3 What Have We Learned from the Korean Economic Adjustment Program?
- David Coe, and Se-Jik Kim
- Published Date:
- September 2002
Yoon Je Cho*
The Korean economy faced a severe financial and currency crisis in November 1997 and started an IMF program in early December 1997. It fell into a deep recession, with real GDP contracting 6.7 percent in 1998. The economy started a rapid recovery in late 1998, with growth rates of 10.7 percent in 1999 and 8.8 percent in 2000 (Table 1). But the economy started to slow in late 2000, and by mid-2001 a recession appeared likely. Thus, the Korean economy has gone through a full cycle since the 1997 crisis.
The three-year IMF program expired in December 2000. The program has been assessed by many as a success. By the end of 2000, Korea had accumulated foreign exchange reserves of about US$95 billion from less than US$5 billion at the depth of the crisis, becoming number five in the world in terms of foreign reserve holdings. The cumulative current account surplus during the three-year program amounted to US$76 billion, or about 21 percent of annual GDP. Korea also attracted a lot of foreign direct investment as well as portfolio investment. Thus, the Korean economy seems to have fully recovered from the currency crisis.
Nevertheless, its corporate and financial sectors remain weak. Even though the Korean economy has recovered from the currency crisis, it has not fully solved its deep economic problems.
The Korean currency crisis mainly reflected deep-rooted structural problems that had accumulated over many years (see Cho, 1998). Large losses in the corporate sector were concealed by irregular and dishonest accounting practices, and supported by imprudent access to credit. Trade liberalization limited the ability of monopolistic or oligopolistic domestic chaebol to pass their inefficiency on to customers in the form of higher prices. Financial liberalization increased financial fragility by weakening corporations’ financial structure through expanded short-term financing on one hand (Cho, 2001), and by limiting the government’s ability to manage bailout programs for already deeply troubled firms on the other.
The immediate causes of the 1997 crisis may have been the severe maturity mismatch between foreign debts and assets of the Korean banking sector, and contagion from neighboring countries. But more fundamentally, the 1997 Korean crisis hit an economy that was in the process of shifting toward a more liberalized and open system from a heavily protected economy with a deep reliance on a government-led development strategy.
The economy was opened and liberalized without properly dealing with long accumulated losses and extremely high corporate debt ratios—the legacy of the past development paradigm—and without changing the old style of economic management. In this paradigm, government, businesses, and banks had formed an implicit risk partnership that facilitated rapid investment expansion and high economic growth. But the development of the necessary institutions and market infrastructure for an efficient and stable market-based economy was lacking. This made the economy extremely vulnerable to external shocks.
The gaps between the speed of changes in the economic environment brought about by liberalization and opening, and the speed with which institutions developed made a crisis unavoidable.
This paper raises four issues regarding the economic adjustment program in a crisis-hit economy based on the Korean experience. First, in the case of a twin crisis—currency crisis and financial crisis—the traditional measures to address the currency crisis such as high interest rate policy can deepen the financial crisis. This effect is magnified in an economy with a high corporate debt ratio. This points to the importance of seeking other measures to stabilize the exchange market complementary to interest rate policy in a twin crisis.
Second, an asymmetric approach to the restructuring and strengthening the regulatory rules among different segments of the financial sector can lead to a rapid shift of funds from the sector in which the regulation is being strengthened to the sector with looser regulation. The Korean investment and trust companies took advantage of poor regulatory oversight in the early stage of financial restructuring and expanded explosively, leaving the overall systemic risk of the financial sector undiminished. This approach to corporate restructuring also had asymmetric consequences for large firms and small firms by contracting bank loans and expanding corporate bond markets. This suggests the need for a careful balance in the approach to the financial restructuring among different segments of the financial system.
Third, financial restructuring and strengthening of regulatory rules have a strong contractionary effect by diminishing the money creation function of the involved intermediaries. During the period of drastic financial restructuring and strengthening of regulatory rules, the actual monetary stance can be affected more strongly by the actions taken by the supervisory authorities than by the policies of the monetary authorities. This suggests a need for close coordination between monetary policies and supervisory policies.
Finally, the Korean experience revives the old question on the speed and sequencing of economic reforms. The Korean corporate and financial sectors faced extraordinarily large problems at the time of the 1997 currency crisis. The introduction of global standards in banking supervision—such as rules on loan classification, provisioning, accounting and disclosure, and BIS capital adequacy ratio—exposed enormous amounts of non-performing assets (NPAs) that had been concealed under lax supervisory rules and poor (or even deceiving) accounting practices. The flood of NPAs has been beyond the capacity of the country’s political economy to digest. This pushed the government to forbearance and resort to the old interventionist policies, which compromised its own stated principles of restructuring, thus undermining the credibility of the reform process. This suggests that too ambitious a reform program may backfire. A credible reform program must be based on the economic and political realities in the country.
The paper is organized as follows. The first section deals with the high interest rate policies adopted in the early stage of the IMF program. The second section discusses the impact of the asymmetric approach to the restructuring of the banking and non-banking financial sectors. The third section deals with the effectiveness of monetary policies during the period of financial restructuring. The fourth section discusses the issue of the speed and sequencing of economic reforms.
Dilemma of Interest Rate Policies in Twin Crises
The initial crisis resolution strategy under the IMF program with Korea was composed largely of two parts: macroeconomic policies and structural adjustment measures. The macroeconomic policies were traditional IMF stabilization policies with a tight monetary and fiscal stance. The main goal of these policies was, understandably, to stabilize the exchange market and to improve the current account. The main components of the structural reform policies were financial restructuring and the rapid adoption of global standards in financial supervision, accounting standards, disclosure requirements, and corporate governance. The main goal was to increase transparency and accountability in management and thus to improve economic efficiency.
The direction and goals of each of these policies were admirable. However, the high interest rate policy adopted to deal with the currency crisis aggravated the financial crisis. The 1997 Korean crisis was a “twin crisis”—a currency crisis as well as a financial crisis. At the initial stage of the crisis, the policy response was understandably to quell the currency crisis. But, in the process, it intensified the financial crisis. The initial macroeconomic policies adopted in Korea under the IMF program were essentially the same as the ones adopted in other countries to deal with short-term currency speculation and current account problems.
