# Korea's FTA Policy: Focusing on the Japan-Korea FTA and U.S.-Korea FTA

Date July 13, 2006 AHN Se-Young(Professor and Dean, Graduate School of International Studies, Sogang University) KAWAMOTO Akira(Director of Research, RIETI)

## Summary

Over the last 50 years, when people were watching the economic miracle of Japan, they called Korea a second Japan. The Korean economy achieved extraordinary development under the "geese flying" development pattern, led by Japan. For Japan its GDP increased 20-fold between 1970 and 2005, but for Korea, over those same 30 years, its GDP multiplied by more than 90 times. As a result, while per capita income in Japan multiplied by 18 times; Korea's jumped up by a factor of 55; in exports, Japan's output volume in U.S. dollars multiplied by 31 times, while Korea's increased by more than 400 times.

Let me explain Korea's trade balance. In 1997 Korea experienced a financial crisis. Ironically, before that crisis Korea was suffering from a chronic trade deficit, but after the crisis began to enjoy a trade surplus. Nowadays the Korean trade surplus is hovering between $20 billion and$40 billion. When it comes to Korea's trade balance with its major trading partners, Korea is enjoying a huge, and increasing, trade surplus with the United States and China, but suffering a chronic trade deficit with Japan. This is because Korea imports high-quality parts, components, and machinery from Japan, assembles them, and exports them to the U.S. In turn, Korea exports mid-quality parts and components to China, which assembles them and exports them to the U.S. In this sense, the economic prosperity of the big three Asian countries is very substantially related to based on the market opening of the U.S.

Japan is Korea's third largest export market, and Korea is Japan's third largest export market. For Japan, the U.S. is the most important export market. This used to be the case in Korea as well, but over the last several years China has become Korea's most important trading partner. Some Korean scholars and intellectuals are worried that the Korean economy is becoming too dependant on China.

Japan's foreign direct investment (FDI) in Korea rose between 1995 and 2000. In spite of the 1997 financial crisis, Japan and other nations invested in Korea to buy Korean firms; there is still debate about the "fire sale" of Korean firms to foreigners. After the burst of the IT bubble around 2000, Japanese FDI into Korea decreased, but in the last three years, it has again been on the way up. The European Union (EU) is the largest investor into Korea, accounting for around 31% of total FDI. The second largest investor is the U.S., which accounts for around 30%. Japan is the third largest, with around 17% of total FDI.

Korea currently has free trade agreements (FTAs) with Chile, Singapore, the European Free Trade Association (EFTA) and the Association of Southeast Asian Nations (ASEAN). The Japan-Korea FTA negotiations have been stopped since December 2004. The governments of the U.S. and Korea have been holding FTA negotiations since this June, eliciting a strong political reaction from anti-U.S. protestors. Korea is also negotiating bilateral trade agreements with Canada, India and Mexico, and Korea and China have been conducting a joint study since last year. Recently, the EU also proposed joint research into an FTA with Korea, starting this fall.

Let us now look at the importance of a country's trade with FTA partners. As of December 2005, around 35% of U.S. trade was conducted under the intra-FTA framework. In the case of Mexico, 88% percent of trade was with its FTA partners, and for Singapore the figure was around 50%. Thus for the U.S., Mexico and Singapore, intra-FTA trade is very important, and even China has 20%. For Korea and Japan, however, it is around 5% or 6%.

Why is the Japan-Korea FTA at a standstill? From 1998-2003, the two countries conducted joint research between the governments, business communities and intellectuals, and at the Asia-Pacific Economic Cooperation (APEC) Summit meeting in October 2003, political leaders agreed to open government-to-government FTA negotiations. The Korean people were told that the agreement would be concluded by 2004, but to our surprise, the negotiations stopped in December 2004 after six rounds of negotiations. There are many reasons for the standstill. Some political and historical issues cause very complicated and delicate problems between the two countries. However I want to emphasize for this Japanese audience the importance of domestic politics on the Japan-Korea FTA.

