The Republic of Korea's economic growth and catch-up: Implications for the People's Republic of China

Lee, Jong-Wha Working Paper The Republic of Korea's economic growth and catch-up: Implications for the People's Republic of China ADBI Working Paper, No. 571 Provided in Cooperation with: Asian Development Bank Institute (ADBI), Tokyo Suggested Citation: Lee, Jong-Wha (2016) : The Republic of Korea's economic growth and catch-up: Implications for the People's Republic of China, ADBI Working Paper, No. 571, Asian Development Bank Institute (ADBI), Tokyo This Version is available at: https://hdl.handle.net/10419/161447 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by-nc-nd/3.0/igo/ ADBI Working Paper Series The Republic of Korea’s Economic Growth and Catch-Up: Implications for the People’s Republic of China Jong-Wha Lee No. 571 April 2016 Asian Development Bank Institute The Working Paper series is a continuation of the formerly named Discussion Paper series; the numbering of the papers continued without interruption or change. ADBI’s working papers reflect initial ideas on a topic and are posted online for discussion. ADBI encourages readers to post their comments on the main page for each working paper (given in the citation below). Some working papers may develop into other forms of publication. Suggested citation: Lee, J.-W. 2016. The Republic of Korea’s Economic Growth and Catch-Up: Implications for the People’s Republic of China. ADBI Working Paper 571. Tokyo: Asian Development Bank Institute. Available: http://www.adb.org/publications/republic-korea-economic-growth-catchup-implications-prc/ Please contact the author for information about this paper. Email: [email protected]c.kr Jong-Hwa Lee is a professor at Korea University. The views expressed in this paper are the views of the author and do not necessarily reflect the views or policies of ADBI, ADB, its Board of Directors, or the governments they represent. ADBI does not guarantee the accuracy of the data included in this paper and accepts no responsibility for any consequences of their use. Terminology used may not necessarily be consistent with ADB official terms. Working papers are subject to formal revision and correction before they are finalized and considered published. Asian Development Bank Institute Kasumigaseki Building 8F 3-2-5 Kasumigaseki, Chiyoda-ku Tokyo 100-6008, Japan Tel: +81-3-3593-5500 Fax: +81-3-3593-5571 URL: www.adbi.org E-mail: [email protected] © 2016 Asian Development Bank Institute ADBI Working Paper 571 Lee Abstract This study investigates the economic growth and catch-up of the Republic of Korea over the past half-century. The gap of output per worker between the Republic of Korea and United States has decreased rapidly, as the Republic of Korea’s lower per capita income, relative to its potential level, has led to higher growth, confirming the prediction of a conditional convergence theory. Cross-country regression further suggests that the Republic of Korea’s catch-up to the United States is also attributable to strong investment, lower fertility, greater trade openness, and improvements in human resources and rule of law, while improvement in democracy tends to slow the pace of the catch-up. Yet as the Republic of Korea catches up to the United States and its steady-state level in per worker output, it is subject to growth slowdown unless it improves institutions and policy factors. While manufacturingand export-oriented development served the Republic of Korea’s success well, poor productivity performance in the services sector has hampered overall productivity growth. The Republic of Korea’s experience implies that the People’s Republic of China’s potential growth rates are likely to slow in the coming decades due to the convergence effect and with the rebalancing toward a domestic consumption and services-based economy. The People’s Republic of China needs to upgrade its institutional quality and improve productivity, particularly in its services sector, to sustain strong growth. JEL Classification: O11, O14, O19, O47, O53, O57 ADBI Working Paper 571 Lee Contents 1. Introduction ................................................................................................................ 3 2. The Republic of Korea’s Economic Growth and Catch-Up ......................................... 4 2.1 The Experience of the Republic of Korea ....................................................... 4 2.2 Catch-Up and Convergence in Output and Productivity ................................. 7 3. Determinants of Economic Growth and the Republic of Korea’s Catch-Up .............. 12 3.1 Cross-Country Analyses of Economic Growth .............................................. 12 3.2 The Republic of Korea’s Economic Growth in Comparative Perspective ..... 16 4. Sector Productivity and Economic Growth in the Republic of Korea ........................ 19 5. Implications for the People’s Republic of China’s Sustained Growth ........................ 24 6. Conclusion ............................................................................................................... 28 References ........................................................................................................................... 3 Appendix ............................................................................................................................... 6 ADBI Working Paper 571 Lee 3 1. INTRODUCTION The Republic of Korea has had a remarkable economic performance since the early 1960s, achieving per capita income of $27,000 to become the world’s eighth-largest trading nation.1 However, the economy’s recent growth performance has been rather disappointing. Gross domestic product (GDP) growth averaged only 4.1% during 2000–2010, marking a significant drop from the average of 7.9% achieved during 1960–2000. Moreover, from 2011 to 2015, the Republic of Korea’s GDP growth averaged only 3.0%. The Organisation for Economic Co-operation and Development (OECD) (2014a) has projected a further decline in the country’s growth rate to around 2.0% in the coming decade. Some researchers argue that the Republic of Korea’s strong economic performance is an outcome of factor accumulation rather than efficiency improvement (e.g., Krugman 1994), while others attribute the growth largely to “good fundamentals,” including a high savings rate, strong human