35427-01-prc-tacr

8/8/2019 35427-01-prc-tacr

1/209

Chreod Ltd. Chreod Ltd.

Suite 200, 111 Sparks Street Shanghai Representative OfficeOttawa, Canada K1P 5B5 Suite A1301, Building A

527 Huai Hai Zhong RoadShanghai 200020, China

Tel: 01 (613) 238-3954 Tel: (86-21) 5306-3477Fax: 01 (613) 238-4668 Fax: (86-21) 5306-1358e-mail: [email protected] e-mail: [email protected]

www.Chreod.com

Asian Development BankHebei Provincial Finance Bureau

TA No. 3970-PRCHebei Provincial Development Strategy

May, 2004

International Case Studies

Chreod

8/8/2019 35427-01-prc-tacr

2/209

Hebei Provincial Development StrategyInternational Case Study

Chreod Ltd.

CONTENTS

A1: Case of California

Water Markets as a Mechanism for Inter-sectoraland Inter-jurisdictional Allocation

A2: Case of New York City

Inter-Jurisdictional Water Resources Co-operation

B1: Case of South Korea

South Koreas Experience Upgrading its Heavyand Chemical Indus tries in the 1970s & 1980s

B2: Case of Transitional Economies

Cluster-Based Regional Economic Development

in Transitional Economy Countries

C1: Case of Pittsburgh, Pennsylvania

Economic Transformation in the North American Rust Belt

C2: Case of Ireland, Portugal and Canada

Industrial Restructuring in Peripheral Regions to Major Markets

C3: Case of Pueblo, Colorado

Restructuring of an Isolated, Small Industrial City in Western USA

D1: Case of South Korea

Ports Development in South Korea

E1: Case of Paris

Paris Metropolitan Spillovers

E2: Case of Randstad, The Netherlands

Managing Regional Development

E3: Case of Rhein-Ruhr, Germany

Regional Urbanization

E4: Case of South KoreaRegional Urbanization

F1: Case of South Korea and Canada

SME Financing in South Korea and Canada

G1: Case of Australia

Fiscal Case Study of AUSTRALIA

G2: Case of India

Fiscal Reform Case Study of INDIA

G3: Case of Korea

Fiscal Reform Case Study of KOREA

8/8/2019 35427-01-prc-tacr

3/209


Chreod Ltd.

A1: Case of California, USA

Water Markets as a Mechanism for Inter-Sectoral and Inter-jurisdictional Allocation

Prepared by Stephen Dolan

8/8/2019 35427-01-prc-tacr

4/209

Hebei Provincial Development Strategy Chreod Ltd.Case Study A1: Californias Water Markets 26 February 2004

A1_1

California: Water Markets as a mechanism for inter-sectoral andinter-jurisdictional allocation

1. Introduction

1. As in China, with a growing population and urbanization, water is undoubtedlyCalifornias most precious resource. In this context, there is a growing trend towardsreallocating water from agriculture to urban areas. If cities in California were to get 15percent of what agriculture in California currently uses, urban water availability would rise bymore than half (Haddad, 2000). It is estimated that this water savings would be more thanenough to meet new urban demands well into this century. It is also increasingly clear thatmarkets will play an important role in this reallocation. There are a number of importantimplications and parallels to Hebeis situation.

2. Under these circumstances, dramatic gaps between the demand for and supply ofwater, the resulting resource management debate is typically driven by a need to use water

more efficiently. Further, it is also usually driven by the necessity to anticipate and addressinter-sectoral conflicts over allocation and use of water. The standard approach in NorthAmerica so far has been to advocate reform of water pricing across sectors to reflect thescarcity value of water. This advocacy is based on theoretical and empirical evidence on theneed and desirability of such reforms including willing-to-pay studies. Nevertheless, majorusers of water, particularly of irrigation water have usually resisted these reforms given thatthey will likely result in dramatic increases in their cost of water.

3. Economic theory indicates that markets increase economic efficiency by allocatingresources to their most valuable uses. In other words, if certain conditions are met, marketsprovide the correct incentives (and disincentives) and lead to efficient resource use. Oneway to change the incentives so that water users support the reallocation of water, and to

achieving a more efficient allocation of water is through water markets. Water markets allowwater users to buy and sell water, thus changing the whole incentive structure and breakingthe logjam of water pricing reforms when water users can gain from reallocation, theywould be willing to sell water or pay a higher price for new supplies.

4. Water Markets: The primary function of the market system is to allow supplies tomeet changing demands in a manner that reflects the economic priority of competingdemands.1 There are certain conditions or criteria that must exist to transfer the use ofwater between sectors, jurisdictions, or users within a market framework:

1. There must be a definable product to trade in the market. The product (water)must be capable of being measured, controlled, and traded as a commercial

good. A market in water use rights will only develop if ownership, quantity,measurability, and reliability are defined so as to generate confidence that theright is secure and viable.

2. Demand for water must exceed supply.3. The supplies derived from water use rights must be transported to where water is

needed and to be available when needed. Water available at the right time and inthe right location has economic value. The infrastructure must be in place forwater to be stored and transported to areas of demand.

4. Buyers must feel confident that they will receive and be able to use the rightpurchased. For water markets to exist there must be a system of allocation,permits, licenses or property titling that is respected by the market. There needsto also be an administrative system that registers ownership and title transfer.

5. The water rights system must also resolve conflicts, be it administrativearbitration, peer group resolution or the justice system.

1 Simpson, L and Ringskog, K. Water Markets in the Americas. The World Bank, Washington D.C.1997.

8/8/2019 35427-01-prc-tacr

5/209


A1_2

6. The system must also apportion supply during period of shortages and excess7. Well-defined and enforced mechanisms and criteria must be in place to assure

that users are adequately compensated when their rights are confiscated ortransferred to higher societal preferences. Within the context of California, forexample, formal water trading occurs between government entities, the variouswater districts.

8. It is crucial in gauging the potential acceptability of water markets that the culturaland societal values of water resources be considered.

9. For any management program, including a market-based system, to succeed inthe long term, it must be financially sustainable.

2. Californias Water Market

5. The formal water market in California has developed only recently in response to majorwater shortages precipitated by expanding demand, a lack of conservation practices, and a

major drought. The transfer of water rights in this context went from being prohibited by lawto being advocated as a principal means for bridging the gap between demand and supply.Reflecting this change in the regulatory environment, California has seen, especially duringthe past two decades, the development of a number of both formal and informal watertransfer mechanisms. This flowering of innovation reflects the large gaps that exist betweenthe supply of and demand for water.

6. Historically the transfer of water between users was precluded under state law. Theowner of a water right did not originally have the freedom of transfer because, until recently,the law was interpreted to mean that a water user who attempted to sell or transfer a righthad demonstrated that they no longer had a beneficial use for the water and, consequently,had technically abandoned the right and were forced to relinquish it. In 1914 the State Water

Resources Control Board was formed with the authority to issue permits for the use of watersupplies. Historically, the state board held that water rights could be transferred but that thestate board would decide whether a transfer right could affect all other uses. Because thestate water board was responsible for maintaining return flows, its actions tended todiscourage transfers.

7. This situation continued until specific legislation in 1980 clarified that sale of a right didnot indicate abandonment or non-beneficial use of the water. Throughout the 1980s, thestate legislature continued to pass additional bills in an attempt to create a water market.This included establishment of a program to facilitate long-term water transfers by setting upa data bank of entities interested in conducting water transfers. The new law also replacedthe state board with the Department of Water Resources and required that this agency and

all other public water agencies make available a portion of unused capacities in waterconveyance facilities to facilitate the mobility of water transfers. In 1991, in response to amajor drought, the state legislature passed emergency legislation creating a Drought WaterBank within the Department of Water Resources. This Water Bank provided for the buybackof water supplies from the holders of water use rights as a temporary measure to offset theeffect of the drought. The idea was to develop a permanent program for buying water userights and renting them on an annual basis to maintain a controlled Water Bank.

8. The idea of a Water Bank was not totally new. During the 1976 and 1977 drought, theU.S. Bureau of Reclamation established a Water Bank in the Central Valley Project thatbought more than 57 million cubic meters of water within the system at an average value of$40.00 per thousand cubic meters. It then sold this water to other users within the projectwho had critical needs, for an average value of $41.00 per thousand cubic meters. Thiswater bank primarily provided emergency water supplies to maintain the viability of orchardsor perennial crops that might have been lost otherwise, with devastating economic effects.

