by K Lee · 2009 · Cited by 99 — Thus, many countries simply resorted to devaluation or standard trade liberalization, which led to export booms from the price effects and certain stabilization of

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Copyright © UNU-WIDER 2009 * School of Economics, Seoul National University, Seoul, email:; This study has been prepared within the UNU-WIDER project on Country Role Models for Development Success, directed by Augustin Kwasi Fosu. UNU-WIDER gratefully acknowledges the financial contributions to the project by the Finnish Ministry for Foreign Affairs, and the financial contributions to the research programme by the governments of Denmark (Royal Ministry of Foreign Affairs), Finland (Finnish Ministry for Foreign Affairs), Sweden (Swedish International Development Cooperation Ag encyŠSida) and the United Kingdom (Department for International Development). ISSN 1810-2611 ISBN 978-92-9230-205-4 Research Paper No. 2009/34 How Can Korea be a Role Model for Catch-up Development? A ‚Capability-based View™ Keun Lee* June 2009 Abstract There is some scepticism about Korea as role model of development as the Korean model involved a considerable degree of state activism, unacceptable in today™s global environment. This paper propose a ‚capability-based view™ of the country™s catch-up development, arguing that the real lesson from Korea is not the role of government but the fact that it was able to strengthen the capability of firms, thus inducing sustained growth for several decades. This paper points to the mid 1980s as the critical juncture in this process of capability-building, as the Korea emphasized in-house R&D in private sectors, pushing the aggregate R&D/GDP ratio to the threshold level of 1 per cent or more. This led to another core aspect of the Korean modelŠcontinuous upgrading within the same industries as well as advancing successive entries into new promising industries. The paper argues that without capability-building, devaluation or standard trade liberalization alone cannot bring sustained catch-up as these often result in short-run, albeit temporary, export booms. The study analyses how Korea utilized various access modes to learning and knowledge to enhance its technological capabilities, and concludes with a discussion of the transferability of the Korean lessons to other countries. Keywords: Korea, development, catch-up, role model, capabilities JEL classification: O10, O20, O53

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The World Institute for Developmen t Economics Research (WIDER) was established by the United Nations University (UNU) as its first research and training centre and started work in Helsinki, Finland in 1985. The Institute undertakes applied research and policy analysis on structural changes affecting the developing and transitional economies, provides a forum for the advocacy of policies leading to robust, equitable and environmentally sustainable growth, and promotes capac ity strengthening and training in the field of economic and social policy making. Work is carried out by staff researchers and visiting scholars in Helsinki and through networks of collaborating scholars and institutions around the world. UNU World Institute for Development Economics Research (UNU-WIDER) Katajanokanlaituri 6 B, 00160 Helsinki, Finland Typescript prepared by Liisa Roponen at UNU-WIDER The views expressed in this publication are those of the author(s). Publication does not imply endorsement by the Institute or the United Nations University, nor by the programme/project sponsors, of any of the views expressed. Acknowledgements An earlier version of this paper was pr esented at the UNU-WIDER conference on Country Role Models for Development Success, 13-14 June 2008, in Helsinki. The author would like to thank Augustin K. Fosu, the project director, for his guidance and suggestions. Acronyms IPO initial public offering IPRs intellectual property rights JVs joint-ventures M&As mergers and acquisitions MNCs multinational corporations NIEs newly industrialized economies OBM original/own brand manufacturing ODM original design manufacturing OEM original equipment manufacture SMEs small and medium enterprises

