Korean economic Crisis

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Korean economic crisis: The intervened Banking system

This paper is divided into 2 parts. The first part seeks to validate that government intervention on the banking system in Korea as a primary cause for the collapse of the economy in 1997; the second part examines the intent and rationale behind the intervention.

Causes for the collapse of the Korean economy

Currency crisis is commonly cited as a main result of improvident macroeconomic policies (Hong, p.206-207). However, economic indicators on Table 1 reveal no indications of imprudent macroeconomic policies by the Korean government.

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Table 1

The GDP growth rate though faced a slow down from 1995's 8.9% to 5.9%, it generally remained a steady positive growth rate though the 5-year period. The Domestic Savings rate hovered around an average of 36.3. Since there was no drastic increase or decrease in the domestic savings rate, it reflected that the outlook of the economy was stable and that the economy was growing steadily. Saving is proportionally related to investment, ceteris paribus. Domestic Savings rate are commonly used to measure the level of investment on resources that are devoted to the increases in physical, human capital and technological improvements (Rittenberg, p.407). The current account deficit confirms the high level of investment rather than consumption (Hong, p.206-207). Clearly, all the indicators do not suggest the collapse of the Korean economy in 1997.

The economy downturn was sparked off by a mistake in the forecasting of major export items. It was speculated that the international prices of semiconductors, steel and petrol-chemical products would rebound; the prices, however, did not recover. They instead plunged significantly during 1995-1996 (Hong, p.207). The chaebols (large family-owned conglomerates) had high corporate leverage and overly invested in risky projects hence, suffered tremendous losses. The condition was made worse, since chaebol firms are highly interdependent financially through cross sharing and cross loans guarantee (Hong, p.209). This triggered a series of severe financial crisis among the chaebols resembling a "domino effect". The conglomerates, competing with each other to expand capacity in automobiles, semiconductors, and other industries, were granted excessive loans from the Government-supported banks (Shorrock, par.17). To the surprise of many economists, the Korean government actually encouraged short–term borrowings by lowering mandatory requirement ratios of medium and long–term borrowings for financial institutions (Suh, par.9)

The series of large corporate insolvencies inevitably undermine the health of the financial institutions with large exposure to these conglomerates. According to an official report, non-performing loans (NLPs) of commercial banks as of the end of 1996 stood at 11.9 trillion won (3.9 percent of total loans made by commercial banks), and they almost doubled to 22.7 trillion at the end of 1997 (Hong, p.209-210).

Furthermore, the proximity of the general presidential election and the Hanbo scandal weakened and divided the ruling party, inhibiting its capacity to act effectively (Haggard, p.57). As such, foreign investors began to lose confidence in the Korean economy; large inflows turned to sudden outflows, which amounts to about 9.8 billion dollars (Hong, p.208). This resulted in a serious liquidity problem. Korean firms had difficulty in turning non-liquid investments (such as expensive machineries) into liquid assets (cash) to repay their loans. This phenomenon paved way for the collapse of the Korean economy in 1997.

Possible reasons for government intervention

Although Korea's financial crisis of 1997-98 was triggered by foreign currency shortages in financial institutions, there is little doubt that financial troubles in the corporate sector, particularly the chaebols (large family-owned conglomerates), were at the epicenter of the crisis (Luna-Martinez, p.3-4). The troubles at the large chaebols had put banks in a very difficult position. Under government intervention, the Korean corporate sector shifted the pain to the large banks, which must accept debt-for equity swaps, maturity extensions or outright forgiveness of loans (Fons, par. 20). This paper seeks to explain the government intervention from the social, political and economic perspective. These factors are closely related and interconnected; some even having complimentary effects, magnifying each other's effects in policies making and stands that the government take. Before I continue, I must stress that the collapse of the Korean is not due to a single factor; it is a collective effect from all the factors. However, I argued that Korean government's intervention in the Korean banking system is the primary core of the factors that caused the economy to collapse. Thus, I am interested to know why the Korean government would want to show such favoritism.

Before we begin analyzing and examining the factors, it is important to have some background information about the culture and working attitudes of Asians. In the Asian region, as Lee Kwan Yew unblinkingly puts it, "authoritarian arrangements are essential to economic success." The culture of the Asian community advocates deference and obedience to the authorities (Hitchcock, par.2-5). Korea follows closely to the teachings of Confucius. The Confucian heritage focused on (1) emphasis on education; (2) respect for the moral value of loyalty to the King and the nation, which is translated to loyalty to the constitution; (3) the teaching of public integrity in the public service. On the other hand, it brought about the open oppression of the commoners by the ruling class (Nam, p.4-5). The Confucian heritage stresses diligence, self-help and cooperation. This notion ensures social harmony, which was an important ingredient for the Asian economic miracle. Nevertheless, as a country modernizes, it requires transparency through its ranks to ensure efficiency and effective working of the free market mechanism. However, the culture indirectly created pragmatism among people. They were inculcated with values, which asked for their "blind" obedience to the authority. This facilitated special transactions and relationships among businessmen and government officials behind closed doors.