8/8/2019 35427-01-prc-tacr

6/209


A1_3

9. The state Water Bank was established primarily to meet the emergency conditions ofthe 1987 to 1992 drought. The Department of Water Resources purchased more than 975million cubic meters of water at an average price of $102.50 per thousand cubic meters.Administrative rules established prices based on estimates of what the selling farmers couldhave received if they had used that water to grow high-value crops, plus an incentive tofacilitate the trade. The Department of Water Resources expended approximately $100million for this water bank. The water assembled in the bank was then sold for a value of$144.00 per thousand cubic meters plus the cost of transportation, primarily to high-valueagricultural purposes and to critical urban needs. Of the water sold from the bank, 80percent went to municipal users in Southern California and in the San Francisco Bay area.

10. In parallel with the development of the State Water Bank, another trading system hasdeveloped through the 1980s and 1900s between state agencies, in particular, between theSouthern California Metropolitan Water District (MWD) and the Imperial Irrigation District(IID).Both entities are major users of Colorado River water and located in Californias semi-arid region. According to the 1922 Colorado River Compact, allotments for use of theColorado River are divided among seven western states and Mexico. California currentlyuses approximately 6.5 billion cubic metersper year, more than its 5.4 billion cubic metersallotment. Most of Californias Colorado River allotment goes to the Imperial Irrigation District(IID), with 3.4 billion cubic meters and the Metropolitan (Los Angeles) Water District (MWD,with 616 million cubic meters).

11. The MWD has spent $2 billion over the past decade to increase efficient water use inanticipation of rising demand. This has resulted in a high price for water with the MWDcurrently selling water for approximately $431 per cubic meter. In comparison, agriculturalwater is extremely cheap IID sells water to farmers for $14 per cubic meter. Thus, thereare enormous potential gains from trade. Further, studies show that farmers are sensitive tochanges in water price increasing the price of agricultural water by 10 percent decreasesdemand by 20 percent. In other words, the demand is price elastic. Thus, a marginalreduction in subsidies for agricultural water would reduce its use by this sector. It is not

necessary (as some have argued) that agricultural output would decline as a consequence.Increasing the price of agricultural water would simply give agricultural communities anincentive to use water more efficiently, e.g., by using new technologies and planting highvalue crops such as nuts, fruits and vegetables that are less water intensive (Fowler 1999).Further, even if water markets reduced agricultural production, it would probably be onmarginally productive lands and crops (where in the first instance cultivation took placebecause of cheap water). In this context, it has been estimated that agricultural water usecould decline by as much as 15-20 percent through conservation without significantdecreases in production (Wahl 1989).

12. Under an agreement, the MWD is leasing 130 million cubic meters of water per year for35 years from the Imperial Irrigation District (IID). The water comes entirely from increases in

water-use efficiency brought about through techniques such as lining irrigation canals orreplacing them with pipes to reduce waste. The MWD has paid for these improvements. As aresult, it has been able to acquire the conserved water without reducing the number of acresirrigated within IID (Reisner and Bates 1990).

13. Further, a smaller, more localized intra-sectoral market has also developed during thissame timeframe. Irrigators in California have been trading water among themselves foryears, both formally and informally and trading even occurs in some districts supplied withfederal water. Members of the Westlands Water District (WWD), for example, negotiatedroughly 4,500 transfers during 1990-91 alone. In March 1996, WWD established anelectronic bulletin board system that enables farmers to buy and sell annual entitlements tofederal water over the internet (Anderson and Snyder 1997).

14. Crucial to the development of water market mechanisms in California is its extensivenetwork of canals and pipelines, which allow for the transport of bulk water within andbetween watersheds. The Southern California Metropolitan Water District maintains amassive pipeline that transports bulk water from the Colorado River across the Rocky

8/8/2019 35427-01-prc-tacr

7/209


A1_4

Mountains to the urbanized coastal regions. This pipeline has been a lifeline supporting therapid urbanization along the coast. Given that California cannot take any more water fromthe Colorado River, in the 1960-1970s it began to build a massive internal pipeline systemthat transports bulk water from the water rich north to the rapidly urbanizing central andsouthern regions of the state.

15. There are also numerous examples of water trading between agricultural and urban

users in other western U.S. states Utah, Arizona, Colorado and Nevada. For instance,groundwater in Arizona was made freely transferable by law in 1980. Following this the citiesof Phoenix, Tucson, Mesa and Scottsdale acquired more than 50,000 acres of farmland inorder to retire the fields and to utilize the water. A study by researchers at the University ofArizona found that during the late 1970s and during the 1980s there were about 6,000transaction in Utah, 1,455 in New Mexico, and 1,500 in Colorado (Steinhart 1990).

16. With respect to legislation, the leading proposal for water markets in California isembodied in the Model Water Transfer Act for California. It provides a detailed framework forinstitutional reform of this sector. Though it did not go far when introduced in the state senatein 1997, the Model Act remains influential since it still represents the best thinking on watermarkets in the state (Haddad 2000). The Model Act endorses voluntary water transfersbecause they provide flexibility in resource allocation and because they promote reallocationbased on the principle of economic efficiency. At the same time it also acknowledges theimportance of protecting other parties who might be adversely affected by water transfers.One of the major aims of the Model Act is to streamline the cumbersome administrativeprocess of review and approval of long-term (market-like) water transfers. At present thisprocess severely limits the number of transfers that can take place. Among other keyprovisions, the Model Act proposes to strengthen ownership rights to water. The objective isto assure the rights owners that if they decide to part with water rights temporarily, theirdoing so will not be viewed as an indication that they do not really need the water andtherefore should eventually give it up.

17. Conclusions: California illustrates the potential that exists for bartering or paying formore-efficient agricultural systems in exchange for receiving a portion of the water saved. Insuch instances, both the original agricultural user and the purchaser receive benefits as theefficiency of the system improves.

18. Within California, the concept of water markets, water banks, and barteredimprovements in efficiency continues to be hotly debated. Some of the questions still facingthe legislature and regulators in California are the same as those facing politicians andregulators in developing countries. Such questions include whether a water market shouldbe free or regulated, who should benefit from the sale and transfer of water supplies thathistorically have been viewed as the property of the sovereign, where should environmentaland ecological uses and needs for water within river systems stand in comparison with other

priority uses of water, whether the market should be allowed to determine the distribution ofwater within the economy, and whether less-advantaged water users will be able to competein a market environment. These questions are being considered and addressed in California,just as they will have to be addressed in the developing world.

8/8/2019 35427-01-prc-tacr

8/209


Chreod Ltd.

A2: Case of New York City

Inter-jurisdictionalWater Resources Co-operation

Prepared by Stephen Dolan

8/8/2019 35427-01-prc-tacr

9/209

Hebei Provincial Development Strategy Chreod Ltd.Case Study A2: New York City, Inter-Jurisdictional Water Co-operation 25 February 2004

A2_1

Case Study: New York City

1. Introduction: During the past decade New York City has undertaken a rather innovativeapproach to the planning and management of its water supply system. In the early 1990sNew York Citys Department of Environmental Protection (DEP) embarked on an aggressiveplan to enhance the quality of the Citys drinking water through improved protection of its rawwater supply. The DEPs watershed management program is an explicit recognition that thehealth, welfare and well-being of New York City residents was dependent of the quality of itsraw water drinking sources, the Croton, Catskill and Delaware watersheds, all three of whichlie outside of New York Citys administrative jurisdiction.

2. New York Citys water supply system: The water supply system consists of threeunfiltered surface water sources (Croton system, Catskill system, and the Delaware system)

that lie to the north of the metropolitan region (Figure 1.1) and a system of wells in Queens.

1

The three upstate water collection systems consist of a system of 19 reservoirs and 3controlled lakes with a total storage capacity of approximately 550 billion gallons. Thesystem of reservoirs are linked through various interconnections to increase flexibility inmanaging both water quality and supply targets and to mitigate the potential impact oflocalized droughts. The three systems cover 8 counties in northern New York State and onecounty in the adjoining state of Connecticut. The system supplies drinking water to almosthalf the population of New York State, including over eight million people in New York City.In 2001 overall consumption averaged 1.3 billion gallons a day.

