The Korea Institute for International Economic Policy (KIEP) was founded in 1989 as a government-funded economic research institute. It is a leading institute concerning the international economy and its relationship with Korea. KIEP advises the government on all major international economic policy issues and serves as a warehouse of information on Korea’s international economic policies. Further, KIEP carries out research by request from outside institutions and organizations on all areas of the Korean and international economies by request.

Preface
Contributors
Introduction and Overview

Part 1. Investment Requirements and Strategies for Cooperation in Infrastructure and Energy Development in Northeast Asia

The Socio-Economic Situation in the Russian Far East and Prospects for Developing
Investment Cooperation with Northeast Asian Countries
A. B. Levintal

Cross-Border Economic Cooperation: Notes on Creating a Northeast Asian Economy
Tony Michell
1. Economic Cooperation in the Region
2. Chinese Investments in the Far East and Siberia
3. Agricultural Development
4. Multilateral Funding and Day to Day Banking
5. Why Land Transit Is Important
6. Road Connections
7. Cross-border Cooperation, Hubs, and Clusters
8. Multilateralizing Kaesong Industrial Estate
9. Dandong-The Last Frontier
10. The Disruption of Sanctions on Third Parties–The Need for A Study
11. The Disruption of Sanctions and the Need for a Fairer Sanctions Regime Development in the Future
12. Sanction Exempt Cross-Border Economic Cooperation
13. Conclusion: A Cross-Border Economic Cooperation Wish List for 2014

Challenges to a Northeast Asia Regional Logistics System Satoshi Inoue Port Cooperation in the Northeast Asia
Dong-Keun Ryoo
1. Introduction
2. Concept of Port Cooperation
3. Cases of Port Cooperation
4. Conclusion

Japan’s Sustainable Electric Future
Yoshiki Iinuma

A Note on Power Grid Interconnection in Northeast Asia
Mitsuho Uchida

Russia and Northeast Asia Energy Security
Sergei Sevastyanov
1. Key Findings
2. Introduction
3. The Main Principles of Russia’s New Energy Policy
4. Energy Security and Energy Market in Northeast Asia
5. Russia’s Activities and Vision for Energy Policy in Northeast Asia
6. Evaluation of Russia’s Input into Northeast Asia Energy Security
7. Recommendations and Conclusions

The Yellow River and Cooperation in Northeast Asia
Liu Ming

Part 2. Financing Economic Integration and a Regional Multilateral Bank: Research Papers on the Northeast Asian Bank for Cooperation and Development (NEABCD)

Creation of a Joint-Venture Bank by China, Japan, and Korea
Jai-Min Lee
1. Introduction
2. Challenges for development finance in Northeast Asia
3. Creation of a Joint-Venture Bank by China, Japan and Korea
4. Conclusion

Economic Development of the Russian Far East and the Northeast Asian Development Bank (NEADB)
Dmitry A. Izotov
1. Introduction
2. Economic Development Prospects of the Russian Far East and Foreign Economic Activity Alternatives
3. Development Programs of the Russian Far East and the Northeast Asian Development Bank (NEADB)
4. Conclusion

Re-analysis of Innovation in Asian Infrastructure Financing Mechanisms
Liqun Jin
1. Demand for Innovation in Asian Infrastructure Financing Mechanisms
2. Feasibility of Innovation in Asian Infrastructure Investment

Review and Strategy for the Proposed Northeast Asia Bank for Cooperation and Development
Byungwon Bahk

A Perspective from the Republic of Korea
Jae Hyong Hong

Appendix

Summary

The Seventh Meeting of the Ad Hoc Committee for Establishing the Northeast Asia Bank for Cooperation and Development
Nankai University, Tianjin, China
July 1-2, 2013