capital, maintenance of good institutions, high trade openness, and prudent fiscal and monetary management (e.g., Radelet, Sachs, Lee 2001; De Gregorio and Lee 2004). In particular, trade openness, driven by outward-looking development strategy, has often been emphasized as a key growth factor, as it has provided access to inexpensive imported intermediate goods, larger markets, and advanced technologies, thereby contributing to rapid productivity growth of the Republic of Korea’s manufacturing industries. The government has also played an important role in promoting export-oriented industrialization, as export-oriented policies designed to offer performance-based incentives for exporters have facilitated continuous upgrading of Republic of Korea firms’ comparative advantage in global markets.2 It is debated whether the Republic of Korea’s current slowdown is an indication of a permanent drop in its growth potential. Some scholars believe that the Republic of Korea’s economic downturn will be exacerbated, eventually leading to a situation comparable to Japan’s “lost decades” (Cho 2014). Others, however, consider that the dynamic forces that have enabled the Republic of Korea’s fast growth—in particular manufacturing exports—remain vibrant; thus, the Republic of Korea can continue its strong growth trajectory aided by appropriate policies (Sharma 2012). This study investigates the Republic of Korea’s growth performance and assesses the country’s future growth prospects. The changes in the country’s per capita income and growth rates over the past 5 decades are discussed and compared with Japan. This study also assesses changes in the gap of per worker output between the Republic of Korea and United States (US) over time, and analyzes the extent to which the gap is explained by differences in factor inputs and total factor productivity (TFP). In addition, the study adopts a general framework of cross-country analysis, putting the Republic of Korea’s experience in a global context, discussing the major factors that enabled the Republic of Korea to achieve strong growth over a half-century yet caused the recent growth slowdown. Further, the study adopts more detailed industry-level data of the Republic of Korea’s economy to assess the imbalance between the manufacturing and 1 Gross national income per capita in 2014 is from World Bank (2015). 2 It remains controversial to what extent industrial policy that targets specific industries has contributed to overall economic growth. The developmental state view, such as that of Amsden (1992), argued that selective government policies attempted to “pick winners.” In contrast, the World Bank (1993) asserted that government intervention conformed to the market, rather than replaced the market, using a pragmatic and flexible approach. Lee (1996) showed that targeting specific industries was often harmful to productivity growth of the overall economy. ADBI Working Paper 571 Lee 4 services sectors, and compares the Republic of Korea’s sector performance with those of the US and Japan. Thereafter, the study assesses the implications of the empirical findings from the Republic of Korea’s experience for the growth performance and prospects of the People’s Republic of China (PRC). The PRC’s economic performance since the 1980s has been astonishing—its economy has grown more than 9.5% annually. However, its economy, too, is now slowing; it grew only 6.9% in 2015, the lowest since 1990, and is predicted to grow more slowly in the coming years. Considering the PRC’s influence on the world economy, the future of its growth is of concern to many. This study analyzes PRC economic growth in the context of global standards as well as the Republic of Korea’s experience. It discusses the changes in the gap of per worker output between the PRC and US over time and compares the performance of the PRC with that of the Republic of Korea for an equivalent period. It also suggests policy measures that the PRC could adopt to sustain strong growth.3 2. THE REPUBLIC OF KOREA’S ECONOMIC GROWTH AND CATCH-UP 2.1 The Experience of the Republic of Korea During the past half-century, the Republic of Korea’s economy has shown impressive growth, with average annual GDP growth rate surpassing 7.1%, raising the level of real per capita GDP in international prices almost 26 times (Table 1). Average GDP growth rates accelerated to 7.5% in the 1960s, 8.6% in the 1970s, and 9.3% in the 1980s, but the impressive performance was interrupted by the 1997/98 Asian financial crisis. This sudden crisis had a devastating effect on the Republic of Korea’s economy, with real GDP falling by almost 7.0% in 1998, due to the huge, sudden reversal of short-term capital flows triggered by international investor panic (Radelet, Sachs, Lee 2001). Structural problems underlying the economy, including undersupervised financial systems and an overleveraged corporate sector, also led to the accumulation of vulnerabilities that set the stage for the crisis and amplified its shock to the economy. The Republic of Korea managed to recover rapidly from 1999—faster than anyone had expected. However, there seems to have been a permanent decline in growth potential, as the average GDP growth rate remained at 4.1% over 2000–2010. The global financial crisis in 2008–2009, which evolved from the US subprime mortgage crisis, also seriously affected the Republic of Korea’s economy through spillovers from global trade and financial markets. The country’s GDP growth rate dropped to 0.3% in 2009. Although the Republic of Korea managed the global financial crisis relatively well, showing the fastest recovery among OECD members, its economy still has not yet resumed its pre-crisis growth rates. 