According to Putnam's theory of the two-level game, the Japanese government is conducting a Level I game with the Korean government, bargaining for a tentative agreement on the FTA issue. But according to Putnam, the Japanese government conducted not only this Level I game, but also a Level II game, negotiating domestically with various interest groups to persuade them to ratify the tentative agreement made between the Japanese and Korean governments.

Let us look at the Level II game in the Japan-Korea FTA. The two governments could not reach an agreement in the Level I game in 2004, but the Level I game is not the most important for the standstill of Japan-Korea FTA. It is the Level II game; hard domestic politics, in both Korea and in Japan. Robert Strauss, former U.S. STR (special trade representative), noted that he spent as much time negotiating with domestic constituents as he did with U.S. trading partners. In some sense, then, the Level II game is more important than the Level I game.

There are four determinants of domestic politics in the Japan-Korea FTA in the context of Putnam's model: (1) the nature of the negotiation issues, (2) the reaction of domestic interest groups, (3) politicization, and (4) political leadership.

As for the nature of the negotiation issues, if the interests of domestic groups are homogenous, the Level II game is very easy. For example, the South Korean and North Korean governments agreed to a peace treaty - everybody was happy. When it comes to the Japan-Korea FTA, however, there is a very clear distinction between winner groups and loser groups; the nature of the negotiation issues is heterogeneous. In Japan, the losers are farmers and the winners are in the manufacturing sector. The losers in Korea are the more than one million laborers in the parts and components industry, representing 46% of total manufacturing employment in Korea. Thus there is a very strong potential for a political reaction from organized labor in Korea. The second group of losers in Korea is small and medium-size enterprises (SMEs). In the parts and components sector, SMEs account for around 30% of the whole manufacturing sector, a factor that makes it difficult for the Korean government to conduct the Level II game.

The next determinant of domestic politics in the Japan-Korea FTA is symmetry of political reaction. This means that if the losers and winners have the same political voice, it is not so difficult for both governments to conduct the Level II game. The political reaction of domestic interest groups regarding the Korea-Japan FTA is very asymmetric. In Korea, organized farmers, labor unions and SMEs will make a loud political response to the FTA while winners try to enjoy free-riding. In the case of the Korea-Chile FTA, the losers were the Korean farmers associations, and they had a strong reaction. But at the time, the winners, big businesses, were silent.

The next determinant is political issues. When Korea made FTAs with Singapore, ASEAN and EFTA, it did not become a political issue, so it was very easy for Korean government to conduct the Level II game. For Japan-Korea FTA, the FTA is a delicate political issue because it is expected that it will hurt the interests of socially weak groups, such as farmers in Japan and small businesses and labor in Korea.

The last determinant is political leadership. Not only in the case of Japan and Korea, but worldwide it seems that politicians who have to count the votes of both farmers and labor unions will not exercise strong political leadership to persuade domestic interest groups. In the case of the ratification of the Korea-Chile FTA, South Korean President Kim Dae-Jung did not exercise strong political leadership to help the ratification. In contrast, I think U.S. President Clinton used strong political leadership in the ratification of the North American Free Trade Agreement (NAFTA).

All four determinants make the Level II game (domestic politics) of the Korea-Japan FTA very difficult. The nature is very heterogeneous, and the political reactions of domestic interest groups in both Japan and in Korea are very asymmetric. Thus, it becomes a political issue, and we cannot expect strong political leadership, particularly in Korea.

I would like to suggest a mid-level FTA as an icebreaker for the Japan-Korea FTA. Theoretically, there are three kinds of FTA: low-level, meaning a shallow integration; mid-level; and high-level, meaning deep integration. We expect to see the highest economic effect from a high-level FTA, but feasibility is very low, because of domestic politics, among other things. Although the effect of a low-level FTA would be less, it would be easy to form such an FTA between Japan and Korea. Unfortunately, however, this kind of low-level FTA is not allowed by the World Trade Organization (WTO). For Japan and Korea in the future, we have two options: We could try to have a high-level FTA, aiming at maximum effect in the long-term, or we could implement a mid-level FTA in the near future, with a relatively low effect. As a scholar, I would like to propose a mid-level FTA as second best. That would mean, significantly, excluding very sensitive items from the Japan-Korea FTA, as long as it is not against WTO regulations.

