Korea’s Experiences in reforming the Financial Sector toward a Marked-Based System and Lessons for Vietnam

TABLE OF CONTENTS

INTRODUCTION

Chapter I. KOREA’S FINANCIAL SECTOR BEFORE THE ‘TAKE-OFF’
1.1. Korea’s economy after the Korean War
1.2. Financial sector and the need of government control

Chapter II. THE RELATIONSHIP-BASED SYSTEM (period 1960s-1980s)
11.1. The governmental control over banking sector and the export-led policy (1961­1971)
11.1.1. The nationalization of banking system
11.1.2. The allocation of capital supporting exports activities
11.2. Strengthening selective credit policy for the HCI drive (1972-1979)
11.3. The role of the state in reforming financial institutions
11.3.1. Establishing new banking institutions
11.3.2. Improving transparency and efficiency in the market
11.3.3. The capital market’s intervention
11.3.4. The effectiveness of the relationship-based government

Chapter III. THE REFORMING TOWARD A MARKET-BASED SYSTEM AND THE FINANCIAL CRISIS
111.1. The early market-based system before
III. 1.1. The paradigmatic shift from state-led developmentalism to liberal market economy in the period 1980s-1990s
III. 1.2. The rise of chaebols over NBFIs and its negative consequences
111.2. The 1997 financial crisis

Chapter IV. THE NEW REFORM OF KOREA’S FINANCIAL SECTOR AFTER AND LESSONS FOR VIETNAM
IV. 1. The new reform of Korea’s market-based financial system after
IV. 1.1. Strategies and institutional framework of the new reform
IV. 1.2. Progress and results of the new reform
IV. 1.3. Impacts of the new reform and problems need to solve
IV.2. Lessons for Vietnam’s financial sector transitions
IV.2.1. The reform of Vietnam’s financial market since 1990s
IV2.1. Vietnam’s financial market has the same problems as Korea’s
IV.2.2. Suggestion for the development of Vietnam’s financial sector

CONCLUSION

BIBLIOGRAPHY

LIST OF TABLES

Table 1. Share of total loans for banking institutions, 1955-1960

Table 2. The government ownership over Top 10 banks of the country in 1970

Table 3. Exchange rates in the 1953-1965 period

Table 4. Interest Rates for Deposits and Loans (1961-1970)

Table 5. Export loans of DMBs in the period 1961-1972

Table 5. Loans guaranteed by banks, 1960-1971

Table 7. Some main HCI projects during the 1972-1979 period

Table 8. Financing sources of NIF from 1974 to 1981

Table 9. Borrowing cost in the period of 1973-1981

Table 10. Number of NBFIs owned by Top 50 chaebols (as of end of 1997)

Table 11. Comparison of profitability and growth of investment & asset values in Korea, Taiwan, and Japan

Table 12. Number of bankruptcy cases during 1995-2001

Table 13. Financial institutions closed or merged (1997-2004)

Table 14. Share of firms (externally-audited) with IPCR<1

Table 15. Financial conglomeration by types of banking, insurance, securities, and investment trust companies

LIST OF FIGURES

Figure 1. Contribution of exports to GDP growth in Manufacturing, 1960-1973

Figure 2. Third-stage Blueprint for the liberalization and opening of the financial sector (announced June 1993)

Figure 3. Reduction in directed credit (proportion to the total)

Figure 4. Ownership structure of Top 10 banks of Korea

Figure 5. Trend in the expansion of limits on equity investment by foreigners

Figure 6. Ratio of loans by NBFIs over loans by commercial banks (for Top 30 chaebols)

Figure 7. Official NPLs of Korean banks

Figure 8. Share of firms with IPCR<1

Figure 9. The decreasing of ROA of NBFIs

Figure 10. KAMCO purchases and NPLs ratio

Figure 11. The BIS ratio of Korean banking system

Figure 12. Share of assets of financial institutions

Figure 13. Debt/Equity ratios of Korean firms

Figure 14. Ratio of facility investment to operating profit of listed firms

Figure 15. Assets composition of Korean households compare to other countries

Figure 16. Outstanding loans of financial institutions to households

Figure 17. Share of SMEs with negative operating profits

Figure 18. Budget deficit over GDP

Figure 19. Credit to the economy by DMBs

Figure 20. Foreign exchange rate changes from 1989 up to now

Figure 21. Time series of the VN-index (2006-2007)

INTRODUCTION

1. Purpose of the thesis

Korea is now well-known all over the World with its “Han river miracle” in the period of 1960s -1980s and later became one of four Asian Dragons. Contributed to this success, the Korea’s financial sector has had a very important role. In the period 1960s -1980s, the financial system of Korea (and the whole economic system) was a relationship-based system, which means, in theory, will be the factor to pull the development back. But in reality, the miracle development was happened at that time. So, how to explain that fact? More over, nowadays, while Korea is transforming toward a market-based system another question rises up, that is “why it need to transform and how to transform?”. To answer these questions, a research about the Korea’s financial sector from 1960s up to now is needed. And if we can answer these questions, we can apply its experiences into developing the financial system of less- developed countries such as Vietnam.

