Causes of the Decline in Korea s Long-term Growth Trend: Expenditures

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1 MONTHLY FOCUS NO Causes of the Decline in Korea s Long-term Growth Trend: Expenditures By SHIN Changmock 1

2 I. Korea s Long-Term Growth Trend Korea s long-term trend growth, which had been nearly % in the 197s and 198s, has been falling continuously since the 199s. From the enactment of the First Economic Development Plan in 1962, Korean successfully pursued export led industrialization, showing trend growth of 9.2% between 1971 and 199. However, after 199, Korea s long-term trend growth declined markedly, falling to less than % after the foreign exchange crisis, and then falling further to the 3% range after the global economic crisis. Figure 1. Korea s Long-Term Growth Trend 2 1 Real growth rate Long-term trend growth Source: Bank of Korea, Samsung Economic Research Institute. 1. Declining Factor Input and Stagnation in Productivity Growth is determined largely by two factors: production inputs (i.e. labor and capital) and the effectiveness of such production inputs (i.e. productivity). Continuous weakening of these two factors has been indicated as the cause of Korea s growth decline, with most existing research focusing on productivity. On the labor side, labor input has decreased continuously due to population aging and the introduction of the five-day workweek. Rapid aging in the population has slowed growth in the working population (i.e. those aged 1 to 64), and in 2, for the first time ever, brought about an actual decline in the core productive population of people ages 2 to 49. The introduction of the five-day workweek decreased the average number of days worked per month to 21., with the average number of working hours per week falling to

3 Table 1. Trends in the Annual Average Increase in the Productive Population (Unit: %) Classification Core productive population (2 49) Productive population (1 64) Average weekly hours worked Note: Data for average weekly hours worked was available from 198. Source: Statistics Korea. On the capital side, investment declined continuously after the 1997 financial crisis, while efforts to improve productivity have not met expectations. Growth in facilities investment averaged more than 1% annually from 197 to 198; however such growth fell to the % range in the 199s, and then to the 3% range after the foreign exchange crisis. While investments to improve productivity (including R&D spending) have increased, the absolute scale of such investments has not been enough to promote growth in the economy. Table 2. Trends in R&D Expenses Classification R&D expenses ( million won) 69 41,84 121,88 344, ,48 Share of GDP Source: Statistics Korea. 2. The Foreign Exchange and Financial Crises Have Accelerated the Decline in Korea s Growth As mentioned previously, the economic crisis faced by Korea after the 199s accelerated the decline in long-term trend growth. Long-term trend growth, which had averaged 7.2% annually from 1991 to 1997, fell to 4.7% from 1998 to 28 after Korea underwent its foreign exchange crisis. Investment contracted as businesses became more conservative, while labor input declined as large corporations went bankrupt and mass layoffs ensued. Korea s annual average long-term trend growth fell further to 3.8% from 29 to 211, after the global financial crisis. The ensuing credit crunch constrained investment due to rising capital procurement costs (including strengthened financial regulations), and spurred a fiscal crisis in advanced economies, increasing economic uncertainty and depressing production. 3

4 Table 3. Annual Average Growth Trend by Time Period (Unit: %) Classification Real economic growth rate Long-term trend growth Source: Samsung Economic Research Institute. II. Analysis of Factors in the Decline of Korea s Long-Term Growth Trend: Expenditures In contrast to the existing research that focuses on production, this paper looks for the causes of Korea s growth decline in its expenditures. To this end, this paper performs quantitative analysis of Korea s chronically lagging domestic market, and the inability of domestic demand to function as a growth driver and safety valve for the economy. Clear Decline in the Growth Trend for Domestic Demand Domestic demand, i.e. private consumption and facilities/construction investment, showed a clear decline after the 199s in its long-term growth trend. Although private consumption showed stable annual average increases of 7.3% from 1971 to 199, growth declined from the 199s onward, falling to 2.8% by 211. Private consumption became markedly unstable after the foreign exchange crisis (1997), the household credit crisis (23), and the financial crisis (28), and today, is undergoing a long-term slump. The decline in private consumption arises from anxiety about future household income due to increasingly insecure prospects for employment, education, and financial security. Facilities and construction investment have likewise shown a clear decline. Increased dependence on imported capital goods due to a weak parts and materials industry, as well as increased investment in intangible assets as Korean industry reoriented itself toward IT has caused long-term trend growth in facilities investment to fall to the 4% range after the global financial crisis. Long-term trend growth in construction investment, which fell after the 199s, has continued to stagnate over the past few years, dropping to.3% after the global financial crisis. 4

5 Figure 2. Real Growth Rate and Trend Growth Rate for Domestic Demand Private Consumption Facilities Investment Construction Investment Actual increase Trend increase -1 '71 '76 '81 '86 '91 '96 '1 '6 ' '71 '76 '81 '86 '91 '96 '1 '6 ' '71 '76 '81 '86 '91 '96 '1 '6 '11 Source: Bank of Korea, Samsung Economic Research Institute. Exports Remain Comparatively Stable Korea s international trade in goods and services recorded stable long-term trend growth of 12.% and.2% respectively from 1981 to 211. Korea has successfully diversified its export destinations due to enhanced export competitiveness and symbiotic development of traditional heavy industry and IT. Exports to advanced markets (which accounted for 62.2% of Korea s total in 1991) declined continuously to reach 27.4% in 211. This indicates that Korea has successfully broadened its portfolio into emerging economies. Accordingly, even after the global financial crisis, Korea was able to become the world s 7 th largest exporter based on its competitive industrial structure of heavy industry and electronics. At the same time, imports have maintained long-term trend growth due to the internal structure of Korea s industries, where growth in exports tends to increase imports. The import inducing coefficient for exports has continuously increased from.3 in 199 to.33 in 2, while the amount of imports induced per unit of exports has shown an increasing trend. Furthermore, the share of imports intended for use in production of exports has increased from 3.3% as of 1991 to 39.9% as of 211.

