Report No. 61 ‘THE ROLE OF GOVERNMENT IN EXPORT EXPANSION IN THE REPUBLIC OF KOREA: A REVISIT Yun-Hwan Kim* February 1994 * The author is Economist, Economics and Development Resource Center, Asien Development Bank. The author would like to express his sincere appreciation to Dr. Bong-Suh Lee, Vice President, Asian Development Bark—who had been extensively involved in economic policymaking in the Republic of Koreafor his valuable comments. The author is grateful to Dr. S. C. Jha and Dx. M. G. Quibria for encouraging him to do the study. The author acknowledges the comments and suggestions received from Messrs. JM. Dowling, Jr. W.-C. Ho, JS. Lee, and EM. Pemia, He thanks Dr. Keun-Ying Lee, Bank of Korea, for his provision of data for this study. He is also grateful to Ms, Z. M. Acacio for typing many drafts of the paper. However, the author is entirely responsible for the contents and remaining shortcomingsForeword ‘The EDRC Report Series consists of research and conference papers prepared by or under the auspices of the Economics and Development Resource Center. Some of the papers are by-products of research whose main results are published in the Economics Staff Papers series. The EDRC Report Series is circulated mainly to Bank staff and is distributed outside the Bank only upon request S.C. Jha Director and Chief Economist Economics and Development Resource CenterAbstract It is widely agreed that Korea’s rapid economic development since the early 1960s resulted from the rapid expansion in exports and that the Korean government has been heavily involved in this process. There is, however, disagreement over the role of the government in the economic development, particularly in relation to the market forces. Some studies regard the Korean growth model as a neoclassical model that stands upon a free-market and free-trade system, but others not. During the period 1962 to the early 1980s, though export-promotion was strongly undertaken, most commodity prices—interest rates, exchange rates, and wage rates—were not able to change freely in response to market conditions of supply and demand but were controlled by the government. Market disequilibria with rigid prices prevailed in the economy. In this regard, it might be safe to say that Korea's export-led growth (ELG) strategy did not necessarily involve a free market system with equilibrium prices. The study finds that for most of the time before the mid-1980s, the Korean won had always been overvalued in light of relative inflation between Korea and its major trading partners. The disadvantageous effect on exporis of the persistently overvalued exchange rate was partly or completely offset by two kinds of government support for exporters: (i) an ad hoc export promotion system; and (ii) psychological encouragement by President Park. ‘The paper contends that the government support provided an "assured" economic climate that is similar to the "social climate" of Schumpeter in which creative, innovative entrepreneurs receive high social prestige in addition to a high rate of income. The climate, prima facie, must have stimulated dynamism and aspiration among Korean entrepreneurs in their economic activities, including investment, production and exports, creating X-efficiency.WV. Table of Contents Introduction .........6..000- 5 1 Background and Preconditions for the Korea’s Export-Led Growth Model ....... 2.645 waaeven Evolution of the Korean Economy and Role of Exports in Economic Growth «0.0... ...6.4 A. 1950s: The Period of Rehabilitation . B. 1960s: The Period of Outward-Orientation . C. 1970s: The Period of Diversification ...... D. 1980s: The Period of Structural Adjustment Role of Government in Export Promotion—Creation of X-Efficiency with Economic Disequilibrium sees 2 A. Disequilibria in Foreign Exchange and Financial Markets... seocigenaacoeine SB B. Role of the Government in Export Promotion v7 CRRA «ore cow ceases opine ontcamnamoaee 2 Appendixes ........ 0.05 we 4Appendix 1: Appendix Appendix 3: Appendix 4: List of Appendixes Statistical Tables for the Korean Economy Key Economic Indicators of Japan in the 1950s and Early 1960s World Bank's Classification of Forty-one Developing Countries by Trade Orientation Purchasing Power Parity Exchange Rate of the Korean WonI. Introduction Interest in the role of the government in the Republic of Korea’s export-led growth (ELG) is not new.' It is widely agreed that Korea’s rapid economic development since the early 1960s resulted from the rapid expansion in exports and that the Korean government has been heavily involved in this process. ‘There is, however, disagreement over the role of the government in the economic development, particularly in relation to the market forces. Some studies—for example, the World Development Report 1987—that are based on the neoclassical perspective, regard the Korean growth model as an outward-oriented growth model that stands upon a free-market and free-trade system. ‘To the contrary, other studies—for example, Alam* and Kirkpatrick? consider that the Korean model is close to the structuralist approach and differs little only with an import-substitution growth strategy, characterized by an overvalued currency, import licensing, high tariffs, and varying levels of investment planning. The World Development Report 1991 and The Eas! Asian Miracle (published by the World Bank in September 1993) would fall in the ground between the two arguments. It is contended that rapid economic growth in Korea is associated with effective but carefully undertaken government activism. The World Bank termed this approach a "market-friendly” strategy, in which governments do less in those areas where markets work, but they do more in those areas where markets cannot be relied upon.* ‘The main purpose of this study is to revisit the issue concerning the characteristic features of the Korean growth model. This study will try to discuss three issues: (i) the main thrust of the Korean ELG strategy; (ii) the role of exports in Korea’s economic growth; and Gi) the role of the Korean government in the expansion of exports. As is well known, Korea has achieved rapid, significant economic development over the past three decades, Since 1960, the Korean economy has grown by about 8 per cent annually, showing per capita income of about US$7,000 in 1992, compared with $87 in 1962. Per capita exports increased from $2 in 1962 to $1,732 in 1992. Korea started its long-run economic development plans in the early 1960s, under extremely unfavorable economic conditions. Korea lacked development resources, except for a large population in its small space of land. Korea held neither sufficient capital stock nor modern production technology, and was poorly endowed with natural resources. The Korean War that had broken in the early 1950s, when Korea was making efforts to rehabilitate itself as a newly independent nation, caused the destruction of virtually all physical infrastructure and the manufacturing base. "In this paper “Korea” rofors to the Republic of Korea 7 M. Shahid Alam, Governments and Markets in Economic Development Strategies: Lessons from Korea, Tava, and Japan, Praeger, New York (1989), chapter 1 3 Colin Kirkpatrick, "Trade Policy and Industrializaion in LDCs" in Surveys in Deelopment Economics, ed. by Norman Gemmell, Basil Blackwell (1987), pp. 55-89 * World Bank, The Exst Asian Miracle - Economic Growth ant Public Policy, A World Bank Policy Report, Oxford University Press, New York (993). 5 See Appendix Table 41.What is the special character of Korea's growth model? What factors have caused such significant growth and industrialization during a short period? A number of studies have addressed the question and have posed a variety of hypotheses. These hypotheses include, among others, the adoption of a consistent and stable economic policy® or an outward- oriented growth strategy, the leadership of the Korean government, and inordinarily dose cooperation between government and entrepreneurs.” Despite variations in emphasis among analytical scopes and different hypotheses, a widely held conclusion is that exports led economic development in Korea. It is a fact that since the early 1960s Korea has made enormous efforts—with a significant level of success —to expand its scale and depth of exports. In this regard, some researchers who advocate neoclassical development theory define that Korea has adopted an outward-oriented growth strategy that involves free trade, liberal prices and equilibrium markets. As regards the role of government in particular, it has been pointed out that the Korean government has been actively involved in industrialization of the economy and promotion of exports. Some development economists" have argued that export success in Korea was not due to the adoption of a free trade regime, but that considerable state intervention was involved in administering the policy tools used to promote the manufacturing sector and exports. PTs different view merits huther study on this issue, as the Korean experience can provide lessons for current developing countries secking to develop their economies via promotion of the export sector. This study will thus try to assess the role the Korean government played in the ELG process, particularly in the 1960s and 1970s, when President Park Chung-Hee showed unusual personal enthusiasm for economic growth through the promotion of exports. The study includes discussion of the implication of the Korean ELG approach in view of the neoclassical perspective, especially on liberal prices. The study will rely upon descriptive methods, using analytical insights and evaluational judgement based on the author's experience in and understanding of Korea's political and economic history. As the topic "Role of Government’ is s0 broad, the study is obliged to confine itself to addressing whether or not Korea's economic regime was truly neoclassical. Section Il of the study discusses the background and preconditions for the Korea's ELG model. Section III presents an overview of the evolution of the Korean economy, with © Susan M, Collins, “Lessons from Korean Economic Growth,” American Econontc Review, vol.80, 0, 2(May 1990), pp. 101-7; and World Bank,"Korea's Experience with the Development of Trade and Industry,” EDI Policy Seminar Report, No. 14, Washington, D.C, (1991). 