KDI - Korea Development Institute - RESEARCH - Research Areas

Summary

Research Monograph KOR Establishing a Macroeconomic Model System Considering Changes in Economic and Social Structure

This report analyzes economic models from three perspectives to respond to the evolving macroeconomic environment. First, the COVID-19 crisis has substantially increased economic volatility and uncertainty, underscoring the need for timely assessment of economic conditions. However, the delayed release of major indicators like gross domestic product (GDP) limits real-time understanding. In this report, we test the performance of economic models by incorporating high-frequency data from private sources alongside traditional low-frequency data. As data accumulate throughout the concerned quarter, real-time forecasts converge closely with actual outcomes, demonstrating strong potential for real-time economic forecasting models.

Second, South Korea’s economy has likely experienced both short-term fluctuations and structural shifts following shocks such as the COVID-19 pandemic. Macroeconomic policies should address short-term volatility and structural shifts differently, yet structural changes are often unobservable. Therefore, macroeconomic models should estimate these unobservable factors for effective policy responses. This report constructs a model to estimate aggregate demand pressure, a cyclical indicator, and the real neutral interest rate, a key guide for determining monetary policy stance. The estimation results are discussed in detail.

Third, since peaking in 2019, Korea’s working-age population has been declining, with rapid demographic shifts driven by low birth rates and an aging population expected to continue. These demographic changes affect labor input and can be a major factor in slowing down economic growth. Also, long-term forecasts serve as baseline data for managing government finances and national pension funds. In this report, we use population estimates from Statistics Korea to project long-term economic growth rates through 2050. Scenario analyses for demographic changes and trends in total factor productivity are used to suggest policy directions for sustainable growth.

Summary

Research Monograph KOR Policy Strategies for Sustainable Regional Development

Rapid aging and low birth rates have sparked concerns over population extinction in some provinces, and fundamental questions have been raised over the sustainability of basic local governments and effectiveness of regional development systems. In particular, amid the swift progress in digital and new technologies, the accelerating pace of low growth has precipitated the need to enhance regional industrial competitiveness and build innovative growth engines more than ever before. Therefore, the research in this paper was conducted with the following in mind: ① determinants of the transfer of industries or companies; ② effects of the transfer of public regional development institutions; ③ differential factors of regional industrial diversification and innovation systems; ④ sustainability of local government finances; ⑤ measures to resolve the inconsistency between the administration and daily life, and strengthening the connectivity between cities and their surroundings; ⑥ housing policy measures for regional development.

Regional development policies must consider both fiscal efficiency and economic growth at the national level, and connect and cooperate with the central and local governments to narrow regional gaps and bolster uniqueness while enhancing the effectiveness of policies. This highlights a crucial point in Korea's regional development policy. Indeed, when the issues of low growth, aging, and regional gaps facing Korean society and economy are considered, an examination of the sustainability of regional development must first be conducted followed by a guarantee of sustainable growth in which finances are managed.

Accordingly, this study first identifies a strategy for industrial diversification that is effective for regional economic growth, and provides implications by dividing the local environment into the dimensions of industrial diversity and innovation capability. It is found that the diversity of industries can have a positive effect on regional development but the economic impact can vary according to industry. As such, the industrial characteristics and conditions of a region should be considered. Secondly, it is also shown that while the relocation of a company can positively effect employment and investment in the short-term, it can diminish its soundness and profitability in the long-term, and the possibility of survival and growth decreases; which has negative repercussions for regional development. Thirdly, the relocation of public institutions is found to have boosted employment in local manufacturing and services which relates to the improvement of settlement conditions. However, no significant effects were observed in the employment in knowledge-based industries suggesting that the main industry must be nurtured for the region to continue growing. Fourthly, an examination of the financial conditions of local governments confirms that, with the exception of Seoul, unsustainable fiscal operations were implemented in 2013-2018. Fifthly, a direction for the reorganization of administrative districts is suggested as metropolitanization could accelerate the decline of non-capital cities. Besides the linkage between administrative districts, it is also recommended that areas with declining populations identify the living area system and strengthen their connections with neighboring areas. And lastly, a direction for housing policy is also presented since an inflow into and concentration of the metropolitan area can exacerbate the polarization of asset prices and income by region. In particular, this paper proposes a shift from the jeonse-centered lease policy to a guaranteed monthly rent and in the policy direction to respond to the increase in vacant homes in the non-metropolitan area.

