FINANCIAL MARKETS

Korean Stock Exchange, 1998 - Case Study

Section A, MBA 2020

Introduction
Case: The cause for the financial crisis in South Korea in 1997 was due to 2 major policy failures- exchange
rate policy & industrial policy. The financial system in South Korea was such that the government had a
more significant influence on targeting industries for economic growth. The industrial decisions were based
on political grounds rather than economic needs. Also, the government overvalued Won, which led to
excessive foreign borrowing and the government defaulting on debt repayments. Two major financial
facets in the Korean Economy – Banks centred financial system & Chaebol system. People relied on banks
more than the stock market due to the close relationship between industries & financiers. Chaebols are
multibusiness organizations favoured by the government on licensing, borrowing and access to bank
financing. The South Korean economy had unchecked market power and expansion that led to an
enormous setback and damage. The banks in South Korea lent aggressively to these chaebols so they can
expand themselves in new sectors.

Asian economic crisis in 1997 damaged and lowered the confidence of foreign investors in countries like
Thailand and Korea. Their currencies started depreciating, which led to the rapid repatriation of loans by
foreign portfolio investors. This resulted in the depletion of the foreign exchange reserves of Korea. Afraid
of potential default, South Korea approached the IMF for a bailout package of $55 billion to repay their
loans and keep the economy afloat. This became the turning point and acted as a catalyst in shaping the
modern-day economic systems in Korea. Soon after, Kim Dae-Jung was elected as President, who struck
down the relationship of government officials with chaebols and threatened them by stopping the issuance
of fresh credit if new reforms are not implemented. This led to a full revamp of the financial and industrial
sector of Korea. This was termed the IMF Crisis.

The stock market upgraded with a totally computerized floor and a strict closed-circuit television to watch
trading operations. The very fact that the shortage of transparency was one of the weaknesses that
contributed to the present crisis, the Korean government proposed major changes in accounting rules. New
regulations required the 30 largest conglomerates to organize certified financial statements. The target of
this requirement was to enhance the transparency of huge conglomerates. There was also a move to form
a fundamental change in Korean Generally Accepted Accounting Principles. A change
was done through which accounting standards were set. A short-lived board to review that standard
included auditors, accounting professors, and officials.

With consistent efforts by government and business, there was a sign of an increase in foreign investment
in Korean Stocks. However, it still has a long way to go and breach the expectations of Hong In-Kie.

Solutions and their impact

1) Bank Restructuring: South Korea set up a Financial Supervisory Committee, the regulator body
responsible for a strategic restructuring of the economy. It started with the restructuring of banks and
bailed out 7 banks with proper changes in management and processes. Moreover, 5 non-viable banks were
shut down or merged into healthy banks. The government provided fresh capital and also acquired bad
assets to avoid spillovers. To finance these losses, the government issues government bonds and asks
banks to issue fresh equity capital to prevent the money cycle from collapsing.

2) Corporate Restructuring: Government aimed at improving corporate governance and transparency

for the chaebols. FSC classified companies into 3 classes: Viable, Subject to exit and Subject to
restructuring. Approx. 50% of companies that were identified as “Subject to Exit” belonged to the
chaebols. The government focused on lowering the debt-equity ratio from 500% TO 200% by asking
companies to offload debt and issue fresh equity. The “Big Deal” took place wherein the top 5 chaebols
swapped business units with each other to cut down the domestic competition and increase international
competitiveness by leveraging economies of scale.

3) Attracting Foreign Capital: The government liberalized norms for foreign investment and introduced
new rules to protect their interest. However, valuation disagreements, Public unwillingness and lack of
minority shareholder protection laws lowered the confidence level of foreign investors. Moreover, the
auditors couldn’t practice independence, and even fund houses belonged to chaebols which lead to biased
views by analysts.

Recent Developments
The 1989 upturn within the Korean stock market wasn't fruitful. Since it dived and reached its lowest level
at 460 on August 21, 1992, KOSPI, making many small investors seriously disappointed with the stock
exchange. Barely anyone had approached the market from a long-term perspective with emphasis on
various financial aspects.
The stock market upgraded with a totally computerized floor and a strict closed-circuit television to watch
trading. The very fact that the shortage of transparency was one of the weaknesses that contributed to the
present crisis, the Korean government proposed major changes in accounting rules, requiring large
conglomerates to structure their certified financial statements to enhance financial transparency. There
was also a move to form a fundamental change in Korean Generally Accepted Accounting Principles. A
change within the process was done through which accounting standards were set. A short-lived board to
review that standard, including auditors, accounting professors, and officials.

The restrictions on institutional investors’ voting rights were eliminated. Retail investors were also
engaging more in requiring the management to be more transparent and accountable. In May 1998, for the
primary time, foreign shareholders were starting to have a voice within the management of Korean
companies.

Our Analysis
A variety of market failures occurred in South Korea due to asymmetric information & incentive
problems. The huge indulgence of the government in making the financial decisions for investment in the
economy backfired. The facility provided by the government to large companies also led to their
investment in more risky ventures. Also, with political biases and shifting funds for expansion from the
focus on profitability in the economy to prevent social instability, the decisions had many negative
impacts. They did not focus on improving the education system or generating proper intermediaries like
mutual funds, venture capitalists, and financial press, which could have helped solve labour and product
markets problems in the economy.

When faced with the IMF Crisis Korean government adopted a holistic approach to target every
functioning part of the economy to revamp the whole scenario. The triggering event was the IMF crisis
which forced South Korea to adopt the aforementioned holistic approach. IMF has lived up to its
objectives for which it was set up at the global level, and this case is an epitome of the same. The road for
South Korea wasn’t easy, but with the right vision of President Kim Dae-Jung, the restructuring process
was successful.

The biggest learning is about how government support and a systematic approach can tackle any problem.
Korea’s best decision was to start with the backbone of the economy that is the banking sector, and then
spread it to the other sectors. By regulating the credit creation and hunting down the ailments like
relationship funding, shell companies and bribery, they brought the whole economy back. Once the
government could regulate credit, they moved to the chaebols and asked them to restructure according to
new reforms or face severe consequences. Chaebols adopted better corporate governance, improved
transparency and lowered down the debt to equity ratio, which boosted confidence among public and
global investors. Though in our opinion, a heavy issue of equity would have led to oversupply in the stock
markets, it was a necessary step to impose fiscal discipline and bail out companies. The government gave
it a thought and invited foreign investors to counter this oversupply problem. Still, the reputation of South
Korea was damaged, and it was tough for them to attract foreign investors. However, government
incentives and support slowly steadily brought in the required foreign capital in the country. The South
Korean government realised that even though its success was noticed in the West, foreign investors were
still sceptic about investing in their country due to irregularities in their accounting mechanism. The major
influence of Chaebols in the government’s vital decisions was a clear implication of crony capitalism for
foreign investors. To attract foreign investments, South Korean leadership made fresh and required
decisions which were inevitable to make the South Korean economy upscale globally. The scattered and
loose accounting framework and heavy influence of chaebols were the root causes of the scepticism of
foreign investors. The leadership in the South Korean government was quick to solve this with imperative
solutions and made changes such that professional accounting standards were established so that financial
information for the investors was transparent and the top brasses could be held accountable in their major
decisions. Hong In-Kie’s robust vision for the Korean stock market kicked off on a high note, but it’s
upon collaboration and coordination of the rest of the stakeholders that the South Korean Economy
depends upon and has a long way to go.