SEOUL: As South Korean and U.S. negotiators huddle in Seoul for make-or-break free-trade talks this week, corporate South Korea is grappling with a troubling question: How can the country avoid being crushed by competition from low-cost China and high-tech Japan?

South Korea's fear of being caught in a nutcracker between its bigger neighbors is nothing new. Its history is largely defined by the struggle to maintain its political and cultural identity - and economic independence - from China and Japan.

But warnings over the country's economic future have taken on an apocalyptic tone in recent months, as the jewels of South Korea's export-driven economy - including Samsung, Hyundai and LG Electronics - all forecast declining earnings and growing competitive threats to their businesses.

"We are sandwiched," said Lee Kun Hee, chairman of Samsung, which generates 20 percent of the country's exports and is widely seen as the country's most competitive conglomerate.

"China is catching up fast. Japan is racing ahead. But we are running in place. In five or six years, not only Samsung but the whole South Korea could plunge into chaos."

In January, advisers to President Roh Moo Hyun warned that South Korean businesses were not investing aggressively enough in new facilities, even as China was enjoying an unprecedented surge of investment into new, high-tech factories making everything from cargo ships to computer chips.

By 2010, analysts say, South Korean companies will enjoy few technological advantages over China in the export sectors where they dominate today, including mobile handsets, flat-panel displays and high-end steel.

A key part of Roh's strategy for injecting new life into the South Korean economy is simple: Achieve a free-trade agreement with the United States, something that neither Japan, with its politically powerful farmers, nor China, with its huge state-owned industries, can possibly do.

A deal with Washington would not only make South Korean exports more price-competitive in the world's largest export market, but also enhance the country's credibility in the eyes of foreign investors, proponents say.

A deal opening South Korea's markets could lead to an injection of technological skills from all over the world, while weeding out moribund businesses by exposing them to direct competition at home.

But time is running out. Negotiators must clinch a deal by the end of March - Saturday - to give the U.S. Congress a mandatory 90-day review before President George W. Bush asks it to cast a straight yes-or-no vote without amendments.

Once Bush's "fast-track" authority expires, he will find it far more difficult to push a deal through a Democratic-controlled Congress.

As the deadline looms, South Korea's trade minister, Kim Hyun Chong, and his U.S. counterpart, Deputy U.S. Trade Representative Karan Bhatia, must both step gingerly.

Missteps on the most sensitive issues - for South Korea, rice, and for the United States, beef - could kill the agreement either in South Korea's National Assembly, whose members face elections next April, or in the Democratic-controlled U.S. Congress.

Viewed from abroad, it is perhaps difficult to see why South Korea is so apprehensive.

During the four years that Roh has been in office, the country's main stock index, the Kospi, has doubled. The economy has grown at an average of 4.2 percent annually - which, although below the 9 percent annual growth rates posted during the 1990s, still compares favorably to the world's seven largest industrialized economies, including Japan.

Exports expanded an average 19 percent annually over the period, to $326 billion last year. Per capita income is expected to pass the $20,000 milestone before Roh steps down in February 2008.

But South Koreans say their traditional strategy - a combination of quick imitation and selective innovation, enabling them to produce goods that China cannot make, at a lower cost than Japan - is failing them. The country's "ppali ppali" - or "hurry hurry" - approach to business is losing steam, they say.

Meanwhile, Japan has emerged from a long stupor with fantastic research and development resources at its disposal, while China's growing technological prowess is combined with labor costs that prevailed in South Korea three decades ago.

Earnings at Lee's Samsung Electronics, South Korea's biggest and most profitable company, slipped to 7.9 trillion won, or $8.4 billion, last year from 10.8 trillion won in 2004, as Chinese competitors gobbled up Asian market share. Net profit at LG Electronics profits plunged to 212 billion won last year from 1.5 trillion won in 2004. At Hyundai Motor, battered by labor strikes and a weak yen that made rival Japanese cars more appealing, earnings have fallen for four consecutive quarters.

