Financial Crisis and Policy
|Causes of the Liquidity Crisis.|
There are diverse explanations of the causes of the financial crisis in Korea, but most analysts agree that liquidity shortage lies at the heart of the crisis that was resulted from excessive borrowing of hedge fund by the private sector or, to put it another way, a mismatch between short term borrowing and long term investment, even though Korea's economic fundamentals were strong prior to the onset of the crisis. Needless to say, there are many other underlying causes, including structural weakness in banking and corporate governance, inadequate transparency and lax bank supervision.
Those structural weaknesses, however, were well known in the international financial community before the onset of the crisis. They only came to the surface when Korea began to open its financial markets in response to outside pressure. The root of the trouble was that Korea moved to liberalize its capital markets without making the necessary internal adjustments including liberalization of its domestic financial market, narrowing the wide disparity in the interest rate between domestic and international markets, modernizing banking services, strengthening bank supervision, and liquidation of bad debts accumulated by the financial system.
When Korea liberalized its financial markets to some degree early in the 1990s, foreign investors thought that portfolio investment in Korea would be profitable as long as the value of the won remained stable against the dollar, given the high interest rate of 12-13% 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. As a result, the inflow of foreign portfolio investment, starting from almost insignificant amounts before 1990, increased rapidly and the cumulative total from 1991 to 1996 was estimated at as much as $48 billion. 1)
At the same time, banks and big companies took advantage of the liberalization of the capital market to take out low-cost short-term loans abroad for long-term physical investments, and even portfolio investment abroad including Russian "junk bonds". Unfortunately, policymakers and central bankers in Korea, with no experience with hedging operations in the globalized market, were not aware of the danger inherent in the volatility of the hedge funds, and no one could see a liquidity crisis just around the corner that would be triggered by the financial crisis in the Southeast Asian countries.
As the hedge funds were flowing in, the value of the Korean won tended to appreciate (Korea's foreign exchange rate was not pegged to dollar as in Thailand), even though the current account had been showing a chronic deficits since 1990, peaking at $23 billion in 1996.
The Korean experience illustrates that the floating exchange rate system no longer functions as a mechanism by which to automatically regulate the current accounts of the member countries of the IMF as envisaged by the architects of the system, because the foreign exchange rate is no longer determined by commodity trade alone but much more by the cross- border movement of the short-term capital in the globalized financial market. This is, I believe, a fundamental challenge facing the international monetary system today.
Well informed foreign creditors became concerned about Korea's short-terms debts and large current account deficits, particularly in light of the financial crisis that was unfolding in Thailand and Indonesia and even in Japan in a different context. Eventually, foreign investors started to pull their money back out of Korea by dumping stocks and bonds, and refusing to roll over maturing loans to Korean banks and private companies. The reversal of the capital flow depressed stock prices and drove the won further down against the dollar, rapidly draining the foreign exchange reserves of the central bank. The debt crisis had begun.
The IMF intervention
Five months have passed since Korea, on December 3 last year, agreed to the IMF regime of crisis management in return for the IMF loan packages of $58.35 billion in bailout. The IMF undertook to apply its traditional prescriptions of unrestricted floating of the foreign exchange rate, high interest rates, and tight monetary and fiscal policies -- all of which are aimed at continuing the orderly adjustment in current external accounts, building up international reserves, and containing inflationary pressures. In addition to the macro policy framework, the IMF recommended to the Korean government a comprehensive strategy for structural reforms designed to recapitalize the financial sector and make it more transparent, market-oriented, and better supervised and to restructure corporate governance toward more prudent management and a healthier relationship with the financial system.
The Macro Management
Since the shortage of liquidity lies at the heart of Korea's financial crisis, the availability of funds from international sources was the primary requirement for Korea to overcome the crisis. To the extent that foreign capital is readily available, the need for the drastic depreciation of the won and the need for abnormally high interest rates will be reduced and foreign creditors will be more confident of their credits being honored. Yet in reality this was not the actual path Korea could take.
Thanks to the help from the IMF, the World Bank, the ADB, and other financial institutions in industrial countries, Korea has been able to improve its liquidity position in the past five months. So far, $24 billion out of the $58 billion package pledged by the IMF and others has been disbursed to Korea as of the end of April. In March, 123 banks in 31 countries agreed to reschedule short-term debt of $21.6 billion (94.8% of the amount requested) for new terms longer than one year or more. In addition, the Korean government was able to raise $4 billion in the New York money market by selling government bonds in April. This will improve Korea's debt profile by reducing the proportion of short term debt in total external obligations from 63.5% in 1996 to about 30%.
