Sunday, November 20, 2011

South Korea's Economy: What do you do when you reach the top?

To outsiders, South Korea’s heroic economic ascent is a template for success. But now it has almost caught up with the developed world it must change its approach

It is a crisp autumn morning in Seoul, and a hopeful fisherman sits dreaming by the Cheonggyecheon stream as the world bustles happily by. Glass skyscrapers rise behind him housing the capital’s new financial district. The shopfronts at their base are among the swankiest in Asia. Office workers, families and schoolchildren amble past. Busking fills the air. The water tumbles past plum trees and willows.

Twenty years ago, this background would itself have seemed a dream for anyone foolish enough to be trying to fish the Cheonggyecheon. Its waters, dirty and hidden, were trapped beneath a roaring highway; its surroundings were a slum of sweatshops, metal bashing and poverty. The reclamation of the Cheonggyecheon, one of the great urban-regeneration projects of the world, has about it the air of a dream achieved. So, to a large extent, has the Korea through which the stream flows.

In 1960, in the aftermath of a devastating war, the exhausted south was one of the poorest countries in the world, with an income per head on a par with the poorest parts of Africa. By the end of 2011 it will be richer than the European Union average, with a gross domestic product per person of $31,750, calculated on a basis of purchasing-power parity (PPP), compared with $31,550 for the EU. South Korea is the only country that has so far managed to go from being the recipient of a lot of development aid to being rich within a working life.

For most poor countries, South Korea is a model of growth, a better exemplar than China, which is too vast to copy, and better, too, than Taiwan, Singapore or Hong Kong. All three are richer than Korea but all are, in different ways, exceptions: Singapore and Hong Kong are city states, while Taiwan’s disputed sovereignty makes it sui generis.

South Korea has not merely grown fast. It has combined growth with democracy. Though its spurt began under a military dictator, Park Chung-hee, for the past 25 years the country has had a vibrant parliamentary system. Korea scores the same as Japan in the democracy tally kept by Freedom House, a think-tank in Washington, DC. No other Asian country does as well. At the same time Korea has combined growth with equity. Between 1980 and 1997, its Gini coefficient, a measure of income inequality, fell from 0.33 to an exceptionally low 0.28, before rising back up during the 1997-98 Asian crisis. In 2010, the level was 0.31, a bit worse than Scandinavian countries, a bit better than Canada.

A model that worked

Now Korea can add resilience to its roster of achievements. It was walloped during the global financial crisis, but recovered faster than any other rich country. Between June 2008 and February 2009, Korea lost 1.2m jobs. South Korea’s relatively open financial system made it vulnerable to the volatility in world markets, a vulnerability that continues. This September, foreigners withdrew over 1.3 trillion won ($1.1 billion) from the stock market and the currency slumped 10%.

Yet in 2010, GDP grew by 6%. This year’s expansion is likely to be 4%. The unemployment rate is now a covetable 3%. Some of the recovery is the result of Korea’s happy dependence on China: it exports more capital goods to China relative to the size of its economy than anyone else, even Germany. But this is only part of the explanation (which is just as well given China’s slowdown). The government also initiated a public-works scheme that is mopping up over 2% of the labour force. It introduced an old-age pension and began, then expanded, an earned-income tax credit. All this from President Lee Myung-bak, who was once chief executive officer of Hyundai Construction and is widely assumed to be excessively friendly to big business.

Korea’s relentless convergence towards America’s standard of living (see chart 1) has barely missed a beat. China’s dollar GDP per person would have to grow at 7.5-8% a year for 20 years to reach the heights Korea has already scaled. If the Korean economy goes on growing at 4.5% a year and America’s at 2.5%, Korea would overtake America (in PPP terms) only a few years later.

To keep growing that impressively, though, Korea will need some new tactics. And it will need to develop them from scratch. When a country or a company is playing catch-up it can look at what others are doing and do it better. This Korea has done well. Hyundai has outcompeted Toyota in the market for reliable, efficient, cheap cars. Korea’s shipyards have beaten everyone through economies of scale.

All change

But this way of doing things works only when others have blazed a trail before you. As you join the ranks of the richest, you run out of beaten track to follow. Your economy comes to depend more on innovation and on learning from your own mistakes than on improving on the successes of others. The South Korean model of 1960-2010 remains an example for developing countries; but Korea itself now needs something new.

The Korean model had four distinctive features: a Stakhanovite workforce; powerful conglomerates; relatively weak smaller firms; and high social cohesion. All these are either coming under strain, or in need of reassessment, or both.

