Six Markets to Watch: South Korea

South Korea’s development over the last half century has been nothing short of spectacular. Fifty years ago, the country was poorer than Bolivia and Mozambique; today, it is richer than New Zealand and Spain, with a per capita income of almost $23,000. For 50 years, South Korea’s economy has grown by an average of seven percent annually, contracting in only two of those years. In 1996, South Korea joined the Organization for Economic Cooperation and Development, the club of rich industrialized countries, and in 2010, it became the first Asian country and the first non-G-7 member to host a G-20 summit.

To call South Korea an emerging market, therefore, is a bit of an anachronism. The country is a rich, technologically advanced, mature democracy with an impressive record of innovation, economic reform, and sound leadership. Yet South Korea is not exactly a developed market, either. The value of its exports plus imports (at $1.25 trillion a year) exceeds its national income (at $1.1 trillion). That openness, along with the lack of protection provided by a bloc such as the EU, subjects South Korea to greater market volatility than other major industrialized countries and presents some serious challenges. So, too, does its highly concentrated corporate sector, aging population, and politically dangerous neighborhood. South Korea may well be more dynamic than some developed economies, making it attractive to investors, but it is also much riskier.

SO LONG, KOREA DISCOUNT

Given South Korea’s extraordinary accomplishments, it is tempting to try to distill the secrets of its success, so that they can be bottled and used elsewhere. But South Korea’s remarkable leap from poverty to riches owes to a unique set of historical circumstances.

Soon after the division of the Korean Peninsula, in 1945, South Korea already had in place the building blocks for growth: an educated population, property rights, land reform that boosted productivity, and the institutions of modern capitalism. But then came the Korean War, which devastated the country. Investment did not take off until the country began to rebuild in the 1960s, when the authoritarian president Park Chung-hee (father of the current president, Park Geun-hye) embarked on a set of policy reforms that encouraged domestic saving and opened the economy up to international trade.

South Korea’s initial rapid growth was characterized by both political authoritarianism and extensive state intervention in the economy. In the 1970s and 1980s, Seoul channeled massive amounts of capital through subsidies and low-interest-rate loans into trusted family-led chaebol, or conglomerates. These favored firms also enjoyed trade preferences and monopoly rights, among other indulgences extended by the government. Such preferential treatment enabled the chaebol, which today include Hyundai and Samsung, to grow into massive business empires whose brands are now recognized and envied around the world. But the story has a dark side: today, the chaebol’s ongoing dominance poses challenges to regulators seeking to make South Korea’s markets more competitive. And the conglomerates’ historical ties to the country’s early dictators feed resentment among many South Koreans, who regard the businesses as having achieved their dominance unfairly.

In recent decades, South Korea’s politics have gone through an evolution just as stunning as that of its economy. After 40 years of rule by a succession of strongmen, in 1987, South Koreans freely elected Roh Tae-woo as president. Roh, a former general who had been handpicked by his military predecessors, was still linked to the old regime. But his next two successors -- Kim Young-sam (a centrist civilian politician) and Kim Dae-jung (a former dissident) -- most certainly were not. Their elections were a testament to South Korea’s rapid liberalization. As Park’s recent election shows, however, the echoes of the country’s authoritarian past linger, and divisions over that past form one of the main fault lines in modern South Korea.

Despite all this progress, the country’s recent years have not been uniformly easy. Still, one of the things that has distinguished South Korea is its ability to adapt to and learn from setbacks. The country was badly burned during the 1997–98 Asian financial crisis, for example, which exposed a weak, badly regulated financial system; wildly overleveraged firms; and occasionally corrupt corporate governance practices. But the government under Kim Dae-jung responded by undertaking significant reforms: it shut down bad banks, forced the resolution of bankrupt companies, and, most of all, strengthened previously inept financial regulation.

Such changes have paid off handsomely. According to several international barometers, including the World Bank’s Ease of Doing Business Index and the World Economic Forum’s Global Competitiveness Index, South Korea’s financial institutions and business practices, which once dragged down income levels, have steadily converged on global norms. The so-called Korea discount, under which South Korean equities were undervalued due to international concerns about opaque corporate governance, has disappeared.

The reforms of the late 1990s also helped South Korea weather the global financial crisis. Despite a sudden stop in capital inflows and a precipitous fall in its currency in 2008, South Korea was able to avoid a larger crisis or a dramatic decline in output. And its recovery was swift: the International Monetary Fund forecasts that the country’s economy will grow by 3.7 percent in 2014 and by 3.0–3.5 percent a year over the long term.

