Republic of Korea: Selected Issues

International Monetary Fund. Asia and Pacific Dept

doi:10.5089/9781484341636.002.A003

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Republic of Korea: Selected Issues

Author: International Monetary Fund. Asia and Pacific Dept

Publication Date:: 13 Feb 2018

eISBN:: 9781484341636

Language:: English

Keywords:: ISCR; CR; firm; debt; wage; household debt; chaebol; GVC participation; net effect; GVC variable; Global value chains; Current account; Exports; Current account surpluses; Personal income; Global

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Selected Issues

Abstract

Selected Issues

Korea’s Integration into Global Value Chains and External Balance¹

A. Korea’s Integration into GVCs

1. Korea’s economic structure is being transformed by the rapid expansion of GVCs. This occurs through both direct effects on patterns of trade and production, and indirectly through macroeconomic channels that affect the private saving rate and investment. The productivity gains from the expansion of GVCs should yield major economic benefits.

2. There are two forms of GVC integration. Backward GVC integration is where intermediate inputs are imported for use in production of the final good. They typically replace higher-cost domestically produced inputs, improving competitiveness. Forward GVC integration is where domestic firms export intermediate inputs as an input into final production in another country.

3. The relative importance of backward and forward integration in a country reflects its position in the GVC. Backward integration is relatively important in lower income countries that specialize in lower value-added stages of the GVC. These tends to be the last production stage of final assembly where low labor costs are a key advantage. Forward integration predominates in higher income countries further up the GVC, which tend to exports technically sophisticated intermediate inputs for use in this final assembly. Finally, post-production stages like marketing services tend to be done in high income countries that are the export destinations (World Bank, 2017).

4. GVC integration reflects rapid outsourcing. Outsourcing occurs when exporters in a country shift final production of the export good abroad and, instead, export intermediate inputs to support this production. It involves both an increase in forward integration, as intermediate exports rise, and a reduction in final export. Forward integration increases productivity in the outsourcing country by allowing it to specialize in production of the higher value-added goods. The firms doing the outsourcing should earn higher profits from the efficiency gained by shifting final production to a lower labor cost location, which they then can repatriate. The recipient country where production is relocated also benefits from competitiveness gains and higher export earnings from what is for them an increase in backward integration.

5. Korea’s backward and forward participation in GVCs is relatively balanced. The size of these linkages for Korea is in the mid-range of countries, reflecting the fact that the smaller the country the higher is the percentage shares of imported inputs. What distinguishes Korea from other countries is how rapidly this balance in forward and backward participation has shifted.

6. Backward GVC integration expanded rapidly but then contracted. After registering one of the largest expansions from 2001 to 2011, backward participation declined between 2011-14 (Figure, red bar). The early growth in backward participation reflected increasing reliance on imported inputs. It reflects outsourcing of production to Korea by foreign multinationals, especially prior to the GFC, and the shift by Korean firms into higher technology activities more reliant on imported inputs. The reversal during 2011–14 represents a substitution of domestic for these imported intermediate inputs.

7. The expansion of forward GVC integration was quite stable as Korean firms steadily increased exports of intermediate inputs for use in production abroad (see Figures). The evidence indicates that this largely reflects Korean corporates forward participation in GVCs in sectors where they are particularly strong, such as autos and electronics, and services (see Figure). This typically involves outsourcing of final stages of production to locations where labor costs are lower, while retaining domestic production of higher value-added intermediate inputs that are then exported to these locations. A prime example is Samsung smart phones, where 86 percent of final assembly is now done outside Korea, notably in Vietnam. Samsung still produces domestically—and exports—many of the higher value-added components, both for its own phones and for other manufacturers.

8. In Korea, forward integration has been increasing relative to backward integration. This is transforming the structure of its production and trade, with implications for employment and the distribution of income. As Korea move up the GVC, firms outsource production of final export goods to lower wage countries, and increase production and export of higher valued-added intermediate inputs. This involves closing local facilities producing outsourced goods and increasing foreign direct investment (FDI) abroad in facilities to produce these goods. The fall in employment as these local facilities close should be partly offset by the increase in production of intermediate inputs. In addition, corporates earn higher profits from relocating production abroad, which they should repatriate through the income balance of the current account.

