Investment Liberalization Success Story: The Case of Korea

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1 Investment Liberalization Success Story: The Case of Korea Yunjong Wang Director Department of International Macroeconomics and Finance Korea Institute for International Economic Policy March 2002 Korea has seen tremendous changes in its external economic relations since the outbreak of the currency crisis. One notable consequence of the crisis is a significant increase in foreign direct investment (FDI), following dramatic liberalization measures and aggressive solicitation of foreign investors. As a result, during the four years from 1998 to 2001, FDI flowing into Korea amounted to US$51.9 billion, accounting for as much as 67.8% of US$76.6 of the total FDI. In this short paper, I would like to introduce Korea s success stories of FDI in both precrisis and post-crisis periods. During the period of pre-crisis, FDI played a relatively minor role in Korea s economic development. In the case of Brazil and Mexico in the 1950s, FDI contributed significantly to the development of their manufacturing sectors, serving large domestic markets and expanding consumer durable and intermediate good industries. Although Korea s export-led growth strategy also went hand in hand with policies of welcoming FDI and establishing new relations with foreign investors in the early 1960s, Korea s industrialization was heavily based on domestic enterprises since Except for the light manufacturing export sectors, state-owned enterprises and government subsidies to domestic firms acted as a balancing factor against foreign firms dominance in heavy industries. A major change occurred in the early 1980s, as the Korean economy began to experience serious difficulties due to the negative effects of the Heavy and Chemical Industry Plan of the 1970s. The new industrial strategy, adopted in the early 1980s, was based on an attempt to upgrade Korea s industrial structure as a whole by moving into more technology- and skill-intensive sectors. A key component of this technology upgrade was recognized to liberalize FDI. 1

2 Foreign multinationals contributed greatly to the technological capabilities of the Korean firms. One of the most successful episodes is found in the Masan Export Processing Zone (EPZ). 1 Following the experience of Kaohsiung (1965), Taiwan, Korea s first EPZ came into operation in This special zone provided an industrial estate where land, utilities, transport facilities, and even buildings were supplied by the government at highly subsidized rates. The Masan EPZ also allowed the duty-free entry of goods destined for re-export. The zone thus sought to attract 100 percent foreignowned subsidiaries that were vertically integrated into the investing firm s marketing and production structure. As a corollary, the relative importance of the zone declined by the mid-1970s. Nevertheless, about 9,000 workers and technicians employed at the Masan EPZ benefited from the opportunity of having an overseas training program until More importantly, subcontracting outside the Masan EPZ increased significantly, contributing to the value-added of products manufactured by foreign investors. These efficiency gains outside the EPZ, induced by the backward linkages, emphatically reflected the existence of technology spillovers through FDI. These human resource development and technology spillover through foreign multinationals provided a basis for domestic firms spontaneous development. The development process of the Korean semiconductor industry also shows the important role of multinational corporations in the area of technology transfer. In the mid-1960s, U.S. firms [Comy (1965), Fairchild (1966), Signetics (1966), and Motorola (1967)] began to assemble transistors in Korea in order to take advantage of its cheap labor. Following the lead of U.S. firms, Japanese firms [Toshiba (1969), Sanyo (1970), and NEC (1970)] entered into joint ventures with Koren firms. Since the beginning of the 1970s, many Japanese firms producting parts have also established subsidiaries in the Masan EPZ. Before Korean firms emerged as competitive rivals in the domestic market, foreign firms dominated the production and export of semiconductor products. Subsequently, multinationals introduced the technology of wafer processing and IC production, and introduced the possibility of the development of domestic firms in this high-tech industry. In the mid-1970s, many Korean firms entered the market by operating simple assembly plants of semiconductor products. However, fierce competition in the small internal market enabled only a few firms to survive. By the end of the 1970s, Samsung and 1 See Byun and Wang, 1995, Technology Transfer and Multinational Corporations: The Case of South Korea, Journal of Asian Economics 6, No. 2, pp

3 Lucky- Goldstar had established firm positions in the semiconductor industry through mergers and acquisitions of domestic firms and joint ventures that went out of business. In the early 1980s, these Chaebol (large business conglomerate in Korea) firms invested heavily in equipment and R&D despite successive annual deficits, since they could internalize the risks of investment. By the mid-1980s, they began to produce highly sophisticated memory chips. As the Chaebol firms became more competitive in the production of memory chips, the relationship between Korean firms and foreign firms changed. During the early stages, domestic firms had made efforts to catch up with foreign rivals in the domestic market. After the Chaebol firms established a dominant position in the domestic market, foreign firms tended to specialize in other subsectors where Korean firms had not yet acquired technological capabilities. The specialization of foreign firms in the high-tech sectors related to the production of memory chips has reduced the technological bottleneck in the Korean semiconductor industry, and is expected to induce new Korean entrants in the near future as technological know-how and expertise spill over to domestic firms. As Korean firms have become more competitive in price and mass production of memory chips, trade and intellectual property disputes with foreign rivals have worsened. As part of their globalization strategy, the Chaebol firms pursued international strategic alliances with major foreign multinational corporations in the same industry. Korean firms, which were weak in ultra-precision processing technology in the original design or inspection of the technology of more complicated and sophisticated DRAM, and in the production of the technology of manufacturing equipment and machinery, tried to take advantage of international alliances as important channels for technology improvement. There have been many success stories since the crisis. Before the introduction of individual cases, I would like to tell you how FDI has contributed to Korea s economic recovery from the crisis. First, FDI is an important source of long-term foreign capital inflows without any increase of external debts. In 1998 when the shortage of foreign exchange reserves was most serious, FDI increased by US$5.4 billion, which amounted to 17% of the year s increase of foreign exchange reserves, US$31.6. Going further, FDI amounted to US$9.3 billion in 1999, as much as 42% of that year s increase of foreign exchange reserves, US$22 billion. 3