South Korean corporate investment in 1996 was equal to 40 percent of gross domestic product. That ratio had plummeted to 28 percent by last year. South Korea's trade surplus with China last year shrank by 10 percent to $21 billion, the first such fall in five years, while its trade deficit with Japan expanded by 4 percent to a record $25.3 billion.

The data, experts say, testify to the onset of obsolescence for South Korea's role as technological middleman between China and Japan.

Corporate South Korea depends on exports of components and semifinished electronic goods to China for much of its earnings. But it still relies heavily on Japanese high-tech parts and manufacturing skill to produce those exports.

South Korea is the world's biggest producer of computer memory chips and flat-panel displays. But Samsung, Hynix and LG.Philips factories all operate on Japanese machinery. Meanwhile, China is moving fast to build its manufacturing inputs at home - often at a cost South Korea cannot match.

"Many Korean companies are benefiting from strong demand from China," said Tariq Hussain, the Seoul-based author of the book "Diamond Dilemma," which assesses the economic challenges and opportunities facing South Korea. "However, as China-based capacity comes online and longer-term demand eases off, Korean manufacturers will be among the hardest hit."

In January and February, Chinese shipyards won more orders than their South Korean counterparts for the first time, and China will soon overtake South Korea as the world's largest shipbuilding country.

Chinese shipyards build mostly low-tech bulk vessels, while their South Korean shipbuilders focus on value-added vessels, such as mammoth container ships and liquefied natural gas carriers.

Still China's rapid gain is "frightening," said Kim Joon Ho, a spokesman for South Korea's Hyundai Heavy Industries, the world's largest shipbuilder.

South Korea's handicaps are not only cost-based or technological, analysts say.

"Japan has worked assiduously to reduce antagonism in the USA from industrial sectors," said Usha Haley, professor of international business and director of the Global Business Center at the University of New Haven.

"For example, Toyota makes most of the cars it sells in the USA in this country - Korean car companies do not. Conversely, Korea has the most protected automotive market in the industrialized world, causing enormous resistance and umbrage in certain influential sectors."

A free-trade deal with Washington could ultimately change that. But experts say South Korea needs more than open markets to rekindle innovation at home and lure new investment from abroad.

Tightened tax rules and other policy changes contributed to a 7 percent drop in foreign direct investment in South Korea to $7.2 billion in 2005, according to the United Nations Conference on Trade and Development.

The free-trade agreement "is seen as a necessary evil by many Koreans, indicating the continued, deeply rooted skepticism toward opening up," said Hussain. "It is not a panacea for Korea's economic woes."

Korea's Early Ageing

Editorial
Financial Times
March 27, 2007 03:00

Anyone blinded by east Asia's dazzling rise into thinking that the entire region is one unending economic success story should ponder the case of South Korea. Once held up as a model of precocious development, which rapidly transformed itself from an agricultural into an industrialised society, east Asia's third largest economy is sinking into premature middle age.

After bouncing back from the 1997 economic crisis, growth has dwindled to an average of 4.2 per cent in the past four years, well below potential. Competitors in China and other lower-cost countries are fast eroding Korea's industrial base. Its companies are moving plants offshore as fast as they can, while a wave of increasingly strident xenophobia at home risks diminishing still further the country's modest foreign direct investment inflows.

This faltering performance is all the more surprising because Korea still possesses enviable assets. It has a well-educated population, modern infrastructure, a high level of internet penetration and an industrious, if militant, workforce. Its companies are leaders in industries including electronics, cars, steel and shipbuilding, and some are household names worldwide.

What went wrong? Korea has long aspired to Japan's traditional industrial model. Unfortunately, it has succeeded in copying too many of its weaknesses and not enough of its strengths. Its growth depends heavily on exports, concentrated in a relatively narrow range of manufacturing industries. Much of its domestic economy lacks dynamism and is hobbled by restrictive practices. With the arguable exception of television soap operas, it has failed in recent years to develop thrusting new businesses. Korea's economy is also dominated even more heavily than Japan's by large incumbent producers, the chaebol, which stifle emerging rivals at home while increasingly placing their own investments abroad.