On July 1-2, 2013, the Seventh Meeting of the Ad Hoc Committee for Establishing Northeast Asia Bank for the Cooperation and Development (NEABCD) organized by Northeast Asia Economic Forum (NEAEF) was held at Northeast Asia Financial Cooperation Research Center (hereinafter refer to as the Research Center), at Nankai University, Tianjin, China. More than twenty leaders and experts from China, Korea, Japan, and the US attended this meeting. Prior to the meeting, Dr. Jiang Zhenghua, Former Vice Chairman of National People’'s Congress of China and Honorary Chairman of the Research Center, and Mr. Cui Jindu, Executive Vice Mayor of Tianjin Municipal Government and Honorary Chairman of the Research Center met Dr. Lee Jay-Cho, NEAEF and Research Center Chairman and all the foreign participants. The President of Nankai University, Dr. Gong Ke, attended this meeting as well. The meeting was organized by Dr. Lee Jay-Cho and Mr. Wang Shuzu, Former Deputy Chairman of Tianjin People’'s Congress and Deputy Chairman of the Research Center. Mr. Zhang Xiaoyan, Deputy Secretary of Tianjin Municipality and Director of the Research Center, Mr. Zou Ping, the Research Center Secretary General, Prof.
Ma Junlu, Executive Deputy Director of the Research Center, and Dr. Liu Ming, Deputy Secretary of the Research Center all expressed their views on the theme of the meeting. All the participants together discussed the latest developments on the subject of the proposed Northeast Asia Bank, and exchanged their views on new trends, ideas, perspectives and proposals. They agreed on the major issues summarized below.

I. Fully endorse the establishment of Northeast Asia Bank for Cooperation and Development In Dr. Lee Jay-Cho’'s remarks, he stated that at this year’'s summit meeting of Chairman Xi Jinping and President Barack Obama, there was a historic consensus on the need and importance of a mutual and closer relationship between China and the US for the future of the two largest economies of the world. The Assistant Secretary for Asian Affairs of the US state department believes that regional cooperation with Asia is utmost importance in the next ten years, and should be vigorously promoted.
Former Assistant Minister of Finance and Former Executive Vice President of the Asia Development Bank, Dr. Stanley Katz observed that, based on discussions in Washington regarding the BRIC Bank, the proposal lacks basic building blocks and a foundation based on experience and research. However, the US is not opposed to the establishment of the NEABCD. On the proposed Bank, Japan should portray a clearer attitude, China should release a positive massage initially, and then Korea will have a positive response.
The former Japanese Foreign Minister and the Research Center Honorary Chairman, Dr. Taro Nakayama addressed the meeting in a written statement saying that in order to pursue peace and security in Northeast Asia, regional development through economic cooperation should be our goal. If the cross-border gas pipeline from Siberia all the way to China, Busan Korea, and Fukuoka Japan, can be constructed, it can promote mutual understanding among these countries and people, and it might serve to prevent war and strife and build a system of mutual cooperation.
Large-scale cross-border infrastructure requires huge capital and funding. Therefore, it is necessary to establish a regional development bank for Northeast Asia. Dr. Nakayama expressed his willingness to work with meeting participants to realize this vision. Mr. Byungwon Bahk, the former Executive Vice Minister of Planning and Finance and Chairman of the Korean Federation of Banks, pointed out that the ADB only provides 0.9% of its funds to three northeast provinces in China and Mongolia, there still remains a large gap for establishing a Northeast Asian Bank for future dynamic economic development in Northeast Asia. He also stated that China should take the leadership in the Northeast Asian Bank, and persuade Japan, Korea, Russia, Australia, New Zealand, and other countries to participate. China, Japan, and Korea already have shown a willingness and ability to cooperate evident in their funding arrangements in ASEAN. Why can’'t these countries cooperate to establish funding arrangements for the Northeast Asia region? Japan and the US will not take the initiative in promoting the establishment of the Bank, but once China proposes doing so, Japan, and the US would not be opposed to it.
The chief representative of the Japan Bank for International Cooperation’'s Beijing office, Mr. Kikuchi on behalf of the Japanese Cabinet Adviser, JBIC Executive Director, Mr. Maeda stated that the opportunity for establishing the Northeast Asia Bank is ripe and Japan through establishment of the Bank would change the its role from simple investor to beneficiary/partner investor.
Dr. Zou Lixing, Deputy Director of China State Development Bank for Research and the Research Center Advisor, emphasized that the Northeast Asia Development Bank is important for regional strategic cooperation. It will promote the development of regional infrastructure, economic development and corporation through trade, financial cooperation, cultural exchanges, etc. The establishment of the NEABCD will become a new driving force of economic development in Northeast Asia and a useful compliment to the existing international multilateral financial institutions.
Mr. Kwan-Yong Park, Former Speaker of the Korea National Assembly of Korea, underscored the great significance in the establishment of a Northeast Asia Bank. He stated his belief that most important is to promote the cooperation and collaboration of all countries involved and his hope that we can work together for a common understanding of our goal.
The Former Vice Chairman of China’'s National People’'s Congress and honorary Chairman of the Research Center, Dr. Jiang Zhenghua stated that, peaceful development and win-win cooperation is not only the world trend, but also China’'s responsibility.
The leaders of China’'s State Council repeatedly instructed the relevant departments to conduct a study on the establishment of the Northeast Asia Bank, stating that we now have a better vision for establishing the Bank. They stressed that we should not limit ourselves to the region of Northeast Asia, but set a wider framework and be more inclusive. We can start from reality, and consider and envision a long-term strategy.
The information, input, and ideas provided by the participants from China, the US, Korea, Japan, and other countries showed that the continued efforts to set up the Northeast Asia Bank rest on a solid social and economic foundation. The meeting concluded that the establishment of the Northeast Asia Bank is currently in a most critical period –. it requires that all the relevant countries bolster their confidence and continue their work.

