Repot No.6138-K0 Korea Managing the Industrial Transition (in Four Volumes) Volume II: Selected Topics July 31, 1986 Country Programs Department East Asia and Pacific Regional Office FOR OFFICIAL USE ONLY Document of the World Bank This report has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. GLOSSARY AND ABBREVIATIONS DMB Deposit-Money Bank EPB = Economic Planning Board HCI = Heavy and Chemical Industry KDI Korea Development Institute KIET = Korean Institute for Economics and Technology KIRI = Korea Development Institute KSIC = Korea Standard Industrial Classification MOST = Ministry of Science and Technology MTI = Ministry of Trade and Industry (Korea) NBFI = Non-bank Financial Institution NIC Newly-Industrializing Country OECD = Organization for Economic Cooperation and Development OPEC Organization of Petroleum Exporing Countries RCA = Revealed Comparative Advantage SMI Small and Medium Industry TOE = Ton of Oil Equivalent WPI = Wholesale Price Index " OMfCIAL USE ONLY PREFACE Volume II contains five chapters of analytic importance in under- standing Korea's recent economic development. Chapter 6 addresses the issues of industrial transformation, using the latest (1983) input-output table as the basis of analysis, and also examines the issue of industrial concentra- tion. Chapter 7 reviews the conduct of macroeconomic policy in the recent past, focusing in particular on structural changes which affect the relation- ship between instruments and targets. In Chapter 8, the issue of liberalisa- tion sequencing is addressed and the risks of the Latin American experience are reviewed. Chapter 9 includes both a conceptual treatment of the theory of industrial interventions and applications for Korea as well as a sumary of recent Japanese restructuring activities. Chapter 10 examines the link between industrial performance and access to financing. This document hasa restricted distribution and may be usd by recipients only l the performne of thk officahdedas. Its contents may nt odherw be dcoed wah Wordd k mudwhadon. KOREA MANAGING THE INDUSTRIAL TRANSITION VOLUME II: SPECIAL TOPICS Table of Contents Page No. Chapter 6: Korea's Industrial Structure..4.......................... A. Introduction ............................................. 1 B. Structural Changes in the Economy.......................... I Shifts in Production................................... 1 Trends in Manufacturing........ .......................... Increasing Use of Intermediate Inputs.................... 5 Changes in Trade Structure........................0... 9 C. Import Substitution in the HCI Sector.................... 12 Reducing Import Dependency............................... 12 Foreign Markets in HCI Products.......................... 14 Oyerview.. s.................. ............. ............ 1 D. Future Structural Issues.................................17 Future Projections.................................... 17 Employment Issues....................................... 21 Productivity Issues...................................... 21 R&D Policy............................................... 2 E. The Issue of Industrial Organisation....................... 24 Introduction............ ......... ............... .......... 2 Changes i. Establishment Sise........................... 25 Firm Concentration in Manufacturing...................... 28 Rising Influence of Conglomerates........................ 29 Concentration and Efficiency...........e..e...e.......e.. 33 Appendix 6A: International Comparisonsooo.............e............ 35 Appendix 6B: Sources of Goh................... 43 Chapter 7:* The Conduct of Macroeconomic Policy ............ 48 B. The Determinants of Investment and Inflation, 1982-85...... 51 Monetary Policy and Investmentoe..o.......e.............. 51 Investment and Foreign Income (;rowth*e**e***e***.**.**o.. 52 The Incidence of Credit Reductione....................o.* 55 Investment and Interest Rates*.........e................. 57 Macro Policy and Inlto................ 58 Wages and Productivity.................... 59 Energy Use Adjustments and Inflation............. 62 Inflationary Expectatiorts****oooe*o*oo#ooeoooo*.......... 63 Page No. C. Monetary Policy in the Medium Run.......................... 64 Monetary Policy and NBI................................ 64 Monetary Policy and the Corporate Finance Structure...... 65 Sterilization and Current Account Surpluses.............. 66 D. Exchange Rate Management................................... 67 Impact on the Current Account............................ 68 Impact on Inflation...................... 70 D. Lessons for Future Policy-making........................... 72 Chapter 8: Economic Liberalization and the Sequencing of Reforms... 74 A. Conceptual Issues...... ............................ 74 B. The Capital Account, the Current Account and the Real Exchange Rt............................................ 76 C. Economic Reform, Efficiency and Credibility................ 78 D. Review of Sequencing and Implementation.................... 80 Appendix SA: Financial Liberalization Risks: Lessons from the Southern Cone ................................................. 82 Chapter 9: The Theory of Industrial Policy in the Korean Context... 85 A. Incentive Regime.......................... 85 B. Functional Invervention..o........e.............e......... 86 Technology Development.....................0............... 86 Manpower Development .................................... 87 Capital Markets.................................... .7 Competition Policy..................... 88 C. Selective Intervention..................................... 88 Sunrise Industries....................................... 89 Sunset Industries........................................ 91 Appendix 9A: The Japanese Approach to Industrial Restructuring..... 93 Chapter 10: The Role of Finance and Industrial Performance......... 99 A, Introduction............................................... 99 B. The Sectoral Experience.................................... 101 Large Firms vs. Sm.Ll/MediumFirms....................... 102 Heavy Chemical Industry vs. Light Industry............... 102 Fxport Industry vs. Domestic Industry.................... 103 C. The Experiences of Specific Industries..................... 104 D. Overall Assessment......................................... 105 Distortive Allocation of Credit.......................... 105 High Leverage of Firms and Poor Development of the Equity Market..... ................................. 106 High Industrial Concentration........................... 106 Slow Development of the Financial Sector................. 106 The Implications of Financial Liberalization Since 1980............................................. 107 - iii - Page go. E. Future Implications ...................................... 107 The Banking Indust y..........el........l Capital Makt...................... 1b Stable Inflation......................................... 108 Interest Rates and Corporate Profitability............... 108 Policy Coordination................................. 109 List of References ................................................ 132 List of Tables Table 6.1: Structural Change in Production....................... 2 6.2: Structural Change in Manufacturing.................... 3 6.3: Significant Changes in the Metals and Machinery Industry...... ...................................... 4 6.4 Interindustry Linkages................................ 7 6.5: Top Ten Exports....................................... 8 6.6: Changes in Capital-Labor Ratios....................... 9 6.7: Korea's Revealed Comparative Advantage................ 11 6.8: Import Dependency in the Heavy-Chemical Industry...... 13 6.9: Direct and Indirect Import Requirements in Productio.......................................... e14 6.10: Changes in Export Ratios.............................. 15 6.11: Captcity Utilization by Industrial Classification..... 17 6.12: GDP Projections....................................... 19 6.13: Comparison of Output Structures in Korea and Japan.... 20 6.14: Comparative R&D Expenditure-to-Sales Ratios........... 24 6.15: Manufacturing Firms' R&D.............................. 25 6.16: Various Manufacturing Production Indicators by Firm S..................................... 27 6.17: Establishments by Size in Korea and Japan: 1982...... 28 6.18: Average 3 Firm Concentration Ratios................... 28 6.19: Market Structure of Korean Manufacturing.............. 30 6.20: Shares of Largest 50 and 100 Firms in Manufacturing... 31 6.21: Conglomerates Share in Manufacturing.................. 32 Table A6.1: Composition of Value Added in Various Countries....... 38 A6.2: Composition of Value Added in Manufacturing .......... 41 Table 86.1: Changes in Structure of Demand........................ 44 B6.2: Sources of Output Growth in Manufacturing............. 44 86.3: Sources of Output Growth for Various Economiesw...... 45 B6.4: Supply-Side Sources of Growth......................... 46 Table 7.1: Recent Macroeconomic Performance and Policy Stances... 49 7.2: Growth in World Income and Trade...................... 53 7.3: Monetary Development.................................. 55 7.4: Interest Rate Developments, 1982-85................... 56 7.5: Structural Developments in Financial System........... 56 7.6: Composition of Gross Domestic Investment.............. 57 -iv - Page No. 7.7: Productivity and Wages in Manufacturing............... 59 7.8: Average Incremental Capital Output Ratios, 1978-84.... 61 7.9: Import Price Index Developments....................... 62 7.10: Indicators of Energy Use.............................. 63 7.11: Comparative Debt-Equity Ratios (Manufacturing 7.12: Range of Estimates of Key Trade Elasticities.......... 68 7.13: Import Generation Coefficients........................ 70 Table 9.1: Effects of Targetting According to a "Value Added" Table A9.1: Capacity Reductions Under the 1978 Japanese Restructuring Law................................... 95 A9.2: Capacity Reduction Plans Under the 1983 Japanese Restructuring Law................................... 96 Table 11.1: Sources of NIF........................................ 110 10.2: Uses of NIF.......................................... 111 10.3: Interest Rates on Various Loans....................... 112 10.4: Effecti-e Cost of Foreign Loans....................... 113 10.5: Size and Share of Policy Loan by DMB.................. 114 10.6: The Uses of Commercial Banks Net Increase of Deposit (1981)......... ......................... 115 10.7: Access to Borrowings by Each Sector................... 116 10.8: Debt Ratio of Each Sector................o............ 117 10.9: Average Cost if Borrowing by Each Sector.............. 118 10.10: Average Rate of Return on Investment by Each Sector... 119 10.11: Profitability of Each Sector.......................... 120 10.12: Net Sales Growth Rate of Each Sector.................. 121 10.13: Access to Borrowing by Each Industry.................. 122 10.14: Debt Ratio by Each Industry........................... 123 10.15: Average Cost of Borrowing by Each Industry............ 124 10.16: Average Rate of Return on Investment by Each Industry 125 10.17: Profit Ratio of Each Industry......................... 126 10.18: Net Sales Growth Rate of Each Industry................ 127 10.19: Korea............................... 128 10.20: Japan............................. 129 10.21: Bank's Credit Allocation by Industry.................. 130 List of Figures Figure 6.1 Intermediate Input Share in Production............... 6 6.2 Shares of R&D Expenditure inGNP.................... 23 Figure A6.1 Structure of Agriculture and Man*,acturing............ 37 A6.2 Patterns of Development: Heavy industry............. 39 A6.3 Patterns of Development: Light Industry.............. 42 v Page No. List of Boxes Box 6.1 Korea's Industrial Flexibility at the Firm Level,......... 12 Box 7.1 The Determinants of Aggregate Private Investment........... 54 7.2 The Determinants of Curb Market Interest Rates............. 60 7.3 The Determinants of the Real Effective Exchange Rate....... 71 CHAPTER 6: KOREA'S INDUSTRIAL STRUCTURE A. Introduction 6.01 The purpose of this chapter is to briefly review the major changes in industrial structure that have occurred since 1970. Part I examines indus- trial structure per se, utilizing the latest (1983) input-output relationships and analyzes how the economy, especially the manufacturing sector, has changed since 1970. Part II looks specifically at the import substitution phase and attempts to idevtify changes in Korea's industrial structure that emerged from this controversial policy, as well as the linkages between HCI, import depend- ency and export development. In Part III the future structure of Korean industry is reviewed and several policy issues, namely employment, productivity and R&D are identified. Part IV is devoted to the issue of industrial concentration, an issue of rising importance in the Korean context, particularly insofar as conglomerates are concerned. Finally, Appendix 6A examines the Korean experience in the context of the international comparisons of growth framework, while Appendix 68 looks at Korea's historical sources of growth from both the supply and demand perspectives. B. Structural Changes in the Economy Shifts in Production 6.02 The structure of production continued shifting from agriculture to manufacturing throughout the 1970-83 period, regardless of the indicator (output, value added, or employment) of measurement. According to output structure, for example, the share of agriculture declined drastically from 17% in 1970 to 8.3% in 1980, but remained virtually unchanged since then (Table 6.1). On the contrary, the share of manufacturing increased sharply from 40.3% in 1970 to 50.4% in 1975, and maintained that level through 1983. Despite the similarity in the direction of change in production structure measures, the variation in the size of sectoral shares is quite different depending on the indicator chosen. In 1983 agriculture contributed 29.3% of employment and 14.1% of value added, while its share of output was only 8.2%. In contrast, manufacturing captured 50.0% of output in 1983, while it only accounted for 22.2% of employment and 29.5% of value added. Trends in Manufacturing 6.03 Among the manufacturing subsectors, light industry, after gaining marginally between 1970 and 1975, saw its share of total output fall considerably between 1975 and 1983. Heavy industry, on the other hand, saw its share of gross output almost double between 1970 and 1975 and rise significantly again by 1980 (Table 6.2). According to the international comparison of industrial development, reported in Appendix 6A, the share of heavy industry started to increase rapidly in 1973-74, exceeding normal predicted levels. As a result of these contrasting developmets, heavy industry surpassed light industry in its share of total output 5y 1980. Although the shares of all three subsectors (chemicals, primary metals and machinery) in HCI increased between 1970 and 1983, there are some differences - 2 - in their developments between pre- and post-1980 periods. After recording a substantial gain between 1970 and 1980, chemical and chemical pro;ucts and primary metal manufacturing lost ground slightly between 1980 and 1983, while metal products and machinery .Atinued expanding their share3 even after 1980. Table 6.1: STRUCTURAL CHANGE IN PRODUCTION (Percentage shares) Gross output Value added Employment 1970 1975 1980 1983 1970 1975 1980 1983 1970 1975 1980 1983 Agriculture 17.0 12.8 8.3 8.2 25.2 22.7 14.7 14.1 50.2 41.4 32.0 29.3 Mining 1.1 0.9 0.8 0.7 1.7 1.5 1.4 1.1 1.1 1.1 1.1 1.1 Manufacturing 40.3 50.4 51.0 50.0 20.1 26.1 28.2 29.5 12.4 19.2 21.7 22.2 Construction 8.6 6.2 8.0 8.2 6.6 5.2 8.3 8.4 3.7 4.0 5.3 5.6 Social overhead 6.7 6.7 8.1 8.9 8.7 7.5 9.9 11.4 3,8 4.3 4.5 4.9 Services 26.3 23.0 23.8 23.9 37.7 36.9 37.5 35.4 28.7 30.0 35.3 37.0 Source: Bank of Korea, Input-Output Tables. 6.04 A detailed examination of the developments in the metal products and machinery subsector during 1980-83 shows that the increase in the composition share was particularly substantial in general machinery, electrical machinery and transportaion equipment (see Table 6.3). These industries have also provided a significant number of new jobs since 1980 (data) and are expoted to be among the fastest growing industries for future labor absorption, 6.05 Unlike the developments in heavy industry subsectors, the direction of the composition shares among the light industry subsectors was less uni- form. Within light industry, food, beverage and tobacco as well as lumber and wood saw their output share decline continuously throughout the period. Tex- tiles and leather did well in the first half of the 1970s but its share has declined considerably since then, to a point in 1983 where its share of gross output was essentially on par with its 1970 share. The industry continues to 1/ According to KDI estimates, it is expected that the electric and electronics industry will have grown from 10.8% of manufacturing to 14.6% by 1991 and 18.3% by 1996. Smaller but still significant increases are projected for machinery and transport machinery, so that these emerging sectors taken together are expected to increase their combined share of manufactures from 25.3% (1983) to 36.9% (1996). Table 6.2: STRUCTURAL CHANGE IN MANUFACTURING (Percentage shard in total output) Gross output Value added Employment 1970 1975 1980 1983 1970 1975 1980 1983 1970 1975 1980 1983 Light industry 28.4 29.5 24.7 22.1 12.8 14.5 13.7 13.6 9.2 13.5 13.8 13.0 Food, beverages and tobacco 15.9 14.4 10.8 9.6 6.2 6.3 6.2 5.9 2.5 2.8 2.9 3.0 Textiles and leather 7.1 9.9 8.4 7.0 3.8 5.5 4.9 3.9 4.0 7.9 7.4 6.5 Lumber and wood products 1./, 1.2 1.0 0.9 0.7 0.5 0.4 0.4 0.6 0.6 0.7 0.6 Paper printing and publishing 1.4 1.4 1.6 1.8 0.4 1.3 1.1 1.2 0.6 0.8 0.9 1.0 I Nonmetallic metal manufacturing 1.4 1.5 1.9 1.8 1.1 1.3 1.4 1.4 0.6 0.7 0.9 0.9 Miscellaneous manofacturing 1.2 1.1 1.0 1.0 1.0 0.9 0.8 0.8 0.9 0.7 1.1 1.1 Heavy and chemical products 11.9 20.9 26.3 27.9 7.2 11.6 14.5 15.9 3.2 5.7 7.9 9.2 Chemical and chemical products 5.9 10.8 12.6 11.8 4.0 5.9 6.7 6.3 1.2 1.9 2.5 2.7 Primary metal manufacturing 2.0 3.4 5.1 5.0 0.7 1.0 1.7 1.8 0.4 0.5 0.7 0.9 Metal products and machinery 4.0 6.7 8.6 11.2 2.5 4.7 6.1 7.9 1.6 3,3 4.7 5.6 Source: Bank of Korea, Input-Output Tables Table 6.3: SIGNIFICANT CHANGES IN THE METALS AND MACHINERY INDUSTRY (percentage shares in total output) Gross output Value added Employment 1970 1975 1980 1983 1970 1975 1980 1983 1970 1975 1980 1983 Metal products and machinery 4.0 6.7 8.6 11.2 2.5 4.7 6.1 7.9 1.6 3.3 4.7 6.3 Fabricated metal - (0.9) (1.3) (1.7) - (0.5) (0.8) (1.0) (0.4) (0.5) (0.7) (1.2) General machinery - (0.8) (1.4) (2.1) - (0.6) (1.2) (1.5) (0.3) (0.5) (0.8) (1.0) Electrical equipment (2.2) (1.0) (1.2) (1.4) (1.3) (0.7) (0.9) (1.0) (0.2, (0.4) (0.6) (0.7) Electronic and communication equipment (2.0) (2.5) (2.9) - (1.4) (1.7) (1.9) (0.2) (0.9) (1.5) (0.7) Transportation equipment (1.7) (1.9) (1.8) (2.7) (1.1) (1.3) (1.2) (2.2) (0.5) (0.9) (0.8) (1.4) Measuring, medical eqaipment (0.1) (0.3) (0.4) (0.3) (0.08) (0.1) (0.3) (0.2) (0.07) (0.1) (0.3) (0.3) Source: Bank of Korea, Input-Output Tables. - 5 - be important as a source of employment, however, providing the largest share of manufacturing employment, followed by metals aad machinery, which has exhibited the fastest growth in employment since 1970 among subsectors. Light industry's share is expected by Korean planners to continue to decline, in large measures because the share of manufacturing stemming from textiles is projected to decline from 11.0% in 1983 to 8.3% in 1996. This has significant employment implications, as noted in the employment section. Increasing Use of Intermediate Inputs 6.06 Industrialization is usually accompanied by an increase in the use of intermediate inputs in production as measured by the intermediate inputs share. This results from the increasing specialization of economic activity, especially the enlarged share of manufacturing, which uses intermediate goods intensively. The intermediate inputs share in Korea increased continuously from 47.9% in 1960 to 50.42 in 1970, and then to 60.4% in 1980, but it declined slightly to 59.52 in 1983. The rate of increase accelerated in 1970- 80, and it was especially raid between 1970 and 1975, reflecting rapid heavy- chemical industrialization.- A comparative perspective is given in Figure 6.1. Although both Korea and its major competitor experienced a parallel increase in the intermediate inputs share in the 1965-70 period, reflecting the fact that both countries were in the process of rapid industrialization, the rate of increase in Korea between 1970 and 1980 was greater, reflecting its capital-intensive strategy. In contrast to these developments, the intermediate inputs share in Japan declined continuously, probably indicating that Japan was already in the stage where the service sector had started expanding at the cost of manufacturing. 6.07 The increase in the intermediate inputs share indicates deepening of interind ry linkages, an important characteristic of the development process., Historical interindustry linkages in Korea have been much higher than in other developing countries with a similar level of per capita GNP, such as Turkey and Mexico, and much closer to the uttern observed in more developed countries such as Japan (see Table 6.4).- A closer look at the characteristics of interindustry linkages over the 1963-1973 period reveals an important difference between those in Korea and its major competitor on the one hand and those in Japan on the other, however. Although overall linkages in these three countries are comparable, the size of domestic linkages in 2/ The increase in the intermediate inputs share was not affected by oil price increases. The rate of increase in the share of intermediate inputs share in constant prices (51.5% in 1970 and 60% in 1983) is similar to that in current prices. 3/ See, for example, Chenery, Robinson, and Syrquin, Industrialization and Growth: Comparative Study, forthcoming. 4/ Interindustry linkages here are computed as the amount of intermediate inputs (direct and indirect) generated in the process of production in order to meet 100 units of final demand. INTERMEDIATE INPUT SHARE IN PRODUCTION MAJOR COMPETITOR KOREA ECONOMY JAPAN t 62- 60 52 48 46 1S4 1965 t1970 1975 198 itm- YEAR -7- Table 6.4: INTERINDUSTRY LINKAGES (Units of production generated to meet 100 units of final demand) Overall linkages Domestic linkages Korea 1963 89.9 60.9 1970 89.8 58.7 1973 92.8 54.6 Korea /a 1970 97.5 64.9 1975 119.2 72.6 1980 134.4 79.2 1983 133.0 80.3 Major Competitor 1956 76.5 42.6 1961 85.9 55.0 1966 92.9 55.7 1971 93.7 55.2 Turkey 1963 52.1 46.4 1968 56.7 51.5 1973 59.6 52.8 Mexico 1950 54.3 40.5 1960 68.9 51.3 1970 63.9 52.0 1975 69.5 54.2 lapan 1955 89.9 81.3 1960 94.5 82.7 1965 74.6 82.4 1970 106.3 88.7 /a Bank staff estimates based on Korean input-output data. Source: Chenery, Robinson and Syrquin (forthcoming). - 8 - Table 6.5: TOP TEN EXPORTS 1970 1975 1981 1985 1. Textiles and Textiles and Textiles and Textiles and Garments Garments Garments Garments 2. Plywood Electronic Electronic Ships Products Products 3. Wigs Steel Steel Electronic Products Products Products 4. Minerals Plywood Footwear Steel Products 5. Electronic Footwear Ships Footwear Products 6. Fruits and Deep-sea Machinery Machinery Vegetables Fish 7. Footwear Ships Synth. Resin Fish and Products Fish products 8. Tobacco Metal Auto Tires Synth. Resin Products Products 9. Steel Petroleum Metal Automobiles Products Products Products 10. Metal Synth. Resin Plywood Electric Products Products Products Sources: Korea Traders Association, The Trend of Forei&n Trade Bank of Korea, Monthly Statistical Bulletin. - 9 - Korea, for example, which measures interindustry relationships of only domestic goods exclusively, is only about 70% of that in Japan. Furthermore, domestic linkages in Korea are not much different from those in Turkey or Mexico, although Korea's is the only declining trend. These findings indicate that Korea achieved a high level of interindustry linkages (implicitly greater technology interaction) initially through importation of intermediate goods. Using input-output data, an extension of this approach for Korea shows a significant increase in domestic industrial linkages between 1970 and 1980, although these interactions are still smaller than the newly generated international linkages over the period. Changes in Trade Structure 6.08 Changes in Korea's export profile can be seen from a variety of perspectives. A very crude glimpse can be obtained by comparing Korea's top ten export items over time (see Table 6.5). Whereas textiles and garments are still the largest source of foreign exchange, some of the light industrial manufactures, like wigs and plywood, are now moribund, compared with 1970, having been replaced by capital-intensive products like ships and stel. Looking more broadly, the capital-labor ratio for manufactured export3 increased between 1970 and 1983 from 1.6 to 6.3 million won per employee in 1977 prices, while the correspon!ng ratios for import substitutes were 2.1 and 7.5 million won (Table 6.6). Although import substitutes were more capital intensive than exports even in 1983, the gap between them narrowed between 1970 and 1983. A sources decomposition of the changes in capital- labor ratios in exports reveal that about 80% of the increase between 1970 and 1983 is due to the increase in overall capital-labor ratios, and the remaining 20% is due to the shift in the pattern of exports toward more capital intensive products. The findings here seem to indicate that the rapid increase in the capital-labor ratios in the Korean manufacturing exports is attributable not only to rapid capital formation due to active industrializa- tion policies but also to inceotives given to capital intensive exports. Table 6.6: CHANCES IN CAPITAL-LABOR RATIOS Tin million won in 1977 prices) 1970 1975 1980 1983 Domestic output (D) 2.21 3.09 5.76 7.49 Exports (E) 1.61 2.54 5.05 6.32 Import substitutes (MS) 2.10 3.38 5.88 7.46 EMS 0.77 0.75 0.86 0.85 Source: World Bank estimates. 5/ Wontack Hong (1985) finds similar results by computing capital-labor ratios incorporating both direct and indirect factor requirements. In Japan in 1965, production of exports turned more capital intensive compared to the production of import substitutes in Japan. - 10 - 6.09 Comparing the export patterns of Korea and Japan in the 1960s and 1970s, Korea can be seen to be exporting commodities which did not require a high level of human or physical capital intensity while Jpyan exported relatively human and physical capital intensive products.- Aspects of Korea's export structure have been changing rapidly over time, however, as Korean exports have become more physical and human capital intensive very rapidly. As seen in Table 6.7, for example, which reports changes in "revealed comparative advantage," Korea's exports have been experiencing relative declines in traditional industries, such as textiles and cottons, wood products and paper, and basic assembly products. That is not to say that light manufactured exports are generally uncompetitive, as seen by the continued resiliency of clothing, footwear, luggage and cutlery exports. At the same time, Korean comparative advantage has clearly emerged over the last 10 years in shipbuilding, electrical equipment, metal products, and iron and steel - all extentions of the NCI sector. Although costly to establish, these capital-intensive industries h- i now reached the level of international competitiveness, and may legitimately be described as successful infant industries. On the other hand, in some industries, prominantly in the chemicals subsector and in machinery, Korea has yet to establish itself in international markets. 6.10 Korea appears to have made strong progress in shifting its export structure from labor-intensive to capital-intensive and moderately skill- intensive products. An interesting example of the underlying industrial flexibility at the firm level is seen in Box 6.1. More broadly, the initial transition to capital-intensive exports owes its success and speed to the interventions of the 1970s in establishing industries of sufficient scale to be internationally competitive. The 5 fastest growing industries between 1977 and 1981 in Korea's export profile, tellingly, were steel rods, containers (for shipping transport), household electrical equipment, tubes and pipes, and autos. These are industries in which scale and basic technology are important. The next step, to higher-technology intensive and skill-intensive products will be another milestone for Korean exports. 6.11 There is some reason to believe that this second transition will take longer to achieve. Why might this be the case? First, Government, chastened by the difficulties the economy experienced as a result of the HCI experience, is perhaps less likely to attempt another aggressive strategy in establishing skill and technology intensive industries. Second, accumulation of human capital takes longer than physical capital. Third, assuming that the role of the government in investment allocation is diminished in keeping with the financial liberalization goals discussed in Chapter 5, technology invest- ment may not be expected to increase at the rate similar to that achieved for physical investment. 6/ Y.S. Lee, (forthcoming). - 11 - Table 6.7: KOREA'S REVEALED COMPARATIVE ADVANTAGE /a Selected manufacturing items (SITC) 1975 1980 1984 Declining Advantage Textile yarn and thread (651) 1.159 0.996 0.648 Cotton fabrics (652) 0.462 0.219 0.139 Special textiles (655) 0.584 0.483 -0.053 Wood manufacturers (632) 0.462 -0.177 -0.554 Printed matter (892) -0.776 -2.414 -2.570 Sound recorders (891) 0.838 0.103 -0.457 Office supplies (895) 0.876 0.812 -1.467 Comparative Disadvantage Paperboard (641) -1.906 -1.339 -2.654 Cosmetics (553) -3.768 -5.032 -3.798 Paints (533) -3.311 -2.655 -2.155 Agricultural machinery (712) -4.573 -3.811 -4.061 Road vehicles (732) -5.109 -2.907 -2.775 Metalwork machinery (715) -4.213 -1.934 -2.333 Continuing Advantage Clothing (841) 2.103 1.604 1.392 Fur and leather (842) 1.694 1.495 1.384 Footwear (851) 1.514 1.526 1.535 Luggage (831) 2.236 1.738 1.891 Cutlery (696) 1.605 1.439 1.302 Emerging Advantage Ships and boats -0.096 0.916 1.808 Electrical equipment (725) -2.481 -0.807 0.196 Metal products (691) -2.278 0.055 1.044 Iron and steel -0.563 0.316 0.191 /a RCAs are calculated here in natural logarithms. Therefore, a positive RCA implies that Korea's percentage share of a commodity export item compared to world exports of that item exceeds Korean manufacturing's total share in world exports. Source: M. Noland (1985). - 12 - Box 6.1: KOREA'S INDUSTRIAL FLEXIBILITY AT THE FIRM LEVEL In the 1971 the Handok Company was a wig manufacturer, with this one export item accounting for 951 of total sales. By 1976, Handok had diversified extensively, to the point where wigs were only 16% of sales and paper products made up 51% of output, complemented by tuna (22%) and the emergence of a new item, watches (9Z). The industrial transformation was completed by 1981, when watches accounted for 852 of sales. And by 1985, liquid crystal display manufacturing, including monitors and dashboard items for example, were beginning to emerge as new sales items (10% of sales) and the bulk of revenue was due to computers and electronics (41%) and watches (45%). Handok is an example of industrial flexibility in a medium-sized firm employing about 3,500 people and generating sales of about 64 million won in 1984. C. Import Substitution in the HCI Sector Reducing Import Dependency 6.12 It is widely known that the government pursued heavy-chemical industry (HCI) promotion policies through various means. Fiscal and financial policies were generously applied in the mid to late 1970s, while import pro- tection policies in the form of quantitative restrictions and tariff protec- tion, were also increased during the period. This section examines how effec- tive the BCI promotion policies were in reducing the import dependency of the heavy and chemical industries. Table 6.8 indicates that import substitution took place at a rapid rate throughtout 1970-83 in virtually all the subsectors in the heavy-chemical industry as shown by a substantial decline in the import dependency of demand, defined as the share of imports in total demand (i.e., intermediate and final demand). In particular, the rate of import substitu- tion was remarkably high in the primary metal manufacturing, and metal products and machinery industries. 6.13 Turning to import dependency in production, defined as the share of imported intermediate inputs in total inputs including value added, one finds that the reliance on imported intermediate inputs in the production of heavy- chemical products increased between 1970 and 1975, but has been declining slowly and continuously since then. The direction and the magnitude of the changes in the degree of import dependency was not uniform among the subsec- tors, however. In primary metal manufacturing the import dependency declined substantially throughout the period, while in metal products and machinery it increased slightly between 1970 and 1975 before beginning a steady decline from 1975 to 1983. In contrast, the import dependency in chemicals increased continuously throughout 1970-83 probably attributable to the rising price of oil. The decline in import dependency in primary metal and metal products and machinery is directly attributable to import substitution in these industries inasmuch as these industries acquired the capacity to produce more of their own inputs. - 13 - Table 6.81 IMPORT DEPENDENCY IN TIE HEAVT-CHEICAL INDUSTRY /a Demand Production 1970 1975 1980 1983 1970 1975 1980 198 Beavy and chemical industry 37.1 29.5 23.7 22.1 29.1 33.7 31.1 29.1 Chemical and chemical products 23.8 19.6 15.0 16.5 30.5 40.1 42.2 44.0 Primary metal manufacturing 35.3 27.6 18.9 17.0 36.0 30.1 20.2 17.6 Metal products and machinery 50.6 41.7 35.8 29.1 23.6 25.3 21.1 18.5 Light industry 8.0 8.1 7.2 7.7 12.3 13.8 13.7 13.4 All industry 11.3 14.6 14.8 13.9 8.6 12.8 14.2 13.5 /a Import dependency in demand is computed as inputs/total demand (final and interme- diate demand), and import dependency in production as imported intermediate inputs/ total imports including value added. Source: Bank of Korea, Input-Output Tables. 6.14 So far the degree of dependency has been examined by considering only direct requirements of imported intermediate in t1te production. Import dependency can also be measured by considering indirect requirements which would arise from interindustry linkages. Table 6.9 shows the amount of direct and indirect imports required to produce one unit of output. The import requirement for heavy and chemical industry declined slightly in 1980-83, but compared to light industry the production of HCI products requires a signifi- cantly higher amount (about 152 in 1983) of imports. Despite the fact that the import dependency in HCI has been declining rapidly, its reliance on imported inputs is ytill significantly higher than that of the heavy-chemical industry in Japan.- One might expect the import dependency to continue to decline in the future as HCI continues to gain in efficiency, but such a development will have to continue in the context of import liberalization and thus be subject to the yardstick of international efficiency. According to the import liberalization schedule, almost total elimination of restrictions will occur for metal products and iron and steel products by 1987 and for electronics, electrical and non-electrical machines by 1988. This means that continued import substitution will have to be efficient by international standards. 71 The import share in heavy-chemical industry in Japan was 4.3% in 1983. It is not only heavy-chemical industry that has high import dependency in the Korean economy. According to Chenery, Robinson and Syrquin (1986), Korean import requirements in production are much higher than other countries. - 14 - Table 6.9: DIRECT AND INDIRECT IMPORT REQUIREMENTS IN PRODUCTION (M) (percent) 1975 1980 1983 Heavy and chemical industry 48.7 49.0 45.8 Basic chemicals 47.4 53.6 48.4 Petroleum products 71.3 80.7 81.0 Primary iron and steel products 58.9 49.1 43.5 Fabricated metal products 44.4 40.1 36.7 General industrial machinery and equipment 35.0 35.1 35.3 Electronic and communication equipment 49.4 44.6 43.1 Transportation equipment 41.8 42.4 34.6 Light industry 26.4 30.0 28.7 Source: Bank of Korea, Quarterly Economic Review, December 1985. Foreign Markets for Heavy-Chemical Products 6.15 The share of HCI output sold abroad (the export ratio) increased substantially from 7.4% in 1970 to 22.7% in 1983; a large increase of almost 10 percentage points took place between 1970 and 1975 (Table 6.10). All three subsectors (chemicals, primary metal and machinery) contributed to this rapid increase, but the magnitude of the contribution ppears to have been especially high in metal products and machinery.