|The Distinct Nature of the Korean crisis.|
Financial crises usually start from bank failures. The causes of bank failures, however, differ from country to country. In the U.S. for example, bank failures between 1982 and 1992 were due mainly to a depression in agriculture, and in the energy and real estate businesses. In Japan there have been 17 cases of bank failure since 1994, and more are likely to come in the next few months; the major cause of these bank failures was the collapse in the price of land and stocks that started in the early 1990s. In Korea 14 merchant banks have been closed and two of the major commercial banks will be sold to foreign banks or merged into other banks under the current government bailout. Korea's bank failures and the ensuing foreign exchange crisis are unique in that they were neither attributable to depression in any particular industry such as real estate, nor to weakness in the real side of the economy. Although business conditions have been generally sluggish since the middle of last year, macroeconomic performance has been normal until the financial crisis started: the growth rate of GNP for the current year was estimated at around 6%; prices had been stable, exports were picking up, and the current balance of payments was improving; this is why the Deputy Prime Minister loved to say that economic fundamentals are strong and financial instability would be a passing phenomenon -- unlike in Thailand and Indonesia.
What, then, are the major explanations of financial crisis in Korea today ? My simple answer is that Korea's banking system collapsed due to the lose of confidence of foreign creditors as the structural malady of Korea's financial system came to the surface in the course of democratization and globalization, affected also by the catalyst of financial crisis in the Southeast Asian countries and Japan. Let me elaborate my point in what follows.
|Structural Weakness in the Real side of the Economy|
In response to gloabalization, Korea gradually opened up commodity markets beginning early in the 1990s. But domestic industry was not well prepared to compete with foreign products at home as well as abroad because of what I used to call "4 highs and 3 lows": the high wage rate, the high interest rate, high land values, and high transportation costs combined with low technology, low value-added, and low managerial efficiency. Unfortunately there has been little progress in remedying these structural weaknesses in the last ten years due to factors including weak government leadership. For instance, the chief economic minister (the Deputy Prime Minister) was replaced seven times in the past 4 years and ten months, making it almost impossible for the economic ministries to pursue needed policy adjustments in a consistent and sustained manner. The result was that while the GNP growth rate ranged between 5 and 9 percent due to brisk consumption and investment expenditures, the nation's current account turned to the red in 1990 and the chronic deficit thereafter peaked at $23 billion in 1996. Korea's gross foreign debt tripled between 1990 and 1996. 1)
|The Structural Weakness in the Financial System|
Korea's financial system is characterized by a lack of independence from the business conglomerates as well as from the government. For example, I have never seen a bank request that any chaebol (the Korean word for a business conglomerate) prepare a consolidated financial statement combining its member companies to asses the financial standing of the business group as a whole; banks have taken no serious look -- let alone a formal feasibility study or risk analysis -- into the large-scale investment project for which bank credit was requested by a chaebol. The banks did not bother to check misuse of loans by the borrower to make a financial contributions to politicians and the political parties. Something like risk analysis is confined to the powerless small and medium-sized companies.
This abnormal situation is, of course, rooted in the heyday of economic development during the 1960s and 1970s, when the government heavily intervened in bank management to guide fund allocation in favor of development. As a result, Korean banks have had little incentive to learn western style bank management.2)
Even after government intervention was reduced to almost nothing in the early 1990s, there has been little change in the close connection between banks and business conglomerates for the following reasons, among others: the conglomerates comprise not only industrial companies but also financial institutions such as insurance, securities, and merchant banks; therefore it is relatively easy for each conglomerate member to borrow funds from financial member institutions on the basis of cross guarantees among members. Under this situation, for lending decisions the banks simply relied on the financial maneuvers of the chaebol, rather than on a well-founded risk analysis of the business group as a whole. After all, it is important for the banks to maintain good relations with big companies in expanding their business volume and ensuring access to large fees.
This situation prompted chaebol to run into over-investments and the excessive diversification of businesses, driven by a desire to build a self-contained empire rather than to generate profits. It also led to lax risk management on the part of financial institutions.
Another weakness in Korea's financial system is the loose supervision of banks. There are three independent supervisory bodies for banks, insurance, and security businesses. But merchant banks were under the direct supervision of the Finance and Economic Ministry without necessary manpower and competence. It is no wonder that bank failures were concentrated on the merchant banks. Moreover, the government did not care, in the name of liberalization and deregulation, to watch reckless overseas borrowing by banks and enterprises.
