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ECONOMIC DEVELOPMENT
IN THE
REPUBLIC OF KOREA
A Policy Perspective
Edited by
Lee-Jay Cho and Yoon Hyung Kim

Me K
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EL
Ley

An East-West Center Book

Distributed by the University of Hawaii Press
 © 1991 by the East-West Center
All rights reserved
Manufactured in the United States of America

Library of Congress Cataloging-in-Publication Data

Economic development in the Republic of Korea / edited by Lee-Jay Cho
and Yoon Hyung Kim.
eect.
Includes bibliographical references and index.
ISBN 0-86638-131-7 : $49.50
1. Korea (South)—Economic policy—1960- 2. Korea (South)—Social
policy. 3. Industry and state—Korea (South) I. Cho, Lee-Jay.
Il. Kim, Yoon Hyung.
HC467.E266 1991
338.95195—dc20 90-20706
G2

Published in 1991 by the East-West Center

1777 East-West Road, Honolulu, Hawaii 96848

Distributed by the University of Hawaii Press

2840 Kolowalu Street, Honolulu, Hawaii 96822
 Contents

List of Figures

List of Tables 59

Contributors xix

Acknowledgments XX

Preface XXV

PART I: POLITICAL AND ECONOMIC BACKGROUND

Lee-Jay ue = = ae is

2. Major Economic Policies of the Park Administration 15

Lee-Jay Cho and Yoon Hyung Kim

PART II: ECONOMIC POLICIES, 1961-80

MONETARY AND PRICE POLICIES

3. The Development of Financial Institutions and the Role of

Government in Credit Allocation 45
Yung Chul Park

4. Price Control and Stabilization Measures 73

Yung Chul Park

. The 1964-65 Exchange Rate Reform, Export-Promotion

Measures, and Import-Liberalization Program 101
Kwang Suk Kim
vi Contents

6. The Interest-Rate Reform of 1965 and Domestic Saving 135

Kwang Suk Kim

7. The President’s Emergency Decree for Economic Stability

and Growth (1972) 163
Wan-Soon Kim

8. Policy Response to the Oil Crisis and the Presidential

Emergency Decree (1974) 183
Yoon Hyung Kim

9. The Comprehensive Stabilization Program (1979) 207

Sang-Woo Nam

TAXATION POLICIES

10. The 1966 Tax Administration Reform, Tax Law Reforms,

and Government Saving 247
Chong Kee Park

11. Introduction of the Value-Added Tax (1977) 273

Kwang Choi

POPULATION AND PUBLIC HEALTH POLICIES

12. Population Policy 303

Andrew Mason and Lee-Jay Cho

13. The Health Insurance Scheme 327

Chong Kee Park

14. The Population Redistribution Plan (1977) and

Urbanization Problems 349
Lee-Jay Cho and Won Bae Kim
 Contents Vil

AGRICULTURAL POLICIES

15. A Positive Grain-Price Policy (1969) and Agricultural

Development 371
Pal Yong Moon

16. The Saemaul (New Community) Movement (1971) 405

Pal Yong Moon

INDUSTRIAL POLICIES

The Heavy and Chemical Industries Promotion Plan

(1973-79) 431
Suk-Chae Lee

18. Policy Measures to Reduce Industrial Concentration and

Concentration of Economic Power 473
Kyung Tae Lee

19: Promotion Measures for General Trading Companies (1975) ei

Sung-Hwan Jo

20. Promotion Measures for Construction Service Exports to the

Middle East (1975) O27,
Chung Hoon Lee

PART III: CULTURE, EDUCATION, AND SOCIAL CHANGE

553
Lee-Jay Cho

22. The Educational System 567

Lee-Jay Cho and Kennon Breazeale
Vill Contents

23. Changes in the Social Structure 587

Lee-Jay Cho and Kennon Breazeale

PART IV: EPILOGUE

24. Political, Economic, and Social Developments in the 1980s 603

Lee-Jay Cho and Yoon Hyung Kim

References 621

Index 641
 List of Figures

oak. Relationship between the PPP-adjusted official exchange

rate and the ratio of the current balance to total imports
of goods and services: 1965-80 129
8.1 Commercial energy per unit of real GNP: 1960-80 199
il The tracking of inflation by money supply growth
(annual rate of GNP deflator increase): 1972-83 223
Dz Management of the national budget over the business
cycle: 1970-83 226
a Trend of interest rates and deposits: 1978-83 229
10.1 Tax administration before and after the reorganization of
1966 Zao
102 Organizational chart of the ONTA 255
12.1 Birth and death rates in Korea: 1910-80 305
2.2 Age pyramids for the Republic of Korea 307
1233 Flow chart of Suits and Mason Demographic-Economic
Model 313
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 List of Tables

da Annual growth rates of commodity products by indus-

trial origin: 1910-39
Gill Ratios of bank loans to output by sector: 1955-80
3.2 Commercial foreign loans, sector share as a percentage
of total loans: 1962-80
J.3 Public foreign loans, sector share as a percentage of total
loans: 1962-80
3.4 Loans and discounts of deposit-money banks, sector
share as a percentage of total loans: 1955-80
4.1 Price indexes: 1961-80
4.2 Money supply and reserve base: 1961-80
4.3 Interest rates: 1961-80
4.4 Savings, investment, and balance of payments as per-
centages of GNP: 1961-80
4.5 Wages, productivity, and unit labor cost in manufactur-
ing: 1961-80
4.6 Terms of trade: 1963-80
4.7 Indexes of nominal and real exchange rates: 1969-80
4.8 Bank of Korea lending: Selected years, 1975-81
Del Nominal exchange rate movements, won to U.S. dollar:
August 1955 to March 1965
Daz Import restrictions by semiannual trade program:
1961-67 LH2
53 Comparison of the old and new trade programs, by
number of export and import items and control
category: 1967 114
5.4 Import restrictions by semiannual trade program:
1967-83 116
oes) Estimates of net and gross export subsidies per dollar of
export, annual averages: 1962-80 IZ

xi
xi List of Tables

5.6 Estimates of actual and legal tariffs and tariff equivalents

per dollar of import, annual averages: 1962-80 123

57, Nominal and PPP-adjusted effective exchange rates for

exports and imports, annual average basis: 1962-80 124

5.8 Major trends in Korea's balance of payments: 1960-80 128

eye) Sources of manufacturing output growth: 1955-63 and

1963-75 131
6.1 Trend in financial savings before and after the interest-
rate reform: 1962-72 136
612 Trends in money supply, quasi-money loans of deposit-
money banks, and ceiling deposit rate, in both nominal
and real values: 1962-80 138
6.3 Changes in principal interest rates of banking institu-
tions as of 30 September 1965 141
Changes in the ceiling deposit and loan interest rates of
banking institutions: 30 September 1965 to 28 June 1982 146
Trend in the ratio of sectoral gross savings to GNP:
1962-82 152
Trend in household saving rate, adjusted for change in
agricultural inventories: 1962-81 153
Changes in the costs of funds and earnings of commer-
cial banks before and after the interest-rate reform 156
Selected financial ratios in the manufacturing industry:
1963-78 164
Interest rates, rates of return, and real estate prices:
1964-78 174
Structure of the primary energy supply: 1961-80 185
External debt and imports of petroleum and petroleum
products: 1967-82 198
Actual versus hypothetical energy: 1974-80 200
Estimates of energy efficiency by sector: 1970-78 202
Composition and growth of the manufacturing sector:
1970-78 204
Spal Macroeconomic overview: 1976-78 207
92 Expansion of the money supply: 1971-78 208
 List of Tables xt

9.3 Export profitability and export growth: 1976-79 209

9.4 Household income distribution by class and degree of
income concentration: 1965-80 210
Economic trends: 1979-83 220
Average annual rate of money supply growth and
velocity: 1970-81 224
Operation of the Grain Management Fund and Fertilizer
Account: 1975-83 228
Real effective exchange rates: 1980-83 231
Increase rates of base salaries and all compensation:
1977-83 202
Average annual rate of increase in real wages and labor
productivity: 1971-82 233
Unit labor costs for manufacturing in Korea, Taiwan,
Singapore, and Hong Kong: 1976-82 234
Decomposition of inflation by cost factor: GNP deflator,
1971-82 235
Tax revenue as a percentage of GNP: 1957-65 247
Central general government revenues as a percentage of
GNP: 1960-69 249
Result of internal audits, 3 March-31 December 1966 256
Voluntary disclosure program of tax evasion, 1966:
Number of cases and amount of tax collected 257
Changes in statutory tax rates for personal income,
before and after the 1967 tax law reform 259
Trends in tax revenue and other measures of tax perfor-
mance: 1962-72 264
Government saving as a percentage of GNP: 1963-72 268
Pre-VAT and VAT tax rates: 1977 276
Taxes applied to selected goods as a percentage of the
producer's price: 1988 277
National and local tax, 1970-82, and value-added tax
yield, 1977-82 283
Predicted and actual change in price levels due to
implementation of VAT: 1977 285
xiv List of Tables

Prices, wages, and domestic credit indexes, 1974-80:

Three years before and three years after VAT intro-
duction 287

Support of capital investment through VAT refunds by

industry: 1977-82 288
Average annual rebate of indirect taxes per dollar of
exports: 1973-82 291
Effective burdens of VAT on income tiseMi
Burdens of domestic indirect taxes on income under the
pre-VAT and the VAT regimes 293
Population growth: 1900-85 304
Population projections for the Republic of Korea:
1985-2020 306
Determinants of fertility decline 315
Trends in the crude birth rate: Major regions and the
standard development profile 315
The importance of rapid development for fertility decline
in Korea 316
Age-specific fertility rates as calculated from survey data
under specified conditions, Korea 318
Comparison of changes in the total fertility rate as esti-
mated by different procedures: 1955-60 to 1970-75
Comparisons of government expenditures on social
development, by country: 1976-78 averages
Distribution of government expenditures on economic
and social services: Selected years 330
Estimated social security expenditures: 1979
Persons covered by the medical insurance system, by
province and program: 1981
Medical care utilization rate of persons covered by the
medical insurance program: 1977-81
Average contribution and benefit per insured person in
the Employee Medical Insurance Program, by income
level: 1981
Industrialization and urbanization indexes: 1960-80
Urban, rural, and major city population shares: 1960-80
 List of Tables = xv

14.3 Provincial manufacturing employment: 1966-81 351

14.4 Relative contributions of the components of urban
growth: 1960-80 352
14.5 Rural-urban income differentials: 1963-83 358
14.6 Rural-to-urban migration 309
14.7 Provincial shares of production, population, and employ-
ment: 1960-80 360
14.8 Population increase in the capital region: 1960-83 362
14.9 Intercensal migration by area: 1960-80 363
14.10 City size distribution: 1960-80 364
15.1 Government acquisition of domestic rice and barley: Rice
years 1960-82 YAs)
15.2 Determination procedures of rice purchase price:
Selected years, 1965-80 378
15.3 Government purchase price versus selling price for rice:
Selected years, 1960-82 380
15.4 Government purchase price versus selling price for
barley: Selected years, 1969-82 381
15.5 Farm machinery in use: Selected years, 1965-82 383
15.6 Comparison of the average annual rates of growth in
labor productivity and prices: Rice sector versus
manufacturing 390
15.7 Comparison of rural and urban household income:
1965-82 393
15.8 Proportion of grain and rice expenditures in cost of liv-
ing for urban households and labor income share in
manufacturing sector: 1975-81 394
15.9 Monthly distribution of government rice purchases:
1967-82 402
16.1 Cultivated land, rural population, number of farm »
households, and average farm size: Selected years,
1965-82 406
16.2 Distribution of farm households by size of holding:
Selected years, 1965-82 407
16.3 Scope of participation in the Saemaul movement:
1972-82 412
xvi List of Tables

16.4 Government and village contributions to Saemaul

projects: 1972-82 413
Government support by program category: 1973-82 418
Farm saving ratio, average per household: Selected years,
1960-82
Farmers’ deposits and relative share in the total loanable
funds of agricultural cooperatives: Selected years,
1963-80
HCI projects promoted before 1973
Projects included in the HCI promotion plan
Real interest rates in the 1970s
Financing sources of the National Investment Fund (NIF)
Allocation of NIF financing by sector: 1974-82
Incremental credit allocation by the deposit-money banks
and the Korea Development Bank
Commercial bank borrowing costs for HCI projects
Effective marginal tax rate of HCI
Trends in size of government budget support for HCI
programs: 1970-81 450
Allocation of government budget for HCI programs:
1970-81 451
Facility investment in the manufacturing sector 452
Structural change in manufacturing 452
Capacity utilization in HCI 452
Economic circumstances surrounding the 1980 economic
crisis 453
Trends in RCA indices by commodity 455
Trends in major indicators in the manufacturing sector 456
International comparison of incremental capital-output
ratios (ICORs) 462
Exchange rates during the 1970s 464
Effective protection rates by sector 464
Supply of engineers and skilled technical workers 467
 List of Tables = xvii

18.1 Overall concentration ratios for manufacturing: 1970 and

1977 474
18.2 Distribution of large firms: 1977 475
18.3. Number of manufacturing industries and share of ship-
ments by class of industrial concentration ratio: 1970 and
1977 476
18.4 Weighted or simple average concentration ratios for the
manufacturing sector: 1970 and 1977 478
18.5 Degree of asymmetry between the two largest firms:
1970 and 1977 479
18.6 Number of firms owned by 30 largest conglomerates:
1974-80 480
18.7 Market power of the 30 largest conglomerates: 1977-80 480
18.8 Conglomerates’ share of fixed capital and value added in
manufacturing: 1977 and 1980 480
18.9 Conglomerates’ share in technology imports: 1962-80 481
18.10 Market power of the 30 largest manufacturing con-
glomerates: 1977 482
18.11 Value-added share of conglomerates by sector: 1978 484
18.12 Comparison of price increases between monopoly-
oligopoly and competitive commodities: 1973-75 486
18.13 Sectoral growth rates in Korea: 1962-81 487
18.14 Shares of employees, gross products, value added, and
bank loans among small and medium-size firms in
Korea, Japan, and Taiwan: 1981 487

18.15 Number of corrective measures taken against antitrust

violations: 1981-83 492
18.16 Number of corrective measures taken against fair trade
violations: 1981-83 493
18.17 Accomplishments of the Financial Structure Improve-
ment Plan: 1974-77 496
18.18 Disposition of subsidiaries by conglomerates: February
1982 498
18.19 Trends in market concentration: 1977 and 1985 503
 xviii List of Tables

18.20 Value-added share in GDP of the five largest and the 20

largest conglomerates: 1973-81 505
18.21 Shares of bank loans and credits granted to the five
largest and 30 largest conglomerates in totals, as of
October 1982 505
18.22 Bank equity holdings of three super-conglomerates, as of
October 1982 506
18.23 Sectoral distribution of total assets, own capital, and em-
ployment of the top 30 conglomerates: 1980 507
18.24 Distribution of conglomerates’ fixed capital stock in
manufacturing: 1980 507
18.25 Paid-in capital, fixed capital stock, and value added of
small and medium-size firms, conglomerate members
compared to independents: 1980 508
19.1 Minimum requirements for designation as a GTC 514
19.2 Share of exports by type of firm: 1975-82 518
19.3 Share of GICs’ exports by type of product: 1979 and
1981 520
20.1 Exports of overseas construction services 528
20.2 Gross domestic capital formation and its rate of growth 531
20.3 Effects of construction service exports on the balance of
payments 541
ate External debt service 543
20.5 Effect of construction service exports on employment 544
20.6 Wage index of production workers employed by Korean
overseas construction companies 547
22.1 Numbers of students and teachers: Selected years,
1945-85 568
22.2 Registered students in Korea by type of school: Selected
years, 1910-37 oy2
23.1 Net Korean migration to Japan and Manchuria: 1910-40 588
23.2 Estimates of migration into South Korea: 1945-49 588
23.3. South Korean casualties during the Korean War: 1950-53 589
./ 24.1 Major indicators of the Korean economy: 1979-89 609
 Contributors

Editors

Lee-Jay Cho is vice president for academic affairs at the East-West Center,
and director of the East-West Population Institute in Honolulu, Hawaii. Dr.
Cho was an advisor to the government of the Republic of Korea on popu-
lation, human resources, and urban issues in the 1960s and 1970s. Recently,
he has led and participated in many studies on China's population and eco-
nomic development policy. Dr. Cho has a Ph.D. in sociology from the
University of Chicago, a doctorate in economics from Keio University, and
a doctorate in demography from Tokyo University.

Yoon Hyung Kim is professor of economics at Hankuk University of For-

eign Studies in Seoul, and research associate at the East-West Population
Institute, East-West Center, Honolulu, Hawaii. Dr. Kim was director-general
of the Planning Bureau of the Ministry of Energy and Resources of the
Republic of Korea from 1977 to 1980 and chief of the Development Plan-
ning Office of the Korea Development Institute from 1973 to 1978. From 1971
to 1973, Dr. Kim was an economist in the Development Research Center
of the World Bank in Washington, D.C. Dr. Kim received his Ph.D. in eco-
nomics from Stanford University.

Authors
Kennon Breazeale is a research associate at the East-West Center, Honolulu,
Hawaii, serving jointly in the institutes of Culture and Communication,
Resource Systems, and Population. Dr. Breazeale has a doctorate (D.Phil)
in oriental studies from the University of Oxford.

Kwang Choi is professor of economics at Hankuk University of Foreign

Studies in Seoul, and a member of the Budget System Review Committee,
Economic Planning Board, and the Tax Review Commission, Ministry of
Finance, Republic of Korea. He is also on the Board of Directors of the Korea
Development Bank. Dr. Choi was a senior fellow of the Korea Development
Institute during 1981-85. He has a Ph.D. in economics from the University
of Maryland.

Sung Hwan Jo is professor of economics and dean of the College of Eco-

nomics at Sogang University in Seoul. Dr. Jo has a Ph.D. in economics from
Yale University.

x1x
xx Contributors

Kwang Suk Kim is professor of economics at Kyung Hee University in Seoul.

Dr. Kim was an economic advisor to the U.S. Agency for International De-
velopment mission in Korea from 1958 to 1970. He was a research director
and vice president of Korea Development Institute during 1972-82. From
1986 to 1989 he was dean of the Graduate School of Business Administra-
tion, Kyung Hee University. Dr. Kim has a Ph.D. in economics from Korea
University.

Wan-Soon Kim is professor of international economics at the College of Busi-

ness Administration, Korea University, and concurrently chairs the Korean
Trade Commission, Ministry of Trade and Industry, Republic of Korea. Since
1975 Dr. Kim has been a member of several advisory committees for the
government of the Republic of Korea, including the Tax Advisory Commit-
tee of the Finance Ministry. During 1967-71, he was an economist at the
International Monetary Fund, and subsequently spent about two years as
a senior fellow at the Korea Development Institute. He has a Ph.D. in eco-
nomics from Harvard University.

Won Bae Kim is research associate at the East-West Population Institute,

East-West Center, Honolulu, Hawaii. Dr. Kim has taught at the University
of Hawaii and Dong-A University in Pusan, Korea. He has a Ph.D. in ur-
ban and regional planning from the University of Wisconsin-Madison.

Chung Hoon Lee is professor of economics at the University of Hawaii, and

research associate, Resource Systems Institute, East-West Center, Honolulu,
Hawaii. Dr. Lee has a Ph.D. in economics from the University of California
at Berkeley.

Kyung Tae Lee is a senior fellow at the Korea Institute for Economics and
Technology and counselor to the minister of trade and industry, Republic
of Korea. Dr. Lee served as deputy division director of the Banking Bureau
of the Ministry of Finance, Republic of Korea, from 1974 to 1977. Dr. Lee
has a Ph.D. in economics from George Washington University.

Suk-Chae Lee is an economic secretary (assistant minister rank) with the

Office of the President of the Republic of Korea, where he has served since
1984. During this period he was involved in many key economic policy de-
cisions and has been in charge of macroeconomic policy, international eco-
nomic policy, agricultural policy, and recently regional development policy.
Dr. Lee was with the Economic Planning Board during 1970-84 and worked
at various bureaus including service as assistant director and director of
the Economic Planning Bureau. Dr. Lee has a Ph.D. in economics from
Boston University.
 Contributors KCL

Andrew Mason is professor of economics at the University of Hawaii,

and research associate, Population Institute, East-West Center, Honolulu,
Hawaii. Dr. Mason has a Ph.D. in economics from the University of
Michigan.

Pal Yong Moon is professor of economics at Konkuk University in Seoul.

He has also been a member of the Agricultural Imports Committee, Minis-
try of Agriculture and Fisheries, Republic of Korea, since 1980. Previously
Dr. Moon was a member of the Agricultural Policy Advisory Committee,
Ministry of Agriculture and Fisheries (1976-82) and senior fellow, Korea De-
velopment Institute (1972-76). Dr. Moon has a Ph.D. in economics from Ore-
gon State University.

Sang-Woo Nam is senior fellow at the Korea Development Institute where

he has been actively involved in macroeconomic policymaking since 1977.
Dr. Nam served as counselor to the deputy prime minister of the Republic
of Korea in the early 1980s. He was an economist at the World Bank during
1986-88 in the Macroeconomic Division of the Development Research
Department and the Asia Regional Office. Dr. Nam has a Ph.D. in manage-
ment from the Massachusetts Institute of Technology.

Chong Kee Park is professor of economics at Inha University, Inch’on, Korea.

He also is a member of the Board of Directors, Citizens National Bank; Bud-
get System Review Committee, Economic Planning Board; Tax Advisary
Committee, Ministry of Finance, Republic of Korea; and Research Advisory
Committee, Korea Development Institute. He was a senior fellow and
research director of Korea Development Institute during 1971-73 and dean
of the College of Business and Economics at Inha University during 1985-87.
Dr. Park has a Ph.D. in economics from George Washington University.

Yung Chul Park is professor of economics at Korea University. Professor Park

has served as advisor to the Korea Research Institute for Human Settle-
ments, the Bank of Korea, and the Ministry of Finance, Republic of Korea.
He has a Ph.D. in economics from the University of Minnesota.
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 Acknowledgments

The editors would like to express their profound gratitude to the Economic
Planning Board of the Republic of Korea, the Korea Development Institute,
the Korean Research Foundation, the Korean Traders’ Association, and the
Korea Institute of Industrial Economics and Technology for their generous
financia! support which, together with the expertise contributed by many
of their senior staff members, has ensured the successful completion and
publication of this book.
We want to acknowledge the invaluable contributions made by Mr.
Chung Yum Kim, formerly Korea's ambassador to Japan and chief of staff,
Office of the President of the Republic of Korea. Our sincere thanks also
to the many former and current government officials who provided access
to unpublished government data and were a unique resource for back-
ground material on the policymaking process during the Park years.
We are grateful to Dr. Daniel B. Suits of the University of Michigan and
Dr. Kwang Suk Kim of Kyung Hee University in Seoul for their valuable
contributions to the substantive editing of the government policy measures.
Appreciation is also due to Dr. Chung Hoon Lee, Dr. Burnham Campbell,
and Dr. Kennon Breazeale for their helpful suggestions. Dr. Ki-Jun Rhee,
director cf the Asia-Pacific Institute in Seoul and Dr. Shinichi Ichimura of
Kyoto University provided useful comments on an earlier draft. Anne
Stewart, who served as manuscript editor of this volume, has done so much
in the preparation of this work that without her valuable contributions we
would not have seen its publication.
We are indebted to many people who helped bring this book to comple-
tion. The Graphics and Production Services Unit of the East-West Center
brought the book to a camera-ready state. We are especially indebted to
Jacqueline D’Orazio for production coordination, Russell Fujita for the book's
design, and Lois Bender for typesetting. We are also grateful to Corinne
Holland, editorial assistant at the East-West Population Institute, for
proofreading the manuscript and Allison Greenspan for preparing the in-
dex. We also thank Janet Heavenridge, production manager at the Univer-
sity of Hawaii Press, for her assistance with the project.

Lee-Jay Cho
Yoon Hyung Kim

XXII
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 Preface

During the 18 years of President Park Chung Hee’s leadership, from 1961
to 1979, the Republic of Korea underwent dramatic economic development,
maintained relative domestic political stability, and achieved major economic
and political advances in the international arena. A salient feature of this
period of rapid growth was the close and extensive cooperation between
government and business in pursuit of national development objectives.
This cooperation is reminiscent of Japan, where policy reflects a fairly good
consensus of opinion among the principal elements of the Japanese indus-
trial community. In Korea! the government and its development policymak-
ers took much more assertive leadership and set policies, with the business
community cooperating in their implementation.
By any economic criteria, the South Korean economy registered outstand-
ing material performance in the 1960s and 1970s. The gross national product
(GNP) increased in real terms more than thirteenfold when measured at
1980 constant prices (from 3.00 trillion won in 1961 to 39.25 trillion won in
1979). Comparing South Korea with North Korea, the South did not over-
take the North in per capita GNP until the late 1960s. In 1987, however,
the South exceeded the North by more than sixfold in GNP and more than
threefold in per capita GNP. From one of the poorest developing countries
in 1961, South Korea was transformed into a semi-industrial, middle-income
nation by the final year of the Park era, and during that period per capita
income rose from a mere US $82 to US $1,644.
The rapid development was led by export-oriented industrial expansion
and was achieved in spite of poor natural resource endowments. Korean
exports, which remained stagnant at a low level in the 1950s, increased
rapidly at an average annual rate of 39.1 percent when measured in con-
stant 1980 dollars (from US $40.9 million in 1961 to $15.1 billion in 1979),
with manufactured goods accounting for the majority of total exports. As
the rapid expansion of exports stimulated the domestic economy, real GNP
grew by an average annual rate of 9 percent during 1961-79, compared with
only about 4 percent in the immediate postwar period 1954-61. The
manufacturing sector, in particular, expanded at an average annual rate of
17.5 percent during 1961-79, thereby increasing its share of GNP from 13.5
percent to 26.9 percent. Over the same period, the share of agriculture,

1. Throughout this volume, “Korea” refers to the undivided peninsula up to 1945 and to South
Korea—the Republic of Korea—after World War II. Likewise, “Koreans” refers to the entire Korean
populace up to 1945 and thereafter specifically to South Koreans. References to modern North
Korea should be clear from the context of the discussion. This terminology has been adopted
for simplicity of style and does not imply any cultural or political judgment.

XXU
xxvi Preface

forestry, and fishing declined from 38.7 percent to 20.5 percent (BOK, Eco-
nomic Statistics Yearbook, 1986).
What caused this transformation? The rapid economic growth that charac-
terizes the Park era can be attributed to many factors, including investment
and rapid capital growth, expansion of industrial productive capacity, and
the development of human resources and labor productivity. Other con-
tributing factors were the favorable worldwide economic conditions prevail-
ing during the 1960s, Korea's political stability, the commitment of the
country’s leaders to economic development (as illustrated by the launch-
ing of the First Five-Year Economic Development Plan), the outward-looking
strategy of industrialization, the vitality and entrepreneurship of the emerg-
ing corporate leaders, the grassroots support and participation in rural trans-
formation, and the close government-business interplay in Korean economic
development. It can also be argued that the cultural values shared in com-
mon among the Koreans, Chinese, and Japanese contributed to the qual-
ity of the labor force, principally through education.
Manufacturing output expanded dramatically during the 1960s and 1970s,
thereby leading the rapid growth of an economy that had been shattered
by the Korean War (1950-53). As Korea shifted from the import-substitution
strategy of the postwar 1953-61 period to an export-led industrialization
strategy during 1962-79, exports (principally manufactured goods) rose
sharply. Along with the dramatic increase in the proportion of the manufac-
turing sector in GNP, the share of this sector in total employment nearly
tripled during the high-growth period under President Park. In particular,
the output share of heavy and chemical industries nearly doubled (to almost
55 percent) by 1979.
The Park era is also characterized by a dramatic increase in capital for-
mation. The average proportion of GNP devoted annually to gross domes-
tic capital formation increased sharply (from about 15 percent in 1962-64
to about 32 percent in 1977-79). During 1953-63 Korea financed up to two-
thirds of total investment requirements from foreign sources, most of which
was economic aid from the United States. When the major fiscal and finan-
cial reforms were set in motion in the mid-1960s, however, the government
successfully mobilized domestic resources. The gross domestic savings rate,
which was about 3-5 percent until the early 1960s, rapidly increased to 28
percent on average during 1977-79. Moreover, the sectoral savings pattern
underwent drastic changes. Government saving was negative up to 1963
but rapidly increased in the late 1960s and 1970s. Household saving also
remained negative during 1961-63 but increased remarkably to 12.6 per-
cent of GNP in 1977-79. More than 80 percent of GNP was expended on
private consumption until the early 1960s, but Korea successfully reduced
its average propensity to consume to 62 percent in 1977-79. Throughout the
entire 1953-89 period, however, it was the business sector that made the
greatest contribution to the rapid increase in gross domestic saving. As a
 Preface xxvii

result of the sharp increase in domestic saving over the past three decades,
Korea’s national economic capacity has expanded to such an extent that the
country is now able to finance more than its entire gross domestic capital
formation.
The labor force required for expansion of manufacturing production dur-
ing the high-speed growth period was provided by the existing unemployed
urban population and the abundant human resources in the rural sector
already available in the early 1960s. Rapid industrialization was thus not
restrained by shortages of labor and skills. From the early 1960s, concur-
rent with the industrialization drive, the government embarked on a bold
family planning program and successfully reduced the population growth
rate. The sharp growth in per capita GNP in real terms led to a commen-
surate substantial increase in per capita private consumption, greatly im-
proving the living standard of the Korean people as a whole.
Prior to the 1960s, about two-thirds of the Korean labor force resided
in rural areas. Even though total population grew at about 2 percent on
average per year between 1963 and 1979, the “baby boom” after the Korean
War resulted in an increase on average of 3.4 percent per year in the total
labor force. Rapid industrialization, led by the expansion of labor-intensive
manufacturing for export, nonetheless absorbed the existing unemployed
population as well as the newly participating labor force. The growth rate
of urban employment far outstripped that of the rural areas, reducing the
urban unemployment rate by about two-thirds (from 16.0 percent in 1963
to 5.6 percent in 1979). This rapid increase in urban employment substan-
tially alleviated unemployment throughout the economy. In the meantime,
the proportion of urban employment in the total employed population rose
sharply (from 35.6 percent in 1963 to 58.5 percent in 1979). The rising de-
mand for labor in the industrial and urban sectors led to heavy migration
from rural areas. But, although rural employment was declining, value ad-
ded in agriculture in real terms was growing at a fairly respectable rate.
Labor productivity in the manufacturing sector also rose at a healthy rate,
and real wages increased even more rapidly.
High-speed growth could not have materialized without Korea’s abun-
dant human resources and continuous investment in education. Over the
two decades from 1960 to 1980, the average number of years that the em-
ployed population spent in school nearly doubled (from 4.2 years to 8 years).
The improvements in education not only enabled urban employment to
increase quickly without significant shortages of skilled workers until early
in the 1980s, but also contributed to increased labor productivity and wage
levels.
Rapid growth and structural change in such a brief span of time was
not achieved without sacrifices. The tempo of inflation accelerated at an
annual rate of about 19 percent throughout the period 1962-79. This infla-
tion can be attributed mainly to the approximately 29 percent average
xxviii Preface

annual growth rate of the money supply, caused by the accumulation of

fiscal deficits, expansion of preferential policy loans, grain-price subsidies,
and the low level of the domestic savings rate at the outset of industrializa-
tion. Inflation was regarded by the Korean government as the inevitable
price for high-speed economic growth. Although an economic stabilization
program was initiated in the last year of the Park administration, inflation-
ary pressure was not brought under control until the mid-1980s, by which
time Korea was faced with yet another crunch in the form of mounting for-
eign debt.
This book examines the major economic policies of the 1960s and 1970s.
The measures examined in this work, which were formulated and im-
plemented during the administration of President Park, played a critical
role in transforming the structure of the Korean economy and in moving
it to a higher growth path. The conceptual framework underlying the ap-
praisals in this book is also based on the broader premise that Korea's eco-
nomic performance during the 1960s and 1970s was an outcome of the
interactions among environment (defined to include resources, technology,
and international markets), the economic system, government policy, and
the public. The success stories and hard lessons of recent Korean experiences
will serve, moreover, as a valuable set of materials for future socioeconomic
development planning and implementation by both Korea and other de-
veloping countries.
This research project was planned and coordinated by the East-West
Center on a cost-sharing and cooperative basis with the Korean Traders As-
sociation, the Korea Development Institute, and the Korea Institute of In-
dustrial Economics and Technology. Comprehensive and detailed case
studies of 18 major economic policy measures constitute the core of the
book. Additional chapters have been designed to place these policies in
the broader perspective of cultural values, the development of human
resources, and modern political change in Korea. The final chapter sum-
marizes the political, economic, and social development of Korea during
the 1980s.
The case studies have a common structure, thereby providing a basis
for tracing patterns of economic policy, interactions, the Korean model of
economic development, and the lessons for the future. Each examines the
main features of a particular policy measure, its theoretical appropriate-
ness and effects, and the interaction of government, business, and the public
in its formulation and implementation.
Prominent Korean scholars were invited by the East-West Center to write
specific modules in their respective areas of expertise. Active participation
by Korean institutions was an important feature of the project. Subsequent
amendments resulted from information and criticism obtained at consul-
tative meetings. At those meetings, former senior economic policymakers
from Korea, prominant Korean business leaders, and U.S. scholars engaged
 Preface =xxix

in intensive discussions to clarify the historical background of each policy

study and to provide supplementary unpublished data and information.
This book attempts to describe economic policymaking during the Park years
as accurately as possible through the contributions of Korean scholars and
policymakers who were involved directly and indirectly in the economic
modernization of Korea during the last three decades.

Lee-Jay Cho
Vice President for Academic Affairs
East-West Center
and
Director
East-West Population Institute
East-West Center, Honolulu, Hawaii

Yoon Hyung Kim

Professor of Economics
Hankuk University of Foreign Studies
Seoul, Korea
and
Research Associate
East-West Population Institute
East-West Center, Honolulu, Hawaii
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PART I
POLITICAL AND
ECONOMIC BACKGROUND
 1 Political and Economic
Antecedents to the 1960s

by Lee-Jay Cho and Yoon Hyung Kim

Remarkable changes were forced on the Korean people during a relatively

brief time span, not only after World War II but also earlier in this century.
For a better understanding of Korea’s present-day social and economic in-
stitutions, it will be useful to examine first some of the broad historical pat-
terns of the country’s transition from kingdom to colony and finally to
republic.
Korea has always been surrounded by harsh political reality and forced
to tackle the challenges thrust upon it by its powerful neighbors, particu-
larly China and Manchuria. In response, nevertheless, Koreans absorbed
and benefited from the invaders’ culture and know-how. Despite many for-
eign intrusions during its long history, including Japanese incursions on
the mainland in the sixteenth century, Korea was able to maintain its polit-
ical independence until the turn of the twentieth century. The ancient
Korean monarchy survived until 1910 partly because the kingdom remained
a tributary under the protection of the Chinese imperial system. By the end
of the nineteenth century, however, the great Chinese empire was crum-
bling under misrule and was no longer capable of meeting its traditional
obligation to ensure the defense of its tributaries. Korea became a bone of
contention among its three large neighbors and was soon overwhelmed by
the emerging power of Japan.
The Meiji revolution in Japan swept away the Tokugawa bakufu (military
regime) in 1868, launching a new stage of development by bringing in
Western technology and ideas. The resultant modernization touched upon
almost every aspect of Japanese society—from clothing to the constitution
and from the legal system to the education system. For some time after the
Meiji revolution, the Japanese followed the policy of tatsuaron (“getting away
from Asia’), which meant the avoidance of “continental Asian” influences
in general. Viewing China and Korea as technologically backward, Japan
turned to the West for its technology and scientific ideas. By no means,
however, did Japan abandon the values with which it had been imbued
for centuries. On the contrary, its blending of East Asian values together
with Western technology and science greatly expedited modernization and
economic development in Japan. Thus, by the turn of the twentieth cen-
tury, within one generation after the Meiji revolution, Japan became the
only modern power in Asia that was able to challenge the Western powers.
4 Lee-Jay Cho and Yoon Hyung Kim

In contrast to the outward-looking Japanese attitude, Korea continued

to turn inward, maintaining its overly Sinified political system and uphold-
ing its traditional tributary relationship with Beijing. Continuing to view
China as the center of the world, while not realizing that the world was
passing it by, Korea was dubbed the “Hermit Kingdom” (Griffis 1897).
Korea's long history of seclusion ended partly as a result of Japanese gun-
boat diplomacy, which forcibly opened the country to trade under the 1876
Koreans PeenemeanpetemaesRPD ringthe following several decades,
Japanese immigrants began to arrive in Korea to develop businesses. Start-
ing with their monopoly on foreign trade, they gradually established com-
plete control over the Korean economy. The Korean branch of the Japanese
Dai Ichi Bank was opened in 1878 and assumed the role of central banking
in 1905, linking the currencies of the two countries. In October 1909, the
central bank of Korea was established. Thus, for the first time, a modern
financial system was introduced to all of Korea, together with a modern
currency system. (For further discussion, see Palais 1975; Griffis 1897; and
K. Z. Cho 1977.)
ANNEXATION BY JAPAN
Korea was unable to meet the external challenges confronting it at the end
of the century—whether military aggression or international politics—and
could not defend its sovereignty. Rival imperial ambitions b ht Japan
i s for control of Korea—
SOUS Ssosequenily, the Japanese virtually ruled Korea through the
advisory system (kumon kaiji) and supervisors (tokanfu). In 1910 the Korean
peninsula became part of the Japanese empire through annexation.
Prior to the Meiji revolution, the Japanese had always regarded China
as the origin of superior culture and Korea as the transmitter of that cul-
ture to the archipelago. The Japanese, therefore, had looked upon China
and Korea with profound respect. While the Meiji revolution was making
great advances, however, China and Korea were unable to break away from
their political and technological backwardness. In spite of the tradition of
cultural superiority and heritage from continental Asia, Japan began to
regard the Chinese and Koreans as second-class nationalities, giving rise
to the Japanese sense of national as well as racial superiority. Thus, the
Korean peninsula was not regarded after annexation as equivalent to the
provinces within Japan, but rather as a colony governed by the Sotokufu
(Office of the Governor-General)—an institution imposed by the Japanese
government and officially headed by a high-ranking general in the Japanese
army. Traditional Korean administration was swept away.
Basically, the Japanese aim was to structure Korean economic expansion
to meet the overall needs of the Japanese economy. In the beginning, the
Japanese tried to develop the Korean economy as a major source of food
for Japan and as a market for Japanese manufactured products. Thus from
 Political and Economic Antecedents to the 1960s 5

annexation through the 1920s, the Japanese made a major effort to raise
agricultural productivity, especially in the production of rice, by transfer-
ring Japanese technology to increase productivity per unit of land in Korea.
As the Japanese developed the industrial sector in Korea, ownership in this
sector became almost wholly Japanese, and most of this sector’s leadership
consisted of Japanese immigrants. The Japanese share of total paid-in capi-
tal in the industrial sector increased from 32 percent in 1911, to 80 percent
in 1917, and to 90 percent in ioe) Suh 1978:10).
After annexation, Ja Da a: y 1 er-

e vast northeastern part of China (Manchuria)

offered an enticing abundance of the natural resources that Japan lacked.
Its coal reserves were almost comparable to those of the United States; it
also had other important mineral resources, petroleum, and forests. In 1932
Japan established a puppet state in Manchuria that was administered, for
all political and economic purposes, by the Japanese imperial government.
Japan could be best provisioned with the products of this resource-rich ter-
ritory by way of the Korean peninsula, and this link soon became known
as “the lifeline of the great Japanese empire.”
The availability in Korea of mineral resources, hydroelectric power poten-
tial, and cheap labor were advantages for developing the industries needed
to provision both Japan and Japan's forces in Manchuria. The quality of
the Korean labor force was almost comparable to that of Japan, with the
advantages that some of the work force spoke Japanese and had received
a Japanese-style education. After 1932, when the Japanese-controlled
government was established in Manchuria, the geographical position of
Korea gave it increased strategic importance for further development of these
industries in Korea, which in turn enabled further Japanese expansion in
East Asia. Thus, from the early 1930s to 1941, the initial emphasis on rice
production was replaced jas of large-scale industries. This shift

ooo aerate ae with the creation of the new state in

a and followed by the occupation of major coastal cities in China
in 1937, the extension of Japanese power into Vietnam in 1940, and finally
the Japanese attacks throughout Southeast Asia at the end of 1941.
During the period of Japanese colonial rule in Korea the agricultural sector
continued to grow at a low but fairly steady rate, but the manufacturing
sector was growing several times faster, especially during the late 1930s.
Indicators of economic growth, such as annual growth rates in the produc-
tion of commodities (Table 1.1), demonstrate that fairly rapid development
did take place in Korea. The overall growth rate of the economy during this
period was about 3 percent, whereas the population was increasing at a
net rate of only around 1 percent, showing that Korea experienced sub-
stantial economic growth under Japanese colonial rule.
6 Lee-Jay Cho and Yoon Hyung Kim

Table 1.1. Annual growth rates of commodity products by industrial ori-

gin: 1910-39 (%)
Agricultural § Manufacturing Overall
Period sector sector growth
1910-15 to 1916-21 Bez 7.0 3.4
1916-21 to 1922-27 13 8.9 1:9
1922-27 to 1928-33 207 8.2 Ju
1928-33 to 1934-39 1.0 15.0 3.4
1910-15 to 1934-39 2.0 On, 3.0
Source: Suh (1978).

The rapid growth of the Korean industrial sector was an outcome of

Japanese capital investment. It was imposed on the Koreans from outside
and was unconnected to the traditional sectors of the Korean economy.

Some sectors of the Korean economy thus remained rela-

tively backward, whereas others were as advanced as their counterparts
in Japan.
The Japanese favored capital-intensive development in certain military
industries, and introduced the latest technology. This resulted in further
imbalance and sharper wage differentials between the agricultural and
manufacturing sectors. The productivity gap also became wider, as agricul-
tural workers became progressively less productive when compared with
those in manufacturing. The productivities were nearly equal in 1920, when
the real product per worker in agriculture was 91 percent of that in manufac-
turing; by 1940 the ratio had fallen to a mere 24 percent. This unbalanced
dualistic growth in the Korean economy sufficed, from the Japanese view-
point, so long as the growth met the needs of the Japanese economy.

ECONOMIC LEGACY OF COLONIAL RULE

In terms of technical and economic development, the 36 years of Japanese
occupation were not entirely disadvantageous to Korea. In carrying out its
imperialistic expansion, Japan provided the Korean peninsula with sub-
stantial infrastructure, including:

a a strategic link across the peninsula with major towns in Man-

churia

tate the trade in commodities between Korea and Japan

*ashoderctmmsnicglions ete. including telephone and telegraph
n
 Political and Economic Antecedents to the 1960s yi

n which, however, the

medium ' language
, which later became Seoul National University

s fortextiles ig oe
* the modernization of the mining industry
* the modernization of
agriculture»
+ the centralized administrative structure —
While under Japanese rule, Koreans did gain some social and economic
benefits, even if confined to only some segments of society. Many of these
were conducive to later economic growth—in particular, t
,

Despite the colonial policy of extracting

from Korea both natural and human resources, manufactured goods, and
agricultural products to help meet the needs of Japan, despite the relative
backwardness of the traditional sector (as opposed to the large-scale,
Japanese-led industrial sector), despite the fact that Koreans could not play
a leadership role in either the agricultural or the manufacturing sector, they
were nonetheless brought into a development scheme for higher agricul-
tural and industrial productivity. -
d, not for the benefit of Koreans but as a secure source of supply
for Japan. To accelerate this plan, the Japanese built agricultural training
centers and agricultural high schools throughout the peninsula. The
independent-minded Koreans were resentful of such programs, despite their
long-term benefits, because these modernizations were forced on them by
a foreign power.
When the Japanese left Korea in 1945, they could not take with them
the physical plant, and they also left behind the people who had helped
them to manage their plants. Their assistants, who had never played an
executive role before, had acquired enough skills and knowledge from tech-
nology transfer to assume control immediately and did not have to start
building these sectors all over again.
Given the conditions prevailing at the time, the economic development
of Korea was remarkable. The Japanese, of course, never expected to lose
control of Korea; if they had hedged their policies around the possibility
of being dislodged, they would never have invested so heavily to provide
the peninsula with so much infrastructure. But because the Japanese-
controlled Korean economy was designed and structured primarily to
benefit the Japanese, the material benefits to the Koreans were less than
what might appear superficially to be the case in view of such rapid growth.
There was a transmigration of several million Japanese from Japan to the
8 Lee-Jay Cho and Yoon Hyung Kim

Korean peninsula. Large numbers of Koreans also migrated to Japan, where

they supplied cheap labor for the construction of roads, munition works,
and the textile industry, and to Manchuria for frontier development, par-
ticularly agriculture and mining. The Koreans were compelled to migrate
at first. Later, because of Japanese agricultural and land policies in Korea,
many farmers and other Koreans felt that they could make a better living
in Japan or Manchuria, and they therefore migrated voluntarily.
Japanese nationals were always given priority in the new settlements,
in educational institutions, in occupations, and of course in the govern-
ment hierarchy. Koreans were denied a leadership role in their own govern-
ment because Japan (unlike some colonial powers, such as Great Britain)
did not bring the colonized people into their own local civil service.
During World War II enormous sacrifices were forced upon Koreans
through military conscription and the compulsory mobilization for paramili-
tary service in Japan and throughout the war zones of the Pacific and
Southeast Asia.
In the years immediately following the war, after almost four decades
of Japanese rule, anti-Japanese sentiment led Koreans to eliminate virtu-
ally everything readily identifiable as Japanese in origin. In retrospect, this
seems an unfortunate process. By phasing out or eliminating what was per-
ceived to be Japanese, aesKconenneniicaneapnesimenatspoenteTeTesc
accomplishments, but ended up by retaining some negative qualities that
t. At one extreme, even some useful
public equipment was destroyed because it was Japanese-made.
Koreans could straightforwardly reject the tangible manifestations of
Japanese influence, but found it less easy to cast off institutions and habits
developed during the Japanese occupation. centralized
The highly Korean
bureaucracy was modeled after the tightly controlled Japanese colonial ap
paratus; although not perceived as such. Even after the Japanese bureau-
cracy had departed, therefore, some of its more undesirable structural
elements were retained, for the sake of convenience. Onevexamplevis
the,
military police (the much-feared kampeitai of the war years) with its secre-
itori Whereas in Japan the postwar American mili-
tary administration helped to eliminate the vestiges of the old military
machine, the postwar Korean bureaucracy was actually drawn from the rem-
nants of the Japanese military sarAE

5 q e
; it was taught in all Korean elementary
schools, principally for the purpose of assimilating Koreans as Japanese
imperial subjects. With modifications suited to Korean national identity and
national values, the substance could have been useful to the modern Korean
education system. Unfortunately, because it had been instituted by the im-
 Political and Economic Antecedents to the 1960s 9

perial Japanese government, Koreans insisted,on its elimination. Yet by 1945

the Japanese-style school system had already had its effect on Korean edu-
cation, not least because it was Korea’s initial experience with genuinely
universal education.
The South Koreans were still able to employ the Japanese legacy of skills
and technology. Although Korean managers had never been trained to per-
form by themselves without Japanese supervision, those with a three-
quarters grasp of their enterprises’ operations were quickly able to close
the remaining gap in their knowledge. South Korea's greatest resource was
its people. It initially had the larger share of the divided country’s popula-
tion. illi
0-
, further increasing the quality of human resources. The post-
war return of Koreans from Japan and Manchuria likewise brought valuable
skills to Korea.
Because Korea had long been part of the Japanese economic system,
Koreans were able to acquire postwar technological innovations from Japan,
to take advantage of Japanese methods of conducting business, trade, and
manufacturing, and to understand Japanese ways of thinking that could
be profitably utilized by Koreans. These types of interchanges were not pos-
sible for most of the other countries, such as Indonesia and the Philippines,
that had been under the Japanese imperial system only briefly. Added to
this was the massive direct contact with U.S. technology and interchange
that would later contribute to Korean economic development. Although
Koreans had no say in or control over the economic, educational, and other
policies imposed on them for 36 years, the experience gained under the
Japanese and the economic infrastructure forced on Korea contributed in
numerous ways to subsequent Korean economic growth.

NATIONAL LIBERATION AND ALLIED

OCCUPATION, 1945-48
The modern history of independent Korea begins in 1945, when the penin-
sula was emancipated from Japanese colonial rule. Through an unfortunate
sequence of events at the end of the war, the peninsula became divided.
The American leaders’ and policymakers’ lack of understanding of East
Asian history, politics, and cultures brought about this arbitrary division,
which was not intended to be permanent. The Russians had long held ter-
ritorial ambitions in East Asia, and the situation at the war’s end provided
the Soviet Union with the opportunity to advance in the wake of the -
bling Japa pire. The American delegation to ieYalaConference
as unable to resist Soviet pressure for the division of
the Korean peninsula and agreed in principle to joint occupation. The 38th
parallel was subsequently proposed by the Pentagon and accepted by the
Soviet command as the limit of military operations by their respective
10 — Lee-Jay Cho and Yoon Hyung Kim

occupation forces. American troops occupied the southern part of Korea

up to the 38th parallel, and Soviet troops occupied the remainder of
the peninsula. Thus the Soviet Union, for its negligible involvement in the
Far Eastern Theater during the final ten days of the war, was able to form
a strategic alliance with leaders in the North, thereby gaining greater
access to the Pacific Basin through the northern half of the Korean
peninsula.
The years from 1945 to 1948 were a period of political instability and eco-
nomic turmoil, which precluded any orderly movement toward develop-
ment. Wi y

f
eee Thepolitical division diverted most of
the energies of Korean leaders to the political questions affecting the divided
country.
Thelack of seriousness with which American leaders regarded the com-
mitment of the United States to establish a free and independent Korea
resulted in the overall failure to install an effective Korean government. One
reason was that the United States Army Military Government in Korea
(created in January 1946) received instructions from Washington through
General MacArthur's staff in Tokyo, who were concerned primarily with
the occupation of Japan and took little interest in Korean affairs. Whereas
Japan benefited in the long run from some of the changes instituted by the
occupation forces, the U.S. military government in Seoul was unprepared,
erratic, and almost totally ignorant of Korean culture and the economic sit-
uation. icial divisi

To alleviate mutual difficulties in

Korea and Japan, the U.S. staff in Seoul and Tokyo could have allowed some
economic cooperation between the two countries, including barter trade
(Meade 1951). But little thought was given to the economic welfare of the
Korean nation and its populace, although the U.S. military government
made a significant contribution by initiating discussion of land reform. The
politically and economically chaotic period of occupation by U.S. troops
lasted for three years. (For a detailed discussion of the U.S. military govern-
ment in Korea, see Meade 1951.)
The elements for launching postwar economic development were all still
in place at the end of World War II: the benefits of the physical plant, Korean
experience in participating in the modern sectors of the economy, the edu-
cation system, and technology gained from Japan. Also, fairly rapid urban-
ization had taken place during the later colonial period, and by around 1940
about 20 percent of the population was urban. Thus Korea had a relatively
large urban workforce, much of which had received at least a primary
Japanese-style education. Given the necessary capital input from abroad,
Koreans could have embarked on their postwar development almost im-
 Political and Economic Antecedents to the 1960s 11

mediately after the Japanese departure—if they had had the benefit of po-
litical stability and a peaceful international climate.
Unfortunately, as indicated earlier, the peninsula was divided in 1945
by arbitrary, external, political decisions. Because the country’s natural
resources and large-scale industrial plants were mostly in the North,
whereas the South was primarily agricultural, the complementarity between
North and South was lost. Even worse, much of the physical plant, in both
the North and South, was destroyed during the Korean War.
“FIRST REPUBLIC AND THE KOREAN WAR, 1948-60
eee SE Korean independence leader, energetically
pressed the United States to establish a unified and independent country
by all possible diplomatic means. However, North Korean leaders refused
to allow the proposed general election under the supervision of the United
Nations Commission for Korea. When all efforts failed to achieve a unified
government through a general election, no alternative ained except the
formation of a government in the South alone. a general elec-
tion was held in South Korea, under United Natio ision, and Syng-
man Rhee was r u Wage 2.proclaimed
in the South online io the Soviet command was instrumental
in forming the Democratic People’s Republic in the North. The nation was
effectively divided under two politically incompatible and mutually hostile
regimes. The Rhee government eliminated the remnants of Communist ac-
tivity in South Korea and helped diminish considerably whatever sympa-
thy there was for Communi

years, destroyed a quarter of the peste of South Korea, and inflicted the
loss of over a million lives ition for agreeing to accept the Korean
ee ned on , Syngman Rhee concluded amutual
his treaty, which has subsequently
served as the cornerstone of security relations between the two countries,
stipulates that an armed attack on either country would cause each to “act
to meet the common danger in accordance with its constitutional process.”
To ensure the survival of the Republic of Korea against North Korean ag-
gression, the Rhee government also systematically expanded the Korean
armed forces into the largest formal organization in Korean society, there-
by laying the foundations for South Korea as a viable independent nation-
state. (For further details on the Rhee period, see Oliver 1954, 1978.)
Syngman Rhee helped lay the political foundations of an independent,
modern country and some of the groundwork for later rapid economic de-
velopment. Although the idea of land reform came from the United States,
the program was pursued by the Korean government, partly out of politi-
 12 —Lee-Jay Cho and Yoon Hyung Kim

cal necessity in view of the land reform taking place in the North. Presi-
dent Rhee sought land reform as a right that was justly due to the peasan-
try and fought for it against political reactionaries. The program also
coincided with the president's intention to cripple his political opposition,
which was based on the landlord (yangban) class.
Land reform was implemented in two stages. Initially land that was for-
merly under Japanese ownership or control was distributed to farmers. Un-
der Rhee's leadership, the government broke up large Korean-owned estates
and set a limit of three hectares per owner. Land reform probably lowered
crop production during a brief initial period, because the government could
not immediately replace the inputs (notably seed, fertilizers, and credit)
formerly supplied by the landowning class. In the longer term the reform
succeeded in raising productivity, and politically it placated the rural popu-
lation.
The reform helped to bring about a more aiaba gigi of assets
"and income in at least two ways. First, poor ceived a share of
the assets formerly exploited by the Japanese and the landlord class. Sec-
ond, the landowners were partly compensated in the form of government
bonds. The rapid decline in the value of these bonds because of inflation
contributed to the redistribution of income.
Syngman Rhee maintained democratic ideals and allowed some of the
basic elements of democratic institutions to operate. Reflecting on the past
four decades of Korean history, the Rhee period was perhaps the most liberal
in terms of freedom of expression, freedom of the press, and direct elec-
tions of both parliamentary representatives and the president. This period
also witnessed experiments with local autonomy.
The president's political subordinates and other bureaucrats, who made
and implemented many administrative decisions without the president's
knowledge, were responsible for the corruption that spread during the last
years of the Rhee government. Contrary to accusations made at that time,
none of the corruption can be attributed to the president himself. Syngman
Rhee was personally not ostentatious, nor did he accumulate wealth. In
the end, he lost his grip on the country by refusing to obey the dictates
of public opinion which yearned for a more democratic process. He had
simply become too old (he was age 85 in 1960) and too conservative in his
outlook to assess the changing political and social realities of the republic.
He established some bad precedents, which have left a blot upon Korean
constitutional history, notably by forcing an amendment to the constitu-
tion in 1952 (to ensure his own re-election) and again in 1957 (to enhance
his personal authoritarianism). His March 1960 landslide victory for a fourth
term in office was marred by accusations of election-rigging and violence
toward the opposition. As a result of mounting political discontent, cor-
ruption in government, despair over lack of opportunities for the younger
generation, and the economic hardships endured since the Korean War,
 Political and Economic Antecedents to the 1960s 13

Rhee’s mate Eon authoritarian government was overturned by

SECOND REPUBLIC, 1960-61

Out of the ensuing chaotic period emerged a revised constitution, fresh
elections, and a new government formed in August 1960 by Prime Minister
‘Chang Myon, thereby shifting from an authoritarian regime toward a more
democratic one. The “democracy” of 1960-61, however, encouraged and wid-
ened splits, aggravated the power free-for-all, and projected an image of
weakness and hesitation where chaotic conditions demanded strength and
resolution (Henderson 1968).
Although the military remained politically neutral until 1961, largely be-
cause of Syngman Rhee’s strong political leadership and skills, the Chang
government was too weak to maintain civilian supremacy over the mili-
tary. In view of the fact that the military had emerged as the strongest or-
ganization in Korean society since the Korean War, the possibility of military
intervention in government was quite high. In retrospect, it seems regret-
table that the Chang regime was overturned within nine months of assum-
ing office. Given adequate time, the parliamentary system might have
survived, strengthening the foundations for the democratic process in
Korea.
Thus far, efforts toward postwar reconstruction in Korea, which began
after the ceasefire in 1953, had left the economy stagnant and at the subsis-
tence level. The Rhee government had embarked on reconstructing infra-
structure and industrial facilities and stabilizing prices, with American aid
as the major financial resource. Recovery from the Korean War was slow,
and during the period 1953-61 the economy was kept alive largely by mas-
sive economic and military assistance from the United States. Between 1953
and 1961 the average annual growth rate of GNP in real terms was merely
3.9 percent. However, because the population was growing at an average
annual rate of 2.9 percent, per capita GNP in real terms increased by no
more than 1 percent on average each year.
The subsequent growth process was doubtless made easier by the mas-
sive influx of foreign exchange during this critical period of development,
which held the country together and prevented massive starvation and eco-
nomic dislocation. During the entire period 1945-83, aid or assistance from
all sources to Korea is estimated at over US $26 billion (AID, U.S., 1985).
Much of this was in the form of grants or concessions. About one-third
of the total was military assistance, much of which was given during and
just after the Korean War. By expediting postwar reconstruction and the
recovery of the economy, these forms of assistance helped to lay the foun-
dations for subsequent development during the 1960s. As discussed in the
following chapter, economic modernization was one of the most urgent
challenges facing the government that came to power in 1961.
 <

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 2 Major Economic Policies of the
Park Administration
by Lee-Jay Cho and Yoon Hyung Kim

MILITARY GOVERNMENT, 1961-63

The coup d’etat of May 1961, headed by General Park Chung Hee, dramat-
ically increased the influence of the military in Korean society and marked
the beginning of political involvement by the military, which continued for
the next 27 years. The justifications given for the military takeover were
the pervasive orruption i inefficient h aye racy sOcIa dis

ili . Under the encompassing ideology of “modernizing the

fatherland,” the new military regime set out to implement political reform,
bring back social discipline and order, and re-educate or “reform” individu-
als by placing greater emphasis on traditional cultural values and by gener-
ating a national spirit of independence}
When the new military government began to formulate policies for eco-
nomic development, capital was scarce. The domestic savings rate was ex-
tremely low. Foreign aid was rapidly declining, both in quantity and variety.
Business enjoyed little public confidence, and entrepreneurial talent was
deficient. Under these circumstances, thegovernment asserted its leader-
hip b ettinge the stage for formulating 1es for national developme
During the period 1961-63, the military government established the institu-
tional framework for industrial development.
The Economic Planning Board (EPB), established in July 1961, was
headed by a senior minister for economic planning, who was given the
title of deputy prime minister. The EPB has subsequently developed into
a powerful bureaucratic organization responsible for development planning
and policymaking. In this capacity, it coordinates the functions of the Minis-
tries of Finance, Commerce and Trade, Transportation, Agriculture, Health
and Social Affairs, and Science and Technology.

1. To demonstrate that these goals were not just rhetoric, the new regime rounded up gang-
sters and syndicate leaders and paraded them in the streets. To exemplify the seriousness
of their actions, a gangster leader was executed. Housewives caught in secret dance halls were
paraded in the streets as examples of persons violating the Confucian norms of family har-
mony. Several scores of generals in the armed forces were arrested and jailed for corruption.
A few of the largest capitalists were “pointed at” for dishonest accumulation of wealth.

15
16 — Lee-Jay Cho and Yoon Hyung Kim

Government Control Over the National Economy (1961-62)

© implement it, the government embarked on investment plan-

ning. The major issue was how to finance major industrial investment
projects. Under the conditions prevailing in the early 1960s—the extremely
low domestic savings rate, the absence of a well-functioning financial and
capital market, and the decline of foreign aid—the military government had
to develop a means for providing long-term capital to industry. 5
su
see Chapter 3).
This measure was aimed not only at increasing government influence in
the allocation of financial resources but also at expanding the availability
of loanable funds, particularly from foreign sources. In fact, the system of
foreign-loan repayment guarantees (which required EPB approvals to loan
seekers) contributed substantially to increasing the inflow of foreign capital.
Recognizing its role as the predominant source of capital for industry
in the early 1960s, the government resorted to the practice of “overloan-
ing”by the central bank (Bank of Korea), which helped to forge close links
between commercial banks and industry. Through the device of formally
short-term but in reality long-term current-account credits (the so-called
“rollover” of commercial bank loans), commercial banks could play the role
of industrial investment banks designed to finance the long-term invest-
ment needs of En
heeconomy. Koreanenterprises willingto
conform tthe

Ponerntient pee Heed neal over the none and eran decisions
of commercial banks. This so-called “indirect” financing reduced the finan-
cial risks associated with the high-debt levels of Korean enterprises because
the central bank had a major role in deciding the fate of a defaulting com-
pany. By thus reducing the risks for foreign lenders, the government opened
the door to massive foreign borrowing. During the early industrialization
period, therefore, the Korean government not only selected strategic indus-
tries to be nurtured and provided with industrial financing, but also as-
sumed the major risk for large-scale investment ventures undertaken by
private enterprises.
In the meantime
ne,the:printing of money asanexpedient to mobilize

® y UPPITY ana O eC inf] O

tion, the government resorted to (see Chapter 4). The

first policy measure enacted by the military regime in 1961 was the imposi-
 Major Economic Policies of the Park Administration 17

tion of a complete price freeze. Although the price freeze was lifted after
two months, the government continued to rely on a system of selective price
controls to alleviate the burden of the high rate of inflation on low-income
families and to restrain price inflation. Some of the long-term consequences
of government intervention in both the factor market (through interest and
wage controls) and the commodity market (through price controls) resulted
in distortions of resource allocation. The failure of the first two policy meas-
ures al necessitated
s (see Chapter ay which were for-
sere after President Park achieved a popular mandate through his vic-
tory in the October 1963 general election. With aggregate demand policies
directed to promoting growth and employment, the government continued
to rely extensively on price-control measures to stabilize the price level.
Population Policy
Prior to the military takeover of the government, no discussion of popula-
tion control was possible. The traditional Confucian value of the large ex-
tended family was shared by Korea’s leaders. In particular, Syngman Rhee’s
government was not receptive to policy dialogue concerned with popula-
tion control, despite the fact that the Korean population was growing far
more rapidly than at any previous time.
Debate on the implications of Korean population growth and the wis-
dom of establishing a nationwide program to encourage low fertility be-
came possible only upon the overthrow of the Rhee regime in 1960.
President Park Chung Hee as a nationalist and Confucianist was initially
reluctant to introduce family planning to Korea, but arguments by Korea's
technocrats that rapid population growth would impede Korea's develop-
ment were convincing.-A decrease inthe birthrate was adopted as one of”
(see Chap-
ter 12). Funds were provided through the Ministry of Health and Social
Affairs to establish government-sponsored family planning in Korea.
The Korean family planning program accomplished its primary objec-
tive. Korean women are bearing only two children each on average com-
pared with six children each in 1960. Given this fertility level, Korea's

about
60:million
_at —approximately 18 million more than in 1987. Among

__productivity. Moreover, a significant proportion of the increase

in the domes-
18 — Lee-Jay Cho and Yoon Hyung Kim

tic savings rate, which is essential for continued capital accumulation, can
also be attributed to the decline in the number of young dependents?

In accordance with the military regime’s commitment to transfer the pow-

ers of government to a civilian administration through a national election,
there was a constitutionally legitimate and peaceful transition to the Third
Republic in late 1963. Under the new constitution, General Park Chung Hee >

Magnzinés Mas, 1961) kieenoomTS ne ;

authoritarianism for the sake of efficiency and order. His early attraction
to socialism, combined with the need for rapid economic development and
the lessons learned from the Japanese for mobilizing the populace to expe-
dite rapid development, enabled him to combine many positive elements
of capitalism, socialism, and military discipline. 20SsSe
¥ L tUILTIOTLal
(WN OLU UI @

tions were “for the good of the masses” (in the sense used by the Confu-
cian scholar, Mencius), and was very effective in this role.
The president had a strong commitment to eradicating the prevailing ex-
treme poverty in the rural areas, which he himself had suffered during his
childhood and youth. Having lived as a poor farmer himself, he under-
stood the situation of Korean farmers. His Rees beac iks oe l
ant started for the purpose of transferring the benefits of de-
Vi elopment to the backward rural villages (see Chapter 16). The movement
mobilized local labor for local improvements, providing poor villages with
basic infrastructure—paved roads, bridges, better housing, schools, and
training facilities. Some aspects.of the Saemaul training program resem-

2. No consistent and general theory of demographic transition has yet been developed, but
the rapid transition process in Korea has clearly helped to promote and expedite economic
growth (L. J. Cho 1984; Cho and Togashi 1985). The demographic transition in Europe began
in the eighteenth century and was completed in the twentieth. As high birth rates and death
rates were reversed, and birth rates continued to be low, the age structures became similar
in most European countries. Japan was the first Asian country to pass through this transi-
tion, completing it in the 1960s. Korea was already in the midst of transition in the 1970s,
whereas the transition has barely begun in most of the Southeast Asian countries. As econo-
mies such as Korea's and Taiwan's pass through the newly industrialized stage, and export
their own capital and technology, similar benefits may be shifted to the lower-wage Southeast
Asian economies. For economic planning in the latter region, Korea's recent experiences may
thus provide valuable insights.
 Major Economic Policies of the Park Administration 19

bled the Chinese May 7 Cadre Schools? with their training centers to re-
educate leaders for national revival, and recalled the Chinese slogan “With
self-reliance you survive.” The program also reflected the “group solution”
to a problem frequently found in Chinese, Japanese, and Korean traditional
culture and history. By providing incentives with training, technology, and
construction materials, the Saemaul movement was fairly successful in
motivating farmers to participate in projects for the common good, and it
fostered a sense of national spirit.
Another factor contributing to President Park’s popularity was his han-
dling of business leaders. The leaders of the conglomerates were told in
essence that their property was not their own but really belonged to the
nation. Under the president's influence, they curbed their lavish spending
and extravagant life-styles and were also encouraged to invest not merely
in ways that were best for their own corporate profits but in ways that the
government regarded as best for long-term national economic development
goals.
President Park acquired a great following among the masses—especially
among the poor rural people, whom he understood very well. As far as
they were concerned, his leadership during the first 15 years of his presi-
dency was a success, partly because it provided Koreans with a sense of
national pride and renewed their sense of national identity through de-
velopment.

Under the slogan of “Eradicating Poverty through Rapid Economic Growth,”

the military regime gave first priority to the promotion of economic growth.
This strongly appealed to the country in the early 1960s and became a na-
tionally supported goal of the Third Republic. One objective of the Park
regime was to catch up first with Taiwan, a rapidly industrializing country,
and to follow closely Japan, an economic superpower. Having passed
through the prewar Japanese-style education system, Park had learned a
great deal about the role of the Meiji revolution in modernizing the Japanese
economy. He also realized that only through economic growth could a coun-
try earn international respect.
, J

3. The May 7 Cadre Schools got their name from a letter by Mao Zedong, dated 7 May 1966,
addressed to Marshall Lin Piao stating that all Chinese should do physical labor combined
with an educational program (“physical work and study program’) to raise their political con-
sciousness. During the later part of the Chinese Cultural Revolution, all cadres were sent to
re-education farms organized in the spirit outlined in the letter.
20 Lee-Jay Cho and Yoon Hyung Kim

Economic Liberalization and Reforms (1964-67)

One of the principal reasons for the tightening of economic control in the
early 1960s was that Korea was still a major recipient of U.S. aid. The United
States, through its Office of Economic Coordinator, wielded considerable
influence over Korean economic policy, to the extent that assistance funds
‘naccaliahcehiillinAaialaninsaene nen The 1961 coup was not welcomed
by the United States which, therefore, tried to pressure the new govern-
ment to loosen its political grip by various means, such as withholding the
delivery of goods until certain conditions were met. The incomplete flow
of assistance in commodities and raw materials created difficulties for the
Korean government, and measures were taken through government con-
trol of credit and foreign borrowing to limit imports and stabilize the mar-
kets. These measures exacerbated the situation, requiring additional policy
measures as correctives.
Imports of raw materials and industrial machinery increased dramati-
cally, however, because the government was trying to stimulate industrial
activities by pumping money into large-scale projects. By the end of 1963
Korea's foreign exchange holdings had shrunk to no more than $90 mil-
lion. The prospects of a severe foreign exchange deficit for 1964 were even
more serious. The fragility of postwar Korea’s economic health and its con-
sequent poor credit standing in international financial markets, combined
with the political turmoil resulting from rapid changes of government, made
it extremely difficult for Korea to attract foreign capital. Faced with a severe
foreign exchange crunch, the construction of some large-scale industrial
plants was interrupted. Worse yet, because of the shortages of imported
raw materials, some of the existing plants faced a slowdown in operation.

‘idleness deena : Z
with that of“national defense” and was frequently referred to asthe means
for national survival.
Korea had little experience in dealing with large-scale manufactured ex-
ports. In the past they had dealt only with exports of raw materials such
as tungsten and some agricultural products. The government had to rethink
its organizational structure to deal with the new task of expanding trade.
A convenient model for Korea was provided by Japan's Ministry of Com-
merce and Industry (subsequently transformed into the Ministry of Inter-
national Trade and Industry, or MITI). In 1965 Korea's Ministry of Commerce
and Industry, patterned after its Japanese counterpart, was reorganized to
create an export component in each of its industrial bureaus, supplement-
ing the existing Bureau of Foreign Trade. The main function of each export
component was to set annual export targets by commodity, as well as by
region and country of destination, and to monitor the export performance
 Major Economic Policies of the Park Administration 21

of the firms that were under the purview of each bureau. The immediate
task was to enable factories to operate by making raw materials available.
Then the government curtailed domestic sales of exportable commodities
as a means of promoting their export.
One of the major issues the government was confronted with was how
to deal with the possible losses that firms would incur by exporting com-
modities that thus far had not been tested or accepted in world markets.
To be competitive these commodities would have to be marketed below
prevailing world prices. The government recognized the need for substan-
tial financial support and subsidies for the exporting companies to expand
exports. To achieve this objective, theSova RINER SENeHedoRamDEs=cm

program.In 1964-65, as discussed in Chapter 5, the won was devalued and

the system of multiple exchange rates was replaced by a unitary, floating
exchange rate designed to maintain a realistic effective exchange rate. The
exchange reform was combined with export-promotion measures (in the
form of tax concessions, preferential credits, and export subsidies), and with
the import-liberalization program that was designed and implemented dur-
ing 1964-67.
The ideas for these comprehensive export-promotion policies were gener-
ated at the Monthly Export Promotion Meeting, which was initiated in 1965.
The meeting served as a forum for business and government and was
chaired by President Park and attended by trade-related ministers, busi-
ness association leaders, heads of major financial institutions, and repre-
sentatives of major export firms. Institutional arrangements, legal and
procedural issues, and other policy matters for promoting exports were dis-
cussed, and fairly concrete policy recommendations and determinations
were made on the spot. This forum contributed greatly to the elimination
of innumerable bottlenecks that had impeded the promotion of exports.
Subsequently exports expanded rapidly. In June 1964, the government
had set its export target for the end of that year at US $120 million. On
30 November 1964 Korea's exports passed the $100-million mark for the first
time within a single year, and the last day of November has been commemo-
rated annually ever since as Export Day. This remarkable achievement
provided both government and business with such self-confidence that the
old Korean saying equivalent to “He who tries will succeed” was frequently
heard in business circles. The expansion of exports resulted in correspond-
ing
p increases
, in: production,
Pee and therefore
ta es the government framed export —
Pm rere were also — to liberalize imports, with the
aim of reducing various domestic distortions resulting mainly from quan-
titative restrictions on imports. The implementation of the import-
liberalization program, however, was not completely satisfactory, as dis-
cussed in Chapter 5.
22 Lee-Jay Cho and Yoon Hyung Kim

Along with these policy measures, the Park government initiated the
interest-rate reform in 1965 (see Chapter 6). Sustained rapid economic
growth required a continuous rapid increase in investment. Yet limits had
already been reached for financing the required capital investment by means
of domestic saving and the mobilization of financial resources through com-
mercial banks. The government's industrial financing policy resulted in ex-
cessive monetary expansion and inflation. During 1961-65 a high inflation
rate prevailed, despite the government's efforts at direct price controls, and
the highest bank deposit rate became negative in real terms for a number
of years. The time and savings deposits of the financial institutions did not
increase in real terms between 1962 and 1965, despite the nationwide sav-
ings campaign launched by both the government and financial institutions.
An overriding issue for rapid industrialization then was how to mobilize
private savings through financial intermediaries. The principal aims of the
interest-rate reform of 1965, which sharply raised interest rates on both time
deposits and loans of banking institutions, were to attract private savings
through financial intermediaries for ultimate increases in aggregate domestic
saving and investment, as well as to improve the effectiveness of interest-
rate policy for resource allocation and monetary control.
On 30 September 1965 the Monetary Board raised the ceiling on savings
deposits from 15 to 30 percent per annum; the ceiling on ordinary bank
loans was raised from 16 to 26 percent per annum (see Chapter 6). At the
same time, the central bank introduced a new system of subsidizing the
deposit-money banks to compensate them for losses incurred as a result
of the negative margins between the deposit and loan rates. Patterned af-
ter the Taiwan success story of 1957-58, the 1965 interest-rate reform in Korea
was mainly designed to increase the attractiveness of financial saving rather
than to improve the financial soundness of the banking institutions. At that
time, there was an incalculable amount of currency floating in the unoffi-
cial “curb market.” The government tried to encourage the transfer of these
funds to the regulated banking institutions by trying to inculcate the general
public with an appreciation of dependable, stable, institutionalized interest
on their money. The high-i e strateg: ricka 4c Om
intained
ntaine
for
ine,
During 1966-67 major tax reform measures were undertaken to increase
tax revenues and aggregate domestic savings. The reform measures entailed
the reorganization and upgrading of tax administration in 1966 and the sub-
sequent enactment of a comprehensive revision of tax law in 1967 (see Chap-
ter 10).
ing. The revamp-
ing and restructuring of tax administration contributed significantly to the
efficiency of tax collection and more than doubled revenue within a year
 Major Economic Policies of the Park Administration 23

by eliminating corruption, tax evasion, and arbitrary tax assessment proce-

dures. At the same time, there was no apparent public resistance to the
measures.

Agricultural Policy and the Saemaul Movement (1969-71)

It is apparent that the government put utmost emphasis on policy meas-
ures for promoting export-oriented industrialization by mobilizing available
capital resources. Yet President Park, as mentioned earlier, had experienced
the misery of the poor farmer’s life, and his lifelong desire was to promote
rural development and to improve the quality of village life. However, in
the first few years of his government, the president's freedom of policy ac-
tion was constrained by the scarcity of capital resources.
Immediately after the military takeover, the government advocated agri-
cultural reform. This involved rearranging and eliminating some exploitive
elements of the moneylending system that were then operating to the detri-
ment of agricultural communities. The system was especially oppressive
for poor farmers, who had to borrow money during the growing season
and repay at exorbitant interest rates after disposing of their crops.
The government also tried to rearrange some landholdings to consoli-
date small plots of arable land, as a means of increasing productivity.
Another project attempted to improve the exploitation of underground water
resources. Most important of all, shortly after assuming leadership, Presi-
dent Park initiated the National Reconstruction Movement, which was
aimed especially at the rural sector and focused on arousing a spirit of revival
for modernizing the villages. This movement can perhaps be regarded as
the precursor of the Saemaul (new community) movement discussed be-
low. Although some progress was made in the rural sector, it was inevita-
bly overshadowed by the rapid growth of the industrial sector up to 1969,
because of the scarcity of resources available to agriculture.
Moreover, up until 1969 the government had maintained low grain prices
to hold urban wages at a relatively low level. This may have been one of
the major factors responsible for slow growth in the agricultural sector,
which eventually led to food shortages and a growing disparity between
urban and farm household income. By the end of the 1960s, as a result
of sustained industrial growth, the government felt that sufficient (although
still limited) capital resources were available for modernizing the agricul-
tural sector. The government launched a two-pronged reform to stimulate
food-grai ion, raise farm incomes, and promote rural development:

a
16, respectively).
hat took effect with the 1969 harvest,
the government procured grain from farmers at a price higher than what
24 ~~ Lee-Jay Cho and Yoon Hyung Kim

urban consumers had to pay when it was resold to them. This system
provided price incentives for an increase in farm production and at the same
time held down urban consumers’ food costs. The implementation of such
a two-tier price system conflicted in several ways with the objectives of finan-
cial and monetary stability. Nevertheless, it significantly contributed to the
increase in farm income and grain production, in that the measure en-
couraged the expanded cultivation of high-yielding varieties as well as the
improvement of farming techniques. _
was a bold stroke in the govern-
me olicy toward rural development. This movement not only embod-
ied President Park’s ideals about modernizing the rural sector but also
represented his strong personal mission to upgrade the village life of the
poor. It was conceptualized and designed to revitalize and rebuild rural com-
munities by inculcating the “will to work” among villagers and by organiz-
ing rural human resources so that they could be channeled into productive
activities. In some ways, it recalls the “will to economize” depicted by Nobel
laureate Sir Arthur Lewis as a prerequisite of Western economic devel-
opment.
The movement involved close cooperation among government agencies
at all levels in the effort to introduce more rational thinking in the manage-
ment of farm production and village life, to inculcate a national revival spirit,
and to promote diligence, self-help, and mutual cooperation. Numerous
small-scale investment projects were undertaken with government support
and assistance for the improvement of rural infrastructure (such as build-
ing farm access roads, bridges, washing facilities, toilets, and wells), as well
as improving farm income. The basic principle of the Saemaul movement
was that the government provided the necessary construction materials
(such as cement and steel) free of charge; other goods (such as fertilizers
and roofing materials) were provided at subsidized rates. The villagers in
turn supplied the organized human resources for the construction projects.
Work was performed collectively on village projects (such as bridges) but
individually on others (such as house improvements). The movement there-
by mobilized rural residents, insofar as the villagers’ own resources would
permit, for the common goal of improving rural infrastructure.
This movement contributed remarkably to the improvement of the rural
infrastructure and environment, and consequently to better average farm
income. By the mid-1970s rural household income had increased so dra-
matically that it had caught up with and, in one year, even surpassed ur-
ban household income. The Saemaul movement was instrumental in
developing and modernizing rural communities. These poor villages had
been a symbol of poverty in the Korean peninsula for many centuries. The
movement helped to extract poor farmers from a situation of low morale
and frequent despair and to inspire them with a development-oriented men-
 Major Economic Policies of the Park Administration 25

tality and make them good citizens. After it had been in existence for about
ten years, however, the movement came under some criticism, mainly for
its authoritarian approach, which discouraged voluntary participation by
the rural people and even led to some misallocation of resources.

Promotion of Science and Technology

About the time the plans for the Saemaul movement were being imple-
mented, the government launched a major effort to upgrade science, tech-
nology, and professional skills. In 1968 the government founded the Korean
Institute for Science and Technology (KIST). KIST’s objective was not only
to import advanced science and technology but also to introduce and dis-
seminate advanced industrial technology. It was designed as an institute
for research and applied science (operating in part under contracts from
big industries) to provide innovations in manufactured commodities, es-
pecially in the field of electronics. KIST sought to bring leading Korean scien-
tists and technicians residing abroad back to Korea, and to do so offered
these expatriates international-level salaries. As a result, many high-level
Korean scientists returned and joined Korea's scientific research efforts.
These scientists and technicians also worked on industrial applications,
thereby contributing to the quality of Korean manufacturing.
The government also founded the Institute of Advanced Science and
Technology as a teaching institution—it was combined with KIST in the
early 1980s to form the Korea Advanced Institute of Science and Technol-
ogy (KAIST).
The government placed great emphasis on promoting and upgrading
skills in the fields of craftsmanship and services (such as mechanical skills,
metal work, tailoring, and carpentry), which were important to industrial
development. The emphasis placed on the acquisition of scientific and tech-
nical skills resulted in the founding of the Professional Skills and Crafts-
manship Training Center, which has had long-term beneficial effects on the
economy. Pilot projects were started in Seoul by the president and, once
in successful operation, were spread to other provinces of the country. A
national testing center was also established for certifying craftsmanship and
services skills.
Along the same lines but on the economic front, the government estab-
lished the Korea Development Institute (KDI) in 1972, to attract leading
economists and social scientists to study and provide recommendations on
long-range development issues and macroeconomic directions. KDI re-
cruited most of its staff among Koreans abroad, offering salaries on an in-
ternational scale. Such innovative measures to bring in talent, advanced
technology, and scientific knowledge—not only to promote industrial growth
but also to upgrade the country’s level of science and technology—
contributed to the rapid industrialization that followed in the 1970s.
26 ~—_Lee-Jay Cho and Yoon Hyung Kim

External Affairs and National Security

A fairly bold step taken during the Third Republic, which provided a boost
to economic development, was the normalization of diplomatic relations
with Japan in 1965. Syngman Rhee, having devoted most of his life to the
movement of liberation and national independence from the Japanese em-
pire, had a tremendous hatred toward Japan. During his presidency, the
government tried to eradicate everything manifestly Japanese by banning,
for example, Japanese songs, Japanese movies, and the use of the Japanese
language. This policy was implemented even though the Korean leaders
themselves had been trained by and had served in the Japanese bureaucracy
and military. In 1965, when the treaty with Japan was concluded, strong
anti-Japanese sentiments were still widespread and were manifested prin-
cipally through student demonstrations.
In seeking to establish closer ties between the two countries, President
Park had political and economic objectives. The geographical proximity of
Korea and Japan, and their common bond in the alliance of free nations
against the common threat of communism, made it inconvenient and some-
what absurd not to have diplomatic relations. Furthermore, Korea could
benefit from Japanese investment and technology by fostering economic
cooperation through diplomatic relations. Under the reparations terms of
the treaty, Japan transferred US $300 million to Korea as a grant-in-aid and
arranged for a long-term development loan of US $200 million at 3.5 per-
cent interest. These funds were used to develop the Pohang Steel Com-
pany and for irrigation, farm mechanization, and other works designed to
increase productivity in the agricultural and fisheries sectors. The payment
of reparations not only facilitated technology transfer from Japan but also
provided Korea with considerable foreign exchange, which was useful for
the development of the country. In this regard, it is important to note also
that between 1962 and 1981 roughly $42 billion in foreign lending and grants
was received by Korea—one-third from public and two-thirds from com-
mercial sources—further facilitating economic growth during this period
(AID, U.S., 1985). The move to normalize diplomatic relations thus con-
tributed directly to international economic cooperation as well as to subse-
quent growth at home.
The drive to meet the foreign exchange requirements of the expanding
economy likewise benefited from Korea's participation in the protracted Viet-
nam War, from 1965 until the withdrawal of American troops from South
Vietnam in 1973. The war had important ramifications for the Korean econ-
omy. It provided both the military and business sector with invaluable tech-
nical skills and experience. Korean business firms were offered lucrative
opportunities to market their manufactured goods, the Korean service sec-
tor identified numerous openings to provide services to both American and
Korean troops stationed in Vietnam, and Korean construction companies
 Major Economic Policies of the Park Administration 27

took advantage of highly profitable construction projects in Vietnam.

Moreover, two divisions of the Korean armed forces were stationed in Viet-
nam, and their military pay and allowances were provided in U.S. dollars
under international arrangements. The influx of foreign exchange earnings
from these war-related activities was especially valuable to the Korean econ-
omy, which was just taking off during this period.
A few unfavorable international events had serious consequences for po-
litical and economic development in Korea. In 1968 scores of North Korean
armed infiltrators reached Seoul in an attempt to assassinate President Park.
Other guerilla groups struck at villages in the mountainous areas of South
Korea. These actions, combined with the international events that followed,
changed the political and military situation, and the country took a definite
turn toward tighter military security. Then, with the 1969 Guam Doctrine,
the United States emphasized that its Asian allies would henceforth have
to bear the primary responsibility for their own conventional defense. Sub-
sequently, in 1971 the Nixon administration removed one of the two U.S.
divisions from Korea. In July 1971 the United States unveiled its basic shift
in policy toward the People’s Republic of China. As Mason argues,
“Widespread doubt existed in Korea as to the willingness of the U.S. to sup-
port its allies in East Asia and this emphasized the necessity of rallying
around a strong leader” (Mason et al. 1980:53). Under these circumstances,
it was clear that Koreans would have to make greater efforts to achieve self-
reliance and self-defense.
The earlier part of the Third Republic witnessed a more democratic
process with great emphasis on economic development. In the later pe-
riod, the international political and military security situation was chang-
ing, and there was greater concern about national security issues, thereby
causing a movement towards greater regimentation and national mobiliza-
tion. Political development was perceived to have stalled, therefore, stu-
dents and intellectuals in urban centers began to express a sense of
uneasiness and dissatisfaction.

FOURTH REPUBLIC, 1972-80

The Fourth Republic can be viewed as an “emergency regime” in the sense
that the existing regime was structurally transformed to make way for ar-
bitrary rule by the executive authority for as long as it claimed that a pe-
riod of crisis prevailed (Das Gupta 1978). The national security crisis brought
on by the turmoil of superpower politics and the i
OTC ULVdasilt ITO U U

. The proposed constitu-

tion was submitted to popular referendum, and was supported by the
majority of the voters.
28 Lee-Jay Cho and Yoon Hyung Kim

Once President Park had successfully met his major challenges of launch-
ing economic development and modernization and reviving the national
spirit, he felt a great need to maintain the momentum of change and thereby
consolidate the achievements of the previous decade. Having nurtured this
process from the start, the president felt that no one other than himself
could accomplish this task. Because his grand scheme for the nation was
working well at the time, it is understandable that he did not want to leave
office in the midst of a process that had not yet reached the successful con-
clusion that he envisaged. However, the constitutional limitation on his ten-
ure was a stumbling block.

d.
The 1972 constitution was given the title Yushin (Revitalizing), a term that
was used to label the Meiji revolution (called in Japanese the Meiji Yishin).
President Park had begun the work of laying the foundations of a nation-
state that could survive on its own, internationally as well as against the
threat of North Korea, without being totally dependent on the United States
and other allies. He also wanted to complete the task of modernizing Korea
in the way that Japan had modernized during the Meiji era (1868-1912).
Through the initiation of state capitalism, Japan had developed enterprises
as well as entrepreneurs by mobilizing warriors (the samurai class). The
state initiated the development of textile mills, mining activities, shipbuild-
ing, and other enterprises, and later transferred ownership at low prices
to private hands, thus giving rise to the family-owned conglomerates of
the twentieth century. The Japanese modernized education, taking Western
technology and combining it with Japanese thought derived from Confu-
cianism and Legalism+ They also achieved social order and harmony by
encouraging development of individual discipline through adherence to the
values of Confucian ethics, loyalty to the state, filial piety toward parents
and family, and loyalty to the organization (government or private) to which
they belonged. It took more than 40 years in the Meiji period to accom-
plish this, thus laying the foundations for Japan’s subsequent development.
Clearly, numerous parallels emerge when these changes of the late
nineteenth century in Japan are compared to those that began in Korea just

4. Legalism, which was synthesized by Han-fei-tzu (d. 233 B.C.), advocated the enforcement
of law with liberal rewards and heavy punishment, the manipulation of statecraft, and the
exercise of power by the ruler. The Legalist school shared certain concepts with other schools—
such as the equality of all men—but rejected the Taoist natural standard of the Way, the Con-
fucian moral standard of jen, and the religious standard of heaven advocated by Mo-tzu. The
philosophy of the Legalist school was put into strict practice during the Ch'in dynasty (221-206
B.C.), but soon thereafter Confucianism began to gain ground and within less than a century
became the state doctrine (W. T. Chan 1979:417). Nonetheless, Legalism’s influence remained
and its precepts served as the basis for the establishment of the Chinese bureaucracy.
 Major Economic Policies of the Park Administration 29

a little more than a century later under the Yushin Constitution. To the mind
of President Park, a mere eight or ten years in office were not sufficient
to build the modern state that he envisaged, nor sufficient even for some
of the most basic achievements of the Meiji revolution. He set himself the
task of replicating in Korea what was done during the Meiji reforms in Japan.
In essence, the objectives in modernizing the two countries were basically
similar: economic development, a strong defense, and a cohesive society
based on the Confucian ethics of harmony and loyalty. President Park made
explicit efforts to inculcate in the Korean populace the Confucian value of
chung hyo (loyalty to state, filial piety, and harmony). In this respect, the
Japanese and Korean techniques for achieving national goals also appear
similar, notably in terms of education and mobilization of the population.
The Yushin measures, for example, included institutionalization of student
military training, and establishment of hometown militias and a civil defense
corps. Great emphasis was placed on social cohesion and national in-
tegration.
From 1972 onward, the Park regime became more authoritarian, mov-
ing toward increasing limitation of civil liberties and participation in the
political process. The government created a weak national assembly and
sought to counterbalance it with a strong bureaucracy. President Park did
attempt, however, to decrease military influence in political and economic
affairs.
Emergency Decree and Policy Measures for Industry (1972-74)
As Korea entered the 1970s, a few signs in the world economy boded ill
for Korea's export-led industrialization. Economic recession in major indus-
trialized countries, the increase of protectionism in world trade, and inter-
national monetary disturbances in the early 1970s generated uncertainty
in the Korean business community about the short-term prospects for sus-
taining Korea's export growth. When the growth of exports slowed in 1971,
the economy started to cool off and slid into economic recession in 1971
and 1972. In the process, it was realized that the capital structure of many
Korean firms was neither stable nor healthy. By the early 1970s many com-
panies had grown into large-scale enterprises in terms of sales, assets, and
employment. These companies, however, started their businesses with lit-
tle equity; although they grew very large, they subsequently became heav-
ily dependent on loans from domestic commercial banks and on foreign
loans. For their working capital they had to resort to the unorganized curb
market. When the economic slowdown arrived and the 1971 devaluation
of the Korean won reduced their current earnings, at the same time increas-
ing the won-costs of servicing their foreign debts, these large enterprises
faced severe short-term cash-flow problems and the possibility of default-
ing on their foreign loans. Such short-term, high-cost financing forced some
30 _Lee-Jay Cho and Yoon Hyung Kim

of the companies into bankruptcy or to come under bank control. In this

situation economic growth stagnated.
To stave off massive bankruptcies and to stimulate the economy, the
Presidential Emergency Decree for Economic Stability and Growth was an-
nounced on 3 August 1972. This measure, discussed in detail in Chapter
7, was taken essentially to relieve the financial strain on business firms, to
improve corporate financial structures, and to curb inflationary pressures.
Under this decree, loans from unorganized money markets (which charged
extremely high interest rates) were forcibly converted into “new debt claims”
with lower interest rates and rescheduled payments. A credit-guarantee fund
was established for small and medium-size businesses. Bank interest rates
were reduced for both borrowers and depositors. Many in the business com-
munity were cognizant of the extremely serious implications of massive
bankruptcies and also of rampant usury. Business leaders were convinced
that their enterprises could not survive under such a climate and that the
short-term curb market profiteers rather than the institutionalized banks
were running the show. The president finally came to share their view and
announced this drastic measure to eliminate the tyranny of usury. It is ar-
guable that, had business not been saved from bankruptcy, those who con-
tributed in major ways to rapid economic expansion in the decade that
followed would not have been able to make such a contribution. Some ar-
gue, however, that the emergency decree, while giving immediate and sub-
stantial assistance to debt-ridden firms, provided only temporary relief but
no long-term financial solutions to industry
The emergency decree of 1972 went side by side with a policy measure
to open private companies to public shareholding, with emphasis on the
gradual separation of ownership and management. In 1972 the government
enacted the Law on Opening of Closed Corporations to induce large family-
owned enterprises to sell a portion of their equity to the public. President
Park did not have a liking for large capitalists, which is understandable,
considering his own background. He personally examined the results of
this measure by requiring a monthly report on the progress of opening up
the family-held companies. The large corporations found various means
to avoid opening up from the beginning; therefore, on 29 May 1974 the presi-

5. An interesting commentary by Professor Shinichi Ichimura of Kyoto University on Chap-

ter 7 of this book is noted here:
[An assessment of the 1972 emergency decree] requires a view on history rather than
an economist’s analytical mind. The late President Park may have been a historic figure
who played the role that Korea needed just at that time. He reminds me, as a Japanese
scholar, of Oda Nobunaga who achieved an end to the Medieval Age and started a
period of rationalization and secularization [in Japan] and was assassinated by his subor-
dinate. Leave the evaluation of President Park to an outstanding Korea historian some
decade later (Ichimura 1985).
 Major Economic Policies of the Park Administration 31

dent issued a special directive to force recalcitrant companies to comply

(Chapter 18). By 1979 publicly held shares were supposed to be 49 percent
of total shares in 355 of the largest 500 companies in Korea. The ultimate
design for reducing family holdings to only 10 percent of shares was al-
ready in the planning stages, but it was never actually implemented.
Moreover, during the same period, the total value added of the top 20 con-
glomerates, as a percentage of gross domestic product, increased signifi-
cantly, from 7 percent in 1973 to 14 percent in 1978.
The government under President Park made a consistent effort up to 1979
to regulate the excess concentration of economic power in the hands of a
small number of large corporations. Since 1979, however, not much progress
has been made in opening up the family-held companies. Looking at the
situation in the late 1980s, some would argue that efforts along these lines
have met with limited success. However, if the policy intentions of the Park
government had been implemented continuously over a longer span of time
and had not been interrupted by the president's death in 1979, it is con-
ceivable that public shareholding in the larger corporations might have in-
creased to a greater extent than it has.
Another policy measure sought to promote heavy and chemical indus-
tries as envisaged in the Heavy and Chemical Industries Promotion Plan
announced by the government in 1973 (Chapter 17). It was an ambitious
scheme to foster the growth of heavy engineering and petrochemical-process
industries, including iron and steel, nonferrous metals, shipbuilding, in-
dustrial machinery, electronics, and petrochemicals. This plan was seem-
ingly motivated by two arguments. First, the development of defense-related
industries was considered a necessity, in view of the signals from the United
States regarding the eventual withdrawal of U.S. ground forces from Korea.
Second, the increase of heavy industrial goods in the commodity compo-
sition of Korean exports was necessary to increase the value added in its
exports (such goods represent higher value added) and also to cope with
increasing protectionism against labor-intensive light manufactures in world
markets (particularly in view of rapidly rising wage levels in Korea). The
government provided a variety of incentives to the enterprises investing
in the designated heavy and chemical industries, which ranged from
preferential loans and tax concessions to protection through restrictions on
commodity production. The government's big push succeeded in develop-
ing a nucleus of heavy and chemical industries in Korea. But the concen-
tration of scarce capital in this sector had an adverse effect on the economic
stability and export competitiveness of other sectors of the economy (agricul-
ture, light manufacturing, and nontradable goods). The financial insolvency
of many of the latter firms in the early 1980s may be attributable to the lop-
sided allocation of financial resources in favor of the heavy and chemical
industries.
32 Lee-Jay Cho and Yoon Hyung Kim

The rapidly changing international political scene in the early 1970s—in

particular the visits of the American president and other top leaders to China
(viewed in Korea and elsewhere as the “Nixon Shock”) and the opening
of the dialogue between Japan and China—made it extremely difficult for
Korean leaders to assess the implications and future consequences of such
changes for Korea's national security. The sense of insecurity and instabil-
ity resulting from not knowing what was going to happen must have
strongly motivated President Park and his economic policymakers to place
stronger emphasis on heavy and chemical industries, which would enable
Korea to become more self-reliant in national defense. A question arose as
to whether the United States would be trustworthy and reliable in time
of desperate need for military hardware and other direct support for the
defense of Korea. Unbalanced investment in the heavy and chemical in-
dustries caused distortions in the country’s industrial structure, in income
distribution, and in other dimensions of the economy. Nevertheless, the
concern for national security, especially vis-a-vis the increasing belligerence
of North Korea, was the overriding issue facing the Korean leadership. The
threat from North Korea was exemplified by a 1976 incident when North
Korean soldiers ruthlessly hacked to death two American officers who were
attempting to trim the branches of a tree in the demilitarized zone. Joint
US. and Korean military plans for possible counteraction were subsequently
formulated and approved by the presidents of both countries. Another work
crew was sent to continue the trimming. South Korean and U.S. air and
ground forces were on alert and prepared, if they too were attacked, to strike
across the demilitarized zone to recapture territory up to the 38th parallel
that had been lost during the Korean War. This time, the North Koreans
took no action, but under such tense circumstances verging on war, na-
tional security overrode all other concerns as the focus of South Korean
policymaking.
As the government implemented the policy measures to expand heavy
and chemical industries, their will was further intensified by President
Carter's platform for the complete withdrawal of all U.S. troops from Korea
by 1982. The Korean government thus set 1980 as the target date for fulfill-
ing the basic requirements of self-reliance in the defense industry.
Having relieved business firms of severe financial restraints through the
1972 emergency decree, the subsequent massive investment in heavy and
chemical industries spurred industrial growth through the 1970s. Such rapid
industrial expansion entailed significant changes in industrial structure and
market organization. There was also noticeable change in the distribution
of industrial and economic power, and a sizable number of large-scale cor-
porations (perceived as associated with family fortunes) emerged. The emer-
gence of the jaebul (family-connected corporations) was beginning to change
the public’s perception of the benefits of the development-first strategy, in
 Major Economic Policies of the Park Administration 33

that rapid economic growth was perceived to have resulted in distortions

in the distribution of income and wealth. In this context, the freezing of
the curb market was regarded by many as financial relief to help large busi-
nesses at the expense of the middle-income people who had invested in
the curb markets.

Policy Reponse to the Oil Crisis (1974)

The Middle East war of October 1973 and the ensuing oil crisis caused a
sudden panic in Korean economic circles. The Arab oil embargo led to a
quadrupling of the world oil price in 1973-4, followed by recession in the
Japanese and U.S. economies. Korea depended on imported oil for about
55 percent of its total energy requirements, and the situation was serious.
The Presidential Emergency Decree for National Economic Security was
announced in January 1974 (Chapter 8). The essence of the decree was: (1)
to secure the welfare of the majority of the population by minimizing the
impact of oil price increases on low-income groups, (2) to discourage lux-
ury expenditures and promote frugality among high-income groups and
corporations, and (3) to minimize the deterioration in the balance of pay-
ments. The decree’s energy-specific measures aimed to promote energy con-
servation and reduce dependence on imported oil, and were later
consolidated into an integrated policy that became the centerpiece of Korea's
energy policy.
On the macroeconomic side, the government attempted to sustain a high
rate of economic growth by borrowing from abroad. In a sense, the policy
response to the oil crisis was a success in the short run, in that the country
was able to maintain a relatively high rate of growth during 1974-75. The
real rate of GNP growth in 1974 was 7.7 percent, which compares favorably
with those of the major industrialized countries as well as with some of
Korea's major trade competitors such as Singapore and Taiwan. Neverthe-
less, this policy measure may have contributed in subsequent years to in-
creasing Korea's foreign debt-service burden and to inflationary pressure.
The negative impact of the policy measure on the balance of payments was
so serious that net foreign exchange reserves declined nearly to half a
month’s imports at the end of 1974. The deteriorating balance-of-payments
situation was a portent that continued economic growth might not be
possible.

Promotion of General Trading Companies

and Construction Exports (1975)
Changes in the international economic environment immediately follow-
ing the 1973-74 oil shock dampened the prospects for continuous expan-
sion of Korea’s commodity exports. At the same time, the prospects for
exporting construction services to the oil-rich Middle East countries ap-
34 Lee-Jay Cho and Yoon Hyung Kim

peared promising. Against this background, the government undertook two

specific policy measures in 1975 to promote the creation of general trading
companies and exports of construction services.
The measure to designate specific companies to function as “general trad-
ing companies” (GTCs) was taken in early 1975 by presidential decree (see
Chapter 19). Prior to formulating the policy measure, numerous consulta-
tions among some of the major Japanese conglomerates and Korean
policymakers resulted in recommendations containing principally the ideas
of Ryuzo Sejima® of the Japanese conglomerate Itohchu. The top ten com-
panies were designated as GICs. The principal objectives of the establish-
ment of the GICs were to strengthen Korea’s export marketing activities
by using the extensive network of the GTCs’ overseas branches to perform
the role of “windows” or export agents for small and medium-size firms
producing export commodities and to reduce excessive competition among
Korean firms. The small and medium-size industries’ share of export com-
modities constituted about 50 percent of the GTCs export trade a few years
after the initial designation of the GTCs.
Patterned after the Japanese model of general trading companies
(shogogaisha), Korea's GTCs contributed substantially to revived export ex-
pansion. But unlike their Japanese counterparts, the Korean GICs were
much more competitive among themselves (to the extent of cutthroat com-
petition) rather than complementary (as is the case of the Japanese GTCs)
in delimiting functional markets. The Korean GTCs did increase exports
but were perceived as having used their financial resources, obtained
through preferential bank loans, for real-estate speculation and the acqui-
sition of existing medium-size firms and small export firms. For example,
the large conglomerates experienced a dramatic increase in earnings from
overseas construction contracts. Many of the construction companies were
using those funds to buy real estate, either for speculation or for later domes-
tic development projects. Because these construction companies were gener-
ally associated with the GTCs, it looked as though the conglomerates were
buying up real estate, whereas it may be that only the construction compa-
nies were involved in the real estate dealings. In any case, the positive im-
pact of the GTCs for the long term was the recruitment of a new generation
of young, competent, well-trained managers both in the home offices and
abroad, whose subsequent experience and training have contributed to the
quality of corporate entrepreneurship.
The Overseas Construction Promotion Act was promulgated in Decem-
ber 1975 to provide a legal basis for government support to and supervi-
sion of the export of construction services, and to promote the international

6. Ryuzo Sejima, who graduated from the Japanese military academy at around the same
time as Park Chung Hee, is still an active business leader and remains influential in political
circles in Japan.
 Major Economic Policies of the Park Administration 35

sion of the export of construction services, and to promote the international

competitiveness of the Korean construction industry (see Chapter 20). The
Park government saw salvation for the heavy industrialization strategy in
the export of construction services to the Middle East. The act required that
a company obtain a license from the Ministry of Construction to engage
in the overseas construction business. Construction companies licensed by
the ministry were provided with performance bonding by Korean banks
and were insured against exchange fluctuations and other risks of foreign
trade. They also received tax benefits on income derived from foreign con-
struction.
The implementation of this policy measure was not entirely a success.
The more profitable activities of the contractors—building harbor facilities
and industrial plants, for example—were very successful in earning foreign
exchange. A few major companies encountered serious losses, however,
notably in the construction of housing, mainly because of a lack of under-
standing of the culture and behavior of Islamic people. The Middle Eastern
countries complained at first about Korean government control over and
interference in free competition among competing companies. Despite
government efforts to manage construction export services to the Middle
East, some destructive competition took place to the detriment of the over-
all industry, and some Middle East governments later complained about
“dumping” of construction services because some companies were grasp-
ing for any opportunity to obtain contracts regardless of their capabilities
to fulfill them.
Korea's balance of payments improved substantially during 1976-77,
thanks to the boom in Middle East construction activities, but the overex-
pansion of construction service exports was threatening to disrupt the
stability of the economy. The surplus balance was an entirely new phenome-
non for Korea’s economic policymakers. The influx of foreign exchange earn-
ings from the Middle East contributed to the dramatic increase in the money
supply and fanned inflation. Because of the lack of both experience and
insight with respect to the surplus balance, the distortion in the finance
sector was not properly handled and the negative impact lingered, exacer-
bating later difficulties. In the early 1980s, after the boom had ended, the
financial insolvency of many construction firms became evident. In
retrospect the government should have taken more decisive action in stream-
lining and curtailing the overseas construction service industry when the
demand for these services began to decline.

Policy Measures for Social Development

and Urban Growth (1976-77)
While Korea was emerging as a newly industrializing country and eliminat-
ing absolute poverty, concern about social welfare received increasing at-
36 Lee-Jay Cho and Yoon Hyung Kim

tention. As a result of the heavy emphasis on economic growth, efforts

toward social development and welfare were lagging in the mid-1970s. The
Park government was able to launch only a limited social welfare program,
which included the enactment of the Medical Insurance Law at the end
of 1976 (see Chapter 13).
Since the law’s implementation in July 1977, the health insurance pro-
gram has played an important role in making medical services more acces-
sible to the working population. Although the number of persons covered
by the program has increased steadily, many problems remain to be solved
in order to achieve an adequate level of service for the population at large.
The medical insurance system has not received the level of investment
needed to fulfill its function.
During the 1960s, 1970s, and 1980s, the spatial structure of human set-
tlements in Korea was drastically transformed. As discussed in Chapter 14,
rapid industrialization was accompanied by massive rural-to-urban migra-
tion. As a result, the proportion of the total population residing in urban
areas increased from 28 percent in 1962 to almost 60 percent in 1980. The
principal problems in Korean urban growth have been the persistent pri-
macy of the capital city and regional imbalance. This is partly a result of
the government’s development strategy, which stressed economies of scale
and agglomeration.
Although the Korean government began taking some policy initiatives
in the late 1960s to grapple with these problems, the 1977 Population Redis-
tribution Plan was the most ambitious government effort to guide the pat-
tern of urbanization. The 1977 measure was prompted by the increasing
belligerence of North Korea, in that the economic and industrial
predominance of the capital city made South Korea precariously vulnera-
ble to easy attack or sabotage from the North. The plan was comprehen-
sive in the sense that it employed almost every conceivable means and
strategy to achieve the planning objectives.
The Korean population redistribution policy achieved limited success in-
itially. The predominance of the capital city in economic, financial, educa-
tional, and other aspects still seems to be increasing. The ineffectiveness
of the plan can be attributed to its lack of integration with economic de-
velopment policies, the control-oriented nature of its policy measures, and
the lack of a firm political commitment for population dispersal. The redis-
tribution policy should have been formulated in the early 1970s, when the
country was at the take-off point in industrial development. An effective
and comprehensive policy could then have had a greater impact. Neverthe-
less, the Korean experience in population redistribution provides a valu-
able lesson for other countries that are considering the formulation or
implementation of a national urban policy.
 Major Economic Policies of the Park Administration 37

Value-Added Tax (1977)

The Fourth Five-Year Economic and Social Development Plan emphasized
the promotion of heavy and chemical industries to strengthen national
defense, and social development projects to enhance the people's welfare.
The government was painfully aware of the need for increased revenues
as well as other sources of capital.
Up until 1977 Korea maintained a complicated structure of domestic in-
direct taxes. Then in July 1977 the value-added tax (VAT) was formally in-
troduced (see Chapter 11). The principal objectives of VAT were, on the
one hand, to simplify the existing tax structure and, on the other, to in-
crease revenues. Some economic policymakers at that time were greatly
attracted to the VAT system already operating in some of the countries of
the European Economic Community. When the basic idea was first brought
forth for discussion, an Irish tax expert who was a strong advocate of the
merits of the system was consulted. Subsequently, a study team was formed
to review and evaluate the VAT system operating in European countries;
the study results were formulated into recommendations for adopting the
system in Korea. The principal proponent of this system was an economist
who had recently returned to Korea from an American university. The VAT
as implemented in advanced industrial countries was theoretically neat and
persuasive both from the tax administration viewpoint and in the context
of rational behavior. However, the noneconomic aspects of human behavior
based on traditional values, customs, and habits were lacking in this “pure”
frame of thinking. If the majority of the populace are not educated or per-
suaded to cooperate willingly in the implementation of a tax reform, the
costs of enforcement may ultimately outweigh its advantages and merits.
There has been heated argument as to whether VAT caused price in-
creases, thereby contributing to inflation. It has been argued that the
policymakers, by intentionally placing emphasis on the heavy and chemi-
cal industries, were prepared to live with a certain level of inflation in any
case to meet the target of national security self-reliance by 1980. In addi-
tion to revenues generated under the VAT system, the dramatic increase
in Middle East construction earnings was also fanning inflation. It has also
been argued that the rate of price increases in the first half of 1977 was
greater than in the second half (that is, after the introduction of VAT).
However, a proper evaluation of the impact of the new tax system would
have to be carried out over a much longer time frame. The Korean experience
has demonstrated that the VAT system, although simple in principle and
neat theoretically, created voluminous paperwork and procedures that were,
at that time, not consonant with the habits and behavior of the populace,
thereby causing irritation, annoyance, and complaints which were, in the
end, manifested in political consequences. The public's perception of the
38 Lee-Jay Cho and Yoon Hyung Kim

tax was that it would benefit big business but would hurt smaller businesses.
The implementation of VAT contributed to the decrease in popular sup-
port for the government during the general election of 1978 and was the
beginning of serious political trouble for the regime. The VAT reform can
thus be regarded as a political-economic foible. In the Korean cultural set-
ting one has to conclude that VAT was some years ahead of its time.

Comprehensive Economic Stabilization Program (1979)

During the 1961-79 period, the Park government accepted inflation as an
inevitable price for sustained economic growth. The policy response to the
first oil shock in 1974, the massive injection of capital into the heavy indus-
trialization projects in 1976-78, and the sudden increase in money supply
resulting from the influx of foreign exchange earnings from the Middle East
added to the inflationary pressure in the latter half of the 1970s. As infla-
tion accelerated, however, it became clear that sustained economic growth
would be difficult unless inflation was curbed. The weakening of export
competitiveness, inflationary distortions in resource allocation, and the
growing frustration of workers who were increasingly aware of the widen-
ing disparity in the distribution of wealth and income pointed to chronic
inflation as a principal factor undermining economic health.
The government announced the Integrated Economic Stabilization Pro-
gram in April 1979 (see Chapter 9). The essence of this policy package was
to control aggregate demand through restrictive fiscal and monetary
management and investment adjustment in the heavy and chemical indus-
tries. Subsequently, with the change of government in 1980 as a result of
President Park’s assassination, the new team of policymakers modified the
policy package more into controlling costs and prices—for example, by
reducing interest rates and freezing wages. However, before the program
produced any signs of price stability, the economy was hit by the second
oil price increase and the worldwide economic recession. The assassina-
tion of President Park and ensuing political turmoil caused a drastic set-
back in economic activity. The numerous policy measures taken during
1980-86 to stimulate the economy were, in most cases, cautious and sensi-
tive so as not to jeopardize price stability. Nonetheless, the stabilization ef-
fort initiated by the 1979 measures was not abandoned—not even during
the difficult period of the oil shock and recession. It has been continued
and, as a result, there has been a fairly sharp deceleration in inflation since
1981.

ASSASSINATION OF PRESIDENT PARK

AND TRANSITION TO THE FIFTH REPUBLIC
A serious political disturbance began in September 1979 when the head
of the major opposition party was dismissed from the National Assembly
 Major Economic Policies of the Park Administration 39

and his followers resigned in protest. This disturbance was severely

repressed. Then, in October 1979, President Park Chung Hee was assassi-
nated by the head of the Korean CIA, abruptly ending his 18-year term of
state control?
The assassination of President Park was followed by serious civil distur-
bances and economic disruptions during the final year of the Fourth Repub-
lic. President Park’s prime minister, Choi Kyu Hah, was sworn in as interim
president, and a new cabinet was formed. During the next six months, the
government was basically trying to cope with the chaotic disruptions in
the wake of the assassination, including political activism among the op-
position early in 1980 and student rioting in the universities. The business
community became demoralized, and the military grew increasingly un-
easy. Although the government did what it could to stabilize the economy
from the political shocks, the Korean economy for the first time in two de-
cades experienced negative growth (-3.7 percent in GNP in 1980).
President Choi, who rose to the presidency as a docile bureaucrat, was
never groomed for a role that demanded forceful and effective political
leadership. During the critical transitional period in late 1979 and early 1980,
President Choi demonstrated no leadership ability or courage in manag-
ing the political vacuum created by the assassination. In December 1979
a power struggle within the military culminated in an internal leadership
takeover by a group of officers around General Chun Doo Hwan. This group
then began playing an increasing political role. In May 1980, when the
government was confronted by the Kwangju civil uprising for “democrati-
zation,” the military took control of the country, extended martial law, and
restored order in Kwangju (although at the cost of about 190 lives). Gen-
eral Chun formally retired from the army to head the government and
promised a general election under a new constitution within a year.
This chapter has attempted to paint only a broad backdrop to introduce
the main features of the Park administration's policy measures in historical
perspective. The following chapters will review 18 major policy initiatives
that were developed to further the government's rapid economic develop-
ment strategy from 1961 to 1979. Each author provides an analytical assess-
ment of the impact of a particular measure and a detailed examination of
how government and business interacted and cooperated in its implemen-
tation. These policy measures and reforms in some instances played a crit-
ical role in transforming the structure of the Korean economy and helped
put it on a rapid growth path. Some policies, however, not only failed to

7. The assassin was Kim Jae-Kyu, a long-time friend of President Park. He was about to be
removed from his powerful position as head of the Korean Central Intelligence Agency and
was locked in a rivalry struggle with the president’s bodyguard, Cha Jae-Chul. Kim actually
planned to shoot only Cha, but having done so, he assassinated the president as well.
40 — Lee-Jay Cho and Yoon Hyung Kim

achieve the intended results but also led to circumstances in which another
corrective measure was needed. The policy measures included in this book
are by no means exhaustive, and it might be argued that some measures
excluded from this study are equally important. The editors believe,
however, that the measures selected for this study represent the critical pol-
icy events underlying the rapid economic development of the 1960s and
1970s.
PART II
ECONOMIC POLICIES, 1961-80

MONETARY AND
ERIGE PO@LIGIES

TAXATION POLICIES

POPULATION AND
PUBLIC HEALTH POLICIES

AGRICULTURAL POLICIES

INDUSTRIAL POLICIES
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MONETARY AND
PwiGE BORIGIES
 3 The Development of Financial
Institutions and the Role of Government
in Credit Allocation

by Yung Chul Park

In 1961 Korea's financial institutions were largely composed of the Bank

of Korea, the Korea Development Bank (KDB), the Korea Agricultural Bank
(KAB), and a few nationwide commercial banks.
The KDB was established in 1954 with the primary mission of providing
medium- and long-term loans to industry. It was placed directly under the
authority of the Ministry of Finance and so was not subject to the control
of the central bank, the Bank of Korea. However, because of its inability
to attract funds from the public, the KDB had to rely heavily on the central
bank for its supply of funds. The inflationary condition, small private sav-
ings, and low ceilings on interest rates discouraged the public from pur-
chasing long-term debt instruments from the KDB.
The KAB was set up at about the same time, as a bank for the farmers’
associations. Like the KDB, and for the same reasons, it had difficulty in
raising funds from the public and thus had to rely for funds on the govern-
ment and the central bank.
Until 1957 the commercial banks, with the exception of the Choheung
Bank, were largely owned by the government. The government of Korea
received the shares in the banks from the U.S. military government, which
had confiscated them from Japanese owners at the end of World War II.
In 1957 the government denationalized the banks by selling its shares to
private individuals. A stigma was, however, attached to this denationaliza-
tion as many of these individuals (mainly owners of conglomerates) had
become wealthy by reaping high profits, tainted with corruption, in the
importing business controlled by government licenses. This later provided
a rationale for the military government in repossessing the shares held by
large private investors in the commercial banks.
The financial market that existed in Korea just before the military takeover
in 1961 was not, therefore, a single homogeneous market but contained
a dual structure: the KDB and KAB, established and controlled directly by
the government, and the commercial banks, most of which had been dena-
tionalized only a few years before. Of the two, the former exercised a
dominant influence in the allocation of funds, accounting for 71 percent
of total lending in 1960. The latter’s share, which was 45 percent in 1955,
declined to 29 percent in 1960. Thus, contrary to what one would have
45
46 Yung Chul Park

expected, the denationalization expanded the influence of the government

in the financial market. When the military government expropriated the
privately held shares in the commercial banks in 1961, it was not, there-
fore, converting a free market into a controlled market but merely increas-
ing the degree of control.
The military leaders who took over the government in May 1961 were
committed to a mixed economy in which the government and the public
sector would play a dominant role in economic development. They pledged
themselves to powerful government programs aimed at overcoming the
country’s underdevelopment.
As a first step toward achieving financial control, the new leaders, within
three months after their takeover of the government, reorganized the agricul-
tural financing and marketing institutions by combining the agricultural
cooperatives and the KAB into one entity known as the National Agricul-
tural Cooperatives Federation (NACF). The NACF was responsible for
providing credit to farmers, supplying them with agricultural inputs, and
marketing their output, as well as purchasing grain on government account
to help stabilize grain prices and ensure supplies for government needs.
The second major innovation of the military government was the estab-
lishment of the Medium Industry Bank (MIB), also in August 1961, for the
purpose of providing loans to medium and small enterprises. The func-
tions of the MIB (now the Small and Medium Industry Bank) were similar
to those of the commercial banks in that it accepted deposits and made
mainly short-term loans, but its loans had to go only to enterprises with
fewer than a certain prescribed number of employees and whose total as-
sets were less than a certain amount.
Both of these initial ventures—the NACF and the MIB—were manifesta-
tions of the government's desire and commitment to improve the lot of small
farmers and businessmen. The rapid expansion of loans through these in-
stitutions in 1961 resulted in a significant shift in the allocation of credit.
The share of these two banks in total bank credit jumped from 32 to 38
percent during 1961, largely at the expense of the commercial bank share,
which dropped from 29 to 24 percent.
In October 1961 the government repossessed the shares of the commer-
cial banks that were held by large stockholders on the grounds that these
were illegally hoarded properties. Furthermore, the voting interest of any
single stockholder was restricted, under the Temporary Act on Bank Ad-
ministration, to no more than 10 percent of the total shares, regardless of
actual holdings. As a result, the government became the dominant stock-
holder with comprehensive controls over the banks ranging from the ap-
pointment of senior officers to issuing directives on banking operations.
The government was responding to concerns that the privately owned banks
would contribute to the concentration of economic power along the lines
experienced in Japan (B. Kim 1965:66).
 The Development of Financial Institutions 47

The next step in the financial reform program of the military government
was the revision of the KDB charter to increase its capital, authorize it to
borrow funds from abroad, and guarantee foreign loans obtained by Korean
enterprises. This guarantee procedure was subsequently extended to the
other commercial and special banks and proved to be a major factor induc-
ing the inflow of foreign capital.
These institutional changes culminated in May 1962 when the Bank of
Korea Law was revised to bring the central bank unequivocally under the
control of the minister of finance. The minister of finance had wielded de
facto authority over the Bank of Korea from its inception, in part because
of the need for financing the Korean War and postwar reconstruction. There
was continual debate from 1950 to 1962 between those who supported the
autonomy of the central bank as provided in its charter and those who be-
lieved that monetary policy should be one of several coordinated elements
of economic policy with the minister of finance, as chairman of the Mone-
tary Board, providing the focal point of that coordination (B. Kim 1965).
In late 1962 the government consolidated a number of small mutual
financing companies into the Citizens National Bank, which was to con-
centrate on small loans to businesses and households. Also in 1962, the
Central Federation of Fisheries Cooperatives was created to provide credit
and marketing services to the fishing industry comparable to those the
NACF provided to agriculture.
The legislative changes of 1962 were a manifestation of the orientation
of the new government toward development of a core of centrally managed,
powerful institutions and instruments for carrying out the First Five-Year
Development Plan (1962-66).

MAIN FEATURES OF THE POLICY MEASURES

Guaranteeing Repayment of Foreign Loans: A New Role
for Korean Banks
As the main instrument for promoting the inflow of foreign loans, the
government devised, during the 1960s, a system of bank guarantees for the
repayment of loans. The impetus for this appears to have come mainly from
the prospective normalization of relations with Japan. The Korean govern-
ment preferred to have the resulting capital inflow in the form of loans rather
than equity shares so as to minimize Japanese ownership and control of
Korean business. Furthermore, although the arrangement for a loan was
to be worked out directly between the borrower and the lender, it required
government approval. The government, therefore, had ultimate control over
the volume of foreign financing and its allocation among competing sectors.
Korean enterprises wishing to borrow abroad first had to obtain the ap-
proval of the Economic Planning Board (EPB), which in turn sought ap-
proval of the National Assembly for the issuance of a guarantee covering
48 Yung Chul Park

repayment of the foreign borrowings. Once the guarantee had been autho-
rized, the Bank of Korea (and subsequently the Korean Exchange Bank)
issued the guarantee to the foreign lender, while the KDB (and subsequently
the commercial banks) issued guarantees to the Bank of Korea. The ulti-
mate borrower was committed to repay the loan, but he had the backing
of both the KDB and the Bank of Korea that, in the event of his default,
the loan would be repaid. Thus the risk of default for the lender was negligi-
ble, and the Korean borrower had assurances of support not only from the
domestic banking institutions but also from the central bank and the EPB.
The foreign loan guarantee operations became significant in 1963 when
KDB acceptances (time drafts and bills of exchange) went up from 2.2 bil-
lion won in the previous year to 18.1 billion (Cole and Park 1983). Over
the next two years, the total guarantees increased by over 25 billion won
each year and then jumped by nearly 70 billion won in 1966, at which time
they were nearly equal to the total of outstanding bank loans. Also in 1966
the commercial banks assumed a significant role in the guarantee activity,
accounting for nearly 30 billion of the 70 billion increase in that year. Thus
the Korean banking system, while not actually intermediating between for-
eign lenders and domestic borrowers, was facilitating such lending activ-
ity, without committing much of its own financial or human resources. From
1963 to 1966 foreign guaranteed loans were the major source of new financ-
ing for Korean businesses.
Because the banks played a very limited role in the decision-making
process in regard to these loans and issued the guarantees on instruction
from the government, they took little responsibility for evaluating either
the economic or financial feasibility of a project. Eventually when some
of the projects proved unsound, the government had little basis for hold-
ing the banks accountable and therefore had to take extraordinary meas-
ures to relieve the banks of the bad debts.
The Interest-Rate Reform
The interest-rate reform of September 1965 (see also chapter 6), though
sometimes viewed as a revamping of the whole interest-rate structure, was
essentially a major increase in the interest rate paid on time deposits
designed to mobilize private savings through the nationalized financial in-
stitutions. There were some increases in the rates charged on loans, but
these had little impact on the volume of lending or lending practices be-
cause the new rates were still not high enough to affect the demand for
loans. The increase in the time-deposit rate from 15 to 30 percent per year,
however, did result in a quantum jump in the financial resources of the
commercial and special banks and substantially changed their institutional
role. All the banks (except the KDB, which did not raise its deposit rate)
became important mobilizers of financial savings and for the first time be-
gan to give some attention to this role. They were also partly relieved from
 The Development of Financial Institutions 49

their total dependence on central bank credit or government budgetary al-

locations of aid counterpart funds as primary sources for their lending.
Between 1965 and 1969 total bank deposits rose from 10 percent to 30
percent of GNP. During this period, real GNP increased by 57 percent and
nominal GNP by 158 percent, whereas total deposits rose by nearly 700
percent. Total bank loans increased by an amount almost exactly equal to
the deposits between 1965 and 1969 (Cole and Park 1983). A substantial
excess of deposits over loans in the commercial banks was offset by a loan
surplus at the KDB.
The interest-rate reform contributed to mobilizing real private savings
and put vast financial resources at the command of the government. Clearly
the role of the banking system had changed dramatically from the early
1960s when it was mainly engaged in rationing a limited supply of credit.
Although the banks had not acquired any greater degree of independence
in decision making as to the allocation of credit—decisions on all the guaran-
tees and many of the larger loans were made by the government—they did
have a greatly expanded managerial role over a system that exerted a major
influence on the allocation of resources.
New Banking Institutions in the Late 1960s
Specialized banking institutions were established in 1967 and the doors were
opened to the creation of new private banking ventures. The Korea Exchange
Bank (KEB) was created as a separate entity from the personnel, facilities,
and financial resources of the foreign-exchange and foreign-operations
departments of the Bank of Korea. The KEB’s stock was wholly owned by
the Bank of Korea, and it had functioned largely as an extension of the cen-
tral bank since its inception. Thus the change was mainly one of form rather
than substance.
Much the same can be said for the Korea Trust Bank, a consolidation
of the trust departments of the five national commercial banks, also estab-
lished in 1967. Trust accounts in Korea are fairly close substitutes for time
deposits and the Korea Trust Bank had held substantial amounts of demand
deposits since its inception. Thus it functioned much like a commercial bank
and had been treated as such by both the central bank and the financial
authorities until it was merged with the Seoul Bank in 1976 to become the
Bank of Seoul and Trust Company.
The Korea Housing Bank was also created in 1967 “to finance housing
funds for low-income families” (BOK, Financial System, 1983:47). Its pur-
pose was to extend loans for construction and purchasing of houses and
to firms producing housing construction materials. By 1978 the Korea Hous-
ing Bank was raising roughly one-third of its funds through the sale of de-
bentures, and 55 percent through demand and time deposits. Depositors
received preferential treatment in the granting of loans, which provided
an incentive, in addition to the interest rate, for holding its deposits.
50 Yung Chul Park

Nevertheless, in 1978 the Korea Housing Bank’s share of total bank deposits
was only about 4 percent.
Of greater significance was the action by the government in 1967 authoriz-
ing the chartering of local banks to conduct commercial banking business
principally within limited geographic areas. The objectives of the govern-
ment were to achieve greater dispersion of banking services and to see that
the banks would concentrate on meeting the needs of local enterprises. The
local banks engage in branch banking with their head offices in the provin-
cial capitals and branches confined to the same province. Initially they were
prohibited from engaging in foreign-exchange operations, but as they be-
came better established that prohibition was relaxed. Also the local banks
were authorized to charge interest rates on loans up to 2.5 percentage points
higher than the national commercial banks and to pay higher interest rates
on time deposits. These banks are privately owned and less closely regu-
lated and controlled than the government-owned banks.
A final institutional innovation of 1967 was the granting of permission
to a limited number of foreign banks to open branch offices in Korea. In
the first year, five banks (three American and two Japanese) established
branches; by the end of 1974, four more were permitted. Since then the
number of foreign bank branches has risen rapidly, reflecting the growing
volume of external transactions. The kinds of activities in which these
branches can participate are, however, quite circumscribed, and they rely
mainly on funds borrowed from their head offices to make loans in foreign
currency, especially to importers.
Development of Nonbank Financial Institutions
and the Capital Market
Banking and traditional financial institutions had accounted for most of the
financial intermediation during the postwar years (1948-53). Throughout
the 1950s and 1960s, life insurance, postal savings, and the trust business
of commercial banks had a commanding share of the nonbanking finan-
cial sector, although money in trust was actually time and savings deposits
at the deposit-money banks with longer maturities.
The restructuring of the financial system in the 1960s, which gave the
control of financial institutions to the government, was followed by policy
measures in the 1970s aimed at developing nonbank financial intermedi-
aries and the capital market. This financial policy had its major objectives
in diversifying financial assets and institutions and also creating financial
intermediaries that could compete effectively with and eventually eliminate
the unregulated money market. As a result of the government's efforts, a
variety of new nonbanking institutions came into existence, and their as-
sets and liabilities grew rapidly in the 1970s. Considering the nature of their
operations, it also appears that some of these institutions, such as the in-
vestment finance companies and mutual savings and finance companies,
 The Development of Financial Institutions 51

were instrumental in attracting private savings from the unregulated money

markets into the regulated financial sector.
Most of the nonbank financial intermediaries are privately owned, major
exceptions being the KDB and the Export-Import Bank of Korea. Although
the government regulates their financial operations, these institutions, un-
like deposit-money banks, have been left relatively free in their asset
management.
The Export-Import Bank of Korea was created primarily for the promo-
tion of exports of heavy and chemical products. It was legally established
in 1969, but its operations were handled by the KEB for the next seven years.
Since becoming a separate entity in 1976, the size of its loan portfolio has
increased markedly. The bank provides medium- and long-term credit for
foreign trade and overseas investment with its own resources and with
funds borrowed from the government and the National Investment Fund.
A stock exchange was established in 1956, but for more than a decade
thereafter the securities market was plagued by speculation and stock price
manipulation. The “stock exchange” was really a market for government
bonds and did not function as a stock market until the 1960s. By the
mid-1960s it had become evident that heavy reliance on bank loans and
foreign loans for the financing of corporate investment was leading to high
debt-equity ratios dominated by short-term loans for many businesses. With
this realization and the government's desire for greater diffusion of corporate
ownership and diversification of financing sources, the government renewed
its efforts to develop a modern capital market and began to implement a
series of reform measures.
In September 1968 the Law for Fostering the Capital Market was enacted.
This law was aimed at encouraging major corporations to go public. In
December 1972 the government was entrusted with powers to designate
a corporation as eligible to go public and to issue ordinances for it to do
so. The Securities and Exchange Commission and its executive body, the
Securities Supervisory Board, were established in February 1977 to carry
out various functions related to the supervision of the securities market
and institutions.
Efforts to improve the efficiency of the capital market continued into the
1980s. Repurchase agreements were introduced to enlarge the scope of the
bond issue market. As a first step toward liberalizing the capital market
to foreign investors, US $30 million in beneficiary certificates were sold in
the United States and Europe in January 1981.
The rapid growth of nonbank financial intermediaries and the capital
market beginning in the early 1970s brought about a significant change in
the role of the government in resource allocation. The expansion reduced
the scope of government intervention in the allocation of resources. The
numerous measures undertaken to develop the nonbank financial institu-
tions and the capital market also reflected the government's desire to gradu-
ally liberalize the financial system in the 1970s.
52 Yung Chul Park

Recent Liberalization Measures

By the mid-1970s it was apparent to both the government and the business
community that the development strategy that relied on extensive govern-
ment intervention was becoming increasingly counterproductive. After a
decade of rapid growth fueled by the expansion of exports, Korea had de-
veloped a complex and sophisticated economy with a large external sector.
The sheer size and complexity of the economy inevitably reduced the
scope of government control and diminished the government's ability to
administer a system of rigid controls. Doubts were raised as to whether
the government could effect an efficient allocation of real resources through
the credit allocations it controlled.
Although the need for a greater reliance on market mechanisms as an
alternative to the system of control was clearly recognized, government plan-
ners continued to resist relinquishing economic decision-making power to
the private sector. They, in fact, intensified their interference with the allo-
cation of resources in the process of promoting the heavy and chemical
industries as the future export sector. To divert a large share of the nation’s
investment resources to these industries, the government tightened its grip
on the financial system.
The government took further steps to divert more resources to the heavy
and chemical industries as evidenced by the creation of the National In-
vestment Fund (NIF) in 1974. The KDB had played a dominant role as the
long-term credit bank in the 1950s and 1960s, though other special banks
had increased in importance as suppliers of long-term funds in the 1960s.
In the early 1970s, when the Third Five-Year Development Plan was pre-
pared, it was clear that the deposit-money banks (including the KDB) could
not be expected to provide sufficient financing for the development of heavy
and chemical industries—one of the major objectives of the third plan. A
new financing channel, the NIE, was established to augment the flow of
domestic savings to investment in the heavy and chemical industries.
The major sources of NIF loanable funds consisted of: (1) the proceeds
from the sales of NIF bonds; (2) contributions in the form of deposits made
by the deposit-money banks (exclusive of foreign bank branches and fish-
eries cooperatives), the members of the National Savings Association,
money in trust, insurance premiums of nonlife insurance companies, and
various public funds managed by the central and local governments and
other public entities; and (3) transfers (or deposits) from the various govern-
ment budgetary accounts. As for the contributions, the deposit-money banks
were, for instance, required to deposit 15 percent of the increase in their
savings deposits at the NIF and the nonlife insurance companies had to
deposit 50 percent of their insurance premiums and other revenues.
The Ministry of Finance was responsible for the administration of the
fund, but its actual management was entrusted to the Bank of Korea. The
NIF made loans for both fixed investment and working capital to the heavy,
 The Development of Financial Institutions 53

chemical, and other major industries with the deposit-money banks, the
KDB, and the Export-Import Bank of Korea acting as intermediaries.
The NIF loans were made at subsidized rates. In 1978 the lending rates
varied from 6 percent for export suppliers credit to 16 percent for the loans
to the heavy and chemical industries with three- to eight-year maturities,
whereas the interest rates on NIF deposits ranged from 6 percent per an-
num (for three-month deposits) to 18.6 percent (for one year and over
deposits and NIF bonds). The losses resulting from the negative margin
between the deposit and lending rates were fully compensated for by the
government.
Because of a lack of coordination in the development of the heavy and
chemical industries, there was excessive investment and duplication of simi-
lar projects in many subsectors of these industries. The setback in the de-
velopment of heavy and chemical industries and the associated drain on
domestic resources, more than anything else, renewed the debate on the
need for financial liberalization toward the end of the 1970s. Since then it
has been frequently pointed out that such a misallocation of resources could
have been avoided had the management of the financial system been left
in the hands of the private sector.
Government planners and financial specialists agreed that government
control of the financial institutions and interest rates should be relaxed and
eventually eliminated in order to increase competition in the financial in-
dustry. What they disagreed on was the pace at which financial liberaliza-
tion should be pursued and the proper role of the government in a
liberalized financial regime.
The new regime that came into power in 1980 was strongly committed
to financial liberalization as a major policy objective. The government di-
vested itself of the ownership of one of the five commercial banks, the Hanil
Bank, in June 1981. The denationalization was preceded and followed by
abolishing various government directives that had regulated personnel
management, budgets, and other operational matters of commercial banks.
In the same month the monetary authorities established a commercial paper
market that was not subject to government control. This market was ex-
pected to serve as a bridge between the curb market and the organized finan-
cial system and to provide a reference point for setting official interest rates.
This move was widely regarded as a first step toward freeing the interest
rates from government control. In line with this policy direction, the yields
on new corporate debentures were allowed to fluctuate within an upper
and lower limit of 1 percent of the banks’ reference rate.
After the privatization of the Hanil Bank, the government also announced
a plan to charter three joint-venture commercial banks with Korean and
foreign partners to promote competition in the banking industry and to
establish a linkage with international financial markets. One of these banks
began operation in 1982, and another in 1983. In late 1981 two investment
54 Yung Chul Park

funds worth US $30 million were floated to let foreigners buy Korean shares.
At the end of November 1979, the average required reserves were 23 per-
cent of deposits at the deposit-money banks. The ratio was gradually
reduced to 3.5 percent in November 1981, before it was raised again to 5.5
percent in May 1982. The substantial reduction was aimed at giving more
freedom to the banks in their management of lendable resources and eas-
ing the strain on bank profits.
In January 1982 the monetary authorities abolished the direct control over
bank lending through credit ceilings and quotas in preference to an indirect
reserve control. This change also signaled the government's intention to
refrain from interfering with bank credit allocation.
These reform measures were significant and refreshing developments
in a country that had long suffered from financial repression. Most of all,
they reflected the government's determination to develop a freer financial
system where the price mechanism reigns and to open the financial indus-
try to foreign competition.
For almost a year after denationalization of the Hanil Bank, however,
little visible progress toward financial liberalization had been made. For a
while in the early months of 1982 there was a growing feeling that the
government was stalling the reform. The lack of progress could largely be
attributed to the disagreement among the policymakers on the pace of liber-
alization. On the one hand, there were those who believed that gradual
liberalization was nothing but a code word for the continuation of finan-
cial repression and argued for an overhauling of the entire financial sys-
tem within a short period of time. On the other hand, there were the
moderates; they were concerned about the possible adverse effects of prema-
ture and swift reform. In particular, these “detractors” argued that finan-
cial liberalization conflicted with the government's overall as well as sectoral
allocation of investment through the implementation of the consecutive five-
year development plans. According to the moderates, financial control is
a means for effecting the allocation of real resources. As long as the govern-
ment attempts to influence resource allocation, it is argued, it cannot deprive
itself of the most important means of control. More realistically, those who
subscribed to gradual liberalization pointed out the extremely high lever-
age of Korean firms. Few could have survived the scrutiny of privatized
commercial banks, and in the absence of the government's allocational in-
terference in the form of relief financing, they believed, most of the firms
that had borrowed heavily from the banks would have gone bankrupt. Until
their balance sheets improved substantially, as the argument went, freeing
the financial markets could not be implemented.
For a while, the gradualists appeared to have prevailed, but the curb mar-
ket scandal that broke out in May 1982 changed the financial and political
environment and eclipsed their influence. The swindle, ostensibly en-
gineered by a couple extensively involved in curb-market lending, tarnished
 The Development of Financial Institutions 55

the image of a regime committed to building a just society. It jolted an econ-

omy already deep in recession, clouding further the prospects of an early
recovery. It paralyzed the financial markets, severely curtailing the availa-
bility of credit. Under the circumstances, the government had to do some-
thing quickly to stop any further hemorrhaging of the economy. The
monetary authorities began an infusion of fresh credit (created by printing
money) into the economy to supplement the informal credit that had dried
up overnight. The government also had to find a scapegoat for the scan-
dal, which it found conveniently in the curb market. The root cause of the
scandal, however, was the structural deficiencies in Korea’s financial sys-
tem that provided room for the expansion of the informal credit market.
Nonetheless, the swindle set the stage for a complete reversal of the govern-
ment’s macroeconomic policy, quickened the pace of financial reform, and
led to two radical measures on June 28 and July 3, along with other reform
actions. The measures lowered the bank deposit and lending rates by more
than 4 percentage points (June 28) and introduced an identification system
in which depositors at banks and holders of other financial assets were re-
quired to reveal their real names (July 3). The July 3 measure was strongly
opposed and was subsequently indefinitely postponed.

THEORETICAL APPROPRIATENESS
Government Intervention
Allocation of credit is one of the key functions of finance. Whereas finan-
cial growth may not necessarily stimulate private savings and may take place
even when private savings as a proportion of income remains unchanged
or declines, it is widely believed to contribute to efficient allocation of phys-
ical resources. The underlying assumption is that financial intermediaries,
because of their scale economies and specialization, are more efficient in
resource allocation than individual savers. Financial intermediaries are often
able to allocate more resources than they mobilize from private savers be-
cause a major share of funding from the government and foreign sector
is channeled to borrowers through the financial institutions.
Few governments in developing countries seem to believe in the alloca-
tional efficiency of either the financial markets or the financial institutions.
As documented by Shaw (1973) and McKinnon (1973), the financial sector
is perhaps the most heavily regulated industry in developing countries. The
governments of these countries intervene extensively in credit allocation
in the belief that without their intervention credit allocation would not reflect
social and economic priorities—priorities that are often set by these govern-
ments. The Korean government has been no exception in this regard. It has
behaved as if in the absence of its interference some sectors would receive
more credit than socially and economically desirable while other sectors
would receive too little.
56 Yung Chul Park

Government intervention in the allocation of credit is often justified

when: (1) the financial markets are imperfect so that these markets cannot
allocate resources to the sectors with the highest private rates of return,
and (2) a market allocation of resources conflicts with government objec-
tives and therefore does not achieve the greatest social benefits as perceived
by the government. The latter case does not, however, necessarily call forth
government intervention in the allocation of credit. If, for instance, greater
output than a competitive market outcome is desired, a direct subsidy to
production is superior to government allocation of credit as a policy instru-
ment. But, on the grounds that a direct subsidy may be politically undesir-
able, government intervention in credit allocation instead of a subsidy may
be justifiable as a second-best solution.
To allocate financial resources in a manner that is perceived to be desir-
able on social and economic grounds, the government authorities first have
to control the interest rates on loans to keep them below a market-clearing
level. Low interest rates generate an excess demand for credit supplied by
the regulated financial institutions. The excess demand, in turn, requires
either the government or the management of the financial institutions to
ration the available supply of institutional credit to borrowers according to
a set of loan allocation criteria. Second, the government authorities will
have to exercise the credit-rationing power to effect a desired allocation of
resources. This exercise often necessitates government ownership (or con-
trol over the management) of banks and nonbank financial institutions.
Third, the government will have to institutionalize a system of credit ra-
tioning.

Pattern of Credit Allocation by the Government

If government intervention in credit allocation could be justified on eco-
nomic and social grounds in the context of the Korean economy, what are
the allocational criteria that have guided it? And how rational are they? In
any economy, government allocational criteria will be influenced by eco-
nomic and social objectives as well as by economic efficiency, and these
factors will change over time. Governments also attempt to achieve multi-
ple, often conflicting objectives. For these reasons, there are no simple stan-
dards for evaluating the rationality or optimality of government allocational
criteria.
Guidelines on allocation of credit are set forth in the Regulations Per-
taining to the Use of Funds in the Financial Sector. These regulations have
been amended since their passage in 1958, and their scope and emphasis
on the preferred industries and sectors modified from time to time by
government directives (W. Hong 1980:110-45). When a set of allocational
criteria is pieced together from the regulations, directives, annual financial
stabilization plans, and five-year development plans, it becomes clear that
economic efficiency has seldom been the major criterion in the allocation
 The Development of Financial Institutions 57

of credit. Instead, government credit allocation policy was dictated by, and
carried out to accommodate, the development strategies and investment
policies set forth in the four successive five-year development plans. Thus,
one sees that in the 1950s the thrust of government allocational policy was
directed to channeling more resources to support import-substitution ac-
tivities and for the production of daily necessities in order to stabilize the
economy and to ease the burden of the balance-of-payment deficits.
Since the launching of an export-led development strategy in the
mid-1960s, the basic allocational objective of the government was to sup-
port the development of export-oriented sectors in preference to the import-
substitution and nontradable goods sectors, in particular the manufactur-
ing sector. Throughout the 1960s and in the early 1970s (which encompasses
the first two five-year development plans and part of the third), there was
a clear emphasis on allocating more resources to labor-intensive, light
manufacturing industries. During subsequent years, the allocational objec-
tive was shifted to the promotion of heavy and chemical industries as la-
tent export sectors.
Financial needs will vary from industry to industry depending upon
differences in factor intensity, capital-output ratio, investment-gestation
period, and cash-flow requirements. For instance, agriculture will, in gen-
eral, need less financing per unit of output than will the manufacturing
industries. Given the possibility of credit fungibility—that is, the inability
to track the flow of credit to a specific use—there is no reason to believe
that credit rationing will necessarily influence real investment in different
sectors in the intended directions. For these reasons, one could argue that
information for previous periods on loan distribution primarily reflects
differences in industrial characteristics with regard to financial requirements,
rather than the consequences of government allocational policy. The ratio
of bank loans to nominal output presented in Table 3.1, however, shows
that the ratios of the manufacturing and social overhead sectors rose
markedly between 1955 and 1960. This evidence, considered in conjunc-
tion with the strict credit rationing exercised by the government, suggests
that a large portion of bank loans was, in fact, allocated according to a loan-
priority ranking consistent with the policy direction of the 1950s with its
emphasis on import substitution. It is difficult, however, to determine the
extent to which credit rationing contributed to the realization of the changes
in the industrial structure envisioned by the government.
During 1960-69, Korea's period of most rapid financial growth, the
manufacturing sector, which accounted for the bulk of exports and registered
the highest rate of growth, was accorded a growing share of bank loans.
More than 70 percent (on average) of private foreign borrowings was allo-
cated to the manufacturing sector during 1962-67 (Table 3.2; W. Hong
1980:168-69). Over the next five years, there was little change in this lop-
sided allocation.
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60 Yung Chul Park

Although self-sufficiency in grain (rice in particular) remained a major

policy objective, agriculture’s domestic loan share declined gradually from
35 percent in 1960 to about 12 percent at the end of 1969, reflecting the rela-
tive slowdown of growth in this sector. The social overhead sector remained
one of the priority sectors in the 1960s and received a large share of bank
loans relative to its output as it had in the 1950s, although less in terms
of loans per unit of output (Table 3.1). The government also allocated a large
share of its foreign borrowings to the social overhead sector during the pe-
riod (Table 3.3). In the 1960s the total loan share of services and other in-
dustries almost doubled compared with the figure in the 1950s, mostly at
the expense of agriculture (Table 3.4). This was not necessarily the result
of relaxation of credit rationing by the government, but was due to the fact
that more financial resources became available after the interest-rate reform.
Heavy industries in the manufacturing sector received a growing share
of bank credit in the 1970s (Table 3.4). This development reflected the change
in Korea's development strategy that promoted heavy and chemical indus-
tries for both import substitution and export production. Along with the
investment expansion in heavy and chemical industries, there was a notice-
able shift in the allocation of financial resources to them. As presented in
Table 3.4, their proportion of total bank loans rose from less than 20 per-
cent during 1970-74 to over 29 percent by 1980. Throughout the 1970s the
majority of foreign loans whose payments were guaranteed by domestic
banking institutions were channeled to the heavy and chemical industries.
From 1977 to 1980 this sector accounted for more than 80 percent of the
total foreign loans to manufacturing (Table 3.2; Table 3.3). Because a large
portion of these loans were rationed by government authorities, the changes
in the sectoral loan shares reflected the government's efforts to direct
resources to the targeted industries. The decline in agriculture’s loan share
continued into the 1970s. This trend can be explained by the relative decline
in the size of the agricultural sector together with the institution in 1969
of a price-support program in place of a credit-support program for
agriculture.

Conflict with Stability and Long-Term Growth

Although government control of finance is often denounced as the cause
of inefficient allocation of resources and as contributing to a high rate of
inflation and discouraging private savings, none of these negative effects
were visible in Korea during the 1960s. On the contrary, the performance
of the economy was spectacular during the 1965-69 period. The economy
grew by more than 10 percent per annum on average, while the average
annual rate of inflation was moderate at less than 9 percent. Indeed, govern-
ment intervention in the allocation of resources in favor of export-oriented
Nera and other strategic industries appears to have been an appropriate
policy.
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 The Development of Financial Institutions 63

During the Third Five-Year Development Plan (1972-76), however, the

negative effects associated with repressive financial policies began to sur-
face and could no longer be ignored, as they increasingly undermined the
government's ability to stabilize the economy and to mobilize domestic
resources (Shaw 1973).
First, financial growth, which had begun increasing rapidly in the mid-
dle of the 1960s, slowed considerably, barely keeping up with economic
growth. The slowdown was accompanied by an appreciable fall in the
domestic savings ratio, adding a still greater burden to savings mobiliza-
tion efforts and the nation’s resource management problems.
Second, the problems of maintaining the internal and external stability
of the economy were magnified and became more difficult to manage in
the course of pursuing the export-led growth strategy, yet continued finan-
cial control left the economic authorities with no effective anticyclical pol-
icy instruments at their disposal. As the export sector expanded rapidly
and accounted for an increasingly large share of output, domestic business
fluctuations were influenced and often led by changes in world market con-
ditions. Monetary policy loses much of its effectiveness as an anticyclical
weapon in a small open economy under a fixed exchange-rate system. This
would be the case even if the economy had a sophisticated financial sys-
tem; however, such a system did not exist in Korea during the 1970s and
adoption of a more flexible exchange-rate system was opposed because it
was viewed as destabilizing, among other reasons. Therefore, with mone-
tary and financial policies directed toward tiie growth objective, the authori-
ties had no effective short-run stabilization policy instruments and the
existing ones were largely inoperative.
Third, continued government domination of the financial system, from
the viewpoint of the proper role of finance, was in the long-run likely to
interfere with successful implementation of the outward-looking strategy.
Repressive monetary and financial policies resulted in an increasingly rigid
financial system and artificially segmented financial markets. Financial in-
stitutions grew large in number and variety, but had no incentives to im-
prove or expand their role as intermediaries and became unresponsive to
changing financial conditions and the needs of the economy. These insti-
tutions were cut off from the international financial community and, in their
isolation, perpetuated financial practices that were outdated and suitable
only to a closed economy. In contrast, private firms, in particular those that
were export-oriented, aggressively penetrated world markets where they
established a firm foothold and succeeded in enlarging their market share.
The private firms upgraded their production processes and management
practices to international standards and accumulated considerable market-
ing expertise.
Isolated from the international financial centers, however, domestic finan-
cial institutions were unable to provide adequate and efficient international
64 Yung Chul Park

financial services to these world-market-oriented firms. Nor were they ef-

fective or active in channeling much needed foreign credit with favorable
terms and conditions to these firms. This discrepancy between the real sec-
tor, which was rapidly opening up, and the closed financial sector was ul-
timately detrimental to the overall growth of the economy.
Finally, it became apparent that government control of finance was one
of the major causes of the concentration of economic power and the wors-
ening inequality in income distribution. According to SaKong (1980:2-13),
preferential credit allocation that favored large and established borrowers
with a subsidized rate was the major cause of the growth of business con-
glomerates during the 1970s in Korea.
Faced with these disturbing problems arising largely from continuing
financial repression, many economists in Korea and abroad began to advo-
cate a fundamental change in monetary and financial policies aimed toward
gradually building a more liberalized financial system. That financial liber-
alization should be the ultimate goal of the authorities was generally ac-
cepted. Like any other economic policy, however, liberalization was not
without problems. These problems produced strong opposition, in partic-
ular from policymakers and the business community. Financial liberaliza-
tion was opposed because: (1) it could result in a very high and unstable
interest-rate structure that would produce a cost-push effect on inflation
and put an enormous burden on a large number of highly leveraged firms;
(2) it was in conflict with what some economic authorities saw as the proper
role of the government in a mixed economy; and most important, (3) liber-
alization would not allow for the successful implementation of the new in-
dustrial development strategy that emphasized the development of skill-
and technology-intensive heavy and chemical industries.
The first problem was the least important. Liberalization would certainly
result in high interest rates, but there was no evidence it would bring about
an unstable interest-rate structure or accelerate inflation.
The second problem was related to the paradox that the Korean econ-
omy depended in a large measure on private enterprises operating under
highly centralized government guidance, and it was therefore in part a po-
litical issue. With the rapid growth of the external sector, the sphere of
government influence and scope of government control over the conduct
of economic affairs had diminished. Export-oriented growth strategy, to be
successful, also required gradual relaxation of import-control and foreign-
exchange regulations. The economic authorities were aware of the need for
such external liberalization and took steps to institute the required policy
changes. At the same time, however, the government felt the need for (and
attempted to obtain) a tighter grip on the economy for political, social, and
to some extent economic reasons. The problem was not so much the govern-
ment's direct involvement but rather the means by which it attempted to
influence the economy, namely, through direct control over the financial
 The Development of Financial Institutions 65

system. This would certainly necessitate and perpetuate financial repression.

The third problem did indeed pose a serious dilemma. As early as the
preparation stage of the Third Five-Year Development Plan, it became ap-
parent that the high-growth objective could not be achieved by following
the same industrial development strategy pursued during the first and sec-
ond plans. The third plan thus called for major shifts in production and
export through the expansion of heavy and chemical industries. This shift
in strategy, which signaled the entering of the secondary import substitu-
tion and export promotion stage of development, was made public in late
1972 and was fully reflected in the Fourth Five-Year Plan (1977-81).
Although the new strategy was viable and perhaps the only alternative
consistent with the high-growth objective, it also presented a number of
formidable problems. One of these problems was that the strategy would
require the intensification, rather than relaxation, of government interven-
tion in the financial system. The strategy required that enormous foreign
as well as domestic resources be invested in industries with relatively high
capital-output ratios, long investment-gestation periods, and uncertain rates
of return on capital. Its success was dependent on unpredictable foreign
demand at a time when trade protectionism was increasing and the
prospects for any substantial increase in domestic savings were not favor-
able. It was, of course, theoretically possible to overcome the shortage of
domestic savings by foreign borrowings over and above what was neces-
sary to meet the need for foreign exchange. But Korea's external require-
ments were already large enough to preclude this as a viable option for
any extended period of time.

Fungibility and the Effectiveness of Government Intervention

The ultimate objective of government controls over credit allocation is to
bring about an allocation of physical resources that furthers the govern-
ment’s overall objectives for the country, even if the allocation is not the
most efficient use of resources. To what extent has the Korean government
since 1961 succeeded in attaining this objective? This is a difficult question
to answer, even at a theoretical level, and one that requires reliable microdata
for an empirical examination.
There is little or no reliable data on Korea that could be used to inves-
tigate the causal relationship between credit allocation and physical resource
allocation. The task is further complicated by the unanswered question on
the causality between finance and economic development. The key to the
answer lies in the fungibility of credit. If credit fungibility is of a high degree,
the government cannot expect to be successful in effecting what it considers
to be an optimal allocation of physical resources.
It is often alleged that when the financial markets are imperfect and the
financial sector is in an infant industry stage, government intervention may
be warranted and effective. The effectiveness stems from the fact that finan-
66 Yung Chul Park

cial market imperfections reduce credit fungibility. That is, when financial
markets are fragmented among regions and different classes and groups
of borrowers, funds do not flow freely from one separated and artificially
segmented market to another. In such a financial regime, government in-
tervention has a better chance of success in channeling bank credit to the
ultimate use of physical resources.
Financial market fragmentation exists in Korea perhaps because the finan-
cial markets have not had enough time to develop into a unified national
market. The financial markets are, however, segmented largely because of
government controls over the interest rates and management of the finan-
cial institutions. Therefore, the fragmentation may be viewed as a result
of a deliberate effort on the part of the government to facilitate its directed
credit allocation. The growth of the unregulated money market could, in
part, be attributed to the financial market fragmentation engineered by the
government. One of the major functions of the unregulated money market
has been to facilitate the flow of funds among markets that are geographi-
cally separated and artificially segmented by interest rates, sectors, and bor-
rowers. The existence of the huge unregulated money market, therefore,
suggests a strong possibility of credit fungibility in Korea, which would in
turn reduce the effectiveness of government intervention in resource allo-
cation.
The fungibility issue could be examined at the two stages of the credit
allocation process. At the first stage, which is related to the lending behavior
of the financial institutions, it is quite possible that the financial intermedi-
aries may simply evade or ignore the credit guidelines and directives and,
therefore, may themselves be guilty of credit diversion. This problem does
not appear to have been serious in Korea because of the government's close
supervision of the day-to-day operations of the deposit-money banks and
other financial intermediaries. It is widely suspected, however, that the
financial institutions have consistently evaded government guidelines for
the allocation of credit to medium- and small-scale enterprises. For a pe-
riod of time during the latter part of the 1970s, the deposit-money banks
were required to make available a minimum of 30 percent of their total loans
to small- and medium-scale industries. No one believed that the actual al-
location of these institutions was anywhere close to the guideline quota.
Because of the ambiguities in the definition of small and medium enter-
prises, the banks were easily able to meet the quota without necessarily
lending the required amount to small-scale businesses. Given their tradi-
tional aversion to small borrowers, the banks may have taken advantage
of the vagueness in the regulations and thereby facilitated credit diversion.
At the second stage of credit allocation, which is related to the behavior
of borrowers, it is quite conceivable that a large part of bank credit was
diverted to uses other than those predesignated by the government. This
diversion would be possible because the deposit-money banks and the KDB
 The Development of Financial Institutions 67

do not have an effective system of credit-use supervision. Even if they did

have an effective system, the management of these financial institutions
would not be much concerned about (and hence would not actively super-
vise) the actual use of bank credits, because the management is not respon-
sible for the provision of directed and policy loans. The lack of autonomy
in bank management may thus have aggravated credit diversion.
The fact that business firms invest heavily in real assets is evidence of
credit fungibilty. A special measure, issued in September 1980, required
1,217 large firms to report their holdings of land and buildings, classified
into those used for business operations and others presumably held for
real asset speculation. The responses showed that business groups and cor-
porations held a large share of their total assets in the form of real assets
such as land and buildings. According to the government, the holdings of
these assets were far greater than the level normally required for the firms’
business operations. The presumptions are that businesses invest in real
assets as a hedge against inflation and as a source of collateral for bank
loans and that the majority of their holdings were financed by bank loans
in the first place. One large business group, formerly a ranking exporter,
was so heavily involved in real estate speculation with export loans that
it went bankrupt in 1978 when its export earnings fell sharply and the real
estate boom cooled off. Undoubtedly, there have been numerous similar
cases involving smaller businesses.
As noted before, a more important reason to suspect a considerable
degree of credit fungibility was the existence of and the important role
played by the unregulated money market, particularly prior to the curb-
market freeze measure of 3 August 1972. These unregulated markets acted
as a short-term money market for large business borrowers and as a retail
credit market for consumers and small businesses. In so doing, they pro-
vided a linkage among the segmented markets and hence a channel for
diverting government-controlled credit from the intended uses. As shown
in Cole and Park (1983:119-20), large businesses often borrowed their work-
ing capital from and lent their idle funds through the unregulated money
market. In doing so, the large businesses assumed the role of financial in-
termediaries, in addition to their normal business activities. They did so
largely because there was no active short-term money market, and the
government-dominated financial institutions could not provide adequate
short-term credit facilities.
Financial requirements for investment and production activities and
seasonality in the demand for loans will vary according to the industry and
will change over time. The major requirement of some sectors is long-term
external financing, whereas others need short-term loans. The processing
of a bank loan, with the exception of overdrafts, takes a long time from
application to an actual loan disbursement. No matter how sophisticated
and detailed a credit-guideline system the government devises, it cannot
68 Yung Chul Park

expect to account for all the factors that determine the sectoral demand for
loans in formulating its control system. Indeed, if the credit-allocation guide-
lines and directives were enforced to the letter, the financial system would
be paralyzed. The unregulated money markets have complemented an
otherwise extremely rigid financial system and thereby facilitated smooth
flows of funds between the different markets in Korea.
Inflationary Implication
Monetary accommodation—that is, easy credit to export industries result-
ing in a rapid expansion of the money supply—was a logical consequence
of the government's use of the financial system and policy as a means of
intervening in the allocation of resources. As a result, the scope of mone-
tary policy as an instrument of anti-inflationary policy was severely re-
stricted. The majority of subsidies to preferred industries had been financed
by borrowings from the central bank, and these borrowings were immune
to stabilization policy. In addition, a large fraction of bank credit had been
earmarked in the form of “policy” or “directed” loans for strategic indus-
tries and uses. These loans thus escaped from monetary tightening.
Government control over financial institutions also complicated the ef-
fective management of monetary policy. With government control, deposit-
money banks, which dominate Korea's financial system, have been no more
than a banking bureau of the government. Their main role was to allocate
deposits and new credit supplied by the central bank to the sectors and
industries and often to individual borrowers designated by the government.
Under these circumstances the portion of lendable resources the banks
could allocate under their own discretion was greatly limited. In recent years
more than 50 percent of the deposit-money banks total loans could be
classified as “directed” policy loans whose volume and allocation were de-
termined by the government itself, often independently of monetary stabili-
zation. To the extent that the government attempts to mobilize domestic
resources by means of excessive credit creation and inflation, it becomes
logical and perhaps unavoidable to allow continuous rollovers of short-term
loans and the accumulation of overdue loans when the deposit-money
banks are confronted with a huge chronic excess demand for loans.
The large share of “directed” loans and the practice of rollovers have made
deposit-money banks’ portfolios extremely illiquid. This illiquidity has made
it difficult for the banks to adjust their asset portfolios in response to changes
in financial market conditions or monetary policy. Thus, credit tightening
has elicited little response from the banks in the short run and has become
ineffective as an anti-inflationary measure.
EFFECTS OF THE POLICY MEASURES
Before discussing the effects of the financial policies during 1961-80, we
need first to address the issue of credit fungibility. If the degree of credit
 The Development of Financial Institutions 69

fungibility were high, the pattern of real-resource allocation would not cor-
respond to the pattern of credit allocation planned by the government. In
the extreme case of perfect fungibility, the government would find itself
incapable of influencing real-resource allocation with its control of credit
allocation. Clearly, then, if the government's development strategy relying
on credit allocation were to succeed, the degree of credit fungibility would
have to be tolerably low.
What was the degree of credit fungibility in the two decades after the
military takeover of the government in 1961? Our attempt at empirical esti-
mation has led to a tentative finding that anywhere from 50 to 70 percent
of each dollar of government funds allocated to a particular sector was di-
verted to other sectors. Although this seems to be a high degree of “slip-
page,” it cannot be denied that in the case of Korea the government did
have some influence on real-resource allocation through its control over
credit.
Even though there is no firm evidence to support the hypothesis, it seems
reasonable to argue that the degree of credit fungibility has increased over
time in Korea. In the early 1960s it was probably low because the economy
was simple, the financial market segmented and underdeveloped, and the
number of enterprises receiving preferential credit small. In such a situa-
tion, the recipients of credit would have found few alternative ventures to
divert funds to and also might have felt that they were under close scru-
tiny by the government.
With rapid economic growth, the degree of credit fungibility probably
increased. There were now more enterprises and more alternative ventures
to which funds could be diverted. To an individual recipient, the expected
rate of return from diverting funds from their designated use may have in-
creased, whereas the expected cost from being caught and penalized may
have decreased. The increasing degree of credit fungibility must then have
reduced the government's ability to control real-resource allocation via credit
control.
A more fundamental issue relating to the use of financial policies as an
instrument for economic development is the question of whether or not
the real-resource allocation engineered through credit allocation has pro-
moted Korea's economic development. This is not an easy question to an-
swer and is part of the controversy over the use of industrial policy as an
instrument for promoting economic development or a high rate of economic
growth. Chalmers Johnson (1982), for instance, has argued in his MITT and
the Japanese Miracle that the industrial policy of the Ministry of International
Trade and Industry (MITI) had been critically instrumental in the rapid eco-
nomic growth of postwar Japan. Despite his persuasive argument, sup-
ported with well-documented research, the question of the role of MITI
has yet to be answered to the satisfaction of many economists.
If the positive effects of the financial policies on economic development
70 Yung Chul Park

are in dispute, there seems to be no disagreement on their negative effects.

