At Hyundai Motor’s noisy factory near Beijing airport, fresh-faced workers are busy attaching bumpers to Sonata sedans or mirrors to Tucson sports utility vehicles and spraying the multi-coloured Elantras that are destined to become taxis for the Chinese capital.

In five different models, 68 vehicles roll off the South Korean group’s production line every hour. The plant is producing 300,000 cars a year but output will double with the completion of a second facility next year.

The 4,200 Chinese employees – average age 26 – receive a base salary equivalent to $360 (£185, €270) a month and belong to a workers’ organisation whose main task seems to be to encourage harder effort rather than push for higher wages. “The workers here are very flexible – it’s the opposite to Korea, where the situation is impossible,” says Noh Jae-man, president of Beijing Hyundai. “And because we pay our workers better than other companies, they are proud to work at Hyundai and carry out their jobs well.”

By contrast, at Hyundai’s main Ulsan plant in South Korea the workers – their age averaging 41 – earn $4,580 a month, build only 55 cars an hour, refuse to produce more than three models on each production line, will not allow second shifts (which would eat into their overtime) and are heavily unionised. Last year a 25-day-long strike cost Hyundai about 7,800 vehicles or Won120bn ($127m, £65m, €95m) in lost sales.

Like other global manufacturers, Korean companies have flocked to take advantage of China’s cheap, productive labour and superb infrastructure. LG, the electronics and chemicals conglomerate, has such a huge presence in Nanjing, the capital of Jiangsu province, that Chinese authorities have renamed the main street “LG Road”.

But while China represents a huge opportunity for manufacturing-dependent South Korea, it also represents a looming danger, as Chinese companies threaten not just to complement but entirely consume Korea’s industries. Hyundai may be benefiting in China but it is worried about the aggressive expansion of local car­makers such as Chery – and that many Chinese models bear a strong resemblance to the cars made by Korean and other producers. Indeed, South Korea’s old economic model of imitation and manufacturing-led growth is now China’s model.

Although it underwent radical restructuring and opened its market after the Asian financial crisis struck in 1997, there is a widely held belief that South Korea, one of the world’s top dozen economies, needs a second wave of reforms if it is to maintain its competitive edge over emerging China and move to the next stage in its remarkable development.

Indeed, with the economy remaining dependent on manufacturing and exports – and, moreover, on just a few types of product, such as mobile phones, semiconductors and cars – concern is growing that Korea is losing its dynamism. Economic growth has averaged 4.2 per cent in the four years of President Roh Moo-hyun’s administration, below what is seen as its potential rate of 5 per cent. “We had two or three years of major restructuring following the financial crisis but now Korean companies have become conservative again,” says Jung Ku-hyun, president of the Samsung Economic Research Institute, a think-tank funded by the conglomerate. “We need new initiatives for reform and restructuring.”

Seoul economists regularly talk about the “sandwich” or “nutcracker” theories – a metaphor for Korea being squashed between low-cost China and high-tech Japan – and raise the spectre of a Japanese- or German-style “hollowing out” of Korean industry. A free trade agreement being negotiated with the US was supposed to serve as a catalyst for that second wave of reforms, exposing overprotected sectors such as cars and agriculture to competition and leading to the introduction of international standards in corporate governance, accounting and government administration.

“If Korea wants to keep ahead it has got to use platforms such as the FTA to reform and to signal to the market that it’s really pushing to open its economy,” says Myron Brilliant, president of the US-Korea Business Council. “Japan is not going to sit on the sidelines forever and China already is not sitting on the sidelines, so Korea has got to consider its position in the region and strive for change.”

The deal would also allow Korea to benefit from closer ties with a technological leader. Indeed, while Hyundai’s Beijing plant is more productive than those in Korea, none can match Hyundai’s factory in Alabama, which has a much higher level of automation and produces 72 vehicles an hour.

But after eight tortuous rounds, trade talks between the US and Korea broke off without agreement last Monday. Negotiators plan to meet in Washington on Monday to try to close the deal by the end-of-March deadline. Both sides are optimistic a deal can be reached but it is becoming increasingly clear that it will not be the “big bang” Seoul was hoping for.

Cho Won-dong, head of economic policy in the finance ministry, says that concerns about Korea’s declining dynamism are too “drastic”: “If you look at our economic growth potential, it’s still around 5 per cent and a lot of growth is coming from productivity gains.”