-I Despite the rapid growth in the early 1970s, the rate of increase in the export ratio slowed down in all three subsectors after 1975. In 1983, the export ratios in chemicals, primary metal and machinery were 12.1%, 20.1Z and 35.12, respectively. Relatively low export ratios in chemicals and primary metal manufacturing seem to be due to the fact that they are intermediate goods used domestically for 8/ Within metal products and machinery, transportation (mainly ships) appears to have contributed most to the rapid increase in the export ratio between 1970 and 1975. - 15 - the production of metal9Y roducts and machinery, more than one-third of which is ultimately exported.- Among the machinery subsectors, the ratios in electronic and communications equipments and transportation equipments were especially high at 47.1% and 46.32, respectively, in 1983. These ratios are slightly higher than the ratio observed in textiles and leather, and it is only slightly lower than the ratio for miscellaneous manufacturing such as toys, sporting goods and wigs. Table 6.10: CHANCES IN EXPORT RATIOS (percent) 1970 1975 1980 1983 Heavy and chemical industry 7.4 17.2 19.3 22.7 Chemical and chemical products 6.2 10.5 10.4 12.1 Primary metal manufacturing 5.5 14.5 20.9 20.1 Metal products and machinery 10.0 29.1 31.6 35.1 Light industry 11.9 19.2 19.0 19.2 Textiles and leather 25.8 .c.4 37.7 44.1 Miscellaneous manufacturing 54.1 58.6 53.4 53.6 Source: Bank of Korea, Input-Output Tables. 6.16 These results mirror those of the demand side sources of growth decomposition reported in Appendix 68, which indicates that export expansion provided the most significant impetus to output growth not only for light industry but also for heavy and chemical industry in the 1970-83 period. Moreover, the contribution of export expansion to output growth in HCI accel- erated over time -- from 35.9% in 1970-75 to 41.3% in 1975-80, and then to 54.1% in 1980-83. Export incentives through financial and trade policies played an important role in the rapid expansion in the 1970s, while the depre- ciation of won provided an additional incentive ia the 1980q. Observing a continuous increase in the magnitude of the export contribution to output growth leads to the query whether such a trend can continue in the future or 9/ The indirect export ratios (outputs used as intermediate inputs in the production of exports) would be significantly higher than the direct export ratios for chemicals and primary metals. This can be seen by comparing the contribution of export expansion in the demand sources calculation between direct and total measures. In chemicals and primary metals the contribution computed by the total measure is significantly larger than that computed by the direct measure. - 16 - whether domestic demand must at some point take on larger significance. The issue needs to be addressed in the context of the year 2000 projections. Overview 6.17 This section has viewed the HCI episode from the trade perspective, namely, how was import dependency affected and how export-intensive was OCI production. The rationale is that Korea as a small, very open economy is unlikely to pursue an industrial strategy without an ultimate export aim. Thus, to merely characterize the HCI period as a classic import substitution experiment is incorrect. There is no doubt that the large-scale investments in HCI were distortionary of capital market (see Chapter 4) and onomically costly in the medium-run, as seen by Table 6.11 on utilization.-, Yet, the policy was unique in o;her respects. First, while its aim was to establish Korean capacity in some "Y ic industries, the investment program itself was fairly import-intensive. Second, the HCI sector did manage to export, indicative either of its ability to compete international.y or reflective of heavy subsidization on the capital side. Export ratios, seen in Table 6.10, show that all J ee subsectors had already experienced considerable export gains by 1975 Although further gains have been uneven, the sector as a whole now exports directly almost 23% of its production, more than the comparable figure for light industry. Moreover, while the direct import dependency of HCI production has fallen since 1975 (in subsectors other than chemicals), Korea's overall import requirements are still quite high, and attest to it being highly integrated with the global economy. 10/ The problem of underutilized capacity was especially acute in some subsectors, like fabricated metals and machinery, which were characterized by capacity utilization rates of 55-65% during 1976-79, considerably below the average in manufacturing as a whole. 11/ This helps to explain the finding in Technical Appendix 5B on the sources of industrial growth that NCI growth appears to have been fueled primarily by export expansion and relatively modestly by import substitution factors. 12/ This finding is supportive of the evidence presented in Technical Appendix 4A, which indicates on the basis of international norms that Korea's big surge in pushing HCI above the pattern expected occurred between 1970 and 1974. * 17 - Table 6.11: CAPACITY UTTLIZATION BY INDUSTRIAL CLASSIFICATION (2) (percent) 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 Manufacturing 78.9 81.7 88.3 82.1 69.5 70.3 69.4 75.8 80.4 79.2 Light industry Food and beverages 62.4 75.8 85.6 82.4 69.3 64.3 64.9 75.4 73.8 73.0 Textiles and leather 87.5 85.9 84.8 82.1 80.1 80.9 80.2 19.0 78.9 76.7 Wood products 84.6 94.4 99.0 84.6 61.0 39.9 46.6 54.4 51.4 55.4 Paper products 72.8 80.8 88.4 85,1 75.4 74.8 72.5 76.4 82.1 79.5 Nonmetallic mineral products 81.9 88.2 87.3 77.9 63.6 61.1 68.3 77.6 78.4 72.6 Reavy industry Chemical products 91.9 98.1 110.4 95.4 80.3 76.0 70.9 75.4 78.5 79.6 Basic metal 78.6 81.1 88.1 81.0 71.3 71.2 74.7 83.8 87.3 88.9 Fabricated metal products, machinery 61.0 57.1 61.7 62.6 53.1 61.0 60.0 67.9 77.9 75.5 Note: Seasonally adjusted figures. Source: Ministry of Trade and Industry D. Future Structural Issues Future Projectione 6.18 Before closing the section on the patterns of change in economic structure, let us examine briefly how the Korean government projects its production structure to evolve in the future. Projections ave examined at two different levels: one covering the entire economy, the other covering only - 18 - the manufacturing sector.131 Table 6,12 reports KDI projections for production structure of CDP in years 1990 and 2 W, as well as the corresponding Japanese shares in 1966 and 1982.- The projected pattern reveals a decline in agriculture's share and offsetting increases in the other three sectors. Despite the continuing increase in the manufacturing share through the year 2000, it should be noted that in Japan, the manufacturing share peaked around 1970, when per capita GNP in 1984 US dollars was 7700, and the share of the service sector began to expand. The major policy implication of these projections is the sharp drop in the size of the agricultural sector, which currently accounts for 30% of national employment. A conservative implication of these projections, ignoring technical progress, is that employ- ment in the agricultural sector might fall to half its present share by the year 2000. This raises a clear issue of labor absorption in the nonagricultural sector. 6.19 Table 6.13 shows the projections of the manufacturing structure for years 1990 and 2000, along with the corresponding employment projections. According to KIET estimates, output will continue to shift frg light manufac- turing to heavy manufacturing between 1983 and the year 2000.-, The output composition within heavy manufacturing is expected to change drastically, however. The sectors projected to gain shares are machinery, electronics, automobile and industrial chemicals, while the sectors projected to lose shares are shipbuilding, petrochemicals, petroleum refinery, and iron and steel. Employment shares reflect these anticipated output shifts quite strongly, with the share of employment provided by electronics almost doubling, and by autos more than doubling, while textiles falls by 70% over the period. 13/ This two level approach was necessary because the two sets of projections have been provided by two different institutes. The Korea Development Institute (KDI) published the projections of overall economic structure in Long-term Development Plan for the Year 2000 in September 1985 by incorporating the projections on the manufacturing sector by the Korea Institute for Economics and Technology (KIET). Since then KIET revised the earlier projections and published new projections in October 1985 (Projections of manufacturing structure and development strategy toward 2000). For this reason, the KDI projections are used for the overall economy and the revised KIET projections are used for manufacturing. 14/ Per capita CHP for Japan in 1966 in 1984 US dollars was 5249.5, close to the projected level of 5,016 US dollars in 1984 prices for Korea in 2000. 15/ The KDI projections assume 32 and 6% annual growth rates in the world economy and in world trade (in constant prices), respectively, and 7.4% and 6.1% in annual real GNP and real per capita CUP growth, respectively, between 1985 and 2000. As a result, GNP and per capita CNP in the year 2000 are expected to be $252 billion and $5,103, respectively (in 1984 prices). - 19 - Table 6.12t GDP PROJECTIONS (percentages based on current prices) Korea Japan 1984 1990 2000 1966 1982 Shares of CDP Agriculture, forestry, fishing 14.0 11.0 7.5 8.8 3.5 Mining and manufacturing 30.4 31.9 33.0 33.5 30.3 Social overhead 18.6 19.2 19.2 16.9 18.5 Services 37.0 37.9 40.4 40.8 47.7 Total GDP 100.0 100.0 100.0 100.0 100.0 Memo Items: GDP in 1984 billion US Dollars 81.1 112.0 248.0 523.8 1,395.8 Per capita GDP iu 1984 US Dollars 1,999 2,542 5,016 5,249 11,785 Source: Korea: Long-Term Development Plan for the Year 2000 (in Korean), Korea Development Institute, 1985. Japan: Yearbook of National Income Accounts Statistics, UN. These projections are based on the assumption that the Korean economy will gain a comparative advantage first in capital intensive goods and then in skill intensive goods. This pattern mirrors quite closely the production and export patterns of Japan, which between 1965 and 1981 was transformed 17om a physical capital-intensive exporter to a human-capital intensive one.,- The major differences to be kept in mind, however, are the relative disparities in domestic market size as well as the changing environment for international trade. Neither the domestic nor the external base conditions facing Japan in the 1960s and 1970s is now operative for Korea. Therefore, the implications of the significant industrial transformation being planned merit further examination. 16/ See Noland (1985). - 20 - Table 6.13t COMPARISON OF OUTPUT STRUCTURES IN KOREA AND JAPAN (percent) Employment Output 1983 2000 1965 1983 Machinery 10.4 12.1 12.2 14.3 Electronics 8.2 15.4 9.5 18.0 Automobile 3.6 8.6 2.7 6.3 Shipbuilding 4.3 3.3 3.3 2.6 Petrochemical 3.2 2.6 } } ) } Industrial chemicals 3.4 4.6 } 4.6 ) 3.1 ) } Petroleum refining 9.9 3.8 } ) Iron and steel 7.6 6.2 3.3 2.7 Textiles (excl. garments) 13.9 8.3 17.3 10.2 Food 10.9 7.0 6.7 4.3 Other manufacturing 24.6 28.1 40.4 38.5 Total Manufacturing 100.0 100.0 100.0 100.0 Source: KIST: Projections of Manufacturing Structure and Development Stra- tegy Toward 2000, 1985. 6.20 Three basic issues can be identified as being of critical importance as Korea attempts this major industrial transformation. The first relates to employment and concerns not only the overall rate of job creation but also the skill mix requirements. The second issue relates to productivity, particu- larly total factor productivity, since at some point limitations on further very high rates of increase in the savings rate must be anticipated, and combined with natural limits on labor growth, greater productivity must be squeezed out of Korea's factor inputs. And third, technology will need to be upgraded if Korea is to compete in new industries, and thus a major focus on productive R&D investments is to be anticipated. - 21 - Employment Issues 6.21 Employment is already a serious concern to policymakers, as prospects for higher unemployment rates among white-collar workers rise and labor displacement occurs in both structurally declining industries (such as overseas const tion) and cyclical depressed industries (such as shipbuilding)' The employment issue is widely expected to become more prominent as: (i) the employment elasticity with respect to output has fallen from an estimated 0.45-0.50 in the 1970s to about 0.25 in the early 1980s, where it is expected to remain; (ii) significant labor displacement in agriculture is expected; and (iii) the skill mix requirements will change substantially as employment opportunities shift fir the low-skill to high- skill jobs as a consequence of industrial change, 6.22 With respect to overall job creation, capital for labor substitution can only proceed so far; however, the increases in employment will occur in skilled areas and in the service sector. Investments in human capital will take on greater importance as the overall technology level of the economy increases. The rural employment problem may prove less tractable, as the rural population may be older, less mobile and less trainable. Government has already given priority to the location of industry, including agro-industry, in rural areas. And with respect to the labor mix, the three industries pro- jected to grow fastest between now and 1996 (vis, electronics, machinery and autos) will increase their share of the current manufacturing work force and will in generall 4 requiring higher skill levels than do the light manufactur- ing industries.- This brings the area of retraining to light, in which public sector initiatives would be helpful. It also serves to illustrate the potential additional benefits of SMI promotion policies, as smaller firms are more employment-intensive, and the electronics, auto, and machinery components industries are quite suitable for SMIs in terms of subcontracting. Productivity Issues 6.23 One key for achieving the industrial objectives reflected in the out-year projections is productivity. Total factor productivity (TFP) calcu- lations, as reported in Appendix B of this chapter, show clear drops in TFP 171 See KDI, "Long-Range Prospects for Manpower Supply and Demand and Policy Tasks," December 1985. 18/ A recent KDI study on manpower policy indicates that projected annual output growth rates for the 1983-96 period will be highest for the electronics industry (12.7%), followed by the machinery industry (10.5%), and transport equipment (9.4%). 191 KDI and KIET resources. - 22 - during the 1970s in Korea.2' It is the microeconomic level where TFP lapses must be attacked. Government's actions to reduce economic rents and increase domestic competition, through import liberalization for instance, are useful to increase the incentives to innovate and cut costs at the firm level. A second area of importance in reviving TFP is in the area of so-called know- ledge factors. InOeed, it is this factor in particular which according to the sources of growth decomposition in Appendix B has performed poorly in recent years in Korea. And this is precisely the factor of production which must be boosted if Korea is to apply scientific technology effectively. Whereas past industrial transformation have been based on superior labor productivity, organizational skills and the like, the current shift being attempted will rely on application of technology and human skills. In that respect R&D and manpower training policies will take on far greater significance than in the past. R&D Policy 6.24 It can perhaps be said that no area of industrial policy commands greater importance in the eyes of Korean policymakers than R&D policy. R&D investment has increased substantially in recent years, increasing almost fivefold between 1980 and 1984 to W 958 billion in 1984, or 1.46% of GNP. This is still low compared to the OECD countries (see Figure 6.2) but is among the highest for industrializing counties. The mix of funding has shifted from almost entirely public expenditures to rough parity in 1980 and now to a one- quarter/three-quarter sharing with the private sector. This is important because the private sector must ultimately adapt and use technology. While Korea still lags far behind in the basic sciences, and in the production of scieMsts, it is making great strides in reducing the science and technology gap. Government recognizes the importance of R&D investments, for example, and is aiming to reach 2% of GNP by this year, which would be a doubling since 1983. The challenge, of course, is to successfully apply the new technol- ogies, to adapt foreign technology successfully, and to develop sufficient indigenous capacity to be able to interac 2yuccessfully with the major new technology producers in Japan and the US.- Data from Table 6.14 reveals the extent to which Korea has begun to rival Japan and the US in R&D expenditures. 20/ According to KDI estimates, Korea's annual growth rate of TFP fell to less than 1% during 1970-77 from 3.1% in 1960-69 compared to 4.2% for Japan, 5.7% for Germany, and 2.3% for the U.S. Korea Exchange Bank, 1985. 21/ See Science and Technology Policy in Korea (Ministry of Science and Technology, 1985) and W.Y. Lee (1984) for details. 22/ Is is known, for example, in the semi-conductor field, as reported in the case study on electronics (Volume III of this report), that technology is more likely to be licensed among technological equals. - 23 - Shares of R&D Expenditure in GNP (%) e z0g Fed. Re. Germany (G6) 2.42.3 lansU. S. 2.1 Japan u6s' France 8 1.• l o 1 w s 1.13 1.73 L 1.73 iJ.*1.63 1.6 1..5 106 1.0u Korea 0. 0..o1 .2-!. 0.5 00.42 0%.-420.9 &.29 '70 '71 '72 1t '14 ' '76 'TI •?S •il '0 'SI •83 '8n Science and Technology Yearbook, 1984, MOST Figure 6.2 - 24 - Table 6.143 COMPARATIVE R&D EXPENDITURETO-SALES RATIOS Industry Korea Japan US (1984) (1983) (1984) Industry average 1.01 2.03 2.88 Manufacturing 1.27 2.31 2.84 Food 0.65 0.70 0.87 Textiles 0.82 0.90 0.81 Pulp and paper 0.56 0.55 0.98 Chemicals 0.71 1.96 1.94 Petrochemicals 0.31 0.49 0.91 Nonferrous metals 0.99 1.82 2.44 Machinery 2.25 3.38 4.27 General 1.45 2.57 3.53 Electrical 3.51 4.70 5.19 Transportation 1.21 2.66 3.61 Precision 3.07 4.02 5.98 Others 1.38 1.40 2.58 Source: Korea Industrial Research Institute (KIRI). 6.25 On an industry-specific basis, as can be seen in Table 6.15, very substantial R&D rates as a percentage of sales are taking place in the machinery, plastics, transportation and other chemicals areas. These are clearly the industries targetted for rapid growth in Korea's long-term development plan. E. The Issue of Industrial Organization Introduction 6.26 During the 1970s and the early 1980s the output structure shifted from primary to non-primary sectors, and from light manufacturing to heavy manufacturing. These changes were accompanied by a deepening of capital-labor as well as intermediate input ratios. The purpose of this section is to examine the structure of production in the manufacturing sector from the view- point of industrial organization. The first issue examined is how the size of establishments changed during the 1970s, an aspect of considerable importance in shedding light on the effect of industrialization on the structure of pro- duction, and the second relates to how these changes in organizational struc- ture were associated with the changes in the market power of firms and on - 25 - Table 6.15t MANUFACTURING FIRMS$ R&D R&D Expenditure-to-sales ratio Industries 1977 1980 1983 Food 0.34 0.36 0.70 Textile and clothing 0.48 0.53 0.73 Wood products ) 0.36 0.34 0.66 Pulp and paper ) 0.65 Industrial chemicals ) 0.58 ) Other chemicals ) 1.62 } Petroleum refining } 0.08 } Rubber products 0.78 0.26 0.98 }(0.56) Plastic products and } ) miscellaneous ) 1.74 } Ceramics 1.45 0.52 0.77 Iron and steel 0 } 0.28 } Nonferrous meatls } 0.52 } 0.18 } 0.55 } (0.43) Fabricated metals } 0.54 ) (0.33) 0.93 ) Electrical machinery 2.70 1.90 3.01 Machinery ) 1.23 ) 2.00 } Transport equipment } 0.99 0.62 } (0.78) 1.48 ) (1.63) Precision machinery } 1.64 } 1.28 } Other manufacturing 2.68 0.16 1.30 Total 0.95 0.50 0.80 Source: MOST, Science and Technology Annual. allocative efficiency in the manufacturing sector.31 A preliminary assessment of allocative and technical efficiency is possible by extending the coverage from the firm level to the group or conglomerates level. Changes in Establishment Size 6.27 Interesting differences are observed in the average size of establishment between the 1973-78 and 1978-83 periods. In terms of employment, for example, the average number of employees per establishment increased from 49.7 in 1973 to 71.8 in 1978, and then declined to 56.4 in 1983. The large increase in the average number of employees per establishment between 1973 and 23/ The distinction between the size measured by establishments and by firms is important, because the former pertains to the production unit while the latter pertains to the marketing unit. Usually there is no one to one correspondence between them because a firm often operates multiple establishments. - 26 - 1978 had two primary causes. First, the number of establishments employing more than 50 employees increased significantly, as is indicated by an increase in its share from 14.1% to 21.8% (Table 6.16). Second, the average size of large establishments (those with 300 or more employees) increased rapidly from 883.4 employees per establishment in 1973 to 984.2 in 1978. The decline in the average size in 1978-83 was mainly attributable to a rapid increase in the number of small establishments. These patterns mirror official policy towards industry fairly closely insofar as the HCI promotions in the 1970s was accom- panied by a shift in the size distribution of establishments to larger firms, and the more recent policy of promoting SNIs in the early 1980s has led to an expansion of the number of small establishments. Using 1983 data, however, two-thirds of output and almost half of manufacturing employment stems from large firms. 6.28 There are clear disparities among industries. Broadly speaking, the nine KSIC 2-digit manufacturing sectors can be classified into three groups according to the importance of large relative to small and medium establish- ments. The share of large establishments is highest in chemicals, primary metal and metal manufacturing, the BCI sector which is characterized by scale economies, while the share of large establishments is lowest in lumber and wood products, paper and publishing, nonmetallic mineral products, and miscel- laneous manufacturing. The remaining two sectors, food, beverages and tobacco, and textiles and leather are intermediate in size. This disparity in the size of establishment is translated into some differences between heavy and light industry with respect to the concentration of output and employment. In HCI, for example, about 22 of the establishments (essentially 400 produc- tion units) account for 712 of output and 51% of employment in the sector. Again using 1983 data, comparable figures for light manufacturing show that 2.2% of establishments (about 550 producers) account for 552 of output and 40% of employment. (Figure 6.2 shows the degree of concentration.) 6.29 Compared to the Japanese production structure, the share of large establishments in terms of production activities appears much greater in Korea (see Table 6.17). Although the proportion of large establishments in Korea is less than in Japan, the importance of large establishments in production activities is much greater in Korea. This concentration is important in at least two senses. First it may increase the economy's vulnerability to shocks, insofar as employment in particular is concerned. Second, it demon- strates the extent to which Government may find its hands tied in trying to redirect credit to SMIs while at the same time pusuring ambitious growth objectives, which necessitate strong performances from large production units. The concentration takes on even greater significance in the Korean setting when examined at the firm rather than establishment level because of the high degree of integrated ownership. Table 6.16: VARIOUS MANUFACTURING PRODUCTION INDICATORS By FIRM SIZE Size by No. of establishments No. of employees /a Gross output /b Value Added /b (employees) 1973 1978 1983 1973 1978 1983 1973 1978 1983 1973 1978 1983 5 - 49 20,002 23,328 31,750 236.6 351.0 491.7 363.7 1,907.2 5,793.4 140.3 814.3 2,348.0 (85.9) (78.1) (80.9) (20.4) (16.6) (22.2) (9.8) (9.0) (9.6) (10.2) (9.9) (11.2) 50 - 99 1,390 2,818 3,713 97.4 198.0 258.9 247.6 1,441.2 4,524.5 93.2 583.4 1,605.4 (6.0) (9.4) (9.5) (8.4) (9.4) (11.7) (6.7) (6.8) (7.5) (6.8) (7.1) (7.7) 100 - 299 1,201 2,581 2,750 205.4 444.0 463.1 642.9 3,511.6 10,713.3 235.8 1,461.3 3,814.4 (5.2) (8.6) (7.0) (17.7) (11.0) (20.9) (17.4) (16.6) (17.7) (17.1) (17.8) (18.2) 300 > 700 1,137 1,030 618.4 11 0 0 1,001.5 2,441.0 14,299.5 39,514.5 910.6 5,333.4 13,143.5 (3.0) (3.8) (2.6) (53.4) (53 1) (45.2) (66.1) (67.6) (65.3 (66.0) (65.1) (62.9) Total 23,293 291864 39,243 1,157.8 2,111.9 2,215.2 3,695.2 21,150.5 60,545.7 1,380.08 8,192.4 20,911.4 /a JO employees. /b Billion won. /c Percentage shares are shown in parenthesis. Source: Major Statistics of Small and Medium Industries 1984, Small and Medium Industry Promotion Corporation. Report on Industrial Census. 1983, EPB. - 28 - Table 6.17: ESTABLISHMENTS BY SIZE IN KOREA AND JAPANs 1982 (W) Z of Z of Z of establishments employees Value added Korea Japan Korea Japan Korea Japan 4 - 99 93.0 96.7 35.6 55.5 19.6 38.6 100 - 299 5.1 2.5 20.4 16.4 18.1 17.3 300 1.9 4.8 44.0 28.1 62.3 44.1 Source: Small and Medium Industry Promotion Corporation, Major Statistics of Small and Medium Industries, 1984. Economic Planning Board, Report on Industrial Census, 1983, Vols. I and II. Firm Concentration in Manufacturing 6.30 Firm concentration can be measured as either market or aggregate concentration: market concentration is usually measured as the sales share of largest 3-5 firms in a single market, while aggregate concentration is usually defined as the share of largest 50 or 100 firms in manufacturing sales across markets. The former measure is of interest to Korean policymakers because it measures the degree of market power exercised by a few firms and is thus a public policy concern insofar as protection for consumers is concerned. On the basis of Table 6.18 which compares average "3-firm concentration ratios" for Korea, Japan and a major competitor economy, one can conclude that the market structure in Korea is the most concentrated. In a different vein, since aggregate concentration reflects the extent of total manufacturing activities controlled by a small number of firms irrespective of the nature of operation, it indicates the extent to which the economy is controlled by the jaebol, Korean conglomerates. Table 6.18: AVERACE 3 FIRM CONCENTRATION RATIOS All sectors Korea (1981) /a 62.0 Japan (1980) 7- 56.3 Major Competitor Economy (1981) /c 49.2 /a C.H. Yoon and K. Lee (1985). 7- A. Senoo (1983). 7- T.C. Chou (1985). - 29 - 6.31 The pattern of market structure measured by industrial concentration ratios in Korean manufacturing changed over the course of the 1970-82 period; namely, between 1970 and 1977 in terms of both the number of commodities and the sales value, the share of industries characterized as monopolies increased, while between 1977 and 1982 the importance of oligopoly industries increased markedly, as seen in Table 6.19. The increase in the share of monopoly industries in 1970-77 is probably attributable to the early phase of OCI promotion and a lack of enforcnment of any anti-trust actions. Although a decline in the importance of monopolies in 1977-81 is a favorable development, policymakers have tG be concerned with a simultaneous decline in the import- ance of the con-petitive sales market. The rise of oligopolies in particular points to the prevalence of industrial groups tending to establish dominant positions in a variety of industries, so that conglomerate level concentration is probably even higher than that reflected in firm level data. 6.32 Table 6.20 shows the aggregate concentration for Korea, Japan and a major competitor economy. The shares of sales captured by largest firms in Korea are much higher than in Japan or in the other economy; in 1982, for example, the largest 50 and 100 firms in Korea controlled 37.5 and 46.8% of total manufacturing sales, respectively. In contrast, in a major competitor, corresponding shares were as low as 16.4 and 21.9%, respectively in 1980. Moreover, the aggregate concentration ratio in Korea has been increasing slowly but continously, while the ratios in Japan and the other economy have been essentially declining. The underlying cause may well have been government policy in the area of industrial finance. Historically, public policy has rewarded fast-growing firms with preferential access to credit and industrial survivors have been tapped for expansion. This nurturing of large firms continued during the HCI period and is evident in the bias in industrial finance towards large firms, noted in Chapter 4. The Korean industrial scene is now clearly dominated by very large groups, the jaebol. Rising Influence of Conglomerates 6.33 Market power was analyzed at the firm level in the previous sections. But this may underestimate the extent of market power exercised in the Korean economy because a substantial number of big firms are controlled by a small number of conglomerates. The importance of conglomerates in the Korean manufacturing sector is seen in Table 6.21. Moreover, conglomerates grew substantially faster than the non-conglomerates as shown by a rapid increase in their sales share, tightening their grip on total manufacturing. The expansion of conglomerates in the 1970s mainly took the form of establish- ment of new companies rather than acquisition of other companies, while in the 1980s the number o 4 ompanies belonging to conglomerates declined through mergers and sales Thus the size of Korean conglomerates is very large compared to firms in other developing countries is attested to, for example, by the fact that 10 Korean conglomerates are listed among 27 developing 24/ The average number of firms in the conglomerates increased rapidly from 4.2 in 1970 tr 14.3 in 1979, but then it declined slightly to 13.4 in 1982. See K.U. Lee and J.H. Lee (1985). - 30 - Table 6.19: MARET STRUCTURE OF KOREAN MANUFACTURING (2) 1970 1974 1977 1982 Itonopoly /a Commodities 29.6 30.8 31.6 23.6 Sales 8.7 12.7 16.3 11.4 Commodities 18.7 17.9 20.1 11.1 Sales 16.3 12.6 11.0 6.6 Oligopoly /c Commodities 33,2 34.2 32.0 47.4 Sales 35.1 38.6 33.9 50.6 Total Noncompetitive Commodities 81.5 82.8 83.7 82.1 Sales 61.1 63.9 61.2 68.6 Competitive /d Commodities 18.5 17.2 16.3 17.9 Sales 39.9 36.1 38.8 31.4 /a Firm concentration exceeds 80%. /b Firms produce more than 80%. /c Top three firms produce more than 60%. Source: Yoon and Lee (1985), and Lee (1985). - 31 - Table 6.20: SRARES OF LARGEST 50 AND 100 FIRMS IN MANUFACTURING (Z) Korea Japan MaLor Competitor Economy 50 100 50 100 - 50 - -- 100 1970 30.3 40.6 1972 32.9 43.6 1973 1974 16.9 (20.3) 23.4 (28.1) 1975 28.4 15.8 (19.3) 21.7 (26.4) 1977 35.0 44.9 15.2 (18.1) 22.4 (26.8) 1980 27.3 16.4 (20.4) 21.9 (27.4) 1982 37.5 46.8 Note: For the Competitor Economy, the figures in parentheses indicate the shares of total private manufacturing. Sources: C. H. Yoon and K. U. Lee, (1985), A. Senoo (1983), T. C. Chou (1985). - 32 - country firms in the "Fortune 500" list of the largest non-US industrial com- panies. However, the size of individual firms in Korean manufactu lo is still substantially smaller than those in the developed countries, 6.34 Whereas Government clearly sees advantages in terms of improved international competitiveness in having large, integrated firms, it also is concerned about conglomerate control over financial resources, and has as a result administratively decreed that one-third of banking sector credit be reserved for small and medium firms. This approach may also aim at eventually diluting the power of conglomerates, which, while initially needed to promote Korean exports (i.e., the general trading company concept), have now taken on a life of their own despite the existence of a much enlarged entrepreneurial pool. Contrary to Japan, subcontracting relationships have never really developed in the Korean context, and aggressive forms of vertical integration, as well as horizontal reaching into other product lines has characterized jaebol behavior. 6.35 The jaebol tend to be thinly capitalized, and engage in cut-throat competition, especially when confronted with excess capacity, e.g., the HCI years. More recently, this problem re-emerged in the case of declining indus- tries, such as overseas construction and shipping. Vigorous competition may be seen as adding efficiency and dynamism to the economy, but it also adds additional risk if that competition is conducted under a public umbrella of financial protection. Contrary once again to the case of Japanese business groups (Zaibatsu), which are often reputed to add to the economy's resiliency by internally shifting employment from declining to expanding sectors, Korean firms offer no such implicit employment insurance. An important corollary issue concerns the efficiency of very large economic units. Table 6.21: CONGLOMERATES SHARE IN MANUFACTURING (%) Sales Employment Conglomerates 1978 1980 1982 1978 1980 1982 Top 5 15.7 16.9 22.6 9.5 9.1 8.4 10 21.1 23.8 30.2 13.9 12.8 12.2 20 29.3 31.4 36.6 18.2 17.9 16.0 30 34.1 36.0 40.7 22.2 22.4 18.6 Source: Y.K. Lee (1985). 25/ See Y.K. Lee (1985). - 33 - Concentration and Efficiency 6.36 In examining the production and market structure of Korean manufacturing, one may conclude that heavy-chemical industrialization in the 1970s was associated with an increase in the size of production units (estab- lishment size), an increase in market as well as aggregate concentration, and an increase in the size of conglomerates. Unlike the uniform increases in these measures in the 1970s, their development in the 1980s has been more diverse: the size of establishments and market-concentration declined, while aggregate and conglomerate concentration continued to increase, reflecting oligopolization at the industry level and a general trend away from competi- tive structure at the manufacturing-wide level. These findings are of inter- eat because production2974 market structure have been shown to be related with allocative efficiency.- 6.37 Empirical evidence tends to support the view that the efficiency of small medium firms caught up with that of large firms by the end of 1970s.- These findings tend to support the government's contention that the SMI sector igyld be expanded and that it can supply new sources of growth to the economy, While this is undoubtedly true, and while "affirmative action" policies for SMIs are advantageous in light of the HCI distortions, it is not clear that government should take a position of economic structure on the basis of perceived levels of efficiency. In some industries, in which R&D and large scale technologies dominate, size may be an important determinant of efficiency. In others, minimum critical size may be important to compete internationally. On the other hand, the balance of incentives in the absence of an active 5MI promotion policy would clearly favor further agglomeration, which may be undesirable for a number of reasons (see Chapter 7 on conglomerates). 26/ Several cross-section studies of the market structure and performance in Korean manufacturing have found that highly concentrated sectors tend to have high profitability. See studies by K.U. Lee (1977), I.B. Choi (1986), and S.S. Lee (1985). There are two radically different interpre- tations as to the casuality of the positive correlation between concen- tration and profitability in recent industrial organization literature. The "structuralist view" asserting that the positive correlation is evidence of rent-seeking behavior by firms in oligopolistic industries. It also maintains that larger firms do not have a substantial efficiency advantage over their smaller rivals. On the other hand, the "efficiency- based viewle argues that the positive relationship reflects the superior performance of large firms. See, for example, R. Clarke, S. Davies, and Waterson (1984). 271 KDI estimates show that total factor productivity of SMIs grew con- siderably faster than that for large firms over the 1970-79 period (4% p.a. compared with 1.4% p.a.) su that they were on par by 1979. See J.W. Kim (1985). 