As noted earlier, monetary accommodation and the control over financial
institutions: had reduced the scope and effectiveness of monetary policy
as an anti-inflation instrument. Lacking monetary policy as a stabilization
policy, the government had to rely on price controls and incomes policy.
The distortionary effect on resource allocation resulting from these meas-
ures must, therefore, be ultimately traced back to the financial policies that
rendered monetary policy ineffective as a stabilization policy.
Another negative effect is the socially and politically undesirable con-
centration of economic power and the resulting inequities in income dis-
tribution. As SaKong (1980) has shown, the preferential credit allocation
favoring large and established borrowers contributed to the growth of
business conglomerates during the 1970s. Even if these firms had the ad-
vantage of large-scale economies, there was no compelling reason for sub-
sidizing their growth.
In the final analysis, if there is one lasting effect of the financial policies
of 1961-80 that has been beneficial to Korea’s economic development, it may
be the growth and development of a variety of financial institutions. Their
growth, which was initiated by the government, has gradually increased
their role as true financial intermediaries, has reduced the scope of govern-
ment intervention in the financial market, and thus has brought about its
gradual liberalization.

CRITICISM AND LESSONS

In the early 1960s Korea's financial sector was dominated by a few nation-
wide commercial banks mostly supplying short-term working capital to large
businesses. The securities market was moribund, and the financial needs
of medium- and small-size firms and consumers were served by unregu-
lated money markets or curb markets, which were fragmented and scat-
tered throughout the country. Under these circumstances, the government
probably had no alternative to controlling the financial institutions for
mobilizing domestic savings and for guiding the resources in the desired
directions.
Beginning in the early 1970s, the government moved toward diversify-
ing financial assets and institutions. With the promulgation of the August
3rd (1972) measures, the government established several nonbank finan-
cial intermediaries and subsequently encouraged new types to come into
the financial system to compete with commercial banks. The government
was determined to develop a modern capital market, and this determina-
tion led to a series of measures that culminated in a partial opening of the
market to foreign investors.
The growth of the nonbank financial intermediaries and the expansion
of the securities market brought about a noticeable change in the role of
the government in the allocation of the economy’s investable resources. Be-
 The Development of Financial Institutions 71

cause the government did not, or could not, intervene in the asset manage-
ment of nonbank intermediaries and dictate the allocation of funds through
the capital market, the share of domestic financial resources controllable
by the government declined. More important, this development coincided
with the realization of the need for gradual financial liberalization in the
mid-1970s.
The government was indeed prepared to loosen its tight grip on finan-
cial institutions and conduct a more flexible interest-rate policy after the
1970-71 recession. These liberalization efforts were thwarted, however, by
the first oil crisis and, more important, by the shift in development strat-
egy toward the promotion of heavy and chemical industries. Given the high
rate of inflation triggered by the first oil crisis and the subsequent invest-
ment and export boom, the government found it extremely difficult to pur-
sue a flexible interest-rate policy. Also, given the enormous amount of
resources required for the development of heavy and chemical industries,
the government did not expect that the necessary funding could be raised
in the private market without government intervention. The government
decided it could not relinquish control of, or make any major changes in
the financial system, though it was certainly in need of a serious reform.
For a number of reasons that include the second oil price increase in
1979 and the worldwide recession that followed, the promotion of heavy
and chemical industries as the future export sector was far from success-
ful. The promotion effort resulted in a considerable drain on the econo-
my’s investment resources, a slowdown in growth with rampant inflation,
and a growing current-account deficit beginning in 1979. The worsening
economic situation was further aggravated by the assassination of Presi-
dent Park in October 1979, followed by a renewed debate on the needs for
greater reliance on price mechanisms and the private sector for the manage-
ment of the economy. As a first step toward laying the foundation for a
market- and private-sector oriented economy, many within and outside
Korea began to advocate financial liberalization. Some people believed that
the repressive financial system was primarily responsible for the massive
investment in heavy and chemical industries.
The new government that came into power was strongly committed to
a free-market economy and financial liberalization measures, including the
transfer of the government-owned shares of four nationwide commercial
banks to private owners. However, the government authorities have yet to
show any indication of floating interest rates, which is the crucial prerequi-
site for liberalization. Although the five nationwide commercial banks are
now fully owned by private shareholders, the government continues to ap-
point all the senior bank officials and to interfere with their asset manage-
ment in the form of “relief financing” set up to bail out troubled firms.
Despite the strong commitment and numerous liberalization measures, one
cannot but feel that it is business as usual as far as Korea's finance is con-
cerned.
72 Yung Chul Park

Can we say, with the benefit of hindsight, that events warranted the in-
terruption of the process of financial liberalization? If the survival of the
established firms was at stake, why couldn't the government subsidize them
directly? Also, if the government thought it necessary to promote heavy
and chemical industries, why didn’t it make direct subsidies to the produc-
tion of output of these industries? Direct subsidies would have accomplished
the same objectives, but without distorting relative prices as did credit
control.
Some might argue that Korea's limited fiscal capacity would have made
tax-cum-subsidy measures impracticable, if not impossible. Given the suc-
cess in building financial institutions, it is, however, difficult to believe that
the government would not have succeeded in building an effective fiscal
system if it had tried to do so.
The answer to the questions above may lie in the characteristics inher-
ent in the economic system. In a mixed economic system where the role
of government is more direct than that of setting broad rules and policies,
the government regards it as imperative to take quick administrative action
in response to a disturbance to the system. To the government, then, credit
control is an important policy instrument that is relatively easy to use ad-
ministratively and highly visible in terms of its apparent effectiveness. In
other words, credit control is a policy instrument that the government can
ill afford to give up unless it is intent on changing the basic features of the
system.
A fundamental reform that is needed, therefore, is a move toward an
economic system where the role of government is less direct and is largely
confined to setting broad rules and policies. To a government committed
to carrying out such a reform, financial liberalization should be only one
in a series of policy changes that need to be carried out to achieve its long-
term objectives.
 4 Price Control and Stabilization
Measures

by Yung Chul Park

Growth and stability have been the two most important economic policy
objectives in Korea since 1961. The nearly 9 percent annual economic growth
rate that Korea experienced during 1961-80 was remarkable by international
standards; the same could hardly be said about the stability record. The
rate of inflation, as measured by the wholesale price index (WPI), was more
than 16 percent per year on average for the same period—almost three times
as high as the inflation rates of Korea’s major trading partners (the United
States and Japan)—and ranged from a low of 64 percent to a high of 42
percent. Calculated using the GNP deflator, the rate of inflation was higher
still, at 18 percent per year on average for the 1961-80 period (Table 4.1).
The high rate of inflation, coupled with an overvalued exchange rate, was
largely responsible for the persistent balance-of-payments problem. Despite
the rapid growth of exports, Korea consistently recorded a deficit in its cur-
rent account throughout the period (except for 1965 and 1977). The deficit
fluctuated between 1 and 11 percent of GNP.
To facilitate a better understanding of the environment in which the poli-
cies were designed and implemented, it will be instructive to first review
the history and analyze the causes of inflation in Korea since 1961.
INFLATIONARY TRENDS IN KOREA
There were periods of relatively moderate annual rates of inflation (less than
10 percent) in the latter part of both the 1950s and the 1960s, alternating
with periods of relatively high rates in the early 1960s and throughout the
1970s. For the purpose of this study, it is convenient to divide the period
1961-80 into three subperiods: (1) resurgence of inflation during 1961-64
(after a period of relative price stability in the latter part of the 1950s), which
resulted from numerous government measures to stimulate economic
growth and was exacerbated by poor agricultural harvests; (2) rapid growth
and relative internal and external stability from 1965 to 1973; and (3) the
period of 1974-80 during which abrupt swings in the external sector buf-
feted a more open economy, and attempts at maintaining high rates of
growth resulted in high rates of inflation and external imbalances as part
of the adjustment process.

73
74 Yung Chul Park

Table 4.1. Price indexes: 1961-80

Wholesale price index GNP deflator

Index Change Index Change
Year (1975=100) (%) (1975=100) (%)
1961 14.8 13.8 9.8 14.0
1962 16.1 8.8 11.6 18.4
1963 19.4 20.5 15.0 29.3
1964 26.2 30, 1 1955 30.0
1965 28.8 9:9 20.7 6.2
1966 31.4 9.0 23.7 14.5
1967 33.4 6.4 27.4 15.6
1968 36.2 8.4 31.8 16.1
1969 38.5 6.4 36.5 14.8
1970 42.0 951 42.2 15.6
1974 45.7 8.8 47.3 19
1972 B20) 13.8 54.7 15.6
1973 55.6 6.9 61.9 134
1974 79.0 42.1 80.2 30.0
1975 100.0 26.6 100.0 24.7
1976 12258 124 117.7 17.7,
1977 122.2 9.0 136.9 16.3
1978 136.5 T7, 165.1 20.6
1979 162.1 18.8 197.0 193
1980 220.2 38.9 247.9 25.8
Sources: BOK, National Income (1982); BOK, Economic Statistics Yearbook (1965, 1970, 1980, 1982);
EPB, ROK, Major Statistics (1982).

Development Financing and Inflation, 1961-64

One of the main reasons given by the military leaders for their coup d'etat
in May 1961 was the economic stagnation under the previous two regimes.
It was, therefore, not surprising that the military government initiated a
series of measures to stimulate economic growth. Finding meager tax
revenues and declining foreign aid, the government had to run substantial
budgetary deficits to carry out the stimulative measures. The deficits, which
were financed by printing money, led to a rapid expansion of domestic li-
quidity. After a negative rate of expansion in 1960, the supply of money
had grown by almost 58 percent by the end of 1961 (Table 4.2).
Concerned about the rapid liquidity expansion and believing that money-
lenders and businessmen were hoarding their wealth in currency and
deposits, the government undertook a currency reform in June 1962. The
reform succeeded in slowing down the rate of growth of money to below
10 percent per year for the next two years, but failed to channel hoarded
wealth into productive investment. Instead, its more pervasive effect was
 Price Control and Stabilization Measures 75

Table 4.2. Money supply and reserve base: 1961-80

Money (M;) Total money (M,) Total reserve base
Amount Change Amount Change Amount Change
Year (10? won) = (%) (10? won) (%) (10? won) = (%)
1961 35.8 otfy 41.3 60.7 25.4 S172
1962 39.4 10.1 5L6 24.9 29.8 17.3
1963 41.9 6.3 55.4 7.4 279 -6.4
1964 48.5 16.7 63.6 14.8 O2t7 V7e2
1965 65.6 34.2 OF Ail ae RehLy/ 48.4 48.0
1966 85.1 297, 170% ="Gie7. 80.2 65.7
1967 123.0 44.5 25:0 --6197, 110.9 38.3
1968 177.9 44.6 436.6 72.0 156.2 40.8
1969 252.0 41.7 704.6 61.4 216.0 38.3
1970 307.6 221 897.8 27.4 299%7 38.8
1971 358.0 16.4 1,084.9 20.8 288.2 -3.8
1972 519.4 45.1 1,451.8 33.8 427.5 48.3
1973 730.3 40.6 1,980.5 36.4 624.1 46.0
1974 945.7 295 2,456.5 24.0 775.0 24.2
1975 11817 25.0 Sf150 0082282 1,077.0 39.0
1976 1,544.0 30.7 4,204.8 33.5 1,437.7 33.5
1977 2,172°6 40.7 57874,5° = VOIl7 2,071.6 44.1
1978 2,713.8 24.9 7,928:7°° 2 35,0 2,802.0 35.3
1979 3,274.5 20.7 9,877.8 24.6 3,468.0 23.8
1980 3,807.0 16.3 12,534.55 22619 3,243.9 -6.5

Source: BOK, Economic Statistics Yearbook (1982).

Note: Total reserve base = currency issued + bankers’ deposits.

to undermine confidence in financial institutions and assets, thus encourag-

ing the holding of real assets and expansion of unregulated money-market
transactions.
The 1962 financial debacle was aggravated by a rice crop failure in the
same year and by a severe decline in the barley harvest the following spring.
The liquidity expansion in 1962, caused by the currency reform and a poor
grain harvest, built up strong inflationary pressures in the economy.
In 1964 the government devalued the won by almost 100 percent.
Although that measure helped to improve Korea's export competitiveness,
it had a devastating effect on prices. A sharp decline in imports, along with
higher import prices, set off the a surge of inflation of over 35 percent in 1964.
The estimated effect of currency devaluation on prices in Korea varies
from study to study. The simulation results of S. W. Nam (1981) and the
Bank of Korea quarterly economic model (unpublished) show that a 1 per-
cent devaluation in the won exchange rate to the U.S. dollar would raise
domestic prices (WPI) by 0.3 to 0.4 percent in one year.
76 Yung Chul Park

Rapid Growth and Relative Price Stability, 1965-73

The years between 1965 and 1973 were a period of outstanding performance
for the Korean economy. Output grew at an average annual rate of 10 per-
cent and price increases were relatively modest at an average of about 8
percent as measured by the WPI (15 percent on the GNP deflator). The
current account was in deficit throughout the period, but the continuous
expansion of exports and large inflows of foreign capital, induced by the
monetary reform in 1965, helped to reduce anxiety over the growing current-
account deficits. The deficit remained at a level of over 8 percent of GNP
between 1968 and 1971 before falling to about 3 percent in 1972 and 1973.
The stimulus for industrial growth came mainly from the export sector and
the government's successful campaign to promote exports.
The period of 1965-73 was a kind of “golden age” in Korea’s economy,
characterized by relative price stability and high growth. What factors and
developments could explain the exceptional performance? On the demand
side, export expansion was undoubtedly the engine of growth. Exports,
consisting mostly of labor-intensive manufactures, increased annually at
a rate of 37 percent in real terms during the period, thereby increasing the
exports-to-GNP ratio to 30 percent in 1973, compared with less than 6 per-
cent in the early 1960s. The increase in fixed-capital formation was equally
impressive. Between 1965 and 1973, fixed investments in real terms increased
sevenfold. As a result the proportion of investment in GNP more than dou-
bled, from 11 percent in 1964 to 24 percent in 1973. Largely because of an
overall balance surplus caused by large capital inflows, the supply of money
(M,) expanded by 35.4 percent and M, (M, plus saving deposits with com-
mercial banks) increased by 41.7 percent a year on average from 1965 to
1973 (Table 4.2).
These developments in aggregate expenditures and domestic liquidity
would normally generate strong inflationary pressures. There were,
however, other favorable developments on the demand side that moder-
ated price increases. The financial reform in 1965 raised the interest-rate
ceiling on bank time deposits from 15 percent to 30 percent per year. This
readjustment increased the real interest rate (the nominal interest rate ad-
justed for inflation) to a positive 19 percent in 1966, from a negative 15 per-
cent in 1964, and maintained the rates at a level of 12 to 22 percent for the
following four years (Table 4.3). The sharp increase in interest rates induced
savers to substitute financial assets for real assets such as real estate, house-
hold durables, and inventory. These portfolio substitutions dampened in-
creases in land and housing prices and subsequently lowered housing rents.
The interest-rate readjustment also encouraged households to save more.
As a percentage of GNP, domestic savings more than tripled between 1965
and 1973 (Table 4.4). More important, the large interest-rate differential be-
tween the domestic and foreign capital markets, together with the govern-
ment repayment guarantee (which eliminated any risk of default and
 Price Control and Stabilization Measures Wh

Table 4.3. Interest rates: 1961-80

Nominal
interest Curb
pasepee Real interest rates ee Seoul land values
deposits (A)? (B)> rate Index Change
Year (%) (%) (%) (%) (1963=100) (%)
1961 225 -1.1 -1.3 u u u
1962 15.0 D7 -2.9 u u u
1963 15.0 -4.6 -11.1 52.4 100 u
1964 15.0 -14.9 -11.5 61.4 168 68.0
1965 18.8 8.1 11.9 58.8 225 33.9
1966 30.0 19.3 S25 58.7 u u
1967 30.0 2252 125 56.4 495 u
1968 27.6 WAZA 9.9 55.9 755 52.5
1969 24.0 16.6 8.0 Sil.” 1,390 84.1
1970 22.8 12.6 6.2 50.8 1,445 4.0
1971 2222. 1293 9.0 46.3 1,860 28.7
1972 557 th/ 0.1 38.9 1,966 bey,
1973 12.6 Be. 0.5 39.2 1,997 1.6
1974 14.8 -19.2 -11.4 37.6 2,610 30.7
1975 15.0 -9.2 -7.8 41-3 3,315 27.0
1976 1535 320) -1.9 40.5 4,196 26.6
1977 16.2 6.6 -0.1 38.1 5,606 33.6
1978 16.7 4.5 -3.2 41.7 8,354 49.0
1979 18.6 Oo -0.6 42.4 9,740 16.6
1980 22.4 -11.9 -2.7 45.0 10,879 alls
Sources: BOK, Economic Statistics Yearbook (1965, 1970, 1975, 1982); Mills and Song (1979); un-
published data obtained from the Ministry of Construction, ROK.
u—data unavailable.
WPI;_4
a. (1 + col. L cprtaneh

GNP deflator;_1
bin (dL ja
tees) GNP deflator;

exchange-rate depreciation on foreign loans), caused a massive inflow of

foreign capital in the form of trade credits, cash loans, and direct invest-
ment, thereby enlarging Korea's capacity of importing much-needed capi-
tal goods and raw materials.
On the supply side, the high interest rates raised the cost of production.
This cost-push effect was partially offset, however, by other developments.
The unit labor cost (nominal wages adjusted for labor productivity) rose
by less than 4 percent on average per year, though it displayed considera-
ble year-to-year fluctuations (Table 4.5). Import prices of food grains,
78 Yung Chul Park
aa gh a a
Table 4.4. Savings, investment, and balance of payments as percentages of
GNP: 1961-80 (current prices)
ee ee

Year ‘National savings Gross fixed investment Current account

Ventas Wana rete 810 eRe eeeneaie teem TA a Ee
1961 2.8 LY 1.4
1962 3.3 7 -2.0
1963 8.7 335 -3.7
1964 8.7 eS -0.7
1965 7.4 14.8 OFS
1966 11.8 20.2 -2.7
1967 11.4 21.4 -4.1
1968 Syl 25.0 -7.4
1969 18.8 25.8 -7.3
1970 17.3 24.4 -7.2
1971 15.4 2225 -8.9
1972 UB ei 20.6 -3.6
1973 Pee ys: 24.0 -2.4
1974 20.5 25-5 -11.2
1975 18.6 26.0 -9.3
1976 23.1 23.8 -1.1
1977 25.1 26.0 0.0
1978 26.4 30.6 -2.3
1979 26.6 S2E5 -6.9
1980 19.9 Byae7/ -9.4

Source: BOK, National Income (1982).

energy, and other raw materials remained virtually unchanged between 1966
and 1969, though thereafter they climbed sharply.
Despite these favorable demand and supply developments, the mone-
tary authorities were concerned about the rapid growth of money supply
and domestic credit and took measures to restrain liquidity growth. Reserve
requirements were raised to unprecedented levels—a marginal rate of 50
percent on demand deposits from October 1966 through March 1967—but
the credit expansion continued unabated. That it was possible to have such
a rapid expansion of credit without causing inflation could be attributed
in part to the lagged effect of monetary growth. But it was mostly the result
of the matching growth in the demand for bank time deposits with the sub-
stantial increase in savings.
After five years of uninterrupted high growth it looked as though the
economy was finally cooling off in 1970. Export growth declined from its
previous high levels largely owing to the economic slowdown affecting
Korea's major trading partners and rising trade protectionism. The rate of
growth of exports fell for three consecutive years beginning in 1969. This
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80 Yung Chul Park

slowdown was accompanied by an appreciable drop in investment demand.

Tight monetary policy pursued over the preceding three years (1967-69)
began to pay off. Together with a fall in export demand, which automati-
cally reduced domestic credit expansion, the tightening managed to reduce
the rate of expansion of M, from more than 40 percent in 1969 to 22 per-
cent in 1970 and to 16 percent in 1971. That curtailment in domestic liquid-
ity might have accounted in part for the sluggishness in investment demand.
In 1970 the economy registered a relatively low rate of growth (7.3 percent),
but the sharp deceleration was caused mainly by a poor rice harvest. The
economic slowdown in manufacturing activities did not begin until the first
quarter of 1971 and lasted less than a year. In retrospect, the downturn did
not call for any expansionary measures, given the accelerating consumer-
price increases. This was not, however, the course the policymakers took.
To revive export demand the government devalued the currency by 17
percent in June 1971. The devaluation raised the prices of imported goods
and (with a lag) domestically produced goods. More important, it caused
a corresponding increase in the cost of servicing foreign loans, which had
grown dramatically since 1963. In the scramble for funds to meet foreign
obligations, businesses had three major potential sources: domestic banks,
foreign lenders, and the unregulated financial markets. The tight mone-
tary policy markedly reduced the availability of bank credit. Foreign loan
guarantees by government-owned banks went up sharply in 1971, but about
half of the increase was a reflection of the devaluation. In 1972 the loan
guarantees actually declined, and businesses were forced to turn to the un-
regulated money-market lenders.
After considering various measures to relieve the financial pressure on
business, the government implemented the Presidential Decree for Eco-
nomic Stability and Growth on 3 August 1972. The decree reduced official
interest rates to the pre-1965 reform levels; more important, all the curb-
market, high-interest, short-term loans were converted into low-interest,
long-term loans with a grace period of several years. These measures relieved
the financial burden of firms with large foreign borrowings, but they also
resulted in a substantial expansion of M,. The rate of increase of M, jumped
to 45 percent in 1972, then declined to 40 percent in 1973. As a result of
the reduction in interest rates, real interest rates (adjusted in terms of the
GNP deflator) fell to 0.1 in 1972 and rose to 0.7 percent in 1973.
The slowdown and financial distress of 1972 were moderated by the ex-
port and investment boom of 1973. Korea's devaluation, followed by Japan’s
appreciation of the yen in late 1972, resulted in a doubling of Korea's total
exports. The spectacular growth of exports, the liquidity expansion by more
than 40 percent for two years in row, and negative real interest rates all con-
tributed to a large excess demand for goods and services. That excess de-
mand, ignited by the oil price increase of late 1973, erupted into violent
inflation.
 Price Control and Stabilization Measures 81

Oil Crisis and Suppressed Inflation, 1974-80

The oil price increases of late 1973 dealt a severe blow to the Korean econ-
omy. The crisis suddenly dampened Korea's growth prospects and, together
with the excessive credit expansion of the previous two years, provoked
a steep increase in the rate of inflation for the next several years. Because
Korea was (and still is) heavily dependent on imported oil, the oil price
increases caused more than a 20 percent deterioration in Korea’s terms of
trade during the 1976-79 period (Table 4.6); and the subsequent world reces-
sion led to a sharp drop in world demand for Korea's exports.
Korea's response to the oil crisis was to impose heavy taxes on oil products
to minimize their use, and to borrow heavily abroad to finance the imports
needed to sustain production and investment. These measures were
designed to mitigate the worst effects of the price increases and to main-
tain overall growth. Little effort was made, however, to hold down domes-
tic price increases. Assuming that Korea's competitors (Taiwan, Hong Kong,
and Singapore) would equally suffer the harshness of the oil crisis, the
policymakers opted to fully accommodate the price increases. Bank credit

Table 4.6. Terms of trade: 1963-80

Unit value index Netubarter

Exports Imports term of trade
Year (A) (B) (A/B) x 100
1963 54.4 45.0 121.0
1964 55.6 45.5 12233
1965 57.7. 46.3 124.7
1966 63.0 45.3 139;2
1967 65.9 45.7 144.2
1968 67.9 45.3 149.9
1969 64.5 44.6 144.7
1970 67.4 46.2 145.7
1971 66.5 46.0 144.5
1972 67.3 46.8 143.7
1973 85.2 62.5 136.4
1974 107.9 Oiae 111.0
1973 100.0 100.0 100.0
1976 117; 98.0 114.0
1977 122°3 100.2 122.0
1978 135.4 105.8 128.0
1979 161.8 129.2 12 Deo
1980 170.3 163.9 103.9

Source: BOK, Economic Statistics Yearbook (1965, 1970, 1975, 1982).

82 Yung Chul Park

was expanded by nearly 50 percent to help finance needed imports. As a

result of this accommodation policy, wholesale prices rose by 42 percent
in 1974. About a year after the oil price increases, in an effort to improve
Korea's export competitiveness, the policymakers undertook a 21.8 percent
devaluation to stabilize the real exchange rate, which had been appreciat-
ing with the growing differential between domestic and foreign inflation
rates (Table 4.7). This devaluation was partly responsible for another 26 per-
cent in inflation in 1975. There was a sharp deterioration in the current ac-
count but, through heavy borrowing abroad, the government managed to
produce a substantial overall balance surplus by 1975. On the positive side,
GNP continued to grow by 8 percent in real terms during 1974 and 1975.
This gambler’s approach to the external shock seemed to have paid off hand-
somely as far as growth and employment were concerned, but at a high
price. The growth-first response to the oil crisis seriously undermined eco-
nomic stability and made it increasingly difficult to restore price stability
in subsequent years. The task of restraining price inflation was further ex-
acerbated by the upturn of the world economy, which contributed to another
boom year for Korea's exports in 1976.
Alarmed by the two years of high inflation following the oil crisis, the
authorities began to pay more attention to restoring price stability. Starting
in 1976 they tightened the supply of credit and money, but given the auto-
matic credit expansion associated with export growth, there was a limit on
their ability to squeeze the credit supply. To complement the restrictive
monetary policy, a comprehensive incomes policy was put into effect that
included strong price-control measures covering a wide range of consumer
and producer goods. In 1976 and 1977 inflation showed a sharp decelera-
tion, but beginning in 1978 prices began to soar again and by the end of
the year had risen by more than 20 percent in terms of the GNP deflator.
This sudden upsurge was to be expected. In fact, a close examination of
developments since the early 1970s indicated that several inflationary fac-
tors had been lurking behind the scene for some time.
In the midst of strong inflationary pressures, Korea was hit by the sec-
ond oil crisis in 1979; as in 1974 the cost increase resulting from the exter-
nal shock was accommodated by credit expansion. For the next three years
prices measured by the WPI continued to climb at a high rate. The average
annual rate of inflation during this period was close to 27 percent. Along
with high rates of inflation, a substantial divergence between price increases
of tradable and nontradable goods occurred. The inability of the govern-
ment to control domestic credit was (as in earlier periods) one of the greatest
contributors to rampant inflation after the second oil crisis.
On the demand side, the inflationary impact of the oil crisis was further
aggravated by the promotion of heavy and chemical industries that began
in the early 1970s. Low nominal interest rates, which drove down real in-
terest rates to a negative level, induced savers to move out of financial
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84 Yung Chul Park

assets and into real assets. The subsequent real-estate speculation hiked
the prices of housing and land and thereby raised inflationary expectations.
On the supply side, real wages shot up and so did unit labor costs. The
rice price-support program, which had been in effect since 1968, added to
the inflation problem. The price-control measures introduced in 1975 dis-
torted the relative price structure and, as expected, resulted in black mar-
kets for a number of commodities. With the realization of the adverse
consequences of price and wage controls, the government reduced the num-
ber of controlled goods from 148 to 35 in 1979. That relaxation led to a realign-
ment of relative prices and a subsequent high rate of inflation. One favorable
development was that prices of imported goods remained stable between
1976 and 1978, before rising again in 1979 with the second oil crisis.

CAUSES OF INFLATION
In Korea's inflation history, one can see that every inflationary upsurge, one
way or another, had a monetary connection. The annual rate of money
growth (M,) averaged 31.7 percent in the 1960s and 29.6 percent in the 1970s.
Given a real income elasticity of the demand for money (M,) of less than
1.0, those rates were too high, even when the economy was growing at
almost 10 percent a year on average, to achieve the government's annual
target rate of inflation below 10 percent. The corresponding growth rates
of M, were 464 percent and 30.3 percent respectively. Although much of
the M, expansion was associated with the increase in real savings, this meas-
ure of money with its income elasticity of 1.2 also indicated a substantial
excess supply of money (elasticity figures are from S. W. Nam 1981).
From an analytical point of view, such a monetary connection is neither
surprising nor interesting. What is necessary, and in fact crucial, is to ascer-
tain why monetary expansion was occurring. From 1945 through the
mid-1960s, money growth was an autonomous policy instrument. Mone-
tary expansion during that period resulted from the government's effort
to reconstruct the war-ravaged economy and to develop industry by extract-
ing savings from households through the inflation tax and channeling these
resources to strategic industries.
Since the launching of the First Five-Year Development Plan in 1962,
monetary expansion has by and large been accommodated to factors other
than stabilization goals. For example, the government's response to the oil
crisis was to accommodate fully the cost-push effects of the oil price in-
creases through a monetary expansion. Other policy measures that ren-
dered monetary policy passive and accommodating were the export-led
growth strategy, the grain price-support program, and the promotion of
heavy and chemical industries. This section focuses on these policies as
the major causes of inflation in the 1970s.
 Price Control and Stabilization Measures 85

Export Promotion and Inflation

From 1965 and throughout the 1970s, the deposit-money banks provided
loans through the central bank rediscount facilities at very favorable interest
rates to all exporters and to producers supplying intermediate goods to be
used in export goods production. These loans were granted automatically
on the basis of valid letters of credit or similar evidence of export orders.
In the early years of the export-financing system, the loan amounts grant-
ed were set at 80 percent of the domestic costs of export production for
terms ranging from 90 to 120 days at an annual interest rate of 6.5 percent.
Through the use of a domestic letter of credit covering orders of exporters
from their domestic suppliers, these suppliers also shared in the favorable
bank loan schemes.
The main defect of the automatic credit system is that it results in con-
siderable loss of control over credit expansion by the monetary authorities.
This was not a serious problem when exports were a small fraction of GNP,
but as they rose to over 40 percent of GNP, the importance of this continu-
ing outflow of credit became more serious. Initially, the monetary authori-
ties attempted to compensate for the expansion of export credit by restricting
the supply of other types of bank lending, but that was not easy to do.
Squeezing other types of credit meant that nonexporters and producers
in the nontradable sector had to obtain financing through the unregulated
financial markets at higher interest rates. This differential effect of tight
monetary policy biased against nonexporters and its implications for infla-
tion through the relative contraction of the nontradable sector clearly limited
the extent to which the credit squeeze could be enforced.
In the 1970s actual exports frequently exceeded expected levels. When
that happened, there was a double expansionary effect on money supply.
Not only was there an automatic increase in bank credit, but there was also
a related increase in foreign-exchange reserves through an improvement
in the overall balance that added to the supply of money. An increase in
export demand is expansionary and, other things being equal, generates
inflationary pressure. In Korea this expansionary effect has been exacer-
bated by the monetary expansion associated with the export credit and a
fixed or managed floating exchange-rate system.
The quantitative effects of the export-credit system on money supply and
prices are difficult to measure, because the system directly affects the level
of output and balance of payments, as well as prices. Using regression equa-
tions, S. Kim (1980) estimates that between 1962 and 1978 automatic export
credit contributed to 6.2 percent of the outstanding reserve base each year
on average. Although this figure was low, its variability was high. The con-
tribution ratio, which is defined as the increment due to the export credit
extension to the actual level of reserve base, ranged from a high of 27.5 per-
cent to minus 9 percent in 1977. The standard deviation of this ratio for the
86 Yung Chul Park

period was 9.23. The high variability may explain in part the equally high
variability of the reserve base and money supply. Again using single regres-
sion equations, S. Kim (1980:122-25) shows that the additional reserve base
increase was accountable on average for about 1 percentage point of the
annual rate of increase of the gross domestic product (GDP) deflator dur-
ing the sample period. The inflationary effect of the export credit was not
important for any given year; its cumulative effect over time, however, was
substantial. According to S. Kim (1980), termination of the export credit
could have lowered the base-year rate of inflation by 2 to 3 percentage points
within two or three years.

Grain Price-Support Program

After World War II the American military government in Korea imposed
a rice price-control system that strictly enforced rice collections from farm-
ers and a complete rationing system for urban consumers. The control sys-
tem was partially relaxed by the new government established in 1948. In
1950 the government enacted the Grain Management Law, which remains
to this day the basic legal authority for food grain policy. The primary ob-
jective of the system was to enable the government to secure sufficient grain
from farmers so as to stabilize the rice price and the economy by exercising
control over grain distribution and consumption through manipulation of
government stocks (Ban, Moon, and Perkins 1980:234-59).
The grain market in Korea is characterized by a dualistic system that com-
bines free market transactions and government control. Free market trans-
actions exist by tacit assent of the government, which has the sole right
to import and export grain. During the First Five-Year Development Plan
(1962-66), the government pursued a low grain-price policy in an effort to
stabilize prices and wages in the urban industrial sector. That policy dis-
couraged grain production and encouraged rice consumption, widening
the food gap and imposing a burden on the balance of payments. From
1952 through 1962 the government purchase price continued to be lower
than the estimated cost of production (Ban, Moon, and Perkins 1980:240).
With the increasing food shortage and the growing income disparity be-
tween urban and rural households, the policymakers reversed the low grain-
price policy and adopted a two-tier price system beginning with the 1968
crop. For the next seven years the terms of trade between agricultural
products and nonfarm products improved considerably, although thereafter
they deteriorated. The two-tier price system, which was intended to pay
a higher price to farmers and charge a low price to urban wage earners,
posed a serious problem for economic stability in Korea in the 1970s.
There are no strict formulas for determining the government purchase
and selling prices, but these controlled prices have been influenced largely
by price movements and grain market conditions. Past experience shows
that determination of the rice purchase price (the most important grain price
 Price Control and Stabilization Measures 87

with a CPI weight of more than 200) has taken into consideration increases
in the general price level and prices paid by farmers to maintain a stable
farm parity ratio. Setting the rice price has always been a political issue
and as such has often been dictated by political considerations.
The selling price has also been determined in consideration of stability
objectives and financial problems that arise when it is set below the pur-
chase price plus handling costs. Free-market prices of rice have fluctuated
depending upon supply availabilities and the government selling price; ow-
ing to the difficulties of estimating rice production, however, the manipu-
lation of government stocks has not been effective in keeping the free-market
prices in line with the government selling prices. Overall, it appears that
under the two-tier price system the rice price has been partially indexed
to the movements in the general price level. This indexation feature has
contributed to high inflation in Korea. When the purchase and selling prices
of rice are set toward the end of each year, the new prices cause an upward
adjustment of prices of other goods and services and raise nominal wages.
In a highly inflationary environment, purchase and selling prices have had
to rise in step with other price increases, and then with a lag the announce-
ment of new rice prices leads to high prices of other commodities. This
process has been under way since the late 1960s.
Partial indexation has been only a part of the problem with the two-tier
price system. Since 1970 the selling price plus intermediate handling costs
has always been lower than the purchase price, with the exception of 1972.
The difference, or deficit, arising from the grain-management program has
been financed mostly by borrowing from the central bank. At the end of
1982 the accumulated deficit financed by printing money was 1.5 trillion
won, equivalent to 26 percent of the money supply (M,). The expansion
of the grain management deficit has been one of the major sources of credit
expansion and of reducing the scope and flexibility of monetary policy in
Korea.
Dynamics of Development Strategy, Exchange-Rate Policy,
and Inflation in the 1970s
After a decade of export promotion of labor-intensive manufactures, the
Korean authorities began, in the early 1970s, to develop skill- and tech-
nology-intensive industries (known in Korea as “heavy and chemical in-
dustries”) as the export sector of the future. A massive investment program
in these industries, financed largely by foreign loans and central bank credit,
was put into effect in 1973 and pursued vigorously until 1979. To the dis-
may of the policymakers who conceived this industrial restructuring, the
development strategy ran into a host of financing, engineering, quality, and
marketing difficulties. Except for shipbuilding and iron and steel, these in-
dustries have yet to become efficient exporters.
Much of the investment in the heavy and chemical industries, which
88 Yung Chul Park

was by and large induced by distorted incentives, took place during the
1977-79 period, when the economy was already experiencing a high rate
of inflation. As a result of the large investment, the ratio of fixed invest-
ment to GNP shot up from a historic average of about 25 percent to 33 per-
cent in 1979. Given a stable domestic savings-to-GNP ratio, a high rate of
investment expands aggregate demand (total spending for goods and ser-
vices) and, other things being equal, causes the external position of the
economy to deteriorate. To make matters worse, the investment program
entailed serious supply-side problems that intensified inflationary pressures
emanating from the demand side. During 1977-79 more than 70 percent of
manufacturing investment was undertaken in heavy and chemical indus-
tries. This lopsided allocation of investment resources generated severe sec-
toral imbalances between the tradable and nontradable sectors and within
the tradable sector. The lack of investment in light manufacturing—the tradi-
tional export sector—had an adverse effect on Korea’s export performance,
while the sluggish investment in the nontradable sector created a supply
shortage and rapid price increases in this sector.
After the one-shot devaluation in 1974 the nominal exchange rate was
kept at 480 won per U.S. dollar. The high rate of domestic inflation relative
to the rates experienced by Korea’s major trading partners resulted in an
18 percent real appreciation of the won between 1974 and 1979 (Table 4.7).
Other things being equal, such a real appreciation results in a shift of na-
tional aggregate demand in favor of traded goods that include exportables
and importables whose prices in a small open economy are greatly in-
fluenced by the conditions prevailing in the world markets. The real ap-
preciation, on the supply side, induces a shift of domestic resources to the
more profitable nontraded-goods sector. These demand and supply shifts
would, in general, slow price increases and would be reflected in a deteri-
oration in the current account. In Korea the expected resource shift did not,
however, take place as a large share of resources was channeled to the
tradable-goods sector (heavy and chemical industries, in particular) through
the government's directed resource allocation. As a consequence, the ex-
cess demand for nontradables remained unabated and their prices went
up further. To complicate matters even more, this forced allocation of
resources to heavy and chemical industries did not help meet the domes-
tic demand for tradables. One reason for this was that a large increase in
the domestic demand for tradables consisted of consumer goods such as
high-quality and processed food products and consumer durables. Because
the majority of investment resources were allocated to the capital-goods
producing sector, the excess demand for consumer tradables had to be satis-
fied by imports. Another reason was that Korean firms continued to im-
port machinery and petrochemicals, because of suspected low quality and
the difficulty of securing domestic finance for the purchase of the domes-
tic import substitutes.
 Price Control and Stabilization Measures 89

Although most of the heavy and chemical industries (shipbuilding, basic

metals, and power-generating equipment, in particular) were from the be-
ginning developed for export markets, the results were less than expected.
Thus, while the tradable-goods sector was saddled with huge idle capac-
ity, the import demand for tradables rose sharply. The combined effects
of these developments were reflected in a widening trade deficit and ram-
pant inflation. Available evidence bears out the causal relationship between
inflation and a current account deficit. From 1975 to 1978 the price of im-
ports increased on average less than 1 percent a year and export prices,
about 8 percent; in contrast, the deflator for social overhead capital and
services (which may be used as a proxy for a price index for nontradables)
rose by 23 percent on average per annum. The current account deficit rose
to 9.4 percent of GNP in 1980 from a small surplus in 1977.
The heavy and chemical industry investment program also produced a
cost-push effect. The production inefficiencies and underutilized capaci-
ties considerably reduced labor productivity. Despite declining productivity,
nominal wages (and hence the unit labor cost) soared as skilled workers,
who were in short supply, were bid up by firms in heavy and chemical
industries and as construction workers were sent to the Middle East. This
cost-push effect was accommodated through money expansion and subse-
quently undermined Korea's international competitiveness.
Finally, the inflationary environment built up high price expectations,
which in turn began to accelerate the rate of price increases. At the same
time, the official interest rates, which were adjusted downward in 1972, were
kept well below a market-clearing level. The negative real interest rates in-
duced household savers to shift out of financial assets and into real assets
and commodity inventories. The surge in the demand for houses, land,
jewelry, antiques, and art objects pushed up prices of these assets mark-
edly. As shown in Table 4.3, the land-price index almost quadrupled over
the five-year period of 1974-79.
Although the data do not show it, partly because of price control and
estimation problems, such a steep rise in land prices must have increased
housing rents. It certainly brought about a housing and construction boom.
Under normal circumstances, the speculation would have been moderated
through an increase in housing supply; the export of construction services
and materials, however, reduced the supply capacity of new housing and
commercial buildings. Real-asset speculation in the latter part of the 1970s
provoked a further increase in expected inflation, which in turn added to
the inflationary pressure.)

1. It is not surprising, therefore, that S. W. Nam (1981) finds that the coefficient of the ex-
pected rate of inflation is close to 1 in an expectation-augmented Phillips curve estimated by
using quarterly data for 1972-81 in Korea.
90 Yung Chul Park

Ineffectiveness of Demand-Management Policy

The poor stability record in Korea has been largely the result of the combi-
nation of the lack of effective policy instruments and the unwillingness of
government to sacrifice growth for price stability. Among the various
demand-management policy instruments, monetary policy stands out as
the most effective and flexible in developing economies. Monetary policy
has been extensively relied upon in Korea and has served as almost the
sole tool for controlling aggregate demand. The annual financial stabiliza-
tion program, which focuses on monetary management, specifies year-end
money supply targets and coordinates short-run stabilization policies. The
targets of M, and M, growth rates have been the most publicized aspects
of the stabilization programs, but have seldom been attained.
Monetary policy cannot be blamed entirely for the poor stability record.
After all, it is no more than one of many instruments that must be coordi-
nated in any serious effort to control inflation. There has been a glaring
lack of such coordination as evidenced by mounting fiscal deficits when
a contractionary credit policy was pursued.
On the institutional side, some traditional instruments such as open-
market operations (buying and selling of government securities on the open
market) could not be utilized because of the absence of well-developed
money and capital markets in which the price mechanism functions. For
that reason, the monetary authorities have had to rely on direct control
measures—control of ceilings and quotas on these banks’ loan expansion,
changes in required reserve ratios, manipulation of the deposit-money
banks’ stabilization accounts with the central bank, and forced sales of
stabilization bonds to these banks and institutional investors. These direct
control measures have been affected and to some extent offset by Korea's
growing access to international financial markets and a large unregulated
financial market that has met a considerable portion of business needs for
working-capital finance. With the growth of the external sector in both size
and importance, the increased foreign-capital transactions have weakened
the effectiveness of monetary policy. Despite supposedly strict government
control of capital movements, businesses somehow have managed to bor-
row from abroad when domestic financial markets have become tight,
though the reverse phenomenon of lending abroad has been rather rare.
The control over official interest rates resulted in fragmented and artifi-
cially segmented markets for a large number of financial assets and an un-
even flow of funds among these markets. As long as the prices of these
assets were controlled by the government, an equilibrium in these markets
could be maintained only through quantity rather than price adjustments.
As a result, exogenous changes in the rates of return to any assets, or the
expectation of change, triggered sizable asset substitutions in the aggregate
wealth portfolios, thereby making financial-asset markets highly unstable.
In the absence of price adjustments that could abate the large and frequent
 Price Control and Stabilization Measures 91

movements of funds between asset markets, the effects of monetary policy

were unpredictable.
The absence of well-functioning financial markets and the lack of policy
coordination were only part of the monetary policy dilemma in Korea.
Monetary accommodation severely restricted the scope of monetary policy
as an anti-inflationary instrument. The main cause of monetary accommo-
dation was the government's use of the financial system and policy as a
means of intervening in the allocation of resources. The bulk of subsidies
to preferred industries and fiscal deficits were financed by borrowing from
the central bank. These borrowings were relatively immune to stabilization
policy. The export-credit system, with its automatic credit expansion fea-
ture, and the grain price-support program, whose deficits were almost en-
tirely financed by printing money, in fact worked as built-in destabilizers
in the Korean economy and made monetary policy procyclical rather than
anticyclical (Cole and Park 1983:248-52). Together with the grain-manage-
ment deficits and export subsidies, the types of central bank credit that could
not be controlled through the manipulation of traditional policy instruments
accounted for anywhere from 30 percent to 45 percent of the reserve base
in the 1970s (Table 4.8). In addition, a large fraction of bank credit was ear-
marked in the form of “policy” or “directed” loans for strategic industries
and uses. These loans always escaped monetary tightening.

MAIN FEATURES OF PRICE CONTROL MEASURES

Complete Freeze and Relaxation, 1960-63
One of the first economic policy measures announced by the military council
that succeeded the Chang Myon government in May 1961 was an across-
the-board freeze on prices of goods and services. Ever since, some type
of price control has been maintained as a means of slowing inflation in
Korea. The various control programs have differed mainly in the number
of commodities subject to price control.
Two months later, the complete freeze was lifted with the exclusion of
the prices of the main staples—rice and barley. The relaxation in July was
followed by the enactment of a law on price controls in November of the
same year. The law, which provided the legal basis for direct price controls,
gave the government the authority to select the commodities to be con-
trolled and to determine the maximum level of their prices.
For the next two years the government managed a limited system in
which five commodities—rice, barley, coal briquettes, coal, and fertilizer—
were subject to price controls. Subsequently 13 additional major commodi-
ties and raw materials including flour, soybeans, beef, pork, steel plates
and bars, cotton fiber, and cloth were added to the list.
It was not long before the authorities realized that the control system
was not working. Shortages of some controlled items (and inevitably black
92
neh
eS
Yung Chul Park
6 ie A A el SS

Table 4.8. Bank of Korea lending: Selected years, 1975-81

piers ah a RE Rt Soe S eT eae
Type of lending 1975 1978 1980 1981
Directed loans (10? won)
Export financing 3,797 Jyh tel 2; 912 gael Ons
Energy conservation loans 5 raw
Long-term export financing 1,266
Agriculture loans 260 7i1 661
Fisheries loans 55 284 500 619
Defense industry support loans 90 167 119
Other 41 1,140 253 4
Subtotal (A) 4,153 9326599 614/511. 9919 /659
Total BOK lending (B) (10? won) 7,961 11,785 24,450 33,711
(A/B) (%) 522 78.6 So ie 58.3
Reserve base (C) (10° won) 10,770 28,020 32,439 28,016
(A/C) (%) 38.6 33.1 44.7 70.2
Source: BOK, Economic Statistics Yearbook (1985).

markets for them) developed. Even the prices of those products whose sup-
plies were adequate went up along with other prices because of hoarding
and the spread of inflationary expectations.
With the realization of these classical problems associated with price con-
trols, the government shifted the thrust of its stabilization policy to demand
management in June 1963, confining direct intervention to those items
whose prices could be controlled administratively. In addition, to comple-
ment monetary and fiscal policy, the government began to manage the sup-
ply of and demand for daily necessities and important raw materials, instead
of controlling their prices directly. This change in stabilization policy was
reflected in an overall policy measure issued in January 1964.
As noted before, the period from 1965 to 1969 witnessed spectacular
growth in a stable environment and a clear movement away from market
intervention and toward greater reliance on price mechanisms. Beginning
with the adoption of a unified and floating exchange-rate system in March
1965, the government took a number of measures for raising interest rates
to a more realistic level and liberalizing imports. Aided by these policies,
which stimulated domestic savings, supported export expansion, and
brought in a large amount of foreign capital, the economy could grow
without provoking another round of inflation. As a result, the need and
political demand for price controls greatly diminished.
Imposition of a Comprehensive Control System, 1972-73
Toward the latter part of the 1960s, several symptoms appeared that indi-
cated a rapid build-up of inflationary pressure. The most noticeable was
the acceleration of liquidity expansion. The rates of price increases during
 Price Control and Stabilization Measures 93

the first two years of the 1970s were moderate in retrospect, but higher than
the target rates and thus a serious policy issue. The relatively high rate of
inflation was accompanied by a mild recession. The setback in the perfor-
mance of the economy was attributed to “structural problems” accumulated
during the period of rapid growth and led to the enactment of the Presiden-
tial Decree for Economic Stability and Growth on 3 August 1972. The decree
signaled an end to liberalization efforts and a return to control-oriented eco-
nomic management.
One of the policy objectives specified by the decree was to reduce the
rate of inflation to 3 percent per annum. To attain this target rate of infla-
tion, the government announced, in February 1973, a comprehensive pol-
icy package for stabilization that included 16 measures. The most important
element of this package was the imposition of a rather comprehensive price-
control system that had been discarded in the mid-1960s. The system was
geared to control nearly all prices that mattered. To administer the control
program, the Economic Planning Board (EPB) revived the functions of the
governmental committee for price stability, which had been dormant since
its inception in 1963. The committee reviewed price developments for major
product items monthly and issued specific measures for restraining price
increases product by product.
A month later the government promulgated the Law of Price Stability,
which was designed to strengthen the government's ability to control prices.
Before the enactment of this law, the concerned ministries primarily had
relied on the cooperation of business in following government guidelines,
because they did not have the legal authority to set and alter prices directly.
If a firm did not comply with the government's guidelines, it was threat-
ened with an audit of its tax return or a revocation of its business license.
Under the new law the government could control practically all prices in-
cluding rents, real estate, and services, and could prosecute those engaged
in unfair trading activities (for instance, charging a price higher than the
ceiling) for excessive profit taking. For essential products such as foodstuffs,
medical supplies, and building materials, the law required businesses to
post their prices.
The onset of the first oil crisis produced insistent demands for controls
and administrative solutions as inflation erupted with new force, and un-
der pressure the government issued its third special measure of the year
for price stability in December. The measure was aimed at minimizing the
impact of oil price increases on domestic prices. Predictably, the main fea-
ture of the special measure was the direct control of prices of about 60
products consisting mostly of daily necessities and important raw materials.
The hope of achieving the 3 percent price-increase target was shattered
toward the end of 1973 as the prices of oil and other primary commodities
began to skyrocket. The target was raised to a more realistic level of 10 per-
cent. Together with this change, the EPB (which was in charge of price-
94 Yung Chul Park
Se
a
control administration) allowed some prices—in particular those of petro-
leum products—to be adjusted upward to reflect the sharp oil price increase
in December 1973.

Back to Partial Relaxation

In a country that depends entirely on imported oil, the quadrupling of oil
prices was bound to inflict severe damage on the economy. It was also real-
ized that the stabilization attempt through price controls in the face of ra-
pidly rising prices of imported commodities was simply not possible. Nor
was it efficient from the standpoint of resource allocation. The selective price
controls also produced supply shortages and black markets in the controlled
items.
In recognition of these problems and to lessen the adverse impact of the
oil crisis, the government issued an emergency measure in January 1974
for restoring economic stability. This measure was followed by a compre-
hensive policy package for price stability three weeks later (5 February 1974).
One of the significant aspects of the package was the introduction of a mild
form of wage control.
The new stability measures emphasized increased reliance on demand
management and a relaxation of price-control measures. In an effort to im-
prove the archaic distribution system, which was one of the causes of sup-
ply shortages, higher prices, and black markets for many important
products, the government implemented a number of measures designed
to encourage the establishment of corporate retail chains, stores specializ-
ing in daily necessities, and distribution outlets for the goods produced
by small and medium-size firms.
Most of all, the two stability measures issued early in 19/4 recognized
that external-supply shocks could not be depreciated away and had to be
reflected in domestic prices to whatever extent possible. While there was
a clear departure in anti-inflation policy from direct intervention in com-
modity markets to classical demand management and building up of the
distribution infrastructure, price controls continued to be imposed during
the latter part of the 1970s, though somewhat less stringently than before.

Antitrust Legislation
Government efforts to legislate antitrust laws in Korea date back to 1963,
when excess profits amassed by a monopoly firm erupted into a political
issue. The government continued to press its case for the legislation dur-
ing subsequent years, but on each occasion the government proposals were
opposed and postponed. In December 1975 the government finally suc-
ceeded in pushing through the National Assembly its Law on Price Stabil-
ity and Fair Trade, the forerunner of the Fair Trade Law promulgated in 1981.
 Price Control and Stabilization Measures 95

The major objective of the legislation was twofold. First, it attempted

to regulate unjustifiable price-setting practices by monopolies and oligop-
olies. Second, it aimed at developing an environment for orderly and fair
competition among businesses, which is generally the spirit of any antitrust
law. But in Korea the legislation was primarily motivated by the desire to
establish a more effective and stronger administrative authority for price
controls.
According to the law, a firm was classified as a monopoly if its market
share was greater than 30 percent in an industry and it had total annual
sales of 2 billion won or more. Three firms could be regarded as forming
an oligopolistic market structure if, together, they accounted for more than
60 percent of the market as a whole and if each firm had a 20 percent mar-
ket share or more. Even when their market shares were not dominant, firms
could be placed in the category of either monopoly or oligopoly if they were
powerful enough to set prices. In implementing the law, the EPB identi-
fied 127 products and 203 business concerns and placed them under the
regulation of monopoly and oligopoly.

Real-Asset Price Regulation and Value-Added Tax

Inflation showed little sign of abating during 1977-78. High and continuing
inflation inevitably induced the public to form high inflationary expecta-
tions, which in turn led to rampant speculation in real assets as a hedge
against inflation. For a while it seemed that prices of land sites, housing,
antiques, and even consumer durables would rise without limit. Price con-
trols on building materials, electronics, and other products were aggravat-
ing the situation further. To worsen an already serious situation, the
government introduced a value-added tax (VAT) system in July 1977, which
necessitated an across-the-board adjustment of the entire price structure.
The adjustment, it was feared, could accelerate inflation further. Conse-
quently, the number of products subjected to the fair trade law increased,
maximum prices of many products were set, and fees and charges of vari-
ous services had to be posted. In general, the range of administrative price
controls was greatly expanded.
Despite the reinforcement of the administrative price controls, the im-
plementation of the VAT raised many prices. Real-asset speculation inten-
sified further and was getting out of control. Something had to be done
to reverse the dangerous trend, and in August 1978 comprehensive meas-
ures for stabilizing land prices and curbing real estate speculation were put
into effect. One of the measures required that all future land transactions
be reported to and approved by the government. Another measure ex-
panded the areas subject to the government standard land price. These
measures were complemented by heavier taxes on capital gains realized
through land transactions and on idle land sites.
96 Yung Chul Park

Greater Relaxation of Price Controls

Inflation continued to be the most serious economic problem and under-
standably became the focus of intense policy discussions within the gov-
ernment. These discussions, together with public concern, led to the
formulation and implementation of various measures for economic stabil-
ity in April 1979. The measures marked an important change in economic
policy management, signaling a move toward overall economic liberaliza-
tion. First, the comprehensive policy package left little doubt that economic
stability was placed ahead of growth as a policy objective. Second, it em-
phasized the need to restore market mechanisms to guide the allocation
of resources and the need for a greater private-sector role in the management
of the economy. In line with this market-oriented economic philosophy,
the government relaxed price controls and reduced the number of products
regulated under the Law of Price Stability and Fair Trade. To lessen the bur-
den on low-income families caused by the high rate of inflation, the govern-
ment identified 25 products whose prices were to be monitored and kept
stable by augmenting their supplies through imports and provision of tax
incentives to the producers.

THEORETICAL APPROPRIATENESS AND EFFECTS

Price Controls as an Anti-inflation Measure
In its attempt to achieve and maintain price stability, the Korean govern-
ment has, since 1961, administered price controls extensively and inten-
sively—oscillating between a comprehensive and a limited system of controls
and guidelines. The “permanency” and oscillation of the administrative
price controls make it difficult to analyze their effectiveness empirically.
Were price controls effective in slowing inflation? Were they a theoreti-
cally appropriate instrument for controlling inflation in a Korea bent on rapid
economic development? These questions are difficult to answer in a rigorous
manner, and little help is available from the theoretical and empirical studies
that have been carried out for other countries.
Proponents of incomes policy argue that “temporary” wage-price con-
trols could speed up the decline in inflationary expectations by providing
a period of relative price stability and indicating to the public that the govern-
ment was serious about pursuing an anti-inflationary program. This argu-
ment essentially rests on the assumption that price controls could induce
economic agents to adjust their inflationary expectations downward. If in-
flationary expectations are adaptive in formation and hence depend on past
rates of inflation, price controls would break expectations. If, however, ex-
pectations are formed rationally, price controls would have no effect on in-
flationary expectations as long as other policies affecting the rate of inflation
remained the same. To the extent that the controls were keeping prices be-
low the equilibrium level, business firms and workers would surely expect
 Price Control and Stabilization Measures 97

renewed inflation at the end of the control period. In such a case the ter-
mination of controls would cause a rebound in the price level.
Korea's experience with incomes policy as an anti-inflation instrument
casts serious doubt on whether price controls indeed lowered the rate of
inflation below what it might have been in the absence of the controls. Sev-
eral reasons can be suggested for this skepticism. Some prices have been
controlled consistently since 1961; the numerous special, emergency, and
regular measures aimed at combating inflation have always included price
controls. These measures have differed, as far as the controls are concerned,
mainly in their coverage of controlled-price products. Since price controls
have become a way of life in Korea, an announcement of new ones could
not have produced a strong effect. After so many impositions of price con-
trols, people have become callous about what the government has been
saying about the control measures.
Another reason to doubt the effectiveness of price controls as a stabili-
zation instrument is that enforcement has been uneven. Despite the efforts
of a strong government, price controls have frequently been evaded by busi-
ness firms and have created black-market prices, lowered quality, and led
to shortages of the controlled products. As a result, people have seldom
sensed any actual decline in the rate of inflation and have begun to dis-
trust official price statistics that dutifully record official prices. Under these
circumstances, it is difficult to believe that people would adjust their infla-
tion expectations downward in response to an imposition of price controls.
There is another reason why expectations have failed to adjust. As noted
before, in administering incomes policy the government has moved back
and forth between a comprehensive and a limited control system. On each
occasion a comprehensive system has been discontinued and replaced by
a relatively limited one. As a consequence people have come to expect failure
from comprehensive controls because of the harm they inflict on the econ-
omy by interfering with the allocative function of the market.
The fourth factor responsible for the ineffectiveness of the control meas-
ures may have been that expansionary aggregate demand policies have been
used to sustain rapid growth while price controls have been imposed to
stabilize prices. Experiences of other countries clearly show that incomes
policies cannot be a substitute for restrictive aggregate demand policies as
a cure for inflation.
Price Controls as a Distributional Device
Although the primary objective of price controls may have been to lower
the rate of inflation, price controls have also served other purposes, such
as the redistribution of income. The goods and services that have been
selected for price control are what may be called basic necessities and their
prices have a significant effect on the real income of low-income house-
holds. By controlling those prices the government has been able to raise
98 Yung Chul Park

the real income of this group. The price of rice, for instance, has been con-
trolled, regardless of the size of harvest, in order to supply it at low prices
to urban consumers whose welfare is critical for political stability. It has
been controlled also to provide favorable terms of trade to rice farmers.
During the 1960s and 1970s the government relied more or less on credit
control and on credit expansion by the central bank to mobilize domestic
resources for rapid economic development. This development strategy led
to inflation, with an inordinate share of the inflationary tax burden falling
on low-income wage earners. Price controls may be viewed as the govern-
ment’s attempt to attenuate the burden by providing basic necessities to
this group. If and when the resulting shortages were acute enough, they
could easily be blamed on profiteering businesses. Price controls have thus
served the government well by helping maintain political stability and al-
lowing it to stay with its development strategy.
Were price controls necessary as a distributional device? In the case of
rice, for example, the price could have been freely determined in the mar-
ket, and people below a certain level of income, whether farmers or urban
wage-earners, could have received an income subsidy. Whether or not the
Korean economy had the fiscal capability to carry out such a scheme is a
difficult question to answer.
Whatever the situation may have been in the past, there seems to be
no reason for continuing with price controls as a distributional device. Their
adverse effects on allocative efficiency and equity are too well known to
be repeated here. In their place the government should find measures that
would bring about an equitable distribution of income but would not at
the same time load the economy with an excess burden from price dis-
tortion.

Price Controls as an Antimonopoly Measure

As noted earlier, price controls have been used as an antimonopoly or anti-
oligopoly measure. If price controls are used as a bona fide measure for
regulating monopoly because of its anticompetitive conduct, they should
be judged by their effect on allocative efficiency and not by their effect on
inflation.
Whatever merit there may be in regulating monopolies with price con-
trols, it is hard to overlook the fact that monopolies are to a large extent
the products of government policies. Credit control, for example, has fa-
vored large, established firms at the expense of small, new ones. It is ironic
that having created monopolies with one set of policies the government
is now compelled to regulate them with another set of policies.
With the exception of those in the nontraded-goods sector, monopolies
or oligopolies can operate as such in a small open economy because of
government protection from import competition. Their protection may be
warranted in their “infant” stage, but if the government is concerned with
 Price Control and Stabilization Measures 99

their monopoly conduct, they are no longer in need of protection from im-
port competition. Instead of regulating monopolies with price control, the
government should go directly to the root cause of the problem and
eliminate protection from import competition and government-created bar-
riers to entry.

CRITICISM AND LESSONS

During 1945-80 Korea experienced erratic and relatively high inflation (in
comparison, that is, with its export competitors and major trading part-
ners). Until 1964 the inflation was attributable to war, political instability,
periodic mismanagement of a shallow and small financial system, and print-
ing money as an expedient to mobilize resources for growth and employ-
ment. During that period monetary factors certainly played an initiative role.
In the 1965-80 period, which was characterized by successful export pro-
motion and rapid growth, the role of monetary factors was more accom-
modative than initiative. The efforts to allocate a large share of the nation’s
limited resources to the sectors producing exports (intensive in labor be-
ginning in the mid-1960s and in skill and technology after the first oil cri-
sis) and to the farm price-support system contributed to excessive monetary
expansion. The oil price increases were largely accommodated to minimize
their disruptive effects on growth and employment.
During the period under review, Korean planners might have felt that
the cost of reducing inflation through a restrictive aggregate-demand pol-
icy, when measured in terms of foregone output and a higher unemploy-
ment rate, was too large for a labor-abundant developing economy like
Korea's to bear. So long as rapid growth was the prime objective, restrictive
ageregate-demand policies predictably ran into strong resistance from the
most affected group—the business community that had grown in power
and influence—and were soon reversed, even if the prevailing economic
conditions called for a continuation of restrictive policies. Thus, when the
economy was sluggish, an expansionary credit policy could be implemented
with little objection. Unfortunately, the converse has not been the case, and
inevitably monetary policy has become procyclical.
With aggregate-demand policies directed to promoting growth and em-
ployment, the planners have had no choice but to rely extensively and con-
tinuously on incomes policy—mostly in the form of price controls—to
stabilize inflation. That is, the government has assigned incomes policy to
combating inflation and aggregate-demand policy to sustaining rapid
growth.
Price controls do not have any measurable effect on the long-run rate
of inflation. Even in the short-run, unless employed as a means of buying
time to prepare a more flexible policy, price controls do not seem to work
because they do not induce people to lower their inflationary expectations,
especially in an economy where price controls have become a permanent
fixture.
100 Yung Chul Park

One more lesson from Korea's experience with price controls is that in-
comes policy cannot be used to control inflation while expansionary de-
mand policies are used to stimulate employment. As a tool for controlling
inflation, price controls cannot be a substitute for restrictive demand-
management policies.
The Korean planners must have been aware of the nonsubstitutability
between the two policy instruments. An important question, then, is why
the government made monetary policy accommodating and procyclical. One
answer may be that the government chose a development strategy that
necessitated continuation of repressive financial policies—mobilization of
domestic resources through printing money and allocating these resources
through credit rationing based on a set of criteria that made monetary policy
passive and accommodating. Another answer may be that, given the choice
between stagnation and inflation, the government saw inflation as the lesser
evil.
 5 The 1964-65 Exchange Rate
Reform, Export-Promotion Measures,
and Import-Liberalization Program
by Kwang Suk Kim

Industrial policy during the postwar reconstruction period (1953-60) was

inward-looking. The government controlled imports not only for balance-
of-payments reasons but also to promote import-substitution industries.
The government used both high tariffs and various quantitative restrictions
to control imports, while maintaining an overvalued exchange rate in the
face of rapid domestic inflation. A complex structure of multiple exchange
rates was also developed to avoid balance-of-payments difficulties. These
measures, in effect, encouraged import substitution mainly in the consumer-
goods industries. Although some minor attempts were made to increase
exports, the structure of incentives during the period was, on balance, biased
against exports.
After the frustrating economic performance in the late 1950s and the col-
lapse in 1961 of the Chang Myon government, the military government be-
gan to shift economic policy from reconstruction and inward-looking
industrialization to a program of rapid industrialization based on exports.
Since this shift in industrialization policy called for changes in many exist-
ing policies, the government committed itself to a variety of reforms. The
military government first attempted to complete the task of unifying the
exchange rate begun by the preceding civilian government. In 1962 the
government undertook reforms of the exchange controls, the national cur-
rency, the government budget system, and the tax system. It also took neces-
sary measures to encourage the introduction of foreign capital in the face
of declining foreign assistance. Some of these measures, however, turned
out to be ineffective or detrimental to economic growth due mainly to the
expansionary policy of the government.
The military government devised several measures to promote exports
during 1961-63. It made direct subsidy payments to selected categories of
export commodities. Preferential loans for exports became an important in-
strument of export promotion beginning in 1963 because the interest rate
on such export credit was gradually reduced from nearly percent 14 per
annum in 1961 to 8 percent in 1963 while other loan rates were unchanged
at the 14 percent level. In addition to tariff exemptions on imports of raw
materials for exports, which had been instituted in 1959, the government
formalized the exemptions of domestic indirect taxes on exports and inter-
101
102 Kwang Suk Kim

mediate inputs used in export production by making the necessary legal

provisions in 1961. The government also granted a 50 percent reduction
in income tax on earnings from exports and sales to United Nations forces
in Korea and from tourism in 1962. In addition, the Export Promotion Law
enacted in 1962 included a provision that licenses for imports using Korea’s
foreign exchange should be limited in any year to those traders who, dur-
ing the previous year, had achieved a certain export minimum. This export
minimum-value requirement for obtaining an import license was set at US
$10,000 in 1962 and then gradually raised to $30,000 in 1964.
What was really important for export promotion during this period,
however, was the export-import link system adopted in 1963, under which
exporters could use the import rights linked to their export earnings for
importing or could sell them on the free market at a premium rate of ex-
change. This indicates that most of the export promotion measures adopted
during 1961-63 had the characteristic of ad hoc measures to offset the dis-
incentive effect of an overvalued official exchange rate on exports. Even on
the import side, the export-import link system played an important role
in restricting imports, since the value of non-aid commercial imports for
any year could be automatically limited to the amount of Korea's annual
export proceeds. In addition, the government tightened import controls by
means of quantitative restrictions in 1963, while maintaining the structure
of highly differentiated tariffs by commodity groups that had been estab-
lished originally in 1949 and revised in 1957.
As a result of the ad hoc export-promotion measures, commodity ex-
ports increased rapidly during 1961-63 from a very low base. However, im-
ports also increased rapidly, despite government measures to control them.
Although commercial imports were effectively controlled by the export-
import link system as well as by quantitative restriction, total imports in-
creased fairly rapidly during the same period, due mainly to increased
imports of food grain and capital goods as separately recommended by the
government. For this reason, Korea's foreign exchange reserves declined
rapidly from US $207 million at the end of 1961 to $132 million by the end
of 1963 (at which time foreign reserves were not even adequate to cover
import requirements for three months on the basis of actual imports for
that year). A rapid decline in foreign assistance also contributed to creat-
ing foreign exchange shortages. In any case, due to this foreign exchange
shortage, the new civilian government that succeeded the military govern-
ment around the end of 1963 had to focus its attention increasingly on the
problems of foreign exchange shortages and inflation.
The 1964-65 exchange-rate reform, export-promotion measures, and
import-liberalization program were designed and implemented as a pack-
age of reform measures to unify the exchange rate and to establish a sys-
tem of incentives consistent with an export-oriented industrialization
strategy for growth. In the process of formulating and implementing the
 The 1964-65 Exchange Rate Reform 103

reform package, there was much opposition from interested business

groups, particularly against the exchange-rate reform and import liberal-
ization. Despite the internal opposition, the government did implement
the reform measures, some of which were considered drastic by many
observers. It seems, in retrospect, that the government was able to resist
opposition to the reform measures and to follow through on their implemen-
tation because it considered them indispensable for achievement of high
economic growth through export-oriented industrialization.

MAIN FEATURES AND IMPLEMENTATION

OF THE POLICY MEASURES
The Exchange-Rate Reform (1964-65)
For over a decade, from the end of the Korean War until early 1964, Korea
maintained a system of multiple exchange rates. Under the regime of mul-
tiple exchange rates, the official exchange rate was almost always overvalued
despite large periodic devaluations to offset the progressive inflation of the
won. The official exchange rate was not really important, however, because
practically all trade and other commercial activities were conducted at ex-
change rates that were significantly higher than the official rate in terms
of won per U.S. dollar. For instance, during the late 1950s the official ex-
change rate was fixed at 50 won to the dollar (Table 5.1). Because exporters
and others with foreign exchange earnings were generally given transfer-
able rights to use their foreign exchange earnings (or proceeds) for import-
ing, free-market exchange rates on export dollars, differentiated according
to the source of earnings, developed in Korea. In the 1950s and the early
1960s, the free-market exchange rates on export dollars from Japan were
in general much higher than the rates on export dollars from other coun-
tries, mainly because the foreign exchange earnings from exports to Japan
could be used only for importing from that particular country. Separate
exchange rates also applied to foreign exchange obtained by remittances
from religious organizations and by selling services to United Nations forces
in Korea between September 1954 and January 1961. In addition, the U.S.
military payment certificate was transacted at market-exchange rates that
differed from those for the U.S. greenback.
Multiple rates were also applied in the allocation of both government-
owned foreign exchange and U.S. aid dollars because government alloca-
tions of such foreign exchange were made under a system of foreign ex-
change bidding, by imposing a foreign exchange tax, or other methods to
increase the de facto exchange rate to a level higher than the official rate
(Frank, Kim, and Westphal 1975:29-36).
After the large devaluation in early 1961, the government attempted to
unify the exchange rate. That attempt failed, mainly owing to high infla-
tion caused by the expansionary policy of the military government. A
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 The 1964-65 Exchange Rate Reform 105

system of multiple exchange rates reappeared in early 1963 due to the adop-
tion in that year of the export-import link system under which exporters
were given the right to use their export earnings for imports. In 1963 the
average market premium on foreign exchange earned by exporting was
about 30 percent of the official exchange rate (Table 5.1).
A significant step in the unification of the foreign exchange rate as well
as in the transition to an export-oriented industrialization policy was the
exchange-rate reform of 1964-65. In May 1964 the government devalued the
official exchange rate from 130 to 256 won per U.S. dollar and announced
that the existing fixed exchange-rate system would be changed to a unitary
floating exchange-rate system. According to Gilbert Brown, who participated
in the Korean exchange-rate reform as a USAID (United States Agency for
International Development) adviser, the new exchange rate was based on
a median value of the purchasing-power-parity (PPP) ratio calculated at the
end of 1963 (Brown 1973:139). Because there was no reliable benchmark
with which to work, the PPP ratio was calculated for those domestic goods
for which the prices of comparable foreign goods were available.
It was not until March 1965, however, that the government allowed the
actual floating of foreign exchange. It feared that the floating might set off
foreign exchange speculation, resulting in further devaluation of the won
and higher inflation. The first stage of the exchange-rate reform was, there-
fore, nothing more than a simple, large devaluation. The new exchange rate
based on the PPP ratio was considered by many to have undervalued the
won slightly at the time of devaluation. As a result, Korean exports of goods
and services increased rapidly in 1964 while the absolute level of imports
declined. Contrary to the situation in the early 1960s, the government con-
tinued the tight fiscal and monetary policy it had started during the latter
part of 1963. Thanks to that effort, the domestic price level was relatively
stabilized beginning in the second half of 1964, despite the large devaluation.
Following the exchange-rate reform, the government gradually abolished
the full-scale export-import link system and lessened nontariff barriers on
imports by increasing the number of importable items in the Ministry of
Commerce and Industry’s semiannual trade programs. The government,
however, announced the implementation of special tariffs beginning in 1964
for the restriction of nonessential imports. The special tariffs, which were
to be levied on top of the regular tariffs, were introduced to soak up excess
profits accruing to importers of selected commodities. The tariffs were levied
at the rate of either 70 or 90 percent of any profit in excess of the normal
profit, or the spread (assumed to be 30 percent) between the c.i.f. import
price! of goods plus regular tariffs, domestic indirect taxes, and the esti-
mated resale price of the same goods. These tariffs were actually imposed
on the basis of market surveys on domestic wholesale prices of imported

1. The c.i.f. import price includes cost of merchandise, shipping insurance, and freight charges.
106 Kwang Suk Kim

items, as well as the import prices. Initially about 2,200 commodity items
were selected for the imposition of these special tariffs.
The government also suspended direct subsidy payments to exporters
immediately following the devaluation but reintroduced the system in the
fourth quarter of 1964. Export dollars were still transacted on the gray mar-
ket at premium rates of exchange. The premium rates showed some fluctu-
ation but generally declined after May 1964 because the government
gradually increased the proportion of export earnings that traders could
use for commercial imports? During the first quarter of 1965 (until March
22), premiums on export dollars ranged from 23 to 29 won per dollar, or
from about 9 to 11 percent of the official exchange rate.
On 22 March 1965 the government announced that the unitary floating
exchange-rate system was being put into effect from that date. Domestic
price levels were becoming relatively stabilized beginning in the latter half
of 1964 owing to the strong implementation of financial stabilization pro-
grams during the previous year. The International Monetary Fund (IMF)
provided a stand-by credit in the amount of US $9.3 million for the pur-
pose of exchange-rate stabilization. That enabled the Korean government
to feel more confident about maintaining a stable rate of foreign exchange.
The unitary floating exchange rate system was to operate in the following
manner:
1. All foreign exchange earned by exporting and by sales to United Na-
tions forces in Korea were supposed to be converted into foreign exchange
certificates to be issued by foreign exchange banks (except in cases of
amounts less than US $50). The foreign exchange certificates were to be
effective for 45 days after the date of issuance, and could be freely trans-
acted on exchange markets during that period. When the certificates ex-
pired, they were to be surrendered to the exchange bank for conversion
into domestic currency.
2. All those who required foreign exchange for imports, including im-
ports financed by USAID (but excluding PL 480 funds), were to submit ex-
change certificates at the time of issuance of import licenses by the exchange
banks.
3. The Bank of Korea (the central bank) was to announce the daily for-
eign exchange buying and selling rates of both the central bank and the
foreign exchange banks on the basis of free-market prices on exchange cer-
tificates during the previous day.

2. Although the full-scale export-import link system was abolished in May 1964, the premium
on export dollars existed because the traders whose export record did not meet the minimum
requirement had to buy export dollars on the gray market to maintain the status of licensed
traders and to maintain their imports for commercial activities.
3. The exchange certificates were originally (from March 1965) effective only for 15 days, but
the effective period was gradually extended to 45 days by June of the same year (Kim and
Westphal 1976:82).
 The 1964-65 Exchange Rate Reform 107

4. The foreign exchange department of each commercial bank was to

play an exchange bank role by buying and selling the exchange certificates.
5. The Bank of Korea was given the right to intervene in the exchange
market for prevention of any large fluctuations in exchange certificate prices
that could result from seasonal and speculative factors.
Following the adoption of the new system, the market price on the ex-
change certificates was first formed at 270 won per U.S. dollar. The market-
exchange rate then gradually declined to 256 won to the dollar in April.
Beginning in early May, however, the market-exchange rate gradually in-
creased to reach 280 won per dollar by the end of the same month, as de-
mand for imports increased. In June the central bank began to intervene
in the exchange markets by increasing the supply of exchange certificates.
From 22 August 1965 until 1967 the central bank could actually peg the
market-exchange rate at around 270 won to the dollar by continuously in-
creasing the supply of exchange certificates. That indicates that the Korean
monetary authorities (the Ministry of Finance and the central bank) actu-
ally transformed the system of the unitary floating exchange rate into a fixed-
rate system, after some initial floating.
When the exchange-rate reform was announced in 1964, some in the busi-
ness community, particularly powerful, large business groups, expressed
opposition to the reform. Although both export and import-substitute in-
dustries could gain by the devaluation, the large business groups opposed
it because they preferred to operate under extensive controls rather than
under a realistic exchange rate and relatively free-market situation. Some
of the business groups that were highly dependent on imported raw materi-
als also opposed the devaluation. The business groups’ opposition to
devaluation was, however, not so strong during 1964-65, mainly because
the business sector's foreign debts were still relatively small.
It seems, therefore, that the exchange-rate peg at around 270 won to the
dollar in 1966 and 1967 was more attributable to the rapid accumulation
of foreign reserves than to the business community's opposition to further
depreciation of the won. The increase in foreign reserves during this pe-
riod was mainly the result of the rapid increase in foreign borrowing after
the interest-rate reform of 1965, which widened the interest-rate gap be-
tween domestic and foreign financial markets. The rapid expansion of ex-
ports might also have contributed to the accumulation of foreign reserves.
In any case, the Korean monetary authorities were faced with the difficult
job of sterilizing the monetary expansion caused by the accumulation of
foreign reserves. Because further depreciation of the won would make it
more difficult to control the money supply, the Korean monetary authori-
ties left the exchange rate pegged for over two years.
Between 1968 and 1974, a gradual depreciation of the won was allowed
by the government, mainly to offset a widening inflation-rate gap between
Korea and its major trading partners. In many cases the government used
108 Kwang Suk Kim

the method of periodic devaluation rather than allowing a clean floating

on the foreign exchange markets. Although most exporters were urging
more rapid depreciation, at least to maintain a PPP-adjusted exchange rate
constant at the 1965 level, the depreciation of the won proceeded more
slowly, mainly because of strong pressure from the huge business firms
that had borrowed heavily from abroad. The business firms with large for-
eign debts opposed devaluation because it would increase the won cost
of the foreign debt-service burden proportionately. These firms had become
an influential group opposing devaluation in Korea by the late 1960s.
After December 1974 Korea actually maintained a fixed exchange rate of
484 won to the dollar until the early 1980s, despite the gradual overvalua-
tion of the won and the resulting deterioration in the country’s balance of
payments. The delay in devaluing the currency in the late 1970s was partly
attributable to political instability, in addition to the usual opposition from
the business group with large foreign debts. The government of the late
President Park could not take the unpopular policy of devaluation in 1978
and 1979, although the need for some devaluation was well understood by
many policymakers.
Export-Promotion Measures
The Korean government employed various ad hoc measures to promote
exports, even before the exchange reform of 1964-65. The price competi-
tiveness of Korean exports was greatly enhanced after the devaluation in
1964, which was proportionally quite substantial. For that reason, the
government reduced the direct subsidy payments to exporters in 1964 and
abolished such payments beginning in 1965. The export-import link sys-
tem was also gradually eliminated except for a small number of unprofita-
ble export items. At the same time, however, the government not only
maintained many of the export-incentive measures that had been adopted
before 1964, but also introduced new schemes resulting in an overall in-
crease in export incentives after the exchange-rate reform.
Immediately following the announcement of the exchange-rate reform
in May 1964, the Ministry of Commerce and Industry (MCI) was asked to
prepare a comprehensive plan for export promotion, consistent with the
new exchange-rate system. The ministry drew up a list of export-promotion
incentives for discussion with the business community, as well as with other
government agencies. The MCT’s list included tax concessions, preferential
loans for exports, local letters of credit, wastage allowances, minimum ex-
port requirements for licensed traders, and government support for over-
seas marketing activities. In addition, the MCI recommended an increase
in the amount of preferential export credit per dollar value of exports to
match the increased need for domestic funds for exports under the new,
realistic exchange rate. The MC's list also included some new recommen-
 The 1964-65 Exchange Rate Reform 109

dations, such as subsidies for export firms suffering losses, assigning

commercial attaches to Korean embassies abroad, sending other export pro-
motion teams abroad, and removing restrictions on foreign travel related
to the export business. The additional recommendations were formally
adopted by the government in 1964-65, although the incentive effects of
those measures appear not to have been as important as those discussed
below.
Tax concessions. The 50 percent reduction in income tax on earnings from
exports and other foreign-exchange earning activities was continued in
1964-66, as was the exemption of domestic indirect taxes on export products
and intermediate inputs into export production. Accelerated depreciation
was allowed in 1966 for export industries. The government extended the
scope of tariff exemptions to the import of machinery and equipment for
export industries in 1966, in addition to the tariff exemptions on imports
of raw materials for exports (which had been granted since 1959).
Preferential loans for exports. The preferential interest rate on export loans
was further reduced from 8 percent per annum to 6.5 percent in early 1965.
Because the interest-rate reform of 1965 sharply raised the interest rate on
ordinary bank loans from 16 percent per annum to 26 percent, while leav-
ing the preferential rate on export credit unchanged, the subsidies implicit
in the preferential loans for exports increased greatly beginning in 1965.
These preferential loans were mostly financed by the rediscount of export
bills at the central bank.
Local letter of credit and standby credit. Two credit systems to support ex-
port industries were put into effect in 1965 through a revision of the foreign
exchange control regulation. Under the local letter of credit system, an ex-
porter who had received an export letter of credit from a foreign buyer could
issue a “local letter of credit” to the domestic producers of export products
and raw materials for export on the basis of the export letter of credit. The
local letter of credit issued by the domestic exporter was to be settled by
foreign exchange certificates when the export shipment was made. That
indicates that all production activities supported by the local letter of credit
could be subject to preferential export credit, and to the tax and tariff con-
cessions usually granted to export activities. The system was, in fact, meant
to encourage the use of domestic raw materials for export production. At
the same time, the standby credit system was intended to assist in the over-
seas marketing activities of Korean exporters. Standby credit, a type of clean
letter of credit, was normally issued by the Bank of Korea for an exporter
on the basis of a foreign exchange payment guarantee from any foreign ex-
change bank. The credit could be used as guarantee money for the over-
seas branch's opening of an export letter of credit to the head company and
for other contracts related to foreign exchange earning activities.
110 Kwang Suk Kim

Wastage allowances. Beginning in 1965, the government formally in-

troduced a system of wastage allowances on raw materials imported for the
manufacture of exports. The system allowed for technical and other han-
dling losses of imported raw materials, in addition to the actual require-
ments for export production. The ratios of wastage allowances to total
imports, which varied by type of export commodity, were determined by
the MCI on the basis of technologically set requirements. However, because
neither tariffs nor indirect taxes were levied on imports of such raw materi-
als, those exporters who were able to conserve on raw materials could
greatly profit by using them for production for the home market or by sell-
ing them in the market. In fact, the government gave generous wastage
allowances to exporters in the latter half of the 1960s to increase export in-
centives.
Minimum export requirement to maintain the status of licensed trader. The
minimum export requirement for licensed traders, established in 1962, was
continued simply by gradually increasing the minimum export performance
from US $30,000 in 1964 to $100,000 by late 1966.

Government support for overseas marketing activities. The government in-

tensified its support for overseas marketing activities of Korean exporters
through the expansion of the overseas network of the Korea Trade Promo-
tion Corporation (KOTRA) beginning in 1964.
From this summary, it becomes clear that the system of export incen-
tives was well established by the end of 1965, with some minor exceptions.
The system that remained in effect into the early 1980s was generally es-
tablished by 1965. Although some modifications to the system have been
made since then, they were mainly to accommodate changing economic
conditions in Korea. Probably one exception was the scheme of discounted
prices for such overhead inputs as electricity and railway transport, which
was authorized for bulky mineral and other exports during the late 1960s
and the first half of the 1970s. The value of overhead price reduction was,
however, quite small in relative terms.
The government abolished direct tax reduction on income earned from
export and other foreign exchange earning activities effective from 1973,
partly because of pressure from such international organizations as the
General Agreement on Tariffs and Trade (GATT) and the IMF and partly
because such a measure was no longer required for export promotion. The
government did, however, provide some tax concessions to facilitate the
overseas activities of Korean exporters in the same year. In 1975 the system
of outright tariff exemptions on imports of raw materials for exports was
changed to a drawback system, under which exporters were, in principle,
required to pay tariffs on imports but refunded the payments when exports
were actually shipped out. This drawback system was intended primarily
 The 1964-65 Exchange Rate Reform 111

to improve tariff administration because the annual volume of such imports

for the manufacture of export commodities had, by the mid-1970s, increased
substantially.
Turning to the implementation aspect of the measures, it should be em-
phasized that each of the export-promotion measures was actually im-
plemented to meet its purpose and was applied indiscriminately to all
exporters who could satisfy the criteria specified in the regulations. In other
words, the government agencies did not, in general, have much discretion-
ary power in the implementation of export-promotion measures. For in-
stance, preferential export credit could be obtained by any exporter who
could present to a foreign exchange bank an export letter of credit from
foreign importers. It seems that this aspect of the export-promotion meas-
ures has been very important in increasing exports since the mid-1960s.
Finally, in the formulation and implementation of Korea's export-
promotion policies, we should not overlook the important role played by
the export-targeting system and the Monthly Export Promotion Conference.
The export-targeting system in early 1962 was originally used to set the an-
nual target of total commodity exports. But by the latter half of the 1960s,
the export-targeting system was well instituted in the government as a regu-
lar instrument of export promotion. The annual export target was broken
down by major commodity group and by destination (major countries and
regions). The target was usually established in the early part of each year
by accepting the MCI’s export projections, which were based on past per-
formance and the forecasts of related industrial associations for the year.
The targets by major commodity group were allocated to related industrial
associations, while the targets by destination were allocated to Korean em-
bassies in respective countries or regions for implementation. The MCI
maintained a “situation room” to monitor export performance, comparing
it with the annual targets, which were broken down by quarters. The sta-
tus of export performance was then reported to the Monthly Export Pro-
motion Conference, which was regularly attended by the president.
The Monthly Export Promotion Conference, initiated in early 1966, was
renamed the Monthly Trade Promotion Conference in the early 1970s to
avoid any friction with countries that were export competitors. The confer-
ence was usually attended by all cabinet members, heads of major finan-
cial institutions, business association leaders, and representatives of major
export firms. The people attending the conference were asked to give their
opinions on the MCTI’s report on the status of export performance and its
recommendations to solve any expected shortfall from the targets. Business-
men, in particular, were asked to present their problems, difficulties, and
opportunities. Government officials had to respond to businessmen’s criti-
cisms of past government performance and their recommendations for im-
provement in the presence of the president. In essence, the conference
served to disseminate the president's emphasis on export promotion and
112 Kwang Suk Kim

also contributed to quickly solving many problems encountered by export-

ers, particularly in the early stages of export expansion, through the final
decisions of the president. Most of the export-incentive measures described
above actually took their final form through deliberations of this conference.
Import-Liberalization Program
Although tariff barriers against imports were, in effect, increased by the
enforcement of special tariffs after the 1964 devaluation, nontariff trade bar-
riers were gradually lessened. The main instrument of import control, other
than tariffs, has been the semiannual trade program of the MCI. The pro-
gram usually classified and listed the commodity items by automatically
approved items, restricted items, and prohibited items until the first half
of 1967, although there were some additional classifications from time to
time (Table 5.2). The automatic approval items could be imported without
prior approval from the MCI or other ministries, whereas the import of re-
stricted items required prior approval from the government ministries. The
prohibited items were not, of course, eligible for import licenses. There was
a gradual lessening of import restriction by the semiannual trade program
between 1964 and 1967 (Table 5.2), as evidenced by the gradual increase

Table 5.2. Import restrictions by semiannual trade program: 1961-67

Automatic Import
approval Restricted permissible Prohibited Total
Period (A) (B) (C=A+B) (D) (E=C+D)
1961 I 1,546 oo 1,581 305 1,886
II 1,015 117 deg ey 305 1,487
1962 I 1,199 149 1,314 366 1,680
II Lous, 121 1,498 433 1,931
1963 I 776 713 1,489 442 1,931
I 109 924 1,033 414 1,447
1964 I u u 1,124 617 1,741
I u u 496 631 112%,
1965 I 1,447 1115 1,558 624 2,182
II 1,495 1385 1,633 620 2253
1966 I 2,104 1365 2,240 583 2,823
II 2,307 139 2,446 386 2,832
1967 I 2,950 132 3,082 362 3,444
Source: Kim and Westphal (1976:72, 89).
u—unavailable.
a. Includes the 309 items that could be imported only with export earnings.
b. Includes both the ‘’partially restricted’ and ‘‘restricted’’ items that were distinguished
in the trade programs for these periods.
 The 1964-65 Exchange Rate Reform = 113

in the number of automatic approval items as well as the decline in the

number of prohibited items.
In 1967 an important step was taken in the direction of import liberaliza-
tion. Between 1964 and 1967, Korea's foreign reserves accumulated rapidly
due to several factors: a rapid expansion of exports, an increase in foreign
exchange remittances from Korean workers in Vietnam and West Germany,
and the increased inflow of foreign capital (including cash loans), which
was strongly attracted by high interest rates in Korea. For those reasons,
the government initiated a program of import liberalization in the middle
of 1967.
An ad hoc working committee was created within the MCI in early July
1967 to prepare an import-liberalization program. The committee, which
consisted mainly of officials of division-chief level from related government
ministries, was chaired by a director-general level official from MCI. The
committee agreed to adopt a negative-list system for future trade control,
instead of the positive-list system that had been in use until that time. Un-
der the new system, the trade program listed only those commodity items
whose import was prohibited or restricted—implying that all items not listed
were automatic approval items.
The committee agreed that commodity items to be prohibited or restricted
would include: (1) items already under import restriction in accordance with
existing laws, (2) items hazardous to public health, (3) items considered
harmful to national security and public safety, (4) items deleterious to sound
public morals or violating social norms, and (5) items considered too luxu-
rious in proportion to the country’s current stage of economic growth. In
addition, the committee decided that the import items to be liberalized
would include: (1) items that had already been liberalized, (2) items on
which basic tariffs exceeded 50 percent, and (3) items with a ratio of domestic
wholesale price to c.i.f. import price exceeding 500 won to the dollar.
On the basis of those criteria, the committee examined each of the 30,000
commodity items classified in the 1963 edition of the United Nations Stan-
dard Industrial Trade Classification (SITC) Manual. The criteria could not,
however, be strictly observed due mainly to strong pressure from related
industrial associations and the government organizations dealing with the
problems of industrial development. The number of automatic approval
items was increased substantially by the import-liberalization program of
1967. The real effect of that program on domestic industries was, however,
considered very small because it did not liberalize items for which imports
were expected to increase rapidly. For this reason, the effect of the program
on imports was not very significant.
Table 5.3 compares the old and new programs in terms of the number
of commodity items by control category. The number of automatic approval
items for imports increased considerably with the adoption of the negative-
list system. For instance, more than half of the total 30,000 commodity items
114 Kwang Suk Kim

Table 5.3. Comparison of the old and new trade programs, by number of
export and import items and control category: 1967
Trade program New program
effective until effective from
1967
24, Die 25, 19672
July igs
Control
barbed category
teebated =a) Ae ee Oe ee July
eee, Alc Eee Vater Ee 2)
Export items
Prohibited 57 Yb |
Restricted 2,465
Automatic approval 610 26,956
Total 667 30,000
Import items
Prohibited 244 2,617
Restricted 92 10,255
Automatic approval 3,760 17,128
Total 4,096 30,000
Source: Kim and Westphal (1976:96).
a. The classification of commodity items is based on the highest digit classification given in
the 1963 edition of the United Nations Standard International Trade Classification (SITC) Man-
ual. This classification is roughly equivalent to the level of commodity classification used in
the old trade program.

classified in the SITC Manual could be considered automatic approval items,

because they were not listed in the new trade program. It is not, however,
actually possible to compare the numbers of restricted and prohibited items
in the new program with those in the old program, because under the old
system those items not listed in the trade program were the restricted or
prohibited items. In any case, we can say that the adoption of the negative-
list system in the second half of 1967 was an important mark of progress
toward import liberalization in Korea.
Together with the adoption of the negative-list system for nontariff im-
port restrictions, the government worked out a tariff-reform proposal in the
second half of 1967, which was to be effective from early 1968. The main
purpose of the tariff reform was to reduce the import tariff barriers in com-
pliance with the basic direction of trade liberalization. Ronald McKinnon,
who was invited to Korea to advise on the tariff reform, recommended that
a uniform tariff rate of 20 percent be applied across the board to most com-
modities, and an exceptionally high tariff rate of 90 percent be applied to
the limited number of industrial products that Korea wanted to protect as
infant industries and on other grounds (McKinnon 1967). Although some
initial work was done by the Ministry of Finance along the lines suggested
by McKinnon, the basic structure of the new tariff rates finally approved
by the National Assembly turned out to be not much different from the
original. This reflects the fact that the original reform proposal prepared
 The 1964-65 Exchange Rate Reform 115

by the ministry underwent many changes because of pressure from vari-

ous industrial associations and strong opposition from other ministries. The
tariff reform actually reduced the maximum rate from 250 to 150 percent
but raised the simple average of tariffs for a majority of the commodity
groups classified by the two-digit Brussels Tariff Nomenclature (BTN) groups
(Kim and Westphal 1976:101).
Although the government had originally announced in mid-1967 that
it would continue to promote import liberalization, it was not able to in-
crease the rate of import liberalization after the first half of 1968, measured
in terms of the ratio of automatic approval items to total tradable commodi-
ties (Table 5.4). As the balance of payments situation deteriorated due to
accelerating domestic inflation and to an increase in foreign debt service
burdens beginning in that year, the government generally tightened im-
port controls. For that reason, the rate of import liberalization showed a
declining trend from 62 percent in the first half of 1968 to 49 percent by
the second half of 1975. The rate of import liberalization gradually increased
thereafter, but it was still around 69 percent in 1980. Although the rate in-
creased to 77 and 80 percent in 1982 and 1983, respectively, it seems that
these increases were partly attributable to the change in the system of com-
modity classification (Table 5.4).
Similarly, the government was not able to make much progress in effec-
tively reducing the level of tariff protection on domestic industries after 1967,
although tariff reforms have taken place a few times since then. At the time
of the 1973 tariff reform, the government abolished the special tariffs that
had been imposed on top of the regular tariffs since 1964. The government
reduced the tariff rates on 1,067 items, while increasing the rates on 440
items, thus resulting in a reduction of average tariff rates from 38.8 to 31.3
percent. A far-reaching tariff reform, effective from early 1977, increased
the number of commodity items subject to the (approximately) 20 percent
tariff from 35.7 percent of total tradable items to 52.8 percent, while the num-
ber of high-tariff items was reduced (MOF, ROK, 1978:297-98). Despite these
reforms, the basic structure of tariffs remained a “cascade” type through-
out the period, because tariff rates generally escalated from a lowest level
on unprocessed raw materials to the highest level on consumer luxuries
until 1983. A new reform was undertaken to revise the tariffs effective from
1984.
THEORETICAL APPROPRIATENESS
It seems clear that the package of policy reform measures was undertaken
by the Korean government with the following basic objectives: (1) to unify
the exchange rate through a large devaluation and then to maintain a realistic
rate by floating on the foreign exchange market; (2) to adjust the system
of export incentives so as to make it consistent with the new exchange-rate
system; and finally, (3) to liberalize imports and thereby reduce various
Table 5.4. Import restrictions by semiannual trade program: 1967-83
ee .. ——_———_—__ nnn enn

Number of commodity items Rate of import

Automatic liberalization
approval Total (A/B)

1967 II 118 402 792 1312 60.4

1968 I 116 386 810 1312 61.7

II 71 479 756 312 57.6
1969 I 71 508 728 1,312 SPs)
II 7S) 514 723 sey v4 55.1
1970501 74 530 708 1,312 54.0
II 73 526 713 1312 54.3
197bat 73 524 715 1,342 54.5
I 73 518 721 1,312 55.0
107 Zeal 73 570 669 1312 51.0
II vis) O71 668 1312 50.9
Rye il 73 569 670 iow DLE
II 73 556 683 1,312 D2
1974 I 73 570 669 aBre5 51.0
II 73 574 665 1,312 50.7
1975 eel 71 592 649 112 49.5
II 66 602 644 1312 49.1
1976" 1 66 584 662 312 50.5
II 64 579 669 1,312 1D
Cyme il 63 580 669 S12 51.0
I 54 496 547 1,097 49.9
19731 50 458 589 1,097 53.7
I 424 673 1,097 61.3
1979 II 327 683 1,010 67.6
1980 II 312 693 1,010 68.6
1981 II 1,886 ey Ae) 7,465 74.7
1982 II 1,769 5,791 7,560 76.6
1983 II 1,482 6,078 7,560 80.4
Source: MCI, ROK (1967-83).
Note: The classification of import items is based on the four-digit SITC codes through the
first half of 1977, on the four-digit codes of the Customs Cooperation Council’s Nomencla-
ture (CCCN) from the second half of 1977 to the same period of 1980, and on the eight-digi
CCCN codes thereafter. i cee Abe,
 The 1964-65 Exchange Rate Reform 117

domestic distortions arising from high tariffs and quantitative restrictions.

As already suggested, the government attained the first two objectives to
a certain extent but was not quite successful in attaining the third one. This
indicates that the actual achievements of the policy measures did not in
fact reach the levels necessary to meet all the basic objectives of the meas-
ures. We are, however, attempting to examine the theoretical appropriate-
ness of the policy measures in terms of the intended objectives, rather than
in terms of actual achievements.
We will first consider whether or not it was theoretically appropriate for
Korea to shift its industrialization strategy from import substitution to ex-
port promotion in the early 1960s. The industrialization experiences of other
developing countries generally support the policy shift made by the Korean
government, particularly in view of that country’s small land size and limited
natural resources.
Many developing countries in the postwar period adopted a policy of
import substitution as an indusirialization strategy. In countries where this
policy was emphasized, the domestic production of manufactured goods
was protected by high tariffs, quantitative restrictions of imports, and other
controls. Exports were usually discouraged by an overvalued exchange rate,
the prevalence of inefficient industries, and the higher profitability of domes-
tic sales relative to exports. The countries that emphasized import substi-
tution made rapid progress in industrialization during the early stage of
easy import substitution when domestic production replaced the imports
of nondurable consumer goods and intermediate goods used in their
manufacture. Once the stage of easy import substitution was over, however,
the production of nondurable consumer goods and their inputs could not
be expanded rapidly because of the limited domestic market. These coun-
tries then turned to import substitution in durable consumer goods and
machinery and in the intermediate inputs used in their production. Because
the industries producing these types of goods are generally more capital-
and technology-intensive than the nondurable consumer goods industries,
and usually require high levels of output for efficient operation, many coun-
tries encountered difficulties in this stage because of the small size of the
domestic market and the technological and capital requirements of such
industries (Balassa and Associates 1982; Balassa 1971; Little, Scitovsky, and
Scott 1970).
By the early 1960s Korea had completed the stage of easy import substi-
tution and was faced with slow growth of output due to the limitations
of the domestic market. Instead of emphasizing further import substitu-
tion in durable consumer goods, machinery, and their intermediate inputs,
Korea started to promote the export of consumer goods and other light in-
dustry products that could be more efficiently produced by labor-intensive
methods. Because Korea had been one of the typical developing countries
following the path of import-substitution-oriented industrialization, it might
118 Kwang Suk Kim

have encountered the same difficulties experienced by other countries had

it pursued further import substitution in durable consumer goods and
machinery. Korea not only lacked economically important natural resources
but also faced shortages of capital and high-level technologies in the early
1960s. It was a poor country with only an abundant supply of relatively
well-educated labor. For this reason, the shift to an export-oriented strat-
egy in the early 1960s was an appropriate policy choice and led to the rapid
growth of the labor-intensive exports for which Korea had comparative ad-
vantages.
It is generally understood that export-oriented industrialization brings
economic efficiency and increased resource productivity to a small econ-
omy that could not be expected under a regime of import-substitution-
oriented industrialization. First, increased productivity of resources can
result from economies of scale in production, which can be realized by ex-
panding production for exports. If a small developing country pursues an
import-substitution-oriented policy, economies of large-scale production
cannot be expected, because the protected domestic market is usually lim-
ited, and inefficient domestic industries cannot expand their production
beyond that market. Second, increased efficiency and productivity of
resources may come about because export-oriented industries generally un-
dertake more rapid technological innovation for improving product qual-
ity to meet international standards, and usually face greater pressure to find
ways to lower costs than do firms producing for protected domestic mar-
kets. Finally, increased efficiency and productivity can be realized through
import liberalization and the increased availability of imports, which are
usually possible only in a country following an export-oriented strategy.
Once it is accepted that the shift to an export-oriented industrialization
strategy in the early 1960s was the right policy choice for Korea, the theo-
retical appropriateness of the package of policy measures can be dealt with
in terms of international trade theory. If a country is pursuing an export-
oriented strategy, a free-trade regime will provide an ideal or optimal situ-
ation, as conventional trade theory teaches us. An assumption in the static
theory of trade and development is that world prices of tradable commodi-
ties reflect the true opportunity costs of production of those commodities.
Thus the tariffs, import controls, and multiple exchange rates that distort
world-market prices are considered to result in economic inefficiencies and
loss of welfare for the country in question, as well as for the world. To
achieve external balance under this situation, a country has to maintain
a unified exchange rate at an equilibrium level so that the demand for and
supply of foreign exchange can be equated, without any price-distorting
policy.
There are only two exceptional cases where we may justify some diver-
gence between world-market prices and domestic prices. One is the case
of an infant industry requiring protection for a limited period of time. The
 The 1964-65 Exchange Rate Reform 119

other is the case of optimal tariffs that can improve the terms of trade for
the country imposing the tariffs. The latter case is, however, relevant only
for those products in which a country can enjoy some monopoly in world
trade and is applicable only on the assumption that there is no retaliation
by other countries.
This kind of free-trade situation does not actually exist in the real world.
Practically all national states use tariffs and other price-distorting measures
to protect their industries from imports and to attain an equilibrium in their
balance of payments, although the degree of price distortion from the norm
of world market prices may vary widely by country. We cannot, therefore,
expect that any country will, in the near future, dismantle all the price-
distorting measures that have been in use. Likewise, it is quite unrealistic
to expect that Korea will abolish all tariffs and nontariff barriers to trade
and maintain its external balance only on the basis of a unified exchange
rate. The theoretical appropriateness of the Korean reform package should
be considered in this perspective. That is, although the reform package could
not remove much of the price distortion that had existed prior to the re-
forms, it did represent an advance in the direction of removing various price-
distorting measures.
The exchange-rate reform of 1964-65 was able to eliminate the multiple
exchange rates that had existed prior to the reform and succeeded in unify-
ing the exchange rate, thereby reducing the deviations of exchange rates
from a unified equilibrium rate. The adjustment of export-promotion meas-
ures following the exchange-rate reform and the program of import liber-
alization were carried out for the purpose of reducing the divergence
between world prices and domestic prices resulting from various govern-
ment interventions.
Regarding the export promotion measures, it was thought that Korean
exporters deserved government subsidies even under the unified floating
exchange-rate system. The main reason was that they were new entrants
to the international markets and would not be well accepted there unless
they could trim their prices below quoted world prices—in addition to the
fact that many other countries were giving direct and indirect subsidies to
exporters. The subsidies implicit in the government promotion measures
for exports have therefore been gradually reduced since the mid-1960s.
EFFECTS OF THE POLICY MEASURES
The exchange-rate reform of 1964-65, the export-promotion measures, and
the import-liberalization program were designed and implemented as a
package over a four-year period. Because the three policy measures are all
interrelated, the effect of an individual reform or policy measure on the
economy cannot be easily isolated from that of the other individual meas-
ures. For this reason, we will consider the effects of the entire package of
policy measures on the economy rather than dealing with the measures
separately.
120 Kwang Suk Kim

Effects on Relative Incentives

A quantitative assessment of the effects of the policy package is attempted
here by making time-series estimates of three indicators of relative incen-
tives: (1) export subsidies per U.S. dollar export, (2) tariffs and tariff equiva-
lents per dollar import, and (3) effective exchange rates for exports and
imports.
Table 5.5 presents estimates of net and gross export subsidies per U.S.
dollar export for Korea during the period 1962-80. The net export subsi-
dies include direct cash subsidies, the export dollar premium, direct tax
reduction, and interest-rate preferences, whereas the gross export subsi-
dies include the exemptions of both domestic indirect taxes and tariffs on
top of the net export subsidies
The net export subsidies can be called genuine subsidies in the sense
that they directly affect the profitability of exporting. Since domestic in-
direct tax and tariff exemptions do not add to exporters’ revenues and do
not affect the profit rate on export sales, these are included not in the net
export subsidies but only in the gross subsidies. These indirect tax and tariff
exemptions, however, make domestic production for exports using exist-
ing capacity more attractive than production for domestic sales, because
they reduce production costs of exports below those for domestic markets.
In this sense, we suggest that the gross export subsidies give the level of
incentive to exporting, relative to selling domestically, while the net subsi-
dies indicate the level of export incentives compared with a free-trade situ-
ation (Westphal and Kim 1982).
The net and gross export subsidies per dollar of export are examined
in terms of their ratios to the official exchange rates. As shown in Table 5.5,
both the net and gross export subsidies per dollar accounted for a much
higher percentage of the official exchange rate in 1963-64 than in later years.
A major reason was that the export dollar premium was quite substantial
during 1963-64 because of the use of the export-import link system, whereas
the official exchange rate was still quite unrealistic. In 1965, the year in which
the exchange rate was completely adjusted by the reform, net export subsi-
dies per dollar dropped to 3.7 percent of the new official exchange rate but
gradually increased to around 6.4-74 percent of the exchange rate during
1966-71. After 1971, however, the ratio of net export subsidies to the ex-
change rate further declined to a range of 1.9-3.2 percent, owing to the
abolishment of direct tax reduction beginning in early 1973 and to the reduc-
tion of the gap in interest rates between preferential export credit and

4. Because of the lack of consistency in time-series data, it was not possible to estimate subsi-
dies implicit in excessive wastage allowances for export production, accelerated depreciation
allowances, discounts on the prices of overhead inputs, or the effect of the limited export-
import bank system in use after 1964. According to Westphal and Kim (1982), the subsidy
implicit in the wastage allowance alone was equivalent to 2.4 percent of total merchandise
exports in 1968, but subsidies resulting from other measures were much smaller in relative terms.
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122 Kwang Suk Kim

ordinary bank loans beginning in 1972. The gross export subsidies per dol-
lar showed a similar pattern of change over time, but maintained a much
greater percentage of the exchange rate than the case of net export subsi-
dies, implying that the relative incentive to export vis-a-vis domestic sales
was much greater than the net export incentives.
Table 5.6 shows the estimates of actual and legal tariffs and tariff equiva-
lents per dollar of imports for the period 1962-80. The actual tariffs and
tariff equivalents are much lower than the legal tariffs and tariff equiva-
lents, reflecting the fact that significant tariff exemptions were granted for
export and other purposes during the period. If we calculate the ratio of
these tariffs and tariff equivalents per dollar of imports to the official ex-
change rate, as in the case of export subsidies, the results are the average
actual and legal tariff rates weighted by the amount of imports. According
to the data (Table 5.6), the average actual tariff rate generally showed a grad-
ual decline from about 14-15 percent in 1963-64 to the 5-6 percent range
in the first half of the 1970s. The average legal tariff rate generally remained
over 20 percent until 1973, although there were a few exceptions. Begin-
ning in 1974, however, the legal tariff rate declined significantly, owing
mainly to the reduction to a zero rate of legal tariffs on oil imports which
had increased rapidly in nominal terms after the first world oil crisis
(1973-74). In any case, the actual and legal tariff rates do not really reflect
changes in the degree of domestic protection over time because they do
not include the impact of quantitative restrictions on imports. This is even
truer for the period after 1964 during which time the quantitative restric-
tions were significantly lessened compared with earlier years.
Despite the limitations in the estimated export subsidies per dollar of
export, and the estimated tariffs and tariff equivalents per dollar of import,
some of these estimates are used to derive the nominal effective exchange
rates for exports and imports, as shown in Table 5.7. In other words, the
net export subsidies per dollar were added to the official exchange rate to
obtain the nominal effective exchange rate for exports, while the actual tariffs
and tariff equivalents per dollar were added to obtain the effective rate for
imports. This implies that the effective exchange rate for exports gives an
index of net export incentives compared with a free-trade situation, whereas
the effective rate for imports gives an index of actual trade protection on
domestic industries. These estimates of nominal effective exchange rates
are then adjusted by a PPP index to correct for changes in domestic prices
and in the prices of Korea's major trading partners. The results are the PPP-
adjusted effective exchange rates for exports and imports shown in Table 5.7.
The PPP-adjusted (real) effective exchange rate for exports increased in
terms of the number of won per dollar between 1962 and 1964, indicating
that the exchange-rate reform of 1964-65 increased the net incentive to ex-
port. Another important point was that the exchange-rate reform substan-
tially reduced the gap between the official and the effective exchange rates
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 The 1964-65 Exchange Rate Reform 125

by largely replacing the market premium on foreign exchange earned by

exporting with the official devaluation of the won. The reform, therefore,
stabilized export incentives by superseding the ad hoc administrative meas-
ures that had been frequently changed by the government. The real effec-
tive exchange rate for export, however, gradually declined in the latter half
of the 1960s mainly because the government failed to maintain the real offi-
cial rate constant in the face of domestic inflation. For this reason, the 1965
level of the real export rate could not be regained until 1972. Between 1972
and 1975, Korea was able to maintain a realistic real effective rate for ex-
port, despite a decline in net export subsidies during the period. That ac-
complishment was partly attributable to the readjustment of the dollar value
in relation to other major currencies that took place in 1972-73 and partly
to the more rapid adjustment of the exchange rate in Korea during the pe-
riod. In the second half of the 1970s, some overvaluation of the won was
again allowed by the government.
The real effective exchange rate for imports, which was also increased
by the exchange-rate reform, generally moved in parallel with the export
rate between 1965 and 1980, although the former was slightly higher than
the latter throughout the period. That indicates that the real effective rate
for imports could have been somewhat unrealistic in the second half of the
1960s and again during the same period of the 1970s, as in the case of the
export rate.
In summary, the package of reform measures that was undertaken dur-
ing 1964-67 did bring about some increases in the measurable incentive
to export, as well as in the level of protection for domestic industry. What
was more important than these increases was that the reform package
replaced a complicated, largely ad hoc system of export incentives based
on multiple exchange rates and direct cash subsidies with a simplified and
more stable system. The reform package may therefore be credited with
having laid the foundation for continued rapid growth of exports by en-
suring more stable profit margins for exporters than in the past (Westphal
and Kim 1977:120). The government could not, however, completely suc-
ceed in maintaining the stable levels of incentives to export and import sub-
stitution after 1965, as evidenced by the won overvaluation in the latter half
of both the 1960s and 1970s.
Effects on Export Growth and the Balance of Payments
The package of policy reforms discussed above should have had a great
impact on Korea's export growth and balance of payments. In fact, Korea's
rapid export growth began in the early 1960s starting from a very small base.
Between 1960 and 1965 the nominal value of commodity exports increased
by an average annual rate of about 40 percent from US $33 million to $175
million. Even after 1965 the rapid rate of export growth continued despite
the expansion of the base figures, thanks to the effect of the reform package.
126 Kwang Suk Kim

During the following 15 years, the nominal value of exports grew by about
35 percent annually to reach approximately $17.5 billion, or 35 percent of
nominal GNP, by 1980. The total value of exports for 1980 was roughly
equivalent to 1 percent of world exports.
The rapid growth of exports was accompanied by a substantial change
in the commodity composition of exports. Korean exports in the early 1960s
were mostly primary products, such as tungsten, iron ore, raw silk, agar-
agar, and fish. Manufactured exports accounted for a small fraction of total
exports in the early 1960s but increased more rapidly than the exports of
primary products thereafter. Manufactured goods—principally clothing,
electrical machinery, textile yarns and fabrics, footwear, transport equip-
ment (mainly ships), iron and steel sheets, and plywood—accounted for
about 90 percent of total exports by 1980. Accompanying this structural
change in export commodities was significant diversification of export mar-
kets. In 1965 about 60 percent of Korean exports went to two countries—
the United States and Japan. By 1980 the percentage declined to about 44
percent as sales to the Middle East, Europe, and other areas outside Asia
expanded. The diversifiction of export markets can also be shown by the
number of countries to which Korea exported: 163 countries in 1980, com-
pared with only 24 countries in 1965 (BOK, Economic Statistics Yearbook,
1960-80).
The reform package of 1964-67 also brought about a rapid increase in
imports, although the direct impact of the import-liberalization program
was relatively small. The nominal values of commodity imports, which had
remained almost constant during the period 1953-60, increased by an aver-
age annual rate of 6 percent during the following five years, despite a gradual
reduction in foreign assistance. Between 1965 and 1980 the nominal value
of imports increased at an average annual rate of about 30 percent to reach
US $21.6 billion by 1980. Thus the ratio of imports to GNP rose from about
15 to 39 percent during the same period. The increase in imports directly
caused by the import-liberalization program of 1967 was estimated by the
MCI to have amounted to only US $27 million in the final five months of
1967 and $68 million in 1968, therefore, most of the import growth cannot
be explained by import liberalization alone. The rapid growth of imports
depended upon several other factors as well.
First, the rapid expansion of exports during 1965-80 not only increased
the availability of foreign exchange for imports but also necessitated a cor-
responding increase of imports for export production. Second, external
finance, such as foreign loans, direct investment, and properties and claims
funds from Japan, increased continuously during the same period, more
than offsetting the decline in U.S. assistance. Third, the world-market prices
of important resources, including crude oil, increased rapidly in the 1970s
and the early 1980s. Fourth, the rapid export-oriented industrialization and
growth created an ever-increasing real demand for imports. Finally, it should
 The 1964-65 Exchange Rate Reform 127

be emphasized that the won was overvalued from time to time due to the
more rapid rise in domestic prices than in the prices of Korea's major trad-
ing partners.
Because the rapid growth of exports was matched by growth in imports,
Korea could not significantly improve its trade balance during 1965-80. The
trade deficits actually increased in absolute level between 1965 and 1980,
although there were some fluctuations in the interim years (Table 5.8). The
net balance on goods and services in the country’s balance of payments
also showed a similar trend during the period. The current balance in the
balance-of-payments account, which is equivalent to the net balance in
goods and services plus net transfer receipts from abroad, also showed a
deficit in most of the years under observation, implying that Korea's exter-
nal debts should have accumulated to a considerable magnitude by 19805
To explain some basic causes of these continuous balance-of-payments
deficits, an attempt was made to correlate the current balance with both
the PPP-adjusted official exchange rate and the index of net barter terms
of trade for Korea (Figure 5.1). The figure presents the ratio of the current
balance to total imports of goods and services, so that the relative magni-
tudes (rather than absolute levels) of the current-account deficits can be
shown for respective years. The real exchange rate is shown in an index
with the base year 1965 equal to 100, as in the case of the terms of trade
index.
What we can observe from Figure 5.1 is that the relative size of the cur-
rent balance is generally positively correlated with the index of the PPP-
adjusted official exchange rate (measured in terms of won to the U.S. dol-
lar), except for a few years (1974-75 and 1980) during which the terms of
trade index for Korea declined sharply because of the world oil shocks. That
observation seems to indicate that Korea could have avoided the continu-
ous large deficits in its current balance, had it maintained the 1965 level
of the real exchange rate unchanged throughout the whole period 1965 to
1980. Maintaining the real exchange rate at the 1965 constant level, however,
was made difficult by Korea’s high rate of domestic inflation as compared
to that in major industrialized countries throughout the period. It is sug-
gested therefore that domestic demand management, which allowed high
inflation in the economy during the period, was ultimately responsible for
the chronic deficits in the balance of payments.
Effects on Industrialization
The package of policy reforms had a significant impact on the pattern and
sources of industrialization in Korea. Because the reform package resulted

5. Korea's foreign debt outstanding actually increased to US $37.3 billion by the end of 1982
and to approximately $40 billion by the end of 1983.
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130 Kwang Suk Kim

in rapid growth of manufactured exports as described above, value added

in the manufacturing sector grew very rapidly after the early 1960s. For in-
stance, the growth rate of the manufacturing sector, which had averaged
about 11 percent annually during 1953-62, accelerated to 16 percent in the
following two decades. Although the growth rate of GNP also accelerated
from 3.6 percent during the earlier period to 8.4 percent during the later
period, the share of the manufacturing sector in GNP more than doubled
from about 14 percent in the early 1960s to 29 percent by 1980.
This rapid growth of manufacturing was accompanied by a consider-
able structural change within the same sector. The light industries, mainly
food processing and textile industries, which had accounted for 70 percent
of total value added in manufacturing until 1963, gradually declined to 47
percent by 1980. During the same period, however, the share of heavy and
chemical industries in total manufacturing value added rose rapidly from
30 to 53 percent.
How did the major sources of industrialization shift because of the re-
form package undertaken in the mid-1960s? To deal with this question, we
compare the sources of growth of manufacturing output between the two
periods, 1955-63 and 1963-75, on the basis of the author’s previous work
(Kim and Roemer 1979:99-124; Mason et al. 1980:149-54). In contrast to the
usual method of decomposing the sources of growth in terms of changes
in the amount and productivity of broadly defined primary factors, the
sources of manufacturing output growth are analyzed here in terms of the
relative contributions of domestic demand expansion, export expansion,
import substitution, and technological change to the output growth’
The analysis of the sources of industrialization is based on the input-
output tables for 1955, 1963, 1970, and 1975, which have been consistently
deflated into 1968 constant world prices to eliminate the effects of domes-
tic price distortions arising from tariffs, domestic indirect taxes, and quan-
titative restrictions on imports. The tables were also adjusted to make them
consistent for comparison. The sources of industrial growth were decom-
posed for three time intervals (1955-63, 1963-70, and 1970-75), and then the
results for the last two periods were linked to give a single estimate for the
period from 1963 to 1975. Although the decompositions were made for the
whole economy, including the primary and the social overhead and ser-
vices sectors, only the result for manufacturing is summarized in Table 5.9.
It should also be noted that the table presents both direct and total meas-
ures of the sources of growth; the difference should be taken to reflect the
backward linkage effects of direct change in various autonomous factors
on the expansion of output.

6. The analysis of sources of industrial growth was made by using the Syrquin method (Syr-
quin 1976), which is a modification to the pioneering work of Chenery, Shishido, and Watanabe
(1962). This approach essentially starts from the basic demand-supply balance and attributes
change in the structure of production to various demand factors.
 The 1964-65 Exchange Rate Reform 131

Table 5.9. Sources of manufacturing output growth: 1955-63 and 1963-75 (%)
Sources of growth 1955-63 1963-75
Domestic demand expansion
Direct 68.3 Z Aah
Total Diao D1D
Export expansion
Direct 6.1 24.7
Total 8.7 38.8
Import substitution
Direct 25.6 4,2
Total 34.9 7.0
Technological change
Direct
Total -1.5 pT
Total output increase 100.0 100.0
Total output increase in billion won 241.2 3, 283-3
Source: Mason et al. (1980:152-53).
Note: By Syrquin’s method—first difference (Syrquin 1976).
The relative sizes of both the direct and total contributions of various
autonomous factors to total manufacturing output growth varied consider-
ably from 1955-63 to 1963-75 (Table 5.9). The direct contribution of export
expansion (EE), for instance, was about 6 percent of total manufacturing
output growth in the earlier period, but it increased to 25 percent in the
later period, while the direct contribution of import substitution (IS)
declined from 26 to 4 percent between the two periods. Similarly, the total
contribution of EE increased sharply from around 9 percent in 1955-63 to
39 percent during the later period, while the total IS contribution declined
from 38 to 7 percent. The direct contribution of domestic demand expan-
sion (DDE) increased between the two periods, while the total contribu-
tion (including indirect effects) of the same factor showed a decline. The
contribution of technological change (TC), or more specifically changes in
input-output coefficients, showed a small increase during the later period.
This indicates that the growth of manufacturing output was mainly at-
tributable to DDE and IS in the early period and to DDE and EE in the
later period. DDE was the most important factor for the growth of manufac-
turing output in both periods, as would usually be expected. Trade effects,
however, shifted significantly between the two periods. These results sup-
port the conclusion that import substitution was much more important to
Korea's industrialization during the period 1955-63 than was export growth,
but that situation reversed itself during the later period. This conclusion
partially corroborates the hypothesis that the reform package of the
mid-1960s was quite effective in altering the pattern of industrialization in
Korea.
132. Kwang Suk Kim

CRITICISM AND LESSONS

The objectives of the reform package could not all be accomplished owing
partly to the unsatisfactory implementation of the policy measures by the
government and partly to changes in the economic environment after the
initiation of the policy measures. For instance, the government was able
to succeed in completely unifying the exchange rate but was not quite able
to maintain the realistic 1965 level of the PPP-adjusted exchange rate after
the exchange rate unification in 1965. We can say that the government suc-
ceeded in almost completely institutionalizing the system of export incen-
tives, consistent with the new exchange rate and the export-oriented
industrialization strategy. With regard to the import-liberalization program,
however, no significant progress could be observed after the initiation of
that program in 1967. It seems that this failure to make progress in import
liberalization was at least partially attributable to the unsatisfactory perfor-
mance of exchange-rate management by the government.
The limited success in the implementation of the reform package is re-
flected in the effects of that package on the economy. The reform package,
on the whole, greatly increased the relative incentive to export vis-a-vis
domestic sales, although the level of net export incentives compared with
a free-trade situation was relatively low and was gradually reduced after
the reform. As a result, commodity exports continued to increase rapidly
in the late 1960s and 1970s, thereby making possible a rapid industrializa-
tion and growth of GNP during that period. The reform package was also
effective in changing the pattern of industrialization in Korea. That is, it
made the major sources of manufacturing output growth shift from domes-
tic demand expansion and import substitution to domestic demand expan-
sion and export expansion. Despite the rapid growth of exports and the
rapid progress in industrialization, however, Korea could not significantly
improve her balance of payments following the reform package. The main
reason is that imports also expanded very rapidly after the reform meas-
ures, not because of progress in import liberalization but for other reasons.
Although one can give many reasons why the imports expanded so rapid-
ly as to cause a chronic deficit in the trade balance, the overvaluation of
the won from time to time was certainly a major factor.
The first lesson we can draw from the Korean experience seems rather
obvious. That is, it is critical to maintain a realistic effective exchange rate
if a country is to achieve rapid export growth and an external balance simul-
taneously. Korea was able to achieve a rapid growth of exports by increas-
ing direct and indirect subsidies to exports whenever the exchange rate
became unrealistic, because of the higher inflation in Korea than in its major
trading partners, but failed to attain an equilibrium in its balance of pay-
ments. Consequently Korea's external debts accumulated to a high of US
$40 billion by the end of 1983, equivalent to nearly 50 percent of GNP. If
Korea had maintained the 1965 level of the PPP-adjusted exchange rate
 The 1964-65 Exchange Rate Reform 133

through the 1970s, the country could have avoided the chronic deficits in
its current balance on external transactions.
The second lesson is that although maintaining a realistic exchange rate
is as critical as suggested above, it is not easy to succeed in the face of chronic
high domestic inflation. Because devaluation usually raises the relative
prices of imports, it causes a further increase in the rate of domestic infla-
tion. For this reason, policymakers tend to delay devaluation for fear of its
effects on domestic price levels. Once they have started to delay, the Korean
experience indicates that it becomes more difficult to change the exchange
rate because the margin of change would be much greater than the adjust-
ment originally avoided. The adjustment then waits until the adverse ef-
fects of the currency overvaluation become intolerable in light of the
country’s balance of payments. I would therefore suggest that domestic price
stabilization is very important in maintaining a realistic effective exchange
rate.
The third lesson is that in the early stage of export promotion by a de-
veloping country, a big push by the government may be helpful for export
expansion since products of new entrants into the world market are not
well accepted and have to be offered at prices lower than prevailing world
prices. The level of net export incentives, however, should be gradually
reduced so that domestic industry becomes efficient and able to compete
with foreign industries without much government support. Because the
continuous expansion of exports and national product depends upon the
development of efficient and competitive domestic industry, technological
innovations should be promoted to enhance industrial productivity, mainly
by means of gradual reductions in protection and government subsidies
after a certain stage.
Fourth, the Korean experience suggests that it is a difficult task for a small,
open developing country to attain its internal and external balances simul-
taneously. When world market conditions are favorable for Korean exports,
Korea's external balance may be improved by the rapid expansion of ex-
ports. This improvement, however, causes rapid expansion of the money
supply from the foreign-exchange sector, thereby creating a new problem
in the country’s demand management. During a period of recession in ad-
vanced industrial countries, however, the country experiences a recession
and a deterioration in its balance of payments, caused not only by a decline
in foreign demand for the country’s exports but also by the contraction of
liquidity by the foreign sector. The small, open developing country is also
vulnerable to external shocks, as shown by the experience of Korea during
the two worldwide oil shocks (1974-75 and 1979-80). In those circumstances
the effects of external disturbances on the balance of payments could be
reduced if the country had adopted a fluctuating exchange rate. But then
the country’s policymakers lose their ability to control domestic prices by
means of fiscal and monetary policy. Any small developing country adopt-
134 Kwang Suk Kim

ing an export-oriented development strategy should, therefore, take into

account the problem of increasing vulnerability to external disturbances and
prepare appropriate countermeasures.
Finally, it is suggested that devaluation becomes increasingly difficult
to undertake as a country’s external debts increase. Development theory
suggests that the introduction of foreign capital is desirable for a capital-
scarce developing country with a relatively high rate of return on capital.
The inflow of foreign capital then augments the shortage of domestic capi-
tal and contributes to an acceleration of economic growth rate in the coun-
try. Although this theory might be correct, we should not neglect the fact
that once the external debts accumulate to a substantial level, the govern-
ment may lose its ability to adjust the exchange rate freely when required
for attainment of an external equilibrium, because of strong pressure from
large business groups with foreign debts. There is a danger, when a coun-
try cannot devalue its currency to achieve an external balance, that exter-
nal debts may continuously increase to a level unmanageable by the
economy. It is therefore emphasized that a developing country should first
try to increase domestic saving before trying to borrow from abroad. In this
way, the level of foreign debt could be restricted to a manageable level to
retain the country’s ability to freely adjust its exchange rate.
 6 The Interest-Rate Reform of 1965
and Domestic Saving
by Kwang Suk Kim

During 1960-65 the level of gross domestic investment was less than 15 per-
cent of GNP, except in 1963 when it was 18.1 percent. Inasmuch as gross
domestic savings ranged only from 0.8 to 8.7 percent of GNP during that
period, the larger part of the gross domestic investment still had to be
financed by foreign grants and loans. Despite the low ratio of investment
to GNP, the growth rate of GNP started to accelerate in 1963. The average
annual growth rate of GNP during 1963-65 was about 8.2 percent, which
was more than double the 3.6 percent average annual growth rate of the
preceding nine years (1954-62). The high growth during 1963-65 seems to
have resulted from both increased utilization of existing industrial capacity
to meet rapidly increasing demand, and increased agricultural production
because of favorable weather conditions (ROK 1966:22).
To make up for the shortage of domestic capital and to activate the slug-
gish domestic economy, the government resorted to fiscal deficit financing
and monetary expansion in 1961-63. The result was a return to high infla-
tion after a period of price stability in 1958-60, which had been attained
by strong implementation of the financial stabilization program. A new
stabilization program had to be instituted in late 1963. The rate of price in-
flation measured by the national WPI declined from an annual average of
about 20 percent during 1960-64 to about 10 percent a year beginning in
1965. However, because Korea had experienced a long period of inflation,
a general expectation of price inflation still existed.
The economic environment that existed in 1965 was not favorable for the
country’s financial development. Korea's organized financial market as of
1965 consisted mainly of the central bank, five commercial banks, and four
special banks—the National Agricultural Cooperatives Federation (NACF),
the Medium Industry Bank, the Korea Development Bank (KDB), and the
Citizens National Bank. Each of the commercial banks maintained a large
network of branches throughout the country, and offered not only check-
ing accounts but also various savings deposits with different terms. Spe-
cial banks, excluding the KDB, offered similar savings accounts. The general
public, however, avoided depositing their savings in these financial insti-
tutions; time and savings deposits did not increase in real terms between
1962 and September 1965, despite strong savings campaigns by both the
government and the financial institutions (Table 6.1 and Table 6.2).

135
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 The Interest-Rate Reform of 1965 and Domestic Saving 137

The deposit rates offered by the financial institutions were unfavorable

in the light of people's price expectations. Interest rates on bank deposits
and loans were maintained at low levels owing to the artificial ceiling rates
imposed by the monetary authorities (the Ministry of Finance and the cen-
tral bank). For many years during the period 1960-65, the highest bank
deposit rate (equal to a ceiling rate) was actually negative in real terms, if
the annual rate of inflation is taken into account. It was natural, therefore,
to expect that demand for loans from the financial institutions would chron-
ically exceed the supply of loanable funds generated by deposits into the
financial institutions. The government or the monetary authorities had to
intervene directly in the allocation of scarce loanable funds, because the
rate of interest could not bring about an equilibrium in the financial mar-
ket. Although the government well understood the need to increase sav-
ing through financial institutions, it was more concerned about the negative
effect of high interest rates on investment and, as a result, was slow in mov-
ing toward raising the interest rates on bank deposits and loans.
Under such conditions, investment in equities would be attractive to in-
dividual savers. There was, however, little opportunity for average individual
savers to invest in such equities in an economy where the predominant
form of enterprise was a closely held or family corporation. As of 1965 the
stocks of only 17 corporations were listed in the Korea Stock Exchange, and
most of these stocks were actually issued by public corporations. It is not
surprising that the lack of financial investment opportunities resulted in
reduced personal savings and the use of savings for real estate speculation
and for lending out in the unorganized financial markets that operated out-
side the domain of the monetary authorities’ regulations.
The unregulated or unorganized financial markets flourished notoriously
in Korea during 1960-65. One estimate put outstanding assets and liabili-
ties in the unorganized markets on the order of 40-45 billion won in 1964
(Gurley, Patrick, and Shaw 1965:81). That figure was equivalent to almost
one-quarter of private-sector liabilities in primary securities and one-third
of the private sector’s portfolio assets in primary securities. The size of out-
standing assets and liabilities in the unorganized market ranged from 56
to 63 percent of total domestic credit at the end of 1964. Interest rates on
loans from the unorganized money markets varied widely, depending upon
the credit standing of borrowers and the amount of the loans involved. The
interest rate most frequently quoted in the unorganized market was about
48-60 percent per annum in 1964-65 (before the reform), whereas the
highest bank rates on time deposits and loans were only 15 and 16 per-
cent, respectively.
MAIN FEATURES OF THE REFORM
The Democratic Republican government that came into power in Decem-
ber 1963, succeeding the military government, started in early 1964 to
138 Kwang Suk Kim
e
a OE a e
Table 6.2. Trends in money supply, quasi-money loans of deposit-money
(in 10° won, unless otherwise stated)
pee ey es ee en ee

In current prices GNP

Money Quasi- Money Loans deflator>
End of | supply (M,) money supply (M2) of DMB? (1975=100)
year (A) (B) (C=A+B) (D) (E)
1962 39 13 52 43 11.6 (18.4)
1963 42 13 55 49 15.0. (29.3)
1964 49 15 64 ao 19.5 (30.0)
1965 66 31 97, 72 20:Firy(622)
1966 85 72 457 103 23.7 (145)
1967 123 131 254 178 27.4 (15.6)
1968 178 259 437 331 31.8 (16.1)
1969 252 453 705 563 36.5 (14.8)
1970 308 590 898 722 42.2 (15.6)
1971 358 ite 1,085 920 47.3 (12.1)
1972 519 933 1,452 1,198 54.7 (15.6)
1973 730 1,251 1,981 1,588 O19 (13.2)
1974 946 Lou 2,457 2,428 80.2 (29.6)
1975 1,182 1,968 3,150 2,906 100.0 (24.7)
1976 1,544 2,661 4,205 3,725 117.7 (7.4
1977 273 3,703 5,874 4,709 136.9 (16.3)
1978 2,714 5215 7,929 6,609 165.1 (20.6)
1979 3,279 6,604 9,878 8,978 197.0 (19.3)
1980 3,807 8,728 123535 12,204 247.9 (25.8)
Source: BOK, Economic Statistics Yearbook (1962-81).
a. Deposit-money banks (DMB) include all commercial and special banks except the Korean
Development Bank.
b. Figures in parentheses indicate annual percentage change in the GNP deflator.

promote various economic policy reforms for attaining the basic goal of
export-oriented industrialization and growth. The exchange-rate reform was
carried out in May 1964. The second target of the policy reform was to
change the structure of bank interest rates. Tax reform and trade liberaliza-
tion were on the agenda for future action.
To prepare for the interest-rate reform, the Korean government and the
Bank of Korea began, in early 1965, to study the complicated structure of
interest rates. At that time, interest rates in the organized financial market
were not only unrealistically low compared with the average market yield
on national bonds and interest rates in unorganized markets, but also
showed wide variation by source of funds and by lending institution. On
the basis of their study, the government prepared a reform proposal recom-
 The Interest-Rate Reform of 1965 and Domestic Saving 139

banks, and ceiling deposit rate, in both nominal and real values: 1962-80

In 1975 constant prices

Money Quasi- Money Tans Ceiling deposit rate (%)
supply (M,) money supply (M,) of DMB? Nominal Reald
(F=A/E) (G=B/E) (H=C/E) (I=D/E) (J) (K)
336 112 448 371 15.0 1.0
280 86 366 327 15.0 -3.4
201 Tf. 328 272 15.0 -14.3
319 149 468 348 18.8 als ey
359 303 662 435 30.0 23.8
448 478 927 650 30.8 15:5
560 814 1,374 1,040 27.6 12.0
690 1,241 1,931 1,542 23.8 Ded
729 1,398 Pyl27, 711 22.8 8.0
797 1,536 2,293 1,945 Papas 6.5
949 17705 2,654 2,190 15.8 3.7
Ly? 2,021 3,200 2700) 12.6 -3.0
1179 1,884 3,063 3,027 15:0 1.8
1,182 1,968 3,150 2,906 15.0 -14.6
1312 2,260 hey 3,165 1535 =o2
1,587 2,705 4,290 3,440 15.8 i)
1,644 3,158 4,802 4,003 16.5 0.2
1,662 3,302 5,014 4,557 18.6 2.0)
1,536 3,520 5,056 4,923 22.9 3.6
c. Average nominal rate for each year estimated, weighting by the number of months.
d. Column (J) minus the annual percentage increase in column (E) lagged one year.

mending that the high interest-rate strategy be implemented by the second

quarter of the same year. The actual implementation of the reform proposal
was delayed, however, until the end of September owing partly to some
opposition within the government and partly to the National Assembly’s
slow action in amending the Interest Rate Limitation Law, which prescribed
the upper ceiling on interest rates at 20 percent per annum. The National
Assembly amended the law on 14 September, raising the upper ceiling from
20 to 40 percent per annum. The interest-rate reform was finally announced
and put into effect on 30 September 1965. Cole and Park (1983:201) suggest
that the interest-rate reform was announced on that date because there was
a provision in the annual stabilization program for 1965, jointly agreed upon
by the Korean and American governments as the basis for the annual U.S.
aid program to Korea, that such reform would be implemented by the third
quarter of that year.
140 Kwang Suk Kim

It seems that the monetary authorities designed the high interest-rate

strategy for Korea mainly on the basis of the successful experience of Tai-
wan’s high interest-rate policy during 1950-58. The Bank of Korea had sent
its research staff to Taiwan in early 1965 to study the design, implementa-
tion, and results of Taiwan's high interest-rate policy. (For details on the
Taiwanese experience, see Irvine and Emery 1966.) In addition, recommen-
dations made by John Gurley, Hugh Patrick, and Edward Shaw—renowned
experts on money and finance—provided valuable guidance to Korean
policymakers. These American professors collaborated on a study of the
Korean financial system, commissioned by the USAID program. Recom-
mendations in their report of July 1965 covered a wide range of necessary
policy measures for improvement of the Korean financial system, includ-
ing the suggestion that the interest rates on both bank deposits and loans
be raised by removing artificial ceilings (Cole and Park 1983: 298-303). It
seems that the authors played an important role in the formulation of the
reform package, not only because they provided technical advice but also
because they were influential in persuading high-level government officials
and politicians who had been reluctant to accept the high interest-rate policy.
When the government announced the reform measure, the Korean busi-
ness sector, particularly large enterprises, expressed considerable displea-
sure. The reason for their complaints was the expected increase in the cost
of bank loans, and therefore that the high interest-rate strategy would lead
to a high rate of domestic inflation due to the cost-push effect of the higher
interest rates on the price level. Some business leaders also expressed con-
cern that the high interest rates might reduce domestic investment and con-
sequently result in a recession. The government responded with an
advertisement campaign for the reform. It seems, however, that the govern-
ment considered the complaints of large businesses when it raised the in-
terest rates on special bank loans financed from government funds in
October 1965.
The purpose of the reform was to sharply raise both deposit and loan
rates of financial institutions in order to attract private savings into the or-
ganized financial markets and at the same time to discourage bank loans
for unproductive purposes. The Monetary Board of Korea, a committee
within the central bank, announced that the ceiling rate on saving deposits
was being raised from 15 percent per annum to a high 30 percent, while
the ceiling rate on ordinary bank loans (unspecified short-term loans) was
being raised from 16 to 26 percent per annum (Table 6.3).
The Monetary Board set the maximum interest rate on savings deposits
at 2.5 percent per month so that each bank could adjust its deposit rates
by term structure within the ceiling rate. All banking institutions, however,
adopted a uniform schedule of deposit and loan rates (Table 6.3), by an
agreement of the Korean Bankers’ Association, thus avoiding severe inter-
bank competition. The reform measure not only sharply raised the interest
 The Interest-Rate Reform of 1965 and Domestic Saving 141

Table 6.3. Changes in principal interest rates of banking institutions as of

30 September 1965 (% per annum)

Interest rates Old rate New rate#

Rates on deposits
Time deposits
3 months maturity 9.0 18.0 (1.4)
6 months maturity 12.0 24.0 (1.8)
12 months maturity 15.0 26.4 (2.0)
18 months maturity 30.0 (2.2)
Notice deposits 3.65 5.0
Savings deposits 3.6 Tee
Installment savings deposits 10.0 30.0
Passbook deposits 1.8 1.8
Demand deposits 0.0 0.0
Rates on loans
Discount on commercial bills 14.0 24.0
Loans on other bills (unspecified) 15.0 26.0
Overdraft 18.5 26.0
Overdue loans 20.0 36.5
Call loans 12.0 22.0
Credits for exports and supply of goods to U.S.
armed forces 6.5 6.5
Source: BOK, Economic Statistics Yearbook (1967).
a. Indicates the actual rates agreed upon by the Korean Bankers Association. The rates given
in parentheses are the monthly interest rates corresponding to the annual rates indicated.
(No compounding of the monthly rate is formally permitted by financial institutions.)
b. In the case of unperformed export or supply of U.S. offshore procurement, the rate on
other bills is applied.

rate on time deposits but also set the interest rate on a monthly basis, fol-
lowing the general practice in unorganized money markets during the pe-
riod. That meant that, for time deposits, depositors could take interest
earnings at the end of each month. An automatic compounding of interest
earning by month was not permitted by the banking institutions, but depos-
itors could have the interest earning compounded monthly by contracting
to deposit it into installment savings accounts.
Interest rates on various types of bank loans were also raised after the
ceiling rate set by the monetary authorities was raised to 26 percent. But
one of the special features of the reform was that the ceiling loan rate was
set lower than the maximum deposit rate. The purpose of this “reverse mar-
gin” between the deposit and loan rates was, of course, to place emphasis
on increasing financial saving, while not raising the cost of loans so high
as to discourage sound business borrowing. To make up the possible
142 Kwang Suk Kim

reduction of bank earnings resulting from the reverse margin between the
deposit and loan rates, a new system of subsidizing deposit banks was in-
troduced. That system required the central bank to pay interest on the bank
reserves against time and savings deposits deposited at the central bank.
The interest rate that the central bank would pay on bank reserves was not
fixed, but was to be adjusted according to the size of reduction in bank
earnings: A higher rate of 36.5 percent was set, however, for overdue loans
to prevent loans from being overdue because of the deposit rate being higher
than the loan rate.
To determine how realistic the new interest rates on deposits and loans
were in the Korean context, it might be helpful to give some indications
of the market rate of interest and the rate of return on capital in the coun-
try. As already suggested, the interest rates in unorganized money mar-
kets generally ranged between 4 and 5 percent per month. This unorganized
market rate could not be accepted as the market rate of interest that would
bring about an equilibrium in the organized financial markets, because, as
Bottomley (1963:637-47) suggested, it included an additional premium for
risk. An average yield on national bonds floated in the market was around
1.9 to 2.0 percent in 1964 and during the first nine months of 1965. The
monthly yield on national bonds provided an important indicator of the
market rate of interest because it was generally determined by market de-
mand for and supply of such bonds without much intervention by the
monetary authorities. Therefore, even though the ceiling deposit rate of
2.5 percent per month was about half the interest rate in unorganized
money markets, it was much more attractive than the market yield on public
bonds.
As regards the bank loan rate, the government originally announced that
even if it were sharply raised to 26 percent, the average interest burden
of industries might not increase. The government announcement indicated
that if business borrowing from unorganized markets at a higher interest
rate were reduced by the increased supply of bank loans at an annual in-
terest rate of 26 percent, a weighted average interest burden on industries
might be unaffected or reduced in the long run. In any case, the new ceil-
ing loan rate was not considered too high to discourage business borrow-
ing from the financial institutions, in view of the rate of return on capital
in Korea, and also the lending rate in unorganized markets. A study of cap-
ital costs based on the survey of selected industrial establishments suggested
that an average annual rate of return in Korean manufacturing industries
was 13.5 percent in real terms in the mid-1960s (KEDI 1967:79). The Bank
of Korea's analysis, however, disclosed that the ratios of net profit to net
worth in Korean manufacturing in 1963 and 1964 were 19 and 15 percent,

1. This system of paying interest on reserves was originally suggested by Gurley, Patrick, and
Shaw (1965:30-36), as was the establishment of a stabilization account in the central bank as
a monetary control technique.
 The Interest-Rate Reform of 1965 and Domestic Saving 143

respectively. The same source also indicated that the ratio of payable in-
terest and net profit to gross capital was about 12 to 13 percent in 1963-64
(BOK, Economic Statistics Yearbook, 1966:210-11). Because of the general prac-
tice of statistical underreporting on profits during this period, however, it
was generally believed that the marginal product of capital in Korea was
as high as 20 percent in real terms2
There was no explicit aim to set the real rate of interest equal to the aver-
age rate of return on capital. The government, however, tended to com-
pare the implicit real rate of bank loans with the various indicators of capital
profitability, assuming an annual inflation rate of about 10 percent as in
1965. Inasmuch as the interest elasticity of investment demand was
unknown in Korea, the maximum loan rate that would not discourage in-
vestment could be found by such a comparison.
It must be made clear that the loan rates described above were to be ap-
plied only to loans from banking funds. Although rates on loans from
government funds were also raised, they were much lower than those for
bank funds. The rates on long-term, government-fund loans generally
ranged from 7.5 to 12.0 percent per annum depending upon the govern-
ment budgetary source, with the exception of long-term loans for irriga-
tion and housing, which ranged only from 3.5 to 4.0 percent per year. These
government-fund loans at lower interest rates were supplied mainly through
the KDB and the NACF for long-term investment in key industries and in
the agricultural sector.
Because the changes in interest rates on government-fund loans were
small, the interest-rate reform resulted in a widening of the gap between
the loan rate on banking funds and that on government funds. This was
a major point of criticism at the time of reform. The government, however,
argued that the preferential rate on loans from government funds was
needed to attract private investment in certain sectors or industries that the
government wanted to promote. Another argument was that the rate on
long-term loans should be based on a long-run expectation of interest-rate
movements. That argument shows that the Korean policymakers who had
designed the reform considered the high interest-rate strategy to be a tem-
porary measure to cope with the problems of low savings and high demand
for investable funds under inflationary conditions. The Korean policymak-
ers seemed to have thought that price stability could be attained in the near
future and that the interest rates would decline in the long run.
The interest rate on export credit was maintained at its pre-reform level
of 6.5 percent per annum (Table 6.3), thus widening the interest-rate gap
between export credit and other commercial loans. As a result, the lower

2. Brown (1973:203-06) attempted to estimate the real rate of return on capital in Korea using
national income account data for 1962-67. His results indicate that the real rate of return on
new investment was somewhat higher than 20 percent during that period.
rate on export credit further intensified incentives to exporters. This favorable
export credit was made available to all exporters who could present export
letters of credit as collateral. Despite the lower interest rate on their export
credit, it was quite profitable for the banking institutions that extended such
credit, because they could obtain financial resources through the central
bank’s rediscount of export bills at an annual interest rate of only 3.5 percent.
The interest-rate reform of 1965 was accompanied by a shift in monetary
control techniques from the previous reliance on a direct method to the
use of indirect instruments. Before the interest-rate reform, domestic credit
had been controlled by imposing ceilings on bank loans. During the re-
form these ceilings were removed, thereby allowing the banking institu-
tions to expand loans within the limits of their excess reserves. At the same
time, the Bank of Korea introduced the stabilization account proposed by
Gurley, Patrick, and Shaw (1965) and also decided to use the method of
forced sales of the central bank’s stabilization bonds to the financial insti-
tutions for the purpose of monetary control through manipulation of bank
reserves. These two instruments were to be used to complement the in-
strument of legal reserve requirements.
The interest-rate reform resulted in a rapid increase in bank savings
deposits beginning in the fourth quarter of 1965. Bank loans also expanded
rapidly as savings deposits increased, because the loan ceilings that had
been imposed by the government before the reform were completely
abolished. In addition, the inflow of foreign capital started to increase rap-
idly in 1966, partly because of the signing of a diplomatic normalization
agreement between Korea and Japan in 1965 and partly owing to the in-
creased differential between domestic and foreign interest rates. The sys-
tem of bank guarantees for the repayment of foreign loans, instituted in
1962, began to be actively used immediately after the interest-rate reform
as an instrument to facilitate borrowing from abroad by Korean enterprises?
In any case, the rapid increase in foreign capital inflow, together with the
continued expansion of Korean exports, caused a sudden jump in the
growth of foreign exchange reserves, thereby creating a new source of ex-
cessive monetary expansion. The main issue of the monetary policy was,
therefore, how to control excessive liquidity arising from the increased for-
eign capital inflow, as well as the expansion of domestic bank loans.
To control the money supply for price stabilization, the monetary author-
ities had to raise the legal reserve requirements for loans drastically in Febru-
ary 1966. Between October 1966 and March 1967 a high marginal reserve
requirement of 45-50 percent was imposed on incremental deposits on top

3. The system of bank guarantees for repayment of foreign loans might have increased the
interest rate differential between domestic and foreign loans by lowering interest rates on for-
eign loans more than would have been the case without such a system.
 The Interest-Rate Reform of 1965 and Domestic Saving 145

of the basic reserve requirements, which were 35 percent for demand

deposits, 20 percent for short-term savings deposits, and 15 percent for long-
term savings deposits. In addition to this method of increasing reserve re-
quirements, the Bank of Korea attempted to sterilize the excess reserves of
deposit-money banks by forcing the banks to purchase its stabilization bonds
and to deposit bank reserves in the central bank’s stabilization account. That
action indicates that the sharp increase in banks’ time and savings deposits
that was made possible by the higher interest rate was used largely for
sterilizing the excessive expansion of bank reserves coming mainly from
the explosive inflows of foreign capital, including cash loans. These develop-
ments contradicted the original purpose of the interest-rate reform.
Under the situation, the government could adopt one of three policies,
consistent with the basic goal of export-oriented industrialization and
growth. The first policy option was to restrict foreign capital inflows by
means of direct control or by the imposition of an interest-equalization tax
on imported foreign capital. This policy option was suggested by many
economists but was not accepted by the government, out of fear that such
action might shut off foreign finance, which had just begun to increase.
The second alternative was to increase imports through trade liberalization
so that foreign exchange reserves would not accumulate too rapidly. That
policy alternative could not be undertaken because of strong business pres-
sure to protect domestic industries. The third option was to accumulate for-
eign reserves, squeeze the supply of domestic credit, and gradually reduce
domestic interest rates, particularly bank deposit rates. The third option
was the one the government adopted. (These points are also discussed in
Cole and Park 1983:208-09.)
The high deposit and loan rates of banking institutions, which became
effective in September 1965, were maintained without change until April
1968, when the monetary authorities started gradually to reduce the bank
rates (Table 6.4). By June 1969 the maximum interest rates on deposits and
loans were reduced to 22.8 and 24 percent, respectively, thereby completely
eliminating the reverse margin between the deposit and loan rates that had
been hurting the profitability of financial institutions. The high interest-
rate strategy ended on 3 August 1972, when the government announced
the Presidential Emergency Decree for Stabilization and Growth, which in-
cluded a drastic reduction in interest rates of banking institutions among
other important policy measures. After the August 3rd measure of 1972,
the high interest-rate strategy was not adopted again except for a short pe-
riod in the early 1980s when the economy was under a high inflationary
condition due to a sharp rise in world oil prices and to a domestic excess
demand situation. Thus, the high interest-rate strategy was applied in Korea
for about seven years after its adoption in late 1965.
146 Kwang Suk Kim

Table 6.4. Changes in the ceiling deposit and loan interest rates of banking
institutions: 30 September 1965 to 28 June 1982 (% per annum)
ale SS a a ee 8 ee

Ceiling Ceiling

09/30/65 30.0 26.0

04/01/68 27.6 26.0
10/01/68 25.2 25.2 b
06/01/69 22.8 24.0
06/28/71 21.3 22.0
01/17/72 17.4 19.0
08/03/72 12.6 15.5
01/24/74 15.0 15.5
08/02/76 16.2 18.0
10/04/77 14.4 16.0
06/13/78 18.6 19.0
01/12/80 24.0 25.0
09/16/80 21.9 22.0
11/08/80 19.5 20.0
11/09/81 18.6 19.0
11/30/81 17.4 18.0
12/29/81 16.2 17.0
01/14/82 15.0 16.0
03/29/82 12.6 14.0
06/28/82 8.0 10.0

Source: BOK, Economic Statistics Yearbook (1965-83).

a. Indicates short-term rate on ordinary loans (loans on other bills) for other than ‘superior
enterprises.’’ Local banks, however, could charge a slightly higher rate than the rate reported
here.
b. End of reverse margin.

THEORETICAL APPROPRIATENESS OF THE REFORM

The primary objective of the 1965 reform was to increase private saving
through financial institutions, and the secondary objective was to enhance
the role of interest rates in resource allocation and monetary control. Here
I consider only the theoretical appropriateness of the reform in relation to
its primary objective. The theoretical appropriateness is expected to be more
controversial in relation to the primary objective than to the secondary ob-
jective.
As previously stated, financial saving in the form of bank deposits were
not increasing in real terms during the first half of the 1960s, but the de-
mand for such saving was growing rapidly for financing domestic invest-
ment. The most probable reason for the sluggish growth of financial saving
during that period was the low real interest rates offered by financial insti-_
 The Interest-Rate Reform of 1965 and Domestic Saving 147

tutions, which were, in fact, negative in some years when the annual rate
of inflation was taken into account. In that respect, the interest-rate reform
of 1965 was an appropriate policy choice of the government for an increase
in financial saving.
It is generally believed that economic development is accompanied by
rapid growth of financial assets, because the financing of economic develop-
ment in a market economy necessitates the accumulation of debt and finan-
cial assets, as explained by Gurley and Shaw (1956:257-76; 1955:515-38;
1967:257-68). The process of financing economic development through the
accumulation of debt and financial assets is generally divided into two
types—direct finance and indirect finance. In the mid-1960s, when the
interest-rate reform was undertaken, the technique of direct finance was
still underdeveloped in Korea. Indirect finance, therefore, played a far greater
role in mobilizing savings and directing them to productive investment in
Korea than it did in developed countries where the technique of direct
finance was well developed.
In economies where the capital markets are highly developed, saving
deposits in banking institutions is only one of the saving instruments avail-
able to individuals. An increase in the bank savings deposits may there-
fore represent only a shift between savings deposits and other financial
assets. In that case, raising the interest rate on bank time deposits may not
contribute to increasing financial saving even if the higher interest rate brings
about an increase in bank savings deposits. The situation of Korea in 1965,
however, was quite different from that of developed countries. In Korea,
where the bond and equities market was still underdeveloped, financial
saving through banking institutions was the most important savings in-
strument available to the majority of the population, if savings through un-
organized money markets were excluded. Life insurance and postal savings
could be important in attracting small savers, although savings through such
nonbank financial intermediaries had been relatively small until 1965. The
interest rates applied in such savings schemes were usually adjusted in
response to the change in the bank interest rates, without much time lag.
The rate adjustments indicate that a sharp increase in bank deposit rates,
which could increase savings deposits, may contribute to increasing the
flow of savings into the organized financial market of Korea. An important
question, then, is whether this increase in financial saving will ultimately
contribute to increasing aggregate domestic saving. This question is actu-
ally equivalent to asking whether the high interest rates of banking institu-
tions contribute to increasing aggregate real saving and investment.
Conventional theory does not seem to support the hypothesis that higher
interest rates will increase aggregate domestic saving. According to the
Keynesian view, aggregate saving is a function of income level in an econ-
omy. Some development economists have taught that aggregate saving is
determined primarily by the growth of a modern business sector in an
economy. For that reason, the saving strategies suggested for developing
countries during the 1960s usually emphasized forced saving through tax-
ation and credit expansion while often neglecting the possible strategies
for increasing voluntary saving. As pointed out in a report published by
the Economic Commission for Asia and the Far East (ECAFE 1962), many
developing countries in Asia deliberately designed monetary and fiscal poli-
cies to maintain interest rates in organized money markets at low levels.
An immediate objective of such policies was the reduction of the interest
burden on government borrowing. Aside from that purpose, the policies
were based on the Keynesian view that aggregate saving is a function of
income and that there is a strong inverse relationship between the level
of the interest rate and the volume of investment (ECAFE 1962:22)4 That
kind of low interest-rate policy was not a unique case for developing coun-
tries in the Asian region but a general phenomenon for most developing
countries in all regions, as suggested by Tun Wai (1956:249-78). That it was
so indicates that there were no strong theoretical and empirical supports
for adopting the high interest-rate strategy as a means of mobilizing volun-
tary private savings. Despite the weak support on both theoretical and em-
pirical grounds, Korean policymakers announced that the high interest-rate
policy would greatly contribute to increasing aggregate domestic saving.
Justifications for this view were not made clear at the time of the reform.
Nevertheless, the high interest-rate policy was an appropriate policy choice
for increasing domestic savings in Korea.
First, bank deposits in Korea played a far greater role in the mobiliza-
tion of savings than in many developed countries. The higher interest rate
on bank time deposits may have resulted in some shift of savings from other
forms to bank deposits. But, because the capital market was still under-
developed, it was not expected that any substantial amount of savings could
be shifted from the capital market to the financial market. It was expected
that an increase in time deposits would come mainly from the reduction
of household current consumption and the shift in savings from unor-
ganized money markets. Because savings in the form of unorganized money
market assets not only were risky for savers but also were used largely for
unproductive purposes, such as the purchase of consumer durables and
family ritual expenses, the shift of savings from the unorganized market
to the organized market was considered beneficial in that aggregate sav-
ings were increased and directed into productive investment.
Second, it was expected that domestic investment would increase despite
the higher interest rate on bank loans, because the rate of return on invest-
ment was thought to be higher than the new loan rate. In the mid-1960s
the shortage of domestic savings was considered to be a major constraint

4. Along this line, Jain (1965:29-40) even suggested that a zero (or nearly zero) rate of interest
should be maintained for a higher level of savings and high growth of GNP.
 The Interest-Rate Reform of 1965 and Domestic Saving 149

on economic growth because intended investment far exceeded the sup-

ply of savings, unlike the situation in advanced countries. Therefore, if
higher interest rates could initially induce people to save a larger share of
their incomes, this increase in saving would in turn contribute to an in-
crease in investment and consequently to the growth of national income.
The growth of national income induced by the initial increase in saving
would again positively affect the saving propensity of the nation. This
process of increasing domestic saving would be repeated and domestic sav-
ing would continue to grow after the interest-rate reform. (This point was
also suggested by Brown 1973:199-202.)

EFFECTS OF THE REFORM

The interest-rate reform of 1965 had been expected to have wide-ranging
effects on the economy, including both direct and indirect effects on finan-
cial markets, aggregate saving and investment, and the pattern of resource
allocation in the country. The discussion here is limited to the direct effects
of the reform on financial saving, aggregate real saving and investment,
organized financial market operations, and unorganized money market con-
ditions.
Rapid Increase in Financial Savings
Contrary to conventional expectations regarding public responses to changes
in interest rates in developing countries, the people's response to the sharp
rise in interest rates was both rapid and substantial. The rise in bank deposit
rates was followed by a rapid increase in financial savings, defined to in-
clude the time and savings deposits of banking institutions as well as com-
mercial banks’ trust accounts. Some of the rapid response was also due
partly to an intensified savings campaign staged by the government im-
mediately after the interest-rate reform.
Total financial saving (time and savings deposits plus money in trust)
increased by about 25 percent within one month of enactment of the interest-
rate reform. The rate of increase in time deposits was much greater than
the rate of increase for total financial saving (Table 6.3). Other types of sav-
ings deposits remained almost unchanged, whereas time deposits more
than doubled during the first month after the reform> This pattern of in-
crease in financial saving was expected because the interest rate on time
deposits was more favorable than that on short-term savings deposits such
as notice deposits, or installment savings deposits (including mutual in-
stallment deposits). Installment savings could not be increased within a
short period of time because under these savings schemes individual savers

5. A small shift from demand deposits to time deposits was observed immediately after the
reform. The shift was relatively small and temporary, however. Demand deposits also increased
after the reform. See BOK, Economic Statistics Yearbook (1966:table 26) and the Bank of Korea
yearbooks for later years.
150 Kwang Suk Kim

would usually deposit a small sum of money each month (by installment)
until the contracted deposit target amount was reached. In any case, that
pattern of increase in financial saving generally continued until December
1965 (Table 6.1).
To compare such a sharp increase in financial saving after the interest-
rate reform with other financial indicators over a longer period, the data
in Table 64 are helpful. To highlight some of the major changes after the
reform, the total quasi-money (which is roughly equivalent to time and sav-
ings deposits of banking institutions) more than doubled in real terms be-
tween December 1965 and December 1966. It increased more than ten times
in real terms in the six years from December 1965 until the end of 1971.
Such a rapid increase was in marked contrast to the negative growth of
real quasi-money between 1962 and 1964, during which time the ceiling
deposit rate was held constant at 15 percent per annum despite a much
higher rate of inflation in the country. The increase in real quasi-money
was initially due to the rapid saving response by households and individu-
als. According to the flow of fund data published by the Bank of Korea,
about 81 percent of the small increase in time and savings deposits in 1964
was contributed by individuals (BOK, Economic Statistics Yearbook, 1966, 1972).
The share of contributions by individuals increased to 88 percent in
1966—that is, after the reform. The individual sector share in the increase
of time and savings deposits, however, gradually declined thereafter to reach
around 70 percent by 1971.
The increase in real quasi-money was very sharp as already explained,
but the total level of money supply (M,) was kept under control through
a stabilization program. Real money supply increased by about 13 percent
in 1966 and by about 137 percent between 1965 and 1971. In contrast, the
broadly defined money supply (M,) increased at a much more rapid rate
than the narrowly defined money supply, because real quasi-money ex-
panded sharply after the reform. Real M, increased nearly five times be-
tween 1965 and 1971. As a result, quasi-money, which had been roughly
less than a quarter of the broadly defined money supply before the interest-
rate reform, increased to 46 percent of M, by the end of 1966 and to 67 per-
cent by the end of 1971. The nominal value of quasi-money expanded shar-
ply from a mere 2 percent of money GNP in 1964 to nearly 7 percent in
1966 and then to 22 percent by 1971, but the narrowly defined money sup-
ply increased only from 6.8 percent of money GNP to roughly 11 percent
between 1964 and 1971. Loans of deposit-money banks were also able to
expand rapidly after the reform as the rapid increase in quasi-money made
possible a rapid expansion of loanable funds.
Although the quasi-money expanded rapidly in relation to M,, M>, and
GNP during the period of high interest rates, the rate of increase in quasi-
money seems to have slowed considerably after 1972, the year in which
the bank interest rates were sharply reduced by the monetary authorities.
 The Interest-Rate Reform of 1965 and Domestic Saving 151

After 1972 real deposit interest rates often became negative. Reflecting the
decline in incentives to financial savers, real quasi-money increased by only
106 percent during the eight-year period from 1972 to 1980, though the nar-
rowly defined money supply increased by about 62 percent during the same
period. The nominal value of quasi-money barely increased from 23 to 25
percent of nominal GNP between 1972 and 1980.
Effect on Aggregate Saving and Investment
One who expects a rapid increase in savings through financial institutions
after a rise in interest rates may not necessarily agree that the change in
interest rates affects the aggregate levels of real saving and investment.
Although this chapter has emphasized the important role of financial sav-
ing through banking institutions in the mobilization of domestic saving in
Korea, it is still unclear whether the high interest-rate strategy actually
caused a sharp increase in the aggregate levels of real saving and investment.
Two previous studies on the effect of the Korean interest-rate reform on
aggregate domestic saving give somewhat different results. One by Brown
(1973) attempted a regression analysis mainly to measure the effect of the
1965 reform on aggregate private saving. For that analysis Brown generally
assumed that annual domestic private saving was a function of private dis-
posable income, a nominal or real interest rate, and the domestic private
savings lagged a year. Most of his regression results indicated that the regres-
sion coefficient of the interest rate variable was not only positive as expect-
ed but also statistically significant in explaining the ratio of private saving
to private disposable income. Brown therefore concluded that the interest-
rate reform of 1965 “caused the saving function to shift upward as people
desired to save a larger share of their incomes” (Brown 1973:200). A more
recent study by Cole and Park (1983), however, which did not undertake
a regression analysis as in Brown's study, suggested that “the effect of the
financial reform on domestic savings is ambiguous, because it was only one
of many changes that contributed to the upward shift in the saving func-
tion” (Cole and Park 1983:211).
To examine the effect of the 1965 reform on aggregate domestic saving,
I first prepared a statistical table showing the trends in the ratio of sectoral
gross savings to GNP for Korea during 1962-82. Table 6.5 shows that the
ratio of gross domestic saving to GNP increased rapidly after 1965. A close
look at the data, however, indicates that the rapid increase in the gross
domestic saving rate was mainly due to the increase in government saving—
which could not have been affected by the higher interest rates of banking
institutions.
During the period of high interest rates (1965-71), gross domestic sav-
ing increased from 74 to 15.4 percent of GNP. Only government savings
showed a sharp increase, from 1.7 to 5.4 percent of GNP, during the same
period, while business-sector savings remained almost unchanged at 7.5
152.
Be
Kwang
rn
Suk leKimi
i a RP A OI

6.5. Trend in the ratio of sectoral gross savings to GNP: 1962-82 (%)
Table deel
tres Din ands Oi a Le 0 bn ee eS eS

Gross
: Statis- saving=
Gross domestic saving rate Foreign Heal gross
Govern- Busi- House- Sub- saving discrep- invest-
NE anlle pA aie elses Ei ans matics SI
1962 -1.5 Ga —2.3 3.3 10.7 -1.1 12.8
1963 -0.4 Ta 2.0 8.7 10.4 -1.0 18.1
1964 0.5 6.5 1.8 8.7 6.9 -1.6 14.0
1965 7 Led. -2.1 7.4 6.4 12 15.0
1966 2.8 fs) 1.6 11.8 8.4 is 21.6
1967 4.1 79 -0.6 11.4 8.8 Ls 219
1968 Gal 7.8 tet joy yWier: -0.4 25.9
1969 3.9 PU hye 18.8 10.6 -0.6 28.8
1970 6.5 ipke 3.4 Iv 9.3 0.2 26.8
1971 5.4 (bs) Ze 15.4 10.7 -0.8 25.2
172 3.6 ot 3.0 17 “2 0.7 21.7
1973 4.2 11.4 7.9 23:0 3.8 1.7) 25.6
1974 2.3 12st 6.1 20.5 12.4 -1.9 31.0
1975 4.0 113 3.4 18.6 10.4 0.4 29.4
1976 6.2 10.9 6.0 peea 2.4 -0.0 29.9
1977 5.6 10.9 8.6 Passa 0.6 1.6 27.3
1978 6.5 99 10.0 26.4 =Re) le 31.1
1979 V2 2.7 a7 26.6 7.6 12 35.4
1980 6.2 8.2 <9) 199 10.2 1.4 31.5
1981 6.7 8.3 4.6 19.6 ide 0.9 28.4
1982 6.7 a, Syl 25 4.8 -0.1 26.2

Source: BOK, National Income (1982).

