2 Alternative Growth and Adjustment Strategies of Newly Industrializing Countries in Southeast Asia

Paul Streeten
Published Date:
September 1988
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I. Introduction

Probably most notable in the development history of the last quarter century is the emergence of newly industrializing countries (NICs) in Southeast Asia. The remarkable export and growth performance of these countries is widely viewed as a successful case of export-oriented development strategies. However, frequently overshadowed by the outstanding growth record is the fact that even these economies are not free from structural adjustments.

A most obvious case in point was the economy of the Republic of Korea in the later years of the 1970s, with accelerating inflation, real appreciation of the exchange rate, and a complicated and differentiated industrial incentive structure. Koreans were relatively quick to tackle these problems with a comprehensive stabilization program and various structural reforms. What makes the Korean adjustment efforts more interesting is that the adjustments, as manifested in the deceleration of inflation and improved balance of payments, were, unlike those made in Latin American countries, made at the minimum sacrifice of growth.

This paper, in the next section, briefly reviews the growth performance of the Southeast Asian newly industrializing countries in connection with their export-oriented strategies. From their experiences, an attempt has been made to derive conditions critical for a successful export-oriented strategy. Then, macroeconomic developments in the 1970s in Taiwan Province of China and the Republic of Korea are compared to highlight the consequences of macropolicies that are inconsistent with export orientation.

In the following section, major features of the Korean adjustment efforts in the 1980s are presented, with an emphasis on stabilization policies—the centerpiece of the whole adjustment program. Some lessons from the experiences of the Republic of Korea, as well as the other Southeast Asian newly industrializing countries, are presented in the concluding section.

II. Strategies and Performance

1. Export Orientation and Growth

It is well known that four newly industrializing economies in Southeast Asia—the Republic of Korea, Taiwan Province of China, Singapore, and Hong Kong—have achieved remarkable economic growth through the successful implementation of export-oriented development strategies. The average annual growth rate of per capita gross national product (GNP) for these countries ranged between 6.2 percent (Hong Kong) and 7.8 percent (Singapore) over the 1966—84 period. This growth performance was exceeded only by Botswana and Malta.1

Identifying the major factors that contributed to this outstanding growth performance is certainly not an easy task. Frequently suggested factors include export-oriented development strategies, a favorable world trade environment, a high level of education or a critical mass of educated members of an elite, political stability, and a Chinese cultural background, which tends to produce people who are hard-working, thrifty, disciplined, and respectful to authority. Even though it seems almost impossible to assess the relative importance of these factors in accounting for the growth of these economies, convincing arguments have been given why higher growth could be expected for countries pursuing export-oriented strategies.

Export-oriented development means the division of labor and specialization—a more efficient use of productive resources. For relatively small countries, economies of scale cannot be attained without relying on overseas markets. Exposure to, and competition in, the world market also drives firms to be more efficient and tends to produce a more competitive domestic market structure. In addition, policies centered on export promotion tend to be less distortive than alternative strategies. For instance, there has been ample evidence that import-substitution regimes generally lead to a complex incentive structure involving differential tax treatment and direct controls over prices, credit allocation, and imports. Export-oriented strategies, however, usually provide fairly uniform incentives among export industries and make it possible to pursue consistent macroeconomic policies over time without succumbing to the stop-and-go pattern associated with periodic foreign exchange crises.

Empirical studies have shown a significant positive correlation between the openness of an economy to world trade and its growth rate.2 Although one may argue that the direction of the association is ambiguous, the experiences of the Southeast Asian newly industrializing countries seem to indicate that the causality runs from openness to high growth.

In these countries, the high growth since the mid-1960s has been accompanied by rapid export expansion and growth of the manufacturing sector. Especially pronounced is the case of the Republic of Korea, where commodity exports grew 3.2 and 2.1 times as fast as gross domestic product (GDP) during 1966-73 and 1974-84, respectively, to increase the GDP share of exports of goods and nonfactor services from 9 percent to 37 percent between 1965 and 1984. Even in Hong Kong and Singapore, where commodity exports have not grown particularly faster than GDP, trade-related services seem to have contributed greatly to the overall growth.

It has frequently been argued that export-oriented economies are more vulnerable to external shocks and will suffer more under an unfavorable external environment. Table 1 shows that this claim is not valid, at least for the growth of the Southeast Asian countries under study, since the first oil price shock. The average annual growth of these economies dropped by 2.5 percentage points, from 10.5 percent during 1966-73 to 8 percent during 1974-84, which compares favorably with a 3 percentage point drop for all middle-income countries. Export-oriented economies, typically with a high import/GDP ratio and a more flexible and innovative business sector, may be in a better position to adapt themselves to changes in world market conditions.

Table 1.Real Growth of Production and Exports(In percent)
GDP1ManufacturingCommodity Exports
Republic of Korea10.
Taiwan Province of China11.07.618.79.026.312.1
Hong Kong7.99.111.712.9
Middle-income group7.
Sources: International Bank for Reconstruction and Development, World Development Report. 1986(Washington, 1986); Taiwan Province of China, Council for Economic Planning and Development, Taiwan Statistical Data Book, 1985 (Taipei); Directorate-General of Budget, National Income in Taiwan Area, The Republic of China (Taipei, 1985).