28/ See Appendix 6B on sources of growth. - 34 - 6.38 In terms of domestic public policy, one clear way of controlling unwanted reductions in competition is through trade liberalizations. While the items subject officially to monopoly oversight will be liberalized at an accelerated pace, there are a wider range of goods praduced in ol polistic markets. Therefore, in the absence of strong antitrust measures,-- trade liberalization should be aggressively pursued to raise domestic living standards. 29/ There is legislation in the form of Monopoly Regulation and Fair Trade Act (1980) to protect the consumer from unfair practices. - 35 - Appendix 6A Page 1 INTERNATIONAL COMPARISONS A6.01 The similarity of the Korean pattern of change in at7icultural and manufacturing GDP shares with international norm calculations,- is instructive, yet there are some striking differences, as seen in Figure A6.1. It should be noted, in particular, that the share of manufacturing increased very sharply in 1972 and it surpassed the international norm in 1973, while the agricultural share remained higher than the international norm throughout the period, perhaps reflective of the high protection accorded to agriculture, as noted in Chapter 5. As a result of these developments, the share of both agriculture and manufacturing was about 2.0 percentage points higher than the corresponding international norms in 1983 (Table A6.1). A6.02 An important and unique aspect of Korea's structural transfor- mation was the rapid increase in the share of heavy industry during the 1970s, which has been attributed to deliberate government policies. Several reasons are given for the promotion of heavy-chemical industries (BCI) in the 1970s. First, the promotion of HCI was seen to facilitate a shift in Korea's compara- tive advantage from labor intensive to capital intensive goods in light of various changes taking place at that time, such as rising domestic wage and rising protectionism against unskilled labor intensive goods in developed countries. Second, the threatened withdrawal of American forces from Korea prompted the political leaders to consider rapid establishment of heavy- chemical industries. Finally, the strong aspiration and zeal of the late President Park's regime to achieve the so-called "advanced industrial state" in a relatively short period also played an important role. To promote HCI, various incentive policies were adopted, including special tax treatment, 2/ import protection, preferential credit allocation and government investment.2 A6.03 To investigate the effect of UCI push on changes in production structure, Figure A6.2 compares the actual share of heavy-chemical manufac- turing in GDP to the corresponding international norm. One interesting finding is the sharp increase in the share of heavy-chemical manufacturing which took place in 1973-1974 compared with the predicted structure. Accord- ing to the data on credit allocation by sector in Technical Appendix 4, the financial preference towards HCI only began to see in 1975, yet the surge in BCI performance compared to international noms had already begun. Moreover, the impetus of the increase in 1973 appears to be different from that in 1974. In 1973, export expansion, due to unprecedented rate of growth in the world trade, contributed a great deal to output expansion of manufacturing while in 1974 it was investment that provided the major impetus to output growth. Between 1972 and 1973 Korean heavy-chemical exports increased by 112.4%, compared to the average annual increase of 63.4% for 1967-1972 while the 1/ Predicted shares are obtained from regression analysis similar to H.B. Chenery and L. Taylor (1968). For recent extensions of this methodology, see Chenery, Syrquin, and Urata (forthcoming). 2/ Por a detailed description, see T. Kwack (1984) and W. Hong (1985). Appendix 68 Page 3 86.04 Results of demand sources of growth for various periods show that in Korea import substitution was very significant before 1963 (see Table 86.3). In 1963-70 import substitution turned negative and remained negative until 1970-75, reflecting an opening of the economy. From 1975 to 1983, however, the contribution of import substitution reversed sign again, reflecting a positive contribution from import substitution during the period. Export expansion, on the other hand, contributed significantly to output growth throughout 1963-1983. The magnitude of the contribution of export expansion was particularly high during 1970-73, when the Korean exports expanded rapidly thanks to its successful export promotion policies and the expansion in the world trade. 86.05 An international comparison of the demand sources of growth presents interesting variations in country patterns depending on population size and the trade policies adopted. Large countries (e.g., China, India and Japan) tend to exhibit larger contributions of domestic demand expansion because of their large home market. There are noticeable variations in the importance of foreign trade factors even among the small countries, however. The differences appear to reflect different trade policies pursued in different countries. In Mexico, Turkey and Colombia, all of which more or less adopted import substitution policies during the period, trade factors contributed much less than in other countries of smaller size and endowments. Although export expansion contributed greatly to output increase in Korea, a major competitor economy, Israel, Norway and Yugoslavia, negative import substitution was significant only in Israel, Norway and Yugoslavia, which adopted open economic policies in both export and import markets, and not in Korea or its competitor, where export promotion and import restriction policies were purused simultaneously. B6.06 Supply Side Sources of Growth. The traditional approach (due to Denison)1/ to assess the magnitude of various supply factors which contribute to the growth decomposes net output growth of the whole economy to seven supply factors: (i) increase in labor inputs, (ii) increase in capital inputs; and (iii) total factor productivity, which can include, inter alia, economies of scale, advances in knowledge, and miscellaneous determinants. Recen Iresuts for the 1963-72 and 1972-82 periods are reproduced in Table 86.4,- showing that labor inputs grew at around 3%, and the increase in labor inputs was the largest single contributor to net output growth in both two periods, accounting for around 35Z of the total. The rate of growth of capital increased substantially from 1.14% in 1963-72 to 2.10% in 1972-82, most likely reflecting increased capitalization in UCI and, as a result, its contribution to overall growth rose from 13.9 to 26.2% between the two periods. Total factor productivity (TFP) declined considerably over the period, with the largest decline occurring in the rate of advances in know- ledge. It contributed only 3.7% to growth in the later period. Declining I/ See Denison (1974). 2/ See K.S. Kim and K.K. Park (1985). STRUCTURE OF AGRICULTURE AND MANUFACTURING 0.50 0. 45 0. 40- Actual 0.35 Agriculture 30- 4 Actual Predicted Kanufacturing 0. 2 - - 0. 15- 0. 1 -- ..... ..... ....... ......i........ .. . .. .*.... .......MTI1..m m08. 0.2 .mnie5 ..1 500 600 700 00 900 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 Y Per Capita OU (in 1980 US$) Table A6.1: COMPOSITION OF VALUE ADDED IN VARIOUS COUNTRIES Country Korea Korea Argentina Brazil China Hong Kong Japan Malaysia Singapore Turkey US Year 1983 Predicted 1982 1982 1982 1982 1982 1982 1982 1982 1982 Per capita GNP in 1980 US$ 1,880 1,880 1,625 1,864 311 5,824 9,410 1,774 5,613 1,366 11,311 Sector Agriculture 13.7 11.6 12.5 11.6 36.9 0.7 3.5 22.6 1.0 20.7 2.6 Oa Mining 1.4 7.7 2.5 0.8 1.7 0.2 0.5 6.7 0.4 2.0 3.9 1 Manufacturing 27.5 25.2 27.7 27.1 35.9 21.3 29.7 19.4 24.1 22.5 21.5 Construction 8.3 5.5 6.3 5.4 4.0 7.1 8.8 5.1 11.0 4.4 4.2 Utilities 10.7 11.9 8.0 7.6 6.1 9.1 9.7 9.6 14.7 13.0 9.4 Services 38.3 38.0 43.1 47.4 15,4 61.7 47.7 36.6 48.7 37.5 58.4 Source: "Patterns of Development, 1950-83," World Bank research project (RPO 673-85). PATTERNS OF DEVELOPMENT: HEAVY INDUSTRY 0.150- Actual 0. 125- 1974 S 0.100 A 'E 197 0.075 Gl - D 0.050- P 1962 0.025 0.000 . 400 600 soo 1000 ?o 1400 1600 1800 PER CAPITA GNP (IN 1980 US $) - 40 - Appendix 6A Page 5 corresponding growth rates for light industry were 94.6% and 40.8Z, respec- tively. In 1974 the share of gross capital formation of GNP increased to 31% from 25.7Z in 1973. The findings here cast doubt on the conventional wisdom that a shift in the production structure toward heavy-chemical manufacturing was due primarily to the encouragement given by the HCI promotion policies. Instead, the findings suggest that the shift had already started in 1973 and that at least in the early years HCI was export driven as well. This view is further supported by the sources of growth decomposition in Appendix 6B. It should also be noted that the expansion of HCI did not deter the relative international performance of light industry vis-a-vis its norm as shown in Figure A6.3, where the actual share of light injVstry was significantly higher than the predicted level throughout the period.- Clearly, however, in the counter-factual case, its performance might have been even better, had HCI not received the preferences it did. A6.04 A comparison of the actual values with the predicted values indicates that the manufacturing share as a whole was substantially higher than the predicted share in 1981 (Table A6.2). It also shows that the actual share is greater than the corresponding predicted share in every sector, except for "other manufacturing" but the structure of production of subsectors within manufacturing is closer to those expected based on level of economic development and size, except for food and beverage sector, where the Korean share is much higher than the predicted share. The high food and beverage share is due to the unusually large agricultural sector, attributable to high domestic agricultural prices. A number of subsectors that exceed expectations are, in fact, in decline (viz., wood and paper) on experiencing excess capacity (viz., chemicals). Comparing the Korean structure with other countries, one finds that the Korean structure is again similar to that of Brazil. Noticable differences are only in textiles and basic metals; Korea has 2.5 percentage point higher share in textiles, while Brazil has 1.9 percentage point higher share in basic metals. Compared to Korea, Hong Kong and Singapore have significantly higher share in textiles and in metal products, respectively. In sum, around 1980 the share of manufacturing as a whole is much higher in Korea than in other countries, but the compositional shares within the manufacturing in Korea are similar to those in other countries. 31 It should be noted that high protection of primary products is partly responsible for the high share of light manufacturing as the primary products are used as inputs into light manufacturing. - 41 - Table A6.2: COMPOSITION OF VALUE ADDED IN MANUFACTURING (2) Country Korea Korea Bra2il Hong Kong Japan Singapore Turkey US Year 1981 Predicted 1978 1980 1981 1981 1981 1980 Per Capita GNP in 1980 US$) 1,680 1,680 1,852 5,468 9,180 4,926 1w336 11,562 Food, beverages 4.4 1.2 3.8 1.1 2.8 1.4 4.6 2.4 Textiles, apparel 5.5 5.3 3.0 9.3 1.9 1.4 3.6 1.4 Wood, wood products 0.4 0.1 1.2 0.3 1.0 0.8 0.3 0.7 Paper, paper products 1.2 0.6 1.5 1.3 2.4 1.4 0.7 2.2 Chemicals 5.6 4.7 5.3 2.3 4.5 7.4 4.6 3.7 Nonmetallic and 1.4 0.8 1.7 0.2 1.5 0.8 1.9 0.7 mineral products Basic metals 2.4 1.7 4.3 0.2 2.7 0.5 2.0 1.4 Fabricated metal 6.5 5.3 5.8 7.6 13.3 15.2 4.2 10.2 products, machines Other manufacturing 0.6 1.3 1.0 0.8 0.5 0.4 0.07 0.4 Total Manufacturing 28.0 21.1 27.5 23.1 30.7 29.4 21.8 23.1 Source: "Patterns of Development, 1950-83," World Bank research project (RPO 673-85). PATTERNS OF DEVELOPMENT: LIGHT INDUSTRY 0.150 Actual 1970 0.125 1974 1962 S 0.100- H - rdce - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -- -- tE 0.075 to 0 0.050 P 0.025 0.000 400 600 800 1000 1200 1400 1600 1800 PER CAPITA GNP (IN 1980 US $) - 43 - Appendix 6B Page 1 SOURCES OF GROWTH B6.01 Changes in the structure of production observed in the earlier sections result from the interaction of demand factors, such as changes in patterns of intermediate and final demand, and supply factors, including the accumulation and efficiency of use of factors of production. Although an ideal approach would involve a simultaneous examination of demand and supply factors, no studies of the mechanisms of development and change have dealt satisfactorily with this issue. In the absence of a methodology that simul- taneously incorporates demand and supply factors, the conventional strategy involves analyzing these factors separately. The demand side sources of growth exercise decomposes output growth into changes in consumption, invest- ment, exports, import substitution and input-output coefficients, while the supply side sources of growth decomposes output growth into the changes in factors of production, namely, capital, labor, intermediate inputs, and residual. B6.02 Demand Side Sources of Growth. The pattern of final demand changed substantially between 1970 and 1983. (See Table B6.1) The most notable change is a drastic increase in the share of exports: from 13.8% in 1970 to 35.4% in 1983 with a major increase taken place during 1970-75. The patterns of the changes in the shares for investment and imports are similar insofar as both increased between 1970 to 1980 and then declined. In contrast the share of consumption declined continuously from 1975 to 1983 after a slight increase in 1970-75. Finally the share of intermediate demand in total demand increased from 1970 to 1980, but then declined slightly since. This general pattern is consistent with the view that export expansion was realized at the cost of consumption in the post-1975 period and that the investment and intermediate demand surges were in large part met via imports. 86.03 The methodology applied to estimate the contribution of the various demand factors on output incorporates interindustry linkages expli- citly. The change in output for a particular sector in this case is influ- enced not only by the changes in demand for its own sector but also by the changes in demand for all the other sectors in the economy. Evidence from Table 86.2 shows that export expansion provided a major impetus to the expansion of the heavy-chemical industry during 1970-83, including the 1975-80 period when HCI was being actively promoted. The same strong growth impetus is not evident in either investment expansion or import substitution, how- ever. These data suggest that the role played by both investrent expansion and import substitution towards the heavy-chemical industries during the 1975- 80 period may have been overstated and the role played by export expansion understated. Nevertheless, in some HCI industries, such as primary metals and metal products, import-substitution does show up as a significant growth source in the 1980s, although comparisons with direct sources of growth (excluding inter-industry linkages) show that these industries are supplying production inputs for ultimate export purposes. Therefore it would be incor- rect to see Korea's HCI push as classic import substitution. Its ultimate goal is enhanced competitiveness in export markets and the efficiency yard- stick used is whether Korea can produce more cheaply than imports. - 44 - Table 36.1: CHANGES IN STRUCTURE OF DEMAND Composition of final demand (2) Growth rate of demand 1970 1975 1980 1983 1970-75 1975-80 1980-83 Consumption 84.2 84.7 78.7 74.1 29.1 28.9 15.6 Investment 27.6 26.6 31.5 30.1 28.1 35.2 16.2 Exports 13.8 29.1 33.6 35.4 49.7 34.6 20.1 Imports -25.6 -40.5 -43.8 -39.6 41.4 32.8 14.2 Total Final Demand 100.0 100.0 100.0 100.0 29.0 30,8 18.0 Source: Bank of Korea, Input-Output Tables. Table B6.2: SOURCES OF OUTPUT GROWTH IN MANUFACTURING Changes Consumption Investment Export Import in 1-0 expansion expansion expansion substitution coefficient 1970-75 Heavy and chemical industry 24.0 23.5 35.9 3.6 13.0 Chemical and chemical products 35.7 9.7 30.6 2.4 21.6 Primary metal manufacturing 8.6 31.1 45.3 8.5 6.6 Metal products and machinery 13.0 41.8 39.8 3.1 2.2 Light industry 57.8 7.9 32.5 -0.8 2.6 Total Industry 54.8 15.5 27.3 -1.3 3.7 1975-80 Heavy and chemical industry 25.6 22.7 41.3 7.1 3.3 Chemical and chemical products 44.3 7.9 34.9 5.6 7.3 Primary metal manufacturing 7.0 29.8 57.2 12.7 -6.7 Metal products and machinery 9.9 39.9 40.8 5.8 3.6 Light industry 51.7 13.1 31.7 1.4 2.0 Total Industry 48.1 21.2 27.3 1.7 1.8 1980-83 Heavy and chemical industry 30.5 14.6 54.1 7.9 -7.1 Chemical and chemical products 55.6 15.9 52.8 -3.7 -20.5 Primary metal manufacturing 18.7 -2.7 74.2 19.6 -9.8 Metal products and machinery 17.5 19.2 48.8 12.0 2.6 Light industry 55.6 - 6.7 37.0 -1.2 2.0 Total Industry 45.8 19.8 32.9 3.7 -2.2 Source: World Bank estimates. - 45 - Table B6.3: SOURCES OF OUTPUT GROWTU FOR VARIOUS ECONOMIES Changes in Domestic Export Import input-output expansion expansion substitution coefficient China 1956-65 107.2 1.9 9.2 -18.3 1965-75 85.7 5.6 -1.3 10.1 1975-81 80.3 16.4 -7.9 11.2 India 1959-68 81.0 5.1 7.4 6.6 1968-73 91.6 6.0 9.3 -7.0 Japan 1955-60 87.9 8.0 -4.1 8.3 1960-65 90.8 15.1 -2.1 -3.8 1965-70 82.6 14.9 -3.2 5.7 Korea 1955-63 74.5 10.0 21.4 -6.0 1963-70 81.8 21.9 -1.8 -1.9 1970-73 51.9 55.7 -3.2 -4.4 1970-75* 70.3 27.3 -1.3 3.7 1975-80* 69.3 27.3 1.7 1.8 1980-83* 65.7 32.9 3.7 -2.2 Major Competitor Economy 1956-61 54.3 23.9 15.1 6.7 1961-66 61.3 37.6 -1.1 2.2 1966-71 52.7 49.5 -0.2 -2.0 Mexico 1950-60 85.5 1.0 5.4 8.1 1960-70 94.1 3.1 6.0 -3.2 1970-75 89.8 5.9 -1.3 5.b Turkey 1953-63 92.3 2.5 1.8 3.3 1963-68 83.6 4.9 8.3 3.2 1968-73 86.2 11.8 -1.4 3.5 Colombia 1953-66 76.1 10.0 6.9 7.0 1966-70 69.5 21.8 6.5 2.1 Israel 1958-65 76.7 25.6 3.1 -5.4 1965-72 69.1 42.0 -18.9 7.9 Norway 1953-61 60.7 40.4 -10.6 9.5 1961-69 60.2 49.1 -13.3 4.0 Yugoslavia 1962-66 87.6 23.9 -6.2 -5.3 1966-72 82.0 30.2 -18.4 6.1 Source: Those without an asterisk are taken from S. Urata, (forthcoming). - 46 - Table B6.4: SUPPLY-SIDE SOURCES OF GROWTH (Annual growth rates) Korea Japan United States 1963-82 1963-72 1972-82 1953-71 1963-73 1973-82 Standardized national income 8.13 8.23 8.02 8.81 3.92/a 1.55/a (100.0) (100.0) (100.0) (100.0) (100.0) (100.0) Labor 2.92 2.74 3.04 1.51 1.32 0.66 (35.9) (33.3) (37.9) (17.1) (a3.7) (42.6) Capital 1.58 1.14 2.10 2.10 0.85 0.69 (19.4) (13.9) (26.2) (23.8) (21.7) (44.5) Total factor productivity 3.63 4.35 2.88 5.20 1.75 0.20 (residual) (44.6) (52.9) (35.9) (59.0) (44.6) (12.9) Of which: Advances in knowledge 1.09 1.89 0.30 /a Excludes educational impact on workers, included in TFP for comparability. Note: Figures in parentheses are precentage shares of total growth in standardized national income. Sources: K.S. Kim and J.K. Park (1985) and Denison (1985). - 47 - Appendix 6B Page 6 TFPs have been noted in the US for recent years, for example, and has prompted a livelier interest in R&D expenditures and other knowledge*augmenting activities. 86.07 The Korean trend may well be dominated in the 1970s by the HCI experience. Additional KDI studi covering manufacturing industries show sharp TSP drops in the mid-1970s.T Numerous explanations are offered, including overestimation of labor hours worked, lack of competition in domestc product markets, and adjustments to new energy-efficient technolo- gies, A shift in trade strategy from export promotion in the mid to late 1960s to import substitution in the mid and late 1970s may well have led to a decline in TPP growth. Opening up of the economy in the 1960s due to export promotion policies is believed to have resulted in an improvement in produc- tive efficiency through strong competition from abroad, exploitation of scale economies, and introduction of foreign technology. In contrast import substi- tution policies, which were adopted to promote heavy-chemicl industries in the mid to late 1970s, nurtured inefficiency in production.4 Lack of domestic competition might have contributed to slow rate of growth in TPP as well. During the 1970. market concentration increased significantly in the aftermath of HCI episode which encouraged the expansion of firm size. In the absence of significant import liberalization efforts, firms in the concentra- ted market might have opted not to improve their productive effciency, result- ing in low TFP growth. Finally, the oil price increase in 1973-74 forced firms to adopt new energy-saving technology, which is not additionally produc- tive, at least in the short run. This could also produce a decline in TFP growth. Most likely, however, is the overcapaci5y in manufacturing caused by the ambitious HCI investments of the mid-1970s.1- It would be important to know whether the recent liberalization program, and the better NCI perfor- mance, have succeeded in turning this around. Clearly, as Korea's productive inputs become increasingly constrained, it will have to turn to more efficiency ways of utilizing those inputs to generate growth. 3/ TFP estimates for 1966-71 versus 1971-75 by Kim and Sohn (1979) show a drop from 3.78% during the former period to 1.07% in the latter. A similar exercise for mining and manufacturing by Rhee (1982) shows a decline in TFP growth from 6.142 in 1967-71 to 2.39% in 1972-76. 4/ See Park and Kim (1985). 5/ Nishimizu and Robinson (1984) support this argument, as it found that TFP growth is positively correlated with export expansion while it is negatively correlated with import substitution by examing their relations in Korea, Japan, Turkey and Yugoslavia, among other countries. 6/ See Westphal (forthcoming). - 48 - CHAPTER 7: THE CONDUCT OF MACROECONOMIC POLICY, 1982-85 A. Introduction 7.01 During 1980-82, Korea's principal macroeconomic goal was the achievement of stability and recovery from the difficulties engendered by the overheating of the economy in the late 1970s, the rise in oil prices and interest rates in 1979-80 and the subsequent international recession. In the process, Korea further increased its external debt from about $21 billion in 1979 to over $37 billion by the end of 1982, at an annual average rate of growth of 22%. Believing that this rate of growth of debt exposed the country to unacceptable risks (given the unsettled international financial environ- ment) Korea has sought, since 1982, to achieve an improvement in its external debt position while simultaneously maintaining price stability and a reason- able rate of CNP growth. Specifically, the Fifth Plan (1982-86) aimed at balance of payments equilibrium in the current account together with an iniflation rate of under 4Z and CP growth of 7.5%. Macroeconomic policies have had to be chosen carefully to accomplish these goals since policy dilemmas abound when multiple goals are sought. 7.02 Policy Tradeoffs. The notion of a policy tradeoff arises since aggregate demand management policies typically achieve desirable goals (such as the reduction of inflation) at the cost of some undesirable consequences (such as reduced investment and growth and increased unemployment). In Korea the policy environment of the past several years has been characterised essentially by tight money, balanced budgets and exchange rate depreciation (see Table 7.1). Money supply has been kept tight so as not to reignite inflation or put pressure on the balance of payments (BOP). The worry, expressed usually by the business community, is that tight money can have negative effects on investment, exports and employment. Balanced budgets are deemed necessary for price stability and BOP improvement and Korea has pursued tight fiscal policy not simply through nearly balanced budgets but also by keeping the ratio of expenditures to CNP constant. The downside risk to this policy is similar to that for tight monetary policy -- possible adverse conse- quences for investment, employment and growth. Finally, the won has been steadily depreciated so as to promote the balance of payments objective. The policy dileams that faced Government was a possible adverse effect on infla- tion and domestic output (the so-called contractionary devaluation problem), and the possible ineffectiveness of depreciation, in an import-dependent economy, in improving the overall payments position. - 49 - Table 7.1: RECENT MACROECONOMIC PERFORMANCE AND POLICY STANCES 1980 1981 1982 1983 1984 1985 Policy Stance Monetary NDA growth Ia 35 39 34 18 14 24 Interest rate: Nominal /b 21 20 12 10 11 12 Real /c -2.2 4 5 7 7 8 Fiscal Deficit/CNP -3.2 -4.6 -4.4 -1.6 -1.4 1.5 Expenditures/CNP 22.8 24.8 24.2 21.3 21.1 21.4 Exchange rate REER change /d -6.8 2.7 -0.3 -7.3 0.2 -11.0 Macroeconomic Performance /e CNP growth -5.2* 6.6 5.4 11.9 8.4 5.1 CNP deflator 28.6* 15.4 6.6 3.9 3.8 3.6 Current account/CUP -8.8 -7.0 -3.8 -2.2 -1.7 -1.0 Investment growth -23.7* 6.3 0.1 17.5 18.6 1.6 Investment/CNP 32.1 30.3 28.6 29.9 31.9 31.2 Savings/CNP 20.8 20.5 20.9 25.3 27.9 28.4 Debt ($ b1n) 27.3 32.5 37.1 40.2 42.6 45.6 Debt service (Z) 19.7 21.2 22.6 20.9 22.6 23.6 Short-term to total debt (%) 34.3 31.5 33.5 30.1 26.8 25.4 Unemployment rate 5.2 4.5 4.4 4.1 3.8 3.8 /a NDA refers to Net Domestic Assets of banking system. 7T Ceiling lending rate on loans of one-year maturity by commercial banks. 7- Nominal rate adjusted by GNP deflator measure of inflation. 71 Rate of change in the value of the real effective exchange rate (REER). 7e All data unless asterisked is based on the new System of National Accounts and thus is not strictly comparable to pre-1980 data. Source: Bank of Korea, Economic Statistics Yearbook, and Economic Planning Board data. 7.03 The following sections examine the manner in which these policies have been implemented in recent years, discuss why certain consequences occurred and others did not and indicate how policy effectiveness may be affected by changes taking place in the economy. Four themes emerge. Perhaps the most important theme is that the achievement of macroeconomic objectives in Korea is conditioned strongly by external developments. During 1982-84, - 50 - favorable external developments such as the decline in the prices of oil and other commodities and the economic recovery in the OECD countries (and especi- ally in the US) enabled Korea to reduce inflation as well as to maintain a high rate of investment and growth despite a conservative domestic macroeco- nomic policy stance. External developments were also important to Korea's economic performance in 1985. As the US and other OECD economies entered a period of stagnation from mid-1984 on, Korean exports plummetted and both investment and growth faltered. 7.04 The response to this withdrawal of external demand stimulus illus- trates a second theme which is that the conduct of macroeconomic policy has been flexible and selective. As the economy faltered in 1985 monetary restraint was moderately relaxed, fiscal expenditures were rearranged without being increased, and depreciation was accelerated. Domestic stimulus was provided selectively for investments in the export sector, a strategy that helped boost aggregate demand while maintaining the impetus towards external balance. Flexibility and selectivity were also present during 1982-84. For example, while the overall macroeconomic policy stance was tight, the private sector was treated more liberally than the public sector. 7.05 A third theme is that the job of demand management was made easier by the simultaneous implementation of supply-side policies. Initiatives taken in the direction of trade and financial liberalization and industrial policy reform began to pay off in the form of higher domestic savings, a pass-through of low international inflation, a reduction of import dependence, and improve- ments in labor productivity and investment efficiency. While restrained macroeconomic policies have helped curtail inflation, part of the inflation reduction has also come about through such supply side developments. Thus favorable external developments, such as the low rate of inflation in Korea's import supplying countries, ccmbined with lower trade barriers and an increase in the efficiency of import use to keep downward pressure on domestic infla- tion. Similarly, while depreciation and a tight macroeconomic policy stance have improved the current account and reduced the rate of growth of external debt, part of this outcome is attributable to policies which have raised the domestic savings rate. 7.06 The fourth theme that emerges is that the effectiveness of macroeco- nomic policy, in particular that of monetary policy, is conditioned by two structural features of the domestic financial system namely, the growth of a non-bank financial institution (NBFI) segment and the high degree of debt- reliance in Korea's corporate sector. The growth of the NBFI segment relative to the primary banking sector has increased the uncertainty regarding the ultimate effect of monetary policy, exercised through the banking system, on investment, output and inflation. This is because monetary developments in the NBFI sector can offset developments in the primary banking sector. During 1983-84, for instance, the authorities sharply reduced the rate of growth of. domestic credit through banks and simultaneously raised nominal interest rates. Both of these moves were partially offset by developments in the NBFI sector where the rate of growth of credit did not decline as sharply (and in fact rose during 1984) and real interest rates generally fell. Similarly when a more relaxed stance was adopted in 1985, it was offset to some extent by contraction in the NBFI sector. Moreover, the high degree of debt-reliance in - 51 - Korea's corporate sector has constrained the independence of monetary policy as a policy instrument. B. The Determinants of Investment and Inflationt 1982-85 7.07 The monetary policy that has been followed since 1981 can be gener- ally characterized as tight. The rate of growth of the net domestic assets of the banking system (NDA) was reduced progressively from 34Z during 1982 to 18% in 1983 and 14% in 1984. At the same time, nominal bank tending rates were permitted to rise and real 1 ding rates almost doubled between 1981 and the end of 1985 (from 4% to 8%).- During 1985, an emerging recession caused largely by a sharp fall-off in export growth, prompted some monetary relaxa- tion and net domestic assets were permitted to grow at 24%. However, a target of 14% growth in NDA has been set for 1986, which indicates that the 1985 interlude should be considered a temporary deviation from a monetary trajec- tory that has been, and is intended to remain, essentially restrained. 7.08 The aim of tight monetary policy has been to reduce inflation and the current account deficit. Inflation had been brought down from the unusual heights (for Korea) of 25.6% in 1980 to 15.9% in 1981, while the current account deficit had been reduced from 8.7% to 6.9% of CNP. These levels were still considered unacceptably high and he fe monetary policy was set to help achieve further progress on these fronts.- Monetary Policy and Investment 7.09 An interesting aspect of Korea's recent experience with monetary policy is that while the monetary deceleration (as measured by the rate of growth of real and NDA bank lending rates) has been sharp and while inflation and the current account deficit have been reduced partly by this (and partly 1/ It is important to note that the period 1983-85 is being referred to here since nominal interest rate policy changed in this period. Nominal bank lending rate ceilings were reduced sharply during 1982 in the wake of a large drop in inflation because of the concern that very high real interest rates might stall the business investment recovery that seemed to be occurring. By late 1983 inflation appeared to be stabilizing at a low level and Government began a program of financial liberalization under which the nominal lending rate ceiling was adjusted upwards (see Chapter 4 for details). 2/ A lower rate of monetary growth and higher real interest rates are thought to reduce the rate of growth of economic activity by reducing investment. As this happens, the rates of growth of incomes and prices decline. In this manner, contractionary monetary policy achieves both lower inflation and a reduced current account deficit since import growth declines as domestic income growth falls and exports rise as domestic prices fall. While the economy is adjusting to the lower rate of expansion of money supply and higher interest rates, investment, employment and growth are typically expected to fall relative to trend. - 52 - by exchange rate management as discussed later), this has apparently not come about at the expense of a slowdown in economic activity. In fact, while the monetary deceleration was underway, investment grew steadily, continuing a recovery from a negative growth rate in 1980 (see Table 7.1). As a proportion of GNP, gross domestic investment rose from 28.6% in 1982 to almost 32Z in 1984. CUP also grew at an average rate of about 8.5Z and unemployment declined from 4.5% in 1981 to 3.8% by the end of 1985. Clearly other factors were at work to offset the potentially adverse consequences of tight monetary policy. 7.10 Three factors can be identified as being important. The first was the pull exerted by the recovery of the OECD economies beginning in late 1982. The second was the fact that the monetary restraint was not as severe in actual experience as appears from movements in the rate of growth of the banking system's NDA and lending rates. Broader measures of liquidity which include the deposit and credit creation activity of nonbank financial interme- diaries indicate a deceleration of smaller proportions. Furthermore, real interest rates in the unregulated curb market actually fell somewhat during 1982-84. A third factor was a shift in the distribution of credit from the public to the private sector. These factors are elaborated below. Investment and Foreign Income Growth 7.11 Beginning in the last quarter of 1982, the OECD countries, and especially the US, began to pull out of the recession in which they had been mired. As a result their demand for imports grew and world trade volume rebounded substantially from the trough of 1981-82. In particular, the sharp growth of import demand in the US proved a boon for Korean exports. The US market normally accounts for over 30% of Korean exports. The elasticity characterizing the response of Korean exports to foreign income is very high (between 3.5 and 4.5) and, as the OECD recovery accelerated (see Table 7.2) the prospects for exports brightened enormously and fixed investment grew rapidly despite the contractionary stance of monetary policy. It is easy to cast this argument in terms of a standard investment function (see Box 7.1). Among the determinants of private fixed investment are not only the interest rate and credit availability, but also current and expected levels of income and profits. Foreign income growth raised current as well as expected income and profits of Korean exporters and thereby led to higher investment. The Role of NBFIs 7.12 In fact, closer scrutiny of the data indicates that even interest rates and credit availability did not exercise a very strong negative effect on investment. Movements in the banking system's credit supply figures and lending rates do not accurately reflect the overall liquidity situation faced by the private sector to the extent that credit is provided through two other segments, a relatively unregulated segment consisting of NBFIs and a - 53 - Table 7.2 CROWTH IN WORLD INCOME AND TRADE 1981 1982 1983 1984 1985 CDP growth rates (%) Industrial countries 1.6 -0.2 2.6 4.9 2.8 USA 2.5 -2.1 3.7 6.8 2.6 Others 1.1 0.9 2.0 3.5 3.0 Japan 4.0 3.3 3.4 5.8 4.4 Korea la 7.4 5.7 10.9 8.6 5.2 Trade growth rates (Z) Industrial countries imports (volume) -2.5 -0.8 4.2 11.7 6.1 Korean exports (volume) 16.4 4.6 15.5 9.8 Korean exports (value) 20.2 1.0 11.0 13.3 /a New System of National Accounts methodology. Source: IMF, World Economic Outlook, October 1985 and Bank of Korea data. completely unregulated segment, the curb market.Y When total credit, including that generated by NBFI, is examined, it is found to have decele- rated much less than the rate of growth of banking system credit (see Table 7.3). In fact, after declining in 1982 and 1983 this measure of liqui- dity actually rose in 1984. Similarly, when interest rates in the curb market or the yield of commercial paper sold by NBPIs is examined, the trend over 1983-85 is downward (see Table 7.4) in contrast to the trend in bank lending rates. Thus while the government was reducing credit supplied through the banking system, other sources of credit supply did not follow suit. The reasoc for this is to be found in the particular strategy of financial libera- lization followed since 1982. 