So far, the purposes of this thesis are focus on:

- To research more clearly and deeply about the financial system of Korea before the crisis 1997.
- To research more clearly and deeply about the financial system of Korea
after 1997 and current situation.
- To research more clearly and deeply about the reforming process from a relationship-based system to a market-based system of Korea’s financial sector.
- To apply these experiences into Vietnamese financial sector.

2. The Methods and Strategies

The thesis will use the combination of various methods like describing, analysis, logic, comparison, statistics, etc. in which:

- Using time-series analysis to understand the process and trend of Korea’s financial sector’ development.
- Using describing to explain the changes in tables and graphs and the reason of these changes.
- Using comparison to compare between Korea and Vietnam.
- Etc.

3. Chapter headings

Introduction

Chapter I. Korea’s financial sector before the “take-off”

1.1. Korea’s economy after the Korean War

1.2. Financial sector and the requirements for “take-off”

Chapter II. The relationship-based system (period 1960s - 1980s)

Chapter III. The reforming toward a market-based system

III. 1. The early market-based system before 1997

III.2. The 1997 crisis

Chapter IV. The new reform of Korea’s financial sector and Lessons for

Vietnam

Conclusion

Bibliography

Chapter I KOREA’S FINANCIAL SECTOR BEFORE THE ‘TAKE-OFF’

I.1. Korea’s economy after the Korean War

At the end of Korean War, South Korea (hereafter Korea) was destroyed heavily. The loss of life and physical destruction were enormous. In 1953, the South was literally in ruins. The war had destroyed a quarter of the real wealth of South Korea and killed over 5% of the civilian population. The situation was further exacerbated by an influx of 3 million refugees immigrated from the North. Life was grim with most Koreans living at or below subsistence. Economic recovery was slow; the GNP for 1953 was at the level of 47.9 billion won in current market price; per capita GNP was at $67 at current price (or $757 in 1990 constant dollars); average growth of per capita GNP in the 1953-1961 period was merely 1% per year; and the economy was kept from collapse only through massive economic assistance by the United States. In 1953, total consumption expenditure accounted for 91 percent of GNP, implying an average saving ratio of 9 percent of GNP (this ratio was high this year because of the large increase in agricultural inventories caused by a bumper rice crop). Gross domestic investment in 1953 was about 15 percent in which gross fixed investment, excluding changes in stocks, was only 7 percent of GNP, barely enough to cover depreciation costs of the existing capital stock. Ninety percent of imports were consumer goods, and constituted emergency relief for the population. Little attention was paid to long-term economic development during this period. The bulk of government investment during this period was on social development: Of total government expenditures, 8.8% went into research and education, 5.6% into health and welfare, 8.7% into current transfers to households and 2.8% into roads, waterways, fire protection, water supply and sanitation as compared with a total of only 14% for capital formation.

The primary policies of the period were aimed at ensuring the population's survival, reconstructing economic and social infrastructure, rebuilding industrial facilities and stabilizing prices. However, government tax revenue fell short of the expenditures needed so it had to rely on U.S aid funds such as the International Cooperation Administration (ICA) and Public Law 480 for the reconstruction projects^[1]. With that little helps, the government tried to use the fiscal policy (1957) to stabilize prices and the direct control of money and credit supply to channel the funds throughout the economy. For the fiscal policies, beside of setting the annual money supply (M1), the government also cut down its expenditures, reduced borrowings for the special account of grain management, and strengthened efforts to increase tax revenue. In the financial sector, the rate of increase in bank loans was limited to the rate of increase in savings deposits. As a result, the growth rate in the money supply was reduced from 29.7% in 1956 to 9.0% in 1959 and 4.3% in 1960; and the wholesale price showed only a modest annual increase rate of 5.8% from 1957 to 1960, and even recorded a decline of 6.1% in 1958^[2]. For money and credit control, the loan priority system was introduced in October 1953 (and was maintained until 1960) to classify industries into three types A, B, and C, according to their significance to the national economy. Different firms in different types of industries will be treated differently, for example, only type A firms can get rediscount loans from central bank. Along with this system, the existing loan ceiling system was also strengthened. While limitations were previously applied to the increase rate of loan amounts, the ceilings began to be applied to the loan amounts themselves according to the type of project in 1954. This ceiling system was sooner replied by the ceiling of central bank rediscount in 1955, but the BOK still continued to give guidance to financial institutions regarding loan ceilings until March 1959.