The anomaly of the financial system is mainly responsible for the skewed distribution of loans to conglomerates at the expense of small and medium-sized firms and industries; the accumulation of many bad debts and non-performing assets 3)by banks, and the lack of transparency in the managerial and financial
|The Exposure of Weakness|
The malaise of Korea's financial system first came to the surface in the course of democratization. As the civil government came to power in 1993, party politics opened a Pandora's Box of financial irregularities involving two former presidents, several national assemblymen, a son of the incumbent President, and a dozen chaebol tycoons, including, of course, heads of commercial banks. To the surprise of the whole world, and to the deep dismay of the Korean people, all of them were found guilty and sentenced to imprisonment, except for the chaebol heads who were given a suspended sentence. 4)
The changing political climate had its own impact on the financial institutions. Faced with the warning that lax lending might land them in prison, the bank presidents started to tighten up lending policies, driving many financially weaker companies to the verge of default. Several conglomerates at last went bankrupt, followed by a default of the well-known Kia Mortor Company. Caught between the need for a hands-off policy toward private business, on the one hand, and the call for intervention to avert bank failures and labor unrest, the government was at a loss for the proper response. As a result of indecision on the part of banks and government for more than three months, the economic climate and the confidence of overseas investors began to deteriorate rapidly. (Kia was finally placed under the court procedure for bankruptcy. )
The weakness of the financial system was also well exposed in the course of opening the market for financial services in response to the call for globalization without making the necessary internal adjustments. When the Korean government opened the market slightly in the early 1990s, foreign investors found that portfolio investment in Korea was profitable as long as the value of the won remained stable against the dollar, given the high interest rate of 12-3% per annum in Korea which was far above the cost of borrowing (6-7%) in their home countries. They also thought that stock prices in Korea were generally undervalued, and overall economic performance was fairly good. They brought short-term capital to invest in Korea. The inflow of foreign portfolio investment, starting from almost insignificant amounts before 1990, increased rapidly and the cumulative total from 1991 to 1996 was figured at as much as $48 billion. At the same time banks and big companies took advantage of the liberalization of capital market to borrow short-term loans abroad for long-term physical investments or portfolio investment abroad, including Russian junk bonds. Unfortunately, no policy makers or central bankers in Korea were aware of the danger inherent in the volatility of the short-term capital and no one could foresee the foreign exchange crisis just around the corner.
In the information age, such political drama, financial scandals, the unprecedented size of trade deficits, and the bankruptcy in a series of business conglomerates were well publicized throughout the world, shaking the confidence of the international financial community in Korean banking. The erosion of confidence was further precipitated by the on-going foreign exchange crisis in Thailand, Indonesia, and the banking crisis of different nature in Japan. At last foreign investors started to pull their money back from Korea by dumping stocks and bonds, and refusing to roll over the loans that came due to Korean banks and private companies. The capital exit plunged stock prices and drove won further down against the dollar, rapidly draining the foreign exchange reserves of the central bank.
The government chief official was still optimistic, vowing that he would never take recourse to IMF rescue. I personally had to strongly urge through newspaper columns and direct interviews with the newly appointed Deputy Prime Minister that he has no time to loose before going to the IMF. At last he officially filed the request for a rescue loan with the IMF on November 14, and an agreement on the terms and conditions for a $57 billion funding package was reached on December 3.
|The IMF Intervention|
The IMF program was built around: (i) a strong macroeconomic framework designed to continue the orderly adjustment in current external accounts; to build up international reserves; and to contain inflationary pressures, involving a tighter monetary stance and significant fiscal adjustments; (ii) a comprehensive strategy to restructure and recapitalize the financial sector, and make it more transparent, market-oriented, and better supervised; (iii) measures to reduce the high degree of reliance of corporations and financial institutions on short-term debt and to allow a better diversification of risk in the economy.
When the reform program was announced it was a great shock not only to the financial and business community, but also to the general public, because it meant a loss of jobs, credit crunches, business failures, and rising prices. Without knowing the full implications of the IMF medicine, people on the street denounced their government, the IMF, and their big brother, the United States, for their misfortune. To make matters worse, the IMF intervention became a focal point in the campaign rhetoric for the presidential election scheduled on December 18, in which one candidate, the president elect himself, inadvertently announced that he would take a second look at the IMF agreement if elected. The campaign rhetoric seemed to have raised doubts on the part of foreign creditors and governments as to Korean political leaders' will to carry out the reforms imposed by the IMF.
