Observations on the Reform
Policies in Korea
|The Causes of the Crisis|
Much has been said about the causes of Korea's currency crisis that started in November 1997. In my view, the currency crisis can be explained in terms of three factors: liquidity shortage, structural weakness, and changes in expectation and loss of confidence.
IIn Korean case, liquidity shortage was resulted from the excessive borrowing of the short term fund by the banking and corporate sectors or, to put it another way, a mismatch between short term borrowing and long term investment. This in turn was prompted by some degree of liberalization of capital market without having remedied structural weakness of the banking and corporate sector which were highly vulnerable to currency crisis, as well as without having strengthened prudential regulation of the baking sector in response to the financial exposure to the volatile movement of the short term capital across the borders. Although the structural weakness was long standing and was no secrete to the international financial community prior to the crisis, the financial crisis in Southeast Asia caused a shift in the expectation and confidence of foreign investors with regard to financial viability of Korean economy. Once a sign of the liquidity shortage was manifest, the herd instinct and self-fulfilling pessimism overtook the money market, and there was no way to dodge the currency crisis with rapidly dwindling foreign exchange reserves. The currency crisis readily developed into financial crisis, which, in the course of structural reform, further deteriorated into a full scale economic crisis.
The economic fundamentals underlying Korean crisis differ
in many respects from those in the affected countries in Asia. For example,
unlike Thailand, Korea's currency had not been pegged to the dollar and
its value more or less reflected market forces prior to the crisis. Thus,
according to an estimate of Professors Michael Dooly and Menzie Chin of
University of California 1)
|Objective of the IMF intervention|
Since the Stand-By Arrangement was signed between the Korean government and the IMF immediately following the outbreak of the foreign exchange crisis in November last year, sweeping structural reforms have been undertaken not only to contain the currency crisis but also to rebuild the financial system and to reform corporate governance with the aim of creating a new basis for the long-term growth of the Korean economy.
Pursuant to this objective, the IMF undertook to apply its traditional macroeconomic prescriptions of unrestricted floating of the foreign exchange rate, high interest rates, and tight monetary and fiscal policies, aimed at orderly adjustment of the current external account, building up international reserves, and containing inflationary pressures.
In the area of structural adjustment, more than 20 reform bills have been legislated to provide the legal basis for financial reforms, which are directed at recapitalizing the financial sector and making it more transparent, market-oriented, and better supervised; restructuring corporate governance toward more sound management and a healthier relationship with the financial system; enhancing flexibility in the labor market; and further liberalizing the capital market as well as international trade in goods and services.
|Effect of the Reform Measures|
The reform policies implemented during the past 8 months have produced both positive and negative results. The positive development is found in the area of containing the currency crisis. The IMF measures were successful in that relative stability in the external account has been restored as can be seen in the following developments: the exchange rate and interest rate have come down closer to the pre- crisis level; the current account marked $22 billion surplus for the first half of this year mainly due to the decrease in imports, contributing to the increase in usable foreign reserves that reached $41.3 billion at the end of August, surpassing the level targeted for the end of this year; and the share of short-term debt in total external liabilities significantly dropped from 44 percent in December 1997 to 25 percent in August 1998.
On the other hand, Korea now is experiencing an unprecedented economic downturn under the impact of the reform policies. Industrial production during the first half of this year decreased by more than 10% compared with the corresponding period of the last year; exports have turned to negative growth since May, registering a 13.7% decrease from the level of a year ago for the month of July; the rate of operation of surviving firms is currently as low as 60% of capacity; unemployment has climbed to the 2 million mark, or 7.6 percent of the work force, as of July this year; and contrary to the expectation in the standby Arrangement that " the program is intended to limit the deceleration in real GDP growth to about 3 percent in 1998, followed by a recovery toward potential in 1999," the actual growth rate turned out to be minus 3.8 percent in the first quarter, and further plunged to minus 6.6% in the second quarter of 1998..
Looking at the both positive and negative developments, one may sum up the situation by saying that Korea, with the aid of the IMF, and other international institutions, was able to restore external solvency and embark on structural reforms at the cost of the severe economic crisis at present, recognizing that the positive results of the structural reforms can only be fully realized in the future.
At any rate, alarmed by the regression of the economy, the Memorandum on the Economic Program of July 24 1998 submitted to the IMF by the Korean government noted that the government would "shift the focus of macroeconomic policies toward supporting an early recovery of domestic demand," placing the priority on taking "strong actions to contain the economic recession to a manageable level." In line with this policy emphasis, the Korean government decided to expand the budget deficit from the one percent previously agreed with the IMF to 5 percent of GDP. The government also cut special excise tax rates by 30 percent on consumption of durable goods, effective July 10. On the monetary side, the central bank pledged to expand the money supply to ease the credit crunch and lower interest rates within the limit of maintaining a stable exchange rate and price stability.
