A New Paradigm For Korea's Economic Development: From Government Control to Market Economy (Studies in the Korean Economy)

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A New Paradigm for Korea’s Economic Development From Government Control to Market Economy

Sung-Hee Jwa

A New Paradigm for Korea’s Economic Development

Korea's Economic Development, Sung-Hee Jwa

Studies in the Korean Economy General Editors: Malcolm Falkus and Kwan S. Kim The South Korean economy is one of the economic wonders of the late twentieth century. War-torn and poverty-stricken in the 1950s, with a per capita income below that of Haiti, Thailand or India, the country then emerged as an economic giant by the 1980s. Rapid industrialization, phenomenal growth rates and rapid social transformation characterized a process that has made Korean products and firms, such as Hyundai and Samsung, familiar throughout the world. The study of Korea’s transformation is fascinating in itself, but there are also many general aspects of the process which make Korea of particular significance in understanding Asian economic development. How was South Korea able to achieve its rapid, equitable growth? What parts were played by the state, the banks, the giant corporations, imported technology, foreign investment and trade, and by the unique balance between competition and control? Korea felt the full force of the Asian economic crisis in 1997, and was one of three countries forced to call for IMF assistance. Korea’s response to the crisis (reverberations from which will remain for a long time) is of considerable significance not only for Korea but for the future handling of global financial disturbances. The present series of books aims to explore Korea’s development and its unique economic governance structure. The appearance of such a series is timely, for not only does it give the opportunity to review Korea’s growth in perspective after several decades of unparalleled advance, but it also provides an opportunity to bring to a western readership the increasing contributions of Korean scholars to the understanding of their country’s transformation.

Titles include: Sung-Hee Jwa A NEW PARADIGM FOR KOREA’S ECONOMIC DEVELOPMENT From Government Control to Market Economy

Studies in the Korean Economy Series Standing Order ISBN 0–333–71501–2 (outside North America only) You can receive future titles in this series as they are published by placing a standing order. Please contact your bookseller or, in case of difficulty, write to us at the address below with your name and address, the title of the series and the ISBN quoted above. Customer Services Department, Macmillan Distribution Ltd, Houndmills, Basingstoke, Hampshire RG21 6XS, England


A New Paradigm for Korea’s Economic Development From Government Control to Market Economy Sung-Hee Jwa President Korea Economic Research Institute Seoul


© Sung-Hee Jwa 2001 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1P 0LP. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2001 by PALGRAVE Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N. Y. 10010 Companies and representatives throughout the world PALGRAVE is the new global academic imprint of St. Martin’s Press LLC Scholarly and Reference Division and Palgrave Publishers Ltd (formerly Macmillan Press Ltd). ISBN 0–333–76063–8 This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Chwa, Sung-hui. A new paradigm for Korea’s economic development : from government control to market economy / Sung-Hee Jwa. p. cm. Includes bibliographical references and index. ISBN 0–333–76063–8 (cloth) 1. Korea (South)—Economic conditions—1960– 2. Korea (South)—Economic policy—1960– I. Title. HC467 .C6483 2000 338.95195—dc21 00–053096 10 10

9 09

8 08

7 07

6 06

5 05

4 04

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Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham, Wiltshire


2 02

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To my wife, Soo for her unwavering support


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Contents Series Editor’s Preface List of Tables List of Figures Acknowledgements 1

2

3

x xi xiv xv

Overview of the Korean Economy over the Past Thirty Years 1. Overview of Korea’s economic growth 2. Experiences of macroeconomic management 3. Korea’s experiences of microeconomic management: industrial policies and the Chaebol 4. Summary of main points 5. Aims of this volume Appendix 1.1: Korea’s experience of industrial policies The Role of Government versus the Market for Sustainable Development 1. Introduction 2. The debate over the role of the government 3. Korea’s experiences 4. The natural market order and the role of government in economic management 5. Summary and lessons Legacies and Lessons of Korea’s Macroeconomic Management 1. Introduction 2. Some features of macroeconomic developments 3. Existing patterns of macroeconomic management 4. Changing prospects in macroeconomic policy environments 5. Reforms in the macroeconomic policy regime 6. Macroeconomic policy issues in a small open economy setting 7. Summary and lessons vii


1 1 5 8 12 13 17

33 33 34 37 41 46

48 48 49 52 55 58 67 81

viii Contents

4

5

6

7

The Evolution of the Chaebols: The Property Rights System and Economic Organization in Korea 1. Introduction 2. Some testable hypotheses of new-institutional economics 3. Empirical evidence of the impact of transaction costs on economic behavior 4. Empirical evidence of the impact of the individual property rights system on economic behavior 5. Property rights and the evolution of large business firms in Korea 6. Summary and lessons Globalization and the Diversification Behavior of the Chaebols 1. Introduction 2. New industrial organization under globalized markets 3. Globalization and Korea’s industrial organization 4. Lessons for industrial policy Appendix 5.1: An integrated theory of endogenous economic organization Reform Prospects for Korea’s Financial System 1. Introduction 2. Risk and returns of Financial–Industrial interaction: the Korean Experience 3. The endogenous financial system and the prospects for Korea’s financial structure Experiences of Economic Reforms in Korea and Future Challenges 1. Introduction 2. Neoclassical interpretation of economic institutional reforms 3. A brief evaluation of institutional reform 4. Political economy of economic reform 5. Lessons for future economic reforms 6. Concluding remarks


83 83 84 90 98 101 111

114 114 117 119 126 127 132 132 133 143

154 154 155 161 163 167 172

Contents ix

8

9

Korea’s 1997 Currency Crisis: Causes and Post-Crisis Macroeconomic Developments 1. Introduction 2. A quick look at the crisis itself 3. A deeper look: structural and long-term factors 4. A deeper look: cyclical and short-term macroeconomic and external factors 5. Post-crisis macroeconomic developments 6. Some reflections on the IMF prescriptions in hindsight 7. Concluding remarks Appendix 8.1: Quantitative examination of the role of a strong exchange rate Appendix 8.2: 1. Letter to the Managing Director of IMF from leaders of Korean industry (drafted by the author) 2. Letter of reply from Michel Camdessus, Managing Director of IMF Kim Dae-Jung’s Structural Reforms and Some Evaluations 1. Introduction 2. Structural reforms in four major sectors of the economy 3. A brief evaluation of the Kim Dae-Jung reforms 4. Concluding remarks: some suggestions for future reforms

174 174 178 180 188 193 208 210 211

214 218

220 220 221 236 245

10 A Final Word: The Future of the Korean Economy 1. Challenges and opportunities for the twenty-first century 2. Changes in twenty-first century economic environment and implications for Korea’s development strategy 3. Long-term growth prospects

249

Notes

264

Select Bibliography

276

Index of Names

283

Index of Subjects

285


249 252 259

Series Editors’ Preface The South Korean economy is one of the economic wonders of the late twentieth century. War-torn and poverty-stricken in the 1950s, with a per capita income below that of Haiti, Thailand or India, the country then emerged as an economic giant by the 1980s. Rapid industrialization, phenomenal growth rates, and rapid social transformation characterized a process that has made Korean products and firms, such as Hyundai and Samsung, familiar throughout the world. The study of Korean’s transformation is fascinating in itself, but there are also many general aspects of the process which make Korea of particular significance in understanding Asian economic development. How was South Korea able to achieve its rapid, equitable growth? What parts were played by the state, the banks, the giant corporations, imported technology, foreign investment and trade, and by the unique balance between competition and control? Korea felt the full force of the Asian economic crisis in 1997, and was one of three countries forced to call for IMF assistance. Korea’s response to the crisis (reverberations from which will remain for a long time) is of considerable significance not only for Korea but for the future handling of global financial disturbances. The present series of books aims to explore Korea’s development and its unique economic governance structure. The appearance of such a series is timely, for not only does it give the opportunity to review Korea’s growth in perspective after several decades of unparalleled advance, but it also provides an opportunity to bring a western readership the increasing contributions of Korean scholars to the understanding of their country’s transformation.

x


List of Tables 1.1 A1.1 A1.2 A1.3 A1.4 A1.5 A1.6 A1.7 3.1

3.2 3.3 4.1 4.2 4.3 4.4 4.5

4.6

4.7 4.8

Key economic and demographic indicators Content of industrial and corporate restructuring prior to the 1997 economic crisis Share of policy loans in domestic credit Various interest rates Reduction of corporate tax Effective marginal tax rates Regulations on economic concentration as of 1990 Economic concentration of the chaebols Correlation coefficients for monetary growth, GNP growth and inflation from 1976 to 1997 (5 year moving average) Various economic indicators related to sterilization policy Macroeconomic benefits and costs of alternative targeting policies Extent of protection of property rights and economic behavior Cash ratio in M2 for selected countries as a proxy for transaction costs (period average) Inter-country comparison of firm size distributions in the manufacturing sector Inter-country comparison of self-employed as proportion of total employment (SEP) Regression result of the weight of self-employed to the total employment (SEP) on transaction costs in the case of Korea Cross-country regression results of the weight of self-employed to total employment on transaction costs (dependent variable: SEP) Inter-country comparison of individual property rights system index Cross-country regression results of the weight of self-employed to total employment on individual property rights (IPR) systems index (dependent variable: SEP) xi


2 20 23 24 25 26 29 30

51 75 79 90 92 93 94

96

97 99

101

xii List of Tables

4.9

5.1 5.2 5.3 5.4 6.1 6.2 8.1 8.2 8.3 8.4

8.5 8.6 8.7 8.8 8.9 8.10 8.11 8.12 A8.1 A8.2 9.1 9.2 9.3 9.4 9.5 9.6

Inter-country comparison of aggregate concentration for the 30 largest corporations in the manufacturing sector (1993) 108 Chaebol concentration ratio: 30 largest, mining and manufacturing 120 Number of subsidiaries and industries affiliated to chaebols 120 International comparison of degree of business diversification based on the Rumelt Method 122 Within-group ownership concentration: 30 largest chaebols 123 World’s ten largest non-financial businesses and ten largest banks in 1996 140 Korea’s ten largest non-financial businesses and ten largest banks in 1996 141 Key macroeconomic variables for 1990–98 175 Rapid deterioration in Korea’s credit rating 179 Official foreign exchange reserves (US$ billion) 180 Ratio of FDI flows to Gross Fixed Capital Formation in the Asian countries most affected by the financial crisis, 1990–96 181 International comparison of factor costs 185 Real effective exchange rate 187 Terms of trade for Korea 190 Details of Korea’s total external liabilities 192 Mid-year profits of listed firms, 1995–97 192 IMF Stand-By Agreement Summary of the Economic Program (5 December 1997) 196 Changes in the agreement between the Korean government and the IMF 201 Industrial activities and economic indicators in the post-crisis period 204 Vector error correction model of nominal wage, consumer price index and output per hour 212 Forecast accuracy statistics for inflation one- to sixquarters ahead inflation (1988Q1–1996Q4) 213 Major reforms in financial institutions 223 Downsizing of Korean financial institutions, 1997 to 1998 225 Outline of public support for financial sector restructuring 226 Five principles for chaebol reform 228 Debt-reduction of the top five chaebols 229 Objectives and strategies of public sector reform 232


List of Tables xiii

9.7 10.1 10.2 10.3

Reform plan for SOEs Projections of potential growth rate through contribution by factors Projection on industrial structures Korea’s long-term growth projections through economic reforms


233 260 261 262

List of Figures A1.1 3.1 3.2 4.1 A5.1 7.1 7.2 7.3 7.4 8.1

8.2 8.3 8.4 9.1

Debt/equity ratio of the 30 largest business groups Investment and savings ratios Monetary growth, GNP growth, and inflation in Korea (1976–97: 5 year moving average) The constitution of an economic system Classification of multi-product industry equilibria Efficiency enhancement through market competition and price stabilization Goal and targets of economic reform A reform agenda for price stabilization A reform agenda of economic institution for efficiency Outward direct investment (left scale), inward direct investment (left scale) and total external debt (right scale) Real GDP growth rate (four-quarter moving average) Current account/GDP (%) The rate of dishonored checks and the number of bankruptcies A disciplinary system of corporate behavior

xiv


28 50 51 85 130 156 157 159 160

182 89 191 203 243

Acknowledgements This book has been a long time in the making. I owe much to various institutions that have provided an ideal research environment, and to several individuals whose commitment to this study has ensured that the jumble of thoughts I have harbored over the years has finally taken shape into a relatively coherent publishable form. In more general terms, I am deeply grateful to the Korea Development Institute, a Korean government-funded think tank, for providing me with a first-class research environment. My longer-thana-decade experiences of policy research for the strong interventionist government has had a very profound effect on the nature and direction of my own research pursuits along the lines of a free-marketoriented philosophy. Hence, my more recent post at the Korea Economic Research Institute (KERI), a purely privately run research institute, has given me the opportunity to further these pursuits considerably. I am also very grateful to KERI for dedicated research support. Specifically, I would like to thank Dr Huh Chan-Guk of the Federal Reserve Bank of San Francisco for co-writing Chapter 8 on Korea’s currency crisis with me and offering many helpful suggestions regarding the original draft of the manuscript. Similarly, I am very grateful to Dr Kim Jun-Il, Dr Yi In-Sil, Dr Seo Jung-Hwan and Dr Nam Kwang Hee for their varying contributions to this volume. I would also like to thank Palgrave editors, Professor Kwan S. Kim and Professor Malcolm Falkus for reading the final draft and for their invaluable ideas and suggestions. I am particularly indebted to Suji Chang and Yong Yoon for reading the constantly revised manuscript countless times and providing magnificent editorial support throughout the writing of this volume. I have already dedicated this volume to my wife, Soo but I cannot emphasize enough how much her lifetime support and warm enthusiasm has helped me incalculably all the way through my career. Finally, I would like to mention my son Edward (Hoonjoon) and daughter Annie (Chungwon) for always being supportive and encouraging. SUNG-HEE JWA

xv


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1 Overview of the Korean Economy over the Past Thirty Years

1.

Overview of Korea’s economic growth

The last thirty years have seen the Korean economy achieve growth of remarkable proportions, thanks mainly due to the successful combination of a number of factors, both domestic and foreign. A skilled and educated workforce, vigorous entrepreneurship, a high savings rate, greater foreign investment and growth in export markets in general have all contributed to Korea’s recent spurt in growth. Together with post-Korean War restoration drives financed by foreign aid, the 1950s saw the implementation of an importsubstitution strategy. During the 1960s, this strategy was updated to an export-led development policy. In the 1970s, it was a capital-intensive heavy chemical industry (HCI) that provided the foundations for further industrialization during the 1980s. It was during the latter decade that both successful economic stabilization policies and favorable developments in the overseas trade climate served to augment competitiveness in the HCI. With the added price stabilization, Korea’s economy expanded very quickly. A surge in investment accompanied the rapid rise in industrialization, funded in part by high domestic savings. A high savings rate has remained a long-standing feature of the Korean economy, with a gross savings rate of 19.5 per cent in 1975, rising to 35.5 per cent by 1995. As a result, by 1995 the Korean economy was on the threshold of becoming a ‘developed nation’, with real GDP growth of between 7 and 9 per cent per year (compared to 1.2 per cent in 1960) and an unprecedented national per capita income of US$10 000. Given that per capita income was less than US$100 in 1960, this was a truly remarkable ‘rags to riches’ story (see Table 1.1). 1


Period

2

Table 1.1

Key economic and demographic indicators 1960 1965 1960s

1970

1975

1970s

1980

1985

1980s 1990

1991

1992

1993 1994

1995

1996

1997

21.1 9.3 10.8 9.2

13.4 5.3 7.7 5.4

12.9 5.7 7.0 5.5

16.6 8.1 7.2 8.9

10.8 4.8 3.9 6.8

8.1 2.1 3.2 5.0

Key macroeconomics variables (% growth) Nominal GNP 12.6 Real GNP 1.1 GNP deflator 11.7 Real GDP 1.2 Per capita income (US$) 79 Consumption (Real) 3.5 Investment (Real) 7.0 Imports growth (customs Clearance) 13.1 Exports growth (customs Clearance) 65.7 Current account (million of US$) surplus/ deficit* 13 C/A balance to GDP ratio 0.7 Producer price index 4.2 Consumer price index Na

12.5 5.8 6.2 5.7

25.8 7.8 17.0 7.7

24.4 8.9 14.2 8.8

33.4 4.5 26.5 6.5

30.1 8.3 20.2 8.6

20.4 –5.3 24.6 –2.1

11.0 6.0 4.5 6.5

17.0 7.7 8.8 7.5

105

120

253

594

725

1,597

2,242

2,691 5,886

6,810

7,183

7,811 8,998

10,823 11,380

10,307

6.3

6.0

10.6

5.6

6.9

1.1

6.5

6.6

9.2

7.9

5.6

5.4

7.1

8.2

7.2

3.2

27.1 22.9

6.8

7.7

15.0

–10.7

4.3

8.2

25.9

13.3

–0.7

6.3

10.7

11.9

7.3

–2.2

14.6 17.5

8.8

6.2

24.1

9.6

1.6

11.4

13.6

16.7

0.3

2.5

22.1

32.0

11.3

–3.8

47.0 41.7

34.2

13.9

30.4

16.3

3.6

13.1

4.2

10.5

6.6

7.3

16.8

30.3

3.7

5.0

9

–145

–623

–1,887 –1,160 –5,312 –795

18552 –2,003 –8,317 –3,943 990

–3,867 –8,508 –23,005 –8,167

0.3

–4.2

–7.8

–8.9

–4.4

–8.5

–0.9

1.7

–0.8

–2.8

–1.3

0.3

–1.0

–1.7

–4.4

–1.7

9.3

12.6

9.1

26.5

15.5

39.0

0.9

6.3

4.2

4.8

2.1

1.5

2.7

4.7

3.2

3.9

6.8

11.2 (65-)

16.9

24.7

15.1

28.7

2.3

8.1

8.5

9.3

6.3

4.8

6.2

4.5

4.9

4.5


20.9 8.7 10.8 9.0

16.5 8.4 7.6 8.3

Table 1.1 Key economic and demographic indicators (continued) Period

1960

1965

1960s 1970

1975

1970s 1980

1985

1980s 1990

1991

1992

1993

1994

1995

1996

1997

Key macroeconomics variables (% growth) (contd) Interest rate

Na

Na

Na

Unemployment rate 7.9 7.3 6.6 Savings and Investments ratios (%) Gross savings ratio 9.0 13.2 14.5 Domestic gross investment ratio 10.0 14.1 17.2 Key Monetary indicators (% growth) Monetary base 3.7 48.0 29.6 M2 –3.0 52.7 38.8 M2 velocity 16.05 –26.49 –8.87 Exchange rate (Won/US$) 650 272.6 276.6

Na

20.1

22.2 (75-)

30.1

14.2

16.9

16.5

18.9

16.2

12.6

12.9

13.8

11.9

13.4

4.4

4.1

4.1

5.2

4.0

3.8

2.4

2.3

2.4

2.8

2.4

2.0

2.0

2.6

17.8

19.5

25.6

24.4

31.1

31.1

37.5

37.3

36.4

36.2

35.5

35.5

33.8

33.4

24.9

28.9

28.0

32.2

30.5

30.7

37.6

39.8

37.3

35.4

36.5

37.3

38.1

34.4

38.8 27.4

39.0 28.2

32.0 30.0

–6.5 26.9

1.7 15.6

14.0 19.5

7.7 17.2

18.2 21.9

10.9 14.9

27.5 16.6

9.2 18.7

16.3 15.6

–12.2 15.8

–12.5 14.1

16.03

6.00

–0.04

–3.22

–0.41

–1.13

–0.48

2.11

–4.19

–4.77

0.80

1.05

–4.59

–9.16

316.7

484.0

439.0

607.9

870.5

764.0

708.0

733.6

780.8

802.7

803.6

771.0

804.8

951.1

38 123 40 805 40 461 42 869 43 296 43 748 44 195 44 642 45 092 45 545 45 991 14 431 15 592 15 817 18 539 19 048 19 426 19 803 20 326 20 853 21 243 21 662 57.3

65.4

—

74.4

—

—

—

—

78.5

—

—

27.2

36.4

35.3

33.2

33.2

34.3

38.4

45.3

51.4

54.9

60.1


3

Key demographic indicators Population (1 000) 25 012 28 704 28 319 32 240 35 280 34 947 Economically active Population (1 000) 7 686 8 754 8 690 10 062 12 192 12 103 Urban population ratio (%) 28.0 Na — 41.2 48.4 — Advance rate of students to tertiary education (%) 23.7 Na 32.3 26.9 25.8 25.6 (62-)

4

Table 1.1 Key economic and demographic indicators (continued) Period

1960

1965

1960s

1970

1975

1970s

1980

1985

1980s

1990

1991

1992

1993

1994

1995

1996

1997

44.8

34.0

24.39

26.4

17.9

16.4

15.8

14.7

13.7

12.4

11.7

11.3

19.1

22.5

24.4

25.0

27.6

27.3

25.9

24.5

23.9

23.6

22.6

21.4

36.2

43.5

50.6

48.6

54.1

56.4

58.4

60.8

62.4

64.0

65.7

67.3

9 874

9,899

9 914

9 913

9 927

9 930

9 931

9 939

9 939

9 927

9 931

9 937

Sectoral contribution to employment (%) Agriculture, forestry & fishing Employment 56.8 Na 58.5 50.4 45.7 (63-) Mining and manufacturing 11.5 Na 10.4 14.3 19.1 (63-) Services and other sectors 31.7 Na 31.2 35.3 35.2 (63-) Land size of South Korea (1 000km2) Total land area (territory) 9 843 9 843 9 845 9 848

9 881

Notes: 1960s, 1970s and 1980s are period averages unless marked by * (aggregate) ; GNIP(Gross National Product) became GNI (Gross National Income) after 1970


Korea over the Past Thirty Years 5

A brief consideration of other key economic growth factor tells a similar story. Exports constituted only a tiny proportion of the economy three decades ago but, following the export drives beginning in the 1970s, exports burgeoned at an increasing rate; by 1980 they had soared to over five hundred times the level recorded in 1960. By 1995, exports had expanded even further – to seven times the 1980 level. Economic performance of this caliber meant that just before the economic crisis broke out in 1997, Korea was ranked 11th in the world in terms of GDP volume and twelfth in terms of trade volume. Moreover, regardless of the fact that the Korean population had almost doubled within the same time period, unemployment levels actually fell from the 7.9 per cent recorded in 1960, before settling to a very low 2 per cent in 1995. Another indicator of economic development, the movement away from agriculture and towards an industrialized base, was also witnessed in Korea in a relatively short period of time. Table 1.1 shows the substantial decline of those employed in agriculture, forestry and fishing from 68 per cent of those employed in 1960 to half of that figure by 1980 and to 12.5 per cent by 1995. Finally, another key factor pointed out in discussions of Korea’s rapid development is its consistently high levels of education. While only 26.9 per cent of the population had attended tertiary school in 1970, by 1995, this figure had grown to 51.4 per cent, competing with the best of the world’s high school level advancement rate.

2. 2.1

Experiences of macroeconomic management The export drive since the 1960s

The turning point in Korean economic development came in 1961 when President Park Chung-hee began instituting a series of major changes in economic policy. Since the 1960s, Korea’s industrialization has been carried out under strong government-led economic management. The scope of government intervention was extensive, including policies such as managing resource allocation and designating to the private sector the task of nurturing strategic industries. The primary goal of industrial policy in the 1960s was to promote exports. This was an important shift in strategy from the importsubstitution policy undertaken in the 1950s. The export-drive policy was focused on the labor-intensive industries, utilizing the relatively well-educated and abundant labor force. To implement the exportdrive strategy, the government launched the first five-year economic


6 A New Paradigm for Korea’s Economic Development

development plan (1962–1966). This was drawn up by the Economic Planning Board (established in 1961), which thereafter served as the major policy coordinator. For the credit allocation, the government also undertook measures to strengthen ‘state control over finance’, such as the revision of the Bank of Korea Act (1962) to subordinate the power of the central bank to the government. In addition, in 1961 the government undertook measures to nationalize major commercial banks, which were then utilized to support government policy with loans to target industries. In another development, in 1964 exchange rate reform was undertaken to transform the system from a unitary floating rate to a crawling peg system. The Korean won was devalued at the same time. Macroeconomic statistics show that the Korean economy did successfully take off during the 1960s. Korea’s economic growth reached an annual rate of 7.8 per cent with annual export growth at 41.7 per cent. During this period, however, Consumer Price Index (CPI) inflation was relatively moderate, reaching an annual rate (aggregated from 1960–1969) of about 11 per cent (see Table 1.1). 2.2

The Heavy and Chemical Industry drive of the 1970s

The 1970s in Korea have been described as the period of heavy and chemical industry (HCI) promotion. Korea introduced the HCI strategy in 1973 to address concerns regarding the transformation of industry from being labor-intensive to being capital-intensive and the reduction of the mounting current account deficits caused by an ever-increasing import demand for capital goods and intermediate inputs for export production. Another important consideration was improving selfdefense capabilities through the fostering of heavy industries. The fall of South Vietnam in 1975 heightened concerns about national defense issues. However, the HCI drive was essentially an import-substitution policy in the HCI sector. Of course, even under this drive, Korea’s economic development strategy continuously supported the export promotion policy. To support the HCI drive, a more active government role in resource mobilization became necessary. The central bank’s rediscount window, as well as the commercial bank’s credit supply, was geared to support the HCI in addition to the export industries. However, this policy resulted in an excessive expansion in the money supply which, in turn, produced high inflation. In addition, the two oil price shocks experienced in the 1970s, one in 1973 and another in 1979, aggravated the inflationary situation. During this period,



Korea achieved economic growth at an annual rate of 8.9 per cent, which is commendable, but also experienced a high annual inflation rate – about 15.1 per cent. The inflation rate shot up to over 20 per cent by the end of the decade. This generated the concern that growth could not be sustained without some strong corrective measures to curb inflationary pressures. 2.3

Economic stabilization policies since the 1980s

In Korea, the 1980s saw the introduction of some strong antiinflationary policy measures. Monetary growth was decelerated and fiscal expenditures were tightly monitored. In addition, various policy measures were undertaken to change the degree of government intervention in resource allocation. The HCI drive was toned down and attempts were made to alleviate the structural problems through various adjustment measures.1 Deregulation and market opening were also advocated and adopted as a part of the general economic policy stance. The emphasis of economic management changed from strong government intervention in resource allocation with various regulations on prices, quantities, entries, imports, and other important economic activities to a more market-oriented system of resource allocation and mobilization. For example, until June 1981, prior approval was required for any changes in the prices of many manufactured goods. Thereafter, a new and much more relaxed system of ‘price surveillance’, which closely monitored price changes in key manufactured goods, was implemented. The stabilization program was firmly maintained in spite of the low growth performance in the first half of the 1980s. Consequently, Korea succeeded in curbing inflationary pressures. Inflation in the GNP deflator fell to 11 per cent in the first half of the 1980s, a marked drop from the 20 per cent range which had been seen during the late 1970s. During the period from 1986 to 1988, after a five-year fight against inflation, Korea experienced a strong economic boom thanks to favorable external conditions, among them the so-called ‘three lows’: the low exchange value of Korean won vis-á-vis the dollar and yen; low international interest rates; and low oil prices. Korea responded to the opportunities that arose, producing double-digit growth rate of 12 per cent and low, single-digit inflation of 5.6 per cent. However, success of this magnitude naturally had its costs. In this case, the nation’s extraordinary economic performances actually weakened the government’s efforts to make changes in the policy pattern as well as the private sector’s perception of the need for structural adjustment.



Thus, the booming economic environment meant that neither the government nor private firms were motivated to make serious efforts towards a shift in policy regime and structural adjustment respectively. The downturn in 1989, due to the deterioration in external economic conditions and the economic fluctuations since then, led to the revival of the typical interventionist role of the government in economic management, although this time for different purposes from those pursued in the 1960s and 1970s. The popular view was that the economic downturn and sluggish export performance were attributable to the weakness of Korea’s industrial competitiveness, primarily caused by the concentration of economic activities of the chaebols relative to that of small and medium-sized firms. Therefore, the view that the promotion of small and medium-sized firms was necessary to curb the chaebols’ excessive business diversification activities began to receive popular support. The so-called balanced industrial structure was thought of as an important element for industrial competitiveness. Of course, the anti-chaebol sentiment, which had been gaining momentum since the democratization process started in 1987, added to the increasing popularity of this view. In recent years, financial support for small and medium-sized firms has been emphasized as the most important lending priority at every financial institution. In this way, the pattern of active government intervention in economic management during the 1960s and 1970s was subdued during the first half of 1980s under the efforts to stabilize the economy, but regained momentum, though for different reasons, towards the end of the 1980s. From 1992, inflation pressures had eased somewhat and macroeconomic conditions appeared to have stabilized. However, the pace of economic growth started to pick up in 1994 and 1995. After two years of real GDP growth of over 8 per cent, the Korean economy started to slow in the second half of 1995 and this was accompanied by a sharp cutback in investment. The current account deficit showed a widening trend in 1996 as imports did not fall commensurately with domestic aggregate demand. The slowing trend continued throughout 1997 until the onset of the foreign exchange crisis.

3. Korea’s experiences of microeconomic management: industrial policies and the ‘chaebol’2 In the previous section, we considered the history of Korea’s past macroeconomic management. In the 1960s, the government led the export drive. During the 1970s, the government promoted the HCI



drive. In the 1990s, the Korean government’s macroeconomic concerns have been focused on the promotion of anti-inflation and stabilization policies. Along with the changing concerns of macroeconomic management, the government’s industrial policies have also changed. Supported by government measures, significant changes have taken place in the main industries and in major enterprises. The government allocated scarce resources to targeted industries and under this preferential treatment, these industries grew rapidly. Eventually, many of those enterprises formed into the conglomerates, known in Korea as chaebols, that have come to occupy an essential portion of the Korean economy. In Korea, the government’s macroeconomic and industrial policy had an enormous influence on the development and organization of industry and firms. In the following section, we briefly consider these industrial policies and the progress of the chaebols under these policies. 3.1

Korea’s experience of industrial policies3

Korean industrial policies over the last thirty years could be depicted as a developmental cycle in the following ways: (i) government selection of industries and corporations to be supported; (ii) mobilization of tax and financial resources and the drafting of trade policies supporting selected industries and corporations; (iii) government-led restructuring of industries and corporations in distress. The government intervened at every phase of this cycle, using entry and exit barriers and financial and tax supports as tool to carry out industrial policy. During the 1950s, and following the Korean War, Korea concentrated its energy on rebuilding industrial facilities and no coherent industrial policy as such existed at that time. Meaningful industrial policies were first implemented in the 1960s, when the first Five Year Economic Development Plan was launched.4 The government targeted the construction of key industries through import substitution. The strategic industries selected included those that produced fertilizers, refined oils, synthetic chemical fibers and electric machinery. The investment resources ploughed into these industries largely came from foreign loans. The most extensive government intervention took place in the 1970s with the HCI drive. The key industries selected by the government included iron, steel, nonferrous metals, shipbuilding, general machin-



ery, chemicals and electronics. Along with the promotion of HCIs, the government adopted an export-oriented policy. For this purpose, it sought economies of scale in export industries, resulting in the establishment of the so-called ‘General Trading Companies’. Trade policies also supported the selected industries and corporations. It was almost impossible to import foreign products if similar goods were produced domestically. However, if an exporting firm needed to import parts for the production of export goods, it was exempted from this rule. In the 1980s, the problems caused by these industrial policies became increasingly apparent. Overinvestment in the HCIs and the expansionary monetary policy that brought about high inflation gave the government reasons to refrain from carrying out active industrialization policies. Instead, industrial policy was limited to supporting technology-intensive industries. The underlying motive for this shift was to correct the structural imbalance that had started to appear in the manufacturing sector during the 1970s. However, this resulted in severe overcapacity in the neglected HCIs. In the 1990s, the government’s economic policy making emphasized deregulation. The government rescinded many existing regulations but sometimes revived the repealed ones. 3.2

Growth of the chaebols

In the early stages of Korea’s economic development, the government allowed a few selected corporations to enter protected or targeted industries. Since those industries were HCIs and therefore subject to economies of scale, it was inevitable that they would increase in size. This practice set the stage for further government intervention in the course of economic development. At a later stage, the larger corporations were given preferential entry into other targeted industries, while restricting entry to other private firms. The key large firms were showered with further financial benefits, giving them every incentive to diversify their operations according to the government’s industrial targeting policy. These large business groups were also reinforced by the government’s policy of transferring the ownership of insolvent firms to the ever-growing chaebols. As if that was not enough, government policy went as far as to bail out some non-viable chaebols so that the conglomerates had no real opportunity to restructure themselves according to market discipline. The growth of the chaebols soon became a burden to economic policy. Accountable as they were for a large share of the Korean economy’s assets, sales and debts, the chaebols inevitably influenced



the majority of the industrial policy measures. From their priviliged position, the chaebols initiated large-scale projects without fear; in fact, strategic concerns in oligopolistic markets forced them to expand their capacity. They grew larger and larger, generating the notorious ‘too big to fail’ legacy of the chaebols. In addition, Korea’s financial system was heavily skewed towards indirect financing through banks, with relatively little being financed directly through the stock market. The banking system was controlled by the government, which channeled financial resources to support large businesses. As a result of this financial structure and their own over-expansion, the chaebols ended up with a high debt/equity ratio. 3.3

Legacies of interventionist industrial policies

The government-led interventionist industrial policy strategy generated various structural problems. First, policies targeting certain industries and certain firms greatly distorted resource allocation as they frequently substituted for the price mechanism. This resulted in overinvestment in HCIs and the subsequent restructuring of this industry. Preferential industrial policies worsened economic concentration, resulting in a monopolistic economic structure and structural imbalance between large firms and the small and medium-sized enterprises. Second, the financial sector was often used as a tool to support the government’s industrial policies. Subsequently, this crucial economic sector ceased to develop properly and financial institutions found themselves unable to discriminate between viable and non-viable firms, or even to monitor the performance of borrowing firms. Third, persistent government intervention essentially removed the incentive for private firms to innovate and maximize efficiency, making the private sector dependent on governmental guidance and coordination. In fact, the large firms generally assumed they were ‘too big to fail’, a fallacy resulting in moral hazard. Finally, the government’s preferential industrial policy generated scope for rent-seeking. Together with the significant lobbying power of the large firms and the scope for corruption, this contributed to an increasingly prevalent anti-chaebol sentiment. The result of the interventionist industrial policies greatly contributed to the development of the financial crisis. With the effectiveness of market discipline eroded away and moral hazard rife within the economy, the need for economic restructuring was not recognized. An economy lacking in market flexibility and adaptability cannot be expected to be resilient enough to endure sudden external shocks.



What is more, in the aftermath of the 1997 crisis, the government was forced to intervene once again to clear up the mess brought about by its own interventionist policies.

4.

Summary of main points

One of the ‘Four Asian Tigers’ at the vanguard of Asia’s miraculous leap into accelerated economic development, over the last thirty years Korea has enjoyed a period of particularly rapid growth. Kick-started by the export-driven policies of the 1960s, the Korean economy successfully changed gear in the 1970s with its HCI policies. The 1980s seemed to maintain the furious pace of growth and in 1997, just before the outbreak of the economic crisis, the Korean economy was estimated to be the 11th largest in the world. The main thrust behind Korea’s success story was the close adherence to economic management plans mapped out by the government. However, record levels of economic growth have also been accompanied by some long-lasting negative legacies. One of the most fundamental weaknesses of the Korean economy was the slow emergence, or in some cases a complete absence, of market institutions. Similarly, the economic system failed to offer agents the appropriate incentives to ensure that decisions were made on a commercial basis. A prominent example of the former was the weak Korean banking sector. State intervention in credit extension by banks in Korea, a prevalent practice throughout the last three decades, led to an accretion of nonperforming loans on the bank balance sheets. It is widely acknowledged that the troubled banking sector provided the perfect setting for the outbreak of the 1997 currency crisis and served to amplify the problems inherent in the Korean economy. The onset of the foreign exchange crisis, which prompted the subsequent IMF intervention in November 1997, was a development that dramatically changed Korea’s economic outlook. While external factors certainly contributed to the crisis, some domestic factors also played a critical role in bringing about the crisis. The Korean government has pursued strong industrial policies for several decades, mainly by granting licenses to a limited number of firms to operate in various fields of businesses, particularly those seen to be strategic to economic development. The resulting industrial organization structure was inclined to be oligopolistic, reducing competition within the product market, and in turn fostering inefficiency in many businesses. A different manifestation of such a policy is the Korean



government’s long-held inclination to protect producer interests over those of consumers. Since the overriding concern for economic policy makers was how to achieve rapid industrialization, it is easy to understand the relative imbalance in the government’s focus. For example, the government has actively encouraged banks to lend to industries while any type of lending to consumers has typically been viewed negatively and actively discouraged. Another example of economic policies favoring domestic producers over consumers was the restriction on imports, which banned most foreign consumer products. This restrictive practice has only recently been phased out in part. The resulting lack of competition in the product market ultimately led to inefficiencies in the businesses sector.

5.

Aims of this volume

The major aim of this book is to help integrate the new paradigm of market-oriented economic management into the Korean economy in order to pave the way towards becoming an advanced economy in the 21st century. This new paradigm is closely related to the economic reform issues that the Korean economy is currently facing. Thus, we have tried to analyze various aspects of the economic reforms; reviewing and evaluating past experiences of economic management policies and drawing lessons from these in planning future directions for reform in Korea. Historically speaking, the Korean economy has been government-led, with the government constantly attempting to intervene in economic matters within the private sector. However, in order for the Korean economy to develop further, we will suggest that and the government will have to change its leading and interventionistic role for this to become a reality. With this and our key aims in mind, a brief overview of the structure of this volume is now in order. Chapter 2 takes a critical look at Korea’s past economic policy and lessons to be learned for the Korean economy in the future. We offer discussion on the appropriate role of government and markets in economic management in a general context before focusing on the case of Korea. The key point of this chapter is that market failure is generally a result of institutional failure – a form of government failure – and that it therefore needs to be dealt with by encouraging an unhindered market order. It is our belief that the role of government should therefore be confined to cultivating a suitable economic environment for just such a smoothly operating market while leaving endogenous variables for market forces to determine.



Chapter 3 narrows the focus further to consider Korea’s macroeconomic management over the last three decades. Macroeconomic policy performance and the patterns that have emerged over the last three decades are examined. This is followed by a general discussion about various necessary reforms in Korea’s macroeconomic policy regime, some of which are already taking place at the time of writing. In particular, we look at monetary, fiscal and foreign exchange policies, arguing that a policy system that relies on indirect methods should be implemented for macroeconomic stabilization. Another important issue discussed is the importance of safety nets to protect this policy stance from the influence of political parties and various interest groups via such measures as an independent central bank, a consolidated rulebased system of economic policy making and a lengthened policy horizon. Finally, the changing macroeconomic environment is examined, especially in conjunction with the more open flow of goods and capital across national borders, and Korea’s past experience in dealing with this phenomenon. Chapters 4 and 5 explore the issue of the Korean conglomerates, or chaebols. These have been described in this chapter as large business groups made up of companies that have diversified into a variety of business areas. Chaebols are also characterized by the concentration of their economic power, the failure to separate ownership and management and by the practice of passing on managerial power from family member to family member. In both chapters, we take a deeper look into key determining factors behind the peculiarities of chaebol behavior. Discussions in these two chapters will help increase our understanding of how large businesses in Korea have emerged and why they exhibit their characteristic behavioral patterns. In Chapter 4, we adopt a new-institutional economic standpoint and discuss the importance of a private property system in determining the structure and peculiar behavior of Korean conglomerates. Our main conclusion here is that a weak property rights system has led to high transaction costs within the Korean economy. In trying to alleviate the high transaction costs, the Korean government adopted a policy of protecting the chaebols at all costs. As a result, businesses saw the advantages of organizing themselves into chaebol-type organizations. Over the last three decades, these factors saw the Korean conglomerates evolve into overly dominant economic organizations. The discussion in Chapter 5 concerns economic and industrial organization issues that are related to the so-called excessive diversification behavior of the chaebols. Our discussion shows that this behavior is



partly attributable to the extent of the economies of scope that can be reaped from engaging in various lines of businesses. In addition, the limited size of the domestic market in Korea and the government’s own brand of industrial policy have also influenced diversification behavior. As the world economies move towards globalization on an increasingly greater scale, chaebols will be forced to reassess the extent to which they choose to diversify. In the face of greater international competition, the chaebols as they are currently operating will simply be unable to remain competitive Chapter 6 looks at Korea’s financial system and presents some basic issues that should be considered in any serious future attempts to reform the Korean financial sector. In the banking sector, the most prominent group within the financial market, we find that relative mismatch between the sizes of businesses and banks as well as the concentration of lending were key sources of the recent serious afflictions in the Korean financial system. In thinking about the direction of future reforms, we conclude that the designation of appropriate business areas for various financial institutions should be made on the basis of sound economic reasoning alone. Chapter 7 considers economic reforms that we believe will be paramount in rebuilding and maintaining an economy capable of operating efficiently in an era of global competition. The chapter begins with a theoretical framework for economic reforms and analyzes the underlying reasons for the mediocre success or, as in some cases, outright failure of the past reform efforts. The second part of this chapter draws some conclusions from Korea’s reform experiences, highlighting the importance of adopting a systemic approach and choosing the optimal sequence of reforms. In particular, we address the importance of resolving the problem of moral hazard and of strictly enforcing government policies. Finally, it is also emphasized that the government’s role in overseeing the institutional reform process is more important now than ever before. Unless the government can take responsibility for the new reforms, Korea will face severe difficulties in regaining any form of economic stability in the future. The approach of Chapter 8 is to take a critical look at the causes and implications of Korea’s currency crisis in late 1997 and to overview the post-crisis macroeconomic development. Among the former, we look at domestic structural problems. A key factor was the inept handling of foreign exchange policies in the period immediately preceding the crisis. Under the situation faced by the Korean economy, nothing short of a complete removal of the exchange rate band sometime in early



1997 could have made a difference to the final outcome. The obvious implication of this conclusion is that there is a critical need to implement structural reforms in order for such a crisis to be avoided in the future. This chapter also charts post-crisis macroeconomic developments under the IMF program and offers some thoughts on the effectiveness and appropriateness of the IMF prescriptions. Chapter 9 takes a look at some of the key reforms under the Kim Dae-jung administration in the financial, industrial and public sectors. Under the watchful eyes of the IMF and other external observers, these reforms appear to have had the desired effect – so far. It is generally accepted that Korea escaped the worst of the economic crisis relatively quickly – a conclusion borne out by the first positive growth figures published in early 1999. However, at the time of writing, Kim Daejung’s reforms have been in place for two years and the long-term effects are impossible to gauge. This chapter emphasizes the necessity to adopt the market paradigm as explained throughout this volume. Unless the Kim Dae-jung and subsequent administrations strive to shape their reform policies in this way, the future success of the Korean economy is far from assured. The volume ends with a word on the future of the Korean economy toward the twenty-first century. Emphasis is laid on intellectual capital and superior human resources as the primary engines for new growth and development. Our main conclusion here is that in order to benefit from the changing economic environment, Korea must not only comply with global requirements but also strive to become more liberalized and attain economic flexibility. In addition, a brief discussion of Korea’s long-term growth prospects is presented. Assuming that the various reform efforts will be successful, the Korean economy will have a potential growth rate of between 4 and 6 per cent into the twenty-first century. Before moving on to the role of government in Chapter 2, we would like to state clearly that this volume will not deal comprehensively with every issue relating to the economic sector in Korea. Our aim is not to provide a source book with an overview every aspect of the Korean economy. Such a task, apart from being a truly gargantuan endeavor, would be rather pointless considering the abundance of material already in existence that focuses on all major areas of the Korean economy. Rather, we seek to focus on a number of important issues concerning the reforms of economic sectors in Korea. In doing so, we deal not only with macroeconomic policy issues including the role of government in



economic management but also with various structural characteristics, such as the problems directly related to chaebols, as well as the financial and institutional weaknesses within the Korean economy. We argue that all of these are underlying causes of the economic crisis that hit the nation so severely in 1997. We will closely examine these and other factors in detail, in places offering theoretical analysis on the basis of empirical observations. It is within this framework that we approach the matter of economic reform in a range of sectors, and in doing so we offer some thought on the reforms instigated by the Kim Dae-Jung administration.

Appendix 1.1:

Korea’s experience of industrial policies

Schematically, the pattern of Korean industrial policies during the last thirty years could be depicted as a cycle of: (i) government selection of industries and corporations to be supported → (ii) mobilization of tax and financial resources and drafting of trade policies to support the selected industries → (iii) government-led restructuring of industries and corporations in distress. The government actively intervened at every phase of the cycle. Entry and exit barriers, and financial and tax supports, were the tools of industrial policy. Entry barriers basically allowing only the existing large corporations to enter targeted industries and policies designed to support these corporations contributed to the rise of big diversified enterprises, the Korean chaebols. Moreover, exit barriers erected as a result of active governmental intervention in industrial and corporate restructuring inhibited the natural flow of economic resources fro non-viable firms to viable ones. Financial support included loans of scarce financial resources at preferential, subsidized rates, with long maturity periods to corporations chosen to operate in selected industries. These practices resulted in very biased resource allocation. During the 1950s, Korea concentrated its energy on rebuilding industrial facilities. No industrial policy existed at that time. Meaningful industrial policies were first implemented in the 1960’s, at which time the First Five-year Economic Development Plan was launched. The government targeted the construction of key industries through import-substitution. It selected several industries, including fertilizers and oil refining as strategic industries to be supported. Laws supporting these industries were enacted. The government allocated most investment resources, which were procured mainly through foreign loans, to firms operating in these industries.



The most extensive government intervention took place in the 1970s when it carried out ‘the heavy and chemical industrialization (HCI) drive’. The government designated certain industries as key industries. These included iron and steel, non-ferrous metals, shipbuilding, general machinery, chemicals and electronics. Tax and financial resources as well as trade policies were used to promote the development of these industries. Entry barriers were set up, contributing to the rise of the chaebols. During this period, the average size of HCIs grew larger and larger. In the 1980s, problems caused by the previous decade’s industrial policies started to become evident. Overinvestment in HCIs and the expansionary monetary policy that caused high inflation led the government to refrain from active industrial promotion policies. Industrial policy was redrawn to support technology-intensive industries. The underlying motive for this shift was to correct the structural imbalance that started to appear in the manufacturing sector in the late 1970s. Massive inflows of funds into HCIs were cut off, leaving many of these industries with severe overcapacity. Moreover, the government actively intervened in industrial and corporate restructuring. In the 1990s, the government’s economic policy emphasized deregulation. The government rescinded many existing regulations, although it sometimes reversed this policy. The government’s interventionist habits and the private sector’s persistent expectations of government initiation/intervention in the market have continually impeded the development of market economy in Korea. Selective nurturing of industries by the Korean government For the sake of rapid economic growth, the government set up economic development plans and selected strategic industries. Furthermore, in the course of promoting these industries, the government restricted entry through regulations, contributing to the growth of a few large corporations. In the early 1960s, fertilizers, oil refining, steel, synthetic chemical fibers and electric machinery were selected as the industries to be supported. The government also set up a division of labor. The government was supposed to build the oil refineries while the private sector was in charge of the other industries. During that period, 60 per cent of total investment was procured through foreign loans, 55 per cent of which was used for the fertilizer, refined oil, cement and textile industries. Moreover, 25 per cent of foreign loans were spent on SOC such as electricity, telecommunication and transportation.



In the second half of the 1960s, the government targeted the steel, petrochemical, and general machinery industries. During this period, these three industries absorbed 60 per cent of total investment in the manufacturing industry and 77 per cent of foreign loans. In the 1970s and early 1980s, the HCIs were targeted as strategic industries.5 They included iron and steel, nonferrous metals, shipbuilding, general machinery, chemicals and electronics. Once again, tax and financial resources, as well as trade policy, were used to support these industries. The government only permitted existing large corporations to enter the targeted industries, and as a result they enjoyed the benefits emanating from the government’s support of these industries. The government allowed foreign loans for firms in the targeted industries on a preferential basis. Entry and exit barriers Once the strategic industries were selected, the government decided which ones it would take care of and which ones it would delegate to the private sector. There was fierce competition in the private sector to get permission to enter these industries. However, once the entry permission was obtained, the selected firms were protected by entry restrictions and supported through tax and financial policies. After industrial capital began to be accumulated in the 1960s, the government recycled the corporations – in other words, those that had been selected in the 1960s were selected again to participate in the HCI drive of the 1970s. For example, ‘the Promotion Plan for Heavy and Chemical Industries’, announced in June 1973, stated that the companies wishing to enter the HCIs must procure 30 per cent of total investment with their own capital. This was a way of ensuring that only those enterprises that had been selected in the 1960s would be eligible, because they were the only ones able to put up such a large amount of capital.6 Along with the promotion of HCIs, in the 1970s the government adopted an export-oriented policy. For that purpose, it sought economies of scale in export industries, resulting in the establishment of the so-called ‘General Trading Companies’. These companies were private enterprises specializing in the export of Korean goods, and enjoyed government backing. Trade policy also supported the selected industries and corporations. It was almost impossible to import foreign products if similar goods were produced domestically. However, if the exporter needed to import inputs for the production of export goods, it was exempted from this rule and moreover it benefited from the tariff rebate system. As such,



the general trading companies engaged in the export and import businesses as well as in the HCIs through their subsidiaries, and benefited greatly from the system. As a result, HCI output accounted for 57 per cent of the general trading companies’ total exports in 1980.7 In addition to entry selection, the government actively intervened in the corporate restructuring process, including the liquidation and M&As of private firms. Table A1.1 shows the main content of industrial and corporate restructuring that took place during Korea’s rapid economic development period. Throughout the 1960s, the country’s export-oriented economic development strategy, financed by large investments, generated many incompetent firms which lacked both commercial experience and managerial skills. The funds needed to finance the projects of the Table A1.1 Content of industrial and corporate restructuring prior to the 1997 economic crisis Content 1969–1971

1972 Industrial Rationalization

Late 1979s–early 1980s Restructuring of HCIs

1990s Business Specialization Inducement

– 112 insolvent firms in the PVC, automobile, steel, chemical and textile industries were liquidated or acquired by other firms. – Due to a tight monetary policy recommended by the IMF and a sharp devaluation, firms took out loans at high interest rates and with a short maturity. The financial problems of these firms worsened considerably. – Industrial Rationalization. • Covered 61 firms, including 30 in heavy industries, and 10 in light industries. • Self-rationalization through specialization, M&As and R&D supported by the government through financial and tax support. – The government decreased flow of money to HCIs to correct over-investment in those industries. – The electricity generating, heavy construction equipment, automobile, and diesel engine industries were covered. – Main restructuring tools were M&As. The government supported restructuring with bail-out financing and interest rate subsidies. – Induce the big 30 business groups to specialize by easing regulations on business groups choosing the core business areas.



1960s were mainly procured through foreign loans under government guarantees and were allocated by the government. The government worried that the emergence of many non-viable firms could lower the nation’s credit status in international financial markets, which would impede economic growth, greatly dependent on foreign loans. As a result, the government, despite criticism that it was itself partly responsible for failures in resource allocation, actively intervened in the corporate restructuring process. Between 1969 and 1971, 112 incompetent firms were either liquidated or acquired by other firms. The government’s corporate restructuring strategy was to transfer ownership without liquidation. However, problems of high financial costs and capital structure vulnerability persisted in all firms. The tight monetary policy recommended by the IMF in the early 1970s and sharp currency devaluations aggravated those financial problems. Thus, the government took comprehensive measures and applied them uniformly to the remaining firms in order to alleviate their financial difficulties. Those measures included transforming short-term debts into long-term debts, lowering interest rates, and tax exemptions. From the late 1970s, the main problems of the Korean economy were overinvestment and persistent inflation caused by the expansionary monetary policy. From 1979, the government switched the focus of economic policy to the stabilization of the economy and the scalingdown of investment in HCIs. In 1979, the government set the M2 growth rate at 25 per cent, 10 per cent lower than the 1978 rate. It also diverted financial support toward the expansion of consumer goods industries, which led to a reduction of investments in HCIs. Throughout the 1980s, the government reorganized the HCIs to raise their competitiveness through the creation of economies of scale and to reduce the social costs associated with massive corporate bankruptcies. The restructuring process covered the electricity generation, heavy construction equipment, automobile, and diesel engine industries. However, the government underestimated not only the transaction costs of M&As, but differences in production technologies and the technological levels of the merged firms or the acquired and acquiring firms, leading to many idle facilities. In addition, the government carried out a program of industrial rationalization. It revised the tax reduction regulation law. The revision states that: (i) the government sets the industry rationalization criteria; and (ii) firms going through rationalization according to these criteria will benefit from tax reductions or exemptions. Until 1988, 70 firms were classified as firms necessitating rationalization. Among them, 67 firms were disposed of



through government-led M&As, two firms went through a reorganization process and one firm was liquidated. Note that most firms were merged with or acquired by third parties based on criteria set by the government, not through market discipline.

Financial and tax support The government allocated financial resources and provided tax support to the corporations given the permission to enter the industries it deemed economically strategic. During the 1960s, the government assumed control of nearly all domestic financial resources. It revised the Korea Central Bank law and Bank Law, took over the stocks of commercial banks owned by private enterprises, and established special-purpose state banks such as Kookmin Bank for the general public and the Industrial Bank of Korea for small and medium-sized firms. In the early 1960s, the government allocated 55 per cent of foreign loans to the strategically selected industries. In the second half of the decade, 60 per cent of investments in the manufacturing sector were allocated to three strategic industries – petrochemicals, steel, and machinery. In addition, the government applied low interest rates on loans to firms entering the selected industries, reinforcing private sector dependency on the government. Even after the industrial restructuring program of the late 1960s, many of the surviving firms (selected and helped by the government) experienced financial difficulties. The government relieved them with comprehensive and uniformly applied measures. It allowed short-term private-sector debt to be changed to long-term debt, lowered interest rates (from 19.0 per cent to 15.5 per cent for the discount rate of commercial bills), issued special bonds (30 per cent of which were changed into long-term low interest rate loans), raised the depreciation rate of fixed facilities from 30 per cent to 40–80 per cent, and raised the corporate exemption rate from 6 per cent to 10 per cent. In the 1970s, the government became deeply involved in the allocation of investment funds not only to strategic industries but also to individual investment projects. To provide large investment resources into the heavy and chemical industries, the government established the National Investment Fund in 1974, and commercial banks, virtually controlled by the government at that time, were told to extend loans to targeted investment projects. In addition, the government gave priority to companies operating in the heavy, chemical, and export-oriented industries to introduce foreign loans. The loans to



these companies and other earmarked loans were called ‘policy loans’, and their rates were kept low (see Table A1.3). Table A1.2 shows the share of policy loans compared to total domestic credit during the period 1975–1985. The earmarked loans were for the agricultural sector, small and medium firms, residence construction, and so on. The foreign trade loans were used to finance exports in general. Hence, loans that were not earmarked were the most likely source of investment funds for the heavy and chemical industries. More than half of total investment funds were under government control and more than two-thirds of them were allocated to HCI firms and exporters. In the late 1980s, more than 93 per cent of national investment funds and 42 per cent of the Korea Development Bank’s loans were allocated to those industries. Table A1.2

1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985

Share of policy loans in domestic credit (%) Not earmarked

Foreign trade

Earmarked

Total

27.67 26.98 29.52 32.14 33.05 32.76 31.52 29.65 27.7 25.73 25.03

8.86 9.84 10.20 10.62 10.49 11.15 12.56 12.16 12.56 12.62 12.75

18.52 17.78 18.03 19.17 16.34 15.44 16.24 14.25 15.98 16.94 16.98

55.04 54.61 57.76 61.93 59.88 59.35 60.31 56.05 56.24 55.29 54.76

Notes: 1. Domestic credit includes all loans and discounts to the private sector by deposit money banks (commercial banks and special banks) and two development institutions, the Korea Development Bank and Korea Export Import Bank 2. ‘Not earmarked’ includes loans from the National Investment Fund, loans denominated in foreign currencies, all loans by the Korea Development Bank, and other miscellaneous items. 3. ‘Foreign trade’ includes loans for foreign trade by deposit money banks and all loans from the Korea Export and Import Bank. 4. ‘Earmarked’ includes loans for agriculture, small and medium-sized firms, and residence construction. Source: Yoo (1989).