South Koreans lay great store by education and hard work. They put in 2,200 hours of work a year, half as much again as the Dutch or Germans. Their reaction to the 2008 slump was to work harder still. During the 2009-10 recovery, reckons Richard Freeman of Harvard University, Korea had the second-largest increase in hours worked in manufacturing, after Taiwan. And the quality of labour has been even more important than the quantity. Along with Finland and Singapore, Korean schools regularly top international comparisons of educational standards, such as those run by the Organisation for Economic Co-operation and Development (OECD), a rich-country club. Korea spends a larger share of GDP on tertiary education than any rich country other than America. Given relatively low wages, this superbly educated workforce is hard to beat.

But with Korea already top of the league tables, it is harder to generate further jumps in income from big increases in hours and skills. Indeed, the immediate problem is merely to maintain its excellence. According to Yeong Kwan Song of the Korean Development Institute (KDI), a think-tank, companies are starting to worry that graduates are emerging from university with the wrong skills. On some estimates, half of recent graduates are failing to find full-time jobs and are going into further study or part-time employment. So while general education remains good, some industrial skills may be declining.

One way to boost the skilled labour force might be to have rather more people working rather fewer hours. The extra people would be women, often highly educated ones. Quite a lot of Korean women stay at home—the participation rate for women aged 25-54 is only 62%, the fourth-lowest in the OECD—even though they are usually better educated than men. In almost all rich countries, the best-educated women are more likely to work than their less-educated sisters. Not in South Korea.

Shorter hours might encourage some of these skilled women into the workforce. So might a change in attitudes to schooling. The job of supervising a child’s education falls to women, which is one of the reasons why relatively few women have jobs.

This does not mean that they have a lot of children instead. Korea has a fertility rate of 1.2, one of the lowest in the OECD. This is in part because those good educations make having children a pricey proposition. An unusually large part of the spending that makes Korean education so good is private, not public. The government spends just under 5% of GDP on education, slightly below the rich-country average. Families add an extra 2.8% of GDP on top of that, easily the highest rate in the OECD. At universities, family spending is three times that of the state. And families spend an estimated 8% of their household budgets on after-hours programmes for each child, an investment which explains the effort mothers put into making sure it pays off. If you have three children, their after-school activities alone could swallow up a quarter of the household budget.

The power of conglomerates. Much of South Korea’s miracle has been the work of big conglomerates, or chaebol. Barry Eichengreen of the University of California, Berkeley, argues that they are “among the most technologically and commercially progressive agents in the Korean economy”. Samsung Electronics, for instance, one of 83 constituent parts of the Samsung empire, sells more smartphones than Apple. Korea’s shipyards have just started work on a new class of container ships called the triple E-class which are easily the largest container ships ever built (Maersk, the ships’ buyer, says the three Es refer to economy of scale, energy efficiency and environmental cleanliness; simpler just to see them betokening EEEnormity). Korea’s large companies employ slightly less than a quarter of the workforce and produce more than half the country’s output. Chaebol-alikes exist round the world, from Carlos Slim’s Group Carso in Mexico to Lee Ka-shing’s holdings in Hong Kong.

The surviving chaebol have proved resilient. During the 1997-98 crisis, some chaebol’s debt-to-equity ratios soared to over 500%; half of them went bust and conglomerates were widely seen as a drag on the economy. Now, those that came through the time of trial have returned to profitability and respectable debt ratios—but their success still has a downside.

After the founding fathers

The chaebol system has proved prone to fraud, dodgy accounting and illegal political contributions. Many of the companies depend to an unhealthy degree on a founder or his family. About half the managers of Samsung’s firms used to work in the chairman’s secretariat—and thus directly for the founder or his son—and owe their promotion to the associated patronage. As with any family business, the moment of greatest danger is when the leadership passes to the next generation. Samsung passed this test in 1987 when the founder handed over to his son, Lee Kun-hee. Now Mr Lee’s son, Jay Y. Lee, has been appointed chief operating officer of Samsung Electronics and a new transition looms. If Mr Lee the third has business acumen, fine. If not, the whole country could suffer.

Find out how much of an Apple iPhone is actually a Samsung with our "teardown" infographic.Moreover, there are signs that the chaebol may be stifling innovation and entrepreneurship. They have proved expert at applying and improving existing technology, even the high technology of touch-screen smartphones. But except in some internet businesses and computer gaming, South Korea has few start-ups or cutting-edge technology firms. It lacks nationwide venture-capital businesses, says Hasung Jang, the dean of Korea University’s Business School, because each chaebol has one of its own. The firms snap up the best and brightest and turn them into company men. Mr Jang compares the conglomerates to light-hogging trees in a forest: their canopy may be impressive, but it is hard for anything to grow underneath.

