Excerpt
Table of content
Introduction
I. Internal Factors
A. Korean Banks’ Structurally Unsound Method of Lending Money
B. The Government-Bank Relationship
C. A Highly Leveraged Corporate Sector
D. The Development of the High-Cost and Low-profit Economy
E. Macroeconomic Developments before the Crisis
F. Policy Mistakes
II. External Factors
A. An Unfriendly International Environment
B. Contagion Effects from Southeast Asia
C. The Appreciation of Japanese Yen
Conclusion
Appendix
References
Introduction
On Nov. 1997, Korea faced the IMF crisis, or also known as the financial crisis, which caused severe damage to the Korean economy. The new OECD member was reduced from being the world’s eleventh largest economy to an economy surviving on overnight loans from the international money markets. The won, the Korean currency, fell by more than 50 percent against the US dollar. Also, KOSPI (the Korea Composite Stock Price Index) fell by thirty percent, and the short-term interest rate shot up to forty percent per year. Consequently, on Dec. 1997, Korea called the IMF for rescue, owing $58.3 billion of financial aid. As shown in table 1 and 2 in the appendix 1, Korea had performed continual rapid GDP growth at the rate of 7.8 percent per year in average from 1960 to 1997. Then, what had happened to Korea, and why did the nation have to face the IMF crisis in 1997 all of a sudden? To see what the causes for the crisis were, analyses from six essays of scholars and experts in the field of economics will be introduced and compared. While they have similar and different views for the causes at the same time, their views can be grouped into two categories: internal factors and external factors. When the Korean currency crisis broke out, the IMF and many scholars focused the whole crisis on Korea’s internal problems. However, there are many other scholars who attribute the causes not only to internal but also to external problems. The experts who see the causes as internal problems think the crisis originated from internal factors of Korea such as policy mistakes, highly leveraged corporate sectors, and banking system. The external factors refer to the external shocks such as contagion effect from South-east financial crisis and appreciation of Japanese yen. Although all the causes for the crisis are closely related with each other, addressing the causes separately would give people better understanding of the context.
I. Internal Factors
While only a few writers of the essays this paper refers to attribute the crisis to external factors, all the writers agree that internal factors have responsibility for the crisis. The internal factors they have raised are plenty. One thing to notice is that each of the internal factors is referred to particular reference. To clearly state, the factors are referred to as follows: Korean banks’ structurally unsound method of lending money (6); the structural weaknesses in the government-bank relationship (1, 2, 3, 4 and 5); a highly leveraged corporate sector (1, 3, 4 and 5); the development of the high-cost and low-profit economy (5); macroeconomic developments before the crisis (4); and finally, policy mistakes (2, 3 and 4). What kind of negative effects would have these factors brought to the Korean economy?
A. Korean Banks’ Structurally Unsound Method of Lending Money
Kim, the author of The New Korea an Inside Look at South Korea’s Economic Rise 6 , expresses the Korean banks’ method of lending money as, “THEY DON’T EVALUATE, THEY JUST LEND.” According to Kim, one must understand the scope of the economic growth that occurred in Korea for the previous thirty years in order to understand why such a method was dominant. Since the early 1960s, Korea had averaged between 6 and 8 percent annual growth. To support such rapid growth, the country had settled on a system of low-interest loans from banks to the industrial sector. The banks could give low-interest loans to companies on a permanent basis because of guarantees provided by the government. The government used loan guarantees to control and direct the manufacturing industry.