Table A1.3 shows the gap between the preferential interest rate and other interest rates. The difference between the earnings rate of commercial bills and the interest rate on loans for equipment grew from 3.0 per cent in 1965 to 12.6 per cent in 1970 to 15% in 1980. The difference between commercial bills and loans for foreign trade is even



greater, although those differences diminished after 1985. In addition, since the inflation rate ranged between 10 and 28.7 per cent during the period 1975–1985, real interest rates on policy loans were negative. In sum, until the mid-1980s the export sector and the heavy and chemical industries enjoyed easy access to financial resources at low interest rates. Table A1.3

Various interest rates (%)

Commercial bills Loans for equipment Loans for foreign trade

1965

1970

1975

1980

1985

1990

1992

1993

14.0

24.6

20.1

30.1

14.2

16.5

16.2

12.6

11.0

12.0

12.0

20.0

12.0

12.0

12.0

9.5

6.5

6.0

9.6

15.0

10.0

10.0

10.0

8.5

Source: Lee (1998).

In general, tax support to the corporations operating in the selected industries included tax reductions on export sales, reductions of indirect and customs taxes on inputs for export goods, reductions of corporate tax, and a high rate of depreciation. Table A1.4 shows the trend of corporate tax reduction. The reduction rate slowly increased until the 1970s, but then started to increase very sharply in the late 1970s and early 1980s. Table A1.5 shows the effective marginal tax rate for selected industries. The favorable tax treatment lowers the tax rate to around threequarters of what it would otherwise have been. In addition, the effective tax rate on HCIs during the 1970s was 20 per cent, while that of light industries was almost 50 per cent.8 The growth of the chaebols The strategy of government-led economic development set the ground for the growth of business conglomerates, called chaebols. As we explained earlier, in the early stages of economic development, the government allowed a few corporations to enter the targeted industries. Since those industries were HCIs subject to economies of scale, the size of the corporations involved could not but grow larger. Afterwards, the government continued to make use of their experience and managerial skills in the course of economic development. The government gave those large corporations preferential entry into the targeted industries. Moreover, entry barriers hindered competition, and


Table A1.4

Reduction rate

Reduction of corporate tax (%) 1966

1967

1971

1976

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

23.1

20.4

21.5

35.2

64.8

82.7

61.3

34.4

14.2

13.7

15.1

15.6

12.2

16.8

Source: Lee (1998).

25


26

Table A1.5

Effective marginal tax rates (%) Chemical products

1973 1975 1978 1980 1981 1982 1983

Basic metal and product

Electrical and electronic machinery

General

Special

General

Special

General

Special

48.90 54.20 41.10 45.30 55.80 57.10 37.60

46.30 38.80 29.50 32.00 42.40 50.80 34.80

49.00 53.20 41.20 45.50 55.00 56.40 38.10

46.90 38.70 31.00 32.90 42.60 50.80 35.80

49.30 53.70 42.00 45.80 55.60 57.00 38.40

47.10 39.10 30.90 33.00 43.00 51.20 36.00

Notes: ‘General’ rates are applicable to firms that are not qualified to get special tax treatment and ‘special’ rates are for qualified firms. Source: Kwack (1984).



the government offered financial and tax inducements to the chosen firms. Thus, the large corporations had every incentive to diversify their operations according to the government’s industrial targeting policy. As a result, they became large business groups. Furthermore, in disposing of insolvent firms, the government reorganized the industrial structure by transferring their ownership to the big business groups, reinforcing the growth of the chaebols. In addition, the government, in order to avoid the huge potential social cost of chaebol bankruptcies, resuscitated insolvent chaebols or their subsidiaries through preferential measures. As a result, the big business groups had little chance to restructure themselves according to market discipline. The formation and growth of the chaebols was the result of the interaction between industrial policies and the chaebols’ responses to them. Chaebols had a distinguishable management system. The controlling shareholder, the chairman, controlled the management of all of its affiliates. The chairman of a chaebol has maintained control rights over its subsidiaries through cross shareholding. Consequently, the boards of directors and auditors of all subsidiaries do not perform their usual function of monitoring the management. In fact, board members may be expelled from the board if they oppose the chairman. The growth of the chaebols became a burden to the economic policy. Since the chaebols are accountable for a large share of the Korean economy’s assets, sales and debts, most industrial policy measures had to consider their interests. The chaebols, as leading companies in major industries such as petrochemicals, automobiles, and semiconductors, which are export-oriented industries exposed to harsh international competition, initiated large-scale projects. Moreover, strategic concerns in oligopolistic markets forced them to expand their capacity. They became larger and larger with little experiences of how to restructure, generating the notorious ‘too-big-to-fail’ legacy of the chaebols. In addition, Korea’s financial system was heavily skewed toward indirect financing through banks compared to direct financing through the stock market. Moreover, the government controlled the banking system. It allocated financial resources so as to support big businesses and sometimes to resuscitate them through the government-controlled banking system. As a result, through over-expansion as well as the given Korean financial structure, chaebols end up with a high debt/equity ratio. Figure A1.1 shows the debt/equity ratio trend of the big business groups. From the early 1980s, the anti-monopolist policy began to focus its attention on regulating economic concentration. The Regulation on



Per cent

600 500 400 300 200 100

386.5 355.7

518.9 379.8

347.5 396.3

302.7

286.8

317.7

303.0

0 1994

1995 top 30 groups

Figure A1.1

1996

1997

1998

Year manufacturing companies

Debt/equity ratio of the 30 largest business groups

Sources: Bank of Korea and Fair Trade Commission of Korea.

Monopoly and Fair Trade Act (‘The Fair Trade Act’ hereafter) was enacted in 1980. The regulations on M&As and big business group financing were introduced in 1986. The regulations on market concentration and cross-payment guarantees among subsidiaries of a chaebol were introduced in 1990 and 1992, respectively. Table A1.6 presents the main regulations regarding economic concentration. The Fair Trade Commission selected the top thirty chaebols, based on the size of their assets, as its main target of regulation. In addition, the government placed restrictions on loans to the chaebols to prevent concentration. During the 1990s, it introduced the business specialization policy to induce the chaebols to limit diversification to just two or three specialized business lines, as shown in Table A1.1. These regulations were not as effective as expected. Both the net assets and cross-holdings of the chaebols have increased by 2.1 times between 1993 and 1997. Market concentration is still high – the top thirty chaebols accounted for 41.5 per cent and 48.5 per cent of total sales and for 40.3 per cent and 46.7 per cent of total assets in 1990 and 1995, respectively (see Table A1.7). The top thirty accounted for 24.2 per cent and 21.5 per cent of total financial loans in1990 and 1995, respectively. There are several reasons for the failure of regulations on economic concentration. First, restrictions on competition including entry barriers and price regulations were still effective. Second, the government could not commit the fate of non-viable or incompetent chaebols to the care of market mechanisms because of the potential social cost of


Korea over the Past Thirty Years 29 Table A1.6

Regulations on economic concentration as of 1990 Contents

Market structure

Corporate behavior

Suppression of economic concentration

– Holding companies are prohibited. – Restrictions on total investment in subsidiaries. – Restrictions on cross guarantees. – Restrictions on voting rights of financial and insurance companies having shares of affiliates.

Restrictions on M&As

– Anti-competitive M&A is prohibited – Unfair M&A is prohibited.

Restrictions on exercising market power

– Restrictions on unjust price determination and change. – Restrictions on entry barriers. – Restrictions on hindering other firms’ operations.

Restrictions on collusion

– Restrictions on collusive determination of prices and sale conditions. – Restrictions on regional demarcation and exclusive dealing.

Restrictions on unfair transactions

– Maintaining resale prices is prohibited. – Restrictions on unfair international contracts.

their financial problems and bankruptcies. The government kept incompetent chaebol subsidiaries alive with public money or merged them with other chaebols’ subsidiaries. The court reorganization processes were usually ignored. Furthermore, the M&A market was inactive and bankruptcy laws including reorganization processes were inadequate. Third, the financial industry was too immature to exercise its role to check on the chaebols’ over-expansion. Korean banks did not perform their duty of loan screening thoroughly because they were used only as tools to support the government’s industrial policy in the so-called ‘government-managed financial system,’ a product of excessive government intervention in the banking sector. Banks and other financial institutions became used to governmental guidance and coordination. The interest rates on loans for the chaebols were lower than market rates because of governmental intervention. They hardly needed and so lacked the requisite ability to conduct credit and project analyses. Since they lacked such ability, for every loan they provided, even for credit loans, they required debt guarantees or collateral to


30

Table A1.7

Assets Sales Employment

Economic concentration of the chaebols (%)

5th 30th 5th 30th 5th 30th

1985–1989 (average)

1990

1991

1992

1993

1994

1995

1996

1997

30.7 48.0 24.4 44.3 2.6 4.4

23.4 40.3 27.0 41.5 2.5 4.2

24.0 43.5 27.2 41.3 2.6 4.3

24.5 44.4 28.6 43.8 2.4 4.2

24.0 43.2 27.6 41.7 2.4 4.1

23.5 41.7 28.2 42.4 2.5 4.2

25.4 44.6 30.7 45.8 2.6 4.4

27.2 46.7 32.8 48.5 2.7 4.6

28.7 44.8 32.4 45.5 2.7 4.1

Source: Hwang (2000).



reduce risks. So the chaebols satisfied the banks with cross-payment guarantees among their subsidiaries, which allowed them to obtain as much as needed for expansion. All of these factors not only made regulating the chaebol ineffective but also created inconsistency of government policies towards the chaebols and possibly even led to the erosion of their competitiveness. Legacies of interventionist industrial policies The government-led interventionist industrial policy strategy generated various structural problems. First, industry- and firm-targeting industrial policies greatly distorted resource allocation. They frequently tended to substitute for the price mechanism. It resulted in overinvestment in and subsequent restructuring of the HCIs. Preferential industrial policies have worsened economic concentration, resulting in a structural imbalance between large and small and medium-sized firms and a monopolistic economic structure. Second, government control of the financial sector as a tool to support its industrial policy undermined financial institutions’ ability to discriminate between competent and incompetent firms and projects and to monitor the performance of borrowing firms. It eventually led to the underdevelopment of the financial sector. Third, persistent government intervention destroyed private sector incentives for creative economic ventures. State support of selected industries and firms, and government control of the financial sector, made the private sector dependent on governmental guidance and coordination. In addition, since the government helped the large enterprises, especially the chaebols, to survive financial difficulties by showering them with preferential measures, the ‘too big to fail’ legacy emerged and moral hazard ensued. Lastly, in a political economic sense, the government’s ability to select and support strategic industries and to enforce restructuring programs generated room for rent-seeking. The corporations lobbied government officials, which raised suspicions of corruption. It also contributed to spreading anti-chaebol sentiment. By and large, interventionist industrial policies greatly contributed to the development of the crisis. They frequently substituted for the operation of the market mechanism, nourishing the private sector’s dependence on government, which lead to discouragement of private sector’s autonomy and creativity. As a result, the effectiveness of market discipline was reduced, leading in the end to a situation where moral hazard prevailed in the economy. Because of this moral hazard, banks lent out too much to corporations who were stretching themselves to overborrow and overinvest – all under the assumption that the govern-



ment would rescue these corporations if they showed signs of flagging business. This led to a situation where the need for economic restructuring to allow market mechanisms to work was likely to be unrecognized. The agents in the economy didn’t have much of an incentive to exert themselves to adapt to the changing economic environment. All of these factors provided the environment for the crisis. An economy lacking market flexibility and adaptability cannot be expected to be resilient enough to withstand sudden external shocks. Moreover, it had to resort to another round of government intervention to respond to the crisis; in other words, the economy had to depend on the government to clear up the mess that had been made by government interventionist policies in the first place. Industrial policies are based on the belief that the government has sufficient information about the changing economic environment and the ability to fully anticipate the optimal industrial structure. However, in an area of increasing globalization the economic environment has been changing rapidly. It is increasingly more dynamic and therefore more uncertain. Market participants have more information about changes in the economic environment than the government. In addition, as the economy grows in size and complexity, it is becoming less and less viable for the government to be able to absorb these changes and determine the optimal industrial structure over time on behalf of the private sector. It is thus safe to say that Korea’s industrial policies should adapt to the changing economic environment.


2 The Role of Government versus the Market for Sustainable Development*

1.

Introduction

Moving directly on from the general overview offered by the first chapter, this chapter looks closely at the issue of the appropriate role for government in promoting sustainable private sector-led economic development. Defining the role of the government in economic management will depend upon what line is drawn between the government’s role and that of the economy’s private sector. This contentious issue is traced back to the discussion over the feasibility of the socialist economic calculation during the early twentieth century (originally initiated by Ludwig von Mises and Oscar Lange) and has continued right through to the more recent debate on the desirability of a government-led economic development strategy in the 1990s. In spite of the innumerable works of economists with radically varying viewpoints, the ongoing debate can ultimately be reduced down to the simple issues of market failure or government failure. Traditionally, market failures have been seen as the most justifiable reason for active government intervention. However, it should also be emphasized that market failures are in most cases a reflection of institutional failure – which is in essence a form of government failure. The chapter outlines some ‘lessons’ to be learned from the Korean experiences of government-led economic development over the past thirty years by examining the policy patterns, defining their characteristics, and suggesting the desirable role of the government in a global* This chapter is based on Sung-Hee Jwa (1997) ‘The Role of Government in Economic Management: Korea’s Experiences and Lessons’, Korea Journal, 37(4) (Winter) pp. 5–14. 33



izing world. Korea’s experiences suggest that active and protracted governmental intervention in properly allocating resources might achieve some short-term goals, but only at the expense of some long-lasting adverse side-effects. For example, the distorted relative price system and incentive structure resulting from such interventionist policies has meant that the private sector has been reluctant to economize. After the government utilized them as credit distribution stations for over three decades, Korean banks paid more attention to the volume of deposits than to their overall profitability. In other words, Korean banks considered a corporation in terms of how much it borrowed rather than its profitability. It has been argued that although government intervention in resource allocation enjoyed some success in the 1960s and 1970s, this is no longer the case because the size and complexity of the Korean economy have already reached a point where the informational superiority of the government over the private sector can no longer be guaranteed. Finally, this chapter provides a basic framework within which we discuss the optimal role of the government in a general context. We invoke the oriental philosophy of Taoism ‘being natural without coercion’ – and the Hayekian philosophy of interpreting market competition as a discovery procedure of the optimal solutions to the resource allocation problems. This chapter concludes that the government’s role should be confined to preserving the spontaneity and endogeneity of the market order and cultivating an economic environment conducive to the proper functioning of the market. In other words, while the government concentrates on determining exogenous variables for the market order, the determination of endogenous variables should be left to the market.

2.

The debate over the role of the government

The government’s role in economic management remains an unresolved issue in the current discussions of economic policy. The debate began in the early twentieth century, particularly in the context of the argument over socialist economic calculation, and was led by Ludwig von Mises, Oscar Lange, Friedrich von Hayek, and the Austrian School. Mises argued that rational economic management in a socialist economy is impossible because of the absence of market and price mechanisms. Lange disagreed with Mises, offering his concept of market socialism. Lange contended that a central planning board can substitute for a market or price mechanism and resolve decentralized


Government versus the Market 35

resource allocation problems. Lange’s planning board would be able to search for the optimal allocation or discover an equilibrium price vector either through trial and error or a process of successive approximation. Later, Hayek (1948) joined the debate, contributing to the rising prominence of the Austrian School as well as to the development of the concept of market competition as a dynamic discovery procedure. Although Hayek recognized the theoretical possibility of economic calculation by the central planning board in the socialist economy, he doubted whether such a system would work practically because of the excessive information requirements. In the Hayekian world, no manmade system can discover optimal outcomes of resource allocation without a process of dynamic competition.1 During the 1940s and 1950s, the debate over the government’s role in economic management centred on the issue of whether or not a mixed economy and a welfare state are desirable. The experience of the Great Depression during the 1930s began to cast doubt on the automatic coordination function, and especially the macroeconomic coordination function of the capitalistic free market economy. As a result, the Keynesian counter-cyclical macroeconomic policy function of the government became a new sub-topic within the debate, overriding the mostly microeconomic issue of resource allocation in the socialist economic calculation debate. The Keynesian economists advocated government intervention to remedy the market failures in the macroeconomic level, particularly the unemployment phenomenon. This increased the popularity for a mixed economy and welfare state, and, as a result, the government’s role continued to grow.2 Interestingly, the new argument for government intervention in the macroeconomic level was also strengthened by the development of macroeconomic modeling, which was partly spurred by the socialist planning theory that developed in response to the earlier debate on the possibility of socialist economic calculation. The government macroeconomic intervention, including the finetuning of macroeconomic policies in order to maintain stable output and employment growth, turned out to be ineffective as was proven by various episodes of macroeconomic development during the 1970s and 1980s, such as the oil price shocks and subsequent misalignment of exchange rates. Perhaps the most notable case was the ‘stagflation’ experienced by the US economy during the 1970s’ when rising inflation was accompanied by a steadily worsening unemployment rate. This development completely refuted the trade-off between the two undesirable phenomena which had formerly been taken for



granted and thus nullified the Keynesian fine-tuning policy prescription which had been based on balancing the evils of inflation and unemployment. These experiences in turn provided an environment for the revival of the liberal tradition: neoliberalism led by Hayek (1984a, 1984b, 1989), the birth of the public choice school led by J.M. Buchanan, and the surge of political conservatism led by Margaret Thatcher. Deregulation or liberalization of the private sector has become the core of economic reform in most advanced countries in recent years, and the importance of a long-term perspective in macroeconomic policy making, such as maintaining a rule-based policy, has been emphasized time and time again. It has also been stressed that government failures are due not only to excessive informational requirements, as stipulated by the Hayekian framework, but also to the inherent nature of self-seeking government officials, as seen in the public choice framework. A new and interesting debate on the role of the government in economic development has also emerged following the rapid growth of the East Asian economies. This debate focuses on somewhat different concerns from the earlier calculation debate, assessing whether or not the government in an underdeveloped capitalistic market economy can improve upon the market outcome of resource mobilization and resource allocation. This is why the debate is ultimately reduced to measuring the importance of market failure (or absent market institutions) versus government failure (or the government’s inability to assume the role of markets or to introduce market institutions). In observing the remarkable success of economic development in East Asian countries such as Japan, Korea, and Taiwan over the past thirty years or so adherents of the neoclassical theory emphasize one important lesson that can be learned from the East Asian experiences. This is the importance of getting the basics right. They argue that the government should provide a stable macroeconomic environment and a reliable legal framework in order to create an environment favorable to the free play of market forces. According to this critique, minimum intervention with the lowest degree of relative price distortion is a virtue. They see that Asian economies benefited the most from a government strategy that followed the lead of the market, rather than trying to actively direct it. On the other hand, a group of economists known as revisionists attribute greater significance to other aspects of the East Asian success story that have gone relatively unnoticed in the neoclassical analysis. They observe that the East Asian governments have taken a much



more active role in the economic development process than the one envisaged by neoclassicists and thus argue that, despite efforts to do quite the opposite, the government has actually been leading the market. Revisionists even go on to argue that during the late industrialization stage, the state should deliberately set prices at marketdistorting levels in order to create profitable investment opportunities.3 Also emphasized is the existence of market failures in developing economies due to market imperfections such as a lack of relevant markets. It is thus contended that an active role on the part of the government is necessary to guide resource allocation for the highest growth of the overall economy. Amsden, one of the staunchest revisionists, even suggests that the central bank may support the priority industries at the cost of macroeconomic stability.4 The World Bank (1993) answered the revisionists’ argument with the reassertion of an obvious truth: ‘For interventions that attempt to guide resource allocation to succeed, they must address failures in the working of markets. Otherwise, the market would perform the allocation function more efficiently’.5 Again, macroeconomic stability is emphasized as the most important precondition for extensive economic development. In sum, the debate on the role of the government in economic development centered around the issue of market failure versus government failure. Of course, market failure generally reflects the failure of institutions, another form of governmental failure – this time the failure lies in the government’s inability to set up the right institutions or, in other words, the rules of the game in the economy. Therefore, market failure on its own cannot be considered as an automatic justification for direct government intervention. Rather, the government should try to introduce ‘right’ institutions to provide an optimal environment for better economic performance.6 Furthermore, in most cases of apparent market failures, it should not go unnoticed that government regulation or its practices of preferential treatment usually turn out to be the major causes of those failures.

3. 3.1

Korea’s experiences Patterns of economic management

Korea has achieved a remarkably high level of economic growth over the last thirty years. Its economic development process during this period has generally been described as following a government-led export promotion strategy. The government has been actively involved in almost every important aspect of economy related decision-making



and the private sector has followed the signals given by the government. The government-led order has always taken precedence over the spontaneous market order. In the context of the optimal utilization of economic resources, the economic development process usually entails two interrelated aspects of resource utilization – the mobilization and the allocation of economic resources. Very little attention has been paid to the possible side-effects of emphasizing the active role of government in resource mobilization. The mobilization drive has tended to create a detrimental environment for macroeconomic management. In general, once priority is given to domestic resource mobilization, monetary and fiscal policies will also tend to be ‘mobilized’ as the instrument to support economic development, thereby making the role of macroeconomic stabilization inoperative. Low interest rates, base money creation, and tax-and-expenditure instruments all tend to be utilized to support policy loans for important industries. The search for the best methods of mobilizing available resources to support economic development becomes the dominant concern to the detriment of macroeconomic stability. Broadly speaking, the Korean government has actively participated in resource mobilization, even though the degree of participation has fluctuated during the development period according to the situation faced by the country. In the course of these developments, Korea evolved a very peculiar macroeconomic management pattern. While the economy was subject to inflationary pressure stemming from the base money and credit expansion and the low official interest rates geared towards maximum mobilization of investment funds, conventional monetary policy instruments such as control of the money supply and interest rate policy became inoperative. Direct controls on individual prices, important for the CPI basket and even to economic activities within the private realm, became widely utilized as the instruments for maintaining macroeconomic stability. In sum, macroeconomic policy function was performed by micro regulations. On the other hand, the Korean government intervened directly in the microeconomic resource allocation through discriminatory policies – such as favoring certain sectors and groups of economic agents. The government controlled the financial resource allocation by regulating interest rates and the lending activities of financial institutions. In the earlier stage of development – until the late 1970s – the large business groups and heavy and chemical industry sector were favored, but since the 1980s, small and medium-sized firms have been relatively favored.



Instead of allowing market competition freely rein as a kind of ‘discovery procedure’, the government has assumed the responsibility of making important allocation decisions. The government has determined the sectors the conglomerates can engage in, and stipulated that the financial institutions can lend only to selected businesses. This pattern of direct intervention in private decision areas has improved somewhat through the liberalization process in recent years, but has generated far-reaching and long-lasting interventionistic mind-set of the policy makers regarding the role of the market. In contrast to such legacies of government-led development, the environment for Korea’s economic policy has undergone a drastic change in recent years, forcing the reform of the existing economic management system. The Korean economy became increasingly open during the 1990s, integrating with the global economy through various policies of financial liberalization, including capital flow liberalization. Given the increasing openness of the economy, Korea can no longer rely on direct regulations for macroeconomic management. 3.2

Characteristics of government-led economic management

It is generally accepted that the Korean government has played a decisive role in the nation’s successful economic development during the last thirty years. However, one should be aware that it is very difficult to define the concept of government-led economic management precisely. For the purposes of our analysis, we suggest that a governmentled economic management regime is an economic policy regime in which the government determines major endogenous economic variables within the realm of private economic agents by imposing its will on the market as an outsider. Under such a regime, the government predetermines the outcome that would otherwise be determined endogenously through market competition processes. A government-led economic management such as that defined above exhibits the following characteristics. The government macroeconomic management generally relies on direct regulation such as credit rationing over open-market operations for money supply control and on wage–price controls over aggregate demand management for antiinflationary policy. In addition, the government microeconomic policy takes the form of picking the winners before the market process works itself out and provides the means (i.e. financial support) necessary for the chosen to win. In order for this interventionistic economic management to be successful without causing severe distortions in resource allocation, the government must have informational superiority over



the private market participants, as well as a complete set of solutions ready to be put into action to tackle difficult policy issues. Unfortunately, the requirements that must be fulfilled so that government intervention can be of benefit are difficult to satisfy – particularly as the economy grows in size and complexity. Since a complete recipe for solutions to various economic problems cannot be readily available, the degree of government intervention should be reduced in order to benefit the economy. Korea seems to have entered this stage of economic development already and is in need of active initiatives on the part of the private sector in order to secure further sustained economic development. 3.3

Legacies of government-led economic management

More than thirty years of active government intervention have created legacies that pose serious obstacles to the policy regime shift toward greater participation by the private sector. Although informational requirements for efficient economic policy making have become increasingly difficult to maintain, Korean policy makers, including economists who are accustomed to the mind-set of the past regime, still assert that they can and should manage the economy down to the finest details. These economists believe they can and should regulate the deregulation process. This mentality severely impedes the processes of economic reform and liberalization. To compound this problem, many private economic agents have lost their sense of independence and fear that liberalization may create chaos. Thus, they often seek government intervention, even in the affairs of the private sector, and ask the government to ‘control the process of economic liberalization’. For example, it was the Korean government which made decisions for commercial banks over such issues as how much to lend to what important business and at what interest rates. Indeed, even during the process of financial liberalization, before the financial crisis of 1997, the commercial banks were asking for government intervention through guidance on how to manage banking businesses.7 In addition, active government economic management has created various barriers to entry that have led to the creation of monopolistic and oligopolistic industrial structures. The tendency to rely on direct regulations for economic management has also produced widespread regulations of prices and quantities, which have created a distortion in the economic incentive structure. As a result, the individual economic



agent has not been presented with sufficient motivation to economize and innovate. Finally, as government intervention has become more widespread, thereby creating an excess demand for intervention beyond its true capability or necessity, the effectiveness and therefore the credibility of government economic management policy has rapidly declined.

4. The natural market order and the role of government in economic management 4.1

Philosophical background: Taoism – an Oriental liberalism

It has been generally accepted that the critical factor behind Asia’s rapid growth was the influence of so-called ‘Asian Values’. Many commentators have argued that the emphasis on strong government leadership, industrious work ethic, and close government–business partnerships facilitated rapid economic development in East Asia. The public cooperation with government policies was instrumental in the infant stages of development for the orderly mobilization of scarce resources. Asian Values are understood as based on Confucianism; which stresses the fulfillment of human morality through learning and training. It emphasizes that elite groups, who are supposed to have moral superiority, should lead the morally lacking general public using principles and rules that they have chosen themselves. Adherents to Asian Values insist that the government and the elite group of officials should manage the economy. Some political leaders in East Asian countries have strongly supported the maintenance of Asian Values. Their argument is that the government and its officials have been capable of generating rapid economic growth and therefore that future prosperity should depend on the government. However, the political leaders seemed to make references to Confucian Asian Values mainly to justify their almost authoritarian political systems. But at the onset of the crisis in 1997, these same Asian Values were blamed for causing the crisis. The crisis of 1997 revealed the defects of the Asian Values which generated a legacy of crony capitalism, such as informal and non-transparent business practices, favoritism, and insider trading. Connecting Asian Values only with Confucianism is an oversimplification. In traditional Asian philosophy, there exists another school of thought, Taoism, whose influence has been largely unrecognized in the process of industrialization. Taoism is skeptical about confining



people within specific moral values and an artificial order. To that effect, even defining the Tao and naming things is regarded as selfdefeating. In Taoism, The Tao that can be told is not the eternal Tao, The name that can be named is not the eternal name, The nameless is the beginning of heaven and earth. The named is the mother of ten thousand things.8 It emphasizes the spontaneity and the accommodation to being natural. The central theme of Taoism is ‘being natural without coercion’. Give up the desire to ‘be a sage’ and abandon ‘wisdom’ And the people will benefit a hundred times over. Give up the desire to ‘be benevolent’ and abandon ‘justice’ And the people will regain their old kindness Give up the desire to be cunning and abandon material gain And there will be no more robbers.9 In an economic context, Confucianism will emphasize governmentled economic management while Taoism tends to stress the importance of natural and spontaneous market order. Government-led economic management based on Confucian Asian Values may have contributed to the growth of East Asian economies. However, emphasis on the leading role of the government and its officials resulted, in general, in more regulations and restrictions on economic activity than in Western countries. In addition, emphasis on the elite group as a leading social force resulted in non-transparent national system of governance relying on government’s arbitrary and discretionary decisions rather than rule of law. He who tries to take hold of the world by force will not succeed. The world is a mysterious thing; it cannot be controlled. He who tries to do so will fail, he who tries to grasp the world will lose it.10 According to Taoism, due to the complexity and diversity of the real world economy, governments will come across great difficulties in playing the role of an omnipotent and objective economic system



manager. To cope with the changing economic environment, it will be wiser to follow the spontaneous market order and principles of competition rather than attempting to artificially manage the economy. The economy is a system in which diverse agents interact with each other. It rises above artificial manipulation. The government, recognizing the complexity and diversity of the economy, should adapt to its nature. The economy is not a system that the government can operate by control. It is a system in which continual search and evolution take place. A passage in Taoism reads ‘The world [economy] is ruled by letting things take their course. It cannot be ruled by interfering’.11 Unnecessary government interference is easy to come by, whether in the form of rules, laws or direct intervention, and this will have adverse effects on the economy and the welfare of the people. The more laws and restrictions there are, the poorer the people become. The sharper men’s weapons, the more trouble in the land. The more ingenious and clever men are, the more strange things happen. The more rules and regulations, the more thieves and robbers.12 Taoism in the economic sense is similar to neoliberalism. Hayek, the leader of the Austrian School and neoliberalism, emphasizes the spontaneous market order and competition as a discovery procedure over government interventionist strategy in resource allocation. We are only beginning to understand on how subtle a communication system the function of an advanced industrial society is based – a communication system which we call the market and which turns out to be a more efficient mechanism for digesting dispersed information than any that man has deliberately designed. If man is not to do more harm than good in his efforts to improve the social order, he will have to learn that in this, as in all other fields where essential complexity of an organized kind prevails, he cannot acquire the full knowledge which would make mastery of the events possible. He will therefore have to use what knowledge he can achieve, not to shape the results as the craftsman shape his handiwork, but rather to cultivate a growth by providing the appropriate environment, in the manner in which the gardener does this for his plants.13



Stated succinctly, under a Taoist perspective governments should nurture the economy by providing proper surroundings for market mechanisms to operate. 4.2 The framework for the role of the government in economic management The basic argument concerning the role of government economic policy taken in this chapter is based on the oriental philosophy of Taoism and the Hayekian philosophy: that there exists a natural market order in the economy that arises endogenously and spontaneously, independent of any outside intervention. Competition in the market is a natural process of discovering the optimal outcome, which cannot be determined in advance. According to this view, the economic role of government should be confined to preserving the spontaneity and endogeneity of the market order – it should refrain from intervening through direct regulation. To this end, the government should establish a regime of fair competition in the economic and social system so that the discovery function of the market order can be utilized to the highest degree. Within this framework, the role of the government should be limited to defining the economic and social environments; that is to say, to determine the exogenous variables for the market order, while the determination of the endogenous variables should be left to the market. If the government wants to influence the endogenous variables, it must participate in the market order in the same manner as private economic agents, or change the environment or incentive structure for the market order in such a way as to influence the endogenous variables in the desired direction. Instead of allowing the market to guide the economy, over the past thirty years the Korean government has manipulated endogenous variables in order to facilitate rapid growth. For example, a steep rise in property prices caused by a surge in demand has not been uncommon in Korea over the past three decades. One key cause of the rise was a legal ceiling on interest rates in the face of recurrent high inflation. Inflation in general erodes the real value of any nominal assets, especially if there is a limit to the compensation one can demand for high inflation (i.e., inflation premium in nominal interest rates) and thus real assets such as land and buildings are quite desirable alternatives. The Korean government has typically adopted special regulatory measures to control prices (or set official prices) to curb rising land prices and also has tried to discourage speculation by appealing on moral and ethical grounds. Instead of fixing the endogenous variable – that is,



prices – the government could have perhaps removed the ceiling on interest rates and more fundamentally should have adopted antiinflationary monetary policies. In another example of direct intervention, the government used to place the blame on the chaebols for peculiar behavioral patterns, characterized by overdiversification, overconcentration of economic power, non-separation of ownership and management, and inheritance of managerial power. These are, however, endogenous variables. It was the interventionistic mode of thinking that led to policies relying completely upon the direct regulation of the chaebols, endogenous behaviors, without addressing the causes of or institutional environment for such behaviors. As a result, chaebol policy was unsuccessful. As we will illustrate further in later chapters, government policy should concentrate on fixing exogenous variables such as institutions or an incentive structure. 4.3 Macroeconomic stability as an exogenous environment: an essential element for growth One of the most important economic conditions for the private market order is the state of the macroeconomic environment. Maintaining macroeconomic stability is understood as a prerequisite for efficient long-term economic decisions and therefore regarded as the most important responsibility of the government. In the debate on the role of the government in economic development, the World Bank (1993) has consistently argued that the most important contributing factor to the East Asian economic miracle was macroeconomic stability. One can also say that in the context of the current situation, maintaining macroeconomic stability is just like providing a better exogenous environment for the market order and therefore belongs to the domain of the government’s active policy function. 4.4 Globalization and the role of the government in economic management Even before the recent efforts of official bodies for international cooperation, private sector initiatives have long been an important driving force behind international economic integration. Globalization implies the expansion of economic activities across politically defined national and regional boundaries through the increased movement of economic agents and resources such as firms, capital, and other economic factors. But how will globalization change national economic policy making? Primarily, preferential and discriminatory policies will become increasingly ineffective under an economic environment that is moving



towards globalization. Economic agents and resources subject to unfair treatment by the government policy will move away to a more investor-friendly environment. In this way, government-led economic development strategies and policy instruments will also become less effective. It is easy to see how direct regulations to promote or protect targeted industries would eventually constitute obstacles to further economic development. Generally speaking, globalization ensures that economic policy making and implementation will be guided on principles of non-discrimination and market mechanisms. The implementation of an industrial policy similar to those adopted by the successful East Asian economies such as Japan, Taiwan, and Korea seems to have become very popular with other late-developing governments.14 This tendency is even more conspicuous when discussing the possible policy response to the so-called ‘unlimited competition’ resulting from globalization. An increasingly common view is that the government should help firms compete successfully in the international market and that the government should intervene, to a large extent, in adjusting the industrial structure to the globalized competitive environments. Yet the basic stance concerning the role of government taken in this chapter supports a concept diametrically opposed to this new trend of industrial policy. Globalization is a diversified and sometimes conflicting phenomenon that has different economic implications depending on the context.15 Therefore, it is especially difficult for a government to design a particular industrial structure that will be optimal for its economy in all circumstances. In this sense, one can further conjecture that the economists’ search for an alternative industrial organization among the so-called American Fordist, German Craft, and even the lean and flexible production systems will not yield any definitive, single structure of industrial organization.16 Instead of adopting an active interventionist industrial policy that requires a tremendous volume of information and is not guaranteed to produce the correct solutions, an effective response to globalization may be to allow the market order to prevail in discovering an optimal business and industrial structure. This entails giving the private sector maximum freedom to make structural adjustments in response to the globalization.

5.

Summary and lessons

In this chapter, we have provided an overview of the debate on the role of government in economic management and included an



evaluation of the Korean experience of government-led economic development strategy over the past thirty years. Based on these discussions, we briefly consider the optimal role of the government in general. Recognizing that the debate is reduced to the issue of market failure versus government failure, the key point of this chapter is that market failure in most cases is the reflection of institutional failure – another form of government failure. Korea’s experience suggests that the intervention into endogenous decision variables has created many problems. This is because the believed informational superiority of the government was no longer valid in the handling of a sizable, complex structure such as the Korean economy. Based on the lessons of the Korean experience, our contention is that the role of the government should be confined to preserving the spontaneity and endogeneity of the market order and to cultivating a better economic environment for the smooth operation of the free market. We have tried to provide a philosophical underpinning for this type of government in economic management, derived from the oriental philosophy of Taoism with the central theme of ‘being natural without coercion’. The government should determine exogenous variables for the market order while the determination of endogenous variables should be left to market competition, especially under the conditions of globalization which will make government intervention virtually ineffective.


3 Legacies and Lessons of Korea’s Macroeconomic Management*

1.

Introduction

Chapter 2 introduced the main theme of this volume by stating the importance of a government that recognizes its boundaries and, in doing so, limits itself to maintaining a sound institutional environment for the operation of a spontaneous market order, rather than trying to substitute for market forces itself. The Korean government has been actively involved in almost every important aspect of the decision-making process during Korea’s economic development. Simply put, government-led order has always dominated over spontaneous market order in Korea. However, as the previous chapter has shown, even if it is agreed that the government should hand over some of its roles to market mechanisms, it is still unclear just how much of a role the government should take in the economic development process. To note the implications of so-called government-led economic development strategy on macroeconomic management, one has to highlight the fact that the Korean government has played a very active role in resource mobilization, culminating in a very peculiar macroeconomic management pattern. Investment has almost always outpaced domestic savings (Figure 3.1), leading to the borrowing of foreign credit in order to meet excess demand for funds. Credit extensions to targeted industries, particularly in the export sectors, have made up an important part of the central bank operations and growth in monetary * This chapter is based on Sung-Lee Jwa (1998) ‘Reorganization of Korea’s Macroeconomic Management’, in Lee-Jay Cho and Yoon Hyung Kim (eds), Korea’s Choices in Emerging Global Competition and Cooperation (Seoul: Korea Development Institute), pp. 1–56. 48


Korea’s Macroeconomic Management 49

aggregates was typically strong, hence the double-digit inflation of the 1960s and 1970s. The rather single-minded pursuit of continued growth effectively ruled out the customary employment of standard fiscal and monetary policy tools as a means of controlling aggregate demand. As a result, for macroeconomic stabilization, the government had to rely on some other non-traditional instruments, such as price regulation and direct controls on economic activities within the private sector. However, Korea’s macroeconomic policy environment has undergone a rapid change in recent years. The Korean economy is becoming increasingly open and integrated with the global economy, through measures such as capital flow liberalization, and can no longer rely upon non-traditional regulatory microeconomic measures for macroeconomic stabilization. This chapter focuses on the government’s intervention in the macroeconomy with an overview of Korea’s macroeconomic developments and patterns of macroeconomic management and seeks a new system of macroeconomic policy making. This last objective is particularly appropriate in view of the more recent developments in macroeconomic policy environments such as the liberalization and globalization of the domestic economy and the onset of the 1997 exchange crisis. Some reform issues are discussed and the chapter closes with a discussion of macroeconomic policy issues, including sterilization policy and the policy mix, in the open economy setting.

2.

Some features of macroeconomic developments

Korea’s economic development experience often reveals several notable characteristics of macroeconomic management. One is that the Korean economy has demonstrated outstanding economic growth as well as a steady and considerable increase in the investment rate. In the period 1961–1972, the investment ratio was 19.4 per cent. This rose to 30.1 per cent in the 1973–1980 period and, after staying close to the 30 per cent range in the 1980s, started to rise again in the early 1990s and remained in the 35 per cent–40 per cent range until 1997 (Figure 3.1). The rising expansion of investment helps the economy to accumulate capital. The neoclassical growth theory argues that capital accumulation is a key factor in explaining economic growth. According to various growth studies, capital accounts for about 2.2 per cent to 3.7 per cent of manufacturing output for the sample periods ranging from the late 1960s to the 1980s (Kim and Hong, 1997; Kim and Park, 1985;



45 40 35 30 25 20 15 10

0

1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996

5

Investment ratio Figure 3.1

Saving ratio

Investment and savings ratios

Lee, 1998). According to Perkins (1997), capital accounts for 3.7 per cent of the total GDP growth of 8.6 per cent for the period 1960–1990. Total factor productivity and labor account for 2.5 per cent each. It appears then that in the past thirty years, growth in capital stock has been the most important growth factor. Figure 3.1 shows that both domestic investment and the national savings ratio have been rising rapidly. However, for most periods, the former has been higher than the latter – with the exception of the late 1980s. As a result, foreign savings were used to finance the difference and current account balances recorded deficits during most of the period. The chronic current account deficit raised the worry of a foreign debt crisis. In addition, overinvestment has accelerated the financial debt problem for firms during the recent period of recession. In fact, one may argue that these long-term structural problems contributed directly to the 1997 currency and financial crisis. Another interesting aspect of macroeconomic management is monetary neutrality. That is, there does not seem to be a perceptible positive relationship between growth in the money supply and an upturn in economic activity. In spite of the Korean government’s continuous



efforts to support economic development with an ever-increasing credit creation, the long-run neutrality of money seems to hold (see Figure 3.2). The movements of money supply (M2) growth and inflation (in the GNP deflator) seem to be closely matched, showing a correlation coefficient of 0.97 during the period from 1976 to 1997 (see Table 3.1). However, the real GNP growth rate seems to have no strong relationship to monetary growth and the correlation coefficient between them actually turns out to be –0.30 for the same period. This could be taken as supporting evidence against the fine-tuning of counter-cyclical monetary policy.

Percentage 35.0 35.0 25.0 20.0 15.0 10.0 5.0 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997

0.0

M2

Nominal GNP

Real GNP

Year

GNP Deflator

Figure 3.2 Monetary growth, GNP growth, and inflation in Korea (1976–97: 5 year moving average) Table 3.1 Correlation coefficients for monetary growth, GNP growth and inflation from 1976 to 1997 (5 year moving average)

Real GNP Nominal GNP GNP deflator

M2

Real GNP

Nominal GNP

–0.3019 0.9251 0.9717

–0.0033 –0.2882

0.9583



3. 3.1

Existing patterns of macroeconomic management Distortions in macroeconomic management

In general, successful macroeconomic policy should contribute to the effective control of the total size of aggregate demand while at the same time having a minimal impact on relative price structures and resource allocation in the economy. However, Korea’s macroeconomic management has relied heavily on the direct regulation of prices and particular industrial sectors or behaviors, thus distorting the relative price structures and the behavior of the private sector, and finally leading to resource misallocation. The main reason for this pattern is that traditional macroeconomic policy instruments, monetary and fiscal, have not been readily available since financial resource mobilization for industrial development became a prime concern under the government-led development strategy. It is beyond the scope of our analysis to evaluate in detail the overall merits and demerits of the government-led strategy in economic development, but it can be observed that Korea’s development strategy produced a distortionary macroeconomic management pattern, as was discussed in Chapter 2. As for monetary policy, the financial authority has maintained direct control over the credit policies of commercial banks as well as maintaining official interest rates that were kept below the market equilibrium levels. ‘Money supply for economic growth’ has been the policy maxim and, as a result, the central bank’s base money was almost automatically provided to targeted industrial sectors. Therefore, monetary policy had more or less simply been reduced to a money multiplier management policy with differential effects on various economic and financial sectors. At the same time, the interest rate has not been allowed to play its most important role – that of a financial resource allocation mechanism – because the provision of low-cost funds to the targeted industrial sector has been the major concern. By slowing down the development of financial instruments and markets in general, policy loans with low interest rates became a stumbling block to the introduction of the indirect monetary policy instruments that could be used in open market operations. Korea’s monetary policy was characterized by interest rate regulation, direct credit control, nonopen-market allocation of government and central bank bonds to the financial sector, frequent changes of reserve requirement ratio and other regulatory measures.1



Fiscal policy has also had some weaknesses as regards issues of macro-stabilization. Korea does not even have a consolidated and consistent data set on the total size of the nation’s fiscal budget. Even now, the consolidated government budget (inclusive of the central government’s general account, special funds, and special accounts) does not include the budget of the provincial government. The lack of exact and timely data on the overall fiscal expenditure is one reason for the fact that Korea has not been in a position to effectively utilize fiscal expenditure policy for macroeconomic stabilization. Macroeconomic stabilization has not been a major consideration as far as exchange rate policy was concerned either. Policies were constrained by the dual concerns of maintaining export competitiveness during the 1980s and of controlling inflation during the 1990s. It was found that exchange rate depreciation had been used to boost exports, particularly during the recession period (Nam, 1988). However, during the 1990s, the real exchange rate tended to appreciate due to the policy bias towards inflation control. In this way, the exchange rate was rigidly managed. When appreciation pressure was felt, the exchange rate was subject to large and sudden changes at the last minute after a stubborn resistance to the pressure for exchange rate changes as experienced in the mid-1980s.2 On the other hand, in the period 1996–1997, the resistance to depreciation pressure from the mounting current account deficits eventually triggered the currency crisis in late 1997 with depreciation that was higher than 50 per cent. Therefore, macroeconomic management has had to rely on other non-traditional instruments (such as direct regulations). For example, in order to manage aggregate investment expenditures, the construction industry (which has the largest share in domestic investment) has been regulated by government. Even the investment decisions of large business groups in the manufacturing sector have been subject to government influence through entry barriers or informal moral suasion. A national campaign appealing to the public to refrain from ‘extravagant consumption’ and the temporary imposition of high taxes and import restrictions on certain consumer goods were frequently employed instruments in managing aggregate consumption expenditure. On the other hand, in order to reduce the current account deficits, import restrictions were frequently used, sometimes with campaigns to promote the consumption of domestic goods. Furthermore, individual price controls were widely utilized to ‘manage the price index’. This was not just the case for important



industrial products in the manufacturing sectors as public utilities and various service products in the non-tradable sectors have also long been subject to government price regulations. Even public campaigns to restrain factor price increases such as interest rate regulation as well as those for wage and land price restraints were also regarded as the key policy instruments for controlling inflationary pressures. 3.2

The short-term horizon in macroeconomic management

In its economic management policies, Korea has utilized two sets of management plans: annual macroeconomic management plans and five-year economic and social development plans.3 In the early period of economic development, the five-year plan was taken as a strict action program and therefore provided the guidelines for annual as well as medium-term investment projects to achieve the growth target for the plan period. As the economy expanded and became more complex, the economic development plan was extended to include the social sector, turning into an economic and social development plan. At the same time, the nature of the plan also evolved from a directive to an indicative plan. In the beginning, it was necessary to build a skeletal infrastructure characterized by the establishment of a variety of industrial plants. However, as the industrial framework developed and became more complex, the economic plan became more concerned with the types of industries to develop, rather than the drawing up of exact details for the development of a particular industry. Accordingly, the plan became a general reference guide rather than a formula to be strictly adhered to. However, in order to effectively handle and respond in a timely fashion to the rapidly changing foreign and domestic economic environments, an annual review of the economic performance became inevitable. Therefore, the annual economic management plan began to be actively utilized as a concrete directive for annual economic management – in effect, taking over the role of the five-year plan. Of course, officially at least, the five-year plan continued to be in effect, but the actual management of the economy was generally directed by the annual plan. Even quarterly economic management plans have been regularly announced and reviewed, thereby weakening the medium or long-term concerns in economic management. A short policy horizon in macroeconomic management could produce many problems. Most significantly, it could create macroeconomic instability since the annual management plan tends to be based on the idea of fine-tuning, possibly leading to a ‘stop–go’ policy pattern. Furthermore, fine-tuning policy patterns and short horizon in economic management tend to create time inconsistencies in economic policy



and therefore tend to lead in turn to a degree of short-sightedness in the investment decisions of the private sector.4 As a consequence, economic policies lose their credibility and become less effective over time. As the possibility of frequent redirection of the policy stance tends to encourage powerful interest groups in the economy, such as the associations of big business groups, and of small and medium-sized firms to lobby for expansionary policy, it can also create an inflation-prone macroeconomic policy stance. Once the importance of the share of the interest groups in the national economy is established, it will be very difficult to take a macroeconomic policy stance that acts against the interest of those groups. In Korea’s recent economic history, it is interesting to observe that genuine and lasting anti-inflationary policy has been a very rare occurrence, exercised only once during the first half of the 1980s. 3.3 Political democratization and political economy in the making of macroeconomic policy Since the mid-1980s, Korea has experienced a rapid political democratization process. As a result, labor unions, small and medium-sized firms and other socio-economic interest groups that claimed to have been neglected gradually gained power, eventually joining the ranks of the powerful lobbying groups that were previously dominated by the wellestablished large business groups. In general, these groups have a common short-term interest in maintaining an ever-expanding economy and so tend to push for an inflationary macroeconomic policy stance: high wage growth, low interest rates, easy monetary policy and so forth. So far, it seems that this political force has not been strong enough to produce a serious macroeconomic imbalance, although at times it has imposed a constraint on macroeconomic policy making. However, in the future, it is possible that political economy in macroeconomic policy making, due to political democratization and the already mentioned characteristic of a short horizon in policy making, could develop the process toward an inflationary economy unless some counteracting safety nets are set in place.

4. Changing prospects in macroeconomic policy environments 4.1 Globalization and its implications for economic management Recently national economies have become increasingly integrated into a global economy, moving from shallow integration under the GATT system to deeper integration under the new WTO system.5 In addition



to such international efforts among national economies through official bodies of international cooperation, the private sector initiatives for globalizing economic activities has continually been an even more important driving force for economic integration. Thus, political and geographical borders of national economies are becoming less and less effective as obstacles to the international flow of economic activities. Globalization implies the expansion of economic activities across politically defined national and regional boundaries through the increased movement of goods and services, which include labor, capital, technology, and information. What does globalization imply for Korean economic policy making? Most importantly, any preferential or discriminatory policies will become increasingly ineffective under the globalized economic environment due to two factors. The first is that as a member of the WTO system, Korea must abide by the rules and norms of international organizations that do not allow such policies to be used. The second factor is the increased mobility of economic goods and services and people and the resulting inability of the national economic authority to hold these elements within the national boundaries. From this perspective, the government-led economic development strategy, to which Korea has thus far adhered, will also become less effective. In this context, one can easily see that many existing regulations to promote or protect targeted industries could become obstacles to further economic development. Quantity and price regulations, which are administrative conveniences to control the ‘price index’, will also burden the economy in global competition. Therefore, the prospect of globalizing the Korean economy implies that economic policy making and implementation should be guided by the principles of non-discrimination and the market mechanism. 4.2

Liberalization and problems of direct regulation

In the coming decades, as the pace of globalization accelerates, domestic economic liberalization and reform will gain a new momentum; and as a result, economic management based on direct regulation in macro- and microeconomic policies will tend to lose its effectiveness and become inconsistent with the general philosophy of economic liberalization. Starting in 1991, measures to deregulate various interest rates have been taken in four steps. This process was more or less completed in 1997 with the implementation of the fourth step, which deregulated interest rates on short-term and demand deposits.6



Management of private investment, consumption, and imports by regulatory measures will not be available as instruments for macroeconomic stabilization policy. Price regulations will be lifted and ‘price index management’ will also be unavailable. Therefore, macroeconomic management should rely on traditional macroeconomic stabilization policies based on indirect control methods through the market system. 4.3 Capital flow liberalization and its implications for macroeconomic management Since the early 1980s, Korea has been engaged in a process of opening up its banking and capital markets. Foreign banks and securities firms are expanding their branching networks in Korea, and since 1992 a stock market has been opened and is expected to open up even further. When Korea joined the OECD in 1996, this provided the momentum to introduce various capital flow liberalization measures. The speed with which financial markets have opened has accelerated dramatically in the wake of the foreign exchange crisis of 1997. Korea’s capital account has now been fully opened, as they are in the advanced OECD countries. In addition, various regulations and restrictions in the foreign exchange market have been removed and the exchange rate of the Korean won is now freely floating. The immediate implication of these changes for macroeconomic policy making is that although domestic policy can be conducted mainly on the basis of domestic issues, careful consideration should now also be given to external economic developments and reactions inside the international capital market. In addition, the autonomy of Korean monetary policy and exchange rate policy cannot be simultaneously guaranteed under the open economy setting. The autonomy of monetary policy can be obtained in principle with the free floating of exchange rates. However, the free flow of capital in and out of Korea could weaken and in some cases cancel the intended effect of monetary policy actions when such volatility in the exchange rate is not tolerated. For example, suppose interest rates have been raised by the central bank to slow aggregate demand. Even under the floating exchange rate system, an increase in capital flow from abroad seeking higher interest yields could increase credit availability and thus at least partly cancel the intended effect of the tight monetary policy. Unless the Korean government is willing to accommodate a sharp appreciation in the exchange value of won, the capital inflow might continue



for a while. Furthermore, Korea has to consider the international political economy in macroeconomic policy making as a member of OECD and if necessary, preparations must be made for its active participation in international macroeconomic policy co-ordination. 4.4

Democratization and the political business cycle

As political pluralism and a democratic political system are continuing to develop in Korea, the possibility of a political business cycle becoming evident will increase. As a result, macroeconomic policies may become swayed by internal political considerations within the ruling political party as well as from lobbying by interest groups. Until recently, Korea’s political system has been rather authoritarian and the chances of the ruling group losing its election were almost non-existent. Under these circumstances, there was little incentive for the ruling group to implement short-term economic policies to increase its re-election prospects. At the same time, the old authoritarian government inevitably felt that improving economic performance justified its seizure of power, although possibly with a much longer horizon than the five-year terms of democratic government. Under the current one-term presidential system in Korea, implemented in 1987, this does not appear to be the case. The current political situation, with presidential elections every five years, national assembly elections every four years, and the newly initiated local elections every four years, could generate a good environment for political business cycles in the future. This point has become more relevant with the 1997 presidential election victory for Kim Dae-jung, who has led the opposition party for almost thirty years. In order to provide a stable macroeconomic environment to maintain a high rate of economic growth, certain safety devices will be necessary in the macroeconomic management system to prevent political factors from becoming the key determinant of the macroeconomic policy stance.

5.

