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The private sector as “principal engine”of development: Korea - How the private sector played a critical role in Korea’s economic growth

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
June 1982
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Larry E. Westphal

Between 1963 and 1978 the Republic of Korea (often referred to as South Korea, and here as Korea) was one of the most dynamic and successful developing economies. Yet in the late 1950s many observers feared that it was a “basket case” incapable of self-sustained development. Why were Korea’s prospects then rated to be so unpromising’ Why did Korea begin its remarkable economic takeoff in 1963?

The answer lies in the political changes that in the early 1960s brought to power a leadership strongly committed to economic development and able to formulate and implement effective policies to promote export-led industrialization and to increase domestic saving. But those policies and their implementation—do not stand alone. They were superimposed on a legacy of social, political, and economic structures which were favorable to economic development. One expression of this legacy can be found in the flexible and pragmatic relationship between business and government. Korea’s rapid economic growth since the early 1960s “has been a government-directed development in which the principal engine has been private enterprise” (Mason, et al.. 1980. p. 254). While not all aspects of the Korean experience could or should be replicated elsewhere, it does provide some broad lessons, many of which could be relevant to the economic management of other developing countries.

Chung Hee Park assumed control of the Government after a military coup in 1961, was elected president of the newly constituted civilian government in 1963, and was re-elected several times to remain president until his assassination in 1979. From the beginning, the overriding objective of Park’s rule was economic growth. Typical of Park’s thinking is the following statement, made in 1962: “In human life, economics precedes politics or culture.” Another statement, in 1963, suggests the reasoning behind the primacy of the growth objective: “Economic resurgence is an integral part of a nationalistic vision of a more independent Korea to come—more independent of the United States aid and control and, as an economically stronger and independent entity, more able to deal with North Korea” (both quotations from Mason, et al., 1980, p. 251 and p. 46). Park was not alone in holding these views, and the rapid economic growth achieved under his leadership established the legitimacy of his government. Although there was a recognition of the desirability of changing Korea’s development strategy before Park came to power—for example, the first major reform was introduced in 1961, when a complex multiple-rate system was replaced by a unitary exchange rate—Park’s sustained commitment was central to the ultimate success of the process of reform.

The economic policy reforms in the 1960s had two principal objectives. The one that dominated policymakers’ efforts was to shift from an inward-looking strategy to one of export-led industrialization. The other concerned efforts to increase public and private saving. The specific details of the several reform programs had more than once to be adjusted in major respects as circumstances changed. For example, the unitary exchange rate was abandoned in 1963, when a reduction in aid caused a balance of payments crisis, and was then reintroduced a year later. Moreover, the reforms were spread over many years. The last major reform—a liberalization of import controls—came in 1967.

Implementing the shift in development strategy required many policy changes. The official exchange rate of the won was increased from 62.5 won to the dollar in 1960 to 265.4 in 1964 and was thereafter generally maintained at levels that realistically reflected economic costs. A free trade regime was created for exporters, who were given unrestricted access to imported inputs as well as exemptions from tariffs and indirect taxes, and were also granted reduced charges on overheads together with credit and direct tax preferences.

Changes in the foreign exchange regime relating to imports greatly reduced the incentives for socially unprofitable import substitution. More generally, the reforms brought the financial profitability of different activities more nearly in line with their true economic profitability. The administration of government revenue collection was overhauled to achieve a much higher ratio of revenue to gross national product (GNP), and determined measures were taken to hold down government expenditure. In addition, the pricing policies of public enterprises were changed to achieve full cost recovery, so that these enterprises became net contributors to the government budget. To stimulate private saving, the interest rate was raised in real terms to about 10 per cent a year by means of higher bank interest rates and the introduction of a price stabilization program.

Korea’s rapid economic growth dates from 1963, the middle of the period of policy reform. But the acceleration of growth was not abrupt; the transition lasted roughly three years. Selected indicators showing the results of Korea’s shift to a strategy of export-led industrialization are given in the table. Domestic savings in relation to GNP in current prices rose from 3 per cent in 1960–62 to 18.7 per cent in 1974–76, with increased government saving responsible for slightly more than half the change. Total employment increased 3.9 per cent a year from 1963 to 1976; while manufacturing employment rose 12.1 per cent (comparable figures are not available for earlier years).

The historical legacy

In addition to the policy reforms associated with the shift to an export-led strategy, the principal keys to understanding Korea’s remarkable performance since the early 1960s are to be found in its history before the economic takeoff and the character of the Government’s intervention.