The Korean crisis was not simply a foreign liquidity crisis, but a deep financial and corporate crisis. The corporate sector had been suffering from severe debt payment problems and long-accumulated losses that had been veiled behind irregular accounting. Corporations relied on continuous credit expansions by banks and foreign creditors for survival. Over-investment, high leverage ratios with heavy reliance on short-term debt, and poor earnings were common to most corporations. This was caused by a distorted incentive structure and misaligned relative prices such as real wages, interest rates and the exchange rate. Lack of adequate competition policies, poor corporate governance, and weak banking supervision allowed reckless investment expansion, which sustained high demand for capital and labor despite deteriorating corporate profitability. This allowed the persistence of high interest rates exceeding rates of return to investment, and high wages exceeding labor productivity (Cho, 1998). The overvalued exchange rate reduced profitability of exporting firms. Poor prudential regulation and supervision failed to curb reckless lending of financial institutions to finance risky investments by corporate firms. Poor accounting and disclosure practices and lack of financial market discipline over corporations contributed to the deterioration in the economic situation.
The Korean economy has experienced three major crises since its take-off in the 1960s: 1971-72, early 1980s, and 1997-98. Each of these crises occurred after a sustained investment boom and a period of lower returns to corporate investment with lower-than-average cost of debt (Figure 1).
Figure 1.Return & Cost of Capital Investment of Firms
Source: BOK, Analysis of Financial Statements of Corporate Firms, various issues
In each crisis, the government relied on the “growing-up” strategy, with heavy intervention in the financial system. The common elements of this “growing-up” strategy were the interest rate cuts with massive rescheduling of existing debt under favorable conditions, the extension of new loans, and forced mergers and takeovers of firms supported by favored access to credit and tax exemptions. Currency crises were dealt with mainly by seeking a rollover of debt and new borrowing (including bilateral loans), and by IMF-supported stabilization policies.1 But the stabilization policies relied mainly on direct control of credit rather than high interest rates. Interest rates were actually cut substantially in most previous crises (Figure 2).
Figure 2.Inflation and Interest Rates
Source: BOK, Monthly Bulletin, various issues.
The 1997 crisis was different. In response to the drastic reversal of capital flows, a key component of the macroeconomic policies under the IMF program was a high interest rate policy (Figure 3). This was needed to curb speculation in the foreign exchange market. But it was extremely costly to the Korean economy, since Korean firms were extremely highly leveraged (Figure 4).
Figure 3.Interest Rates (1995-2000)
Source: BOK, Monthly Bulletin, various issues.
Figure 4.Interest Coverage and Debt/Equity Ratios
In Korea, total corporate debt was already more than one and a half times the level of annual GDP,2 extremely high compared to most economies. About one third of this had been allocated to firms whose earnings before tax were smaller than the interest payment obligation. A sharp increase of interest rates in this situation magnified potential non-performing assets, deepened the financial crisis, and increased the ultimate burden on taxpayers.
The Korean currency crisis was basically a run of foreign creditors on domestic banks in the form of foreign banks refusing to roll over short-term loans. Korea had previously had controls over foreign portfolio investment both inbound and outbound, and hence there was little possibility of a massive outflow of portfolio investment.3 Several studies (Ohno, Shirono and Sisli, 2000; Goldfajn and Baig, 1998; Furman and Stiglitz, 1998) suggest that the high interest rate policy was not effective in stabilizing exchange rates.4 In addition, the overall macroeconomic policy stance did not need to be that tight to improve the current account position, which was already turning to surplus in the last quarter of 1997. Household consumption and investment were also rapidly falling. High interest rates in the Korean case did not stop the foreign banks’ run, but perhaps aggravated it by increasing skepticism over the future health of Korean banks.
This suggests that, in dealing with a currency crisis in a highly leveraged economy and with substantial foreign exchange control, the appropriateness of the traditional policy response, especially a high interest rate policy, may need to be reconsidered.
Asymmetric Financial Restructuring and Its Impact
The way financial restructuring was implemented in Korea after the crisis has had important macroeconomic consequences and has affected the subsequent development of financial market structure and the progress of corporate restructuring.
The financial restructuring plan under the IMF program initially underestimated the depth and scope of Korea’s financial sector problems. As a result, it concentrated mainly on the restructuring of banks and merchant banking companies (MBCs) in the first year of the program. Strengthening regulatory standards also focused on these institutions. This was not surprising since the origin of the crisis was the run of foreign creditors on Korean banks and MBCs as the asset quality of these institutions became increasingly doubtful.5 However, the problems were equally or even more serious in other non-bank financial institutions (NBFIs), including investment and trust companies (ITCs), mutual savings banks and insurance companies. When financial restructuring was initiated under the IMF program in 1998, these other financial institutions were largely unaffected by the strengthening of supervision or restructuring. The supervisory authorities benignly neglected the many irregularities in fund mobilization and management by these institutions. As a result, these institutions, especially the ITCs, took advantage of weak or nonexistent regulatory oversight for explosive expansion.
This had both positive and negative impacts. The positive impact was immediate. It mitigated the economic impact of the credit crunch in the banking sector and MBCs as the less regulated non-bank institutions expanded rapidly. It allowed many chaebol to obtain finance from this expanding sector to tide over the credit crunch and liquidity crisis. Some chaebol even aggressively expanded their investments during the financial crisis. Overall, this helped spur the quick recovery of the economy in late 1998 and 1999.
The negative impacts were realized in the longer term. The financial restructuring during 1998-99, by shifting funds from the sector over which regulation was strengthened to the sector that remained poorly regulated, did not improve the overall risk in the financial system. The rapid expansion of investment and trust business sustained firms that should have gone bankrupt and increased the level of nonperforming loans in the financial sector. When the investment and trust business imploded, the securities market collapsed, contributing to an economic recession after the short-lived recovery.
In sum, the failure to implement a comprehensive strengthening of supervision and restructuring of the financial sector reduced, intentionally or unintentionally, the degree of economic contraction by sustaining weak chaebol but increased the ultimate cost of financial restructuring. It also had the effect of lengthening the period of corporate and financial restructuring.
Furthermore, the impact of financial restructuring was asymmetric among firms: small-to medium-sized firms, which relied mainly on bank borrowing, suffered more severely than large chaebol, which benefited from the expanding of corporate bond markets during the initial period of financial restructuring.