7 Te name a fow, Bola Balassa, "Export Incentives and Export Performance in Developing Countries: A Comparative Analysis,” Welteirtschuftliches Archiv, Band 114(1978); A. O. Kruoger, "Import Substitution versus Export Promotion," Finance and Development and, vol, 22, No.2 Guno 1985); and World Bank, World Development Report 1987, Chapter 5, Washington, D.C. (1987) * For example, Yung Chul Perk, “Development Lessons from Asia: The Role of Government in South Korea ane Taiwan,” American Economic Reveww, vol. 80, No. 2 (May 1990), pp. 118-21. * World Bank, “Korea's Experience with the Development of Trade and Industry,” EDI Policy Seminar Report, nod, Washington, D.C. (1991) *® For example, Colla Kirkpatrick, op.clt; A. K. Sen, “Development: Which Way Now? Eeouomic four, vol. 93 (1983), pp 745-62; and World Bank, The East Aslan Miracle, op. citfocusing on the expansion of exports and the role of exports in economic growth. Section IV investigates whether Korea’s ELG model truly employed a free market system, as the neoclassical development theory contends. Section V presents conclusions. TI. Background and Preconditions for the Korea’s Export-Led Growth Model Korea’s growth model is comparable to other countries’ in earlier and contemporary times. The Korean model is different from the 18th and 19th century model of England in that England could easily utilize raw materials from overseas to manufacture industrial products which could then be sold to overseas markets. Before starting industrialization in the 18th and 19th centuries, France, Japan and England had already accumulated substantial capital surpluses in the agricultural sector, which were easily translated into investment funds for the construction of the manufacturing capacity and social overhead capital; in Korea, the agricultural sector had never been a capital-supplier. Australia, Canada and the United States were able to utilize their rich natural resources in their economic development; Korea is not well endowed with resources. The Korean model is also different from that of the Middle East countries, which are rich in oil money available to finance development projects. In the 1950s, Korea favored import substitution over export promation. As a country with extreme poverty, Korea had placed the first policy priority on the provision of the basic necessities, i.e., food, clothes and housing. Under this policy, the Korean government pursued increases in domestic production of such items as flour, rice, sugar, cement and textiles. U.S. assistance, which was mostly composed of consumer goods, was helpful for obtaining those basic necessities. To protect local producers, the government imposed various restrictions on importers, including prior approval to import, prohibitive tariffs, quotas, and a multiple exchange system under which the exchange rate applied to the imports was unfavorable compared with the rate applied to exports. Through the 1950s, export activities were encouraged in Korea to earn foreign exchange, which was extremely scarce, and some export promotion measures—preferential treatment for export financing, an export-import link system, and the privilege of exporters to use foreign currencies—were implemented. However, overall policy structure in the 1950s favored import substitution. In 1961, a military government was established in Korea. This government was firmly committed to economic development in order to increase employment and per capita income and the social welfare of the Korean people. The government laid the highest policy priority on rapid and sustained economic growth and in 1962 initiated the First Five-Year Economic Development Plan.” Apart from the fact that for the first time Korea had started systematic, long-term development planning, the most important aspect of the First Five- Year Plan was that Korea had changed its growth strategy from the import substitution 1 Since 1962, Korea has had seven Five-Year Beonomic Development Plans. The First covers the period of 1962- 1966; the Second 1967-1971; the Third 1972-1976; the Fourth 1977-1981; the Fifth 1982-1986; the Sixth 1987-1991; and the Seventh 19921996.Pursued in the 1950s to export promotion. Despite some variations in its emphasis and tone, an ELG strategy has been preserved until now. In the 1950s and 1960s, import-substitution growth (ISG) strategy was popular among governments in developing countries, including Latin American countries, South Asian countries, and Southeast Asian countries such as Indonesia and the Philippines. Behind the selection of ISG strategy there were both economic reasons as well as ideological resistance to previous colonial rulers that had adopted open trade systems. It is noteworthy that in conirast with other developing countries under the circumstances, Korea selected an ELG strategy. Several factors and preconditions might explain this. * Incontrast with most of the aforementioned developing countries, Korea was poor in natural resources, which inevitably made the Korean economy depend heavily upon foreign resources, In Korea, basic raw materials such as iron, coal, raw cottons, raw wool, and lumber exist only in small quantities, and petroleum is non-existent, * As the size of domestic market was small, the ISG strategy was not considered a proper strategy. * Deficiency in financial resources was intended to be bridged by foreign borrowings, while domestic savings were mobilized to the maximum extent. Mobilized financial resources were allocated to the growth-leading sectors such as infrastructure and manufacturing sectors, so that the scarcity of capital might have been alleviated. In this process, the government played a key role in determining the criteria by which financial institutions allocate financial resources. * In order to reduce the foreign debt burden attributable to imports of raw materials and investment goods, policy emphasis was placed on foreign exchange earning by promoting exports. In view of the abundance of labor force, production essentially had to be labor-intensive. Labor-intensive light industries such as textiles and gar- ments, plywood, wigs, and footwear were first selected as major export industries. * The government provided strong export promotion schemes to prevent pro-import substitution bias, which resulted in an anti-export with pro-domestic sale bias by domestic producers. The export promotion schemes included preferential treatment in importing necessary materials, imposing taxes, and allocating financial resources and foreign exchange. In selecting the ELG strategy, the economic performance of Japan, a neighbor country that had achieved significant success with exported economic growth in the 1950s and early 1960s, had provided lessons to Korean policymakers.” In addition to the economic reasons described above, a serious political condition also compelled Korea to choose an outward-oriented development strategy—facing constant military threat from the communist " See Appendix 2 for the Japanese economic performance in the 1950s and early 1960s,North Korea, Korea wanted to attract foreign investors and traders into the Korean peninsula and establish a close link with foreign countries, expecting their contribution to the protection of Korea. It should be noted that the new ELG strategy was fairly successfully translated into actual economic achievement, partly because a socioeconomic environment helpful to economic development, as discussed below, had been prepared. One element of this helpful economic environment was land reform. Possession of farm holdings beyond a certain size limit was prohibited under land reform undertaken in 1949. The reform contributed not only to a reduction of an unequal distribution of wealth and income, but also to an increase in political stability and stimulation of competition in agricultural sector encouraged by the ownership of farmland. This competitive climate spread to the other sectors. In 1947, before the reform, the proportion of full owners in total farm households was only 165 per cent, while the rest of farm houscholds were mostly tenant farmers. However, after the reform, for instance in 1964, the proportion of full owners rose to 71.6 per cent, which indicates that, if desired, any farmer was virtually able to purchase farmland. This change in land possession had an enormous impact on the overall economy at that time, when the agricultural sector was dominating the Korean economy. The most significant impact was that the competitive climate arising in the agricultural sector was diffused throughout all economic sectors. In this regard, the competitive environment that is essential for an export-led economy had already been to a considerable degree prepared in Korea. Also contributing to the creation of a positive economic environment was education. By the early 1960s, the literacy rate was very high, thanks to the rapid expansion of educational facilities, attributed to the government's policy for human capital development combined with the enthusiasm of Korean parents to educate their children. The literacy rate, which was only 22 per cent in 1945, reached 72.1 per cent in 1960. This improvement allowed the Korean people to understand and easily adjust to better production methods, new economic policies, and the changing socioeconomic environment. A final factor in the economic environment was the fact that there were virtually no religious, cultural, or traditional obstacles hindering the introduction of prerequisites for economic development such as entrepreneurship, respect for economic efficiency and population control. As will be discussed later, entrepreneurship in the business sector wes Tather strongly encouraged by the President (and his government) through both visible and invisible incentives provided for exports and investment in physical and human capital. In Korea, there ate four broad categories of religion or spiritual beliefs, namely, Buddhism, Catholicism, Confucianism, and Protestantism. According to the study of Jones and akong, relative to other societies, religion played an extremely minor role in differentiating the entrepreneurial elite from the population as a whole.” The attitudes of the Buddhist-Confucians have proven to be business-neutral or weakly held, and no comparative advantage is conferred on non-traditional religious groups. Yo control population, in the mid-1960s the Korean government started a nationwide campaign of "two children per parents,” with provision for measures of birth control that included contraceptives and education of husbands and wives at productive ages. The campaign was generally accepted by Korean families; acceptance is reflected in the rapid } Leroy P, Jones and Il Sakong, Governnient, Business, atd Entreprencrship in Economic Development: The Korean Case, Council on East Asian Studies, Harvand University (1980), pp 221-3,reduction of the population growth after the 1960s. Annual average population increase rates were 2.7 per cent during the 1960s and 1.7 per cent during the 1970s; and 1.2 per cent during the 1980s. A\ll of these socioeconomic conditions are considered conducive to the strengthening of growth potential in Korea. This conclusion accords with Adelman and Morris's finding that of 74 developing countries, Korea was 60th in 1961 per capita income but 14th ina composite indicator of socio-cultural development, including size of traditional sector, extent of dualism, character of basic social organization, size of the indigenous middle class, extent of social mobility, extent of mass communication, crude fertility rate, and the degree of modernization of outlook.'