The economic statecraft idea

In recent years, the securitization of international trade has garnered increased attention.Footnote ⁶ Notably, discussions on economic statecraft, spanning economic sanctions, trade policies, investment strategies, and financial measures, have captured the interest of scholars and policymakers. Aggarwal and Reddie have been particularly active in this field, examining various forms of economic statecraft and analyzing how states utilize economic instruments to influence the behavior of other states, advance national interests, and achieve geopolitical objectives.Footnote ⁷ Their research highlights the intricate and multifaceted nature of economic statecraft, recognizing that it encompasses both coercive and cooperative measures.Footnote ⁸ Economic statecraft can thus exert pressure on other states, incentivize preferred behavior, or establish economic interdependencies that foster stability and cooperation. Additionally, they explore domestic and international factors shaping the effectiveness of economic statecraft, including the role of domestic politics, economic interdependence, international institutions, and the power dynamics among states.Footnote ⁹

The aggressive trade policy of the Trump administration, operating under the guise of “America First,” stands as a worst-case example of economic statecraft. Leveraging the asymmetric power relationship between the U.S. and its trading partners, Trump’s policy plunged America’s trading partners into chaos. Countries with significant trade surpluses with the U.S., such as China, Japan, and South Korea, faced threats of being labeled as currency manipulators and subjected to trade restrictions.Footnote ¹⁰ The revival of neo-mercantilism has further intensified the trade-security nexus, evident in the battle for techno-hegemony amid high-stakes geopolitics and geo-economics.Footnote ¹¹

Against the backdrop of growing interest in economic statecraft, industrial policy is back in fashion. The theoretical and normative debate has thus far revolved around the question of whether governments should intervene in market activities at all. However, the question of how they should do so is increasingly becoming relevant and prevalent. Governments have always implemented policies to promote industrial activities. Even during the heyday of free trade and market fundamentalism, major trading states embraced interventionist policies to support their domestic industries, often under the disguise of national security and economic prosperity.Footnote ¹²

As noted by Paul Krugman back in the 1980s, the practical implications of interventionist policy to support particular industries deemed strategically important are complex.Footnote ¹³ Nevertheless, scholars have developed a theoretical justification for industrial policy based on technological and learning externalities, as well as coordination failures. Even in the U.S., some form of industrial policy has never been scarce and is likely to persist. Defense-related industries, in particular, have been the principal beneficiaries of government subsidies and procurement programs.

The economic crisis that struck the world economy in 2008 was a decisive moment that brought industrial policies back onto the stage in full force. It united mercantilism with protectionist populism and the idea of economic statecraft, especially in the affluent world. The restructuring efforts, inevitable during the global financial crisis, inflicted significant pain on workers and caused protectionist thinking to resurface in the political marketplace. Many observed that neoliberal assumption of a non-interventionist government generating greater prosperity for all was contradicted by the rising inequality, economic insecurity, and labor market polarization worldwide, affecting both the rich and poor. Governments are increasingly seen as a last resort. The Covid-19 pandemic exacerbated the situation, but the protectionist clock had already been set in motion even before the pandemic struck, threatening to disrupt global trade.Footnote ¹⁴

A new industrial policy framework

Indeed, there is a growing recognition, even among economists, that government intervention under certain circumstances can promote specific industries or sectors, thereby fostering national security and economic growth. Additionally, there is a concerning awareness regarding China. Its industrial and technological ascent is exemplified by Made in China 2025, which aims to achieve global dominance by the centennial of the Chinese Communist Party in 2049 across ten high-tech industries, including next-generation information technology, electric vehicles, advanced rail and shipbuilding, high-end numerical control machinery and robotics, and aerospace and aviation equipment.Footnote ¹⁵ Such a perception of a “China threat” has resulted in a near-consensus in the rest of the world that governments need to respond by enhancing key technology and industrial capabilities.Footnote ¹⁶

Among others, Dani Rodrik emphasizes a strategic approach to industrial policy that reflects on a country’s unique conditions, capabilities, and market failures. According to him, successful industrial policy should concentrate on creating a conducive environment for business to thrive rather than picking winners or specific companies.Footnote ¹⁷ Along this line of thought, he suggests some design principles for new industrial policy, which can be categorized into two different but related dimensions: (1) policy goals and tools and (2) requirements for government agencies, as illustrated in Figure 1.Footnote ¹⁸

Figure 1. Ten Design Principles of NIP by Dani Rodrik.