Koreans perceive fewer opportunities for entrepreneurship than any of their peers in rich countries except Japan, according to an annual survey by the Global Entrepreneurship Monitor, set up by the London Business School and Babson College, Massachusetts. As South Korea moves towards the technological frontier, such attitudes will have to change. Innovation is not going to come if everyone shelters from risk in the chaebol.

Weak small firms. There is a huge productivity gap between Korea’s export-oriented chaebol and small and medium-sized firms (SMEs) which dominate services. Value added per worker in small firms is less than half that in large ones. SMEs’ operating profits were 4.5% of sales in 2007, compared with about 7% for large firms. Small firms spend about half as much on research and development as large ones per unit of sales and borrow far more relative to assets. Over time, their performance seems to be getting worse. Korea, in short, has first-world manufacturing exporters and third-world services.

Coddled, not coping

There are several reasons for the mismatch. Small firms are crowded out of markets for people and skills by the chaebol. And because chaebol pay scales often rise according to years in service, they squeeze wage bills by firing older workers, with the service sector working as a recycling system for surplus labour. Small firms have also been coddled by the government. Korea maintains various entry barriers to shelter mom-and-pop stores from competition. Government support to SMEs rose from under 6 trillion won in 2008 to 10 trillion in 2009. Public credit guarantees rose from 33 trillion won in the Asian crisis to almost 60 trillion won in 2009. Last year, the government “requested” banks to roll over their loans to small firms. Randall Jones of the OECD argues that all this help has made SMEs less, not more, efficient, and damaged competitiveness. The richest economies are switching into services that in Korea are dominated by small firms which cannot compete.

Social cohesion. Korea’s equal distribution of income is changing. Judging by the relationship between the richest and poorest tenth, Korea is becoming more unequal than it used to be. Worse, the growing number of poor people is disproportionately elderly. In other rich countries, people between 66 and 75 are no more likely to be poor than the population as a whole. In Korea, they are three times as likely to be poor. This is all the more worrying because the low birth rate means the country is ageing more rapidly than any other rich country. In 2009, people over 65 were outnumbered ten to one by the working-age population. By 2050, there will be seven over-65s for every ten working-age adults. Disproportionate old-age poverty would have a huge impact on the social backing for policies designed to foster growth.

Not to be left behind
Korea’s equitable income distribution used to provide a sense that society as a whole was benefiting from breakneck catch-up. But discontent is rising both about inequality and about the role of the chaebol, producing growing disenchantment with both main political parties. The recent election for mayor of Seoul produced an upset win for a left-wing anti-establishment maverick.

It is proving hard to resist the trend towards inequality because of another basic feature of Korea’s economic model: total tax revenues are just 26% of GDP. Taxes are especially low on labour, a choice designed to boost work and foreign investment. But as a result, social spending is low (11%); public spending on family benefits is exceptionally low (less than a quarter of the rich-country average); and the tax-benefit system is the worst in the OECD at reducing inequality and poverty. Korea’s tax-benefit system reduces poverty by only 18% (compared with what it would have been without the benefits). Sweden’s tax-benefit system cuts its poverty rate by 80%.

Korea, argues Mr Jones, needs to increase taxes and social spending in order to reduce poverty and inequality. One reason it is reluctant to do this is because it is afraid of the impact on jobs. Its changing demography also suggests caution in expanding the social safety net too fast or far, as it will be used ever more over the decades to come.

And then there is the ever-present imponderable: the possible need, at some point, to finance the horrendous costs of reunification with destitute North Korea when that state collapses. That would make the vast expense of unification in Germany pale into insignificance. At some point in the future Korea may need all the room for future fiscal expansion it can get.

A bridge to the future

The problems of the South Korean model should not be allowed to obscure either its achievements or its continuing strengths. True, over the past 40 years annual GDP growth has declined from about 10% to 4-5% (see chart 2). Business investment has halved from over 30% of GDP in the mid-1990s to 17% in 2010—but that is still 50% over the OECD average. Further declines in growth seem likely.

That is not surprising. As Kwanho Shin of Korea University and Dwight Perkins of Harvard show, every country’s growth starts to ebb as its income reaches about $10,000 a year. South Korea has kept going longer than most. If it can increase public spending a little to reduce inequality and poverty, boost its labour supply by encouraging more women to work and avoid compromising its educational standards and penchant for hard work, then it should be well placed to pull ahead of Europeans and catch up with America, too.

