South Korean Financial Crisis - Case Study Example

South Korean Financial Crisis The year 2007 marks the 10th anniversary of the South Korean financial crisis and reminds us of the struggle that shocked the Korean economy in the last quarter of 1997. Undoubtedly, this had a significant impact on the South Korean economy, and led to Korea's worst recession since the aftermath of the World War 2. The causes for the crisis were many and led to diverse effects, both constructive and negative. But what were these underlying causes and effect of this financial crisis Was such an event inevitable or could it have been prevented In this essay I am going to outline the chronology of the events that took place leading to the eventual financial crisis and in continuation I will identify and discuss about the causes and effects of the Financial Crisis based on the South Korean economy. I hope that this essay will help in further understanding why the crisis happened and how the economy can be better managed to prevent such disasters in the future. The chronology of the crisis Korea was progressing well in 1996 and had become a part of the Organisation for Economic Cooperation and Development (OECD). As people celebrated, nobody knew of the impeding disaster about to strike.1 During the latter part of 1996, the current account deficit increased to 5% from previous year's 2%, a decrease attributed to lessened competition among Korean industries. The GNP declined from 14.1% to become 7.1% and foreign debt rose to a high 100 billion dollars. These and various other debt related indicators were showcasing the upcoming crisis for Korea.2 The first half of 1997 surfaced a few more indicators of the disaster. Foreign investors in Korea were starting to get wary of the market and lacked confidence in investing because of long recessions, large deficits in current accounts and growing short-term external debt. In January 1997, Hanabo Steel, the 17th largest Korean seller went into bankruptcy. Soon the Sammi Group, another steel company, failed and major affiliates of the Jinro Group went bankrupt. In July 1997, another major automobile manufacturer, Kia motors failed. With the downfall, foreign capital began to flow out of the country. In July 1997, the Southeast Asian crisis broke out first in Thailand, followed by Indonesia, Malaysia and in Hong Kong in October as the stock market crashed. Within October to December the Korean economy crashed by 112% compared to the US Dollar. From October 1997, the yield spreads of the global bonds of Korean Development Bank (KDB)3, Korea's indicators of the sovereign risk premium, started to jump. By early December, Korea's bonds were reassessed by Moody's and Standard & Poor's and were demoted to junk bonds from their A1 status. Soon the banks could not renew the maturing loans and needed to withdraw from the Korean markets. Foreign lending crashed from the $100 from January to October 1997, to minus $20 billion by the end of the year. The won plunged lower to 50% in a span of two weeks in the month of November. As of November 1997, foreign reserves were seen to stand at 24.2 billion dollars, of which only 9.3 billion dollars was finally available. The figure was much lower than the required foreign reserve level of 36 billion dollars. Korea did not have enough money to repay back its 10 billion dollars short-term borrowings. At the edge of sovereign default, foreign debt touched highs of 119.7 billion dollars and the whirlpool of the crisis was pulling in Korea. The Causes and effects of the Crisis The causes that led up to the crisis were many and experts state that a single cause cannot be pinpointed as the culprit. While the economy crashed along with that of other nations, many experts also state that the currency crisis in Korea is quite different from other traditional situations. This crisis had little to do with the mismanagement of monetary and fiscal policy. The macroeconomic fundamentals were also good. The effects were as diverse too, but boiled down to the financial destruction of Korea. However like every failure or bad experience, this episode has also taught much. It has given Korea the realization that financial stability is important and can only be achieved by close financial supervision and a sound understanding of the macroeconomics. Let us take the varied causes and how they have affected Korea. Cause: A structural and strategy weakness Firstly, Korea's main weakness lied in its structure4. It was victim to situations that were inherent and caused by inadequacies in the institutions. Various attempts by the government towards structural reform had also gone wasted due to vested interests of politicians, labor unions and business men. The nation was also subject to its development strategies like the one that focused on growth through exports5. Finally Korea was vulnerable to changes in the external environment. Recessions in Japan, Europe and other countries in East Asia led to false appreciation in the won and Korea became even more vulnerable. Effect: Because structural weakness was a major reason for Korea's crisis, any number of macroeconomic factors could not stop the crisis. As markets crashed the major strategy of exports failed. Because the economy of Korea was small and open, it was influenced greatly by external fluctuations in prices and markets. Recessions in Japan and Europe and a decline in world markets on the prices of computer parts, garments