* II. Evolution of the Korean Economy and Role of Exports in Economic Growth The economic performance of Korea in the 1950s is different when compared with performance in subsequent periods. As discussed earlier, in the 1950s Korea had notadopted an outward-looking or export-led development strategy. In fact, it may have been beyond the country’s capability to pursue a long-term export-led development strategy due to lack of human and financial resources required for formulation and implementation of the strategy, policies, and projects of relevance In the 1950s, the annual average volume of exports of merchandise was only $27 million, with a rate of increase of 10 per cent per year, while the annual average growth rate of real GNP remained at 3.9 per cent. Savings and investment ratios as a percentage of GNP were also low (Table 1). Taking into account the export ratio, as a percentage of GNP at a minuscule at 2.9 per cent, exports did not play any significant role in economic growth in the 1950s. Since the 1960s, exports served as the main driving force behind the rapid economic growth in Korea. The contribution to the growth of real GNP by exports was only 3.3 per cent in the 1950s, but it increased to 23.6 per cent in 1960s, reaching by 59.6 per cent in the 1970s and 39.2 per cent in the 1980s. In the 1970s, when the contribution of exports to economic growth was highest, exports provided major economic impeius, particularly to the manufacturing sector, as seen in Appendix Table A2. Exports accounted for about 60 per cent of the growth of the manufacturing sector in the first half of the 1970s and 42 per cent in the period 1975 to 1978. Within the manufacturing sector during the two periods, the pattern of growth differed between the light industry and the heavy and chemical industry. In the first half of the 1970s, light industry was boosted slightly more than heavy and chemical indusiries, whereas the second period showed a reverse pattern. Following are brief discussions on the Korean economy by period. ¥ Irma Adelman and Cynthia Taft Mortis, Society, Ptiicsand Economic Development: A Quantitative Approach, Johns Hopkins University Press, Balkimore (196%), pp 151-2, 170.TABLE 1 Exports, Savings, Investment and Economic Growth in the 1950s and Afterwards After 19508 1950s! 19605? 19708 1980s 1990s" (in US$ million) Expors! 2 21 677 33,596 66,352 ncrease rate) (10.0) 415) G64) 54) G4) (as a per cent of GDP) Export ratio 16 36 212 310 253 Gross investment ratio 22 18 260 306 383 National savings ratio 20 10.7 27 28.0 359 Growth rate of GNP (7) 39 89 94 79 88 iecovers the period 1953 0 1961 except forthe gross investment ratio anc nadonal savings rato whish stat from 195% due to data constraint. The statintical dats are available only from 198) and the Fist Five-Year Ezonounie Development Plan, which adopted the ELGstrategy, arted in 1962 This covers the period 1952 t 1968, 8 This covers 1990 and 1991, * Exports of merchandise only. Sousees: Eoonomic Planning Board, Korea Suita! Yeaybwo (vatious Issues); dnd Bank of Korea, Economic Statistics Yearbook (various deraes), Soon A. 1950s: The Period of Rehabilitation The primary concern for Korea in the 1950s was rehabilitating the infrastructure and manufacturing capacity that wes virtually destroyed by the Korean War (1950-1953). During the 1950s per capita income remained at a level of $60 to $70, at that time placing Korea among the poorest countries in the world (Appendix Table A3). Primary industry and the services industry accounted for more than 85 per cent of total output. In particular, the services industry comprised the highest ratio, 40-50 per cent, mainly attributable to a large number of less skilled workers hidden in retail and other services industries that usually did not require expertise. There was vast underemployment during this period, accommodated by the services sector. Primary industry output was also high at 47.3 per cent in 1953, with this percentage being maintained until the mid-1950s and thereafter declining slightly. Reflecting the industrial structure in which primary industry was dominant, the commodity composition of exports was not sophisticated in the sense that more than two-thirds of exports were traditional products and primarily crude materials such as unprocessed minerals, B. 1960s: The Period of Outward-Orientation In 1962 Korea adopted its First Five-Year Economic Development Plan, the first system- atic long-term economic development plan in Korea. Plans introduced in the 19503 were based on the short-term timehorizons and essentially were counter-cyclical or sector-specific.‘The most salient feature of the Development Plan was to regard exporis as the locomotive of growth, with a large part of government policy efforts being put on the promotion of exports. The Plan also encouraged borrowing, from external sources to meet the cost for construction of infrastructure and manufacturing facilities. In the 1950s, these two objectives, Le,, increasing both exports and foreign borrowings, were never regarded as. key policy goals, while there was a popular sentiment that foreign borrowings could hurt national prestige. A noteworthy policy measure undertaken for the promotion of exports was the provision of tax and financial incentives for exporters. Further discussion on the contents of the incentives and their role in the stimulation of exports will be made in the next section of this paper. ‘The second policy measure under the Development Plan for promoting exports was to devaluate the Korean won by nearly 100 per cent, from 130 won per US dollar to 255.77 won per US dollar in 1964. Since the exchange rate of the Korean won moved from 65 won per US dollar to 130 won in 1961, the won had retained the same level for several years, eroding international competitiveness of the Korean products under the circumstances that inflation, in terms of the increased rate of the consumer price index, averaged 18 per cent during the period 1961 to 1964. The third important policy change was the 1967 move to create a favorable export environment by shifting the import control system from a positive list system to a negative list system, to lessen the difficulties of exporters in importing necessary intermediate materials and investment goods for producing exportable goods. This change was the first step towards the liberalization of imports. Last, of paramount importance was comprehensive institutional reform throughout the 1960s, which included the creation of the Economic Planning Board (EPB) and the Korea Trade Center (KOTRA), financial reform for modernization as well as diversification of financial institutions, and tax reform, including the establishment of the National Tax Bureau, to revamp tax administration. Among these, the EPB and KOTRA deserve special attention for their role in promoting foreign trade, because EPB undertook coordination, formulation and implementation of overall economic development policies, including foreign trade policies, while KOTRA provided information on overseas markets, world economy, and foreign competitors. The aforesaid changes in economic policies and systems, combined with President Park's strong leadership and a prosperous world economy with relatively fewer trade barriers against developing countries during the 1960s, made great contributions to the growth momentum of exports as well as to the overall Korean economy." From 1962 to 1970, total exports increased 18-fold, while the per capita value of exports rose from $2 to $27 (Appendix Table Al). Imports also sharply increased, reflecting the rapidly increasing demand for intermediate materials, particularly for export use, and for capital goods, to support dynamic capital formation. As for the transformation in the economic structure (Appendix Table A4), one important point is that the trade ratio—a combined ratio of exports and imports as a percentage of GNP—rose sharply, from 14 per cent in 1962 to 31 per cent in 1970. This means that the Korean economy was more involved in international trade in the early 1970s than in the early 1960s, thereby being more dependent upon the world economy. The world trade, in torme of current US dollar prices, inoroaced by 7.4 per contin the 1950s; 9.3 per cent in the 1960s; 203 per cent in the 1970s; and 5.8 per contin the 194s. These data show that the world trade was gonorally active in the 1960s and 1970s.There was also a large change in the industrial structure, with the portion of production of primary industry declining in total production, while manufacturing and services picked up. Reflecting the economy's increased manufactures and decreased primary products, export structurealso became increasingly dependent upon manufactured goods, mostly light industrial products such as textiles and footwear. C. 1970s: The Period of Diversification Tt was in the 1970s that the Korean economy experienced the most significant changes in all arcas, especially trade, industry, and finance. The changes can be characterized by diversification of economies, especially industry and trade, together with expansion of production and trade volume. The 1970s began with tremendous changes in financial markets, particularly money and capital markets. In 1972, with the promulgation of the Presidential Emergency Decree, the Government declared that all borrowings by business corporations from the unofficial financial markets would be subject to a repayment moratorium.'