Lee Myung-bak's landslide election victory was greeted enthusiastically by foreign investors who expected growth-oriented business-friendly policies, rapid implementation of economic reforms, and Korean ratification of the Korea-US free trade agreement. In Korean politics, however, the only constant change and the intervening months have brought dashed hopes and lowered expectations. The chastened president was forced by extensive public protests to curtail economic policy initiatives.

As a result, investors continue to flee Korea and pundits speculate whether the politically weakened Lee is already a lame duck only six months into his five year term. In order to reverse this dangerous trend, Lee must reassure investors by implementing critically needed economic reforms. Ratifying the KORUS FTA is particularly important since it will improve the country's competitiveness against regional economic rivals China and Japan; provide momentum for significant economic reforms; and send a powerful signal that Korea is receptive to critically needed foreign and domestic investment.

Economic fallout from Korea's protest mentality

President Lee spoke of the Korea "national brand" in his August 15th National Liberation and Founding Day speech. He warned that the "very first images that come to foreigners' minds are labor-management disputes and street rallies. In this context, if the nation wants to be labeled as an advanced country, it will be necessary to improve its image and reputation significantly."

His description is correct, though it understates the extent of Korea's difficulties. In recent years, the Korean national image suffered in the international business community as a result of President Roh Moo-hyun's vacillating but generally anti-business economic policies as well as the anti-foreign sentiment evident in the crusade against overseas investment firms.

This year's anti-beef protests only affirmed investor perceptions that Korea is not a business-friendly investment environment. Moreover, the fierce public nationalism unleashed against Japan and the United States over the Dokdo dispute, and the government's willingness to succumb to it, suggests that Korea remains an immature democracy. President Lee's quest for Korea to be recognized as a top-tier status country was dealt a severe setback.

The root of the problem - economic nationalism

The South Korean public remains ambivalent about the effects of market liberalization. While cognizant of the need for open economies as trading partners for their own export-driven economy, Koreans maintain a xenophobic apprehension about the dangers of opening their country to foreign firms.

Perceptions that foreign investment funds gained excessive "predatory" profits from purchasing troubled Korean firms during the Asian Financial Crisis and making large tax-free profits upon their sale triggered a populist backlash. This, in turn, triggered legislative and regulatory action against foreign financial firms during the Roh administration and fueled demands for additional restrictions on foreign direct investment. For example, the announcement by U.S.-based Lone Star Funds that it intended to sell its majority shareholdings in the Korea Exchange Bank triggered at least four separate agency investigations.

Regulatory agencies also stepped up raids against foreign firms, the finance ministry tried to retroactively apply new tax laws, and the National Tax Service announced a campaign in 2006 to investigate 4,889 firms in which foreign investors owned at least 10 percent share holdings. These actions led to accusations of a government "witch hunt" against foreign firms.

Circling the Wagons Against Foreign Firms. The attempted hostile takeover of Korea Tobacco and Ginseng by corporate raider Carl Icahn set off protectionist alarms over the perceived danger of foreign firms stealing Korean businesses. Korean regulators during the Roh administration sought to implement defensive measures to protect domestic companies from foreign hostile takeovers.

Foreign business representatives criticized the government's anti-takeover initiatives as politically motivated attempts to impede foreign competition. The government's actions and advocacy of protectionist measures undermined Seoul's efforts to dispel perceptions that it was targeting foreign firms, and contributed to declining levels of foreign direct investment in Korea.

Lack of investment by Korean firms

Korean firms were also a part of this economic exodus. Roh's economic policies, including his strict prohibition on building manufacturing plants near Seoul, exacerbated business concerns about high labor costs and government restrictions. As a result, the chaebol hoarded enormous stockpiles of cash and moved operations overseas rather than investing in Korea. The outflow of Korean firms to overseas markets has generated concerns of a "hollowing out" of the country's production capability and a steady decline in employment opportunities.

A concurrent shortfall in long-term investment in domestic research and development led to a dwindling technological lead over the rapidly approaching Chinese economic dragon. Chinese industry has matured from a low-cost, labor-intensive manufacturing platform to become a direct challenger in many industries. Although Beijing's growing competitiveness has been perceived as a long-term threat sometime over the distant horizon, Chinese firms are already gaining market share and imperiling South Korean small and medium-sized enterprises.

Foreign investors looking elsewhere

South Korea has typically had lower profit return ratios than other Asian competitors and, for an increasing number of firms, the investment is simply not worth the risk. During 2008, there has been a continuance, if not an acceleration, of foreign direct investment outflow, foreign sell-offs on the KOSPI, and an overall shift to other Asian markets.

To be sure, some of the trend is due to worldwide economic trends; there has been a collective investor retreat from all emerging markets, which includes South Korea. But in the past, hedge fund managers had typically hedged their investments by reserving a percentage of their emerging market portfolio for the more stable Korean sector. The recent trend, however, has been to reduce exposure to the vagaries of Korea's economic xenophobia.

Regaining the economic initiative

To avoid economic stagnation, Korea must revitalize and strengthen its efforts at reform. Restrictive governmental policies and unfavorable labor conditions are sapping economic strength. While Korea's reform efforts are stalled, those of its economic rivals are not. Without a second wave of economic reforms, Korea will suffer declining competitiveness, and investors will increasingly look to more profitable markets.

Korea must upgrade its technological base if it hopes to remain ahead of its competitors, particularly China and Japan. This means that firms must be able operate in a flexible and market-driven environment, but Korea's business environment remains inhospitable because of labor market inflexibility, rigid institutions, and government regulations.

Korea's economic challenges are too severe to allow for a timorous president to bunker down in the Blue House. Although the anti-beef demonstrations unleashed forces inimical to free trade, President Lee Myung-bak must stand firm and regain the initiative to press for economic reform. Like a prize fighter dazed and bloodied in the first round of a lengthy championship bout, President Lee must pull himself up and continue for the length of his administration.

Fortunately, he does not stand alone. The ruling Grand National Party enjoys a majority in the National Assembly, enabling it to implement economic reform legislation. The Blue House and GNP must work closely together to delineate and articulate a common blueprint for enhancing South Korea's economic competitiveness. The government must also prepare an effective public diplomacy campaign to counter the inevitable campaign of falsehoods, strikes, and demonstrations that protectionists will bring to bear.

Though initially unpopular, remedial economic reform will eventually bear fruit and improve Korea's economy. Allowing obstructionists to maintain an economically stagnant status quo works against the well-being of the South Korean people.

l Bruce Klingner is senior research fellow for Northeast Asia in the Asian Studies Center at the Heritage Foundation.