Korean Economics in 1997 South

Korean Economics

In 1997 South Korea would spark a financial crisis that would spread to all of Asia. Where, the GDP growth rate would go from averaging between 5% to 10% growth a year, to seeing a contraction of 5.8%. During this time the unemployment rate would rise from 2% before the crisis to 8.1% by March 1999. (Hahm, 2000) As a result, the underlying causes of the crisis would only be discovered once the effects have passed. To fully understand these different causes requires an examination of the various factors that helped mitigate the situation. This will provide the greatest insights as to what were the biggest reasons that caused the crisis to begin and how they helped spread the effects to the rest of Asia.

There are a number of different factors that contributed to the Korean financial crisis the most notable would include: excessive risk taking, increasing interest rates and a sharp devaluation of the currency. All of these three different causes are interconnected in one way or another, as they would work similar to one domino falling on top of another. Where, one situation would lead to another, with even greater consequences. The combination of them together, is what would make the situation so explosive. What happened was; South Korea was having large amount of foreign investment capital flowing into the country. This is significant because as this money was coming in, many of the different bankers were making a variety of loans. The problem was that they were not accounting for risk. At which point, it was only a matter of time until a number of bad loans would go into to default. This would cause the balance sheets of the different banks to deteriorate. Once this took place, the various financial institutions became nervous, where they would begin raising interest rates. This was problematic, because once the balance sheets deteriorate and interest rates begin to rise, it is a sign that many banks are nervous about lending money. When this takes place, it means that a panic can occur and possible runs could take place, at a number of different financial institutions. To prevent this situation, the central bank provided additional funding to the various financial institutions. (Hahm, 2000)

However, they faced an entirely new problem; the currency was pegged to the U.S. dollar. This allowed interest rates to remain artificially low, because the peg would make the different investments in Korea look less risky. Once interest rates began to rise, a divergence would occur as the policy of the maintaining the peg would invite speculators to take advantage of this. This could cause the financial system to collapse, as the central bank would lose control of the economy. If they removed the peg, this would allow the forces of supply and demand to balance everything out. Where, the currency would face increased short-term pressures and interest rates could rise even more. Yet, over the long run this policy would help to force the banks to address various balance sheet issues. Once this took place, is when they could begin to have confidence in the financial system. As interest rates would fall because the overall fear associated with lending has been greatly reduced. The problem with removing the peg; is that it would have effects that would be felt throughout the financial markets around the world. (Hahm, 2000)