South Korea's Economic Reforms and U.S. Interests

CRS Report for Congress
Received through the CRS Web
South Korea's Economic Reforms
And U.S. Interests
Raymond J. Ahearn
Specialist in Trade Relations
Foreign Affairs and National Defense Division
From the perspective of U.S. exporters and investors, gaining fair and effective
access to South Korea's market is part of a broader problem of doing business in an
economy that limits the role of market forces. Extensive government intervention and
regulation of economic activity, non-transparent and often discriminatory bureaucratic
actions, and a strong drive for autonomy all make South Korea one of the most difficult
markets in the world to do business in. To the extent that the South Korean government
implements economic reforms that expose more segments of its economy to market
forces, the sources of U.S.-South Korean trade tensions are likely to dissipate.
Over time, South Korea appears likely to implement fundamental economic reforms
in order to bolster its international competitiveness. But the recent, dramatic drop in
President Kim Young Sam's popularity, combined with the politics of a presidential
election in December 1997, have all but eliminated the possibility of new reform
initiatives this year.
A loss of momentum for reform, in turn, has varied implications for U.S.-Korean
economic relations. Some past reforms that have facilitated increases in U.S. exports
(primarily of capital goods, and raw materials) and investment should not be affected.
Coupled with falling South Korean competitiveness, the recent U.S. trade surplus with
South Korea should persist. But little or no progress in liberalizing other sectors of
Korea's economy that are of considerable interest to U.S. business (particularly consumer
goods and finished manufactures that compete directly against Korean-made products)
can be anticipated, and backsliding in other areas is also possible. As a result, 1997 may
witness an increase in U.S.- South Korean trade tensions.

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In South Korea today, there are growing concerns among elites, as well as the public,
that the country's economy is off-track. A slower economic growth rate (the economy
grew at 6.7% in 1996 compared to the 8-9% growth rates in the previous few years), a
large ($22 billion) and growing current account deficit, a depressed stock market, and
continuing out-sourcing of production to other Asian countries by the country's large
conglomerates or chaebol are behind the fears that the country's competitiveness may be
The slowdown in the economic growth rate is due to a combination of cyclical
(temporary) and structural (deeply rooted) factors. A weakening of the Japanese yen and
falling prices for some of Korea's major exports are the major cyclical factors. The weaker
yen has made it more difficult for Korean exporters of cars and ships to compete against
Japanese producers, and declining global demand for semiconductors, which account for

20% of Korean exports, has contributed to the widening of the trade deficit.1

A number of structural weaknesses are increasingly recognized by Koreans as the
source of the country's declining competitiveness. Rigid labor markets, an inefficient
financial system, an overburdened infrastructure system, and a difficult environment for
foreign direct investment have all contributed to the country's rising production costs and
declining competitiveness.2
To curb rising business costs and attract the technology and foreign capital that are
necessary to meet rising competitive pressures, many Korean economists and technocrats
have long urged the government to initiate fundamental and comprehensive economic
reforms. They have called upon the government to radically reduce its role in the
economy, to curb monopolistic practices of the chaebol, to reform an out-dated labor-
management system, and to open the economy further to foreign goods and services.3
President Kim's Reform Record
Korean reformers pinned considerable hopes on President Kim Young Sam when he
assumed office in 1993. A leading opposition figure for over three decades and a critic of
heavy government regulation of the economy, President Kim proposed a blueprint for a
"New Korean Economy" based squarely on the principles of private sector autonomy, fair
competition, and open markets. Despite the considerable powers of the Korean presidency
and high initial popularity ratings, President Kim to date has enacted only a few significant,
yet partial, reforms relating to tax avoidance (real name reform) and membership in the
Organization for Economic Cooperation and Development (OECD).

1Burton, John. Slowdown in Seoul. Financial Times, January 9, 1997, p. 11.
2Burton, John. Structural Inefficiencies Persist. Financial Times Survey: South Korea,
November 15, 1996, p. I-VI.
3For a full discussion, see Ahearn, Raymond J. South Korea: Prospects for Greater Market
Openness. Congressional Research Service, Report 96-299 F, March 26, 1996, 32 p.