The total value of assets of the ITCs6 tripled during January 1998-June 1999, from 84 trillion won to 255 trillion won. Figure 5 compares the actual growth of the ITCs with their ‘expected normal’ path of growth between 1983 and 1999. The latter was derived by applying the growth rate of total savings (1983) to the volume of ITCs’ assets in 1983, which is shown by the dashed line. In the past, the growth of the ITCs had been more or less at the same pace as that of the overall financial sector. But starting in early 1998, its growth far surpassed that of the total financial sector.
Figure 5.Actual vs. Expected Normal Volume of Assets of ITCs
Source: KITCA, Investment Trust and MOFE, Financial Statistics Bulletin, various issues.
Note: “Expected” is based on the growth rate of M3.
The growth of the ITCs came mostly at the expense of banks’ trust accounts and the merchant banking industry (Figure 6). By April 1999, total funds mobilized by the ITCs reached about 80 percent of M2, from about 40 percent at the end of 1997.
Figure 6.Growth of the Financial Sector
Source: Ministry of Finance & Economy, Financial Statistics Bulletin, various issues.
The extraordinary expansion of ITCs during this period reflected at least two factors. First, a sharp reduction of interest rates starting in early 1998 resulted in large capital gains to the funds established by ITCs in late 1997 and early 1998. Second, ITCs used this capital gain to offer higher than the prevailing market interest rates by illegally transferring high yielding bonds from the old funds to new funds. These transfers were neither properly regulated by the supervisory authorities nor monitored by investors. Many ITCs controlled by chaebol aggressively mobilized funds, sometimes with misguiding advertisements, through their affiliated security companies. As Figure 7 shows, the yields of beneficiary certificates offered by the ITCs became substantially higher than the corporate bond yields in the second half of 1998 even though the former was with shorter maturities. This was possible by the illegal transfer of high-yield bonds purchased by previously established funds to the newly established funds. In this way, they attracted many individual investors as well as institutional investors seeking interest rate arbitrage (Figure 8).
Figure 7.Interest Rate of Time Deposit, Beneficiary Certificate, and Corporate Bond
Source: BOK, Monthly Bulletin, various issues.
Note: Time deposit is of more than one year and less than two years; beneficiary certificate is of long-term bond fund; and corporate bond is of three years.
Figure 8.Interest Rates and Growth of ITCs
This rapid growth took place despite the extremely poor financial status of the ITCs. The ITCs, especially the largest three, had been in negative capital for some time,7 and their financial situation was further aggravated by the economic crisis (Table 2). Nevertheless, they had not been subject to any corrective actions by the supervisory authorities, and were allowed to mobilize and manage funds with benignly neglected irregularities.8
|Three ITCs||Regional ITCs||Three ITCs||Regional ITCs||Three ITCs||Regional ITCs|
|1.1. Current Assets||5,686.1||2,217.9||4,393.6||3,285.4||2,925.0||670.8|
|1.2. Non-Current Assets||1,119.6||530.1||2,176.1||524.1||4,780.9||462.1|
|2.1. Current Liabilities||7,366.5||2,538.5||10,068.8||3,831.6||8,291.1||1,114.0|
|2.2. Non-Current Liabilities||212.6||50.5||60.4||37.3||2,157.7||11.2|
|3. Owner’s Equity||−773.6||158.9||−3,559.5||−59.6||−2,743.0||7.7|
|3.1. Contributed Capital||520.0||600.0||610.2||280.0||610.2||370.0|
|3.2. Capital Surplus||−1,293.6||−141.1||−4,169.7||−339.6||−3,353.2||−362.3|
Because they did not disclose their asset portfolio and were not audited, the ITCs were not properly monitored by investors or the supervisory authorities. Funds shifted from banks and merchant banking companies to ITCs, leaving the overall underlying risk and distortions in the financial system unchanged or even expanded.
In 1993-96, insufficient regulatory oversight of the commercial paper (CPs) market and the merchant banking industry allowed a rapid expansion of this segment of the financial market, as corporations increasingly financed long-term investment with short-term funds, creating a severe maturity mismatch. Reckless investment was also encouraged since the credit ratings and monitoring of corporate firms by the financial market was extremely poor. The weak financial structure of chaebol eventually led to a string of bankruptcies, contributing to the financial crisis of 1997.9
The lack of regulatory oversight of the investment and trust industry in 1998-99 was equally dangerous. The ITCs became a channel of funding for some big chaebol-affiliated firms in weak financial health. Many of the large ITCs were owned by chaebol and mobilized about 130 trillion won within a year, equivalent to about one-fourth of the 1999 GDP. The major four chaebol—Hyundai, Samsung, Daewoo, and LG—mobilized 77 trillion won during 1998-99. These funds were used directly or indirectly to support affiliated firms by purchasing the bonds or commercial paper issued by affiliated firms and placing them in affiliated or other ITCs (to circumvent regulatory rules), with the implicit mutual agreement to cross-purchase the bonds or commercial paper of affiliated non-financial firms.
Table 3 shows the amount of commercial paper and corporate bonds purchased by the ITCs for the big five chaebol. As of April 1999, the ITCs held 92 trillion won of securities issued by the big five chaebol compared with 70.2 trillion won financed through the banking sector. It shows that 25 trillion won was used to purchase the Daewoo securities and another 24 trillion won was used to purchase Hyundai securities. These two chaebol increased their domestic debt substantially in the midst of economic crisis and bank restructuring.
|Total||The Big Five Chaebol|
|Total trust assets||244,723||(37.7%)||(9.9%)||(7.4%)||(10.2%)||(6.5%)||(3.6%)|
The total debt of Daewoo increased by 17 trillion won in 1998. While the banks and other financial institutions were reducing their credit to Daewoo, the investment trust industry provided new financing to Daewoo for their continuous expansion in 1998, and similarly for Hyundai. The force behind the aggressive expansion and avoidance of necessary restructuring for these two chaebol during this period was their control of the investment and trust business.
While the authorities were pushing corporate restructuring by tightening regulations over banks’ and other financial institutions’ lending, this was undermined by the explosive expansion of investment and trust business, which was almost completely out of the proper regulatory enforcement. Furthermore, the fact that funds shifted to financially troubled ITCs meant that the potential systemic risk in the Korean financial market had not diminished significantly despite hard efforts of the financial supervisory authorities to improve the soundness of the Korean financial system during this period.
