Source: Lim (2000) 1

III. Financial Crisis of 1997

Growth Rate of GDP (1971 – 2006) Bank of Korea 2

Exchange Rate (Won/Dollar) Bank of Korea 3

The Financial Crisis of 1997

Foreign Debt Crisis In 1997, Korea was fast accumulating foreign debts, mostly foreign short-term loans to commercial and merchant banks in Korea.

Questioning the ability of Korean banks to pay back these loans, foreign banks declined to roll over the loans.

Lacking foreign reserves to pay off debts, Korea turned to IMF, resulting in a rescue program amounting to $57 billion, the largest in IMF ’ s history.

Foreign Exchange Crisis Because of the dollar shortage and the speculative forces, the Won/Dollar exchange rate skyrocketed from 900 to 1700 over several months.

4

The Financial Crisis of 1997

Banking Crisis For most banks, the amount of non-performing loans exceeded equity, and was in a state of bankruptcy.

Left alone, bank runs would break out and paralyze the economy.

The root cause of the crisis

Korean Model of Growth – Risk partnership between government and business 5

The root cause of the crisis

Korean Model of Growth – Risk partnership between government and business Government select target industries and select Chaebols to develop these industries => Government has implicit responsibility to bail out Chaebols if they fail. => Moral hazard of underestimating the downside risks arises.

Government subsidize Chaebols by providing loan guarantees and low-interest rate loans

=>

Excessive investment 6

Korean Model of Growth – Mobilizing resources through state-controlled banks State-controlled banks channel household deposits and foreign loans to firms designated by the government.

 Banks do not develop the ability to assess and manage risks in loan-making business Interest rates are set by government.

Banks absorb losses from bail-out operations dictated by the government.

=> Incompetent banking industry 7

Delayed Reform

Lim (2000) pp. 42-55 Park assassinated in 1979.

Chun takes power by a military coup in 1980.

A sharp recession following the second oil shock, political instability and the results of over-investment in late 1970s => Korea on the verge of a major financial crisis Chun adopt the stabilization package recommended by IMF 8

Tight monetary policy Consolidating industries and chaebols Reformatory ideas Of Chun ’ s technocrats Korea outgrew the Korean Model of Development.

The economy became too complicated to be understood and controlled by the government.

The market and the private sector should lead.

– Liberalizing the banking industry Privatizing commercial banks Interest rates chosen by banks  Ministry of Finance keeps the lever by retaining the power to select bank presidents From State-owed to semi-public.

9

– Pro-competition policy New Fair Trade Law  Without splitting Chaebols or opening up trade, limited impact on competition structure Government tries to regulate the behavior of Chaebols.

Bureaucratic control of the government remains.

Political resistance of vested interestes Chaebols and bureaucrats Korea democratized in 1987 Chaebols form a new relationship with presidents and politicians thorough (legal or illegal) campaign funds 10

The Crisis of 1997: Causes and Developments

Cho (1999) In terms of macroeconomics, the Korean economy was doing well.

Low inflation: 5% Strong Growth: 8% Current account deficit enlarged, but quickly receding.

Different from Latin American debt crises.

Many thought a Korean crisis is impossible.

Causes Corporate overinvestment Vulnerable financial structure Banks mismatch of foreign assets and liabilities 11

Corporate overinvestment Investment surge in 1994-1996 Liberalized non-bank financial institutions.

Deregulation of entries into industries Short-term debt increased.

High interest rates and wages Interest rate liberalization.

Democratic labor movements Terms of trade shock in 1996  Profitability of firms sharply declined.

 Non-performing loans of banks increased.

Source: Cho (1999) 12

Capital market opening and term mismatch Korea became a member of OECD in 1996.

Capital market opening stock market short-term trade credits allowed merchant banks to deal with foreign loans 13

Cho (1999) 14

Imprudent interventions in the foreign exchange markets Upward pressure on Won/dollar exchange rate Tried to sustain the value of Won by selling dollars.

Drained most foreign reserves.

Unwise reactions to the crisis Tried to rescue the troubled conglomerates in the old fashioned way.

No persuasive plans for restructuring troubled banks => Failed to bring confidence to uneasy foreign investors.

15

Imprudent lending and herd behavior of foreign lenders High interest rates in industrializing countries Low interest rates in advanced countries Debtor – Creditor – borrowed too much lent too much?

Crisis occurred in the summer of 1997 in Indonesia, Thailand and Malaysia.

Contagion and herd behavior of international investors.

Sachs Both debtors and creditors should be blamed.

Both have to share the costs of the crisis.

IMF should not act as an agent of the US.

16

Adjustments under IMF

Macroeconomic adjustments Tight monetary policy and high interest rates Brings down the exchange rate.

Decreases investment and consumption and thereby decrease the current account deficits.

Tight fiscal stance 1.

2.

3.

Structural Reform Trade liberalization Financial market opening Corporate Restructing 17

10 years after

Fast Recovery of GDP Source: Burton and Zanello (2007) 18

Corporate Restructuring Source: Burton and Zanello (2007) 19

Bank Restructuring Source: Burton and Zanello (2007) 20

Challenges ahead

Maintaining competitiveness in manufacturing Consolidation of Chaebols Spun off non-core business Korean exports are highly concentrated on a small number of products Semiconductors, LCDs, Mobile Phones, Steel, Ships, Automobils Catch-up of China and India Sandwiched economy Coping with open financial markets Enhancing the competitive ness of financial sectors Coping with volatile capital inflows and outflows Containing bubbles in stock and housing markets 21

Worsening Income Inequality Source: Kyung-Joon Ryu (2007) Gini 0.32

0.31

0.3

0.29

0.28

0.27

0.26

0.25

1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 22