An important crucial stage in Korea's economic expansion can be reflected in 1997 Korean financial crisis, when Korea had no other alternative than to resort to the IMF for a bailout programme that would stabilize the Korean economy and integrate it to the global structure. IMF imposed certain conditions, such as a stringent macroeconomic policy and above all else a gradual financial and corporate adaptation to international standards, which were necessary for the country to overcome its long-standing structural problems in the economy.
But Korea's economic indicators in the years up to the crisis had not been suggesting such a grim future for the economy. Instead, Korea's incessant development during the last four decades and especially its spectacular economic growth throughout the years before the crisis, its upcoming membership of the OECD in 1996, its low rate of unemployment and inflation and performing either a fiscal balance or surplus established Korea as an encouraging economic environment comparing with other crisis-ridden countries. Thus, Korea's macroeconomic and foreign-debt indexes had been showing good signs and no one expected of this contagion to occur, as there were no signs that the foreign exchange crisis that hit neighbouring economies such as Thailand and Indonesia would influence the country significantly. The only discouraging factors were the current account deficit that was growing worse especially in 1996, but then diminishing again quickly and its low rate of foreign reserves.
Reviewing the causes that led Korea to get involved in the financial and currency crisis, we can point out that it was certainly a result of "macroeconomic fatigue" arising from long-standing structural problems in the Korean economy. But it was the combination of inadequate macroeconomic policies pursued by the Kim Young-sam administration before and during the crisis and the importance of these existing structural problems that caused the corporate sector to expand excessively and recklessly that contributed to the advent of the crisis.
Korea's "macroeconomic fatigue" arising from long-standing structural problems in the economy contributed to excessive corporate investment, increasingly weak financial sector and banks' too much concentration of foreign bad debts comparing with their property.
Excessive investment in the corporate sector funded mainly by short-term credit contributed to the bankruptcy of companies. The immediate result of it was that banks' bad loans were increased heavily. Financial liberalization strategy of the 1990s was the cause of the rapid development of investments despite corporate sector's increasing economic losses. It was because companies thought they would be tacitly rescued by the government and would not suffer bankruptcies. So, the administration moved from its previous policy direction and liberalized limitations on foreign credit, entry barriers of financial institutions. Moreover, it finally put an end to its intervention over which companies should enter into particular industries.
What is more, the situation of companies' poor liquidity, high operating costs, low profitability and high level of leverage ratio was compounded by the beginning of the domestic economic recession in late 1995 and the intense trade crisis in 1996. Thus, such growth of strong economic effects and corporate sector's crisis allowed the long-standing structural problems of the economy to come into view for the first time in early 1997, when a great number of chaebol defaulted.
Government could not rescue the chaebol and foreign credit was not available to the financial sector any more because of the increasing non-performing assets of Korean banks.
After the Asian crisis burst out, foreign investors' confidence in the Korean economy was increasingly too low, as a result of inefficient governmental reaction to the shock. Inadequate oversight let the banks' foreign debts to increase rapidly comparing with their assets after financial liberalization policy had been inaugurated by the government. The result was that the Korean economy had become too weak and vulnerable to foreign shocks like the Asian crisis of 1997, while lacking the appropriate mechanisms to discourage a contagion into the country and support effectively such an economic strategy.
Government's practice to provide and distribute capital among industries according to its own criteria has been well known and more common in Korea than in any other East Asian country. (Kwon, 2001, 2) Its rapid economic expansion since 1960s has been relied on a harmonious relationship between government and the corporate sector. Government encouraged the development of new industries and business ventures providing them with the necessary low-priced capital, stimulated the expansion of export trade and manufacturing sectors, creating an environment of collaboration, as well as of risk participation and continuous support on behalf of the government. Up to the early 1980s, most important merchant banks were owned and their management was appointed and checked by the government and their resources were distributed according to its plan, even after it lost their control. (Haggard and Mo, 2000, 198) In case of a company's bankruptcy resulting from its over-investments or its vulnerability to a foreign exchange crisis, government would immediately provide it with the appropriate capital to be financially rescued by socializing this cost. (Chang et al, 1998, 742) If companies made profits, they could maintain them and support their further development. That was what the chaebol did and managed to expand their presence and power into most sectors of the economy, reflecting thus a major number of the corporate sector and employing a remarkable number of the human capital.
