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For three decades, Korea was held up as an economic icon. The country's typical blend of high
savings and investment rates, autocratic political systems, export-oriented businesses, restricted
domestic markets, government capital allocation, and controlled financial systems were hailed as
ideal ingredients for the strong economic growth of developing countries (Shapiro, 1999).
However, in July 1997, currency turmoil erupted in Thailand, spreading to Korea and other
countries leading to the South East Asian crisis. The Asian financial crisis involves four basic
problems or issues : first a shortage of foreign exchange that has caused the value of currencies
and equities in Thailand, Indonesia, South Korea and other Asian countries to fall dramatically,
secondly inadequately developed financial sectors and mechanisms for allocating capital in the
troubled Asian economies, thirdly effects of the crisis on both the United States and the world,
and lastly the role, operations, and replenishment of funds of the International Monetary Fund.
Many economists have predicted that South Korea¶s economy was strong and would be able to
survive this crisis but however there were many factors prior to the crisis which were indicating
the weaknesses and the problems present in the South Korea and these factors was contributed to
the collapse of the financial market and the economic crisis. The crisis came as a complete
surprise to many. Until the last moment, government officials insisted that everything was under
control and denied the possibility of Southeast Asian financial crisis spreading to Korea. On
November 21, 1997, South Korea's Finance Minister announced that the government was
officially seeking an IMF rescue package. This was a desperate move to prevent a complete
collapse of the economy from a rapid depreciation of currency and credit crunch The main focus
will be the on the internal causes and external factors resulting the South Korean crisis, the
impact of the crisis on the different industries, lastly the solutions and remedies adopted to
reform the economy with help of the International Monetary Fund (IMF). We also consider to
what extent the IMF aid have been proved efficient.

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The financial crisis of 1997 in East Asia has had a major impact on conventional thinking
regarding the world economy. Prior to the crisis the East Asian economies--be they the 'tiger
economies' of South Korea, Taiwan, Singapore and Hong Kong, or 'tiger cubs' (such as Thailand
and Malaysia), or the old giant Japan and the emerging giant China--were viewed as paragons of
the virtues of the free market that increasingly set the standards across the globe but it all
happened so fast.

By year's end, the crisis had spread throughout Southeast Asia and even affected the richer
economies to the North, especially South Korea. First, the crisis was a major setback to the
overall economic trend of the region. A significant 'output gap' had opened up for Indonesia,
Malaysia, South Korea and Thailand so that by 1999 output was significantly below the pre-
crisis trend (ranging from 7 percent for Malaysia to almost 17 percent for Indonesia). The value
of currencies across the region collapsed-not just the Thai baht but also the Indonesian rupiah
and the Malaysian ringgit, Southeast Asian financial markets crashed as well. Plummeting stock
prices and plunging currencies combined to slaughter three-quarters of the value of Indonesian
and Thai financial assets. Financial capital, unlike the proverbial ocean liner, turned on a dime,
withdrawing more funds in less than a year than accumulated in the region over the previous
seven years.

The miracle economies of Southeast Asia were in depression. Conditions vary from country to
country. Recession prevails in Malaysia, and in Thailand the steep downturn caused over two
million workers their jobs by the end of 1998. In Indonesia, crippling stagflation threatens to
double prices at the same time that it pushes nearly one half the population into poverty.

More pessimistic observers fear that the Southeast Asian financial crisis has triggered a
deflationary spiral likely to suck all of East Asia, and perhaps the world, into a depression. The
threat of economic collapse is real enough, especially when conditions worsen in Japan, the
region's most important economy and already suffering a decade-long recession. During most of
the 1990s, East Asia accounted for nearly one-half of the expansion of the world economy. In
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addition, the region's financial crisis has rattled financial markets around the globe in a way the
Mexican peso crisis of 1995 never did. Latin American, European, and Russian currencies all
have come under attack. Even the booming U.S. economy slowed that summer under the weight
of a ballooning trade deficit caused by fewer exports to East Asia

The financial crisis in Southeast Asia differs in important ways from previous crises in the
developing world. Unlike the Latin American debt crisis of the 1980s, the roots of the current
turmoil are in private sector, not public sector, and borrowing. Most of the afflicted countries
have run budget surpluses or minimal budget deficits in recent years. At the same time, private
sector borrowing increased heavily, especially from abroad and especially _ short-term. For
instance, loans to Thai corporations from international banks doubled from 1988 to 1994. By
1997, Thai foreign debt stood at $89 billion - four-fifths of which was owed by private
corporations. But most disturbingly, one-half of the debt was short-term, falling due inside a
year.

The Southeast Asian miracle economies got into trouble when their export boom came to a halt
as these short-term loans were due. For instance, stymied by a decline in First World demand,
especially from recession-ridden Japan, Thai exports grew not at all in 1996. Also, opening
domestic markets to outside money (under an early round of pressure from the IMF) brought a
deluge of short term foreign investment and spurred heavy short-term borrowing from abroad,
fueling a building boom.

At the time that the bubble has burst, the region endures a horrendous drying out process.
Southeast Asian exports from autos to computer chips to steel to textiles now glut international
markets, all made worse by intensifying competition from Chinese exports. Foreign financial
capital has fled. Domestic spending was collapsing. Banks fail at unprecedented rates.
Unemployment mounts, and as more and more people across the region fall into poverty, the
Southeast Asian financial crisis has become a story of tremendous human suffering.

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In the language of economists, the crisis is also a story of market failure. Southeast Asian capital
markets failed in three critical ways. First, too much capital rushed in. Lured by the prospect of
continued double digit growth and searching for new places to invest its overflowing coffers,
financial capital continued to flow into the real estate sectors of these economies even when
financial instability was widespread and obvious to all. Second, the capital markets and the
banking system could not channel these - funds into productive uses. Too much money went into
real estate and too little went into productive investments likely to sustain the export boom.
Third, too much capital rushed out, too quickly. The excessive inflow of capital reversed itself
and fled with little regard for the actual strength of a particular economy.

In addition, we should remember that this crisis hit first and hardest in Thailand and then
Indonesia, the two Asian economies with private domestic banking systems recently deregulated
and opened to foreigners. The shortfall of Japanese investment in the early 1990s left Thailand
desperate for foreign funds.

Rather the root cause of the crisis, at that time, threatening the world with depression is the
abrupt reversal of the excessively rapid rise of capital inflows and the falling global demand for
the exports from the region that arose from a global economy increasingly turned over to the rule
of markets.

But the real nature of the crisis can be gauged by the impact on the population. It needs
emphasising that, though East Asia has made considerable progress over the past three decades,
welfare provisions are rudimentary in comparison with the West's. Public expenditure on health,
education and social security remains a very small proportion of national income--with the least
expenditure devoted to social security and welfare

This means that when a crisis hits there are few social safety nets. Millions move rapidly from
having the basics to penury. This is precisely what happened between 1996 and 1998, as tens of
millions more people were added to the ranks of those living in poverty.

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The basic weaknesses in the Macro-Economic fundamentals itself led to Low productivity and
competitiveness vis-à-vis other regions of the world. Inadequate supervision of Financial
institutions and lack of adequate disclosure by the corporate world further worsened the
situation. Weak governments lacked the political autonomy or will to enact the deflationary
policies necessary to reduce current account deficits and domestic asset bubbles. They also
contributed to the cronyism and ethical problem that encouraged over borrowing, over lending,
and over investment in the private corporate sector as well as in state projects.