3. The New York City Department of Environmental Protection (DEP) is the agencyprimarily responsible for overseeing the operation, maintenance and management of the

water supply infrastructure and the protection of the 5,100 square kilometer watershed.Within the DEP, the Bureau of Water Supply manages the upstate watersheds andinfrastructure and all drinking water quality monitoring in-City and upstate. The Bureau ofWater and Sewer Operations operates the Citys drinking water distribution and sewagesystem.

4. The Croton watershed is the oldest portion of the water supply system. In 1842 the Cityfinanced a dam to impound the water of the Croton River, in what is now WestchesterCounty. An aqueduct, with a capacity of 90 million gallons a day, was constructed to carrywater from the Croton Reservoir to the City. The City was given the responsibility to managethe reservoir. Presently, the Croton Reservoir accounts for 10% of New York Citys waterdemand.

5. The Catskill watershed was identified in the early 1900s as a potential water source. TheBoard of Water Supply, a state-level institution, planned and constructed the initialcomponents of the system the Ashokan Reservoir and Catskill Aqueduct. Uponcompletion of the construction, the Board of Water Supply turned over the operation andmaintenance of the system to New York City. Subsequently, New York City and the Statehave invested expanding the Catskill system and it now accounts for approximately 40% ofNew York Citys water demand.

1 The system of wells in Queens account for less than 5% of New York Citys water supply.

8/8/2019 35427-01-prc-tacr

10/209


A2_2

Figure 1: Watershed Map for New York Citys Water Supply SystemSource: Department of Environmental Protection (2001)

6. The final component of New York Citys water supply is the Delaware system.Development of this system of reservoirs and aqueducts began in the 1920s and 1930s.Currently, the Delaware system accounts for system accounts for approximately 50% of NewYork Citys water demand.

7. The Problem: Declining Water Quality: Each of the three systems face continuingthreat from the cumulative and episodic impact of pollution sources generated by certainland uses and activities in the watershed. Land use within the watersheds is diverse, with thebulk of it being forested. Approximately 70% of the land is privately owned. There are over500 farms and 60 towns in all three watersheds. Forestry and agricultural activities play asignificant role in the local economy.

8. The Croton system has experienced the most difficult water quality problems of the threesystems. This is partly the byproduct of it being both the smallest watershed, as well as themost urbanized. The Croton currently meets all health-based regulatory standards (e.g. e-coli) for a surface water supply, but through the late 1980s and 1990s it began to experienceperiodic violations of the aesthetic standards for color, taste, and odor. In 1990 this declinetriggered the United States Environmental Protection Agencys Surface Water TreatmentRule (1989) (SWTR). The SWTR requires all public water supply systems supplied byunfiltered surface water sources to either provide filtration or to meet a series of criteriarelating to water quality and watershed control. The SWTR was promulgated pursuant torequirements outlined in the Safe Drinking Water Act (1986). Triggering the SWTR forcedthe City of New York to invest more than US$800 million in the construction of a water

filtration plant for the Croton system to satisfy the EPAs regulatory requirements.

9. Though not as serious as the problems facing the Croton system, the Catskill andDelaware systems have also experienced localized and seasonal water quality problems. Toavoid building filtration facilities for both the Catskills and Delaware systems, at an estimated

8/8/2019 35427-01-prc-tacr

11/209


A2_3

cost of $6 billion dollars for construction and a further $300 million per year for O&M, NewYork City decided to focus its investment in the development of watershed managementprogram. The development and implementation of an effective watershed management plan,which would protect water quality in the Catskill and Delaware systems, was identified by theEPA as a necessary prerequisite for granting a Waiver to the SWTR filtration requirement,which would would allow the City to, at least temporarily, avoid building filtration facilities forthe Catskill and Delaware systems. Any evidence of declining water quality or other violationof SWTR criteria would result in the EPA canceling the Waiver and requiring the constructionof filtration plants/capacity for the Delaware and Catskill systems. In short, the timing andscope of the program, was largely determined by the regulatory environment and, byextension, cost avoidance.

10. In 1997 New York City, communities of the Catskill/Delaware watershed, the USEnvironmental Protection Agency (EPA), New York State signed a Memorandum ofAgreement (MOA), which defines the key parameters of the watershed plans for bothsystems. The MOA establishes the institutional framework and relationships forimplementing a range of protection programs identified as necessary by New York City, NewYork State, and the EPA, as necessary for protecting water quality. The fundamental goal ofthe MOA is to protect water quality within the watershed while promoting the economicviability of the local communities. The MOA sets mutually agreed upon parameters forprotection and compensation to watershed communities in exchange for an SWTR waiverfrom EPA.

11. Building Inter-Jurisdictional co-operation: The program involves direct investmentand compensation by New York City in the cities, towns, villages, and farms of the Catskilland Delaware systems. The investment program is based upon two planks. First, theregulatory and administrative justification for New York financing investments andprogramming initiatives outside of its administrative boundaries is partly premised on aSupreme Court decision from the early-1930s. During the initial stages of the development ofthe Delaware system, the State of New Jersey brought an action in the Supreme Court

against the State of New York to stop it from using the waters of any Delaware Rivertributary. The State of New Jersey argued that the water development project would have adeleterious impact on downstream states. In May 1931 the Supreme Court of the UnitedStates upheld the right of the City to augment its water supply from the headwaters of theDelaware River. As a consequence, the Supreme Court gave New York City the right toundertake projects outside of its administrative boundary in support of the maintenance of itswater supply.

12. Further regulatory justification is found within the implementing rules and regulations forthe watershed management program, which are entitled The Rules and Regulations for theProtection from Contamination, Degradation, and Pollution of The New York City WaterSupply and its Sources. The implementing rules and regulations were promulgated by the

City pursuant to New York State laws and approved by the New York State Department ofHealth.

13. Second, during the early stages of program development, the cities, towns, and villagesof the Delaware and Catskill watershed voiced their displeasure with what they perceived asNew York City municipal officials interfering in the development of their communities. Inresponse to this initial skepticism and periodic hostility, a participatory, multi-stakeholderapproach was adopted. Further, reflecting this participatory and multi-stakeholder approach,the watershed program enshrines a commitment to promoting local ownership anddeveloping win-win solutions. This approach is captured in the MOA wherein it states that:

the goals of the drinking water protection and economic vitality within Watershed

communities are not inconsistent and it is the intention of the parties that enter into anew era of partnership to co-operate in the development and implementation of aWatershed protection program that maintains and enhances the quality of the NewYork City drinking water supply system and the economic vitality and social character

8/8/2019 35427-01-prc-tacr

12/209


A2_4

of the Watershed communities.

14. To enhance program delivery and promote local ownership, New York City typicallycontracts local institutions for implementation. In some instances, New York City hasprovided support to the development of local multi-stakeholder institutions, such as theWatershed Agricultural Councils (WAC). The WACs are not-for-profit organizations formedto contract with the City to encourage farmers to devise whole farm management plans and

install best management practices as opposed to regulating agriculture. Members of theBoard for the WACs are local farmers, with one vote being allocated to the DEP. The WACshave proven to be particularly effective in integrating local stakeholders into theimplementation process. In other instances, it has employed established delivery agencies todeliver program initiatives.

15. Catskill and Delaware Watershed Program: Based on the program outlined within theMOA, New York City, with some co-financing from New York State, has investedapproximately $500 million in protection measures in the Catskill and Delaware systems,which has provided a substantial savings compared to the cost of filtration. A further benefitis that the two watersheds have gained long-term protection.

16. The Catskills/Delaware watershed management plan reflects an integrated approach towater resources management. Fundamental to the watershed strategy is the recognition thatdifferent surface water bodies (reservoirs, streams, rivers, etc.) face different threats andmanagement challenges. Consequently, the management program needs to be flexible torespond to the unique challenges facing each water body in the area of concern. Thewatershed management program is composed of range of sub-programs that reflect thetarget priority issues in the watershed. Further, the identification of the priority issues ineach watershed is based on extensive analysis and ongoing evaluation and assessment.

17. New York Citys water resource management strategy is composed of seven majorinitiatives, which are designed to target the principal sources of pollution within thewatershed:

1. Watershed Agricultural Program:The City teamed with upstate stakeholders todevelop this voluntary program. The implementing partner is a multi-stakeholderinstitution Watershed Agricultural Council (WAC). Through the WAC the City fundsthe development of farm-level management plans and implementation of bestmanagement practices (BMPs). BMPs such as buffers and setbacks, soil-conservingtilling and grazing practices, streambank fencing to keep animals out of waterways,and erosion-preventing forestry strategies help preserve the natural water filteringcapabilities of the land and prevent potential disease-causing contaminants fromentering waterways. As of 2001, more than 90% of the farms in the system hadsigned up to the program, developed farm-level management and implementedBMPs.