Such deals made behind closed doors and through connections provided an ideal sanctuary for bad loans and indebtedness, such as the $50 billion of underreported Korean debt (Hitchcock, par.7). The spark that ignited the whole series of aftermath that eventually led to the collapse of the Korean economy was the bankruptcy of the Hanbo Group in January 1997.

Hanbo, which started as a construction company, invested heavily in steel operations relying mainly on borrowings from Korean banks. While Hanbo was making a huge capital investment in steel, the world steel industry went into recession. A combination of large debt and recession drove Hanbo to the brink of bankruptcy as early as mid–1996, but creditors tried to save Hanbo through a series of emergency loans. By the time Hanbo filed for bankruptcy in early January 1997, its debt amounted to 5 trillion won (Suh, par.14-16).

It was suspected that Korean banks gave such a high line of credit due to Hanbo chairman Chung Tae-Soo's political lobbying activities, but investigations revealed a political scandal. More than a dozen of influential politicians from both the ruling and opposition parties were implicated in bribery and influence peddling; even the incumbent president's son, Kim Hyun Chul, was arrested on these grounds. This seriously tarnished the reputation of the president and severely affected the capacity of both the president and the ruling party to overcome the emerging currency crisis.

Before further analysis, we must understand that South Korea was ruled under a strong, and effective leadership by the authoritarian government. Similar to the other 3 tigers of Asia, South Korea's successful economic development was led by export-oriented activities centering especially on the northern American market. The export-based, outward-looking development strategy had led Korea to consistently high economic growth from the 1960s to the 1970s (Rohlen, p.10-11). The South Korea government played an active role in its economic development.

In the 1960s, the government intervened its economy actively by directing its resources into the growth industries. In addition, it gave assistance to selected firms, allowing them to carry out strategic investment projects, achieve economies of scale, absorb foreign investment and technology and above all, maximize exports (Nam, p.6-7). The government intervention was arguably the most important element in the successful take-off of the Korean economic development.

In the 1960s till 1970s, the government played an active role in the banking systems. Since there were limited financial resources, the government intervened actively in the banks' loaning decisions. The government ensured that the limited resources were allocated to the priority sectors, such as exports and basic industries; non-productive sectors such as tertiary sectors received the least allocation (Nam, p.6-7).

This trend has not changed much through the years. In the early 1990s, banks continued to believe that the chaebols were extremely stable due to their size; financial institutions continued to trust that government would intervene and protect them from bankruptcies. Thus, many risky or unprofitable investments were financed (Hong, p.208-209). On the other hand, the chaebols continued to embark on aggressive, leveraged expansion, believing that this export-based strategy will continue to provide them with returns well exceeding the cost of the capital (Luna-Martinez, p.5).

The Government did impose stricter limits on connected lending and credit risk exposure that prevented banks from increasing their loans to the chaebols, whose leverage had already exceeded the reasonable level. However, the policies came too late to produce any effect. Table 2 shows the selected indicators of the banking system in Korea.

Table 2: Selected banking system indicators in Korea

Indicators Korea (1995) Korea (1996) Korea (1997)

Number of domestic institutions 26 26 26

Total assets in US dollars 552 billion 658.2 billion 712.9 billion

Total assets as % of GDP 157 170 169

Assets of banks as % of total assets of the financial system 52 49 51

Total loan portfolio in US dollars 311 billion 389 billion 385 billion

Growth of the lending portfolio over the previous years 19% 25% -1.1%

Non-performing loans as % of total loan portfolio 5.2 3.9 5.8

Provisions for loans losses as % of total loans 1.4 1.4 1.9

Capital adequacy ratio 9.3 9.1 7.0

Return on assets (ROA) 0.32% 0.26% 0.93%

Return on equity (ROE) 4.19% 3.8% -18%

Note: Assets of commercial banks in Korea include both banking accounts and trust accounts.

