Foreign Direct Investment in Korea

The Role of the State

Bernie Bishop

• Publisher: Taylor & Francis
• Year: 2019
• Print ISBN: 9781138313262
• eBook ISBN: 9780429855498
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Published in 1997, this book traces the history of foreign investment policy in South Korea from 1961 until the present. It shows how Korea adopted a highly successful interventionist strategy towards foreign direct investment channeling it into areas of the economy where it could achieve the most benefit for the country's economic development. In recent years Korea has tried to adopt a more market driven approach. However, differences within various institutions within the public and private sector led to policy confusion and ineffectiveness in meeting policy goals. The conclusion reached is that moving from an interventionist strategy to a market orientated strategy is difficult in this policy area. The book breaks new ground because it shows that while the conventional wisdom is that a 'market economy' approach is beneficial, moving from an interventionist policy to a market-orientated one is problematic and cannot be accomplished quickly.

1 ‘State’ and ‘Market’ Approaches to Foreign Investment Policy

Introduction

The approach that policy makers adopt towards foreign investment tends toward either an interventionist or a more market oriented stance. These alternative policy orientations have their basis in statist theory and neoclassical theory. The approach that a particular set of policy makers adopts may well depend upon the extent to which they accept the underlying assumptions and principles involved in either approach.

Economic policy is not made in a vacuum. Those who are charged with the task of policy making have views and assumptions of their own as to which pathway should be chosen to economic development. These views are conditioned not only by cultural values but also by educational experiences, the domestic and international economic and political environment and perceptions of the success or failure of previous policy initiatives. The transmission of policy relevant knowledge occurs across international boundaries and results in policy makers also learning from the policy successes and failures of other states.

This chapter sets out the underlying assumptions and principles for each policy approach. As noted by Rasiah (1995) the neoclassical approach has perhaps been the dominant paradigm in the literature on foreign investment policy. For this reason this chapter seeks to develop the statist approach in a little more detail.

The purpose of this chapter is to lay the foundations for later chapters which show that Korean policy makers in the 1960s and 1970s adopted an interventionist approach to foreign investment but in the early 1980s sought to abandon this in favour of a more market oriented policy. Differences in view developed as to which strategy was the more appropriate. Much of the debate which has occurred concerning policy since that time has centred around the differences inherent in each approach and the effect that each has on the interests of various participants in policy processes.

A Market Oriented Approach to Foreign Direct Investment

A market oriented approach to foreign investment policy is based on assumptions made by neoclassical theorists concerning the role of the state in economic development. Using the works of Smith and Ricardo as their basis, proponents of this school of thought believe that the optimal path to economic development occurs when the state plays a minimalist role, confining itself to the provision of a stable economic and political environment in which free enterprise guided by the market produces the goods and services which lead to improvement of the community's welfare (Reidel 1988: 35-7). The state is seen as limiting its function to the provision of public goods, a stable and predictable macro economic environment and a free trade regime. State intervention should only occur to correct clear cases of market failure (Islam 1994: 93; Wade 1991: 11) relying on the market mechanism as the ultimate arbiter of production.

A fundamental requirement for the proper functioning of the market mechanism is the existence of competition between firms. Neoclassical theorists recognise that in certain limited circumstances markets may fail in adequately providing competition. In those circumstances, there may be a case for government intervention in the form of competition laws to ensure that goods and services are available at the lowest possible price in the interests of maximising the overall welfare of the community.

Neoclassical theory is extended to the international arena by the assumption that different states have different factor endowments and for this reason some states will be more efficient at producing some goods rather than others. States are therefore said to have a comparative advantage in the production of those goods which their factor endowments allow to be produced more cheaply than in other states. International trade is the mechanism by which states exchange those goods in which they have a comparative advantage for those goods in which they have a comparative disadvantage. It is therefore in the best interests of community welfare for states not to interfere in the free flow of goods and services across state boundaries.

In pure neoclassical theory then, there should be no reason for firms to establish operations in other countries (Krugman 1983: 57). In a world where each country efficiently produces goods and services in accordance with its comparative advantage, those goods and services should be able to be traded without firms having to move across country boundaries. In order to explain the phenomenon of foreign direct investment, neoclassical theory has to resort to explanations which, in theoretical terms are second best.