Gross domestic product.

Sources: International Bank for Reconstruction and Development, World Development Report. 1986(Washington, 1986); Taiwan Province of China, Council for Economic Planning and Development, Taiwan Statistical Data Book, 1985 (Taipei); Directorate-General of Budget, National Income in Taiwan Area, The Republic of China (Taipei, 1985).

Gross domestic product.

2. Ingredients of a Successful Export-Oriented Strategy

What was the major momentum forcing these industrializing economies to be oriented toward manufacturing exports? For Hong Kong and Singapore, their small size and lack of natural resources almost dictated the choice of an export-oriented strategy. Under British rule, they had grown as the commercial and financial entrepôts for South China and British Malaya, respectively, and inherited economic liberalism as well as modern infrastructures.

With the United Nations embargo on trade with China after the outbreak of the Korean war, and the resulting flush of Chinese refugees, including capitalists and skilled workers, Hong Kong had no alternative to developing manufacturing for export during the 1950s. The success of Singapore as a manufacturing exporter came a little late, after its independence in 1965. Increased demand related to the Viet Nam war, oil exploration in the region, and an active role by multinational corporations, together with a boom in world trade, helped in the transformation of the Singapore economy.

Table 2.Structure of Production and Demand

(In percent of nominal GDP1)

Republic of Korea38141828937830
Taiwan Province of China246264219582134
Hong Kong2124711072929
Sources: Same as Table 1.

Gross domestic product

Exports of goods and nonfactor services.

Sources: Same as Table 1.

Gross domestic product

Exports of goods and nonfactor services.

In Taiwan Province of China and the Republic of Korea, however, the choice of development strategy was not that obvious. Not only were their domestic markets much larger than those of the other two economies, but their policymakers were influenced by the popular postwar belief in the import-substitution policy. Both had maintained highly overvalued currencies and strict quantitative import controls, as well as a high tariff wall. With the relatively small domestic markets and the noncompetitive environment, economic growth was slow, not to mention the development of export industries. Foreign aid was an important source of funds to cover the deficit in the balance of payments.

It was in the spring of 1958 that, after some debate, Taiwan Province of China switched to an export-oriented strategy. The currency was devalued substantially, and the complicated multiple exchange rate system was unified in the following year. Import restrictions were also relaxed gradually. For the Republic of Korea, it was not until 1964 that similar reorientation was made. By then, the country had almost exhausted easy import substitution, and further import substitution of capital goods and durable consumer goods was not considered feasible owing to the small domestic market and large capital requirement. Furthermore, U.S. assistance programs were being phased out, which made foreign exchange earnings through export promotion an imminent task.

For both of these industrializing economies, an export-oriented development strategy was more than just removing previously existing disincentives to export activities. It included various export promotion measures: subsidized export credit, tax exemption or remission on export-related activities, allowing the use of export earnings for imports, and support of overseas marketing through information services. Although the complicated incentive structures defy any precise quantification of the subsidy, it has been estimated to be well over 10 percent of gross export earnings.3

What can be said about any prerequisites or conditions for a successful export-oriented strategy, given the above brief description of motivations and economic transformation? Above all, strong government commitment to, and consistent pursuance of, an export-oriented strategy is critical.

More specifically, there should be no institutional barriers for exporters to overseas intermediate inputs, technology, and export-related services. Reducing physical barriers by adequate communication and transport infrastructure is also important. Furthermore, macroeconomic policies, particularly those related to the exchange rate and wages, should be consistent with an export-oriented strategy.

Since the exchange rate directly affects export profitability, maintaining an adequate and stable real exchange rate is critical for the smooth and sufficient allocation of resources into the export sector. Under an inflationary environment, however, keeping the real exchange rate stable is not, practically speaking, an easy task. Thus, an export-oriented strategy frequently involves price stabilization efforts. The labor market should also be allowed, without any major institutional rigidity, to adjust in response to market forces, to ensure not only adequate export profitability but also flexible and resilient adaptation of the economy to world economic changes.

3. Macroeconomic Imbalance in Export-Oriented Economies

The success of export-oriented strategies for Southeast Asian newly industrializing countries, as manifested in their outstanding export and growth performances, seems to have been possible because, by and large, they met the above conditions. Nevertheless, not all the countries have been equally successful; nor has one country done equally well over time. In this section, macroeconomic developments in these countries since the early 1970s will be more closely reviewed in relation to their macropolicies. Such comparisons as are made, mainly between the Republic of Korea and Taiwan Province of China, depend very much on their unique geographies and histories, and are less relevant for most developing economies.

Table 3 shows the economic performance of the two countries since the latter half of the 1960s. During 1966-73, Korean export growth surpassed that of Taiwan Province of China, though Korean GNP growth was slightly lower. That reflects mainly the small Korean export base; Taiwan Province of China’s GDP share of exports was more than twice that of the Republic of Korea in 1965.