Actually, many countries have announced officially that they have high-level FTAs, but according to my survey I think that the majority are in fact mid-level FTAs, because in many cases highly sensitive items are left out. For example, sugar is an exception in the U.S.-Australia FTA, the Singapore-India FTA is just over 50% of the two countries' bilateral trade volume, and in the China-ASEAN FTA many exceptions are made for agricultural products.

How can we create this kind of mid-level FTA between two countries? This question relates to negotiation strategies. I will introduce a win-set game for mid-level FTAs. Understanding the role of the win-set is very important. The size of the Japanese and Korean governments win-set is decided by the Level II game; for example, the Japanese government's win-set vis-a-vis the Korean government is decided by the political reaction of Japanese farmers' organizations. The Korean government's win set vis-a-vis Japan is decided by the political reaction from organized labor and SMEs. When the two governments' win-sets overlap, we will be able to have an FTA agreement.

Let us look at some extreme scenarios. If, for example, we were to maximize Japanese trade interests by putting 100% of manufacturing production into the Japan-Korea FTA and no agricultural products, the Japanese domestic interest groups would be very happy, but Korea would not accept it. The opposite extreme would maximize Korean interests, with no manufacturing products and 100% of agricultural products included, but Japan would not accept it. I assume that if the Japanese government agreed to 50% opening of the agricultural market, and the Korean government agreed to open 50% of the manufacturing sector, this kind of win-set could not be agreed upon. Let us assume that in the future the Japanese government succeeds in persuading the Japanese organized farmers to open 100% of the agricultural sector. In that case, Japan's win-set would move toward the Korean side. It looks great, but then the Japanese government asks the Korean government in return to offer 100% opening of the manufacturing sector in exchange. In this case, the Korean win-set will not be able to move toward the Japanese win-set, because if Korea offers 100% of the manufacturing sector, there will be a strong reaction from organized labor and SMEs. The Korean government will be unable to stand up against this political reaction, and the win-set will move back.

The solution I propose is a mid-level FTA in which, for example, Japan proposes opening 70% of the agricultural market and the Korean government agrees to open 70% of the manufacturing sector. Then there is an overlap in win-set and an agreement on the Japan-Korea FTA. This is the basic idea of negotiation strategy based on win-set theory. As a scholar, my basic idea is that to have a mid-level FTA between Japan and Korea is better than not having an FTA at all. Even if its economic effect is not particularly high, Japan and Korea will be able to move toward deep integration, just like the EU, which took more than 40 years to realize.

Let me explain why I suggest a mid-level FTA between Japan and Korea. I already mentioned the hard domestic politics factor, but there is also a new geopolitical landscape emerging in East Asia as the result of the ongoing U.S.-Korea FTA negotiations and the development of the Greater Chinese Economic Zone. There are about 4 million overseas Chinese in ASEAN countries, representing about 10% of the total population in this region, holding over 60% of the local economic power. I think the basic direction of Chinese FTA policy is moving south, and that if there is a successful agreement on the China-ASEAN FTA in the year 2010, I think we will see such a zone emerge. The only remaining countries in East Asia are Japan and Korea. The geese flying development pattern will be replaced by this Greater Chinese Economic Zone. As a midsized country, what is Korea's choice? It is between Japan and China. In my opinion, there should be a mid-level FTA between Korea and Japan first, and then an FTA with China. In that way, China, Japan and Korea will be able to move toward full economic integration in the East Asian region.

