On the Causes of Financial Crisis in Korea

The paper analyzes causes of the current crisis in Korea. The immediate cause of the foreign exchange crisis, leading to a banking crisis, was a complete disintermediation by foreign lenders, which, in turn, was a reflection of the belated realization of the weakness of Korean economy. The propensity for reckless expansionism is most fundamental. The propensity is a product of the hasty promotion of industrialization over the past three decades. The Korean economic development policies involved severe financial repression, combined with policy loans, often with negative real interest rates. Policy loans encouraged expansion because they are so cheap. Expansionism has an added advantage: If you grow big enough, you are too big to be allowed to fail. Those who out-expanded others became jaebol. But expansionism has often resulted in waste of capital and negative cash flows. The liberalization of financial markets in the 1990s enabled Korean firms not only to postpone the day of reckoning by borrowing from overseas, but to further indulge in expansionism. A belated realization of the unsustainability of the situation led to disintermediation and the crisis ensued. The paper recommends that government stop interfering in the economy and let the market rule. INTRODUCTION The aim of the paper is to present a comprehensive view of the current crisis in Korea through an analysis of various factors that have contributed to it. It goes without saying that any attempt for policy action must be based on a sound understanding of the situation. The outline of the paper is to analyze (1)the immediate causes of the crisis in foreign-exchange markets and the banking crisis in Korea, (2)the intermediate causes of the crisis--with a focus on the deteriorating economic conditions in Korea that well preceded the current crisis, the mistaken Korean government policies, and the excessive leverage of Korean firms, and (3)the fundamental causes characterized as the cult of leveraged growth, resulting in over-investmen, and inefficiencies. The paper ends with an overall assessment and some thoughts on what needs to be done. 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. During the subsequent period of uncertainty--protracted negotiations between Korea and IMF, negative reactions to the terms of the IMF rescue package and the threat of impending banking insolvency, etc.--the situation became much worse. The currency continued to depreciate rapidly, accompanied by a severe credit crunch and mounting bankruptcies before it became stabilized from April 1998. What was involved is much more than the embarrassing fact that the depreciation meant that the per capita GDP of Korea, in dollar terms, is reduced by roughly half. Since Korean firms depend heavily on imported materials and capital goods for their operations, the depreciation had crippling effects by sharply raising import prices. Furthermore, there was the problem of servicing Korea's very large external debt, $153 billion as of December 1997. What made matters worse was the fact that foreign lenders were refusing to roll them over. The depreciation meant a doubling of the debt burden in local currency. The scrambles to meet debt payments that came due, created a series of secondary disintermediation and a severe credit crunch. This resulted in mounting bankruptcies--123 bankruptcies per day in December 1997 and 151 per day in January 1998--as well as cancellation of investment projects, factory closures, layoffs and wage-cuts, etc. The crisis has had truly devastating effects. 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. …