Financial liberalization of the 1990s was spurred by great economic development, as well as changing internal and external economic conditions. Although there were efforts to be introduced since the early 1980s, it did not move forward until Kim came to power in 1993. It involved the liberalization of domestic interest rates and corporate sector's entry barriers and the relaxation of foreign credit. (Kwon, 2001, 2) However, the actual implementation of financial liberalization deviated from what had been formally announced, as it failed to maintain a proper balance between banks and the non-bank financial institutions (NBFIs), nor between the short-term and long-term markets. (Cho, 1999, 2) Concretely, it did not remove its restrictions regarding foreign investments in financially safe domestic assets thatyield regular returns, like bonds and securities. But it rapidly allowed foreigners to invest in the domestic stock market and liberalized short-term credit from abroad. (Hart-Landsberg and Burkett, 2001, 411) Thus, its purpose was to liberalize foreign exchange transactions and banks' finance from abroad, but exercise control over companies' external funding. In this way foreign debt, mainly transmitted through banking sector and to a smaller degree through companies' foreign credit, gathered rapidly.
The rapid capital market opening did not destabilize substantially the macroeconomic consistency of the country during the 1990s, as the administration implemented careful, as well as sensible fiscal and monetary regulations trying to avoid possible risks during the process. So, its macroeconomic policy was generally reasonable leading to its outstanding financial growth, mainly in 1994-96 and to its stable inflation rate, while although its interest rates were high enough because of great demand of capital by the corporate sector, they were increasingly going downwards.
Regarding its monetary policy, it was logically steady, although a bit increasing money supply but finally stable since early 1994 in spite of the fact that foreign credit was growing quickly, exerting thus incessant greater pressure. (Cho, 1999, 10) The growing budget surplus since 1993 was also a good sign and concerning its fiscal policy, government's policy was completely reasonable. (Park and Rhee, 1998, 4)
The only structural problem was the current account deficit during the 1990s, which grew significantly in 1995-96. (Hart-Landsberg and Burkett, 2001, 409-410) But its foreign exchange capital became greater due to the large quantities of foreign credit. The reasons behind the growing current account deficit were increasingly high corporate investment, Korea's progressively uncompetitive exports as a consequence of the severe international trade crisis caused from the crash of the external semiconductor sector and the decrease in external prices of its main export manufacturing products.
Furthermore, another inefficient measure taken by the Kim's administration had to do with exchange rate policy. Korea introduced comparatively fluctuating exchange rate strategy abandoning the won's maintenance at a particular value in 1990. Thus, it was not until 1995-96 that the currency's appreciation as a result of yen's depreciation made its export products unattractive and increased the current account deficit to a great degree. (Haggard and Mo, 2000, 202)The administration did not allow the currency to depreciate, as it was driven by market forces in late 1996, but attempted to keep it high by interfering in the market. (Haggard and Mo, 209)The main reasons behind that were to avoid inflationary pressures that depreciation would exert and restrict the chaebol's excessive foreign debt losses. But in retrospect and regarding the growing current account deficit and comparatively little foreign exchange capital, it proved to be an inefficient policy reaction.
Thus, the growing current account deficit along with the financial liberalization contributed heavily to the large concentration of foreign debt during the 1990s. The increase of the foreign short-term credit caused by the rapid financial liberalization also led to the great accumulation of foreign debt. (Haggard and Mo, 2000, 200)
Manifestation of structural problems
But the firm macroeconomic conditions could not prevent the structural problems of the Korean economy to be compounded and were easily perceived, as the economic liberalization was a prominent governmental policy in the 1990s. These problems had to do with incorrect motivational influences that led to promote the excessive development of corporate and financial sectors and raised steeply relevant prices and wages and appreciating the currency. (Hart-Landsberg and Burkett, 2001, 404) The result was that the resources had been allocated inefficiently and export-oriented industry was no more attractive. (Park and Rhee, 1998, 5)
Regarding the rapid rising of the real wages, it was because the labour unions were given the right to negotiate them as a result of Korea's recent democratization process. In fact, domestic wages were distorted in the 1990s, as they outgrew the labour productivity and even surpassed those of Singapore, Hong Kong and China. (Hart-Landsberg and Burkett, 2001, 407) Thus, corporate and export-oriented companies were faced with severe economic losses and were not profitable and attractive any more.
Concerning the asset inflation, it had been created a real estate bubble that caused rental charges and gains to move upwards, as well as the value of services. (Cho, 1999, 29) Thus, living costs were raised and workers needed higher wages. In such an environment of distorted prices, the chaebol increased their power in the society by simply growing stronger rather than by allocating resources wisely in the economy. This is why interest rates continued to stay at a high level and wages outgrew labour productivity. And above all the inefficient administrative control and oversight practices did not manage to restrict financial institutions' excessive and careless lending to high risk investments.