A few years before the crisis, primarily in 1995 and 1996, the government raised interest rates to avoid massive foreign capital inflow. At that time, Korea was in the process of joining the OECD (Organization for Economic Cooperation and Development). It was an honor and a grand symbol for the country that was once too poor to enter into such a group. The government wanted to achieve the honor without facing any problem. However, there was one problem. One of the requirements of entry into the OECD was to relax the rules against foreign capital inflows, meaning that the government had to allow foreign money to come into Korea in a massive form. The government had no choice but to allow foreign money to flow into Korea. But it didn’t want to go all the way, letting foreign investors to invest in Korean companies without any obstacle. Therefore, it figured out a way: it would reduce the regulations against short-term capital flows, but at the same time it would raise long-term interest rates to ensure that Korean banks could lend to Korean companies and still make a good profit. Meanwhile, the Korean companies would still get the government loan guarantees, so that paying high interest rates for long-term debts wouldn’t be a problem. The system still made it possible that the important business of lending money to Korean companies would remain in Korean government. The system seemed to work well for the first few years. However, there was a significant defect. By reducing regulations against short-term capital flows, the government also deregulated restrictions on Korean banks borrowing money as short-term loans. As a result, Korean merchant banks started to borrow money from Hong Kong banks as short-term loans with low interest rates. Then, the merchant banks brought the dollar-denominated capital into Korea and lent it to Korean companies for the long-term with high interest rates. By doing so, the merchant banks made a good fortune. The risk for the merchant banks was that the banks had to pay back the money to Hong Kong in short term, while they were lending money in long term. However, Hong Kong banks continuously rolled over the short-term loans for the Korean merchant banks, solving the problematic risk. Consequently, the Korean merchant banks could afford to lend more than enough money, making the banks possible to generate more fortune. Therefore, the banks started to borrow to lend money. To lend more money to more people, the banks lowered the credit ratings and reduced restrictions for lending money, becoming irresponsible with their money. In 1997, when Hong Kong was attacked by currency speculators, who are the people who trade currencies with the sole purpose of making a profit, the Hong Kong banks stopped the rollovers and demanded the Korean merchant banks to pay back cash in dollars so that they could fight the speculators. However, the Korean merchant banks could get money from the borrowers only after a long period. In addition, the banks needed a huge amount of dollars due to the sudden demand from Hong Kong. As a result, the Korean banks exhausted all their dollars and helplessly sold whatever won-denominated assets they could get for dollars. Kim saw that the rush for dollars and selling any won-denominated assets in Nov. 1997 as the main cause of the collapse of the Korean economy.
B. The Government-Bank Relationship
In the essays of 1, 2, 3, 4 and 5, the problem of a weak financial system such as the government’s excessive intervention and guarantees (the ones that were discussed in section A) given for the Korean banking sector is discussed. Unlike in section A where Korean banks’ responsibility for the financial crisis is focused, the government’s role in the crisis is mainly addressed. What they say about the government is that banks were privatized in the early 1980s, but the government kept exerting a high degree of control over their management, even on the appointment of senior management. For example, the Banks of Korea had a lack of autonomy in its monetary policy because the minister of the Ministry of Finance and Economy was the decision maker of the Monetary Board where the supreme policy of the bank was made. Furthermore, the minister recommended a candidate to the President for appointment of the governor of the bank. Not only that, the government had intervened in credit decisions as well. Such intervention played a role as an obstacle for the development of a strong risk management and credit analysis skills. Since the government made the decisions, the banks found no need for developing such skills. Consequently, the banks did not follow proper loan review processes. For instance, the banks made huge loans for firms to invest even when the investments reached overcapacity. Loan classification criteria and provisioning were far less strict in Korea than in many OECD countries. Such unsound banking practice caused the banks to accumulate a huge debt from worthless credit and heavily leveraged chaebols, a Korean term for conglomerates. Because of such loose restrictions on credit evaluation, conglomerates such as Hanbo (steel), Jinro (retail), Kia (automobiles) and New Core (retail) that were heavily leveraged depended mainly upon bank financing. The serious problem was that, when those conglomerates fell down right before the IMF crisis, non-performing loans, the sum of substandard, doubtful and estimated loss loans of commercial banks and merchant banks rose from 13 trillion won (about 1.5 billion dollars) on Dec. 1996 to 43 trillion won (about 4.8 billion dollars) on Dec. 1997 (Table 3). The banks fell into a serious financial crisis.
