Korean Financial Crisis in the Late 1990s Lesson for Current Euro Area

Korean Financial Crisis in the Late 1990s: Lesson for Current Euro Area

The objective of this study is to examine what is unique or different about the Korean financial crisis as compared to other Asian financial crises and to determine the primary causes of the financial crisis in Korea. This work will further examine the government response to the crisis and what it is that can be learned from the Korean financial crisis and applied in Korea to the Euro Area.

The major components of the Korean financial system in the 1960s and 1970s are stated in reports to have been nationalized with "lending targeted toward favored sectors and firms including the exports and heavy industries. (Jeon and Miller, 2005) Regional banks came on in 1967 and could only operate in their own provinces, which provided encouragement for development that was regionally-based. In the early 1980s, plans were made for deregulation of the financial system and to place Korean commercial banks in the private sector. (Jeon and Miller, 2005, paraphrased) The power of commercial banks was expanded by deregulation in the 1980s allowing them to offer credit cards, issue negotiable certificates of deposit, and provide automated teller machines. At the same time, there was an easing of foreign exchange controls and restrictions on foreign ownership of Korean assets. (Jeon and Miller, 2005) However, the Korean government still had a hold that was strong in that they controlled interest rates on some loans and deposits and their informal credit policy still favored some sectors. During the middle part of the 1980s, it is held that the Korean commercial banking system underwent a crisis due to a high level of bad loans but it is stated that no banks failed during that crisis since charge-off rates for bad loans "were allocated slowly to maintain individual bank viability." (Jeon and Miller, 2005)

Introduction

The inflation rate nearly doubled in 1998 as compared to 1997 in Korea and simultaneously the unemployment rate more than doubled and this followed interest rates in Korea rising from 12.5 in 1996 to 21.3 in 1997 with the exchange rate in 1996 at 845 doubling to 1695 in 1997 in Korea. The Gross Domestic Product (GDP) rate in Korea dipped sharply in 1998 as shown in the following graph labeled Figure 1 in this study.

According to Jeon (2012), the value of Korean currency fell by more than one-half when there was an exodus of foreign capital in 1997 and the GDP contracted approximately six percent in 1998. This was preceded by a sharp contraction in corporate investment and consumer spending and a surge in corporate bankruptcies, which increased the unemployment rate. (Jeon, 2012, paraphrased)

I. Korean Financial Crisis

According to the work of Jeon and Miller (2005) entitled "Performance of Domestic and Foreign Banks: The Case of Korea and the Asian Financial Crisis" the economy of the world has witnessed quite a few financial crisis over the past ten years. Following a lengthy process of deregulation and privatization, "the Asian financial crisis hit the Korean economy." (Jeon and Miller, 2005) The Korean banking system is reported to have "evolved from an industry with large state ownership and significant government direction of credit flows to a more deregulated and privatized industry." (Jeon and Miller, 2005) The industry's viability as well as its structure and stability were tested severely by the Asian financial crisis following what was a "significant transition." (Jeon and Miller, 2005) This resulted in the government recapitalizing the banks, which were previously believed to be "too-big-to-fail." (Jeon and Miller, 2005) These banks were Korea First and Seoul banks receiving government financial support and in overseeing the closing and takeovers of smaller banks that were insolvent. (Jeon and Miller, 2005, paraphrased) It is stated that in the circumstances "the performance of the Korean banking system in the wake of the Asian financial crisis appears remarkable, probably helped by that government intervention." (Jeon and Miller, 2005)

II. Foreign Bank Lending Examined

It has been suggested by analysts that "foreign bank lending played a unique role in the Asian financial crisis vis-a-vis other similar events. Domestic banks supplied major quantities of credit to domestic firms and relied more heavily on foreign bank lending. When the crisis hit, the supply of foreign lending evaporated quickly, creating a liquidity crisis for domestic banks." (Jeon and Miller, 2005) It is related that there are some who "indict the initial International Monetary Fund (IMF) rescue programs as worsening the liquidity crisis by requiring tighter credit." (Jeon and Miller, 2005) The Korean financial crisis is differentiated in the work of Noland (2000) from other financial crisis in southeast Asia on the basis that the "Korean investment boom occurred in the manufacturing sector, especially the chaebols, rather than in real estate. Since short-term capital controls were liberalized while the long-term controls were not, investment growth was funded largely by short-run capital inflows." (Jeon and Miller, 2005) Basically the result of the financial crisis was that there were some primary corporate borrowers that defaulted on their loans to the banks resulting in reinforcement of the negative shock, which was "compounded by the loss of foreign lending to domestic banks." (Jeon and Miller, 2005) This resulted in intervention by the central bank providing assistance in locating merging partners and some of them foreign for the takeover of operations of the banks that had failed. (Jeon and Miller, 2005, paraphrased)