Note: Ratios are based on current price series. Percentages may not sum to totals because
of rounding errors.

to 7.7 percent of GNP. In contrast, household savings, which should have

been most affected by the high interest-rate policy, increased from -2.1 to
2.5 percent of GNP between 1965 and 1971. But the base year 1965 was
an unusual year. The household saving rate even in 1963 and 1964 was 1.8
to 2.0 percent. Thus it might be more correct to say that the household sav-
ing rate simply showed a wide fluctuation by year during the period of high
interest rates, rather than a notable increase.
Such a yearly fluctuation in the household saving rate may be an arti-
fact resulting from the inclusion of “changes in agricultural inventories” in
household saving. Although the changes in agricultural inventories directly
affect the level of gross capital formation and therefore the level of domes-
tic saving, they are primarily determined by the level of agricultural produc-
tion in the current year because the major crop, rice, is harvested near the
 The Interest-Rate Reform of 1965 and Domestic Saving 153

end of the calendar year in Korea. That implies that household saving in
the form of increases in agricultural inventories is determined independently
from the household propensity to save out of the current income. To
eliminate the yearly fluctuation in the household saving rate caused by the
fluctuation in agricultural inventories, one can easily adjust the income and
saving data by subtracting the increases in agricultural inventories from both
household disposable income and savings (Table 6.6). Apart from that ad-
justment, the adjusted household saving rate given in Table 6.6 is a better
indicator of the household saving propensity than that given in Table 6.5
because it measures that sector’s saving propensity out of all current dis-
posable income—including transfers from abroad. The household sector's

Table 6.6. Trend in household saving rate, adjusted for change in agricul-
tural inventories: 1962-81
Change
in agri- Adjusted
cultural Adjusted household
Disposable inven- disposable Adjusted saving
income Savings tories income savings rate
(10? won) (10° won) (%) (10? won) (10? won) (%)
Year (A) (B) (C) (D=A-C) (E=B-C) (F=E/D)
1962 291.0 -3.4 -5.6 296.6 2.2 0.7
1963 421.3 16.9 17,7. 403.6 -0.8 -0.2
1964 617.8 25.2 20.8 597.0 4.4 0.7
1965 673.0 1,5 -0.1 673.1 1.6 0.2
1966 853.7 42.9 8.3 845.4 34.6 4.1
1967 1,022.4 d7a1 -18.3 1,040.7 35.4 3.4
1968 1,279.3 48.3 -16.7 1,296.0 65.0 5.0
1969 1,681.1 152.4 47.7 1,633.4 104.7 6.4
1970 2,058.7 119.6 50.3 2,008.4 69.3 3:5
1971 2,554.0 118.1 62.3 2,491.7 55.8 22
1972 3,126.4 169.3 72:9 3,053.5 96.4 3:2
1973 4,000.6 477.2 44.7 3,955.9 432.5 10.9
1974 5709 7.8 Sila 80.7 5517s 430.4 7.8
1975 7,350.0 405.1 115.4 7,234.6 289.7 4.0
1976 9,601.8 890.2 143.1 9,458.7 747.1 732
1977 12,308.29 ad55337, 198.6 12,109.6 1,355.1 11.2
1978 16,748.2 2,509.4 75.8 16,672.4 2,433.6 14.6
1979 21,108.0. _ 3,001.1 261.6 20,846.4 2,739.5 13:1
1980 25,173 Depo ey l309. ~458.2 24/715:3 ¢92,0894. 10.5
1981 30;791):2 ryeyi2 20833 588.8 30,202.4 1,669.5 5D
Source: BOK, National Income (1982).
Note: Amounts are expressed in current won.
154 Kwang Suk Kim

domestic saving rate in Table 6.5 does not include saving out of such trans-
fers from abroad.
In any case, the adjusted household saving rate showed a large increase
after the interest-rate reform of 1965. As shown in Table 6.6, adjusted house-
hold saving, which had been less than 1 percent of disposable income un-
til 1965, increased to 4.1 percent in 1966 and remained at least higher than
34 percent of disposable income until 1970. The adjusted household sav-
ing, however, declined to 2.2 percent of disposable income in 1971. It is
normally expected that the higher interest rates would mainly affect house-
hold saving. There is no good reason to expect that government and busi-
ness savings would be positively affected by the higher interest rates. In
this respect, one may argue that the sudden jump in the adjusted house-
hold saving rate after 1965 reflected the positive effect of the interest-rate
reform on domestic saving. There may be some truth in such an argument
because the adjusted saving rate after 1965 became consistently higher than
that prior to the 1965 reform.
The adjusted household saving rate, however, remained at a relatively
high level even after 1972, when bank interest rates (both nominal and real)
were again arbitrarily reduced by the government, although household sav-
ing had been fluctuating widely between 3 and 11 percent of disposable
income. The fact that the household savings propensity was sustained at
the higher levels after 1972 may reflect a habit-forming effect on saving. That
is, the households that were induced to save a greater share of their in-
come by the rise in interest rates were continuing to save a similar or even
higher share of their increased income, even though the incentives to savers
were largely removed by the reduction of interest rates. The higher saving
rate after 1972 may also reflect the effect of average disposable income per
household in the 1970s being higher than in the 1960s. In view of these
developments after 1972, it is doubtful whether the sharp increase in the
household saving rate (adjusted) after 1965 only reflected the effect of the
high interest-rate policy adopted in 1965 and continued until early August
1972. As suggested by Cole and Park (1983), the higher ratio of household
saving to disposable income after 1965 could have been made possible not
only by the higher interest rates but also by many other factors, including
the higher growth rate of income, better investment environment, and the
relative price stability attained during 1965-73.
After the interest-rate reform of 1965, gross domestic investment ex-
panded continuously in relation to GNP. As already suggested, gross
domestic investment, which had been generally less than 15 percent of GNP
until 1965, increased to 22 percent in 1966 and continuously expanded to
reach about 29 percent by 1969. Even after 1969, the gross domestic invest-
ment rate was generally maintained at a level higher than 25 percent of GNP
(22 percent in 1972 being the only exception). The large increase in gross
domestic investment was made possible not only by the rapid increase in
 The Interest-Rate Reform of 1965 and Domestic Saving 155

domestic saving but also by the continuous inflow of foreign saving. In any
case, the growth of domestic investment after 1965 indicates that the higher
interest rates of banking institutions did not discourage domestic invest-
ment, as expected by some people, but rather contributed to increasing such
investment by increasing the supply of both domestic and foreign loans.
Effect on Organized Financial Markets
Because bank deposits, particularly time and savings deposits, increased
rapidly after the interest-rate reform, the monetary authorities could ex-
pect to improve the techniques of monetary control as originally planned
at the time of the reform. The monetary authorities therefore abolished the
loan ceiling system and attempted to control the money supply through
the indirect techniques of bank reserve manipulations. In early 1966 the
monetary authorities began to experiment with all the indirect techniques
of monetary control available in Korea. The inflow of foreign capital, main-
ly in the form of foreign loans, greatly accelerated in early 1966, because
of the increased gap in interest rates between domestic and foreign finan-
cial markets after the 1965 reform. The increased inflow of foreign capital,
together with the rapid expansion of Korean exports, caused a rapid ac-
cumulation of foreign reserves. To contract the monetary expansion com-
ing from the rapid accumulation of foreign reserves, the central bank had
not only to increase legal reserve requirements for banking institutions but
also to freeze a substantial portion of bank deposits by means of forced
sales of stabilization bonds and compulsory deposits in the central bank's
stabilization account.
As a result, bank loans declined in relation to deposits until around the
end of 1967, although the absolute level of bank loans expanded rapidly.
The relative decline in bank loans, in addition to the profit squeeze caused
by the reverse margin between the bank deposit and loan rates, contrib-
uted to a further deterioration of profitability in banking operations after
the interest-rate reform.
Table 6.7 provides data on the profitability of banking operations before
and after the 1965 reform. The weighted average annual rate of interest due
for all commercial bank deposits increased from 2.7 percent in the first half
of 1965 to 11.1 percent during the same period of 1966. The average interest
rate on commercial bank loans also increased from 16.1 to 25.0 percent dur-
ing the same period. The difference between the earning and cost ratios
to all available funds, however, declined from 1.5 to -0.7 percentage points
between the first half of 1965 and the same period of 1966. That is, the ratio
of earnings (interest and other income) to total available funds was 9.5 per-
cent, which was 1.5 percentage points higher than the ratio of costs (in-
terest and operating costs) to total funds in the first half of 1965. The ratio
of earnings to total available funds, however, became lower than the cost
ratio in the first half of 1966. This was partly because the ratio of loans to
156
a
Kwanga
Suk Kim

Table 6.7. Changes in the costs of funds and earnings of commercial banks
before and after the interest-rate reform
First half
Description 1965 1966
Average interest rate on deposits
(A) Interest accrued during the period (10° won) 504 3,606
(B) Average balance of deposits for the period (10° won) 36,933 65,052
(C) Annual average rate on deposits [2(A)/(B)] (%) PLY taka

Average interest rate on loans

(D) Interest accrued during the period (10° won) 2,180 5,769
(E) Average balance of loans for the period (10° won) pli keV 46,230
(F) Annual average rate on loans [2(D)/(E)] (%) 16.1 25.0
Annual ratio of costs and earnings
(G) Annual ratio of costs to available funds (%) 8.0 13.6
(H) Annual ratio of earnings to working funds (%) 9.5 12:9
(I) Difference between the cost and earning ratio
(A) - (G)] (%) Be -0.7
Source: BOK, Economic Statistics Yearbook (1967).

deposits was reduced from 73.5 to 71.1 percent between the two periods
and because the ceiling rate on loans was lower than on deposits.
To provide some compensation for the reduction in the rate of banking
funds utilization and for the reverse margin between the deposit and loan
rates, the central bank paid a 5 percent rate of interest on bank reserves
against time and savings deposits during 1966-67. But banking institutions
actually started to benefit from the system of bank guarantees for the repay-
ment of foreign loans as the inflow of foreign loans accelerated beginning
in 1966. The banks could then collect about 1.0 to 1.5 percent on the face
value of foreign loans as guarantee fees without really committing their
own resources. Beginning in early 1968, the banks were able to gradually
expand their loans in relation to deposits because monetary control had
been relaxed somewhat.
Although a substantial portion of the increased financial savings was
sterilized for the purpose of monetary control, particularly in the early pe-
riod of the reform, bank loans to the private sector expanded sharply after
September 1965. The higher interest rates on loans did not become a factor
restricting loan activities in Korea. The banking funds derived from the in-
creased financial savings were lent out to the business sector mostly for
working capital; only about 10 percent of commercial bank loans was used
for the purchase of industrial equipment. Even though the loans of bank-
ing institutions expanded rapidly after the reform, the supply of loanable
funds remained as a scarce factor in the sense that demand for loanable
 The Interest-Rate Reform of 1965 and Domestic Saving 157

funds exceeded the supply of such funds at the new rate of interest. This
was probably due to the complementary relationship between domestic
bank loans and foreign financing. Since the introduction of foreign capital
was authorized mainly for fixed investment purposes, the domestic enter-
prises borrowing from abroad had to borrow also from domestic financial
markets for working capital requirements. Of course, the restriction of bank
loans for stabilization purposes also contributed to the continuous scarcity
of bank loans in Korea.
Even so, the increased supply of bank loans at the higher rate of interest
made it easier for the average business person to obtain a bank loan. Bank
loans now were no longer the source of easy profits for corporations and
individuals, because the loan rates were high enough to discourage un-
productive investment. After the reform, it seemed that the bank loans were
largely replaced by foreign loans as a source of easy profits since the in-
terest rates on foreign loans were generally much lower than those on
domestic loans. Because of the large inflows of foreign loans at rates lower
than the domestic bank rate, the monetary authorities had to freeze a sig-
nificant portion of domestic savings deposits to meet the overall money sup-
ply target. If the inflows of foreign capital had been effectively controlled
to a reasonable minimum, the organized financial markets could have func-
tioned more effectively in both mobilizing and allocating domestic resources.
Effect on Unorganized Money Markets
The activities of unorganized money markets were widespread in all sec-
tors of the Korean economy before the interest-rate reform. The unorganized
money markets were involved not only in money lending for households
and small business but also in mobilizing and lending a fairly large amount
of funds to big enterprises. It is difficult, however, to evaluate the effect
of the interest-rate reform on unorganized money markets. Available data
on the unorganized money market activities are not only scant, but also
may not be reliable. For instance, a Bank of Korea survey conducted in the
first quarter of 1967 indicated that no significant change had occurred in
the unorganized market after the reform (BOK, A Survey on Business Finance,
1967:5-8). Some businesses still borrowed a portion of their financial re-
quirements from the unorganized markets, where the dominant rate of in-
terest was still about 4 to 5 percent per month as before the reform.
According to Bank of Korea survey data for the previous periods, interest
rates in the unorganized market showed an upward trend until about
mid-1966. The trend was probably due to a temporary shift of funds from
the unorganized markets to bank deposits after the 1965 reform, whereas
demand for such nonbank loans was not largely replaced by bank loans.
The unorganized market rate, however, returned to the original level there-
after. There are indications that the activities of unorganized money mar-
kets continuously expanded in the late 1960s, with some setbacks in the
158 Kwang Suk Kim

initial period of the reform. In any case, the unorganized markets flourished
until August 1972, when the Presidential Emergency Decree was issued to
force both private moneylenders and business borrowers to report the out-
standing volume of loans to the business sector and the business sector's
debts to the unorganized money markets. The size of business enterprises’
borrowings from the unorganized markets, reported and confirmed in ac-
cordance with the decree, amounted to about 346 billion won, equivalent
to 23 percent of total domestic credit in 1972 and 42 percent of all outstand-
ing loans of banking institutions, including the KDB, as of August 1972.
But this volume of unorganized money market loans excludes the outstand-
ing loans of the household sector, including farm households, which were
not required to be reported by the government decree (Cole and Park
1983:163-65).
That explains why the interest-rate reform could not succeed in reduc-
ing unorganized money market activities as originally anticipated. How,
then, could the unorganized markets continuously flourish even when the
interest rates in the organized markets were substantially raised, and when
the sizes of both domestic and foreign credit could be rapidly expanded
after the reform? Here are a few points—not answers—related to these
questions.
First, a rapid increase in domestic bank loans, together with the increased
inflow of foreign capital after the interest-rate reform, made possible the
rapid expansion of Korean industries, which in turn necessitated a further
increase in external finance. This brought about a continuously increasing
demand for domestic bank loans despite the high loan rates. Because of
the increasing demand for bank loans and also for foreign loans, domestic
bank loans were still allocated to industries on the basis of government
guidelines that gave priority to those industries the government wanted
to promote. Industries not favored by the government could not easily ob-
tain bank credit or foreign capital even after the reform, and had to turn
to unorganized markets for necessary external finance. This situation ex-
plains the continuous expansion of demand for unorganized money mar-
ket loans after the reform.
Second, even if bank loans could be expanded, the unorganized market
loans could not be completely replaced by bank credit, partly because of
the rigid loan procedures of Korean banking institutions. The Korean bank-
ing system tended to place a heavy emphasis on loan securities (particu-
larly real estate collateral), but moneylenders in the unorganized markets
put more weight on the credit standings of borrowers. Bank loan proce-
dures usually were also complicated and time-consuming, and therefore,
were not a good source of for short-notice funding needs. A formal short-
term money market had not yet been established in the late 1960s, so the
unorganized money markets provided an economic source of credit for tem-
porary short-term requirements (e.g., daily loans, loans for a month or two),
 The Interest-Rate Reform of 1965 and Domestic Saving 159

whereas bank loans usually required various incidental expenses includ-

ing insurance costs, paperwork, and time.
Finally, unorganized money market activities flourished even after the
reform because they provided the only source of credit for the average
household in Korea. As suggested, Korean banking institutions restricted
their loans for household consumption needs (including housing finance)
in the late 1960s.

CRITICISM AND LESSONS

The interest-rate reform of 1965 certainly brought about a sharp increase
in savings through financial intermediaries, which in turn made possible
an increase in the supply of bank loans. After the reform, the household
saving propensity adjusted for the increases in agricultural inventories rose
substantially, suggesting that the higher interest rates could have positively
contributed to the growth of aggregate domestic saving in Korea. However,
there is not enough evidence to show that the sudden jump in the house-
hold saving rate after 1965 was entirely attributable to the higher interest-
rate strategy.
It may be true that the higher interest rates contributed to the upward
shift of the household saving propensity in the late 1960s, but many other
changes favorable to saving and investment also took place during the pe-
riod. Investment in industries was not hindered by the higher interest rates
but expanded sharply owing to the increased supply of loanable funds from
both domestic and foreign sources. Although the interest-rate reform did
not succeed in reducing the activities of unorganized money markets, the
organized financial markets were substantially expanded by the reform. As
bank deposits increased after the reform, the monetary authorities improved
the techniques of monetary control by relying more upon the indirect
method of controlling the reserve base of the banking system, rather than
imposing loan ceilings.
The interest-rate reform, however, widened the gap in interest rates be-
tween domestic and foreign financial markets, thereby greatly increasing
incentives to borrow from abroad. The system of bank guarantees for the
repayment of foreign loans instituted in 1962 could therefore be actively
used to facilitate the inflow of foreign capital after the reform. The increased
inflow of foreign capital undoubtedly contributed to increasing gross domes-
tic investment in Korea, but it created a difficult problem for monetary stabili-
zation. The increased inflow of foreign capital, together with the rapid
expansion of Korean exports, caused a rapid accumulation of foreign
reserves, thus creating excessive monetary expansion. To control the money
supply for price stabilization, a considerable proportion of the increase in
bank deposits had to be frozen. This implies that the higher interest-rate
policy, which was originally aimed at mobilizing domestic financial sav-
ings for domestic investment, was only helping in the conversion of such
160 Kwang Suk Kim

savings (after succeeding in creating them) into foreign-reserve assets. Be-

cause the supply of domestic credit was continuously squeezed while in-
directly encouraging business borrowings from abroad, some sectors of the
economy that could not gain access to foreign finance had to rely continu-
ously on credit from unorganized money markets. The increased inflow
of foreign capital at a low interest rate contributed to further increasing de-
mand for domestic credit mainly owing to complementarity between for-
eign finance and domestic credit. As a result, the government could not
succeed in balancing demand for and supply of loanable funds even at the
higher interest rates and had to intervene continuously in the allocation
of loanable funds as it had done before the reform.
Despite the squeeze of domestic supply of loans, which was necessi-
tated by the rapid accumulation of foreign reserves, domestic credit could
be expanded much more rapidly during the period of high interest rates
than in the earlier years because financial savings had increased rapidly
after the reform. On the whole, therefore, the high interest-rate policy
adopted in 1965 made a great contribution to the development of financial
markets in Korea, although this contribution may be difficult to define in
detail. Financial assets and liabilities grew rapidly in relation to GNP dur-
ing 1965-71. Because the high interest-rate policy was suddenly reversed
to one of extremely low interest rates in August 1972, however, the finan-
cial development fostered by the interest-rate reform of 1965 came to a halt
in 1972. Thereafter, real interest rates in organized financial markets were
so often negative that the real growth of financial savings became sluggish
despite the rapid growth of GNP in the 1970s. It is the opinion of many
economists outside the government that if the abrupt reversal of interest-
rate policy had not been made in 1972, Korean financial development could
have made rapid progress even during the 1970s. Given the rate of domes-
tic inflation, a policy of gradual reduction in interest rates might have
produced a much better result for Korea's financial development than the
abrupt policy reversal.
What kind of lessons can be learned from the Korean experience with
the high interest-rate policy described? Four lessons may be important for
other developing countries and also for Korea’s future development.
First, a reasonably high rate of interest should be maintained in develop-
ing countries, where insufficient capital is one of the major constraints to
economic growth. As the Korean experience suggests, a high interest rate
will bring about a rapid increase in saving in the form of financial assets.
Saving strategies suggested for developing countries tend to emphasize
government saving. It is generally difficult, however, to sharply raise the
ratio of government savings to GNP because increasing tax revenues every
year is not an easy task for any representative government to undertake.
The high interest-rate strategy would be easier to put into effect for increas-
ing voluntary saving in developing countries. Nevertheless, it is widely
 The Interest-Rate Reform of 1965 and Domestic Saving _ 161

believed that households in many developing countries have been ac-

cumulating a large proportion of their savings in the form of tangible as-
sets such as residential dwellings, noncorporate business structures, and
durable consumer goods. A high interest rate could therefore contribute
to diverting such savings from unproductive tangible assets into financial
intermediaries where the saving could then be channeled to productive in-
vestment. Even if one assumes that the high interest rates cannot increase
the aggregate level of real saving, their implementation will result in a more
“efficient composition of wealth” (Patrick 1966:181). The efficient composi-
tion of wealth is expected to have a positive effect on the growth rate of
the national economy.
Second, it is important to equalize interest rates on various types of loans
available within a country, regardless of sources of funds, except for minor
differences in maturity term and credit standing of borrowers. In the Korean
case, preferential interest rates were applied to special bank loans from
government funds and to export credit financed out of the central bank’s
rediscount. What was more critical in the Korean experience was that the
domestic high interest-rate policy opened up a new source of disturbance
to domestic financial markets because no measure was taken to equalize
interest rates on foreign loans with the domestic rate. As long as these
preferential loans from both domestic and foreign sources were available
at an interest rate much lower than the rates on ordinary commercial bank
loans, the demand for such loans would continuously expand because the
loans represented windfall gains to borrowers. Because of the large expan-
sion of preferential credit, the supply of nonpreferential credit had to be
squeezed to meet the money supply target. It is suggested that developing
countries that adopt a high interest-rate policy should at least take meas-
ures to equalize the interest burden on foreign borrowings with that on
domestic loans, if they are to succeed in equilibrating the domestic finan-
cial market at the high interest rate.
Third, a consistent interest-rate policy would be much more desirable
than an abrupt change in policy direction from a high interest rate to a low
one. In the case of Korea, the abrupt change in policy direction in 1972 (and
also in 1982) seems to have hurt the general public’s confidence in govern-
ment policy, thus reducing public support for government policy. Instead
of suddenly reversing the policy direction, the Korean government should
have taken a gradual approach, and at least maintained a positive real rate
of interest in the country. The real rate of interest should be estimated by
taking into account people's expected rate of inflation, rather than just the
current or lagged rate of inflation measured by either the WPI or the CPI.
Although it is not easy to exactly measure the expected rate of inflation,
it seems that people's price expectations in Korea have been influenced more
by rises in real estate prices than by changes in the WPI or CPI in recent
years. In any case, the gradual approach to monetary policy would probably
162 Kwang Suk Kim

have resulted in a much better performance in financial aspects of develop-

ment than what actually happened after 1972. This is an important lesson,
not only for other developing countries but also for future policymaking
in Korea. The abrupt reduction of the interest rate in Korea in June 1982
(the so-called June 28 measure) indicated that Korean policymakers had
not learned the lesson from the failure of the August 3rd measure in 1972
Finally, a reverse margin between bank deposit and loan rates should
be avoided except for short periods of time. In the Korean case the bank
deposit rate was set at a slightly higher level than the loan rate to increase
the attractiveness of financial savings compared with returns from alterna-
tive forms of saving at the time. Such a reverse margin was probably neces-
sary in the initial stage of the high interest-rate policy to change the attitudes
of the general public toward financial saving. The reverse margin of bank
interest rates, however, not only made it necessary for the central bank to
find other means of compensating for banking institutions’ losses arising
from the reverse margin, but also contributed to creating excess demand
for loans. Inasmuch as the deposit rate was higher than the loan rate, some
business enterprises with enough funds of their own still retained bank
loans while depositing their idle balances in the form of time deposits. Some
pyramiding of deposits on loans might also have taken place as people
redeposited bank loans to take advantage of the after-tax interest rate, which
was higher on deposits than on loans. These practices are partly attribut-
able to the tax system in Korea but actually increased because of the reverse
margin of bank interest rates.

6. On 28 June 1982 the government announced a drastic reduction of interest rates on bank
deposits and loans. The banks’ ceiling deposit rate was reduced by a wide margin, from 12.6
to 8 percent per annum, and the rate on ordinary bank loans was cut from 14 to 10 percent
per annum. On 3 July, about a week after the June 28 measure, the government announced
that, beginning in 1983, it would enforce the use of real names for the possessors of all finan-
cial assets. Although the actual implementation of this measure was later postponed indefinitely,
that announcement, combined with the earlier June 28 measure, seems to have had a con-
siderable negative impact on Korea’s financial development, probably increasing incentives
for capital flight.
 vF The President’s Emergency
Decree for Economic Stability and
Growth (1972)
by Wan-Soon Kim

“Enrich the Nation and Strengthen the Army” was perhaps the most popu-
lar slogan of the late President Park Chung Hee’s inherently authoritarian
government. In practical terms, this meant that economic development was
the key to the regime’s political success and stability, because it was the
means for overcoming political and social unrest and frustrations. Having
thus enshrined rapid economic growth near the top of its value hierarchy,
the Korean government was prepared to intervene directly in economic
management whenever it believed that its vigorous pursuit of a high-growth
policy was being stifled.
The President’s Emergency Decree for Economic Stability and Growth,
announced on 3 August 1972, is a classic case in point. In early 1971 the
economy appeared to be cooling off. There was an appreciable drop in in-
vestment demand, partly caused by the tight credit policy, whereas price
increases appeared to be accelerating. With the collapse of the Bretton
Woods system as a result of the Nixon price and wage freeze in August
1971, international economic and monetary disturbances generated uncer-
tainty within the Korean business community about the short-term
prospects for Korea’s renewed export growth. The combination of all these
elements led to a definite slowdown in the Korean economy in the latter
half of 1971, which continued throughout most of 1972.
In particular, the economic slowdown revealed the chronically unstable
and weak financial structures of many business firms, especially the large,
highly leveraged ones. Between 1965 and 1969 the total domestic indebt-
edness of manufacturing industries to financial institutions had increased
from 2.6 to 9.2 percent of GNP, and the amount of the curb-market loans
was reported to have reached about 190 billion won, or about 28 percent
of domestic credit (Cole and Park 1983:126). Likewise, the rate at which
the annual volume of external borrowing was expanding was no less than
that of domestic indebtedness. From a negligible amount in 1965, gross ex-
ternal borrowing had reached US $1,800 million in 1969, about 189 percent
of Korea's total exports, the highest since 1962 (I. C. Kim 1983a:111-17). Over
the four-year period 1966-69, foreign saving accounted for, on average,
almost 40 percent of total investment and about 10 percent of GNP. In sum,
corporate indebtedness was stretched to such an extent that a moderate
163
164 Wan-Soon Kim

slowdown in demand could cause a number of firms to experience serious

financial difficulties.
Because of the heavy reliance on borrowed capital during the 1966-69
investment boom, the average debt/equity ratio of manufacturing indus-
tries almost reached 400 percent by 1971. Furthermore, the 1971 devalua-
tion of the won caused a sudden jump in the cost of foreign-debt servicing,
creating severe short-term cash-flow problems. Interest expenses rose from
5.9 percent of net sales in 1968 to 9.9 percent in 1971 (Table 7.1). Conse-
quently, the ratio of net profits to net sales decreased very sharply from
about 6 percent to a negligible 1.2 percent over the same period. In the
case of firms with high debt leverage, the burden of fixed financial charges
was extremely heavy, and the number of business failures increased
alarmingly.
Influential business associations reacted quickly to the sagging economy.
In the latter part of 1971 the Federation of Korean Industries, representing
Korea's major firms, sought a meeting with President Park to convey their
ideas for dealing with highly leveraged or bankrupt firms. They called for
direct government intervention and made a number of policy recommen-
dations, including the conversion of curb-market loans into bank claims,
reduction of the corporate tax burden, and lower interest rates.
Table 7.1.Selected financial ratios in the manufacturing industry: 1963-78
Interest
expenses/ Net profit/ Share of securities
Debt/equity net sales net sales _in corporate invest-
Year ratio? ratio ratio ment financing (%)
1963 92.2 3.0 oa 14.8
1964 100.5 4.9 8.6 Tey
1965 83.7 3g 79 93
1966 17 37, Si, wad 8.1
1967 151.2 D2 6.7 3:5
1968 201.3 59 6.0 6.4
1969 270.0 7.8 4.3 115
1970 328.4 9:2 3.3 14.9
1971 394.2 9:9 1.2 15.1
1972 313.4 ve 3.9 19.5
1973 272.7 4.6 15 215
1974 316.0 4.5 4.8 8.2
1975 339.5 4.9 3.4 12.2
1976 364.6 4.9 3.9 16.0
1977 350.7 4.9 3.5 17 7.
1978 366.8 4.9 4.0 30.8
ee ee Le
Sources: BOK, Financial Statements Analysis (1981); BOK, Flow of Funds Accounts (1980).
a. Total liabilities/net worth.
 The President's Emergency Decree (1972) 165

The Korean government could have allowed the debt-ridden firms to go

bankrupt, but it was feared that an increasing number of bankruptcies
would seriously undermine the nation’s credit rating in the international
capital markets. More important, that option would have had adverse po-
litical consequences for the Park government, which had identified its po-
litical success with the attainment of rapid economic growth (Cole and Park
1983:160-61). For these reasons, the Park government decided to intervene
directly in an attempt to relieve the financial strains on business firms, con-
tain inflationary pressures, revive business confidence, and reform corporate
financial structures. Until the announcement of the emergency decree in
August 1972, a series of meetings between three economic ministers and
certain business leaders were held to work out policy tools.
True to his commitment to rapid economic growth, President Park re-
sorted to temporary stopgap measures to alleviate the business slump and
to provide relief to debt-ridden firms. The President’s Emergency Decree
for Economic Stability and Growth placed a moratorium on curb-market
loans, stretched commercial bank loans, reduced interest rates, provided
rationalization funds to assist key industries in improving productivity, and
launched an all-out campaign to stop inflation.
This chapter will examine and evaluate the successes and failures of the
emergency decree, which lasted for about one and one-half years, in terms
of its intended purposes and apparent effects. This is basically a short-run
analysis. Although neither the benefits nor the costs can be calculated, the
crucial factor here is to examine the long-run implications of the use of the
decree for government economic management during the ensuing years.
The principal argument is that the emergency decree had a remarkably small
effect on Korea's financial development. As the economy became increas-
ingly complex, the government's use of discretionary command procedures
became both limited and inefficient in the face of strong market forces.
This study relies upon three major sources for its approach and infor-
mation. First, the author is indebted to the theoretical work of Shaw (1973)
and McKinnon (1973, 1976), who regard the poor results of savings mobili-
zation in developing countries as a consequence of financial repression.
Second, Jones and SaKong (1980), in their in-depth study of the roles of
government and of business in Korea's rapid industrialization, illustrate,
in particular, how the Korean government made use of discretionary com-
mand procedures as a method of policy implementation. Third, for data
to support and verify a number of points made here, the author has bene-
fited from the work of Cole and Park (1983) on the evolution of Korea's finan-
cial system and its contribution to Korea’s economic development.

MAJOR FEATURES OF THE EMERGENCY DECREE

The emergency decree of 3 August 1972 provided for a series of drastic meas-
ures that, in the short-run, were intended to revive business confidence
166 Wan-Soon Kim

and to attack the inflation problem at its roots. The long-run intentions were
to achieve a more balanced capital structure and to strengthen the com-
petitiveness of private business firms. Foremost among the measures to im-
prove the financial position of business enterprises was that of freeing major
companies from the stranglehold of the high interest rates (about 36 per-
cent per annum on the average) charged by the underground moneylenders.
In essence, the decree consisted of the following five measures:
1. All loan agreements between firms with business licenses and lenders
in the curb market were nullified as of 2 August 1972, and converted into
officially confirmed “new” debt claims. Loans exceeding 3 million won were
rescheduled for repayment over a five-year period after a three-year grace
period, at 16.2 percent annual interest, or the lenders had the option of
converting their loans into equity shares, the latter being mandatory for
creditors with substantial ownership interest in the borrowing firms. In other
words, the (so-called “disguised”) informal money-market loans made by
large stockholders or executives to their firms were converted into shares
or stocks.
2. Approximately 30 percent of the short-term, high-interest (15.5 per-
cent per annum) commercial bank loans held by business firms, amount-
ing to 200 billion won, were replaced by long-term loans at 8 percent annual
interest payable over a five-year period after a three-year grace period. The
actual amount of replacement was about 194 billion won.
3. The establishment of a credit guarantee fund for small and medium
industries, and for agricultural, forestry, and fishery businesses, amount-
ing to 2 billion won in government funds, allowed the banking system to
make loans up to ten times the amount of the fund without collateral re-
quirements.
4. An Industrial Rationalization Fund of 50 billion won was created to
provide long-term, low-interest loans to support mergers and moderniza-
tion of priority industries to improve their efficiency, profitability, and com-
petitiveness. In addition, business firms that could meet the rationalization
criteria were granted higher depreciation rates and investment tax credits
for investments using domestic resources.
5. In support of anticyclical flexibility in budgetary procedures, the decree
abolished the existing pegged revenue sharing with provincial governments
and made equalization grants dependent on the budgetary conditions of
the central government at a given time.
In addition to these emergency measures, the Economic Planning Board
(EPB) was instructed by the president to take five supplementary steps. First,
as an explicit digression from the hiking of interest rates in 1965, the com-
mercial banks’ annual lending rate was reduced from 19 to 15.5 percent;
and time deposit rates, from 16.8 to 12 percent. The reduction in interest
rates was intended not only to provide financial relief to debt-ridden en-
terprises but also to eliminate immediately the cost-push effects of higher
 The President’s Emergency Decree (1972) 167

interest rates. Second, the exchange rate, which had been eroding since
the beginning of 1972, was to be pegged at 400 won to the dollar, with the
proviso that the won would not be devalued by more than 3 percent per
year. Third, as a direct attack on inflation, the annual increase in whole-
sale prices was to be controlled within 3 percentage points per annum.
Fourth, to keep inflation rates at 3 percent, utility rates were not allowed
to increase. Finally, maximum restraint was exercised on the 1973 govern-
ment budget by reducing increases of wages and salaries of government
employees and by restraining increases in public investments.

EFFECTS OF THE EMERGENCY DECREE

Unorganized Money Market and Financial Policies
In an inflationary environment of ample investment opportunities with high
rates of return, the government's rapid growth strategy induced larger firms
with easy access to bank credit to rely heavily on bank loans for their in-
vestment capital. And, as growth was extremely rapid in relation to the
existing scale of operations, internal cash generation could not cover an ap-
preciable proportion of the financial requirements for investment and work-
ing capital. Interest payments on rapidly accumulating debt, both external
and internal, seriously eroded net profits.
In addition, other critical factors supported the continued preference for
debt financing against the generation of retained earnings for reinvestment.
First, the special tax on retained earnings of closely held family corpora-
tions, charged in addition to the applicable corporate income tax, tended
to encourage companies to dispose of much of their profits by paying divi-
dends. Second, Korean investors had a general tendency to emphasize cur-
rent cash yields and to expect a steady annual return from an investment,
which resulted in disproportionately high dividend payments to profits—
an element of considerable rigidity in corporate dividend policy. Third,
depreciation allowances (a tax-deductible business expense item, as well
as a source of corporate savings) were permitted in generous amounts but
were seldom consistently charged by companies because of their desire to
avoid losses. (Tax authorities were said to “penalize” companies showing
losses in this manner.) This led to low internal cash generation. Fourth,
businessmen were taking advantage of the corporate tax system that allowed
interest paid on borrowed funds as a cost in determining profits (subject
to a 40 percent tax rate), whereas interest income from high-yielding time
deposits was granted a tax-exempt status. In other words, firms earned an
interest spread and gained a tax advantage by depositing their own funds
and then borrowing them back. Finally, the supply of equity funds from
sources external to the companies was limited because of the par-value pric-
ing method and the high financing cost of new issues.
The net effect of those factors was the extremely high debt/equity ratio
168 Wan-Soon Kim

of manufacturing enterprises—nearly 400 percent on average—prior to the

emergency decree (Table 7.1). Therefore, in times of financial stringency,
or when they were pressed for cash to make external debt-service payments
on schedule or to satisfy short-term working capital needs, the debt-ridden
firms (mostly large ones) came to the curb markets to borrow at rates that
were generally between 30 and 50 percent per annum.
In developing countries, where financial markets are fragmented and un-
derdeveloped, financing capital needs is generally more difficult for small
and medium-size firms than for large ones. Korea was no exception. There
were several reasons why the smaller firms and traditional businesses had
to rely on the informal financial markets for most of their working capital
and for some financing of fixed investment. First, the banking sector was
not able to mobilize adequate financial savings to meet the growing de-
mand for bank loans, largely because of the low return on saving deposits.
Second, banks and other financial intermediaries tended to refuse credit
to small borrowers, who were often unable to offer acceptable collateral.
Third, in financing traditional activities, informal lenders could offer greater
flexibility and lower transaction costs because of their intimate knowledge
of local business conditions. Last, the government allocated a large share
of bank credit to the so-called “essential” industries and very little to “small-
scale” industries, small farms, or small processing industries (Cole and Park
1983:168-69).
On the supply side, individual savers who would otherwise have depos-
ited their funds in formal financial institutions were encouraged by high
interest rates to enter the curb market as lenders. Business firms were also
able to maximize profits by channeling temporary excess liquidity into the
curb market on a short-term basis (Cole and Park 1983:169).
The curb market served, therefore, as a short-term money market for
both large and small business borrowers. But even though the unorganized
money market served useful functions, the government attempted to eradi-
cate it, using command procedures instead of trying to eliminate the in-
efficiencies of the institutional banking system. The government strongly
objected to the existence of the informal credit institutions for two valid
reasons. First, they wanted to recoup lost tax revenues from the unreported
financial transactions and profits of the “underground” institutions. Second,
in times of financial stringency they found that their tight monetary policy
measures became ineffective because of the capacity of the curb market to
reallocate credit and raise the velocity of money (Cole and Park 1983:158).
As an outcome of the emergency decree, reliable information on the size
of the informal money markets was revealed by debt-ridden business firms.
The total of the curb-market loans declared by them amounted to about
350 billion won, equivalent to 80 percent of the broad money supply and
to 34 percent of the outstanding domestic credit of the banking system (Cole
and Park 1983:127). Approximately 114 billion won of these borrowings were
lent to enterprises by their owners and shareholders.
 The President’s Emergency Decree (1972) 169

Although thousands of curb-market lenders went bankrupt, the lower

interest rate on the rescheduled debts provided immediate and substantial
assistance to heavily indebted firms. According to a rough estimate by the
Bank of Korea, the annual savings from the reduction of the interest bur-
den in 1973 reached more than 100 billion won (BOK, Report on the Results
of the August 3, 1972, Presidential Emergency Decree, 1973:63). As a whole, the
emergency decree was believed to have directly caused a 3.2 percent reduc-
tion in the average ratio of financial costs to total business costs for all
manufacturing, thereby increasing the ratio of profit to net worth for the
same industry by about 9 percentage points (K. S. Kim 1972:45-66).
The debt-refunding operations proved, however, to be only a temporary
relief to firms in financially difficult positions. In the long run, the meas-
ures directed at improving the capital structure of private business firms
failed because they were not followed up by basic policies to deal with the
institutional and economic factors that led to the emergence of the curb
market.
Most crucial, the government failed to eliminate the disparity between
interest rates in the formal and the informal markets. The general down-
ward interest-rate revision contained in the emergency decree marked a com-
plete return to financial repression and conveyed clearly the government's
message that it would adhere to a policy of low interest rates and credit
rationing—the major causes of the continued expansion of the unorganized
financial markets and the persistence of financial dualism.
In addition, institutional factors failed to deal with the country’s finan-
cial market anomalies. It was widely believed that many debtors did not
bother to report their debts, despite the apparent inducement to the bor-
rowers for declaration under the emergency decree, because they knew that
the curb market crackdown would not last indefinitely and that institutional
sources of funds would remain as scarce as ever. Furthermore, the biggest
private moneylenders, who were the most important source of capital for
the informal money market, were able to take their money out of the mar-
ket through a sort of information sharing arrangement among ultimate
lenders, borrowers, brokers, and dealers. According to Kang Kyong Shik,
the minister of finance during 1982-83, the emergency decree failed because
the government did not make it impossible for curb-market lenders to hide
behind anonymous bank deposits (Far Eastern Economic Review, 9 July
1982:48-50). Under the banking laws, technically anyone could deposit an
unlimited amount of money just by giving any name and a matching seal
for bank registration and withdrawals. Curb-market operators probably took
advantage of this protection of anonymity and used banks as conduits for
secret lendings.
By requiring a resident registration number to identify depositors, the
government might have marginally succeeded in identifying curb-market
loans that were secretly advanced to companies or anonymously deposited
170 Wan-Soon Kim

in banks. However, big private moneylenders were also the owners of large
business enterprises and could easily say that such large deposits were for
investment in their own companies. “Dummy” names could be used for
bank deposits to hide curb-market operations. Minister Kang’s proposal to
require a “real-name” deposit system, if implemented, could have contrib-
uted to a more equitable taxation of capital income. The tax on property
income, such as income from bank deposits, is relatively lower than the
tax on wage income. By using “anonymous” names, financial transactions
can be easily concealed. It would have been an almost impossible task,
however, for the proposal to have effectively eliminated the role of the curb
market in the nation’s economy and business.
The informal money markets were temporarily suppressed but began
to revive only one year later. The emergency decree simply resulted in a
large-scale capital levy on curb-market lenders and a transfer of capital to
borrowers, causing a temporary disruption of the informal money markets
in their effective and competitive role of funding the small-scale sector over
the limits of formal market intermediaries (Cole and Park 1983:165).
The emergency decree had little impact on the recovery and subsequent
expansion of the economy. The major factor in the sharp upturn of eco-
nomic activity after the emergency decree was an upsurge in export de-
mand and a consequent revival in fixed investment. Merchandise exports
rose during 1973 by more than 98 percent (in current dollars) compared
to the previous year. An important factor in the almost unprecedented
growth in Korean exports was the sharp expansion in total Japanese im-
ports estimated at about 70 percent during 1973. Korea benefited from this
expansion because of its traditional trade links with Japan and its improved
export competitiveness due to its devaluation of the won. Between 1971
and 1973 the won had been devalued by 18 percent against the dollar and
39 percent against the Japanese yen, which was considerably larger than
the increase in the domestic price level.
Similarly, the emergency decree had little impact on Korea’s financial de-
velopment. Within a year most of the indicators measuring the extent of
financial development, profitability, and other elements of management ef-
ficiency began to deteriorate and then returned to the levels that had
prevailed before the emergency decree. The debt-refunding operations might
have had more serious repercussions for the economy in the following years
if the upsurge in export demand had not more than offset the effects of
the disruption of the credit system (Cole and Park 1983:164-65).
Price Stabilization
An ambitious goal of the emergency decree, aimed at paving the way for
renewed economic growth, was to limit wholesale price increases to 3 per-
cent annually, beginning in 1973. Because “expectations of inflation” were
blamed for propelling the price movement and as inflation had been strongly
 The President’s Emergency Decree (1972) 171

built into every aspect of economic life in Korea, the gradual attainment
of price stabilization seemed almost impossible. It was argued that if the
inflation psychology was ever to be eliminated in Korea, it would have to
be done within a short period of time by government-imposed, drastic,
shock-therapy measures (K. S. Kim 1977).
The Korea Development Institute rendered theoretical, as well as em-
pirical, support to the government's program by substantiating the feasi-
bility of the 3 percent price stabilization target, by applying Song Heeyhon’s
price equation derived from quarterly data for 1965-71. Song developed a
Harberger-type dynamic model of inflation to explain the short-term vari-
ations of the wholesale price in Korea. The short-term variations of the
wholesale price were explained by changes in money supply, income, the
foreign exchange rate, public utility prices, and the price of rice. Having
analyzed the factors increasing the WPI, Song (1972:192) forecasted that
the 3 percent price stabilization goal might be attained in 1973 if the govern-
ment could keep the exchange rate at about 400 won per U.S. dollar and
hold the annual average rates of increase in the rice price, public utility
charges, and money supply within the assumed levels of 5 percent, 3 per-
cent, and 19.9 percent, respectively, while achieving a high annual growth
rate of real nonagricultural GNP of 12.3 percent.
In 1972, at the same time that the government was making efforts to re-
strain undue monetary expansion, improve industrial productivity, and
stabilize the exchange rate, rice prices, and public utility charges, it was
also creating broad-based, direct measures to control private prices. Direct
measures were also being taken to stabilize import prices. For example, when
the international prices of scrap iron and lumber shot up, the import
predeposit ratios for these commodities were temporarily reduced. Restric-
tions on the export of some commodities were also imposed when sup-
plies were short in the domestic market.
The government negotiated directly with each industry to persuade them
to reduce their prices. The so-called cost-reduction campaign under the
Ministry of Commerce and Industry succeeded in suppressing the prices
(warehouse delivery) of about 42 industrial goods by 2 to 15 percent in three
months (February to April 1973). Also, the Office of National Tax Adminis-
tration set up 460 “mobile price control patrols” and 80 “price assurance
forces” to monitor price increases. Where “gouging” and “cornering” were
found, violators were subjected to an immediate tax investigation, a spe-
cial excess profits tax, and curtailment of bank credit. Moral suasion was
also attempted through a major meeting between government and busi-
ness leaders (Jones and Sakong 1980:125).
The results of the direct price controls were predictable, leading to un-
desirable developments such as under-the-table payments, supply short-
ages, poor product quality, and other strategies to circumvent the controls.
The government responded with production quotas and daily checks on
172 Wan-Soon Kim

shipments of major producers. The Law on Price Stability, enacted in March

1973, prohibited both sales at greater than ceiling prices and restricted
shipments.
Realizing the inefficiencies and long-term ineffectiveness of such direct
price controls, the government lifted the freeze in December 1973. Because
prior approval was required for price increases, and some justifiable price
increases were long overdue, when allowed, prices tended to leap upward.
Finally, on 5 February 1974, in the wake of the 1973 oil shock, direct price
controls were abolished and replaced by selective controls on 32 items. That
marked the end of the emergency decree as well.
The government's direct price-control measures contributed, in the short
run, to preventing some monopolistic price increases, but with massive ad-
ministrative costs. Besides, certain fundamental factors made government
control over prices unworkable. First, the complete elimination of inflation
psychology within a short period of time by shock measures was a formi-
dable (if not an impossible) task for the government. Second, price con-
trols encouraged the emergence of black markets. The discrepancy between
controlled and black-market prices caused expectations of high future prices
that tended to aggravate the prevailing inflation psychology and made the
price stabilization effort all the more difficult. Finally, the government's price
stabilization efforts were frustrated by the upheaval in world commodity
markets and by the acceleration of price pressures in the United States and
Japan. Overseas price developments could not have been foreseen when
the target of limiting price increases to 3 percent was adopted in 1972 as
part of the emergency decree.

Change in Interest-Rate Policy

A policy of high nominal rates of interest is generally unpopular and there-
fore often politically difficult. The 1965 financial reform in Korea provoked
an outcry of protests in business circles and drew dire predictions of infla-
tion, bankruptcies, and a slowdown of growth. None of these happened.
Businessmen and the general public tend to think of inflation in cost-
push terms. They see the possible adverse effects of higher interest rates
and rising capital costs but fail to see the much more important effect of
financialization of household savings and improvement of efficiency of in-
vestment, both leading to a higher level of savings, investment, and growth.
The high-interest-rate policy of 1965 was gradually relaxed over the years.
With the onset of the business slowdown and the resurgence of inflation
in 1971-72, the average debt/equity ratio of Korean firms at 4 to 1 became
almost untenable under the high interest rates, in particular the annual aver-
age of 36 percent interest charged on curb-market loans. Therefore, quick
financial relief to those debt-ridden enterprises was considered imperative.
Also, Korean officials argued that if reasonable price stability could be ex-
pected through the government's drastic anti-inflationary measures, a posi-
 The President’s Emergency Decree (1972) 173

tive real rate of interest would be attainable even at relatively low nominal
rates. Furthermore, the rising real cost of capital was believed to be an ele-
ment of cost-push inflation that, if not checked, would weaken Korea's com-
petitiveness in the export markets. For those reasons the emergency decree
reduced the commercial bank basic lending and time-deposit rates by 3.5
to 4.5 percentage points. Thus, the government returned to the pre-1965
style of financial repression.
Korean officials have a deep-rooted belief in the efficacy of a low-interest-
rate policy. To begin with, there has been an historical antipathy to high
interest rates. Second, policymakers thought that market-determined in-
terest rates would rise to very high nominal levels and contribute to infla-
tion. Third, the economic authorities held that the cost of capital should
be kept low in order to achieve a high rate of economic growth in line with
the government-led development strategy and to cajole reluctant business-
men into taking the risks inherent in the development of the heavy and
chemical industries. Fourth, in the 1970s saving was shown to depend on
income, the remittances of overseas workers, and other factors more than
on changes in interest rates. Finally, even if the policymakers had realized
the merits of a positive real interest-rate policy, they were not willing to
pursue an unpopular course in the face of strong opposition from the fa-
vored borrowers (Cole and Park 1983:138-40).
After the general downward adjustment of nominal interest rates in Au-
gust 1972, the real interest rates in the banking sector were, on average,
close to zero and sometimes negative during 1973-78, because of the higher
rates of inflation. In comparison, the curb-loan rates consistently carried
annual interest rates at about 36 percent on average, reflecting the nominal
rate of return to fixed assets and to capital in the manufacturing sector (Ta-
ble 7.2). The residential land-value index almost doubled between 1972 and
1975. As a result, the growth of the formal financial sector slowed down,
and much of domestic savings shifted back into the curb markets or into
other assets. In short, the reduction in the real interest rates on bank deposits
drove savers away from the banking institutions to the markets for real as-
sets (land, apartments, and houses) for speculation and to the informal
money markets.
The low-interest-rate policy generated an excessive demand for credit and
necessitated discretionary allocation of funds, which usually excluded
smaller firms because of their inadequate collateral and credit standing. Not
surprisingly, priority in credit allocation or “policy” loans was given first
to the government-owned or controlled enterprises, then to those indus-
tries considered strategic to economic development, such as large export
firms. Although Jones and SaKong (1980:109) maintain that resources were
generally allocated to qualified users under the Park government, some per-
sonal bias and corruption were nevertheless the predictable outcome of dis-
cretionary credit rationing.
174
Nene
eee
Wan-Soon Kim ee

Table 7.2. Interest rates, rates of return, and real estate prices: 1964-78
Rates of
return
Nominal to fixed Resi-
interest Curb assets in dential
rate Real market manufac- Housing land
ontime WPI interest interest turing prices prices
deposits (1975 rate rate sector (1965 (1965
Year (%) = 100) (%) (%) (%) = 100) = 100)
1964 15.0 26.2 -14.9 61.4 32.0
1965 30.0 28.8 8.1 58.8 43.0 100 100
1966 30.0 31.4 1922. Dee7, 40.0 142 165
1967 30.0 33.4 ONG) 56.4 37.0 165 200
1968 26.0 36.2 AV 50.9 28.0 217 303
1969 24.0 38.5 16.6 Lz 28.0 365 675
1970 22.8 42.0 12.6 50.8 25.0 379 676
1971 POY) 45.7 12.3 46.3 23.0 516 993
ive 15.0 52.0 1.7 38.9 Zi 593 1,033
1973 12.6 55.6 es! ee wed 34.0 683 1,116
1974 15.0 79.0 -19.3 37.6 30.0 802 1,400
1975 15.0 100.0 -9.2 41.3 29.0 1,108 2,009
1976 15.6 121 3.0 40.5 33.0 1,414 2,707
GE 15.8 1222 6.6 38.1 ile ges) 3,472
1978 16.9 136.5 4.5 41.7 3,055 7,895

Sources: Cole and Park (1983:tables 30 and 49); KNHC, Handbook of Housing Statistics (1983:322).

Following the policy of low interest rates and government efforts to foster
the capital markets, the demand for stocks and corporate debentures grew
significantly, and dependency on them rose from 6 percent of total sources
of corporate funds in 1968 to 22 percent in 1973 (Table 7.1). The long-term
securities markets, however, neither reduced the heavy reliance on bank
and foreign-loan financing nor weakened the direct link between the govern-
ment and the large corporations. To keep the large industrial groups under
effective control, the government could not let the market dictate the allo-
cation of credit. Two additional factors impinged on the adequate supply
of securities. First, few firms were willing to raise funds through the equity
markets beyond the amounts required by the government because of the
par-value pricing method and the high financing cost of new issues (Cole
and Park 1983:274). Second, as noted before, the low-interest-rate policy,
in combination with inflation and tax deductibility, increased the prefer-
ence of corporations for debt over equity financing.
Cole and Park (1983) argue that the renewed financial repression after
1972 had no apparent adverse effects on either overall economic growth
or aggregate domestic savings, at least until 1978. Indeed, the Korean econ-
 The President’s Emergency Decree (1972) 175

omy grew at an average annual rate in excess of 10 percent over the period
1973-78. Domestic savings rose from 19 percent of GNP in 1969 to 26 per-
cent in 1978.
Cole and Park (1983) do not discount upward-biased economic growth
by allowing for non-national account components, but externalities such
as the environmental effects of industrial growth have aroused serious con-
cern in Korea. Water and air pollution and the disposal of wastes are the
main environmental problems Korea faces. Wastes discharged into the four
main rivers and the coastal waters near the big cities increased rapidly dur-
ing the 1970s.
Income distribution, however, seems to have deteriorated since the lat-
ter half of the 1970s. Soaring prices of real estate may have been responsi-
ble for the deterioration in the distribution of wealth. Between 1972 and
1978 average housing prices increased by more than five times and residen-
tial land prices increased by more than seven times, whereas wholesale
prices rose less than threefold (Table 7.2). As a result, the differences in
wealth between those with their own houses and those without have wi-
dened markedly.
A highly regressive set of rapid growth strategies, especially preferen-
tial low interest credit and tax concessions, generally accorded to large in-
dustrial enterprises at the expense of small and medium-size business firms,
contributed to the concentration of business in Korea. At present, the level
of industrial concentration in Korea is relatively low by historic Asian stan-
dards, but it is increasing at a rapid rate.
Moreover, government encouragement of capital-intensive projects has
preempted investment funds that might have gone to the small and me-
dium industries, which produce a large part of the country’s daily necessi-
ties. Consequently, both the shortage of consumption goods and the excess
demand for them have become an important source of inflation in recent
years.
Finally, some symptoms of inefficiency have been visible. Owing in large
part to the government's growth-promotion measures, the rapid expansion
of the heavy and chemical industries caused by overinvestment has resulted
in some duplication of investment and excess capacity. The rapid increase
in the incremental fixed capital output ratio from 2.5 during 1964-73 to 3.7
during 1974-81 was a matter of some concern (BOK, National Income,
1982:351-52). This evidence of the deteriorating efficiency of invested capi-
tal was a warning note to Korea's long-run debt servicing capacity. Thus,
the importance of industrial deepening and technological upgrading for
an improvement of productivity of capital cannot be overemphasized.
A high positive interest rate is called for, not because it functions as an
unambiguous, direct inducement to save, but because it represents the op-
portunity cost of holding financial assets. If the growth of the organized
financial system is a top policy priority and if the intention is to induce
176 Wan-Soon Kim

a shift in savings from curb markets, the monetary yield on the latter should
at least be comparable to the rate of return on holdings of goods or other
tangible assets, as determined by the rate of change in their prices.
Industrial Rationalization
As Korea entered the 1970s its industrial sector had become more oriented
toward heavy manufacturing and chemical industries and more dependent
on export demand than in the 1960s. It was widely recognized by both
government and industry that simply promoting industrialization was not
sufficient and that manufacturing industries had to be able to export at com-
petitive prices. Therefore, with the onset of the business slump in 1971-72,
the decline in profitability of major industry groups caused serious concern.
Clearly influenced by the experience of the Japanese Ministry of Inter-
national Trade and Industry in modernizing and rationalizing key indus-
tries during the period 1952-60, the Park government decided to create,
through the emergency decree, an Industrial Rationalization Fund of 50 bil-
lion won to provide long-term, low-interest loans to modernize equipment
and machinery, initiate mergers, and improve the capital structure of
manufacturing industries. These measures were intended to make Korean
industries more productive so that they would contribute to achieving the
3 percent rate of domestic-price stabilization. The government also meant
to make priority industries more competitive in the world market, and
where appropriate, to force mergers and consolidations that would bring
about economies of scale.
The Industrial Rationalization Council was established under the Office
of the Prime Minister to determine who would obtain financial privileges
under the emergency decree. The council was chaired by the minister of
the EPB and its membership included various economic ministers, gover-
nors of special banks, and other private members designated by the presi-
dent. The council examined candidate companies to determine whether
they met the eligibility criteria under which they would receive preferen-
tial loans, tax allowances, preferred access to loans of banking institutions,
and various administrative favors. Final approval, however, rested with the
president.
To be eligible to receive financial privileges under the decree, compa-
nies iad to fit within one of the following categories: (1) industries produc-
ing goods or services indispensable to the nation; (2) industries promoting
related industries; (3) machine and raw material manufacturing industries;
(4) export industries, tourism, and other foreign-exchange earning indus-
tries; and (5) farmers’ subsidiary businesses or agricultural/fisheries process-
ing industries that would significantly increase the incomes of farmers and
fishermen.
Furthermore, companies had to demonstrate that their rationalization
and development would make them more productive and profitable and
 The President’s Emergency Decree (1972) 177

thereby benefit the overall national economy. Rationalization funds were

to be used to facilitate mergers and consolidations in order to encourage
specialization and vertical affiliation of production, optimum scale and
methods of production, and the liquidation and transformation of busi-
nesses that were redundant. Funds were also to be used for improvement
of the physical plant and equipment, to increase captial and otherwise
strengthen the financial structure of an industry, and for development of
technology and innovation.
Concerned about the considerable increase in the concentration of Korean
industry during the period 1966-71, the Industrial Rationalization Fund en-
deavored to assist small and medium industries important in textiles. The
criteria for rationalization of small and medium industries or enterprises
were supposed to be determined on an individual basis, taking into con-
sideration the special position and characteristics of those industries.
In addition to providing favorable loans, the emergency decree set al-
lowable accelerated depreciation at 50 to 80 percent for companies that met
the economic eligibility criteria. A further stimulus to the substitution of
capital for labor was provided by the tax investment credit for investments
using domestic resources. The new credit allowed corporations to deduct
10 percent (the rate had previously been 6 percent) of the cost of new in-
vestments using domestic resources from their income and corporate tax
liability, until the end of 1974. Accelerating depreciation and the investment
tax credit together increased the level of corporate investment. According
to one crude estimate, an investment of 14 billion won would have been
generated for the manufacturing sector if the maximum depreciation rate
of 80 percent had been applied (W. S. Kim 1972:143-52).
Some 36 billion won of the 50 billion fund was released by the end of
1973. Manufacturers of polyvinyl chlorides were one of the first groups to
take advantage of the financial assistance offered by the government in their
attempt to merge companies and rationalize production facilities and pro-
grams by expanding the most efficient units and shutting down the un-
economic ones. The amount of government loans distributed for the
expansion of facilities in such key industries as electric power, steel, poly-
vinyl chlorides, and others supplying raw materials accounted for more than
75 percent of the total, whereas less than 4 percent of the funds were given
to small and medium-size industries.
It is apparent that the screening procedures left virtually complete dis-
cretion to the Industrial Rationalization Council. Because almost any en-
terprise could construct an argument for privileges under some provision
of the decree, and given the excess demand for preferential credit at a low
rate (8 percent per annum), discretion was thus inevitable. The success or
failure of the rationalization scheme depended on the government's ability
to make the right judgments about trends in international trade and about
which Korean industries would have a comparative advantage. Pointing to
178 Wan-Soon Kim

the considerable difficulties in documenting the manner in which discre-

tion was actually exercised under the Park regime, Jones and SaKong
(1980:107-09) conjecture that the government made a genuine effort to ascer-
tain whether the applicant met the economic eligibility criteria, and
resources were generally allocated to qualified users. It is more than likely
that if a consensus in the council on an industry plan were reached through
coercion rather than persuasion, personal bias and wrong judgment would
have misallocated the resources.
Tax Revenue Sharing
The principal type of central government grant in Korea is tax revenue shar-
ing. The amount of locally shared revenues is the difference between the
amount needed for standard services defined by the central government
(calculated on the basis of a system of unit costs) and the amount yielded
by 80 percent of the local taxes at the legal or standard rates enumerated
in the Local Shared Tax Law. Although this method appeared objectively
to recognize inequalities of financial capacity and needs existing at the lo-
cal level, the total grant disbursed was not the aggregate of the excess of
total needs over total revenue. Instead, the grant was pegged at 17.6 per-
cent of the estimated national internal taxes (central government taxes, ex-
cluding custom duties and monopoly profits), and actual distribution
procedures became subject to political negotiations between the central and
local governments.
Still other defects existed. First, the amount needed for standard ser-
vices was computed only on the basis of the units of services enumerated
in the Local Finance Law, which inadequately measured minimum public
service levels. Adjustments made to expenditure requirements due to un-
foreseen factors, such as price increases, were inadequate. Second, a region-
ally differentiated unit-cost method without due regard to population size,
for instance, was discriminatory among provinces. The third defect stemmed
from the fact that the local governments had neither their own kinds of
tax nor the power to raise or lower tax rates in response to the needs of
the local residents. In short, Korea's equalization scheme offered no op-
portunity for the provinces to exercise their own tax efforts.
The 1972 emergency decree, drawing upon the experience of the previ-
ous 20 years, eliminated the legal stipulation of the proportions of revenue
sharing in order to reduce the 1973 government budget and to enhance the
anticyclical role of future budgets. In other words, the emergency decree
made central government financial transfers subject to the policies of the
central government at a given time. In the 1973 budget, the funds trans-
ferred from the central government to local governments decreased by 0.93
percent to 16.67 percent of national internal taxes.
It was believed at the time that the end to guaranteed earmarking left
local governments uncertain that minimum financial requirements could
 The President’s Emergency Decree (1972) 179

be met, because transfers could fluctuate from year to year depending on

national policy demands on the budget. This author has argued that local
governments were entitled to revenue growth linked to the growing econ-
omy and that transfers should be put on a more stable and objective basis
to preserve local autonomy (W. S. Kim 1977:342-46).
Between 1972 and 1980, locally shared tax revenue, measured as a per-
centage of national internal taxes, declined from 17.6 percent to 10.2 per-
cent (EPB, ROK, Budget Summary, 1983, 1985). A precise formula for the
determination of the grant amount was restored in July 1982, but with the
reduced percentage of shared tax revenue at 13.27 percent of the estimated
national internal taxes.

REFLECTIONS ON
AND LESSONS OF KOREAN EXPERIENCES
Although Korea is predominantly a private-enterprise economy, a policy
environment exists in which private business firms have been compelled
to follow government direction. Given the government's highest policy pri-
ority of rapid economic growth and identification of rapid growth with the
regime's political success, the Park government could not allow any finan-
cial deterioration or constraints to interfere with that objective.
The monetary reform of 1965, although not a consistent financial liber-
alization, demonstrated the effectiveness of a positive real rate of interest.
The measure led to a dramatic rise in household deposit savings, the growth
performance of the economy was impressive, and the rate of inflation
dropped sharply. In contrast, the thrust of the 1972 economic policies was
a major retreat to financial repression.
The abrupt attack on the curb market did not work. Its total elimination
turned out to be an impossible task, precisely because the measures en-
forced did not address the real reasons why the informal money market
had flourished. First, to achieve a high rate of economic growth in line with
the government-led development strategy, the government deliberately ca-
joled businessmen into relying heavily on the “policy” loans of the finan-
cial institutions under its effective control. Second, the government had
a policy of providing preferential low-interest credit, so that priority projects
got started right away, but the government failed to institutionalize the in-
formal money market. Furthermore, because the commercial banks failed
to supply short-term liquidity and improve their loan operations, the curb
market has been a major source of funds, meeting urgent short-term finan-
cial requirements for a large number of firms, both big and small. Contrary
to what the government argued, the curb money market has not been a
constraint to economic growth. It did not inflict harm on the public, espe-
cially the small businesses, nor did it impede the efficiency of capital as
a whole. In sum, a low-interest-rate policy and consequent credit rationing
were the major causes of the continued expansion of the unorganized finan-
cial markets in Korea.
180 Wan-Soon Kim

Therefore, any rash attempt to close the market that supplements the
very deficiencies of the organized financial markets would seriously im-
pair the normal operations of the nation’s businesses. Thus, Cole and Park
(1983:290- 91) conclude that one important lesson to be learned from the
Korean experience with the curb markets is that the social costs incurred
by the administrative control of the credit market are too great and that
it is difficult for the government to destroy a financial system that is fulfill-
ing a useful role. Thus, Cole and Park indict any abrupt attempts to sup-
press the curb markets, such as the emergency decree, as being contrary
to the broader public interest.
The principal short-term target of the decree was price stabilization. Ac-
cording to Jones and SaKong (1980:290-91), however, the government's at-
tempt at broad-based price controls proved to be inefficient and was in fact
an aberration. Furthermore, a year after the emergency decree, the outcome
of this domestic policy was completely overshadowed by the worldwide
recession following the Arab oil embargo (October 1973), the food crisis,
and the recession in the United States. In December 1973 alone, wholesale
prices jumped by 5.4 percent; and during the first quarter of 1974, the WPI
increased by 22.5 percent. Under such a situation approaching hyperinfla-
tion, the real interest rates in the banking sector were on an average close
to zero or sometimes even negative. And the curb money market appeared
to gain its market share once again.
The emergency decree was believed by many policymakers to have
brought some improvements. But, at best, they were short-lived and more
apparent than real. The recovery and subsequent expansion of the econ-
omy were largely due to an upsurge in exports. The decree had no apprecia-
ble impact on Korea's financial development. Hence, one conclusion that
can be drawn from the Korean experience is that repressive measures re-
quire continued intervention to make up for their flaws. The Korean govern-
ment’s failure to enhance financial deepening in subsequent years
persuaded the monetary authorities to retreat farther from liberal financial
policies. Likewise, any success would only have reinforced the rationale
of the repressive measures (Min 1976:56).
Finance had mattered as much as the real-sector variables, such as in-
vestment, saving, and export, in explaining growth and development. The
sharp increase in the incremental fixed capital-output ratio during 1974-81
raises a serious question as to the efficiency of invested capital during this
period. Symptoms of inefficiency are obvious in some industrial sectors,
largely brought about by officially directed, subsidized credit, and govern-
ment coercion that had initiated various industrial projects, in spite of their
dubious comparative advantage. As a result, excess capacity emerged in
heavy industries, while excess demand in the face of capacity limitations
for light industrial goods fueled inflationary pressures. Furthermore, the
long gestation periods of heavy industrial investment, creating income gains
without immediate output gains, also boosted domestic prices.
 The President’s Emergency Decree (1972) 181

One important legacy of the emergency decree is the continuing antipa-

thy to high nominal interest rates. Since 1980 downward adjustments of
the interest rate on one-year time deposits continued until the rate reached
8 percent per annum in June 1982. As in the case of the emergency decree,
such sharp reductions were justified on the grounds of providing financial
relief to debt-ridden enterprises. As usual, the government argued that be-
cause of its successful anti-inflationary measures, a positive real rate of in-
terest would be attainable at relatively low nominal interest rates. Obviously,
the government used the current rate of inflation in its computation of the
real interest rate, but failed to consider whether the yield on monetary sav-
ings was at least comparable to the rate of return on holdings of goods or
other tangible assets. The currently used price indexes underweigh the
rapidly rising housing costs and cannot represent the opportunity cost of
holding financial assets.
Another important legacy of the emergency decree is a borrowing pro-
file that business firms in Korea have developed over the years. Since
“problem” firms have been rescued so long as they have conformed to
government policies and have responded to government suggestions, they
are assured that the government is likely to assist them in any future peri-
ods of financial stringency. This, in turn, has prompted the new en-
trepreneurs to incur, even if not recklessly, the risk of overexpansion and
excessive corporate indebtedness. In other words, a system of credit allo-
cation based on preferential financing has encouraged Korean enterprises
to rely more on debt financing than on internally generated funds. Indeed,
it is a moot question if Korean business firms, after having been addicted
to borrowing, would be able to overcome their financial difficulties without
external assistance.
Some people argue that the authorities “know best” and that they can
intervene directly in economic management, enforcing discretionary deci-
sions that will prove, in the end, to be both coherent and desirable. In the
past, the combination of persuasion, inducement, and coercion often suc-
ceeded under a repressive political system. But as the emergency decree
illustrates, even the use of the government's discretionary command proce-
dures was limited in the face of strong private market forces. The curb mar-
ket has survived many repeated assaults. As the Korean economy becomes
more complex, the bureaucracy simply cannot control as many aspects of
the economy in as much detail as it would like. On the grounds of reduced
complexity and more efficient allocation of resources, the repressive finan-
cial system should be dismantled and the discretionary bureaucratic deci-
sion making should be withdrawn.
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 8 Policy Response to the Oil Crisis
and the Presidential Emergency Decree
(1974)
by Yoon Hyung Kim

The Middle East war of October 1973 and the oil crisis brought home to
Korea its extreme vulnerability to external developments. The Arab oil em-
bargo and the quadrupling of the world oil price, coupled with the reces-
sion in the Japanese and U.S. economies and the high price of food grains
and raw materials, posed a major threat to the future prospects of the Korean
economy. When the oil price shock occurred, Korea depended on imported
oil for 55 percent of its total energy needs, and was, therefore, hit hard by
the sharp increase in the world oil price.
Korea's energy resources are limited to anthracite coal, hydropower, and
firewood. Anthracite coal is the main domestic energy resource with total
reserves estimated at 1.5 billion tons, of which no more than 545 million
tons are recoverable (about 30 years’ supply at the 1980 production rate).
Anthracite coal deposits are in mountainous areas, which require draft- and
shaft-type underground mines and labor-intensive mining with low produc-
tivity compared with other methods of mining. The quality of coal is poor
(about 3,500-5,500 kcal/kg) and is not suitable for coking coal. Korea's
hydroelectric potential is estimated at 2,000 MW and is concentrated on four
main river systems—Han, Naktong, Kum, and Sumjin. Most of the sites
are small and have a low head, so that costly dams are needed to regulate
the river flows.
At the beginning of the industrialization drive of the First Five-Year Eco-
nomic Development Plan (1962-66), fuelwood was the basic energy source.
It could not, however, provide sufficient energy for industrial production
and power generation, which were growing at average annual rates of 15
percent and 17 percent, respectively.
Because firewood had been the predominant source of primary energy
through the early 1960s, the mountains were denuded. Concerted efforts
for reforestation have been pursued since the early 1960s. A law for the
preservation of forests was enacted and a reforestation program was un-
dertaken to control erosion and to protect watersheds. Only limited fuel-
wood was available from the thinning and removal of excess trees and
cutting was allowed only by permit.
The government encouraged not only the industrial sector but also the
urban residential and commercial sectors to replace firewood with domestic
183
184 Yoon Hyung Kim

anthracite coal. Most of the limited firewood could then be used by the
rural sector. Accordingly, the share of firewood used for industrial energy
declined sharply from 71 percent in 1961 to 16 percent in 1966; its share
in the residential and commercial sector declined from 58 percent to 52 per-
cent. The share of firewood in the total supply of primary energy declined
from 57 percent in 1961 to 43 percent in 1965 (Table 8.1).
The government took a series of steps to encourage domestic coal produc-
tion. The most impressive policy was the enactment of the Provisional Coal
Development Law in December 1961, providing for the amalgamation of
small, private coal mines. As a result, the production of anthracite coal in-
creased twofold from less than 6 million tons in 1961 to about 12 million
tons in 1966, showing an average annual growth rate of about 15 percent.
The share of coal in total primary energy consumption rose from 33 per-
cent in 1961 to 44 percent in 1965 (Table 8.1).
As the economy spurted in the early 1960s, the domestic supply of an-
thracite coal could not meet the growing demand for fuel by the industrial
and power sectors. The growth rate of the manufacturing sector increased
from 15 percent per annum in 1962-66 to an average rate of 22 percent per
annum in 1967-71; the growth rate of the electric power sector increased
from 17 percent to 22 percent per annum.
The urban population (i.e., inhabitants of cities and towns of more than
20,000 persons) rose from 28 percent of total population in 1961 to 34 per-
cent in 1966. The rapid growth of urban areas led to a virtual explosion
in the urban residential and commercial demand for fuel and, in late 1966,
brought about severe supply shortages of coal briquettes used for house-
hold cooking and heating. The 1966 coal shortage was the turning point.
The government then adopted a new energy-transition policy to replace
oil for anthracite coal as the major fuel.
To restructure consumption patterns, the government took measures
ranging from administrative orders and guidelines to publicity campaigns
about the greater convenience and cleanliness of oil heat. It made the im-
port of kerosene space heaters duty-free, encouraged the use of other oil-
heating appliances, imported large quantities of heating oil to meet immedi-
ate needs, and began drawing up plans for future growth in fuel needs
to be met from an expanded domestic refinery capacity and direct imports.
The government restricted coal consumption by the nonresidential sec-
tor. The Korea Electric Power Company was ordered to use oil instead of
coal for all generating plants capable of burning either fuel. This restrictive
policy led to inefficiencies and maintenance problems in coal-fired power
plants. The government also strongly encouraged industrial plants to replace
coal with oil and to install oil-burning equipment.
The substitution of petroleum for coal was successful because of the ex-
perience and knowledge in the field of petroleum acquired through joint
ventures with foreign oil companies, the comparative technical and
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186 Yoon Hyung Kim

economic advantages of petroleum for power generation and industrial use,

and the greater convenience and cleanliness of oil heating for middle- and
upper-income households and for commercial uses. This comparative ad-
vantage lasted, of course, only as long as oil supplies were cheap and
abundant.
The increased competition from petroleum fuels led to a decrease in coal
production by 17 percent in 1968. It then remained at the lower level until
1969, increasing unemployment and hardship in coal-producing regions.
To encourage investment in coal mining and to slow the growth of oil im-
ports, the government increased the import duty on bunker-C fuel oil, from
5 to 10 percent in 1969, using the additional revenue for investment or sub-
sidies in the coal industry.
During the Second Five-Year Development Plan (1967-71), coal’s share
in industrial use and power generation declined considerably. In 1966 coal
accounted for 78 percent of thermal power generation and 40 percent of
industrial requirements; in 1971 the respective shares were only 5 percent
and 6 percent. This important shift in Korea’s energy policy can be better
seen in the sharply increased share of oil in total primary energy supplies,
from 8 percent in 1961 to 55 percent in 1973 (Table 8.1).
The quadrupling of the world oil price in 1973-74 raised the costs of oil
imports to $1.1 billion in 1974 from about $296 million in 1973. In addition
to the serious deterioration in its terms of trade resulting from the sharp
rise in the price of oil, the attendant world recession led to a weakened
world demand for exports, thereby exacerbating the immediate international
balance-of-payments position.
In response to the oil crisis, the government assumed four major tasks:
a diplomatic mission to the Middle East, a mission to the international finan-
cial markets, macroeconomic policy measures, and energy-specific policy
measures. The government identified a top-level Korean manager of an oil
company with intimate contacts in Saudi Arabia and employed him as an
intermediary to contact the Saudi government. In December 1973 the Korean
government dispatched a presidential envoy to Saudi Arabia, carrying a
letter from President Park. The Saudi government proposed in response
that the Korean government issue a statement sympathetic to the position
of the Arab countries. While the government was withholding the state-
ment and consulting with the U.S. government, the Japanese prime minister
visited Saudi Arabia and issued the same statement. The Korean govern-
ment then followed suit.
To secure channels of credit, the government made use of three former
Korean bankers who had good relations with foreign bankers. The govern-
ment sent these financial experts to New York, London, and Tokyo to con-
vince foreign bankers of the growth potential and credit-worthiness of the
Korean economy.
The government implemented a set of policies in January 1974 designed
 Policy Response to the Oil Crisis (1974) 187

to deal with the changes in the external environment. The two main policy
measures were the energy-specific measures aimed at energy conservation
and reduced dependence on imported oil, and the financial policies of rely-
ing heavily on external savings. The government thus made little attempt
to control inflation, which it viewed as imposed by external factors, and
allowed bank credit to expand by nearly 50 percent to finance imports for
economic growth (Cole and Park 1983).
In the face of external shocks such as that of 1973-74 a country could
respond by: (1) expanding its exports, (2) replacing imports with import
substitutes, (3) reducing imports by maintaining a lower economic growth
rate, or (4) increasing external debt to sustain a high economic growth rate.
Korea’s main response was to combine measures (1) and (4), thereby achiev-
ing a real GNP growth rate of 8 percent in 1974, an average annual GDP
growth rate of 7.2 percent during 1974-82, and an increase in the external
trade (exports plus imports) to GDP ratio from 40.3 percent in 1972 to 67.7
percent in 1982. The effectiveness of Korea's response to the external shock
must be attributed, in part, to its outward-oriented trade and industrial-
ization policies and market-oriented pricing policies. These contributed to
the resilience of the Korean economy to external shocks.
What is unique, however, about Korea's response to the external shock
is that, in addition to the policies described above, it undertook certain
microeconomic and energy-specific measures to cope with the shock. The
Presidential Emergency Decree for National Economic Security is a meas-
ure specifically designed to sustain the standard of living for low-income
groups, promote consumption restraints, conserve resources, better utilize
domestic resources, and maintain the balance-of-payments equilibrium.
This chapter focuses on these microeconomic and energy-specific meas-
ures, analyzing how they helped the Korean economy cope with the exter-
nal shock of 1973-74 and its aftereffects.
MAJOR FEATURES OF THE POLICY MEASURES
In December 1973 the president’s Economic Secretariat began an intensive
effort to produce a set of policy measures. Their work was confidentially
guided by the senior secretary for economic affairs of the Office of the Presi-
dent, mobilizing only selected government bureaucrats and a few
economists from the Korea Development Institute. Within one month, the
government issued a set of policy measures known as the Presidential Emer-
gency Decree of 14 January 1974,'to mitigate the worst effects of the oil price
increases and to maintain overall growth.
The Korean government also brought together its then widely dispersed
energy experts to formulate energy policy. Their review of the Japanese Heat
Management Law and energy conservation legislation in France, Germany,
and Scandinavian countries led to formulation of the Heat Management
Law, which was enacted in January 19/4.
188 Yoon Hyung Kim

The Presidential Emergency Decree for National

Economic Security
The Presidential Emergency Decree of 14 January 1974 was a set of sophisti-
cated policy measures that: reduced the burden of oil-price adjustments
on low-income groups, thus sustaining their standard of living; imposed
heavy taxes on the incomes of high-income groups and on the consump-
tion of luxury goods; improved working conditions of low-income wage
earners; reformed the system of tariff-rate exemptions; and adjusted the
1974 budget.
The decree provided a substantial, one-year temporary cut in business
income tax and earned income tax. The cut ranged from 30 to 100 percent,
increasing as the level of income decreased. The exemption limit of the ac-
quisition tax and property tax was raised from 30,000 to 60,000 won. In ad-
dition, the implementation of the newly enacted National Welfare Pension
Program and the Private Schoolteachers Pension Program was postponed
for one year in 1974 to relieve the low-income groups of the burden of con-
tributing to pension funds. Moreover, as a price-stabilization measure, the
sales prices of rice, barley, and coal briquettes—basic necessities of daily
life—were heavily subsidized and administrative guidance was used to se-
cure a balance of their supply and demand. An “unjust-profit” tax was ap-
plied to windfall gains made through price manipulations. The government
also suspended the travel tax on train, streetcar, city bus, van, and
passenger-ship fares, and reduced the travel tax on taxicabs from 20 per-
cent to 10 percent. To maintain the farmers’ standard of living, the govern-
ment increased the purchase price of rice by 500 won per bag (from 10,877
won to 11,377 won per bag) in 1973, with no limit on the quantity of rice
purchased. For the urban poor, the government executed public works
projects amounting to 10 billion won, which expanded employment op-
portunities for low-income urban workers. Another measure created a fund
totaling 30 billion won to be used as a special credit for small and medium-
size firms at the subsidized interest rate of 12 percent, or 3 percent below
the normal bank rate. The government compensated the commercial banks
for the resulting interest loss. Two billion won from the government bud-
get was also contributed to the Trust Guarantee Fund to enhance the mort-
gage position of small and medium-size firms.
The government restrained consumption and promoted conservation by
raising taxes on certain commodities, thus making up for the revenue losses
caused by reduction in the tax burden for the poor. Substantial increases
in customs tariffs and commodity taxes were applied to liquors, passenger
cars, and luxurious items such as jewels, precious metals, and furs. To fur-
ther restrain luxury consumption, entertainment-related taxes were in-
creased by 50-200 percent. Acquisition taxes on villas, deluxe cars, and golf
courses were raised and corporate real estate used for nonbusiness pur-
poses became subject to the tax. The property tax on residential property,
 Policy Response to the Oil Crisis (1974) 189

which had been a uniform 0.2 percent, was made progressive with a maxi-
mum rate of 5 percent. Taxes on vacant land and land held by corporations
for nonbusiness use were raised from 0.2 percent and 0.4 percent, respec-
tively, to a flat rate of 5 percent. The gasoline tax was raised by 50 percent.
The decree specified that priority be given to wage payments and other
claims against employers arising from employment service when employ-
ers disposed of their properties. Heavy punishments were imposed on en-
trepreneurs for overdue wages, unjust dismissals, and poor working
conditions.
The system of tariff-rate reductions and exemptions was modified to se-
cure the balance between supply and demand and thus maintain price sta-
bility by increasing the items eligible for elastic tariff rates from 25 to 70,
including rice, salt, raw materials, agricultural chemicals, and assorted feeds.
To limit imports and improve the balance-of-payments position, tariff reduc-
tions and exemptions were made item-by-item instead of industry-by-
industry, as applied earlier, and the range of exemptions was reduced.
Finally, the government modified the budget for 1974 because of the dras-
tic changes in internal tax and tariffs. Although the revenue from the in-
come tax and the travel tax was expected to decline by 39.6 billion won,
the revenue from the liquor tax, entrance tax, commodity tax, acquisition
tax, property tax, and taxes on petroleum products was expected to increase
by 63.8 billion won. Out of the net revenue increase, 32.8 billion won was
appropriated for financing the public works projects, the subsidy to farm-
ers, the subsidies to the coal industry and to small and medium-size firms,
and a 30 percent increase in salaries of government employees. Moreover,
43 billion won from the general account plus 7 billion from the special ac-
count were held in reserve to suppress aggregate demand by controlling
government expenditures. Use of this reserved fund required approval from
the president.

Energy-Specific Policy Measures

The Korean government's immediate response to the 1973 oil crisis was to
introduce emergency measures for energy conservation and nationwide
publicity campaigns for voluntary conservation of energy. This first emer-
gency program was consolidated later into a more comprehensive energy
program, the main objective of which was to achieve economic growth with
less energy consumption and less dependence on oil. Accordingly, several
energy-specific policies, which were designed to conserve energy and sub-
stitute other fuels for oil, were implemented in 19/.
Energy conservation measures. Some of the most important conservation
measures include pricing policies, publicity campaigns, financial and fis-
cal incentive schemes, regulations for registration, and institutional ar-
rangements.
190 Yoon Hyung Kim

Subsidized electricity had been used to promote industrial development

and coal briquettes were subsidized for the poorest segment of the popu-
lation. The increase in the price of petroleum in 1974, however, drastically
altered that policy. The government increased the domestic prices of petro-
leum products to fully reflect the increased cost of imported oil. Passing
on the sharp rise in the world oil price to final consumers generated strong
incentives for conservation. Furthermore, a heavy tax was imposed on gaso-
line, increasing from 200 percent to 300 percent.
Initially, the government was reluctant to increase abruptly the prices
of coal and electricity, especially in the case of coal briquettes, because these
were used by the middle- and lower-income groups. Later, when a govern-
ment study on coal consumption patterns showed that many users of coal
briquettes could afford the full cost of coal, the price of coal briquettes in
real terms increased sharply from 1977 through 1980. This had the effect
of inducing conservation and stimulating coal production. In 1975, after
charging subsidized rates for many years, the Korea Electric Company
(KECO) obtained substantial rate increases; to encourage energy conser-
vation KECO introduced peak-load pricing in 1977 and increasing block
schedules in 1979.
These pricing policies appropriate for energy conservation were further
augmented with other conservation programs. The Heat Management Law,
enacted on 1 January 1974, was aimed at promoting effective use of energy
by industry. The law, which was amended in December 1975, required that
every firm using more than 500 tons of anthracite coal (or its equivalent)
submit an annual plan for energy conservation and employ a heat manager
to supervise the plan’s execution.
The Heat Management Law also provided for the establishment of energy
consumption standards and the creation in May 197 of the Korea Energy
Management Association (KEMA). The law commissioned KEMA, under
the guidance of the Ministry of Commerce and Industry, to perform heat
audits, train heat managers, inspect fuel-using equipment, provide techni-
cal assistance to large heat users, and recommend methods for improving
efficiency in energy use.
During 1975-80 KEMA conducted numerous activities including heat au-
dits of large-scale industrial plants, technical guidance visits to medium-
size industrial and large commercial plants, on-site energy conservation
reviews, and consultations. It also carried out inspection of boilers and pres-
sure vessels for pressure and safety. If the recommended improvements
had been carried out the savings would have been, according to KEMAs
estimate, 9.4 percent of industrial energy consumption in 1975-80. KEMA
also held energy conservation meetings, seminars, and training workshops
for heat managers, engineers, and technicians.
Since 1975 the government has been promoting an annual National Con-
vention on Energy Conservation Promotion and an annual Energy Con-
 Policy Response to the Oil Crisis (1974) 191

servation Exhibition. Case study reports by heat managers, engineers, and

technicians are discussed and energy-savings systems, new developments,
and models of new concepts are exhibited. The national convention, held
in Seoul and presided over by the prime minister, is attended by more than
3,000 participants each year. Commendations are announced for success-
ful conservation cases, and prizes ranging from the President's and Prime
Minister's Prizes to the Minister's Prize are awarded.
The efforts of the government to promote energy conservation were also
reflected in institutional developments. The Korea Institute of Energy Con-
servation (KIEC) was established in September 1977 to conduct research
on several aspects of conservation, with special emphasis on maximizing
the efficiency of fuel-using equipment. KIEC became the Korea Energy
Research Institute (KERI) in 1980, performing integrated energy-policy
studies. In 1978 the Ministry of Energy and Resources was formed, taking
its staff largely from the Ministry of Commerce and Industry. The new minis-
try assumed responsibility for national energy planning and energy con-
servation.
In response to the second oil shock of 1979-80 and the doubling of the
world oil price, the Ministry of Energy and Resources promulgated the Law
Governing Rationalization in the Use of Energy in June 1980, which replaced
the Heat Management Law. The objective of the new law was to promote
the rational use of energy in all areas and for all users, including residen-
tial, commercial, and transportation sectors not previously covered. It has
the same strict regulations as the Heat Management Law, but also empow-
ered KEMA to order fuel conversion and to designate uses of fuels. The
new law also included provisions for improvement of the total energy sup-
ply system and established a fund to assist in rationalizing energy utiliza-
tion. The fund provided preferential loans for: (1) introduction of
energy-saving equipment, (2) installation of combined heat and power sup-
ply systems, (3) installation of building insulation, and (4) research on and
development of energy-saving equipment.
Within the framework of the above legislative and institutional arrange-
ments, the Korean government introduced several conservation policies spe-
cifically aimed at industrial, transportation, residential, commercial, and
the power sectors.
The Law Governing Rationalization in the Use of Energy of 1980 in-
troduced fiscal and financial incentives to encourage investment in energy-
saving techniques and equipment. Preferential loans for industrial energy
savings investment, insulation of buildings, and solar system installation
were provided by the Energy Rationalization Fund, the Energy Savings Fa-
cilities Fund, and the Solar Energy Promotion Fund. The government also
provided tax incentives for energy-saving investment, such as special
depreciation allowances (100 percent of investment for the first year) and
an investment tax credit of 8-10 percent from corporate or income tax. The
192 Yoon Hyung Kim

government also reduced the tariff rates on imported energy-saving facili-

ties from 15-30 percent to 0-15 percent.
To promote energy conservation in the transportation sector, the govern-
ment restricted the private ownership of automobiles by imposing high ac-
quisition and quarterly use taxes on cars and a gasoline tax of 300 percent.
Since 1977 a special excise tax of 180 percent on gasoline and 7 percent on
diesel fuel has been levied, in addition to the general value-added tax of
10 percent. Furthermore, the government enforced temporary conservation
restrictions during the first and second oil crises—gas stations were closed
on Saturdays and Sundays, limitations were put on the use of official cars,
and speed limits were strictly enforced. In the residential and commercial
sectors, the government launched various publicity and educational cam-
paigns to encourage voluntary energy conservation, such as using less light
and heat at home, limiting the use of private cars, and walking any dis-
tance shorter than two kilometers between home and office and school.
During the first and second oil crises, the government imposed many
temporary but mandatory restrictions on the use of energy. Air-conditioning
was banned except during the period from July 10 to August 20; outdoor
signs using electricity were not allowed except for hospitals, pharmacies,
and emergency purposes; the number of street lights or the level of light-
ing was cut in half; restaurants and similar commercial establishments were
instructed to close one night per week; elevator operations on floors lower
than the third were banned; and surcharges were imposed on individual
households using more than 500 kilowatt-hours (kwh) of electricity per
month.
Building codes for new homes and buildings were made mandatory. The
government also instituted schemes for labeling energy efficiency for a lim-
ited number of consumer electric appliances. Finally, preferential loans were
made available for home insulation and installation of solar hot-water
heaters.
Because the power sector was the largest end-user of primary energy,
the government embarked on a coordinated effort to improve overall en-
ergy efficiency for power plants and to promote energy conservation at the
consumer end. KECO gradually retired old plants with low thermal effi-
ciency and set up mandatory targets of thermal efficiency for each remain-
ing plant. The 345-kV transmission network, commissioned in 1971, became
the backbone of the transmission system. KECO also upgraded the distri-
bution voltage from the 100/200V to the 220/330V level. Furthermore, an
automatic load-dispatching facility installed in 1979 enables KECO to pro-
vide economic dispatch. The most important measure for saving electric
energy, however, was the revised tariff structure. Residential and commer-
cial consumers were put on an escalating block schedule so that, as they
used more electricity, the average charge per kwh increased. Furthermore,
the previous decreasing rate schedule for industrial customers was replaced
 Policy Response to the Oil Crisis (1974) 193

in 1979 by a flat-rate schedule for all energy consumption. Finally, for load-
management purposes, peak-load pricing was introduced in 1977 for large
industrial customers. Such revisions of the tariff structure were introduced
as an incentive to reduce consumption and shift use to hours when aver-
age electricity costs were lower.
Transition away from oil as the dominant source of primary energy. The
Korean economy has undergone three energy transitions. The first transi-
tion, from firewood to anthracite coal, was made during the period of the
First Five-Year Economic Development Plan (1962-66). The second transi-
tion was characterized by the replacement of coal by oil during the period
of the Second Five-Year Economic Development Plan. Since the oil crisis
of 1973-74, a new transition from oil to a different mix of imported fuels
has been under way.
The oil crisis of 1973, the steep rises in oil prices in 1974, the prospect
of further oil price increases, and the possibility of future shortages led the
government to promote the maximum exploitation of domestic energy
resources and to diversify imported fuels among oil, coal, and nuclear en-
ergy. The government promptly launched an interim program for increased
development of domestic energy resources and a nationwide campaign to
conserve energy. It also prepared a long-term plan for rationalizing energy
supplies and minimizing their costs. To increase production of domestic
coal, the government raised the price by 51 percent in 1974 and by another
26 percent in 1975. It also provided a grant of up to 70 percent of the cost
of getting a mine into operation and concessionary loans for up to 15 per-
cent of these costs for the coal industry. This subsidy was mainly financed
with the proceeds from the special tax levied on bunker-C oil. Although
the government had promoted maximum exploitation of hydroelectric
resources, hydropower could not meet the sharp increase in fuel demand
arising from rapid economic development and industrialization. Conse-
quently, the government looked to other imported fuels, particularly nuclear
fuel and coal.
The government strongly encouraged the cement industry to replace oil
with imported bituminous coal through subsidized credit measures. It also
ordered the power company to burn coal instead of oil in all generating
plants capable of burning either fuel. Furthermore, the government
switched its major fuel for power generation from oil to a mix of nuclear
energy, bituminous coal, and oil by constructing nuclear power plants, coal-
fired power plants, as well as oil-fired power plants. Since the first oil cri-
sis, the central feature of the Korean program for power expansion has been
a massive shift to nuclear power and coal-fired thermal power. Finally, as
domestic coal nearly reached its maximum rate of production, the govern-
ment began to import anthracite coal to slow down the substitution of
petroleum products for coal in the residential and commercial sector.
194 Yoon Hyung Kim

THEORETICAL APPROPRIATENESS
The Presidential Emergency Decree
The principal objectives of the decree were to bring about an equitable dis-
tribution of the burden of the imported inflation and to cushion the effect
of the worldwide recession on domestic economic growth. To this end, tax
reductions for low-income groups and tax increases for high-income groups
were introduced, along with lower controlled prices on basic necessities
and higher taxes on luxuries and leisure activities. The decree also included
measures preventing the deliberate deterioration of the work environment
and established the rights of workers to protect them from abuses by their
employers.
Although one of the objectives was to distribute the burden of the im-
ported inflation in an equitable manner, the decree actually sought to reverse
the increasing disparity in income distribution of the preceding several
years. Earlier economic policies were oriented toward achieving economic
growth and little attention was paid to equitable income distribution. The
gap between the rich and poor had become, however, a cause for social
unrest by the early 1970s and it became necessary for political stability that
the government undertake measures to bring about income redistribution.
The oil crisis gave the government a timely opportunity for introducing the
measures, which under other circumstances would have met with greater
resistance from certain segments of the society.
Given the objectives of redistributing income in favor of the poor and
restraining the consumption of luxuries by the rich, were the measures in
the decree appropriate? Lowering taxes for low-income groups and raising
taxes for high-income groups for the purpose of redistribution are meas-
ures consistent with efficient allocation of resources, if they have a negligi-
ble effect on the work-leisure choice. Also, given the objective of curtailing
the consumption of luxuries and leisure activities and what might be called
conspicuous consumption, heavy taxation of such activities was an ap-
propriate measure.
Additional measures for income redistribution such as the provision of
low-priced basic necessities and the dual-pricing system for rice (selling rice
at a low price and buying it at a high price) created a price distortion in
the economy. The dual-pricing system—which required government
financing—contributed to inflation and inefficient allocation of resources.
The low controlled prices of basic necessities brought about occasional short-
ages in supply and necessitated the provision of subsidies to production
to increase their supply. Where subsidies were not offered or were insuffi-
cient to increase production to meet the demand, shortages were met with
imports. These imports, which were larger than they would have been if
prices had not been held artificially low, required additional foreign ex-
change.
 Policy Response to the Oil Crisis (1974) 195

Although heavy taxation of the consumption of luxuries and leisure ac-

tivities is appropriate to the objective of curtailing these activities, it may
not have been needed if the financial institutions had been liberalized. Given
the repressed financial regime and low interest rates, there was little in-
centive for the rich to save for future consumption. The consumption pat-
tern of the rich of overspending on current consumption should be viewed,
therefore, as a consequence of the distortion in the financial market.
In Korea the rich and the middle class could lend money in the unor-
ganized money markets, earning rates higher than those offered by the
banks. The Presidential Emergency Decree of 3 August 1972, which was
intended to relieve the debt burden of large businesses, had a confiscatory
effect on moneylenders in the unorganized money markets. After that ex-
perience and faced with low interest rates in the organized money market,
it would not be too difficult for anyone to decide to spend more now and
save less.
The distortion in the financial market and government actions like the
decree of 3 August 1972 may have caused the saving ratio of households
to be lower than it would have been without such distortion and thereby
led to the heavy reliance on foreign savings. Thus, the distortion in the finan-
cial market; government actions affecting property rights, consumption of
luxuries and leisure activities; and foreign debt should be considered not
as separate but as interdependent issues. High taxes on leisure activities
and the consumption of luxuries may help restrain such activities, but will
do little to increase domestic saving, and thus decrease dependence on for-
eign savings, without financial liberalization and the security of private
property.
The decree made a provision for preferential credit assistance to small
and medium-size firms on the verge of bankruptcy. Its objective was to
maintain employment and thus ensure the livelihood of low-income wage
earners. Although the measure is commendable, one must ask why the
small and medium-size firms were more vulnerable than others to bank-
ruptcy. The large firms have been favored customers in the organized money
markets whereas small and medium-size firms were the major borrowers
in the unorganized money markets. The latter paid higher interest rates
than the former and were probably adversely affected by the decree of 3
August 1972, as it had the effect of drying up the credit supply in the unor-
ganized money markets. This is an example of how distortion in one mar-
ket necessitates the introduction of distortion in another market. The result
is “patch-on-patch-up” economic policies where the excess burden of the
two policies is additive, not offsetting.
The effectiveness of the decree of 14 January 1974 in coping with the first
oil crisis may lie in its moderating influence on wage increases. Tax cuts
for low-income groups and lowering the prices of basic necessities
cushioned the decrease in real wages caused by oil price increases. These
196 Yoon Hyung Kim

measures, combined with increased taxes on high-income groups and on

luxury items, made it possible for the government to hold wage increases
to a moderate pace. These moderate wage increases contributed to Korea's
ability to increase its exports of services and merchandise, to carry out suc-
cessful import substitution, and to allow an annual GDP growth rate of
7.2 percent during 1974-82. This was accomplished, in part, by making
Korean labor internationally competitive; the decree made this possible
without bringing about political instability. Income redistribution and re-
straints on luxury consumption, which were the principal objectives of the
decree, could be thus regarded as intermediate steps toward this end.
Energy-Specific Policy Measures
Broadly speaking, energy-specific policy measures may be broken down
into price and nonprice measures. These measures were introduced to
achieve energy conservation and substitution of other fuels for oil.
The key to understanding the Korean energy policy and response to the
oil crisis lies in recognizing that, throughout the 1960s and into the early
1970s, the use of energy was subsidized for industrial users to promote in-
dustrial development and for households because it was a basic necessity.
Oil price increases, however, made this cheap energy policy too costly to
continue. Adjustments were thus made in the prices of fuels to reflect the
increases in the world price of oil which brought about energy conserva-
tion and interfuel substitution.
A more fundamental issue is whether or not nonprice measures such
as publicity campaigns and the employment of heat managers were neces-
sary. As additional measures to price adjustments they may have contributed
to the speed at which energy conservation and interfuel substitution were
carried out. The effectiveness of such measures, however, depends on the
moral leadership of politicians or the coercive power of the government.
The effectiveness of the moral leadership of politicians is short-lived and
the coercive power of the government entails enforcements costs and cre-
ates room for discontent and corruption. A society must choose, given its
historical and political background, an optimum combination of price and
nonprice measures to bring about energy conservation and interfuel sub-
stitution. Whether or not the combination introduced in the decree was
optimal is difficult to say, but the effectiveness of the moral leadership of
politicians and of the coercive power of the government is subject to the
law of diminishing returns.

EFFECTS OF THE POLICY MEASURES

The Presidential Emergency Decree!
In 19/4 GNP grew at an annual rate of 8 percent in real terms, and in 1974-82
GDP grew at an annual rate of 7.2 percent. Compared with the rate of 9.7
 Policy Response to the Oil Crisis (1974) 197

percent in 1964-73, this was a slight decrease. Relative to other developing

countries in Asia and to the rest of the world, Korea fared well during the
turbulent period of 1974 through 1982. What accounts for this performance
of the economy? How much did the decree contribute to it?
In their study of external shocks and policy responses of Asian coun-
tries, Naya, Kim, and James (1984:18) conclude:

The NICs [newly industrializing countries] were able to withstand the

impacts of the external shocks much more successfully than countries
in Southeast and South Asia, though the effects on the NICs were
greater relative to the size of their economies. The reason for the better
performance of the NICs lay in their long-term strategies and policies
rather than in their short-term responses. Their outward-looking trade
and industrialization policies and market-oriented pricing policies, es-
pecially for production inputs, added to the resilience of their economies.
Although we agree with the above conclusion, we believe that the decree
as a short-term measure had the effect of stabilizing wages in the face of
deteriorating terms of trade. Among the NICs, Korea relied less on import
reduction through lower GNP growth as a policy response to the external
shocks, but more on export-market penetration and import substitution.
The reason for the latter is, we argue, the international competitiveness of
Korean labor. The decree contributed to that competitiveness by holding
down the rate of wage increase.
In analyzing the factors accounting for Korea's economic growth in
1974-82, the role of external savings cannot be ignored. Table 8.2 shows a
close relationship between the imports of petroleum and petroleum
products and the increase in foreign debt. There were clear quantum jumps
for both items in 19/4 and 1979the years of oil crisis. We also find three
distinct phases in the table. In 1968-73 the average annual imports of petro-
leum and petroleum products was $169 million and the average annual
increase in foreign debt was $603 million. These amounts increased, respec-
tively, to $1.7 billion and $2.1 billion in 1974-78, and to $5.8 billion and $5.6
billion in 1979-82. These figures indicate that Korea's foreign debt in effect
financed its oil imports. Thus, without having to reduce imports, the country
increased its exports and carried out its successful import substitution with
a small decrease in its economic growth rate.
In 1982 Korea had an external debt of $37 billion. One could have ar-
gued then that its excellent record in 1974-82 was purchased at the price
of this huge external debt and that the day of reckoning was due at any
moment. Naya, Kim, and James (1984) argued, however, that given its ability
to adjust to external shocks, and with continuing excellent export perfor-
mance, Korea should be able to meet its debt obligations. According to their

1. The author is grateful to Dr. Chung H. Lee for contributing this section concerning the
effects of the Presidential Emergency Decree.
198 Yoon Hyung Kim

Table 8.2. External debt and imports of petroleum and petroleum products:
6 ee A
1967-82 (10° US $)
eR eee

External debt Increase in Imports of petroleum

Year petroleum l
debt__andrna
outstanding __exte products
1967 645 59
1968 1,199 554 73
1969 1,800 601 108
1970 2,245 445 133
1971 ole 677 187
1972 3,589 667 218
1973 4,260 671 296
1974 5,937 1,677 1,020
1975 8,456 2,519 1,339
1976 10,533 2,077 1,658
1977 12,648 27115 2,065
1978 14,871 2,223 2,312
1979 20,500 5,629 3,416
1980 27,365 6,865 6,164
1981 32,490 57125 6,918
1982 37,314 4,824 6,740
Source: Adapted from Table 4 in I. C. Kim (1983b) and BOK, Economic Statistics Yearbook
(1970-85).
Note:
Average annual increase in external debt
1968-73: $603 million
1974-78: $2,122 million
1979-82: $5,611 million
Average annual imports of petroleum and petroleum products
1968-73: $169 million
1974-78: $1,679 million
1979-82: $5,810 million

calculation, Korea’s debt service to GNP ratio was 4.7 in 1973, 4.8 in 1980,
and 5.7 in 1982. Their estimates of the debt service to exports ratio during
these three years were 15.1, 12.2, and 13.1, respectively. The figures were
taken to indicate that Korea’s ability to service external debt did not signifi-
cantly deteriorate during 1974-82. The current account surpluses of recent
years have indeed proved their prediction to be correct.
Energy-Specific Policy Measures
Progress in energy conservation. Some conservation measures have already
brought about important changes in energy efficiency, particularly in the
industrial sector. Although it is difficult to define the exact effect of these
measures, the use of macroindicators backed with more disaggregated in-
 Policy Response to the Oil Crisis (1974) 199

dicators provides a useful means of monitoring progress in energy efficiency.

Overall energy efficiency and intensity of energy use (measured by en-
ergy consumption per unit of real GNP), rose sharply between 1960 and
1973 (Figure 8.1). But since then, this trend has been reversed due to in-
creased conservation efforts and structural changes in the economy.
Inasmuch as the energy/GNP ratio is not an exact measure of energy
conservation potential, more detailed analyses are needed to assess gains
in energy efficiency. Hence, we estimated an energy-demand equation us-
ing time-series data from 1961 to 1980 (see note in Table 8.3). With this equa-
tion we estimated the hypothetical energy consumption—the consumption
that would have prevailed if there had been no oil crisis—at 43,299 thou-
sand TOE (tons of oil equivalent) in 1980 (Table 8.3). Compared with the
actual energy consumption, these hypothetical figures are higher by about
3 to 8.4 percent. These estimates suggest that Korea’s energy conservation
program was fairly successful.

110

100

90

100 80

1973=
70

60

50

0
1960 1965 1970 1975 1980
Year

Figure 8.1. Commercial energy per unit of real GNP: 1960-80

Source: EPB, ROK, Handbook of Korean Economy (1980).
200 Yoon Hyung Kim

Table 8.3. Actual versus hypothetical energy: 1974-80

eeeS = Se SS

Estimated reduction
Total primary energy (10° TOE) of energy consumption
Year Actual Hypothetical (%)

1974 25,510 27,654 8.4

1975 27,076 28,673 ere
1976 29,805 31,566 9
1977 33,074 34,761 wey
1978 36,157 38,660 6.9
1979 40,503 41,727 3.0
1980 41,103 43,229 5.2

Source: Ministry of Energy and Resources, ROK, unpublished data.

Note:
InE = 0.5892 + 0.5442 InE_, + 0.4518 Y — 0.0560 D,
(2.29) (6.10) (5.80) (-3.03)
R? = 0.998, DW = 1.92
where E = energy consumption in 10? TOE
E_, = lagged energy consumption in 10? TOE
Y = GNP in 1975 billion won
D = 0, 1961-73
1, 1974-80
Figures in parentheses are t-values for the estimated coefficients.
The equation is statistically significant, explaining 99.8 percent of the variance in aggregate
energy consumption for the period. It was used to estimate hypothetical energy consump-
tion for 1974-80, assuming that D = 0. The estimated values were then compared with ac-
tual energy consumption, the difference between the two being a rough indicator of the
reduction in energy demand obtained in 1974-80.
TOE—tons of oil equivalent.

An accurate estimate of conservation results is hampered by conceptual

difficulties and by data limitations. Nevertheless, an econometric model can
provide a useful means of monitoring progress in energy efficiency, espe-
cially if it is backed up by more disaggregated indicators such as sectoral
energy consumption per unit of output. In the case of Korea it is possible
to use input-output tables for 1970, 1975, and 1978, and derive physical coeffi-
cients of total energy use for the industrial sectors. Table 8.4 shows these
fixed-coefficient estimates used for industrial energy savings during 1970-75
and 1975-78, assuming that no technical change in energy use occurred be-
tween these periods.
Table 8.4 clearly reveals a large decrease in energy requirements between
1970 and 1978. If technology as represented by the 1970 energy-use coeffi-
cients had persisted until 1975, all industries would have required 23 per-
cent more than their actual use. The difference would have been even greater
(34 percent) by 1978. If, however, technology as represented by the 1975
energy-use coefficients had persisted until 1978, all industries would have
 Policy Response to the Oil Crisis (1974) 201

required 8 percent more energy. That is, energy savings of more than 8 per-
cent did occur between 1975 and 1978 over and above those achieved be-
tween 1970 and 1975.
Table 8.3 indicates that direct energy coefficients in the manufacturing
sector declined more sharply between 1970 and 1975 than between 1975
and 1978. These large changes between 1970 and 1975 happened soon after
the petroleum price increases and resulted mostly from short-run, improved
energy-conservation management rather than from long-run economies as-
sociated with new plant or equipment. They seem to have occurred mainly
in light and heavy manufactures where energy is used primarily for process-
ing, materials forming, cutting and handling (e.g., textiles, electrical ma-
chinery, transport, and machinery) rather than in the production of basic
materials. Savings in energy-intensive manufactures occurred in 1975-78,
as energy-saving designs and economies of scale were incorporated into
new plants and equipment. Table 8.4 also indicates that an important tech-
nical change in energy consumption occurred in rapidly expanding indus-
tries that have higher energy costs.
The input-output studies suggest that the heavy industry path of in-
dustrialization, adopted in the early 1970s, was accomplished without re-
quiring more energy for a given level of industrial activity. Table 8.4 shows
that direct energy-use coefficients of manufacturing, which were expressed
in thousand tons of oil equivalent (10? TOE) per 1975 billion won of gross
output, declined from 1.28 TOE/10° in 1970 to 1.02 in 1975 and then to 0.824
in 1978. This was achieved through a greater emphasis on less energy-
intensive heavy and chemical manufactures.
Table 8.5 shows the structural changes in the manufacturing sector be-
tween 1970 and 1978. The output share of light manufactures declined gradu-
ally from 52.6 percent to 44.2 percent, while that of heavy and chemical
manufactures rose from 474 percent to 55.8 percent. Note, however, that
within heavy and chemical manufactures the output share of energy-
intensive manufactures decreased from 39.9 percent in 1970 to 34.0 percent
in 1978. (For a more detailed study, see Y.H. Kim 1983.)
Progress in energy transition away from oil. Korea has made considerable
efforts to decrease its oil dependency mainly through restructuring fuel pat-
terns for power generation away from oil to a mix of nuclear energy,
bituminous coal, and oil. Although the main benefits of the restructuring
are expected to accrue in the next 5-10 years because power plants have
the longest investment gestation period in the economy, some of the deci-
sions made since 1974 have already brought about important changes in
energy supply patterns with the oil dependency of the electric-generation
sector declining from 81 percent in 1973 to 77 percent in 1980. Korea's oil
dependency rose from 53 percent in 1973 to 63 percent in 1979, but declined
to 61 percent in 1980 (Kim and Smith 1989).
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204 Yoon Hyung Kim

Table 8.5. Composition and growth of the manufacturing sector: 1970-78 (%)
Composition Annual growth rate
Subsector 1970 1975 1978 1970-75 1975-78
Light manufactures 52.6 47.3 44.2 18.8 20.4
Food, beverages, and
tobacco 26.8 Sway 16.4 11.8 20.0
Textiles and apparel 14.2 20.3 18.8 30.3 20.0
Lumber and wood products 4.5 2.6 2.5 8.8 214
Miscellaneous manufactures gps 6.7 6.5 19.9 223,
Heavy manufactures YBe) 14.9 ps Ne, 392 39.4
Fabricated metal products 1.1 1.8 2.6 33.0 40.1
General machinery 1.6 1.8 25 23.9 36.4
Electrical machinery and
equipment Pie) 6.6 10.8 48.0 44.9
Transport machinery 1 4.1 4.9 41.7 30.6
Precision and optical
products 0.4 0.6 0.9 30.3 40.0
Energy-intensive manufactures 39.9 37.8 34.1 20.0 19.0
Pulp and paper 20 Zot 2.0 19.5 211
Chemicals, coal, and
petroleum 27.8 24.8 20.9 18.6 16.3
Nonmetallic mineral
products 5.0 3.3 3.0 V5 92
Primary iron and steel 4.1 6.7 7.0 SER 25.3
Primary nonferrous metals 0.7 0.9 2 2.7 35.1
Grand total 100.0 100.0 100.0 21.4 23.1
Source: Table 8.4.

CRITICISMS AND LESSONS

The Presidential Emergency Decree
There is no doubt that by most standards we may regard Korea's response
to the external shock of 1973-74 (and that of 1979) as a success. One meas-
ure of this success is that GDP grew at an average annual rate of 7.2 per-
cent during the turbulent 1974-82 period. This is higher than the rate
achieved by any of the other Asian developing countries, except Hong Kong
and Singapore.
This success in maintaining a high rate of economic growth was in part
due to the fact that the government did not deviate from its basic macro-
economic objectives—rapid economic growth and industrialization—in the
face of a severe external shock. Instead of reducing imports by lowering
the rate of economic growth and instituting import-substitution, the govern-
 Policy Response to the Oil Crisis (1974) 205

ment continued with its policies of export promotion and external financ-
ing. These policies made it possible to pursue macroeconomic objectives
without being overly concerned with the balance-of-payments constraint.
One consequence of the policies was, however, a rapid increase in Korea's
external debt, which rose from $3.6 billion in 1972 to $12.6 billion in 1977
(J. H. Kim 1987). Such a rapid increase in external debt, which eventually
reached $40 billion in 1983, raised doubts in some quarters as to the sol-
vency of the Korean economy—but these doubts disappeared by the
mid-1980s with the continuing success of the economy and current account
surpluses.
The Presidential Emergency Decree of 14 January 1974 played a critical,
short-term role complementary to the macroeconomic policies. Given the
terms of trade deterioration resulting from the oil price increase, there would
have been pressure for wage increases if the burden of the deterioration
was not equitably shared. In one sweep the decree brought about income
distribution, thus mitigating the effect of the oil shock on the poor and wage
earners. The government was thus able to moderate wage increases and
maintain the competitive edge of the Korean economy. The decree proba-
bly made it easy for the government to stay with its macroeconomic poli-
cies and thus achieve its objectives of export expansion and economic
growth.
It is obvious that drastic measures such as the decree cannot be under-
taken by a weak government or a government subject to pressure from
strong interest groups. Such policy instruments may not be easily dupli-
cated in other countries or even in Korea in later years. In other words, we
may say that the decree was an economically efficient and effective instru-
ment that was politically feasible at the place and at the time it was im-
plemented. Whether an equally drastic measure would be politically feasible
in Korea at a later date is highly questionable.
Energy-Specific Policy Measures
With rapidity and flexibility the Korean economy achieved three energy
transitions, and its energy conservation efforts were also successful in reduc-
ing the energy growth rate. The energy transitions and energy conserva-
tion were accomplished through a set of policy packages that included
pricing policies, regulation, fiscal and financial incentives, and institutional
reforms. But these various measures were taken in a rather piecemeal
fashion lacking an overall coordination that recognized their interde-
pendence.
Korea's indigenous energy resources remain limited and the country will
continue to be heavily dependent on imported fuels, especially oil. Accord-
ing to projections of the Korea Development Institute, the contribution of
domestic supplies of energy will continue to diminish, from 31 percent in
1980 to 13 percent in 1991. If the projections are correct, 87 percent of the
206 Yoon Hyung Kim

country’s total energy requirements will have to be imported. Continua-

tion of the recent rapid economic growth rate—around 8 percent—thus en-
tails acceleration of the third energy transition, from oil to a mix of other
imported fuels, and economies in the use of energy.
Because energy pervades all aspects of economic activity and its demand
is derived from the structure and growth of the whole economy, the policy
goal of achieving an optimal mix of fuels and conservation of energy will
be realized only if it is supported by adequate policies of demand manage-
ment in the consuming sectors—industry, transportation, and residen-
tial/commercial. It is, therefore, essential that the energy implications of
alternative development policies in all these sectors be properly appraised,
and that effective trade-offs be made between energy efficiency and addi-
tional capital expenditures, fuel conversion and additional capital expen-
ditures, and technologies that differ in energy intensity and capital cost.
Clearly, maximization of energy efficiency requires changes in the eco-
nomic structure. The essence of restructuring the sectoral output mix is to
redirect final demand and producers’ purchases away from energy and
energy-intensive goods. Accordingly, the current incentive system should
be reformulated to accelerate changes for both the final demand mix and
the input proportions of domestic production. Meeting the energy challenge
entails a large-scale reallocation of resources and thus calls for bold policy
changes covering prices, tariffs, subsidies, tax incentive schemes, and finan-
cial policies. Unless Korea realigns its economic policies in this way, before
oil becomes scarce and more expensive, its economic security will be en-
dangered.
Critical to such realignment would be further institutional arrangements
to make the Ministry of Energy and Resources stronger and more expert.
But no matter how good the Ministry of Energy and Resources becomes,
much of its work will involve coordination with other ministries as well
as with businesses and the public. In formulating and implementing en-
ergy policy, the ministry will have to judge political, economic, technical,
and other market forces affecting energy choices. Such judgments must
be based on support from other key ministries such as finance, industry,
transportation, construction, foreign affairs, and defense. This puts a high
premium on the political standing of the energy minister and on his skill
in interministerial decision making.
The Ministry of Energy and Resources should develop a considerable
capacity for negotiating with other ministries and official bodies, cultivat-
ing allies, and finding ways to persuade reluctant officials, businessmen,
and others about the efficient use of energy and the consequential changes
in regard to fuels. Thus a premium is also placed on the kinds of contacts
the ministry’s experts and policy planning staff have with all other parts
of the government. The extent to which these other government bodies par-
ticipate in the ministry's effort to have close exchanges rests on the power
of the minister and on the caliber of his staff.
 9 The Comprehensive Stabilization
Program (1979)

by Sang-Woo Nam

By the early 1970s Koreans had learned to live with a high rate of inflation—a
rate that had averaged well over 10 percent per year since 1960. Korean
policymakers and others tended to look at inflation as an inevitable price
for high economic growth. After the first oil price shock of 1973, however,
there were obvious signs that inflation was accelerating.
During the nine years preceding the energy crisis, the rate of increase
in consumer prices had averaged 11.4 percent per year, but during 1974-75
the rate jumped to 25 percent. These high rates were caused by more than
just the import price hike; they reflected inflationary pressures that had
built up over many years. By 1976-78, the inflation rate was several percent-
age points higher than it had been before the oil crisis. Even with virtually
no import price increase, consumer prices continued to rise at an annual
average of 13 percent (Table 9.1).

Table 9.1. Macroeconomic overview: 1976-78

Item 1976 1977 1978

GNP growth (%) oe! 10.3 11.6
Fixed investment (%) 14.7 26.6 39.4
Exports of goods and services (%) 43.0 26.7 1725
Employment growth (%) 6.1 3.0 4.3
Unemployment rate (%) 3.9 3.8 eZ.
Current account balance (10° US $) -314 12 -1,085
Commodity exports (10° US $) 7,815 10,047 27
Receipts from overseas construction
(10° US $) 247 657 1,049
New orders received (10° US $) 2,502 3,516 8,145
Inflation rate (%)
Wholesale prices By 9.0 11.7
Consumer prices 1573 10.1 14.4
Food and beverages 17.8 11.6 16.7
GNP deflator 177 16.3 20.6
Wages 0.0 32.1 35.0
Sources: BOK, Economic Statistics Yearbook (1979); Ministry of Construction, ROK, unpublished
data.

207
208 Sang-Woo Nam

It is not difficult to trace the sources of the accelerating inflation. One

of the main causes was the excessive expansion of the money supply, which
grew at an average annual rate of 32.1 percent during the 1976-78 period.
That rapid expansion of money was largely a consequence of the growth
of net foreign assets, a large deficit in the government's Grain Management
Fund, brisk investment demand, and the expansion of preferential policy
loans (Table 9.2).
On the supply side, the sectoral imbalance in the allocation of capital
for fixed investment aggravated inflationary pressures. During 1976-78 more
than 77 percent of all manufacturing equipment investment was undertaken
in the heavy and chemical industries. To make the investment possible, an
increasing share of bank credit was allocated to these industries, a share
that reached 60 percent in 1978 even though heavy and chemical indus-
tries accounted for only half of manufacturing production (KDI 1981).
With a disproportionate share of scarce capital being diverted to invest-
ment projects that required a long gestation period, the modernization and
capacity expansion of other sectors was constrained. These sectors included
agriculture, small and medium-size businesses, and the commodity distri-
bution system—sectors that together ensure the smooth supply of daily
necessities and other essential commodities. Low productivity in these sec-
tors and the resulting supply shortages were major sources of inflation and
threatened to disrupt the stability of the economy.
Government efforts to reduce inflation through price controls did more
harm than good. In the course of regulation the government usually
deferred justifiable price adjustments for far too long. Once increases were

Table 9.2. Expansion of the money supply: 1971-78 (%)

Item 1971-73 1974-75 1976-77 1978

Money supply (M,) 34.0 27.3 35.7 24.9
(3327) (24.5) (34.7) (32.2)
Sectoral contribution
Government 7.8 21.0 -2.0 4.5
(Grain and fertilizer management) (8.9) (26.4) (13.6) (8.5)
Private 17,2 51.0 5.8 46.9
Foreign 10.8 -31.3 41.9 -11.6
Other -1.8 -13.4 -9.9 -15.0
Quasi-money 28.5 25.6 37.2 40.9
Money supply broadly defined (M,) 30.3 26.1 36.6 35.0
(33.6) (26.6) (33.1) (39.3)
Sources: BOK, Economic Statistics Yearbook (1979); Ministry of Finance, ROK, unpublished data.
Note: Based on year-end figures except for those in parentheses, which are based on annual
averages.
 The Comprehensive Stabilization Program (1979) 209

allowed, prices tended to acquire an independent upward momentum. This

pattern of “stop-go” price setting also led to such undesirable effects as
supply shortages, deteriorating product quality, and inadequate investment.
On the cost side, high inflation was accompanied by a rapid rise in wages.
During 1976-78, wages increased at an annual rate of 34.2 percent, far sur-
passing the growth of labor productivity—an indication that wage increases
were a major inflationary factor. With soaring housing and land prices, the
rapid wage increases seemed to have produced little improvement in work-
ers’ welfare (Table 9.3). Finally, it was frequently alleged that the introduc-
tion of the value-added tax (VAT) system in 1977 exacerbated inflation. The
VAT system may have indeed contributed to accelerating inflation because
of the downward rigidity of prices in the process of price restructuring.
Persistent high inflation threatened the prospects for high growth by erod-
ing the competitiveness of Korean exports in the international market.
Weakening export competitiveness means slow growth for the Korean econ-
omy, which is dependent on an outward-looking growth strategy. Korean
export growth slowed between 1977 and 1979, as export profitability deteri-
orated with the acceleration of wage and price increases. During 1976-79,
Korea's export profits dropped by 32 percent as unit labor costs rose by 137

Table 9.3. Export profitability and export growth, 1976-79

1976 1977 1978 1979
Nominal wage (manufacturing) (A) 134.7 180.2 242.1 311.4
Labor productivity (manufacturing) (B)
KPC index?@ 107.2 118.8 135.1 154.1
National income data? 101.0 110.5 123.8 13122
Unit labor cost [(C)=(A/B)]
KPC index 2B a 5137. 181.9 202.1
National income data 133.4 163.1 195.6 23733
Unit value of exports (won) (D) 111.7 12259 135.4 161.8
Export profitability (D/C)
KPC index 88.9 80.6 74.4 80.1
National income data 83.7 75.0 69.2 68.2
Growth of exports (%)°
Korea 51.8 30.2 26.5 18.4
Taiwan 53.8 14.6 35:5 26.9
Singapore 2259 Paarl 23.0 40.4
Hong Kong 41.9 1259 Be 31.7

Sources: BOK, Economic Statistics Yearbook (1980); IMF (1982); Directorate General of Budget,
Accounting and Statistics, Taiwan, Monthly Bulletin of Statistics (1977-80).
a. Korea Productivity Center (KPC) index (1975 = 100).
b. Computed by using national income data (value added per worker, 1975 = 100).
c. Percentages computed on the basis of current US dollars.
210 Sang-Woo Nam

percent and the unit value of exports increased only about 62 percent (Ta-
ble 9.3). Unit labor costs, measured in U.S. dollars, rose only 23 percent
in Singapore and 40-45 percent in Taiwan and Hong Kong during the same
period.
There was increasingly strong evidence that the potential energy of the
nation was being wasted by the high inflationary pressures and diverted
from effective concentration on economic development. Korean en-
trepreneurs, lured by incentives to speculate in real estate and inventories,
were distracted from the technological and managerial innovation needed
for long-term growth. Businesses were frequently blamed for being preoc-
cupied with borrowing as much money as possible from banks, only to
invest it in real estate or to expand unproductive businesses.
The waste of productive resources was also evident in the more diffused
atmosphere of society at large, and it was closely related to the widening
disparity in income distribution. The rich made speculative fortunes over-
night that far outstripped what an honest wage earner could save in a life-
time. Thus, more and more resources, including some of the nation’s best
managerial talent, were enticed into speculative activities. Finding them-
selves unrewarded, workers grew frustrated and developed negative atti-
tudes toward their work. Their discontent was occasionally expressed in
organized demonstrations.
Although consistent data on income distribution are scant, income dis-
tribution seems to have deteriorated in the latter half of the 1970s. Tighter
credit rationing in favor of the heavy and chemical industries, which oc-
curred at the expense of small and medium-size businesses, and various
government regulations restraining competition among producers contrib-
uted to the concentration of economic power. Soaring prices of real estate
was probably an even more important cause of the deterioration in the dis-
tribution of wealth. Between 1973 and 1978, average housing and residen-
tial land prices jumped by factors of 4.5 and 7.1, respectively, while consumer
prices and urban household income multiplied only 2.3 and 3.5 times (EPB,
ROK, Annual Report on the Family Income and Expenditure Survey, 1982; KNHC
1980). Thus the differences in wealth between those with their own houses
and those without widened (Table 9.4).

Table 9.4. Household income distribution by class and degree of income

concentration: 1965-80
Item 1965 1970 1976 1980
Gini coefficient 0.344 0.332 0.391 0.389
One-tenth distribution ratio
(lower 40%/upper 20%) 19.3/41.8 19.6/41.6 16.9/45.3 16.1/45.4
Sources: Figures for 1965, 1970, and 1976 are from KDI (1979), estimated by Dr. Choo Hak
Joong. Figures for 1980 are from EPB, ROK, Social Indicators (1982).
 The Comprehensive Stabilization Program (1979) 211

MAJOR FEATURES
OF THE STABILIZATION PROGRAM
Major Contents of the Program
A consensus within the government that a major policy change was needed
had been developing for some time. The newly appointed deputy prime
minister, Shin Hyon Whack, was strongly in favor of a stabilization policy.
Therefore, in December 1978, President Park asked three institutions—the
Economic and Scientific Council, the Bank of Korea, and the Korea Develop-
ment Institute (KDI)—independently to propose policy measures to deal
with the problems of the Korean economy. Upon being briefed by each of
the these institutions, President Park asked the Economic Planning Board
(EPB) to formulate and implement comprehensive stabilization measures
based on the three reports.
The result was the Comprehensive Stabilization Program announced on
17 April 1979 by the EPB. The major features of the program were:
* restrictive budget management with expenditure cuts and deferral of some
public investment projects;
restrictive monetary policy with particular attention given to improving
the operation of preferential policy loans and interest rates;
¢ adjustment of investment in the heavy and chemical industries;
facilitation of the supply and stabilization of the price of daily necessi-
ties, including improvements in the commodity distribution system,
financial and tax support for producers, elimination of institutional bar-
riers restraining supply capacity, and a deceleration of price controls; and
reaffirmation of the government's determination, originally announced
in the August 1978 Comprehensive Measure, to prevent a recurrence of
real estate speculation.
Restrictive Fiscal and Monetary Management
To cool off the overheated economy, the government further limited mone-
tary expansion, which had already been restricted since late 1978. The year-
end target of monetary expansion was set at 23-25 percent, a drastic reduc-
tion compared with the record of the previous three years, when growth
in the broadly defined money supply had ranged from 33 to 40 percent
annually. However, the trend of strong private investment and consump-
tion expenditures early in 1979 indicated that the GNP growth rate for 1979
would greatly surpass the original target which had been set at 9 percent.
Thus, the government thought that monetary restrictions should be
strengthened to make sure that the monetary target would be attained. Be-
cause the government had already planned to restrict the foreign sector's
contribution to the expansion of the money supply by limiting the increase
in net foreign assets to below $300 million, it had to tighten credit in the
government and private domestic sector.
212 Sang-Woo Nam

The stabilization program included measures to reduce the money sup-

ply available to the government sector by about 300 billion won, an amount
equal to 7 percent of total government revenue and 15 percent of the total
increase in the money supply planned for 1979. The program for the reduc-
tion of government expenditures included a 5 percent cut in current spend-
ing, a reduction in subsidies to local governments, a postponement of
construction plans for government offices and government-backed institu-
tions, and adjustments in other public construction work plans.
Attention was also called to the need for conservative fiscal management
for 1980, underscoring the importance of a substantial reduction in the
deficits generated by the high grain-price support program. Suggested pri-
ority areas for the 1980 budget included stabilizing the livelihood of the
people and enhancing the nation’s economic growth potential by: (1) spon-
soring more diversified and mechanized farming, (2) expanding investment
in social infrastructure and manpower development, (3) providing greater
support for the modernization of the nation’s distribution system and to
small and medium-size firms, and (4) promoting the machinery industry.
For more efficient financial management and effective credit control, the
program emphasized the need to improve the operation of preferential pol-
icy loans, including export-support credit and interest-rate adjustments.
Specifically, the program's sponsors noted that the designated strategic
sectors had been given priority in the allocation of bank credit causing an
excessive reduction in the availability of funds for less favored sectors. It
was also recognized that too many sectors were eligible and that there were
no clear rules for selection. These were to be corrected to ensure that
preferential financing would be sufficiently sustained to provide adequate
future support to such strategic sectors as the heavy and chemical indus-
tries, particularly in providing financing for exports on a deferred payment
basis. On the basis of this diagnosis, officials in charge of the program sug-
gested that preferential financing be decreased and managed by an invest-
ment coordination committee that would not only decide the total size but
also determine allocation priorities and the desirability of individual projects.
With regard to the export-financing system, qualification for access to
export credit was eased to include exporters with annual exports of over
$10 million regardless of their ratios of net foreign exchange earnings content.
Procedures for exporters to obtain credit for raw material imports were sim-
plified and made more flexible. Interest-rate adjustments for the mobiliza-
tion of additional savings were made on some categories of bank deposits,
corporate bonds, and short-term finance company paper. Interest rates on
bank installment time deposits, for example, were raised from 13.2 to 16.2
percent per annum. Furthermore, a more comprehensive program for im-
provement of the financial sector, including the operation of preferential
policy loans and interest rates, was to be prepared by the end of June 1979.
 The Comprehensive Stabilization Program (1979) 213

Readjustment of Investment
Investment in the heavy and chemical industries was disproportionately
large; the supply of skilled labor and the capacity to absorb related tech-
nology lagged far behind the huge investments in these industries. Thus,
the products of those investments could not be expected to compete favor-
ably in international markets. The investment needs of the heavy and chem-
ical industries were beyond the capacity of domestic savings, and served
to limit investment and supply capacity in the light manufacturing and re-
lated service sectors, which produce consumer goods for domestic con-
sumption.
The picture on the demand side was no brighter. The level of investment
in the heavy and chemical industries surpassed potential demand even be-
fore the second oil price shock in 1979.
Recognizing these problems, stabilization program authorities outlined
the following general directions for the support of the heavy and chemical
industries.
1. More attention was to be given to such basic requirements for the suc-
cessful promotion of the heavy and chemical industries as workforce de-
velopment, the smooth introduction of foreign technology, and an effective
incentive system.
2. The support system for the heavy and chemical industries was to be
designed to be more concentrated and selective. Support would be limited
to areas in which Korea had a strong international comparative advantage.
But the industries selected would be given effective and systematic sup-
port until they graduated from the import-substitution stage and became
competitive export industries. For industrial sectors other than selected
heavy and chemical industries, government protection from foreign imports
would be reduced and competition allowed.
3. The scale, content, and timing of investment plans for heavy and chem-
ical industrial projects were to be readjusted. The basic guideline for ad-
justing investment projects was to postpone or cancel projects that led to
excess capacity or duplication of facilities. Projects without a long-term com-
parative advantage in international markets, or without adequate private
financing, were also to be reconsidered.
As proposed in the program, the Investment Coordination Committee
was established to oversee investment readjustment. Headed by the deputy
prime minister, the committee was composed of the ministers of finance,
commerce and industry, and energy and resources, together with the chief
economic secretaries to the president, and a few others. The committee was
to review and consider postponement of all new investment projects and
those already under construction that were using over $5 million in for-
eign loans or domestic loans in foreign currency.
214 Sang-Woo Nam

Price Stabilization for Daily Necessities

Because the high rate of inflation during 1976-78 was largely caused by a
demand-supply imbalance in food and some other essential commodities,
the program included measures to forestall any recurrence of a rapid rise
in prices of those commodities. The measures designed to increase the sup-
ply of agricultural and marine products were highly comprehensive. Sta-
bility in the prices of daily necessities and other essential commodities was
also pursued through financial supports, tariff cuts, and institutional
reforms.
Improvement of the commodity distribution system was given continu-
ous attention in the stabilization program. The establishment of specialized
wholesale dealers and large-scale retail sales outlets such as supermarkets
and chain stores was encouraged, and the drafting of a more comprehen-
sive program for the modernization of the nation’s distribution system was
planned. Finally, to minimize distortions originating from extensive price
controls, the number of monopolistic and oligopolistic products whose
prices were under government control was to be reduced from 7 items to
the roughly 30 items considered critical to the stable livelihood of the people.
To alleviate the economic burden of people most adversely affected by
price decontrol, the government planned to extend direct assistance to the
poor. A total of about 30 billion won was appropriated to aid the poor. Tui-
tion subsidies for middle-school children were extended and wages for relief
employment in public works were increased. Compensation for rises in coal
briquette prices was also provided.

IMPLEMENTATION
Policy Response to the Second Oil Price Shock
Less than three months after the Comprehensive Stabilization Program was
launched, the nation was hit by a round of steep increases in international
oil prices. The immediate impact of the increases, together with the removal
of price controls from a large number of commodities, was a sharp acceler-
ation of domestic inflation. Both wholesale and consumer prices rose by
as much as 18 to 19 percent in 1979.
Economic activity also slowed suddenly in the latter half of 1979. The
growth of GNP, which had been over 10 percent during the first half of
the year, dropped to 6.4 percent for the year as a whole. Owing to the in-
creasing uncertainty resulting from higher oil prices, fixed investment de-
celerated drastically. Commodity exports, which had been slowly weakening
since 1977, registered a negative real growth rate (-2.5 percent) in 1979. The
current account deficit rose to $4.2 billion, almost four times as large as
that of 1978.
By early 1980 prospects were even more gloomy than they had been in
1979. The oil import bill for 1980 was expected to increase by more than
 The Comprehensive Stabilization Program (1979) 215

$3 billion, and there was little hope for a comparable expansion of Korea’s
exports. Under the circumstances, economic policymakers strongly felt that
some action should be taken in response to the unfavorable overseas de-
velopments and the economic complications caused by domestic political
developments. They seem to have been convinced that a doubling of the
number of unemployed, to more than one million, would be a critical threat
to social and political stability and that a further deterioration in the balance
of payments might lead to serious questioning abroad about the credit-
worthiness of the Korean economy.
Immediately after the New Year's holiday, Dr. Kim Mahn Je, president
of KDI, was asked to prepare a report for President Choi Kyu Hah called
“Measures to Cope with Economic Difficulties’” The report was the basis
for the policy package announced on 12 January 1980 by the minister of
finance. The package included two important policy adjustments: devalu-
ation of the won and an increase in interest rates.
Given the accumulated overvaluation of the Korean won since 1975, the
exchange-rate adjustment was inevitable. The won was devalued by 20
percent—from 484 to 580 won per U.S. dollar. As a follow-up measure, a
floating exchange-rate system based on a basket of major currencies was
adopted in late February. The decision to float the won was made to pre-
vent abrupt and excessively large exchange-rate adjustments and also to
avoid sudden shifts in the terms of trade vis-a-vis non-U.S. trading partners.
The upward annual interest-rate adjustment averaged 5 to 6 percent for
all financial assets in the organized markets. The interest rate on general
bank loans, for example, was raised from 19 percent to 25 percent per an-
num. The interest-rate adjustment was designed mainly to offset part of
the newly fueled cost-push effect of the won devaluation by absorbing li-
quidity. In other words, the interest-rate adjustment could be construed
as a continued commitment to the stabilization policy on the part of the
government.

Reflationary Policy Packages

in Response to the 1980 Predicament
Several months after the interest-rate adjustment, financial savings increased
substantially, helping to absorb excess liquidity. However, as the economic
situation continued to deteriorate in the midst of social unrest, the govern-
ment gradually eased the original restrictive policy stance on three separate
occasions—in June, September, and November 1980.
The government announced a set of policies on 5 June 1980 calling for
the allocation of additional funds for public works programs and the ex-
pansion of loans to small and medium-size enterprises and for housing con-
struction targeted for low-income families. To stimulate investment and boost
business confidence, the official interest rates were lowered by 1 to 2 per-
centage points and a planned upward adjustment of interest rates for short-
216 Sang-Woo Nam

term export loans was postponed. To accommodate these policy adjust-

ments, the targeted money-supply growth rates were adjusted upward by
5 percentage points to 20 and 25 percent for the narrowly and broadly de-
fined money supply, respectively.
In spite of the June measures, general economic activity remained slug-
gish except for the export sectors, which reacted favorably to the exchange-
rate depreciation in January. Therefore, two more policy packages were
prepared—one in September and the other in November—to expand hous-
ing construction, to stimulate exports and investments, and to support pur-
chases of selected consumer durables.
The policies included measures to reduce the range of capital gains tax
rates on real estate transactions from 50-80 percent to 35-75 percent, and
to make more credit available to stimulate residential construction. Meas-
ures to promote exports included an upward adjustment of export loans
per dollar of letter of credit and strong financial support for exports of heavy
industrial products on a deferred payment basis. As a means of stimulat-
ing fixed investment by easing the financial burden of businesses, bank and
nonbank interest rates were readjusted downward by an average of 2 to
3 percentage points in September and another 2 to 3 percentage points in
November. Finally, to encourage purchases of selected consumer durables,
easy credit and a 30 percent cut in sales tax rates were offered.
Despite these expansionary measures, monetary management continued
to be tight, in part as a result of large deficits in the balance of payments.
The annual monetary expansion for 1980 was contained at 16.3 and 26.9
percent for the narrowly and broadly defined money supply, respectively.
The performance of the Korean economy in 1980 was disappointing. In
the midst of weak domestic demand, GNP declined to 6.2 percent, while
unemployment rose sharply to 5.2 percent. An unusually long spell of cold
weather throughout the summer months of 1980 resulted in a crop loss
amounting to a quarter of the expected yield. Because of the sharp deterio-
ration in the terms of trade, the current account deficit widened to $5.3 bil-
lion. Inflation of wholesale and consumer prices accelerated to record levels
of 39 and 29 percent, respectively. The 36 percent exchange-rate deprecia-
tion vis-a-vis the U.S. dollar together with the 20 percent rise in unit im-
port prices were the primary causes of the rapid rise in the inflation rate.
Stabilization Efforts and Initial Steps
Toward Structural Improvement in 1981
In spite of a strong surge in export orders, recovery remained elusive, with
little sign of any pickup in investment. This situation prompted the an-
nouncement of an additional reflationary package in April 1981, which in-
cluded additional credit for exporters and small and medium-size firms to
replace or upgrade their facilities, and expanded fiscal support for purchases
of domestic machinery and equipment.
 The Comprehensive Stabilization Program (1979) 217

The housing construction industry remained weak despite the reduc-

tion in the capital gains tax rate in September 1980. Therefore, another pro-
gram was drafted in late June 1981 to encourage housing construction. The
program included an extension of the temporary tax reduction on capital
gains, an increase in the deduction for the annual inflation allowance from
10 to 15 percent in the calculation of capital gains, and additional loans for
the purchases of small apartment units.
During the last two months of 1981, the government relaxed its tight
monetary policy somewhat by lowering the interest rates three times by
a total of about 3 percentage points, in step with a sizable decline in the
inflation rate. The rates of money supply growth were 4.6 and 25 percent
for the narrowly and broadly defined money supply, respectively. In addi-
tion to rather tight monetary management, the government resorted to
moral persuasion for wage restraint to prevent the effect of the exchange-
rate depreciation from being offset by a corresponding wage-price spiral.
To enhance popular understanding of the difficult economic situation
and to build a broad consensus behind the new economic policy direction,
economic education was started toward the end of 1980 on a presidential
initiative. In December 1981 an economic education task force was formed
within the EPB until a formal organization—the Bureau of Economic
Education—was established a year later.
Stabilization efforts were also reflected in the exchange-rate policy. Ex-
change rates were maintained within a narrow range and prices for
government-held rice and public utility services were set cautiously.
As a result of these efforts, as well as the relative stability in import prices
and domestic food prices, the rate of inflation was substantially reduced
to a level slightly over 20 percent.
The GNP growth rate for 1981 was 64 percent, representing a substan-
tial recovery from the 6.2 percent decrease in 1980. Commodity exports ex-
panded by more than 18 percent in real terms and led the economic recovery.
Consequently, the current account deficit was narrowed to $4.6 billion, a
$700 million improvement over the previous year.
The significance of 1981 goes beyond the aggregate economic performance
of that year. To enhance the efficiency of the entire economic system, the
government took important first steps toward major reforms in at least three
areas during 1981: financial liberalization, realignment of the industrial in-
centive system, and promotion of competition among domestic and for-
eign firms.
The government divested itself of equity shares in the Hanil Bank, one
of the nation’s five major commercial banks. An over-the-counter commer-
cial paper market was developed for short-term finance companies and mer-
chant banking corporations. Interest rates on these notes were left to market
forces, although a ceiling was later imposed.
In the area of industrial policy, new guidelines for industrial promotion
218 Sang-Woo Nam

were introduced. The basic idea was to equalize incentives for investment
in all industries and to gradually phase out the existing discriminatory sys-
tem. The new guidelines were geared to benefit industries with a current
or potential international competitive edge, and projects related to either
manpower and technology development or higher energy efficiency.
The Fair Trade and Anti-Monopoly Act, which has been in effect since
April 1981, has minimized the purview of direct price controls. To promote
foreign competition, commodity imports and direct foreign investment were
further liberalized.
Reflationary Measures in Response
to the Delayed Recovery of the World Economy
On 14 January 1982, soon after the cabinet reshuffle in early January, the
new economic policymaking team—the so-called “real economy” team
headed by Deputy Prime Minister Kim Joon Sung—prepared a policy pack-
age designed to stimulate economic recovery. The package included meas-
ures to promote exports, encourage housing construction and other
domestic investment, and expand support for the agricultural sector.
In May the government implemented another set of policy measures to
further stimulate the economy. A large-scale road-paving project with a cap-
ital requirement of 200 billion won was announced. Small and medium-
size firms were given increased financial support amounting to 220 billion
won. Efforts to further stimulate housing construction included sharp reduc-
tions or the elimination of capital gains taxes on newly built houses and
on land to be used for small housing plots, as well as a reduction of the
acquisition and registration taxes on small housing units.
Shortly before the May measure, however, an unfortunate incident in
the curb-loan market forced two of the largest corporations into bankruptcy.
The shock of the incident led to a sharp curtailment of the curb-loan mar-
ket and also of the activities of the organized short-term financial market.
Consequently, many businesses were suddenly faced with a shortage of
operating funds, leading to a brief rash of corporate defaults.
Another policy package, released on 28 June, had as its most important
feature the reduction of bank interest rates on both deposits and loans by
an average of 4 percentage points. Virtually all bank lending rates were low-
ered to 10 percent per annum, eliminating special consideration for prime
borrowers or preferential policy sectors, such as exporters or small and
medium-size firms. In addition, the government planned to reduce the cor-
porate income tax rate, and special consumption taxes on some consumer
durables were reduced to promote demand for those products.
Finally, with a view to correcting the structural weaknesses of the Korean
financial sector, a banking reform program was incorporated into the pack-
age. The reform led to three more major commercial banks being priva-
tized by 1983.
 The Comprehensive Stabilization Program (1979) 219

In early July, several days after the June measures, the Ministry of Finance
announced a proposal to require all financial transactions to be made in
the original names of the persons concerned. This proposal sought to
weaken the unregulated curb-loan market and to establish an institutional
foundation for more equitable taxation. Implementation of this controver-
sial proposal was repeatedly postponed by the National Assembly on the
grounds that its potential disruptive impact on the financial market would
be too serious and that more administrative preparation was needed prior
to its implementation. Nevertheless, some progress was made toward dis-
couraging people from holding financial assets anonymously or under fic-
titious names by imposing heavy taxes. The “real-name” requirement for
financial transactions is scheduled for implementation in 1991.
Bank credit expanded fairly rapidly in the wake of the curb-loan scan-
dal in May. The growth of the broadly defined money supply reached as
high as 32 percent during the 12-month period before the end of the third
quarter of 1982, but it decreased to 27 percent by the end of the year.
Inflation rates as measured by wholesale and consumer prices were fur-
ther stabilized at 4.7 and 7.2 percent, respectively, for 1982.
The real GNP growth rate for 1982 remained at 5.3 percent. Commodity
exports rose only 2.5 percent, reflecting a delayed recovery of the world
economy, but domestic fixed investment showed a sharp 11.6 percent in-
crease. The 1982 current account deficit decreased to $2.7 billion from $4.6
billion in the previous year, or from 7.5 to 4.5 percent of GNP.
Strong Recovery with Further Reduction of Inflation in 1983
Given the expected recovery of the world economy in 1983, top priority
in economic management for 1983 was focused on maintaining continu-
ous price stability while fully exploiting the momentum of economic recov-
ery by strengthening the competitive position of Korean industries.
The rate of monetary expansion in 1983 was originally planned at 18 per-
cent in broadly defined terms, compared with a 27 percent increase in 1982.
This target was later revised to 15 percent as prices stabilized more than
expected partly because of a cut in oil prices in the spring.
During the fall of 1982, several months after the 4 percentage point drop
in bank interest rates, the real estate market started to show signs of heat-
ing up. Tentative antispeculation measures implemented in December 1982
included a stepped-up monitoring of real-estate transactions in areas of
widespread speculation and improvement in the housing distribution sys-
tem. As a speculative housing boom reappeared in the early spring and
summer of 1983, however, the government took additional measures to stop
real estate speculation in April and September 1983.
By 1983 the Korean economy had regained the strong growth momen-
tum of old, registering a GNP growth rate slightly in excess of 9 percent
for that year (Table 9.5).
220 Sang-Woo Nam

Table 9.5. Economic trends: 1979-83

ee ee eee ee eee

1979 1980 1981 1982 1983

EEE EE EE

GNP growth (%) 6.4 -6.2 6.4 B33 912

Fixed investment (%) 7. -12.0 -6.1 11.6 12.3
Exports of goods and
services (%) -3.6 99 1722 4.4 1333
Employment growth (%) 133 0.3 2.5 27 2Be
Unemployment rate (%) 3.8 5.2. 4.5 4.4 4.2
Current account balance
(10° US $) ~4,151 5 -5,321., --4,646,... —2,650,..-.=1,619
Trade balance (10° US $) -4,396 -4,384 -3,628 -2,594 -1,649
Exports (10° US $) 14,705 i eZ 214 th20 G7 Mic 20,87 Dieta
Services and transfers
(10° US $) 244 -937. -1,018 -55 30
Inflation rate (%)
Wholesale prices 18.8 38.9 20.4 4.7 02
Consumer prices 18.3 28.7 21.3 73 3.4
GNP deflator 1973 25.8 16.2 1f- 2.8
Wages 28.3 23.4 20.7 15.8 12.0
Expansion of money supply? (%)
Narrowly defined (M;) 20.7 16.2 4.6 45.6 17.2
Broadly defined (M,) 24.6 26.9 25.0 27.0 f
tae
Unified budget deficit
(ratio to GNP) 118) 3.4 5.0 4.6 2.0
Interest rates* (%)
One-year time deposit 18.6 REY 16.2 8.0 8.0
General loans (one-year) 18.5 ANS, 16.5 10.0 10.0
Exchange rate* (won/US $) 484.0 659.9 700.5 748.8 795.5
Sources: BOK, Economic Statistics Yearbook (1984); Ministry of Finance, ROK, unpublished data.
a. Year-end.

The rapid increase in commodity exports since the latter half of 1983 has
mainly been the result of the U.S. economic recovery and its overvalued
currency. The current account deficit was reduced to $1.6 billion in 1983.
Prices remained remarkably stable throughout 1983 despite the full-
fledged economic recovery and the relatively high increase in wages. On
an average annual basis, wholesale prices rose only 0.2 percent, and con-
sumer prices showed a modest rise of 3.4 percent.
Consistent with the efforts to stabilize costs, monetary policy remained
rather restrictive. That was a significant achievement in light of the depress-
ing impact on the domestic financial market of two tragedies in 1983—the
shooting down of the Korean Airlines aircraft and the terrorist bombing
of senior Korean officials in Rangoon. Expansion of the money supply dur-
 The Comprehensive Stabilization Program (1979) 221

ing 1983, narrowly and broadly defined, was contained to 17.2 and 15.3 per-
cent, respectively.
During 1983 significant progress was made toward structural improve-
ment of the economy. In the financial sector, divestiture of government
shares of the major commercial banks continued, and the lowering of en-
try barriers late in 1982 was rewarded with the opening of two joint-venture
banks, many short-term finance companies, and mutual savings and finance
companies.
Efforts to expose the economy to the bracing effects of foreign competi-
tion also continued. New policy measures were released in October 1982
that allowed direct foreign investment in an additional 94 Korean Standard
Industrial Classification (KSIC) industries, and simplified administrative
procedures surrounding such investment.
Korea's import liberalization ratio was again raised from 74.6 to 804 per-
cent as the government liberalized imports of an additional 305 Customs
Cooperation Council Nomenclature (CCCN) eight-digit commodities in July
1983.

THEORETICAL BASIS AND EFFECTS OF THE POLICY

Monetary Management
The central policy tool in stabilization efforts after 1979 was the restriction
of the money supply. The basic approach to stabilization was to let the tight
money policy reduce inflationary pressure and, at the same time, to stabi-
lize all the major cost factors such as wages and interest. One could say
that Korea's stabilization efforts were basically based on the monetarist thesis
that, in the long run, the quantity of money is the key variable determin-
ing inflation, whereas real economic activity is little affected by the money
supply.
Lene described, the growth of the money supply slowed signifi-
cantly after 1978 (Table 9.5). The drastic fluctuation of money supply growth
during 1981-82 largely reflected changes in the bank-deposit system that
included the July 1981 strengthening of interest-rate incentives to expand
savings deposits, and the July 1982 abolition of the notice deposit."
A major question in managing monetary policy and monitoring its ef-
fects is to decide which monetary aggregate to use as a central indicator.
In Korea the pivotal indicator shifted from the narrowly defined money sup-
ply (M,) during most of the 1960s, to domestic credit during 1970-78, and
then to the broadly defined money supply (M,) in 1979. The rationale for
relying heavily on the broadly defined money supply is that it is a more
comprehensive indicator and thus a more stable one.

1. A type of deposit requiring notice prior to withdrawal of funds. Firms were the main
depositors.
222 Sang-Woo Nam

It is true that a broadly defined monetary aggregate is less vulnerable

to a shift of funds among different types of deposits due to changes in the
interest-rate structure and the deposit system. The fact that an indicator
shows a more stable trend, however, does not necessarily indicate that it
is a more reliable monetary aggregate in the sense that it has a closer rela-
tionship with economic activity. Quite to the contrary, S. W. Nam (1982)
shows that the correlation between the rate of monetary expansion and that
of nominal GNP is much higher for the narrowly defined money supply.
That is why it is mainly the narrowly defined money supply that is used
for the analysis in this paper.
In connection with monetary policy after 1979, one may ask whether there
is any significant relation between money supply and the inflation rate and,
if so, how is it possible to explain the disparity between the relatively high
growth rate of money and the slow rate of nominal GNP growth during
1982-83. To answer these questions, the monetarist approach holds that
inflation is determined in the money market with the money supply as-
sumed to be more or less exogenously given. Demand for money will de-
pend not only on income, but also on interest rates and the expected
inflation rate. Then, a downward adjustment of interest rates and deceler-
ating inflationary expectations will lower the inflation rate for a given rate
of monetary expansion by increasing the demand for money.
A simple money-determined price model, presented in Appendix 9.1,
seems to strongly support this thesis. The inflation rate is well fitted with
the growth of money supply per unit of production, real interest rates, and
a measure of inflationary expectations (Figure 9.1). Viewing the same model
from another angle, demand for real-money balances also turns out to be
significantly affected by real interest rates and inflationary expectations. The
rate of growth of the money supply during 1982-83 was high—25 percent
in the narrowly defined money supply and 23.8 percent in the broadly de-
fined money supply on an annual average basis—compared with the 13
percent growth of nominal GNP. To a large extent, the difference between
the growth rates of the money supply and nominal GNP seems to be ex-
plainable by the large drop in interest rates and the decline in inflationary
expectations since late 1981.
In this connection, it is not difficult to find examples of steady and sig-
nificant drops in inflation and interest rates over the course of several years
being followed by a period when prices showed stability even with the rela-
tively rapid expansion of the money supply (Table 9.6). After inflation in
consumer prices in Taiwan decreased steadily from 18.5 percent in 1960 to
2.4 percent in 1962, the money supply grew at an annual rate of 23.2 per-
cent during 1963-64. Still, prices remained stable and nominal GNP grew
only 15.1 percent a year during that period. Chile is another case in point.
There, the rate of consumer price increases dropped from 506 percent in
19/4 to 40 percent in 1978, and, as the money supply increased at an aver-
 The Comprehensive Stabilization Program (1979) pas)

|
if
|

m\
1

\ Fitted
i

(SOAR: Toe eae: Ha: a DY REM Ga? BR eG Rm age Re ine Th Ue Bae

1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983
Year
Figure 9.1. The tracking of inflation by money supply growth (annual rate
of GNP deflator increase): 1972-83
Note: For the equation from which the fitted values are derived, refer to Appendix 9.1.

age rate of 63 percent a year during 1978-80, the nominal GNP grew at an
annual rate of only 48 percent.
Although there is a consensus that a tight money policy is necessary
to curb inflation, resistance from business circles has proven to be rather
strong. Business leaders have argued for years that Korea’s money stock
is too small to adequately support economic activity; thus the money sup-
ply growth rate should be increased rather than restricted. How erroneous
this argument is can easily be seen by comparing countries with differing
rates of money supply growth. In the case of Chile, where the money sup-
ply grew at a very high annual rate of 125 percent during 1971-81, the
M,/nominal gross domestic product (GDP) ratio dropped from 18.4 percent
in 1970 to 5.8 percent in 1981, when the inflation rate went as high as 165
percent. A similar trend was also evident in other Latin American coun-
tries suffering from hyperinflation such as Argentina, Uruguay, and Brazil.
Japan and West Germany are the opposite cases in which stable growth
of money has led to low inflation and a slight rise in the M,/nominal GDP
ratio. They offer strong evidence that higher levels of money supply growth
increase the velocity of money and thus increase the elasticity of nominal
GDP (or prices) with respect to the money supply. This is simply because
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 The Comprehensive Stabilization Program (1979) 225

expectations of high inflation are produced by rapid monetary expansion

and, having these expectations, people become less interested in holding
large real-money balances.
Fiscal Policy
The performance of fiscal management in relation to the stabilization ef-
forts may be evaluated by the response to two questions: whether fiscal
policy was anticyclical, and how much progress was made toward improv-
ing the budget structure and reducing the budget deficit.
Tight fiscal policy was one of the essential elements of the Comprehen-
sive Stabilization Program of April 1979. The program called for a reduc-
tion of government expenditures by 100 billion won, the postponement of
some public construction projects, and a tight government budget for 1980.
Furthermore, in 1979 a surplus of 368 billion won in the general account
of 1978 was not appropriated for general budget spending but used to re-
pay borrowings of the Grain Management Fund and the Government Sup-
ply Fund. The result was a contraction of the money supply by 129 billion
won in the government sector.
As the economy started to plunge into recession in the latter half of 1979,
however, fiscal management could no longer serve the stabilization effort
single-mindedly. Enacting anticyclical measures, the government expanded
construction activity for the purposes of maintaining growth momentum
and creating job opportunities, and it augmented its support to low-income
households that were badly squeezed by high inflation.
As a result, deficits in the unified budget, which included 16 special
accounts and 25 government-managed funds together with the general ac-
count, widened sharply to 4.3 percent of GNP during the 1980-82 reces-
sionary period from 2.8 percent of GNP during the overheated period of
1976-78. The public sector’s contribution to money supply growth was also
substantial. During 1980-82, some 1.8 trillion won of money was created
through this sector, accounting for 72 percent of the growth in the narrowly
defined money supply (Figure 9.2).
In 1983, when tax revenue increased much faster than had been planned
owing to the strong economic recovery, the ratio of the unified budget deficit
to GNP dropped to 2.6 percent from 4.6 percent in the previous year, and
there was a slight contraction of money through this sector. What is more
noteworthy is that the 1984 budget forecasted a surplus of 580 billion won
in the general account and its expenditure level was set 30 billion won be-
low that of the 1983 budget. That represented a strong commitment to stabili-
zation efforts on the part of the government. Moreover, the fact that the
National Assembly supported the government’s budget proposal seemed
to indicate that a broad consensus had been reached on the need to im-
prove fiscal management.
The experiences of many developed countries clearly show that sound
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budget management is essential for maintaining stable prices, avoiding a

crowding-out situation in the capital market, promoting a more efficient
public sector, and building a healthy reserve. However, the rigidity of the
Korean budget structure seriously limits the flexibility of fiscal management.
It is more or less accepted that the minimum defense expenditure will
be around 6 percent of GNP or approximately one-third of total spending
in the general account. Legally prescribed subsidies to local governments
and for education account for another 25 percent. Wages for government
employees and the burden of government debts are also nondiscretionary
rigid expenditures. These nondiscretionary expenditures, accounting for
roughly 70 percent of all general account spending, highlight the impor-
tance of reducing the budget deficit.
One of the most critical tasks in the reduction of the budget deficit is
improving the operation of government-managed funds. The National In-
vestment Fund and the National Housing Fund could be easily replaced
by bank credit. Closing the deficits in the Grain Management Fund and
the Fertilizer Account, however, is much tougher.
It took much effort for the government to persuade farmers to accept
a lower rate of increase for the government purchase price of rice and barley.
Despite a high rate of adjustment for the government’s selling price of rice
in 1981 and a steady drop in the rate at which purchase prices have in-
creased since 1982, a substantial deficit still remains whose accumulated
total at the end of 1983 reached 1.5 trillion won. In 1983 the deficit wid-
ened as the government increased purchases and was forced to cut the sell-
ing price of rice slightly in situations of stable market prices and growing
government stocks (Table 9.7).
The Korean fertilizer industry had been suffering from high production
costs because of inefficient facilities, overcapacity, and unprofitable exports.
As fertilizer prices were adjusted only once during the 1976-83 period, the
deficit in the Fertilizer Account was substantial, leading to an accumulated
deficit of 680 billion won at the end of 1983. Borrowings from the Bank of
Korea by the Grain Management Fund and the Fertilizer Account together
contributed as much as 6.8 percentage points to the 20.9 percent annual
growth of the narrowly defined money supply during 1979-83.
Interest and Exchange Rates
After the substantial increase in interest rates in early 1980, the rates were
readjusted downward in eight steps. The interest rate on one-year time
deposits, for instance, was raised from 18.6 percent to 24 percent per an-
num in 1980 but was lowered on three occasions and was down to its previ-
ous level of 18.6 percent in November 1981. The downward adjustments
continued until June 1982 when the rate was lowered from 12.6 to 8 per-
cent per annum (Figure 9.3).
The government considered the interest-rate reductions as justified
228 Sang-Woo Nam

Table 9.7. Operation of the Grain Management Fund and Fertilizer Account:
1975-83 (annual averages)
ee te eee ke eS ee ee See

Increase in Deficit Borrowings from

government (10° won) BOK (10? won) Contri-
rice price Grain Grain bution
Buy- Sell- Manage- Ferti- Manage- Ferti- to M,
ing ing ment __lizer ment __lizer growth
Year (%) (%) Fund Account Fund Account (%)

1975-78 23.0 18.8 92 22 166 ee bee |

1979 15.4 18.2 209 48 200 0 7.4
1980 22.0 20.8 242 126 130 30 4.9
1981 25.0 3720 144 162 220 100 8.4
1982 14.0 0.0 atey| 117 200 100 7.5
(2024
1983 ies} -2.3 286 102 250 100 6.0
(-1.9)@
Accumulated
total 15533 679 1,642 570

Source: Ministry of Agriculture and Fisheries, ROK, unpublished data.

a. High-grade rice.
BOK—Bank of Korea.

because the anti-inflationary measures were viewed as successful enough

to allow positive real interest rates. It also wanted to ease the excessive finan-
cial burden of corporations hard-pressed for funds during the recession.
Given these policy shifts, one may ask what role the official interest rate
was expected to play in Korea and how reasonable was the real interest
rate argument?
In the Korean economy, where excess demand for funds has always been
a problem, there are limitations on the effectiveness of using interest-rate
policies to adjust the demand and supply of funds. Thus monetary policy
mainly relied on controls over the money supply in a rather direct way un-
til 1981, but since then it has used a more indirect approach. In practice,
interest-rate adjustments have been made with different objectives in mind
on each occasion. These included the mobilization of savings, lightening
corporate financial burdens in a depressed business environment, and
preventing the economy from overheating.
While lowering interest rates in line with decelerating inflation to allevi-
ate the business interest burden, the authorities also attempted to squelch
speculative investment in real estate and to lower people's inflationary ex-
pectations by stepping up educational efforts to attract financial savings.
When the authorities argued that adequate real interest rates were be-
ing given to depositors despite lower nominal interest rates, they were
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230 Sang-Woo Nam

obviously using the current rate of inflation in their calculation of the real
interest rate. When it comes to inflation, however, people usually have long
memories and this is particularly the case when they have experienced
chronic inflation in the past. The shift of funds from time and savings
deposits to demand deposits, the shortening of deposit maturities, and the
sporadic speculative movements in the real estate market that followed the
June 1982 interest-rate cut seem to indicate that the cut was somewhat larger
than justifiable. As time passed and prices remained stable, however, peo-
ple adjusted to the low interest rate.
Nevertheless, indications are that adjustment is a slow process. The mar-
ket interest rate, measured by the yield on corporate bonds, was about 5
percentage points higher than the one-year time deposit rate before the June
1982 interest-rate adjustment, but the interest rate differential widened to
7 percentage points in the latter half of 1982 and narrowed only marginally
to 6.3 percentage points in 1983. The corporate bond yield was only 27 per-
cent higher than the deposit rate in 1981 but was 78 percent higher in 1983.
Time and savings deposits, which grew 19 percent in real terms in the year
preceding the June 1982 interest-rate adjustment, increased during 1983-85
at the modest rate of about 10 percent.
In the process of lowering interest rates, important progress was made
toward creating a more rational interest-rate structure. By June 1982 the
preferential interest rates applied to various policy loans were abolished
to make them subject to the same rate as general loans. Until then, the com-
plicated and fairly arbitrary interest-rate structure was believed to be partly
responsible for the alleged inefficiency in resource allocation during the
1970s. By eliminating the interest-rate incentive for preferential policy loans,
it became easier to scale down or phase out some of the policy loans.
Since early 1980 the exchange rate has been floated against the perfor-
mance of the currencies of Korea's major trading partners vis-a-vis the U.S.
dollar and the differences in the inflation rates between Korea and those
countries. This rule enables the exchange rate to be adjusted in such a way
as to maintain Korea's overall export competitiveness. The Bank of Korea,
which is in charge of managing the exchange rate, seems to have followed
this principle fairly closely, even though there has been some deviation.
A look at the degree of exchange rate distortion shows that, during
1981-83, the nominal exchange rate vis-a-vis the U.S. dollar depreciated at
a stable 6 to 7 percent a year. Based on a calculation of the real effective
exchange rate, the Korean won seems to have been overvalued by about
6 percent during 1981, although that number may vary slightly depending
on the composition of the currency basket and the relative weight given
to each currency. Since then, owing to the deceleration of the inflation rate,
this overvaluation has been essentially corrected (Table 9.8).
Nevertheless, a mechanical calculation of the real effective exchange rate
may lead to a misleading conclusion as to the trend of export competitive-
 The Comprehensive Stabilization Program (1979) 231

Table 9.8. Real effective exchange rates: 1980-83

Naminal Nominal Effective Real effective
exchange exchange — exchange Relative exchange
Enc of vate rate rate@ price rateC
month (won/US $) Indexes (end of 1980 = 100)
12/80 659.9 100.0 100.0 100.0 100.0
6/81 685.1 103.8 96.2 106.1 90:7
12/81 700.5 106.2 100.0 106.5 93.9
6/82 740.8 11253 97.8 106.3 91.8
12/82 748.8 173.5 102.1 106.9 95:5
6/83 776.7 1177, 103.6 105.9 97.8
9/83 789.3 119.6 105.2 105.6 oo,
12/83 793.5 120.5 105.7
Sources: BOK, Economic Statistics Yearbook (1984); IMF (1983).
; BN won per US $
a. Effective exchange rate Lw; ( basket curenqyy pep Ss ;

Basket currencies include those of Korea’s seven major trading partners. The weight given
to currency i(w;) is based on its relative trade volume: United States 0.424, Japan 0.397, West
Germany 0.067, United Kingdom 0.039, Canada 0.032, France 0.022, and the Netherlands 0.020.

b. Relative price = ul (sores). F

X1 (w; WPI})
c. Real effective exchange rate = effective exchan, ——-
relative price

ness. For one thing, wholesale price indices may not correctly reflect prices
of the goods actually traded. Moreover, the interest rate on export loans
was not lowered as much as that on general loans and unit labor costs rose
relatively faster than did wholesale prices. Thus export competitiveness after
1982 might have been overestimated because of the difference in interest-
rate reductions in the export sector, and to the extent that the export sector
is more labor-intensive than the domestic sector.

