Mr Chon speaks on the topic of
restructuring and monetary policy in Korea
Speech given by Mr Chol-Hwan Chon, Governor of the Bank of Korea, to the European Union
Chamber of Commerce in Korea, in Seoul on 12 October 1999.
* * *
It is a great pleasure for me to speak on the topic of "Restructuring and Monetary Policy" to embassy
staff and businessmen from the EU, who are contributing so greatly to furthering the economic
cooperation between Europe and Korea.
The European Union opened up a new chapter in the history of the world economy this year with its
successful launch of a common currency, thereby creating a true single market and becoming a single
economic entity. Economic exchanges between Europe and Korea will become more dynamic thanks
to the integration. In particular, more and more European companies are expected to enter Korea since
it is opening up for foreign inward investment. Such investment will serve as a basis for further
strengthening the relationship between Europe and Korea.
Prospects for the Korean economy
Before I launch myself into the topic, I would first like to give you a brief introduction to the Korean
economy and its prospects.
The Korean economy, which recorded negative 5.8% growth last year due to the ramifications of the
foreign exchange crisis, is now recovering at a considerable speed. The GDP growth rate stood at
7.3% for the first half of this year and when the continuous increase of manufacturing and
consumption related indexes are taken into consideration, the growth rate for the whole of this year is
forecast to be as high as 8.8%. Imports have increased but thanks to strong exports, Korea's current
account is seen to continue in surplus this year, reaching about US$21 billion . The annual average rise
in the CPI is expected to be around the 1% level despite destabilizing factors such as the rapid growth
of the economy and the international oil price hike.
As is clearly illustrated by the GDP growth numbers, the Korean economy has rediscovered its
vitality. This is due to hard efforts by all participants in the Korean economy.
The foreign currency crisis erupted in part because of some fault lines in the international financial
architecture, but in retrospect, the structural problems of the Korean economy were the major cause.
Based on this recognition, the Korean government is strongly pushing for restructuring measures to
overcome fundamentally the frailties of the Korean economy that have surfaced in the wake of the
financial crisis. The topic of my speech has been selected with this in mind.
The role of the central bank in the restructuring process
Rather than explaining in great detail about Korea's restructuring measures or their outcomes, I would
like to focus on how the central bank is contributing to the process through its monetary policy.
The restructuring process requires both a micro and an administrative approach since it aims to reform
individual companies and financial institutions. Therefore government ministries in a position to draft
and revise legislation, or those government agencies which oversee or monitor the detailed
management of financial institutions, should be in charge of the process. The central bank, on the
other hand, faces natural limits on the extent to which it can share actively in the restructuring process.
It conducts monetary policy based on the efficient workings of the market rather than on
administrative devices or legislation. Moreover, monetary policy influences economic entities as a
whole rather than acting on individual institutions or businesses.
Despite these limitations, a central bank can contribute to the restructuring process within the
monetary policy framework. There are four ways in which it may do so.
1. Create a macroeconomic environment conducive to the restructuring process
First, the central bank creates an economic environment which helps the successful implementation of
restructuring measures.
The economy needs some degree of dynamism if restructuring measures are to be implemented
smoothly.
Looking back, most restructuring was carried out when the real economy had contracted due to the
ripple effects of a crisis. Korea is not the only country to experience negative growth after a crisis.
Several countries which suffered a crisis in the 1990s including three Scandinavian countries, Mexico,
Thailand and Malaysia all went through a period of negative growth lasting for one or two years.
However, a deep economic downturn is likely to act as an obstacle to successful restructuring. If a
company or a financial institution is to improve its financial structure, it should pay back its debt by
realizing profits or increasing its capital through a public offering. During a recession, such attempts
do not yield the desired outcomes. Moreover, since job mobility decreases significantly in a recession,
bold management rationalization which inevitably entails large-scale job shedding, is difficult to carry
out.
Another reason why a certain degree of economic vitality is necessary for successful rescheduling is
related with the problem of the "black sheep" of the economy. When a specific sector clearly needs
emergency surgery, but it is feared that there would be a heavy toll in terms of unemployment and
financial market disturbance, then the government will be tempted to put off the operation, especially
when the economy is depressed. This sector will remain the "black sheep" of the economy for as long
as the economy does not pull itself out of recession, gradually turning into a time-bomb for the
economy as a whole. For example, if the Korean economy had not recovered this year, the
restructuring of the Daewoo Group (a large chaebol some of whose interlinked companies have been
placed under a workout program) and the problems involving investment trust companies - two major
issues which have come to the fore since July - might have remained under the surface with the
potential to cause even greater trouble in the future.