III. Performance of Korean Banks

While the performance of Korean banks "deteriorated dramatically in 1998. Most banks recovered somewhat in 1999." (Jeon and Miller, 2005) The results from studies are stated to show that there was a global advantage rather than a home field advantage with explanations including:

(1) foreign banks were not subject to the credit allocation directives from the Korean government to selected, favored industries; and (2) foreign banks, reliant on their mother bank in their own country achieved better efficiency and better asset and liability management; and (3) foreign banks rely more heavily on fee-for-service income rather than loan revenue. (Jeon and Miller, 2005)

IV. Examination of Foreign Banks in Domestic Financial Markets

The Asian financial crisis highlights the importance of markets that are strong and financially stable for maintaining economic development. (Jeon and Miller, 2005, paraphrased) It is argued by some analysts that foreign bank participation in domestic financial markets serve to strengthen the domestic economy while others hold that the financial service industry "possesses public good characteristics and that the unfettered private interests (markets) especially interest with foreign connections, should not control credit allocation decisions." (Jeon and Miller, 2005) The implication is that foreign banks should not operate in the domestic economy according to Jeon and Miller (2005). Stated as a more conservative view holds that state ownership and state mandated credit allocation "needs to send credit to those sectors most crucial for economic development." (Jeon and Miller, 2005)

Korea is reported to have "transverse this spectrum of views from a system with large elements of state ownership and state-directed credit flows to a more open and competitive financial market with a significant presence of foreign banks including a large privatization of state-owned banks." (Jeon and Miller, 2005) Foreign bank entry has been examined in the work of many authors and stated is that foreign banks serve to "facilitate capital inflows to finance domestic activities, which stimulates the domestic economy if such funding, adds to, rather than substitutes for, domestic funding." (Jeon and Miller, 2005) It is reported that a path for capital flight is provided by the capital flow channel when finances are strained and the increase in competition in banking serves to improve bank performance and financial services cost on the average lower. However, the foreign banks with a competitive advantage results in them being able to pick the best of the available domestic funding options and they also bring experiential regulatory and supervisory experience with them. Domestic regulators are not familiar with this type of experience in the banks and this results in complex situations that make the regulatory and supervisory process more difficult.

The difference between the performance of foreign banks and developed and developing countries is noted in the work of Clasessens et al. (2002) since higher profitability is usually achieved by foreign banks and in developed countries foreign banks generally achieve lower profitability. The explanations of the differences in the performance of foreign banks in developed and developing countries includes:

(1) low net-interest margins in developed countries may reflect participation in whole-sale rather than retail markets; and (2) the technical advantage that foreign banks possess may not cover informational disadvantages in developed countries. (Jeon and Miller, 2005)

These two explanations are stated by Jeon and Miller to "reverse themselves in developing countries. Foreign banks may enter retail markets more fully and/or they may possess higher levels of technical efficiency that overcomes any informational disadvantages in developing countries." (Jeon and Miller, 2005)

The work of Claessens et al. (2001) conducts an examination of foreign bank operations in 80 countries and states conclusions that foreign banks "experience lower (higher) net-interest margins, overhead expenses, and profitabilities than domestic banks in developed (developing) countries. They also conclude that a larger foreign bank presence associates with a lower profitability and a higher provisioning for bad loans by domestic banks." (Jeon and Miller, 2005)