2. Conservation Reserve Enhancement Program:A City/federal cost-sharingprogram that pays farmers to take sensitive riparian buffer lands, adjacent to waterbodies, out of active farm use and re-establish the vegetative buffer.

3. Land Acquisition:The City solicits owners of environmentally sensitive land withinthe watershed. The environmentally sensitive land has previously been demarcatedby a comprehensive land-use planning exercise. The Citys has budgeted upwards ofUS$300 million over the next 10 years. Many of the parcels are opened hiking, cross-country skiing, and snowshoeing, which enhances the recreational values of thelandscape.

4. Environmental Infrastructure Programs: The City has funded a program that inconjunction with local partners has implemented a range of programs, including:remediating septic tanks, upgrading buildings and facilities, implementing stormwaterBest Management Practices in key areas, and addressing wastewater collection and

8/8/2019 35427-01-prc-tacr

13/209

8/8/2019 35427-01-prc-tacr

14/209


A2_6

program outlines a comprehensive program of investments and budgeted. The investmentprogram is a multi-year and annual investment planning process based on the rolling planapproach whereby the annual plan is updated each year based on progress during thepreceding year and changes in priorities and market demands. The broader strategicframework for the program plans within a 25- and 50-year time-horizon. The watershedprogram uses scenario-based forecasts that projects land-use and population trends out tothe year 2050. These estimates represent extrapolations based on historical trends andrepresent likely future land-uses and population sizes, assuming that growth rates followhistorical trends. These population and land-use projections are then use to estimatepotential future pollution loadings.

20. Conclusions: The Catskill and Delaware watershed program has achieved itsobjectives, water quality within the watersheds has stabilized and, in many instances,improved. For a US$500 million investment the City has been able to avoid investment US$6billion in construction of a filtration plant and year on year operation and maintenance coststotaling US$300 million. The success of the program is based in large measure on acollaborative model that explicitly integrates local communities and stakeholders into theplanning and management process.

21. The New York City case study involves investments directed towards improving waterquality by the City in the communities that populate the Catskill and Delaware watersheds.The Catskill/Delaware model provides an illustration of the development of a multi-facetedstrategy to protect and improve water quality for a variety of stakeholders. It is also anexample of integrating downstream and upstream users. The program also underlines theimportance and benefits accruing to a comprehensive, long-range approaches to watershedmanagement.

22. Lessons learned: The keys to success of this program is stakeholder involvement in aparticipatory process guided by local leadership. Other lessons that can be drawn from thiscase and potentially applied elsewhere include:

Local Leadership is central to successful participatory programs

Early buy-in by local stakeholders (i.e. farmers, households, small business)who are usually mistrustful of regulators is essential

Reduction of nutrient, pollutants, and pathogens in the management ofupland agricultural runoff is important. Efforts to control the source of pollutants (i.e.barnyard areas, silage systems, stored manure), runoff from landscapes (viastormwater control measures), and watercourse protection (such as stream bankbuffer strips) are all successful components in the citys watershed program.

Whole farm management that integrates a variety of BMPs is an affordablemeans of sustainable agriculture, in terms of conserving both farming resources and

water quality. What happens upstream can have a profound impact on conditionsdownstream. Links must be made between economic development policies andsustainable management policies.

8/8/2019 35427-01-prc-tacr

15/209


Chreod Ltd.

B1: Case of South Korea

South Koreas Experience Upgrading its HeavyAnd Chemical Industries in the 1970s &1980s

Prepared by ECG

8/8/2019 35427-01-prc-tacr

16/209

Hebei Provincial Development Strategy Chreod Ltd.Case Study B1: South Korea Heavy Industry Restructuring 14 May 2004

2004 Economic Competitiveness Group, Inc. All Rights Reserved.

Korea, Inc.: A Review of South Koreas

Experience Upgrading its Heavy and Chemical

Industries in the 1970s and 1980s

Prepared for:

Chreod Ltd.111 Sparks Street, Suite 200

Ottawa, OntarioCanada K1P 5B5

Submitted by:

Economic Competitiveness Group2236 Sixth Street, Suite BBerkeley, CA 94710 USA

Tel (510) 849 8400 * Fax (510) 849 8406Email: [email protected]

www.ecgroup.com

8/8/2019 35427-01-prc-tacr

17/209


2004 Economic Competitiveness Group, Inc. All Rights Reserved.

Table of Contents

1. INTRODUCTION............................................................................................................................... 1

2. HISTORICAL SETTING: UNDERLYING REASONS FOR UPGRADING .............................. 33. IMPLEMENTATION STRATEGY: HOW ACCELERATION IN SOUTH KOREANINVESTMENTS AND EXPORTS WAS ACTIVATED........................................................................... 4

TABLE 1: KOREAS INDUSTRIAL VISION AND STRATEGY .......................................................................... 4THE INTERVENTIONIST STATE .................................................................................................................... 5

Top-Down Policy-Making Process ....................................................................................................... 5State as the primary driver of entrepreneurial activity for big businesses ........................................... 6Protectionist Policies: Subsidies and Price Controls .......... ........... ........... .......... ........... ........... .......... 6 Incentive Packages................................................................................................................................ 6Discipline the State Exercises over Private Firms................................................................................ 7Knowledge Transfer and Development of R&D ................................................................................... 8 Importance of Foreign Direct Investment............................................................................................. 8

Debt Financing and Productivity.......................................................................................................... 9SKILLED WORKFORCE ................................................................................................................................ 9

4. THE CHAEBOL: MAGNITUDE AND CAUSES OF CHAEBOL CONCENTRATION ........ 10

INTER-CHAEBOL OLIGARCHIC COMPETITION........................................................................................... 11CASE STUDY 1:THE ELECTRONICS INDUSTRY ......................................................................................... 12

Limits of Government Discipline: 1979-1982 Restructuring ........... .......... ........... ........... .......... ........ 13

5. SME SECTOR DEVELOPMENT .................................................................................................. 14

SME Support System Policy Chronology............................................................................................ 14Subcontracting .................................................................................................................................... 14Collective Support System................................................................................................................... 15

CASE STUDY 2:SMES-AUTOMOBILE PARTS AND COMPONENTS INDUSTRY ............................................ 16

6. SUSTAINABILITY OF OUTCOMES............................................................................................ 17

TABLE 2:RATES OF MANUFACTURING GROWTH IN ASIAN TIGERS (% PER ANNUM)................................ 17THE 1997ECONOMIC CRISIS .................................................................................................................... 17CHANGING MARKETS AND COMPETITION FROM LOWER-COST PRODUCERS IN OTHER COUNTRIES:MOVING UP THE VALUE CHAIN ................................................................................................................ 19

7. CONCLUSION ................................................................................................................................. 21

8/8/2019 35427-01-prc-tacr

18/209


2004 Economic Competitiveness Group, Inc. All Rights Reserved. B1-1

1. Introduction

South Koreas evolution from a backwards country to an economic powerhouse offersconsiderable insight for other transitional economies interested in making a similar transition.

Indeed, South Korea was one of the first countries to attempt to penetrate world export marketswith little more competitive advantage than low wages. South Koreas economic policiesefficiently modernized its heavy and chemical industries (HCI) among others and the countrysimpressive recent economic record speaks for itself:

Believing that the developed markets of western Europe and North America were openenough to absorb labor-intensive manufactures in large quantities the governmentscentral objective of export-led industrialization has resulted in the value of merchandiseexports growing from 10% of GDP in the early 1970s to nearly 40% in 2003;

In 1973, the manufacturing industry accounted for a quarter share of the nations GDP.This share grew to nearly one-third by 1988 and since then has stabilized around 30%;

Manufacturing's real value added rose at an average rate of 16.9% per year between 1963and 1978;

The share of HCI products in total exports rose from 21.3 % in 1972 to 34.7 % in 1978.

