South Korea’s coming era of stagnation Analysis by Foreign Affairs

The Foreign Affairs magazine has published an article questioning whether Seoul can save its economy from Japanese-style paralysis or not. Caliber.Az reprints the article.

Much of South Korea’s modern history is a record of a spectacular economic and social success. The country rose from the ashes of the Korean War to become an industrial powerhouse. It successfully transitioned to liberal democracy. Names like Hyundai, LG, and Samsung are shorthand for its technological dominance, and K-pop has become a global cultural phenomenon.

But the impressive façade is showing cracks. Long before the pandemic and the current inflation spike, the country’s economy was sputtering and socioeconomic fractures were deepening. It is no accident that another of its recent breakout cultural hits was Parasite, Bong Joon-ho’s dark-humoured thriller on the inequities of modern South Korean society: The gap between the country’s rich and poor is now among the widest in industrial countries. The less fortunate are mired in debt, young Koreans are struggling to find employment, and poverty is pervasive among the elderly.

The fertility rate is the lowest in the world, and the population is ageing at an alarming pace. That is to say nothing of the external uncertainties facing the country, such as the escalating tensions between its two largest trading partners, China and the United States.

The South Korean economy is at an inflection point. If the country pushes forward with bold structural reforms, it could regain its erstwhile momentum. The alternative, more likely by the day, is something more akin to “Eurosclerosis,” or worse, Japanification: high debt, an ageing population, and long-term stagnation. The political challenge runs even deeper. Reversing South Korea’s current path requires bipartisan support for comprehensive reforms, but years of confrontational party politics have crippled consensus building and the ability to compromise. The result often is policy paralysis and a political class struggling to respond to the challenges that lie ahead.

A decline long in the making

South Korea’s long era of Asian-tiger GDP expansion ended two decades ago. Growth downshifted to below five per cent in the early years of this century and continued to decelerate following the 2008 financial crisis. This year, the economy will likely grow by just 1.4 per cent, its second-worst performance since 2009. The years following the Great Recession revealed another worrying trend: the contribution of exports and investment to overall output became increasingly weaker, which was a dramatic departure from previous decades, when exports and investment were powerful drivers that allowed the country to quickly bounce back from recessions.  

One reason is that the forces that once propelled South Korean exports to record heights are in retreat. Some of that pullback has been felt the world over, with the global financial crisis, the pandemic, and deglobalization slowing growth most everywhere in recent years.

In part, however, it is specific to South Korea’s unique industrial structure, with its heavy reliance on manufacturing exports in just a handful of industries, which leaves it vulnerable to sector-specific shocks such as the current tech downturn. Some of these industries are showing signs of decline, having entered a stage of maturity with less room for growth.

Meanwhile, a slowing economy in China—still a key destination for South Korean exports—is depressing demand even as China’s rise as a tech superpower in its own right is creating additional competitive pressures. Once the darlings of Chinese consumers, South Korean cosmetics, smartphones, cars, and information technology products have all lost large chunks of market share in China. Their losses have been exacerbated by Beijing's response to Seoul's decision in 2017 to deploy a US antimissile system, which included nontariff measures against South Korean products and a ban on group tours to Korea.

Underpinning the country’s economic slowdown is a steep, decades-long decline in labour productivity growth. That decline, in turn, is largely explained by the slowing pace of capital accumulation and plummeting growth in total factor productivity—a measure of how efficiently an economy allocates resources and harnesses technological progress, among other things. As a result, labour productivity and total factor productivity levels remain strikingly low compared with nations in the Organization for Economic Cooperation and Development and fellow Asian-tiger economies.

In 2019, South Korean workers were only about half as productive as their American counterparts, measured by output per labour hour. Much of this labour productivity gap is explained by South Korea’s poor total factor productivity, which stood at just 37 per cent of the US figure. Little has changed in the years since. Simply accumulating more physical and human capital alone will likely have limited effects on productivity, partly because the country already has relatively high levels of them. Moreover, the exceptional export growth and investment levels seen during the heyday of globalization are likely a thing of the past.