Table 3.Republic of Korea and Taiwan Province of China: Economic Performance. 1966—85
Real GNP growth (percent)
Republic of Korea10.07.312.2-0.27.5
Taiwan Province of China11.02.712.57.86.4
Export growth1(percent)
Republic of Korea43.925.535.717.411.6
Taiwan Province of China33.38.833.725.09.2
Foreign savings (percent of GNP)
Republic of Korea7.511.
Taiwan Province of China-2.05.8-4.30.2-9.0
Republic of Korea13.927.719.423.06.6
Taiwan Province of China5.916.35.713.73.7
Sources: Republic of Korea, Economic Planning Board, Major Statistics of Korean Economy 1986 (Seoul) and Taiwan Province of China, Council for Economic Planning and Development, Taiwan Statistical Data Book 1985 (Taipei); Directorate-General of Budget, National Income in Taiwan Area, the Republic of China (Taipei, 1985).Note: GDP denotes gross domestic product, GNP gross national product.

Measured in nominal U.S. dollars.

As measured by the GDP deflator.

Sources: Republic of Korea, Economic Planning Board, Major Statistics of Korean Economy 1986 (Seoul) and Taiwan Province of China, Council for Economic Planning and Development, Taiwan Statistical Data Book 1985 (Taipei); Directorate-General of Budget, National Income in Taiwan Area, the Republic of China (Taipei, 1985).Note: GDP denotes gross domestic product, GNP gross national product.

Measured in nominal U.S. dollars.

As measured by the GDP deflator.

A striking contrast between the two countries can be seen by examining their growth and export performance during the two oil price crises. During 1974—75, Korean GNP and export growth rates were much higher, while during 1979-80 the Korean GNP growth rate was negative, compared with annual growth of 7.8 percent for Taiwan Province of China.

Sharp differences also lie in their balances of payments and inflation rates. While foreign savings have constituted a substantial portion of GNP in the Republic of Korea, foreign savings (net lending and transfers to the rest of the world) in Taiwan Province of China have been negative since the early 1970s, except for the oil shock periods. During 1981—85, negative foreign savings reached as high as 9 percent of GDP. The annual inflation rate measured in terms of the GDP deflator had been about 10 percentage points higher for the Republic of Korea, until the gap narrowed to 3 percentage points during 1981—85. Compared with inflation in Taiwan Province of China, Korean inflation was particularly bad during the boom years after the first oil price shock.

As will be elaborated in the next section, the Korean economy started to show a macroeconomic imbalance from the early 1970s. Noteworthy is how differently the two countries reacted to the first oil price shock. In Taiwan Province of China, there was a sharp deceleration of the money supply (M1B) growth to below 12 percent in 1974 and upward adjustment of the rediscount rate from 8.5 percent to 12 percent during 1973-74. The Korean money supply (M1) growth was almost 30 percent in 1974, and the bank lending rate (15.5 percent per annum, which was much lower than the inflation rate) was not changed during 1973—75. To ease the slowdown of exports, the Korean authorities devalued the currency by 20 percent in December 1974.

These differential policy responses resulted in a wider gap in the inflation rates of the two countries and a deterioration of Korean export competitiveness in the following years.4 The Korean macroeconomic imbalance during the second half of the 1970s is more evident from developments in the real exchange rate and wages.

Table 4.Nominal and Real Exchange Rates(Indices: 1975 =100)
Nominal (per U.S. dollar)Real1

of Korea


of China2

of Korea


of China
Source: International Monetary Fund, International Financial Statistics Yearbook, 1986 (Washington, August 1986).

Adjusted for not only the relative wholesale price index (WPI) inflation (against the United States) but also the U.S. dollar/SDR exchange rate.

Average of the two year-end values.

The WPI was calculated from the consumer price index (CPI) using the ratio of average WPI inflation rate to CPI inflation rate during 1975-85.

Source: International Monetary Fund, International Financial Statistics Yearbook, 1986 (Washington, August 1986).

Adjusted for not only the relative wholesale price index (WPI) inflation (against the United States) but also the U.S. dollar/SDR exchange rate.

Average of the two year-end values.

The WPI was calculated from the consumer price index (CPI) using the ratio of average WPI inflation rate to CPI inflation rate during 1975-85.

As shown in Table 4, the real (effective) exchange rate of the Korean won appreciated by as much as 21 percent during 1974-79 and, despite substantial nominal depreciation in 1980, appreciated further during 1981—82. This exchange rate development seems to be the main cause for the deceleration of Korean export growth during the latter half of the 1970s. The real (effective) exchange rates for Taiwan Province of China and Singapore were much more stable. Even though the Korean real (effective) exchange rate could have been kept stable with faster nominal depreciation, that would have accelerated already-high inflation, aggravating the imbalance in other sectors of the economy.

A weakening of Korean export competitiveness was also obvious in the trend of unit labor costs. Table 5 shows that, during 1976-78, the annual increase in unit labor costs in U.S. dollars was as high as 24 percent for the Republic of Korea, against 7 percent for Taiwan Province of China. Faced with a severe profit squeeze, Korean exporters had to raise unit export values at an annual rare of 10.6 percent during this period, compared with 4.9 percent for Taiwan Province of China, which resulted in a loss of some export markets.