3/ The primary banking system denotes a set of seven nationwide commercial banks, ten regional or local banks, fifty-two foreign banks and a number of specialized institutions which lend for specific purposes only (e.g., Korea Bousing Bank). This is also referred to as the deposit money bank (DMB) system since only these institutions are allowed to generate regular savings deposits. The NBFIs consist essentially of short-term finance and investment companies, and insurance and securities companies. These are permitted to raise cash and lend at rates higher than those permitted to banks. They are also allowed to issue as well as to guarantee bonds. NBFls have grown significantly in recent years. See Chapter 4 for details. - 54 - Box 7,1: THE DETERMINANTS OF AGGREGATE PRIVATE INVESTMENT Private investment is a significant component of aggregate demand in Korea. It is affected not only by domestic macroeconomic policy but also by external developments. Variables representing both of these sets of determinants are included in the investment function estimated below: I = 22.9 + 0.75*l(-1) + 0.49*ACC - 0.85*RUM + 1.91*DC (2.9) (17.5) (3.4) (-3.7) (5.3) where the dependent variable, I, represents private real aggregate investment and I(-l) represents investment in the year before. ACC is the accelerator term which is measured as the change in real output during the previous two years; this allows the effects of external developments to be captured indirectly through their effects on domestic incomes and profits. RUM is the real interest rate in the unorganized or curb market and DC is the real flow of domestic credit through the banking system. The results provide strong statistical support for three claims: (i) increases in real output raise private investment; it is the change and not the level of output that is important; (ii) increases in the cost of capi- tal reduce aggregate investment; and (iii) increases in credit availability increase aggregate investment. These findings have important implications for macroeconomic policy. For example, if financial liberalization increased the cost of capital, there is a risk that investment may suffer. On the other hand, financial liberalization could, by stimulating higher deposits and more efficient intermediation, increase the flow of domestic credit. This would have a positive effect on private investment. Which effect of financial liberalization dominates is ultimately an empirical matter. Experiments with large macroeconomic models tend to indicate that the positive effect will dominate, especially in the long run (see Kwack, 1985). Estimation details: An instrumental variable technique has been used to predict the curb market interest rate (RUM). Serial correlation in the residuals has been adjusted for (Rho - -0.68). The model is estimated using annual data for the period 1969-83. The numbers noted in parentheses are t-statistics. A t-statistic value greater than 2 indicates that the coefficient is significant at the 95% level. See Edwards (1986). - 55 - Table 7.3: MONETARY DEVELOPMENTS (Ananal percentage change) 1981 1982 1983 1984 1985 Domestic credit A /a 31 25 16 13 18 Domestic credit B 34 30 19 21 23 Domestic credit C 41 39 26 34 29 Domestic credit A Private sector credit 26 25 18 14 19 Public sector credit 138 24 -7 -2 2 /a Domestic credit A is domestic credit supplied by monetary institutions while domestic credit B includes credit extended by NBFIs. Domestic credit C measures credit supplied only by NBFIs and development finance institutions such as the Korea Development Bank. Source: BOK, Economic Statistics Yearbook. 7.13 This strategy had two elements: one was to improve incentives for domestic savings by permitting higher deposit interest rates to be paid and the other was to deregulate the NBFI segment first and permit it to raise deposits and lead at rates higher than those allowed the regular banking segment. As a consequence, total financial deposits have risen since 1982 and NBFIs have captured by far the larger share of the increase. This bias in deposit creation carried through into credit creation (see Table 7.5). Thus the government's financial liberalisation strategy has allowed the system to operate with greater liqua*ity than can be seen by looking at the banking system's liquidity alone. The Incidence of Credit Reduction 7.14 The manner in which the rate of growth of credit in the banking system was reduced also had implications for investment. The curtailment of credit was borne to a greater extent by the public sector than by the private sector. In fact, in 1983 and 1984 claims on the public sector (government plus public agencies) declined and whatever growth there was in credit supply went to the private sector (see Table 7.3). It can be argued that credit to 4/ The same sort of effect may not occur in the future because Government has moved to reduce the bias in favor of NBFIs. Banks have recently been allowed wider spreads and more deposit-attracting instruments such as certificates of deposit. As a consequence their share of financial deposits should stabilise and may even increase. - 56 - Table 7.4: INTEREST RATE DEVELOPMENTS, 1982-85 1982 1983 1984 1985 Selected Lending Rates Bank lending rate 12.6 10.0 10.6 11.5 Corporate Bond yield 17.3 14.2 14.1 13.5 Curb market rate 30.6 25.8 24.7 - Commercial paper yield 19.1 14.4 13.6 13.4 Selected Deposit Rates 12-Month Deposits Banks 8.0 810 10.0 10.0 NFIs 9.0 9.0 10.5 10.5 3-Month Deposits Banks 7.6 7.6 6.0 6.0 NBFIs 17.8 13.0 13.0 - Memo item CNP deflator la 6.7 3.9 3.8 3.6 a/ New SNA methodology. Source: BOK, Economic Statistics Yearbook. Table 7.5: STRUCTURAL DEVELOPMENTS IN FINANCIAL SYSTEM Percent shares in: 1975 1980 1984 Deposit Liability Banks 84.1 73.3 57.6 NBFIs 15.9 26.7 42.4 Corporate Finance Banks 67.4/a 57.3 35.6 NBFIs 32.67a 42.2 64.4 /a Refers to 1972-76 average. Sources: 80K, Economic Statistics Yearbook. - 57 - the public sector tends not to have as powerful an effect on investment and growth as credit to the private sector because of differences in investment efficiency. Thus a curtailment of credit which falls mostly on the public sector tends to be less contractionary than the average impact parameter would suggest. The character of investment growth since 1981 reflects this change in the public/private proportions of credit growth. As Table 7.6 shows, while investment has grown as a percentage of GNP since 1982, the share of investment due to government and public enterprises has declined, while that due to private enterprises has increased. Table 7.6: COMPOSITION OF GROSS DOMESTIC INVESTMENT (percentage of CNP) /a 1980 1981 1982 1983 1984 Gross domestic investment 31.3 29.2 27.0 27.8 29.8 Private and public enter- prises 24.8 22.2 21.1 22.7 24.4 (Public enterprises) (5.5) (5.0) (4.6) Government 6.5 7.0 5.9 5.1 5.4 /a Based on unrevised SNA methodology. Source: BOK, Economic Statistics Yearbook, and Economic Planning Board data. Investment and Interest Rates 7.15 Just as the deceleration in monetary growth in the banking system was partially offset by acceleration in the NBFI segment, so also were higher interest rates in the former partially offset by declining interest rates in the latter. As Table 7.4 shows, bond and commercial paper yields (which reflect the price of credit in the Y BFI segment) as well as curb market inter- est rates declined during 1982-85., (Interest rate behavior in the non-bank segment is examined in Box 7.2). For present purposes suffice it to note that monetary developments in the primary banking system can be an unreliable guide to predicting real sector consequences. 5/ The yield on commercial paper handled by NBFI's is supposedly determined by the free market and is not regulated by the monetary authorities. The yield on corporate bonds, however, is regulated in the sense that it is not allowed to rise above a ceiling. During 1982-85 these two yields have moved closely together in a downward direction. With the stabilization of inflation in the : 4% range during 1983-85, these yields have dropped in real terms also. - 58 - 7.16 The link between private investment and interest rates is important from the point of view of financial liberalisation. If interest rate decon- trol were to result in a substantial upward movement of the real cost of credit, and if private investment were highly interest elastic, at least in the short-run consequences of financial reform would be strongly contrac- tionary. This has not happened in recent years partly because of offsetting developments in the non-bank (and curb market) segments and partly because of the effects of foreign income growth. It may also have been due to a low elasticity of investment with respect to interest rate changes. 7.17 As far as future policymaking is concerned, however, it should be noted that structural changes appear,to be occurring in the business environ- ment which suggest that the interestirate elasticity of aggregate investment may rise in the future. Among these changes is the fact that the proportion of total investment that is undertaken by the private sector, which tends to be more cost conscious, has been rising in recent years (see Table 7.6). Second, the guarantee of adequate credit even when profit margins are low or financial structure shaky, can no longer be taken for granted; in the past Korean business could afford to be relatively complacent about interest rate increases because credit availability was what really mattered. But now that Government has signalled its intention of a following more of a hands-off approach and of allowing credit availability to be determined to a larger extent by individual firm performance and financial structure, interest rates should become a more critical determinant of investment decisions. Third, real curb market rates have fallen in recent years because of the possible unwinding of inflationary expectations; once such expectations are completely unwound the relationship between controlled rates and curb market rates will once again be dominated by domestic liquidity and foreign interest rate (adjusted for devaluation) developments and the conventional transmission mechanism of monetary policy should assert itself in a stronger fashion. Macro Policy and Inflation 7.18 Inflation reduction has been a prominent aspect of recent macroeconomic performance in Korea. Inflation came down sharply from 15.9% in 1981 to 4% in 1984. To what extent was this due to contractionary macroecon- omic policy? It can be argued that the dramatic inflation reduction of recent years was probably due more to favorable developments on the supply side rather than to demand-management policy. Nevertheless, demand management policy may have played an extremely important, but indirect, role by reducing the level of inflationary expectations. 7.19 The major reduction in inflation occurred during 1980-82 (when the inflation rate was brought down from about 29Z to about 7%) when monetary and fiscal policy were in fact rather expansionary (see Table 7.1). When macro- economic policy became relatively tight in 1983 and 1984 inflation was reduced further but by a small amount to an average of about 3.52. Furthermore, when monetary policy was relaxed in 1985, inflation did not rise. These develop- ments indicate that factors other than domestic macro policy have probably played a more important part in influencing the course of inflation in recent years. Among these are (i) the decline in the rate of growth of wages and improvements in the rate of growth of productivity; (ii) the substantial - 59 - decline in prices of imports; (iii) adjustments in the use of energy imports and (iv) a reduction in inflationary expectations. Wages and Productivity 7.20 Nominal wage growth has decelerated sharply in recent years, from a rate of about 152 in 1982 to about 8.5% in 1984-85 (see Table 7.7). One cannot definitively state whether this deceleration was a cause or an effect of declining inflation. However, attempts were made by Government to bring wages down during this period. These attempts took the form of mandated reductions in the rate of growth of public sector wages (including a freese in 1984) and of moral suasion in the matter of private sector wage settlements. Since 1982 also, productivity growth, as measured by changes in value-added in the manufacturing sector, has been rising. This increase in the rate of productivity growth has probably reduced the pressure on inflation by reducing unit labor costs. Table 7.7: PRODUCTIVITY AND WAGES IN MANUFACTURING (Annual percent change) 1982 1983 1984 1985 Nominal wage growth 14.7 12.2 8.1 9.0 Real wage growth 7.6 9.2 4.1 5.0 Productivity growth/a -2.0 3.2 12.0 n.a. /a Refers to index calculated from value-added in manufacturing data (in 1980 prices). Note: The nominal wage refers to gross monthly earnings. The real wage growth rate is obtained by adjusting the nominal rate using the CP deflator. Sources: BOK, Economic Statistics Yearbook. 7.21 Mirroring the increase in productivity is an improvement in invest- ment efficiency as indicated by a decline in the average ICOR characterizing the manufacturing sector. It is clear from Table 7.8 that investment - 60 - Box 7.2: THE DETERMINANTS OF CURB MARKET INTEREST RATES In a semi-open financial system and economy such as Korea's, both external and internal policies and events can be expected to affect domestic financial markets. Among the factors expected to determine the curb market interest rate are foreign interest rates and expected depreciation (which determine the effective cost of foreign credit), the degree of excess liquid- ity in the domestic economy, and inflationary expectations. These determin- ants are included in the following regression model: i = 0.47 + 0.08*(iw+d) + 0.47*i(-1) -0.08*log DC (-1) (1.8) (2.0) (3.0) (2.6) + 0.08*log Y + 0.38* TDR (0.3) (1.8) The dependent variable i is the nominal curb market interest rate. The variable iw is the US Treasury Bill rate and the variable d measares the actual rate (a proxy for the expected rate) of devaluation of the Won with respect to the US dollar. DC(-1) is the amount of domestic credit supplied by the banking system in the previous period. Y is the level of real GDP and is a proxy for the demand for money. Together, DC and Y provide an indication of the degree of excess liquidity in the economy. TDR is the term deposit rate for one-year bank deposits; this variable adds further information about the state of domestic liquidity and about the opportunity cost of borrowing from the curb market. As far as inflationary expectations are concerned they should presumably be reflected in the expected rate of devaluation. The statistical results shown above indicate that the curb market interest rate is indeed influenced by both external and domestic liquidity factors. From a policy point of view, the results suggest that nomin.l devaluation can raise the domestic cost of credit. If the latter is an important component of unit costs, inflation cold be increased and/or output decreased. However, the effect detected here is quantitatively rather weak. The results also suggest that curb market interest rates tend to rise when controlled interest rates in the primary banking system are permitted to rise and to fall when credit supply in the primary banking system is increased. Thus, government monetary policy can affect developments in the unregulated segment of the financial sector. Estimation details: The model was estimated by the method of ordinary least squares using quarterly data for the period 1977-85. The R- squared statistic was 0.88 and the Durbin-Watson statistic was 1.38. The numbers in parentheses are t-statistics. A t-statistic value greater than 2 indicates that tbLe coefficient is significant at the 95% whereas one greater than 1.6 indicates significance at the 90% level. See Edwards (1986). - 61 - efficigcy has begun to increase after deteriorating sharply in the late 1970s.- The improvement can be attributed to the decline in the proportion of investment originating in the public sector or at the behest of Government through directed credit arrangements. In particular, the improvement in effi- ciency can be attributed to the reduction of the rate of growth of investment in the HCI sector and an increase in capacity utilisation in this sector. It is also possible that some of the improvements in efficiency and productivity have come about because of intersectoral shifts of resources from low produc- tivity to high productivity uses, from the growth of skills in the labor force and from technological improvements arising from indigenous R&D or imports. While it is difficult to quantify the contributions of each of these ft7torsp there is evidence which suggests that they have indeed been important.. Table 7.o8: AVERAGE INCREMENTAL CAPITAL OUTPUT RATIOS, 1978-84 /a 1978-81 1982-84 Agriculture, forestry & fishing 6.13 3.6 Manufacturing 5.33 1.6 Construction 2.69 1.0 Wholesale & retail trade, restaurants & hotels 7.96 2.6 Transport, storage & communications 13.25 1.6 Financing, insurance, real estate & business services 1.01 0.7 /a Changes in output are lagged by one year. Both output and fixed invest- ment are in 1980 constant prices. Source: Economic Planning Board and Bank of Korea. 6/ It should be noted that ICOR's are a crude measure of investment efficiency. Nevertheless, in the absence of more refined measures, ICOR's can convey useful information. In particular, trends in ICOR values over time are typically consistent with those of more elaborate measures of efficiency. 7/ For example, the supply of skilled manpower is steadily increasing partly because of increases in univer-ity enrolments and partly because of on- the-job training imparted in the new industries that Korea moved into in the late 1970s. The proportion of government and private resources devoted to R&D activities has risen since 1980 and this may have provided some technological improvements, but a more important source of such improvement has probably been imports. Intra-industry trade is becoming important in Korea's trade structure and trade liberalisation promises larger technology improvement bonuses over time. - 62 - Import Price Developments 7.22 The softness that has characterized the prices of Korea's main imports (such as oil, intermediate goods) has probably helped significantly in the control of inflation since imports are a large fraction of Korea's GNP and import prices typically account for 40% of the wholesale price index (WPI). The import price index has declin6d from a level of 104 in 1981 to 94.4 in 1984 as oil and commodity prices have slackened. This -onstitutes a rather significant improvement and given the weight of imports in the WPI $t is not surprising that domestic inflation has eased considerably during 1982-84. (See Table 7.9.) These developments continued into 1985 and show every sign of continuing to be important in determining domestic inflation in 1986. 7.23 The fact that such favorable external price developments have been allowed to pass-through into the domestic economy by way of a general lowering of trade barriers illustrates a benefit of the trade liberalization process that Korea has embarked upon. This pass-through would have had even more of a restraining effect on domestic inflation had it not been for the fact that considerations of export competitiveness prompted exchange rate depreciation during 1983-85, and especially in 1985. Energy Use Adjustments and Inflation 7.24 The control of inflation since 1980 has also been aided by the substantial adjustments achieved by Korea in the level and pattern of energy use. If investment in the 1980s had been based on the pattern of energy use established in the 1970s, a high rate of inflation would undoubtedly have occurred as a rising energy coefficient (ratio of energy use to CDP) would have exaggerated the effects of the sharp rise in the price of oil, the economy's main energy input, in 1979-80. Even when the relative price of oil began to decline after 1982, rising energy use (in volume terms) could have offset this effect. Table 7.9: IMPORT PRICE INDEX DEVELOPMENTS (Weights in parentheses) 1980 1981 1982 1983 1984 1985 All commodities 100 104.0 98.7 94.4 94.4 90.7 Mineral products (33.1) 100 112.0 108.6 96.4 92.3 91.7 Agriculture and related (20.6) 100 97.8 81.9 82.2 86.1 75.0 Industrial products (46.3) 100 101.0 99.1 98.4 99.6 96.9 Sourcet BOK, Economic Statistics Yearbook. - 63 - 7.25 There are several reasons why the energy coefficient could have been expected to rise in the 1980s. Korea's industrial structure changed durinj the 1970. in the direction of greater energy intensity as such high-energy- consuming sectors as heavy and chemical industries were fostered. Also, the mechanization of agriculture was more or less completed in the 1970s and further investment in agriculture would have had to contend with higher levels of energy use. rinally, real incomes had risen substantially in the 1970s and the consumption of energy intensive durables such as household appliances and cars had begun to rise. Thus, going into the 1980s, Korea could have expected to see a rise in the ratio of its energy consumption to GDP. 7.26 As a result of strong conservation and substitution measures, how- ever, this did not happen. As Table 7.10 shows the ratio actually declined from 1980 to 1983. The principal measures employed were the continuation of a fuel substitution program (begun in the 1970s), which featured the building of nuclear power plants and the passing along of high oil prices to final con- sumers to reduce oil consumption. Devaluation and surcharges made the retail price of oil even higher than that imposed by OPEC. The elasticity of oil v)nsumption with respect to the CDP fell from 1.2 during 1973-78 to 0.45 dur- ing 1978-84 and the elasticity of total energy consumption with respect to manufacturing output (in real value added terms) declined from 0.85 in 1973-78 to 0.37 in 1978-84. Table 7.10: INDICATORS OF ENERGY USE 1980 1981 1982 1983 Energy/CDP ratio TOE/$'000 /a 0.77 0.75 0.71 0.70 Index (1980 - 100) 100 97.4 92.3 91.5 /a TOE = ton of oil equivalent. Inflationary Expectations 7.27 Finally, the role of inflationary expectations should also be mentioned. The 1970s were a period of relatively high inflation and govern- ment attitude towards investment and growth fed inflationary expections. The process came to a head in 1980 when inflation soared to 25.6%, while real GNP actually declined (by 5.2%) for the first time in Korea's modern economic history. The reorientation of government attitude since then and the steadi- ness with which the government has pursued a price stability objective has reduced inflation considerably and must have reduced inflationary expecta- ticns. Korea has never enjoyed inflation rates so low and for so long as during the past four years. The ensuing decline in inflationary expectations has been of great importance in reducing inflation and has probably itself been affected strongly by the governments aggregate demand policy stance. - 64 - While the actual reduction of demand stimulus as a consequence of conservative policy may not have been large, the psychological effect on inflationary expectations has probably been quite strong. C. Monetary Policy in the Medium Run 7.28 The conduct and effectiveness of monetary policy will be influenced over the mediu run by some structural aspects of the Korean financial system. Among these are recent shifts in the structure of the financial system resulting in an enhanced role for NBFI's, and a pattern of corporate finance featuring high debt-equity ratios. In addition, the conduct of monetary policy will be influenced by the goal, emphasized in the Sixth Plan, of maintaining systematic surpluses on the current account. Monetary Policy and NBFIs 7.29 The structure of the Korean financial system has changed in several respects over the last ten years or so. NBFI's now attract a substantial proportion of household savings deposits and generate a substantial proportion of domestic credit to the corporate sector. They have garnered by far the largest chunk of incremental asset growth in the financial system since 1973. If their role in the issuance and guarantee of commercial bills and corporate bonds is also taken into account, it would be fair to say that they have become as important as the established deposit money banks (DMBs) in the overall financial intermediation process in Korea. This increase in their relative importance has come about at the expense of both DMB's and the curb market. The shifts in asset shares between DMBs and NBFIs has already been documented (see Table 7.5). 7.30 A major Lmplication for monetary policy of the growth of NBFIs is that this complicates the business of setting monetary targets and achieving desired real sector effects. The monetary authorities have more control over the credit creation and credit pricing behavior of DMBs than they do over NBFIs because the latter are subject to less regulation and do not rely on the Bank of Korea for rediscounting or deposit enhancement. As a consequence, when the authorities fix a domestic credit supply target through the DMB system, they cannot be sure what effect this will have on overall liquidity in the economy. As shown earlier (see Table 7.3), overall liquidity can differ both in magnitude and direction of change from DMB liquidity. For example, while the rate of growth of dometic credit supplied through DMBs was reduced from 16% in 1983 to 13% in 1984, that of credit supplied through NBFI's accelerated from 262 to 34%. As a result, over&ll liquidity growth accele- rated from 19% in 1983 to 21% in 1984. Furthermore, when the rate of growth of domestic credit supplied through DMB's was accelerated to 18% in 1985, that supplied through NBFI's decelerated to 292. The net result was a modest acceleration in overall liquidity to 22.5%. 7.31 These variations in the rates of growth of alternative monetary aggregates indicate the existence of potentially powerful offsets between credit supply behavior in these two market segments. Sufficient experience has not yet been gained through which to specify a rule of thumb that would - 65 - allow the authorities to predict the overall liquidity consequences of credit supply policies framed with respect to the primary banking sector alone. This adds further uncertainty to the matter of predicting real sector consequen- ces. Korea's experience is not unique in this respect. As new financial instruments have proliferated in the OECD economies and as financial deregu- lation has spread, overall liquidity positions have become less subject to government control. To the extent that this is so, uncertainty regarding the ultimate eIfect of government policy on investment, output and inflation is increased.,' 7.32 It is also possible that the relative growth of NBFIs will alter the resource allocation effects of monetary policy. The firms, sectors and activ- ities that draw largely upon the DMBe for credit will be more strongly affec- ted by monetary policy changes/initiatives than those who draw credit largely from NBFIs. This effect, of course, will be smaller the greater the extent to which these segments have overlapping clients. While large firms can switch more easily between these two segments (indeed, many NBFIs are owned by large firms), small firms cannot. Since the sectoral pattern of access to the different segments of the financial system is not known, Government may wish to investigate the potential bias in monetary policy on small and medium industries versus large firms. Monetary Policy and the Corporate Finance Structure 7.33 The structure of corporate finance is perhaps the Achilles heel of the Korean economy. Debt-equity ratios for Korean manufacturing firms (see Table 7.11) tend to be high in comparison woh those for firms in most developed countries as well as in the NICs, As a consequence, the financial viability of Korean firms is threatened whenever interest rates rise or credit supply is curtailed by amounts that would be considered quite manageable in other countries. This constrains monetary policy and the process of financial liberalization. Government has had to proceed gingerly with respect to financial liberalization in recent years because of the implicit threat of financial distress among Korea's highly leveraged firms, and especially some large conglomerates which are disproportionately important to output, employment and export performance. The structure of corporate finance will 8/ This need not imply that the broadest measure of liquidity is the most appropriate indicator for macroeconomic performance prediction. Narrower measures may still remain appropriate for specific purposes. 91 Debt-equity ratios have historically been high in Korea essentially because of government-mandated cheap debt and expensive equity policies. Real interest rates have typically been very low or negative while equity has been discouraged through a variety of disincentives such as the prohibition of new issues at prices above par. Government has recently taken steps to improve corporate debt-equity ratios by raising the cost of debt and reducing disincentives to the issue of equities. While some success has been achieved, debt equity ratios remain high and Korean corporations remain hostage to their financial structures. - 66 - continue to affect monetary policy in the future until such time as when the excessively heavy reliance on debt is reduced to international norms. Paradoxically, tight monetary policy featuring high interest rates and lower levels of credit supply is one of the ways in which to discourage debt reliance. This is best implemented, however, when business conditions are good and firms have higher levels of profits with which to finance credit needs and/or can issue equity at attractive prices. Table 7.11: COMPARATIVE DEBT-EQUITY RATIOS (MANUFACTURING SECTOR) 1980 1981 1982 1983 1984 Korea 488 452 386 360 343 Japan 385 378 392 324 na US 101 105 106 104 na Germany 214 222 216 218 na Source: BOK, Financial Statements Analysis. Sterilization and Current Account Surpluses 7.34 As mentioned earlier, the most prominent macroeconomic goal of the Sixth Plan is the achievement of systematic surpluses on the current account. Normally this would have implied a continuation of the aggressive, competitiveness-oriented nominal exchange re 3 policy that Korea has success- fully followed in recent years. The sudden and sharp decline in the price of oil and the sharp akpreciation of the yen relative to the won in early 1986 reduce the necessity for such a policy. These favorable external developments are likely to produce current account surpluses directly. The implications for monetary policy are not as clear-cut. On the one hand, the downside inflation and external deficit risk to looser monetary policy is now consider- ably lower. On the other hand, such surpluses will tend to result in exchange rate appreciation and eventually propel the exchange rate to a level consi- stent with external balance. If, however, Korea seeks to geperate systematic surpluses in order to reduce its net debt it will have to be ready to steri- lize the foreign exchange liquidity inflows associated with such surpluses. 7.35 Even if Government possesses the will to sterilize it may not have the ability to do so. Successful sterilization requires monetary instruments that are widely acceptable (such as Treasury securities in the US) and formal financial markets that are the predominant channel of the flow of funds in the economy. Korea is at present lacking on both counts. There does not exist a government security that the general public is willing to hold in meaningful quantities. Stabilization and sterilization are presently conducted through the forced sale of government securities to commercial banks. To the extent also that financial markets are segmented and commercial banks do not control the bulk of the flow of funds in the economy, sterilization operations may be neutralized by offsetting movements in the nonbank segment. If the capital - 67 - account is open there is an additionfsource of offsetting liquidity in the form of international capital flows.-- 7.36 The development of a strong sterilization instrument is linked to the process of financial liberalization. The main reason why government secu- rities are not widely held is that Goverment has found it more convenient to "borrown from pliant commercial banks at essentially zero interest rates. Government could spread the distribution of its securities among the public by offering interest rates competitive with those available to the public in the nonbank segment of the financial system. Once all interest rates in the financial system are allowed to be market-determined, the system will become unified and once government control over the asset management of commercial banks is reduced Government too will have to borrow at market rates of inter- est. Both of these outcomes will strengthen the sterilization ability of the government. D. Exchange Rate Management 7.37 In recent years the exchange rate has featured prominently among the macroeconomic instruments employed to stabilize the economy and to adjust to the economic change wrought by the events, already alluded to, of 1918-81. The stabilization goal has essentially been to avoid large current account deficits. The adjustment goal has had two aspects: one to adapt to the changing structure of international prices (especially for oil) and interest rates and the other to facilitate the liberalization of imports (in order to benefit from gains from trade and transfer of technology) and to open up Korea's domestic market without serious dislocation. Towards these ends, the nominal exchange rate has been depreciated in small steps (after a devaluation of 17Z in January 1980). The nominal depreciation has been accompanied, for the most part, by a real depreciation. According to one index, Korea's real 10/ The empirical evidence on the Bank of Korea's ability to sterilize is mixed. The results tend to range from suggesting complete inability to control monetary aggregates to a rather strong ability to do so in the short run. The difficulty of interpreting the existing empirical studies is compounded by the fact that the policy environment, which reflects the will to sterilize, has not remained constant and hence the selection of different periods for study can yield different results. - 68 - effective exchange rate has depreciated by almost 20Z since 1982.LU The results of this exchange rate management have been successful so far and Government is expected to continue to use the exchange rate to attain both short-run macroeconomic objectives and long-run structural ones. Impact on the Current Account 7.38 One measure of this policy's success has been the taming of the current account deficit; this has been brought down from 6.9% of GNP in 1982 to about 12 in 1985. The success of depreciation in boosting export and restraining imports has been due in considerable measure to the price elasti- cities that characterise Korean tradeables: -a 10% decrease in export prices raises exports by almost 17%, while a similar crease in import prices causes imports to fall by about 52 (see Table 7.12). One should avoid the Table 7.12: RANGE OF ESTIMATES OF KEY TRADE ELASTICITIES Earlier period Recent period (1962-78) (1974-84) Income elasticity of imports 1.4 to 2.3 1.0 to 1.3 Import price elasticity of imports 1.4 to 1.7 0.4 to 0.6 Foreign income elasticity of exports 5.5 to 6.4 3.5 to 4.3 Export price elasticity of exports 1.4 to 3.2 1.4 to 1.7 Sources: Kwack (1985); Kwack-Mered (1980); Y.B. Kim (1984). 11 While the nominal exchange rate is the policy instrument available to the authorities it is the real effective exchange rate which actually deter- mines ultimate effects on the balance of payments and resource allocation between tradeables and non-tradeables. This rate is affected partly by nominal devaluation, partly by domestic macroeconomic policy, and partly by external developments (see Box 7.3). In this sense, exchange rate management is not entirely independent of macroeconomic policy. 12/ Korea's success with exchange rate depreciation in recent years should not come as a surprise to students of Korea's macroeconomic history. Two episodes are worth recalling. A devaluation of 182 (against the dollar) in late 1974 produced a spectacular recovery of the export growth rate in 1975 even though the volume of world trade (in manufactures) fell that year by about 5%. A similar development occurred in 1980 when a devaluation of 17% (against the dollar) helped produce an export growth surge in 1980-81. The general policy of depreciation to enhance external competitiveness and control the current account deficit has been more or less consistently followed since the devaluation of 1980. The overall effects of a nominal depreciation are estimated in a number of large macroeconomic models for Korea (see Kwack, 1985, and BOK, 1985). It is generally confirmed that such a policy can improve the current account. - 69 - temptation of extrapolating into the future from these elasticities, however, because a larger proportion of Korean exports are covered by increasingly tight protectionist arrangements now (and will be through the foreseeable future) than has been the case in the past. In addition to textiles and clothing, the traditional Korean exports, newer Korean exports such as steel products are now subject to quotas in OECD markets. The greater the extent to which such important exports are controlled by quota arrangements, the less the advantage to be gained by price reductions. In fact a different incentive may apply under quantitative restrictions to the extent that higher value- added, higher price items should be exported so as to maximize the value of the quota to the exporter. It should also be emphasized that Korea faces intense competition from other NIC's and aspiring NIC's in its major export markets. Depreciation of the won is unlikely to be successful in expanding market shares if competitors follow suit and depreciate their currencies proportionately. This aspect of increasing competition should be kept in mind by Korean policymakers when assessing the future role of exchange rate management. 