More importantly, two recent events -- the bankruptcy of Hanbo Iron and Steel and
a weak revision of Korea's labor law -- have contributed to President Kim's popularity
dropping to around 15% and have undermined his credibility as a force for economic
reform. In addition, the December 1997 presidential election is largely viewed as a major
reason why President Kim is unlikely to adopt reformist positions on economic issues
during the remainder of 1997. As the opposition parties (headed by perennial presidential
candidates Kim Dae Jung and Kim Jong Pil), have adopted relatively populist and
nationalistic positions on most economic issues, President Kim has become more cautious.
Real Name Reform
In part to loosen the traditional close and collusive ties between government and
business, the Kim Administration in August 1993 implemented a real-name system for
financial transactions. In the past, it had been possible to open accounts and conduct
business under false names, directly and indirectly fostering institutionalized corruption,
tax avoidance, and other illegal financial dealings. The reform was intended to reduce
collusive aspects of government-business relations and allow funds once channeled into
bribes to become available for more productive uses.
The real-name reform did reveal major political scandals in 1995 with the arrest, trial,
and sentencing of two former Presidents on corruption charges. The Kim Administration,
however, did not use the public outrage as a lever for reducing the tight economic
regulations that give rise to illicit payments in the first place. Concerns that such reforms
could harm some of Korea's largest chaebol, thereby undercutting the growth of the
Korean economy, seemingly deterred the administration from heading in this direction.4
Real-name reform has been no more successful in freeing up capital for more
productive uses. Before the law was passed, many small and medium size companies
borrowed from wealthy individuals who held their money in "false name" accounts to
avoid taxes. This was necessary because the banks, consistent with government guidance,
mostly lent to the chaebol. But when real name reform was implemented, this important
source of funding dried up as many people shifted their money from "false name" accounts
to tax-free bonds.
OECD Membership
In late 1996, the South Korean national parliament approved Seoul's membership in
the Organization for Economic Cooperation and Development (OECD), a grouping of
advanced industrialized countries designed to coordinate economic policies and promote
economic growth. Despite domestic political opposition, President Kim supported making
Korea the 29th member of the OECD (and the second Asian member) largely on the
grounds that admission to this club would confer on Korea advanced-country status and

4Kristoff, Nicholas D. Korean Tycoons Dodge A Bullet. New York Times, December 8,
1995, p. A7; and Hoon, Shim Jae. What, We Worry: South Korea's Chaebol Remain Unscathed
by Scandal. Far Eastern Economic Review, November 23, 1995, p. 79.

Overtime, membership in the OECD is expected to force Korea to open its financial
markets and reduce their regulation of its economy. With regard to the banking system
which now is heavily controlled and protected by government regulations, Korea will have
to lift certain kinds of restrictions on capital flows, allow market forces to determine
interest rates, and provide foreigners substantially more freedom to make portfolio and
direct investments. However, according to the terms Korea negotiated for its accession,
these reforms could take a number of years to implement.
Korea accepted only 65% of the various OECD financial liberalization obligations,
as compared to the organization's average of 89%. Seoul promised to proceed with full
liberalization once the gap between Korean and international interest rates falls by 2%
from its current 6-7 percentage points, and inflation falls to 3% from its present 4.5%
level. Some analysts believe that these economic preconditions are unlikely to be met until
well after 2000.5
Hanbo Bankruptcy
Hanbo, Korea's 14th largest chaebol, filed for bankruptcy in January, 1997, amid
allegations that Kim Administration officials exerted pressure on banks to provide loans
to Hanbo in return for illegal political contributions. Besides the political corruption issue,
the scandal exposed continuing government efforts to support ambitious, but risky,
industrial projects that result in production overcapacity and heavily indebted companies.
Hanbo's attempt to build the world's fifth largest steel mill precipitated the crisis.
Management greatly underestimated the cost of the mill from the beginning, and ended up
amassing a debt that totalled 22 times its shareholder equity. So large was the debt, that
even under best case projections of operating profits, few analysts thought that it could be
retired. Why banks continued to lend Hanbo enormous sums of money for this project
without a feasibility study or without demanding adequate collateral is a matter under
investigation. 6
The bankruptcy filing on March 18, 1997 by Sammi Steel, one of Korea's 30 largest
chaebol, has heightened concerns that other industrial conglomerates could be near
collapse. Unlike a number of past chaebol financial crises, however, the government has
not rushed-in to bail-out creditors. As a result, chaebol management may become more
cautious and hesitant to expand into non-core business areas in the future.
Labor Law Reform
President Kim did try to reform Korea's rigid labor laws in late December 1996, but
rising public opposition, including several weeks of strikes and public protests, caused him
to reverse course and support a watered-down version. This compromise legislation,
which was supported by the opposition parties, was approved by the National Assembly
in early March, 1997.

5Burton, John. S. Korea Braces for Restructuring. Financial Times, October 14, 1996, p. 4.
6Clifford, Mark L. Meltdown in Seoul. Business Week, February 10, 1997, p. 50-51.