This all leads to the conclusion that economic recovery is vital for the smooth implementation of
restructuring measures. Having said this, we must bear in mind that if the economy recovers too
quickly and exuberantly, causing overheating, economic units may not feel the need to restructure
themselves.
Too low interest rates choke off companies' incentives to reduce their debt. With the improved cash
flow, companies are lured into expanding their business. Also, financial institutions become less
interested in clearing bad debt from their books since the opportunity cost of holding it decreases with
lower interest rates.
Another problem can spring up in the choice of monetary policy stance when inflationary pressures
begin to rise due to an over-accommodating policy. In most cases, the period of restructuring
corresponds to a deflationary phase so that the central bank can ease monetary policy without
worrying about inflation. However, if inflation raises its head before the restructuring has proceeded
very far, the central bank may be in a position where it has to choose between price stabilization and
maintaining an environment favorable to the restructuring process. This is a dilemma for the central
bank because either choice will have negative effects. If the central bank, for example, adopts a
monetary-tightening stance to fight inflation, then the short-term profitability of companies and
financial institutions will deteriorate, which may blunt the momentum for restructuring. On the other
hand, if a relaxed monetary policy stance is maintained to keep restructuring on the road, prices rise
and companies may once again turn to their debt-dependent, expansionary management style, which
ran riot in the past. As a result, people will come to lose faith in restructuring itself.
For successful restructuring, therefore, the economy must not be allowed to overheat nor should the
recovery be less than adequate. Achieving a well-balanced, unbiased economic environment for
sustainable growth creates the best condition for reform measures. In other words, the central bank has
to conduct monetary policy supportive of economic recovery, but subject to the constraint that
adequate discipline is exercised over economic entities so that they have their own incentives for
change. Such a policy, by its nature, does not attract the spotlights, but it is quite important in that it
may affect the final outcome of the restructuring measures.
In this regard, the Bank of Korea has been steadily lowering interest rates since the second quarter of
1998. As a result, the Korean economy is showing clear signs of recovery and on the basis of these
trends, the restructuring process is well under way. However, in May 1999, the Bank decided against a
further lowering of the overnight call rate, which is its policy rate, taking the view that the economic
recovery was proceeding at a faster pace than expected, and that asset prices had risen sharply within a
short period.
Recently, even though the economic recovery has been gaining greater momentum, the Bank of Korea
has maintained call rate unchanged, which implies that it takes a neutral position. The reasons behind
this decision are that no signs of imminent inflation are visible, and that the financial markets have
been unsettled by the restructuring of the Daewoo Group.
2. Supply liquidity to ensure financial market stability
Second, the central bank should supply liquidity flexibly in response to the financial market turmoil
which may arise in the course of restructuring.
It is quite common for the financial market to become destabilized during the process of structural
adjustment due to high credit risks and reduced trust among market participants. As a result, a credit
crunch may occur, which brings about a prolonged economic recession because financial institutions
and corporations may not be able to raise sufficient money for their normal operation. In addition,
market participants favor the short-term end of the market. The consequent large pool of short-term
funds makes the movements of interest rates and stock prices extremely volatile, while financial
institutions may become illiquid because of the short-term nature of their liabilities and the long-term
nature of their assets.
Admittedly, financial market unrest is unavoidable in the process of restructuring. However, if the
degree of unrest becomes so acute as to be insupportable, it may threaten to cut short reform itself.
Therefore, the central bank, which is supposed to be responsible for stabilizing financial markets, can
take an active role by providing liquidity through open market operations.
At the outset of the crisis, the Bank of Korea provided funds to stabilize the financial markets in
response to market turbulence, and it induced banks to expand lending to small and medium
enterprises in order to ease the credit crunch whose effects were concentrated on them.
A central bank can play a role as a lender of last resort in order to maintain financial market stability.
