This Selected Issues paper for the Republic of Korea focuses on the role of monetary policy in the current context of slowing growth and rising inflation pressures. Korea has not remained immune to the global slowdown, and with the cycle turning downward, the trade-off between inflation and growth is deteriorating. Subprime-related turbulences in financial markets add an extra element of uncertainty to the economic outlook, and have led to a noticeable increase in Korea’s stock market and exchange rate volatility.

Abstract

This Selected Issues paper for the Republic of Korea focuses on the role of monetary policy in the current context of slowing growth and rising inflation pressures. Korea has not remained immune to the global slowdown, and with the cycle turning downward, the trade-off between inflation and growth is deteriorating. Subprime-related turbulences in financial markets add an extra element of uncertainty to the economic outlook, and have led to a noticeable increase in Korea’s stock market and exchange rate volatility.

V. What Determines Investment in Korea?47

A. Introduction

111. Promoting investment is a central part of the government’s strategy for increasing the potential growth rate of the Korean economy. The government plans to reduce corporate tax rates, currently 13 and 25 percent to 10 and 20 percent by 2010, and introduce new tax incentives to spur investment. There are also plans to streamline business regulations and improve the functioning of the labor market.

112. This chapter assesses the extent to which there is a role for public policy to stimulate investment in Korea, and what measures are most likely to be effective. Using disaggregated data on listed companies covering the period 1989–2007, the paper attempts to shed light on the role of fundamentals—such as expected profitability, financing constraints, uncertainty, gearing ratios as well as tax parameters—in determining the investment patterns of Korean firms. The analysis allows for differences across both types of firms and over time, and the results are compared to those from other Emerging Asian economies.

113. It finds that while a return to pre-crisis investment levels—which are difficult to justify on the basis of fundamentals—appears to be neither likely nor warranted, the government’s strategy for promoting investment should focus on small firms. Policies most likely to be effective include: developing capital markets to promote financing on risk-based terms and venture capital; supporting SME restructuring, including by reducing credit guarantees and reform of bankruptcy laws; and lowering uncertainty about government policies affecting risk perceptions, such as tax policy and regulations. While reducing tax rates could have some impact, it is likely to be more modest, while tax incentives would likely be less cost-effective and introduce new distortions into business decisions. At the same time, international surveys suggest that further improvements to Korea’s business climate, notably through deregulation and enhanced labor market flexibility, would also help.

B. Investment in Korea: Stylized Facts

Aggregate Investment

114. Korea has witnessed a sizeable decline in investment since the Asian crisis. Comparing the period 2000–07 to 1990–97, aggregate investment has declined by 7½ percentage points, settling at around 30 percent of GDP. With public investment rising slightly, this decline reflects a sharp fall in private investment. In particular, a sustained slump in fixed investment—investment in machinery and equipment and factories—accounts for almost ⅔ of the overall decline. By contrast, FDI flows have been considerably less volatile and more modest over this period: outflows have remained broadly constant as a share of GDP while there has been a modest increase in inflows of around ½ a percentage point. While low inflows are potentially a matter of policy concern, FDI flows do not help explain the decline in aggregate investment in Korea since the crisis.

115. Taking a longer term view, however, current investment ratios in Korea are close to their historical average. While it is difficult to assess whether investment is now at the “optimal” level, it is in line with the historical average over the last three and a half decades, which includes Korea’s highly capital-intensive initial take-off phase. If anything, it is the rapid build-up in investment immediately preceding the crisis that appears anomalous and some subsequent pruning of overinvestment may have contributed to bringing investment to more sustainable levels. Despite the post-crisis decline, it is also notable that current investment levels are still on the high side for an economy of Korea’s level of economic development and by far the highest in the OECD area, where the average is around 22 percent of GDP.

uA05fig13

Gross Capital Formation

(In percent of GDP)

Citation: IMF Staff Country Reports 2008, 296; 10.5089/9781451822236.002.A005

Sources: CEIC Data Company Ltd., Bank of Korea, and Fund staff calculations.

