What Happened?

Friday, October 30, 1998

On November 21, 1997, the South Korean government formally asked the International Monetary Fund for standby loans. With that request, the Korean government admitted its inability to meet international debt payments with its own means.

Regardless of the success of the IMF program, Korea is bracing for a painful restructuring and stabilization process that will fundamentally change its economic system. Growth will slow: The Korean government agreed to a 3 percent economic growth rate for 1998 as a condition for accepting the IMF rescue plan; some research institutions even forecast negative growth. Planned cutbacks in government spending and private sector investment will mean the loss of jobs for millions of workers. With the Korean currency, the won, at half its value, the prices of imports will jump, unleashing an inflationary spiral.

As part of its agreement with the IMF, the Korean government pledged to take drastic reform measures to deregulate and liberalize its economy. Restrictions on capital movement and foreign ownership will be lifted to induce foreign investment in Korean assets. To ease corporate restructuring, the government has proposed to make it easier for firms to lay off workers.

By any measure, the current crisis represents a major setback in economic performance. It will take at least two to three years before Korean per capita income in dollar terms regains its 1996 level. What happened?

The origins of the crisis date back to early 1995. At that time, the Korean government adhered to a strong won policy despite market pressures for currency devaluation amid sluggish exports and surging imports. The banking and financial sector, big business, and state enterprises all benefited from the strong won. They enjoyed windfall profits by borrowing foreign capital with low interest rates. Their vested interests and political lobbying delayed the timely devaluation of the Korean won, laying the foundation for the financial crisis in late 1997.

But the flawed foreign exchange policy was only a necessary condition. The crisis was triggered by failures of the corporate sector and dismal economic management by the government. In fact, many attribute the immediate cause of the crisis to the bankruptcy of the Hanbo Group in January 1997. Hanbo, built around a construction company, invested heavily in its steel operations by borrowing from Korean banks. While Hanbo was making such a capital investment, the world steel industry went into a recession. A combination of massive debt and the recession drove Hanbo to the brink of bankruptcy as early as the second quarter of 1996. Despite a series of emergency loans provided by Hanbo’s creditors, Hanbo defaulted.

If this had happened in any other country, it would have been a simple story of a firm making a bad investment decision. But in Korea it sent a shock wave not only internally but also internationally. The international financial community, which lent heavily to Korean firms, reacted to the Hanbo incident with alarm not because it did not know Hanbo’s troubles in advance (it did) but because the Korean government let it collapse. Korean firms had always been heavily leveraged but had been able to borrow from foreign banks under the implicit understanding that the Korean government would stand behind them in times of trouble. When the international financial community realized that Korean firms and banks were no longer safe, it became reluctant to lend or roll over existing debts; when it did lend, it asked for higher interest rates.

But the Hanbo collapse did not immediately result in a full-scale crisis because the company was relatively small and people expected the Korean economy to weather its bankruptcy. This kind of optimism, however, gradually gave in to pessimism in 1997, as a number of other chaebol (corporate conglomerate) groups followed Hanbo into bankruptcy. Then came Kia in July.

Kia, a major automobile producer with an international reputation, was the seventh largest chaebol in Korea. When Kia declared bankruptcy, the crisis was in full swing. If Kia could go under, nobody seemed safe. The problem was compounded by the indecisiveness of the Korean government. The banks were willing to reschedule Kia’s debts to avoid bankruptcy, in which case they would have to write off their loans to Kia. The government, however, opposed Kia’s request for rescheduling while demanding the resignation of Kia’s top management. Three months went by before the government finally put Kia on court receivership and turned it into a state-owned enterprise by converting government loans into equity. But the damage had been done.

By October 1997, the floodgate had opened. Foreign banks began to call in loans and stop rolling them over. As a result, Korea faced a situation in which its banks and companies could not secure new funds at any price. The international financial community, jolted by the Hong Kong stock market crash of October 23, counted Korea as the latest victim of the contagious Asian financial crisis that began in Thailand and Indonesia.

As foreign banks and investors pulled out of Korea, the Korean won began to feel the pressure. Korean banks and companies needed dollars to pay back their foreign debts, as did foreign investors dumping their Korean assets. The supply of dollars, however, was limited. Korea was running a current account deficit, and Korean banks and companies could not borrow from abroad. With foreign banks refusing to inject new capital into Korea, the Korean government was left only with the dollar reserves of its central bank, the Bank of Korea, to defend the won. The Korean government was thus in a no-win situation. If it defended the won, it would risk the depletion of its dollar reserves, in which case no one in Korea would be able to meet his or her foreign debt payment. If the government did not defend the won, it would place enormous pressure on Korean banks and firms by increasing their debt service costs.

In retrospect, it would have been better if the Korean government had decided to float the won. For two months, in October and November, the Korean government spent close to $15.1 billion to prop up the won in foreign exchange markets. With its dollar reserves depleted and no prospects for new private borrowings, the Korean government had no choice but to turn to the IMF.

If we look at the situation from the outside, the Korean problem was rather simple. There was plenty of capital in international financial markets in 1995 and 1996. In East Asia, cheap capital was available from Japan, which kept its interest rates low, less than 1 percent, to stimulate its sagging economy. The demand for foreign capital in Korea, by contrast, was strong. These favorable conditions in the international money market led to massive borrowing by Korean firms.