Source: Adapted from Rodrik (Reference Rodrik and Rodrik2007) by the author.

In the following sections, this study shifts focus to the Japan–South Korea whitelist dispute and South Korea’s industrial response to Japan’s restrictive measures. The South Korean case, operating under the guise of economic nationalism, serves as both a to-do and a not-to-do example of economic statecraft and industrial policy. By leveraging anti-Japan sentiments within South Korea, the then-South Korean government not only strained bilateral economic ties to a breaking point but also incurred significant opportunity costs for South Korea’s industrial ecosystem.

The power implications of bilateral trade for the two neighbors

Since normalizing its diplomatic relations in 1965, South Korea has consistently faced a trade deficit with Japan. The scale of this deficit continued to grow in the 2000s, particularly after the financial crisis. From 2000 to 2019, Japan remained South Korea’s largest trade deficit partner, excluding oil-producing Saudi Arabia. ^{Footnote 19} The global economic crisis in 2008 further exacerbated this dependence, with the trade deficit reaching a record high of USD 36.1 billion in 2010. ^{Footnote 20} While there has been a recent reduction in the trade deficit with Japan, the imbalance persists.

From the perspective of the overall balance of trade, the trade deficit itself is not a big problem. As long as there is a surplus or balance at the multilateral level, a bilateral deficit is considered sustainable. Deficits resulting from imports of intermediate capital goods, such as parts and materials, can be offset by exporting intermediate goods or finished products to third countries within a global production network (GPN).

Both Japan, which has a comparative advantage in MPE sectors, and South Korea, which has a comparative advantage in the production of intermediate and final goods, have benefited from their bilateral trade. In 2010, for instance, South Korea’s massive surplus in trade with China, Hong Kong, and the U.S. resulted in a total trade surplus of USD 41.2 billion, surpassing the deficit with Japan.

A noteworthy example is the memory chip industry, South Korea’s largest surplus item, which began to flourish by importing MPE products from Japan, manufacturing finished goods, and exporting them globally within a GPN system. However, trade dependence and the resulting distribution of relative gains create unintended power dynamics.Footnote ²¹ When political and diplomatic relations between trading partners become strained, a less dependent country may be tempted to leverage the relationship to exert pressure on a more dependent country.Footnote ²²

Shortly after the G20 summit held in Osaka in June 2019, the Japanese government amended export control regulations vis-à-vis South Korea, making it more difficult to export three products crucial for the manufacturing of high-tech products like liquid crystals and semiconductors. Japan argued that the measure was not in retaliation for the South Korean Supreme Court ruling in 2018, but because “the relationship of trust between the two countries was significantly damaged.” Japan also claimed that its measures did not violate any trade rules under the WTO, asserting that South Korea threatened Japanese security by illegally re-exporting materials from Japan to hostile countries.Footnote ²³

Japan’s export restrictions dealt a severe blow to South Korea’s industrial vulnerabilities.Footnote ²⁴ Despite substantial growth in South Korea’ MPE industry in the 2000s, its focus on mass-producing readily developed general products has resulted in a significant dependence on a handful of countries, especially Japan, for the supply of essential MPE products to advanced industries such as semiconductors and displays. Japan held a dominant share of 70–90% in the global market for the three core items subject to export restrictions. As the trade dispute unfolded in the summer of 2019, the Bank of Korea anticipated adverse effects on the South Korean economy should Japan’s export restrictions continue. In contrast to big chaebol companies equipped with substantial inventories and diversified import sources, some small and medium-sized enterprises found themselves in a state of panic, struggling to navigate the abrupt export restrictions and find alternatives to Japanese products.Footnote ²⁵

The legal dispute behind the scenes

Following unsuccessful consultations with Japan requested in September 2019, the South Korean government filed a complaint to the WTO DSB, which established a panel in June 2020. Seoul contended that Tokyo’s measures violated several WTO obligations, including GATT Article 1 (General Most-Favored-Nation Treatment), Article 8 (Fees and Formalities Connected with Importation and Exportation), Article 11 (General Elimination of Quantity Restrictions), Article 13 (Non-discriminatory Administration of Quantitative Restrictions), and Article 23 (Nullification or Impairment), along with relevant provisions of the Trade Facilitation Agreement, Trade-Related Investment Measures Agreement, Trade-Related Aspects of Intellectual Property Rights Agreement, and General Agreement on Trade in Services.