Wage Policy
Wage guidelines in Korea have a rather short history. They first appeared
in a statement by Deputy Prime Minister Nam Duck-Woo in February 1977,
when he said, “When a price adjustment is demanded based on wage in-
creases given by monopolistic or oligopolistic producers, the maximum ac-
ceptable wage increase will be 15 to 18 percent only.” Since the fall of 1981,
government announcements of planned pay increases for public servants
have served as informal wage guidelines for the private sector. The an-
nounced increase rates were 9 percent for 1982, 6 percent for 1983, and a
freeze for 1984. Acting through the Bankers’ Association of Korea, the
232 Sang-Woo Nam

government also tried to keep wage increases low by having banks restrict
credit to firms that increased wages beyond government guidelines. This
move in late 1980, however, faced strong resistance from the Federation of
Korean Trade Unions. Whenever there was a more explicit confrontation
over this issue, the government would say “There is no official guideline.
It is just a suggestion on the part of the government.”
That rather insincere and evasive attitude did not help to build a con-
sensus behind the need for wage guidelines. Consequently, workers have
become suspicious of any suggestion of wage guidelines, and government
efforts to stabilize wages have been ineffective. In spite of a variety of educa-
tional programs geared to stabilize wages, the rate of wage increases did
not slow as fast as the government had hoped.
Under government influence, negotiated base salary increases in the pri-
vate sector in 1982 and 1983, which averaged 9.5 and 6.9 percent, respec-
tively, were very close to those for public servants. However, de facto wage
increases in the private sector were much higher than the negotiated rates—
15.8 percent in 1982 and about 12 percent in 1983 (Table 9.9)—indicating
that effective wage guidelines depend on a broad consensus among labor,
management, and the government. Otherwise, businesses can easily cir-
cumvent guidelines under the existing complicated wage structure.
Whenever official wage settlements were proposed, the most commonly
used formula called for holding wage increases to the rate of inflation plus
growth in labor productivity. In practice, ambiguities have always remained,
such as which inflation rate (the past or the expected one) should be used
and how labor productivity would be measured.
A commonly used labor productivity measure is the productivity index
compiled by the Korea Productivity Center (KPC). The KPC productivity

Table 9.9. Increase rates of base salaries and all compensation: 1977-83 (%)

Public servants Private-sector workers

Base All Base salaries All
Year salaries compensation (negotiated) compensation
1977 32.0 25.0) 36.0 32:1
1978 20.0 26.0 29 7. 35.0
1979 15.0 23.0 26.8 28.3
1980 10.0 22.0 215 23.4
1981 10.0 17.0 16.1 20.7
1982 9.0 99 9.5 15.8
19834 6.0 8.5 6:9 11.6
1977-83 average 14.6 18.8 20.9 23.8
a ee a ee ee ee eee
Sources: Budget Office, EPB, ROK, unpublished data; Korea Employers Federation, unpub-
lished data.
a. Estimated.
 The Comprehensive Stabilization Program (1979) 233

index, however, seems to have an upward bias, particularly during reces-

sionary periods. Furthermore, there has been a tendency to apply the rate
of labor productivity increase in the manufacturing sector to other sectors,
where productivity growth is slower. Measured as value added per worker,
labor productivity grew at an annual rate of 5.6 percent during 1976-78,
whereas real wages rose as much as 18.5 percent annually. Owing to the
stabilization efforts, real wage increases slowed to 2.8 percent a year dur-
ing 1979-82, although labor productivity declined slightly during the pe-
riod (Table 9.10).
The rationale for wage restraint was that stable wages were essential for
export competitiveness because many of Korea's exports were still labor in-
tensive. Furthermore, because labor costs constitute a large share of total
costs of final goods and services, price stability is impossible without sta-
ble wages.
As mentioned earlier, Korea's export competitiveness deteriorated sharply
during the 1976-79 period because of a sharp increase in unit labor costs.
During 1980-82 Korea’s unit labor costs in the manufacturing sector rose
50 percent, much faster than in other Asian newly industrializing coun-
tries. Nevertheless, because the exchange rate depreciated 51 percent, unit
labor costs measured in U.S. dollars did not rise, and they even recovered
part of the loss in relative export competitiveness that took place during
1976-79 (Table 9.11).
Misunderstanding and confusion concerning the causal relation between
wages and inflation and the contribution of wages to inflation have been
frequent. On the basis of regression analysis, some have argued that wage

Table 9.10. Average annual rate of increase in real wages and labor produc-
tivity: 1971-82 (%)
Item 1971-73. 1974-75 1976-78 1979-80 1981-82
Nominal wages 14.8 30.7 34.2 25.8 18.2
Manufacturing 16.0 31.1 34.3 2ouF 17.4
Consumer prices 9.3 24.8 13.3 23.4 14.1
Real wages 5.0 4.7 18.5 2.0 3.6
Manufacturing 6.1 5.0 18.5 1.8 yi)
Labor productivity
KPC index* 8.3 10.5 9.5 12.9 11.8
Manufacturing 9.0 11.4 10.0 1352 1257
Value added per worker? toe 0.9 5.6 -2.4 0.4
Manufacturing 8.2 2.4 7.4 5.0 4.2

Source: BOK, Economic Statistics Yearbook (1975, 1980, 1983).

a. Korea Productivity Center (KPC) index.
b. Nonagricultural sector.
234
cs
Sang-Woo Nam
lg Ss

Table 9.11. Unit labor costs for manufacturing in Korea, Taiwan, Singapore,
and Hong Kong: 1976-82 (1975 = 100)
ee ee I eh ps es eee eS

Singa-
Taiwan pore? Kong
Hong> eee?
Item
Te mints we AS oteKorea
gee EE Siem Eeeeseiepprver
Nominal wage (A)
1976 134.7 116.8 104.7 115.9
1979 311.4 188.1 128.6 IWAVAL
1982 526.6 297.0 19bs 240.4
Labor productivity> (B)
1976 101.0 106.9 103.0 107.0°
1979 131.2 136.7 114.2 119.6°
1982 148.2 157.4 1289 oe 5
Unit labor costs in national
currency [(C) = (A/B)]
1976 133.4 109.3 101.7 108.3
IV 237 = 137.6 112.6 142.2
1982 eens! 188.7 148.3 179.8
Exchange rates per US $ (D)
1976 100.0 100.0 104.2 99:3
1979 100.0 94.9 91.7, 101.3
1982 151.1 103.0 90.2 1279
Unit labor costs in US $
((E) = (C/D)]
1976 133.4 109.3 97.6 109.1
1979 237 ac 145.0 122.8 140.4
1982 230.4 153.2 164.4 146.3
Sources: BOK, Economic Statistics Yearbook (1980, 1983); Council for Economic Planning and
Development, Taiwan (1980, 1983); Directorate General of the Budget, Accounting and Statis-
tics, Taiwan, Quarterly National Economic Trends (1977-83); Department of Statistics, Singa-
pore (1980, 1983); Census and Statistics Department, Hong Kong (1977-83); United Nations,
Monthly Bulletin of Statistics (1977-83).
a. All industries.
b. Value added per worker.
c. GDP/total employment in all but the construction industry.

increases have not had significant responsibility for inflation, although a

causal linkage the other way around is fairly strong. However, their price
equations usually include the money supply as well as cost variables, com-
bining two independent price models. Thus the claim that wage increases
have played only a passive role in the inflationary process seems ill-
grounded.
Another erroneous argument based on business accounting data is that
the contribution of wages to inflation is very small because wages account
 The Comprehensive Stabilization Program (1979) 235

for less than 10 percent of total costs in the manufacturing sector. These
data are composite income statements aggregated across individual firms
at all stages of production. Thus material costs constitute the major share,
and they can be decomposed into raw materials, both imported and domes-
tic primary goods, and value added (including wages) in previous stages
of processing. The wage share of total costs is therefore much higher than
these accounting data indicate.
As for the GNP deflator, a rough estimate of the wage share can be ob-
tained from national income data. Assuming that 70 percent of unincorpo-
rated business income consists of wages, and forgetting some minor
categories, one can attribute 59 percent of the GNP during the 1970-82 pe-
riod to wages, 30 percent to return to capital, and the remaining 11 percent
to net indirect tax.
By estimating a cost-based price equation utilizing these data, one can
decompose the past inflation rate. The explanatory variables in the price
equation include composite cost of productive factors calculated by using
the above shares, the cost of imports, and a measure of demand pressure
in the nonagricultural sector. An agricultural price index is also included,
because agricultural prices are, for the most part, determined independently
of costs.
According to this analysis, the rise in unit labor costs during 1979-80 was
responsible for more than half of the annual inflation rate of 22.6 percent
as measured by the GNP deflator (Table 9.12). Although the increase in
unit labor costs slowed somewhat during 1981-82, it still contributed more
than three-quarters of the 12.2 percent annual inflation rate. Labor costs
were not as important in determining wholesale prices as were import costs
during the 1979-82 period. They contributed about 9 and 6 percentage points

Table 9.12. Decomposition of inflation by cost factor: GNP deflator, 1971-82

(%)
Item 1971-73. 1974-75 1976-78 1979-80 1981-82
Import costs D2 he ae 0.5 11.6 4.6
Unit import value 2-7, i2aL 0.1 8.3 0.6
Exchange rate 3.2 3.0 0.4 3.3 4.0
Cost of productive factors ~- 5.2 o22. 11.8 14.3 8.2
Wages 5.5 9.0 11,9 12.6 he)
Demand pressure -0.3 -0.9 1.7, -4.6 -2.2
Agricultural prices Zes Py 4.2 1.6 15
Other 0.0 -0.1 0.0 -0.3 0.1
Actual price increases 13.5 27.0 18.2 22.6 PAP)
Sources: BOK, Economic Statistics Yearbook (1975, 1980, 1983).
Note: For the equation on which this analysis is based, refer to Appendix 9.1.
236 Sang-Woo Nam

to the annual wholesale price increase of 28.4 percent and 13.4 percent,
respectively, during the 1979-80 and 1981-82 periods.

Economic Education Program

A policy-related economic education scheme began in Korea in the late 1970s
with the efforts of some economic technocrats to persuade top policymakers
and other high-ranking officials to deal with the increasing problems with
the economy. Their efforts led to the enactment of the Comprehensive
Stabilization Program in April 1979. To be successfully implemented, the
program needed to secure broad understanding and cooperation from the
people. At the initial stage government officials were targeted for educa-
tion because they were to be the driving force behind the new economic
policies.
Since the end of 1980 the economic education program has made rapid
strides under presidential sponsorship. In December 1981 an EPB task force,
headed by the assistant minister, was established to give the program greater
continuity. In November 1982 a regular EPB organization, the Bureau of
Economic Education, was established to undertake economic education pro-
grams on a more systematic and permanent basis. The target group has
been broadened to include all classes of people, and the educational me-
dia have been diversified to include lectures, slides, video tapes, news-
papers, booklets, radio, and television. The Bureau of Economic Education
formulates an annual education program, supports education in other or-
ganizations by preparing educational materials and appointing education
officers, and sends materials on major economic policies to about 5,000 pub-
lic opinion leaders in academia, the press, parliament, business, and the
army.
Economic education in Korea was started as an attempt to get the broad
and active support of the people for the government’s economic policies.
A good example has been education on economic stabilization, a program
in which the government tried to convince people of the gravity of infla-
tion caused by excessive wage demands based on high inflationary expec-
tations.
Not all economic education, however, has been limited to the promo-
tion of government policies. Many programs have given information to
economic units to help them rationalize their economic decisions or to
enhance people's understanding of the workings of the economy at home
and abroad. This approach enables people to plan with greater certainty
and to narrow differences in the perception of economic realities that
inhibit the domestic consensus needed for effective economic policy-
making.
Given the short history of economic education in Korea, it may be too
early to evaluate its performance. The nature of the education defies easy
evaluation in any case.
 The Comprehensive Stabilization Program (1979) 237

LESSONS AND REMAINING TASKS

OF THE STABILIZATION POLICY
Lessons
From the 1960s through the early 1980s Korea had one of the highest infla-
tion rates in the world. Among over a hundred countries included in the
World Bank, World Development Report (1983) for which inflation data for
1960-81 in terms of the GDP deflator are available, Korea stood in eleventh
place, behind only the Latin American countries that had suffered from
hyperinflation. By the late 1970s it became obvious that high inflation was
undermining the growth potential of the Korean economy. The Compre-
hensive Stabilization Program of April 1979 was born from the understand-
ing that inflation is not an inevitable product of high growth but something
that must be cured to sustain growth.
The Comprehensive Stabilization Program faced rough going in its early
stages. The twin blows of the oil price increase and the assassination of
President Park several months after the program was launched endangered
the program's prospects, requiring constant discipline from the government.
In 1980 the Korean economy experienced unprecedented difficulties with
political and social unrest, a severe crop failure, a contraction in world trade,
and a major exchange-rate depreciation on top of soaring import prices.
In this environment, it was painful and took courage to maintain the
restrictive monetary policy stance. To compensate for the weakening of eco-
nomic activity, a series of reflationary policy measures were enacted dur-
ing 1980-82. To business circles, the policy packages fell short of expectations
and were too weak to boost business activity. To the many academicians
who strongly supported the austerity moves, they meant the abandonment
of the stabilization policy. In general, the government was cautious in
preparing these reflationary packages, with the possible exception of the
June 28 measure in 1982 that significantly lowered interest rates. The rate
of monetary expansion was substantially reduced, except in 1982 when the
relatively rapid growth of money was more or less justified as a response
to the weak activity of the financial market in the wake of the curb-loan
scandal in the spring.
Around the end of 1982, there was renewed concern over the possibility
of reigniting inflation because of the large expansion of the money supply
since the early summer, an expected recovery of the economy, and the an-
ticipation of increased raw material import prices in 1983. The government
moved quickly after late 1982, however, to tighten its rein over the money
supply. The external environment has also been favorable given the cut in
oil import prices in the spring of 1983. A lighter financial burden for heav-
ily indebted corporations together with the improving capital utilization
ratio partly compensated for the steady rise in unit labor costs. The result
was a continued deceleration of inflation to a 3 percent level for 1983.
238 Sang-Woo Nam

Inflation rates were low and stable through 1987, but inflation acceler-
ated in 1988 when CPI inflation rose to 7.1 percent from the 1 percent level
that had prevailed during 1983-87. From Korea's stabilization efforts and
performance, what lessons can one derive that might serve as a reference
for other countries?
First, Korea’s experience seems to indicate that it takes time—several
years—and strong leadership commitment to cure chronic inflation. If a
country is to deal with any incidental inflation such as that induced by an
oil price shock, the prescription may be a tight money policy for a brief
period. However, consistent and uninterrupted care for a considerable time
period seems to be required for a country suffering from chronic high in-
flation. Inflation is fundamentally cured only when the suppliers of produc-
tive factors such as workers, capitalists, farmers, and entrepreneurs are
satisfied with a low rate of nominal income growth, and this can only be
achieved in stages in an inflation-prone country. Therefore, a strong com-
mitment to stabilization policies by the country’s leaders is critical. It was
apparent that President Chun was serious about curbing inflation; presiden-
tial support was the key ingredient responsible for the consistency of the
stabilization efforts throughout the prolonged recession.
The second lesson is that for best results stabilization policies should
be accompanied by efforts to improve the efficiency of resource allocation.
When the allocation of more limited resources is distorted, the supply ca-
pacity of some sectors will be constrained and overall industrial efficiency
will suffer, resulting in price instability. Korean policymakers were keenly
aware of this problem because distorted resource allocation was already
an important cause of inflation before the stabilization effort. The Korean
approach was to promote more competition not only among domestic sup-
pliers but also with foreign imports, to encourage direct foreign investment
in Korea, to realign the industrial incentive system, to allow more auton-
omy in banking operations, and to check the expansion of the public sector.
Even though the above measures were all appropriate and essential for
the long-run efficiency of the economy, Koreans seem to have been less
successful in dealing with ongoing resource allocation problems. The
process of redressing overinvestment and duplicative investment in some
heavy and chemical industries has been slow and ineffective in many cases.
Preferential policy loans and credit extended to bail out troubled corpora-
tions have restricted credit availability in other sectors. And under a rigid
and low-interest-rate regime, banks have had a strong incentive to favor
larger corporations in spite of strenuous encouragement by the authorities
to give more credit to small and medium-size firms. Moreover, there were
some signs of disintermediation (transfer of financial resources when the
short-term interest rate exceeds the savings dividend) from financial insti-
tutions to the unorganized money market, the real estate market, and con-
sumption.
 The Comprehensive Stabilization Program (1979) 239

The third lesson is the importance of a broad consensus on the need

for policies to ensure price stability. When relying only on a tight money
policy, stabilization efforts may be painful and time consuming. Thus Korean
policymakers in recent years have directed much of their efforts to stabiliz-
ing the costs of productive factors. These moves have included informal
guidelines to restrain wages in the private sector, to keep nominal interest
rates low, to discourage high dividend payments, and to stabilize agricul-
tural prices. These efforts cannot be successful without the full support of
the parties involved. Such support in turn hinges on convincing them that
their relative share of income will not be squeezed by conformity to govern-
ment guidelines or policies.
The attempt to build a national consensus in Korea and to secure broad
cooperation from all sectors often has not been handled very well. Arbitrary
and overly ambitious approaches have led to unnecessary resistance and
to misunderstandings on the part of groups who feared they were bearing
the brunt of the government's efforts to stabilize prices. This reaction is evi-
dent from the large wage drifts from negotiated increase rates, instability
in the financial market, and widespread distrust among farmers toward
government policies. The approach might have been more effective when
the income of all factor suppliers was simultaneously dealt with in a more
balanced manner.
Finally, for any stabilization effort to be widely appreciated, its primary
emphasis should be stabilizing the livelihood of the people. Wage earners
are generally observed to have money illusions. Even in situations where
their real wage increase is the same, they are more sensitive to price in-
creases when their nominal wage increase is only 10 percent rather than
30 percent. If their shopping basket happens to cost more than the official
price index indicates, they are liable to distrust government statistics and
are not likely to cooperate with government policies.
Realizing this, the EPB has, since 1981, compiled a separate price index
of ten basic daily necessities, including rice, and has tried to stabilize their
prices. The government has failed, however, to maintain stable prices in
one essential area—the real estate and rental housing market. During 1983,
when consumer prices rose only 2 percent on a year-end basis, house rents
rose 13 percent. More dramatic was the rise in Seoul's house and land prices,
which increased more than 30 percent and 50 percent, respectively, during
1983. As buying homes becomes a more and more remote possibility every
year, renters have had to pay an increasing portion of their income for hous-
ing. In these circumstances, the government's talk of wage restraint on the
basis of stable prices may not sound very convincing.

Remaining Tasks
Although the inflation rate has been reduced much faster than the original
target because of restrictive monetary and fiscal management and the
240 Sang-Woo Nam

favorable trend in import prices, the revised Fifth Five-Year Development

Plan (1982-86) concludes that continued efforts to ensure price stability are
needed on a more or less permanent basis. More specifically, the plan called
for stable monetary expansion at an average annual rate of about 12 per-
cent for the broadly defined money supply, and for the elimination of the
unified budget deficit by 1986. (Although this was not achieved, the bud-
get deficit shrank considerably.) Improvement of the commodity distribu-
tion system and mobilization of domestic savings were also important
objectives of the plan.
Apart from those mentioned, there remain many additional tasks to be
undertaken for the successful realization of stabilization goals. An institu-
tional realignment is needed to empower the Bank of Korea with sover-
eign control over the supply of money. The prime responsibility of the
central bank should be in controlling inflation by maintaining a stable money
supply; this requires greater independence from the government. As peo-
ple's inflationary expectations subside, the inflow of savings into the financial
market should become more stable and the differential between the free
market and official interest rates will narrow. Then, the workings of the
financial markets should be improved by gradually liberalizing interest
rates. Interest rates should be determined in closer relation to demand and
supply conditions in the market as well as by the credit-worthiness of bor-
rowers.
Eliminating the deficit in the government’s Grain Management Fund re-
mains a persistent problem. On the assumption that the shift in diet will
continue to reduce rice consumption, the agricultural sector may have to
undergo a substantial change and the two-tiered price system will no longer
be tenable. Farmers will have to be encouraged to switch gradually from
major grains to high-value vegetables, stock raising, and fruit. Moreover,
in light of the fact that more than two-thirds of farm households own less
than one hectare of cultivated land, some institutional changes may have
to be made to facilitate the farm mechanization essential for the enhance-
ment of agricultural productivity.
Under the current real estate tax system, large capital gains can be ob-
tained from real estate investments. The incomplete land registration system
and the complex regulatory laws on land use make it difficult to establish
an effective monitoring system on real estate ownership and transactions.
In addition, real estate speculation was, to some extent, the result of the
government practice of using taxation on real estate as part of its anticycli-
cal measures. Thus, the antispeculative measures of the government have
to be more comprehensive, tackling fundamental problems of supply and
demand in the market. The basic approach to the stabilization of real es-
tate prices may include making property and capital gains taxes heavier
and more progressive, reforming the housing financing system, and increas-
ing the supply of housing lots and rental houses.
 The Comprehensive Stabilization Program (1979) 241

Finally, in an effort to stabilize wages, the government's wage guidelines

should try to induce improvements in the wage structure rather than be
obsessed with wage restraint alone. In addition to encouraging the larger
corporations to restrain the wage increases of highly paid white-collar work-
ers, the government should also consider adoption of a minimum-wage sys-
tem for production workers. Introduction of a minimum hourly wage will
lead to higher productivity, not only by giving workers stronger motiva-
tion, but also by inducing firms to become more managerially and techno-
logically innovative. Furthermore, to secure wage stability when substantial
changes are taking place in the labor market structure, stepped-up efforts
will have to be directed to on-the-job training, retraining programs, and
the establishment of an efficient employment information system.

APPENDIX 9.1
Money Demand and Price Equations
The equations presented below were estimated, unless otherwise specified,
with semiannual period-averaged data for a sample period of 13.5 years
from the first half of 1970 through the first half of 1983. Superscript m in
a variable notation denotes the moving average of the current and the previ-
ous periods, while 4m denotes the moving average of the current and previ-
ous three periods. A dot (-) indicates percentage change over the same
period of the previous year, and numbers in parentheses below coefficients
are t-values.
A. Demand for Money (Ordinary Least Squares [OLS] Estimate)
1
(1) In(M,/Pv) = — 1.271 + 0.938 In 44V; — 2.478 In(1 + P5/100)
eats ynies (5.78)
— 2.039 In[(100 + r;)/(100 + P®)] — 0.044 Df
(7.08) (2.67)
— 0.214 D(81/82) — 0.111 D(82/83)
(6.31) (2.35)
R2 = 0.9841 D.W. = 1.43
%)
(2) In(M,/Pv) = — 1.877 + 1.038 Indy V; — 1.925 In(1 + P6/100)
(3907) ee (5.07)
— 0.799 In[(100 + 7;)/(100 + P&)] — 0.034 Df
(3.19) (2.40)
+ 0.110 D(81/82) + 0.114 D(82/83)
(3.75) (2.75)
R?2 = 0.9918 D.W. = 1.68
242 Sang-Woo Nam

where D(81/82): Dummy variable for the second half of 1981 and
the first half of 1982
D(82/83): Dummy variable for the second half of 1982 and
the first half of 1983
Df: Seasonal dummy variable for the first half of a year
M,, M,: Narrowly and broadly defined money supply, respec-
tively
Pv: GNP deflator (1975 = 1.00)
Pb: A measure of the expected inflation rate based on past
inflation rates with the weights assumed to show a geo-
metrically declining distribution
5 5
= i=>;0.3(1 — 0.3)-1 Po«/ 7240.31 — 0.3)-1
r: Interest rate on one-year time deposits, and
V: Gross national product in 1975 constant prices
B. Money-Determined Price Equations (Estimated with the Cochrane-Orcutt
Iterative Technique)
6
(1) In Pv = 1.746 + 1.045 24 w; In(M,/V); + 1.154 In(1 + P5/100)
(7.03) = (4.69)
+ 0.691 In[(100 + 7)/(100 + P6)]
(3.22)
e@ = 0.499 _R? = 0.9990 D.W. = 0.194
where w;’s are polynomially distributed lag coefficients:
Wo = 0.092 W, = ORI22 W2 = 0.144 W3 — 0.159

W, — 0.165 Ws = 0.163 We = 0.154

6
(2) In Pw = 6.079 + 1.011 >;w; In(M,/V)_; + 1.509 In(1 + Pi&/100)
(26.8) '~ (3.64)
+ 0.745 In{(100 + 7,)/(100 + P&)
(1.90)
@ = 0.6442 R2= 0.9964 D.W. = 1.87
where Pw: Wholesale price index (1975 = 100)
56 A measure
Pw: : ‘ ;
of the expected inflation rate in terms of whole-
sale prices.
 The Comprehensive Stabilization Program (1979) 243

5 5
= Lu 0.3(1 — 0.3)-1 Pw il 240.3(1 — 0.31, and
= i=

Wo = 0.154 w, =0.195 w, = 0.209

w, = 0.196 w,=0.156 w, = 0.089
C. Cost-Based Price Equations (OLS Estimate)
(1) In Pv = — 9.358 + 0.336 In(Pm - Rex) + 0.750{0.59 In ULCn4m
(10.5) (8.94)
+ 0.30 In COC™ + 0.11 In(Ti/CVj")] + 0.624 In Rcu™
(4.00)
+ 0.148 In Pv,a + 0.022 Df
(2.19) (1.86)
R2 = 0.9991 D.W. = 1.68
(2) In Pw = — 6.221 + 0.493 In(Pm - Rex)™ + 0.443 In ULCm4™
(17.8) (16.7)
+ 0.203 In COC" + 0.017 Df
(2.28) (1.66)
R? = 0.9986 D.W. = 1.64
where COC: Estimated overall cost of capital
= DEP/CV + (0.4 Rb + 0.25 Rf) (1 — Tc) + 0.15 Rum
+ 0.2 Reg
CV: Nominal gross national product
DEP: Capital depreciation allowance
Rb: Bank interest rate on general loans
Req: Dividend yields based on face value of equity
stocks
Rf: Approximated effective cost of borrowing from
abroad
= (Reuro + 1.0) (1 + RISKex/100) + RISKex
Reuro: Eurodollar rate on three-month maturity
loans
RISKex: Exchange risk measured as annual rate of
exchange rate depreciation during the re-
cent two-year period
Rum: Interest rate on unorganized money market
loans, and
Tc: Corporate income tax rate for the highest in-
come bracket
244 Sang-Woo Nam

CVn: Value added in the nonagricultural sector in cur-

rent prices
Pm: Unit price for commodity imports in U.S. dollars
Pya: Price deflator for agricultural value added
Rex: Exchange rate in won per U.S. dollar
Reu: Capital utilization ratio in the nonagricultural
sector
= (Vn — Vf)/Vnf
Vn: Value added in the nonagricultural sector in
1975 constant prices
Vf: Net factor income from abroad
Vnf; Estimated potential nonagricultural value
added excluding Vf, which was obtained
from the following equation based on
quarterly data (1969-82)
= — 15.375 + (0.342 D1 + 0471 D2
(14.1) (5.85) (8.07)
+ 0.448 D3 + 0.503 D4) (K™)_,
(7.69) (8.68)
+816702)1n.(K2)4
(13.9)
R2 = 0.9944 DW = 0.27
where D1, D2, D3, D4: Seasonal dummy variables for the first, sec-
ond, third, and fourth quarters, respectively,
and
K,: Capital stock in the nonagricultural sector (period-end)
Ti: Indirect internal tax revenue, and
ULCm, ULCn: Unit labor cost (productivity-adjusted wage
cost) in the manufacturing and nonagricultural
sectors, respectively, where productivity
was measured as value added per employment
 sae

| k
ao -
p zZ
Les

4 ry f

a |

nie
| ; Ls

wel! a
|a Te - re ‘

' WAG ji VON a =

ere dayns¢ i} |, . ce
Fhe ns fare {Tale W ie : = wp Po ee

Pectine th hws rani ee, ipa Vaghire

- S
 ~

i =
a

os ——' :
ae

et
%
TAL Searce
retry i octomits
_ at =
tothrertng and 7 thei
wr
Oy

“* : 7 = ~~

TES @ (345 ers Dare Oe

Mi) al 7:4 an te
Ls
—— | “e
 10 The 1966 Tax Administration
Reform, Tax Law Reforms, and
Government Saving
by Chong Kee Park

Tax reform is a continuous and sensitive process that promotes the improve-
ment of tax law and administration to ensure they remain responsive to
changing economic and social conditions and to the changing priorities and
objectives of public policy. There have been numerous tax reforms in Korea
since 1961, but the two most important were the reorganization and im-
provement of tax administration in 1966 and the enactment of a compre-
hensive tax law revision in 1967. The immediate objectives of these reform
measures were to narrow the gap between tax law and practice, and to make
the tax structure more responsive to changing rates of inflation and eco-
nomic growth. The ultimate objectives were to mobilize domestic resources
and improve the saving function of the government sector.
Tax revenues increased more rapidly than GNP during 1957-62 (with the
exception of 1961), but during 1963-65 failed to keep pace with rising lev-
els of GNP (Table 10.1). Several interrelated factors were responsible for
the decline in the tax ratios after 1962, including the rate of growth in GNP
Table 10.1. Tax revenue as a percentage of GNP: 1957-65

Eaeev
as percentage of GNP
Nominal
GNP
GNP
price
_ Inflation
aie
National Local Total tax growth deflator (% per
Year taxes taxes revenue rate (1965=100) year)
1957 6.7 0.8 7.5 29:7 37.8
1958 Slay e708 8.9 (8.1) 4.8 37.6 -0.5
1959 11,0 9(8:6)) 41.0 12.0 (9.6) 6.7 38.4 oes
1960 PETES.) er 0:9 1220" (9:7) 11.6 41.9 8.7
1961 8.7 0.9 9.6 20.3 48.4 14.4
1962 i) 15 10.8 17.4 54.9 12.6
1963 7.4 C5 8.9 40.0 70.4 24.9
1964 6.0 1:2 Hees 42.8 92.9 2 7e7
1965 ges 1.4 8.6 15.7 100.0 7.4

Sources: ONTA, ROK, Statistical Yearbook of National Tax (1960, 1967); BOK, Economic Statis-
tics Yearbook (1967).
Note: Numbers in parentheses are exclusive of education tax, foreign exchange tax, and land
income tax levied in 1958, 1959, and 1960.

247
248
ee Chong
I Kee ee
Park ee ee
and changes in its composition, changes in price levels, changes in the tax
system structure, shifts in the composition of imports, and the altered ef-
fectiveness of tax administration. It is important to note that the largest
declines in the nation’s tax/GNP ratio occurred in 1963-64 when prices were
rising most rapidly. The most significant increases in the ratio, however,
were recorded in 1958-59 when prices remained relatively stable and the
growth in nominal GNP was modest. The big increase in the ratio in 1962
may represent a recovery from the decline in 1961, which was partly at-
tributable to major tax reforms occurring in that year. Thus, the relation-
ship between the tax yield and GNP during 1958-64 suggests that the
Korean tax system as a whole was not responsive to changes in nominal
GNP, particularly when such changes were accompanied by rapidly rising
price levels.
Rapid inflation magnifies the differences in the rates of change among
the various economic sectors and types of income. Moreover, in a rapidly
developing economy, relatively large structural changes take place within
a short time. If these differential rates of growth and structural changes
increase the relative importance of sectors subject to lower effective tax rates,
total tax revenue would grow less rapidly than GNP, even if revenue yields
from taxes increase in proportion to their respective taxable bases. This is
what happened in Korea in 1964. The agricultural sector accounted for the
unusually large proportion of the growth in GNP in that year, increasing
by 15.6 percent in comparison with 9.6 percent for the overall economy. The
share of agriculture in GNP rose from 37 percent in 1962 to 47 percent in
1964 (BOK, National Income, 1980). Because of the low tax on agricultural
income, the total increase in tax yield was small relative to the growth in
GNP.
The downward trend in the ratios of tax revenue to GNP since 1962 also
reflects unusual increases in prices triggered by a poor harvest in late 1962
and a structural defect in the tax system that prevented the system from
responding to increases in prices and money income. The sharp increase
in government expenditure and the budget deficit in 1962 further aggra-
vated the inflation that impaired tax collections in the following two years.
Over the 1960-62 period total government expenditures increased sharply
from 17.0 percent to 25.4 percent of GNP, while total revenues including
counterpart funds rose only slightly from 18.8 percent to 20.8 percent of
GNP. As a result a huge fiscal deficit, equivalent to 4.5 percent of GNP,
was generated in 1962 (Table 10.2). Most of the decline in tax revenues af-
ter 1962 was in indirect taxes, the assessment base of which failed to keep
up with the soaring inflation of 1963 and 1964. Some of the excise and com-
modity taxes—such as those on liquor and sugar—were unit taxes (a fixed
tax per unit of the commodity) rather than ad valorem taxes (a fixed percent-
age of the value of the commodity), with the result that their tax liabilities
fell behind the increase in GNP at current prices. The ratio of liquor tax
 The 1966 Tax Administration Reform 249

Table 10.2. Central general government revenues as a percentage of GNP:

1960-69

Item 1960 1962 1964 1966 1967 1968 1969

As percentage of GNP
Internal taxes 8.0 Ou Al) 6.8 8.3 9.9 10.4
Other taxes# 3.0 Shi 1.9 2.4 2.8 3.4 3.4
Other domestic revenue? EO) 3h 1.4 2.0 ei 2.0 3.0

Total domestic revenue A ZEO Ree 226 ae le 2 O eee | Sel OL

Counterpart fund 68 82 4.0 3.7 Belek 2.1) i0.8
Total revenues itestom AOE} Gh ET) NO Zs). IAS.
Total expenditures TAU 25 2 10:5 13.77 14:5) 916.69 17-8
Fiscal balance 18 -4.5 0.6 cle 1.4 09 -0.2
As percentage of total revenues
Total tax revenues@ 58.6 44.3 53.0 61.7 69.6 76.3 78.4
Other domestic revenue? 53160) 2s 1354 OLS eee Le eel ee
Counterpart fund Coe Bey sig) Pe NO, iwp 4.5
Total revenues 100.0 100.0 100.0 100.0 100.0 100.0 100.0

Sources: BOK, Economic Statistics Yearbook (1971); Brown (1973: table 5).
a. Includes customs duties and monopoly profit.
b. Includes trust fund and interest.

revenue to GNP dropped by more than 40 percent between 1962 and 1964,
and yields from indirect taxes as a whole declined from 3.1 percent of GNP
in 1962 to 1.6 percent in 1964 (C. K. Park 1970).
The decline in the tax ratio after 1962 was also partly due to increased
tax exemptions and reductions and because much of the growth in GNP
during that period took place in industries enjoying substantial tax benefits.
The exemptions and reductions granted under the Corporation Income Tax
Law rose sharply from 110 million won in 1961 to 1,046 million won in 1964,
representing 6.4 percent and 25.5 percent, respectively, of corporate income
taxes actually collected in those years (C. K. Park 1978). Most of these statu-
tory exemptions and reductions were allowed under various provisions of
the law to encourage investment in specific industries and to stimulate rein-
vestment of earnings.
This type of tax concession was not limited to income taxes; tax liabili-
ties of indirect taxes such as customs duties and commodity taxes were also
waived for businesses earning foreign exchange. Between 1962 and 1964
customs duties declined from 1.9 percent to 1.2 percent of GNP, while com-
modity tax revenues dropped from 1.4 percent to 0.5 percent of GNP. Be-
cause the share of imports in GNP was at an all-time high in 1962 and 1963,
250 Chong Kee Park

the declining ratios of tax revenues (from customs duties and commodity
taxes) to GNP may have resulted from large tax concessions granted on
raw materials for manufacture of goods for export and changes in the com-
position of imports. The decline also is attributable to the unrealistic ex-
change rate, which understated the won value of imports to which customs
rates applied. The large decline in commodity tax revenues during this
period was caused by a tightening of import restrictions, forced by the un-
realistic exchange rate, that sharply reduced imports of such major revenue-
yielding items as radios, TV sets, films, and manufactured textiles (Brown
1973).
The weakening position of tax revenue in the fiscal system was a major
cause of concern for fiscal authorities and planners in the government. The
implications for future tax and fiscal policies were clear. If the government
sector were to provide the necessary share of financial resources to imple-
ment the forthcoming Second Five-Year Development Plan, reversal of the
declining trend in the tax ratio would be necessary. With the anticipated
decrease in counterpart funds and uncertain prospects for private savings,
financing from domestic sources, including tax revenues, would have to
cover an increasing proportion of total budget requirements.

MAIN FEATURES OF THE POLICY MEASURES

Within certain limits, restoring the tax/GNP ratio could be achieved by im-
proved administration of existing taxes. Lack of tax compliance was still
widespread. Strict penalties were not imposed for tax evasion, and tax offi-
cials failed to enforce fair and equitable assessments. Bargaining between
tax collectors and taxpayers and the resulting payoff were common features
of the assessment process. Thus, it was absolutely necessary that tax ad-
ministration be tightened. Nonetheless, more stringent enforcement of tax
laws would not be sufficient; the growth and changing structure of the econ-
omy required adjustments in the tax system itself if the government were
to play a leading role in financing development. Maintaining required ra-
tios of tax revenue to GNP would necessitate higher tax rates, new tax
sources, or both.
Shortly after assuming power in 1961, the military government began
to make numerous revisions both in the tax administrative regulations and
procedures and in tax laws. To encourage voluntary taxpayer compliance,
the Tax Collection Temporary Measures Law and the Tax Delinquent Spe-
cial Measures Law were enacted, whereby the government gave up all ex-
isting claims to penalties for past tax delinquencies but pledged to deal more
strictly with future delinquencies. In addition, a tax reduction was provided
for voluntary filing of tax returns for personal income tax, corporation tax,
and business activity tax. To assist taxpayers in filing voluntary tax returns,
a tax accountant system was adopted by enacting the Tax Accountant Law.
Additional measures taken during the early phase of the military govern-
 The 1966 Tax Administration Reform 251

ment to improve tax enforcement included the strengthening of the tax with-
holding system, reorganization of regional tax offices, and screening and
retraining of tax officials.
In December 1961 the government overhauled the entire tax system by
making extensive revisions in tax laws. The basic objectives of the tax re-
form set forth by the new military regime were to: (1) simplify the tax struc-
ture to ensure voluntary compliance on the part of taxpayers; (2) improve
the income elasticity of the tax system to meet rapidly rising revenue re-
quirements; (3) redesign the tax system to promote savings and investments
for economic development; (4) bring about a more equitable distribution
of the tax burden; and (5) improve the local tax system to increase the
revenues to local governments from their own tax sources (MOF, ROK,
1979b, 1:340-41). Although the 1961 tax reform was extensive in nature and
coverage, additional revisions and minor changes of tax laws were enacted
almost annually to support the implementation of the First Five-Year De-
velopment Plan (1962-66).

Tax Administration Reform

Despite strenuous efforts by the military government to improve the revenue
productivity of the tax system, the results were disappointing. Various cor-
rections in administrative procedures and in tax laws failed to produce the
expected additional revenues. It was not until the president gave his full
support to drastic administrative reform and to the tax collection effort that
tax revenues began to rise rapidly. The year 1966 marked the beginning
of a new era in tax administration in Korea. The Law Amending the Govern-
ment Organization Law, dated 28 February 1966, provided that “for the pur-
pose of supervising the assessment, exemption, reduction and collection
of national domestic tax, as well as all matters pertaining to the manage-
ment of state-owned property and property vested to the government, the
Office of National Tax Administration is hereby created under the direc-
tion of the Minister of Finance” (Law No. 1750, Article 26, paragraph 10).
Thus, the major function of the Office of National Tax Administration
(ONTA), mandated by the law, was to administer all national tax laws in
connection with the assessment, exemption, reduction, and collection of
taxes and to manage state-owned properties. ONTA consisted of a national
office made up of four bureaus and 11 sections, and a field organization
consisting of five regional offices located in four cities (Seoul, Taejon, Kwang-
ju, and Pusan), each headed by a regional commissioner reporting to the
commissioner and deputy commissioner of the national office. Below the
regional office level there were originally 77 district tax offices throughout
the country, each headed by a district chief reporting to the regional com-
missioner and the commissioner of the national office. The number of dis-
trict offices was later increased substantially; by the end of 1982 there were
six regional and 105 district offices throughout Korea (ONTA, ROK, 1982).
252 Chong Kee Park

The organizational reform of national tax administration split the origi-

nal function of the former Bureau of Taxation in the Ministry of Finance
into the semi-autonomous ONTA and the Tax System Bureau (Figure 10.1).
While ONTA was responsible only for administration of the national tax
laws, the Tax System Bureau in the Ministry of Finance was charged with
the primary responsibility for matters related to taxation policy, tax legisla-
tion, international tax treaties, and tax analysis and research. In addition
to separation of these functions, the reorganization provided for great ex-
pansion of the investigation and inspection activities of the tax administra-
tion agency. Upgrading of the status of the newly created tax administration
agency is shown in Figure 10.1, which compares the organizational struc-
tures of the tax administration before and after the 1966 reform. The top
tax administrator was raised from bureau director rank (Grade II civil ser-
vant) before the reorganization to subcabinet vice minister rank commis-
sioner after the administrative reform. All other positions of tax officials
below the commissioner level were also upgraded.
Recognizing that weak tax administration was a source of public discon-
tent, President Park Chung Hee took a strong personal interest in the im-
provement of tax enforcement, and appointed one of his closest associates
in the 1961 military coup as Commissioner of National Tax Administration.
The president gave him his full-fledged support against mounting political
pressures brought by those who sought relief from higher taxes (Cole and
Lyman 1971). Dubbed the “quiet revolution” by President Park, the develop-
ments of the last nine months of 1966 thrust the tax administration authority
into a position of previously unparalleled prominence. Created during a
period of considerable uncertainty, facing an enormous responsibility and
burden under the forthcoming Second Five-Year Development Plan, and
headed by a relatively unknown individual with no experience in the tax
field, ONTA compiled a remarkable record.
The existence of substantial tax evasion and avoidance was at the time
widely recognized. In the face of rapidly rising domestic revenue require-
ments for the economic development programs, it was imperative that this
revenue requirement be met first by those who were not paying their fair
share of tax imposed by existing law. Unless these people met their tax ob-
ligations, additional burdens would have to be placed on those taxpayers
who paid their taxes honestly, and the inequity in the distribution of tax
burdens would be increased. For these reasons, the commissioner firmly
believed that improved enforcement through reduction of evasion and in-
tensification of collection efforts was the most urgent task facing the new
tax administration authority.
Accordingly, the initial efforts of the new tax agency concentrated on ex-
tensive fraud investigations and internal audits. The new investigation proce-
dure used by ONTA involved a centrally controlled and coordinated
information production, processing, and evaluation system. Information
 BEFORE REORGANIZATION

Minister
of Finance

Vice
. Minister

Taxation
Bureau

Tax Direct Indirect

Collection lax Tax

Regional Office

District Office

AFTER REORGANIZATION

Minister
of Finance

Vice

Regional Tax
Officesb System
Bureau

District Tax International Direct Indirect

Offices¢ Policy Tax Tax Tax

Figure 10.1. Tax administration before and after the reorganization of 1966
a. Headed by a commissioner with vice minister rank.
b. Headed by a regional commissioner with bureau director rank (Grade II civil servant).
c. Headed by an officer with division chief rank (Grade IV civil servant).
254 Chong Kee Park

was then channeled to the appropriate field investigation teams for final
disposition or referred to regional or district offices for disposition after
preliminary investigation. The new procedure was particularly relevant to
business conditions and taxpayer practices then existing in Korea. These
operations also involved close coordination and cooperation with other per-
tinent investigative agencies on an unprecedented scale, which in itself was
a significant development. Implementation of the improved investigative
procedures was impressive, even at the earlier pilot stage.
The number of investigations completed increased sharply from 924 in
1965 to 13,242 in 1966. Additional taxes and penalties collected as a result
of implementing new investigation procedures amounted to 2,209 million
won in 1966, compared with only 303 million won for 1965. The revenue
effect of the improved investigation procedure was manifest in the 1966
figure. The 1966 total amounted to 1,77 million won collected as taxes and
435 million won collected as fines (ONTA, ROK, An Outline of Korean Taxa-
tion, 1967). The fact that a considerable sum of taxes was collected as a result
of fraud investigation suggested that there still existed a great number of
tax evaders. The actions of ONTA clearly demonstrated that all citizens and
business enterprises were subject to taxation.
Abuse by tax officials was one of the widespread grievances against the
government. The Office of Inspector-General was created within ONTA,
under the direct supervision of the commissioner (Figure 10.2), to strengthen
the internal audit function of ONTA. The new units under the inspector-
general were charged with the important tasks of investigating tax officials’
misconduct and examining the operations of all segments of ONTA. The
significance of the new internal auditing function was its independent sta-
tus. Previously, internal investigations were staffed on an ad hoc basis with
personnel recruited from other divisions of the tax agency; now the reor-
ganized unit had its own permanent staff. Thus, more objective appraisals
were possible by the auditing personnel who had no direct ties or allegiance
to the activities being audited. As for the other function—internal security—
an effective program in that area contributed greatly toward minimizing
corruption and improving the public image of the tax administration agency.
During the nine-month period after the inauguration of ONTA on 3
March 1966, a total of 59 district tax offices underwent extensive internal
audits. As a result, a total of 350 million won in penalty taxes was collected.
According to Table 10.3, which breaks down the sum of penalty tax collec-
tion by tax sources, corporate income tax accounted for more than 64 per-
cent of the total penalty taxes collected, followed by personal income tax
with 26 percent. Internal audits were conducted on 68 tax offices in 1965,
compared with 59 offices in 1966. The incidence of tax delinquencies de-
tected through the audits reached 2,887 in 1965 and 1,237 in 1966, but the
sum of penalty tax collected amounted to 18.9 billion won in 1965 and 350.4
billion won in 1966 (ONTA, ROK, An Outline of Korean Taxation, 1967:155).
Thus the revenue impact of the internal audit was enormous.
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256 Chong Kee Park ee
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Table 10.3. Result of internal audits, 3 March-31 December 1966

Amount of
penalty taxes Percentage
Item (10° won) of total

Persona] income tax 89.5 25.6

Corporation income tax 225.6 64.4
Inheritance and gift tax RE) 0.9
Business activity tax 1L7 3.0
Liquor tax 0.7 0.2
Stamp tax 0.3 0.1
Excise taxes 17 0.4
Other 17:5 4.9
Total 350.4 100.0

Source: ONTA, ROK, An Outline of Korean Taxation (1967).

ONTA experimented with another application of a new tax compliance

procedure: the voluntary disclosure program. Two voluntary disclosure pro-
grams of tax evasion were carried out in the last half of 1966. As a new
concept adopted in Korea's tax administration policies, these programs en-
couraged tax violators to confess past evasion in return for immunity from
civil and criminal action. Proclaimed as grace periods preceding intensi-
fied fraud investigation efforts, the programs achieved noteworthy results.
During the first period, which lasted for 45 days between June and July
1966, taxpayers in 771 cases voluntarily disclosed and paid 282 million won
in additional taxes. At the beginning, only one period for making disclosures
was planned. But, petitions from business associations and the Chamber
of Commerce and Industry calling for another chance to disclose past er-
rors led to the scheduling of a second period. During 20 days in Septem-
ber 1966, additional taxpayers in 9,794 cases voluntarily disclosed and paid
1,059 million won in evaded taxes. Voluntary disclosure cases and amounts
of tax collection by major regions are presented in Table 10.4.
One of the most important aspects of the improvement in tax adminis-
tration was the introduction of the “green return” system. Labeled the “green
return” simply because of the color of the form used, this system represented
a transitional measure taken to encourage individuals and firms to file tax
returns on a self-assessment basis rather than under government supervi-
sion. Adoption of a voluntary return filing system was thus the first major
step toward movement away from the traditional method of having tax offi-
cials prepare returns for taxpayers. Under this system, firms that kept satis-
factory accounting records and whose accounting books were open to the
public were allowed to file their tax returns on a self-assessment basis
without interference from tax officials. The pilot operation initially selected
1,57 eligible taxpayers. The number of taxpayers responding totaled 1,359
 The 1966 Tax Administration Reform 257

Table 10.4. Voluntary disclosure program of tax evasion, 1966: Number of

cases and amount of tax collected
Cases Amounts (10° won)
First Second First Second
Region period? period Total period? period> Total
Seoul 204 3,022 3,226 a2 7 Ay, 809
Taejon 36 724 760 11 30 41
Kwangju 284 1,975 2,209 23 85 109
Pusan 247 4,073 4,320 156 227, 382
Total 771 9,794 10,565 282 1,059 1,341
Source: ONTA, ROK, An Outline of Korean Taxation (1967).
a. Refers to 45-day period during June-July 1966.
b. Refers to 20-day period during September 1966.

or about 86 percent of those eligible. There were, however, approximately

2,800 taxpayers actually eligible for this program. To pave the way for ex-
panding the program and bringing all taxpayers under a voluntary system,
the government continued to promote voluntary filing and payment by tax-
payers through various activities, such as conducting seminars and town
meetings, extensive coverage by the mass media, and establishment of tax-
payer information and service centers. To stimulate an awareness among
the public of the importance of paying taxes and to secure the active sup-
port and cooperation of taxpayers, the Ministry of Finance officially desig-
nated March 3 as “National Tax Day,’ to be observed annually.
Tax Law Reform
Subsequent to the large tax law reform of December 1961, there were rela-
tively minor revisions of tax laws between 1962 and 1966 in conjunction
with the implementation of the First Five-Year Development Plan. In the
1962 tax revision, for instance, the number of personal income tax brackets
was increased from three to four and corporation income tax rates were
increased to meet the rising revenue requirements of the government. In
1963-64 the laws relating to corporate income tax, the commodity tax, and
the petroleum tax were revised. The corporation income tax was made
progressive with two income brackets and rates. The commodity tax base
was substantially expanded by adding 24 new taxable commodity items in-
cluding jewels and precious-metal products, and the tax rates on certain
luxury goods were increased. The Petroleum Products Tax Law was also
amended to reduce the gasoline tax rate from 300 percent to 100 percent
while doubling rates on diesel oil and heavy oil. To provide incentives to
invest in certain key industries and to foster foreign exchange earnings by
export, the Law Governing Tax Reduction and Exemption was promulgated
in 1965. This law in effect consolidated into a single piece of legislation all
258 Chong Kee Park

provisions pertaining to tax concessions to businesses that had previously

been included in separate tax laws.
As the government embarked on the Second Five-Year Development Plan
(1967-71), another major tax reform was enacted to provide financial sup-
port to the economic development plan. The tax reform of 29 November
1967 was the most comprehensive reform since that of 1961. Thirteen exist-
ing tax laws were revised and two new tax laws were enacted as an integral
part of the government's effort to promote rapid economic growth and in-
dustrialization. The major objectives of the tax law reform were to: (1) make
the tax structure more conducive to economic development; (2) enlarge the
taxable base of the economy; (3) improve equity in the distribution of the
tax burden; (4) improve the efficiency of tax administration; and (5) protect
the rights and interests of taxpayers (MOF ROK, 1967:31). Specific meas-
ures included in the reform were designed to facilitate the implementation
of other policy measures such as avoidance of undue credit expansion, redis-
tribution of income, active promotion of exports, increased private savings,
and strengthening of financial institutions.
As a first step toward a gradual transition to a “global” personal income
tax system, the 1967 reform introduced a partial globalization of the exist-
ing “schedular” system of personal income tax, under which tax rates varied
among five schedules (sources) of income: wages and salaries, business
income, real estate income, dividends and interest, and other income. If
a taxpayer had an annual income in any one of the five categories of the
schedular income taxes equal to or greater than the specified amounts, then
all of his income was subject to the global tax, provided that total income
from all sources exceeded 5 million won. Specified amounts of a minimum
annual income were 2.4 million won for wages and salaries, 3 million won
for business income, 1.5 million won for real estate income and dividend
and interest income, and 1 million won for other income. As tax relief for
low-income taxpayers, the exemption for wage and salary earners was raised
from 5,957 won to 8,000 won per month. This rise in the exemption amount
was accompanied by a partial tax credit system under which a taxpayer was
allowed to credit against tax liability an amount equivalent to 3 percent of
the difference between 15,000 won and actual monthly income. By means
of this credit system, the effective tax rate was reduced on all wage and
salary incomes lower than 15,000 won per month. Similar provisions were
made for business and real estate income. The statutory rate structure was
also revised by increasing the number of income tax rate brackets from five
to seven for wage and salary income and from five to six for business and
real estate income. Tax rates for each income bracket were adjusted accord-
ingly (Table 10.5).
One of the most important changes in the corporation income tax was
an introduction of discriminatory rates for closely held family corporations;
for which tax rates were from 5 to 10 percentage points higher than for
 The 1966 Tax Administration Reform 259

Table 10.5. Changes in statutory tax rates for personal income, before and
after the 1967 tax law reform

Before the reform After the reform

I. Wage and salary income

Rate Rate
Monthly income level (%) Monthly income level (%)
20,000 won or less vi 15,000 won or less WL
In excess of 20,000 won 1S In excess of 15,000 won 9
In excess of 40,000 won 25 In excess of 20,000 won 16
In excess of 60,000 won 35 In excess of 30,000 won 18
In excess of 80,000 won 40 In excess of 40,000 won 30
In excess of 60,000 won 40
In excess of 80,000 won 50

II. Business and real estate income

Rate Rate
Annual income level (%) Annual income level (%)
200,000 won or less 15 200,000 won or less 15
In excess of 200,000 won 20 In excess of 200,000 won 20
In excess of 500,000 won 30 In excess of 500,000 won 30
In excess of 1,200,000 won 40 In excess of 1,200,000 won 40
In excess of 4,000,000 won 50 In excess of 3,000,000 won 50
In excess of 5,000,000 won 55

Source: MOF, ROK (1967).

“open” corporations. In addition, dividends paid by “open” corporations

were tax exempt, while those paid by “closed” corporations were taxable
at 15 percent. Also, temporary profit tax exemption or reduction provided
under the Corporation Income Tax Law was replaced by the investment
tax credit. In another area of direct taxation, the tax reform of 1967 in-
troduced a new land speculation control tax—a capital gains tax levied at
50 percent on profits from transfers of urban real estate.
One of the most significant measures in the area of commodity taxation
was the increase in the list of items subject to the tax from 46 to 80. Some
of the new items were the result of subdividing previously taxed categories,
but many were items that had been removed from the taxable list in the
1961 tax reform but whose sales had subsequently increased. Another major
feature of the commodity tax reform in 1967 was the introduction of a sys-
tem levying the tax at the retail instead of the manufacturing stage on items
such as jewels, pearls, and precious metals. Tax rates on luxury commodi-
ties and imported items were also increased. To make liquor taxes more
responsive to price changes, they were shifted from a unit basis to an ad
260 Chong Kee Park

valorem rate schedule. Kerosene and bunker-C oil, which had been previ-
ously untaxed, were made subject to rates of 30 percent and 5 percent,
respectively; kerosene used for lighting purposes in rural areas was,
however, exempt from the new tax. Another new tax introduced in the 1967
tax reform was a 10 percent tax imposed on telephones.
In conjunction with the Third Five-Year Development Plan (1972-76),
another major tax law reform took place at the end of 1971 and new tax
laws were put into effect beginning 1 January 1972. The 1971 reform was
designed to accomplish, among other things, the following specific objec-
tives: (1) to reduce the tax burden of low-income persons, (2) to provide
tax inducements to encourage saving by individuals and businesses, (3) to
reduce excessively high marginal income tax rates, and (4) to improve
horizontal equity so that those with equal ability would be taxed equally
(MOE, ROK, 1972:11). In line with these objectives, personal income tax
rates on wages and salaries and business income were reduced and the
basic tax exemption level was increased. Interest income from bank deposits,
which previously had been exempted entirely, became subject to a 5 per-
cent tax. In addition, the minimum income subject to the global income
tax was lowered from 5 million won to 3 million won. Corporation income
tax rates also were adjusted downward and the application of the invest-
ment tax credit system was expanded to cover a wider range of businesses
and industries. All told, ten major tax laws were affected by the 1971 reform.
In response to the oil crisis and consequent economic deterioration at
home, the Presidential Emergency Decree was declared on 14 January 1974,
providing a substantial temporary tax cut for low-income wage and salary
workers. The magnitude of tax reduction was 50 percent for annual incomes
between 600,000 won and 840,000 won and 30 percent for incomes ranging
between 840,000 won and 1,200,000 won. Incomes below 600,000 won were
completely exempted from personal income tax for one year (C. K. Park
1978:74).
Until 1974 Korea's personal income tax system consisted of both schedu-
lar taxes and a global tax. Under the schedular system, exemptions, deduc-
tions, and rate structures varied considerably depending on the type of
income. The system was complex and difficult to administer and produced
haphazard incidence effects. The primary objective of the 1974 reform was
to correct these defects in the personal income tax by replacing the schedular
system with one that was almost completely global. Under the new sys-
tem, virtually all personal incomes (excluding interest and dividend in-
comes), which were previously included in the five different schedules,
are taxed only under the global system. The new system also provided an
additional exemption for bonus income, widened the range of deductions
to reduce the tax burden on families, increased substantially the maximum
levels of deductions, and reduced tax rates over most ranges of taxable in-
come (MOE, ROK, 1975b:9-78). The land speculation control tax, introduced
 The 1966 Tax Administration Reform 261

in 1968, was replaced by the capital gains tax. The other nine tax laws were
also affected by the tax law reform of 1974.
In July 1975 the Defense Tax Law was enacted for the purpose of provid-
ing financial resources required for modernization of the national defense
force. Under this law, most taxpayers became subject to a surtax at rates
ranging from 0.1 percent to 30 percent. Specifically, the defense surtax cov-
ered customs duties, four national internal direct taxes, four national inter-
nal indirect taxes, six local tax items, and commercial advertisement (MOF,
ROK, 1975a:14-18). The tax, adopted as a temporary measure in 1974, was
originally scheduled to expire in 1980, but the expiration was subsequently
postponed twice and is now scheduled for 1990.
In a drastic change of the existing indirect tax structure, the 1976 tax law
reform adopted a new value-added tax system to replace eight of the 11
existing indirect tax items (the business activity tax, commodity tax, textile
products tax, petroleum products tax, electricity and gas tax, transporta-
tion tax, admissions tax, and entertainment and restaurant tax). In addi-
tion to the value-added tax, special consumption taxes were also levied on
luxury consumer goods. The value-added tax law provided for a singie basic
rate of 13 percent, adjustable within a range of 3 percentage points without
legislative approval. Initially, however, a 10 percent rate was applied to
minimize inflationary effects of the tax. Exempted from the tax were un-
processed foodstuffs and basic daily necessities such as tap water, coal bri-
quettes for home heating, and medical services. A zero rate was applied
to exports (MOF, ROK, 1977).

THEORETICAL APPROPRIATENESS
OF THE POLICY MEASURES
Government-sector financing has several objectives. The role of a tax struc-
ture is to accomplish the transfer of resources from the private sector of
the economy to the government in an efficient and equitable manner. Tax-
ation also has other important economic objectives, such as the promotion
of economic growth and adjustments in the distribution of income and
wealth (Musgrave 1959). It may be useful to review briefly the appropriate-
ness of the 1966-67 tax reform measures in the light of these overall ob-
jectives.
Broadly speaking, the goal of economic development is to improve the
general welfare of the people by raising the standard of living. To attain
such improvement the economy has to grow not only in terms of total in-
come but also in terms of per capita income. Tax policy has an important
bearing on the rate of economic growth, by affecting the rate of investment
and other determinants of growth. Over the long term, growth requires
increases in investment, whether in manufacturing plant, in the form of
infrastructure such as highways and electric power, or in human capital for-
mation such as education and health. To finance the desired rate of growth
262 Chong Kee Park

in a noninflationary manner, savings have to be large enough to pay for

the required level of investment. Savings not derived from the private or
foreign sectors must, therefore, be provided by the government sector
through increased domestic revenue, including taxes.
The fundamental premise underlying the 1966-67 tax reform was that
a substantial increase in government domestic revenue was needed to pro-
vide for noninflationary financing of the investment requirements of the
development plan. The attainment of the required level of domestic sav-
ings depended, to a large extent, upon the degree to which the govern-
ment could continue to increase the ratio of tax revenue to GNP and to
restrain the growth in current domestic expenditure. Strengthening the
revenue potential of the tax system was thus the major concern of the tax
reform. The 1967 tax law reform program was formulated so as to provide
for changes estimated to produce a net increase of 6.7 billion won in 1968
national internal tax revenues. Another important source contributing to
the growth in tax revenues was the administrative improvement of tax en-
forcement.
The objective of tax reform is to provide a tax structure compatible with
the financing of a desired rate of economic growth. As the required rate
of growth increases, so must the necessary level of finance. The issue,
however, is not one of total tax revenue only. The way in which a given
amount of total tax revenue is raised influences the private savings rate.
Certain measures, such as taxes on luxury commodities, are more conducive
to household saving than are others, like higher marginal rates under the
personal income tax. That was one important reason that the 1967 tax law
reform sharply increased the reliance on taxation of luxury items by sub-
stantially expanding the base of taxable goods, coupled with increased tax
rates. Increased commodity taxation also increased government saving by
increasing tax revenues. A savings incentive was provided by exemption
of interest income on bank deposits from the personal income tax, even
though the provision is objectionable on equity grounds. Similarly, the
higher rate of taxation on corporate dividends was designed to encourage
the retention of earnings in corporations and to stimulate business saving.
Tax policies affect not only the level but also the pattern of private in-
vestment, and it is important to avoid causing serious distortions as a result
of tax measures. Distortion often results when tax incentive provisions are
implemented without clearly defined objectives. The 1967 tax law reform
was designed to minimize distorting effects by limiting future use of in-
centives to situations where they would be most needed. Provisions deal-
ing with profit tax exemption or reduction under the Corporation Income
Tax Law were replaced by the investment tax credit. The investment tax
credit is usually preferred because it applies only to investment in deprecia-
ble assets, which are the primary source of productivity gains, whereas rate
reduction applies to earnings from all physical capital, including inventory
investment (Musgrave 1967).
 The 1966 Tax Administration Reform 263

Although economic growth is an important objective of tax policy, eq-

uity goals must be considered as well. (For a discussion of equity standards
applied by tax theorists, see Bittker 1980.) It is important to consider how
tax laws contribute to distribution of income and wealth. In particular, policy
should aim at improving the welfare of those segments of the population
that have lagged behind and whose standards of living have remained very
low. Tax reform should contribute to securing more equitable distribution
of income and improved distribution of the tax burden—a distribution that
will reduce the share borne by the low-income groups. Adjustments in the
distribution of income must be subject to the constraint, however, that they
take into account the adverse effects on incentives and economic growth
which might arise from them.
The tax law reform program of 1967 presented the improvement of eq-
uity in the distribution of the tax burden as an important policy objective.
To reduce the tax share borne by low-income taxpayers, the exemption limit
was raised, removing a considerable number of low-wage earners from the
tax roll. In addition, by means of the newly introduced tax credit system,
the effective tax rate was reduced on all salary and wage incomes lower
than 15,000 won per month. These two adjustments in the personal income
tax law resulted in revenue losses of approximately 4.2 billion won in 1968
(MOE, ROK, 1967:42).
Attainment of the target rate of revenue growth depends to an impor-
tant degree on increased effectiveness in administration of the tax system.
The imposition of new taxes, the increases of tax rates, and the broadening
of the base of existing taxes may all be needed to meet rising revenue
requirements. But such measures will have only limited effects on the
government's ability to meet its responsibilities in financing investment re-
quirements unless the capabilities for tax administration are also strength-
ened. Improved administration is, therefore, a vital aspect of tax reform.
Tax evasion and avoidance were widespread in Korea, especially among
the self-employed in commerce and trade and in the professions. The
primary objectives of administrative reform were to reduce tax evasion,
eliminate unnecessary administrative burdens on the taxpayer, and to se-
cure a more equitable and effective application of the law. Unless taxpay-
ers feel that the tax system is reasonably equitable and efficiently enforced,
not much can be done to improve taxpayer cooperation and morale. The
tax administration reform of 1966 was a first step toward achieving these
broad objectives.
EFFECTS OF THE POLICY MEASURES
One of the major characteristics of Korea's tax system has been the per-
verse response of tax yields to changing rates of inflation and growth. Dur-
ing periods of relative price stability, 1958-60 for example, tax enforcement
was tightened and tax revenue yields increased sharply; but in 1963 and
264 Chong Kee Park

1964, when inflation accelerated, the increase in tax revenue slowed con-
siderably. The tax reforms of 1966-67 were designed to improve these struc-
tural deficiencies and to strengthen the revenue potential of the tax system.
The creation of ONTA brought much more forceful tax enforcement in
Korea. The most important administrative improvements introduced by the
new tax agency were the reorganization of tax administration, the growing
emphasis on investigation and audit, and the promotion of voluntary fil-
ing and payment of taxes. The tax law reform enacted late in 1967, effective
for fiscal year 1968, included a number of changes in rates, coverage, ex-
emptions, credits, and so forth that affected the yields of some major taxes
in the system. These, and subsequent structural and administrative modifi-
cations, were reflected in the changes in revenues from 1966 to 1968 as well
as from 1962-64 to 1966-68 (Table 10.6).
The increase in tax revenues, both in absolute amounts and relative to
GNF, reflects the government’s determination to reverse tax trends that
partly contributed to the inflationary pressure of the early 1960s. Follow-
ing the tax reforms of 1966 and 1967, total internal tax revenue rose sharply
from 42.1 billion won in 1965 to more than 70 billion won in 1966 and to
156.4 billion won by 1968. The unprecedented tax revenue goal of 70 billion

Table 10.6. Trends in tax revenue and other measures of tax performance:
1962-72

Percentage Tax Income

Tax increase revenue as elasticity
revenue* in tax percentage of tax
Year (10? won) revenue of GNP revenue
1962 215 20.1 6.2 1.49
1963 24.7 14.9 oe 0.44
1964 292 18.2 4.2 0.49
1965 42.1 44.1 De 2.44
1966 70.0 66.5 6.8 1.68
1967 103.8 48.3 8.2 1.44
1968 156.4 50.6 9.8 1.49
Averages
1962-64 2). 1 Whe ae 0.81
1966-68 110.1 55.1 8.3 1.54
1969 218.1 39.4 10.5 1.14
1970 283.8 30.1 11.0 1.08
ial 355.5 25.3 11.3 1.04
1972 374.3 5.3 9.7 0.32
oe

ae ONTA, ROK, Statistical Yearbook of National Tax (1968, 1974); BOK, National Income

a. Refers to national internal tax revenue.

 The 1966 Tax Administration Reform 265

won for 1966, adopted by the new commissioner of taxation upon taking
office, was exceeded by 11 million won. This amounted to an annual rate
of increase of 66.5 percent in 1966. A hefty increase of more than 66 per-
cent in a single year was the highest growth rate ever recorded in the his-
tory of Korea's tax collection. It was obvious that administrative
improvements, rather than changes in tax laws, were the key factors in this
unprecedented increase in tax revenue in 1966. Minor tax law changes oc-
curred in 1965, but these had little impact on revenue yield. Although both
tax law changes and administrative improvements, without even consider-
ing economic growth, contribute to the increase in tax revenue, it is difficult
to separate the two effects because they usually occur at the same time.
One estimate of ONTA shows, however, that the revenue effect of improve-
ment in tax compliance and investigation of tax evasion alone was about
6.5 billion won in 1966, representing more than 9 percent of the total taxes
collected in that year (ONTA, ROK, An Outline of Korean Taxation, 1967:140).
From 1967 to 1968 total tax revenue rose from 103.8 billion won to 156.4
billion won, an increase of 50.6 percent. However, more than 48 percent
of this increase was in the form of personal and corporation income taxes,
which together grew by 53.9 percent in 1968. Structural changes in the in-
come taxes contained in the 1967 tax law reform are reflected in these
changes in revenues for 1968. The marked increase in revenue from per-
sonal income tax appears to have resulted from growth in the number and
income of taxpayers, better enforcement and compliance, or a combination
of these factors—rather than from changes in tax rates or exemptions. The
increase of more than 8.6 billion won in corporation income tax revenue
in 1968, however, reflected other factors in addition to the structural changes
made in the 1967 tax law reform. With the large increase in corporate net
income in 1968, the increase of 54.1 percent in corporation income tax
revenue reflected primarily the growth in the tax base.
Table 10.6 also shows several indicators of long-term tax revenue perfor-
mance after 1962. The rate of increase in tax revenues rose sharply from
an annual average of 17.7 percent during the confused 1962-64 period to
an average of more than 55 percent during the fiscal push of 1966-68. From
1966 to 1968 tax revenues more than doubled; over the same period GNP,
at current prices, increased barely more than 50 percent. The tax effort meas-
ured by tax/GNP ratios of these two distinct periods rose from 5.2 percent
in the confused period to 8.3 percent in the accelerated tax drive period.
While tax revenues increased in absolute amounts in the years between 1962
and 1964, the growth in tax revenues failed to keep pace with the increase
in GNP. Reversing this deteriorating trend, the ratio of tax revenue to GNP
began to increase rapidly after 1966 when tax collection efforts began to
gain momentum. According to the measures of tax elasticity shown in the
last column of Table 10.6, the elasticity of total tax yields with respect to
GNP averaged 1.54 for the 1966-68 period, as compared with an average
266 Chong Kee Park

of only 0.81 during 1962-64. It should be noted that the income elasticity
of tax revenue was only about 0.4 in both 1963 and 1964.
While total tax revenues continued to rise steadily after 1966, increased
revenues from improved tax administration reached an upper limit and the
high revenue growth rates experienced in the 1966-68 period began to slow
in the early 1970s. Three aggregate measures of tax behavior presented in
Table 10.6 show some signs of decline in the early 1970s. The sharp decline
in growth rate as well as in other measures in 1972 is largely attributable
to major tax reforms of 1971 that reduced the personal income and corpo-
ration income tax rates. Tax revenues from these two sources actually
declined in absolute amounts in 1972, substantially reducing the growth
rate of total internal tax revenue to a mere 5 percent and the overall tax/GNP
ratio down to less than 10 percent. Moreover, the elasticity of total tax yields
with respect to GNP sharply declined to 0.32 in 1972. The tax law reform
of 1971 as well as the slowdown in economic growth during 1971-72 had
an adverse effect on revenue yields.
Most of the decrease in personal income tax revenue that resulted from
the tax law changes was the result of reductions in tax rates and a 50 per-
cent increase in the size of the basic tax exemption. In addition, the Presi-
dent’s Emergency Decree for Economic Stability and Growth on 3 August
1972, which provided additional investment tax credits and other incen-
tive provisions to encourage increased investment in industrial plant and
equipment, resulted in a sharp decline in the absolute amount of corpora-
tion income tax yields in 1973 (I. K. Hong 1974). Corporation income tax
revenue declined from 56.7 billion won in 1971 to 54.8 billion won in 1972
and to 49.8 billion won in 1973. Tax collection efforts were again lax in 1977,
reflecting substantial changes in the tax structure contained in the tax law
reform of 1976. This reform provided for substantial increases in tax exemp-
tions for personal income tax. As a consequence, the annual growth rate
of personal income tax revenue abruptly declined from 60.6 percent in 1976
to 10.5 percent in 1977, while that of total internal tax revenue dropped from
35.4 percent to 22.2 percent over the same period.
That the drive to increase tax collection through tax reforms of 1966-67
was successful is also suggested by the improved fiscal position of the gen-
eral government budget sector. As shown in Table 10.2, central general
government domestic revenue increased rapidly from 7.4 percent of GNP
in 1964 to 12.9 percent and 16.8 percent of GNP, respectively, in 1967 and
1969. From 1962 to 1964 the relative importance of the general government
budget sector including counterpart funds contracted sharply under the
impact of rapid inflation. In 1964, for instance, the total revenues of the
sector were equivalent to only 114 percent of GNP, as compared with 20.8
percent GNP in 1962. From 1964 to 1969, however, total revenues of the
general government budget increased considerably, so that the ratio of these
revenues to GNP rose from 114 percent in 1964 to 17.6 percent in 1969.
 The 1966 Tax Administration Reform 267

Between 1964 and 1969, the composition of general government budget

revenues underwent a significant change, as shown in the bottom half of
Table 10.2. The increasing share of total revenue derived from internal taxes,
customs duties, and profits transferred from the Office of Monopoly after
1966 stands in sharp contrast to the much smaller contributions from these
sources in the early 1960s. In 1962, when counterpart funds still accounted
for nearly 40 percent of total revenues, national taxes and monopoly profits
accounted for 44 percent. But the share of the latter has increased sharply
since 1964, reaching nearly 70 percent in 1967 and more than 78 percent
of total receipts in 1969. Because the relative importance of counterpart funds
as a source of general budget revenue continued to diminish from more
than 39 percent in 1962 to less than 5 percent in 1969, the government budget
sector had to rely to an ever-increasing degree on tax revenues—the tax re-
form of 1966-67 made a significant contribution to this effect. The neces-
sity of meeting a rising share of budget revenues from tax sources has
undoubtedly served as a constraint on expansion of government expendi-
tures from the budget. The rate of increase in tax revenue was much faster
than that in expenditures during the 1964-67 period, and an expanding
surplus generated in the budget helped finance the nation’s development
programs. In 1967 there was a budget surplus equivalent to 1.4 percent of
GNP.
The shift in the budget sector from a deficit to a surplus position after
1964 made a major contribution to the growth in domestic savings, which
facilitated rapid growth. Given the low level of income and the difficulties
involved in bringing about a rapid increase in private savings, the fiscal
sector assumed a major share of the task of meeting the national domestic
savings requirement during the 1966-68 period.
Domestic savings continued to be dominated by the private sector until
about the mid-1960s, but the government sector moved from negative sav-
ing to positive saving in 1964. The effect of the 1966-67 tax reform meas-
ures is amply demonstrated by sharp increases in the level of government
saving through 1970. Table 10.7 shows that government saving increased
steadily from dissaving (negative saving) of 1.8 billion won in 1963 to more
than 100 billion won in 1968 and to 175 billion won in 1970. As a percentage
of GNP, government-sector saving rose from a negative rate of minus 0.4
in 1963 to a positive rate of 6.5 in 1970, raising the total domestic savings
rate from 8.7 percent to 17.3 percent. This was accompanied by rapid in-
creases in tax revenues and a growth in the overall tax/GNP ratio from 8.6
percent in 1963 to 14.8 percent in 1970. This progress was possible only by
substantially increasing the government's ability to collect more tax revenues
and by restraining the growth of government consumption.
From 1963 to 1970 government saving increased by 176.9 billion won, ac-
counting for 42 percent of the increase in domestic savings. As a result,
the government saving share in domestic savings rose from less than 6 per-
268
Ea
a
Chong Kee Park SS

Table 10.7, Government saving as a percentage of GNP: 1963-72 (10? cur-

rent won)
Government
saving as
; “ < percentage
Government saving Domestic saving Bi tiomecnc
Year Amount Rate (%) Amount Rate (%) saving
1963 -1.84 -0.4 43.72 8.7 -4.6
1964 3.33 0.5 62.64 8.7 Sai
1965 13279 IY SEE) 7.4 23.0
1966 28.55 2.8 122.83 11.8 Zool,
1967 2855 4.1 145.76 11.4 36.0
1968 100.87 6.1 249.33 1521 40.4
1969 127.45 oie) 405.92 18.8 31.4
1970 175.06 6.5 465.21 5Wee| 37.6
1971 178.30 5.4 506.17 15.4 Sout
1972 143.65 3.6 633.10 157, 22.9

Source: EPB, ROK, Major Statistics (1983).

cent in 1964 to more than 40 percent in 1968 but then slightly declined to
37.6 percent in 1970.
That the increase in tax revenues was accompanied by increased sav-
ings in the government sector is quite clear. But what is not clear is the
effect of increased government revenues and savings on total domestic sav-
ings. It is probable that certain taxes work to reduce private saving by more
than the amount that government saves out of the additional revenues. We
may speculate that heavy reliance on tax revenues to raise government sav-
ing might have had some adverse effects on the growth of private saving,
but it is difficult to verify this with existing data. As one observer put it,
“as for the effects of taxation on private saving, on the one hand private
saving as a percent of income probably would have risen more rapidly if
the growth of government revenues (about 30 percent per year in constant
prices) had been less. On the other hand, income probably would not have
grown as rapidly as it did if it were not for the increase of efforts to expand
government revenue and saving” (Brown 1973:192). Out of all this, one may
draw the general conclusion that increased tax revenues and government
saving made a significant contribution to moving the Korean economy to
a high-growth path during the second half of the 1960s (Mason et al. 1980;
Johnson 1972).

CRITICISMS AND LESSONS

OF THE KOREAN EXPERIENCE
The rapid expansion of government functions and activities in Korea after
1961 resulted in renewed emphasis on the role of taxation in the promo-
 The 1966 Tax Administration Reform 269

tion of economic growth and welfare. As the economic and social struc-
tures of the nation became more complex and interdependent, the concept
of the role of taxation also changed. Taxation is no longer considered merely
as a device to finance government activities but has been increasingly recog-
nized as an important tool for achieving economic objectives and for bring-
ing about a more equitable distribution of income and wealth.
What can other developing countries learn about taxation and its effects
from the Korean experience? Tax policy played only a minor role in the de-
velopment process of Korea until the early 1960s. Compliance problems
were severe, tax collection was lax, and a continuing rapid rate of inflation
limited what could be accomplished through structural reform. It was not
until the government began to make more conscious and systematic efforts
to correct serious deficiencies in the whole tax system that there were dra-
matic increases in tax collections and in the efficiency of tax administra-
tion. A major breakthrough in the tax effort came in 1966-67, when the
national tax ratio increased from 7.2 percent of GNP in 1965 to 13.2 percent
in 1968. The substantial improvement in tax administration was probably
the most important single factor in this breakthrough. Korea was well aware
that efficient administration was a crucial aspect of tax policy, and no sys-
tem could be better than its actual implementation.
It would be less than candid, however, to leave the impression that tax
reform and administrative improvement in Korea faced no problems. There
were some major difficulties. Resistance from vested interest groups, both
public and private, and inertia constituted major barriers. A serious short-
age of trained managers and technicians, rigid government employment
practices, an unpredictable political climate, and commercial intrigues were
some of the other problems.
There was a growing feeling that increased tax revenues through im-
proved administration would soon reach an upper limit and, therefore, that
growth in revenues should be more directly related to growth in the tax
base and changes in the tax structure. Another view also prevailed—that
rapid increases in the ratio of total tax revenues to GNP were constrained
by widespread inequities inherent in the tax structure, and that these in-
equities had become less tolerable as improvements in tax administration
pushed assessments to higher levels to meet revenue requirements. Thus,
the 1967 tax law reform concentrated on structural improvements of the tax
system. There have been numerous tax law changes since 1961, but the 1967
revision can be considered one of the few comprehensive tax law reforms
that occurred during these years. The reform broadened the tax base, raised
tax rates, and introduced a number of equity and incentive features into
the tax system.
The Korean experience provides evidence for the general expectation that
the tax structure changes in the course of economic development. During
the course of economic development since 1961, the composition of the tax
270 Chong Kee Park

structure in Korea gradually shifted from commodity-oriented indirect tax-

ation to income-based direct taxes and back again to indirect taxation. One
of the most important lessons that can be learned from the Korean ex-
perience is that, contrary to what has often been widely observed, the in-
come tax has an important role to play even on a limited scale in the revenue
system of developing countries. Income taxation was found to be an im-
portant source of government revenue in Korea, where revenue yields from
both personal and corporation income taxes represented 34 percent of to-
tal tax revenue of the central government in 1968, compared with only 15-25
percent in the early 1960s. Despite such inhibitions as the lack of tradition
in income tax compliance and enforcement, Korea has made significant
progress in developing a system of taxing incomes. Korea's experience clearly
shows that income tax is a potentially productive source of tax revenue in
the context of rapidly rising revenue requirements of developing countries.
Did Korea pursue appropriate tax goals? Tax reform cannot be adapted
to any single goal, such as adequate revenue, economic growth, stability,
or equity. Since there are trade-offs among these conflicting objectives, all
must be taken into account. The primary concern underlying most of the
major tax reforms occurring in Korea during 1960-80 was, however, the
stimulation of economic growth. An improved tax treatment of business
and investment was common to these reforms. Though the equity objec-
tive was mentioned, the major focus of the 1967 reform was “to make the
tax structure more conducive to economic growth.” One of the greatest defi-
ciencies in Korea’s tax system results from the wide range of tax incentives
and special tax privileges provided to business, which led to a built-in ero-
sion of the tax base. It is generally agreed that these provisions have been
costly, inequitable, and ineffective in achieving their intended objectives.
In 1979 the cost of lost revenue was as high as 40 percent of the total corpo-
ration income tax that would have been collected in the absence of the tax
incentive system. Even more significantly, this relief has been used mainly
by the largest corporations (Tait, Faria, and Heller 1979). It is, therefore, im-
portant to reassess carefully whether tax incentives are essential to stimu-
late new investment and thus justify the distortions in resource allocation
and the huge revenue loss.
In Korea, where heavy reliance is placed on fiscal incentives to spur eco-
nomic growth in the private sector, some regressiveness of the tax system
is unavoidable. In past tax law reforms only minor emphasis has been placed
on the equity aspect of taxation. Although the improvement of equity in
the distribution of the tax burden was cited as one of the stated objectives
of the 1967 reform, tax policy per se did not have an important equalizing
effect on the distribution of income. Some changes in the personal income
tax have been enacted to increase tax exemptions for low-income groups
and to improve its progressivity in the rate structure. The 1967 reform, for
example, provided for an increased tax exemption limit and also introduced
 The 1966 Tax Administration Reform 271

the partial tax credit system to provide some progression in the lower in-
come ranges. Another example of a tax relief measure was the Presidential
Emergency Decree of 14 January 1974, which provided a substantial tem-
porary tax cut for the low-income wage and salary earners. But major areas
of the personal income tax reform in the past have had to do with adjust-
ing the incentive effects inherent in the direct tax system. Some of the fis-
cal incidence studies on Korea indicate that tax impacts on income
distribution have not been substantial in Korea (Bahl, Kim, and Park 1986).
Others also pointed out that the redistribution of income and wealth was
not a major concern of government economic policy (Cole and Lyman 1971).
The tax law reform of 1967 introduced a partial globalization of the
schedular system of personal income tax, and another comprehensive tax
reform of 1974 made the personal income tax almost completely a global
tax system. In spite of this modernization reform, personal income tax in
Korea plays a far less important role than it should. The share of personal
income tax in total tax revenue has been declining steadily since the early
1970s. While the principle of the global income tax system has been ac-
cepted, the present form of this tax is unsatisfactory. There are several pro-
visions that limit the usefulness of this tax as a means of bringing about
more equitable treatment of taxpayers with incomes from different sources.
This limited role reflects the fact that a large proportion of personal income,
such as dividend and interest income, is only partially taxed. From the
standpoint of equity and of raising more revenue for the government, all
dividend and interest income must be fully included in the global income
tax base.
In another area of direct tax, more vigorous efforts should be made to
increase tax revenue from land, financial assets, inheritance, and gifts. Just
as income and consumption expenditures are considered an important crite-
rion for taxation under the current income and value-added taxes, wealth
should also be treated as an important criterion for taxation under an equita-
ble tax system. Taxation of wealth should form an important element of
the overall tax structure of the nation. Improved methods for more vigorous
enforcement of inheritance and gift taxes would certainly increase the share
of wealth taxes in total tax revenue. Revenues from inheritance and gift taxes
currently account for much less than 1 percent of total central government
tax revenue. But the tax effort in this area should improve considerably in
the future, so that the inheritance and gift tax yield may eventually account
for 2-3 percent of total tax revenue.
The value-added tax has been contributing significantly to the increased
tax revenue since its introduction in 1977. As a result, indirect taxes (in-
cluding value-added tax) now account for more than 65 percent of total in-
ternal tax revenues. The tax structure needs to be improved to prevent the
regressive nature of the value-added tax from having severe adverse effects
on the distribution of income and of the tax burden. Special attention needs
272 Chong Kee Park

to be focused on the likely impact of the tax on the expenditure patterns

of different household groups, particularly the burden on low-income wage
earners.
 11 Introduction of the Value-Added
Tax (1977)
by Kwang Choi

In December 1976 the Korean government passed legislation to bring a value-

added tax (VAT) into effect from 1 July 1977. The introduction of VAT in
Korea—as a substitute for a complicated system of indirect taxes—was part
of a large-scale tax reform in 1976, in which 18 taxes were created or
amended. VAT, together with a newly enacted special consumption tax,
replaced eight categories of indirect taxes: the business tax, commodity tax,
textile tax, petroleum products tax, admissions tax, travel tax, gas and elec-
tricity tax, and entertainment and food tax.
Each of the previous indirect taxes replaced by VAT had its own rate struc-
ture as well as a different tax base and administrative procedure. The con-
solidation and incorporation of numerous indirect taxes into VAT was
expected to simplify the rate structure, tax base, and administration of the
indirect tax system, thereby eliminating the overlapping auditing practices
that had plagued the previous system. VAT is also an important instrument
against tax evasion by means of the reciprocal controls exercised by taxpay-
ers themselves.
The concurrent introduction of the special consumption tax along with
VAT was designed to inject some progressivity into the indirect tax system
through increased taxes on goods and services consumed disproportion-
ately by high-income groups.
VAT was also expected to promote exports and capital formation. Under
VAT, exports are zero rated at the final stage of production and rebates are
available on taxes paid at earlier stages of production. With the previous
system the cumulative taxes at earlier stages of transactions in export goods
were either not rebatable or only partly refundable. Therefore, it was be-
lieved that the introduction of VAT would have a favorable effect on exports,
which have been the driving force behind the rapid growth of the Korean
economy. Because the previous indirect tax system did not provide credit
for the taxes paid on investment goods, and because taxes were not to be
imposed on capital investment under the new regime of consumption-type
VAT, VAT was expected to encourage capital formation.
The introduction of VAT was strongly recommended because the previ-
ous cascade turnover tax system was believed to have several disadvantages
resulting in resource misallocation and inefficiency. First, the turnover tax
encouraged vertical integration because the reduction of interfirm sales

273
274 Kwang Choi

reduced total tax liabilities. Second, it penalized specialization for the same
reason. Third, estimates of the tax content of a price at any particular stage
of production were perforce arbitrary, which in turn made indirect tax ad-
justment at country borders arbitrary. All in all, the adoption of VAT was
regarded as a reform of an unwieldy and distortionary indirect tax system.
Although the government emphasized that VAT was designed not to in-
crease tax revenue but to remove the negative effects of the previous gross
turnover taxes, it must be stated that the government expected VAT to yield
the substantial revenue necessary to meet the fiscal demands required for
the successful implementation of the Fourth Five-Year Economic Develop-
ment Plan. The influence of budgetary needs was, if not the only cause,
at least an important reason for the decision to establish VAT in Korea.
VAT is superior to a business tax or a sales tax from the viewpoint of
revenue security for two reasons. First, under VAT, only buyers at the final
stage have an interest in undervaluing their purchases because the deduc-
tion system ensures that buyers at earlier stages will be refunded the taxes
on their purchases. Therefore, tax losses due to undervaluation should be
limited to the value added at the last stage. Under a retail sales tax, however,
both retailer and consumer have a mutual interest in underdeclaring the
actual purchase price.
Second, under VAT, if payment of tax is successfully avoided at one stage,
nothing will be lost if it is picked up at a later stage. Even if the tax is not
picked up subsequently, the government will at least have collected VAT
paid at stages previous to that at which the tax was avoided. If evasion takes
place at the final stage, the state will lose only the tax on the value added
at that point. If evasion takes place under a sales tax, however, all the taxes
due on the product are lost to the government.
There is a big difference between the theoretical advantages of a hypothet-
ical tax and the actual advantages of a particular form of tax. However sim-
ple VAT may be in theory, the Korean experience with VAT makes it clear
that it is not simple in practice. It creates a host of problems that give rise
to voluminous paperwork, more or less arbitrary distortions in trade and
consumption, and inequities in the tax burden. This chapter examines the
Korean VAT and draws lessons from its effects since its introduction in 1977.
MAIN FEATURES OF THE KOREAN VAT
The structure and administration of VAT in Korea are basically similar to
those of the countries in the European Economic Community (EEC). It is
a consumption-type VAT, the variety in use throughout Europe. Under
Korean VAT businesses are permitted to deduct immediately from sales not
only current inputs but also the full value of capital goods accrued during
the taxable period.
VAT is collected by the invoice method—each firm must collect VAT on
the value of its sales (unless they are exempt) but is entitled to a credit for
 Introduction of the Value-Added Tax (1977) 275

taxes invoiced by its suppliers. As credit is allowed only if supported by

invoices provided by suppliers, this method of administration is expected
to facilitate audits because each firm is required to supply evidence on taxes
that should have been paid by its suppliers.
Scope and Tax Base of VAT
The scope of VAT is usually defined with reference to both taxable transac-
tions and taxable persons. The Korean VAT code defines taxable transac-
tions as the supply of goods or services and importation of goods. Supply
of goods is the delivery or transfer of goods by contractual or legal action,
including the sale of goods on an installment basis and the personal use
of business assets, as well as inventory goods when a business closes. Sup-
ply of services includes the rendering of services or having a person use
or utilize goods, facilities, or rights on any legal or contractual basis. Im-
portation of goods is simply the entry of goods into Korea from abroad.
A taxable person is anyone who independently engages in the supply
of goods or services. Taxpayers include individuals, corporations, any or-
ganization of persons, foundations, and state and local authorities, regard-
less of whether the taxable transactions generate profits. The requirement
that a taxable person act in an independent capacity excludes employees
from an obligation to charge VAT on services provided to their employers.
The taxable amount or tax base is the full amount received for the sup-
ply of goods or services. It includes taxes (other than VAT and the defense
surtax), duties, and incidental expenses such as packing, transportation,
and insurance costs charged to the purchases. For sales on installment or
credit, the tax base is the total price of goods supplied. The taxable amount
does not include discounts or rebates and the value of goods returned or
broken, lost, or damaged before they are delivered to their purchaser.
Tax Rates
Before the introduction of VAT, Korea suffered from a complicated rate struc-
ture of indirect taxes. The business tax, which was a major target of the
tax reform, had five differentiated rates ranging from 0.5 percent to 3.5 per-
cent of turnover, depending on the category of business. The previous in-
direct tax system had more than 50 rates ranging from 0.5 percent to 300
percent (Table 11.1). The complicated structure of the indirect tax system
had created a strong desire to simplify and consequently to adopt a single
VAT rate.
Although Korea has a single-rate VAT system, like those of Denmark and
Sweden, the VAT code has allowed the government to adjust the normal
rate (13 percent) by as much as 3 points when deemed necessary to im-
prove the general state of the economy or to adjust tax revenue. Since its
inception the VAT has been implemented at the minimum level of 10 per-
cent. In 1988 the National Assembly passed legislation fixing the VAT rate
276
EE
Kwang Choi Ee

Table 11.1. Pre-VAT and VAT tax rates: 1977

Pre-VAT regime VAT regime

Tax rates Tax rates

Num- Mini- Maxi- Num- Mini- Maxi-

Item ber mum mum Item ber mum mum

Business tax 5 0.5 3.5 VAT?:

Commodity tax 17 2.0 100.0 General
Textile tax 7 10.0 40.0 taxpayers 1 10.0 10.0
Special
peocleun taxpayers 2 2.0 ee)
%
products tax 4 10.0 300.0
250.0 Spec
pe ialer con-
Admissions tax 12 5.0
sumption tax 13 10.0 180.0
Travel tax 3 5.0 20.0
Gas and
electricity tax Leet) Sie Lo
Entertainment
and food tax 4 2.0 20.0

Source: MOF, ROK (1980).

a. Rates effective at the time of VAT introduction.
b. Special taxpayers are taxed at 2 percent or 3.5 percent of their turnover, whereas general
taxpayers are taxed at a 10 percent rate.
c. The minimum and maximum rates of the special consumption tax as of 1 January 1988
are 5 percent and 100 percent, respectively.

at 10 percent, removing the discretionary power of the government to ad-

just the tax rate by plus or minus 3 percent.
There are also exceptions to the single 10 percent rate. Businesses whose
sales are less than 36 million won a year (24 million won a year prior to
July 1988) are taxed at a rate of 2 percent of turnover. Furthermore, individu-
als engaged in brokerage and intermediary services are subject to a 3.5 per-
cent tax on their turnover unless it exceeds 6 million won.
The Korean VAT system cannot be directly compared to the VAT systems
of other countries. Most European countries have multiple-rate VAT struc-
tures that apply higher rates to luxuries and lower rates to necessities. But
we must look at the indirect tax system as a whole to make a valid compar-
ison of one country with another. For example, although Korea does not
have a multiple-rate VAT system, many items are subject to other taxes (such
as the special consumption tax, liquor tax, defense tax, and education tax)
in addition to VAT, which produces the same effect as a multiple-rate sys-
tem (Table 11.2).

Zero Rating and Exemption

Korean VAT provides two types of tax exemption: “zero rating” and “ex-
emption.” “Zero rated” supplies are technically taxable but at a zero rate.
 Introduction of the Value-Added Tax (1977) 277

Table 11.2. Taxes applied to selected goods as a percentage of the producer's

price: 1988

Special
con-
sump-
Pro- tion tax De- Educa- Deliv- Con-
ducer or liquor fense tion ery sumer
Item price tax tax VAT tax price _ price
Subject to special
consumption tax
TV (black and
white 14’’) 100.0 5.0 £5 10.6 117.1 140.4
TV (color 20’’) 100.0 28.0 8.4 13.6 1500917522
Refrigerator
(below 250 1) 100.0 28.0 8.4 13.6 10 LOL
Washing machine
(w.p. 350B) 100.0 40.0 12.0 1522 1672p 192.2
Piano 100.0 20.0 6.0 12.6 138.6 162.6
Passenger car
(below 2,000 cc) 100.0 15.0 4.5 12.0 1315 eto.
Coke (355 ml) 100.0 20.0 6.0 12.6 138.6 170.4
Sugar (15 kg) 100.0 30.0 9.0 13.9 152.05 6168:9
Coffee (2 kg) 100.0 40.0 12.0 15.2 167529219536

Subject to liquor tax

Unfiltered liquor
(takju) 100.0 10.0 11.0 121.0 u
Beer 100.0 150.0 45.0 31.0 190.063 241.0 u
Distilled spirits
(soju) 100.0 35.0 3.5 13.8 152.3 u
Whisky 100.0 200.0 60.0 38.0 20-0053 18.0 u
Wine 100.0 40.0 4.0 14.8 4.0 162.8 u
Vodka 100.0 40.0 4.0 14.8 4.0 162.8 u
Source: MOF, ROK (1983a).
u—unavailable.

The implication is that VAT charged on inputs relating to them can be

reclaimed just as were inputs relating to taxable supplies. “Exempt” sup-
plies are outside the scope of VAT altogether so there is no question of
reclaiming the relevant input tax.
The zero rate applies to exports from Korea, services rendered outside
of Korea, international transportation by ship and aircraft, and other goods
or services supplied to earn foreign exchange. Zero rating is applied only
to traders who are residents or to domestic corporations; however, for
278 Kwang Choi

international shipping and aerial navigation, nonresident traders and for-

eign corporations are subject to zero rating on a reciprocity basis.
For exempted goods or services, tax is charged on purchases from the
exempt supplier but not on the value added by the exempt organization.
If the exempt firm sells to households and has positive value added, ex-
emption reduces net liabilities. If the exempt firm sells to other firms, its
exemption increases their tax burdens, because businesses that purchase
exempt inputs have no credits to apply against their own tax liability.
Korean VAT allows a variety of exemptions for social, political, and ad-
ministrative reasons. Exemptions are applied to basic necessities such as
unprocessed foodstuffs and piped water; to certain classes of commodities
that would be hard to tax, such as banking and insurance services and
owner-occupied housing; and to certain commodities classified as social
and cultural goods, such as medical and health services, education, books,
newspapers, and artistic works. Goods and services supplied by public en-
terprises, independent professional services, and duty-exempt goods are
exempt from VAT. Monopoly goods, telephone services, postage stamps,
and so forth are exempt from VAT because supplementary separate taxes
are imposed. Finally, to reduce administrative and compliance problems,
small taxpayers whose annual tax liability is less than 20,000 won (10,000
won prior to December 1988) are exempt from VAT.
Administrative Aspects
Registration with the VAT authorities is the initial step in the administra-
tive process. A trader must register at the VAT office in the district in which
he resides within 20 days after he commences taxable activities. A record
of all registered taxpayers is maintained on a computer file that includes:
the VAT registration number, taxpayer’s name and residence number, and
firm’s name and address, telephone number, business code, trade, classifi-
cation, date of registration, and date of commencement of business.
The Korean VAT law requires an enterprise to register separately at each
place it conducts business and to furnish a separate return for each loca-
tion. This is an unfortunate carryover from earlier business tax laws and
deters efficient business administration without increasing the tax yield.
When a registered trader supplies goods or services, he must issue an
invoice to the buyer showing the date of supply; the seller's name, address,
and VAT registration number; the customer's name and registration num-
ber; the value and identity of the goods or services supplied; and the
amount of VAT. There are two types of tax invoices. General tax invoices
are presented by the taxpayers to the district office and numbered serially.
Special taxpayers use simplified tax invoices and are not required to sub-
mit any invoices to tax authorities.
Each invoice must be prepared in quadruplicate. One is kept by the seller,
 Introduction of the Value-Added Tax (1977) 279

another is sent by the seller to the district tax office, and the third copy
is kept by the purchaser, who sends the fourth copy to his district tax office.
The two copies received at tax offices are forwarded to the computer data
processing unit, which carries out a cross-check of sales against purchases.
In the latter half of 1977, 7.2 percent of all invoices (buyer and seller) failed
to match; in 1982 the proportion of mismatches decreased to 1.4 percent.
Interestingly, output invoices caused fewer difficulties than input invoices.
The mismatching ratio for output invoices for each year was about half of
that for input invoices. This result is consistent with our expectations since
VAT tax liability can be minimized by maximizing input claims. The per-
centage of mismatched input invoices fell from 12.1 percent in 1977 to 2.4
percent in 1982. Erroneous data, which mean that sales and purchases of
invoices match but the details of the invoices do not, decreased from 5.9
percent in 1977 to 0.3 percent in 1982 (MOF, ROK, 1983a).
Initially, all tax invoices in which the value of a transaction exceeded
100,000 won were computerized for auditing, but as of July 1980 computer
processing was restricted to tax invoices with a value of 300,000 won or more.
As a result, the number of invoices processed by computer dropped from
112 million in 1978 to 33 million in 1982 (MOE, ROK, 1983a).
There are two steps in the tax payment and return procedure. First, tax-
Payers are required to furnish the tax authorities with preliminary returns
stating their tax base and the tax amount payable or refundable within 25
days (50 days for foreign corporations) from the date of termination of each
preliminary return period. The first tax period is from January through June
and the second is from July through December. Second, taxpayers must
file with the tax authorities the tax base and tax amount payable or refund-
able for each taxable period within 25 days (50 days for foreign corpora-
tions) after its expiration. Taxpayers are required to submit tax invoices at
the time of the preliminary or final return concerned. This quarterly pay-
ment of VAT has proved easier to work with than the more frequent two-
month tax period used under the old business tax system.
Traders who are engaged in retail businesses or who operate ordinary
restaurants and hotels must install a cash register (with tape for audit pur-
poses) and issue tax invoices showing the value of supply. By such compli-
ance traders are deemed to have fulfilled their obligations of bookkeeping
and receive a tax deduction equivalent to 0.5 percent of total sales.
Penalties are imposed for failure to register or apply for inspection, for
nonissuance of tax invoices, and for default on tax returns and payments.
Penalties equivalent to 1 percent and 2 percent of total sales for individuals
and corporations, respectively, apply for the biannual inspection. For failure
to issue a tax invoice in transactions between taxable persons or failure to
keep proper records, the penalty is 1 percent of the sales amount for in-
dividuals and 2 percent for corporations. Where a trader fails to file a return,
280 Kwang Choi

or does not pay the tax amount due, or files a tax return under-reporting
his obligations, he is liable to a penalty equivalent to 10 percent of his tax
liability (ROK 1976). Penalties have been imposed mostly on general tax-
payers for failing to issue tax invoices, for delaying the submission of in-
voices to government, or for submitting incorrect returns (MOF, ROK,
1983a).
Transitional measures were necessary to eliminate certain problems of
double taxation that otherwise would have arisen when VAT was introduced
in Korea. Taxpayers were allowed to take credits for previous taxes that had
already been paid on inventories on the date of the changeover. Since the
taxes replaced were of a multistage turnover variety, a difficult problem arose
in determining the effective tax rate on the many types of goods in inven-
tories, so the government imposed the average rate on each inventory item.

Treatment of Small Businesses

Under any form of sales taxation, small businesses have to be granted spe-
cial treatment because of their inability to cope with the requirements of
keeping adequate records that larger enterprises can handle at a reason-
able cost. The purpose of the special treatment is to reduce the administra-
tive burden on small enterprises but not the taxes that normally would be
charged on the goods and services they supply.
Small businesses, called “special taxpayers” under Korean VAT, are those
whose total sales are less than 36 million won a year. For businesses en-
gaging in transactions through a proxy, agent, intermediary, cosignee, or
contractor, any trader whose annual sales are less than 6 million won is
treated as a special taxpayer. Unlike general taxpayers whose tax base is
value added, a standard 2 percent tax rate is used to calculate the amount
of tax due to the government. Small businesses engaged in transactions
through a proxy, agent, intermediary, cosignee, or contractor are taxed at
a rate of 3.5 percent on their annual sales.
When a business eligible for special taxation has submitted tax invoices
to the government, an amount equivalent to 5 percent of the input tax
amount is deducted from the tax amount payable. Special taxpayers issue
simplified tax invoices and file their tax returns every six months, whereas
general taxpayers issue standard tax invoices and file returns and pay taxes
every three months. Special taxpayers do not have to file a preliminary tax
return but do have to pay half of their taxes to the government during the
immediately preceding tax period.
In Korea special taxpayers file about 76-78 percent of all VAT tax returns
(MOE, ROK, 1983a). Although general taxpayers are in the minority, they
are the more important source of revenue. General taxpayers pay approxi-
mately 94-95 percent of the total VAT, whereas the tax amount contributed
by special taxpayers comprises only about 5-6 percent of VAT collected
(MOE, ROK, 1983a).
 Introduction of the Value-Added Tax (1977) 281

IMPLEMENTATION PROCESS
Careful examination and long preparation preceded the introduction of VAT
in Korea. Much of the interest in the introduction of VAT was undoubtedly
stimulated by the widespread acceptance of VAT in Europe. Although the
decision to introduce VAT was made in 1971, the law was not enacted until
22 December 1976, and took effect on 1 July 1977. It is not clear, however,
whether the two years or so immediately prior to the adoption of VAT were
sufficient to prepare for its implementation.
Extensive studies of the VAT system were conducted before the govern-
ment’s formal VAT announcement on 19 January 1976. To benefit from the
experience of European countries, the government sent a small delegation
to talk to officials who were administering the tax in the EEC countries where
it had already been enacted. The Korean VAT also embodies proposals pre-
pared by such well-known authorities as James D. Duignan, Carl S. Shoup,
and Alan A. Tait, all of whom contributed to the development of the new
tax law.
The Korean government allowed less than one year for disseminating
information and conducting educational programs to explain the new law
to taxpayers and the general public before the tax became effective.
To secure the cooperation of the business community, the government
set up a special Deliberation Committee for the Implementation of VAT,
composed of government officials and representatives of the Chamber of
Commerce, the Korean Federation of Industries, the Korean Traders’ As-
sociation, the Korea Tax Accountants Association, the Korea Institute of Cer-
tified Public Accountants, and the Customs Brokers Association.
Nationwide tryout exercises of filing tax returns were carried out on three
separate occasions (in March, May, and July 1977) before the changeover
to VAT. On average, more than 98 percent of the taxpayers in the groups
concerned participated in these trial runs. Important steps taken before the
introduction of VAT included the introduction of new invoices for business
tax withholdings at the beginning of 1975. This was a good transition process
to the invoicing system needed for VAT. The withholding system under the
business tax was successfully adapted to the transitional needs of the ad-
ministrative structure needed for VAT.
Concurrent with the consultation and information program, the Korean
government expanded and retrained its tax administration staff. This task
was facilitated by a substantial reservoir of trained personnel experienced
in administering the complicated business tax and other indirect taxes. The
government provided additional training for 32,444 public officials under
the auspices of the Ministry of Finance, the Office of National Tax Adminis-
tration (ONTA), and the Office of Customs. The ONTA staff increased by
1,999 from 9,443 in 1976 to 11,442 in 1977. Most of this increased recruit-
ment was a result of VAT. However, the new recruits did not go directly
into VAT work but were assigned to other sections to release more
282 Kwang Seislivish
macminesheds Choi oD etl ot bee wba hse a wen Se
experienced officers for VAT. Because VAT replaced another kind of con-
sumption tax, there were no structural changes in the organization of tax
administration.
To introduce the new tax to officials who would be dealing with VAT,
the government prepared a staff handbook explaining the tax procedures
in detail. Answers were provided in advance to questions that were likely
to be asked either by the staff themselves or by the taxpayers. Despite the
government's efforts, insufficient communication with taxpayer organiza-
tions and consumer groups damaged the prospects for close cooperation.
Passive and active opposition to the introduction of VAT came from many
sources. Each interest group had its own reasons for opposing the new tax
and each had different reasons. VAT was opposed by labor as regressive.
Business in general, particularly small business, opposed the tax compli-
ance costs as being too high. At the Economic Ministers’ Meeting, however,
in which every major economic policy measure is deliberated, only the
minister of commerce and industry opposed the adoption of VAT. He
pointed out the likelihood of a substantial increase in the prices of indus-
trial products. Furthermore, the Democratic Republican Party, the ruling
party at the time, was not in favor of introducing VAT because the party
feared it would weaken support in the upcoming general election. Unhap-
piness with VAT on the part of the business community was demonstrated
by its call to postpone the implementation of VAT immediately before VAT
became effective. Some tax administrators also did not support the tax,
pointing out the administrative problems of collecting the tax from retail-
ers and the higher cost of collecting VAT than of collecting the taxes it would
replace.
The designers of the tax did their work well. Although VAT has gone
through a number of changes since its introduction, these have been minor.
By 1 January 1984, the VAT law had been amended three times, the VAT
presidential decree 15 times, and the VAT ministerial ordinance 12 times,
but the basic structure of the tax remained unaltered. The difficulty en-
countered has been within the bounds of what can be expected on the oc-
casion of any major tax reform.

EFFECTS OF VAT
Since its introduction, VAT has become a major source of revenue in Korea,
fulfilling the chief, if tacit, goal of the government. In 1982 VAT yielded 2,094
billion won, or 22 percent of the total tax revenue of the Korean govern-
ment, national and local, making it by far the single largest tax in Korea
(Table 11.3). VAT represents more than 36 percent of the national taxes on
goods and services and accounts for approximately 6.5 percent of private
consumption.
The central government of Korea relies heavily on taxes on goods and
services, which account for more than 68 percent of the total national tax
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284
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revenue (Table 11.3). Though the relative importance of indirect taxes in
the Korean tax system has been high, there was no significant change in
their importance before and after the introduction of VAT. National taxes
on goods and services as a percentage of GNP were 10.2 percent in 1976
and 11 percent in 1978.
The burden of VAT in Korea is still low compared with that in developed
industrial countries. VAT has been approximately 4 percent of GNP in re-
cent years. The relatively low overall burden of VAT in Korea can be ac-
counted for by the fact that the ratio of total tax revenue to GNP is below
20 percent in Korea, whereas the figure is well above 30 percent in most
advanced countries.
Tax policy has pervasive effects on the economy, influencing the level
of economic activity, prices, wages, foreign trade, and the distribution of
income and wealth. Adoption of VAT is widely viewed as a move toward
a more desirable system of indirect taxation. Because so much has been
happening to Korea’s fiscal structure, it is difficult to sort out empirically
the effects of the introduction of VAT on the economy. To encompass all
of these economic effects systematically would require a fully articulated
econometric model, which is almost entirely lacking at the moment.
Although the economic effects of VAT are not known with certainty be-
cause no systematic analysis has been carried out in Korea so far, our aim
here is to summarize whatever evidence is available and to point out pol-
icy issues regarding economic effects that were controversial both before
and after the introduction of VAT in Korea.
With regard to the economic effects of VAT, we are concerned with four
major issues: VAT’s effects on the price level, investment, exports, and dis-
tribution of the tax burden.
Price Level
In assessing the impact of VAT on the general price level, a conceptual dis-
tinction must be made between VAT as an additional tax and as a substi-
tute revenue source. As a new or additional tax, VAT is likely to increase
prices, provided there is an accommodating monetary policy. It should be
pointed out that although VAT would be reflected in higher prices, this result
would be a one-time increase—not a recurrent increase—in the price level
unless mismanagement of aggregrate demand led to a wage-price spiral.
In the strictly logical sphere, assuming parity in the yield of suppressed
taxes and of the new VAT and a perfect market, it may be stated that the
substitution of VAT for existing indirect taxes should not have increased
the overall price index because the level of public expenditure was not
changed nor was the economic nature of taxation, which, in all of these
hypotheses, presents the same forward shifting characteristics.
Since VAT in Korea was expected to yield the same amount of revenue
as the replaced indirect taxes, direct effects on the general price level were
 Introduction of the Value-Added Tax (1977) 285

expected to be small, if present at all. Nevertheless, significant changes were

expected in the effective tax rates on individual goods and services because
the distribution of the replacing and replaced taxes was not identical. There
were some fears that the prices of goods on which the tax burdens were
reduced would not fall or would fall by less than the prices of goods on
which the tax liabilty rose. To the extent that increases in the prices of com-
modities on which the tax burden increased were more certain than
decreases in the prices of commodities on which the tax burden decreased,
some increase in price level would occur.
Table 11.4 compares the price changes forecasted with those observed
in major industries. It was predicted that the introduction of VAT of a 10
percent rate would lead to an increase in the wholesale price level of 0.155
percent and to a decrease in the consumer price level of 0.537 percent. In
the two months after the introduction of VAT, the wholesale price level went
up 3.4 percent, of which the implementation of VAT is estimated to have
contributed 0.061 percent points.
At the time VAT was introduced, the government estimated that a 13 per-
cent VAT rate would boost consumer prices by 3.4 percent and a 10 percent
VAT rate would have no effect on the consumer price index (CPI). During
the six- and 12-month periods before the introduction of VAT, the CPI rose
by 6.7 percent and 10.1 percent, respectively, compared to increases of 3.9
percent and 14.0 percent in the first six and 12 months, respectively, fol-
lowing the introduction of VAT.
How much of the increase in prices should be attributed to the introduc-
tion of VAT is far from clear. However, it can be safely concluded that, due
to the tight price controls by the government, the introduction of VAT does

Table 11.4. Predicted and actual change in price levels due to implementa-
tion of VAT: 1977 (%)
Predicted change Actual change
Item WPI CPI WPI?
Agricultural products 0.244 -0.050 0.148
Textile products -0.439 -0.094 -0.307
Wood products -0.006 -0.010 0.007
Chemical products 0.136 -0.110 0.053
Ceramics and glass -0.013 -0.039 0.034
Metal products 0.329 -0.157 0.288
Fuel and electricity -0.153 -0.029 -0.170
Other 0.057 -0.048 0.008
Total 0.155 -0.537 0.061
Source: MOF, ROK (1980).
a. Actual change within two months of introducing VAT in 1977.
286 Kwang Choi

not seem to have had a strong impact on prices, and that most of the in-
crease in prices was attributable to the general inflationary situation in the
economy.
In an attempt to meet widespread uncertainty about the price effects of
VAT, the Korean government took two steps. First, the government decided
to reduce the initially proposed single tax rate from 13 percent to 10 per-
cent just before the introduction of VAT. Second, to prevent use of the new
tax as an excuse for firms to raise their prices to consumers, the govern-
ment imposed strong price controls.
The government had control over the prices charged by monopolies and
oligopolies and set ceilings on factory and wholesale prices for 251 goods.
A list of pre-July 1977 prices was prepared in order to hold prices to that
level immediately before the tax change. The government launched a large-
scale campaign to publicize recommended retail prices for a variety of
consumer goods. This campaign and the existence of widespread price con-
trols curbed any price increases that could have occurred through uncer-
tainty, increased business margins, and profiteering.
Despite the inflationary condition of the economy, as indicated by the
excessive provision of domestic credit and accelerated wage increases, price
controls appear to have been successful in dampening the wage-price nexus
for inflation (Table 11.5). It is also noteworthy that increases in the general
price level were due mainly to a price increase in food products. During
the period from the third quarter of 1977 to the last quarter of 1978 food
prices went up by 28.7 percent while nonfood prices increased by only 8.4
percent (Table 11.5). This increase in food prices immediately after the in-
troduction of VAT, which was mainly due to crop failures and the increase
in government selling prices of rice, led the general public to believe that
VAT was the cause of the increase in the general price level. Food products,
however, are exempt from VAT.
Broadly speaking, the introduction of VAT does not seem to have had
a major impact on the rate of price increases in Korea. The full effects on
prices of the implementation of VAT depend not only on the initial impact
but also on market interactions, the stage of the business cycle, and other
policy measures. This is confirmed by the experiences of other countries
that have adopted VAT. According to Alan A. Tait, who analyzed the ef-
fects of introducing VAT on the CPI, VAT was not a contributory factor to
inflation in 26 out of the 31 countries examined (Tait 1980).
Investment and Savings
Unlike most of the taxes it replaced, VAT does not burden capital goods
because consumption-type VAT provides full credit for the tax included in
purchases of capital goods. The credit does not subsidize the purchase of
capital goods; it simply eliminates the tax that has been imposed on them.
Because investment was taxed under the previous indirect tax system
 Introduction of the Value-Added Tax (1977) 287

Table 11.5. Prices, wages, and domestic credit indexes, 1974-80: Three years
before and three years after VAT introduction (third quarter,
1977 = 100)

Index Index of
of food nonfood Wage Credit
Year Quarter CGPI WPI prices prices index index

1974 Ill 63.6 65.9 54.4 WPA 42.3 45.2

IV 65.1 68.4 58.4 WUBI 47.7 52.4
1975 I 69.7 76.5 65.0 81.8 47.2 59.4
II They 80.6 TANS) 84.9 50.2 62.3
Ill 80.3 82.4 74.7 86.1 55.4 66.0
IV 83.6 84.5 76.6 88.2 60.7 69.3
1976 I 85.3 88.3 80.3 92.2 62.4 72.8
Il 88.2 90.0 83.9 92.9 68.1 76.2
Il 91.5 91.6 86.6 94.0 76.7 78.6
IV 91.3 93.1 87.6 95.6 82.1 84.3
1977 I 94.2 96.0 91.8 98.0 82.1 87.4
II 96.9 98.0 95.7 99.3 91.0 92.1
Ill 100.0 100.0 100.0 100.0 100.0 100.0
IV 101.0 101.8 103.9 100.9 108.7 104.3
1978 I 106.5 106.5 ae) 7 103.3 107.7 115.5
II 109.9 109.1 119.3 104.4 12285 127.0
Ill 114.7 111.6 124.9 105.4 136.3 136.6
IV 117.9 114.9 128.7 108.4 149.8 52a
1979 I 1pAES, 118.2 131.8 111.8 145.7 162.9
II 132.6 126.5 136.0 pd 158.4 171.5
I ikeS}7/ 138.1 136.7 138.8 172.5 185.6
IV 140.7 142.0 136.5 144.7 188.2 206.2
1980 I 156.1 165.0 15331 170.1 180.3 226.2
II 167.4 180.6 67a, 186.3 198.1 241.9
Ill 174.9 186.8 178.4 190.8 218.6 261.1

Sources: MOF, ROK (1980); BOK, Monthly Bulletin (1981); BOK, Price Statistics (1982); BOK,
Quarterly Gross National Product (1982); Administration of Labour Affairs, ROK (1981).

but was exempted under VAT, investment costs fell accordingly. Support
for capital investment by means of VAT refunds is summarized in Table 11.6,
which shows that the switch to VAT provided industries such as manufac-
turing and electricity and gas with substantial benefits. The tax refunds for
investment amounted to 18,336 million won for the second half of 1977 and
64,655 million won for all of 1982.
Comparison of the rates of savings and investment in years before the
introduction of VAT with those in years since its adoption is not instructive
enough to produce any conclusion regarding the effects of VAT on savings
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 Introduction of the Value-Added Tax (1977) 289

or investment. Although there is no evidence that investment or savings

increased, a questionnaire survey by the government shortly after the adop-
tion of VAT showed that VAT was more conducive to investment than was
the old indirect tax regime (MOE, ROK, 1980).

Exports
It is commonly agreed that the introduction of VAT with zero rating on ex-
ports has a favorable influence on exports. Zero rating removes any tax paid
on goods at any stage because zero-rated goods are fully exempt from any
tax when sold, and producers of such goods are entitled to a refund of any
tax paid on purchases to produce such goods.
In abstract terms, VAT is neutral with regard to international trade if ex-
ports are exempt from payment of tax and imports are subject to the tax.
The exported commodity is totally exempt from any taxes, whereas the im-
ported commodity pays a tax equal to that levied on the commodity sold
in the domestic market. In actual fact, the neutrality of VAT with regard
to international trade is subject to two limitations. The first is the difficulty
of verifying the forward shift in the incidence of tax burdens; the second
is the technical regulation needed to enforce the neutral characteristic of
the tax limit.
Giving greater tax benefits to exporters was one of the stated goals for
introducing VAT into Korea. Although this goal is politically appealing, it
is logically incorrect. A lot has been said and written about the effects that
the adoption of VAT would have on the competitiveness of Korean indus-
try, and subsequently on Korean exports and the balance of payments. To
examine the effects of VAT on exports, we have to distinguish between two
cases: substitution of direct taxes for VAT and replacement of indirect taxes
by VAT. When a country adopts a VAT system as a replacement for direct
taxes or with a reduction in direct taxes, it gains a trade advantage because
the government can rebate a larger proportion of the tax content of exports
and collect VAT on imports. When a country substitutes VAT for indirect
taxes, as in Korea, the trade advantage of VAT substitution is negligible be-
cause the refund system on export goods is a part of the replaced indirect
tax system.
Regardless of which tax VAT replaces, many believe that a VAT rebate,
in itself, will expand exports and that a VAT levy will retard imports. This
belief might have a positive effect on trade if it encourages businesses to
compete more rigorously in international markets. This result would de-
pend on the importance of nonprice considerations in explaining export
activity. In a questionnaire survey conducted by the government, a large
number of Korean businessmen expressed the view that the new VAT was
more favorable to exports than the old indirect taxes (MOF, ROK, 1980).
The effect of VAT on exports can be indirectly investigated by comparing
the general characteristics of the new VAT system with those of the previous
290 Kwang Chot

tax system and by looking at the trend of the indirect tax rebates in sup-
porting exports.
The exact determination of taxes paid under the turnover tax scheme
was generally difficult and frequently impossible to calculate. Because the
business tax and other indirect taxes were hidden in the price of export
goods, they could not be readily rebated although rebates of all indirect
taxes were permissible under the law. Because of the cumulative nature
of the turnover-type business tax, export goods were exempt only at the
final sales stage, and the government had to estimate the border tax ad-
justment for export rebates on the taxes previously paid in the production
and distribution process. The awareness of the problem that it is impossi-
ble to calculate the tax content of prices was one of the factors behind the
reform of the indirect tax system in Korea.
As it was difficult to determine the amount of taxes included in the price
of export goods under the previous indirect tax system, the government
had to issue rules prescribing how much tax was buried in the price of each
type of export good. The average rate on the credit for export goods was
imposed by the government. Therefore, the prescribed average rate was
normally either lower or higher than the actual payment. As a result, ex-
port prices usually included either a hidden subsidy or a hidden penalty.
The substitution of VAT for the previous indirect tax system has made
the determination of taxes paid on exports much easier because the charac-
teristics of a typical VAT can overcome the problem of calculating the taxes
paid. This so-called border tax adjustment merely guarantees that both im-
ports and domestically produced goods consumed in Korea bear the same
tax and allow Korean exports to enter the world markets free of tax. It should
be noted, however, that this border tax adjustment does not stimulate ex-
ports but does inhibit imports more than would a comparable turnover tax
imposed on sales to Korean consumers.
By examining the trend in the average indirect tax rebate per dollar of
exports, one can indirectly estimate the impact on exports of the change
in the Korean indirect tax system. Table 11.7 shows that the average tax re-
bate per dollar of exports has been increasing during the past ten years
or so. Though the actual effect may differ from product to product, there
was a sharp increase in the average tax rebate per dollar of exports, from
33.56 won per dollar in 1976 to 53.56 won per dollar in 1978. This result
shows that the government underestimated the border tax adjustment un-
der the previous tax system. In this sense, the adoption of VAT benefited
the export industry.
According to the poll on the new rebating system, a majority of export
company officials agreed that the introduction of VAT had a positive effect
on the trade competitiveness of their goods (MOF, ROK, 1980). The survey
also showed they felt that VAT supported exporters more than the previ-
ous tax structure. Though we may conclude that a switch to VAT with zero
 Introduction of the Value-Added Tax (1977) 291

Table 11.7, Average annual rebate of indirect taxes per dollar of exports:
1973-82

Total Rebate
Exports rebate@ per dollar
(10¢ US $) (10° won) (won)
1973 Op22) 68,523 21.24
1974 4,460 101,488 Pa fas
1975 5,081 168,728 33.21
1976 TINE 258,913 33.56
1977 9,687 514,226 53.08
1978 ee 680,813 53.56
1979 15,055 852,150 56.60
1980 17,505 1,306,584 74.64
1981 21259 1,748,125 82.23
1982 21,853 1,892,966 86.62

Source: MOF, ROK, internal data.

a. Total rebate under the previous system and VAT, including the special consumption tax.

rating on exports may have made a modest contribution to the improve-

ment of balance of payments in Korea, particularly due to its ease and .
precision in calculating tax rebates, this contribution should not be over-
emphasized. Because exchange rates or domestic inflation would soon ad-
just in response to any initial improvement in the balance of payments, any
competitive edge induced by tax substitution would soon dissipate.

Distribution of the Tax Burden

Like other taxes, VAT has distributive properties in that its burden will fall
more heavily on some sections of society than on others. Perhaps the most
controversial issue when the introduction of VAT was under consideration
was its effect on the distribution of tax burdens. The regressivity issue of
VAT continues to be a topic for heated debate.
A comprehensive VAT is regressive because lower-income taxpayers con-
sume a higher proportion of their income than do middle- and upper-
income taxpayers. A number of studies (Heller 1981; Oh 1982; Han 1982)
have been carried out to estimate the distribution of VAT burdens. The
results of these estimates are summarized in Table 11.8. Using the house-
hold income and expenditure survey, these studies all base the distribu-
tion of VAT burdens on consumption patterns and the estimated rate of
taxation on each category of consumer goods.
In all these studies (Heller 1981; Oh 1982; Han 1982), VAT is shown to
be more or less regressive with respect to income. According to a study
by Peter S. Heller (1981), VAT in Korea is regressive, with the burden declin-
ing from 5.55 percent of income at the lowest decile to 3.91 percent at the
highest. The burden is lower in the farm sector than in the nonfarm sector,
292
Wels -~
Kwang
i
Choi e —————E——————— e

Table 11.8. Effective burdens of VAT on income (%)

Income decile

Itemahai tr ails1st nia2nd

SN Iceni
4thtae
3rd SSeba Sth 7th
A ae 6th weet
8th een 10th
tk hee9th
Heller
All households 5.55 5.19 4.19 5.00 4.67 4.84 4.79 4.04 4.11 3.91
Nonfarm
households 5.94 5.63 5.82 5.75 5.46 5.38 5.51 5.31 5.02 3.91
Farm households 4.80 4.02 3.42 3.27 3.13 2.89 2.73 2.46 2.22

Oh
1976 data 362,290 2:9822.94 2.86285 2-7Om/o ee 9 eae
1978 data 3.56 3.10 3.07 3.05 3.05 2.99 2.91 2.86 2.77 2.60

Han
Nonfarm
households 9.38 7.50 6.70 6.40 5.99 5.69 5.38 5.06 4.67 3.82
Farm households 8.44 5.96 5.14 5.07 4.24 4.18 3.73 3.53 3.17 2.90

Sources: Heller (1981); Oh (1982); Han (1982).

with the relative burden declining at the upper deciles in the farm sector.
Whereas Yeon-Cheon Oh’s analysis claims that the distribution of VAT bur-
dens is only slightly regressive, Seung-Soo Han’s study concludes that
regressivity is quite strong (Oh 1982; Han 1982). According to Han’s esti-
mate, the effective burden of VAT on income for the highest decile is about
40 percent of that for the lowest decile. The corresponding figure based
on Oh’s study is around 70 percent.
Not only is the regressivity of VAT more pronounced in Han’s study than
in Oh’s, but the absolute burden of VAT throughout all income classes is
also much higher in Han’s study than in the study by Oh. Those in the
lowest decile pay 9.38 percent of their income as tax according to Han (1982)
and 3.56 percent according to Oh (1982). But the people whose incomes
are in the top 10 percent are estimated to have tax burdens of 3.82 percent
and 2.6 percent of their income in Han’s and Oh’s analyses, respectively.
A variety of indirect taxes were replaced by VAT and the special con-
sumption tax in Korea. Therefore, it is worth ascertaining whether VAT sub-
stitution led to increased or reduced regressivity. As shown in Table 11.9,
which summarizes the burdens of domestic indirect taxes before and after
the streamlining, the empirical studies done to date yield mixed results.
According to Oh (1982), the distribution of the tax burden by income
decile appears on the whole to have become slightly less regressive after
the tax reform. Two other studies by Heller (1981) and Han (1982), however,
show that regressivity has generally increased. Two explanations can be
offered to account for the fact that the distribution of the indirect tax bur-
den changed relatively little in the shift from the pre-VAT to the VAT re-
 Introduction of the Value-Added Tax (1977) 293

Table 11.9. Burdens of domestic indirect taxes on income under the pre-
VAT and the VAT regimes
Income decile
Item 1st 2nd 3rd 4th Sth 6th 7th 8th 9th 10th
Heller
All households
Pre-VAT Vea 229% LOU 01/6 0.) O14 Or Om 01458 (61228 7,00
VAT 7281 7207 86.29 715'6,85) 2/222 16.800 6-20 6.208 6.85
Nonfarm households
Pre-VAT Tse eeTigee) tye) Psy VAT ASP Voy teil 7/4) YALL
VAT 8.39 8.40 8.70 8.29 8.07 8.15 8.03 8.38 7.71 6.85
Farm households
Pre-VAT 6.98 6.25 5.45 5.00 5.02 4.74 4.41 4.37 3.79
VAT 6:70 5-968 Sal 84279436514 30m. 97 OOOO.0
Oh
1976 data
Pre-VAT 5.93 4.75 4.91 4.79 4.61 4.67 4.51 4.47 4.53 4.12
VAT 4.93 4.07 4.22 4.13 3.98 4.01 3.87 3.82 3.92 3.54
1978 data
Pre-VAT 5.82 5.15 5.14 5.09 5.07 4.99 4.90 4.81 4.78 4.54
VAT 5.71 4.98 4.97 4.96 4.93 4.85 4.75 4.68 4.62 4.34
Han
1976 15.70 13.10 12.40 11.90 11.50 11.20 10.80 10.40 9.70 9.10
1978 20.40 15.80 13.80 13.10 12.10 11.40 10.60 9.90 9.00 7.10

Sources: Heller (1981); Oh (1982); Han (1982).

gimes or has become worse over time. First, the VAT system was designed
to be quite regressive. Second, the tax rates and tax base of the special con-
sumption tax, which was concurrently introduced to supplement VAT, are
insufficient to allow it to play its assigned role. In all the studies reviewed,
the burden of the special consumption tax is proportional to income or is
even somewhat inversely related to income.
The incidence studies reviewed above vary in their estimates of the dis-
tributive effect of VAT itself, and in their comparisons of the distributive
effect of VAT and previous indirect taxes. Still, all these studies indicate,
as expected, that VAT is regressive and that the replacement of the previ-
ous indirect taxes with VAT and the special consumption tax has not les-
sened the regressivity of overall indirect tax burdens.
Because Korea relies heavily on indirect taxes for its revenue, the regres-
sivity of indirect tax burdens implies that the overall tax burden in Korea
is regressive. Therefore, there remains a need for the government to im-
prove the distribution of income by moderating the regressivity of VAT and
294 Kwang Choi

the indirect tax system in general and by moving toward greater reliance
on direct taxes.
CRITICISMS, CURRENT ISSUES, AND LESSONS
Because more than a decade has elapsed since the implementation of VAT
in Korea, an interim assessment is possible. VAT in Korea has been work-
ing relatively well, in some cases much better than its designers and the
taxpayers had anticipated. The number of complaints has been small,
though some have been loud. Complaints have been made and will con-
tinue to be made about various aspects of the tax structure and the details
of its operation. Many of these protests, however, are more in the nature
of special interest pleading or general grumbling than attacks on the con-
cept of the tax.
Korean experiences with VAT clearly show the importance of good book-
keeping practices and the implications of the habit of requesting receipts
by buyers after each transaction. A precondition for the introduction of VAT
was well-established record keeping, which proved to be too demanding
and cumbersome for Korean firms, especially small ones accustomed to poor
bookkeeping or to keeping no records at all. The practice of bargaining be-
tween sellers and buyers to settle prices, which most Koreans take for
granted, was a hindrance to the introduction and acceptance of VAT. Other
countries planning to adopt VAT should make every effort to establish the
system of attaching price tags to retail products.
On almost all counts, VAT in Korea should be considered an improve-
ment over the indirect taxes it replaced. Its base is broader. It permits more
precise border tax adjustment. Taxpayers have by now familiarized them-
selves with VAT. There is no evidence of large-scale tax evasion. Revenue
from VAT is large and in line with the calculations based on the volume
of private consumption.
Although VAT can and does work in Korea, it is not free from arbitrary
elements and controversies. To deal with the annoying problems associ-
ated with VAT, a distinction must be made between problems inherent in
VAT and those also true of other taxes. By way of conclusion, the major
issues currently facing the VAT system in Korea are reviewed to help other
countries learn from the Korean experience.
Scope and Coverage of VAT
One recurrent question about the structure of VAT in Korea concerns the
possibility of extending VAT to sales that are currently exempt. The
widespread use of exemption is founded on the desire to reduce the regres-
sivity of the VAT burden. Needless to say, the extensive use of exemptions
reduces the efficiency advantage that might have been gained from a more
neutral tax structure.
Exemptions facilitate the administration of VAT. This is true particularly
 Introduction of the Value-Added Tax (1977) 295

of exemptions for small taxpayers and certain services. It should be borne

in mind, however, that excessive exemptions complicate administration be-
cause of the difficulty of distinguishing taxable from nontaxable transac-
tions and the resulting need for more detailed records and invoices.
Current issues on the Korean VAT exemption scheme center around two
major questions. The first is the very purpose of the VAT exemption, and
the second is the possibility of narrowing the scope of the exemption. It
is generally understood that exemptions are allowed to reduce the regres-
sivity of the VAT burden. It must be pointed out, however, that the reasons
for the exemption scheme in the VAT structure lie not in the reduction of
regressivity but in the simplification of administration and compliance.
Moderation of the regressivity could be achieved more effectively through
the zero-rating scheme rather than through the exemption scheme. This
simple but important point has not caught the attention of VAT designers
in Korea and many other countries. Zero-rated supplies are technically tax-
able but at a low rate; the implication is that VAT charged on inputs relat-
ing to them could be reclaimed just as were inputs relating to taxable
supplies. Exempt supplies are outside the scope of VAT altogether so there
is no question of reclaiming relevant input taxes. Because an exempt trans-
action bears some VAT, the relief of the tax burden on low-income people
should be sought through the application of a zero-rating scheme rather
than an exemption scheme for goods and services consumed dispropor-
tionally by the poor.
Even under the current exemption scheme, a review of the list of goods
and services currently exempted leads one to question the appropriateness
of the inclusion of some items on the list. In principle, exemptions from
VAT should be limited to basic necessities such as unprocessed foodstuffs
and to goods and services the government wishes to exempt for social or
cultural reasons.
Several selections on the exemption list have been controversial, includ-
ing services provided by financial institutions and insurance companies,
government-provided goods and services that compete with commercial
operations, and independent professional services. On the grounds of tax
equity between privately and publicly supplied goods and services and the
economic efficiency of preserving the capacity of private firms to compete
for business with public agencies, it has been strongly suggested that some
commercial activities by semi-governmental bodies should not be exempted.
The exemption of rent, insurance, and financial services means that
traders of these outputs have to bear input taxes but cannot reclaim them.
They are expected to pass the tax on to their customers. Business users of
those services thus have to bear some VAT costs, despite the philosophy
of the tax. The major problem with taxing financial services is the difficulty
of recalculating the correct tax base. One way to tax the value added of in-
surance and banking services would be to rely on the direct additive
296 Kwang Choi

method, that is, adding together their annual wage and salary payments,
rental payments, and profit. A tax of 0.5 percent on gross receipts of bank-
ing and insurance companies has been imposed in Korea since the begin-
ning of 1982. To determine whether it is desirable to bring these financial
institutions within the scope of VAT, one has to consider whether to
eliminate the special tax recently imposed or to accept the consequences
of imposing a heavier burden on this sector than on others.
Practically all independent professional services, such as those provided
by doctors, lawyers, accountants, and architects, are currently exempt. It
has been suggested that all these professional services should be taxed.
Given the fact that these independent professionals currently pay relatively
little tax under the personal income tax, it would seem advisable to make
their services subject to taxes unless they can fully shift their tax burdens
to their customers. Furthermore, from an equity point of view, it is desir-
able to adopt a common policy toward all professional services rather than
to single out one particular service for exclusion from the exemption.
All in all, exemptions should be held to a minimum not only to keep
the VAT base broad but also to minimize administrative problems and dis-
tortions in the economy. The neutrality of the tax would be improved if
the coverage of services were broadened and if exemptions were replaced
by zero ratings. Increased use of zero ratings rather than exemptions would
reduce the advantages that large firms have over small ones.
Tax Rate Structure
A single rate of 10 percent has been used in Korea since the introduction
of VAT in 1977. If VAT were imposed at a uniform rate on all consumption,
it would be regressive when measured against income, because consump-
tion expenditures take a decreasing fraction of personal income as income
levels rise. To reduce the tax burden on low-income taxpayers and to inject
an element of progressivity into VAT, suggestions have been made to use
differentiated multiple rates rather than a single uniform rate.
Experiences with rate differentiation elsewhere do not recommend its
use in Korea; the EEC countries have found that such a differentiation com-
plicates administration and compliance and destroys both neutrality and
the advantages that uniformity brings. Furthermore, using multiple rates
is an inefficient way to achieve redistributive objectives.
The tax rate structure of VAT has a direct influence on its administration
and compliance. Many problems arise from the use of multiple rates. First,
the rate structure may not be sufficiently defined, leaving products that can
fit into more than one category. Second, the categories themselves may be
based on criteria for which information is not readily available. Third, mul-
tiple rates cost too much for small businesses dealing with a variety of goods,
because it is extremely time-consuming for them to account separately for
each different category when filling out tax returns. Fourth, multiple rates
 Introduction of the Value-Added Tax (1977) 297

provide taxpayers with the oppportunity to evade the taxes either through
miscalculation or other manipulations.
Given the limitations of record keeping on the part of taxpayers and au-
ditors, it is imperative that the tax be kept simple, and the most important
requirement for simplicity is the use of a single rate. If a higher tax burden
is desired on certain classes of goods or services, this should be attained
by separate levies like the special consumption tax either at the importa-
tion or manufacturing level, as is the case now in Korea.
The regressivity of VAT can be moderated, but not eliminated, by spe-
cial measures like exemptions and differentiated rates. Even if many com-
modities were zero rated, a significant progressivity or even a substantial
decrease in regressivity could not be obtained. A set of distributional goals
can be more easily achieved using the available alternative devices.
Participants at the Brookings conference, which reviewed the European
experience with VAT, agreed that the use of multiple rates and exemptions
complicates administration and compliance and distorts consumption in
ways that are unlikely to promote economic efficiency (Aaron 1981). They
held that distributional objectives should be pursued with other instru-
ments, notably transfer payments and income taxes. Many of the European
countries that have adopted a multiple-rate VAT have been moving to sim-
plify their tax rate structure. The United Kingdom, Belgium, and Ireland
have all decreased the number of their VAT rates.

Administrative Problems
The administrative problems posed by VAT have been considerable although
administrative efficiency for the VAT system was an important considera-
tion behind its adoption in Korea. All taxable transactions must be fully
recorded. Invoices must be issued so that the purchaser can deduct the
tax charged on the sale. For some time administration of VAT has been sub-
ject to criticism. The administrative aspects of VAT are still controversial,
and recent public concern about the VAT system in Korea centers around
the issues of administrative efficiency and compliance costs.
The degree of compliance and the cost of administration depend on
whether businesses are accustomed to keeping good written records, on
the establishment of a modernized distribution system, and on the share
of business activity carried out by small establishments. The lack of sys-
tematic record keeping in many parts of the Korean economy would make
administration difficult and evasion easy even under the best of circum-
stances. Unless distribution channels through which commodities change
hands are modernized and solidly established, there is no way of controll-
ing the illegal transfer of tax invoices to a third party.
VAT is said to be self-enforcing because of how it is usually administered.
Korean experience with VAT, however, suggests that the so-called built-in,
self-enforcing aspect of the tax, which permits the matching of the tax credits
298 Kwang Chot

of one taxpayer against the tax payments of another, is illusory or, at least,
a much overrated advantage because invoices can be falsified.
The advantages of the invoice method have not been fully realized in
practice and are not likely to be fully realized, because of the practical im-
possibility of checking all invoices on the part of tax collectors and because
of efforts to evade the tax on the part of taxpayers. Much evasion occurs
through the failure of some parties to report all transactions. There is a meas-
ure of self-policing in that evasion by suppliers through the understatement
of the tax collected is balanced by the purchasers’ interest in ensuring that
all tax payments are recorded. Similarly, evasion by purchasers who over-
state the taxes they pay runs counter to the interests of suppliers.
It must be stressed that VAT is not a self-enforcing tax. Although tax-
payers do have an incentive to request invoices for their purchases to in-
crease their input of tax audit, this incentive is in many instances
counterbalanced by the desire to suppress both purchases and sales to avoid
not only VAT but also income taxes.
The ability to administer VAT is a function of a large number of factors.
One group of factors, which are internal to the VAT system, is the scope
of the tax, the degree of its complexity in terms of rate structure, the
exemptions, the reporting techniques and procedures, the tax payment
procedures, and the treatment of small businesses. Another group of fac-
tors, which are external not only to VAT but also to any other kind of tax,
includes the degree of literacy, the size of the monetary economy, the ade-
quacy of bookkeeping, the attitudes toward taxation and tax administra-
tion, and the efficiency of tax administration services. Administrative
difficulties can be overcome when the intrinsic complexity of the tax law
is compatible with the external factors mentioned here.
Special Taxpayers
One of the major criticisms ef VAT in Korea has been the burden on busi-
nesses, particularly on small businesses, to keep books and file returns to
the tax authorities in the prescribed format. Taxpayers’ records must clearly
show not only total sales and the taxes payable but also all purchases and
taxes paid. Whereas large and medium-size firms can absorb the account-
ing and procedural requirements of VAT with relative ease, the problem
lies in the size of small businesses. Although the control and audit of spe-
cial taxpayers may be kept to a minimum, their numbers alone pose
problems of registering, filing returns, and collecting taxes that could im-
pede efficient administration of the entire tax system. The cost of manag-
ing a large number of special taxpayers must be weighed against the
considerations of revenue and equity. If the administrative burden out-
weighs their revenue potential, it may be better for such special taxpayers
to be exempt from VAT.
In 1982, 78 percent of all special taxpayers had annual sales lower than
 Introduction of the Value-Added Tax (1977) 299

5 million won, and this group of taxpayers contributed less than 3 percent
of total VAT collected. From a purely administrative point of view, exemp-
tion of special taxpayers from VAT is attractive in that both administration
and compliance would be made easier with no substantial loss in revenue.
Some suggest that the authorities should be lenient in applying VAT to
small traders. The temptation to move toward more lenient treatment of
troublemaking small taxpayers should be resisted, however, because such
concessions are costly in terms of government credibility and would have
a profound effect on the bookkeeping and accounting practices of all tax-
payers, both general and special.
Another important policy issue is the question of how to determine which
taxpayers should be considered special or small. Prior to 1988 the dividing
limit was total yearly turnover of 24 million won. In 1983 the opposition
Democratic Korean Party suggested that the limit be increased to 36 mil-
lion won per year; the limit was increased to that level in 1988. The increase
should have been rejected because the aim of special treatment of small
businesses is not to give them more favorable treatment but to provide a
simplified system, which approximates the true tax liability without im-
posing an intolerable burden on either the taxpayer or the tax adminis-
tration.
Taxpayers are hesitant or reluctant to be categorized as general taxpay-
ers simply because special taxpayers are treated preferentially relative to
general taxpayers. The manipulation of sales totals and the disguised clos-
ing of businesses are well-known practices. These illegal practices in large
part explain the fact that despite the rapid growth of the economy there
is no change in the number of special taxpayers as a percentage of total
VAT taxpayers.

Coordination of VAT with Direct Taxation

A high degree of coordination between the staff in charge of VAT and those
in charge of direct taxes is very important. It is an open secret that in Korea
taxpayers cheat on their sales not to evade VAT but to evade personal and
corporate income taxes. Operation of VAT resembles that of the income tax
more than that of other taxes and an effective VAT system greatly aids in-
come tax administration.
Countries differ in the degree to which they combine administration of
their VAT with individual and corporate income taxes. To secure close coor-
dination between them, institutionalization is necessary at the technical level
through means such as automatic processing of data obtained through tax
returns or audits, the exchange of this information, consultation as to spe-
cial audit programs, and the design of forms. In any event, close coopera-
tion with the income tax administration is of great importance for
strengthening both VAT and the income tax.
One lesson that the Korean experience holds for a country contemplating
300 Kwang Choi

the adoption of VAT is that implementation of VAT is bound to fall well

short of the theoretical ideal. However simple VAT may be in theory, Korean
experience makes it clear that it is not simple in practice. It creates a host
of special problems that give rise to paperwork and more or less arbitrary
distinctions.
POPULATION AND
PUBLIC HEALTH POLICIES
yn
 12 Population Policy
by Andrew Mason and Lee-Jay Cho

At the very moment of partition, demographic forces began to exert con-

siderable influence on South Korea's future. Between the end of World War
Il and the end of the Korean War, over 2 million refugees flooded into the
South. Although the influx of refugees brought urban problems to Seoul
and other cities where they settled, they also brought a stronger human
resource base to the South—valued by a country still threatened from the
North and only recently independent of Japanese control after 36 years of
occupation. But another demographic force, one less noticed but with far
greater long-run implications, also emerged at the end of the Korean War.
At the same time that death rates were declining with great rapidity, birth
rates reached record heights, pushing the rate of population growth to near
3 percent per year.
The fact that Korea’s population was growing far more rapidly than at
any previous time was only one of many concerns that occupied Korean
policymakers in the early 1950s. Per capita GNP was only US $80, much
of the country’s physical infrastructure had been destroyed by the war, the
development of its human infrastructure had been impeded by Japanese
occupation, and domestic saving was so inadequate that there seemed to
be little hope for significant economic progress. These problems were more
immediate and occupied a much higher place on the national development
agenda than did consideration of population policy. Beyond these economic
realities, traditional Confucian values emphasizing the importance of the
large extended family held sway among Korea’s leaders, particularly Syng-
man Rhee, and discouraged policy dialogue concerned with reducing the
rate of population growth.
With the overthrow of the Syngman Rhee regime in 1960, debate on the
implications of Korea's population growth and the wisdom of establishing
a nationwide program to encourage lower fertility became possible. Park
Chung Hee, as a nationalist and Confucian, was reluctant to introduce fam-
ily planning to Korea. But arguments by Korea’s technocrats that rapid popu-
lation growth would impede Korea’s development efforts won the day. In
1961, the Planned Parenthood Federation of Korea was established with the
blessing of the government, and the First Five-Year Development Plan
(1962-66) established fertility reduction as one of the goals of Korea’s na-
tional development effort and provided funds through the Ministry of
Health and Social Affairs (MOHSA) to establish government-sponsored
family planning in Korea.

303
304. Andrew Mason and Lee-Jay Cho

The concern of the formulators of Korea’s early population policy is evi-

dent in the demographic situation of Korea today. With a 1985 population
estimated at just over 41 million, Korea is one of the most densely popu-
lated countries in the world. Even so, its population continues to grow at
a rapid pace and will approach 50 million by the year 2000 and, barring
a further decline in fertility, will reach 53 million sometime during the
twenty-first century (EPB, ROK, 1986). The extent of Korea’s population
growth is most evident in its enormous urban populations. In 1985 Seoul
proper was the home of nearly ten million Koreans; another four million
resided in Pusan (W. B. Kim 1986).
The origins of Korea's population growth can be traced to the early 1900s
when mortality first began to decline. Population growth, however, did not
average 2 percent per year (decadal average) until after the Korean War (Ta-
ble 12.1). The source of rapid population growth is clear from Figure
12.1—fertility persisted at a high level until the mid-1960s despite a steady
decline in mortality.
The speed with which fertility has declined since 1965 is virtually without
precedent. Korea's birth rate dropped nearly in half in only two decades,
from over 40 births per thousand women to well under 30 per thousand
in 1980. Whereas women were typically bearing six children in 1960, they
were bearing fewer than three by 1980. The latest available data indicate
that total fertility had declined further to two births per women in 1985
(EPB, ROK, 1986). If the further declines targeted in Korea’s Sixth Five-Year
Development Plan (1987-91) are achieved, the population will peak at 54
million in the year 2023 (EPB, ROK, 1986).

Table 12.1. Population growth: 1900-85

Population Rate of

All Korea
1900 17ek
1910 17.4 0.2
1920 18.1 0.4
1930 20.4 2
1940 23.5 1.4
South Korea
1949 19.9
1960 25.0 eX
1970 32.2 2.5
1980 38.1 AI
1985 40.4 La?
Source: Mason (1986b); NBS, EPB, ROK (1987).
 Population Policy 305

1,000)
Births
deaths
and
(per © Births per 1,000 persons
ry(=)

® Deaths per 1,000 persons

0
1910-15 1920-25 1930-35 1940-45 1950-55 1960-65 1970-75
Period

Figure 12.1. Birth and death rates in Korea: 1910-80

Source: Kwon et al. (1975).

Population projections by the Bureau of Statistics are based on the as-

sumption that total fertility will decline further, but more slowly, to reach
1.75 births per woman in 1995 (Table 12.2). Continued improvements in
mortality are also anticipated with life expectancy at birth reaching 69.3 years
for males and 76.2 years for females by the year 2000. Based on these as-
sumptions the annual rate of population growth will average 1 percent over
the next 15 years and the population will reach 48 million in the year 2000.
The reduction in fertility has had far-reaching effects in Korea. Had popu-
lation growth rates observed during the 1970s prevailed, Korea’s popula-
tion would be more numerous by 20 million in the year 2000. The age
distribution of Korea's population has also changed considerably as a con-
sequence of declining fertility. Figure 12.2 shows age pyramids for Korea
in 1960, 1980, and projected to the year 2000. As is characteristic of high
fertility countries, the 1960 population was relatively young with 42 per-
cent under 15 years of age and only 3 percent 65 or older. By 1980 only
one-third and, by 2000 less than one-quarter of the population will be un-
der 15 years of age.
It is, of course, only the number of young that is influenced by Korea's
306 Andrew Mason and Lee-Jay Cho

Table 12.2. Population projections for the Republic of Korea: 1985-2020

Population (in thousands) Age distribution (%)
Year Total Male Female 0-14 15-64 65+

1985 41,056 20,702 20,354 30.6 65.2 4.2

1990 43,601 21,981 21,620 27.2 68.1 4.7
1995 45,962 23,161 22,800 25.2 69.6 D2
2000 48,017. 24,187 23,831 231 70.7 6.2
2005 49,710 25,033 24,677 21.3 713 7.4
2010 51,028.” ©25,692% 25,335 19.8 71.8 8.4
2015 51/9638 26, lOOme 20,700 18.6 120 9.4
2020 52,473 26,416 26,057 17.6 71.4 11.0
Source: EPB, ROK (1986).
Note: Figures for 1985 are preliminary estimates from 1985 census.

family planning success. In 1980 there were no more than 5 million mem-
bers in each of the age groups shown in Figure 12.2. In the absence of fer-
tility decline, however, each young cohort would have exceeded the previous
one by 10 to 15 percent and the number of children under five years of age
could have been twice the number of that age actually living in Korea in 1980.
The way that these demographic changes have, in turn, affected Korea's
economy is a matter about which there has been considerable discussion.
Although there is disagreement about the effect of demographic factors on
education (Schultz 1987; NRC 1986), the rapid expansion of Korea’s educa-
tional system, already straining existing resources, would surely have been
impeded. The decline in childrearing responsibilities among Korean women
has been partly responsible for increased labor force participation by women
(Bauer and Shin 1986). And a significant portion of the rise in domestic
saving rates, so important to continued capital expansion, has been attrib-
uted to the decline in the number of young dependents (Mason et al. 1986).
All things considered, Korea has achieved its objective of lowered fertility
and population growth and this success has complemented other efforts
to achieve rapid economic growth.