Summary

Research Monograph KOR Reconsideration of Tax and Fiscal Policies after COVID-19

The purpose of the study is to put forth tax and fiscal policies necessary to make worsened fiscal conditions after COVID-19 more constructive and sustainable. We first present the long-term fiscal baseline projections until 2060 and suggest four policy measures that could enhance the future fiscal space of Korea. Then, we analyze the possible positive impact of intangible investment other than R&D on improvements in total factor productivity (TFP), which could result in a natural increase in government revenues through economic growth. Finally, we also empirically evaluate the pros and cons of several types of fiscal rules and suggest rules for spending that could be one plausible alternative considering the current policy environment in Korea. The main findings and policy implications are summarized as follows.

In chapter 2, we present policy measures needed to achieve the long-term fiscal policy goal announced by the Korean government in September 2020, the government debt-to-GDP ratio of 81.1% in 2060. Before delving into specific measures to enhance fiscal space, we look at the baseline debt-to-GDP ratio for 2060, projected at 144.8%. Among three risk factors considered in this study, the failure of discretionary expenditure control was most detrimental to future fiscal conditions. If the discretionary expenditure ratio to GDP is kept at 14.7% until 2060, the debt-to-GDP ratio is expected to add 86.1%p compared to the 2060 baseline.

Even if these risk factors are not realized and remain as the assumption of the baseline outlook, the 2060 debt-to-GDP ratio far exceeds 81.1%, the government's long-term fiscal goal. The analysis finds that the government debt ratio in 2060 could be reduced to 87.6% by reforming local education financial grants, additional control of discretionary expenditures, raising effective tax rates of income and value-added taxes, and reducing tax expenditures.

Over the past two decades, the Korean economy has experienced low economic growth despite the persistent expansion in traditional inputs, capital, and labor. In this circumstance, TFP has come into the spotlight as a new engine to revitalize economic growth, which could enhance government revenues and fiscal sustainability.

In chapter 3, we investigate the determinants of TFP, focusing on the role of intangible assets on firms' productivity. Exploiting firm-level data from Kisvalue, we first estimate the TFP of sample firms by applying Olley-Pakes (1995) method and examine the determinants of TFP. Our findings show that other intangible assets such as patents and copyrights play a more decisive role in improving the productivity of firms rather than R&D investment. This tendency appears to have strengthened after the global financial crisis. Thus, our results indicate that Korean firms have not achieved effective allocation among their investments in intangible assets. In this sense, we suggest the Korean government seriously consider re-designing the institutional system to encourage firms to diversify their investment in intangible assets.

In chapter 4, several empirical analyses were conducted to understand the expected positive and negative effects of the controversial introduction of the fiscal rules to enhance fiscal soundness. An international panel analysis confirmed that introducing such rules could increase fiscal space mainly by reducing the intrinsic interest cost of the existing national debt. On the other hand, it also confirmed concerns that the pro-cyclicality of fiscal spending could increase if fiscal resources were insufficient, especially in developing countries, or if applied excessively multi-layered fiscal discipline. In addition, it was shown that the introduction of the spending rules regulating the total amount of fiscal spending significantly lowered the probability of occurrence of a systematic banking crisis.

In Korea, it is difficult to set realistically achievable national debt and fiscal balance ratios due to rapid changes in demographic and industrial structure. Given this reality, the government needs to prepare reasonable fiscal rules for the growth rate of government spending and the ratio of expenditure to GDP in order to reduce the excessive burden on the national economy due to fiscal uncertainty. Although the current level of the national debt is relatively low, it is desirable to manage its increasing rate by applying reasonable fiscal expenditure rules coupled with the appropriate fiscal balance rules when a rapid increase in national debt raises concern.

Summary

Policy Study KOR External Capital Accounts and Macroeconomics: Capital Flows and Aggregate Productivity

We examine the correlation between aggregate productivity and inefficiencies in the distribution of a production factor, capital. We also discuss how these misallocation of capital is correlated with capital flows. It has been well known that the growth rate of the Korean economy has declined over the past 20 years. Using ORBIS company data, we confirm that the marginal revenue productivity of capital productivity has been continuously rising since 2002. We argue that the pattern signals the rise of capital misallocation, which could hamper the aggregate productivity growth. Furthermore, comparing with other ten countries, we show that the Korean economy exhibits a tendency to show the GDP growth rate decreas with the increase of the dispersion of MRPK(marginal revenue product of capital). Also, the economy tends to show the increase of the dispersion of MRPK(marginal revenue product of capital) when net capital inflows increase. We note that we are abstract from the causality or full dynamic system of the aforementioned macroeconomic variables, which we will remain for the future research.

