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Building financial stability: Korea’s crisis resolution strategy aims to restore confidence and promote sustained recovery

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 2000
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Korean economic recovery

Within a two-year span, Korea’s economy plunged into a severe recession and now is recording a dramatic turnabout. What triggered the crisis? What prompted the recovery? And what remains to be done to ensure that Korea’s economy sustains strong growth within a stable macroeconomic environment?

Most observers in late 1997 were shocked to see Korea—the world’s eleventh largest economy with an impressive record of macroeconomic performance—swept into the financial market turmoil then raging in Southeast Asia. In retrospect, however, the country’s remarkable growth had masked a number of structural weaknesses, in particular a weak financial sector and an overleveraged corporate sector. These weaknesses contributed to a sharp buildup of short-term external debt (estimated in excess of $100 billion by mid-1997) that left the economy vulnerable to external shocks and adverse shifts in investor sentiment.

Indeed, in the second half of 1997, there was a marked deterioration in Korea’s external financing situation following a number of large bankruptcies earlier that year and a series of downgrades of Korea’s credit rating. In particular, new financing dried up, and it became increasingly difficult to roll over the large stock of short-term debt. With external reserves almost depleted by November 1997, Korea was at the brink of default. In the ensuing financial crisis, the country faced massive capital outflows, a sharp depreciation of the won, a collapse of confidence, severe distress in the corporate and financial sectors, and a substantial decline in private demand.

To deal with the crisis, Korea agreed to a $21 billion Stand-By Arrangement with the IMF on December 4, 1997 (see IMF Survey, December 15, 1997, page 385). Policies adopted under this program successfully restored external stability, rebuilt reserves, and initiated reform of the financial and corporate sectors. Following a sharp recession in 1998, the economy is again growing rapidly and output is now above its precrisis level. The won has strengthened substantially after losing half its value soon after the crisis erupted, and the stock market has registered large gains propelled in part by purchases by foreign investors.

Crisis strategy

The objectives of Korea’s crisis resolution strategy were, first and foremost, to restore confidence and stabilize financial markets, and second, to lay the foundation for the resumption of sustained recovery in the real economy. The program thus included a mix of macroeconomic policies and far-reaching structural reforms, as well as the largest financing package in IMF history. Combined with the IMF’s resources, the total package amounted to $58 billion, including support from the World Bank and the Asian Development Bank, and a “second line of defense” pledge from bilateral donors. In addition, Korea reached agreement with foreign banks in late 1997 to extend the maturity of short-term claims on its banks to avoid a default on external obligations.

At the outset of the program, Korea’s macroeconomic policies focused on a temporary interest rate hike aimed at stabilizing the won and avoiding a depreciation-inflation spiral. This step helped restore financial stability by early 1998 (see chart, this page), and once the won was stabilized, macroeconomic policies quickly eased to provide stimulus to the economy. The overnight call rate progressively declined, falling below its precrisis level by July 1998 and below 5 percent by March 1999. The authorities also adopted an expansionary fiscal stance early in the program to mitigate the impact of the inevitable recession.

Korea: interest and exchange rates

Data: Bank of Korea

The government recognized early on that the smooth implementation of adjustment policies would require broad social consensus. It fashioned a Tripartite Accord involving labor, business, and the government that ultimately paved the way for an array of important measures that exposed corporations more fully to market forces, created a more flexible labor market, and attracted foreign investment. The authorities also strengthened the social safety net by expanding the unemployment insurance system and providing direct support through public works programs, temporary livelihood protection, and other social programs.

Structural reforms

While a severe international liquidity squeeze triggered the crisis, structural weaknesses were at the heart of Korea’s problems. If the confidence of foreign investors was to be regained, structural issues needed to be addressed. Korea realized that it would be critical to take measures from the outset that would boost investor confidence and enhance the credibility of the stabilization program. Its ambitious structural reform agenda focused on liberalizing the capital account, restructuring the financial and corporate sectors, enhancing labor market flexibility, and improving data reporting.