From an economic statecraft point of view, the crucial issue of the linkage between trade and security remains ambiguous and lax in its rules under the WTO system. Article 21 of the GATT provides one of the few primary legal foundations. Generally interpreted as allowing trade-restrictive or discriminatory measures on the grounds of national security, concerns were raised about the potential abuse of the term “essential security interests” from the outset.Footnote ²⁶ A drafter of the GATT expressed apprehension that a Member’s essential security interests “would permit anything under the sun” and stressed the need for balance.Footnote ²⁷

The most recent legal case, DS512: Russia—Measures Concerning Traffic in in Transit, had its panel report adopted in April 2019.Footnote ²⁸ Initiated in September 2016 when Ukraine requested consultations with the Russian Federation, the case involved alleged multiple restrictions on traffic in transit from Ukraine through Russia to third countries like Kazakhstan and Kyrgyzstan.

In a ruling issued in 2019, the WTO panel determined that all WTO members, including Russia, can impose trade restrictions on trade issues with “essential security interests,” provided such restrictions are made in “good faith.” The panel also concluded that Russia, in its relations with Ukraine, was in a situation equivalent to the “hard core of war or armed conflict,” as in the 2014 Crimean War, allowing it to ban Ukrainian cargo from transiting through its territory in accordance with Article 21.

The key question revolves around the interpretation of “core security interests” rather than its application. The panel defines this as “those interests relating to the quintessential functions of the state,” with judgment left to “the particular situation and perceptions of the state,” which “can be expected to vary with changing circumstances.” The crux lies in how each member perceives its own core security interests.Footnote ²⁹

Unlike the Russia-Ukraine case, it appeared challenging for Japan to prove that export control measures were necessary for national security when the risk of armed conflict between South Korea and Japan is low.Footnote ³⁰ However, given the WTO’s acknowledgement of the “self-judging nature” concerning the assessment of core security interests in the Russia-Ukraine case, the possibility of Japan’s claim being accepted could not be entirely excluded.Footnote ³¹

The legal battle over the application and interpretation of Article 21 was poised to center on two related issues: (1) whether South Korea had imported strategic items from Japan and re-exported them to other hostile countries and (2) whether the relationship of trust between South Korea and Japan had thus been significantly damaged to the extent that it threatened Japan’s essential security interests. However, the case abruptly concluded as South Korea withdrew its complaint against Japan from the WTO DSB in March 2023, leaving numerous legal and normative questions unanswered and the depths of security-trade nexus unexplored.

The economic statecraft tango that takes two

The Japanese trade-restrictive measure sent a series of shockwaves to South Korea, which heavily relied on Japan for a significant portion of MPE imports required for semiconductor and LCD manufacturing.Footnote ³² This measure could act as a headwind for Japanese exporters as well. In the worst case for Japan, if South Korean semiconductor companies achieve self-sufficiency or diversify their business partners, Japanese companies could lose their biggest customers, such as Samsung Electronics and SK Hynix. Why did the Japanese government make such a move nevertheless?