The consequences of higher asset prices were that corporations' asset values outgrew their excess of liabilities making it possible for them to uphold their investments by borrowing even more money from nonbanking organizations. Hence, corporations' investment development could be maintained despite their incessant excess of liabilities. The "macroeconomic fatigue" arising from long-standing structural problems became clear only in early 1997, when some of the chaebol went bankrupt.
The problems of the corporate sector
The chaebol activities and thus their power in the society increased significantly and so did their investment projects despite their low return of capital. (Chang et al, 1998, 740) Actually, there was strong competition among them to allocate resources in almost every important industry. The high rate of domestic savings did not prevent interest rates from remaining at a high level, as the demand for money was high. (Haggard and Mo, 2000, 209) Similarly, wages remained high because of strong demand for labour and the democratization process during the 1990s.
During the 1990s, there was a great and quick increase in the credit provided by financial institutions and mainly by commercial banks to the chaebol and their closely linked companies, contributing thus to the creation of the bubble economy. Companies could not be profitable, as labour costs had soared and surpassed labour productivity and interest rates had exceeded capital productivity. Until the early 1980s, the administration had under its control the function of the financial sector and labour market, managing to maintain interest rates and wages lower than the real return on capital and labour productivity growth respectively. Hence, excessive revenues of companies were reinvested to finance their new developmental projects and increasing activities. This is how their incessant and outstanding development can be easily explained and mainly the growth of the big ones, which had greater possibilities.
Nevertheless, from the late 1980s onwards when the financial liberalization had been inaugurated, the situation changed to the contrary. Wages and interest rates soared; it was worrying that they exceeded companies' productivity. This in fact meant that people had excessive money to spend, but debts rose steeply causing thus financial deficits to companies. These deficits were maintained by the rapid increase of debt, as companies' assets were appreciated, non-bank financial institutions' credits proliferated and inefficient accounting methods concealed true economic results. (Chang et al, 1998, 743)
Firms' profitability became even worse than that of firms in countries, which have substantially lower economic costs like Japan, China and US. (Kwon, 2001, 2)
Before the financial liberalization, the chaebol could socialize their costs exerting their great power and bear high wages, interest rates and rents. (Cho, 1999, 32) But after the official inception of WTO and the opening of imports, they found it difficult to transfer their losses to consumers and thus their financial situation deteriorated significantly.
Appreciation of the currency and the collapse of the manufacturing export industry
Despite the tight monetary policy pursued by Kim's administration, the Korean currency was appreciated in 1995-96 because of financial liberalization and the great amounts of money that flowed into the market. Hence, export industries lost their competitiveness, whereas the ones producing for the domestic market experienced high profitability rates, although they deprived of high technology. Consequently, there was a rapid shift of resources from the export towards the non-traded sector. The share of the manufacturing sector reduced significantly, while the share of the services sector rose steeply to almost 50 percent. (Cho, 1999, 2) And a great number of workers were rapidly moved from manufacturing to services industry. But this process was too rapid for an immature economy like Korea, while some developed economies had not yet moved from the manufacturing to services sector so drastically.
In 1997, seven of the biggest chaebol could not finally avoid bankruptcy, as a result of "macroeconomic fatigue" arising from the recession since late 1995, the trade shock of 1996, the excessive and careless investments during 1993-95 and low amounts of capital available for them since 1995-96. (Park and Choi, 2002, 6) Another structural problem in the economy was the reduced confidence of foreign creditors as a result of the banks' bad loans. (Park and Choi, 2002, 1)
Kim's financial liberalization and the development of the corporate sector
But also the rapid financial liberalization in the 1990s like the total relaxation of domestic interest rates and the rapid increase of non-bank financial institutions, whose principal activity was to provide short-term credit, led to the worsening of the corporate sector's financial function. (Mo, 2001, 482-484)Thus, companies appealed to these institutions for short-term credit, being so dependent on them and even susceptible to a liquidity risk. (Park and Rhee, 1998, 8)
The financial liberalization contributed to the development of the corporate sector after its continuous growth in the 1980s due to high interest rates and unchanging inflation. (Park and Rhee, 1998, 4) Corporate investment grew rapidly in 1990s financed by monetary policy, but especially in 1995-96, as the yen began to increase in value since late 1993 and thus bringing the Korean economy in a favourable position. (Haggard and Mo, 2000, 202)
Moreover, Kim's administration declared publicly in 1994 its goal to become part of OECD causing anticipations of greater financial liberalization. (Park and Choi, 2002, 12) Thus, the consequent fall of domestic interest rates convinced the domestic companies to invest further in production capacity. Actually, domestic interest rates begun gradually to decrease and approach the foreign ones in 1992. (Park and Rhee, 1998, 4)
Furthermore, before the financial liberalization, authorities prevented companies from entering into industries that considered as functioning at full capacity. Thus, government could control, to some point, careless investment and excessive output caused by the moral hazard symptom of the government's taking tacitly the full consequences and responsibilities of the conglomerates' actions and intense competition among them.