3 Japan’s experiences, in particular asset bubble burst and long-term stagnation since the early 1990s, can be also useful for PRC policy making. However, the PRC’s per capita output, as well as economic structure, lags over 40 years behind those of Japan, which makes difficult to compare two economies and draw useful policy implications for the PRC. ADBI Working Paper 571 Lee 5 Table 1: Economic Growth in Selected Countries, 1960–2010 Country GDP per Capita Average Annual GDP Growth 1960 2010 2010/ 1960 1960– 1970 1970– 1980 1980– 1990 1990– 2000 2000– 2010 1960– 2010 Republic of Korea 1,078 27,578 25.59 7.45 [4.82] 8.58 [6.83] 9.28 [7.90] 6.33 [5.65] 4.07 [3.60] 7.14 [5.76] Japan 4,795 30,916 6.45 9.66 [8.62] 4.37 [3.25] 4.53 [4.00] 1.12 [0.84] 0.74 [0.68] 4.08 [3.48] United States 15,254 42,371 2.78 4.11 [2.84] 3.19 [2.26] 3.18 [2.20] 3.37 [2.28] 1.52 [0.58] 3.07 [2.03] People’s Republic of China 1,057 8,426 7.97 3.24 [0.92] 6.03 [4.15] 8.87 [7.34] 9.92 [8.89] 9.95 [9.40] 7.61 [6.14] GDP = gross domestic product. Note: Per capita GDP levels and growth rates are based on the international prices of 2005 (adjusted for purchasing power parity), which are based on the Penn World Table 8.1 in Feenstra, Inklaar, Timmer (2015). Source: Feenstra, Inklaar, Timmer (2015). Over the past half-century, due to the Republic of Korea’s strong growth performance, its economy has experienced a fast catch-up to advanced economies in per capita output and income (Figure 1).4 The Republic of Korea has achieved the high-income level in a half-century, with per capita income of $27,578 purchasing power parity (PPP) in 2010. In 1960, it was still a lower-middle income country, with a per capita GDP of only $1,078 PPP. Figure 1: Trends in per Capita Gross Domestic Product in Selected Economies (purchasing power parity international dollar, 2005 constant prices) Source: Feenstra, Inklaar, Timmer (2015). 4 For an international and intertemporal comparison, this study uses data on per capita GDP at PPP international dollars from the Penn-World Table 8.1 in Feenstra, Inklaar, and Timmer (2015). ADBI Working Paper 571 Lee 6 Japan has also experienced a significant growth slowdown since early 1990s. The burst of asset bubbles in the 1990s left Japan’s financial system and private sector saddled with a huge debt overhang. During its “lost decades,” Japan suffered from deflation and economic stagnation due to its dysfunctional financial system and lack of private demand. Consequently, the gap in per capita GDP between Japan and the Republic of Korea has narrowed rapidly, and has been close to zero in recent years. In the last 35 years, since Deng Xiaoping embarked on economic opening and reforms, the PRC has shown astounding output growth of more than 9.5% annually. It has rapidly narrowed its per capita output gap with advanced economies. Yet despite this stellar performance, the country’s per capita output continues to lag behind those of advanced economies. The GDP per capita in 2011 was $8,850 PPP, which is comparable to the Republic of Korea’s 1988 level (i.e., $9,137 PPP) and Japan’s 1968 level (i.e., $9,527 PPP). The PRC is thus more than 20 years behind the Republic of Korea and more than 40 years behind Japan. Figure 2 shows the evolution of per capita GDP levels of the three Asian economies relative to the US over time. The values are 5-year averages, matched with average GDP growth rates in the corresponding period.5 The Republic of Korea’s sustained growth contributed to narrowing the gap in its per capita GDP with the US, as it experienced a very rapid catch-up to the US in per capita output. The value of per capita output increased from approximately 10% of the US value in 1960 to more than 60% in the late 2000s. Figure 2 shows that the pace of the catch-up slowed as the Republic of Korea economy narrowed its per capita income gap compared to that of the US. While income per capita in the Republic of Korea was less than 20% of the US average in the 1970s and 1980s, annual per capita GDP growth reached only 7%–8%. By the time the Republic of Korea reached 50% of US per capita income in 2000, its annual growth rate had slowed to 3%–4%. The Republic of Korea experience resembles that of Japan. Japan’s annual per capita GDP growth dropped from 8.6% in the 1960s to 3%–4% in the 1970s and 1980s as its per capita income jumped from about 40% to over 60% of the US level over the period (Figure 2). The evolution of per capita income and growth rates over time can be explained by the conditional convergence theory. Conditional convergence of per capita (or per worker) output is predicted by an extended version of the neoclassical growth model, as described by Barro and Sala-i-Martin (2004). A country with a low initial per capita output relative to its own long-run (or steady-state) potential level of per capita output grows faster than a country with a higher level of per capita output. The basic concept is that the farther a country is located from its steady-state output or income level, the greater the gap of reproducible physical and human capital stock and productivity (i.e., technology) from its long-run levels. The gap of existing physical and human capital from steady-state levels offers the chance for a rapid catch-up via high rates of physical and human capital accumulation, which are encouraged by higher rates of return on investment. In addition, the greater technology gap stimulates faster productivity improvement via the diffusion or imitation of technology from more technologically advanced economies. Therefore, the lower the initial level of per capita output relative to the steady state, the higher the subsequent growth. 5 The underlying data are the adjusted PPP values from the Penn-World Table 8.1 in Feenstra, Inklaar, and Timmer (2015). For 2012, 2013, and 2014, the values are estimated from information on real GDP growth rates from IMF (2015). ADBI Working Paper 571 Lee 13 steady-state level over time. In the cross-country context, countries with higher per worker output would grow slower than those with lower per worker output when controlling for the variables influencing the steady-state level. Consistent with the production function, the dependent variable is expressed as the growth in per worker output rather than per capita output. Note that the per capita output growth rate is calculated by the per worker output growth rate added to the growth rate of the share of the working-age population to the total population. The long-term level of per worker output depends on various external environmental and policy variables. In the extended neoclassical growth model, the steady-state level of per worker output is determined by investment rate, population growth, and human capital (Mankiw, Romer, Weil 1992). Previous theoretical and empirical studies consider institutions and policy factors as other important determinants of long-run per worker output. These factors include government consumption, institutional quality, macroeconomic stability, trade openness to the world