II. The new connotation and orientation of the Northeast Asia Bank
Liqun Jin, the Chairman of China International Capital Corporation Ltd., Advisor of the Supervision and Guidance Committee of the Northeast Asia Financial Cooperation Research Center, and Former Vice Minister of Finance stated in a written statement that, given Asia’'s economic growth and its energy and infrastructure investment demands, currently available financing channels are inadequate and therefore, innovative financing mechanism are necessary. Asia should establish a multilateral financial institution that would run parallel to the ADB system, and would help meet the need for infrastructure construction and economic development. China needs to further strengthen financial cooperation with Northeast Asia and Asia. The Northeast Asian Bank represents such an innovative financing mechanism.
Zou Ping, Chairman of the China Asia Pacific Institute and Secretary General of the Research Center for Financial Cooperation in Northeast Asia stated that in accordance with the “"open development, cooperative development, and win-win development”" requirements, we should insert the establishment of the Northeast Asian Bank into a broad strategy of innovative mechanisms for investment in and financing infrastructure development in Asia. The Northeast Asian Bank would be open to participation by Northeast Asia and Asian countries with China taking a lead and in Northeast Asia it would principally focus on cross-border infrastructure investments.
Zhang Jianping, Senior Economist and Director of the Department of International Regional Cooperation, Institute for International Economic Research, National Development and Reform Commission (NDRC) argued that China, Japan, and South Korea already work together through the China-South Korea FTA and the China-Japan-South Korea FTA negotiations. The regional trade will increase rapidly after the two FTAs are established and they will need the safeguard and guarantee of the Northeast Asian Bank. The establishment of the FTAs and Northeast Asian Bank share some common ground and thereby the establishment of each will contribute to the other.

III. Main consensus and suggestions at the meeting
1. The meeting approved in principle “"The report in 2013 on setting up the Northeast Asia Bank for Cooperation and Development”" drafted by the research center.
After modification and improvements, the report is scheduled to be submitted for discussion at the twenty-second annual Forum Conference in Vladivostok, Russia in August 2013, aimed at obtaining a broader consensus and further extending the international thrust. The Northeast Asia Economic Forum will submit it to the relevant policy institutions of the Chinese, Japanese, and Korean governments at an appropriate time.
2. The meeting endorsed the proposal that the Northeast Asia Bank can be put into an innovative mechanism of investment and financing for developing cross-border infrastructure interconnections. The most important task is to act as soon as possible. The Northeast Asian countries will play the leading role and the participating countries can be expanded to other areas of Asia, including Australia and New Zealand.
3. Expecting China to play an important role in the establishment of the Northeast Asia Bank, we suggest China could initiate the proposal for the establishment of the Northeast Asian Bank initiatively. South Korea will give a positive response and jointly promote the establishment of the Northeast Asia Bank with China as well as leading the way for Japan, Russia, Mongolia, the United States and other Asia countries to participate in it.
4. The Northeast Asia Economic Forum will continue to play a coordinating and catalytic role, by disseminating relevant information and promoting dialogue with policymakers in Northeast Asia. Tianjin Municipal Government, according to the needs of an innovative mechanism for investment and financing Northeast Asian infrastructure interconnections, will pursue further studies and develop strategies for the Northeast Asian Bank taking into consideration any new international circumstances. This will serve as a reference base for policy decisions.
5. It is hoped that the participants will make timely report on the meeting results to the relevant government institutions, in order to obtain the support of central governments. At the same time, we hope each country will encourage their national think-tanks to exert their influence by participating in policy research on the establishment of the Northeast Asian Bank.
The Seventh Meeting of the Ad Hoc Committee finds that, through the exchange of communication, we can further understand what should be done and how, and we can promote mutual understanding to reach a necessary consensus for further achievements. The meeting stressed that the Tianjin Municipal Government has and will play a very important role in the establishment of the Northeast Asian Bank. We expect China to play the leading role in encouraging breakthroughs in financial cooperation in Northeast Asia.