MAIN FEATURES OF POPULATION POLICY

The formulators of Korea’s population policy would no doubt be pleased
by the demographic trends outlined above. But the success of Korea's popu-
lation policy must be judged on the extent to which it was responsible for
reduced childbearing. At the very time the government was introducing
family planning, Korea was also experiencing rapid changes in child mor-
tality, educational attainment, urbanization, modernization, and standards
of living—all factors widely believed to be responsible for fertility decline
in today’s developing countries. Nonetheless, research described below
 Male [_] Female

65+
60-64
55-59
50-54
45-49
40-44
35-39
30-34
25-29
20-24
15-19
10-14
5-9
0-4

65+
60-64
55-59
50-54
45-49
40-44
35-39
30-34
25-29
20-24 of
Years
age
15-19
10-14
5-9
0-4

65+
60-64
55-59
50-54
45-49
40-44
35-39
30-34
25-29
20-24 of
Years
age
15-19
10-14
5-9
0-4

Population (millions)

Figure 12.2. Age pyramids for the Republic of Korea

Source: Mason (1986b).
308 Andrew Mason and Lee-Jay Cho

shows that the preponderance of Korea's fertility decline cannot be ac-

counted for by its rapid social and economic development. Rather Korea's
family planning program was critical to the reductions in childbearing
achieved during the 1960s and 1970s.
Korea first embraced family planning as a national objective in 1961. That
year saw the establishment of the Planned Parenthood Federation of Korea
(supported by the International Planned Parenthood Federation and pri-
vate donors), the abrogation of the law prohibiting the import and produc-
tion of contraceptives, and the adoption of the First Five-Year Development
Plan which provided for the establishment of a national family planning
program.
Beginning in 1962 the government committed financial resources to fam-
ily planning through MOHSA. At its inception, the program emphasized
the distribution of contraceptive services through established health centers
and the provision of family planning information and education through
home visits by family planning workers. By 1964 family planning field work-
ers had been assigned to each of 1,473 myons (counties) and contraceptive
services were being provided to nearly 300,000 men and women. To achieve
these gains required a substantial commitment on the part of the govern-
ment—the program employed over 2,000 workers. The government was
aided in its effort through the provision of technical and material assistance
from the United States and other countries.
Although the program enjoyed some early successes, it also faced a num-
ber of problems. Traditional Korean values were not supportive of efforts
to reduce family size with the Confucian emphasis on expanding one’s clan
and maintaining the family’s name over generations. Thus, local leaders
and government officials were decidedly mixed in their support of efforts
to reduce childbearing. Given the hierarchical nature of Korean society and
the pressure to conform, the support of local leaders was critical to pro-
gram success (L. J. Cho 1971). A second problem was encountered in ur-
ban areas. Whereas in rural areas family planning workers could generally
gain access to the target population, in urban areas home visits proved to
be an ineffective method of promoting contraceptive acceptance and use.
Contraceptive services were provided to nearly 600,000 men and women
in 1966, but the family planning program languished somewhat in the late
1960s. Delivery of all three of the methods provided at the time—interuterine
devices (IUD), vasectomy, and condoms—declined from 1966 to 1967 and
again in 1968.
Several steps were taken to reinvigorate the program in the late 1960s
and early 1970s: The political commitment to family planning was strength-

1, Deputy Prime Minister and Minister of Economic Planning Kim Hak Yul’s leadership and
commitment to population policy are reflected in the major advances in the family planning
program during this period.
 Population Policy 309

ened and conveyed more effectively to the provincial administration by in-

volving the Ministry of Home Affairs which established family planning
as a high priority program. Beginning in 1968, Mothers’ Clubs were estab-
lished throughout the country. The Mothers’ Clubs proved to be an impor-
tant and effective means by which the importance and value of family
planning was communicated throughout rural Korea. In 1968 the pill was
introduced and quickly became as popular as the IUD as the method of
choice. In 1972 the family planning organization was strengthened by es-
tablishing the Bureau of Maternal and Child Health in MOHSA. And in
1973 the legal grounds for induced abortion were liberalized.
Reflecting the strengthening of the program and significant improvements
in socioeconomic circumstances in Korea, delivery of contraceptive services
recovered beginning in 1969 and grew steadily throughout the early 1970s.
By 1973, 36 percent of all women of childbearing age were practicing con-
traception, and 30 percent had experienced an induced abortion. Total fer-
tility had declined to fewer than four children in 1973 from six children per
woman in 1960.
In the 1970s a broad-based approach was taken to improve the perfor-
mance of the family planning program. First, all segments of society were
involved in the family planning movement as part of the New Community
Movement. Family planning information was more effectively disseminated
in urban areas by actively involving both the public and the private sec-
tors. Medium and large corporations were required to establish family plan-
ning programs for their employees. Trade unions were required to provide
population education to their members. And the Ministry of Defense pro-
vided population education and contraceptive devices to all military per-
sonnel.
Second, attention was turned toward the cultural and institutional un-
derpinnings of high fertility. Population education was expanded and in-
troduced into secondary schools and universities. The Ministry of Education
revised textbooks and incorporated material on the dangers of rapid popu-
lation growth into the regular school curriculum. With funding from the
United Nations Fund for Population Activities, materials on population were
distributed throughout the school system. A variety of incentives and dis-
incentives were established to reinforce small family norms. In 19/4 the
Ministry of Finance revised the tax codes to allow exemptions for three chil-
dren only, reduced further to two children in 1977. Expenditures by corpo-
rations on family planning services for employees was exempted from
corporate income tax, and public housing priority was given to steriliza-
tion acceptors with one or two children.
Efforts to attack the social underpinnings of high fertility are particu-
larly well illustrated by the response to son preference. Quantified by the
most widely used measure, the Coombs scale, Korea had the strongest
preference for sons of any country in one recent study (Arnold and Kuo
310 Andrew Mason and Lee-Jay Cho

1984). Couples with two daughters were twice as likely to bear an addi-
tional child as couples with two sons (C. B. Park 1983) and fertility decline
leveled off at three children per couple, widely viewed to be a direct conse-
quence of son preference. A two-pronged approach was employed to at-
tack son bias. Efforts were made to raise the status of women by amending
family law, including inheritance practices, and the preference for males
was attacked directly via public education campaigns.
The nationwide, broad-based effort to reduce fertility culminated in the
establishment of the Population Policy Council as part of the Fourth Five-
Year Economic and Social Development Plan beginning in 1976. The coun-
cil was chaired by Deputy Prime Minister and Minister of Economic
Planning Nam Duck Woo. Under his leadership the implementation of
population policy was the direct responsibility of the vice-ministers of rele-
vant ministries including home affairs, education, finance, transportation,
and health and welfare. The central position of the Economic Planning Board
(EPB) in population policy considerably strengthened family planning’s
budgetary clout and its ability to mobilize government resources for family
planning efforts.
The strengthened commitment to family planning paid dividends dur-
ing much of the 1970s. More than 700,000 people received contraceptive
services through government-supported programs during 1961-78. Further-
more, an increasing number opted for sterilization rather than temporary
measures such as the IUD and pill. By 1979 over half of all women of child-
bearing age were practicing contraception, and women were averaging
around three births apiece.
During the late 1970s and early 1980s, the family planning effort lan-
guished. The delivery of all methods of contraception through government
programs dropped below delivery in previous years, and the rate of con-
traceptive practice barely increased between 1979 and 1982. Fertility decline
slowed, as well. The reason for the disappointing progress during this pe-
riod is not altogether clear. It may reflect turmoil in Korea associated with
President Park’s assassination in 1979 and economic collapse in 1980.
Although low fertility is generally associated with an economic downturn,
its disruption of the family planning effort may have impeded further
decline in fertility.
But at some point in the early 1980s, the family planning effort began
to pick up steam. The delivery of contraceptive services through
government-supported programs was much more extensive in 1982 and
thereafter than in 1981. More important, the method of choice shifted toward
sterilization and away from temporary techniques of contraception. In 1982
the number of vasectomies performed exceeded 50,000 and the number of
tubectomies performed exceeded 200,000 for the first time. Reflecting these
renewed efforts, contraceptive practice increased from 54.5 percent of all
women of childbearing age in 1979, to 57.7 percent in 1982, and to 704 per-
 Population Policy 311

cent in 1985. In 1984 total fertility reached replacement level—2.1 births per
woman—four years before the target date specified in Korea's Fifth Five-
Year Development Plan?
In an important sense, the Korean family planning program has accom-
plished its primary objective. Because women are bearing only two chil-
dren each, on average, Korea's population will stop growing some time
during the twenty-first century. Without further declines in fertility, Korea’s
population will stabilize at around 60 million. The Sixth Five-Year Develop-
ment Plan (1987-91) has as its objective further reductions in fertility re-
quired to reach zero population growth in the year 2023 at a population
of about 53 million. To achieve this goal, contraceptive use is targeted to
increase to 76 percent of all women of childbearing age, and fertility is tar-
geted to decline to 1.86 births per woman by 1991 reducing the rate of popu-
lation growth to only 1 percent by 1993.
As in the past, these objectives will be pursued via an all-encompassing
approach to family planning. The potential for intensifying the program
through family planning workers in local administrative units, for the most
part, has been exhausted. But efforts will be made to improve the quality
of contraceptive services and to integrate family planning and programs
to promote maternal and child health. Further efforts will be made to foster
a social environment that is supportive of small families. Further modifica-
tions of family and inheritance laws in favor of women will be aimed at
reducing a persistent tendency for childbearing and contraceptive practice
to be affected by the gender of surviving children.
KOREA‘S FERTILITY DECLINE:
DEVELOPMENT OR FAMILY PLANNING?
Korea's family planning program has undeniably provided valuable services
to millions of men and women since the early 1960s. But to what extent
has the family planning program been responsible for the decline in child-
bearing? Our review suggests an important contribution, but some would
argue that family planning programs did no more than fill a need gener-
ated by underlying social and economic change, and that in the absence
of government-sponsored family planning, the private sector would have
filled the need and childbearing would have declined just as rapidly.
Proponents of this view believe that development is the best or, in a few
cases, the only contraceptive. But the evidence presented below based on
a recently completed study carried out by the East-West Population Insti-
tute, the Nihon University Population Research Institute, and the United
Nations Fund for Population Activities (Mason et al. 1986) shows that, at

2. Replacement fertility is the level necessary to eventually achieve zero population growth;
however, even with replacement fertility Korea's population would continue to grow for many
decades.
312 Andrew Mason and Lee-Jay Cho

most, social and economic development played a secondary role in reduc-

ing Korea's fertility.
The Case for Development
The relationship of fertility to economic development has long been a sub-
ject of theoretical speculation and empirical research. Many studies have
shown that increased education, especially of women, tends to reduce fer-
tility (Michael 1974; Rosenzweig and Evenson 1977; Cochrane 1979). Urbani-
zation is also recognized as closely related to fertility reduction (Kuznets
1974). In addition, it has been shown that increased child survival leads
to fewer births (Ben-Porath 1976; Schultz 1976; Scrimshaw 1978; Trussel and
Olsen 1983).
The influence of income on fertility continues to be a matter of dispute.
Economic theorists contend that, other things being equal, higher income
generally leads to more children (Becker 1960; Becker and Lewis 1973; Wil-
lis 1973, but for an alternative view, Easterlin, Pollak, and Wachter 1980).
A number of empirical studies appear to support this view, but many others
have failed. In any event, the direct effect of income on fertility appears
to be small (Schultz 1973; Simon 1974).
Because of the complex interrelationships between demographic change
and economic growth, careful assessment of the link between fertility and
development is facilitated by employing an econometric model. The model,
described in detail in Suits and Mason (1986), consists of a system of equa-
tions statistically fitted to data drawn from a cross-section consisting of all
nations in the world with labor forces of at least one million workers.
Although the key relationships that compose the model are of interest
in themselves, more important is the way they fit together to constitute the
structure of economic development and demographic change. Figure 12.3
is a highly schematic representation of this structure. Proceeding from the
top left across the figure, we see that per capita GNP affects labor force
participation, enrollment, urbanization, the total fertility rate, mean age at
childbearing, and, along with improvements in technology, life expectancy
at birth. The total fertility rate is also affected by urbanization, child mor-
tality, and educational attainment. Total fertility and mean age at childbear-
ing translate into age-specific fertility rates, whereas life expectancy translates
into age-specific survival rates. These combine to determine the rate of in-
crease in population, its size, and its age structure. The age structure of
the population, along with past educational attainment, and past school
enrollment combine to determine current educational attainment. Next, the
figure shows the three key components of economic growth: labor force
size (determined by per capita income, school enrollment, and demographic
characteristics of the population); labor force quality (determined by educa-
tional attainment and population); and investment (determined by the rate
of growth of income and the population growth rate). These three factors
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314 Andrew Mason and Lee-Jay Cho

combine to determine growth in GNP which, together with population

growth carries us back to the left side of the figure with a new level of per
capita GNP.
If we begin at the left with per capita income, population, labor force,
investment rate, educational endowment, and other characteristics of a
modern poor developing nation, we can, with the aid of a computer, work
across the figure to determine new conditions to be expected from one year’s
development. The new conditions become the new starting point for a sec-
ond year’s development, and so on for as many years as we choose to
simulate.
The results show the development path to be expected of a nation with
an initial per capita GNP equivalent to US $100, of which 20.4 percent is
saved and invested. Of the working-age population, 73.4 percent of the men
and 36.1 percent of the women are employed. Farming occupies 75.1 per-
cent of the labor force, the remainder is engaged in urban occupations. The
total fertility rate is 5.45 births per woman, life expectancy at birth is 41.3
years, and the population growth rate is 1.59 percent per year. Of children
of appropriate ages, 78.6 are enrolled in elementary school, 24.5 percent
are enrolled in secondary school, and 1.7 percent in college.
From this initial state, a nation whose performance matched that of the
world average would grow in 100 years to a developed country with real
per capita income approaching $5,000, an increase of about 50 times. Popu-
lation would grow to more than 5 times the initial level, but fertility would
have been cut by more than half. The nation would have gone through a
demographic transition from a high fertility, short-lived society to one with
low fertility, long life, and slow and declining population growth. Labor
force participation by males would have declined steadily in keeping with
rising school enrollment and earlier retirement, while that of women would
have varied irregularly, with only modest growth under the opposing in-
fluences of falling fertility and rising school enrollment. The proportion of
the labor force engaged in farming would have fallen to 13 percent, with
a corresponding increase in urbanization of the population.
Uses of the Econometric Model
The standard profile depicts a long-run path of income and population that
is consistent with observed differences among modern nations. As such,
it is interesting in its own right, but, more important, it helps to isolate
and analyze the effects of policy measures designed to contribute to de-
velopment. For example, before we can evaluate the true effect of an offi-
cial program intended to reduce fertility, we must be able to distinguish
what is attributable to the program from what would be expected to occur
naturally in the course of development. But the historical development of
any one nation departs from that of the standard profile for any number
of reasons, of which the official program is only one. An unusually rapid
 Population Policy 315

decline in fertility, for example, might be largely the result, not of the offi-
cial program, but of an unusually rapid rise in income, or an accelerated
effort at education.
In the model, fertility is linked to child survival, education, income, ur-
banization, and religion by an equation statistically fitted to data from the
world cross-section of nations as of 1970. The contribution of each factor
to fertility decline is calculated by holding all others at their levels as of
the beginning of the decade and calculating the change in the total fertility
rate associated with the change in the factor in question. As shown in Ta-
ble 12.3, which gives the decomposition for each of the decades, the im-
portance of each factor varies along the profile. At early stages, education
exerts the most pressure on fertility, whereas at later stages increasing in-
come has more impact.
Since the standard profile is derived from a cross-section of countries
in the world today, it is important to compare its performance to actual
historical experience. Table 12.4 compares recent trends in the crude birth
rate for major developing regions of the world. In East Asia and in Latin

Table 12.3. Determinants of fertility decline

Initial Change Ean

fertility in Urbani- Edu-
Years (TFR)@ fertility zation cation Income _ Survival
10-20 5.01 0.30 0.05 0.17 0.04 0.04
50-60 4.00 0.26 0.09 0.04 0.09 0.05
90-100 2.81 0.38 0.02 0.01 0.35 0.01

a. The total fertility rate (TFR) reports the average number of live births were a woman ex-
posed throughout her childbearing years to the schedule of age-specific fertility rates cur-
rently in effect.

Table 12.4. Trends in the crude birth rate: Major regions and the standard
development profile
Years Total
Place 1955-59 1960-64 1965-70 1970-75 1975-80 change
Africa 46 47 46 46 47 -1
Latin America 43 41 39 36 33 10
East Asia 39 33 ep 26 22 U7.
South Asia 44 42 44 41 38
Profile 38 37 36 Ss) 34 4

Sources for regional data: United Nations, Demographic Yearbook (1978, 1985).
Note: Profile values are for years 0 to 15.
a. The crude birth rate is the number of births per 1,000 persons in a given year.
316 Andrew Mason and Lee-Jay Cho

America the crude birth rate has been declining substantially faster than
the standard profile. In South Asia, the rate of decline has been much nearer
to that of the profile, whereas there is no evidence of any fertility Hoots
at all among African nations during last 25 years.

Comparison of the Standard Profile

with Recent Experience in Korea
The fertility patterns embodied in the profile are those observed worldwide
as of 1970, and they are roughly representative of the situation in Korea
at that time, as well. The total fertility rate for Korea in 1970 was only 0.2
births per woman higher than predicted from its level of socioeconomic
development. Although the observed fertility level of 1970 accords well with
international experience, the rate of decline does not. Whereas the model
requires 30 years to reduce fertility by one birth per woman, the total fertil-
ity rate in Korea from 1960 to 1980 declined at the rate of one birth every
five years.
Korea's rapid decline in fertility is widely appreciated by those familiar
with that country’s demographic experience. Less well understood is why
the decline has been so rapid, but two sets of causes can be distinguished.
In the first place, model fertility declines in pace with the simulated aver-
age rate of economic development, but development in Korea has been more
rapid, and the rate of fertility decline has been correspondingly greater.
Second, cultural and other forces affecting fertility differ from those in the
rest of the world, and these unique features have caused fertility in Korea
to decline more rapidly than would have been expected, even given its ex-
ceptional rates of economic progress.
Table 12.5 separates the two sets of causes by comparing the total fertil-
ity rate recently observed to a corresponding rate calculated based on the
standard profile, given urbanization, education, per capita income, and child
mortality as of the same years. The rate of decline in the calculated values
is an estimate of the contribution of economic growth to fertility reduction,
and its difference from the observed decline constitutes an estimate of the
contribution of noneconomic factors. The contribution of economic growth
is, in turn, decomposed into the 0.03 per year reduction associated with

Table 12.5. The importance of rapid development for fertility decline in

Korea
Total Average annual
fertility rate rate of decline Decline associated with:
Esti- Esti- Normal Rapid Special
Date
a Actual mated Actual mated growth growth factors
eee
1960 6.54 4.60
1980 2.80 3.54 0.187 0.053 0.030 0.023 0.134
ee ee
 Population Policy 317

the rate of economic development along the development profile, and a

residual attributable to the more rapid development. As the table shows,
economic development accounts for only one-quarter of the observed
decline in fertility. This leaves a substantial component of fertility decline
associated with factors not taken into account in the standard profile.
Evidence from Household Data
The conclusion that rapid development, by itself, has not been sufficient
to generate the fertility decline observed in Korea is of sufficient impor-
tance to require independent confirmation. Data on 4,050 ever-married wom-
en are available from the Korean World Fertility Survey which describe
childbearing by women during the early 1970s. Analysis of these data,
reported in Koo, Phananiramai, and Mason (1986), substantiates both the
basic importance of economic development and the importance of elements
outside the development process detailed above.
Analysis of survey data permit age-specific fertility rates for Korean
women to be related to development factors one at a time. When age-specific
rates are summed over all ages, the result is the corresponding total fertil-
ity rate. Fertility rates calculated for women with selected characteristics
are shown in Table 12.6. The top three rows show age-specific rates for ur-
ban women with average child mortality experience in households where
both spouses have primary education. In the first row, however, household
income is taken at only 25 percent of the mean for the age-urbanization
group. In the second row, income is taken at the mean, and in the third
row, at two and one-half times the mean. Comparison of the calculated
values shows the effect of income differences, all other things held con-
stant. In similar fashion, other rows of the table permit examination of the
difference among women with different educational attainment, residence,
or child mortality experience.
As can be seen, fertility declines with rising income. The tenfold increase
in income from a level of 25 percent of the group mean to one 2.5 times
the mean is associated with a 4 percent drop in the total fertility rate; but
among women of ages 35 to 39 fertility declines by 17 percent, and by 30
percent among women of ages 45 to 49.
The total fertility of better-educated households is significantly lower than
that of the less well-educated. Education beyond primary school is associ-
ated with fertility rates about 10 percent lower than in households with
primary-school education only. Households with college-educated spouses,
however, display somewhat higher fertility than those with only secondary
education, although fertility is still lower than those with only primary edu-
cation.
Economic Development Versus Other Factors
The standard profile and the survey analysis are both attempts to estimate
the contribution of economic development alone to fertility reduction.
318
SSSSS
| Andrew Mason and Lee-Jay Cho

Table 12.6. Age-specific fertility rates? as calculated from survey data un-
der specified conditions, Korea
Total
Years of age fertility
15-19 20-24 25-29 30-34 35-39 40-44 rate (TFR)

Per capita GNP

.25 X mean 0.12 1.54 L5iL 0.89 0.31 0.10 4.47
Mean 0.11 1.54 1.50 0.87 0.30 0.09 4.41
2.5 X mean 0.11 1.54 1.49 0.83 0.26 0.07 4.30

Urbanization
Urban 0.11 1.54 1.50 0.87 0.30 0.09 4.41
Rural 0.10 1.14 1.45 1.13 0.67 0.34 4.83

Education (both spouses)

Primary 0.11 1.54 1.50 0.87 0.30 0.09 4.41
Secondary 0.10 1.03 Bee) 0.97 0.31 0.08 4.04
College 0.10 1.03 1.69 ac12 0.34 0.08 4.36

Child mortality
Mean 0.11 1.54 1.50 0.87 0.30 0.09 4.41
.01 below 0.11 153 1.50 0.87 0.30 0.09 4.40

Note: Except as indicated, all rates are calculated for urban women in households with aver-
age income and child mortality for age-urbanization group, and where neither spouse has
more than a primary education.
a. The age-specific fertility rate is the number of births in a given year to women in a certain
age group divided by the midyear population of women in that age group.

Comparison of these estimates with recent historical records yields new

insight into whether and to what extent the rapid fertility decline observed
in Korea involves something beyond economic development.
Table 12.7 presents three sets of estimates of Korea's total fertility rate.
The first row contains published estimates for 1970-75 and for 1955-60. The
second row contains estimates based on the survey data. For 1970-75, the
rates are legitimate estimates of actual total fertility, and any difference from
the corresponding estimate in the first row arises solely from differences
in estimating procedure and is unrelated to causal factors. For 1955-60,
however, the figures in the second row are estimated by carrying back the
analysis of the 1970-75 survey data, adjusted to match income, education,
urbanization, and percentage of women married in each nation as of
1955-60. The resulting 1955-60 estimates of marital fertility bear the same
relationship to income, education, and child mortality as those of 1970-75,
so any difference between the two reflects the influence of these factors
alone. But any difference between the average historical rate of fertility
decline as shown in the first row and the calculated average displayed in
 Population Policy 319

Table 12.7, Comparison of changes in the total fertility rate as estimated

by different procedures: 1955-60 to 1970-75

Average annual
1970-75 1955-60 decline
KIFP estimates 3.9 6.3 -0.16
WES estimates 4.1 4.94 -0.064
Cross-section 3.96 52° -0.086

a. Back projection based on marital fertility equations derived from World Fertility Survey data.
les, IVAS
AO).
KIFP—Korea Institute of Family Planning.
WFS—World Fertility Survey.

the second row is a measure of the extent to which factors other than eco-
nomic development have played a role in fertility reduction.
The influence of economic development isolated from everything else
is also estimated by evaluating the world cross-section relationship at the
levels of income, urbanization, education and child mortality observed in
1955-60 and in 1970-75, respectively, and inspecting the difference. The
results of these calculations are recorded in the third row.
Despite the great differences in data and methodology, the three esti-
mates of the 1970-75 level of the Korean fertility are quite close. The close
agreement of average annual rates of fertility decline within each country
as calculated from the survey analysis on the one hand and from the inter-
national cross-section on the other confirms that economic development
alone was responsible for an annual decline of .06 to .09 births. However,
the historical rate of fertility reduction was several times what can fairly
be attributed to economic development. One-half of the fertility reduction
actually observed during the period 1955-60 to 1970-75 must be ascribed to
factors other than development.
Noneconomic Factors in Fertility Reduction
For those who have extensively studied these countries and others like them,
neither the remarkable decline in fertility nor its weak relationship to so-
cioeconomic change can be any surprise. Cho, Arnold, and Kwon (1983)
summarize current evidence on fertility determinants in Korea by saying:
. . . economic and social development may be a fundamental cause of
fertility transition. However, the family planning program has expedited
the process. . . . Cultural factors, [such as] the absence of barriers to
ready acceptance of abortion and sterilization, cultural homogeneity in
ethnicity, language, and religious tradition, and geographic and polit-
ical unity, have contributed to rapid fertility transition. The character-
istics in turn promote social integration in the form of efficient
communication and shared values, norms, and institutions.
320 Andrew Mason and Lee-Jay Cho

A common thread in these discussions is the view that although social

and economic development underlies fertility decline, timing and pace are
strongly influenced by imperfectly understood diffusion processes that are
bound up in the interaction between population policy and cultural factors
(Knodel 1977; Freedman 1979; Retherford and Palmore 1983). Furthermore,
cogent arguments have been made that change in the family and in the
roles of its members is responsible for rapid fertility decline. Caldwell (1976),
in particular, points to “Westernization’—which has proceeded largely in-
dependently of social and economic development—as the motivating force
in the nucleation of families and the decline in the value of children and
family size. Ben-Porath (1980) and Willis (1982) point to changes in the fam-
ily institution more closely linked to social and economic development.
Fertility Decline and Economic Development
No discussion of population policy is complete without consideration of
the contribution of fertility decline to economic development. Korea's popu-
lation policy first began to have a noticeable impact on the structure of the
population after 1966. Between 1960 and 1966, the number of dependents
(those under 15 or over 65 years of age) per working age adult (those be-
tween 15 and 64 years) actually increased from 0.83 to 0.89. But after 1966
the so-called dependency ratio actually declined, falling to 0.71 by 1975 and
to 0.53 in 1985. The original framers of Korea’s population policy were moti-
vated by the belief that slower population growth and the declining de-
pendency ratio would play a key role in their efforts to achieve rapid
economic development. To what extent has this view been supported by
subsequent events?
As described more fully elsewhere in this volume, Korea's basic develop-
ment strategy has been to exploit its comparative advantage, principally
a skilled, low-wage labor force, via a policy of vigorous export promotion.
In several key ways, demographic change has complemented this develop-
ment approach. First, because the onset of fertility decline does not affect
the size of the working age population for at least 15 years, fertility decline
has no immediate adverse impact on the size of the labor force. Moreover,
the decline in childrearing responsibilities frees women to participate more
fully in the labor force (Bauer and Shin 1986). Thus, labor force growth
has been rapid throughout most of the last 25 years. Between 1975 and 1980,
for example, the number of workers grew at an annual rate of 2.9 percent.
Korea is now beginning to experience slower growth in the number of
workers. Between 1980 and 1984, for example, employment rose at an an-
nual rate of only 1.3 percent. As labor force growth continues to slow and
wages rise, Korea will have to continue its shift into industries that are less
dependent on low-cost labor.
A second path by which fertility decline has affected Korea's develop-
ment prospects has been through its impact on education. Korea has ex-
 Population Policy 321

panded its educational system at a rapid pace in the last two decades so
that Korean students are unusually well-educated for living in a country
with Korea's material standard of living. Fertility decline, by reducing the
number of school-age children, has either reduced the fiscal burden of
Korea's educational system or allowed the application of more educational
resources to each student, or both. One recent study presents evidence that
fertility decline in Korea has resulted in higher rates of enrollment, partic-
ularly at the secondary level, and greater expenditures per student than
would have prevailed under a high fertility regime (Suits and Mason 1986).
Finally, available evidence indicates that fertility decline contributed to
the substantial rise in domestic saving in Korea after 1960. In 1962, gross
domestic savings amounted to only 3 percent of GNP and the lack of in-
vestable funds was considered a key bottleneck to Korea's development ef-
forts. Over the last two decades, however, saving has risen gradually but
steadily so that by 1985 gross domestic savings were close to 30 percent
of GNP. A number of factors contributed to this rise, but close to one-third
of the increase can be attributed to changes in the age structure of the popu-
lation resulting from fertility decline (Mason 1986a).
CONCLUSIONS
Korea's population policy is of great interest to those trying to formulate,
implement, and improve family planning policy in other developing coun-
tries. It is of particular interest because Korea represents one of the great
success cases of the developing world. In the early 1960s Korean policymak-
ers chose, as their goal, rapid fertility decline to slow population growth.
They chose this goal in the belief that it was integral to their efforts to achieve
rapid improvements in the material standard of living of the Korean peo-
ple. It is evident that, 25 years later, these multiple goals—rapid economic
growth and slow population growth—have been achieved. But exactly how
these achievements are interconnected is less evident.
The evidence presented here demonstrates that much of Korea’s fertility
decline is a consequence of the modernization and development process
to which Korea has been exposed. Child mortality has dropped, education
has improved, people have moved to cities, and incomes have risen. As
these changes occurred, and occurred with great rapidity, women chose
to limit their childbearing. Yet despite the great social and economic changes
that Korea has undergone, they are insufficient to account for the speed
with which childbearing has declined. The available information indicates
that socioeconomic development, in and of itself, accounts for less than
half of Korea's fertility decline.
Korea's population policy has facilitated the family planning impact of
development by providing contraceptive services to millions of women who
have chosen to limit their childbearing over the last 25 years. Just as im-
portant, the family planning program has been successful in educating the
322 Andrew Mason and Lee-Jay Cho

public about family planning techniques, increasing the availability of ser-

vices, and influencing attitudes about contraception and childbearing.
We can point to a number of features that have contributed to Korea's
family planning success.
1. Constancy of effort. From the inception of the family planning program
in the early 1960s, Korea has actively pursued its objectives. For the most
part, this effort has not been disrupted by outside events or policy reversals.
2. Broad-based attack. Korea has not taken a narrow approach to family
planning, limiting its efforts to the mere promotion of a “public health”
program. Rather, it has mobilized many segments of society—public and
private, economic, social, legal, and cultural—to achieve its single-minded
purpose of reducing fertility.
3. Pragmatic approach. The family planning program has been continu-
ally scrutinized and successful approaches were emphasized while failures
were abandoned.
4. High-level support. The success of family planning has been of interest
at the highest levels of government. The political will has been present to
mobilize the necessary resources and to sweep away impediments to achiev-
ing program objectives wherever they have existed.
Korea's program is not, of course, transplantable in its entirety. There
are cultural and social features of Korea that are present to a greater or to
a lesser extent in other countries. Nonetheless, Korea's experience does pro-
vide some important lessons to those trying to frame and to implement
successful population policy in other developing countries of the world.

APPENDIX 12.1
Population Policy Chronology

1961 © Adopted national family planning program policy as a part of eco-

nomic development plan starting in 1962
e Abrogated the law prohibiting importation and domestic produc-
tion of contraceptives
e Established the Planned Parenthood Federation of Korea (PPFK)
as a nongovernmental voluntary organization
e Adopted family planning slogan “Have few children and bring
them up well”
1962 ¢ Started the national family planning program under the jurisdic-
tion of the Ministry of Health and Social Affairs (MOHSA) through
the government's health service system
e Established a family planning counseling room and assigned two
family planning workers to each of 183 health centers
° Started training programs on vasectomy procedures for family
planning workers and for physicians
 Population Policy 323

¢ Introduced vasectomy, condoms, and jelly into the national pro-

gram
1963 Established the Maternal and Child Health (MCH) Division under
the Bureau of Public Health, MOHSA
Assigned two additional family planning senior workers to each
of 183 health centers
1964 Assigned a family planning field worker at each of 1,473 town-
ship health subcenters
Started training program on IUD insertion for physicians and
introduced IUD into the national program
Introduced family planning mobile teams to cover remote areas
1965 Established Family Planning Survey and Evaluation Team in
MOHSA
1966 Included family planning target system in the national program
1968 Organized family planning Mothers’ Clubs throughout the
country
1971 Established the Korean Institute for Family Planning (KIFP)
Adopted family planning slogan “Stop at two regardless of sex”
72 Strengthened government family planning program organization
by establishing the Bureau of MCH in MOHSA
1973 Promulgated Maternal and Child Health Law providing legal
grounds for induced abortion under certain medical conditions
or for psychiatric reasons
Allowed IUD insertion by paramedics
1974. Initiated special urban family planning projects
Introduced menstrual regulation service into the national program
Introduced social support policy measures—income tax exemp-
tion for up to three children and population education project
1975 Started training program for physicians on female laparoscope
sterilization procedures
Established the Korean Association for Voluntary Sterilization
(KAVS) as a voluntary organization
1976 Introduced female sterilization into the national program
Established the Population Policy Deliberation Committee (PPDC)
under the deputy prime minister
Assigned a male information officer at each of 138 county health
centers
324 Andrew Mason and Lee-Jay Cho

1977 Allowed income tax exemption for up to two children only

Exempted corporation tax for corporations’ expenditures for fam-
ily planning services to employees
Revised family law concerning women’s property inheritance
Integrated Mothers’ Clubs into Saemaul Women’s Association
Included population education in the high school curriculum
1978 Gave priority in allotting public housing to sterilization acceptors
with one or two children
Exempted raw materials imported for the manufacture of con-
traceptives from tariffs
Adopted family planning slogan “A well-bred girl surpasses ten
boys”
Included population education in the middle school curriculum
1979 Included population education in the primary school curriculum
1980 Reduced child delivery charges for sterilization acceptors after sec-
ond delivery in public hospitals
1981 Issued 49 innovative policy measures to place great emphasis on
social support policies and activation of family planning programs
Established the Family Health Division in MOHSA to integrate
the division of Family Planning and Maternal and Child Health
Upgraded health workers’ status from temporary workers to regu-
lar health officials
Inaugurated the Korea Institute for Population and Health (KIPH)
by integrating the Korean Institute of Family Planning and the
Korean Health Development Institute
1982 Reorganized Family Planning Sections of provincial governments
making them Family Health Sections covering family planning and
maternal and child health services
Provided sterilization and menstrual regulation services through
the medical insurance systems
Gave priority of livelihood loans for the needy and housing loans
to sterilization acceptors with one or two children
Provided monetary subsidies to low-income sterlization acceptors
to compensate for lost wages
Provided free primary medical services at the health centers for
the children up to five years of age of sterilization acceptors with
one or two children
 Population Policy 325

Implemented pilot projects: monetary incentive for sterilization

acceptors with one or two children and introduction of new con-
traceptive methods—the copper-T and foam tablets
1983 e Provided family and education allowances for government em-
ployees with up to two children
Provided medical insurance delivery allowance for the first two
deliveries only
Introduced copper-T into the national program
Provided IUD services through medical insurance system
Established family planning evaluation unit at the provincial level
and local health centers
Assigned an additional male information officer to each of 85 city
health centers
Introduced new family planning slogans “Even two are too many”
and “Have one child with happiness and love”
Lowered sterilization age range for women from ages 15-44 to
15-34 years
1984 e Provided mid- and long-term loan priority for public housing to
the sterilization acceptors with one child
e Revised regulation banning the employment of female ship crews
e Expanded medical insurance benefit to the parents of married fe-
male employees
1985 e@ Provided free delivery service through the clinics and maternal
and child health centers for women who want only one child
e Provided free medical service for children below six years of age
and hepatitis vaccination for children below four years of con-
traceptive acceptors with only one child
e@ Designated the private pharmacists as “demonstration drug store
for family planning counseling”

Source: N. H. Cho (1986).

 yore é @
REED Aerio

lft.

ff7
 13 The Health Insurance Scheme
by Chong Kee Park

The record of growth of material wealth in Korea over the past two decades
has been impressive. But with its increased living standard and the inter-
nal strains that rapid economic growth has generated, Korea is confronted
with newly emerging problems in the social sphere. Among these problems
are a discrepancy between economic and social development, an imbalance
in the distribution of income and wealth among social groups and among
different regions, and the various pressures arising from rapid urbaniza-
tion. These growth-induced phenomena are likely to multiply unless coun-
teracted by specific policies and measures.
During the first 15 years of the nation’s five-year development plans,
which began in 1962, the nation’s scarce resources were devoted mainly
to rapid economic growth, whereas social development was given low pri-
ority in the allocation of resources. In the pursuit of a “growth first and
distribution later” development strategy, the government gave greater pri-
ority to industrialization and economic growth in general than to equity
and social development.
Not until the Fourth Five-Year Economic and Social Development Plan
(1977-81) did the government begin to recognize that economic growth can-
not be regarded as satisfactory if rising output and income are not shared
by wider segments of the population. The Fourth Plan identified equity
as one of the three guiding principles of the plan and promoted social de-
velopment as one of its basic goals. No previous five-year plan had accorded
such eminence to social development. The Fourth Plan, which placed in-
creasing emphasis on development in the social sector, therefore represents
a significant departure from the growth-first distribution-later priorities of
previous plans. As a result, during the second half of the 1970s Korea be-
gan to witness a gradual shift in policy emphasis from rapid industrializa-
tion to broader social development.
During the late 1970s, the use of catch phrases such as “the prosperous
eighties” and “the welfare state” greatly stimulated expectations of the so-
ciety as a whole and raised levels of aspiration of the under-served and
the underprivileged, in particular. Yet, in the actual allocation of the na-
tion’s resources, the social development sector continued to lag behind eco-
nomic development, and popular expectations in many social development
areas remain largely unfulfilled. The social development programs actu-
ally adopted and implemented during this plan period covered only lim-
ited areas of manpower development, education, and health; and not

327
328 Chong Kee
pemraiidsc: at aPark eee a ee ee Ee ee
enough investable resources were provided to support other areas of so-
cial development.
It is important to recognize that social development does not take place
in a vacuum. Neither the type of social problems we are concerned about
nor their ultimate solutions are of a purely social nature. The process of
social development is as much affected by economic and political consider-
ations as by social welfare factors. One of the objectives of social develop-
ment is to provide an opportunity for each member of society to participate
in economic and social progress and to attain a decent standard of living.
But in Korea an institutional structure is lacking through which a greater
number of people could participate equally in the rapidly expanding in-
dustrial base of the economy, and this has been one of the causes of the
inequitable distribution of developmental benefits.
The predominant policy role of the Korean government in the nation’s
economic affairs has been widely recognized, and various government eco-
nomic policies have had important social consequences. Economic policies
and measures that the government adopted to accomplish specific economic
objectives in the process of rapid growth and industrialization have often
served to perpetuate the economic power of the upper stratum of Korean
society. The export-oriented, rapid industrialization policy provided rela-
tively greater economic benefits to the entrepreneurial group constituting
this upper stratum and relatively fewer benefits to those who were on the
outside and had to make their way without benefiting directly from govern-
ment policies. Undoubtedly, this trend helped bring about greater concen-
tration of the ownership of wealth and restricted the pattern of income
distribution in Korea.
Korea's urban-oriented industrialization policies have also caused im-
balances in the geographic distribution of the benefits of economic progress,
with resultant undesirable social and political consequences. When a largely
agricultural country is so rapidly transformed by export-oriented industri-
alization, it is the cities that will reap the lion’s share of the benefits in the
short term. Rural people have gained relatively less access than urban
dwellers to the social benefits of economic prosperity because the prepon-
derance of investment has been in the industrial sector of the economy.
The high rate of return on capital investment in Korea's industrial urban
sector has, moreover, made private investment in rural areas less attractive
than ever. Although the government has tried to promote rural develop-
ment, especially through the Saemaul movement (the self-help commu-
nity program discussed in Chapter 16), rural people still do not have access
to the hospitals, schools, and similar benefits that the urban population
has come to enjoy during the recent period of rapid industrialization.
Today, as in the past, regional disparities exist in the availability of edu-
cation, health care, and other services. The concentration of educational
institutions and health facilities in urban areas is a factor that does not con-
 The Health Insurance Scheme 329

tribute to the objectives of more equal distribution and, if not corrected,

will retard the full development of human resources. It has also created
additional pressures on the rural population to intensify the already rapid
urbanization that has been taking place in Korea. The recent massive migra-
tion of rural people to urban areas was prompted in part by the widening
urban-rural differential in the quality of life, and not solely by the availa-
bility of jobs.
The primary purposes of this study are to examine the health insurance
scheme of 1976 in the light of recent changes in social and economic condi-
tions in Korea, and to identify the lessons that can be learned from the
Korean experience with national health insurance. To provide a wider per-
spective on the historical context in which this policy measure was taken,
however, and to assess the major effects of the health program within the
broader framework of national policies for socioeconomic development, it
will be instructive to outline first some of the other social development pro-
grams of the 1960s and 1970s.
OTHER SOCIAL DEVELOPMENT POLICIES
Improvements in social welfare through the early 1970s can be attributed
not so much to the planned expansion of social development expenditures,
but rather to development strategies and policies that resulted in expanded
employment opportunities and to concomitant increased investment in so-
cial infrastructure. In contrast to other countries at similar levels of income,
Korea has committed a much smaller proportion of government expendi-
ture to health, housing, income security, and other social services. Social
development expenditure during 1976-78 (Table 13.1), for example, was given
relatively high priority by the governments of Brazil (accounting for 51.5
percent of total government expenditure), Mexico (45.6 percent), Malaysia
(33.2 percent), and Turkey (27.6 percent). The lower priorities given to such

Table 13.1. Comparisons of government expenditures on social develop-

ment, by country: 1976-78 averages (%)
Social Per capita
security Total, GNP,
Educa- and excluding 1978
Country tion Health welfare Other Total education (US $)
Brazil 6.2 Toe 37.6 0.6 BS 45.3 1,510
Mexico 19.2 4.2 22.0 0.2 45.6 26.4 1,400
Malaysia 21.7 6.5 2.8 24 33.2 1 L150
Turkey 20.1 2.4 2, Pd) 27.0 ae) 1,250
Korea 15.6 Lo 4.7 0.7 22.5 6.9 1,310
Taiwan 6.4 ial WLS 20.0 13.6 1,453

Sources: IMF (1981); IMF (1978-80).

330 Chong Kee Park

services in Korea (22.5 percent) and Taiwan (20 percent) during the same
period can be partly explained by heavier national defense burdens. If edu-
cation is excluded, however, the magnitude of difference among all these
countries is even bigger, ranging from a high of 45.3 percent in Brazil to
a low of 6.9 percent in Korea.
The composition of government expenditure in Korea has undergone
considerable change since 1961, but public spending on social development
has always been less than that on economic development. Moreover, the
share of social development in total government expenditure declined from
21.5 percent in 1963 to 20.7 percent in 1980 (Table 13.2). Government sup-
port of health and other social development programs has never been sub-
stantial in Korea, and the government has left the provision of these services
largely to the private sector (Mason et al. 1980).
Housing
Government investment in housing has been low. The public-sector con-
tribution to the nation’s housing supply increased gradually after 1965, ac-
counting for an average of about 30 percent during the Fourth Five-Year
Development Plan of 1977-81 (KNHC, Housing Policy Development Research,
1983:315). Only a small proportion of total public-sector housing investment
funds was allocated for low-income housing, however, and government in-
vestment in low-income family housing in urban areas has been lagging,
especially in view of the rapid urbanization occurring since the mid-1960s.
Two major problems retarding development of low-cost housing are the
high cost of money and property price escalation spurred by real estate
speculation. A third problem is the difficulty of obtaining housing loans.
Institutional arrangements are needed to ensure that affordable housing
is available to low-income families, possibly through government-guaranteed
mortgages at low rates of interest.

Table 13.2. Distribution of government expenditures on economic and

social services: Selected years (% of total expenditures)

Item 1963 1968 1975 1980

Social services (total) 25 227 2225 20.7

Education 13.4 16:1 14.7 14.9
Health 1.1 0.9 0.6 1.0
Social security and welfare 5.3. 4.8 6.3 3.4
Other, including housing Let 0.9 0.9 1.4

Economic services oe ie| 32.4 33.5 2727,

Source: BOK, Economic Statistics Yearbook (1964-81).

 The Health Insurance Scheme ool

Education
During the 1960s and 1970s, the majority of social development expendi-
ture was devoted to education, and only a small fraction was allocated to
health, housing, and other social services (Table 13.2). Social development
programs, for example, constituted just over one-fifth of government ex-
penditure in 1980, with 14.9 percent of total expenditure going to educa-
tion and the remaining 5.8 percent going to non-education programs.
Despite the preponderance of education in the overall government alloca-
tions for social development, public expenditure on education has remained
relatively low (about 3 percent of GNP) in recent years. The government
share of in-school expenditure (the expenses incurred in the construction
and operation of schools) declined from 57 percent in 1971 to 51 percent
in 1976, leaving the increased share of the financial burden to private house-
holds (KDI 1980a; McGinn et al. 1980). However, even though privately
financed education has become increasingly important, government expen-
diture on education has increased in real terms because the student popu-
lation remained relatively constant while GNP was growing rapidly during
the 1970s.
Pension Programs
Korea's fragmented social security programs originated in the early 1960s.
The first social welfare legislation was the Livelihood Protection Law of 1960,
which remains in force as the basic legal instrument for present-day public
assistance programs for the poor. There are two major groups of persons
entitled to receive public assistance under this law: (1) those unable to work
(persons 65 years old and over, children under age 18, and the mentally
and physically handicapped) and (2) deserted, pregnant women and those
regarded as absolutely poor. Eligibility conditions require first that a per-
son in either of the above categories not have a legal guardian (or the legal
guardian not be capable of supporting the person) and second that the per-
son’s combined income and wealth not exceed a fixed ceiling (set annually
by the government).
This law was followed by the Civil Service Pension Law in 1960 and the
Military Pension Law in 1963. By a separate law enacted in December 1973,
university professors and teachers in private educational institutions were
provided with either pension or lump-sum benefits to replace the income
loss resulting from old age, disability, and death. The nature and scope
of benefits provided under this law are very similar to those provided un-
der the civil servants’ pension program, which covers teachers in the pub-
lic institutions. By the second half of the 1970s, therefore, retirement benefits
were available to at least a limited segment of the population comprising
civilian officials, military personnel, and the teaching profession. One con-
sequence of the implementation of these three pension laws is that a large
portion of government funds allocated annually for social security purposes
332 Chong Kee Park

is automatically committed to former public-sector employees. The re-

mainder is divided among a variety of other social security programs—
broadly defined to include social insurance, public assistance, veterans’
relief, and social welfare institutions. In 1979, for example, government
spending on all social security programs was 328.9 billion won (Table 13.3),
which represented a mere 1.1 percent of the 29,357 billion won GNP in
that year. Expenditures on the pension schemes and veterans’ relief ac-
counted for 45 percent of social security expenditures that year, therefore,
only a small fraction of 1 percent of GNP was available for allocation among
all other social security programs.
The social security system inherent in Korea's tradition of extended fam-
ilies has tended to deteriorate rapidly in the increasingly urbanized and
industrial society of recent decades, and yet it is not being replaced at the
same rate with alternative social welfare institutions and systems. The Na-
tional Welfare Pension Law was originally conceived to fill such a gap. The
avowed purpose of this system, as stated by the Ministry of Health and
Social Affairs (MOHSA) in the December 1973 draft of the law, was “to con-
tribute to the promotion of the secure life and welfare of the people” by
providing protection to workers and their families against loss of earnings
resulting from retirement, death, or disability. The National Welfare Pen-
sion Law represented the first expression of a changed direction in public
social welfare policy and gave promise of being the first step toward the
development of a manageable social security system for all Koreans.
The law envisaged a national welfare pension program that would pro-
vide four types of benefits to workers in firms with at least 30 employees.
Table 13.3. Estimated social security expenditures: 1979
Amount Percentage
Item (10° won) of total
Social insurance 223.4 67.9
Old-age pension insurance
Government officials 52.9 16.1
Military personnel 39.6 12.1
Professors and teachers 3.2. 1.0
Medical insurance 73.9 2215
Industrial accident insurance 53.8 16.3
Public assistance 99.7 30.3
Veterans’ relief Cy2 il 15.8
Other public assistance 47.6 14.5
Social welfare institutions 5.8 1.8
Total 328.9 100.0
Source: C. K. Park (1981).
 The Health Insurance Scheme 0 f3}9)

Persons who attained insured status would be entitled to receive retirement

benefits for themselves and dependent benefits for their spouses and chil-
dren. When the insured died, survivor benefits would be paid to the sur-
viving spouse, children, or dependent parents. Benefits would likewise be
paid in the event of serious disability. The law also provided for a lump-
sum payment to persons not qualified to receive pension benefits. The for-
mula by which these benefits would be calculated is weighted to replace
a greater proportion of preretirement earnings for low-income earners than
for persons at the upper end of the income scale (C. K. Park 1975).
The National Welfare Pension Law was enacted in December 1973, at a
time when the nation’s policymakers were already grappling with foresee-
able adverse effects of the recent Middle East war and oil shock on the
Korean economy. The Presidential Emergency Decree of January 1974,
promulgated in the wake of the worldwide energy crisis, postponed the
implementation of the newly enacted pension program because the govern-
ment feared that an attempt to finance this nationwide scheme would ex-
acerbate the economic downturn. Thus, although this was one of the most
important and comprehensive of the government's social development in-
itiatives in the early 1970s, the law was not brought into force until 1 Janu-
ary 1988.
Industrial Accident Insurance
As in most other countries, the provision of medical care and the better-
ment of the financial plight of victims of industrial accidents and occupa-
tional diseases received early attention by the Korean government. The
Industrial Accident Insurance Law, enacted in November 1963, applies to
firms with 16 workers or more. In certain types of hazardous employment,
such as mining, chemicals, and plastics, however, the compulsory cover-
age extends to enterprises with a minimum of only five employees. The
benefits provided under this compensation program are broadly classified
into medical benefits and cash benefits. The medical benefits provide full
medical and hospital care to injured workers until they recover completely.
The cash benefits are divided into those for temporary sickness and those
for disability. If a temporary injury prevents an employee from working
while receiving medical care, the employee receives cash benefits equal to
a specified proportion of regular earnings. The second type of cash benefit
is provided in cases of permanent disability. Severely disabled workers have
a choice of either a pension or a lump-sum payment. The program pro-
vides lump-sum payments to less severely disabled persons and also to
the survivors of any worker who dies as a result of an industrial accident
(Park et al. 1981). The industrial accident insurance program, which has
a relatively long history, is generally considered one of the most success-
fully operated social security branches in Korea.
334 Chong Kee Park

HEALTH INSURANCE PROGRAM:

ENACTMENT AND IMPLEMENTATION
During the mid-1970s, the government identified health care as a priority
area. Better health standards contribute to national economic progress
through the improvement of the quality and productivity of the labor force
by reducing absenteeism, debility, and disability of individual workers. The
high private cost of basic minimal health care, however, works against
egalitarian objectives and discriminates against low-income groups. Heavy
reliance on private expenditures in areas of basic needs such as health care
and compulsory education does not contribute to the elimination of inequal-
ities so long as overall per capita income is still relatively low. A national
health care program therefore came to be seen as an essential element of
socioeconomic development policy. With the acknowledgment that health
care is a basic necessity of life along with food, clothing, and shelter, it be-
came not only one of Korea's most important social issues but also a focal
point of the social development component in the Fourth Five-Year Develop-
ment Plan.
The enactment in 1976 of the medical assistance program for the poor
and the national medical insurance scheme for the general population
represent the beginnings of a stepped-up evolutionary process of social de-
velopment in Korea. The primary purpose of the noncontributory medical
assistance program that was put into effect in January 1977 is to provide
adequate medical care to those without the means to pay. The beneficiaries
are the indigent (those who receive public assistance under the Livelihood
Protection Law) and persons whose incomes fall below a certain level (iden-
tified annually by local government authorities). Under the medical as-
sistance program, recipients are eligible to receive both ambulatory care and
hospital treatment free of charge. Low-income persons are also entitled to
receive free ambulatory care, but only one-half of their hospitalization costs
are paid by the government (and the recipients have to provide reimburse-
ment for the remaining half within three years).
Under the Medical Insurance Law enacted in December 1976, Korea em-
barked on a nationwide, comprehensive medical insurance program. As
stated in the first article of this law, the program was designed to “improve
national health and enhance social security by facilitating access to medi-
cal care in the event of illness, injury, childbirth, or death.” In its coverage
and impact, the new law represented the first comprehensive social secu-
rity program in the nation. Its enactment was thus a landmark in the his-
tory of Korea's social legislation. The implementation of this law began in
July 1977, and the health insurance program has subsequently played an
important role in promoting medical care to more effectively meet the health
needs of the working population.
The Medical Insurance Law established a two-part program including
(1) a plan requiring employers with at least 500 workers to provide speci-
 The Health Insurance Scheme 335

fied medical insurance benefits for their employees and their dependents
(Class I), and (2) a voluntary community-based plan providing medical in-
surance for all others (Class II). In January 1979, complementary legisla-
tion extended compulsory insurance coverage to government officials,
teachers, and the ancillary staff of private schools. Beginning in January
1980, coverage by this insurance scheme was extended also to dependents
of military personnel. Although eligibility under Class I is still available only
to the personnel of companies or organizations employing at least the mini-
mum number of persons fixed by government regulation, the legal mini-
mum has been reduced over time so that it covers, for example, companies
with as few as 10 employees. All others, including the self-employed and
persons working for companies that have fewer than the legal minimum,
are grouped under Class II.
The medical insurance law provides broad medical and maternity benefits
such as medical examinations, pharmaceutical supplies, surgery, hospital-
ization, nursing, and ambulance service. The insurance program is ad-
ministered by the health insurance societies established for the workers in
enterprises and industrial parks, and in the case of the self-employed and
others (Class II) by the community-based insurance societies set up in
county, town, and city administrative districts. The scheme is financed by
a fixed percentage (3 to 8 percent) of the payroll, up to a certain ceiling,
collected as a premium from the employer. Half of this premium must be
charged to the employee. The government contributions to the system are
limited to defraying the administrative costs.
Medical care is delivered through purchase of services from existing med-
ical practitioners and facilities. The providers of services are reimbursed
(subject to coinsurance) by the insurance societies on the basis of a speci-
fied fee for each service rendered. The standard fee schedule for each com-
ponent of services provided under the medical insurance scheme is set and
occasionally adjusted by MOHSA in consultation with the medical profes-
sion. As in most other countries with medical insurance schemes where
the cost-sharing provision is enforced, patients covered by the insurance
program in Korea also share a part of the cost of medical care services. The
Medical Insurance Law of 1976 provided that the patient share up to 40
percent of the cost of outpatient care services and up to 30 percent of
hospitalization costs.
Institutional Setting
With increasing emphasis on equity and social development, Korea wit-
nessed a major change in concern about the health of the people during
the second half of the 1970s. There was a growing awareness among
economists and planners of the importance of health care in development
strategies for meeting basic needs. The president stressed the importance
of expanding the accessibility of health care services to the underprivileged,
336 Chong Kee Park

by stating that health care is the “fourth basic necessity of life” along with
food, clothing, and shelter. This change was also manifested in a five-year
health sector loan agreement signed between the government of Korea and
the United States Agency for International Development in September 1975.
One of the major purposes of this agreement was to strengthen the capa-
bility of the government to plan, implement, and evaluate a low-cost health
care delivery scheme directed primarily toward under-served communities
(Park and Yeon 1981).
For the first time, Korea became actively engaged in major planning aimed
at improving the organization, delivery, and financing of health care ser-
vices. A new health development strategy was incorporated in the crea-
tion of the National Health Council, the National Health Secretariat in the
Korea Development Institute, and the Korea Health Development Institute.
The ultimate objective of these sector-planning efforts was to provide ac-
cess to adequate medical care regardless of income, age, or place of resi-
dence. A related objective was the provision of quality health care with
reasonable efficiency.
The absence of a well-coordinated mechanism for planning and allocat-
ing resources in the health sector attested to the low priority that this sec-
tor had been accorded in previous development plans. In the initial stages,
the government did not have adequate experience with institutional arrange-
ments, and the public sector would not have been entirely dependable. But
because private organizations had been relied upon for the provision of
health services for so long, investments of scarce resources were made
without an appropriate framework of socioeconomic development goals.
A coordinated national health development strategy might have enabled
the government to assign priorities to investment projects in accordance
with their expected benefits and impact on equity.
At the same time, fragmentation of responsibilities and authority among
government ministries and agencies has often resulted in inefficiency and
waste of scarce resources in the management of health services in Korea.
MOHSA has responsibility for broad health policy coordination through-
out the nation. The responsibility for administering programs that substan-
tially affect health, however, are scattered among several other ministries
as well. The Ministry of Home Affairs, for instance, is responsible for financ-
ing and operating a network of provincial and municipal hospitals and
health centers. The Ministry of Education has the administrative responsi-
bility for universities and other institutions training medical professionals
and other types of health-care manpower. Finally, the Economic Planning
Board (EPB) has the overall responsibility for national development plan-
ning and resource allocation.
To provide a coordinating mechanism among the health programs of the
various operating agencies, the National Health Council (NHC) was estab-
lished at the cabinet level in 1976. The membership of this council was com-
 The Health Insurance Scheme 337

posed of the deputy prime minister (concurrently minister of the EPB) as

chairman, the minister of health and social affairs as vice-chairman, the
minister of home affairs, the minister of education, and three private
citizens. The NHC was created to provide an effective forum for policy coor-
dination, resource allocation decisions, and implementation for the health
sector. The National Health Secretariat (NHS) was set up within the Korea
Development Institute (KDI), which is operated under the aegis of the EPB,
to provide inputs and resources to the council for sound planning and oper-
ation. The Korea Health Development Institute (KHDI) was also created
to develop low-cost health delivery schemes and to engage in microlevel
health planning research.
Thus the institutional basis for coordination in health planning and im-
plementation was well established, and the birth of this innovative setup
linking three new institutions—NHC, NHS/KDI, and KHDI—was greeted
by researchers, health experts, and other interested groups as a highly
desirable development in the health field in Korea. However, because of
the lower priority given to health issues and problems by policymakers in
ministries other than MOHSA, this coordinating mechanism was not fully
utilized. Although an initial meeting was held to organize the NHC for-
mally, the council met only twice during the ensuing years and no serious
health policy problems were resolved during the meetings. As one observer
put it in 1980,
. . . the present composition of the council seems top heavy for the
amount of time that has to be spent on this work. It seems too burden-
some for the deputy prime minister and other key ministers . . . Look-
ing at the large task ahead the council may require the full-time service
of a distinguished chairman so that the intensive planning exercise can
be launched successfully (Clarkson 1980).
Although the NHC has been criticized as being inactive or indifferent
in the face of mounting health problems, the system itself has produced
some positive results. It provided an opportunity for NHS/KDI economists
to participate in a wide range of interdisciplinary research dealing with crit-
ical health policy issues and to interact with health researchers from the
academic community and medical organizations, as well as with MOHSA
officials at the working level. The active involvement of the NHS/KDI in
interdisciplinary health research and policy planning has not only facili-
tated cooperation (which had previously been lacking) between research-
ers and policymakers, and between economic planners and health planners,
but also made significant contributions to the design and implementation
of a number of important health policy measures.’

1. Ina study commissioned by the minister of health and social affairs in 1978, for example,
the NHS/KDI strongly recommended that local hospitals, run by city and provincial govern-
ments as government agencies, be managed by a newly created independent institution un-
der the broad supervision of MOHSA. The study served as a broad basis for extensively
reforming city hospitals in Seoul in 1982 (NHS, ROK, 1978).
338 Chong Kee Park

Health Care Delivery System

The nation’s health resources became concentrated in the urban areas be-
cause the higher population density and the relative affluence of urban
dwellers created a greater effective demand for such services, as compared
with the rural sector. It is estimated that in the mid-1970s almost 87 percent
of physicians and 90 percent of medical facilities were in urban areas,
although only about half of the nation’s population resided in those areas
(C. K. Park 1979). Furthermore, there was little organized delivery of primary
health care services within the system. The expansion of the health deliv-
ery system has followed the traditional pattern of emphasizing a high degree
of specialization in the training of physicians, thus limiting the number of
physicians available for primary care. Not surprisingly, under the growth-
first distribution-later philosophy that pervaded the early 1970s, the modern
hospitals in urban centers prospered and benefited from the most advanced
medical technology available, while primary health care services in the rural
areas lagged far behind.
Although innovations of less traditional, low-cost alternative approaches
to the delivery of health services to the rural and urban poor have been
widely discussed, their use has been substantially limited because of the
influence of organizations with vested interests in preserving the traditional
methods. There was, however, a growing feeling in the mid-1970s that the
climate was suitable for the gradual introduction of these innovative
methods. Thus KHDI was created in April 1976 to demonstrate and test
these innovative approaches, often referred to as a community-based
primary health care system (KDI 1980b).
The basic purpose of the KHDI demonstration project was to improve
the delivery capacity of the public rural health system so that it would pro-
vide curative as well as preventive and promotional services to at least two-
thirds of the rural residents. This system makes maximum use of the new
types of health personnel, such as community health practitioners, com-
munity health aides, and village health agents, who operate at different
levels in the community.
In this connection one of the important tasks assigned to NHS/KDI
was to conduct an economic analysis and evaluation of the implementa-
tion and outcome of the KHDI demonstration project. Four specific evalu-
ation objectives were: (1) to assess the performance of three new types
of health personnel and to study the operation and management of the
health care delivery system; (2) to measure the cost-effectiveness of the
demonstration projects in three areas and to test for economies of scale;
(3) to measure the accessibility to and acceptance of health services by con-
sumers in the three demonstration areas; and (4) to assess the financial,
social, and administrative feasibility of replicating nationwide the key fea-
tures of the health delivery system developed by the KHDI project (Yeon
1981).
 The Health Insurance Scheme 339

Cost and Financing

Throughout the mid-1970s much attention was focused on the rising cost
of medical care and its effect on consumers and on the society as a whole.
The relative cost of health care was increasing rapidly—due partly to the
introduction of advanced medical technology—placing such care beyond
the reach of many individuals, especially rural residents and disadvantaged
groups in the urban sector. The cost barrier thus emerged as one of the
major factors in preventing most people from receiving adequate medical
care. The role of the government in financing health care was very limited,
and there were no commercial insurance carriers. Direct spending by in-
dividual consumers was the major source of financing health services.
Therefore, it was not surprising at the time to find a consensus that a
medical insurance scheme would play an important role in overcoming the
cost barrier through spreading risks and pooling financial resources, and
that it was necessary to introduce such a scheme without further delay.
The passage of the Medical Insurance Law in December 1976 was the major
accomplishment of the Fourth Five-Year Development Plan so far as social
development programs were concerned. The objectives of the law were to
raise national health standards and enhance social security coverage by
facilitating access to medical care and eliminating the financial hardship
of large medical care bills.
One of the most important and often hotly debated issues of the Korean
medical insurance scheme has been the method of remuneration. Accord-
ing to the new system, providers of medical services are reimbursed on
the basis of a fee-for-service schedule (a specified fee for each service ren-
dered) approved by MOHSA. The schedule uses a point-unit method and
is periodically reviewed by the ministry.
Prior to the implementation of the medical insurance system, MOHSA
posted a standard fee schedule to be used by the insurance system. The
newly adopted point-unit system assigned point values to more than 700
services performed by providers. The new fee schedule lowered the charges
for insurance patients by as much as 40 percent of normal charges. In ad-
dition, the ministry fixed prices for some 3,000 pharmaceutical items, al-
lowing a margin of only 12 percent over factory prices (C. K. Park 1977).
In view of the rapid rise in medical costs at the time, the new government
measure was intended to regulate and contain further increases in hospi-
tal fees and charges. Immediately after the announcement of the new stan-
dard fee schedule by the government, however, the Korean Hospital
Association claimed that it could not provide adequate treatment to insured
patients at such a low standard fee. It further asserted that the quality of
medical care for insured patients might deteriorate and there would be dis-
crimination in favor of patients not covered by insurance. In a stern warn-
ing to the medical profession, the ministry countered that providers found
to be charging more than the standard fee officially set for insurance
340 Chong Kee Park

patients would be suspended from practice for up to three months (The

Korea Herald, 19 July 1977).
It was subsequently revealed, however, that after the introduction of the
medical insurance system, the utilization rate increased sharply, to the ex-
tent that hospitals that had previously had many empty beds were facing
shortages of bed space. Physicians who originally protested the 60 percent
remuneration suddenly realized that greater use of their services, even at
lower rates of remuneration, was resulting in higher total revenues. Con-
sequently, MOHSA was, on several subsequent occasions, able to suc-
cessfully ward off excessive demands from providers. Realizing that the
long-term success of the newly instituted medical insurance system de-
pended, to a great extent, on the support of physicians and the medical
industry, MOHSA has sought the cooperation of the Korean Medical As-
sociation and the Korean Hospital Association through informal consulta-
tion and discussion.
The number of persons covered by various health insurance programs
increased steadily, from 3.2 million (or 8.8 percent of the population) in 1977
to 11.4 million (almost 30 percent) by 1981. During the 1977-81 period, a
fund of 631 billion won ($927 million at the 1981 exchange rate) was mobi-
lized through the health insurance scheme, and 423 billion won of that
amount ($621 million at the 1981 exchange rate) was channeled into or-
ganized medical services to improve the health and welfare of the people.
Despite these promising beginnings, the share of government expendi-
ture devoted to health care is and has always been low. Government sup-
port of health programs amounted to only 77 billion won in 1980, accounting
for merely 1 percent of total government expenditure. In comparison, dur-
ing the same year the government committed 342 billion won for manufac-
turing industries and another 120 billion won for air transport (EPB, ROK,
Korea Statistical Yearbook, 1982). This limited government support of health
services reflects the government's approach in general to social services,
which have been left largely to the private sector, resulting in unevenness
and inequity in distribution (Mason et al. 1980:405).

EFFECTS OF THE
MEDICAL INSURANCE POLICY MEASURE
One of the important advantages of a medical insurance system is that it
ensures the flow of funds to the health sector and channels them into or-
ganized services. Hence a medical insurance program, even if the cover-
age is initially limited to a small segment of the population, has the effect
of mobilizing additional financial resources for the whole health sector. By
facilitating access to health care services, medical insurance can have, over
the long run, a favorable effect on the state of health of many workers. Ob-
viously much depends on its scope, on the type of financing mechanism,
and on the manner in which the medical benefits are provided.
 The Health Insurance Scheme 34]

Since its introduction in July 1977, the medical insurance program has
played an important role in promoting the delivery of medical care services
to meet more effectively the growing health care needs of the population.
Although a latecomer in the field of medical insurance, Korea is one of the
few developing countries in which the extension of coverage under the med-
ical insurance scheme has progressed at such a rapid rate.
In July 1977 Korea embarked on a new medical insurance program re-
quiring employers with 500 workers or more to offer medical insurance
benefits to their employees and dependents. Provision was also made to
include on a voluntary basis firms employing fewer than 500 workers. The
automatic coverage requirement was lowered in July 1979 to include firms
with at least 300 workers and in January 1981 to include all firms with 100
workers or more. Subsequently government officials, teachers, support staff
in private educational institutions, dependents of military personnel, and
certain categories of pensioners all became eligible for medical benefits un-
der an act of supplementary legislation.
More than 11.4 million people were entitled to receive medical benefits
under various programs of medical insurance in 1981. Nearly 70 percent
of this total were dependent family members of insured workers. More than
60 percent of the insured were employed in private industries; the remainder
were government officials including public school teachers and professors,
and teachers in private educational institutions. The proportion of the to-
tal population covered by various medical insurance schemes increased from
8.8 percent in 1977 to 29.5 percent in 1981, an increase of 8.2 million in-
sured in only four years (MOHSA, ROK, 1983).
The extent of population coverage varies considerably, however, from
province to province, ranging from a low of less than 15 percent in Cheju,
South Cholla, and North Ch’ungch’ong provinces to 63 percent in Seoul
and 31 percent in Pusan. Moreover, though the nation’s two largest cities
(Seoul and Pusan) contain only about 31 percent of the total population,
nearly 57 percent of the persons covered by the medical insurance system
are concentrated in those two urban centers. Under the present scheme,
in which eligibility extends mainly to Class I employees (i.e., those work-
ing for a company or other institution with 10 or more employees), this
concentration of medical services in the larger urban areas is virtually un-
avoidable in the short term. More effort needs to be directed toward ex-
tending insurance coverage to the residents of North Ch’'ungch’ong, South
Ch’ungch’6ng, North Chélla, South Chdlla, and Cheju provinces, where
less than 20 percent of the population are insured compared with the na-
tional average of 30 percent (Table 13.4).
The scale of medical insurance operations in terms of population cover-
age has expanded at an exceptionally rapid rate since its introduction in
1977. The growth of the program in both numbers of patients treated and
size of benefit payments has also been remarkable.
342
oe
Chong Kee Park

Table 13.4. Persons covered by the medical insurance system, by province

and program: 1981
General Specified
popu- occu- Yo %
lation pations Total distri- of popu-
Province (103) (10?) (103) bution lation

Seoul city 4,176 1,269 5,446 47.7 62.8

Pusan city 714 292 1,006 8.8 31.0
Kyonggi 796 324 1,120 9.8 21.9
Kangwon 258 177 435 3.8 24.1
North Ch’ungch’ong 65 142 207 1.8 14.4
South Ch’ungch’ong 184 292 476 4.2 15.8
North Cholla 189 one 419 of, 18.2
South Cholla 118 394 512 4.5 13.4
North Kyongsang 556 454 1,011 8.9 20.1
South Kyongsang 478 243 (pal 6.3 201
Cheju 7 47 54 0.5 11.5
Total 7,544 3,863 11,407 100.0 29.5
Source: MOHSA, ROK (1983).
Note: Line and column totals are subject to rounding errors.

The medical insurance system has considerably improved the accessi-

bility to health care services for a wide segment of the populace, resulting
in increased use of a greater variety of medical services. The number of
treatment cases handled through employee medical insurance societies in-
creased from 884,000 during a six-month period in 1977 to 54 million in
1979 and to 14.0 million in 1981. Including government officials and teachers
and their dependents (who have been covered by another program ad-
ministered by the Korea Medical Insurance Corporation since 1979), the total
number of treatment cases in 1981 amounted to more than 22.3 million (Fed-
eration of Korean Medical Insurance Societies 1983).
The number of treatment cases, however, is largely influenced by changes
in the population covered by the medical insurance system. To isolate this
effect, Table 13.5 presents the utilization rates for hospitalization and out-
patient care, derived by dividing total number of treatment cases by the
number of persons covered by medical insurance. As shown in the table,
the overall utilization rate (visits per person per year) increased from 0.56
in 1977 to 2.11 in 1981. The level of hospitalization appears to be stabilizing
at about 0.05 in recent years, but that of outpatient consultation continues
to rise rapidly. Thus the increase in the overall utilization rate largely reflects
the increase in the utilization rate for outpatient care.
The growth in the number of persons entitled to medical insurance
benefits is reflected in the increased revenues and benefit payments of the
 The Health Insurance Scheme 343

Table 13.5. Medical care utilization rate of persons covered by the medical
insurance program: 1977-81 (visits per person per year)
Hospital- Outpatient
Year ization care Total
1977 0.030 0.532 0.562
1978 0.038 0.718 0.756
1979 0.052 1.314 1.366
1980 0.057 1.853 1.910
1981 0.055 2.058 DaliliS

Source: Federation of Korean Medical Insurance Societies (1983).

Note: Figures include medical insurance programs administered by both employee medical
insurance societies and the Korea Medical Insurance Corporation.

system, but the disproportionate increase in the latter also reflects sharply
increased utilization rates and increased treatment costs since 1977. Expen-
ditures have increased at a much faster rate than revenues, therefore, ex-
penditures as a proportion of revenue rose sharply, from 34.3 percent in
1977 to 76.4 percent by 1981. During the 1978-81 period, revenue grew 5.6
times, from less than 50 billion won in 1978 to almost 275 billion won in
1981. In comparison, expenditures rose 8.3 times, from 25 billion won to
210 billion won over the same period. Expenditures for medical care benefits
usually accounts for roughly 90 percent of total expenditures. During the
entire period between 1977 and 1981, a total fund of about 631 billion won
was mobilized through the medical insurance system, and 423 billion of
that amount was channeled into organized medical services to improve the
health and welfare of the people (Federation of Korean Medical Insurance
Societies 1983).
As mentioned earlier, sharp increases in expenditures can be attributed
to increased unit costs as well as increases in utilization rates. Medical care
cost per treatment case increased from 8,390 won in 1977 to 11,830 won in
1981, but the increase was attributable for the most part to a sharp increase
in the unit cost of hospitalization care. During the 1977-81 period the cost
of hospitalization care per case treated more than doubled, while the cost
of outpatient care increased by about 35 percent (Federation of Korean Med-
ical Insurance Societies 1983).
As stated in a preamble of the Medical Insurance Law of 1976, the new
insurance scheme was introduced to improve the health and welfare of the
working class, particularly of people who are unable to pay their mount-
ing medical bills. Accordingly, the contributions to the scheme are linked
to salary level, with lower premiums for lower-paid workers. It would be
appropriate, therefore, to ask who bears the insurance cost and who benefits
most from expenditures of medical insurance schemes. Although it is
difficult to ascertain the magnitude of real costs and benefits owing to the
344 Chong Kee Park

brief experience of the medical insurance program and the dearth of data,
a recent study by KDI provides some clues as to the redistributive effects
of Korea's medical insurance system (Yeon et al. 1983).
Table 13.6 presents the amounts of contributions paid and benefits
received per person by monthly salary scale under the 184 separate em-
ployee medical insurance societies in 1981. According to this table, mem-
bers of medical insurance societies who were making on average less than
100,000 won per month paid 31,650 won in contributions in 1981, while
receiving 19,600 won in medical benefits. The difference resulted in a
benefit/contribution rate of 61.9 percent. By contrast, the rate for employees
with average monthly salaries in the range of 100,000-150,000 won per month
was higher (66 percent) and higher still (nearly 80 percent) for those in the
200,000-250,000 won salary range. As the table also indicates, the medical
insurance societies with a membership earning on average less than 200,000
won per month accounted for about 60 percent of the total number of soci-
eties in operation in 1981, and their benefit/contribution rates were much
lower than the 74.1 percent average for all employee medical insurance so-
cieties. These differences can be partly explained by age structure (younger,
healthier workers falling in the lower salary ranges). Those blue-collar work-
ers who have more extended family support, moreover, may be less likely
to seek medical treatment in cases of minor illness.
LESSONS OF THE KOREAN EXPERIENCE
The experience of Korea clearly shows that even if rapid growth of the econ-
omy is achieved and the overall standard of living is improved, a point is
soon reached when it becomes necessary to increase emphasis on social

Table 13.6. Average contribution and benefit per insured person in the
Employee Medical Insurance Program, by income level: 1981
Distribu-
tion of
members of Average Benefit as
insurance — contri- Average % of De-
Salary range* societies bution benefit contri- pendency
(won) (%) (won) (won) bution rate
< 100,000 2.2 31,650 19,600 61.9 1.58
100,000-150,000 21.8 46,800 31,010 66.2 2.02
150,000-200,000 35.3 62,230 45,920 73.8 2.58
200,000-250,000 21.4. 78,750 62,720 79.6 3.32
250,000-300,000 11.4 84,010 64,820 1/2 3.49
> 300,000 1.6 84,790 42,800 50.5 3.35
Total 100.0 65,020 48,180 74.1 2.75
See Se ee ee Si ee Ot eee) Aner verre:
Source: Yeon et al. (1983).
a. Average monthly salary of members of the insurance societies.
 The Health Insurance Scheme 345

development. By then, the growth of inequities in income and wealth, in

conjunction with rising aspirations throughout the society, accounts for
many of the frictions and instabilities with which social development plan-
ning must cope. The government as a dominant force in Korean society
is able to influence the ownership of wealth and the pattern of income dis-
tribution. This ability could be used to formulate policies leading to more
widely based participation in the prosperity that the country has been en-
joying. It is also able, to some degree, to establish priorities and set the
pace for social development.
Social development is lagging behind the rapid pace of Korea's economic
development. Unless the gap is reduced, it will continue to foreshadow
social, economic, and political problems of increasing gravity. There is a
growing awareness now among economists and planners that the goal of
more equal distribution of benefits could be better achieved if more social
development policies were enunciated from a broader perspective to parallel
and complement economic growth. These policies, translated into well-
conceived, concrete programs and services, could then be incorporated into
national development plans.
There is a need for a rational health care plan based on the equitable
distribution of services and the efficient utilization of resources. In urban
areas, low-cost housing and a wide range of environmental improvements
are urgently needed. The rapid industrialization of the economy and the
aging population, coupled with a disintegration of the traditional extended
family system, emphasize the need for an old-age pension system for in-
dustrial and other workers in the private sector. At present old-age pen-
sion benefits are available only to a small group of the elite—principally
government officials, military personnel, teachers, and professors. The
modernizing trend in education must be encouraged and technical inno-
vations introduced so that the rapid extension of compulsory education can
be accomplished without incurring prohibitive costs.
The government has identified health care as a priority, but government
investment in health has been extremely small, and private medical care
has been beyond the means of most Koreans. The resulting situation has
been further aggravated by a shortage and maldistribution of medical facil-
ities and personnel. The national medical insurance scheme has been a
major policy instrument for overcoming the cost barrier, which prevented
a substantial number of people from receiving adequate medical care.
The introduction of the medical insurance system was an important
milestone in Korea’s social development, and it proved to be very popu-
lar. Nonetheless, there are inherent weaknesses and shortcomings in the
system, particularly in regard to efficiency and equity standards. First, the
extent of coverage is grossly inadequate. With only about 30 percent of the
population covered by the system, the majority of the low-income groups
—i.e., workers employed by marginal firms, self-employed persons, rural
346 Chong Kee Park

community residents—remain unprotected. These groups are more likely

to be medically indigent and in much greater need of health care services
than those already protected by the system. Although nearly 83 percent
of the regularly employed persons in the industrial sector are covered by
medical (Class I) insurance, it has been estimated that only about 3 per-
cent of the community residents (Class II insurance) are protected by the
medical insurance program. There are also glaring regional disparities in
the availability of medical insurance. The proportions of the population en-
titled to medical insurance benefits vary from only 11 percent in Cheju and
13 percent in South Chdlla to 63 percent in Seoul.
Another serious shortcoming of the employee medical insurance scheme
is the regressive nature of its coinsurance provisions. Under these provi-
sions, the patient pays for 20 percent of hospitalization costs and 30 per-
cent of the costs of outpatient care services. In the case of hospital outpatient
care, the patient’s share is 50 percent. Although there are justifications for
cost sharing, serious questions may be raised as to its ill effects. Since the
coinsurance system is based on uniform rates, regardless of income level,
it places a heavier relative burden on low-income families. As a consequence,
these families may be deterred from seeking needed health services, thereby
undermining a major goal of medical insurance, which is to encourage
greater use of health care services by the low-income groups.
Korea’s medical insurance system has been accumulating surplus funds
in substantial amounts. The total revenues of the system have always been
greater than the amount it actually spent—for every year since the begin-
ning of the program in July 1977. The accumulated surplus fund for the
employee scheme at the end of 1981 amounted to 1184 billion won (138.6
billion won if the scheme for government officials is also included), roughly
equivalent to the total amount expended during 1981. Unless the govern-
ment deliberately intends to accumulate reserve funds to be used for con-
structing health facilities for the insured in badly needed areas, there is
no justification for accumulating such a huge reserve with contributions
collected from a large number of low-income workers. Until now, however,
no surplus funds have been used for such purposes.
Sound financial planning and operations are essential if the system is
to earn public confidence and popular support. Such planning can be
achieved only by more accurate actuarial estimates of the quantity of medi-
cal services demanded and received, the level of reimbursement for
providers of services, and the amount of administrative expenses. Along
with these improvements, serious consideration should be given to the
reduction of either the contribution rate or coinsurance rate, particularly
for low-income workers who are single. Another alternative would be to
improve the level of benefits. A major deficiency in benefits is the limita-
tion of benefit payments to six months for any single diagnosis, which de-
nies relief from the financial burden of prolonged medical care in cases of
catastrophic illness.
 The Health Insurance Scheme 347

It is anomalous that a compulsory medical insurance program established

by a national law is administered by a large number of relatively small, pri-
vately managed insurance societies. Most of the 184 medical insurance so-
cieties currently being operated throughout the nation are still too small
to take advantage of risk pooling and economies of scale. Many problems
and disadvantages are associated with this type of multiple system, as is
evident from the experience of Japan. Among these problems are inequali-
ties in contributions and benefits, double standards, and duplication of ad-
ministration. At this stage of Korea’s development, it is critically important
to try to avoid the mistakes other countries have made in the past. Because
of the potential advantages of economies of scale and of maximum uni-
formity in coverage, facilities, and internal operation, the centralized
management of a medical insurance program is likely to result in lower
administrative costs and better control over benefits and coverage. Since
the private sector alone does not have adequate experience in this area,
centralization in the initial stages would also help to prevent duplication,
abuses, and waste and could thus direct scarce health resources to where
they are most needed.
All these shortcomings of the medical insurance system need to be
resolved. The most urgent need is to speed up the extension of coverage
to as large a portion of the populace as available medical facilities and per-
sonnel permit. A failure to do so would result in the continued waste of
the most basic ingredient in social development—the human resource.
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 14 The Population Redistribution
Plan (1977) and Urbanization Problems
by Lee-Jay Cho and Won Bae Kim

During the past two decades, the spatial distribution of human settlement
in Korea has been drastically transformed. Rapid industrialization was ac-
companied by an enormous upsurge in both the volume and rate of popu-
lation movement into urban areas. As a result, the proportion of the total
population living in urban areas increased from 28 percent in 1960 to 57.2
percent in 1980. Urbanization was both a cause and an effect of rapid in-
dustrialization. Although industrialization preceded urbanization in Korea
(Table 14.1), the speed of industrialization from 1960 to 1980 was irregular
whereas that of urbanization was more or less steady.
The two major problems in Korean urbanization are the persistent pri-
macy of the capital city and regional imbalances. Another feature is the
bipolar development of the urban system. For example, in 1980 Seoul and
Pusan together accounted for 30.8 percent of the total population and 53.8
percent of the urban population (Table 14.2). Such a pattern of urbaniza-
tion was partly a result of the government’s development strategy, which
stressed economies of scale and agglomeration. The effects of several de-
velopment programs can be identified as factors contributing to the cur-
rent distribution of population and industries.
First, the Korean government has played an active role in promoting and
directing industrialization. The successive five-year development plans,
which emphasized growth maximization, can be characterized as “top-
down” and “sector-oriented.” The spatial dimension of development was
ignored. There were few inputs from local and provincial governments into
the centralized decision-making process.

Table 14.1. Industrialization and urbanization indexes: 1960-80 (%)

1960 1966 1970 1975 1980

Nonagricultural employment as a
percentage of total employment 20.5 42.1 49.5 51.0 62.2
Rate of change in industrialization 105.4 16.9 3.0 22.0
Urban population as a percentage
of total population 28.0 95,0 9004.1.1. 48.4 Dee
Rate of change in urbanization 20 Oiae2io 17.8 18.2
Source: EPB, ROK, Population and Housing Census (1960, 1966, 1970, 1975, 1980).

349
350 — Lee-Jay Cho and Won Bae Kim
eee
ee

Table 14.2. Urban, rural, and major city population shares: 1960-80
e
_s soe 3 ee e ee

Population Average annual

(10° persons) growth rate (%)
1960 1970 1980 1960-70 1970-80 1960-80
Urban 6,997. 12,953 21,409 6.35 6:15 Do
(28.0) (41.2) (57.2)
Seoul 2,445 5,536 8,364 8.50 4.24 6.35
(9.8) (17.6) (22.4)
Pusan 1,164 1,879 3,160 4.89 ee) 5.12
(4.7) (6.0) (8.4)
Other cities 3,388 9,598 9,885 5.02 5.98 5.45
(13.5) (17.6) (26.4)
Rural 17,99 2ee 18, D1 St Oo, 0.27 -1.43 -0.59
(72.0) (58.8) (42.8)
Total 24,989 31,466 37,406 an Fd BAS) 2.04
Source: EPB, ROK, Population and Housing Census (1960, 1970, 1980).
Note: Percentage shares are shown in parentheses.

Second, Korea's export-oriented industrialization has contributed to the

rapid growth of the two largest cities. As international trade increases, most
manufacturing industries—which rely heavily on foreign countries for raw
materials as well as for markets—have been located near international
seaports. Therefore, the Seoul-Inch’6n region and the Pusan region with
their large ports have played a dominant role in the process of export-
oriented industrial expansion. This bipolar development of the Seoul and
Pusan regions is evident in the regional distribution of manufacturing em-
ployment over the past 15 years (Table 14.3).
Third, public investment decisions have been guided by strong locational
predispositions. The allocation of social overhead capital and the establish-
ment of industrial bases, which were primarily governed by national effi-
ciency criterion, favored the economically advanced areas—Seoul and
Pusan. After the mid-1970s when growth policy emphasized heavy and
chemical industries, an industrial belt took shape along the southeast coast
and absorbed a substantial proportion of national employment. The con-
struction of the Kyung-Bu (Seoul-Pusan) Highway also spurred a concen-
tration of development in the large cities along the route. Other regions
were relatively neglected and regional imbalances were intensified.
Fourth, despite considerable efforts devoted to rural development, the
government's urban-based industrial development policies and programs
were a far greater success. Massive rural out-migration occurred in the 1960s
and the early 1970s partly because of the urban bias inherent in outward-
looking economic development strategies. Notably, the terms of trade be-
tween agricultural and manufacturing products was a major cause of the
heavy rural out-migration (Renaud 1977).
 The Population Redistribution Plan (1977) 351

Table 14.3. Provincial manufacturing employment: 1966-81

1966 1973 1981
Number of Number of Number of
workers workers workers
Province (108) % (103) % (103) %
Seoul city 180.2 31.8 389.1 33.6 428.0 20.9
Pusan city 102.8 18.1 191.4 16.5 336.0 16.4
Kyonggi 51.6 9.1 163.0 14.1 489.5 23.9
Kangwon 1352 253 18.8 1.6 19.3 0.9
North Ch’ungch’ong 13.7 2.4 25.6 Dae, 38.4 1.9
South Ch’ungch’dng Boro 5.9 54.9 4.7 88.5 4.3
North Cholla 29.1 eal. 3725 a2 Rany/ Dey
South Cholla 40.0 Teal 49.9 4.3 69.2 3.4
North Kyongsang 72.3 127, 1257055 10,6 2/205 #13,3
South Kydngsang 30.6 5.3 102.0 8.8 247.9 eel 2,1
Total 566.7 100.0 1157-8) 100.0 2,044.3 100.0

Source: EPB, ROK, Mining and Manufacturing Survey (1966, 1973, 1981).
Note: Cheju province is included in South Chdlla province.

Finally, the government’s foremost concern was the industrial sector,

whereas basic needs such as health care, housing, and education were left
largely to private initiative. This served to increase the disparity between
the big cities and other areas in social services. Numerous migrants moved
to Seoul or other large cities to take advantage of sociocultural amenities.
The concentration of such amenities, especially top-quality universities, at-
tracted highly motivated young people not only from the rural areas but
from the small cities as well.
Urban growth in Korea in the 1960s is primarily attributable to the mas-
sive influx of migrants from the rural areas, although natural increase con-
tributed more or less equally to urban growth in the 1970s. Most of these
migrants went to the cities in pursuit of job opportunities and higher in-
comes (H. K. Kim 1981; H. S. Lee 1983). Selectivity in terms of age, sex,
and education is apparent in this process (L. J. Cho 1974; E. Y. Yu 1978).
As a consequence, the age structures of the rural and the urban popula-
tions became unbalanced—most significantly, people in the older and
younger age brackets remained in rural areas. Educational selectivity is
another characteristic in the migration stream. As in many other Asian coun-
tries, the more educated a person is the more mobile he is likely to be.
Seoul and Pusan were the centers of this movement. “Step-wise”
migration! was not frequent in Korea, unlike in many other developing

1. “Movement from a rural birthplace first to a local village, then to a small town, and even-
tually to a major city” (Petersen and Petersen 1986).
352 Lee-Jay Cho and Won Bae Kim

countries. A considerable proportion of migrants moved directly to Seoul

from their places of origin (Barringer 1974). Almost two-thirds of all migrants
between 1960 and 1970 moved into the metropolitan areas of Seoul and Pu-
san and those migrants were the major force underlying the population
implosion that drastically changed the distribution of the Korean popula-
tion in the 1960s (L. J. Cho 1974). Although the proportion of total migrants
moving to Seoul and Pusan has declined in recent years (36 percent dur-
ing 1975-80), the annual population growth rate in the two cities still ex-
ceeds 5 percent. This trend is likely to continue because of the demographic
multiplier effect. For example, the relative contribution of net migration to
Seoul’s population growth was 85.3 percent from 1966 to 1970, while in the
same period the relative contribution of natural increase was 14.7 percent.
However, in the 1970s—particularly during the latter half of the decade—
the relative contribution of natural increase expanded considerably (Table
14.4).
The problems associated with rapid urban growth and the persistent
primacy of Seoul have become major social concerns and policy issues in
Korea. Even though the economic case against the largest cities is not con-
clusive, no one questions the existence of the following acute problems:
¢ Inadequate supply of infrastructure, housing, and educational facilities;
e Pollution, environmental deterioration, and congestion in metropolitan
areas;

Table 14.4. Relative contributions of the components of urban growth:

1960-80

Increase in urban el a Pemeniaper due tc in eee

population per Reclassi- =Annex- Net Natural
Period 1,000 persons fication ation migration increase
1960-66
Seoul 1,358 0.0 11.4 O77 30.8
Total 2798 8.0 ee) 40.6 42.1
1966-70
Seoul Tol 85.3 14.7
Total 3,148 73.1 26.9
1970-75
Seoul 1,354 1.0 49.7 49.3
Total 3,841 5.0 3.1 48.8 43.1
1975-80
Seoul 1,477 36.3 63.7
Total 4,638 10.5 4.1 39.7 45.7
Source: EPB, ROK, Population and Housing Census (1966, 1970, 1975, 1980).
 The Population Redistribution Plan (1977) 353

¢ Unbalanced regional development with respect to national lands and

resource utilization;
¢ Persistent inequalities among regions and among cities in access to public
infrastructure and sociocultural amenities;
¢ Potential social and political unrest in large cities because of a large con-
centration of marginal workers and students; and
¢ National security concerns owing to the large concentration of popula-
tion and industrial facilities near the border.
There is much disagreement, however, as to whether these problems can
be effectively addressed through population redistribution programs. Pol-
lution and congestion, for example, may be more closely related to density
and the spatial configuration of cities than to their size. If so, such problems
can be more effectively addressed through controlling emissions or regulat-
ing the location of polluting industries than through attempts to contain
city size (Tolley, Graves, and Gardner 1979). In any event, the Korean govern-
ment began taking policy initiatives in the late 1960s to grapple with these
problems.
MAIN FEATURES OF THE PLAN
Government efforts to achieve balanced spatial development began in the
late 1960s. The Ministry of Construction, the Metropolitan Government of
Seoul, and the Ministry without Portfolio prepared plans to restrict the
amount of in-migration allowed in the capital region. The major instruments
of these plans were industrial dispersal, siting new educational and cul-
tural facilities in local areas, and decentralizing some government agencies.
In addition, laws were enacted to serve as legal bases for regional
planning—notably the Comprehensive National Land Development Plan-
ning Law and the City Planning Law. These plans were, however, largely
symbolic. Not until the 1970s was the policy dealing with metropolitan con-
centration actually implemented. In 1971 the First Comprehensive National
Physical Development Plan (1972-81) was formulated to direct regional de-
velopment projects based on the growth-center approach. The plan was
not entirely effective in guiding public investment decisions because of its
lack of integration with economic development policies, which were largely
sector-oriented. The centerpiece of the government's efforts was the Seoul
Population Redistribution Plan announced in 1977.
It was recognized even in the 1960s that control over rapid population
growth and industrial concentration in Seoul could not be achieved using
a piecemeal approach. The need for a comprehensive planning effort was
fully understood; consequently, the Population Redistribution Plan was pre-
pared and implemented in 1977. The specific objective of the plan was to
divert the projected increase in Seoul's population of 4.3 million people by
354 —— Lee-Jay Cho and Won Bae Kim

1981 to several selected growth centers throughout the country thereby hold-
ing the population of Seoul at the then current level of 7 million.
To achieve the planned population distribution, various population meas-
ures and programs were adopted regarding industrial location, urban de-
velopment of five countermagnet metropolitan areas and the southeast
coastal industrial belt, and regional distribution of educational institutions.
It was even proposed that a new administrative capital be created. The plan
was quite comprehensive in the sense that almost every conceivable means
and strategy to achieve its objectives was employed.
The plan contained detailed programs for: (1) controlling the expansion
or establishment of factories in the capital region and encouraging reloca-
tion of existing factories to other regions; (2) the creation of population-
absorbing capacity in other designated regions in the southern part of the
country; and (3) restricting the expansion of the educational institutions
in the capital region and encouraging their redistribution. These programs
were to utilize various financial benefits and infrastructure development
techniques as incentives and disincentives. The expansion and new develop-
ment of industries in the capital region were prohibited, whereas indus-
trial development in the designated areas was to be encouraged by every
possible means. Differential tax treatment and financial assistance to relocat-
ing industries were also included. Detailed educational policies were pro-
posed. The expansion of existing educational institutions and the
establishment of new ones was prohibited. Instead, the opening of local
campuses of the universities existing in Seoul was encouraged and assisted
financially. The transfer of students to Seoul was discouraged and the ex-
change of professors between Seoul and other regions promoted.
It is in this plan that the importance of service industries was recognized
for the first time by including the educational institutions as one of the large
employment and population-absorbing sectors in metropolitan areas.
Land-use regulations were to be used to prevent a further concentration
of office activities in Seoul. These regulations and other restrictive measures,
however, were not strictly enforced and, in effect, were later abandoned
when Seoul was chosen as the site for both the 1986 Asian and 1988 World
Olympic Games.
The Population Redistribution Plan became inactive around 1980. The
plan had been criticized on a few important grounds. First, the target to
reduce Seoul’s population to 7 million in 1986 from a peak level of 8 mil-
lion in 1981 was regarded as infeasible. Second, the idea of a new capital
was quite controversial. Many doubted the desirability as much as the feasi-
bility of the planned construction of a new capital. The funding problem
alone would have jeopardized the plan. In any case, only the restrictive
measures, including the tight control over industrial development and ex-
pansion of educational institutions in the capital region, were strictly
enforced whereas positive development of population-receiving areas,
 The Population Redistribution Plan (1977) 355

particularly five stronghold urban centers, was either delayed or not effec-
tively implemented for various reasons.
Industrial Location Policies
It was recognized within the circle of government policymakers, even at
the early stage of industrialization, that industrial location is an important
policy tool in achieving balanced development among regions. Since 1964
the government has tried to restrict the establishment of new industries
and the expansion of existing ones in Seoul to curb the rapid concentra-
tion of industries and population. Policymakers knew that it would be im-
possible to stop industrial growth in Seoul, where enormous locational
advantages existed at the early stages of economic development, unless in-
centives to locate elsewhere were created. The Local Industrial Develop-
ment Law, enacted in 1967, provided the legal basis for governmental
assistance in promoting local industrial development through such means
as tax exemptions and infrastructure development in designated industrial
areas. Nine heavy industrial estates and 24 local industrial estates have been
developed by the central and local governments since 1962. The heavy in-
dustrial estates were mostly developed along the eastern and southern
coastal areas from P’ohang to Yoch’6n.
Land policy measures were adopted to facilitate industrial estate develop-
ment. The standard price system, one of these measures, was adopted to
eliminate speculative land value increases. The government makes a de-
termination of standard prices of land prior to the designation of indus-
trial estate areas. These prices are applied in the compulsory or negotiated
purchase of the land for industrial estate development. The cheap land,
which is developed for industrial uses, combined with certain tax exemp-
tion schemes constitutes an attractive incentive for incoming industrial firms.
The enactment of the Industrial Distribution Law of 1977 opened up a
new dimension in industrial location policy. The law authorizes the minister
of the Ministry of Commerce and Industry (MCI) to make a comprehen-
sive industry redistribution plan and to classify areas for the purpose of
industrial location into three zones: (1) relocation encouragement zone; (2)
limitation and coordination zone; and (3) location encouragement zone. The
law defines the relocation encouragement zone to be the large cities and
surrounding areas with an extremely high concentration of industries and
an extremely high growth rate of population. The limitation and coordina-
tion zone is defined as the area with a relatively high concentration of in-
dustries and high growth of population. Both the relocation encouragement
zone and the limitation and coordination zone, therefore, need a restric-
tion of expansion or new establishment of industries. The encouragement
zone is the area where the industrial base is presumably weak and where
the need to attract industries is strong. The MCI classifies the industries
in Seoul into those subject to relocation, and those permitted to stay in the
area.
356 —_Lee-Jay Cho and Won Bae Kim

The use of a differential tax scheme and real assistance such as infra-
structure development and government loans were major tools for im-
plementing industrial decentralization policies.

Recent Plans
In 1980 the major responsibility for planning and implementing popula-
tion dispersal policy was transferred from the Ministry without Portfolio
to the Ministry of Construction (MOC). The MOC drafted the Second
National Land Development Plan (1982-91), which set forth the basic guide-
lines for population dispersal, to complement the Fifth Five-Year Develop-
ment Plan (1982-86). Both plans were administered by the Economic
Planning Board (EPB) and promoted a better integration of population redis-
tribution goals with related sectoral plans.
The Second National Land Development Plan is designed to curb ex-
cessive population growth in large urban centers and emphasizes balanced
national development. The plan has four principal elements:
1. To ensure balanced national development, the country is divided into
28 “integrated regional settlement areas” based on functional economic
areas.
2. Potential migrants who are otherwise likely to move to Seoul and Pu-
san will be redirected to 15 growth-inducement cities such as Taejon, Kwang-
ju, and Taegu. To facilitate this redirection of migration, the government
will strengthen public administration and management functions in the
growth-inducement cities.
3. Underdeveloped areas will receive special attention to bring their lev-
els of development up to a national standard.
4. To strengthen interregional socioeconomic interactions, the existing
transportation and communications networks will be expanded and new
facilities will be built in less developed areas.

THEORETICAL APPROPRIATENESS OF THE PLAN

Migration Policy
The primary objectives of the 1977 plan were to: (1) discourage massive
population movement from the countryside into Seoul; (2) divert the fu-
ture potential migration flow which would otherwise be directed to Seoul
to a few intermediate-size growth centers; (3) disperse development potential
away from Seoul to the rest of the country; and (4) attain a more balanced
spatial organization of the national economy.
To meet these objectives a “growth center” approach was adopted and
five medium-size cities with populations between 200,000 and one million
were designated as priority investment urban centers in 1978. These are
Taejon, Taegu, Masan, Kwangju, and Chénju, which happen to be either
provincial capitals or industrial complexes. These centers are not “induced”
 The Population Redistribution Plan (1977) 357

growth centers but “spontaneous” growth centers that had already exhibited
rapid population growth due to their strong economies.
The underlying rationale for growth centers is to capitalize on spatial
economies of scale and to complete a network of communication and eco-
nomic flows to capture all systemic effects. It is, however, difficult to justify
economically a growth center approach on the basis of spread effects, i.e.,
benefits to the surrounding areas of a growth center. The idea has the com-
pelling advantage that it implies internally consistent industrial decentral-
ization and migration policies. Growth centers can properly serve as regional
centers of in-migration, thus reducing migration flows to the national
centers.
Other policy measures set forth in the 1977 plan such as those designed
to discourage in-migration to Seoul and to relocate a portion of the existing
urban population of Seoul were not only less sound in principle but also
often ineffective in practice. These measures are susceptible to the criticism
that they work against the well being of the urban poor and potential rural
out-migrants. The urban poor would be worse off because they would have
to pay extra for either commuting farther or for new housing accommoda-
tions if they were willing to make a residential relocation. In theory, rural
out-migrants will in all likelihood be better off if they move to urban sec-
tors of any size. Any migration policy aimed at discouraging in-migrants
destined for big cities would be contrary to their welfare.
Industrial Location Policy
The manufacturing sector's potential for decentralization and job creation
has been well recognized and accordingly the possibility of influencing in-
dustrial location has received top priority by policymakers in many develop-
ing nations. This emphasis is consistent with the widely accepted theory
of an “economic base,” which postulates that certain types of manufactur-
ing industries are critical to the growth of a local or regional economy. Fur-
thermore, from the policymaker’s viewpoint, manufacturing activities are
more amenable to location policies than service activities because the lat-
ter are often subject to local markets.
Industrial location policy proposed in the 1977 plan aims at the redistri-
bution of manufacturing employment through the reallocation of capital.
Policy instruments for this purpose take two forms: incentives such as finan-
cial subsidies and tax concessions, and disincentives like administrative con-
trols and penalties.
The policy of encouraging capital movement between regions is based
on the premise that many types of manufacturing activities can be trans-
planted with relative ease and can operate efficiently in a wide range of
alternative locations. Also, it is based on the premise that an adequate level
of basic industrial facilities are available everywhere. These assumptions
may be correct for the United States and the Western European countries
358 — Lee-Jay Cho and Won Bae Kim

but were not valid for Korea in the 1970s. Basic utilities and support infra-
structure are not ubiquitous in Korea. Furthermore, an underdeveloped cap-
ital market means very distinctive advantages for firms located in or near
the primary metropolitan area—the cost of obtaining financial capital in-
creases with the distance from the primary metropolitan area. In addition,
an underdeveloped transport system may focus links to the primary city.
Also, the external benefits of locational agglomeration may be dispropor-
tionately large in developing economies compared with more developed
economies. All of these lead us to suspect the effectiveness of tax conces-
sions and financial subsidies for industrial relocation or capital redistri-
bution.

EFFECTS OF THE POLICY

Rural-—Urban Balance
The Korean government implemented various policies in the 1960s and 1970s
designed to reduce the rural-urban income gap. These policies certainly
improved the farmers’ terms of trade, raising them from the low point to
which they had fallen in the late 1960s (Table 14.5). On a per capita basis,
the rural-to-urban income ratio largely recovered from the dramatic plunge
it took in the late 1960s. In 1983 per household rural income was close to
per household urban income. The policies did not succeed, however, in
significantly reducing the gap in per worker income between rural and ur-
ban areas.
Most economic models of migration point to income differentials as the
main cause of rural-to-urban migration (Harris and Todaro 1970; Yap 1977).
The farmers’ terms of trade—the principal determinant of rural income
(Adelman and Robinson 1978)—is portrayed as the most important factor
for explaining rural-to-urban migration in Korea (Renaud 1977). However,
despite an improvement in the farmers’ terms of trade and hence in per
capita rural income relative to per capita urban income and also in off-farm

Table 14.5. Rural-urban income differentials: 1963-83

Year 1963 1966 1968 1970 1973 1975 1978 1980 1983
Terms of
trade 100.7. 75.8 81.4 89.6 101.0 100.0 99.2 94.5 84.9
Ratio of rural to
urban income
Per capita 107 75 or 61 80 93 89 76 94
Per worker 43 31 27 31 41 48 u 44 59
Source: EPB, ROK, Annual Report on the Family Income and Expenditure Survey (1964-1984); BOK,
Economic Statistics Yearbook (1964-84); NACF, ROK, Agriculture Yearbook (1964-84).
u—unavailable.
 The Population Redistribution Plan (1977) 359

employment opportunities, rural-to-urban migration did not decline dur-

ing 1960-80. In terms of absolute numbers, rural-to-urban migration rose
substantially during 1965-70 and then fell slightly during 1970-75 (Table 14.6).
The number, however, surged up again during 1975-80. The relative inten-
sity of rural-to-urban migration (migrants divided by rural population) has
not decreased either.
This persistent rural-to-urban migration may be due to such structural
problems of the rural sector as the small size of landholdings, decreasing
labor intensity in the agricultural sector, and unstable rural incomes (J. B.
Kim 1979). The uneven distribution of benefits from rural development poli-
cies among income groups and among different regions could be another
contributing factor to continued rural-to-urban migration (Nam and Ro 1981;
Choe and Kim 1985).

Interregional Balance
Regional economic disparities have been one of the major motivations for
the national urbanization policy in Korea. In the early 1960s there was a
substantial imbalance between the geographical distributions of popula-
tion and production (Table 14.7). During the same period, “lagging”
provinces with a heavy dependence on agriculture remained underdevel-
oped and their GNP share fell. “Advanced” provinces increased their GNP
share and possessed a disproportionate concentration of production capac-
ity. Inter-provincial migration during 1960-80 was largely a process of adap-
tation to the changing regional structure of production.
Seoul and Pusan were at the receiving end of inter-provincial migration,
whereas the other provinces, except KyOnggi, were sending out migrants
throughout the entire period (EPB, ROK, Population and Housing Census,
1966, 1970, 1975, 1980). This inter-provincial migration flow from poor areas

Table 14.6. Rural-to-urban migration

Period 1961-66 1965-70 1970-75 1975-80
(A) Total number of migrants
(1,000 persons) 1,422 3,189 3,569 4,887
(B) Rural-to-urban migrants
(1,000 persons) 588 1,845 1,754 2,924
Percentage of total migrants
(B/A) 40.7 57.8 49.2 51.6
(C) Rural population at beginning
of year (1,000 persons) 17,992 19,388 18,506 17,910
Rate of rural-to-urban migration
(B/C) (per 1,000 rural population) O27 » al 94.8 140.9

Source: EPB, ROK, Population and Housing Census (1960, 1966, 1970, 1975, 1980).
360 —_Lee-Jay Cho and Won Bae Kim
ee
2

Table 14.7. Provincial shares of production, population, and employment:

1960-80 (%)

LeTe SOLIS CEL nH 900, HIRO eae 2 neal ick ZF

Advanced provinces
Seoul city pak 2D07. 2fe2 28.5 27st
Pusan city 7.6 79 8.1 8.8
Kyonggi 10.9 ey 10.1 12.2 13.4
Intermediate provinces
North Kyongsang 7 13.0 11.4 11L9 11.4
South Kyongsang 15.25 9.0 9.9 9.8 11.0
Lagging provinces
Kangwon 6.9 eps 4.8 4.0 3.9
North Ch’ungch’ong 4.4 4.7 4.3 sp 3.4
South Ch’ungch’ong 8.2 8.3 7.8 6.4 6.2
North Cholla 7.8 rie 6.3 <p 4.9
South Cholla 10.6 10.6 9.3 8.5 8.3
Cheju 1.0 td. 1.0 aby 1.0
Population share© 1960 1966 1970 1975 1980
Advanced provinces
Seoul city 9.8 13.0 17.6 19.8 22.3
Pusan city 4.6 4.9 6.0 7A 8.4
Kyonggi 11.0 10.6 10.7 11.6 13.2
Intermediate provinces
North Kyongsang 15.4 15.3 14.5 14.0 13.3
South Kyongsang 1250 10.9 9.9 95 8.9
Lagging provinces
Kangwon 6.5 6.3 5.9 5.4 4.8
North Ch’ungch’ong BD 5.3 4.7 4.4 3.8
South Ch’ungch’dng 10.1 10.0 ot 8.5 79
North Cholla 9.6 8.6 77 7.0 6.1
South Cholla 14.2 13.9 1227, 11.5 10.1
Cheju i 1.2 2 1.2 2

to prosperous areas during 1960-80 contributed to a convergence of per ca-

pita provincial product, while resulting in an increasing population con-
centration indicated by the increasing values of the Gini coefficient (Table
14.7). A comparison of the distribution of population and employment
among the provinces indicates a less clear trend of convergence in per ca-
pita employment opportunities; however, during 1975-80 the deviations be-
tween the two distributions were reduced.
The dispersion of educational opportunites, however, must be analyzed
not only in terms of quantity but also in terms of quality, considering the
substantial gap in educational quality between Seoul and the rest of the
nation (Nam and Ro 1981).
 The Population Redistribution Plan (1977) 361

Table 14.7. (continued)

Employment share 1960 1966 19705 5 1975. » 1980

Advanced provinces
Seoul city 7.4 CL 16.0 16.8 20.2
Pusan city 4.3 5.3 6.0 Tol
Kyodnggi 10.3 10.1 10.3 AWey 12.8
Intermediate provinces
North Kyodngsang 15.1 16.1 14.8 14.6 13.7
South Kyongsang 16.05 11.1 10.4 10.4 a9
Lagging provinces
Kangwon 6.4 5.8 6.1 5.4 4.6
North Ch’ungch’dng 4.9 5.7 4.9 4.9 4.0
South Ch’ungch’dng 9.9 10.1 9.3 9.4 8.4
North Cholla 10.5 8.9 Sat 7.6 6.1
South Cholla 17.7 15.5 13.6 AW: LZ
Cheju 1.8 1.4 1.3 TZ. 1.3
1960 1966 1970 1975 1978/80
Sum of absolute differences
between population and
production distributions 25.8 26.8 23.0 21,2 16.2
Sum of absolute differences
between population and
employment distributions 10.2 7.0 5.4 5.2 6.8
Index of provincial population
concentration@ 0.272 0.307 0.352 0.385 0.434
a. MOHA, ROK, Annual Report (1980); Seoul, The Special City of (1981); BOK, Regional In-
come Accounts (1963).
b. Pusan is included in South Kyongsang province.
c. EPB, ROK, Population and Housing Census (1960, 1966, 1970, 1975, 1980).
d. The Gini coefficient was used to compute the index.
n n

G= Lin -yti- Vat i-yn=1..., 01

1= i=

where x; is area share and y; is population share.

Intraregional Balance within the Capital Region

Since 1970 the pace of Seoul’s population growth has slowed, although it
is still higher than the national average. Six satellite cities surrounding Seoul
grew very rapidly during the 1970s and the early 1980s (Table 14.8). The
suburbanization of Seoul’s population began after 1970. The relative decen-
tralization process occurring within the capital region has been praised as
a success of population dispersal policies. It should not be confused,
however, with a policy success at the national level. The population in the
capital region grew very rapidly in the 1970s and in the early 1980s.
The suburbanization of Seoul’s population started with the suburban-
ization of employment. Industrial employment led the process. Other
362 — Lee-Jay Cho and Won Bae Kim

Table 14.8. Population increase in the capital region: 1960-83 (% growth per
annum)

Year 1960-66 1966-70 1970-75 1975-80 1980-83

Capital 4.9 6.3 4.1 3.9 3.6

Seoul 7.6 9.4 4.4 3.9 32
Suburban districts u 6.3 6.1 6.5 5.9
Rest of Kyonggi u -1.9 0.8 0.0 0.4

Source: Choi and Lee (1985).

a. Suburban districts include the cities of Inch’dn, Uijongbu, Suwon, Songnam, Anyang,
and Puch’dn, and the counties of Namyangju, Shihing, Koyang, Kwangju, and Kimp’o.
u—unavailable.

sectors, such as trade and services, were slower in responding to industri-

al deconcentration. The establishment of a green belt surrounding Seoul
in 1971, restrictions on industrial expansion after 1973, and other policy
measures undoubtedly contributed to the deconcentration process.
The very slow pace of deconcentration in the nontradeable sectors,
however, indicates the relatively strong locational inertia in these sectors
compared to the industrial sector. This was a reflection of the superior ad-
vantages of Seoul vis-a-vis other cities within the capital region. Seoul’s
share of office-type employment in the capital region declined by only 3.6
percent between 1970 and 1980, with Seoul retaining 91.2 percent of total
office-type employment. In comparison, Seoul's share of total production-
related jobs within the capital region dropped from 71.8 percent in 1970
to 60.2 percent in 1980. The government decentralization policy, therefore,
had only limited success even at the intraregional scale. Furthermore, the
importance of the service sector in Seoul’s economy and the difficulties in-
volved in steering service activities away from Seoul imply the unlikelihood
of widespread decentralization of Seoul’s office employment in the near
future (W. Y. Kwon 1981; H. K. Kim 1985).

Urban Size Distribution

During the 1960s Seoul absorbed nearly 52 percent of total urban popula-
tion growth and about 40 percent of total migration. The proportion of
migrants heading toward Seoul of total migrants dropped to 29.5 percent
during 1970-75 and to 25.2 percent during 1975-80 (Table 14.9). Other cities
became increasingly important as alternative destinations for internal
migration in the 1970s. The rapid growth of population in a number of
intermediate-size cities (those with populations of between 100 and 500
thousand) helped to reduce the primacy of Seoul and stabilized the city
size distribution (Table 14.10; Rondinelli 1985).
The fast-growing intermediate-size cities that doubled their population
 The Population Redistribution Plan (1977) 363

Table 14.9. Intercensal migration by area: 1960-80 (10? persons)

Period 1961-66 1965-70 1970-75 1975-80
In-migration to
Seoul 675.3 1,182.3 105372 1232.2
(46.8) (37.1) (29.5) (25.2)
Pusan 187.2 308.7 376.3 Dor?
(13.0) (9.7) (10.5) (11.0)
Other cities B20 1,023.4 1,328.3 2,168.9
(15.6) (32.1) (37.2) (44.4)
Rural 354.2 674.9 810.9 948.7
(24.6) (21.2) (22.7) (19.4)
Total 1,442.2 3,189.3 3,568.7 4,887.8
(100.0) (100.0) (100.0) (100.0)
Out-migration from
Seoul 1209 247.9 524.3 696.2
(8.5) (7.8) (14.7) (14.2)
Pusan 130.7 127.4 169.3 226.0
(9.1) (4.0) (4.7) (4.6)
Other cities 401.5 672.4 868.2 1,174.2
(27.8) (21.1) (24.3) (24.0)
Rural 788.2 2,141.6 2,006.9 2,791.4
(54.7) (67.1) (56.2) (57.1)
Total 1,442.2 3,189.3 3,568.7 4,887.8
(100.0) (100.0) (100.0) (100.0)
Source: EPB, ROK, Population and Housing Census, (1966, 1970, 1975, 1980).
Note: Percentage shares are shown in parentheses.

during the 1970s can be grouped into two types: satellite cities of Seoul
enjoying spillover effects from the capital city, and newly industrializing
cities that received disproportionate attention from the central government.
The first type of city includes Suwon, Anyang, Puch’6n, SOngnam, and
Uijongbu. Pohang, Kumi, Ulsan, and Masan belong to the second category.
The economies of these two types of cities differ in some respects. The
newly industrializing cities did not, on the whole, experience severe eco-
nomic distress (measured by an aggregate unemployment rate), whereas
the satellite cities of Seoul suffered from high unemployment rates (EPB,
ROK, Population and Housing Census, 1960, 1970, 1980; MCT, ROK, 1984; EPB,
ROK, Special Labor Force Survey Report, 1974). The high unemployment rates
in the satellite cities of Seoul indicate a supply-induced growth, meaning
population growth preceded employment growth. The newly industrializ-
ing cities suggest a demand-induced growth where employment growth
precedes population growth (W. B. Kim 1985). However, the characteristic
common to both type of cities is the large proportion of manufacturing
364 — Lee-Jay ChoLe
pen
and Won Bae
ee
Kim ee SS SS SSS

Table 14.10. City size distribution: 1960-80

City size (10° persons)
Over 500- 250- 100- 50-
Item Seoul 1,000 1,000 500 250 100 Total

1960
Number of cities 1 1 il 2 4 18 27
Population (10°) 2,445 1,164 675 716 704 1,292 6,997
Percentage of total
population 34.9 16.6 ON WO isl ikeys 100.0
1970
Number of cities 1 2 2 pA 11 14 32
Population (10°) Ses) Ds 1 els 676 1,530 1,096 12,929
Percentage of total
population Wf p29) 8.9 52 ales 8.5 100.0
1980
Number of cities 1 3 2: 7 Da 6 40
Population (10%) 8,367 5,851 1,379 2,366 3,036 442 21,441
Percentage of total
population 39.0 27.3 Gh. 1K. Te Dal 100.0
Average annual increase
in population (%)
1960-70 59.8 oan Oe 6.t- 10 6.3
1970-80 A tagedels LON eA S.o Fed OT a2
Source: EPB, ROK, Population and Housing Census (1960, 1970, 1980).

employment in their total employment compared with stagnating or slow-

growing cities (EPB, ROK, Population and Housing Census, 1960, 1970, 1980;
MCT, ROK, 1984; EPB, ROK, Special Labor Force Survey Report, 1974).
The rapid growth of the newly industrializing cities in the southeast
coastal area appears to be directly related to the government's industrial-.
ization strategy that emphasized heavy and chemical industries and its con-
comitant efforts to accommodate key plants in industrial estates and
complexes in those cities. In contrast, the stagnating or slow-growing cities
are those that were for the most part not included in the central govern-
ment’s social overhead capital investment (K. S. Lee 1982).

CRITICISM AND LESSONS

Korean population redistribution policy in the 1970s was a limited success.
Disparities in the level of development remain between the rural and ur-
ban areas and between regions. A degree of success, however, can be
claimed for employment dispersal within the capital region. But the rapid
expansion of population in the satellite cities of Seoul, which are in fact
a part of Seoul’s economy, resulted in regionwide negative externalities such
 The Population Redistribution Plan (1977) 365

as congestion, pollution, and higher unemployment, and an increasing de-

mand for regionwide urban services (T. J. Kwon 1983; H .K. Kim 1984; W.
B. Kim 1985).
Selective urban growth, for which national economic and sectoral poli-
cies are primarily responsible, helped to reduce urban primacy and to stabi-
lize city size distribution in Korea. The rapid growth of intermediate-size
cities during the 1970s implies that these cities will have an increasing role
in future urban growth (Rondinelli 1985). The relatively weakened role of
small-size cities, however, resulting from the underdevelopment of the rural
sector, implies that there will be difficulties in integrating the rural econ-
omy with the urban economy in the future. A rethinking of the spatial
development strategy seems to be necessary for balanced national de-
velopment.
The selection of manufacturing activities as a key to population distri-
bution policy in Korea seems justifiable. The manufacturing sector, with
its rapid growth, provided room for decentralization. However, theoretical
justifications such as the higher multiplier effects of manufacturing and loca-
tional flexibility are dubious in the Korean case. Heavy and chemical in-
dustries are not freely located anywhere. Their location is constrained by
site requirements such as good port facilities, transportation convenience,
and access to raw materials. Once the investments for heavy and chemical
industries are made in particular locations, the locational flexibility of these
industries are greatly reduced because of their heavy fixed capital invest-
ment. The importance attributed to the multiplier effects of manufacturing
activities in a local economy was not warranted (A. J. Kim 1978).
Considering the declining capacity of the industrial sector to generate
employment in the future (the manufacturing sector is moving toward a
more capital-intensive and skill-intensive structure in Korea), the govern-
ment’s past and current emphasis on industrial decentralization as a key
for population redistribution must be modified. The growing importance
of the service sector and related office activities should be recognized. De-
centralization of business and industrial service activities that are indis-
pensable for manufacturing activities must be considered together with
manufacturing decentralization (Clapp and Richardson 1984). However, the
dispersal of business and industrial service activities will require much more
effort than did dispersal of the manufacturing sector. A narrowly conceived
strategy depending heavily on controls and meager incentives, would not
succeed in steering those service activities to local areas. Building roads
and factories alone will not be enough. Human capital investment is a ba-
sic prerequisite for successful dispersion of the business and industrial ser-
vice activities. In this respect, policy options emphasizing labor (i.e., labor
training and labor subsidy schemes) deserve more attention than those en-
couraging capital movement, which has been the dominant policy approach
in Korea and elsewhere (Allen 1979; Townroe 1979).
366 —_Lee-Jay Cho and Won Bae Kim

Policy measures taken in the 1970s in Korea were largely controls. In-
centives were not strong enough to bring about the desired level of popu-
lation dispersal. Controls and regulations have the obvious advantage of
a low budgetary cost to the government. However, these controls might
incur heavy real costs or unintended side effects, such as the rise in oper-
ating costs of the firms relocated to peripheral locations (Choe and Song
1982) and the soaring land prices after the imposition of a greenbelt around
Seoul (Mills 1980).
The considerable evidence presented in this chapter suggests that na-
tional economic and sectoral policies have had the paramount effect on the
urbanization process and spatial transformation in Korea, often overriding
the impact of explicit spatial policies. Unfortunately, population redistri-
bution policy in Korea in the 1970s was not integrated with national eco-
nomic and sectoral policies. An integration and interaction between national
economic and sectoral polices, on the one hand, and explicit population
distribution polices, on the other hand, has been emphasized for a suc-
cessful population distribution policy (Renaud 1981; Richardson 1981; Fuchs
1983). This integration can be achieved at the various levels of policy de-
sign, evaluation, and implementation. For example, formal requirements
can be made within the national government to take account of the spatial
effects of some of their sectoral programs that have potentially strong con-
sequences on the distribution of population. Or, the population distribu-
tion goal can be added as a constraint in a conventional policy evaluation.
At the same time, the impact of explicit spatial policies on national ag-
gregates such as GNP, employment, and income, needs to be estimated
to understand the trade-offs between national economic growth and spa-
tial equality. At the level of policy design, for example, the currently sepa-
rated packages of industrial and locational incentives in a number of Asian
countries (Shome and Kee 1977) can be modified into a unified system of
incentives differentiated by industry and location.
Frequent changes in policy directions or vacillating commitment to them
would be destructive. A consistent policy is essential for both firms and
individuals to be convinced that opportunities outside the core region are
real and reliable. A firm political commitment also means substantial govern-
ment investments and concrete development projects. Symbolic gestures
and empty rhetoric harm the credibility of the government policies. A policy
dependent upon controls focusing on the core region would not solve the
problem of concentration. Instead, it would delay or transfer the problem
in time and in space because that kind of policy cannot improve the de-
velopment potential of the periphery, whether it is a rural area or lagging
region. To help industrialists and individuals in making their business and
residential location choices, the government should develop and publicize
a detailed investment schedule for alternative locations outside the core
region.
 The Population Redistribution Plan (1977) 367

The conceptual separation of the urban sector from the rural sector was
an important policy deficiency in Korean population redistribution efforts.
Urban policies cannot be formulated and implemented separately from rural
policies. The rural-to-urban migration that has been the major force driv-
ing rapid urban growth is one indication of the rural-urban linkage. Without
simultaneous attention to the urban and rural dimensions of the popula-
tion concentration problem, any policy would be ineffective. This seems
particularly true for nations at the early stage of development with a low
level of urbanization. The recently proposed concept of “integrated regional
settlement areas” in the Second National Land Development Plan in Korea
appears to be appropriate for the consideration of urban and rural sectors
as a whole in policy formulation. The concept still views the problem of
population distribution from an urban perspective, however, anticipating
that “spread effects” will flow outward from the city to the hinterland. Con-
sidering the dubious evidence for such a phenomenon in Korea (A. J. Kim
1978) and elsewhere (Salih et al. 1978; Hansen 1981), population redistri-
bution policy should give greater emphasis to rural development so that
an increased demand from rural areas for urban goods would enable those
small cities and local centers to survive. Without entailing necessary con-
siderations for rural development, a less coordinated strategy of urban de-
velopment would not guarantee a reduction in the imbalances between rural
and urban areas and between different regions.
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AGRICULTURAL POLICIES
 15 A Positive Grain-Price Policy
(1969) and Agricultural Development
by Pal Yong Moon

Until the early 1960s, Korea remained a typical preindustrial country with
almost half of its GNP generated by agriculture and the overwhelming por-
tion of its population engaged in farming. But the vigorous industrializa-
tion and export drive undertaken in the early 1960s rapidly transformed
the agrarian character of the economy. Between 1960 and 1982 the share
of agriculture in GNP declined from about 37 percent to 14 percent, and
the proportion of rural population declined from 58 percent to less than
25 percent. Expansion in the nonagricultural sector has proceeded far more
rapidly than in the agricultural sector. While total GNP expanded at an aver-
age annual rate of about 8 percent, the agricultural sector grew at an aver-
age of about 3 percent.
Agriculture’s declining contribution and slow growth relative to the
nonagricultural sector was not, however, the result of unusually poor per-
formance. In fact, Korea's agricultural performance since the early 1960s
has exceeded the world average and that of most Asian countries. Korea
is probably one of the highest ranking countries in land productivity. Rice
yields, for example, were more than double those of most Southeast Asian
countries. One of the main reasons for this high land productivity is that
Korea had an adequate supply of farm workers relative to its scarce land
resources. Korea's land endowment—acreage of cultivatable land per
person—is probably one of the smallest in the world.
It is also important to note that the declining contribution of agriculture
to overall economic growth is not due to the farmers’ failure to respond
to various stimuli but rather is basically a result of unfavorable factor en-
dowments. Given the poor land resources and the limited substitutability
of capital and labor, it was inevitable that the growth of agriculture would
lag behind other sectors.
Despite a declining contribution of agriculture to overall economic
growth, the interaction between agricultural and other economic sectors
has had important implications for rapid industrialization. The growth of
industry has provided increased employment opportunities outside agricul-
ture, thus preventing further fragmentation of existing small-scale farms.
1. One estimate indicates that if the population that shifted into the nonagricultural sectors
had remained on the farm, the rural areas of Korea would have become much more crowded,
and the average farm size by the early 1980s would have been reduced to around 0.5-0.6
hectares—half the current size. The result would certainly have aggravated the difficulty in-
herent in the marginality of Korean agriculture, because nearly all the problems in the rural
sector have their origins in the marginal scale of farming.

371
372 Pal Yong Moon

Large increases in foreign exchange earnings, mainly from the export of

industrial products, made it possible to build fertilizer plants and farm
machinery plants as well as to import the requisite technical expertise. The
improved foreign exchange earnings also enhanced the nation’s ability to
obtain more foreign loans to finance various rural development projects for
irrigation or other rural infrastructure. Rapid urbanization and industrial-
ization have created a substantial shift in urban consumption patterns
toward higher quality foods, which has provided a great incentive for farm-
ers to expand the cultivation of cash crops, instead of concentrating on such
mono-grain crops as rice and barley. Thus, Korea’s industrialization, urban-
ization, and export policies have all contributed to the growth of agricul-
tural productivity.
This is not to say, however, that agriculture simply remained as a major
beneficiary of industrialization. Instead, it assumed an increasingly impor-
tant role throughout the process of industrialization. Agriculture continued
to provide the main source of income for the rural population and food
for the growing and increasingly affluent urban and industrial population.
Growing rural demand for farm inputs and consumer goods provided a
key stimulus for the expansion of the manufacturing and service indus-
tries. Investment in the education of the young rural population, many of
whom subsequently migrated to the cities, represents another significant
role of agriculture in the process of economic growth. The government pol-
icy of maintaining low agricultural prices in the 1950s and 1960s, combined
with the massive transfer of surplus farm labor, contributed to keeping ur-
ban wages at a relatively low level thereby benefiting the expanding indus-
trial sector.
American grain made available after 1955 under U.S. Public Law 480
provided one of the major props that enabled the Korean government to
pursue a low-price policy for staple food grains. The acquisition of grain,
excluding rice, for government use became relatively easy under this new
aid source. The U.S. farm products imported under this program were
wheat, barley, raw cotton, corn, milo, and tallow—of which wheat and barley
accounted for about 50 to 60 percent of the total value of imports. The quan-
tity of grain imported was, on the average, equivalent to 8-12 percent of
annual domestic grain production during the 1956-65 period. The availa-
bility of large quantities of aid grain from the United States that could be
purchased with local currency made it possible for Korea to attain more
or less balanced food-grain supplies without draining the country’s foreign
exchange. Although the significant contribution of PL 480 grains to gen-
eral economic stability has been widely recognized, the availability of aid
grain undoubtedly had negative effects on domestic grain production result-
ing from lower market prices for grain. Another possibility is that the easy
availability of free grain may have induced food administrators to overesti-
mate grain shortages, thus creating a disincentive in their attempts to in-
crease domestic production by means of price incentives.
 A Positive Grain-Price Policy (1969) 373

As the economy entered the 1960s and was gradually rehabilitated from
its war-wrecked state, there was a strong tendency among policymakers
to identify economic growth with industrialization. In both the First Five-
Year Economic Development Plan (1962-66) and the Second Plan (1967-71),
the major objective was rapid industrial growth. This industry-oriented
strategy necessarily required massive investment resources in the non-
agricultural sector. It is a widely accepted notion that savings in the rural
sector, whether created by voluntary savings of farm surplus or derived
through such compulsory measures as land taxes, provide essential sources
of investment financing in the initial stage of industrialization2 This hardly
seems to have been the case in Korea, for there is little evidence that the
agricultural sector provided sizeable financial resources for investment in
the nonagricultural sectors during the 1950s and 1960s3
Agricultural price policy was a different story. The government's major
efforts were directed toward maintaining low prices for staple food grains
and preventing wide seasonal price fluctuations, rather than maintaining
adequate prices to support farm incomes. Government purchase prices were
below market prices in almost every year. Although the rationale for low
food prices for urban workers was based on the principle of equitable in-
come distribution, it served primarily to increase industrial profits and cap-
ital formation at the expense of farm producers. When the supply of labor
was highly elastic, with rural areas overpopulated in the early stages of in-
dustrialization, low food prices helped reduce the cost of living in urban
areas and made it possible to maintain industrial wages at a level lower
than would otherwise have been possible.
The long-lasting adverse terms of trade for farm producers due to the
low-price policy further impoverished the already poor rural economy. It
also hindered efforts to increase food production and at the same time
stimulated rice consumption, resulting in a widening food gap. As long
as a large portion of the food grain shortage could be met by local-currency
purchases under the U.S. PL 480 program, the food gap itself did not im-
pose a serious burden on the country’s foreign exchange position. But once

2. In Japan, for example, heavy taxation on farmland served as one of the important transfer
mechanisms through which the agricultural sector provided investment resources for the
nonagricultural sectors (Hayami 1975:365). In Taiwan, increases in agricultural productivity
and the resultant farm surpluses were important sources of investment financing that accelerated
the process of industrialization (Hsieh and Lee 1966:2-3).
3. To begin with, there was not much farm surplus in the form of rural savings. Second, the
political atmosphere in Korea after World War II was such that it did not permit heavy taxa-
tion of the rural sector. In the 1950s farmers in general had a negative cash flow. In the 1960s
farmers were able to save a portion of their income, but relatively little of their savings went
into the nonagricultural sector. Beginning in the 1970s, Korean farmers achieved substantial
cash savings, but varied evidence indicates that most farm savings remained on the farm in
the form of farm equipment purchases, housing improvements, and the like. Moreover, the
government financial policy was not executed in such a way as to transfer substantial sums
of money out of agriculture to other sectors.
374 Pal Yong Moon

the U.S. policy shifted in the late 1960s to cash or credit sales in U.S. dol-
lars, the food grain situation became directly related to the balance-of-
payment position.
Faced with the increasing food shortage, the resultant foreign exchange
constraints and, at the same time, the growing income disparity between
urban and rural households, policymakers were obliged to give serious con-
sideration to expanding food-grain production and to a more equitable in-
come distribution between the agricultural and nonagricultural sectors. In
particular, the world food crisis in the early 1970s and soaring grain prices
in the world market made it almost inevitable that the government would
shift the emphasis in its development strategy toward agriculture. Against
this background, the government began in the late 1960s to turn its atten-
tion to agriculture, taking the initiative to improve the terms of trade for
agricultural products and, at the same time, effecting a two-price system
for rice and barley. The level of government investment in the agricultural
sector was also substantially increased.

GRAIN-PRICE POLICY
Grain Procurement and Distribution
The combined grain management programs are among the largest non-
defense activities of the Korean government. The wide range of govern-
ment grain programs in Korea reflects a situation of chronic grain deficits
in a country where the population is largely dependent on a cereal diet
and the belief that direct government action in grain procurement and dis-
tribution is necessary to maintain economic stability and ensure a steady
flow of grain supplies to consumers. It is also consistent with the belief
that it is the government's obligation to provide sufficient supplies of grain
to feed the people.
Administration of the grain management programs is the responsibility
of the Food Administration Bureau of the Ministry of Agriculture and Fish-
eries (MAF). The Food Bureau formulates and implements food policies
and programs at the national level. There is a Food Division in each provin-
cial and special city government to handle food programs at those levels.
Each county (gun) has a Food Administration Section that administers its
food programs.
Financial matters are handled by the National Agricultural Cooperatives
Federation (NACF), as agent for the Food Bureau. NACE, through its city
and county branches and unit cooperatives, disburses funds to pay for grain
purchased from farmers. The Agricultural Inspection Office, with provin-
cial, city, and county branches, is in charge of inspecting and grading all
grain received from farmers.
The government acquires rice from farmers through various programs
at prices set by the government during or after the harvest season. The major
 A Positive Grain-Price Policy (1969) 375

acquisition programs include: (1) direct purchase, (2) rice-fertilizer barter,

and (3) collection of harvest taxes in kind. Almost all of the rice procured
is acquired through direct purchases (Table 15.1). Grains are purchased at
government purchasing stations at various localities.
The barter of fertilizer for rice has been the second largest source of
government rice supplies. Under that program, farmers obtain fertilizer from
NACF by paying the cash equivalent of 40 to 50 percent of the fertilizer cost;
the remaining cost is paid by rice delivered after the harvest. Since the
government sells fertilizer at a heavily subsidized price, farmers found it
more advantageous to purchase fertilizer with cash rather than in exchange
for fixed quantities of rice. The rice-fertilizer barter program was discon-
tinued in 1977.
Farmers producing rice crops can pay their land tax in kind or in cash.
The average rate is about 6 percent of the harvest. If the total output of
the crop is less than 1.4 metric tons, no tax is levied. This exemption ap-
plies to about two-thirds of the farmers in Korea.

Table 15.1. Government acquisition of domestic rice and barley: Rice years
1960-82 (10° metric tons, polished)
Rice Barley
Total Direct Fertilizer Land Direct
Rice year rice purchase _ barter tax purchase
1965 183 66 23 94 76
1966 297 58 150 89 152
1967 336 77 155 104 89
1968 286 107 114 64 114
1969 153 21 78 54 203
1970 326 162 101 63 Zoo
1971 346 244 70 32 173
1972 507 405 68 34 382
1973 507 439 35 33 370
1974 480 407 32 41 414
1975 735 657 23 55 520
1976 784 673 42 69 571
1977, 1,043 871 81 91 189
1978 1,404 1,316 0 88 485
1979 1,355 1,261 0 94 Dah
1980 1,301 1,212 0 89 481
1981 546 465 0 81 407
1982 915 840 0 75 415

Source: MAF, ROK, Agriculture and Fisheries Statistics Yearbook (1965-82).

Note: The rice year begins with November of the preceding calendar year and extends through
October—e.g., rice year 1982 lasts from November 1981 through October 1982.
376 Pal Yong Moon

In addition to the above three programs, the government implemented

the rice-lien program which, though not precisely a part of the government
acquisition program, was nonetheless an important part of Korean grain
policy. That program was analogous in principle to the nonrecourse price-
support loans made by the Comrnodity Credit Corporation in the United
States. The government was authorized to provide nonrecourse loans and
required to buy rice used as security for the loans whenever the borrowers
wished. The program was initiated as one of the measures to prevent a
sharp decline in the price of rice during the harvest season. The loan rate
ranged from 65 to 90 percent of the government-determined purchase prices.
The program was considered quite successful in that it enabled farmers to
borrow money on rice after harvest and redeem or sell it later when the
price was seasonally higher. With the expanding scale of government direct
purchases, the program was discontinued in 1974.
The principal supply programs are for: (1) military use, (2) government
institutions, (3) prisoners and detainees, (4) relief, (5) seed grain distribu-
tion, (6) grain loans, (7) grain exchange, (8) price stabilization, and (9) con-
tingency or emergency programs. The purpose of “price stabilization” sale
of grain is to even out or at least moderate seasonal price fluctuations. Ini-
tially the major function of the government grain operation was to supply
the armed forces and government institutions, but with the expansion of
the operation's scale, the emphasis shifted to stabilizing seasonal grain prices
through sales to the grain market.

Grain Pricing
The most important decisions in government grain policy are determina-
tion of the amount of grain to be purchased and determination of the price
to be paid to farm producers. In both cases, the MAF is responsible for
preparing a proposal, which it submits to the five-member Economic
Ministers Council for formal approval. In the past, approval was required
also from the National Assembly, but since the 1972 “Yushin revolution’
this procedure has been discontinued.
In determining purchase prices for grain, a number of formulas can be
applied, including: (1) cost of production criteria, (2) price parity ratio, (3)
income parity ratio, and (4) international market prices. No one of these
formulas or criteria has been used as a single, standard basis for determin-
ing government purchase prices for rice and barley. Instead, purchase prices
estimated on the basis of these formulas are used as references only. In
other words, the method of determining government purchase prices for
rice and barley has varied from year to year depending on the prevailing
external and internal economic conditions. But in fact, the assessment of
overall economic conditions to be reflected in determining purchase prices
is largely a matter of judgment and depends much on the viewpoint of the
one who makes it.
 A Positive Grain-Price Policy (1969) 377

In the absence of an objective standard formula, therefore, the different

government agencies concerned tend to have different opinions on the level
of purchase prices that should be paid to farmers. For example, the MAF
is tempted to set the purchase price as high as possible with a view to en-
hancing farm incomes and domestic production of grain, whereas the Eco-
nomic Planning Board (EPB), whose main concern is to stabilize general
price levels, wants to set the price as low as possible. The resistance of the
Ministry of Finance is another restraint against higher purchase prices. These
differences in viewpoint among agencies—often called the “interministe-
rial purchase price war’—cause a delay almost every year in final determi-
nation of purchase prices, resulting in delayed purchases to the detriment
of farm producers. Table 15.2 presents the information referred to in deter-
mining rice purchase prices and the final prices for selected years.
Two-Price Policy
Widening negative price differentials. Korea's food-grain price policy has
tried to achieve a multitude of objectives, many of which are in conflict.
The determination of the purchase and selling prices of Korean rice has
been closely intertwined with a number of objectives and constraints in
the overall development strategy+
Of the many conceivable objectives of the government's agricultural pol-
icy, the following six are regarded as having direct relevance in determin-
ing price levels:
¢ reducing foreign exchange expenditures on grain imports;
¢ stabilizing the general price level;
¢ reducing government expenditures on its grain operations;
¢ enhancing farm income;
¢ increasing incentives for farm producers; and
¢ improving urban consumer welfare.
Determining which objective should be given the highest priority depends
on policymakers’ preferences, which may be governed in turn by their per-
ceptions of political, social, and economic conditions. If the government
attempts to minimize foreign exchange expenditures on grain imports, both
purchase and selling prices must be maintained at a relatively high level
to keep aggregate demand and supply in balance with reduced imports.
The resulting high prices of grain contribute to high farm income as well

4. Ina linear programming framework, objectives and constraints are two different concepts.
From a policy point of view, however, factors can be viewed as either objectives or constraints.
For instance, foreign exchange expenditure on food grain imports can be classified as an ob-
jective if the government attempts to reduce spending through policy intervention, or it can
be treated as a constraint if the government imposes a certain limit within which a food grain
program must be operated.
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380 Pal Yong Moon

as to high domestic production, but the same prices exert upward pres-
sure on the general price level and raise costs to consumers.
A two-price system for rice and barley—a higher price for farmers and
a lower price for urban consumers—was an attempt to resolve this dilem-
ma. The two-price system for barley went into effect beginning with the
1969 summer crop, and for rice beginning in the fall of 1969.
Until 1968 the selling prices for rice were determined by adding inter-
mediate handling costs to the original acquisition prices, resulting in no
financial loss due to price differentials. Beginning with the 1969 crop, the
selling prices (with the 1971 crop as the sole exception) have been below
the costs of acquisition and intermediate handling (Table 15.3). After 1973
the difference between the purchase and selling prices continued to widen,
and the government lost 20-35 percent on each bag sold.
In the case of barley, the price differences were even wider (Table 15.4).
Government efforts to keep barley selling prices low were motivated by a
desire to encourage consumers to substitute barley for rice in their diet.
Prior to 1968 the market barley price was maintained at about 65 percent
of the rice price. But with the increasing subsidy for barley prices after 1969,
the price of barley for urban consumers has been about 50 percent or less
than the price of rice.
Deficit in grain operation and inflationary financing. The implementation
of the two-price policy caused the costs for the government's grain opera-
tions to increase at an accelerating pace. The total accumulated loss incurred
by the government in the operation of the Grain Management Fund (GMF)
from 1970 to 1982 amounted to 1,235 billion won. The loss due to the price

Table 15.3. Government purchase price versus selling price for rice: Selected
years, 1960-82 (won/80 kg bag)
Government
Purchase Handling Government's _ Selling gain or
price cost total cost price loss (%)
Year (A) (B) (C=A+B) (D) [((D-C)/D]
1960 1,059 1S7, 1,216 1,216 0
1964 2,967 346 3,313 3,450 4
1970 7,000 664 7,664 6,500 -18
1971 8,750 738 9,488 9,500 .
1973 17,372 915 12,287 11,264 -9
1974 15,760 1,488 17,248 13,000 -33
1979 36,600 7,126 43,726 32,000 -37
1982 55,970 9,358 65,328 52,280 -25
ae ee oe ee
Source: Data obtained from Food Bureau, MAF, ROK.
* Less than 1 percent.
 A Positive Grain-Price Policy (1969) 381

Table 15.4. Government purchase price versus selling price for barley:
Selected years, 1969-82 (won/76.5 kg bag)

Government
Purchase Handling Government's _ Selling gain or
price cost total cost price loss (%)
Year (A) (B) (C=A+B) (D) [((D-C)/D]
1969 3,348 439 3,787 2,750 -38
1970 3,850 548 4,398 3,100 —42
1973 6,993 909 7,902 6,000 -32
1974 6,091 1,412 7,503 8,320 10
1979 22,000 9,618 31,618 10,120 -212
1982 33,780 9,473 43,253 28,000 -54
Source: MAF, ROK, Agriculture and Fisheries Statistics Yearbook (1969-82).

subsidy for rice alone represented 48.4 percent of the total (598 billion won);
for barley, 44 percent (544 billion won). The loss due to the flour price sub-
sidy during the 1972-76 period, when international wheat prices soared,
was 10.4 percent (128 billion won) (Food Bureau, MAF, ROK, unpublished
data).
To break down the GMF loss by source of expenditure, 25 percent (305
billion won) of the total loss is attributable to the negative price differen-
tials, whereas 75 percent (930 billion won) resulted from operation and
management costs, including interest payments on the borrowed funds.
The interest payments on both the long-term borrowings from the Bank
of Korea and the Grain Bonds issued represent 50 percent (494 billion won)
of the total operating and management costs (Food Bureau, MAF, ROK,
unpublished data).
Increasing government intervention in the grain market. The grain market
in Korea is characterized today by a dualistic system, combining free-market
transactions and government control, although the degree of government
control has varied from year to year. The Grain Management Law of 1950
gave the government legal authority for complete regulation of the grain
market whenever the government considered it necessary. The purpose of
the law was to enable the government to secure sufficient grain from farm-
ers, allowing it to stabilize the national economy by exercising control over
grain distribution and consumption through manipulation of government
stocks. In 1963 and 1967 the main provisions of the law were reaffirmed
and additional authority was given to the government, but the basic direc-
tion remained the same. Free-market grain transactions exist only by govern-
ment sufferance. The government has the authority to import or export grain
and can give orders to grain dealers, shippers, and processors, and to hotels
and restaurants whenever deemed necessary.
382 Pal Yong Moon

The government directly conducts the procurement, transport, storage,

milling, and sale of government-controlled grain. In the early years, the
government acquisition program was mainly concerned with rice, but more
recently the share of barley has substantially expanded. Whenever the
government could not secure sufficient domestic grain, the gap was filled
by imports. During the 1950s the market share of government rice was less
than 10 percent, but by 1982 had expanded to nearly 50 percent. The govern-
ment handled almost 90 percent of the barley marketed in 1982.
The primary function of the government grain program during the 1950s
was to secure an adequate supply of grain for the armed forces, govern-
ment institutions (such as the police force and public hospitals), and for
other ministries for relief and work programs. Whether intentionally or
unintentionally, this procurement action had the effect of providing sup-
port for prices at harvest time when grain prices normally fell.
In the 1960s the government expanded the scale of its grain operations
through increased purchases from farmers. In addition to the original func-
tion of supplying grain for institutional uses, the government began to put
emphasis on seasonal price stabilization through direct sales in the market
during the nonharvest season, when prices normally rise. These direct sales
for seasonal price stabilization accounted for almost 80 percent of the total
government grain supply by 1982, reflecting the shift in the government's
main concern toward dampening seasonal rises in grain prices. In recent
years there has been much criticism of the increasing share of government
operations in the grain market and the way in which the government oper-
ates the grain program to de-seasonalize rice prices throughout the year.

OTHER AGRICULTURAL POLICIES

Land and Water Resource Development
The development of agricultural water resources has been one of the most
intensive projects undertaken since the beginning of the Second Five-Year
Development Plan (1967-71). During that period the government empha-
sized small-scale irrigation projects, such as the construction of small-scale
dams, pumping stations, tubewell irrigation, and weirs. But the Third Five-
Year Development Plan shifted the emphasis to larger-scale, integrated
regional development projects.
The integrated plan for developing the four major river basins that was
set out in 1971 included the construction of 13 dams and electric power
plants. In addition, afforestation and erosion-control projects on watershed
areas of the Han, Kum, Nakdong, and Yongsan Rivers were also under-
taken. Projects for developing multipurpose, large-scale farming areas were
completed in the Kum River and Pyongtaek Basins, where reservoirs, tidal
dikes, water-pumping and draining plants, and canals were constructed.
The two tidal dikes completed at Asan and Namyang Bays in 1974 were
the biggest water resource development projects in Korean history.
 A Positive Grain-Price Policy (1969) 383

Completion of these projects brought 11,000 hectares (27,200 acres) of

land reclaimed from the seabed under cultivation and also irrigated 16,000
hectares (39,500 acres) of existing farmland. Paddy field consolidation
projects, initiated in the mid-1960s, continued to be promoted under pub-
lic financial subsidy with a view to facilitating farm mechanization and in-
creasing farming efficiency. By 1982 the total area of paddy fields rearranged
under this program amounted to 400,000 hectares (988,000 acres), or ap-
proximately 33 percent of Korea's total paddy lands.
Farm Mechanization
Stimulated by rapid changes in rural conditions, in particular the steady
outflow of rural workers coupled with rising rural wages, the government
initiated various supportive measures designed to facilitate the introduc-
tion of labor-saving farm equipment. As a result, the quantity and variety
of farm machinery in use in Korea has increased sharply in recent years.
The government began in 1979 to provide loans for the purchase of
mechanized field equipment such as tractors, transplanters, harvesters, and
combines. Although this equipment is still in an early stage of diffusion,
the numbers are expected to increase rapidly in the years to come (Table
15.5). The levels of farm mechanization attained thus far, however, are
not yet high enough to offset the effects of the rural labor shortage to a

Table 15.5. Farm machinery in use: Selected years, 1965-82

Item 1965 1970 1975 1980 1982

Power tiller
Number (10%) pa 11.8 85.7 289.8 422.0
Farms per machine 206.9 27.8 7.4 4.7
Power sprayer and duster
Number (103) 7.6 45.0 13737 330.6 403.7
Farms per machine S02 £753 6.5 4.9
Transplanter
Number (103) 0 0 0 Adal 19:7
Farms per machine 194.1 101.3
Harvester
Number (10%) 0 0 0 13:7 1733
Farms per machine 157.3 115.4
Tractor
Number (10%) 0 0 0.7 ay 5.6
Farms per machine
Combines
Number (10%) 0 0 0 12 32D
Farms
Sure nL
per machine
Source: MAF, ROK, Agriculture and Fisheries Statistics Yearbook (1965-82).
384 Pal Yong Moon

satisfactory extent. This is because the utilization as well as diffusion of

farm machinery has been impeded by the prevailing small-scale, fragmented
farming operations and by a lack of adequate physical and economic con-
ditions for mechanization.
Agricultural Credit Policy
A major part of the institutional basis for agricultural credit in Korea was
consolidated during the 1960s. Major developments in the agricultural credit
field since the early 1970s include the growth of mutual financing through
agricultural cooperatives, the strengthening of cooperative lending func-
tions based on the cooperatives’ enhanced ability to raise funds on their
own, and increased provisions for medium- and long-term development
loans.
Mutual financing through basic cooperatives refers to savings and loan
arrangements made by economically weak farmers to promote mutual finan-
cial help for cooperative members trying to overcome their fund shortages.
This mutual financing system was put into practice as part of a program
to strengthen the ability of basic cooperatives to become self-funded in con-
junction with the enactment of the Credit Union Law in August 1970. The
mutual financing system is an extension of traditional cooperative financ-
ing practices. It is aimed at pooling small sums of idle funds in rural com-
munities and private capital hitherto used for usurious lending operations.
The pool is then utilized for farming loans, thereby facilitating the efforts
of basic cooperatives to become financially self-supporting by building up
their own financial resources, instead of depending on government help.
To keep pace with the expansion of the physical volume of agricultural
credit, institutional improvements have continued in the rural credit sys-
tem. Such institutional changes include the implementation of a credit-
worthiness guarantee system for farmers and fishermen that is designed
to supplement the limited ability of economically weak farmers and fisher-
men to provide collateral for their loans. This system was put into effect
in 1972 under the Law on Guaranteeing Credit-worthiness of Farmers and
Fishermen. NACF administers these funds.
Another major change in the agricultural credit system was the introduc-
tion of a farmland mortgage system. The land reform of 1950 made it virtu-
ally impossible to mortgage agricultural land, causing confusion and
difficulty in the rural credit system for some time. The farmland mortgage
system was put into effect in 1970. Farmland may be mortgaged only when
the farmer-owner wants to obtain a loan. No one other than an agricul-
tural or fisheries cooperative is authorized to be a mortgagee, and charg-
ing advance payments of interest or compound interest on the mortgage
loan is prohibited.
In the early 1970s a group lending system was instituted with the aim
of improving loans to individual farmers. The new system was designed
 A Positive Grain-Price Policy (1969) 385

to make loans to productive organizations, such as crop cultivation teams

and farm complexes, with the aim of linking the production and market-
ing of farm products to agricultural credit. Also, a system of advance an-
nouncement of credit availability was put into force, and lending procedures
were substantially simplified.
Fertilizer Price Policy
With limited land resources, increasing land productivity is the only means
of increasing aggregate farm output. A high rate of fertilizer application is
part of the answer. Throughout the 1960s and 1970s, the government made
substantial efforts to increase fertilizer use through provision of price sub-
sidies and purchase credits and by means of the rice-fertilizer barter pro-
gram. As a result, fertilizer consumption in nutrient terms more than
doubled during the 1965-80 period, increasing from 393,000 metric tons in
1965 to 800,000 metric tons in 1980, marking an annual average growth rate
of 6 percent.
This rapid increase in fertilizer consumption led to the construction of
a series of large-scale fertilizer plants. By 1970 the country had not only
achieved self-sufficiency in fertilizer supply but was also exporting surplus
fertilizer. In 1972 average annual production reached 1,200,000 metric tons
of nutrient, exceeding the annual domestic requirement by 400,000 metric
tons.
In spite of the surplus produced, the prices paid by farmers, even after
subsidizing, are higher than those in the world market. The subsidized price
of nitrogen fertilizer is almost double the world market price, and prices
of phosphate and potash fertilizers are about 20 percent higher. Such high
pricing for domestically produced fertilizer is mainly attributable to the un-
favorable terms that were imposed at the time of joint ventures with for-
eign enterprises in constructing the fertilizer plants. For instance, the Korean
government is obliged to procure the entire amount of fertilizer produced
at guaranteed profit rates ranging from 15 to 20 percent.
The cumulative deficit in the fertilizer account due to the price subsidy
during the 1966-82 period was 570 billion won. If the procurement price
actually paid to Hankuk Fertilizer Company were applied to other manufac-
turers uniformly, 47 percent of the total deficit would accrue to the subsidy
for manufacturers and the remaining 53 percent to the subsidy for farm-
ers. If the world price were used as a benchmark price, most of the deficit
would accrue to the subsidy for the fertilizer industry.
An interesting study to determine which sector—the fertilizer industry
or the farmers—actually benefits from the current fertilizer price policy, es-
timated the protection rate on the basis of world prices (D. S. Lee 1983).
According to the estimates for the 1976-82 period, the protection rate for
the Korean fertilizer industry was 68 percent, whereas that for Korean farm-
ers was -18 percent. In the case of urea, the protection rate for the fertilizer
386 Pal Yong Moon

industry was 61 percent, but was -51 percent for Korean farmers. These
results indicate that the fertilizer industry has benefited from the govern-
ment price subsidy program. Korean farmers, however, have paid high fer-
tilizer consumption taxes; therefore, it can hardly be said that the Korean
fertilizer subsidy program has been implemented in a manner that pro-
tects the agricultural sector.

THEORETICAL APPROPRIATENESS OF THE POLICY

Roles Played by Agricultural Prices in Industrialization
Much of the literature on economic development views agricultural develop-
ment as a precondition for industrialization in the early stages of develop-
ment. For example, Kuznets (1961) argues that a rise in productivity per
worker in agriculture is a precondition of the industrial revolution in any
part of the world. Bairoch (1964) also emphasizes that increases in agricul-
tural productivity and growth in demand for agricultural inputs supplied
by industry are major forces that give impetus to the process of cumulative
economic growth. Since agriculture is by far the largest sector in a tradi-
tional economy, it is often assumed that the rural sector not only consti-
tutes a source of capital and labor for industry but also provides the major
source of demand for industrial output as well as supplies of industrial raw
materials.
Among the various aspects of the interaction between agriculture and
other economic sectors, agricultural prices have played one of the most sig-
nificant roles throughout the process of industrialization. Historically, as
part of development policy, agricultural price policy has generally been used
negatively. In other words, the terms of trade of agriculture are deliberately
depressed with a view to maintaining food prices at a low level and hence
sustaining low levels of industrial wages that would otherwise cut into in-
vestment in the nonfarm sectors.
The standard explanation of the depressing effect on industrial invest-
ment from rising agricultural prices can be traced to Adam Smith and later
to W. Arthur Lewis and the basic argument of food as a wage good. Inter-
preted in terms of price, rising food prices cause upward pressure on money
wages, and this in turn causes a squeeze on industrial profits, thereby reduc-
ing the incentive and ability to invest by reducing the profits that serve as
a major source of investment funds.
A low agricultural price policy has been a common feature of economic
policy in the early phases of development in both capitalist and socialist
countries, although the institutional mechanisms used in implementation
have differed. A variety of evidence to illustrate this effect can be cited from
the experiences in the early stages of development of the developed
countries.
In the United Kingdom, the whole free-trade movement that came to
 A Positive Grain-Price Policy (1969) 387

repeal the Corn Laws in the nineteenth century had the aim of lowering
the price of food and raw materials relative to the price of manufactured
goods (Tracy 1964). In Russia, the collectivization of agriculture was theo-
retically endorsed by Lenin and carried out in practice by Stalin to squeeze
from the peasantry their whole surplus production at a zero or low price
(Kahan 1964). The Japanese story is another illustration. During the early
period of economic development, the terms of trade of agriculture were
deliberately kept low, and, in addition, agriculture was taxed heavily to
finance industrial expansion. The land tax provided about 70 percent of
public revenue during the period 1878-1907 and 40 percent during 1908-17.
Rents remained at more than half of the rice yield in the earlier period
(Okawa and Rosovsky 1960).
In Korea, too, the government's primary efforts were centered on main-
taining low prices for food, particularly rice. Because of the role of rice as
a wage good, a rise in rice prices was believed to be one of the major causes
of an increase in the general price level. Thus, cheap grain played an im-
portant role in the early stages of industrialization during the 1950s and
1960s, especially when labor-intensive light industries such as textiles and
handicrafts predominated, particularly in the export manufacturing sector.
The process of industrialization cannot rely, however, on a continuous
squeeze on agriculture. There is some critical minimum rate of agricultural
growth, high or low, without which development efforts will not be able
to achieve their general targets, because of the initial dominance of agricul-
ture in income generation, employment, and exports, and because of the
dynamic complementarity of agricultural growth and general economic
growth. A variety of evidence shows that in many developing countries
the minimum rate of agricultural growth consistent with rapid and sus-
tained general growth is quite high and that a continuous negative price
policy designed to achieve the goal of industrialization will have a negative
effect upon industrialization itself.
There are a number of reasons why a negative agricultural price policy
and a stagnant, slow-growing agricultural sector seriously constrain the
general rate of growth. First, the rapid increase in population creates an
added demand for food that cannot be met under conditions of stagnation
or even slow growth. Second, a negative price policy has naturally created
disincentives for the increase of farm output, aggravating the food short-
age problem as well as causing food prices to soar, which was exactly the
opposite of the original purpose of depressing food prices. Third, a nega-
tive agricultural price policy can create formidable political difficulties in
rural areas, as well as economic ones.
Many countries that once adhered to a negative agricultural price policy
as a policy norm began to introduce producer-price support schemes for
major crops. The Korean experience offers some of the most dramatic evi-
dence concerning the turn toward a positive price policy.
388 Pal Yong Moon

Price Support Versus Input Subsidization

It is often argued that since the transformation of traditional agriculture
is primarily of a technical and organizational nature, this transformation
cannot be achieved by high product prices alone. It requires innovation,
the absorption of new inputs, the utilization of idle resources, and institu-
tional adjustments. If the policy aim is to accelerate the growth of agricul-
tural output through diffusion of innovations, input subsidization would
be a more effective means than product price support?
Krishna (1967) gives several reasons in support of an input-subsidization
scheme. If product prices are raised, farmers may or may not invest in im-
proved cultivation methods. They may simply spend the extra income on
consumption, resulting in the waste of government expenditure on price
supports. If, however, inputs are subsidized, the benefit of government ex-
penditure can be derived by the farmers in proportion to their use of im-
proved inputs. Input subsidization for agriculture will also help keep the
prices of food and raw materials low which will benefit the growing indus-
trial sector.
These propositions are valid so far as the same degree of farm producers’
response is induced by either scheme. If it does not matter whether the
profitability of a product is increased, either by raising the price of the
product or by lowering the prices of inputs, the government can use either
input subsidies or product price supports to induce a given output response.
But there are reasons why ordinary farmers, even in traditional agriculture,
are more sensitive to changes in product prices than to input price manipu-
lation.
First, input-price subsidies can cover only the purchased inputs, whereas
price support induces an increased use of purchased as well as self-supplied
inputs. More specifically, it is possible to subsidize the price of fertilizer,
pesticides, farm implements, and irrigation fees, but it is impossible to sub-
sidize family-supplied compost, labor, and land use, which account for a
large portion of production costs. Second, most farm producers are con-
cerned with the downward fluctuations in product prices more than with
the upward fluctuations in the price of purchased inputs that form a small
part of total production costs. Third, input-price subsidization cannot dis-
criminate among products, but product-price supports can be applied selec-
tively to induce increased production of specific products.
In actual policy implementation, however, neither scheme can be a com-
plete substitute for the other. In fact, both are needed as complementary
instruments of policy, because farmers become more willing to adopt im-
proved methods of cultivation if the terms of trade for their products be-
come favorable—that is, higher product prices and lower input prices. The

5. The theoretical explanations concerning the comparison of the effectiveness of both schemes
in this section draw heavily on those given by Krishna (1967:526-28).
 A Positive Grain-Price Policy (1969) 389

improved technology accompanies an increase in productivity of farming

resources employed. Thus price incentives have a double effect in increas-
ing agricultural production—fast adoption of improved technology by farm
producers and increased use of productive factors, both purchased and non-
purchased.
This is the very effect that high grain prices for major food grain and
subsidized prices for major farm inputs has brought about in Korea. Since
the initiation of economic development plans in the 1960s, the government
has put a major emphasis on making the required farm inputs available
at heavily subsidized prices. For example, the subsidy component on farm
equipment purchases averaged 30 to 50 percent of the purchase prices dur-
ing most of the 1960s and 1970s. Considering its limited land resources,
Korea had to depend on increasing yields per hectare. An important part
of the solution was increased use of inputs, such as chemical fertilizer, pes-
ticides, and improved crop varieties as well as the expansion of irrigation
facilities. These, combined with high grain prices, contributed to the in-
crease in aggregate production during the 1970s.

Terms of Trade and Labor Productivity

When one appraises whether a certain industry is in a favorable condition
or not, relative to other industries, one is apt to judge by the movements
of terms of trade. When one does this, one loses sight of an important aspect
of price changes, that is, changes in labor productivity. Labor productivity
is one of the most important factors (along with price changes) determin-
ing supply conditions and incomes. Therefore, in evaluating the relative
position of different industries one must not make judgments on the basis
of price phenomena alone. To have economic significance, the relative move-
ments of prices must be evaluated by simultaneously taking into consider-
ation the relative changes in labor productivity.
To put this in concrete terms, assuming perfect competition, if labor
productivity in a certain industry increases with the adoption of capital-
intensive, mass-production methods, the unit cost of production necessar-
ily declines and therefore the product price must decline. If the price does
not fall, despite substantial growth of labor productivity, then. the price rose
relative to other industries. Conversely, if the product price of the industry
with stagnant or slow-growing labor productivity does not rise, then that
price actually fell relative to that of the fast-growing industry. In short, the
rate of change in price is inversely related to the change in labor productivity.
Now let us evaluate the actual movement of the terms of trade in rela-
tion to the changes in labor productivity between agriculture and manufac-
turing in Korea. Table 15.6 compares the differences in both the average
annual rate of increase in prices and labor productivity between rice grow-
ing and manufacturing for three different periods. For the period 1960-70,
the average annual rate of increase in the rice price was 16.5 percent, whereas
390 Pal Yong Moon

Table 15.6. Comparison of the average annual rates of growth in labor

productivity and prices: Rice sector versus manufacturing (%)
Item 1960-70 1970-76 1977-82

Rice price received by farmers (A) 16.5 24.3 18.8

Prices paid by farmers (B) 1222 19:9 25.0
(A - B) 4.3 4.4 -6.2
Labor productivity in manufacturing (C) 12.6 10.1 1
Labor productivity in rice sector (D) 22 10.3 4.9
(C - D) 10.4 -0.2 6.6
Sources: Computed from data in MAF, ROK, Farm Household Economy Survey (1960-83); EPB,
ROK, Monthly Statistical Review (1960-82).

that of manufactured goods was 12.2 percent. This means that the prices
of rice were at a relatively favorable level for farmers during the 1960s. But
when we compare the rate of change in labor productivity, the above judg-
ment may lose ground. Although labor productivity in manufacturing grew
at the annual rate of 12.6 percent, that in rice growing increased at a rate
of only 2.2 percent.
For the high grain-price period of 1970-76, the picture is completely differ-
ent. Not only did the price of rice rise at a faster pace (an annual rate of
24.3 percent) compared to that of manufactured goods, but also the annual
rate of growth of labor productivity slightly exceeded that in the manufac-
turing sector. This implies that the terms of trade for rice farming were un-
precedentedly favorable in that period. That was the period when the
government turned its policy emphasis toward high rice prices and during
which the high-yielding rice variety (Tongil) was widely diffused.
After 1976-77 the situation reversed again. The price of rice rose at an
annual rate of 18.8 percent, and the price of manufactured goods increased
at a rate of 25 percent. Labor productivity in the manufacturing sector far
exceeded that in the rice-growing sector. The low growth rate of labor
productivity in rice production in this period can be explained by diminish-
ing returns as the yield potential of the new rice variety was substantially
exhausted. But the adverse movement of the terms of trade for rice is a
reflection of the government's retreat to its old low grain-price policy.
EFFECTS OF THE POLICY MEASURES
Although the Korean economy is basically oriented toward the free-market
system, government intervention in the grain market has been continuously
intensified over time through price controls as well as demand and supply
adjustments. Government intervention has been historically accepted as
a given condition, justified on the grounds that undesirable developments
that hinder the attainment of policy goals would occur in the grain sector
if the determination of grain prices were completely left to market forces.
 A Positive Grain-Price Policy (1969) 391

Which developments should be considered undesirable and what are

the policy goals? These are a matter of judgment that depend on the eco-
nomic conditions of the country concerned. So far as the grain-price poli-
cy is concerned, the following policy goals are regarded as relevant: (1)
increased food grain production, (2) enhanced farm income, (3) general price
stabilization and protection of urban consumers, (4) equitable income dis-
tribution, and (5) substitution of barley for rice. The effects of grain-price
policy can best be assessed in terms of the degree to which it contributes
to achieving the above-stated policy goals.

Effects on Food Grain Production

It has been widely questioned whether farmers engaging in traditional
agriculture, where a large portion of their own products are used for fam-
ily consumption, respond to changes in prices in their production decision
making. Some economists have even gone so far as to claim (though never
to support the claim empirically) that price responsiveness was reverse, im-
plying that higher output prices result in smaller total output on the basis
of the “fixed revenue hypothesis.” These views were either abandoned or
publicly renounced as a result of extensive research on the price respon-
siveness of farmers.
Generally, it is said that the extent to which farmers are responsive to
external economic conditions varies according to region and to their stages
of agricultural development. For example, farmers in relatively more com-
mercialized agriculture or those living close to an urban market are more
sensitive to changing market conditions than are those in subsistence farm-
ing or those living in remote areas. In Korea, however, where commercial
and subsistence farmers coexist side by side in terms of residences and cul-
tivated fields, there is every reason to believe that the behavior of subsis-
tence farmers is influenced by that of commercial farmers.
A change in the relative level of grain prices induces farm producers to
change the level of inputs used as well as their allocation among different
crops, resulting in changes in aggregate production. The degree of
producers’ response to price changes is in general measured in terms of
price elasticities. The price elasticity of supply measures the willingness
as well as the ability of farm producers to adjust to changing price
conditions—one of the most important aspects of a dynamic economy.
The price elasticity of supply for rice was estimated by one study to range
from 0.2 to 0.3 (Moon 1982). This means that a 10 percent rise in the real
price of rice leads to a supply increase of 2 to 3 percent. It is generally ac-
cepted that as the yield potential of a crop is exhausted, the price response
of output in general slows down. But this does not mean that farmers do
not respond in their grain production to changes in relative product prices.
In Korea the overall rate of self-sufficiency in all grain has declined from
80-90 percent in the 1960s to nearly 50-60 percent in the early 1980s, with
392 Pal Yong Moon

almost half of the total requirement filled by imports. This rapid decline
of the self-sufficiency rate is mainly due to a rapid increase in the importa-
tion of feed corn and soybeans. The level of self-sufficiency in rice, however,
has been maintained at 95-100 percent despite a continuous increase in de-
mand due to the growth in population and real income. Total rice produc-
tion increased from 3.5 million metric tons (polished basis) in 1965 to 5.5
million metric tons in 1982, an increase of nearly 60 percent during a pe-
riod of 17 years. This remarkable increase in production and a stable rate
of self-sufficiency for rice are mainly attributable to the high rice-price pol-
icy, combined with wide diffusion of a high-yielding rice variety.