7.39 On the import side, however, there may be increasing room for maneu- ver. This is largely a consequence of changes in investment mix and of adjustment to higher oil prices in recent years. As Government has gradually abandoned its promotion of heavy industries, which were highly import-inten- sive, the import-dependence of Korea's exports, investment and consumption goods has begun to decline (see Table 7.13). Second, the development of the capital goods industry in the 1970s is now paying off. Finally, conservation and other responses to high oil prices have made Korea less depend BY on oil imports (on a per unit output basis) than before (see Table 7.10).- Nevertheless, at least in the short-run, sharp movements of the won vis-a-vis the yen, for example, will not provide an immediate and sizeable payments improvement to the extent that Korean exports are dependent on intermediate inputs which cannot easily be sourced. 7.40 Exchange rate management to promote improvement in the current account has been helped by conservative macroeconomic policy in recent years. The literature on the effects of devaluation is fairly unanimous in indicating that expansionary macroeconomic policy tends to cause an appreciation of the real effective exchange rate (REER). High ratios of public expenditure to GNP and high rates of growth of domestic credit tend to be associated with higher rates of inflation and, if they occur after a nominal devaluation, they often offset the relative price effects of the devaluation. Empirical analysis for the Korean case (see Box 7.3) confirms this. The implication is that the con- servative monetary and fiscal policy that has been implemented in recent years 13/ The share of petroleum products has declined from 27Z of all imports in 1980 to 21% in 1984. This has been partly due to declining oil prices and partly to strong conservation measures. - 70 - has probably been very important in maintaining exportopetitiveness through downward pressure on the real effective exchange rate.- Table 7.13: IMPORT GENERATION COEFFICIENTS 1970 1975 1980 1983 Consumption 0.13 0.19 0.23 0.22 Investment 0.39 0.48 0.42 0.35 Exports 0.26 0.36 0.38 0.36 Final Demand 0.20 0.29 0.30 0.28 Notes: The import generation coefficient is the value of imports generated to satisfy one unit of final demand. It captures both the direct and indirect requirements for imported intermediate goods. Source: World Bank estimates. Impact on Inflation 7.41 Another measure of the success of depreciation in recent years is the concurrent achievement of price stability and reasonably high growth. No serious stagflationary effects have followed the fairly steady depreciation undertaken since 1980. The lack of any visible effect of recent depreciation on inflation is striking because most empirical studies confirm the existence of a positivelf7lationship between domestic inflation and the rate of depreciation,- The principal offsetting factor must have been the decline in the import price index (measured in dollars). The moderation of the devaluation -- inflation connection may also be due to two developments mentioned earlier, via., the decline in import dependence in general and the 14/ It is possible also that tight fiscal policy reduces import demand in addition to reducing domestic inflation. If government expenditures have a high import content, restraining government expenditures could improve the current account directly. 15/ Devaluation is thought to affect domestic inflation through two channels. The first is the direct effect through the won price of imports since imports are important intermediate inputs for many of the products that enter the won price index for Korean manufacturers. The second channel operates through the curb market interest rate. Devaluation raises this interest rate and thereby raises costs of production for Korea's highly leveraged manufacturing sector. These costs can be passed along in the form of higher prices. Empirical verification of the inflationary effects of devaluation in the Korean context is provided in Kwack (1985) and of the transmission channels in Van Wijnbergen (1981). - 71 - Box 7.3: THE DETERMIMANTS OF THE REAL SFFECTIVE EXCHANGE RATE The effective value of a county's exchange rate depends on a set of real and monetary variables which reflect the strength of the demand for (and supply of) the country's currency. Among such variables could be included the terms of trade, the amount of capital inflow, the rate of productivity growth, and measures of domestic macroeconomic policy such as the level of public expenditures, the growth of domestic credit and the level of the nominal exchange rate. The regression analysis reported here takes the logarithm of the REER index to be the dependent variable and suitably modified measures of the above variables as independent determinants of this index. The terms of trade variable (T) measures the relative price of imports to exports. This variable is affected both by nominal depreciation and by external price developments. The capital flow variable used (CINF) measures the ratio of capital inflows to GNP. It is expected that the higher this ratio the greater the tendency for the exchange rate to appreciate. The rate of productivity growth is most appropriately measured as a differential between Korea and its major trade partners since it is the differential that determines the net demand for individual currencies involved. It is expected that the higher the differen- tial in favor of Korea the greater the tendency for its exchange rate to appreciate. In the empirical analysis such differentials are proxied by the average output growth differential between Korea and its major trading part- ners (PGD). The effects of domestic macroeconomic policy are captured through three variables; the ratio of public expenditures to GNP (PER); the rate of growth of domestic credit (CDC); and dummy variables (D and D(-1)) denoting years in which nominal devaluations occurred. Estimation of the above model, by the method of ordinary least squares corrected by first-order serial correlation and using annual data from 1964 to 1980, yielded the following results (- denotes appreciation): log REER a 0.55 - 0.58*log T - 0.36*log (1 + GDC) + 0.15*log (1 + CINF) (10.08) (-4.6) (2.5) (0.23) - 0.72*log PER - 0.78*log (1 + PGD) + 0.53*D + 0.98*D (-1) (-5.4) (-1.4) (1.4) (3.4) These results show that all coefficients with the exception of the capital inflows have the expected signs and that most of them are significant at conventional levels. Particularly important are the signs and magnitudes of the domestic credit growth and public expenditure ratio coefficients. They indicate that in the past expansive monetary and fiscal policies have been associated with appreciating real effective exchange rates. This means that the authorities need to be particularly careful to avoid expansionary macro policies in order not to undermine a nominal devaluation. These results also indicate - through the value of the coefficients of the devaluation dummy variables - that nominal devaluations have, with with other things given, a positive effect in the short run on the real exchange rate. That means that by managing the nominal exchange rate -- while maintaining an unchanged monetary and fiscal policy -- it may be possible to manipulate the real exchange rate in the short run. For details see Edwards (1986). - 72 - decline in energy or oil dependence in particular since the late 1970s. Once again it appears that favorable external as well as supply side developments have worked to offset the potentially adverse consequences of macroeconomic policy. 7.42 Finally, arranging the devaluation in small and gradual steps has moderated debt service difficulties for the highly leveraged corporate sector. The increase in exports and profits has apparently kept pace with the increase in the debt service that the corporate sector has had to bear because of the devaluation. As a consequence, the policy of devaluation has not attracted much opposition from business circles. E. Lessons for Future Policy Making 7.43 Korea has approached its stabilization and adjustment tasks creatively and in-so-doing it has benefitted from not relying exclusively on one approach or one policy instrument. It has also benefitted in that it has not applied any one instrument with great force and thereby not risked a sharper, more adverse policy tradeoff in the form of a temporary, but disrup- tive, recession. From the demand side it attacked inflation and an unsustain- able BOP deficit by means of restrictive monetary and fiscal policies. The possible adverse effects of contractionary demand management were offset by supply-side policies which sought to raise efficiency and productivity. Incentives to promote savings and investment and policies to reduce distor- tions in the trade and financial regimes have helped maintain output even as the economy was otherwise being cooled down and a revolution of falling expec- tations being brought about. Accentuation and attenuation of the demand-side and supply-side effects has been judiciously achieved, as and when necessary, by a flexible exchange rate policy. 7.45 The consequences of macroeconomic policies may differ in the future to the extent that certain key macroeconomic relationships appear to be changing. For example, structural changes appear to have been brought about by recent changes in what may be called the "rules of the (economic) game:" specifically, the Government's progressive abstention from intervention in the economy appears to be changing the investment and savings behavior of the private sector. The implicit socialization of business risk that was the hallmark of industrial policy and development in the 1960s and 1970. is no longer to be counted upon now that Government has announced an industrial policy which limits active industry-specific intervention and emphasizes functional incentives. When fully effected, this transformation should make private investment more sensitive to monetary policy exercised through interest rates and to fiscal policy exercised through variations in tax rates. 7.46 Similarly, the mobilization of private savings has been enhanced by recent financial policy which has featured rising interest rates (in the primary banking system), a proliferation of savings instruments, and declining inflation. Should this policy persevere, additional gains could be reaped in - 73 - the form of increases in financial and investment efficiency. However, oppo- sition to further financial liberalization could become stronger if the exter- nal environment is not as supportive of growth in the future. A foretaste of this came in 1985 when deteriorating exports and profits fed industry opposi- tion to Governments financial policy and succeeded in getting credit controls (on conglomerates) lifted and nominal interest rates rolled back slightly. 7.47 Structural changes have also been wrought by the sustained experience of stabilization and adjustment in recent yearst specifically, both inflationary expectations and energy and import dependence appear to have been reduced. These developments would appear to increase the latitude for expansionary macroeconomic policy. The risk of sizable increases in inflation or the 809 deficit from expansionary policy is less now than was the case in the early 1980s. However, this must be set against the possibility that administrative wage and price guidance may also have played a considerable role, for example, in the reduction of inflation. If such repression has indeed been important in recent years, it is possible that there may be greater resistance to wage and price austerity in the future. This would impart greater rigidity to the aggregate supply responsiveness of the economy. Another development that would have a similar effect is a reduction in the growth of productivity. If, as is possible, recent productivity advances have occurred largely because of increases in capacity utilization, then the rate of such advances in the future will diminish as fuller rates of utilization are achieved. 7.48 The effects of changes in the external environment have been described at several points in the foregoing. It is clear that growth of GNP and imports in the OECD countries exercises a powerful influence on Korea's macroeconomic performance and on the effectiveness of Korea's macroeconomic policies. Korea remains an open economy and while some structural develop- ments (e.g., successful import substitution and generalized reduction of import dependence) may make it less vulnerable to external sAocks in the future, Korea is a long way from acquiring the sort of independence that Japan and the US enjoy on account of their large domestic markets. Furthermore, the high debt that Korea has acquired in the process of growth is best managed in the future by maintaining an export orientation. Flexible macroeconomic policy, and especially a competitiveness-oriented exchange rate policy, can be of great help in negotiating external shocks of a cyclical nature. Where the shocks are structural in nature, an appropriate industrial policy is called for. - 74 - CHAPTER 8: ECONOMIC LIBERALISATION AND THE SEQUENCING OF REFORM A. Conceptual Issues 8.01 It has long been argued that developing countries should reduce their restrictions to international trade and become more integrated with the rest of the world. The benefits of free trade are well established theoreti- cally, and have become increasingly well documented empirically. Trading at world prices allows a country to use its resources efficiently and permits its consumers to acquire a larger quantity of goods for a given level of income. Cross country empirical studies have documented in a very convincing way that countries with more open economies have outperformed, in terms of growth and other indicators, those natlyns that have relied on heavy restrictions to international transactions- 8.02 The general thrust of policy recommendations favoring a more liberalized economy is not restricted to the elimination of distortions in the external sector, however. It is widely accepted that the reduction (elimina- tion) of distortions in all sectors would be desirable and for this reason, traditional policy prescriptions call for eliminating price controls, allowing (real) interest rates to rise, reducing import tariffs and quotas, and increasing the deg ge of integration of the economy with international financial markets.- 8.03 Although there is widespread agreement on the desirability of pursuing these reforms, the problem of recommending a specific sequencing for these policies is difficult on both theoretical and practical levels. Many times, due to political or other constraints, it is not possible to pursue the liberalization of all sectors simultaneously. In those cases, the question of sequencing becomes very important. Until recently, very little analytical work had focussed on issues such as: should domestic interest rates be raised before, after or at the same time as capital controls are lifted? S uld the trade account be opened up before the capital account or vice versa?- 1/ See Little, Scitovsky and Scott (1970), Krueger (1978), and Bhagwati and Srinivasan (1979). 2/ From a theoretical perspective there is a question related to the benefits of partial reforms where only some distortions are eliminated. This, of course, is a typical second best problem. See the discussion in Krueger (1985). Of course in a textbook world with no distortions the question of appropriate sequencing is trivial. All markets should be liberalized simultaneously and instantaneously. In the real world, however, complications arise. 3/ See, however, the studies by Edwards (1984), and Krueger (1985). - 75 - 8.04 Given the present commitment of the Korean Government to liberalize the economy, by dismantling trade controls and raising interest rates, the question of sequencing becomes current and increasingly important. In this section some of the more important aspects of the sequencing of economic reform will be analysed. The discussion will basically deal with the order of liberalization of the current and capital accounts, and will emphasize macro- economic effects of alternative sequences. The analysis will also deal with efficiency and credibility issues. The problem of determining the appropriate sequencing of reform is particularly difficult from an analytical point of view inasmuch as the analysis depends heavily on the initi't conditions. In Korea, these conditions are quite different from those encountered in the most publicized liberalization attempts in the Southern Cone of Latin America, and thus, the results emerging from that latter experience may not directly apply to the KXyean case. Still, the Latin American experience offers valuable lessons, 8.05 How might conditions in Korea in 1986 be characterized as it approaches further liberalization? Very simply put, these conditions aret (i) a negligible inflation; (ii) basically balanced public sector finances; (iii) a very open economy with some export bias; (iv) a repressed and segmented capital market, where an official market with fixed rates coexists with a spectrum of less controlled markets, including a freely functioning unorganized (curb) market; (v) the existence of import restrictions which are being dismantled; and (vi) selective controls to capital movements, based on a "negative list," where inflows of capital have to be approved on an individual transactions basis. 8.06 One aspect of sequencing that is well established is that impediments to capital movements (both inflows and outflows) should not be fully relaxed before liberalizing the domestic financial sector. The rationale is that if the capital account is liberalized at a time when domestic interest rates are fixed arbitrarily low or negative real levels, an outflow of capital will result It is clear that Korea has begun to take some of the steps necessary to bolster the domestic financial systems in anticipation of ultimately opening its capital market, but considerable 41 Much of the discussion on the sequencing of reform has been done using Latin America as the benchmark. See McKinnon (1982), Edwards (1984, 1985), Corbo and de Melo (1985), and Edwards and van Wijnbergen (1986). 5/ Capital flight has indeed been the result of acute imbalances between domestic and international real interest rates of a number of developing countries, i.e., if the domestic interest rate is below the world interest rate, appropriately corrected for expected devaluation and other risk premia, financial capital will tend to exit. Much of th.e capital flight that Argentina experienced in the early 1980s, for example, was in response to the fact that the (anticipated) interept rate was perceived to be well below that in the rest of the world. In the current Korean case real interest rates are positive -- although probably below their equilibrium level -- and it is not likely that a relaxation of exchange controls would result in massive capital flight. - 76 - further reform will be needed to make this possible. Positive real interest rates now exist, but well functioning capital markets, ready to compete with external markets, would also require less segmentation, a wider range of maturities, and some financial instruments to hedge exchange rate risk effectively. Thus, in some sense, it is possible to say that Korea has taken the initial steps towards financial liberalization. B. The Capital Account, the Current Account and the Real Exchange Rate 8.07 Perhaps one of the most critical issues related to the dynamics of economic reform is the sequencing of liberalization of the current and capital accounts. Different sequences of the liberalization will imply different paths for the critical macroeconomic variables, in particular the real exchange rate. In general, the opfw1ing of the capital account and relaxation of exchange controls in a developing country will generate important movements in financial capital. In most countries, if the fiscal deficit is under control and the domestic financial market liberalized, the opening of the capital account will very likely result in significant inflows of foreign capital, triggered perceived differentials between the domestic and foreign returns to capital. These add4tional funds from abroad will allow domestic economic agents -- households, firms, and the Government -- to increase their expenditure over preliberalization levels. This additional expenditure will generally fall both on domestic and international goods. The increased expenditure on international goods will generate the current account deficit that usually mirrors the capital account surplus generated by the increased capital inflows. On the domestic side, the increase in expenditure will be translated in a higher demand for domestic (or nontraded) goods, and in a higher relative price for these goods. This relative price increase or real exchange rate appreciation is one of the most important consequences of a liberalization of the capital account in a capital importing country. 8.08 Under these conditions, the opening of the capital account will generate a real appreciation; however, a successful liberalization of the trade account (i.e., reduction of import tariffs and elimination of import quotas) will generally require a real depreciation of the domestic currency. This real depreciation will help the exportables sector expand, as the new structure of relative prices replaces the old protective structure, dnd conse- quently wll be instrumental for reestablishing external equilibrium after import restrictions have been reduced. If, however, the opening of the capital account precludes this real depreciation, then the transition in the exportable and importable goods sector from a protective to a freer environ- ment will become more difficult. The appreciation generated by the relaxation of capital controls will squeeze profitability in the tradable goods sector precisely at the moment when it is going through a costly readjustment. This would be a major risk for Korea in prematurely opening up its capital market. 6/ This assumes that the developing country has relative abundance of labor, and scarcity of capital. In the present world economic conditions with many LDCs affected by the international debt crisis, an opening of the capital account may not result in massive capital inflows. - 17 - 8.09 Consequently, it has been suggested that the capital and current accounts should not be opened simultaneously and, moreover, that during the transition period fter trade has been liberalized, capital inflows be care- fully controlled.- This view is reinforced by the fact that, in general, the opening of the capital account will result in an overshooting of capital inflows, which will provoke a steep real appreciation in the short run. In other words, experience has shown that immediately after the relaxation of controls, capital inflows are likely to be quite large, but that after some time they decline towards a new long-run equilibrium level. There are a number of examples where the opening of the capital account has resulted in massive c aital inflows and a significant real appreciation of the domestic currency*- 8.10 The conflicting movements of the real exchange rate as a result of opening the capital and current accounts (i.e., real appreciation and depre- ciation respectively) capture the fact that these policies will exercise pres- sures for resources to move in opposite directions. To the extent that there are adjustment costs associated with resource movements between sectors it is advisable to implement policies that would avoid unnecessary resource switches i.e., resource movements that will be reversed after a short period of time- 7/ See McKinnon (1973, 1982), Dorn.usch (1983), Frenkel (1982), Edwards (1983, 1984). 8/ Perhaps the best known recent case was Chile during 1979-81 when massive capital inflows resulted in a reach exchange rate appreciation of 30%. The Korean experience during the 1960s has also been cited in connection with capital inflows following a capital account liberalization. In mid- 1966, a large inflow of short-term financial capital flooded the Korean economy. As a result, there was an increase in inflation and a substan- tial real appreciation. It should be noted, however, that throughout their experiences with major inflows of capital, Korea and Chile followed different strategies. Whereas in Korea the nominal exchange rate was adjusted periodically, in Chile a fixed nominal rate was in effect during most of the period. In both countries, however, a real appreciation took place, with the real exchange rate moving against exporters. 9/ Once more Chile provides a good example. Starting in 1976 -- after the path of trade liberalization had been announced - exporters embarked on extensive investment programs aimed at increasing their export capacity, only to find that in 1979-81 the real exchange rate turned drastically against them. At this point investors moved away from the export sector and switched their resources to the nontradable sectors and especially towards construction. It has been suggested that one simple way of avoiding these unnecessary resource switches is by opening the current account first, and, only after the new productive structure has been well established, opening the capital account slowly. See McKinnon (1982), Frenkel (1983). - 78 - 8.11 The preceeding discussion has assumed that once the capital account is opened, domestic agents would be able to borrow from abroad and capital would flow into the country. This is indeed what would be expected under normal conditions, where uncontrolled (real) domestic interest rates would be substantially higher than abroad. This would, in fact, very likely be the situation in Korea if all exchange controls were suddenly lifted. However, given the current mood in the international financial community regarding lending to the developing countries, there is a risk that these incoming funds might be of short-term maturities ,0o that the real appreciation which would occur might be of short duration. C. Economic Reform, Efficiency and Credibility 8.12 Policymakers considering the macroeconomic consequences of alterna- tive sequences of reform may wish to consider two additional issues. The first of these deals with the effects of the reforms on the efficiency of the resource allocation and consumption processes. The specific question is how the economy's ovnll efficiency will be affected by removing distortions in only one sector Even though the evidence is not conclusive, there is a strong presumption that the relaxation of capital controls in the presence of tariffs will amplify existing distortions, reducing the efficiency of the economy. Once capital controls are lifted a proportion of the funds obtained from abroad will be used to increase investment in the import substitution sector. However, since tariffs have not been lowered yet, this sector is already producing "too much" and "too inefficiently" relative to what it would produce under a neutral trade regime; the existing distortion may, thus, be amplified. On the other hand, the presumption is that the reduction of tariffs in the presence of capital controls will generally not produce negative amplifications of existing distortions. On the contrary, it is 10/ In the current debt environment countries may face a situation of international credit rationing. Under these circumstances it is likely that the opening of the capital account will not result in additional capital inflows. Moreover, depending on the approach the country is taking to solving its debt problems, capital may even tend to flow out when capital restrictions are relaxed because in some instances the stabilization program is carried out timidly. These slow adjustments introduce significant uncertainties regarding the future behavior of the exchange rate and domestic interest rates. These considerations again point towards delaying the opening of the capital account until the smooth functioning of domestic capital markets has been demonstrated. 11/ According to the "second-best" theorem of welfare economics, if existing restrictions are only relaxed sequentially it is not possible to know a priori whether some of the remaining distortions will be magnified due to the partial liberalization. If this is the case, partial reforms may generate negative results and if the magnification of the remaining distortion is big enough, partial reforms may have a negative overall short-run effect on the economy. - 79- likely that a positive indirect effect will result because the r 4fction in tariffs will likely result in a higher demand for foreign funde 8.13 The second important issue is related to the degree of credibility of economic reforms. Credibility will generally affect the perceived path of relative prices and incentives. If a trade reform announcement is credible, firms and investors will expect a particular set of future movements in prices and relative returns to investment to ensue and they will react accordingly, mobilizing resources, and investing in the "new export industries." On the other hand, if the public believes that the reform is not credible, and that there is some probability that the reform will be reversed in the future, "cheap" foreign funds, obtained through the opening of the capital account, may be used by the owners of firms in the import substitution industries to maintain their firms functioning at a (temporary) loss until such time as the reforms are reversed. 8.14 It is important to stress that the degree of credibility - which is critical for the analysis of the sequencing of liberalization - should not be viewed as completely exogenous. On the contrary, the strategy followed during the liberalization process will tend to affect this credibility. A fundamen- tal and critical aspect of establishing credibility is related to the inter&I consistency of the policies that have been and are currently being pursued,- This aspect of reform has been a strong point of the Korean efforts inasmuch as Government has used a long preannouncement period for basic reforms and has stuck to it. Credibility has thus not been a problem in the Korean context. 8.15 Summarizing, although there is no ironclad rule regarding the appropriate sequencing of liberalization, both analytical considerations and historical evidence suggest that a prudent policy consists of liberalizing the current account well before the capital account is fully opened. A corollary is that the domestic financial sector must be sufficiently strong and the capital market sufficiently developed to allow the benefits of capital account liberalization to be reaped. Premature liberalization, before domestic insti- tutions are capable of operating effectively is usually ill-advised. Equally important perhaps to the sequencing of reform is the confidence these policies inspire. In that sense, a crucial aspect of the liberalization process is to define a consistent and credible policy package. 12/ See Krueger (1985) and Edwards and van Wijnbergen (1986). 13/ For example, the inconsistency between fiscal and exchange rate policies in Argentina in the late 1970s, played an important role in the eventual abortion of that country's liberalization program. Also, in Chile, many agents thought that since tariff reduction was accompanied by a significant real appreciation of the exchange rate, the trade reform was actually unsustainable. The extraordinarily large current account deficit observed in that country during 1979-81 further fueled the feeling of the reforms being unsustainable. This aspect of credibility should be an important consideration for policymakers undertaking trade policy reforms. - 80 - D. Review of Sequencing and Implementation 8.16 The Korean Government's commitment to liberalizing the economy is clearly serious and reforms are progressing at a steady pace. The general approach followed has been gradual and prudent. Progress, in terms of liberalization, has been different across sectors, with reform of the trade account proceeding at a relatively more rapid pace thwthe reform of the internal domestic market, and of the capital account.- 8.17 The fact that the liberalization of trade -- movement of items to the AA list and reduction of tariffs -- has proceeded in a preannounced, gradual fashion is a clearly positive step. This strategy, if well designed, will help those firms affected by the reform to adjust in a smoother fashion. Generally, the problem with this type of policy is to define a time span for the reform to be carried out that is sufficiently long, so that the adjustment can be indeed smoother, and sufficiently short, so that the announced liberalization measures are credible. To date it seems that policy- makers have been successful in defining this timing. The reforms are credible - although interest groups still lobby against it - and those firms that expect to be affected by it are taking some measures towards adjust- ment. On the other hand, until now no major disruptions in production associated with the reforms have been observed, which can either imply that initial trade restrictions were not terribly binding, that they still are operative in some guise, or that recent real depreciations in the exchange rate have had their desired effect. As noted earlier, changes in the degree of coverage of the AA list provides biased information, since many items are still affected by special laws. This procedure reduces the transparency of the importation process and it is recommended that the necessity of these special restrictive laws be reviewed. If necessary for their abolition, a temporary hike in their respective tariff levels could be considered, and would probably be preferable to any binding constraints imposed by these devices. 8.18 It is important to realize that the purpose of a trade liberaliza- tion reform is to increase the degree of openness of the economy and to improve the domestic sector's efficiency, The purpose of these reforms is not to generate a large trade deficit. This means that, in order to increase the amount of imports without increasing the trade deficit, exports should increase pari pasu with imports. This has to be achieved through higher incentives to exports. These incentives, in turn, come from two sources. Generally by liberalizing imports, imported intermediate inputs are made available at a lower price to the exports industries. Second, in order to maintain trade equilibrium, liberalization must usually be accompanied of a 14/ Liberalizing the trade account before the capital account and the domestic capital market account before the external capital account are both clearly warranted, although there is no clear consensus concerning the appropriate sequencing between trade and domestic finance. See Park (1985). - 81 - real depreciation. In the current Korean experience this real depreciation has indeed taken place; in 1985 alon2 the real effective rate fell by 12%. In that regarl he Korean reform is proceeding in the way most experts would recommend It should be emphasized that in the next few years the evolu- tion of the real exchange rate will continue to be very critical for the behavior of the external sector. 8.19 The strategy followed in Korea has also been prudent regarding the sequence of liberalization of the current and capital accounts. As discussed, there are strong presumptions that the liberalization of the capital account should be postponed for a substantial period until after trade reforms have been finalized. By maintaining some control over capital movements, erratic and counterproductive changes in the real exchange rate can be avoided. The current policy of monitoring capital movements is therefore quite important during the next few years to ensure that there is little impetus for backsliding on trade reform. 