About 22 percent of corporate bonds issued between December 1997 and December 1999 became defaulted by the end of 2000 as the companies that issued the bonds went bankrupt (Oh and Rhee, 2001), suggesting that the investment trust sector lacked the capacity to assess risk. As a result, Korea’s financial savings were further wasted. Expanding finance to insolvent firms limited the opportunities for more profitable and promising firms to obtain financing, eroding the long-term growth potential of the economy.
The rapid expansion of the ITCs and the corporate bond market during 1998, when domestic interest rates were high, effectively lengthened the period of high interest payment burden on the corporate sector. As shown in Table 4, corporations paid back short-term loans and commercial paper by heavily issuing bonds, most with a maturity of three years. Corporate bond issues increased sharply during the period of December 1997 to March 1999. This switching from short-term debts to long-term debts during the period when interest rates were relatively high extended the adverse impact of the high interest rate policy adopted after the crisis.
Thus the asymmetric approach to financial restructuring or benign regulatory oversight over the ITCs, whether intended or not, contributed to the quick economic recovery in 1999, but delayed corporate restructuring and deepened financial sector problems. The increased market uncertainty and the resulting collapse of the securities market caused the economic recovery to be short-lived. Since the ITCs expanded most rapidly from mid-1998 to mid-1999, the amount of corporate bonds issued during this period was substantial, with a large proportion of them maturing in 2001 and 2002. In 2001 alone, 65 trillion won of corporate bonds fell due, of which about 25 trillion won were rated below investment grade. Thus, the impact of the ITC debacle has not been fully realized and will continue to exert strain and uncertainty on the Korean financial market.
The above analysis indicates the importance of a careful balance in the strengthening of regulatory rules and in the initiation of restructuring across different financial institutions and market segments to avoid unexpected development in financial markets.
Coordination of Monetary Policy with Supervisory Policies
After the crisis, the actual stance of monetary policy in Korea has been dominated more by the supervisory policies of the financial restructuring authority, the Financial Supervisory Commission (FSC), than by the monetary policy of the central bank, the Bank of Korea (BOK). Money multipliers have been unstable during the last three years. They changed depending on the timing of restructuring of financial institutions (e.g., banks or NBFIs) and the strengthening of regulatory rules and practices over them (Figure 9). In fact, the financial restructuring and strengthening of regulatory rules have themselves had strong contractionary effects.
Figure 9.Money Multipliers
Source: BOK, Monthly Bulletin, various issues.
Loan/deposit ratios have fallen sharply as the banks and other depository institutions became subject to restructuring, and became concerned about their BIS capital ratios and possible runs by depositors. The loan/deposit ratios of commercial banks and mutual savings companies fell significantly after 1998, with the timing of each related to the strengthening of regulations and the increased risk of depositor runs (Figure 10).
Figure 10.Loan/Deposit Ratio
Source: BOK, Monthly Bulletin, various issues.
On the other hand, financial institutions increased their holdings of public securities significantly during this period. Commercial bank holdings of government bonds increased from 6.7 trillion won at the end of 1997 to 19.5 trillion won at the end of 1999, a threefold increase in two years. If all public bonds (including bonds issued by government-owned entities such as KDB, KDIC, and KAMCO) are included, commercial bank holdings increased from 47 trillion won to 110 trillion won during the same period, from 23 percent to 44 percent of their total loans.
Figure 11 shows the movements of reserve money, M3, and total domestic credit based on the BOK’s Financial Survey.10 It shows that, despite rapid growth of M3, total domestic credit to the private sector has been declining since the end of 1997. This reflects the unwillingness of financial institutions to lend to the private sector after the supervisory rules were strengthened and the restructuring of financial institutions was initiated, including by prompt corrective action based on their BIS ratio.
Figure 11.Domestic Credit, M3, and Reserve Money
Source: BOK, Monthly Bulletin, various issues.
The above experience suggests that the central bank’s monetary policy needs to be closely coordinated with the supervisory authorities’ policy in order to achieve the intended goal of the monetary policy. It also suggests that, in the future, the macroeconomic and structural reform components of the IMF programs should be carefully coordinated to avoid unexpected macroeconomic consequences. This is especially true in the countries where previously lax regulatory standards and practices are rapidly strengthened by following international standards.
Speed and Sequencing of Economic Reforms
The Korean experience during the last three years highlights the issue of the proper speed and sequencing of economic reforms. The introduction of global standards in an economy where accounting and supervisory practices had been extremely weak pushed long accumulated (but veiled) non-performing assets to the surface at a pace that the political economy of the country could not readily accommodate. A consequence was granting forbearance or exceptions to recently introduced rules, benignly neglecting the rules, or relying on old measures of administrative guidance to roll over credit to troubled firms so that their loans would not be classified as non-performing. All these measures undermined the credibility of the reform program and made future restructuring more difficult.
The Korean experience has also shown that pursuing simultaneous restructuring of the financial and corporate sector is very difficult. Weak banks could not effectively drive corporate restructuring. There was a collective incentive problem that encouraged banks to bail out troubled firms in order to protect their BIS ratios. In a highly concentrated economy like Korea, where chaebol dominate, there are so many financial institutions involved in a single chaebol that coordination is very complicated. The progress of restructuring the corporate capital structure is also limited by the pace of changes in the country’s financial market structure.
Political Economy Aspect
In an economy where the initial problems were very deep and the gap between international standards and domestic practice was wide, the speed of reforms, including the opening of the capital market and the introduction of global standards, may have to be tuned with the society’s capacity to endure the economic contraction. If a social safety net is not well established to accommodate a sharp increase in the unemployment rate, and if increasing social tension cannot be properly soothed by the political leadership, too ambitious a speed of reform can backfire, putting at risk the reform process itself.
The Korean corporate sector problem was extraordinarily deep. According to a study by Nam (2000), about 25 percent of corporate firms, accounting for 40 percent of total borrowings, had an interest rate coverage ratio below one in 1999 (Table 5). Therefore, in terms of the amount of debt, about 40 percent of firms were not able to pay interest out of their earnings.
|Number of firms (A)||Number of troubled firms (B)||Percentage of troubled firms (B/A)||Total borrowing (C)||Borrowing by troubled firms (D)||Percentage of Borrowing by troubled firms (D/C)|
Other studies show similar results. According to an analysis undertaken by the BOK of 3,701 companies in the manufacturing sector, roughly one in four manufacturers were unable to pay their financial costs with their cash income in 1997. A more recent BOK study of 1,807 firms for the first half of 2000 found that about 27 percent of firms still had an interest coverage ratio of less than one.