I.2. Financial sector and the need of government control

To strengthen such a weak economy, the main policy of the Korean government in the financial market was to privatize the commercial banks and reduce government control over commercial banks. A significant development in the banking system was the introduction of regional banks. The first regional bank was the Bank of Seoul (established in 1959 and operated in Seoul and Kyung-gi areas). Another important financial development to support the reconstruction in industry and agriculture was the reduction of government direct authority over the commercial banks. In 1954, the government started to divest its holdings of shares in the commercial banks - an early state of privatization. This action of government to auction off its controlling power over commercial banks was completed in 1957. Even though this move was unsuccessful (because of large business groups emerged as the owners of these commercial banks which created conflicts of interests between the owners and managers and customers), but there were some improvements. First, it helped the government to restrict the overexpansion of commercial banks credit easier.(WHY???) Second, it reduced the burden of KRB by developing the role of special banks, at that time was Korea Agriculture Bank (KAB), in funding the reconstruction of the economy. As in Table 1, the share of loans for commercial banks was decreased (obviously after 1957, the year in which ownership was transferred from government to private); the share of loans for special bank increased; and the share for KRB after increased a bit then began to fall back.

Table 1. Share of total loans for banking institutions, 1955-1960

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The non-bank financial market also had some developments. By September 1953, four securities companies were established, dealt mainly in government bonds. The securities exchange market, which was closed down in 1946 by the U.S military government, was reopened in February 1956 with the listing of stocks of thirteen companies and government bonds of three types. For the insurance market, the non­life insurance companies grew significantly during the late 1950s as they were acquired by large business groups. The life insurance market remained stagnant due to the chronic inflation.

At the same time, the government also tried to create its own banks to manage the investment funds. In 1954, the Korean Reconstruction Bank (KRB), which later became Korea Development Bank (KDB), was established with the primary objective of granting medium and long-term loans to industries. Its missions were to take over some assets, liabilities and facilities of the Korea Industrial Bank

(KIB), which strongly emphasized on the short-term loans during the inter-war and the Korean War periods. The short-term loans were very helpful and successful in the time of war, but for now, what Korean needed was to encourage the private savings and invested more on reconstruction, which required medium and long-term capital. So far, after KRB controlled KIB, it shifted the policy back to longer-term loans. Theoretically, the KRB was under direct control of the Ministry of Finance, but in reality, KRB proved to be heavily dependent upon the Bank of Korea (BOK), especially for funds. The fact was, with the poor Korean economy after war, the saving ratio was very low, the inflation was high, and the high ceiling on interest rates, etc. created a strong barrier to prevent KRB to sell its long-term debt instruments to the public to fund itself, and therefore, the KRB ended up borrowing heavily from the BOK. By the end of 1955, roughly two-third of loans that the KRB provide to the public was come from the BOK^[3].

In spite of these improvements, in late 1950s, it was obviously that the saving ratio was low and Korea had to depend mostly on foreign aids. So far, with this limited amount of capital, it was hard for the market to decide how to distribute these funds, and there was a need for a stronger influence from the government.

Chapter II THE RELATIONSHIP-BASED SYSTEM (period 1960s-1980s)

II.1. The governmental control over banking sector and the export-led policy (1961-1971)

II.1.1. The nationalization of banking system

After the military coup in 1961, economic development became national top priority and reorganizing the financial system was highly required to finance such development. In this situation, President Park Chung-Hee decided to create a strong banking system.

Firstly, the government reorganized the agricultural financing and marketing institutions by combining the agricultural cooperatives and the KAB into one entity known as the National Agricultural Cooperatives Federation (NACF). NACF was responsible for providing credits to farmers, refinance a sizable amount of the existing debts of farmers to private money lenders, etc. Through these activities, the government could reduce the dependence of farmers on the curb market and thereby reduce the importance of curb market.

Secondly, in August 1961, the Medium Industry Bank (MIB) was established to provide more and easier loans to medium and small enterprises. With the help of MIB, small farmers and small businessman can get loans for their investment, which in turn created a rapid expansion of loans during the early 1960s. After 5 months, at the end of 1961, the share of these two banks (NACF and MIB) in total bank credits jumped from 32 to 38 percent while the share of commercial banks dropped from 29 to 24 percent^[4].