and automobile sectors contributed to affect Korea's exports. Cause: Management of bank credit The problem was also largely affected by the banking system. Banks in Korea followed a Japanese model, and were privatized and liberal. This also meant close communication channels between lenders and borrowers. The mode is often unsuitable for globalized financial systems. Also the major instrument used for promoting exports in Korea was the allocation of bank credit. The financial system of Korea was quite underdeveloped. The stock market and the non financial intermediaries were also not much advanced. Curb market loans, though freely available were highly expensive6. Most of the creditors were foreigners and various non-performing loans were forming a burden on the banks. Aggressive expansions were being fueled with finances and this in turn led to huge debts. The country indulged too much in debt financing, wrong capitalism and a weak hold of financial intermediaries. Effects: The wrong banking systems led to deterioration in the balance sheets which made it difficult to raise new capital. Also interest rates slowly increased and so did the market uncertainty. When the Won was devalued, banks did not have anything left to repay loans with. However, the episode brought out the quality in Korea to quickly pick itself up and start progressing with undying enthusiasm. This was most evident in the reorganisation of the banking system, a process that is still taking place. Businesses have also restructured themselves through various modes that range from outright sales to partnerships and mergers with multinational corporations. Foreign companies are also investing in Korean companies as the crisis has made them much cheaper and affordable for purchase. Cause: Wrong government policies The financial market was firmly controlled by the government, which missed various good opportunities to restore the confidence of financial investors. Once the crisis began, the government made various erroneous policy changes7. The major areas where the government failed were the exchange rate policy and the industry policy. Under the exchange rate policy, the government tried to relate the won to the US Dollar. Also as per the industry policy, financial institutions and business enterprises made collective business decisions more on political grounds. One stark example where the government could have controlled the issue as it spiraled out of hand was its decision in October to provide guarantee to all foreign liabilities of financial institutions in trouble. Because of this action, what began, as a private banking problem became a national crisis. Effects: When the US Dollar appreciated, the exchange rate policy led the Won to appreciate in value too. However, this was only a false appreciation and in 1997, the Won was said to greatly overvalued. Finally when the government offered the strong guarantee of a fixed exchange rate, businesses did not realize the foreign exchange risk that existed. They did not realize the amount of foreign debt that would accumulate if the Won devalued. Once the Won was devalued, businesses went bankrupt and foreign debt rose to touch new levels. The industry policy led to decisions that were more political than economic that caused more investments to be wrong decisions. However, the episode led to the unification of varied financial supervisory bodies into one single agency. The Financial Supervisory Service was born and the laws and regulations to govern its functions were laid out. The international community also garnered its support for the nation. IMF and the World Bank offered a suitable rescue package and all emergency measures were taken quickly. The situation was controlled to the best of the world's ability. Conclusion The crisis brought out in Korea a sense of social commitment. In early days while people were not willing to work long hours, the magnitude of the crisis brought out the nation as a unified entity. People lined up outside banks with gold jewelry to help solve the acute financial shortage. Corporate restructuring took place and companies that were best equipped to handle the crisis were distributed the losses first. Salary cuts took place and the people accepted all this gracefully. Most importantly, the Korean unions, though extremely militant in thought and action, took all this quietly in their stride. As we go through the chronology of events, causes and effects that took Korea in a new direction, we are forced to ask ourselves once again: Could the crisis be prevented Yes, it could have been. If the government had made the right policy changes, if Korea was structurally strong and not so dependent on international markets, if politicians were not corrupt and if businesses were not selfish, the crisis could have been prevented. But then, we all know that such a perfect nation is difficult to fathom. The crisis occurred because the environment, external and internal was unsuitable. The crisis occurred because its time had come. And the crisis occurred to wake up a nation to be more alert and unified. Bibliography http://times.hankooki.com/lpage/biz/200612/kt2006120514434711860.htm http://plaza.snu.ac.kr/rhee5/korea/Kcrisis3.pdf http://www.dwnam.pe.kr/home/imf01.doc http://are.berkeley.edu/adelman/crisis.pdf http://news.nate.com/Service/natenews/ShellView.aspLinkID=4&ArticleID=2006122203143599118 http://en.wikipedia.org/wiki/Asian_financial_crisis#South_Korea Read More