8.20 An important aspect of the Korean reform which has not generated sufficient attention is related to the liberalization of the service sector. Korea is preparing to open selectively its insurance market to foreign under- writers in 1987, for example. Some care should be taken to avoid confusing the liberalization of the service sector, which has benefits if the cost of those services to Korean industry can be reduced, with a selective opening of the capital account. For example, this could be the case, to some extent, if foreign insurance companies operating in Korea were allowed to freely diversify their portfolios internationally, with resulting surgep in capital outflows. 8.21 Overall the liberalization of Korea's external sector is proceeding smoothly and deliberately. It is noteworthy that liberalization proceeded according to schedule, despite dim export performance in 1985 and ensuing lower growth. This reflects a genuine commitment to liberalization. At the same time, restraint is being exercised during the transition. In light of the still somewhat immature state of domestic financial markets, and the fragility of certain aspects of corporate finance, this is prudent. The next priority in terms of achieving overall liberalization objectives should be the bolstering of the financial sector and, in particular, financial institutions. In order to compete effectively with foreign firms in financial markets, greater attention to profitability and risk will be needed, and some of the kinks endemic in the Korean system of industrial finance will need to be ironed out. Premature opening of the capital account is to be avoided until such time as domestic capital markets achieve the requisite level of stability and sophistication. 15/ While it is true that some of the real depreciation has been quite unintentional, and has basically been the result of the Yen's appreciation, Korean policymakers opted to accept the lower value of the won. - 82 Appendix SA Page 1 FINANCIAL LIBERALIZATION RISKSS LESSONS DRON THE SOUTHERN COME A8.1 The recent Latin American Southern Cone experience with liberalization has been traumatic, and has had an important effect on conventional thinking. Interventionists have found in these failed attempts new amunition with which to attack the merits of market oriented development strategies; supporters of the liberalization process, on the other hand, have been forced to rethink their views on the optimal path to be followed during the transition period of a liberalization attempt. The Southern Cone experiments provide very useful lessons that should be closely scrutinized by policymakers who want to avoid the mistakes made, especially during the transitional period, whi h eventually contributed heavily to the collapse of the reform experiments. In this section some of the more relevant aspects of the Southern Cone experience will be analyzed, and the potential risks for Korea will be highlighted. Most of the analysis will focus on the case of Chile, since it was in this country where the reforms were pushed furthest. A8.02 It should be stated at the outset that the current economic conditions in Korea are significantly different from the initial conditions encountered in the Southern Cone in the mid-1970s. First, Korea does not have a serious inflation problem, while rampant inflation was perhaps the most urgent problem in Argentina, Chile and Uruguay. Second, the fiscal sector in Korea is under control; in the Southern Cone, on the contrary, the fiscal deficit was initially gigantic, and in Argentina it was never really reduced to manageable levels. Third, Korea's external sector is very open, and has had a long successful tradition of export growth. Fourth, Korea's financial sector, while controlled and therefore distorted, has been in place for a long time, and has in the last few years been operating with (significantly) positive real interest rates. In the Southern Cone - and particularly in Chile - on the contrary, the financial sector was in shambles when the reforms were first started. All these factors make the cases of Korea an. the Southern2 one quite different and comparisons should be handled with A8.03 Perhaps the two more striking features of the financial reforms in these Latin American countries were the high real interest rates, and, particularly in Chile, the large proportion of nonperforming loans that the banks accumulated. Immediately following the liberalization of interest rates, these became extremely high in real terms. For example, in Chile they averaged more than 40% for long periods of time. At the same time the maturity of bank operations was very short, seldom exceeding 30 days. These 1/ See Bruno (1985), Corbo (1985), Corbo and de Melo (1986), And Edwards (1985). 2/ There are, however, perhaps surprisingly, some similarities between Korea's and Chile's financial reforms. In both cases, big conglomerates bought major interests in the national banks. Also, in both cases banks had a large proportion of nonperforming loans, firms were very highly leveraged and reportedly could actively use borrowed funds as equity capital. - 83 - Appendix 8A Page 2 high rates persisted throughout the period, in spite of the massive inflow of capital that followed the relaxation of exchange controls. Most domestic banks in Chile, and to some extent in Korea as well, were basically owned by large 10aglomerates, accumalated a large proportion of nonperforming loans.- At the end, in Chile - and to a lesser extent in Argentina - the combination of high real rates, large proportion of bad loans in the banking sector, and widespread expectations of devaluation conspired to generate a major collapse of the financial sector. In Chile several conglomerates and banks failed, and had to be rescued by the Government. In Argentina a number of banks also had to be bailed out by the Government. A8.04 With hindsight it is possible to say that perhaps the most serious problem related to the reforms of the domestic capital market, both in Chile and Argentina, was the lack of effective supervision of the financial sector. For example, in Chile, as early as 1974 it was well known by everyone involved - including, of course, the "regulators" - that the different conglomerates were finding ways to circumvent the rales covering excessive ownership concentration in the financial sector. In fact, it was knoV that these conglomerates had managed to control most of the largest banks.- Starting in 1974-75, many banks concentrated large fractions of their loan portfolios on related firms owned by the conglomerate that controlled that particular bank. The basic scheme used by many of these conglomerates was co use the financial resources obtained through the newly acquired banks to buy firms that were being privatized; some of these funds were also used to expand the level of operations of these and other firms. However, many of these loans to related firms did not represent, from a purely financial point of view, sound banking practices. In fact, banks were used as pawns in the conglomerates strategy of "growth at almost any cost" in a tightly speculative environment. A8.05 It has been argued that the existence of an evergrowing "false demand" for credit by the conglo rates played a central role in the explana- tion of the high interest rates. This "false demand" consisted of the rolling-over of loans, which in turn, had their origin in the privatization of a large number of firms during the early years of the military regime. As pointed out above, many of these firms had to spend significant resources in order to operate, modernize and expand these companies. Many of them did not turn out to be profitable, and increasingly resorted to additional borrowing in order to stay afloat. A8.06 The financial problems faced by banks and firms alike were compounded, both in Chile and Argentina, by a steep real appreciation of the domestic currency. This tendency towards overvaluation was the result, among other things, of the exchange rate policies followed in these countries which consisted of preannouncing a rate of devaluation significantly lower than the ongoing rate of inflation - and of the massive inflows of capital that 3/ See Table 5.16. 4/ Another major difference is the vigiltnt role played by the Ministry of Finance in Korea, and the close coord nation among economic ministries. 5/ Barberger (1985). - 84- Apedi SA Page 3 followed the opening of the capital account of the balance of payments.11 One of the most important consequences of the real appreciation of the domestic currencies was that the tradable goods sector suffered an important loss of competitiveness, and that a large number of firms ran into serious financial trouble. In both Chile and Argentina most of these firms faced these problems by resorting to heavy borrowing from the financial sector, exercising addit- ional pressure on the demand for credit and on interest rates. This circle of events came to a sudden end in both countries with major exchange rate and financial crises. A8.07 The main lessons -- in terms of reform of the financial sector - that emerge from the Southern Cone fall into four categories. The first category refers to bank supervision, It is essential that the process of financial reform is accompanied by strict supervision of the banking and financial sectors, in order to avoid fraud, circumvention of sound banking practices, or misuse of the financial resources. This supervision should be particularly strict when conglomerates play such a crucial role in the structure of industrial organization, as in Chile and Korea. Strong supervision should reduce the chances of a major bank collapsing with the attendant dangers for foreign borrowing, in which creditworthiness is dominated by a herd mentality among lenders. A8.08 The second area where lessons emerge refers to the speed and extent to which interest rates should be freed. The Southern Cone case suggests that a prudent attitude may be warranted when dealing with financial liberalization. More concretely this means that interest rates should be raised slowly, with an effort being made for maturities to be extended. The slow and prudent raising of interest rates will allow the authorities to detect and tackle early on any market reaction based on destabilizing expectations or lack of credibility. A precipitious rise in the cost of borrowing would m ly serve in a highly leveraged corporate environment to distress financing and greater instability. A8.09 The third lesson relates to the liberalization of the capital account and the relaxation of exchange controls. A number of authors analyzing the Southern Cone experience have concluded that the timpa used to open the capital account was ill-conceived in all three countries.- As argued in Section I of this chapter there are compelling reasons to suggest that the opening of the capital account should be pushed significantly back until after the trade account has been opened. The fourth lesson relates to exchange rate policy. It is extremely dangerous to reform the financial sector in an environment of overvalued domestic -currency. If this happens, as in Chile and Argentina, large distortions in terms of "excessive" borrowing from abroad may take place, in anticipation of real devaluations. In this context, Korea's realistic exchange rate policy serves as a useful lesson of the liberalization experience. 6/ See Corbo (1985) and Edwards (1985). 7/ See Edvsrds (1983, 1984), Dorbuasch (1983), McKinnon (1982), and Bruno (1985). - 85 - CHAPTER 9: THE THeORY OF INDUSTRIAL POLICY IN THE KOREAN CONTEXT A. Incentive Regime 9.01 Many arguments are offered to justify industrial interventions. On the basis of economic criteria, there are only a few clearly delineated cases for such public actions. In general, interventi n can be justified by evi- dence of nonexistent or malfunctioning markets.i In developing countries, imperfections are most often claimed to occur in markets for capital, tech- nology, and knowledge. But often far more important is the economic environment in which these markets operate, namely, the incentive regime. 9.02 The general structure of incentives is often the most important element of industrial policy in developing countries. The consensus among development theorists favors an outward-oriented incentive regime with rela- tively uniform incentives for different production activities. The case for such a regime rests, in the first place, on the proposition that a country can maximize its income and growth (at world prices) by shifting resources into areas of comparative advantage and later by adjusting this allocation to track changes in comparative advantage. An outward-oriented regime also reduces uncertainty about the government's priorities and policy directions. The outward-oriented strategy has received stro p empirical support from evidence accumulated in postwar development history, 9.03 The benefits of outward orientation appear to be greater, in fact, than what might bi,reasonably attributed to the achievement of allocative efficiency alone. Korea's openness has provided positive externalities in 1/ Even this evidence is theoretically insufficient, to warrant interven- tion, however. Since a compensating policy may cause undersired side- effects, there must be also a strong presumption that the economy will be closer to its "first-best" optimum with intervention than without. 2/ Work by Balassa, Krueger and others has shown that countries with outward oriented regimes grew faster than those with strong incentives favoring production for domestic markets. Improved performance was also commonly observed for countries which changed to an outward oriented regime during the postwar period. Needless to say, Korean experience figures impor- tantly in this research. See, for example, Frank, Kim and Westphal (1975). 31 Krueger (1985) and others argue that open economies are more flexible than import-substituting economies because they have greater "cushions" of unessential imports to squeeze under adverse circumstances. According to Westphal, Kim, Dahlman (1984) and others, openness can also facilitate the absorption and mastery of foreign technologies. Nishimizu and Robinson (1983) have shown that the rate of technical progress was faster in countries with outward oriented policies than in those pursuing an import substituting strategy. - 86 - the areas of macroeconomic flexibility and the absorption of technical pro- gress. These externalities justify even greater participatiin in trade than would be optimal from the allocational viewpoint alone and validate Korea's past proexport bias. While recent analyses agree that an outward orientation is conducive to rapid development, the precise implementation of such a policy is somewhat more controversial. According to some, it implies low, uniform levels of effective protection, with perhaps some escalation to permit infant industry development in higher stages of assembly end production. Others see a somewhat greater role for selective support for outward oriented infant industries. Despite these differences, however, there is wide concensus that protection ought to be lower and more uniform than is currently the case in Korea as well as in most other developing economies. It is in this light that the Korean trade liberalization, described in Chapter 2, is quite important, as a natural successor to the effective export-promotion activities of the past two decades. B. Functional Intervention 9.04 Since the case for the open economy assumes well-behaved markets (for factors of production as well as final products), the absence or imper- fection of markets provides a key rationale for nondiscriminatory functional intervention. This rationale points to policies that correct the market failures themselves or compensate for them throughout the economy by offering functional incentives. It does not provide an argument for selective inter- vention in favor of specific sectors or subsectors, however. To be sure, the implementation of corrective measures may involve a sectoral focus and sectoral coordination, but efforts to correct market failures should not generally require comprehensive programs of aid to a specific industry. Technology Development 9.05 The development of technology generates positive externalities if the benefits of innovation "leak out" from the innovating firm to its competi- tors. In the absence of compensating public subsidy, firms will invest less in research than is justified by social returns. The decision of individual firms to allocate revenue to R&D expenditures may be influenced also by their competitive setting and by the minimum scale required to undertake specific forms of R&D activities. There may, therefore, be an added role for Government in subsidizing or coordinating research where competitors cannot effectively pool their efforts for market reasons. In cases where R&D investments are socially suboptimal, tax incentives can be used to increase the implicit private rates of return on investment, while in cases where private scale is inadequate, coordinated (public or private) activities are legitimate alternatives. 9.06 Not all research externalities justify public intervention, however. To merit public support, a research project should generate externalities for other national firms, but not for firms in other countries. While the general case for public policy toward research is widely recognized, few governments appear to apply the test of "commercial externality" to guide the specifics of their technology policy. In the Korean high technology sector, for example, individual firms are relatively large, - 87 - while the sector as a whole is relatively small (as compared, for example, to its OBCD competitors). Thus implies that external benefits from the research of a large Korean firm are relatively more likely to accrue to foreign compe- titors and relatively less likely to accrue to other domestic firms. 9.07 Intellectual property rights - protection afforded to inventors through patents and copyrights - represent an important, related area of policy. The problem is familiar; the strict protection of property rights raises the price of new products above marginal cost and (from a static economic perspective) excludes too many potential users. On the other hand, it provides strong incentives for innovation. The optimal system for a given country depends on the net balance of innovations produced and used, and on the effect of property rights laws on the inflow of foreign technology. Manpower Development 9.08 Education and training are hard to finance privately because of the absence of institutions (families excepted) that lend to individuals against uncertain and distant future income returns. Thus, market forces generally lead to underinvestment in human capital. In addition, advanced training and foreign training may involve externalities: the benefits of inventions and technological transfers made possible by technical and foreign training may not wholly accrue to any one employer. consequently, wages will fail to reflect the contribution of advanced training. All these possibilities argue for some public subsidy. 9.09 Retraining can be justified by the same arguments as education in general, but additional motives may be present. Retraining provides targeted assistance to people who are suddenly and adversely affected by changes in trade or production patterns. In this context, retraining helps to achieve distributional goals as well as increasing the political acceptance of changes in industrial structure. Moreover, retraining increases the flow of labor from declining sectors to growing sectors. Thus, retraining constitutes a "second best" policy where factor mobility is hampered. Capital Markets 9.10 Underdeveloped capital markets represent a frequent rationale for government intervention in the allocation of credit. In many cases, however, the problems attributed to faulty capital markets represent not so much market imperfections as the high real costs of providing or administering credit. For example, markets may be "missing" for financing new ventures if the number of such ventures is too small to support adequate risk pooling. Similarly, domestic capital markets may be too small to diversify risks for the estab- lishment of new large-scale industries. But the problem of small risk pools is a real problem whether credit is publicly or privately allocated; to reduce such risks it is necessary to enter arrangements that pool risks across countries. These arrangements may be either private or public. Similarly, the high cost of capital to small or new businesses often reflects the absence of organised credit information on businesses and entrepreneurs. This makes the real costs of administering credit high; it would not be efficient to increase the flow of credit to such borrowers at subsidized or controlled rates. - 88 - 9.11 A more compelling rationale for public intervention in credit markets must rest on unequal access to credit for reasons other than the high real costs of credit. In the Korean case, it has been argued that borrowers that are large compared to relatively isolated domestic credit markets apply strong bargaining (monopsonistic) powers to actieve unusally good terms on loans. Large companies may be getting low cost loans also because they enjoy an implicit government guarantee -- that is, they are more likely to be rescued than small firms. These examples provide a rationale for compensating government intervention. In designing an intervention program, however, it must be recognized that costs of providing credit to large firms are generally lower than for small firms, due to differences in administrative costs, information availability, and risks of bankruptcy. Thus a differential in borrowing rates in favor of large firms is not, in itself, evidence of market imperfection. Competition Policy 9.12 Covernments in the industrialized countries frequently act to preserve or enhance competition in product markets. For swaller countries, such as Korea, the need to exercise control, at least with regard to industrial subsectors, is closely linked to the extent of protection. In the case of an open economy world markets provide ample competitive pressure. In the case of protected markets and markets for nontraded goods particularly markets that are small relative to the minimum efficient scale of production, large firms may exercise market power with adverse implications for consumer welfare, innovation, and product development. The problem is especially serious if protection is administered by quantitative restrictions rather than tariffs. C. Sele,;tive Intervention 9.13 Selective intervention, defined as policies that change the alloca- tion of resources among specific industrial sectors or subsectors can be justifed by a variety of arguments. First, specific externalities and market failures may warrant intervention in a particular industry. Second, govern- ment intervention may be also essential (and profitable) in support of firms that are competing in internationally oligopolistic markets. Third, nor.- economic objectives may exist with respect to industrial structure, such as greater economic independence, or greater capacity to produce arms or transport the nation's essential goods. Fourth, industrial policy objectives may also include other, quasi-economic aims, such as the location of industry, employment, and income in certain geographical areas or the desire to reduce the vulnerability of the economy to particular markets. It must be explicitly recognised that interventions designed to achieve these structural goals are often costly and inefficient, and that their burden must be compensated by the benefits of achieving the government's noneconomic objectives. Alternative ways of achieving industrial policy goals often differ with respect to cost as well as the distortions they creat relative to market outcomes. 9.14 There is an active ongoing debate on selective industrial policy in industrialized as well as more advanced developing countries which is relevant for Korea. In "sunrise" sectors the debate centers as why an activity ought - 89 - to operate at a higher level than dictated by market forces. From an economic perspective, the case must rest either on the superior decision-asking capability of government, or more likely, or interfirm externalities from learning on technical progress. In "sunset" industries, the proponents of interaction must demonstrate that the pace and/or patterns of decline dictated by the market are inappropriate, or more specifically, that market forces are leading to socially inefficient outcomes. The attendant issues which require normative judgments include (i) the desirable balance between social costs and benefits, and (ii) the extent to which the existing private institutional framework is capable of efficiently reallocating productive resources among industries. Sunrise Industries 9.15 Two kinds of questions must be answered with respect to emerging industries: what makes an industry a potential winner and why does the private capital market fail to provide the required support? Before addressing legitimate economic arguments for selective support, it is import- ant to note that common notions about what makes an industry "strategic" are often poorly founded. Consider, for example, the strategy of aiding "high value added" industries. The implied (and flawed) reasoning is that such industries generate high levels of national income per unit of output. Depending on how precisely "high value added" is defined, a policy that encourages such industries may lower national output, employment, and welfare (see the implications of alternative definitions in Table 9.1). At best, under the most favorable definition, the value added criterion produces the same ranking as would result from applying the conventional economic criteria of profic maximization and production according to long-run comparative advan- tage. In this case, other market imperfections aside, the ranking does not need to be implemented through government policy because it will simply corre- spond to the ranking that market agents use to decide on alternative invest- ments. 9.16 The existence of inter'irm externalities provides a more solid rationale for intervention. Such externalities may involve goods, services, and technology created by the firm (in addition to its conventional products) for which the firm is not (fully) compensated. They may include the acquisi- tion of knowhow that is partly passed on to other firms, on-the-job training of managers and workers who later move to other businesses, or the development of markets for more differentiated and higher quality inputs, which in turn help other production activities. These externalities are variously referred to as agglomeration economies, scope economies, and linkage economies. This kind of argument forms part of the r 0ionale for highly selective support for a few appropriate infant industries.-' 9.17 Assuming that intervention is justified, the size of the subsidy should just match the externality identified; it should correct the incentive system so that the production of a good is rewarded by the full social 4/ This corresponds to Westphal's (1982) recommendation. - 90 - benefits achieved. The rest - whether or not the industry actually develops -* should be left to market forces. In practice, unfortunately, once governments commit themselves to aiding a particular industry they seldom try to provide the "correct" subsidy; rather, they adopt a package of development measures designed to make the industry grow whether it is economically viable or not. Practioners of this approach would claim that there is no such thing as a flawed industrial policy, merely an insufficiency of incentives. Put differently, there is a great temptation for policymakers not only to pick winners but also to ensure winners. Table 9.1: BMCTS OF TARGETING ACCORDING TO A "VALUE ADDED" CRITERION Precise Implied Economic consequences definition structural of promoting the sectors of criterion bias selected by the criterion Value added as Against goods Reduced productivity as structure favors percent of with inter- sectors at the beginning of the production gross output mediate goods chain, rather than those in which value requirements added per unit of input is highest Domestic Against goods Reduced productivity as structure favors value added as with high sectors that use chiefly domestic raw percent of imported inter- materials and intermediate inputs, rather output mediate goods than those in which economy has comparative requirements advantage; diminished intra-industry trade and technology transfer Valued added Against goods Artificially high demand for capital, per worker in which a possible unemployment, declining large part of productivity value added goes to labor, i.e., against labor-intensive goods Value added Against goods Increasing productivity; rank corresponds per unit of in which total to economic profitability and comparative total factor income gene- advantage (assuming no market input rated per unit imperfections or externalities) of input is low 9.18 A new view on sunrise industry policy, potentially relevant to Korea, is that governments can strengthen the international market power of their national firms vis-a-vis foreign oligopolistic competitors by adopting supportive policies, even including protection of domestic markets. More broadly, the realities of international trade, which include protectionist - 91 - agreements as well as possible collusive behavior, may make it difficult for Government to totally distance itself from the activities of its firms. In particular, these considerations may affect government policy towards indus- trial organization within Korea, and towards joint ventures between Korean firms and foreign partners. Sunset Industries 9.19 In declining industries, ten quite different issues are at stake. In some cases, government policy may be needed to aid the withdrawal of resources from a declining industry. In other cases, government participation may be needed to "restructure" an industry, that is, to add resources and/or alter management in order to reach a stable and profitable operating structure. These goals involve different analytical issues. The withdrawal of resources from a declining industry does V9t, under usual market conditions, require government intervention.41 The existence of large adjustment costs, for example, is in itself not a valid reason for intervening to either slow or accelerate the market rate of adjustment. Similarly, well- functioning markets are also able, in principle, to engineer optimal restructuring. As in other dimensions of policy, intervention needs to be justified with specific market failures or imperfections, or by virtue of noneconomic objectives. 9.20 Restructuring involves turning a declining activity into a competi- tive one. When restructuring is in fact possible, it requires an infusion of new resources -- capital, management, and technology - into an activity which is presently unprofitable. If the returns on such new investments can be clearly separated from obligations on older debt, then private capital markets can be relied on to supply restructuring capital, and in general to determine whether restructuring is feasible or not. However, the separation of "old" debt from "new" debt is not easily effected in practice. Bankruptcy is one way to do so -- it wipes the slate clean so that new investors can lay claim to future returns. But bankruptcy is complicated and disruptive; it is often impractical for large economic units. In Korea, for example, the bankruptcy of a large group may create concern for the creditworthiness of the entire financial sector. In some countries, one or a few banks control a suffi- ciently large part of a company's debt to step in with a restructuring plan. 5/ Market imperfections may lead to ineffi'-fently slow or fast adjustment, however; for example, high unemployment compensation in industrialized countries accelerates the decline of sunset industries (compared with ideal market conditions), as workers are reluctant to accept wage cuts that would permit their companies to compete. At the same time, unemployment compensation reduces incentives to move into new sectors (which may involve significant financial and psychic adjustment costs) and thus decelerates the growth of sunrise industries. Retraining and adjustment assistance policies represent second-best solutions for compensating for these effects. -92- In others, however, private capital markets could'faiL to support even very profitable projects in declining industries. 9.21 Public support of restructuring can take various forms. Government loans provide funds directly. Loan guarantees may assure creditors the returns that cannot be assigned to them under conventional arrangements. Cartels organized by governments may enable troxYled industries to raise prices and, in effect, be rescued by consumers. Mergers among competitors may permit a rational scrapping of capacity. In all of these cases, public intervention has adverse side effects and should be pursued %eluctantly; at a minimum, intervention should be contingent on a package of measures that promises a return to profitability. 9.22 It has been recently suggested that government intervention may be justified even in the absence of maet imperfections in the case of oligopolistic declining industries.-' The argument is that oligopolistic firms sometimes continue to fight for market share even if this involves selling at below marginal cost, in the hope that they will "win" a large share of a profitable market as their competitors withdraw. If the firms of the industry are similar -- equally likely to win -- excessive (that is, below below-marginal cost) competition may persist for a long time, implying an inefficiently high level of output. A government restructuring plan which reduces capacity (perhaps by compensating the withdrawing firms) would improve national welfare. Though particularly appealing, this cannot justify intervention in most declining industries, such as the Korean shipping, for example, where the distribution of capacities is highly skewed, and different firms have obviously different probabilities of financial survival. Indeed, in the typical case the possibility of a government restructuring plan may in itself serve to delay adjustment, as potential losers have added incentive to wait for a government rescue. 9.23 As the Korean economy becomes more sophisticated and the cases of overt market failure shrink, the rationale for industrial intervention declines. In keeping with this trend, Government has redirected its philoso- phical stance in recent years to favor functional incentivoi rather industry- specific incentives. It has not yet withdrawn from industrial decision-making entirely, however, particularly on the side of declining industrieL, where public externalities include effects on employment, the capacity to borrow on international capital markets, and perhaps the integrity of the banking sector. Therefore, the emerging challenge to policymakers is to rein-in government's tentacles, while at the same time improving those markets still characterized by imperfections and bolstering those institutions which are needed to improve the functioning of those markets. 6/ This is in fact the Japanese solution. See Peck, Levin and Goto (1985) for a detailed description. 7/ Okuno and Suzumura (1985). - 93 - APPENDIX 9A Page 1 THE JAPANESE APPROACH TO INDUSTRIAL RESTRUCTURING A9.01 Introduction. Recent Korean intervention in several major industries, including shipping and overseas construction, somewhat resembles Japanese policies in industrial restructuring. Since the early 1950s Japanese law has authorized the formation of so-called "de-ression cartels" in distressed industries, aimed at lowering output and raising prices f4r a limited period of time, as well as "rationalization cartels," aimed at encour- aging the improvement of industu profitability through cooperation in research and product standards.