The shifting policy emphasis may be justified by the relative stability achieved in the financial sector, yet it is an indication of a wide discrepancy between what policy makers originally expected and what actually happened under the impact of the reform policies. What then are the major reasons for such discrepancies? Since increasing business failures or bad debts with financial institutions are typical indicators of an economic downturn, we may examine why business failures and bad debts increased so fast during the past 8 months. .
|Major Reasons for the Economic Crisis|
Non-performing loans of the banking system defined in Korean standard steadily increased from 5.8% of total loans at the end of 1997 to 7.3% in March, and to 10.2 % in June of this year. The Financial Supervisory Board is predicting that non-performing loans, in the newly instituted definition to include the loans over-due for three months or more like in the United States, will reach 118 trillion won (about $80 billion) by the end of this year, which is equal to about 25% of GDP for 1997.
It is difficult to say to what extent the increase in the bad debt were due to poor management of the indebted businesses and to what extent due to the impact of the financial austerity policies upon otherwise viable companies. No doubt these policies worked to weed out inefficient marginal firms, but it is also true that many good firms were victimized by the impact of the financial austerity policies.
The first serious blow to the enterprises came when the IMF pressed the government to abolish the legal limit of 24% on interest rates in January and to raise the lending rate of the central bank to 40%, signaling an overall rise in other interest rates in the money market. It is a matter of common sense that few companies can survive, servicing debt with interest rates as high as 20-30% per annum even for a short period of time, especially in Korea where corporations are generally highly leveraged.
Moreover, the exchange loss of the companies with foreign debt increased sharply as the exchange rate of the won against the dollar jumped from 844 won at the end of 1996 to a peak of 1,992 won on December 23, 1997, thereafter coming down gradually to the current level of 1331 won (at the end of August 30, 1998). The value of foreign debt and its servicing cost in terms of local currency increased by more than 70% on average during the period. The abnormally high interest rates on top of the exchange loss drove many companies into financial crisis over night. .
In addition, the credit squeeze was another important-- even more important--cause of the rapid increase in business failures and non-performing assets on the part of banks. It was reported that during the first half of this year, net outstanding loans of banks decreased to 12 trillion won from 23.4 trillion won for the same period of 1997 according to the Ministry of Economy and finance .2)
The credit contraction was related to the so called BIS capital adequacy ratio of 8%. The licenses of 5 commercial banks and 16 merchant banks were revoked on the grounds of negative capital ratios, and other weaker banks were directed to improve their capital ratios to the level of 6% by March 1999, and to 8 percent by March 2000. Banks are also "encouraged" to increase their capital ratios further to 10 percent by December 2000. If the implementation plans of the banks to achieve these targets are found inappropriate by the regulatory agency, the banks in question will be subject to mandatory merger or transfer of business under P&A, or to an exit order under the Prompt Corrective Action procedures.
Apart from the regulatory requirement, banks realized that unless their capital ratios were improved, their international credit rating would go down, making it more difficult for them to obtain rollovers of foreign debts due, let alone obtain fresh loans. Thus, the capital adequacy ratio became the number one criterion on which the destiny of a bank depended. Under this regulatory as well as international financial environment, banks were obliged to call in all but the safest loans. Unfortunately, this strategy was self-defeating because recalling of loans and contraction of new lending, combined with high interest rates and foreign exchange loss, produced more business failures only to increase non-performing assets on the part of banks. This vicious circle is making structural reform in the banking sector more difficult.
Credit contraction was further aggravated by the paralysis of the banking network in the reform process involving closure, mergers, and the attempted sales of non viable banks.
In addition, companies are currently caught between a credit squeeze and declining revenue in the wake of sagging demand for consumption and investment at home and demand for imports abroad, particularly in the other Asian countries in financial and economic crisis.
The economic calamity facing Korea today may be viewed as the inevitable or even necessary cost of the resolution of the currency crisis and overhauling of economic structures in response to changing conditions in the international economic environment. Yet, the severity of the economic downturn seems to pose questions regarding the way the crisis has been managed by the government and the IMF. A renowned foreign observer told me that although Korea deserves to pay a price for the misguided economic policies of the past and for its deep rooted structural weaknesses, it is paying a premium on top of the high price. Let me share with you some of my observations.
