Are South Korea’s FDI Outflows Becoming Alarming

Foreign Direct Investment outflows are helpful for developing new markets and combining the international division of labor in production by responding flexibly to demand and production. But South Korea’s outflows have been increasing steadily since 2010.

The Export-Import Bank of Korea reports that outflows have increased from US$25.5 billion in 2010 to US$43.7 billion in 2017. Between 2015 and 2017, FDI increased by 15.7 percent annually. During this period, outflow more than doubled, from US$13.7 billion to US$30.35 billion. FDI outflow increased by 33 percent each year. How should we make sense of this surge?

There are three issues. First, the pros. FDI is desirable to allow corporations to promptly adapt to global demand and production. It helps corporations be closer to overseas markets and flexible on changes in local consumer demand. It helps to develop new markets. Corporations can build international divisions of labor in production by organically linking partners and subsidiaries dispersed inside and outside of the country.

For example, after 2011, when Hyundai Motor Company’s Beijing sales surged, its partners in South Korea increased employment, sales, and exports. FDI in the automobile industry helped enhance the competitiveness of the South Korean automobile parts industry.

Second, the cons. FDI outflow results in production facilities in South Korea moving offshore. The burden of higher wages, higher corporate tax rates, and preferential regulations cause corporations to move their production facilities offshore, substituting for production in South Korea. As a result, capital drains from South Korea. Corporations and the industrial foundation weaken. Employment drops.

South Korean jobs and production facilities are substituted with jobs and production overseas. This steady outflow results in a hollowing out of the manufacturing industry, leading to a decrease in South Korean jobs and economic growth.

Third, FDI is desirable from the perspective of dynamic time analysis of FDI in the short- and long-run. In the short-run, it does decrease South Korean jobs if FDI outflow substitutes onshore production facilities with overseas ones. But it is not the case when the outflow of FDI is meant to develop new markets in the mid- to long-run, after ample investments are made in onshore production facilities.

When new FDI increases exports of onshore mother corporations, onshore jobs increase as production, sales, trade, and investment increase. Onshore jobs may be sacrificed as opportunity costs, but in the long-run, the economy will benefit as the market expands, and, due to economies of scale, production expands, jobs are created, and technology develops.

Business Environment and Corporate Concerns

Among the corporations that invest overseas, it is mostly large corporations that incorporate a local subsidiary to develop a new market and flexibly adapt to demand and production. Overseas expansion is desirable when its objective is to develop a new market and proliferate the division of labor in production.

However, small-and medium-sized enterprises (SMEs) face hardships as they expand overseas because of the not-so-friendly business environment in South Korea. The Bank of Korea reports that SMEs have begun joining the FDI outflow since 2010. Overseas investment is now one of the options to overcome domestic business burdens, such as high wages, high corporate tax rates, and irrational regulations in South Korea.

In an interview with Yonhap News Agency, Kim Sang-bok, the CEO of Doowon Cable, a cable manufacturing company located in Boryeong, South Chungcheong, said that “rising wages and shortened work hours mean that corporations should move overseas.” The Korea Economic Daily reported in a survey that 9.5 percent of SME CEOs said they have either decided to or are considering transferring abroad.

This overseas expansion does not help with the expanding international division of labor in production. Rather, it exposes SMEs that need protection in order to compete with foreign contractors. It makes it harder for SMEs to grow. Unintended consequences result.

The Moon Jae-in administration’s economic policies have had unintended consequences. The corporations and laborers that it targets to help are those who are getting hurt. Market conditions in South Korea changed dramatically this year. The business environment worsened as minimum wages increased and working hours shortened.

The minimum wage in 2018 is W7530 (US$7.05)per hour, an increase of about 16 percent compared to 2017. This is affecting the employment crisis facing SMEs. The minimum wage is mostly applied to non-regular workers, regular workers, youth, and the elderly. Workers applicable for minimum wage are mostly hired at SMEs. They cannot afford to improve their competitive edge by enhancing productivity through wage increases. They have no choice but to decrease employment or working hours.

Beginning on July 1, 2018, maximum working hours will decrease from 68 hours to 52. This will result in weaker competitiveness for SMEs with fewer than 30 workers. It will make it harder to meet deadlines. They can lose clients, and see a decrease in jobs due to less revenue. This change has been postponed until the last day of 2019 for companies with fewer than 300 workers. SMEs will face higher wage burdens and a setback in production due to lower rates of operation.

