Asian Economic History Essay, Research Paper

Brief Economic History and Government Policy

Korea was one of the poorest countries in world after experiencing two wars. World War II and Korean war (1950 ~ 1953). The country even experienced a food shortage so that it had to heavily rely on the foreign aid. Yearly per capita consumption was a mere $88 as late as 1965. However, since 1965, Korea has been transformed from its underdeveloped agricultural economy to a leading Newly Industrializing Country. Between 1965 and 1981, its gross national product GNP multiplied twenty times from $3 billion to $63 billion and per capita GNP increased sixteen times from $88 to $1,554.

There have been many explanations for Korea?s successful story. Among those, the strong role of government would be probably the most important one. At the same time, this would be also responsible for current recession.

After Koran war, the government in fact had no sense of direction and also due to the unstable political situation, the country didn?t have specific economic policy until 1961 when military government came to power and established the major institution guiding its economic planning called Economic Planing Board (EPB). This government set economic development as the top national priority and recognized the financial system in support of economic development plan. To achieve this purpose, it focused its policies mainly on export expansion moving its emphasis from import substitution. The result was considered quite successful for economic growth. Between 1965 and 1973, exports grew at average annual rate of 45%, from $175 million to $3,271 million. The success of the expansion was due primary to three factors (Kwack, 72). The first was a favorable international economic environment, which saw total world imports expand from $175 billion in 1965 to $536 billion by 1973. This boom in imports of the world reflected the fact that the industrialized had not yet erected import barriers against exports from developing countries and were, on the contrary, quite active importers of cheaper goods from Newly Industrializing Countries such as Korea. A second significant factor was the Korean government?s policy of promoting exports, which was set in motion in 1965. Initially, the government introduced a number of fiscal and financial incentives, which I will discuss more later. A third factor was Korea?s abundant and highly productive labor force. This gave Korea a strong comparative advantage in producing labor intensive products and provided the impetus for the notable expansion for exports. In order to expand total exports over time periods, however, Korea turned to new export industries that were expected to have a comparative advantage with abundant labor, but skilled labor at this time, such as shipbuilding, electronics, and steel industries. This attempt was viewed as a manufacturing shifting of its emphasis from light industries to heavy industries which later started to produce intermediary goods as substitutes for imports (Kwack, 77). However, this government?s promotion of heavy industries for large-scale economies led to under-investment in light manufacturing industries causing productive gap between small and large firms. Actually, the large firm that runs heavy industries has been given priorities, and small and medium firms relatively disregarded in government?s allocation of loanable funds and other administrative preference. As a result, conglomerates later known as chaebol (family owned conglomerate) have been formed through this expansion of heavy industries.

Government?s Policy Before 1961

As seen above, the Korean government has been focused on import substitution for economic growth during 1953 ~ 65 period and followed by export expansion policy after 1965. However, to progress its policy efficiently, the government had to face to one of serious problem, poverty. After two major wars, the country even with a food shortage experienced lack of capital. There was no source for savings and investment to finance economic growth domestically, so it depended heavily on foreign capital which inflow in a form of mostly aid and loan in the early stage of economic growth. The proportion of foreign capital to total capital formation in 1965 was approximately 40 percent.

In addition to inflow of foreign capital, the government faced allocation of capital with using its financial system. Before the military government in 1961, the loan decisions of commercial banks were heavily influenced by political interference (Haggard, 26). Well, in fact the loan decisions in Korea mostly were affected by political interference rather than bank themselves until recent time, but during the 1948 ~ 1961 period, the rent generated by low interest rate was used for its political activities rather than economic growth.

Government?s Export Promotion Policies

In the economic development, the government?s creation of economic rent for certain segments of business takes critical role. It can be either a source of political and bureaucratic corruption, but if wisely used, it can be a useful or powerful policy instrument in supporting business operation and government policies. Furthermore, it can increase capital formation in the country if it effects a redistribution of income from consumption to investment activities (Haggard, 23).