116. These broad trends have been mirrored in much of the rest of emerging Asia. Aggregate investment in the crisis economies (defined as Indonesia, Korea, Malaysia, Singapore, Thailand and the Philippines) has fallen by between 6 and 17 percentage points of GDP over the same period. Unlike Korea, however, in some countries, principally Malaysia and Thailand, excess investment in residential construction appears to have played a significant role in the pre-crisis boom and subsequent slump, while a fall in FDI inflows has been partly responsible for the decline in Indonesia and Malaysia.

uA05fig14

Selected Asia: Changes in Investment

(2000–07 relative to 1990–97, percent of GDP)

Citation: IMF Staff Country Reports 2008, 296; 10.5089/9781451822236.002.A005

Sources: CEIC Data Company Ltd.; and Fund staff calculations.1/ Breakdown not available
uA05fig014

Selected Asia: Changes in FDI Flows

(2000–07 relative to 1990–97, percent of GDP)

Citation: IMF Staff Country Reports 2008, 296; 10.5089/9781451822236.002.A005

Sources: CEIC Data Company Ltd.; and Fund staff calculations.

Firm–Level Investment

117. Similar patterns are reflected in the micro data. 48 Both the peaks of the early/mid-1990s and the slump in the investment rate (the ratio of investment to the capital stock) associated with the crisis are replicated in the firm-level data. While investment rates remain below their previous highs, the subsequent recovery is also visible and has been more pronounced than in most of the other crisis economies. The 6 percentage point fall in Korea’s investment rate between 1990–97 and 2000–07, while sizeable, is only around half the average decline for these economies.

uA05fig15

Emerging Asia: Investment Rate

(Median) 1/

Citation: IMF Staff Country Reports 2008, 296; 10.5089/9781451822236.002.A005

Sources: Worldscope; and Fund staff estimates.1/ Investment-to-capital ratio.

118. Investment in Korea was high pre-crisis despite not very favorable conditions, compared to other emerging markets or other Asian economies. Indeed, Korea was an outlier on the weak side based on a number of corporate indicators (Table V.1). Common measures of profitability—including operating margins and returns on equity or assets—were among the lowest in Emerging Asia during the pre-crisis period. Forward-looking fundamentals—such as expected profitability reflected by Tobin’s Q—and liquidity indicators were also on the low side, while corporate leverage was by far the highest in the region. These findings suggest that many Korean firms may have been guilty of “irrational exuberance” in their investment decisions during the lead-up to the crisis.

119. Corporate soundness indicators have improved since the crisis. Most measures of profitability have improved, and the gap relative to the rest of the region has narrowed. At the same time, leverage has decreased markedly, although the composition of debt seems to have shifted toward shorter-term maturities. Moreover, liquidity indicators have improved, reflecting progress in financial restructuring, particularly for larger companies.

120. While investment by large firms has tended to recover strongly, smaller firms have lagged behind, reflecting weaker fundamentals since the crisis, notably lower profitability and liquidity and relatively greater reliance on short-term debt. Investment patterns also shows some interesting differences across sectors, falling especially sharply in IT and services.49

Table V.1

Emerging Asia: Corporate Soundness Indicators 1/

article image
Sources: Worldscope; and Fund staff calculations.

Medians.

Operating earnings (EBIT) in percent of sales.

Current assets to current liabilities.

Cash and receivables to current liabilities.

Operating earnings (EBIT) to gross interest expenses.

uA05fig16

Korea: Investment Rate 1

(Median)

Citation: IMF Staff Country Reports 2008, 296; 10.5089/9781451822236.002.A005

Sources: Worldscope; and Fund staff estimates.1 Investment-to-capital ratio.
uA05fig016

Korea: Investment Rate1

(Median)

Citation: IMF Staff Country Reports 2008, 296; 10.5089/9781451822236.002.A005

Sources: Worldscope; and Fund staff estimates.1 Investment-to-capital ratio.

C. Econometric Analysis

Model

121. We use firm-level panel data on listed companies from the Worldscope database to estimate the standard neoclassical investment model, which relates current investment to expectations of future profitability through the Tobin’s Q ratio, augmented by additional factors. The model estimated can be expressed as follows:

Δ(IK)it=ct+bΔQit+cΔZi,t+Δεit(1)

where I/K is the investment rate, Q is Tobin’s Q50, and Z is a vector of additional variables, including:

  • cashflow, which measures the internal funds available to finance investment projects and is typically used in the literature as a proxy for financing constraints;

  • sales growth, to reflect potential accelerator effects, whereby an increase in sales may trigger investment by signaling increased demand for a firm’s output;

  • leverage, measured by debt-to-asset and short-term debt-to-asset ratios, as a proxy for the effect of financial restructuring on investment; and

  • the volatility of sales growth or stock market returns to capture the potential negative impact of uncertainty on investment, suggested by the “real options” literature.51

122. The model is estimated using a GMM approach, to allow for endogeneity and measurement error in the dependent variables. Estimation is in first-differences and includes year dummies, to control for firm-and time-specific effects. This approach yields consistent parameter estimates, provided there is no higher order serial correlation in the residuals and the instruments are valid.52 The instruments we report are lagged values of the dependent variable and our regressors, but the basic results were robust to using alternative instrument sets.