B. Insights from the Literature on GVC Integration

9. Integration into GVCs will impact the current account through a variety of channels. Economic theory implies that GVC integration improves the current account. The productivity gain from GVC integration will lead to a transitory, relative improvement in competitiveness that should be gradually eroded as competing countries achieve similar improvements by following suit. Residents recognize that the income gain from the productivity shock will be temporary and, therefore, save part of it to smooth consumption. This rise in the private saving rate contributes to a temporary improvement in the current account (Brumm et.al., 2017). How this occurs in practice will depend on the form and pace of GVC integration, and whether the adjustment process occurs smoothly, consistent with theory, or is slowed by structural impediments.

10. There is by now a substantial literature on the impact of GVC integration. The theoretical analysis in this literature focuses largely on the trade channel, as the expansion of GVCs generated major shifts in the structure of global trade and production. This work has typically relied on general-equilibrium microeconomic models of trade that can capture the employment impact and the effect on income accruing to factors of production. Adjustment through the other channels (see below) is assumed occur smoothly and rapidly in the model as resources are shifted to new activities and kept fully employed; and, in general, these channels are not analyzed specifically. Many models build on the seminal analysis by Melitz (2003) of trade in differentiated products, notably Demidova et. al. (2013), which extends this model to cover trade in intermediate inputs. Consequently, this research primarily yield insights into the trade channel. However, these other macroeconomic channels can become qualitatively important when structural impediments prevent the smooth and rapid adjustment process assumed in these models. This is the case in Korea and, probably, in other countries also, and will differ depending of the economic structure of the country.

11. Most recent empirical literature estimate the cross-country, cross-industry effects of GVCs. It exploits major recent improvement in data on trade in value-added (intermediate) goods. This panel estimation approach has yielded valuable insights that reflect the average effect across many countries, and is reported in papers cited here. However, the experience of each country will depend on its specific economic structure, which makes case studies of countries, like that for Korea here, a essential complement to this more formal cross-country estimation approach.

C. Channels through which GVC Integration Impact Korea

12. GVC integration impacts the current account through different channels. The immediate impact occurs through the trade channel where productivity gains from outsourcing alter the structure of trade, production and employment. Then, second round effects occur through the macroeconomic channels of domestic investment, FDI, labor income, foreign investment income, and the distribution of income. These affect the private saving rate and investment and, hence, the current account. The impact on the current account depends on the extent that these channels affect Korea differentially vis-à-vis other countries, in line with the principle of multilateral consistency where current account balances should sum to zero globally.

Trade channel. The effect of GVC participation through this channel depends on whether it takes the form of forward or backward integration. These two channels are relatively balanced for most countries, including Korea, which lies almost on the 45° line (Figure).
An increase in forward integration is a rise in exports of intermediate inputs. However, when this is associated with outsourcing, the short-term net effect on the trade balance should be negative: the additional exports of intermediate inputs for use in production of the outsourced good will be more than offset by the fall in the exports of this good. Over time, this negative effect should reverse as exports of intermediate inputs increases strongly as the productivity gain from outsourcing increases external demand for these intermediate inputs. In Korea, recent GVC integration has been driven by forward integration, with exports of intermediate inputs rising steadily from 13 to 20 percent of value added (Figure).
An increase in backward integration is a rise in imports of intermediate inputs. This results from a fall in the cost of imported relative to domestically-produced inputs. The impact of this rise in imports on the trade balance should be offset by the positive effect on exports from the lower cost of imported inputs that makes firms more competitive.² In countries where the increase in backward integration is associated with the outsourcing of production to that country, the net effect on the trade balance will be positive as exports of these outsourced goods is likely to exceed the imports of intermediate goods used in their production. In contrast to the rise in forward integration, backward integration has declined over the last few years (Figure). Moreover, this outsourcing has been concentrated in sectors where Korean firms are particularly strong, where productivity and competitiveness gains are likely to be substantial.
Investment/FDI channel: the outsourcing of production in GVCs lead local firms to invest abroad through FDI rather than at home, which tends to reduce domestic investment (Figure). The associated weakness in domestic demand widens the current account surplus. Over time, this effect can be partially reversed as the increase in intermediate input exports necessitates new investment to ramp-up production. Moreover, as the labor displaced by this outsourcing is redeployed in other domestic activities, this could necessitate new investment. Data for Korea are consistent with this channel, with outward FDI growing strongly and the domestic investment ratio declining steadily (Figure).
Foreign investment income channel: outsourcing in GVCs should increase productivity, generating higher profits in Korean corporates’ foreign operations. These profits will be repatriated through the investment income balance, which raises the current account surplus directly. The strong growth in foreign investment income inflows following the surge in FDI associated with outsourcing suggesting that this channel is significant (see Figure). This positive effect on the current account is likely to be partly offset as this income is received by residents who spend part of it, boosting demand.
Income-distribution channel. Outsourcing can temporarily worsen income distribution, raising the aggregate private saving rate. Higher corporate profits raise corporates’ income that accrues to their shareholders, investors or managers. In parallel, the shift in production abroad reduces domestic employment that initially is likely to be only partly offset by employment for additional production of intermediate exports. As a results, employment and labor income weaken. The net effect is a fall in the share of labor relative to capital income; and, since the former has a high propensity to consume than the latter, this should increase the private saving rate. As this labor is redeployed, employment and labor should recover, reversing this effect. In Korea, the falling share of labor income, and rising capital share, is consistent with this.