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Overvalued exchange rates tied to an appreciating U.S. dollar led to large current account deficits
and inadequate or declining long-term capital inflows. This resulted in heavy dependence on
short-term external debt and the depletion of foreign exchange reserves. The Opening up of
Capital Account led to local financial institutions over borrowing more from foreign sources. All
this made a currency devaluation inevitable and attracting speculator eager to benefit from it.
Borrowed Short-Term funds were invested in the Stock market and in Real Estate. The overall
quality of investments declined with reduction investor confidence which was a result of bad
news that the export market had slowed down

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Prior to the economic crisis of 1997, Korea's impressive growth performance was part of what
has been described as the East Asian miracle. The three decades of extraordinary growth that
transformed Korea from one of the poorest agrarian economies to the 11th largest economy and
exporting country in the world, On October 1997, the Korean Stock Exchange began to plunge
followed by a sharp fall of the Korean Won against dollar. Economies in Southeast Asia such as
Thailand and Indonesia have already developed instabilities in their markets, to termed "crises",
and the changes occurring in Korea was seen as a part of a regional contagion effect deriving
from the Southeast Asian crisis. However, by November 21, Korea's foreign reserves were
nearly depleted, and to prevent the total collapse of the economy, the government announced that
it would seek emergency loan from the International Monetary Fund (IMF) to overcome the
difficulties in the financial and currency markets.

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Prior to the crisis, the Korean economy was characterized by a dichotomy between a strong real
economy and a growing financial problem. In 1996, Korea had experienced a severe trade shock
and a cutback in business investment following a boom in the early 1990s. These forces had
reduced GDP growth from an annual rate of 9 percent in 1994-95 to 7 percent in 1996. The first
quarter of 1997, when GDP growth fell to 5.7 percent, appeared to mark a successful soft landing
(OECD, 1998).

Although domestic demand was weak, GDP still grew 6 percent during the first three quarters of
1997. Other macroeconomic statistics, such as inflation (4.3 percent) and unemployment (2.3
percent) were low by Korean historical standard as well as OECD standards. At the same time,
the current account deficit, which had soared to $23 billion in 1996, had been cut in half by the
third quarter of 1997. Thus, many analysts concluded that the economy was firmly underpinned
by cautious monetary and fiscal policies.

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The Korean crisis has been triggered by internal and external factors causing the collapse of the
financial market and economy of the country. These factors are considered below

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The financial crisis in Southeast Asia acted in a trigger for the Korean crisis. First, a drastic
devaluation of the currencies of the crisis countries impeded Korea¶s already-shredded
international competitiveness, and this contributed to strong downward pressure on the Korean
currency. Second, trouble in Southeast Asia acted as a wake-up call for foreign investors to re-
evaluate the risk of Korea, and to find out that Korea was already experiencing difficulties in the
financial market with the surge in non-performing loans. When the Hang Seng Index of the Hong
Kong stock market recorded a big downturn on 23 October 1997, foreign investors suddenly
started together in a panic to withdraw their investment and cut back their short-term loans to
Korea. The won depreciated by about 20 per cent against the US dollar through November 30
and the stock market index fell by about 30 per cent to a ten-year low. 2 Usable foreign currency
reserves declined sharply as the Bank of Korea financed the repayment of short-term debt of
Korean commercial banks¶ offshore branches.

The first trigger was the movement of the US dollar. A large part of the investment in Korea, and
for that matter elsewhere in the Asia-Pacific region during the first half of the 1990s, was
undertaken with the expectation that the dollar would stay weak. Moreover, while the dollar
continued to weaken, the prospect of borrowing in the dollar was too great a temptation for
Asian investors to resist. However, from mid-1995, at about the time Mr. Robert Rubin took over
the US Treasury, Washington reversed its policy of benign neglect of the dollar. For better or for
worse, the US considered a strong dollar in its national interest. As the dollar became stronger,
particularly against the Japanese yen, Korea¶s export competitiveness suffered. This was the case
for two reasons. As the US dollar weighed heavily in the determination of the Korean won under
the managed float system, the Korean won failed to depreciate as much as the yen. In addition,
Korean exports were similar in composition to Japanese exports and hence competed directly in
the international markets. Consequently, as the dollar became stronger against the Japanese yen,
Korea not only experienced an accelerated increase in its trade deficit, but also a severe drop in

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the profitability of investments undertaken for exports in particular. Some large business
conglomerates ran into financial difficulties around this time and non-performing loans (NPLs)
at Korean banks sharply increased, thus undermining the financial soundness of domestic
banking institutions.

The second trigger was the weakening Japanese yen had yet another consequence. It dried up the
flow of Japanese direct investment into Korea and other Asian countries, thus bringing to an end
the investment boom that had been going on in the region. As the yen weakened,

The value of dollar-denominated assets held by Japanese banks became larger in yen terms. As a
result, the BIS ratios of Japanese banks fell, which in turn, forced them to recall loans from their
clients in Japan as well as from those in Korea and other countries in Asia. This had two
consequences was an increasing frequency of refusal on the part of Japanese banks to roll over
their loans to both domestic and foreign clients and a strain on the foreign exchange reserves of
the countries, including Korea, giving rise eventually to a credit crunch for the whole region.

The last trigger was a combination of international and domestic developments. While the doubts
in the minds of foreign investors were growing, the currency crisis of Southeast Asian countries
continued to deepen. This soon developed into a region-wide contagion. In late October 1997,
the contagion spread to Hong Kong in the form of a speculation attack on the currency and a
sharp decline in the stock market. Although the currency attack subsequently failed, at the time it
was not clear whether Hong Kong government authorities had the capacity to prevent the
contagion from developing into a full-fledged crisis. With Hong Kong in difficulty, foreign
creditors, particularly American and Japanese banks, refused to roll over their loans to Korean
financial institutions. This forced the Korean government to use its limited foreign currency
reserves to help Korean financial institutions honor their short-term obligations. In this process a
substantial portion of the nation¶s foreign reserves was advanced to the overseas branches of
Korean banks. This quickly reduced the nation¶s usable foreign reserves to a dangerous level.
The withdrawal of foreign funds accelerated even more leading to a crisis and forcing the
government to officially request help from the IMF

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The Korean crisis had its roots in the weakened fundamentals of the Korean economy that had
accumulated in the process of rapid growth led by the government. Fundamental weaknesses of
the economy had exposed since the late 1980s onwards. The government-led economic policy
which was considered to have led the nation to its remarkable economics in the 1960s-1980s,
was no longer suited in the1990s as the Korean economy became larger and more complex and
as global competition became intensified. Instead excess government involvement in the
economy caused inefficiency, over-capacity and imbalances in many sectors.

The political sector had its ties with some businesses, intervening in the process of extending
loans to huge family-controlled conglomerates or chaebols and in deciding major state-funded
projects for political kickbacks in return and Korean banks had traditionally been easily
influenced by the government. They lent money according to the government's wishes, without
regard for the soundness of the borrower. Bank directors' elections are influenced by the
government, making them vulnerable to corrupt government officials

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The huge conglomerate cultivated a symbiotic relationship with the government, which could
help them out if something went wrong with investment. The Korean state¶s intervention in the
financial sector ended up in the problem of moral hazard .The results were over-borrowing by
the chaebols, putting them in an unstable debt-equity position, and a rise in external debt for the
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economy and Which in turn resulted in excessive risk-taking, overinvestment, low profits, and
insufficient attention to credit and exchange risks. These fault lines, which had existed for some
time but had not prevented rapid growth, nonetheless left Korea vulnerable to shocks in an
increasingly global financial market. As the financial meltdown spread through Asia beginning
in mid-1997, these fault lines were transformed into an outright fracture in Korea's fragile
financial system.The society as a whole came to accept the so-called "too-big-to-fail"
expectation. Under such a belief, the business firm's main concern became expansion in size
rather than to earn profits. To finance the expansion of businesses, firms chose the option of
debt-financed growth rather than equity-financed growth. The high debt-equity ratio that resulted
from such strategy exceeded 400 % by the end of 1997, and the average ratio for the 30 largest
chaebol reached 518 %. These figures are approximately twice the rate of Mexican firms and
four times the rate of Thai firms at the time of their crises

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Korea¶s financial system, corporate sector, and government elite shared an unhealthy symbiotic
relationship since Park Chung Hee¶s adoption of the classic model of state-led economic
development. Sanctioned with the authority to pick "winners"²whether it be firms or
industries²and ensure a limitless flow of capital to the chosen few, the government created a
host of moral hazard problems. The government¶s financial and policy backing led chaebols, or
conglomerates, to develop a "too big to fail" mentality; at the same time, heavy government
intervention in bank management led financial institutions to grow lax in scrutinizing loan
applications for creditworthiness and risk.