These have proceeded down a number of different pathways but in recent times Dunning's eclectic theory of international production has perhaps provided the most comprehensive framework for the analysis of the determinants of foreign investment (UNCTC 1992a). Drawing together various theoretical approaches which had been developed by earlier writers, Dunning (1988) hypothesised that there are three sets of factors which determine international production. The first of these he called ownership advantages. In the course of their operations some firms acquire particular advantages such as marketing skills, research and development skills or production skills which allow them to become more competitive than their rivals within the same industry. The acquisition of these advantages means they are able to provide goods and services more competitively not only in their own country but also in other countries. In order to exploit these advantages firms invest overseas despite the obstacles faced by the firm in operating in a different cultural and regulatory environment.

The second element of Dunning's theory explains why firms invest to exploit their ownership advantages rather than simply exporting the product or entering into licensing arrangements or strategic alliances. The explanation relates to the transaction costs which arise in international trade transactions. These can be simple transport costs, different rates of taxes and charges from country to country or other market imperfections which make it more profitable for a firm to exploit its ownership advantages by locating in the overseas country rather than selling direct or licensing the technology to firms in the host country. The third element of Dunning's theory seeks to explain why firms choose to invest in one country rather than another. He argues that certain features of a host country's natural and policy environment lead firms to choose that country in preference to others. Location advantages, as Dunning calls them, include natural resources, domestic market potential, labour costs, political stability and government policies which affect the economic environment in which the firm operates.

Although foreign investment is a second best option in theoretical terms, it can still confer a benefit on the host country through its operation as a resource transfer (Hill and Johns 1991; Ahiakpor 1991; Helleiner 1991). A resource transfer approach places emphasis on aggregate flows of foreign investment to a recipient country. The positive benefits to the recipient country not only include an addition of capital, but also flow from the foreign firms' ownership advantages of advanced technology, increased ability to penetrate overseas markets, employment growth and backward and forward linkages (Johnson H.G. 1967: 61; Thirlwall 1972: 263; Islam and Chowdhury 1993; Hill and Johns 1991; Parry 1988; Ahaiakpor 1991). It is assumed that any negative side effects of foreign investment such as the crowding out of local investors will be counteracted by the fact that foreign investment will only flow into those areas where it has a comparative advantage. This leads to the country as a whole being better off with local industries specialising in areas where they have a comparative advantage offsetting any specific disadvantages of particular firms.

The neoclassical position is that policies which attempt to steer foreign investment into selected sectors of the economy will lead to distortions in the allocation of scarce foreign capital resources and will lead to a risk of 'government failure' in their allocation. It is argued that the government does not know where foreign investment can be most productive in the economy (Goldsmith 1995: 647). This decision is best determined by firms themselves. Consequently the government should confine itself to providing a conducive policy environment such as realistic exchange rates, free movement of foreign capital, competitive interest and tax rates and minimal bureaucratic interference in the foreign investment process (Rasiah 1995: 11; Lee H.K. 1994).

Negative effects of foreign investment are due to inappropriate government macro economic and industry policies of which foreign investment policies are a small subset (Parry 1988: 122; Johnson H.G. 1967: 61-2). Results of these policies may be either monopolies or highly protected and inefficient local or foreign invested firms. Host countries can avoid these negative effects by way of suitable general policies. Refraining from protecting any sector whether through foreign investment policies or more general industry policies will prevent inefficiencies from arising (Fry 1993(b): 61-2).

Foreign investment policy in the form of either incentive or restrictive measures is criticised by neoclassical theorists. Restrictive foreign investment policy measures which, for example, seek to confine it to certain industries or set limits on levels of foreign ownership in any project are criticised on a number of grounds. At the outset it is argued that they deter foreign investors thereby reducing investment flows and depriving the country of the advantages which it brings. It was the acceptance of this point of view by policy makers in many developing countries including Korea which led to attempts by key policy makers to reduce restrictive measures at the beginning of the 1980s (Contractor 1990; Aranda 1988).

Restrictive measures are also criticised because they amount to no more than devices to protect domestic industry from foreign competition. As such they are argued to be subject to the same failings as all protectionist devices which lead to rent seeking by narrowly based interest groups leading to a lower level of overall community welfare than that which would have been possible in their absence (Matthews and Ravenhill 1994: 71). In extreme cases policies which seek to distort foreign investment flows in this way may lead to decreases in overall welfare (Naya and Ramstetter 1988: 66; Fry 1993(b): 19).