In October 1961, President Park, who was affected a lot by Japanese economic system, nationalized all commercial banks by repossessing the shares held by large stock holders. In following, the Bank of Korea Act also was revised in May 1962 with intention to bring the government - not the central bank - to the highest position to be responsible for monetary and financial policies. ‘The Board’s membership was expanded to nine, adding two more appointed members while eliminating the alternative membership. The power of the Minister of Finance (MOF) increased so as to make request that the Board reconsider a resolution that had already passed... The central bank was also subject to an audit by the finance minister at least once a year and its annual budget had to be approved by cabinet’^[5]. This was a completion from previous period when MOF only had part of its authority over the central bank, and now, it totally owned the BOK. ‘As a result, the BOK was relegated to the status of a virtual rubber stamp for MOF decisions and served as a ready source of government debt financing when necessary’^[6]. Examples of these Acts were reinforced restriction on loans without collateral, restriction on asset management, office tenures of board members and auditors, and new punitive provisions for bank officials, etc. Through them, the government took banking operations including annual budgeting and the appointment of high-ranking bank officers under its tight controls. This action helped the government ‘seized control over the entire financial system, gaining an extraordinary leverage over the private sector’ (You, 1995). The result was, in 1970, more than 56% of assets of top 10 banks in Korea were owned by the government.

Abbildung in dieser Leseprobe nicht enthalten

Table 2. The government ownership over top 10 banks of the country in 1970

(Unit: percent)

11.1.2. The allocation of capital supporting exports activities

Starting from 1961, President Park decided to turn Korea from an inward­looking country to an export-oriented industrialization country. The goal of this outward-looking development strategy was to make maximum use of Korean comparative advantage in labor-intensive manufactured goods for exports. One of the important policy actions taken by the government to promote the export-oriented industrialization was to take the exchange-rate reform in 1964-1965.

Through reform of the exchange rate system in two steps, the government devalued the won and adopted the system of a unitary floating rate that was supposed to allow flexibility in the exchange rate reflecting demand and supply conditions on the market. An excessive intervention by the monetary authorities in the exchange market, however, resulted in transforming the system of a unitary floating rate into a crawling peg. Nevertheless, the nominal exchange rate was allowed to fluctuate so that a roughly constant level of purchasing power parity (PPP) adjusted, real exchange rate might be maintained beginning in 1965.

Table 3. Exchange rates in the 1953-1965 period (won/dollar)

Abbildung in dieser Leseprobe nicht enthalten

(Dong Se Cha, Kwang Suk Kim and Dwight H.Perkins et al., 1997)

The exchange rate reform, and the concurrent implementation of comprehensive export promotion following it, was able to create an institutionalization system of incentives consistent with the export oriented industrialization strategy. However, the government did not only rely on this system alone. It had three major administrative instruments to support that strategy. One was the government export targeting system, under which annual export targets were usually set by major commodity group and by destination, and export performance was monitored against these targets. The second was the support of the government owned, Korea Trade Promotion Corporation (KOTRA) for overseas marketing activities of Korean exporters through a continuous expansion of its overseas network. The last was the Monthly Export Promotion Conference (later renamed the Monthly Trade Promotion Conference) which essentially served to disseminate the government emphasis on export promotion and also to quickly resolve problems encountered by exporters through the final decision of the president. Through KOTRA, firms working in export-related areas can borrow loans from banks at lower interest rates.

Along with the interest rates policy, the Park Chung Hee’s government also tried to sponsor the export-related firms through Central Bank’s discount window.

This policy was indeed a rediscount policy to firms who already received letters of credit (L/C). If a firm could get its hands over a L/C, then it means it could get an exporting contract and became a ‘potential exporter’. Thus, financed these kind of firms was beneficial to the economy. Therefore, such firm could use the L/C as a mortage to borrow from the BOK with lower rediscount interest rates - compare to normal firms. This rediscount loans from the BOK were also applied to pre-shipment exports, imports of raw materials and intermediate goods for exporter use, and to the purchase of export content from local suppliers 1 Kim Joon Kyung (2006), ‘Capital accumulation and resource mobilization’ et al. (unit: percent)

Table 5. Export loans of DMBs in the period 1961-1972

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Along with creating the incentives for firms in exporting, the government also tried to help these firms to get capital needed for their investments. In 1962, the government legislated the Act for Payment Guarantee of Loans in which the BOK (and subsequently the Korea Exchange Bank (KEB)) issued a guarantee to the foreign lenders when they lend their capital to Korean businessmen. The Korean borrower therefore was backed up by both BOK and KEB that, in the worse scenario that he cannot repay his debt then the BOK will pay for him. This Act became significant in 1963 when the KDB acceptances went up from 2.2 billion (in 1962) to 18.1 billion won and after that the guarantee amount of the whole banking system increased rapidly, around 80 percent per year.