Problems related to over-investment by the major conglomerates and the accumulation of non-
performing loans by financial institutions--which had financed this investment binge were
becoming increasingly apparent. Beginning with the collapse of the Han-Bo Group in January
1997, South Korea faced a growing list of business failures among its chaebols. This trend
reached a climax in July with the failure of the Kia Group, South Korea's eighth largest chaebol
lead to major investors to lose confidence and to retrieve all the money and hence to a crisis.

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Korea's economic vulnerability was the highly leveraged corporate financial structure. The
corporate debt relative to nominal GDP ratio was lowest in 1987-1988 when Korea enjoyed
current account surpluses. However, since then, the ratio increased substantially to reach over 1.6
in 1996. Due to the highly leveraged financial structure, largely driven by the over-investments
of Korean conglomerates, chaebol, the corporate sector has become increasingly vulnerable to
unfavorable shocks.

A large portion of Korean short-term, unhedged debt had been directed into long-term, risky
investments such as real estate. In 1997, Korea had $170 billion in foreign debt, and practically
none of it was hedged. This means that the collapse of the won by 50 percent doubled the foreign
debt load of already highly leveraged Korean corporations virtually overnight causing a crisis.

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Korean external debt alone was not large enough to cause the economic crisis by traditional
criteria such as the debt-export ratio and the debt-- GDP ratio. Nevertheless, twin problems in
Korea-- weak financial systems and poor corporate governance practices--caused the country to
see its foreign debt almost double from $89 billion in 1994 to $170 billion in September 1997.

The ratio of short-term debt to foreign reserves (STDFR) is a rough measure of a country's
ability to meet its current obligations from its liquid resources. Table 1 (see appendix) shows that
ratios of short-term debt to reserves ratios increased sharply from 1994 to 1997 in most of the
crisis countries. In the three worst-affected countries--Indonesia, Korea, Thailand--short-term to
reserve ratios were well over 100 percent by mid- 1997; they received huge emergency rescue
packages from multilateral institutions in 1997. Other Asian countries with short-term exposures
less than 100 percent, such as Malaysia and the Philippines, faced economic difficulties in 1997
but avoided the need for emergency financial rescue packages from outside sources.
Thepolicymakers were more concerned about the capital inflow from export and hence the

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government neglected the need for adequateprudential regulation in this move. This led to an
increase in the short-term foreigncurrencydebts of financial institutions. Furthermore, as part of
the requirements forjoining OECD in 1996, the government implemented further financial
deregulation and capital market opening. But it chose to liberalize short-term capital inflows
ahead of long-term capital inflows

Korea had the highest short-term debt to reserves ratio, and the country's corporate sector had the
highest debt-to-equity ratio among the most seriously affected countries .This high debt-to-equity
ratio in the corporate sector reflected the high level of bank credit in Korea. Given the highly-
leveraged position of the corporate sector and resulting balance-sheet problems, the slowdown of
economic growth in 1997 triggered a 50 percent jump in the number of insolvencies.

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Corruption is considered as one of the main cause of Korean economic troubles. The corruption
of politician and businessmen would imply a lack of transparency, failure to observe a market
discipline (See Eun, et al. 1997). Decision making inevitably would be based on personal
relations. Past experience of military government was also said to contribute to corruption. Such
problems as cheap loans, tax breaks and other benefits in exchange of bribes triggered land
speculation and environmental exploitation. These problems were exposed when the economy
began to slow down.

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The governments' futile attempts to keep their currencies at artificially high levels; government-
directed banking systems and lending decisions; crony capitalism; massive overinvestment by
corporations funded by excessive borrowing; the lack of transparency that masked the extent of
problems they developed; inadequate; financial regulation and supervision; labor market
"rigidities", and a pronounced mismatch in the duration of assets and liabilities in both the
corporate and banking sectors (E. Han Kim, 1998). Then the Korean won should have
depreciated; otherwise the current account deficits would have continued. However, the Korean

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government adopted a strong won policy. The strong won policy was maintained with the so-
called market average foreign exchange rate system, which was adopted in 1990. The exchange
rate was allowed to move within the daily fluctuation band, which was kept narrow. The reasons
for why the government tries to maintain a high currency was, Firstly to achieve the target of one
digit inflation rate per annum, the Korean government insisted on the nominal exchange rate
stability. That is, inflation control was the overriding priority of macroeconomic policy and the
exchange rate was an µanchor¶ for inflation control. Secondly, the Korean government
maintained the position that strong won would push Korean firms to strive to increase their
productivity and hence international competitiveness. Thirdly, the government wanted to keep
the exchange rate stable in order to help domestic corporations and financial institutions by
lowering the domestic currency costs of servicing foreign debts denominated in the US dollars
and fourth, a political consideration also made the exchange rate policy less flexible.

Government-directed banking systems and their policymakers' unwillingness to relinquish

control, had created weak banking governance structures, resulting in concessionary loans to
prop up large firms in difficulty at the expense of small firms and shareholder value.

Responding to the precarious economic situation, the government launched the Presidential
Commission for Financial Reform to begin a comprehensive reform of the financial market. In
the labor market, a separate Labor Reform Commission was launched in early 1997. But such
early actions taken to prevent further economic deterioration failed due to several reasons. First,
conflicts soon surfaced as the Presidential Commission for Financial Reform and the Labor
Reform Commission began implementing sectoral reform measures. At the time, the
administration of President Kim Young Sam, who was also nearing the end of his term in office,
could not provide necessary leadership to aid those reform efforts. Second, the government's
unwarranted heavy-handed actions taken subsequent to the bankruptcies of Hanbo and Kia
disappointed foreign investors

In addition the excessive government control of the banking system made banking institutions
rely more on government intervention than on profit-first business. This, in turn, resulted in the
misguided advancing of bank loans to nonviable or insolvent borrowers. Thus, the active
government¶s involvement in the market resulted not only in corruption, but also in moral hazard

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and inefficiency in the general economic sector, and a weakening of the competitiveness of
enterprises and banks. These altogether, of course, left Korea vulnerable to shocks in an
increasingly globalizing financial market.

The Korean government also made a mistake with the exchange rate policy. When speculative
attacks on the Korean won began in October and accelerated in November, the Korean
government maintained a narrow daily fluctuation band and tried to defend the Korean won
inexplicably, wasting valuable foreign exchange reserves. As a consequence, Korea¶s available
foreign exchange reserves fell far below the outstanding short-term foreign debts. In retrospect,
if the band had been widened earlier and the exchange rate had been allowed to float freely, the
Korean won would have depreciated gradually and this would have helped limit the extent of the
crisis. In fact the Korean government underestimated the early signs and denied the possibility of
a financial crisis, repeatedly citing its strong GDP growth rates, high savings rates, budget
surplus and moderate inflation rates. Accordingly, even when warnings of the likelihood of a
crisis were circulating among foreign investors, it did not react to the signs properly and
decisively to prevent the actual crisis

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Perhaps the biggest contributor to the Korean financial crisis of 1997 is its gross misallocation of
capital and human resources, combined with a flagrant disregard for the bottom line. This
misallocation of capital and human resources caused by the lack of corporate governance had
resulted in the widespread value destruction by Korean companies, which in turn had led to a
lower value for the overall economy and weakened the banking sector. For example, only 27
percent of the listed companies (570 nonfinancial firms) created shareholder value from 1992 to
1996 and the rest--nearly three quarters of them--destroyed value (E Han Kim, 1999)

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There was a lack of supervision of the financial markets turned out to be a serious mistake. As
noted above, during the early 1990s, the financial market underwent a very rapid liberalisation
and deregulation. This allowed domestic financial institutions to have easy access to foreign
capital to finance domestic investment. The problem was that financial liberalization was done
without adequate process and provision of the safety net. Financial liberalisation was carried out
mostly on short-term rather than long-term capital inflows. For instance, the net foreign portfolio
investment, which was merely US$ 0.1 billion in 1990, increased drastically to US$ 3.1 billion in
1991, US$5.8 billion in 1992, US$ 10.0 billion in 1993. This upward trend continued until
1996.However, the net direct investment continuously revealed negative values, indicating that
the foreigners¶ direct investment in Korea was smaller than Korea¶s direct investment overseas.