In the meantime, D.J. Kim was elected as the next president, and he lost no time to announce that he would abide "100 percent" by the commitment of the government to the IMF. Since then, the president elect has been busy and more visible than the incumbent lame-duck president in dealing with the financial crisis, making a telephone call to the managing director of the IMF and the Prime Minister of Japan to ask for help, and eliciting a pledge of chaebols and a cooperative posture of labor unions for implementation of the reform program.
U.S. Treasury Secretary Robert Rubin finally took the initiative to persuade the world financial community that in order to avert a global crisis, the private sector had to play its part in rescuing Korea because the official sector cannot do the whole thing by itself. He began telephoning senior executives at several U.S. banks on Christmas Eve. By midnight of the same day, the Korean Deputy Prime Minister announced that G-7 countries and the IMF agreed to rush $10 billion to Korea by early January, speeding up the disbursement of loans pledged under the IMF rescue plan.. Officials of the six major banks in the United States met in New York on December 29 and agreed in principle to roll over some of the short-term credits to Korea for longer terms. The U.S. move has helped Korea avoid the worst scenario of the crisis and the derangement of the foreign exchange rate subsided for a time.
In the meantime, on December 30, the National Assembly passed 19 pieces of legislation which are needed to carry out some of the IMF-imposed reform programs. Legal amendments in the National Assembly consist of (i) establishing an independent central bank with the primary goal of controlling inflation; (ii) creating a consolidated supervisory body with jurisdiction over all financial institutions and both operational independence; (iii) mandating companies to report audited and consolidated financial statements.
However, some additional legislation is yet to come in the
current session of the National Assembly or later. One of the hot issues
confronting the legislature is to amend a labor law to legalize immediately
the lay off of employees in case of merger, acquisition, and corporate
Negotiations between labor
The price for the reform is formidable in terms of the credit crunch, business failures, mass unemployment, and rising prices. Yet Korean people are bracing up to the hardship and prepared to play their part to overcome the current economic woes. Their determination found its expression in a campaign sponsored by civil organizations for collecting gold jewelry held by households; they will be melted into gold bullion and sold on the international market for dollars. The campaign has reportedly collected about 15 tons of gold ornaments in a week since the campaign started. One estimate goes that billions of dollars could be mobilized by this means to augment the nation's foreign exchange reserves.
On January 15, The Federation of Korean Industries, a powerful organization of big businesses, including conglomerates, officially announced its resolution that member companies would fully support the reform program mandating restrictions on the cross guaranties, disclosure of consolidated financial statement, and liquidation of the inefficient business units within conglomerates.
Labor unions also finally consented to sit at the conference table for the tripartite Committee of the Government, Business, and Labor, in which the lay-off of labor for corporate restructuring will be discussed together with adjustment burdens to be shared by other two parties.
The IMF has asked the Korean government to aim at a GNP growth rate of 2-3% and no more than a 9% (originally 5%) rate of inflation in the current year, placing a high priority on improving the nation's balance of payments. Given the current turmoil in the financial sector, both targets are not likely to be met. In particular, price inflation is one of the major concerns given the skyrocketing of import prices due to more than a 100% depreciation of the won since the end of last year, combined with monetary expansion, which is inevitable because the government has committed the central bank to providing emergency credit for the repayment of deposits in failing banks, and to ease the credit crunch, a hardening of the financial arteries.
The single most serious problem at present is the credit crunch, due mainly to the shrinking attitude of the banks, particularly to reduce risk assets to meet the capital-asset ratio of the BIS standard imposed by the IMF. It is reported that many viable enterprises are falling due to the abrupt rupture of credit lines in normal operation. Some sort of safety net for the healthy enterprises seems to be badly needed. Professor Jeffery Shachs of Harvard University argued in an interview with a Korean newspaper that the IMF's conventional formula for financial stabilization without regard to the particular realities of Korea may kill healthy enterprises en mass, destroying the very foundation of economic growth.
For all the high prices to be paid, however, I expect that the ongoing structural adjustment will be well carried out, transforming Korea into a new economic regime in which the financial system, including the central bank, will be much more independent from the government and industries; the newly established Financial Supervisory Committee will exercise more effective vigilance over banking practices to ensure the protection of depositors and the managerial soundness of the financial institutions.
Corporate governance also will undergo a remarkable change as pledged by the Federation of Korean Industries. A legalized lay-off system will make the labor market more flexible, and the wage rate will become more compatible with productivity.