Source: CNBV, FSS, BOK and BANXICO

The data showed that the growth of the bank credit slowed down in 1997, however, the total growth of bank credit from 1995 till 1997 was still significantly large, considering that in 1995 and 1996 the growth was 19% and 25% respectively whereas the decrease growth rate in 1997 was a mere 1.1%. The table shows that the amount of assets non-bank financial institutions (NBFIs) possessed collectively was nearly the amount the commercial banks owned; in 1996, they even held more assets than the commercial banks. The government intervention to reduce bank credit was not effective from preventing the chaebols from embarking on large-scale and risky expansion or pursuing in unprofitable projects. The chaebols merely turned to the NBFIs, such as, credit unions, insurance companies, investment companies, merchant banks and development banks etc. to finance their projects (Luna-Martinez, p.4).

A series of factors including the Hanbo scandal and the weakening international prices of the major export of the South Korean industries plunged the chaebols into a series of financial crisis. The Korean government pushed the chaebols to seek short-term loans from foreign financial institutions to ease the burden of the domestic financial institutions already sustaining medium and long-term loans. The amount of short-term loans from foreign financial institutions amounted to almost 60 percent of the total foreign debt at the time of crisis in November 1997 (Suh, par.12). This action was a temporary solution to ease the immediate crisis. Instead of solving the problem, it led the Korean economy to an utter collapse in 1997 when there was a sudden outflow of foreign funds.

The government's intervention in pushing for short-term foreign loans could be based on several possible reasons. The proximity of the presidential elections should be noted. The relationship between the voters and the ruling party follows closely to the Clientelism model. This patron-client relationship maintained its reciprocity in the form of welfare granted to the voters and their support in return (Handelman, p.145). In view of the proximity of the presidential election on December 18, 1997, the ruling party's effort to ensure the continual good welfare of the people is possibly magnified, in order to secure support in the upcoming election.

I believe that the rationale behind the Korean government's decision is based largely on the concept of Nationalism. A nation as Anderson puts it, "it [nation] is an imagined political community - - and imagined as both inherently limited and sovereign" (1991, pp. 5-7). It could be perceived that it is the politicians' responsibilities to uphold the nation's pride and protect the welfare of the citizens.

The chaebols are large conglomerates recognized internationally as the economic pillars of South Korea. The chaebols, such as, Samsung and Daewoo, are recognized internationally and may be perceived as the symbols of economic achievements of Korea well-known brands. Their economic success is closely tied with that of South Korea's. Furthermore, the collapse of the chaebols will reflect badly on the economic outlook of South Korea, which might trigger a loss of confidence in foreign investors that leads to a sudden foreign capital outflow.

One other possible consideration for the ruling party could have been the possible rise in unemployment rate. The collapse of a chaebol could result in a massive unemployment, in the case of the collapse of Daewoo, 320,000 employees were threatened with unemployment (Fernandez, par.9). The unemployment rate is a common indicator used to gauge the ability of a government. Besides the loss of support from the voters in the case of massive unemployment, the government had to consider the negative effects that unemployment entails, such as, an increase in dependence on government's support, a rise in crime rates, decrease in revenues and other social problems. A report on the social impact of the financial crisis verified the worrying consequences of massive unemployment. There was a high employment rate due the implementation of the contractionary fiscal and monetary policies that came as part of the IMF rescue package. There were approximately 1.5 million people put out of work which lead to approximately 5000 babies were left at the orphanage without adoption, 6200 families left the cities "to seek a better life in the countryside" and 650,000 members, staged a hunger strike to protest the government-led unilateral reform of the economy (Ching, par.35-44).

Moreover, massive unemployment together with a failing economy could possibly lead to stagflation. This is a situation when there is an increasing inflation together with an increasing unemployment rate. The collapse of the failing chaebols possibly lead to a sharp rise in structural unemployment. Workers from other industries foreseeing worse economic outlook ahead could possibly push for higher wage rates to cushion the harsh times ahead. The rise in the cost of production of the industries inevitably leads to more unemployment and inflation (Rittenberg, p.335-343). Furthermore, discontent workers and citizens may challenge the legitimacy of the ruling political leadership when faced with massive unemployment and inflation. These effects would pose more problems for the government. The government possibly encouraged short-term loans from foreign financial institutions and injecting of funds into the faltering chaebols in order to curb massive unemployment.

Conclusion

The financial crisis was caused by a series of events. It was triggered by a slow-down in the major export industries and a drop in the international prices in the core export products. The situation was worsened by the weakness of the banking sectors of Korea. A lack of transparency in the financial systems led to the forming of "special relationships" within the community. This resulted in excessive reliance on bank borrowing by conglomerates, political collusion between conglomerates and politicians, non-transparent business accounts, and ineffective bank supervisory mechanisms (Suh, par.17-18). This non-transparency is a stark difference Korea from other less affected economies like Singapore, who developed quickly using a similar export-oriented industrialization strategy.