D. Implications of GVC Integration for Korea’s Current Account

13. The channels documented above have differing impact on Korea’s current account. The effect through the trade channel is dominated by the recent expansion in forward integration driven by outsourcing. The impact effect of this reduces the current account surplus as outsourcing shifts production of exports abroad, reducing net exports. Over the medium term, the trade channel effect could reverse, as gains in competitiveness drive strong growth in exports of intermediate goods. The other three “macroeconomic” channels all widen the current account surplus. While the net effect through these channels should ultimately be temporary, how long it lasts in practice will depends on how rapidly labor is redeployed in higher value added production activities and the gain in competitiveness from GVC integration are eroded by productivity gains in other countries.

14. GVCs integration alters the saving-investment balance. This is reflected in the recent widening in the gap between saving and investment (Figure). Domestic investment has been weakened by outsourcing as firms invest in production facilities abroad through FDI. In parallel, outsourcing raises the private saving rate by altering the distribution of income. The employment impact weakens labor income growth, while the productivity gains from outsourcing raises corporate earnings. This tends to reduce the share of national income going to labor – which has a high marginal propensity to consume (MPC)—and increasing the share accruing to capital—where the MPC is lower—raises the private saving rate. Over time, these effects should reverse—narrowing the current account surplus—as labor is redeployed and domestic investment expands for production of higher value added intermediate inputs for export. This wider gap between the saving and investment rate has been associated with a larger current account surplus (Figure).

15. To assess whether backward and forward participation in GVCs is correlated with the current account, these two variables are added to the IMF’s multilaterally consistent model of current account determination.³ This modified specification shows forward integration has a positive, and backward integration a negative, correlation with the current account (Figure). The addition of a component of the trade balance (which is part of the dependent variable) as a regressor can give rise to endogeneity problems, thus, the results should only be viewed as indicative. They show that the effect of GVC integration on the current account has shifted from negative to positive, although this effect remains quite small relative to the size of the current account surplus (7 percent of GDP in 2016).

16. In sum, integration into GVCs will yield long run benefits for Korea. GVC integration results from the capacity to take advantage of developments in information and logistics technology that facilitate coordination of production processes across several different countries. Korean firms are leaders in key export industries where GVC participation can yield large productivity gains. This results from the capacity to outsource lower value added parts of the production process (e.g. final assembly of goods from exports) to countries with lower labor costs, while retaining the higher value added parts of the process in Korea (e.g. sophisticated microprocessors). While the increase in global integration of Korean industry into GVCs yield benefits, it also increases vulnerability to external shocks, including from protectionism.

References

Bloom, D., and J. Finlay, 2009, “Demographic Change and Economic Growth in Asia,” Asian Economic Policy Review, Vol. 4 (1), pp. 45–64.
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Prepared by R. Sean Craig and Johanna Schauer (APD)

Lee et. al. in “Offshoring, Exports and Employment: Theory and Evidence from Korean Firms” develop a model showing the conditions under which this effect will be positive. Estimation of their model on Korean sector level data shows that this effect is positive on balance for many sectors and, hence, for the economy as a whole.

The External Balance Assessment (EBA) model is a panel regression encompassing a large number of countries, and is described in the IMF’s 2017 External Sector Report, July 28^th, 2017.

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