- These laws were originally designed to deal with cyclical downturns and did not address structural adjustment problems in declining industries. As a consequence of the economic turmoil of the 1970s, a "Law of Special Measures for the Stabilization of Specific Depressed Industries" was adopted in 1978, with a five-year horizon, and it was replaced by a "Law of Special Measures for the Structural Improvement of Specific Industries" in 1983. A9.02 Under the 1978 law an industry could be designated as a depressed industry if (a) it had severe excess capacity; (b) more than half of its firms faced "dire" financial conditions for at least three years; and (c) more than two thirds of its firms requested designation. Designation also required the approval of the affected Ministry (typically the MITI, but in the case of shipbuilding, for example, the Ministry of Transport). Designation exempted an industry from antimonopoly s in order to permit the negotiation of a joint capacity reduction plan.Y It also provided limited low interest loans for financing retirement allowances, and made an industry eligible for loan guarantees. In fact, tht financial provisions of the Law proved unimportant; the loan guarantee fund, for example, was very much undersubscribed. A9.03 The 1983 law has similar provisions with respect to designation and capacity reduction; however, it offers somewhat broader financial support, including (i) low-interest loans from the Japan Development Bank for modern- ization and improvement; (ii) grants for R&D spending, especially in the field of energy conservation; and (iii) accelerated depreciation for equipment for modernization and additional minor tax benefits. It also permits the forma- tion of "business tie-ups" in which firms can agree to join together to fully coordinate their production and/or sales activities. These business tie-ups, 1/ For broader discussion of Japanese industrial policy see Magaziner and Rvat (1980), Johnson (1982) and Petri (1984). 2/ The Ministry relevant to a designated industry was charged with develop- ing a stabilization and capacity reduction plan, in close consultation with the industry's trade association and individual firw.- The Govern- ment had no power to implement the capacity reduction >Ian, although the establishment of new plants &nd the expansion of existing p.ants was in principle prohibited. There is in fact a case of capac cy :xpansion by a "renegade" firm under a capacity reduction program, in the electric steel furnace industry. - 94 - APPENDIX 9A Page 2 which must be approved by the Fair Trade Commission, resemble mergers in that the unit formed by the "tied-up" firms typically acts as a single competitor against other tie-ups. A9.04 Operation of the Laws. Of the fourteen industries designated under the 1978 law, seven were authorized to form legally binding capacity reduction aartels. In each case several rounds of capacity reduction negotiations took place among firms. The dimensions of the capacity reduction programs are sum- marized in Table A9.1. On average, industries agreed to a 24% reduction of 1977 c&pacity. The planned reductions roughly equalled underutilized capacity in highly oligopolistic industries, but represented a substantially smaller share of underutilized capacity in more competitive ones. According to government reports, 12 of the 14 industries Osposed of at least 90% of the capacity targeted by the stabilization plan.- Importantly, in fact, under market pressure, the more competitive industries generally exceeded their capacity.reduction targets. A9.05 The economic effects of the capacity reduction were mixed. In general, industry finances improved. For example, in a sample of the desig- nated industries, the balance of outstanding bank loans declined by 31% between 1977 and 1982. This improvement came at the expense of consumers; between 1975 and 1978 the average price of the desigg ted industries declined by only 31, and between 1978 and 1981 it rose by 9%.2' Given the apparently positive effect of stabilization programs on prices, and presumably profits, and the fact that the industries involved tend to produce homogeneous, exten- sively traded products, one has to assume that these output adjustments took place behind some form of protection. Generally in the case of a declining, import-competing industry, a significant price increase cannot occur in the absence of some formal or informal trade barrier. In the case of an export industry, it implies some cartelization of foreign markets. Capacity reduc- tion was also accompanied by reductions in employment on the order of 15%. Surprisingly, about 70% of these workers were reported to have become unemployed for at least some period of time, despite tight labor market condi- tions, and intense efforts by Japanese firms to place workers with other establishments or other firms. 3/ Those familiar with the negotiating process suggest that most of the capacity reduction programs affected capacity proportionally across firms. In some cases the programs allocated half of the reduction target in proportion to capacity, and another half in proportion to under- utilized capacity as of a date prior to the beginning of the program. In general, "side payments" were not made, and thus there was no mechanism for concentrating cutbacks on firms that owned relatively inefficient facilities. One exception is shipbuilding where an industry-wide Stabilization Association was formed independent of legislation to buy out and eventually close smaller, inefficient shipyards. Another excep- tion is the Joint Scrapping Plan of the textile industry, where interest free government loans were used to buy out smaller companies. 4/ See Peck, et. al. (1985). - 95 - APPENDIX 9A Page 3 Table A9.1: C&PAITY REDUCTIONS UNDER THE 1978 JAPANESE RESTRUCTURIM LAN Tons of Goal of capacity Goal of percent of Net reduction before percent of excess as percent Industry reduction capacity capacity of goal Concentrated Industries Aluminum smelting 1,642 57 210 97 Nylon filament la 367 20 96 83 Polyester staple la 398 20 84 76 Polyacrylonitrile staple la 43' 20 100 92 Urea* 3,985 45 90 93 Polyester filament /a 350 13 55 35 Unconcentrated Industries Amonia* 4,559 26 38 100 Ferrosilicon 487 20 45 164 Shipbuilding 9,770 35 24 105 Linerboard la 7,549 15 37 93 Phosphoric acid 934 20 42 91 Wool la 182 12 36 236 Cotton spinning /a 1,204 6 29 136 Electric furnace 20,790 14 37 - /a Industries with formal capacity reduction cartel. Source: Peck et al. (1985). A9.06 A retrospe,tive analysis of the effects of the 19833 law is not possible because its implementation is not scheduled to be completed until 1968. A listing of the industries designated and the capacity reductions planned and already achieved appears in Table A9.2. Importantly, about half of the industries designated are "recidivists" from the 1978 law. Approx- imately half of the industries designated under the 1983 law have taken advan- tage of the provision to form business tie-ups. A9.07 An Assessment. Essentially, a capacity reduction cartel raises prices to alleviate the financial distress faced by an industry. This transfer from the consumer to the producer may be justified on distributional grounds. Another line of argument is that the tendency of Japanese firms to engage in "excessive competition" rather than orderly private capacity reduc- tions or the absence of adequate markets and institutions for private mergers - 96 - Table A9.2: CAPACITY REDUCTION PLANS UNDER THE 1983 JAPANESE RESTRUCTURING LAW Disposal Disposal goal as % of Capacity as % of goal by utilization capacity 1985 in 1984 Electric furnace@ 14 0 87 Aluminum refining@ 50 0 39 Nylon filament@ (Disposal program completed) 87 Acrylic staple@ (New investment regulated ) 93 Polyester filament@ (until 06/30/86 ) 78 Polyester staple@ ( ) 92 Viscose staple 15 21 85 Ammonia@ 20 83 74 Urea@ 36 23 62 Wet phosphoric acid@* 17 62 71 Solubole phosphoric 32 46 45 Chemical fertilizer* 13 44 67 Ferrosilicon@ 14 100 53 High-carbon ferrochromium 10 0 50 Ferronickel 12 0 62 Paper* 11 28 86 Coirugated board paper@ 20 12 66 Ethylene* 36 74 93 Polyolefin* 22 74 100 Vinyl chloride resin* 24 90 96 Ethylene oxide* 27 61 86 Styrene 26 0 79 Rigid PVC* 18 100 76 Sugar 26 60 65 Cement 22 85 60 Electric wire 14 0 70 Legend: * - Industries participating in a business tie-up. @ - Industries continuing from the 1978 law. Source: 'Industrial Development Bank of Japan. -97 - APPENDIX 9A Page 5 and acquisitions.51 From a distributional viewpoint, the price increase engi- neered by a capacity reduction cartel typically reverses a steep decline in prices due to world market conditions. These cartels, therefore, tend to prevent, rather than create, windfall transfers between consumers and pro- ducers. While the cartel-induced transfer could in theory be targeted to ease the specific income dislocations caused by the change in world prices, the nvidence suggests that Japanese transfers primarily compensated creditors *nd not employees. From an efficiency perspective, it is very likely that inter- vention raised prices above marginal production cost and generated ineffi- ciency. While the scope of this inefficiency may be modest in the short run, long-run losses are more significant, especially since cartelized price levels can be maintained for several successive five year periods. Routine rescue efforts tend to discourage capacity reduction, particularly by smaller firms, since the cartels generally allocate production targets irrespective of effi- ciency. Also, the program creates "moral hazard" among lenders, who may bear much lar 9r risks than they would in the absence of a government rescue program, A9.08 Implications for Korean Policy. Japan's industrial adjustment policies have enjoyed wide domestic political support. In sharp contrast to the adjustment efforts of many other OECD countries. To be sure, Japan's adjustment problems were more modest, and occurred in the context of rapid growth. Still, the Japanese experience is of great interest to Korea, both because of its supposed success and because of other parallels between Japanese and Korean development patterns. The Japanese approach may have some limited reference in the medium term, that is, until Korean capital markets develop enough to provide wider options for dealing with restructuring. At the same time, there are major structural differences between the Japanese and Korean economies that preclude direct application of Japanese methods and which may impose intolerably high costs on the economy if this approach is followed. A9.09 Most obviously, Korean domestic markets are much smaller than Japanese markets because of differences in both population size ad per capita income. Thus Korean firms are less likely to 77gage in unprofitable produc- tion simply to maintain long-run market share.- Second, the Korean economy is more open, and Korean industries depend on foreign markets to a far greater extent than Japanese industries. Third, in Korea, transfers from 5/ Indeed, mergers are very rare in Japan, but this observation alone does not prove that capital markets are flawed. In any case, capital market imperfections are more likely to call for capital market interventions than government intervention in industrial structure. 6/ Ultimately, these rescues prove too costly, in particular if market signals are ignored. Thus, fe example, Japan recently permitted the bankruptcy of the nation's largest shipping firm. 7/ Relative to Japan, Korean industry is less capital-intensive, and there is no equivalent of Japanese lifetime employment. -98 - APPNDIX 9A page6 domestic consumers could at best represent a small fraction of the financing requirements nf industries in distress. Furthermore, the trade barrier required to implement domestic cartels are likely to elicit external pressure from Korea's trade partners. A9.10 Perhaps because of differences in economic size, the financial "mis" of Japanese restructuring programs emphasises transfers from consumers (through the formation of cartels and deemphasizes direct financial support from government. The absence of government financing is desirable, but it hinges on the close relationship between Japanese firms and their banks, which are often members of the same group, and which in some cases own a substantial share of the troubled company. To the extent that the Korean private sector becomes involved in restructuring, it would directly involve financial support which exacerbates the problem of moral hazard, retards the process of finan- cial liberalization, and perpetuates Government's role in industrial decision- making. Moreover, the inefficiencies inherent in increasing the prices of intermediate goods can be especially severe in Korea, as they impair the profitability of up-stream export industries. For all of these reasons, the Japanes adjustment =)del, despite is apparent attractions, has limited applicability in the Korean context. - 99 - CHAPTER 10: TdE ROLE OF FINANCE AND INDUSTRIAL PERFORMANCE A. Introduction 10.01 Korea started an ambitious economic development and industrializa- tion plan in the early 1960s. In the process, the Korean Government made extensive and forceful use of a wide range of incentives designed to assure private industry's close compliances with its plans. Among them, probably the most widely used has been differential access to credit from commercial banks as well as specialized banks under government control. In addition, foreign loars which were an attractive source of borrowing required government author- ization and its allocation was largely controlled by the government. Availa- bility of credit was, and continues to be, an extremely effective instrument because of the highly leveraged nature of Korean industry and the implicit subsidy inherent in preferential credit which had to be rationed. This was accomplished essentially by government directive. 10.02 Under these circumstances, access to a stable and low-cost source of credit, e.g., bank loans, was considered to be crucial for firm performance. Being disfavored by Government, which owned the banks and controlled their loans, could easily lead to a firm's demise, particularly since firms are heavily indebted, and, furthermore, because about two thirds of their liabil- ity is in the form of short-term debt. In essence, the Korean Government pro- vided two incentives for the development of strategic industries which had an important bearing on private firms' investment decisions. First, the Govern- ment changed the expected rate of return of investment by controlling the interest rate and allocation of bank loans. By favorably allocating cheap bank credit to a strategic sector, the Government could reduce the cost of investment and increase the expected rate of return in that sector. Second, the Government could change the perceived risk of investment by assuring a stable flow of bank loans to selected industries regardless of their economic or financial performance. Thus, if a firm followed government policy by investing in projects which had government support, its bankruptcy risk was reduced, perhaps even eliminated. In other words, the Government, by control- ling the financial sector, became a risk partner of firms, encouraging them to undertake projects which might have been declined otherwise. Therefore, in the case of Korea, it would not be very meaningful to discuss industrial development without looking at the role of government in financial allocation. 10.03 It is not easy, however, to evaluate the role of finance in the industrial development and performance. The performance of a firm or an industry is affected not only by factor market conditions, such as financial cost and labor cost, but also by product market conditions such as the degree of competition, market structure and external and internal demand condi- tions. Furthermore, it is affected by other government policies with respect to trade, foreign exchange, pricing and taxes, among others. In these circumstances, it is difficult to separate out the effect of particular factors. Most studies on industrial performance snd structure assume that - 100 - factor markets are competitive and neutral.X Clearly, however, this has not been the case in Korea, where Government's intervention in factor markets (viz., the finav1al market) was so extensive that it may as well have affec- ted the performs..e of industry as much as product market conditions OU4. 10.04 Therefore, an attempt is made here to investigate the role of government-directed finance on the development of industry since, in the Korean context, access to concessionary credit has been a primary signal of strategic industry policy on the part of Government and also has been an important factor for firm performance. In the 1970s, foreign and bank loans, the allocation of which was controlled by Government, accounted for about half the source of funds of the corporate sector and the costs of these two sources of credit were the cheapest among various sources of borrowing due to the strict interest ate ceilings on the bank credit and continuously fixed exchange rates.- Therefore, firms which had better access to those sources of borrowing, especially to bank policy loans, which were much lower cost than the alrelly highly subsidized general bank loan, faced a lower average cost of capital.- 10.05 The approach taken in this chapter is to assess the degree to which differential access to credit by the different sectors of the economy was created by Government's control of credit allocation and the difference in the average cost of capital paid during the sample period, 1972-84. In conjunction with this, the question of whether the allocation of government- controlled credit was efficient or not will be examined, to a limited extent, by comparing the access to credit of different sectors with the average rate of return on the investment in the sectors. The approach also looks at whether Government favoritism in terms of credit allocation has affected the performance of particular sectors and industries. Furthermore, it addresses the issue of how financial liberalisation in the 1980s improved the allocation of credit between different sectors ot industries compared to that of the 1970s. 10.06 The measures examined include the ratios of (i) total bank loans and foreign loans over total assets was chosen as a measure of access to Government-controlled credit, (ii) financial expense (interest rate paid plus discount) over total borrowing as a measure of average cost of borrowing, (iii) profit before subtracting financial expense over total asset (capital stock) as a measure of average rate of return on capital investment, and (iv) normal ratio, as well as (v) net sales growth rate adjusted for inflation 1/ In other words, in the literature of industrial economics, firms usually compete equally in the factor markets and factor markets just take the role of passively meeting the firm's demand for input which again is dependent on the output market conditions. 2/ See Tables 10.3 and 10.4 for the measure of implicit subsidy that accom- panied the bank and foreign loan allocation in the 1970s. 3/ See Table 10.5 for the relative size of policy loans. - 101 - as measures of performance of each industry. The data originate from the Bank of Korea's (BOK) Financial Statement Analysis, which reports aggregated balance sheets and income statements by industry and sector, and includes 92% of total corporate sales, although only 45% of total firms. 10.07 The sectors compared here are (i) large firms vs. small firms, (ii) export industry vs. domestic industry, and (iii) heavy and chemical industries (CI) vs. light industries, following the BOX classification.- In Korea, as was mentioned, the sectors which received the highest government priority in the 1970s were export and BC industries. In the process of severe credit rationing under low interest rate ceilings, large firms were favored over small and medium firms because of the low transaction costs and perceived risk to bankers. B. The Sectoral Experience 10.08 The analysis of the period of 1972-84 yielded the following conclu- sions. In the 1970s, there were substantial gaps in the access to capital with favored sectors having greater access to subsidised sources of capital (bank loans and foreign loans) than others (Table 10.7). This seems to have contributed to their rapid growth and high profitability despite their rela- tively low rates of return. The Government's strong intervention seems to have created substantial distortions in the allocation of financial resources by creating large disparities in the average cost of capital among different sectors. It is to be expected that substantial gaps in the marginal rates of return on investment across sectors should have resulted. Large firms, the export industry and HCI had greater access to capital and, as a result, had lower capital costs than did small/medium firms, domestic industry and light industry, respectively, in the 1970s (Table 10.8). Although the former's rates of return on investment were significantly lower, indicative perhaps of capital underutilization, they did exhibit higher growth rates (Tables 10.10- 10.12). 10.09 In the 1980s, however, the gaps in accessibility to and cost of capital have been greatly reduced, or in some cases (small/medium vs. large firms, for example) completely eliminated as a consequence of the financial 4/ According to the Financial Statements Analysis, large firms are those which employ more than 300 employees in the case of manufacturing firms, more than 200 in the case of the service industry. HCI includes: industrial chemicals (351), petroleum refineries (353), other nonmetal- lic mineral products (369), basic metals (37), fabricated metal products (381), machinery (382), electrical, electronic machinery and appliances (383), transportation equi-ment (384), and precision equipment (385). A firm is classified into export industry if export constitutes 50% or more of its total sales. Otherwise, it is classified as domestic indus- try. Therefore, the classification of domestic industry vs. export industry is not as clear as other classifications. The figures in parentheses are the code numbers of the Korean Standard Industry Classification. - 102 - liberalization effort in this period. The shrinking share of government- controlled credit (bank loans and foreign loans) in corporate finance and the explosive expansion of credit from nonbanking sectors (including the securi- ties market), in which the cost of borrowing is much freer of government intervention, contributed to more equalized cost of and access to capital in the 1980s. At the same time, some progress in the liberalization of the bank- ing sector, more importantly the elimination of the interest rate gap between general loans and various policy loans, has contributed to reducing the dispa- rity in the cost of capital, and, as a result, contributed to reduce distor- tions in the financial allocation. Changes in government credit allocation policy to correct past misallocations and favoritism also contributed to better allocation. Comparisons of access to capital by different sectors and their relative performance are described below, with particular attention paid to the protection cum repression period of the 1970s versus the liberalized period of the 1980s. Large Firms vs. Small/Medium Firms 10.10 Large firms had relatively much greater access to preferred credit than did small/medium firms during most of the period (Table 10.7). The gap was sizable during the 1972-76 period, began to narrow over the 1977-81 period and was reversed thereafter. Since 1982, small/medium firms have enjoyed better access to borrowing from banks and abroad than have large firms. This reversal seems due to (i) a reduced share of foreign borrowing on the part of large firms, (ii) government policy to increase the bank lending to small/medium firms, and (iii) increased real interest rate which gave rise to less bank rationing in favor of large firms. As a result of greater access to subsidized credit, large firms faced a lower average cost of capital than did small/medium firms in the 1970s (Table 10.9). The disparity in borrowing cost was consistently present over the 1972-78 period, and was sizable on a percentage basis. Abruptly in 1979, this disparity was eliminated and has hovered at close to neutrality since then. Greater access to and lower cost of capital seems to have enabled the large firms to grow faster than small/medium firms, despite the former's relatively low rate of return on investment (Tables 10.10-10.12). Heavy Chemical Industry vs. Light Industry 10.11 A similar pattern result is observed in the comparison between HCI vs. light industry: RCI had greater access to capital, especially in the latter half of 1970s durigg which Government continued to promote HCI development (Table 10.7).;41 As a result of substantial access to preferential 5/ HCI's advantage in access to capital seems to be greater than the data in Table 10.7 suggests if we consider that the HCI is leveraged to a lesser extent than light industry (Table 10.8) due to the higher proportion of its fixed assets which are financed through equity. This is, the proportion of bank and foreign loans in total borrowing (net assets) should be much higher for HCI compared to light industry than the figures in Table 10.7 suggest. - 103 - borrowing,y/ the cost of capital to the BCI sector was considerably below that for ligbt industry in the same period (Table 10.9), by as much as 20% to 35Z as seen in Figure 2.3. This great advantage in terms of access to and cost of capital, among other things, seems to have contributed to BCI's rapid growth in the 1970s. It grew faster than light industry despite the fact that it haO much lower investment efficiency compared to the latter (Tables 10.10 and 10.12) in the 1970s. This lack of efficiency is continued by the data on capacity utilization as well as sectoral ICORs (see Tables 2.6 and 6.11). 10.12 The gap in the access to and cost of capital between HC and light industries started to decrease in the 1980s. The elimination of preferential lending rates for policy loans in 1982 and expansion of the noubanking sector with a relative diminution in the role of bank and foreign loans seems to have contributed to reducing the gap. On the other hand, the disparity in the rates of return on investment of the MCI and light industry has been falling in the 1980. as the excess capacity of MCI has been gradually reduced as the export *hare of the industry increased (see Chapter 4). As of 1984, there was no significant difference in the cost of capital and return on investment measures between the two, which provides some evidence that the efficiency of capital allocation between the two sectors has much improved compared to the 1970s. Export Industry vs. Domestic Industry 10.13 There was also a substantial gap in the access to credit between export and domestic industries over the period, with the former exhibiting greater access, and, as a result, experiencing lower costs than the domestic industry during most of the period. Interestingly, its advantage vis-a-vis domestic industry in terms of access to and cost of capital was biggest during 1980-82. This may be partly explained by the impact of automatic access to export-related loans under conditions of tight credit control during this period. The rate of return on investment for the export industry was much lower than that for the domestic industry during 1974-79. This seems to be greatly influenced by the fixed exchange rate policy of the period which led to overvaluation (see Table 10.4), which appears to have offset the favorable impact of cheaper credit. 10.14 The growth of exports was, on average, lower than the growth of domestic industry in the 1970s, although there were ups and downs, reflecting the internal and external environment. In a sense, export credit in the 1970s was partially neutralizing the negative effect of high protection and overval- nation on the export industry. Without favored access to borrowing at subsi- dized rates, the performance of the export industry could have been much poorer indeed. Or putting it differently, the export industry faced disadvan- tages in the 1970s despite favored treatment in the credit allocation process, 6/ According to the RDI, 93% of policy loans (excluding export loans and smalllmedium firms' promotion funds) was given to HCI and only 7% was given to light industry in 1978. See The Issues of Industrial Policy and Its Direction (Korean), EDI, December 1982, p. 46. - 104 - although, as can be teen from Figure 2.3, that preference was quite variable, and indeed was declining over the 1975-79 period. It took a jor reversal in 1980 to restore any semblance of an export credit preference Continuous depreciation and import liberalization in the 1980s seem to have contributed to the improved return on investment in the export industry and its profita- bility in the 1980s (see Tables 10.10 and 10.11). As of 1984, the rates of return on investment were almost equalized between the two sectors. C. The Experiences of Specific Industries 10.15 Similar results are observed when the specific industries cases are studied. In general, manufacturing, electricity, fishing and transportation industries had good access to subsidized credit and consequently paid rela- tively less for capital. On the other hand, wholesale and retail trade, mining, and real estate and business service industries had poor access to borrowing and faced relatively high costs of capital (see Table 10.13). The construction industry has increased its access to bank and foreign loans in the 1980s, due to exceptional circumstances, while all other industries' share of foreign and bank loans over total assets have been falling. Among manufac- turing industries, the HC industries and the export industries benefitted from good access to borrowing while light industries, especially the industries which produce mainly for the domestic market, exhibited poor access. Textile and apparels, and wood and furniture industries, which were the major export industries in the 1970s, had favorable access to capital while the food and beverages, and paper and printing industries, which basically produce for domestic market, had relatively poor access (Table 10.13). Consequently, the latter had significantly higher costs of capital than did the former (Table 10.15). Among HC industries, basic metal industry, which includes iron and steel industry, had rapidly increasing access to borrowing from banks and abroad in the latter half of the 1970s, suggesting that it attracted a large part of new loans during this period. Fabricated metal product and equipment industry (which includes shipbuilding and automobile industries) also had good access to borrowing in the latter half of the 1970s. Consequently, these industries, especially basic metal industry, paid much less for capital than did on average manufacturing industries. 10.16 Although it is not possible to establish an exact linkage between access to capital, the resulting cost, and the relative performance of different industries, the analysis of data strongly suggests that the government-controlled access to and cost of credit affected the profitability and growth of specific industries. The fishing industry, for example, was able to secure access to bank loans in the 1970s, while its profit rate was negative for most of the period (Table 10.17). Without cheap bank credit, therefore, this industry may have declined faster. The electricity industry, despite its very low rate of return on investment relative to other indus- tries, enjoyed high profitability, largely due to its access to bank and foreign loans and resulting cheap cost of capital. Service industries 7/ See Rhee Sung Sup (1985) for similar findings on the decline of incen- tives to exports. - 105 - (wholesale and retail, and hotel, real estate and business service, and construction) had very high rates of return on investment relative to other industries in the 1970s (Table 10.16). However, their access to capital was quite poor in the 1970s. If the credit market had not been strongly con- trolled, the growth of these industries may have been faster and its current share in Korean industry might have been higher. Similar arguments can be made for industries in the manufacturing sector. Without intervention in credit allocation, some of the HC industries such as the basic metal industry would not have obtained such cheap access to funds (see Table 10.16 for its relatively low rate of return in the 1970s) and may not have grown as fast. On the contrary, it may be said that paper and printing, and food and beverage industries may have grown faster had financial allocation been determined in the free and competitive market. D. Overall Assessment 10.17 The Korean Government's intervention in the financial sector seems to have been quite distortive, especially in the latter half of the 1970s when it strengthened the control over credit allocation to favor the development of HC industries, although the interventions in the 1960s and 1970s to support export activities may have had positive aspects in the sense that they neutra- lized the distortive effects of other government policies such as high protection and overvaluation. By creating wedges between the average cost of capital among various sectors, public policy helped produce disparities in the marginal rates of return to capital. In addition, the Government's strong control over the financial sector affected firm behavior and may have promoted decision-making patterns, now deeply rooted, which were not conducive to the efficient use of resources in the economy. In general, the strong government intervention in the financial sector during the last two decades seems to have affected the following developments which have deeply permeated through the patterns of industrial development in Korea. Distortive Allocation of Credit 10.18 The government-controlled financial allocation gave rise to a high distortion in the allocation of capital among various sectors by increasing the gap in the cost of capital, and consequently the gapsfin marginal rate of return of capital between the favored sector and disfavored sector. As a result, it is suspected that the resulting alqcation of capital could not maximize the growth potential of the country.21 The data suggest that a higher proportion of bank credit went to less productive borrowers, or the borrowers who could get much of bank loan with subsidized cost expanded their business or production lines in a way too much capital-intensive and consequently low marginal rate of return on capital given the endowment of capital and labor of the economy (see large firms vs. small firms, for example). The significant gaps in the cost of capital and the rate of return 8/ A qualification of this argument is that product market distortions were not as significant as the distortions in the financial cost among various sectors. - 106 - on the capital among different sectors and industry suggest that the overall efficiency of capital allocation could have been increased if the financial allocations had been determined by the more market-oriented financial system. High Leverage of Firms and Poor Development of the Equity Market 10.19 The cheap cost of debt due to interest rate ceilings made debt finance quite attractive to the corporate sector. The real cost of bank loans, a major source of corporate debt, was negative throughout most of the 1970s. In addition, Government's de facto risk partnership with the corporate sector, exercised through its control over the banking institutioz, increased corporate access to debt finance even further. Past government actions to avoid explicit bankruptcies of large firms in favored industries created the perception that debt finance was not very risky compared to equity finance. As a result, the corporate debt ratio became increasingly high in the 1970s, and development of the equity market was slow despite government efforts to the contrary (see Table 10.18). Paradoxically those who could have raised capital through the equity market, the large and well-established firms, had no incentive to do so because of their preferred borrowing position. The ensuring high debt ratios made the corporate sector as a whole very vulnerable to external shocks and economic fluctuation, thus prompting more government involvement in the banking system, and its credit allocation, to bail out troubled firms and industries. High Industrial Concentration 10.20 The financial repression and the resulting credit rationing tended to favor large firms because of low transaction costs involved. The best thing the banks could do to increase their profits in the presence of strict interest rate ceilings and undifferentiated (for risk) interest rates was to reduce the transaction cost and default risk. This led them to favor large firms in those sectors favored by government. This resulted in higher loan concentration and eventually higher industrial concentration (See Chapter 6). Slow Development of the Financial Sector 10.21 Heavy government financial intervention interfered with the development of the financial sector not only with respect to its growth, but also with respect to quality of its services. Intervention in the banking industry (i.e., in its asset management and day-to-day operations) removed any incentive for the banks to innovate in their operations or to become more efficient in the intermediation of financial resources. Nor did the banks have much incentive to select profitable borrowers because they were not rewarded for doing so. Rather, banks passively accommodated the credit demands of the government-favored borrowers. The repressed interest rates which fluctuated around zero or were negative in real terms made bank deposits quite unattractive financial assets and made the holders of bank deposits the ultimate bearer of the cost of financial intervention. Consequently, the financial sector's growth was more sluggish than it would otherwise have been. Furthermore, in the process of channeling government-directed loans, the commercial banks accumulated a substantial amount of nonperforming loans which reduced profitability and limited its future development. - 107 - The Implications of Financial Liberalisation Since 1980 10.22 The financial liberalization efforts since 1980 have greatly improved various aspects of financial allocation. First, it reduced the gaps in the access to and cost of capital between different sectors as we see in Tables 10.7 and 10.9. By reducing these gaps, the financial allocation since 1980 became less distortive. The small/medium firms could get better access to borrowing and this has resulted in more equalized cost of borrowing between large firms and small firms. Owing to this improved access to capital, small/medium firms since 1980 have been growing faster than large firms which seems to be desirable in the sense that the latter's rate of return to investmet is higher. This may well indicate that overall allocative efficiency has increased. It will also help to reduce the market concentration and encourage more competition in the domestic market. 