In the first place, the crisis in Korea started in the form of a liquidity crisis. I make a distinction between the currency (or liquidity) crisis and financial crisis for the reason that a country, such as Japan at present, can experience a financial crisis but not a currency crisis.
Since the shortage of liquidity lay at the heart of the Korean crisis, the availability of funds from international sources was the primary requisite for Korea to overcome the crisis. To the extent that foreign capital was readily available, the need for drastic depreciation of the won and abnormally high interest rates would be reduced and foreign creditors would rest more confident of their claims being honored. Under these circumstances, the structural reforms could proceed in a more orderly manner. Yet, in reality, this was not the path Korea could take.
To be sure, the IMF's response to the Korean crisis was prompt and efficient, organizing a funding package of $58 billion, including $21 billion of its own resources from the newly created Supplementary Facility as well as from the general resources, which together far exceeded the eligible amount based on Korea's quota with the IMF. In addition, the IMF sponsored rescheduling of short term debts for longer terms by private banks in the amount of $21 billion. The two amounts put together were more than enough to cover Korea's entire short term debts of $65 billion outstanding at the time of the crash. However, the problem was that disbursement of the IMF fund was made on a piecemeal because of the conditionality attached to the loans. So far only 43% of the total package of $58 billion have been disbursed as of the end of May 1998. I am moved to speculate that if an amount of $30 billion or so had been injected by the IMF into Korea's dwindling reserves at one shot at the critical juncture, market confidence might have been maintained and the crisis might have been contained at an early stage without recourse of the abrupt shift of monetary and fiscal policies.
The IMF, with limited resources available, relied on highly contractionary policies, including a steep raise in interest rates. However, the normal functioning of high interest rates, intended to reduce the outflows and induce the inflow of foreign capital, was overwhelmed by the herd instinct as foreign investors were already panicked by financial crisis in Southeast Asia. On the other hand, such high interests had devastating impact on business operations. I don't mean to deny the need for higher interest at the critical moment of the crisis, but no one can really tell if a 30% is better than a 20% rate when the herd distinct dominates the market. Policy makers may not care too much as long as it is much higher than the previous rates, but the difference matters very much for business operations.
In hindsight, the Korean experience seems to demonstrate that the IMF is most effective when it maintains its role of lender of last resort, avoiding excessive contractionary policies. I understand that the IMF currently is not able to play fully the role of lender of last resort without adequate financial resources and that's why the management of the IMF has been working hard to realize a 45% increase in the IMF quota. I also understand that the conditionality attached to the IMF loan is inevitable, yet assurance of fulfillment of the conditions may be pursued by imposing an escalating penalty rates on the offending member instead of withholding disbursement of the loans at the time of currency crisis.
Finally let me remind you that Article 1 of the IMF Charter clearly defines it as an objective of the institution "to give confidence to members by making the general resources of the Fund temporarily available to them under adequate safeguards thus providing them with opportunity to correct maladjustments in their balance of payments without resorting to measures destructive of national and international prosperity." I believe this statement in the Charter clearly mandates the IMF to play fully the role of lender of last resort as a central bank of the world. At any rate, the statement makes me pause for thought in reference to what is now happening in Korea and elsewhere.
Second, the imposition of BIS capital adequacy requirement needs to be reconsidered. I don't mean that the required capital ratio of 8% is too high; on the contrary, an even higher ratio may be needed in the Korean situation to promote sounder banking practices. What I mean is that the realization of capital adequacy in Korea in a short period of time is unrealistic, while its side effects are unduly severe. For one thing, more than 30 trillion won, after the provision of 16 trillion won by the government to recapitalize those viable banks which take over the insolvent bank, is needed for the financial institutions as a whole to meet the BIS capital requirement before the dead line of March 2000, according to the estimates of research institutions and the government. However, this amount is roughly equivalent to 40% of the total current value of stocks listed on the Korea Stock Exchange. It is difficult to believe that the stock exchange will be able to raise that much equity capital in a matter of a few years, given the current situation in which bank credit is dried up and the economic outlook is extremely uncertain. (Related to this, the business conglomerates also have been requested to reduce capital-debt ratio from the current average of more than 400% to 200% in the next two years which will also strain the stock market.)The banks are seeking M&As with foreign banks or investors, but this cannot be done overnight. The only way open to the banks is to reduce their risk assets as much as possible at a great cost to corporate borrowers.
Again in hindsight, I am of the opinion that improvement of capital structure should have been pursued in steps over time extending beyond the year 2000. The enforcement of the BIS ratio in a short time frame intensified the credit crunch and perhaps led to distortions of the financial statements of banks, running counter to the objective of the banking reform. It may be noted in this regard that even in the United States it took about 10 years for the banks to reach an average leverage ratio of 8% in the mid-1990s from a little more than 6% in the mid-1980s, according to a statistics of the U.S. Federal Reserve Board - although the definition of the leverage ratio is different from that of the BIS ratio.