Also, appropriate supervision and prudential regulation did not accompany financial
liberalisation. Especially, the secondary financial institutions such as merchant banks, which
increased sharply from six until 1993 to thirty by 1996, were not under appropriate supervision.
With the belief that the government would not allow financial institutions to fail, Korean banks
borrowed unhedged short-run foreign capital at lower rates, denominated in the US dollar, and
made long-term loans at higher rates, with expectation that they could continually renew short-
term borrowing. This led to serious mismatch in maturities between borrowing and lending.
Short-term loans accounted for 63 per cent of the total debts on the eve of the financial crisis.
With this fragile structure of foreign debt, Korea became very vulnerable to the instabilities of
the international financial markets.

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The banking crisis stemmed from certain long-standing characteristics of the country's industrial
policy. Banks played a significant role in Korean industrial policy by directing resources to firms

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that pursued investments in line with the government's aims. Although commercial banks were
privatized between 1981 and 1983, government interference remained high. The pattern of bank
privatization fragmented ownership structures with no shareholder permitted to own more than 4
percent of a bank's equity. In view of the ineffective monitoring of corporate sector behavior by
financial markets, this had often meant that the banks' management was accountable to no one,
except government, even after privatization.

In Korea, financial systems had allowed inside lending and close connections between lenders
and borrowers. Implicit and explicit government guarantees encouraged banks to take excessive
risks since banks would receive high profits if projects were successful and the government
would absorb the losses if projects failed. Thus, these practices further eroded incentives to
evaluate credit and inflated prices of financial and physical assets.

Korean banks posted a combined loss of 14.48 trillion won ($12.32 billion) in 1998, far higher
than the 1997 loss of $3.3 billion. Analysts estimate that the total loss of the banking sector in
1999 reached about $10 billion. Non-performing loans--defined as those in arrears for more than
a month or those that banks view as risky--at 10 major banks reached 30 percent of total credit
by the end of 1999, up from 23 percent at the end of 1998 and 13.5 percent at the end of 1997.
Banking analysts also say that the total cost of recapitalizing the banking sector would reach
$123 billion. The government had allocated about $60 billion to clean up non-performing loans
by the end of 1998 (Schuman 1999)

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The rapid expansion of debt-financed investment by large conglomerates, known as chaebols,

created excessive capacity, declined profits, and squeezed balance-sheet positions. These
problems, which are related to weak corporate governance, placed Korea in a dire predicament
despite its fundamental structural strengths such as high rates of savings and government budget
surpluses

Such an internal ownership of the chaebols tends to be centralized in one or more of the core
companies near the top of the pyramid of ownership. The chairman, often the founder of the
chaebol, tightly controls group policy through an informal but powerful centralized management
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team called the "planning and coordinating office," which directs the individual companies in the
group. The important role of this office appears to impinge on the authority of the directors of the
individual companies, which, in theory, are independent. The concentration of corporate
ownership, the strong influence of the founder's family, and the central management team on the
affiliated companies resulted in weak corporate governance practices.

/
| 2| |"|||

|
|'|(|
|
3|a|Hanbo Steel defaults on its loans, the first of a string of major corporate failures
in 1997.
|
|a|Speculators attack Thailand¶s baht.
|
3|a|The Bank of Thailand announces a managed float of the baht and asks the IMF for
technical assistance.
|
%! |a|Indonesia abandons its managed exchange-rate regime.
|
 *|a|The Korean won begins to rapidly depreciate.
|
- *|a|The IMF approves a $21 billion loan for South Korea, part of a bailout package
that will total $58.4 billion. Dae-jung Kim is elected president of South Korea.

3|a0|International creditor banks and the South Korean government agree to exchange
$24 billion of short-term debt for new loans with staggered one- to three-year maturity dates.
The Korean government shuts down a third of its thirty merchant banks.
|
4*|a0|Layoffs are officially codified under the amended Labor Standard Act following
the Tripartite Agreement reached by the government and the business community. The
Legislation of the Manpower Lease Act legalizes the use of temporary workers.

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%! | a| The South Korean government begins dismantling the second biggest
conglomerate in the country, Daewoo, which is in technical default.
'$*|a|To avoid financial market seizure due to the collapse of the Daewoo group, the
Korean government organizes a commercial paper market stabilization fund and raises $24
billion.
|
- *|a|President Dae-jung Kim announces the end of the currency crisis.
|

%! |

a|Korea repays its $19.5 billion IMF loan.


| $ |||'|(|

|

|
The crisis has led to several impactson the different industries of South Korea more especially on
the financial marketand on the economy as a whole.

 a| -*|4

!|
The total corporate debt measured as the ratio between company's liabilities and its capital
employed was increasing steadily throughout the 1990's, achieving its peak in 1997. There were
several remarkable features of this debt, which explicitly contributed to the collapse of many
corporations and implicitly, through the growing number of non-performing loans, to the
bankruptcy of banks and non-banking financial institutions (NBFIs). First, the increasing trend
towards indirect financing of the corporate sector in Korea mirrored the relatively undeveloped
bond and equity markets (between the first half of 1996 and 1997 the exposure of banks and
NBFIs to cheabols almost doubled while direct financing declined by 20 percent (OECD, 1998)).
In 1996, in terms of capitalization, the equity market in Korea was equal to 25.4 percent of GDP.
This fell far below that of the developed world (108.7, 67.6, 47.8 for the United States, Japan and

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G-10 Europe, respectively) and represented a sharp fall from 1990, when the equity market
capitalization was equal to 43.6 percent (BIS, 1997 Annual Report). Highly leveraged cheabols
became prone to shocks that cause a fall in cash flow (i.e. a terms of trade drop) or an increase in
payment obligations (due to an interest rate increase). The situation became worse at the
beginning of 1997 when an almost 50 percent slide of market equity value was observed
compared to its 1995 high. This affected not only cheabols, but also banks as cheabols were
purchasing equity for loans granted. The similar trend was observed in terms of the market
capitalization of shares of domestic companies (main and parallel markets, excluding investment
funds). In 1994, the capitalization was equivalent to around 118 percent of GDP. However, by
the end of 1997 it dropped together with the stock market decline to only 23 percent of GDP.

Secondly, the corporate sector debt in Korea was, to a high degree, concentrated in the thirty
largest cheabols. The exposure of the thirty largest chaebols to non-bank financial institutions in
Korea was increasing as shown by table 2 (see appendix). Between 1988 and 1992 the share of
banks in corporate debt financing dropped by 6.3 percent, but that of NBFIs increased by 8.1
percent. Taking into consideration the minimum supervision imposed on non-banking financial
intermediaries, there was no doubt they were eager to make loans to the business sector and
individuals. Overall, the high dependence of the Korean corporate sector on debt as opposed to
equity finance was clearly evident and extremely high even by international standards.
Throughout all the 1980's and 1990's the debt/equity ratio averaged from around 400 percent to
500 percent plus [4]. On the other hand, the debt/ equity ratio for the United States oscillated
around 50±100 percent, for the United Kingdom slightly less at that time. Even Japan, which
expanded beyond 350 percent in 1980, in 1994, was down to around 150 percent. Enormous
debt/equity imbalances in Korea had their roots in the system of debt guarantees within cheabols,
lax capitalization rules and low effective tax rates on interest income implemented to pursue the
rapid growth of the economy [IMF, 1999]

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| $
|

The industrialization strategy implemented in Korea fuelled by the financial system liberalization
resulted in domestic credit expansion. Furthermore, the surge in banking borrowing was typified
by five important characteristics (all key for the future of the banking system):
± Credit, in the most part, was extended to the private sector to finance new investments; public
sector borrowing played a minor role,

± Explicitly, it indicated a falling quality of loans and amplified the probability of

acceleratingnon-performing loans,

± Borrowing, for the most part, was short-term and foreign currency dominated,
± Non-banking financial institutions were the major intermediaries of funds,

± Expansion of overseas branches of domestic financial institution resulted in the situation where
70 percent of total debt accounted for the banking sector, direct finance played a minor role
[Dooley et al. 1999].