The transfusion of funds helped Korea restore relative financial stability as can be seen in the following developments.
On the other hand, the abnormally high interest rates combined with a credit crunch have been taking a heavy toll on the economy as evidenced by the following developments.
Looking at this situation, I am moved to speculate that a bold "one shot" infusion of funds immediately following the IMF intervention might have reduced the scope of won depreciation and the rise in the interest rate, lessening the negative effect of the credit squeeze. In any case, I am pleased to hear that the IMF finally agreed to a policy of lower interest rates.
With the growing pain of adjustment, many uncertainties remain, including a potentially devastating banking crisis in Japan that could make Japanese banks wary of rescheduling Korean debt, a weakening yen that could hurt Korean exporters, and the possibility of eventual devaluation of the Chinese Yuan that could undermine Korea's trend toward exchange rate stability.
Aware of these prospects, and Korean government is now trying to increase foreign exchange reserves to $40 billion by the end of this year with the aid of the projected current account surplus of more than $20 billion; The government will support a syndicated loan of $3 billion by domestic banks plus an increase in credit lines and continuing role-overs of maturing loans held by banks and private corporations. At the same time, the government will be amending relevant laws and regulations to fully liberalize foreign investment and the capital market and allow hostile M&A by foreign investors.
Nonetheless, I should stress that it would be very difficult for Korea to regain international confidence and for private Korean companies to return to the international capital market unless Korea accelerates the pace of structural reform in banking and corporate governance. This is indeed a daunting challenge to the Korean government and business community, which will be discussed in the following sections.
The effort for structural reform dates back to the former administration, as illustrated by the 19 pieces of legislation which were pending with the National Assembly before the financial debacle took place last November, and long before the newly elected president, D.J. Kim, was sworn into office on February 25 this year. The National Assembly hurriedly passed the reform bills with minor revisions on December 30 in response to the outbreak of the crisis and the ensuing onset of the IMF regime.
The major contents of the reform bills include: greater independence of the central bank with the aim of promoting price stability; establishing a consolidated supervisory body with jurisdiction over all financial institutions; requiring the large conglomerates - or chaebol - to disclose audited and consolidated financial statements; limiting the practice of cross guarantees among chaebol member companies for loans from financial institutions; easing M&A by both domestic and foreign firms; further opening of the financial market to foreign participation; and legalizing layoffs of employees in case of merger, acquisition, and corporate restructuring. Thus, the reform measures effected by the legislation were more or less in conformity with IMF recommendations. However much more remains to be done.
As for banking reform, the Korean banking system has been plagued by three major institutional setbacks: (1) lack of managerial independence from the government and close ties with business conglomerates; (2) lack of a responsible managerial system to ensure accountability to shareholders and (3) lax supervisory functions of the government. These institutional defects and unhealthy practices will be remedied by the changed laws and regulations and by the setting up of the new supervisory body. The real issue is to how to pay for the consequences of the institutional legacies, that is to say, to clean the huge burden of bad debts accumulated within the financial system, dispose of insolvent banks, recapitalize financially weaker banks, and make shareholders take their losses.
So far, licenses of 13 merchant banks and one investment trust company have been revoked. Also, the government has suspended three merchant banks and two securities companies. The two major commercial banks are currently on sale, preferably to foreign investors. All banks have been directed to submit restructuring plans to meet the BIS capital-adequacy requirement by the end of April. At that point, the Financial Supervisory Commission will evaluate their plans, and by the end of June, will decide the modality of restructuring and will impose prompt corrective actions. If a bank fails to meet the corrective measures within the set time table, then it will be merged or closed. All banks except a few banks are currently striving to meet the minimum requirement of the equity-asset ratio of 8% by recalling loans and limiting new lending only to highly selected clients.
Under this situation business failures are increasing, and if the present pace of business failure continues, the non-performing assets are likely to reach, by the end of this year, 100 trillion won, (about $74 billion) or 25% of GDP projected for 1997, according to a forecast by the Korea Development Institute (KDI), Korea's most influential think tank for economic policies.
The Korea Asset Management Corporation (KAMC) was set up to buy up non performing assets of the banks by using the Resolution Trust Fund capitalized by the government and the banking community. The Fund has been authorized to issue public bonds in the amount of 12 trillion won (about $8,8 billion) this year for the purpose. An additional 10 trillion won will be needed to buy up a half of the non-performing assets (100 triillion won) projected for this year by the KDI.