Korea’s precolonial heritage includes social, political, and economic structures that had already experienced significant development along modern lines. For nearly a thousand years before their separation at the end of World War II, North and South Korea constituted an autonomous ethnic, cultural, linguistic, and political entity. Traditional Korea was not “opened up” to the West until 1876, after which it gradually fell under the dominance of Japan, finally becoming a Japanese colony in 1910. The homogeneity and historical unity of the populace distinguish Korea from many other developing countries. So too does the peninsula’s colonial experience. Japanese colonialism was harsh in social and political terms; in economic terms, there is evidence that at least half of the Korean populace suffered a fall in real incomes during the colonial period. Nonetheless, Japanese colonialism appears to have left a richer legacy of human capital and institutional forms than was typical of Western colonialism. It also is true that Korea’s economy in the nineteenth century was relatively well developed. The process of modernization in the precolonial period centered on agriculture and commerce.

“…Korea’s successful export performance derived and still derives primarily from initiatives taken by firms acting within a decentralized system and in response to generalized incentives as well as strong government prodding.”

By the nineteenth century, Korea had developed a complex and relatively advanced agricultural technology, together with a land tenure system that, though based on landlordism, had a number of “modern” characteristics and a rural labor force that had gradually been freed from slavery and serfdom. The commercial sector and urban centers in traditional Korea were also far more developed than were those of many present-day developing countries in the nineteenth century. Confucianism was an important part of its heritage; the emphasis on education permeated all traditional institutions. An excellent phonetic alphabet—Hańgul, invented in the fifteenth century—appears to have been used extensively in commerce, and most of the rural male population could probably read some Hańgul, if not write it.

Korea’s economic transformation as we know it today began during the colonial period (1910–45), when the peninsula’s economy was managed as an integral part of the Japanese Empire. Led by a dynamic export sector, the economy grew at what, for that time, was a rapid pace: it is estimated that from 1910–12 to 1939–41 real value added in manufacturing grew more than 10 per cent a year. And by 1936–40 manufactured goods accounted for more than 40 per cent of exports, which in turn accounted for well over a quarter of commodity production.

This economic development was heavily dependent on Japanese residents in Korea. In industry they contributed more than 90 per cent of the capital and were disproportionately represented in the labor force, particularly among engineers and technicians. In agriculture the Japanese established an effective extension service, which introduced the use of chemical fertilizers and high-yielding plant varieties. They also instituted modern fiscal and monetary systems. Power generation facilities were built (most in what was to become North Korea), as were a north-south railway and other infrastructure. In addition, the educational system was greatly expanded by the Japanese, particularly at the primary level, but also at the secondary and college levels.

Human capital formation is the most important legacy of the colonial period. But formal education was less important than the learning-by-doing in modern economic activities and the demonstration effect of development under the Japanese.

Growth checked

Korea’s historical heritage, all too often neglected in analyses of Korean development, comprised many elements conducive to self-sustained development. But circumstances constrained the realization of the benefits of that legacy. Economic activity collapsed in 1945, in the aftermath of the withdrawal of Japanese, the loss of external markets occasioned by the dissolution of the Japanese Empire, and the economic dislocation and political instability that accompanied the peninsula’s division. Korea became independent in 1948, when U.S. military rule ended. But the Korean war (1950–53) again devastated the South’s economy: in all sectors, output in 1953 was substantially below what it had been in 1939–40.

Many creations of the colonial period did not survive the departure of the Japanese at the war’s end. The fiscal and financial systems suffered severe retrogression and did not attain colonial levels of development until the late 1960s. The agricultural extension structure almost disappeared and was only slowly reconstructed, starting in the second half of the 1950s. In manufacturing and construction, the number of operating establishments in South Korea fell from 10,000 in 1943 to 4,500 in 1947–48; manufacturing output in the latter years was only 15 per cent of what it had been in 1939.

But it is significant, particularly in light of circumstances at the time, that the South Koreans were able, just after the war and with relatively little foreign managerial or technical assistance, to operate nearly half the manufacturing plants that existed in 1944—producing such goods as shoes, textiles, rubber tires, and a wide variety of engineering products. Nevertheless, Korea’s economic performance during the 1950s and early 1960s was poor—despite the fact that foreign assistance financed more than 60 per cent of total imports and 80 per cent of investment. Although real value added in manufacturing increased at a respectable rate, there were clear signs of rapidly diminishing returns to the import substitution on which this growth was based. Government policies, which subordinated economic growth to reconstruction and price stabilization, were largely to blame for the poor performance.

