South Korea during the Asian Crisis - Essay Example

?South Korea during the Asian Crisis: The IMF and Lessons in Public Finance The Asian Currency Crisis of 1997 also known as the “Asian Crisis” and asthe “Asian Financial Crisis” preceded the United States and the current global crisis also known as the “global financial crisis” that started in 2008. One important country that can be studied is South Korea. It is a country that used to be badly hit by the crisis but the country seems to be doing well recently. One manifestation of South Korea’s success is that its Samsung is able to present a strong competition to the United States’ Apple. This work looks into the experience of South Korea and identifies a few lessons in public finance. Describing the Asian Crisis as a financial crisis, Heo and Sumwoong reported that South Korea prior to the crisis, “average a growth close to 10% per year” commencing in the early 1960s (490). The authors described the Asian Crisis as a failure of a development paradigm premised on a statist approach that called for a strong government role in the economy (490). Statism or statist pertains to a strong role of the state. In their assessment, Heo and Sumwoong estimated that in 1997, the exchange rate against the dollar “went from below 900 won to the dollar that summer to around 900 won to the dollar the summer to around 1,500 in mid-November” (490). Kwan attributed the financial crisis in South Korea to the South Korean government practice of targeting large conglomerates in Korea known as chaebols and extending to chaebols various types of government assistance and support. According to Kim, the chaebols in both the banking and corporate sectors received a lion’s share of government financial assistance (5). Assistance and guarantees of assistance to the chaebols “led to a rapid rise in industrial concentration but also rendered Korea’s corporate sector and the economy vulnerable to external shocks” (Kim 5). In particular, Kim noted that the South Korean assistance to banks created the problem of moral hazard in the banking sector. Given government support and guarantees of support in bankruptcy, both the banks and the corporate sector became inclined to invest in risky investments (Kim 5). The situation resulted to over-borrowings by the corporate sectors on the banks and over-investment and excessive loans of the banks to risky investments which were thought to be good investments because of government guarantees (Kim 5-6). With this as background, “by the end of 1996 the average debt-equity ratio of the top 30 chaebols reached 400%, which was twice the international banking norm of 200%” (Kim 5). Kim presented the table below to describe how the Asian crisis affected Korea during the late 1990s. Table 1. Macroeconomic Indicators of South Korea, 1994-1998 Source: Table 1 of Kim (8) In Table 1, we see that the Asian crisis caused South Korea to acquire a 7% unemployment rate in 1998 from the usual of 2% and to have a negative 5.8% real gross domestic product growth rate from the usual positive real GDP growth rate. We also see in Table 1 that the won/dollar exchange rate deteriorated from the usual 700-800/won to a won/dollar rate of more than 1,000. For Kim, the “most significant blunder was the decision for an abrupt financial liberalization in 1996 when Korea did not have a fully developed, market-disciplined financial system” (10). According to Kim, “many newly-created financial institutions, called the ‘merchant banks,’ procured foreign currency funds on short-term basis which were used for long-term investment in Southeast Asian Countries like Thailand and Indonesia” (Kim 10). This was the formula for a multiple whammy or multiple blows: it was bad enough that South Korea is vulnerable to a crisis (as the policy of state support for chaebols encouraged the banks to put money on risky investments) but South Korean investments on countries equally vulnerable to crises complicated the risk, problem, or vulnerability by so many times. The Kim material of year 2000 used the notion of moral hazard in explaining why the South Korean economy was vulnerable to the Asian Crisis in 1997. The work of Kharroubi and Vidon attribute to moral hazard many of the world’s financial crises, covering the financial crisis involved in the Asian Crisis of 1997 as well as ongoing financial crisis in the United States today that was transmitted worldwide (51-26). A simplified definition of moral hazard was articulated by Kevin Dowd. According to Dowd, “a moral hazard is where one party is responsible for the interests of another, but has an incentive to put his or her own interests first” (142). Dowd also described moral hazard this way: heads I win, tail you lose (142-143). In other words, much of the financial crisis involved in the Asian Crisis of 1997 that affected South Korea and the rest of the Asian countries can be attributed to the problem of statism in which state support for the corporate sector as well as the high risk-taking behavior of the banks promoted risky investments. As a result of this public finance environment, the private, bank and the public sectors become vulnerable to a financial mess: a crisis or a financial trouble in one sector can spread like wildfire to the rest of economy and can trigger a crisis. According to Lim, the immediate response of the International Monetary Fund to the crisis was to assist South Korea (and the rest of the countries of Asia) and prescribed that the South Korea reduce its current account deficit to below 1% of the GDP, contain inflation below 5%, limit the deceleration of South Korea’s GDP, implement a tight monetary policy and a flexible exchange rate (4). More important, the IMF prescriptions focused on the structural roots of South Korea’s problems. In particular, the IMF helped South Korea implement reform measures to revise the Bank of Korea Act, improve bank supervision and enforce consolidated financial statements and certification by external auditors (Lim 4). We can interpret the IMF initiatives as attempts to facilitate accountability in the South Korean banking system. Promoting the accountability of the bank executives to its stockholders and the public is an important way to address moral hazard. In the past, bank executives and officers were handing out loans to corporate giants without looking into the risks of investments because government is committed to bail them out anyway. However, with the crisis, it is clear that such a policy is not sustainable. Bank executives and officers, therefore, must be accountable to investors and must see to it that investments are made consistent with expected returns and risks. The other structural reforms facilitated by the International Monetary Fund in South Korea included the usual: “trade liberalization, capital account liberalization, reform of corporate governance, corporate structure and the labor market, and the provision of information on foreign exchange reserves and other financial data” (Lim 4). The last set of measures has something to do with enabling policy analysts to assess economic risks as well as promote reforms in South Korea. Moral hazards can be reduced or eliminated if collusion between large corporate sector executives and government officials are eliminated and investments are decided based on market or investment criteria rather than on the closeness of affiliation between a bank executive and a public official. In conclusion, based on our short narration of the South Korean case, at least three lessons can be derived. First, moral hazard is one important problem that should be addressed in public finance management. Second, one important way to address moral hazard is to promote accountability in the financial and corporate sectors. Finally or third, multilateral institutions like the International Monetary Fund play an important role in promoting sound public finance. Work Cited Dowd, Kevin. “Moral Hazard and the Financial Crisis.” CATO Journal 29.1 (Winter 2009): 141-166. Heo, Uk and Kim Sunwoong. “Financial Crisis in South Korea.” Asian Survey 40.3 (2000): 492-507. Kharroubi, E. and Edouard Vidon. “Liquidity, Moral Hazard, and Interbank Market Collapse.” International Journal of Central Banking 5.4 (December 2009): 51-86. Kim, Kwan S. “The 1997 Financial Crisis and Governance: The Case of South Korea.” Working Paper #272. The Helen Kellog Institute for International Studies, March 2000. Lim, Gill-Chin. “South Korea, Brazil and the IMF: Coping with Financial Crisis.” Global Dialogue 1.1 (Summer1999): 1-9. Available 19 January 2013: http://worlddialogue.org/content.php?id=18. Read More