In such a situation, the rapid introduction of global standards in banking supervision (e.g., loan classification based on forward-looking criteria) and accounting caused a flood of NPAs in the financial sector. This in turn would cause the bankruptcy and liquidation of many de facto insolvent firms and a sharp increase in unemployment. In order to deal with these problems properly, an economy must first mobilize sufficient public funds to re-capitalize troubled financial institutions on one hand, and to deal with high unemployment on the other. Otherwise, the resulting social tension may frustrate the reform process itself. Thus, a dilemma is faced in a crisis-hit country regarding the speed of reform: if it is too slow, foreign confidence cannot be recovered quickly; if it is too fast, the domestic political economy cannot digest it.
Difficulty of Simultaneous Restructuring of the Corporate and Financial Sectors
The Korean financial crisis was caused by a corporate debt problem. Thus, the progress of financial restructuring is closely linked to the progress of corporate restructuring. But the simultaneous restructuring of the corporate and financial sector has been very difficult.
Korea adopted a creditor-led, out-of-court framework along the lines of the London approach to corporate restructuring. Workout units were established in eight lead banks, which were responsible for dealing with the problem loans belonging to the second tier, or 6-64, chaebol. In order to reduce the difficulties arising from inter-creditor differences (e.g., between banks and non-banks), the government encouraged 210 financial institutions to sign a Corporate Restructuring Agreement (CRA), based on which Corporate Restructuring Coordinating Committee (CRCC) was empowered to advise on the viability of corporate restructuring candidates, arbitrate inter-creditor differences, and provide guidelines for workout plans proposed by creditors. Although this approach was an appropriate response to a systemic crisis and has achieved some temporary financial stabilization, it has not been a fully effective scheme for promoting real restructuring.
Concerns about realizing losses have made banks unwilling to force necessary divestitures, asset sales, management changes, and other operational improvements. Instead, banks have tended to provide term extensions, rate reductions, grace periods, and conversion of debt into convertible bonds.
It has been difficult to proceed with the progress of corporate restructuring while financial institutions, which themselves are subject to a restructuring program, are heavily burdened with NPAs. Unless a sufficient amount of public funds is mobilized up-front to re-capitalize banks whenever their capital base is eroded due to realistic debt restructurings, and the government is willing to accept temporary, and potentially severe, financial market instability, rapid progress of both corporate and financial restructuring cannot be expected. Furthermore, corporate restructuring will be constrained by the degree of labor market flexibility. If layoffs of redundant workers are difficult for legal or political reasons, the progress of corporate restructuring will also be limited.
Financial Market Structure and Corporate Capital Structure
Korean firms’ debt ratios are extremely high by international standards. The average debt ratio of the top 30 chaebol in Korea was estimated at about 570 percent at the end of 1997. If global standards are applied, perhaps a majority of Korean firms will be classified as below investment grade. Therefore, in a country such as Korea, a successful corporate debt restructuring will have to rely heavily on the conversion of debt to equity. But the record so far shows only a very small amount of debt—less than four trillion won out of more than 600 trillion won of total domestic debt—has been converted to equity. This however is not surprising since the debt/equity conversion can be facilitated only when there is a concomitant change in the financial market structure toward a deeper equity market.
During the last three years or so, corporate debt ratios have been reduced. However, this is mainly due to asset revaluations and increases in capital rather than to debt reduction. With a high level of corporate debt, financial institutions of Korea will remain vulnerable to business cycles and external shocks. Thus, the improvement of the corporate capital structure is key to the success of Korea’s financial restructuring.
But the corporate capital structure will not be changed significantly unless concomitant changes are made in the financial market structure. And it will take substantial time for the latter to take place.
Total financial debt of Korean companies reached approximately 600-700 trillion won in year 2000.11 Assuming that the debt ratio of the corporate sector before the crisis was approximately 400 percent, its total capital would be approximately 150 trillion won. To decrease the debt/equity ratio to, say, 200 percent, either capital must increase by approximately 150 trillion won or debt must decrease by 300 trillion won, or some combination of the two. However, it would not be practical to expect that this would happen within a short period of time.
An effective way to expedite the reduction of the corporate debt ratio in the current situation would be a substantial debt/equity conversion. However, the magnitude of conversion of debt into equity that the Korean economy can afford in the short run will be limited, since simply converting loans from financial institutions into equity investment will weaken the cash flow of financial institutions. Thus, in the end, the corporate restructuring must be supported by reconstructing the financial market structure—by developing a deeper equity market. This also requires changes in the patterns of the financial savings by Korean households. In other words, the job of successful financial restructuring in Korea is equivalent to the enormous job of reconstructing the balance sheet of the national economy.
The development of equity markets and changes in the structure of financial markets will also require the establishment of various institutions, including vulture funds, corporate restructuring vehicles, and mutual funds. This means that the improvement in the corporate sector’s capital structure will take substantial time, and for the time being, the corporate sector will remain vulnerable to the business cycle and external shocks. Thus the opening of the capital market and adopting global standards overnight can make the overall economy quite vulnerable to a financial crisis.
The Korean economic adjustment experience of the past three and a half years raises many questions regarding the process of structural reforms and market liberalization. Korea, like many other developing countries in East Asia, achieved “condensed economic growth”. This growth was based on a development strategy with strong government interventions in the market. But now it faces the challenge of having to go through a condensed economic liberalization. It took centuries for the Western economies to industrialize themselves. In the process, they established necessary institutions and market infrastructures through generations and through the learning experience of many crises. The East Asian economies achieved industrialization within a generation or two, and this has been done through heavy protection and government intervention in resource allocation. But their rapid industrialization has coincided with the era of rapid integration of the global economy and the revolution of telecommunication and information technology. They cannot resist the trend of global integration, and this requires them to open and liberalize their domestic economy very fast. But, as discussed above, the lack of necessary institutions, social safety nets, and the economic structure they created make it an extremely challenging task to carry out a rapid transition to a fully liberalized and open economy. The domestic political economy also makes it hard to digest a rapid shift in the economic policy paradigm.
The introduction of global standards under the IMF program has released a flood of non-performing assets that had accumulated for a long time behind loose regulatory standards and accounting practices. This also required massive corporate and bank restructuring, and led to levels of unemployment and public debt, the scale of which the economy had never experienced in the past. This has not been easy to deal with, given the political reality of most of these countries. Either the speed of reform or abiding by the changed rules had to be compromised. In the first case, international capital markets became impatient, putting pressure by responding through adverse capital flows; and in the second case, the credibility of the reform program itself was undermined.