In the electronics industry, production of radios increased from 158,000 units in 1963 to6.7m in 1976 and 9m in 1986. Production of color television receivers began in 1975 androse to 10m in 1988, before peaking at 21.5m in 1996. Electronic calculator productionalso began in 1975. South Korea has been making refrigerators since 1968, cameras since1980, and videocassette recorders and microwave ovens since 1982;

In the steel industry, lead by the success of Pohang Iron and Steel (POSCO), one of theworld's largest and most efficient steel producers, South Korea now ranks alongsideJapan, China and the US as one of the world's largest steel producers;

In the automotive industry, South Korean production grew from 935,271 cars and

225,328 trucks in 1990 to 2.7m passenger cars and 274,698 trucks in 2002; In terms of technological advancement, Samsung Electronics has become a world leader

in the export of memory chips, having closed the gap that separated it from Japanese andUS firms in this specialized field in a short period of time and the automotive industryhas moved beyond the utility stage to one in which, without competing head on withJapanese technological excellence, it provides good value for money within thetechnological niche that it has established.

1

The overriding salient features of South Korean economic growth have been: the immenselyactive role the central government has taken in almost every facet of the economy; thegovernments top-down strategic planning process; and the emergence of large, diversifiedbusiness groups, or chaebol. Growth began to accelerate when the central authority, once tooweak to defend itself against foreign aggression, became strong enough to mediate market forcesto advantage.2 The governments central strategy was to build up a strong indigenous industrial

1 The Economist Intelligence Unit. South Korea: Country Profile 2004.2 Amsden, Alice H. Asias Next Giant: South Korea and Late Industrialization. Oxford University Press, NewYork, 1989.

8/8/2019 35427-01-prc-tacr

19/209



and technological base by building up large private conglomerates. 3 And South Koreas lateindustrialization has been largely a process of the chaebol diversifying into new industries on thebasis of their technological capability rather than individual entrepreneurs acting as independentagents of further industrial change on the basis of their personal experience and education.4

But potential enthusiasm pertaining to the incorporation of the South Korean model intotransitional economies current economic polices must be tempered by the facts that theprotectionist policies that in great part nurtured the South Korean economy to its position ofprominence occurred in a pre-WTO world, and there are numerous examples of other transitionaleconomies that employed similar economic policies that have not fared nearly as well. And asthe enormous financial crisis that struck Korea in 1997 clearly demonstrated, an unintendedconsequence of the countrys economic growth strategy that seemingly could do no wrong, wasthat it actually created pervasive structural problems that directly led to the financial meltdown.These structural problems, coupled with the growing threat of low-cost competitors and therestraints against protectionist policies membership in the WTO entails, compel many analysts toquestion the long-term sustainability of South Koreas state-driven economic model.

Many economic development professionals presently advocate a more bottom-up approach tostrategic economic planning where the private sector is the primary driver and economicinitiatives are formulated via a collaborative process involving the public and private sectors, thenon-profit/NGO community and other stakeholders. For transitional economies that aregoverned by the rules and regulations embodied in the WTO, implementing this type of bottom-up economic planning process increases the likelihood of consensus in regards to economicinitiatives across regions, industries, sectors and institutions.

3 Lall, Sanjaya. Competitiveness, Technology and Skills. Edward Elgar Publishing Limited, UK, 2001.4 Amsden, Alice H. Asias Next Giant: South Korea and Late Industrialization. Oxford University Press, NewYork, 1989.

8/8/2019 35427-01-prc-tacr

20/209



2. Historical Setting: Underlying Reasons for Upgrading

The following excerpt succinctly captures the underlying reasons behind South Koreas lateindustrialization push:

The journey to industrialization began in the early 1960s with the introduction of FirstFive-Year Economic Development Plan. It was at this point the government made aconscious policy shift from the inward-looking growth strategy of import substitution tothe outward-looking growth strategy of export promotion. The essence of exportpromotion growth strategy was to promote exports of light manufactured goods in whichKorea possessed comparative advantage given its cheap labor cost. The governmentutilized various macroeconomic mechanisms at its disposal in implementing this strategy,such as maintaining high interest rates to mobilize domestic savings, and enacting theForeign Capital Promotion Act to encourage the inflow of foreign investment.

In order to promote exports, the government also devalued the currency by nearly 100 %and replaced the previous multiple exchange rate system with a unified exchange rate. Italso provided short-term export financing, allowed tariff rebates on materials importedfor re-export use, and simplified customs procedures.

The worldwide commodity shortage of 1972-1973 and the oil shock of 1973-1974 merelycompounded the problem. Korea had to respond decisively to the deteriorating tradebalance by modifying its export promotion strategy. The measures undertaken by thegovernment were to restructure the composition of commodity exports in favor of a moresophisticated, higher value-added products and to diversify its trade partners.

To upgrade the composition of its exports, Korea turned to HCI. With the announcementof the Heavy and Chemical Industry Development Plan in 1973, the government set forthan accelerated development schedule for technologically sophisticated industries.Investment in new industries produced significant results, and the country soondeveloped successful undertakings in electronics, shipbuilding, and other fields.5

5http://www.asianinfo.org/asianinfo/korea/eco/start_of_growth_in_the_1960s.htm andhttp://www.asianinfo.org/asianinfo/korea/eco/heavy_and_chemical_industry_prom.htm

8/8/2019 35427-01-prc-tacr

21/209



3. Implementation Strategy: How Acceleration in SouthKorean Investments and Exports was Activated

According to Alice Amsden, late industrialization is characterized by three facets of growth:6

1. Diversification, or entrepreneurial decisions concerning penetration of new industries-which ones to penetrate, when, and with what size investment.2. Stabilization, or short-run macroeconomic policies to maintain the level of economic

activity.3. Growth momentum, growth gains a momentum whose properties are distinct, depending

on the presence or absence of new technological discoveries.

To incorporate these facets of growth into a comprehensive economic policy, South Koreaseconomic model focused on five key issues outlined in Table 1 below:

Table 1: Koreas Industrial Vision and Strategy7DeepeningIndustrialStructure

RaisingLocal

Content

FDI Strategy RaisingTechnological

Effort

Promotion ofLarge LocalEnterprises

Strong trade andcredit interventionsto promote capital,skill andtechnology

intensive industry,especially heavyintermediates andcapital goods.Selective exporttargeting andpromotion

Stringent localcontent rules,creating supportindustries,protection of local

suppliers,subcontractingpromotion

FDI kept outunless necessaryfor technologyaccess or exports,joint ventures and

licensingencouraged

Ambitious plansfor R&D inadvanced industry,heavy investmentin technology

infrastructure.Targeting ofstrategictechnologies

Sustained Drive tocreate giant privateconglomerates tointernalizemarkets, lead

heavy industry,create exportbrands

6 Amsden.7 Lall, Sanjaya. Competitiveness, Technology and Skills. Edward Elgar Publishing Limited, UK, 2001.

8/8/2019 35427-01-prc-tacr

22/209



To pursue this industrial vision, South Korea leveraged several institutions that have accentuatedits success in becoming a late industrializing nation. These include:8

1. An interventionist state2. Large diversified business groups

3. An abundant supply of competent salaried managers4. An abundant supply of low-cost, well-educated labor.

The Interventionist State

Top-Down Policy-Making Process

South Koreas economic decision-making and planning is extremely top-down in nature.When preparing five-year development plans, the Economic Planning Board (EPB) issued,preliminary guidelines in terms of major policy targets and directions, together withmacroeconomic projections for both the international and domestic environment of the economyduring the plan period and beyond.Individual ministries then formulate[d] their own sectoral

plans in accordance with the guidelinesIt is noteworthythat policy proposals prepared by theministries are seldom open to the public for discussion and popular reactionThe lack ofconsensus-building in the policy-making process reflects a top-down approach to governmentpolicy formulation. 9

Given this top-down approach, every major shift in industrial diversification in the 1960s and1970s was activated by the central government:

10

The state masterminded the early import-substitution projects in cement, fertilizers, oilrefining, and synthetic fibers-the last greatly improving the profitability of the over-expanded textiles industry;

The government also kept alive some unprofitable factories inherited from the colonial

period, factories that eventually provided key personnel to the modern general machineryand ship-building industries;

The transformation from light to heavy industries came at the states behestin the early1960s;

The governmentwas responsible for the Big Push into heavy machinery and chemicalsin the late 1970s;

The government also laid the groundwork for the new wave of import substitution thatfollowed heavy industry and that carried the electronics and automobile industriesbeyond the simple stage of assembly;

The government enacted the automobile protection law [in] 1962 [and] promoted the oil-refining industry.