Results

123. Estimating equation (1) on our full sample of Korean firms yields the following results (Table V.2):

  • Investment is positively associated with expectations of future profitability, as summarized by Tobin’s Q. While the coefficient is marginally insignificant at typical significance levels, the implied elasticity (estimated at the means of the sample) is economically large, at around 0.26.

  • The coefficient on cash flow is positive and highly significant, with an implied elasticity of around 0.23. While the interpretation of this coefficient is contentious, it may indicate that the average firm in Korea is financially constrained, and therefore forced to rely more on internal funds to finance its investment projects.

  • Investment is negatively associated with both gearing—in particular short-term debt—and uncertainty, with large implied elasticities of -0.5 and -1.3, respectively.53

  • While tax parameters also affect investment through their effects on expected profitability, their impact is between 3 to 16 times smaller than the factors above: on average, a 1 percentage point decrease in the corporate tax rate is estimated to raise the investment rate by only 0.05 percent, and a 1 percentage point increase in depreciation allowances or investment tax credits, on average, by only 0.07 to 0.08 percent.

  • Other variables appear to be less important. In particular, we did not find any significant effect of sales growth, suggesting that the accelerator channel is not very important in Korea, with investment determined by more forward-looking variables.

Table V.2

Korea: Investment Equation 1/, 2/, 3/

article image
Sources: Worldscope; and Fund staff calculations.

For readability, only selected variables–such as those referred to in the text–are shown.

First-differenced GMM specifications, with a full set of year dummies included.Instruments are (I/K), Q and CF/K dated t-3 and t-4. Time period for full sample is 1989-2007.

Robust t-statistics in parentheses, with * indicating significance at 10 percent and ** at 5 percent level.Diagnostic tests (not reported) did not reject validity of instruments or detect higher-order correlation in residuals.

124. The determinants of investment have changed over time, with little role for fundamentals pre-crisis. It is difficult to find any significant association between investment and our explanatory variables prior to the Asian crisis. While this may reflect large standard errors due to the smaller size of the sub sample, the magnitude of the coefficients on cash flow and uncertainty is also very different from that in the post-crisis period. This is consistent with our earlier hypothesis that the pre-crisis investment boom may not have been fully justified by economic factors. By contrast, the strong relationships we observe between investment and fundamentals in the full sample seem to be driven by the behavior of Korean companies during the more recent period.

125. The effects of fundamentals differ significantly based on firm characteristics, notably size and trade exposure. While almost all types of firms respond to profit expectations, smaller firms are much more sensitive to cash flow suggesting that financing constraints may be more binding, while larger firms are more affected by uncertainty, perhaps reflecting their exposure to a broader set of macro and microeconomic factors. A similar dichotomy exists between firms that are domestically-oriented versus those with foreign exposure through exports.54 This cross-sectional variation of the coefficient on cash flow supports its interpretation as an indicator of financing constraints.

126. Corporate investment behavior also varies across sectors (Table V.3). While profit expectations matter strongly in the industrial and consumer sectors, financing constraints appear to be more broad-based. The only exception is the materials sector, which is characterized by low profitability due to competition from lower wage manufacturing economies so that demand for additional investment may itself be low. Despite post-crisis restructuring, short-term leverage continues to dampen investment across almost all sectors, but only significantly so in services, while uncertainty has a especially strong impact in the IT, consumer and materials sectors.

Table V.3

Korea: Investment Equation by Sector 1/

article image
Sources: Worldscope; and Fund staff calculations.

See footnotes in Table V.2.