Bank credit grew more than 20 percent per annum in 1996 and 1997. Moreover, the ratio of bank
credit to GDP was also increasing at a very high pace. The fact that loans were invested in the
risky business of low profitability and declining rates of return led many of them to become non-
performing, putting an extraordinary burden on the banking sector.

Alongside the domestic credit growth, total claims on the private sector were also increasing.
Between 1994 and the first quarter of 1996, total claims of deposits in banks as a percentage of
GDP was averaging around 55 percent of GDP. From the second quarter on, it was

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systematically growing, reaching 65 percent at the onset of the crisis as shown in figure 1(see
appendix).

  | %*
|
 
 |
Compounding the impact of the crisis has been a substantial fall in consumer confidence and
spending. The automobile sales within the region are expected to decline significantly during
1997-1998. At the end of 1996 the debt to equity ratio of Ssangyong Motors, a company that
specializes mainly in four-wheel drive vehicles, stood at 10,496%. The average debt ratio for
autoproducers increased from 416% in 1995 to 530% in the following year, substantially above
the (very high) average level of 300% for all manufacturing companies (Korea Herald, May10,
1997). Ssangyong and Kia were alleged to have made no profits in their autooperations
throughout the 1990s. As the crisis hit and exports and earnings slumped, prospects for financing
those debts dimmed. More than one-quarter of the chaebol have now collapsed, including the
automotive conglomerate Kia and the Halla Group, involved in ship-building, engineering and
auto parts.|
|
 &| '|(5 | 
|

||

Economic and financial liberalization did not cause significant macroeconomic imbalance,
because the Government maintained prudent fiscal and monetary control and pursued a cautious
approach to capital market opening. The macroeconomic environment was stable throughout the
1990s. Economic growth rate was high, especially in 1994-1996, averaging at 8 percent as
shown in Table 3 (see appendix). Inflation was steady at about 5 percent. The domestic interest
rate was high due to strong investment demand by firms, but gradually declining. Fiscal and
monetary policies were also sound. Monetary policy was reasonably stable, although somewhat
expansionary when measured by the growth of M3, which was not subject to control by the
monetary authorities. Monetary growth rate further stabilized beginning in 1994 despite
continued expansionary pressure from increased foreign capital inflow. The consolidated budget

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has produced a surplussince 1993. The only imbalance was in the current account position. The
country had a current account deficit throughout the 1990s, except in 1993, and this expanded in
1995-1996 as shown in Table 3 (see appendix). Nevertheless, official foreign reserves increased
owing to large capital inflow.
|
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'|(|6|
|
The Korean won, meanwhile plunged to less than 1700 per dollar from less than 1000, however,
despite initial sharp economic slowdown and many companies going bankrupt. This crisis has
caused the devaluation of the WON. However South Korea has managed to triple its per capita
GDP since the 1997 crisis to 2006 in dollar terms, continuing its growth from 1960 as the world's
fastest growing economy in the period (1960-2006), per capita GDP having grown from $80
capita to over $18,000. However, like the chaebol, South Korea's government didn't come out
unscathed, as its national debt to GDP ratio more than tripled after the crisis.

 
|!7|
|
Figure 2 (see appendix) shows the annual growth rate of real per capita GDP for South Korea
1960 to 2000. The sharp economic contractions in 1998 for South Korea are evident: real per
capita GDP fell by 8 percent n South Korea. In 1999-2000 economic recoveries occurred, and
the per capita growth rates were positive in the economy. Among the five crisis countries, the
annualized per capita rates were 8 percent in South Korea.
|
$||

South Korea essentially enjoyed full employment from 1988 to 1998, with an unemployment
rate around 2%. However, it sharply surged to 6.8% in 1998 and 6.3% in 1999. From the second
half of 1999 onward, the Korean economy started to recover, and unemployment decreased to
4% in 2000. For 2001, the rate is forecasted to be around 3.7% to 4.2% as shown in Figure 3 (see
appendix). The figure below shows that the mass unemployment crisis would not recur.
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However, there seems to be no chance of restoring the ³low unemployment structure´ Korea had
before the economic crisis.

The economic conditions of high growth and low unemployment from 1987 to 1997 were
beneficial for the Korean labor movement. But, the Korean economy has become more
unpredictable and unstable, with negative growth and high unemployment in 1998 and then high-
growth/high-unemployment conditions in 1999. In short, the Korean economy is transitioning to
an economic structure characterized by midlevel growth and mid-level unemployment.

$|   |
|

During the economic crises, high operating profit rates resulted from enormous cuts of
employment costs through the reduction of jobs and wages. While the proportions of
employment costs to sales had been stabilized around 12% to 14% between 1988 and 1996, it
declined to 11.4% in 1997 and to 9.8% in 1998. Even in1999, when the economy recovered, it
stayed at a relatively low 9.8% as shown by Figure 4 (see appendix). Accordingly, the proportion
of employment costs-to-sales in the manufacturing sector has remained at its lowest level since
the 1970s.

|8*||
|
$|
|
The number of employed persons continuously increased through 1997, with 21.1 million
workers, or an employment rate of 60.6%. But, the advent of economic recession and full scale
implementation of structural adjustment after the 1997 crisis reduced employment by 1.1 million
in 1998, shaving 4.1% off of that rate. By 1999, however, the economic recovery was under way,
and in 2000 the numberof employed persons recovered its pre-crisis level. Even so, the
employment ratein 2000 stayed at 58.4%, which is far beneath the 1997 level as shown by Figure
5 (see appendix).

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Considering employed persons by industry, the share of employed persons in
agriculture/forestry/fishing and in mining/manufacturing had decreased continually through the
1990s as shown in figure 5 (appendix). Employment shares in agriculture/forestry/fishing
increased from 11.3% in 1997 to 12.4% in 1998, and in mining/manufacturing, employment
increased from 19.6% in 1998 to 19.9% in 1999 (temporary phenomena due to the scarcity of job
opportunities in other sectors at that time).
The number of employed persons in wholesale/retail trade/hotels/restaurants and other
community/social and personal services continued to increase even in 1998. The share of
employed persons in these industries among all industries increased from 42.0% in 1990 to
51.5% in 1999.
|
!|7 |
|
While the number of wage workers had been increasing continuously, it decreased by 1.04
million in 1998. Since 1999¶s economic bounce back, the total number of wage workers began to
increase again and recovered its pre-crisis level in 2000. While the total number of employed
workers generally continued to grow, the number of regular workers has kept decreasing since
1995 after hitting a record high of 7.43 million workers. In 1998, it decreased by 690,000 year-
on-year. And in 1999 when the economy recovered, it decreased by 410,000 year-on-year; Korea
had to wait until 2000 for this trend to reverse.

 |

*
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|
The rate of wage increases between 1987 and 1996 had been close to the level of GDP¶s growth
rate plus the CPI growth rate. And, as the number of wage workers had increased, employment
costs-to-gross value added was improved. However, as wage growth in 1997 was 6.1% less than
GDP growth plus CPI growth, and the number of wage workers decreased in 1998, the
employment costs-to-gross value added hit a record high of 64.2% in 1996 before beginning to
decline. In 1999, when the number of wage workers again increased, the rate of wage increase
was 10.5% less than GDP and CPI growth combined. As a result, employment costs-to-gross
value added declined to 59.8%. These can be shown by figure 6(see appendix). Furthermore, as

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the number of contingent workers in Korea¶s labor market has increased, the wage inequality
between workers by employment form continues to widen. Since 1993, the GINI coefficient and
the proportion of the bottom fifth¶s income to the top fifth¶s income (top 20% income ÷ lowest
20% income) have continued to increase. As the number of contingent workers has sharply
increased and the wage gap has widened, the GINI coefficient reached 0.3294, and the
proportion of the bottom fifth¶s income to the top fifth¶s income has stood at 5.49.
.
 |

The massive currency devaluations that inaugurated the crisis had an almost immediate impact
on prices of goods and services with high import content. Food prices rose more rapidly in most
countries than non-food process. Overall inflation occurred to varying extents in crisis countries,
depending on fiscal and monetary responses.