8 Amsden.9 Ibid.10 Ibid.

8/8/2019 35427-01-prc-tacr

23/209

8/8/2019 35427-01-prc-tacr

24/209



Discipline the State Exercises over Private Firms

An interesting characteristic of South Koreas state intervention-oriented economic expansionpolicy that strove to create price distortions that direct economic activity toward greaterinvestment was the degree South Korea of discipline the state exercised over private firms. Thechaebol, consolidated [their] power in response to the governments performance-based

incentives. In exchange for good performance in the areas of exports, R&D, or new productintroduction, leading firms were rewarded with further licenses to expand, thus enlarging thescale of big business in general. In exchange for entering especially risky industries, thegovernment rewarded entrants with other industrial licenses in more lucrative sectors, thusfurthering the development of the diversified business group in particular.16 The result of thisapproach was that the government repeatedly supported a small set of big business groups inexchange for good performance which was evaluated in terms of production and operationsmanagement rather than financial indicators.

Given the export-orientation of the South Korean economy over the past half century, it is notsurprising that the strictest disciplinary measure imposed by the government related to export

targets. Additionally, firms have been subject to five general controls in exchange forgovernment support:

1. The government has owned and controlled all commercial banks.Government controlof the purse has helped orient the chaebol toward accumulating capital rather than towardseeking rents.

2. In luring firms to enter new industries with the plums of protection an subsidies, thegovernment has imposed discipline by limiting the number it has allowed to enter(although usually to not fewer than two firms per industry). This has ensured therealization of scale economies.

3. Discipline has been imposed by on market-dominating enterprises through yearly

negotiated price controls, in the name of curbing monopoly power.4. Investors have been subject to controls on capital flight, or the remittance of liquid capital

overseas. [This measure is] believed to have been a credible deterrent to private investorswho otherwise might have used public subsidies to build personal fortunes abroad.

5. The middle classes have been taxed, and the lower classes have received almost nothingin the way of social services. This has enabled a persistent deficit in the governmentaccount to reflect long-term investments. 17

The importance of the governments central disciplinary role cannot be overstated:

These interventions shaped the nature of industrial development at a very detailed-oftenproduct and technology-level. There was also the technological effort needed to competein world markets, with export orientation providing the discipline on firms andbureaucrats. Entire sets of industries were promoted together to exploit linkages and

16 Amsden.17 Amsden.

8/8/2019 35427-01-prc-tacr

25/209

8/8/2019 35427-01-prc-tacr

26/209



The government permitted FDI only when other means of accessing technology were notavailable; it consistently sought to keep control firmly in local hands. Foreign majorityownership was not permitted unless it was a condition of having access to closely-help

technologies, or to promote exports in internationally integrated activities. Some MNCswere induced to sell their equity to local partners once the technology transfer was

complete.the government pushed local firms to acquire independent capabilities [suchas] the mastery and improvement of imported technologies to the absorption of foreignmanagement practices and, later, to innovative R&D.

The government also intervened in major technology contracts to strengthen domesticbuyers. It sought to maximize the participation of local consultants in engineeringcontracts to develop basic process capabilities. The 1973 Engineering Service PromotionLaw protected and strengthened domestic engineering services. The Law for theDevelopment of Specially Designated Research Institutes provided legal, financial andtax incentives for private and public institutes in selected activities. (emphasis added) 21

Debt Financing and Productivity

Rising productivity was also a critical factor in South Koreas rapid return to growth. Anoteworthy detail concerning South Korean industrialization is that at the beginning and end ofthe period of massive foreign borrowing to finance heavy industry, the debt/GNP ratio remainedmore or less constant, falling slightly from 34% in 1972 to 32% in 1979. 22

Rather than utilizing austerity measures to minimize external shocks, the South Koreangovernment has been reluctant to adopt expansionary policies and borrow its way out of balance-of-payments difficulties. This has been possible because heavy foreign borrowing has beenbalanced by large productivity increases. In general, and dependent on institutional constraints:

High growth rates of output generate high growth rates of productivity, and vice versa.There is circular and cumulative causality. Once started, a momentum builds betweengrowth and productivity that drives industrialization forwardOn the one hand, thiscumulative relationship between productivity and growth underscores the importance ofgovernment intervention to keep momentum going. On the other hand, the fact thatproductivity has little to do with imminent events at the world technologic frontier andmuch more to do with production capability-investing in foreign designs, producing atthe appropriate scale, and learning-by-doing-highlights the importance of firm-levelmanagement practices.23

Skilled Workforce

Another important component of South Koreas policy to expand its indigenous capacity was thegovernment-driven initiative to develop a native force of engineers and technicians. Thedevelopment of engineering-oriented and technically-experienced workforce was deemed

21 Lall.22 Amsden.23 Amsden.

8/8/2019 35427-01-prc-tacr

27/209



important because, salaried engineers are a key figure in late industrialization because they arethe gatekeepers of foreign technology transfers. 24In addition, key features of South Koreas towards workforce developing program include:

1. Korean firms have shown a preference for hiring engineers over administrators.

2. Even as managerial capitalism in Korea has spread, overhead has been kept incheck.They have appointed mangers to production positions on the shop floor, which iswhere the competitive advantage of late-industrializing countries lies.

3. The number of layers of management has been kept quite small in Korea.

4. The Chaebol: Magnitude and causes of ChaebolConcentration

As Alice Amsden notes:

Below the level of the state, the agent of expansion in all late-industrializing countries isthe modern industrial enterprisedescribed as large in scale, multidivisional in scope andadministered by hierarchies of salaried managersIn Korea, the modern industrialenterprise takes the form of the diversified business groups, or chaebol.

In addition to the economies of scale that the chaebol developed as a result of the governmentseconomic policies, they also developed important economies of scope that arose in the form oftheir capability to diversify. In the United States, the tendency has been for firms to build anddiversify on areas of expertise and specialization. In late-industrializing countries, with littleexpertise, the tendency has been to diversify into unrelated areas. For example, the Hyundaigroup branched out vertically from construction to cement manufacture and shipbuilding, andfrom shipbuilding to shipping and steel structures. The Samsung Group diversified horizontallyin entertainment with a broadcasting company, a daily newspaper and a hotel. Before 1980, the

chaebol grew primarily by internal investment. Subsequently, acquisition was their primaryvehicle of growth. Moreover, the chaebols increased productivity allowed the government touse borrowing as a tool to nullify balance-of-payment difficulties and sustain fast growth,aggressive borrowing coupled with bailouts of financially troubled firms created a supportiveenvironment for big business.

Additionally, import-substitution played a great role in the consolidation of the chaebol involvedin heavy industries:

The chaebol have their antecedents not in the cotton spinning and weaving but in thesimpler import-substitution heavy industries that the government encouraged on the

periphery of [light manufacturing]the importance of [import-substitution activity]stems from the fact that even the simple heavy industries like cement have qualitativelydifferent technologies-and hence, modes of competition-from those of the labor-intensivepursuits like cotton spinning and weaving. The heavy industries expand by capitaldeepening, or a rise in the capital/labor ratio, rather than capital widening, or amultiplication of production units with the same ratio of capital to labor.

24 Amsden.

8/8/2019 35427-01-prc-tacr

28/209



These policies had reinforcing effects as the chaebol developed their own internal capacitieswhich strengthened the willingness and ability of chaebol to be a more active partner in the statediversification effort. Two factors propelling this willingness on the part of the chaebol to aligntheir interests with the central governments overall diversification effort include:

1. The modern industrial enterprises acquired more technical and business experience.Their opinions then gained more respect in terms of decisions about which industries,when, and on what scale.

2. The modern industrial enterprises came to appreciate not just the high risks of enteringthe heavy industries but also the high rewards.

The chaebol were able to grow quickly and prosper due to a variety of reasons:

1. Bought industry-specific technical expertise;2. Borrowed abroad with credit guarantees and subsidies from the government;3. After growth, were able to hire experienced, salaried managers;

4. Transferred qualified managers from established groups to new subsidiaries;a. Business groups were multi-product yet still governed by overall group

management and strategy;5. Korean management accumulated experience in the areas of feasibility studies, task force

formation, purchase of foreign technical assistance, training, equipment purchase, newplant design and construction and operation start-up. This experience became aninvaluable competitive asset in the absence of proprietary technology because it allowedthe chaebol to be Koreas first movers in many industries.

6. Risk diffusion shifted people and money around the group to increase the probabilitythat risk-diffusing projects would earn profits.