127. Some of the determinants of investment in Korea differ from those affecting investment in the rest of the region (Table V.4). As in Korea, gearing (although not specifically short-term) and uncertainty also tend to dampen investment in other parts of Emerging Asia. However, in most of the rest of the region, profit expectations are less important and firms appear to be less financially constrained, the latter perhaps partly reflecting the more dominant role played by small companies in Korea.55 There is also stronger evidence of an accelerator mechanism in other parts of Asia, suggesting a tighter link between lagged economic growth and future investment, and hence a more prominent role for cyclical factors in determining investment patterns.

D. Policy Implications

128. While a return to pre-crisis levels is unlikely to be sustainable, a strategy for promoting investment in Korea will need to focus on small firms. Pre-crisis investment levels were at historic highs despite relatively subdued corporate indicators, and are difficult to rationalize based on economic fundamentals. While current aggregate investment levels in Korea are close to their long-term average and still-high by developed country standards, small firms have lagged behind, largely reflecting weaker fundamentals in the aftermath of the Asian crisis. Small firms also tend to dominate the services sector (representing around 85 percent of firms), where productivity growth has been lackluster. Looking ahead, a vibrant SME sector will be vital for accelerating Korea’s shift to a knowledge-based economy and sustaining high rates of growth.

129. Credit guarantees have held back restructuring and limited access to external finance for many small firms. Significant progress has been made on corporate and financial restructuring since the crisis, but smaller companies have tended to fall behind. This partly reflects the still-sizable credit guarantees for SMEs. With Korean banks tending to direct loans to those SMEs that have secured credit guarantees, since around 85 percent of the associated default risk is borne by the government, existing and well-established firms have an advantage. In turn, this limits their incentives for restructuring, makes it difficult for many newer firms to access bank credit and creates a barrier for new entrants.56 While these guarantees have declined from 8 percent of GDP in 2001 to around 6 percent in 2005, they remain, for example, more than three times larger than in Taiwan Province of China and almost thirty times larger than in the United States.

Table V.4

Emerging Asia: Investment Equation 1/

article image
Sources: Worldscope; and Fund staff calculations.

See foonotes in Table V.2.

For Korea, refers to short-term debt to assets ratio; for all others, refers to total debt-to-assets.

130. Improving the incentives for SME restructuring and broadening access to market-based financing for small firms are key to boosting investment. Restructuring could be promoted by phasing out credit guarantees and assisting the exit of nonviable companies, through a reform of the onerous personal and corporate bankruptcy systems. In addition, the financial infrastructure for SMEs could be upgraded by promoting lending on risk-based terms by reforming collateral laws to allow for a wider range of securitization (beyond real estate and other fixed assets); and widening the pool of venture capital funding available for start-ups in technology sectors.

131. Reducing uncertainty through improvements in the business climate is also likely to lead to a positive investment response. While investment decisions of firms can be affected by uncertainty about many, potentially exogenous, elements of their operating environment—such as demand, prices, costs, and exchange rates—other risks stem directly from the policy environment, notably the tax code and other business legislation, government regulations, the legal system and administrative procedures. As suggested by most international surveys of investor perceptions, a less complex and more transparent tax system and regulatory framework, together with a more flexible labor market and more effective investor protection, could help reduce investor perceptions of risk in Korea as well as raise expected rates of return. Korea consistently ranks on the low side in these areas for a country of its level of development, both globally and among comparator economies in the region (Table V.5).

132. Lowering corporate tax rates is likely to have a modest impact on investment, while international experience suggests that tax incentives are unlikely to be cost-effective. The limited impacts of cuts in corporate tax rates on investment are consistent with the fact that effective tax rates in Korea are already relatively modest by OECD standards, as a result of generous tax exemptions.57 They are also in line with literature suggesting that tax effects on investment may be secondary if other factors such as the quality of governance, regulatory framework, infrastructure, macro/political stability; labor market conditions; and administrative certainty are problematic.58 The general case against the use of tax incentives to encourage particular types of investment has been made both internationally and by many observers of the Korean tax system. 59 Their key weaknesses include costliness, scope for abuse by taxpayers, lack of transparency, introducing distortions into business decisions and ineffectiveness, relative to other measures, in reaching intended goals. International evidence suggests that establishing a simple, transparent, credible, and broad-based tax regime would be a better strategy for creating a conducive environment for investment.

uA05fig17

Effective Corporate Tax Rates in OECD

(In percent)

Citation: IMF Staff Country Reports 2008, 296; 10.5089/9781451822236.002.A005

Source: Institute for Fiscal Studies; and Fund staff estimates.1/ Plant and machinery, equity financed
Table V.5

The Regional Business Environment: Selected Indicators

(Global rankings, unless otherwise indicated)

article image
Sources: EIU: Country Forecast (July, 2008), covering 82 economies; World Economic Forum: Global Competitiveness Report (2005/06), covering 131 economies; IMD: World Competitiveness Year Book (2008), covering 55 economies; and World Bank: Doing Business Survey (2008), covering 178 economies.

