1 II. Understanding the Miracle Korean Model of Development Strong and stable government Dictatorship of Chung Hee Park Stable and consistent policty State-led development Government plans and private enterprise executes plans Symbiosis between politics and business Symbiosis between politics and business Export-oriented growth vs. import substitution vs. import substitutionChaebols a family controlled network of big conglomerates

2 Market vs. State Prosperity of the Western Europe and the US in the 19 th century Liberalism : free market, free trade, small goverment Rapid expansion of industry and international trade World war I, the Great Depression of 1929 Shattered belief in liberalism Statism : experimenting with state-led systems in less developed regions Socialism in Russia Fascism in Germany, Italy and Spain Newly liberated countries after World War II Statism was a popular choice

3 Export Promotion vs. Import Substitution Developing country exports good X and import good Y X: primary products or labor-intensive low-skill goods M: capital-intensive or high-skill goods Export promotion (outward-looking policy) develop industries producing X import M with money generated by exporting X both X and M increase rapidly => more dependency on foreign trade adopted by Asian miracle countries Import substitution (inward-looking policy) develop industries producing M –decrease imports and save dollars spent on importing M both X and M decreases => self-sufficiency adopted by Latin American countries, India and Pakistan

4 A Brief History Long tradition of centralism – Chosun Dynasty ( ) No feudal or local powers. King and bureaucratic scholars dominate in political power and distribution of economic resources. Compare Japan. Colonial rule of Japan ( ) Modernization under the Japanese colonial rule. US Army Military Government ( ) – South Korea Some efforts to implant democracy and capitalism Period of political and economic chaos Syngman Rhee ( ) Korean War ( ) inefficient and corrupt distribution of Japanese enterprises, banks, US aids, imports. failed to for economic development laying foundations Korea was in a dismal state in It was as poor as sub-Saharan African countries.

5 Perkins (1997), in the early 60s, share of agriculture and mining – 50% (15% higher than comparable countries) share of manufacturing – 15%, unusually low. share of exports only 3% - compared with 30% under the Japanese colonial rule Source: Lim (2000)

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7 Chung Hee Park ( ) Period of authoritarian politics and rapid economic development Anti-communist Threatened by the economic success of the North Korea Economic development has all the priorities political freedom and reunification put aside State-led economic development Economic Planning Board created – 5 year plans Nationalized commercial banks Put the Bank of Korea under the control of the Ministry of Finance Initial plan – import substitution development a la Latin American countries exporting primary products developing steel and machinery industries

8 Switch to Export-led growth Export drives of labor-intensive products Historical accidents - Lim US tried to manipulate Park with US aids. Park, fierce nationalist, tried to be independent of US pressures by developing dollar-generating industries. US pressures US preferred market-oriented outward-looking growth strategy. No FDI (foreign direct investment) Heavily relied on foreign loans Government directly borrowed from the world and distributed to the private sector Government guaranteed foreign loans of private businesses Development based on private entrepreneurship -backed by foreign loan guarantees and low interest rate loans -closely monitored by the government in export performance Lim : government - principal private sector- agent private sector- agent task - exports task - exports

9 Reasons for success High level of education Much higher than average developing countries’ Stable and consistent policy Dedication to growth and export promotion Coping with moral hazard through monitoring Moral hazard Borrow at cheap rates and invest recklessly in unprofitable business Monitoring Government supplied low interest rate loans only to firms maintaining good export performances Firms were disciplined by competitive forces in their export markets Concentrating on right business with right technology Learning from Japanese experience Reliance on Japanese technology

10 HCI drives in the 1970s Promoting heavy and chemical industries Industrial upgrading: from labor-intensive consumer goods to capital-intensive intermediated goods US withdrawal of armed forces in Asia Creation of Chaebols ( 財閥 ) Chaebol literally means “wealth clique.” Japanese Zaibatsu vs Korean Chaebol Family-controlled industrial conglomerates Samsung – Lee Hyundai - Chung SK - Choi LG - Koo GS - Huh Diversification – controls a large number of unrelated business Samsung – Amusement park, electronics, insurance, credit cards, construction Hyunday - automobile, ship-building, construction, securities, electronics

11 Controls a network of companies with small holdings of equity Multi-pyramid => firm A => firm B => firm C => firm A => firm B => firm C Circular investment firm A => firm B => firm C Government –Chaebol partnership Government select target industries Government select firms to enter target industries Government provides low-interest loans and trade protection What if a project fails? Government has a moral responsibility to bail out firms without threatening governance. => moral hazard Government has a moral responsibility to bail out firms without threatening governance. => moral hazard

12 Source: Lim (2000)

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15 Advantages of Chaebols Shortage of entrepreneurial talents Inefficient legal enforcements and low level of trust –Integration saves transactions costs Diversifying heavy risks in investment in heavy industries –Large sunk costs –Long gestation periods “Without chaebols, would automobile, ship-building and semiconductor industries have been possible in Korea?” Inefficient labor markets –Evaluation of employees –Intra-firm mobility of labor Coping with informational problems in banking industries –Mutual loan guarantees –Transfer pricing

16 III. Financial Crisis of 1997 Growth Rate of GDP (1971 – 2006) Bank of Korea

17 Exchange Rate (Won/Dollar) Bank of Korea

18 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 IMF’s 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.

19 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

20 Government select target industries and select Chaebols to develop these industries => Government has implicit responsibility to bail out Chaebols if they fail. => Moral hazard of underestimating the downside risks arises. Government subsidize Chaebols by providing loan guarantees and low-interest rate loans => Excessive investment The root cause of the crisis Korean Model of Growth –Risk partnership between government and business

21 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. => Incompetent banking industry Korean Model of Growth –Mobilizing resources through state-controlled banks

22 Delayed Reform Lim (2000) pp Park assassinated in Chun takes power by a military coup in A sharp recession following the second oil shock, political instability and the results of over-investment in late 1970s => Korea on the verge of a major financial crisis Chun adopt the stabilization package recommended by IMF

23 Tight monetary policy Consolidating industries and chaebols Reformatory ideas Of Chun’s 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.

24 –Pro-competition policy New Fair Trade Law New Fair Trade Law  Without splitting Chaebols or opening up trade, limited impact on competition structure 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 Chaebols and bureaucrats Korea democratized in 1987 Chaebols form a new relationship with presidents and politicians thorough (legal or illegal) campaign funds