President Kim's initial bill, which was passed by his ruling New Korea Party in a
predawn, secret session on December 26, 1996, without the presence of opposition
parties, gave employers greater rights to lay-off or terminate workers. At the same time,
the bill failed to provide workers with greater freedom to organize, a commitment that the
government had made to the OECD. The compromise version, by postponing
management's right to lay off workers by two years and by maintaining government's
capacity to severely restrict union activity, made neither side -- big business or organized
labor -- happy. President Kim's retreat prompted one Korean government official to
comment that he "appears to have lost courage in pushing economic reforms."7
Implications for U.s. Economic Interests
While fundamental economic reforms are likely to be implemented over time to
bolster South Korea's declining international competitiveness, the recent, dramatic drop
in President Kim's popularity and the impending presidential election make further reforms
problematic this year. This development, in turn, has varied implications for U.S.-South
Korean economic relations in the near-term. Some reforms that have facilitated significant
increases in U.S. exports and investment should not be affected. However, little or no
progress is likely in liberalizing some sectors of Korea's economy that are of considerable
interest to U.S. business, and backsliding in other areas is also possible. As a result, 1997,
on balance, may witness an increase in U.S.-South Korean trade tensions.8
Due to tariff and non-tariff barrier reforms implemented over the past 15 years, the
Korean market has become more accessible to U.S. and other foreign exporters and
investors. Many of the reforms have eliminated, reduced, or redressed some of Korea's
most formidable barriers that had been erected at the border to keep the Korean market
for Korean producers. In the process, U.S. exports to South Korea have recorded steady
increases commensurate with the rapid rise of the Korean economy over the past ten years.
In 1996, U.S. exports totalled $26.5 billion, making Korea the fifth largest market for U.S.
exports. The United States now exports more to Korea than it does to France and Italy
combined and runs a trade surplus (in 1996) in excess of $3 billion.
The bulk of U.S. exports consist of capital goods and raw materials that are used by
Korean chaebol to modernize factories and build products such as cars, ships, and
electronic goods for exports. In addition, Korea is the third largest export market for U.S.
agricultural products, mostly bulk commodities such as feed grains, cotton, and wheat.
As long as the Korean economy continues to grow at a healthy pace, the Korean market
should continue to absorb growing volumes of these kinds of U.S. products.
The story on the investment side, however, is somewhat different. The total stock of
U.S. foreign direct investment is less than $5 billion, a relatively low level compared to
U.S. investment position in other Asian countries. While U.S. foreign direct investment
flows to Korea increased substantially in 1995 and 1996, due in part to a liberalizing

7Burton, John. S. Korean Leader Gives Way On Job Reform. Financial Times, March 1,

1997, p. 6.

8A number of U.S. political and security concerns, however, could militate against strong
U.S. market opening pressures. See Sutter, Robert G. Korea: U.S.-South Korean Issues.
Congressional Research Service, Issue Brief 96005 [continuously updated].

foreign investment regime, major sustained increases are unlikely to occur in the absence
of basic reforms that address Korea's "high cost" environment. The same considerations
that are deterring foreign companies to invest in Korea - - high costs for land, labor, and
capital -- are also the same factors driving Korean chaebol to invest abroad.
The areas where little or no progress can be expected this year in opening Korea's
market to U.S. exports are ones where U.S. products compete directly with Korean
products or services and where market reforms have lagged other sectors or industries. On
the product side, one would not expect, for example, additional reforms to be forthcoming
that would accelerate U.S. sales of pharmaceuticals, automobiles, or telecommunications.
These are all sectors that still provide Korean producers with considerable protection from
foreign competition. And on the services side, one would not expect any accelerated
movement on financial sector reform this year, an area where Korean banks, insurance
companies, and securities firms are relatively inefficient and protected.
More ominous is Korea's current attempt to address its current account deficit by
promoting a frugality campaign. Korean businesses and citizen's groups are currently
sponsoring boycotts of foreign products in response to President Kim's call last year to end
"luxurious consumption," and there are signs that the government may be indirectly
hampering imports of consumer durables. This development has the potential for reversing
gains the Korean government recently has made in shedding its image as a "one-way" free
trader. 9
Beyond 1997 and the December presidential election, a major unknown is whether
the next Korean President will embrace reformist economic policies and push hard to
dismantle the various instruments of state control over the economy. Procrastination is
likely only to hurt the Korean economy and U.S.-South Korean economic ties.

9Lee, Charles S. Buy Korean: Imports Get the Blame, Again. Far Eastern Economic Review,
March 6, 1997, p. 58.