Inter-Chaebol Oligarchic CompetitionAnother noteworthy fact concerning the development of the chaebol is that because the EPBcontrols most prices, the chaebol mainly compete on non-price factors. These include:

1. Competition for industrial licenses and other favors from government;2. Competition for foreign technical licenses;3. Competition for labor;4. Competition in the marketplace on the basis of quality and delivery.

Thus, the centrally-planned approach to economic development that characterizes the SouthKorean model still allowed for a high degree of competition between the various chaebol which

allowed them to develop specific areas of expertise and in-house capabilities relative to oneanother.

8/8/2019 35427-01-prc-tacr

29/209



Case Study 1: The Electronics Industry 25

In 1969 the Electronics Industry Promotion Law was enacted to stimulate

investments in assembly operations of black-and-white televisions in order to:o Change the electronics industry structurally from assembly-type

production to one which produced mainly basic components and parts.o Promote the electronics industry as a major export industry through the

development of new technology products and the expansion of overseasactivities.

o On the basis of product life cycles and comparative advantage, 57 itemsincluding semiconductors, computers and related items selected asstrategic products.

To promote higher value-added products, the government took steps which alsoincluded $221.6 million in foreign loans:

o Established an industrial estate for the production of semiconductors andcomputers.

o Established the Electronics and Telecommunication Research Institute(ETRI) for product development, and allocated it a $60 million fund.

o Protected the domestic market from international competition by passinglegislation in 1983 restricting imports of computers and peripherals in thelow and medium market segments.

o Restricted direct foreign investment in electronics, however thegovernment encouraged joint ventures.

In semiconductors, implemented the VLSI project which involved collaborationbetween private sector R&D labs and public sector institutes.

In 1983:o The government contributed $28 million to 182 research projects of 131

firms.o The government contributed $40 million to 7 semiconductor and

bioengineering projects.The government also:

o Set aside a lower tariff rate on equipment imported for R&D.o Allowed firms to tax-exempt a percentage of profits for a fixed period for

investment in R&D.

25 Amsden.

8/8/2019 35427-01-prc-tacr

30/209



Limits of Government Discipline: 1979-1982 Restructuring

By the late 1970s however, the government began to see the advantage in curbing the chaebolsmonopolistic power by encouraging the development of the SME sector. The government wasinterested in stimulating SME productivity through state-led coordination and management so

that the income ratio of SMEs would not be less than that of the bigger enterprises.

In pursuit of diversification into the SME sector, instead of regulation, the government choseliberalization, as the meansto discipline big business and reverse the institutional legacy oftwo decades of state controls.26 The government implemented a structural adjustment packagein 1980 that:

In effectliberalized [South Koreas] imports slowly, though on paper the number ofquantitative restrictions and tariff rates came down rather rapidly.the governmentretained strong elements of industrial policy while withdrawing from some of the morepervasive and detailed interventions it had undertaken in the 1970s under the HCI drive.The liberalization itself was carefully formulated so as not to damage existing industries,pre-announced to give enterprises time to adjust, variegated to suit industrial needs andaccompanied by large sprinklings of infant industry promotion. As a result, [South]Korean industry continued to grow with no noticeable loss of production, exports oremployment; perhaps more importantly, he process of technological deepening continuedapace, with the heavy industries launched in the previous decade taking over the bulk ofmanufacturing and export activity.27

Thus, the government liberalized imports (to a degree) and to compensate the chaebol, thegovernment rewarded big business with freer financial markets.

1. Government reduced regulation of nonblank financial intermediaries (NBFIs), many ofwhich had long been controlled by the chaebol;

2. Denationalized commercial banks.

However, these measures in general did little to minimize the monopolistic power of the chaebolas they were able to successfully gain control of individual banks. In the new regulatoryenvironment, they used their new financial resources to:

1. Buy state enterprises that were being privatized;2. Buy financially troubled firms, sometimes at the governments instigation.28

Thus consolidation actually increased as a result of these liberalization policies. The increase inconcentration was especially sharp at the aggregate level where the share of manufacturingoutput of the largest business groups rose from 32.8% in 1979, to 67.4% in 1984. As the World

26 Amsden.27 Lall.28 Amsden.

8/8/2019 35427-01-prc-tacr

31/209

8/8/2019 35427-01-prc-tacr

32/209



the remainder of the productive economy. 32 Subcontracting has served as a transfermechanism in three manners:

1. Prime contractors impose on-time, on-spec delivery conditions on subcontractors;2. Subcontractor production systems have become extensions of those prime contractors

3. Salaried managers have been transferred to supplier firms.

33

South Koreas efforts in the area of SME subcontracting have had positive effects. In 1968 only18.6% of Koreas SMEs received revenue from subcontracting, which grew to 70% by 1990.This development is important because, subcontracting can act as a substitute for experience oreducational background. 34

Collective Support System

In addition a comprehensive collect support system has developed in South Korea to sustain theSME sectors development:

The collective support system for small and medium-size enterprises (SMEs) is moreimportant in [South] Korea than in other countries, but is less important than privatesupport mechanisms. The success of [South] Korea's collective support lies in well-functioning governance structures, in which hierarchical controls and human resourcepolicies are especially important.

Although [South] Korea has a dense network of public technology-support institutions,[South] Korean SMEs tend to turn to private sources of technical support (especiallyfrom buyers, suppliers, and moonlighting engineers) more often than to publicinstitutions. Even so, some collective support was used often and valued highly,especially in technologically dynamic sectors.

For technical assistance to be timely and relevant, its delivery must increasingly bedecentralized-to industry-specific institutes and to geographic clusters of SMEs in thesame industry. Generally, networks of local agents and foreign traders developed asfirms gained in export experience.35

32 Amsden.33 Amsden.34 Kim & Nugent.35 Kim & Nugent.

8/8/2019 35427-01-prc-tacr

33/209



Case Study 2: SMEs-Automobile Parts and Components Industry 36

Before 1960, South Koreas auto parts sector existed only to meet replacement

demand for imported military vehicles and to rebuild civilian vehicles frommilitary equipment.

In the 1960s, the government designated the auto industry as a strategic sector.

In 1962, South Korea began assembling Japanese Nissan cars.

In 1979, government designated automobiles one of the nations ten strategicexports and began to set progressively higher local content requirements.

o Auto parts of SMEs began to qualify for targeted export finance. The government provided guidelines for linkages between chaebol auto

assemblers and smaller automobile parts firms, specifying which items werereserved for SME subcontractors.

South Koreas automobile production rose from 28,000 in 1970 to 123,000 in

1980 to 1.5 million in 1991. South Koreas automobile parts exports grew from 37.1 million in 1983 to 417.2

million in 1991 while the SME share of automobile parts exports rose from 9.6%to 44.1% in the same period.

A lack of in-house technological expertise exists among automobile parts SMEs.o Stimulus for SMEs in the automobile parts sector to meet the demands of

assemblers comes largely from the auto assembly firms that place orderswithin the SMEs, rather than from within the firm itself.

o Since technical specifications are determined by the final assemblers,international exhibitions and other imitative forms of technical assistanceare of little value to South Korean automobile parts makers.

However, South Korean automobile parts SMEs are upgrading their technologicalcapabilities.

o SMEs are using various sources of support for product and processimprovements including the The Small and Medium Industry PromotionCorporation (SMIPC) and the Industrial Advancement Administration(IAA) for most technical assistance and the Korea Productivity Centerand the Korea Standards Association for most training.

Nevertheless, car assemblers demand for increasingly sophisticated parts hasmotivated SMEs to seek further product innovations.

o The industry specific trade association, Korea Academy of IndustrialTechnology (KAITECH) is assuming a role to improve collective supportsystems in the automobile sector.

36 Kim & Nugent.

8/8/2019 35427-01-prc-tacr

34/209



6. Sustainability of OutcomesAs the economic indicators on Page 1 and Table 2 demonstrate, South Koreas policies resultedin remarkably robust manufacturing growth relative to three other Asian Tigers that werethemselves, concurrently experiencing unprecedented, prolonged periods of economic growth.