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1 1 Introduction Korea has been one of the most successful latecomer economies to achieve rapid economic growth and is approaching the ra nks of the advanced economies, with per capita GDP of US$20,000 in 2007 compared to approximately US$160 in 1960 (Lee and Kim 2009). While Korea has often been proposed as a role model for other developing countries, there is also some scepticism. Such scepticism seems to stem from the perception that the Korean model involved a great degree of state activism, including targeted protection for some industries or firmsŠan intervention not acceptable in today™s global environment. The perception continues to prevail, as early literature tended to focus on the role of the government versus markets in catching-up development (Amsden 1989; Chang 1994; Worl d Bank 1993). But another stream of literature, namely a technology-based view (such as OECD 1992; Hobday 1995; L. Kim 1997a; Dahlman, Westphal and Kim 1985), cont ends that Korea and other newly industrialized economies (NIEs) have tried to catch up by assimilating and adapting the more or less obsolete technology of the advanced countries (Vernon 1966; Utterback and Abernathy 1975; Kim 1980). This paper intends to propose a ‚capability-based view™ of the Korean and Asian experience in the catching-up development process. This approach can be considered an extension of the technology-based view, albeit somewhat removed from the government-market dichotomy as its microeconomic foundation is more sound. We are taking this view because the real lesson from Korea is not the role of government in economic development but the fact that the country was able to strengthen the capability of firms, thus inducing sustai ned growth for several decades. Sustaining long-term growth is not easy. Th ere are numerous cases of macro-oriented reform bringing immediate recovery but with out it being sustained, and eventually the economy is faced with another crisis (Lee 2006). The most fundamental barrier to sustained development is local capabilities . Without a certain critical degree of capabilities, growth, which is based on lower wage rates or simple price competitiveness, tends to be short-lived. Th e Korean success was based on capabilities, and since the mid 1980s Korea has emphasi zed in-house R&D in private sectors, pushing the aggregate R&D/GDP ratio to the threshold level of 1 per cent, and eventually to 2.5 per cent or higher. One of the most obvious differences between the developed and developing countries is their per capita GDP. But what accounts for the differences in income levels? These result from the varying capabilities of each country, including the capability to produce and sell internationally competitive products for long periods. One core element of the Korean model was its focus on building thes e capabilities, which enabled the economy to achieve continuous upgrading within the same industries as well as advancing successive entries (another kind of upgrad ing) into new promising industries. But it is not easy to enhance capabilities. Mainstream economics tend s to concentrate on macroeconomic stabilization and trade liber alization, but these are only remotely connected to capacity-building, if at all. This bias in economics dates back to the intrinsic limitations of mainstream economics when th e word ‚capabilities™ (and by implication, ‚learning™) did not exist. Mainstream economics advocates the optimization of resources, but starts from the implic it assumption that all resources (inputs or capabilities) are already in existence and th e only task is to find their most efficient

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2 utilization. But in reality, most of the developing countri es do not have to worry about the optimal usages of resources (capabilities) simply because they are not available. For these countries, the more critical issue is how to strengthen such capabilities. Next, we define capability-building and successive upgrading, the essence of the Korean model, and then discuss how the country has overcome the disadvantage of being a latecomer to capability-building. S ection 3 elaborates the process of capability- building over four stages. Section 4 summarizes each capability-building phase, highlighting the first half of th e 1980s as the critical juncture in the process. The final section discusses the transferability of the Korean model to other countries. 2 Capability-building and successive upgrading as the essence of the Korean model 2.1 Development as a process of capability-building Openness and export promotion have generally been regarded as key policy ingredients for the developing countries. Thus, many count ries simply resorted to devaluation or standard trade liberalization, which led to export booms from the price effects and certain stabilization of external balances. However, there are numerous cases of macro- oriented reform bringing immediate, albeit unsustained, recovery and eventually another round of crisis. For example, the three reform cycles in In donesia (1983-91, 1994-97 and the post-1998) show that rapid success with macro-reform, if not supported by microeconomic changes, tends to fade fa irly soon, triggering another balance-of- payment crisis. A similar pattern is unfoldi ng in Nepal with respect to the 1990s reforms (K. Lee 2006). Korea was in the same predicament as th e other developing countries, faced with continual external imbalances and persistent trade deficits during the first two decades of industrialization in the 1960s and 1970s. However, since the 1970s the government has put emphasis on technological devel opment by publicly funding and conducting R&D. The results were shared with private firms, private R&D was promoted with tax incentives and in the 1980s a public-private joint R&D was set up for bigger, risky projects. Intensification of R&D expenditure and a focus on higher education laid the basis for knowledge-driven growth. This is apparent in the rise in US patents filed by Koreans. In the early 1980s, approximately fift y US patent applications were instigated by Koreans, similar to the situation of the Latin American countries. The R&D/GDP ratios for east Asian and Latin American countries were also similar, around 0.5 per cent (Table 1). But by 2000, Korea was filing more than 5,000 US patents per year and its R&D/GDP ratio was 2.5 per cent. In cont rast, the ratio for most of the Latin American countries had remained around 0.5 to 1.0 per cent, and none of Latin American countries were filing more than 1,000 applications annually. This often unnoticed policy initiative was su ccessful in strengthen ing the manufacturing sector, an important factor behind the late 1980s trade surplus, the first in the modern history of Korea. Since then, Korea has been able to overcome the persistent trap of external imbalances or stop-go cycles of cris is and reforms. Countries that followed the Washington consensus, focusing on macroeconomic stabilization and trade liberalization, experienced some improvement but this tended to be short-lived. When