In addition, the use of the banking sector as a tool by the authoritarian Korean government to achieve its economic objectives, such as boosting the highly prioritized export-oriented industries and consciously reducing the funding for the lowly prioritized tertiary sector, severely inhibited the growth and maturity of its banking sector. As such, bank managers developed few skills for independent, efficient and prudent management. They merely relied on the government, who made decisions based on availability of collateral rather than on a proper assessment of risk or future repayment capacity, for determination of interest rates as well as lending decisions (Luna-Martinez, p.10).

The effect was inflated by a loss of confidence among the foreign investors. The foreign investors lost confidence due to the deterioration of the soundness of the banking system, the weakening Korean economic outlook and the weak bankruptcy laws. The Korean government's framework to protect and enforce creditors' rights was deficient. The government maintained industrial development and market stability by restraining controversial debt collection and by actively encouraging voluntary schemes of rescheduling (Luna-Martinez, p.7). The foreign investors facing with inadequate protection withdrew their investments in South Korea, resulting in a sudden capital outflow. This firmly sealed the fate of the failing economy, leading to a total collapse of the economy in November 1997 (Lindgren et al., p.2).

Government intervention in the banking system proved to be the core factor that resulted in the collapse of the Korean economy in the Asian financial crisis in 1997. The reasons behind the intervention spanned a huge array of diverse factors. The Confucian heritage, the ex-military authoritarian government, the corruption and collusion between the conglomerates and the politicians, the proximity of the 1997 presidential election and the concern for the reputation of the faltering chaebols, possibly influenced the government intervention in the banking sector.

Four years have passed since the collapse of the Korean economy. A mixture of short-term contractionary monetary and fiscal policies and long-term expansionary policies from the International Monetary Fund (IMF) had miraculous effects on the recovery of the Korean economy. The Korean economy has shown a strong recovery with substantial economic growth, however, whether the economic growth is sustainable, depends on the structural reforms' contribution to the enhancement of international competitiveness (Hong, p.218).

Works cited

Anderson, Benedict. Imagined Communities: Reflections on the Origin and Spread of Nationalism. Revised Edition ed. London and New York: Verso, 1991.

Ching, Frank. Social Impact of the Regional Financial Crisis. The Asian Economic Crisis: Policy Choices, Social Consequences and the Philippine Case. Asia Society. Columbia International Affairs Online. November 15, 2001. < http://www.ciaonet.org/wps/lil01 /lil01b.html>.

Fernandez, Luciano and Peter Symonds. "Daewoo collapse threatens further financial crisis in South Korea" 8 October 1999. World Socialist website. November 14, 2001. < http:// www.wsws.org/articles/1999/oct1999/kor-o08.shtml>.

Haggard, Stephan. The Political Economy of the Asian Financial Crisis. Institute For International Economics, Washington, DC: August 2000.

Handelman, Howard. The Challenge of Third World Development. 2nd Ed. Prentice Hall, Inc.: 2000.

Hitchcock, David I. Asian Crisis Is Cultural As Well As Economic. The PacNet Newsletter 1998. April 10, 1998. The Center for Strategic and International Studies. Columbia International Affairs Online. November 15, 2001. < http://www.ciaonet.org/pbei/csis/ pac98/hid02.html>.

Hong, Kiseok and Jong-Wha Lee. "Korea, Returning to Sustainable Growth?" 203-225. Rpt. in The Asian Financial Crisis: Lessons for a Resilient Asia. Ed. Wing Thye Woo, Jeffrey D. Sachs and Klaus Schwab. The MIT Press Cambridge, Massachusetts and London, England, 2000.

Jons, Jerome S. Asia's Banking Systems Still At Risk. Conference on Crisis & Credit: Restructuring Asia's Financial Sector Asia Society October 1, 1999, New York. Speeches and Transcript: 1999. Asian Society. Columbia International Affairs Online. November 20, 2001. < http://www.ciaonet.org/conf/asoc_spch99/foj01.html>.

Lindgren, Carl-Johan., et al. Financial Sector Crisis and Restructuring: Lessons from Asia. International Monetary Fund: 1999.

Luna-Martinez, Jose De. Management and Resolution of Banking Crisis: Lessons from the Republic of Korea and Mexico. The International Bank for Reconstruction and Development/ The WORLD BANK: March 2000.

