Two Koreas too many

There is a limit to how far a country can sustain a disconnect between economic and corporate performance

During the boom years in East Asia, the economy and the stock market were distant cousins. A case in point was South Korea, where the benchmark Kospi index peaked in 1989, while the economy continued to grow at an 8 per cent pace until the outbreak of the Asian financial crisis in 1997. Critics said the Asian corporations were too inefficient and poorly managed to capture the economic story. Now it seems South Korea is turning the model inside out.

Even as trend-line economic growth has fallen to a much lower plateau of 4 per cent, equity returns have picked up significantly. In dollar terms, the Kospi index has risen eightfold since the lows set during the crisis in 1998 and Korea is the only East Asian emerging market to have subsequently hit all-time highs. It8217;s a new tale of two South Koreas 8212; large companies have never been in better shape while economic growth hasn8217;t been slower since the 1960s. Continuing their radical transformation from being the wastrels of capital in the past, Korean conglomerates now understand the importance of adding economic value by investing in Research and Development R038;D. South Korea8217;s R038;D expenditure as a share of the economy is one of the highest in the world at 2.6 per cent of its gross domestic product. The focus on moving up the value chain by investing in technology and building global brands is what distinguishes Korean companies from many of their Asian emerging market counterparts that are still stuck in low-margin contract manufacturing businesses.

As a result, South Korea has been one of the largest recipients of foreign portfolio flows in the current emerging market bull-run even though its economy hasn8217;t participated in the boom. Korean conglomerates have become growth plays on emerging markets as they are benefiting from the accelerated growth profile of China and India after having established an early presence in such key developing countries. A furious pace of outsourcing by South Korean companies has also helped raise the rate of overseas investment as a percentage of Korea8217;s gross domestic product to 7 per cent while the ratio of domestic fixed-investment to GDP has steadily declined to 26 per cent.

But herein lies the problem for the South Korean economy and the consequent angst among the populace. It seems the only way to succeed is to go abroad, and not just for corporate jobs. The country is running a deficit of 20 billion a year in its service sector as Koreans venture out in huge numbers seeking better education and healthcare.

For a country fast approaching a per capita income of 20,000, Korea8217;s sclerotic service sector is a major anomaly in its economic structure and possibly the main reason why domestic trend growth is significantly lower. While it can be argued that it8217;s only natural for the law of large numbers to catch up and for growth to decelerate as the economy approaches a high per capita income, there8217;s no reason why Korea can8217;t grow at 5 per cent to 6 per cent. Indeed, Japan, Singapore and Hong Kong did expand at such a pace at similar stages of the development cycle. But to achieve that, Korea needs to cut its dependence on manufacturing. The services sector accounts for a rather low 52 per cent of Korea8217;s GDP compared to 70 per cent in most developed countries and that is an impediment in the country8217;s aspiration to become a financial hub of North Asia.

A large manufacturing sector has also led to widespread underemployment in Korea. The big producers have streamlined their cost base at home to remain globally competitive but the service sector isn8217;t productive enough to pick up the slack. The current government has done little to usher in any meaningful reforms in a service sector bedraggled by extensive regulation. The productivity rate of Korea8217;s service is half that of its manufacturing sector as the government continues to interfere in areas ranging from pricing of key utilities to maintaining a monopoly in a poorly run education system. To increase the competitiveness of the service sector the government needs to expose it much more to foreign competition.

The experience of the 1980s and the 8216;90s showed that there is a limit to how far a country can sustain a disconnect between economic and corporate performance. The two variables are highly correlated in the emerging market cycle; in countries like India and Russia, economic and equity market behaviour shows that the economy and the stock market can be Siamese twins.

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South Korea has gone from one extreme to another. Now the slowing domestic economy is producing a rise in anti-foreign sentiment and discontent over underemployment. Policymakers need to fix the disparity before it8217;s too late again.