® With this measure, the Government intended to reduce the debt burden of the business corporations in order to boost their production and investment activities. At the same time, the Investment and Finance Companies were established to undertake short-term dealings in commercial paper issued by business firms. Various institutional arrangements and reforms, including the 1972 creation of a corporate bond market, were also pursued in the capital markets. Financial reforms continued throughout the 1970s. The next policy move was to develop the heavy and chemical industries, In the 1960s, light indusiry had grown rapidly, playing a key role in boosting exports, generating employment and increasing national output, Despite many advantages inherent in light industry, particularly its labor-intensiveness, light industry also revealed two disadvantages. First, it created a relatively small amount of added value because most items, such as apparel, footwear and plywood, were heavily dependent upon imported raw and inter- mediate materials. Second, increased investments in light industry expedited the import of capital goods, which aggravated the balance of payments. To address these problems, the government promoted import substitution for intermediate materials and capital goods, and eventually developed a new source of exports on which Korea would rely. In 1973, the government announced the Heavy and Chemical Industry (HCI) Development Plan, which utlined the need, scope, and implementation program for developing future strategic industries, including shipbuilding, automobiles, steol products, machinery, non-ferrous metals, and petrochemicals.” * At hat time, largely because of underdevelopment of official nancial markets and government intervention ‘in interest rate devermination in official nancial markets, unoffidal curb marke's were flourishing. Business firms were heavily dependent upon curb markets where loan rates were very high and business practice not organized. This caused aggravation of the financial siatus of business firms. Under the circumstances, the Korean. government promulgated the Presidential Emergency Decree which allowed a repayment momaterium for the borrowings by business firms from curb markets, The Decree was unusual and extraordinary, "To promote the HCI, the government provided varied incentives in finance, tax and tariff to the firms which initiated HCI projects, As for financial incentives, above ll, the government established the National Investment Furd which provided long-term loans to strategically selected heavy and chemical industries to help finance their capital formation, While the Fund was partly funded by the government source, much of it was funded through a com Pubory transfer of private deposits from the commercial banking institutions to the Fund, Froe entry to certain arcas of heavy and chemical industry was prohibited, while high tariff barriers were sot up in order to protect theso “infant” industries. At the same time, strong lax incentives were given to the firms which speat resources for training workers and for R&D to strengthen production technology.10 The above-discussed efforis of the government substantially contributed to rapid development of the HCI in Korea. The industrial change is reflected in the commodity composition of manufacturing and exports as shown in Appendix Table Ad. The share of the heavy and chemical industry in the total output of the manufacturing sector rose from 33 per cent in 1970 to 50 per cent in 1980. Exports, which in the 1960s had mostly comprised light industrial products such as textiles and footwear, by the 1970s were showing some HCI products (such as electronics, machinery, ships, and iron and steel products) as important exporting items. Another noteworthy development was that in the 1970s there was dramatic expansion not only exports of merchandise but also of services, particularly overseas construction services (OCS). The exports of OCS increased markedly during the construction boom in the petroleum exporting countries in the Middle East after the first ofl shock. In 1977 the inflow of foreign exchange earnings from OCS exports reached $1,246 million, or 41.2 per cent of total invisible trade receipts. In the second half of the 1970s, the foreign exchange earnings from OCS contributed greatly to the improvement in the balance of payments (Appendix Table AS). Along with the increased OCS exports, the number of overseas Korean workers also increased rapidly from the mid-1970s. scribed to the abovementioned changes at home and abroad, in the 1970s the Korean economy gained further growth momentum. Exports showed 2 speedier growth rate in the 19703 than in the 1960s because of the development of the HCI as a new source of exports. ‘Together with growth in volume, the exports ratio to GNP also rose impressively, from 10 per cent in 1970 to 28 per cent in 1980 (Appendix Table A4). The imports ratio also went up from 21 per cent in 1970 to 35 per cent in 1980. However, as the Korean economy pursued, through investment, rapid growthin output and exports, this growth inevitably caused an excessive demand situation, high inflation'® and accumulation of foreign debt. The increase in rate of the consumer price index reached 16-17 per cent annually in the 1970s, and outstanding external debt expanded from $2.3 billion in 1970 to $27.2 billion in 1980. A fast increase in foreign debt since the mid-1970s to finance active investment in the HCI apparently led to a sharp increase in the debt service burden. D. 1980s: The Period of Structural Adjustment ‘The Korean economy exhibited many positive features in the 1970s, but on the other hand it also revealed severe problems, including high inflation, a high degree of government intervention in economic operation, low efficiency, and increasing foreign debt. It was a widely accepted view that the main cause of those problems was the overlapping, excessive, and inefficient investment in the HCI, under an interventionist government policy. Most of firms in the HCI were operating production capacity much below. their full utilization, causing enormous business loss and heavy debt-service burdens.” As the government ‘began a bail-out of firms, it further intervened in management of some firms. % Two world energy shocks—one in the early 1970s and the other in the late 1970s—and the increased influx of BY ly foreign exchange earnings from the Middle Fast as discussed above were also major eause for the high inflation, © The sluggish HCl production was also caused by the world-wide recession due to the second energy crisis in the late 1970su Under the circumstances, there arose a sirong demand for structural adjustment of the Korean economy. The main thrust of the demand was characterized by liberalization, deregulation, and internationalization of the economy on the grounds that further heavy government intervention would be neither desirable nor effective in light of the already sophisticated and large-sized Korean economy. It was further argued that the production efficiency of the Korean economy should be raised by having price mechanism play a principal role in the determination of prices of commodities (i.e., goods, services, and funds) and in the allocation of resources. In addition, pressure from foreign countries to open the Korean markets mounted from the early 1980s. With this background, the government took several important steps toward deregulation and internationalization of the economy. First, to open domestic markets and to stimulate competition in the economy, it reduced import barriers to a considerable extent by lowering tariff rates and increasing the numbers of importable items without any authority's approval. The average tariff rate was down to 20 per cent in 1985 from 39 per cent in 1978, while the import liberalization ratio, ie., the percentage of the imporiable items without prior approval in the total commodity items classified for custom use, rose from 68 per cent in 1979 to 92 per cent in 1986. Next, financial incentives given to export industries and the HCI were reduced dramatically to heighten the self sustaining capability of these industries. In fact, policy- based loans had occupied a substantial portion of total domestic credit, reflecting a variety of financial incentive systems provided to a wide range of industries including the export sector, HCI and small and medium industries. This brought about a distorted allocation of financial resources, impairing the independent operation of commercial banks and preventing flexible monetary policy. Together with a drastic reduction of financial incentives, liberalization of the financial sector was initiated through privatization of the five commercial banks and the lowering of barriers set against foreign banks’ entry into the Korean financial markets. Another important change in macroeconomic policies in the mid-1980s was to emphasize stabilization of the economy, compared with the previous policy in the 1960s and 1970s, which had focused upon economic growth. Money supply, on average, had kept a high growth rate in the 1970s, with this tend continuing into the early 1980s, as seen in Appendix Table A6. However, the rate of growth in M2 sharply declined from 1983 onwards. in addition, during 1983-1986, under an austerity program, government spending was cut, leading to a dramatically lowered budget deficit ratio as a percentage of GDP. Along with such a tight monetary and fiscal policy, inflation in terms of the rate of increase in the consumer price index came down drastically from a double digit rate to less. than five per cent from 1983 onwards. The tight monetary /fiscal policy was rot the single most important factor causing such a dramatic stabilization in price. The high inflation rate, exceeding 20 per cent per year in 1980 and 1981, was attributed to several factors that embraced not only the loose monetary /fiscal policy but also the second oil shock in 1979 and its subsequent time-lagged inflationary effect, and severely sluggish production in 1980 and 1981 in the wake of political turmoil. By 1983, those exogenous disturbances had been significantly stabilized, leading to a virtually normalized socioeconomic situation. This positive change contributed to the stabilization in price, but nonetheless the tight monetary /fiscal policy was among the most important factors that led to such a dramatic stabilization of the long-time, persistent inilation.n The structural adjustment and stabilization efforts in the 1980s were thought to have been successful. Since the mid-1980s, the Korean economy had demonstrated dramatic price stability and huge surpluses in the current account, while maintaining high-growth momentum (Appendix ‘Table A7). In view of the decades-long experience of high inflation rates and large deficits in the current account since the early 1960s, stabilization in price and the balance of payments in the mid-1980s was indeed important and remarkable. From 1986, exports began to increase by about 30 per cent per year, resulting in large trade surpluses. Several factors accounted for these sharp increases in exports. First, a radical appreciation of the Japanese yen occurred in 