Numbers in parentheses indicate rank out of 17 regional economies: Australia, Bangladesh, China, Hong Kong SAR, India, Indonesia, Japan, Malaysia, Pakistan, Philippines, Singapore, Korea, Sri Lanka, Taiwan POC, Thailand, and Vietnam.

Appendix V.1: Description of the Data

The data used in the empirical analysis include all listed nonfinancial firms in Indonesia, Korea, Malaysia, the Philippines, Singapore and Thailand covered in the Worldscope database during the period 1989–2007. The Worldscope database is well-known for its standardized presentation of global investment portfolios and its good coverage of historical data. The database covrs over 96 percent of the world’s market value represented by it. One important advantage of using the database is that it provides standardized data for countries with different reporting practices, yielding relatively more reliable cross-country comparisons. Many of these firms entered the data set after 1995, implying somewhat shorter series for them. Outliers were excluded from the analysis based on standard criteria.

The company-specific variables included are those that potentially affect firm-level investment decisions, as suggested by the standard model of investment outlined in section D. These variables are obtained primarily from cash flow statements and include expected future profitability (Tobin’s Q), cash flow, sales growth, leverage (defined as either total debt to total assets or short-term debt to total assets) and uncertainty (measured either as the coefficient of variation of sales growth or stock market returns). The capital stock measure was estimated using the standard perpetual inventory method, with the net book value of plant, property, and equipment was treated as the starting value, and subsequent values determined using data on investment, disposals, and acquisitions.

Incorporating the standard adjustments for debt, taxes and current assets, Tobin’s Q is defined as:

Qit=11-τi[Vit+Bit-Ait-Citpt(1-δ)Ki,t-1-(1-Γit)]
A05lev2app01

where τ is the marginal corporate tax rate; V is the firm’s fundamental value or the expected present discounted value of future payments to shareholders; B is the book value of its outstanding debt; A is the present value of the depreciation allowances on investment made before period t; C is current assets; K is the replacement value of the firm’s tangible capital stock; pt is the price of the investment good; and Γ is the present value of the tax benefit for each dollar of current investment spending. For example, with an investment tax credit at rate k, Γ is:

Γit=Kit+Σs=t(1+rs+πse)s-tτsDEPis(s-t),

where r is the default risk-free real interest rate (assumed to equal 3 percent), πe is the expected inflation rate, and DEP is (a) is the depreciation allowance permitted for an asset of age a.

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47

Prepared by Murtaza Syed.

48

The Appendix describes the firm-level data and the main variables used in the analysis.

49

For IT, this may, to some extent, reflect the relatively thin coverage of the sector in the pre-crisis period of our sample.

50

Defined as the ratio of the stock market valuation of the firm to the replacement cost of its capital stock, incorporating standard adjustments for tax parameters.

51

Risk features prominently in more recent microeconomic theories, with greater uncertainty providing an incentive for agents to delay investment (Dixit and Pindyck, 1994).

52

We use diagnostic tests–namely m1 and m2 tests for serial correlation, and the Hansen test for instrument validity–to verify these conditions.

53

The measure of uncertainty used in the reported results corresponds to sales growth volatility. Results using the alternative measure, based on stock market return volatility, were similar.

54

This only partly reflects overlap between these classifications, with around 80 percent of small companies being domestically-oriented and nearly 50 percent of large companies having foreign exposure in our sample.

55

In Korea, SMEs account for almost 50 percent of manufacturing output and over 85 percent of total employment.

57

A wide range of incentives are currently provided under the special tax treatment and control law (STTCL) of 1999.

58

See Norregaard and Khan (2007) for a review of this literature.

59

Among others, see Zee and others (2002) for a survey of the evidence.

Republic of Korea: Selected Issues
Author: International Monetary Fund