The roots of Korea’s crisis

By Martin N. Baily, Cuong V. Do, Yong Sung Kim, William W. Lewis, Victoria Lee Nam, Vincent Palmade, Eric Zitzewitz

The best manufacturing technology did not lead to high productivity. Now is the time for deregulation. But it must embrace both manufacturing and services.

With per capita income swelling better than fivefold from 1970 to 1995, Korea was on the leading edge of the East Asian miracle. But 1997’s financial crises brought the miracle to an abrupt end, raising questions about Korea’s economic prospects and the underlying reality of the East Asian boom.

To help answer these questions, we studied Korea’s current economic performance and used this knowledge to gauge what its medium- and long-term growth potential might be.1 We examined how the regulatory environment has affected Korean companies in four manufacturing industries (automobiles, steel, food processing, and semiconductors) and four service industries (retail banking, general merchandise retailing, housing construction, and telecommunications). Our main conclusions are:

  • Overall, the old regulatory environment led to high inputs (especially in manufacturing), and low productivity. Despite massive investment in the best available manufacturing technology, protectionism and poor corporate governance prevented Korean companies from adopting the best management practices. As a result, labor and capital productivity in most manufacturing sectors stands at less than half of US levels.
  • Service sector industries were systematically starved of capital. As a result, companies are well below scale and highly inefficient. Their performance is further hindered by regulations—stringent zoning laws in retailing and product and pricing restrictions in retail banking—that dampened competition.
  • Thorough reform of the economy is the only way to restore high growth and employment. This reform must include removing often-overlooked service sector regulations. Our work shows that Korea’s old regulatory environment has reached its limit. Even with sustained high investment, the potential for annual GDP per capita growth under the current regulatory regime could not exceed 3 percent per year for ten years following stabilization, and even then the economy would still remain vulnerable to further financial crises. By contrast, GDP per capita growth was 6.7 percent per year between 1970 and 1996.

If growth in GDP per capita is to return to these levels, across-the-board economic reform is essential. Our previous studies have shown that the service sector is the engine of job growth in all major economies. Without reform, Korea’s service sector will not create jobs for the workers displaced as manufacturing productivity rises. Reform plans that neglect the service sector and deal only with corporate governance and increasing foreign competition in the financial and manufacturing sectors are thus especially dangerous in the short term because they will increase unemployment.

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