Financial Markets

Case Study: Korea Stock Exchange, 1998

Submitted By: Group 2

Economy of Korea

The Korean economy grew at a high rate from the 1970s until the late 1990s, reaching an annual
growth rate of 8.6% in 1996, making it the world's 11th largest economy. It had a very
unconventional economic framework for a developing country. The Chaebol, who had strong
links with the banks and government, pushed for their rapid rise. Because the economy relies
heavily on its banking system and not so much on its stock exchange. This system has only been
observed in industrialised economies when safeguards, such as laws and other institutions, are in
place to ensure that the system is not abused.

System of Banking

Even though the banks were private, the government had a great influence over them because
they nominated the directors and so on. In this approach, the government can sway who gets
money from whom. The government was interested in supporting Chaebol to promote heavy
industries. Financial institutions back corporations in a bank-based financial system. In 1998, the
entire country of South Korea banded together to collect gold from its citizens in order to pay off
the IMF's foreign exchange commitments. They were able to raise approximately 1.8 billion
dollars in gold through this effort. By 2001, the campaign had paid off the IMF loan of $19.5
billion, three years ahead of schedule.

System of chaebols

Multi-business conglomerates known as Chaebols, such as Samsung, LG, and Hyundai,

controlled the Korean economy. Korea's top 30 chaebols accounted for 51.8 percent of the
country's overall industrial production. In order to compete in worldwide markets, the Korean
government backed Chaebols through preferential regulations in industrial licences, foreign loan
distribution, financial services, and other areas. The Korean government hoped to build a strong
local industry in this way. Advantage - Entrepreneurs who deal with labour, growth rate, and
financing issues early in their businesses build strong foundations. Disadvantages - Financial
intermediaries are absent or weak.

New ventures backed by the Chaebols benefited because, like the Chaebols, they are favoured by
the government and banks. For greater access to resources, many of the ventures joined into the
Chaebols. Also, Chaebols have a strong brand name, which helps them build and capture new
markets because they are well-known and trusted.
Highlights - 1) Attracting future employees and developing universities are two of the
highlights. 2) The economy's bank-centered nature can help (Banks favour Chaebols) 3)
Ownership by a family (10.6 percent avg ownership of family in 30 large chaebols) 4) The
debt-to-equity ratio is too high. 420 percent

IMF Crisis

It began in 1997, when foreign investors lost faith in Thailand's economy, which included Korea
at the time. As a result, foreign financial institutions began to cancel their loans due to concerns
about the Korean economy's potential for instability. In addition, portfolio investors began selling
their holdings in fear, which continued for four months. To solve this, the Korean government
sought assistance from the International Monetary Fund, which agreed to pay the US $55 billion
in a bailout package.

Why- With their broad strategy and market, chaebols can readily obtain bank loans and
concentrate on growth and expansion rather than profitability. The absence of bank supervision
and the government's concentration on job development were the primary causes.

Effects- 1) The newly elected president of Korea declared that the chaebols should bear the
burden of debt, while profitable businesses will only receive government assistance.

2) The IMF requires bailout loan recipients to follow the IMF's economic programmes.

Restructuring of banks

Why- In order to advance financial sector reforms and chaebol restructuring, the FSC required
that 12 banks with an adequacy ratio of less than 8% submit rehabilitation plans. Through
diligence assessments, banks initially identified nonperforming loans and made provisions for
them, as well as the real quantity of nonperforming loans. The Federal Reserve Board of
Governors approved a bailout for seven banks, and banks were required to submit
implementation plans. Changes in management, cost reduction, and recapitalization plans were
all part of the execution plans. Healthy banks were to buy five non-viable banks.

Several safeguards were adopted to protect purchasing banks from bad loans spilling over: the
only good asset would be sold within six months.
The government would provide funding to acquiring banks in order to boost their capital
adequacy. The Korean Asset Management Corporation would buy a bank's substandard assets
and finance them with public funds.

Develop a strategy for clearing bank-issued nonperforming loans.

The Korean government planned to issue bonds worth 50 trillion won to cover losses from
nonperforming loans. 41 trillion would be set aside for nonperforming loans and recapitalization,
while 9 trillion would be set aside for enhanced deposit protection.

