1. Understanding the Korean Miracle E. Young Song Sogang University Summer, 2011

2. 2 Delayed Reform Park assassinated in 1979. Park assassinated in 1979. Chun takes power by a military coup in 1980. 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 => Korea on the verge of a major financial crisis Chun adopt the stabilization package recommended by IMF Chun adopt the stabilization package recommended by IMF Tight monetary policy Consolidating industries and chaebols Problems of the Chaebol System in 70s suppresses the development of small and medium size enterprises. excessive leverage excessive dependency on a few major export items

3. 3 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-owned to semi-public.

4. 4 –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 interests 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

5. 5 VI. Financial Crisis of 1997 Growth Rate of GDP (1971 – 2006) Bank of Korea

6. 6 Exchange Rate (Won/Dollar) Bank of Korea

7. 7 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 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.

8. 8 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.

9. 9 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

10. 10 Mobilizing resources through state-controlled banks 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. Incompetent banking industry  Incompetent banking industry

11. 11 Cho (1999) In terms of macroeconomics, the Korean economy was doing OK. 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. Contagion effects Causes Corporate overinvestment Vulnerable financial structure Banks mismatch of foreign assets and liabilities

12. 12 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)

13. 13 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. 14 Cho (1999)

15. 15 Imprudent interventions in the foreign exchange markets Upward pressure on Won/dollar exchange rate 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 => Failed to bring confidence to uneasy foreign investors.

16. 16 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.

17. 17 Adjustments under IMF Macroeconomic adjustments Tight monetary policy and high interest rates Brings down the exchange rate. Brings down the exchange rate. Decreases investment and consumption and thereby decrease the current account deficits. Decreases investment and consumption and thereby decrease the current account deficits. Tight fiscal stance This IMF package is harshly blamed later and IMF fundamentally changes its policy. Structural Reform 1.Trade liberalization (inappropriate) 2.Financial market opening (inappropriate) 3.Corporate Restructuring 4.Bank Restructuring – capital injection and nationalization

18. 18 10 years after Fast Recovery of GDP Source: Burton and Zanello (2007)

19. 19 Corporate Restructuring Source: Burton and Zanello (2007)

20. 20 Bank Restructuring Source: Burton and Zanello (2007)

21. 21 Death of the Korean Model of Development? Is the Asian model of growth doomed to failure? Post-bubble economy of Japan since 1989 Asian Crisis of 1997 Can China keep on growing? –The Korean Crisis cannot be blamed on nepotism and crony capitalism. –The fast recovery demonstrates that the Crisis was basically a liquidity crisis. Herd behavior and contagion should be blamed. –Chaebols became more competitive and resilient after the crisis. –Crises do happen in an advanced capitalist economy as in the US housing market crisis of 2008. –Needs to prevent overinvestment and excessive leveraging of the private sector and the governent Needs to reform the international financial market Needs to regulate excessive short-term cross-border capital flows. Needs to reform IMF and the international financial system.

22. 22 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, Automobiles Catch-up of China and India Sandwiched economy Coping with open financial markets Enhancing the competitiveness of financial sectors Coping with volatile capital inflows and outflows Containing bubbles in stock and housing markets

23. 23 Worsening Income Inequality Income gap between rich and poor sharply increased after the crisis. Chaebols became stronger, but most small and medium size enterprises are on the verge of collapse. More demand for income redistribution and social welfare Slow Growth and Aging Population GDP growth rate sharply dropped after the Crisis. Decreasing work force and the aging of the society. Sharp increase in household debts