Another thing the five essays imply about the government is that the government traditionally treated private financial institutions as a strategy of economic growth, making them offer low-interest loans for corporations, and in return overly protecting them, giving too much of guarantees (Table 4). Therefore, the institutions were not run according to the market principle of profit maximization. The overprotection provided by the government was another reason for the collapse of banking system.
C. A Highly Leveraged Corporate Sector
The government’s excessive guarantees not only caused problems in the banking sector, but also in the corporate sector. Many experts in the field of economics characterize the Korean economy prior to the crisis as a loan economy. Korea’s corporate sector was excessively indebted, as a result of the nation’s rapid growth strategy, which is providing low-interest loans for corporate sector supported by the government’s guarantee. Because there was little chance of bankruptcy, the chaebols were highly motivated to make loans and keep expanding without careful consideration of returns and risks of their investments. Furthermore, the government almost always bailed out failing chaebols, and its repeated bailout implicitly guaranteed chaebols’ careless investments. The chaebols’ careless excessive expansion obviously caused them a serious problem.
When the world market was booming, the chaebols earned a large profit, and their weak point did not show. During this time, the chaebols invested their profits to expand further into industries such as automobiles, semi-conductors (the biggest single Korean export item) and steel, which were already highly competitive. Then in 1996, the world market including semi-conductor market began to shrink, causing the price of the firms’ export goods to drop, specifically 80 percent decrease in the price of semi-conductors. And the chaebols found themselves competing with each other in similar businesses, causing their profits to decrease significantly. At the same time, the amount of export fell and overcapacity made by careless excessive expansion became problematic. While the firms could not lay off redundant labors and decrease labor costs, their net income dropped to 0.5 percent of sales. Due to such a serious drop in profits, chaebols’ debts could not be paid off. At the end of 1997, the average corporate debt to equity ratio was extremely high, around 400 percent. Regarding the thirty largest chaebols, the ratio was even higher, 519 percent as shown in table 6. In the same period, the ratios were 154 percent and 193 percent in the United Stated and Japan respectively. The significant amount of debts imposed indebted firms debt service costs which amounted to about 17 percent of their total costs in 1997. Plus, interest expenses in corporate sector rose from 5.5 percent of sales in 1995 to 6.8 percent in 1997, which worsened the situation of the firms that already had low profit problem.
Furthermore, the lack of transparency in the corporate sector exacerbated the situation. Corporate financial statements in Korea did not follow internally accepted accounting and auditing standards, which prevented a clear evaluation of firms’ performance. Consequently, foreign investors were not attracted to invest in Korean companies.
All of these problems in the corporate sector finally dismantled Korean companies in 1997. Starting from the Hanbo Steel, which is Korea’s second largest steel manufacturer, chaebols that seemed to be too big to fail went bankrupt, one by one.
D. The Development of the High-Cost and Low-profit Economy
Korean economic structure has been weakened by the high costs and low profits caused by rising wage, interest rates, and transportation. The real wage was increased by 9.1 percent on average from 1987 to 1996, which was the highest among Asian countries except for Japan and relatively higher than other OECD countries’ rates. The significant increase was caused by inflexible labor market and sustained low unemployment over a long period of time. During the period prior to the financial crisis, jobs were generally considered by people to be held “life-long” in Korea. This was partially due to several laws that made firms difficult to lay off workers. Thus, the companies had to face the high wage. Another increased cost, the market interest rate was 11.9 percent in 1996, compared to 3 percent in Japan and 7.1 percent in Taiwan. Most importantly, the ratio of financial costs to total revenue was 5.8 for Korean firms while the ratios were 1.3 for Japanese firms and 2.2 in Taiwanese firms. Furthermore, in 1995, Korea had insufficient infrastructure, causing the firms to pay high transportation costs. The ratio of transportation costs to total revenue was 16.7 for Korea in 1995, while the ratio was 7.7 for the United States and 8.8 for Japan in 1994. In addition, deficits in goods and services accounts were increasing as imports of capital goods, luxury consumption goods, and travelling abroad increased. The deficits were even deepening further with the fall in the unit prices of Korean export goods, especially in semiconductors. The current account deficit increased from 8.5 billion dollars in 1995 to 23 billion dollars in 1996, resulting in the ratio of the current account deficit to GDP to increase from less than 2 percent in 1995 to 4.7 percent in 1996. Another serious problem was that the frequent labor disputes initiated by labor union seeking for better working conditions and against chaebols lobbying for new laws eased many restrictions on laying off workers, leading to many branches of foreign banks in Korea to leave. For example, Barclays Seoul, Chase Manhattan Seoul, Tokyo-Mitsubishi Seoul and Montreal Seoul closed down in 1996, followed by the close down of BOA Pusan, Credit Lyonais Pusan, First National Boston Pusan, AMEX Pusan in 1997.