Table 5.Republic of Korea and Taiwan Province of China: Wages, labor Productivity, and Unit Labor Costs in Manufacturing(Annual increase, in percent)
Republic of KoreaTaiwan Province of China
Nominal wages31.134.325.713.726.016.521.812.4
Consumer prices24.813.323.48.324.
Real wages5018.
Labor productivity
Unit labor cost28.423.819-47.430.06.219-88.7
Exchange rate10.
Unit Labor cost (in U.S. dollars)16.523.
Sources: Same as Table 3.

Labor productivity is measured as value added per employee.

Sources: Same as Table 3.

Labor productivity is measured as value added per employee.

In addition to the effects on export profitability, an annual real wage increase of 18.5 percent for the Republic of Korea during 1976—78 was hardly consistent with an 8.4 percent growth of labor productivity in the manufacturing sector. In the absence of strong labor unions in the Republic of Korea, this wage inflation might only be explained by the overheated economy and high inflationary expectations, as well as by sectoral labor shortages.

III. Korean Adjustment Efforts in 1980s

1. Background

As mentioned above, high inflation in the Republic of Korea was mainly responsible for the dislocation of the real exchange rate and the ensuing slowdown in export growth in the later years of the 1970s. What, then, were the major factors contributing to the Korean inflation, and what other imbalances or distortions did inflation cause in the economy? As is generally the case for many high-inflation countries, rapid monetary expansion and wage-push played a major role.

In the early 1970s, the Nixon administration reduced substantially the number of U.S. troops in the Republic of Korea, and after the oil price shock, industrial countries strengthened protectionist barriers against many light manufactured goods from developing countries. These unfavorable external developments forced the Republic of Korea to make enormous investments in heavy and chemical industries, with a view to enhancing the industrial structure and developing a domestic defense industry.

In an effort to finance large-scale development projects in these industries, preferential bank loans were extended in an undisciplined manner. This effort was also responsible for the rapid monetary expansion, the credit squeeze on less-favored sectors, and the excessive and inefficient investment in heavy and chemical industries.

A sharp rise in grain import prices after the oil price shock also lent support to the argument for promoting self-sufficiency in major foodgrains. The resulting deficits in the government-run Grain Management Fund and the Fertilizer Account accounted for 37 percent of the total growth of the money supply (M1) during 1976-78.

On the other hand, a 20 percent devaluation of the Korean won in late 1974 and the boom in Middle Eastern construction activity resulted in a substantial improvement in the current balance of payments. The easy availability of oil money and the low cost of recycling it also contributed to heavy foreign borrowing, to which the Government failed to react in order to ensure a stable monetary expansion. As a result, the broadly defined money supply (M2) grew by more than 35 percent annually, leading to a 19 percent inflation rate in terms of the GDP deflator, in spite of virtually no increase in import cost during the period.

On the cost side, wage-push was the major source of inflation. With a nominal wage increase of over 34 percent a year during 1976—78, the real wage increase far surpassed labor productivity growth. The strong demand pressure of the economy, coupled with labor shortages in some fast-growing sectors, was mainly responsible for the soaring wages. The rapid growth of large business groups, usually associated with a strong investment boom in the heavy and chemical industries, brought about competitive recruiting for better college graduates and scouting of experienced workers from competing firms. The rush of many construction companies and workers to the Middle East also generated wage pressure for relatively unskilled workers.

The Korean economy during the later years of the 1970s was full of distortions and resource misallocations typical of any high-inflation country. Financial saving, which usually entailed earning a negative real interest rate, was not attractive. Instead, feverish demand for real estate and other real assets caused their prices to shoot up. Many business firms were preoccupied with borrowing as much as possible from banks, only to invest in real estate by expanding unproductive businesses, leading to an increasingly fragile corporate financial structure. The Government’s attempt to repress inflation through price controls led only to inadequate investment, supply shortages, black markets, and deteriorating product quality.

Table 6.Republic of Korea: Household Income Distribution
Gini coefficient0.3440.3320.3910.3890.357
One-tenth distribution ratio (lower 40 percent/ upper 20 percent)19.3





Source: Korea Development Institute staff estimates.
Source: Korea Development Institute staff estimates.

Although the economy was still booming, it became increasingly apparent that the income/wealth distribution was worsening and that the rapid growth was undermining the long-run growth potential of the economy. Tight credit rationing in favor of larger firms in the heavy and chemical industries and various government regulations restraining competition among producers accelerated economic concentration. A still more critical factor contributing to distributive inequality was the soaring price of real estate, which more than offset the real wage gain for the poor.5

At the same time, it became increasingly clear that persistently high inflation was threatening sustained growth by eroding the competitiveness of Korean exports. As described in the previous section, indications were that Korean export growth, compared with nearby competitor countries, had been slowing down since 1977. Many policymakers felt that Korea—a country strongly committed to an export-oriented growth strategy—could not afford to neglect this situation for long.

2. Stabilization Policies

To correct the situation induced by high inflation, a comprehensive stabilization program was adopted in the spring of 1979. Restrictive fiscal and monetary policies, adjustment of investment in heavy industry, and special attention to stabilizing the prices of daily necessities were the major contents of the program. A 5 percent cut in current expenditures was called for; interest rates were adjusted upward; and the investment adjustment involved the postponement, cancellation, or scaling down of some of the excessive and duplicative investment plans.