Reforms in the macroeconomic policy regime

5.1

Indirect macroeconomic management system

5.1.1

General direction

Macroeconomic management should stabilize the aggregate economy and inflationary pressures, but without distorting relative price structures and thereby disturbing the allocation of microeconomic



resources; in other words, how much to produce, consume, save and how much to work. However, for a long time Korea’s macroeconomic management has relied on direct price and quantity regulations, which did distort the relative price structures. Furthermore, traditional macroeconomic policy instruments – such as the manipulation of the money and credit supply, preferential tax treatment and fiscal expenditure measures – have usually been geared to support the targeted industries. As a result, the role of macroeconomic stabilization policy has been increasingly deteriorating, although actual inflationary pressure has always been felt more severely than the managed and officially announced price index suggests. At the same time, the distortionary impacts on the relative price structure must also have been growing. Therefore, the reforms that are most urgently needed in macroeconomic management involve the active development and utilization of traditional macroeconomic policy instruments and the establishment of indirect macroeconomic management systems. First, the focus of macroeconomic policy should be shifted more towards using macroeconomic policy instruments for genuine macroeconomic stabilization rather than to support development policy. Next, all regulated prices should be liberalized. This measure should not merely be limited to the prices of major services like public utilities, but should also be applied to major industrial product prices. Through this reform, Korea should be ready to discard the so-called price index management practices, an action which will pave the way for a genuine macroeconomic policy system that focuses on affecting the aggregate demand to control inflation. Various quantity regulations should also be liberalized at the same time. Thirdly, Korea should try to avoid a macroeconomic management system, which relies heavily on various regulatory measures designed to encourage or discourage the economic activities of specific sectors for the purposes of macroeconomic stabilization. More specifically, the government should refrain from making direct regulations on individual firm investment projects to stabilize the aggregate investment level or on imports for current account management. Finally, it should be kept in mind that it is not advisable to actively utilize macroeconomic policy in a counter-cyclical manner. The experiences of Korea have proven that the counter-cyclical macroeconomic policies over the past two decades have not been very effective. Not only have they fallen short of expectations but even worse, they have often destabilized completely. Note that the correlation between the



real GNP and the monetary growth rates for Korea was actually negative for the last thirty years (see Table 3.1). Therefore, while Korea should establish a macroeconomic management system in which more standard monetary and fiscal policy tools are developed for macroeconomic stabilization purposes, the actual operation of these measures should be guided by the lessons learned from past experiences of active counter-cyclical macroeconomic policy. As the economic environment becomes increasingly uncertain and the government finds it harder to retain the information superiority needed for successful stabilization policy more difficult to satisfy, a stable macroeconomic policy stance may be a better choice than a counter-cyclical one. In addition, Korea is in the midst of various economic reforms. In this regard, one should also remember an important lesson from the New Zealand economic reform which, although still ongoing, has been praised as one of the most successful reforms in recent history. In this case, counter-cyclical demand management policies were largely eschewed during the reform period. Fiscal policy was focused largely on reducing the fiscal deficit in a progressive, credible manner, while monetary policy was aimed at reducing inflation steadily over time, with neither responding significantly to the state of the business cycles (Evans et al., 1996). 5.1.2

Reform of monetary policy practices

Korea’s current monetary policy practices can be characterized as a mixture of money multiplier manipulation and money demand control. To illustrate this, let us suppose that the money supply and the aggregate expenditure are expressed as follows: Money supply equation : M = m • B Aggregate expenditure equation : Y = M • V

(1) (2)

where M, m, B, Y and V are monetary aggregate, money multiplier, base (or high-powered) money, aggregate nominal expenditure and income velocity, respectively. Equation (1) is a simple money supply equation and equation (2) is a simple form of quantity equation. Indirect monetary management means controlling M by changing B through open-market operation given the relatively stable m. On the other hand, monetary control under the regime of macroeconomic management with direct regulation usually takes the form of manipulating M by controlling m more than controlling B. In Korea, the base



money (B) has been utilized as a source of policy loan for most of the last three decades to the point where it was almost beyond the central bank’s control. Therefore, the central bank has no choice but to rely on direct regulation of the money multiplier (m) to control money supply (M), such as direct controls on commercial bank credit behavior and frequent manipulation of required reserve ratio. In addition, efforts to control M via the manipulation of m have been supplemented by attempts to influence V. Naturally, the ultimate object of monetary policy was to influence the aggregate demand of Y. Controlling consumption, business investment and import behaviors with direct regulatory measures is a typical form of money demand (income velocity) manipulation practice. In this sense, the money multiplier and velocity management play major roles in aggregate demand management under the so-called direct monetary and macroeconomic control regime. Concerning the specific measures for establishing the indirect macroeconomic management system, an introduction of indirect monetary control system should be given a very high priority. Instead of relying on the commercial bank credit control, direct manipulation of interest rates, frequent changes of required reserve ratio, and non-market allocation of government bonds to the private sector financial institutions, the open-market operations should be used as the main channel of monetary policy implementation. The central bank’s burden of supporting the priority sectors chosen by the government’s industrial policies with base money creation should be relieved. The discretionary power of the central bank to manage the base money supply solely for the purposes of monetary policies should also be strengthened. Interest rate regulation in the short-term securities market has already been liberalized to aid the development of the short-term money market as a market for open-market operation. However, efforts should also be made to broaden the variety of the securities that can be used in openmarket operations. With further reforms, the monetary policy can continue to operate indirectly through the central bank’s base money control without causing distortions in financial resource allocation. 5.1.3

Reform of fiscal policy practices

Until very recently, the role of fiscal policy in Korea as a macroeconomic policy tool was rather minor, to say the least. According to Cho and Park (1994), the IMF fiscal impulse measures suggest that the fiscal policy was pro-cyclical for 11 years out of twenty from 1974 to 1993



and especially pro-cyclical for four consecutive years in the 1990s, thus adding to the volatility of the business cycles.7 They attributed their findings to the following three reasons. First, an incorrect stance was taken regarding fiscal policy itself. Second, the rigidity of fiscal policy management yielded a belated policy response to the demand from the public in previous years. Third, the government concentrated only on general accounts of the central government, overlooking a consolidated budget, including various special accounts and funds as well as provincial government budgets. Therefore, ample room remains for fiscal policy to play a more useful role as a macroeconomic policy tool. Above all, the government industry-supporting policy for economic development should be de-emphasized, except for the necessary cases of government involvement such as social infrastructure investment and R&D support. At the same time, however, it is also necessary to improve the flexibility of fiscal expenditures by lengthening the expenditure planning horizon to beyond a year while taking care not to succumb to political pressure for fiscal expansion which may arise in response to the increased flexibility. In addition, in order to increase the capability to correctly monitor fiscal stance and in order to take proper policy actions, Korea should prepare a consolidated account of central government and public sector data on a quarterly basis with the shortest time lag possible. (The current time lag at the time of writing is about two months.) Local government account should also be included in the public sector data. 5.1.4

Reform of exchange rate policy practices

Korea’s exchange rate system has been liberalized considerably since 10 March 1990 when a band system known as the market average exchange rate system was substituted for the former pegged exchange rate system. The central value of Korean won/US dollar exchange rate was determined as an average of individual exchange rates weighted with respective foreign exchange volumes of all exchange transactions executed during a previous market day. At first, the band around the central value within which the market rate was allowed to fluctuate was 0.4 per cent. The band was subsequently expanded further8 until the government eventually adopted a free-floating exchange rate system on 16 December 1997 in response to the economy’s currency crisis. In retrospect, we may say that Korea’s exchange rate policy has not been fully utilized as a genuine macroeconomic policy tool. The exchange rate was overemphasized as a critical factor affecting export



performance especially during the late 1980s after experiencing chronic current account deficits in the earlier period of economic development. The major concern in exchange rate management was maintaining export competitiveness. A typical example was the reluctance to appreciate the Korean won during the period 1986–1987, when the economy was rapidly expanding due to the sharp real depreciation caused by the strong yen. Korea paid the due price for its mismanagement in the form of inflation and a loss of international competitiveness which was caused by a belated exchange rate overshooting in the period 1988–1989, as well as domestic inflation (see Table 3.4). While the exchange rate system was liberalized during the 1990s, the actual exchange rate was still so rigidly managed within narrow constraints that it was unable to operate effectively in its function as a macroeconomic policy tool. During the 1990s, the major concerns of exchange rate management were to control domestic inflation and to put pressure on the exporting firms to improve international competitiveness by permitting the appreciation of the won. This may have been due to the difficulties experienced in using domestic policies to reduce high domestic factor costs such as the high cost of wages and land as well as the high interest rate, all of which were damaging Korea’s competitiveness abroad. The most appropriate policy response to the high factor cost situation seemed to be to allow the depreciation of Korean won in order to help improve the price competitiveness of exports. However, in reality the policy turned out to put more pressure on the already weakened domestic firms. An example of a success story for this policy type does exist, however, in the case of Japanese exporting firms that have survived the strong yen policy. Furthermore, capital flow liberalization proceeded with greater speed to meet eligibility requirements for the OECD, which Korea joined on 11 October 1996. This triggered further capital inflows that were already substantial due to the high domestic interest rate, increasing pressure on the Korean won. In the end, in spite of large current account deficits, the added weight of internal policy concerns and vast capital inflows brought about the overvaluation of the won (see Table 3.4), which eventually contributed greatly to the 1997 currency crisis. As Korea’s economy continues to open and becoming further integrated with the world economies, particularly in the aftermath of the 1997 currency crisis, exchange rate policy cannot be confined to the role of export promoter or inflation controller but should promote macroeconomic stabilization and act as a buffer against foreign shocks.



5.2

Maintaining a politically free macroeconomic policy stance

5.2.1

General direction

During the last thirty years, Korea has succeeded in achieving a relatively stable macroeconomic environment, despite the single-minded drive for industrial development through the central bank’s base money creation and commercial bank policy loans. However, the degree of central bank autonomy in Korea has been relatively low in terms of legal independence, governor turnover rate and also the overall independence index given by the weighted average of both measures.9 In spite of the relative lack of central bank independence, the Korean government’s inflation consciousness has helped achieve relatively low inflation, even under conditions of rapid economic growth. In this sense, the Korean government seems to have placed national economic stability above any other political concern. However, the Bank of Korea and the Ministry of Finance (now merged with the Ministry of Finance and Economy) have both been functioning to some extent just like any other inflation-fighting central bank, despite the fact that the independence of the central bank was relatively low. The political environment has already been moving towards further democratization so that interest groups and political parties will seek their own interests more actively. Interest groups such as national federations of big businesses as well as small and medium-sized firms and labor unions will lobby the political parties, in turn pressuring the government to change the macroeconomic policy stance for their own interests. Furthermore, the political parties, concerned with re-election and staying in power, will try to manipulate macroeconomic policy to increase their chances of re-election. It is clear from this that a socalled political business cycle is not such a remote possibility. To prepare for these changing realities, Korea has to introduce some safety nets to prevent political forces from influencing the macroeconomic policy stance. Here, one can propose three possible policy directions: (i) reform of the central banking system toward more independence from political influences; (ii) emphasis on rulebased policy making; and (iii) lengthening of the policy horizon. It is encouraging to note that the laws related to the central banking system in Korea (the Bank of Korea Act) were changed in late December 1997 in the general direction of enhancing the independence of the central bank. In the following, we make a brief overview of this reform.



5.2.2

Reform of the central banking system

The National Assembly passed the revised Bank of Korea (BOK) Act on 29 December 1997. This was preceded by a period of rancorous debate between the related ministries and the Bank of Korea over the proposed reforms in the latter, evidencing the difficulty involved in efforts to reform such entrenched systems and institutions. The sense of urgency that followed the financial crisis and the IMF’s emergency intervention in late 1997 was the main impetus for its passage. The Korean central banking system consists of the Monetary Board and the Bank of Korea. The Monetary Board is the nation’s supreme committee on monetary policy and is supposed to play, for example, the combined role of the Board of Governors of the Federal Reserve System as well as that of the Federal Open Market Committee of the FRS in the United States. According to the new BOK Act, the governor of the Bank of Korea assumes the chairmanship of the Monetary Board. Until the 1997 revision of the law, the chairmanship was assigned to the Minister of Finance while the BOK governor assumed the position of vice-chair. In addition, all seven Board members are now engaged full-time. Along with this, changes have also been made regarding the authority to nominate the Board members to reduce the appointment slots for the administration to one (out of a total of seven) from five (out of a total of nine). These together significantly improved institutional independence of the central bank from the administration and its political influences. In addition, the new law requires the Monetary Board to make public the minutes of the meetings and decisions taken in order to enhance transparency of the policy deliberations. On the other hand, the Bank Supervisory Board, which had been the key supervisory agency for banks, was removed from the central banking system and put under the control of the newly created Financial Supervisory Committee (FSC). The FSC has been given consolidated supervision and regulation responsibilities for three major financial businesses in banking, insurance, and securities. However, the Bank of Korea still possesses some recourse in the area of bank supervision in that it has access to the reports compiled by the FSC and it can also request a joint inspection of financial institutions. These changes should not have a noticeable impact on Korea’s financial industry, except that there will be long-term benefits under a more independent central bank and a consolidated financial regulatory agency. The recent changes are positive, especially as a more



independent central bank would bring about a less inflationary environment in the long term. Furthermore, as there is an ongoing trend of removing barriers within the broad category of financial businesses, a consolidation of supervisory functions appears to be timely. Although there do not appear to be any glaring deficiencies that would require immediate changes, if we would like to maintain some aspects of the new independence of monetary policy making, we should be open to further modifications and improvements in the future. 5.2.3

Emphasis on rule-based economic policy making

The main reason for interest groups to lobby the government, either directly or through political parties, is because they see the possibility of changing a policy stance. Therefore, the surest way to protect economic policy making from political influences is to convince the public that policy stances cannot be changed except in exceptional circumstances. The issue of rule versus discretion in economic policy making has been raised in the context of how to maintain time consistency in economic policy making and implementation after experiencing high inflation under the discretionary macroeconomic policy regime (notably in the US during the 1970s).10 A rule-based policy is recommended as a substitute for a fine-tuning, discretionary policy. The underlying reason for fine-tuning, discretionary policy regime’s tendency to become time inconsistent is the economic agent’s perception that government policy making is endogenous or can be made to become endogenous. Therefore, the issue of maintaining time consistency in policy making is exactly the same as protecting the economic policy from interest-group politics. In this sense, the government should make itself less free in policy changes, not only to improve the time consistency of macroeconomic policy but also to avoid the distortion in macroeconomic policy stance due to lobbying by interest groups. This would signal to the public the government’s unwavering commitment to the given policy stance. Once the public is convinced that the government has is determined to stick to the given stance under any circumstances, then the leadership of the government policy over the public can be greatly improved. For this purpose, it will be necessary to introduce some characteristics of a rule-based policy in macroeconomic management. In order to protect the monetary policy stance from political pressure, it is important to have an independent central bank, but it is even more



important to emphasize rule-based policy in monetary policy making. In the past, the government announced a monetary growth target annually. However, the target was often not kept to or changed in due course. Therefore, the growth target of money supply has not constrained central bank behavior in the usual sense. 5.2.4

Lengthening the economic policy horizon

Rule-based policy making is an important step toward the improvement of the macroeconomic policy environment, but may not be enough on its own to achieve its intended purposes unless the rule making is projected over a long enough horizon. As we have already mentioned, Korea has utilized a series of five-year economic development plans, but recently, the horizon of economic policy making has been shortened to as little as a quarter. It seems that Korea has abandoned its long-term policy horizon – as a result, the government will be perceived as less resolute regarding its policy stance. In principle, the economic policy stance can be changed as often as once a quarter and the longest horizon has been reduced to twelve months. Even a rule-based policy is unlikely to be beneficial if it is only adopted on a quarterly basis. If a monetary growth target is adopted as a strict rule but can be easily and regularly changed every quarter, the rule cannot form effective protection against the political economic forces. Therefore, it would be beneficial to expand the policy horizon to at least a year. For this purpose, it may be more useful to have a long-term development strategy rather than the more typical five-year economic plan that has been used in Korea. The latter type of plan will become increasingly ineffective as the Korean economy grows in size and complexity.

6. Macroeconomic policy issues in a small open economy setting This section discusses the macroeconomic policy issues in a small open economy setting. In recent years, Korea has started to accelerate the process of opening its financial market with the liberalization of the foreign exchange market and capital flow and now, in the wake of the 1997 economic crisis, this has almost been completed. The degree of liberalization of capital flow and foreign exchange transaction in Korea has now reached the level of other OECD countries. Therefore, the single most important issue in macroeconomic management is determining how to maintain a stable growth path in an open



economy setting in order to recover from the effects of the current crisis. In this context, Korea will have to be ready to deal with macroeconomic issues such as autonomy of monetary and exchange rate policies, exchange market intervention, and policy mix under an open economy environment. One important lesson from Korea’s experiences during financial liberalization is that capital flow regulations inconsistent with the market incentive structure will eventually contribute to an inability to guide the flow in the desired direction.11 Therefore, it is important to remember that in order to stabilize capital flows in the desired pattern, the country must first restructure market incentives, including interest rates and exchange rates, through appropriate macroeconomic policies. Following this line of thought, Korea must set up a suitable macroeconomic policy regime to successfully handle various macroeconomic problems arising from free capital flows. First, Korea must fully liberalize domestic interest rates and allow interest rates to move with the overall demand and supply of funds, including foreign funds. Second, the recently introduced freely floating exchange rate system should be kept intact. It may be the case that greater interest rate and exchange rate flexibility is necessary to improve the absorption capacity for more active capital flows. Third, an indirect monetary control system should be developed, substituting for the direct credit regulation system in order to absorb excess liquidity brought in by capital inflows without distorting financial resource allocation. For this purpose, open-market operations should be activated by liberalizing short-term money market and interest rates, including those in the government bond market. With these changes in the policy regime, the government will be in a position to contain more effectively the liquidity shocks stemming from active and free capital flows without micro-misallocation of financial resources. 6.1

Autonomy of monetary policy and exchange rate regime

In a closed economy with no international transaction in capital or trade, a country can adopt an independent monetary policy stance and pegged exchange rate regime. It can ignore the possibility of the effects of the domestic policy leaking through international linkages. Tightening the money supply will reduce the availability of bank credit and increase the domestic interest rate. These effects will be fully absorbed domestically without leakage into and feedback from the outside world. Therefore, monetary independence can be preserved without any loss of freedom in choosing the level of exchange rate.



However, once free international flows of goods are allowed, but with limited or no capital flows, monetary independence under the freely chosen exchange rate can only be preserved in the short run and not in the long run. This type of economy has been described as an ‘insular economy’ (OECD, 1990). With little or no capital flow, the interaction between countries can take place mainly through trade flows. Therefore, if the insular economy chooses pegged or fixed exchange rates, then the effects of domestic macroeconomic policy can be affected by the extent to which the excess in domestic expenditure leaks through exports and the shortage is supplemented by the imports respectively. Domestic monetary policy can, at least in the short run, be geared to manage the domestic economic activity subject to the government’s willingness to sterilize the changes in foreign reserves. Once the government decides to sterilize the shocks to the foreign reserve holdings of net balance of payments, then the insular economy can maintain the independence of domestic monetary policy under the pegged or fixed exchange rates. However, it will be difficult for macroeconomic policy alone, especially in the case of monetary policy, to achieve both the external and internal equilibria in the long run, given the pegged exchange rate. For example, if the domestic unemployment and the external balance of payments deficits take place simultaneously, then a conflict in monetary policy operation may arise. Easy monetary condition may help reduce the degree of domestic unemployment, but only by exacerbating the external balance deficits. Furthermore, as sterilization will cause fiscal difficulty to the authority due to the difference between domestic and foreign interest rates, the feasibility of sterilization will also be greatly reduced in the long run. Allowing freer capital mobility will damage the independence of monetary policy even further under independent exchange rate policy. Once the independent level of exchange rate is chosen, whether it is pegged or fixed, the independence of monetary policy should be sacrificed. On the other hand, once a particular level of money supply or interest rate is decided upon, the freedom of choosing an independent level of exchange rate should be sacrificed. Under free capital mobility, any difference between domestic and foreign interest rates will induce capital flows, which in turn will cause the exchange rate to change. Therefore, in this case a conflict arises between the levels of domestic interest rate and exchange rate unless the capital flow pressure is fully neutralized. In general, the problem of simultaneously maintaining a pegged or fixed exchange rate and controlling the money supply or interest rate is increasingly worsened with the degree



of international capital mobility. However, it has been argued that sterilization may save the independence of monetary policy, even with a pegged or fixed exchange rate. Therefore, it will be useful to discuss whether or not sterilization is feasible as an independent macroeconomic policy instrument. 6.2 The feasibility of sterilization policy as an independent policy instrument 6.2.1

Background discussion

In general, three possible ways have been advanced to overcome the difficulties in maintaining an independent monetary policy with pegged or fixed exchange rate under free capital mobility. One obvious and traditional method is to appeal to exchange and capital controls, a rather unrealistic approach in the current global market. The second response is to fully liberalize the mechanism of exchange rate determination so that a flexible exchange rate becomes a preserver of the domestic independence of monetary policy. This is perhaps the most likely policy goal for Korea, which is already moving towards a completely open and liberal economy following the 1997 crisis. However, exchange rate liberalization can sometimes turn out to be an unwelcome policy choice for a country such as Korea that relies on exports as an engine of growth. For example, a rapid capital inflow can cause a sharp appreciation in the exchange value of won, thus adversely affecting export competitiveness. Therefore, in this case, it may be argued that a flexible exchange rate system will not be a good solution in the short run, even though it may be a desirable and indeed inevitable policy goal in the long run. The third option is known as a sterilization of foreign reserve shock to the domestic money supply given the chosen level of exchange rate. As suggested before, monetary policy to maintain the domestic interest rates at a different level to the foreign interest rate, i.e., the interest rate implied from the interest rate arbitrage condition, can always trigger the capital flow which in turn disturbs the existing level of exchange rate. If the country wants to keep the domestic interest rate higher than the foreign rate and to maintain the existing exchange rate level, then exchange market intervention becomes necessary. This involves the purchase from the private sector of the foreign exchange brought in by the capital inflows. At the same time, the money creation from the increased level of foreign asset’s should be sterilized with openmarket sales of government (or central bank) bonds or with the contraction of central and commercial bank credit to the domestic sector.



This can be carried out through policy instruments, such as curtailment of central bank rediscount, increase in reserve requirements and so on. Sterilized intervention is preferred by countries facing capital inflow pressure in the process of economic opening in order to buy time for the gradual adjustment toward full opening and to minimize the possible impacts of capital inflows on money supply and exchange rate, which in turn can influence trade flows. Korea has also experienced these processes in recent periods. 6.2.2

Effectiveness of sterilization policy

Sterilization is always technically possible, as we have already discussed. However, its effectiveness depends on various conditions. First, the extent to which the private sector regards domestic and foreign assets as substitutes is an important condition because sterilization is essentially a process of exchanging foreign assets for domestic assets. When the central bank intervenes in the exchange market through the purchase of foreign currency (assets) in exchange for domestic currency to absorb the capital inflows, this operation eventually increases the money supply. However, the sterilization of the money supply increase through the sales of domestic bonds in the open market can only be effective if private sector agents are ready to purchase the increased supply of domestic bonds in addition to the existing stock of foreign and domestic bonds. Suppose that the private sector agents see no difference between domestic and foreign bonds and so concern themselves solely with the total stock of both types of bonds, regardless of their composition. Naturally, they would sell foreign bonds continuously to absorb the increased supply of domestic bonds, thereby prolonging capital inflows and making the sterilization effort ineffective. This latter case can be characterized as the perfect asset substitution between domestic and foreign bonds. Higher interest rates on domestic bonds due to larger supply will quickly be arbitraged through the rapid reshuffling of respective bond holdings so that the uncovered interest rate parity always holds, regardless of the relative supply of those bonds. Therefore, there is no reason to expect that exchange rate will be responsive to the sterilized intervention. On the other hand, if both bonds can be characterized as imperfect substitutes, then the relative supplies of respective bonds can affect the relative yield due to the country and exchange risks. Higher yield on domestic bonds due to the larger supply will reflect a risk premium,



which will not be arbitraged away because the bonds are imperfect substitutes. In general, if domestic and foreign assets are imperfect substitutes and therefore non-zero country as well as exchange risks arise that vary with relative stocks of domestic and foreign assets, then a sterilized intervention becomes an independent policy instrument that can effectively change the exchange rate. In the case of sterilizing capital inflows, the central bank exchanges domestic bonds for incoming foreign currency. Thus, the relative stocks of domestic and foreign currencies remain unchanged, but the relative stocks of respective bonds changed with the larger stock of domestic bonds supplied. The question is whether such a change in the relative stocks of respective bonds, without a change in relative stocks of respective currencies, can relieve the pressure for an exchange rate appreciation. The answer is yes if the larger stocks of domestic bonds increase the risk premium so that the merit of holding domestic bonds is not increased relative to foreign bonds and so the incentive for further capital inflow will disappear. On the other hand, if both bonds are perfect substitutes and no risk premium is required, so that the higher return on the domestic bond relative to the foreign bond induces further capital inflow, then the answer is no.12 The second factor adversely affecting the effectiveness of sterilization is the financial burden on the authority executing the sterilization. As we have already suggested, sterilization eventually results in the holding of zero-yielding foreign currency or low-yielding foreign assets and the selling of high-yielding domestic assets. Therefore, interest rate differentials can create a serious financial burden or fiscal difficulties to the central bank or the government, which in turn will cast doubt on the long-run feasibility of a sterilization operation, especially if the need for sterilization continuously arises. The third factor affecting the feasibility of sterilization may be the possible distortionary effects of monetary base reshuffling and of direct regulation measures other than the open-market sales of public bonds to absorb excess liquidity, such as reserve requirement management, rediscount window operations and non-market allocation of government bonds. The sterilization to absorb the capital inflows necessarily results in base money reshuffling towards greater foreign reserves but lower domestic credit. Thus, economic sectors such as small and medium-sized firms and members of the general public who rely heavily on bank loans originating from domestic credit sources become increasingly disadvantaged while large businesses with easy access to



foreign capital become increasingly advantaged. In addition, if the country lacks a well-developed short-term money market for openmarket operations, direct multiplier management should be maintained. Similarly, government bonds should be allocated to private financial institutions via non-market mechanisms in order to absorb the excess liquidity. In these cases, financial resource misallocation will take place. Therefore, as the sterilization operation continues on an increasingly larger scale, those distortionary effects will also get larger, which in turn will tend to limit the feasibility of the sterilization policy. 6.2.3

Empirical evidence and Korea’s experience

Empirical studies which have tried to show the effectiveness of a sterilization policy as an independent macroeconomic policy instrument were surveyed by the authors such as Weber (1986) and Edison (1993). It turns out that most of these studies base their empirical works on the portfolio balance model and test the asset substitutability. Empirical findings in those studies have been interpreted to suggest that domestic and foreign assets are close to perfect substitutes and so the sterilized intervention is not very effective. This conclusion seems to be consistent with a presumption that the world financial markets become increasingly integrated and capital flows take place almost instantaneously so that each country faces the increasing difficulties in maintaining independent level of interest rate deviated from interest rate parity condition. This may be true for the developed countries without many restrictions on capital flow and foreign exchange market regulations; in other words, without a strong rationale for risk premium. However, in the developing countries, the story is a little different as domestic assets can be treated as imperfect substitutes for foreign assets. Various capital flow controls and exchange market restrictions will render non-zero risk premium required for domestic assets. Sterilization has been utilized as an important policy instrument in the developing countries at least in the short run. According to surveys by the IMF (1993) and Glick and Moreno (1994), the majority of the developing countries such as Latin American and East Asian economies utilized sterilization policy as the initial response against the capital inflow pressures since the second half of 1980s. The sterilization was effective in controlling the immediate pressures on exchange rate and inflation for the first year but tended to lose its effectiveness in subsequent years and was gradually phased out.



Until recent events culminating in the 1997 currency crisis, Korea had adopted a foreign currency centralization system in which all foreign currencies entering the country, barring a few small exceptions, was surrendered to the central bank, thus maintaining the exchange rate. Therefore, exchange market intervention took place automatically given the rigidly determined exchange rate level. In order to alleviate the inflationary pressure of excess liquidity brought in by capital inflows, the central bank of Korea issued monetary sterilization bonds, which were allocated to financial institutions through non-market mechanism at a below-market interest rate. So, in Korea, the motivation for the sterilization policy was to stabilize the inflation and exchange rate variation under the capital inflow pressure. During the period 1986–1989, Korea’s large current account surpluses became a source of the foreign currency inflow that generated pressures culminating in the appreciation of the Korean won and the increases in money supply. Very much concerned about the possible adverse impact on export competitiveness of the exchange rate appreciation, as well as the inflationary impact of the excess liquidity, the Central Bank of Korea became actively involved in the massive sterilized intervention. The current account surpluses reached 4.9 per cent, 9.0 per cent, and 10.9 per cent of GDP in 1986, 1987 and 1988, respectively, while the capital account recorded net outflows of 4.4 per cent, 9.2 per cent and 3.8 per cent of GDP, thanks to the strong government efforts to ship out the excess liquidity through the payment of foreign borrowings (see Table 3.4). However, to absorb the remaining and still large net inflow of foreign exchanges, the central bank actively intervened in the exchange market. Official foreign reserve holdings rapidly increased and once reached 6.7 per cent of GDP in 1988, pressuring for monetary increases. At this point, a sterilization effort was initiated through the sale of Monetary Stabilization Bonds, resulting in a sharp reduction in the level of domestic credit. In 1988, when sterilized intervention was the strongest, foreign assets accounted for 81.2 per cent of the 30.2 per cent increase in the monetary base, while the level of domestic credit fell by 50.9 per cent. In addition, while the monetary base showed a drastic increase in spite of the sterilization effort in this period, the broad money growth (M2) was relatively stable, implying additional sterilization measures to reduce the money multiplier such as raising required reserve ratio were also implemented (see Table 3.2). During the period 1992–1996, Korea was also involved in sterilization activity, although to a much lesser degree than in the earlier


Table 3.2

Various economic indicators related to sterilization policy1

Year

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

Current account surplus Capital and financial account Direct investment Portfolio investment Other investment Net errors and omissions Changes in reserve assets

–1.0 2.0 –0.4 2.1 0.4 –1.1 –0.0

4.9 –4.4 –0.8 –0.3 –3.2 –0.6 –0.0

9.0 –9.2 0.1 –0.3 –8.9 1.1 0.8

10.9 –3.8 0.3 –0.8 –3.0 –0.4 6.7

3.6 –1.9 0.3 –0.5 –1.6 0.5 2.1

–1.1 1.4 –0.1 0.0 1.7 –1.0 –0.7

–3.9 3.0 –0.1 1.4 1.9 0.4 –0.5

–1.6 2.7 –0.2 2.4 0.7 0.4 1.5

0.4 1.0 –0.3 3.7 –2.3 –0.3 1.1

–1.3 3.4 –0.5 2.0 2.0 –0.6 1.5

–2.4 4.8 –0.5 3.3 2.1 –0.4 2.0

–5.9 6.0 –0.6 3.9 2.8 0.3 0.4

–1.9 0.3 –0.4 3.4 –2.6 –1.2 –2.8

Monetary base Net foreign asset Domestic credit Broad money growth(M2) Money multiplier Won/dollar exchange rate Real effective exchange rate2 Price inflation in CPI Corporate bonds yields (%/year)

1.7 10.0 –8.4 15.6 13.7 7.6 — 2.5 14.2

16.2 4.1 12.1 18.4 2.0 –3.2 13.8 2.8 12.8

48.9 18.1 30.8 19.1 –20.0 –8.0 –0.9 3.0 12.6

30.2 81.2 –50.9 21.5 –6.7 –13.7 –9.8 7.1 14.2

31.8 19.7 12.1 19.8 –9.1 –0.7 –11.9 5.7 15.2

7.7 2.0 5.8 17.2 8.8 5.4 2.0 8.6 16.5

18.2 –1.2 19.4 21.9 3.1 6.2 0.3 9.3 18.9

10.9 19.0 –8.0 14.9 3.6 3.6 5.0 6.2 16.2

27.5 15.8 11.6 16.6 –8.5 2.5 1.4 4.8 12.6

9.2 16.9 –7.7 18.7 8.7 –2.4 –3.9 6.2 12.9

16.3 20.3 –4.0 15.6 –0.6 –1.8 –2.5 4.5 13.8

–12.2 9.3 –21.5 15.8 32.0 9.0 –2.8 4.9 11.9

–12.5 –50.2 37.7 14.1 30.4 67.6 9.3 4.4 13.4

Notes: 1. Upper panel in percentage of GDP and lower panel in annual percentage rate of increase. 2. Based on Korea’s trade weights with 16 major trading partners. The base year is the year from the second half of 1985 to the first half of 1986 when Korea’s current account was balanced. A positive rate of increase means a depreciation. The trade weight was calculated using the actual bilateral trade data of the previous year; thus the weights vary over time.

75



episode. In this period, the inflow of excess foreign exchanges was ignited mainly by the stock market opening on 1 January 1992 and the subsequent measures for capital flow liberalization were similar to the earlier episode. In evaluating these experiences, it seems that Korea was involved in almost complete sterilization as can be seen in the following central bank reaction function estimated:

.

.

DC = –1.05NFA – 0.85gy + 1.04gy–1 – 0.35p + 0.71p–1 (–10.4) (–0.82) (0.90) (–0.13) (0.26) – R2 = 0.67, D – W = 2.30

.

where DC, NFA, gy and p represent change in domestic credit, change in net foreign assets, GNP growth rate and CPI inflation rate, respectively, the subscript, –1 represents the lagged variable and the number in parentheses is the t-value. The OLS regression utilized quarterly data for 1985.1–1998.1. Here the coefficient of NFA differs insignificantly from –1, implying complete sterilization. The economic meaning is that a change in net foreign assets has been countered by a change in domestic credit of the same magnitude in the opposite direction. In addition, the monetary base shows a large increase during the episodes but a much lower increase compared to the increase of net foreign assets due to sterilized intervention, especially in 1988, 1992 and the period 1994–1996. Furthermore, the money multiplier decreased during the period 1987–1989 and 1993.13 As a result, the money supply (M2) could be maintained at a reasonably stable growth rate compared to the monetary base increase (see Table 3.2). Nominal exchange rate appreciation was contained within the relatively low range during the period 1986–1987, but reached a doubledigit figure in 1988. However, the real effective exchange rate depreciated at a double-digit rate in 1986 but experienced a belated large appreciation in 1988 and 1989. CPI inflation also showed a remarkably stable trend until 1987 but began to increase from 1988 (see Table 1.1). These observations imply that sterilization policy can be effective in stabilizing exchange rate and inflation in the early phase but tends to lose its effectiveness as the need for sterilization continues. In the 1990s, continued current account deficits were financed by strong capital inflows, which were in turn induced by the high domestic interest rate under rapid capital flow liberalization. Large increases



of net foreign assets, due to the overall balance (current account and capital account) surpluses, have been sterilized by the corresponding reduction of domestic credits. Thanks to this effort, the monetary increases were maintained at a relatively stable level while the rigid exchange rate management, which didn’t allow enough exchange rate depreciation to reflect current account deficits and domestic inflation, led to real appreciation. A high won policy vis-à-vis the US dollar combined with current account deficits provided an economic environment that was instrumental to the outbreak of the currency crisis in 1997. In sum, judging from Korea’s experiences, it may be tentatively noted that sterilization policy can be effective in the short run. However, in the long run, the macroeconomic environment that is inducing capital inflows should be appropriately realigned so that the need for sterilization policy itself eventually disappears. In the case of Korea, current account surpluses during the mid-1980s, and a high domestic interest rate in the 1990s, were the key causes of the wave of capital inflows and, therefore, appropriate macroeconomic solutions for these problems should have been called for from the outset. Sterilization can buy the time required for adjustment in transition but is not a long-term solution in itself. 6.3

Macroeconomic policy mix under capital flow pressure

The management of free capital flow will continue to be the key macroeconomic policy issue in the coming years. Once it is understood that the sterilization policy is not effective in the long run and is to be used only as a transitional measure, it is necessary to design the appropriate macroeconomic policy mix to deal with capital flows. We have already argued that the fiscal measure in Korea is in need of an overhaul if it is to be used as a major macroeconomic policy instrument. However, in this case of absorbing the excess liquidity brought in by the capital inflows, it can be argued that fiscal restraint, in whatever form, will always be a precondition for maintaining macroeconomic stability. Therefore, our discussion concentrates mainly on monetary and exchange rate policies to deal with capital flow pressures, given the sound stance of fiscal policy assumed to be already in place.14 This issue of policy mix has been discussed in the context of alternative targeting policies – that is, monetary aggregate versus exchange rate targeting to maintain price stability. A study of the theoretical aspects and empirical evidence of this subject based on the experiences



of the advanced OECD countries has been published by OECD (1985). A summary table of relative merits and demerits of monetary targeting versus exchange rate targeting discussed in this study is reproduced in Table 3.3. One conclusion from this study is that both regimes have costs and benefits depending on the types and sources of the shocks, and, therefore, it is difficult to present definitive criteria in choosing one regime over the other. Therefore, once it is fully understood that a trade-off exists between domestic money supply or interest rate and the exchange rate, it may be possible to mix both monetary and exchange rate policies in an appropriate manner to achieve the stated policy goals, given the nature of the shocks. According to the summary of the benefits and costs reported in Table 3.3, it appears that, generally speaking, a money supply target combined with floating exchange rates has a considerable advantage in the face of macroeconomic shocks, such as wage disturbance, fluctuations in the budget deficit and changes in foreign monetary policy (for example, a foreign interest rate shock due to the changes in the monetary policy stance). On the other hand, maintaining an exchange rate target is unambiguously more advantageous than keeping to a money supply target if it is achieved through non-sterilized intervention, in the case of shifts in the money demand function. It is also preferable if the exchange rate target is achieved through sterilized intervention in the case of the changes in preferences for interest-bearing debt denominated in different currencies. These results seem to imply that one can roughly evaluate the alternative targets by judging how strongly the monetary accommodation, given the exchange rate target, will produce inflationary pressure or how effectively the floating exchange rate, given the money supply target, will block inflationary pressure to the domestic economy. Of course, the short-run output effect is also an important consideration. Based on the experiences of the major industrial countries, Darby (1985) found that long-run neutrality (or even long-run super-neutrality, though to a lesser extent) of monetary policy effects on the real output and the real exchange rate holds to an acceptable degree of approximation. It also seems that Korean experiences favor monetary neutrality. Thus, care should be taken not to overemphasize the aspect of short-run output losses when evaluating the results reported in Table 3.3. Three cases in which money supply target is advantageous imply that flexible money supply responses to maintain exchange rate targets will ultimately accommodate inflationary pressures generated


Korea’s Macroeconomic Management 79 Table 3.3

Macroeconomic benefits and costs of alternative targeting policies Monetary target

Exchange rate target

Wage shock

Benefits: inflation stabilizing, rapid real adjustment to reduce wage resistance and restore real exchange rate Costs: larger short-run output loss

Benefits: less short-run output loss due to partial monetary accommodation Costs: less real adjustment, resulting in longer distortion of real exchange rate: possible inflation expectation effects

Fiscal impulse

Benefits: stabilizes shortrun output and price effects Costs: probable temporary appreciation of real exchange rate

Benefits: initial real exchange rate effect confined to possible small price rise Costs: monetary accommodation leads to more important output and subsequent price effects, which may be enhanced by expectations mechanisms ; the latter would imply subsequent real exchange rate distortions

Upward shift of money demand

Benefits: None Costs: short-run output loss and real appreciation

Benefits: output, price and real exchange rate stability Costs: none

Increased foreign preference for domestic currency assets

Benefits: None Costs: short-run real appreciation and Ambiguous output effect

<Sterilized intervention> Benefits: output, price and real exchange rate stability. Costs: none

Rise in foreign interest rate

Benefits: isolation from direct money supply effects of changes in foreign monetary policy, minimizing output and price responses. Costs: temporary distortion of exchange rate and possible fall in real money balances via increased prices, particularly if wage indexation is important.

Benefits: initial stability of the real exchange rate. Costs: monetary contraction, output loss, and possible subsequent price expectations and real exchange rate effects.

Note: 1. Costs are defined in terms of a simple macroeconomic objective function of minimizing deviations from medium-term final objectives for inflation and output growth such as (i) controlling inflation in the long run; and (ii) minimizing fluctuations in output. Source: OECD (1985), p. 26.



by the original shocks, such as exogenous wage increases, fiscal deficits, and a loose foreign monetary policy. The short-run output fluctuation in the case of the wage shock is a necessary adjustment step, but for the other two cases, a money supply target will actually help avoid output fluctuations. Monetary accommodation in the case of the shifts in the demand function for domestic money is obviously an optimal policy response if it can be managed through non-sterilized intervention – by selling domestic currency on the exchange market to maintain the exchange rate target. In the case of the shift in relative demand for different currency assets, the shift itself can only originate from the assumption of imperfect substitutability between different currency assets. Therefore, sterilized intervention is an obvious response. Note that, in this case, sterilized intervention will be effective in the long run as well as in the short run, given the assumption of imperfect substitutability. Returning to the Korean case, the pressure of capital inflows in the 1990s stemmed from an interest rate differential that was favorable to Korea, due to the differences in domestic and foreign monetary policy stance as well as to growth potential. This case is similar to the case of the shift in monetary policy stance (the reversed case of the rise in foreign interest rate in Table 3.3), in which a money supply target combined with flexible exchange rate is unambiguously advantageous. However, the policy mix adopted by the Korean government aimed at keeping the Korean won strong and money supply relatively tight, thereby seeking both monetary targeting as well as exchange rate targeting. This policy proved inappropriate because the real sector, heavily dependent on exports, lost export price competitiveness due to the high level of the won. The situation was further aggravated by high factor costs such as the high domestic interest rate and high wage rates. Strong anti-inflationary policies with overvaluation of the Korean won and a tight money supply, especially in 1997 when the Korean economy was experiencing the worst cyclical downturn since the early 1970s, hit businesses in weak financial positions. The weakened economy could not stand this policy mix which made it particularly vulnerable to adverse shocks. This was soon apparent to foreign investors who, on witnessing this sequence of events, rapidly pulled out of their Korean holdings, thus contributing further to the collapse into currency crisis in late 1997.



7.

Summary and lessons

This chapter includes many issues related to Korea’s recent macroeconomic management as well as that of the coming decades and in it we have argued that, until recently, macroeconomic management patterns such as direct regulatory measures were dictated by a development strategy of financially supporting the targeted industries. A shortsighted policy horizon and a political distortion of macroeconomic policy were also characteristic of recent macroeconomic management. We have argued that the new economic environment, characterized by globalization and economic openness, capital liberalization and rapid political democratization, are dictating all new adjustments of macroeconomic policy practices. We have argued that Korea should reform the practices of monetary, fiscal, and foreign exchange policies, so that a policy system that relies on indirect methods can be implemented. Above all, maximizing the stability of macroeconomic policy itself is more important than maintaining anti-cyclical macroeconomic policies in order to stabilize the economy. In doing so, monetary policy would rely more on openmarket operations, fiscal policy would work as an effective means of macroeconomic stabilization, and the foreign exchange market would play a primary role in determining exchange rates. In addition, a safety net could be established to protect the macroeconomic policy stance from the political parties as well as the socio-economic interest groups. The safety net may include enhancement of central bank independence, rule-based economic policy implementation and a lengthened policy horizon. Finally, this chapter discusses the macroeconomic issues in a more open-economy setting, anticipating freer capital flows in coming decades. The trade-off in policy independence between monetary and exchange rate policies is discussed, as are theoretical and empirical issues concerning the effectiveness of sterilization policy, particularly in the Korean context. It is suggested that, in the Korean case, sterilization would be an effective and useful policy response to the excessive inflow pressure of foreign currencies in the short run but would tend to lose effectiveness in the long run. This chapter searches for an optimal policy mix of monetary and exchange rate policies that could effectively deal with capital inflow pressures in the medium and long term, given the fiscal restraints resulting from the overall domestic stabilization effort. The theoretical considerations suggest that monetary



targeting with exchange rate flexibility would be the best measure for the policy mix in this case, and the Korean experience also seems to confirm this.


4 The Evolution of the Chaebols: The Property Rights System and Economic Organization in Korea*

1.

Introduction

Having taken a close look at Korea’s macroeconomic policy environment in the previous chapter, we will now consider some microeconomic features peculiar to the Korean economy. Arguably the most influential of these are the Korean conglomerates, known in Korea as chaebols. The purpose of this chapter is to apply the new-institutional economic approach to issues regarding the chaebols, as well as to a number of controversial issues concerning the Korean economy as a whole. Specifically, we seek to emphasize the pivotal role of a country’s property rights system in determining the nature of economic behavior and organization. From these discussions, we draw some lessons to be learned in charting the future course of institutional reforms for the sustainable development of Korea’s economy. One of the most important economic institutions in a market economy is the property rights system; no economic organization can operate outside this system. In our view, the chaebol is no exception and, as with any other economic organization in Korea, the evolutionary process of chaebol formation can only be meaningfully analyzed in the context of Korea’s own property rights system. Recently, proponents of new-institutionalism, led by North (1990, 1992) and Eggertsson (1990), inspired by Coase (1937, 1960), Alchian (1961), Alchian and Demsetz (1972), Demsetz (1967) and others, began to emphasize the existence of non-zero transaction costs in the real world economy. Another key concept is the importance of economic * This chapter is based on Sung-Hee Jwa (2000), ‘Property Rights and Economic Behaviors: Lessons for Korea’s Economic Reform’, in Kenneth L. Judd and Young Ki Lee (eds), An Agenda for Economic Reform in Korea, Hoover Institute and Korea Development Institute, pp. 401–30. 83



institutions in determining economic behavior and performance. Simply treated as a given under neoclassical economics, new-institutionalism returned the economic institution to the forefront of economic analysis. In the non-zero-transaction-cost world, the economic institution becomes the ultimate determinant of the size of the transaction costs the economy should bear, thereby influencing the structure of economic organization and performance. Therefore, the type of economic institution built into the economy becomes the most crucial factor in determining the nature of economic organization and the performance of the economy in general.

2. Some testable hypotheses of new-institutional economics 2.1

Transaction costs and economic institutions

Transaction costs are all the costs involved in operating an economic system. These include the costs incurred in the negotiation, monitoring, co-ordination and execution of transactions. All of these costs are derived from the fact that information is not a free good and is shared asymmetrically among agents involved in transactions. An economic institution embodies the rules that regulate economic activities and the degree to which they are enforced. These include formal laws and regulations as well as more informal constraints such as customs that have come to be widely accepted over time. Enforcement is a critical component of an economic institution since a formal rule that is not properly enforced is not really a rule. The property rights system has been regarded as the most important economic institution in any free market economy. Under the zero-transaction-cost assumption of the neoclassical world, the issue of economic institution does not arise at all. The issue of optimal resource allocation is generally seen as institution-free. Coase (1937, 1960) has shown that with the assumption of zero transaction costs, the differences in economic institutions, and particularly property rights systems, do not affect the outcome of resource allocation. Thus, an economic institution could be treated as exogenously given without affecting the substance of relevant economic analysis. However, once non-zero transaction costs are introduced, as is inevitable in any real economy, the size of the transaction costs incurred in economic activities is inherently and systematically affected by the difference in economic institution, which in turn has


The Evolution of the Chaebols 85

effects on resource allocation and economic performance. Therefore, in the real world economy, an economic institution that has been adopted by a society becomes an important factor in determining the extent of the transaction costs incurred and furthering the performance of the economy. New-institutionalism starts with the introduction of non-zero transaction costs into the economic analysis and with the recognition of a systematic causal relationship between the economic institution, the extent of transaction costs incurred and economic performance. In particular, the system of property rights is considered to be the most important factor in determining the structure of economic organization, optimal resource allocation and, ultimately, economic performance. An additional innovation of new-institutionalism is to treat the economic institution as evolving endogenously. To see this aspect more clearly, it is useful to distinguish three different levels of an economic system (Eggertsson, 1990). An economic system can be described as consisting of individual economic agents, economic organizations which organize individual agents and finally economic institutions which regulate the agents and organizations (see Figure 4.1).

Institutions

Organizations

Agents

Figure 4.1

The constitution of an economic system



According to this classification, one can distinguish three different levels of economic analysis of an economic system. The first and most simple level would be to analyze the effects of the given structure of economic organizations and the given type of economic institutions on the economic behavior of individual agents. The second, intermediate level would be to analyze the effects of the given types of economic institutions on the structure of economic organizations. Finally, the most comprehensive level of analysis would be to treat the economic institutions as endogenously formed and to explain how the institution evolves through various political processes. This also involves seeing how the different types of economic institutions affect the economic behaviors of individual agents and economic organizations, and the economic performance of a society. In this level of analysis, economic agents and organizations are treated as the players who take the initiative in changing the existing institutions for their own advantages. If necessary, they exert pressures on the government who can make necessary institutional changes. At the broadest level of analysis, the neo-institutional approach sounds very much like a public choice approach or a positive theory of political economy (Buchanan and Tollison, 1972). 2.2

Property rights and transaction costs

The transparency and security of the property rights system is considered to be the main determinant of the size of transaction costs that the economy should incur in making economic transactions for optimal resource allocation. The property rights system is a rule that defines the relationships among the economic agents in their use of scarce economic resources. This system delineates entitlement of exclusive rights to particular economic resources, thereby resolving in advance the possible conflicts among agents that will stem from the issue of who has the right to use and dispose of those resources. This in turn will help determine the boundaries of an individual agent’s free economic decision-making. Therefore, a property rights system can be considered as a social behavioral norm concerning the utilization of scarce economic resources. In this context, it is interesting to note what Fisher says, namely that property rights constitute the liberty or permission to enjoy benefits of wealth while assuming the costs which those benefits entail ‘… property rights, unlike wealth or benefits, are not physical objects nor events, but are abstract social relations. A property right is not a thing’ (Fisher, 1920, p. 27). Pejovich has a similar interpretation: ‘Property



rights specify the norms of behavior with respect to economic goods that all persons must observe in their interactions with other people or bear the penalty cost of non-observance’ (Pejovich, 1990, p. 27). In relation to the implications of property rights on economic behavior and performance, one has to identify the following three aspects of the right of ownership. The first is exclusivity, which means that the owner has the right to choose what to do with their assets. The second is transferability of ownership, which means that the owner has the right to transfer their assets to others under terms that have been mutually agreed upon. The third is a constitutional guarantee of the ownership that divorces economic wealth from political power. Exclusivity provides incentives for those who own assets to put them into the highest-valued uses; transferability provides incentives for resources to move from less-productive to more-productive owners; and the constitutional guarantee of ownership separates the accumulation of economic wealth from the accumulation of political power (Pejovich, 1990, p. 28). An additional point is that in relation to the new-institutional approach which emphasizes non-zero transaction costs, alternative property rights systems could also affect the size of transaction costs the society should bear in resource allocation, thereby affecting current economic behavior and performance. The lack of a clear and secure system of property rights in the present economic reality of non-zero transaction costs implies high transaction costs. If a secure and welldefined system of property rights does not exist, only physical power can be relied upon to resolve the conflicts concerning the right to economic resources and therefore there would be no room for ‘voluntary’ economic transactions to take place. 2.3

Property rights and economic organization

The relationship between the system of property rights and the structure of economic organization in the new-institutional approach can be deduced from the following remarks by North (1990, p. 67): Firms come into existence to take advantage of profitable opportunities, which will be defined by the existing set of constraints. With insecure property rights, poorly enforced laws, barriers to entry, and monopolistic restrictions, the profit-maximizing firms will tend to have short time horizons and little fixed capital, and will tend to be small scale. The most profitable businesses may be in trade, redistributive activities, or the black market. Large firms with substantial



fixed capital will exist only under the umbrella of government protection with subsidies, tariff protection, and payoffs to the polity – a mixture hardly conducive to productive efficiency. The fact that property rights are not securely protected implies a low probability that all of the market contracts made with other agents are fully honored and faithfully observed. If a formal system of property rights protection is not clearly established (or not fully enforced even though clearly defined), attendant excessive transaction costs will make the formation of large business firms more difficult. Large business organizations are founded upon complicated economic relationships – both formal and informal – between various individual agents. These economic relationships are characterized by indirect as well as direct transactions, which incur relatively high transaction costs. With an insecure protection of property rights, substantial fixed investments and large business organizations are highly unlikely to be formed smoothly from natural economic forces. However, the potentially high transaction costs resulting from an insecure system of property rights will naturally induce the economic agents to minimize the transaction costs by coming up with a less costly way of economic organization. In this case, a natural alternative to large business organizations may be small business organizations, the formation of which requires relatively low transaction costs when compared to a large business organization. This is particularly the case in the non-manufacturing trading and distribution sectors and is due to the fact that the formation of small firms may only be possible through simple interactions among family members, relatives or a small number of agents. In contrast, the formation of larger firms is usually based on complicated interactions between a relatively large number of agents. Recently Fukuyama (1995, 1996) introduced the concept of social capital as a part of human capital in the broader sense. He argues that social capital encourages the mutual trust and co-operation between social members in forming common solidarity, and that as the social capital accumulates, this mutual trust becomes deeper and the formal economic organizations become more active relative to informal organizations. In terms of new-institutionalism, Fukuyama’s social capital can be interpreted as a kind of informal constraint and, therefore, it can be argued that the accumulation of social capital informally encourages individuals to mutually respect each other’s property rights, and thereby lowers transaction costs. According to this view, a



strongly family-oriented social tradition as a particular form of social capital tends to create a social environment, members of which are more likely to distrust non-family members and to discourage the formation of large economic organizations, possibly leading to social and economic stagnation. Fukuyama argues that China and Korea, societies in which the family-oriented tradition is strong, tend towards an economic organization based on small firms, but that Japan, with a grouporiented tradition, tends to create strong mutual trust among social members, thereby promoting the advent of large economic organizations. In this way, he supports the argument of new-institutionalism, which is that informal constraints such as customs and traditions can affect the amount of the transaction costs that the society should pay for its economic organization and therefore can systematically influence the structure of economic organization. In sum, the attenuation of property rights protection tends to increase transaction costs, which, in turn, creates an environment favorable to small firms rather than large business organizations and to short-term liquid assets rather than long-term fixed investment activities. One can further extend this reasoning to argue that property ownership attenuation tends to create an economic environment favorable to family-owned businesses. In other words, non-separation of ownership and control is preferred to the type of a modern business management with specialized managers and separation of ownership and control (see Table 4.1). 2.4

Property rights and economic performance

So far, we have examined the relationship between the extent of property rights protection and the economic performance of a society. The point is that unless a system is designed to compensate for them, potentially high transaction costs stemming from insecure property rights protection will be realized, impeding optimal resource allocation and economic development. Therefore, the establishment of a secure and transparent property rights system becomes a necessary prerequisite for high economic performance in any society. The exclusivity of private property rights creates an incentive structure which strongly encourages the will to economize. The owner decides what to do with their property, both enjoying the benefits and bearing the costs of their decisions. In other words, the secure private property rights create strong incentives for the owner to seek the highest-valued use for resources – that is, to maximize what Lewis (1955) called the ‘willingness to economize’.


90

Table 4.1

Extent of protection of property rights and economic behavior Economic organization

Extent of property rights protection

Transaction costs

Types of organization

Types of management

Types of economic activities favored

Attenuated property rights

High

• Small-sized firms • Self-employed businesses

• Family management • Closed management • Non-separation of ownership and control

• Trade and distribution • Small and liquid investment • Black market

• Large businesses

• Specialized manager • Open management • Separation of ownership and control

• Manufacturing • Large and fixed investment

Secure property rights

Low


Economic performance

Low

High


According to the new-institutional approach (North, 1981; Wallis and North, 1986), the secure establishment of a property rights system has been the most crucial factor in determining the long-term trend of economic development in economic history. North (1992) has argued that the centralized bureaucracy in a monarchical system tended to allow only a very limited level of private activity, including the protection of property rights as well as individual freedom, compared to the decentralized feudalistic political system. Clague, Keefer, Knack and Olson (1996) (henceforth, Clague et al.) have also shown that a democratic political regime tends to provide a relatively secure private property rights system, while an unstable and insecure autocracy tends towards rather weak protection for private property rights. Of course, an unstable democracy presents a much worse environment for property rights protection than a secure and stable autocracy, but as permanently unstable democracies and permanently stable autocracies are becoming impossibilities in the modern world, this is an increasingly unlikely scenario. To conclude, the centralized bureaucracy under monarchism and autocracy in the modern world tend to be unfavorable to property rights protection, compared to both decentralized feudalism and democracy. North (1990) has further observed that countries under the tradition of Spanish centralized bureaucratic monarchism exhibit low economic performances in the long term relative to the countries under the English tradition of the decentralized feudalistic monarchism. He attributes this phenomenon to the relative uncertainty of property rights protection under the former system. In this context, Fukuyama’s contention that Japan is a high-trust society could imply that Japan, with a tradition of feudalism, has succeeded in establishing informal constraints to respect each others’ property rights, thus achieving high economic performance, in comparison to China and Korea. This aspect of the causal relationship between the ownership protection and economic performance is summarized in Table 4.1.

3. Empirical evidence of the impact of transaction costs on economic behavior 3.1

Measurement of transaction costs

In order to empirically investigate the relationship between the transaction costs and economic behavior summarized in Table 4.1, we try to measure the transaction costs in the economy by proxy.



We adopted a cash ratio in a broadly defined money (M2) as a proxy for transaction costs. Clague et al. (1996) utilized contract-intensive money in M2, (M2 – C)/M2 where M2 is a broad definition of money and C is currency outside banks as a proxy for a measure of security of property rights.1 Their concept of contract-intensive money is directly opposite to the cash ratio, C/M2. Therefore, following the same logic, the cash ratio can be taken as a measure for the degree of property rights attenuation. Furthermore, it can also be taken as an index for the extent of the transaction costs incurred due to the attenuated property rights system, not only in the financial sector but also within the overall economy. In Table 4.2, the cash ratios in M2 for the selected countries from 1970 to 1994 are compared. The cash ratio tends to be high in countries such as Portugal and Spain, categorized as high-transaction-cost countries by North (1990) under the Spanish tradition of centralized bureaucracy. The cash ratio is also high in France, Italy and Korea, all described as low-trust countries by Fukuyama (1996). However, it turns out that the cash ratio tends to be low in England (especially in recent years), the United States, Canada and Japan, all of which are described as low-transaction-cost countries by North (1990) and as high-trust countries by Fukuyama (1996). Korea has also been ranked among the highest transaction costs countries in the sample of OECD countries during 1970s to 1990s. Table 4.2 Cash ratio in M2 for selected countries as a proxy for transaction costs (period average) Nation

1970–79

1980–89

1990–94

1970–94

Australia Canada France Germany Italy Japan Korea Norway Portugal Spain Sweden Taiwan U.K.