Effects on Farm Income

Although the contribution of rice to farm household income varies among
farms of different sizes, data show that on average about 57 percent of the
total agricultural receipts originated from grain cultivation (MAE, ROK, Farm
Househoid Economy Survey, 1982). For farmers with less than 1 hectare, 52
percent of total receipts was contributed by grain; for the farmer cultivat-
ing between 1 and 2 hectares, the contribution was 60 percent; for the farmer
with more than 2 hectares, grain constituted approximately 65 percent.
According to a recent study applying an econometric technique, a 10 per-
cent rise in the terms of trade for agricultural products results in an increase
in agricultural income of farm households by 7 to 8 percent. Regression
equations to determine farm income by the recursive method on the basis
of 1962-82 data indicate that a 10 percent rise in agricultural labor produc-
tivity due to increases in government investments and loans and in educa-
tional level is estimated to increase real income by about 5 percent, whereas
a 10 percent increase in the agricultural terms of trade raises farm house-
hold real income by almost 8 percent (Moon 1982:199-200).
A comparison of incomes of farm households and urban wage earners
provides further evidence that the income position of farmers relative to
urban wage earners improved during the high grain-price period but
declined thereafter when the government policy changed to a low grain-
price policy (Table 15.7). This reflects the fact that grain prices, particularly
rice prices, are the most critical factor in determining farm household
income.
Many economists and public officials argue that farm income should be
improved, from the long-run point of view, through increased agricultural
productivity instead of subsidizing the prices of agricultural products at
government expense. They also claim that the efforts should be directed
toward expanding the sources of off-farm income through fostering rural
industries Given the recent trends and various constraints inherent in rural
industrialization, however, the predominance of farming activities in de-
termining farm income is destined to continue for quite some time to come.
 A Positive Grain-Price Policy (1969) 393

Table 15.7. Comparison of rural and urban household income: 1965-82 (10°
won)

Farm household Urban household (A/B)

Year (A) (B) (%)
1965 112 113 99.1
1966 130 162 80.2
1967 149 249 59.8
1968 179 286 62.6
1969 217 334 65.0
1970 256 381 67.2
1971 356 452 78.8
1972 429 517 83.0
1973 481 550 87.5
1974 674 645 104.5
1975 873 859 101.6
1976 1,156 1,158 99.8
1977 1,433 1,405 102.0
1978 1,884 1916 98.3
1979 2,227 2,630 84.7
1980 2,693 3,205 84.0
1981 3,688 3,450 106.9
1982 4,465 4,520 98.8
Sources: MAF, ROK, Farm Household Economy Survey (1965-82); EPB, ROK, Urban Household
Living Expenditure Survey (1965-82).

Effects on General Price Stabilization

and Protection of Urban Consumers
In Korea the percentage of income spent on grain is greater than that of
any other single item. An increase in the prices of grain, therefore, pushes
up the cost of living, causing upward pressure on wages, which in turn
drives up the cost of production for manufactured goods and services. The
magnitude of this cost-push effect depends largely upon the proportion
of grain expenditure in the cost of living. The higher the share of grain in
the cost of living for urban workers, the greater the upward pressure on
wages will become when grain prices rise. The share of grain in the cost
of living for an average urban worker’s household was about 19 percent

6. When one talks about rural industrialization, he is likely to be concerned with the effects
of increasing employment opportunities in rural areas. But one must not overlook the ad-
verse impacts on the overall productivity of agriculture: (1) diversion of farmland into residential
and industrial sites, (2) increase in farmland prices, (3) likely overinvestment in farm mechani-
zation due to rise in rural wages, and, most important of all, (4) disincentives for farming
due to increasing opportunities for off-farm employment.
394 Pal Yong Moon

in 1975, but it had declined by 1981 to about 11 percent (Table 15.8). It is

expected to decline further as real income continues to grow. However, the
labor share of income has been maintained at the relatively stable level of
50 percent, that is, other things being equal, a 10 percent rise in grain prices
causes an increase of 0.5 percent in the general price level?
The declining share of grain in the cost of living does not mean that
changes in grain prices have little or no effect on the prices of other com-
modities. Contrary to the prevailing concern of public officials, however,
the evidence is clear that the cost-push effect of a rise in grain prices has
been substantially weakened.
As the economy continues to grow, product lines will become increas-
ingly diversified and the pattern of consumption will undergo a substan-
tial change. As a result, both the variety and volume of nonagricultural
goods in the domestic market will increase, while the relative share of grain
falls. Therefore, unless there is an extraordinarily sharp rise or fall in the
price of grain (say, 30 or 40 percent), maintaining low grain prices will no
longer be an effective means of attaining the policy goal of general price
stabilization.
Effects on Income Distribution
There are important trade-offs and conflicts among various direct influences
and indirect effects of grain-price policy on the real incomes of different
income groups. Changes in grain prices, of course, effect a transfer of

Table 15.8. Proportion of grain and rice expenditures in cost of living for
urban households and labor income share in manufacturing
sector: 1975-81 (%)
Proportion of expenditure Tie eae
Year All grain Rice share
1975 19.2 17.4 40.8
1976 18.8 17.6 42.6
1977 15.9 14.6 47.6
1978 nO: 11.8 51:2
1979 10.8 10.0 50.3
1980 10.5 10.4 51.0
1981 10.8 2.7, 47.5
Sources: EPB, ROK, Urban Household Living Expenditure Survey (1975-82); EPB, ROK, Economic
Statistics Yearbook (1975-82).

7. The effect of changes in grain prices on changes in the general price level can be measured
in a number of ways. For example, it can be measured by applying the price inverse matrix
of the input-output table or by using regression techniques. Considering the quality of the
data in the prepared input-output table, however, it is doubtful that such efforts are worth-
while. Furthermore, a straightforward guess/estimate is sufficient for present purposes.
 A Positive Grain-Price Policy (1969) 395

income between the agricultural and nonagricultural sectors of the econ-

omy, but what draws our interest is the income distribution between small
and large farms within agriculture and between high- and low-income
groups in the urban area.
Changes in agricultural prices affect the incomes of individual farms in
proportion to their sales of produce. Large farms normally sell a larger por-
tion of what they produce than do small farms. Therefore, the largest ef-
fects, both relative and absolute, fall on the largest producers. Some data
indicate that farmers with less than 0.5 hectares sold only 21.5 percent of
their 1981 rice crop output, the rest being kept for home consumption,
whereas those with more than 2 hectares sold 56.2 percent. When the price
of rice increases by 10 percent, the real income of the small farm increases
by slightly more than 2 percent, whereas the real incomes of large farms
rise by 5.2 percent. The difference in absolute terms may be even greater,
because the higher percentage increase experienced by large farms is ap-
plied to a larger initial income.
These relationships refer to effects of price changes on producers when
quantity produced stays constant. In actuality, however, changes in grain
price affect rice output, although with some time lag. In general, the farm-
ers with larger holdings market a higher proportion of their production and
are more responsive to price changes.
Hence price changes exert a much greater effect on the output of larger
than smaller farms, adding further to the disparity. In fact, the smallest
farms may be hurt by the price increase. Many farmers with marginal hold-
ings are net purchasers of rice during the off-season when their incomes
are earned from off-farm activities. Insofar as they purchase with cash, an
increase in rice prices affects them primarily as consumers, causing a decline
in real income.
Among urban consumers, a roughly converse situation arises. Agricul-
tural prices affect urban consumers in proportion to the ratio of expendi-
ture on food to their incomes. Generally, lower income urban consumers
spend a much higher proportion of their incomes on food grain than do
those with higher incomes. According to EPB, ROK, Urban Household Liv-
ing Expenditure Survey (1982) data in Korea, although the top 10 percent in
income of urban wage earners spend approximately 1.8 times as much on
rice as the lowest 10 percent, they allocate only 4.2 percent of their total
living expenditure for rice purchase, compared with 13.3 percent for the
lowest-income class. Therefore, a 10 percent rise in the price of rice has the
effect of reducing real income only by 04 percent for the upper-income
group, but reduces the income of the lowest-income group by 1.3 percent.
Thus a high grain-price policy tends to provide benefits primarily to larger
farmers and the upper-income class of urban consumers. The majority of
small farmers and urban lower-income earners are helped relatively little
by a high grain-price policy. On balance, a rise in agricultural prices tends
396 Pal Yong Moon

to redistribute income away from low-income urban consumers toward high-

income farm producers.
This is not to say, however, that the degree of effect on income distribu-
tion must be used as the sole criterion for policy decision in determining
grain prices. For Korea, where a chronic food-grain shortage persists and
a substantial amount of foreign exchange is spent for grain imports, increas-
ing domestic production of grain and reducing imports is probably more
important.

Effects on Substitution of Barley for Rice

A two-price system for barley, which was put into effect beginning with
the 1969 crop, was originally designed to induce consumers to substitute
barley for rice in their diet. Prior to 1968, the market price had been main-
tained at a level of more than 65 percent of the rice price; but with the in-
creasing subsidy for barley prices after 1969, the price of barley for urban
consumers was lowered to almost 40 percent of the rice price.
Other measures were taken to encourage consumers to substitute barley
and other grains for rice. Restaurants were required to serve a mixture of
75 percent rice and 25 percent barley. They were also required to serve noo-
dles and other non-rice food items on Wednesdays and Saturdays. Lunches
carried by school children had to contain a similar mixture.
The lower price ratio of barley relative to rice along with various adminis-
trative measures was conducive to diversion of consumption away from
rice during the early 1970s. An official estimate indicates that the amount
of rice saved by this policy was about 600,000 metric tons in 1972. However,
as per capita income grew, the average consumer became less responsive
to changes in the relative price of barley because of a strong preference for
rice. It is doubtful, therefore, that the two-price policy for barley exerted
a continuous effect on the marginal rate of substitution between rice and
barley. The effort to conserve rice through a price policy and other adminis-
trative measures cannot be pursued as a long-run policy.

SOME POLICY RECOMMENDATIONS

Enhancing Agricultural Productivity
Owing to the expanded cultivation of high-yielding varieties and improved
farming techniques, promoted by a positive price support program during
the 1970s, a remarkable increase has been recorded in aggregate farm out-
put, especially grain production. Nevertheless, overall food-grain supply
has been lagging behind overall consumption because of the increase in
population and per capita income. Overall self-sufficiency in all grains
declined from 93.9 percent in 1965 to 53 percent in 1982, with nearly half
of the total requirement filled by imports. Self-sufficiency in rice was nearly
attained in the mid-1970s, but then declined to 93 percent in 1982.
 A Positive Grain-Price Policy (1969) 397

The fact that the rice yield in Korea is on the average 10-15 percent lower
than that in Japan and is only 70 percent of experimental farm yields sug-
gests, however, that there is potential for achieving yield increases by ap-
plying improved technology and building up the production base. In this
context, the following policy measures are suggested along with continu-
ous implementation of a positive agricultural price policy.
Farmland development. Since the mid-1960s a significant amount of farm-
land has been lost to urban expansion and industrial plants. The average
annual rate of diversion to nonagricultural uses is estimated at around 8,000
to 10,000 hectares during the 1970s. As industrialization expands, much more
farmland is expected to be lost to other uses. Investment opportunities in
the expansion of farmland through tideland development and conversion
of hilly land into arable land should be intensively investigated. A good
beginning has been made in this regard. The Agricultural Development Cor-
poration (ADC) has conducted an extensive survey of the southeast coast-
line. The results indicate that over 450,000 hectares of sea land has potential
for conversion to arable land.
Expansion of irrigation facilities. In Korea more than two-thirds of the to-
tal paddy land area is only partially irrigated or rainfed. Moreover, a large
portion of paddy land is poorly drained and lacks adequate flood control
structures. Also, many of the existing irrigation and drainage systems are
obsolete or nearing obsolescence due to lack of repair. It is necessary to
launch a massive repair project to recover the original capacity of these fa-
cilities. The achievement of higher yields depends upon improvement of
irrigation, drainage, and flood control facilities.
Adequate pricing of fertilizer. Recently the government has been planning
to totally eliminate the deficit in the Fertilizer Account. If the deficit is to
be eliminated by raising selling prices to farmers with the procurement
prices for the fertilizer industry remaining unchanged, the selling prices
must be increased by 72 percent. If, however, the deficit is to be eliminated
by reducing the procurement price paid to the fertilizer industry, then it
must be reduced by 32 percent of what is currently being received.
To eliminate the deficit in the Fertilizer Account, the government should
direct its efforts toward reducing the cost of fertilizer production, which
is substantially higher than world market prices, by taking appropriate meas-
ures to enhance the technical and managerial capabilities of the manufac-
turers. An attempt must also be made to revise the unfair contract with
foreign investors in the direction of reducing the quantity obligation in
procurement, and at the same time the current marketing and distribution
system must be improved so as to reduce marketing costs. Raising fertil-
izer prices to farmers and maintaining the current level of subsidization
for fertilizer manufacturers simply to eliminate the deficit are in no way
justifiable.
398 Pal Yong Moon

Expansion of agricultural credit. The primary issue confronting agricultural

credit is a need to obtain sufficient funds to meet the rising demand for
capital. From a long-range point of view, it is undoubtedly most desirable
that the agricultural credit institution expand its funds sufficiently to en-
able it to operate on a self-supporting basis.
In view of the fact that capital formation within the rural sector still re-
mains at a relatively low level, however, financial support at least for the
strategic sector should appropriately be provided by the government.
Furthermore, Korea's traditional rural society has been rapidly transform-
ing into a more commercially oriented one. This period of transition re-
quires an increased supply of medium- and long-term development funds,
part of which must inevitably be supplied by the government.
Under the current system, agricultural credit in Korea involves too many
types of loans requiring many different procedures and terms. This com-
plexity unnecessarily limits farmers’ access to the credit and not only ham-
pers efficient operations of cooperatives but also impairs fairness in
providing lending services to farmers. Therefore, the lending methods and
terms should be simplified, if not unified, merging those types of loans
that are intended for similar purposes.
Expansion of credit for marginal farmers deserves special consideration
in Korea. Farm households owning less than 0.5 hectares of arable land still
account for more than 30 percent of all farms. Because of their sizeable
proportion, these marginal farmers have a fairly substantial bearing on the
nation’s total agricultural production. Not infrequently, however, these mar-
ginal farmers are bypassed in credit provision on grounds that their repay-
ment capability is low due to low productivity and low income.
Given these circumstances, it is both necessary and desirable to estab-
lish a special credit system catering exclusively to the needs of marginal
farmers. Such a fund, to be operated separately from the regular institu-
tional credit, should be financed with government funds as a part of the
social welfare program.
Efficient farm mechanization. Emphasis under the farm mechanization pol-
icy has thus far been laid almost exclusively on quantitative aspects. Little
or no attention has been given to the need to create conditions favorable
to mechanization or to the need to develop systems for ensuring full utili-
zation of machines made available to farmers. Thus, the rate of utilization
of machinery purchased by farmers continues to be below par, and in spite
of rapid diffusion of farm machinery, the original goal of effectively easing
labor shortages during periods of peak agricultural activity has yet to be
attained.
In view of the anticipated diffusion in the future of such high-
performance implements as tractors, combines, transplanters, and har-
vesters, the continuation of a simplistic farm mechanization policy of stress-
ing numerical expansion alone would lead to a decline in the rate of
 A Positive Grain-Price Policy (1969) 399

utilization of individual implements, almost in inverse proportion to the

rate of their diffusion. This would have an adverse impact on the profit-
ability of farming enterprises due to a rise in the unit cost of work. And
from the standpoint of the national economy, excessive investments in farm
mechanization could result.
Because the current smallholder system in Korea is expected to persist
for some time to come, the task of mechanizing Korea's agriculture should
be carried out in close association with plans for improving the agrarian
structure itself.
Effective farm mechanization can hardly be achieved unless it is pur-
sued simultaneously with renovation of the foundations of farming opera-
tions, including the agrarian system and conditions of farmland as well as
with development of farm machinery utilization systems suitable to the ac-
tual circumstances prevailing in rural communities.

Increased production of livestock and non-cereal products. Rapid economic

growth and the subsequent increase in income levels have brought about
considerable changes in food consumption patterns. Consumer tastes
shifted from carbohydrates to foods containing more protein such as meat
and high-protein processed foods. For example, the annual per capita con-
sumption of beef and pork increased nearly threefold, that of chicken five
times, and that of milk more than 20 times during the 1965-82 period. The
demand for vegetables and fruit also increased rapidly.
To cope with these rapid changes in the pattern of food consumption
and the resulting increases in demand for non-cereal foods, higher prior-
ity should be given to investment for the expansion of the livestock indus-
try and cash crops.
Improved agricultural marketing. The high rate of income growth and ur-
banization, combined with the increasing rate of commercialization in rural
areas, has created a rapid increase in demand for marketing services. There
has been some public and private investment in marketing facilities, but
many of those currently in use are inadequate for storage, processing, and
distribution. There is an urgent need to upgrade and modernize facilities
for marketing farm products and distributing farm inputs.

Elimination of the GMF Deficit

One of the main features of the grain-price policy in Korea is that the finan-
cial deficit arising from grain operations has been largely compensated for
by inflationary financing. If the deficit were compensated from the general
budget account, the effect would be a reduction in budget expenses for other
sectors. This was not the case with the grain operation.
Faced with increasing budgetary requirements in nonagricultural sectors,
especially for defense purposes, while budgetary sources remain limited,
the government has been obliged to rely upon inflationary financing. Most
400 Pal Yong Moon

of the deficit has been financed through a long-term overdraft from the cen-
tral bank and also partly through the issue of short-term grain bonds with
a one-year maturity period. The outstanding balance of the long-term bor-
rowing totaled about 1.4 trillion won (approximately US $20 billion) at the
end of 1982. Repayment of grain bonds has been financed in turn either
by a long-term overdraft or the reissue of grain bonds. Therefore, whichever
method is used in financing the GMF deficit, the result is an increase in
the money supply.
The GMF deficit accounted for about 22 percent of the total increase in
the money supply in 1972 and rose as high as 98 percent in 1975. There-
after approximately one-fourth of the total increase in the money supply
occurred in the grain section (Food Bureau, MAF, ROK, unpublished data;
BOK, Economic Statistics Yearbook, 1970-82).
Considering the importance of enhancing the socioeconomic status of
farmers, who still account for a large proportion of the population, and of
protecting consumer welfare, the government grain operation and grain pric-
ing policy must be viewed from a perspective different from that of mone-
tary policy alone. However, the continued reliance on a long-term overdraft
from the central bank for financing the grain deficit is definitely inconsis-
tent with a policy goal to achieve fiscal and financial stability.
A net increase in the money supply resulting from the current inflation-
ary financing of the government grain operation is bound to cause upward
pressure, with some time-lag, on the general price level This is because
lump-sum funds released at the time of grain acquisition are very likely
to be spent immediately by farmers whose cash demand is usually high.
For this reason, it is obvious that the two-price policy, though it would tem-
porarily restrain consumer prices, is self-defeating in its purpose of stabiliz-
ing the general price level.
An important lesson is that either the grain deficit must be financed from
the general account budget, which is noninflationary, or an attempt must
be made to eliminate the deficit by narrowing the negative price differen-
tials between government purchase and selling prices. In other words, once
the government purchase price is set, the selling prices must cover the costs
of transport, handling, storage, administration, and interest.
As long as the government requires grain purchases from farmers, there
are two ways to narrow the price differentials: relative reduction in pur-
chase prices or relative increase in selling prices. Whichever method is

8. In Japan, the grain deficit arising from the two-price policy for rice is financed by the general
account of the national budget. The effect of such financing on the income distribution is ex-
actly opposite to that of financing with an overdraft from the central bank. Financing from
the general account means that funds are derived in principle from tax revenue. Inasmuch
as a direct tax is concerned, higher tax rates are applied to higher income earners. Therefore,
financing the grain deficit from the general account has the effect of transferring income from
higher to lower income groups.
 A Positive Grain-Price Policy (1969) 401

chosen, the problem boils down to one of determining purchase prices,

high or low. According to the analysis of the effects of grain prices in the
foregoing section, a 10 percent rise in the real price of grain would have
the positive effects of increasing rice production by 2 to 3 percent and of
boosting farm household income by 7 to 8 percent. From the opposite view,
the same percentage rise in the real price of grain would result in only a
0.5 percent increase in the general price level and a 1 percent increase in
the consumer cost of living. In view of this trade-off relationship, one eas-
ily reaches the conclusion that government selling prices must be raised
to such a level as to eliminate the grain deficit. It would probably save the
government more than it would cost the private sector.

Excessive Government Share in

and Shrinkage of the Private Grain Market
With the increased scale of the government grain operation, the volume
of nongovernment rice transacted through the wholesale market has drasti-
cally declined, in both absolute and relative terms. However, the volume
of rice handled directly by retailers in the urban areas has substantially risen.
In Seoul, for example, the market share of rice traded through the whole-
sale market declined from 23.6 percent in 1975 to 3.8 percent in 1981, while
the shares of government-controlled rice and that shipped into the city
through direct trade between retailers and farm producers increased from
33.4 percent and 37 percent to 52.7 percent and 40.2 percent, respectively,
during the same period (Food Bureau, MAF ROK, unpublished data; Korea
Grain Dealers Association, unpublished data). This predominance of grain
transactions by poorly financed, marginal-scale retailers who bypass the
legally established wholesale market not only impedes efforts to improve
the efficiency of grain marketing, but also tends to give rise to various forms
of unfair trade. The most desirable form of grain marketing, as far as non-
government rice is concerned, is one in which grain transactions take place
in large volumes through the wholesale market on a competitive basis. The
shrinkage of the normal functions of the wholesale market is mainly due
to the current government grain management system, which is operated
in such a way as to discourage the spontaneous, healthy growth of private
grain wholesalers’ networks.
Uniform Pricing in Procurement
and Selling of Government Grain
The use of a uniform purchase price throughout the rice acquisition pe-
riod, usually from November through January, has been subject to a num-
ber of criticisms. More than 95 percent of government acquisitions are
concentrated during this two-month period annually (Table 15.9). Because
farmers are paid the same price regardless of when they deliver the grain,
they are tempted to dispose of grain as soon as possible, partly because
402 Pal Yong Moon

Table 15.9. Monthly distribution of government rice purchases: 1967-82

Total November December January
purchase Quantity Ratio Quantity Ratio Quantity Ratio
Rice year (103 MT) (10? MT) (%) (10? MT) (%) (103 MT) (%)
1968 286 86 30.2 177. 61:8 23 8.0
1969 156 23) S531 11/758 16 941.
1970 326 86 =.26.3 210. 9642 30 95
1971 365 S7ee0272) 248 67.6 18 a3
1972 517 225 ea) 255m0@50-1 37 4.7
1973 507 76 221520 238 46.9 193 quest
1974 480 241 50.2 210 43.8 29 6.0
1975 730 608 82.7 119 16.2 8 1.1
1976 789 5/17 724 20L 2525 17 2.1
1977 1,043 81258778 204 19.6 27. 2.6
1978 1,404 742/-52:9 5/7421 87 6.0
1979 17355 967a es 346 25.6 42 3:1
1980 1,301 1194 9128 100 Leh if 0.5
1981 546 B98 Ma 729 148 3927.1 0 0
1982 915 655 671;6 23.24 27; 3.0
1983 1,091 687 63.0 340 3L1 64 5a,
Average 63.2 31.5 2

Source: Data obtained from Food Bureau, MAF, ROK.

Note: ‘‘Rice year’’ refers to the calendar year beginning in January (last two columns). Novem-
ber and December figures are thus from the end of the preceding calendar year.
MT—metric tons.

of lack of adequate storage facilities and partly because of an acute cash

demand after the harvest. This practice gives rise to a number of problems.
1. The lack of incentives to retain grain for later sales discourages farm-
ers from investing in storage facilities. And because the acquisition is con-
centrated into a two-month period, the burden of financing storage falls
mostly on the government.
2. The storage of excessively large quantities of government grain often
results in deterioration of its quality. This causes a substantial price differen-
tial of about 20 to 30 percent between government and nongovernment rice.
Taking advantage of this price differential, the intermediate grain dealers
are inclined to pursue illicit profit by fraudulently selling repolished govern-
ment rice as nongovernment rice, though the size of the illegal profit differs,
depending on the quality of the government rice.
3. The release of a large amount of funds within a short period of time
due to the heavily concentrated acquisition cannot but cause a lump-sum
increase in money supply toward the end of each year.
One possible way of improving the acquisition program is to adopt
 A Positive Grain-Price Policy (1969) 403

differential pricing for varying months, the price difference being at least
large enough to cover the farmers’ storage costs. If the government were
to raise the purchase price for deliveries in later months, farmers would
have an incentive to hold their grain and to distribute their sales more evenly.
In addition, there is no particular reason why the purchase program should
be limited to only a three-month period each year. Extending the purchase
period until March or April in the following year would alleviate budge-
tary constraints because the government would not require all acquisition
funds within such a short period of time. Furthermore, the concentration
of purchasing power toward the year-end in rural areas would also be
avoided.
Along with the uniform pricing in purchases, the uniform pricing in sell-
ing has received no less criticism. Because seasonal stabilization of grain
Prices is viewed as having an anti-inflationary effect, major emphasis has
been placed upon dampening seasonal rises in rice prices. The government
customarily uses the change in the WPI to measure price stability. A rise
in the price of rice is automatically reflected in this index via its weight (4.6
percent in 1980 as the base year). If the price of rice rises to its seasonal
peak (say 20 percent), the WPI automatically rises about 0.9 percent, other
prices remaining unchanged. This rise in the WPI is viewed as inflationary
by policymakers.
When the market share of government-controlled rice (including imports)
was telatively low in the 1960s, the rate of seasonal variation in rice prices
ranged from 15 to 25 percent. But with the increased share of government
rice, seasonal price fluctuations were substantially dampened, and the range
was reduced to 4-9 percent throughout the 1970s and early 1980s (MAF,
ROK, Agriculture and Fisheries Statistics Yearbook, 1960-82).
The policy of maintaining such a low rate of seasonal variation in mar-
ket prices causes a number of undesirable effects:
1. Because there is little or no incentive for intermediate grain dealers
to invest in storage and other marketing facilities, it is difficult to develop
efficient distribution links between farm producers and urban wholesal-
ers. Consequently, a substantial portion of free-market grain is distributed
by small, poorly financed retailers who operate in a disorganized and in-
efficient way.
2. Since grain is available at the same price throughout the year, urban
consumers tend to purchase a small quantity sufficient to meet only a few
days’ needs. Consequently, the government must bear the heavy burden
of storing and financing it.
3. The low profit margin rate for handling government grain, usually fixed
at 5-6 percent per bag, often causes grain dealers to engage in fraudulent
practices such as cheating on quantity as well as selling lower-priced govern-
ment rice at higher prices, thus impeding the sound development of grain
marketing.
404 Pal Yong Moon

To eliminate all these undesirable defects in grain marketing, the govern-

ment sale price should have a proper rate of seasonal variation, that is, a
higher price during the off-season and lower price during or after the har-
vest season. This practice would induce seasonal variation in the private
grain market that is consistent with the wholesalers’ costs of holding rice.
It is also important that policymakers not view the seasonal pricing policy
per se in terms of general price stabilization objectives, and that a seasonally
adjusted WPI be used as a stabilization indicator. In short, the current
government grain-pricing system must be improved in such a way as to
provide the private sector, including farmers and intermediate grain deal-
ers, with greater investment incentives.
 16 The Saemaul (New Community)
Movement (1971)

by Pal Yong Moon

A fundamental change occurred in the early 1970s in the Korean govern-

ment’s policy toward rural development. The core of this change was the
Saemaul (new community) movement begun in the winter of 1971. This
government-initiated movement for community development was strongly
backed by the late President Park and government agencies at all levels.
With government support and assistance, massive-scale investment projects
were undertaken for the improvement of physical infrastructure and farm
income. Efforts were also directed at influencing rural people’s ways of think-
ing and lifestyle by means of a series of educational campaigns. Rural peo-
ple were mobilized to participate in community development, the rural
infrastructure and environment were greatly improved, and farm-household
incomes were substantially increased. In short, during the 1970s the Sae-
maul movement helped to transform almost every aspect of rural Korea.
After more than a decade of experience, however, the movement is now
being criticized mainly because of its top-down authoritarian administra-
tion. There is considerable evidence that the authoritarian approach hin-
dered voluntary participation by rural villagers and even led to misallocation
of resources.
The general pattern of agricultural development in Western Europe can
be described as a continuous process of farming-scale expansion accompa-
nied by technological progress. Progress in agricultural technology enlarges
disparities in the productive capabilities of individual farmers within the
same rural community. This leads to a disintegration of those classes of
farmers with low productive capabilities, enabling the more successful farm-
ers to remain on farms and expand the scale of their farming operations.
This in turn facilitates the introduction of advanced technology centered
around farm mechanization. The chain of cause and effect has been con-
tinuous.
In contrast, Korea's agriculture has long been characterized by small-scale
farming, which restricts the adoption of new technology and impedes the
improvement of agricultural productivity. This cycle has been constantly
repeated. It is hardly an exaggeration to state that virtually all problems
confronting Korean agriculture stem from its smallholder nature. Whereas
the exodus of rural labor can be considered conducive to the growth of
labor productivity through an adoption of new technology such as farm

405
406 Pal Yong Moon

mechanization, the small size of farms and insufficient capital investment

impedes such progress.
Since the early 1960s the Korean government has been striving to im-
prove the agrarian structure, but it has been unable to do much to enlarge
the scale of farming operations owing to the limited land resources. Farm-
ers who cultivate 1 hectare or less constituted more than one-third of the
total number of farm households. The fragmentation of the country’s limited
cultivatable land is a major constraint on expanding agricultural labor
productivity and farm income. Many people have begun to advocate an
easing or even a repeal of the 3-hectare ceiling on individual ownership
of farmland. Their rationale is to expedite the expansion of individual land-
holdings by increasing the transferability of land titles. Although the pro-
posed relaxation of the limitation on landownership could pave the way
for some farmers to expand the scale of their farming operations, there has
been disagreement over the principal reason why farming operations have
not expanded thus far—whether it has been the statutory ceiling on in-
dividual ownership, the low profitability of farming, or the general eco-
nomic conditions surrounding Korean agriculture that kept farms small.
Over the past two decades the rate of decrease in number of farm house-
holds has been much lower than that of the farm population. As a result,
the average area of farmland per household has remained almost static at
about 1 hectare (Tables 16.1 and 16.2).
The second factor responsible for rural poverty was the persistent nega-
tive farm-price policy, particularly affecting major grains. During the 1950s
the government's main efforts were directed toward the rehabilitation of
the war-wrecked economy and the alleviation of postwar inflation.
Policymakers were particularly sensitive to the effects of grain prices on
urban wage earners’ cost of living and on inflation, so efforts were made

Table 16.1. Cultivated land, rural population, number of farm households,

and average farm size: Selected years, 1965-82
Average
Total Total Number Average size
cultivated rural of farm size of of farm
land population households holdings family
Year (103 ha) (109) (103) (ha) (persons)
1965 2275 15,812 2,507 0.91 6.3
1970 2,295 14,432 2,484 0.93 5.8
1975 2,240 13,244 2,379 0.94 5.6
1980 2,196 10,831 2,155 1.02 5 <1
1982 2,180 9,688 1,996 1.09 5.0
ee ee ee ee ee
Source: MAF, ROK, Agriculture and Fisheries Statistics Yearbook (1965-82).
ha—hectare (equivalent to 2.47 acres).
 The Saemaul (New Community) Movement (1971) 407

Table 16.2. Distribution of farm households by size of holding: Selected

years, 1965-82 (%)

Farm size (hectares)

Year 0.5 or less 0.5-1 1-1.5 1.5-2 2-3 3 or more

1965 35.8 31.6 16.5 9.3 5.6 ee.

1970 31.6 34.3 18.5 8.0 5.1 ASS
1975 30.3 36.2 18.9 8.2 4.8 1.6
1980 28.8 35.0 20.6 9.0 5.1 5)
1982 29.6 37.0 19) 8.1 4.2 12

Source: MAF, ROK, Agriculture and Fisheries Statistics Yearbook (1965-82).

to keep grain prices low. Government investment in and loans to agricul-

ture were severely limited owing to the increasing budgetary demand for
rehabilitation work and defense. About all that the budget was capable of
financing in the agricultural sector was maintenance for existing irrigation
facilities and importation of fertilizer. The low farm-price policy was fur-
ther reinforced by the easy availability of American surplus grain on con-
cessionary terms under the U.S. Public Law (PL) 480 program, begun in
1955.
The low-price policy for major food grains eventually hindered efforts
to promote increased domestic food production in the 1960s. The long-
lasting adverse terms of trade for farm products further impoverished the
already poor rural economy. With the aggravating food shortage, resultant
increases in foreign exchange spending on food imports, and the growing
income disparity between rural and urban households, the government was
obliged to give serious consideration to expanding food-grain production
and enhancing the income position of farmers. When a large portion of
the food-grain shortage was met by local currency under the PL 480 agree-
ment, the food gap itself did not impose a serious burden on the country’s
foreign exchange position. But as U.S. aid began to be phased out, food-
grain imports caused a substantial drain on the country’s foreign exchange
reserves.
By the late 1960s rural people became increasingly conscious of the
widening standard-of-living gap between urban and rural areas. Since in-
dependence, rural voters had tended to support passively whichever re-
gime happened to be in power, despite its pursuit of export-oriented
industrialization which favored the urban sector. But over time the situa-
tion changed. The government of the late President Park began to perceive
evidence of a decline in rural political support. The government's percep-
tion of a decline in its political popularity spurred the shift in policy em-
phasis toward rural development.
Starting with the 1969 crops, the prices at which the government pur-
chased rice and barley were steadily increased with a view to improving
408 Pal Yong Moon

the terms of trade for farm producers. The initiation of higher purchase
prices for major grains represented a dramatic change in agricultural price
policy and was part of a government effort both to stimulate domestic
production of food grain and to upgrade farm incomes. Another major shift
in policy was the initiation of massive-scale investment in the rural develop-
ment sphere, which is now generally called the rural Saemaul (New Com-
munity) movement.

MAIN FEATURES OF THE SAEMAUL MOVEMENT

Initiation of the Movement
It is generally agreed that the starting point of the Saemaul movement in
Korea was related to the disposal of surplus cement. In 1971 cement produc-
tion far exceeded demand, causing an excessive inventory in the country.
After a series of interministerial meetings, a decision was made to use the
surplus cement for productive purposes in rural areas.
The government provided, free of charge, 335 bags of cement to each
of a total of 33,267 villages during the winter of 1970-71. The recipients were
instructed to use the cement only for the purpose of meeting their com-
munity’s needs as determined by consensus. Local administrations recom-
mended that the cement be used for projects such as: improvement of farm
roads, establishment of a sanitary water-supply system, sewage improve-
ments, river-dike repairs, and construction of common wells and public
laundry facilities (J. H. Park 1981).
The program was widely welcomed by villagers, who found good uses
for the cement, and the results greatly exceeded the expectations of the
government officials. Encouraged by the performance of the rural people,
the government selected as models 16,600 villages that had responded ac-
tively to the cement offer and successfully carried out their projects. In 1972
the government supplied an additional 500 bags of cement together with
one ton of steel rods to each of these selected villages.
Further encouraged by this experimentation, the Ministry of Home Af-
fairs (MOHA) conducted a nationwide village survey, classifying all the vil-
lages in the country into three categories on the basis of degree of
performance and level of development: (1) basic (underdeveloped) village;
(2) self-help (developing) village; and (3) self-reliant (developed) village.
On the basis of this classification, the government adopted a different ap-
proach for each class of village, giving greater assistance to higher-level vil-
lages. This was intended to create a sense of competition among villages
and to stimulate those in the two lower classes to make more efforts toward
advancing to a higher village class. Each village was required to achieve
a minimum level of performance prior to advancement in the classification
scheme.
 The Saemaul (New Community) Movement (1971) 409

Having observed this early experience and success, President Park

began to take a keen interest in the program and ordered that it be intensi-
fied and extended. He emphasized the importance of identifying and
motivating village leaders as well as the need for educating and training
them.

Basic Ideology and Contents

According to an official definition used by MOHA, the “Saemaul Undong
[movement] is anew community movement in which people cooperate with
one another in order to construct better and richer villages, and as a conse-
quence, a richer and stronger nation.” In other words, the Saemaul move-
ment is a Korean model of the community development movement with
the ultimate goal of developing a strong nation through the elimination of
poverty and the construction of a dynamic society. To achieve this goal,
leaders of the movement enunciated three strategic objectives: rural enlight-
enment, social development, and economic development.

Rural enlightenment. The movement sought to enhance rural villagers’ will-

ingness to practice self-reliance. It aimed at promoting the spirit of diligence,
austerity, thrift, mutual cooperation, and solidarity, which are the moral
foundations for the introduction of rural innovation and development. The
spirit of self-reliance emphasized the importance of viewing oneself in a
correct perspective and solving problems with one’s own efforts, thereby
encouraging rural people to change deep-rooted fatalistic attitudes. Korean
farmers have traditionally adhered to the notion that poverty was their fate—
something they could not change by themselves.
Historically, the Korean people were subjected to exploitation by the rul-
ing classes of successive dynasties. More recently, during the Japanese
colonial period, they suffered from a painful economic squeeze. The polit-
ical and socioeconomic systems were such that voluntary participation in
community development and cooperative productive activities was not very
common.
Moreover, the extended family system, combined with an authoritarian
power structure, severely restricted the development of individualism and
decision-making abilities. People tended to be dependent upon outside de-
cisions and help. They lacked confidence in themselves and were unable
to realize their own potential for improving their lives.
Given these circumstances, spiritual enlightenment was regarded as in-
dispensable to the Saemaul movement as a means of changing people's
attitudes. To this end, various training and educational programs were es-
tablished to augment the physical aspects of the movement.
Social development. The social-development aspects of the Saemaul move-
ment include programs aimed at improving the environment in which
410 Pal Yong Moon

villagers live. As rural people have become increasingly conscious of

differences between urban and rural living standards, narrowing those
differences has received priority in the movement. Social-development pro-
grams were of three types: environmental improvements, housing improve-
ments, and public-utility expansion. Each type comprised individual
projects. Environmental projects included the establishment of sanitary
water-supply systems, improved sewage systems, public bathhouses, vil-
lage conference halls, public wells, and village laundry yards. Housing-
improvement projects included roof improvements, house repairs, and vil-
lage restructuring. The expansion of rural electrification and the develop-
ment of communication networks, in particular the installation of public
telephones in villages, were also a high priority.
Economic development. The economic-development program had two major
components: buildup of the production infrastructure and an income-
augmentation program. Included in the infrastructure program were farm-
road expansion and small-scale irrigation projects such as construction of
weirs, irrigation ponds, and irrigation and drainage canals. Road-improve-
ment projects were undertaken to widen village roads so that farm
machinery could pass and to connect village roads to fields and main roads.
This program has facilitated farm mechanization and transportation ser-
vices even in remote areas.
Small-scale irrigation projects led to another important infrastructure im-
provement fostering agricultural productivity. Much of the existing irriga-
tion and drainage system was obsolete or nearing obsolescence due to lack
of repair work over many years. Recovery of the original capacity of these
facilities was urgently needed to assist small-scale irrigation.
All these rural infrastructure projects were in the nature of social over-
head capital. And as most of the projects were labor-intensive, they could
be carried out with indigenous technology. Outside assistance was obtained
for only those projects that required technical expertise. Because the work
was undertaken during the off-season when labor mobilization was rela-
tively easy, the rate of return on capital was expected to be high.
Included in the income-augmentation program were livestock raising,
introduction of cash crops, development of specialized production areas,
group farming, and the establishment of Saemaul factories to increase off-
farm income sources. The area-specialization project had four types of
production: general crops, fruits and vegetables, livestock, and cash crops.
After 1977 there were package programs to integrate such projects as in-
frastructure building, production, establishment of marketing facilities, and
farm mechanization. In addition to these income-augmentation projects,
the government has provided various kinds of support—financial and
technical— for constructing Saemaul factories to increase employment op-
portunities during the off-season.
 The Saemaul (New Community) Movement (1971) 411

Major Developments of the Movement

Initially, the movement's main emphasis was on projects for improving the
rural environment, such as piped water-supply systems, sewage improve-
ments, and public wells. From this initial stage emerged an important les-
son: that projects should be selected that would contribute immediately
to the improvement of villagers’ incomes. Although environmental improve-
ments directly benefit the villagers and enhance their hopes for the future,
such improvement without accompanying income growth may lead to un-
fulfilled expectations. Tangible results were needed to promote villagers’
adaptability to changing rural conditions and technological progress.
Thus, beginning in the mid-1970s, the emphasis shifted from environ-
ment-oriented projects to income-generating ones. The government set a
target for increasing average farm income to 1.4 million won (approximately
US $3,500) by 1981, the target year concluding the Fourth Five-Year Economic
and Social Development Plan. To achieve this goal, income-augmentation
projects were introduced and government support was provided in the form
of subsidies and credit.
Major income-augmentation projects were regional specialization of
crops, livestock raising, group farming and marketing, and wage-earning
self-help projects. To implement the projects effectively, especially those
involving crop production, villagers were encouraged to organize Saemaul
production units for group farming, with every farmer belonging to at least
one unit. Rural women were encouraged to organize Saemaul women’s
clubs and existing 4-H clubs were renamed “Saemaul youth clubs” so that
all would participate more actively in the Saemaul movement. A Saemaul
credit union was organized in each village with government support to pro-
mote the spirit of thrift and saving, and a campaign was launched to in-
duce every farmer to maintain a savings account in the union.

Extensive Participation
The government has widely advocated participation of individuals and
groups in the community development movement. Local participation is
the major element of community development, distinguishing it from other
forms of social and economic policy. The Saemaul movement of Korea is
probably unprecedented in its scope of participation.
Having begun with village-centered, environmental improvement proj-
ects, the movement rapidly expanded in scope of participation and range
of activities. It has been extended to “factory Saemaul,” “urban Saemaul,”
and “school Saemaul.”
One can see the Saemaul flag flying beside the national flag and the Sae-
maul slogan painted at the top of almost every public building throughout
Korea. At least once a day there is a television program portraying a suc-
cess story of the Saemaul movement, accompanied by the Saemaul song.
As suggested by cynics, everyone is doing something under the name of
412 Pal Yong Moon

Saemaul. This fact alone indicates how wide participation in the movement
has been and how enthusiastically it was launched on a nationwide basis.
An official record compiled by MOHA indicates that more than 36,000
villages have participated in the Saemaul movement every year since 1975.
This means that almost every village in Korea—large and small—has been
involved in the movement. Participation in rural areas alone has increased
from 32 million workdays in 1972, to 117 million workdays in 1975, and 273
million workdays in 1982. Calculated on a per village basis, participation
was 923 workdays per village in 1972, 3,160 workdays in 1975, and 7,380
workdays per village in 1982—an almost eightfold increase over a 10-year
period. With an average of 60 farm households per village, this implies that
the average household was devoting about 123 workdays (or four months)
to Saemaul activities in 1982.
The rapid expansion in activities is also indicated by the increasing num-
ber of projects undertaken over the period. The projects numbered 320,000
in 1972 and reached a peak of 2,667,000 in 1978—8.3 times as many as in
1972. Since then the number of projects has gradually declined, and a total
of 1,080,000 projects were implemented in 1982 (Table 16.3).
The scope of participation is further demonstrated by villagers’ contri-
butions of cash, labor, land, and materials. In 1972 investments in Saemaul
projects totaled 31.6 billion won, of which rural people contributed 27.3 bil-
lion won, or 86.6 percent, while the government's financial assistance
amounted to only 3.6 billion won, or 11.3 percent (Table 16.4).
But as the movement has proceeded, the relative shares between the
two sources have become reversed, although the absolute amount of

Table 16.3. Scope of participation in the Saemaul movement: 1972-82

Number Number Number of Investment
Number of of projects per
of workdays projects per project
Year villages (109) (103) village (10° won)
1972 34,665 32,000 320 14 98
1973 34,665 69,280 1,093 32 88
1974 34,665 106,852 1,099 32 121
1975 36,547 116,880 1,598 44 185
1976 36,547 117,528 887 24 364
1977 36,557 137,198 2,463 67 189
1978 36,257 270,928 2,667 74 232
1979 36,271 242,078 1,788 49 424
1980 36,938 227,856 1,836 x 510
1981 36,792 257,472 1,310 35 O37
1982 36,894 272,751 1,080 29 802
eee

Source: MOHA, ROK, Saemaul Undong (1972-82).

 The Saemaul (New Community) Movement (1971) 413

Table 16.4. Government and village contributions to Saemaul projects:

1972-82

Total Share of total investment (%)

investment Government Village
Year (103 won) contribution _contribution® Other
1972 31.6 abe 86.6 2
1973 96.1 17.8 80.0 22
1974 132.8 pos 74.4 I)
1975 295.9 42.1 5753 0.6
1976 322.7 213 70.5 22
1977 466.5 29.6 69.7 0.7
1978 634.2 23.0 76.9 0.1
1979 758.2 56.1 43.3 0.6
1980 936.0 u u u
1981 702.9 Se) 40.2 0.6
1982 866.6 48.3 34.4 17.3
Source: MOHA, ROK, Saemaul Undong (1972-82).
u—data unavailable.
a. Includes loans and credit.
b. Donations from nongovernment organizations.

investment has increased. The proportion of the people’s contributions

declined to 57.3 percent in 1975 and dropped further to 34.4 percent in 1982.
Conversely, the government's share increased to 124 billion won or 42.1
percent in 1975, and again increased to 419 billion won or 48.3 percent in
1982, the rest being donated by various private organizations (Table 16.4).
The reason for the shift in relative contributions by villagers and the govern-
ment is that an increasing number of government-sponsored development
activities has been added to the Saemaul category. The amount of invest-
ment per project has also increased, from 98,000 won in 1972 to 802,000
won in 1982 (Table 16.3).
Villagers’ contributions in the form of labor accounted for 77.2 percent
in 1972 but had declined to only 25.2 percent by 1982. Over the decade the
major part of villagers’ contributions shifted from labor to cash (MOHA,
ROK, Saemaul Undong, 1972-82).

Training and Education

Early experimentation in implementing projects taught the government an
important lesson: leadership is a prerequisite for self-reliant and self-
sustaining community development. Village leaders play a crucial role in
inducing villagers’ participation in the Saemaul movement.
As a result, leadership-training institutions were established, beginning
in late 1972. The Saemaul Training Institute was the main training institution
414 Pal Yong Moon

at the central level. Under government sponsorship, 14 other central-level

and 10 provincial-level training institutions were formed in succession. In
addition, various types of informal training programs were provided at the
county and village level.
Potential Saemaul leaders were elected from among villagers and offered
a special training program that aimed at equipping them with effective
leadership skills for becoming agents of change in rural areas. From 1973
onward, as the movement progressed, village women leaders, youth lead-
ers, and county officials were included in the training program. In 19/4 so-
cial elites and government officials were also included. In 1975 the training
program was further expanded to include such classes of social leaders as
cabinet members, parliamentarians, religious leaders, university presidents
and professors, journalists, corporate leaders, and managers of business
corporations.
In training these elites, the government encouraged them to participate
positively and to give full support to the basic ideology and strategy of the
Saemaul movement. Elites were to receive the training together with vil-
lage leaders and under the same conditions, regardless of their social sta-
tus, with a view to bringing them closer to rural situations and fostering
the spirit of solidarity. The training included lectures and self-learning
through case studies, group discussions, and field work and tours for
“learning-by-doing.”
The main features of the Saemaul movement can be summarized as
follows.
1. The initiative for the movement came from the president and govern-
ment leadership. All levels of government—central and local—were involved
in one way or another, and every rural village was affected by the move-
ment. Such a massive scale of participation and government support is prob-
ably unprecedented in the history of community development.
2. The Saemaul movement was designed and implemented around the
individual village as the basic unit of community life, characterized by the
pursuit of common traditional interests.
3. The movement does not differ much from other community-
development efforts in pursuing material betterment of rural society. But
it does differ greatly from others in that it has combined education and
enlightenment with material goals.
4. The general procedure elsewhere in launching community-develop-
ment programs has been to adopt an ideology and formulate a plan with
objectives and strategies prior to actual implementation. But in the case
of the Saemaul movement, action preceded the development of an ideol-
ogy and appropriate strategies.
5. A wide range of development activities characterize the Saemaul move-
ment. At the central level, almost all of the government's rural-development
programs have been organized under the Saemaul label.
 The Saemaul (New Community) Movement (1971) 415

Organizational Arrangements and the Planning Process

Owing to the wide range of development activities and the complex na-
ture of the Saemaul movement, it is essential for its programs and projects
to be well organized and coordinated. To facilitate program formulation,
implementation, and coordination among different projects, government
agencies, and regions, a series of councils and consultative bodies was es-
tablished, linking the central level with the village level.
Among these councils is the Saemaul Undong Central Consultative
Council, headed by the minister of home affairs. Its members consist of
vice-ministers of other ministries of the central government. Their major
responsibility is to make decisions regarding the basic direction of support
policies, government financial assistance, and guidelines for program plan-
ning at the local level.
At the provincial level is the Provincial Coordinating Committee, with
the provincial governor as chairman and its members consisting of the direc-
tors of regional offices of such central agencies as the Office of Rural De-
velopment, the National Agricultural Cooperatives Federation (NACF), the
Agricultural Development Corporation, and the National Livestock Cooper-
atives Federation. The primary responsibility of this committee is to coor-
dinate among different functional departments of the provincial government
and regional agencies the planning and resource allocation for various types
of Saemaul projects.
At the county level, the County Saemaul Coordinating Committee has
responsibility for promoting and guiding Saemaul projects. Its chairman
is the county chief (gunsoo), and its members are chiefs of various county-
level public offices, including rural agricultural extension, public health,
the forestry association, agricultural cooperatives, and livestock cooperatives.
At the myon (township) level, the lowest unit of administration, the Myon
Saemaul Movement Promotion Committee is responsible for decisions about
assistance for the Saemaul village projects. The committee’s members in-
clude officials and a few Saemaul leaders selected from villages of the myon.
The committee assumes the crucial function of coordinating various kinds
of development activities, in particular the delivery of necessary govern-
ment support and guidance in project planning and implementation.
The identification of individual projects is the responsibility of village
members. Project planning at the village level generally consists of project
identification by villagers, design for implementation, and determination
of the kind and amount of resources required, including necessary govern-
ment assistance. The proposed plan is subject to approval by the Village
Development Committee, which has 12 members and is chaired by the vil-
lage chief or Saemaul leader. The committee then submits the plan to the
village general meeting for approval by consensus.
The next step is submission to the Myon Promotion Committee, which
screens and revises the proposed plans from all villages in the myon, taking
416 Pal Yong Moon

into consideration available resources and the possibility of government as-

sistance. The selected projects are then submitted to the county chief, who
coordinates the proposals from different myons in consultation with the
County Consultative Council. After going through a similar process of
review at the provincial level, all the proposed projects are transmitted to
the Central Consultative Council. The council, after compiling all the pro-
posed projects, conducts the final review based on basic policy guidelines
from the perspective of national and rural development.
In addition to the consultative bodies at various levels, departments and
divisions specializing in Saemaul projects were established within the minis-
tries of the central government to avoid unnecessary duplication and con-
flict in the planning and implementation process. Such divisions were
established in the Ministries of Agriculture and Fisheries, Commerce and
Industry, and Education. Within MOHA, the Saemaul Bureau was estab-
lished to take responsibility for developing overall Saemaul policies and
strategies. At all levels of local administration, divisions dealing with the
Saemaul projects were established to support and guide Saemaul-related
activities at the local level.
Operational Strategy for Government Support
At the national level the government plans a sequence of support, both
financial and technical, for the Saemaul movement. It integrates a continu-
ous evaluation of the capacity and performance of individual villages into
the process of planning and coordination. The objective of government as-
sistance is not simply to provide direct benefits to rural communities in the
form of funds or materials, but also to enable the communities to launch
development activities on their own.
Government financial and material support is provided for projects that
are beyond the financial capacity of villages. Financial support is given in
grants and loans. Efforts are made to supply the funds and materials in
a timely manner so that the villages can make the best use of idle labor
and other resources.
The government also provides technical support whenever necessary.
This technical support includes provision of standard designs for such
projects as piped water-supply systems, village hall construction, small
bridge construction, and village restructuring; and consultation and train-
ing in marketing, management of group action, management skills for the
Saemaul credit union, and improved farming methods, such as seedbed
preparation, livestock raising, pasture development, and farm-machinery
operation.
Technical support for farm activities is provided by rural extension agents.
To provide technical services in nonagricultural fields, the Saemaul Tech-
nical Service Corps was organized in 1975 under the sponsorship of the
 The Saemaul (New Community) Movement (1971) 417

Ministry of Science and Technology. The corps is composed of specialists

drawn from various fields, such as engineering, medicine, and food process-
ing. At the local, especially myon, level, every official is assigned, in addi-
tion to his routine work, to a specific village to promote and guide the
Saemaul projects. Police officers are instructed to lend all possible support
to the activities of Saemaul leaders.
To maximize the effectiveness of its support measures, the government
adopted four general principles of operation. They are:
1. The best-first principle. Villages that conduct the most successful Sae-
maul projects receive government help first. A successful project is defined
as one in which villagers display a high degree of willingness, participa-
tion, self-help, and cooperative spirit.
2. The step-wise principle. As already mentioned, villages are classified
into three categories depending on their level of development: basic (un-
derdeveloped), self-help (developing), and self-reliant (developed). Projects
are recommended to villages in the different classes according to their size,
resource endowment, and physical and socioeconomic condition. Each vil-
lage is advanced to the next higher class, step-by-step, when the minimum
requirement for that class is fulfilled, measured by participation and the
villagers’ own contributions to project implementation.
3. The learning-by-doing principle. Villagers are expected to learn by do-
ing, not merely by talking, through the process of trial and error. Although
the process may cause inefficiency or even a waste of resources in the short
run, it is expected to lead to greater efficiency in the long run, once ex-
perience and self-confidence are gained.
4. The matching-fund principle. Government support, particularly finan-
cial and material, is provided to villages that mobilize at least half of their
total investment requirements in the form of cash or labor (Y. B. Choe 1978).
In addition to these four operational strategies, the government followed
four guidelines in selecting and implementing projects. First, projects were
selected by the consensus of village members rather than on the judgment
of a few influential leaders. The Saemaul leader must try to obtain a con-
sensus, which contributes both to village solidarity and to a democratic way
of thinking. Second, projects should provide common benefits to the whole
village, not to just a few persons or a small group. Further, projects that
contribute to increased productivity and income receive priority. Third, the
scale of a project must be based on a realistic assessment of villagers’
resources and capabilities, because each village is obligated to contribute
half of the total investment. A too ambitious project may discourage vil-
lagers’ participation and result in the project’s abandonment. Fourth, the
selection and design of a project should take into consideration the condi-
tions of the village, such as its geographical features, transportation, mar-
ket access, village traditions, and financial resources.
 418 Pal Yong Moon

Investment Patterns
During 1972-82 total investment in Saemaul projects increased 28 times in
nominal terms and five times in real prices, while government's investment
increased 116 times in nominal terms and 23 times in constant prices (Ta-
ble 16.4). These investments can be classified as production infrastructure,
income augmentation, environmental improvements, rural enlightenment,
and urban and factory Saemaul projects.
Investment in production infrastructure, such as the expansion of farm
roads and improvement of small-scale irrigation, received 61.8 billion won
(or 64.3 percent of the total) in 1973 (Table 16.5). By 1982 the amount had
increased to 191 billion won in nominal terms, but the relative share had
declined to 22 percent. In the case of income-augmentation projects, the
relative share increased from 6.1 percent in 1973 to 43.3 percent in 1982.
In contrast, the investment in environmental projects marked a substantial
increase in absolute terms, but the relative share remained fairly stable
throughout the period (Table 16.5; MOHA, ROK, Saemaul Undong, 1972-82).
The investment in education/enlightenment projects, which include train-
ing for leaders and establishment of community libraries, increased in both
absolute and relative terms. The investment in urban and factory Saemaul
projects, which cover improvements in labor-industry relations, improve-
. ments in working conditions, and beautification of factory surroundings,
remained relatively stable in terms of relative share (Table 16.5).

Table 16.5. Government support by program category: 1973-82

Share of total investment (%)
Total Environ- Education/
invest- Produc- Income mental rural Urban
ment tion infra- augmen- improve- enlighten- Saemaul
Year (10° won) structure tation ments ment projects
1972 31.6 u u u u u
1973 96.1 64.3 6.1 28.7 0.8 u
1974 132.8 42.5 25.4 217 2.4 8.0
1975 299.9 21.5 63.4 10.3 1.6 Doe
1976 O22u7 a fe | 47.8 20.9 1.8 1.6
1977 466.5 Pag Ce pa 23.6 Ze 5.9
1978 634.2 20.6 38.3 38.5 2.0 0.6
1979 100.2 20.9 43.1 32.0 1.0 3.0
1980 936.8 u u u u u
1981 702.9 15.0 49.9 28.0 fe) 4.3
1982 866.6 22.0 43.3 24.5 4.1 6.1
ee ie en eee be holies ren nee end den a eee Un Ses
Source: MOHA, ROK, Saemaul Undong (1972-82).
u—data unavailable.
 The Saemaul (New Community) Movement (1971) 419

The shift in the pattern of investment, especially from environmental

projects to income-generating ones, reflects the changing emphasis in the
Saemaul movement.

EFFECTS OF THE SAEMAUL MOVEMENT

It is difficult to make a quantitative assessment of the Saemaul movement's
contribution to the rural economy, for two reasons. The movement com-
prised not only physical aspects of rural community development, but also
a wide range of intangible but important aspects such as motivation, at-
titudinal and behavioral change, and education. In addition, a wide vari-
ety of other related projects were undertaken under the label of Saemaul
(including even those carried out prior to the Saemaul movement), and
one can hardly distinguish the effects of the Saemaul movement from those
of other policy measures.
Effects on the Environment
Improvement of the rural living environment is one of the most notable
achievements of the movement. The establishment of sanitary water sup-
ply systems and improved sewage systems made a substantial contribu-
tion to reducing the frequency of water-borne diseases. Prior to the Saemaul
movement, most farm households had depended for water for drinking
and other purposes on unsanitary village wells, which were located at a
distance from most residences. The installation of running-water supply
systems has not only provided disease-free water but has also been a great
convenience to households.
Housing-improvement projects also contributed substantially to the
modernization of the rural environment. In the past, the grey straw-thatched
roofs of farm houses were viewed as a symbol of rural poverty and eco-
nomic stagnation. A straw roof had to be replaced every year, at the cost
of considerable labor. Replacement of the straw with tiles and other per-
manent materials has made it possible for farm families to use the straw
for other purposes, such as making straw bags and compost.
Village restructuring projects, consisting of relocation, redevelopment,
and partial improvement of villages, have modernized rural villages and
raised villagers’ confidence in further improvements in their living con-
ditions.
Another important achievement has been the expansion of electrical and
communication networks. As of 1971 only about 20 percent of the more
than 2 million farm households had electric lighting, while the remaining
farmers relied on kerosene lamps. By 1982, however, rural electrification
and the installation of a telephone system were almost completed, except
in remote mountainous areas and on isolated, small islands. The socio-
economic impact of these projects is quite impressive in rural areas. The
projects helped reduce the cultural gap between rural and urban sectors.
420 Pal Yong Moon

Electrification created new consumer demand for home appliances, such

as television sets, refrigerators, electric cookers, and electric irons. It also
led to the use of electric power for productive purposes, such as the repair
of farm machinery. The expansion of communication networks, especially
the widespread installation of public telephones, has not only reduced the
social distance between villages and cities but also increased the efficiency
of transmitting public information, including news about farm products and
market conditions.
The construction of village roads, farm feeder roads, and small bridges
facilitated farm mechanization, the marketing of farm products, and the
mobility of farm inputs.
Effects on Farm Income
With the shift in emphasis from projects designed to improve the living
environment to projects designed to boost farm income, two types of
projects have received major attention. One is to increase farm income
through the introduction of cash crops and livestock raising, area speciali-
zation, and group farming and marketing. The other is to increase non-
farm income by creating off-farm employment opportunities and wage-
earning and self-help projects.
The effects of these projects can be measured by the growth of farm in-
come over time and by a comparison of farm income with the income of
the urban wage-earner’s household. During the 1965-69 period, when the
government's economic policy favored the urban sector, the average annu-
al growth of income for the urban wage earner was 14.6 percent, whereas
that for the farm household was only 3.5 percent. During 1970-76 the situ-
ation was reversed: farm household income was increasing at an annual
rate of 9.5 percent and that of urban wage earners at only 4.6 percent. This
was the period in which the high grain-price policy was effected and mas-
sive investment projects were implemented under the Saemaul movement.
By 1970-82, the rates of income growth for the two sectors were equalized,
at 6.6 percent per annum (MAF, ROK, Farm Household Economy Survey,
1960-82).
Another indicator of the income effects of the Saemaul movement is
found by comparing the income levels of farm and urban wage-earners’
households. During the period 1967-70, the average income of farm house-
holds averaged between 60 and 70 percent of urban wage earners’ income.
But since 1974 the gap between the two sectors has substantially narrowed.
In some years farm household income even exceeded that of urban house-
holds. (See Table 15.7 in Chapter 15 for a comparison of rural and urban
household income.) Of course, this improvement in the farm-income posi-
tion cannot be attributed to the Saemaul movement alone. The high grain-
price policy, put into effect two years before the Saemaul movement was
launched, also contributed to the improvement of farm income.
 The Saemaul (New Community) Movement (1971) 421

Effects on Employment
In the early decades of Korea's development, employment objectives were
often treated as a byproduct of economic growth. Today, employment
problems are among the central issues to be considered in formulating de-
velopment strategies. The Saemaul movement is an example of employment-
oriented rural development.
Although an accurate estimate of its employment effect is not possible
owing to a lack of quantitative information, its positive impact is suggested
by the number of workdays that rural people have contributed to various
Saemaul projects. Official statistics indicate that 1,858 million workdays of
labor were expended in Saemaul projects from 1972 through 1982. Even
if this labor contribution was not motivated by wage earnings, its purpose
was to produce public goods for the common benefit of all villagers and
to enhance the convenience of community life as well as incomes. There-
fore, all of the labor participation can be viewed as an employment effect.
But various wage-earning projects were undertaken to absorb the idle
labor force during the agricultural off-season. These projects were linked
to the improvement of large-scale rural infrastructure and the living environ-
ment, such as road construction, development of new land, sewage projects,
reforestation, and erosion control. Some 78,000 projects were undertaken
that created employment equivalent to 94 million workdays during the
1974-82 period. The government's investment of 226 billion won was paid
as wages during the same period (MOHA, ROK, Saemaul Undong, 1974-82).
The Saemaul movement has served as an employment-oriented develop-
ment strategy to absorb large numbers of workers from the rural labor force.
It has also alleviated underemployment in farm areas by implementing most
projects during the farm off-season.
Effects on Rural Savings
The enhancement of saving propensity in rural areas has been another sig-
nificant achievement of the Saemaul movement. From its beginning, the
movement has emphasized thrift and saving; these virtues have been
promoted by an ongoing nationwide savings campaign. Although this sav-
ing propensity has been made possible by increased income, a separate
assessment is made of it here because of its importance in capital forma-
tion in rural areas.
Increases in saving ratio and in the amounts deposited by farmers in
the agricultural cooperatives are used as indicators. Throughout the 1960s,
when there was neither a high grain-price policy nor the Saemaul move-
ment, farmers were able to save only negligible portions of their incomes.
But since 1970 a substantial portion of their income has been saved. The
ratio of savings to total income was less than 10 percent during the 1960s
but increased to more than 20 percent in the 1970s (Table 16.6). This increase
in saving propensity is attributable mainly to an increase in income, but
422
SS
Pal Yong Moon

Table 16.6. Farm saving ratio, average per household: Selected years, 1960-82
oo a a ee ee eS SS SS SS SS

Farm income Farm savings Saving ratio

Year (10? won) (103 won) (%)

1960 45 -0.7 -1.6

1963 83 5 6.0
1965 112 9 8.0
1967 139 i 79
1970 256 38 14.8
1973 481 123 25.6
1975 873 227 26.0
1977, 1,433 401 28.0
1980 2,693 405 15.0
1981 3,688 803 21.8
1982 4,465 968 217
Source: MAF, ROK, Farm Household Economy Survey (1960-82).

it is undeniable that the saving campaign under the Saemaul movement

helped to accelerate the pace.
In the past, most of the savings were in the form of cash at home be-
cause of the lack of modern banking institutions in rural areas. With the
establishment of a mutual financing system within the agricultural cooper-
atives, not only the absolute amount of cash deposits but also the relative
share in the total loanable funds have substantially increased (Table 16.7).
In 1963 the relative share of farmers’ deposits was only 20.6 percent, but
it had increased to almost 50 percent by 1980. The saving campaign of the
Saemaul movement played a decisive role in inducing farmers to save more
and to make deposits in the agricultural cooperatives.
CRITICISM AND LESSONS
From the beginning, the Saemaul movement has been a government-
initiated rural-development movement. Initiated by the president and the
central government, efforts have been made to mobilize support for the
Saemaul programs among all levels of government officials, including even
the police and locally based army units. As the movement proceeded, an
increasing range of government programs came under the Saemaul um-
brella, to the extent that the term “Saemaul” became a synonym for gov-
ernment-sponsored development activities, especially in rural areas. As a
determined government policy, implemented through an authoritarian and
bureaucratic administrative structure, the movement has undoubtedly af-
fected almost every rural household either by its ideology or through a
project.
The Saemaul movement has contributed to the development of the na-
tional economy through a series of government investment projects. It has
 The Saemaul (New Community) Movement (1971) 423

Table 16.7. Farmers’ deposits and relative share in the total loanable funds
of agricultural cooperatives: Selected years, 1963-80
Funds from other
Total loanable funds Farmers’ deposits sources*
Amount Share Amount Share Amount Share
Year (10? won) = (%) (10? won) (%) (10? won) = (%)
1963 2 Tock 100.0 Bw, 20.6 22.0 79.4
1965 44.2 100.0 10.6 24.0 33.6 76.0
1967 73.4 100.0 27:38 37.7 45.6 62.3
1970 1922) 100.0 95.4 49.6 96.8 50.4
1973 313.5 100.0 169.4 54.0 144.1 46.0
1975 615.1 100.0 264.8 43.0 350.3 57.0
1980 2,126.7, 100.0 1,052.0 49.5 1,074.7 50.5
Source: NACF, ROK, Agriculture Yearbook (1963-80).
a. Includes such sources as government funds, loans from the Bank of Korea, and agricul-
tural credit bond issues.

helped to reduce the income disparity between the urban and farm sectors
by boosting farm income. It has fostered a spirit of thrift and saving, thus
channeling farm surpluses into banking institutions for continued capital
formation in the rural areas. It has contributed to balanced growth between
the urban and rural sectors as well as among regions (Whang 1981).
Many people, including government officials and scholars, tend to at-
tribute this successful performance of the Saemaul movement to a strong
“top-down” approach, which made it possible to mobilize the massive par-
ticipation of rural people on the one hand and all levels of administrative
agencies on the other. Considering the history of fatalism and economic
stagnancy in rural Korea, this top-down approach was an effective way of
bringing about change in rural areas. It may have been a necessary step
in motivating farmers and mobilizing resources at the village level as well
as the bureaucracy at all levels of administration, and it had far-reaching
effects throughout the rural areas.
An authoritarian approach could be justified in the initial stage of the
movement on economic grounds as well. Rural Koreans did not have suffi-
cient financial and technical resources to improve their own social and eco-
nomic status. Some kind of inducement mechanism was necessary to
stimulate the rural people. Government alone could perform this function
and provide momentum as an agent of change.
After more than ten years of experience, however, the question arises
whether this top-down authoritarian approach can be effective in ad-
ministering community-development programs. There are many examples
of the authoritarian approach hindering rather than encouraging farmers’
voluntary participation and even leading to misallocation of resources in
the implementation of projects.
424 Pal Yong Moon

First, at the level of the central government, almost all agricultural and
rural-development activities tended to be categorized under the Saemaul
label even without direct participation by village farmers. The centralized,
authoritarian nature of the government (in particular the fact that it has
virtually complete control of local finance) enabled it to exert great pres-
sure on local administrators to produce immediate, dramatic, and concrete
results.
At the local levels, officials tended to define the Saemaul movement in
terms of the range of directives they received from higher authorities, often
with specific targets attached. By and large they did not see themselves
as representing or reflecting the opinions, desires, and needs of villagers
in their districts. Rather, they tended to be concerned with finding ways
of handling pressures from higher units to fulfill predetermined plans and
quotas.
In the actual implementation process, therefore, officials at all levels have
been concerned with meeting their immediate targets, without giving ap-
propriate attention to the adaptability of programs and without concern
for the end product—that is, service to villagers.
In many cases officials of both central and local governments have been
too concerned with superficial results. For example, in some projects,
resources and efforts were focused on villages close to expressways or rail-
ways, while less visible communities were left untouched. This happened
especially in housing-improvement and village-restructuring projects. For
housing improvement, it was necessary to follow the government design,
which was in many cases more suitable for urban-style than farm living.
In many village restructuring projects, all the houses were built facing north,
which is contrary to custom in Korea, simply because expressways or rail-
ways were situated to the north.
Another example concerns the implementation of most Saemaul projects.
Middle-echelon administration, including provincial, county, and myon
offices, have tended simply to convey the higher-echelon administration’s
instructions to the lower-level administrations without considering local con-
ditions, needs, and the capabilities of local administrators.
A third criticism is that, since individual reputations and promotions
depend to a considerable extent on performance in achieving the Saemaul
targets determined by higher units, there has been a tendency for the lower
level of administration to overstress positive achievements in reporting to
superiors. This practice may have led to an inflation of work performance,
even to falsification of reports, so that the ordered targets could be fulfilled
on paper.
Moreover, because of fierce competition among officials at all levels, for
resources and credit for accomplishments, villagers have often been forced
to donate, in the name of the Saemaul spirit, their land and labor without
being properly compensated. There have been many cases in which exces-
 The Saemaul (New Community) Movement (1971) 425

sive bureaucratic zeal in carrying out an assigned task has resulted in

widespread resentment among rural people. Such situations have even
reminded villagers of compulsory measures during the Japanese colonial
period. Examples of this kind of blind execution of instructions from su-
perior administrations are numerous. The planting of a new, high-yielding
rice variety (Tongil) presents one of the most conspicuous cases.
With the aim of increasing rice production, the government allotted,
through administrative channels, a target of acreage to be planted with the
new rice variety. When it was first introduced in the early 1970s, farmers
were willing to adopt quotas because of the high yields and favorable prices
paid by the government. Market prices for the new rice began to fall be-
cause of consumers’ strong preference for traditional varieties, and farm-
ers realized that they could make more profit from traditional varieties. Many
farmers resisted the quotas, but the government continued to insist that
they grow the new variety. This led to severe conflicts between the govern-
ment and rice farmers. In many cases, local officials destroyed seed beds
planted with traditional varieties.
A fourth criticism of the movement is that the hierarchical nature of in-
stitutional structures has impeded horizontal coordinating efforts, despite
the existence of formally organized consultative bodies at all levels. These
bodies exist only in name. Officials tend to be narrowly preoccupied with
their own immediate assignments—particularly with visible results.
There are local development headquarters, consisting of rural extension
offices, agricultural cooperatives, health centers, forestry associations, and
farmland improvement associations. The organizations are all mobilized to
participate one way or another in the Saemaul movement. But the lack of
horizontal coordination among these organizations has too often resulted
in duplicate instructions that only confuse and embarrass rural people.
For instance, on many occasions the administrative authorities have
unilaterally determined the types of projects to be implemented and the
loan criteria without due consultation with the agricultural cooperatives.
This lack of coordination among the related organizations not only reduced
the efficiency of credit funds but also impeded the independence of cooper-
ative functions.
A fifth criticism relates to the voluntary participation of villagers, con-
sidered to be one of the most crucial factors for the successful implementa-
tion of the Saemaul projects. That voluntary participation has been
enunciated as a goal of the movement. In practice, however, there was an
increasing tendency toward administrative coercion rather than encourag-
ing villagers’ voluntary participation and cooperation.
Various organizations have been formed within the villages to promote
the Saemaul movement. The Village Development Committee is a typical
village-level organization, formed under instructions from MOHA. The
chairman of this committee is appointed on government authority, taking
426 Pal Yong Moon

on the character of a public administrator. Therefore, the committee tends

to channel the administrative orders of the upper-level authorities to the
village level, regardless of the interests of the villagers. Under these cir-
cumstances, it is almost impossible to expect active participation by the vil-
lagers in the decision-making process.
The first lesson of the Saemaul movement is that its style of administra-
tion has been obviously inconsistent with the originally enunciated ideol-
ogy of voluntary participation and cooperation. There is little evidence that
the movement itself has promoted a process of planning at the village level
or incentives to implement projects voluntarily. Willingness to participate
in collective activities has been due in large part to villagers’ traditional pat-
tern of cooperative farming, such as labor exchange and joint work for pest
control.
The second lesson is that the authoritarian and bureaucratic approach,
once considered to be necessary and initially effective, seems to have come
to its limit. With the advent of industrialization and urbanization, the rural
people have been integrated into the monetary economy, and their educa-
tional levels have been enhanced to the extent that they are capable of mak-
ing their own decisions. Government authorities can no longer expect
villagers to submit passively to coercion. The implementation of rural pro-
grams depends ultimately on the voluntary efforts of individual farmers
as well as on local administration. Planning “from above” must be com-
plemented by planning “from below” for it to be effective.
These lessons imply the need for institutional reform of a fundamental
sort as well as for changes in the strategy for rural development. The fol-
lowing suggestions are made in this regard.
1. A new type of administrative system must be sought under which
provinces, counties, and myons may exercise full administrative functions
suitable to their districts. Under the present public administration system,
the lower a level is, the more restricted is its autonomy. For local adminis-
tration, which is most closely related to local development projects and the
daily lives of rural people, too little autonomy hinders the implementation
of projects suitable to local needs. In the past, some efforts have been made
to promote local autonomy to varying degrees, but at present there is vir-
tually no participation by local authorities in the formulation of the poli-
cies they are expected to implement. If a system of complete autonomy is
not acceptable for political reasons, a system must be devised in which the
higher-level administration communicates its intentions to lower-level offi-
cials through indirect, rather than direct, involvement. Gradual measures
must be taken to devolve work activities, on an individual basis, from plan-
ning to execution, to the lower administration.
2. Agricultural cooperatives should reflect farmers’ opinions and pres-
sure policymakers accordingly so as to influence the direction of policy. But
in reality the agricultural cooperatives in Korea act more as a monopolistic
 The Saemaul (New Community) Movement (1971) 427

arm of the government than as a farmers’ organization. It is urgent that

the nature of agricultural cooperatives be changed so that they can func-
tion as true farmers’ organizations. The cooperatives’ involvement in a wide
variety of government development projects should be discontinued. In-
stead, the selection of projects must be left to each cooperative, based on
community requirements. This change will enhance the autonomy of
cooperatives’ operations and promote farmers’ interests in cooperative
programs.
3. Korea's rural sector is now in the grip of increasing labor shortages
due to a steady outflow of the rural work force to the urban, industrial sec-
tor. Such a situation has led, among other things, to sharp rises in rural
wages, constituting a major factor in the decline of the profitability of farm
production. For this reason, the task of modernizing Korea's agriculture must
necessarily be carried out in close association with farm mechanization.
Effective farm mechanization can hardly be achieved unless it is pursued
simultaneously with renovation of the agrarian system and the condition
of farmland, as well as with development of systems for utilizing farm
machinery that are suitable to the circumstances prevailing in rural com-
munities.
4. Although the programs of the Saemaul movement have undoubtedly
contributed to upgrading overail agricultural productivity, it is question-
able whether or not the programs enhanced the profitability of individual
farms. There has been a tendency to emphasize the achievement of an ag-
gregate target alone and to neglect the profitability of individual farming
activities. Emphasis must be directed toward enhancing individual profit-
ability rather than meeting targets expressed in aggregate terms. Resource
endowment, economic worthiness of projects, and the timing of their im-
plementation should all be taken into account. Since the commercializa-
tion and monetization of agriculture are proceeding rapidly, market access
should receive high priority in project selection.
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 17 The Heavy and Chemical
Industries Promotion Plan (1973-79)
by Suk-Chae Lee

In the course of Korea's highly successful economic development since the

1960s, its economy has confronted many challenges and hardships, but each
time, the government has responded with ingenious economic policies. One
of the most daring of these policies, and one that is still controversial, is
the plan to promote heavy and chemical industries (HCI) launched during
the 1970s.
Known informally as the HCI Plan, the plan has been blamed as one
of the fundamental causes of the 1979-81 economic setback, during which
period the Korean economy faced its worst ordeal. At that time, the govern-
ment’s economic policy was restructured primarily to overcome the
problems that had risen in the 1970s from implementation of the HCI Plan.
From 1986 to 1988, however, the improved performance of the heavy and
chemical industries led to rapid economic growth. The HCI sectors were
widely accepted as leading sectors for future growth, and a more positive
view of the HCI Plan began to emerge.
With the benefit of hindsight, this chapter reappraises the debate over
the appropriateness of having promoted HCI during the 1970s and searches
for the lessons to be learned from the HCI Plan. In the next section I out-
line, briefly introduce, and analyze the characteristics of the HCI Plan. Then
I present the reasons for promoting HCI, and, after surveying the major
support measures of the HCI Plan, examine the outcome of implementa-
tion of the HCI Plan, and review the plan's theoretical appropriateness. Prob-
ing the plan’s effects on Korean economic development in the subsequent
section, I conclude the chapter by drawing the lessons to be learned from
the HCI experience.
THE HCI PLAN: CONTENT, AMENDMENTS,
AND DISTINGUISHING FEATURES
Korea’s HCI Plan had its inception in the first half of 1973; even before 1973,
however, HCI-related projects such as the Pohang Iron and Steel Mill and
Hyundai Shipyard were under way (Table 17.1). The term “heavy and chem-
ical” was first introduced in the government's Third Five-Year Economic
Development Plan (1972-76). This plan, however, was neither an invest-
ment plan nor a master plan for promotion of HCI. By contrast, the HCI
Plan of June 1973, formally known as the Heavy and Chemical Industries
431
432
a
Suk-Chae Lee

Table 17.1. HCI projects promoted before 1973

ee ee a a 2 oe ea es 2 ee SS Se
Building
Sector Project name Size period
Steel Pohang Steel I 1,030,000 MT 1970-73
sushi Foundry 200,000 MT _ -——-1972-74
Special steel 60,000 MT 1972-74
Nonferrous Copper, zinc, lead refineries Planned but
metal not built
Machinery Heavy machinery factory 1973-74
Shipbuilding Hyundai shipyard 300,000 MT 1972-73
5 ships
Chemical Ulsan petrochemical complex
Naphtha resolution center 100,000 MT 1968-72
9 affiliated factories 1968-74
Sources: Figures taken from various HCI documents, compiled and arranged by the author.
MT—metric tons.

Promotion Plan, was a comprehensive investment plan that embodied the

strong will of the government.
The Original Plan
In his New Year’s Address of 12 January 1973, President Park Chung Hee
announced his intention to launch the HCI Plan. In May 1973, the Heavy
and Chemical Industries Promotion Council, an interministerial commit-
tee chaired by the prime minister, was established. And in June 1973, the
HCI Plan, requiring a total investment of US $9.6 billion between 1973 and
1981, was formally announced. It was declared a key strategy that would
increase Korea's per capita GNP and exports to US $1,000 and $10 billion,
respectively, by 1981 (HCI Promotion Council 1973). The corresponding
figures for 1972, the year that had just ended when the plan was announced,
were a mere $318 for per capita income and only $1.6 billion for exports
(EPB, ROK, Major Statistics, 1989).
According to the HCI Plan, six industries were designated as “key” in-
dustries to be promoted: steel, nonferrous metal, machinery (including au-
tomobile), shipbuilding, electronics; and chemical (see Table 17.2 for detailed
project plan). There were several basic reasons for designating these six
as key industries. First, these industries were expected to make the most

1. The heavy and chemical industries, narrowly defined, do not include the electronics in-
dustry. However, the electronics industry was one of the core industries slated for promotion
in Korea’s HCI Plan; therefore, any analysis of the HCI Plan should include the electronics
industry.
Table 17.2. Projects included in the HCI promotion plan
Construction
Sector Project name and description period
Iron and steel Pohang steel extension
(1.03 million MT to 7 million MT) 1979
Second iron and steel mill (5 million MT) 1976-80

Nonferrous metal Copper refinery (100,000 MT) 1974-76

Zinc refinery (80,000 MT) 1975-77
Lead refinery (50,000 MT) 1979-80
Aluminum refinery (100,000 MT) 1976-78

Machinery Changweon machinery industry complex

Complex construction 1973-76
Factory construction 1974-80
26 material factories
39 general machinery factories
7 electric instrument factories
8 precision instrument factories

Shipbuilding Construction of 9 shipyards Completed

(2 small, 2 medium, 5 large) 1981
Construction of 5 shipyards Completed
(2 medium, 3 large) 1985

Electronics Gumi electronics complex construction

Ist phase 1971-73
Expansion 1977-81

Chemical Oil refinery enlargement (860,000 barrels) 1973-81

Completion of 3 subsidiary factories
of Ulsan petrochemical complex
Ulsan complex enlargement
Naphtha resolution center
(100,000 MT to 150,000 MT) 1974
(300,000 MT to 350,000 MT) 1976
New affiliated factory construction
Yoicheon integrated chemical complex 1976-79
construction
Fertilizer plant construction (7th plant) 1974-75

Sources: Figures taken from various HCI documents, compiled and arranged by the author.
434 Suk-Chae Lee

of domestic resources, particularly of Korea's relatively abundant human

resources. Second, they would be attractive to foreign investors, so that
financing of the projects was expected to be relatively easy. Separate from
these six industries, five projects were already under way, with strong
government support, to develop special steel, brass, foundry, heavy
machinery, and shipbuilding (Hyundai) plants?
The HCI Plan was organized around a few large key projects, including
the projects that were already under way. Key projects were expected to
induce related investments through linkage effects. In the case of the elec-
tronics industry, however, the “key projects” approach was considered un-
tenable, since it would be difficult to identify them; therefore, to induce
private businessmen to make investments in these industries, a general in-
centive system was devised3
It was expected that private enterprises would undertake key projects,
except for expansion projects in iron and steel and construction of new
chemical fertilizer plants, which would be undertaken by public enterprises.
Most of the industries were designed to be developed as future leading
export industries, whose share in commodity exports was expected to ex-
ceed 50 percent by 1980. Thus, the implication was that HCI’s share in
manufacturing value added would be increased to more than 50 percent
by 1980 as well (HCI Promotion Council 1973).

Amendments to the Plan

After the oil shock of 1973, it was questioned whether the HCI Plan should
be implemented, particularly under the conditions of high inflation and
lack of foreign exchange reserves resulting from the oil shock. Despite this
doubt the original plan was implemented without significant changes.
Nevertheless, the first amendments to the HCI Plan were made in the
Fourth Five-Year Economic and Social Development Plan (Fourth

postponing projects related to the three other original key industries of the
HCI Plan of 1973. In the case of steel, the overall supply and demand con-

2. As will be discussed in the following subsection, the HCI Plan was an outgrowth of an
evolving consensus among Korea's leaders on the need for long-term industrial restructuring.
The slant toward heavy industry began to be revealed publicly as early as 1970, and the five
projects initiated prior to adoption of the HCI Plan in 1973 represent the beginning of the
implementation of a strategy to develop HCI.
3. The incentive system for the electronics industry was composed of the following three ele-
ments: (1) a more open policy stance toward inducement of foreign direct investment and
technology (e.g., permission for 100 percent foreign ownership); (2) preferential access to finan-
cial credit; and (3) provision of large industrial estates, solely for the electronics industry, with
the infrastructure provided by the government.
 The Heavy and Chemical Industries Promotion Plan 435

dition dictated that additional construction was not urgent; the nonferrous
metal and chemical fertilizer and pulp industries were viewed as lacking
comparative advantage (EPB, ROK, Fourth Plan, 1975). The revisions of the
HCI Plan announced by the Ministry of Trade and Industry following the
Fourth Plan were as follows:
e Postponing the fourth expansion of the Pohang Iron and Steel Mill for
one year (scheduled to finish in 1982);
e Reducing the scale of the copper smelter (from 100,000 to 80,000 metric
tons);
e Dropping the aluminum smelter project;
e Discarding the planned expansion of three chemical fertilizer plants;
¢ Reducing the scale of the chemical pulp production plant (from 800 to
300 metric tons per day);
¢ Reducing the number of new arian 3 from nine to two.

lization program was announced in April 1979. By then, however, most

of faefoisted projects had already been either completed or were well
under way. Thus, all of the adjustments made thereafter served to ease
financial difficulties faced by participants in the HCI program or to salvage
sinking ventures?

Distinguishing Features of the HCI Plan

Launching of the HCI Plan might seem like a mere extension or continua-
tion of the government's past approach to industrialization. Even after the
liberal reforms of the mid-1960s, Korea continued or strengthened various
industrial policy measures, including enactment of industry-specific laws
to promote so-called strategic industries such as oil refining, iron and steel
production, shipbuilding, and the production of chemical fertilizers and
cement. Furthermore, into the 1970s, the government did not hesitate to
reveal its intention to build up heavy and chemical industries. And indeed,

4. On 28 June 1974, President Park delivered the following remarks in a speech regarding the
HCI Plan: “This ambitious HCI Plan once faced severe challenge due to last year’s oil shock
and consequent worldwide inflation. Some of us suggested that the HCI Plan should be modi-
fied substantially considering new economic environments caused by the oil shock. The govern-
ment, however, continued to implement the HCI Plan with its basic framework intact, and
this began to bear fruit.” (Office of the President, ROK, 1974).
5. For a full discussion of adjustment policies, see H. S. Chung (1985).
436 Suk-Chae Lee

this constituted one of the central themes of the Third Five-Year Economic
Development Plan (EPB, ROK, Third Plan, 1971).
The HCI Plan distinguishes itself from past approaches and plans,
however, in several important respects. First, no past plans were as com-
prehensive in terms of the coverage of HCI projects, nor were they as am-
bitious. The past plans, covering five-year periods, set direction of industrial
structure but fell short of singling out industrial projects that must be un-
dertaken. The HCI Plan, however, covered a ten-year period and was com-
posed of detailed, project-wise investment programs along with timetables
for their construction. This leads to the second distinguishing aspect of the
HCI Plan.
The past plans were far from being imperative plans’ though they
strongly influenced resource mobilization and patterns of resource alloca-
tion. The HCI Plan, by contrast, was designed from the very beginning
as an imperative plan, representing the government's strong will to com-
plete each of the planned investment programs on schedule.
Because of the great size and the uncertainty of the business prospects
of HCI projects, only the large business groups were qualified to take on
such projects. They were extremely reluctant to participate in HCI programs,
however. Thus the government had to handpick private investors for the
key projects and coerce them into undertaking the projects by using the
carrot-and-stick method. It accorded various incentives to those undertak-
ing HCI projects, details of which are presented later on in the chapter.
Korea’s resource endowment and level of economic deve t
however, made it highly unlikely that planned investments in. mae

In the early 1970s, Korea clearly lacked financial resources, technically

able manpower, and business experience, all of which are vital for the suc-
cessful construction and operation of HCI sectors. This led the government
to take a key project-oriented approach in implementing the HCI Plan. In
this approach, the government would initially construct one or two large-
scale plants in each targeted industry, usually in the form of final or inter-
mediate assembly plants, and thereafter establish a business foothold in
those projects. Through this approach, the planners expected to secure at
least a minimum market size for related projects such as parts and compo-
nents, in turn triggering chain investment activities by small and medium-
size firms. In a sense, it was a top-down rather than a bottom-up approach
to industrial restructuring.

6. An imperative plan, in contrast to an indicative plan where only broad objectives and strate-
gies are provided, is quite detailed. The programs in the imperative plan are expected to be
executed meticulously.
 The Heavy and Chemical Industries Promotion Plan 437

An additional characteristic of the HCI Plan was the collective accom-

modation of related projects in large industrial parks. Typical examples of —
such industrial parks were Changwon Park for the machinery industry and
Yeochon Park for the petrochemical industry. This approach was expected
to result in savings so MCT Sie: costs aumeee pollution problems.
¥ nbitious scope nd keypies approach of the
tos and speed
of Korea’s
lev | The next section reviews the reasons why the
government Popecced such an ambitious plan.

BACKGROUND OF THE HCI DRIVE

Changes in both international and domestic conditions prompted Korea's
decision to promote HCI. Internationally, Koreans faced a shift in U.S. for-
eign policy toward Asia and a potential change in Korea's comparative ad-
vantage due to economic development in other Asian nations. Domestically,
Korea's successful construction of light industries as well as lessons from
late-industrialized countries gave planners confidence that Korea should
indeed construct its own HCI sector? The following subsections describe
in detail the circumstances and logic behind Korea's decision to promote
HCI.
Concern for National Security
The advent of the Nixon administration signaled a rapid evolution in U.S.
Far Eastern policy. Announced in Guam on July 1969, the Nixon Doctrine
asserted that, barring a threat from a major military power, the defense of
each Asian nation—both conventional and strategic—lay in the individual
nation itself.
The Nixon Doctrine was intended to address the U.S. intervention in
Vietnam, and it implied a decreased direct American role in Asia in the
wake of worsening Sino-Soviet relations due to the Cultural Revolution in
China. The withdrawal of American troops from Vietnam, therefore, sig-
nified the prospect of Washington's decision to withdraw its troops from
Korea as well. The issue of U.S. troop withdrawal from Korea was decided
in the spring of 1970, and the first phase of withdrawal was completed by
March 1971.
Thus, under the rapidly changing conditions in Asia, President Park
Chung Hee decided to adopt a policy of self-defense to ensure the national
security of Korea. Such a policy required an economy centered on defense
industries and supported by the development of HCI.

7. Most of these arguments are found in World Bank (1986:38-39). Some of them, on the other
hand, reflect the author’s personal observation as a participant in economic policy decision
making since 1970.
438 Suk-Chae Lee

Limitations of Light Industry-Led Growth

Several concerns with the limitations of light industry-led growth further
convinced Korea's leaders of the necessity of constructing the HCI sector.
First, import restrictions began to be put on Korean light industry exports
by the United States and other developed countries in the late 1960s, and
thus it was feared that the world market for light industrial products might
not expand very rapidly? Second, expectations of increased light industry
product exports in the world market from less developed countries (LDCs)
such as the People’s Republic of China signaled that Korea's comparative
advantage in light industry would be eroded. Third, Korea would not be
able to overcome its trade deficit and consequent foreign debt burden as
long as it continued to rely on foreign capital goods and intermediate materi-
als to produce light industry export products.
Through development of HCI, Korea hoped to overcome the limitations
of light industry-led industrialization. Moreover, the government gained
substantial confidence in promoting HCI after completing the Pohang In-
tegrated Iron and Steel Mill and the Hyundai Shipyard.
Confidence in Constructing HCI
Despite overwhelming skepticism on the part of economists, including those
on the World Bank staff, toward the idea of Korea's building a large-scale
iron and steel mill, President Park pushed the project, which carried much
of his personal prestige. The mill’s first machine was installed at Pohang
in April 1970, with financial and technological support from Japan. During
the month of July 1973, the firm produced more than 100,000 tons of steel;
eventually it produced one million tons of steel annually. By 1974, the project
was considered a great success because it produced quality steel products
at internationally competitive prices°
In the private sector, the Hyundai Group constructed a large-scale
modern shipyard in 1972 with support from European business circles.

8. One example of why Korea's leaders were pessimistic about the prospects for light indus-
trial exports is found in the Korea-United States Synthetic Textile Fiber Agreement signed
in 1971. The Korean government and business circles were shocked when they received less
favorable treatment in synthetic textile trade from the United States than that received by Japan.
The Koreans had expected special treatment from the United States because: (1) the textile
industry was vital to Korea's economy, as indicated in its 40 percent share of total Korean ex-
ports in 1970; (2) Korean textiles posed no threat as their market share in the United States
was only 2 percent; (3) Korea fought alongside the United States in Vietnam; and (4) Korea
was still a very poor country.
9. The price competitiveness of the Pohang Mill at its initial stage stems partly from govern-
ment assistance in the form of infrastructure provided and discounted utility costs. However,
most of its competitive strength came from the low cost of construction, state-of-the-art facili-
ties, and the increase in capital costs after the first oil shock. (For a detailed discussion, see
Amsden 1989:chap. 12. Amsden (1989:chap. 11) also includes a description of the success
of Hyundai shipyard.)
 The Heavy and Chemical Industries Promotion Plan 439

Again, it became an instant success because it could compete in the world

market.
The government concluded that these successes did not occur by acci-
dent but were the natural outcomes of a combination of bold risk-taking
and careful utilization of changing domestic and international economic
conditions. The economic conditions considered favorable to Korea's drive
to build HCI were as follows:
First, Korea enjoyed the advantage of an abundant, well-trained work
force and relatively low wage rates compared to the advanced countries,
which were experiencing manpower shortages, workers’ avoidance of heavy-
labor jobs, and high wage rates.
Second, Korea could start with state-of-the-art facilities, and thereby ac-
quire comparative advantage against advanced countries having relatively
old facilities. This had been verified by the success of Korean steel mill and
shipyard projects.
Third, Korea could attract sufficient amounts of foreign capital for the
HCI projects, given the country’s credit rating in the international financial
market.
Fourth, as a result of Korea’s successful promotion of light industry, the
critical market size for the HCI products could be secured domestically with
“temporary” protective measures, thereby resolving the marketing problem,
which was so crucial to success of the HCI Plan.
Fifth, Korea’s businessmen as well as government officials were ex-
perienced in running industrial businesses for the world market, and could
play a pivotal role in promoting HCI sectors as new export industries.
In addition to these favorable economic conditions, Korea had the benefit
of the Japanese model, which could serve as a rationale for the HCI Plan
in many respects. As a latecomer, Japan had relied heavily on foreign tech-
nology and equipment in its HCI development efforts. Yet, in the 1960s,
Japan developed a world-class steel industry, and in the early 1970s the
nation deeply penetrated the world’s steel, machinery, electronics, and au-
tomobile markets, surpassing the United States and Europe in competi-
tiveness. These accomplishments, which were pay-offs to its early efforts
to build up HCI, enabled Japan to become a fully developed nation. There-
fore, in order for Korea to catapult into the ranks of advanced nations, the
government felt that development of HCI was the only available choice,
and that there was little reason why Korea could not repeat the Japanese
success.

10. The competition between the industrial countries and the deep economic recession after
the oil shock of 1974 allowed Korea to gain easy access to the most modern technologies in
the development of its HCI sector. Though some countries were reluctant to transfer advanced
technology to potential competitors, there were always some countries that were willing to
do so.
440 Suk-Chae Lee

POLICY MEASURES TO PROMOTE THE HCI PLAN

To execute the HCI Plan, the government devised a new incentive system
and readjusted the way it managed economic development. The most
pronounced aspect of this change was a shift away from its previous de-
velopment strategy, which had been characterized by export-oriented in-
dustrialization guided by market forces. Under the previous strategy, which
was successfully implemented from the early 1960s to the early 1970s, most
of the industrial projects were undertaken by private initiatives, and the
government played only a supporting role. Exceptions were limited to stra-
tegic industries such as iron and steel, fertilizer, and oil refining.” After
examining the development management and incentive systems of the 1960s
and early 1970s, I will discuss how they were modified by the HCI Plan.

Development Management and Incentive Systems

Prior to the HCI Drive
Even before the implementation of the HCI Plan, the technocrats who
played the central role in formulating medium-term economic development
plans sometimes had a hard time accommodating some of the big projects
that were conceived by the president and thrust into their planning frame-
work. Examples of such projects were the Pohang Integrated Iron and Steel
Mill, the Seoul-Pusan Highway, and the Soyang Multipurpose Dam. These
projects were introduced one by one, however, so the basic macro-frame-
work charted by medium-term planners did not have to be discarded and
the foundation of the incentive system did not have to be modified. These
projects usually reflected an entrepreneurial spirit that was at odds with
the technocrats’ rational approach. They turned out to be successful and
provided various external economies. Thus, the thrusting of big projects
by political leaders into development plans often reinforced the rational ap-
proach of technocrats.?
The incentive regime of the period before the HCI Plan can be summa-
rized as follows. First, various incentives, including preferential loan facili-
ties and tax credits were targeted to foster export activities and export sectors
in general rather than key industries. Second, the exchange rate was fre-
quently adjusted to reflect the won’s real scarcity value. Third, imports of
the raw materials, intermediate goods, and capital equipment that were
needed for exports were kept free of tariff and non-tariff barriers.
Thus, under this incentive regime, export-related activities and export
industries were not discriminated against as compared to import-substi-

11. For a detailed analysis of Korea’s development strategies and industrial policies during
this period, see World Bank (1986:29-38).
12. This argument again represents the author's personal observation as a staff member of
the Economic Planning Board from 1970 through 1984.
 The Heavy and Chemical Industries Promotion Plan 441

tuting activities or industries. Indeed the World Bank (1986:44) noted that
the maintenance of an incentive regime with little sectoral bias was a remark-
able aspect of Korea's development strategy.
The government attempted to reduce fragmentation and repression of
the financial market even in its financial policies, by setting the real interest
rates positive. Also, the trade regime was scheduled to be more open, as
shown by the policy shift from a positive to a negative system in announc-
ing the lists of importable items.
With these development management systems and incentive regimes,
which prevailed from the early 1960s to the early 1970s, however, promo-
tion of the HCI Plan seemed very difficult. Thus, a powerful promotion
body was set up in the Presidential Office, and modifications both in the
existing development management system and the incentive regime began
to be made.

New Development Management and Incentive Systems

With the announcement of the ambitious HCI Plan as an imperative plan,
the Third Five-Year Development Plan, which had been formulated in 1971
to provide the basic macro-framework for economic management for 1972
through 1976, was effectively superseded. The simultaneous launching of
numerous large-scale projects that required huge outlays of resources was
simply impossible within the Third Plan’s resource allocation framework.
As described earlier, most of the projects in the HCI Plan were to be un-
dertaken by private enterprises. The private sector, however, considered
business prospects for HCI to be uncertain and resource requirements for
the projects to be beyond their capacity. Therefore it was difficult for the
government to induce even the biggest enterprises to participate in the HCI
programs without some kind of coercion plus sufficient incentives.4 This
situation led to the birth of a new incentive regime and the modification
of the development management system. The main focus of the new in-
centive regime was on channeling resources into the targeted industries
and thus securing their markets. To this end, financial and trade policies
had to be changed and shifts in fiscal preferences also had to be made.
Among these, the change in financial policy had the greatest impact on
the industrial incentive structure.
To secure an adequate flow of financial resources into HCI and to lessen
the risks involved, the government had to control the entire credit system
and give preferential access at greatly subsidized rates to targeted indus-
tries. To do so, it established a special fund called the National Investment

13. For a review of financial reform, see McKinnon (1973:105-111) or Cole and Park (1983).
For trade policies during this period, see World Bank (1986:32-37) or Krueger (1979:82-130).
14. A typical method of coercing was to convey to the concerned businessman President Park's
wish to see the businessman's participation in the HCI Plan's projects.
442 Suk-Chae Lee

Fund (NIF), which was funded by the government and financial institu-
tions. Because the size of NIF was insufficient to cover the financial needs
of the entire HCI Plan, the government decreed that a portion of commer-
cial bank lending should be allocated to HCI projects as well.
Since a lower interest rate would reduce the risks involved in undertak-
ing HCI ventures, the government discontinued the high interest-rate policy
of the 1960s. Throughout the 1970s, the real interest rate remained nega-
tive (Table 17.3); this, in turn, created an excess demand for bank credit.
Under these circumstances, credit rationing by the government became the
eventual rule of the game, and governmental intervention in and influence
on real resource allocation expanded continuously (World Bank 1986:39).
The liberalization of the trade regime that had been pursued since 1967
was reversed, and the government restricted imports of intermediate goods
and of equipment needed to produce export goods. Such imports had
hitherto faced no trade barriers.
In its fiscal policy, the government increased the budget for construc-
tion of HClI-related infrastructure. Large-scale industrial parks were con-
structed to accommiodate HCI factories. And, with government funding,
education and training systems were overhauled to produce engineers and
skilled workers. Science and technology research institutes were also es-
tablished to develop the technology needed for HCI.
The eventual consequence of these efforts was the transformation of a
privately led market economy into a government-controlled one, in which
the market mechanism was largely replaced by an imperative plan for the
promotion of HCI.

Table 17.3. Real interest rates in the 1970s

Year General loan rate GNP deflator Real interest rate

1972 155 16.3 —0.8

1973 15.5 Pel 3.4
1974 15:5 30.4 —14.9
1975 55 24.6 -9.1
1976 17.0 to 18.0 21.0 —4.0 to —3.0
1977 15.0 to 19.0 15.9 -—0.9 to 3.1
1978 18.5 to 19.0 21.6 -—3.1 to —2.6
1979 18.5 to 19.0 20.0 -—1.5 to -1.0
1980 19.5 to 24.0 2060 —5.8 to -1.3
1981 16.5 to 17.0 15.4 DeItOMe6
ee ee

Source: BOK, Economic Statistics Yearbook (1974-82).

Note: Real interest rate = general loan rate — GNP deflator.
 The Heavy and Chemical Industries Promotion Plan 443

The following subsection briefly analyzes the actual implementation of

the incentive system for the execution of the HCI Plan.

Actual Implementation of the Incentive System

Establishment of the HCI Promotion Council. As noted earlier, the HCI Pro-
motion Council, with the prime minister as its chairman and the related
ministers as its members, was set up to promote the HCI Plan. President
Park wanted a closer control over the plan, however, and this led to the
appointment of a senior economic secretary to the president solely in charge
of the plan. The secretary was supported by a special task force whose for-
mal status was the secretariat of the council. The senior economic secre-
tary and the task force then made up the core organization that was
empowered to implement the HCI Plan, under the supreme power of the
president.
This organization had many functions, from choosing the enterprises
that would participate in HCI programs, to developing incentives to induce
Participation and clearing obstacles to the execution of the plan.
The National Investment Fund and HCI’s financial support. The initial fund-
ing of the NIF was only about 70 billion won—more than one-half of which
was contributed by the banking sector. The size of the NIF grew rapidly,
however, and by 1979 equaled 540 billion won. Although this growth was
partly financed by contributions from forced savings schemes (the National
Savings Association and National Life Insurance), the banking sector con-
tinued to provide the lion’s share of funding for the NIF (Table 17.4).
The HCI sector was not the sole recipient of NIF financing. During the
initial two years of the NIF, only about one-half of its funds was lent to
HCI. Beginning in 1976, however, the proportion of lending by the NIF to
HCI rose sharply and accounted for three-quarters of new lending. About
14 to 25 percent of NIF funds were lent in the form of credits for buyers
of HCI products—both at home and abroad (Table 17.5).
The NIF was not, however, large enough to finance the execution of the
HCI Plan alone. The banking sector, therefore, had to extend a large por-
tion of their new lending to HCI. The share of incremental lending to HCI
by the whole banking sector more than doubled from 32.2 percent in 1974
to 65.8 percent in 1975. Although this ratio dropped slightly after 1975, bank
lending to HCI still accounted for more than 56 percent of incremental lend-
ing throughout the second half of the 1970s (Table 17.6).
Between 1975 and 1978, HCI sectors enjoyed borrowing costs that were
25 percent below those of other sectors. Terms of the loans made for HCI
projects were also favorable: repayment periods were long (eight to ten
years), and interest rates charged were, on average, 5 percentage points lower
than the general loan rate. This difference in borrowing costs, however, dis-
appeared during the HCI adjustment period of 1979-81 (Table 17.7).
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 The Heavy and Chemical Industries Promotion Plan 447

Table 17.7, Commercial bank borrowing costs for HCI projects (%)

Interest rate on
Discount rate on equipment loans
Year commercial bills for HCI projects
1970 24.30 12.00
1971 23.00 12.00
1972 17.79 TY
1973 15.50 10.00
1974 150) 10.00
1975 15.29 12.00
1976 16.33 12.42
1977 17.25 13.00
1978 18.02 14.17
1979 18.75 15.00
1980 23.33 20.50
1981 19.50 18.00
1982 12.38 12°75
1983 10.00 10.00
Sources: BOK, Economic Statistics Yearbook (1970-85).

Tax incentives and other financial adjustments. To support the HCI Plan,
the government instituted tax incentives and adjusted financial parameters
in favor of HCI sectors. A major support measure for the HCI Plan was
the Tax Exemption and Reduction Law of 1975, which offered a variety of
tax incentives including tax holidays, investment tax credits, and acceler-
ated depreciation to participants in HCI programs. As a result, the margi-
nal effective corporate tax rate for program participants was between 15 and
20 percent, whereas the rate was between 48 and 52 percent for non-HCI
firms (Table 17.8).
Meanwhile, export industries suffered a decline in competitiveness due
to elimination or reduction of tax exemptions and other subsidies. Further-
more, as a result of the government's expansion of the money supply and
fixing the exchange rate in order to contain inflationary pressure, the real
value of the won rose, which lowered the competitiveness of Korea’s ex-
port sector (World Bank 1986:42-44).
Modifications of trade policy and limitations on domestic competition. Im-
plementation of the HCI Plan required a reversal of the government's trade
policy, from export promotion to import substitution. This required institut-
ing import restrictions and rolling back tariff exemptions on imports of cer-
tain items in order to encourage the purchase of products from domestic
HCI companies.
448 Suk-Chae Lee

Table 17.8. Effective marginal tax rate of HCI (%)

Fabricated
Petro- Basic metals and HCI
Year chemicals metals equipment (average) Non-HCI#

1972 29.5 24.8 28.8 IaES 29.8

1973 33.6 30.8 36.1 33. 38.6
1974 33.8 33.7 pH) 29.9 37.7
1975 16.9 12.4 18.3 15.9 52,4
1976 19.1 11.9 2153 17,5 49.5
1977 19.3 11.9 2423 17.5 49.5
1978 18.2 11.0 21.6 16.9 48.4
1979 2A 6 10.6 pany! 18.3 48.5
1980 yao 15.0 22.8 18.3 48.5
1981 12S 16.4 26.0 20.6 D1LF

Source: Kwack (1985:63-70).

a. The average of food and beverages, textiles and apparel, wood and furniture, paper and
printing, nonmetallic mineral products, and other manufacturing.

The so-called Limited Tariff Drawback system, for instance, placed tariffs
on imported items needed by Korean exporters. And establishment of
domestic content requirements for industrial facilities further helped to in-
crease turnover for firms participating in the HCI Plan. Moreover, higher
investment tax credits were granted to businesses purchasing domestically
produced machines, and in most cases high business entry barriers were
imposed.
Cultivation of technical manpower. Construction and development of the
HCI sectors would require a great amount of skilled manpower. It was es-
timated that the demand for skilled manpower in 1982 was 750,000, a six-
fold increase from 127,000 in 197135
To meet the demand, several efforts were made. First, the government
increased the enrollment capacities of science and engineering colleges, ex-
panding the total capacity from 26,000 in 1973 to 58,000 in 1980. At the same
time, the total enrollment in technical high schools doubled, and enroll-
ment in technical junior colleges increased more than fivefold between 1973
and 1980. In the same period, the government established 22 vocational
training centers, which produced 12,000 technicians per year.
The government also established six research institutes for science and
technology, especially for the machinery, chemistry, and electronics sectors.

15. Expansion of technical manpower and promotion of science and technology had also been
among the key objectives of the Third Five-Year Economic Development Plan.
 The Heavy and Chemical Industries Promotion Plan 449

Furthermore, it rapidly increased research and development expenditures.

From 1974 to 1979, the amount financed by the government was 306 billion
won, representing 54.5 percent of total R & D expenditure in the Korean
economy (EPB, ROK, Major Statistics, 1989).
Construction of industrial complexes and other government support. Con-
struction of industrial complexes was undertaken to save overall infrastruc-
ture costs, to realize operating efficiencies resulting from forward and
backward linkage effects, and to minimize and control pollution produced
by the chemical, nonferrous metal, and other industries. Between the an-
nouncement of the plan in 1973 and 1979, nine complexes were constructed.
HCl-related factories were placed at different locations based on their
characteristics. For example, a steel industry complex was placed in Pohang,
the nonferrous metal industry in Kunsan, the electronics industry in Kumi,
the machinery industry in Changwon, the shipping industry in Ulsan,
Ok-po, and Chukdo, and the chemical industry in Ulsan and Yeochon.
Besides these industrial complexes, the government supported major HCI
projects through direct investment or subsidized NIF credits, or both. Be-
cause iron, steel, and fertilizer were essential to the development of the
manufacturing and agricultural sectors, the government made direct invest-
ments in them through the Pohang Iron and Steel Company (POSCO) and
the Korea General Chemical Corporation.
From 194 through 1981, government spending on HCI projects amount-
ed to 893 billion won, representing 3.0 percent of the total economic de-
velopment budget (Table 17.9). Of that total, direct investment in major
projects amounted to 466 billion won; construction of industrial complexes,
344 billion won; and interest rate subsidies, 211 billion won (Table 17.10).
Nevertheless, HCI’s share of expenditures in relation to the total of all
economic development expenditures showed no substantial increase. The
government made large investments (relative to the economic development
budget) in POSCO and the Korea General Chemical Corporation even be-
fore the announcement of the HCI Plan in 1973, and this explains the lack
of a substantial increase in the ratio of HCI expenditures to total economic
development expenditures.

OUTCOME
The basic framework of the HCI Plan, as described earlier, remained intact
despite cancellation or postponement of some HCI programs. Even the first
oil shock and the consequent adverse world economic environment could
not shake the government's determination to fulfill the goals of the HCI
Plan. Thus, by 1975, with its new incentive system, the plan had gained
an irreversible momentum.
At that time, most of the big business groups in Korea were scrambling
for a ride on the HCI bandwagon expecting to reap huge benefits from the
450
ee
Suk-Chae Lee

Table 17.9. Trends in size of government budget support for HCI programs:
1970-81 (10° won; %)
Percentage
Percentage of economic
Total Budget for of total development
central economic Budgetary budget expenditures
government development support devoted to devoted to
budget expenditures for HCI HCI support HCI support
Year (A) (B) (C) (C/A) (CIB)
1970 446.3 121.8 172 3.9 14.1
1971 555.3 153.0 29.4 5.3 19.2
1972 709.3 209.0 80.6 11.4 38.6
1973 659.7 143.5 13.6 24 9.5
1974 1,038.3 222.8 40.6 3.9 18.2
1975 1,586.9 397.0 80.8 5.1 20.4
1976 2,258.5 576.5 123.0 5.4 21.3
1977 2,744.6 654.7 91.3 3.3 13.9
1978 3,517.0 716.1 137.0 3.9 19.1
1979 4,905.7 1,431.9 93.2 1.9 6.5
1980 6,118.2 1,338.8 222.0 3.6 16.6
1981 8,040.0 1,493.9 104.8 1.3 7.0
Source: Figures from EPB, ROK, Budget Summary (1970-81), compiled and arranged by the
author.
Note: General account basis.

new incentive system rather than from profitability of the ventures. Such
eagerness on the part of Korea’s major business groups enabled the HCI
investment plan to be implemented successfully, and between 1977 and 1979
investments in HCI accounted for more than 75 percent of all investments
in manufacturing (Table 17.11).
The policy goal of making Korea's industrial structure more sophisticated
was also generally successful, at least from the HCI Plan's perspective. Such
sophistication was generally considered identical to raising the share of HCI
in total value added and in exports of manufactured goods. The plan tar-
geted the share of HCI to exceed 50 percent by 1980. Though there was
a slight delay in this timetable, the share of HCI in manufacturing value
added and exports indeed had surpassed the 50 percent benchmark by the
early 1980s (Table 17.12). It is noteworthy that the HCI Plan was success-
fully executed and produced at least the targeted statistical results.
Despite the statistical success, most of the HCI projects suffered from
extremely low capacity utilization (Table 17.13) resulting in consequent finan-
cial difficulties for Korea’s major business groups by 1979. The difficulties
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Table 17.11. Facility investment in the manufacturing sector (10? won)
Percentage of
facility investment
All Manufacturing HCI in HCI
industries (A) (B) (B/A)

1973-74 1,054 707 434 61.4

1975 1,098 621 481 71D
1976 a272 838 622 74.2
1977 2,026 1,380 1,040 75.4
1978 3,125 2,148 1719 80.0
1979 3,734 2,469 1,870 750
Average 7229

Source: Korea Development Bank (1984).

Table 17.12. Structural change in manufacturing (% share)

Value added Export
1970 19751980) 1983 1970 » +1975), £1980" 21983
Light industry 64.0 55.5 48.6 46.1 S18 66.1 5247 S435
HCI 36.0 44.5) 5514 753.9 18.2) 133.9: 9.47.6: S65
Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0
Source: Compiled by the Ministry of Trade and Industry, ROK, using data from BOK, Input-
Output Tables (1985).

Table 17.13. Capacity utilization in HCI (%)

Industry 1976 1977 1978 1979 1980

Chemical 219 98.1 110.4 95.4 80.3

Basic metals 78.6 81.1 88.1 81.0 Z1:3
Fabricated metals and machinery 61.0 57.1 OL 362.6 53.1
Source: Compiled by the Ministry of Trade and Industry, ROK.
Note: ‘’As of 1980 Korean urea production costs were five times as high as U.S. and Cana-
dian costs, and ten times as high as Middle Eastern costs. Thus substantial capacity had to
be scrapped. Utilization of automobiles had fallen to about one-third of capacity. The Chang-
won machinery complex’s huge foundry shops were operated at only a fraction of capacity’
(World Bank 1986).
 The Heavy and Chemical Industries Promotion Plan 453

became more severe when a new economic policymaking team formed in

early 1979 began to tighten the money supply, which had been previously
loosened in the wake of implementing the HCI Plan. The tight monetary
policy and the severe world economic recession that followed the second
oil shock, among other factors, worked together to transform the difficul-
ties into a crisis.
In 1980, Korea experienced its worst economic crisis since the end of the
Korean War. Its growth rate plunged to -3.7 percent, while the inflation rate
soared to 39 percent in terms of the wholesale price index and the balance-
of-payments deficit climbed to approximately 9 percent of GNP (Table 17.14).
Though the assassination of President Park and the ensuing political and
social turmoil on the eve of the second oil shock undoubtedly contributed
to these results, the financial crisis faced by Korea's major business groups
and the weakening competitiveness of Korea's light industries were con-
sidered the fundamental causes of the disasterous economic conditions.
When the second oil shock took place, Korea was poorly prepared to
weather the consequent adverse world economic environment. Most new
investments in the second half of the 1970s had been made in the form of
HCI projects, very often at the expense of light industries. Also, various
economic parameters worked against not only these light industries but
against exporting activities in general as well. (A detailed analysis of this
situation will be made below.)
In addition, Korea still lacked the basic conditions required for success-
ful operation of HCI businesses even by the end of the 1970s. These con-
ditions include having enough scientists and skilled manpower, as well
as experience in marketing HCI products. Moreover, the leaders of HCI
businesses failed to realize the importance of upgrading their technology
and productivity, a vital requirement, in the long run, for the successful

Table 17.14. Economic circumstances surrounding the 1980 economic crisis

Economic indicators 1978 1979 1980 1981
Economic growth rate (%) 9.8 pe -3.7 529
Price increase rate (%)
WPI 11.8 18.6 39.0 20.4
CPI 14.5 18.2 28.7 21.4
Current account deficit (106 US $) 10.9 41.5 53.2 46.5
Foreign debt (10° US $) 148.7 205.0 273.7 324.9
Oil price ($/barrel) 13.1 18.0 30.9 34.5
International interest rate
(Asian dollar rate) 120 14.8 18.1 13.9

Source: EPB, ROK, Major Statistics (1990).

454 Suk-Chae Lee

operation of the HCI businesses. This problem could arise because the
benefits accorded to the participants of the HCI program under the new
incentive regime were large enough to guarantee profitability even without
state-of-the-art technology and productivity.
The unpreparedness of Korea’s major business groups to run the HCI
businesses and the financial crisis that they faced worked together to con-
vince the new government's top decision makers, who took power in 1980,
that most of the newly built HCI projects were de facto white elephants.
Their pessimistic view of the future prospects of HCI was hardened by the
realization that, due to high real oil prices, most of Korea’s basic petrochem-
ical businesses could not compete with their counterparts in natural-gas-
producing countries.
These developments led the new government to launch a wide range
of economic reforms to salvage the future of the Korean economy. Its first
step toward reform was focused on relieving Korea’s major business groups
of their financial difficulties, most of which were caused by their participa-
tion in the HCI programs. Thus, major heavy electrical equipment producers
(Hyosung, Kolon, and Ssangyong) were merged in 1980 and were granted
monopoly status. Automobile producers were required to specialize: Hyun-
dai and Daewoo in passenger cars, Kia in trucks, and Dong-A in specialty
vehicles. Hyundai Heavy Machinery Company was nationalized, but it was
ultimately broken into smaller firms that were handed over to the manage-
ment of Samsung, Lucky-Goldstar, and the Korea Electric Power Company
(KEPCO). In addition, the fertilizer industry was merged and its capacity
reduced (World Bank 1986:50; H. S. Chung 1985).
At the same time, price stabilization, rather than growth, was accorded
top priority, and industrial policy shifted its focus away from industry-
specific policies toward a functional approach. Under this new industrial
policy, the incentive regime was reorganized to give R & D activities and
the training of engineers and skilled workers tax incentives and financial
support irrespective of industry. Also, the wide dispersal of effective pro-
tection rates among industries was narrowed. As a result, exporting activi-
ties and export sectors—both light and HCI sectors—came to enjoy at least
neutral treatment compared to the import-substituting activities of HCI.
The government also shifted its role away from making investment deci-
sions toward coordinating industrial policy and promoting small and
medium-size firms while encouraging science and technology development
efforts.
Along with adjusting its own role, the government lifted various market-
entry barriers in order to promote competition. It believed that only through
competition would Korean enterprises regain their competitiveness in the
world market, and that this, in turn, was the only way to put the economy
back on a rapid growth track. It was this spirit that promoted the rapid
liberalization of the trade regime and enactment of a new fair trade law
 The Heavy and Chemical Industries Promotion Plan 455

(EPB, ROK, Fifth Plan, 1981).

Despite these painful structural adjustment efforts, general performance
of the HCI sectors remained sluggish until 1984. According to a Bank of
Korea survey (BOK, Comparative Advantage of Korean Industries, 1985), for
example, the competitive position of HCI, measured in terms of revealed
comparative advantage (RCA) indices, still remained very weak, as shown
by RCA indices of below 100 for all HCI sectors except shipbuilding, iron
and steel products, and cement for 1982. Even in the case of the electronics
industry, the RCA barely exceeded 100 (Table 17.15).
Dramatic changes have occurred, however, since 1986. The changes were
foreseen even before then, with the electronics and petrochemical indus-
tries taking off in 1983. The petrochemical industries, whose outlook was
particularly gloomy because of high real oil prices,1* experienced a sudden
swing of fortune as real oil prices began to drop, contrary to the expecta-
tions of many economists. The turning point for HCI sectors as a whole,
however, arrived in early 1986, with the “three lows’—low oil prices, low

Table 17.15. Trends in RCA indices by commodity

Commodity 1970 1975 1980 1982
Chemical products 8.3 123 18.1 TS
Rubber products 56.6 18177; 27 oul 142.7
Shipbuilding 18.0 99.6 278.7 666.6
Fertilizer 155.3 0.1 265.6 154.5
Cement 130.8 261.4 234.3 239.0
Pottery and china 11.4 73.6 209.9 184.9
Watches 3.5 164.2 157.2 109.4
Iron and steel 25.4 61.7 154.4 174.4
Electronic equipment 74.6 107.8 134.8 108.7
Glass products 16.1 32.3 29.8 38.8
Railroad vehicles 0.0 wy 8} 87.4 94.3
Automobiles 1.9 18.5 ify 16.0
Machinery 6.8 9.1 12.8 Ailtt
Nonferrous metals 14.2 2.6 12.9 16.1
Precision instruments, etc. 22. 24.5 30.0 21.5
Average 3725. 78.0 128: 133.9

Source: BOK, Comparative Advantage of Korean Industries (1985).

RCA—Revealed comparative advantage.

16. Even in 1986, the World Bank’s outlook for Korea’s petrochemical industry was very dark
(see World Bank 1986:46).
456 Suk-Chae Lee

world interest rates, and low value of the U.S. dollar (which in turn reflected
a substantial depreciation of the Korean won versus the Japanese yen and
the deutsche mark). Since then, the vast, empty sites of Changwon and
Yeochon industrial parks, which had come to symbolize the wastefulness
and recklessness of the HCI Plan, have been fully occupied by new busi-
ness projects.
The phenomenal increase in HCI activities and investments, as witnessed
by the change in the industrial parks, was helped tremendously by the suc-
cess of car exports to America. It not only induced a continuation of new
investments into the steel and auto parts and components industries but
also improved the overall image of Korean manufactured products. It was
at this time that Korea's leading business groups began to secure a beach-
head into high-tech electronics sectors such as videotape recorders,
microchips, and computers. As the following table indicates, the double-
digit economic growth since 1986 was clearly led by the exports of and in-
vestments into the HCI products (Table 17.16). Furthermore, the success
of HCI sectors contributed greatly to the achievement of the long-cherished
goal of attaining a balance-of-payments surplus by leading the rise in ex-
ports, on the one hand, and by replacing domestic supply for hitherto

Table 17.16. Trends in major indicators in the manufacturing sector

(% increase)

Average
Indicators 1980 1982 1984 1986 1988 1986-88
Manufacturing growth rate —0.7 6.7 17.3 18.4 13.0 16.5
HCI —2.9 8.9 20.4 20.9 17.0 20.2
Others 1.4 4.4 13.6 15.0 7.1 11.4
Total employment in
manufacturing —4.6 6.1 2.0 IZ ef 10.0
Full-time employment —3.6 3.5 3.4 3.6 0.7 3.4
HCI -4.5 6.0 6.4 oe) 3.1 bY
Others — 2h a1 0.2 10 =2.3 0.7
Manufacturing exports
(current) 17.6 3.7 20.2 jh 30.1 27.0
HCI 25.2 14.6 24.1 She 36.8 2557.
Others 11.7. -6.1 18.1 29:3 yale) 38.9
Manufacturing
fixed investment = 20, 3.7 37.1 25.1 14.0 2353
HCI —20.1 22 49.6 43.9 12.1 27.6
Others — 43.0 6.4 17 9OR ASS 18.9 20.3
Sources: BOK, National Income (1985-89); Ministry of Labor, ROK, Monthly Labor Statistics
alt 2s Fixed investment by sector was calculated by the Research Department, Bank of
orea.
 The Heavy and Chemical Industries Promotion Plan 457

imported industrial intermediate inputs, on the other.

Further success of the HCI Plan can be seen in the performance of the
petrochemical and steel industries. The petrochemical industry, which be-
came a new star of the Korean economy, continued to support the produc-
tion and expansion of Korean exports by providing a stable supply of
petrochemical products even in the midst of worldwide shortage. The steel
industry also played a key role in sustaining the competitiveness of Korea’s
manufactured exports by serving domestic industrial activities even when
the world’s demand for steel outstripped its supply. In addition, the suc-
cess of HCI generated a lion’s share of productive job opportunities, there-
by ending Korea's labor surplus (Table 17.16).
Currently the Korean economy’s future depends on the performance of
HCI sectors, since Korea has transformed its industrial structure away from
one led by labor-intensive light industries to one led by skill-intensive HCI
sectors. This new status of HCI sectors, therefore, suggests a positive, though
cautious, evaluation of the HCI Plan. In the following sections, I will look
at the plan’s theoretical appropriateness and its impact on Korea's long-term
economic development.

THEORETICAL APPROPRIATENESS

Theoretical Issues of the HCI Plan

We should understand both the objectives of the HCI Plan and the logic
behind it in order to test its theoretical validity. Unlike most Latin Ameri-
can nations, which have promoted industrialization by import-substitution
while ignoring the benefits of the international division of labor, Korea with
its HCI Plan aimed to gain the long-term benefits of international trade from
the very beginning. Thus, industries such as electronics, automobile, ship-
building, and machinery constituted the core of the plan. It was believed
that Korea would have dynamic comparative advantage in these rapidly
expanding, technology-intensive industries.
Projects targeted by the government under the HCI Plan also included
producer-goods sectors such as chemicals, nonferrous metals, and steel,
which the government believed should be promoted for reasons other than
merely to gain dynamic comparative advantage. In addition to developing
these industries as a prerequisite to the promotion of defense industries,
it was conceived as a way to ease the balance-of-payments deficit by sub-
stituting domestically produced goods for imports; they would also serve
as cushions in case of worldwide shortage. The HCI planners thought that
even these industries could gain a competitive edge, if they were built in
the optimum scale with state-of-the-art facilities. However, the basic rationale
behind the plan for these producer-goods industries stems not from effi-
ciency but from noneconomic considerations.
458 Suk-Chae Lee

If investment decisions had been left solely to private initiatives or mar-

ket forces, neither investments into nor an international competitive edge
in these industries would have been possible. This was the reason for de-
veloping the HCI Plan and the incentive system for implementation of the
plan.
Considering the objectives of and the logic behind the HCI Plan, we can
narrow the focus of the plan’s theoretical validity to two issues. The first
issue is related to sectoral resource allocation, which has favored HCI sec-
tors in order to attain a desirable industrial structure even at the expense
of light industries. The second relates to how to secure desired resource
allocation. Specifically, the issue is whether the government should syste-
matically select investment projects and intervene in the market to realize
the planned resource allocation, or whether it should let private initiatives
and market forces determine investment allocation.
Theories Supporting the HCI Plan
and Its Implementation Method
The Soviet economist Fel’dman, whose works were introduced to the West
by Domar, shows in his two-sector model that, in the case of a developing
country like the Soviet Union, allocation of greater resources into the capital-
goods sector would not only accelerate the economic growth rate but also
ensure a greater consumption level in the long run (Domar 1957:223-61).
The Indian economist Mahalonobis (1953/54) reached the same conclusion
(Bhagwati and Chakravaty 1969). The development strategy advocated by
Fel’'dman and Mahalonobis was adopted in Joseph Stalin’s development
plans for the Soviet Union and in India’s First Five-Year Economic Develop-
ment Plan.
Galenson and Leibenstein, the postwar development economists, insisted
that developing countries should invest in capital-intensive industries to
maximize future income stream. Their theory rests on the assumption that
capital-intensive industries have relatively high profit margins, which would
effect a rise in the savings rate and thus lead to an increased growth rate
(Galenson and Leibenstein 1955). If we assume that HCI sectors are capital-
intensive, then we can interpret their argument to be in support of the HCI
Plan.
Many studies that use historical analysis also support this strategic em-
phasis on capital-goods industries. From the development experiences of
advanced countries, Hoffman (1958) showed that as an economy develops,
the weight of the capital-goods sector, and therefore the share of HCI, in-
creases. Also, Gerschenkron (1962) pointed out that the “late-industrialized
countries” of Europe concentrated on the promotion of capital-goods in-
dustry rather than on the consumption-goods industry. Nakamura, a
Japanese economist, also indicated that Japan’s postwar economic success
was helped largely by the nation’s HCI sectors, which were built at the
 The Heavy and Chemical Industries Promotion Plan 459

government's initiative since the late 1930s in preparation for the Second
World War (Nakamura and Grace 1985:56-57).
A different theoretical approach was taken by development economists
such as Rosenstein-Rodan, Hirschman, and Chenery, who advocated that
the developing countries should allocate their resources to sectors with tech-
nological or dynamic external economies. Chenery (1961), in particular, sug-
gested that the neoclassical resource allocation theory should be modified
to emphasize dynamic comparative advantage. These theories support the
HCI Plan's strategy of promoting the electronics, machinery, automobile,
and shipbuilding industries, since the reasons for promoting these indus-
tries rest on the principles of dynamic comparative advantage and exter-
nality.
The second point, that industrialization of a developing country should
be led by government instead of market forces, has also been supported
by the postwar economists’ analysis of the experiences of “late-indus-
trialized” countries. A detailed explanation of the experiences of the
“latecomers” will not be made in this chapter, as they have been well
documented in Gerschenkron (1962).
Similar prescriptions were offered by the development economists who
were active after World War II. It is well known that they cited industriali-
zation as the surest way to economic development for underdeveloped coun-
tries. They also believed that industrialization efforts in the developing
countries were hampered by constraints such as shortage of entrepreneurs
and savings, distortions arising from the existence of externalities on a wide
range of market prices, and segmentation of domestic markets. Thus, they
argued that without deliberate, intensive, and guided governmental effort,
developing countries would not achieve industrialization (Sen 1983;
Rosenstein-Rodan 1984).
These theories, in combination with a pessimistic attitude toward export
of industrial products, gave birth to the Latin American-style development
strategy, which denies resource allocation by market forces. Even Asian
countries under the influence of the above theory (with the exception of
Hong Kong and Singapore, both of which adopted a development strategy
of making the most of the benefits of the international division of labor)
considered a development plan supported by strong government leader-
ship to be essential to achieving industrialization.
Empirical Evidence and Counterarguments
I have examined a variety of historical evidence and development theories
supporting the logic behind Korea's HCI Plan. Yet the empirical evidence
of postwar development efforts shows clearly that these theories, in many
cases, failed to deliver on their promises. Failure was particularly pro-
nounced when a nation failed to exploit the benefits of the international
division of labor. The experiences of the Soviet Union and India are
460 Suk-Chae Lee

examples of such cases. Their development performances have shown that

emphasizing the capital-goods sector while ignoring the benefits of the
international division of labor impairs a nation’s long-term economic com-
petitiveness and fails to increase national output.
Such failures appear inevitable because the great obstacles to the develop-
ment of underdeveloped countries were the lack of savings and foreign
exchange. Nevertheless, these nations sacrificed profitable and foreign
exchange-earning light industries and therefore experienced an inadequate
supply of foreign exchange. In addition, their use of expensive but poor
quality machines and inferior intermediate goods produced by domestic
heavy industries undermined the international competitiveness of their light
industries.
Such apparent failures notwithstanding, the infant industry argument,
which considers dynamic comparative advantage and various externalities,
is still deemed reasonable by even the most conservative economists, though
there remains some disagreement on the method of promotion. The real
issue, therefore, does not lie in selecting the industries for promotion, but
in charting the role of government and the kind of incentive system that
needs to be established.
In this respect, Harberler (1964) represents one extreme, opposing any
kind of activist government role, whereas the World Bank takes a more prac-
tical view. In his counterargument to Chenery’s assertion that neoclassical
resource allocation theory should be modified, Harberler (1964) once in-
sisted that no kind of government planning could be superior to the func-
tioning of the market mechanism and that government could not supersede
the role of private entrepreneurs. Evaluating the postwar development ef-
forts of LDCs, the World Bank (1983:41) concluded that the best way to
achieve continued economic growth is to maintain a price system reflect-
ing relative scarcity (see also World Bank 1987). In other words, even if a
government takes an active role in developing its economy, it should not
distort or shrink the market function but encourage the market function
and pursue the benefits of the international division of labor.
Conclusion
In light of the above discussion, one should criticize the HCI Plan not for
its sectoral choice but for the validity of the government's role and the cost
Korea paid to achieve the plan’s target. Even in this regard, one must note
that there are abundant cases that make it inappropriate to criticize the HCI
Plan solely on the basis of theoretical norms of static neoclassical economics.
The trend until the 1970s, for instance, was to promote infant industries
and to accept an active role for government to that end. Both Germany and
Japan completed their industrialization successfully, with approaches that
differed from static neoclassical economics, and caught up to the United
States, Great Britain, and France (Gerschenkron 1962; Nakamura and Grace
 The Heavy and Chemical Industries Promotion Plan 461

1985; Morishima 1982). Such cases indicate that the development processes
in the real world are much more complex than might be judged by pure
economic theory.”
Nevertheless, harsh criticism of the HCI Plan continued in the early
1980s. The criticism centered on the misallocation of resources that resulted
from its “pick the winner” approach and its deliberate ignoring of market
forces. The incentive regime designed to support the plan’s implementa-
tion was another target of criticism, on the grounds that it distorted mar-
ket prices and induced economic behavior that damaged Korea's economic
growth potential. Since much of the criticism has centered on the cost of
the HCI Plan (J. H. Yu 1989), let us review its costs as well as its benefits
to the economy.

EFFECTS ON KOREA’S ECONOMIC DEVELOPMENT

There are two contrasting views of the impact of the HCI Plan on Korea's
economic development. A critical view, which emerged out of the economic
crisis of 1980, is now widely accepted because it has been supported by
rigorous economic analysis. This view has recently been challenged by
another view that came to the fore after the HCI’s successful performance
during the mid-1980s. This second view, however, lacks the support of sys-
tematic analysis based on empirical or theoretical evidence. In this section,
I will assess the validity of both views after briefly reviewing their argu-
ments. In the assessment, due attention will be given to fundamental differ-
ences between the theoretical and the real world.
The Critical Viewpoint
The critical view can be summarized as follows: First, contrary to the logic
underlying the HCI Plan, the plan’s execution led to misallocation of
resources, thereby weakening the Korean economy’s growth potential. Sec-
ond, the process of implementation of the HCI Plan distorted various mar-
ket prices. The distortion caused a sharp drop in the domestic savings rate
and a proliferation of undesirable business behaviors, and, above all, dis-
couraged export activities. Third, implementation of the overambitious plan
was responsible for the rapid inflation of the late 1970s and early 1980s.
Fourth, the plan led to excessive concentration of economic power and an
uneven distribution of wealth and income. Fifth, some of the HCI Plan's
pet projects have put great strains on Korea's resources while producing
poor results. For example, projects such as Okpo Shipyard and Hankook
Heavy Machinery Company are still unprofitable. Sixth, the recent success
of various HCI sectors stems in fact from the revival of private initiative

17. Even in the United States the opinion that reliance on market mechanisms and macroeco-
nomic policy alone will not reverse the declining industrial competitiveness and power of the
American economy is gaining adherents (see Dertouzos 1989:46-50). Aggressive industrial
strategies and an increased government role in the economy are advocated by Prestowitz (1988).
462 Suk-Chae Lee

and market function that resulted from the painful structural adjustment
efforts of the 1980s. I will elaborate further on these criticisms below.

Misallocation of resources. Given the factor endowments and the economic

constraints of the 1970s, the critics continue, Korea should have aliocated
its capital and foreign exchange to labor-intensive, foreign-exchange-earning
sectors and should have reduced its dependence on foreign energy. Under
the HCI Plan, however, most of Korea’s scarce capital and foreign exchange
was preempted by capital-intensive and high energy-consuming sectors such
as petrochemicals and copper smelting.
This misallocation of resources not only deprived Korea’s most competi-
tive sectors, light industries, of opportunities to expand and renovate their
production capacities but also raised Korea's incremental capital—-output ratio
(ICOR) far above that of most other developing countries as well as above
its historic pattern (Table 17.17). Moreover, Korea's energy dependence rose
sharply!® despite an uncertain world oil situation, thereby weakening the
nation’s ability to weather another worldwide oil crisis. Thus, the sudden
decline in its economic growth and its bulging balance-of-payments deficit
since the second half of 1979 were expected consequences of the implemen-
tation of the plan.

Table 17.17. International comparison of incremental

capital-output ratios (ICORs)
Country 1960-70 1970-80
Argentina 4.6 9.0
Brazil 3.5 ww
Greece 3.5 ae
Hong Kong 2.4 2.2
Korea 1.8 3.6
Philippines 3.9 4.3
Portugal 3.3 3.7
Singapore 2.3 4.0
Thailand ed. 3.5
Yugoslavia 5.5 5.4
Average 3.4 4.4
Source: World Bank (1986).

18. When measured by total energy consumption per $1,000 of gross domestic product, this
argument is not substantiated, as the figure declined slightly from 0.68 in 1973 to 0.64 in 1978.
There is, however, an obvious trend of increasing dependence on oil as the share of oil in
total energy consumption rose sharply from 54 percent in 1973 to 63 percent by 1979.
 The Heavy and Chemical Industries Promotion Plan 463

Distortion of the pricing system and its adverse effects on the economy. As
we have seen earlier, the execution of the HCI Plan necessitated the distor-
tion of various economic parameters including the interest rate, exchange
rate, and effective protection rates among industries. The negative interest
rate entailed an implicit subsidy to capital, encouraging the adoption of
capital-intensive technology and thus further raising Korea’s overall ICOR;
on the other hand, it also resulted in a lower domestic savings rate by
penalizing savings.° The declining domestic savings rate drove the econ-
omy to depend further on foreign debt, and the increased debt service bur-
den weakened Korea's growth potential. In addition, the intentional
channeling of subsidized loans into favored HCI sectors enabled Korean
businesses to remain profitable without their making the all-out effort to
improve productivity and technology that is vital to the development of HCI.
To meet the overambitious goals of the HCI Plan, the Korean govern-
ment had to rely on an excessive growth in the supply of money, and this
fueled inflationary pressures? As a major policy tool to curb this inflation-
ary pressure, the government held the nominal exchange rate constant. This,
in turn, resulted in appreciation of the real exchange rate throughout the
second half of the 1970s (Table 17.18), causing a wide range of export in-
dustries to experience a si nt erosion in competitiveness.
4 Se PP
NOT r Oe

x HCI produ is, Ca used a W1

n of effective protection rates EPRs) among industries by the late 1970s.
The economy’s target sectors were offered high EPRs, whereas tradition-
ally important exporters were offered very unfavorable, in some cases nega-
tive, rates (Table 17.19). By the late 1970s, this drift, in combination with
the appreciation of the real exchange rate, had substantially narrowed the
margin of incentives that favored exports?1
The overwhelming support that the HCI Plan offered to “key” indus-
tries, on the other hand, drove businesses to expend their energies on mak-
ing inroads into HCI programs rather than on producing efficiently or on
building export markets. For these reasons, the economic crisis that occurred
after the second oil shock was not at all surprising.

19. Beginning in 1976, the domestic savings rate began to rise sharply reaching a level of 29
percent of GNP by 1978. The rate then dropped to 22 percent in 1979 and stayed at that level
during 1979-81. The sharp drop may in large part be due to a decline in real income caused
by the deterioration of Korea’s terms of trade after the second oil shock. Korean planners,
however, tended to attribute the decline in the domestic savings rate to negative real interest
rates (EPB, ROK, Fifth Plan, 1981).
20. During 1974-79 M, grew by 30.9 percent and M, increased by 26.4 percent annually. The
annual average GNP deflator was 22.7 percent during the period. The actual causes of the
excessive growth of the money supply during this period are quite complicated, but the in-
flow of foreign earnings from overseas construction activities was considered a prime cause
of the high monetary growth rate since 1976.
21. For an analysis of the effects on trade-related activities of the policies to promote the HCI
Plan, see World Bank (1986:42-44).
Table 17.18. Exchange rates during the 1970s (won per US $)
ke ee a ee

Year Nominal rate Real effective rate

1971 37/353 84.69

1972 398.9 92.29
1973 397.5 104.45
1974 484.0 89.56
1975 484.0 90.24
1976 484.0 83.88
1977 484.0 83.56
1978 484.0 85.60
1979 484.0 78.99
1980 659.9 81.29
1981 700.5 79.02

Source: Jwa (1988).

Note: Calculated using the real effective exchange rate during the period from 3 April 1985
through 2 April 1986 as a base (100).

Table 17.19. Effective protection rates by sector (% of value added)

Sectolans vayrsrive a0) Albt Baad Wo6SRolsS: Medes, onco198lE
Agriculture 18.5 Nea 74.3
Mining 4.0 —1.5 —1.7,
Manufacturing -1.4 3.7, 28.2
Food =18:2 —44.0 —48.4
Beverages, tobacco —19.3 33.4 15.0
Construction materials —11.5 11.8 51.1
Intermediate I =20.0 37.6 61.9
Intermediate II 26.1 20.6 39.6
Nondurable consumer goods —10.5 67.4 42.4
Durable consumer goods 64.4 242.9 52.5
Machinery 44,2 44,2 31.3
Transport equipment 163.5 326.6 123°9
Source: World Bank (1986). For original data see KDI (1982:187-210).
Note:
Intermediate I—Industrial inputs requiring raw processing, such as yarn, naphtha, fuel, etc.
Intermediate II—More processed industrial inputs such as textiles, paper, petrochemcial
products, and steel products.
 The Heavy and Chemical Industries Promotion Plan 465

Inflation and the HCI Plan. Simultaneous construction of a multitude of

HCI projects necessitated a rapid expansion of the money supply, as ex-
plained earlier. At the same time, the projects triggered a rapid rise in wages
during the late 1970s”* because they required a large number of engineers
and skilled workers despite the short supply of qualified personnel in Korea.
The inflationary pressure, which continued to rise as the HCI Plan was be-
ing executed, was contained by direct government price controls and by
appreciation of the real exchange rate. In 1980, however, containment meas-
ures failed, and the inflation rate exploded out of control.
The high inflation rate discouraged domestic savings as well as business
activities designed to improve both technology and productivity. It was also
responsible for the weakening of Korea’s export competitiveness. These fac-
tors worked against Korea's economic development.
The HCI Plan and concentration of economic power. The large scale of HCI
projects as well as the huge risks involved prompted the participation of
Korea's big business groups in the HCI Plan. They were subsidized with
government-directed policy loans and provided with many newly built in-
dustrial sites. Thus big businesses were able to accumulate wealth rapidly
and take over many smaller firms. During this period a few of Korea's big
business groups grew extremely fast, mostly at the expense of small and
medium-size firms?
Both the financial subsidies to big business and the high effective pro-
tection rate favoring them widened wage disparities between big and smaller
firms. At the same time, employment opportunities in the big firms were
relatively shrinking. Therefore, income distribution deteriorated during the
second half of the 1970s24
Poor performance of some HCI programs. Despite structural adjustment ef-
forts and financial support provided to the HCI projects, the Okpo Ship-
yard and Hankook Heavy Machinery continued to rely heavily on the
government's debt relief programs; they still show no sign of becoming

22. For three consecutive years beginning in 1976, real wages grew on average by 18.5 percent
per annum while labor productivity rose by only 10 percent. The growth rate of the real wage
was far higher than the historical trend of about 6 to 8 percent.
23. SaKong (1980) showed that the share of value added by conglomerates in gross domestic
product more than doubled during the 1970s. The share of the top ten conglomerates was
5 percent in 1973 but rose to 10.9 percent in 1978. K. Lee (1990:28) computed the conglomer-
ates’ share in manufacturing sales, and showed that the degree of concentration was acceler-
ating even after 1978, when the share of the top ten conglomerates was 22 percent, and reached
its peak in 1982, when the share of the top ten conglomerates in manufacturing was 30.2 percent.
24. Estimates of Korea’s size distribution of income show that income distribution deterior-
ated sharply during the first half of the 1970s, but remained virtually unchanged in the sec-
ond half of the decade. In the second half of the 1970s, however, the people became more
acutely aware of the inequality in income distribution. This might be explained by the
466 Suk-Chae Lee

viable businesses25 These projects were directly conceived by the govern-

ment and received the bulk of the economic resources. According to crit-
ics, these unsuccessful projects demonstrate once again how costly the HCI
Plan was.
Challenges to the current success of the HCI projects. It is true that today
most of the HCI sectors are performing well, and that they acted as the
engine of Korea’s rapid economic growth during the 1980s. A careful ex-
amination, however, would refute any claim that the success can be solely
attributed to the HCI drive.
The electronics and automobile industries, which have been most suc-
cessful, are not products of the HCI Plan. Instead, they have been left to
the play of private initiatives and given little financial help from the govern-
ment. This is verified by the electronics industry’s relatively stagnant per-
formance during the second half of the 1970s. Furthermore, some of the
most successful projects were conceived and started in the 1980s, for in-
stance, microchips, computer-related firms, and Hyundai’s new Pony Ex-
cel automobile project.
Therefore, paradoxically, the current successes of HCI projects strengthen
the claim that the “pick the winner” policy of the government, which was
the core of the HCI Plan, does not work in a complex economy like that
of Korea.
The Positive Viewpoint
Even while acknowledging the adverse effects of the HCI Plan on Korea's
economic development, those with a positive view toward the HCI Plan

deterioration of wealth distribution caused by the sharp increases in real estate prices and
the increased concentration of economic power that occurred during this period. The follow-
ing table shows the income shares (in percent) of the 20 percent of the population with the
highest incomes compared with the share of the 40 percent of the population with the lowest
incomes.
Percentage share of total income
Income group 1970 1976 1980
Top 20 percent 41.6 45.3 45.4
Bottom 40 percent 19.6 16.9 16.1

Note: The figures for 1976 and 1980 are not really comparable since
the former was estimated by Choo (1979) and the latter by the Bureau
of Statistics of the EPB (EPB, ROK, Social Indicators, 1982).
25. The Korean government had to take a debt-relief measure for the Okpo Shipyard Com-
pany in 1989. The relief measure consisted of exemption from the interest rate burden and
extension of the amortization period for the firm’s debt to Korea Development Bank. Decid-
ing how to salvage the sinking Hankook Heavy Machinery Company, on the other hand, in-
volved a long debate. After futile efforts to privatize Hankook, it was decided to maintain
it as a public enterprise with an additional capital subscription of 100 billion won by KEPCO
and the Korea Development Bank. The firm was also made the exclusive supplier of electricity-
related facilities and plants.
 The Heavy and Chemical Industries Promotion Plan 467

assert that attention must be paid to the following points2é

First, considering its changing pattern of comparative advantage, Korea
had no alternative but to build up HCI sectors, and the policy goals set
by the HCI Plan could not be challenged.
Second, the huge cost involved in implementing the HCI Plan has been
more than paid off by the recent successes of the HCI projects and by ex-
ternal economies generated by the plan. The external economies include
the pecuniary external economy, or linkage effects, as witnessed by the
booming investment activities related to the HCI projects such as parts and
components for both the automobile and the machinery industries. In ad-
dition, a wide range of Korea’s industries benefited from having a stable
domestic supply of petrochemical products and iron and steel products dur-
ing the world shortage of these items during the mid-1980s’ economic boom.
Moreover, the HCI Plan helped that industrial boom by producing large
numbers of scientists, engineers, and skilled workers through its manpower
and technology programs. Since such programs take time to bear fruit, the
early start of the HCI Plan was able to do away with the shortage in hu-
man resources and technology at the right time by expanding the supply
of engineers and skilled workers (Table 17.20).
Third, given the nature of HCI sectors and the difficulties involved in
building them, a nation can hardly expect to build a sophisticated indus-
trial structure simply by responding to price signals. Price signals usually
do not carry information about the future, especially in developing econo-
mies. Even if they do, reacting to price signals alone is not a promising

Table 17.20. Supply of engineers and skilled technical workers (100 persons)
Category of worker 1973 1975 1979 1980 1982
Graduates of technical high schools 273 332 553 591 640
Graduates of engineering junior
colleges 1.6 0.3 0:4" 319 328
Graduates of university
departments of engineering 65 72 113 136 206
Trainee graduates of public
training centers 12 30 127 150 157
Sources: Ministry of Education, ROK, Education Statistics Yearbook (1975-85); Ministry of Labor,
ROK, Labor Statistics Yearbook (1975-85).
a. The junior college system was not firmly established until 1979; therefore, the number
of graduates before and after 1979 are not really comparable.

26. A written, well-documented argument in defense of the HCI Plan does not seem to exist.
Therefore, most of the arguments introduced here represent widely scattered individual opin-
ions including those of Korea’s businessmen and people from the Ministry of Trade and In-
dustry.
468 Suk-Chae Lee

approach to building up the HCI sectors, which usually require a long gesta-
tion period and specialized business experience—both of which can be se-
cured only through first-hand experience—as well as skilled manpower.
Because of the volatility of the current world economic climate and
because the major competitors in HCI sectors are advanced countries, de-
veloping countries can capture the world HCI markets only through prein-
vestment and the trial-and-error method. In other words, to be successful
in building up an industrial base for HCI, one must be ready to penetrate
established markets. Such penetration is possible only when a crack oc-
curs in the established markets, and to be able to take advantage of such
a situation requires years of careful preparation.
In the Korean experience, market cracks usually occurred unexpectedly,
as in the cases of microchips, automobiles, and petrochemicals. The mar-
kets for these products became available to Korean suppliers given conflicts
and failures in the advanced countries’ policies or sudden changes in the
world economic environment. Markets for the automobile industry, for in-
stance, opened up when Japan shifted its marketing strategy away from
cheap, small cars toward bigger, more expensive cars in the wake of the
stronger yen and because of trade friction with the United States. Markets
for petrochemical products opened up when real oil prices dropped sharply
and natural-gas-using petrochemical products lost their competitiveness
while the advanced countries failed to expand their facilities.
Examples are endless, and the message is clear. Developing countries
must be prepared to seize opportunities if they want to secure a beach-
head in the world HCI, and simply responding to price signals does not
lead to such preparedness. In addition, past experiences of late-industri-
alized countries such as Germany, Japan, and Italy point to the importance
of being prepared.
Fourth, the positive view contends that some of the criticisms directed
at the HCI Plan have been misleading or misdirected, though not totally
mistaken. For example, the high capital-output ratio suggested as a cost
of the HCI Plan would be lower if the ratio is calculated after HCI projects
are fully operational. As for the appreciation of the real exchange rate and
the high inflation rate of 1979-81, overseas construction activities and govern-
ment policy mistakes of the period, rather than the HCI Plan, should take
more of the blame. Earnings from overseas construction activities, for in-
stance, disguised the balance-of-payments situation and led to both the over-
valuation of the won and rapid expansion of the domestic money supply2”

27. In 1977 Korea recorded, for the first time, a current account surplus of US $25 million,
mainly due to earnings from overseas construction activities. Because of this surplus, mone-
tary policy faced severe disarray; to fix this, appreciation of the Korean won was seriously
discussed among policymakers. This phenomena could be construed as a typical Dutch disease.
 The Heavy and Chemical Industries Promotion Plan 469

In sum, the positive view holds that the critics have overemphasized the
costs of the HCI Plan while ignoring its dynamic benefits to Korea's eco-
nomic development.

Assessment of the Two Viewpoints

Despite all of these positive aspects of the HCI Plan, one cannot deny that
it was very costly and that many of its objectives might have been achieved
with less cost (World Bank 1986:46-48). Yet questions linger.
Could Korea have successfully developed its electronics, automobile, iron
and steel, and petrochemical industries if investment decisions had been
left to market forces alone or if there had been no active government
support for those industries, as was indicated in World Bank (1986:45-48)?
Why did the “late-industrialized” countries take different routes in the
“catching-up” process from those of the front-runners and achieve great
success? Given that economic development in the real world requires a
quantum leap to be successful, that the development process is character-
ized by indivisibility or discontinuity or a process of making the best use
of external economies, that market information is imperfect or short-sighted
(or even when it is not, and that the opportunities to capture the world
market are volatile or short-lived), it seems extremely naive and irrespon-
sible for policymakers of developing countries to denounce totally the HCI
Plan.
In the real world, no country and no economic system is free of errors.
But there are two kinds of errors. The first occurs as a result of doing noth-
ing, and the second, as a result of doing something. If successful economic
development results from aggressively seizing opportunities and taking bold
risks, particularly for the presently developing countries, then doing some-
thing is certainly better than doing nothing. Being active, for instance, en-
abled Korea’s automobile and electronics industries to seize the opportunity
to enter the world market.
This, however, does not imply that doing something is always good. As
will be indicated in the concluding section, for such an activism to be suc-
cessful, economic conditions must also work in its favor. Beyond that, when
economic conditions dictate it, a government should be able to dismantle
or reform the incentive regime that has supported such an activism. In the
Korean case, the incentive regime built for the HCI Plan was dismantled
only because a new government, free of past commitments, came to power.
Otherwise, such a reform would have been impossible, since any incen-
tive regime carries its own political momentum, thus making existing re-
gimes very hard to change, let alone reform. In this regard, Korea’s good
fortune in having a change of leadership transformed a potential disaster
into a brilliant success.
470 Suk-Chae Lee

LESSONS AND CONCLUSION

In drawing lessons from Korea’s experience with the HCI Plan, we need
to take a careful look at the case of India in the 1950s, which provided a
marked contrast to Korea's success in the 1980s with construction of HCI
while building up rapid growth momentum.
India sought rapid economic growth by directing its resources into its
HCI sectors in the early 1950s, but the results were unsuccessful28 Korea,
by contrast, overcame the initial costs and strains caused by the HCI Plan
and is now back on a rapid growth track, mainly led by the booming HCI
sectors. What differences account for such contrasting consequences?
First, Korea, unlike India, launched its HCI drive with the goal of par-
ticipating in the international division of labor. Thus, the top architects of
the HCI Plan always strived to achieve competitiveness in HCI.
Second, Korea had a solid light industrial base, which continued to earn
valuable foreign exchange and to provide employment opportunities in the
economy despite the HCI Plan’s unfavorable effect on competitiveness.
Third, while the HCI Plan was being vigorously executed, Korea had
a well-educated and motivated industrial labor force?? And the abundance
of engineers and skilled workers that resulted from the HCI Plan’s man-
power training measures greatly helped to resurrect the Korean economy
in the 1980s.
Fourth, Korea's entrepreneurs were vigorous and experienced in com-
peting in the world market. Thus, when they were freed of regulations and
forced to seek survival on their own, they took innovative, bold measures
to vitalize the HCI projects3°
Fifth, the Korean government was pragmatic and bold enough to reform
the entire incentive and economic management regime when circumstances
dictated it. The reforms of the early 1980s, for example, contained inflation
and encouraged exports while raising domestic savings beyond the amount
required for domestic investment. The rising savings rate and the develop-
ment of financial markets gave further impetus to the success of HCI
projects.
Sixth, the Korean economy benefited tremendously from a favorable
world economic environment characterized by low interest rates, low oil

28, India’s development experience since its independence was described as one of few suc-
cess stories by Higgins (1968:653-77). India, however, has the lowest recorded per capita GNP
growth rate, and it still remains one of the poorest nations in the world.
29. Gerschenkron (1962) noted that one of the major bottlenecks of developing countries’ eco-
nomic development is lack of a qualified labor force in industrial work; he argued that LDCs
are not labor-abundant economies but labor-scarce ones.
30. Hyundai Motor Company and Samsung IC Company are typical examples of successes
due to bold entrepreneurship. Until 1982, Hyundai was still considered unsuccessful, but it
survived successfully after it collaborated with a Japanese firm. Samsung IC grew into a world-
wide firm after the deregulation of business activities by the government.
 The Heavy and Chemical Industries Promotion Plan 471

prices, and above all, a realignment of exchange rates in Korea's favor.

These differences show how risky and difficult it is for developing coun-
tries to take such bold measures as those required by the HCI Plan. If a
developing country lacks the right combination of elements to make its HCI
drive work, then the country is well advised to look for another develop-
ment strategy. Considering the difficulties, therefore, the most recom-
mended development strategy for a government to pursue in order to
successfully develop its economy may not be a drastic one like the HCI Plan,
but rather a more stable one as suggested by the World Bank (1983:41):
To bring performance into line with potential, governments must play
a central role in ensuring, first, a stable macroeconomic environment,
by adopting sustainable monetary, fiscal, and foreign exchange policies;
second, a system of incentives that encourages resources to be allocated
efficiently and used optimally; and third, a pattern of growth in which
benefits are widely shared.

ACKNOWLEDGMENTS

I am grateful to Dr. Keum Chung-Yeon (Ministry of Finance), Mr. Chang

Seok-Jun (Economic Planning Board), and Mr. Chung Joon-Seok (Ministry
of Trade and Industry) for their assistance and comments. Most of the basic
facts, figures, and government documents related to the HCI Plan were
provided by them. I am also grateful to Mr. Chung Hong-Shik (Office of
the President) for his comments and assistance in supplying valuable docu-
ments on HCI. Mr. Chung was in charge of HCI projects for over ten years
at Chong-Wa-Dae. I must express my thanks to Ms. Sarah Serafim, Ms.
Anne Stewart, and other reviewers for their valuable comments and good
editing.
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 18 Policy Measures to Reduce
Industrial Concentration and
Concentration of Economic Power
by Kyung Tae Lee

The Korean economy experienced remarkably rapid growth throughout the

1960s and 1970s, with the exception of a few sluggish periods resulting from
internal and external disturbances. The average annual growth rate of real
GNP was 8.5 percent in the 1960s and 8.1 percent in the 1970s. The quan-
titative expansion of the aggregate economy was accompanied by drastic
qualitative changes in industrial structure, market organization, and open-
ness of the economy. Among these changes, the increasing concentration
of market power on macro, industrial, and commodity levels is of special
interest.
In 1972 the Korean legislature passed a law aimed at encouraging family-
owned big enterprises to go public by selling some minimum portion of
their equities in the open stock market. In 197 the late President Park is-
sued a special presidential decree, generally called the “May 29th meas-
ure,’ to improve the financial structure of the big business groups by forcing
them to go public and to regulate more stringently the volume of credit
available to them. These two measures and the “September 27th measure”
in 1980 represent government policies to curb excessive concentration of
economic power in the hands of the small group of conglomerates.
Policies to regulate monopoly-oligopoly and unfair trade in individual
industries or commodity markets were implemented in accordance with
the Price Stability and Fair Trade Law and the Antitrust and Fair Trade Law,
which were put into effect in 1976 and 1981, respectively. These antitrust
measures were taken for securing the rules of the game in the capitalist
economy in order to accommodate an official policy change toward freer
competition instead of government-controlled operation of the economy.

ECONOMIC BACKGROUND
OF THE POLICY MEASURES!
Industrial Concentration in the Manufacturing Sector
The high growth rate of the aggregate economy in the 1970s was led primar-
ily by the manufacturing sector. During the period 1970-77, manufacturing

1. Much of this section is directly quoted from or draws upon Lee and Suh (1981).
473
474 Kyung Tae Lee

grew at an annual average rate of 18.1 percent, compared with 9.8 percent
for the economy as a whole, 4.1 percent for the primary sector, and 9.0 per-
cent for social overhead capital and other services. As a consequence, the
share of the manufacturing sector in GNP increased from 17.9 percent to
29.2 percent during the same period, while that of the primary sector
decreased from 30.2 percent to 20.8 percent (Lee and Suh 1981). The num-
ber of employees in the manufacturing sector rose 2.2 times. Real value
added in the same sector rose 4.0 times, while the number of firms increased
by only 11.1 percent (SaKong 1980). This indicates that the expansion of
the manufacturing sector was achieved mainly by the enlargement of ex-
isting firms rather than the establishment of new ones.
An overall concentration ratio is used to measure the degree of concen-
tration in the entire manufacturing sector, without further disaggregation
into subsectors. Table 18.1 shows the percentages of employment, gross out-
put, and value added in the manufacturing sector accounted for by the top
50 firms and top 100 firms in 1970 and 1977. The top 100 firms accounted
for 44.6 percent of total manufacturing shipments in 1970 and 38.9 percent
in 1977. These firms’ share also declined similarly in terms of value added.
Although the large firms’ share declined somewhat during the period,
it is apparent that production was highly concentrated in an extremely small
group of firms, since the 100 firms represented only 0.41 and 0.37 percent
of the total numbers of firms in 1970 and 1977, respectively.
Furthermore, since more than half of the 100 firms belonged to the 30
largest conglomerates, real concentration of economic power was even more
serious (Table 18.2).
The industrial concentration ratio measures the market organization of
the individual industry. The ratios in Table 18.3 are based on the percent-
age shares of shipments of the three largest firms in 213 individual indus-
tries. A comparison of 1970 and 1977 data reveals a general decline in
industrial concentration—the number of industries in which the concen-
tration ratio of the top three firms exceeded 60 percent decreased from 105
to 94, and the share of shipments of these industries also decreased from
52.8 to 41.1 percent. Despite this trend, the fact that highly concentrated
industries shipped more than 40 percent of the total indicates a significant
degree of concentration.

Table 18.1. Overall concentration ratios for manufacturing: 1970 and 1977 (%)
Top 50 firms Top 100 firms
Employ- — Ship- Value Employ- — Ship- Value
Year ment ments added ment ments added
1970 10.8 33.8 38.6 18.2 44.6 48.1
no77, Te 29.4 28.2 16.2 38.9 36.8
-_e———

Source: Lee and Suh (1981).

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Table 18.3. Number of manufacturing industries and share of shipments

by class of industrial concentration ratio: 1970 and 1977

Class of the concentration ; ; :

Share és
in total
ratio of top three Number of industries shipments (%)
firms (%) 1970 1977 1970 1977

80 to 100 58 49 24.3 27.5

60 to <80 47 45 28.5 13.6
40 to <60 56 64 22.4 31.0
20 to <40 39 41 16.0 18.6
0 to <20 13 14 8.8 9.3

Source: Lee and Suh (1981).

