The impeachment of President Park Geun-Hye has plunged South Korea into election season. In less than two months, the world’s 11th-largest economy will have a new chief executive. Regardless of who wins the election, addressing the challenges facing the South Korean economy should be a high priority. The country is experiencing not only near-term pressures from a weak regional growth outlook and tensions with major trading partners, but must also prepare for medium term headwinds that include a shrinking labor force, rising inequality, and high levels of household debt.
Beginning in the 1990s, Japan fell into a protracted economic slump that has lasted through the present day. This is now referred to as the “lost decades.” To avoid risking a similar outcome in South Korea, the next administration will need to pursue an aggressive domestic reform agenda.
South Korea’s modern prosperity makes it easy to forget how far the country has come since the end of the Korean War. At the time, the South’s GDP per capita was less than $1000, and the North was the richer half of the peninsula. It took well over a decade, and billions in American aid, to reverse this position, but South Korea has since become one of the world’s greatest development success stories. Today, it has a per capita GDP of more than $35,000, full membership in the Organization for Economic Cooperation and Development (OECD), and a host of world-famous manufacturing and cultural brands, from LG and Hyundai to Big Bang and BTS.
Despite this history of success, the medium-term outlook for the South Korean economy is weak. South Korea is the world’s fastest-aging economy, and is expected to see its labor force decline by 0.94 percent a year from 2020 through 2050. Given the country’s already large capital stock, this means that most future growth will need to come from productivity increases—especially in the service sector, where South Korea has traditionally struggled. Unfortunately, recent trends have moved in the opposite direction, with South Korea’s average annual productivity growth over the past five years marking a dramatic slowdown from historical levels. On the demand side, rising security tensions in the Asia Pacific and the likelihood that global trade growth will remain sluggish mean that boosting domestic consumption will be vital to future economic prospects. However, the combination of a weak social safety net, high household debt levels, and elevated levels of youth unemployment all suggest that this will be difficult to achieve. Finally, China and other emerging markets are embracing aggressive industrial policy measures that are already putting renewed pressure on South Korean manufacturers of goods such as LCDs, integrated circuits, and industrial robots.
A near-term economic meltdown is unlikely. South Korea has solid macroeconomic fundamentals, including ample foreign exchange reserves, low public debt, and an outsized current account surplus. Even facing a series of rates hikes by the Federal Reserve, the value of the won has held relatively stable, the main KOSPI Index is near a five-year high, and both consumer and business confidence have begun to recover from the lows reached during the impeachment process. Add to this an accommodative monetary policy stance by the Bank of Korea and the likelihood that the next administration will act swiftly to put forward a fiscal stimulus package to shore up any near-term weakness, and South Korea’s GDP growth in 2017 will likely reach the 2.7 percent the IMF projected back in October 2016.
Nonetheless, debt, demographics, and slowing productivity together suggest a real possibility that South Korea is facing a “lost decade.” In this context, the next administration might be tempted to look outward for opportunities to boost growth. This has been South Korea’s traditional policy approach, and helps explain why the country boasts a trade-to-GDP ratio of over 100 percent, unusual for its size and level of development. However, such a policy is likely to prove ineffective—if not counterproductive.
First, there is little scope for South Korea to boost exports through policy, such as expanding its network of free trade agreements (FTAs). Seoul has already negotiated deals with China, the United States, and the European Union, the world’s three largest markets and South Korea’s three largest trading partners. The economic benefit of further agreements will be marginal at best—and the next administration will likely have its hands full just managing relations with current FTA partners. The Trump administration has signaled that it views the current balance of the bilateral trade relationship as tilted unfairly in Seoul’s favor. It is looking to redress this perceived imbalance. Less than two years after the conclusion of the South Korea-China FTA, the Chinese economy continues to slow and Beijing is pursuing both an aggressive campaign of economic coercion against its smaller neighbor and an ambitious industrial policy agenda. Both are ill portents for South Korean exports, especially in high technology sectors. Growth prospects in Europe are also likely remain limited, given the slow pace of the bloc’s post-crisis recovery. In short, none of South Korea’s largest markets would appear to offer much in the way of near-term opportunities.
Second, there is a strong likelihood that doubling down on exports would undermine the country’s long-term economic development. South Korea has an unusually large and unusually export-oriented manufacturing sector, but its domestic service sector is a comparative laggard in terms of both productivity and share of overall economic activity. These outcomes are closely related; the same historical policies that fed (and continue to feed) resources into building a manufacturing powerhouse have helped to starve the South Korean service sector. Further pursuing this approach is nonsensical. South Korea’s low service sector productivity means that services are where potential productivity gains are greatest. Investments of political capital in this area will likely generate greater returns than comparable efforts aimed at boosting manufacturing exports. Moreover, modern manufacturing is a sector where labor intensity is low and falling. Continuing to funnel resources in this direction will generate few to no additional jobs and further retard service sector development, the latter of which may be one of South Korea’s best opportunities to help mitigate its proliferating social ills.
Instead, the next administration should look to pursue an aggressive structural reform program at the outset of its first—and only—five-year term. Given the centrality of productivity growth to the country’s economic future, two areas deserve special attention: labor market reform to increase the efficiency of human capital allocation; and deregulation to improve broader resource allocation and reduce barriers to entry and exit, especially in the service sector. This will be a complicated process, requiring Seoul to overcome powerful vested interests and act on multiple fronts simultaneously. For example, doing away with excessively rigid laws governing the firing of workers is likely to be both ineffective and a political non-starter without accompanying measures to improve a weak social safety net. However, South Korea has few alternatives; the threat of a lost decade has emerged at a time when its enjoys a lower level of average income than did Japan, greater inequality, and less accumulated wealth. It also faces a far more competitive and uncertain global economic landscape.
Like much of the developed world, South Korea is in a difficult position as the effects of globalization become more sudden, more individual, more unpredictable, and more uncontrollable. From the pressure cooker of the education system to the intensity of civil service application processes, South Koreans have shown they are willing and able to compete with an extraordinary degree of intensity, but sustaining the country’s success will require channeling these energies in new directions. This will likely be uncomfortable and controversial, both for those currently ensconced in positions of privilege and for those struggling to make ends meet. However, there are no risk-free options for South Korea. The next administration has two choices: embrace the risks inherent in bold reform or accept the risks inherent in inaction. The former, at least, offers some upside.