1985, corresponding to the Plaza Accord of the Group-7 countries. The appreciation played an important role in improving the inter- national competitiveness of certain Korean products, (namely, steel, cars, electronic consumer durables, and semi-conductors), which were competing with Japanese products in the international markets. The second factor was the improved quality of Korean manufactures, ascribed to technological development, R & D efforts and the governments support and enthusiasm for the HCT in the 1980s, which stimulated production of new exportable goods. Last but most important, Korea’s economic reforms, geared toward liberalization, internationalization, and stabilization of the economy, significantly contributed to strengthening of the international competitiveness of Korean products through stabilized price and enhanced efficiency. IV. Role of Government in Export Promotion— Creation of X-Efficiency with Economic Disequilibrium A. Disequilibria in Foreign Exchange and Financial Markets As seen above, exports grew at a rapid rate and played a leading role in economic growth in Korea during the 1960s to 1980s. This section will try to answer the question of what role the Korean government played in export expansion. According to one World Bank report”? an export-led or outward-oriented growth strategy is defined as one in which trade and industrial policies do not discriminate between production for the domestic market and exports, nor between purchases of domestic goods and foreign goods. This notion is essentially based upon the neoclassical perspective which regards achieving the right price as the starting point for an economy to function efficiently. It presumes that wage rates, interest rates, commodity prices and foreign exchange rates are determined freely by the market forces, generating market equilibrium at equilibrium prices. ‘To classify the orientation of a country’s growth strategy, the World Bank report used several quantitative and qualitative indicators, including degree of exchange rate overvaluation and use of export incentives. The greater the degree of overvaluation and use of export incentives in a country, the more inward-oriented it is. Using information from 41 countries for the period 1967 to 1985, the World Bank report divided the 41 countries into four categories: strongly outward-oriented, moderately outward-oriented, strongly inward- 2» World Bank, World Development Report 1987, (Washington, D.C.), Chapter 5.13 oriented, and moderately inward-oriented. Under these classifications, Korea was labelled a "strongly outward-oriented country" (refer to Appendix 3 for the World Bank's classification of the 41 countries). It is useful to consider the Korean case against these criteria. It isa well-known fact that the Korean government influenced the determination of prices, wage rates, interest rates, and foreign exchange rates either through direct tools or through indirect moral suasion. In particular, interest rates and exchange rates were direcily determined by the Korean monetary authority until only recently. Before the mid-1980s, all types of interest rates of banks and non-bank financial institutions were determined by the Ministry of Finance or the Bank of Korea (Central Bank). By the mid-1980s, liberalization had begun in a phased manner. The official interest rate set by the monetary authorities was mostly lower than that of the unofficial financial market, where the interest rate was determined by market forces, giving a sign that the official rate was somewhere below an equilibrium rate. Therefore, the official markets always faced excessive demand for funds, causing a disequilibrium credit rationing by financial institutions. In the area of exchange rates, for exporters exchange rates would be much more important than interest rates as exchange rates affect directly and immediately the proceeds from exports. It is presumed that in the regime of an outward-oriented growth strategy or export-led growth strategy, the effective exchange rate for exports (EERx) should, on balance, not differ significantly from that for imports (EERm), such that the EERx would be roughly equal to the EERm* In short, the effective exchange rate does not show a bias against exports. Korea adopted an exchange rate system in which until 1980 foreign exchange rates were pegged to the US dollar. In January 1980, a trade-weighted currency basket system was introduced. During the dollar pegging period, the exchange rate” was determined by the monetary authority, being reviewed and adjusted from lime to time. Under the trade- weighted currency basket system which was employed from January 1980 to March 1990, the exchange rate was determined basically by the movements of currencies of major trading partners such as the U.S., Japan and Germany (Federal Republic of Germany at that time), Only in March 1990 was a kind of free market exchange rate system introduced, though the system still imposed a band within which the exchange rate could fluctuate in a single day. For most of the history of the exchange rate system in Korea—until March 1990—the exchange rate was determined not by market forces but by the monelary authority or by movements of the currencies of trade partners. It can be concluded that the exchange rate did not reflect the demand /supply situation in the Korean foreign exchange market, which would have established the market equilibrium rate had a free market system been allowed. Table 2 shows the real effective exchange rate (REER) of the Korean won. The REER is calculated based on real term movements of the US dollar, Japanese yen, Deutsche mark, ° Jaggtish N, Bhagwati, "Rethinking Trade Strategy,” in Development Strategies Reconsidered, ed. by Jobn P. Lewis and Valeriana Kallab, Overseas Development Council, Washington, D.C. (1986), Chapter 3. % Unless otherwise noted, in this section the term “exchange rate” refers to the exchange rate of Korean won per US dollar, Under the US dollarpegging system and the trade-woighted currency basket system, the monetary authority determined first the exchange rate of Korean won against US dollar and then against other currencies such as Japanese yen by multiplying the dollar rate by exchange rates of those currencies vis a vis US dollar in the international financial marketsu pound sterling, and Australian dollar, reflecting relative changes of consumer prices in Korea compared with those in the U.S, Japan, Germany, U.K., and Australia, the five dominant trading partners of Korea Table 2 provides two REERs, one which sets 1977 as the equilibrium point of time and another using 1985 as the equilibrium point of time2* In Case | in Table 2, where 1977 is selected as the equilibrium point, except for 1973, 1978, and 1984-1991, the Korean won had always been overvalued in light of relative inflation between Korea and its major trading partners. This implies that for most of the time before 1983 the exchange rate was not supportive of Korean exports. However, recent analysis by the World Bank shows a different view, suggesting that during the period 1961- 1973 Korean exporters were supported through various incentives, including multiple exchange rates, direct cash payments, tax and tariff incentives, and permission to retain foreign exchange earnings to import restricted commodities.* However, the World Bank's computation of real exchange rates coniains problems, as the multiple exchange rate system was abolished on 21 February 1961 and direct cash payments had not been provided since the early 1960s. Under the circumstances, other things being equal, the exchange rate environment was such that imports were encouraged but exports discouraged. If the year 1985 is set as a basis period, the argument mentioned above is strengthened. For the period 1962-1991, only in the period 1978 and 1986-1989 was the won undervalued or in equilibrium, For the rest of the period, the Korean won was always highly overvalued. When 1977 and 1985 are compared, 1977 seems better as equilibrium point simply because if 1985 is set as a basis point, the exchange rate in 1977 will be overvalued, causing difficulties in explaining the surplus in the current account of 1977. However, in any of the two cases, the REER of the Korean won was overvalued for most of the period from 1962 until the early 190s, ® The REER was calculated by this formula: REER, = Ew,E,P\/P,, where REER, is REER of Korean won; w is ‘Weight of each country, which is determined by the volume of imports of Korea from each country, namely the US,, Japan, Germany, UK, and Australia; Ei exchange rate of Korean won per currency of each country; and P, and Py are consumer price index of the five countries and Korea, respectively, % The reason for choosing the two differont years as equilibritum points is that the current account was more or less in balance in those periods. Balance in the current account means there is no excess demand /supply of forcign exchange in the exchange market, if voluntary capital movements independent from trade of goods and services — for instance, portfolio investment — are excluded from the considerations. Here, such a situation is regarded as an equilibrium point for the REER, {In fact, the current account was in balance not only in 1977 and 1985, but also in 1965. If the structure of the current account in 1965 is carefully examined, however, the year does not appear to be an equilibrium point, In 1955, the current account surplus of US58 million iwas simply attributed to the aid from the U.S. and sales of Korean goods and services to the U.S. military forces stationed in Korea, A strictly-defined foreign trade, which comprises only transactions of Korean goods and services with international markets, underwent a substantial amount of deficits. In view of this, it would te proper to take into account only the year 1977 and 1985 when there was ne more US. ald to Korea and when the supply of Korean goads and services to the U.S, forces remained at a negligible level relative to the large volume of Korea's international trade * The World Bank, The East Asian Miracle, op. cit, pp 127-29, 2% A simplified version of the purchasing power parity exchange rate (PEPER) was also computes to check the overvalucdness of the Korean won. The computation result is shown in Appendix 4. Despite the problem of the PPPER showing that the Korean won was highly overvalued by more or less 20 per cont oven in 1988 and 1989, when the current acount exhibited huge surplus, the PPPER isnot mach differen from the REER particularly for the period before the mici-1980s,15 ‘TABLE 2 Real Effective Exchange Rate of the Korean won* Current