 

Necessity and Directions of Korea's New Northern Economic Cooperation

 

Yeo-Cheon Jeong

 

 

 

The area of the Eurasian continent north of the Korean Peninsula not only has special historical-cultural significance for the Korean people, but is also important in terms of national security and economy of the Republic of Korea (hereafter, Korea). Bearing these facts in mind, Korea needs to pursue a 'New Northern Policy' for strengthening relations with that area referred to as “the Northern Area” in this report. Insofar as this policy targets a specific area, it should be different from traditional external policies toward individual countries.

 

 

 

It is thus perfectly reasonable to state that Korea's New Northern Policy now needs to focus on the Russian Far East and the Chinese Northeast Provinces where large-scale regional development is underway. As development plans both in the Russian Far East and the Chinese Northeast Provinces are mainly aimed at modernizing regional industrial structure; construction of numerous industrial complexes and infrastructure are currently in progress which are intended to increase efficiency in production and transportation networks across the two regions. The extensive development of the Russian Far East and the Chinese Northeast could provide a firm base for Korea's New Northern Policy.

That both Chinese and Russian governments are emphasizing, more than ever, international cooperation for their regional development plans, is very meaningful for Korea's New Northern Policy. The Russian government under president Putin, for example, considers 'Integration into the Asia-Pacific region' as one of the basic tenets of Russia's external economic policy. In the Federal Program for Developing the Russian Far East, expansion of trade and economic exchange with the Asia-Pacific countries was adopted as one of the main tasks while a number of important projects related to development of mineral resources and transportation infrastructures were set up, with full consideration of establishing direct connections with neighboring countries. Moreover, nationwide industrial policies of the Russian government such as the “Federal Strategy for Energy by 2030” were forwarded, taking direct connection with countries in the Asia-Pacific and, in particular, the Northeast Asian countries into account.

 

 

 

Meanwhile, the Chinese government has been emphasizing international cooperation in connection with its development plans for the Northeast Provinces since the mid-2000s. In particular, Chinese government has been pushing forward policies to develop their border regions in close connection with its neighboring countries. These policies were well-expressed in the “plan for the integration of land routes, sea ports and zones with North Korea” and “plan for integration of land routes, sea ports and the customs with Russia” formulated by Chinese central government in 2007. Such policies of the China's central government were reflected in numerous bilateral cross-border cooperation projects enacted by 3 Northeastern Provinces of China.

 

 

 

Of various aspects of international cooperation taking place in "the Northern Area" today, the one between China and Russia plays key roles in terms of magnitude as well as influence on international relations. For example, the agreement in 2009 between governments of the two countries, which aims at cooperative and concerted development of the Russian Far East and the Chinese Northeastern Provinces, included more than 200 projects ranging from cross-border transportation, customs, labor supply, sightseeing, to environmental preservation. Progress in these cooperation projects will greatly enhance bilateral economic ties between Russia and China vis-a-vis their common border.

 

 

 

Another series of important international cooperation efforts in the development of Korea's “Northern Area” is taking place along the border of North Korea. Since mid-2000s up until the present, a number of Chinese business firms, especially those from Jilin Province, initiated various infrastructure development projects with focus on utilization of the port of Rajin, North Korea. Chinese and North Korean governments signed a convention in 2010 for cooperation in the development of North Korea's Rajin-Seonbong Economic/Trade Zone and Hwanggeumpyong Special Economic Zones that border, respectively, on Liaoning and Jilin Provinces of China. Russia, prompted by Chinese initiatives, embarked upon modernization of the 60 km railroad route between Rajin and Hasan (in the Southern end of Russia's Primorsky Province) in 2007, and subsequently acquired the right to use the No. 3 wharf of Rajin Port for 49 years, which will serve as a logistics hub for Russia's advance into Northeast Asia.

