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Source: Lim (2000). III. Financial Crisis of 1997. Growth Rate of GDP (1971 – 2006) Bank of Korea. Exchange Rate (Won/Dollar) Bank of Korea. The Financial Crisis of 1997. Foreign Debt Crisis

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III. Financial Crisis of 1997

Growth Rate of GDP (1971 – 2006)

Bank of Korea



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The Financial Crisis of 1997

  • Foreign Debt Crisis

    In 1997, Korea was fast accumulating foreign debts, mostly foreign short-term loans to commercial and merchant banks in Korea.

    Questioning the ability of Korean banks to pay back these loans, foreign banks declined to roll over the loans.

    Lacking foreign reserves to pay off debts, Korea turned to IMF, resulting in a rescue program amounting to $57 billion, the largest in IMF’s history.

  • Foreign Exchange Crisis

    Because of the dollar shortage and the speculative forces, the Won/Dollar exchange rate skyrocketed from 900 to 1700 over several months.


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The Financial Crisis of 1997

  • Banking Crisis

    For most banks, the amount of non-performing loans exceeded equity, and was in a state of bankruptcy.

    Left alone, bank runs would break out and paralyze the economy.

The root cause of the crisis

  • Korean Model of Growth

    • Risk partnership between government and business


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The root cause of the crisis

  • Korean Model of Growth

    • Risk partnership between government and business

Government select target industries and select Chaebols to develop these industries =>

Government has implicit responsibility to bail out Chaebols if they fail. =>

  • Moral hazard of underestimating the downside risks arises.

  • Government subsidize Chaebols by providing loan guarantees and low-interest rate loans

    => Excessive investment


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State-controlled banks channel household deposits and foreign loans to firms designated by the government.

  • Banks do not develop the ability to assess and manage risks in loan-making business

    Interest rates are set by government.

    Banks absorb losses from bail-out operations dictated by the government.

    => Incompetent banking industry


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Delayed Reform

Lim (2000) pp. 42-55

Park assassinated in 1979.

Chun takes power by a military coup in 1980.

A sharp recession following the second oil shock, political instability and the results of over-investment in late 1970s =>

Korea on the verge of a major financial crisis

Chun adopt the stabilization package recommended by IMF


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Tight monetary policy

Consolidating industries and chaebols

  • Reformatory ideas

    Of Chun’s technocrats

    Korea outgrew the Korean Model of Development.

    The economy became too complicated to be understood and controlled by the government.

    The market and the private sector should lead.

    • Liberalizing the banking industry

      Privatizing commercial banks

      Interest rates chosen by banks

    • Ministry of Finance keeps the lever by retaining the power to select bank presidents

      From State-owed to semi-public.


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  • Pro-competition policy

    New Fair Trade Law

  • Without splitting Chaebols or opening up trade,

    limited impact on competition structure

    Government tries to regulate the behavior of Chaebols.

    Bureaucratic control of the government remains.

    Political resistance of vested interestes

    Chaebols and bureaucrats

    Korea democratized in 1987

    Chaebols form a new relationship with presidents and politicians thorough (legal or illegal) campaign funds


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The Crisis of 1997: Causes and Developments

Cho (1999)

In terms of macroeconomics, the Korean economy was doing well.

Low inflation: 5%

Strong Growth: 8%

Current account deficit enlarged, but quickly receding.

Different from Latin American debt crises.

Many thought a Korean crisis is impossible.

Causes

  • Corporate overinvestment

  • Vulnerable financial structure

  • Banks mismatch of foreign assets and liabilities


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  • Corporate overinvestment

    Investment surge in 1994-1996

    Liberalized non-bank financial institutions.

    Deregulation of entries into industries

    Short-term debt increased.

    High interest rates and wages

    Interest rate liberalization.

    Democratic labor movements

    Terms of trade shock in 1996

    • Profitability of firms sharply declined.

    • Non-performing loans of banks increased.

      Source: Cho (1999)


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  • Imprudent interventions in the foreign exchange markets

    Upward pressure on Won/dollar exchange rate

    Tried to sustain the value of Won by selling dollars.

    Drained most foreign reserves.

  • Unwise reactions to the crisis

    Tried to rescue the troubled conglomerates in the old fashioned way.

    No persuasive plans for restructuring troubled banks

    => Failed to bring confidence to uneasy foreign investors.


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  • Imprudent lending and herd behavior of foreign lenders

    High interest rates in industrializing countries

    Low interest rates in advanced countries

    Debtor – borrowed too much

    Creditor – lent too much?

    Crisis occurred in the summer of 1997 in Indonesia, Thailand and Malaysia.

    Contagion and herd behavior of international investors.

    Sachs

    Both debtors and creditors should be blamed.

    Both have to share the costs of the crisis.

    IMF should not act as an agent of the US.


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Adjustments under IMF

  • Macroeconomic adjustments

    Tight monetary policy and high interest rates

    Brings down the exchange rate.

    Decreases investment and consumption and thereby decrease the current account deficits.

    Tight fiscal stance

  • Structural Reform

    • Trade liberalization

    • Financial market opening

    • Corporate Restructing


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10 years after

  • Fast Recovery of GDP

    • Source: Burton and Zanello (2007)


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Challenges ahead

  • Maintaining competitiveness in manufacturing

    Consolidation of Chaebols

    Spun off non-core business

    Korean exports are highly concentrated on a small number of products

    Semiconductors, LCDs, Mobile Phones, Steel, Ships, Automobils

    Catch-up of China and India

    Sandwiched economy

  • Coping with open financial markets

    Enhancing the competitive ness of financial sectors

    Coping with volatile capital inflows and outflows

    Containing bubbles in stock and housing markets


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