Uncertainty in Seoul: Korea's Economy in the Months Ahead 

February 19, 2003
By Marcus Noland

While most commentators have focused on the military/security implications of the North Korean crisis, there are economic questions of equal significance to be considered.  Indeed, economic factors appear to be driving South Korea's policy of engaging the North. Pyongyang already holds Seoul hostage with its forward-deployed artillery.  To many South Koreans, it is worth engaging with the North.  Either Pyongyang will evolve toward a less threatening regime, or engagement will undermine the ideological basis of the Kim Jong-il regime and eventually cause its collapse. Either way the military threat to Seoul is eliminated.  

Seoul would prefer, however, to avoid precipitating a crisis that would bring about a sudden collapse of the regime in Pyongyang. Over the past decade, South Koreans have swung from an excessively optimistic assessment of their ability to handle an East German-style collapse in the North to an excessively pessimistic assessment of collapse and absorption, to the point some fearing it more than an ongoing North Korean nuclear weapons program! 

For the foreseeable future, however, Seoul must deal with a number of uncertainties. Given the complexity of the situation—two separate and distinct nuclear programs that require different solutions, the administrative transition in South Korea, and the looming war in Iraq—all point to a protracted resolution of the crisis, which almost certainly will involve multilateral negotiations, if not the UN Security Council. As a consequence the crisis is likely to drag on for months, punctuated by intermittent periods of heightened tensions. As a result, South Korea is likely to experience an extended period of market sensitivity, regardless of the insouciance of South Korean politicians. 

Financially, South Korea is more integrated into the world economy now than it was in 1994. Foreigners are major players in the capital markets, accounting for nearly 40 percent of stock market transactions, and South Korean residents have greater opportunities to move their funds abroad. The use by South Korean financial firms of off-balance sheet transactions and financial derivatives, which did not exist in 1994, is expanding rapidly. While it is true that the South Korean stock market actually rose during the last crisis, the expanded role of foreign participants and the increased complexity of the financial transactions mean that the market today is far less susceptible to political intervention than it was a decade ago. 

The popular image of capital flight occurring when foreigners flee for the exits is belied by historical experience the world over‹almost invariably it is the better-informed locals who are out the door first. Indeed, the latest figures indicate that while foreigners were net buyers in the stock market, South Koreans were net sellers. And although at present there is no indication of capital flight, enabling mechanisms that did not exist in 1994 are in place today and if December's election is any indication, the South Korean population is badly split with respect to its attitudes toward the North.  

As a result, South Korean investors may prove more risk-averse than their new government and move their savings abroad. A slowdown in the purchase of consumer durables is another possibility.  Indeed, the incoming government—populist and untested—is another source of uncertainty. While President-elect Roh Moo-hyun has largely managed to avoid economic controversy in the run-up to his inauguration, the markets will monitor his government's economic policies particularly closely during the early stages of his administration.  

What can be done, then, to prevent the South Korean recovery from petering out?  The new administration should do three things. First, it should commit to the principle that engagement with the North must be done on efficient, transparent terms. Subsidization of engagement with the North can be justified from a social standpoint but it should be done as neutrally as possible with respect to specific projects and firms. No more implicit hidden subsidies and political quid pro quos should be delivered through the public-sector financial institutions. 

Second, while engaging the North, South Korea must prepare for the possibility of collapse. The relevant policies could be thought of as those that are contingent on specific circumstances and those that are relatively invariant to the timing and specifics of an eventual North Korean collapse.  North Korea can be thought of as the world's largest contingent liability. South Korea should, as it has been doing, pursue a fiscal policy that might be considered relatively restrictive in the long run to minimize current public borrowing and debt under the expectation that this liability will come due sometime in the future. 

Finally, South Korea should also pursue a variety of policies that would strengthen its economy. Such policies would be desirable whether or not North Korea existed‹North Korea's existence simply underscores the desirability of their adoption. The overarching goal should be to improve the functioning of markets. For this to occur, accurate information must be accessible, property rights must be enforced, and agents should be motivated by efficiency, not political considerations. In practice, this means continued strengthening of accounting conventions and practices.  Seoul should continue the process of denationalization and privatization, especially in the financial sector where the state still owns about one-third of the banking sector. 

In the financial sector, the Roh Administration would be well advised to continue the policy of the Financial Supervisory Service to tighten risk assessment and to increase provisions for bad loans and increase scrutiny of financial derivatives and off-balance sheet transactions by South Korean financial entities.  It should create firewalls to limit industrial firms' ownership of financial entities, and consider using national pension assets to foster domestic institutional investors capable of monitoring corporate management, independent of the chaebol (the Korean financial-industrial conglomerates).  Finally, Seoul should look more favorably on foreign ownership of Korean assets. 

With respect to labor-market policy it is important to recognize two things. First, financial-market policies impact labor-market behavior. Situations in which management does not face hard budget constraints encourage labor militancy. Corporate bailouts through the provision of concessional loans by public-sector financial institutions discourage compromise on the part of unions.  Second, the rate of unionization is not much different in South Korea than it is in the United States or France, but labor markets are far less flexible in France than the United States.  In other words, policies and institutions count. As a consequence it is important that the Tripartite Commission (made up of representatives of labor, management and the government, which prepares labor legislation) not become the locus of efficiency-reducing corporatism as similar bodies have become in continental Europe. 

Finally, it is important to note that these reforms are self-reinforcing: Reforms in the financial sector will encourage better results with respect to corporate decision-making and labor-market outcomes. 

We are entering a period of great uncertainty on the Korean peninsula.  A healthy, robust South Korean economy is an important source of stability and it is in U. S. national interests to see this occur. 

Marcus Noland is a Senior Fellow at the Institute for International Economics (http://www.iie.com).  This essay is based on recommendations he has presented to President Roh of the Republic of Korea concerning economic policy.