 

 

 

As economic development of the Russian Far East and the Chinese Northeast Provinces is the most essential part as well as the most important driving force that will bring about changes in the “Northern Area”, the New Northern Policy of Korea should utilize it as a foothold. This means that the “New Northern Economic Cooperation” should be the main facet of the New Northern Policy of Korea. However, Korea's New Northen Economic Cooperation should, insofar as it is a part of the New Northern Policy, not only aim at economic gain, but strive towards broader goals such promoting favorable international circumstances, bolstering national security and, furthermore, improvement of inter-Korean relations.

 

 

 

The directions and objectives of Korea's New Northern Economic Cooperation should be as follows. First, Korea should actively participate in the development process of the “Northern Area” in order to increase Korea's presence and have Korea's interests reflected within that process. To this end, entry of Korean businesses, especially small and medium-size firms, into the region would be a necessary precondition. Therefore, the first and foremost objective of Korea's New Northern Economic Cooperation is to support Korean businesses interested in investing in the Russian Far East and Chinese Northeast where the business environment is still relatively poor. It is advisable to establish a number of business information centers in those regions that could provide Korean businesses with proper information, and on-site consultation. Also, it is recommended that industrial parks for Korean businesses in the Russian Far East be established, as no such facilities has been set up presently.

 

 

 

Second, from the perspective of economic interest, it is important for Korea to secure certain production factors from the “the Northern Area”. Considering that Korea is one of the World's manufacturing and export powerhouses but very poor in natural resources, Korea's cooperation with “the Northern Area” should prioritize securing natural resources, especially energy and mineral resources, from that region which are essential for stable development of Korea's manufacturing sectors. Besides, it is also very important for Korea to make use of the trans-Eurasian transportation infrastructure in “the Northern Area” in order to enhance efficiency of its international export distribution lines. In this regard, Korea needs to pay more attention to the railroad networks of “the Northern Area” as a whole; meaning present discussions on utilization of Trans-Siberian Railroads should be extended to include other main railroads lines in “the Northern Area” such as the Trans-Manchurian Railroad.

 

 

 

Third, Korea's New Northern Economic Cooperation needs to focus more on multilateral cooperation. As Russian and Chinese governments are stressing multilateralism in their development plans regarding “the Northern Area”, it is expected that opportunities for multilateral cooperation in that region will increase greatly in the near future. Korea should not only participate actively in multilateral projects, but also spontaneously initiate new multilateral projects to lead the development processes in “the Northern Area”. In this case, it would be even better for Korea's New Northern Policy to organize those types of multilateral cooperation projects that, on the one hand, North Korea could take part in and, on the other, could contribute to the formation of a common economic community among Northeast Asian countries as a whole.

 

 

 

The New Northern Economic Cooperation is closely related to other policies of the Korean government. Hence, a concerted action among ministries and government agencies is essential to the success of the New Northern Economic Cooperation. Also, in order for the New Northern Economic Cooperation to come to fruition, Korean government should endeavor to create efficient consulting channels with governments of counterpart countries both at the central and regional level.

 

 

 

Even though Korea's New Northern Policy will be enacted mainly in the economic field, this policy pursues more wide-ranged goals involving international politics as well as national security. This means that Korea strives to upgrade overall relations with “the Northern Area” by means of the New Northern Policy. If the Korean government's New Northern Policy and the development policies of “the Northern Area” by Chinese and Russian governments can reach common ground, Korea, China and Russia will be able to form a “strategical partnership” not only in name but also in reality.