Since the mid 1960s, the military government used regulated finance as one of tool to create rent and achieve exports expansion. What it did were nationalizing commercial banks and amending the Bank of Korea so that it can control financial systems directly. In general, the Bank of Korea, in its role as the country?s central bank, determines the allocation of loans, interest rate level and the supply of money but the decision making in these area is controlled by the Minister of Finance. In other words, it was government?s responsibility generating monetary and fiscal policy, not by the central bank.

Since foreign aid started to decline later 1960s, the government reformed interest rate. It raised the interest rate on (one-year) time deposits from 15% per year to 30% per year and general loan rate from 16% to 26%. The reform successfully attracted private saving. In the first three months after reform, saving deposits increased by 50%. More importantly, this meant more rent, in other words, more capital to be distributed under government influence.

In addition, the financial reform contributed to a massive inflow of foreign loans due to the existence of gap between domestic and international interest rate and since the Korea Development Bank guaranteed to pay back to foreign lender, the inflow of the loans were accelerated.

Also this gap of interest rate was used to promote export expansion which was the most economic priority. For example, while domestic interest rate was so high comparing with international rates, the exporters, mostly big business in heavy industry, were able to get loan at little interest rate. They were not only able to get low interest rates, but variety of supports that the government could do such as tax break and easy approval of the loans for exporters. For example, profits earned on exports have been exempt from corporate or individual income tax and the short-term export credit system gave borrowers holding export letters of credit (L/C) ?automatic approval?.

As a result, an increase in domestic savings and huge inflow of foreign borrowings had positive effect on economic growth in Korea due to an increase in capital accumulation.

Controlling exchange rate is another good example to describe the effect of government?s role on Korean economic development. After switching its economic policy from import substitution to export expansion in the mid-1960s, the Korean government officially moved from a fixed parity to a unitary floating exchange rate system. Although the exchange rate system has been ?floating?, its actual (real) rate was managed by government?s market control and Korean currency ?won? was undervalued mostly against the U.S. dollar so that the price of exports remain cheap.

Followings are the plans that the Korean government set over time period as a guide for economic growth. They are quite helpful to understand how major government?s policies on financial sector have been varied with given the world economic situations like oil crisis and its own economic recession.

The First Five Year plan (1962 ? 1966)

The first plan was prepared in a hurry by the military government that took power in 1961. The major contents of fiscal and financial policies as stated in the plan document were largely about the tax, budget, and monetary system, financial market and foreign exchange system. During this period, its main purpose was, however, to expand exports as much as possible by providing export firm with cheap loans, tax benefits, export compensation schemes, and various administrative support. Economic growth in this period was result by an increase in export and output and as well as price level (since output and price level are positively correlated), so there was inflationary pressure at the end of the first plan- actually the inflation rate exceeded 23 percent in 1964.

The Second Five-Year Plan (1967 ?1971)

During this period, the major reforms include a financial reform assuring positive interest rate in 1965, and exchange rate reform normalizing highly overvalued exchange rate, and trade reform allowing wide imports of parts and machinery used for the production of export goods. These reforms were reflected in the second plan and carried further throughout the second plan period. In addition, there was an increase in domestic savings and a decrease in foreign borrowing.

The Third Five-Year Plan ( 1972 ?1976)

The third five-year plan put its major emphasis on the promotion of heavy and chemical industries. The government made great effort to raise domestic savings to finance the heavy and chemical industries, but the amount of domestic savings fell far short of investment requirement. As a result, foreign borrowing expanded enormously, and management of foreign borrowing and debt became a major policy issue.

In addition, due to different emphasis on light and heavy industries, the growth gap increased substantially.

Inflation caused by the first oil shock in 1973 also takes a part of unstable situation of economy. Inflation rate exceeded 40 percent in 1974.

The Fourth Five-Year Plan (1977 ? 1981)

Because of high inflation cause by the first oil crisis, stability was given relatively high policy priority. The government adopted monetary rule of fixing money supply growth at a prescribed constant rate of 20 percent per annual to stabilize price level and overall economy.