The growing challenge from China is fast making this situation untenable. If Korea is to continue to prosper, it must wean itself off its dependence on volume manufacturing and rapidly generate profitable new activities in which China does not compete head-on. That calls for radical action to stimulate diversification, innovation and enterprise by opening its economy to competition from new entrants. It needs to make its market contestable by international as well as domestic producers, particularly in sectors such as financial services, where it is unlikely to succeed without foreign expertise.

Regrettably, President Roh Moo-hyun's administration has lacked both the vision and political courage to pursue vigorous reforms. However, the inauguration of Mr Roh's successor and parliamentary elections next year offer an opportunity for a fresh start. History suggests that, with the right political leadership, Korea is quite capable of seizing it. But the time left to do so is starting to run out.

Is the Korean Economy 'Sleepwalking'?

The Chosun Ilbo March 21, 2007 The Financial Times of London ran a special report on Korea's economy under the headline "Seoul Sleepwalk." The report depicted Korea's economy as having awoken suddenly and wandering around as if in a daze, like a sleepwalker. The reason why export powerhouse Korea is in danger of losing its direction becomes clear when we compare the Beijing and Ulsan plants of Hyundai Motor. Workers at the Beijing plant produce 68 cars per hour and receive US$360 per month. In contrast, workers at the Ulsan plant make 55 cars per hour and receive $4,580. Korean workers make ten times more than their Chinese counterparts, yet produce less. If you look at the situation from a purely economic standpoint, Hyundai should close down the Ulsan plant and expand the one in Beijing. If not, Hyundai Motor will lose out to Toyota which has a plant in Beijing and Mercedes Benz which has a plant in Shanghai. Only the workers and management at Hyundai Motor seem to be oblivious of this simple fact. The Korean economy has lost its vitality. Private sector investment fell to just 28 percent of gross domestic product last year. It wasn't always that low. In 1998, private sector investments accounted for 30 percent of GDP and 40 percent in 1996. This decline in investments shows businesses have lost the urge to prepare for the future. To outside observers, it's clear that time is running out for small and mid-sized businesses in Korea, as the big business customers seek to buy products at lower prices, while Chinese competitors are ratcheting up the heat. There are also numerous "zombie" companies that are surviving with government aid, even though their products have lost their appeal. There is nothing surprising about the Financial Times article. For some time now, the facts reported in the piece have been widely known in the industry. What's shocking is that the fact that Korea's economy has been sleepwalking has been known around the world for some time, yet the president doesn't seem to be aware of this. At his cabinet meeting on Tuesday, the president spoke at length about the departure of former Gyeonggi Province governor Sohn Hak-kyu from the Grand National Party. But he didn't say a word about the state of the economy. Not a single one of his ministers mentioned the Financial Times article. The so-called commanders and sentries who lead and guard Korea's economy are all dozing off. People who pay no attention to the setting sun end up having to sleep on the streets. It's a shame that the ones who will pay the greatest price for such laxness are the Korean people.

Seoul sleepwalk: why an Asian export champion is at risk of losing its way

By Anna Fifield in Seoul
Financial Times
March 19, 2007

At Hyundai Motor's noisy factory near Beijing airport, fresh-faced workers are busy attaching bumpers to Sonata sedans or mirrors to Tucson sports utility vehicles and spraying the multi-coloured Elantras that are destined to become taxis for the Chinese capital.

In five different models, 68 vehicles roll off the South Korean group's production line every hour. The plant is producing 300,000 cars a year but output will double with the completion of a second facility next year.

The 4,200 Chinese employees -- average age 26 -- receive a base salary equivalent to $360 (£185, €270) a month and belong to a workers' organisation whose main task seems to be to encourage harder effort rather than push for higher wages. "The workers here are very flexible -- it's the opposite to Korea, where the situation is impossible," says Noh Jae-man, president of Beijing Hyundai. "And because we pay our workers better than other companies, they are proud to work at Hyundai and carry out their jobs well."