10.23 The gap in the cost of borrowing between the export industry and the domestic industry also has been reduced since 1982 as the preferential lending rates were abolished, although the gaps in access still exist. Similarly, the gaps in the cost of and access to capital have been significantly reduced between HC industry and light industry. All these suggest that the financial allocation since 1980, especially since 1982, became much less distortive, compared to that of the 1970s. The high real cost of debt along with the reduced degree of (implicit) government commitment to be a risk partner in the case of bad performance of industrial firms also pushed firms to reduce their dependence on debt. As a result, the debt ratio has been decreasing rapidly since 1980 which seems to be desirable not only for the stability of the corporate sector and lower vulnerability to with espect to ternal shock, but also for further liberalization of the finan4ial system.- E. Future ImplicatiojA The Banking Industry 10.24 The government's current financial policy is characterized by an emphasis on small/medium firm financing, a reduced commitment to financial support for HC industry, and the abolishment o 07arious preferential lending rates on policy loan (including export loans).- It seems to have 9/ Financial liberalization, grounded on decelerating inflation, also contributed to a rapid expansion of the financial sector, especially less regulated nonbanking financial institutions, as was seen in Chap- ter II of this report. With more savings channeled through financial institutions which became less regulated, it is expected that the overall capital allocation became more efficient and the intermediation cost of capital in the economy has decreased. 10/ This does not imply, however, that credit rationing does not continue to be necessary with interest rates in the banking sector still uader government control. - 108 - contributed to correcting distortions in the financial allocation caused by previously heavy financial repression. One area in which Government has not pursued liberalization as strongly as its other efforts seems to be vis-a-vis its commitment to bailing out troubled firms. Since the -elief loans of banks and distress borrowing of industrial firms put a significant yoke on the development of the banking industry and further liberalization of the financial sector, it may be desirable to reduce the burden on the bank's asset management by reducing support for some inefficient firms and helping to extricate the banks. Although this may give rise to temporary shocks in the economy, this type of policy will also facilitate the industrial restructuring of the economy and reduce the structural adjustment costs in the long run. Capital Market 10.25 If the process of further financial liberalization is to involve a decreasing role of Government as a risk partner of the industrial sector, it would be advisable to st.. a substitute source of risk capital. Of course, this is particularly tricky in the highly leveraged Korean industrial environment. In the case of the United Kingdom and the United States, a well- functioning equity market and merchant banks provide risk capital to the corporate sector. In Germany and France, universal banks and industrial banks provide risk capital and become risk partners of the industrial sector. In Japan, the group banks provide loans to the group firms and become risk partners. As the Korean economy becomes more industrialized, and its banking system more liberalized, the capital market which could provide the risk capital to industrial firms needs further developint. Stable Inflation 10.26 It also seems desirable for the stable growth of the industrial as well as the financial sector to maintain the current low rate of inflation. Korean firms' profitability is, as we see in Table A5.19, quite sensitive not only to the level of nominal but also real interest rates. Of course, inappropriate inflation accounting may have underestimated the profitability of firms which are net debtors in the inflationary period. However, it is true that a substantial part of corporate debt will be held in the form of liquid financial assets which cannot be fully hedged against inflation (such as demand deposit or cash) and firms also suffer from inflation as their costs (financial expenses) increase faster than its revenue if the nominal interest rate increases as fast as inflation. High real rates are necessary to encourage financial saving whereas high real rates are a serious problem for the industrial sector which must roll over a high level of debt. As long as inflationary expectations can be contained, interest rates can be brought down somewhat without a loss in savings generation but with a considerable gain for firm profitability and financial stability. Interest Rates and Corporate Profitability 10.27 If the current low level of inflation continues, and if peoples' expectations settle down, the Government may be able to reduce slightly the current nominal interest rates at some point in the future to boost the profitability of industrial firms. Currently, the corporate sector seems to - 109 - be confronted with historically high real interest rates, although it is not possible to judge what would be the optimal level of interest rate in the absence of controls. If we compare the cost of borrowings and profitability of Japanese firms in the 1970s (see Table AS.20), Korean firms are now paying higher real interest rates and their profitability is lower. However, we have to note that, if the Government reduces interest rates prematurely, it may risk retarding financial sector growth. Policy Coordination 10.28 Finally, it cannot be overemphasized that the financial liberaliza- tion policy that the Government is pursuing now should be well coordinated with other government policies. Even if financial distortions are small due to relaxed regulations on the financial systems, the system may be allocating resources to economically inefficient projects if -,he price and profitability signals it receives are incorrect. Therefore, in order to maximize the growth potential of an economy, it is very important to have a consistent liberalization strategy which fully integrates macroeconomic policy, trade policy, pricing policy and financial sector policy. Table 10.1: SOURCES OF NIP (illon won) Sources 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 Total 1. NIP bonds issued 71,722 131,688 165,213 276,129 307,471 291,901 372,069 492,152 353,933 443,760 73,326 2,979,362 and deposits (98.7) (97.8) (90.0) (89.3) (68.2) (64.1) (71,7) (64.1) (46.0) (53.9) (12.6) (58.8) National savings 8,776 11,307 12,121 17,027 26,448 38,990 41,814 47,964 39,671 13,086 18,055 275,259 association (12.1) (8.4) (6.6) (5.5) (5.9) (8.6) (8.1) (6.2) (5.2) (1.6) (3.1) (5.4) Public funds 11,512 16,771 25,341 45,368 54,586 64,381 91,459 75,597 37,416 40,046 189,498 277,979 (15.8) (12.5) (13.8) (14.7) (12.1) (14.1) (17.6) (9.8) (4.9) (4.9) (32.5) (5.4) National life insur- &ace and postal 10,046 15,000 18,500 -2,089 - * * -24,275 -17,184 - - - savings (13.8) (11.1) (10.1) (0.7) - - - (3.2) (2.2) - - - Barking institutions 38,746 81,153 97,044 197,769 202,359 172,281 214,768 372,200 286,064 275,129 158,102 2,095,614 (53.3) (60.2) (52.8) (64.0) (44.9) (37.8) (41.4) (48.5) (37.1) (33.4) (27.1) (41.3) t Insurance companies 2,642 7,457 12,207 18,054 24,078 16,249 24,029 20,664 7,966 115,449 86,667 335,511 a (3.6) (5.5) (6.6) (5.8) (5.3) (3.6) (4.6) (2.7) (1.0) (14.0) (14.9) (6.6) Nonlife insurance 2,642 7,457 12,207 18,054 24,078 16,249 24,028 20,664 7,966 42,290 1,002 174,633 companies (3.6) (5.5) (6.6) (5.8) (5.3) (3.6) (4,6) (2.7) (1.0) (5.1) (0.2) (3.4) Life insurance - - - - - * - - - 73,209 87,669 160,878 companies - - - - - - - - - (8.9) (15.1) (3.2) 2. Collections of 954 5,712 7,469 27,987 75,166 92,801 131,365 195,242 254,675 338,793 419,280 1,549,444 loans (1.3) (4.2) (4.1) (9.7) (16.7) (20.4) (25.3) (25.4) (33.1) (41.2) (72.0) (30.6) 3. Carryover from - 2,731 10,963 5,103 68,482 70,820 15,712 80,730 164,428 40,033 89,995 540,535 previous year - (2.0) (6.0) (1.7) (15.2) (15.5) (3.0) (10.5) (21.0) (4.9) (15.4) (10.7) Total 72,476 134,669 183,645 309,219 451,119 519,146 768.124 770,036 822,586 582,601 506.934 Note: ( ) * share. Table 10.2t USES OF NIF (Million won) Uses 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 Total Beavy and chemical 44,120 61,348 100,677 147,218 239,447 285,299 266,704 332,997 445,003 472,636 318,708 2,714,158 Industries (58.5) (49.6) (56.4) (61.2) (62.7) (64.9) (60.8) (54.9) (61.0) (64.5) (65.2) (61.1) Agriculture 10,547 11,400 19,415 9,998 14,946 19,835 21,711 38,698 45,000 44,954 30,000 266,506 (14.0) (9.2) (10.9) (4.2) (13.9) (4.5) (5.0) (6.4) (6.2) (6.1) (6.1) (6.0) Power Industries 17,000 43,200 40,000 50,000 92,000 100,000 120,000 160,000 140,000 40,000 50,000 852,000 (22.5) (34.9) (22.4) (20.8) (24.2) (22.7) (27.4) (26.4) (19.2) (5.5) (10.2) (19.2) Seemeul factories 3,740 4,757 8,450 3,521 4,222 4,676 * * - - * 29,365 (5.0) (3.8) (4.7) (1.5) (1.5) (1.1) - * - * * (6.6) 2 asport on deferred - 3,000 10,000 30,000 29,684 30,000 30,000 75,000 10,000 175,000 100,000 582,674 Payne"t - (2.4) (5.6) (12.5) (6.2) (6.8) (6.8) (12.4) (1.4) (23.9) (20.5) (13.1) Total (A) 75 407 123 706 178 542 240 738 380 29 438 810 438 415 606 69 730 003 732 59 498 708 444 913 (A) 15)(1. (t.1 (t.0 (t4) (1.7 (1.6 (1.8 (1.7 (1.3 (M) Total Domestic Credit (B) In 3.0 397 438 5.979 8.722 11,826 16.778 22.016 27.529 S1.S47 36.056 /a Billion won. Note: Numbers to parenthesis are percents. - 112 - Table 10.3: INTEREST RATES ON VARIOUS LOANS (1) Bank loan Curb Corporate Selected policy loan Inflation Year market /a bond General Export MIPF Lb NIP (GNP Deflator) 1971 46.41 - 22.0 6.0 - - 13.92 1972 38.97 - 19.0 6.0 - - 16.11 1973 33.30 - 15.5 7.0 10.0 - 13.40 1974 40.56 - 15.5 9.0 12.0 12.0 29.54 1975 41.31 20.1 15.5 9.0 12.0 12.0 25.73 1976 40.47 20.4 17.0 8.0 13.0 14.0 20.73 1977 38.07 20.1 15.0 8.0 13.0 14.0 15.67 1978 41.22 21.1 18.5 9.0 15.0 16.0 21.39 1979 42.39 26.7 18.5 9.0 15.0 16.0 21.20 1980 44.94 30.1 24.5 15.0 20.0 22.0 25.60 1981 35.25 24.4 17.5-18.0 15.0 11.0 16.5-17.5 15.90 1982 Jan 32.64 17.29 15.5-16.0 12.0 15.0 15.5-16.5 13.20 Mar 32.60 17.29 13.5-14.0 11.0 13.5-14.5 13.5-14.5 13.20 Jun 33.12 17.29 10.0 10.0 10.0 10.0 7.60 1983 25.77 14.23 10.0 10.0 10.0 10.0 3.00 1984 24.84 14.12 10.0-11.5 10.0 10.0-11.5 10.0-11.5 3.90 1985 24.0 14.2 10.0-13.0 10.0 10.0-11.5 10.0-11.5 3.50 /a Source: BO. 73' Machinery Industry Promotion Fund. 7c National Investment Fund. - 113 - Table 10.4: EFFECTIVE COST OF FOREIGN LOANS Interest cost of Exchange Rate of domestic Foreign Interest Cost Gap Year Rate change Bank loan Nominal/a Effective/b (A) - (B) (Dec-Dec) of E.R. (A) (B) 1968 Dec 281.50 8.00 25.2 7.13 15.13 10.07 1969 Dec 304.45 4.00 24.0 10.06 14.06 10.06 1970 Dec 316.65 17.85 24.0 6.75 24.60 -6.00 1971 Dec 373.20 6.88 22.0 5.81 12.69 9.31 1972 Dec 398.90 -1.00 15.5 6.19 5.19 10.31 1973 Dec 397.50 21.76 15.5 10.03 31.79 -16.29 1974 Dec 484.00 0 15.5 10.19 10.19 5.31 1975 Dec 484.00 0 15.5 6.63 6.63 8.87 1976 Dec 484.00 0 17.0 5.38 5.38 11.62 1977 Dec 484.00 0 15.0 7.50 7.50 7.50 1978 Dec 484.00 0 18.5 12.31 12.31 6.19 1979 Dec 484.00 36.34 18.5 14.44 50.78 -32.28 1980 Dec 659.90 6.1 19.5 16.75 22.85 -3.35 1981 Dec 700.50 6.78 16.5 14.81 21.59 -5.09 1982 Dec 748.00 6.35 10.0 9.50 15.85 -5.85 1983 Dec 795.50 3.79 10.0 10.06 13.85 -3.85 1984 Dec 825.70 7.6 11.0 10.75 18.35 -7.35 1985 Dec 888.45 /a Libor-based cost of borrowing. 7-b Nominal cost adjusted for annual rate of change of exchnage rate, Source: Bank estimates. - 114 - Table 10.5t SIn2 AND SHAM OF POLICY LOAN BY DMB (Of which Year Total General loans Policy loans exort loans) 1970 722.4 510.5 (70.7) 211.9 (29.3) 55.9 (7.7) 1971 919.5 647.2 (70.4) 272.3 (29.6) 80.1 (8.7) 1972 1,198.0 846.4 (70.4) 351.6 (29.3) 108.4 (9.1) 1973 1,587.5 1,052.4 (66.3) 535.1 (33.7) 224.1 (14.1) 1974 2,427.8 1,637.2 (67.4) 790.6 (32.6) 360.2 (14.8) 1975 2,905.5 2,117.9 (72.9) 787.6 (27.1) 339.2 (11.7) 1976 3,724.9 2,497.9 (67.1) 1,227.0 (32.9) 461.8 (12.4) 1977 4,709.0 3,115.4 (66.2) 1,593.6 (33.8) 567.4 (12.0) 1978 6,609.0 4,154.7 (62.9) 2,454.3 (37.1) 883.2 (13.4) 1979 8,977.8 5,827.1 (64.9) 3,150.7 (35.1) 1,227.2 (13.7) 1980 12,204.4 7,904.8 (64.8) 4,299.6 (35.2) 1,720.8 (14.1) 1981 15,955.0 10,585.6 (66.3) 5,369.4 (33.7) 2,197.2 (13.8) 1982 20,225.8 13,801.6 (68.2) 6,424.2 (31.8) 2,278.4 (11.3) 1983 24,150.3 16,190.8 (67.0) 7,959.5 (33.0) 2,620.0 (10.8) 1984 27,978.9 19,101.6 (68.3) 8,877.3 (31.7) 2,765.4 (9.9) 1985 33,810.7 23,382.6 (69.2) 10,428.1 (30.8) 3,129.9 (9.3) Source: Bank of Korea. - 115 - Table 10.6: THE USES OF CONMERCIAL BANKS NET INCREASE OF DEPOSIT (1981) (100 million won) Amount Share Net deposit increase (A) 16,664 100.0 Directed uses (B) 9,445 56.7 Reserve requirement 917 5.5 Contribution to NIF 2,176 13.1 Policy loan /a 6,352 38.1 (Export credit) (780) (4.7) (Other) (5,572) (33.4) Undirected uses (A) - (B) 7,219 43.3 Source: Korean Economy and Banking. B. J. Kim and Y. C. Park, 1984. Table 10.7: ACCESS TO BORROWINGS BT EACH SECTOR /a (2) 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 Tot Mnf 45.41 43.21 45.22 40.27 40.97 41.32 39.29 36.94 38.55 38.05 32.53 30*81 28.17 L Mnf 45.72 43.55 45.65 40.93 41.36 41.38 39.69 37.32 39.25 38.81 32.26 30.76 27.84 S muf 27.27 26.54 24.44 27.38 34.98 40.79 37.02 34.60 33.79 34.31 33.87 3119 30.40 8 Mnf - L Mnuf -18.45 -17.00 -21.20 -13.56 -6.38 -0.59 -2.67 -2.72 -5.46 -4.50 1.61 0.43 2.56 X Inds 47.13 45.95 49.78 45.07 43.11 44.06 42.85 41.10 48.57 45.63 38.07 35.53 32.28 Dons Inds 44.63 41.75 42.93 36.62 39.91 39.83 37.54 35.24 31.66 32.84 29.00 28.08 25.98 D Inds - X Inds -2.50 -4.20 -6,85 -8.45 -3.20 -4.23 -5.31 -5.86 -16.90 -12.79 -9.07 -7." -6.29 $ Rv Chen lIds 49.20. 43.43 41.25 38.52 41.59 42.53 41.60 37.07 39.67 40.86 32.81 31.08 27.72 Light Inds 42.30 43.02 49.05 41.96 40.32 40.04 35.94 36.79 37.11 33.89 32.13 30.41 28.96 Light - Ev Chem -6.91 -0.42 7.79 3.44 -1.27 -2.48 -5.66 -0.28 -2.56 -6.96 -0.68 -0.67 1.25 /a The figures are the ratios of total bank loans and foreign loans over total asset of each sector. Source: Financial Statement Analysis, B0K, various issues. Table 10.8: DMST RATIO OF EAC SECTOR 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 Tot Naf 270.00 328.40 394.20 313.40 272.70 316.00 339.50 364.60 367.20 366.80 377.10 487.90 451.50 385.80 360.30 342.70 L Kaf 272.90 331.80 402.10 319.10 276.50 322.40 351.50 372.20 369.30 363.30 377.50 504.70 451.10 377.0 360.60 339.50 S maf 106.80 206.80 161.30 138.80 148.80 140.90 185.90 272.20 347.50 388.10 374.30 394.90 453.20 433.00 357.80 366.00 S Mnf - L %nf -166.10 -125.00 -240.80 -180.30 -127.70 -181.50 -165.60 -100.00 -21.80 24.80 -3.20 -109.80 2.10 55.40 -2.80 26.50 X Inde NA NA NA 403.90 324.10 402.20 337.00 489.01 479.20 519.50 406.40 496.10 427.90 333.80 325.30 286.50 Dom Inds KA NA NA 282.20 250.10 283.00 314.60 320.30 322.40 316.50 366.00 482.40 469.00 425.90 383.20 379.90 Dom - 1 Inds NA NA NA -121.70 -74.00 -119.20 -22.40 -168.71 -156.80 -203.00 -40.40 -13.70 41.10 92.10 57.90 93.40 wy Chem IndS NA NA NA 315.40 259.20 275.10 284.70 324.00 316.30 344.50 331.30 460.00 407.00 327.90 305.20 307.30 Light Inde NA NA NA 311.70 285.30 365.00 408.70 417.00 437.10 403.40 449.10 527.90 533.40 500.10 472.50 421.30 Light - cv Chem NA NA NA -3.70 26.10 89.90 124.00 93.00 170.80 58.90 117.80 67.90 126.40 172.20 167.30 114.00 Source: Fiaancial Statement AaiV,lo BOK, varims issues. Table 10.91 AVERAGE COST OF BORROWING BY EACH SECTOR 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 Tot Manfact 12.00 8.60 10.50 11.30 11.90 13.10 12.40 14.40 18.70 18.37 15.97 13.63 14.42 L Manfact 11.98 8.48 10.49 11.19 11.80 11.91 11.91 14.42 18.42 18.30 16.08 13.71 14.45 S Manfact 14.16 11.59 11.41 13.92 14.39 13.80 15.55 14.16 20.74 18.77 15.38 12.95 14.13 S Mnf - L *4af 2.18 3.11 0.92 2.73 2.59 1.89 3.64 -0.26 2.32 0.47 -0.70 -0.76 -0.32 K Inds 11.06 9.78 9.82 9.82 11.34 12.87 12.68 15.70 16.01 15.81 13.55 12.39 12.91 Dos Inds 12.46 9.84 10.88 12.60 12.25 13.24 12.25 13.80 21.03 20.36 17.59 14.37 15.20 D Inds - X Inds 1.40 0.06 1.06 2.78 0.91 0.37 -0.43 -1.90 5.02 4.55 4.04 1.98 2.29 Rv Chem Inds 10.53 8.65 10.38 10.24 10.14 11.50 10.09 12.51 17.58 17.49 15.29 12.93 14.39 Light Inds 13.31 10.90 10.59 12.16 13.70 14.29 15.85 16.62 20.05 19.64 16.93 14.63 14.46 Light - Hv Chem 2.78 2.25 0.21 1.92 3.56 2.79 5.76 4.11 2.47 2.15 1.64 1.70 0.07 Source: Financial Statement Analysis, BO# various issues. Table 10.10: AVERAGE RE OF RETURN 0N INVESTKENT BY AC SECToR 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 Tot Nanftact 10.55 12.77 10.91 9.50 10.42 10.27 11.03 10.74 9.14 9.98 8.80 9.59 9.67 L Naftact 10.55 12.75 10.86 9.43 10.37 10.06 10.82 10.57 8.84 9.70 8.82 9.50 9.59 8 Nanfact 10.42 13.61 12.81 10.87 11.22 12.25 12.23 11.81 11.10 11.44 8.68 10.30 10.21 8 u - L *af -0.13 0.86 1.95 1.44 0.85 2.19 1.41 1.24 2.26 1.74 -0.14 0.80 0.62 x IndS 10.44 15.14 8.21 7.75 9.10 8.75 8.53 8.55 9.22 10.65 7.94 8.91 9.82 Doms Indu 9.23 11.62 12.25 10.82 11.08 11.12 12.33 11.68 9.08 9.54 9.33 9.98 9.58 D lade - X Inds -1.21 -3.52 4.04 3.07 1.98 2.37 3.80 3.13 -0.14 -1.11 1.39 1.07 -0.24 Ev Che lada 7.92 10.06 12.45 9.34 9.41 8.96 9.69 9.32 7.36 9.11 8.56 9.20 9.75 Light Ind 11.00 15.30 9.45 9.65 11.50 11.57 13.80 12.50 11.40 11.28 9.13 10.15 9.52 Light - Ev Ch.. 3.08 5.24 -3.00 0.31 2.09 2.61 4.11 3.18 4.04 2.17 0.57 0.95 -0.23 Sourcet Financial Statement Analysis, BOK, varfous isSues. Table 10.11: PROFITABILITY OF BACH SECTOR 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 Tot Manfact 3.69 2.49 1.00 3.80 7.90 5.70 3.90 4.60 4.50 5.00 3.40 -0.20 0.02 1.03 3.29 3.41 L Manfact 3.64 2.47 0.83 3.75 7.88 5.59 3.78 4.55 4.24 4.93 3.24 -0.59 -0.51 0.88 3.07 3.22 S Manfact 6.60 3.49 4.31 4.93 8.96 9.02 5.96 5.48 5.72 5.30 4.19 1.98 2.68 1.78 4.86 4.65 S Mnf - L Mnf 2.96 1.02 3.48 1.18 1.08 3.43 2.18 0.93 1.48 0.37 0.95 2.57 3.19 0.90 1.79 1.43 69-75 76-79 81-84 1 T Maf Avg 4.07 4.38 1.94 V- L MNuf Avg 3.99 4.24 1.67 W S Maf Avg 6.18 5.17 3.49 X Inds NA NA NA 4.55 10.03 2.92 2.45 3.25 2.61 1.78 0.35 0.15 1.30 1.03 3.07 4.33 Dome Inds NA NA NA 2.93 6.87 7.03 4.96 5.28 5.72 6.65 4.67 -0.05 -0.84 1.03 3.38 2.91 Done - X Inds NA NA NA -1.62 -3.16 4.11 2.51 2.03 3.11 4.87 4.32 -0.65 -2.14 0.00 0,31 -1.42 72-75 76-79 81-84 X Inds Avg NA NA NA 4,99 2.00 2.43 Doms Inds Avg NA NA NA 5.45 5.58 1.62 Rv Chem Inds NA NA NA 2.27 5.79 7.63 4.64 4.65 4.55 4.09 3.00 -1.29 -0.26 1.13 3.32 3.71 Light Inds NA NA NA 4.40 9.88 3.80 3.17 4.56 4.51 6.26 3.83 1.12 0.43 0.89 3.20 2.88 Light - Rv Chem NA NA RA 2.13 4.09 -3.83 -1.47 -0.09 -0.04 2.17 0.83 2.41 0.69 -0.24 -0.12 -0.83 72-75 76-79 81-84 Hv Chem Inds Avg 5.08 4.07 1.98 Light Inds Avg 5.31 4.79 1.85 Source: Financial Statement Analysis, BOK, various issues. Table 10.1) NET SALES CROTH RATE OP ACM SECTOR la 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 UPI (Ail Prod.) 17.10 18.70 20.30 23.10 24.70 35.10 44.40 49.80 54.30 60.60 72.00 100.00 120.00 126.00 126.30 127.20 W Crth Rate 1.07 1.09 1.09 1.14 1.07 1.42 1.26 1.12 1.09 1.12 1.19 1.39 1.20 1.05 1.00 1.01 Tot manfact NA NA 15.15 16.88 48.70 10.48 11.47 23.93 21.06 22.76 10.26 -1.36 11.67 6.67 17.72 17.17 L Nanfact NA NA NA 17.76 49.64 11.19 12.26 23.93 21.06 21.86 10.26 1.52 11.67 7.62 16.72 16.17 S Nanfact NA NA NA 8.09 55.25 3.44 5.14 21.25 21.06 22.76 7.73 -14.32 11.67 5.71 21.71 20.14 8 nef - L Nf NA NA NA -9.67 5.61 -7.74 -7.11 -2.67 0.00 0.90 -2.53 -15.84 0.00 -1.90 4.99 3.97 72-75 76-79 81-84 Naf Av# 21.88 19.50 13.30 L Nwf AvS 22.71 19.28 13.04 8 ffl Av# 17.98 18.20 14.81 X Inde NA NA NA NA 58.99 -6.41 7.51 33.73 21.06 20.07 0.16 0.08 15.00 6.67 12.73 25.11 Doms Inde NA NA NA NA 44.02 21.74 13.84 18.58 21.06 23.65 15.31 -2.08 9.17 7.62 19.71 13.19 Doe - I Inde NA NA NA NA -14.96 28.15 6.32 -15.16 0.00 3.58 15.15 -2.16 -5.83 0.95 6.98 -11.92 73-75 76-79 81-84 1 Inde Avg NA NA NA 20.03 18.76 14.88 Doma tnds Avs NA NA NA 26.53 19.65 12.42 ft Chem Inds NA NA NA NA 58,05 35.11 9.89 23.93 22.90 25.45 11.94 -2.08 13.33 8.57 19.71 18.16 Ligbt Inde NA NA NA NA 44.96 -5.00 13.05 23.04 19.23 20.07 7.73 -0.64 9.17 5.71 14.73 16.17 Light - N Chem NA NA NA NA -13.09 -40.11 3.16 -0.89 -3.67 -5.38 -4.21 i.44 -4.17 -2.86 -4.99 -1.99 73-75 76-79 81-84 Sv Oheh Inds Av& 34.35 21.05 14.94 Light Inde AvS 17.67 17.52 11.44 t. The figures are adjueted for inflation by the formulae, 1 + net sales growth rate/1 + Nl grmotb rate. Source: Pinancial Statement Analysis, aO, various issues. Table 10.13: ACCESS TO BORROWING BY EACH INDUSTRY (%) 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 Fishing (1) NA 51,08 46.24 40,14 47.20 54.30 48.49 55.46 42.68 41.47 40.49 31.02 36,75 Mining (2) 39.56 33.05 27.67 26.59 22.88 25.25 21.46 23.78 14.36 12.54 11.08 10.80 7.41 Manufacturing (3) 45.41 43.21 45.22 40.27 40.97 41.32 39.29 36.94 38.55 38.05 32.53 34.73 28.17 Food & beverages (31) 42.44 45.63 43.90 37.18 37.67 29.24 23.18 24.04 25.46 20.25 20.51 16.54 19.59 (Beverage) 40.93 37.39 38.92 34.55 30.21 21.95 26.56 17.89 17.19 16.77 14.51 9.99 12.63 Textile & apparels (32) 47.04 44.59 54.52 44.23 42.24 43.69 42.64 45.14 44.56 39.26 37.50 37.18 34.35 Wood & furniture (33) 47.52 47.76 67.10 59.44 54.24 54.20 44.54 44.33 46.51 51.63 48.46 52.81 52.53 Paper & printing (34) 40.01 34.21 46.77 38.32 39.23 36.73 37.46 32.45 32.31 35.67 27.46 27.61 28.10 Chem, petr. & coal (35) 39.57 39.12 35.15 31.86 31.77 15.11 29.41 28.97 27.01 33.88 28.90 28.95 21.95 Nonmetallic min prod. (36) 67.27 53.57 51.09 44.79 47.35 42.96 40.97 37.61 36.29 35.29 29.80 23.51 22.36 Basic metal (37) 46.37 44.64 43.85 47.14 48.61 49.41 50.64 48.28 57.42 52.55 36.53 32.89 28.84 (Iron & steel) 46.89 45.17 42.02 47.40 48.85 50.52 51.54 51.43 62.38 50.65 36.27 33.16 25.74 Fab wet prod & equip (38) 43.87 41.32 40.28 36.64 40.47 38.96 41.56 34.55 37.07 38.19 33.70 31.66 30.35 ' (Transport equipment) 51.48 47.59 50.01 51.79 51.51 46.54 47.71 34.11 36.56 4.20 34.32 33.13 30.25 1 Other manufacturing (39) 26.83 29.11 28.41 14.65 31.04 40.48 14.22 32.75 37.03 33.43 29.21 24.43 26.99 Electricity & gas (4) 55.68 49.78 48.77 52.64 27.26 47.58 48.15 53.18 60.70 52.73 50.54 50.48 49.65 Construction (5) 40.90 37.15 44.88 29.26 23.62 20.57 12.67 16.49 29.15 .32.68 32.85 26.95 29.56 W & R trade & hotel (6) 27.62 23.01 28.96 20.56 29.52 30.87 28.09 26.08 26.78 23.65 27.04 17.84 21.36 Transport & storage (7) 51.10 44.16 38.08 36.67 38.42 37.03 34,82 34.90 44.06 42.35 31.68 35.36 31.62 Real est 6 bus serv (8) 30.59 29.95 20.10 15.03 29.54 17.91 30.74 28.29 30.81 11.17 15.88 12.50 9.82 Rec, cul & other serv (9) 31.18 33.76 22.68 17.67 17.02 29.28 21.48 17.46 9.91 12.36 9.04 14.08 18.04 Source: Financial Statement Analysis BOK, various issues. Table 10.14: DEBT RATIO By EACH INDUSTRY 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 Fishing (1) NA 10,361.10 2,160.60 7,839.60 7,281.20 2,361.40 2,850.40 - 2,690.70 1,929.60 3,590.10 1,072.20 2,078.80 Mining (2) 201.40 159.00 153.30 143.00 167.30 240.90 257.40 369.60 262.00 295.00 225.90 181.90 137.20 Manufacturing (3) 313.40 272.70 316.00 339.50 364.60 367.20 366.80 377.10 487.90 451.50 385.80 360.30 342.70 Food & beverages (31) 334.90 375.50 415.60 410.20 453.50 390.50 395.50 409.50 471.90 528.80 422.40 395.60 374.50 Textile & apparels (32) 386.90 310.90 440.60 505.70 497.30 528.10 548.60 638,80 820.10 637.70 598.60 579.60 524.80 Wood & furniture (33) 548.00 442.30 1,688.60 1,751.10 631.10 558.30 560.40 604.70 2,051.40 4,894.80 10,253.00 -2,616.10 10,253.00 Paper & printing (34) 202.10 160.30 243.20 257.50 283.20 310.00 307.50 287.50 382.80 483.80 539.40 393.50 337.20 Chea, petr. & coal (35) 212.80 226.40 257.90 259.30 242.50 276.00 228.20 299.80 414.70 439.20 367.70 297.00 273.30 Nonmetallic min prod. (36) 597.00 373.00 376.00 282.90 '23.60 270.30 406.90 422.80 447.90 399.00 290.70 274.40 250.00.. Basic metal (37) 552.00 233.80 192.10 282.30 342.20 318.90 301.90 324.90 496.60 463.60 243.80 236.90 219.50t: Fab net prod & equip (38) 272.00 245.00 291.90 286.90 381.00 379.00 477.70 335.50 403.00 349.60 374.70 375.70 385.10 1 Other manufacturing (39) 181.60 167.10 139.10 233.40 262.70 457.90 408.00 598.90 310.00 247.20 355.70 252.70 322.60 Electricity & gas (4) 289.60 330.80 320.60 200.60 133.50 138.80 167.40 197.20 257.90 262.50 158.30 176.90 176.50 Construction (5) 312.40 193.90 306.50 256.60 368.70 300.90 349.80 383.50 524.90 522.80 497.20 481.10 450.80 W & R trade, hotels (6) 190.50 174.30 202.60 281.60 396.10 367.10 431.00 442.10 566.30 590.10 523.20 403.10 465,70 Transport & storage (7) 463.70 342.10 233.00 602.50 419.00 477.70 488.50 449.00 628.40 544.70 485.30 496.90 537.10 Real eat & bus serv (8) 176.80 332.70 161.00 416.00 446.00 426.50 185.00 189.00 209.20 183.30 182.10 162.10 285.20 Rec, cul & other serv (9) 9.34 13.05 13.41 99.80 106.80 174.10 141.40 311.00 300.40 252.90 275.50 235.70 196.30 Sources Financial Statement Analysis, B0, various issues. Table 10.15t AVERAGE COST OP BORROWING 8 EACH INDUSTRY 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 Fishing (1) NA 8.96 7.31 8.17 8.72 8.98 10.64 11.83 14.81 15.90 14.55 13.36 14.44 Mining (2) 17.48 7.98 11.10 8.20 11.00 8.80 8.70 10.80 14.70 17.40 15.00 12.70 14.12 Manufacturing (3) 12.00 8.60 10.50 11.30 11.90 13.10 12.40 14.40 18.70 18.37 15.97 13.63 14.42 Food & beverages (31) 14.58 8.10 10.62 13.90 16.53 16.57 16.80 16.28 20.58 19.36 18.86 16.97 17.04 (Beverage) (18.85) (12.59) (12.87) (15.76) (19.66) (20.95) (:-.89) (16.52) (22.60) (20.04) (20.23) (16.03) (18.51) Textile & apparels (32) 10.99 8.72 9.05 10.25 12.23 13.54 15.53 16.02 18.92 18.72 15.98 14,55 14.16 Wood & furniture (33) 12.29 6.72 9.80 12.72 9.88 9.83 10.57 13.96 22.39 20.17 15.18 13.26 12.97 Paper & printing (34) 16.80 11.65 14.44 14.99 16.59 17.08 16.96 18.76 20.99 20.09 19.17 13.92 12.21 Chem, petr. & coal (35) 10.33 9.26 13.23 13.11 13.34 12.34 15.30 17.31 23.58 20.85 18.12 13.91 17.45 Nonmetallic min prod. (36) 9.84 10.39 8.33 11.54 10.37 11.34 10.56 13.34 15.72 17.54 16.06 14.69 13.59 (Porcelain) (26.50) (14.62) (11.67) (11.17) (18.51) (18.23) (12.48) (15.74) (29.87) (24.92) (19.51) (14.91) (14.56) Basic metal (37) 11.38 5.55 8.09 8.19 7.75 7.73 6.89 9.97 12.24 15.62 11.67 11.36 12.29 (Steel) (11.81) (5.93) (7.93) (7.77) (7.85) (7.28) (6.63) (9.67) (11.36) (15.00) (11.23) (10.52) (12.47) Fab met prod & equip (38) 14.57 8.62 12.11 10.61 11.66 12.32 11.51 13.46 19.71 17.51 15.69 13.08 13.98 (Shipbuilding & auto) (13.88) (7.27) (10.50) (8.87) (9.28) (9.27) (9.28) (13.02) (17.35) (15.58) (13.15) (11.50) (14.15) Other manufacturing (39) 16.93 11.74 14.60 15.96 14.06 14.86 14.19 17.61 20.33 15.60 15.44 .13.04 14.52 Electricity & gas (4) 4.98 4.85 5.30 5.40 5.10 4.00 4.80 5.30 7.40 8.20 5.80 5.70 6.45 Construction (5) 12.69 12.28 11.70 12.90 15.00 11.80 15.30 17.20 18.40 19.50 16.10 15.40 13.55 W & R trade, hotels (6) 17.02 11.18 12.00 14.70 15.80 16.40 16.70 20.30 23.70 24.80 18.40 16.30 17.19 Transport & storage (7) 8.84 5.95 8.30 10.00 8.10 11.90 11.10 12.60 15.60 18.00 16.10 12.90 13.89 Real eat & bus serv (8) 17.73 10.49 8.20 7.70 8.80 8.70 4.00 4.70 7.00 16.20 11.40 9.50 11.06 Reec, cul & other serv (9) 16.32 9.03 10.00 8.20 14.10 12.10 11.90 21.10 30.80 18.60 14.00 14.10 10.83 Source: Financial Statement Analysis. SOK, various issues. Table 10.16: AVERAGE RATE OF RETURN ON INVESTMENT By EACH INDUSTRY 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 Fishing (1) NA 7.08 1.23 1.43 5.36 5.37 7.13 5.34 2.29 6.17 -1.29 6.30 6.44 Mining (2) 4.36 10.21 16.89 12,03 10.70 6.34 3.81 0.16 3.38 5.36 5.53 3.82 3.88 Manufacturing (3) 10.55 12.77 10... 9.50 10,42 10.27 11.03 10.74 9.14 9.98 8.80 9.59 9.67 Food & beverages (31) 12.13 11.51 9. ,c 11.28 13.21 15.36 16.83 13.55 11.97 11.52 10.55 10.97 8.88 Textile & apparels (32) 10.02 16.06 7.42 6.71 9.58 8.30 11.02 10.37 9.82 11.54 8.30 8.59 8.23 Wood & furniture (33) 14.56 16.72 -1,00 7.77 7.71 10.62 14.72 8.24 -0.16 5.04 3.28 8.89 4.67 Paper & printing (34) 13.69 16.04 14.89 11,05 13,75 14.47 14.22 14.53 10.80 7.38 8.71 10.00 9.97 Chem, petr. & coal (35) 10.54 12.60 12.45 12.89 13.16 10.53 14.12 13.98 12.18 10.91 10.75 10.98 12.40 Nonmetallic min prod. (36) 12.72 18.75 15.77 12.26 10.15 12.81 10.53 11.96 10.50 S.39 9.56 11.66 12.16 ic metal (37) 7.83 8.95 18.18 4.12 7.09 7.55 7.70 8.38 6.24 9.56 6.61 8.35 9.62 ab met prod & equip (38) 10.64 10.92 12.26 11.70 10.03 11.25 8.78 8.93 7.04 8.71 8.45 9.04 8.81 Other manufacturing (39) 11.12 11.77 12.89 17.32 13.67 11.40 9.15 6.93 12,52 14.34 12.95 13.54 12.07 Electricity & gas (4) 4.98 4.51 4.12 5.09 5.48 7.60 6.61 11.28 10.91 9.00 6.50 6.31 8.36 Construction (5) 11.34 10.86 10.72 12.87 15.49 18.41 17.14 13.36 12.24 11.70 10.49 9.74 7,79 W & R trade, hotels (6) 8.53 10.11 11.20 12.42 13.05 11.30 11.85 11.95 11.48 11.19 8.57 9.19 8.29 Transport & storage (7) 7.38 9.77 6.93 7.28 6.58 8.94 8.60 9.39 8.33 9.94 8.27 4.73 5.53 Real est & bus serv (8) 9.42 9.35 9.24 6.98 6.57 7.81 8.32 8.57 7.67 11.58 8.66 9.36 5.58 Rec, cul 6 other serv (9) 131.20 132.20 90.50 12.91 21.10 15.03 19.30 16.30 16.65 7.62 8.17 10.95 10.36 Source: Financial Statement Analysis. 80Kp various issues. Table 10.17: PROFIT RATIO OF EACH INDUSTRY 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 Fishing (1) NA 0.68 -2.66 -3.61 0.28 -0.65 0.53 -1.61 -6.28 -1.49 -8.73 -0.26 -0.55 Mining (2) -0.29 6,58 12.80 8.90 7.10 8.20 1.10 -3.90 -0.60 0.80 1.63 1.00 0.82 Manufacturing (3) 3.80 7.90 5.70 3.90 4.60 4.50 5.00 3.40 -0.20 0.02 1.03 3.29 3.41 Food & beverages (31) 4.06 6.36 4.10 4.09 5.10 8.23 10.46 6.10 2.96 10.67 2.86 4.39 2.20 Textile & apparels (32) 3.47 10.61 2.10 0.92 3.20 1.40 2.93 1.15 -0.71 0.53 -0.05 1.29 1.65 Wood & furniture (33) 7.58 12.16 -7.00 -0.48 1.32 4.52 9.01 0.95 -13.10 -9.24 -6.08 -1.23 -4.70 Paper & printing (34) 5.15 10.51 7,55 3.68 5.05 6.11 6.12 5.47 -0.17 -3,72 0.08 3.55 3.96 Chem, petre & coal (35) 5.59 8.17 7.03 7.70 7.90 5.21 8.42 6.84 3.29 0.81 2.57 5.08 5.59 Nonmetallic min prod. (36) 0.40 3.63 3.59 5.79 4.46 6.75 4.84 4.71 2.06 -0.56 1.01 5.03 6.35 Basic metal (37) 1.41 5.65 14.35 3.20 3.15 3.42 3.75 2.66 -1.09 -0.05 0.73 3.19 4.66 Fab met prod & equip (38) 2.04 6.17 6.86 6.84 4.41 5.58 2.82 1.86 -2.94 -0.30 0.68 2.74 2.43 Other manufacturing (39) 5.48 6.69 8.29 10.48 6.70 4.95 2.74 -0.47 3.27 7.47 7.39 9.09 6.21 Electricity & gas (4) 1.54 1.09 0.80 2.00 2.80 5.60 4.10 8.40 6.40 4.40 3.10 3.20 4.74 9 Construction (5) 4.59 5.54 5.20 7.90 10.50 14.90 13.50 8.90 5.40 3.00 2.70 2.90 1.40 W & R trade & hotel (6) 2.58 6.54 7.00 8.10 7.50 5.40 5.90 3.80 2.40 2.10 1.50 2.70 1.70 Transport & storage (7) 2.17 5.84 3.00 2.00 1.80 3.90 3.40 3.20 0.60 0.80 1.10 -1.20 -0.24 Real est & bus serv (8) 3.61 4.43 7.20 5.00 3.30 6.00 7.00 6.90 5.30 9.00 6.30 7.30 3.73 Ree, cul & other serv (9) 4.43 8.89 10.30 11.10 18.10 12.20 16.10 10.40 10.60 3.80 6.00 8.20 7.39 Source: Financial Statement Analysis, BOK, various issues. Table 10.18: NET SALES GROWTH RATE OF EACH INDUSTRY 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1962 1983 1984 Fishing (1) NA 63.05 -11.38 14.69 40.01 9.65 3.33 -11.24 -16.36 8.27 -9.864 14.56 9.32 Mining & quarrying (2) -2.99 19.34 15.13 3.72 9.66 19.50 2.95 10.09 -6.90 17.75 4.57 5.95 8.48 Manufacturing (3) 17.14 48.98 10.62 11.47 23.57 20.69 22.31 9.84 -1.22 11.58 6.95 17.52 16.73 Food & beverages (31) 11.83 32.06 3.86 16.44 3.87 18.54 18.46 13.97 -2.39 5.97 1.51 21.55 10.39 Textile & apparels (32) 34.29 57.94 -10.31 19.81 32.82 18.60 19.72 -0.33 4.72 14.67 4.46 6.54 18.74 Wood & furniture (33) 15.75 45.64 -29.49 -1.56 28.56 18.11 18.21 7.50 -17.18 -4.23 4.68 23.19 2.14 Paper & printing (34) 8.41 33.96 -1.13 -7.29 20.78 18.66 8.42 13.64 2.47 12.87 14.52 26.75 16.09 Chem, petr. & coal (35) 11.06 39.58 41.51 19.75 14.65 14.07 14.20 17.58 13.34 8.72 3.90 11.31 9.19 Nonmetallic win prod. (36) 7.43 30.27 14.39 31.41 15.93 22.80 10.07 15.72 -4.44 1.41 11.17 23.82 12.20 Basic metal (37) 30.95 105.35 30.20 -16.32 35.46 20.27 28.99 14.00 -4.10 12.68 9.47 19.76 12.05 Fab met prod & equip (38) 10.24 69.94 16.15 7.98 37.76 35.17 40.53 6.71 -18.01 18.56 13.05 30.38 29.28 Other manufacturing (39) 9.96 37.06 -2.60 11.37 18.09 33,45 18.41 8.12 -20.55 7.25 10.87 11.31 32.51 - Blec, gas & water (4) 13.35 14.48 16.32 51.47 18.76 19.78 10.66 37.86 19.74 14.08 10.57 8.74 8.70 a Construction (5) -9.99 15.59 -5.56 15.58 51.92 96.08 72.58 25.41 3.97 22.92 17.71 7.34 -0.39 V & R trd & rest & htle (6) 52.53 38.65 -6.48 24,83 54.42 40.78 39.87 18.00 9.94 13.25 10.67 18.12 18.27 Trans, storage & commun (7) 16.53 48.87 3.87 13.76 11.45 30.78 25.18 16.91 2.53 7.42 6.57 6.75 6.10 Fin, ins, I est & bus arv (8) -6.65 54.31 21.25 7.75 50.32 65.27 5.91 44.09 -13.89 20.92 19.43 27.40 20.81 Social & personal serve (9) -18.47 15.96 17.59 18.11 26.78 34.27 24.46 7.90 -10.94 -1.25 15.43 7.44 22.96 Sources Financial Statement Analysis, 80K, various issues. Table 10.19: KOREA 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1963 1964 Average cost of borrowing 13.39 14.66 13.40 12.00 8.60 10.50 11.30 11.90 13.10 12.40 14.40 18.70 16.37 15.97 13.63 14.42 9DI growth rate 6.88 9.36 8.56 13.79 6.93 42.11 26.50 12.16 9.04 11.60 18.81 38.89 20.00 5.00 0.24 0.71 GP deflator 14.80 13.92 16.11 13.40 29.54 25.73 20.73 15.67 21.89 21.16 25.63 15.90 7.08 2.90 3.90 Average cost of borrowing - WDI growth rate 6.51 5.30 4.84 -1.79 1.67 -31.61 -15.20 -0.26 4.06 0.80 *4.41 -20.19 -1.63 10.97 13.39 13.71 emoal profit ratio 3.69 2.49 1.00 3.80 7.90 5.70 3.90 4.60 4.50 5.00 3.40 -0.20 0.02 1.03 3.29 3.41 Met earnings ratio 4.50 16.70 30.30 22.70 16.50 21.60 21.30 22.90 15.60 -1.30 0.10 5.30 15.50 15.20 Debt ratio 270AA 328.40 394.20 313.40 272.70 316.00 339.50 364.60 367.20 366.80 377.10 487.90 451.50 385.80 360.30 342.70 Sourcet PSA, SO, various Issues. Table 10.20* JAPAN 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 Average cost of borrowing 8.50 8.60 8.60 8.10 8.40 10.30 9.60 9.40 8.50 7.30 7.70 9.60 9.40 8.40 0.00 qA MDI growth rate 2.20 3.60 -0.80 0.60 15.70 31.60 3.00 5.00 1.90 -2.60 7.30 17.80 1.40 1.80 -2.20 NA Average cost of borrowing - WDI growth rate 6.30 5.00 9.40 7.30 -7,30 -21.30 6.60 4.40 6.60 9.90 0.40 -8.20 8.00 6.60 10.20 NA Normal profit ratio 6.90 5.90 3.90 4,70 7.10 4.70 1.40 3.20 3.40 4.00 5.80 5.30 4.30 3.90 4.10 NA Net earnings ratio 29.20 19.90 24.30 38.30 26.20 8.30 18.90 19.50 22.60 30.10 26.40 20.80 17.60 11.40 Debt ratio NA 403.00 421.00 424.00 449.00 459.00 488.00 488.00 475.00 446.00 418.00 385.00 378.00 342.00 324.00 NA Sources SA, VOK, various issues. Table 10.21: BANK'S COEDIT ALLOCATION BY INDUSTRY (2) 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 Fishing (1) 9.43 6,71 7.14 10.05 10.04 6.71 5.63 5.45 7.77 5.04 11.29 11.91 0.7 NinIng & quarrying (2) -1.91 1.01 1.10 2.14 -0.06 1.14 1.56 0.34 -0.36 1.43 0.04 -0.42 0.6 Nanufacturing (3) 68.22 65.26 52.94 60.50 59.41 49.96 59.58 59.94 58.75 37.01 36.10 35.83 45.9 (19.20) (20.60) (21.60) (23.40) (24.10) (26.60) (27.60) (28,80) (29.10) (28.60) (28.90) (30.90) lee, gas 6 water (4) 2.10 3.31 9.71 3.87 5.06 5.64 4.37 3.35 4.27 1.60 2.55 2.67 4.4 (1.20) (1.20) (1.40) (1.40) (1.50) (1.60) (1.70) (2.00) (2.00) (2.10) (2.20) (2.20) Construction (5) 6.68 10.51 2.50 6.92 6.75 10.27 15.06 12.01 2.14 13.47 23.40 27.60 24.1 (6.80) (6.50) (6.90) (6.70) (7.50) (8.40) (8.10) (8.40) (7.50) (8.50) (9.50) (8.80) V & R trd 6 rest 6 htle (6) 3.98 4,79 7.02 8.56 7.21 12.86 4.22 6.20 8.35 17.01 8.75 9.66 10.4 Trans, storage & commun (7) 4.76 3.23 14.08 6.41 8.90 6.72 7.25 8.03 9.19 11.44 8,12 4.A7 11.2 (5.40) (5.30) (5.50) (5.40) (6.00) (6.50) (7.10) (7.70) (7.80) (7.80) (7.70) (7.50) Fin, ins, R est & bus arv (8) 3.55 1.94 3.42 0.89 0.77 2.77 1.45 1.75 3.64 0.72 6,65 3.m0 1.6 Social & personal serva (9) 3.18 3.24 2.08 0.65 1.93 3.93 0.88 2.93 6.25 12.29 3.11 4.89 1.1 Note: The figures are the share of net credit increase of DfBs and KDR.. 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