The average concentration ratios for the manufacturing sector given in

Table 18.4 are either the weighted or the simple averages of the concentra-
tion ratios of 213 individual industries measured in terms of shipments.
The table shows both weighted and simple average concentration ratios for
the three largest firms in the manufacturing sector in 1970 and 1977. The
sector is divided into two broad groups—producer goods and consumer
goods—and the latter group is further broken down by durable and non-
durable consumer-goods industries. Several interesting points can be ob-
served. First, the average concentration ratio of strongly monopolized
industries declined while that of weakly monopolized ones increased. Sec-
ond, the concentration ratio of the producer-goods industries declined,
while that of consumer-goods industries, particularly nondurables, showed
an increase. This was possibly because the government's big push to de-
velop heavy and chemical industries during the period induced more en-
tries of new firms into the producer-goods industries, whereas the
nondurable consumer-goods industries were already mature. Thus the ex-
ercise of stronger monopoly power by big firms in the consumer-goods in-
dustries through product differentiation or advertising could be practiced
more easily. In addition, different market orientations might be important:
for instance, producer-goods industries are more export-oriented whereas
nondurable consumer-goods industries are more domestic-market oriented.
Third, the weighted average concentration ratio for all industries in the
manufacturing sector stayed almost unchanged during the period. At the
absolute level, the three big firms in 1977 accounted for 57 percent of all
shipments in the manufacturing sector, which indicates considerable con-
centration in this sector.
Commodity markets are classified into four different categories or types:
monopoly, duopoly, oligopoly, and competitive market. The generalized
criteria for classification are:
Monopoly: CR, > 80%, S,/S, > 10.0%
 Policy Measures to Reduce Industrial Concentration 477

Duopoly: CR, > 80%, S,/S, < 5.0%, S; < 5.0%

Oligopoly: CR; > 60% (except monopoly and duopoly)
Competitive market: CR; < 60%
where CR is the share of cumulated shipments by the top i-number firms
in the relevant commodity market, and S is the share of the ith firm in the
relevant commodity market.
The commodity market was highly concentrated and almost invariant
between 1970 and 1977. In 1977 the monopoly and oligopoly markets
produced 83.7 percent of commodities (1,766 of the total 2,109 items) and
accounted for 61.2 percent of total shipments. Another observation is that
large commodity markets are less monopolized than the smaller ones. In
1977 almost 40 percent of the commodities in the markets of more than 10
billion won transactions were produced in the competitive markets, whereas
only 4 percent were produced in the competitive markets of less than 1
billion won. This is consistent with the theoretical prediction that large mar-
kets provide increased opportunities for competition through easier entry
of new firms and fewer incentives for leading firms to maintain monopoly
power (Lee and Suh 1981).
Computing the share of the three largest firms provides us with a meas-
ure of the absolute level of industrial concentration, but it captures neither
the relative market power of these three firms nor their effects on the charac-
ter of market organization. The degree of asymmetry between the top two
firms measured by the ratio of their shipments is shown in Table 18.5. In-
dustries with lower concentration ratios have a noticeably lower degree of
asymmetry; that is, there is less difference in market power between the
top two firms in more competitive industries. For example, among 14 in-
dustries with concentration ratios of less than 20 percent in 1977, 11 had
a degree of asymmetry less than 1.5 and none greater than 2.5. On the other
hand, among 48 industries with a concentration ratio of more than 80 per-
cent, 26 had degrees of asymmetry larger than 2.5. This implies that potential
competition between the top two rival firms in the duopoly-oligopoly mar-
ket is quite limited.
Conglomerates (Jaebul)
Thus far the discussion of market concentration has been based on the in-
dividual firm as a unit of measurement, not taking into account whether
an individual firm is an independent entity in terms of ownership or a mem-
ber of a large business group in which firms are interrelated through owner-
ship or management or both. If numerous large firms belong to a few
conglomerates (jaebul), the actual concentration becomes more serious than
the concentration ratio alone might indicate. Conglomerates in Korea have
been expanding rapidly both in the numbers of their subsidiaries and the
shares of their production in the aggregate economy. Between 1974 and 1980
the number of firms in the entire industrial sector belonging to the 30
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480 Kyung Tae Lee

largest conglomerates increased from 304 to 608 (Table 18.6). Considering

only the manufacturing sector, in 1980 these 30 conglomerates owned 327
firms, comprising 23.7 percent of total manufacturing employees and 34.7
percent of total manufacturing production (Table 18.7). In particular, the
five largest conglomerates were the predominant force, accounting for 15.7
percent of total shipments, 14.5 percent of value-added products, and 9.1
percent of employment in the manufacturing sector for 1977. Tables 18.8 and
18.9 show other aspects of economic power concentration among large con-
glomerates.

Table 18.6. Number of firms owned by 30 largest conglomerates: 1974-80

(entire industrial sector)

Firm integration during 1975-79

Joint Disposi-
1974 New Purchase Merger venture tion (-) 1980
304 152 173 tS 17 38 608

Source: Lee and Suh (1981).

Table 18.7. Market power of the 30 largest conglomerates: 1977-80 (manufac-

turing sector)
Employment Shipments
Number of Persons Share Value Share
Year member firms (108) (%) (10° won) (%)
1977 239 410 20.5 496 32.0
1978 290 487 22.2 732 34.5
1979 348 536 24.4 S17 35.0
1980 327 497 23:7 1,244 34.7

Source: EPB, ROK, Tasks for earlier settlement of the antitrust system (1983).

Table 18.8. Conglomerates’ share of fixed capital and value added in

manufacturing: 1977 and 1980
Fixed capital Value added
1977 ~—-1980 1977. = 1980
Manufacturing value® (10° won) 3,936.7 12,862.3 5,604.0 11,863.2
Share of top 5 conglomerates (%) 10.9 16.7, 14.5 13.8
Share of top 30 conglomerates (%) 33.6 36.9 31.4 31.3
Source: EPB, ROK, Proceedings of the Industrial and Technological Policy Advisory Meet-
ing (1983).
a. In current prices.
 Policy Measures to Reduce Industrial Concentration 481

Table 18.9. Conglomerates’ share in technology imports: 1962-80 (number

of cases)

Category of Total technology Imports by top 12

conglomerate imports (A) conglomerates (B) (B/A)
Oil refineries and
chemicals 306 59 1933
Electronic and electrical
equipment 326 114 35.0
Machinery Diz 221 43.2
Total 1,144 394 34.4
Source: EPB,ROK, Proceedings of the Industrial and Technological Policy Advisory Meeting
(1983).

The market power of conglomerates at the industry or commodity mar-

ket level are shown in Table 18.10. According to this table, a single conglomer-
ate occupies more than 60 percent of the market share in 14.5 percent of
total commodity items (140 out of 968 items). This may indicate that the
market power of conglomerates is not visibly significant, but the measure-
ment of market power by market position has a different implication. The
top 30 conglomerates hold the largest market share for 314 commodities
(23.4 percent), and they are either the first, second, or third largest suppli-
ers in 595 commodity markets (61.5 percent). All in all, conglomerates in
Korea are characterized by a high degree of aggregate market concentra-
tion, persistent expansion through mergers, and considerable market power
in individual commodity markets.
Causes and Effects of Concentration
In a sense, the high concentration of economic power in Korea on indus-
trial and macro levels is a natural consequence of economic conditions and
government policies in the country. Economies of scale and the small size
of the domestic market provide leading firms with a considerable advan-
tage because of their ability to exploit lower costs stemming from large ca-
pacity. Any new entrant faces serious risks in attempting to penetrate a
market already dominated by another firm. Moreover, government poli-
cies were inclined to promote and encourage such concentration in the early
stage of economic development.
It is well known that Korea vigorously pursued import substitution and
then export promotion by combining foreign capital and technology with
domestic labor. In the design process, more capital-intensive technologies
embodied in large-scale production units were preferred on the basis of
economies of scale and the resulting cost advantage in international com-
petition. Large firms were also advantageous in terms of technological
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484 Kyung Tae Lee

innovation and capital accumulation. Thus from the very beginning, in-
dustrial concentration in Korea was initiated rather than left to evolve by
means of mergers or integration among firms as has been generally observed
in the history of economic development of other industrialized countries.
The excessive expansion of a large business group or conglomerate can
possibly be explained by the circular political-economic process. Economic
size means economic power and influence on the government's resource-
allocation decisions (Jones 1980). Although access to government decision
makers was necessary, the government was expected to be very selective
in deciding to undertake a big project because of its commitment to eco-
nomic growth (SaKong 1981). In this regard, large business groups with
managerial ability and experience, talented manpower, and capital-
mobilizing capabilities were better positioned to take part in the allocation
of scarce resources, particularly in the heavy and chemical industries. Pur-
chases or mergers of existing firms by a conglomerate played a greater role
than the establishment of new firms within conglomerates (Table 18.6). This
suggests that conglomerates allocate much of their monopoly profits, bank
credits, and surplus resources for the acquisition of existing firms in the
industrial sector. Although manufacturing and construction are the major
sectors in which the conglomerates have invested, they have nonetheless
diversified into other sectors, including transportation, communications,
and finance, among others (Table 18.11).
Increasing criticism has been raised about industrial concentration and
its negative effects on resource allocation, income distribution, macroeco-
nomic stability, and sociopolitical imbalances.

Table 18.11. Value-added share of conglomerates by sector: 1978 (%)

Number of conglomerates
Top Top Top Top
Sector 5 10 20 46
Agriculture, forestry, fisheries 0.14 0.10 0.14 0.12
Mining 0.88 0.66 0.62 0.51
Manufacturing 54.05 ksh 56.55 59.91
Construction 17.54 24.74 20.77 19.85
Electricity, water, and sanitary services 0.11 0.08 0.07 0.05
Transportation and communication 9.90 9.24 ae02. 6.69
Wholesale and retail trade 4.11 3.26 4.58 4.05
Finance and insurance 9.53 752 6.45 6.34
Pure services 3.74 3.10 2.90 2.48
Total 100.00 100.00 100.00 100.00
Source: SaKong (1980).
 Policy Measures to Reduce Industrial Concentration 485

Concentration and economic efficiency. Theory predicts that optimum

resource allocation is fulfilled when factor and commodity markets are in
perfect competition. Monopoly and oligopoly firms produce less than op-
timum levels of output at prices that are higher than marginal costs, there-
by creating monopoly profits. Resources are used in less productive areas
causing net losses in economic welfare. In addition to these static efficiency
considerations, dynamic impacts of concentration on economic growth
deserve due attention. Korea’s economic growth has been mainly attrib-
uted to the increase in the factor inputs of labor and capital. The abundant
supply of cheap skilled and unskilled labor and the subequilibrium real
interest rate provided a competitive edge in the export market for labor-
intensive goods such as textiles, plywood, wigs, and home electronics. But
as the economic structure shifted to more capital-intensive, technology-
oriented industries, export promotion by mere increases in factor inputs
had reached its limit.
An increase in total factor productivity through technological innovation
and managerial improvement is imperative to provide a better competitive
edge to Korean export goods in terms of price and quality. There are con-
flicting arguments as to whether atomistic firms in a perfectly competitive
market or big firms in a monopoly-oligopoly market are more favorable to
innovation. But there is no doubt that big firms whose monopoly positions
are protected by legal and administrative barriers have little, if any, incen-
tive to devote scarce resources to create changes needed to place themselves
in a superior competitive position vis-a-vis their rivals. Their monopoly rent
is a windfall profit earned by external institutions rather than through in-
novations in quality and marketing techniques. This description is typical
of the situation in which the economic activities of Korea’s enterprises are
molded. In this context, there is a growing body of opinion that market
mechanisms designed to enhance competition and new entries should be
introduced.
Concentration and income distribution. It is frequently asserted that the
high level of concentration was one important cause of the deterioration
of equitable distribution in the 1970s as measured by the Gini coefficient.
This may be true but there are few empirical studies to support or con-
tradict such an assertion. Jones (1980) argued that even if the government
were to tax away the entire distributed earnings of the large conglomerates
and reallocate them to the population as a whole, the redistributional ef-
fect would be negligible. On a priori grounds the distributional effect of con-
centration is determined by factors other than the degree of concentration
itself.
As an example, ownership patterns and efficiency considerations are im-
portant. If ownership is not separated by stock dispersion and if dynamic
inefficiencies are created by industrial and aggregate concentrations, the
486 Kyung Tae Lee

adverse effect on income distribution will be magnified. In this context,

Korea’s high concentration of ownership among a few business families and
inefficiencies caused by a highly monopolized market structure should have
worsened income distribution.
Concentration and inflation. On a priori grounds it can be hypothesized
that monopolized industries have higher inflation than competitive ones.
Three factors underlie these assumptions: the monopoly firm has discre-
tionary control over the price of its output, whereas the competitive one
is a price taker; the monopoly firm uses its control power to maximize profit
margin over the cost (mark-up pricing theory); and the monopoly firm is
able to transfer more of a given change in cost conditions to the output
price than are competitive firms. Table 18.12 shows that monopoly-oligopoly
commodities experience much higher price rises than competitive ones. The
sample period covers the sharp price rise of crude oil during the second
oil crisis. This may have generated higher price increases for monopoly-
oligopoly commodities since these commodities are more sensitive to in-
put price changes. Thus the interpretation that price rise differentials are
indicative of market power should be accepted with some caution. Kyuuck
Lee (1977:135-40) performed multiple regression analysis using the price
equations in which labor cost, material cost, and concentration ratio are
explanatory variables. In the test results, the concentration ratio had a posi-
tive and significant relationship with price rise.
Concentration and sectoral disequilibrium. The domination by big firms
over market structure is manifest in the serious imbalance between
small/medium-size firms and big firms. As shown in Table 18.13, the growth
rate of the output of small and medium-size firms was significantly lower
than the average growth rate of the economy throughout the 1960s and
1970s. The lower growth rate resulted in the relatively inconspicuous posi-

Table 18.12. Comparison of price increases between monopoly-oligopoly

and competitive commodities: 1973-75 (%)
January January January
Commodity type 1973-74 1974-75 1973-75
Monopoly-oligopoly
(31 sample commodities) 23.0 72.3 113.2
Competitive
(19 sample commodities) 18.3 28.2 51.7
Total
(50 sample commodities) PANS: DO.7 86.5
Wholesale price rise® 212 45.5 74.9
Source: K. Lee (1977).
a. Added by the author.
 Policy Measures to Reduce Industrial Concentration 487

tion of small and medium-size firms in output, employment, and bank loans
(Table 18.14). In 1981 Korea’s small and medium-size firms shared 51.1 per-
cent of total employment, 32.3 percent of gross output, and 45.2 percent
of bank loans, compared with 71.5, 52.7, and 61.1 percent, respectively, in
the case of Japan.
Behind the numerical indicator lies the structural problem of a deficient
complementarity between small firms and big ones. Their production lines
are not efficiently linked. Instead of a harmonious interdependent relation-
ship between the big firms which have large-scale assembly lines and the
small firms that supply parts, large firms often undertake the entire produc-
tion process by themselves. Moreover, conglomerates often diversify into
areas where small firms could operate more efficiently.
Concentration and flexibility of economic power. As was said, economic
power embeds the political influence by which big businesses are able to
exploit the benefits of government intervention in credit rationing, taxation,
foreign exchange control, and distribution of economic rents. This implies

Table 18.13. Sectoral growth rates in Korea: 1962-81 (% per annum)

Small and medium-
Years GNP Manufacturing size firms
1962-66 7.8 139 2.8
1967-71 10.5 paet's) 4.2
1972-76 10.1 26.2 16.1
1962-79 9:3 26.6 11.0
1980 -6.2 -1.1 -8.3
1981 Zh 6.8 14.5

Source: EPB, ROK, Economic Statistics Yearbook (1971, 1981, 1982); EPB, ROK, Survey Report
of Mining and Manufacturing Statistics (1971, 1981, 1982).

Table 18.14. Shares of employees, gross products, value added, and bank
loans among small and medium-size firms in Korea, Japan,
and Taiwan: 1981 (%)

Item Korea Japan Taiwan

Small and medium-size firms as a
percentage of total firms 96.0 99:2 u
Employees eyes 71) 68.2
Gross product 92.3 527. u
Value-added product 34.8 Cylon 50.4
Bank loans 45.2 61.1 u

Source: EPB, ROK, Tasks for earlier settlement of the antitrust system (1983).
u—unavailable.
488 Kyung The Lee

that government intervention worsens market imperfection rather than im-

proves it.
Big business groups also use their economic and political power to pro-
tect their own interests from macro- and micro-level economic policies. For
example, they have expressed strong objections to the policies of import
liberalization, tight credit, price controls, and fair trade, which are essen-
tially designed to increase the efficiency and equity of the overall economy
at the cost of certain sectors of the economy.
Considering the serious imbalance of power among interest groups (e.g.,
large versus small businesses, producers versus consumers), the lobbying
efforts of big conglomerates often cause government policies to tilt toward
excessive protection of their interests. A typical example is the long-delayed
government regulation over conglomerate diversification by merging firms
in different industries and by purchasing real estate for purely speculative
purposes.
Concentration and market-oriented economic policy. In the 1960s and early
1970s, Korea pursued government-led economic growth. Resource mobili-
zation and allocation were undertaken through direct and indirect govern-
ment intervention in a wide range of economic activities. As the absolute
size of the economy grew and its structure became increasingly complicated,
the appropriateness and feasibility of government-led economic growth
declined correspondingly.
The private sector came to possess more competent managerial talent
and gained better access to market and technological information than the
government. In contrast, the government encountered increasing difficul-
ties in collecting the vast amount of information required for efficient in-
tervention. For this reason, deregulation and a greater role for the market
mechanism have been emphasized since the late 1970s. But that market
mechanism presupposes a set of rules of the game that ensure competi-
tion on an equal basis. Industrial and business concentration is conducive
to the abuse of market power, which nullifies the otherwise advantageous
operation of the private sector.

MAIN FEATURES OF THE POLICY MEASURES

Policies Toward Industrial Concentration
The Price Stability and Fair Trade Law, 1976. The Price Stability and Fair
Trade Law was enacted in March 1976. Its important provisions are as
follows:
1. The government is authorized to set price ceilings for goods and ser-
vices when needed for economic stability.
2. Monopoly and oligopoly businesses are obliged to declare their product
Prices to relevant government ministries, which then examine the validity
of those prices.
 Policy Measures to Reduce Industrial Concentration 489

3. The government is authorized to control the supply conditions of goods

when the prices of goods increase sharply due to supply shortages. The
measures may include administrative decrees to control production plans,
shipments, exports, imports, transport and storage, and improvement of
the distribution system.
4. Monopoly-oligopoly firms are prohibited from engaging in unfair trade
practices, such as discrimination against certain customers, unfair proce-
dures to compel a rival’s customers to make transactions with the firm, false
or misleading advertising, and hoarding or cornering in pursuit of exces-
sive profits.
5. Monopoly-oligopoly firms are prohibited from attempting to restrict
competition by fixing, maintaining, and raising output prices; by impos-
ing restrictive conditions on commodity sales, service provisions, and pay-
ments; by restricting production, sales, and shipment of goods and services;
and by restricting sales of output to certain customers or geographic regions.
6. As an exception to the provisions in item 5 above, cartels are permit-
ted to rationalize industrial structure on a selective basis.
The purpose of the law was twofold: to regulate certain prices directly
and to control unfair trade practices. Direct price regulation was introduced
to curb inflationary pressure caused by monopoly power. Control of unfair
trade was pursued mainly by regulating market performance rather than
by improving market structure.
To be designated as a monopoly-oligopoly firm, firms must satisfy the
following criteria: (1) a 30 percent or greater market share; (2) a 20 percent
or greater share in a market where the three largest firms produce more
than 60 percent of the total; and (3) substantial monopoly power in a com-
modity market essential to the national economy. Using these criteria, the
Korean government annually designates monopoly-oligopoly commodities,
the prices of which must be reported to the government for evaluation. The
number of designated monopoly-oligopolgy commodities ranged between
148 and 157 between 1976 and 1979 (EPB, ROK, Policy proposals for im-
proving the antitrust system, 1981).
The government also designates certain commodities whose ceiling prices
are subject to official approval. The number of commodities with a
government-set price ceiling declined from 251 in 1977, to 19 in 1978, and
to two in 1979. The government's efforts against unfair trade practices be-
tween 1976 and 1979 resulted in 80 indictments, six corrective orders, and
three warnings (EPB, ROK, Policy proposals, 1981).
The Antitrust and Fair Trade Law, 1981. Several shortcomings of the Price
Stability and Fair Trade Law enacted in 1976 were revealed in the course
of its implementation. Direct regulation of prices may have price-stabilizing
effects in the short run, but only at the risk of creating black markets, dou-
ble prices (open market and black market prices), disincentives for capital
490 Kyung The Lee

investment, and resultant supply shortages in the long run. Determining

what constituted normal profit also necessitated estimating production costs,
which was a difficult burden for the government.
Another critical drawback of the law was that it did not attempt to regu-
late such monopolizing behavior as mergers and interlocking directorships.
Hence the law could not contribute to making the market structure more
competitive. Such behaviors are, however, explicitly restricted by the An-
titrust and Fair Trade Law that was enacted in April 1981.
The new law also prescribes the regulation of monopoly-oligopoly com-
modity prices, although this regulation is somewhat different from the old
system of ex ante and direct price control. The important provisions of the
new law are as follows:
1. A market-dominating firm is prohibited from using its market power
in an “inappropriate manner” to: determine, maintain, or change commod-
ity prices; control the volume of sales; interfere in the affairs of other firms;
add new capacity or expand existing capacity for the purpose of blocking
entry of a rival firm or excluding rival firms from a certain business area;
collude in raising the prices of homogeneous or similar commodities; or
engage in other activities that substantially reduce competition or impede
consumer welfare. The term “inappropriate manner” is defined as the case
in which the price fluctuates excessively in light of supply and demand,
or cost conditions in the market; the case in which the profit rate of the
market-dominating firm is very high; or the case in which the marketing
expenses of the market dominator are abnormally high. By definition, a
market dominator has to have annual transactions exceeding 30 billion won
as a supplier in the commodity or service market in which either a single
firm’s market share exceeds 50 percent, or the combined market shares of
the three biggest firms exceed 70 percent.
2. Business combinations through the purchase of equities, interlocking
directorships, mergers, transfers of all or important parts of the business
activities of other firms, or the establishment of new firms are prohibited
if they substantially reduce competition in certain business areas. Excep-
tions can be granted by government permission in cases where such
combinations are required for industrial rationalization or to strengthen
international competitiveness. This antitrust provision is applicable to a firm
whose paid-in capital is more than 1 billion won, or whose total assets are
valued at more than 5 billion won.
3. Cartels are prohibited if they substantially reduce competition. But
exceptions are acknowledged when the firms concerned can prove that a
cartel is necessary in order to survive a depression or rationalize their in-
dustrial structure.
4. The following unfair trade practices are proscribed: improper discrimi-
nation among customers; improper trading to exclude rival competitors;
 Policy Measures to Reduce Industrial Concentration 491

enticing or forcing a competitor's customers to make transactions with one-

self; using an advantageous position in an improper manner when deal-
ing with one’s customers; dealing with one’s customers on conditions that
restrict their business activities improperly; false or misleading advertis-
ing; and misrepresentation of the quality or quantity of a commodity.
5. Business organizations are prohibited from engaging in the following
activities: limiting competition substantially in certain business areas by en-
gaging in practices proscribed in item 4 above; restricting the current or
future number of competitors; restricting the business activities of a mem-
ber firm improperly; and forcing a member firm to engage in unfair trade
proscribed in item 4 above or resale price cartels proscribed in item 6 be-
low. Business organizations are defined as business interest groups con-
sisting of more than two mutually independent business entities in
manufacturing, wholesale and retail, transportation and storage, construc-
tion, or other personal services.
6. An individual firm or a business organization is prohibited from mak-
ing international contracts or arrangements involving improper cartels or
unfair trade. An international contract or arrangement covers foreign loans,
joint investment, import of technology, and long-term import contracts for
commodities and services.
7. The 1981 law established a five-member Fair Trade Commission in the
Economic Planning Board (EPB) to deliberate and decide on important mat-
ters relating to the implementation of the law. (For a discussion of its func-
tions, see “Institutional Setting for the Antitrust Policy” below.)
Since antitrust policy in Korea is still in a developing stage, emphasis
is placed on the consolidation of operational institutions and increasing
the public's understanding of the issues. Moreover, substantial efforts have
been made to develop the administrative capability to supervise and cor-
rect collusive and unfair trade practices.
During 1981-83, 195 firms were designated as market dominators and
placed under extensive supervision by the fair trade authorities with regard
to pricing and improper use of their market power. Corrective measures
were taken in the two cases of mergers attempted by means of purchasing
equity. A cement industry sales cartel that had lasted more than ten years
was dissolved. A total of 780 business organizations were supervised with
regard to possible competition-restricting activities, and 41 of these were
ordered to revise their articles of association that stipulated collusive pric-
ing, production and shipment allotments among members, and restrictions
on new capacity and expansion of existing capacity.
Additional measures were taken to provide a solid environment for fair
trade. Twelve typical unfair trade patterns were identified and subjected
to extensive supervision, including dumping, improper refusal of transac-
tions, and improper enticement of customers. To promote competition in
492 Kyung Tae Lee

price and quality, restrictions were imposed on the value of gifts accom-
panying sales and on the frequency and duration of such sales, while dis-
count sales in a single store were limited to 90 days per year. Fact-finding
investigations were carried out in the food, medicine, cosmetic, clothing,
footwear, and real estate sectors to gather information on labeling and ad-
vertising of price, quality, ingredients, and place of origin. Based on these
investigations, 70 firms were warned about false or misleading labeling and
advertising. Measures to improve unfair trade in construction subcontract-
ing include prohibitions against delayed payments and improper determi-
nation of construction costs and against delayed payments and improper
determination by assembling firms regarding the prices of commodities de-
livered by the producers of parts. Violations were found in ten firms engaged
in highway and subway construction and 17 firms in the manufacturing
sector; all of these were corrected. Finally, retail price fixing by cosmetics
producers was gradually curtailed, from 14 kinds of cosmetics labeled with
a uniform retail price in 1981 to only five in 1983.
The number of corrective measures taken by type of violation is tabu-
lated in Tables 18.15 and 18.16. The tables show that a major effort has been
made to improve market behavior by regulating such unfair trade practices
as false advertising and improper transactions in subcontracting.

Policies Restricting Aggregate Concentration

Our discussion of policies toward aggregate concentration is centered on
policies affecting conglomerates because the majority of the biggest 100 or
200 firms are affiliated with one conglomerate or another. Government ef-
forts to restrict both the excessive accumulation of wealth in the hands of
a small number of conglomerates and the unrestrained use of that wealth
have a longer history than that of the antitrust policies discussed above.
In June 1961 the military government enacted a special law, aimed at
punishing the plutocrats who had accumulated wealth in an improper way,
and nationalized the commercial banks. This legislation reflected the new
government's determination to sweep away the old injustices and wrong-
Table 18.15. Number of corrective measures taken against antitrust viola-
tions: 1981-83

Type of violation 1981 1982 1983 Total

Merger 0 2 0 2
Competition restrictions e) 8 5 18
Unfair trade 16 25 24 65
International contracts 80 162 130 372
Total 101 197 159 457
Source: EPB, ROK, Tasks for earlier settlement of the antitrust system (1983).
 Policy Measures to Reduce Industrial Concentration 493

doings that had been committed in the process of wealth accumulation af-
ter the country’s liberation in 1945. It was also in response to the general
public's criticisms that many of the big businesses had been created through
political connections and were thus responsible for much of the corrup-
tion and favoritism that had prevailed in the previous decade.
Thereafter there were no explicit anticonglomerate policies until 1974. The
government's growth-oriented economic policies emphasized export pro-
motion as an engine of growth and promoted big businesses. In May 1974,
however, a measure that reflected a policy change from an implicit promo-
tion to a balanced control of conglomerates was taken.
May 29th (1974) measure. The focal point of the measure enacted on 29 May
1974 was to induce big businesses to go public by providing incentives and
disincentives in bank credit, tax, and foreign exchange policies. As men-
tioned, conglomerates in Korea accomplished rapid growth largely through
easy access to bank credit and foreign exchange, which in turn worsened
their financial positions.
Policies to open the big businesses to the public and develop the equity
and bond markets had been attempted before the May 29th measure. These
were embodied in the Capital Market Development Law enacted in 1968
and the Law for the Promotion of Going Public enacted in 1972. Neither
of these laws was very successful in promoting the opening of large family
corporations, mainly because of the passive or uncooperative response of
the private firms. The new measure in 197 introduced some compulsory
clauses and stronger incentives for the opening of closed corporations to
augment the preceding laws.

Table 18.16. Number of corrective measures taken against fair trade viola-
tions: 1981-83
Type of violation 1981 1982 19834 Total
Improper refusal of transactions z 0 1 3
False advertising 6 12 10 28
Excessive gifts 1 5 2 8
Abnormal discounted sales a 2 1 4
Sales price fixing 1 2 5 8
Sales area fixing 3 1 0 4
Unfair subcontracting 1 pe A 7
Enforcement of transactions i a J 3
Total 16 25 24 65

Source: EPB, ROK, Tasks for earlier settlement of the antitrust system (1983).
Note: This table is the disaggregated contents of the unfair trade category listed in Table 18.15.
a. January through September.
494 Kyung Tae Lee

The May 29th measure had two objectives. The first was to separate
ownership and management by opening family-owned businesses to the
public. The purpose of opening up family corporations was twofold: to
return profits to society by paying dividends to a wider range of equity
holders, and to modernize management by enabling professional managers
to undertake important roles in business administration. The second ob-
jective was to improve the financial structure of the conglomerates and to
correct the credit allocation mechanism that was tilted toward big busi-
nesses.
Both objectives were important from the viewpoint of conglomerate pol-
icy. The open-market sales of equity shares was a necessary, although in-
sufficient, condition for decentralizing decision making and for bringing
about a wider distribution of conglomerate income. At the same time, more
stringent loan management would decelerate the rapid expansion of con-
glomerates that had been purchasing other firms and expanding existing
capacity mainly with borrowed capital. The May 29th measure was initi-
ated by an administrative order from the Office of the President and fol-
lowed up by a series of implementation measures.
The major objectives of the May 29, 1974, Special Order of the President
were:
* more active enforcement of laws promoting the opening of large family
corporations;
¢ improvement of the financial structure of big businesses;
¢ realization by firm owners of their social obligations and responsibility
to bring competent professional managers into their business operations;
and
¢ development of the heavy and chemical industries with maximum effi-
ciency to meet international competition.
To improve the firms’ financial structure, excessive domestic and foreign
currency borrowing needed to be corrected, particularly in those firms that
were passive about going public. Moreover, a firm’s management system
should be transformed from the closed family type to an open public type,
and a balanced relationship developed between ownership and man-
agement.
To accomplish the above objectives, the presidential order stipulated that
appropriate ministries should implement the following measures:
1. Financial, foreign exchange, and tax policies should give preferential
treatment to open corporations established by competent entrepreneurs.
2. A centralized information management system should be adopted to
facilitate analysis of the overall situation regarding loans, other financial
transactions, and tax payments of the individual big businesses or the big
business groups and their major shareholders who receive large domestic
and foreign loans.
 Policy Measures to Reduce Industrial Concentration 495

3. An excessive allocation of domestic and foreign loans to big businesses

(particularly those that do not go public) should be corrected by strength-
ening the loan management system.
4. Finally, when a businessman with a high debt-ratio plans to start a
new venture, he should be guided to finance part of the required capital
by selling a portion of his existing firms and equities.
The Banks’ Agreement on Credit Management of Big Businesses, en-
acted on 13 July 1974, was based on the Government Policy Concerning
Financial Credit and Concentration of Ownership announced by the Minis-
try of Finance on 30 May 197. It stipulated specific guidelines and criteria
for improving the financial structure of big business groups. All business
groups whose total outstanding loans exceeded 5 billion won were sub-
jected to strict credit management by the banks. These groups were catego-
rized into “A’ and “B” groupings according to debt ratio. An “A” business
group was required to submit a stringent plan for improving its financial
structure, which contained a scheme for going public by selling equities
in the open market, as well as a scheme for repayment of debts by selling
the equities of large shareholders and affiliated firms and real estate hold-
ings not actually used for business purposes. Business groups were also
put under severe restrictions for new foreign capital borrowing, investment
in new ventures, and purchases of real estate.
Finally, the Credit Management Agreement by Major Banks was intended
to centralize all information concerning the financial transactions of each
big business within its major bank. Big businesses generally conducted
financial transactions with as many banks as possible to maximize credit
mobilization. The lack of understanding of the integrated financial posi-
tion of an individual firm or a big business group made it extremely difficult
for the authorities to supervise actual executions of the financial improve-
ment plan submitted by that firm. Under this agreement, a major bank of
the business group was made responsible for guiding the group's business
management, establishing the ceilings on working-capital lending, coor-
dinating joint lending with other banks, and supervising the execution of
the financial improvement plan submitted.
From July 1974 through December 1977, the execution of the financial
improvement plans submitted by the pertinent business groups was strong-
ly promoted by the major banks and the Banks Supervisory Board within
the central bank. Table 18.17 outlines the accomplishments of the plans sub-
mitted and shows that the only ones falling short of the planned objec-
tives were the numbers of businesses going public and the disposition of
nonbusiness real estate holdings.
September 27th (1980) measure. The Korean economy faced its most seri-
ous challenges after the second oil crisis in 1979. Worldwide recession
reduced foreign demand for Korea’s export goods, and the double-digit
496
ee
eae
Kyung Tae Lee

Table 18.17. Accomplishments of the Financial Structure Improvement Plan:

1974-772
Planned Actual (B/A)
Type of accomplishment (A) (B) (%)
Going public (number of firms) 146 90 61.6
Mergers (number of firms) 50 61 122.0
Capital increases (10? won) 168.7 443.4 262.8
Sales of equities by major shareholders
(10° won) 66.6 68.8 103.4
Disposition of subsidiaries (number of firms) 38 40 105.2
Disposition of nonbusiness real estate
holdings (103 pyung)> 7,149 3,819 53.4
Source: MOF, ROK (1979a).
a. From 1 July 1974 through 31 December 1977.
b. 1 pyung = 0.65 square meters.

interest rate imposed a heavy burden on debt service. To make things worse,
the political chaos after the assassination of President Park created uncer-
tainties for private sector businesses.
On 27 September 1980, newly elected President Chun announced an im-
portant policy aimed at strengthening the efficiency and competitiveness
of private businesses, particularly big businesses. The policy stressed that
the sluggishness of the domestic economy was at least partially attribut-
able to the critical problems created by big businesses—for example, the
big businesses’ excessive investment in real estate for purely speculative
purposes, their disorderly diversification into a wide range of industries
instead of specializing in their principal industries, and their excessive busi-
ness expenditures.
Such critical problems were so deeply rooted in Korean entrepreneurial
behavior that economic recovery was considered unattainable without a
drastic change that would lead to rational and efficient management. Only
by drastically changing attitudes and behavior could the social responsi-
bilities and obligations of big businesses be fulfilled satisfactorily. This would
in turn contribute to improving the unfavorable public opinions regarding
the behavior of big businesses.
The September 27th measure was designed to accomplish four principal
objectives: disposition of nonbusiness real estate owned by big business;
disposition of peripheral firms affiliated with conglomerates; auditing of
incorporated companies’ accounts by outside auditors; and rationalization
of the tax system to improve the financial structure of big businesses. The
first two are directly related to the issues of business concentration and
therefore a more detailed description of them is given below.
Any firm affiliated with a conglomerate whose total bank credit exceeds
20 billion won or any individual firm whose total bank credits exceed 10
 Policy Measures to Reduce Industrial Concentration 497

billion won is obligated to report all of its real estate holdings to its prin-
cipal bank. Land and other real estate not actually classified for business
use should be sold and the proceeds used to repay the firm’s bank loans.
If the real estate is not sold in the open market, a public enterprise such
as the Land Development Corporation or the Housing Corporation may
purchase it, by making payment in bonds.
One of the characteristics of conglomerates in Korea is that they have
many firms in a wide range of industries. Diversification of a conglomer-
ate’s resources into many unrelated business areas inevitably results in slug-
gish managerial and technological innovations because an innovation would
more likely result from a concentration of its resources in certain special-
ized areas. To deal with the 20 largest conglomerates in terms of the num-
ber of affiliated firms, the September 27th measure laid down the following
principles for the disposal of peripheral firms.
1. The 20 conglomerates should voluntarily choose the principal type
of industry most suitable to their respective managerial and technical capa-
bilities.
2. The conglomerates should dispose of all firms other than the main
ones engaged in the principal type of industry.
3. The proceeds from the sales of these peripheral firms should be used
to improve the financial structure of the main firms.
4. First priority should be given to the sale of small and medium-size
firms.
5. All these plans should be formulated and implemented on the basis
of voluntary cooperation by the conglomerates. The government's role
should be limited to coordinating and adjusting the plans from the view-
point of macroeconomic efficiency. If necessary, the government may also
provide financial and tax incentives to support these plans.
6. If voluntary implementation of a plan proves to be unsatisfactory
within a certain period of time, the government can consider punitive
measures.
The amount of nonbusiness real estate and the number of firms sold
by the big businesses up to the end of February 1983 were substantial. Ac-
cording to the data prepared by the Ministry of Finance for the National
Assembly in 1980, about 77.8 percent of the planned target was met in the
disposal of land and other real estate; the 240 billion won revenue was used
to repay financial debts. During the same period, the 20 largest conglomer-
ates disposed of 122 of their peripheral firms out of a planned total of 166.
More detailed data prepared by the Federation of Korean Industries (1983),
however, reveal that although 95 firms were disposed of by February 1982,
in fact 32 of them had been disposed of prior to the September 27th meas-
ure and 26 others were merely reclassified as nonsubsidiaries of conglomer-
ates (Table 18.18). These data indicate that some caution is necessary in
498 Kyung The Lee eat xe Te i
Saini: th cs) nan ep Die eared
Table 18.18. Disposition of subsidiaries by conglomerates: February 1982
(number of firms)
ee ee ee ee a SS Se eee

Type of disposal Planned Actual

Sale 58 16
Merger 43 17
Dissolution 7 4
Reclassification® 26 26
Previously disposed of? 32 32
Total 166 a3

Source: Federation of Korean Industries (1983).

a. Reclassified as nonsubsidiaries.
b. Disposed of prior to the September 27th (1980) measure.

evaluating the true performance of the scheme in the disposal of periph-

eral firms.
THEORETICAL APPROPRIATENESS
In a perfectly competitive market structure, Pareto optimality conditions
are satisfied and social welfare is maximized in the sense that nobody’s util-
ity can be increased without reducing the utility of somebody else. The
stringent conditions of perfect competition are hardly ever met in the real
world. If Pareto optimality conditions are unsatisfied in several parts of the
economy, a public policy to restore them in a particular part of the econ-
omy—a second-best solution—does not necessarily increase the total wel-
fare of the overall economy. Whether or not such partial competitive
solutions are in fact optimal will depend on the particular situation and
on the nature of the constraints present in the economic system. Although
this argument is appealing on theoretical grounds, its use as a guideline
for actual policymaking poses many difficulties because the social welfare
function and supply-demand elasticities for each commodity should first
be ascertained to identify the cases where antitrust policy increases total
welfare.
Accordingly, actual antitrust policy is guided by the concept of effective
competition, which does not require all the rigorous conditions of perfect
competition but preserves the merits of perfect competition on more realistic
grounds. Effective competition is said to prevail when the following condi-
tions are fulfilled: (1) a considerable number of suppliers and demanders
exist in a commodity market; (2) an individual supplier or demander does
not possess market power strong enough to manipulate the market price;
(3) there is no collusive agreement among transactors; and (4) new entry
is not limited by noneconomic forces such as administrative and legal re-
strictions or by deliberate intervention by existing rival firms.
 Policy Measures to Reduce Industrial Concentration 499

The Antitrust and Fair Trade Law of 1981 was aimed at improving mar-
ket structure and behavior, bringing them closer to effective competition.
By banning mergers and other monopolizing business combinations and
by establishing strict guidelines to rule out unfair trade and other
competition-reducing behavior, the law is expected to increase consumer
welfare, allocative efficiency, and distributional equity. It is also expected
to contribute to economic growth by providing increased incentives for
managerial and technological innovation because firms whose monopoly-
oligopoly positions are secure have little, if any, motivation to allocate scarce
resources for innovative activities. These dynamic aspects of antitrust pol-
icy are more important than static efficiency considerations in the context
of a developing economy like Korea. In the early stages, Korea’s economic
growth was based on combining foreign capital and technology with abun-
dant domestic labor, producing unskilled labor-intensive products to ex-
port to developed countries. But as Korea’s comparative advantage shifts
to skilled-labor and technology-intensive products, innovative entrepreneur-
ship is urgently required for continuous economic growth. The reward and
punishment system inherent in the competitive market mechanism should
be given a relevant institutional backing so that it can freely operate to render
incentives for higher profits by applying new technology and cost-saving
and efficient production methods, rather than by supranormal price in-
creases using monopoly power.
There is a strong argument that a big business is more capable than a
smaller one of making research and development investments and in
managing the ensuing technical changes, and hence antitrust regulations
based on bigness are ill-suited to Korea's present needs. Research and de-
velopment investments in high technology require human and financial
resources that a small business can seldom mobilize. Antitrust policy in
Korea adequately addresses this point. It does not attempt to split a big
firm into several smaller ones through divestiture. It only prohibits busi-
ness combinations that substantially reduce competition. Even in that case,
a merger or other type of business combination essential for industry ra-
tionalization and stronger international competitiveness is permitted.

FORMULATION AND IMPLEMENTATION

Long-Delayed Enactment of the Antitrust Law
Antitrust legislation was first discussed by government authorities in 1963.
Not until 13 years later was a law finally enacted, suggesting a sharp con-
flict of interests among government, private business, and consumer groups.
A scandal arose in 1963 involving wheat, sugar, and cement. The pro-
ducers of these necessities— all big firms wielding considerable monopoly
power—were earning enormous excess profits by selling their products at
prices much higher than the ceiling prices set by the government. Moreover,
500 Kyung The Lee

they were accused of evading taxes by underreporting sales revenues. Faced

with strong public criticism of the collusive market manipulations by the
monopoly and oligopoly firms, in 1964 the EPB drafted an antitrust bill that
focused on the regulation of unfair cartel activities.
Private businesses adamantly opposed the enactment of such a law on
various grounds. First, since economies of scale should be utilized fully
to secure competitiveness in the export market, they were concerned that
monopoly-oligopoly regulations based solely on the criterion of produc-
tion capacity would decelerate the growth of production scale. Second, the
biggest plants, which are built with foreign loans, lead to monopolization
from the start. An antimonopoly policy in this situation might hinder for-
eign borrowing. Third, the demerits of monopoly-oligopoly can be suffi-
ciently taken care of by price control. Other antimonopoly policies would
only dampen the motivation to engage in business activities. It was thus
argued that such policies were premature. In the end, the draft of the an-
titrust bill was shelved even before it reached the legislature.
In 1966 the government drafted another, slightly revised bill and sub-
mitted it to the legislature. Once again, strong objections from business
circles played a major role in preventing its passage.
In 1968 President Park ordered the deputy prime minister to draw up
an antitrust bill and have it passed by the legislature. The order reflected
strong public criticism concerning the excess profits enjoyed by monopolistic
firms. Bad feelings were sparked with the public when a legislative inspec-
tion uncovered a smuggling scandal involving a large automobile manufac-
turer. The EPB proceeded more cautiously this time, consulting all relevant
organizations, including the ruling party. The bill was discussed in public
hearings before it was submitted to the legislature. Surprisingly, it failed
to pass, presumably blocked by the powerful business lobby.
In 1971 the government again submitted the bill to the legislature, and
once again it was abandoned. By this time many academics and consumer
groups had begun to doubt the willingness of the government to pass any
antitrust legislation.
In 1975 the antitrust bill was finally enacted into law. It is difficult to ex-
plain why the bill was passed at that particular time. The protracted de-
bate had, however, gained a momentum of its own. Moreover, private
businesses became passive in opposing the bill after benefiting enormously
from the government's August 3rd measure of 1972.
Policies restricting business concentration did not encounter strong op-
position from the big business groups. Although private business circles
did not welcome the May 29th measure when it was announced in 1974,
they accepted the policy recognizing that sound financial structure and eq-
uity dispersion of big businesses were essential for long-term economic
growth. Because of considerable anxiety about the possible constraining
impacts of the measures, they repeatedly asked the government to take a
 Policy Measures to Reduce Industrial Concentration 501

cautious, flexible, and realistic attitude in the implementation of the meas-

ure. In response, the government emphasized that the measure should be
beneficial to private businesses in the long run, and the government listened
closely to their suggestions and recommendations concerning the techni-
cal aspects of the measure.
Business circles were seemingly more cooperative with regard to the Sep-
tember 27th measure in 1980. On the day following the announcement of
the measure, they organized a committee called the Commission on Con-
solidating the Constitution of Business Enterprises. This prompt response
can be attributed to the following factors. First, the government repeatedly
emphasized that the measure should be carried out through the initiatives
of the business itself. Second, the business circles felt uneasy about mount-
ing public criticism pertaining to the excessive concentration of economic
power, real estate investment by big businesses, and significant imbalances
between big and small firms. They recognized that the bad public image
of big business—right or wrong—was too serious to be ignored. They thus
had to do something about it on their own.
Tension still exists between the government and private business regard-
ing the scope and degree of actual implementation of the antitrust law.
Government officials often complain about the lack of cooperation from
private business when they gather data to analyze antitrust behavior. Re-
cently the Federation of Korean Industries—an interest group for big
business—recommended that the enforcement of the law be eased. In par-
ticular, the criteria for designating market-dominating firms should be loos-
ened to reflect realities in individual industries.
Institutional Setting for the Antitrust Policy
The institutional framework for the implementation of antitrust policy has
a three-tiered structure. The minister of the EPB is in charge of final deci-
sions concerning the enforcement of the law and violations against it. The
Fair Trade Commission deliberates upon and resolves the important issues
before the minister announces his final decision. The Fair Trade Bureau
within the EPB is a secretariat that is in charge of investigating violations,
drafting legal and administrative ordinances, and other operational
procedures.
The Fair Trade Commission, which undertakes the very important func-
tions of deliberation and resolution, is comprised of five members (includ-
ing the chairman), three of whom are permanent. The members are
appointed by the president on the recommendation of the minister of the
EPB who may himself serve as commission chairman. The term of mem-
bership is three years and members cannot serve more than two consecu-
tive terms. Members cannot be dismissed against their will unless they are
convicted of a crime or are unable to carry out their duties because of chronic
illness.
502 Kyung Tae Lee

The commission deliberates and makes decisions on the following im-

portant issues: (1) enactment or revision of the law in areas such as anti-
trust policy, designation of exemptions from the antitrust law, and legal
restrictions on competition; (2) designation of market-dominating firms, un-
fair trade activities, and criteria defining improper international contracts,
(3) corrective measures on violations of the antitrust law; (4) orders requir-
ing market-dominating firms to pay penalties for abusive pricing behavior;
(5) lawsuits to nullify a business combination or the establishment of a new
firm; (6) processing appeals from businesses that have been charged with
violating the antitrust law; and (7) other matters that may be submitted
to the commission by the minister of the EPB.
Violations of the antitrust law are handled according to the following
procedures:
1. Recognition: A violation is recognized either by government authori-
ties or through a report by an outsider or a concerned party.
2. Investigation: The case is investigated by an inspector of the Fair Trade
Bureau under the EPB. The inspector is authorized to make inquiries among
persons involved in the case, collect necessary data and other materials,
and conduct on-the-spot investigations if necessary.
3. Post-investigation development: The minister of the EPB has three op-
tions for discretionary action once an investigation has been completed.
He can disregard the case if he decides the charge is minor; he can suggest
that the firm either discontinue activities deemed to be in violation of the
law or take corrective measures with the consent of the victims if this is
more desirable; or he can present the case to the Fair Trade Commission
for consideration. In the latter instance, the commission deliberates on the
case following a quasi-judicial procedure, after which it either dismisses
the case, suggests corrective measures to the violator, or files a suit in the
courts.

EFFECTS, CURRENT ISSUES, AND LESSONS

A more elaborate evaluation of the effects of the antitrust policy on the mar-
ket structure would include a comparison of the degree of industrial con-
centration before and after the implementation of the antitrust law in 1981,
and an identification of the various factors contributing to this difference
between the two periods. The market structure showed slight improvement
during the period 1977-85. The market share of the competitive firms in-
creased from 17.1 percent to 22.3 percent in terms of number of commodi-
ties, and from 26.1 percent to 37.8 percent in terms of shipments. But as
of 1985, the market share of monopolgy-oligopoly firms remained high at
77.7 percent in terms of number of commodities and 62.2 percent in terms
of shipments (Table 18.19). The number of market-dominating firms and
commodities designated by the government show continuous upward
 Policy Measures to Reduce Industrial Concentration 503

Table 18.19. Trends in market concentration: 1977 and 1985

Monopoly Oligopoly | Competitive Total

1977. 1985 1977 1985 1977 1985 1977 os L985
Number of
commodities 475 534 807 1,421 264 561 1,546 2,516
Share of
commodities (%) Osea. By) PS 722-3 100.0 100.0
Share of
shipments (%) 12.7 9.4 61525 52.8 PX VEL} 100.0 100.0

Source: K. Lee (1988),

trends, increasing from 48 commodities of 87 firms in 1982, to 58 commodi-

ties of 107 firms in 1983, and to 71 commodities of 136 firms in 1984.
Another possible method of evaluation is to look into the specific ac-
tions of the government to improve the market structure. Two types of
government action can be considered in this regard: the enforcement of
divestiture by existing monopoly-oligopoly firms, and the prohibition of
attempted mergers. Since the antitrust law took effect in 1981, no actions
have been taken in the first category and only two attempted mergers have
been prevented. Thus it can be concluded that the antitrust policy did not
have a significant effect on improving the market structure or on making
it more competitive.
The antitrust policy nonetheless has had obvious effects on market be-
havior and performance. Besides these specific actions, the antitrust pol-
icy also contributes to improving market behavior and performance by
infusing a new consciousness about the importance of enhanced competi-
tion into the minds of both producers and consumers. Producers are in-
creasingly aware that the pursuit of excess profits through monopoly pricing,
collusive marketing, and other unfair trading practices cannot continue
without the risk of substantial penalties.
Consumers are becoming more intensely cognizant of their rights of pro-
tection against the abuse of monopolistic market power. This awareness
is reflected in the significant increase in charges brought by consumers
against violations of the fair trade laws, from 7,365 in 1980 to 21,727 in 1982.
One of the issues yet to be settled is the balance between economies
of scale and a competitive market structure. As the economic structure
moves toward more capital- and technology-intensive heavy industries, the
minimum efficient scales in technological and managerial terms tend to in-
crease, thus inevitably leading to monopolistic-oligopolistic market struc-
ture given the small domestic market. Import liberalization fits into this
situation, augmenting actual and potential competition by increasing the
number of actual and potential substitutes in a given commodity market.
504 Kyung The Lee

In 1983 the Korean government announced a gradual but ambitious plan

to liberalize imports by removing quantitative restrictions on 80.4 percent
of total tradable items in 1983, increasing to 95.2 percent in 1988. However,
the import liberalization ratio for monopolistic-oligopolistic commodities
is much lower than that for the competitive ones. As of 1983 almost 80.4
percent of all tradable commodities were liberalized from quantitative res-
trictions and the average tariff rate was 23.7 percent. In contrast, only 37.5
percent of the commodities produced by the monopoly-oligopoly firms were
import-liberalized from quantitative restrictions and the average tariff rate
on such commodities was 41.5 percent. The stated rationale for this differ-
ence is that many of the monopolized commodities are either strategically
important or produced by infant industries. Critics insist, however, that
many of the monopolized commodities are protected largely because their
producers wield strong influence upon government trade policy. Compe-
tition with foreign goods should be an important instrument for attaining
a more atomistic market structure in a small economy like Korea’s. To max-
imize protection efforts, the protection given to an infant industry should
be minimized and its duration should be specified in advance.
Barriers against new entries still remain to a considerable extent. Re-
strictions on the establishment of new plants and on the expansion of ex-
isting ones are embodied in various administrative decrees and practices
on the grounds of industrial policy. Although the antitrust law requires ex
ante consultation regarding legislative attempts to restrict competition, the
lack of specific operational criteria impedes full-fledged application of the
law. Such consultation could be invigorated by means of closer coordina-
tion among government agencies.
The current antitrust law regulates manufacturing, wholesale and retail
services, transportation and storage, construction, food services, and lodg-
ings. Other industries such as the banking and nonbanking financial insti-
tutions, insurance companies, and real estate services are not subject to
regulation by the antitrust law. The fair trade authorities insist that these
sectors should be made subject to the antitrust law. They argue that, be-
cause these sectors are so closely related to everyday life, consumer protec-
tion could be affected seriously if they are not regulated. Also, if the flow
of funds through financial intermediaries is distorted by discriminatory or
collusive lending behavior, competition in the real sector of the economy
will be distorted accordingly. Other opinions are opposed to or cautious
about regulating these sectors (particularly the financial sector) within the
same framework as the real sector. It is often argued that financial inter-
mediation plays too important a role in the economy to be entrusted to free-
market mechanisms.
One thing to be considered in this discussion is the privatization of com-
mercial banks. As government-held shares of the commercial banks are sold
to private shareholders, the management will eventually be taken over by
 Policy Measures to Reduce Industrial Concentration 505

the big businesses that own the majority of the equities. The increasing
discretionary power of the private stock owners might lead to abusive market
power or discriminatory lending behavior, which would impose serious con-
straints upon competition in the real sector.
In spite of government measures, such as the May 29th and September
27th measures, the situation concerning the degree of economic power con-
centration has hardly improved. The shares of output (value added)
produced by the five largest and the 20 largest conglomerates have increased
steadily since 1973 (Table 18.20). The number of subsidiary firms belong-
ing to the 30 largest conglomerates also increased from 327 in 1980 to 481
in 1982. The share of bank lending to conglomerates in total financial credit
remained at a very high level—in October 1982 the five largest conglomer-
ates held 20.3 percent of total bank loans and 264 percent of total bank
credits (Table 18.21).
A new development in recent years is the participation by conglomer-
ates in the ownership of commercial banks. In 1982 the government de-
cided to denationalize the banks by selling state-owned shares in the open
stock market to remove bureaucratic intervention in the purely financial
operations of the banking system. As anticipated, the conglomerates pur-
chased a major portion of the shares offered. As of October 1982, 37 per-
cent of the commercial banks’ total capital was accounted for by the 20 largest

Table 18.20. Value-added share in GDP of the five largest and the 20 larg-
est conglomerates: 1973-81 (%)

Category of
conglomerates 1973 1975 1978 1981
5 largest SFr) 4.7 8.1 oH
20 largest 9.1 9.8 14.0 155

Source: EPB, ROK, Proceedings of the Industrial and Technological Policy Advisory Meet-
ing (1983).
»

Table 18.21. Shares of bank loans and credits granted to the five largest and
30 largest conglomerates in totals, as of October 1982
Bank loans Bank credit
Category of Amount Share Amount Share
conglomerates (109 won) (%) (109 won) (%)

5 largest 4,118 20.3 10,764 26.4

30 largest 7,811 38.6 20,832 B12

Source: EPB, ROK, Proceedings of the Industrial and Technological Policy Advisory Meet-
ing (1983).
a. Bank credit is the sum of bank loans and guarantees.
506 Kyung ‘ae Lee

conglomerates. Among them, three super-conglomerates held enough

shares to control the management of some commercial banks (Table 18.22).
This combination of industrial and financial capital increases the possi-
bility that the allocation of credit will worsen. Conglomerates with high
bank equity holdings may tend to favor their subsidiary firms by giving
them easier access to scarce credit. It is too early to derive any empirical
conclusion on this matter since the new, large shareholders are not yet al-
lowed to control the actual management of the banks. The government has
also taken measures to prevent any further concentration of bank lending
to conglomerates.
Economic power concentration within a small group of conglomerates
is one of the most serious issues in today’s economy, drawing wide atten-
tion and provoking heated discussions. Economic and political power some-
times go hand in hand, affecting the government's decisions on resource
allocation. The imbalance between large conglomerates and small and me-
dium industries also reduces the overall efficiency of the Korean economy.
Misunderstanding and distrust by the public of the economic and social
functions of conglomerates will be detrimental to the continuous growth
of a capitalist economy. The conglomerates account for the dominant por-
tion of Korea’s GNP and labor force. Mutual cooperation and understand-
ing between big business groups and consumers is therefore indispensable
for the political and economic stability of Korea.
It may not be fair to ask the conglomerates to assume full responsibility
for their bad public image. The public should acknowledge the following
facts: first, the primary objective of a private enterprise is profit maximiza-
tion; second, the excessive expansion of the conglomerates has been in-
duced or encouraged by growth-oriented government policy; and finally,
the conglomerates have made significant contributions to Korea’s econom-
ic development over the past two and a half decades. It is widely believed
that better integrated measures should be taken to regulate the negative
side effects of conglomerate growth. Individual policies relating to antitrust
law, credit management, taxation, securities markets, and industry in gen-
eral should be coordinated to maximize their effects and to make them con-
sistent with other economic policy objectives such as capital accumulation

Table 18.22. Bank equity holdings of three super-conglomerates, as of

October 1982

Conglomerate Percentage held

A 29.8% of the total equities of 3 banks
B 30.5% of the total equities of 2 banks
Cc 23.5% of the total equities of 2 banks
are ei ROK, Proceedings of the Industrial and Technological Policy Advisory Meet-
ing (1983).
 Policy Measures to Reduce Industrial Concentration 507

and export promotion. Two important areas toward which this integrated
policy should be directed are discussed below.

Conglomerate Diversification
Table 18.23 shows the distribution of conglomerate business activities in
Korea. The top 30 conglomerates are engaged in an almost comprehensive
range of industries, among which manufacturing, construction, and inter-
national trading are predominant.
Table 18.24 presents the distribution of the fixed capital stock of the top
five and the top 30 conglomerates in the manufacturing sector. Their produc-
tion lines cover labor-intensive textiles, capital-intensive chemical and non-
ferrous metal industries, and technology-intensive machinery and electron-
ics. The top five conglomerates have invested more heavily in machinery
and electronics than the smaller conglomerates. There is no doubt that their
diversification has gone beyond the optimum level that can be explained

Table 18.23. Sectoral distribution of total assets, own capital, and employ-
ment of the top 30 conglomerates: 1980 (%)
Trans-
Manu- Con- portation
factur- _struc- and
Item ing tion Trade storage Finance ‘Tourism
Total assets 46.3 15(2 15.8 10.7 7D 0.6
Own capital 53.6 15.0 8.2 d2s4 4.3 22
Employment 56.3 20.6 9.0 8.1 2.3 0.4

Source: EPB, ROK, Proceedings of the Industrial and Technological Policy Advisory Meet-
ing (1983).

Table 18.24. Distribution of conglomerates’ fixed capital stock in manufac-

turing: 1980 (%)
Food and Chemicals and Machinery and
Category textiles nonferrous metals electronics
5 largest conglomerates 10.3 31.6 58.1
(47.5)@
30 largest conglomerates 23.0 30.3 46.6
(37.6)4
Total manufacturing 2/%D 27.0 45.5
(24.8)
ee ee ee ee ee ae Be eee
Source: EPB, ROK, Proceedings of the Industrial and Technological Policy Advisory Meet-
ing (1983).
a. Machinery only.
508 Kyung Tae Lee

by risk-pooling or the utilization of surplus resources in a closely related

business area. One way of interpreting this phenomenon is to regard it as
the natural consequence of the conglomerates’ attempts to eventually diver-
sify into newly emerging industries. But a more plausible view is simply
that conglomerates take part in almost all industries whose profit outlooks
are promising.
The dispersion of human and material resources across a wide range
of unrelated industries is detrimental to technological innovation, which
is carried out more efficiently by specialization in certain areas. With a given
amount cf resources, it would be much more beneficial for the economy
to invest in research and development rather than in expanding the super-
ficial size of the conglomerates by purchasing other firms and real estate.
Excessive diversification by the conglomerates constricts the maneuver-
ability of small and medium-size firms, which are placed in a strikingly
disadvantageous position relative to the big firms. This is clearly illustrated
by comparing Korea to Japan and Taiwan (Table 18.14).
The conglomerates often establish their own small and medium-size firms
to supply parts and materials to their own member firms. Table 18.25 com-
pares the paid-in capital and value added of the member firms of three
conglomerates with those of independent small and medium-size firms.
The former clearly hold a superior position to the latter.
In an attempt to curb the increasing diversification of the conglomer-
ates, the May 29th (1974), September 27th (1980), and other measures were
implemented but without much success. One reason for the unsatisfactory
result may be the existence of too many legal loopholes. As a typical exam-
ple, a large firm with a high debt ratio can be exempted from stringent credit
controls when a bank loan is judged essential to export promotion. It is
not difficult to imagine that many firms have been exploiting this escape
route to the maximum extent. It must also be recognized that the govern-
Table 18.25. Paid-in capital, fixed capital stock, and value added of small
and medium-size firms, conglomerate members compared to
independents: 1980 (108 won)

Fixed
Paid-in capital Value
Category capital stock added
Member firm (averages of top 3
conglomerates) (A) jee, 25:3 15i7
Independent firm (average of all
firms) (B) 03 1.1 2
Ratio (A/B) (%) 37.7 23.0 13.0
eee eee
ae EPB, ROK, Proceedings of the Industrial and Technological Policy Advisory Meet-
ing (1983).
 Policy Measures to Reduce Industrial Concentration 509

ment was not ready to sacrifice its other policy objectives such as rapid
export-led economic growth even in the short run. Government financial
policy cannot be so stringent that it prevents consideration of discrete situ-
ations. However, effective implementation of anti-diversification policy could
be achieved if the commercial banks were required to take greater respon-
sibility and exercise sound judgment in allocating credit.
In addition to the role of credit management, antitrust law can be an
effective instrument for restricting diversification. The current antitrust law
cannot readily regulate a business combination between diverse industries
because the effects of such combinations on competition in specific busi-
ness areas are dubious. The competition-reducing effects of these kinds of
business combinations need to be defined in a broader sense to encom-
pass the stronger economic influences on the behavior of other firms
through access to political decision making, monopolistic power in labor
and credit markets, and the supply of intermediate goods, rather than defin-
ing by a static criterion applicable to the same commodity market.
Industrial policy should also be directed toward curbing a certain kind
of diversification. In the past, a large-scale new venture or a firm with a
default risk was almost always entrusted by the government to a conglomer-
ate on the grounds that other business entities lacked the capital and
managerial ability to undertake the task. This policy can hardly be justi-
fied when it is considered that the conglomerates depend upon additional
bank loans for the required capital. Independent small and medium-size
firms should receive stronger protection from conglomerates’ intrusions by
designating some industrial sectors as areas exclusively for small and
medium-size firms.
Ownership and Management Patterns of Conglomerates
In Korea a conglomerate’s member firms are controlled directly by a cen-
tralized management system whose top echelon consists of a small num-
ber of owner-managers. These owner-managers are in many cases family
members of the founder of the conglomerate. Two unique characteristics
are derived: first, a conglomerate is itself an independent entity that can
mobilize all the human and nonhuman resources of the member firms
in a highly coherent manner; second, its ownership and management
are monopolized by a handful of the founder’s family members. (This is
very similar to the pre-World War II stage of development of the Japanese
zaibatsu. See SaKong and Jones 1981:290-92.) These characteristics reinforce
the real concentration of economic power that creates a barrier to main-
taining harmonious relationships with other interest groups in the society.
To separate ownership from management, the first thing to be done is
to lower the minimum portion of the total equities that can be held by
oligopolistic shareholders of a single family. When that is accomplished,
510 Kyung Tae Lee

professional managers should replace the owner-managers in the actual

operation of the conglomerates.
According to widespread opinion, it may be too late to control the con-
glomerates because their enormous power has already exceeded the limit
within which some type of equilibrium could be achieved by means of mar-
ket mechanism checks and balances. This is why strong political will on
the part of the government is required to solve this long-avoided problem
of the Korean economy.
 19 Promotion Measures for General
Trading Companies (1975)
by Sung-Hwan Jo

Korea's general trading companies (GTCs) were not the natural outcome
of the evolution and expansion of Korea's export-oriented trading firms—
they were artificially created by government decree in 1975. It is, therefore,
appropriate to review the economic background and circumstances that led
to the government's decision to create GTCs rather than to focus our atten-
tion on the firm-specific aspects of the internationalization of Korean busi-
ness enterprises.
Changes in the international economic environment after the 1973-74 oil
shock were extremely detrimental to prospects for a continuous expansion
of Korea's exports. Overseas demand for labor-intensive industrial exports
from developing economies fell sharply due mainly to the oil shock-related
stagflation in the developed countries—Korea’s major export markets—and
to the growing neo-protectionism against industrial exports. On the domes-
tic front, general price inflation and increases in wages for unskilled and
semi-skilled workers since 1973 had weakened the international competi-
tiveness of Korea's industrial exports.
However, because the government's drive for export expansion had been
intensified by a strong incentive system and profit earnings from export
activities had begun to rise, the number of export-oriented trading firms
increased tremendously—from 816 in 1970 to 1,842 in 1975. Notwithstand-
ing the increasing number of establishments, the average size of exporting
firms remained relatively small. The average value of exports per firm in-
creased from US $10.2 million in 1970 to US $27.6 million in 1975. Further-
more, an increasing number of processing firms began to expand their
activities into export trading (forward linkage), while many trading firms
began to expand their activities into processing (backward linkage). Thus,
export trading was overcrowded with small and mid-size traders, leading
to cutthroat competition in overseas export markets.
In addition, after President Park forcibly carried out the politically con-
troversial constitutional amendment in 1972 that virtually guaranteed his
continued rule, Park and his government viewed export-oriented economic
growth and prosperity as the most effective means of pacifying political
discontent among the Korean people. The “export target of US $10 billion”
was a politically attractive goal, and the government made an all-out effort
to attain this quantitative target.
bil
512 Sung-Hwan Jo

In short, faced with the changed external and internal circumstances and
out of political necessity, the government took a series of measures to ex:
pand exports that included the creation of the GTC system, which was
designed to increase economies of scale and functional specialization in
the overcrowded and fragmented export trading sector.
MAIN FEATURES OF THE POLICY MEASURES
Korea’s GTCs, following more or less the Japanese model of general trad-
ing companies (shogogaisha), were designed to cope with problems affect-
ing Korea's export trading activities, including: (1) declining export market
demand due to worldwide recession and rising protectionism; (2) lack of
a functional division of labor between export traders and export manufac-
turers and among export traders; and (3) excessive competition among
small-scale exporters. The government expected the GICs to:
¢ Strengthen on-site export marketing activities by using their networks
of overseas branches to reach out to final consumers in existing export
markets and develop new markets through the diversification of products
and regions
e Act as “windows” (or representatives) for small and medium-size export
processing enterprises by taking care of all aspects of their export trade,
thereby promoting the functional division of labor between export trader
and producer
¢ Reduce excessive competition and dumping in overseas markets, partic-
ularly among small and medium-size exporters, through economies of
scale and the functional specialization to be gained from the GTCs’ world-
wide network of branches and information sources, and their massive
supply capacity
By appointing the trading subsidiaries of large business groups to the
status of GICs, the government hoped to use the limited resources or funds
for subsidies more effectively among a small number of oligopolistic trad-
ing firms rather than stretching its resources among a large and increasing
number of small and financially weak exporters.
Requirements for GTC Designation
Against the economic background and the government objectives reviewed
above, the Ministry of Commerce and Industry established, by decree, a
set of formal requirements for qualification of the GTCs. In 1975 these re-
quirements were: (1) minimum capitalization of 1 billion won, and a mini-
mum value of exports per year of more than US $50 million; (2) exports
of each of at least seven items valued at more than US $500 thousand; (3)
annual exports worth more than US $1 million to each of ten or more coun-
tries; and (4) encouraging public ownership of GTCs through stock issue.
 Promotion Measures for General Trading Companies (1975) 513

Minimum requirements for capitalization and value of exports were in-

creased, respectively, from 1 billion won and US $50 million in 1975 to 1.5
billion won and US $100 million in 1976, and further to 2 billion won and
US $150 million in 1977. Such increasing minimum requirements were meant
to encourage economies of scale in GTC operations and to strengthen their
market power in export trading.
The requirement for exports of at least seven items valued at US $500
thousand or more was designed to promote product diversification. This
requirement was especially suited to large business groups (Korea's con-
glomerates) with multiple product lines, and triggered a wave of takeovers
of small enterprises by larger business groups.
The requirement for exports worth more than US $1 million to each of
ten or more countries was designed to indirectly induce new market de-
velopment and regional diversification of exports. The minimum number
of overseas branches for each GTC was not specified in the list of formal
requirements, though the expansion of overseas branch networks subse-
quently was encouraged in the process of providing government incentives
and assistance to the GTCs.
The requirement for going public through stock issues was in part polit-
ically motivated to justify government loans, subsidies, and other forms
of public support and in part to encourage the development of Korea's stock
market.
Because the GTCs were created by the government as a byproduct of
its export drive rather than through the natural evolution and growth of
export-oriented Korean firms, the government came to specify minimum
export targets, capitalization requirements, number of export items, num-
ber of overseas branch offices, and extent of public share ownership for
each GTC. From 1975 to 1977, the minimum requirements for amount of
exports, product diversification, and regional specialization were again in-
creased. These requirements soon proved too tough for the GTCs to meet,
and led them to take the myopic approach of mere quantitative maximiza-
tion of exports to the point of disregarding long-run profit potentials. In
1978 the requirements for number of export items, number of countries,
and capitalization were greatly relaxed. Later, the formal requirements for
achieving and maintaining GTC status were also eased. These modifica-
tions were considered necessary because the first and second oil shocks
had created an unfavorable international business environment that increas-
ingly deteriorated the export performance and profitability of GICs. The
formal requirements for GTC status were again revised in January 1981 (Ta-
ble 19.1).
In 1978 the requirement for a minimum level of capitalization was
abolished. The various requirements for specific minimum amounts of ex-
ports were replaced with the requirement that a GIC’s exports be at least
514
ie eee
Sung-Hwan
re ee
Jo ee SS eee

Table 19.1. Minimum requirements for designation as a GTC

Period of qualification
Before’: Annual requalification required at the beginning of each year
Current: Qualification effective as long as it is not cancelled by the
government
Minimum requirements
Export
Before: 2 percent or more of the country’s total commodity exports
Current: Same
Number of overseas branches:
Before: 20 or more
Current: Requirement abolished
Number of export items worth more than US $1 million
Before: 5 or more
Current: Requirement abolished
Form of ownership
Before: Public share ownership
Current: Same
Conditions for cancellation of GTC status
1. Failure to meet the minimum requirements for two consecutive years
2. Engaging in unlawful and unfair practices in domestic and overseas trading
activities
3, Mismanagement and financial insolvency
a. Prior to January 1981.
b. After January 1981.

2 percent of the country’s total commodity exports. This meant that GTC
export requirements would be automatically escalated by the annual growth
of exports.
In 1977 the requirements for regional diversification of exports for GTCs
included: (1) exports over US $1 million to each of more than 20 countries;
(2) at least 20 overseas branches; and (3) a specific minimum value of ex-
ports and minimum number of overseas branches for new export markets
in the Middle East, Latin America, and Africa. Of these three requirements,
items 1 and 3 were abolished in 1981. Therefore, one of the major func-
tions originally envisaged for GTCs, namely, the development of new export
markets, was no longer subjected to government control. This development
opened up the possibility of increasing export concentration in existing ex-
port markets—the United States, Japan, and Western Europe.
The requirements for product diversification were also relaxed. In 1977
a GTC was required to export ten items, each with a value of more than
US $1 million. In 1978 this was reduced to five items and the requirement
 Promotion Measures for General Trading Companies (1975) 515

was abolished altogether in 1981. This implies that any trading company
exporting a single item comprising 2 percent of the value of the country’s
total commodity exports could achieve GTC status.
Such a major relaxation in the requirements for GTC status once again
pushed to the forefront the quantitative export maximization of a small num-
ber of commodities going to the existing export markets of the developed
countries, while denigrating the initial objectives of product and regional
diversification.
Incentives
The incentives given to the GTCs can be considered as the “rights” (or
benefits) that counterbalanced the “obligations” (or costs) of meeting the
requirements for GTC designation. These incentives are reviewed in terms
of international trade, administrative, financial, and foreign exchange aspects
(BOK, Present State of General Trading Companies, 1977).
Trade and administrative incentives. GTCs are given preferential treatment
in international bidding. They have access to membership in various trade
and export associations because the government has eased membership
eligibility requirements for GTCs and allows them to pay reduced mem-
bership fees. GTCs also enjoy easy access to the import of raw materials.
Financial incentives. GTCs are given preference in obtaining bank loans
within the limit of their past export performance for a specific period. In
addition, local trade credit is allowed for the GTC’s domestic purchase of
finished products within the limits of one-third of the firm’s export records
for the previous year. In this connection GTCs are permitted to issue a “lo-
cal” letter of credit to local suppliers without receiving a “master” letter
of credit from foreign importers, and to use the local letter of credit as col-
lateral for loans for financing domestic purchases. This privilege accorded
exclusively to GTCs was designed to permit them to accumulate a stock
of exportable products in anticipation of actual demand.
Foreign exchange incentives. Overseas branches of GTCs are awarded Class-A
status, and parent companies can dispatch up to ten persons to each of
their overseas branch offices. But this privilege is accorded to all other trad-
ing companies with large annual volumes of exports (US $10 million or
more). Overseas branch offices of GTCs can repeatedly use a letter of credit
guaranteed by a home-country bank in obtaining loans from overseas banks
for working capital and in opening letters of credit for importing from the
home country without obtaining a new letter of credit for each new loan.
However, this revolving utilization of the guaranteed letter of credit, within
the upper limit of the amount guaranteed, is not confined to the branch
offices of the GTCs alone. The same system is widely available to many
other classes of trading companies as well.
516 Sung-Hwan Jo

Other incentives. Although the upper limit of business funds that can be
accumulated by overseas branch offices of non-GTCs is set at US $300 thou-
sand, GTC branch offices are exempt from such an upper limit. Other in-
centives are given to all exporters, but the benefits from those incentives
are bound to be greater for the GICs because of the volume of their exports.
Direct incentives for tax savings include the return of value-added taxes
on purchases and the exemption of business income tax up to 24 percent
of the increase in capital. Indirect benefits can be accrued in the form of
interest savings from the deferred payment of corporation taxes authorized
for such company reserves as market development funds, reserve funds
for export losses, reserve funds for overseas direct investments, and reserve
funds for price changes. GTCs can lower their interest costs by making
deferred installment payments for taxes on these special reserves.
Unlike other trading companies, GTCs are allowed to hold regular con-
sultation meetings with other GTCs to discuss various issues of common
interest, exchange information, and prepare their collective recommenda-
tions for presentation to the government authorities. The collective opin-
ions and policy recommendations of the GTCs have greater influence on
government agencies than do those of other business associations. GTC
status enhances an individual firm’s public image and its credibility in per-
sonnel recruitment, as well as its effectiveness in dealing with the govern-
ment and in international and local business dealings.
Most of the government incentives discussed above are provided not only
for GTCs but also for other trading companies. Preferential treatment in
international bidding, the privilege to issue a local letter of credit and gain
access to trade credit based on that letter of credit, and the flexible upper
limits on overseas business funds accumulated in branch offices are the
exclusive incentives offered to the GTCs.
THEORETICAL APPROPRIATENESS
Before examining the outcome of interactions between government incen-
tive policies and GTCs’ performance, it is appropriate to ask the following
questions: (1) Is the government policy of fostering the development of GICs
appropriate considering the nation’s economic and social goals? (2) Are the
policy measures for GTC promotion appropriate for the attainment of the
stated objectives?
The first question is directly related to Korea's basic strategy of economic
development. At issue is whether the collective social gain from the eco-
nomic efficiency achieved in concentrating export trading activities into the
hands of a small number of large business groups is greater than the social
gain—creative dynamism, social harmony, and equitable distribution—that
the free entry into export trading by a number of small and medium-size
enterprises could bring. Is the attainment of efficiency and relative stabil-
ity in export activities more important than equity in income distribution
 Promotion Measures for General Trading Companies (1975) 517

and employment generation? These are the kinds of questions that should
have been considered in the government's decision to create GTCs. Because
of its continuous efforts to promote the GTCs, it appears that the govern-
ment has put more emphasis on economic efficiency than on social equity.
The second question asks whether the policy means adopted by the
government to support the growth of the GTCs are appropriate to the at-
tainment of the policy objective of sustained export growth through product
and regional diversification. This question can be considered in two stages.
One is whether the policy decision to promote the GTCs would have been
better than the absence of such a policy or the policy of nonintervention,
and another is whether the particular policy measures actually adopted are
better than alternative measures to attain the stated objectives in creating
GTCs. At this stage the following preliminary observations are offered:
1. The government's decision to create GTCs out of the existing large busi-
ness groups (Korean conglomerates) clearly reveals the Park government's
view that economic efficiency was a higher priority than social equity as
a development objective.
2. Because the formal requirements for achieving and maintaining GTC
status have been relaxed gradually, particularly in connection with product
and regional diversification objectives, and because most of the export in-
centives were provided not only for the GTCs but also for all other export-
ers, two points can be made. First, the special incentives for the GICs were
not much greater than those enjoyed by all other exporters. The govern-
ment could have promoted the GTCs or similar entities through informal
administrative discretion under the general package of export incentives.
Second, the tough requirement for quantitative export targets (or quotas)
and the subsequent abolishment of the formal requirements for product
and regional diversification only led to the short-run quantitative maximi-
zation of a limited number of industrial exports to the established developed-
country markets at the expense of developing long-run export profit incen-
tives, product diversification, and new markets.

IMPLEMENTATION AND EFFECTS: INTERACTIONS

BETWEEN THE GOVERNMENT AND GTCS
Because of the government's active export drive and the business groups’
positive responses to government incentives, the relative position of the
GICs in total export activities increased rapidly over a short period of time.
Five business groups’ trading firms—Samsung, Daewoo, Ssangyong, Kukje,
and Hanil—were registered as GTCs in 1975, the initial year of the decree.
Six more trading companies—Hyosung, Bando, Sunkyong, Samwha,
Kunho, and the government-owned Koryo Trading Company that special-
ized in exports from small and medium-scale producers—were designated
GTCs in 1976. Hyundai joined the group in 1977. The number of GTCs in
518 Sung-Hwan Jo

subsequent years has been fairly stable at around ten to 12, with one or
two joining and others dropping out.

Share of Exports
Over the period 1975-82, the share of GTCs in total commodity exports in-
creased rapidly, from 13 percent in 1975 to 48 percent in 1982. The share
of the small and medium producer-exporters declined from 36 percent in
1978 to 22 percent in 1982. The share of large-scale producers also shows
a gradual decline from 36 percent in 1978 to 30 percent in 1982. The share
of Japanese GTCs operating in Korea remained quite stable at a level of about
10 percent (Table 19.2).
The rapid decline in the export share of the small and medium indus-
tries can be attributed to several factors: (1) a relative decline in competi-
tiveness of the industries; (2) the shift from direct export by small and
medium industries to indirect export through the GTCs as the unfavorable
external conditions developed after the oil shocks; and (3) the tendency
of actual exports by these industries to be understated in the export statis-
tics as these industries “transferred” (sold), for a premium, part of their
export records to the GTCs, which were sometimes eager to inflate their
own export performance to maintain GTC status.
The relative decline in the share of the non-GTC large-scale producers
in total commodity exports mainly reflects the growing tendency of large
business groups to export their products through their own GTCs and the
corresponding decline in the share of exports by large-scale producers with
no GICs of their own. The Japanese GTCs have been quite active in export
and import activities ever since they started operations in Korea.

Table 19.2. Share of exports by type of firm: 1975-82 (%)

Large-scale Small-scale
Korean export export Japanese
Year GTCs producers producers Total GTCs
1975 13.3 u u 100.0 u
1976 72 u u 100.0 u
Lory, 217 u u 100.0 12.1
1978 27.0 36.6 36.4 100.0 10.2
1979 33.9 37.4 28.7 100.0 10.4
1980 41.0 33.4 25.6 100.0 10.0
1981 42.9 u u 100.0 10.0
1982 48.2 29.3 22.3 100.0 10.0
-e————————
SSFSSSSSSSSSSSSSSSSSMSssFFeFeFseses
ee

Source: Korean Traders Association and the Korean Association of Small and Medium In-
dustries, internal reference materials.
u—unavailable.
 Promotion Measures for General Trading Companies (1975) 519

GTCs came to dominate Korea's international business activities mainly

through three routes:
First, compared with other trading companies, GTCs are well positioned
to facilitate export activities, obtain market information, and identify busi-
ness opportunities using their extensive networks of branch offices and over-
seas subsidiaries.
Second, GTCs have made efforts to develop and expand exports of heavy
and chemical industrial products manufactured by the subsidiaries of their
own business groups. GTCs are not only under pressure from the govern-
ment to diversify their export products and markets—they are compelled
to explore and expand new export markets for the heavy and chemical in-
dustry products that their own subsidiaries produce. The scale of the newly
erected plants and equipment in some heavy and chemical industries (HCIs)
has been far larger than current domestic demand warrants; only by ex-
panding overseas markets can the underutilization of productive capacity
be remedied. GTCs have been particularly active in expanding the exports
of ships, iron and steel, chemical fertilizer, electric machinery, and other
chemicals to the new export markets of developing regions. HCI exports
arranged by GTCs increased from 39.8 percent of total HCI exports in 1979
to 57.6 percent in 1981 (Table 19.3). The growth rate of HCI exports arranged
through the GTCs for this three-year period was 126.9 percent, far surpass-
ing the 56.9 percent growth rate of Korea’s total exports for the same period.
Third, GTCs have increased their share in total commodity exports by
acting as export agents and representatives for small and medium-size in-
dustrial producers. GTCs not only act as export agents for small and
medium-size export processing firms but in some cases also participated
in equity investment. GTCs even provided these smaller firms with manage-
ment assistance, operational funds, and raw materials. In 1976 about 21 per-
cent of exports supplied by small and medium-size industries were arranged
by the GTCs. The share increased to 32 percent in 1979.
The relationship between the GTCs as exporters and the small and me-
dium industry producers as subcontractors has not been well coordinated
and developed to take full advantage of the potential complementarity. In
some cases, the conflict of interests and the lack of mutual trust impeded
the natural development of linkages between the large exporters (the GTCs)
and small industry producers.
Major Characteristics of Korean GTCs
Although it is true that the GTCs were created by the government as an
expedient approach to its export drive, it cannot be overlooked that the
formation and growth of the GICs have been closely linked with the for-
mation and growth of the country’s unique “business groups” (conglomer-
ates), which have exerted a pervasive influence over every facet of business
activity in the past quarter century. Korea's business conglomerates are
520 Sung-Hwan Jo

Table 19.3. Share of GICs’ exports by type of product: 1979 and 1981
(US $ 10°)
Percentage of
Exports by exports by GTCs
Total exports GTCs of total exports
Type of product (A) (B) (BIA)
Primary
1979 1,485 213 14.3
1981 1,484 72 4.9
Growth rate 1979-81 (%) -0.1 -19.2 na
Light industrial
1979 7,509 2,475 33.0
1981 a 97098 3,346 3o5
Growth rate 1979-81 (%) oon Soe2 na
HCI products
1979 6,062 2,415 39.8
1981 9,510 5,480 57.6
Growth rate 1979-81 (%) 56.9 126.9 na
Total products
1979 15,056 5,103 339
1981 20,992 8,898 42.4
Growth rate 1979-81 (%) 39.4 cise na
Source: Korean Traders Association, internal reference materials.
na—not applicable.

characterized by: (1) their strong propensity to follow the government's

policy lead; (2) their external orientation through export expansion; and
(3) their drive toward all-inclusive business diversification through takeovers
and mergers.
During the primary import-substitution period, business firms actively
participated in government-initiated industrial development projects by tak-
ing full advantage of the strong industrial incentives and protectionism.
In this stage of early industrialization, they gained entrepreneurial and
industrial experience and consolidated their base for industrial growth. As
government development policy shifted from inward-looking to outward-
looking industrial development, incentives were mainly given for export
activities. Business firms rapidly followed the government's lead by expand-
ing labor-intensive, export-oriented industrial activities. In the process of
ever-expanding, export-oriented growth, certain business firms grew into
all-inclusive giant conglomerates. From 1973, when the government began
to place top priority on the promotion of HCls, these business groups joined
the government in developing HClIs while still maintaining their existing
export-oriented industrial activities (Jo 1984). As a result, each of about ten
 Promotion Measures for General Trading Companies (1975) 521

business groups now has diverse business lines across all industries. The
Samsung group, for instance, has been involved in diverse business lines
including foreign trade, textiles and clothing, electronics, shipbuilding,
heavy engineering, petrochemicals, food processing, construction, news
media, tourism and hotels, insurance, nonbanking finance, department
stores, and overseas joint ventures. The Hyundai group has numerous sub-
sidiaries in civil engineering, export and import, automobile assembly, con-
struction, cement, shipbuilding, industrial machinery, electric generators,
marine engineering, gas, and nonbanking finance. The Daewoo group, start-
ing from textile exports, has expanded into leather products, exportable
sundry goods of all kinds, insurance, machinery, automobile assembly, con-
struction, shipbuilding, and overseas joint ventures.
The business groups’ strong propensity to follow the government's policy
shift, their all-pervasive business lines, and their strong export orientation
could have resulted in the formation and growth of the GTCs or similar
entities even without explicit government policy measures.
The unique feature of Korea’s GTCs can be thus characterized by the fol-
lowing points: (1) the GTCs as a group or system are receptive instruments
of the government's export-oriented policy; (2) they are almost exclusively
externally oriented to the point of neglecting domestic trading activities;
and (3) they act as “windows” for their own business groups by exporting
the diverse products produced by their own subsidiaries in many indus-
tries. In this connection it is instructive to compare the main differences
in orientation and function between the Korean and the Japanese GTCs
(Ta'S: Cho; 1983-9vol.d).
Comparison of Korean and Japanese GTCs
Japanese GTCs are not engaged in manufacturing activities themselves but
specialize in a variety of trading activities, including domestic commerce
(50 percent of total sales), export (20 percent), and import (20 percent) ac-
tivities and also in facilitating trade among Third World countries (10 per-
cent). Korean GTCs are engaged in manufacturing as well as export trading.
Japanese GTCs are profit-oriented, taking advantage of differences in sell-
ing and buying prices of commodities between countries (between Japan
and foreign countries as well as between Third World countries). In addi-
tion to dealing with many kinds of products, they have, from the early stages
of Japan’s economic development, played an important role in international
technology markets. Korean GTCs put top priority on exports of products
from their own plants and subsidiaries of their own business groups, and
consider exports for other producers to be of secondary importance. They
import materials and technology merely to meet their own internal and
intra-business group needs.
There is a basic difference between Japanese and Korean GTCs in their
relationship with small and medium-size industries. Japanese GTCs have
522 Sung-Hwan Jo

played a pivotal role in developing small and medium-size firms into strong,
well-coordinated supply bases for exports by providing them with finan-
cial loans, managerial and technical assistance, market information, and
steady supplies of imported raw materials. They are also instrumental in
industrial restructuring and development of new industries in response to
the changing overseas demand (Kohama and Yamazawa 1982).
The unique relationship between the Japanese GTCs and small and me-
dium producers can be characterized as follows:
1. Financing for small and medium-size export industries in Japan is
channeled mainly through the GTCs; the banking institutions are not di-
rectly involved. The GTCs are in an excellent position to assess the finan-
cial needs, credit-worthiness, and profit potential of the export industries
because of their close working relationship (Yamazawa 1979).
2. Because Japanese GTCs are not directly engaged in manufacturing,
they do not compete with small and medium producers and, therefore, take
a neutral attitude toward all producers. Furthermore, the small and me-
dium producers have no reason to fear being taken over by GICs. There-
fore, their own long-run interests coincide with the demands made by the
GTCs for managerial improvement and product development (C. Y. Lee
1984).
The relationship between GTCs and small and medium export producers
in Korea is not as complementary as the Japanese case, mainly for the fol-
lowing reasons:
1. Because under Korea's export incentive system all exporters, includ-
ing the GICs, have access to export financing and other benefits from the
government, the GTCs are partly in competition with small and medium
export producers for the same source of government support.
2. Because the GTCs are engaged in many areas of export processing,
they are in direct competition with small and medium export producers.
To the extent of overlapping activities and competition, the potential for
systematic coordination between the two is weakened.
3. Mutual trust in the business community in Korea is not yet strong
enough to bring about a stable and well-coordinated relationship between
the large and the small firms.
Whereas Japanese GICs have been dealing with relatively capital- and
technology-intensive products and are rapidly shifting emphasis toward
higher quality, more expensive consumer durables and producer goods,
Korean GTCs are still dealing with unskilled and semiskilled labor-intensive,
low-priced products. Japan is competing in the international markets on
the basis of quality and technology, whereas Korea is competing on the
basis of quantity and low unit price. Accordingly, Korean GTCs tend to put
emphasis on mass production and mass distribution to reduce unit costs.
 Promotion Measures for General Trading Companies (1975) 523

Export marketing strategy, therefore, tends to differ between the two coun-
tries’ GTCs.

CRITICISMS AND LESSONS

There is no doubt that the formation and growth of GTCs in Korea have
made a great contribution to the quantitative expansion of Korea's indus-
trial exports. They have been particularly instrumental in increasing the
share of HCI exports. Although the quantitative expansion has been at-
tained, quality improvement and product and regional diversification of
exports have left much to be desired.
Export marketing activities have been improved through the expansion
of the GTCs’ overseas branch offices; the market information scanning func-
tion of these offices has been strengthened and a large pool of marketing
personnel with international expertise has been created.
The performance of the GTCs as the specialized trade agents for export
producers has produced somewhat mixed results, mainly because of the
dual nature of the GTCs as both exporters and producers. The GTCs as
producers have been in competition with other exporters and have created
conflicts of interest and mutual distrust between the two groups.
The government's encouragement of scale expansion of the GTCs has
resulted in mergers and takeovers of export producers and excessive com-
petition among GTCs, as well as between the GTCs and export producers.
This phenomenon has resulted in excessive concentration of economic and
market power of large business groups, leading to socio-political tension.
Too much emphasis placed on efficiency through scale economies by a small
number of large business groups in export and production has resulted in
too little attention paid to economic equity and social justice.
Because both the GTCs and other exporters have been competing for
export incentives, the social cost of the unbalanced allocation of loanable
funds in favor of the GTCs and the manufacturing sector and tax revenue
losses due to exemptions have been excessive.

Criticisms
The main fault with the government's policy of promoting the formation
and growth of GICs lies in its strategy of economic development via ex-
port growth that emphasizes the expansion of a few conglomerates in the
name of efficiency at the expense of economic equity and social justice.
When a small number of large business groups dominate industry, their
GTCs cannot be expected to be neutral in promoting the exports of other
export producers. The GTCs are primarily export windows for the “depart-
ment store-type” operations of their own groups, and as export processors
tend to suppress rather than assist other export producers. The separation
between exporting and producing is an essential precondition if GICs are
expected to equitably serve all exporters. Such a separation of functions
524 Sung-Hwan Jo

is unlikely to take place unless the concentrated economic power in the

hands of a small number of large business groups is broken up and their
ownership widely dispersed through a rather radical policy shift.
The near total dependence of the GTCs on export trade and their lack
of a domestic trade base is one of the main sources of the instability in the
GICs’ earnings and profits. Their profit position is vulnerable to fluctua-
tions in international markets, and their risks associated with the export
of heavy industrial products are great because exports of these kinds in-
volve long-term trade credit and deferred payments of a large magnitude.
The existence of a reliable domestic market for the GICs would serve as
a cushion in stabilizing earnings.
The government's preoccupation with the attainment of the quantity tar-
get of exports assigned to the GICs has produced many undesirable side
effects: (1) the purchase at a premium by the GTCs of the export records
amassed by small and medium export producers; (2) a short-run quantity
maximization of exports at the expense of long-run profits; (3) deteriora-
tion in the quality of exported goods; and (4) excessive competition among
the GTCs in overseas export markets.
Although they are expanding and diversifying exports, the GTCs are still
weak in import markets. A strong position in the import markets would
be a potential source of earnings for GTCs, ultimately reducing the unit
cost of Korea's exports, which depend on imports of raw materials, compo-
nents, and equipment.
Lessons
There is a limit to what the government can do in export promotion. The
government cannot just impose an institution like the GTCs by decree and
incentive schemes to promote industrial exports. Judging from the relative
performance of Korea's GTCs in recent years, it can be said that Korean ex-
porters’ networks of overseas branch offices and their marketing activities
would have evolved to the same extent even without an explicit govern-
ment push for creating the GTCs while maintaining the existing general
export incentive schemes.
If a small number of large business groups are increasingly predominant
in almost all industries and are competing with a large number of small-
scale producers in many areas, the GTC of a particular business group will
become merely the “super” export department (or the export window) of
all the subsidiaries of that particular group. It would tend, therefore, to com-
pete with, rather than to complement, the small and medium export
producers. In other words, the GTCs cannot become neutral and honest
brokers of exports for other producers and therefore cannot line up small
and medium industries under them for well-coordinated export promotion
because of conflicts of interest, fear of takeovers and mergers, and a gen-
eral feeling of mutual distrust. In short, the extreme concentration of
 Promotion Measures for General Trading Companies (1975) 525

manufacturing and economic power that currently exists in Korea—centered

in the very companies that have been designated as GTCs—precludes the
sound development of GTCs as impartial specialized exporters, along the
lines of the Japanese GTCs.
The stability of the profit earnings and viability of the GTCs requires a
strong base in domestic- and import-market transactions, in addition to ex-
port expansion and diversification. The diversification of sources of earn-
ings in export, import, and domestic trade is a condition for survival and
sound growth of the GTCs.
If economic and business conditions are not ripe for the sound develop-
ment of the GTCs as specialized exporters and importers, a less ambitious
but more sensible alternative to GTCs would be the development of an
export-import trading agency out of a group of export producers, large and
small, operating in the same industry, or in a group of related industries.
Such an agency, acting as an industry-wide association of export producers,
would specialize in trading functions and would thus act as manufacturers’
representatives in both export and import markets.
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 20 Promotion Measures for
Construction Service Exports to the
Middle East (1975)
by Chung Hoon Lee

One of Korea's outstanding economic achievements during the past three

decades is the phenomenal growth in exports of construction services to
the Middle East. Although Korea has been exporting construction services
since 1965, only since 1973 have they been exported to the Middle East.
That year Sam Hwan Corporation obtained a contract from Saudi Arabia
to build a highway for $24,059,000. After 1975 the value and number of over-
seas construction contracts obtained by Korean companies from the Mid-
dle East grew rapidly, reaching a figure in excess of $12 billion and involving
72 contracts in 1981. Over the eight-year period from 197 through 1981,
Korea obtained construction contracts from Middle East countries worth
approximately $41 billion—94.4 percent of the country’s total overseas con-
struction service exports during the period. Given the modest beginning
of $24 million in 1973, which accounted for only 5.7 percent of total over-
seas construction service exports for the 1965-73 period, the $41 billion at-
tests to the accomplishment achieved by the Korean construction industry
in only eight years (Table 20.1).
What were the effects on the Korean economy of these overseas con-
struction service exports? The exports brought in scarce foreign exchange—
directly through the remittance of wages and profits, and indirectly through
the export of machinery, equipment, and materials related to overseas con-
struction projects. The increase in foreign exchange earnings in turn in-
creased the domestic money supply, which, along with the increase in
national income, had a multitude of effects on the domestic economy. To
determine how important these effects were requires building a fully speci-
fied, general equilibrium model of the economy, but such a task is beyond
the scope of this chapter.
It is possible, however, to gain a sense of the importance of construction
service exports by comparing them with merchandise exports. For the nine-
year period from 1965 through 1973, the value of merchandise exports was
approximately $8.6 billion whereas the value of construction service exports
to the Middle East was only about $24 million, a mere 0.3 percent of mer-
chandise exports. For the eight-year period from 19/4 through 1981, however,
the value of construction service exports to the Middle East increased to
44 percent of the value of merchandise exports, which had risen to $94

527
528 | Chung Hoon Lee

Table 20.1. Exports of overseas construction services (10? US $)

Destination
Year Middle East Southeast Asia All others Total

1965-73 24,059 300,363 98,288 422,710

(5.7) (71.1) (23.3) (100.0)
1974 88,813 145,048 26,711 260,572
1975 751,210 42,513 20,973 814,696
1976 2,429,112 34,631 37,996 2,501,739
1977 3,387,000 119,273 9,963 3,516,236
1978 7,982,393 91,041 71,588 8,145,022
1979 5,958,383 378,010 14,943 6,351,336
1980 7,819,404 408,996 30,974 8,259,374
1981 12,670,601 838,200 172,203 13,681,004
1974-81 41,086,916 2,057,712 385,351 43,529,979
(94.4) (4.7) (0.9) (100.0)
1965-81 41,110,975 2,358,075 483,639 43,952,689
(93.5) (5.4) (1.1) (100.0)

Source: Adapted from Overseas Construction Association of Korea (1984: tables 1-7 and 1-9).
Note: Percentages are shown in parentheses.
a. In terms of the value of contracts.

billion. Construction service exports had become a major component of

Korea's external trade.
While there are numerous issues of interest relating to overseas construc-
tion service exports, the main focus of this chapter will be on the policy
measures that the Korean government took to promote these exports. In
December 1975 the government established the Overseas Construction Pro-
motion Act and thereby began taking active measures to promote construc-
tion service exports. How effective were the measures? What effects did
they have on the Korean economy? These are some of the questions that
I will attempt to answer in this chapter.

BACKGROUND
Excess Capacity for the Export of Construction Services!
By the early 1970s the Korean construction industry, which had reached
the international standard in terms of technology and management know-
how, was suffering from excess capacity. It was, therefore, more than ready

1. The discussion of the history of the Korean construction industry is based on Overseas
Construction Association of Korea (1984).
 Promotion Measures for Construction Service Exports 529

to seize the opportunity when some of the OPEC countries began spend-
ing part of their huge oil revenues on construction projects. How then did
the construction industry of Korea, a country in the process of industrial-
ization, acquire technology and management know-how on a par with the
international standard? And what is the reason for its excess capacity in
the early 1970s?
At the time of liberation from Japanese colonialism in 1945, the Korean
construction industry consisted of only two firms. However, the industry
grew rapidly during the Korean War owing to the demand for construction
of military facilities by the United States Army. Thereafter, the construc-
tion industry continued to expand as the Korean government gave priority
to the reconstruction of infrastructure and factories that had been destroyed
during the war. In 1957 the industry entered a new stage when the U.S.
government started building up its military strength in Korea, and the U.S.
Army thus placed orders for large-scale construction projects.
As the U.S. Army contracted with Korean companies to build harbor fa-
cilities, airfields, roads, bridges, barracks, warehouses, and fortifications,
the number of construction companies increased to 1,700 by the end of the
1950s. These were the kinds of projects that many of the Korean compa-
nies would not have had the experience of building if the U.S. Army had
not been in Korea. By undertaking these construction projects, they acquired
the experience of handling large projects, which they could later utilize in
the Middle East.
Doing business with the U.S. Army meant that Korean construction com-
panies had to draw blueprints and write contracts in English in the man-
ner acceptable to the U.S. Army. By being forced to carry out business at
the level practiced in an advanced industrialized country, these companies
acquired an advanced level of technology and management know-how. This
type of technology transfer occurs in a country when an external military
force from a technologically more advanced country is present? Another
requirement for doing business with the U.S. Army was that Korean com-
panies had to use imported heavy machinery and equipment. The use of
this sophisticated equipment must certainly have resulted in a capital-labor
ratio inappropriate to the factor prices prevailing in Korea. However, when
these companies went abroad to carry out massive construction projects,
they were already experienced in the use of sophisticated machinery and
equipment.
There are two other factors, in addition to the experience of doing busi-
ness with the U.S. Army in Korea, that contributed to the modernization
of the construction industry. One is the construction experience gained in

2. Spencer (1965) found that the Japanese acquired technology from the U.S. Army stationed
in Japan. He found the same process, albeit less strong, operating in Korea.
530 Chung Hoon Lee

Vietnam during the second half of the 1960s when Korean companies un-
dertook construction projects for both the U.S. Army and the Korean Army.
The other contributing factor is that, beginning in 1962, Korea launched
its program to industrialize the economy and began building highways,
refineries, cement factories, fertilizer plants, high-rise housing complexes,
and a subway system. Many of these massive projects were financed by
international development organizations ($115.6 million during the 1961-66
period and $810.8 million during the 1967-71 period). As a condition of the
loans, the lending organizations imposed a much higher standard on the
construction projects than that normally practiced in Korea. As a result
Korean companies involved in these projects had to improve their technol-
ogy and management know-how for all phases of construction.
By the early 1970s the construction industry had thus acquired advanced
technology and management know-how and had gained experience in car-
rying out massive construction projects in foreign countries using sophisti-
cated machinery and equipment; that is, it had accumulated both the human
and nonhuman capital necessary for undertaking overseas construction
projects. Furthermore, the industry found itself in the early 1970s with ex-
cess capacity in both human and nonhuman capital.
By the end of the Second Five-Year Economic Development Plan (1967-71),
the initial phase of Korea’s industrialization had ended, and much of the
basic infrastructure (social overhead capital) had been built. During the
1970-4 period, fixed capital formation (excluding transport equipment,
machinery, and other equipment) grew at an average annual rate of only
6 percent in contrast with 30 percent during the 1964-69 period
(Table 20.2).
Furthermore, Korea began the withdrawal of its troops from Vietnam in
December 1971, thus bringing an end to war-related construction projects
in Vietnam. Although Korean firms had undertaken some construction
projects in countries other than Korea and Vietnam (Hyundai Construc-
tion Company had a contract to build a highway in Thailand in 1965), the
impetus to search for new markets for construction services came with the
shrinking of opportunities at home and in Vietnam in the early 1970s.
The First Oil Crisis and the Demand
for Overseas Construction Services
The first oil crisis of 1973 brought huge increases in oil revenues for the
oil-producing Middle East countries. Intent on economic development but
lacking in necessary human resources, these countries had to rely on for-
eign companies and workers to build their physical capital. Starting in 1974
there was a tremendous increase in the demand for construction services
in the Middle East. Korean firms, well-equipped with modern technology
and management know-how and suffering from excess capacity, were ready
to seize the opportunity.
 Promotion Measures for Construction Service Exports 531

Table 20.2. Gross domestic capital formation and its rate of growth

Gross domestic capital formation

at 1970 constant prices Rate of growth
Year (10° won) (%)
1964 109.35
1965 139.10 27
1966 174.63 26
1967 204.95 17
1968 295:79 44
1969 396.82 34
1970 416.57 5
1971 406.91 =A
1972 386.98 -5
1973 505.19 31
1974 514.99 2
Source: BOK, Economic Statistics Yearbook (1977: table 141).
Note: The figures in the table refer only to gross domestic capital formation in dwellings,
nonresidential buildings, and other construction and works, excluding transport equipment,
machinery, and other equipment.

An effect of the oil crisis, seen from Korea's point of view, was a drastic
change in the composition of demand for its exports. The oil crisis brought
about a transfer of income primarily from the industrialized countries to
the OPEC countries. Korea’s exports to the former had been mostly labor-
intensive manufactured products, and the income transfer and the world
recession subsequent to the oil crisis dampened the growth of Korea's mer-
chandise exports to these countries. The income transfer, however, led to
an increase in the demand for construction services, which are labor-
intensive, in the oil-rich Middle East countries. Many developing countries
could not adjust to the changing composition in their external demand—
from commodities and manufactured products to construction services—
but Korea, for the reasons mentioned above, was in a position to respond
readily to the changing external demand.
The Middle East war of October 1973 and the attendant oil crisis brought
home to Korea its extreme vulnerability to external developments. The to-
tal cost of petroleum imports alone rose from $313 million in 1973 to $1,055
million in 1975. The oil price increases caused a 19 percent deterioration
in Korea's net barter terms of trade in 1974 and during 1975 it deteriorated
by a further 10 percent. The related deep recession in the United States
and Japan, Korea's major trade partners, caused a sharp 3 percent decline
in the real export growth rate in 1974. The current account deficit, which
had declined from $848 million in 1971 to $31 million in 1973, shot up to
532 Chung Hoon Lee

a staggering figure of about $2 billion in 1974 and 1975. Under these cir-
cumstances, the Korean government saw salvation for the economy in the
export of construction services to the Middle East.
Since 1975 the Korean government has taken various measures to pro-
mote the “advance to the Middle East.” Here we have classified these meas-
ures into three categories: legislative, administrative and diplomatic, and
other supportive measures. (For a more detailed discussion of the policy
measures, see H. J. Kim 1982.)

MAIN FEATURES OF THE POLICY MEASURES

Legislative Measures
The Overseas Construction Promotion Act was promulgated in December
1975, exactly two years after the contract for the first construction project
in the Middle East was signed by a Korean company. Since then it has been
amended three times. The stated objective of the act is to support and
manage the export of construction services and thereby strengthen the in-
ternational competitiveness of the Korean construction industry. It speci-
fies the administrative requirements for licenses and permits, and describes
measures for promoting the export of construction services.
The act requires that a construction company be licensed by the Minis-
try of Construction (MOC) before it may engage in overseas construction
business. The stated purposes of the requirement are to enhance the profes-
sionalism of the construction industry, thereby improving its level of tech-
nical competence, and to strengthen the international competitiveness of
the industry by granting licenses only to those firms meeting the neces-
sary standards.
The act also requires that a licensed company obtain from the MOC a
permit to bid for a construction project. This is to prevent disorderly com-
petition among Korean companies for the same construction project, but
it has in fact given the MOC the authority to ration the right to make bids
for construction projects.
In the name of strengthening the international competitiveness of the
construction industry, the act empowers the minister of the MOC to en-
courage formation of joint ventures among Korean companies when war-
ranted by the size of a project. The minister may also restrict some firms
to the status of subcontracting. Such subcontracting is to be made only with
Korean companies that have obtained overseas construction contracts. The
purpose is again to reduce the number of Korean companies bidding for
the same project. For the same purpose, the minister may also designate
the countries or regions in which certain companies can compete.
 Promotion Measures for Construction Service Exports 533

Institutional Reforms
Until 1973 Korea had had little contact with and was largely ignorant about
the Middle East. To remedy that situation, the government created in Janu-
ary 1976 the Institute of Middle East Affairs as an information and guidance
center concerned with the study of markets in the Middle East. The insti-
tute played an active role in gathering and compiling political, diplomatic,
and economic information on the countries in the region, analyzing and
evaluating that data, and distributing the results of its analyses, fact find-
ing, and projections to interested government agencies and business firms.
As the institute successfully carried out its mission, it expanded the scope
of its functions to other regions of the world and in January 1977 became
the Korean International Economic Institute.
Another institution established by the government in January 1976 was
the Commission on Middle East Economic Cooperation. The commission,
which is composed of the prime minister and several ministers, is the
highest policymaking body in the government on matters relating to the
export of construction services to the Middle East. To support the commis-
sion’s work and to implement its decisions, a standing working committee
chaired by the vice minister of the Economic Planning Board (EPB) was also
established. In February 1976 the Office of Middle East Economic Cooper-
ation was created within the EPB, and the offices dealing with overseas
construction service exports in the MOC were expanded. The establish-
ment of new commissions and offices and the expansion of existing offices
were made for the purpose of formulating policies, coordinating the func-
tions of various government agencies, and streamlining administrative
procedures.
To strengthen its relationship with Middle East countries, the govern-
ment created many channels for diplomatic exchange. It established bilateral
economic cooperation commissions with Saudi Arabia and Iran. It also be-
gan exchanging ambassadors with many countries in the region, increas-
ing the number of embassies in the region from five in 1975 to 12 in 1981.

Other Supportive Measures

To promote construction service exports, the government has provided var-
ious forms of assistance to companies engaged in overseas construction
projects. One form of assistance is the provision of bond services by
government-controlled banks. Once an overseas construction project
receives a contract permit from the government, a commercial bank is ob-
liged, according to the Overseas Construction Promotion Act of 31 Decem-
ber 1975, to issue a financial guarantee on behalf of the company against
performance default to the foreign contractee. However, as construction
projects grew larger and larger in scale, Korean commercial banks became
534 Chung Hoon Lee

hesitant to post bonding (e.g., bid bonds, performance bonds, advanced

payment bonds) for overseas construction projects worth more than $50
million. Accordingly, on 3 December 1976, the Deliberation Council of Eco-
nomic Ministers decided to enforce a system of joint guarantees among com-
mercial banks. On 30 December 1977, the bank law was revised to increase
the limit of guarantees to up to 20 times of a bank's equity capital. This
limit, however, can be increased by a resolution of the Monetary Board.
Because the export of construction services has been mostly to the Mid-
dle East and other developing countries, there are risks of loss resulting
from foreign exchange control, war, or abrogation of contracts. To reduce
this risk the government provides insurance on such losses, thus encourag-
ing the export of construction services to these countries.
A more direct subsidy to construction service exports is provided in the
form of a lower tax rate. In December 1975 the corporate income tax on
income earned from overseas construction service exports was reduced by
50 percent. This subsidy, however, was reduced in 1982 by a government
measure, which exempts from tax only 2 percent of the foreign exchange
thus earned.
While subsidizing overseas construction service exports with these and
other supportive measures, the government also has taken measures to con-
trol certain financial practices of the construction companies. One meas-
ure, which has had a significant effect on Korea's money supply and on
macroeconomic stability, is the requirement that 80 percent of employees’
wages, denominated in dollars, be paid in Korea and that the companies
may keep only up to 3 percent of its foreign exchange earnings on site, the
rest being remitted within 30 days. As will be discussed later, this require-
ment led to a significant improvement in official foreign exchange holdings
but at the same time had various ill effects on the economy.

THEORETICAL APPROPRIATENESS
As discussed in the preceding section, the government has taken various
measures to promote construction service exports since 1975. A question
that follows, then, is how appropriate were these measures to the objec-
tives of the government. We need to consider two sets of objectives. One
is the explicit, proximate objective of expanding overseas construction ser-
vice exports, and the other, implicit but ultimate, involves macroeconomic
objectives such as reducing the balance-of-payments deficit, increasing na-
tional income, reducing unemployment, maintaining economic stability, and
bringing about an equitable distribution of income. Therefore, discussion
of the theoretical appropriateness of the policy measures must be under-
taken with the criteria of the two sets of objectives.
In analyzing the theoretical appropriateness of the measures, we will
look into only the theoretical appropriateness in the sense that if the meas-
ures had any effect it would be as intended. It is possible that, although
 Promotion Measures for Construction Service Exports 535

qualitatively correct, the measures may have had no significant quantita-

tive effect.

Appropriateness to Promoting Construction Service Exports

Although the Overseas Construction Promotion Act was designed to pro-
mote the export of construction services, its immediate effect was to im-
pose regulation over the construction industry with its system of licenses
and permits. A question to be asked, therefore, is how is it possible to pro-
mote the exports by controlling which companies can bid for contracts.
By granting licenses only to those companies that are “qualified,” the
government has assumed the role of screening the qualified from the un-
qualified bidders, which otherwise would have been undertaken by the
party offering the contract. If the latter trusts the “seal of approval” of the
Korean government, it would save the cost of screening. The cost of screen-
ing construction services is high because information on the performance
of a particular construction company is obtained by the potential buyer of
the service through the experience of using it. That is, construction ser-
vices are analogous to what are called “experience goods” for which the
brand name or reputation is important in conveying information on their
characteristics? Thus, in competition with companies such as Bechtel of the
United States, Korean companies would have had a disadvantage without
the government's seal of approval. Of course, a license is only as good as
the credibility of the licensor.
Another reason licensing may possibly increase exports of construction
services is the external effect. Within Korea the failure of one construction
company to complete its project under the contract will not adversely af-
fect the entire construction services. Buyers of construction services would
have no alternative to using domestic construction companies because of
the high barriers to entry by foreign construction companies.
In the world market for construction services, however, the adverse ef-
fect of a Korean firm’s failure to perform under a contract will not be con-
fined to the firm itself. The credibility of the entire Korean construction
industry may be damaged by the action of that one company. In the world
of imperfect information, stereotyping is a way of economizing on infor-
mation costs, and the government may be justified in attempting to main-
tain a good “image” for the Korean construction industry abroad. It should
be added, however, that with the accumulation of experience in using
Korean firms the buyers of construction services would acquire informa-
tion on the qualifications of individual Korean firms and thus would be
less swayed by stereotype information. Thus, the argument in favor of li-
censing because it reduces the buyers’ screening costs and because of the

3. See Nelson (1974) for the difference in informational characteristics between “experience
goods” and “search goods.”
536 Chung Hoon Lee

external effect seems to be valid only for a short period after Korean firms
began to move to the Middle East.
Finally, by limiting the number of Korean companies bidding for the same
contract, the government has attempted to reduce competition among
Korean companies. Actually, limiting the number makes sense only when
they would be the lowest bidders compared with their foreign competi-
tors. Then, by reducing competition, a Korean company would be getting
the contract at terms more favorable than would be the case if competition
were not abated. For Korea what matters is that a Korean company,
whichever it may be, gets the contract at the most favorable terms. If Korean
companies as a group are not the lowest bidders, then by limiting the num-
ber of potential bidders the government increases the risk of Korea not get-
ting the contract. Thus, unless the government has prior information on
how Korean companies would behave as a group, limiting the number of
companies bidding for a contract may not be in the country’s interest.
The institutional reforms may be regarded as an investment in social over-
head capital, and in that sense they have been productive in promoting
the export of construction services. There are, however, two issues that need
to be addressed. The first is that some of the administrative measures were
productive only because the Korean economy was very much a government-
directed economy. The government intervened extensively in and regulated
the economy. Given the multitude of agencies and bureaus dealing with
the construction industry and overseas construction service exports, ad-
ministrative measures for coordinating the agencies and bureaus became
a necessity. Their coordination for a common objective was probably produc-
tive, but we must ask first of all whether the existence of these agencies
and bureaus could be justified in terms of economic efficiency or even eq-
uity. If the economy had been basically more of a free market economy,
the only measure needed to promote the export of construction services
might have been a subsidy to exporters.
The second issue is whether or not a research institute such as the Insti-
tute of Middle East Affairs should be publicly funded. Because what is be-
ing produced by the institute is in the nature of a public good, the
government's action can be justified in terms of efficient allocation of
resources. There is, however, the question of whether the research carried
out at the institute is relevant to the promotion of exports. The implicit as-
sumption in the argument for the public provision of a public good is that
it is a good and not a “nongood.” The fact, however, is that the output of
such a research institute may not be useful to construction companies,
although in the opinion of the government it is. Given the possibility that
what is being produced by the institute is a mixed bag of relevant and
irrelevant information, we may argue that an alternative arrangement, a
market solution, may be better. A construction company may produce in-
formation internally or hire a consulting firm to provide the necessary
 Promotion Measures for Construction Service Exports 537

information. This arrangement leads to socially suboptimal production of

information, but it will bring about the production of information that the
construction company would find useful.
The other supportive measures such as bond service, insurance, and
lower tax rates, mentioned in the preceding section are subsidies to the ex-
porters of construction services, and as such they promote exports.
The foreign exchange control measures requiring the payment of 80 per-
cent of wages in Korea and remission of 97 percent of foreign exchange
earnings within 30 days would have a disincentive effect on exports of con-
struction services. If firms and workers were free to place dollars wherever
they wanted and free to bring them to Korea whenever they wanted, they
would have chosen the place and time to maximize their gains from in-
terest arbitrage and exchange rate speculation. By preventing them from
doing so, their income and profit were less than if no exchange control ex-
isted. Obviously, the government wanted to maximize the amount of remit-
tances and prevent capital flight, even at the expense of possibly reduced
exports of construction services.

Appropriateness to Macroeconomic Objectives

Even though the policy measures were theoretically appropriate to the ob-
jective of expanding the export of construction services, were they also
appropriate to macroeconomic objectives such as reducing the balance-of-
payments deficit, increasing national income, reducing unemployment,
maintaining economic stability, and bringing about an equitable distribu-
tion of income? Or to put it differently, could the government achieve all
or at least some of these objectives by promoting the export of construc-
tion services? The answer to this question depends crucially on whether
the economy had an unlimited or a limited supply of labor. Even though
the policy measures were appropriate to an economy with an unlimited
supply of labor, they might have become inappropriate once the economy
no longer had an unlimited supply of labor. Thus, the policy measures,
once appropriate, might have become inappropriate as the underlying con-
dition of the economy changed.
The oil crisis of 1973 was a traumatic experience for Korea, which relies
entirely on imported oil and is heavily dependent on the world market for
the export of its manufactured products. The oil crisis had in fact the effect
of “scissors” on the Korean economy in the sense that it was being squeezed
by the high price of oil on the one hand and the sagging world demand
for its manufactured exports on the other. The looming current account
deficit and the unemployment problem called for some immediate action,
and the government found its answer in the promotion of construction ser-
vice exports to the Middle East.
Given the initial condition of labor surplus and excess capacity in the
construction industry, the expansion of construction service exports had
538 Chung Hoon Lee

all salutary effects on the economy. With unemployed resources in the econ-
omy, the policy measures brought about the foreign trade multiplier effect
on the economy. The current account improved immediately and, of course,
the unemployment rate went down with the export of construction services.
It seems, however, that even before the government took measures in
1975 to promote construction service exports, the private sector had already
responded well to the opportunities in the Middle East. That is, equilibrat-
ing adjustments had been going on in the economy even without govern-
ment measures. Their effects, therefore, were to bring about the recovery
from the effects of the oil crisis and the consequent recession in the world
economy sooner than would have been the case otherwise.
Beginning in the late 1970s, the condition of labor surplus no longer ex-
isted in the Korean economy. In fact Bai (1982) argues that the Korean econ-
omy passed the Lewisian turning point from unlimited to limited labor
supply around 1975. Whatever the exact time of the turning point may have
been, the economy no longer suffered from the problem of surplus labor
in the late 1970s, and in such an economy the effects of the policy meas-
ures cannot be analyzed simply in terms of the foreign trade multiplier ef-
fect. Now the expansion of construction service exports resulting from the
policy measures was made less with unemployed resources and more at
the expense of the tradable and the nontradable goods sectors of the econ-
omy. The question, therefore, becomes why should the government pro-
mote the expansion of one sector—construction service exports—at the
expense of other sectors in the economy?
Two reasons can be suggested as justifications for the government's ac-
tion. One is the argument that the construction industry was in the infant
stage of development and thus could not compete with those of developed
countries without the government's support. The evidence, however, does
not seem to support this argument. As mentioned, some Korean firms were
already doing business abroad and even in the Middle East when the
government began taking measures to promote construction service exports.
These firms did not have the most sophisticated technology and manage-
ment know-how, but what they had was probably quite adequate for con-
struction projects in the Middle East. That is, although they may have been
incapable of undertaking the most technologically sophisticated construc-
tion projects in the world, Korean firms may have had a competitive edge
in the projects being built in the Middle East.
The other reason is the external effect. That is, firms operating abroad
acquire technology they would not at home, and the technology thus ac-
quired becomes diffused among firms in Korea. But, as argued above,
Korean firms already had technology quite adequate for projects in the Mid-
dle East, and it is unlikely that there was any transfer of technology to them
in the Middle East from firms in developed countries.
 Promotion Measures for Construction Service Exports 539

In sum, the policy measures promoting construction service exports were

probably appropriate for a couple of years after 1975 when Korea had a labor-
surplus economy. They became inappropriate, however, when the econ-
omy no longer suffered from surplus labor. By then the overseas con-
struction service sector had already expanded too much and painful
contractionary adjustments had to be made.

FORMULATION AND IMPLEMENTATION PROCESSES

Since its enactment in December 1975, the Overseas Construction Promo-
tion Act has been amended three times. The act is augmented by five
presidential decrees and five MOC administrative rules. How were they
formulated and implemented? What was the interaction, if there was any,
between government and business? These are difficult questions to answer
because the processes of policy formulation and implementation as prac-
ticed in Korea are not open processes observed by and reported to the
public.
In their study of the role of government in Korea’s economic develop-
ment, Jones and SaKong (1980) argue that the executive branch overwhelm-
ingly dominated the formulation and execution of policy. They argue,
furthermore, that President Park was the ultimate power, both in substance
and formality, making major decisions and settling disputes. In an impor-
tant case such as the export of construction services to the Middle East,
there is no reason to expect an exception to the rule.
According to Doe (1984), President Park summoned the heads of the jae-
bul (family-based industrial conglomerates) sometime in 1975 to a meeting
where he personally urged them to look for business opportunities in the
Middle East. He recognized that a potentially huge market for construc-
tion service exports existed in the region and thought that Korea should
exploit the opportunities. One reason for his keen interest in the Middle
East was, according to Doe, that President Park was deeply worried about
the huge current account deficits resulting from the high cost of oil imports.
Doe also says that within the government there was some opposition
by the Ministry of Finance to providing supportive measures for the ex-
port of construction services. The opposition was on the grounds that the
measures would lead to dumping of construction services and weakening
of the financial health of the banks providing bond services. However, be-
cause of the president's strong interest in promoting these exports, the
Ministry of Finance did not prevail. In fact, once President Park’s view on
this matter was known, the export of construction services was said to have
become a sacred cow and no one dared to oppose supporting the exports.
Jones and SaKong (1980) point out that for Korea short-term policy for-
mulation was made quickly without studying problems in depth and
without taking into account all possible ramifications of policy. However,
540 Chung Hoon Lee

they argue that the government monitored the results continuously, ad-
justing policy as necessary to achieve the desired outcome. Such a practice
seemed to have been applied to the Overseas Construction Promotion Act
to a certain extent, as demonstrated by the amendments and new decrees
and rules. An example of the government's ability to monitor and adjust
policy is the institution of the requirement that firms obtain permits to bid
for a contract. According to Doe (1984), it was a practice of Korean firms
to retain local agents to assist them in getting contracts. Competition among
Korean firms for the services of an agent was so keen that certain local rules
governing the relation between principal and agent were violated with the
consequence of imprisonment of certain Korean businessmen. The require-
ment for permits was a result of such cases.
Although Jones and SaKong (1980) argue that the government monitored
the results of policy, making appropriate adjustments when necessary, it
seems that regarding some basic principles—such as the promotion of ex-
ports of construction services and how not to promote them—the govern-
ment did not demonstrate much flexibility and openness. As argued in the
preceding section, the policy measures promoting construction service ex-
ports may have become inappropriate by the late 1970s. There was, however,
no attempt (as far as we are aware of) to terminate the policy measures.
It is difficult to say how much influence the jaebul had on policy formu-
lation. If they had a strong influence, they would have tried to limit the
number of construction companies licensed to go to the Middle East.
Although the government maintains a licensing system, it does not seem
to have used it to erect barriers to entry in favor of the jaebul. At the end
of 1976 there were 73 companies licensed to undertake overseas construc-
tion business. The number then increased to 121 in 1977 and to 132 in 1979.
Of these 132 companies at least 100 were not jaebul. If the family-owned
conglomerates had had strong influence on government policy formula-
tion, it is unlikely that so many non-jaebul companies would have competed
with them in the Middle East.

EFFECTS OF THE POLICY MEASURES

What were the effects of the policy measures? To answer this question, we
first need to know what the economy would have been like in the absence
of the policy measures. Only by comparing this counterfactual economy
with the actual economy can we say what the effects were. To make such
a comparison is a rather formidable task, theoretically and because of data
requirements, and is beyond the scope of this chapter. I will instead carry
out a less rigorous analysis without the aid of a formal model of the econ-
omy. The analysis first involves an investigation of the effects of construc-
tion service exports on the balance of payments, employment, economic
stability, and the structure of the economy. I will then attempt to answer
how the policy measures might have influenced these effects.
 Promotion Measures for Construction Service Exports 541

Effects of Construction Service Exports

Effect on the balance of payments. The importance of construction service
exports in Korea's balance of payments is clearly demonstrated in Table 20.3,
where I compare net receipts from construction service exports with oil im-
ports during 1977-82. Net revenues from construction service exports—
revenues minus on-site purchase expenses for foreign machinery, equip-
ment, and materials and other expenditures made locally—ranged from 24.1
percent of oil imports in 1980 to 46.8 percent in 1978. For the six-year period
total net revenues were equal to 33.1 percent of oil imports, which amounted
to more than $25 billion. What the figures show is that Korea was able to
pay for one-third of its oil imports directly by exporting labor services to
the Middle East. Many other developing countries borrowed externally or
increased their merchandise exports to pay for oil imports. Borrowing

Table 20.3. Effects of construction service exports on the balance of pay-

ments (10° US $)
Item 1977 1978 1979 1980 1981 1982
(1) Net revenue from over-
seas construction
service exports GS ee e024 eel 06mm |SOOM (OOM 207,
(2) Oil imports? PO Gee, | Oe LOO mm) OOOO S/plummn Oy UOT,
(3) [(1)/(2)] (in %) B2 a 46.8 45.0 24.1 27.3 37.0
(4) Exports of machinery,
equipment, and materi-
als related to construc-
tion service exports 452 942 389 498 422 492
(5) Induced imports4
[(4) multiplied by 0.64] 289 603 249 319 270 315
(6) Net exports [(4) - (5)] 163 tert) weed 4c th N179d 152 wee177
(7) Net revenue from ser-
vice and merchandise
exports [(1) + (6)] 781 1,363 ‘1, 536yan 1 534 We 1,890 aq 27434
(8) Percentage of oil im-
ports paid for with net
revenue from service
and merchandise ex-
ports [(7)/(2)] 41 62 50 27 30 40

a. From Overseas Construction Association of Korea (1984: table 4-1).

b. From Overseas Construction Association of Korea (1984: table 4-2).
c. From Overseas Construction Association of Korea (1984: table 4-5).
d. 0.64 is the marginal propensity to import of the merchandise exports related to construc-
tion service exports.
542 Chung Hoon Lee

abroad, of course, simply meant the postponement of the burden of oil

imports, and financing the imports with increased exports of merchandise
meant for some countries a terms-of-trade deterioration, increasing the bur-
den of oil imports. Korea was fortunate in being able to pay for a third of
its oil imports by exporting labor services to the Middle East, where bur-
geoning oil revenues had increased the demand for labor.
The export of construction services led to exports of machinery, equip-
ment, and materials related to overseas construction projects. The export
of construction services also brought about increases in imports, first
through the spending effect of net oil revenues remitted to Korea, and sec-
ond through the linkage effect arising from the export of machinery, equip-
ment, and materials. The latter required the import of raw materials and
intermediate products.
Using an input-output analysis, B. H. Park (1983) estimated the imports
induced by merchandise exports to the Middle East for 1973 through 1980.
His estimates of the ratio of imports to exports range from 62.1 percent to
664 percent with a simple average of 64 percent. If I assume as a first ap-
proximation that this ratio also applies to merchandise exports related to
total overseas construction service exports and not just to those related to
the exports to the Middle East, the value of induced imports during 1977-82
amounts to more than $2 billion (Table 20.3, item (5)). The value of net mer-
chandise exports during 1977-82 resulting from the export of overseas con-
struction services would then be about $1.1 billion (Table 20.3, item (6)),
which indicates that the latter had a positive effect on the balance of trade.
The estimates range from $140 million in 1979 to $339 million in 1978. The
effect of overseas construction service exports on the current account is as
shown in item (7) of Table 20.3.
The figures in item (7) may be regarded as a rough measure of the direct
and indirect effects of construction service exports on the balance of pay-
ments. As an indicator of their importance for the economy, I divided the
figures by the cost of oil imports in item (2). As reported in item (8), the
result ranges from 27 percent in 1980 to 62 percent in 1978, and for the six-
year period the total net revenues from construction service exports paid
for 38 percent of oil imports.
Until recently Korea had a large external debt. In 1982, for instance, its
total outstanding debt was $37.3 billion and debt-service payments (amor-
tization and interest payments) were $5.9 billion. Korea's ability to earn for-
eign exchange to meet debt-service was, therefore, a matter of great
importance. One measure commonly used to evaluate a country’s capacity
to service external debt is the debt-service ratio. This is the proportion of
foreign exchange earnings from merchandise and service exports used to
meet debt-service payments.
As a rough measure of the importance of construction service exports
to the Korean economy, I calculated the debt-service ratio that would have
 Promotion Measures for Construction Service Exports 543

Table 20.4. External debt service

Item ley 1978 1979 1980 1981

(1) Debt service (103 US$) W097 s20982,991.08 937/173.3.004, 233.7 05,6354
(2) Exports of merchandise
and services (10? US$)> 13,073.5 17,160.7 19,530.7 22,577.3 27,504.4
(3) Debt-service ratio
[(1)/(2)] (%) 42 14 16 19 20
(4) Net revenue from
exports of construction
services and related
merchandise (103 US$)° 781 1,363 L536 1,534 1,890
(5) Counterfactual debt-
service ratio
{(1)/[(2) - (4)]} (%) 13 15 18 20 22

a. From I. C. Kim (1983b: table 2).

b. From BOK, Economic Statistics Yearbook (1982: table 122).
c. From Table 20.3.

existed if there were no construction service exports and related merchan-

dise exports, and compared it with the actual debt-service ratio. As shown
in Table 20.4, the actual debt-service ratio was 12 percent in 1977, steadily
increasing to 20 percent in 1981. The counterfactual debt-service ratio is,
however, 13 percent for 1977, increasing to 22 percent in 1981. That is, it
appears that the debt-service ratio would have been 1 to 2 percentage points
higher if there were no construction service and related merchandise ex-
ports. A debt-service ratio exceeding 20 percent is regarded as undesirable;
without construction service exports, Korea would have reached that point
in 19814
Effect on employment and the real wage rate. The export of construction
services had direct and indirect effects on employment. Workers were sent
overseas on construction projects, and they numbered up to 171,170 in 1982.
Employment opportunities also were created in industries manufacturing
machinery, equipment, and materials exported to construction projects
abroad. The estimated induced employment effect increased from 30,000
jobs in 1977 to 132,000 in 1982 (Table 20.5, item (2)). Adding the number
of workers thus employed in domestic industries to the number of workers

4. See J. Lee (1983) for a discussion of various debt indicators. Obviously, for Table 20.4 I made
the assumption that external debt would have been the same whether or not Korea had ex-
ported construction services. This is a rather extreme assumption and the figures on the table
should be viewed as a benchmark for comparison.
544
Oe
ae ee
Chung Hoon Lee

Table 20.5. Effect of construction service exports on employment

oh ee

1978 1979 1980 1981 1982

Item See
oO ea)1977 Oe Oe ee
(1) Workers employed
in overseas con-
struction projects 45,725 84,964 105,696 131,137 163,088 171,170
(2) Induced
employment?# 30,000 114,000 99,000 102,000 125,000 132,000
(3) (1) + (2)] 75,725 198,964 204,696 233,137 288,088 303,170
(4) Total labor force
(103) 13,440 13,932 14,206 14,454 14,710 15,080
(5) [(3)/(4)] (%) 0.6 1.4 1.4 1.6 2.0 2.0
(6) Unemployment
rate (%) 3.8 Oe 3.8 5.2 4.5 4.4
(7) Change in real
wage rate (%) vel iv 10.1 4.5 -3.4 u
Source: Adapted from Overseas Construction Association of Korea (1984: table 4-6).
a. Workers employed in the manufacture of merchandise exported to overseas construction
projects.
b. From R. Y. Park (1983: table 7).
u—unavailable.

sent abroad provides the total effect on employment of the export of con-
struction services. This total employment effect constituted 0.6 percent of
the total labor force in 1977 and increased to 2.0 percent in 1982.
The employment-creating effect of construction service exports shown
in Table 20.5 is based on the highly unlikely assumption that those em-
ployed in overseas construction projects and in the related industries at
home would have been unemployed otherwise. The other extreme assump-
tion is that the employment created by the export of construction services
was entirely at the expense of employment in other sectors of the econ-
omy. The truth probably lies somewhere between these two extreme cases.
It is likely that the magnitude of the employment-creating effect de-
pended on the general state of the economy. As shown in Table 20.5, the
real wage rate increased significantly in 1977, 1978, and 1979 but decreased
by 4.5 percent in 1980 and by 3.4 percent in 1981. It seems reasonable to
conclude then that during the years when the real wage rate was increas-
ing, the overseas demand for labor was competing with the domestic de-
mand for labor, and consequently there was some “crowding-out” effect
on the labor market. It is, however, unlikely that overseas demand for labor
was competing with domestic demand in 1980 and 1981 when the real wage
rate was in fact falling in absolute terms. In those years there probably was
 Promotion Measures for Construction Service Exports 545

no crowding-out effect and the figures shown in item (3) of Table 20.5 may
be net additions to employment. In terms of the unemployment rate, then,
one could argue that for 1977, 1978, and 1979 the unemployment rate without
construction service exports might have been slightly higher than those
shown in item (5); but for 1980 and 1981 it would have been more like 6.8
percent (5.2 percent + 1.6 percent) and 6.5 percent (4.5 percent + 2.0 per-
cent), respectively. For these years the Middle East may be said to have
served as a residual market for Korea's unemployed labor.
Effect on economic stability. One of the charges made against construction
companies in the popular press is that they have invested huge profits
earned from overseas construction projects in real estate, thus starting and
fueling speculation in the real estate market. These companies also took
over other established companies.
The proximate cause for real estate acquisition and the takeover of other
companies is no doubt the profits earned from the overseas construction
projects. Another source of funds was advance payments on contracts,
which until recently amounted to 20 percent of the contract value. The ar-
gument that construction companies are responsible for the speculation,
however, misses the point. The fact that they had funds to invest in real
estate does not mean that they would have done so if other opportunities
for investment existed. They had limited choices imposed by the govern-
ment, and the blame for real estate speculation and other adverse effects
must be laid on the government. There are several reasons for assigning
the blame to the government.
First, the government has required that construction companies remit
all but 3 percent of their foreign exchange receipts to Korea. Once remit-
ted, they were converted into won, thus increasing the funds available for
investment or speculation. Because some of the foreign exchange receipts
were advance payments, which were eventually spent abroad as well as
at home as the construction projects proceeded, they could have been al-
lowed to be kept abroad. Profits earned by the companies also could have
been invested in foreign assets instead of being brought back as foreign
exchange earnings. Thus, if there were less restrictive exchange control,
some of the foreign exchange receipts would have been kept abroad and
consequently less would have been converted into won for domestic
circulation—official foreign exchange reserves would have been less and pri-
vate foreign capital outflow would have been larger. Given the alleged ob-
sessive, daily concern shown over the amount of foreign exchange reserves
by President Park after the first oil crisis, it is doubtful if anyone could then
have persuaded the government to relax exchange control. In any case,
according to B. H. Park’s (1983) estimate, the money supply attributable
to the exports to the Middle East increased at an average annual rate of
343 percent during the 1971-80 period, whereas the total money supply
increased at an average annual rate of 28.4 percent. It seems that, given
the record of real estate speculation, the government failed to ask what the
companies were going to do with these large sums of money, which were
increasing at a rapid rate.
Second, the government controlled interest rates on deposits at finan-
cial institutions and kept them artificially low> Time or savings deposits
could not, therefore, compete with real estate for funds from the Middle
East.
Another problem with the repressed financial system was that the
government could not use standard sterilization policy to offset the increase
in money supply resulting from foreign exchange earnings remitted from
the Middle East. If the government could sell bonds in the open market
to offset the increase in money supply, the construction companies and the
public would have had less liquid government bonds instead of money.
But the sale of bonds would have increased interest rates, which the govern-
ment controlled.
Even though a sterilization policy could not have been pursued in such
a setting, the government could have allowed the construction companies
to purchase nontransferable, long-term bonds from the central bank, prefer-
ably with staggered maturity. This would have prevented the sudden in-
crease in money supply and would have been less onerous than outright
taxation. This scheme should have been applied only to profits and not
to advance payments, which the companies should have been free to place
at home or abroad.
Third, as discussed before, remittance of 80 percent of wage payments
was required. Workers and their families would not have found time or
savings deposits any more attractive than did the construction companies.
Furthermore, the income elasticity of demand for houses was high for peo-
ple who did not own homes.
While the demand for houses increased at a rapid rate, their supply could
not respond as rapidly. The factors of production required for construction
were the factors that had been and were being exported to the Middle East.
With the increasing demand for houses but with the lagging supply of
houses, prices of houses inevitably had to rise.
Given the regime of financial repression, the government should have
sold housing bonds to the workers and their families with five- to ten-year
maturities. The government should have been able to predict that the Mid-
dle East construction boom could not go on forever. The companies and
their workers would have to come back home sooner or later, and they
would have been the resources that could be used to build houses. In other
words, the demand for houses could have been postponed with the issue

5. For a thorough discussion of Korea’s financial system and policies, see Cole and Park (1983).
 Promotion Measures for Construction Service Exports 547

of housing bonds until the supply could meet the demand at prices that
would not start housing speculation.
Another cause for instability is the requirement that workers be paid in
the amount specified in terms of the U.S. dollar. Table 20.6 reports the in-
dex wage payments, both in the won and the dollar. Beginning with 100
in 1976, the wage payment reached an index of 145.9 in dollars in 1982. That
is, in Six years wage payments increased by 45.9 percent, measured in terms
of dollars. But the payment, when remitted and converted into won, in-
creased by 116.5 percent during the same period. The difference is due to
the won devaluations in 1980, 1981, and 1982. Therefore, the workers gained
from current devaluation in those three years. The money supply increased
further, and the increase in their nominal wage rate could not have had
a stabilizing effect on the domestic wage rate.
Effect on the structure of the economy. The problems that the Korean econ-
omy has had in adjusting to the inflow of earnings from the Middle East
are similar to those experienced by countries that have the “Dutch disease”
or “booming sector” economic problem (Corden 1982). It refers to the ad-
verse effect on traditional manufacturing industries of an oil or gas field
discovery. The discovery leads to a higher real exchange rate than other-
wise and, as a consequence, resources move out of the traditional manufac-
turing sector and its exports decline.
In Korea there was no discovery of an oil or gas field but instead the
discovery of a booming market for labor services. Thus resources moved
abroad instead of moving to a booming sector within the economy, but still

Table 20.6. Wage index of production workers employed by Korean over-

seas construction companies*

Year U.S. dollar index Won index?

1976 100 100
1977 120 120
1978 132 132
1979 141 141
1980 145 173
1981 146 203
1982 146 217

Source: Adapted from R. Y. Park (1983: table 8).

a. Basic pay plus fringe benefits.
b. Exchange rates:
1976-79: $1 = 485 won
March 1980: $1 = 580 won
March 1981: $1 = 674 won
March 1982: $1 = 720 won
548 Chung Hoon Lee

moved away from the tradable goods sector (mostly manufacturing) and
the nontradable goods sector (such as housing).
There was a further shift of resources out of the tradable goods sector.
With the income remitted from the Middle East and with a positive income
elasticity of demand for nontradable goods, there was an excess demand
for them at constant prices. Their prices thus rose relative to the prices of
tradable goods, which were largely determined in the rest of the world.
This increase in the relative price of nontradable goods shifted resources
away from the tradable goods sector to the nontradable goods sector (C.
H. Lee 1986).
To demonstrate empirically how much relative contraction the tradable
goods sector has experienced is a difficult task requiring a counterfactual
model of the Korean economy. However, a crude measure of the relative
contraction may be seen by comparing the 1972-78 period, when merchan-
dise exports in Korea grew at an average annual rate of 43.4 percent, with
the 1979-81 period when they grew by only 17.6 percent (IMF 1983). Dur-
ing the latter period, Taiwan’s exports grew at an average annual rate of
20.8 percent (Director of Intelligence, U.S., 1983). Although there may be
other reasons for the higher growth rate of Taiwan's exports, the higher rate
is consistent with the hypothesis that Taiwan’s tradable goods sector did
not experience a relative contraction because Taiwan did not export con-
struction services.

Effects of the Policy Measures

What were the effects of the policy measures promoting construction ser-
vice exports on the balance of payments, employment and the real wage
rate, economic stability, and the structure of the economy? To the extent
that the measures were successful in promoting exports of construction ser-
vices, the effects on the economy discussed previously were greater than
they would have been in the absence of the measures.
By bringing about an overexpansion of construction service exports, the
government hurt the export of manufactured products and fueled a specula-
tive boom in the real estate market, given its policy of financial repression.
Moreover, with the contracting demand for construction services in the Mid-
dle East, the overexpansion burdened the country with a problem of
retrenchment greater than would have occurred otherwise. The booming
sector was no longer booming, and resources had to move back to the trad-
able and the nontradable goods sectors. The necessary adjustment would
have been less if the overseas construction service exports had not overex-
panded.
As already discussed, the policy measures were probably appropriate
during the early years of construction service exports to the Middle East.
However, they should have been discontinued late in the 1970s when they
were no longer appropriate to an economy that had passed the Lewisian
turning point.
 Promotion Measures for Construction Service Exports 549

CRITICISMS AND LESSONS

Since 1975 the Korean government has undertaken various measures to pro-
mote exports of construction services. At the time when the Overseas Con-
struction Promotion Act was established, the Korean economy had just
experienced the first oil crisis and was staggering under the weight of the
high cost of oil imports. Moreover, it suffered from the weakening demand
for merchandise exports resulting from a worldwide recession. The export
of construction services helped to reduce the excess capacity in construc-
tion as well as in manufacturing industries.
However, further expansion beyond the point where unemployed
resources could be absorbed brought about some adverse effects on the
economy. Even without the further expansion induced by government sub-
sidies, exports of construction services would have created problems of ad-
justment for the rest of the economy. Obviously, these problems, referred
to as the “Dutch disease,’ were intensified by the measures that had pro-
moted the exports. The government instead should have devised measures
to cope with the problems arising in a booming sector economy rather than
making them worse by fueling the boom.
The adjustment process would have been less costly if the government
had not pursued the policy of financial repression. One consequence of
the policy was the underdevelopment of the capital market, and as a result
the market could not accommodate with any degree of stability the sud-
den influx of large sums of money. Given the state of the market, the govern-
ment should have controlled the growth in money supply by adopting
measures such as those discussed in the preceding section.
The policy of promoting exports of construction services, formulated in
the atmosphere of a crisis, probably became inappropriate by 1978. Jones
and SaKong (1980) claim that in Korea short-term policy was continuously
monitored and adjusted when necessary, and as a result problems that
might not have been foreseen in the process of quick formulation of policy
were corrected in time or their effect on the economy was mitigated. Their
claim, however, depends on the condition that the government had the abil-
ity and resources to monitor continuously and had the political will to make
necessary adjustments even in opposition of the established constituency
of the policy. For some policies, this condition may have existed but for
others it may not. It seems that for a complex issue such as the export of
construction services, in which the jaebul have had a big stake, the govern-
ment probably had neither the ability and resources to monitor nor the po-
litical will to make necessary adjustments. A hastily formulated short-term
policy, once appropriate, thus became a long-term policy kept on regard-
less of its appropriateness.
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PART II
CULTURE, EDUCATION,
AND SOCIAL CHANGE
—
 pa | Ethical and Social Influences of
Confucianism
by Lee-Jay Cho

This study treats the subject of economic development in a somewhat un-

orthodox way, based on the premise that an understanding of development
policies requires an examination of many factors outside the discipline of
pure economics. Government economists do not simply sit together, dis-
cuss their facts and research findings, and make policy decisions. Their
formulation of policies is a far more complex, political process, and a fun-
damental understanding of this process must give due consideration to the
society in which it operates. This chapter has been included to give the
reader a sense of how Koreans behave, what they value, and how they re-
late among themselves and to their leaders. Rigorous analysis is not ap-
plied here to topics such as the role of culture and values in development,
national sensitivities and priorities, and the ways in which Korean leaders
manage the government and the public. Yet, after accounting for the quan-
tifiable variables, these factors have undeniably influenced the direction
of Korean economic development discussed earlier in this volume. It is
hoped that a simplistic overview and the brief anecdotes and illustrations
cited will give the reader a better perspective on the cultural dimensions
of modernization and will perhaps stimulate further research in this area.
A principal reason for the increasing interest in the relationship between
Confucianism! and the economy is the rapid development achieved dur-
ing the past three decades by the countries that have been strongly in-
fluenced by Confucianism and other East Asian cultural influences. How
do we account for the rapid economic development in Japan, Korea, Tai-
wan, Hong Kong, and Singapore, all of which are poorly endowed with
natural resources for economic growth? Human capital formation has un-
deniably been a major contributing factor, and in this regard exploring the
influence of Confucian ethics and values on contemporary approaches to
problem solving is an intriguing exercise.
The literature on Korea contains numerous references to Confucianism
as an impediment to reforms and development. The ways in which Confu-
cianism has been interpreted and applied by governments and societies have

1. The term Confucianism is used here to refer to the popular value system of China, Korea,
and Japan, which is derived from the synthesis of the traditional cultural values espoused
by Confucius and his followers and subsequently influenced by elements of Taoism, Legal-
ism, Mohism, and even Buddhism, and in the case of Korea and Japan, by Shamanism.

bo
554 — Lee-Jay Cho

probably been inhibiting factors for development under certain circum-

stances2 It would be wrong, however, to depict Confucianism only as a
barrier to development, just as it would be wrong to claim that it is solely
responsible for recent economic achievements in East Asia. Our purpose
is to examine not the elements that inhibit but those that promote human
capital formation, thereby exerting a positive influence on rapid economic
development. This is not an exhaustive study of Confucianism in economic
development but an examination of some positive elements of Confucian
ethical values based on “humanity, righteousness, and frugality” that have
clearly contributed to economic growth in Korea and neighboring countries.
CONFUCIAN VALUES AND ETHICS
Throughout history Korea has been dominated by Chinese culture, which
has predominated among the nations of East Asia. For several millenia
China was a feudal state, in which Confucian values and ethics, mixed with
Taoism and later with Buddhism, played the paramount role in shaping
not only the form of government but also the ways in which people relate
to their leaders, peers, and families.
Up to about the sixth century, the predominant influences in Korean so-
ciety were Confucianism and Taoism (Rutt 1972). Beginning in the sixth
century, Buddhism also exerted a significant influence over Korean cultural
values. The Buddhist doctrines of benevolence and samsara (the cycle of
rebirths), intermingled with the traditional values of Confucianism, pro-
vided the core of Korea's cultural values for a period of about a thousand
years, from the era of the Three Kingdoms (A.D. 57-668) and the united
Silla dynasty to the end of the Kory6 dynasty in the late fourteenth cen-
tury. At the beginning of the Yi dynasty (1392-1910), however, Confucian-
ism became the predominant state ideology of Korea, and Buddhist
influence receded. During the succeeding five centuries, Confucianism
played the predominant role in social, political, and all other spheres of
Korean society. The traditional cultural values that have exerted the long-
est and most lasting influence on the Korean pattern of modernization are
therefore deep-rooted in Confucianism.
Traditional Chinese philosophy is based on Confucianism, which is not
a religion but the prevailing ethics and values that evolved over thousands
of years. Confucius, who lived in the late sixth century B.C., summarized
and synthesized these ethics and values, giving them a form that became
known as Confucianism. The teachings of Confucius were expanded upon

2. Palais (1975:22), for example, cites “Confucian dogma” as one of three features of the old
political order contributing to the failure of reforms in Korea more than a hundred years ago.
The same author (1975:19) notes, however, the ambivalence of Korean leaders in sometimes
upholding and sometimes ignoring Confucian doctrine, to suit their own purposes or con-
venience.
 Ethical and Social Influences of Confucianism 555

further by Mencius (380-289 B.C.), a Chinese philosopher whose influence

in defining orthodox Confucianism was second only to Confucius.
The main axis of Confucian political philosophy is formed by the con-
cepts of chung (harmony between the leadership and the masses) and hsiao
(filial piety). The principal relationships upon which emphasis is placed
are those between the ultimate ruler and his people, between parents and
their children, and between peers. The latter, horizontal relationships are
maintained through trust and friendship. With respect to the first two,
however, harmony is maintained by stipulating that the relationship be-
tween the masses and the ruler is like that between children and their par-
ents. Hence, filial piety is the basis for harmony within the family as well
as the state. The emphasis on family and communal relationships and col-
lectivism contrasts with the Western emphasis on individualism. Filial
piety is the “generalizing principle” in defining relationships within the
group?
The energizing force in working out and implementing these relation-
ships is the emphasis placed on harmony, learning, and diligence. A con-
stant learning process is the ideal, where unceasing efforts are made to
achieve perfection. From the earliest times, the Chinese classics placed em-
phasis on being prepared for hard times and hard work, but also on being
prepared to take advantage of opportunities. This is already evident in the
earliest Chinese poetry, as illustrated in the following passage quoted from
writings dating from about B.C. 1100-1200 (Legge 1959):
It is said in the Book of Poetry,
“Before the heavens were dark with rain,
I gathered the bark from the roots of the mulberry trees,
And wove it closely to form the window and door of my nest.”
People of Tse have a saying,
“A man may have wisdom and discernment,
but that is not like embracing the favorable opportunity.
A man may have fine farm implements,
but what use are they if the planting season has passed?”
The notions of preparedness, illustrated by the parable of the bird that must
prepare itself for the coming storm, existed long before and were reinforced
by the codification of such ethics by Confucius. The emphasis on prepared-
ness is redoubled in the second quotation, in which the farmer not only
must prepare for physical work (with his tools) but must also be ready to
seize his opportunities (the farming season). Preparedness is a quality that
has been cherished by the Chinese for thousands of years.

3. As Max Weber distinguished, “whereas Puritan rationalism has sought to exercise rational
control over the world, Confucian rationalism is an attempt to accommodate oneself to the
world in a rational manner” (Morishima 1982:2).
556 —_Lee-Jay Cho

The Confucian classics also stress diligence as an important quality, typi-

fied by the admonition in the Zhong Yong (Lyall and King 1927) on striving
constantly to attain the golden mean—a center course of moderation that
avoids all extremes. The diligent scholar is encouraged to engage in a con-
stant process of reexamination and to seek the truth through facts. Empha-
sis is also placed on learning for the purpose of application. This in turn
encourages adaptability, flexibility, and pragmatism.
Confucius is said to represent the “complete concert” of the three ideal
types of sages that are described in the writings of Mencius (Legge
1959:812-17). One type of sage is an incorruptible purist, another under-
takes even the most difficult public-service task in pursuit of the common
good, and the third is the sage of “harmony,” who accepts even the most
humble position and responsibilities. According to Mencius, the second
type of sage took upon himself the heavy charge of empire, regarding the
people's sorrows and burdens as his own. These qualities, if properly in-
culcated in modern leaders, are well suited to economic leaders and to others
who have to deal with the problems of government and society.
Confucianism teaches that human relationships are increasingly refined
through the process of learning and acquiring knowledge. Education also
served as the primary vehicle for advancement in imperial China. For these
reasons, the Chinese emphasis on education—which is also an emphasis
on diligence—has been handed down over the centuries, serving to enhance
traditional respect for intellectual achievement and public service and the
modern emphasis on higher education.
According to Max Weber, the Protestant ethic contributed to Western in-
dustrial development as the driving force for capital formation through hard
work, frugality, and saving. The accumulation of wealth was considered
a measure of success and an indication of “good” behavior. An interesting
parallel can be drawn with the Chinese ethic of diligence, hard work, and
thrift. The Chinese measures of success were attaining high government
office and accumulating wealth, but it was also important for the success-
ful individual’s ancestors to “see” his achievements. Ancestor worship,
which Koreans shared in common with the Chinese, was based on the be-
lief in the continuing existence of a person/s spirit after death. When some-
one gained an honorable title or achieved some other success, it was
customary to visit the family tombs and “report” to the ancestors in the
presence of other relatives and friends. Although the beliefs and rituals
differ fundamentally, the actual driving forces of the Protestant ethic and
the Confucian ethic are similar.
Neo-Confucianism, which was articulated by Sung dynasty (906-1279)
scholars led by Zhou Dwan Yi and Zhu Xi, was a reaction against and at-
tack on the then-prevailing Buddhism. Although it incorporated some
Buddhist elements, it emphasized the revival of the original Confucian
values (Fu 1985: vol. 2). The basic concept was respect for “heavenly
 Ethical and Social Influences of Confucianism 557

order” and the “oneness” of the universe and of human existence. Accord-
ingly, human nature is the same as the nature of the universe. This move-
ment’s notion of violating heavenly order is illustrated in a statement—
attributed to the two Cheng scholar-brothers and based on the “abstract”
Confucian tenet of “internal self-respect, external righteousness’—that star-
vation is a minor matter when compared to a loss of propriety, which is
a serious human event. Neo-Confucianism as practiced during the Sung
dynasty was a conservative philosophy that defended feudalism and served
aS a weapon against the “New Policies” proposed by Wang An-Shih
(1021-1086), a writer and statesman whose proposed administrative and
economic reforms were designed to break up powerful groups and the
landlords.
Neo-Confucianism was imported to Korea over a period of several cen-
turies, beginning in the late Kory6 dynasty (fourteenth century) and ex-
tending into the early Yi dynasty (established in 1392). Unlike in China,
Neo-Confucianism in Korea provided the early Yi dynasty with a basis for
major reforms, and it served as a powerful weapon against the rich and
powerful, the landlords, and the corruption that prevailed under the later
Kory6 dynasty when Buddhism was the predominant religion.
The Korean version of Neo-Confucianism was codified principally by Yi
Toegye (also known as Yi Huang) and Yi Yulgok, who also elaborated on
the elements of pragmatism implicit in the Confucian tradition. Yi Toegye
called for reforms in government and for more efficient agricultural produc-
tion through better irrigation and improved technology. He also wanted
to expand the private school network and was an advocate of higher edu-
cation for the Korean population (Tsukuba University 1986).
Korean Confucianism during the centuries after Yi T’oegye's life evolved
into a more orthodox, conservative school that emphasized propriety and
rituals, thereby preserving the class structure and reflecting the deteriorat-
ing distribution of wealth and power. It became so orthodox that, at cer-
tain times during the Yi dynasty, the Korean royal family and government
officials became perhaps more “abstract” Confucian than their Chinese
counterparts. This trend is reflected in the respect paid by the Korean
government to the Chinese emperor as the Son of Heaven and to China
as the center of the world, and in the fact that Korea was depicted, in com-
munications to China, as “a small, distant country.’ Over the centuries, offi-
cial Korean Confucianism became increasingly ritualistic and impractical
and served to defend the existing order favoring the rich and powerful.
In the seventeenth and eighteenth centuries, Korean scholars on a mis-
sion to Beijing came into contact with and were impressed by Catholic
missionaries who were trying to gain influence among potential converts
by introducing Western science, mathematics, and astronomy. They also
were influenced by adherents of the pragmatic school of political economy
that had been established in the eleventh century by a small group of
558 — Lee-Jay Cho

Confucian scholars including Xue Ji Xuan. In China, however, this prag-

matic school had never had significant influence (Fu 1985: vol. 2).
In the eighteenth century, some of Yi Yulgok’s followers started the “prac-
tical’ school (Shilhak) in Korea. The practical school (which called itself
the Political Economy School) advocated a minimum of ritual and formali-
ties and concentrated instead on the practical elements of Confucianism
in combination with Western science, focusing on agriculture, industry, com-
merce, and empiricism (Historical Association of Korea 1973; H. H. Kim
1979). During the first half of the eighteenth century, the principal goals
of the school were agrarian land reform and organizational reform in govern-
ment and other institutions The adherents of the practical school were
labelled as “heretics” because they deviated from orthodoxy, and they were
also accused of importing undesirable Western influences from the Catholic
missionaries in China.
During the second half of the century, the emphasis of the practical school
(under the new name of Utilitarian Economy School) shifted to commerce,
industry, trade, science, technology, skills, and strong national defense. In
the first half of the nineteenth century, when the school was facing conser-
vative government control and oppression, it turned to more scholastic pur-
suits. Renamed the “school for seeking truth through facts,” it focused its
attention on the validation of the Confucian classics through facts and em-
Pirical data.
Orthodox Confucianism prevailed until the end of the Yi dynasty, and
the practical school never succeeded in gaining official acceptance> The
philosophy underlying subsequent modernization movements, however,
is based on some of the practical school’s more important ideas, which in-
clude agrarian reform, social harmony, equitable distribution of wealth, and
the promotion of industry, trade, science, and technology. The leaders of
the modernization movement who promoted efforts to open the country
at the turn of the present century had either received a Japanese education
or were Japanese influenced. Despite their efforts at modernization,
however, this movement was cut short by Japan’s expansion into the penin-
sula, which ended with Korea becoming a colony of Japan. Only during
the second half of the twentieth century were leaders such as President
Park Chung Hee able to put into practice on a massive scale some of these
practical values inherent in Confucian ethics.