account Nominal rate” REER of won‘ (US$ million) (Won/US dollar) Case T Case TT 1962 “55 120.0 oat 64a 1963 143 120.0 599 55.9 1964 26 213.9 785 732 1965 8 266.4 887 82.8 1965 -104 2713 843 73.7 1967 “192 2705 776 24 1968 441 276.7 761 71.0 1969 “549 288.2 734 685 970 623 310.6 733 ot 1971 “48 347.2 777 725 1972 362 392.9 898 838 1973 299 398.3 703.9 969 1074 2,019 4045 97 90.6 1975, -1,889 484.0 955 89.1 1975 310 484.0 954 89.0 197 2 484.0 100.0 93.3 19738 -1,085 484.0 1126 105.1 79 “4151 484.0 93.7 874 198) 5,321 07.4 958 a4 1981 4,646 681.0 93.6 97.3 1982 -2,650 731.1 884 82.5 1933, -1,606 775.8 95.9 aS 19st “1,372 806.0 106.6 94 1085 “887 870.0 307.2 100.0 1985, 4617 861.5 149.4 199.4 1987 9854 8226 1471 1373, 1988, 14,161 71S 130.4 17 1989 5,056 os 107.3 100.2 1990 2,172 2078 1053 983 1991 “8,726 733.4 1082 100.9 # The REER b a urade-welghtet exchange rate of Korean won adjusted for rave {nflaion betwoon Korea ond its five lagost trading partners, namely the US, Jopan, Germany, UK and Australia, An inrease/decrease indicates deprecation /apprecaton in the value of Korean won, For details for ealalaton ofthe REER, refer t9 Faotote 73 ® This denotes the annual average rate and w, $ ard yare Kerean won, US dolla, and Japanese yen, respectively © Case! assumes the year 1977 a8 an equilibrium point and Case Il the year 198 Sources: Bank of Korea, Feomomic Starbtics Yearbook (various fsues), Seoul, and Intemational Monctary Fund, Interestioeal Financial Stastise Yeorboot (various issues), Washington, D.C.180 160 140 0 100 REER Figure: Movements of REER of the Korean Won during 1962-1991 Cs wissen nse : sees se ee eins: ceeselctn ie slewee weet eine ou pp ram L 1962 67 1972 1977 1982. 1987 191 Source: Table 2. aL7 B. Role of the Government in Export Promotion What factors offset the disadvantage associated with the persistently overvalued exchange rate while encouraging Korean manufacturers (o increase their sales of goods and services to foreign markets? Before looking into this question, it is necessary to discuss what the Korean government generally did during the economic development of Korea. Though it would not be easy to summarize the roles undertaken by the Korean government, they might fall into the following five activities: (i) operating and developing the economic infrastructure—energy, transportation, and communication, etc—the construction of which could not be left to the private sector; (ii) developing and stimulating human resources and people’s aspiration; (ii) presenting medium- and long-term targets for economic development; (iv) promoting strategic industries, including agriculture, small and medium industry, and key manufac- turing sectors; and (v) enhancing the productivity of the overall economy—boosting the R&D efforts, modernizing production technology, and disseminating information on domestic and foreign economies However, it could be said that these activities are those that were pursued not only by the Korean government but by most other governments in developing and developed countries, Is there any other particular role undertaken by the Korean government to promote exports? It is considered that there is. That is strong, direct support that motivated exporters to explore foreign markets. Since the early 1960s, when the First Five-Year Economic Development Plan started, the government provided two kinds of support for exporters: (i) financial and tax incentives (until the early 1980s); and (ii) psychological encouragement. The former can be considered visible support and the latter invisible, moral support. PP, concerning the financial incentives, exporters were offered bank credit at lower interest rates than those on other commercial loans. A short-term export financing scheme (EFS) commenced in the early 1960s and ceased in the early 1980s when, as mentioned earlier, an extensive structural adjustment program was undertaken. The EFS was one of the effective means of resource switching, from domestic to export use, through the automatic availability of credit under eligibility for rediscount by the Central Bank” ‘The EFS covered all categories of the process of export activities, such as domestic purchases and importation of raw materials for export use. Borrowing procedures for funds were much less complicated than for other loans, but to prevent the beneficiaries from using the loan funds for other purposes than export activities, an extensive follow-up process was implemented. ‘As seen in Table 3, the interest rate of EFS was much lower than the commercial loan rate during the 1960s and 1970s. In 1967, the export loan rate was only 6.0 per cent per annum, one-fourth of the commercial rate, providing a substantial degree of interest sub- ® Chang-Kyu Lee, A Study on Export Financing in the Republic of Korea,” presented to the 15th SEANZA Central Banking Course, 4 February-12 April 1985, Kathmandu (reprinted by the Bank of Korea).18 Sidies to exporters. Interest subsidies, in terms of a percentage per dollar of exports, peaked in 1967 at 17.7 per cent and thereafter declined gradually: In the tax area, exporters were also provided with various incentives, including discount of corporate income taxes on earnings from exports, tariff rebates on inputs imported for export production, reduced rates on public utilities for exporters, and accelerated depreciation allowances for export firms. Despite some criticism of the EFS, several considerations made the Korean people accept the policy” At an early stage of ELG, due to little experience in foreign trade and resultant uncertainty concerning exports, business firms would be reluctant to start export activities. Therefore, it was necessary for the government to reduce uncertainty and support and expedite export activities by providing certain incentives, including the supply of credit and providing information on overseas markets. Next, governments in developing countries needed to create a neutral or pro-export financial environment so that the financial market situation that domestic exporters faced would be similar to that which exporters in developed countries faced. In developed countries, where financial markets are diversified and efficient, exporters encounter few problems in securing bank loans to cover financial needs for the export business. In contrast, developing countries have underdeveloped financial markets, characterized by an absolute deficiency of financial resources, inequitable financing opportunities, and lack of diversity in financial markeis. Therefore, in Korea an export promotion scheme with government involvement was necessary (0 establish a financial environment similar to that which existed for exporters in developed countries. TABLE 3 Interest Subsidies under Export Financing Scheme (EFS) (in per cent per annum) 1968 1967 1975 1977 11980 1982 ‘Commercial loan rate (A) 140 24.0 155 160 20.0 100 Export Ioan rate (B) 80 60 70 80 120 100 Difference (A ~ B) 60 18.0 85 80 80 - Interest subsidies* 69 7 67 37 53 - * Asa percentage per dollar of exports. For details of estimation, refer to Footnote 28, Source: Dank of Korea, Seoul and author's estimates i Interest subsidies are estimated by the formula: (4)(R, - R)/X, where F ls the outstanding of the export loans 'n USS dollar term at the end of each yoar; Ry and R. are the expor lean rate and commercial loan rate, respectively, and X is total annual exports in US. dolar term, Taking into account that by Central Bank regulation export loans were to be repaid within 90 days, F gives information only on the volume of export loans givon to exporters during the las three months before the end of each year. Therefore, the outstanding of the export loans was multiplied by four to transform it into an annual term. ® Chang-Kyu Lee, op. cit,19 ‘The last rationale was the proposition of "equalizing compensation,” ie. equalization of incentives for exporters and import-substitutors.” To protect domestic industries, most developing countries, including Korea, impose ceriain restrictions on imporis through tariffs, foreign exchange control, and other non-tariff instruments. Under the circumstances, an import-substitution industry may be preferred to an export industry. Therefore, profitability considerations call for providing equal incentives to exporters and import-substitutors; in other words, equalizing compensation by offsetting the bias between anti-export and pro- import substitution. With respect to the invisible psychological encouragement made by the government, particularly in the 1960s and 1970s under President Park, all Korean exporters received the immediate and close attention of the President, with successful exporters regularly honcred by the President. As a result, anyone who had accumulated wealth via export activities virtually was considered a national hero and was assured that the blessings of society were deserved. This had an immense psychological impact on entrepreneurs. This honor and encouragement given to exporters assuredly helped channel the best of the entrepreneurial class in Korea into export activities. This action by the government seemed to create the “social climate’ of Schumpeter in which entrepreneurs receive generally high social prestige as well as high income rates.*! The entrepreneur is the person who sees the opportunity for introducing a new production technique or a new commodity, for improving production system, or for developing newly discovered resources or exploring new markets. In Schumpeter’s world of economic growth, the supply of entrepreneurship is the factor ultimately determining the rate of economic growth. The supply of entrepreneurship is, according to Schumpeter, dependent upon the "social climate,” a complex phenomenon reflecting the entire social, political, and sociopsychological atmosphere within which entrepreneurs must operate. [t includes the attitude of society toward business success—the nature and extent of the prestige and other social rewards accompanying business success—apart from profil. President Park, prima facie, created such a business and export environment. The Korean government adopted the "Export First" policy and communicated this clearly to all of society. Exports activities were virtually free of all the bureaucratic sequirements associated with the protectionist import regime, with preferential tax treatment and credits being available to exporters as discussed in the above paragraphs.” As one World Bank report points out, "Communicating strategy, however, is usually not enough to ensure proper compliance, as bureaucracies often fall into rigid, routinized, and procedural-type behavior. President Park played a major role in avoiding this pitfall with a series of institutional reforms."