The Korean economy was successful in achieving rapid economic growth during the last several decades. Now it is facing the challenge of rapid and successful economic transition. So far, the economic transition has not been all that smooth and stable.
This paper has not provided solutions to deal with this enormous challenge of economic transition. What it has done is to highlight problems faced in the process of economic adjustment based on the Korean experience during the last three and a half years. But these issues certainly deserve much further study.
Comments on Papers 2 and 3
The commentator’s dream is to be presented with a set of papers of uniformly high quality that disagree with one another, providing a controversy to discuss. In this sense the present authors constitute a “dream team” of Olympic caliber. Both papers offer analytical overviews of Korea’s crisis and recovery. But while covering many of the same events, they reach quite different conclusions and offer quite different policy recommendations.
Before highlighting their differences, I should emphasize the extent of our authors’ agreement. They agree that the Korean crisis reflected a unique conjuncture of macroeconomic and structural imbalances. Korea had been pursuing an investment-and debt-led growth strategy for more than three decades. While this strategy had been eminently successful, it left the economy increasingly susceptible to shocks, owing to Korea’s heavy commitment to sectors like semiconductors, its heavy debt load, and its lack of financial transparency. As the rate of return on investment fell relative to the cost of capital, it became clear that this game could not go on indefinitely. Corporate and financial restructuring had been needed even before the crisis to redeploy resources to more profitable sectors, to consolidate or close down financially-troubled enterprises, and to convert debt to equity. Deteriorating macroeconomic and export-market conditions (associated with the collapse of global semiconductor markets in 1996) together with the turmoil in global capital markets (ignited by the crisis in Thailand and its spread to other Asian economies) only brought these realities to the fore. Note that we are no longer debating whether Korea’s crisis was caused by structural weaknesses or investor panic. Rather, it was the investor panic, in combination with other factors, that brought the severity of those structural weaknesses to the surface, and the structural weaknesses, in combination with other special factors, that left Korea so vulnerable to investor panic in the first place. Everyone now appears to agree on this interpretation, or so it appears.
Turning now to specifics, I will use Professor Cho’s four themes to organize my remarks. Cho’s first theme has to do with the destabilizing effects of using high interest rates to stem capital flight and currency collapse in a highly-leveraged economy. Korea’s corporate debt on the eve of the crisis was 150 percent of GDP. About a third of these debts were the obligations of firms whose earnings were less than their interest obligations. Against this background, anything that interrupted the flow of new finance or even raised interest rates was extremely disruptive. In particular, interest rate hikes could cause financial distress sufficient to undercut the currency-strengthening effects that the higher interest rates were designed to achieve.
This observation leads Professor Cho to conclude that “in dealing with a currency crisis in a highly leverage economy… the appropriateness of … high interest rate policies, may need to be reconsidered.” But the need is not just to “reconsider” but to decide what to do instead. Not raising interest rates can cause foreign deposits to hemorrhage out of the banking system, force banks to curtail their domestic lending, and lead to equally severe financial distress. Maybe raising interest rates, while painful, is the lesser evil. This is the cautious conclusion of the IMF authors. I agree with them when they say that empirical studies of this question are inconclusive, and not with Professor Cho when he says that studies show that the “high interest rate policy was not effective in stabilizing the exchange rate.” That results to date are inconclusive is all but inevitable, in my view, because pinning down the effects of interest rates on exchange rates in this environment is intrinsically difficult, if not impossible. We are essentially estimating the relationship between two endogenous variables. The model is nonlinear, since the effects of small and large interest rate changes are surely very different, and the effects of interest rate innovations are state contingent. These are not circumstances where econometrics are likely to speak clearly.
Even if we believe that the high interest rate policy was counterproductive, the question is what should have been done instead. A larger financing package? Korea’s was already an extraordinary 1,900 percent of quota. The imposition of exchange controls to prevent foreign banks from repatriating their balances, as Professor Cho does not state but seems to suggest? This is not an instrument that was available to a country with obligations to the OECD, and in any case its utilization would have had reputational costs. Efforts to bring the banks to the table earlier to negotiate collective forbearance, as the IMF paper suggests? In principle, this may have been the most attractive option. But this observation raises the further question of why it was not pursued. Were the IMF and Korean authorities oblivious of the need to concert the banks before the end of December? I doubt it. I wonder whether this option was in fact feasible in the period of political uncertainty that preceded the installation of the new government. And, even in the absence of the election, would it have been possible to concert the banks before the severity of the crisis was apparent, and before the least patient creditors had been allowed to exit? These issues are not addressed in either of our papers.
In any case, this kind of Monday-morning quarterbacking may not usefully inform policy toward future crises. The ratio of bank debt to new bond issues has declined very significantly since the Asian crisis, and it is infinitely more difficult, as we know, to bring a dispersed bondholder community to the table and negotiate its forbearance.
Professor Cho’s second theme is that the incomplete coverage of financial-sector restructuring in Korea allowed financial problems, rather than being solved, to simply shift location, from the commercial and investment banks to the investment and insurance companies. The initial focus on the problems of the commercial banks flowed from the fact that it was they who experienced the decline in foreign deposits at the end of 1997. The problems lurking in the investment trusts, while less visible, were every bit as severe, as the paper by Chopra et al. describes. Some investment companies had borrowed illegally from their trust funds. Others held a significant proportion of the debt of the top five chaebol, which put them in a weak position to decline these customers’ requests for additional credit. That several were already under water led them to gamble for redemption, explaining the rapid expansion of their balance sheets through the first half of 1999.
So what were the consequences? Professor Cho characterizes these as a mixed blessing. Allowing the liberal provision of credit by investment companies prevented an even more severe credit crunch and plausibly hastened Korea’s recovery from the crisis. At the same time, it deepened the problems of the investment trust sector, in turn leading to fears of another financial crisis in the summer of 1999. And it slowed the process of corporate and financial restructuring by easing weak chaebol’s continued access to credit.