6 Figure 3. Real Growth Rate and Trend Growth Rate in Korea s International Trade Export of Goods and Services Import of Goods and Services Real increase Trend increase '71 '7 '79 '83 '87 '91 '9 '99 '3 '7 '11-2 '71 '7 '79 '83 '87 '91 '9 '99 '3 '7 '11 Source: Bank of Korea, Samsung Economic Research Institute. Domestic Growth Drivers Are Weakening, While Export Growth Drivers Are Strengthening Analysis of the contribution of domestic demand and exports to potential growth indicates that the main causes of the decline in Korea s long-term trend growth are stagnant domestic demand and weakening growth drivers. In particular, private consumption, which accounts for half of the people s economy, weakened the most in its contribution. Private consumption had formerly played a major role in promoting long-term trend growth, adding an annual average of 4.% percentage points to long-term trend growth from 1971 to 199. After the foreign exchange crisis, however, private consumption weakened significantly, contributing only 1. percentage points to long-term trend growth from 28 to 211. Facilities and construction investment also weakened considerably as growth drivers after the 1997 foreign exchange crisis. Before the foreign exchange crisis, facilities and construction investment contributed an average of one and two percentage points respectively to long-term trend growth. After the foreign exchange crisis, facilities investment contributed only.4 percentage points, while construction has ceased contributing to growth due to an extended recession in the construction industry. On the other hand, exports are gradually strengthening as a growth driver, and have continued to drive the economy even after the foreign exchange and financial crises. From 1971 to 199, exports contributed an annual average of 4.2 percentage points to long-term trend growth, and this actually increased after the financial crisis, contributing an annual average of 4.3 percentage points from 1998 to 28. Exports have in effect displaced private consumption. Furthermore, from 29 to 211, after the financial crisis, exports largely drove the recovery of the Korean economy by contributing an annual average of 4.9 percentage points to trend growth. At the same time, however, the continuation of an export led economy has increased Korea s dependence on foreign trade, and worsened polarization between exports and the 6

7 domestic market. Korea s trade dependence worsened from 64.4% in 2 to 97.1% from the first to third quarters of 211. Table 4. Trends in Contribution to Economic Growth by Expenditure Item for Each Period (Unit: %, % point) Period Annual average contribution (percentage points) for main expenditure items Annual average trend growth rate Private Facilities Construction Exports Imports Other consumption investment investment Note: 1) Contribution to economic growth is the degree of contribution to the increase in long-term trend values for GDP by each expenditure item s long-term trend value. Actual contributions to economic growth for each expenditure item may differ. 2) Exports and imports refers to exports and imports of goods and services 3) Other includes government expenditures, intangible fixed assets, changes in inventory, and statistical discrepancies Source: Samsung Economic Research Institute. III. Summary and implications Korea Urgently Needs to Restore Domestic Demand as an Economic Growth Driver While Maintaining Growth in Exports Domestic demand is weakening as a driver of domestic growth, and is not functioning as a safety valve for the economy, making the revival of domestic demand an urgent priority for Korea. In particular, the slump in domestic demand after the second half of 211 constitutes a stumbling block to Korea s recovery, and is making itself felt in the long-term growth trend in Korea s economy. Accordingly, reviving domestic demand and increasing its contribution to the economy will be critical to reviving Korea s long-term growth potential, let alone its short-term economic recovery. At the same time, exporters, the strong point of the Korean economy, must maintain and develop their competitiveness if the Korean economy is to maintain stable growth. Korea, as a small and open economy, has inherently limited domestic demand, and exports will be a necessary growth driver in the future. 7

8 Figure 4. Proposals for Improving Korea s Long-Term Growth Trend: Focusing on Expenditures Private consumption must be revitalized to increase the long-term growth trend as it has been the most important factor in its decline. In the short-term, it will be necessary to control inflation and household debt, which are the main cause of stagnant consumption. In the mid to long-term, it will be necessary to address anxiety about future income by expanding employment opportunities. When consumers have weak expectations about their ability to maintain a stable income throughout their lives, they have strong incentives to constrain their current consumption. Revival of facilities investment is also critical to recovery of the growth trend. Korea s weak parts and materials industry does not provide sufficient support for manufacturing, ensuring that increasing exports increases imports. Parts and materials will thus be critical to revitalizing facilities investment. Efforts also need to be made to improve the business environment, which can ensure an appropriate scope for the overseas activities of domestic businesses. Finally, more effort needs to be made to train the core personnel that can improve the quality of facilities investment. It is also necessary to ensure that Korea s already strong exports continue to be stable. To this end, pioneering of new markets and conclusion of FTAs can ensure that Korea has stable access to markets. Discovering new growth engines and securing global competitiveness in new growth industries can also enhance the competitiveness of Korea s exporters going forward. 8

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