By contrast, at Hyundai's main Ulsan plant in South Korea the workers -- their age averaging 41 -- earn $4,580 a month, build only 55 cars an hour, refuse to produce more than three models on each production line, will not allow second shifts (which would eat into their overtime) and are heavily unionised. Last year a 25-day-long strike cost Hyundai about 7,800 vehicles or Won120bn ($127m, £65m, €95m) in lost sales.

Like other global manufacturers, Korean companies have flocked to take advantage of China's cheap, productive labour and superb infrastructure. LG, the electronics and chemicals conglomerate, has such a huge presence in Nanjing, the capital of Jiangsu province, that Chinese authorities have renamed the main street "LG Road".

But while China represents a huge opportunity for manufacturing-dependent South Korea, it also represents a looming danger, as Chinese companies threaten not just to complement but entirely consume Korea's industries. Hyundai may be benefiting in China but it is worried about the aggressive expansion of local car-makers such as Chery -- and that many Chinese models bear a strong resemblance to the cars made by Korean and other producers. Indeed, South Korea's old economic model of imitation and manufacturing-led growth is now China's model.

Although it underwent radical restructuring and opened its market after the Asian financial crisis struck in 1997, there is a widely held belief that South Korea, one of the world's top dozen economies, needs a second wave of reforms if it is to maintain its competitive edge over emerging China and move to the next stage in its remarkable development.

Indeed, with the economy remaining dependent on manufacturing and exports -- and, moreover, on just a few types of product, such as mobile phones, semiconductors and cars -- concern is growing that Korea is losing its dynamism. Economic growth has averaged 4.2 per cent in the four years of President Roh Moo-hyun's administration, below what is seen as its potential rate of 5 per cent. "We had two or three years of major restructuring following the financial crisis but now Korean companies have become conservative again," says Jung Ku-hyun, president of the Samsung Economic Research Institute, a think-tank funded by the conglomerate. "We need new initiatives for reform and restructuring."

Seoul economists regularly talk about the "sandwich" or "nutcracker" theories -- a metaphor for Korea being squashed between low-cost China and high-tech Japan -- and raise the spectre of a Japanese- or German-style "hollowing out" of Korean industry. A free trade agreement being negotiated with the US was supposed to serve as a catalyst for that second wave of reforms, exposing overprotected sectors such as cars and agriculture to competition and leading to the introduction of international standards in corporate governance, accounting and government administration.

"If Korea wants to keep ahead it has got to use platforms such as the FTA to reform and to signal to the market that it's really pushing to open its economy," says Myron Brilliant, president of the US-Korea Business Council. "Japan is not going to sit on the sidelines forever and China already is not sitting on the sidelines, so Korea has got to consider its position in the region and strive for change."

The deal would also allow Korea to benefit from closer ties with a technological leader. Indeed, while Hyundai's Beijing plant is more productive than those in Korea, none can match Hyundai's factory in Alabama, which has a much higher level of automation and produces 72 vehicles an hour.

But after eight tortuous rounds, trade talks between the US and Korea broke off without agreement last Monday. Negotiators plan to meet in Washington today to try to close the deal by the end-of-March deadline. Both sides are optimistic a deal can be reached but it is becoming increasingly clear that it will not be the "big bang" Seoul was hoping for.

Cho Won-dong, head of economic policy in the finance ministry, says that concerns about Korea's declining dynamism are too "drastic": "If you look at our economic growth potential, it's still around 5 per cent and a lot of growth is coming from productivity gains."

The intended trade agreement with the US would cover services as well as manufacturing, so could boost both parts of the economy, he adds. Although the deal is unlikely to be as wide-ranging as initially hoped, Mr Cho says "something is better than nothing" and any such pact would help precipitate reform.

Yet many economists and business leaders in Seoul are alarmed at the slow pace of change, saying that China is fast moving up the value chain and will soon be making the kinds of computer chips and flat-screen televisions for which Korea has become known. China's export structure, where the proportion made up of electronics and other high-technology products has grown to comprise almost 40 per cent, much more closely resembles that of South Korea than it did a decade ago. Although most technology exports come from foreign-invested companies and the highest-tech components are still imported, the sudden change is giving Korean companies reason to be scared. "Korea and China were like geese, flying in formation," says Kim Joon-kyung, vice-president of the Korea Development Institute, a state-linked think-tank. "But now the Chinese goose is catching up.