economy, and democracy (Barro and Lee 1994, Barro and Sala-i-Martin 2004). The empirical framework can be represented by a reduced form, such as10 𝐷𝐷𝑦𝑦𝑖𝑖,𝑖𝑖=𝛽𝛽0+𝛽𝛽1log�𝑦𝑦𝑖𝑖,𝑖𝑖�+𝛽𝛽2𝑋𝑋𝑖𝑖,𝑖𝑖+𝜀𝜀𝑖𝑖,𝑖𝑖, (6) where Xi denotes an array of the variables that influence country i's steady-state level of per worker output. The regression of equation (6) applies to a panel set of cross-country data for 75 countries over 10 5-year periods from 1960 to 2010: 1960–1965, 1965–1970, 1970–1975, 1975–1980, 1980–1985, 1985–1990, 1990–1995, 1995–2000, 2000–2005, and 2005–2010. The panel is unbalanced, with 713 observations in total. This system of 10 equations is estimated by adopting instrumental variable (IV) estimation techniques to control for the endogeneity of explanatory variables. Instruments are mostly lagged values of the explanatory variables. The estimation results from the IV panel estimation with and without country-fixed effects are presented. The exclusion of country-fixed effects can cause bias of the estimates; however, the fixed-effects technique eliminates information from cross-section variations and could exacerbate measurement errors, especially if the timing of relationships is not known (Barro and Lee 2015). The representative set of the explanatory variables, Xi, includes investment, fertility, and human capital as fundamental growth factors. The stock of human capital is measured by the average years of schooling for the population aged 15–64 years. In addition, the regression includes the reciprocal of life expectancy at birth as a measure of the health of workers in an economy. Five other variables are included to control for institution and policy variables: government consumption, overall maintenance of the rule of law, inflation rate, trade openness, and democracy. A measure for changes in the terms of trade is included as an exogenous factor.11 In addition, the regressions include period dummies to control for common shocks to per worker GDP growth in all countries. Summary statistics of the variables for 1965–1970 and 2005–2010 for the Republic of Korea, Japan, PRC, US, and the world are presented in the Appendix. 10 The specification and data follow those of Barro and Lee (2015), with the updated national accounts data from the Penn World Table 8.1 in Feenstra, Inklaar, and Timmer (2015). 11 A measure of financial crisis was also considered as an independent variable, but it is statistically insignificant. As discussed in footnote 9, the impact of financial crisis on growth can occur through its adverse effect on investment. ADBI Working Paper 571 Lee 14 Table 3: Cross-Country Panel Regressions for per Worker Gross Domestic Product Growth Rate Regression (1) (2) Log (per worker GDP) –0.0230*** –0.0343*** (0.00236) (0.00352) Investment/GDP 0.0364** 0.0353* (0.0162) (0.0208) Log (total fertility rate) –0.0246*** –0.0185*** (0.00445) (0.00622) Average years of schooling –0.00352* –0.00552** (0.00183) (0.00243) Average years of schooling squared 0.000292** 0.000365** (0.000122) (0.000158) 1/Life expectancy –3.275*** –2.157** (0.662) (0.990) Trade openness 0.00616** 0.00702 (0.00302) (0.00601) Government consumption/GDP –0.00954 –0.00697 (0.0127) (0.0153) Rule of law index 0.0184*** 0.0115 (0.00572) (0.00806) Inflation rate –0.0163* –0.0272** (0.00942) (0.0132) Democracy index 0.0402** 0.0249 (0.0181) (0.0224) Democracy index squared –0.0380** –0.0200 (0.0164) (0.0203) Growth rate of terms of trade 0.0665** 0.0588** (0.0262) (0.0264) Country fixed effect no yes Period dummies yes yes No. of economies, observations 75, 713 75. 713 GDP = gross domestic product. Notes: 1. The system has 10 equations, corresponding to 1960–1965, 1965–1970, 1970–1975, 1975–1980, 1980–1985, 1985–1990, 1990–1995, 1995–2000, 2000–2005, and 2005–2010. The sample consists of 75 economies. The system is estimated by adopting instrumental variable (IV) estimation techniques. Instruments are mostly lagged values of the explanatory variables. The dependent variables are the growth rates of per worker GDP. 2. Standard errors are shown in parentheses. ***, **, and * indicate significance at the 1%, 5%, and 10% levels, respectively. 3. The specification and data closely follow those in Barro and Lee (2015), but use the updated national accounts data from the Penn-World Table 8.1 in Feenstra, Inklaar, and Timmer (2015). 4. Per worker GDP levels and growth rates are based on 2005 international prices (adjusted for purchasing power parity). 5. The investment ratio is the ratio of real investment (private plus public) to real GDP. 6. The government consumption measure is the ratio of real government consumption to real GDP, based on the Penn-World Table 8.1. They are averaged over the period. 7. Schooling data are the average years of schooling for the population aged 15–64 years from Barro and Lee (2013). 8. Life expectancy at birth and the fertility rate are from World Bank (2015). 9. The rule of law index, expressed on a 0–1 scale, with 1 being the most favorable, is based on the maintenance of the rule of law index in PRS Group (2015). 10. The inflation rate is the growth rate over each period of a consumer price index. 11. The trade openness variable is the ratio of exports plus imports to GDP. 12. The democracy index, expressed on a 0–1 scale, with 1 being the most favorable, is based on the indicator of political rights compiled by Freedom House (2015). 13. The growth rate of the terms of trade is the change of export prices to import prices over the period. ADBI Working Paper 571 Lee 15 Column 1 of Table 3 presents the regression results of equation (6) without country-fixed effects. The negative estimate of the coefficient on the first explanatory variable, the log of per worker GDP at the start of each period, reveals a strong conditional convergence effect. The estimated speed of conditional convergence is about 2.3% per year, implying that a country at half of the per worker output level of another country tends to grow by 1.6 percentage points (= 2.3 x ln(2)) faster than the richer country, assuming the same level of long-term per worker output. The investment rate has a positive and statistically significant effect on growth. The log of the total fertility rate is significantly negative. The estimated coefficient on the reciprocal of life expectancy at birth is negative and highly significant, indicating that better health is