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3 Table 1 R&D/GDP ratios in selected countries 1965 1980 2000 Korea 0.5 0.56 2.65 Taiwan 0.71 2.05 Philippines 0.2 0.2 Thailand 0.3 (1969) 0.3 (1985) 0.25 Malaysia 0.10 (1988) 0.49 China 0.68 (1985) 1.00 India 0.4 (1968) 0.7 (1982) 0.85 Brazil 0.3 (1974) 0.6 (1982) 1.04 Argentina 0.2 ( 1969) 0.5 0.44 Chile 0.4 0.53 Mexico 0.1 (1970) 0.6 (1984) 0.37 Ghana 0.2 (1966) 0.9 (1976) Nigeria 0.5 (1969) 0.3 (1977) South Africa 0.89 (1985) 0.62 (avg. of 1988 & 2002) Source: Authors™ database detailed in Lee and Kim (2009); K. Lee (2006). the momentum of the initial macro-based reform slowed down and the economy started to show signs of a crisis or recession, bolder economic reforms were tried in the next round. These included financial liberalization or capital market liberalization, which exposed the economy to volatile short-te rm finance capital. When financial liberalization lacked proper design and management, it often led to a foreign borrowing spree, speculation, a financial bubble, and ultimately another financial crisis. Although Rodrik (1996b) acknowledges the importance of the sequential adoption of the ten policy recommendations of the Washington cons ensus, he overlooks the fact that east Asia since the mid 1980s had more advan ced capabilities already prior to deeper marketization. It needs to be noted that one of the most important elements of Korea™s success was the emphasis on capability and technological development, which may lead to a consolidation of private exporting and R&D capacity. Without strengthened R&D capability, sustained export growth is not possible. The difference between the more and less successful Asian economies was the prior ity given to technology and, in particular, higher education to enhance long-term grow th potential. These are missing from the Washington consensus, even though they can be considered as the distinctive core elements of the approach adopted in northeast Asia. A recent World Bank assessment of the refo rm decade of the 1990s concedes that growth entails more than the efficient use of resources and that growth-oriented actions, for example, on technological catch-up or encouragement of risk-taking for faster accumulation may be needed (World Bank 2005: 11). Also, recent ECLAC studies on reform in Latin America find that macroeconomic stability is not a sufficient condition for ensuring long-term growth, which is li nked more closely to the dynamics of the production structure. Furthermore, a well-f unctioning broader institutional context and infrastructure are essential, but these gene rally do not play a direct role in bringing about changes in the momentum of growth (Ocampo 2005). Then, our point is that microeconomic interventions should be co mbined with capacity-enhancing elements (technology and education), so that the costs of distortions (rent-seeking) can be offset by growth-generated new additional rents.