Income Distribution and Welfare Effects of Trade Liberalzation in Korea

Chul Chung, Bonggeun Kim, Young Jun Chun and Joun Won Lee

Over the last few decades, the world has achieved notable progress regarding globalization, followed by economic growth through the proliferation of Free Trade Agreements (FTAs), and multilateral trade liberalization under the General Agreement on Tariffs and Trade (GATT) and World Trade Organization (WTO). Despite the improvement of the overall standards of living thanks to trade liberalization and rapid economic growth in South Korea, however, critics argue that the income inequality has worsened as a result of globalization. According to them, fruits of globalization and economic growth are biased toward certain classes and mainly the upper class. As issues of worsening income inequality and wider economic disparity between classes are not only limited in South Korea, but is rather considered global phenomena which can be easily observed all around the world, including in the developed countries such as the United States and Europe, as well as in the developing countries. Therefore, establishing policies for alleviating social conflict, and the search for development balancing the classes has long remained a necessity that transcends national borders.
This study, therefore, mainly aims at not only giving profound analysis of the correlation between openness and income distribution facilitated by liberalization, but also examining the effects of how liberalization actually affects levels of welfare depending on the income class. This is achieved through statistical and econometric analysis and policy simulation via careful scrutiny of actual impacts of liberalization on the real income of each class and income inequality. Also, we expect this study to be used as a foundation for establishing necessary policies aiming at remedying the income inequality in Korea.
To give a summary of the research methodology used in this study, we first calculate the consumer price index (CPI) and import price index (IPI) associated with each income class. Then we recalculate the real income of each class using those calculated price index measures to examine the trend of the income inequality for the last two decades. We also employ Hamilton (2001 and 2005)’s methodology to measure price indices since the movement of the Engel curve may vary with income class. Lastly, we conduct a simulation analysis by applying the general equilibrium model to evaluate how the liberalization affects the welfare of each income class.
The primary findings of this study can be summarised as follows; in chapter 2, we confirmed that Korea has continuously made progress in liberalization by examining the trend of Korea’s openness in terms of the share of trade (or import) relative to GDP and the average tariff rate. From 1996 to 2012, the average bound tariff rate has dropped from 11.3% to 4.4, which clearly shows that trade liberalization has been accomplished in gradual but consistent fashion. When we divide the households into 10 classes based on incomes and investigate correlations between trade liberalization and the percentages of household expenditure, we found that the average tariff rate for certain in-demand items, weighted by the percentages of household expenditure, tend to be lower for the high-income class. In terms of the average tariff rate, the reduction rate for the low-income class is much higher than the high-income class, and we believe this is closely linked with not only the difference of items demanded by each income class, but also the tariff reduction rate and percentages of household expenditure for the certain items. When looking into the correlation between trade openness and household expenditure for specific consumption items by income class, it can be seen that in most items there exists a positive relationship between the degree of liberalization and percentage of expenditure for the high-income class, whereas it is inversely related for most items (except fuel expenses) for the low-income class. It implies that the overall percentage of consumption expenditure increases proportionately with the degree of liberalization for the high-income class.
In chapter 3, we present an econometric model and examine the trend of income inequality based on the statistical analysis of chapter 2. First, we derive an index for costs of living by reflecting the difference in consumption structure for different income classes. Then, we investigate the real income inequality based on real income, which is recalculated using the costs of living index for each income class. Results show that levels of income inequality, measured by the Gini coefficient and the deciles distribution ratio (P90/P10, the ratio of the upper bound value of the ninth decile (i.e. the 10% of people with highest income) to that of the first decile), have increased particularly fast in Korea since the 1990s, during which trade liberalization had started to accelerate. This means that the income inequality has become worse, even when we use different measures of real income, which take costs of living for different income classes.
However, conventional price indices have the problem of overestimation as in the well-known CPI bias, which might have distorted the income inequality measure. In order to address this bias, we employ the Engel curve methodology to measure the price index more accurately for income classes, and the results show that the income inequality was exacerbated to a lesser degree compared to results when using the conventional price index. In particular, when limiting data to households with more than 2 people and labour income for consistency over the entire period, the analysis using the Engel curve methodology suggests that the income inequality has not significantly changed for the past two decades, or possibly even improved
The caveat of this study is the limited coverage of data only including households living in the city and hence unintentionally excluding farming and fishing households. Thus the difference in living expenses depending on the income classification does not account for huge areas of the real income distribution. Nonetheless, the results in chapter 3 clearly show the validity of constructing the real income inequality by using the Engel curve methodology to account for the difference in living expenses depending on income class in relation to trade liberalization. They are expected to be useful in establishing relevant policies or serve as a base for further research in any related field.
In chapter 4, we conduct policy simulation analysis in the general equilibrium model on how trade liberalization affects the welfare of different income groups in which all the income classes are divided into three groups: high-income, middle-income, and low-income group. The result shows that the reduction in tariff rates leads to an increase in the general production level, particularly raising production significantly in the import sector. These changes in the production structure of the Korean economy following the tariff reduction increase the demand for skilled labor disproportionately more, which in turn raises skilled labor wages. Since the majority of the high-income group consists of highly skilled workers, whose income gains disproportionately more as trade liberalization takes place, liberalization obviously enhances the welfare of the high-income group. Meanwhile, the tariff reduction lowers price index for the low-income group, who consumes disproportionately more on imports and import substitutes, of which prices decline with tariff cuts. Consequently, the low-income group also benefits from trade liberalization as their real income rises. On the whole, the reduction in tariff rates improves overall welfare by minimising the distortion of consumption components. It can be argued that trade liberalization leads to an overall increase in economic efficiency and welfare for the entire income groups, a “Pareto improvement.” Notwithstanding, the degree of welfare-enhancement varies with income groups and classes. It is worth to note that the middle-income group, which accounts for the majority in the Korean economy, benefits the least from it. This is obviously one of the areas for the government to establish policies for improving the condition and path of the economic growth as well as alleviating potential conflicts in the economy.