Certainly, it was not the first high-profile trade dispute between the two neighbors. In the early 2000s, there was a countervailing duties dispute over Hynix Semiconductor, and in the 2010s, there was a dispute over Fukushima seafood products. Both disputes involved fierce legal and diplomatic battles that reached the WTO DSB but were not overly politicized in South Korea or Japan. They were waged and managed at the administrative levels. However, the whitelist dispute escalated into a significant controversy not only in South Korea but also in Japan. This case became politically charged because security and historical issues were intertwined in all directions.Footnote ³³

Frustrated with the rapid escalation of South Korean sentiments against Japan and the potential seizure and sale of Japanese corporate assets to compensate South Korean wartime forced workers, the Japanese government attempted to link trade to security (and wartime history). ^{Footnote 34} Japan clearly recognized that South Korea’s trade dependence on Japan was high, especially for MPE imports. As of 2019, the share of MPE products in South Korea’s imports from Japan was 68%, while the shares from China and the U.S. were 53% and 40%, respectively.Footnote ³⁵

It was likely that Japanese measures would harm its own companies exporting products to South Korea. From the welfare economic standpoint, Japanese measures were irrational. Inflicting damage on foreign companies, even at the expense of domestic companies, suggests that there were political benefits that might outweigh the economic damage. It is difficult to measure the extent to which Japan has gained in this regard. However, the fact that Tokyo lifted trade sanctions against South Korea the moment Seoul showed a friendly gesture regarding the forced labor issue indicates that Japan also experienced considerable economic losses. Table 1 below summarizes the chronological sequence of actions and reactions between Japan and South Korea.

Table 1: Chronological overview of the whitelist dispute

Source: Adapted from National White Paper Compilation Committee (2022).

Ideologically driven policy goals and tools

In response to the Japan’s retaliatory measure, the Moon government promptly initiated a localization policy for core MPE products, seeking to mitigate the adverse impacts of Japanese regulation. However, President Moon’s ambitious policy encountered challenges from the outset, as government incentives primarily supported “old” activities with the hope that they would spawn “new” areas of comparative advantage.Footnote ³⁶

The government measures were specifically designed to strengthen the competitiveness of MPE industries for 100 selected items, aiming for a stable supply of 20 items within one year and 80 items within five years. These 100 items were chosen from six major sectors, including semiconductors, displays, automobiles, electrical and electronics, machinery/metals, and basic chemistry. In late 2020, the Special Law on Materials, Parts, and Equipment was enacted, committing to an investment of approximately USD 10 billion in MPE sectors by 2024. In accordance with this special law, the Special Account for MPE and the Committee for Reinforcing the Competitiveness of MPE were also established.Footnote ³⁷

Following the establishment of the Special Account, the budget for the MPE support projects from 2020 to 2022 amounted to KRW 7.1 trillion (about USD 5.4 billion), allocated among the Ministry of Trade, Industry, and Energy (MOTIE), the Ministry of Science and ICT (MSIT), the Ministry of SMEs and Startups (MSS), and the Financial Services Commission (FSC). Among them, the MOTIE held the highest proportion with KRW 4.5 trillion (See Table 2). As shown in Table 3, the budget for MPE support projects was categorized into “Technology Development” for MPE technology development, “Infrastructure Building” for enhancing trust lines and strengthening upward cooperation bases, and “Investment and Loans” for financial support. Among these, the “Technology Development” category consistently recorded the highest budget amount and proportion each period, occupying the majority of the overall budget for MPE support projects.Footnote ³⁸

Table 2: Budget allocations for the MPE special account by ministries (Million KRW, %)

Source: National White Paper Compilation Committee (2022: 155).

Table 3: MPE special account budgets by categories (Million KRW, %)

Source: National White Paper Compilation Committee (2022: 156).

However, the MPE localization policy lacked clear benchmarks and criteria for success and failure, with no built-in sunset clause, tying up scarce resources in non-performing activities for an extended period. Unsurprisingly, the number of “zombie” MPE companies, whose profits were lower than their financing costs, doubled from 2019 to 2021.Footnote ³⁹ Generous government subsidies have been identified as contributing to moral hazards, trapping these firms in precarious situations. The absence of project audits and an ambiguous selection process fostered administrative and managerial loopholes, incubating rent-seeking behaviors in marginal enterprises.