However, the significance of this stabilization program went beyond its contents. The program was an expression of consensus of the people and firm commitment of the Government. Actually, less than three months after the program was launched, the nation was hit by another oil price shock; political uncertainty caused by the sudden death of President Park, together with a poor harvest in 1980, also seriously aggravated the economic situation, and a — 5.2 percent GNP growth was recorded for 1980. Noteworthy, however, was the fact that, even though the Government adopted a series of reflationary policy packages during the 1979-82 recession, it was in general very cautious not to rekindle inflation.

After experiencing negative growth in real exports in 1979 and a continuing decline in export profitability, and anticipating a substantial increase in the oil import bill, the Government devalued the exchange rate by 20 percent against the U.S. dollar and switched to a floating exchange rate system in early 1980. To offset part of the inflationary effect of the devaluation, a wide range of interest rates was also adjusted upward by 5—6 percentage points.

However, as the economic situation continued to deteriorate in the midst of social unrest, the original restrictive policy stance had to be eased gradually. Within less than two and a half years the general bank loan rate dropped, in about eight steps, from 24.5 percent to 10 percent per annum. Financial support was augmented for public construction works, small and medium-sized firms, residential construction (especially for low-income families), and export of heavy industrial products on a deferred-payment basis. Tax instruments were also actively utilized to introduce temporary investment tax credit and various tax reductions.

There was still substantial monetary expansion, and the public sector deficit rose as high as 4.6 percent of GNP in 1981. On the other hand, exchange rate management was kept somewhat rigid during 1981-82 in an effort to minimize inflationary pressure from rising import costs. Since 1981, stabilization efforts have relied heavily on an incomes policy, in the belief that relying on demand-management policy alone to stabilize prices would require too much time and an excessively large sacrifice in income growth.

In step with the economic recovery since 1983, the focus of macropolicies has shifted to both consolidating price stability and eliminating the current account deficit as soon as possible. The emphasis on improving the balance of payments has stemmed mainly from a sharp rise in the international interest rate and uncertainty surrounding the international financial market. During 1983-85, the macroeconomic policy stance was fairly restrictive, though it was relaxed slightly in response to disappointing growth performance in 1985.

On the zero-based budgeting principle, the general account budget was prepared to produce a sizable surplus to finance deficits in some of the government-run funds. Consequently, the public sector deficit was reduced to 1.4—1.6 percent of GNP during 1983-85. The expansion of the broad money supply (M2) also slowed down drastically during 1984—85. Bank interest rates were adjusted slightly upward to make them relatively attractive for depositors compared with nonbank rates. On the contrary, in keeping with the objective of stabilizing prices, as well as the renewed concern about the external balance, exchange rate management was flexible enough to allow a substantial depreciation of the real effective exchange rate.

a. Fiscal Policy

To evaluate the Republic of Korea’s fiscal policy stance, the Fund’s measure of fiscal impulse was estimated.6 This is actually a crude indicator of change in fiscal stance, adjusted only for the deviation of output from its potential level.

Chart 1.Republic of Korea: Fiscal Impulse and Change in GNP Growth Rate1

Note: The regression line was fitted for fiscal impulse excluding observations for 1980 and 1981.FI=0.162(0.57)0.210(3.14)ΔY˙R2=0.496

1 GNP denotes gross national product. An x denotes the fiscal impulse, and a dot (.) denotes the change in the actual deficit/GNP ratio.

The extent to which fiscal management was countercyclical may be evaluated by examining changes in the fiscal impulse over the business cycle. Actually, by examining Chart 1, a rather close inverse relationship between the change in the GNP growth rate and the fiscal impulse could be confirmed for the sample period of 1971-84, with notable outlying years 1979-81. These outlying years can easily be explained by the stabilization efforts which delayed (until 1981) the fiscal reaction to the sluggish economy of 1979-80.

It is noted that the fiscal impulse for a given change in the GNP growth rate was generally weaker after the launch of the stabilization program in 1979. It was particularly restrictive in 1983, in addition to the 1979-80 period. The accumulated fiscal impulse during 1971-78 was 1.6 percent of GNP, in contrast to — 2.3 percent of GNP during 1979-84.

b. Monetary Policy

The assessment of the monetary policy stance was based on the estimation of the demand-for-money equations. Equations, run for the period 1970—78, were used to estimate the money supply anticipated in the absence of any stabilization efforts.7 Chart 2 indicates that monetary policy was not restrictive until about the first half of 1982. The annual rate of growth for broadly defined money (M2) was as high as 26-28 percent during 1980—82, when a series of reflationary policy packages was adopted in the situation of delayed recovery.

From late 1982 to 1984, however, monetary expansion fell short of the demand for money, which grew much faster than nominal GNP owing to the declining inflationary expectations of the people. The average broad money supply (M2) grew at a rate of only 11— 12 percent during 1984-85. In 1985, no indication of a restrictive flow of the supply of money could be found, when nominal GNP grew by only 8.9 percent and there was little additional demand for money arising from subdued inflationary expectations.