associated with higher economic growth. The regression result shows the nonlinear relationship between human capital stock and growth, as discussed in Barro and Lee (2015). The coefficients on average years of schooling and its square term are negative and positive, respectively, although only the square term is marginally statistically significant. The pattern of the coefficients demonstrates that the growth rate increases with the level of educational attainment only when the society has attained 6.0 average years of schooling. Hence, only countries that have accumulated human capital above a certain threshold are able to experience higher GDP growth induced by an increase in educational attainment for given values of the other explanatory variables. The regression results show that government policies and institutions play a significant role in determining economic growth. A subjective measure of the extent of maintenance of the rule of law is significantly positive. Increased openness to international trade is a positive determinant for growth, although the estimated coefficient is marginally significant. The level of democracy has a nonlinear relationship with growth, as found by Barro (1996). The coefficients on the indicator of democracy and its square term are positive and negative, respectively, and both coefficients are jointly statistically significant. The pattern of the coefficients on the indicator of democracy and its square term indicates that the GDP growth rate increases with political freedom at low levels of democracy but decreases with democracy once the society has attained a certain level of political freedom. The threshold level is 0.53. The nonlinear relation suggests that autocracy can have negative effects on growth if a leader uses his or her power to steal the nation's wealth, but more democracy above the threshold level can also retard growth if it promotes income-redistributive policies, rather than pro-growth ones, in systems of majority voting. Inflation, an indicator of macroeconomic instability, has a negative effect on growth, but the estimated coefficient is not statistically significant. The government consumption–GDP ratio is statistically insignificant. A higher growth rate of the terms of trade (i.e., export prices relative to import prices) has a strong, positive effect on economic growth. In summary, the regression results in column 1 show that per capita GDP growth has strong relationships with the initial per capita GDP level, investment, fertility, the quality of human resources, rule of law maintenance, trade openness, and democracy. ADBI Working Paper 571 Lee 16 Column 2 of Table 3 adds country-fixed effects. The results are similar to those of column 1. The estimated coefficient on the log of per worker GDP remains statistically significant. The estimated speed of conditional convergence increases to about 3.4% per year. Since the unobserved country-specific factors that influence the steady-state value of per worker output are likely to have positive relationships with current per worker GDP, the omitted variables tend to bias upward the estimated effect of lagged per worker GDP on growth. Consequently, the inclusion of the country-fixed effects tends to lower the convergence rate below zero. The results with country-fixed effects show that some economic policy and institutional factors, such as rule of law and trade openness, become statistically insignificant. In contrast, the estimated coefficient on inflation becomes statistically significant. 3.2 The Republic of Korea’s Economic Growth in Comparative Perspective The growth regressions imply that the Republic of Korea has grown faster than high-income countries by many factors, including convergence, due to the low level of per worker output relative to its long-term level as well as favorable environmental and policy factors influencing the long-term potential level of per worker output, 𝑦𝑦𝑖𝑖∗, to which the Republic of Korea has been converging. The Republic of Korea’s relatively favorable environment and policy factors have facilitated faster catch-up to the advanced economies than other developing countries with the same level of per worker output over the transition to a higher steady-state level of per worker output. Note that these factors could affect both the rate of factor accumulation and of productivity growth. The cross-country regression results allow analysis of the growth performance of the Republic of Korea relative to that of the US. The point estimates of the parameters in the regressions of Table 3 are used for simple accounting that breaks down the fitted values of growth rates for each country into the contributions from each explanatory variable. Although the residual errors in individual country growth rates are substantial, it is worthwhile to examine the differences in the explanatory variables that generate the differences in the fitted growth rates. The accounting results can be used to explore the sources of the differences in the fitted growth rates between the Republic of Korea and US.12 Table 4 presents the results of the accounting exercise in this study. The basic regression can account for a substantial part of the growth differences between the Republic of Korea and US over time. The predicted growth rates of the Republic of Korea are higher than those of the US over the period. Growth rate differentials are shown by the averages over three subperiods: 1960–1980, 1980–2000, and 2000–2010. The results in panel A of Table 4 are based on the estimates in column (1) of Table 3; the estimated growth rate differentials are 2.0, 2.6, and 3.1 percentage points for each subperiod, while the actual differences are 4.0, 3.9, and 2.9 percentage points. Therefore, the model underestimates the Republic of Korea’s relative growth performance in the earlier subperiods. 