However, the role of the lender of last resort must be carried out following strict rules, since a central
bank's right to issue paper money can be easily abused and invite moral hazard on the part of financial
institutions. First, the central bank must maintain "constructive ambiguity" to prevent individual
financial institutions from becoming too dependent on it. This phrase means that although the central
bank is able to intervene in the market to insure financial stability, it must not give any assurance of a
bailout to individual financial institutions, whether covertly or overtly. Second, even if support is
given to individual financial institutions, punitive rates or at least market interest rates must be applied
in order to avoid the exploitation of the interest rates differential. Lastly, an element of conditionality
including a resolute self-rescue plan must be clearly imposed and its performance closely monitored
by the central bank.
3. Mediate structural adjustment
Third, the central bank may play the role of a mediator in the process of restructuring.
There have been examples of some central banks mediating in debt rescheduling negotiation among
interested parties. The Bank of England, for instance, was actively involved in corporate sector
restructuring from the 1970s until quite recently upon the voluntary request of creditor banks. The
Federal Reserve System of the United States has also served as a mediator when cash-strapped
financial institutions were on the brink of failure.
There are many reasons why the Bank of England and the Federal Reserve System were able to
mediate in the restructuring process. One of them, I believe, is that at that time they both undertook the
responsibilities of financial supervision. If a central bank supervises banks, it can accurately analyze
their current business conditions and status. Moreover, it can also get easy access to information on
individual companies which borrow money from them. The central bank, therefore, can be an effective
mediator. In addition, the strong credibility arising from their carefully cultivated reputation for
neutrality and fairness, may well have helped in reconciling the conflicting interests of the groups
involved.
In the case of Korea, the relationships between financial institutions and enterprises, and those
between individual enterprises are closely intertwined. Therefore, structural reform in Korea cannot be
restricted to one or the other specific sectors: rather, it should be very broadly based. This implies that
in Korea, perhaps more than in any other country, accurate analysis of financial institutions and
enterprises is badly needed for successful restructuring. However, since the revision of the related
legislation in April last year, the Bank of Korea can no longer supervise banks directly. Consequently,
it is not easy for it to monitor and scrutinize the business conditions of individual banks and
enterprises, making it hard for the Bank to serve as a mediator.
4. Foster international cooperation to improve overseas confidence
Lastly, the central bank can contribute to brightening the country's external credibility by closely
cooperating with international financial circles.
Restructuring entails extensive friction and conflict on the domestic front. So if the process is to
proceed smoothly, it is imperative to avoid extra turbulence stemming from international investors
who have large claims on Korea. This requires that international confidence in the country be
maintained at the existing level or, if possible, improved. To be sure, international credit ratings will
be upgraded with substantial progress in the reform drive, but it is also very important to reassure
foreign investors and to keep them well posted as to the domestic economic situation. Towards this
end, international cooperation is necessary, and the central bank, I believe, is well suited for this job,
in particular, on financial matters.
A number of cooperative groupings linking central banks like BIS (Bank for International
Settlements), EMEAP (Executives' Meeting of East Asia and Pacific Central Banks) and SEACEN
(South East Asian Central Banks) have already been set up. They allow governors and working level
officials of the central banks ample opportunities to discuss current issues and build up
mutually-cooperative relationships. In an emergency, central bank governors are thus able to tackle
issues very promptly thanks to their close contacts and cooperation. By the influence they hold over
their domestic financial institutions, the central banks are well-placed to persuade them to prolong the
maturities of overseas credits and provide fresh loans at the request of a fellow central bank, and to
promote a better understanding of the economic situation of the debtor countries.
Closing remarks
The Bank of Korea has supported the smooth implementation of structural reform through open
market operations and financial market stabilization policy. In the future, the Bank intends to conduct
a balanced monetary policy both to ensure the success of restructuring and to support economic
recovery. It is also supporting structural adjustment indirectly through the strengthening of cooperative
links among central banks worldwide.
I am fully aware that there are critics overseas who rate Korea's structural reform as far from
satisfactory. However, as the experience of other countries attests, it is difficult to achieve satisfactory
outcomes in a short time because restructuring by definition entails conflict and pain. Considering
these points, I venture to ask for your continued warm interest and support for Korea's restructuring
efforts. I hope the Korean economy will become more advanced thanks to its restructuring and also
wish that its practical cooperative relationship with the EU may continue to deepen in the future.