Table 6. Loans guaranteed by banks, 1960-1971 (Unit: billion won)

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In general, due to two strong impacts both from private sector (indirectly through KOTRA) and government (exchange rate reform and Act for payment guarantee of loans) then the development of exports can contribute more than 16 percent to GDP growth in the 1960-1970 period.

Figure 1. Contribution of exports to GDP growth in Manufacturing, 1960-1973

Abbildung in dieser Leseprobe nicht enthalten

Source: Re-quoted from Choong Yong Ahn, 2004

II.2. Strengthening selective credit policy for the HCI drive (1972-1979)

In the first and second Five year economic development plan (1962-1966 and 1967-1971), the Korean government more or less focused on import-substitute light

industries to build a ‘strong nation’. But from the third and fourth periods (1972-1976 and 1977-1981), the selective industry policy of the Korean government tended to focus on heavy and chemical industrial (HCI) plan. In 1973, the government announced the HCI plan that envisioned a total investment of approximately $9.6 billion for construction of six industries - iron and steel, electronics, petrol-chemical products, automobile, ship building, and machinery - during the period 1973-1981 (Lee, 1991). The HCI project was declared in the HCI promotion council 1973 to be a key strategy that would increase Korea’s per capita GNP to $1,000 and exports to $10 billion by 1981 (in 1972, GNP per capita of Korea was $318 and exports was $1.6 billion only).

Table 7. Some main HCI projects during the 1972-1979 period

Abbildung in dieser Leseprobe nicht enthalten

Source: Suk Chae Lee, 1991

The motivation of this changing in strategy was due to three reasons. First, it was that the development of HCIs was considered inevitable for the purpose of constructing a domestic defense industry which was essential for enhancing the nation’s self defense capability. Second, the nation’s industrial policy emphasized the construction of HCIs, since Korea had to face the increasing in trade barriers of advance countries against its labor intensive goods while the domestic wage-rental ratio was rising rapidly. Lastly, the development of HCIs was considered important for improving the country’s balance of payments, since the past strategy emphasized light industries which cause the increasing in imports of both capital and intermediate goods, and thus was ineffective in reducing the current account deficit. In order to mobilize the necessary resources (capital, technology, entrepreneurship, etc.) to the HCI sector, the government had to use various measures such as increased preferential long-term loans for HCIs; provided tax incentives to enterprises working in HCI sector; improved the engineering and technical schools as well as broad access to these schools to improve human capital for HCI development; established several new research institutes to promote research and development (R&D) in the HCI fields; etc. (Kwang Suk Kim & Joon-Kyung Kim., 1997). As an example for the increasing of manpower of Korea in HCI related sector, from 1977 to 1991, Korea won nine times in a row in the International Vocational Training Competition (Joon- Kyung Kim, lecture note).

But, as the HCI plan was affected strongly by the development of private enterprises, thus, financial policies towards these enterprises had to change. To secure an adequate flow of financial resources into HCIs and to lessen the risks involved, the government had to control the entire credit system and give preferential access at greatly subsidized rates to targeted industries. To do so, it established a special fund called the National Investment Funds (NIF). In fact, NIF was a combination of domestic fund from private financial intermediaries (such as commercial banks and insurance companies) and the government fund (such as Civil Servants’ Pension Fund and Veteran’s Pension Fund) with the contribution proportions as follow: commercial banks had to send to NIF 10-30 percents of the net increase in their saving deposits, insurance companies had to contribute 40-50 percents of their premiums, and pension funds had to contribute 90 percents of their reserved. In the period of 1974-1984, in average NIF got its fund contributed up to 17 percent from public funds, 64 percent from banks and 18 percent from insurance companies (Cho and Kim, 1997).

[...]

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^[1] Pyung-Joo Kim (1997), “Financial policies and institutional innovation”, pp.191, in Dong Se Cha, Kwang Suk Kim and Dwight H.Perkins et al.

^[2] Pyung-Joo Kim, 1997, pp. 191.

^[3] David C. Cole and Yung Chul Park (1983), “Financial Development in Korea 1945-1978”, Harvard University Press, pg. 52.

^[4] Cole and Park., 1983, pp. 57.

^[5] Pyung-Joo Kim, 1997, pp. 196.

^[6] Byung Sun Choi (1993), “Financial policy and big business in Korea: The perils of financial regulation” in Stephan Haggard, Chung H. Lee and Sylvia Maxfield (ed.), “The politic of finance in developing countries”, Cornell University Press, London.