Third, nothing is more urgent at present, in my view, than revitalizing the financial system to stop further deceleration of economic growth and stimulate recovery from the current recession. Unless the financial institutions are revitalized, fiscal and monetary expansion is not likely to produce its full effect. I was told by a central banker that even if the central bank expanded the money supply, the new money would flow back to the central bank because banks would choose to buy back the risk free financial instruments previously sold to the central bank in order to improve their capital ratios.
One of the major ways to revitalize financial institutions is to speed up resolution of bad debts and debt "workout". For this purpose I would recommend to either remodel the existing Korea Asset Management Corporation or set up a new bridge bank capitalized by the government and the central bank and financial community, and if possible, international financial organization such as IFC. This organization will engage in resolution of the non-performing assets and "workout" for failing but potentially viable business units turned over from financial institutions-- in a similar way the Resolution Trust Corporation functioned at the time of banking crisis in the mid-80s in the United States. .
The KAMC was set up for the same purpose but it is not well functioning with inadequate financial and human resources available and limited scope of business mandated by the government. It is learned that officers in the organization, afraid of the controversy over their decisions in the later days, are reluctant to carry out their duties. Korea's political culture being what it is, it seems to be extremely difficult for the organization to be free from the political influence and possible irregularities. For this reason, participation of the international financial organization is highly desirable as a way of shielding against undue political and social bad influence and protect the management from the unfounded censure in the later days, thereby speeding up resolution of the bad loans and failing enterprises. As it is today, only part of the bad loans of banks have been sold to the Corporation, and a system of debt workout for failing companies is not yet well established. The key point here is that ailing banks or companies should be hospitalized in one place so that they can receive expert treatment while the banks, cleared of the bad debts and accruing losses, can go back to their normal operations and get busy with introducing new standards of transparency, disclosure, and new techniques of risk management.
Lastly, granting that a high degree of disruption, confusion, anxiety, and uncertainty is inevitable in the course of drastic and sweeping reform, the destabilizing impact can be minimized by choosing the right policy strategy. I am aware of the controversy over the "big bang" v.s. gradualism in structural reform. No doubt gradualism has a danger of sliding into inaction and maintaining the status-quo. On the other hand, if I may be allowed to mix metaphors, the "big bang" should not, in my view, imply reshuffling the economic deck at random. The reform program must be comprehensive enough to cover all problem areas, yet the implementation of each part of the program must be made mutually consistent and sequenced according to priorities decided on the basis of its impact on the economy and the social costs involved.
As I mentioned earlier the top priority at present should be the banking reform for the obvious reason that the circulation of fund is the blood vessel of the market economy. The government needs to concentrate its energy on this crucial sector so as to resolve its problems as speedily as possible. Once the banking sector is firmly established on the basis of a new order in which the supervisory scope and criteria are transparent and rigorous and the banks are abide by market as well as regulatory discipline, the corporate sector is bound to adjust itself, without a large measure of government intervention, to the new environment, correcting its outmoded managerial practices. At present the new order is yet to emerge and the inertia and old habits of the government, banks, and the corporate sector are interacting to produce inconsistency, confusion, and inaction at the cost of deepening recession. In view of this situation, what is required above all is government leadership with a clear vision of the new economic order that is needed and the political will to achieve it.
I have reviewed some aspects of the currency, financial, and economic crisis and offered some comments on policy matters related to the resolution of the crisis. Nevertheless, I would like to say that for all the difficulties Korea is currently facing, the Korean government has come a long way toward resolving the currency crisis and implementing the structural reform that promises to dramatically improve financial management and corporate governance in Korea in the years to come.
At any rate, Korea's current economic difficulties should give much food for though to this audience from the academic community. As we are still in the midst of the crisis, and its outcome is uncertain, we are not yet able to view the situation from a proper scholarly distance. However, my remarks today will have served their purpose if they stimulate at least some of you to pursue your own studies on this rather grim, but fascinating, subject.
1) Prepared for a Seminar on Banking Reform held at the World Bank, October 5, 1998 See Menzie D.Chin aand Michael P. Dooly , "Why Latin America 1995 and East Asia 1977 are Alike," A paper presented at the Seminar on Korea's financial Crisis held at the East West Center, Honolulu, Hawaii, August 9-11.
2) Press release titled "Challenges and Changes: Korea's Response to the New Economic Reality" June 15, 1998