This worked for a while. But a recession hit the Korean economy in the second quarter of 1996. Korean firms suffered from an overvalued currency and downturns in key export industries such as semiconductors, steel, and shipbuilding. Domestic industries such as construction and retail had gone into a recession even before export industries and were not in a position to take up the slack. As a result of the recession, Korean firms became largely unprofitable and found it difficult to service their debts.

But external factors alone cannot explain why Korea fell in 1997. Other countries in East Asia, especially Taiwan, have been able to escape the financial crisis so far. So we have to look for internal factors. In terms of economic factors, it took a congruence of three forces to create a banking and currency crisis in Korea: (1) deterioration of bank balance sheets, (2) mounting foreign debts, and (3) declining corporate profits. Korea could have survived the adverse international conditions if one of the three factors had been absent.

The current economic crisis in Korea began essentially as a banking crisis. The kind of corporate bankruptcies that Korea experienced in 1997 would shake any banking system. But the Korean banking sector was particularly vulnerable. If the banks had been stronger, they may have been able to withstand the initial crisis without undermining their credit ratings in the international financial markets. Korean banks have long been loaded with significant amounts of nonperforming loans. When lending to businesses, banks based their lending decisions mainly on the size of collateral, not on the merit of investment proposals.

The present state of the banking sector resulted from the long period of government intervention and dominance, when it allocated credit to favored sectors through policy loans and administrative guidance. Since it was the government that decided where money went, the banks did not have an incentive to develop capacity for project evaluation. Moreover, the risk for the banks was minimal. The government provided explicit guarantees for depositors while bailing out the companies it supported. The implicit coinsurance scheme among government, banks, and industry worked well for a long time, fueling the industrialization of the Korean economy. But it left the banking sector inefficient, backward, and dependent.

Although the banking sector has always been weak, why did weak banks become a problem in 1997 and not before? Ironically, the banking problem was exacerbated by the very measures that sought to make the banking sector more competitive. Under foreign and domestic pressures for liberalization and deregulation, the government has over the years relaxed or removed many financial regulations. The old model of the coinsurance mechanism began to unravel. Freed from government interference, the banks expanded and entered new businesses, some of which carried high risks. Many of them went on a borrowing binge and made risky investments at home and abroad. In retrospect, the Korean banks were not ready to compete under the newly deregulated environment. In the name of globalization and democratization, however, the government failed to supervise and monitor their activities to the point of negligence. There are disturbing parallels between Korean banking problems and the savings and loan crisis of the early 1980s in the United States. In both cases, deregulation led to a boom environment with reckless lending practices and lax government oversight.The second culprit in the economic crisis was the size of Korea’s external borrowing. If Korean banks and firms had not borrowed so much abroad, the series of bankruptcies in 1997 would not have triggered a currency crisis. Korea has always relied on external borrowing to finance its investment. As a result, Korea has always had substantial foreign debt. The problem by November 1997 was not the absolute size of foreign debt but its structure. Short-term debt (loans with maturity of less than one year) accounted for 58.8 percent; long-term debt represented 41.2 percent of the total, a composition unusual by historical standards.

The third contributing factor was the declining profitability of Korean firms, especially in foreign markets. Corporate profits have always been low in Korea, but they fell to their lowest level ever in 1996. Korean businesses have long blamed “three highs” for their troubles—high costs of labor, high costs of capital, and high costs of distribution. Whereas costs have risen significantly since the late 1980s, productivity or efficiency gains have lagged.

Critics of chaebol, however, point to corporate mismanagement. They argue that chaebol companies turned a blind eye to productivity and research and development because of their obsession with expansion and market share. Chaebol could expand because they basically faced a risk-free environment—they were able to borrow without fear of bankruptcy. The chaebol have also suffered from their own structural and organization limitations. Their organization is highly centralized. The corporate governance structure of the chaebol has undermined their competitiveness. Decisions by owner-managers go unchallenged, and no effective internal or external monitoring mechanism for investment decisions exists.

The current crisis reflects the failure of the political system as much as of the economic system, for it is the job of the political system to correct the problems of the economic system. But the Korean political system failed to carry out long overdue reforms and to contain the unfolding financial crisis. In view of the strength of the three economic forces that interacted to create a crisis environment, it is fair to say that it would have been difficult to prevent a crisis solely with government actions. But the Korean government cannot escape responsibility for the current crisis because it had, for a long time, recognized but failed to reform its labor, chaebol, and financial systems that caused the crisis.

Since democratization began in 1987, the Korean political process has been characterized by paralysis and gridlock, particularly when the interests of powerful groups are threatened. In their effort to maximize their private interests, they play a game of attrition against their opponents instead of trying to find a negotiated settlement. This failure of dispute resolution has been the most salient feature of the Korean democratic experience and explains why Korea has failed to reform its economic system.

Government paralysis and gridlock played an important role in the government handling of the economic crisis. In the critical month of November 1997, the government was paralyzed for two weeks by bureaucratic infighting over control of monetary policy and the supervision of financial institutions. What was remarkable was that the dispute in question had gone on for almost ten years and had come back to haunt the government at a time of crisis.

Why did the Korean political system fail? The most significant cause of the government failures was the immature nature of Korean democracy. Likewise, the ultimate cause of the economic crisis in Korea can be found in the failure of the political system that has undergone the process of democratization. Although Korea has struggled to adjust itself to the new democratic environment, the forces of globalization have shaken its “fragile” economic system. The rapid pace of technological innovation and the emergence of low-cost competitors made obsolete the model of Korean development that had served so well in the past. Korea might have needed more time to learn to work with democracy, but the forces of globalization could not wait for Koreans to sort out their differences.