4 Second, FDI contributed to weathering the economic crisis by increasing domestic production and employment. Foreign invested enterprises (FIEs) increased employees by 51,300 from 1997 to Third, FIEs contributed to exports. In 1999, the exports of FIEs in the manufacturing sector were US$21.3 billion and their imports were US$16.5 billion, which resulted in US$4.3 billion trade surplus. FIEs export amounted to 15% out of the total Korean export. Fourth, FDI is also an important channel of advance technologies as mentioned above. After the crisis, many Korean corporations faced the challenges of how they should enhance their value added. FDI with advanced technologies and managerial know-hows contributed to enhancing productivity, as well as transforming operations into higher value-added. Fifth, FDI stands as a facilitator to restructure Korean corporate culture. FIEs in Korea brought international practices to their local business partners and clients. Furthermore, foreign investors purchased many subsidiaries previously owned by Korean Chaebols. Although there were some concerns about fire sale FDI, foreign investors mergers and acquisitions (M&A) was an inevitable choice in the whirlpool of bankruptcy crisis for many Korean corporations. Let me now introduce a few success stories among many. Large discount retailers, a form of commerce permitted by Korea s Foreign Direct Investment Law reform, are now emerging in urban Korea. Armed with a combination of marketing technique, capitalization, and superior product-sourcing capabilities, the foreign discounters pose a severe challenge not only to the diffuse, a small-scale pattern of the Korean retail market but also to their Korean counterparts such as Samsung s Home Plus and Lette Department Store s Magnet in their continual bid to provide consumers with ever-low prices. Spearheading this trend is Wal-Mart International. The company opened many outlets and also took over insolvent local discounters. French hypermarket group Carrefour was an early entrant to the Korean market. Carrefour currently operates about 20 sites with a nationwide network. Industry observers see the new competitive environment in the retailing sector as boon to consumers and ultimately the economy as a whole. Although markets are opening and barriers are falling in Korea, there is a perception out there that Korea is a difficult country in which to do business. However, this negative perception is now disappearing in many companies doing business in Korea. British Petroleum is one company that is breaking those stereotypes prevailing in Korea. The company has chosen a path to success that could well serve as a model for others wanting to enter this market and seek real collaboration with Korea s industrial giants. 4

5 BP s concentration in Korea is in chemicals, and their biggest project is a joint venture with Samsung that manufactures 200,000 tons of acetic acid per year in Ulsan. The plant was built in Korea in 1991, basically to meet the rising demand for the chemicals in Korea and around East Asia. BP Korea s president, Jim Graham, says, We knew the growth in demand for the product in Korea was possibly higher than in any other market, with the possible exception of Taiwan. In addition, Korea has a well-recognized ability to manage technology, and we were satisfied that the companies we were considering as partners could handle the technology safely and responsibly. But at the end of the day, everything becomes a balance between achieving your absolute requirements in terms of structure and control, and the need to have safe, reliable operations. Most of foreign investors also felt extreme skepticism towards the Korean labor problems. Let me introduce a successful story of Sony Electronics of Korea. Masan Free-export Complex, where the Sony Electronics of Korea is based, prohibited formation of labor union by related laws up until mid However, at the end of 1980, with sweeping democratization all over the country, the labor union was established even in the prohibited areas such as Masan. Masan Free-export Complex had to confront the extreme situations of permanent shutdown or indefinite suspension of business due to the labor disputes of 1980s. Sony Electronics of Korea also faced the same difficulties as the others. However, the company concentrated all its efforts on labor stability and management. As a result since the establishment of the company (1972), there have not been one walkout or a labor dispute within the company. The company prides itself as the model company that upholds the peaceful relationship between the labor and management. At the beginning of the company, Sony Electronics of Korea had clearly made public of its performance relating to the management. This kind of transparent management system is the cornerstone of building the confidence between the labor union and the management. With transparency comes the proper wage increase and the establishment of a rational wage system. In 1996, the company established the general meeting called Labor and Management Harmonious Resolution and both the labor union and the management made the joint declaration of cooperative working relationship. The declaration promised to settle labor disputes in peaceful manner, expand production, upgrade the product quality and put all efforts to heighten the business competition. The declaration also marked an occasion to reinforce the awareness that the labor union and the management are one body of the company. 5