Recapitalization of viable financial institutions will also require injection of public funds. Let me explain why this is imperative. According to a KDI estimate, a capital increase of about 35 trillion won (about $30 billion) is needed for the banks as a whole to meet the IBS capital requirement at the present time. However neither existing bank share holders nor new investors are likely to buy new bank shares given the current situation in which bank credit is dried up and the economic outlook is uncertain. The banks are seeking M&A with foreign banks or investors, but this cannot be done overnight. The only way open to the banks is to reduce their risk assets, which will, however, end up increasing business failures and non-performing assets. This is a dangerous situation threatening to undermine industrial base of Korean economy.
Two alternatives are available to the government. One is to make the capital ratio requirement more flexible, allowing banks approach the 8% target in steps over time. After all, the ratio is in a sense a political number agreed upon at the G12 meeting of central bank presidents in July 1988. There is no absolute ground for the ratio. The other option is to use public funds to increase bank capital with the understanding that the government divest shares as soon as the bank is taken over by new shareholders and management. Notwithstanding the market ideology of moral hazard, there seems to be no other alternative. Recognizing this, the government has allocated 7.2 trillion won for the recapitalization of the failing banks as a means of attracting foreign buyers.
There is still another need for public funds in the resolution of insolvent banks. Since the liability of bank stockholders is limited to the value of their stocks, the remaining loss has to accrue to depositors or other creditors. Under the present circumstances, it seems inevitable that the government will have to assume most of the loss. Accordingly, the government has authorized the Deposit Insurance Corporation to issue bonds for the amount of 12 trillion (about $8,8 billion) for the protection of depositors with insolvent banks.
The core issue in restructuring of business conglomerates is to make the chaebol reduce their debt-equity ratios from the current average of more than 400% to 200%. This has been agreed in principle between the chaebol and their main banks. Under this agreement, the chaebol are required to sell off some of their member companies as well as real assets, including land.
The major difficulty here is that even though the chaebol want to sell assets to raise money, few domestic firm have the funds to buy them and it takes time to find foreign investors and negotiate with them for sale or M&A. Moreover, 40 triillion won is needed to lower the chaebol's debt-equity ratios to 200%, which is equal to about 40% of the total current value of stocks listed on the stock exchange.
To help the chaebol sell off their real estate, the government has taken the following measures, among others: provision of 3 trillion won for the Korea Land Corporation to buy up real estate from the chaebol and other companies; allowing commercial banks to issue asset-backed trust securities against a pool of real estate collateral; providing temporary tax incentives to induce business firms to sell real estate for the purpose of debt repayment; and full liberalizaton of the capital market to attract foreign investors to buy assets held by the chaebol and other companies. Thus, Korea Inc. is now offering for sale to foreign investors at "bargain basement" prices a wide variety of assets including companies, banks, real estate, portfolios investment and what not.
Despite all these measures, it seems unrealistic to assume that the chaebol will be able to restructure themselves in a short period of time without help form the banking system and the government. The banks may well capitalize and/or reschedule the chaebol's loans, and the government, may extend an indirect support by making additional funds available to the fragile banking system. Although these measure are unpopular at home and abroad on account of the moral hazard involved, still they are, in my view, the only alternative open to Korea at this moment to tide over the twin crises of the corporate sector and the financial sector. Unless bold actions are taken by the government as quickly as possible, more conglomerates will go bankrupt with perhaps catastrophic repercussions on the economy, further eroding confidence in Korea on the international money market and possibly even touching off another round of foreign debt crisis.
The IMF medicine has produced some positive results as we have seen, yet its negative side effects of mass unemployment and massive business failures cannot be underrated or ignored. Some safety net is called for to protect labor and small and medium sized business, who are the economic players least responsible for the foreign debt crisis. The safety net provided by the government to the labor includes unemployment insurance, retraining, financial aid to subsistence households, and job creation through expansion of public works. The government has allocated two trillion won in the budgetary program for these purposes.
Unfortunately, there is no well established safety net to protect viable companies under the IMF program. The single most valuable program as a safety net came from the World Bank in the form of Structural Adjustment Loan (SAL). On March 26, the Bank approved the first installment of $2 billion SAL for Korea, which will be used for payments of imported raw materials by small and mid-sized enterprises. This is exactly what we need under the present situation. I must stress that unless healthy businesses continue their industrial and trade activities, withstanding the brunt of the reform policies, there is no way to increase exports and stabilize the nation's external account.