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5 The necessity for these two types of upgrading extends partly from the international industrial lifecycles wherein new industries tend to be created in the developed world, and the latecomer countries and firms inherit these once they mature and their products become standardized. Given this lifecycle, an important feature of successful catching- up is the ability to enter at earlier (higher value-added) stages of the cycle, and this is possible only with enhanced absorption capability. Otherwise, the alternatives are lower-wage activities or industries, with limited opportunities for long-term success. Such a dynamic view of industrial change is clearly contradictory to the mainstream emphasis on static comparative advantages; uncritical application of industrial change can lock the world at a stage whereby the developed countries specialize more in the high value-added or high-margin products wh ile the developing countries are tied to low value-added or low-margin products. Fu rthermore, no guidance is offered on how to manage the transition from marginal -profit production to high value-added production, which makes the prospects of upgrading development uncertain. There has been a dramatic change in the e xport structure of Korea, starting from the labour-intensive goods (apparel) to automobiles and electronic goods. The share of exports in total GDP was less than 2 per cent in the early 1960s or at the beginning of the industrial take-off, reaching 10 per cen t in the early 1970s and 30 per cent by the mid 1980s. This growth in exports was firs t driven by such labour-intensive goods as apparel and footwear. Their share increased rapidly in the 1960s and 1970s to 10 per cent of total exports by 1965 and almost 30 per cent by the early 1970s. Since then, the share of apparel and footwear dropped to about 10 per cent in 1990 and to less than 3 per cent by 2000, as they were replaced by other higher-valued goods, such as electric and electronics goods and automo biles. The share of these latter items increased to about 10 per cent by the mid 1970s, accounting for 20 per cent two decades later, and finally almost 30 per cent by 2005. Behind this change in export structure is the continuous improvement of firm-level capabilities, upgraded from OEM to ODM a nd then to OBM (Mathews and Cho 2000; Hobday 2000; Lee 2005). This became necessary because the forerunning vendor firms tended to transfer their OEM orders to lowe r-wage sites, and latecomers needed to expand to higher value-added orders. There are many instances of upgrading within the same industry in east Asia. For example, semiconductor firms in Korea and Taiwan started from IC-packaging or testing (low value-added activities), then moved to IC- fabrication and eventually to IC-design (highest valued-added) (Mathews 2005, 2006). In Korea, there are also many cases of successive entry into higher value-added industries. The Samsung group is well-known for its successive convergence of new industries during its 60-year history. As shown in Figure 2, Samsung started in light manufacturing industries (tex tiles) but then expanded into consumer electronics, followed by semiconductors and telecommunications and finally flat panel displays, etc. In this process, the state had an important role in providing institutional support through joint R&D and technology transfer arrangemen ts, as well as tax and credit concessions for newer industries.

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6 Figure 1. Changing trend in the composition of major export items, 1960-2005 (% share in total exports) Source: Drawn by the author using data from the Korea International Trade Association Database (available at, and the Unit ed Nations Commodity Trade Statistics Database (available at, based on MTI Code, formulated by ministry of knowledge and economy, or by the relevant SITC Rev. 1 Code. Figure 2 Changes in the Samsung Groups™ Sales Composition Note: Numbers are share percentages in total sales (billion won ). Source: Figures drawn by the author using the data in Chang (2003).