Korea: real GDP

(4-quarterly percent change)

Data: Bank of Korea

To liberalize the capital account, the authorities took steps to ease restrictions on portfolio investments and direct corporate borrowing abroad to attract much needed foreign capital and reduce the excessive amount of short-term debt. In addition, they also liberalized regulations on foreign takeovers of nonstrategic Korean companies and restrictions on foreign ownership of corporations to promote foreign direct investment and impose greater market discipline on corporations.

Korea’s financial restructuring sought to restore stability to the financial system quickly through liquidity support, a time-bound blanket guarantee, and closures of nonviable institutions. The financial restructuring effort also aimed at resolving the problem of nonperforming loans, recapitalizing banks, and strengthening the institutional framework by bringing prudential regulations and supervision in line with international best practices.

The restructuring and recapitalization of weak banks have proceeded quickly. The Korean government moved swiftly to close 5 commercial banks and 14 merchant banks, nationalize 4 commercial banks, and acquire sizable stakes in 7 other banks. The authorities used public funds to facilitate the liquidation of failed institutions, the restructuring of weak but viable banks, the recapitalization of both commercial banks and specialized and development banks, and the purchase of impaired assets from financial institutions. Banks that benefited from public funds were required to provide a viable recovery plan and write down shareholder capital. To date, public outlays for recapitalization and purchases of nonperforming assets have amounted to about 15 percent of GDP.

Over the last two years, banks have made considerable progress in strengthening their capital base, but they are likely to need additional capital in the period ahead as accounting standards and loan classification criteria are strengthened. Tighter loan classification criteria, introduced at the end of 1999, are expected to give rise to further provisioning requirements, as loans are reclassified based on the ability to repay rather than the earlier delinquency criterion. In addition, ongoing corporate restructuring could identify additional non-performing loans that banks would have to resolve.

Korea has also taken important steps to improve its supervisory oversight and to bring its prudential regulations in line with best international practice. It strengthened the operational independence and autonomy of the Financial Supervisory Commission (FSC) and unified functions of four separate supervisory agencies under the Financial Supervisory Service, the executive body of the FSC. Legislative action bolstered the independence of the Bank of Korea and allowed it to focus on maintaining price stability, while relinquishing direct supervision of the banking system.

Corporate restructuring efforts initially concentrated on improving governance and competition policies. Subsequently, the focus shifted to financial and operational restructuring, with the goal of reducing debt levels and strengthening capital structure. Unlike past interventions, however, the government has limited its role to reforming the institutional framework to provide for a market-based restructuring. The government has also signaled that no conglomerate is “too big to fail.” The Daewoo Group—the second largest chaebol—has been forced to enter into a workout program with its creditors.

The restructuring of the top five chaebol (Hyundai, Daewoo, Samsung, LG, and SK) is taking place within the framework of capital structure improvement plans reviewed by banks. With the exception of Daewoo, the top five chaebol have made significant progress in meeting their pledges under these plans. Equity issues, spin-offs, asset sales, and strategic alliances with foreign investors have accounted for most of the improvement. For the Daewoo Group, the workout plans for its affiliates will restructure control of these affiliates and lead to strategic sales and other operational changes. A creditor-led out-of-court debt workout process is overseeing restructurings of highly leveraged second-tier chaebol and other large corporations.

Korea has also taken major steps to strengthen market discipline and governance. It has clarified the responsibilities of corporate boards and enhanced their independence, strengthened minority shareholder rights, improved bankruptcy procedures by strengthening creditor rights and streamlining the bankruptcy process, implemented accounting and auditing standards (with effect for 1999 accounts) consistent with international best practice, bolstered the Fair Trade Act on competitive business practices, and greatly liberalized the foreign investment regime.

Korea: Key macroeconomic indicators
1996199719981999

Est.
Real GDP6.85.0-5.810.0
Private consumption17.13.5-9.69.0
Gross fixed investment17.3-2.2-21.14.4
Stockbuilding20.6-2.0-5.64.0
Exports111.221.413.318.5
Imports114.23.2-22.027.3
Inflation14.94.47.50.8
Unemployment (percent)2.02.66.86.3
Budget balance30.0-1.7-4.3-4.6
Current account balance4-23.0-8.240.225.2
Net capital inflows (+)4523.9-28.0-14.39.1
Usable reserves429.49.148.574.0
Per capita GDP (in dollars)11,423.010,361.06,905.08,962.0

‘Percent change.

