Why Did Korean Domestic Demand Slow Down after the Asian Financial Crisis?
97 Pages Posted: 14 May 2016
Date Written: December 30, 2015
Economic growth in Korea has slowed down dramatically after the Asian financial crisis of 1997. The average growth rate of real GDP of Korea before the crisis (1981-1996) was 9.3%, while it was reduced to 3.7% during the period (2003-2014) after the credit card lending boom following the financial crisis. Coincidentally, the patterns of domestic demand growth before and after the crisis were similar to the GDP growth: the average growth rate of Korean real domestic demand was 8.8% and -0.3%, in the respective periods.
This remarkable decline in both growth rates should not be attributed to the factors that are linked to the short-run economic fluctuations because these phenomena have lasted more then 10 years after the Asian financial crisis. Instead, structural factors related to the domestic market or exports are more likely to induce the significant declines in the growth of these two variables. In this study, we focus on identifying those structural factors that are responsible for the decline in the growth rate of domestic demand after the Asian financial crisis, which may result in the decrease in economic growth.
Motivated by observing dramatic changes in the growth rates of the relevant variables such as GDP, domestic demand, investment, and exports, we consider two structural problems that the Korean economy faced after the Asian financial crisis: i) one is the dampened ripple effects of exports on domestic demand and thus on GDP; ii) the other is the decrease in the growth of household disposable income.
First, exports can contribute to the economic growth via two channels. One is the direct contribution to the GDP. The other is the indirect contribution to the GDP through the domestic demand (that is, the ripple effect of exports on GDP). As firms export more, they tend to use more production inputs and thus are more likely to increase investment and employment, which results in the increase in domestic demand. In fact, the data reveal that about one third of GDP growth can be accounted for by exports directly in the period of 1981-1996. This implies that two third of GDP growth can be explained by the domestic demand. In contrast, the Korean economic growth after the Asian financial crisis is entirely driven by export growth, that is, the growth of export sector does not boost domestic demand after the crisis. In other words, the ripple effect of export sectors on GDP has significantly dampened after the Asian financial crisis. Furthermore, we found two potential reasons for the dampened ripple effect from the export sector. These reasons are closely related to changes in investment behaviors of large-sized Korean exporting firms before and after the Asian financial crisis: i) the large-sized exporting firms do not invest their earnings from exports any more to create new industries; ii) they tend to use more foreign value added contents for their exports and to increase outward FDI by participating in the Global Value Chains (GVCs).
Second, another structural factor that affects the pattern of domestic demand before and after the Asian financial crisis is closely associated with the decrease in the growth of household real disposable income. Its growth rate was 10.3% in the former period (1981-1996), which is higher than the GDP growth rate. Its growth rate, in contrast, was 2.3% after the financial crisis, which is lower than the GDP growth rate. This remarkable decrease in the growth of household income may influence household consumption, and hence economic growth. In fact, the data reveal that the real consumption growth rate was 8.4% in the former period and 2.4% in the latter period, respectively. These patterns of consumption growth rates before and after the crisis were similar to the patterns of both the GDP and the income growth rate. In addition, the decrease in household disposable income is more likely to induce increase in household debts and thus an increase in the burden of debt service.
This will further restrict consumption and domestic demand growth, which may result in an overall decline in economic growth. To be more specific, we pointed out three potential factors that are closely linked to the decrease in the growth of household disposable income. These reasons are related to the labor market reforms after the Asian financial crisis: i) a seizable number of necessity-driven entrepreneurs (i.e., self-employed households) whose income are relatively low, ii) a large proportion of temporary workers whose wages are about 70 to 80% of the regular workers, and iii) a relatively low wage in small and medium-sized enterprises (SMEs) which employ a large portion of total workforce.
In the two subsequent chapters, we examined the two issues related to the structural problems of the Korean economy using the micro-level data: i) a link between temporary employment contract and firms’ productivity and ii) a difference in consumption behavior between wage workers and self-employed households. Motivated by concerns that an increase in the share of temporary workers in total employment can potentially harm firm productivity, we empirically investigated the relationship between temporary employment and firms’ productivity. The estimated results show that using temporary workers decreases firms’ productivity.
Besides, we found some evidence that a higher conversion rate from temporary to permanent worker leads to the increase in firm’s productivity. Finally, we looked into the seriousness of the self-employed household debt that may negatively affect consumption, and thus the overall domestic demand. To do this, we examined the different patterns of consumption behavior between wage workers and self-employed households using the household-level panel survey data.
The key finding is that the financial debt of self-employed households is negatively associated with consumption expenditure, while this relationship is positive for wage workers. That is, the self-employed households tend to make a loan (i.e., business loans) that is not directly related to consumption itself. Rather, they tend to reduce their consumption due to a heavy debt burden from business loans.
To the extent that the dampened ripple effects from the export sectors after the Asian financial crisis are mainly due to the changed investment behaviors of large exporting firms, policy makers should develop policies which aim at providing a better environment where small and medium-sized firms can participate in global value chains more actively. Those firms are not likely to use more foreign value added contents or invest in foreign countries because of their small sizes and limited capabilities. Instead, they may participate in global value chains by attracting multinational firms. To do this, those firms should develop better technologies or produce high quality goods and/or services which can be differentiated from foreign small- and medium-sized firms so that they can have comparative advantages. And policies should be able to encourage small and medium-sized firms to develop those technologies and to produce those goods and services.
Most importantly, polices should be aimed at attracting foreign multinational firms so that domestic firms benefit from the active participation in global value chains. To the extent that the decrease in the growth of household disposable income is due to the presence of significant share of necessity-driven entrepreneurs and non-regular workers, and their relatively low income, policy makers should reform labor markets to deal with these issues. In particular, policies should be aimed at reducing the use of temporary workers by raising the conversion rate from temporary to permanent employment. In addition, alternative job opportunities which may absorb those self-employed workers should be created.
There is a large degree of human capital mismatch: retired workers, in general, are more likely better matches for new businesses such as food and beverage franchise and agency for selling mobile phones. If there exist jobs where they can take advantage of their human capital, they would have less incentive to open those businesses which contribute to decreasing labor productivity in the service sector.
Keywords: Economy - Korea, Structure Problem, Ripple Effect, Domestic Demand, Employment, Household Debts
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