The same observation seems to have led the Ministry of Finance and Economy to unveil on April 14 a plan to create a one trillion-won (about $700 million) for buying shares in companies and another 1 trillion-won debt restructuring fund for rolling over short-term debts of viable companies impacted by the IMF measures. The funds to be established in June will be capitalized by the Korea Development Bank and other financial institutions. Hopefully, the funds will then be expanded by drawing upon the World Bank, Asian Development Bank, and other international sources.
It has been reported that the World Bank has not responded positively to the idea of using the bank's funds for such purposes. However, there seems to be some miscommunication among the Korean government, the World Bank and the mass media.. As far as I know, the funds proposed are not intended to bail out failing companies nor buy up non-performing assets of the banks; they were intended to provide a safety net to healthy businesses to prevent them form becoming innocent victims in the course of financial reform. There are many viable small and medium sized companies and venture businesses which are highly innovative and competitive in the international market in the normal business environment. Nothing is more urgent for the Korean economy than increasing export revenue to pay for, among others, interest charges which are expected to increase to $20 billion a year for the next several years. However exports are not increasing these days despite the weakness of won mainly because of the high interest rate and credit squeeze. It is simple common sense that no company can possibly survive paying interest on loans as high as 20-30% per annum. The healthy companies deserve a safety net and some reasonable protection. I hope the IFC looks into this matter carefully and positively and work out an effective program for the purpose I defined above, which will also help the structural reform led by the World Bank proceed more smoothly.
Using public funds to aid businesses is criticized for violating market principle and for the moral hazard involved. However, we cannot ignore the fact that the system of market discipline is inadequate in Korea and that's why structural reform is called for. Given the present circumstances, there is no other alternative than using public funds in banking reform. The real question is whether the cost involved is sustainable in the fiscal sector without prejudice to sound fiscal management. Korea is fortunate in this respect as it has a relatively small government debt equal to about 15% of the GDP.
According to the KDI, about 67 trillion won (about $50 billion) will be needed over the next five years to help the banking system to clear up its bad debts, increase equity capital, assume the net loss of the closed banks, and provide a safety net to labor and viable businesses. The annual requirement is roughly within the range of 9-16% of the projected GDP. This is comparable to 12-15% for Mexico in the financial crisis of 1995. The KDI estimate is based on many assumptions regarding relevant variables, but it provides an order of magnitude involved and a useful perspective on solving the budgetary problems.
It seems safe to say that the fiscal sector can accommodate that level of fiscal requirement without an unbearable impact on the welfare of the people in the coming years. The required funds could be raised mostly by new issues of public bonds to pay for the purposes outlined above, involving a minimum outflow of cash, and therefore less risk of crowding out private businesses in the money market. Interest payments equivalent to about to 2% of GDP can be met by budgetary cuts including defense expenditure, and increasing tax revenue, which, however, require political courage and determination.
I have made some general observations on the major policy challenges facing the Korean government in its effort to resolve the current financial crisis. As a former civil servant, I am impressed by the amount of work which has already been done in a short period of time by the policymakers in the Korean government, the IMF, and the World Bank not only with regard to crisis management and but also in mapping future course of action to address the challenges facing Korean economy. I am pleased to say that, formidable as these challenges are, the Korean people and the new government headed by President D.J. Kim are firmly committed to overcome the difficulties and hardship with the help of the international financial institutions, including the World Bank and the IMF as well as our friends and allies, above all the United States.
It is true that the Korean economy has stumbled in the course of globalization. Yet, in historical perspective, the current crisis may be viewed as the necessary price of transition and renewal for the coming century. In that sense, what is happening in Korea now is developmental in nature. 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 free and fair competition will prevail and all economic players will be better able to exert their best efforts for themselves and society.
There was a time when Korea was heralded as a showcase for the success of the U.S. foreign policy and international development policies represented by the World Bank and the IMF. I am personally confident that Korea will again be seen as a success story for democratization and globalization in Asia, playing an important role in Northeast Asia during the years to come.
Thank for your time and attention
1) The Bank of Korea, Economic Statistics Yearbook, 1997, p.208
2) The IMF loan package includes $21 billion from the IMF, $10 billion from the IBRD, $4 billion from ADB, $10 billion from Japan, $5 billion from the U.S, and $8.35 billion from other developed countries.
3) "Total external obligation" of $150.3 billion in the IMF definition at the end of February is larger by $30.1 billion than the "total foreign debt" in the World Bank definition.