SEOUL – In the last half-century, South Korea has become a model for developing countries, with remarkable economic growth enabling it to become the world’s eighth largest trading country and achieve per capita income of $26,000. But lately its economy has been faltering, with GDP growth averaging 3.6% for the last ten years – a significant drop from the 8.1% annual growth rate that prevailed in 1965-2005. And the OECD projects a further decline – to around 2.5% – in the coming decade.

But a forecast is not fate. With a new economic strategy that nurtures more diversified sources of growth, while reducing the country’s excessive reliance on exports and large enterprises, South Korea can reinvigorate and sustain strong growth.

South Korea’s economic performance over the last 50 years was attributed largely to good fundamentals, including a high savings rate, strong human capital, sound institutions, and prudent fiscal and monetary management. Trade openness provided access to inexpensive imported intermediate goods, larger markets, and advanced technologies, thereby contributing to rapid productivity growth in the country’s manufacturing industries. Performance-based incentives facilitated the continuous upgrading of South Korea’s comparative advantage in global markets.

The problem is that such policies have led South Korea to become excessively dependent on exports for growth. Exports accounted for about 56% of South Korea’s gross national income in 2013, compared to 34% in 2002 and just 15% in 1970. As a result, South Korea’s economy has become highly vulnerable to changes in external demand – a fact that became starkly apparent during the 2008 global economic crisis.

South Korea’s relationship with China perfectly illustrates the challenges it faces. As China’s economic growth soared, so did its share of South Korea’s total exports, which doubled, from 12% to 24%, in the period from 2001 to 2013. But China’s economy has recently begun to slow, and its growth trajectory is expected to be much less steep in the coming years than it was over the last three decades.

Moreover, China is posing increasingly tough competition for South Korea, by encouraging the emergence of more technologically advanced industries like electronics, information technology, motor vehicles, semiconductors, shipbuilding, and high-end steel products. China’s efforts to upgrade its own growth model, together with the possibility of long-term stagnation among advanced economies, raises serious concerns about South Korea’s prospects.

Compounding these problems is the wide imbalance between South Korea’s manufacturing and services sectors. Though services account for 76% of employment, its contribution to overall economic growth is small, owing to low productivity. Indeed, value added per worker in the services sector remains just 40% of that in the manufacturing sector, and annual productivity growth was only 2% from 1980 to 2010 – significantly lower than the manufacturing sector’s rate of 8.2%.

Against this background, South Korea’s new growth strategy should aim to achieve both a demand-side rebalancing and supply-side productivity increases.

On the demand side, South Korea must begin by boosting household expenditure. This will require reversing the sharp decline in the proportion of middle-income households, which is down to 67.5%, from 75.4% in 1990. With more than half of these households earning less than they spend every month, household debt has been rising fast, and now stands above 160% of disposable income – one of the highest levels in the OECD. Transferring unused corporate savings to households, while reducing the number of low-wage temporary and part-time workers, would boost domestic demand and reduce income inequality.

Policies aimed at increasing female labor-force participation and lowering private education spending would also help. At the same time, South Korea should work to improve the investment climate to raise the quantity and quality of investment, particularly of small- and medium-size enterprises (SMEs) in the services industry.

On the supply side, structural reforms to stimulate productivity growth could, for example, emphasize the development of modern services industries, including health care, education, telecommunications, business processing, and legal and financial services. Efforts to ease product regulations and lower barriers to foreign investment would promote competition and technological innovation.

South Korea must also dismantle the obstacles that start-up businesses face. To this end, the government must redress shortcomings in the venture-capital market, nurture the labor force’s skills, and encourage entrepreneurship. It must also confront the huge, family-controlled chaebols – such as Hyundai, LG, and Samsung – that contributed significantly to rapid industrialization and technological advancement but also block competition from start-ups and SMEs, stifling dynamism and innovation. Stricter rules are needed to improve corporate governance and prevent unfair practices by those affiliated with the chaebols.

South Korea is at a crossroads. Though President Park Geun-hye’s administration, which took office in 2013, has unveiled many economic initiatives to foster a "creative economy,” their effect so far has been minimal. But her government still has three years to pursue reforms that support the emergence of the services sector, start-ups, and SMEs as South Korea’s new growth engines, capable of powering a more dynamic and innovative economy for the next 30 years.

Lee Jong-Wha, Professor of Economics and Director of the Asiatic Research Institute at Korea University, was a senior adviser for international economic affairs to former President Lee Myung-bak of South Korea.

Copyright: Project Syndicate.