8.65 9.33 14.09 10.12 10.15 9.16 15.92 14.44 19.12 10.77 11.70 12.48 15.45

8.69 6.77 4.52 10.12 8.16 7.91 12.01 9.32 11.75 10.42 10.30 8.30 7.68

6.77 5.85 4.371 10.41 9.14 7.67 9.84 7.051 8.00 13.06 9.53 4.96 3.141

8.29 7.61 8.482 10.18 9.15 8.36 13.14 11.072 13.95 11.09 10.70 9.30 10.162

Note: 1. Average from 1990 to 1993. 2. Average from 1970 to 1993. Source: International Monetary Fund, International Financial Statistics Yearbook, 1995.



In sum, the cash ratio in a broad concept of money can be a useful proxy for transaction costs incurred due to the uncertainty of property rights protection and Korea was included among the high-transactioncost countries. 3.2 Transaction costs and the number of small and medium-sized firms 3.2.1

Data overview

One of the interesting hypotheses of new-institutionalism is the positive relationship between transaction costs and the weight of small firms in the economy. In this section, this hypothesis will be tested by utilizing Korean data as well as cross-country data. The structure of Korea’s industrial organization has been criticized as being almost completely dominated by large business groups called chaebols. Based on this perception, the logical conclusion is that Korea has to promote small and medium-sized firms in order to maintain a balanced industrial structure. An observation of the structure of Korea’s industrial organization reveals some very interesting facts, which seem to contradict these common perceptions. Table 4.3 shows the inter-country comparison of firm size distribution. In this comparison, Korea exhibits an extremely high ratio of small firms,

Table 4.3 Inter-country comparison of firm size distributions in the manufacturing sector (%) Size in term of number of employees

Korea (1993)

Japan (1993)

U.S.A. (1985)

Below 10 10–19 20–99 100–299 300–499 500–999 Above 1000

79.7 9.7 9.1 1.1 0.16 0.13 0.07

73.5 11.8 12.4 1.8 0.27 0.18 0.10

48.2 16.5 24.8 6.51 3.42 0.01

U.K. (1989)

West Germany (1986)5

3.04

— — 69.9 20.46

0.04 0.04

3.1 2.5

96.13

Note: 1. 100–249 persons. 2. 250–500 persons. 3. Below 99 persons. 4. 100–499 persons. 5. Only above 20 persons. 6. 100–499 persons. Sources: Korea, Report on Industrial Survey; Japan, Industrial Statistics; USA, Census of Manufactures; UK, Census of Production; Germany, Produzierendes Gewerbe.



especially those employing less than ten persons. Japan also carries a similarly high proportion of small-sized firms relative to other developed countries, a fact inconsistent with Fukuyama’s classification of Japan as a high-trust country. On the other hand, Table 4.4 shows the share of the self-employed to the total employed persons (SEP) in the non-agricultural sector for the 14 selected countries including Korea as before. Interestingly enough, Korea ranked highest in the comparison of the weight of the self-employed persons, higher even than Italy and Taiwan, economies which are both known to be dominated by small and medium-sized firms. Therefore, in terms of the number of firms, it seems that Korea does have a significant proportion of small and medium-sized firms, which is contrary to the common perception of Korea.2 It is also interesting to observe that Italy, Taiwan and France – described as low-trust countries by Fukuyama – and Spain and Portugal – described as high-transaction-cost countries by North – exhibit a relatively high proportion of self-employed persons. Similarly, Canada, England and the USA – described as low-transaction-cost countries by North – exhibit a relatively low weight, as expected. However, Japan, a country characterized as a high-trust country, shows a relatively high weight, which again seems inconsistent with Fukuyama’s classifications. Table 4.4 Inter-country comparison of self-employed as proportion of total employment (SEP)1 Period

1970–79

1980–89

1990–93

1970–93

Australia Canada France Germany Italy Japan Korea Norway Portugal Spain Sweden Taiwan UK

10.51 6.47 11.27 9.02 21.09 13.86 29.96 7.202 12.31 15.78 4.73 24.17 7.02

12.38 7.06 10.54 7.46 21.01 12.97 25.50 6.54 16.31 17.46 5.26 20.20 9.43

10.91 7.91 9.08 7.66 22.79 10.91 22.59 6.14 17.65 17.83 7.77 18.27 11.82

11.60 6.96 10.60 8.14 21.68 13.00 26.87 6.713 14.87 16.82 5.46 21.54 8.82

Notes: 1. Period average and for the non-agriculture, forestry, or fishery sectors. 2. Sample Period is 1972–1979. 3. Sample Period is 1972–1993 Sources: ILO, Yearbook of Labor Statistics, 1998, 1990 and, 1993; Korea, Ministry of Labour, Yearbook of Labour Statistics, 1982, 1988, and 1994.



The data seems consistent with the prediction offered by new-institutional economics: Korea exhibits a high cash ratio (implying a high transaction costs) as well as a high weight of small firms. Also, broadly speaking, the positive relationship between the cash ratio and the weight of small firms is easily observable with some exceptions even from this cursory comparison of cross-country data. 3.2.2

The Korean evidence

To analyze the relationship between the number of small and medium-sized firms and the index of transaction costs in the Korean economy more systematically, we regressed the weight of the selfemployed in the total employment (SEP), as a proxy for the weight of the small and medium-sized firms, on the index of transaction costs (CR), and the logarithm of per capita income.3 The per capita income variable enters the picture, taking into account the possible impact of economic growth on the number of small and medium-sized firms. This income variable may have two counteracting effects. One is the negative impact because the scale of production and the average size of the firm are expected to become larger as the extent of market increases and thereby the economies of scale become more fully utilized in the process of economic development. Another is the positive impact because economic growth could accompany new entries of small firms. Therefore, it will be difficult to judge a priori which impact will dominate. However, it should be noted that because GNP (income variable) and CR show a strong negative correlation, both theoretically and empirically (– 0.84 in this case), per capita GNP is regressed on CR and the series of the residuals (RESGNP) is actually utilized as the per capita income variable. The empirical results are shown in Table 4.5 and seem to support the a priori expectation that transaction costs variable will have a positive impact. On the other hand, the GNP effect turns out to be significantly negative, which seems to imply that the economic development tends to accompany more of the growth in the firm size than the growth of the number of firms. 3.2.3

Cross-country empirical evidence

In this section, we will present the results of the cross-country regression analysis on the relationship between transaction costs and the weight of the self-employed in the economy. In the cross-country regression, the weight of the self-employed to the total employed


96

Table 4.5 Korea

Regression result of the weight of self-employed to the total employment (SEP) on transaction costs in the case of

Independent variable Dependent Variable Weight of the self-employed to the total employed persons (SEP)

–

Constant

Transaction costs (CR)

RES GNP1

D–W

R2

Estimation period (DF)

16.10 (14.76)

75 (9.23)

–1.42 (–4.24)

0.96

0.82

1971–93 (20)

Note: 1. The series is obtained with the following relationship: – Log (per capita GNP) = 19.25 – 0.41 CR + RESGNP: R2 = 0 .73, D – W = 0.34 (27.16) (–7.72) Estimation period = 1971 to 1993. 2. ( ) is the t-value.



persons (SEP), again used as a proxy for the weight of small and medium-sized firms in the economy, is regressed on the variables of transaction costs (CR) and per capita income. As already discussed, the per capita income variable enters to take account of the effect of economic development and the income variable actually utilized in the regression is obtained as a series of residuals of the regression of the per capita income on the CR variable. We used three data sets.4 Data set (1) is the one in which all the individual country data is averaged out over a 20-year period from 1972 to 1991. Data set (2) is the panel data in which the same individual country data is averaged out over a ten-year period and so pooled over two periods. Data set (3) is the panel data, constructed in the same way as data set (2), but averaged over five years. All the data is averaged out over a long-term period in order to take account of the long-term nature of the impacts of institutional change on the organizational structure, which could not be tried in the context of Korea due to data limitations. The regression results are reported in Table 4.6. The results seem to align with those expected, with high transaction costs having a positive impact and economic development having a Table 4.6 Cross-country regression results of the weight of self-employed to total employment on transaction costs (dependent variable: SEP) Independent variables –

Data Set

Constant

Transaction costs (CR)

RESGNP

D–W

R2

D.F.

Data Set (1)

2.17 (0.47) 7.92 (2.71) 8.36 (4.01)

1.07 (2.32) 0.49 (1.72) 0.44 (2.21)

–11.361 (–4.91) –7.742 (–5.18) –6.043 (–6.28)

1.64

0.68

11

1.84

0.51

25

1.22

0.44

53

Data Set (2) Data Set (3)

Notes: 1. RESGNP is obtained with the following relationship: LPGNP = 10.80 – 0.18 CR + RESGNP (18.57) (–3.11) – R2 = 0.40, D – W = 3.11, D.F. = 12, where LPGNP is log (per capita GNP) and CR is cash ratio. 2. LPGNP = 10.59 – 0.17 CR + RESGNP (27.56) (–4.62) – R2 = 0.43, D – W = 2.10, D.F. = 26. 3. LPGNP = 10.60 – 0.18 CR + RESGNP (35.91) (–6.23) – R2 = 0.41, D – W = 1.42, D.F. = 54. 4. ( ) is the t-value.



negative impact on the number of small and medium-sized firms in the economy. One interesting point concerning the process of economic development is that it is the growth of firm size rather than growth in the number of new small firms that has spurred economic development. This is most observable in the case of Korea.

4. Empirical evidence of the impact of the individual property rights system on economic behavior Now we take a closer look at the impact of the property rights system on the economic organization. In the above analysis, the cash ratio in the economy is used as a proxy measurement for transaction costs and property rights systems. An empirical measure for property rights systems alone does exist, although this offers a relatively crude measure. The aim of this section is to extend the above analysis by incorporating this property rights system variable in place of the transaction costs variable, thus testing the hypothesis of the newinstitutional approach more directly. 4.1

Index measuring individual property rights systems

The International Country Risk Guide (ICRG) gauges the effectiveness of government protection of individual property rights using five measures, namely: 1. rule of law – the extent to which laws are implemented, disputes are adjudicated and the manner in which power is passed on; 2. government corruption – related to the frequency of bribes in areas such as international trade, taxation and police protection; 3. expropriation risk – the risk of outright confiscation or enforced nationalization; 4. quality of bureaucracy – including the degree of autonomy from political pressure; 5. repudiation of contracts by government – including those that arise from changes in government. The five measures listed above are independently indexed on a scale from 0 to 10 and, subsequently, the individual property rights (hereafter IPR) system index is obtained from the average value of all five indices.5 Knack and Keefer (1995), Barro and Sala-i-Martin (1995, ch. 12), Redelet, et al. (1997) showed that the degree of protection offered to property rights, i.e., IPR system index, as measured in this



way by the ICRG, explained the differences between each country’s growth rate. In Table 4.7, the IPR system index for each country is taken from the average values in the period 1982 to 1990. When we compare the countries above, we see that the IPR index tends to be low in countries such as Portugal and Spain, categorized as high-transaction-cost countries by North (1990) under the Spanish tradition of centralized bureaucracy. The IPR index is also low in Italy, Taiwan and Korea, all described as low-trust countries by Fukuyama (1996). However, the IPR index tends to be high in the UK, the United States, Canada and in Japan, all of which are described as low-transaction-cost countries by North (1990) and as high-trust countries by Fukuyama (1996). Thus, this data appears consistent with the prediction offered by new-institutional economics. It will be useful to check if the IPR index has a systematic relationship with the CR variable, the proxy for transaction costs used in the previous section. According to the calculation of correlation coefficient between the CR variable (average from 1982 to 1991) and IPR index (average from 1982 to 1990), correlation coefficient turns out to be –0.559 (0.0472), suggesting a significant negative relationship between two variables as implied by the framework of new-institutional economics. Table 4.7 index

Inter-country comparison of individual property rights systems

Country

Individual property rights (IPR) systems index (period average for 1982–1990)

Australia Canada France Italy Japan Korea Norway Portugal Spain Sweden Taiwan United Kingdom United States Average

9.33 9.80 9.47 8.33 9.67 6.05 9.73 8.39 8.47 10.00 8.46 9.67 9.63 9.00

Source: Barro and Sala-i-Martin (1995, ch. 12) which quotes the International Country Risk Guide (ICRG).



4.2 Individual property rights system and the weight of small and medium-sized firms: empirical analysis Now, we turn to the investigation of a direct relationship between individual property rights systems and the weight of small and mediumsized firms. Looking at the data in Tables 4.4 and 4.7, we can see that Korea has the distinction of having the highest self-employed to total employed ratio (SEP) as seen in Table 4.4, while maintaining the lowest IPR index of all the countries selected for analysis in Table 4.7. While Italy, Spain and Portugal also have a relatively high SEP and low IPR index, at the other end of the scale, Sweden, Norway, Canada, the United States and the UK all have a relatively low SEP but enjoy higher than average IPR indices. This would suggest a negative relationship between SEP and the IPR index. To confirm the relationship between the two variables more systematically, we have regressed the weight of the self-employed to the total number of employed persons (SEP) on the IPR index. Using the same method of analysis as in the previous section, the regression results were compiled in Table 4.8. For the SEP and per capita income figures, we used three data sets (see Appendix 5.2). Data set (1) is the individual country data averaged over a 20-year period, 1972 to 1991. Data set (2a) is the same individual country data but averaged over 1972 to 1981. Data set (2b) is the same individual country data but averaged over 1982 to 1991. For the IPR, the data set reported in Table 4.7 was used. All the data was averaged out over a long-term period in order to take into account the long-term nature of the relationship between the property rights system and economic behavior. The results of the regression analysis seem to lend strong support to the expected negative impact the IPR would have on the weight of small and medium-sized firms in the economy. In other words, the higher the income and the more secure protection is for individual property rights, the lower the weight of self-employed to the total number of employed persons. Here, we come to the conclusion that our two methods of analysis – both direct and indirect – confirm the importance of property rights systems in explaining the economic organization, and lends strong support to the neo-institutional approach.


The Evolution of the Chaebols 101 Table 4.8 Cross-country regression results of the weight of self-employed to total employment on individual property rights (IPR) systems index (dependent variable: SEP) Data set

Data Set (1) Data Set (2a) Data Set (2b)

Independent variables Constant

IPR

RESGNP

63.01 (8.54) 45.33 (7.74) 39.10 (6.82)

–5.54 (–6.81) –3.73 (–5.63) –2.97 (–4.58)

–2.131 (–0.82) –3.242 (–1.04) –4.073 (–1.48)

–

D–W

R2

DF

1.80

0.79

10

1.00

0.72

10

1.57

0.64

10

Notes: 1. RESGNP is obtained with the following relationship: Log (per capita GNP) = 4.74 + 0.47 (IPR) + RESGNP (5.58) (5.04) – R2 = 0.67, D – W = 1.88, D.F. = 11 2. Log (per capita GNP) = 5.00 + 0.40 (IPR) + RESGNP (8.82) (6.17) – R2 = 0.76, D – W = 2.09, D.F. = 11 3. Log (per capita GNP) = 6.69 + 0.30 (IPR) + RESGNP (10.63) (4.18) – R2 = 0.58, D – W = 1.88, D.F. = 11 4. ( ) is the t-value.

5. Property rights and the evolution of large business firms in Korea 5.1

Overview of the issues to be addressed

The cross-country comparison of transaction costs, individual property rights system, and the proportion of self-employed in the economy seems to suggest that Korea has a relatively poorly protected system of individual property rights, relatively high transaction costs and a relatively high number of small companies. This observation is quite intriguing when we take into account the fact that Korea has achieved an extraordinarily high level of growth over the last thirty years and is dominated by large manufacturing business firms – the chaebols. This section will try to resolve these apparent contradictions by carefully reviewing the factors that influence the informal customs as well as formal systems of property rights protection in Korea and investigating their implications on the industrial structure and on the organizational behaviors of large business firms. First we examine the effectiveness of the third party with particular emphasis on the government enforcement of private property rights



protection in Korea, by documenting some important historical events that are said to have influenced both formal and informal systems of private property rights. This discussion will show that Korea’s property rights system has operated under the discretion of the administration rather than under transparent legal rule, which has made the protection of private property rights rather uncertain. In recent years, the formal system has been continuously eroded away by the government in the name of expediting economic development. Another feature that has added to the fragility of ownership protection is the formation of informal customs arising from the long-held general perception of property rights attenuation. In the following, we discuss some details of individual events of property rights attenuation in Korea which are deemed to influence the informal as well as formal system of Korea’s property rights protection. 5.2 Anecdotal observations of historical events in property rights attenuation 5.2.1

Disorder in the tax system of the Yi dynasty (nineteenth century)

The Yi dynasty had a strong centralized monarchy system with an irregular tax system, especially during the last century of the dynasty.6 Government bureaucrats were generally perceived as being corrupt and local officials in particular were often known to exact heavy taxes by interpreting and applying tax laws in an extremely arbitrary manner. This practice has been called ‘garyum jugoo’, a term denoting the extortion of heavy and unjust taxes. The tax system of the Yi dynasty from the mid-eighteenth century was a tripartite system consisting of a land tax, a military tax, and a grain exchange. Some important aspects of the operation of the tax system during this period can be characterized as follows. First, the total sum of taxes was levied on the basis of the collective provincial unit, regardless of the number of taxpayers and/or the size of lands in the relevant province. The provincial head and bureaucrats were encouraged to exercise all their powers in order to meet the allocated tax burden. Second, in the operation of the land tax system, taxes were often levied on waste and fallow land, and any public funds unlawfully appropriated by public officials were made up for with additional land taxes on their tenants. Land taxes in these times were not so much property taxes but rather direct taxes on the harvests on the land in question. Taxes levied on wasteland and fallow land amounted to little more than the unjust confiscation of private property.



Third, the military tax imposed a levy of a given quantity of cotton fabric for military use for every adult male unless he volunteered for military service. However, this tax was often levied on deceased men as if they were alive and on children as if they were adults. Furthermore, if the taxpayer was unable to pay the specified duty, as often happened, then his relatives and even neighbors were forced to pay for him. The fourth point is concerned with the system of grain exchange, which was supposedly intended to alleviate the grain shortage during the sowing season. Old grain was loaned out during the sowing season and paid back with new grain during the harvest season. In practice, the manipulation of the exchange rate in the public authority’s favor, including price manipulation, arbitrary alteration of the kind of exchange grain (which effectively meant a confiscation of high-grade rice in return for a low-grade barley) and other similar measures were widespread. In sum, the tax system during the Yi dynasty could be characterized as an official system to extort wealth from the people. Almost all property was subject to the possibility of arbitrary appropriation by the government authorities while the property rights system, regardless of its formal code, was subject to continuous government attack, in turn generating the common feeling that the system of property rights protection was essentially non-existent. Another factor that cannot be ignored is the way Korea has been ruled over the centuries. A very strong centralized bureaucratic monarchy reigned during the Yi dynasty from the fourteenth to the nineteenth century, followed by a period of Japanese colonial rule until the mid-twentieth century. After this and until very recently, the nation’s affairs were managed entirely by the pro-growth authoritarian government. All of this implies that Korea may not have had the opportunity to establish a transparent and secure rule-based property rights system. 5.2.2

The land reform of 1950 and the fall of the landlord class

It is wellknown that agricultural capitalists in Korea failed to transform themselves into industrial capitalists because the compensation method used for land reform in 1950 was so unfair that land property rights became seriously compromised. First of all, landlords were forced to surrender their lands at specified compensation terms. These involuntarily accepted compensation terms were rather unfair to say the least. When the land was given up, the



ex-landlord was issued with a bond, the face value of which was set in terms of a specific grain and according to a formula which reduced the grain land value above a specified amount of grain at an increasing rate of reduction. The monetary value of this bond was evaluated by applying the government-set price for grain (usually below half the market price). The combination of these two policies effectively amounted to the systematic confiscation of agricultural capitalist assets. 5.2.3 The privatization of banks in the 1950s and the confiscation of private banks in the 1960s After liberation from Japanese rule, the Korean government privatized banks in the 1950s (which had formerly been under Japanese ownership), but then confiscated the stocks of those banks held by big businesses during the 1960s, after the military coup in 1962. This policy was justified on the grounds that unfair wealth accumulation should be punished. During the 1950s, unfair privatization was carried out by allocating stocks not to the highest bidder in a public auction but rather to a lower bidder – most likely an outcome of some personal favoritism. The mass confiscations during the 1960s were no fairer to the majority stockholders. The military government not only confiscated bank stocks held by the so-called ‘unfair wealth accumulators’, but also established an upper limit for bank stock to be held by private concerns and regained a majority stockholding in order to control bank management to finance economic development. It is interesting to note that this incident set a precedent for so many similar measures thereafter in which private property rights have been infringed in the name of promoting economic development. 5.2.4

Emergency measures for stable growth (3 August 1972)

In 1972, the Korean government took emergency measures to rapidly improve the economic conditions for business activities. A presidential decree implemented the deferment of firm borrowing on the curb market, drastically cut interest rates for firm borrowing in the official financial market and marked out comprehensive tax cuts for business firms. In addition, a policy of special government lending at preferential rates was initiated. Particularly important among these measures was the payment deferment of unofficial market borrowings,7 which included loans from relatives, friends and neighbors as well as those from the professional curb market lenders. This measure infringed on the individual property



rights on an extensive scale. Similarly, the unprecedented interest rate cuts on the loans in the official financial market became a serious infringement of financial property rights. What is more, whenever firms complained about the hardships of foreign competition, as happened on a number of occasions, the response was to implement these measures again ‘to reactivate business activities’. 5.2.5

Structural adjustment policies during the 1980s

Various structural adjustment policies were enacted from 1986 to 1988 in order to deal with the large business insolvency problems arising from the overinvestment of the heavy and chemical industry (HCI) promotion policies during the 1970s (as discussed in Chapter 2). These policies were intended to improve Korea’s industrial competitiveness and have in fact had some positive effect on the process of industrialization. However, the criteria used to identify the problem firms in need of structural adjustment policies were so broad that there was ample room left for government discretion to play a bigger role than the supposedly transparent rules might have otherwise allowed. Naturally, this generated some far-reaching negative implications for property rights protection. The target firms were selected on the basis of their financial solvency, but other matters were also taken into consideration – industrial policy concerns such as upgrading the industrial structure and promoting specialization of the chaebols. A particularly controversial issue was the non-transparent manner of selecting firms for the government-enforced ownership transfers – a prime example being the government’s dissolution of Kukjae, one of the larger chaebols. In February 1985, the Korea First Bank, the main bank of Kukjae, announced the dissolution of the Group. The Korea First Bank cited financial difficulties arising from lax management as the reason for its action. The Kukjae Group had some twenty subsidiaries and was ranked among the ten largest chaebols. The official explanation notwithstanding, the previous owners of the Group have continued to maintain that the government’s action was a result of the loss of political favor with then President Chun. The constitutional court ruled that the 1985 dissolution was in violation of the free market principle guaranteed by the constitution. 5.2.6 Introduction of the real name system for financial transactions and increased uncertainty in financial property rights The Korean government introduced the Real Name System for financial transactions on 12 August 1993 in a package of reforms to the income



tax system, scheduled to be fully effective from 1997. The government intended to improve equity in the tax system by introducing a comprehensive income tax system inclusive of financial income, which had previously been treated separately, and therefore applied an equal tax system to all income regardless of its source. To achieve this purpose, it was necessary to have every financial transaction carried out under the real name of the individual or group carrying out the transaction. However, the Real Name System for financial transactions led to another development. The newly available information on financial transactions was not only used for tax purposes or criminal investigations but also for general investigations into financial sources for political purposes.8 The government requires that information on all financial transactions above a certain amount should be made available at all times, not only to the tax authorities but also to assist the investigation of sources of financial funds. Investigations target all large funds, regardless of whether or not the concerned asset holder is under suspicion of being involved in illegal activities. This requirement actually puts almost all the major financial asset holders under the increasing risk of having their private financial property confiscated by the government for the following reasons. Firstly, some major financial asset holders are suspected of accumulating financial wealth via not entirely legitimate means in the past. Secondly, it is likely that almost all financial asset holders have violated a tax law at some time – even if, to some extent, this may be due to the complexity and the arbitrary application of the tax system, as will be discussed in the following section. As a result, the Real Name System for financial transactions has created the risk of increasing uncertainty over financial property rights, even though it is of course hoped that it will improve the equity of the tax system at the same time. This risk of increasing uncertainty over financial property rights should be minimized as far as possible. In other words, the Real Name System for financial transactions should not be used as a ‘general’ means of political punishment and criminal investigation. It is important to understand that although bribery and corruption might have been facilitated by the pseudonym system, the latter cannot be held responsible for the existence of such practices. Rather, corruption is more correctly to be seen as the by-product of a non-transparent and rent-seeking political system and government regulation, and until institutional reforms are undertaken in these areas, the Real Name System is unlikely to have much effect in eliminating bribery and other forms of corruption.



5.2.7 Lack of fair enforcement of law and weaknesses in the formal protection of property rights Law enforcement has been emphasized as an important part of the economic institution, together with formal as well as informal institutional constraints (North, 1992). Even if an ideal economic incentive structure is legalized, that institution will be of no use if it is not fully and fairly enforced. Korea is notorious for introducing many important economic institutions without paying due attention to their enforcement. From the National Assembly, the nation’s lawmaker, to the law enforcement authority of the government, right through to the administrative officials who enforce various government regulations at the lowest level, the importance of transparent and fair legal enforcement does not seem to be well understood. It seems that concern for political and administrative conveniences in law enforcement have dominated over that of fairness so that the average citizen has become very insensitive to the issue of fair law enforcement. However, because the government can always selectively enforce the law when it is convenient and beneficial to its own goals, the situation tends to create a lot of uncertainty with respect to formal economic institutions. The tax laws can be regarded as a typical example. It is very well known that Korea’s tax system is revised so often (at least annually) and is so complicated that the enforcement of payments by the tax authority and the ordinary citizens’ comprehension of this system have both become extremely difficult to achieve. Therefore the system tends to have been enforced to a large extent through some rather arbitrary judgements on the part of the authorities. Taxpayers inevitably end up violating tax laws in one way or another, both because of their ignorance of the current regulations and also due to the arbitrary enforcement of the tax system All these experiences concerning the enforcement of formal economic institutions have led the general public to the perception that this society is not under a fully enforced formal economic institution, and in particular that no well-defined and secure property rights system exists. As a result, Korea’s economic institutions have become more strongly influenced by informal constraints rather than by formal rules, thus increasing uncertainties over the property rights system. 5.3

Implications for the behaviors of large business firms

In this section, we will discuss the implications of the attenuated property rights system in Korea, with particular reference to the issue of the



organizational behavior of large business firms and how they might successfully evolve. Once we agree on the fact that Korea’s property rights protection has been relatively attenuated throughout its economic history, it will be easy to infer the possible pattern of economic behaviors of large business firms. First of all, as already summarized in Table 4.1, the most important implication is that Korea’s industrial structure should be dominated by small, family-owned and managed firms with a closed management pattern, mostly operating in the trade and distribution sectors. This is because Korea has become a high-transaction-cost economy due to the attenuated property rights protection. Second, large-scale firms in the manufacturing sector requiring large long-term fixed investment commitments will only be able to survive if private property rights, as well as many complicated contractual arrangements for those investments, are fully honored under the strong protection of some external authority. The most obvious candidate for this position that comes to mind is that of the government, which is exogenous to both formal and informal institutional constraints. We have shown the business concentration ratios for the thirty largest corporations of selected countries in Table 4.9 to see if Korea really is dominated by large businesses. The table is constructed for the year 1993, when the data was available for all of these countries. The evidence suggests that Korea’s business concentration is indeed high, but not extraordinarily so when compared to other developed Table 4.9 Inter-country comparison of aggregate concentration for the 30 largest corporations in the manufacturing sector (1993) (%)

Assets Shipments Employees

Korea1

United States

Japan

Germany

United Kingdom

France2

Sweden3

32.2 (46.5) 31.3 (42.5) 11.3 (18.5)

22.4

22.7

22.7

29.5

28.6

37.3

34.6

25.8

38.8

46.2

46.2

65.5

22.9

15.0

31.7

32.6

36.9

58.6

Notes: 1. The figures in parentheses represent the aggregate concentration ratio of the 30 largest chaebols in the manufacturing sector. 2. Concentration ratio for the 20 largest corporations. 3. Concentration ratio for the 10 largest corporations. Source: Inhak Hwang (1997).



countries. As has been shown earlier in this chapter, although Korea has a very high proportion of small firms, at the same time, large businesses dominate in terms of asset size and sales volume. How can this conflicting evidence be rationalized? First of all, as has already been suggested, one possible explanation for large businesses successfully evolving, even under the high-transaction-cost environment, can be found in the role of the government. The Korean government has promoted and protected large-scale heavy and chemical industries with, among many other measures, subsidies, entry barriers and preferential bank loans. It can be thus be argued that strong governmental support for the protection of property rights and the enforcement of various contractual arrangements on long-term fixed investments contributed to the reduction of economic uncertainty on property rights and transaction costs, all crucial to the rapid growth of large-scale business firms and the subsequent rapid economic growth. In this way, the government-favored businessman felt secure that his property rights were being afforded more than adequate protection – at least while he maintained a good relationship with the government. Once the relationship soured, no guarantee for his fortune could realistically be expected. On the other hand, from another perspective one can actually rationalize the behavioral patterns of large business firms that have been criticized as being abnormal. After all, these large firms were facing attacks from two sides: the possibility of property rights attenuation under a strong interventionist government and the ever-growing antichaebol sentiment among the general public. The long-standing authoritarian government that had been implementing strong interventionist economic policies did draw up a policy of revoking property rights of large firms at its discretion, as can be seen in cases of government-led structural adjustment policies, including the example of the Kukjae Group discussed earlier in this chapter. Here we see that the government has not only promoted large firms, but has also been responsible for the prime source of the uncertainty over property rights protection as far as the owner-managers of big corporations were concerned. Indeed, the government reserved for itself the power to favor an owner-manager of a specific corporation and to provide the necessary resources for the rapid growth of that corporation. However, should the incumbent owner-manager be deemed to be inappropriate or to be behaving in a displeasing way, he would lose the government’s favor, risking various government-implemented measures that would adversely affect the growth of his corporation. It can



thus be said that although large corporations were certainly under government protection, protection of the incumbent owner-manager’s property rights were rather uncertain. The second source of property rights attenuation, as far as the big business firms were concerned, were the so-called ‘anti-chaebol sentiments’ of the general public. Ever since the formation and naming of these large firm conglomerates, the general public has been continuously questioning their ethics. The argument is that as they have prospered under unfair government protection, chaebols should now be penalized by industrial policies, giving small and medium-sized firms an opportunity to prosper. Some anti-chaebol critics even maintain that chaebols should be dissolved altogether. The Korean government has always been sensitive to this public sentiment and this has constrained some economic policy making. Occasionally, the government has even had to make a politically oriented economic policy decision against the interests of large business groups, which include placing restrictions on bank borrowing and business diversification. However, the fact remains that once public sentiment becomes a constraint on government policies concerning big businesses, then it will turn into an informal economic constraint, in the end no less powerful than formal legal constraints in their capacity to strongly influence the behavior of big businesses. If we keep all this in mind, it may be reasonable to assume that, concerned by the high levels of uncertainty regarding property rights protection, the large corporations have been seeking various strategies to avoid the actual nullification of property rights. Among these are the tendencies of the chaebol owners to seek political power and to branch out in all areas of business, even into the banking and mass media industries. In any case, it can be argued that this behavior has originated from attempts to reduce the economic uncertainty on property rights, which would also reduce the probability of failure as governmental decisions have stemmed from political as well as economic considerations. It certainly seems the case that when the owner attains political power, the probability of his corporation being subjected to political threats is greatly lessened. Aggressive expansion by diversification can also help reduce the probability of failure due to a non-market decision or even market competition. This is because the government and the general public are both less likely to accept the economic impact of the failure of large corporations, even if it really is insolvent. In such a scenario, these big firms could be said to be taking advantage of the general policy maker’s sentiment of these firms being ‘too big to fail’.



Similarly, efforts to diversify into the banking sector will not only provide easy access to the finite financial resources but also help to reduce the probability of failure. Banks are treated as a sort of public institution due to the highly contagious impact of a bank run, and so there is a high possibility that any business group diversifying into the banking sector would be protected by the government. Put simply, banks are not generally allowed to fail as the government usually steps in to bail them out of trouble. Finally, we must add the fact that mass media can be wielded into a very powerful tool, not only as a public relations instrument but also as a strong counter-force to the ability of the government and various other sources of political power to protect big business groups. The diversification behavior of the Korean conglomerates will be analyzed more systematically in the next chapter, where three factors will be emphasized as the causes for diversification: (i) the small size of the domestic market for each line of business under the relatively high accessibility to resources; (ii) the technological innovation creating economies of scope among various economic activities; and (iii) the business environment created by government policy where the government took responsibility for a firm’s survival once the firm entered the designated and regulated areas. Here one can add the institutional aspect as the fourth factor: the diversified expansion could be a selfprotective measure against the high probability of property rights attenuation.

6.

Summary and lessons

Transaction costs arise from economic uncertainty in a world of imperfect information, and the extent of transaction costs incurred by any economy is affected by the extent of economic uncertainty dictated by its institutional environment. The existence of ill-defined institutions or the absence of necessary institutions indicate the lack of welldefined game rules and contribute to uncertainty over how economic activities (transactions) are guided, thereby increasing the transaction costs incurred by the economy. With this in mind, any economy seeking development should aim to establish some well-defined ’rules of the game’ through the devising of economic institutions. Only in this way can economic uncertainty be minimized and productive economic activities successfully promoted. This chapter has tried to confirm the importance of economic institutions – with particular emphasis on the property rights system – in



determining the extent of transaction costs and thereby explaining economic behavior. We have shown empirically that the countries known to have a relatively insecure property rights system tend to incur relatively high transaction costs, which in turn generate a systematic pattern of industrial organization of individual economies consistent with implications of new-institutional economics. According to the evidence presented in this chapter, Korea is a country with relatively high transaction costs and a relatively insecure property rights system, particularly in terms of informal institutions and the degree of fair enforcement of formal institutions. The discussion in this chapter suggests that the most important task Korea faces for economic development is to reduce the institutional insecurity in various areas of the economy by establishing new institutions as well as streamlining or repealing existing institutions where necessary. Furthermore, it must be kept in mind that reforms should be carefully designed and implemented so that they do not inadvertently create additional uncertainties. In addition, analyses show that Korea’s system of weak property rights lies at the heart of the nation’s problems of closed and opaque managerial and financial practices within the chaebols. The emphasis that chaebols have laid on diversification and the drive to increase operations to a ’too big to fail’ status are also direct results of Korea’s weak property rights system. Hence, it is implied that improving economic institutions, including the property rights system, will provide a way to make up for the ’abnormal’ managerial practices of the chaebol. We also suggest that although formal institutions and the strict enforcement of them are vital in setting up a general framework for the ’rules of the game’, informal constraints may be just as important. The legal system of private property rights in Korea is probably just as complete as it is in any other developed country. However, there are the issues over the enforcement of the legal system and the people’s perception of this system. The people’s perceptions have acted as an informal constraint, critical in determining economic organizational behavior. In this context, it may be useful to note the point, emphasized by Rapaczynski (1996), that the property rights system is endogenous and tends to be formed in a gradual, incremental and evolutionary manner. While formal institutions may be easily constructed following an advanced model, the whole system of any institution consisting of formal institution and its enforcement as well as informal constraints cannot be implemented easily and made effective overnight. An insti-



tution tends to evolve from a series of experiences with the system operating over a long period of time. An informal system of property rights evolves from what people see and experience in the interrelationship with the government power as well as among themselves concerning their ownership of property, and tends to dominate the formal system. Korea’s experience with a relatively attenuated property rights system seems to confirm this process. How good institutions are formally built, how firmly and fairly the objectives of the institutions have been enforced, and how people perceive the effectiveness of the institutions – these factors are all integral to the smooth functioning of the economic system. It seems that the role of the government as a fair third party referee, as well as the initiator of formal institutions, is of paramount importance in determining the characteristics of an institution. However, Korean experiences also suggest that it is absolutely vital for the government to take special care not to override and infringe on the formal system of private property rights, which would create more economic uncertainties. The government should keep this point in mind when considering institutional reforms so that the reforms themselves do not become another source of economic uncertainty.


5 Globalization and the Diversification Behavior of the Chaebols*

1.

Introduction

The previous chapter started our analysis of the chaebol issue with an empirical account detailing the insufficiencies of economic institutions and the role of an over-interventionist government in creating and sustaining conglomerates which were relatively non-viable. This chapter continues the chaebol discussion from a different perspective, exploring the effects of globalization on the structure of industrial organization in Korea and the reasons behind the characteristic diversification behavior of the chaebols. Another purpose of this chapter is to identify the optimal structure of industrial organization in a globalized market, should such a thing ever exist. To this end, we extend our field of study to offer future directions for structural management in all economies seeking to respond to the challenge of globalization. We complete our analysis by applying these general theoretical implications to the Korean case. In Korea, chaebols and the issue of the optimal structure of industrial organization have long been subjects of debate. Continuing evaluations of the current chaebol-dominated situation, as well as the future direction of optimal structural adjustment, have both been high on the industrial policy agenda. It is usually argued that Korean chaebols are excessively diversified and have outgrown the Korea economy, which now suffers from excessive ownership as well as industrial concentra* This chapter is based on Sung-Hee Jwa (1997) ‘Globalization and New Industrial Organization: Implications for Structural Adjustment Policies’ in Takatoshi Ito and Anne Krueger (eds), Regionalism versus Multilateral Trade Arrangements, NBER-East Asia Seminar on Economics, vol. 6, University of Chicago Press, pp. 313–43. 114


Globalization and the Chaebols 115

tion. To curb the propensity of the chaebols to diversify and to become too large, many initiatives to promote business specialization and ownership diffusion have been undertaken. However, most of those policies merely sought to regulate the business activities of chaebols with measures including restrictions on entry, bank borrowing, ownership concentration, mutual assistance within the same business group, as well as additional measures to encourage business specialization. With this regulatory mind-set firmly in place, policy makers neglected to directly attack the underlying reasons for the undesirable behavior of chaebols. These policies have been regarded as generally unsuccessful. Therefore, on the basis of the theoretical discussions and empirical evidence, we aim to examine the underlying determinants for chaebol diversification behavior and offer a set of appropriate policy responses in order to discipline the chaebols in their future business dealings. Today, globalization affects a full range of political as well as economic issues. Globalization is a phenomenon driven by the strategies and behaviors of individual economic agents, firms, banks, and people in the pursuit of profit and is usually identified with market deregulation, the spread of new information technologies, the intermeshing of financial markets, and innovations in industrial and production systems.1 Globalization is the most critical and difficult challenge for modern firms. It has been observed that the advent of the globalization phenomenon and a crisis in existing production systems are simultaneously taking place. In today’s increasingly interdependent, complex, and dynamic economic environment production systems, the once successful industrial and production systems, namely the American Fordist system, the German Craft system, and even the Japanese flexible and lean production system, all seem to be breaking down and are now in need of serious reassessment. This is sparking uncertainty about how a successful, modern firm should be organized and managed. The post-Fordist system, a new intra- and inter-firm industrial system of organization that emphasizes innovation in work methods and product features, has brought the American Fordist mass production system into crisis with its competitive strength. The detailed compartmentalization of tasks and responsibilities in the Fordist system hinders application of new information technologies to the production process, integration of all levels of production and management, and long-term investment in multi-skilled workers.2 The German Craft system, once praised as a critical factor in German economic



development, is now exposing its inherent rigidities in a similar way. Its fixed skill-identity limits the speed with which new products and technologies can be introduced, while the bureaucratic elements in the system separate production from the development and design lab, as well as isolating various parts of production from one another (Herrigel and Sabel, 1994). Even the Japanese flexible and lean production system, touted not so long ago as a truly worthy alternative to the Fordist system, is beginning to show weakness in the new globally competitive arena. Its distinctive characteristic is a vertical network supported by lifetime and seniority-based employment. However, if employment practice or some other part of the business environment changes as the result of globalization, as many believe it must, the Japanese system will also be pressured to change (Westney, 1994). However, to discuss systematically the implications of globalization for industrial organization, we must first analyze the concept of ‘globalization’ itself. For the purposes of this study, globalization is characterized as a parameter, similar to market price. Globalization is driven by microeconomic forces, but is taken by individual firms as a parameter in making economic decisions on the optimal structure of industrial organization. While the globalization phenomenon encompasses many diverse characteristics in general, this chapter concentrates only on those aspects of globalization most relevant to the current context and simplifies the concept so it can be easily incorporated into economic analysis.3 First, we identify the globalization phenomenon with the integration of world economies into a single market, which in turn implies two specific predictions for market environments: increases of potential market size and intensified competition for market share. In this sense, the challenge of globalization to individual firms lies in dealing with these larger markets. But as a corollary of the extended market size, globalization can also mean intensified competition in international as well as domestic markets, so that existing monopolistic producers may well face the possibility of losing their market shares. Therefore, although globalization gives access to a greater market size in general, this can also imply an effectively reduced market size for firms that have been enjoying unfair privileges under closed market environments. Second, we identify the globalization phenomenon with the introduction and spread of microelectronics-based information technology. Improvements in information technology contribute not only to economic integration through better telecommunications but also to changes in production technologies and managerial relationships



among various economic activities. Specifically, it is expected that scope economies among various economic activities will be strengthened through improved information technology and computer and automation systems.4 In addition, it may be that this improved microelectronics-based information technology will create new synergistic managerial relationships among formerly unrelated economic activities and will reinforce existing relationships by improving the information network system, making it increasingly difficult to isolate a particular economic activity from other activities. So in this sense, the additional challenge of globalization may lie in responding to the enlarged economies of scope among various economic or industrial activities generated by the stronger technological and managerial synergy effects.

2.

New industrial organization under globalized markets

We employ a theory of endogenous industrial organization in deriving the general implications of globalization for the optimal structure of industrial organization. This theory will be constructed on the basis of the theories of specialization (Stigler, 1968) and multi-product firms (Baumol, Panzar, and Willig, 1982; henceforth, BPW). Appendix 5.1 at the end of this chapter develops a formal theory of endogenous economic organization, although the main implications of the theory can be summarized in a simpler manner. First, as the size of the market increases, the optimal structure of industrial organization will be one with more specialization of activities under economies of larger scale and therefore with more specialized larger-size firms. Second, as technological innovation increases the degree of economies of scope, more diversified (multi-activity) firms will be encouraged. One can combine these two simple implications to derive interesting hypotheses about the relationship between globalization and new industrial organization. Convergence of industrial organizations. Every economy will increasingly face identical potential market size and an identical set of available production technologies as the borderless global economy emerges. Therefore, as the world economy becomes more integrated and globalized, the optimal structures of industrial organization will converge among individual economies. This is because basically every firm in the fully integrated and globalized economy will eventually face identical market size and production technologies, that is, identical market and production environments.5



Of course, individual firms may use their own business strategies, diverging from the optimal structure implied by and consistent with potential as well as existing market and technological opportunities, but those firms will ultimately be defeated by market conformists. However, there is still a possibility that alternative strategies targeting various markets can also survive, but only if they conform to the particular market targeted, whether it be local, national, regional, or indeed global. Globalization and large-scale production. Globalization is defined as an enlargement of potential market size, encouraging specialization of larger-scale production under strong economies of scale. According to this specification, one cannot definitively argue that the Fordist system will disappear solely due to its large production scale. Activities subject to strong scale economies will still survive in the large-scale production system in the globalized market environment. Market share competition and small-scale, multi-product production. The intensified market share competition generated by globalization may imply a reduction in market share for firms that are not successful in global competition. At the same time, as already mentioned, innovation in information technology increases economies of scope or network economies among various economic activities. If technology that reduces the optimal scale of production is introduced into this situation, the optimal structure of industrial organization may be a smallscale, multi-activity production, which has been regarded as typical of the new post-Fordist, lean and flexible production system. The background for the new system can be simply characterized in the following manner. As the market share of Fordist firms is reduced due to intensified market competition from new entrants, the large economies of scale that drove the old system in the past now become a burden, thereby motivating new efforts to amortize the large fixed costs associated with achieving the scale economies. These efforts will eventually help introduce multi-functional machinery, through technological innovation such as automation and robotization, and multifunctional workers. This in turn will help reduce the optimal scale by redistributing the large fixed costs to various multi-activities and help to create strong economies of scope among those activities at the same time. The outcome will be the so-called small-scale, multi-product flexible system. Globalization and the choices between large-scale and small-scale production. According to the arguments made thus far, as the world economy becomes globalized, two opposing forces will emerge. One is the pres-



sure for specialization due to growing market size, which may provide an improved environment for large-scale (that is, Fordist) production systems. The other is the pressure for small-scale production and business diversification due to technological innovations creating larger scope economies and intensified market share competition, which continue to provide a favorable environment for the new system. This means that, in contrast to the claim made by Oman (1993, 1994), globalization does not guarantee the diffusion of the new system. While the theory implies a convergence of industrial organization structures among national economies as globalization occurs on a larger scale, one cannot predict at this stage whether the Fordist or post-Fordist system will dominate. However, depending on the size of a targeted market and the nature of technologies adopted by a particular industry, an optimal and efficient industrial and production system for that industry is something that can be determined. One important result of this discussion is that private sector initiatives normally have a comparative advantage in determining the optimal structure for industrial organization in an increasingly globalized world economy. As governments are unable to sort out the complex implications or mixed signals from globalization phenomena and are unable to predict the exact optimal structure, the deregulation or liberalization of the domestic economy may be the most effective strategy in responding to globalization, since it will encourage flexibility in the private sector.

3.

Globalization and Korea’s industrial organization

In this section, we provide a brief discussion of the chaebol-dominated Korean industrial organization structure. We theoretically investigate the underlying forces driving that structure, with emphasis laid on the diversification behavior of the chaebols and discuss future prospects. 3.1

Brief introduction to the characteristics of chaebols

In Korea, chaebols consist of a few lead companies and many subsidiary firms in various business areas under the control of a single ownermanager and his family members. It is argued that the Korean industrial organization structure has been dominated by the excessive industrial and ownership concentration and business diversification of these chaebols. Whether or not these observations are true is not entirely clear. Nevertheless, Korean policy toward industrial organization has generally been framed on the premise that these observations are a true representa-



tion of the behavior of chaebols and that, furthermore, chaebols produce undesirable economic impacts on the efficiency of the national economy. Table 5.1 reports the economic concentration ratios of the thirty largest chaebols in the Korean mining and manufacturing sectors. The numbers suggest that the chaebols’ dominance has been rising in recent years. To see whether the Korean case is exceptional by international standards, one can refer back to Table 4.9 which shows international data on aggregate concentration ratios for the manufacturing industry in 1993. This comparison shows that the Korean case is not extraordinary, being, in fact, rather comparable to those of many developed countries. Table 5.2 shows the diversification behavior of chaebols in 1993–94 and 1997. It turns out that, on average, each of the five largest chaebols Table 5.1 (%)

Chaebol concentration ratio: 30 largest, mining and manufacturing

Ratio

1985 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996

Shipments 42.6 45.0 43.3 44.6 41.2 41.4 43.2 43.1 42.4 45.2 47.3 Value added 22.2 22.3 24.4 27.7 29.0 29.8 31.9 33.3 35.3 41.0 36.6 Fixed assets 41.5 46.3 46.4 47.7 45.7 47.5 50.0 48.7 47.9 55.4 52.9 Employment 2.74 3.12 3.36 3.33 3.13 3.10 3.07 2.98 3.03 3.09 3.12 Note: The numbers for shipments, value-added and fixed assets are the ratio to the total of mining and manufacturing sector, but the numbers for employment is the ratio to the aggregate employment for the overall economy. Sources: Korea Bureau of Statistics; Korea Fair Trade Commission.

Table 5.2

Number of subsidiaries and industries affilliated to chaebols

Chaebol

Subsidiaries1

Financial companies2

Industries covered3 (average)

Top 5 Hyundai Samsung Daewoo LG Sunkyung Top 30

262 (210) 57 (49) 80 (50) 30 (25) 49 (53) 46 (33) 819 (626)

32 (20) 6 (5) 10 (5) 5 (2) 8 (6) 3 (2) 95 (64)

31 (30.4) 37 (36) 30 (34) 31 (27) 29 (32) 28 (23) 19.97 (19.1)

Note: 1. June 1997. Numbers in brackets denote figures from June 1994. 2. April 1997. Numbers in brackets denote figures from April 1993. 3. December 1997. Numbers in brackets denote figures from 1993. The numbers are counted by two-digit KSIC industries. Source: Korea Fair Trade Commission.



owns 52.4 subsidiaries, runs businesses in 31 non-financial industries, and owns 6.4 financial institutions in 1997. These numbers suggest that the extent of diversification of the largest chaebols is indeed extraordinary and has been increasing over time. This could partially account for the rising trend of chaebol concentration ratio in Table 5.1. Table 5.3, reproduced from Yang (1992), to investigate the nature of that diversification and to make an international comparison. According to this information, chaebols, compared to large firms in major developed countries, exhibit the highest weight of technologically unrelated diversification but the lowest weight of technologically related diversification. While Korea’s degree of diversification is very high among the sample countries, it is slightly lower than that of the United States. In sum, this comparison suggests that the overall picture of Korea’s diversification vis-à-vis developed countries could be characterized as a relatively high degree of diversification and an extraordinarily high degree of unrelated diversification. However, Yang (1992) observed that larger groups are consistently more diversified than smaller groups, implying that diversification has been the common chaebol strategy for business expansion. It is interesting, in this context, to note that in the United States from 1950 to 1975, the diversification behavior of large firms was much the same, with the major means of business expansion being diversification through mergers and acquisitions rather than internal growth (Scherer and Ravenscraft, 1984). The high degree of business diversification may itself be a reflection of diversified ownership expansion and could thus be interpreted as evidence of overall ownership concentration among a small number of people in the national economy. Table 5.4 provides data on degree of ownership concentration within the business groups themselves. According to this data, within-group ownership concentration was, indeed, high but since 1993 it has stabilized at a slightly lower level. Looking at the composition, the family share has also steadily declined, but the share of subsidiaries through mutual stockholdings has remained stable during the 1990s. These trends could be interpreted as a reflection of the following aspects: the rapid expansion of the capital market and the disincentive measures implemented by the government to curb individual share expansion in the case of family shares, and the general pattern of business expansion through diversification in the case of subsidiary shares. In sum, the facts about the Korean industrial organization structure seem to confirm the popular concern that it is not only too highly


122

Table 5.3

International comparison of degree of business diversification based on the Rumelt Method (%)1

Types of diversification2

Korea (1989)

Japan (1973)

United States (1969)

United Kingdom (1970)

West Germany (1970)

France (1970)

Italy (1970)

Specialization Complete Specialization (SR > 0.95) Partial specialization (0.95 > SR > 0.7)

36.8

53.3

35.4

40.0

44.0

48.0

43.0

8.2

16.9

6.2

6.0

22.0

16.0

10.0

28.6

36.4

29.2

34.0

22.0

32.0

33.0

63.2

46.7

64.6

60.0

56.0

52.0

57.2

6.1

39.9

45.2

54.0

38.0

42.0

52.0

57.1

6.8

19.4

6.0

18.0

10.0

5.0

Diversification Related Diversification (SR < 0.7, RR > 0.7) Unrelated Diversification (RR < 0.7)

Note: 1. The number of business groups inclusive of vertical as well as horizontal groups are 118 for Japan, 49 for Korea, and 100 for others. 2. SR (specialization ratio) = total revenues of the largest single business / total revenues of a whole business group. RR (relation ratio) = total revenues of the largest subgroup of related business / total revenues of a whole business group. Source: Yang (1992, p.13). The estimates are obtained by the method suggested in Rumelt (1986).


Globalization and the Chaebols 123 Table 5.4

Within-group ownership concentration: 30 largest chaebols (%)

Ownership

1990

1991

1992

1993

1994

1995

1996

1997

Within-group Family Subsidiary

45.4 13.7 31.7

46.9 13.9 33.0

46.1 12.6 33.5

43.4 10.3 33.1

42.7 9.7 33.0

43.3 10.5 32.8

44.1 10.3 33.3

43.0 8.5 33.7

Note: The table includes 616 subsidiaries of the thirty largest chaebols, out of which 164 companies are listed on the stock market as of the end of 1993, accounting for 56.8 per cent of the total equity capital. Source: Korea Fair Trade Commission.

concentrated in business and ownership but also highly diversified over widely ranging areas of business. However, recent trends suggest that some of the problematic aspects of the Korean industrial structure have been alleviated. In particular, ownership concentration has been observed to be on the decline, probably reflecting the rapid growth of the Korean economy and the increased availability of sources of equity capital such as the capital market. Of course, it cannot be denied that various government regulations have also played an important role in generating this trend. However, it is also true that the rising trends of the chaebols’ concentration ratio and of the extent of diversification cast doubt on the effectiveness of the anti-chaebol regulation policies against the market concentration and business diversification. 3.2 Underlying determinants of chaebol diversification behavior and policy implications One of the most intriguing aspects of Korean industrial policy to begin with is that attention is mainly concentrated on methods of curbing diversification without asking why chaebols tend to be so highly diversified. This aspect may explain why Korean chaebol policy has been of the symptom regulation type. However, before any logically and empirically sound policy prescription can be made, it is very important to ask why Korean firms are so ‘excessively’ diversified in the first place.6 Only in this way can one rationally determine whether an industrial area specialization policy that is intended to reduce the degree of business diversification of firms is practical, let alone optimal.7 However, very little serious effort has yet been made to explain the diversification behavior of Korean business groups in a systematic manner.8 According to the theoretical discussions above, the following factors that form particular business environments for Korean business firms can explain the diversification behavior of chaebols.



First, market size can be a critical factor. If the market for products subject to strong economies of scale is too small for the potential benefits of large-scale production to be fully exploited, then a relatively high degree of diversification will result. Not only has the absolute size of Korea’s domestic market been particularly limited, but the market share of Korean firms in the international market has also been low, despite Korea’s pursuit of a export promotion strategy from its earliest stages of development. Moreover, governmental support for industrial development in the form of easy policy loans gave major firms access to larger and larger resources. Therefore, in order to reap the most benefit from available resources, those firms pursued a diversification into various industrial activities that turned out to be individually under-scaled. Second, the degree of economies of scope among industrial activities can be an important factor. Technological innovation over the last thirty years, including information technology, can be argued to have strengthened economies of scope or network economies among various industrial activities. This trend also promoted the diversification drive among Korean firms by alleviating the burden of otherwise inefficient diversification. In fact, Jwa (1997) has shown through empirical estimations that strong economies of scope exist among various industrial activities in Korea, implying that chaebol diversification behavior indeed stems, at least partly, from the technical efficiencies that can be gained from business diversification. Third, the business environment created by government policy can be an important factor. Table 5.3 shows that Korean firms seem to have no qualms about diversifying into technologically unrelated areas. This phenomenon cannot be easily analyzed within the theoretical framework offered in this chapter. In order to explain this phenomenon, it seems to be necessary to grasp the nature of the business environment created by government industrial policy during the past thirty years. One salient feature of Korea’s interventionist industrial policy is the government’s responsibility for a firm’s survival once the firm enters a designated business area.9 Therefore, the government has taken every possible measure to revive those firms whenever they became inefficient and in danger of insolvency. In this environment, the best choice for any firm may have been to make a pre-emptive move into a business area that is subject to government entry regulation because, once it is allowed to enter, the firm’s survival is all but guaranteed. It is our belief that these three factors, individually or in conjunction with each other, can help explain the behavioral patterns of Korean



firms or groups of firms with regard to business diversification. Unless these aspects are fully understood, one cannot determine whether the degree of diversification is excessive or not and, further, it will be difficult to devise a sensible policy prescription to alleviate the degree of diversification if it is indeed excessive. Judging from the above discussion, one may say that, given Korea’s particular business environment, and specifically the pattern of national industrial policy, the current degree of diversification is fairly rational. In this sense, therefore, one cannot definitively conclude that the degree of diversification among Korean firms is excessive. Furthermore, even if the government judges the degree of diversification to be excessive for noneconomic reasons, the policy prescription should not directly set business boundaries for individual firms. One option is for the government to make an effort to change the business environment, including industrial policy, in order to induce the desired diversification level of firms. For example, if more specialization is desired, then the domestic market can be fully opened, encouraging a firm’s efforts to globalize their business activities and to face the global market. Furthermore, the government’s policy of guaranteeing the fortunes of selected firms could be changed so that every firm is responsible for its own success or failure. This will help discourage not only so-called technologically unrelated diversification but also technologically related diversification behavior. Any anti-diversification policy directly limiting the realm or range of business activities without correcting the business environment is unlikely to be effective and may create some serious resource misallocations. 3.3 Globalization and prospects for chaebol diversification behavior In this section, we will speculate on future prospects for Korea’s industrial organization in a globalized market environment. According to Jwa (1997), the empirical estimations of the economies of scale and scope in Korean industrial activities suggest: 1. almost all industrial activities are individually subject to constant returns to scale, 2. the economies of scope among industrial activities are strongly present. Therefore, the scale of production and the degree of specialization will not be greatly affected by the increased market size characteristic



to globalization. However, the processes of globalization will increasingly strengthen economies of scope through innovations in information technology and microelectronics. In other words, globalization may actually hinder the movement of business activities toward specialization. Rather, it is possible that globalization will further strengthen the incentive for diversification in many industrial activities. Furthermore, if chaebols become losers in the global market share competition, as well as in the domestic market, they will tend to retreat from their existing specializations and move toward more diversification. However, if globalization brings about technological innovations that create new economies of scale for certain industrial activities, it is also possible that the specialization of these activities will be encouraged as the size of the market expands.