Mismanagement by the Kim's administration
After the Kim's administration introduced financial liberalization, authorities could not interfere any more to implement entry barriers for new companies. Instead of checking the chaebol's inefficient and careless investment during that period, it only controlled them carefully after the crisis had burst out and the IMF solution had been agreed. The administration did not restrict the mutual support through subsidies among the different but closely connected companies of the same chaebol through cross-guarantee of loans and transfer pricing as it should do. Neither made it clear that it would stop helping out indebted companies.
The great development of investment in the 1990s, mainly during 1994-96, was predominantly a result of the increase in short-term credit, on which the chaebol relied heavily to manage their investments. (Chang et al, 1998, 735) In fact, their short-term liabilities were raised steeply. This practice was not limited to the chaebol, but was common in the corporate sector (Kim, 2002). A source of investment-financing that developed rapidly and contributed to the increase in short-term credit was the commercial paper security. This type of credit was liberalized in 1994 by the administration, making it more attractive for investors due to the removal of governmental restraints in this market, the reduction of the smallest possible quantity unit and higher interest rates than deposit accounts. (Cho and Kim, 1999, 141-142) Another advantage of the commercial paper was that it was not checked by monetary authorities. It was mainly issued by big businesses, sold at a discount to short-term financial institutions and then sold again to people bearing guarantees. Although guaranteeing commercial paper was illegal, regulatory authorities did nothing to control it and there was a lack of regulatory supervision. (Cho and Kim, 1999, 142) Despite the fact that this practice was speculative, it was quite popular financial activity, which was incorrectly regarded by the corporate sector as not subject to risk. And the market's confidence concerning moral hazard of the government's risk participation and financial rescue of the chaebol also led to the rapid increase of this market's share.
It was the relaxation of interest rates' regulations that made short-term securities so attractive and quickly increasing. But it was the lack of suitable controlling and oversight devices that the administration and market failed to introduce in order to improve the situation and reduce risky activities. So the lack of oversight devices resulted in a large concentration of risk in the market and a constant belief from market players that they would be bailed out in case of a bankruptcy (moral hazard effect). (Chang et al, 1998, 742) The corporate sector suffered thus from excessive short-term debts and filled with leverage used in manufacturing, which needed long time for developing their plans. (Mo, 2001, 472) As a result, the corporate sector collapsed, corporations began to lose capital because of their excessive development, high wages and interests' costs.
It was thus the financial opening in the 1990s combined with the inefficiency of the authorities and market to control the build-up of overcapacity, supervise investment projects, reduce overall risk and excessive investing debt caused mainly from short-term securities that made companies susceptible to liquidity risk. Hence, inefficient economic and regulatory structure was compounded by low corporate profitability and the collapse of the corporate sector contributed to the insolvency of a number of chaebol in early 1997.
Mismatched opening of the capital market
Financial liberalization moved faster since 1994, but the administration wanted to open the market gradually. (Cho and Kim, 1999, 140) It reasonably regarded that the abrupt liberalization would make unstable the domestic market due to the big difference between domestic and foreign interest rates. To clarify it, investors would seek for portfolio opportunities in the foreign market upsetting thus the domestic one, so it decided to open simple financial transaction contracts like short-term credit, firstly, and portfolio dealings subsequently, as it wanted to protect the market from sudden changes in portfolio investments, mainly the risky short-term transactions including domestic securities.
It also gradually liberalized the stock market to foreign funds since 1993, but foreigners were controlled from investing in fixed income domestic products. (Cho and Kim, 1999, 139)
The administration, bearing in mind that domestic companies would appeal to foreign capital, did not stop to check their funding from foreigners, but instead was more tolerant with banks, as it gave its official approval to the rapid increase of the financial institutions, which could undertake financial operations with foreign markets. In 1994-1996, it permitted the conversion of 24 short-term finance companies, which were prohibited from undertaking foreign exchange transactions, into merchant banks, which could engage in such activities and 28 foreign branches of domestic banks were established. (Cho, 1999, 10)
These commercial banks started to borrow heavily from abroad and thus along with the increase of current account deficit in 1994-96 contributed to the rapid expansion of external debt, which during 1992-96 indicated more than a twofold increase. (Cho, 1999, 19) This expansion, more noticeable during 1994-96, was principally a result of short-term debt. (Cho, 1999, 20) They deprived of the required knowledge and skill, as they had no previous example of how to carry out this type of transactions. This expansion of short-term debt is not strictly a bad sign on its own, as it may depict an effort of internationalization of an economy and even most developed countries have greater percentages of short-term debt than Korea. The most worrying factor was, instead, the increasing since 1994 foreign liabilities on behalf of the Korean banks, and mainly the commercial ones, comparing with their property. (Cho, 1999, 3) So, foreign lenders realized that they were taking the risk of banks and thus required higher interest rates as compensation in early 1997. It was the administration's mismanagement that did nothing to correct this situation until June 1997, when it finally passed a law that restricted short-term credit for financing long-run property.