Contribution to GDP growth.

In percent of GDP, excluding privatization proceeds.

In billions of dollars.

Balance on capital and financial accounts.

Data: Bank of Korea, and IMF staff estimates

‘Percent change.

Contribution to GDP growth.

In percent of GDP, excluding privatization proceeds.

In billions of dollars.

Balance on capital and financial accounts.

Data: Bank of Korea, and IMF staff estimates

Economic recovery

The severe disruption in financial markets and loss of confidence that characterized the Korean crisis prompted that country’s worst recession in over three decades, with real GDP falling by almost 6 percent in 1998. But the turnaround in economic activity following this severe contraction has been unexpectedly rapid (see chart, page 78). An easy macroeconomic policy stance has helped to spur recovery, and progress made in implementing structural reforms has helped restore market confidence and revive bank lending.

Real GDP is estimated to have grown by 10 percent in 1999 (see table, this page). Indeed, the Korean economic recovery has been faster and stronger than in other countries that suffered similar financial crises in recent years (see chart, page 80). A strong rebound in private consumption, investment in new technology, and strong exports have led the recovery. Inflation has remained subdued following a temporary spike in early 1998, and in line with the fast economic recovery, unemployment fell sharply to about 5 percent in January 2000 from close to 9 percent a year earlier. Given the rapidly changing cyclical position of the economy, it will be necessary to remain vigilant to demand pressures and inflation. In this regard, it is thus appropriate that Korea’s 2000 budget aims at withdrawing the stimulus.

Korea’s external position has also improved notably. Strong external demand and gains in competitiveness have spurred exports and resulted in sizable current account surpluses. Capital inflows increased markedly in 1999, reflecting joint ventures and asset sales related to corporate restructuring, and investors’ favorable outlook on Korea’s economic prospects. International reserves amounted to $80 billion by the end of February 2000—sufficient to provide cover for external short-term liabilities.

Korea: comparison of output recovery with other crisis countries

(crisis = 100)

1Estimate for 1999 and forecast for 2000-01; crisis year = 1998.

2Crisis year = 1992.

2Crisis year = 1995.

Data: IMF, International Financial Statistics, and IMF staff estimates and projections

Remaining agenda

Over the past two years, Korea has accomplished a great deal. Bold policies and a commitment to reform have made Korea a more open, competitive, and market-driven economy. But the country must complete the process it has begun. For balance sheet improvements to be sustained, banks will need to strengthen business practices, especially with regard to risk analysis and lending practices. Priority will also need to be given to privatizing nationalized banks and divesting government stakes in recently acquired banks. Further restructuring of the nonbank financial sector, particularly the investment trust industry, is also urgently needed. On the corporate front, the process of lowering the level of debt needs to be accelerated, and financial restructuring will need to be buttressed by deeper operational restructuring and improved disclosure. For companies, devoting more explicit attention to the bottom line will require increasing profitability through cost cutting, the sale of noncore assets, and strategic alliances.

Much of the credit for Korea’s successful stabilization and recovery belongs to the Korean people, who sacrificed and worked hard, and to the Korean political leadership, who claimed “ownership” of the program from the outset and pushed forward relentlessly with tough reforms. The achievements to date have been remarkable, but the sharp turnaround should not deflect attention from the remaining agenda. The challenge ahead will be to avoid complacency and maintain the momentum of reforms.

Ian S. McDonald

Editor-in-Chief

Sara Kane

Deputy Editor

Sheila Meehan

Senior Editor

Elisa Diehl

Assistant Editor

Sharon Metzger

Senior Editorial Assistant

Lijun Li

Editorial Assistant

Jessie Hamilton

Administrative Assistant

Philip Torsani

Art Editor/Graphic Artist

Carol Greer

Graphic Artist

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