Protectionist Gale

Proliferating protectionism is making countries such as the US and Japan encourage reshoring to protect national companies. President Donald Trump’s “America First” policy is increasing American corporations’ rate of reshoring, because they can now expect lower corporate tax rates and deregulation. The Reshoring Initiative reports that around 70,000 new jobs were created in the US in 2017 due to reshoring. Reshoring and FDI to the US is largely due to incentives provided by the government. Additional incentives are shorter distances to consumers and the availability of a skilled workforce.

FDI outflow, on the other hand, was due to rising shipping costs, production costs, inventory management costs, and wages.

In the case of Japan, the industrial environment has changed favorably due to a reduction in corporate tax rates and a weak yen promoted by the administration of Prime Minister Shinzo Abe. Automobile manufacturers such as Toyota and Nissan are substituting a part of their North American output with domestic production. In addition, camera manufacturer Canon and cosmetics company Shiseido are relocating their production plants from overseas to Japan.

Meanwhile, South Korea is encouraging companies offshore to come back onshore under the expansion of protectionist trade, but success has been limited. According to the Korea Economic Research Institute (KERI), only around 30 (as of February 2017) offshore companies received support and benefits from the reshoring policy and returned to South Korea, with most being SMEs in the shoe manufacturing and jewelry sectors. The actual effects of the policy, therefore, have been relatively low.

South Korean companies do not have much room to choose from in the current situation of expanding protectionist trade. The reshoring policies of South Korea, Japan, and the US share similarities in that they establish good environments for companies by alleviating the burden of labor costs, allowing for reduction of and exemption from taxation, and enacting preferential regulatory policy. The circumstances of South Korean companies, however, differ from those in the US or Japan.

The South Korean domestic market is relatively small. Rather than making offshore companies return home, there is a need to target companies that have the capacity to expand their capabilities onshore and then support them in expanding offshore. In addition, for onshore companies, a favorable business environment should be created by improving labor flexibility. South Korea, because it differs from the US and Japan, should establish a variety of support policies for companies in the domestic market and those offshore to maintain a complementary relationship.

Sustainable Strategic Tangent Point

Where is the strategic tangent point for establishing a good environment for business and also guaranteeing labor rights? On the one hand, there is a need to formulate economic policy by industry type, manufacturing and service, and by the size of a company. The government should clearly identify which workers and companies are the direct targets of economic policies, such as the minimum wage and reduced working hours.

If the minimum wage is set at a higher level than the equilibrium wage, the supply of non-regular workers will increase, while the labor demand of SMEs will decrease, leading to a reduction in employment of non-regular workers.

Workers and corporations, which can be damaged and produce unintended results, should be considered separate from market participants that can receive benefits. For instance, the minimum wage, which can be applied to labor-intensive manufacturing and retailers and wholesaler services, such as textiles and clothing, machines, or metal processing, should be applied differentially. For intensive-labor manufacturing, employment elasticity on the minimum wage is large, so employment reduction as a result of an increased minimum wage may be large.

There is a need to apply minimum wages according to the specific manufacturing and service industry, so that workers will not be disadvantaged due to layoffs and unwanted reductions in working hours. By understanding industry characteristics, policies can be customized individually based on the position of workers in each industry.

On the other hand, in order for FDI outflows to produce positive effects, the export market should diversify, and offshore operations should be encouraged for companies that can flexibly adapt to global demand and production. In particular, trading partners and industries should be clearly defined, and supported so that they can expand overseas. For example, more support should be given to companies that have the capability to enter a local market, targeting Vietnam, which became South Korea’s No.3 target investment country in 2017, and the ASEAN region to invest offshore.

Most of all, the targets and measures of the current government’s economic policy should be clearly distinct. SMEs’ foreign outflow increased by 2017, while only 21 U-turn companies actually operated onshore factories. This is because the targets and measures of reshoring policies were not aligned. In the case of SMEs, support for recruiting talent might be more effective than financial support.

In the case of the automobile industry in 2018, large offshore corporations, onshore South Korean SMEs, workers, and the government cooperated in holding domestic job fairs for second and third tier sub-contractors. These fairs support the recruitment of superior talent for component sub-contractor SMEs.

In order to prevent an unintended outflow of SMEs from South Korea, a region with growth potential should be selected, and an innovative industry ecosystem should be established centering around that region. A good environment for business can be established by connecting SMEs, workers, local governments, the national government, and academia, and with proper training for SMEs’ human resources.

This is reprinted courtesy of the East Asia Foundation in Seoul. It was written by Namsuk Choi, an associate professor, College of Commerce at Chonbuk National University. The views are those of the author.