Inflation not only eroded real incomes but, together with the collapse of regional stock market,
also drastically reduced the real value of household savings. Thus, higher prices and lower real
wages effectively spread the cost of labour market adjustment over a broader population beyond
the unemployed workers


|
!|
In the wake of the Asian market downturn, Moody's lowered the credit rating of South Korea
from A1 to A3, on November 28, 1997, and downgraded again to B2 on December 11. That
contributed to a further decline in Korean shares since stock markets were already bearish in
November. The Seoul stock exchange fell by 4% on 7 November 1997. On November 8, it
plunged by 7% the biggest one-day drop recorded there to date. And on November 24, stocks fell
another 7.2%.
|

|4|!
|
$ |

In line with the IMF Stand-By Arrangement the Korean government was required to implement
tough measures including tight monetary policy and the immediate closure of insolvent financial
institutions as a remedial measure. The IMF¶s pressure of the Korean government to implement

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the radical restructuring of Korea¶s industrial corporations and financial institutions in the midst
of an economic and financial collapse is another controversial issue. Because it is almost
impossible to identify and eliminate weak and inefficient firms and banks when almost every
firm and bank faces insolvency and the entire price-profit system is in chaos. Insistence of IMF
on shuttering many banks despite the fact that systems of deposit insurance hardly exist led
panicky depositors to withdraw their deposits even from sound banks, and hold cash instead. Its
insistence on cutting demand and liquidity accelerated the bankruptcy or radical devaluation of
the value of firms that were efficient and profitable, as well as those that were not.

However, although high deposit rates offered by domestic banks seem to have suppressed
outflow of domestic capital, the social cost of doing this has been a widening income gap
between a few rich and the remaining impoverished population. Moreover, the increase in the
country¶s foreign exchange reserves has largely been attributable to drastic reductions in
domestic demand. In this respect, the IMF prescription for high interest rates was an excessive
austerity measure in a country where the macroeconomic conditions were basically healthy to
begin with and it had been in force during the first six months since the eruption of the crisis.
Above all, the high interest policy failed to achieve its primary objective of inducing net capital
inflows. On the contrary, it diminished investors¶ confidence in the economy as they were
concerned that excessively high rates could push Korea¶s corporate sector into insolvency. The
policy rather served disintegration and restructuring Korean chaebols

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0
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The recovery process differs country by country, depending on the country¶s economic
fundamentals, institutional factors, and the world economic conditions at the time of the crisis.
Even though countries may have similar GDP growth rates during the recovery period, other
economic variables such as domestic credit growth, inflation, and real wage growth rate may
vary. The study of recovery requires careful investigation of each country¶s experience before
theorizing the process in general. South Korea has demonstrated the fastest recovery among the
Asian countries by blocking its downward spiral as shown by the figure 7 (see Appendix).
Korea¶s ability to contain its downward spiral has a lot to do with the government¶s traditional
role as a moderator in the financial market.

0 a| 7||

| |
|% 9|

|
|4|.!|

The International Monetary Fund has been the key player in coordinating support packages for
the troubled Asian economies. The IMF says that it has learned from the Mexican Peso crisis in
1995 and had instituted emergency procedures that enabled it to respond to each the crises in
each Asian country in record time.

The Korean government, realizing that the nation was in serious financial crisis, agreed in
December 1997 to a $58 billion bailout led by the International Monetary Fund (IMF). The
IMF¶s bailout decision was based on the fear of possible default by Korea, which was the

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world¶s eleventh largest economy. The default of Korea would pose a grave threat to the
international monetary system. The immediate purpose of the bailout was to provide a bridging
finance to reduce current-account deficits, keeping inflation in check by restricting domestic
demands. The agreement further stipulated macroeconomic targets for monetary, fiscal, and
exchange rate policies.

On 3 December 1997, Korea and the IMF signed the agreement for a financial aid package
totalling US$ 58.3 billion, subject to a broad range of conditions including macroeconomic
stabilization and structural reform. The IMF committed emergency funds amounting to US$ 21
billion. An additional US$ 14 billion was committed by the World Bank and the Asian
Development Bank. As a second line of defense, a further US$ 23.3 billion was pledged by the
United States, Japan, Australia and other interested countries that would be made available to
Korea by the G-7 countries only if the initial amount of $35 billion contributed by the IMF and
other multilateral institutions proved inadequate.

The key element in the IMF¶s stabilization package was the elevation of the interest rate. Interest
was raised from the precrisis rate of 12% to 27% by the end of 1997 and up to 30% in early
1998. The objective of interest policy was to induce the investors to keep their savings in
domestic currency and additionally to attract foreign investment in the hope of stabilizing the
value of the Korean won. High interest rates would not only attract capital inflow but also crimp
aggregate demand, which should improve the country¶s trade balance.

When Korea faced imminent default by 24 December the IMF, backed by the United States,
decided to press the foreign commercial banks to roll over their short term credits on an enforced
basis. The IMF insisted on the comprehensive debt rollover as a condition for further
disbursements of the IMF lending package. Initially the banks and the Korean government
announced a freeze on debt servicing. On 16 January the Korean government and the banks
formally agreed to a complete rollover of all short term debts falling due in the first quarter of
1998. On 28 January an agreement was reached to convert US$ 24 billion in short-term debt into
claims of maturities between 1and 3 years. The new arrangements put a brake on the fall of the
won and on the decline in the stock market in Korea.
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The interest rate policy, to a certain extent, succeeded in stabilizing the currency market by
preventing capital hemorrhage and Korea¶s trade balance also showed some improvements.
However, its costs seemed to have outweighed its benefits.

The Korean economy faced a difficult situation. The Government had to perform two tasks: (i)
resolve financial sector problems, that is, clean up losses already incurred and (ii) reduce the
structural problems as well as establish new rules and institutions to prevent further deterioration
of the corporate environment.

0 | |4

|' |" |||' |" |
|
Since the Korean crisis had its roots in the weakened fundamentals of the Korean economy,
attempting to stabilize only the financial market without an emphasis on structural reforms is like
treating symptoms without addressing the cause. Upon the signing of the financial aid package
on 3 December 1997, the Korean government agreed with the IMF that it would pursue an
economic reform program in the financial sector, the corporate sector, and labour markets. In
addition, the Korean government has pursued public sector reform to achieve the efficiency
necessary to keep up with other sectors¶ reform.

In order to facilitate the financial sector reform, the National Assembly passed several economic
laws early in 1998, thus creating the Financial Supervisory Commission (FSC), the Korea Asset
Management Corporation (KAMCO) and Korea Deposit Insurance Corporation (KDIC).
Authorities closed or suspended the operation of a number of non-viable financial institutions.
As of July 1999, 144 financial institutions have been liquidated, 48 have been merged, and 59
have had their licences suspended. Disposal of non-performing loans and recapitalisation has
also been an important part of the financial sector restructuring. As of July 1999, KAMCO and
KDIC together financed a total of W 64 trillion for the financial sector restructuring. Capital
market liberalisation and promotion of FDI have also been an important aspect of the financial
sector reform. Various measures have been taken by the Korean government to liberalise the
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capital market and promote FDI. For instance, since May 1998, the foreign equity ownership
ceiling has been completely removed, and hostile mergers and acquisitions (M&A) by foreign
investors has been allowed. Financial restructuring cannot succeed without corporate debt
restructuring.