V. The Asian Financial Crisis Impacts on Korea

The Asian financial crisis is reported to have "product the dramatic domestic economic crisis in Korea" (Jeon and Miller, 2005) however it is stated, "more fundamental factors also added to its severity." (Jeon and Miller, 2005) Specifically too much investment and borrowing overextended the corporate sector and commercial banks are reported as having "overused short-term foreign lending as a source of funds." (Jeon and Miller, 2005) Lastly, the "lack of transparency of balance sheets, income statements, and management practices all led to a crisis of confidence in Korean institutions." (Jeon and Miller, 2005) Jeon (2012) states that the Korean crisis "is believed to be more of a liquidity crisis rather than a structural crisis." Jeon (2012) additionally states that the role of the government in the Korea crisis was unique as the government "controlled the allocation and prioritization of resources and credit. The government also determined restructuring initiatives and took full control of reform agenda to correct its own mistakes and oversights during the post-crisis period." (Jeon, 2012) The neoclassical view would hold that the Korean government's role was "unfair and controversial" however; the reality is that the government's interventionist role "is considered to be one of the significant contributing factors for the so-called Asian miracle as well as the remarkable recovery from the 1997 crisis." (Jeon, 2012) Jeon (2012) additionally reports that Korea has a "culture of uniqueness and a long history of more than 4,300 years. A deep understanding of culture is essential for an accurate appreciation of economic and social changes, including crisis and reform." The example stated by Jeon is the "chaebols (family owned conglomerates), curb corporate bond markets (informal and high interest private loans), unique management-employee relationships and labor unions, compensation systems, the chaebol firms and suppliers' relationship with the promissory note market, localism and the importance of blood and alumni relationships." (2012) Stated as unique Korean features in crisis management tools are Koreas: (1) gold-collection campaign; (2() self-imposed salary reductions by employees; and (3) the tripartite agreement for burden-sharing among management, labor, and government." (Jeon, 2012) Stated four is the IMF conditionality "imposed in an array of reforms in the financial sector, corporate sector, labor market, and microeconomic policy implementations." (Jeon, 2012) Jeon reports that the Korean crisis and subsequent reforms is considered to provide more convincing evidence, than other crisis-hit Asian countries, of the ill-prepared, mechanical and culturally insensitive nature of the IMF rescue plan." (2012)

VI. Korea's Mistakes and Lessons

Stated as a primary challenge for developing countries, which characterizes the Korean economy, is "inadequate domestic saving in spite of their relatively high savings rates and how to finance the nation's economic development with foreign capital and saving." (Jeon, 2012) Capital inflows are critically needed for financing economic development tend to have some negative economical effects in that some of the capital goes to consumptions rather than investment and "increase aggregate demand, and create inflationary pressure." (Jeon, 2012) Jeon states that capital inflows serve to "appreciate real exchange rates and, consequently, generate a deficit in the current account." (2012) Large foreign borrowing and current account deficits serve to bring about an increase in the economical vulnerability to variations in international capital flows. (Jeon, 2012, paraphrased) Inducing more foreign borrowing in order to finance the deficits, which is comprised by short-term sources, which are volatile results in a higher level of vulnerability with foreign investors liable to overreact to any development domestically or internationally and thus their funds being quickly withdrawn. The result is that the capital inflows driving economic growth weaken the financial system and when the domestic banking system is weak this is worsened as the banking system cannot withstand the capital flow reversal. This is what occurred in Korea. While the macroeconomic performance of Koreas was mostly positive prior to Korea being hit hard in October and November of 1997, there were developments that were negative in other areas and specifically "the bankruptcies of chaebols and the increasing trade deficits. Subdued import demand and the plummeting prices of DRAMs." (Jeon, 2012) The chaebols bankrupted in the 1990s resulting in the account deficits, which reached $23.3 billion of 6% of GDP in 1996 and 1997. These deficits were reported as financed primarily by "foreign borrowing of banks and financial institutions along with portfolio investment by foreign investors to Korea." (Jeon, 2012) There was excessive investment in steel and automobiles combined with labor strikes serving to weaken the profitability of exporting firms as terms of trade worsened. These bankruptcies are reported to have weakened the financial system significantly and the Korean won appreciated while the result was non-performing loans. In addition Jeon reports "The exodus of foreign capital invested in Korean stocks and securities and the successive downgrade of Korea's sovereign rating by international credit rating agencies, such as Standard & Poor's and Moody's, exacerbated the confusing crisis situation. Abrupt and massive outflows of foreign capital from Korea made it problematic to maintain an optimal level of international reserves and sharply tightened the availability of external finance in the international financial market, which was already contaminated by Asian flu started in Thailand in July 1997." (2012) Reported as one of the most distinctive characteristics of the Korean model of economic development over the last forty years is the "government-business partnership." (Jeon, 2012) The primary benefactors of the government controlled credit allocation in Korea were the Chaebols as well as benefiting from financial liberalization policy and various export-promotion measures. (Jeon, 2012) In addition, there were some bail-out measures of chaebols that were nearly bankrupt that created "a false belief that the government would implicitly guarantee against their bankruptcy in any event." (Jeon, 2012) One of the primary contributing factors to over-investment, low profitability, and increasing non-performing loans was the nonmarket-based and high cost government-chaebol relationship and this led to the Korean crisis in November 1997. Jeon (2012) writes that the 'Sequence and timing of financial liberalization [was] ill-prepared and hurried." The following table lists the external debts, useable gross reserves, and debt-equity ratios of Korea.

