By Matt Robinson
Economist, Moody's Economy.com

We have been witness to considerable improvements in the Korean economy since the Asian financial crisis of 1997-98. Corporate governance has been enhanced, the financial system is stronger, the current account has moved into surplus and the national currency has recovered to near pre-1997 levels. But one area where the lasting effects of the crisis have persisted is in investment levels.

Investment over the Past Decade

In the aftermath of the financial crisis of the late nineties, there was a marked step-change in investment in Korea - as there was in other crisis affected countries. Gross fixed capital formation in the Republic constituted almost 40 percent of GDP pre-1997; it averaged closer to 30 percent of GDP in the years following the crisis.

Arguably some of the downturn in investment can be attributed to the effect of the pre-crisis excesses. The perceived riskier investment environment and weaknesses in the financial and corporate sectors have deterred foreign investment; a pre-condition of some of the IMF loans involved limitations on public spending; and private sector reluctance to invest in all but the export sector limited the expansion of the non-tradable domestic sector.

A more worrying trend, however, has been the further erosion in capital spending over the past few years. Since 2004, fixed capital investment has gradually declined further, dipping as low as 28 percent of GDP in the first half of 2006.

High levels of capital expenditure were an integral ingredient to Korea's recipe for growth during its boom years in the seventies and eighties. Strong investment means that the quantity and quality of capital equipment that workers have at their disposal is improving. The boost capital investment gives to the nation's productivity is the equivalent of giving a farmer a tractor and dispensing with the horse-drawn plough.

The economy's stock of equipment and machinery, infrastructure, education system and the quality of the country's institutions are fundamental to economic development. Low levels of investment in physical, human and social capital leads to poorer productivity growth, lower wage growth and smaller improvements in living standards. Encouraging productive investment is therefore an essential element in generating and improving economic growth prospects.

Over the past couple of quarters, the trend decline in investment in Korea appears to have finally turned the corner. Since its low during the second quarter of 2006, growth in capital investment as a proportion of GDP has finally turned positive. Given its importance then, policies aimed at sustaining the recent improvement in investment should be a key focus of the Korean administration.

Bank of Korea Inhibits Investment

The recent interest rate increases by the Bank of Korea (BOK) are expected to temper capital expenditure. At this stage in the Korean economic cycle - with little inflationary pressures, the exchange rate remaining elevated and a relatively weak household sector - the BOK appears to have adopted a particularly hawkish stance on monetary conditions.

Rising costs of capital typically curb investment, as higher interest charges discourage acquisitions, delay expansion plans and inhibit businesses' ability to hire - all of which limit the potential for future business activity and growth.

The blunt instrument of increasing interest rates will also have the effect of subduing consumer demand - which for Korea is already in a fragile state - further dampening the outlook for Korean businesses. Tightening monetary conditions in the Korean economy at a time when global financial markets are very anxious about liquidity issues is also questionable.

The BOK's drive to soak up liquidity and curb lending growth may prove to be overly zealous given the current fragility of the consumer sector, the fledgling recovery in investment and, perhaps even more ominously, the recent turmoil in global financial markets. However, as most sectors are showing encouraging signs of growth, the Korean economy should be able to withstand higher interest rates.

For Korea, there may also be a silver lining to the current dark clouds surrounding global financial markets. The sharp appreciation of the Japanese yen in recent weeks, as investors have unwound speculative carry trades, will boost the price competitiveness of Korean exports in the global market. Nevertheless, there is a risk that the current financial market turmoil will affect global economic activity and dampen demand for Korean exports. Recent trade trends have shown the resilience of Korea's manufacturing sector, however a further downturn in demand from major trading partners such as the United States would substantially crimp export receipts.

More Investment Needed in Non-tradables

Much of the capital expenditure activity in recent years that has survived the BOK's tough interest rate stance has been directed toward externally focused sectors. Korea remains at the cutting edge of technological developments in a number of areas and continues to forge strong trade linkages with developing economies - one of the key reasons that the external sector has continued to attract a disproportionate share of investment funds in recent years.

While this lopsided capital expenditure has enabled the development of a world-leading tradables sector, it has left domestically oriented sectors of the economy languishing. The productivity performance of Korea's services sector has lagged the rest of the economy. Its contribution to GDP has not kept pace with its increasing employment share, as the nation continues to make the transition from manufacturing-based to a services-based economy.

Some of the productivity malaise in Korea's services sector can be attributed to the regulatory framework; stiff bankruptcy laws and a tendency to continue rolling over debts, zoning rules, restrictions on competition and inflexible labor laws have all constrained improvements in service-sector productivity. Improving the legal and institutional environment under which business operates remains a key way that government can stimulate the economy and spur investment.

The government recently passed Capital Market Consolidation Act, which should provide a less restrictive operating environment in the financial services sector and encourage investment. Initiatives such as the extension of free economic zones will also sustain foreign investment and encourage research and development.

The need for continued reform remains. However, the transition to a services-based, knowledge economy relies on productivity improvements, so the need to concentrate on sustaining investment will be even more pressing. For the sake of its residents, it is hoped the recent upturn in business investment in Korea (and, for that matter, government policies conducive to a continued improvement in investment) continues.