Chart 2.Republic of Korea: Monetary Policy Stance, Actual and Fitted Money Supply

Note: For equations on which the above fitted values are based, see footnote 7 in the text

c. Exchange Rate Management

Owing to high inflation following the second oil price shock, the substantial devaluation of the Korean won in 1980 did not help much in correcting appreciation of the currency on a real effective basis. Actually, during 1981-82, the earlier period of the comprehensive stabilization program, there was some additional real effective appreciation, indicating that exchange rate management was somewhat biased toward curbing inflation. Moreover, the interest rate subsidy given to export financing vis-à-vis general loans was eliminated in June 1982, which is equivalent to an additional 4—5 percent appreciation for exporters in the real effective exchange rate. Thus, the exporters’ competitive disadvantage was much more substantial than the real effective exchange rate indicates.

However, since 1983, by which time the deceleration of inflation was evident, exchange rate management was free of any stabilization bias and was actually tilted toward stimulating exports and growth. During the three-year period 1983-85, the Korean won showed a real effective depreciation of more than 15 percent.

d. Incomes Policy

The Republic of Korea’s anti-inflation policy relied not only on demand management but also on incomes policy. Incomes policy was intended to keep inflationary psychology from creating a bottleneck in the stabilization process. It included the imposition of informal wage guidelines, or “jawboning” efforts, to moderate wage increases, control of interest rates and dividends, and stingy adjustments to the Government’s purchase price for rice.

Table 7.Republic of Korea and Taiwan Province of China: Real Effective Exchange Rates vis-à-vis the U.S. Dollar, 1970-85(Indices, 1975 = 100)
YearRepublic of KoreaTaiwan Province of China
NominalEffectiveReal effectiveReal effective
Source: Korea Development Institute, staff estimates.
Source: Korea Development Institute, staff estimates.

While one may not negate the effects of these measures altogether, empirical evidence indicates that actual wage hikes in the 1980s were roughly what could be expected without any guidelines.8 Still, the fact that the real wage increase was slightly lower than the labor productivity gain during the 1981–84 period of sharp disinflation (as shown in Table 5) is strong evidence of a flexible labor market. As can be expected, however, the incomes policy was not without side effects: it produced a wider wage gap between public servants and private employees, and some disintermediation (away from financial savings) during 1982–83.9

3. Structural Policies

It was argued above that, without price stability, it is difficult to maintain a realistic exchange rate, which is very critical for an exported-oriented economy, and not worsen the income/wealth distribution. Furthermore, as is evident from the Korean experience in the 1970s, high inflation is most likely to result in inefficiency in resource allocation owing to such associated phenomena as negative real interest rates, credit rationing, and shortening maturities for financial instruments.

Together with the stabilization efforts, the Republic of Korea pursued a series of structural policies designed to reduce various inefficiencies that had become imbedded in the Korean economy. Broadly speaking, they included reducing government intervention in resource allocation, promoting competition, and restoring the functioning of the market mechanism.

Though the importance of these structural policies may be emphasized, one should note that their implementation is often constrained by the macroeconomic situation. If there is a serious balance of payments deficit, for instance, drastic import liberalization may be like a medicine that kills the patient. This is why a stabilization program usually precedes or accompanies any financial or external liberalization.

a. External Liberalization

The Korean current account was in equilibrium in 1977, and the Government planned to relax import controls. However, owing to the second oil price shock, it was only in early 1983 that the Government announced a time-phased schedule for import liberalization and tariff adjustments. It is interesting to note, in retrospect, that in 1982–83 there was not only a considerable improvement in the current account (owing partly to recovery of the world economy) but also a drastic deceleration of inflation as well as a turnaround in the exchange rate, which moved toward real effective depreciation. These developments strongly indicate that the successful stabilization policy facilitated realistic exchange rate management, which, in turn, was an important assurance that an import-liberalization program would be successful.

The liberalization plan has been closely implemented so far, increasing the import-liberalization ratio from 69 percent in 1981 to 91.5 percent in 1986. It is scheduled to reach above 95 percent by 1988. In liberalization, higher priorities are given to overly protected or monopolistic commodities in the domestic market, and domestic producers are given two-to-three-year advance notice of import liberalization to cushion its impact.

Though domestic producers may have been given temporary tariff protection following import liberalization, the average tariff rate has been lowered from 25 percent in 1981 to the current 21 percent, and is to reach 18 percent by 1988. The plan also calls for substantial reduction of tariff differentials to create a more uniform tariff structure.

At the same time, restrictions on technology imports and direct foreign investment have also been reduced drastically. The negative list concerning direct foreign investment is becoming shorter and shorter every year, and the ratio of foreign equity ownership is not controlled in principle.

Even though no major disruptive impact of import liberalization on business survival or the balance of payments has been noted so far, many Koreans are concerned about the speed of the opening-up of their markets when advanced nations are raising their walls against Korean export goods. Yet, the Government seems to be strongly committed to its open-door policy. This may mean that the Republic of Korea, with its large external debt, will keep the exchange rate more depreciated than it otherwise would be, which, in turn, would aggravate the adverse shift in the terms of trade and, to that extent, reduce the standard of living.

b. Domestic Liberalization

Other major structural policies have included lifting price controls during 1978–79, implementing the Fair Trade and Anti-Monopoly Act from 1981, adopting a more flexible and autonomous system of public enterprise management, and a series of financial reforms and realignments of the industrial-incentive system since the early 1980s.