The intended trade agreement with the US would cover services as well as manufacturing, so could boost both parts of the economy, he adds. Although the deal is unlikely to be as wide-ranging as initially hoped, Mr Cho says “something is better than nothing” and any such pact would help precipitate reform.

Yet many economists and business leaders in Seoul are alarmed at the slow pace of change, saying that China is fast moving up the value chain and will soon be making the kinds of computer chips and flat-screen televisions for which Korea has become known. China’s export structure, where the proportion made up of electronics and other high-technology products has grown to comprise almost 40 per cent, much more closely resembles that of South Korea than it did a decade ago. Although most technology exports come from foreign-invested companies and the highest-tech components are still imported, the sudden change is giving Korean companies reason to be scared. “Korea and China were like geese, flying in formation,” says Kim Joon-kyung, vice-president of the Korea Development Institute, a state-linked think-tank. “But now the Chinese goose is catching up.

“Chinese manufacturing workers earn about 10 per cent of what Korean workers earn but the technology gap between the two countries has rapidly reduced,” Mr Kim says. “Korea has already lost the personal computer industry and more will follow.”

Certainly, Korean companies are nervous. Lee Kun-hee, the powerful chairman of Samsung Group – which accounts for about 20 per cent of the country’s exports – warned this month that Korea had to “wake up” or risk “economic chaos” in five to six years. Samsung might relocate its appliance division, which has posted losses since 2003, to less developed countries, he added. In shipbuilding, South Korea has been the world leader for the past decade, but China is closing in so quickly that Seoul’s National Intelligence Service has launched investigations into technology leaks. Meanwhile, Korea’s current four-year lead over Chinese manufacturers of flat-screen televisions is likely to narrow to only one year by 2010, according to the Korea Electronics Association.

This is partly because, after the trauma of the financial crisis, Korean companies remain conservative about investment. “Before the crisis they invested a lot, even though their financial structure was not that good,” says Mr Jung of the Samsung Institute, “but now they have the financial, technological and managerial capacity to invest but they are reluctant to take risks”.

He is far from alone in that view. “South Korea succeeded in overcoming the crisis but, because reforms were implemented drastically and one-sidedly, the side effects were also significant,” says Lee Kyung-tae, president of the Korea Institute for Economic Policy. “One of them is that the Korean economy is losing its dynamism. Dynamism all boils down to investment but investment is not vibrant.”

In 1996, corporate investment was equal to 40 per cent of gross domestic product but it had slipped to 30 per cent by 1998 and has struggled to rise above that since, last year measuring only 28 per cent. Meanwhile, China is pursuing both technological development and investment. The Organisation for Economic Co-operation and Development says China has overtaken Japan to become the world’s second biggest spender on research and development, investing $136bn this year.

South Korea’s top chaebol , the conglomerates such as Samsung and Hyundai, have become global companies and are likely to weather any storm better than the rest of Korea Inc. A much greater concern rests with small and medium-sized enterprises, the mainstay of the economy, which have long supplied components for the big brands but find themselves trapped. “The chaebol are under a lot of margin pressure because of the won’s strength and because they are playing in very competitive global industries. A natural consequence of this will be a squeeze on the margins of their SME suppliers,” says Stephen Bear, head of McKinsey in Seoul.

“In many cases these SMEs are also being squeezed at the other end by emerging competitors from China. The next problem area Korea will likely face is going to be around the hollowing out of the SME sector.”

The sector’s problems are worsened by the survival of uncompetitive players. The government gives credit guarantees, under which 85 per cent of the principal is guaranteed, to banks lending to SMEs, which means that poor performers do not go bankrupt. Mr Kim of KDI says this has led to the emergence of “zombie SMEs” – businesses that cannot pay back their debt but whose loans are continually rolled over because of the government guarantees.

At the same time, Korean companies with bases in China have increasingly localised their procurement of intermediate goods. According to Mr Kim’s calculations, Korean companies operating in China procured one-quarter of their parts locally in 1996 – but it took less than a decade before half the parts were being sourced there.

Together, these factors mean that about one-third of South Korean SMEs are not making profits. “People think that we have to somehow keep these companies alive,” Mr Jung says. “But marginal companies – this is difficult to say – should be let go, so the market can reallocate resources.”

Apart from ground being lost in investment and technological advancement, a further erosion in South Korea’s competitive position has come from a surge in economic nationalism. That change in mood came after foreign investors reaped huge profits on the assets they bought at fire-sale prices following the financial crisis.