"Chinese manufacturing workers earn about 10 per cent of what Korean workers earn but the technology gap between the two countries has rapidly reduced," Mr Kim says. "Korea has already lost the personal computer industry and more will follow."

Certainly, Korean companies are nervous. Lee Kun-hee, the powerful chairman of Samsung Group -- which accounts for about 20 per cent of the country's exports -- warned this month that Korea had to "wake up" or risk "economic chaos" in five to six years. Samsung might relocate its appliance division, which has posted losses since 2003, to less developed countries, he added. In shipbuilding, South Korea has been the world leader for the past decade, but China is closing in so quickly that Seoul's National Intelligence Service has launched investigations into technology leaks. Meanwhile, Korea's current four-year lead over Chinese manufacturers of flat-screen televisions is likely to narrow to only one year by 2010, according to the Korea Electronics Association.

This is partly because, after the trauma of the financial crisis, Korean companies remain conservative about investment. "Before the crisis they invested a lot, even though their financial structure was not that good," says Mr Jung of the Samsung Institute, "but now they have the financial, technological and managerial capacity to invest but they are reluctant to take risks".

He is far from alone in that view. "South Korea succeeded in overcoming the crisis but, because reforms were implemented drastically and one-sidedly, the side effects were also significant," says Lee Kyung-tae, president of the Korea Institute for Economic Policy. "One of them is that the Korean economy is losing its dynamism. Dynamism all boils down to investment but investment is not vibrant."

In 1996, corporate investment was equal to 40 per cent of gross domestic product but it had slipped to 30 per cent by 1998 and has struggled to rise above that since, last year measuring only 28 per cent. Meanwhile, China is pursuing both technological development and investment. The Organisation for Economic Co-operation and Development says China has overtaken Japan to become the world's second biggest spender on research and development, investing $136bn this year.

South Korea's top chaebol, the conglomerates such as Samsung and Hyundai, have become global companies and are likely to weather any storm better than the rest of Korea Inc. A much greater concern rests with small and medium-sized enterprises, the mainstay of the economy, which have long supplied components for the big brands but find themselves trapped. "The chaebol are under a lot of margin pressure because of the won's strength and because they are playing in very competitive global industries. A natural consequence of this will be a squeeze on the margins of their SME suppliers," says Stephen Bear, head of McKinsey in Seoul.

"In many cases these SMEs are also being squeezed at the other end by emerging competitors from China. The next problem area Korea will likely face is going to be around the hollowing out of the SME sector."

The sector's problems are worsened by the survival of uncompetitive players. The government gives credit guarantees, under which 85 per cent of the principal is guaranteed, to banks lending to SMEs, which means that poor performers do not go bankrupt. Mr Kim of KDI says this has led to the emergence of "zombie SMEs" -- businesses that cannot pay back their debt but whose loans are continually rolled over because of the government guarantees.

At the same time, Korean companies with bases in China have increasingly localised their procurement of intermediate goods. According to Mr Kim's calculations, Korean companies operating in China procured one-quarter of their parts locally in 1996 -- but it took less than a decade before half the parts were being sourced there.

Together, these factors mean that about one-third of South Korean SMEs are not making profits. "People think that we have to somehow keep these companies alive," Mr Jung says. "But marginal companies -- this is difficult to say -- should be let go, so the market can reallocate resources."

Apart from ground being lost in investment and technological advancement, a further erosion in South Korea's competitive position has come from a surge in economic nationalism. That change in mood came after foreign investors reaped huge profits on the assets they bought at fire-sale prices following the financial crisis.

It has come to a head over the case of Lone Star, the private equity group that bought the distressed Korea Exchange Bank in 2003 but now finds itself the subject of a high-profile investigation as it tries to sell its investment. The retrospective review of Lone Star's acquisition is alarming domestic and foreign investors alike and suggests that regulatory risk -- one of Korea's few advantages over China -- is more of a problem than before.