While it is crucial to nurture industries related to national security or secure strategically important materials for emergencies, the theoretical basis for arguing that the state should increase domestic production of strategic items when imports are restricted is weak. Even if one accepts the logic of localization of core MPE products for national security, the possibility of political abuse is high due to the ambiguous logic of trade-security nexus. Determining which items are critical to national security is challenging, especially in an era dominated by cyberwarfare, where no industry is unrelated to national security in emergencies. National security is better served by overall national economic capability rather than the growth of specific industries like the defense or strategic industry.Footnote ^{40 ,} Footnote ⁴¹

The government’s program targeted specific sectors rather than activities. Only a handful of subsidized firms demonstrated spillovers and demonstration effects, while others generated a significant diversion effect.Footnote ⁴² Concerns about weaponizing economic interdependence are valid, as South Korea’s linkages with China and Japan have become sensitive and vulnerable.Footnote ⁴³ Paradoxically, South Korea’s effort to distance itself from Japan has increased its reliance on China for both imports and exports of MPE products.Footnote ⁴⁴

Despite these challenges, the Moon government took pride in its localization projects.Footnote ⁴⁵ It asserted that within three years, South Korea had successfully stabilized the supply and demand of the three core products. With domestic production doubling, South Korea’s reliance on high-purity hydrogen fluoride from Japan decreased by 30 percent. Additionally, the dependence on Japanese photoresist dropped from 100 percent to less than 50 percent due to the exploration of new suppliers in other countries. The imports of fluorinated polyimides from Japan effectively reached zero by developing alternative materials, such as ultra-thin glass.Footnote ⁴⁶

However, this assessment is misleading, if not mistaken. For instance, the dependence on Japan for photoresist decreased as South Korean firms identified alternative supply sources in Belgium. During this period, South Korea’s imports from JSR’s Belgium subsidiary increased more than tenfold. Established in 1957, JSR Corporation is a Japan-based company. Meanwhile, some South Korean firms achieved success in localizing the production of high-purity hydrogen fluoride. However, they remain overshadowed by Japan, still depending on joint ventures with Japanese chemical companies.Footnote ⁴⁷

The Japanese share of total South Korean MPE imports did decrease from 2019 to 2021. Nevertheless, the value of imported goods from Japan was USD 32.9 billion in 2019 and increased to USD 39.3 billion in 2021, primarily due to the thriving semiconductor industry (See Table 4). South Korea’s dependence on Japan for the three key semiconductor materials remains significant. If the domestic production or the imports from third countries—where Japanese companies invested their capital and technology—are considered, South Korea’s dependence on Japanese MPE products could be much greater than formal statistics indicates. Japanese subsidiaries have also evaded trade restrictions by expanding investments in South Korea or forming joint ventures with Korean companies to import MPE products to South Korea.

Table 4: South Korea’s imports of materials, parts, and equipment by country (Million USD, %)

Source: National White Paper Compilation Committee (2022: 20).

Until recently, many South Korean media outlets remained silent about the opportunity cost, possibly due to the prevailing anti-Japan sentiments. However, considering the billions of dollars budget invested thus far, it not clear whether the policy has been cost-effective. The competition to increase the localization rate may be politically reasonable but economically unsustainable, given finite government budgets and companies’ time and efforts. Technology localization always carries uncertainty, and even if achievements are made, long-term competitiveness may be compromised in other areas due to resource diversion. There is no evidence to suggest that total welfare has increased compared to before the summer of 2019, when South Korea and Japan mutually benefited in high-tech GPN based on the principle of international division of labor. Consequently, it can be concluded that none of the five “policy goals and tools” criteria suggested by the NIP literature have been met (See Figure 1).

Competent but politically captured implementing agency

At the initiation of MPE localization policy, few in South Korea questioned the bureaucratic legitimacy of the MOTIE as it emerged as a principal implementing and coordinating agency among various government and semi-government entities. The MOTIE appeared motivated and well-informed about its objectives when it requesting supplementary budget from the National Assembly, stating, “For the localization of materials, parts, and equipment highly dependent on foreign countries, we will actively promote projects in related fields such as core technology development, commercialization, and demonstration to reduce dependence on Japan and increase self-reliance for core parts”.Footnote ⁴⁸

The MOTIE promptly responded to the trend of trade securitization. In May 2020, it established a new division-level office, the Trade-Security Policy Bureau, tasked with planning and coordinating various security-related trade matters, including export permits for strategic materials, prevention of technology leakage, and other preemptive measures concerning sensitive technologies.Footnote ⁴⁹ With its demonstrated competence, there was little doubt that the MOTIE was the appropriate authority to implement the MPE localization policy for both security and economic purposes.Footnote ⁵⁰