The corporate sector reform has been led by the creditor banks. The top five 

and their
creditors reached agreement on debt reduction and other restructuring measures in early 1998.
Specifically, they agreed on seven measures namely adoption of consolidated financial
statements, compliance with international standards of accounting, strengthening of voting
rights of minority shareholders, compulsory appointment of at least one outsider director,
establishment of an external auditors committee, prohibition of cross-subsidiary debt guarantees
from April 1998, and resolution of all existing cross-debt guarantees by March 2000. Another
element of the corporate restructuring has involved business swaps referred to as the µBig Deal¶
between the top five 

. The objective of the µBigDeal¶ was to streamline over-investment
and enhance efficiency in such key industries as semiconductors, petrochemicals, aerospace,
rolling stock manufacturing, power plant equipment, vessel engines, and oil refining. In
December 1998, the top five 

reached agreement on much of the deals. In addition, the
top five 

were required to reduce their debt-to-equity ratios and improve their financial
structure by asset sales, recapitalisation, and foreign capital inducement.

Legal proceedings for corporate rehabilitation and bankruptcy filing were simplified in February
1998 to facilitate market exit of non-viable firms, and ensure better representation of creditor
banks in the resolution process. In May 1998 creditor banks assessed the viability of 313 client
firms showing signs of financial weakness, and listed 55 corporations as non-viable. To facilitate
the exit of those non-viable corporations, their banks denied them new credit and cross-subsidy
bailout. As of July 1999 creditor banks have also carried out workout programs for 76
corporations out of 80 candidates, which were subsidiaries of the 6th through 64th 

in
terms of their size. The subsidiaries of Daewoo group, the third largest 
, have been
included in corporate workout programs as Daewoo faced financial troubles in July 1999.

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Labour market reform efforts have also been made. In February 1998, greater labour market
flexibility was instituted with the revision of the Labour Standard Act (LSA), which legalised
layoffs for µmanagerial reasons.¶ The revision of the LSA facilitated necessary layoffs in the
process of financial and corporate sector reforms.

The Tripartite Commission composed of labour, management, and government was established
in January 1998 to deal with industrial relations. The Tripartite Social Accord was signed in
February 1998. The Accord covers not only the labour-related matters, but also a wide range of
socio-economic matters. In particular, it includes matters such as the promotion of freedom of
association, management transparency and business restructuring, labour market policy, the
extension and reform of the social security system, wage stabilisation and the improvement of
labour-management cooperation, and the enhancement of labour market flexibility. The Accord
is a landmark turning point in the history of Korean labour-business relations and corporate
culture. However, the Tripartite Commission has seen ups and downs, as labour representatives
have not considered it a truly beneficial body for workers.

In addition to the new LSA, legislation allowing the establishment of manpower dispatching
businesses took effect in July 1998. Manpower dispatching businesses provide employment-
outsourcing services for 26 occupations. This measure is also expected to further enhance labour
market flexibility. The Korean government has pursued streamlining its organizational structure
and plans to reduce its employment by 11 per cent by the end of the year 2000. In addition, the
quasi-government sector including public institutions and various associations has also been
streamlined.

0  | 2|" |$|'* :|

|
Korea has implemented financial sector reforms since the 1997-98 crisis, in order to achieve two
overriding goals, firstly to reduce the likelihood of a similar crisis in the future by cleaning up
the balance sheets of financial institutions and secondly, to evolve a financial system that can
best help the nation resume growth with stability.

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The contents and significance of the reforms that have been actually undertaken to date can best
be reviewed under six headings namely (a) reforms designed to strengthen the legal and
regulatory infrastructure, (b) reforms implemented to rehabilitate the financial sector, (c) reforms
aiming at strengthening prudential regulation, (d) reforms to reduce moral hazard, (e) reforms to
promote capital account liberalization and (f) reforms to strengthen the corporate governance of
financial institutions.

a)| '!
!|!||!|
  

The first step in comprehensive financial sector reform was laying out a statutory and regulatory
framework to implement necessary reforms. On December 29, 1997, thirteen financial bills,
including a bill to establish a consolidated financial supervisory authority, were enacted. It is
ironic to note these bills were for the most part based on recommendations made by the
Presidential Financial Reform Commission that had been launched in January 1997, and the bills
were for all practical purposes the same bills the national legislature had refused to act on
November 16.

In any case, thanks to this legislation, the Financial Supervisory Commission (FSC) was
established on April 1, 1998, and in January 1998, existing separate financial supervisory organs
were merged into a consolidated Financial Supervisory Service (FSS) to serve as an
administrative body for the FSC. In addition, the Financial Industry Restructuring Act was
amended so as to give FSC and FSS effective statutory authority to order write-offs, mergers,
suspension, and closure of ailing financial institutions. Earlier, the Korea Asset Management
Corporation (KAMCO) was reorganized and an NPL resolution fund was created within
KAMCO to facilitate the purchase of nonperforming loans from financial institutions.

*;| "*


!|

|
 

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Korea¶s banking sector had two major problems: inadequate capitalization and poor-quality
assets. This was of course due to the large number of chaebol bankruptcies that damaged banks¶
balance sheets. These balance sheets carried many non-performing loans. In order to address

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these problems, the government had to step in with public funds. Although the injection of public
funds was sure to generate public controversy, the government had no choice if it wanted to have
a workable financial system for the nation. Once the government decided to inject public funds
to rehabilitate the financial system, the first question it had to resolve was what exactly
constituted ³non-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.

The actual amount of funds disbursed by 2002 substantially exceeded both estimates. It was no
less than 160.4 trillion won, or 30% of the 2002 GDP. Two thirds of public funds were raised
through bonds issued by KAMCO and Korea Deposit Insurance Corporation (KDIC). More than
40 trillion won was 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. In June 1998, five banks with negative BIS ratios were closed, and
seven banks were required to submit restructuring plans by the end of July 1998.

In the non-bank financial sector, merchant banks required urgent policy attention as they were
heavily engaged in activities such as limited deposits, loans, securities investment, international
financing, and leasing. The subsequent bankruptcies of major corporate groups such as Sammi
and Jinro in 1997 eroded market confidence in merchant banks and exacerbated their borrowing
difficulties both at home and abroad. Consequently, the number of remaining merchant banks
was reduced from 30 at the end of 1997 to only three by June 2003 (Ahn and Cha, 2004).

Other non-bank 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.

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In December 1999, under the terms agreed with the IMF, the Korean government strengthened
prudential regulation by introducing a forward-looking approach in asset classification, taking
into account the future performance of borrowers in addition to their track record in debt
servicing. In March 2000, the asset classification standards were further strengthened 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. Other measures the
FSC took over the past several years to strengthen prudential regulations include strengthening
regulations on short-term foreign borrowing by banks, strengthening limits on bank lending to
large borrowers, and strengthening disclosure requirements for financial institutions.

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In addition to tightening asset classification and cleaning up non-performing loans, the
government took forward-looking measures to improve the efficiency and stability of the
financial system through reduction in moral hazard. 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.

As for moral hazard on the part of lenders to large corporate borrowers as well as borrowers
themselves, massive corporate failures 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.

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In order to further liberalize capital account transactions, the government has taken numerous
measures over the past several years. For example, a free-floating foreign exchange rate system
was adopted in December 1997. Restrictions on M&A¶s by foreigners were abolished in
February 1998. Furthermore, foreign investment in Korean equities listed in the Korean Stock
Exchange and KOSDAQ was fully liberalized in May 1998, and foreign investment in the
equities of non-listed firms was permitted in July 1998. The government also 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. It should also be noted that
beginning this year, no advance permission is required for any international capital account
transactions; many transactions, however, need to be reported ex post.

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In order to strengthen the governance of financial institutions, many measures have been taken.
They include allowing foreigners to own commercial banks and become bank executives in
December 1997 and May 1998, 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.