4.

Lessons for industrial policy

In recent years, the popular trend seemed to be for governments to experiment with one form or another of the industrial policy that was previously adopted by successful East Asian economies such as Japan, Taiwan, and Korea.10 This tendency became even more conspicuous in discussions of possible policy responses to the ‘unlimited competition’ forced by globalization. An increasingly common view is that the government should make special efforts to help business firms compete successfully in the international market and that the government should intervene by adjusting the industrial structure to become more attuned to globalizing competitive environment. The arguments presented in this chapter suggest the following implications in relation to this new trend in industrial policy. Above all, globalization is a diversified and sometimes contradictory phenomenon that has a variety of economic implications, depending on the context. This makes it impossible for a government to choose a particular industrial organization structure, which will be optimal for its economy in all circumstance. One can further conjecture that the economist’s search for an alternative industrial organization to the American Fordist, German Craft, and even Japanese network production systems will not yield any single definitive solution. Instead of adopting an industrial policy that requires a tremendous volume of information, an effective response to globalization may be to allow the market order to prevail. In this way, the private sector has the freedom to make structural adjustments and, in the process, to ‘discover’ the optimal business structure.



Appendix 5.1: An integrated theory of endogenous economic organization Basic model Stigler (1968) proposed a theory of the multi-product firm based on Adam Smith’s theory of specialization. He suggested that a multiproduct firm’s scope of activities is determined by the interaction of production technology and market size. The most important concept in his theory is the economies of scale that characterize the production technology of the relevant industry. According to Stigler’s theory, activities subject to economies of scale tend to become detached from the remaining set of activities as the size of the market grows large enough to support a scale of production that can realize these economies. Conversely, activities subject to diseconomies or weak economies of scale tend to be integrated in-house. Even activities with economies of scale become integrated if the size of the market is limited or the remaining set of activities exhibits particularly strong diseconomies of scale that dominate the concerned activity’s economies of scale.11 Therefore, the equilibrium in a multiproduct industry consists of firms that either integrate various activities in-house or specialize in a single activity or subset of activities, depending on market size and the degree of (dis)economies of scale of the different activities. Baumol, Panzor and Willig (1982, hereafter BPW) developed a theory of the multi-product firm, introducing the concept of economies of scope in addition to economies of scale. According to BPW, economies of scope are a necessary and sufficient condition for the existence of multi-product firms (1982, 248–9, props. 9B1 and 9B2). To facilitate discussion, we formally introduce the concepts of economies of scale and of scope through the following equations:

SN =

ST =

C( y)

∑

N

(1)

y i ⋅ C i ( y)

i= 1

[ C( y) −

∑

T

C ( y N − T )]

y i ⋅ C i ( y)

i= 1


(2)




∑  

SC N =



N

I= 1

C ( y I ) − C (.y )  

(3)

C( y)

[ C( y

SCT =

T

) + C ( y N − T )−

C ( y ))]

C( y)

(4)

Where SN and ST measure the economies of scale for the full set of all products N and a subset of products T, respectively. SCN and SCT measure the economies of scope among all products N and between the subset products T and N – T, respectively. C(·) is the cost function; y is the full set of products, y = {y1, y2, …, yn}, and yI = {0, …, 0, yi, 0, …, 0}, yN – T = {0, 0, …, yt+1, …, yn}, and yT = {y1, …, 0, yt, 0, …, 0}. Ci(y) is the marginal cost of yi and [C(y) – C(yN–T)] measures the incremental cost of the subset T. Now, we can formally define economies of scale and scope using equations (1)–(4). SN>1 implies overall economies of scale; SN = 1 implies constant returns to scale; and SN1 and SN – T 0, ST > 1 and SN–T < 1 (II-1)

αT · ST + (1 – αT)·SN–T = 1 with SN = 1, SCT = 0 and αT = 0.8

2 (1,1) 1

Multi-product firm dominant region

0

1

SCT > 0, ST < 1 and SN–T < 1 (I)

2

SN–T

SCT > 0, ST < 1 and SN–T > 1 (II-2) αT · ST + (1 – αT)·SN–T = 1 with SN = 1, SCT = 0 and αT = 0.5

Figure A5.1

Classification of multi-product industry equilibria



stronger economies of scale tend to become integrated. Therefore, as market demand for specific activities increase, those activities are more likely to be specialized, and vice versa – exactly the implications of the Stigler theory. Changes in production technology In the case in which technological innovation creates greater degrees of economies of scope (SCT), SN becomes greater than 1 in equation (5). Therefore, the adjustment process will be analyzed depending on whether the newly created overall economies of scale can be easily exhausted. If market size is unlimited or large enough to allow the newly created overall economies of scale to be fully exhausted by scale expansion, then a new equilibrium with SN = 1 and a higher SCT will be re-established. As a result, under the new equilibrium, the activities will exhibit weaker scale economies – that is, lower ST and SN – T, than under the original equilibrium. Another possibility is the continuation of disequilibrium due to the limited size of the market, since in this case the newly created overall economies of scale, SN>1, cannot be fully exhausted. If this case is combined with the implication of the changes in market size exercise above, one can draw the conclusion that an industry with relatively small market size, undergoing active technological innovation that creates larger SCT, will tend to be subject to noncompetitive structure with excessive diversification or inadequate specialization. Therefore, as the degree of economies of scope among activities increases, the optimal scale of multi-activity organizations and the potential to earn supernormal profits will increase, encouraging the rise of more multi-activity organizations. On the other hand, if activities that have not been part of multi-activity organizations experience a technological innovation, newly creating economies of scope with the incumbent activities of those organizations, then they tend to be integrated within those organizations. In any case, the stronger or newly created economies of scope will imply the proliferation of multiactivity organizations.


6 Reform Prospects for Korea’s Financial System*

1.

Introduction

In our exploration of the significant weaknesses carved into the Korean economy by three decades of strong government-led industrial policies, we now move from the industrial sector to the financial sector. First, we examine the experience of the Korean banking sector, which drew much of the blame for the outbreak of the 1997 recent crisis. From this, we assemble a set of lessons which should interest not only Korean policy makers but also those in the international community who hope to gain useful insights from the Korean experience. Secondly, going beyond the banking sector, any serious consideration of how to reform financial industries in general necessarily involves the issue of optimal boundaries between various financial activities. For example, the question of whether or not to allow banks to engage in businesses that were in the exclusive domain of securities industries has become a particularly relevant topic both here and abroad. Determining the direction of the financial industry’s structure ultimately rests on how best to improve the efficiency of financial industry. Unfortunately, the majority of the policy proposals to date have been limited to imitating the structures and systems of other advanced nations without first gaining a sufficient understanding of them. The current structure of financial industries in advanced countries have been endogenously determined, reflecting both the charac-

* This chapter is based on Sung-Hee Jwa (1995) Endogenous Financial System. Seoul: Dasan Publications (in Korean). 132


Reform of Korea’s Financial System 133

teristics of their past experience as well as related rules and regulations in the past and present, i.e., exogenous factors.

2. Risk and returns of financial–industrial interaction: the Korean experience The Korean banking sector received a good deal of negative coverage from international financial markets and the world media in the wake of the recent financial crisis. An unmitigated spread of business failures of non-bank industries to the banking sector in 1997 gave the impression that the sort of mechanism that might have stopped the kind of contagion that swept through Korea has never existed. However, despite such appearances, Korea has actually maintained some very elaborate legal barriers as well as regulations to separate non-financial businesses from banks. These legal barriers were supposedly installed to minimize risks associated with having an arrangement that does not separate the two types of businesses. The most notable was the emphasis placed on restricting the size of majority shareholdings. However, following the outbreak of the recent crisis, the general consensus is that these regulations failed to do their job. By the spring of 1997, the demise of Hanbo Steel had sparked off a series of failures in businesses within the Hanbo Group. A few more well-publicized business failures followed, such as that of the Kia Motor Group, dealing a near-fatal blow to several Korean banks. Two large banks became technically insolvent, requiring direct government intervention in the form of massive equity participation to ensure their continued operation. So it is not surprising that many in Korea agree that the regulatory regime failed to prevent an unmitigated propagation of trouble in the non-financial business sectors to banks. However, a misfortune for Korea could indeed be a valuable opportunity for others if the correct lessons are learnt from the experience. The key channel for the transmission of business failures to a bank is the latter’s exposure to the former in terms of either concentrated lending or concentrated shareholdings. In Korea’s case, the concentrated lending on the part of banks was responsible for many of the current difficulties. At the root of the issue was the practice of not allowing banks and other financial firms to develop fully as more autonomous profit-oriented business units. Despite a strong emphasis on limiting the overexposure of the banking sector to other industries via restriction on ownership, too



little attention was paid to the risks of exposure through the lending channel. Linking of the two sectors could arise from a bank’s concentrated lending to an industrial firm. Effectively, a bank can lose its ability to exercise discretionary control over its lending to a firm when the bank’s lending exposure to the firm is too great. It is a typical application of the ‘too big to fail’ fallacy. Perhaps it also indicates a failure of the general prudential regulations. This list of problems has been well known for some time. Active intervention by government in most facets of economic life has been standard policy since the 1960s and has remained unchanged in any substantive way since. Consequently, governmental guidance still took priority in key decisions of private banks in such areas as asset allocation and the selection of bank presidents. This intervention from the government was not an entirely bad thing as far as bank managers were concerned, since it more or less excused bank executives from exercising their managerial responsibilities. As expected, banks continued to lend out to economically unviable firms, mainly on the basis of the principle that they were ‘too big to fail’. At the same time, governmental supervision of bank soundness continued to be lax, despite numerous codes restricting lending concentration. These conditions led to a concentration of bank lending to large businesses. Despite the obvious pitfalls of such a practice, circumstances surrounding lending concentration have yet to change in any substantial way. Such experiences seem to suggest that perhaps a duly diligent overall prudential regulation is more important than establishing more legal codes and rules to delineate the separation of the financial and industrial sectors. 2.1

General background and Korea’s case

There are both advantages and disadvantages in erecting a strict barrier separating commerce and banks or banks and non-bank financial businesses. In general, a strict separation allows a tight control over the contagion of business failure from one to the other. For example, a bank affiliated with a steel producer would be threatened if the steel company fails due to a rapid fall in demand for steel, even though this has little to do with the bank’s operation. At the same time, however, a close relationship affords a synergy effect between the two businesses. When there is an ongoing interlocking relationship, the bank might have insider knowledge that the steel company is ordinarily very efficiently run and it is experiencing only a temporary cash-flow



problem. The bank could then extend short-term financing to see the steel company through a temporary difficulty. This could make the steel company more profitable since steel companies who lacked any such link with a bank would have failed, thereby opening up more business opportunities. On balance, the interlocking relationship could offer a higher return for the bank’s investment over time.1 As is well known, few countries allow non-financial business firms to control a bank. However, Germany and Japan both allow their banks to enjoy significant equity participation in non-financial businesses. Moreover, a growing number of countries are removing barriers between banks and non-bank financial businesses. Even in the US, where the Glass–Steagall Act erected a wall between banks and nonbank financial businesses in the aftermath of the 1929 Crash, the movement to remove the barrier is gradually gaining momentum. The recent merger of Citicorp and Travelers Group is the most prominent showcase of such development. It is probably fair to say that the jury is still out on whether one form dominates the other in terms of a higher profitability for the given level of risk. The potential benefits associated with economies of both scale and scope need to be balanced against the increase in risk by the crossover.2 In the case of Korea, strict regulations prohibit the involvement of non-financial capital within the banking industry. At the same time, banks can own shares of non-bank businesses. However, this option has been used strictly for investment purposes and has not led to an interlocking relationship, as has happened with the Japanese keiretsu. In addition, Korea has adopted the Japanese system of allowing banks to own securities firms as subsidiaries. 2.1.1

Mobilization of banks during the period of rapid economic growth

The prudential regulation perspective took a very distant back seat in formulating policies regarding the bank–commerce relationship in Korea, and the greatest emphasis was placed on how best to finance rapid industrialization. A clear priority has been placed on a rapid industrialization since the mid-1960s. The task for economic policy makers since then has been how to devise and organize national economy to achieve rapid growth. Commercial banks were the main depository of domestic financial resources. Thus, assuming the control of banks came naturally as a necessary step to launch and finance economic development plans. In the early 1960s, the Korean government took away the control of commercial banks from private owners. Going further, the government



established a number of special banks to absorb as much saving as possible and also to facilitate exports and industrialization.3 The overriding reason for the existence of a bank was to channel domestic savings to targeted industries as effectively as possible. Many restrictions were imposed on bank asset management to ensure that bank funds went to projects deemed necessary by the government for the nation’s industrialization effort. Simply put, the Korean government took a very active role, not only in setting up the kind of relationship that was allowed between banks and commercial industries, but also in running banks as both the de facto and de jure majority shareholder. 2.1.2

Privatization of banks and restrictions on ownership

Over the past two decades, steps have been taken in Korea to increase the autonomy of banks, including the selling off of government majority shareholdings in all major commercial banks and the privatization of special banks. With the sales of those bank shares previously held by the government, the controversial issue was whether or not a nonbank industrial firm should be allowed to own a bank. The debate arose because of the dominant positions chaebol groups already enjoyed in various Korean industries. To a large extent, it was the development strategy followed by Korea that gave birth to the chaebols. The key development was the government drive for new industries that require economies of scale by relying on existing companies to start a new industrial sector rather than by actively encouraging new companies to set up. This policy drive was supported by easy credit and other incentive and gradually led to vertical as well as horizontal growth of interrelated businesses. However, there has been growing concern about the concentration of economic powers and a notable rise in anti-chaebol sentiment. Two factors might explain why the chaebols sought to acquire ownership of banks. First, due to rapid industrialization and overall growth in the size of a typical industrial project, businesses were chronically in need for funds. As direct financing sources such as the bond and equity market were relatively underdeveloped, banks were the main conduit for funds. Raising funds through banks became even more attractive because the government kept a tight control on both interest rates on deposits and lending at artificially lower levels, especially during the early period of development up to the late 1980s. Second, a high barrier-to-entry existed in the banking sector, as no new bank licenses had been issued for nearly two decades until the early 1980s, when two



licenses were granted. Such a high barrier-to-entry meant that those who did enter into the banking sector enjoyed substantial economic rents. For example, all banks had access to cheap credit provided by the Bank of Korea designated for various industrial sectors, while interest rates on lending were relatively high compared to the international levels even if they were regulated at low levels. Consequently, a strict limit has been placed on the proportion of the single largest shareholding (4 per cent in the case of major commercial banks, starting in 1995). The key justification for this restriction was to prevent potential misuse of a bank by its owner (that is, its largest shareholder) as a private financing arm of a chaebol business group. That is, the bank might exclusively lend to the small number of businesses that have close ties to the chaebols. Presumably, this concern stems from the prudential regulation perspective of not exposing a bank to a single, potentially fatal risk as a result of lending concentration.4 2.1.3

Interest rate control

The Korean government carried out currency reforms in 1962 by changing the denomination from hwan to won, with the new denomination being worth ten times that of the old. In general this move was regarded as a failure – instead of reducing inflationary pressures as planned, it actually aggravated them. Inflation in the CPI was 21 per cent in 1963 and reached 30 per cent in the next year. Partly due to such high inflation, market interest rates hovered at above 40 per cent per annum in the mid-1960s. However, the regulated official rates at banks were kept unrealistically low. For example, the interest rate on one-year time deposits was kept at 15 per cent in 1963 and 1964. In order to rectify this situation and to mobilize domestic funds, official bank interest rates were drastically raised. For example, the rate on one-year time deposits was raised to 26.4 per cent in September 1965. These changes had the expected effects in terms of reducing inflation and attracting substantial additional funds to bank accounts. However, in the medium term, high interest rates placed increasingly heavy debt-servicing pressures on businesses. Such pressures culminated in 1972 when Korean exports, which had been the engine for economic growth, suffered from recessions and protectionism in advanced economies. Under a heavy debt-servicing burden, businesses demanded a drastic measure to lower their financing costs and the government accommodated their demand. On 3rd August 1972 an emergency presidential decree forced lenders in private money markets



(curb market) to convert their short-term lending with high interest rates to long-term loans carrying interest rates of about one-third the original rates. The official bank interest rate on one-year time deposits was also lowered to 12 per cent in late 1972 from the 20 per cent range seen in the previous year. The government did not stop at taking the occasional remedial step. It more or less continuously administered credit flow, as well as the terms under which the credit was supplied. Policy loans, a generic term for loans provided by commercial banks on a concessionary basis, made up about 45 per cent between 1972 and 1976, rising to around 50 per cent between 1977 and 1980. The main recipient of these loans were firms engaged in export businesses (throughout most of the post1960 period), firms in the heavy and chemical industries (since the mid-1970s), and small and medium-sized firms (since the mid-1980s). The interest rate differential between these loans and regular bank lending typically ranged by up to ten percentage points. Commercial banks in turn received credit from the central bank at even lower interest rates for policy loans they extended. From 1984, very gradual steps were taken to deregulate interest rates. Banks were allowed to charge different rates on their lending within a range of 1 per cent to 1.5 per cent, based on the borrower’s creditworthiness. However, progress in this area has been slow. The Ministry of Finance first announced an ambitious and wide-ranging interest rate liberalization plan in December 1988, only to scrap it in the following year due to an economic downturn. Only in the early 1990s was a comprehensive plan of interest rate deregulation implemented. This envisioned the removal of government-prescribed interest rates over the 1991 to 1997 period. Aside from policies to cease intervention in the setting of interest rates, that is, the price of credit, there have also been a series of measures that aimed to dismantle control over the actual flow of loans and their uses, that is, the quantity of credit. Perhaps one should not be so surprised to find that most Korean banks lack the ability to make credit analysis and to function as autonomous profit centers. After all, it has been almost ten years since banks have been able to price their main product – bank loans – as they see fit. 2.1.4

Lending concentration

Current lending practice and the legal status of individual chaebolaffiliated firms has already exposed banks to risk. The key problem is the fact that the de facto chaebol business group is not legally recog-



nized. Due to their interconnected ownership and their close business relationship, it is more appropriate to view firms belonging to a chaebol group as one economic unit. The case of the Hanbo Group is a good example. Other businesses legally unrelated to Hanbo Steel (the initial firm to fail) all experienced difficulty and eventually went bankrupt along with the steel mill. Similarly, a few major Korean banks came dangerously close to insolvency due to their exposure to those firms.5 Individual firms belonging to a chaebol are legally regarded as independent entities, completely separate from each other. Thus, one firm can offer a credit guarantee for another firm to borrow from a bank. Cross-guarantees among firms belonging to the same chaebol group subsequently became a common practice. Although this has been a legal practice widely accepted by Korean banks, it makes no sense in economic terms.6 The cross-debt guarantee is one source of lending concentration in Korea. Another is the fact that banks place heavy reliance on collateral. Large businesses tend to have more tangible collateral and thus obtain bank credit with relative ease. Perhaps related to this, banks generally perceived large borrowers to be ‘too big to fail’. Both banks and large businesses thus exhibited behavior reflecting moral hazard. The government also introduced the ‘main bank’ system in the mid1970s, modeled on that operating in Japan. The idea behind this was also to foster a close relationship between a large business group and a bank so that the designated bank would also perform a monitoring role on the strength of this close relationship. This system was also designed to discourage chaebols borrowing from many different banks as the chaebol firm was required to maintain a close link with the designated bank. Again, the recent bankruptcies of chaebols belonging to the 30-largest category and their immediate impact on the Korean banking sector revealed the ineffectiveness of the measures outlined above taken to prevent the concentration of bank lending. The two banks most severely affected by these failures were in technical default and only a massive government emergency intervention saved them from failing outright. In short, all the past measures taken to limit banks’ risk exposure to non-bank industries failed to limit the spread of adverse shocks from non-bank industries to banks. 2.1.5

Size imbalances among banks and industrial businesses

Another related point is that a bank’s lending exposure to firms might become too great solely because a typical industrial project is so much



larger than the capital of a typical bank. For example, 69 banks were included on the 1997 list of the Fortune 500 largest firms in terms of asset size. The banking industry took the top rankings by far when those 500 firms were grouped according to industry groups, outnumbering the second-largest group (motor vehicles and parts) by 69 firms to 27 and, in terms of asset size, by about 10 to 1. Tellingly, however, out of the 13 Korean firms that made the list, including two insurance companies, not one bank was listed. According to The Bankers 1996 list of 1000 banks, published in in its July 1997 issue, the Korea Exchange Bank topped the list among Korean banks, ranking 140th in terms of assets. The Cho Hung ranked 162nd. By contrast, six Korean industrial and trade firms made the list of the world’s 150 largest firms, compiled by the magazine Fortune in the same year. Table 6.1 shows comparisons of revenues of the ten largest nonfinancial businesses and asset size of the ten largest banks in 1996. This comparison is likely to reveal a global benchmark regarding the relative

Table 6.1 The world’s ten largest non-financial businesses and ten largest banks in 1996 10 largest non-financial businesses General Motors Ford Motor Mitsui Mitsubishi Itochu Royal Dutch/ Shell Marubeni Exxon Sumitomo Toyota Motor

Total

Revenues ($ m) 168 369 146 991 144 943 140 204 135 542 128 175 124 027 119 434 119 281 108 702

1 335 668

10 largest banks Bank of Tokyo-Mitsubishi Deutsche Bank Credit Agricole Sumitomo Bank Industrial & Commerce Bank of China Dai-Ichi Kangyo Bank Fuji Bank Sanwa Bank Sakura Bank HSBC Holdings Total

Assets ($ m) 647 781 569 906 477 336 460 375 437 392

433 860 432 738 427 438 422 769 401 686 4 711 281

Note: The non-financial businesses were taken from the Fortune’s 1997 list of Global 500 largest corporations and the banks were taken from The Banker’s 1997 top 1000 bank list (published in the July 1997 issue).


Reform of Korea’s Financial System 141 Table 6.2 1996

Korea’s ten largest non-financial businesses and ten largest banks in

10 largest non-financial businesses Samsung Hyundai Daewoo Samsung Electronic LG Hyundai Motor Yukong LG Electronic Ssangyong Kia Total

Revenues (billion won) 24 131 20 552 19 012 15,784 14 041 11 489 8 322 7 502 7 371 6 607 134 811

10 largest banks Korea Exchange Chohung Korea First Hanil Bank of Commerce Kookmin Seoul Shinhan Hana Boram Total

Assets (billion won) 44 594 40 260 39 437 39 120 37 388 35 997 31 039 30 774 14 936 12 885 326 430

size of non-financial businesses and banks. Table 6.2 presents similar information for Korea. For the top five businesses and banks in Table 6.1, asset size is typically four times as large as revenue. As a group, the total assets of the ten largest banks in the world is about three-and-a-half times the total revenue of the ten largest non-financial businesses. By comparison, the ratio between Korean top five non-financial businesses and banks averages about 2.0 and as a group the ratio is about 2.4.7 It is thus very likely that the average size of business projects in Korea will absorb a proportionately larger slice of a bank’s capital. This means that, solely due to the disparity in size, a bank in Korea faces more risk per loan compared to foreign banks in advanced economies. 2.2

Some policy implications

Several important policy implications have emerged from Korea’s recent experience. First, the imposition of rigorous restrictions on the ownership of banks is no substitute for ongoing diligent prudential regulations in terms of controlling systemic risks. A corollary to this is that it would be more productive to focus on installing an effective regulatory regime than to expend energy on deciding who can or cannot own a bank.



Second, efforts to enhance the monitoring function of banks require more than the designation of a main bank to a specific group of borrowers. It is clear that the designated main banks for the businesses that failed in 1997 failed either to monitor or to enforce disciplinary actions against their key borrowers when the borrowing firm overextended itself. In the absence of proper economic incentives and autonomous management to make key lending decisions, establishing a main bank system becomes meaningless. Third, policy makers need to think long and hard about artificially assigning a nation’s banking sector the subordinate role of supporting industrialization at any cost. Such a policy could easily lead to a mismatched growth of financial and non-financial sectors. Since a typical Korean industrial policy emphasizes the non-financial sector at the expense of financial industries, a noticeable imbalance between the two sectors could easily develop. For example, the manufacturing sector accounted for about 27 per cent of GDP in 1994, whereas banking and financial services accounted for only 17 per cent. Although we do not know the ‘golden ratio’, the figures for Korea are markedly different to the other Asian Tigers. For example, the two sectors accounted for about 28 per cent (manufacturing) and 27 per cent (banking and financial services) in Singapore in the same year, and in Hong Kong, the figures were 9 per cent and 27 per cent, respectively. The practice of credit rationing by the government has had a debilitating long-term effect by stunting a banker’s inclination or capability to make lending decisions based on strict commercial considerations. In this regard, it would be better if banks were allowed to determine the composition of their asset holdings. For example, lending to the consumption sector should not necessarily be viewed as wasteful. Under the circumstances that have prevailed in Korea, consumer lending could be the only avenue for bank officers to accumulate knowledge and experience in order to assess the creditworthiness of borrowers. In conclusion, it is widely understood that banks and other financial institutions perform useful functions not only in terms of providing finances (that is, lending) to different projects, but also in providing a filter service to weed out (or monitor) unsound projects. As a major lender, banks in Korea have purportedly served to help promote rapid industrialization. However, the Korean banks have not really played any significant monitoring role. It appears that many ASEAN countries have also basically adopted a strategy similar to that followed by Korea



in their efforts to achieve rapid industrialization. As a result, a weak financial sector has been common in most countries that experienced financial crisis. Going beyond the banking sector, enhancing the monitoring function of financial industry in general must be a key policy priority in the future. It might be better to focus less on who can or cannot own a bank, and more on whether or not a bank is following the various rules set up to ensure sound prudential standards. Of course, effective prudential regulation of financial industry has to be a prerequisite to considering any changes in the formal arrangement between financial and non-financial industries.

3. The endogenous financial system and the prospects for Korea’s financial structure Given the enormity of the problems faced by the Korean banking sector at the time of writing, a discussion about the basic types of financial arrangements might not seem particularly pertinent at this time. This is, however, a misconception. An academic discussion of this nature is exactly what is needed. By designing consistent solutions for short term problems, policy makers can ensure that they do not run counter to those ideal objectives of Korean financial industries in the long term. At the moment, policy makers are preoccupied by the question of how best to revive those Korean banks that are more or less technically insolvent. The basic approach currently adopted is to use public funds to rehabilitate banks by taking bad loans off their balance sheet and also by infusing new capital. At present, this appears to be the only viable option. However, the government will be forced to withdraw from this kind of intervention at the earliest opportunity in order to avoid making the same mistakes as discussed in the previous section. When the government does remove itself from the scene, it will most likely have to decide what kind of financial industrial structure should be allowed to operate. 3.1

The debate over financial disintegration and integration

The financial institution of a state can be ascertained by the types of businesses in which banks are authorized to engage themselves. Primarily, this demarcation relates to how much commercial bank and non-banking financial activity is permitted within the financial sector and, in particular, the extent to which these activities can be integrated in-house. A subsequent distinction is the separation of commercial



bank activities from non-financial activities. When ‘side trade’ is permitted, the nation is said to operate a universal banking system; when separated from the main trade, this is termed a specialized banking system. Korea has adopted the second of these. The decision to adopt one or other system relies chiefly on the extent to which the efficiency and the stability of finance are affected by the integration of those activities in-house. The fundamental reason for these separating principles stems from certain peculiarities in the activities of commercial banks. Commercial bank activities are more public, unlike those of the non-banking financial industry or indeed those that are completely non-financial. Banks rely on funds gathered from a large number of individual depositors, who could potentially withdraw their account balances at any time. Consequently, a negative perception of any one bank could lead to a ‘bank run’ scenario, in which the stability of the entire banking institution could be threatened. Of all the non-banking activities, investment banking is generally considered to be a particularly high-risk field. The logical conclusion is to sever the ties between bank activities and investment banking, thus actively contributing to the soundness of the bank in question. Historically speaking, specialized banking systems and universal banking systems have existed side by side. However, with the current trend of financial liberalization, an alleviation of the separation principle is gradually becoming manifest. Let us now turn to the second separation principle. Bank activities such as payment services are important to a nation’s economy; thus, the government offers some sort of protection such as insuring deposits held at banks. By allowing the existence of ‘side trade’ in nonfinancial and bank activities, there are claims that extending these benefits (such as governmental guarantees) to the non-financial affiliated enterprises may not actually be in the best interests of the public. The logic is that, due to the integration of banking and commerce, there is a substantial possibility that preponderance of a bank’s credit will go straight to various affiliated enterprises. Accordingly, as this means that the soundness of the bank is under threat, many are concerned that this will ultimately jeopardize the stability of the whole banking institution. Naturally, similar concerns have arisen over the relationship between non-banking financial activities and non-financial activities. Should they be separated? What should be considered here is the possibility of



the anti-competition effect of industrial integration. It will be necessary to enforce restrictions to counter this threat. Aside from the logical validity of these assertions, experience has shown that despite the trend of global financial liberalization, individual states are still inclined to adhere to the separation principles. In the case of advanced nations, the separation principle between bank activities and non-financial activities is relatively well maintained. There are inclinations of sustaining the present principle of limiting the extent of the relationship. However, regarding the integration of non-banking financial activities and non-financial activities, there are no particular regulations other than anti-trust laws. In recent times advocates of financial liberalization have come to believe that mitigating the industry’s entry regulation and promoting competition would actually raise the efficiency of the financial industry. In this regard, it is necessary to take into consideration an important aspect of the assertion that bank control or management of non-financial businesses will threaten bank stability because of preponderate loans to or excess investment in affiliated enterprises. In other words, the liaison between bank ownership and non-financial businesses is the underlying cause of preponderate loans and excessive investments. Basically, either of these practices can be seen as a form of misconduct in which the bank uses its funds inappropriately and ineffectively. Banks – or the conglomerates in possession of such banks – that manage businesses so inefficiently will not, in the long run, be able to survive in open competition. The inefficient usage of property originates from the monopolistic structure of the related market, rather than from the problem of ownership connections. Even if there were no ownership connections, in a monopolistic market structure, there is always the possibility of preponderate loans or excessive investment problems occurring through business connections that exist between banks and non-financial enterprises. Lending concentration discussed early in this chapter is a case in point. Universal banking management of financial activities within the financial industry and the problem of universal banking management in the manufacturing and financial industries give rise to the question: what kind of economic advantage can be realized? For a theoretical analysis, it is necessary to examine the endogenous financial industrial structure and understand the economic rationale behind different financial systems.



3.2

A framework for financial system restructuring

3.2.1

Theory of endogenous economic organization8

According to the theory of endogenous economic organization, the two factors that determine the structure of economic organization are the extent of the market and the technical conditions of production within which economic activities are carried out. The technical condition of production here is prescribed by two concepts: economies of scale and economies of scope. Economies of scale signify the technical condition by which average cost falls in accord with expansion of the production scale. Therefore, appropriate production processes that include economies of scale enjoy the advantages of mass production. By contrast, economies of scope imply that the technical condition through which economic activities are run together can reduce costs more than if the respective activities are managed separately. Economies of scope generally occur where public inputs exist. In the case where a public input can be used jointly for various activities, the integration of those activities can lower the total cost. The aspect of production is not the only area in which economies of scope arise. By lowering overhead costs and by providing diversified services in the same place, it is possible to realize economies of scope in consumption. Similarly, by integrating functions with a negative covariance of profit, economies of scope in which the fluctuation of the entire profit is mitigated can also be realized. Finally, diversification of financial investment disperses the risk and contrives the stability of profitability and realizes economies of scope. According to this theory, in a case where market demand expands, production activities that have economies of scale show a tendency for separating from other activities through the advantage of mass production. However, when the size of market demand is not great enough to realize the advantages of economies of scale, it is integrated with other activities. Clearly, these activities, which have include economies of scope, manifest an inclination for integrating the management of other businesses. The change of external parameters – that is, the effects that the size of the market or the change in production technique have on the economic organization – can be analyzed in the following way. First of all, ceteris paribus, the size of the market’s demand determines the characteristics of an economic organization. More specifically, the magnification of market demand speeds up the specialization of an enterprise, while demand reduction expedites the integration of its activities.



Changes in an economic organization can be caused by technological innovations. Those that strengthen the effect of economies of scope will reinforce the enterprise’s trend of specialization, which will encourage an organization that performs (or combines) different functions. In addition, by reinforcing economies of scale, the existing multi-function organization will generate new economies of scale. However, if the market does not grow sufficiently, specialization cannot be carried out and the enterprise will remain a monopolistic multi-functional organization. However, suppose that there has been a technical innovation that lowers the level at which the economies of scale can be realized. For the most part, economies of scale are derived from high, fixed investments. If these can be dispersed to many activities through diversification, economies of scope and reduction of the optimum production scale for each individual activity will be achieved simultaneously. The recent rise of technological innovations as global competition intensifies can help to explain the process of small-scale, multi-product flexible systems appearing in place of the Fordist-style mass production system. 3.2.2

Theory of the endogenous financial system

In the short term, the financial institutions of a state are influenced by artificial regulation from the government, but they are ultimately decided upon by the development mechanism inside the financial industry itself. Historically, financial institutions have been constantly regulated by the government – simply because financial organizations have been regarded as public and have been known to have cut corners or to have engaged in unethical activities in order to increase profits. In general, the private financial sector is inclined to lead the flow of government regulations. Therefore, competition between financial organizations usually heightens efficiency and encourages innovations and hence provides momentum for structural changes in the financial industry. Through this process, regulations of the financial industry have generally moved towards devising follow-up measures to heighten the stability and the soundness of banks. In the end, as the financial industry searches for an endogenously efficient structure, the function of financial regulation policy lies in building the conditions through which the exploration process for self-generated optimum financial structure might be facilitated. Here, we look at how the theory of endogenous economic organization can help predict the direction of endogenous responses of financial industry to the changing economic environment. In the



coming decades, world finance market integration and technological innovation will become possible sources of shock to financial industry and, thus, we may attempt to trace the trajectory of financial industry adjustment in line with the implication of this theory. One can apply the implications of the theory of endogenous economic organization to explain the endogenous processes of integration and disintegration in various financial activities. Generally speaking, the integration of various financial activities is more likely to occur if economies of scope exist among these activities. Conversely, the disintegration or specialization of financial activities is more likely to occur under diseconomies of scope among these activities, or where there is a market large enough to realize the potential economies of scale. However, the ultimate configuration of the financial structure will be determined by the nature of production technology and the market size for financial activities. Normally, the market configuration of financial structures consists of a mixture of specialized and diversified financial firms. The following hypotheses can be made in forming a theory of endogenous financial system. First, a financial firm will separate financial activities with both relatively strong economies of scale and relatively weak economies of scope from other activities. Conversely, the firm will integrate activities with both relatively weak economies of scale and relatively strong economies of scope with incumbent activities. Second, differences in the organization of financial industries within countries are determined by the dissimilarities in the sizes of their financial markets, ceteris paribus. Third, as national financial markets become more open and globally integrated, and all countries consequently confront financial markets of increasingly similar size, the financial structures of individual countries will become increasingly similar, assuming that the technological structures of individual financial industries are identical. Fourth, an equilibrium configuration in a deregulated financial industry will consist of both specialized and multi-product financial firms, resulting in a mixed form of so-called specialized and universal (multi-purpose) banking systems. Fifth, a more universal banking system will dominate the deregulated financial industry in countries with relatively small financial markets, while a more specialized banking system will predominate in countries with relatively larger financial markets. However, with specialized and universal banks co-existing, the market configuration of financial industry will ultimately be mixed.



Based on this theory, the next sections will discuss the issues of integration of banking businesses with non-bank financial as well as nonfinancial businesses. 3.3 The integration of financial businesses within the financial industry 3.3.1 Financial market opening and its implications for Korea’s financial industry Since the 1980s, Korea has continuously promoted domestic and foreign liberalization and the opening up of its economy. With the advent of the 1997 crisis and some drastic liberalization measures designed to open the domestic financial market, it is anticipated that the promotion of liberalization will progress more rapidly in the future. This change in the financial market suggests a couple of things. First, as the financial market conditions for individual economies become more homogenized, the optimal financial structure will increasingly emulate those of other economies and, therefore, national policies towards the financial system should also move towards the international norm. Recently, financial regulation policies have gradually blurred the boundaries as far as the domain of business activities is concerned. Consequently, the universal banking system is spreading globally. As the globalization of finance continues, a gradual integration of the world financial industry is expected. Thus, Korea is advised to adopt a universal banking system in order to operate efficiently, with minimum financial friction, with the rest of the world. Second, in order to survive the ever-intensifying competition caused by the opening up of domestic markets, it will be imperative to increase the efficiency of Korea’s domestic financial organizations. Flexible adaptation to newly available technological developments, as well as home-grown technological innovation, will be integral in assisting such developments. 3.3.2 Technological efficiency in the financial industry: the prospects for Korea’s financial structure In the following section, we will discuss the validity of a combination of businesses within the financial industry on the basis of the theory of endogenous financial systems and empirical estimations of scale and scope economies in Korea’s banking industry. Jwa (1994, 1995) examined Korean banking data leading up to 1994, and particularly the technological production condition of banking and investment banking activities.



According to the results yielded from this study, Korean banks are presently enjoying economies of scope in diverse activities, and, therefore, diversification of financial business activities and expansion of the business realm will contribute to the heightening of efficiency. The securities business exhibits both economies of scale and economies of scope with commercial banking businesses, which implies that inhouse integration of securities and commercial banking businesses may be optimal. This finding carries an important policy implication: inhouse integration of commercial banking and securities businesses in the Korean banking industry may not be antithetical to an efficient banking structure driven by market forces. Therefore, replacing the current specialized banking system with the universal banking system may be an optimal policy for the Korean banking industry to undertake. In addition, the credit card business operates under very strong and significant economies of scale, but no economies of scope with other banking activities have been noted. This suggests that there will be increased specialization in the credit card business away from the main body of banking activities as the market grows. Interestingly, in the global banking market, the credit card business tends to be separated from other financial businesses and managed by its own independent financial institutions. Financial institutions of the near future will advance towards broadening the combination of business between financial activities. These changes stem from the technological characteristic of their activities. Specific decisions must be made through the judgement of individual financial organizations, not by government regulation. To sum up the discussion thus far, Korea’s financial industry will gradually move on from specialization to a new system that also incorporates some of the characteristics of a universal banking system. However, a complex financial structure of this nature cannot be artificially manipulated. The only solution to this problem is to go step by step, by trial and error through the effort of each private financial organization and in this way delineate a long-term financial structure. Seen in this light, it can be concluded that the optimal financial structure is the outcome of a type of market competition. 3.4 The integration of banking activities and non-financial industry activities 3.4.1

Grounds for argument on the integration of finance and industry

The kinds of advantages that can be brought about through the integration of finance and industry depend on whether or not economies of



scope exist between financial activities and industrial activities. Generally speaking, observers fall into two categories: those who emphasize the fact that high economies of scope can be attained from the integration of finance and industry and those who underline the fact that an integration of this kind will bring about instabilities within the financial sector. As far as proponents of the first view are concerned, at least four advantages are expected. First, the integration of the manufacturing industry and banks makes possible the mutual utilization of joint input factors. Through this, we can anticipate synergy effects in the areas of cost reduction as well as efficiency improvement via economies of scope. Second, since profitability in different industries is not highly interrelated, a reduction in income volatility can be expected through diversification of activities. Third, by acquiring more information through integration, lending decisions can be made more efficient and stable. Finally, through the influx of surplus capital into the financial field, amplification of bank capital will be much easier to maintain. From a pessimist’s point of view, integrating financial activities with the non-financial manufacturing industry may damage the safety and soundness of the banking sector, eventually leading to systemic financial instability. First, combining finance with industry may cause excessive concentration. Namely, the emergence of gigantic conglomerates (encompassing both banks and industrial firms) could distort the efficient distribution of resources through the function of the market. Second, the possibility of the bank becoming the ‘private safe’ of the affiliated enterprise is much too high. Integration of banking activities and commerce and industry leads to excessive preponderate loans to the affiliated enterprises and, therefore, hampers the soundness and stability of the bank. In addition, there is the probability of unfair action and there may be policy conflicts. Moreover, banks and enterprises that are affiliated to each other have a high ‘contagion risk’ which means that it is relatively easy for the burden of a faltering loan taken on by the enterprise to be propagated to the bank. Third, it is very possible that this might cause inefficiencies within the safety net. If a deposit insurance institution is introduced when bank activities and commerce and industry become integrated, offering assistance to a bank will necessarily entail providing indirect assistance to the affiliated non-bank firms. Conversely, a situation could develop whereby the central bank has to offer assistance in order to preserve the viability of a bank which has been adversely affected by the faltering of its affiliated enterprise. In the end, this can lead to the central bank playing the role of ‘lender of last resort’ to industrial firms.



3.4.2 The technological synergy effect between finance and industry and prospects for Korea’s financial structure Jwa (1995) also reports estimates of economies of scale and scope to chaebols involved in financial activities and manufacturing industry (non-financial businesses). Of the chaebols’ many industries, economies of scale have only been recorded in investment banking businesses, while other industries have nearly exhausted the ones available. As for the individual businesses of the conglomerates, economies of scope also exist in non-financial and commercial banking as well as in investment banking and other businesses, contributing to heightened efficiency of industrial diversification. Investment banking businesses in particular show strong economies of scope. This in turn is of great benefit to increasing efficiency in launching conglomerate investment banking activities. It is also shown that investment banking businesses have a cost-complementary relationship with other chaebol businesses. This result implies that the integration between investment banking activities and bank activities, and between investment banking activities and the manufacturing industry, contributes to cost saving. In this context, it is interesting to observe that chaebols are competitively expanding their investment banking activities. However, it seems that commercial banking businesses do not record strong economies of scope or cost-complementarity with other conglomerate business. In this case, conglomerate advancements into the bank industry may not actually contribute to the heightening of overall efficiency. Why then do the conglomerates want to go into banking? This phenomenon is closely related to the fact that the Korean banking industry has been heavily regulated with entry restrictions and various protective measures, creating substantial economic rent in the banking industry for those who do manage to enter it. Of course, it may be due to the potential rent in banking businesses that conglomerates have worked so hard to get into banking, in spite of the insignificant efficiency gain. Therefore, if the pace of financial liberalization accelerates and the sources of economic rent disappear, the motive for conglomerates to participate in bank activities will also vanish. Consequently, the government must avoid policies that focus too greatly on regulating ownership, and should concentrate on eliminating the factors that caused unnecessary diversification and other motives for entering into financial activities. In addition, by examining production technologies, it seems that the present conglomerates, and the financial industry of Korea in general, have yet to experience any serious decline in efficiency from the inte-



gration of banking and commerce. This is because no evidence exists for diseconomies of scope between commercial banking and commerce. In the long run, then, as there is no clear distortion or heightening effect on efficiency in resource allocation from integration or separation, there seems little point in the government enforcing a particular ownership structure through very restrictive regulation. Rather the bank and the enterprises themselves should decide on the optimum structure through profitability analysis, taking as given the broad ownership structure guidelines. Policy makers must realize that the optimum ownership structure of finance is a purely endogenous variable, selected through the competitive process generated by the individual financial organizations in existence. However, this is not to say that we believe the issue of bank ownership to be unimportant. On the contrary, there are legitimate prudential regulatory concerns for maintaining the separation between commercial and banking activities. In our view, too much attention has been paid to the issue of separation per se at the cost of other important issues and conditions that are essential in maintaining soundness within the Korean banking sector. Moreover, some of the concerns that have been used to justify barring the cross-over of nonfinancial industries to banking business have been related to Korea’s peculiar economic characteristics – namely, a dominant role played by large chaebols in many industries and related concerns over the concentration of economic power. With the recent advent of financial market opening and foreign take-overs of Korean banks in the wake of the 1997 crisis, there is a good chance that banks in Korea will now face genuine competition, which will make it less viable for a bank to act as a private safe for an industrial group. Under these terms of increasing competition, the question of bank ownership will become less important because all financial institutions are forced to discipline themselves under the rules of the market environment.


7 Experiences of Economic Reforms in Korea and Future Challenges*

1.

Introduction

In the wake of the economic crisis, the Kim Dae-jung administration was quick to implement a series of highly publicized economic reforms. As Chapter 9 will show, these have enjoyed some success. However, with every other news item after 1997 heralding yet another addition to this ‘unprecedented series of reforms’, the foreign observer might be forgiven for concluding that the Korean economy is a complete stranger to reform. To a certain extent this is true. Despite some of the fundamental changes wrought by the processes of globalization and liberalization, and despite Korea’s apparent recognition of these trends, three decades of remarkable economic success effected to drown out the voices calling for large-scale structural reform. However, Korea is now forced to consider broad reforms, not just as a ‘quick fix’ in a knee-jerk response to the crisis, but as an ongoing process encompassing all economic sectors. This chapter explores the critical issue of institutional reform and the political economy behind economic reforms, ending with some questions about the implementation and continuance of future reforms. It is only very recently that economic reforms have commanded a higher national priority in Korea, as was the case in the United States and the United Kingdom in the 1980s, and in New Zealand in the early 1990s. Indeed, reform experiences and the following economic prosperity of these countries are truly encouraging to our endeavors in constructing a more open and liberalized economy. * This chapter is based on Sung-Hee Jwa and Jung-Il Kim (1999) ‘Korea’s Economic Reform: Political Economy and Future Strategy’ in Chung-In Moon and Jongryn Moo (eds), Democratization and Globalization in Korea: Assessment and Prospects. Seoul: Yonsei University Press. 154


Economic Reforms in Korea 155

Generally speaking, economic reforms in Korea have gained substantial momentum since 1993 and the initiatives of the Kim Young Sam administration, which were largely propelled by the growing societal demand for reforms. Beginning with the introduction of the Real Name Financial Transaction System in August 1993, a series of economic and political reforms were deliberated over and duly implemented. Nevertheless, the ex-post assessment on various reforms taken under this administration has not been universally favorable. Despite the unprecedented number of initiated reforms, many were critical, suspecting that political bias played a role in these reforms. The content and effectiveness of reforms were also questioned. Furthermore, a lack of the necessary vision and strategy to maintain internal consistency within the overall reform package was seen as a major weakness. By examining this and other Korean reform experiences, the aim of this chapter is to provide a contextual background, from which an analysis of more recent reforms under the Kim Dae-jung administration can be drawn.

2. The neoclassical interpretation of economic institutional reforms What are the ultimate aims of economic reform measures? This apparently simple question is often not addressed clearly enough, resulting in a loss of momentum and a failure to acquire the necessary public support to maintain economic reforms. Although the answer to this question is hardly a simple one, there is a growing consensus that economic reforms should be focused on promoting national economic competitiveness. In an era of globalization, a nation’s economic competitiveness can be gauged by the its capacity to supply superior quality goods and services at the lowest possible price to the world market. Therefore, economic reforms should aim to establish an economic environment that actively promotes the development of such capacities. If creating such an environment is the goal of economic reforms, the next obvious question concerns the optimal method of achieving this aim. There are two fundamentally important factors to be examined here. The first is price stabilization and the second is efficiency enhancement in a stable macroeconomic environment. Although we will discuss both conditions in this chapter, it should be noted that, in light of the direction of recent reforms, our emphasis is placed on the latter condition of enhanced economic efficiency. We illustrate our framework in Figure 7.1. Here, the aggregate demand and supply are measured in the quality-adjusted unit so that



the differences in quality can be incorporated as differences in quantity. With this interpretation of the quantity variable, the price level can be directly interpreted as a general index of national economic competitiveness. Price stabilization and the resultant cost reduction could, in principle, achieve the lower price level without changing the quantity of good supplied. In Figure 7.1, this is represented by the equiproportional downward shifts of both aggregate demand and supply curves from D°D° to DD and S°S° to SS, respectively, or equivalently, the movement from the initial equilibrium E° to the new equilibrium E with lower price but no change in output fixed at Q. The efficiency enhancement through market competition is intrinsically a supply-side measure, and hence has direct implications for the shifts in the aggregate supply curve in Figure 7.1. To simplify the analysis, we can think of two types of shift factors for the aggregate supply curve: an increase in economic efficiency (given factor inputs), and an increase in production factor inputs (given economic efficiency). Obviously, the promotion of market competition and the

Figure 7.1 Efficiency enhancement through market competition and price stabilization



associated efficiency gain will constitute the first-type shift factor of the aggregate supply curve. Moreover, if increased market competition and associated efficiency gain shifts the supply further to the right from SS to S′S′ as shown in Figure 7.1, the equilibrium quantity supplied will increase to Q′ while the equilibrium price will drop to P′. In sum, the improved national economic competitiveness can be traced as the decline in the price level from P° to P′ through the combination of price stabilization and market competition. Increasingly high factor mobility in a globalizing economy will ultimately blur the distinction between ‘resource-rich’ and ‘resource-poor’ countries, and, accordingly, the mere expansion of physical factor inputs will become a less important element in determining the national competitiveness of a country vis-à-vis the rest of the world. In contrast, economic efficiency will become a fundamental determining factor of the national competitiveness of individual countries. Practically speaking, it may be useful to summarize the economic analysis of reforms in a descriptive manner. Figure 7.2 presents a hierarchical structure of working mechanics of economic reforms. As before, the goal of economic reforms is defined as the promotion of national economic competitiveness, which can be achieved through two intermediate targets: price stabilization and the improvement in economic efficiency. Intermediate targets can be achieved by mobilizing appropriate policy instruments. In order to promote price stabilization, it is essential to maintain policy stability. Past experiences of many OECD countries show that, more often than not, Keynesian-type counter-cyclical policies Goal Promotion of National Economic Competitiveness

Target I Price Stabilization

Figure 7.2

Goal and targets of economic reform


Target II Improvement in Economic Efficiency


tend to destabilize the economy. The recent success stories of economic reforms in New Zealand and the United Kingdom also tell us that price stability and fiscal soundness are achieved not by pursuing active counter-cyclical policies, but by minimizing policy disturbances. In this context, policy stability is an important prerequisite for price stability. Under this premise, macroeconomic policies, particularly monetary policy, need to be directed towards price stability. For monetary policy, central bank independence is an indispensable asset in an effort to maintain price stability. Fiscal policy should also be aligned in a coherent manner with monetary policy in order for price stability by aiming at a budget balance in the medium term. Finally, the price mechanism must function properly in the currency market to be consistent with the increasing degree of capital market liberalization and financial integration between internal and external markets. A more detailed reform agenda for price stabilization is summarized in Figure 7.3. In order to achieve an enhancement of efficiency, which is the second intermediate target of economic reform, the major task is to create a more competitive market environment. As Hayek put it, competition is the dynamic discovery process of unknown opportunities and is the driving force for economic development and innovation. In a similar context, Adam Smith emphasized the nature of market competition as a dynamic process of competitive rivalry, although this view has not received enough attention in neoclassical economic theories. The implications of market competition on efficiency enhancement can also be discussed in the context of dynamic theories of economic growth. The old neoclassical model of economic growth (i.e. Solow’s model) emphasizes the role of technological progress as a source of growth. According to this model, the accumulation of physical capital and the expansion of labor input are important factors of economic growth, but their contribution will eventually diminish over time. As a result, growth (measured in terms of per capita GDP growth) solely based on factor input expansion will eventually halt if it is not accompanied by productivity growth. The recent emergence of endogenous economic growth theories has also shed new light on our understanding of the sources of economic growth and national competitiveness. The principal message of the neoclassical model – diminished contribution of factor input expansion on economic growth and the importance of productivity growth as a source of perpetual growth – is also shared by newly emerging endogenous growth theories. The major difference between



Figure 7.3

A reform agenda for price stabilization

the two analyses lies in the mechanics of productivity growth, or, more specifically, the mechanics of technological progress. Deviating a little from the neoclassical theories, new growth theories endogenize productivity growth or technological progress as an outcome of careful choices made by economic agents in the market. According to the new theories, productivity growth is not exogenous but is affected by the agents’ optimizing behavior formulated within the economic institutional setting in a broad sense. In this sense, economic institutional reforms can find their place in the interpretation of productivity growth envisaged by new growth theories since



Improving Economic Efficiency

Promoting Market Competition

Normalization of the Price Mechanism

Enlargement of the Realm of the Private Economic Activity

Liberalization of Price Regulation

• Removing Price Control • Liberalization of Utility Prices

Reducing Transaction Cost

Maximizing the Will to Economize

Reducing Uncertainty

Well Defined Incentive Structure

Reforms of Legal, Institution, and Customs Reducing Government Intervention • Private SectorLed Economic Management • Bureaucrat Reform • Fiscal Reform • Deregulation • Privatization • Financial Liberalization

Figure 7.4

Opening Domestic Market

• Improvement of Property Rights System • Real Name Financial Transaction System • Real Name Real Estate Transaction • Tax Reform • Labor Reform • Education Reform • Legal Reform

• Measures for Fair Distribution of Wealth • Anti-Corruption Measures

• Market Opening • Liberalization of Foreign Direct Investment

A reform agenda of economic institution for efficiency



these theories are directly intertwined with the way economic resources are organized and utilized. The competitive of the economic environment depends entirely on the institutional setting or rules of the game underlying the economic system. A fully competitive market environment requires that economic freedom be guaranteed under the specified set of fair and clear rules of the game. In this context, institutional reforms are instrumental in promoting market competition as they directly affect the ‘rules of the game’. Figure 7.4 presents more detailed agenda for institutional reforms designed to promote competition and ultimately improve economic efficiency. Here, the main emphasis is given to how to establish effective and efficient economic institutions that can support and promote competitive rivalry process. According to the framework set out in Figure 7.4, all economic reform measures should be geared toward the promotion of market competition if they intend to increase efficiency. As Figure 7.4 shows, the promotion of competition can be pursued by reinforcing the following key principles: (i) price mechanism must function properly; (ii) the private sector’s realm of economic activities must be expanded; (iii) transaction costs arising from uncertainties must be minimized by strictly enforcing the fair rules of the game; (iv) economic agents’ will to economize needs to be maximized; and (v) foreign competition needs to be introduced. More detailed reform measures in the Korean context consistent with the reform target are presented in the bottom boxes of Figure 7.4. After all, economic reforms are intended to change or improve the economic rules under which economic agents make optimal decisions about resource allocation. Therefore, in the partial equilibrium sense, economic decisions made by private agents are their endogenous responses to a given environment, and economic reforms are indirectly affecting their decisions by changing the environment. From a broader perspective of evolutionary general equilibrium, however, nothing is exogenous. Economic reforms are also societal choices made in the context of the evolution of the society.

3.

A brief evaluation of institutional reform

The Kim Young Sam administration (1993–1997) implemented various institutional reforms but, with a few exceptions, these failed to achieve visible outcomes. The reform agenda was set out for a number of areas



in the early phase of the administration. Major areas for reform were as follows: •

•

•

•

•

•

The Real Name Financial Transaction System and Real Name Real Estate System to increase the transparency in financial and real estate transactions by enforcing the use of the real name in those transactions. Financial reform to liberalize interest rates, the bank management and various financial transactions including capital flows and exchange transactions. Deregulation to remove various restrictions on economic activities, including price regulations, quantity restrictions, entry barriers, industrial protections and so on. Public sector reform, including fiscal expenditure and tax reform, reform of bureaucrat system and the privatization of public corporations in order to increase the efficiency of the public sector. Labor market reform to increase the flexibility of the labor market adjustment by relaxing various restrictive measures on labor mobility such as restrictions on layoff and firing and by rationalizing the union power. Market opening via imports, FDI, and capital flow liberalization.