Results of the shift to export-led Industrialization
Average annual growth rates
(In per cent)
1953–551960–62
toto
1960–621974–76
Per capita GNP1.77.2
Value-added in:
Primary sectors2.54.5
Manufacturing11.118.4
Investment1.618.1
Exports15.629.1
Imports3.217.3
Source: Derived from national income statistics in 1970 prices.

Government-business relations

A major element in initiating and sustaining Korea’s export-led development was the relationship between government and business—characterized by close cooperation and selective government interventions across a wide range of activities, interventions that go beyond the creation of market (nondiscretionary) incentives. Nonetheless, Korea’s successful export performance derived and still derives primarily from initiatives taken by firms acting within a decentralized system and in response to generalized incentives as well as strong government prodding.

The balance between selective interventions and market incentives is subtle and hard both to define and to describe briefly. It is perhaps best illustrated by the Government’s export promotion program. The Government has relied on market incentive policies to ensure that firms earn adequate profits on their exports. These incentives are applied across the board and generally operate through taxes and measures that affect market prices; they apply to all firms automatically. An example would be automatic exemption from tariffs for imported inputs used in export production.

The Government has also used other, less automatic instruments that apply only to selected firms, industries, or goods. Among selective interventions used are publicly announced quarterly export targets for individual commodities, markets, and domestic exporters. Contact between government and business in the day-to-day implementation of these targets is close. Next to the responsible minister’s office is an “export situation room,” laid out so that potential target shortfalls can be identified at a glance. A large staff maintains almost daily contact with major exporters, and it is not uncommon for the minister to intercede in difficult situations. The progress toward targets and the current trade situation are regularly reviewed at the Monthly Trade Promotion Conference, chaired by the President and attended by ministers, bankers, and the more successful exporters; the highest export achievements bring national awards as well as material benefits, including relaxed tax surveillance.

It would be inaccurate to conclude that the Government independently sets targets to determine export levels. The targets are indicative and are negotiated jointly by the Government and the exporters’ associations, sometimes in combination with export subsidies to secure acceptance of the targets. Moreover, the targets have generally been met or exceeded, even when revised upwards during the year. The target system has thus served to keep the Government well informed about export performance so that timely changes could be made in incentives, often including selective ad hoc assistance to individual exporters.

But the system has also stimulated exports—particularly by newly emerging export sectors, which typically operate as cartels and which, through protection, receive higher incentives to sell domestically than to export. The Government appears to have encouraged the formation of cartels in these industries to promote “infant industry” exports. By using the export target system, the Government could make sure that these industries exported part of their output. The use of targets together with associated selective interventions has thus enabled the Government to link selling in the profitable domestic market to satisfactory export performance. Also important in giving the Government leverage over these industries has been the granting of selective credit incentives through its absolute control over bank credit allocations and access to foreign borrowing.

However, by no means are all new entries into export markets the result of selective intervention by the Government. Indeed, exports from selectively promoted infant industries have never accounted for more than a quarter of Korea’s manufactured exports. For most exports, targets have worked together with the market incentives to promote rapid expansion.

The target system and its trappings have publicized the tremendous importance the Government has attached to exports, and have thus helped to create an atmosphere in which business could be certain that export activity would be rewarded. But it is businessmen, largely private, who have responded by taking the substantial risks of expanding production and capacity for export.

Even though outward-looking, the Government’s strategy has not been one of purely free trade. The Government has selectively promoted import substitution in such nontraditional sectors as producer goods (petrochemicals and electrical machinery, for example) and, of late, consumer durables and automobiles. The most important instruments of promotion have been protection as well as preferential access to credit on preferential terms and the authority to borrow abroad. But in several instances where private interests have been reluctant, public enterprises have been used to initiate import substitution. Korea’s integrated steel mill is a case in point. Among the most efficient in the world, it has penetrated the markets of the developed countries. More generally, the Government has used public enterprises where this best suits its objectives. The share of public enterprises in nonagricultural GDP is comparatively high, being similar to that in India.

The Government has intervened less in other parts of the economy, relying instead on the dynamism of Korean private enterprise. Until the late 1960s and early 1970s, the Government’s approach to the development of agriculture and the social overhead sectors was one of benign neglect. But nonetheless these sectors developed rapidly, largely because of private initiatives in response to market forces. Farmers turned increasingly to the production of noncereal cash crops to meet newly emerging urban demands. Private firms came forth to provide urban mass transit. Numerous medical facilities were established to provide health care. Private schools sprang up at all levels to satisfy the almost insatiable demand for education. In short, the development of the nonindustrial sectors has followed and been pulled by the development of industry, which would not have been feasible without a highly dynamic and responsive private sector.