However, amidst escalating diplomatic tensions with Japan, the MOTIE was granted limited administrative, let alone political, authority and policy autonomy essential for effective industrial policy. Under President Moon, the Presidential Office (then Blue House: BH) assumed a leading role from the outset, relegating the MOTIE to a subordinate position. Ironically, the implementing agency was closely monitored by President Moon, who had a vested interest in anti-Japanese sentiments. The Presidential Office promptly established the “Japan’s Export Restrictions Response Strategy Taskforce,” holding numerous meetings. Under the leadership of the economic advisor to the president, a dedicated BH Secretariat Support Team, encompassing the entire secretariat, was formed to ensure a consistent and systematic response to the situation of Japan’s export restrictions. The response involved meticulous monitoring of trends in companies directly affected, devising support measures, and addressing various aspects such as negotiations with Japan and potential risks to the foreign exchange and financial markets due to export restrictions.Footnote ⁵¹ Under excessive top-down demand for political accountability, the MOTIE had little room to navigate domestic and international politics.Footnote ⁵²

Amid the ongoing uncertainty caused by Japan’s export restrictions, the MOTIE took measures to provide accurate information to businesses and promptly address challenges. On July 22, 2019, The MOTIE established a collaborative system with nine government ministries, including the Ministry of Economy and Finance, the Ministry of SMEs and Startups, the Ministry of Environment, and the Customs Service. It also involved public organizations such as the Strategic Materials Management Office, the Korea Trade-Investment Promotion Agency, the Korea International Trade Association, as well as local governments and industry-specific associations and organizations. With the establishment of the MPE Supply-Demand Response Support Center in July 2019, inquiries began pouring in immediately.Footnote ⁵³

However, the localization of MPE products does not occur in a political and economic vacuum. Domestically, interest group politics is ever-present. The list of strategically important products can be extensive, encompassing hundreds, if not thousands, of goods and items. Government financing of the localization of specific materials, parts, and/or equipment often leads to other fields requesting government support. MOTIE’s effort to maintain communication channels with the private sector worsened the scenario as many, if not all, MPE-related firms sought to capitalize on the situation. As it expanded to meet future industrial demands in developing the MPE sectors, the MOTIE announced a five-year plan to increase the number of core strategic technologies from 100 to 150 in relevant industries. In addition to the existing list of core technologies, including semiconductors, displays, and electrical and electronic products, the target items diversified to include bio and pharmaceutical materials and future-generation vehicles.Footnote ⁵⁴

In theory, an implementing agency should be cautious about causing government failure by doing what it should not do (Type I error). It is also problematic if the government fails to act in areas where market failure occurs (Type II error). Discovering a country’s productive potential inevitably involves both types of mistakes and errors. As Rodrik (Reference Rodrik2022) emphasizes, there is no one-size-fits-all strategy, and that is why the implementing agency should be open-minded in learning from mistakes and adapting its strategies based on feedback, evaluation, and evidence.

From this perspective, MOTIE’s performance in terms of policy learning and adaptation has been limited. There is no clear evidence that the cycle of discovery has become an ongoing process with regards to MPE localization and promotion programs. The MOTIE has not demonstrated the capacity to reinvent and refashion itself. Unsurprisingly, the incumbent Yoon government has decided to cut the special budget for MPE products by 5.7% for the fiscal year 2023. The MPE budget for the Ministry of SMEs and Startups and the Ministry of Science and ICT has the largest cut by 38%. The political and administrative status of the Committee for Reinforcing the Competitiveness of MPE has been downgraded as well, moving from being affiliated with the Presidential Office to being under the Prime Minister’s Office.Footnote ⁵⁵ While these new developments do not necessarily indicate de jure policy failures, the abrupt termination of policy support represents de facto withdrawal of political backing for the MPE localization policy. Consequently, it can be concluded that none of the five criteria suggested by the NIP literature for “policy agencies” have been met (See Figure 1).