The Economics of the Korea-U.S. Free Trade Agreement

President Trump’s visit to South Korea this week occurs under a cloud of uncertainty over the future of our bilateral trading relationship. In an April interview with Reuters, the President said he was considering withdrawing from the Korea-U.S. Free Trade Agreement (KORUS), citing the U.S. trade deficit with South Korea. In the midst of an intensifying military threat from North Korea, President Trump again told reporters in September that he was considering withdrawing from this 5-year-old trade deal with the U.S.'s longtime ally on the Korean Peninsula. Key members of Congress, the business community, and the national security community have argued that strong ties with South Korea are not only good for the U.S. economy, but are also important for stability in the region. In early October, trade representatives from South Korea and the United States announced that they had agreed on a path to renegotiate aspects of the trade deal, though uncertainty remains regarding how this process will take shape.

The U.S. trade deficit in goods with South Korea has doubled since the treaty was implemented, but it could have been larger without the treaty.

The Facts:

• The U.S.-Korea Free Trade Agreement, known as KORUS, slashed tariffs on many goods traded between the two countries, increased U.S. access to South Korea’s services market, and strengthened South Korea’s intellectual property protections. The treaty was negotiated initially by the George W. Bush Administration and signed in 2007. However, ratification faced opposition from Democrats and became stalled in Congress. Due to rising tensions with North Korea, KORUS was given priority later during the Obama administration, when KORUS was seen as a way to support South Korea. The Obama administration negotiated and signed an amended treaty, which was ratified by Congress and came into force in March of 2012 (see here and here for the history of KORUS).
• Critics of the agreement cite the growth of the U.S. bilateral deficit in goods trade with South Korea as evidence that the treaty has not been good for the United States. The bilateral trade deficit in goods with South Korea more than doubled in the five years following the treaty's implementation, going from $13.2 billion in 2011, to $27.6 billion in 2016. However, these figures do not include trade in services. U.S. services exports to South Korea increased by 26 percent between 2011 and 2016, leading to a trade surplus in services of $10.1 billion in 2016. Although Korea is the sixth largest goods trading partner for the United States, it is small in the sense that only about 3 percent of overall U.S. trade is with South Korea. These bilateral statistics may under-represent the importance of U.S. trade with South Korea due to its important role in regional production chains. In contrast, trade with the United States represents about 12 percent of South Korea's bilateral goods trade and the United States is Korea's second most important export market behind China, ahead of Vietnam and Japan.
• Bilateral trade deficit statistics can be misleading and are poor indicators of the benefits of different trade relationships. We can expect the bilateral U.S. trade deficit to increase when the U.S. economy speeds up relative to a trading partner’s. In the case of South Korea, many observers have noted that Korean economic growth as measured by real gross domestic product (GDP) slowed after 2010, just as U.S. growth began to pick up after the Great Recession. It is hard to identify any one cause for a persistent current account imbalance, and South Korea maintains an unusually large current account surplus with the world as a whole, a situation the International Monetary Fund attributes largely to South Korea's tight fiscal policy (see figures 8 and 9). However, the U.S. goods trade balance with South Korea has roughly tracked how fast South Korea’s economy is growing relative to the United States, meaning Korean demand for goods from the U.S. and elsewhere may have declined in recent years due to sluggish income growth relative to its trading partners (see chart).
• The more appropriate question to ask is what would have happened to the trade balance if the deal had not been in place — given all the other economic circumstances. The independent United States International Trade Commission (USITC) used economic models to try to answer that question last year. In a 2016 report, the agency concluded that our $28 billion trade deficit with South Korea would have been $16 billion larger in 2015 if KORUS were not in effect (see page 139). Given the decline in South Korea’s rate of economic growth relative to that of the United States, the USITC’s results suggest that the U.S. trade balance with South Korea could have been much worse without the preferential access that KORUS gives U.S. exports. South Korea’s bilateral surplus in goods trade with the United States declined between 2011 and 2016 by close to one-third as a share of its overall goods trade surplus, despite its slowing relative growth and the large number of free trade agreements it signed with other countries in the years shortly before and after KORUS went into effect. We calculate that the U.S. bilateral trade balance with South Korea has increased relative to the U.S. trade balance with the rest of the world for fully half of all disaggregate (HS 10-digit) goods categories traded between the U.S. and South Korea in 2011, and increased in an absolute sense in more than 40 percent of these goods categories. The first statistic includes goods where the U.S. bilateral trade balance with South Korea may have worsened, but not as much as the U.S. trade balance with the rest of the world (especially given that the overall U.S. trade deficit expanded during the period). The second statistic includes only categories where the U.S. bilateral trade balance with South Korea improved (comparing the level of the bilateral trade balance in 2011 to the level in 2016).
• KORUS may have caused U.S. importers to buy more from South Korea and less from other suppliers, with little net effect on the overall U.S. trade deficit but a big apparent effect on the U.S. bilateral trade deficit with South Korea. This is known as trade diversion and occurs when countries that form a new trade agreement begin to take advantage of lower tariffs by buying more goods from each other and less from outside trading partners. It does not mean there is increased import competition for U.S. industry or a new threat to U.S. jobs. Rather, it suggests that some U.S. importers have found Korean products to be less expensive than those they already imported from other countries and, as a result, have replaced their source for imports. We calculate that for roughly one-third of the categories for which the U.S. trade balance with South Korea worsened, the trade balance with the rest of the world exempting South Korea improved or stayed the same, suggesting trade diversion at work. Trade diversion may be particularly likely for trade in intermediate goods or goods whose production involves metals or textiles, where regional production chains can reorganize across countries in response to changes in tariffs.
• The overall trade figures can mask the ways in which a reduction in tariffs has been helpful for different goods and industries. The U.S. Department of Commerce estimates that U.S. exports to South Korea supported nearly 360,000 U.S. jobs in 2015 and that this number has increased since 2013, the earliest year that estimates are available, and U.S. exporting firms pay higher salaries: between 12 and 20 percent more on average than non-exporters. The United States Trade Representative highlights passenger vehicles, pharmaceuticals, machinery, beef, lemons, almonds, fresh cheese, distilled spirits, intellectual property, and business and management services as a sample of the products whose exports have grown substantially since KORUS took effect. We calculate that between 2011 and 2016, exports grew for more than 40 percent of goods that the U.S. exported to South Korea in 2011 and that the U.S. began exporting about 1,000 new goods to South Korea.

What this Means:

Even though the overall U.S. trade deficit in goods with South Korea has grown since the implementation of the U.S.-Korea Free Trade Agreement, this does not mean it represents unfair trade. It is likely that the bilateral trade deficit would have been even larger in the absence of the deal, given the relatively slow growth of the Korean economy and the introduction of new trade deals between South Korea and other partners. The U.S. bilateral balance improved for many traded goods categories between 2011 and 2016. For about one-third of goods where it worsened, the trade balance with the rest of the world actually improved, suggesting not an unfair deal, but that U.S. buyers found South Korean sources cheaper than other foreign sources after KORUS went into effect—a clear benefit. Finally, U.S. exports grew for more than 40 percent of goods already exported, plus the United States began exporting 1,000 new goods to South Korea after 2011. Given the challenging macro environment for U.S. exports in South Korea since KORUS went into effect, this is a clear win for the hundreds of thousands of workers involved in producing U.S. exports to South Korea. It is also important to remember that uncertainty has a big impact on trade and investment. The threats to withdraw from KORUS and the surprise decision to invoke the renegotiation clause more broadly than it was intended have the potential to inflict some damage both on both Korean and U.S. export industries, even if no changes take place in the end.