Maintaining this economic performance will not be easy, however. South Korea faces a range of challenges, from its aging population and the stresses that the swelling ranks of retirees will put on the government budget to its lagging productivity in the service sector, domestic inequality, and geopolitically unstable region. South Korean business may have gone global, but the country is still wedged between two political and economic giants, China and Japan, which will remain formidable for years to come -- even if the former slows, as expected, and the recovery of the latter proves short-lived.

A downturn in China might give some South Korean midtech manufacturers, such as steel-makers and shipbuilders, a little more breathing room. But it could also threaten South Korea’s trade surplus with its neighbor. Factories in China rely on South Korean machinery for their operation, so a Chinese slowdown would also have an adverse impact on South Korean makers of capital equipment and intermediary industrial products. South Koreans complain bitterly about Japan’s policy of quantitative easing -- buying bonds in large amounts to push down long-term interest rates -- which they regard as a form of beggar-thy-neighbor currency depreciation. But any “tapering” of those purchases, in either Japan or the United States, could hit indebted South Korean households and firms hard.

And then, of course, there’s South Korea’s stunted twin. Even if North Korea manages to avoid starting a war or collapsing, the threat of instability or the sudden need for South Korea to absorb the North’s 25 million citizens will remain a real risk, both for South Koreans and for foreigners looking to do business in South Korea.

TECHNOLOGY VS. DEMOGRAPHICS

Economists normally ascribe growth to the availability of basic inputs -- labor and capital -- as well as to increases in productivity. From 1963 to 1997, when South Korea was growing at its fastest, it benefited not only from the general openness of the world economy but also from a rapid expansion of its labor force and a relatively low number of dependents per worker, combined with a major increase in the education level of its work force. But those favorable demographics are now reversing. In 2010, South Korea’s “core productive population” -- citizens aged 25–49 -- fell for the first time. If current trends continue, its dependency ratio will begin to rise within the next decade, and by 2030, its population will start to decline, falling below current levels by 2050.

If those forecasts prove broadly correct, they will put significant new burdens on South Korea’s health-care and pension systems, forcing the government to consider such measures as raising the retirement age, improving the efficiency of the delivery of health-care and retirement services, and making better use of female labor, especially educated women. South Korea may also have to reconsider its immigration policies, which are currently among the most restrictive in the developed world.

South Korea also needs to squeeze the most productivity it can out of its labor and capital, especially given the competition it faces from its neighbors low-wage China and high-technology Japan. South Korea may be tempted to try to accomplish this feat by emphasizing technology above all else. After all, as competitors from Apple to Toyota will attest, the country’s progress in this field, particularly in information technology and manufacturing, has been phenomenal.

But increasing productivity requires more than just technological innovation; it also takes encouraging innovation in emerging sectors while terminating inefficient practices throughout the economy. In South Korea’s case, the area that needs the most help is the heavily regulated service sector. If the government were willing to lower barriers to entry, the ongoing development of the country’s financial sector could help restructure the service sector by making more capital available to underwrite innovation and boost investment.

South Korea also needs more financial integration between its corporations and their foreign counterparts. Seoul has largely lifted long-term barriers to both foreign direct investment in and equity ownership of South Korean firms. But balancing that integration with South Korea’s desire to preserve its corporations’ autonomy will be difficult, especially given that South Korean public opinion is still sometimes xenophobic and chauvinistic -- an expression of the country’s long-held resentment of being a proverbial “shrimp among whales.”

However, given South Korea’s track record as the quintessential open economy and its major trade relations with China, the EU, Japan, and the United States, Seoul is likely to surmount these difficulties. South Korea is an enthusiastic negotiator of free-trade agreements, including with the EU and the United States, and it is considering agreements with China and Japan. In 1997, South Korea signed the World Trade Organization’s Agreement on Government Procurement, bringing greater transparency to public procurement and creating new opportunities for foreign firms. Trade in manufacturing and the service sector in the country is largely open; only agriculture is still protected. The automobile sector remains a source of contention. Many of the policies that in the past deterred foreign entry into the market have been removed, but foreign car companies still struggle to get a foothold against Hyundai and Kia and their well-established sales and distribution networks.

South Korea still needs to fix a labor market in which some workers have extensive benefits and job protection and others do not. It will also have to phase out its highly restrictive regulations on hiring and firing. At the same time, it should pass legislation that protects the interests of nonregular workers and encourages the smooth deployment of labor to its most productive uses by making wages less dependent on job tenure or seniority and making pensions and benefits more portable.

