To outsiders, South Korea’s heroic economic ascent is a template for success. But now it has almost caught up with the developed world it must change its approach

IT IS a crisp autumn morning in Seoul, and a hopeful fisherman sits dreaming by the Cheonggyecheon stream as the world bustles happily by. Glass skyscrapers rise behind him housing the capital's new financial district. The shopfronts at their base are among the swankiest in Asia. Office workers, families and schoolchildren amble past. Busking fills the air. The water tumbles past plum trees and willows.

Twenty years ago, this background would itself have seemed a dream for anyone foolish enough to be trying to fish the Cheonggyecheon. Its waters, dirty and hidden, were trapped beneath a roaring highway; its surroundings were a slum of sweatshops, metal bashing and poverty. The reclamation of the Cheonggyecheon, one of the great urban-regeneration projects of the world, has about it the air of a dream achieved. So, to a large extent, has the Korea through which the stream flows.

In 1960, in the aftermath of a devastating war, the exhausted south was one of the poorest countries in the world, with an income per head on a par with the poorest parts of Africa. By the end of 2011 it will be richer than the European Union average, with a gross domestic product per person of $31,750, calculated on a basis of purchasing-power parity (PPP), compared with $31,550 for the EU. South Korea is the only country that has so far managed to go from being the recipient of a lot of development aid to being rich within a working life.

For most poor countries, South Korea is a model of growth, a better exemplar than China, which is too vast to copy, and better, too, than Taiwan, Singapore or Hong Kong. All three are richer than Korea but all are, in different ways, exceptions: Singapore and Hong Kong are city states, while Taiwan's disputed sovereignty makes it sui generis.

South Korea has not merely grown fast. It has combined growth with democracy. Though its spurt began under a military dictator, Park Chung-hee, for the past 25 years the country has had a vibrant parliamentary system. Korea scores the same as Japan in the democracy tally kept by Freedom House, a think-tank in Washington, DC. No other Asian country does as well. At the same time Korea has combined growth with equity. Between 1980 and 1997, its Gini coefficient, a measure of income inequality, fell from 0.33 to an exceptionally low 0.28, before rising back up during the 1997-98 Asian crisis. In 2010, the level was 0.31, a bit worse than Scandinavian countries, a bit better than Canada.

A model that worked

Now Korea can add resilience to its roster of achievements. It was walloped during the global financial crisis, but recovered faster than any other rich country. Between June 2008 and February 2009, Korea lost 1.2m jobs. South Korea's relatively open financial system made it vulnerable to the volatility in world markets, a vulnerability that continues. This September, foreigners withdrew over 1.3 trillion won ($1.1 billion) from the stock market and the currency slumped 10%.

Yet in 2010, GDP grew by 6%. This year's expansion is likely to be 4%. The unemployment rate is now a covetable 3%. Some of the recovery is the result of Korea's happy dependence on China: it exports more capital goods to China relative to the size of its economy than anyone else, even Germany. But this is only part of the explanation (which is just as well given China's slowdown). The government also initiated a public-works scheme that is mopping up over 2% of the labour force. It introduced an old-age pension and began, then expanded, an earned-income tax credit. All this from President Lee Myung-bak, who was once chief executive officer of Hyundai Construction and is widely assumed to be excessively friendly to big business.

Korea's relentless convergence towards America's standard of living (see chart 1) has barely missed a beat. China's dollar GDP per person would have to grow at 7.5-8% a year for 20 years to reach the heights Korea has already scaled. If the Korean economy goes on growing at 4.5% a year and America's at 2.5%, Korea would overtake America (in PPP terms) only a few years later. To keep growing that impressively, though, Korea will need some new tactics. And it will need to develop them from scratch. When a country or a company is playing catch-up it can look at what others are doing and do it better. This Korea has done well. Hyundai has outcompeted Toyota in the market for reliable, efficient, cheap cars. Korea's shipyards have beaten everyone through economies of scale. All change But this way of doing things works only when others have blazed a trail before you. As you join the ranks of the richest, you run out of beaten track to follow. Your economy comes to depend more on innovation and on learning from your own mistakes than on improving on the successes of others. The South Korean model of 1960-2010 remains an example for developing countries; but Korea itself now needs something new.