Figure 2 -- Korea's External Debts, Usable Gross Reserves, and Debt-Equity Ratios

Source: Kihwan (2006)

As shown in the previous chart the government of Korea "discouraged long-term foreign borrowing by business firms as it required detailed disclosure on the uses of the funds as a condition for its permission." (Kihwan, 2006) In addition, short-term borrowing was viewed as financing that was trade-related and this did not make a requirement of strict regulation. Because of the incentives provided for short-term borrowing banks and business firms financed long-term investments with short-term foreign borrowings resulting in short-term external debts in the banking sector accounting for "61% of total external debts in 1996." (Kihwan, 2006) Government policy in Korea allowed for a rapid expanse in the number of financial institutions taking part in foreign currency-denominated activities in a short period of time and specifically in regards to merchant banks with an increase in their numbers engaging in foreign currency related activities in a short period of time. The number of merchant banks increased from six to thirty between 1994 and 1996 and most of these were chaebol-owned acting as the funding channel for investments by chaebols. These banks were engaged greatly in borrowing cheap short-term Japanese funds from Hong Kong and financed projects that were primarily long-term. IN addition commercial banks borrowed foreign short-term maturities in order to compete for business with merchant banks. The result was aggravated maturity and currency mismatches on balances sheets in the financial and business sectors of Korea. The result is that by the end of 1997 the total of short-term external debts is stated at $63.8 billion with only $9.1 billion in useable gross foreign reserves. Kihwan notes that the problems from mismatch resulted from "weak prudential supervision. The accounting and disclosure standards expected of financial institutions were below international best practices, and market-value accounting was not widely practiced. Due to weak financial supervision and high chaebol dependence on bank financing, risk was concentrated on banks. Furthermore, chaebol leverage was extremely high…" (Kihwan, 2006)

VII. The Contagion Channel Examined

Reported as a remarkable feature of the Asian crisis is the pace at which this crisis spread beginning in Thailand the region's other countries. Varying explanations and proposals exist for how it is and why it is that this spread so rapidly in the region and specifically the "macroeconomic similarities, trade links across countries and cross-country financial links." (Kihwan, 2006) Stated as well is that careful examination of "macroeconomic indicators around the outbreak of the currency crisis in the crisis-stricken nations reveals the relative irrelevance of the strength of macroeconomic fundamentals with the eruption and contagion of the 1997 Asian crisis." (Kihwan, 2006) Stated as major indicators of financial crises and contagion are "volatile movements in the exchange rate, the depletion of international reserves, sharply rising short-term interest rates and falling stock market prices." (Kihwan, 2006)