South Korea has long been a model for outsiders. President Kennedy’s chief economic adviser, Walt Rostow, wanted to use it as a testing ground for his theories about stages of economic growth. But Koreans do not see themselves as a blank slate, or as a new world power. They stress a long legacy of openness and innovation. Before the wars of the 20th century Korea was a bridge between the more closed worlds of China and Japan. It developed movable metal type two centuries before Gutenberg; its last imperial dynasty benefited from checks and balances more extensive than in its Chinese prototypes. The more Korea brings these qualities of domestic innovation to the fore, the better its chances of blazing a new trail for itself. ◦

Ahn Cheol-soo: A New Voice Grips South Korea With Plain Talk About Inequality and Justice

SEOUL, South Korea — Two days before Seoul elected a mayor last month, an unassuming man slipped into the campaign headquarters of Park Won-soon, an independent candidate. Amid flashing cameras, the man, Ahn Cheol-soo, a soft-spoken university dean who had earlier been seen as a contender for mayor himself, affirmed his support for Mr. Park, entrusted him with a written statement and then left.

“When we participate in an election, we citizens can become our own masters, principle can defeat irregularity and privilege, and common sense can drive out absurdity,” said Mr. Ahn’s statement, an open appeal to voters that quickly spread by way of Twitter and other social networks. “I’m going to the voting station early in the morning. Please join me.”

It was a pivotal moment in an election whose outcome has rocked South Korea. In a country where resentment of social and economic inequality is on the rise, and where many believe that their government serves the privileged rather than the common good, Mr. Ahn’s words — “participate,” “principle,” “common sense” — propelled younger voters to throw their support overwhelmingly behind Mr. Park, the first independent candidate to win South Korea’s second-most-influential elected office.

Nearly 30 percent of the voters who backed Mr. Park on Oct. 26 did so because of Mr. Ahn, according to an exit poll jointly conducted by YTN, a cable news channel, and the Asan Institute for Policy Studies.

Mr. Ahn’s charged comments on themes like inequality, the middle class, the despair of the young and “businesses with a soul and a goal nobler than just making money” are prompting comparisons here with the Occupy Wall Street movement.

Yet, after setting off what stunned politicians called a “tsunami,” Mr. Ahn retreated from public view, declining all requests for interviews. Nevertheless, he remains South Korea’s hottest political star.

His name has attracted those who are disillusioned with the existing political parties. This month, 25 younger lawmakers from President Lee Myung-bak’s governing Grand National Party, responding to the party’s loss in the mayoral race, demanded that the president apologize for “arrogance and disconnectedness.” Recent surveys have found that if the next presidential election were held today and Mr. Ahn were a candidate, he would win.

Politicians have called on him to declare whether he intends to run in the December 2012 presidential election, but he has kept silent. Mr. Park said recently that he did not know whether Mr. Ahn would run, but added, “The fact that he once dreamed of running for Seoul mayor makes it clear that he is disappointed, and in despair, over the country’s politics.”

Although one newspaper columnist has accused him of spreading “the virus of demagoguery,” to his fans he is “Dr. Ahn,” a medical doctor who became an expert on computer viruses and is now ready to turn his healing powers to politics.

“Like Spider-Man, once you have the power, even if you don’t like it, you have to accept the responsibility that comes with it and act accordingly,” Mr. Ahn, a science fiction fan, told the weekly Sisa Journal last year.

The Ahn Cheol-soo phenomenon speaks volumes about why many Koreans often react with distrust to initiatives trumpeted by the political and corporate elite, like the contentious free-trade agreement with the United States, and why Mr. Lee, while winning the admiration of President Obama, is often regarded by his own people as out of touch.

“Professor Ahn represents the people’s aspirations for change,” said Kim Hyung-joon, a political scientist at Myongji University.

Champion of change is a new addition to Mr. Ahn’s unusual résumé. When he was a young medical doctor, Mr. Ahn, now 49, worked for seven years in his spare time to develop what became South Korea’s first widely used antivirus software.

In 1995, he quit medicine and founded AhnLab, the country’s most successful software company. When he retired as its chief executive in 2005, he donated millions of dollars’ worth of shares to his employees. (Many South Koreans see a telling contrast between that gesture and the actions of a parade of well-known businessmen who have been caught breaking the law to channel wealth to their children.)