The Korean model had four distinctive features: a Stakhanovite workforce; powerful conglomerates; relatively weak smaller firms; and high social cohesion. All these are either coming under strain, or in need of reassessment, or both.

South Koreans lay great store by education and hard work. They put in 2,200 hours of work a year, half as much again as the Dutch or Germans. Their reaction to the 2008 slump was to work harder still. During the 2009-10 recovery, reckons Richard Freeman of Harvard University, Korea had the second-largest increase in hours worked in manufacturing, after Taiwan. And the quality of labour has been even more important than the quantity. Along with Finland and Singapore, Korean schools regularly top international comparisons of educational standards, such as those run by the Organisation for Economic Co-operation and Development (OECD), a rich-country club. Korea spends a larger share of GDP on tertiary education than any rich country other than America. Given relatively low wages, this superbly educated workforce is hard to beat.

But with Korea already top of the league tables, it is harder to generate further jumps in income from big increases in hours and skills. Indeed, the immediate problem is merely to maintain its excellence. According to Yeong Kwan Song of the Korean Development Institute (KDI), a think-tank, companies are starting to worry that graduates are emerging from university with the wrong skills. On some estimates, half of recent graduates are failing to find full-time jobs and are going into further study or part-time employment. So while general education remains good, some industrial skills may be declining.

One way to boost the skilled labour force might be to have rather more people working rather fewer hours. The extra people would be women, often highly educated ones. Quite a lot of Korean women stay at home—the participation rate for women aged 25-54 is only 62%, the fourth-lowest in the OECD—even though they are usually better educated than men. In almost all rich countries, the best-educated women are more likely to work than their less-educated sisters. Not in South Korea.

Shorter hours might encourage some of these skilled women into the workforce. So might a change in attitudes to schooling. The job of supervising a child's education falls to women, which is one of the reasons why relatively few women have jobs.

This does not mean that they have a lot of children instead. Korea has a fertility rate of 1.2, one of the lowest in the OECD. This is in part because those good educations make having children a pricey proposition. An unusually large part of the spending that makes Korean education so good is private, not public. The government spends just under 5% of GDP on education, slightly below the rich-country average. Families add an extra 2.8% of GDP on top of that, easily the highest rate in the OECD. At universities, family spending is three times that of the state. And families spend an estimated 8% of their household budgets on after-hours programmes for each child, an investment which explains the effort mothers put into making sure it pays off. If you have three children, their after-school activities alone could swallow up a quarter of the household budget.

The power of conglomerates. Much of South Korea's miracle has been the work of big conglomerates, or chaebol. Barry Eichengreen of the University of California, Berkeley, argues that they are “among the most technologically and commercially progressive agents in the Korean economy”. Samsung Electronics, for instance, one of 83 constituent parts of the Samsung empire, sells more smartphones than Apple. Korea's shipyards have just started work on a new class of container ships called the triple E-class which are easily the largest container ships ever built (Maersk, the ships' buyer, says the three Es refer to economy of scale, energy efficiency and environmental cleanliness; simpler just to see them betokening EEEnormity). Korea's large companies employ slightly less than a quarter of the workforce and produce more than half the country's output. Chaebol-alikes exist round the world, from Carlos Slim's Group Carso in Mexico to Lee Ka-shing's holdings in Hong Kong.

The surviving chaebol have proved resilient. During the 1997-98 crisis, some chaebol's debt-to-equity ratios soared to over 500%; half of themwent bust and conglomerates were widely seen as a drag on the economy. Now, those that came through the time of trial have returned to profitability and respectable debt ratios—but their success still has a downside.

After the founding fathers

The chaebol system has proved prone to fraud, dodgy accounting and illegal political contributions. Many of the companies depend to an unhealthy degree on a founder or his family. About half the managers of Samsung's firms used to work in the chairman's secretariat—and thus directly for the founder or his son—and owe their promotion to the associated patronage. As with any family business, the moment of greatest danger is when the leadership passes to the next generation. Samsung passed this test in 1987 when the founder handed over to his son, Lee Kun-hee. Now Mr Lee's son, Jay Y. Lee, has been appointed chief operating officer of Samsung Electronics and a new transition looms. If Mr Lee the third has business acumen, fine. If not, the whole country could suffer.