Financial reform in the 1980s included divesting government equity shares in the major city banks, lowering entry barriers to the financial market, making institutional changes to bring about a more universal banking system, and making some progress in interest rate liberalization. Still, most interest rates in the organized financial markets are closely regulated by the monetary authorities. Moreover, the share of policy loans in deposit-money-bank credit has not declined noticeably, though the substantial interest rate subsidy attached to these loans was eliminated in 1982.

Further financial liberalization seems to have been hindered by the complications from the excessive government intervention in private resource allocation during the 1970s. Banks as well as the Government could not afford to let troubled firms whose promotion had been heavily supported go bankrupt for fear of the social and economic repercussions. In the meantime, bailout credit has snowballed, and the achievement of managerial autonomy for commercial banks still looks unlikely.

Recently, the Government attempted to improve this situation. Measures introduced included helping the banking institutions, the major victims of government intervention, by allowing attractive deposit rates, compared with those offered by nonbank institutions, and providing subsidized central bank credit, and exempting collateral supplied by the troubled firms from capital-gains taxation. In other words, the cost of imprudent government intervention is paid by consumers and taxpayers, and financial repression continues.

The other side of the problem is industrial adjustment. As early as 1981, with a view to rationalizing industrial incentives, the Government curtailed and simplified differentiated tax incentives given to selected industries, while reinforcing support for small and medium-sized firms and technological innovations. To further streamline the existing industrial incentive system and to deal with both declining industries and promising infant industries, the Industrial Development Law was passed. It is hoped that, under this law, industrial restructuring will be effectively supported by the Government with a minimum risk of failure.

IV. Lessons and Conclusions

Table 8 shows the performance of the Korean economy during the 1980s. While the balance of payments deficit and inflation declined sharply, the drop in GNP growth or the gross investment ratio was not particularly noticeable, except for the negative growth in 1980 which was influenced by a poor harvest and political instability. Although a better external environment—characterized by improved terms of trade, lower international interest rates, and the recovery of the world economy since 1983—was certainly an important factor, the Korean macroeconomic policy mix, coupled with sectoral adjustment efforts, also played a key role.10

Table 8.Republic of Korea: Economic Performance, 1980–85(In percent)
GNP growth 1-
Current account balance (percent of GNP)-8.8-7.0-3.8-2.1-1.7-1.1
Inflation rate (GDP deflator)24.815.
Gross investment/GNP ratio32.130.328.629.931.931.2
Domestic savings/GNP ratio20.820.520.925.327.928.4
Real wage increase2-4.2-
Real interest rate3-9.2-
Source: Republic of Korea, Economic Planning Board, Major Statistics of Korean Economy (Seoul, 1986).Note: GNP denotes gross national product, GDP gross domestic product.

National income data for 1981–85 are based on the new system of national accounts.

Real wages equal non-agricultural wages/CPI.

Bank time-deposit rate (one-year maturity, year end) minus consumer price index (CPI) inflation rate (year average).

Source: Republic of Korea, Economic Planning Board, Major Statistics of Korean Economy (Seoul, 1986).Note: GNP denotes gross national product, GDP gross domestic product.

National income data for 1981–85 are based on the new system of national accounts.

Real wages equal non-agricultural wages/CPI.

Bank time-deposit rate (one-year maturity, year end) minus consumer price index (CPI) inflation rate (year average).

The Korean stabilization efforrs relied on both demand management and incomes policy. The incomes policy, though not free of short-run side effects, was more or less successful in persuading people to revise their inflationary expectations in step with the inflation rate. Furthermore, though fiscal and monetary management was generally tight, it clearly showed an anticyclical pattern and was not significantly restrictive until 1983, when the economy picked up strongly. Conscious efforts were made to keep investment activity from shrinking so much as to weaken the medium-term growth potential of the economy. Together with augmented government investment in rural infrastructure and other construction projects, stronger investment incentives were given through tax benefits and credit availability.

Exchange rate management, however, was somewhat rigid in the initial stage of the stabilization program for fear of the inflationary impact of the depreciation. The movements of key macrovariables—the realistic real effective exchange rate, positive real interest rates, and the fairly high real wage increase still consistent with productivity growth—have been more reasonable since inflation was brought down sharply in 1983. Evidence of a restored macrobalance could also be found in the rising domestic savings ratio, healthier corporate capital structure, and improved income distribution.

It seems impossible to quantify the impact of sectoral structural policies on the macroeconomic performance. Even though these policies were more or less simultaneously pursued with the stabilization efforts, a gradual approach was adopted to make sure that the former did not overly complicate macroeconomic management.

Finally, what lessons can be drawn from the experiences of the Southeast Asian newly industrializing countries? First, the fact that these countries weathered the two oil price shocks better than other countries suggests that the superiority of an export-oriented development strategy may well be maintained even under the current unfavorable environment of the world economy. Surely the export engine of growth will not be as powerful as it was in the 1960s and the early 1970s, and it may need more frequent tune-ups.

Still, as long as the economic structure is flexible enough and adequate incentives are given, businesses will learn to adapt to changes in the world market, generating dynamic externalities extremely valuable for the economy. A country may promote infant industries. However, the Korean experience indicates that, in order to minimize inefficiencies as well as any moral-hazard problem associated with industrial rationalization, protection should be given only to selected industries and then with a definite time limit and minimum government involvement.