The key question is what should have been done differently. In retrospect, the implosion of the investment and trust business in 1999, following the Daewoo crisis, creates a prima facie argument for stronger prudential supervision of that sector. But wouldn’t clamping down earlier on the investment companies have aggravated the credit crunch and slowed Korea’s recovery from the post-crisis recession? Wouldn’t doing so have added to the burden of nonperforming loans, risking more intense political backlash against reform? The IMF authors argue that the growth of bond and equity flotations starting in 1998 would have prevented a severe credit crunch even if vigorous regulation had been extended to the nonbank financial sector. This leads them to conclude that tighter regulation of the nonbank financial sector would have been an unmitigated good. But while large firms with access to stock and bond markets would have been relatively unaffected by earlier steps clamping down on the investment company sector, I am not convinced that the same is true of the small firms and start-ups that are arguably Korea’s economic future. Was the answer, then, to combine less forbearance of the investment companies with more forbearance of the banks, so that minimally acceptable levels of bank finance could still be provided to the small firm sector? Our authors do not say.
The third conclusion of Professor Cho’s paper is that monetary policy and prudential supervision should be closely coordinated when an economy is restructuring its financial system. In Korea, changes in financial supervision and regulation that led to sharp shifts in the money multiplier were not offset by changes in the money base. The rate of growth of domestic credit declined throughout the post-crisis period, as banks faced with stronger enforcement of prudential rules shunned loans to the private sector in favor of less risky government bonds, while the monetary authorities have done little to offset this. Similarly, there was a sharp decline in the M3 multiplier in the second half of 1999, when the crisis broke in the investment company sector. Professor Cho implies that the Bank of Korea should have pursued a looser policy to offset these developments. Interestingly, the IMF paper does not comment on the role of monetary policy in the recovery (other than to say it was possible to reduce interest rates to low levels at a relatively early date). Nor does it discuss the need to coordinate regulatory policy with monetary policy.
My own view is that the two aspects of this problem should be distinguished. One question is whether the Bank of Korea should have followed a more accommodating policy throughout, to offset the decline in private sector credit. I am skeptical. Hourly wages started pushing higher from the second half of 1998, and more inflation would have created credibility problems for a central bank seeking to demonstrate its ability to operate a stable monetary policy and to maintain a floating exchange rate. On the other hand, the collapse of the M3 multiplier in the second half of 1999 due to the Daewoo crisis and regulatory intervention in the investment-company sector seems like a classic instance of a one-time shock that could have been offset without undermining credibility. Here I would argue that Cho’s case for more rapid loosening of monetary policy is on firmer ground.
Finally, Professor Cho argues that the rapid introduction of global accounting standards, which brought the long-submerged problem of nonperforming loans to the surface all at once, backfired in Korea. It slowed financial reform by raising the up-front costs of banking sector recapitalization and creating reform fatigue. The result was pervasive non-application of the newly-promulgated rules. This conclusion is diametrically opposed to that of the IMF team, who argue, if I read them correctly, for even faster application of international standards for accounting, marking assets to market, and classifying loans as nonperforming.
Who is right? This is not a question, alas, that can be answered on narrowly economic grounds. It is also a question of political economy: under what circumstances does the ambition of the reform effort give rise to fatigue and risk a political backlash? Here, you will be aware, we are simply revisiting the classic debate between big-bang and gradual reform. Under what conditions does political sustainability dictate that reform should be spread out over time? And under what conditions do the economic costs of deferring reform militate against delay? As we know from other contexts, this is not a question with a single answer that applies in all times and places. Neither set of authors provides the thorough political economy analysis required to answer it for Korea.
To conclude, this is an exceedingly impressive set of papers. They ask precisely the right questions. If they don’t provide convincing answers in each and every case, they at least point us in the right direction.
Let me start by commending the IMF’s role in helping to overcome the Korean crisis in a relatively short period of time.
There are, of course, questions about the appropriateness of the IMF stabilization policy in the immediate aftermath of the crisis. As pointed out by Chopra et al., the high interest policy was inevitable in that it stabilized the panicky foreign exchange market and helped restore investors’ confidence in the Korean won. But many economists have argued that Korea was hit by twin crises—a financial crisis and a currency crisis—at the same time. Undoubtedly, the high interest rates exacerbated the insolvency of large corporations, thereby increasing the amount of nonperforming loans and further deteriorating the soundness of financial institutions. A crisis resolution strategy must, therefore, give careful consideration to the possibility of a vicious circle of increased corporate failures and financial-sector fragility. Looking back, the IMF could have adopted both the principle of flexibility and that of universal treatment when imposing conditionality. This implies that adjustment programs would have taken into account the special economic situation or institutional characteristics of each individual country.
I also think the IMF should have taken a more flexible stance toward interest rate policy in 1998. The high interest rate policy was maintained for too long a period to be justified by the size and duration of macroeconomic imbalances in the Korean economy. The current account deficit of 1996, which amounted to 4.5 percent of GDP, was large, but much smaller than those of other crisis countries such as Mexico and Thailand. And the duration of the external imbalance was relatively short. Furthermore, the level of the current account deficit was not unsustainable for an economy with a potential growth rate of 7 percent.
Even if a strong case can be made for the high interest rate policy, it is crucial to lower the interest rate as soon as market sentiment improves. Admittedly, there were renewed uncertainties in the spring of 1998, when Indonesia’s political situation deteriorated further. To cope with these uncertainties and possible spillover effects, the IMF may well have decided to maintain the high interest rate policy in Korea for as long as six months until the Asian countries returned to more stable market conditions.
There was an important structural component to the IMF program. Here, I think the IMF conditionality was a little bit too generous, allowing the Korean authorities to secure a lot of discretionary power. This discretion, however, was not used effectively to facilitate the much-needed reform and restructuring. For example, the exiting of nonviable financial institutions from the market was not done swiftly enough. And there did not appear to be a coherent or a comprehensive restructuring program put in place early in the crisis to ensure adequate liquidity as well as solvency of the banking system.
In a sense, the formal structural conditionality in the IMF program was too weak to support the financial sector restructuring in a timely manner. Although Chopra et al. discuss this issue in detail, the paper could benefit from a more analytical discussion of how individual structural performance criteria in the financial sector affected the actual progress of reform and restructuring. In other words, we should ask whether the depth of structural conditionality in the IMF program was optimal, considering the consensus view that one of the root causes of the Korean crisis was financial fragility.
