A blueprint for a service economy

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A blueprint for a service economy

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President Lee Myung-bak presides over the joint government and civilian meeting to promote services industries at the Blue House last year. [Joint Press Corps]

The government began the process of strengthening the service sector, starting with its 2004 regulatory reform task force, and followed by additional initiatives in 2008. But these efforts have not achieved the necessary transformation. Change is never easy. Vested interests resist. The process of “creative destruction” - in which uncompetitive businesses are allowed to fail, workers lose jobs and resources are redirected to more productive endeavors - brings long-term growth, but inflicts considerable short-term pain. And yet, South Korea has no choice but to endure this pain if it hopes to create new jobs with higher incomes.

There are many things that need to be done, but we see three priorities. First, South Korea’s business and government leaders must build political consensus for change. Second, South Korean policy makers must loosen regulations that have hindered the development of services. Finally, the decision makers in government and business must demonstrate stronger leadership.

To start, South Korean leaders need to build popular support for such a fundamental economic transformation so people will commit to bearing the cost of change. The country will never succeed in developing a strong service sector until its policy makers, business leaders and workers really believe the task is urgent, unavoidable and achievable. Change will require political and business leaders alike to articulate a clear vision for South Korea’s future.

Companies must believe that they can adapt and prosper. Workers must have confidence that they can obtain the skills needed in a changed economy. Civil servants must be assured they will not be singled out for political attack for pursuing policies in the interests of the broader economy.

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To instill this confidence, South Korea will need to invest more in its workers. This means establishing incentives so companies invest in helping employees develop new skills. It also means more support for lifelong learning programs, including vocational training. Currently, South Korea spends less than 1 percent of its total education budget on such programs. By comparison, Japan and the United States spend proportionately 8 and 30 times more, respectively, on lifelong learning and vocational training programs. Policy makers should help older employees extend their work lives by expanding continuous education programs and providing incentives for companies to hire them. At the same time, the government needs to ease worker anxieties about change by providing more social safety nets and more employment-placement services.

South Korean leaders also will have to forge a consensus to allow creative destruction. This process is inhibited by red tape that makes it difficult to either open or close a business. Bankruptcy laws, in particular, strongly discourage business failures. The existence of “joint personal guarantees” on business owners make entering corporate bankruptcy often the same as personal bankruptcy. And with more than 100 provisions in various laws discriminating against bankrupt persons, people go to great lengths to avoid that fate. But if weak companies survive, they constrain the growth of the successful organizations that would otherwise consolidate resources, weed out the low-productivity performers, and build enterprises of larger scale. Companies need to be able to fail without the owners being charged with criminal offenses and seeing their families and careers ruined. South Korea must also eliminate the credit guarantees and subsidies that sustain weak companies that would otherwise fail.

South Korea must become more receptive to outside ideas and innovation and upgrade its education services, both to better serve its own citizens and to attract the best students from abroad. The nation’s leaders should encourage more collaboration between domestic and foreign universities, schools, and businesses.

South Korean business leaders also should increase spending on R&D in the service sector. Currently, service sector investments account for 7 percent of total R&D spending by South Korean firms, compared with 25 percent in the G-7 economies. The South Korean government spends only 3 percent of its total R&D budget on services. South Korea also needs to lower the barriers to competition and foreign direct investment. In the mobile-phone industry, for example, the government’s requirement that all mobile phones conform to its standard wireless platform for interoperability effectively prevented foreign phones, such as the iPhone, from entering the South Korean market. Lacking iPhone customers at home, South Korea’s otherwise formidable online gaming companies missed the potential market for iPhone gaming applications and now lag behind global competitors just as global demand for such services is taking off. More broadly, South Korea needs to eliminate the old rules and policies that have traditionally stymied services. This means scrapping the many fiscal, financial and development policies that have favored manufacturing over services, prevented competition within the service sector or held back productivity growth generally. The government, for example, should end punitive taxes and special charges on domestic services, as well as tax breaks and subsidies for manufacturing.

South Korea must also do more to protect intellectual property and other intangible assets. Too many service industries, ranging from banking to telecom, are overregulated, which chokes entrepreneurs, drives up costs, and undermines global competitiveness. Policy makers, for example, should repeal limits on retailing, such as those prohibiting the sale of over-the-counter drugs outside of pharmacies (namely, in supermarkets and convenience stores, as is allowed in other developed countries). South Korea also needs to revise its labor laws to allow employers more discretion in hiring the best people and firing nonproductive workers. Job turnover is higher in services than in manufacturing, meaning that service sector employers require more flexible labor laws. South Korea’s rigid labor rules raise costs, limit job creation, slow adoption of best practices and discourage technological innovation. In South Korea, laying off workers is all but impossible. According to the World Bank, South Korea ranks 101st out of 175 countries in terms of ease of employing workers. The irony is that these laws, which were supposed to protect workers, have inadvertently led to the emergence of a whole new crop of “irregular” younger workers on temporary contracts.

South Korean leaders need to focus on efforts that will quickly produce high-impact, visible success. One quick win could be reform of the legal sector, a highly symbolic segment of protected business services, by accelerating the rate of change beyond what is proposed under the South Korea-United States Free Trade Agreement. Under the current plan, U.S. law firms will be allowed to form partnerships with local law firms and only hire local lawyers five years after the agreement is ratified. Another possibility is to reform medical-services regulations, such as eliminating rules that allow only nonprofit corporations to provide medical services, improve competition and attract investment from the private sector. South Korea must then go on to tackle the most unproductive sectors, such as segments of finance, educational services, health care and social welfare. To get this revolution in the service sector, South Korea must align some of its best business leaders to the long-run task of building the sector. This means redeploying some from manufacturing. In financial services, this means scrapping term limitations for senior management. World-class financial-services businesses can’t be built by chairmen on three-year contracts.

The jaebeol can also contribute. South Korea’s leading jaebeol remain focused on exports and manufacturing. Indeed, only four of South Korea’s top 30 large enterprises in South Korea are in services; in the United States, by comparison, 12 of the 30 largest enterprises are active in the services sector. Jaebeol executives often express concern that their domestic services market is too small and that they are ill equipped to compete in the sector overseas because they lack experience, language skills or cultural savvy. This lack of confidence - surprising for such powerful companies - must be reversed.

Many jaebeol also have talent-rich businesses that serve other group companies in areas such as advertising, IT and logistics. Are these businesses of sufficient scale to compete globally? Or should they be divested, liberating their talent to build Korean national champions that provide outsourced services to the whole Korean economy?

Decades ago, South Korea made the choices required to become a global manufacturing champion, and succeeded. Today, the country can choose to change again, to chart a new economic future. South Korea can and must develop its own rich and productive service sector - one that meets the aspirations of its people at home and competes abroad. But this will only happen if government, business and indeed the entire nation act quickly. South Korea’s highly educated, hardworking labor force is exactly what is required to capture the opportunity.

*Dobbs is a director of the McKinsey Global Institute and is based in Seoul; Villinger is managing director for McKinsey’s Seoul office.

From ‘Korea 2020

28 essays on Korea’s future edited by McKinsey & Company, Inc.

Random House Korea, Inc.

A project with the International Advisory Council to the Korean President


By Richard Dobbs and Roland Villinger

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