On Nov. 14, Mr. Ahn said he would donate half of his 37.1 percent stake in AhnLab to charity. His donation, worth about $130 million, would be used to help “the children of low-income families whose opportunities are limited because of social and economic inequality,” Mr. Ahn said in a statement.

In June, Mr. Ahn became dean of the Graduate School of Convergence Science and Technology at his alma mater, Seoul National University. After the election, he resigned as director of a research institute when the governing party, citing his political activities, threatened to end government financing for it.

Mr. Ahn’s interviews, and the lectures that until recently he gave on campuses across South Korea, reveal Mr. Ahn to be not only a mentor whose talks have inspired younger Koreans, but a social critic whose pointed criticism of the country’s big businesses has struck a deep chord.

“Bill Gates wouldn’t have become Bill Gates if he were born in South Korea,” Mr. Ahn likes to say, accusing Samsung, LG and other major corporations of creating “zoos” and “a realm of predators and lawlessness” where, he says, they have shackled small entrepreneurs with slaverylike contracts.

He took on a national icon: Lee Kun-hee, the chairman of Samsung, whose elitism, analysts say, epitomizes South Korea’s national strategy of letting big business drive economic growth, in the expectation that society as a whole will benefit. Mr. Lee famously said, “We need talented people who can each create livelihoods for 10,000 people.”

“What he failed to add,” Mr. Ahn said in an interview this year with MBC TV, “is that if someone keeps those 10,000 livelihoods for himself and takes more from others, then he’s no help to society, where all of us must live together.”

Such remarks tap into what is arguably the biggest public grievance in South Korean society — and, potentially, a political tinderbox.

President Lee, a former Hyundai chief executive, campaigned in the 2007 election on what he called his “747” vision: the economy would take off like a Boeing 747, giving South Korea a 7 percent economic growth rate, a $40,000 per capita income and the world’s seventh-largest economy.

The economy did grow, though not spectacularly. And many Koreans complained that the 747 of growth had only the rich on board. While big businesses reaped profits, often achieved in part by moving jobs abroad, smaller businesses that supplied them earned less and less.

Older Koreans grew up believing that young people, if they worked hard, could climb high even if their families were poor; the classic example is President Lee himself. But young Koreans tend to see diminished opportunities in a country where the rich can afford private tutors for their children while others struggle to pay skyrocketing tuition and the poor are shut out altogether. Sociologists have sounded alarms about antiestablishment hatred boiling in cyberspace.

“In a way, the current system is worse than the old military dictators,” said Kim Ou-joon, who produces a weekly podcast that satirizes the government and is downloaded by millions of South Koreans. “The dictators beat students, hurting them physically. Today’s ruling class destroys young people’s self-esteem by threatening their livelihood. It humiliates their soul.”

In August, Mr. Ahn told the newsweekly Chosun that many of the students who seek his advice break down, crying in despair.

“A lack of justice is a serious problem,” he told MBC TV, explaining why the book “Justice: What’s the Right Thing to Do?” by the Harvard political philosopher Michael J. Sandel became a No. 1 best seller in South Korea. “If we let this problem balloon, the tremendous social pressures can explode.”

Before the Seoul mayoral election, some polls showed Mr. Ahn potentially running far ahead of Mr. Park, but on Sept. 6 he announced that he would not run and would instead back Mr. Park. “The expectations people have had for me are not solely for me,” Mr. Ahn said. “Our society’s wish for change was merely expressed through me.”

If Mr. Park was the great beneficiary of Mr. Ahn’s popularity, the hardest hit has been Park Geun-hye, a leader of the Grand National Party and the daughter of Park Chung-hee, the country’s president from 1963 to 1979. Until Mr. Ahn came along, she polled higher than any other potential candidates in the 2012 election to succeed Mr. Lee, who by law cannot run again.

“She’s suddenly become a symbol of the status quo — old times, old age, old ideas,” said Hahm Sung-deuk, a political scientist at Korea University.

But he questioned whether the halo surrounding Mr. Ahn would survive an actual political contest. “People want a fresh face, and the first face they see is Professor Ahn’s,” Mr. Hahm said. “If Professor Ahn jumps into actual politics, much of the mystique and aurora surrounding him will evaporate, too.”

In an interview with the daily Chosun Ilbo in August, Mr. Ahn’s wife, a university professor with whom he has a daughter, said she saw “little chance” of Mr. Ahn entering politics.

Still, in one of his lectures to students, Mr. Ahn said: “You can’t find out how fast the river is flowing by sitting on the banks and watching. You have to take off your shoes and socks and jump in.” ◦