The Economic Change in Korea since the 1997 Financial Crisis and Prospects for Future Growth

1. The Economic Change in Korea since the 1997 Financial Crisis and Prospects for Future Growth Alexandre Repkine Konkuk University

2. Chronology of the Crisis

3. How Could the Crisis in Korea Be at All Possible?? • One of the world’s most advanced industrial base • Technological level much higher than that of an average developing country • Labor force highly educated and industrious • Quality of social overhead capital (infrastructure) is outstanding

4. Origins of the Crisis • Financial vulnerabilities • Macroeconomic environment • Asset price deflation and bank failures

5. Origins: Financial Vulnerabilities • Promotion of domestic investment through policy loans • Bailout guarantees to corporate debtors • Moral hazard • Adverse selection • Large amount of bad loans due to lax monitoring and government guarantees • Highly leveraged chaebols • Large short-term capital inflows transformed into long-term debt by domestic investors • Prevalence of unhedged foreign currency borrowing • Short-term debt exceeds gross international reserves (reserves at 1/3 of short-term debt by end of 1996) • Exchange rates policy to keep won stable in real terms

6. Origins: Macroeconomic Environment • Korea was one of the world’s fastest growing economies until 1997 • Overinvestment due to lax monitoring of loans and the rapid industrialization policy • Asian miracle as an investment-led boom • Efficiency-driven growth versus factor expansion growth • Inflation relatively low in the 1990-s prior to the crisis • Sharp decline in exports earning due to plummeting prices of semiconductors, one of Korea’s key export items • Current account balance deteriorating • Growth in total domestic credit exceeding (nominal) GDP growth

7. Origins: Asset Price Deflation and Bank Failures • Declining asset prices (a fall of nearly 20% in Korea in 1996) • Depressed domestic demand through wealth effect • Deteriorating look for growth depressed asset prices • Several of largest chaebols posted losses in 1996 • 6 of top 30 chaebols went bankrupt before the crisis broke

8. Korea: Selected Macroeconomic and Financial Indicators

9. Korea: Key Vulnerability Indicators

10. Coping With the Crisis • General objective of the IMF rescue program: macroeconomic stabilization through financial sector’s reform • Short-term objectives: • Stabilize the exchange rate • Stop the bank runs • Restore confidence in Korean creditworthiness • Long-term objectives: • Creation of transparent financial system • Sound rules for issuing loans • Corporate restructuring • Macroeconomic stabilization

11. Bank Restructuring • Removing nonviable institutions • Replacing owners of nonviable institutions • Improving banking supervision • Promoting transparency in financial market operations • Encouraging new private capital contributions, especially from foreign sector

12. Restoring Soundness of Financial Sector in Korea • Financial Supervisory Commission created to centralize supervision of all financial institutions in the country, independent of the Government • Merging of all deposit insurance protection agencies into Korea Deposit Insurance Corporation (KDIC) • Suspension of 14 merchant banks in December 1997 (10 exited in January 1998) • Remaining 20 merchant banks to submit rehabilitation plans to be approved by FSC • Strict enforcement of minimum capital adequacy ratio of 8% • Encouragement of mergers with stronger banks or between weaker banks • Recapitalization through foreign investment (existing credits to equity, e.g. Commerzbank and KEB)

13. Corporate Restructuring • Strengthening of prudential regulation and supervision of the banks (FSC) • Liberalizing of restrictions on foreign ownership and management • New loan classification standards: loans more than 3 months overdue declared substandard • Tighter exposure limits to single borrowers or groups (chaebols)

14. Immediate Consequences of the Crisis and IMF Austerity Measures • Growing unemployment • Growing inflation • Decreased prospects for growth • Social unrest due to deteriorating economic conditions and increased foreign participation in the Korean economy

15. Immediate Effects of 1997 Crisis

16. Korean Economy in 1998: a Macroeconomic Perspective • Foreign exchange reserves reached $74 billion • Current account surplus of $20 billion • GDP growth at 10% • Inflation rate below 1% • Invested grading recovered • Stock market resumed rally

17. Korean Economy after the Crisis: the Households Perspective Household Consumption of Basic Goods and Services • Households significantly reduced their consumption of durable and luxury goods • Modest scaling back on food, medical services and education

18. Korea after the Crisis: Issues of Inequality Transition Probabilities of Korean Households by Class of Wealth • Household mobility in terms of wealth practically did not change • Half of richest and poorest households was likely to keep status before and after the crisis • Middle class most unstable, but equally likely to move to poor or rich income brackets

19. Disorganization, Creative Destruction and the Eastern European U-Curve • Hard budget constraints and the long-term growth • The Soviet and Korean economic growth • Strong government, centralized decision-making • Factor-led growth • Law of diminishing returns • Disorganization • Removal of inefficient production/finance units requires (significant) short-term losses (The U-curve)) • Hard budget constraints cause unemployment and output fall in the short run, but are essential for growth in the long-run • Creative destruction is unavoidable for any reform package that transforms inefficient economic system to a viable one

20. Five Major Misunderstandings about the IMF Rescue Programs • The IMF failed to predict the crisis • Predictions have been made both by Korean and Western scholars: Krugman (1994) and Choi Jong-Hyon (SK founder) • IMF warned Thai authorities for 18 months before the crisis, same grounds as in Korean case • The IMF instituted high interest rates that stifle businesses by inflating borrowing costs • High interest rates indeed have long-run recessionary effects, but they are necessary to restore the attractiveness of the currency, which was one of the key short-run objectives • The IMF creates moral hazard by bailing out reckless investors • Bailing out of insolvent banks was a short-term measure aimed at restoring international confidence in the Korean financial system • Long-term oriented structural reforms of the financial system are an integral and unconditional part of the IMF rescue package • Korean industry is significantly subordinate to foreign capital • Globalization also means liberalizing international capital flows • Korean economic growth falls far short of its average pre-crisis level • The law of diminishing returns • Initial growth rates always high • “Dead cat jumping”

21. Lessons From the Financial Crisis • Soundness of financial system key to the macroeconomic stability • Pegged exchange rates lull investors into ignoring currency risks • Highly leveraged chaebols financed with short-term debt are a major threat to macroeconomic stability • Globalization makes financial system ever more vulnerable to external shocks (Korea had strong fundamentals before the crisis) • Greater transparency of financial system is key to the early identification of the risky behavior by lenders and borrowers alike • Access to financial expertise is particularly helpful in times of crisis despite the need to incur losses when reforms begin • Bank restructuring provides a key lever for corporate restructuring • Short-term losses were unavoidable under any reform package in 1997 • Foreign expertise and increased foreign participation is crucial to ensure economic safety in an increasingly globalized world