12 Using the same technique, De Gregorio and Lee (2004) compared the economic performance of East Asian economies relative to those in Latin America, and showed that the better growth performance of East Asia is largely attributable to “fundamental growth factors,” including high savings rates, strong human capital, high trade openness, maintenance of good institutions, and prudent fiscal and monetary management. ADBI Working Paper 571 Lee 17 Table 4: Contributions to Growth Differentials between the Republic of Korea and United States, 1960–1980, 1980–2000, and 2000–2010 (%, annual average) 1960–1980 1980–2000 2000–2010 (2000–2010) Without Country-Fixed Effects (A) Difference in Actual growth 0.0395 0.0387 0.0294 Predicted growth 0.0195 0.0259 0.0309 (100.0%) Initial income 0.0484 0.0294 0.0165 (53.3%) Investment rate 0.0023 0.0046 0.0041 (13.2%) Fertility –0.0122 0.0022 0.0132 (42.8%) Schooling –0.0070 –0.0070 -0.0030 (–9.6%) Life expectancy –0.0070 –0.0028 0.0004 (1.3%) Government consumption –0.000029 –0.000023 –0.000189 (–0.6%) Rule of law –0.0092 –0.0082 –0.0021 (–7.0%) Inflation rate –0.0014 –0.0003 –0.0001 (–0.4%) Democracy 0.0069 0.0062 0.0021 (6.6%) Openness 0.0010 0.0019 0.0023 (7.3%) Terms of trade 0.000002 –0.0002 –0.0022 (–7.0%) With Country-Fixed Effects (B) Difference in Actual growth 0.0395 0.0387 0.0294 Predicted growth 0.0501 0.0402 0.0356 (100.0%) Initial income 0.0721 0.0439 0.0245 (68.9%) Investment rate 0.0023 0.0045 0.0040 (11.1%) Fertility –0.0092 0.0017 0.0099 (27.8%) Schooling –0.0044 –0.0062 –0.0029 (–8.0%) Life expectancy –0.0046 –0.0018 0.0003 (0.7%) Government consumption –0.00002 –0.00002 –0.00014 (–0.4%) Rule of law –0.0058 –0.0051 –0.0013 (–3.8%) Inflation rate –0.0024 –0.0005 –0.0002 (–0.6%) Democracy 0.0016 0.0020 0.0008 (2.3%) Openness 0.0012 0.0022 0.0026 (7.3%) Terms of trade 0.000002 –0.0002 –0.0019 (–5.4%) Note: The predicted per capita growth rates in panels A and B are based on the estimation results of columns (1) and (2) in Table 3, respectively. The cross-country regressions represent the “average” relationships applied to all countries across time. Some individual countries undoubtedly differ in terms of the magnitude of the relationships, and in terms of the list of the most important variables affecting growth. The accounting result indicates that while the basic set of explanatory variables explains most of the differences in growth rates between the Republic of Korea and US, there are other unexplained factors that made the Republic of Korea grow faster than other countries in the sample, in particular, in the 1970s and 1980s. ADBI Working Paper 571 Lee 18 The accounting exercise in Table 4 breaks down the predicted differences separately into the contributions from the 11 explanatory variables. The result shows that the lower income level of the Republic of Korea compared to that of the US led to higher growth over the whole period because of the convergence effect. However, the magnitude of the convergence effect became smaller over time as the Republic of Korea caught up to the US in per capita income: this effect declined from 4.8 percentage points a year over 1970–1990 to 2.9 percentage points a year in 1980–2000, and then 1.7 percentage points a year in 2000–2010. While the convergence effect is an important factor explaining the Republic of Korea’s growth performance, the rest of the explanatory variables also influenced a significant part of the growth difference. For example, during 2000–2010, the model predicts an average growth rate for the Republic of Korea that is 3.1 percentage points per year higher than that of the US. The convergence effect explains a difference of 1.7 percentage points, while the rest of the factors influencing growth explain the remainder (1.4 percentage points). The exercise shows that higher investment rates in the Republic of Korea explain about 0.2−0.5 percentage points, and trade openness accounts for about 0.1−0.2 percentage points in growth differentials over the whole period. The gap between the Republic of Korea and US in terms of human resources (i.e., schooling and life expectancy) contributes to lowering the growth of the Republic of Korea relative to that of the US by 1.4 percentage points over 1960–1980. However, as the Republic of Korea experienced improvements in human resources, the human resources variables explain a smaller difference of 0.3 percentage points in 2000–2010. In addition, the Republic of Korea has improved institutional quality, which has contributed positively to growth. The relatively low level of the rule of law variable accounts for about 0.8−0.9 percentage points of slower growth of the Republic of Korea relative to US over 1960–2000. However, this drops to only 0.2 percentage points in 2000–2010. The Appendix shows the values of the variables in 1965–1970 and 2005–2010 for the Republic of Korea and US. The Republic of Korea has caught up rapidly to the US in human resources, policy, and institutional variables from 1970 to 2010. The Republic of Korea had higher fertility rates in earlier periods, but now has lower fertility rates than the US. The change in the fertility gap between the Republic of Korea and US is predicted to contribute positively to the higher growth of the Republic of Korea with a net effect of 1.3 percentage points over 2000–2010. Note that the estimated positive effect of fertility is applied to per worker GDP growth rates rather than per capita GDP growth rates. While the decrease in fertility has a positive effect on per worker (or per capita) output growth by lowering population growth and raising the steady-state per worker output, it eventually has a negative effect on per capita output growth when it leads to a decline in the working-age population. An interesting prediction is that improvement in democracy contributes negatively to the catch-up in recent decades in the Republic of Korea. The Republic of Korea’s level of democracy indicator is slightly lower than the critical level of 0.53 in the 1970s and then increases above the critical level in 1989 (0.533). Thereafter, the nonlinear relationship between democracy and growth works unfavorably for the Republic of Korea’s catch-up to the US in per capita income. Panel B of Table 4 presents the predicted growth rates that are based on the estimates in column 2 of Table 3. The estimated growth rate differentials are 5.0, 4.0, and 3.6 percentage points for each subperiod. Therefore, the model overestimates the Republic of Korea’s actual growth rate differentials in all subperiods. The effect of ADBI Working Paper 571 Lee 19 the difference of per worker output levels between the two countries on subsequent growth differentials becomes much larger in panel B than in panel A due to the larger convergence estimate. The predicted effects of the differences in other environment and policy variables—human resources, investment, fertility, rule