Seoul should also implement smaller reforms to encourage innovation. If South Korea can reduce the risk that its firms will imitate and reverse-engineer technology invented abroad, foreign firms will become less hesitant to transfer technology to South Korean partners. Meanwhile, universities and other public institutions should integrate their research and development with the private sector, and South Korean researchers should look harder for new partnerships abroad.

A final challenge faced by South Korea -- although it is hardly alone in this area -- is the growing inequality of income and wealth. Encouraged by the historically symbiotic relationship between business and the state, the government has concentrated economic, political, and cultural life in Seoul, one of the world’s most expensive cities. As with London in the United Kingdom, the pull of the capital city has stoked inequality elsewhere in South Korea. To fight this, the government has tried to stimulate regional development by establishing “special economic zones” and relocating many government offices to provincial areas. But the movement of government ministries will only complicate the lives of many South Koreans and foreigners currently used to working with the government in Seoul.

Still, addressing the widening wealth gap is critical if South Korea hopes to avoid the kind of political backlash that could damage its economic growth. Park, a conservative, won the presidency in 2012 thanks in part to strong support from older voters who have relatively fond memories of her repressive, though effective, father. But few younger South Koreans share such sentiments. South Korea has a history of alternating between center-left and center-right leaders every decade or so (presidents serve single five-year terms). Given that history, as well as the country’s shifting demographic trends and growing wealth gap, the center-left -- with its greater emphasis on redistribution, or what South Koreans term “economic democracy” -- could return to power in 2017. Such a shift could impede South Korea’s progress if the center-left turns populist, breaking the budget with politically popular measures such as free university education, higher property taxes on the wealthiest, and punitive but dubious legal cases against prominent firms.

THE HARDEST PART OF BREAKING UP

Of course, many countries share such political risks. What makes South Korea unique is the threat that lies just beyond the 38th parallel: North Korea. Most South Koreans agree that economic engagement with North Korea would make Pyongyang less repressive domestically and less belligerent in its foreign relations. Even though North Korea’s new head of state, Kim Jong Un, is a third-generation hereditary leader with a penchant for nuclear provocation, hope springs eternal that he will turn out to be a reformer.

In the meantime, South Korea is hesitantly planning for reunification. Inter-Korean projects, such as the Kaesong Industrial Complex (closed earlier this year by North Korea but recently reopened) and the opening of railroad lines along the east and west coasts, linking South Korea to Russia and China, are broadly popular in the South. Gas pipelines from Russia through North Korea to South Korea (and even onto Japan) could follow.

Despite such efforts, there is no guarantee that a North Korean transition would go smoothly; sudden collapse remains a distinct possibility. Such a scenario would have one of two consequences, both dire: the massive movement of southern money north or of northern people south. Plausible estimates of the money that would be needed to raise North Korean incomes to some significant share of those in the South, and thereby forestall mass emigration, exceed $1 trillion -- equal to South Korea’s annual national income.

Mass emigration from North Korea could also provoke a number of political cleavages within South Korea, especially between capital and labor. Industrialists view Northerners as a potential new source of cheap labor, while labor regards the North as a potential source of competition. The liberation of North Korea could also exacerbate divisions between high-skilled and low-skilled workers in the South and, if foreign capital flows in and drives up the value of the won, between the export sectors, which would suffer, and the local construction sector, which would boom.

In the nearer term, however, the real risks posed by the North have less to do with an abrupt, German-style reunification than with a reversal of South Korea’s own gradual success at regularizing its business-government relations, which are still far too cozy, opaque, and corrupt. In the North, of course, there is no real difference between the state and the economy. Any large-scale economic integration between the two countries would by its very nature be highly politicized, and the expansion of the government’s role in the South Korean economy could seriously undermine recent reforms.

From an investor’s perspective, North Korea represents both a threat and an opportunity. The dangers are obvious. As for the potential benefits, the successful opening of the North would provide South Korean firms with a new source of low-cost labor. And North Korea has underground minerals, including rare-earth metals, possibly worth trillions of dollars.

For investors, South Korea has the deep, well-regulated debt and equity markets of a developed economy such as Japan, but in an economy with higher growth and greater dynamism. It is far more transparent than its giant neighbor, China, with greater protections for investors, including the rule of law. The country’s manufacturers are competitive globally; the service sector represents an emerging opportunity.

Sixty years ago, the U.S. government considered making its destitute ally South Korea a regular line item in its foreign aid budget; many Americans expected Seoul to remain a ward of Washington in perpetuity. South Korea, of course, has proudly proved that expectation wrong -- and seems likely to keep defying skeptics for years to come.