Summary

Policy Study KOR Projecting the Long-Run Natural Rate of Interest: the Case for Korea

The KDI’s long-term projection method for real interest rate has been based on based on a regression that uses the marginal productivity of capital as an explanatory variable. This paper provides a theoretical background for the KDI’s projection method. In addition, as the decline in long-term interest rates was considered as an global and unexpected phenomenon, we argue that the projection method should be augmented to reflect this global trend at least for the near future.

Summary

Policy Study KOR Economic Growth and the Quantitative Expansion of Financial Resources

Based on Korea’s data, this study empirically analyzes the relationship between economic growth and the quantitative scale of financial resources. The scale can be measured in various ways, and this study uses one of the most important indicators applied in preceding literature, private credit as a share of nominal GDP.

The results show that the quantitative expansion of financial resources has a nonlinear effect on economic growth. When private credit (as a share of GDP) falls below a certain threshold, an expansion of private credit causes the mid-term economic growth rate (five-year average of per capita real GDP growth) to ascend―the reserve is true for when it exceeds beyond the threshold for the pertinent year. This finding implies that financial resources and economic growth are in an inverse U-shaped relationship. At the peak of the curve, the growth threshold of financial resources is estimated to be 117.2% in terms of the private credit to nominal GDP ratio.

Additional analysis of the nonlinear relationship found household debt to be a main casual factor. It was revealed that although financial resources can contribute to economic growth, the degree tends to decrease as the share of household credit in private credit increases. The threshold for the household credit ratio is estimated to be 27.8%. Private credit provided as corporate credit can contribute to economic growth but when that of household credit surpasses this figure, the increase in private credit can restrict it.

As of end-2016, the percentage of private credit exceeds 190% of GDP and the household credit ratio is near 50%, exceeding both thresholds estimated from the above analysis results. These results reaffirm that the qualitative development of financial resources needs more emphasis than the quantitative supply in the process of establishing future financial policies.

Summary

KDI Policy Forum Population Aging and Economic Growth: Impact and Policy Implications

■ Korea is aging at a faster pace than any other major country, and the negative impact on the economy is expected to be considerable.

- In thirty years, the old-age dependency ratio is projected to exceed 70% and GDP growth to mark around the 1% range. This would pose a tremendous threat to sustainability unless the economy makes significant improvements in productivity and the employment structure.

■ Korea’s population aging is proceeding at an unprecedentedly rapid pace while policy responses and institutional reforms fail to keep pace.

- Setbacks such as falling labor supply and growth seem to be unredeemable even if Korea’s labor force participation rate (by gender and age group) improves to the level of advanced countries.

- The labor supply policy to boost the economic participation of the working age population may work as a feasible response to the challenges of population aging to a certain extent. However, it is not enough to make a full recovery given the severe imbalance of Korea’s demographic profile.

■ Policy responses should be focused on reversing the quantitative decline in the labor supply by promoting the participation of the senior labor force while pushing towards the ultimate goal of human capital advancement and higher labor force productivity.

- Senior labor force participation can be effective in easing not only the fall in economic growth but also the pressure from the rising dependency ratio.

- At the same time, concerted policy efforts should be made in enhancing the general environment including educational and vocational training programs that could upgrade the productivity of the senior population.

Summary

Research Monograph KOR Korea’s Road to an Innovation Economy: Enhancing Productivity through Structural Transformation and Institutional Reform

This study starts with two premises: first, business enterprises are at the center of the innovation economy and second, entrepreneurial activities are most effective within a well-functioning innovation ecosystem. Accordingly, the analyses are comprised of certain aspects of the innovation activities of business enterprises as well as the systemic aspects of the Korean innovation system (KIS). Policy implications are also presented for Korea’s innovation-driven growth strategy including enhancing the innovative capacities of business enterprises and upgrading the support systems surrounding them.

The first, analytical part of the study deals with some of the key aspects of business enterprises’ innovation activities, such as the patterns of business innovation, the relationship between industrial organizations and business innovation and that between M&A activities and business performance. The section also introduces the results of a management survey, which is the first one of its kind in Korea. The second, systemic part contains two chapters on Korea’s innovation system: one on the distinctive nature of the KIS and the other on its evolutionary process. Additionally, in regards to the importance of human resources as a permanent and ultimate source of innovation, one of the following chapters makes a cross-country comparison between adults’ skills and another deals with Korea’s re-training system.

