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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
III. Financial Crisis of 1997

Growth Rate of GDP (1971 – 2006)

Bank of Korea

the financial crisis of 1997
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.

slide5
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
slide6
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

slide7
Korean Model of Growth
    • Mobilizing resources through state-controlled banks

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

delayed reform
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

slide9
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.

slide10
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

the crisis of 1997 causes and developments
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
slide12
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)

slide13
Capital market opening and term mismatch

Korea became a member of OECD in 1996.

Capital market opening

stock market

short-term trade credits

allowed merchant banks to deal with foreign loans

slide15
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.

slide16
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.

adjustments under imf
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
10 years after
10 years after
  • Fast Recovery of GDP
    • Source: Burton and Zanello (2007)
slide19
Corporate Restructuring
    • Source: Burton and Zanello (2007)
slide20
Bank Restructuring
    • Source: Burton and Zanello (2007)
challenges ahead
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

slide22
Worsening Income Inequality

Source: Kyung-Joon Ryu (2007)

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