The theoretical framework of economic reforms in the previous section suggests, at the risk of oversimplification, that these reforms should aim to promote competition in the economy and thereby strengthen the competitiveness of the national economy as a whole. However, with hindsight we can see that the policy makers in charge of economic reforms did not fully understand the complex nature of economic reform. This seems to be the main cause for the relative failure of various reforms. Without fully comprehending the mechanics of the proposed reforms, policy makers failed to present their reform agenda convincingly to the general public and were unable to maintain the necessary momentum for successful reforms. In this context, it seems that a large gap existed between the reform targets and the actual measures implemented. For example, financial reform aimed at liberalizing the financial industry was tackled with the implementation of new ‘guidelines’, argued as crucial to an orderly liberalization process. In reality, however, these amounted to nothing but additional regulations. This process of ‘regulated deregulation’ in the financial industry severely impeded the fostering of a commercial spirit that might have jump-started true national competitiveness. Ten years



of supposed financial reform did nothing to waylay the onslaught of what many see as the inevitable financial crisis in 1997. Legal and institutional reforms were intended to decrease uncertainties and therefore transaction costs by increasing the transparency of ‘the rules of the game’. However, in many cases, institutional reform tends to affect the existing property right system, in which case there is a strong possibility that the reform could itself become a source of uncertainty. The introduction of the Real Name Financial and Real Estate Transaction System actually turned out to be a case in point. The stated purpose of these reforms was to increase transparency in those transactions and to increase the perceived fairness of the tax system, which, in the end, would contribute to the reduction of economic uncertainty. However, in the process, these reforms were utilized as a ‘general means’ to detect wrongdoings related to bribery and to crack down on the corruption deeply rooted in the Korean political, big business and bureaucrat sectors. As a result, these reforms tended to actually increase the financial uncertainties. In particular, the Real Name Financial Transaction System was eventually suspended after being enacted and implemented for a short time period, due to the unexpectedly high negative economic impact on the economy. In the end, the lack of understanding of the nature of institutional reform on the part of the policy makers made it difficult to maintain the momentum behind reforms and the usual political economy of economic reform encroached upon the whole process. In the next section, we will discuss Korea’s experiences of the political economy of economic reform.

4.

The political economy of economic reform

Economic reforms in Korea during the 1980s and the early 1990s faced substantial resistance from the public and from vested interests, and were thus of limited success. The limited success, or in some cases failure, of the past reforms are clearly reflected in the fact that practically the same reform issues were raised time and time again for more than a decade. The conventional reason given for a reform’s lack of success is that the benefit of reforms tends to be diffused across segments of society and over an extended period of time. In contrast, the cost of reforms is likely to be concentrated among a small group of people within a short period of time. Although this argument has some merit, it does not constitute a sufficiently satisfactory explanation for the delayed or



unsuccessful reforms in Korea. In order to make a more convincing argument, we need to examine the fundamental characteristics of economic reforms as well as the incentive and power structure of the concerned economic players in Korea. To begin with, it should be noted that economic reforms almost always involve a reshuffling of economic benefits or privileges among concerned parties. For instance, trade liberalization in the long run tends to benefit both domestic consumers and producers; consumers benefit from an expanded choice and lower prices, while domestic producers strengthen their international competitiveness through increased competition. In the short run, however, trade liberalization tends to squeeze the domestic producer’s margin of profit because of increased foreign competition in the domestic market. Given the monopolistic structure of the domestic market in Korea, the producer’s cost of trade liberalization (that is, their reduced profit margins) may well be substantial. Such large costs borne by domestic producers impeded trade liberalization in Korea, as implied by the conventional argument of diffused benefit and concentrated costs of reforms. This observation presents an interesting irony. Note that economic reforms are more of a necessity in an economy with significant market monopoly power. Unfortunately, however, the more the market is concentrated, the less likely are economic reforms to succeed. Korea is currently faced with just such a vicious circle.1 Second, in terms of its organization and policies, the Korean government has long inclined towards the protection of producer interests. As in Japan, the Korean government is organized into various economic ministries that represent or protect producer interests. Third, the government’s prolonged market intervention on the basis of industrial policies created substantial inertia in the expectations of the private sector with respect to resource allocation through nonmarket measures. In other words, incumbent firms, workers and interest groups in the market continued to expect government involvement in resource allocation to work in their favor. Predictably, it has been very difficult for the government to operate when such expectations are held by incumbent market players. Fourth, in certain areas of reform the strong resistance of bureaucrats has posed a serious obstacle. The bureaucrats as regulators are inclined to keep their regulatory power over the private sector. As the power of private sector grows along with the increasing trend of political as well as economic liberalization, the bureaucrats’ resistance accordingly strengthens so they do not lose regulatory power. Deregulation or lib-



eralization reform is the area most adversely affected by the political interest of the bureaucrats. Deregulation reform has been evaluated so far as only a mediocre success, despite supposedly having been vigorously implemented for a decade. Last but not least, we must look at the power structure of the key economic players. This has changed significantly since the late 1980s in such a way as to be less favorable to economic reform. Most of all, the predominance of the government in resource allocation and economic coordination has gradually faded in accordance with political democratization since the late 1980s. As can be seen clearly from the industrial rationalization measures implemented in the early and mid1980s, the military government was able to exercise almost unlimited power in resource allocation, whenever required, equipped as it was with not only legal authority but also strong political leverage. Under the civilian regime established in 1993, however, the government’s discretionary intervention, or coordination in resource allocation, was somewhat limited by resistance from concerned parties within the private sector. At the risk of oversimplification, it can be said that there have been four major economic players with influential voices in Korea: government, chaebols, small and medium-sized enterprises (SMEs), and labor unions. Consumers, despite their size, have been a rather silent and therefore disregarded element in policy making and in the struggle for resource allocation. Until the mid-1980s, the government was the dominant player, exerting substantial influence on others. Since the late 1980s when political democratization took force, however, the government’s status in the political power structure was downgraded to being just one of many major economic players. Consequently, the government’s co-ordinatory function in resource allocation weakened significantly, while the power of the other players increased. This has made it extremely difficult for Korea to obtain internal momentum for its economic reforms due to the conflict of interests that arise. However, there has been an increase in the role of the Korean government since the onset of the 1997 economic crisis. This increase in the government’s role has been justified to some extent by the special circumstances the Korean economy has faced since the crisis. Increased prominence of the government’s role in the Korean economy has more to do with one-off structural adjustments than conventional countercyclical pump-priming policy actions. For example, the post-crisis economic landscape called for a massive revamping of the banking



sector, which was seriously plagued by non-performing assets accumulated over time. Given the dire economic conditions, the government was the only agent with the ability to mobilize funds necessary for these efforts. A rapid rise in unemployment, accompanying the close to 6 per cent contraction in real GDP in 1998, was another key area that demanded urgent government attention. For an economy that had never had to deal with any substantial unemployment problems in the past and thus equipped with only a very minimal social safety net, an unemployment rate above 8 per cent does pose a serious threat. Consequently, it would be fair to say that the government should become more active in these areas. However, if economic reforms are to be successfully initiated and implemented, they will also require an additional external thrust. The most likely candidate for an ‘external force’ to propel current and new economic reforms is foreign competition. This would effectively remove market distortions and at the same time serve to discipline the domestic market. One may argue that the decision to open a nation’s market is in fact an endogenous policy choice, requiring a complex process of internal consensus building, and therefore not technically an external force. However, if we consider the reasons behind the efforts of Korea and other nations to join organizations such as the OECD, we see the growing need for multilateral co-operation at a time marked by global trends of increased economic liberalization and negotiations between countries. The emergence of the World Trade Organization has made it clear that countries that do not fully open their markets in accordance with the principle of a ‘level playing field’ will face the high costs of economic isolation. While it might have held true in the past, market opening is no longer an internal decision to be made after due bureaucratic processing. It is an unavoidable consequence of globalization. If anything has shown the crucial importance of external pressures in pursuing domestic economic reforms, the actions of the IMF and the World Bank certainly did so. The financial support of both institutions at the close of 1997 was contingent upon Korea’s acceptance of the strict economic reforms drawn up by the two organizations. Following the IMF proposal, all non-tariff barriers to imports have now been removed and Korea’s domestic industries are now fully exposed to foreign competition. In addition, the government has become significantly constrained in the protection of favored domestic firms or specific sectors via financial or regulatory means.



Such outside forces fundamentally changed the nature of the game among the major players from that of bargaining to one of coordination; all players are now more concerned with the total size of the economic pie than in previous times. Furthermore, Kim Dae-jung’s administration is now able to appeal to an economic rationale to initiate reform measures, relying less on the coercive and discretionary power relied upon by the former non-democratic administrations. It is important, however, to recognize that outside forces do not solve all problems. Internal factors, such as the government’s strong commitment to reforms and effective political leadership, are still indispensable ingredients of successful economic reform.

5. 5.1

Lessons for future economic reforms Systemic approach

Korea needs to adopt a more systemic approach in pursuing economic reforms. A clear vision of the desired objectives should be established at the outset. Since economic reforms involve the reshuffling of economic interests and privileges, public support is essential for the success of these reforms. In order to obtain such support, a clear vision of reforms must be presented to the public. Reforms should also include intermediate targets and tangible instruments with which to carry them out. As for the final goal and the intermediate target of economic reforms, the notion of a free and open market economy and fair competition should be looked to. It is important to recognize clearly that the Korean economy is a small and open economy whose prosperity is heavily dependent on international trade and investment. This implies that Korea has no other choice than to adapt its economic institutions and rules to the international norm of a free market economy and fair competition. Second, liberalization or deregulatory reform in the microeconomic setting should go hand in hand with a new paradigm of macroeconomic management based on the free market principle. Macroeconomic management based on direct regulations on prices and various economic activities has been a stumbling block to economic liberalization. Therefore, in a macroeconomic management, the price mechanism must be respected and indirect controls established. Efficiency gains from market competition can be maximized only if macroeconomic management is in alignment with the free market principle.



Third, the allocation of benefits from economic reforms across concerned parties needs to be matched with the allocation of costs associated with economic reforms. For example, the cost of trade liberalization borne by domestic manufacturers needs to be compensated for by benefits arising from freer access to the financial market through financial liberalization and to the foreign financial market through financial market opening. Such a matching scheme will be valuable in helping the government in obtaining public support, and, hence, for maintaining the momentum of reforms. Finally, the reform measures or instruments should be congruent to the goal and targets of reforms according to the framework set out in the previous section. As mentioned earlier, the goal and targets of institutional reforms have not been well understood by policy makers, making it difficult to implement the consistent reform measures. They have tended to focus on regulation of economic behavior in the name of economic reform rather than on the underlying incentive and institutional structure that gave rise to observed behavioral patterns. Therefore, in many cases, reform efforts failed to achieve the intended goal or effects because the reform measures were designed and undertaken, usually in the contradictory manner to the goal of the reforms. Institutional reform measures sometimes created uncertainties. Needless to say, this was an outcome diametrically opposed to the intended purpose of those reforms – reducing economic uncertainties. In addition, many regulations regarding economic behavior tended to increase rather than reduce economic uncertainties. Such inconsistency between goal and targets and measures and instruments increases uncertainties and confusions on the part of the private agents and creates distorted incentives, which is exactly what reform efforts attempt to avoid. 5.2

The optimal sequence of reforms

It is neither practically feasible nor desirable to implement various reforms at the same time. In addition, it takes time to see if reforms are having the desired effects. In this sense, reform is a dynamic process, and a sequential approach is therefore inevitable. Given this premise, an important issue to be addressed is the optimal sequence of reforms. Since the late 1980s, discussion on the optimal order and procedure for economic reform have been taking place based on the experiences of South American economies and former socialist economies,2 leading to the following ‘rules of thumb’ as regards minimizing adjustment costs:



The domestic market must be liberalized prior to opening the market to foreign competition. • Reforms must first be carried out in the areas where the speed of adjustment will be slower than in others. For example, liberalizing the labor market should come before financial liberalization and trade liberalization should come ahead of financial and capital flow liberalization. •

Several recommendations can be made with respect to the optimal sequence of reforms. First, the implementation of reforms with a longer gestation period needs to be afforded a higher priority. According to this principle, economic reforms should precede political reforms. For economic reforms to fully settle into place, economic practices and mind-sets also need to be adjusted in conjunction with institutional changes – a process which takes a long time. On the other hand, political reform can be executed in a relatively short period of time, as has been demonstrated in the former socialist economies. Therefore, the pace of political transformation will be quicker than that of economic transformation. Interesting observations regarding this principle can be made from the examination of two different transition economies – China and Russia. In China, economic reforms preceded political reforms, while the opposite is true in the case of Russia. China’s successful transformation is a sharp contrast to Russia’s current economic stagnation. Second, within economic reforms, internal reforms (domestic market reforms) need to precede external reforms (market opening). This is because when there is a market opening, an external shock occurs. Its adverse effects can only be minimized when domestic markets and institutions are capable of absorbing them. This principle is particularly relevant for financial market openings and internal reforms in the financial sector. However, this principle produced a typical moral hazard problem in Korea. In fact, this ‘internal before external’ principle was exploited by the government during the 1980s, and, until recently, it was used to delay the capital market from opening. The result was that the capital market did not open and that no noticeable internal reforms in the financial sector occurred as the government and the financial industry had little incentive for internal reform in the absence of the potential threat of foreign competition. However, New Zealand’s experience shows that, as important as optimal order for reform may be, the most important lesson is to carry out reforms with an efficient comprehensive package that will help to maintain the momentum of reforms.3



5.3

Resolving the problem of moral hazard

Perhaps the most serious impediment to structural adjustment in Korea is the moral hazard problem plaguing the economy. This problem has become a much more prominent issue, thanks to the observations of both foreign and domestic commentators, who have pointed out moral hazard as one of the key factors that led to the outbreak of the 1997 crisis. In fact, most of the moral hazard problems are legacies of the past government-led development, during which the government not only provided various financial supports to private firms, but also acted as an effective risk-sharing partner to them. Particularly in the 1970s when the government intensely promoted the heavy and chemical industries (HCIs), it had to provide an insurance policy, either implicitly or explicitly, against the high investment risk in order to induce private firms to actively join the so-called HCI drive. In the 1980s, many firms in the heavy industry sector experienced financial troubles, and the government bailed them out by using fiscal resources and special central bank loans. Such prolonged government intervention neither allowed the market to function properly nor encouraged the private sector to become autonomous and responsible for its own deeds. Consequently, the private sector – particularly firms – developed the bad habit of depending heavily on the government. Even worse was the dual character of the private sector. Private firms called for deregulation and liberalization when it suited them, but they strongly urged government intervention whenever they fell into serious financial trouble. Eventually, the private sector started to exploit the government’s capacity to bail out struggling organization, signifying a moral hazard problem. Patent examples of moral hazard problems can be easily found among the recurrently surfacing chaebol issues and from the bad loan issues within the banking sector. The well-known ‘too big to fail’ argument surrounding the chaebols’ behavior significantly constrained government policies. The interlocking capital structure and cross-debt guarantee of the chaebols made it almost impossible, both politically and economically, for the government to leave troubled subsidiaries of chaebols by the wayside. The chaebols correctly recognized and exploited this incentive structure and tended to make ambitious investments without supporting calculations of the returns and risks, or based on calculations that consider only the upside outcome. The issue of bad loans in the banking sector also exhibited exactly the same incentive problems. Banks had little incentive to write-off bad loans



and restructure their management, simply because they expected the government to rescue them in the event of any trouble. Future reform efforts must take into account these moral hazard problems from the initial stage of reform design to the final phase of implementation. There should be enough discussion and research of the incentive structure of private agents at the design stage, while no compromise should be made on moral hazard incentives during the implementation phase. More importantly, however, an effective institutional reform must be devised to directly tackle the moral hazard problems which are so pervasive in the economy. The most effective (and perhaps the only feasible) strategy of tackling the economy-wide moral hazard problem is to legally tie the government’s hands to some extent. It should be noted that most moral hazard problems in Korea are associated directly or indirectly with the government’s inclination to intervene in microeconomic resource allocation decisions. Therefore, freeing the government from political pressures or a self-generated tendency for intervention would be a much more effective strategy than tackling each moral hazard problem with separate measures. In this context, the role of the government in economic management needs to be reconsidered. The government should strive to complement the market rather than act as a substitute for it. The government reforms to be carried out in the future should address these issues, and should institutionalize the boundary of the authority and responsibility of the government, clearly defining what the government should and should not do. 5.4

Strict enforcement and government reputation

As we have seen, economic reform is a dynamic process, and a sequential approach is inevitable. In this context, the issue of government credibility or reputation has considerable significance. The failure of one reform is likely to adversely affect the success of other reforms in the package. Furthermore, if the government fails to be firm in the enforcement of implemented reforms, the whole reform package is likely to unravel. Therefore, in addition to juggling the different reform measures, the government must also maintain the momentum of each reform measure. Real reforms can only be acquired through a strict enforcement of implemented measures, allowing no exceptions. The slightest display of favoritism will be detrimental to the success of any reform. The importance of adhering to the reform package can also be under-



stood from the experiences of South American countries. In order to control hyper-inflation, in the 1970s Argentina and Chile implemented similar reform measures of fiscal and monetary policies. However, the results were drastically different: Chile enjoyed considerable success while Argentina failed. In Argentina, fiscal deficits were not reduced to a level compatible with the disinflation target, although monetary policy was in line with the pre-announced target.

6.

Concluding remarks

Korea’s economic reforms are a long way from completion; despite recent accomplishments, there is still much more to be done. Given the structural problems evident in every sector of the economy, as well as the rapid and systemic changes in the external environment, further economic reforms are imperative. Political democratization has brought about changes in the preferences and constraints of the government. Former governments, operating under military regimes, were less enthusiastic about economic reforms, but their political environments were more favorable with respect to economic reforms. By contrast, though democratic governments have appeared to be more interested in economic reforms, they have also faced some stringent political constraints. If this is true, the previous administration’s initiatives for economic reforms should be positively evaluated. The reason is that, regardless of their success, such initiatives will set the tone for future reforms. In pushing for economic reforms, the government has a pivotal role to play. After all, economic reforms are mostly institutional reforms, and, hence, the lion’s share of the responsibility for reform efforts should be ascribed to the government. In this sense, government reform is a prerequisite to the success of other economic reforms. Although the external environment, such as the international pressure for market opening, can provide other potential stimuli for reforms, knowing how to realize this potential is the main challenge facing the Korean government today. In this chapter, we have also attempted to identify some key reform issues, although much of the discussion surrounding the future direction of reforms is reserved for Chapter 9, which deals with the reform efforts to date of the Kim Dae-jung administration. Some readers may feel that other areas where reform is an important issue have been overlooked in this section. While it is true that reforms will eventually be necessary in most areas of the Korean economy, we believe that



many essential changes will take place following the key reforms discussed in this chapter. One issue that has received some attention of late is the growing income gap in all aspects of the Korean economy. Thirty years of government policy geared towards rapid growth and industrialization have also seen a continual widening of the income gap between the chaebols and small or medium-sized enterprises.4 In the same way, a conspicuous trend of increasing imbalance has also developed between growth in industry and in agriculture as well as between labor and capital.5 These kinds of disparities, clearly the result of inefficiencies in the management of national resources, are detrimental to the sense of national unity that has helped propel Korea to achievement so many times in its past. While these areas clearly need to be addressed, it cannot be denied that they must currently, take a back seat to reform measures that deal with more pressing structural demands.


8 Korea’s 1997 Currency Crisis: Causes and Post-Crisis Macroeconomic Developments*

1.

Introduction

Thus far, this volume has sought to equip the reader with a solid understanding of the inherent weaknesses of the Korean economy. Apart from providing a general overview of economic policy patterns and their results, we have focused on significant shortcomings within the structural environment, as well as in the industrial, financial and banking sectors. Heavily burdened by these characteristics, it has been suggested that the Korean economy could not help but falter. This chapter aims to show how these weaknesses, coupled with some exogenous factors, led to a severe currency crisis in 1997. We go on to give an overview of post-crisis macroeconomic developments under the IMF program with some reflections on the IMF prescriptions. By the mid-1990s, the Korean economy appeared to have leveled off, having reached a plateau of a high single-digit growth rate. As the world’s 11th largest economy, Korea’s newly found stature was officially acknowledged in 1996 when it became a member of the OECD. At the beginning of 1992, general inflation, measured in terms of the GDP deflator, stabilized at just above 5 per cent. There was no real concern over the financial condition of the government, as it had generally maintained a balanced budget over the years. A current account deficit persisted but hardly seemed to constitute a cause for alarm. In fact, in the previous ten years, the deficit never rose beyond 5 per cent of GDP. These indications were all drawn from key Korean

* This chapter derives from ideas in Sung-Hee Jwa and Chan-gook Huh (1998) ‘Korea’s 1997 currency crisis: causes and implications’, Korea Journal, 38(2) (summer), pp. 5–33. 174


Table 8.1

Key macroeconomic variables for 1990–1998 (growth rate, %)

Real GDP Real Consumption Real Investment Imports in million US$ (growth rate) Exports in million US$ (growth rate) Current Account Surplus/deficit (million US$) C/A balance to GDP ratio Producer Price Index Consumer Price Index Monetary base M2 Unemployment rate Exchange rate (Won/US$)

1990

1991

1992

1993

1994

1995

1996

1997

1998

9.0 9.2 25.9 69 844 (13.6) 65 016 (4.2)

9.2 7.9 13.3 81 525 (16.7) 71 870 (10.5)

5.4 5.6 –0.7 81 775 (0.3) 76 632 (6.6)

5.5 5.4 6.3 83 800 (2.5) 82.236 (7.3)

8.3 7.1 10.7 102 348 (22.1) 96 013 (16.8)

8.9 8.2 11.9 135 119 (32.0) 125 058 (30.3)

6.8 7.2 7.3 150 339 (11.3) 129 715 (3.7)

5.0 3.2 –2.2 144 616 (–3.8) 136 164 (5.0)

–6.7 –9.8 –21.2 93 281 (–35.5) 132 3131 (–2.8)

–2 003

–8 317

–3 942

990

–3 867

–8 508

–23 005

–8 167

40 365

–0.8 4.2 8.5 7.7 17.2 2.4 708.0

–2.8 4.8 9.3 18.2 21.9 2.3 733.6

–1.3 2.1 6.3 10.9 14.9 2.4 780.8

0.3 1.5 4.8 27.5 16.6 2.8 802.7

–1.0 2.7 6.2 9.2 18.7 2.4 803.6

–1.7 4.7 4.5 16.3 15.6 2.0 771.0

–4.4 3.2 4.9 –12.2 15.8 2.0 804.8

–1.7 3.9 4.5 –12.5 14.1 2.6 951.1

12.7 12.2 7.5 –8.1 27.0 6.8 1398.9

175



macroeconomic data until the end of 1996 (see Table 8.1 for trends in key macroeconomic variables in the 1990s). However, the situation started to deteriorate rapidly in 1997. The speed with which foreign exchange liquidity problems reached crisis proportions caught many observers by surprise. Beneath the hitherto placid surface, some potentially serious structural imbalances had been building up over some time. A lack of a self-regulating price mechanism proved to be a fundamental cause of some of the problems. Many viewed the government-led Korea’s economic growth experience as a development model success story in which the government could play a more important role in making resource allocation decisions vis-à-vis markets. Lack of competition in goods markets gave rise to inefficiencies within the corporate sector. Scarce bank credit was used as a key inducement, made inexpensively available to businesses entering the industries targeted by government policy. Such policies created a weak banking sector. Prudential regulations took a back seat to financing industrialization. One immediate consequence was the increase in lending concentration. Another was heavy reliance on cheap foreign short-term capital, encouraged by the recent capital flow liberalization (a precondition for membership of the OECD). Even allowing for an overreaction by foreign investors, the ground was already fertile for such a liquidity problem to bloom into a crisis of full-blown proportions. Our approach here is to provide a systematic account and analysis of the recent developments in and outside Korea, rather than merely to compare data to a particular theoretical model. In our judgement, any shortcomings that arise from not using a specific frame of reference are adequately compensated for by the benefits of offering general descriptions and analyses of factors that have been key in the evolution of the recent crisis. Already, there is a growing body of literature offering a variety of theoretical frameworks to explain the recent crises. Many of them focus on some kind of structural problem such as an excessive implicit government deficit arising out of various implicit and explicit governmental guarantees that had been commonly present in all the affected ASEAN economies, as well as in the Korean economy. Among the most comprehensive are Burnside, Eichenbaum, and Rebelo (1998) and Corsetti, Pesenti, and Rubini (1998). Other authors place more emphasis on the ‘self-fulfilling prophecy’ aspect of the crisis (Radelet and Sachs, 1998). Perhaps one critical point in the theories that focus on some serious structural misalignment is that they require all the affected countries to hit the threshold point more or less at the same time. This is conceivable, of course, but not all that likely.1 The ques-


Korea’s 1997 Currency Crisis 177

tion of a universally accepted explanation of the currency crisis is an open one – at least at the time of writing – and will continue to be so for the foreseeable future. Our purpose is not to adopt a particular theoretical framework and carry out a formal test of its explanatory power but rather to provide an organized overview of structural, cyclical and policy circumstances that appeared to have contributed to the outbreak of the crisis in Korea. In that, our approach differs from the work listed earlier as well as from some accounts offered by Korean authors. For example, Lee and Lee (1998) employ a stylized model of key macro variables to explore whether or not the foreign exchange crisis could have been predicted based on the behavior of a set of key macro and external conditions. In our view, a stylized macro model is not complex enough to incorporate the various structural imbalances that contributed to the crisis. To the extent that many of the problems stem from a mixture of microeconomic and macroeconomic features, a model that focuses on macroeconomic variables alone is unlikely to prove adequate. In considering main causes of the immediate crisis, it is our opinion that it was a combination of measures undertaken by the Korean government in 1997 that triggered the blow-out, rather than any one particular policy measure implemented during the second half of the year. Some Korean authors have understandably focused on trying to find the key catalyst behind the crisis development in late 1997. For example, Park and Rhee (1998) point out the Korean government’s blanket guarantee of deposits and interest on all deposit at all financial institutions including technically insolvent ones in October 1997. Some point to the effective nationalization of the failed Kia Motors and the downgrading of credit ratings of the Korea Development Bank’s papers by Moody’s that closely followed on its heels. The KDB papers carrying de facto sovereign ratings of Korea were traded in international capital markets. Our own view is that under the circumstances faced by the Korean economy, nothing short of a complete removal of the exchange rate band sometime in early 1997 could have made a difference. The crucial factors were the structural backdrop, the Korean government’s insistence on the strong won policy until early 1997 and the breakout of the ASEAN crisis in the summer of 1997. It might be useful to compare our views with those of many commentators who made observations about the Asian financial crisis. We tend to agree with the numerous commentators who cited macroeconomic and institutional fundamentals (Krugman, Stiglitz, Greenspan,



Fischer) and moral hazard (Krugman, Stiglitz, Greenspan) as key contributing factors to the crisis. A weak regulatory system and ineffectual corporate governance and a lack of transparency in various financial data are typically cited in these analyses. We also agree with the view that attributes a good part of the blame to exchange rate overvaluation (Sachs, Stiglitz, Greenspan, Fischer). However, we maintain that macro and international factors such as a worsening current account deficit were not as critical in Korea as some commentators have reported them being in other countries. We believe that exchange rate overvaluation in Korea and attempts to support it constituted the single most obvious policy mistake. Speculative attacks were a definite link in the chain of events, but we do not assign them a central role in the manner of authors such as Sachs. Aside from reasons related to the rapid movement of international capital flow, both structural and cyclical causes for the recent crisis were also in existence. Understanding these factors and how they contributed to the crisis will be invaluable to both policy makers and academicians in Korea and abroad. The next crisis will almost certainly be of a different variety. Nonetheless, a clear understanding of this one cannot help but give us an advantage in preparing for the next one. In this chapter, we provide an overview of key structural as well as cyclical issues using anecdotal evidence and descriptive statistics. The appendix offers a time series Vector Error Correction Model (VECM) of nominal wage, labor productivity, and inflation. In particular, we maintain that Korea’s strong won foreign exchange policy should be held accountable for a large portion of the crisis. In addition, we examine cyclical and short-term Korean macroeconomic and external developments in 1996 and 1997.

2.

A quick look at the crisis itself

This section sketches the key events of Korean financial markets during the latter part of 1997. The single most important development in the period leading up to Korea’s financial crisis was the currency crisis among the ASEAN countries in mid-1997. In the course of these events, the focus of the international capital market naturally shifted towards what was seen as the next set of vulnerable economies – that is, the four first generation tigers (Hong Kong, Singapore, Taiwan, and Korea) with the potential for exchange rate misalignments. International investors started to probe these countries from August for ‘quick profit’ opportunities. Already beset by a series of bankruptcies in large firms that had broken out early in the year, Korea appeared particularly vulnerable.



The uneasiness felt by international investors over the Korean situation manifested itself in several ways. After hovering near 750 in June and July, the KOSPI (stock price index) started to fall rapidly in September. It reached a nadir of 350.7 on 12 December. This falling trend more or less reflected the large-scale exit by foreign investors. Foreign investment in the Korean equity market shrank rapidly by about $1 billion in November alone. From November 1997, Korean banks started to face severe difficulties in rolling over their short-term foreign borrowing. The roll-over rate fell from about 80 per cent in October to close to 50 per cent in November, then to about 30 per cent in December. Korean banks faced the worst in December when only about 30 per cent of their foreign counterparts agreed to extend credit on an ongoing basis. Short-term credit extensions to Korean financial institutions fell to about $46 billion from the 1996 level of $65 billion. The amount fell even further to $29 billion in December 1998. Such a constriction of foreign credit accompanied an accelerated downgrading of Korea’s credit rating, as shown in Table 8.2. The exchange value of the Korean won started to fall precipitously in late 1997. The $/won rate fell by 11.4 per cent and 44 per cent in November and December, respectively. Concurrently, the daily exchange band within which the exchange rate was allowed to fluctuate was widened from 2.25 per cent to 10 per cent in the second half of November. This band was abandoned altogether in mid-December. Foreign exchange authorities started to intervene in the FX market from early 1997 to prevent a rapid fall in the exchange rate, expending a substantial amount of foreign exchange reserves. The usable reserve level had fallen to below $10 billion by late November (Table 8.3). Together, these developments raised the real prospect of a debt moratorium. This perception added to the urgency felt by both foreign and domestic investors in their stampede to sell off won holdings. Seeking to avert a crisis, the Korean government made a request for IMF financial aid on 21 November. The IMF package involved about US$58.3 billion dollars including the line of credit from 13 countries.

Table 8.2

Rapid deterioration in Korea’s credit rating

Standard and Poor’s

23 Oct. 1997

25 Nov. 1997

11 Dec. 1997

23 Dec. 1997

17 Feb. 1998

AA–

A–

BBB–

B+

BB+


180 A New Paradigm for Korea’s Economic Development Table 8.3

Official foreign exchange reserves ($ billion) 1997 Sep.

Nov. Dec. Jan.

1998 Feb. Mar. Apr. May Jun. July

Aug. Sep.

Total 30.4 24.4 20.4 23.5 26.7 29.7 35.5 38.8 41 43 45.1 47 reserves Held at 8.0 16.9 11.3 11 8.2 5.6 4.8 4.4 3.9 3.7 3.7 3.6 overseas branches Usable 22.4 7.3 8.9 12.4 18.5 24.1 30.8 34.3 37 39.2 41.4 43.4 amount Source: Bank of Korea.

The IMF alone committed US$21 billion dollars to be disbursed over a three-year period. The IBRD and the ADB committed US$10 billion and US$4 billion respectively and the rest was made up of credit lines extended by various countries. The IMF intervened and extended the first installment of its agreed financial commitment, a US$10 billion emergency loan, on 24 December 1997.

3.

A deeper look: structural and long-term factors

Unfortunately, there are a number of long-term structural problems that have provided fertile ground for the recent crisis to germinate upon. Bolstered by the success of a government-led growth strategy dating from the 1960s, key economic players – government, businesses, academia – took active government intervention to be most suitable for Korea. A similar experience in Japan during the rapid growth period also provided a useful benchmark. As in many other areas, both foreign exchange demand and supply (quantity) as well as exchange rate (price) were heavily regulated. The obvious and direct legacy of such history has been the lack of a self-correcting price mechanism. In addition, active intervention on the part of the government has stunted the growth of market institutions that ordinarily accompany growth and the maturing of an economy. One critical area where this happened was within the banking sector. After operating under a regime that did not allow for much autonomy, the lending behavior of banks was greatly impacted by moral hazard problems. We will review these key items.



3.1

Mode of external financing

Korea relied on foreign borrowing by the government or banks rather than on foreign direct investment (FDI) for her industrialization. Foreign borrowing was necessary as rapid growth in investment almost always outpaced that in domestic savings. For some reason, very little emphasis was placed on inward foreign direct investment. Table 8.4 and Figure 8.1 show some relevant data that indicate the extent to which Korea relied on foreign direct investment in relation to other sources in order to finance the industrialization effort. Table 8.4 shows, in terms of both absolute size, as well as in proportion to the gross domestic capital formation, that FDI has actually been quite modest. This has been the case even when compared to other Asian economies at different stages of development. For example, in proportion to the overall size of capital formation, FDI measured up to about 1 per cent or less for six years running since 1990. In Indonesia, ranked above Korea in terms of reliance on foreign direct investment, FDI made up between 2.8 per cent and 8.5 per cent of overall capital formation. In comparison, the ratio ranged from 12.1 per cent to 26 per cent in Malaysia. FDI in Korea was similarly minimal in the 1980s. According to Figure 8.1, Korea’s outward direct investment overtook inward investment in 1988–1989 period. Figure 8.1 also shows that FDI has been dwarfed by external debt in Korea. The right- hand scale, which measures the external debt, is about 30 times that of the left-hand scale, which measures FDI. At the same time, tight controls have been imposed on corporate borrowing from abroad.2 This placed excess demand on bank funds, which in turn pushed banks to borrow from abroad. In addition, since Table 8.4 Ratio of FDI flows to Gross Fixed Capital Formation in the Asian countries most affected by the financial crisis, 1990–96 (%) Country Indonesia Republic of Korea Malaysia Philippines Thailand Memorandum: South, East and South-East Asia

1990

1991

1992

1993

1994

1995

1996

2.8 0.8

3.6 1.0

3.9 0.6

4.3 0.5

3.8 0.6

6.7 1.1

8.5 1.3

16.8 5.2 7.1

23.8 6.0 4.9

26.0 2.1 4.8

22.5 9.6 3.6

15.9 10.5 2.3

12.1 9.0 2.8

13.2 7.3 3.2

4.0

3.9

4.5

6.5

7.3

7.3

8.2


182 A New Paradigm for Korea’s Economic Development 5000

Investment ($million)

Debt ($billion)

4000

140 120 100

3000

80

2000

60 40

1000

20 0

0 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 OUTWARD DIRECT INVESTMENT TOTAL EXTERNAL DEBT

INWARD DIRECT INVESTMENT

Figure 8.1 Outward direct investment (left scale), inward direct investment (left scale), and total external debt (right scale)

the early 1990s, the Korean government had adopted policies to discourage long-term borrowing, leaving banks no alternative other than to rely heavily on short-term foreign borrowing.3 This led to the accumulation of a large stock of foreign debt and a vulnerable foreign liability structure. 3.2 Strong industrial policies, weak banking sector and high leverage ratio The strong industrial policy pursued by the government for several decades has left clear marks on Korean industrial organization. Using easy credit as the main inducement, the Korean government encouraged businesses to participate in favored sectors. The push for heavy, chemical industries up until the early 1980s is the most well-known example. In the 1990s, the provision of credit to small and mediumsized enterprises (SME) has been the main area of focus of policy loans. One telling indicator of how central bank credit extension related to policy loans can be found in a multi-country comparison of the relative size of the credit from central bank to the overall credit extended by banking sector. As of 1995, the proportion of credit extended by the Bank of Korea in relation to overall credit was as high as 8 per cent, whereas the comparable ratios were 0.1 per cent (the United States), 0.2 per cent (Switzerland), 2.6 per cent (France), 3.8 per cent (Japan), and 4.6 per cent (Taiwan) respectively as of 1991 (Whang, 1995). The channel of the central bank extending cheap credit to commercial



banks commensurate to their past lending record to the targeted industries has been heavily relied upon in Korea to ensure the smooth flow of commercial bank credit to the targeted industrial sectors. The high proportion shown above is indicative of the relatively active role played by the BOK in the area of industrial development. Such a policy regime has fostered growth in large corporations engaged in many lines of business. It was economically advantageous to get into those industrial areas favored by the government, regardless of immediate difficulties such as a lack of know-how or related experience. This led to a monopolistic or oligopolistic market structure. The resulting industrial organization structure tended to reduce competition among businesses in the product market, which in turn fostered inefficiency in many Korean firms.4 A key consequence of the government’s close involvement in directing bank credit has been that the Korean banking sector has been weak. Other than banks, businesses had few alternative domestic funding sources such as equity and bond markets. Nonetheless, the impetus to expand has remained strong. Hence, they turned to banks for funds. The government-controlled interest rates charged by banks were kept artificially low until a few years ago, making bank funds even more attractive. Consequently, the demand for bank funds has been very strong since the early development period. In addition, a doubledigit inflation rate has not been uncommon during the last three decades.5 The combination of these conditions gave rise to high domestic interest rates and heavy reliance on bank funds by Korean businesses. Another manifestation of the imbalance between banks and non-financial industries is the comparative positions of each type of businesses in their respective global markets, as discussed in Chapter 6. Some authors attribute the currency crisis to this weakness in the banking system.6 The industry–bank nexus discussed above might also have been a key factor in encouraging the high leverage ratio seen in the Korean corporate sector. When there is a plentiful provision of bank funds at concessionary interest rates for those setting foot into the industries targeted by governmental policies, it made sense in every way to load up on as much cheap credit as possible. This directly translates into expanding the overall size of business operations above and beyond the level that might be justified by the prevailing cost of funds in the open market. Such an environment might have determined the initial condition of the corporate financial structure that has persisted ever since. The resulting pattern of corporate financing would require an



ongoing supply of funds with low costs to sustain. By pursuing one industrial policy after another (heavy and chemical industries in the 1970s, ‘high-tech’ industries in the 1990s), the Korean government has continued to provide new sources of subsidy. However, these more direct forms of governmental subsidy have gradually been phased out, thus increasing the financing burden on the Korean corporate sector. In some senses, the series of the bankruptcies of early 1997 may have been taken as a strong signal that the government was ready to withdraw from the close industry–government relationship of the past. This might have set off the alarm to investors regarding the viability and sustainability of many firms, providing another reason to depart from the Korean equity market. According to this view, the implicit guarantee offered by the Korean government, rather than the intrinsic value of firms, was the key component that had made up the rate of return on investing in Korean firms’ equity. The government sent out this signal in early 1997 by allowing a number of large firms to fail. This showed that the government was willing to walk away from floundering large Korean firms that had previously been thought ‘too big to fail’. With the advent of this change in perceptions, foreign investors had to rely on intrinsic values as well as viability of firms in making their investment decisions. However, this was not feasible given the opaque accounting practices in Korea. In addition, there was quite a bit of uncertainty regarding the extent of changes in the government’s policies with respect to the government–business relationship. Under such circumstances, it was fairly prudent for foreign investors to exit the Korean market, even if only temporarily. 3.3

Labor market rigidity and failed attempts to revise labor laws

Next, we turn to labor market issues. Rapid industrialization and a broadening in the scope of economic activities led to high demand for labor, which naturally resulted in a general shortage of labor, and wage level came under heavy pressure. This was particularly noticeable in the late 1980s, when organized labor gained power in the wake of the Korean government’s abandonment of its long-standing anti-laborunion posture. This step was taken as part of the comprehensive liberalization of democratic political activities. Upward wage pressures continued to increase in the early 1990s. The overall wage level rose by 12.8 per cent on average over the 1992–96 period, while the average



CPI inflation rate was 5.3 per cent. These imply an average real wage growth rate of 7 per cent to 8 per cent. It is difficult to believe that there were efficiency-induced productivity spurts of that magnitude per year in the same period. A rapid accumulation of capital during the same period could account for a good part of the increase in labor productivity. In addition, the growing influence of unions added to rigid labor market practices. The number of labor strikes surged in 1987 to 3749, after averaging less than 300 in previous years. The increasing influence and militancy of unions made the laying off of workers much more difficult. The continuing practice of lifetime employment also contributed to the problem of low labor mobility. These factors gave rise to high labor costs (see Table 8.5 for an international comparison).7,8 The Kim Young-Sam administration unsuccessfully attempted to revise the labor law that emphasized the enhancement of flexibility in the labor market. Such a rapid growth in wages had several negative effects, reducing the price competitiveness of Korea’s exports and hence business profitability. Many observers realized the advantage of more flexibility in the labor market in order to improve the efficiency level in general. The new labor law had provisions to allow for layoffs and other steps to improve labor market flexibility. However, no real efforts were made to build broad-based support for the reform and hence the passage of the law in the National Assembly was nullified as a result of vigorous protests by union activists and the threat of general strikes. Many viewed the whole affair as a missed opportunity that could have been used to introduce a measure of flexibility to the

Table 8.5

International comparison of factor costs United States

Average annual wage increase (%) (manufacturing 3.0 1987–1994) Land 5–10 ($/m2, factor cost 1995) Borrowing rate 8.5 of interest (1995) Source: Federation of Korean Industries.


Japan

Taiwan

Korea

1.2

5.4

16.2

195.6

48.4

226.8

4.3

6.2

11.7


Korean labor market, which could thus have increased the resilience of the corporate sector. 3.4

Deteriorating international competitiveness

There have been sporadic attempts to address the problems mentioned so far, particularly since the early 1990s. Unfortunately, these have all failed to produce tangible results. Persistent high domestic factor costs started to erode Korean export competitiveness. Some observers also point to the lack of new product lines to overcome cost disadvantages as another factor for the loss of competitiveness. One way that businesses responded to the declining competitiveness was by relocating manufacturing facilities to China and low-wage Southeast Asian countries. This reaction was particularly common among firms in the light manufacturing sector. The rapid rise in outward FDI shown in Figure 8.1 appears to reflect such a movement by light manufacturing firms. Increases in exports to Southeast Asian countries were another manifestation of weakening export competitiveness. For example, the proportion of exports to Asian countries to the total Korean exports rose from 10.2 per cent in 1991 to 15.5 per cent in 1996. While this could be interpreted as a diversification in the destinations of exports, the fact that the total exports to the United States (and other advanced countries) has declined suggests a less favorable interpretation. The net effect was a deterioration in international competitiveness and terms of trade. Subsequently, current account deficits started to accumulate.9 3.5

Inflexible foreign exchange policy

More directly related to the recent crisis was the foreign exchange rate policy. Until the late 1980s, Korea’s exchange rate policy was never fully utilized as a genuine macroeconomic policy tool. The exchange rate was emphasized as the main factor affecting export performance. A typical example was the reluctance to let the won appreciate during the period 1986–87, when the Korean economy was rapidly expanding owing to a robust export performance aided by the sharp appreciation in the Japanese yen. Korea paid the price for its mismanagement in the form of an inflation flare-up (CPI inflation rose steadily, from 1.4 per cent in 1986 to 9.3 per cent in 1991) and a loss in international competitiveness to which the belated exchange rate overshooting in the period 1988–89 also contributed. While the exchange rate system was liberalized during the 1990s, the actual exchange rate was still somewhat rigidly managed.



Since the early 1990s, Korea’s foreign exchange authorities have pursued a ‘strong won’ policy. The two main reasons for this stance were to achieve domestic price stability and to encourage a shift in the composition of exports to more high value-added items by removing the simple price advantage due to a weak won.10 Both goals were reasonable in that they aimed to address some of the problems explained earlier. However, with the benefit of 20–20 hindsight, we can say that the standpoint of policy makers turned out to have been too rigid. Unfortunately, market pressures for the depreciation of the won were partly deflected by increases in capital inflow that followed the capital flow liberalization measures taken since the early 1990s. Table 8.6 Table 8.6

Real effective exchange rate (Korean Won) Actual rate (A)

Real effective rate

PPP-based equilibrium rate (B)

A–B

1986.12 1987.12 1988.12 1989.12 1990.12

864.49 794.74 685.03 675.17 715.75

104.32 104.19 88.03 81.90 87.29

828.68 762.78 778.18 824.38 820.01

35.81 31.96 –93.15 –149.21 –104.26

1991.12 1992.12 1993.12 1994.12 1995.12

757.28 788.62 809.4 791.86 771.08

87.60 88.55 89.07 85.68 81.47

864.20 890.56 908.69 924.21 946.48

–107.27 –101.94 –99.29 –132.35 –175.4

1996.12 1997.03 1997.06

839.02 896.2 889.49

83.78 86.09 86.65

1001.51 1041.00 1026.57

–162.49 –144.81 –137.08

1997.11 1997.12 1998.01 1998.03 1998.05 1998.06

1035.22 1494.04 1707.3 1489.26 1399.05 1397.77

93.55 129.49 141.17 128.36 118.16 114.62

1106.56 1153.76 1209.37 1160.24 1183.99 1219.53

–71.34 340.28 497.93 329.02 215.06 178.24

Notes: The real effective exchange rate index (REERI) is obtained by the below formula, where i means ith country among the Korea’s major 16 trading partners, St is the foreign currency price in terms of Korean won at period t, and Pt means the price level at t and superscript k means Korea’s variable. The Korea’s major 16 trading partners include Australia, Canada, China, France, Germany, Hong Kong, Indonesia, Italy, Japan, Malaysia, Netherlands, Singapore, Taiwan, Thailand, the United States, and the United Kingdom. REEI = [{(Sit/Si0) × (Pit/Pi0)}/(Pkt/Pk0)] × 100



shows our estimates of an equilibrium won/US$ exchange rate and the extent of the won overvaluation. Another key factor that contributed to the FX policy complacency was the strengthening trend in the yen/dollar exchange rate following the 1985 Plaza Accord. After rising to 168 yen per dollar in 1986 from 239 yen per dollar in 1985, the yen more or less continued to strengthen against the dollar and reached a peak of 84 in the second quarter of 1995. Such a strong yen enhanced the price competitiveness of Korean exports competing against goods made in Japan. Many firms in heavy and chemical industries as well as semiconductor manufacturers enjoyed robust export growth during this period. Largely aided by the strong yen, from 1986 Korea experienced a current account surplus for four years running. A quantitative analysis of the influence of strong won policy in mitigating the inflationary pressures stemming from the high wage growth of the late 1980s and 1990s is provided in the Appendix at the end of this chapter.

4. A deeper look: cyclical and short-term macroeconomic and external factors In addition to the structural issues discussed above, there were medium to short-term cyclical policy developments building up to the recent crisis. Beginning with the cyclical factors, the most recent cyclical peak in output growth was reached in late 1995. However, in some senses, the Korean economy has never really recovered from the extended slowdown that started in 1987. There were identifiable sources for the two subsequent upturns seen in 1989 and 1993 (Figure 8.2). The first one could be attributed to the stimulative government policy drive to add two million new housing units, which was a key campaign commitment.11 For example, the construction sector’s real output grew at the rate of about 15 per cent for a five-year period starting in 1987. In comparison, it had only averaged about 5 per cent over the previous three years. The second upturn can be explained mostly by a stalwart pick-up in semiconductor exports. Aiding the 1993 upturn was the Japanese yen’s appreciation that lasted until 1995. Also, due to healthy economic conditions in many G-7 countries, especially in the US, demands for imports remained strong throughout this time. An expansionary momentum that started to build up in the second half of 1993 persisted in 1994 and real GDP rose 8.6 per cent, well above the pace seen in the previous two years. Such a pick-up in the


Korea’s 1997 Currency Crisis 189 16.0 14.0 12.0 10.0 8.0

72.4 73.4 74.4 75.4 76.4 77.4 78.4 79.4 80.4 81.4 82.4 83.4 84.4 85.4 86.4 87.4 88.4 89.4 90.4 91.4 92.4 93.4 94.4 95.4 96.4 97.4

6.0 4.0 2.0 0.0 –2.0 –4.0

Year and quarter Figure 8.2

Real GDP growth rate (four-quarter moving average)

pace of economic activity was accompanied by rising aggregate demand and widening current account deficits. A rapid expansion in equipment investment in the areas of computer chips manufacturing and heavy industries such as ship building and the manufacture of automobiles was quite noticeable. In addition to the strong exchange value of the Japanese yen, the external environment was favorable in that key G7 economies finally staged a strong recovery from the recession of the early 1990s after having been rather anemic for a few years. For example, the GDP of the United States and Germany grew at 4.1 per cent and 2.9 per cent respectively. Owing to strong demand, Korean exports rose 16.8 per cent, about 10 per cent above its pace of growth during the previous two years. However, imports also grew 22.1 per cent, outpacing the average recorded in the previous two years by about 2 per cent. Consequently, the current account balance recorded a deficit of US$3.8 billion, which was a substantial turnaround from the US$990 million current account surplus seen in the previous year. The Korean economy again experienced a period of rapid growth in 1995, driven mainly by sharp increases in exports and investment spending. Real GDP grew by 8.9 per cent during the year. A steady expansion in consumption also contributed, although to a lesser extent. Despite the strength of the real sector, price pressures eased slightly compared to the trend seen in the recent past owing to both the greater stability of agricultural prices and the lower import prices,



caused by a slightly stronger exchange value of won. Throughout the year, the won/US$ exchange rate appreciated by about 3 per cent. Continuing the trend seen in the previous year, the current account (C/A) deficit for the year widened further to US$8.9 billion – about twice the size of the 1994 deficit. The brisk pace of exports and investments slowed somewhat in the last quarter of the year as the exchange value of the Japanese yen weakened. In addition, many industrial capacity expansion projects were completed by late 1995. The slowing trend seen in the last quarter of the previous year continued into 1996 and the growth rate of GDP in real terms declined perceptibly to 7.1 per cent. This was mainly attributable to lackluster exports and to subdued investment spending. Net of increases in inventories, which added about 1.6 per cent to the growth rate, real GDP grew at a rate of just over 5 per cent (see Figure 6.1 for a breakdown of the contribution of different GDP components). At the same time, the C/A deficit surged to US$23 billion, pushing the C/A deficit to GDP ratio above the 5 per cent level for the first time since 1981. The exchange value of the won depreciated about 9.0 per cent from the end of 1995. Interest rates also started to rise, reversing the trend seen until April, as demand for funds by firms rose due to tight cash flow conditions caused by deteriorating profitability. From late 1995, the macroeconomic conditions started to deteriorate once again due to the ever-worsening terms of trade (see Table 8.7). Conditions for the external sector became unfavorable and the current account balances started to deteriorate (Figure 8.3). Although the situation was not as serious as in the ASEAN countries, the devaluation of the Chinese yuan in the period 1993–94 was also a negative factor

Table 8.7

Terms of trade for Korea

1995 1996 1997 1997

1/4 2/4 3/4 4/4

Unit value of export

Unit value of import

Terms of trade

100.0 86.6 77.8 76.3 75.1 69.0 74.5

100.0 98.8 98.6 93.5 97.1 96.7 96.5

100.0 87.7 78.9 81.6 77.3 71.3 77.2

Note: Base year 1995 = 100.0. Source: Bank of Korea.


Korea’s 1997 Currency Crisis 191 15

10

5

0

Figure 8.3

1998

1997

1995

1996

1994

1993

1992

1991

1990

1988

1989

1987

1986

1985

1984

1983

1982

1981

–10

1980

–5

Current account/GDP (%)

influencing Korea’s exports. The yen started to depreciate against the US dollar in 1995, eroding the competitiveness of Korean exports. In addition, starting in 1996, the price of semiconductors – which made up almost a quarter of the total Korean exports – started to fall rather dramatically. For example, the price of a 16 DRAM chip fell from $50.6 in 1995 to $3 in February 1998. Also, during the period leading up to 1997, imports of both consumption as well as capital goods have increased rapidly. This was a by-product of the strong-won policy, which made imports inexpensive. Consequently, the current account deficit widened to 4.9 per cent of GDP in 1996 from 1.4 per cent in 1995. As shown in Table 8.8, the pace of short-term capital inflow has noticeably quickened since 1994. After remaining below 45 per cent until 1994, the proportion of short-term debts started to increase, exceeding 60 per cent of the total external debts by 1997. Such a shortening of the average debt maturity made Korean economy’s debt structure vulnerable to distresses associated with the rapid movement of foreign capital. In addition, Korean businesses have continued to rely heavily on debt financing. For example, the average leverage ratio for the 30 largest businesses in 1996 was 387 per cent. Thus, the resulting heavy debt service burden has not only depressed profitability but has also exposed the corporate sector to potentially serious cash flow problems.



Long-term debts Short-term debts Total

Details of Korea’s total external liabilities (unit: billion dollars) End of 1996

End of Nov. 1997

End of Dec. 1997

End of Apr. 1998

End of Jun. 1998

57.5 (36.5) 100.0 (63.5) 157.7

72.9 (45.1) 88.9 (54.9) 161.8

86.0 (55.7) 68.4 (44.3) 154.4

113.3 (73.0) 41.9 (27.0) 155.2

115.5 (75.1) 38.3 (24.9) 153.8

Notes: 1. ( ) per cent share. 2. The difference between the total debts between the IMF standard and World Bank standard is $33.6 billion in Dec. 1997. The IMF standards includes the offshore financing of the head office ($17.8 billion) and overseas branches ($15.8 billion) of domestic financial institutions, which has been employed in overseas limitedly. Source: Ministry of Finance and Economy.

Sluggish export growth since 1995 has started to put a damper on the profitability of firms, as shown in Table 8.9. Indeed, starting in early 1997, a string of failures occurred in some well-known businesses. The Hanbo Group topped the list with its sudden demise in January 1997, and then Sammi Steel failed in March 1997, with the Kia Group following in September 1997. These events heightened concerns about the near-term prospects for the Korean corporate sector in general. These led directly to a rapid deterioration in the soundness of the banking industry due to the latter’s exposure to the troubled firms through lending concentration, as discussed in the previous chapter. According to official statistics on the Korean banks’ non-performing loans, which are said to adopt more forgiving definitions, the proportion of non-performing loans to the total rose from 3.9 per cent at the end of 1996 to 6.6 per cent by September 1997. For the two banks that were mostly affected, the non-performing loan ratios rose from 6.7 per cent and 9.3 per cent at the end of 1996 to 17 per cent and 15 per cent respectively by September 1997. Table 8.9 change)

Mid-year profits of listed firms, 1995–1997 (%, Year-over-year

Sales Net profit

1995

1996

1997

25.46 42.05

18.60 –40.22

14.22 –28.45

Source: Bank of Korea.



Such deteriorating conditions among the Korean banks were obviously a real cause for concern in international capital markets. One immediate effect was the cutback in credit extensions to overseas branches of Korean banks by international financial institutions. This in turn forced the Korean foreign exchange authorities to use official foreign exchange reserves to ease financing difficulties experienced by overseas branches of Korean banks (see Table 8.3). Such cutbacks in credit extensions continued towards the end of 1997. This was a special factor that served to exacerbate the currency crisis towards the end of 1997. Roughly concurrent with these domestic developments, foreign exchange market instabilities in the ASEAN countries combined to form a full-blown currency crisis. Some spillover, if not a full contagion of the crises in the ASEAN countries to Korea, was inevitable. Doubts about the sustainability of the exchange rate regime did indeed rise and capital outflow followed from the region. Such an environment could not have been more conducive to a reinforcing escalation of both a perceived and a real foreign exchange crisis.12 Pressures on the won exchange rate continued from the beginning of 1997. One clear indication of a potential misalignment was the growing gap between the onshore market and the rate in the offshore forward market. The offshore won/dollar exchange rate exceeded the onshore rate at times by close to 30 per cent. However, foreign exchange authorities resisted these pressures with vigor. The Korean FX authorities appeared to have successfully resisted the devaluation pressure by late spring of 1997. However, the downward pressures proceeded to intensify with the outbreak of the ASEAN crisis in July. Korean FX authorities continued to expend foreign exchange reserves to defend and/or slow depreciation of the won. Their efforts were decidedly unsuccessful and in the process, a rapid depletion of foreign exchange reserves resulted as shown in Table 8.3. The pace of capital outflow quickened and the downward pressures on the won became inescapable due to dwindling foreign exchange reserves. The prospect of failing to meet external obligations became real. The IMF intervened as this notion became widely acknowledged.