4, Chung Nak Yong is considered a representative scholar who synthesized the philosophy
of the practical school. Some other scholars worthy of mention are Yu Hyung Won, Yi Yik,
and Park Ji Won.
5. In this regard, Dr. Ki-Jun Rhee, former chairman of the Korea Development Institute, ar-
gues that yang ming shue, which emphasizes the unity of knowledge and practice, was in-
troduced to Japan and made an important contribution to the Meiji revolution, whereas this
idea was not adopted in Korea (personal communication from Dr. Rhee).
 Ethical and Social Influences of Confucianism 559

CONFUCIAN SOCIAL ORDER

AND AUTHORITARIANISM
Ascriptive society holds that kings will be kings, scholars will be scholars,
and peasants will be peasants. The basic bifurcation of society into the peo-
ple who are trained to govern and those who are governed is implicit in
the writings of Mencius, who observed that “those who work their minds
rule the people, and those who perform physical labor are governed by
the former” (Legge 1959). The idea of virtuous government as prescribed
by Confucianism is so widely accepted by the majority of the populace in
China, Japan, and Korea that the positive role of government has been taken
for granted. An important characteristic of the policymaking process com-
mon to China, Japan, and Korea is the acceptance by the masses, both histor-
ically and today, of the role of intellectuals in policymaking. For a long time
to come, the general public in all three countries will continue to accept
leadership by intellectuals, and indeed the public expects intellectuals to
play such a role. In contrast to Western-style public opinion, the public per-
spective with Confucian influence is based on the traditional respect shown
to persons with superior intellectual ability. In this regard, Chinese,
Japanese, and Koreans differ in a fundamental way from Westerners be-
cause they expect the government to play an important role in society and
in industry. The public freely accepts the Japanese government's use of “ad-
ministrative guidance” (gyosei shido) and the Korean government's “govern-
ment instructions” (chungboo chishi) when intervening directly in industrial
affairs. The Japanese and Korean public accept this terminology itself in
a way that Westerners find difficult to comprehend. Government-business
relations in Korea have been characterized by strong leadership from a
government that did not hesitate to intervene directly with markets by
means of commands and discretionary measures. The government assumed
the role of senior partner in partnership with business. The acceptance of
the role of junior partner on the part of large private enterprises was in
part by necessity and in part cultural.
The Chinese, Japanese, and Koreans still place great value on entering
the civil service and thereby participating in decision-making processes.
In China the competitive scholarly examination system for entry into the
civil service was introduced during the Han dynasty in the second century
B.C. Similar systems evolved in Korea (in the tenth century A.D.) and Japan
(during the past century) that were instrumental in institutionalizing the
hierarchical arrangement of personnel in formal organizations. The con-
cept of hierarchy has been firmly entrenched in Chinese social philosophy
for so many centuries that it is difficult to conceive how the concept of
egalitarianism might take root in this society. This constraint is likewise felt
in Korea and Japan.
The corollary of this hierarchical perspective is the formation of a uni-
form personality trait that inclines toward authoritarianism. The mitigating
factor for the individual in China and Korea was the tradition of allowing
appeals against government officials whenever an injustice was commit-
ted. From a wider historical perspective, however, the lack of any sufficient
countervailing force among the Chinese has occasionally brought about po-
litical situations in which the existing political forces were eclipsed, mak-
ing way for entirely new successors. Under such situations where total
collapse was deemed essential (notably changes in dynasties), it would have
been difficult to accommodate powerful countervailing forces. This is mani-
fested in human behavior observed in the Chinese cultural setting, with
its holistic or once-and-for-all predisposition, typified by the old saying:
“Mow down everything uniformly with a single, trenchant sweep of the
sword blade.”
To appreciate the extent to which the values of uniformity and harmony
have influenced human behavior—and hence political behavior and poli-
cies—it is essential to grasp the underlying propulsion towards uniformity.
One important implication emerging from these considerations is that, even
if a policy is not itself exceptionally good, people will nonetheless follow
it through, all acting together. Ultimately, the results of their efforts in terms
of overall development may not be bad. It is also true, however, that such
national authoritarian personality traits and the lack of countervailing forces
can bring about a disastrous outcome.
Ever conscious of this tradition, Chinese leaders have strived to achieve
harmony and consensus by means of absolute statements and prescriptions.
It helps to explain why an absolute majority of Mao Zedong’s followers
agreed with whatever he preached about economic reform in the 1950s and
why an absolute majority likewise agreed with whatever Deng Xiaoping
preached about economic reform in the early 1980s. Fairbank (1986:298) suc-
cinctly depicts its impact on China's efforts at postwar development:
Underlying this situation was another inherited factor, the docility of
the Chinese peasantry, who were remarkably inured to following the
dictates of authority because it represented the peace and order on which
their livelihood depended. The vision of the leadership could be im-
parted to the populace because in the early 1950s the CCP [Chinese
Communist Party] and the Chinese people generally still felt united in
a common cause of building up China. The people trusted Chairman
Mao. This at once opened the door to utopianism and illusion because
the party cadres, drawn increasingly from the upper ranks of the peas-
antry, were fervently ready to go along, follow the leader, and bring
the masses with them. Thus the local obedience to the state and party
authority, plus the personal charisma of Mao Tse-tung, could create sit-
uations of mass hysteria where people worked around the clock and
abandoned established ways, almost like anarchists seeking freedom
from all constraints.
 Ethical and Social Influences of Confucianism 561

One example is the period of the Great Leap Forward, when everyone in
China was following the commands of a single leader and moving together
harmoniously and cohesively—but toward economic disaster. The same
follow-the-leader behavioral patterns help to account for Japanese conduct
during World War II. Such cultural traits are stronger than ideology, and
the Chinese have struggled in vain to overcome them. Similar tendencies
are observable in Korea also.
The Confucian ethic was modified in Japan through the process of dis-
semination, the political realities in that country, and the introduction of
Western rationalism during the Meiji era. The Japanese placed more em-
phasis than the Chinese on loyalty (to one’s immediate superior and,
through the hierarchy of society, especially to the ultimate ruler). For most
of Japanese history, the military has played the greater role in government,
leaving only the imperial court itself with a tradition of civilian administra-
tion. In Sung-dynasty China, by constrast, the civilian bureaucracy was
elevated above the military under the slogan zhong wen ching wu (“empha-
sis on the civilian side, de-emphasis on the military”). Korea, too, was con-
trolled primarily by a civilian bureaucracy during the Yi dynasty.
The Confucianism practiced in China, Korea, and Japan (as outlined by
Morishima 1982:4-9) emphasized in varying degrees the qualities of loyalty,
filial piety, benevolence, faith, and bravery. The significant differences are
that the Koreans shared their emphasis on the latter three qualities with
China, whereas Japan (which gave no special place to benevolence) shared
only the qualities of faith and bravery with its neighbors. These differences
in emphasis highlight a distinct difference in philosophy. From very early
in their history, the Japanese placed the strongest emphasis on loyalty,
subordinating even filial piety to loyalty to the state and, moreover, giving
no special consideration to benevolence (ren, which was a central concept
in Chinese Confucianism) and moral obligations and concern for family,
relatives, and friends. Hence Morishima concludes that, whereas the Con-
fucianism of the Chinese and Koreans “is one in which benevolence is of
central importance, Japanese Confucianism is loyalty-centered Confucian-
ism’ (Morishima 1982:8-9). Loyalty is given a preeminent place by the
Japanese because social hierarchy is far more intensive in Japanese society.
In Japan, loyalty to the ultimate ruler took precedence even over filial piety.
According to Dr. Ki-Jun Rhee, who translated Michio Morishima’s book
Why Has Japan ‘Succeeded’? into Korean, the Chinese interpreted the term
chung as a form of loyalty in which the subject serves his ruler with the
greatest sincerity based on his conscience, whereas the Japanese interpreted
it as loyalty that is absolute, to the extent that the subject may even have
to sacrifice his own life for the ruler. For this reason, whenever a conflict
arose in Japan between chung (loyalty to the ruler) and hsiao (filial piety),
the Japanese had to opt for chung.
562 — Lee-Jay Cho

In Korea and China, on the other hand, there was greater emphasis on
ren (benevolence), which Confucius regarded as the foundation of social
morality, deriving from the natural affinities that exist among members of
a family.
Confucian philosophy places particular emphasis on family and ex-
tended-family harmony. If one’s parents have committed some wrong act,
it is the filial duty of the child neither to accuse them nor to report them
to the authorities, but to persuade them not to repeat the act. This is illus-
trated in the following quotation (Legge 1959) from the Analects of Confucius:
The Duke of Sheh informed Confucius, saying “Among us here are those
who may be styled upright in their conduct. If the father have stolen
a sheep, they will bear witness to the act.’
Confucius said, “Among us, in our part of the country, those who are
upright are different from this. The father conceals the misconduct of
the son, and the son conceals the misconduct of the father. Upright-
ness is to be found in this.”
The latter attitude still prevails in China and Korea. The Japanese empha-
sis upon loyalty (to higher authority) and the Western concept of the social-
contract society both run counter to it.
In terms of extended family relationships, the fact that it is your duty
to “look after your relatives” has rendered it extremely difficult for China
and Korea, in particular, to introduce rational, fair, and objective planning
and to implement state policies. The Chinese, despite the introduction of
socialist principles and communism, supposedly based on scientific argu-
ments, have never managed to suppress the cultural values that foster
nepotism. This is a barrier that the Koreans likewise have not entirely over-
come. Since it may derive from certain national personality traits, it will
be useful to look specifically at the evolution of authoritarian tendencies
in society in this context.
One aspect of authoritarian behavior derives from the Confucian con-
cept of the family. The values, obligations, and loyalty prescribed within
the family system extend to all types of social groups—political organiza-
tions, government, schools, and factories. The head of the household not
only provides moral leadership and the family’s livelihood, but also pro-
vides leadership in all other respects. He is not, however, omniscient. He
does make mistakes, and as a result, many families suffer. Although good
ideas may be available among the lower echelons of the family, they are
effectively silenced under authoritarianism.
A hierarchical system contributes to better efficiency in communications.
Such a system can be characterized, within a given group of people, by
lines of communication radiating out from the leader to his numerous subor-
dinates. Each individual is thus linked into the system strictly through his
leader (see Leavitt 1958). In Korea and Japan, such hierarchical systems have
 Ethical and Social Influences of Confucianism 563

considerable merit in terms of management and production efficiency. Un-

der such a system, people are willing to perform in a collective setting
without questioning their leader, whom they regard as better educated and
more experienced than themselves.
The democratic counterpart stands out in sharp contrast. Under the
democratic system, the lines of communication are more complex, form-
ing a network not only between leader and subordinate but also among
the subordinates. Everyone supposedly provides input into decision mak-
ing. The amount of communication in the democratic effort is greater, hence
there is greater satisfaction for the individuals. But this type of system is
the less efficient of the two models in terms of time and energy required
to reach a decision, since much time and energy have to be expended on
arriving at a consensus.
The arguments put forward by Mancur Olson (1982) are especially rele-
vant in this regard. Rigidities and barriers established by labor unions in
some countries have inhibited technology transfer, efficiency in allocating
manpower, and development of the orgariizational structure necessary for
increasing productivity. Fewer social rigidities may make faster economic
growth possible (as in Texas or postwar Japan), whereas greater rigidities
resulting from the necessity to generate sufficient consensus in a democratic
system (as in the northeastern United States with its long-established labor
unions) may slow growth. That is, being too democratic may dampen eco-
nomic growth.
Korean businesses were almost totally free of labor unions during the
initial stage of rapid economic development. There were, of course, many
genuine grievances and accusations of “exploitation.” The lack of labor or-
ganizations also meant that there was no institutionalized forum for ex-
pressing workers’ interests. Korean corporations nonetheless had the
advantage of greater flexibility in organizing and utilizing their manpower.
Each of the models has its relative advantages. Production teams in Japan
have a certain democratic aspect in the sense that the supervisor shares
with the members of his work unit the information on objectives and scope
of the work assigned to them. He does so in the same way that an elder
brother tells his younger brothers or a head-of-household tells family mem-
bers why, for the common good, a certain task must be performed. The
hierarchical system prevails among Koreans and Japanese, because of their
attachment to hierarchy and harmony. They tend to prefer the hierarchical
model, in spite of its disadvantage in providing less satisfaction to the in-
dividual, because they prefer to listen to an older or better-educated person.
The tendency to follow and learn from the “wise” leader has supplied
the Japanese with a valuable productivity edge, which is enhanced by the
readiness of Japanese to subordinate themselves in a collective activity for
the common good, each working in harmony with the others toward a com-
mon goal. Koreans have retained something of this spirit. Although in
564 — Lee-Jay Cho

certain situations one could persuade Westerners to pull together and work
in the same fashion, the concept is not deeply ingrained in their character
and philosophy. Westerners will not almost instinctively subordinate them-
selves within a hierarchy to deal with each and every collective activity.
In The Zero-Sum Solution Thurow (1985) suggests that Americans can benefit
by emulating useful East Asian traits. But his views are not realistic, be-
cause it would be difficult if not impossible for Westerners to duplicate the
learning process that helps to shape such culture-laden behavior.
In Japan, the selection of the leader (and equally important the chang-
ing of leadership) is founded on the premise that most individuals will be
satisfied with the person chosen. Japan has a longer history of formaliza-
tion of industrial organization than Korea, and therefore the selection of
leaders has been institutionalized in Japan under the influence of the Con-
fucian ideal of sharing together as a group both the benefits and the bur-
dens of any undertaking. This idea is illustrated by Mencius (Legge
1959:479):
When a ruler rejoices in the joy of his people, they also rejoice in his
joy. When he grieves at the sorrow of his people, they also grieve at
his sorrow. A sympathy of joy will pervade the empire. A sympathy
of sorrow will do the same. In such a state of things, it cannot be but
that the ruler attain to the imperial dignity.
Within the context of a work unit, the Japanese pay close attention to
their criteria for promotion; universal observance of the accepted rules
makes it difficult for someone to be promoted haphazardly. In Korea, this
selection process has not been entirely institutionalized, in that the peer
group evaluation process has not yet taken root. The founder-owner of a
business is able without much consultation to appoint or replace leaders
at any level. In this context, the feudal values of looking after one’s extend-
ed family and friends and complying with the favors requested by power-
ful government officials have been more extensive in Korea than in Japan.
In the absence of strong labor unions in Korea (up until 1987), the erosion
of the rational recruitment process in the selection of leaders was more per-
vasive than in Japan. Conflict arises when a leader does not turn out to
be entirely capable and fails to make wise decisions, while still expecting
the respect and obedience of others. If the leader of a production unit, for
example, makes many mistakes, the output of his unit will suffer; its produc-
tivity will probably be lower than its democratic-model counterpart. The
lack of institutionalizing the selection of leaders therefore puts Koreans at
risk of being saddled with two negative features—both the lack of satisfac-
tion inherent in the hierarchical model and the inefficiency inherent in the
too-democratic one.
Authoritarian behavior is most prevalent in Korean business enterprises,
including the medium- and large-scale conglomerates. The owner-head of
 Ethical and Social Influences of Confucianism 565

a thriving Korean company, by virtue of his successful past endeavors, es-

tablishes himself in an authoritarian position comparable to that of a head
of household. At the same time, the executives (in the case of a large cor-
poration) consciously build up their leader beyond life size, partly with the
rationale that his contacts among equally high elites in government and
business will ultimately help the corporation to prosper. The chief himself
encourages the construction of this facade, not only for the personal satis-
faction of being depicted as a hero but also for leading the corporation (a
surrogate big family) toward further economic success.
The management system in the corporate world, in contrast to that in
politics and government, is far more authoritarian when an owner-founder
heads the company. Once the corporate hero has been created and is per-
ceived as such, the forum for the discussion of independent ideas ceases
to exist. In the process, it becomes increasingly rare for subordinates to make
critical evaluations of projects and policy decisions. Subordinates will not
offer objections or even raise questions that might displease the hero. The
hero, in turn, does not want to hear anything that might call his wisdom
and abilities into question or that might detract from the aura of his past
accomplishments. Eventually, rational evaluation of the owner-head’s per-
formance becomes almost impossible.
By never disagreeing with the leader or proposing alternatives, the ex-
ecutives cannot then play their proper role. In the Korean corporation, de-
cisions thus become strictly personal ones, revolving around a single
personality. This can be dangerous, especially when a single, overconfi-
dent chief makes a decision solely on a whim, while his executives hesi-
tate to confront him with any rational analysis. Even in an efficient business
organization, therefore, at some stage of development the undesirable facets
of the authoritarian family system come into play. Later efforts to perpetu-
ate earlier successes draw the corporation into rivalry with competitors and
into risky ventures that may be economically unsound (such as acquiring
nuclear electric power reactors for reasons of prestige). If a competitor has
launched a new enterprise, the chief may want to follow suit immediately,
to maintain at least parity with the competitor. The executives acquiesce,
because they want to preserve the image of their corporation, even though
it has been inflated beyond life size and beyond their resources to uphold.
The economic consequences will not be discussed in advance and will prob-
ably be covered up once they become manifest, likewise to maintain the
image.
Another negative aspect of the family authoritarian system is that heads
of corporations want to bequeath not only ownership but also leadership
to their sons, brothers, cousins, and relatives by marriage, who may not
be equally dynamic or even fully qualified. The consequences may not be
so serious in the case of small and medium-size businesses. But can such
a procedure be justified by a conglomerate? Especially if the corporation's
566 _—Lee-Jay Cho

debt to the government is a large percentage of the entire business? One

positive advantage is that a succession of brilliant leaders can stimulate the
greatest possible advances for the corporation, particularly because per-
sonal trust and loyalty are highly valued within the corporation, as they
are within the family. But objective, rational management is difficult to in-
troduce when there are less capable heirs expecting to assume not only
the chief's powers but also his undisputed authoritarian role.
One positive outcome is risk-taking and the willingness to use venture
capital. The confidence built up in the hero will induce him to take greater
risks. (One example of this is the highway project between Seoul and Pu-
san, undertaken by Hyundai and other major Korean construction compa-
nies despite the opposition from the World Bank and other consultants.)
This tendency has had many positive effects, and Koreans are fortunate
that their ventures have proved successful so frequently in the past.
This tendency is also partly a reflection of the division of the country
into north and south. The constant awareness that Koreans must be forever
alert vis-a-vis belligerent North Korea and prepared to defend themselves—
harking back to Confucian admonitions concerning preparedness—has
prompted business to be more alert and to take greater risks. South Koreans
are motivated to surpass the North, even if this means taking greater risks
in order to widen the development gap between North and South. This
motive apparently surmounts the uncertainty from the danger of renewed
war. Although the perspective is a short-term one, taking greater risks to
achieve the desired development gap within a short span of time, it is rein-
forced by the conviction that, if the economy is strengthened as a result,
the South Koreans will be even more capable of defending themselves.
Koreans have not yet developed rational, regularized procedures for mak-
ing decisions in either public or private institutions. Koreans need to ra-
tionalize their family authoritarian notions—which promote diligence and
hard work—extending collective harmony, loyalty, respect with proper in-
centives to industrial and government organizations and institutionalizing
them more fully, so that major institutions will become genuinely surrogate
families drawing upon all these strengths.
In contrast, the Japanese have achieved greater success in rationalizing
and adjusting their authoritarian tendencies—a process that was hastened
during the postwar years under the American military government in Japan.
To understand the broad linkages as well as differences in the modern
Japanese and Korean experiences, it will be useful to examine, in the fol-
lowing chapter, some of the salient features of the educational systems, both
traditional and modern, that have evolved in the two countries.
 apie The Educational System
by Lee-Jay Cho and Kennon Breazeale

The modern educational system in Korea is a new creation built gradually

by a nationwide effort since the time of liberation in 1945 and based partly
on infrastructure developed during the Japanese colonial period! The na-
tional policy to make primary education universally available at the public
expense was enacted into law in the late 1940s. Subsequently, however,
much of the educational infrastructure was destroyed in the Korean War,
and not until the mid-1950s was the government able to implement its basic
plan for education.
Resources were concentrated most heavily at first on making free primary
education available. It was premature to debate the quality and direction
of education until the basic goals of the late 1940s were met—that is, to make
education available to all children eligible to enroll. In the case of primary
schools (ages 6-11), the objective was to make six years of schooling univer-
sally available at public expense. For middle and high school enrollment
(ages 12-14 and 15-17, respectively), eligibility was to be determined by ex-
amination, and the continuation of schooling at these levels was at the par-
ents’ expense.
The early post-liberation achievements are impressive, and primary edu-
cation was rapidly made available to the vast majority of Korean children
during the 1950s. An estimated 71 percent of eligible children in 1952 were
attending primary schools—which managed to continue operations despite
the ravages of war. At the same time, 19 percent of eligible children were
continuing to middle school and 12 percent to high school (UNESCO
1954:32). The traditional value placed on education by even poor villagers
in South Korea provided a strong impetus to support the government's am-
bitious program. A United Nations mission (UNESCO 1954:21) investigat-
ing education during the Korean War reported
. . a burning desire on the part of parents for their children’s educa-
tion today, a condition which is rather difficult to match in other coun-
tries. The greater part of the expenses of construction and repair of
school buildings and of teachers’ salaries comes from the parents’ pock-
ets directly, and many go without food in order to see that their chil-
dren go to school.

1. The authors wish to express sincere appreciation to former minister of education, Profes-
sor Kyo Ho Rhee, and to Drs. Jae Souk Sohn and Sung-Yeal Koo for reviewing an earlier draft
of this chapter and providing valuable insights and suggestions.

567
568 — Lee-Jay Cho and Kennon Breazeale

The implementation of the government's six-year plan for compulsory

primary education was delayed until the war ended. It began in 1954 and
was virtually completed in 1959, when 96 percent of school-age children
entered elementary schools (Ministry of Education, ROK, 1986:26).
The expansion in the number of elementary teachers started from a large
base—nearly 20,000 teachers in 1945, more than trebling within 15 years
and doubling again within the next 20 years. Even more important, the aver-
age number of students per teacher has shown a progressive and substan-
tial decline (Table 22.1).
The rapid increase in the number of primary school teachers was facili-
tated by the existing infrastructure. The graduates of teachers’ colleges, high
schools, and even middle schools were able to find employment as teachers
in the lower levels of the school system. The most difficult task in the early
years of the republic, however, was to provide adequate training for teachers
at higher levels, particularly in the virtual absence of qualified professors
at the tertiary level. Far more than a generation was needed for prospec-
tive teachers from each successive graduating cohort to find their niches
in the school system, thereby gradually raising the quality of instruction
to the desired standard.
The need for a new educational philosophy was already evident during
the Korean War (UNESCO 1954:29). Yet the sheer size of the infrastructure
required—especially the reconstruction of the educational physical plant
lost in the war—took the largest share of available resources in the late 1950s.

Table 22.1. Numbers of students and teachers: Selected years, 1945-85

Item 1945 1960 1970 1980 1985
Elementary schools
Students 1,366,024 3,622,685 5,749,301 5,658,002 4,856,752
Teachers 197729 61,605 101,095 119,064 126,785
Ratio 69.2 58.8 56.9 47.5 38.3
Middle schools
Students 80,828 528,593 1,318,808 2,471,997 2,782,173
Teachers 1,186 13,053 31,207 54,858 69,553
Ratio* 68.2 40.5 42.3 45.1 40.0
High schools
Students 40,2175 273,434 590,382 1,696,792 2,152,802
Teachers 1,720 9,627 19,854 50,948 69,546
Ratio 23.4
a28.4 29.7 33.3 31.0
Source: Ministry of Education, ROK (1986:27).
a. Average number of students per teacher.
b. Data for 1951.
 The Educational System 569

Government policies in the 1960s and 1970s relied on existing human

resources as a basic input in the push toward development, but it was
difficult to overcome the constraints on the expansion of public secondary
education, particularly lack of funding and trained teachers. By the end
of the 1960s, however, the goals in primary education were realized. Dur-
ing the 1970s, educational opportunities at the secondary level were greatly
expanded, although enrollment in middle and high schools continued to
be voluntary and parents still had to pay the costs. Larger and larger propor-
tions of primary graduates continued from primary into middle school and
from middle school into high school (see Table 22.1). In the mid-1980s mid-
dle school enrollment was approaching 100 percent, and high school en-
rollment had surpassed 75 percent (UNESCO 1988:54). The fundamental
goals pursued since liberation had long since been achieved, and univer-
sal, compulsory education even at the high-school level had become fore-
seeable. By this time the nation’s think tanks were reassessing the hard-won
accomplishments of the postwar period. The educational reforms to be un-
dertaken during the coming years will determine to a large extent the qual-
ity of the Korean workforce that will lead the nation into the next century
and meet the new challenges of high-technology industries and increased
internationalization of trade and services.
Although the chronological period covered by this book does not en-
compass new policy directions for schools and universities, the gradual
change in availability and quality of education from World War II to the
present has been vital to the successful implementation of many economic
policy measures. The rapid economic growth of the nation during this pe-
riod can thus be better appreciated through an understanding of the dy-
namics of change in education that are responsible for the quality of the
modern workforce.

CONFUCIAN EDUCATION
AND THE VALUE OF LEARNING
Despite the linguistic and ethnic homogeneity of the modern nation, the
Korean language did not take its rightful place as the first language of
scholarship until after liberation in 1945. By tradition, learning and scholar-
ship were equated with the study of the Confucian classics. Only a small
proportion of Korean men from wealthy families had the means and leisure
time to learn the tens of thousands of Chinese characters necessary to read
and understand ancient texts. Chinese was the language of scholarship,
and the Chinese classics had a revered position (not unlike Latin in the
West, which was still the first language in English schools as late as the
eighteenth century). The examination texts for entrance into the Korean civil
service were in Chinese. There were no social barriers to gaining an educa-
tion in the Confucian classics, but the prerequisite of devoting years of
570 Lee-Jay Cho and Kennon Breazeale

rigorous study to the task excluded virtually all but the sons of the well-to-
do, and women had no place at all in this tradition.
State civil service examinations on the Confucian model were introduced
to Korea during the Koryé dynasty (918-1392). The strengthening of this
examination system, particularly under the Yi dynasty (1392-1910), nurtured
the growth of Korean scholarship and educational institutions. A Confu-
cian university, four official schools in the capital, and official schools in
provincial capitals became the great centers of learning for Koreans. Pri-
vate schools also played an important role in the development of scholar-
ship, as did private tutoring provided by individual scholars across the land.
The outstanding intellectual achievement of the early Yi period was the
Korean script—a scientific phonetic system institutionalized in 1446 by the
scholarly King Sejong.
In theory the civil service examinations were open to all men at all levels
of Korean society. Stressing the Confucian values placed upon literature
as well as upon creativity, these examinations required not only a deep un-
derstanding of classical literature but also the ability to compose poetry and
to write to a high standard. In the past, even an illiterate peasant if he was
not of the servant class would urge his children to study hard and obtain
knowledge, in hopes of improving their situation in life through the ex-
amination system. As a result, traditional Korean culture placed great em-
phasis upon the education of children.
In actual practice, however, as Korean society became more stratified and
as the delineation of class boundaries became rigid, the examinations tended
to become increasingly exclusive and available only to the members of the
upper class (yangban) who possessed the wealth and leisure requisite to
high-quality education. The landed classes were able to generate sufficient
resources to pay for the tuition necessary to prepare their children for the
civil service examinations in the capital city. Rich upper-class families could
support such an education for all their children. But among the typical rural
gentry, only the eldest son was given the privilege—possibly as much as
20 years of instruction—and the opportunity to go to Kaesong (the Koryé
capital) and later to Seoul (the Yi capital) for the examinations. Ordinary
farmers, by contrast, found it virtually impossible to afford the cost of a
tutor. Although the opportunity to enter the civil service was effectively
restricted during much of this half-millenium of state Confucianism, the
most lasting value contributed to Korean society by Confucian ethics was
the emphasis on the value of learning.

TRADITIONAL EDUCATION
IN THE KOREAN LANGUAGE
In parallel with the limited numbers of Confucian literati, an indigenous
literary movement spread throughout the country from the fifteenth cen-
tury onward. This movement was made possible by the invention of a pho-
 The Educational System 571

netic writing system (called han’giil) in the mid-fifteenth century. The sim-
ple characters of the han’giil alphabet (24 in modern usage) were expressly
designed by King Sejong and his court scholars to enable Koreans of even
humble means to obtain for the first time a reading and writing knowledge
of their own spoken language. Easily learned within a matter of weeks or
less, han’gil was the vehicle for Korea’s folk literature—read largely by
women and children—which became widespread after the invention of
moveable printing type in the fifteenth century. The spread of printed
han’gul nurtured the tradition of literacy and an abiding enthusiasm for
reading among women and children, unlike other Confucian countries, thus
making education a goal of the highest importance for everyone, including
poverty-ridden farmers (Oliver 1956:720). Han’giil never gained respecta-
bility, however, in the view of Korea's traditional scholars, who scorned the
use of the vernacular and banned the use of han’gil in the schools as be-
ing too easy to learn and too commonplace for a serious scholar. For these
reasons, up to the end of the monarchy in 1910, Korea had two exclusive
types of education: one in Chinese for the privileged minority and the se-
cond in the vernacular available to the masses.
ORIGINS OF MODERN EDUCATION
Modern concepts of education based primarily on the use of the Korean
language were first introduced into Korea during the 1880s by Protestant
missionaries. Their schools, which used Korean-language texts written in
the easy-to-learn har’gil script, initially attracted the interest of very few
Koreans, and enrollment in substantial numbers did not take place until
the 1920s (Fisher 1928:5-6). A series of government reforms were initiated
in 1894 to create a primary school system, some high schools, and a nor-
mal college, but early in the twentieth century, as Japanese influence be-
came predominant in Korea, education was still available only to the
well-to-do (Adams 1956:19, 22). In the meantime, Korea’s traditional suzer-
ain (China) was eliminated as a rival for influence in Korea after the Sino-
Japanese war of 1894, and Russia likewise was eliminated as a potential rival
after the 1904-1905 Russo-Japanese war. In 1905 Korea became a protectorate
of Japan, and during the next five years a dual system of education (Korean
schools for Koreans, Japanese schools for Japanese residing in Korea) was
instituted. This dual system was retained when Korea was annexed to Japan
in 1910, and it remained in force until 1938 (Adams 1956:24).
The concept of universal primary education was introduced to Korea dur-
ing the period of Japanese rule from 1910 to 1945 (J. C. Chung 1985). The
colonial government provided an increasing proportion of school-age chil-
dren with minimal primary schooling, supplemented by a program of vo-
cational education. The educational system was intended, however, to train
a subservient workforce of subjects loyal to Japan and capable of filling
the growing number of menial and low-paying jobs for the benefit of the
572 Lee-Jay Cho and Kennon Breazeale

Table 22.2. Registered students in Korea by type of school: Selected years,

1910-37 (10° students)
ee,
ee eee

Type of
te school ARs a Bete oth
Ot ROO OY os Be1919
eo 1910 ee ee ere 1937eae
eee 1930
Primary schools (years 1-6)
for Japanese 15,5 42.8 67.4 89.8
for Koreans 20.1 89.3 450.5 901.2
Middle schools (years 7-12)
for Japanese 0.2 2.0 5.8 7.8
for Koreans and Japanese 0.8 B2, A el 15.6
High schools for girls
for Japanese 0.5 1:9 8.3 11.9
for Koreans 0.4 0.7 4.4 ded
Teachers’ seminaries 0.0 0.0 1.3 3.8
Industrial schools M1 4.5 153 26.6
Colleges 0.4 0.9 Zo 4.0
University preparatory schools 0.0 0.0 0.3 0.4
University 0.0 0.0 0.6 0.5
Nonstandardized schools* 71.8 39:2 47.5 142.6
Total> 110.8 184.5 614.4 1,211.4
Source: UNESCO (1954:23).
a. Includes short-course elementary schools.
b. Column totals are subject to rounding errors.

imperial economy. Numerous schools were built, and the enrollment of

Korean children increased dramatically. The major accomplishment of this
period was at the level of primary education (Table 22.2). Toward the end
of Japanese rule, only about 5 percent of Korean children were able to con-
tinue to the secondary level (UNESCO 1954:23). For the handful of Koreans
who gained entrance to universities, the choice of subjects was severely
restricted—mainly law, classical literature, and medicine—and bereft of any
content that might help to prepare a Korean for a leadership role.
Despite the shortcomings of the system, Korea gained at least some basic
educational infrastructure under Japanese rule. The increasing availability
of education brought about improvements in skills and the quality of labor,
thereby contributing to the development of the economy. As a proportion
of the entire Korean population in 1939, there were places for 5.52 percent
at the primary level, 0.13 percent at the secondary level, and 0.12 percent
in vocational schools. At higher levels, virtually no places were available
to Koreans. About 27 Koreans per 100,000 population were receiving edu-
cation at the tertiary level (including teachers’ colleges), whereas less than
 The Educational System 573

one Korean per 100,000 population gained admission to a university (UNES-

CO 1954:24).
The state educational system was supplemented by an extensive network
of Protestant mission schools, mostly at the primary level. In the mid-1920s
these Christian schools were providing primary education to more than
37,000 pupils who attended the more than 750 mission schools that met
government standards. A further 13,000 pupils got at least some minimal
instruction from the more than 300 one-room mission schools (Fisher
1928:2). The missions also operated two Christian colleges for men, two
theological seminaries, Ewha College for Women, and a medical college.
By 1935 about 128,000 Koreans were completing elementary-school edu-
cation annually, and the high schools were producing an additional 11,000
graduates (Suh 1978:152). The decade and a half preceding the Pacific war
brought dramatic changes in school enrollments at all levels. In 1925 only
12.3 percent of Korean children in the age range of 6-12 were enrolled in
school; by 1940 this figure had reached 32.7 percent. During the same pe-
riod, the percentage of children in the age range of 13-18 rose from 0.8 per-
cent to 2.4 percent, and the percentage of Korean youths pursuing advanced
education (those in the 19-24 age range) rose from 0.06 percent to 0.17 per-
cent (Cho et al. 1971:563).
Higher education was confined, as before, to children from well-to-do
families and families that worked for the Japanese administration. Conser-
vative Koreans equated Japanese-style education not only with the foreign
invaders of their land but also with unwanted Western influences. Japanese-
style education in many ways did not fit the Korean national identity and
cultural values. Many Koreans regarded this kind of education as unaccept-
able in the context of traditional Korean values and aspirations for national
independence and thus wanted to avoid it. Yet, there was no alternative.
The entire body of Korean literature and the use of the Korean language
itself were officially banned from 1938 to 1945, even in the primary schools
where they had previously been permitted. Hence the whole generation
of young Koreans educated prior to liberation in 1945 were arbitrarily cut
off from traditional Korean sources of knowledge. The people of this same
generation, once educated, were also denied the full benefits of their learn-
ing, because scores of thousands of Japanese civil servants came to the
peninsula to staff the expanding modern bureaucracy, thereby preempting
potential Korean candidates.
Although Japanese-style education was a cultural shock for the Koreans
and deemed undesirable in the short term, it did bring rapid, positive
change to Korea. It provided even the ordinary people with some exposure
to modern education. It was accompanied by much-needed modern for-
eign technology, which the isolationist Yi dynasty had adamantly denied
itself. The people born during the first three decades of the twentieth cen-
tury are the first generation of Koreans to have received a modern, albeit
574 Lee-Jay Cho and Kennon Breazeale

Japanese, education. Significantly, they became the technocrats who con-

tributed to economic and social development from the beginning of the
Republic of Korea in 1948. President Park Chung Hee was a typical product
of this type of education, having attended a Japanese-run primary school
and a Japanese-run normal school in Korea, a Japanese military school in
Manchuria, and ultimately a military academy in Japan.
EDUCATION AFTER LIBERATION, 1945-50
The development of education in modern, independent Korea was not a
process of reconstructing and modernizing an existing philosophy or insti-
tution. At the time of liberation, Koreans had been isolated from their tradi-
tional educational system by three and a half decades of foreign rule. The
task facing Korean educators was not one of rebuilding and modernizing
an existing system but to create appropriate institutions from the ground
upward. Scarce resources therefore had to be concentrated on creating a
system that was appropriate to the nation’s level of economic and social
development at that time, not looking back to the heritage of the past but
forward to the needs of the country. Perhaps most important, for the first
time Koreans were in a position to use education in the pursuit of their
own political, social, and economic goals.
After the Japanese were repatriated at the end of World War II, virtually
all remaining inhabitants regarded themselves as ethnically Korean. Their
homogeneity precluded potentially divisive identification in linguistic, ra-
cial, ethnic, or other cultural terms. The postwar nation likewise did not
inherit a culture-bound class system. (It can be argued, moreover, that
Japanese tradition permitted less social mobility than Korean, because the
Confucian examination system was not used in pre-Meiji Japan.) These fac-
tors helped to ensure greater mobility and have long-term implications in
many areas of social, economic, and political activity.
The most serious shortage was teachers. Judging from 1938 data, the
departing Japanese represented about 40 percent of all primary school
teachers, 80 percent of all high school teachers, and 70 percent of college
and university teachers (UNESCO 1954:24). The same data show that, on
the eve of war, only about 300 Koreans were employed as teachers at the
secondary level and higher in both the northern and southern regions of
the country. At the war’s end, the shortage of teachers was acute, and no
teachers’ training facilities existed. The only solution was to adopt a
demand-first, quality-later policy by inducting thousands of persons with
inadequate teaching qualifications into the system at all levels.
Even the qualified and experienced teachers, however, were not entirely
suited for the task ahead of them, because almost all of them were products
of the Japanese educational system. Under Japanese rule, the Japanese lan-
guage was the sole medium of instruction at the secondary level and above,
and the curriculum was the same as in Japan itself. The primary schools
 The Educational System 575

for Korean children, on the other hand, used the Korean language and the
han’gul script as the medium of instruction, and a little Korean history and
cultural content were permitted until shortly before the world war. The goal
laid down in the 1922 education law, however, was to increase proficiency
in the “national” (i.e., Japanese) language by expanding instruction in
Japanese at the primary level and eventually eliminating the use of the
Korean language altogether. In 1938 all Korean aspects of the schools were
suppressed, and the school system became uniformly Japanese. All uses
of har’gul were banned, and students were forbidden to speak Korean either
inside or outside the schools.
Unlike some postcolonial Asian nations that moved gradually to in-
digenize the educational systems they inherited, by phasing out the cur-
ricula and language of the colonial power, Koreans suddenly discarded the
entire existing system because it was Japanese and began to build anew.
Japanese textbooks were discarded because both the language and content
were unsuitable for independent Korea. All textbooks at every level had
to be written. The entire content of education had to be created from 1945
onward at every level from primary school to university. The buildings
emerged from World War II undamaged, but the infrastructure had to be
vastly expanded to make primary education universally available. In 1945
there were no Korean textbooks for any level of education, no facilities for
writing or printing books in han’gul, and no precedents for a curriculum
to meet the aspirations of an independent people.
Important tools for modern education had nonetheless been preserved
throughout the war by members of the Han’gtl Society, which was origi-
nally established to compile a complete Korean dictionary and which con-
tinued its work underground after 1938. The society’s text on standardized
spelling published in 1933 was used as a basis for postwar Korean gram-
mar books. A six-volume dictionary had almost been completed by 1945,
although its publication was delayed for many years—first by the lack of
paper and printing facilities, then by the Korean War (in which most cop-
ies of the first edition were destroyed), and later by a lack of funds to com-
plete the printing and to prepare supplementary volumes of badly needed
technical and scientific terminology (UNESCO 1954:121, 124).

THE KOREAN WAR AND POSTWAR ACHIEVEMENTS

Although much of the educational infrastructure was destroyed during the
first year of the Korean War, an extraordinary effort was made to keep the
educational system in operation. Many schools (such as those in Seoul)
were temporarily moved to safer sites. By 1952 about 60 percent of class-
rooms had been destroyed or badly damaged, or were temporarily requisi-
tioned for other uses, and more than 80 percent of equipment, books, and
furniture were lost (UNESCO 1954:119). Yet schools continued to function—
in tents or even in the open air when the weather permitted.
576 Lee-Jay Cho and Kennon Breazeale

Education, like the economy, had to be almost entirely reconstructed

when the war ended. The United Nations’ aid mission for reconstruction
was assisted in postwar educational planning by a team from the United
Nations Educational, Scientific and Cultural Organization (UNESCO). Many
of the UNESCO recommendations were not carried out, but this mission
more than any other set the stage for the types and amounts of educational
aid to Korea during the mid and late 1950s (Adams 1956:226).
As the nation approached the goal of universal, free primary education,
the demand for further education at the middle- and high-school level was
greater than the number of places available. Although substantial progress
was made in expanding the number of higher level schools and universi-
ties, as well as in developing vocational education and educational research,
the increase in student numbers was limited by selection through exami-
nation for entry into middle school. In 1969, after this barrier was removed,
there was a sudden increase in middle-school enrollment. In terms of sheer
numbers, this bold move succeeded within a decade in raising the propor-
tion of primary-school graduates continuing into middle school from less
than 60 percent in 1969 to more than 90 percent in 1979 (Jayasuriya
1980:59-60). By the mid-1980s middle-school education, although not com-
pulsory or free, had become universally available.
From the educators’ point of view, however, this sudden change adversely
affected the quality of education. To cope with the serious shortage of class-
rooms, some schools operated two or three teaching shifts per day. For the
first time, teachers in public secondary schools had to give instruction not
just to the best students but also to those with lesser ability. The govern-
ment’s intention was to bring about a democratic reform by abolishing an
elitist principle inherited from the distant past, but the quality of educa-
tion inevitably suffered in the short term.
The ratio of students per teacher is one measure of quality in education.
There has been a progressive improvement in the ratio at the primary level
ever since liberation (Table 22.1). The ratio for high schools has fluctuated
within a reasonable range since the 1960s. At the middle-school level,
however, the ratio showed a substantial improvement up to the 1960s, wors-
ened in the 1970s, and reverted to the 1960s levels only in the mid-1980s,
reflecting a major change in middle-school enrollment that began at the
end of the 1960s. The impact on the high schools, by contrast, was partly
exacerbated through the expansion of vocational instruction at the secon-
dary school level, and by 1979 about 40 percent of all new high school stu-
dents were being channeled into vocational education (Jayasuriya 1980:61).

REFORMS FOR THE 1990s AND BEYOND

A presidential commission was established in 1985 to examine potential re-
forms in the national educational system and to formulate policy measures
to ensure higher quality education. The need for a better educated work-
 The Educational System 577

force to sustain the pace of national development to the end of the century
and beyond is reflected in the broad composition of the commission, which
included not only educators and other civil servants but also economists,
industrial leaders, scientists, and professionals in social affairs. The initial
recommendations of the Presidential Commission for Educational Reform
were outlined in Strategies for Educational Reform, published by the commis-
sion in 1986. A complementary study carried out by the Korean Education-
al Development Institute (KEDI) underscored the lack of flexibility in the
present system to meet the nation’s changing educational needs (UNES-
CO 1988:49). The final report of the commission, containing its compre-
hensive reform proposals, was completed in 1988. It placed particular stress
on improvement in the quality of education and emphasized that the main-
tenance and further development of Korea's international competitiveness
in economic, technical, political, and other spheres can be achieved only
through maximum development of human resources (Sohn 1988).
During the past few decades, a well-educated workforce has been re-
garded as an important asset for achieving rapid economic growth. The
work of the presidential commission and KEDI indicate, however, that a
major shift in educational philosophy is imperative and that the availabil-
ity of higher quality education must itself be a goal of the development
process. Although nearly all primary graduates were already continuing
to middle school in the mid-1980s, education at this level was not compul-
sory and parents still had to pay for a portion of the costs. One researcher
(K. K. Lee 1986:12), noting that there is no distinction between urban and
rural or rich and poor in the desire for more educational opportunities, poi-
gnantly describes the continuing plight of poorer rural parents:

Education is considered to be the main means for social mobility and

the ladder for promotion in the workplace. In rural areas, parents sell
their rice fields to pay for the education of their children. Yet when a
child has finished college, he will not go back to the farm and his par-
ents’ house. Still, parents want to send all their children to college. When
the economic conditions of the family are too poor to support them all,
the eldest son is sent to college; the other sons complete middle school
and the daughters complete primary school. This division of children’s
education reflects property division in the past.

The government has now announced that education at the middle-school

level will be made compulsory on an incremental basis, concentrating first
on the lesser-developed rural areas that are lagging behind in educational
opportunities and afterward bringing the urban schools formally within
the compulsory system. Meanwhile, the trend of enrollment at the high-
school level (already more than 75 percent) is expected to exceed 86 per-
cent by the turn of the century, thus laying the foundation for universal,
free high-school education (UNESCO 1988:54-55).
578 Lee-Jay Cho and Kennon Breazeale

The most important aspect of the presidential commission's recommen-

dations is to improve the quality and scope of education at the primary
and secondary levels to ensure that the workforce can maintain a competi-
tive edge in the world marketplaces of the coming decades. In this context,
the commission proposes to improve foreign language instruction and to
add international affairs to the curriculum to create greater awareness and
understanding of political, economic, and social issues that shape the world
(Sohn 1988).
The KEDI study highlights the potential role of education as an agent
for social change and an instrument through which the welfare of ordinary
people can be improved. It also concludes that education should have a
complementary relationship with the political process, economic and so-
cial affairs, and national culture, because problems in education derive from
these and other aspects of life. Both studies acknowledge that, as the per-
centages of enrollment in all age brackets increase, the greatest problem
facing educators will be to maintain and improve standards of education
(UNESCO 1988:50, 56). In this regard, it is instructive to examine some of
the problems associated with raising standards, which are in part a legacy
of the pre- and postwar era.

LESSONS FROM THE

MODERN EDUCATION EXPERIENCE
Cultural Identity Conflict
For Koreans, the cultural orientation of prewar curricula was the most dis-
tasteful aspect of the Japanese educational system. It was designed for
Japanese children, fostered the Japanese national identity, and strove to in-
still Japanese nationalistic values in the students. Its enforcement in Korea
produced a conflict in identity for Korean children, who had no alternative
to schools in which they had to speak the Japanese language and act as
though they were Japanese, while always conscious that they were not.
Because of their cultural identity, Koreans resisted the attempt to press
them into a Japanese mold of collective behavior. The Japanese, in their
collective activities, placed great emphasis on adhering to norms. Koreans,
in contrast, did not hesitate to deviate to a certain extent from expected
norms. Even under Japanese tutelage, Koreans did not train themselves
to act together cooperatively as the Japanese do. The fact that Koreans
tended to cause more disruption than the Japanese reflects also the enforced
loss of old Korean values (which in terms of harmony-seeking were actu-
ally similar to the Japanese). Ultimately, the Japanese-style educational sys-
tem, imposed upon the entire first generation of Koreans to benefit from
universal education, prevented the evolution of strong Korean traits based
on Korea's own culture and national identity.
 The Educational System 579

This experience with Japanese-style education made Koreans more in-

dividualistic than the Japanese. Koreans took advantage of the educational
opportunities offered to them, but with the idea of personal gain and ad-
vancement rather than of transforming themselves into the uniform
products for which the Japanese educational system was designed. Koreans
who were fortunate enough to possess both the intellectual ability and the
financial means to continue their education at the professional-school and
university level tended to specialize in medicine or law, thus becoming phy-
sicians or filling the lower administrative and judicial positions in the civil
service.
The individualistic character of the Korean working class is illustrated
in a prewar attitude toward compensation for labor. In the Japanese view
at that time, a group of Japanese laborers could be paid regular monthly
wages and could be relied upon to work together at a certain level of effi-
ciency in carrying out a particular job. The Japanese thought that Koreans,
in contrast, would work slowly and less efficiently if paid regular monthly
wages. At the same time, the Japanese felt that Koreans would in fact work
faster than their Japanese counterparts to complete a particular job if paid
piece-rates for each task performed. In other words, the Japanese were good
at working collectively at a pace determined by the group, but with no in-
dividual trying to outshine his peers, whereas each Korean was working
as an individual for the rewards of his labor. This attitude toward labor be-
came intensified as a result of the Japanese-type educational system. It helps
to explain why Koreans of the present day are fiercely competitive, excel-
ling over other nationalities, for instance, in the implementation of over-
seas construction contracts. If given proper incentives to finish quickly,
Korean laborers are willing to work long hours without complicated labor-
union restrictions.
Placed in the right situation, Koreans will strive to outperform anyone,
even under nearly impossible odds. One author (Griffis 1897:42-43) depicts
this important character trait as reflected in records of warfare ranging across
thirteen centuries. He begins by describing the Chinese rout of a Korean
army in the seventh century:
After so crushing a loss in men and material, one might expect instant
surrender of the besieged city. So far from this, the garrison redoubled
the energy of their defense. In this we see a striking trait of the Korean
military character . . . . Chinese, Japanese, French, and Americans have
experienced the fact and marvelled thereat. It is that the Koreans are
poor soldiers in the open field . . . . But put the same men behind walls,
bring them to bay, and the timid stag amazes the hounds. Their whole
nature seems reinforced. They are more than brave. Their courage is
sublime. They fight to the last man, and fling themselves on the bare
steel when the foe clears the parapet.
580 Lee-Jay Cho and Kennon Breazeale

Korean individualism was reinforced by a trait that might be called a

“sabotage complex,” originating in the period of Japanese rule. Korean stu-
dents, constrained within a Japanese educational system tailored to the
Japanese national identity, funneled their energies into subversive chan-
nels. Unable to act openly against the system, they developed a tendency
to sabotage the process by which they were being Japanized, thereby partly
defeating the purposes of the system itself. Although the original common
target was the Japanese, these behavioral characteristics became strongly
ingrained in a whole generation of Koreans educated by the Japanese and
inevitably persisted even after liberation in 1945. They were, moreover,
passed on to the succeeding generation—their later sabotage objectives shift-
ing from one Korean leader to another. This type of behavior, because of
its origins in a repressive system, has unfortunately taken a destructive
rather than a creative form; several generations may be required to correct
it, possibly by diverting and absorbing the energies derived from this
sabotage tendency into positive political change.
Experiences of the Han’gul Generation
After the departure of the Japanese at the end of World War II, the public
desire for greater educational opportunities resulted in unprecedented ex-
pansion. The modern curriculum had to be both practical and Korean in
concept, reversing the process of distortion that began with the proselytiz-
ing of Western missionary schools followed by decades of suppression of
traditional Korean values by the Japanese-administered schools. At the time
of liberation, virtually everyone wanted to gain more and more education
at higher and higher levels. Koreans willingly invested as much as they could
afford to provide their children with a good education. Investment in univer-
sal education significantly improved the quality of the modern Korean work-
force, thus paving the way to rapid economic development in the 1960s
and 1970s. The new workers of the two decades immediately after World
War II were the first generation exposed to the post-Japanese system of
general education.
The Koreans who received their education immediately after World War
II are frequently called the “han’gil generation.” They learned relatively
few Chinese characters and were the first generation of Koreans to receive
a formal education through the medium of the har’giil phonetic system
of writing. The Korean educators of this period tried to emulate the achieve-
ments of their Japanese counterparts in terms of inculcating nationalism,
and thus the content of postwar Korean education was strongly nationalis-
tic. Unlike the Japanese, however, the Koreans do not have a long tradition
of modern education. In formulating its policies, the Korean government
was selective and sometimes inconsistent.
Official policy concerning the writing system, for example, was reversed
several times. Although the Korean language was restored as the medium
 The Educational System 581

of instruction after 1945, Korean nationalist sentiments were misguided in

insisting that only the han’gil system of writing should be taught in public
schools. Immediately after the war, an attempt was made to eliminate
Chinese characters because they were regarded, incorrectly, as a lingering
influence of Japanese- and Chinese-style education. In fact, Chinese charac-
ters have always served as an integral part of Korean literary tradition, with
the partial exception of folk literature.
Some Koreans still argue that Chinese characters can be eliminated al-
together, but to do so would be disadvantageous in various ways. The use
of select Chinese characters in combination with the har’gil script offers
numerous attractions, and even today few Koreans would willingly aban-
don the thousand or more characters that are still taught and in common
everyday use. Although any Korean word can be written in the Korean
script, it is often more practical to substitute a Chinese character to indi-
cate a precise or complex meaning. The configuration of a Chinese charac-
ter can enable the reader to recognize a precise meaning or concept that
is less efficiently conveyed by the phonetic equivalent. (Chinese characters
thus have the advantage of distinguishing between two words that are
pronounced identically but could not be differentiated in han’gil script ex-
cept when read in context.) Precise or elaborate meanings conveyed visually
by the configuration of a Chinese character cannot be conveyed by a sim-
ple phonetic rendering of the spoken word. Hence Chinese (or Koreans),
when a meaning comes into question, generally write the character so that
the listener can see it, rather than explain the meaning verbally. From a
modern perspective, moreover, familiarity with Chinese characters provides
potentially valuable training to facilitate trade and communications with
the Chinese and Japanese in the future, since schoolchildren in all three
countries learn many of the same characters in common.
Har/gtl was reinstated as the official written language in 1945. Under
the education laws enacted by the Republic of Korea, primary schools were
expected to teach only the har’gil script; secondary schools were required
to use han’gtl textbooks but also to teach 1,000 Chinese characters. In prac-
tice, this limitation on the use of Chinese characters was too severe, since
newspapers and even official documents in the early 1950s continued to
use a larger number of Chinese characters. By the time of the Korean War,
most secondary schools found it necessary to teach more than 2,000 Chinese
characters so that students could read newspapers and official statements
(UNESCO 1954:18). Officially, the total number of required characters re-
mains about 1,000, but well-educated Koreans take pride in learning many
more. The debate about the use of Chinese characters has thus continued,
and the question is not yet fully resolved.
Most of the Korean educators of the han’giil generation had to be recruited
from among the Koreans who had received a Japanese-type education. They
were the “individualists’ who went through the alienation phase under
582 Lee-Jay Cho and Kennon Breazeale

Japanese administration. Their individualist tendencies were fostered by

Japanese-style education, in which they experienced national and cultural
alienation, in terms of both the curriculum and the regimentation of their
training. They did not on the whole become a disciplined group, and they
could not shed the behavioral characteristics that they had acquired from
their educational experiences under the Japanese. Most of them were not
the best possible teachers, and they passed their undesirable behavioral
characteristics to the next generation.
At the university level, most Korean academics during the Japanese
colonial period were graduates of the best imperial universities in Japan.
At that time, however, very few Koreans attained the rank of professor. Af-
ter liberation, the existing corps of first-class Korean academics was too small
to meet the needs of the numerous new colleges and universities that sprang
up throughout the country. To fill the dramatically increasing number of
faculty positions, the new institutions had to recruit Koreans who had only
modest academic credentials obtained from lower-ranked Japanese insti-
tutions. Because of the serious shortage at this level, the government had
to draw also upon the existing pool of high-school instructors, who would
not normally qualify for university-level teaching. The shifting of many
qualified educators away from the secondary schools may have caused both
higher and secondary education to suffer from lack of teachers properly
trained for their respective levels.
The climate created by the post-Pacific war educators lingered on after
the Korean War, in the form of slovenly teaching habits, lack of creativity,
and lack of discipline. The students were eager and capable, but the in-
structors were not equal to the task of providing quality education. The
han’gul generation also seemed less disciplined than the Japanese in terms
of collective behavior. Although the first generation of teachers in indepen-
dent Korea were unable to provide high quality education, there were at
least sufficient numbers of them to meet existing numerical demand. The
government, needing every available teacher, had to employ many whose
work habits were poor and who possessed only limited qualifications. These
were the foundations on which modern Korean education had to be built.
As the demand for education grew, the supply of teachers could not catch
up with the boom, particularly in terms of quality. Today, perhaps too many
educational opportunities are available, although not yet enough of the
highest quality. Competition for entry to the prestigious schools and univer-
sities is fierce, often requiring long hours of private tutoring beyond the
standard curricula and sometimes leaving teenagers with an inadequate
four or five hours each night for sleep. There is pressure on parents, too,
for reasons of social prestige, which in turn puts a grave strain on students
to gain admission to a particular institution, to get a diploma, and to con-
tinue their university education through graduate school.
The diploma itself came to be regarded as the only goal of education,
 The Educational System 583

because the diploma seemed to be the key to a successful career. Unfor-

tunately, some students, including very bright ones, did not value educa-
tion for its own sake and cared only about the coveted diploma. How they
got it—whether by cheating or other means—did not concern them. As a
result, discipline eroded in Korean universities. Pure scholarship requires
persistence and hard work, without expectation of special remuneration.
Once their ties with the old scholarly traditions were severed, Koreans were
never retrained to appreciate this kind of discipline. Many among the scho-
larly community, once they receive their degrees, neither continue to carry
out research nor pursue knowledge for its own sake—except insofar as such
activities may be required to preserve their positions or livelihoods.
American Influences
Korea, unlike Japan, had to overcome many basic obstacles in building a
modern educational system and later in improving standards. Even before
World War II, the Japanese successfully harnessed the positive features of
traditional Japanese education for useful purposes in economic develop-
ment. Korea, however, did not follow the same pattern after liberation. Im-
mediately after the war, there was no modern Korean-style educational
system on which to build, and Koreans therefore had to search for their
own model.
Public education in Korea benefited in material terms from U.S. foreign
aid after the Korean War, although the imposition of American educational
philosophy was resisted. The American effort had three educational pol-
icy goals: democratization, decentralization of administration, and the cre-
ation of coeducational classes to improve the status of women. These basic
objectives were never met: democratization was not achieved, Korean edu-
cation remains hierarchical, and educational administration has become
more centralized. Coeducaiional classes were never accepted beyond the
primary level (AID, U.S., 1985). This attempt to induce policy changes
reflects a lack of cross-cultural perception and understanding. Korean cul-
tural traits proved resistant to the somewhat evangelistic posturing behind
the American offer of aid. The Korean government accepted the material
assistance but did not use the funds to carry out improvements in ways
that the American donors intended.
The 1960s witnessed the first massive flow of Korean students to the
United States and Europe for higher education. Successive age cohorts
among them have returned home to help build better quality higher edu-
cation. Although the period of exposure has been much shorter, the Koreans
have in many ways become much more Americanized than the Japanese.
This tendency is partly a result of the intensity and suddenness of exposure
by Koreans to American values and education during the past quarter cen-
tury, in contrast to the more gradual, century-long Japanese experience,
which was characterized by extensive exposure to many Western nations.
584 Lee-Jay Cho and Kennon Breazeale

Koreans have always had an exaggerated expectation of the people who

have studied in a country that is more advanced than Korea. Great respect
was traditionally given to Korean scholars who journeyed to China, which
was once regarded as the source of advanced learning. Upon their return
home, these scholars were treated as though they knew everything. They
were presumed to be more knowledgeable than people educated in Korea,
wiser, and better teachers. In more recent times, new graduates returning
from the United States were greeted with similar traditional esteem. The
period of the late 1950s onward saw the beginnings of the influx of
American-trained Ph.D.s into the Korean bureaucracy. American-trained
economists played an important role in introducing new skills and ration-
alizing the development process. They were able to play a major role in
Korea, in contrast to their counterparts in Japan, because of the absence
of a sufficient number of indigenously trained Korean bureaucrats. (Immedi-
ately after the Korean War, however, there were still a few older Korean
bureaucrats trained in the Japanese tradition who were formulating eco-
nomic policy.)
The newly returned graduates thus filled an important gap. They were
promoted with astonishing rapidity to senior posts, without passing through
the essential stages of institutional training or gaining experience at vari-
ous levels of the bureaucracy. Because of their unique positions, their roles
may have exceeded realistic limits beyond which, in several ways, they
tended to become dysfunctional. Thus the 1960s and 1970s might be charac-
terized as an important stage of the learning process, one result of which
was a complementary combination of indigenous elitist bureaucrats, on the
one hand, working together with Western-trained technical bureaucrats,
on the other?
Because of the scarcity of Ph.D.s in the late 1950s, anyone with a doc-
torate in economics was held almost in awe—as though he knew every-
thing about the economy. The new degree holders returning to Korea were
expected, moreover, to be able to perform immediately as skilled experts.
Their degrees were, however, only certifications of analytical ability and
training within a specific discipline, and their university studies alone could
not have prepared them to deal with the broad range of problems faced
by policymakers in the real world. In some cases, the theoretical aspects
of their American-university training may have been irrelevant to the Korean
economic setting. Upon their return to Korea, rather than acting with
modesty and prudence, most of them yielded to the pressure and tempta-
tions. Their broad recommendations and suggestions then became the bases
of economic policy.

2. Two examples are Mr. Jong-Yum Kim, who received a Japanese-style education and was
promoted through the bureaucracy in Korea to become minister of commerce and trade, minister
of finance, and President Park’s chief of staff, and Dr. Duk-Woo Nam, former prime minister
and minister of finance, who received graduate training in economics in the United States.
 The Educational System 585

During the 1960s and 1970s, the increasing number of American-trained

economists played a major role in formulating development policy for Korea.
They popularized general Western economics knowledge in Korea, there-
by contributing to rational planning. They were the communicators of
Western economic thinking, rational planning, ideas of market economy,
and analytical tools. They played a positive role by serving as a bridge to
communicate concepts and techniques for analyzing the economic situa-
tion of Korea. One positive outcome is that they were well prepared to in-
teract with Americans and to promote better mutual understanding, which
was especially important because American assistance had played a major
role in the Korean economy since the 1950s. The American-educated
economists were also exposed to (although not necessarily experienced in)
the American way of managing an economy. But the perceptions of such
economists frequently fell short of the mark in their understanding of
Korean conditions, traditional values, and behavioral characteristics rele-
vant to economic development, when compared with the indigenous
bureaucrats who had remained more closely in touch with local conditions.
By contrast, the Japanese postwar miracle of economic development was
led basically by a school of elite bureaucrats (Nobusuke Kishi and others).
In retrospect, as Chalmers Johnson (1982) indicates, these elitists bureaucrats
were insightful and consistent over a longer time frame in nurturing con-
sistent development policies. No American-trained Ph.D. was directly in-
volved in formulating important Japanese development policies within the
Economic Planning Ministry or the Ministry of International Trade and In-
dustry (MITI). Most of the Japanese with American Ph.D.s were filtered
instead into Japanese universities, where their work as researchers and ad-
visers contributed only indirectly to the bureaucrats’ thinking.
Korea did not have enough elite bureaucrats who had received the type
of training that their Japanese counterparts possessed. Indigenously edu-
cated bureaucrats were helpful in assessing local situations, whereas those
who received their doctorates in the West were not trained to grasp the
traditional aspects of the economy and society. They tended to develop poli-
cies based instead on their technical training from Western literature—in
essence, a textbook treatment of economic policies. For example, the im-
plementation of a value-added tax (VAT) system worked well in Europe.
Korean bureaucrats with a sense of traditional behavior and institutional
arrangements were opposed to the adoption of a VAT system in Korea. But
some Korean economists with American training were fascinated by the
European sucess with VAT and persuaded the government to introduce this
tax system in Korea. In spite of their compelling arguments and persuasive
theory, the Korean experiment turned out to be a costly lesson, because
of the failure to take into consideration the way Koreans behave in con-
sonance with their expectations, habits, and customs. Given sufficient time,
Korean behavioral norms could be modified to accommodate the VAT sys-
tem, but such radical change cannot be brought about rapidly.
586 Lee-Jay Cho and Kennon Breazeale ee ieee
ELE RESe BP i Ae oS aE ONE Neer
In some ways, the recent generation of highly skilled graduates return-
ing from the West can be compared with their predecessors who were
products of the Japanese educational system. In the post-Korean War pe-
riod, because of the predominant role that Americans played in military
and economic assistance, which the Koreans appreciated, it seems in
retrospect that Koreans were too ready to accept things American, includ-
ing American-style education and its content. Only later did Koreans see
that American-style education is not the all-encompassing panacea that they
once imagined and that it does not completely fit the traditional Korean
value system. The tendency at present is to look back and search for an
amalgamation of both traditional Sino-Korean and contemporary Western-
technological education.
CONCLUDING REMARKS
The potential for rapid expansion of education in Korea already existed at
the time of liberation in 1945. Japanese rule provided not only a legacy of
basic infrastructure but also modern concepts, the more important of which
were the goal of making schooling universally available and modern cur-
ricula and teaching methods to train the workforce to carry out national
economic objectives. The Japanese use of education to enforce social change,
however, had several negative consequences, fostering a sense of aliena-
tion, stimulating the sabotage complex, and distorting traditional Korean
values that did not fit the Japanese mold. Nevertheless, rapid advances af-
ter liberation were facilitated by the positive Korean outlook concerning
educational opportunities—most notably the high value placed on educa-
tion at every level of Korean society, the Confucian concepts that predomi-
nated among the majority of the population, and the tradition of learning
based on Chinese characters and held in common with the rest of East Asia.
Teachers were held in high esteem. Koreans were very receptive to educa-
tion as a means of personal advancement, and the learning process was
facilitated also by the discipline inherent in the hierarchical nature of soci-
ety, with its emphasis on respect for elders.
The modern educational system provided the nation’s workforce from
1945 to the 1980s with essential basic skills, which industry utilized as one
of the driving forces for economic expansion and industrialization. Future
development, however, especially in high-technology industries and in trade
and services based on medium and high technology, will rely on higher
standards of teaching, increasing technological sophistication in educational
curricula, and a more disciplined labor force. The greatest task for Korean
educators as the nation enters the 1990s is to achieve rapid improvements
in the quality of education, particularly at the secondary and tertiary lev-
els. Such advances are vital if the generation of Korean youth entering the
labor market at the turn of the century are to be adequately prepared to
meet the intensified international competition from other advanced indus-
trialized economies.
 23 Changes in the Social Structure
by Lee-Jay Cho and Kennon Breazeale

The social structure of Korea has undergone disruptive changes during the
past two to three generations, particularly as a result of subjection to colonial
rule, two major wars, and political turmoil under the six successive repub-
lics. By the early 1940s, Korea had ceased to be the “land of the morning
calm” where farmers tilled their fields while the class of landed gentry (yang-
ban) provided community and national leadership and served as the reposi-
tory of traditional values. Large numbers of Koreans were mobilized by
Japan for the war effort, and in Korea itself the number of factory workers
more than doubled within a few years—from 0.27 million in 1939 to 0.55
million in 1943 (H. Choi 1971:291). The economic infrastructure of the penin-
sula was relatively undamaged at the end of World War II but was later
destroyed during the Korean War. Thus, unlike most other countries oc-
cupied during and immediately after World War II, Korea's economic re-
habilitation was delayed for almost a decade. The entire period from the
time of liberation was, however, one of rapid social change.

POPULATION MOVEMENTS
Geographic Mobility
There is a long history of northward migration by Korean farmers in search
of farmland in Manchuria, but the era of large-scale population movement
out of the peninsula coincides with the years of Japanese colonization from
1910 to 1945. Manchuria continued to attract most of the emigrants until
about 1920, when the tide of emigration shifted to Japan (Table 23.1). The
number of emigrants to Manchuria continued to increase, however, and
reached an unprecedented level in the 1930s when Japan was attempting
to develop the resources of the puppet state established in 1932.
These emigration statistics, although only approximations, demonstrate
clearly the magnitude of Korean emigration during this period. On the eve
of World War II, large numbers of Koreans were residing outside the penin-
sula: about 778,000 in Manchuria and 730,000 in Japan in 1937 (H. Choi
1971:275). The emigrants to Japan were largely from the agricultural south,
where the population loss was more noticeable than in the industrial north.
During the war, the Koreans who were sent to Japan for the war effort con-
stituted a substantial proportion of the “emigrants.” Between 1940 and 1945
about 630,000 people, representing 2.5 percent of the entire Korean popu-
lation, moved to Japan. Subsequent emigration from Korea has not been
significant.
587
588
oe
SS
Lee-Jay Cho and Kennon Breazeale

Table 23.1. Net Korean migration to Japan and Manchuria: 1910-40

Net Korean migration to
Years Manchuria ee Japan Both areas
SOS ae a ee
1910-15 150,000 1,000 151,000
1916-20 174,600 34,000 208,600
1921-25 24,200 138,300 162,500
1926-30 101,400 200,300 301,700
1931-35 175,500 262,400 437,900
1936-40 565,200 456,500 1,021,700

Source: Kwon et al. (1975).

Table 23.2. Estimates of migration into South Korea: 1945-49

Data source
Ministry of Ministry Survey of Man-
Place of origin Foreign Affairs of Health power Resources
Japan 1 AI7, 819: 1,407,255 936,000
North Korea 648,784 456,404 209,000
Manchuria O17 ,a27| 382,348 212,000
Rest of China 72,848 78,442 42,000
Other places 32,864 157,916 481,000
Total 2,189,642 2,482,365 1,880,000
Source: C. C. Yun (1974:126).

After the occupation of the peninsula in 1945 by Soviet and American

troops, above and below the 38th parallel, many people moved south across
the artificial dividing line, and most Koreans residing outside the country
tried to return. Although no accurate records were maintained during this
turbulent period, official estimates of migration to South Korea between
1945 and 1949 range from 1.9 to 2.5 million (Table 23.2). Comparisons of
prewar and postwar census data suggest that the total number of immigrants
to South Korea during 1945-49 was in the range of 1.7-1.8 million (Kwon
et al. 1975:33). About 1.0-1.4 million of these came from Japan alone, mostly
returning to their areas of origin in the three southern provinces, but settling
in urban rather than rural areas. The total number of returnees from Man-
churia may never be known, but as many as 400,000 of them resettled in
South Korea by 1949. (For further details, see Kwon et al. 1975:29-36 and
Taeuber and Barclay 1950.)
The social and economic dislocation of this period was exacerbated by
wartime casualties, two waves of migration between the North and South,
and internal migration within South Korea alone. Estimates of those who
 Changes in the Social Structure 589

moved south across the military occupation line during 1945-49 range from
150,000 to 740,000 (Kwon et al. 1975:33; Table 23.2). The great majority of
the migrants from the North settled either in Seoul or simply moved across
the line and into the rural areas of the two northern provinces of South
Korea. During the Korean War (1950-53), the entire peninsula was affected
by the attacks and counterattacks deep into both North and South Korea,
although at the end of the war the country remained divided at the origi-
nal arbitrary occupation line. The toll taken by the war in South Korea in-
cluded more than 760,000 civilians and more than 200,000 military personnel
killed, missing, or abducted and never returned, plus nearly 230,000 civilians
and more than 100,000 military personnel wounded (Table 23.3). In addi-
tion, 16 nations deployed troops to aid South Korea. The U.S. military alone
suffered nearly 33,750 dead and 103,300 wounded among the 0.5 million
U.S. soldiers who fought in the war (Department of Defense, U.S., 1989).
During the Korean War, it is estimated that nearly 650,000 people from the
North moved to South Korea, and nearly 290,000 moved from the South
to the North (Kwon et al. 1975:35-36).

Urbanization and the Emergence of a Middle Class

Seoul was the destination for 45 percent of all migrants from North Korea
during 1945-49. About 48 percent of the refugees from the North during
the Korean War crowded into the cities. During 1950-53 about 44 percent
of the urbanward refugees from the North moved into Seoul. More than
a third settled initially in Pusan, which became the provisional wartime
capital. When the national administrative functions were transferred back
to Seoul during the second half of the 1950s, however, these refugees like-
wise tended to move to the Seoul area (Kwon et al. 1975:36-37).
Because the wartime destruction affected almost every part of the
peninsula, the period up to 1953 and several years beyond was one of

Table 23.3. South Korean casualties during the Korean War: 1950-53
Civilian
Category Male Female Total Military
Killed in fighting 166,104 78,559 244,663 29,494
Executed 97,680 31,256 128,936 —4
Wounded 168,849 60,776. A=<229,625 101,097
Taken prisoner to North Korea
and not returned 78,377 6,155 84,532 65,601
Missing 253,241 49,941 303,212 105,672
Total 764,281 226,687 990,968 301,864
EE

Source: C. C. Yun (1974:126).

a. Combined with ‘‘killed in fighting.”’
590 Lee-Jay Cho and Kennon Breazeale

deprivation and hardship for the majority of the populace, who had to turn
to any means available to survive and provide bare necessities for their fam-
ilies. A large proportion of the people involved in the massive migrations
into and within Korea from 1945 to 1953 were uprooted from their previ-
ous occupational niches, and the only choice for most was to eke out a liv-
ing in an urban area. The Seoul metropolitan area, which had fewer than
1 million inhabitants in 1945, absorbed within the first decade after libera-
tion more displaced persons than its original population. The populations
of the capital and other cities in the South thus swelled suddenly, not as
a result of industrialization and economic growth but because of wartime
chaos and movements of refugees.
Comparative census data show the growing tendency among South
Koreans to change their place of residence after the two wars. The South
had very low interprovincial migration rates prior to World War II, but the
volume of movement away from native provinces increased substantially
in the postwar period. Three-quarters of the internal migration was urban-
ward, predominantly to the two independent metropolitan areas. Seoul (a
metropolitan area since 1945) acquired 51 percent of its population through
in-migration from the provinces by 1960 and 56 percent by 1966; Pusan (a
metropolitan area since 1966) likewise had a high rate of in-migration. At
the same time, almost all of the nine provinces were experiencing a net
loss of population. Hence the increase of the South Korean population dur-
ing the 1960s was absorbed largely by the two metropolitan areas and, to
a lesser extent, by smaller cities (L. J. Cho 1973:25-33).
Although the speed of industrialization between 1960 and 1985 was rapid
but irregular, that of urbanization was steady. The proportion of the total
population residing in urban areas increased from 28 percent in 1960 to
65 percent in 1985. By 1985 the population of Seoul reached 9.6 million and
accounted for more than 36 percent of the nation’s urban population. Be-
tween the end of World War II and 1985, the population of Pusan grew from
200,000 to 3.5 million, accounting for an additional 13 percent of the total
urban population (EPB, ROK, Census Report, 1985:22, 34).
The quality of life in rural areas did not improve after the Korean War,
largely because of rapid population growth and increased agricultural den-
sity. The pressure on the land was already apparent under colonial rule
(average landholding per farm declining by about 12 percent between 1918
and 1936), and although the number of independent farm households re-
mained steady (at just over 0.5 million during 1914-40), representing roughly
one-fifth of all households, the proportion of tenant farming had increased
to more than half of all households by 1940 (H. Choi 1971:264-65). After
the Korean War, rural poverty resulted in another massive influx into the
cities.
Because of the desperate economic conditions, there was a strong desire
at both individual and collective levels to find any means available in urban
 Changes in the Social Structure 591

areas to overcome poverty. The urbanward migrants crowded into the slums
of Seoul and Pusan, where the need to survive fostered an increase in un-
skilled and semi-skilled employment, such as unskilled construction work-
ers, street vendors, tailors, cooks, and drivers. Later, the rapidly expanding
economy, centered mainly on urban areas, attracted increasing numbers
of in-migrants from rural areas, and consequently the proportion of the
populace engaged in agriculture dwindled.
The gradual inundation of original city dwellers by refugees and other
in-migrants brought about important changes in attitudes and self-
perception. At the end of the Korean War, the middle class was a very small
proportion of the populace—mainly teachers, merchants, lawyers, physi-
cians, government officials, and other educated people. Only a few indi-
viduals—notably great landowners and some entrepreneurs—were actually
rich, and the vast majority of the populace regarded themselves as poor.
This perception was overturned, however, by the relative prosperity and
expanding educational opportunities in the 1960s and 1970s. Rapid urbani-
zation exposed an increasing number of rural people to urban occupation-
al opportunities, such as services, sales, and small business. With the
economic take-off of the 1960s, most city dwellers were able to find occupa-
tional niches. Shacks and shabby shops were replaced by substantial and
prosperous-looking buildings, as Seoul’s former refugee slums (such as
Itaewan, Haebangchon or “Liberation Village,” Mok-dong, Oksoo-dong,
Eungbong-dong, Sanggye-dong, and Jungkye-dong) were transformed into
middle-class districts. Objective statistical indicators during the past sev-
eral decades reveal a substantial change in the proportion of the popula-
tion perceiving themselves as middle class—from about 20 percent in 1960
to 30 percent in 1970 and 48 percent in 1980 (D. S. Hong 1980). By 1987,
according to a survey published by the newspaper Dong-a Ilbo, the number
had reached 65 percent. This increase and the emergence of the middle
class as the predominant segment of society reflect the effects of rapid eco-
nomic development on incomes and occupational diversification.

SOCIAL DEVELOPMENT
Social Mobility
Political turmoil and geographical mobility helped to bring about radical
changes in social mobility patterns. The cities became melting pots of peo-
ple from different regions. While some of the poor were growing richer,
however, some of the rich were sliding into poverty. Some of the wealthi-
est Koreans of the 1945-50 period may now be among the poorest, and none
of the ten richest Koreans of that period are among the top ten today. Simi-
larly, none of the top ten businessmen from these interwar years would
rank among the top 50 today. The patterns of mobility in the Korean busi-
ness community can thus be characterized as unprecedentedly dynamic.
592 Lee-Jay Cho and Kennon Breazeale

Lack of education, moreover, no longer seems to be a major barrier to eco-

nomic mobility, since the owners of today’s large business conglomerates
received much lower levels of education than the military elite or the na-
tion’s bureaucrats.
Meanwhile, the position of the landlord class in the social hierarchy, es-
pecially in economic terms, practically ceased to exist. Most former land-
lords gained possession of their property through inheritance and enjoyed
the benefits of rental income. They capitalized on the status accompanying
their positions as board members and managed to build positions for them-
selves in the industrial corporations. After the implementation of land re-
form, some rich landlords used the compensation received for their land
to start businesses and engage in other entrepreneurial activities. Some of
the landed class with the biggest landholdings were able to maintain their
status in the social hierarchy because of benefits accruing from earlier in-
vestments in private educational institutions (such as building schools and
universities). The majority of the former landowners, however, joined the
ranks of the middle class, and some even became impoverished. Regard-
less of economic status, most of them could afford to provide an education
for their children, thereby enabling their descendants to find places in the
universities, other educational institutions, and the major professions.
The rate of social mobility in Korean society has been higher than in other
developing countries in recent decades (D. S. Hong 1980:59-99). Rapid so-
cial change and turmoil have eroded class boundaries and given the Korean
people the idea that the self-perpetuating class is an institution of the past.
The fact that anyone with resources, energy, and luck now has the oppor-
tunity to climb the social ladder has contributed greatly to the emergence
of a strong egalitarian ideology among the masses.
Culture and Values
Large-scale geographic mobility has been accompanied by a dilution of tradi-
tional values. As people have moved away from their ancestral lands and
parents and have become increasingly profit oriented, they have become
less concerned with perpetuating the rituals and customs that reinforce
traditional values and passing them on to the next generation.
Two distinctive features of religious organization in Korea are the low
level of professed religious affiliation and the tendency to blur the lines
of demarcation between major religions. One analysis of 1983 data (I. H.
Yun 1985) showed that fewer than 40 percent of the population categorized
themselves under a specific religion—that is, 18.9 percent (7.5 million peo-
ple) were Buddhist, 13.5 percent (5.3 million people) were Protestant, and
4.0 percent (1.6 million people) were Catholic. The analysis showed fur-
ther that, after a pattern of steady growth during 1971-81, there was a
decrease in the numbers of both Buddhists and Protestants between 1981
and 1983. The decline was especially sharp in the case of Buddhists, prob-
 Changes in the Social Structure 593

ably reflecting a change in self-categorization. Some persons may have up-

held a set of values drawn variously from Buddhism, Christianity, and Con-
fucianism, formerly declaring themselves under one group but later
preferring to place themselves in no specific category. (This factor, which
is basically one of definition, does not apply to Catholics, who registered
a slow but steady increase in number throughout the period measured.)
The recent alienation from traditional culture has been accompanied by
a dilution of the individual discipline that was once typical of the cohesive
village community. Urbanization and economic development have been so
rapid that the villagers have not had sufficient time to make the necessary
social and other adjustments to “urbanism as a way of life.” Korean cities,
unlike those of Japan, have thus become concentrations of villagers and
refugees. The time span of at least a generation will be required for those
new city dwellers to make themselves an integral part of the cities and ur-
ban life.
At least five broad patterns can be discerned among the changes in in-
dividual values since the time of Korean independence. At the end of World
War II, everyone's attention was concentrated on patriotism toward the na-
tion in the wake of liberation from colonialism. By the end of the Korean
War, however, attitudes had changed, and people placed greater weight
on wealth, status, and political power. The attitude that only the end, and
not the means, was important led to an erosion in traditional moral values.
The 1960s witnessed the recovery of traditional moral values and height-
ened economic values. During this time, people tended to attach greater
value to national development, patriotism, diligence, self-reliance, improved
standards of living, and a happy (preferably small or nuclear) family. In
the 1970s there was less emphasis on diligence and wealth but greater value
was placed on social welfare and a happier life. This period witnessed the
emergence of ordinary, nonmaterial aspects of happiness: individualism,
equality, social justice, and human rights. The 1970s also witnessed the re-
emergence of strong family values and respect toward elders. In the 1980s,
the trend turned once again toward wealth, but with less emphasis than
before on patriotism and national development, as people grew more con-
cerned about health and the pleasures of life. The overall trend indicates
that the younger generation of the 1980s exhibits a greater degree of in-
dividualism than the older postwar generation and has experienced a tran-
sition from family and clan consciousness to a wider social consciousness
(Cha 1985).
Student Radicalism
Students have always played a political role by expressing discontent and
pressing for political change in the East Asian countries, and student groups
have often been hotbeds of radical thought. The 1960 student protests in
Korea against corruption and dictatorship helped to overthrow the regime
594 Lee-Jay Cho and Kennon Breazeale

of Syngman Rhee. Later in the 1960s Korean students organized massive

demonstrations to protest the normalization of relations with Japan (just
as Japanese students protested violently in the 1950s against the Japan-
U.S. security treaty). Massive student demonstrations in 1986 and 1987 called
for democratic reform and an end to the military regime under President
Chun. (During the past few years, students in China likewise have called
for more democratic freedoms and a relaxation of the prevailing communist
ideology.) Student rioting and occupation of university buildings in 1988
seems to have taken an even more violent turn, reflecting a more radical
ideology that is anti-establishment, anti-capitalist, and anti-American, in
its opposition to rapid economic development and international trade de-
pendence, it is also to some extent anti-development. (For an academic ap-
proach to dependency issues affecting Korean development, see K. D. Kim
1987.) An intriguing facet of student radicalism is the effort to heighten na-
tionalist sentiments by demanding the unification of North and South Korea
at any cost. It is instructive to examine this radicalization from the perspec-
tive of the contrasting experiences of successive generations of Korean
society.
Student radicalism is related in some ways to the demographic transi-
tion, reflecting the change from high to low fertility levels and from poverty
to prosperity. A common pattern can be discerned in societies that have
undergone extended periods of depression followed by relative prosper-
ity. In the United States, for example, the fertility rate was low during the
depression of the 1930s and the war of the early 1940s. Postwar economic
prosperity was accompanied by a baby boom, and the parents who suffered
during the depression and war years were anxious to provide their chil-
dren with everything that they had never been able to afford for themselves.
But in lavishing upon their children all the necessities of life, a good edu-
cation, and other luxuries, they brought up the new generation in the
absence of want. As the generation of the baby boom approached adult-
hood—a more numerous generation, reflecting the rise in fertility and con-
sequent population increase—many of them were not inculcated with the
older generation’s values such as respect for authority and hard work. The
anti-establishment protests of the 1960s and 1970s were thus partly a reflec-
tion of the markedly different conditions prevailing during the formative
years of the two generations—hence the tendency to oppose or reject
whatever their parents had established or believed. This phenomenon is
also apparent among the radicalized Japanese students of the 1950s who
had not experienced the economic difficulties and war of their parents’
generation.
In China a double reversal of a similar behavioral pattern can be dis-
cerned. Some of the elderly generation among China's leaders came from
the landed class and, in their youth, had heated arguments with their par-
ents over the perpetuation of feudalism, the exploitation of land rights, and
 Changes in the Social Structure 595

the misery of their tenants. That generation a half century ago sought a
solution in the absolute equality implicit in communist philosophy. The
children of today’s leaders, on the other hand, have grown up in the ab-
sence of war and have not suffered the deprivations that their parents did.
In Chinese cities at least, standards of living have improved greatly in re-
cent years. And yet the extreme poverty of the majority of the population
increasingly stands out in contrast to the better standards of living enjoyed
by urban dwellers and by farmers with access to nonstate markets. The
dinner-table debate in the leaders’ homes has thus shifted in the opposite
direction, and many younger Chinese now declare that the older genera-
tion has failed to modernize China and has left it one of the world’s poorer
countries.
The radicalization of Korean students can be better understood in the
context of this behavioral pattern of action and reaction by successive gener-
ations against the values of their parents’ generation. In Korea and China
alike, authoritarianism and the traditional ideal of collective work served
to motivate people, to help them overcome poverty, and to promote de-
velopment. But as people grow richer, the desire for more individual free-
dom emerges. Because of this inherent conflict, a certain amount of political
and economic change becomes inevitable. If a regime becomes so rigid and
entrenched that it does not respond to these generational changes, then
further radicalization and conflict likewise seem inevitable.
REGIONAL POLARIZATION
One interesting phenomenon, despite massive movements of people from
rural to urban areas and from one province to another, is the persistence
of regional or provincial differentiation. The sharpest geographical and po-
litical division is between two traditional rival regions—Kyongsang and
Cholla. This conflict is deeply imbedded in Korean history and can be traced
back to the struggles during the first millenium A.D. between the two king-
doms of Silla (modern Ky6ngsang) and Paekje (modern Cholla)—from
which Silla emerged the victor. The interprovincial conflicts were brought
into increasingly sharper focus by 1950-53 wartime conditions, post-Korean
War industrialization, and the presidential election campaign of 1971.
The southeastern part of the country is divided into North Kyongsang
(which includes Taegu, the nation’s third largest city), and South Kyong-
sang (which until 1966 included Pusan, Korea's second largest city). Kyong-
sang has the largest population of any part of the country, and its people
have played a predominant role in national politics, business, and the mili-
tary since the military coup of 1961. All nine army chiefs of staff between

1. Kim Dae Jung, an opposition leader from Cholla, lost the 1971 presidential election to Park
Chung Hee (a Kyéngsang native) by a small margin.
/ 596 Lee-Jay Cho and Kennon Breazeale

1966 and 1985, for example, were of Kyéngsang origin, as were Presidents
Park, Chun, and Roh. Among the heads of the leading conglomerates, those
of Kyéngsang origin would certainly constitute a majority. The Kyongsang
region not only has two of the largest Korean cities but also has industrial-
ized much faster than the two neighboring Chélla provinces, which con-
stitute the southwestern extremity of the peninsula. Although Cholla’s two
main cities (Kwangju and Chunju) have become important industrial
centers, Chdélla was unable to maintain parity with Ky6ngsang in its shares
of political and military leadership. This was partly because Cholla was
geographically outside the mainline transportation network developed un-
der Japanese rule and remained mostly agricultural. It was also partly a
result of the fortunes of war.
Given the infrastructure that existed at the time of liberation (most nota-
bly the Japanese-built harbor facilities and the Pusan-Seoul rail line), scarce
capital was obviously better invested in the regions around Seoul and Pu-
san. President Park Chung Hee, himself a native of KyOngsang, made an
effort to develop the Cholla region during the 1960s, but the philosophy
of “growth first, distribution later” in this context reflects the undeniable
fact that, for lack of capital and resources, all parts of the country could
not undergo economic growth simultaneously or at equal rates. For the long-
term benefit of the country as a whole, investment had to be concentrated
first on the best economic assets, although in the short term this uneven
growth pattern inevitably resulted in income differentials between the rap-
idly developing southeast and the more slowly developing southwest. In
1970 per capita incomes were 85,000 won for Ky6éngsang and 59,000 won
for Cholla (when the national average was 70,000 won), compared to 8,400
won and 7,500 won, respectively, in 1960 (when the national average was
9,500 won) (Hong and Cho 1986). The persistence of these differentials be-
tween the two provinces is amazing in some ways, particularly since eco-
nomic development has provided mass communications and an elaborate
transportation system, making the country much “smaller” than it was prior
to the Korean War in terms of interactions. These differentials were mani-
fested in the 1987 presidential and parliamentary elections, in which the
people of Cholla denounced the apparent economic and political discrimi-
nation by the governments of the past quarter century against Chdlla and
in favor of KyOngsang. To expedite the initial stage of economic develop-
ment, however, such regional imbalance was probably unavoidable in the
short term.
During the Korean War, the initial offensive from the North in 1950
pushed the South Korean forces into a relatively small perimeter in the
southeast, including Pusan (which became the provisional capital) and
Taegu. Although a counter-offensive moved the front line north beyond
Seoul later the same year, a renewed North Korean offensive shifted it back
into the south by early 1951. At the very beginning of the war, therefore,
the two Cholla provinces became occupied territory. For security reasons,
 Changes in the Social Structure 597

anyone from Chidlla or other provinces overrun by the enemy came under
close scrutiny because of the danger of enemy infiltration among the civilian
populace.
The emergency conditions necessitated an unparalleled expansion of the
military academy, which had to rapidly provide commissions to meet the
need for more officers to conduct the war. The members of Class 10 were
commissioned immediately after their entry in July 1950, and the academy
was then closed temporarily. Subsequent officer trainees were recruited,
given a month's training, and transferred to the army’s training school. The
regular four-year training program resumed only in early 1952, when the
academy was reopened in Chinhae, a naval base near Pusan.
During the next few years recruitment in the army was apparently con-
centrated among young men from the surrounding Kyéngsang area, and
entrants to the reopened academy were drawn from both this area and the
enlisted ranks. It was almost impossible for men living in enemy-occupied
areas to reach Pusan, and the security clearance required of each entrant
excluded virtually everyone outside KyOngsang. Security clearances like-
wise excluded prospective university students from those areas. People from
the other provinces lost out by default, because of the geographic and stra-
tegic position of KyOngsang during a brief period of rapid expansion of mili-
tary personnel. The effects of these wartime conditions are still being felt,
manifested during the 1980s by increasing tension in the two Cholla
provinces during the presidency of Chun Doo Hwan (1981-87) and the 1987
election campaign of President Roh Tae Woo, both of Kyongsang origin and
commissioned with Class 11—the first regular graduates after the academy
was reopened in the Kyongsang area.

POSTWAR INSTITUTIONAL CHANGES

Status of the Military
Immediately after liberation, particularly in the South, a career in the mili-
tary was not regarded with high esteem. This perception was shaped by
Chinese cultural influences over recent centuries. Soldiers were looked
down upon, whereas the literati-cum-officials were granted high profes-
sional prestige, arising from Confucian values and emphasis on scholar-
ship but disdain for military prowess.
The military elite of the post-Korean War period and of today were drawn
mostly from the agricultural and the urban working classes. Military officers
are likely to be the sons of farmers, shopkeepers, or blue-collar workers.
Many of the early entrants into the military after national liberation in 1945
had served in the Japanese army as enlisted men or as student conscripts.
The ranks of the armed forces were expanded by refugees from North Korea
who were not successful in finding stable occupations in the South. In ad-
dition, some who joined the new Korean military service had gone through
the regular selection process in the Japanese military academy and had
598 Lee-Jay Cho and Kennon Breazeale

served as officers. Park Chung Hee, for example, served as an Officer in

Japan’s Manchurian Army.
The outbreak of the Korean War necessitated a dramatic expansion of
the Korean armed forces. All those in uniform before the war (competent
or not) who survived the war were propelled up the social ladder. This was
an unprecedented opportunity for upward social mobility and for gaining
access to leadership positions in society. Such a phenomenon would never
have occurred had the war not broken out. It is reflected in the educational
attainment of today’s military elite, who have achieved a level of education
comparable to that of the civil service or almost any other sector of Korean
society outside academia.
Among the Korean government elite, there appears to be a value con-
gruence between those who have a military background and those who
do not (Hong and Cho 1986). The political party elite with a military back-
ground tend to hold an attitude similar to that of the professional military
elite. The military elite, moreover, share much in common with owners of
small businesses in their perceptions of economic development and social
harmony. The military elite are more progressive in their views regarding
policies for redistribution of income than are corporate executives and own-
ers of large businesses. Over the period of great upheaval and change after
independence, Koreans have become more egalitarian-minded about the
distribution of wealth. This is an important perceptional change that ac-
companied social change during the Park period.
Legacy of the Colonial Legal System
The executive branch of the independent government of Korea was pat-
terned on the structure that existed during the Japanese colonial period,
although it was modified and enlarged to suit the needs of the newly liber-
ated nation. Many of the bureaucrats who served the Japanese administra-
tion were promoted and continued in government service when the First
Republic was established. With the exception of the top leadership, there-
fore, the executive branch experienced no clear break with the past. For
this reason, the workings of the colonial bureaucracy—including attitudes,
values, and practices—were perpetuated to some extent after independence.
The judicial branch likewise was based on the system instituted during
the colonial period, including both a law code patterned after continental
European law and a legal profession trained at Keijo Imperial University
in Seoul or universities in Japan. In theory, the Korean legal system and
laws from the First Republic onward were designed to serve and protect
the people. In practice, however, Korean lawyers and judges helped to per-
petuate the colonial concept that the legal system served primarily as a
means of exercising control over the population. Not surprisingly, there-
fore, many people continued to believe, even after the representative sys-
tem of government was established, that laws were formulated to serve the
elite rather than the ordinary citizen. This perception did not foster a sense
 Changes in the Social Structure 599

of respect for the legal system, and people tended to avoid compliance if
they could do so without personal risk. Although a more rational attitude
has gradually evolved, the perceptions ingrained during the colonial pe-
riod still linger, and lack of respect for the law still contributes to inade-
quate enforcement (Yang 1985). Many people fail to perceive the civil code
as an instrument that helps to guarantee their rights, and they regard legal
action as an embarrassment to family honor and social status. Because of
this aversion to litigation, there is a tendency to pursue out-of-court settle-
ments, which in turn reinforces the lack of confidence in and respect for
the legal system.
Rise of the Labor Movement
Although Korea has a long tradition of labor unions, the labor movement
was shaped by the conditions under which it evolved during the period
of Japanese colonialism from 1910 to 1945. Neither before nor after indepen-
dence did appropriate institutions evolve to accommodate the resolution
of conflict between labor and management, and in some ways the legacy
of the colonial period still lingers.
Two major features of the Korean labor movement bear the imprint of
the colonial period. Under Japanese rule, the workers were all Korean
whereas management was mostly Japanese. The more defiance demon-
strated by labor leaders against Japanese management, the more patriotic
they appeared to their fellow Koreans. Such circumstances precluded any
system of compromise—which was equated with “collaboration” and por-
trayed as a betrayal of the rank-and-file Korean workers. Under these cir-
cumstances, the labor movement developed a political and anti-colonial
orientation rather than concentrating primarily on negotiations for increased
pay and improved working conditions. Hence the process of institutional-
ization to achieve Western-style, business-like trade unionism was stifled
by circumstances that also nurtured a tradition of violence as the principal
recourse in resolving conflict.
After the Korean War, the government formulated an elaborate program
of labor legislation. The laws that were enacted in the mid-1950s, however,
were not a response to labor-management needs but were designed instead
to counterbalance North Korean propaganda. (In essence, when the com-
munist government began publicizing North Korea as a laborers’ paradise,
Syngman Rhee’s government enacted new laws designed to show that labor
conditions in the South were even better.) Because industry and govern-
ment alike could not afford to provide all workers simultaneously with an
attractive package of benefits, it was obvious to labor leaders that the statu-
tory requirements were merely window dressing. Furthermore, the absence
of an institutionalized labor movement in Korea itself forced the lawmak-
ers to look elsewhere for precedents and models. Their draft legislation was
thus copied largely from labor laws recently enacted in Japan, which in turn
were based on American models of the postwar Allied occupation period.
600 —_Lee-Jay Cho and Kennon Breazeale

The Japanese did not find such models to be entirely appropriate for con-
ditions in Japan, and they did not enforce all legal stipulations to the letter
of the law.
The unfortunate consequence of these contradictions is that, from the
outset, all concerned parties simply disregarded the Korean labor laws. Em-
ployers could not afford to provide all the benefits and did not abide by
the law. Labor leaders, on the other hand, could not get the government
to enforce the law. This cycle of delinquincy-by-default prevented the growth
of any sense of mutual obligations among the three parties and established
a behavioral pattern that has persisted up to the present.
The colonial tradition of violence and confrontation as the principal al-
ternative to compromise likewise persists and is particularly noticeable in
recurrent crowd behavior that shows no regard for rules or order. The cur-
tailment of individual political rights during the 1970s and 1980s, moreover,
exacerbated the pent-up feelings of the younger generation at a time of dra-
matic rise in the level of education, increased international communications,
and greater awareness of labor- and political-rights activities in other coun-
tries. Amidst these rapid changes, the labor movement was muted most
of the time, although there were occasional explosive outbursts—such as
the violence that erupted in the last year of the Park administration.
._ With the political liberalization that began in 1987, the relationship be-
tween labor and management began to change dramatically. Up to this time,
labor disruptions were relatively rare in Korea, whereas during a two-month
period alone in 1987 there were 3,300 recorded labor disputes (all wildcat
strikes). Unless there is a major political reversal, the labor movement will
continue to emerge as a major factor in politics and the economy. Many
years will be needed, however, for the three parties concerned—government,
management, and the unions—to develop institutional arrangements for
conducting peaceful negotiations and procedures for settling labor disputes,
thereby achieving the genuine objectives of a labor union: material benefits
for the rank and file, participatory satisfaction of members, institutional con-
straints, and a respect for law and order.
Viewed from the present time, it may be instructive to ponder whether
the rapid industrialization and rapid growth accomplished by the Park re-
gime were worth the restriction of public participation and civil liberties.
When material benefits must be considered together with social and politi-
cal costs, how should the national ledgers of rapid industrialization and
rapid growth be balanced? Although the costs of economic development
are by no means negligible, should not economic development be impera-
tive, when it is the sole alternative for eliminating extreme poverty? For
those who wish to study what to emulate and what to avoid by drawing
comparisons from the past, the experiences of Korea provide a useful per-
spective on the question of whether political development can or should
be postponed under certain circumstances.
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 24 Political, Economic, and Social
Developments in the 1980s
by Lee-Jay Cho and Yoon Hyung Kim

RETROSPECTIVE ON THE PARK ERA

The two decades of political stability that President Park Chung Hee main-
tained through his dexterous political skill and firm leadership, paved the
way for rapid economic growth in Korea. The Park government took rapid
economic growth and the elimination of absolute poverty as its major goals
and assumed the role that many political economists attribute to the
capitalist developmental state Government played an increasingly active
role in managing the economy, beginning with the launching of the First
Five-Year Economic Development Plan and nationalization of all commer-
cial banks in 1961. To overcome rural poverty and motivate the rural peo-
ple to participate in improving their situation, the government launched
the Saemaul (new community) movement, which aimed at rapid rural de-
velopment and transformation. President Park also fostered the develop-
ment of a strong, efficient, and effective economic bureaucracy, enhancing
its capabilities in formulating and implementing policies reflecting the
government's active role in the economy. Institutions and legal systems were
forged to facilitate the implementation of the developmental priorities of
the government. In these ways, the government laid the foundation for sub-
sequent economic growth.
During the rapid international changes of the 1970s, in particular the U.S.
initiative in developing a political and economic relationship with China
and the possibility of a U.S. troop withdrawal from Korea, President Park’s
strong and effective government led Korea not only in dealing effectively
with national security issues but also in readjusting the structure of the
entire Korean economy to achieve long-term goals.
The government's basic purpose in intervening in the management of
the economy at that time was to create the infrastructure needed for self-
defense by accelerating the development of heavy industry. Under the
Heavy and Chemical Industries Promotion Plan, announced in 1973, the
new industrial strategy was to restructure Korean industry by shifting

1. The “capitalist developmental state” exists when the state leads economic development—
“when it mobilizes and allocates capital, when it licenses or subcontracts its projects to pri-
vate entrepreneurs, and when it plays the predominant role in controlling the organization
of workers. . . . Korea since 1961 is a prime example” (Johnson 1989).

603
604 Lee-Jay Cho and Yoon Hyung Kim

manufacturing output and exports away from light manufactured goods

toward more sophisticated and high value-added industrial goods. The
government chose to emphasize the heavy and chemical industries not only
because of national defense concerns but also in anticipation of the indus-
trial transition from the prevailing labor-intensive types of production to
capital-intensive industries.
The government's heavy-handed intervention in the big push for heavy
and chemical industrialization has frequently been criticized for creating
overcapacity (particularly in machinery and shipbuilding) and causing a
sectoral imbalance in investment. Although the Heavy and Chemical In-
dustry Promotion Plan was on the whole consistent with Korea's drive for
greater competitiveness and emerging advantage in international markets,
the pace was too rapid. The plan was also criticized for its excessive cost.
The development plan for the heavy and chemical industries, which ab-
sorbed a large percentage of the nation’s financial resources, essentially
replaced market tests for performance with bureaucratic judgment.
The late 1970s can be characterized as a tumultuous period of rough-
riding and risk-taking for the government. The biggest risk was the push
for heavy and chemical industrialization, which could have had serious
repercussions on the national economy if the destabilizing factors had not
been managed properly. Inflationary pressure had built up during the earlier
expansionary response to the oil shock of 1973-74, and it was accelerated
during the second half of the 1970s by the massive injections of capital in
the heavy and chemical industries and the increase in the money supply
resulting from the sudden influx of foreign exchange earnings from the Mid-
dle East. The introduction of a value-added tax system in 1977 exacerbated
the already serious inflationary pressure, because it necessitated an across-
the-board adjustment of the entire price structure. The weakening of ex-
port competitiveness, inflationary distortions in resource allocation, and
growing frustration among workers (who were increasingly aware of the
widening disparity in the distribution of wealth and income) pointed to
chronic inflation as a principal force undermining economic health. It
became clear that sustained economic growth would be difficult unless in-
flation was curbed. In April 1979 the government announced the Compre-
hensive Stabilization Program to control aggregate demand through
restrictive fiscal and monetary management and investment adjustment in
the heavy and chemical industries.
The single most destabilizing factor for Korea was the assassination of
President Park in October 1979, which sent shock waves through govern-
ment, the business community, and the general public. The shock was so
great that, for the first time in almost two decades, the Korean economy
recorded a negative growth rate (—3.7 percent) in the following year.
Although the economy quickly regained its high growth rate, the assassi-
 Political, Economic, and Social
Developments in the 1980s 605
Se ee ee
nation marked the end of almost two decades of unprecedented political
stability under strong political leadership.
President Choi Kyu Hah, who automatically succeeded to the presidency
under the existing Yushin constitution, did not demonstrate the strong
leadership needed in early 1980 to restore political stability and to direct
and manage the national economy. The consequences for the economy were
disastrous and the morale of the business community and general public
ebbed to its lowest point. The situation was worsened by large-scale stu-
dent demonstrations and disorder.
President Park had built up the nation’s military capabilities to face ex-
ternal aggression, but he had not developed institutional arrangements to
ensure a smooth and peaceful succession in the leadership. Thus, when
the nation abruptly became leaderless in late 1979, the military was in the
strongest position to fill the power vacuum and had a further advantage
because of its role in maintaining law and order. General Chun Doo Hwan
became the most powerful leader within the military after the December
Twelfth (1979) Incident (also known as the “Night of the Generals”). At that
time, the younger officers who were allied to General Chun (then chief of
the military security command) and his classmates consolidated their power.
On 18 May 1980 full martial law was declared and the military assumed
control of national administration? President Choi subsequently resigned.
General Chun was elected to serve for the remainder of the current
presidential term, as stipulated under the constitution, by the National Re-
unification Assembly (which was created in the latter part of the Park re-
gime). In June 1980 the military government established the National
Security Council, which was expanded in August 1980 into an interim legis-
lative body to draft a new constitution. The new constitution, ushering in
the Fifth Republic, was approved by a plebiscite conducted under martial
law in October. A new election law instituted the electoral college system
for the selection of the president and also limited the president to a single,
seven-year term. The presidential election was held in December 1980, and
Chun was elected. A new National Assembly was elected in March 1981.

2. In addition to imposing martial law, the Korean authorities arrested opposition political
leaders and closed the universities. These actions led to massive protests in the city of Kwangju,
which is located in the home province (Chdlla) of opposition leader Kim Dae Jung. These
protests, characterized as riots during the Chun regime, were recently described as prode-
mocracy demonstrations by President Roh Tae Woo. After the protesters gained control of the
city the military instituted a siege and finally mounted a full-scale assault. By the time the
military regained control of the city on 27 May 1980, 190 civilians had been killed.
The Kwangju tragedy remains a major issue in Korean politics, exacerbating regional ten-
sions between Chdlla and Kyongsang provinces. A special committee on investigation of the
Kwangju incident was formed in the National Assembly in June 1989 and President Roh has
called for early implementation of measures to compensate the families of those killed during
the military suppression of the civil uprising.
606 _—_Lee-Jay Cho and Yoon Hyung Kim

RETROSPECTIVE ON THE FIFTH REPUBLIC, 1980-87

The Just Society
From the outset, a reformist and puritanical stance was adopted by the
younger military officers who were the principal architects of the Fifth
Republic and the advocates of a “Just Society.” The first step in the realiza-
tion of this goal was to retire a number of politicians belonging to both the
progovernment majority and the opposition parties, because the govern-
ment considered them to be obstacles to forming a new society. Also as
part of the “purification” drive, the Chun regime purged nearly 8,000 civil
servants in July 19803 The puritanical tendencies were strengthened by the
elimination of part of the news media and the consolidation of newspaper
and broadcasting companies under state control, with the official aim of
remolding the news media into a “more desirable, ethical, and healthy”
industry4 In its efforts to “purify” Korean society, the Chun government
also sent so-called troublemakers (gangsters, hoodlums, armed robbers,
rapists, pimps, and other chronic lawbreakers) to the Samchong re-
education camps, with the goals of training the individuals to be useful
citizens and instilling greater social discipline in general>
By 1982 a certain distance had developed between the more puritan-
minded young officers and the older cohort headed by President Chun.
The gap between the opposing views widened as a result of the “Lady
Chang scandal” over financial maneuvering in which relatives of the presi-
dent's wife were implicated. Ultimately, disagreements about ethics in run-
ning the government culminated in the departure of the younger cohort
from the center of political power. Their major objection was the involve-
ment of the president's relatives in financial dealings and government af-
fairs. In 1982 President Chun consolidated his political power and
established his own political base.

3. After the establishment of the Sixth Republic, the government of President Roh Tae Woo
began to re-examine its predecessor's actions during this period and has, for example, offered
a formal apology and a pledge of monetary compensation to thousands of former civil ser-
vants who were dismissed in the 1980 purge.
4. In November 1990 a Seoul lawcourt ordered Munhwa Broadcasting Corporation, the only
private broadcasting company in Korea, to return some of its shares to their original owners,
who were stripped of their holdings by the Defense Security Command Investigators in the
forced media merger of 1980. This is the first instance in which the judiciary has ruled that
the military intelligence authorities’ acts, committed in the course of the 1980 media merger,
were a “serious breach of the Constitution and law” (The Korea Times, 2 November 1990; The
Korea Herald, 2 November 1990).
5. The criteria for designating “troublemakers” were arbitrary and some innocent people were
sent to the camps. There were instances of mismanagement of the camps and abuses of in-
mates’ human rights—including wrongful death and torture. President Roh has promised to
restore honor and provide compensation to the innocent victims of the Samchong camps.
 Political, Economic, and Social Developments in the 1980s 607

In the succeeding years, the younger cohort and their puritanical orien-
tation had a decreasing influence, and the president did not eliminate the
practices that they strongly cautioned against. In spite of their objections,
for example, the president's younger brother continued in his position as
head of the Saemaul movement. During the Sixth Republic he was charged
with illegally mobilizing political contributions through the Saemaul move-
ment, which was intended to be a pure and clean rural development or-
ganization operated on a voluntary basis. He was convicted and is still
serving a 13-year prison sentence.
Although a good military leader, and very able in mobilizing and taking
care of his troops, President Chun was not endowed with the political acu-
men and vision that came naturally to President Park. His lack of experience
in politics helped to perpetuate the authoritarian features of the Park re-
gime, while differing from it in important ways. One factor that ultimately
contributed to his political downfall was his “taking care of” and mismanage-
ment of his relatives. A second was his arbitrary use of power while lack-
ing any long-term political vision or philosophy of government. He conveyed
the image of a nice and personable man. But he did not appreciate or un-
derstand the fundamental meanings and consequences of power.
The tight monitoring of political contributions from the business com-
munity in the initial stage of the Chun administration represents a change
that is not fully recognized by the general public. During the time of Presi-
dent Park Chung Hee, the channel of political contributions was decen-
tralized. President Park distanced himself personally and left the task of
gathering and managing such funds to the political leaders and senior
government officials serving him. To combat this system, which made cer-
tain parts of the bureaucracy and some politicians amenable to corruption,
the younger puritanical cohort instituted a monitoring system early in the
Chun administration, as part of the movement toward clean government.
The system monitored the business community’s political contributions to
and financial dealings with higher levels of the executive branch (includ-
ing cabinet members) and with senior politicians in the legislature. The
president himself concentrated most of these financial dealings at the very
top of the administration, sometimes acting through his close associates
and frequently also his relatives. Thus the president and his relatives even-
tually bore the full brunt of the assault on corruption’ There were no major
leakages of contributions to the cabinet and senior politicians who, under
Chunr’s watchful eye, were thus spared from involvement in corruption scan-
dals. In this sense, some progress may have been achieved in institution-
alizing a system to resist major corruption in the middle and lower echelons.

6. After leaving office former President Chun Doo Hwan apologized to the nation for the abuses
and failings of his administration and went into seclusion at Pakdam Temple in September 1988.
608 — Lee-Jay Cho and Yoon Hyung Kim

Contributions to Economic Development

With his vision of the “Just Society,’ President Chun established his own
goal of making “My Country, an Advanced Country.” He placed great em-
phasis on mobilizing competent technocrats and academics to promote de-
velopment. The 1980s represent a period of economic stabilization and
liberalization for Korea, with the government still maintaining high growth.
From the economic modernization perspective, the achievements of the Fifth
Republic were substantial. The positive contributions that can be credited
to the Fifth Republic can be assessed under the following three major areas
related to economic development.
Economic progress. Despite the rocky start in the 1980-81 period of severe
recession, the economic performance of Korea in the 1980s has been excel-
lent. When the Chun regime came to power, the Korean economy was be-
set by the strains and structural imbalances created by the heavy and
chemical industry drive of the 1970s and the second oil crisis. There were
strong inflationary pressures, rapidly rising unit labor costs, a negative real
interest rate, and sectoral bias in incentives. These internal imbalances were
aggravated by the second oil crisis, the surge in international interest rates,
and the onset of the international recession.
This confluence of events, coupled with poor harvests and the domestic
political uncertainties caused by the assassination of President Park, brought
the Korean economy to a state of crisis in early 1980. Consequently, during
1980 the Korean economy experienced, for the first time in modern eco-
nomic history, a negative real growth rate (—3.7 percent), which was ac-
companied by a 39-percent jump in the wholesale price index and a current
account deficit that reached 9.4 percent ($5.3 billion) of GNP (Table 24.1).
Given these circumstances, the Chun government embarked on stabili-
zation and structural adjustment as its overriding objectives in economic
policy|The macroeconomic policies followed were essentially a strong im-
plementation of the restrictive monetary, fiscal austerity, and wage control
policies initiated by the Park government in 1979. President Chur’s politi-
cal leadership and commitment to the stabilization policy successfully eradi-
cated the chronic high inflation from which the country had suffered since
the start of modernization and that had seriously undermined the coun-
try’s growth potential, particularly in the latter part of the 1970s. The infla-
tion rate declined sharply from 39.0 percent in 1980 to 4.6 percent in 1982
and remained at less than 1.0 percent during 1983-87Z) The current account
deficit declined to $1.6 billion in 1983 and further to $1.4 billion in 1984.
In the meantime, the GNP growth rate averaged 9.7 percent during 1982-84.
In 1985 a sharp fall-off in export growth caused by the international reces-
sion led to a reduced GNP growth rate of 7.0 percent (Table 24.1).
In addition to the stabilization program, the Chun government in 1981-82
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undertook major structural adjustment programs that a democratic govern-

ment would have found difficult to implement. These economic reforms
were aimed at dismantling the regulations that were constraining the ca-
pacity of the Korean economy to adjust to the new external and internal
environments. As a first step toward financial liberalization, the Chun ad-
ministration started denationalizing commercial banks in 1981 by disinvest-
ing the government's share. By 1983 the government turned all nationwide
city banks over to private ownership and reduced its control over day-to-
day operations. To promote competition among banks, two new nation-
wide commercial banks—joint ventures with foreign banks—were autho-
rized. Perhaps the most important part of the financial reform was the
rearrangement of the interest rate structure. Although the monetary authori-
ties still maintain interest-rate ceilings on bank deposits and loans, the real
rate of interest has been kept positive since 1981. The autonomy and the
efficiency of the banking industry, however, have been limited by the
bailouts of depressed industries and the accumulated substantial amounts
of nonperforming assets (loans) of nationwide commercial banks.
To improve industrial efficiency, a fundamental policy reform was insti-
tuted which aimed at reducing the government's direction of and control
over investment decision making and at increasing the industry’s exposure
to market forces and external competition. The Fair Trade Law was promul-
gated in 1981 to guard against anticompetitive mergers, unfair advertising,
and restrictive trade practices. The Chun government bypassed competi-
tive solutions in most of its restructuring operations. Nevertheless, there
were justifications for some of the interventions, because financial distress
was so widespread that it threatened the viability of the commercial banks
as a group. Most significant, the government began to reverse its past prefer-
ence for large, heavy-industry firms by reserving credit for small and
medium-size firms. Thus industrial policy became more neutral.
Finally, the Chun government committed itself to reforming the import
regime, so that by 1986 it would reach the level of liberalization achieved
by industrialized countries, and to overhauling the import-tariff schedule
to reduce both the average level and the spread of tariff rates. The Tariff
Reform Act, promulgated in 1984, included phased general reductions in
tariff levels and charges, aimed at creating greater uniformity in tariff rates.
Restrained macroeconomic policies, combined with major structural re-
forms on the supply side, enabled Korea not only to achieve price stability
and industrial efficiency but also to be well-positioned to take advantage
in the first quarter of 1986 of an exceptionally favorable sequence of de-
velopments in the world economy. These events included the steep decline
in oil prices, the decline in international interest rates, the sharp deprecia-
tion of the U.S, dollar relative to the Japanese yen, and enhanced OECD
growth prospects.
 Political, Economic, and Social Developments in the 1980s 611

All of these developments made it easier for Korea to achieve a balance-

of-payments surplus and a high GNP growth rate without exceeding its
targets for external debt acquisition and inflation. The decline in the price
of oil helped Korea directly by reducing its import bill and indirectly by
sparking a higher rate of world economic growth and trade. The decline
in interest rates also improved Korea's balance of payments by reducing debt-
service payments. These two developments also made it easier to maintain
price stability. Finally, the effective devaluation of the won relative to the
yen, resulting from the dollar depreciation, enhanced Korea’s export
prospects, especially in the United States and the European Economic Com-
munity, where Korea competes actively with Japan in such important
product lines as automobiles, electronic goods, and iron and steel products.
The Korean economy as it entered 1986 started to revitalize, thanks to
favorable external conditions and the legacy of strong structural reforms.
During the three-year period 1986-88, Korea managed to post very respect-
able real growth rates, with GNP increments averaging 12.7 percent annu-
ally. The current account balance has been in surplus since 1986. As a result,
in 1988 GNP exceeded $170 billion, and per capita GNP reached $4,127.
The current account surplus amounted to $4.6 billion in 1986 and increased
to $9.9 billion in 1987. It further increased to $14.2 billion in 1988 (Table 24.1),
due mostly to export expansion and the inflow of foreign currency from
the Seoul Olympic Games.
Korea is now faced, however, with various social and economic problems
that are the unfortunate byproducts of rapid industrialization and un-
balanced modernization. For example, income and wealth distribution,
which were quite equitable by world standards in the early 1970s, has de-
teriorated in recent years; economic policy decision making is now con-
centrated around highly centralized political power; economic power is
highly concentrated in a small number of major corporations; many banks
have become financially insolvent; and the relationship between manage-
ment and labor has turned acrimonious.
One feature created by the restructuring exercise of the 1980s is the
problem of “moral hazard.” The active government role resulted in a reduc-
tion in incentives for taking tough private adjustment decisions. In some
cases, firms persisted in borrowing rather than take the hard decisions re-
quired to reduce capacity and numbers of employees. Anticipating a govern-
ment rescue, weak firms postponed adjustment, hoping that their shares
in some eventual merger or cartel arranged by the government would
represent an improvement over the immediate prospects for scaling down
or accepting a private merger proposal. Despite these shortcomings, the
government of the Fifth Republic succeeding in remolding business and
industry along the lines of a more “modern” industrial structure through
its trade liberalization policy and changes in incentives.
612 Lee-Jay Cho and Yoon Hyung Kim

Promotion of science and technology. The government's intervention in the

promotion of technology is reflected in the establishment of institutions
for scientific training and for basic and applied research. There has been
a remarkable increase in research and development investment since 1981.
Under a “technology drive” policy, investment in science and technology
increased from 0.9 percent of GNP in 1981 to 2.2 percent in 1987, and roughly
40 percent of public expenditure on science and technology was channeled
to general research and to create and operate special research centers in
areas such as energy, resources, machinery, electronics, telecommunications,
and chemicals (Ministry of Science and Technology, ROK, 1987). In line
with this policy shift, more efforts are being made to improve the research
capabilities of universities.
To broaden and intensify the support for research and development ac-
tivities aimed at industrial innovation, the government began in 1980 to
offer tax and financial incentives to the corporate sector. The commercial
tax law was revised in 1981 and 1982 to encourage the private sector to pro-
mote science and technology. Among the tax incentives for private firms
were a 10 percent tax credit on research and development expenditures,
a local tax exemption on the purchase of real estate for a research establish-
ment, income tax exemptions for foreign technicians, a tariff reduction on
goods imported for research and development, and a lower special con-
sumption tax on products representing new technology. As a result, the
number of research centers in the private sector multiplied almost sixfold,
from 53 in 1981 to 290 in 1987. Investment in the corporate sector, which
was 120 billion won in 1981, increased by a factor of 4.8 by 1985. The de-
velopment of science and technology was further expedited by the estab-
lishment of a national project in 1982 to fund public as well as private-sector
joint research and development activities (Ministry of Science and Tech-
nology, ROK, 1987).
A long-term plan for the development of science and technology through
the year 2000 was launched during the Fifth Republic. The primary em-
phasis of the plan, which calls for increasing investment in science and tech-
nology up to 3.1 percent of GNP by the year 2000, is the development and
mobilization of manpower, which involves investment in education and
training in basic and applied science and technology within the country.
A major effort has been made to recruit highly trained scientists and tech-
nicians from abroad, especially from the United States and Western Europe.
The plan is designed to improve the structure and management of
research institutions as a means of developing a better system of research.
Industry is encouraged to concentrate on industrial technology to improve
product quality, increase productivity, and develop more innovative
products. Just as President Park contributed in the 1970s to generating the
export-oriented mood, President Chun contributed in the 1980s to gener-
ating the technology-minded mood. The big corporations are encouraged
 Political, Economic, and Social Developments in the 1980s 613

to develop and invest in their own scientific and technological research ac-
tivities. The government also offers subsidies to encourage small and
medium-size firms to pool their resources and establish applied technol-
ogy research centers for their mutual benefit.
As a foundation for advancing to the next stage of economic develop-
ment, Korea must create this scientific research infrastructure and highly
trained manpower. The government's plan places great emphasis on “catch-
ing up” with more advanced countries at the cutting edge of modern tech-
nology, including electronics, genetic engineering, high-tech chemistry, and
automation. The government is also trying to promote greater corporate
interaction with industries in the United States and other countries. Korean
corporations are urged to establish research centers, engage in joint research,
and increase their investment in joint ventures in the United States and
other advanced countries, and to attract advanced foreign technology to
Korea. Such activities contribute to identifying the most advantageous
niches that a country the size of Korea can occupy in the international mar-
kets. Basic research provides the necessary underpinning for cutting-edge
technological development. But Korea does not have to be a leader in all
areas of research. To prosper, it is necessary only to gain timely access to
profitable applications or to specialize in something that maintains good
terms of trade with countries that have such access or are already research
leaders.
Education and welfare programs. Investment in education continued to ex-
pand under the Fifth Republic. In the high schools the ratio of students
to teachers improved from 45:1 in 1979 to 36:1 in 1987. During the same
period, high school enrollment rose from 81 percent to 92 percent, and the
number of college and university students trebled from 330,000 to 990,000
(Kang 1989).
Among the significant welfare accomplishments are the compulsory med-
ical insurance system (which applies to both urban and rural areas) and
the minimum wage legislation of 1987. Also, a pension system was estab-
lished in 1988 as part of a larger social security scheme, which is applicable
to all firms with 30 or more employees. Infrastructure for rural develop-
ment was substantially expanded through the construction of houses and
roads and the provision of piped water to rural residents. Rural areas have
also been provided with greater telephone services, and it is now possible
to make a direct-dial international telephone call from almost any village
in the country.
Some recent social indicators reflect continued success in combating rural
poverty. Between 1980 and 1987 the national average per capita daily intake
of protein increased by 50 percent. Between 1980 and 1985, the proportion
of Korean households possessing a refrigerator rose from 39 percent to 70
percent and those equipped with a telephone increased from 22 percent
614 — Lee-Jay Cho and Yoon Hyung Kim

to 50 percent. Income distribution, as measured by the Gini coefficient,

has shown a gradual improvement from the late 1970s to the mid-1980s,
and real annual wage increases of about 7 percent kept up with growth
in productivity until the end of the Fifth Republic (Kang 1989).
The latter half of the 1970s saw an increase in public dissatisfaction, even
though absolute poverty had been overcome, because of the deterioration
in income distribution and the worsening of differentials in regional de-
velopment. During the 1980s the Chun government responded by increas-
ing investment in social development and making a major effort to achieve
more balanced economic growth throughout the country. Between 1982 and
1986, benefiting in part from price stability, the government made at least
a slight improvement in income distribution. To bring about a major im-
provement, however, some drastic institutional reforms would probably
have been necessary.
Diminishing Regional Tensions
Prior to the 1970s, when China initiated its open-door policy and began
experimenting with the market economy, no progress was made in
diminishing mutual hostility between Korea and China. Two international
incidents brought the changing relationship between the two countries to
the general public’s attention and improved the Chinese leadership's im-
age of Korea. The first was the 1983 hijacking of a Chinese airliner, which
was forced to land in Korea. The Korean government's considerate treat-
ment of the passengers and the informal intergovernment cooperation that
was necessary for their return helped to dampen Chinese hostility toward
the government in Seoul. The Chinese perception was further changed by
Korea's cooperative response in 1985 when a Chinese torpedo boat entered
Korean waters, was briefly detained by the Korean authorities, and was
returned with its crew to China.
During the 1980s, much effort was made through business and quiet
diplomacy to open and widen the avenues of communication. A notable
result was China's decision to send a team to the Seoul Olympics in 1988.
Meanwhile, unofficial trade between the two countries has gradually ex-
panded through indirect channels and reached $3.1 billion in 1988. Rela-
tions with the Soviet Union have also developed rapidly since the Seoul
Olympics, and high-level officials, politicians, and businessmen from Korea
have visited the U.S.S.R. in increasing numbers. On 30 September 1990 the
Republic of Korea and the Soviet Union announced the immediate estab-
lishment of full diplomatic relations.
The international political climate has changed remarkably through the
expansion of cultural exchange, international athletics, and other nonpo-
litical relations. There has been a dramatic increase in trade activities be-
tween Korea and her two superpower neighbors, which in turn has
contributed to a reduction of political tensions in the region. Economic
 Political, Economic, and Social Developments in the 1980s 615

activities with China were not affected by the June 1989 Tiananmen Square
incident and are likely to increase steadily. The development of a substan-
tive economic relationship between Korea and her powerful neighbors is
creating a more peaceful mood and helping to ease the tension that per-
sists between North and South Korea.
If these trends continue, the Korean economy will be in a strong posi-
tion to benefit from further development of economic ties across East Asia.
One difficulty is that the policy of the South Korean government toward
China, North Korea, and the Soviet Union has been neither well-coordi-
nated nor based on careful economic and political analysis. Many Korean
moves relating to these three countries were made in the context of short-
term, domestic political gains. In the future, Korea can promote mutually
beneficial relations only through a dependable long-term strategy that is
consonant with Korea's development in the international context as an eco-
nomic and political partner.

PERSPECTIVE ON THE SIXTH REPUBLIC:

THE 1988 OLYMPICS AND BEYOND
Extraordinary amounts of time and resources were lavished by President
Chun and other leaders of the Fifth Republic on the effort to make possi-
ble the Seoul Olympic Games in October 1988. Viewing this event partly
as a vehicle for exhibiting Korea to the international community as an ad-
vanced country, the nation’s leaders took great national pride in planning
for the games.
The circumstances preceding the games were very fortunate for Korea.
The economy was doing extremely well during the years immediately be-
fore the games. The government was therefore able to afford the vast ex-
penditure necessary not only for the athletic facilities but also to improve
the infrastructure of major Korean cities, thereby accommodating an un-
usually large amount of travel and tourism both at home and from abroad.
Five persons, including President Chun, were the architects and political
engineers of the Seoul Olympics. It is ironic that, for political reasons, none
of them was able to participate in the opening ceremonies.
Toward the end of the Fifth Republic, student demonstrations over the
issue of political legitimacy became more intense and numerous. Massive
protests took place in June 1987 in opposition to the president's plan to
choose his own successor. On 29 June 1987, a sweeping plan of action for
political democratization was announced by the head of the Democratic
Justice Party, Mr. Roh Tae Woo, who was not only a presidential candidate
but also a close friend, fellow classmate, and subordinate of President Chun.
The president reluctantly agreed to these demands, haggling between the
government party and the opposition over proposals for a parliamentary
system was stopped, and a new constitution was drafted. The new con-
stitution provides for the direct election of the president, who is limited
616 — Lee-Jay Cho and Yoon Hyung Kim

to a single five-year term, and for the election of National Assembly

members under the “small election district” system (one member per elec-
tion district, rather than multiple members per region as before).
In relinquishing his power in a peaceful transition President Chun took
an important step. Although a historic event for Korea, it is unlikely to be
appreciated as such by Westerners accustomed to rigorous mechanisms for
changes of administration and succession to political power. Syngman Rhee
was forced out of office in 1960 by student agitation; the Chang Myon
government was removed by a military coup in 1961; Park Chung Hee was
assassinated in 1979; and Choi Kyu Hah resigned in 1980 under conditions
of political instability and pressure from the military. Although compelled
to do so under the political circumstances at the time, Chun Doo Hwan
is the only leader who served his term and left office according to the pro-
visions of the constitution.
Roh emerged the victor in the fall 1987 presidential election, which
marked the beginning of the Sixth Republic, although with only 36 per-
cent of the vote and a slim margin over two of his rivals. He thus became
a minority president representing a minority of the popular vote. A poten-
tially more serious problem for the new administration, however, is the
regional pattern of voting. The 1987 election dramatized strong emotional
and regional appeal of the candidates, as did the April 1988 elections for
the National Assembly, when the government party lost its majority, fur-
ther polarizing the regional differences.
Kim Dae Jung’s Peace Democracratic Party got 100 percent of the seats
in his home area (Cholla). Kim Young Sam’s Democratic Party garnered
most of the seats in the Pusan Metropolitan Area and neighboring South
Kyongsang province. Kim Jong Pil’s New Republican Party got most of their
seats in the leader’s home province of South Ch’ungch’6ng. And the govern-
ment party got most of their seats from President Roh’s home area and the
outskirts of the Seoul Metropolitan Area. The absence of a mandate from
across section of the nation undermines the government's legislative basis
for asserting strong political leadership and implementing national develop-
ment policies.
The Sixth Republic inherited many unresolved problems from the preced-
ing administration. The principal leaders of the Fifth Republic (including
former President Chun) were accused of corruption, misuse of power, and
extortion of contributions to establish what was perceived to be Chun’s own
foundation and research institute. Most of the former president's family
and relatives were indicted and have received jail sentences, and Chun’s
personal property (including his house) has been surrendered. A National
Assembly hearing on the misconduct of Fifth Republic leaders was in ses-
sion until the last hour of 1989 but was not able to reach a clear-cut con-
clusion.
 Political, Economic, and Social Developments in the 1980s 617

A serious political issue that has persisted into the Sixth Republic is the
May 1980 Kwangju incident, in which the military was sent to deal with
a prodemocracy demonstration. Some of the protesters had armed them-
selves, and more than 190 demonstrators were killed in a clash with the
army. The responsibility for this incident is still unresolved.
Meanwhile, workers and students have taken to the streets, demanding
higher wages and greater democracy. Korean labor unions are organized
to an extent unimaginable in Western countries and even cover scientific
and technical research institutes. The unions have informed most large and
medium-size corporations that they will join in wildcat strikes, which have
become a daily routine in the Sixth Republic. The government has been
unable to deal with the 25 percent average wage increase demanded by
the labor unions. Korean wages are growing much more rapidly than those
of their competitors, implying that Korea is losing competitiveness in the
international marketplace.
The trade balance began to deteriorate in 1989, and after the middle of
the year the monthly balance became negative again. Although the trade
and the current account balances for the entire year will still be positive,
the magnitude will be much less than in 1988. This deterioration is due
mostly to the government's inability to hold wage increases below produc-
tivity increases, with the consequent loss of international competitiveness
and loss of time due to strikes. Low morale among workers has brought
about laxity in production and deliveries. The business community,
moreover, has drastically reduced investment, which is the key to increased
productivity in subsequent years. In November 1989 the Economic Plan-
ning Board declared the current situation an “economic crisis” and planned
to take drastic action, starting with the lowering of interest rates.
Despite the spiraling wage increases that are the result of succumbing vi
to union demands, income distribution may not have improved, because
of the exorbitant real estate price increases that have ominously affected
the pattern of wealth distribution. During the past couple of years, real es-
tate prices have doubled almost yearly in the Seoul metropolitan area, which
offsets any gains in wage increases. The increase in the value of land and
real estate has thus become a major economic, social, and political issue.
Various options for legislation concerning land utilization are under con-
sideration. Based on the “communal concept” of land, the intention is to
discourage business conglomerates from speculating in real estate by es-
tablishing criteria to identify idle land and taxing it more heavily than land
in productive use. In addition, the government may determine that 200
pyung (661 square meters or 7,117 square feet) is a reasonable limit for
residential use in metropolitan areas. If a plot of residential land exceeds
this limit, the portion above 200 pyung would bear a form of luxury tax set
at a much higher rate. The tax proposals have aroused much controversy.
618 — Lee-Jay Cho and Yoon Hyung Kim

They are supported by the majority of the population—i.e., those with

modest or no land holdings—but corporations and other big landowners
are strongly opposed and argue that such laws would violate the basic con-
stitutional right of property ownership.
The government has likewise been unable to deal with student demands.
Violent demonstrations have taken place at most universities, accompanied
by destruction of university property and equipment. In the span of two
years following the end of the Fifth Republic, there was a change of presi-
dent in virtually every university and college in the country. The lack of
discipline among students in the aftermath of chaotic rioting and demon-
strations may have a serious effect on the quality of education, which it
is essential to improve if Korea is to maintain its competitive edge in the
next stage of development of the capital- and technology-intensive economy.
The Sixth Republic began with a great vision of a democratic society.
But the rapid swing from authoritarian government to political stalement
without clear leadership has produced some negative consequences: the
decline in discipline in factories and other places of work, work stoppages
and strikes, student demonstrations, seizure of university buildings and
influence over university management, the deterioration in law and order,
and the increased incidence of rape, violent robbery, and other crimes. As
a result, the morale of the middle class and business community has been
sinking.
The formulation and implementation of economic policies to solve cur-
rent problems are rendered all the more difficult by the precarious political
situation. Since the opposition parties won a majority of the seats in the
1988 National Assembly elections, the government has been unable to im-
plement effective leadership in economic affairs, and it is becoming clear
that Korea will face very difficult economic problems in the next few years.
Koreans may have to learn the difficult lessons of a pluralistic, democratic
society—its strengths and weaknesses and its costs and benefits—the hard
way. It is likely that the Korean electorate, after several years of the current
precarious and economically costly political situation will opt for a more
stable government and party structure.
In early 1990 the government party and two of the opposition parties
led by Kim Young Sam and Kim Jong Pil announced a merger to form the
new People’s Democratic Liberal Party. This alliance constitutes a majority
in the legislature and has managed to convey at least the appearance of
moving toward a political solution. The big question in the short term,
however, is whether the existing parties can integrate smoothly and effec-
tively to provide stable leadership. Many obstacles must be overcome to
create a viable political entity from this merger. The parties are character-
ized by very different interests, objectives, and personalities and have ex-
perienced different patterns of party history and intraparty struggles for
 Political, Economic, and Social Developments in the 1980s 619

leadership and power. Some of Kim Young Sams followers opted to resign
from his party rather than join the alliance. Such factors do not bode well
for achieving the political stability required for continued healthy economic
performance.
In the long term, however, the vitality, flexibility and hard work of the
Koreans will overcome the transitional difficulties facing the country to-
day. Creative and effective leadership will be essential to bring about the
institutional changes and reforms required to synergize the hard working
labor force and the vitality of entrepreneurs and business leaders toward
sustained economic growth and more equitable distribution of the benefits
of development. Korea will then emerge as a far stronger economic force
in East Asia and the Pacific.
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 Index

Agricultural policies: credit system, 23, Choi Kyu Hah, interim government of
384-85, 398; farm mechanization, (1979-80), 39, 605
383-84, 398-99; fertilizer pricing, Cholla/Kyongsang regional conflict,
385-86, 397; land and water develop- 595-97
ment, 23, 382-83, 397; recommenda- Chun Doo Hwan: acquisition of power
tions for future, 396-404. See also (1980), 39, 605; consolidation of power
Agriculture; Grain management policy (1982), 606; contributions to economic
(1969); Saemaul (new community) development, 608-14; factors contribut-
movement (1971) ing to political downfall, 607; leader-
Agriculture: contribution to economic ship qualities of, 607; relinquishment
growth, 371-/4; role in industrializa- of power, 615-16. See also Fifth Repub-
tion, 371-72, 386-87. See also Agricul- lic (1980-87)
tural policies; Grain management Citizens National Bank, 47, 135
policy (1969) Civil service examinations, exclusivity of,
Allied occupation (1945-48), 9-11; effect pre-1945, 569-70
on economy, 10-11; effect on emigra- Civil Service Pension Law (1960), 331
tion, 588-89 Coal: as a domestic energy source,
Annexation by Japan. See Colonial rule, 183-84; replacement by oil, 184-85
Japanese (1910-45) Colonial rule, Japanese (1910-45): antece-
Anti-conglomerate policies. See Antitrust dents of, 3-4; economic goals of, 4-5;
policies impact on Korean economic develop-
Antitrust and Fair Trade Law (1981), 94, ment, 6-9; impact on Korean educa-
489-92, 499, 610 tional system, 8-9, 571-75, 578-80;
Antitrust policies: appropriateness of, territorial expansion during, 5
498-99; background of, 473-87, Commission on Middle East Economic
499-501; early anti-conglomerate ef- Cooperation, 533
forts, 492-93; effect on industrial con- Community-based primary health care
centration, 505-10; effect on market system, 338
behavior and performance, 502-5; and Community development movement. See
Fair Trade Commission, 501-2; and fair Saemaul (new community) movement
trade promotion measures (1981-83), (1971)
491-92; legislative basis for, 94-95, Comprehensive Stabilization Program
488-91, 499-501; May 29 (1974) meas- (1979), 38, 207-41; background of, 38,
ure, 493-95, 499-501; September 27 207-10, 237, 604; economic education
(1980) measure, 495-98, 501. See also component, 236; features of, 38,
Conglomerates; Industrial concentra- 211-14; fiscal management policies,
tion; Price Stability and Fair Trade 212, 225-27; implementation of,
Law (1976); Antitrust and Fair Trade 214-21; interest and exchange rate poli-
Law (1981) cy, 215, 227-31; investment in heavy
and chemical industries, 213; mone-
Bank of Korea, 16, 45, 47, 48, 135 tary restrictions, 211-12, 214, 221-25;
Banks. See Financial institutions, banking and policy response to 1979 oil crisis,
Birth rates, trends in, 304, 305, 315 214-15, 237; recommendations for fu-
Buddhism, 554, 592-93 ture, 237-41; reflationary modifications
Bureau of Economic Education, 236 (1980-82), 38, 215-21, 237; wage policy,
231-36. See also Inflation; Oil crisis
Capital market, development of, 51 (1979), policy response to
Central Federation of Fisheries Coopera- Concentration, industrial. See Industrial
tives, 47 concentration
Chang Myon. See Second Republic Confucianism: as advocated by Park
(1960-61) Chung Hee, 29; authoritarian
642
ee
Index a a a SE SSS

emphasis of, 559-66; and Chinese Democratic People’s Republic of Korea, es-
philosophy, 554-56; comparison of tablishment of, 11
practices in China, Japan, and Korea, Demographic transition: in Korea, 18
559-66; concept of chung hsiao (chung (note); relationship to student radical-
hyo in Korean) (loyalty to state, filial ism, 594-95
piety, harmony), 29, 555-56; definition
of, 553 (note), 554-55; ethics and Economic Planning Board (EPB): approval
values of, 554-58; historical back- of, for foreign loans, 47; and Compre-
ground of, in Korea, 554-58; Korean, hensive Stabilization Program (1979),
evolution of, 554-58; and Neo- 211; and Emergency Decree for Eco-
Confucianism, 556-57; role of Men- nomic Stability and Growth (1972),
cius, 554-55, 559 166-67; establishment of (1961), 15;
Confucius. See Confucianism and formulation of First Five-Year De-
Conglomerates (jaebul): characteristics of, velopment Plan (1962-66), 16; and im-
519-20, 564-66; current issues concern- plementation of antitrust policies, 491,
ing, 502-7; diversification of, 507-9; 501-2; and population policy, 310; and
growth of, 477, 479-80; market power price controls (1973), 93
of, 474-77, 480-81, 482-83, 502-3; Educational system, 567-86; American in-
ownership and management patterns fluence on, 583-86; Confucian model,
of, 509-10. See also Antitrust policies; pre-1945, 569-70; and development of
Industrial concentration; Price Stability Korean individualism, 579-80; dualistic
and Fair Trade Law (1976); Antitrust (traditional), 569-71; and economic de-
and Fair Trade Law (1981) velopment, 569, 578-86; evolution of,
Construction industry: excess capacity in, 567-78; exclusivity of, pre-1945, 569-70;
528-30; factors influencing the moder- future policy directions for, 576-78;
nization of, 529-30; impact of 1973-74 government expenditures for, 331;
oil crisis on, 530-32. See also Construc- Japanese influence on (1910-45), 8-9,
tion services, export of 571-75, 578-80; and Korean War,
Construction services, export of, 527-49; 567-68, 575-76; post-liberation achieve-
appropriateness as a policy measure, ments, 567-69, 575-76; post-war
35, 534-39, 549; economic effects of, achievements, 575-76. See also Han’gul
35, 527, 540-48; effect on balance of Emergency Decree for Economic Stability
payments, 541-43, 548; effect on eco- and Growth (1972), 29-31, 163-81;
nomic stability, 545-48; effect on eco- background of, 29-30, 80, 93, 163-65;
nomic structure, 547-48; effect on effect on curb market, 168-70, 179-80;
employment, 543-45, 548; government effect on price stabilization, 93, 170-72,
assistance for, 533-34, 537; growth in 180; features of, 30, 80, 165-67; and In-
(1965-81), 527-28; implementation of, dustrial Rationalization Fund, 176-78;
539-40; importance to Korean econo- interest-rate policy of, 172-76; limited
my, 540-49; institutional reforms in economic impact of, 165, 170, 179-81;
support of, 533, 535-37; legislative ba- and tax revenue sharing, 178-79
sis for, 532; licensing for, 532, 535-36. Emergency Decree for National Economic
See also Construction industry; Over- Security (1974): appropriateness as a
seas Construction Promotion Act policy measure, 33, 194-96; back-
(1975) ground of, 33, 183-87; economic effects
Credit allocation: government intervention of, 196-98, 204-5; features of, 33,
in, 55-57; patterns of, 56-62; relation- 188-89; tax reform measures of,
ship to allocation of physical 188-89, 260-61. See also Oil crisis
resources, 65-68 (1973-74), policy response to
Curb market: and Emergency Decree for Emigration. See Migration; Migration,
Economic Stability and Growth (1972), rural-to-urban
166, 168-70, 179-80; functions of, in de- Energy resources, domestic, 183-86
veloping countries, 168; scandal of Energy transitions: coal to oil (1967-71),
1982, 54-55 184, 186, 193; decreased oil dependen-
cy (post-1973), 193, 201-4; firewood to
Death rates, trends in, 304 coal (1962-66), 183-84, 193;
December Twelfth (1979) Incident, 605 Exchange rate: multiple (through 1964),
Demand-management policy, 90-91 103-5; trends (1955-65), 103-5; unifica-
 Index 643

tion attempts, 103-5. See also Exchange- 614-15; economic reforms, 608-11;
rate reform (1964-65) education and welfare programs,
Exchange-rate reform (1964-65), 17, 21, 613-14; financial liberalization efforts,
103-8; appropriateness as a policy 53-54; “Just Society,” 606-7; and 1988
measure, 117-19; background of, 17, Olympic Games, 615; promotion of
20-21, 101-3; criticisms of, 107; effect science and technology, 612-13;
on balance of payments, 127; effect on “purification” measures of, 606; transi-
export growth, 125-27; effect on indus- tion to, 38-39, 605. See also Chun Doo
trialization, 127-31; effect on relative Hwan
export incentives, 120-25; features of Financial institutions, banking: Bank of
unitary floating system, 106-7; limited Korea, 16, 45, 47, 48, 135; Central Fed-
success of, 132-4. See also Exchange eration of Fisheries Cooperatives, 47;
rate Citizens National Bank, 47, 135; com-
Export-Import Bank of Korea, 51 mercial banks, 16-17, 45-46, 135, 504-6;
Export promotion: appropriateness as a foreign banks, 50; Korea Agricultural
policy measure, 117-19; as a cause of Bank (KAB), 45-46; Korea Develop-
inflation, 85-86; and changes in com- ment Bank (KDB), 45, 47, 48, 52, 135;
modity composition of exports, 126; Korea Exchange Bank (KEB), 49; Korea
comprehensive plan for, 108-10; and Housing Bank, 49-50; Korea Trust
consistency with exchange-rate system, Bank, 49; local banks, 50; Medium In-
108-12; and diversification of export dustry Bank (MIB), 46, 135; National
markets, 126; economic impact of, Agricultural Cooperatives Federation
125-27; effect on imports, 126-27; ef- (NACF), 46, 135, 374; specialized
fect on industrialization, 127-31; effect banks, 49-50. See also Interest-rate re-
on relative export incentives, 120-25; form (1965)
and export-targeting system, 111; im- Financial institutions, nonbanking, 50-51
plementation of policies for, 111-12; in- Financial savings, trends in, 135-36, 138,
centives for, 108-10, 440-49; limited 146-47. See also Interest-rate reform
success of, 132-34; and Monthly Ex- (1965)
port Promotion Conference, 21, Financial Structure Improvement Plan
111-12; shift to, as an industrialization (1974-77), 495-96
strategy, 17, 20-21, 101-3, 117-19. See First Comprehensive National Physical
also General trading companies (GTCs) Development Plan (1972-81), 353
Export Promotion Conference, Monthly, First Five-Year Economic Development
21, 111-12 Plan (1962-66): energy policy, 183-84,
Export Promotion Law, 102 193; fertility reduction goals, 17, 303,
Export-targeting system, 111 308; formulation by Economic Plan-
ning Board, 16-17, 603; grain-price
Fair Trade Commission, 491, 501-2 policy, 86; industry-oriented strategy,
Fair trade measures, 491-92, 493. See also 16, 373; investment planning for, 16-17;
Antitrust policies tax reforms, 257-58
Family planning program, national, 17-18, First Republic (1948-60), 11-13; corruption
303-25; accomplishments of, 17-18, during, 12; establishment of, 11; and
304, 308-11, 321-22, Appendix 12.1; Korean War, 11; land reform during,
demographic changes resulting from, 11-12; military strengthening during,
17-18, 305-6, 310-11; economic impact 11. See also Rhee, Syngman
of, 17-18, 320-21; features of, 17, 306, Foreign loan guarantee operations
308-11; problems encountered, 308; (1963-66), 47-48
strengthened commitment to, 308-10 Fourth Five-Year Economic and Social De-
Fertility reduction: as a population policy, velopment Plan (1977-81): expansion of
17-18, 306, 308-10, 311; role of econom- heavy and chemical industries during,
ic development in, 310-19; role of 37, 65, 434-35; fertility control efforts,
noneconomic factors in, 319-30. See 310; promotion of social development
also Family planning program, national and economic equity during, 327, 334
Fifth Republic (1980-87), 38-39, 606-15; Fourth Republic (1972-80), 27-38; antitrust
antitrust measures, 94, 489-92, 495-98, measures, 94-95, 488-95, 500; con-
610; corruption scandal, 607, 616; glomerates, 32-33, 477-81; economic
diminishing regional tensions during, slowdown (1971-72), 29-30; as
644
SSS
SSS ES Eee
Index

“emergency regime,” 27-29; financial 380-81, 407-8. See also Agricultural

controls, 52-53, 63-65, 68-72, 82, policies
92-94; inflationary pressures, 81-84, Grain-price policy. See Grain management
95, 207-10, 604; national security con- policy (1969)
cerns, 32; price stabilization measures, “Growth center” migration policy, 356-57
94, 96; promotion of heavy and chemi- GTC. See General trading companies
cal industries, 31-32, 52-53, 603-4; (GTCs)
response to oil crises, 33, 81-82, 84,
187-93; social development projects, Han’gil (phonetic writing system): early
35-36; and Yushin constitution, 28-29. use of, 570-71; and experiences of the
See also Park Chung Hee; Comprehen- “han’giul generation,” 580-83; as official
sive Stabilization Program (1979); written language of Korea, 581; poli-
Emergency Decree for Economic Sta- cies related to, 580-81
bility and Growth (1972); Emergency Han’gil Society, 575 HCI Plan. See Heavy
Decree for National Economic Security and Chemical Industries Promotion
(1974); General trading companies Plan (1973-79)
(GICs); Heavy and Chemical Indus- HCI. See Heavy and chemical industries
tries Promotion Plan (1973-79); Indus-
HCI Promotion Council, 432, 443
trial concentration; Overseas
Health-care delivery: cost and financing
Construction Promotion Act (1975);
of, 339-40, innovations in, 338; institu-
Population Redistribution Plan (1977);
tional basis for, 336-37; planning for,
Social development projects (1976-77);
335-38. See also Health insurance pro-
Value-added tax (1977)
gram (1976-77)
Health insurance program (1976-77),
327-47; background of, 35-36, 329-34,
General Park Chung Hee. See Park Chung
344-45; cost and financing of, 339-40;
Hee
effects of, 36, 340-44; extent of cover-
General trading companies (GTCs), 33-34,
age of, 341-42, 345-46; implementation
511-25; appropriateness as a policy
of, 334-40; institutional basis for,
measure, 516-17; background of, 34,
335-38; objectives of, 334; shortcom-
511-12; comparison of Korean and
ings of, 345-47. See also Health-care
Japanese, 512, 521-23; contributions to
delivery; Medical Insurance Law (1976)
export expansion, 33-34, 523, 524-25;
Heat Management Law (1974), 187, 190
criticisms of, 523-25; establishment of,
by presidential decree (1975), 511-12;
Heavy and chemical industries: financing
of, 52-53, 57-60; and inflation, 87-89;
export share of, 517-19, 520; features
justification for investment in, 603-4;
of, 34, 512-15, 519-21; incentives for,
projects, pre-1973, 431-32. See also
515-16; requirements for designation
as, 512-15
Heavy and Chemical Industries Pro-
motion Plan (1973-79)
Grain Management Fund (GMF), 380-81,
399-401
Heavy and Chemical Industries Promo-
tion Plan (HCI Plan) (1973-79), 31,
Grain Management Law (1950), 86, 381
Grain management policy (1969), 23-24, 431-71; appropriateness as a policy
measure, 458-61; background and ra-
371-404, 405-8; appropriateness as a
tionale, 437-39; economic effects, nega-
policy measure, 386-90; effect on farm
tive, 461-66, 604; economic effects,
income, 392-93; effect on food grain
production, 391-92, 396; effect on in-
positive, 466-69; features of, 435-37,
come distribution, 394-95; effect on
457-58; financial support for, 441-49;
price stabilization, 393-94; and govern- incentive system, 441-49; Japanese
ment intervention trends, 381-82; and model for, 439; outcome of, 449-57,
Grain Management Fund deficit, 208, 470-71; projects included, 432-34; and
380-81, 399-401; historical context, 23, restructuring of Korean industry, 31,
371-74, 405-7; and inflation, 86-87; 603-604; revisions of (1976), 434-35
price determination, 86-87, 376-80; Housing, government expenditures for,
procurement and distribution, 374-76,
401-4; recommendations for the fu-
ture, 396-404; two-tier price system for Import-liberalization program (1967), 17,
rice and barley, 23-24, 86-87, 377, 21, 112-15; appropriateness as a policy
 Index 645

measure, 117-19; background of, 17, Insurance, health. See Health insurance
20-21, 101-3; effect on balance of pay- program (1976-77)
ments, 127; effect on export growth, Interest-rate reform (1965), 22, 48-49,
125-27; effect on industrialization, 135-62; appropriateness as a policy
127-31; effect on relative export incen- measure, 146-49; background of, 22,
tives, 120-25; and import restriction 135-37, 146-47; economic impact of,
trends, 112-13, 116; limited success of, 22, 76-77, 149-62, 172; effect on ag-
132-34; negative-list system, 113-14; gregate saving and investment, 147,
tariff reform, 114-15 151-55; effect on curb market, 157-59;
Import-liberalization program (1983), 504 effect on financial savings, 48-49,
Import substitution policy: as an industri- 76-77, 144, 147, 149-51; effect on or-
alization strategy in developing coun- ganized money market, 155-57; fea-
tries, 117; shift from, to export tures of, 22, 48, 137-46; reaction to, 140
promotion in Korea, 117-18 Interest-rate trends, 141, 146, 172-74, 229,
Incentives, export promotion, 108-10, 609
440-49
Income distribution: effect of industrial Jaebul. See Conglomerates
concentration on, 485-86; effect of in- Japan: annexation of Korea (1910), 4-6; as-
flation on, 210 sumption of control of Korean econo-
Incomes policy (1976), 82 my, 4-6; economic modernization of,
Industrial accident insurance program, 3-4; industrial development of, 4-6;
333 influence on Korean legal system,
Industrial concentration: causes of, 481, 598-99; normalization of relations with
484; levels of (1970-77), 473-81; in the (1965), 26; Western influence on, 3-4.
manufacturing sector, 473-77, 478; See also Colonial rule, Japanese
negative economic effects of, 485-88. (1910-45); Meiji revolution
See also Antitrust policies; Conglomer-
ates; Price Stability and Fair Trade Law Kim Dae Jung, 605 (note), 616
(1976); Antitrust and Fair Trade Law Kim Jong Pil, 616, 618
(1981) Kim Young Sam, 616, 618-19
Industrial decentralization policies: and Korea: Allied occupation of (1945-48),
Industrial Distribution Law (1977), 9-11; division of, north and south,
355-56; and land policy measures, 355 9-10; economic future of, 618-19; eco-
Industrial Distribution Law (1977), 355-56 nomic trends, 76-80, 609; historical
Industrial location policy, 357-58 overview, pre-1960, 3-11; role of cul-
Industrial Rationalization Fund (1972), ture and values in economic develop-
166, 176-78 ment, 553-66. See also Colonial rule,
Industry, construction. See Construction Japanese (1910-45)
industry Korea Advanced Institute of Science and
Industry, heavy and chemical. See Heavy Technology (KAIST), 25
and chemical industries Korea Agricultural Bank (KAB), 45-46
Inflation: causes of, 84-91, 208; effect of Korea Development Bank (KDB), 45, 47,
industrial concentration on, 486; effect 48, 52, 135
of money supply on, 222-25, Appen- Korea Development Institute (KDI), 25,
dix 9.1; effect on export competitive- 171, 336-37
ness, 209-10; and export promotion, Korea Energy Management Association
85-86; as a limiting factor in Korea's (KEMA), 190
economic development, 208-10, 237, Korea Energy Research Institute (KERI),
604; link to wage increases, 209, 191
233-34; and price control and stabiliza- Korea Exchange Bank (KEB), 49
tion measures, 16-17, 91-96, 208-9. See Korea Health Development Institute
also Comprehensive Stabilization Pro- (KHDI), 336-38
gram (1979); Inflationary trends Korea Housing Bank, 49-50
Inflationary trends: for 1961-64, 74-75; for Korea Institute of Energy Conservation
1965-73, 76-80; for 1974-80, 81-84, 207 (KIEC), 191
Institute of Advanced Science and Tech- Korea Trust Bank, 49
nology, 25 Korean Educational Development Institute
Institute of Middle East Affairs, 533, 536 (KEDI), 577-78
646
ee
Index
eee ee ee —

Korean Institute for Science and Technol- Migration, rural-to-urban, 36, 589-91; as-
ogy (KIST), 25 sociated with rapid industrialization,
Korean International Economic Institute, 36, 349-52; economic effects of,
533 328-29; social effects of, 591-95. See
Korean-Japanese treaty of commerce also Population Redistribution Plan
(1876), 4 (1977); Urbanization
Korean War (1950-53), 11, 589; and ex- Military: postwar expansion of ats
pansion of the military, 597-98 597-98; postwar status of, 15, 597-98
Kwangju incident (1980), 39, 605, 617 Military government (1961-63), 15-18; as-
Kyongsang/Cholla regional conflict, 595-97 sumption of economic control, 16-17,
46-47; export promotion measures,
101-2; financial institutions, 45-47;
Labor movement, evolution of, 599-600 financial legislation, 47, 93; financial
“Lady Chang scandal,” 606 reforms, 16-17, 46-47, 74-75; inflation-
Law Amending the Government Organi- ary trends, 74-75; policy shift toward
zation Law (1966), 251 export-based industrialization, 15, 101;
Law for Fostering the Capital Market population policy, 17-18; price controls,
(1968), 51 17, 91-92; rationale for political
Law Governing Rationalization in the Use takeover, 15; tax reforms, 250-51. See
of Energy (1980), 191 also First Five-Year Economic Develop-
Law on Opening of Closed Corporations ment Plan (1962-66); Park Chung Hee
(1972), 30 Military Pension Law (1963), 331
Law on Price Stability and Fair Trade Military takeover. See Military government
(1975), 94-95 (1961-63)
Legal system, and influence of colonial Ministry of Agriculture and Fisheries
concept, 598-99 (MAF), 374, 376
Legalism, definition of, 28 (note) Ministry of Commerce and Industry, 108,
Livelihood Protection Law (1960), 331 112-13
Loans, foreign: as a source of financing Ministry of Energy and Resources, 191
for Korean businesses, 47-48; bank Ministry of Home Affairs, 408
guarantees for repayment of, 47-48 Mobility, geographic. See Migration;
Local Industrial Development Law (1967), Migration, rural-to-urban; Urbanization
355 Mobility, social. See Social mobility
Money market, informal. See Curb market
Money supply: relationship to inflation
Manchuria: Japanese administration of rate, 222-25, Appendix 9.1
(1932), 5; as supplier of natural Monopoly firms. See Industrial concen-
resources, 5 tration
Manufacturing sector: industrial concen- Mutual defense treaty, with United States
tration in, 473-77 (1953), 11
May 29 (1974) measure, 493-95, 499-501
Medical insurance. See Health insurance National Agricultural Cooperatives Federa-
program (1976-77) tion (NACF), 46, 135, 374
Medical Insurance Law (1976): coverage National Health Council (NHC), 336-37
and benefits, 334-35; effects of, 36; National Health Secretariat (NHS), 336-38
enactment as first comprehensive so- National Investment Fund (NIF): estab-
cial security program, 36, 334, 339. See lishment of (1974), 52, 441; role in
also Health insurance program financing of heavy and chemical in-
(1976-77) dustries, 52-53, 441-45
Medium Industry Bank (MIB), 46, 135 National Reconstruction Movement, 23
Meiji revolution, in Japan (1868-1912): National Security Council, 605
achievements of, 28; role in moderniz- National Welfare Pension Law (1973),
ing of Japanese economy, 3-4, 19, 28 332-33
Mencius. See Confucianism Neo-Confucianism. See Confucianism
Migration: between North and South New community movement. See Saemaul
Korea, 303, 588-89; to Japan, 587-88; to (new community) movement (1971)
Manchuria, 587-88. See also Migration, Night of the Generals, 605
rural-to-urban Nixon Doctrine (1969), 437
 Index 647

Office of Middle East Economic Coopera- People’s Democratic Liberal Party, 618
tion, 533 Planned Parenthood Federation of Korea,
Office of National Tax Administration 303, 308. See also Family planning pro-
(ONTA). See Tax administration reform gram, national
(1966) Population dispersion policies: and rural
Oil crisis (1973-74): and demand for con- development, 367; success of, 364-67.
struction services, 530-32; impact on See also Population Redistribution Plan
Korean economy, 81, 93, 183-86. See (1977)
also Construction services, export of; Population growth rates, trends in, 303,
Oil crisis (1973-74), policy response to 304-5, 307
Oil crisis (1973-74), policy response to: 33, Population movement. See Migration;
81-82, 93, 186-97; appropriateness of, Migration, rural-to-urban
194-96, 198-201, 205-6; decreased oil Population policy. See Family planning
dependency measures, 193, 201-4; program, national
energy conservation measures, 189-93, Population Policy Council, 310
198-201; recommendations for future, Population projections, 305-6, 307
205-6. See also Emergency Decree for Population Redistribution Plan (1977), 36,
National Economic Security (19/4); Oil 349-67; background of, 36, 349-53;
crisis (1973-74) criticisms of, 36, 354-55; effect on eco-
Oil crisis (1979), 82, 84, 214-15 nomic decentralization, 361-62; effect
Oil crisis (1979), policy response to, 191, on interregional economic balance,
192, 214-15. See also Comprehensive 359-61; effect on rural-urban balance,
Stabilization Program (1979); Oil crisis 358-59; effect on urban size distribu-
(1979); Price control and stabilization tion, 362-64; goals of, 353-54, 356;
measures, post-1979 “growth center” migration policy,
Oligopoly. See Industrial concentration 356-57; industrial decentralization poli-
Olympic Games (1988), 615 cies, 355-56, 357-58; level of success,
Overloaning, effects of, during military 364-67. See also Migration, rural-to-
government, 16-17 urban; Urbanization
Overseas Construction Promotion Act President’s Emergency Decree for Eco-
(1975): appropriateness as a policy nomic Stability and Growth. See Emer-
measure, 35, 534-39; effectiveness in gency Decree for Economic Stability
promoting construction service ex- and Growth (1972)
ports, 535-39; features of, 34-35, 532; President’s Emergency Decree for National
formation and implementation of, Economic Security. See Emergency
34-35, 539-40. See also Construction Decree for National Economic Security
services, export of (1974)
Price control and stabilization measures,
pre-1979: and antitrust legislation,
Park Chung Hee: accomplishments, 15-17, 94-95; comprehensive package
603-5; agricultural policies, 18-19; as- (1972-73), 92-93; effectiveness as anti-
sassination (1979), 38-39, 71, 604-5, inflation measures, 96-97, 99-100; ef-
616; background, 18; economic de- fectiveness as anti-monopoly meas-
velopment views, 18-19, 28-29, 163, ures, 98-99; effectiveness in
603; economic goals, 19, 28-29; and redistributing income, 97-98; and
Emergency Decree for Economic Sta- Emergency Decree for Economic Sta-
bility and Growth, 163-81; leadership bility and Growth (1972), 80, 93,
qualities, 18-19, 603; population con- 170-72; Law of Price Stability, 93; price
trol views, 17, 303; promotion of freeze and relaxation (1960-63), 16-17,
science and technology, 25; rural de- 91-92; in response to oil crisis
velopment views, 18-19, 23. See also (1973-74), 93-94; stabilization efforts
Military government (1961-63); Third (1974), 94. See also Comprehensive
Republic (1963-72); Fourth Republic Stabilization Program (1979); Value-
(1972-80); Heavy and Chemical Indus- added tax (1977)
tries Promotion Plan (1973-79); Sae- Price control and stabilization measures,
maul (new community) movement post-1979: economic education com-
(1971) ponent, 236; effectiveness of, 238-39;
Pension programs, 331-32, 613 effect of exchange-rate adjustments,
648
Pe
Index
ae ee

230-31; effect of interest-rate reduc- scope of participation, 411-13; training

tions, 227-30; effect of tight fiscal pol- component, 413-14
icy, 225-27; effect of wage policies, Second Five-Year Economic Development
231-36; monetary management, 215-18, Plan (1967-71): agricultural policies,
221-25, 219-20; reflationary policies of 382-83; energy policies, 186; tax re-
1981, 216-18; response to, 237; tasks forms, 258-61
yet to accomplish, 239-41. See also Second National Land Development Plan
Comprehensive Stabilization Program (1982-91), 356, 367
(1979) Second Republic (1960-61), 13, 616
Price Stability and Fair Trade Law (1976), Securities and Exchange Commission, 51
488-89 Seoul: bipolar development of, with Pu-
Pusan, bipolar development of, with san, 349-53; suburbanization of,
Seoul, 349-51. See also Population 361-62. See also Population Redistribu-
Redistribution Plan (1977) tion Plan (1977)
September 27 (1980) measure, 495-98, 501
Shogogaisha (Japanese general trading
Radicalism, student, 593-95
companies), 34, 512
Regional polarization, 595-97 Sixth Republic (1987- ): economic crisis
Republic of Korea, fifth. See Fifth Republic during, 617-18; and Korea’s economic
(1980-87) future, 618-19; labor movement dur-
Republic of Korea, first. See First Republic
ing, 617; land reform proposals dur-
(1948-60) ing, 617-18; student unrest during,
Republic of Korea, fourth. See Fourth
618; trade balance deterioration dur-
Republic (1972-80)
ing, 617; transition to (1987), 616
Republic of Korea, second. See Second
Social development projects: education
Republic (1960-61)
programs, 331; government expendi-
Republic of Korea, sixth. See Sixth Repub-
tures for, 329-34, 344-45; historical
lic (1987- )
context of, 35-36, 327-29; housing pro-
Republic of Korea, third. See Third Repub-
grams, 330; industrial accident insur-
lic (1963-72)
ance, 333; pension programs 331-33.
Resources, energy: indigenous supplies
See also Health insurance program
of, 183-84; policies to reduce depen-
(1976-77)
dence on oil, 184
Social mobility, patterns of, 591-92
Rhee, Syngman: anti-Japanese policies of,
Social security programs. See Pension
26; contribution to Korea’s economic
programs
development, 11-12; early liberalism
Soviet Union: diminishing tensions with,
of, 12; and Korean War, 11; land re-
during Fifth Republic, 614-15; occupa-
form of, 11-12; mutual defense treaty
tion of North Korea (1945), 9-10
with United States (1953), 11; removal
Stock exchange, development of, 51
from office (1960), 13, 616; views on
population control, 17, 303. See also
Tariff reform, 114-15
First Republic (1948-60)
Roh Tae Woo, 615-16. See also Sixth
Tariffs, import restriction, 105-6
Tax Accountant Law, 250
Republic (1987- )
Rural development. See Saemaul (new Tax administration reform (1966), 22,
community) movement (1971) 251-57; appropriateness as a policy
measure, 261-63, 270-72; background
of, 247-51; criticisms of, 268-70; effect
Saemaul (new community) movement on government saving, 267-68; effect
(1971), 23-25, 405-27; criticisms of, on tax revenues, 22, 264-67; fraud in-
423-27; economic achievements of, vestigations, 252, 254; internal audits,
24-25, 419-22; environmental improve- 254, 256; Office of National Tax Ad-
ment projects, 24, 409-10, 419-20; ministration (ONTA), 22, 251-57; or-
features of, 18-19; goals of, 24; govern- ganizational changes, 252, 253, 255,
ment support for, 416-19; historical 281; voluntary disclosure program,
context, 23-24, 405-8; ideology, 18-19, 256-57
24, 409, 414; income-generating Tax, business. See Tax, indirect
projects, 24, 410-11, 420-22; initiation Tax Collection Temporary Measures Law
of, 408-9; organization of, 415-16; (1961), 250
 Index 649

Tax Delinquent Special Measures Law 38th parallel. See Allied occupation
(1961), 250 (1945-48)
Tax, indirect: disadvantages of, 273-75;
rate structure of, 275. See also Value- Unitary floating exchange-rate system. See
added tax (1977) Exchange-rate reform (1964-65)
Tax law reform: of 1961, 250-51, 257-58; United States: influence on Korean eco-
of 1967, 22, 258-60, 261-63, 264-68, nomic policy, 20; postwar military aid
270-72; of 1971, 260; of 1974, 260-61, to Korea, 13. See also Allied occupation
271; of 1976, 261. See also Tax adminis- (1945-48)
tration reform (1966) Urbanization: economic effects of, 328-29;
Tax reform. See Office of National Tax Ad- and emergence of middle class,
ministration (ONTA); Tax administra- 589-91; factors contributing to, 349-51;
tion reform (1966); tax law reform; problems resulting from, 36, 349-53;
Value-added tax (1977) regional imbalances, 36, 349-50;
Tax revenue sharing, 178-79 regional polarization, 595-97; resulting
Tax revenue trends, 247-50 from wartime and postwar migration
Tax System Bureaus, 252-53 to Seoul, 589-90; social effects of,
Tax, turnover. See Tax, indirect 592-93; and social mobility, 591-92;
Tax, value-added. See Value-added tax trends, 589-91. See also Migration,
(1977) rural-to-urban; Population Redistribu-
Third Five-Year Economic Development tion Plan (1977)
Plan (1972-76): promotion of heavy
and chemical industries during, 52, 65,
Value-added tax (1977), 37-38, 95, 273-300;
431; effects of repressive financial poli- administration of, 278-80, 297-98; effect
cies, 63-65; tax reform during, 260. See
on exports, 289-91; effect on inflation,
also Heavy and Chemical Industries 209; effect on investment and savings,
Promotion Plan (1973-79) 286-89; effect on prices, 95, 284-86,
Third Republic (1963-72), 18-27; antitrust 287; effect on tax burden distribution,
measures, 499-500; economic liberali-
291-94; exemption scheme, 276-78,
zation and reforms (1964-67), 20-23;
294-96; features of, 274-75; implemen-
economic slowdown (1972), 80, 163-65; tation process, 281-82, 299-300; in
economic trends, 76-80; establishment
Korea, compared with European sys-
of specialized banking institutions, tems, 274-76; objectives of, 37-38,
49-50; export growth, through 1970, 273-74; problems with, 37-38, 271-72,
21, 60, 76-77; financial policies, 45-72; 294-300, 604; rate structure of, 275-76,
international politics, 26-27; promotion 296-97; as replacement for indirect tax-
of science and technology, 25; tax re- es, 273; and small businesses, 280,
forms, 22-23; transition to, 18. See also 298-99; tax base of, 275; tax yield of,
Park Chung Hee; Agricultural policies; 282-84; theoretical advantages of,
Emergency Decree for Economic Sta- 273-74; zero rating system, 276-78
bility and Growth (1972); Exchange- Values, traditional: changes in, resulting
rate reform (1964-65); Export promo- from geographic mobility, 592-93
tion; Grain management policy (1969); VAT. See Value-added tax (1977)
Import-liberalization program (1967); Vietnam War, 26-27
Interest-rate reform (1965); Office of
National Tax Administration (ONTA);
Saemaul (new community) movement Yushin constitution, 28-29, 605
(1971); Tax administration reform
(1966); tax law reform, of 1967 Zero rating, in value-added tax, 276-78
THE EAST-WEST CENTER is a public, nonprofit educational institution es-
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