The real problem behind South Korea’s low productivity lies elsewhere: in its structural rigidities in the product and labour markets and in its poor-quality institutions. Outdated or excessive business regulations, entry barriers for startups, and the dominance of conglomerates all shield its companies from healthy competition while often frustrating innovation and entrepreneurship.

Likewise, administrative red tape, pay based on seniority rather than performance, and inflexible hiring and firing rules—including strong employment protection for regular, often unionized, workers—prevent firms from quickly adjusting their workforces to new technologies and business opportunities. This is one of the factors driving up the country’s youth unemployment, and it has also caused an ever-greater reliance on so-called nonregular workers, such as temporary contract workers, whom employers hire to avoid burdensome requirements and constraints. Last year, these nonregular workers made up 37.5 per cent of the total workforce.

South Korea’s institutional problems extend even into the halls of public power. A dynamic and innovative economy needs a state that fosters public trust and puts up guardrails against rent-seeking and corruption. On this front, too, the country is falling short. There is, to name just one example, widespread suspicion that its judiciary is corrupt and fails to sanction abuses of power by the rich and powerful. Claims of judicial capture are not without merit, considering that judges who miss out on a coveted promotion often resign to join the legal teams of the chaebol, South Korea’s large business conglomerates.

Even the education system has not kept pace with the times. Instead of learning to think critically and master basic science and technology, students are condemned to rote memorization. That traditionalism is not suited for a knowledge economy that runs on creativity and multidisciplinary thinking. No wonder that South Korea has seemingly failed to produce much high-tech innovation despite having the world’s highest percentage of college-educated 25- to 34-year-olds.

The upside is that taking on these structural bottlenecks could still unleash major gains in productivity and, by extension, growth. The country’s stagnant service sector holds particular potential in this regard. The sector is beset by a lack of access to finance, low investment in research and development, anticompetitive behaviour by large enterprises, and excessive regulations. As a result, its productivity is only about half as high as that of the manufacturing sector. Regulations, in particular, often make it harder for new technology and businesses to succeed.

Consider the case of Tada, a South Korean van-hailing service that in recent years gained explosive popularity with more than 1.7 million users—that is, until lawmakers, responding to criticism from established taxi operators, passed new rules in 2020 requiring drivers to hold a taxi license. Tada went out of business shortly thereafter. Strict financial regulation, albeit intended to safeguard financial stability, has hobbled and slowed the country’s financial technology industry. Internet banks, for example, were long prevented from scaling up by banking rules that prohibited them from raising more than four per cent of their capital from tech companies and other nonfinancial firms. It took lawmakers more than two years, until 2018, to raise that limit to 34 per cent.

An overhaul of the regulatory framework would help correct these distortions. It would also nurture a more vibrant and competitive business ecosystem. Loosening the labour market, for instance, could facilitate job creation, make it easier for workers to move into the firms and sectors that best match their skills, and allow entrepreneurs and innovators to pursue ideas and ventures without the constraint of rigid employment structures.

To manage the resulting disruption, labour market reforms should go hand in hand with measures to strengthen the social safety net. No less essential, considering South Korea’s looming demographic challenges, are efforts to retrain and reskill older workers, in conjunction with revisiting questions around the retirement age and pay and pension systems. Doing so will reduce the drop in labour supply and the fiscal burden that an ageing workforce will entail.

Tackling structural issues would help lessen inequality, too. To be sure, some of that inequality is driven by the same complex processes of technological change and globalization with which other economies are grappling. But South Korea’s income disparities are also an outgrowth of its structural problems, including its rigid labour market, the gulf between a relatively productive manufacturing sector and a far less productive service industry, and a decreasing but nonetheless persistent gender pay gap.

Compound risks

In the best-case scenario, South Korea manages to enact sweeping structural reforms while global growth recovers from its current slump. Long-term economic forecasts are imprecise and fraught with uncertainty, but under the right conditions, the country might be able to sustain growth near, or perhaps even above, three per cent over the next ten years. Absent improved global economic conditions and an ambitious domestic overhaul, however, annual growth could drop to as low as one per cent by the late 2020s.