Finally, the U.S.-Korea FTA. The U.S. is Korea's second-largest trading partner, and Korea is the U.S.' seventh-largest trading partner. Both governments agreed to hold multiple rounds of negotiation by March of 2007. I was surprised that the U.S. accepted Korea's request for open dialogue on a bilateral FTA. As you may be aware, the U.S. is negotiating or has signed FTAs with 29 countries, and 25 countries, including Japan, are on the waiting list to open dialogue on an FTA with the U.S. There could be many reasons why the U.S decided to enter negotiations with Korea, but I would like to explain it with two factors. First, historically, the U.S. has engaged in three types of FTA. The first is for the pursuit of purely economic cooperation, as in the cases of NAFTA and the U.S.-Australia agreement. The second category is for security purposes, as in the FTAs between the U.S. and Israel and Jordan. The aim of the U.S.-Korea FTA is a third type, a mixture between economic cooperation and strategic alliance. A second reason is the emergence of the Greater Chinese Economic Zone. The U.S. is trying to respond to this development of the GCEZ by making FTAs with a good number of countries in East Asia. The U.S. has FTAs with Australia and some countries (Malaysia, Thailand, etc.) in the southern part of Asia. Among countries in Northeast Asia, Japan's economy is too strong, too competitive for the U.S. to have an FTA. Korea, by contrast, is a mid-sized country, and the U.S. feels very comfortable with the situation there.

Let me now explain some of the hot issues between the U.S. and Korea. The U.S. insists on opening the service market in Korea, as well as agricultural products such as rice and beef, and the automotive tax system issues. But the Korean government is insisting that the U.S. agree to open up to products made in the Gaesung Complex, an industrial complex located in North Korea in which some South Korean companies have invested. This is one of the hottest issues in the negotiations, but the Korean government is also demanding more transparent regulation of U.S. anti-dumping regulations and other business migration issues. Also, there are certain people in Korea strongly against globalization, so the U.S.-Korea FTA is becoming a fiercely political issue. Already, more than 280 Korean NGOs, organized labor unions, and farmers' organizations have formed an anti-U.S.-Korea FTA alliance.

Let me make a very cautious prediction about how the U.S.-Korea FTA will develop. I think it will be a very hard, thrilling concession-making game. The political reaction will skyrocket by the end of this year.

Here is my cautious forecast: from the end of this year and/or the beginning of next year, I think that there will be big progress, because both governments have mutual interest in a U.S.-Korea FTA, so both will try to find a political solution. The Gaesung Complex issue, for instance, is related to an outsourcing clause in the bilateral FTA; the U.S. has acceded to such an outsourcing clause in two previous cases: the U.S.-Israel FTA and the U.S.-Singapore FTA.

C: I think you are quite right and pragmatic to say that most of the existing FTAs in today's world are somewhat mid-level FTAs. If we really want to reach an agreement between Korea and Japan, we must find a mutually satisfactory compromise.

With regard to losers and winners in Korea and Japan, it is often said that Japanese farmers and Korean manufacturers are the losers. I sometimes wonder whether this is true. Korea is not a net farm product exporter; like Japan, it is a farm product importing country. If the barriers are eliminated between Korea and Japan, some products will be exported to Japan, but I doubt that Korean products will inundate the Japanese market. On the other hand, although Japanese farmers are very defensive, in a few years I think it is likely that some Japanese farm products will be exported to Korea and two-way trade will increase. Likewise in the manufacturing sector, as you pointed out, the Japanese and Korean industries are highly integrated; imports from Japan benefit the Korean industrial sector. In this sense, eliminating barriers in the industrial sector would actually benefit Korea. My sense is that we need to examine this more carefully. In the middle and long term, I think there are some Japanese farmers who will benefit from an FTA, and some Korean industry sector people who would benefit from a bilateral FTA.

A: When Korea made its FTA with Chile, organized Korean farmers strongly protested that the import of Chilean grapes would destroy Korean agriculture. Three years after the FTA was enacted, almost nothing had happened. Korea's per capita income is high enough allow consumers to decline to buy chemically-treated, imported Chilean grapes, and I think the same thing would happen in the Japanese market if Japan and Korea had an FTA. I also agree about winners and losers in the manufacturing sector. In the parts and components industry there might be serious damage, but the most important winners in Korean manufacturing would be those who use imported Japanese parts and components. Companies like Samsung and LG would be able to enjoy inexpensive Japanese parts and components and enhance their international competitiveness.

Q: How did leadership changes in Korea affect the FTA negotiation standstill in 2004?

A: I did emphasize the influence of domestic politics on the FTA between Japan and Korea, but it is a complicated, very controversial relationship, and I do not think I am in a position to answer at this moment.