Despite the necessity of the government’s involvement in building an effective innovation ecosystem, government intervention is not straightforward. Governments face the same uncertainties as the market― although often with much more intensity―caused by the rapid changing nature of techno-economic paradigms. In this regard, the fourth industrial revolution presents a prime example. Policies will be most effective when business enterprises respond to the government’s initiatives with their own investments. The list of such policies includes: creating open, competitive market environments; pursuing a two-thronged labor policy of strengthening labor competence and enhancing flexibility in the labor market and; redirecting science and technology policies in a way that enhances the linkage between innovation actors such as business enterprises, universities, and government-funded research institutes. The government should also strive to improve system efficiency with consistency over longer-terms.

Summary

Research Monograph KOR A Decade after the Global Financial Crisis and a New Growth Agenda for the Korean Economy

1. Shift in the Economic Policy Paradigm

Most notable among the changes in major economies in the wake of the 2008 global financial crisis is the shift in the economic policy paradigm in regards to the expansion of the government's role in the market. Consequently, growth agendas are seeking to enhance growth potential and a policy combination that could resolve structural problems to improve growth sustainability.

In Korea, although have been studies that linked the decline in the growth rate to problems in the social structure such as income inequality, the majority were unable to go beyond the trade-off between growth and distribution. After the global financial crisis, however, debates have grown over the fact that actively responding to social problems can contribute to sustainable growth. There is growing recognition that growth and distribution are no longer a target of contradicting policies and can be pursued in a complementary manner.

Thus, even if growth policies can satisfy the demands from an era of a paradigm shift to a universally strengthened policy, and presents the explicit goal of actively responding to concerns that the economy will be stuck with slow growth, the validity and effectiveness of the policies need to be constantly checked and supplemented. This study intends to analyze the post-crisis progress made on addressing Korea’s socioeconomic issues and to provide a basis to explore whether social structural phenomena, now being the target of policy correction due to their role in current problems, will be actually and empirically identifiable beyond some logic. This study analyzed the structural changes in major sectors that are considered as an important premise in planning and executing policies for sustainable growth but require a more thorough review. It also aims to ascertain how these changes are related to the key growth factors such as productivity.

2. Analysis of the Factors of the Recent Growth in the KoreanEconomy

This study first looks into slowing economic growth, the most obvious macroeconomic change faced by Korea since the global financial crisis. In particular, by analyzing the changes in growth factors using the growth accounting method, this study rechecked whether the fall in the growth rate was due to cyclical factors or was driven more by long-term structural characteristics.

According to the authors, the decline in economic growth in 2011-2017 can be explained by the drop in the contribution of physical capital and total factor productivity (TFP). Based on the finding that the decreased growth in TFP led to the reduced growth in marginal capital productivity and thus, diminished the contribution of material capital, the authors consider it too early to conclude that investment in physical capital has been stagnant since the global financial crisis. In addition, considering that Korea’s growth capacity is slowing on rapidly aging demographics, the future will be dependent on how well the productivity growth can buffer the pace of slowing growth. Even with continuous efforts to enhance productivity, Korea’s economic growth in the 2020s is expected to slow down to about an annual 2% on average. This result implies that the slowing growth of the Korean economy can be seen as a long-term structural phenomenon, and that a clearer understanding of the structural economic changes is needed when designing responsive policies.

3. Corporate Labor Share of Income and Market Dominance

This study found that contrary to domestic studies stating that labor share has continued to descend since the foreign exchange crisis in the late 1990s, large enterprises—subject to the external audit system—exhibited a rebound since the 2000s following a decline from the early 1990s. The study focuses on 'market changes' such as technological progress, growing trade represented by globalization, and the increase in monopoly profit as factors driving the change in the labor share of income. This point is where this study distinguishes itself from previous studies, concentrating on labor market flexibility, including rising non-regular workers, in the post-crisis period, and the ensuing relative sluggishness of labor and household income growth. In particular, this study found a close correlation between the markup—that represents the market concentration of Korean firms—and labor income share, and the fact that the markup has declined since the 2000s while labor income share has risen suggests that there have probably been positive welfare effects on the Korean economy.

This study reviews various adjustment measures and provides alternatives for measuring labor income share. Taking into account their problems, the author reexamined the trend of labor income share and analyzed the relationship between markup and labor income share—as a variable related to corporate decisions and market structural changes. In doing so. this study intends to suggest an important reference point in understanding the causes and backgrounds of social structural problems such as income inequality in our economy, and seeking solutions.

4. Causes of Increased Corporate Savings and the Ripple Effects onGrowth and the Distribution Structure

This analysis targets the problem of increased corporate savings. The mounting savings by corporations implies that firms are relatively indifferent about developing production capabilities for the future, indicating that the economy will slow as the growth of total factor productivity (TFP), including technology input and progress, decelerates. Some view this as a sign that the economy will face low growth as TFP growth—including capital input required for growth as well as technological progress—slows down. Others argue that rising cash holdings is the optimal choice for firms coping with increasing uncertainties, and most of the savings are used for the formation of fixed assets and hence, there is no need to view it only negatively.

