The economy of South Korea, Asia's third-larg­est economic power, shows favorable but conflict­ing indicators. Current performance reflects a strengthening recovery, but inconsistent eco­nomic policies, lingering systemic deficiencies, and increasingly competitive rivals create signifi­cant long-term challenges.

South Korea has made significant strides since the 1997 Asian financial crisis forced it to open its markets and implement sweeping market-ori­ented reforms, but failure to implement necessary follow-on reform measures could undermine long-term competitiveness. The five years of the Roh Moo-hyun administration were marked by uneven economic policies, conflicting signals from senior officials, and rising public animosity toward overseas companies, all of which hindered domestic and foreign investment.

To avoid economic stagnation, South Korea must revitalize and strengthen its reform efforts. Restrictive governmental policies and unfavorable labor conditions are sapping economic strength. Moreover, while South Korea's reform efforts are stalled, those of its economic rivals are not. With­out a second wave of economic reforms, investors increasingly will bypass South Korea for more prof­itable markets.

The December 2007 presidential election will be a referendum on South Korea's economic future. Economic issues are at the center of the debate, and the leading candidates offer strikingly different pol­icy prescriptions. Lee Myung-bak, the conservative Grand National Party candidate, and independent conservative candidate Lee Hoi-chang advocate a pro-growth economic strategy based on deregula­tion, tax reform, and more openness to investment. United New Democratic Party candidate Chung Dong-young advocates redistributionist economic policies, growth through economic cooperation with North Korea, and maintaining current protec­tionist policies against foreign investors.

What Should Be Done. U.S. policymakers should emphasize to the next South Korean presi­dent the mutual benefits of free-market economic policies. In particular, Washington should:

• Build support for a stronger U.S.-South Korea economic relationship. The U.S. must explain clearly and fairly the advantages of the Korea-U.S. Free Trade Agreement (KORUS FTA) without prejudice to any one sector's treatment.
  
• Communicate U.S. priorities to South Korea through open and early dialogues. The U.S. must assure the new leadership that it is willing to provide unequivocal and vigorous support for South Korea's financial, economic, and political reforms.
• Encourage South Korea to create a more invit­ing business atmosphere. To maintain its advantage over its regional competitors and advance economically, South Korea must over­come xenophobic fears of foreign investment and accelerate ongoing reform efforts.

For its part, South Korea's next economic team should (among other actions):

• Improve competitiveness by enhancing eco­nomic freedom. Commitments to slashing the regulatory burden and increasing transparency must be strengthened to encourage more entre­preneurial activity.
• Shore up public support for the KORUS FTA. Implementation of the KORUS FTA would give South Korea a significant regional trade advan­tage and send a powerful signal to foreign and domestic investors.
• Promote the rule of law in dealing with mili­tant labor unions. South Korea's labor market flexibility has long been hampered by high costs and the militancy of the country's labor unions.
• Accelerate corporate governance reform. South Korea's corporate governance reform project remains incomplete despite progress since the 1997 financial crisis.
• Pursue tax reform. South Korea needs to con­sider a more competitive corporate tax rate, both to attract greater corporate investment and to remain competitive in Northeast Asia.
• Open the service sector and increase its flexibility. Increasing the viability of the ser­vice sector would give South Korea another engine of growth and reduce its excessive reli­ance on exports.
• Reduce balanced regional growth restrictions. The economic damage caused by the decision to move the capital from Seoul to a regional area could be minimized by reducing the number of government agencies to be moved and making a portion of the land available for business use.

Conclusion. South Korea possesses enviable economic strengths. It enjoys a stable political sys­tem, a strong cultural work ethic, a highly educated workforce, and a history of technological innova­tion. But the country is fast approaching a critical juncture. If it continues the policies of President Roh Moo-hyun, it will see its economic growth gradually diminish.

The danger is not that South Korea's economy will burst but that it will become less attractive to investors, causing them to invest elsewhere. Chang­ing perceptions of the political, security, and invest­ment environments will lead to changes in the amounts that portfolio managers choose either to invest in South Korea or to redirect elsewhere. These alterations in investment behavior are deter­mined not only by risk assessment but also by changing perceptions of profitability. South Korea has typically had a low payout compared with regional rivals.

To avoid economic stagnation, South Korea must allow market forces to replace government and labor intervention. If implemented, such reforms would unleash the full potential of the South Korean peo­ple and significantly improve the country's eco­nomic competitiveness and strength as a U.S. business partner. Seoul should improve its invest­ment environment through legislative reforms and implement structural reforms to increase the com­petitiveness and profitability of South Korean firms.

The South Korean economic engine requires a major overhaul, not just tinkering under the hood. South Korea's next president needs to show a more adept hand on the economic helm as well as a will­ingness to take bold action early in his term.

Bruce Klingner is Senior Research Fellow for Northeast Asia in the Asian Studies Center, and Anthony B. Kim is Policy Analyst in the Center for International Trade and Economics, at The Heritage Foundation.