Find out how much of an Apple iPhone is actually a Samsung with our "teardown" infographic

Moreover, there are signs that the chaebol may be stifling innovation and entrepreneurship. They have proved expert at applying and improving existing technology, even the high technology of touch-screen smartphones. But except in some internet businesses and computer gaming, South Korea has few start-ups or cutting-edge technology firms. It lacks nationwide venture-capital businesses, says Hasung Jang, the dean of Korea University's Business School, because each chaebol has one of its own. The firms snap up the best and brightest and turn them into company men. Mr Jang compares the conglomerates to light-hogging trees in a forest: their canopy may be impressive, but it is hard for anything to grow underneath.

Koreans perceive fewer opportunities for entrepreneurship than any of their peers in rich countries except Japan, according to an annual survey by the Global Entrepreneurship Monitor, set up by the London Business School and Babson College, Massachusetts. As South Korea moves towards the technological frontier, such attitudes will have to change. Innovation is not going to come if everyone shelters from risk in the chaebol.

Weak small firms. There is a huge productivity gap between Korea's export-oriented chaebol and small and medium-sized firms (SMEs) which dominate services. Value added per worker in small firms is less than half that in large ones. SMEs' operating profits were 4.5% of sales in 2007, compared with about 7% for large firms. Small firms spend about half as much on research and development as large ones per unit of sales and borrow far more relative to assets. Over time, their performance seems to be getting worse. Korea, in short, has first-world manufacturing exporters and third-world services.

Coddled, not coping

There are several reasons for the mismatch. Small firms are crowded out of markets for people and skills by the chaebol. And because chaebol pay scales often rise according to years in service, they squeeze wage bills by firing older workers, with the service sector working as a recycling system for surplus labour. Small firms have also been coddled by the government. Korea maintains various entry barriers to shelter mom-and-pop stores from competition. Government support to SMEs rose from under 6 trillion won in 2008 to 10 trillion in 2009. Public credit guarantees rose from 33 trillion won in the Asian crisis to almost 60 trillion won in 2009. Last year, the government “requested” banks to roll over their loans to small firms. Randall Jones of the OECD argues that all this help has made SMEs less, not more, efficient, and damaged competitiveness. The richest economies are switching into services that in Korea are dominated by small firms which cannot compete.

Social cohesion. Korea's equal distribution of income is changing. Judging by the relationship between the richest and poorest tenth, Korea is becoming more unequal than it used to be. Worse, the growing number of poor people is disproportionately elderly. In other rich countries, people between 66 and 75 are no more likely to be poor than the population as a whole. In Korea, they are three times as likely to be poor. This is all the more worrying because the low birth rate means the country is ageing more rapidly than any other rich country. In 2009, people over 65 were outnumbered ten to one by the working-age population. By 2050, there will be seven over-65s for every ten working-age adults. Disproportionate old-age poverty would have a huge impact on the social backing for policies designed to foster growth.

Not to be left behind Korea's equitable income distribution used to provide a sense that society as a whole was benefiting from breakneck catch-up. But discontent is rising both about inequality and about the role of the chaebol, producing growing disenchantment with both main political parties. The recent election for mayor of Seoul produced an upset win for a left-wing anti-establishment maverick. It is proving hard to resist the trend towards inequality because of another basic feature of Korea's economic model: total tax revenues are just 26% of GDP. Taxes are especially low on labour, a choice designed to boost work and foreign investment. But as a result, social spending is low (11%); public spending on family benefits is exceptionally low (less than a quarter of the rich-country average); and the tax-benefit system is the worst in the OECD at reducing inequality and poverty. Korea's tax-benefit system reduces poverty by only 18% (compared with what it would have been without the benefits). Sweden's tax-benefit system cuts its poverty rate by 80%. Korea, argues Mr Jones, needs to increase taxes and social spending in order to reduce poverty and inequality. One reason it is reluctant to do this is because it is afraid of the impact on jobs. Its changing demography also suggests caution in expanding the social safety net too fast or far, as it will be used ever more over the decades to come. And then there is the ever-present imponderable: the possible need, at some point, to finance the horrendous costs of reunification with destitute North Korea when that state collapses. That would make the vast expense of unification in Germany pale into insignificance. At some point in the future Korea may need all the room for future fiscal expansion it can get.

A bridge to the future