Second, an export-oriented strategy may include more than an assortment of several export incentives. Exporters in the Southeast Asian NICs have been allowed to do business in a virtually free trade regime. Still important are stable and consistent macroeconomic policies. In this connection, exporters in these countries, with remarkably low inflation rates and no major second-stage import-substitution industries, seem to have been in an advantageous position compared with Latin American exporters.

They were not interrupted by frequent episodes of currency overvaluation, nor asked to use domestically produced inputs. A notable exception was the Republic of Korea in the latter half of the 1970s, when the exchange rate was overvalued under accelerating inflation, obscuring the medium-term prospect of the economy. To the extent that high and variable inflation increases uncertainty for exporters, an export-oriented strategy will have a lesser chance of success under a severely inflationary environment.

Third, its stabilization experience seems to indicate that curing chronic inflation takes time, strong leadership commitment, and a broad consensus among the people, not to mention consistent macropolicies. Incomes policy, potentially a critical element in economic stabilization, cannot be successful without the support of all parties involved, which hinges on the conviction that the stabilization effort will succeed and that, in the process, their relative income shares will not be squeezed as a result of their conforming to government guidelines.

Unfaltering presidential backing was the key ingredient in the consistency of the Korean adjustment efforts, as the program faced rough going in its initial stages as a result of the assassination of President Park and the second oil price shock, which was followed by the prolonged recession. The Government’s approach in dealing with the incomes of workers, farmers, and capitalists simultaneously in a more or less balanced manner also seems to have helped secure public support for the stabilization program.

Finally, stabilization and sectoral structural policies may be pursued simultaneously as long as they do not seriously interfere with each other. This is so because they are typically mutually reinforcing. Price stability itself is limited when the allocation of scarce resources is distorted, and it is easier to adopt structural policies in a less inflationary or otherwise more favorable macroeconomic environment.

The Republic of Korea was rather cautious in pursuing financial and external liberalization for fear of their possible depressionary and adverse balance of payment effects, as well as other macroeconomic complications. Liberalization of capital transactions has been delayed until the early 1990s, in light of the recent Latin American experience. Delay in financial liberalization has been due mainly to the unhealthy asset portfolio of the banking sector accumulated during the inflationary period of the 1970s.


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See international Bank for Reconstruction and Development, World Development Report, 1986 (Washington, 1986).


The annual growth rate of commodity exports dropped sharply, from 41 percent during 1976–77 to 22 percent during 1978–79, for rhe Republic of Korea, while that of Taiwan Province of China declined only marginally, from 33 percent to 31 percent, during the same period.


Between 1975 and 1978, average housing and residential land prices jumped by 180 percent and 300 percent, respectively, while consumer prices and urban household income rose by 45 percent and 123 percent, respectively.


The Fund’s measure of fiscal impulse is Δ(B+t0Yg0YpY) where B denotes actual budget balance for the public sector excluding provincial governments; t0 and g0 denote the revenue and expenditure ratios to GNP, respectively, in the base year when actual and potential GNP are judged to be the same; and Y and Yp denote actual and potential GNP (nominal), respectively. Yf was estimated basically by regressing peak-through interpolated GDP with capital stock. The fiscal impulse was evaluated as follows:

Actual deficit/GNP2.
Fiscal impulse0.71.6-
Note: GNP denotes gross national product.
Note: GNP denotes gross national product.


Estimated equations (semiannual, 1970–78) are as follows:












where figures in parentheses are t values, and p denotes the GNP deflator; Vm the moving average of current and previous real GNP; pr the expected inflation rate, measured as the weighted (geometrically declining) average of rates of increase in the GNP deflator over the past four years; r the interest rate (rt denoting the one-year bank time-deposit rate, while rn denotes the curb loan rate); and DI the dummy variable for the first half of the year.


For instance, the dummy variable for the wage guidelines in the following wage equation was not statistically significant: ΔlnW=0.078(0.99)+1.16(3.60)ΔlnCPI+1.08(1.67)ΔlnPDm+0.39(2.55)Δln(Px/Pm)+0.0045(1.68)(1/U)0.016(0.38)D(8184)R2 = 0.743 D-W = 1.36 (1.68) (0.38) Sample = 1966–84 (annual)

where W denotes non-agricultural wages, CPI consumer prices, PDm non-agricultural value-added labor productivity (two-year moving average), Px/Pm the terms of trade, U rhe unemployment rate, and D(81–84) the dummy variable for the wage-guideline period.


The wide wage gap resulted because the Government used the rate of wage adjustment for public servants as a wage guideline for the private sector, whose wage increase, however, turned out to be higher than that suggested by the guideline. The phenomena of disintermediation and shortening maturities for financial assets were the result of lowering interest rates faster than the adjustment of inflationary expectations (though not faster than the deceleration of actual inflation).


While about one third of the $4.4 billion drop in the annual current account deficit between 1980 and 1985 was attributable to the improvement in the terms of trade, the direct contribution of the stable unit import value to the deceleration of inflation was relatively small.

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