I fully agree with Professor Cho that the delayed restructuring of nonbank financial institutions, such as the investment trust companies (ITCs), led to a typical moral hazard problem. The government’s lax response to the liquidity crisis of some ITCs also distorted the incentive structure that determines the behavior of financial institutions as well as their customers. The government’s decision to bail out the failing Hannam ITC and five other ITCs, though designed to avoid a run on the ITCs, raised the expectation of public support in a crisis situation and encouraged excessive risk-taking by other weak ITCs.
Another issue is whether the decision to provide fiscal support to the ITCs was appropriate by international standards. As far as I know, the established principles set by the IMF and other international financial institutions holds that the injection of public funds is to be strictly limited to the restructuring of deposit-taking institutions such as banks, not investment institutions such as the ITCs. However, the ITCs continued to be treated like banking institutions due to long-standing market practices and policy pressures. This created a serious moral hazard problem for local investors who accumulated a huge amount of the ITCs bond-type beneficiary certificates without regard to the viability of the ITCs until after the Daewoo group’s liquidity crisis in mid-1999. Furthermore, the institutional framework for prudential regulation and supervision was very weak for the ITCs; the system of prompt corrective action, for example, did not exist in the ITC sector.
Despite the significant progress made in corporate restructuring, much of the corporate sector remains highly leveraged by international standards. This indicates that corporate debt should be reduced more actively through asset sales or debt-equity swaps. Only a very small amount of the corporate debt has been converted to equity. Professor Cho is right when he emphasizes the need to develop a deeper equity market to facilitate debt-equity conversion. However, even that will not be enough. It is more crucial to change the mindset of Korean corporations, who are not yet fully adjusted to the new principle of a free market economy and are still resentful of the loss of managerial control to foreign investors. In addition, more incentives should be given to creditor banks who want to enter into debt-equity swaps. In many cases, creditor banks are very reluctant to engage in swap deals because of the negative consequences for their balance sheets.
As Chopra et al. note, the structural reform part of the program consisted of measures to increase the market orientation of the Korean economy. And significant progress has been made in this area. However, market discipline is not yet entrenched. In some sectors, there is still a wide gap between global standards and market practices. People’s mindsets are not yet fully adjusted to the principles of a free market economy. In this situation, I wonder what should be the optimal role for the government. The Korean government recently announced that it will promote constant, market-driven reform, shifting away from the government-led approach of the last three years. This means that corporate restructuring should be carried out by market forces with the government serving as a system manager or fair referee.
Though desirable, market-driven reform will not be an easy process because it will have to work in a second-best situation in which a significant portion of the market is not functioning properly. The market needs to include a well-functioning financial system that can monitor and weed out potentially insolvent companies in a timely manner. However, the establishment of a well-functioning financial system entails huge administrative, human capital, and legal requirements. In this regard, we should try to support the proper functioning of the market system by improving the still-not-up-to-date managerial software at banks, for example through better training and education of the bank managers. However, the urgency of upgrading operational systems suggests that we must tap other sources of expertise, such as foreign experts who know international best practices in every area of bank management.
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ChoYoonJe2000 “Restructuring Financial System in Korea—Key Issues,” Sogang Institute of International and Area Studies Working Paper 00-01October.
ChoYoonJe2001“The Financial Crisis of Korea: A Consequence of Unbalanced Liberalization?” in Financial Liberalization: How Far? How Fast? edited by GerardCaprioPatrickHonohan and JosephStiglitz (Cambridge University Press).
ChoYoonJe1998 “The Structural Reform Issues of the Korean Economy,” Sogang Institute of international and Area Studies Working Paper 98-01January.
DekleRobertChengHaiao and SiyanWang1999“Do High Interest Rates Appreciate Interest Rates During Crisis?”forthcoming inOxford Bulletin of Economics and Statistics.
FloodRobert and Andrew K.Rose2001“Uncovered Interests Parity in Crisis: The Interest Rate Defense in the 1990s,”mimeo.
FurmanJason and Joseph E.Stiglitz1998 “Economic Crises: Evidence and Insights from East Asia,” Brookings Papers on Economic Activity(2)pp. 1-135.
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The original draft of this paper was prepared for the international workshop, “Reexamination of Development Strategies: Experience and Lessons of Crisis,” organized by the Institute of Developing Economies, Tokyo, March 21, 2001.
In my view, Korea faced currency crises, i.e., the status of near default of foreign borrowing, in the early 1970s when the rapidly increased foreign debt of the second half of 1960s fell due; in 1975 after the First Oil Shock; and again in 1980 after heavy borrowing from the eurocurrency market in the second half of 1970s and the Second Oil Shock.
According to Flow of Fund Statistics (BOK, 1998), the corporate sector’s total borrowing from financial institutions and direct financing through CPs, bonds, and trade credits exceeded 650 trillion won at the end of 1997.
There was the possibility of speculation on foreign currency by domestic residents, but this could be addressed by temporarily (and partially) limiting conversion of domestic deposits to foreign deposits by residents.
There have been many studies that have tried to examine empirically the effectiveness of interest rate policy in supporting exchange rates (Kraay, 2000; Flood and Rose, 2001). Among them, Basurto and Ghosh (2000) argue that the fact that the coefficient of the real interest rate on the risk premium on Korean bonds issued abroad was positive (although it was not statistically significant) suggests that tightening would have been unlikely to improve the exchange rate and may have been counterproductive.
In fact, only these two types of financial institutions had been allowed for foreign borrowing business until the crisis.
During 1997-2000, two types of investment and mutual companies were allowed: investment and trust companies (ITCs) could mobilize and manage funds; and investment trust management companies (ITMCs) could only manage funds that were mobilized by their affiliated securities companies. Now ITCs have been converted to investment trust securities companies and ITMCs. In this paper, ‘ITCs’ include ITMCs as well as ITCs.
The problems of three major ITCs had been aggravated by government intervention in asset management for other policy goals such as sustaining the stock market value and by the lack of professional management.
The financial insolvency problem of ITCs had dragged the government action to strengthen supervision over the practice of this industry. The government feared the possibility of a run, given a bad financial situation of major ITCs, and has been reluctant to enforce the proper regulatory norms for these institutions.
Cho (2001) discusses how the asymmetric liberalization of interest rates and regulatory oversight led to the rapid expansion of the commercial paper market and ‘shortermization’ of corporate finance during 1993-97.
The Financial Survey statistics include assets and liabilities of banks as well as NBFIs.
This is an approximate figure after subtracting “stocks” and “other equities” from “total external financing”.