"We risk alienating foreign investors when we should be welcoming them with open arms," says one Korean investment banker, asking not to be named. "Korea is not as exciting a growth story as China or India and is not as mature as Japan, so we are at a critical stage in the development of our markets. But we are risking becoming more isolated."

Foreign direct investment has fallen to only 7 per cent of GDP, compared with 35 per cent in China. In Unctad's latest world investment report, South Korea ranked 114th out of 141 countries for foreign investment flows. The key to rejuvenating the business environment, economists say, lies in encouraging competition through foreign investment and in embarking on reforms regardless of whether or not they are required by the proposed free trade accord.

"Korea has to allow entrepreneurs to flourish and to allow SMEs to flourish," says Mr Brilliant from the business council. "This is not to say that the chaebol don't have a role to play but that the business sector must be expanded. If Korea wants job creation, innovation and technology, it has to seek a way to diversify its industrial structure."

Nevertheless there are several glimmers of hope for the future. Mr Jung points to Korea's obsession with education and the knock-on improvements in human capital, and its creativity, as expressed through a "Korean wave" of music and films that is spreading across Asia. "I think we are at the stage where our future growth will come from technology, design, education, ideas," he says, adding that Korea filed the second largest number of patent applications with the World Intellectual Property Organisation last year.

Yet the key will be taking advantage of Korea's geographical advantage by producing goods that China cannot make and at a price with which Japan cannot compete.

Kwon Tae-shin, Korea's ambassador to the OECD, tells a joke to illustrate his country's predicament. A shop-owner hangs a sign outside his store saying "Best prices", leading to floods of customers. The shop-owner two doors along retaliates with a banner reading "Best quality". But the shop-owner in the middle has the last laugh by erecting a sign saying "Enter here".

It is a strategy that Korea is desperately trying to mimic. Squashed between China and Japan, it must turn its position in the middle into an asset.

Textile success is at a stretch

If any Korean company knows about the threat of China, it should be the Hyosung Corporation, one the country's midsized conglomerates.

Hyosung has seven business divisions -- chemicals, construction, industrial materials, information and communication, power and industrial systems, textiles and trading -- several of which have come to face direct Chinese competition.

"China is definitely competing directly with us in chemical and fibres and that has hurt us to some extent. But it hasn't hurt us as much as it could, as we're concentrating on moving into more technically advanced areas," says Kim Jin-hyun, senior adviser to Hyosung's president.

For example, while Chinese companies make spandex, one of the materials that Hyosung is strong in, they find it harder to compete on quality. "The manufacturers have certain requirements when it comes to things like spandex -- the look, stretch, consistency and reliability -- and when it comes to the finished product Chinese manufacturers can't compete," Mr Kim maintains. "Some fabrics have become commodities but this is an area where we are still ahead."

Hyosung was founded in 1957 and expanded in the 1970s through acquiring small industrial companies and establishing polyester and dyeing subsidiaries. In the 1980s it moved up the value chain, venturing into plastics, carpets and cash machines and, more recently, nanotechnology fibre and automotive parts.

Its main focus is on manufacturing and distributing synthetic fibres such as polyester and nylon for the textile industry, but in recent years it has been struggling in some areas. It returned to the black last year after a 2005 loss. To deal with the threat of China, Hyosung is moving into higher technology areas rather than exiting sectors.

Like Hyundai Motor, it is also taking advantage of the opportunities that China offers. Last month Hyosung announced plans to expand production in Korea and China to meet shortages in spandex, buying a factory in Zhuhai, China, that will help it increase total capacity from 54,000 tonnes in 2005 to 65,000 tonnes this year.

But that is not to say Hyosung is not looking over its shoulder at emerging Chinese competitors. "We are developing and trying to distinguish ourselves," Mr Kim says. "I think Chinese and Korean companies can co-exist in the same fields in the short term -- just as long as we're a few steps ahead. In the longer term, who knows?"