third the entire amount invested inKorea since the mid-1960s.  While the  U.S. share of foreign direct investment in Korearemains around one-third, South Krea’s growing receptivity to foreign investment couldlead to a much larger U.S. corporate presence in Korea over time.

South Korea’s economic prospects

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South Korea’s economic prospects

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