Q: Do you expect that the Japan-Korea FTA negotiations will resume, or will the standstill continue?

A: I think the Japan-Korea FTA will not move forward under the current Korean government. But at the end of next year, Korea will have a presidential election, and I hope that our new president will take the right approach in conducting an FTA with Japan.

Q: What are the prospects for WTO acceptance of your proposed mid-level FTAs? Also, regarding the Korean government's proposal for trade adjustment assistance, if the FTA with the U.S. becomes realized: Is there any proposal already on the table?

A: I am going to reply optimistically to your first question. GATT Article XXIV stipulates something against low-level FTAs, but in reality, it is not easy to identify if an FTA is high-level, mid-level or low-level. I am saying that not only Japan and Korea, but also the U.S. and Korea had better have a mid-level FTA.

As for your second question, that is an important policy agenda for Korean farmers. A trade adjustment assistance act has been proposed and is in the National Assembly, but the problem is that it only covers the manufacturing sector, not the very controversial agricultural sector. Many things remain for the government to do in this field.

Q: When you suggest a mid-level FTA as a way for Japan and Korea to move forward, what is the degree that you would suggest?

A: My concept of the mid-level FTAs is vertical; that is to say, in the degree of market opening in terms of tariff reduction. For example, in the case of the Korea-Chile FTA, as I told you, the hardest issue was grapes, although grapes represent 0.1% of bilateral trade volume between the two countries.

Q: You said that the FTA winners in Korea are free-riding, that big businesses were silent. If that is true, who is promoting the FTAs? What is the motivation of the Korean government to pursue FTAs, especially in the case of the U.S.-Korea FTA? Perhaps the U.S. has strongly requested the opening up of the market. But why would the government of Korea pursue this FTA?

A: In the case of the Korea-Chile FTA, Korean big businesses are now enjoying the Chilean market, but at the time they did not raise any voice against the organized farmers' political reactions; the relationship between the winners and losers was very asymmetric. Now, with the U.S.-Korea FTA, many members of the business and intellectual communities are fighting against the anti-FTA groups; the political reaction is no longer asymmetric. Why, when they were silent about the Korea-Chile FTA, are they now responding to anti-U.S. FTA groups? It is because the business people are worried about that the anti-U.S.-Korea FTA activities are too politically and ideologically motivated. Actually, many Korean people think that substantial parts of these people of anti U.S.-Korea FTA are anti-U.S. and pro-North Korea.

Q: How do you see the future of Korean FTA policy as a whole, especially on the East Asian economic integration?

A: Both former President Kim Dae-Jung and current President Roh Moo-Hyun frequently speak about East Asian economic integration, to say the creation of the China-Japan-Korea FTA. This is diplomatic leadership, but in my opinion it is not possible to have China, Japan and Korea in an FTA at once. As for the future, if the U.S. and Korea conclude an FTA next year, I think it will be China which has to move toward Korea, because there will be a trade-diverting effect at China's expense. Many agricultural products currently coming to Korea from China will be replaced by imports from the U.S. In response, I think China will propose an FTA with Korea. After that, I hope that Korea and Japan will be able to reopen our dialogue on the FTA. In the long term, China and Japan will have an FTA and be able to move toward full economic integration, but I am not sure how long it will take. If there is a long way to go, we have to start taking the first steps now.

Q: I can imagine how strong the resistance is from Korean farmers. What benefits does the Korean government see in a U.S.-Korea FTA sufficient to overcome this resistance? Are there any real economic interests?

A: What is the real interest of Korea in having an FTA with the U.S.? Personally, I did not expect that the Korean president would ask the U.S. to have an FTA, but he did, and the U.S accepted. To answer your question, in the long term it is good for the Korean economy to open up. McDonald's, Coca-Cola and Wal-Mart are all big global players; whenever they step into the local market of a country, they occupy the number one place. In Korea, however, they could not compete with local businesses. I am strongly convinced that if Korea opens up its domestic market, Korean enterprises will do their best to compete with the foreign businesses, and by doing so will enhance their international competitiveness.

*This summary was compiled by RIETI Editorial staff.