VIII. Financial Sector Reform Examined

The first step in reforming the financial sector is reported as having laid out a statutory and regulatory framework to assist in the implementation of needed reforms. It is stated that thirteen financial bills were presented for establishing a consolidated financial supervisory authority and the bills were based on Presidential Financial Reform Commission recommendations in 1997 and were identical to the bills that were refused for enactment in 1997 by the national legislature. The Korea Asset Management Corporation (KAMCO) is reported to have been reorganized with an NPL resolution fund being created for facilitation of the purchase of loans that were nonperforming from financial institutions. There were two primary problems to rehabilitation of the banking sector of Korea: (1) inadequate capitalization; and (2) poor-quality assets. (Kihwan, 2006) This is stated to be due to the chaebol bankruptcies in large numbers damaging the balance sheets of banks. The government had little choice in the injection of public funds toward a national financial system that was workable. Kihwan (2006) states that once the government made the decision for the injection of public funds it had to answer the question of "what exactly constituted non-performing loans. Before the crisis, only loans in arrears for six months or more had been classified as non-performing loans. In estimating the true magnitude of the NPLs, the government decided to include loans in arrears for three months in line with internationally acceptable standards. Using this standard, the government estimated the total size of the outstanding NPLs at 118 trillion won or roughly 28% of Korea's GDP in 1998 This was twice the amount of NPLs estimated earlier on the old asset classification standards." (Kihwan, 2006) It is reported that two thirds of the public funds were raised through KAMCO issued bonds and Korea Deposit Insurance Corporation (KDIC) with more than "40 trillion won used to settle deposit insurance obligations and to provide liquidity to distressed financial institutions. The rest was for recapitalization and purchase of NPLs with better prospects for recovery." (Kihwan, 2006)

Five banks with negative BIS ratios were closed in June 1998 and seven banks were under the requirement of submitting plans for restructuring by the end of July 1998. 14 merchant banks were shut down in December 1997 and later 22 additional merchant bank licenses were revoked and three merging with others. The total of merchant bank reduction was 27 as the 30 banks were reduced to 3. Kihwan (2006) reports that other institutions that were non-banking institutions "…including securities companies, insurance companies, investment trust companies, mutual savings and financial companies, credit unions, and leasing companies went through more or less similar restructuring processes as commercial and merchant banks." (Kihwan, 2006) The Korean government is reported to have strengthened prudential regulation with the introduction of a forward-looking approach to their track record in debt servicing." (Kihwan, 2006) Asset classification standards were again strengthened in March 2000 with the introduction of the enhanced FLC classifying loans as non-performing "when future risks are significant even if interest payments have been made without a problem." (Kihwan, 2006) The reduction of moral hazard is addressed by Kihwan (2006) who states that asset classification was tightened for the purpose of clearing up nonperforming loans and there were additionally government focused forward looking measures for improvement of the efficiency and stability of the Korean financial system through a process of reduction in moral hazard. It is stated that the most significant institutional reform in this area "was the introduction of partial deposit insurance. Before the crisis, depositors and investors had typically assumed that their assets were fully protected by the government. Starting January 2001, the deposit insurance limit was set at 50 million won per person per financial institution. The introduction of partial protection was initially opposed by many who believed that it would increase the instability of the financial system by inducing a sudden and large transfer of deposits among institutions. Such side effects, however, failed to materialize, and partial protection introduced market discipline by providing incentives to depositors to seek out healthy institutions." (Kihwan, 2006) Lender and large corporate borrowers moral hazard involved massive corporate failures that are reported to have "served as credible signals that the government's implicit guarantee regime had indeed ended. Indeed of the 30 largest business conglomerates in 1996, 14 had gone bankrupt or entered into out-of-court workouts by the end of 1999." (Kihwan, 2006)

In the area of promotion of capital account liberalization the Korean government is reported to have taken measures in the past including: (1) a free floating foreign exchange rate system adopted; (2) restrictions on M & As by foreigners were abolished; (3) foreign investment in Korean equities listed in the Korean Stock Exchange and KOSDAQ was fully liberalized; and (4) fore3ign investment in Korean in the equities of nonlisted firms was permitted. (Kihwan, 2006) In addition, the Korean government is reported to have "implemented full liberalization of foreign investment in Korean bonds in December 1997, full liberalization of money market instruments in May 1998, and abolition of restrictions on foreign ownership of land and real estate on the basis of national treatment in July 1998." (Kihwan, 2006) There is not no need for gain permission in advance for any international capital account transactions and the governance of financial institutions has been strengthened through several measures reported to have been taken including: (1) allowing foreigners to own commercial banks and become bank executives in December 1997 and May 1998; and (2) respectively, improving governance of financial institutions and strengthening the rights of commercial bank minority shareholders in January 2000, and raising the limit of bank ownership of domestic residents from 4% to 10% in April 2002." (Kihwan, 2006)