5. 5.1

Post-crisis macroeconomic developments Overview

With the help of positive counter measures implemented by the Korean government as well as the IMF and other international organizations,



the possibility of another crisis breaking out in Korea now seems quite remote. Moreover, major economic indicators show a clear sign of economic recovery, following the deep recession and whirlwind of structural reforms that ensued. However, one and a half years under the stewardship of the International Monetary Fund meant tumultuous and often painful changes for the Korean economy. For a nation that had thrived on expansion and growth over the past thirty years, a contraction of the economy, estimated at 5.8 per cent in 1998, was a real shock to the system. Bold restructuring of the financial and corporate sectors meant that the unemployment rate soared to a year average of 6.8 per cent in 1998, peaking at 8.6 per cent in February 1999 before falling to 6.2 per cent in July 1999. Despite this recent improvement, a further substantial decrease in these figures is not likely in the immediate future. This convulsion of the economy was inevitable, as the main policy stance of Kim Dae-jung’s new government under the IMF stewardship in the early post-crisis period was to secure macroeconomic stability by means of tight macroeconomic policies, including a high interest rate policy. However, the government’s timely relaxation of the tight macroeconomic policy stance eventually succeeded in pulling the economy out of the crisis. The tight macroeconomic policy stance adopted in the immediate post-crisis period succeeded in bringing stability back to the foreign exchange market but, at the same time, hit both the real and the financial sectors of the economy very hard. Recognizing the devastating effects of the tight macroeconomic policies on the economy, the Korean government and the IMF pursued expansionary monetary and fiscal policies throughout the latter half of 1998, which greatly contributed to the recovery of the macroeconomy in the recent months. The macroeconomy regained its stability, reaching 1997 pre-crisis levels by the end of 1999. This macroeconomic stability would not have been possible without an effective policy response by the government. In this section, we will review the IMF programs and the post-crisis macroeconomic developments, and offer some reflections on the IMF prescriptions. 5.2

The IMF program in action

The IMF attached a wide-ranging set of policy conditions to the emergency loan. The ‘Policy Framework’ section of Korea’s Letter of Intent describes the basic tenet in the following manner: The government has put in place a comprehensive policy package to address decisively and promptly the structural weaknesses that are



the root cause of the present difficulties so as to restore market confidence and arrest the decline of the won. Tighter monetary and fiscal policies will provide the macroeconomic conditions to support comprehensive structural reforms. The aim of macroeconomic policies agreed upon between the Korean government and the IMF was basically to restore stability in the foreign exchange market. Table 8.10 provides the key components of the first IMF memorandum of understanding related to macroeconomic management as well as the restructuring of financial and corporate sectors. Table 8.11 shows the key items related to the macro management of the economy between the Korean government and the IMF and how they have evolved since December 1997. As can be seen from these tables, the main thrust of the early policy guidelines was to maintain a high interest rate regime to restore confidence in the stability of the exchange value of won and therefore stemming capital outflow. For example, the Korean version of a usury law that had previously limited the maximum interest rate to 25 per cent was to be abolished, allowing interest rates to rise to 40 per cent (2nd consultation of 24 December 1997). Table 8.11 also shows the recommendation of a tight fiscal policy stance of allowing no or very little budget deficit. At the same time, provision of a social security net was emphasized to mitigate the adverse impact of these rather constrictive macroeconomic policies on the poor. The Korean government’s response has been to follow the policy guidelines spelled out in the IMF agreement. Early on, the Korean government’s policy responses were directed to putting out the fire and preventing its spread. The key measures taken by the government included the closing down of insolvent merchant banks (16 with deficient capital adequacy ratios have been closed as of August 1998) and providing wide-ranging deposit guarantees to prevent a potential bank run that could threaten the viability of the whole financial system. Attention was also paid to the completion of negotiations with international creditors on extending the maturity of various short-term loans coming due, which was completed in March 1998. Following the initial round of crisis management, the government turned to implementing various reform measures and strengthening the supervision of financial institutions rather than on considering macroeconomic policy combinations, which received little attention. This was mainly because the stringency imposed on the macroeconomic policy guidelines left little room for policy makers to maneuver.13


196 A New Paradigm for Korea’s Economic Development Table 8.10 IMF Stand-By Agreement Summary of the Economic Program (5 December 1997) Macroeconomic policies Objectives

The program is intended to narrow the external current account deficit to below 1% of GDP in 1998 and 1999, contain inflation at or below 5%, and – hoping for an early return of confidence – limit the deceleration in real GDP growth to about 3% in 1998, followed by a recovery toward potential in 1999.

Monetary policy and exchange rate policy

To demonstrate to markets the authorities’ resolve to confront the present crisis, monetary policy will be tightened immediately to restore and sustain calm in the markets and contain the impact of the recent won depreciation on inflation. In line with this policy, the large liquidity injection in recent days has been reversed, and the call rate has been raised from 121/2% on December 1, 1997 to 21% today, and will be raised further in the next few days. Money growth during 1998 will be limited to a rate consistent with containing inflation at 5% or less. A flexible exchange rate policy will be maintained, with intervention limited to smoothing operations.

Fiscal policy

A tight fiscal policy will be maintained in 1998 to alleviate the burden on monetary policy and to provide for the still uncertain costs of restructuring the financial sector. The cyclical slowdown is projected to worsen the 1998 budget balance of the consolidated central government by about 0.8% of GDP. The present estimates of the interest costs of financial sector restructuring is 0.8% of GDP. Offsetting measures amounting to about 1.5% of GDP will be taken to achieve at a minimum budget balance and, preferably, a small surplus. This will be achieved by both revenue and expenditure measures to be determined shortly. These may include, among others: – increasing VAT coverage and removing exemptions; – widening the corporate tax base by reducing exemptions and certain tax incentives; – widening the income tax base by reducing exemptions and deductions; – increasing excises, luxury taxes, and transportation tax;


Korea’s 1997 Currency Crisis 197 Table 8.10 IMF Stand-By Agreement Summary of the Economic Program (5 December 1997) (continued) Macroeconomic policies (continued) – reducing current expenditures particularly support to the corporate sector; and – reducing low priority capital expenditures. Financial Sector Restructuring Financial sector reform bill

1. The following financial sector reform bills submitted to the National Assembly will be passed before the end of the year: – A revised Bank of Korea Act, which provides for central bank independence, with price stability as its main mandate. – A bill to consolidate supervision of all banks, including specialized banks, merchant banks, securities firms, and insurance companies in an agency with operational and financial autonomy, and with all powers needed to deal effectively with troubled financial institutions. – A bill requiring that corporate financial statements be prepared on a consolidated basis and be certified by external auditors.

Restructuring and reform measures

Troubled financial institutions will be closed or if they are deemed viable, restructured and/or recapitalized. The government has already suspended 9 insolvent merchant banks (on December 2, 1997). These banks have been placed under the control of MOFE and required to submit a rehabilitation plan within 30 days. These plans will be assessed in consultation with Fund staff end, if not approved, the institution will have its license revoked. A credible and clearly defined exit strategy will include closures as well as mergers and acquisitions by domestic and foreign institutions, provided the viability of the new groupings is assured. Clear principles on sharing of losses among equity holders and creditors will be established. – The disposal of non-performing loans will be accelerated. – The present blanket guarantees will be replaced by a limited deposit insurance scheme. – A timetable will be established for all banks to meet or exceed Basle standards. – Prudential standards will be upgraded to meet Basle core principles. – Any support to financial institutions will be given on strict conditions.


198 A New Paradigm for Korea’s Economic Development Table 8.10 IMF Stand-By Agreement Summary of the Economic Program (5 December 1997) (continued) Financial Sector Restructuring (continued) – All support to financial institutions, other than BOK liquidity credits, will be provided according to pre-established rules, and recorded transparently. – Accounting standards and disclosure rules will be strengthened to meet international practice. Financial statements of large financial institutions will be audited by internationally recognized firms. – Manpower in the unit supervising merchant banks will be sufficiently increased to make supervision effective and to allow proper handling of troubled banks. – The schedule for allowing foreign entry into the domestic financial sector will be accelerated, including allowing foreigners to establish bank subsidiaries and brokerage houses by mid-1998. – Borrowing and lending activities of overseas’ branches of Korean banks will be closely monitored to ensure that they are sound. Nonviable branches will be closed. BOK’s international reserve management will be reviewed with the intention to bring it closer to International practice. Deposits with overseas branches of domestic banks will not be increased further, but gradually withdrawn as circumstances allow. Financial institutions will be encouraged to improve their risk assessment and pricing procedures, and to strengthen loan recovery; actions in these areas will be reviewed as part of prudential supervision. Other Structural Measures Trade liberalization

Timetables will be set, in compliance with the WTO commitments, at the time of the first review, to: – eliminate trade-related subsidies; – eliminate restrictive import licensing; – eliminate the import diversification program; and – streamline and improve the transparency of the import certification procedures.

Capital account liberalization

The present timetable for capital account liberalization will be accelerated by taking steps to: – liberalize foreign investment in the Korean equity market by increasing the ceiling on aggregate ownership from 26% to 50% by end-1997 and to 55% by end-1998. The ceiling on individual


Korea’s 1997 Currency Crisis 199 Table 8.10 IMF Stand-By Agreement Summary of the Economic Program (5 December 1997) (continued) Other Structural Measures (continued) foreign ownership will be increased from 7% to 50% by end-1997. – effective immediately, for foreign banks seeking to purchase equity in domestic banks in excess of the 4% limit requiring supervisory authority approval, the supervisory authority will allow such purchases provided that the acquisitions contribute to the efficiency and soundness of the banking sector; legislation will be submitted to the first special session of the National Assembly to harmonize the Korean regime on equity purchases with OECD practices (with due safeguards against abuse of dominant positions.) – allow foreign investors to purchase, without restriction, domestic money market instruments. – allow foreign investment, without restriction, in the domestic corporate bond market. – further reduce restrictions on foreign direct investment through simplification of procedures. – eliminate restrictions on foreign borrowings by corporations. Corporate governance and corporate structure

Timetable will be set by the time of the first review to improve the transparency of corporate balance sheets, including profit and loss accounts, by enforcing accounting standards in line with generally accepted accounting practices, including through – independent external audits, – full disclosure, and – provision of consolidated statements for business conglomerates. The commercial orientation of bank lending will be fully respected, and the government will not intervene in bank management and lending decisions. Remaining directed lending will be eliminated immediately. While policy lending (agriculture, small business, etc.) will be maintained, the interest subsidy will be borne by the budget. No government subsidized support or tax privileges will be provided to bail out individual corporations.


200 A New Paradigm for Korea’s Economic Development Table 8.10 IMF Stand-By Agreement Summary of the Economic Program (5 December 1997) (continued) Other Structural Measures (continued) The ‘real name’ system in financial transactions will be maintained, although with some possible revisions. Labor market reform

The capacity of the new Employment Insurance system will be strengthened to facilitate the redeployment of labor, in parallel with further steps to improve labor market flexibility.

Information provision

There will be regular publication of data on foreign exchange reserves, including the composition of reserves and net forward position with a two weeks delay initially. Data on financial institutions, including nonperforming loans, capital adequacy, and ownership structures and affiliations will be Published twice a year. Data on short-term external debt will be published quarterly.

5.3

Post-crisis macroeconomic developments

The high interest rate policy regime imparted a huge negative momentum to the Korean economy, amplified by the added financing burden borne by businesses that had relied on debt to a degree unusual for an OECD economy. The Korean economy started to experience the true extent of the adverse repercussions of the financial and foreign exchange market turmoil in early 1998. The real GDP contracted by 6.3 per cent in the first half of 1998 and again by 7.0 per cent in the second half of 1998. The unemployment rate, after remaining in the low 2 per cent range over the past three years, started to rise in early 1998 and was recorded at above 7 per cent by the third quarter of 1998. The adverse employment conditions have also been reflected in terms of the declining wage trend. For example, nominal wages for manufacturing sector workers fell by 13.7 per cent (on a year-on-year basis) in January and the declining trend has continued since. One indication of the financial stress placed upon the corporate sector since the beginning of the year is the extent of failure to meet short-term financial obligations. Figure 8.4 shows the trend in the rate of dishonored checks and bills since September 1997. There has been a distinct peak in the series during the December–January period and a discrete rise in the level since. A similar trend has been seen in the bankruptcy rates for the same period.


Table 8.11

Changes in the agreement between the Korean government and the IMF

Indicator

1998 Growth rate of GDP

1998 Inflation

Budget deficit/GDP

Initial Agreement (97.12.3, 12.24)

3%

5%

Balanced or small deficit

1st quarter agreement (98.2.7)

1%, negative growth possible

Below 10%

Allowing Deficit. –0.8%

15.2% in 1st quarter, 15.7% in 2nd quarter

13.5% in 1st quarter, 14.1% in 2nd quarter

Removing interest Surplus of above rate ceiling, US$8 billion keeping yearly average 20% level. Consider to decrease cautiously and step by step when exchange rate is stabilized

2nd quarter –1%, Single agreement allowing digit (98.5.2) adjustment

–1.75%

14.2% in 3rd quarter, 13.9% in 4th quarter


Decrease it flexibly and in a balanced way when exchange rate is stabilized

Surplus of US$21–23 billion

3rd quarter agreement (98.7.8)

–4%


Decrease flexibly if necessary

Surplus of US$33–35 billion

9%

—

—


Growth rate of M3

Interest rate

15.4% Allowing at the end of ’97, 14–16% 9% level of market 1st quarter of ’98 interest

1998 Current account US$4.3 billion (below 1% of GDP)


–4%

Growth rate of monetary base

202

Table 8.11

Changes in the agreement between the Korean government and the IMF (continued)

Indicator

1998 Growth rate of GDP

1998 Inflation

Budget deficit/GDP

Growth rate of monetary base

4th quarter agreement (98.10.12)

positive growth rate in 1999

5% in 1999

–5%

Remove this 14.1% as an indicative in 1st quarter of 1999 limit


Growth rate of M3

Interest rate

1998 Current account

Flexible interest rate policy

Surplus of US $20 billion for 1999


Figure 8.4

The rate of dishonored checks and the number of bankruptcies

The fall in the GDP growth rate was somewhat mitigated by a rise in net exports caused both by the rising volume of exports, which benefited from the weaker won, and falling imports. The level of foreign exchange reserves started to rise at the beginning of 1998, bolstered by the infusion of the IMF fund. More importantly, the steady growth in current account surpluses throughout 1998 contributed to the rebuilding of the reserve holdings. The usable reserve amount rose to US$40.9 billion in the second quarter of 1998 and US$52.04 billion in the last quarter of 1998. This was well above average levels seen in the past, perhaps removing Korea to a safe distance, away from the foreign exchange illiquidity condition seen in December 1997, when the comparable figure stood at US$8.9 billion. The exchange rate value of the won more or less stabilized at around 1385.2 won per US dollar during the second quarter and 1373.6 won per US dollar in the third quarter, after having reached a record low of 1706.8 in January 1998. The weakening exchange value of the Korean won appears to have had positive effects on the external balances, mainly by reducing the level of imports. As shown in Table 8.12, both exports and imports have been cut back in dollar terms when compared with the same period last year. However, the fall in the level of import, has been quite sharp – in the range of 30 per cent to 40 per cent – while exports had fallen by less than 10 per cent. Thus, large positive current account balances have resulted. Also contributing to the relatively strong performance of exports is the steady improvement in terms of trade since the beginning of 1998 (Table 8.12).


Industrial activities and economic indicators in the post-crisis period (%, billion US $) 1997

Monetary Base growth

–12.1

1998

204

Table 8.12

1999

1st Q

2nd Q

3rd Q

4th Q

Annual

1st Q

2nd Q

3rd Q

4th Q

Annual

–13.1

–7.2

–9.5

–4.4

–7.1

6.9

12.0

18.0

18.4

12.1

M2

14.1

14.5

15.4

20.6

24.6

19.0

29.5

30.7

25.3

26.4

27.9

M3

16.3

14.9

14.2

13.8

13.0

13.9

13.7

13.3

10.5

8.2

11.4

Call Rate Interest 3year Yield Rate of Corporate bond

13.6

23.7

18.7

10.2

7.1

15.0

5.3

4.8

4.7

4.7

4.9

13.4

20.7

17.5

12.9

9.3

15.1

8.4

8.0

9.6

9.5

8.9

–1.5

—

—

—

—

–4.2

—

—

—

—

–2.7

Budget deficit/GDP Exchange rate (Won/US$)

1415.2

1378.8

1385.2

1373.6

1207.8

1207.8

1224.7

1155.9

12187

1145.4

1145.4

Real GDP

5.0

–4.6

–8.0

–8.1

–5.9

–6.7

5.4

10.8

12.8

13.0

10.7

Consumption

3.2

–9.9

–11.3

–10.5

–7.6

–9.8

–5.3

8.4

10.1

10.1

8.5

Investment

–2.2

–19.9

–23.9

–22.4

–18.3

–21.2

–4.2

4.9

7.0

7.6

4.1

Imports in million US$ 144 616 (Inc. Rate) (–3.8)

23 655 (–36.1)

23 541 (–37.0)

21 462 (39.9)

24 624 (–28.7)

93 282 (–35.5)

25 567 (8.1)

28 760 (22.2)

29 759 (38.7)

35 667 (44.8)

119 753 (28.4)

Exports in million US$ (Inc. Rate)

136 164 (5.0)

32 233 (8.4)

34 878 (–1.8)

30 481 (–10.8)

37 723 (–5.5)

132 313 (–2.8)

30 254 (–6.1)

35 742 (2.5)

35 087 (15.1)

42 602 (22.7)

143 685 (8.6)

Current account surplus/deficit (million US$)

–8 166.7 10 712.5 11 007.3 9 744.0 8 901.1 40 364.9 6 058.1 6 145.4 6 596.6 5 676.6 24 476.7


Table 8.12

Industrial activities and economic indicators in the post-crisis period (%, billion US $) (continued) 1997

1998

1999

1st Q

2nd Q

3rd Q

4th Q

Annual

1st Q

2nd Q

3rd Q

4th Q

Annual

–1.7

—

—

—

—

12.7

—

—

—

—

6.0

20.41

29.74

40.9

46.99

52.04

52.04

57.45

61.98

65.66

74.05

74.05

Producer Price Index

3.9

14.4

13.9

12.0

8.6

12.2

–3.5

–3.3

–1.9

0.5

–2.1

Consumer Price Index

4.5

9.0

8.2

7.0

6.0

7.5

0.7

0.6

0.7

1.3

0.8

Unemployment rate

2.6

5.7

6.9

7.4

7.4

6.8

8.5

6.6

5.6

4.6

6.4

C/A balance To GDP ratio Usable Foreign Exchange Reserves

Note: All figures represent monthly averages except the exchange rate and usable foreign exchange reserves. Source: National Statistical Office, Bank of Korea, Ministry of Finance and Economy

205



Reflecting this trend, Korea’s exports have increased by about 20 per cent in terms of volume in 1998 compared to the previous year, suggesting that the weaker exchange rate has indeed had a positive impact on the external balances. The large movement in the exchange value of won has also had a destabilizing impact on the domestic prices. The rapid depreciation of the won had an almost immediate pass-through impact on the domestic prices and the producer price index (PPI) rose by 14.4 per cent and 13.9 per cent (year-on-year basis) in the first and second quarters of 1998, respectively. The consumer price index (CPI) also rose by 9.0 per cent and 8.2 per cent (year-on-year basis) during the same period. The inflationary initial pass-through effect notwithstanding, the rapid fall in aggregate demand that has taken place since the beginning of 1998 appears to have had a deflationary impact. For example, after the initial increase towards the end of 1997 and early 1998, the PPI growth rate dropped to 8.6 in fourth quarter of 1998. A similar pattern can also be observed in the CPI. After rising to a rate 9.0 per cent in the first quarter, the CPI growth rate dropped to 6.0 per cent in the fourth quarter of 1998. Thus, when we allow for the initial pass through of the devaluation in the exchange rate, this trend suggests a significant downward momentum in the general price level. A similarly falling trend in many asset prices (stocks, properties, etc) has also been observed. Although aggregate demand did pick up, this was not enough to offset the sharp drop in demand at the outset of the crisis, and deflationary trend continued as illustrated by the negative growth rates in the PPI and the stability of the CPI in 1999. In addition to this, low inflationary pressure continued due to the stabilized exchange rate, the opening up of the market for capital and intermediate goods of major manufacturing industries as well as for general importables, and the downward pressure due to the general markup generated by the rapid advancement of e-commerce. A comparison of Tables 8.11 and 8.12 shows that the actual deterioration of macroeconomic conditions far outpaced those of the agreedupon macroeconomic indicators, the only exception being that of the current account surplus. For example, the fifth agreement envisioned unemployment for the year at between 6 per cent and 7 per cent, but the actual unemployment rate in the second quarter was already 6.9 per cent. In terms of output growth, the fifth agreement saw –1 per cent (or less) for the year but real GDP had shrunk by 5.3 per cent in the first half of 1998. Over time came the realization that the contraction in domestic aggregate demand was far worse than expected and



rehabilitation of the banking sector would require a huge amount of public funding. Consequently, it became more and more obvious to all parties concerned that both fiscal and monetary policies would have to take a more active role. At the same time, the exchange value of the won remained stable from spring 1998. Thus, the stance taken for both monetary (measured in terms of reserve money growth and interest rate) and fiscal (measured in terms of budget deficit) policies has shifted from being extremely tight to relatively expansionary in the second half of 1998. For example, the Bank of Korea agreed to add a reserve money supply of 6.8 trillion won, which amounted to the shortfall at the end of September 1999 – that is, the amount between the actual reserve supply (18.6 trillion) and the reserve supply target agreed with the IMF (25.4 trillion). It also lowered the interest rate from 5 per cent to 3 per cent, charged on the central bank credit extended to commercial banks under the aggregate credit ceiling system, which is a mechanism for supporting commercial bank lending to targeted areas such as small and medium-sized enterprises and export sectors. In terms of fiscal policy, the official estimate for the financial resources needed to address the banking sector rehabilitation and provision of minimum benefits to the unemployed was about 100 trillion won in the third quarter of 1998. The Korean government was planning to issue 66 trillion of the hundred trillion won worth of national as well as public bonds by the end of 1998. However, many forecasts of the extent of the bad loans in the Korean banking sector estimate the total size of the problem to be much greater than the official figures have stated. Regarding the unemployment benefit and basic social safety net, the lack of any significant past experience in dealing with these issues, as well as the fluidity of the current situation, present difficulties in estimating the true extent of the necessary financial resources. All in all, the fiscal policy stance for the latter half of 1998 shifted drastically from ‘balanced or small deficits’ to ‘5 per cent of GDP of fiscal deficits’. Aided by expansionary monetary and fiscal policies, the economy began to show some signs of recovery towards the end of 1998, with a clear trend of rapid recovery becoming evident into 1999. Entering 1999, interest rates continued to remain stable, keeping the overnight call rate at record low levels of 4 per cent to 6 per cent, thereby leading the three-year corporate yield rate to reach its own record levels of between 7 per cent and 9 per cent. The exchange rate policy has remained somewhat flexible and BOK market interventions are limited



to ‘smoothing’ operations. Usable foreign exchange reserves steadily increased throughout 1999, from US$57.45 billion in the first quarter to US$74.05 billion by the final quarter. The won/dollar exchange rate also stabilized at around 1150 in 1999 (see Table 8.12). In 1998, the Korean economy recorded annual growth of –6.7 per cent. However, the economy bottomed out around the third quarter of 1998 and has steadily improved. The first and second quarters of 1999 saw GDP growth rates of 5.4 per cent and 10.8 per cent respectively. However, there are also concerns over the pattern of recovery. The recovery seems lopsided, depending heavily on a few sectors such as semiconductors, shipbuilding, and automobile manufacturing as well as other sectors propelled by export demand. CPI inflation in 1999 has also subsided after reaching an annual rate of 7.5 per cent in 1998, but in recent months this has become something of a concern. The easy monetary and fiscal policies are much more expansionary than those adopted at any other time. The rapid recovery of GDP and the re-emergence of the rising wage among others were expected to add to the inflationary pressures, but this did not materialize due to the stable exchange rate and the still low aggregate demand. Also, the current account recorded surpluses in both 1998 and 1999 by US$40.4 billion (10.9 per cent of GDP) and US$24.5 billion (5.8 per cent of GDP), respectively. However, the high unemployment rate remains a heavy social burden despite showing some signs of easing towards the latter half of 1999. All in all, while the economy is clearly moving ahead, some factors are still uncertain, such as the unstable financial markets, rising unemployment, and the slow down in the restructuring efforts in the financial as well as the corporate sector. Whether the current pace of recovery will prove to be sustainable has yet to be seen.

6.

Some reflections on the IMF prescriptions in hindsight

There have been continuing debates as to whether the IMF succeeded in formulating the correct prescriptions for each of the crisis-ridden economies it was called upon to aid in the 1990s. The debate is not only restricted to Korea but addresses other Asian economies under IMF programs.14 Is the IMF prescription of a high interest rate policy an appropriate one given the economic conditions of the concerned economy? The main thrust of the IMF’s early policy prescription was to maintain a high interest rate regime in order to restore confidence in the stability



of the exchange value of the Korean won, therefore putting an end to large-scale capital outflows. There are some critical points regarding this particular policy prescription. First, as we have already discussed, the single most significant policy mistake leading to the crisis was the overvalued Korean won and the ineffective attempts to defend the currency right up to the last minute. An overvalued currency leads not only to the depletion of foreign exchange reserves if unsuccessfully defended but also to the depressing effects on domestic industries if maintained for an unjustifiably long period, as seems to have been the case in Korea. In this case, the high interest rate policy after the prolonged won overvaluation will have a cumulatively depressing impact on both the domestic firms and economy as a whole. Secondly, the capital outflows will have a contractionary impact on domestic liquidity, which will in turn have the same effect on the domestic firms and economy as a whole. Therefore, by squeezing the liquidity supply, a high interest rate policy will have a doubly devastating impact on the domestic firms. Thirdly, due to the high interest rate policy, the combination of these depressing effects will be felt even more severely by the Korean firms, which have traditionally maintained high leverage ratios. Fourthly, long-term investors, and short-term ones for that matter, cannot be expected to invest in an economy where corporations are in deep distress, solely on the basis of gains to be made from comparatively high short-term interest rates. Considering these aspects, one may argue that the proper policy prescription during a currency crisis of the kind experienced in Korea may be an easy monetary policy with an additional injection of liquidity and a relatively low interest rate policy – a prescription that contrasts sharply with the actual IMF stipulations. Looking back to the early phase of crisis, however, one may counter the above view by pointing out that the high interest rate policy succeeded in stabilizing the exchange value of Korean won; the evidence itself speaks for this. In fact, the trend toward stabilization of Korean won seems to move in line with high interest rates, but this may be a reflection of the effects of the mounting current account surpluses in 1998, which demonstrated the strength of the domestic exporting firms despite being in distress. Therefore, it seems that the financial policies will be destined to fail unless the possible impact on the real economy is fully taken into consideration.



In this regard, it may be that the IMF prescription should be very carefully reviewed in order to learn lessons for similar crises that may arise in the future.

7.

Concluding remarks

Most macroeconomic indicators betrayed no signs of things being seriously wrong in the Korean economy until the end of 1997. However, thereafter the situation started to deteriorate very rapidly indeed. Foreign exchange liquidity problems reached crisis proportions within months. Among the probable causes was an element of understandable overreaction on the part of foreign investors. However, regardless of such a modus operandi of foreign capital, efforts need to be focused on implementing any structural reforms that are beneficial to the Korean economy in the long run. The recent experience heightened awareness about the need to reform various sectors of the Korean economy. Now that the worst of the currency crisis has passed without inflicting too much structural damage, one beneficial legacy will be that the experience will have increased the awareness of businesses, government, the press and the general public of the need to improve efficiency in all areas. Indeed, since the implementation of the IMF regime, Korea has undergone significant institutional changes that are unlikely to have been enacted in the absence of such developments. In addition to the high interest rate policy for macroeconomic management, another important aspect of the IMF prescription is the strong recommendation for structural reforms. The IMF seems to believe that the cause of the Korean currency crisis lies in the structural weakness of the Korean economy. This point has also generated much debate. Our conclusion is that the structural weakness certainly provided an environment conducive to the outbreak of a crisis, but that it cannot be blamed as the immediate and direct cause for it. The most important cause lies in the failure of macroeconomic policy to deal with the exchange market in the process of market opening, including capital account liberalization. Thus, we believe that a macroeconomic response is the top priority, although the stance should be of a different kind.15 However, the IMF has pushed the Korean government to carry out structural reforms within the financial and corporate sectors in a very short time-span, the presumption being that this is the only way to pull the economy out of a crisis situation.



Structural reforms are indeed very important for sustained growth in the Korean economy, a point emphasized throughout this volume. However, structural reform should not be carried out hastily, only as quick fixes in response to the crisis. The next chapter will tackle the issue of the structural reforms undertaken by the Kim Dae-jung government under the guidance of the IMF over the two years since the outbreak of the crisis.

Appendix 8.1: Quantitative examination of the role of a strong exchange rate In this appendix, we attempt to add more quantitative content to the key issue of the strong exchange value of the Korean won overviewed in the previous section. Our approach is to estimate a time-series model of the effect of nominal wage, labor productivity, and inflation on the general price level using data since the 1970s as a benchmark. Once we have established the baseline model we can then examine the question of how unusual the behavior of those variables in the recent period has been. We also gauge whether or not some of the factors discussed in the previous section could account for the unusual behavior in those variables included in the model. The baseline model consists of nominal total compensation (nominal wage), output per hour (labor productivity), and the consumer price index (inflation). The setup is motivated by the reasonable assumption that real wage and labor productivity should move together – that is, that they should have a co-integrating relationship over a long horizon.16 Based on this premise, real wage can be separated into the two components of nominal wage and price level. Hence, they make up a three-variable system of the vector error correction model. Table A8.1 shows the estimation results of the baseline model using data from the two sample periods of 1975Q1–1987Q4, and 1975Q1–1996Q4.17 Table A8.1 shows that the model does much better in explaining inflation in the CPI and nominal wages than in explaining productivity. This is intuitive because one can expect a closer coherence between wages and inflation than between either one with productivity. Hence, it is reasonable to expect a simple model of the three variables to exhibit the pattern of explanatory power as seen in Table A8.1. It is interesting to note that the error correction term enters significantly only in the inflation equation for the first sample period


212 A New Paradigm for Korea’s Economic Development Table A8.1 Vector Error Correction Model of nominal wage, consumer price index and output per hour (Sample 1975: 1–1987: 4)

(Sample 1975: 1–1996: 4)

Variables

CPH

PDF

OPH

CPH

PDF

OPH

Constant

0.04 (1.55) –0.71* (–2.19) –0.03 (–0.10) 0.48 (1.70) 0.11 (0.50) –0.45 (–1.71) 0.52 (1.97) –0.00 (–0.00) 0.16 (0.61) 0.22 (0.47) 0.11 (0.20) –0.05 (–0.11) –0.34 (–0.85) 0.18 (0.95) 0.44 (0.22) 0.05

0.028 (1.96) –0.49 (–2.62) –0.28 (–1.42) –0.26 (–1.65) 0.08 (0.66) –0.00 (–0.05) 0.21 (1.38) 0.32 (2.12) 0.18 (1.19) 0.61 (2.22) 0.38 (1.23) 0.21 (0.73) 0.11 (0.47) 0.41 (3.59) 0.73 (0.63) 0.03

0.03 (2.34) –0.12 (–0.79) 0.04 (0.25) 0.11 (0.84) 0.05 (0.50) –0.06 (–0.54) 0.08 (0.64) 0.08 (0.64) 0.03 (0.25) –0.48 (–2.13) –0.24 (–0.96) –0.23 (–1.00) 0.02 (2.34) 0.15 (1.63) 0.39 (0.15) 0.02

0.07 (4.92) –0.40 (–3.06) –0.10 (–0.67) 0.14 (0.97) 0.13 (1.07) –0.15 (–0.79) 0.51 (2.64) –0.11 (–0.55) 0.20 (1.14) –0.34 (–1.15) –0.55 (–1.70) –0.59 (–1.87) –0.79 (–2.87) –0.09 (–3.74) 0.42 /0.31 0.04

–0.00 (–0.09) 0.66 (0.85) 0.15 (1.59) 0.06 (0.65) 0.12 (1.60) 0.15 (1.31) 0.39 (3.32) 0.20 (1.73) –0.08 (–0.72) 0.03 (0.17) –0.05 (–0.26) –0.12 (–0.63) –0.02 (–0.12) –0.02 (–1.06) 0.59 /0.52 0.03

0.01 (1.70) 0.13 (1.96) 0.14 (1.86) 0.11 (1.48) 0.09 (1.38) 0.02 (0.20) 0.09 (0.95) 0.05 (0.47) –0.05 (–0.51) –0.51 (–3.43) –0.25 (–1.58) –0.22 (–1.44) –0.10 (–0.77) –0.01 (–0.56) 0.22 /0.07 0.02

CPHt-1 CPHt-2 CPHt-3 CPHt-4 PDFt-1 PDFt-2 PDFt-3 PDFt-4 OPHt-1 OPHt-2 OPHt-3 OPHt-4 EC(–1) R2/adj.R2 S.E.E

CPH: Growth rate in Compensation for an hour, PDF: Growth rate in Consumer price index OPH: Growth rate in Output per hour, EC(–1): Error Correction Term – EC(1975:4 1987:4) = CPH – 0.380449PDF – 1.239144OPH + 0.003717 – EC(1975:1 1996:4) = CPH + 1.312306PDF – 5.030434OPH – 0.731934 *Numbers in parentheses are t-statistics. Significant cases (5% or less) are marked by bold prints.

then in the wage equation in the second case. Such a shift suggests that the relationship between the two variables of nominal wage and price index might have altered since 1987. In terms of short-term dynamics,



there is generally more interaction between nominal wage and the CPI inflation than between either of the two and productivity. Our intention is to use the model as a frame of reference to learn about potential misalignments in the Korean economy during the late 1980s and into the 1990s. One way to capture unusual data patterns is to compare the model’s forecast to actual data. For these, we use the model estimated from the 1975Q1–1996Q4 sample period to forecast one to four quarters ahead until 1996Q4. The top panel of Table A8.2 provides the forecast accuracy statistics for the model’s inflation forecast. One clear pattern that stands out is the fact that the model consistently overpredicted actual inflation. Since a forecast error is measured as an actual minus forecast, minus signs on mean errors suggest this point. This is not surprising given the rapid rise in nominal wages in the forecast period. Also noticeable is the fact that mean errors and mean absolute errors have identical magnitudes with the opposite sign. This is a clear indication of the model’s overpredicting bias. One conjecture raised from the discussion given in the previous section is that strong won exchange rate has helped to keep inflation low despite very strong wage growth. This can be examined by gauging Table A8.2 Forecast accuracy statistics for one- to six-quarter ahead inflation (1988Q1–1996Q4) Base line model

1 quarter ahead 2 quarter ahead 3 quarter ahead 4 quarter ahead 6 quarter ahead

Mean errors

Mean absolute errors

Root mean square

Number of observations

–0.075 –0.078 –0.108 –0.115 –0.147

0.077 0.081 0.110 0.115 0.147

0.089 0.914 0.124 0.128 0.162

36 35 34 33 31

Mean errors

Mean absolute errors

Root mean square

Number of observations

–0.038 –0.020 –0.028 –0.009 0.002

0.055 0.051 0.059 0.062 0.063

0.066 0.059 0.068 0.070 0.072

36 35 34 33 31

Model with exchange rate variable

1 quarter ahead 2 quarters ahead 3 quarters ahead 4 quarters ahead 6 quarters ahead



the impact of adding an exchange rate variable in the model. The bottom panel of Table A8.2 compares forecast accuracy measures from the model that includes exchange rate variable. The variable used for this exercise is the difference between actual won/dollar exchange rate and a Purchasing Power Parity-based equilibrium exchange rate. Both are shown in Table 8.6. They are to be compared to those shown in the top panel. The first strong contrast is that the mean errors drastically smaller in the case with exchange rate. For example, for the six-quarter ahead forecast, the forecast error of the model with the exchange rate is about one-seventieth of that for the baseline case. Adding the exchange rate variable clearly reduces the model’s tendency to overpredict actual inflation. Furthermore, all forecast accuracy measures improve substantially. That is, the robust inflation record since the late 1980s can be explained by the strong exchange rate value of the Korean won.

Appendix 8.2 1. Letter to managing director of IMF from leaders of Korean industry (drafted by the author) February 9, 1998 To: Mr Michel Camdessus Managing Director The International Monetary Fund CC: Mr Stanley Fisher Senior Deputy Managing Director The International Monetary Fund CC: Mr Gregory F. Taylor Executive Director The International Monetary Fund CC: Mr Hubert Neiss Director of Asia and Pacific Department The International Monetary Fund CC: Mr Chang-Yuel Lim Deputy Prime Minister Ministry of Finance and Economy The Republic of Korea Subject: Short-term difficulties experienced by Korean businesses



Dear Mr Camdessus: We, the representatives of key organizations of Korean industries, are particularly appreciative of the emergency help offered by the IMF in averting the recent foreign exchange liquidity crisis. Regardless of proximate causes, we feel heavy responsibility and are determined to take any steps necessary to overcome the current difficulties as soon as possible. We are vigorously implementing reform measures to improve the transparency of business practices and to address other issues raised by the government, the government-in-waiting, and the IMF. However, we would like to share our concern regarding the high interest rate policy that you have mandated and ask for your understanding and action in resolving this adversity in a cooperative spirit. In our view, we should immediately reconsider the current macroeconomic condition that is imposing unbearably high interest costs on Korean businesses. The primary aim of such a tight monetary policy stance has been to arrest the instability of the exchange value of the Korean won. We fully agree that stabilizing the exchange rate is most important in solving the current foreign exchange illiquidity problem. We must restore confidence in Korea as a good place to invest in world capital markets. Since in a situation like this, the necessary interest rates are usually punitively high, it exacts a very high cost in terms of contracting economic activity. Hence, a high interest rate policy is typically expected to be temporary until there are convincing indications that normalcy has returned to the exchange market. Several developments since the beginning of this year have buttressed international investors’ confidence in Korea. First, the Korean government and the government-in-waiting have duly implemented significant measures, required by the IMF, to bolster the Korean financial sector (e.g. closing of insolvent merchant banks and addressing the bad-loan problem of commercial banks). Second, the current account balance has generated surpluses for three consecutive months as the result of Korean citizens’ determined efforts to boost exports and to endure an austere life. Third, the Korean delegate completed a comprehensive debt renegotiation with foreign lenders last week in New York. Obviously, the terms of the renegotiation were reasonably fairer than those expected by some observers. This, in our view, reflects strong confidence in the Korean economy by leading international banks and the international financial market at large.



We would like to suggest that developments to date have brought a sufficient degree of calm to our foreign exchange market. This warrants a serious second look at easing the tight credit market policy stance. The positive developments mentioned notwithstanding, there are other compelling reasons for our recommendation. The tight credit policy indeed has taken a grave toll on our ability to make prompt and deep structural adjustments to our economy. First, the tight credit condition has seriously impeded the individual firm’s effort to increase exports. We understand banks’ credit retrenchment under the current circumstances to a degree. But, given that banks have large credit exposure to businesses in Korea, a fundamental improvement in the soundness of banks hinges on businesses making the most of their borrowing by generating healthy earnings. Furthermore, an increase in exports is absolutely necessary in meeting our external and IMF obligations, at this point. If businesses are effectively denied credit by prohibitively high interest costs, many of them might unnecessarily fail thus putting a further weight on the current difficulties. Currently, the ratio of dishonored bills based on the value amount has skyrocketed to 1.49 per cent in December 1997 from the monthly average of 0.14 per cent seen in 1996. As a result, the number of bankrupt firms has increased to 3,197 during December 1997 from the monthly average of 966 during 1996. How can firms increase exports if they have difficulties in obtaining credit to buy raw materials for exports, and if they have such extensive failures resulting from short-term liquidity constraints? High interest rates are retarding efforts to rationalize and downsize businesses. Almost all industries have seriously begun steps to consolidate their corporate finances. Disposal of assets and some operations are a crucial part of this effort. However, there are only a few interested takers under current macroeconomic, as well as tight credit, conditions. As yet, there have not been many foreign buyers either. Presumably foreign investors are apprehensive of the profitability of available business opportunities in the near term. One important hindrance will be due to the uncertainty regarding how long and how deep the current contractionary trend will continue. We are hopeful that reform measures will soon follow, and allay some of the concerns raised, as evidenced by the recent fruitful tri-party talks on labor market reform measures. But we are afraid that the process might take too long, and asset prices might fall too steeply in the meantime for many businesses who would have been viable otherwise. Consequently, businesses want a more bearable level of interest rates,



not to facilitate expansion by increasing debt load, but to help streamline operations. Despite the consensus reached on the labor market reform measures, the impending adjustment is potentially a very serious issue with broad ramifications. One thing is clear, however, fully engaged production facilities will mitigate the extent of the approaching unemployment problem. The more firms remain economically viable and fully operational, the greater the ability to share the burden for affected workers and their families. As mentioned earlier, we fully understand the need to provide firm support for exchange rate stability. Recently, we have observed the increasing net purchases made by foreign investors in the stock market. However, we have not yet seen any substantial increases in the beginning stage of the new inflow of capital from interest rate differentials, which is regarded as the key benefit to the high interest rate policy. High costs accompanying the tight monetary policy thus appear even harder to justify. Perhaps improving domestic business conditions through a somewhat less tight policy will induce more inflow of foreign capital. Additionally, our assessment is that the positive developments to date might be sufficient enough to offer solid support to the exchange value of the won. We concede that this judgement is subject to the uncertainty of future developments. Thus, we reiterate the proposal that interest rates be adjusted to a more bearable level with a clear understanding that a reversal will be automatic should any future developments threaten the exchange market stability. Finally, the recent extraordinary contraction of bank lending as well as of overall financial activities, have greatly reduced the effect of the money velocity and multiplier. Subsequently, under such special circumstances, it is not clear how much credence should be given to the estimates of parameters that were based on past data. This raises the question whether the current policy guidelines regarding the money growth target proposed by the IMF are realistic. Hence, we would also like to urge you to take this matter into account while negotiating the next round of macro-policy re-evaluations. Again, we would like to express our appreciation for your continued efforts in helping us overcome the current economic difficulties. Respectfully yours, Chey, Jong Hyon Chairman, Federation of Korean Industries



Kim, Sang Ha Chairman, Korea Chamber of Commerce Koo, Pyong Hwoi Chairman, Korea International Trade Association Park, Sang Hee Chairman, Korea Federation of Small Businesses Kim, Chang Sung Chairman, Korea Employers Federation 2. Letter of reply from Michel Camdessus, managing director of IMF March 10, 1998 Dear Sirs: Thank you for your letter of February 9 and the analysis you provided about the current situation facing the Korean business sector. We appreciate how difficult economic conditions are at the moment, and we welcome your efforts to make Korean businesses more efficient and more transparent. These efforts, together with the economic policies that the government is pursuing, with the full support of the IMF, should help Korea to emerge from the crisis and put the economy back on a path of sustainable growth. We understand your concerns about high interest rates and are fully aware of their potentially adverse implications for the highly leveraged corporate sector in Korea, and of the current difficulties experienced in obtaining working capital and financing, both for domestic operations and exports. As confidence returns, there should be increased scope for lower interest rates. However, as you correctly point out, high interest rates are necessary to ensure exchange rates stability and to avoid a future episode of sharp declines in the value of the won. Here we are encouraged by the experience of recent weeks when we have begun to see substantial foreign inflows into the bond market (W1.5 trillion to date), so high interest rates are having an effect on stabilizing the won. Nevertheless, despite recent signs of stability, the foreign exchange situation in Korea remains fragile and there are risks that continuing turbulence in some other Asian markets could have adverse impacts on Korea. In this situation, the room for maneuver is very limited. I note your suggestion that interest rates should be lowered now and raised



again should the won come under renewed downward pressure. The risk with this strategy, however, is that in a situation where the exchange rate remains fragile, a premature cut in interest rates is likely to result in renewed instability, requiring interest rates to be raised again, to levels even higher than at present, and it would be completely uncertain when they could again be lowered. Therefore, the IMF has recommended a strategy to lower interest rates only when the won has durably stabilized. In this way, we hope to avoid a renewal of exchange market pressure, which could set back the progress Korea has made so far. As you know, interest rates have been lowered somewhat during January and February and we hope that the foreign exchange market will become fully stabilized. Once we are confident that this is the case, we would fully support bringing down interest rates further. In the meantime, measures have been put in place to help the business community under the present conditions, including a limited Bank of Korea export financing facility and a significant extension of the credit guarantee funds. These measures should provide some help in the present circumstances of high interest rates. Please also be assured that we are continuously monitoring the level of interest rates, the value of the won, and economic developments in Korea. We are aware of the difficulties of setting monetary targets in a period with as much uncertainty as the present one and that, in judging the monetary conditions, we set more store by the behavior of interest rates rather than monetary aggregates. To conclude, I would note that the Executive Board, management, and staff of the IMF have been deeply impressed by the strong commitment of all the Korean people to undertake the reforms necessary to overcome the current crisis. We are confident that if the current pace of reforms continues, Korea will emerge from the crisis soon, and as an even stronger economy. Yours sincerely, Michel Camdessus


9 Kim Dae-jung’s Structural Reforms and Some Evaluations

1.

Introduction

Chapter 8 has suggested that one of the most urgent recommendations made by the IMF was to reform the banking sector as well as the corporate sector. The new government under Kim Dae-jung accepted the IMF’s diagnosis that the economy’s structural weakness was the underlying cause for the crisis and has thus emphasized structural reforms of the economy. In fact, structural reforms, including financial and corporate sector reforms, have been top priorities on the reform agenda for Kim Dae-jung’s government as well as the previous governments, because rapid progress in these areas is a prerequisite for keeping the Korean economy on a path of sustained growth. Confronting such challenges, and having witnessed the very limited success attained by the previous government, Kim Dae-jung’s government has been pushing for sweeping structural reforms designed not only to ensure a rapid recovery from the crisis but also to take Korea into the twentyfirst century as a thriving economy. The Korean government has been driving ahead with the restructuring and recapitalization of the financial sector and the strengthening of prudential regulations and supervision. Major steps have also been taken to improve the institutional framework so as to facilitate corporate restructuring through market discipline, such as the frameworks for improved management transparency, enhanced corporate governance structure, liberalized mergers and acquisitions, and opening up the market to foreign investment. Banks are playing a central role in the restructuring of corporate debt and in working to strengthen the corporate financial structure. The Korean government’s policies to restore financial stability have begun to regain the confidence of inter220


Kim Dae-jung’s Structural Reforms 221

national investors. Furthermore, the dismissal of workers as a part of the process of corporate restructuring is now permitted, a step which it is hoped will ease the rigidities of the labor market. From the onset of the crisis, Kim Dae-jung’s government has argued that the underlying cause for the economic crisis is the kwanchi kyungche (government-controlled economy), and kwanchi keumyung (government-controlled finance) confirming what we have repeatedly stressed in this volume. Based on the understanding that excessive government intervention in the economy is the source of the problem, the Kim Dae-jung government has announced its agenda for reform as the development of democracy and market economy. Despite the success in facilitating economic recovery, the government has drifted many times from market-oriented and democratic methods in order to administer swift restructuring programs. In order to ride out the current crisis and build up medium- and long-term growth potential, market principles should be enshrined in the economy through the pursuit of market-oriented policies. Therefore, it may be useful to overview the economic reforms of Kim Dae-jung’s government since the crisis in order to gain some insights and lessons for future reforms in line with the goal of bringing more market principles to the Korean economy. The rest of the chapter is structured as follows. Section 2 overviews active reforms in four major sectors that the new government undertook immediately following the crisis. Section 3 will briefly evaluate the recent reforms and section 4 will conclude with some suggestions for future reforms.

2.

Structural reforms in four major sectors of the economy

While the greatest effort has been made to deal with macroeconomic difficulties arising from the foreign exchange reserve depletion and the recession, the Kim Dae-jung government has also worked to accelerate reform efforts in four major areas. Recognizing that the moral hazard problem in financial and corporate sectors which lead to overlending and overborrowing was at the core of the structural weakness which led to the crisis, the new government prioritized the simultaneous restructuring of the financial and corporate sectors. In addition, labor market and public sector restructuring has also been pursued in order to promote the flexibility and efficiency necessary to keep up with reforms in other sectors. Labor market flexibility is a prerequisite for the smooth restructuring of both the corporate and financial sectors.



Finally, the reform of the public sector is critical to the success of the entire reform effort. The public sector’s effort to improve its own efficiency could help gain public support for painful reforms in other sectors, and improve the government leadership in this difficult reform drive. More importantly, as we emphasize throughout this volume, the public sector reform should also be concerned with the role of the government in economic management. 2.1

Financial sector reforms

2.1.1

Restructuring in banks and non-bank financial institutions

The most pressing task for Korea in the immediate post-crisis period was to restructure the financial sector. It was important to stop the vicious circle of corporate insolvency, which led directly to financial sector insolvency. With this in mind, the first thing the Korean government tried to achieve was to restore intermediary functions based on voluntary credit screening and to rebuild a financial system on a commercial basis. An important step was the establishment of an independent and consolidated financial supervisory organization. With the agreement of the IMF, the Financial Supervisory Committee (FSC) was formed. This body has authorized the closure of defaulting financial institutions and assumed leadership for restructuring the financial sector. It has set clear exit strategies and standards for loss sharing among parties to enhance market discipline within the financial sector. The government first targeted the merchant banking corporations, which were overridden with foreign currency dealings and short-term debt to a much larger extent than the next target, the commercial banks. The FSC used the capital adequacy ratio as part of its evaluation standards to check the asset soundness of all commercial banks. Banks that fell short of the 8 per cent BIS ratio at the end of 1997 were required to submit recapitalization plans, which included timetables for achieving the ratio. Banks that were not approved upon evaluation were forced to take drastic steps, such as undergoing M&As and liquidations. Table 9.1 shows the result of the first round of financial restructuring. A total of 171 financial institutions, including five banks, were either closed down or had their operations suspended. The restructuring of merchant banks had the most dramatic consequences, because these institutions were deeply involved in dealing with short-term loans and in managing risky investments. As a result, 16 of the 30 merchant banks existing prior to the financial crisis were either suspended or had their licenses revoked. Relatively comprehensive restructuring programs for leasing and insurance companies have also been imple-


Kim Dae-jung’s Structural Reforms 223 Table 9.1

Major reforms in financial institutions Number of Institutions

Financial institutions

Reform contents End 1997

April 1999

Banks

33

24

Merchant Banks

30

12

Security Firms

36

30

Insurance Companies

50

45

Investment Trust Companies Leasing Corporations

31

25

25

21

Mutual Savings 231 and Finance Companies Credit Unions 1666

208 1566

Total

1931

2102

• Exit of five banks through Purchases and Assumptions • M & As involving nine banks • Two major commercial banks to be sold to foreign investors (Korea First Bank and Seoul Bank) • 16 merchant banks closed down • 2 merchant banks M&Aed with commercial banks • Closing down 2 security companies • 4 security companies have their operations suspended • Exit of 4 insurance companies through P&As • Two M&As • Management Improvement Notice to 16 companies • Two investment trust companies closed down • Four leasing companies closed down • Assets and liabilities removed from 6 leasing companies by Bridge Leasing Company

Source: Ministry of Finance and Economy.

mented. Restructuring of investment trust companies is expected to be implemented in the near future. Forcing insolvent financial institutions to leave the market provided a basis for reducing uncertainty and increasing efficiency. However, so far only small financial institutions have exited and this has not helped to improve the competitiveness of the financial institutions as a whole. In order for Korean financial institutions to meet the international standards, major banks that do not meet the BIS ratio must adhere to the same reform policies.



At the same time, financial institutions have intensified their own rehabilitation efforts. For example, banks have reduced their personnel from 114 619 at the end of 1997 to 75 604 at the end of 1998 (a drop of about 34 per cent of the total staff) and also shut down 994 branches (about 16 per cent) in 1998. (see Table 9.2). The most severe restructuring program in terms of reducing personnel has been carried out in the leasing sector. More than half of the supporting staff and managers in leasing companies has left their workplace. From the point of view of improving the efficiency of the financial industry, layoffs and downsizing would have an immediate positive effect on average productivity – though it remains uncertain whether productivity will continue to increase in the medium and long term. 2.1.2

Public support for financial restructuring

Eliminating non-performing loans (NPL) within the Korean banking sector is a staggering task. However, the actual amount of cash involved in the implementation of NPL removal is only a fraction of the total amount of NPLs. The Korea Asset Management Corporation (KAMCO) has been entrusted with this task. KAMCO, modeled after the US Resolution Trust Corporation (RTC), purchases NPLs from banks at market value, which is only a fraction of the book value. However, KAMCO does not pay for the purchase in cash but in kind by issuing its own bonds. The Korean government guarantees the KAMCO bonds and agrees to pay for the interest at maturity in cash. The banks welcome such an arrangement, since government-guaranteed bond holdings raises the BIS capital ratio. The same strategy is employed in the recapitalization of banks. The Korea Deposit Insurance Corporation (KDIC), modeled after the FDIC (Federal Deposit Insurance Corporation) of the United States, pays for the capital subscription of the bank not in cash but in kind with the issuance of its own bonds. The Korean government guarantees the KDIC bonds and agrees to pay for the interest at maturity in cash. The bank welcomes the receipt of the government guaranteed bonds, since such bonds also raise the BIS capital ratio. In both of these NPL disposal and recapitalization operations, the level of cash transactions should be kept to a minimum. KAMCO can resell its purchased NPLs to retrieve the cost of the purchase and minimize the eventual burden on the public. Likewise, KDIC can also sell its acquired equities in the banks to the foreign or domestic investors. Therefore, KAMCO and KDIC are supposed to manage their assets such that the amount of public support can be minimized.


Table 9.2

Downsizing of Korean financial institutions, 1997 to 1998

Banks

Merchant Bank Leasing Co. Securities Firms

Insurance Co. Investment Trust Co. Mutual Savings & Finance Co. Credit Unions

Managers Supporting staff No. of Domestic Branches Abroad Managers and Supporting Staff Managers and Supporting Staff Managers Supporting staff No. of Domestic Branches Abroad Managers and Supporting Staff Managers and Supporting Staff No. of Companies Managers and Supporting Staff No. of Companies Managers and Supporting Staff No. of Companies

End of 1997

End of 1998

Changes

501 114 118

345 75 259

156 (31.1%) 38,859(34.1%)

5 987 190 1 922 2 172 362 26 870

5 056 127 1 628 1 080 271 22 084

931 (15.5%) 63 (33.2%) 294 (15.3%) 1,092 (50.3%) 91 (25.1%) 4,786 (17.8%)

1 260 89 83 304 6 230 31 10 425 230 30 122 1 666

1 108 41 64 879 5 004 24 8 226 209 28 767 1 592

152 (12.1%) 48 (53.9%) 18 425(22.1%) 1 226 (19.7%) 7 (22.6%) 2,119 (21.1%) 21 (9.1%) 1 355 (4.5%) 74 (4.5%)

Source: Financial Supervisory Services.