Those who seek to reduce protection do so because of acceptance of the argument that protection benefits narrow sections of society at the expense of society generally. Protection has the tendency to lead to inefficient firms which are not internationally competitive thereby depriving society at large of goods and services at least cost. While key policy makers may recognise this argument, it is more difficult to implement because of the interests which arise from protectionist policies. It is here that the capacity of the state is crucial. This will become apparent in later chapters which deal with the attempts by top policy makers to reduce protectionist measures in Korea in the 1980s.

While criticism of restrictive foreign investment policies has proceeded under the banner of general criticisms of protectionist policies, there is more specific research to support the neoclassical position that foreign investment policy in the form of investment incentives should be avoided. Rather, various features of the investment environment provide a far stronger explanation. Lim (1994: 837) summarises the position as follows:

Empirical studies show that there is no support tor the belief of the governments of most developing countries that the provision of fiscal incentives is necessary to attract direct foreign investment. Nor is there support for the belief that the greater the generosity of the incentive programs, the greater will be the level of investment. What matters are the presence of natural resources and the pursuit of sound economic policies. The latter would include the type of fiscal monetary and budgetary policies that lead to high savings.

A large number of studies undertaken over the past two decades have tended to show that incentives are not a major determinant of foreign investment flows. One of earlier studies was that of Root and Ahmed (1978) who carried out a study of 41 developing countries categorising them as unattractive, moderately attractive and highly attractive based on the amount of investment that had entered these countries between 1966 and 1970. They found that there were six variables which explained the differences in investment flows. Tax incentives were not one of them. Agodo (1979) studied the investment decisions of 33 firms in African countries and concluded that tax concessions were insignificant in influencing their decisions to invest.

In 1983, Lim published a study in which he investigated patterns of investment for 27 developing countries. He used regression analysis to test the significance of natural resources, level of economic development, rate of economic growth and tax incentives as influences on foreign investment flows. He found that all variables other than tax incentives were positively related to foreign investment flows. He also concluded that the level of generosity of tax incentives was negatively related to the amount of foreign investment and explained this by saying that fiscal hyper generosity in the form of tax incentives was seen as a danger signal and not as a lure (Lim 1983: 210).

In 1984 the Group of Thirty conducted a study concerning the effect of tax incentives on the decision by 52 international corporations to invest in 12 different countries. In his report of this study, Helleiner (1991: 148) notes that not one corporation was found to have listed tax incentives in their top three reasons for investing. However, there was some recognition that in cases where all other factors were approximately equal, tax incentives, while not a major reason for investing, might tip the balance in favour of a particular country.

Sheperd, Silbertson and Strange (1985) found in their survey of investment by British companies that tax regulations and government incentives had negligible effects. Dunning (1986) also found in his survey of Japanese firms investing in the UK that incentives and foreign investment policy only had a modest influence. O'Sullivan's (1985) study of foreign investment in Ireland during 1960-79 found that the primary determinants were labour costs, the exchange rate and market size. Fiscal incentives were not statistically significant.

A study by the United Nations Centre for Transnational Corporations to determine which variables had the greatest influence on foreign investment flows selected 46 countries (21 developed countries; 5 newly industrialising countries and 20 less developed countries); 7 investment policy variables (tax incentives, ownership policies, convertibility of foreign exchange, price controls, performance requirements, application and other procedures and sector specific controls) and 3 macro economic variables (market size, political risk ratings and the exchange rate) (UNCTC 1991). It was hypothesised that announced policy changes in the seven policy categories might positively affect foreign investment flows or that investment flow might be positively associated with the market size or the growth rate of the economy. Correlation and regression analysis showed that, for the most part, changes in foreign investment policy including incentives had only a weak and scattered influence on investment flows. However, restrictive measures in the form of performance requirements, were found to negatively affect foreign investment flows for industrialised and newly industrialising countries. It was also found that a 'more powerful explanation of investment flows was the size and growth rate of the host country economy' (UNCTC, 1991: 59).