It has come to a head over the case of Lone Star, the private equity group that bought the distressed Korea Exchange Bank in 2003 but now finds itself the subject of a high-profile investigation as it tries to sell its investment. The retrospective review of Lone Star’s acquisition is alarming domestic and foreign investors alike and suggests that regulatory risk – one of Korea’s few advantages over China – is more of a problem than before.

“We risk alienating foreign investors when we should be welcoming them with open arms,” says one Korean investment banker, asking not to be named. “Korea is not as exciting a growth story as China or India and is not as mature as Japan, so we are at a critical stage in the development of our markets. But we are risking becoming more isolated.”

Foreign direct investment has fallen to only 7 per cent of GDP, compared with 35 per cent in China. In Unctad’s latest world investment report, South Korea ranked 114th out of 141 countries for foreign investment flows. The key to rejuvenating the business environment, economists say, lies in encouraging competition through foreign investment and in embarking on reforms regardless of whether or not they are required by the proposed free trade accord.

“Korea has to allow entrepreneurs to flourish and to allow SMEs to flourish,” says Mr Brilliant from the business council. “This is not to say that the chaebol don’t have a role to play but that the business sector must be expanded. If Korea wants job creation, innovation and technology, it has to seek a way to diversify its industrial structure.”

Nevertheless there are several glimmers of hope for the future. Mr Jung points to Korea’s obsession with education and the knock-on improvements in human capital, and its creativity, as expressed through a “Korean wave” of music and films that is spreading across Asia. “I think we are at the stage where our future growth will come from technology, design, education, ideas,” he says, adding that Korea filed the second largest number of patent applications with the World Intellectual Property Organisation last year.

Yet the key will be taking advantage of Korea’s geographical advantage by producing goods that China cannot make and at a price with which Japan cannot compete.

Kwon Tae-shin, Korea’s ambassador to the OECD, tells a joke to illustrate his country’s predicament. A shop-owner hangs a sign outside his store saying “Best prices”, leading to floods of customers. The shop-owner two doors along retaliates with a banner reading “Best quality”. But the shop-owner in the middle has the last laugh by erecting a sign saying “Enter here”.

It is a strategy that Korea is desperately trying to mimic. Squashed between China and Japan, it must turn its position in the middle into an asset.

TEXTILE SUCCESS IS AT A STRETCH

If any Korean company knows about the threat of China, it should be Hyosung Corporation, one the country’s midsized conglomerates.

Hyosung has seven business divisions – chemicals, construction, industrial materials, information and communication, power and industrial systems, textiles and trading – several of which have come to face direct Chinese competition.

“China is definitely competing directly with us in chemical and fibres and that has hurt us to some extent. But it hasn’t hurt us as much as it could, as we’re concentrating on moving into more technically advanced areas,” says Kim Jin-hyun, senior adviser to Hyosung’s president.

For example, while Chinese companies make spandex, one of the materials that Hyosung is strong in, they find it harder to compete on quality. “The manufacturers have certain requirements when it comes to things like spandex – the look, stretch, consistency and reliability – and when it comes to the finished product Chinese manufacturers can’t compete,” Mr Kim maintains. “Some fabrics have become commodities but this is an area where we are still ahead.”

Hyosung was founded in 1957 and expanded in the 1970s through acquiring small industrial companies and establishing polyester and dyeing subsidiaries. In the 1980s it moved up the value chain, venturing into plastics, carpets and cash machines and, more recently, nanotechnology fibre and automotive parts.

Its main focus is on manufacturing and distributing synthetic fibres such as polyester and nylon for the textile industry, but in recent years it has been struggling in some areas. It returned to the black last year after a 2005 loss. To deal with the threat of China, Hyosung is moving into higher technology areas rather than exiting sectors.

Like Hyundai Motor, it is also taking advantage of the opportunities that China offers. Last month Hyosung announced plans to expand production in Korea and China to meet shortages in spandex, buying a factory in Zhuhai, China, that will help it increase total capacity from 54,000 tonnes in 2005 to 65,000 tonnes this year.

But that is not to say Hyosung is not looking over its shoulder at emerging Chinese competitors. “We are developing and trying to distinguish ourselves,” Mr Kim says. “I think Chinese and Korean companies can co-exist in the same fields in the short term – just as long as we’re a few steps ahead. In the longer term, who knows?”