*? One institutional product was the establishment of the Export Promotion Conference, a joint body of economic ministers, major economic % Fronch-Davis, Ricardo, and Joso Pinera Echonique, "Colombia Export Promotion Policy," paper prepared for the ECLA/IPRD Seminar on Export Promotion Policies, Santiago, Chile (November 1976), % Benjamin Higgins, Economie Development - Problems, Principles, and Folicies, revised edition, W. W. Norton & Company, New York (1968), pp 93-95. © The World Bank, "Korea's Experience with the Development of Trade and Industry.” opt. © The World Bank, “Korea's Experience with the Development of Trade and Industry,” op. cit, p15.20 institutions, and leading businessmen. The conference was held every month, chaired by the President. In the conference, all the problems impairing exports and suggestions to promote exports were discussed concretely and intensively. After discussion, the President immediately ordered relevant ministers or officials to take necessary policy actions and in the next meeting, followed up. ‘The attitude of the President gave a clear signal to businessmen and government officials that the President was enthusiastic about export promotion and that he was laying the highest priority on expanding exports. Under an authoritarian ruling system rooted in both the President's personality and the Confucius tradition of obedience to the government, (parents, teachers and aged people), such leadership and enthusiasm by the President must have made businessmen and government officials increase their efforts for promoting exports. worn important attitude of the Korean government under President Park was a timely implementation of the policies, ie., the timely translation of policy abstractions into concrete actions by a production unit. President Park did not sit back and let market forces reign. On the contrary, he was actively and pervasively interventionist. He proferred a pragmatic non-ideological mixture of market and non-market forces to laissez faire. When markets worked, fine; when they did not, the government showed no hesitation to intervene by means that ranged from a friendly phone call to public ownership. Implementation by any possible means was the characteristic, prevailing feature of policy in Korea." The two factors—visible incentives and psychological encouragement by the government (the President)—must have provided businessmen with a high degree of “assurance’*? on investment, production and exports, while certainly bringing about dynamism, aspiration and enthusiasm in business activities, including exploration of foreign markets. The disadvantage caused by the overvalued exchange rate of the Korean won had been partly or fully removed by the financial and tax incentives. Lee (op. cit.) evidences the Positive role of the EFS in promoting exports in Korea.”* The study suggests that the export supply of Korean products to foreign markets was positively affected by export financing, whereas the foreign exchange rate did not explain variations of export supply in Korea during the period 1964-1982. The "assurance" provided by the government must have created something that conventional economic theory cannot explain. It relates to the motivational system within the economy. As the X-efficiency theory points out” the special amount and nature of the % Leroy P. Jones and Ii Sekong, ibid, p. 3 8 Jagdish N, Bhagwati, op. ct * Lee(op. cit) estimated an export supply function of Korea by using the annual data from 1964 to 1982: Lox’ =-21648 + O69LUP, -1.26LnPy + 1L.84LnK + 1.33LnS. (aan 4.8)" ¢287) G08) G20) where Ln is natural logarithm operator; X' isthe supply of experts by Korea; P, is export prices; Py is domestic prices; K is domestic supply capacity; and S is export financing. However, the eftimation which included the foreign exchange rate as the explanatory variable was unsatisfactory. © H, Leibenstein, “Microeconomics andl X-Eificlency Theory,” in The Crisis in Economie Theory, ed. by Daniel Bell and Living Kristol, Dasic Books, New York (i981), pp. 97-110.21 efforts of Koreans which were stimulated by the assured climate were critical in realizing the increased scale of returns in production and exports. In this environment, "there is no relationship between the percentage increase in costs of inputs (abor, raw materials, machinery, etc.) and the percentage increase of the cost of output. The cost of output can turn out to be very much smaller, or, not rise at all."* ‘The subsidy given to exporiers through low interest rates was different from what was given to public enterprises to cover financial losses in many developing countries. The subsidy to public enterprises tended to provide a shelter under which entrepreneurs could escape market competition, causing easygoing management and inefficient production. In contrast, despite several drawbacks to be discussed later, the Korean EFS neither impaired market competition among local exporters nor allowed an abuse of the export funds. ‘The system was open to any exporters who received foreign orders for Korean products, with no room for inequitable treatment of certain groups of exporters. Competition among exporters was not lessened at all. Misuse of the funds under the EFS was not possible because the scheme had a strict supervisory system to check whether the funds provided were used only for export use, and for the purpose for which the funds were requested. Furthermore, if the exporters who received funds did not fulfill the export requirement, not only would the exporter be required to return the funds to the system, but their access to the system would be forbidden for a ceriain period of time. Taking the low interest rate of the EFS funds and automatic access to the funds into account, if any exporter was forbidden to use the EFS, it would be a severe penalty that might make the exporter non-competitive with other exporters. ‘The EFS was abolished in the early 1980s when a comprehensive structural adjustment program was initiated. Despite the abolition, however, it is considered that the assurance- providing role of the government was preserved throughout the 1980s. The first factor to evidence this was the change in exchange rate policy. As seen in Table 2, REER had been devalued and had maintained an undervalued position from 1984, when the preferential interest treatment on export loans was abolished. This policy change should have contributed to maintaining a favorable export environment despite the ending of EFS. The supportive role provided by the previous EFS had been replaced by a new exchange rate policy in 1984. ‘Another factor in the creation of the assurance role of the government was stability and consistency of trade policies. This made entrepreneurs understand clearly the goals of the society and the rules under which they had to operate. Since the early 1960s, the Korean government had in fact never given up the ELG strategy and never reduced the amount of enthusiasm to expand exports, though the main thrust of policies had changed period by period. Before the 1980s, the government supported exporters particularly in improving price competitiveness, but from the 1980s, the government paid more attention to the technological improvement of exportable goods. From 1980s onwards, the government assisted local industry in developing new technology and enhancing production efficiency. Increased openness to foreign direct investment speeded technology acquisition. Further more, import liberalization undertaken since the early 198s as a major element of the structural adjustment program had further stimulated competition between local and foreign manufacturers, contributing to enhancement of production efficiency of the local industry. The import liberalization had also made exporters expeditiously acquire the needed foreign materials Hi, Loibensiein, op. ot,2 V. Conclusion It has been contended by some researchers that Korea, together with Hong Kong, Singapore, and Taipei,China, adopted the ELG strategy and that the strategy essentially was based on the neoclassical perspective of a free market system and liberal prices. However, during the period 1962 to the early 198s, though export-promotion was strongly undertaken, most commodity prices—interest rates, exchange rates, and wage rates—were not able to change freely in response to market conditions of supply and demand but were controlled by the government. In this regard, it might be sae to say that the ELG strat did not necessarily involve a free market system with equilibrium prices. ‘The ELG stratezy may work even in economies where market disequilibria with rigid prices prevail.” In Korea, the disadvantageous effect on exports of the persistently overvalued REER before the mid-1980s was partly or completely ofiset by an ad hoc export promotion system. The promotion system contained an interest subsidy, automatic access to credit availability, and concessional tax treatment. This clearly implies that in addition to high administration costs involving the control of the export promotion system, there was persistent disequilibria in all financial markets, specifically, the foreign exchange market and domestic financial markets where the monetary authorities had heavily intervened in the determination of the exchange and interest rates. itapparently was envisaged that the overvalued exchange rate must have encouraged imports of foreign commodities and exports of domestic capital, having further aggravated the balance of payments, which had already suffered deficits for most of the time before the mid-1980s. This led to further intervention by the government in imports and capital transactions, In the financial markets, artificial interest rates, which usually were lower than the expected market rates, caused excessive demand for bank loans and contributed to a birth of and sometimes prosperity of curb markets. Government intervention in the 1970s in the allocation of financial resources to establish an incentive system, particularly for the export sector and the heavy and chemical industry, also generated structural problems such as misallocation of financial resources, underdevelopment of financial institutions and markets, and reduction in monetary policy effectiveness. Another important lesson from the Korean ELG model is that "once government assumes a certain role in the development process, it tends to persist with the same role, often failing to adjust to changes in economic environment." More important, the private sector, which was used to an incentive system, did not easily discard its