Table 2: Rates of Manufacturing Growth in Asian Tigers (% perannum)37

1980-85 1985-90 1990-93

Korea 9.3 10.3 4.6

Hong Kong 3.0 2.9 -1.1

Singapore 1.3 10.3 4.4

Taiwan 6.5 5.8 3.4

Moreover:

Over the past four decades, South Korea has enjoyed an average economic growth rate of8.6% per year and has emerged as the worlds 11th largest trading nation, establishingitself as one of the worlds leading shipbuilders, and a leading manufacturer ofelectronics, semiconductors and automobiles. These achievements enabled the country tojoin the Organization for Economic Cooperation and Development in 1996.38

The 1997 Economic Crisis

Though South Koreas economy has obviously witnessed impressive growth over the past fewdecades, competitive pressures from low-cost producers and the financial crisis the countryexperienced in 1997 illustrate that these same economic policies have also left the economy

rather vulnerable in some respects. This has forced some analysts to question the merit of theSouth Korean economic model. :

On October 1997, the Korean Stock Exchange began to plunge followed by a sharp fallof the Korean Won against dollar. Economies in Southeast Asia such as Thailand andIndonesia have already developed instabilities in their markets, to termed "crises", andthe changes occurring in Korea was seen as a part of a regional contagion effect derivingfrom the Southeast Asian crisis. However, by November 21, Korea's foreign reserveswere nearly depleted, and to prevent the total collapse of the economy, the governmentannounced that it would seek emergency loan from the International Monetary Fund(IMF) to overcome the difficulties in the financial and currency markets.39

One of the primary causes of the economic crisis directly related to the chaebol and theirextraordinary influence on the South Korean economy.

37 Lall.38 http://www.kieff.com/gary/StudentExamples/South%20Korea/SK_econ_labor.htm39 http://www.asianinfo.org/asianinfo/korea/eco/economic_crisis_of_1997.htm

8/8/2019 35427-01-prc-tacr

35/209



[A] factor behind [South] Korea's economic vulnerability was the highly leveragedcorporate financial structure. The corporate debt relative to nominal GDP ratio waslowest in 1987-1988 when [South] Korea enjoyed current account surpluses. However,since then, the ratio increased substantially to reach over 1.6 in 1996. Due to the highlyleveraged financial structure, largely driven by the over-investments of [South] Korean

conglomerates, chaebol, the corporate sector has become increasingly vulnerable tounfavorable shocks.

Such deficiencies in [South] Korea's economic structure were the legacies of its pastdevelopment process. The 30 years of government-led growth process created a close andcollusive relationship between the government and chaebol. Chaebol often engaged inprojects at the government's bidding and the government, in turn, implicitly providedinsurance against project failures. The society as a whole came to accept the so-called"too-big-to-fail" expectation. Under such a belief, the business firm's main concernbecame expansion in size rather than to earn profits. To finance the expansion ofbusinesses, firms chose the option of debt-financed growth rather than equity-financed

growth. The high debt-equity ratio that resulted from such strategy exceeded 400 % bythe end of 1997, and the average ratio for the 30 largest chaebol reached 518 %.

Unfavorable terms of trade shocks in 1996 severely damaged profits of Koreancorporations in 1997. Series of corporate bankruptcies, even among the major chaebols,including Hanbo, Kia and Yuwon, increased the size of outstanding non-performing bankloans at an astounding speed. The deterioration of the corporate sector translated into theweakening of the financial sector. The stringent lending policies adopted by financialinstitutions in an attempt to minimize the effects of a worsening economic situation,resulted in the shortage of capital which further increased the number of bankruptcies.

In other words, insolvent corporations and financial institutions damaged Korea'scredibility abroad, leading to foreign capital flight. The vicious cycle of foreign exchangeshortage and deterioration of Korea's credibility developed into a full-fledged foreignexchange crisis at the end of 1997. 40

In sum, by taking the top-down economic policy approach that effectively facilitated theconsolidation of the chaebol, the South Korean government unintentionally instituted numerousstructural problems into the economic system that have come back to haunt it. Many of theseproblems were rooted in a, distorted incentive structure which encouraged overexpansion ofcorporate investment and misaligned relative prices, especially the overvalued exchange ratewhich distorted resource allocation and reduced export competitiveness.41

40 http://www.asianinfo.org/asianinfo/korea/eco/economic_crisis_of_1997.htm41 Cho, Yoon Je. The Financial Crisis in Korea: Causes and Challenges. Professor, Graduate School ofInternational Studies, Sogang University, Seoul, Korea, 1998.

8/8/2019 35427-01-prc-tacr

36/209



Changing Markets and Competition from Lower-cost Producers inOther Countries: Moving up the Value Chain

And even though South Korea has rebounded well from the 1997 economic crisis, the countryscontinued economic growth is by no means assured. The country faces the same competitive

pressures that all members of the WTO presently do. And as South Korea has moved into therealm of developed countries, it is beginning to be confronted by the competitive threat posedby low-cost economic rivals, namely China:

Even the Asian financial crisis, severe as it was, may prove to have less of an impact onKorea's future than China will have. China last year overtook the U.S. as the topdestination for Korean exports. This year, the gap will widen, as exports to China jump35%, to $47.5 billion, compared with a 7% rise, to $36.7 billion, in exports to the U.S.Some 25,000 Korean companies -- many small or midsize -- manufacture in China, and adozen or so new ones make deals everyday. Korea's leading zipper maker, YBS, last yearmade $20 million worth of zippers in China. JS International Co. closed its factory in

Korea last year and now makes some $8 million worth of shirts every year in China forJapanese brands. "Dyeing and sewing are simply too expensive in Korea," says JSPresident Park Chang Ik.

If Seoul gets too dependent on China, the thinking goes, it could end up as a satellite, withlittle competitive advantage intact to keep South Korea growing. An early warning sign:Korea's National Science & Technology Council in December reported that Korea is only1.7 years ahead of China in the sophistication of its technology, and that the gap couldshrink to zero within five years. In the crucial cell-phone market, Korean companies todayonly have a two-year lead over their Chinese rivals in terms of new products andtechnologies. By 2007, Chinese companies will have caught up, Korea's CommerceMinistry says.

Unless something is done to increase Korea's competitiveness, its current $13 billion tradesurplus with China will become a deficit by 2011, cautions the Korea International TradeAssn. "China has been a goose laying golden eggs," says Jeon Byeong Seo, head ofresearch at Daewoo Securities Co. in Seoul. So golden, in fact, that last year he requiredall his analysts to include some discussion of the "China effect" in every report. Jeonwarns, however, that "Korea's prosperity will depend largely on how long companies cankeep this goose alive."

So far, the benefits have largely flowed to Korean corporations, not their workers. AndKorea's labor laws and union contracts may not be flexible enough to adapt to thechanges. Since 1992, 770,000 manufacturing positions have disappeared from Korea. Inthe same period, Korean companies have created well over 1 million jobs in China. "Areckless corporate exodus has accelerated since last year," says Lee Jung Sik, a seniordirector at the Federation of Korean Trade Unions, whose membership has fallen by110,000, to 890,000, in the past six years.

For decades, the Korean economy depended on low-cost manufacturing. But themanufacturing arms of the country's textile and shoe makers have largely been relocated

8/8/2019 35427-01-prc-tacr

37/209



to China. Petrochemical, steel, lower-end shipbuilding, white goods, and even electronics-- except for a handful of leading-edge products -- will likely face a similar fate withinfive years. These industries employ about half of South Korea's workforce, so it is vitalfor Korea to create more jobs in services and high-end manufacturing, says Woo CheonSik, senior economist at think tank Korea Development Institute. "Demand from China

will benefit only a small number of leading companies," Woo says. "For the rest, China ismore of a threat." That threat is starkly revealed in rising corporate defaults in Korea,which hit an all-time monthly high of 133,195 in January, up 14% from 116,707 a yearearlier, according to the Korea Federation of Banks.

Auto parts are another example of the phenomenon. Korean companies last year sold$944 million worth of mufflers, door handles, windshield wipers, clutches, and headlights,more than five times the $169 million recorded in 2002. But Chinese companies arecoming on strong. They are already competitive with the Koreans in making bearings,seats and seat belts, air-conditioners, and bumpers.

And the problem goes beyond autos. Parts and intermediary goods account for nearly 70%of Korea's exports to China. But the local content in China's manufactured goodsincreased to 49.9% in 2001 from 34.8% in 1999, according to the Export-Import Bank ofKorea. One victim: Kohap Ltd., a Seoul-based textile firm that once employed 2,000workers in Korea and had revenues of more than $1 billion. Rapid development ofsyntheti

35427-01-prc-tacr

Documents