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Despite various potential risks remaining in the financial sector, the overall outcome seems to
have been positive. As a result of extensive restructuring of the financial sector, many insolvent
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or very weak institutions have been weeded out. As a matter of fact, 787 insolvent financial
institutions, or 37.5% of the total, were closed or merged by June 2003. In addition, both the
capital adequacy ratios and profitability of most of the nation¶s financial institutions have greatly
improved. For example, the BIS ratios of the nation¶s commercial banks are now comparable to
those in other industrially advanced countries, 15 and the commercial banks began to earn profits
in 2001. In 2005, they recorded 24.5 trillion won in profits and both financial institutions and
their customers have freed themselves from the high dose of moral hazard they had been
suffering from.
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Due to those reforms that have liberalized capital account transactions, trading volume in
Korea¶s foreign exchange market has grown significantly since the crisis. Some of the increasing
foreign exchange derivative activities reflect the increasing hedging activities. Moreover, the
foreign exchange authorities in recent years have shown remarkable restraint in intervening in
the foreign exchange market, producing a noticeable increase in exchange rate flexibility. The
money market also has become liquid at least for maturities below 90 days. The market for
corporate and government bonds has become deep and active, and recently there has also been
issuance of 10-year treasury bonds, which enhances the market¶s ability to price risk for long
maturities.

Hence, as can be observed from the Table 4 (see Appendix), Korea has made a recovery from the
crisis and regained its economic vitality. Not only have Korea¶s economic fundamentals
improved, but also its external vulnerability has been sharply reduced. Although their positive
effects on Korea¶s long-term growth potentials are very questionable, neoliberal restructuring
reforms have had a positive impact on confidence, which boosted capital inflows. During 1998-
2001, Korea has received a total of 52 billion dollars foreign direct investment, more than twice
the amount that landed during the past three decades. Korea¶s foreign exchange reserves, which
were nearly depleted in the depth of the crisis, have been replenished substantially. Its foreign
currency reserves of US$115.0 billion as of July 15, 2002 rank as the fourth largest in the world,
following Japan, China, and Taiwan (- "&| 2002). With the assistance of these swelling
reserves, the government fully repaid its IMF loan (US$19.5 billion) in August 2001, three years
ahead of the schedule. The nation¶s current economic health has been widely recognized.
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Following the Moody¶s and Fitch upgrades, Standard & Poor¶s raised the long-term Korean
foreign currency rating from ³BBB+´ to ³A-´ on July 24, 2002. Korea¶s foreign currency rating
has been returned to pre-crisis ³A´-levels by the three major credit rating agencies.


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The Korean 1997-98 crisis was inevitable in the wake of rapid economic liberalization and
opening of the highly regulated economy. The crisis was not due to a single factor but rather to a
confluence in time of a multitude of factors to which both domestic and international
circumstances contributed significantly. The crisis also demonstrates how unforgiving global
capital markets are to mistakes in economic policy and to institutional inadequacies within
countries and how severe the penalties for mistakes are. This is not surprising to specialists in
international finance. Keynes (1930), Tobin (1974) and Davidson (1997) have long warned us
about the dangerously excessive volatility of world financial markets and urged alternative ways
of restructuring them so as to make them more robust. But the Asian economic crisis, which
occurred in the best performing economies in the world, brings this forcefully to the fore. In a
country such as Korea with high savings and a balanced budget, the IMF¶s harsh austerity
program transformed a currency crisis into a severe economic recession. Such painful
contractions could have been avoided with a less restrictive condition on the macroeconomy
(Feldstein 1998). Although emerging markets may be intrinsically vulnerable to the volatile
forces of external capital, the root cause of the Korean crisis must nevertheless be seen as
originating from the factors internal to the domestic economy. The process of liberalization
should thus be gradual and prudential, proceeding only as the domestic financial system is
strengthened. The Korean case demonstrates the economic imperative of proper state governance
in market reforms. Market forces by themselves cannot serve as a mechanism to correct various
forms of market failure. Success in policy reform should be seen as ephemeral unless there is
assurance that similar crises will not be repeated. Financial reform in an emerging economy can
serve only as the stepping stone to the next phase of comprehensive structural reform. Though
the Korean economy has overcome the worst of the crisis and the possibility of a repetition of
1997¶s external liquidity crisis has been significantly reduced, nevertheless, the situation calls for
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caution, as there are many obstacles to the full recovery of the Korea economy. If the positive
preconditions are met and the structural reform is accomplished smoothly the crisis could turn
out to be a blessing in disguise which will pave the way for the sustainable and equitable growth
in Korea for the future. A decade later, the Korean economy is facing another crisis. The current
crisis has spilled over from the U.S. subprime mortgage crisis, rather than from the Southeast
Asian currency and banking crises that started in 1997. The current crisis is different from the
previous one in its origin, contagion channel, nature and scope. The Korean economy, however,
is believed to be better prepared for this crisis.

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| "  |
J| Kim Kihwan (2006) ³The 1997-98 Korean Financial Crisis«´
www.imf.org/external/np/seminars/eng/2006/cpem/.../kihwan.pdf

J| Yoon Je Cho ³The Financial Crisis in Korea«´

www.adb.org/Documents/Books/Rising_to_the.../kore-mac.pdf

J| Hyun-Hoon Lee ³Korea¶s 1997 Financial Crisis«´

cc.kangwon.ac.kr/~hhlee/paper/Lee_Agenda.PDF

J| Kwan S. Kim (2000) ³The 1997 Financial Crisis«´

www.nd.edu/~kellogg/publications/workingpapers/WPS/272.pdf

J| Jahyeong Koo and Sherry L. Kiser (2001) ³Recovery from a Financial Crisis«´
unpan1.un.org/intradoc/groups/public/documents/.../unpan033326.pdf

J| Lee, Keun S (1998) Financial Crisis in Korea and IMF. Department of Marketing &
International Business.
http://www.hofstra.edu/pdf/biz_MLC_Lee1.pdf

J| Pollack, Andrew (1997) "SOUTH KOREA SAYS I.M.F. HAS AGREED TO HUGE
BAILOUT." http://query.nytimes.com/gst/fullpage.html
J|
J| BBC News (1997) "South Korea: How the IMF Deal Works.".
http://news.bbc.co.uk/2/hi/world/

J| CNN News (1998) "South Korea, IMF Try to Finalize Economic

Bailout.".http://www.cnn.com/WORLD/9712/02/korea.imf/
J|
J| Copy.Lee, Hyun-Hoon (1999), µA µStroke¶ Hypothesis of Korea¶s 1997 Financial Crisis:
Causes, Consequences and Prospects¶, the University of Melbourne Department of
Economics (ResearchPaper, No.696).
http://www.ecom.unimelb.edu.au/ecowww/research/696.pdf

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J| Brander, James A. and Barbara J. Spencer, 1985. \Export Subsidies and International
Market Share Rivalry," Journal of International Economics

J| Cathie, John, 1997. \Financial Contagion in East Asia and the Origins of the Economic
and Financial Crisis in Korea," Asia Paci¯c Business Review

J| Economist, The, 1995. \The House that Park Built: A Survey of SouthKorea."

J| Hattori, Tamio, 1997. \Chaebol-Style Enterprise Development in Korea," The

Development Economies,

J| Kim, KonSik, 1995. Chaobel and Corporate Governance in Korea, Ph.D. Dissertation,
University of Washington.

J| Smith, Heather, 1998. \Korea," in East Asia in Crisis: From Being A Miracle to Needing
One?, edited by Ross H. McLeod and Ross Garnaut. London: Routledge

J| Saxena, Sweta C. and Kar-yiu Wong, 1999. \Currency Crises and Capital Controls: A
Selective Survey, mimeo University of Washington.

J| Steers, Richard M., YooKeun Shin, and Gerardo R. Ungson, 1989. The Chaebol: Korea's
New Industrial Might, New York: Harper & Row Publishers

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