Sequencing refers to the fact that fiscal consolidation and macroeconomic stability are a prerequisite to financial liberalization and current account convertibility, which is itself a prerequisite to capital account liberalization. Scope refers to the extent to which market forces are allowed to determine the price and allocation of public resources. They can be narrowly limited to certain transactions of the Treasury or widely open to all public sector uses. Another episode in Korea’s development during the early 1980s provides an interesting lesson on how to manage key nominal prices (i.e., interest rate, exchange rate, and wages) to avoid serious relative price misalignments in the course of liberalization. The successful price‐level stabilization program in 1981‐1984 allowed to stabilize the domestic price level, while retaining competitiveness in foreign trade (see Box 4). As a result, Korea’s GDP growth and financial development for several years after the program were truly remarkable. The rapid deepening of financial flows within the Korean economy made possible large net repayments of foreign debt through trade surpluses.

# **Box 4.  The Republic of Korea’s Price Stabilization Program of the Early 1980s**<sup>**85**</sup>

Like many countries, in the early 1980s, Korea was confronted with high inflation. It decided to implement a price‐level stabilization program in 1981‐1984 that successfully adjusted the real interest rate to decrease inflation and improve competitiveness, while delaying the full liberalization of the banking system.

During 1979‐81, Korea’s inflation averaged over 20 percent and its standard nominal loan rates were negative in real terms. With a strong fiscal consolidation and monetary stringency, the inflation rate was drawn down to about 7 percent in 1982 and to 3 percent in 1983. Because of the credibility of the fiscal and monetary programs and overall macroeconomic signaling, the Bank of Korea could quickly reduce the standard nominal loan rate in stages from 20 percent in 1981 to 10 percent by mid‐1982, while making it positive in real terms—albeit below market‐clearing levels.

Because of tight monetary conditions, central bank credit to commercial banks was constrained and thus was the banks’ credit to the private sector. However, because the government’s fiscal deficits were simultaneously reduced, the Bank of Korea reduced the banks’ reserve requirements and the real flow of loanable funds to the private sector could increase, thus relieving the supply constraint on domestic output. No net credit squeeze on the private sector was necessary once the Korean government and its various special agencies stopped directing the flow of bank credit itself.

The Bank of Korea did not attempt to use its exchange rate as the forcing variable for domestic price‐ level stabilization. Between 1980 and 1983, the won depreciated a bit faster than the reduction in the domestic inflation rate (to reflect the inflation differential with trading partners). The nominal exchange rate was managed by an informal downward crawl to adjust passively to declining domestic inflation. Foreign capital inflows were limited to secure the desired deflation without significant exchange‐rate overvaluation. Thus, as price‐level stability was secured, the syndrome of exchange overvaluation was avoided.

The government was however less benign in addressing the difficulties of the banking system. Because of its determination to support the development of domestic heavy industry, the government had coerced the banks into making risky long‐term loans in the 1970s—many of which proved nonperforming. In the 1980s, the Bank of Korea still <u>provided subsidized credit lines (i.e., at below</u>

> 85 This box draws on McKinnon (1993).

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