Corporate Restructuring

The government began corporate reorganisation by closing down nonviable businesses and
improving the financial status of the rest. In the long run, the goal was to strengthen corporate
governance and management, particularly among chaebols. FSC resolved on five methods to do
this: strengthening financial structure, boosting transparency, focusing on core business,
improving corporate governance, and eliminating the practise of reciprocal guarantees among
associated enterprises.

Firms were split into three groups as part of this process: (1) viable, which would receive
financial support; (2) subject to exit, which would be sold or shut down; and (3) subject to
restructuring, which would receive financial institute help for restructuring. The average Korean
D/E ratio of the top 30 companies was 420 percent; the upper limit was established at 200
percent, forcing companies to sell assets or raise fresh equity to meet the new D/E ratio.

To speed up business restructuring, the government established many new legislation, including
permitting some tax benefits for restructuring, simplifying the mergers and acquisitions process,
and allowing corporate spin-offs and carve-outs.

Attracting foreign capital

The importance of recruiting foreign finance was recognised by President Kim Dae-Jung. It
would not only bring new money to Korea, but it would also assist in the introduction of
world-class management and governance standards. New measures were proposed in order to
attract foreign investments. For example, a foreign entity can now form its own mutual fund; a
foreign investor no longer needs board of director approval to purchase more than a 10% equity
share; and domestic enterprises that sell assets or attract international investment now have
unique privileges.
Another significant stumbling block was the disparity between Korea's and foreign investors'
valuation assessments. This was exacerbated by the accounting policies used by Korean
corporations. Furthermore, investors were concerned about the difficulty they would have in
completing the restructuring and the resulting layoffs. An accord between the government,
industry, and labour unions alleviated the tension.

There were other issues in the market, including as the lack of strong rules or institutions to help
protect the rights of various small investors. Foreign investors had a wide range of accounting
policies, as well as a close contact between directors and management. To attract foreign money,
it was necessary to bridge the institutional deficit that existed in Korea, which made domestic
and international investors apprehensive of engaging in the Korean market.

Impacts due to Developing capital markets

Excessive IPOs following the 1976 Securities Exchange Law Amendment: From 1972 to 1997,
the number of publicly traded firms increased by 1075 percent. The value of publicly traded
stocks increased by 2285 percent.

Falling Stock Market Value: Despite large increases in the value of traded equities and market
capitalization, (Market cap / GDP) fell from 30% in 1996 to 17% in 1997. In 1997, the KOSPI
decreased by -302.14% compared to 1992. The stock market's share of total financing has
decreased.

Reasons :

Long-term economic instability was disregarded due to a lack of financial supervision.

● Increased number of short-term investors seeking high returns in a short period of time
rather than focusing on a company's financials and growth;
● Liberalisation allowed US and other overseas investors to invest substantially.
● Government intervention - a large cash injection to boost share prices.
● Instability in the KOSPI exacerbated concerns about the Korean stock market's long-term
viability and lowered investor confidence.

Recent Developments

Following the crisis, the administration and new president Kim Dae-Jung took a number of
initiatives.
● Changes in the stock exchange's infrastructure and functionality;
 ● Strict accounting regulations to ensure openness, particularly in multi-business groups.
● Improvements in shareholder rights once the FSC took over the oversight of accounting
standard-setting. Reduce the minimum number of shares ( percent ) required to launch a
lawsuit against management, eliminate the Director position, and audit the company's
records.
● To encourage transparency, rules should be made easier, and company acquisitions
should be restricted.
● Management accountability through third parties (NGOs, institutions) to guard against
corporate malpractices that cause investors to lose money.

Future challenges

Authorities such as the KSEC and the government took swift and decisive action to help resolve
the financial crisis in a timely manner. However, there are a few prospective challenges:

Challenges in implementation: It was easy to demand openness from corporations, but due to
the intimate ties between stakeholders, the entire system had to execute it. Audit reports of high
quality: Financial accounts must be audited by reputable accounting companies in order to
obtain the confidence of international investors. The stock market's long-term trajectory: The
IMF recommends that the stock market be made more sustainable, transparent, responsible, and
open.