Korean Financial Crisis of 1997–98: Causes, Reforms, and Lessons

Introduction

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 further examines the government's response to the crisis and what can be learned from the Korean experience and applied to the Euro Area.

The major components of the Korean financial system in the 1960s and 1970s were reportedly nationalized, with "lending targeted toward favored sectors and firms including the exports and heavy industries" (Jeon and Miller, 2005). Regional banks emerged in 1967 and could only operate within their own provinces, which encouraged regionally-based development. In the early 1980s, plans were made for deregulation of the financial system and to transfer Korean commercial banks to the private sector (Jeon and Miller, 2005). Deregulation in the 1980s expanded the powers of commercial banks, allowing them to offer credit cards, issue negotiable certificates of deposit, and provide automated teller machines. At the same time, foreign exchange controls and restrictions on foreign ownership of Korean assets were eased (Jeon and Miller, 2005). However, the Korean government still retained a strong hold: it controlled interest rates on some loans and deposits, and its informal credit policy continued to favor certain sectors. During the mid-1980s, the Korean commercial banking system underwent a crisis due to a high level of bad loans, yet no banks failed during that period since charge-off rates for bad loans "were allocated slowly to maintain individual bank viability" (Jeon and Miller, 2005).

The inflation rate nearly doubled in 1998 compared to 1997 in Korea, and simultaneously the unemployment rate more than doubled. This followed a rise in Korean interest rates from 12.5% in 1996 to 21.3% in 1997, with the exchange rate moving from 845 won per dollar in 1996 to 1,695 in 1997. Korea's Gross Domestic Product (GDP) dipped sharply in 1998.

The Korean Financial Crisis and Banking System

According to Jeon (2012), the value of the Korean currency fell by more than one-half when there was an exodus of foreign capital in 1997, and 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 drove the unemployment rate higher (Jeon, 2012).

According to Jeon and Miller (2005), the world economy has witnessed numerous financial crises over the preceding decade. 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, structure, and stability were severely tested by the Asian financial crisis following this "significant transition" (Jeon and Miller, 2005). This resulted in the government recapitalizing banks previously believed to be "too-big-to-fail" (Jeon and Miller, 2005). These banks — Korea First Bank and Seoul Bank — received government financial support while the government oversaw the closing and takeover of smaller insolvent banks (Jeon and Miller, 2005). Under these 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).

While the performance of Korean banks "deteriorated dramatically in 1998, most banks recovered somewhat in 1999" (Jeon and Miller, 2005). Studies show that foreign banks enjoyed a global advantage rather than a home-field disadvantage. Explanations include: (1) foreign banks were not subject to the credit allocation directives from the Korean government to selected, favored industries; (2) foreign banks, relying on their parent institutions, achieved better efficiency and better asset and liability management; and (3) foreign banks relied more heavily on fee-for-service income rather than loan revenue (Jeon and Miller, 2005).

Analysts have suggested that "foreign bank lending played a unique role in the Asian financial crisis vis-à-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). Some have indicted the initial International Monetary Fund (IMF) rescue programs as worsening the liquidity crisis by requiring tighter credit (Jeon and Miller, 2005). Noland (2000) differentiates the Korean financial crisis from other Southeast Asian crises 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). The primary corporate borrowers defaulted on their loans to banks, reinforcing the negative shock, "compounded by the loss of foreign lending to domestic banks" (Jeon and Miller, 2005). This resulted in central bank intervention to assist in finding merger partners — some of them foreign — for the takeover of failed banks (Jeon and Miller, 2005).

The Asian financial crisis highlighted the importance of strong, financially stable markets for sustaining economic development (Jeon and Miller, 2005). Some analysts argue that foreign bank participation in domestic financial markets strengthens the domestic economy, while others hold that the financial services industry "possesses public good characteristics and that unfettered private interests, especially those with foreign connections, should not control credit allocation decisions" (Jeon and Miller, 2005). 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).

Foreign Bank Lending and Domestic Market Dynamics

Korea is reported to have "traversed 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 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). Capital flow channels can also provide a path for capital flight when finances are strained, and increased banking competition tends to improve bank performance and lower the average cost of financial services. However, foreign banks with competitive advantages can select the best available domestic funding options and bring with them regulatory and supervisory experience that domestic regulators are unfamiliar with, creating complex situations that make oversight more difficult.

Claessens et al. (2002) note a difference between the performance of foreign banks in developed and developing countries: foreign banks generally achieve higher profitability in developing countries and lower profitability in developed ones. Explanations include: (1) low net-interest margins in developed countries may reflect participation in wholesale rather than retail markets; and (2) the technical advantages foreign banks possess may not overcome informational disadvantages in developed countries (Jeon and Miller, 2005). Jeon and Miller note that "these two explanations 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).

Claessens et al. (2001) examined foreign bank operations in 80 countries and concluded 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).

The Asian financial crisis is reported to have "produced the dramatic domestic economic crisis in Korea" (Jeon and Miller, 2005); however, "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 "overused short-term foreign lending as a source of funds" (Jeon and Miller, 2005). In addition, 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." The role of government in the Korean crisis was unique: the government "controlled the allocation and prioritization of resources and credit. The government also determined restructuring initiatives and took full control of the reform agenda to correct its own mistakes and oversights during the post-crisis period" (Jeon, 2012). While a neoclassical view would regard this interventionist role as "unfair and controversial," the reality is that it "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) also 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." Uniquely Korean features include "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" (Jeon, 2012). Uniquely Korean crisis management tools include: (1) a gold-collection campaign; (2) self-imposed salary reductions by employees; and (3) a tripartite agreement for burden-sharing among management, labor, and government (Jeon, 2012). A fourth factor was IMF conditionality, which "imposed an array of reforms in the financial sector, corporate sector, labor market, and macroeconomic policy implementations" (Jeon, 2012). Jeon reports that the Korean crisis and its 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" (Jeon, 2012).