Between these two opposing views, this study begins with checking the validity of the latter. In the Korean economy, the increase in corporate savings is usually due to a rise in fixed capital consumption and savings-investment gap. Particularly after the 2000s, firms may have chosen to increase their corporate savings to deal with the increase in fixed capital consumption resulting from technological changes. This could lead to a widening productivity gap between firms actively adapting to the technological changes and those that do not. This study found that corporate savings have a significant positive correlation with productivity growth―instead of the possibility that firms accumulating cash will exhibit inefficiency. These findings suggest that a policy curtailing corporate savings could undermine the efficiency of the market as it could distort the optimized corporate decision-making and reduce incentives to push for technological change.

5. Household Debt and Private Consumption

This study analyzes the macroeconomic risks inherent in rising household debt and draws on the implications for growth policy. The problem of mounting household debt has been recognized as the most characteristic risk factor for the Korean economy over the past several years. On the other hand, unlike most advanced economies who have expanded their debt to avoid a plunge in growth after the global financial crisis, Korea has put fiscal soundness before others in pursuit of growth at the expense of the financial soundness of the household sector.

This study can be of great importance for discussions on future growth policies as it examines the role of household debt in relation to sluggish private consumption after the crisis and draws on the implications of slow growth. It empirically showed that Korea’s household debt could amplify the instability and thus, weaken the growth of consumption, resulting in sluggish growth. Debt will have a bigger negative impact on consumption during the phase of aggravating recession, possibly leading to a longer slump and delayed recovery.

Based on these discussions, this study calls for a more active solution to the excessive household debt, as it will weigh heavily on the economy and entail enormous losses for social welfare. The author suggests that in normal situations, macroprudential policy should be strengthened by, for example limiting the proportion of overly indebted people in order to induce a soft landing. But, in a recessionary phase with shrinking domestic demand, monetary and fiscal policies should be managed through an expansionary stance. This is because macroprudential policy alone cannot restrain the downward pressure of aggregate demand from becoming prolonged particularly for heavily debted households. This study also stressed consistent efforts to rectify the financial weakness in the household sector as a full-fledged recovery of consumption cannot be expected unless financial soundness improves.

Summary

Policy Study KOR The Impact of Large Firm-specific Shocks on the Aggregate Volatility and Its Policy Implications

This study analyzes how idiosyncratic shocks to a small number of large firms in Korea affect its aggregate volatility. Korea's unique large firm-oriented economic structure, on the one hand, has been one of the biggest drivers of the nation's economic growth so far, but on the other hand, raises concern that adverse shocks to large firms can escalate into a crisis for the entire nation. This concern has intensified as a large-scale recall of the smartphone (Galaxy Note 7) released by Samsung Electronics in 2016. This study attempts to clarify whether such idiosyncratic shocks to a few large companies affect the volatility of the Korean economy as a whole, and if so, how much.

The analysis finds some interesting facts. First, the idiosyncratic shocks Korean firms received by themselves have a significant impact on the aggregate volatility (direct effect), but the impact has been found to further amplify the volatility of the economy by transmitting shocks through other firms in the input-output relationship or firms in the same business group (linkage effect). These results are somewhat predictable considering the country's multi-layer supply chain subcontracting structure, but this study is the first to establish such a fact through data. Quantitatively, it is estimated that the magnitude of the linkage effect is about twice that of the direct effect.

The role of large firms is shown to be huge here as well. For example, the volatility driven by the idiosyncratic shocks to the three major Korean firms (based on sales) accounts for about 59 percent of the total direct effect, and that number rises up to 84 percent when expanded to the 30 largest companies. Although it was not possible to obtain an accurate estimate, much of the linkage effect seems to be originated from the shocks to those few large firms, given the transmission mechanism (i.e., the transmission of the shocks to another company in relation to input-output relationships or internal transactions within a business group).

The findings in this study indicate that the concentration of economic power to a small number of large firms or their business groups can certainly increase the system risk across the country. Therefore, systematic management of the concentration of economic power is required. Of course, it should not come to the simple conclusion of restricting production activities of large firms through, e.g., regulations. Above all, it is the most fundamental and desirable way to prevent the concentration of economic power by creating an environment in which good companies are constantly emerging and growing so that any market dominance is weakened and a competitive landscape is formed.

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