Pfefferman (1991: 218-19) summarised a study by the International Finance Corporation on the effect of tax incentives for both export oriented investment and domestic market oriented investment. It found that in 38 export oriented investments, incentives ranked in the top three reasons in 15 cases. In 36 domestic market oriented investments incentives ranked in the top 3 reasons in only 2 cases. This led to the conclusion that incentives have little influence in domestic market oriented investments but may have a bearing on the investment decision in export oriented projects.

The findings of these studies supports the proposition that investment incentives are not an important determinant of investment flows. In their study of the impact of incentives on investment decisions by both domestic and foreign firms, Boadway and Shah (1992: 26) point out that the major limitation of tax incentives for foreign investors is that while tax exemptions for foreign firms may lead to less tax in the host country, they will more often than not lead to the firm paying the tax in its home country. For that reason firms do not consider incentives to be important.

The specific evidence for Korea is confined to survey type studies which are subject to criticism as mentioned below. However the studies that have been undertaken generally support the findings set out above.

Lee (1980) refers to two surveys which were carried out in the 1970s. The first of these by Chu in 1975, surveyed both US and Japanese firms concerning their motives for investing in Korea. Tax incentives were not mentioned as a significant factor. The most important factor was the cost of labour, followed by the growth rate of the economy and the size of the domestic market. The second survey was carried out by Chung in 1976. It is the only survey for Korea which rates tax incentives as an important factor in investment decisions by foreign firms. Chung found that cheap labour was of secondary importance to the incentives offered by the Korean government.

Further surveys were carried out in the 1980s. Koo and Bark (1988) refer to a survey carried out by the Korea Industrial Research Institute in 1985. The survey results showed that the overwhelming motivation for investors was that of accessing the domestic market. Eighty five (85 per cent) of the firms surveyed identified this as their primary motive. Other significant reasons included the use of Korea as an export platform (61.8 per cent); cheap labour (38.2 per cent); good technological capability (20.6 per cent) and others, including tax incentives, (17.6 per cent). It is clear that factors associated with the investment environment rated much more significantly than tax incentives.

These results are consistent with a survey conducted by Cho (1984). He surveyed US companies investing in Korea and reports that 77 per cent did so to expand their market for goods. Only 7 per cent invested because of the lower costs. Thus incentives, as a part of the factors which lower costs, did not rate highly. In 1991 a further survey was carried out by the Ministry of Finance (MOF 1993). It was found that 43 per cent of the firms surveyed indicated that the domestic market was the major motivation for investment. Only 4 per cent of those surveyed mentioned tax privileges as a reason for investing (MOF 1993: 566).

It is difficult to find more general studies to show conclusively that incentives do positively affect foreign investment flows. A survey of manufacturing firms by Reuber in 1973 showed that 48 per cent of respondents would have abandoned their investment plans in export oriented areas had it not been for the incentives offered (Reuber 1973). However, survey studies of this type are criticised by neoclassical theorists because they fail to survey firms which do not invest and therefore do not establish the true impact of incentives on the investment decision (Boadway and Shah 1992: 73).

A study by Guisinger (1985) of 74 cases of investment by manufacturing companies in Latin America in the automobile, food, computer and petrochemical industries found that in 'two thirds of the cases surveyed, the choice of country was influenced by host country policy' (Guisinger 1985: 317). However, as noted by Pfefferman (1991: 218-19), Guisinger's study adopted such a broad range of possible incentive measures it was not possible to isolate the relative influence of tax and other direct financial inducements from more general features of the host country's policy environment.

The studies set out above have formed the basis of opinions of development related bodies such as the International Monetary Fund (IMF), the Organisation for Economic Cooperation and Development (OECD) and the World Bank which advise against the use of investment incentives (IMF 1985; OECD 1983, 1993; World Bank 1987, 1993, 1994). However while...

Table of contents

• Cover
• Half Title
• Dedication
• Title
• Copyright
• Contents
• List of Tables
• Acknowledgments
• List of Abbreviations
• Introduction
• 1 'State' and 'Market' Approaches to Foreign Investment Policy
• 2 Foreign Investment during the Park Regime
• 3 State Capacity and Foreign Investment during the Park Regime
• 4 Chun Doo Hwan and Attempted Foreign Investment Policy Reform
• 5 Roh Tae Woo and the Slow Down of Foreign Investment Policy Reform
• 6 Kim Young Sam and the New Foreign Investment Policy Regime
• Conclusion
• Bibliography
• Index