In the worst-case scenario, multiple risks compound to perpetuate stagnation over the next decade and beyond. Beside rapid population ageing, such risks include an outright financial crisis or, more likely, a negative feedback loop between subpar growth and growing financial distress among highly indebted households and small businesses. The ingredients for this toxic mix are already present: growth is lackluster, private sector debt is high, and the housing market is shaky. Many countries experienced rapid debt buildups during the pandemic, but debt levels in South Korea were already troubling going into the crisis.

Household debt is now at a record high, standing at 106 per cent of GDP and about 166 per cent of household disposable income. Overloaded with obligations, many Koreans are vulnerable to adverse shocks—and such a shock is now materializing in the form of inflation and high interest rates. Meanwhile, the housing market is facing the prospect of a prolonged downturn. After nearly doubling within just a few years, house prices in Seoul have fallen more than 20 per cent from their 2021 peak and are expected to fall further.

Although worrisome, household debt is a drag on growth more than it is an immediate threat to South Korea’s financial stability. Thanks to stringent regulations on lending and substantial down payment requirements, most borrowers can still service their debts for the time being. Still, the medium-term risk of a negative feedback loop remains. The rise in the number of firms struggling to service their debts is particularly troubling. The percentage of South Korean companies whose operating income cannot cover the cost of debt servicing has been rising for years. In 2021, the most recent year for which comprehensive data is available, it reached 40.5 per cent of all companies in the country.

Asleep at the wheel

Even if it averts economic calamity, South Korea will contend with the political fallout of slowing growth and rising inequality for the foreseeable future. If enacted, structural reforms will bring economic disruption and the potential for social conflict—between the vested interests of the old guard and the newcomers, between the winners and losers of economic change. To mitigate such conflict and ward off the rise of populist leaders with myopic solutions requires a government that can engage diverse stakeholders in a constructive national dialogue, something the South Korean political class has proven incapable of so far.

Take the conservative administration of Park Geun-hye, who served as president from 2013 to 2017. Park put forth an ambitious reform agenda that encompassed education, labour, the public sector, and the service industry. Yet aside from some progress on public sector reform, her plans ran aground in the face of concerted resistance from the main opposition party and labour unions.

In a sense, Park had the right idea when it came to economic reforms but embodied some of her country’s other systemic issues, above all its weak institutions and persistent corruption. Her impeachment in 2017 and later conviction on charges of abuse of power and corruption was a historic watershed. Many hoped that the liberal government of her successor, Moon Jae-in, would catalyze much-needed changes beyond the realm of economic reform. Moon was given a strong mandate to restore public trust in the government, and his pitch for a more just society resonated broadly.

But to implement that vision, his administration often took a blunt interventionist approach that only exacerbated labour market rigidities, regulatory burdens, and social polarization. Even before the pandemic, job creation in the private sector had at one point ground to a near-total halt. Housing prices soared, wealth and income inequality rose, and growth expectations worsened.

The most recent election, held last year, pitted Lee Jae-myung, a popular candidate of Moon’s party who vowed to fight social inequities with progressive policies, against the right-wing opposition candidate Yoon Suk-yeol. That Yoon managed to eke out a narrow victory over Lee is a testament to the depth of voters’ economic dissatisfaction and anger at the then ruling party. Yoon, for his part, has pledged to revitalize the economy by rolling back outdated regulations and reforming the labour market, public pensions, and higher education. But he lacks a majority in parliament and his first year in office has been marred by missteps, scandal, and controversy, frustrating initial hopes that he might unify an increasingly polarized electorate.

The travails of Yoon and of his predecessors underscore a sobering new political reality. South Korea’s supercharged exports once offset or at the very least masked policy mistakes and social fault lines at home. That balm and binding glue is gone in an era of slow growth. Instead, the stakes are higher than ever for the government to get economic policy right—and even if it does, the painful adjustments this will entail will bring social and political discontent of its own. The country needs reform-minded and bold leadership that can transcend the political divide. Perhaps, then, South Korea’s best hope is that a future generation of politicians lives up to that task.