Nam, Duck Woo. Korea's Economic Takeoff in Retrospect: 3-19. Rpt. in The Korean Economy at a Crossroad: Development Prospects, Liberalization, and the South-North Economic Integration. Ed. Sung Yeung Kwack. Praeger Publishers: 1994.

Rittenberg, Libby and Timothy Tregarthen. Macroeconomics. 2nd Ed. Worth Publishers: 2000.

Rohlen, Thomas P. A "Mediterranean" Model for Asian Regionalism: Cosmopolitan Cities and Nation-States in Asia. Asia/Pacific Research Center Stanford University. The Board of Trustees of the Leland Stanford Junior University: April 1995.

Shorrock, Tim, Martha Honey and Tom Barry. Asian Financial Crisis: Foreign Policy In Focus. April 1998. Columbia International Affairs Online. November 20, 2001. < http://www. ciaonet.org/pbei/fpif/sht01.html>.

Suh, Sang-Mok. The Korean Currency Crisis: What Can We Learn From It? May 1998. Asia/Pacific research center. Columbia International Affairs Online. November 20, 2001. < http://www.ciaonet.org/srchfrm.html>.

Works cited

Anderson, Benedict. Imagined Communities: Reflections on the Origin and Spread of Nationalism. Revised Edition ed. London and New York: Verso, 1991.

Ching, Frank. Social Impact of the Regional Financial Crisis. The Asian Economic Crisis: Policy Choices, Social Consequences and the Philippine Case. Asia Society. Columbia International Affairs Online. November 15, 2001. < http://www.ciaonet.org/wps/lil01 /lil01b.html>.

Fernandez, Luciano and Peter Symonds. "Daewoo collapse threatens further financial crisis in South Korea" 8 October 1999. World Socialist website. November 14, 2001. < http:// www.wsws.org/articles/1999/oct1999/kor-o08.shtml>.

Haggard, Stephan. The Political Economy of the Asian Financial Crisis. Institute For International Economics, Washington, DC: August 2000.

Handelman, Howard. The Challenge of Third World Development. 2nd Ed. Prentice Hall, Inc.: 2000.

Hitchcock, David I. Asian Crisis Is Cultural As Well As Economic. The PacNet Newsletter 1998. April 10, 1998. The Center for Strategic and International Studies. Columbia International Affairs Online. November 15, 2001. < http://www.ciaonet.org/pbei/csis/ pac98/hid02.html>.

Hong, Kiseok and Jong-Wha Lee. "Korea, Returning to Sustainable Growth?" 203-225. Rpt. in The Asian Financial Crisis: Lessons for a Resilient Asia. Ed. Wing Thye Woo, Jeffrey D. Sachs and Klaus Schwab. The MIT Press Cambridge, Massachusetts and London, England, 2000.

Jons, Jerome S. Asia's Banking Systems Still At Risk. Conference on Crisis & Credit: Restructuring Asia's Financial Sector Asia Society October 1, 1999, New York. Speeches and Transcript: 1999. Asian Society. Columbia International Affairs Online. November 20, 2001. < http://www.ciaonet.org/conf/asoc_spch99/foj01.html>.

Lindgren, Carl-Johan., et al. Financial Sector Crisis and Restructuring: Lessons from Asia. International Monetary Fund: 1999.

Luna-Martinez, Jose De. Management and Resolution of Banking Crisis: Lessons from the Republic of Korea and Mexico. The International Bank for Reconstruction and Development/ The WORLD BANK: March 2000.

Nam, Duck Woo. Korea's Economic Takeoff in Retrospect: 3-19. Rpt. in The Korean Economy at a Crossroad: Development Prospects, Liberalization, and the South-North Economic Integration. Ed. Sung Yeung Kwack. Praeger Publishers: 1994.

Rittenberg, Libby and Timothy Tregarthen. Macroeconomics. 2nd Ed. Worth Publishers: 2000.

Rohlen, Thomas P. A "Mediterranean" Model for Asian Regionalism: Cosmopolitan Cities and Nation-States in Asia. Asia/Pacific Research Center Stanford University. The Board of Trustees of the Leland Stanford Junior University: April 1995.

Shorrock, Tim, Martha Honey and Tom Barry. Asian Financial Crisis: Foreign Policy In Focus. April 1998. Columbia International Affairs Online. November 20, 2001. < http://www. ciaonet.org/pbei/fpif/sht01.html>.

Suh, Sang-Mok. The Korean Currency Crisis: What Can We Learn From It? May 1998. Asia/Pacific research center. Columbia International Affairs Online. November 20, 2001. < http://www.ciaonet.org/srchfrm.html>.

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