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7 The illustration of upgrading and market entr y shows that these two processes are inter- linked: successive entry is possible only after latecomer fi rms first acquire the design capability needed for upgrading in a given industry. In other words, to overcome problems related to the OEM-based growth, latecomer firms should first acquire the necessary design capability, and with these design capabilities, they tend to become late albeit fast-following entrants into new emer ging industries. Latecomers cannot afford to languish in any given industry because ol d industries continue to change, often becoming declining industries, and/or new indu stries are set up through the initiatives of the forerunners to take a dvantage of higher profits. A notable feature here is that new industries in the advanced countries tend to be created by new, different firms, whereas in the la tecomer countries, new emerging industries are developed by the same firms diversifying but possibly utilizing different access modes. For example, the Korean firms (Samsung or LG) have become highly diversified through entry into the manufacturing of numerous consumer goods. Although such a dynamic change in the comp aratively advantageous industries could evolve without state intervention, often some coordinatio n by state agencies could expedite the process and provide a better chance of success. 2.3 The roles of the developmental agency and industry targeting Gerschenkron, the great Russian economic hist orian, analysed the industrialization of Germany and Russia and introduced the notion of the ‚latecomer e ffect™ in the 1950s and 1960s (Lee and Mathews 2008). Gerschenkron (1962) notes that relative economic backwardness plays a role in inducing systematic substitution for the assumed prerequisites of industrial growth, and regards state intervention as necessary to compensate for the deficiencies . He points out that England, the locus of the industrial revolution, could advance with free market guidance along the lines of Adam Smith, but that France, beginning later, would have needed greater intervention to compensate for its limitations, and that in Germ any, the key innovation would have been the formation of large banks to provide access to the capital n eeded for industrialization, just as Russia™s greater backwardness required larger and more direct compensatory role by the state. The situation confronted today by the developing world is worse than that faced by Germany or Russia, because many of these countries lag behind the leaders. Thus it is understandable if the developing countries seek special or more radical ways to compensate for their latecomer deficiencies. Therefore, while the ultimate goal of developm ent is to raise the capabilities of local private companies, pilot agencies are needed to guide and coordinate the whole process. Such needs exist because key resources are s carce, and should be mobilized for sectors or projects with the greatest externalities. As was understood by Gerschenkron who identified latecomer agenciesŠsuch as large state-owned investment banksŠas the engines of process in Germany and Russia, it is such agencies that can compensate for gaps in a country seeking to industrialize. All the east Asian countries set up specific state agencies that played a role in guiding the industrialization process. In Korea, the institu tions established in the 1960s under the Park regime included the economic planning board to set economic plans; the ministry of trade and industry to support industrial policy and export; and the ministry of finance to fund

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8 the economic plans. These government agencies were important in targeting and promoting key industries and technologies in Korea, as is explained below. The development process concerns growing industries, where firms can flourish and develop enhanced capabilities. But industries cannot be chosen randomly, or left to the whim of the multinational corporations. Enhancing the capabilities of private firms requires giving them the assurance of initial rents (profits) and learning opportunities until they mature enough to compete successfully in world mark ets. One effective way of assuring such opportunities is to target certai n industries or technologies, such as those that exhibit externalities or market failure in terms of the gap betw een private and social return. While mainstream economics would focus only on such industries, we can go deeper than this and contend that there ar e more justified targets in the catching-up context. The negative attitude towards targeting comes from the uncertainty of selecting the right industry or technology. For example, it is impossible to predict which industries or technologies are going to become prominent in a particular country. This concern, however, makes more sense in the context of the developed countries where firms are on the frontier of technology and are faced w ith greater uncertainty. But the latecomer economies have more justified targets: these are the industries or technologies that are being imported or purchased at prices mono polized by foreign companies. In this situation, targeted import-sub stitution transfers the rents from the foreign to local companies. With such a strategy of targeted import-substitution, local operations face less uncertainty or risk because the targeted technology often constitutes mature inventions that are possible to emulate through the concentrated efforts of local indigenous R&D centres. Many successful examples abound in east Asia, including the development by the local R&D consortium, TDX (digital telephone switches) in Korea in the early 1980s (Lee, Mani and Mu 2008). Korea in the 1970s and 1980s faced a telephone service bottleneck. But the country had neither its own telecommunications equipment manufacturing industry nor an R&D programme until the late 1970s. As a result , most of the equipment and related technologies were imported, and Korean techni cians merely installed foreign switching systems into the nation™s telephone networks. With rapid development of its industrial a nd commercial bases and in population growth (approaching 36 million), telecommunications se rvices in the late 1970s fell far behind the demand. After prudent consideration, Kor ea decided to build its own manufacturing capability and the R&D infrastructure needed for the creation of state-of-the art digital phone switching systems. In collaboration with a na tional network of switching system manufacturers and distributors, the Korean consortium and the Korean Electronics and Telecommunications Research Institute (ETRI) developed in 1981-83 a proprietary digital switching system called the TDX (time-division exchange) series. Thus development of the Korean system was phased through manual switch, step-by-step switch, skipping the crossbar switch to leapfrog to the analogue electronic switch and the digital electronic switch. This indigenous product took over markets previously dominated by imports and the MNCs. Korea™s experience, accumulated and enhanced over the preceding decades, led to the growth of indigenous capabilities in wireless telecommunications in the 1990s. Similar take -over of the mobile phone market from

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