Source: Lim 2000

1
Source Lim (2000)
2
III. Financial Crisis of 1997
Growth Rate of GDP (1971 2006) Bank of Korea
3
Exchange Rate (Won/Dollar)Bank of Korea
4
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 IMFs
  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.

5
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

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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 gt
• Government has implicit responsibility to bail
  out Chaebols if they fail.
  gt
• Moral hazard of underestimating the downside
  risks arises.
• Government subsidize Chaebols by providing loan
  guarantees and low-interest rate loans
• gt Excessive investment

7

• 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.
• gt Incompetent banking industry

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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 gt
• Korea on the verge of a major financial crisis
• Chun adopt the stabilization package recommended
  by IMF

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• Tight monetary policy
• Consolidating industries and chaebols
• Reformatory ideas
• Of Chuns 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.

10

• 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

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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

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• 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)

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• 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

14
Cho (1999)
15

• 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
• gt Failed to bring confidence to uneasy foreign
  investors.

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

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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
• Structural Reform
• Trade liberalization
• Financial market opening
• Corporate Restructing

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10 years after
Fast Recovery of GDP Source Burton and Zanello
(2007)
19
Corporate Restructuring Source Burton and
Zanello (2007)
20
Bank Restructuring Source Burton and Zanello
(2007)
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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

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• Worsening Income Inequality
• Source Kyung-Joon Ryu (2007)