The king of innovation

Innovation and technology are the key factors that have underpinned South Korean export competitiveness and fueled the country's remarkable economic rise over the past decades. The growth rate has been so impressive that the East Asian nation went from being one of the poorest countries in the 1960s to becoming the world's 13th largest economy in 2014, according to the World Bank.

"South Korea has been transformed since the Korean War from a very poor agricultural society to an urbanized, high-technology economy with a highly skilled workforce," Rajiv Biswas, Asia-Pacific Chief Economist at the Global analytics firm IHS, told DW.

And Seoul recognizes that the need for developing new ideas is now more important than ever, as neighboring China, the largest importer of South Korean goods, has begun moving away from a labor-intense and low-value production towards higher value-added manufacturing.

World's top innovator

As a result, the country is investing much more in research and development (R&D) as a share of GDP than other advanced economies. According to recently released data by the Organization for Economic Co-operation and Development (OECD), South Korea spent 4.29 percent of its GDP on R&D in 2014, followed by Israel (at 4.11 percent), and Japan (3.58 percent).

In addition, the 2016 Bloomberg Innovation Index ranked the country as having the world's most innovative economy, ahead of Germany, Sweden, Japan and Switzerland. The index evaluated nations according to six different categories, including R&D, high-tech companies, manufacturing, research personnel, patents and education.

"South Korea notched top scores worldwide for manufacturing value-added as well as for tertiary efficiency - a measure that includes enrollment in higher education and the concentration of science and engineering graduates," said a recent Bloomberg report.

Innovation is key to South Korean companies, as they face increasingly stiff competition on the global markets. Large multinationals have also invested heavily in R&D and innovation - factors which are essential to support global sales. "Companies such as Samsung and LG have become global leaders in the area of consumer electronics thanks to their cutting-edge technology and innovative product designs," said Biswas.

'A product of necessity'

According to Kyle Ferrier, Director of Academic Affairs and Research at the Korea Economic Institute of America (KEI), innovation in the Korean economy is a product of necessity.

"Korea has had to make its own path in a region where it competes with China's low labor costs, and Japan's high-tech, capital-intensive industries. Spending more on R&D than any other economy not only reflects a domestic consumer base with a high demand for new technological developments, but also the government's objective to build a creative economy," Ferrier told DW.

Korea's 'chaebols'

South Korea's economic success after the Korean War initially reflected the government's strategy to catalyze the development of low-cost manufacturing exports. But it was the emergence of the Korean conglomerates, known as "chaebols," as strong multinational corporations which became essential to the economic transformation of the country.

The scale of these large companies - such as Samsung and Hyundai - not only enabled a massive pooling of resources, but also resulted in Korean manufacturing moving into a new phase of growth driven by technological leadership and innovation, with a reputation for high-quality and leading-edge products.

According to analyst Biswas, one of the chaebols' strategies to become global technology leaders was to invest heavily in R&D and develop a global footprint through mergers and acquisitions in the US and Europe, which, in turn, allowed them to enhance their technological capabilities.

The Korean government has also played an important role by creating world-class physical infrastructure as well as high-quality education systems in the country.

Slowing growth

But despite its edge in innovation, South Korea, which has a population of 50 million, is facing problems such as growing inequality and the risk of stagnating growth. For instance, China's economic slowdown has impacted the growth of Korean manufacturing exports, with the appreciation of the won against the Japanese yen also hurting Korean export competitiveness.

"Chinese economic woes not only hurt bilateral trade between the two countries, but dampen global demand as well, which is directly tied to South Korea's intermediary product exports, accounting for 70 percent of total exports," Ferrier indicated.

Furthermore, the economy is vulnerable to the risks arising from a rapid build-up in debt in recent years, say experts. "Korea's private sector debt is one of the highest among emerging markets and, more importantly, has seen one of the sharpest increase as a share of GDP over the past decade," Krystal Tan, Asia Economist at Capital Economics, a London-based research firm, said in a research note.

Although the expert stresses that the economy is unlikely to face a major crisis, he reckons the high debt levels will weigh on growth.

"The need for deleveraging in the private sector is a reason why we expect Korea's medium-term growth to slow to 2.0-2.5 percent from an average of 3.5 percent over the past decade," he said.

Growing inequality

In recent years, Korea's economic growth has outpaced the domestic labor market regime, thus leading to growing inequality, say analysts.

There also seems to be growing inequality in terms of educational opportunities. Education is highly prized by South Koreans, whose social and economic status is determined to a large extent by their academic achievement. This is why parents lay great emphasis on providing high-quality education for their children.

"But although Korea has been praised for its consistently high test scores, the OECD has noted the economy is facing a widening mismatch of skills between those taught in schools and those needed in the labor market, which is contributing to the youth unemployment problem," said Ferrier.

Furthermore, major sticking points in the current attempts to reform the labor market, such as fixing the dual system and defining grounds for dismissal standards, have brought down progress on talks between labor groups, management, and the government, prolonging problems such as youth unemployment, noted Ferrier, who also pointed to a recent KEI paper which found that inequality will likely continue to grow as the Korean economy shifts from manufacturing to services.

An aging population

South Korea is also aging faster than all other OECD countries, a development likely to become a further drag on the nation's long-term growth rate.

Moreover, with the country facing the prospect of fewer working-aged people with the necessary skills to match labor market demand, the need for higher productivity cannot be understated. "Korea's 39th ranking in productivity on the Bloomberg Innovation Index shows there is much space for Korea to improve on this," said Ferrier.

South Korea also needs to overcome a number of challenges in order to maintain its competitiveness and innovation in the future. For instance, analyst Ferrier explains that Korea's comparative advantage has been in process innovation, making existing products more efficient and cheaper, and not in the development of entirely new products.

Difficulties for SMEs

The dominance of chaebols in the Korean economy thus makes it difficult for small and midsize enterprises with new ideas to grow, despite the government's efforts to boost these companies. As a result, patents from Korean institutions tend to be half the value of that of US institutions, the KEI expert added.

Marcus Noland, director of studies at the Washington-based Peterson Institute for International Economics, has a similar view. "If you're a scientist or engineer at Samsung Electronics, and you come up with some brilliant new idea, you don't quit and start pitching your ideas to venture capitalists and set up your own firm - you go to management within Samsung," the expert was quoted by Bloomberg as saying.

Adapting to China

Another tough challenge for Seoul will be finding ways to deal with Beijing's strategic shift into higher value-added manufacturing, which will become a competitive threat to Korean manufacturing exports into China as well as into third markets.

"Due to South Korea's relatively high wages compared to many other East Asian countries, its manufacturing sector also faces the competitive challenge of low-cost competitors in other Asian countries, such as Vietnam and India," said Biswas.

While chaebols will still be able to compete by shifting their production facilities to lower-cost emerging markets, this could gradually erode the size of the manufacturing sector in Korea, he added.

Innovation remains key

How the Korean economy fares in the medium- to long-term future will depend on how the domestic challenges of low productivity and an aging population are addressed as well as how international demand responds to new developments in the global economy, say experts.

In light of this, Korea will need to maintain its position as a global leader in technology and innovation in order to retain its global competitive advantage. A key priority for Korea is also to diversify its economy, including through high-value innovation and measures to increase global competitiveness, and create new growth industries for the future, particularly in the service sector.