The result has not only been rapid growth; in addition, the benefits of development have been spread relatively evenly across the population. This can be traced to the employment intensity of Korea’s export-led development and to events early in Korea’s history as an independent nation. A far-reaching land reform program—which was initiated by the U.S. military authorities in 1948 and completed by the newly independent Korean government in 1949—together with the economic dislocation caused by war and the departure of the Japanese, produced in Korea a relatively egalitarian distribution of assets, which subsequent development has not greatly changed.

Lessons

The experience of Korea is of obvious interest to policymakers in developing countries. It is widely appreciated that the adoption of an export-led strategy of industrial development was responsible for the transformation of Korea’s economy. But it is a popular misconception to ascribe Korea’s success to its special relationships with the United States and Japan, which are supposed to have resulted in massive aid flows and trade preferences, without which the Korean economy would not have grown so rapidly. Korea did benefit from massive aid flows, but this was before its economic takeoff. Since then most capital inflows have been private and in the form of credit rather than equity. Moreover, there is no evidence that Korea has received special trade preferences from any country. It would also be wrong to ascribe Korea’s success to its having copied the Japanese model. Japan’s experience demonstrated the advantage of export-led industrial development, but the Korean government has by no means slavishly copied Japanese policies or institutional forms. Korea did follow the Japanese in establishing large trading firms for foreign marketing. But to cite one major difference, public ownership of the banking system has given the Korean government far greater control over industry than exists in Japan, where major banks are privately owned and closely linked to the large industrial conglomerates.

“the effectiveness of the Government’s direction of economic activity can also be ascribed to the leadership’s single-minded commitment to economic growth and, at a deeper level, to its identification of rapid growth with export-led development.”

Korea’s development parallels that of several other fast-growing East Asian economies which also took advantage of the unprecedented growth in world trade during the 1960s and early 1970s. But the success of these economies owes more to internal factors, including the policies followed, than to the favorable external environment—Korea’s distinctive mix of market incentives and selective interventions is clearly a case in point. The effective implementation of flexible and pragmatic policies has been critical to Korea’s performance.

But what explains the effectiveness of these interventions in Korea, when not very different interventions are widely castigated in the literature as being responsible for the failings of an inward-looking strategy?

Korea’s historical heritage of social, political, and value structures has been an important ingredient. But the effectiveness of the Government’s direction of economic activity can also be ascribed to the leadership’s single-minded commitment to economic growth and, at a deeper level, to its identification of rapid growth with export-led development. Export prospects and performance have been the predominant considerations in the Government’s choice of where and how to intervene, and the Government has continually monitored the accumulation of information and experience to determine its implications for present and future exports. Some mistakes have been made, but the Government has learned from them and generally taken fast and decisive remedial action. The result has been the development of a remarkably efficient industrial sector.

The relevance of Korea’s success for other countries turns on whether these sources of its rapid growth are necessary elements and, if so, whether they are present elsewhere. The evidence—not simply from Korea—is that other developing countries would benefit from adopting market incentive policies, such as those followed in Korea. But my view is that the benefits would depend greatly on historical factors and on the effectiveness with which policies—general as well as selective—are implemented.

Less effective policy implementation helps to explain the dramatic downturn in Korea’s recent economic performance. Failure to maintain a properly valued exchange rate was largely responsible for the decline in the volume of exports in 1979. Although export growth has since resumed in response to exchange rate changes, problems continue to plague the development of the chemical and machinery industries. These problems stem from the Government’s decision in the mid-1970s to promote too many infant industries at once—a decision from which the Government did not retreat until late in the 1970s. Korea’s setbacks in the late 1970s thus give further testimony to the critical importance of strong leadership combined with flexible and pragmatic policy implementation.

Economic Development and the Private Sector

Even though the World Bank and IDA must operate on the basis of requests from borrowing member governments, the Bank, with its affiliate the IFC, is one of the most important sources of foreign finance for private enterprise in the developing world. The Bank has consistently sought to help countries obtain the advantages of private initiative and market discipline as well as the benefits of soundly conceived and efficiently executed programs that are beyond the scope of the private sector.

This booklet presents a series of nine articles, prepared for Finance & Development, that explains what the relationship between the public and private sectors has been in development projects supported by the Bank, IDA, and IFC and what policies and forces have shaped that relationship.

Copies of the booklet can be obtained without charge by writing to the Publications Unit, World Bank, 1818 H Street, N.W., Washington, D.C. 20433.

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