of law, inflation, democracy, and trade openness—on growth differentials between the Republic of Korea and US are broadly similar to those in panel A. For the Republic of Korea, the ratio of the working-age population to total population is expected to decline from 73.1% in 2010 to 70.6% in 2020, and further to 62.3% in 2030 (United Nations 2013). The decline in the working-age population ratio has additional negative effects on per capita GDP growth of −0.3% in 2010–2020 and −1.3% in 2020–2030 (Table 5). Table 5: Population and Working-Age Population Growth for the People’s Republic of China, Japan, Republic of Korea, and United States (per year, %) Country Growth 1960– 1970 1970– 1980 1980– 1990 1990– 2000 2000– 2010 2010– 2020 2020– 2030 2030– 2040 Republic of Korea GRp 2.63 1.75 1.38 0.68 0.47 0.57 0.39 –0.19 GRw 2.12 3.07 2.47 1.00 0.66 0.22 –0.87 –0.95 GRw–GRp –0.51 1.31 1.09 0.33 0.19 –0.35 –1.26 –0.76 Japan GRp 1.03 1.11 0.53 0.28 0.07 –0.12 –0.41 –0.51 GRw 1.86 0.90 0.87 0.06 –0.54 –0.93 –0.70 –1.23 GRw–GRp 0.82 –0.21 0.34 –0.22 –0.6 –0.81 –0.29 –0.72 United States GRp 1.27 0.93 0.97 1.09 0.94 0.73 0.64 0.49 GRw 1.50 1.57 0.97 1.18 1.05 0.31 0.05 0.41 GRw–GRp 0.24 0.64 –0.01 0.09 0.11 –0.43 –0.59 –0.09 People’s Republic of China GRp 2.32 1.88 1.53 1.03 0.56 0.62 0.09 –0.15 GRw 2.14 2.54 2.56 1.34 1.45 –0.07 –0.31 –1.06 GRw–GRp –0.18 0.66 1.03 0.31 0.89 –0.69 –0.40 –0.91 GRp = population growth, GRw = working-age population growth. Source: Author’s calculations based on the United Nations (2013). Overall, the Republic of Korea’s historical experience of economic growth and catch-up to the US is largely attributed to the Republic of Korea’s favorable growth factors. Relatively low per worker output level, high investment rate, strong human capital, high trade openness, maintenance of good institutions, and low inflation have contributed to strong growth. Since the Republic of Korea’s rapidly growing economy has continued to narrow the gap with the US in per capita income and levels of environmental and institutional variables, it has inevitably encountered a slowdown in growth potential. 4. SECTOR PRODUCTIVITY AND ECONOMIC GROWTH IN THE REPUBLIC OF KOREA The Republic of Korea’s remarkable economic transformation since the early 1960s has been characterized by fast industrialization and strong economic growth, with the manufacturing sector being a key growth driver. In the early 1960s, the Republic of Korea shifted its economic policy focus from import substitution to export orientation, to support industrialization and economic growth. Export-oriented policies, designed to provide incentives to export firms based on their performance, were effective in pushing the pace of change in comparative advantage. The exposure to ADBI Working Paper 571 Lee 20 international export markets and performance-based government support stimulated efficiency improvement and faster productivity growth in manufacturing industries, which successfully underwent diversification stages. The numbers of goods produced expanded along with quality upgrades of existing products. Exporters were able to build up their comparative advantage in labor-intensive manufacturing and then to move to more capitaland technology-intensive industries, including electronics, machinery, automobiles, ships, chemicals, and information and communications technology products. Overall, the Republic of Korea’s export-oriented growth strategy has worked in its favor, enabling the country to sustain strong growth and transform into a more technologically advanced economy. However, the strategy has also made the country vulnerable to external shocks. The Republic of Korea economy came to rely increasingly on external demand to drive growth. Exports accounted for about 56% of GDP in 2014 from 15% in 1970 and 34% in 2002. As during the global financial crisis, overreliance on external demand has made the Republic of Korea susceptible to the economic recession in industrial countries as well as drop in global demand. An imbalance between the Republic of Korea’s manufacturing and services sectors is another outcome of its export-promotion strategy that encouraged more investment in manufacturing than in services. Despite the size of the Republic of Korea’s services sector, which employs 76% of the country’s workers, the sector’s contribution to overall economic growth is small, owing to its low productivity. Value added per worker in the services sector remains just 48% of that in the manufacturing sector. Table 6 shows value added per worker for nine sectors, including four services industries for the Republic of Korea, Japan, PRC, and US in 2010. Within the services sector, the levels of labor productivity across services industries are diverse. In general, labor productivity is relatively high in the transport, storage, and communications industry and the finance, insurance, real estate, and business services industry (Table 6). In contrast, the wholesale and retail trade, hotels, and restaurants industry has shown a lower productivity level relative to the manufacturing sector. It is notable that the finance, real estate, and business services industry had higher labor productivity than the manufacturing sector in Japan, US, and PRC, but had lower productivity in the Republic of Korea in 2010. The annual labor productivity growth in the services sector was only 1.6%, which is significantly lower than that in the manufacturing sector of 7.7% for 1980–2010 (Table 7) The average annual growth in per worker value added dropped from 2.5% during 1980–1990 to an annual average of 1.2% during 1990–2000 and 1.1% during 2000–2010. The Republic of Korea services industries, including finance, real estate, and business services as well as community and government services, have shown negative or zero growth of per worker value added over all subperiods. The lower productivity growth of the stagnant services sector relative to the manufacturing sector has been well known since the seminal study of Baumol (1967). Hence, the fact that the Republic of Korea services sector has had relatively lower productivity growth than the country’s manufacturing sector is not extraordinary. However, the differentials in labor productivity (i.e., per worker value added) and growth rates in labor productivity between the two sectors have been much larger in the Republic of Korea compared