inertia towards the system, though the economic enyironment at home and abroad did not allow the system to continue. In light of the above, it seems very risky to say that the Korean approach is better than a neoclassical approach, in which prices, particularly exchange rate, are allowed to move flexibly to reflect the market conditions, with direct export incentives abolished or substantially reduced. This neoclassical approach is similar to the model that Hong Kong * The World Bank's publication East Asion Miracle (op.cit.) draws « similar conclusion on the government intervention. “Yung Chul Park, "Development Lessons from Asia: the Role of Government in South Korea and Taiwan, American Economie Review, vol. 89, no. 2 (May 1990), pp 118-21,23 pursued. While the two approaches may provide a similar economic environment for exporters, the latter does not distort financial and foreign exchange markets. This is partly evidenced by a better economic performance in Korea in the period after the mid-1980s, when the price mechanism was toa substantial extent freeand the incentive system virtually removed from the economic scene. Moreover, though the "hard"! development model, led by a strong leader, may have served well in Korea, it should be remembered that it is a risky strategy, potentially subject to abuses of powers and positions. Taking into account the Korea-specific culture, population structure and geographical location, and the world economic situation in the 1960s and 1970s, all of which might be supportive for the model, the model would in no sense be universally applicable. To imply that it would serve equally well in other countries may be dangerous. ‘Nevertheless, the leadership's unusual enthusiasm for the export expansion and timely implementation of required certain government policies, in particular under President Park in the 1960s and 1970s, provided an “assured” economic climate that is similar to the "social climate’ of Schumpeter in which creative, innovative entrepreneurs receive high social prestige in addition to a high rate of income.” The climate, prima facie, must have stimulated dynamism and aspiration among Korean entrepreneurs in their economic activities including investment, production and exports, creating X-efficiency. + Myrdal made distinction between "hard and "soft" states. Inthe “soft” states, economic regulations are seldom enforced, whereas they are strongly enforced and governments can quickly transiaie decisions into action in the “hard” states, Gunnar Myrdal, Asian Drama: An Inquiry into the Poverty of Nations, Pantheon, New York (1968). Benjamin Higgins, op. ct,APPENDIXES: Appendix 1 Statistical Tables for the Korean Economy TABLE Al Developments of Macroeconomic Aggregates from 1962 onwards 1962465197975 t980 1985198099, {in USS bittion) GNP 27 30 88 MB AAT 228s Exportst 0.05 02 09 50 72 64 BBL 752 imports* 04 04 18 6768S 65.1 773 External debts 01 02 23 85 268 350 459 Gnuss) Per capita CNP 7 073 589 1,584 5552 6,745 Por capita exports 2 6 7 2452 1a. 732 * Covering omly merchandise at FOB prices, Sources: Intemational Monstary Fund, Inertial Fiuanclal Stasis (various issues), Washington, D.C.and Bank of Korea, Eamomic Statisties Yertsok (various seuss}, Soul TABLE A2 Contribution of Exports to Industrial Growth in the 19703" (in per cent) 1970-1975 1975-1978, fn Agriculture, forestry and fisheries 155 93 Mining, 217 195.9 Manufacturing 58.8 422 Light 60.1 327 Heavy and chemical 57.6 45.2 Services and others 63.9 181 Fs ees * Ttis based en the 1975 constant prices. Exports indude both merchandise and non- Ihctor services exports. Source: Bank of Korea, Input-Output Tables, Seoul,25 TABLE A3 Main Macroeconomic Indicators in the 19508, | 1953 1955 1957 1959 1961 (in USS) Per capita income 670 65.0 740 810 92.0 (Gn per cent; at current prices) (industrial structure) Agriculture & fisheries 473 445 452 338 30 Mining é& manufactaring 101 126 127 159 155 SOC & other services 426 429 421 503 484 ‘Total 1000 1000 1000 1000 100.0 (in US$ million) (Exports by commodity groups) Food, beverages & tobacco i 1a 34 42 94 Crude materials . 47 146 nz no Manufactured goods : 09 34 2 40 Others : 13 08 18 68 Total 04 130 22 198 409 Sources: Bank of Kerea, National Income Accounts (various issues); and Economic Planning Board, Keres Statistical Yeook 1363, Seoul26 Table Aa: Structural Change of Korean Economy (in per cent) 3625651971975 9809851990191 Exports ratio (D* 14 58 101 37H HS Dts Imports ratio (I)* Wt 9 68H Travte ratio (L410, m8 197 07553. Industrial structure 10.0 1000 1000 1000-1000» 1.0 1000-1000 Agriculture and fisheries 37.0380 26544 B2 78 72 Mining and Manufecturing 164 200 © 2237 24 dH Services and others 6 20 512 a8 Ba 578583. Manufacturing Structure 100.0 10010001000 10.0 © 1000 1000 Light 6735388 B6 34632 Heavy and chemical 32500 4 SA 678 Export structure 1000 1000-1000 100.0 100.0 10001009 ©2000 Manufactured goods 64 825 82k Dts (of which) Textiles 31200 «40862 Foorwear 24 24 38 50 51 64 51 Electronics 23 45 68 65 72 135045 Machinery 14 10 15 22 39 7 80 Ship 0 09 27 35166 43 57 Tron and Steot 102 38 720 4413 89 84 Cars os 1B 33 36 Others 34607818 94 80 54 61 * Asa per cent of GDP. Expors/ Sources: Intemational Monstary Fund, Intormtiona Finacial Stat Imports cover merchandise only. Econom: Statistics Yearbook (various issues), Seo ttc (varlous issues), Washington, D.C; and Bank of Korea,7 Table AS Expansion of Services Exports and Contribution to Improvement in the Balance of Payments in the 1970s (in USS million) 1967 1972 197 1982 1983, Current account 192 362 2 2,650 1,606 ‘Trade account 874 574 7 2594 =1763 Exports 335 1676 10,046 20,79 23,204 Imports 809 2,251 10,523 23,473 -24,967 Invisible Trade 157 43 266 555 435 Receipts 308 556 3,027 ATT 7179 (of which) Overseas construction = u 1,246 2,452 1890 ‘Travel 16 75 370 502 1484 Shipment and insurance u 53 304 1423 1484 Payments 51 513 2,761 8,052 1614 Source: Bank of Korea, Seoul Table A6 Developments of Monetary and Fiscal Indicators in the Early 1980s (in per cent) 1970-74 1975-79 1980 198119821983 1584 19851986 Rate of increase in M2 23 1 69 230 m0 182 77 186 184 Surplus /deficit of budget/GDP AS A6 220 34 BN tad ta Inflation ratet W767 BF B72 8B * In terms of rate of increase in the consumer price index. Source: Dank of Korea, Economic Staistie Yeuruok (various issues), Seoul‘TABLE A7 Major Macroeconomic Indicators in the 1980s 1980 1981 198219831984 19851986 398739881999 Gin per cent RateofgrowhinGNP 307457 1098“ CTS Infetion rte! wy 237288227 én USS bition) ‘Current account 53 45 27 -16 a4 Og 46 99 142 51 ‘rade account 44 36 26 48 40 00 42 77 na 46 Export 172 207 9 2D 7) 23 6) Mo C3) 0 Go Ged CO BO Imports? 216 243 BS 50 74 265 29.7 386 48.2 56.8 (3.1) 25 GD 64) 06 3 02) GO M49 «7H # in terms of increased rate in the consumer price index. 2 The figures in parentheses are rates of increase over the previous year. ‘Source: Bank of Korea, Economic Satctics Verb (various issues), Seoul2 Appendix 2 Key Economic Indicators of Japan in the 1950s and Early 1960s 1951 19521953 195419551956 195719581959 19601961 (in per cent) Growth rate of NPY ona, 13079238 A ROBOT Growth rate of output Electric power na 62 75 60 68 M48 U4 61 147 17S 154 Crude steel M4 75 96 «11 MA B80 82363723317 Passenger cars 50 667 «9 O59 BS BAD 1089515 Rate of inflation® 1 40 75 55 «AS 09 30 10 14 36 53 {in thousand persons) Unemployed na. na, 750-92) 1050 980820 900980750660 Gin USS million) Exports® 1385 1273 1.275 162 2011 2501 2858 2877 3.456 4.055 4.235, G2 61) ©) (7H) Bs GL C43) (7 02 G73 45) Imports? 1995 2028 2410 2309 2471 3230 4284 3,003 3599 4401 5810 (048) 7) 088) (OBO BA G26) 292) 87) 48) 09.4) * Tt shows fiscal year which covers the period from April to March of next year. eis the increased rate in the consumers price index in Tokyo. © At the FOB priess. The figures in parentheses are ratss of increase. "At the CIF prices. The figures in parentheses are rates of increase. Source: The Bank of japan, Exosomic statistics Annual (various Issues), Tokyo.30 Appendix 3 World Bank's Classification of Forty-one Developing | Countries by Trade Orientation (1963-73 and 1973-85) Outward oriented Inward oriented Period Strongly Moderately Moderately Strongly 1963-73 Hong Kong. Brazil Bolivia Argentina Korea, Republic of Cameroon FI Salvador Bangladesh Singapore Colombia Honduras Burundi Costa Rica Kenya Chile Cote dIvoire Madagascar Dominican Republic Guatemala Mexico Ethiopia Indonesia Nicaragua India Israel Nigeria Pakistan Malaysia Philippines Pers Thailand Senegal Sri Lanka Tunisia Sudan Yugoslavia Tanzania Turkey Uruguay Zambia Ghana 1973-85 Hong Kong Brazil Cameroon Argentina Korea, Republic of Chile Colombia Bangladesh Singapore Israel Costa Rica Bolivia Malaysia Cole d/Ivoire Burundi Thailand El Salvador Dominican Republic Tunisia Guatemala Ethiopia Turkey Honduras Ghana Urignay Indonesia India Kenya Madagascar Mexico Nigeria Nicaragua Poru Pakistan Sudan Philippines Tanzonia Senegal Zambia Sri Lanka Yugoslavia Source: World Bank, Wield Development Reyort 1987, Figure 5.1, p. 83.31 Appendix 4 Purchasing Power Parity Exchange Rate of the Korean won’ Carrent account ‘Nominal rate! _ REFER of wort. (USS million) (wis) Case T Case IT 1962 55 1300 86.8 175 1963 143 130.0 75.6 674 1964 -26 2139 98.7 885 1965 8 2664 m3 1000 1966, 104 2713 106.5 954 1967 270.5 98.4 884 1968 2767 96.1 862 1969 288.2 92.7, B32 1970 310.6 92.5 83.0 1971 3472 96.2 864 1972 392.9 1015 911 1973, 398.3 108.3 972 1974 4045 103.9 93.2 1975 4840 108.9 985 1976 484.0 102.7 921 1977 484.0 100.0 B97 1978 1,085 484.0 924 829 1979 4151 484.0 835 749 1980 5321 607.4 89.8 806 1981 —4/t6 6810 B04 802 1982 2,650 731.1 93.4 837 1983 -1,506 7758 98.1 88.1 1984 -1372 806.0 102.9 923 1985 887 870.0 TLS 1000 1986 417 8815 12 998 1987 9854 822.6 102.7 922 1988 14,161 BS 87.2 783 1989 5,056 6715 3 705 1990 ~2172 707.8 5 714 1091 876 7338 79 700 1 The FPPER was computed by this formula: FPPER = El,/PPP where PPP = P,/(vPy + Ww; Pyr El, te exchange rate index of the Kerean won per US. dolla; PPP is purchasing power parity Index P,P, and B, are consumer price index of Korea, US. and Japan, respectively; and w,, and are weight of the US. and Japan, Le, 05 and 05, respectively. An increase decrease indicates 2 depreciation/ appreciation in the value of the Korean won. 2 This denotes the annual average rate and w and $ are Kerean won and US. dcllar, respectively. 3 Case | assumes the year 1977 a an eqquiltrium point and Case Ll the year 1985, ‘Sources: Bank of Korea, Famomic Statistics Yeerfook (various Issues), Seoul; and International ‘Monetary Fund, Interatial Financial Statistics Yearbook (varions issies), Washington, D.C.