E. Macroeconomic Developments before the Crisis
While the authors of South Korea: Challenging Globalisation and the Post-Crisis Reforms 5 reports that Korea was developing high-cost and low-profit economy prior to the crisis, Richards, the writer of From Crisis to Recovery in Korea: Strategy, Achievements, and Lessons 1, argues that the Korean economy was still growing at that time. Richards further raises a point that the soundness of the economy rather caused a problem in Korea because its impressive macroeconomic performance may have blinded people from noticing the structural weaknesses in the banking and corporate sector that was addressed in the previous sections.
The economic growth in Korea remained strong until right before the crisis. With the strategy of the Korean government for economic growth, supporting companies’ investment boom by providing the guarantees and protections, the growth averaged 8 percent per year over 1994-96 (Table 2). In addition, both the inflation and the real exchange rate did not indicate signs of growing imbalance. During the investment boom, the government was concerned about the inflation because the broad money and the credit was increasing at an average annual rate of 20 percent due to the sustained expansion. Therefore, the government tightened the monetary policy. The policy was successful; the average inflation rate was at 4.5 percent in 1997 (Figure 1). In addition, the real exchange rate was fairly stable from 1990 to 1996 (Figure 1). Unlike the experts’ view for the current account deficit in section D, Richards contended that the deficit was not a serious issue since it was “sustainable” considering Korea’s external debt position. The deficit averaged about only 2.5 percent of GDP before the crisis (Table 5), while the gross external debt was about 30 percent. However, since Korean banks were able to refinance their short-term debts from foreign banks such as Hong Kong banks before the crisis, the external debt position was also considered to be sustainable. The whole economy seemed to be flourishing. Therefore, many economists, investors, and government authorities did not foresee the potential problems of the structural weaknesses in the banking and corporate sector until the financial crisis erupted.
F. Policy Mistakes
In addition to the government’s strategy for rapid growth of the economy, several other policy mistakes it had committed contributed to the crisis: the overvaluation of won, a guarantee for foreign liabilities, the use of fixed exchange rate system, and the dishonest bailout.
Although the balance of payments deficit was accumulating, an appropriate adjustment for the imbalance such as the devaluation of won was not accomplished on time. Beginning in 1990, the Bank of Korea adopted a strong won policy. Therefore, the won was overly evaluated. The won per dollar rate appreciated 2.46 percent in 1994 and 1.81 percent in 1995 even though there was a large deficit in the balance of payments in those years (Table 5). The overvaluation of won added more problems in Korea since the nation’s export fell further. Then why did the government maintained a strong won policy? There are four possible answers. First, because the government have concerned with high inflation, it tried to achieve a single-digit inflation. Second, the government considered that keeping the exchange rate from depreciating would help the Korean companies and the financial institutions by lowering the domestic currency costs of adjusting the foreign currency denominated debts. Third, when $10,000 per capita income was achieved, the government did not want that income to decrease because of won depreciation. Fourth, the government judged that the effect of increasing exports and hence, improving current account deficit by lowering the value of the won has been diminished because Korea’s industrial structure was heavily relying on imports. Regardless of which speculation was valid, the policy was not successful.
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