He major change in trade policy during the fourth plan period included the expansion of imports related to exports, maintenance of effective exchange rate, expansion of export subsidies, tax benefits and foreign loans to export firms. In addition, the government improved the number of industrial estates for export firms by creating industrial export estates and free export zones.

The fifth Five ? Year Plan (1982- 1986)

In the early 1980s, the Korean economy was characterized by very slow growth rapidly expanding foreign debt, and high inflation. Consequently, export promotion was given the highest policy priority again, so the major change in trade policy included intensive promotion of export goods and market diversification, reform of the export support system, lowing tariff rates to expand importation of good used in manufacturing.

The Sixth Five year Plan (1987 ? 1991)

As of 1986 the Korean economy realized high economic growth, stable price, and a trade surplus and thus faced a new phase of growth with enhancing the efficiency and strengthen the international competitiveness of the Korean economy in general by reforming the free enterprise market system. Thus the major contents of policy reforms included the dramatic reduction of various government regulations constraining growth of enterprises plus extensive promotion of liberalization of finance, imports and foreign exchange.

The Seventh Five ? Year Plan (1992 ? 1996)

This plan was formulated after Korea became a member of the United Nations and emphasized the role of private sector in preparation and implementation of the plan.

The Eighth Five ? Year Plan (1993-1997)

The preparation of this plan started with the beginning of the Seventh Republic and the plan emphasized that management of the economy will no longer be government led or government controlled, as in the past, but will be based on the participation and innovative spirit of the Korean people. It also stresses the importance of reform of finance, government administration, budgets, ethics, etc.

Even though the government on each period recognized the problems it was facing and made five-year plans, they were not always successful. Throughout the plans above, we will be able to find a common policy used without difficulty. That is the government?s massive supports toward export firms. It must work during the early stage of development when the country had little capital accumulation. However, the government?s unbalanced incentives on big businesses which are mostly in heavy and chemical industries, later known as chaebol, actually led them to depend too long on protection and debt financing. This policy wasn?t a serious problem when the economy boomed, but when it slowed, most debt ridden firms fell back on the government for relief causing the issue whether the policy and the industry are efficient or not. (Haggrd, 24). For example, the combined sale of the five largest big companies, chaebol, take 37percent of Korea?s gross out, and their exports were 44 percent of total exports in 1997. If there is a little slow down of the one of the largest business, then it is obvious the economy is not in quite safe situation. Since chaebol?s share of Korean economy is already huge, if they are allowed to fail or banks are to write off their debt, then the whole banking system would be pushed into collapse. This is real problem, nor chaebol or their associated companies, be easily shut down (Economist). As a example, the price of a 16 MB dynamic random access memory (DRAM) chip fell from more than US $40 in January 1996 to less than US $10 by the end of 1997. The dollar export price index for Korea?s electronic components fell by 50 percent over the same time period.

Another example is current collapse of Daewoo, a second largest chaebol, which had huge debt to equity ratio (over 400 percent), went to a bankruptcy this year. This company was well known with a very close relationship with the governments in the past. It was ironic to see that Daewoo was expanding its size when the country was in recession and other chaebols tried to reduce their size and increase efficiency. Actually, this is not the first time Daewoo asked for the government?s help. Every time the company went into a trouble, the government didn?t let the company to fail and put more capital available into the company. However, this time it doesn?t seem happening that way. Actually, the government is trying to solve the problem under the market operation, so this inefficient and insolvent chaebol can be sold.

Chaebols may not be the only one to be blamed, even though they were blamed as a major cause of Asian financial crisis happened in Korea brining the country to the brink of insolvency, as well as weak banking system, in fact, they could be victims of misleading government policy. The long term close relationship between government and big business creating rent and using them with unbalanced support between industries had worked well in the early stage of development, but as stated early, rent can bring corruption of bureaucracy or industries also, since it is caused by inefficiency. Allocation of financial resources is not an easy job, but this would be best time for Korea to consider again about the efficiency of closed relationship between the government and businesses while the country is restructuring its economy system.

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