to other industrialized economies. ADBI Working Paper 571 Lee 21 Table 6: Ratio of Each Sector’s per Worker Value Added to Manufacturing per Worker Value Added in 2010 Industry Republic of Korea Japan People’s Republic of China United States Agriculture, hunting, forestry, and fishing 0.24 0.22 0.18 0.55 Manufacturing 1.00 1.00 1.00 1.00 Services 0.48 0.94 0.64 0.64 Wholesale and retail trade, hotels, and restaurants 0.25 0.60 0.56 0.38 Transport, storage, and communications 0.61 1.00 1.06 0.83 Finance, real estate, and business services 0.83 1.55 1.79 1.25 Community and government services 0.47 0.84 0.31 0.48 Others 0.74 0.95 0.83 0.82 Mining and quarrying 1.99 1.14 1.82 2.44 Electricity, gas, and water 3.64 6.41 2.70 2.90 Construction 0.59 0.72 0.50 0.48 Aggregate economy 0.58 0.91 0.58 0.68 Notes: Japan uses 2009 values for 2010. For international comparison, the relative level of per worker value added is calculated using nominal value added. Sources: World KLEMS, http://www.worldklems.net; Asia KLEMS, http://asiaklems.net; and RIETI. China Industrial Productivity (CIP) 3.0 Database. http://www.rieti.go.jp/en/database/CIP2015/index.html. Table 7: Growth Rate of per Worker Value Added by Sector (%) Industry 1980– 1990 1990– 2000 2000– 2010 1980– 2010 Republic of Korea Agriculture, hunting, forestry, and fishing 7.02 5.58 4.73 5.78 Manufacturing 7.58 9.94 5.47 7.66 Services 2.45 1.22 1.13 1.60 Wholesale and retail trade, hotels, and restaurants 4.90 1.34 2.56 2.94 Transport, storage, and communications 3.72 5.14 4.13 4.33 Finance, real estate, and business services –0.55 –1.05 –1.37 –0.99 Community and government services –0.20 –0.08 –1.06 –0.45 Others 5.54 2.09 1.20 2.94 Mining and quarrying 5.12 14.84 –2.07 5.96 Electricity, gas, and water 11.40 10.08 3.20 8.23 Construction 5.21 0.80 0.59 2.20 Aggregate economy 5.54 4.14 2.56 4.08 continued on next page ADBI Working Paper 571 Lee 22 Table 7 continued Industry 1980– 1990 1990– 2000 2000– 2010 1980– 2010 Japan Agriculture, hunting, forestry, and fishing 3.92 2.33 1.34 2.57 Manufacturing 3.25 1.48 2.00 2.25 Services 1.39 0.45 0.26 0.71 Wholesale and retail trade, hotels, and restaurants 2.02 1.41 –0.53 1.02 Transport, storage, and communications 2.43 0.96 1.93 1.77 Finance, real estate, and business services –0.09 0.05 –0.81 –0.27 Community and government services 0.16 –0.61 0.47 –0.01 Others 2.91 –2.30 0.66 0.42 Mining and quarrying 1.94 –0.42 –1.98 –0.09 Electricity, gas, and water 6.16 2.69 2.39 3.79 Construction 2.53 –3.41 0.37 –0.19 Aggregate economy 2.43 0.63 0.72 1.28 People’s Republic of China Agriculture, hunting, forestry, and fishing 2.34 2.73 4.14 3.09 Manufacturing 10.64 19.51 14.54 15.04 Services –0.70 –1.33 5.78 1.32 Wholesale and retail trade, hotels, and restaurants –16.02 –2.76 8.64 –2.95 Transport, storage, and communications 0.87 4.83 11.22 5.80 Finance, real estate, and business services 11.02 3.41 –3.00 3.56 Community and government services –2.35 –8.90 2.63 –2.89 Others –1.31 –0.19 4.78 1.17 Mining and quarrying –3.65 6.39 1.43 1.56 Electricity, gas, and water 6.63 –8.75 12.46 3.34 Construction –3.87 –1.93 3.38 –0.70 Aggregate economy 4.72 7.25 9.94 7.39 United States Agriculture, hunting, forestry, and fishing 8.67 3.33 2.54 4.85 Manufacturing 4.07 4.82 4.12 4.34 Services 0.34 1.16 1.32 0.94 Wholesale and retail trade, hotels, and restaurants 3.29 3.76 1.29 2.78 Transport, storage, and communications 1.40 2.09 3.59 2.36 Finance, real estate, and business services –1.56 0.78 2.32 0.51 Community and government services –0.12 –0.36 0.01 –0.15 Others 0.24 –0.73 –1.25 –0.58 Mining and quarrying 6.36 1.67 –3.46 1.52 Electricity, gas, and water –0.26 1.26 2.08 1.03 Construction –0.55 –0.45 –3.03 –1.34 Aggregate economy 0.98 1.45 1.33 1.25 Notes: Data from the People’s Republic of China are from 1981 to 2010, and data from Japan are from 1980 to 2009. Sources: World KLEMS, http://www.worldklems.net; Asia KLEMS, http://asiaklems.net; and RIETI. China Industrial Productivity (CIP) 3.0 Database. http://www.rieti.go.jp/en/database/CIP2015/index.html. ADBI Working Paper 571 Lee 29 Like the Republic of Korea, the PRC’s economic slowdown is an inevitable trend, partly an outcome of its earlier success. The PRC has narrowed its income gap continuously from its long-run potential over time; according to the prediction of conditional convergence, economies with higher initial income can expect slower growth. The PRC’s average potential GDP growth will decline to 5%–6% over the coming decade, unless it significantly improves institutions and policy factors. The slowdown could be accelerated if policy makers make major mistakes in handling domestic weaknesses and political transformation. 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ADBI Working Paper 571 Lee 6 APPENDIX Table A: Summary of Key Variables for the World, People’s Republic of China, Japan, Republic of Korea, and United States, 1965–1970 and 2005–2010 Republic of Korea Japan People’s Republic of China United States World 1965–1970 Per worker GDP growth 0.072 0.090 0.015 0.018 0.032 Per worker GDP in 1965 2,354 10,626 1,721 30,046 8,977 Investment/GDP 0.237 0.317 0.153 0.208 0.191 Fertility rate in 1965 5.157 2.139 5.872 2.913 5.173 Schooling in 1965 5.676 7.796 3.400 10.416 4.108 Life expectancy in 1965 56.82 70.20 51.29 70.22 58.17 Trade openness 0.165 0.186 0.018 0.096 0.363 Government consumption 0.147 0.162 0.164 0.143 0.166 Rule of law index 0.500 1.000 0.500 1.000 0.576 Inflation 0.117 0.053 0.040 0.042 0.062 Democracy index 0.474 0.951 0.117 0.946 0.643 Terms of trade 0.002 –0.001 0.002 0.001 0.002 2005–2010 Per worker GDP growth 0.029 0.010 0.095 –0.002 0.019 Per worker GDP in 2005 34,012 46,378 8,059 64,366 23,361 Investment/GDP 0.345 0.244 0.394 0.212 0.227 Fertility rate in 2005 1.076 1.260 1.668 2.054 2.771 Schooling in 2005 12.272 12.124 8.020 13.011 8.531 Life expectancy in 2005 78.43 81.93 72.17 77.34 70.45 Trade openness 0.722 0.374 0.312 0.283 0.662 Government consumption 0.128 0.171 0.217 0.113 0.174 Rule of law index 0.833 0.833 0.750 0.833 0.642 Inflation 0.030 –0.001 0.029 0.022 0.051 Democracy index 1.000 1.000 0.000 1.000 0.738 Terms of trade –0.032 –0.009 –0.001 0.001 0.006 GDP = gross domestic product. Notes: For the world, the figures are unweighted averages of the sample of the 75 economies that are used in the regressions in Table 3. See the notes to Table 3.