To sum up, the financial liberalization process along with the absence of proper regulatory mechanisms needed to control the banking sector were the most important causes of the financially weak and progressively subject to a foreign liquidity shock Korean economy.
During the 1990s, the Kim administration's primary policy objective was the growth of the economy to a global scale and rapid economic integration. Thus, anticipated membership of the OECD was reasonable and compatible with this policy, whose main goals were rapid financial and economic liberalization. As a consequence, foreigner investors and creditors could intervene in the domestic financial sector; domestic interest rates were adapted to the foreign ones and foreign investments in the stock market grew considerably.
However, quick globalization of the economy since 1993 was not combined with complete restructure of the domestic market's organizations and mechanisms needed to support such a spectacular transition. In retrospect, an effective action would be the behaviour modification regarding the competition policy, corporate sector and banking sector's excessive freedom to foreign credit to match the new policy direction. By the mid-1990s, economic development surpassed financial institutions' capacity rendering the economy extremely weak and vulnerable to external economic shocks and financial destabilizations.
Although administration's macroeconomic strategy can be characterized as logical and predictable, it actually proved insufficient to solve the long-standing structural problems that caused bubble effects in the early 1990s in the Korean economy.
Administration's inefficient competition policy let companies to increasingly cross-subsidize their affiliates using transfer pricing and cross-loan collaterals. Inefficient accounting methods concealed true losses and prevented small stockholders from examining the effective functioning of management and reaching to a safe conclusion.
Thus, inefficient accounting methods, moral hazard cases, as well as inadequate regulatory mechanisms and oversight contributed to the careless and excessive credit support from financial institutions to unsafe corporate investments, increasing further the need for money and labour.
As soon as early 1990s, severe increasing structural problems had been appeared into the Korean economy like high wages, interest rates, rents and logistics services. However, corporate investment did not stop, but instead continued to grow, because of the badly formed economic environment and incentives, as well as the incorrect and unreasonable economic expectations that were never redefined during the fast integration of the Korean economy to the global one.
The Korean financial crisis was a result of the administration's insufficiency to improve and adapt harmoniously the state's financial institutions to its new financial environment, characterized by increasing liberalization and globalization. Korea's rapid economic development during the last four decades endowed the market and corporate sector with sufficient knowledge and skill that rendered government's intervention in planning capital distribution inadequate and ineffective. So capital market openness was a right and logical measure by Kim's administration, although to some point it was compelled by domestic as well as by foreign forces. On the one hand, WTO rules and incessant trade conflicts with developed countries coerced Korea to open the foreign exchange sector and liberalize its financial sector. The opening of the foreign exchange sector placed emphasis on limiting non-tariff barriers and liberalizing FDI and trade, as its tariff barriers were not comparatively so high. On the other hand, Korea was not simply coerced by foreign forces, but by the chaebol as well to liberalize its financial sector, as their activities had already turned into worldwide.
Thus, the pressure exerted to Korea to liberalize its financial sector was extreme and a suitable measure taken in accordance with new financial conditions. But the administration did not respond wisely and did not combine it with the needed reforms of financial institutions and business organizations. The administration did not improve the mismatched competition policy and did not implement strict prudential controls, but instead let only the market to impose its rules. Thus, as the administration did not implement a dual-track strategy, domestic companies and financial institutions had ample scope to exploit several moral hazard situations in that open financial environment and that was what they finally did.
Before the financial liberalization, regulatory authorities established industries' entry limitations as well as imposed certain restraints on domestic and foreign funding, which were controlling practices that, to some extent, countervailed the moral hazard problem. On the contrary, during the financial liberalization, the Kim's administration did not introduce institutional changes in competition policy, prudential control measures and the labour market, in order to correct the chaebol's malpractices and abuses of their power.
From a macroeconomic perspective, too much emphasis was placed on keeping prices stable during the overestimation of the currency. Ultimately, this strategy hampered its depreciation and consequently rendered the country's exports unattractive, causing thus excessive speculation on its possible decrease in price.