Effects of Trade and Investment Liberalization on Korea’s FDI

Jong Duk Kim, Seungrae Lee, Jungu Kang and Hyuk-Hwang Kim

After Korea-Chile FTA became effective since 2004, Korea has made multiple free trade agreements with 47 countries including United States and European Union, and is currently negotiating upcoming free trade agreements with other countries, such as Indonesia, China, Vietnam, Australia, and New Zealand. Along with the global spread of trade liberalization, it is necessary to evaluate the post-effects of FTA that came into effect and the strategies for the upcoming FTAs. However, prior reports and papers analyzing the effects of FTA were mainly focused on evaluating its economic effects on goods, while most of FTAs are influential not only on product sector but also on investment and service sectors. In particular, since foreign direct investment (FDI) is directly and indirectly related to goods trade, FTA is also associated with foreign direct investment sectors. This report analyzes the effects of FTA on outward and inward foreign direct investment (IFDI and OFDI) of Korea. Our report provides detailed analysis on the contents of FDI openness in the trade agreement and construct FDI openness indices by dividing investment sectors from the previous 8 free trade agreements that became effective into 5 sectors and 25 sub-sectors and quantifying FDI openness based on those sub-sectors. By adding our constructed FDI openness indices to the regression, we find that FTA significantly increases both IFDI and OFDI in the short run. Examining the effects of investment liberalization on IFDI and OFDI, the results indicate that investment liberalization from FTA increases IFDI. In particular, its magnitude becomes larger as investor-state dispute settlement is included in the chapter of agreement. On the other hand, the results imply that FTA has heterogeneous effects on OFDI from different industry sectors on the basis of investment related articles. For instance, OFDI from manufacturing sectors is likely to increase to FTA partner as agreement involves high FDI openness articles in general, while OFDI from wholesale and retail sectors is more likely to increase as agreement involves FDI openness articles on service related sectors. Furthermore, based on the relative GDP per capita difference between Korea and its FTA partner, we find that IFDI flow increases from FTA partners that have similar GDP per capita with Korea, while GDP per capita difference and FDI openness indices have interaction effects on OFDI flow from different industry sectors. For instance, we find that FDI openness indices have significant and positive effects on OFDI from manufacturing sectors to FTA partners that have higher income-level but small GDP per capita difference with Korea. Alternatively, OFDI from wholesale and retail sectors are likely to increase to FTA partner as a country has higher income-level and large GDP per capita difference with Korea, with high FDI openness on service sectors included in the agreement.
Based on the results, our report provides policy implications for expanding Korea's OFDI and IFDI. We find that Korea’s OFDI and IFDI have increased at the aggregate level and they are positively affected by trade and investment liberalization. As our results indicate that FTA significantly increases OFDI and IFDI, we should carry forward upcoming FTAs more aggressively. In particular, upcoming FTA negotiations should focus on including FDI openness in service sectors, FDI regulation and protection, and investor-state dispute settlement provision. Furthermore, as trade and investment liberalization are known to have different effects on OFDI and IFDI based on the GDP per capita difference between Korea and its FTA partner, upcoming negotiations should be proceed by considering country’ GDP per capita relative to Korea and the agreement should include investment related articles that could have positive effects on OFDI and IFDI from different industry sectors.