The new regime will fully meet the WTO and OECD standard in opening the market for trade, investment, and financial services, and the foreign companies will find it much easier to do business in Korea either by themselves or with Korean partners.
|The Implications for Korea-U.S. Relations|
Once again the Korean people owe a great deal to the United States in coping with the current financial difficulty. Koreans are well aware that the U.S. was behind the IMF and has played a key role in the IMF rescue operation. The unfailing cooperation between our two countries stems not only from the traditional friendship, but also from the awareness of economic interdependence between our two countries and among the many other nations involved. It was already mentioned in the U.S. that the financial crisis in Asia, including Korea, negatively impacts U.S. exports, and the overall economic outlook for the next few years. We also appreciate that the U. S. recognizes the implications of Korea's economic woes for the maintenance of peace in the Korean Peninsula.
No doubt the ongoing reform will create conditions favorable for the participation of U.S. firms in the financial sector, as well as in other industries. U.S. investors can now hold up to 55% of the equity capital of Korean companies, and the aggregate ceiling on foreign investment will be gone by the end of the next year. There will be no limit on investments in the Korean bond market. We are hoping that some American banks take over the ownership and management of at least two ailing city banks.
Finally, let me remind you that the real fundamentals of the Korean economy remain strong with a powerful industrial base, a high savings rate, a highly educated population, a strategic location in the Northeast Asia, and the first example of achieving democracy in the developing world on the basis of economic development in the past four decades.
The Korean economy has stumbled in the course of democratization and globalization. Yet, in historical perspective, the current crisis may appear as the necessary price of transition and reform. In that sense, what is happening in Korea now is developmental in nature. For instance, the financial scandals mentioned earlier led to the revision of laws governing political parties and elections. The result was that the last presidential election was the most clean and corruption-free election the country has ever seen, and the ruling power is shifting from the government party to the opposition for the first time since the birth of the Republic a half century ago.
In a sense, the current financial crisis is a blessing for the Korean economy because ongoing reforms promise to bring about a new economic order in which economic units will be able to exert the best effort in a new environment in which free and fair competition will prevail.
There was a time when Korea was heralded as a showcase of the success story of U.S. foreign policy, and that of the international development effort represented by the World Bank and the IMF. I am personally confident that Korea will make another success story for democratization and globalization in Asia, playing a pivotal role in Northeast Asia during the years to come.
Thank you for your attention and patience.
The IMF Reform Policy Program
As disclosed by the government, the IMF conditions imposed on Korea may be summarized as follows:
1. Banking Reform
Voting before the end of the current year for the financial reform bills submitted by the Administration to the National Assembly earlier than the IMF intervention.
2. Corporate Governance
Mandating business conglomerates to prepare reliable and transparent financial statements combining all members of the conglomerate, attested by an independent and honest auditor. Restricting or banning the practice of cross guarantees among members of business conglomerates. Measures to improve the capital-debt ratio of enterprises and banks.
3. Further liberalization
Speeding up the market opening for trade, investment, and financial services.
4. Labor market flexibility
Legalizing the lay off of employees in case of corporate restructuring.
1) The latest estimate of total "external liabilities " at the end of November, 1997, in the IMF definition has turned out to be $156.9 billion compared with $ 116 billion of total "foreign debt" in the World Bank definition. The difference represents borrowings by overseas branches of banks and overseas subsidiaries of the home companies for overseas business activities. About 59% of the total foreign debt, or $92.2 billion, are short-term borrowing with the maturity of less than one year. See Table 2.
2) As finance minister I tried to cope with the adverse effects of government intervention by introducing what was known as the "May 29 Measures" in 1974. The contents of the measure are very similar to the reform measures currently requested by the IMF. Unfortunately, these measures were not followed up faithfully after the Park Administration.
3) The amount of non-performing loans held by banks totaled W32 trillion (7.5% of GDP or 6.2% of the total loans of the commercial bank) at the end of September, 1997, according to the official announcement of the government. However, if loans in arrears of more than three months are included according to international standards, the total amount more than doubles. In Korea and Japan, non-performing loans are defined as loans in arrears of more than 6 months.
4) Most of them were given presidential amnesty and freed a few days before Christmas Day in 1997, allegedly for the cause of reconciliation and national unity.
5) Under the current law as amended after a bitter confrontation between the government party and the opposition in November, 1997, provision of labor lay-off was to take effect in 1999.