225



By the end of 1998, KAMCO issued 19.9 trillion won worth of government-guaranteed bonds to purchase 44 trillion won worth of NPLs from the banking sector (see Table 9.3). In the same period, KDIC issued 21 trillion won worth of its government-guaranteed bonds for recapitalization and depositor protection. Hence, KAMCO and KDIC together had financed a total of 40.9 trillion won for the sake of financial sector restructuring by the end of 1998. With an additional 23.1 trillion won in financing in 1999, total financing amounts to 64 trillion won (about US$53.3 billion). Table 9.3 Outline of public support for financial sector restructuring (trillion won) Purchase of NPLs

Recapitalization

Deposit payment

19.9 12.6 32.5

13.2 4.3 17.5

7.8 6.2 14.0

Total 1997.11–98.12 1999 Total

2.1.3

40.9 23.1 64.0

Liberalization of foreign exchange transactions and capital accounts

Capital account liberalization has been one of the most difficult market-opening issues for Korea in the process of joining the OECD in 1996. Korea has been concerned about the possibility of the drastic inflows of foreign capital, which a spread between the domestic and international interest rates may bring. Therefore, the government has taken a very cautious approach to capital account liberalization. Interestingly, and rather unexpectedly, the capital outflow turned out to be the most disturbing phenomenon during the currency crisis. The IMF agreement includes the bold implementation of capital account liberalization. In particular, the 6th Letter of Intent called for the opening of all capital markets, including opening the short-term capital market to foreigners. To overcome the foreign liquidity crisis, the Korean government liberalized the capital account ahead of the schedule agreed with the IMF. Implementing full liberalization measures, the new Foreign Exchange Transaction Act replaces the old Foreign Exchange Management Act. The new law, that came into effect in April 1999, liberalizes corporate overseas borrowing, and establishes a futures market. In addition, Korea saw a significant expansion of the financial derivatives market. The Korea Futures Exchange (KFE) was inaugurated in April 1999.



However, the liberalization of foreign exchange transactions will also raise new challenges. Rapid, borderless transactions of short-term capital may destabilize the foreign exchange market and render the Korean won more susceptible to speculative attacks. Therefore, the government should devise various measures to counter potential market instability, such as reinforcement of prudential regulations and supervision of financial institutions. Capital market liberalization and the promotion of FDI are also important aspects of capital account liberalization in the restructuring process. The Korean government’s renewed zeal for attracting FDI is a case in point. The new Foreign Investment Promotion Act, drafted and legislated after months of intense deliberation, abolished the old legal framework on FDI. A new FDI policy of ‘promotion and support’ replaced the old ‘regulation and management’ approach.1 Local authorities now have greater discretion in attracting FDI in their own jurisdictions. Extensive tax exemptions are given.2 Local authorities can give additional local tax breaks at their own discretion. The government’s goal is to make Korea the most investor-friendly destination for FDI in the world. Measures taken by the Korean government to promote FDI since the outbreak of the crisis reflect not just changes in the policy matrix, but more fundamental changes in the government’s philosophy. Such measures include the removal of the foreign equity ownership ceiling (May 1998), the freedom for foreign investors to make hostile takeovers or to invest in local bonds and short-term money market instruments (May 1998) and the complete liberalization of foreign exchange transactions (April 1999) among others. 2.2

Corporate sector reform

2.2.1

Chaebol restructuring

The IMF pinpointed chaebols as the main culprits for Korea’s structural weakness and stressed the need for rigorous corporate restructuring. High leverage ratios and a very poor use of capital in the Korean corporate sector prior to the crisis aggravated the impact of tightening liquidity on corporate cash flows and investment activities during the post-crisis adjustment. Cross-debt guarantees between affiliates of conglomerates helped create massive debt levels in most conglomerates. In early 1998, an agreement to improve the financial structure of the business sector was signed between creditor banks and the chaebols under the ‘Five Principles of Corporate Restructuring’ program. This agreement covered: (1) the enhancement of transparency of corporate



governance; (2) strengthening the accountability, such as allowing voting rights of institutional investors; (3) resolution of cross-debt guarantees; (4) improvement of financial structure; and (5) streamlining business activities (see Table 9.4). Table 9.4

Five principles for chaebol reform

Objectives

Measures

Schedule

Enhanced transparency

• Adoption of consolidated financial statements • Adoption of international accounting principles • Strengthening the voting rights of minority shareholders • Compulsory appointment of outside directors • Establishment of external auditors committee • Strengthening the legal liability of controlling owners • Allowing voting rights of institutional investors • Introduction of cumulative voting system • Resolution of existing cross guarantees • Prohibiting new cross guarantees between subsidiaries • Prohibiting financial institutions from demanding cross guarantees • Agreement with banks to improve the capital structure • Removal of restriction on capital infusion to subsidiaries with consideration to defend against hostile takeovers (measure to be re-enforced by April 2000) • Exclusion of income tax deduction on interest payments on excessive borrowings • Introduction of asset-backed securities • Requirement of 200% debt/equity ratio (added later) • Adoption of corporate-split system • Improving M&A procedures • Liberalization of foreign ownership of real estate • Full liberalization of M&As • Streamlining bankruptcy procedures

• FY 1999

Strengthening accountability

Resolution of cross-debt guarantees

Improvement of financial structure

Streamlining business activities


• Oct. 1998 • May 1998 • Feb. 1998 • Feb. 1998 • Jun. 1998 • Sept. 1998 • Dec. 1998 • Mar. 2000 • Apr. 1998 • Apr. 1998 • Apr. 1998 • Feb. 1998

• FY 2000 • Sept. 1998 • Dec. 1999

• Jun. 1998 • Jun. 1998 • Jun. 1998 • May 1998 • Feb. 1998


Another element of the corporate restructuring process involves business swaps (the so-called ‘Big Deals’) between the top five chaebols to streamline overinvestment and enhance efficiency in such key industries as semiconductors, petrochemicals, aerospace, rolling stock, power plant equipment, vessel engines, and oil refining. The top five chaebols in the order of the size of their assets are Hyundai, Samsung, Daewoo, LG, and SK groups. The policy outcome of the Big Deal between the chaebols is yet to be seen. In his Liberation Day address on 15 August 1999, President Kim Daejung vowed to implement three additional sets of measures toward chaebol reform in addition to the five principles shown in Table 9.4. President Kim Dae-jung continued to emphasize strong chaebol reform, targeting their fleet-style operations in particular. These three new reform measures are: (i) to restrict the chaebols’ control of non-banking financial institutions; (ii) to prevent them from making cross-subsidiary capital infusion or equity investments (a policy reversal from the removal of the restriction 18 months before) and insider trading; and (iii) to ban inheritances and transfers of wealth among family members of chaebol leaders who attempt to exploit loopholes. As a result of the implementation of these policy measures, the corporate sector has thus far reduced cross-debt guarantees more aggressively than originally planned. Chaebols are taking steps to reduce their debt/leverage ratio to the government set limit, 200 per cent by the end of 1999, as a part of broader efforts to re-focus on their core Table 9.5

Debt reduction of the top five chaebols (unit: trillion won) End of 1997

Debt 220.4 Shareholder’s equity 46.9 Debt/equity ratio (%) 470.2 (D/E ratio w/ asset revaluation) Restructuring effort (A+B) Asset sales (A) Capital expansion (B) Foreign investment (US$bn) Reduction of cross-holdings Rationalized affiliates (number)

End of 1998

target

225.1 165.7 58.3 83.6 386.0 198.3 302.1 14.7 48.8 7.4 24.4 7.3 24.4 2.70 14.66 4.3 111

1999 1stH target 1stH result 215.3 64.1 335.7 266.1 14.7 6.4 8.3 2.35 2.1 62

Source: Financial Supervisory Commission. Note: The top five chaebols are Hyundai, Samsung, Daewoo, LG and the SK Group.


222.7 73.7 302.2 235.1 17.3 7 10.3 2.67 3.4 61


business areas and raise their returns in the process, thereby improving their financial soundness. There has been a significant reduction in the debt/equity ratio for the five largest chaebols, from 470.2 per cent at the end of 1997, to 302.2 per cent at the end of the first half of 1999 through asset sales, and capital expansion as shown in Table 9.5. 2.2.2

Corporate workout program and non-viable firm exit

In addition to the five principles for corporate restructuring outlined above, the government has launched a range of corporate reform packages depending on the size of the chaebol. One is the big deal operation for the top five chaebols, as explained in the above. The others are workout programs for medium-sized chaebols, namely the 6th to 64th largest, and the forced exit of non-viable firms. The workout programs, which most Koreans are unacquainted with, were intended to recover companies that look promising in the medium and long term, but which are experiencing financial difficulties in the short term. In May 1998, creditor banks established a formal review committee to assess the viability of 313 client firms showing signs of financial weakness. Upon completion of their evaluation, creditor banks listed 55 firms as non-viable, of which 20 were affiliated with the top five chaebols, and 32 with the top 6 to 64. Outstanding loans to the 55 nonviable firms were approximately 5 trillion won. Creditor banks denied new credits and cross-subsidy bailouts to these firms in order to effectively wipe them out of the market. Legal proceedings for corporate rehabilitation and bankruptcy filing were simplified in February 1998 to facilitate the market exit of non-viable firms and to ensure better representation of creditor banks in the resolution process. Procedural simplification for market exit also has important implications for corporate workouts, in that the presence of an expeditious exit scheme induces more efficient negotiations of workout programs between creditor banks and firms. The World Bank actively participated in the Korean workout program by providing Korea with expertise and a Technical Assistance Loan of US$33 million to employ outside experts as advisors for the design and implementation of the program. Corporate workouts extend to small and medium-sized enterprises as well. Creditor banks have evaluated the financial status of approximately 22 000 small and medium-sized enterprises (SMEs) with outstanding loans of one billion won or more. Approximately 13 000 firms listed as viable were selected as candidates for workouts. So far, creditor banks concluded workouts with more than 11 800 SMEs.



2.2.3

Enhancement of corporate governance

To enhance the credibility of corporate financial accounting, from the beginning of the fiscal year 1999, chaebols were required to adopt more rigid accounting standards and to publish combined financial statements for subsidiaries. The system of outside directors was adopted in order to rectify the practice of illicit control of firms through proxy equity participation. Appointed by the shareholders’ meeting, outside directors represent the interest of minority shareholders and the public interest at large. All listed companies are required to appoint outside directors, and by October 1998 the 752 listed companies had appointed a total of 764 outside directors. Recent introduction of rather drastic changes in the corporate governance system is being discussed under the guidance of the government. These changes include the provision that the top 30 chaebols and all listed companies are now required to organize ‘independent audit committees’ consisting of outside directors as majority members as a way of increasing management transparency and accountability. In order to accelerate the corporate restructuring process, measures to revitalize the domestic M&A market were developed. M&A activity which involves foreign firms has been promoted through the amendment of the Foreign Capital Inducement Law. Management efficiency was sought through the establishment of greater accountability to shareholders. Limits on the voting rights of institutional investors were lifted, and the rights of minority shareholders were strengthened. Finally, in order to facilitate the exit of insolvent firms, the bankruptcy and corporate reorganization laws have also been revised. 2.3

Public sector reform

The Kim Dae-jung government set out three objectives for carrying out public sector reform. The first is to create a small but efficient government by streamlining government functions and vastly reducing its size. The second is to achieve a highly competitive government by incorporating the principle of competition among civil service organizations and personnel. The last objective is to pursue a customer-oriented government by fostering a user-friendly behavior and attitude on the part of government employees. To achieve these three objectives, the new government has launched a wide-ranging set of programs (see Table 9.6). Downsizing of the government is an important feature of the public sector reforms necessary for the raising of efficiency. The government streamlined its organizational structure in February 1998. The necessity of restructuring the government administration had emerged before



Objectives and strategies of public sector reform

Objectives

1. Principle of customer priority 2. Entrepreneurial government management 3. Flexible and transparent administration

Strategies

1. Redesign government’s role 2. Promote competition in the public sector 3. Introduce a responsible management organization 4. Maximize the use of information 5. Establish a competitive personnel compensation system based on ability 6. Increase delegation of responsibility and authority to subordinates 7. Transfer authority to local government 8. Transparent administration 9. Creation of responsible work ethics

Source: Ministry of Finance and Economy, Djnomics: A New Foundation for the Korean Economy, 1999.

the crisis. However, the crisis served to expose the weaknesses of governing infrastructures and made restructuring an urgent task. The three basic directions established for government reorganization were: (i) to consolidate redundant functions; (ii) to speed up deregulation and privatization for state-owned enterprises (SOE), thereby encouraging competition in the private sector; and (iii) to decentralize authority by giving more power to local governments. As for government restructuring, Kim Dae-Jung’s government can take some credit for its policy designed to reduce the size of the bureaucracy. The number of employees working for the central government was reduced by 9084 (5.6 per cent) in 1998. It plans to reduce cut the number of government employees by 16 per cent by 2001. Local governments have also streamlined their organizations, by reducing the number of total employees by 12 per cent in 1998. It plans to bring that number to 30 per cent by 2002. Inefficiency has characterized the quasi-government sector, which includes public institutions and various government-affiliated associations. State-owned enterprises (SOEs) in particular require drastic overhaul by a combination of privatization and management reform. Twenty public institutions of the 109 SOEs have already been privatized in 1998. As shown in Table 9.7, more efforts to streamline this sector have been introduced by the new government. Eighty-nine subsidiaries of the 30 parent SOEs are also subject to privatization or management reform.


Table 9.7

Reform plan for SOEs Gradual privatization

Management reform and restructuring

Deadline

By end 1999

By end 2002

Ongoing

Targeted SOEs

Five parent companies (including POSCO, Korea Heavy Industry and Construction, and Korea Technology Financing Corporation), and 21 subsidiaries.

Six parent companies (including Korea Telecom, Korea Tobacco and Ginseng Corporation and Korea Electric Power Corporation) and 31 subsidiaries.

13 parent companies (including Korea Securities Printing and Minting Corporation, Korea Trade Investment Promotion Agency, Korea National Tourism Corporation, and Korea Coal Corporation), and 37 subsidiaries.



Full/immediate privatization


The future status of the 21 subsidiaries of the SOEs slated for immediate privatization in 1999 will be determined by the private firms acquiring them. Of the remaining 68 subsidiaries, 31 will be privatized either immediately or in time, while 37 will be restructured or consolidated. So far, the privatization of state-run enterprises has been implemented as scheduled. A considerable amount of Korea Telecom, POSCO, and Korea Electric Power Corporation stakes have been sold to foreign investors through the issues of depository receipts (DR). The successful issuance of DRs in international financial markets has contributed to the rise in international confidence in the Korean economy. Elimination of excessive regulations is another important task in the public sector reform. The Regulation Reform Committee (RRC) has abolished 4465 regulations, some 40 per cent of the total. Twenty-three laws were abolished, and 248 laws revised. These numbers seem to speak for the government’s strong commitment to drastically reducing unnecessary regulations. Abolition of unnecessary regulations is also conducive to the enhancement of transparency in corporate, financial, and public sectors. At the same time, the ongoing reforms will bring Korea’s regulatory system more closely into alignment with the frameworks of the World Trade Organization (WTO) and the Organization for Economic Cooperation and Development (OECD). In May 1999, the Presidential Commission on Personnel Affairs was inaugurated with the aim of making government personnel management more efficient. Legal grounds for hiring civilians for government posts (the open hiring system) have been prepared. The Korean government plans to introduce competitive salaries and incentives in place for government jobs. These measures are hoped to increase competitive pressures in the bureaucratic system. 2.4

Labor market reform

One particular area in which dramatic changes have taken place is in the labor market. As a result of the sharp economic contraction that marked the onset of the economic crisis in 1997, the unemployment rate rose rapidly to unprecedented levels in 1998 and 1999. This was accompanied by a sharp fall in wage rates. Nominal wages fell by as much as 2.5 per cent in 1998 – having risen 15 per cent on average per annum since the late 1980s. Such a drastic shift in general labor market conditions has also changed perceptions of what constitutes acceptable practices in the labor–business relationship. Furthermore, Korea’s labor market reform laid down by the Tripartite Commission also helped improve the labor market flexibility, the



absence of which constituted one of the factors contributing to the deterioration in Korean export competitiveness and hence the profitability of Korean businesses in the 1990s.3 Some potentially important changes were made to labor laws to increase flexibility in the labor market by removing barriers to large-scale layoffs. However, the actual implementation of layoffs is still extremely difficult. A clear result of developments following the economic crisis is the weakening influence and diminishing militancy of the labor unions. One of the most crucial aspects of the Korean government’s efforts to overcome the current economic crisis is the effort to improve the working relationship between labor and management. In the belief that a new working relationship between labor and management is essential to economic recovery, the Tripartite Committee decreed that all parties concerned should be consulted before initiating restructuring of certain companies (23 July 1998). The Tripartite Committee also agreed to push revision of laws governing political funds and legalization of unions for the unemployed (28 September 1998). It also decided on a draft of a National Pension Act (1 December 1998) and to hold public hearings regarding labor and management policies. An important characteristic of the 1998 labor–management compromise is that there was reasonable give-and-take between the labor and management. With 4357 (or 84.5 per cent of the businesses) employing 100 or more workers, labor took a pay cut or pay freeze in return for the management’s promise to limit layoffs to a minimum. In 308 companies, both labor and management agreed not to go to extremes, settling any differences at the negotiation table. This type of friendly pact is setting a new trend in the traditionally acrimonious labor– management relations. Even during the economic crisis, activities to promote labor rights continued. A teachers’ union and limited collective action by civil servants in the form of a workplace council was legalized. A bonds system that aims to guarantee three months’ wages for workers of bankrupt businesses is now in place. The Labor Standards Law now covers all workers, including those working for a company with four or fewer employees, this last provision having added on extra 1.6 million workers to the scheme. Labor law violators are now aggressively dealt with. Employment adjustment was inevitable during the restructuring process, unemployment soared, increasing the potential for social unrest. In order to minimize this risk, the Korean government and the IMF agreed on the need to design and implement a social safety net.



The Unemployment Task Force was organized under the jurisdiction of the Prime Minister’s office and spearheaded the government’s effort in this regard by promoting job relocation through job placements and training and by providing incentives for firms taking part in this promotion. The employment insurance system has also been augmented to cover all regular, temporary, and daily employees. Funds to establish social programs, such as expanding employment insurance and job placement agencies, were appropriated from the government’s budget. In 1999, the government spent 7.7 trillion won (up from 5.7 trillion won in 1998) on various programs of unemployment protection. Also the Korean government unveiled a proposed 2.5 trillion won package comprising tax deductions and subsidies to help reduce the burden of middle- and low-income workers.

3. 3.1

A brief evaluation of the Kim Dae-jung reforms Public sector reform

Generally speaking, the impact of reform in the Korean public sector has been quite positive, with a number of observable changes taking place during the first half of 1999. During this time, the administration has succeeded in downsizing a significant percentage of its staff, SOE privatization has been successfully launched and the government appears to be making some headway with deregulation and the adoption of an open hiring system. Of course, it is still too soon to say and the long-term results of this ongoing process have yet to be determined. It is sincerely hoped that the current efforts will not be derailed by political considerations and that the government maintains its momentum as regards further downsizing, privatization, deregulation and further opening of the bureaucratic system. While generally positive comments have been made, this is not to say that there have been no criticisms. For one thing, government reform has not been addressed in a systematic way – there has been little attention given to public sector reform. The establishment of a new role for the government in economic management should be given the highest priority and this is particularly the case in Korea. Instead, great confusion has arisen over the supposed transformation of the government’s role in economic management, both before and after the economic crisis. This has limited the effectiveness of reforms in other key areas, causing delays in the deregulation process and impeding the launch of large-scale privatization reform in particular.



This absence of a clear-cut perspective on the government’s role makes it very difficult for both private economic agents and the bureaucrats themselves to have faith in the substance of the proposed reforms. In the Korean economy, the government has been the most important player in setting the appropriate economic conditions for an efficient economy. As the most influential and well-equipped arbiter between economic agents, building an efficient government is critical to providing the market-oriented environment for firms to operate in. However, public sector reform has been progressing slowly because, caught between adhering to their traditional interventionism and attempting to adopt free market principles, the Korean government has found itself adrift. The proposed public sector reform programs call for the privatization of SOEs and elimination of unnecessary regulations. Meanwhile, the government intends to retain control of most aspects of the economy and society through various regulatory measures and by intervening even in the realm of the private sector – for example, in the corporate management process. In developed economies, the public sector reform focuses on making this sector more productive or more efficient because a capitalistic market order with effective and appropriate institutions is already in place and the role of government poses no real problem. However, this is not the case in Korea. Before matters of productivity and efficiency can be usefully addressed, the role of the government must first be delineated. To be sure, some reorganization has taken place within the government ministries, but reforms have not been pursued with the genuine goal of changing the role of the government. To a certain extent, many aspects of a planned economy still exist. Another criticism of the post-crisis reform efforts is that amid the noise of the massive reforms undertaken in the financial and corporate sectors, public sector reform has been neglected. It remains a fact that the slowest sector to take up reforms is the public sector. The few reforms that have been instigated in this area have been criticized for not producing the desired results. It is clear then that the momentum for public sector reform should be renewed, with a greater emphasis laid on deregulation and SOE privatization, as well as on downsizing and expanding the open hiring system. To improve efficiency within the public sector, in addition to the continuing downsizing efforts, more opportunities should be made for civilians to take up public positions; in other words, the government should continue to expand its open hiring system. This has only been conducted on a minor scale so far and far from constituting a real



reform, this superficial measure has only paid lip service to the spirit of the administration’s wide-reaching reforms. However, this measure should be more aggressively pursued as it may be the most important conditional requirement for an efficient public sector. As far as privatizing SOEs goes, the government’s delay in implementing successful measures reflects the vacillation between interventionism and market principles. After the crisis, the government announced its plans to privatize SOEs and began selling SOE stock to the public. In this case, merely selling off these stocks does not constitute privatization and the subsequent increase in management efficiency. In order to obtain the ultimate benefit of privatization, SOEs must be managed by private hands. The Korean government should expose SOEs to completely open competition, first eliminating the privileges and rents that SOEs have enjoyed. As we have stated throughout this volume, deregulation is the other critical component of reform that will significantly contribute to the transformation of the government function in line with the development of a market economy. Here, we come full circle to our initial premise laid out in Chapter 2. Namely, the function or role of government needs to be newly defined, as it gives way to Korea’s search for a market-oriented paradigm for the twenty-first century. The drive for deregulation may well be the most powerful means that can be employed to achieve this goal. 3.2

Financial sector reform

The measures undertaken by the Kim Dae-jung government so far have been successful in stabilizing the financial market. They also have been instrumental in convincing international capital markets of a positive near-term outlook. By alleviating the NPL problem through the injection of public funds, the Korean government cleaned up the financial sector’s balance sheets, and stability seems to have returned to the financial market. Furthermore, the macro picture of the financial industry except for some non-banking sectors seems sound as far as the capital adequacy ratio is concerned. However, there is still the strong possibility that the NPL problem could re-emerge as the corporate sector restructuring continues. More importantly, moral hazard behavior on the part of banks, which we have identified as a major cause of the 1997 financial crisis may continue because the injection of public funds into unsound banks will actually encourage such behavior. Despite the apparent success of these reforms, however, severe criticism has been levelled at the way that the government has carried out



its financial reform measures and at the behavior of financial institutions in this process. The financial institutions are not behaving any differently from the past pattern under the so-called kwanchi kumyung (government-controlled finance). While there is a consensus regarding the real need for a substantive reform of the Korean banking sector, the active role assumed by the government in the reform process raises concerns. In the past, active government participation in commercial bank credit allocation gave rise to the weak condition of the banking sector, characterized by the lack of management autonomy and commercial spirit, and eventually lead to the underdevelopment of the financial industry. In addition, the government policy of guaranteeing the ‘safety’ of bank liabilities was not matched at all in terms of prudent supervisory efforts to ensure the ‘soundness’ of bank assets. Such government-led practices have provided an ideal background for a moral hazard problem and impeded the development of a market-oriented banking sector. Therefore, it is up to the financial institutions, in tandem with the government, to make a concerted effort to break with past habits in dealing with financial business. For this, it will be most important to reform the institutional setting under which the banking industry operate, thereby introducing a better system of incentive structure for the market-oriented behavior of banks. In this regard, it is worth noting that the government has introduced a new corporate governance system in the banking sector. In the past, the majority stockholders could not exercise their right over bank management. Recently, the function of the board of directors has been enhanced, with the strengthening of stockholders’ role in selecting non-executive directors. For example, most Korean banks have adopted a new system that segregates executive directors from the board of directors, in which the majority stockholders are now allowed to participate in selecting non-executive directors. Executive directors can carry out only what has been decided by the board of directors. In addition, the auditing function is enhanced by the introduction of a separated audit committee, which will help the auditor maintain a level of independence. Other measures, such as accounting rules and prudential regulations, have also been strengthened to the level of global standards. These new measures are certain to improve the governance of financial institutions. Having a well-designed bank governance structure of this sort may help improve transparency but may not be sufficient to elevate the efficiency and autonomy of bank



management unless the government is willing to withdraw from its strong and active role in the bank management. A full evaluation of the financial reforms that have taken place is not really possible, however, one thing that has become apparent even from this short experience is that independent bank management is of paramount importance on the financial reform agenda. There are several steps that can be followed to ensure the restructuring of the banking sector in a manner that will narrow the government’s interventionist role and at the same time nurture the autonomy of the bank management in the future. First, the Banking Act needs to be revamped to change the composition and operation of the banks’ board of directors, if and when necessary, in order to guarantee a greater autonomy of shareholders than the current system allows. The management structure of banks has not allowed shareholders to exercise their rights fully and this has prevented the emergence of autonomous and accountable managerial practices. Institutional investors who are not eligible for stockholder rights in the current system should be allowed to exercise their rights in this regard. Second, the opening of the banking industry to both domestic as well as foreign participants and deregulation that facilitates mergers and acquisitions is imperative. Delays in opening the Korean banking sector to foreign participation and excessive restriction on domestic non-bank capital entry into the banking sector are obstacles preventing the growth of the financial industry and improvements in competitiveness. One should not expect banks that are sheltered from competition to take initiatives aimed at enhancing their competitiveness simply because the government demands them to do so or because some superior system of governance has been put into place. Third, there is a need for an incentive system to encourage the formation of groups of investors which will monitor banks. With such a system, market players can internalize financial regulations through the shareholders’ monitoring process. This will help simultaneously achieve the efficiency and stability goals of the financial system. Fourth, the immediate task in the restructuring process is to restore the banks’ capital base, which has been eroded in the wake of a recent string of business failures. The government should remove the ceiling on the shareholdings by individuals (currently set at 4 per cent for major commercial banks) and set it to an OECD level. It will be almost impossible for the government to restore the banks’ capital bases without the infusion of profit-motivated new financial capital.



Finally, the most important banking sector restructuring task is for bank supervisors to move away from creating a ‘cook book’ of rules to follow, instead returning to prudential regulation functions. Believing that the separation of bank and non-bank industries would be sufficient to prevent problematic lending concentrations, Korean bank supervisors did not implement the necessary prudential regulatory rules, as pointed out in Chapter 6. Instead, they interfered in the internal management of banks, at the same time abandoning their role of preventing chaebol lending concentration. These factors have contributed significantly to bringing about the recent crisis in Korea. Thus, regulators will need to focus on enforcing important rules, such as limiting lending concentration and improving capital bases, but at the same time they will need to boldly remove entry barriers and allow managerial autonomy. 3.3

Corporate sector reform

3.3.1

A brief evaluation

Corporate sector reform has emerged as a key task since the onset of the 1997 currency crisis. However, much of the discussion surrounding the implementation of such reform has not been based on a systematic understanding of the corporate governance structure, which has a direct bearing on how businesses behave. Too much attention is being paid to changing outward symptomatic characteristics rather than fixing the underlying institutional and incentive structures. As a result, the Korean corporate restructuring had to proceed under strong government guidance. According to Mo and Moon (1999, p. 162), ‘The administration has also circumvented democratic procedures in carrying out corporate reforms… The government has used its control over the banks to force the chaebol to improve their financial structure and streamline their business activities.’ This restructuring style is reminiscent of the government’s industrial restructuring attempts of the 1970s and 1980s. The new government’s paradigm for economic management, ‘the promotion of the market economy’, seems to have yielded to the traditional interventionist reform method. For example, in big deals, the government forced M&As upon firms and gave them deadlines by which they must be completed, and determined which firms would acquire the insolvent firms in advance. In addition, the government infringes on the property rights of the companies participating in ‘big deals’. The big deals could also raise doubts as to the consistency of the government policy. First, they may lead to a significant increase in market concentration,



which could be in conflict with government regulations on economic concentration. Second, after the deals are over, would the government prohibit new entry in the industries affected by the big deals? What if the potential entrants are foreign investors? Current efforts by banks and the government to improve financial conditions in the corporate sector, such as eliminating cross guarantees between group subsidiaries, will eventually help the corporate sector. However, the policy of lowering firm’s debt/equity ratio raised doubts about its propriety. The government applied a 200 per cent debt/equity ratio guideline to each of the five big chaebols and did not give any consideration to the diversity of each chaebol and industry. As each chaebol has different business characteristics and management strategy, this ratio must also differ. It is very questionable to imply that the uniform application of the same numerical target and deadline is a sensible policy. In 1998, Korea merely laid out a basic framework to improve corporate governance. In the future, more efforts should be made to ensure the proper operation of this new system. Institutional investors, including banks and other financial institutions, have started to exercise voting rights at shareholders’ meetings. Previously, institutional investors, even in cases where they held a greater stake than the largest individual shareholder, were not able to use their voting rights to influence decisions. The appointment of more than a quarter of the total number of directors from outside was made mandatory for all publicly traded companies. The government has made plans to strengthen the role of the external, non-executive directors on the board of directors so that the power of the controlling shareholder/manager can be checked further, although this plan has the danger of being too restrictive on business management. Minority shareholder rights have been strengthened. During the course of corporate restructuring, corporate governance is expected to improve gradually, either by sharing ownership with foreign firms or by transferring ownership to creditor banks through debt/equity conversions. Above all else, corporate restructuring should proceed on the basis of market principles. As such, the government needs to adopt a noninterventionist policy. It should allow creditor banks to voluntarily evaluate the viability of firms and decide on debt restructuring. Transparency of corporate management through enhanced disclosure of business performance is the basis upon which management should be held accountable. In order to achieve this, the financial



statements of listed companies have to satisfy international financial standards. In fact, for the affiliates of large business conglomerates, their consolidated financial statements are to be disclosed by the end of 1999. 3.3.2

Recommendation for a systematic approach to corporate restructuring

Government-driven restructuring without the provision of appropriate institutional foundation will have no lasting effect. Systematic approaches such as establishing an economic environment encouraging to voluntary restructuring through the process of competition is more favorable to the economy. Broadly speaking, there are two distinct systems of disciplining corporate behavior. The first is the market-based system and the second is an internal discipline-based system (as shown in Figure 9.1). The market-based system can be further broken down in terms of product market, direct financing market, indirect financing market, and market for managers. The competition in the product market is the key conduit through which consumers sort efficient and competitive businesses that produce good products from those that do not. In the direct financing market, corporate managers face discipline from share-

System of Corporate Behavior Discipline

Market-based system

Internal discipline system

Corporate organization

Product market

Figure 9.1

Indirect financing market

Direct financing market

Board of directors

Market for managers

A disciplinary system of corporate behavior


Others


holders, who exercise their oversight rights, as well as the threat of mergers and acquisitions. In the indirect finance market, creditors keeps close checks on corporate managers, not only by means of close creditworthiness analysis before extending credit to firms, but also by closely monitoring a firm’s use of funds. Competition among professional managers in the market for managers contributes to the improvement of overall managerial efficiency by sifting out managers displaying poor managerial performance. On the other hand, the internal discipline system of oversight relies on inside organizations such as holding companies, as well as on the board of directors fulfilling their role of providing checks and balances over managers. In addition, there is a hybrid approach of institutional investors appointing ‘outside’ directors to perform an oversight function over managers. The ideal role for the government to play is for it to concentrate on adapting laws and institutions – in other words, the external environment for corporate management – to ensure a normal functioning of the various approaches listed above. Which system of discipline should the Korean government favor in its effort to implement corporate restructuring? Since internal disciplinary measures, such as the organization of a business operation and the composition of a board of directors, can be said to be endogenous, the optimal designs for these measures might differ across diverse businesses. Hence, it will be more sensible to emphasize a market-based system instead of presenting some uniform design of the internal discipline system. With regard to the implementation of a market-based system, the importance of the product market cannot be emphasized enough since it is ultimately within that market that the managerial proficiency of different firms can be judged by consumers. However, the role of the product market in this regard has been distorted in Korea due to many (anti-competition) regulations on entries, pricing, and the lack of a welldefined corporate bankruptcy procedure. Restrictions on the influence which institutional investors are permitted, along with the ban on M&As in the past, have basically shut off any significant disciplinary role of the direct financing market. Banks have been unable to perform a monitoring role due to the underdeveloped Korean banking sector, owing to the heavy level of government intervention. Hence it is imperative for Kim Dae-jung’s government to revitalize these related institutions so that the market-based discipline system can function properly. Once the external oversight functions are being properly performed, the endogenously generated incentive to actively improve the internal



discipline system will become evident. Through these procedures, internal as well as external disciplinary systems will begin to operate – businesses will start restructuring at a faster pace once they realize that their survival depends on it. This situation will be much more preferable than one in which businesses merely implement changes in reaction to governmental decree. 3.4

Labor market reforms

One particular area in which much development has taken place is the labor market. As a result of the sharp economic contraction that marked the onset of the economic crisis in 1997, the unemployment rate rose rapidly to unprecedented levels in 1998 and 1999 (see Chapter 8 for a related macroeconomic discussion). This was accompanied by a sharp fall in wage rates. Nominal wages fell by as much as 10 per cent in 1998, after having risen by 15 per cent on average per annum since the late 1980s. As discussed in Chapter 8, this was one factor that contributed to the deterioration in Korean export competitiveness and hence the profitability of Korea businesses in the 1990s. Such a drastic shift in general labor market conditions has also changed perceptions of what constitutes acceptable practices in the labor–business relationship. In 1997, some potentially important changes were made to labor laws to increase flexibility in the labor markets by removing barriers to large-scale layoffs (see Lee and Kim, 1997, for more details of the changes). However, the actual implementation of layoffs has thus far proved extremely difficult. A clear result of developments following the economic crisis is the weakening influence and diminishing militancy of the labor unions. However, once again, as with other reforms, the longer-term effects of these changes in the labor market have yet to be seen. This is an area that will require a great deal more detailed analysis in the future.4

4. Concluding remarks: some suggestions for future reforms The most important lesson we can draw from the recent experience of crisis is that it is absolutely vital to construct and manage an economic system in tune with market principles and globalization. Although Korea has pursued a policy of market opening since the early 1990s, the sophistication of the economic system and the mentality of economic agents had failed to keep pace with these trends. It can be said that the Korean economy has stumbled in the course of globalization.



With hindsight the current crisis can be viewed as a necessary phase for Korea in its process of development into a mature, market-oriented economy. The Korean financial crisis may be seen as a blessing for the future as long as the ongoing reforms continue to bring about a new economic order. This new economic system should provide the foundations on which free competition can flourish. Future economic growth will depend upon how successfully Korea carries out reforms consistent with the principles of the market economy in all the sectors concerned. In sum, the general direction of the Korean government’s structural reform after the 1997 financial crisis seems adequate. Along with the efforts to overcome the financial crisis, the government pushed reforms in four major areas: the financial industry, the corporate structure, and the public and labor sectors. However, it would seem a little premature to say that these structural reforms will ensure the sustainable development of the nation’s economy. Moreover, some commentators have criticized the Kim Dae-jung government for not living up to the principles of market economy and democracy as was promised. Even when facing an immediate need for reforms, the government must suppress the urge to control of every aspect of the economy and allow the market to prevail. President Kim Dae-jung pledged to lead the country under the paradigm of democracy and market order. The new government implemented several successful macroeconomic policies and structural reforms that have pulled the economy out of crisis. However, the principles of democracy and market order have been compromised for the sake of rapid recovery and economic restructuring. In a recent paper (1999), Mo and Moon agree that, On the whole, one may conclude that, under difficult economic and political conditions, Kim Dae-jung has been able to introduce significant economic reforms, and that these have begun to bear fruit. But he has also compromised democratic principles along the way, especially in his dealings with the opposition and the chaebols. Some of this can be attributed to the urgent imperatives of speedy economic reform. Yet his governing style also reflects the immature nature of Korean democracy, in which Korea’s deep-rooted political culture undermines the rule of law and inhibits the development of democratic values such as accommodation and compromise. (pp. 163–4) Not only was the democratic principle compromised in the reform process, but, in many cases, the government also violated the principle



of market economy in the reform process, significantly slowing down the development of the market order. The government has, of course, attempted to build institutions to promote the role of the market (by promoting transparency, liberalization of financial markets and so on), but in doing so, it has used traditional authoritarian methods, using credit instruments to pressure businesses into acquiescing to government driven corporate reforms. In this sense, the reforms reveal inconsistencies in government perspective. In order for the restructuring process to be sustainable, the government must be sincere in its desire to embrace democracy and market economy. After wide-ranging reforms under the Kim Dae-jung administration, the economy seems to be recovering and macroeconomic stability seems for the most part to have been regained. The inclination is to become overconfident and to ignore any negative signs but this is a mistake. It is now, just as the Korean economy appears to be on the threshold of full recovery that we must take a step back and reflect on the efforts that have been made. It is important to listen to any criticisms of the reform effort, for example over the asserted re-emergence of the kwanchi kyungche (government-controlled economy) and to address these as effectively as possible. Policy makers must continue to pay greater attention to specific issues that arise and to consider how best to introduce the spirit of market competition into all aspects of the economy. It is extremely important to stay focused at this critical time so that wider reforms in the future can be steadily approached under the broader vision of truly living up to a fair and free market paradigm. In this regard, it might be useful to recollect some of the arguments in Chapter 7 and their implications for future reforms. First of all, structural reform should be pursued through institutional reforms. Generally speaking, for every structural weakness, there is a corresponding problem with the underlying institution. Economic agents try to maximize their own survival possibility given their economic environment, the main component of which being the economic institutions and as such, the behavior of these agents is often directly attributable to the economic institutions. For example, the moral hazard behavior evident in the Korean banking and corporate sectors, widely blamed as one of the main causes of the currency crisis, is merely a reflection of institutional failure. Practices such as kwanchi kumyung (government-controlled finance) have led to a lack of autonomy and prudent lending practices in the banking sector, which has resulted in overlending on the part of banks and overborrowing on the part of corporations. This ‘institutional foundations’ logic can also be



applied equally to structural weaknesses observed in any other sector such as the labor sector, the public sector, and even the political, educational and legal sectors. Structural reforms without corresponding institutional reforms tend to rely on non-market forces such as direct regulations imposed on the behavior of economic agents – as observed in reforms not only under the Kim Dae-jung administration reviewed in this chapter, but also in those carried out under previous administrations. However, this type of reform is sure to incur larger transformation costs than a reform policy that emphasizes institutional reform. Secondly, successful institutional reforms, by their very nature, manifest themselves very gradually and, because of this, it is not unusual to lose patience with them. However, it is this sort of impatience to see tangible results from a reform effort as soon as possible that inevitably results in direct government-enforced reforms. The necessity of patience when implementing real institutional reform cannot be emphasized enough here. Thirdly, structural reform should be sought through a comprehensive and systematic program, as we have already suggested in Chapter 7. The promotion of competition in the economy should be the first step in carrying out comprehensive structural reform and this premise should be applied to any specific reforms. Furthermore, the specific instruments taken for reforms should have the lowest possible transaction costs to remain consistent with the ultimate goal of reforms – to enhance the nation’s efficiency. Therefore, in the course of reform, government directives should be kept to a minimum because excessive government involvement tends to infringe on private property rights and increase uncertainties and transaction costs. This will not only hinder the pace of reform but also nullify the intended positive effects of the reform. In addition, structural reforms should be planned as an integral component of a comprehensive reform package. In other words, in addition to the four sectors currently at the center of the Kim Dae-jung administration’s reform efforts, the political and social sectors should be systematically integrated into one reform package. Unless a comprehensive reform package is implemented, it is entirely possible that the limited reform efforts in these four sectors alone may not achieve the desired efficient outcomes because those sectors not included in the reform will become a burden to the reform process, increasingly slowing the momentum for new initiatives and future reform.


10 A Final Word: The Future of the Korean Economy

To close this book with a view to looking ahead to Korea’s future, this final section will examine the ever-growing trend of globalization and speculate on its implications for the Korean economy in the early part of the twenty-first century. In particular, we consider the question of how Korea can best adjust to the changing environment brought about by the trend of globalization and what kinds of economic strategies can enhance the opportunity for the Korean economy to continue to prosper in the twenty-first century. In addition, we offer prospects for Korea’s growth in the medium to long term.

1. 1.1

Challenges and opportunities for the twenty-first century The overseas economic environment

The world economic order has rapidly reorganized itself into a globalized market economy following the unmitigated collapse of the socialist economies during the late 1980s and early 1990s. Consequently, future economic cooperation and competitive relations among nations is certain to take precedence in both domestic and international policies. The twenty-first century marks the dawn of a new era of global economic unity. At the same time, Korea’s outlook for the external advancement of its economy is certainly optimistic. However, there are rising concerns that the expanding production capacity of newly industrializing countries is likely to result in fiercely increased global competition. Quite separate from the general trend towards the increased interweaving of the world’s economies, multi-polarization is also being further deepened by the construction of regional trading blocs, as evidenced by the trade agreements between North American (NAFTA) and European (EU) countries. 249



In the twenty-first century, nations will enjoy a much closer ‘economic proximity’, thanks to improvements in transportation, information, and communication technology, which make production factors such as labor, capital, and technology more globally mobile and accessible. The real future of national economic competitiveness will thus depend upon the efficiency of the nation’s economic system, government, and social overhead capital, which are all relatively immobile. Moreover, in the face of increasing economic uncertainty, the government will play an increasingly minor role in the economy as agents in the private sector, who are in a better position to obtain and interpret information, assume a greater role. As production cycles become shorter due to technological innovations, the pace of restructuring in the industrial sector will naturally accelerate. With new science and information technology, the high value-added industry will become the basis for any further growth and as such, the value of human creativity as a source of high value-added economic activity is expected to increase substantially. The progress of information technology will provide new opportunities to work towards Korea’s continuing modernization process as an information society has the potential to apply a totally different paradigm for progress from that of a manufacturing industry-oriented society. An industry-oriented society is characterized by its focus on material wealth whereas an information-oriented society, with its focus on information- and technology-based innovations, can benefit to a considerably greater extent from the ‘intellectual capital’ consisting of the knowledge and capabilities of well-educated and trained individuals. With the increase in contributions of such non-material resources to production, even a less industrialized nation such as Korea could boost its industrial competitiveness by using the latest and most up-todate kinds of knowledge. By using these new resources efficiently and innovatively, Korea can eventually become a leading economy operating in the twenty-first century’s new global market. 1.2

The domestic economic environment

In the twenty-first century, heightened interest in the quality of life and in the development of a multifaceted society will provide greater opportunities for a new value system emphasizing a variety of individual choices in order to lead the way for the future of society. With this general picture in the background, the domestic economic environment will be expected to evolve in the following ways: First, if the rate of population growth slows down as expected, and the population starts to age overall, the growth rate of the labor force


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will drop. Thus, the labor force, although better educated, will be older and the proportion of women represented will likewise increase. It is projected that by 2028, the Korean population will stabilize at around 52.78 million people, and, due to extended life expectancy, the percentage of persons aged 65 and over will increase from 5.9 per cent in 1995 to 7.1 per cent by 2000, and to 13.2 per cent by 2020. These demographic changes will certainly have a noticeable effect on economic vitality, as extra provisions for the administering of care to increased numbers of elderly people will require more funding. Nevertheless, Korea currently enjoys a relative advantage over other developed nations and regions such as the United States, Japan, and Europe, because a substantial proportion of the new entrants to the Korean workforce over the next decade or so will be young and highly-educated. More significantly, it will include higher and higher proportions of women who have been educated to high-school or university level but have traditionally remained in the home. Excess demand for labor due to the slower growth of the labor force will provide a relatively receptive environment for higher female participation in labor force. Second, the general trend in occupations is becoming increasingly diverse and narrowly specialized as more and more people decide on a profession on the basis of non-monetary goals such as self-fulfillment or the realization of individual ideals. Accordingly, it will become necessary to provide more flexible professional training opportunities so that a smoother labor supply structure can be created in response to the changing structure of labor demand. As disposable income increases, the desire to improve one’s quality of life along with the increased importance attributed to leisure time will continue to increase and as a result, working hours will decrease while the demand for welfare provision will increase. All of these developments will lead to an unprecedented expansion in culture and leisure-related industries. Third, as these societal structures evolve, a likely outcome is a trend of de-urbanization, where the population gradually migrates from centralized urban communities to more pleasant rural locations. Increased cooperation between central government and local government and among local autonomous entities themselves will therefore become necessary, with each region instituting their policies according to their individual characteristics and needs. With the sudden expansion of the local government’s role and its increased autonomy, a more practical utilization of national territories in dealing with matters of environ-



ment, health, and culture will result. If this is the course that is ultimately taken then rural districts will prosper and ‘green resting areas’ attracting tourism and leisure industries and ‘silver town’ businesses will all share in the new opportunities that arise. Fourth, with the emergence of the global economic era and the enforcement of global standards by international organizations such as the WTO, IMF, and OECD, levels of direct governmental control and management of the economy, suffering from cumbersome inefficiency, will eventually diminish. Domestic regulation and policy direction should be amended in accordance to international standards. In order to reinforce the nation’s ability to compete internationally, a continued policy of deregulation must be pursued in order to establish a liberal economy that can effectively be compared to other advanced nations. Finally, it is expected that the gradual expansion of economic exchanges between South and North Korea will help bring about economic integration in the Korean peninsula, in turn opening up further opportunities for the Korean economy to become a major player in promoting global cooperation.

2. Changes in the twenty-first century economic environment and implications for Korea’s development strategy 2.1

The significance of a borderless global economy

Due to the increasing mobility of production factors and resources in the era of borderless global competition, the determining elements of national competitiveness will vary over time. The international competitiveness of the national economy will be dependent on the quantity and quality of the relatively immobile production resources, the key issue thus being how to attract and retain high-quality mobile resources. Relatively fixed factors may include political, social and educational systems, the level of technology, social infrastructure, unskilled labor, land endowment, the climate, living environment and particularly important factors such as economic institutions and customs and the efficiency of the government sector. On the other side of the equation, skilled labor, capital resources, and corporations are examples of variable resources. In order to attract high-quality mobile resources, the domestic economic environment must be improved by upgrading the productivity and efficiency of the nation’s relatively fixed resources.1


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During the process of integration of national economies into a global economy, every economy is sure to experience some qualitative changes. With the origin of goods and services, production factors, and corporations gradually becoming less relevant, and as the line between the concepts of ‘domestic’ and ‘foreign’ economies begins to blur, the term ‘national economy’ will become more and more difficult to define. There is an increased possibility of diverse economic regions beneficially co-existing within a single nation and it will become more natural for a region within that nation to form strong systematic economic ties internationally, rather than within the nation itself. For instance, the provincial areas of Young-Nam and Ho-Nam in the southern part of Korea might benefit more from strengthening economic ties with suppliers and consumers in neighboring Japan or China rather than with those from other domestic regions such as Seoul. The main conduits for business in Seoul, on the other hand, are centered upon advanced technologies in telecommunications and financial services, giving rise to instant links to counterparts around the world. It is clear that these regions could serve themselves better by operating globally, rather than by pursuing economic activities within the national borders alone. 2.2 The increasing need to attract superior resources and the importance of domestic economic institutions In maximizing economic growth potential according to the changing determinants of economic competitiveness, issues that are sure to gain more importance are the procurement of more high-quality resources in addition to the efficient utilization of existing resources. Individual businesses will establish global economic networks, through which they will be capable of producing increasingly larger quantities and higher quality of both goods and services than was possible through traditional domestic sources. Consequently, a nation’s economic performance, now more than ever before, is highly dependent on the nation’s ability to attract more international investment and internationally competitive enterprises. The fact is, since the 1980s, numerous South-East Asian nations including China experienced vigorous economic development with the help of foreign investment, further indicating that the era of globalization is already dawning. Therefore, the role of government regarding economic policies should be changed from that of intervention in the allocation of resources to one that improves the domestic economic environment, most importantly by rationalizing and strictly enforcing domestic



economic institutions. This would help attract mobile resources of the highest quality. In other words, it should concentrate on improving the quality of fixed resources to create a favorable economic environment for high-quality mobile resources. In this regard, raising the standards of domestic economic institutions and of tangible and non-tangible social infrastructures to the level of other advanced nations will be a key strategic consideration. 2.3

Economic management through market mechanisms

When the mobility of resources increases with diminishing border barriers, the significance of the national economy, and the effectiveness of government intervention and direct regulatory policies also tend to be diminished. This is in large part due to resources being able to freely escape from an economy with a poor economic environment. Therefore, it will no longer be possible for the government to enforce the arbitrary interventionist policies that were so readily practiced before without risking the loss of economic resources. These kinds of inadvisable interventionist economic policies can have an immense effect on both domestic as well as global economies, resulting in large-scale shifts of highly mobile resources and production factors, such as capital and corporations. The government becomes less and less capable of holding economic resources within the national boundaries through regulation. Rapid capital outflow that precipitated the 1997 crisis in Asian countries is a case in point. Misalignment in macro and foreign exchange policies and somewhat lax banking and business practices prompted large-scale capital outflows from those countries. Therefore, if the government wishes to attract and retain highly mobile resources within the national borders, its only option is to implement economic policies which corresponded more closely to the market mechanism. In due course, this can help sustain stable and consistent economic growth. Henceforth, the government should grant as much freedom as possible to the economic activities of the private sector, by actively pushing for increased deregulation, autonomy, and eventually an open economy. As the formulation of economic policy in the global economic environment will inevitably be based on non-discrimination and openness, it will no longer be possible to avoid curtailing governmental privileges and intervention in the domestic economy. Therefore, the government’s economic management method should become more indirect, ensuring a smoother operation of the market economy.


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2.4 The advent of an era of uncertainty and the need to raise economic flexibility In the era of globalization characterized by scientific and technological advances and by the arrival of the information and competitive age, economic uncertainty will reach an unprecedented level. Globalization implies the advent of a new society based on a new development paradigm, very different from the old one based on the existing industrial society. Therefore it is not at all clear if national economic development and business strategies that thus far have been successful in the manufacturing-based industrial age will continue to be viable in this new information age. In other words, the new era will signal the coming of value creation based on the service industry, where wealth will be created through the employment of non-material resources such as information, knowledge, and technology. Thus, the modern economic policies and growth strategies that were so successful during the period of manufacturing industrialization will no longer be valid in the upcoming information era. Additionally, as economic competition expands to global dimensions and as the effectiveness of national economic policy rapidly declines due to the collapse of borders, each nation will face total economic uncertainty in searching for new industrial policies. The promotion of a specific industry based on an industrial targeting policy will no longer be as effective. However, despite the convergence of economic and industrial structures during the process of globalization, the peculiar features of each individual economy – such as immobile resources, non-transplantable and inimitable social and economic systems – of are likely to remain in different and complex heterogeneous forms. This will make it necessary to follow more flexible strategies in seeking the optimal outcome for industrial structure and business organization.2 For instance, depending on which areas of the domestic, regional, and world markets are targeted, production and sales strategies may differ. For the organization of production, depending on which technology between specialization technology (exploiting economies of scale) and diversification technology (exploiting economies of scope) will be chosen, either the Fordist mass production system or the lean and flexible production system of small volume and many varieties should be selected. In the current state of growing economic uncertainty, governments tends to be slower at accessing information than private economic agents, resulting in the ineffectiveness of interventionist government



economic policies and the declining role of government leadership in economic management. Therefore, the government should start by increasing the autonomy of the private sector through liberalization and actively promote competition because competition is a discovery procedure of unknown opportunities. It is only through competition that the private sector can be induced to prepare for the increasing economic uncertainties.3 Taking steps towards liberating the economy and promoting market competition will increase the functioning of spontaneous market order and the flexibility of the private sector and thereby enable private economic agents to overcome uncertainty and respond appropriately to the economic paradigm shift. 2.5 The pursuit of new strategies for economic growth and the importance of intellectual capital As the international mobility of capital increases in a borderless global economy, local shortages of capital will become less severe. However, there will be a change in the age structure of the population in Korea. An aging population structure, due to a rapid decline in the population growth rate, will hinder the supply of an immobile, low-wage labor force. In the past, strategies adopted for growth maximization meant simply injecting more capital and labor into production – a solution that is not successful for long. In addition, because of the increasing international mobility of capital and highly skilled labor, a simple quantitative increase in low-skilled labor and capital will no longer guarantee international competitiveness. Moreover, due to improvements in science and information technology, the source of wealth and economic growth will increasingly depend on the degree of accumulation of ‘intellectual capital’ – that is, knowledge and information – rather than on the factors of physical production. Therefore, economic growth strategies should be adapted appropriately. The reason for this is that future economic growth strategies will be to build up knowledge-intensive economic industrial structures based on science and information technology. However, intellectual capital such as knowledge of scientific and information technology needs to be embodied in human capital through education and experience. Therefore the cultivation of creative human resources, specifically trained for the new technological era, will play a key role in the future of economic growth. For this reason, in order to establish a basis for economic growth in the twenty-first century, it will be necessary to improve productivity by


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transforming the economy from a manufacturing-based structure to a knowledge-intensive one. Thus, in order to cultivate human resources to spearhead this goal, the education system must be made more open and competitive. On the other hand, in a pluralistic twenty-first-century society, the values and aspirations of individual citizens will become increasingly diverse. Extrapolating from current trends, it would seem that new generations will give an increase emphasis to individual freedoms and achievements, and subjective values. Furthermore, in a borderless global era, multi-culturalism in all aspects of Korean society is expected to become evident as the new individualistic thinking and democratic order are extended to a wide range of areas of society. Moreover, with the aging population structure and growing economic role of female workers, Korean society will also naturally gravitate towards policies that accommodate the desires of the aged and female members of the population. Therefore, it will be far more difficult to maintain social and value systems that will enlist the sacrifice of an individual’s values for the single goal of achieving ‘quantitative economic growth’. Without trying to actively accommodate the diverse desires of societal members, it will be impossible to keep up with continual economic and social growth. In sum, efforts to improve the population’s quality of life will be paramount. 2.6 Extension of an open economy and pursuit of co-operative external strategies With the advent of world economic integration and the reorganization of the world’s economic order, the trend of expediting an open economy through continued market opening cannot be avoided. However, the remnant of various trade regulations and industrial protection policies, first adopted in the early period of economic development, are still deeply rooted in Korea. To add to this, today’s policy makers and a majority of citizens do not fully understand the need for opening and globalizing the domestic economy, society, and culture. It is necessary to persuade this group of the importance of open markets to improve international competitiveness and to build a springboard that will help catapult Korea to a position among the top ranking world economies. In addition, as national economic borders begin to erode, and the mobility of economic agents increases, making distinctions between countrymen and foreigners becomes meaningless. To be responsible members of the world economy, therefore, it is vital to eradicate any



discrimination based on nationality and the discord between domestic and international norms. In other words, domestic laws and regulations ought to be amended according to agreements of the WTO and other international organizations, regarding issues such as trade and investments, subsidies to domestic industries, and intellectual property rights. Policies for competition, labor, environment, and technological development also need to be accommodated to be consistent with the international rule, which is being discussed in the ‘new round’. Hereafter, what must be recognized is that the future of the Korean economy lies in making the most out of opportunities in the foreign market because Korea depends a great deal on overseas markets and must therefore maintain an active attitude in abiding by international rules and norms. To be a leading country in the era of globalization, Korea must contribute towards world growth through the spirit of being in a ‘global village’, in which all nations can co-exist harmoniously without prejudice and discrimination. In managing trading and other economic activities, it will be increasingly important not to discriminate against foreigners and their businesses so that this spirit of being part of the global village can be cultivated to the benefit of both Korea and the global economy. Efforts to financially support newly developing nations and to share its own growth experiences should also be actively pursued. Furthermore, with the advent of an era of unlimited competition, it will be necessary for Korea to abolish economic systems, policies, and customs that may bring disadvantages to foreign companies – not least in order that Koreans are not in turn subject to disadvantages as ‘foreigners’ abroad. As for the WTO, OECD, and other international economic organizations, it will be important for Korea to take active part in the construction of a fair and open global economy. Nothing could make the case for this point more convincingly than the developments following the worst of the recent economic crisis. It is widely accepted that at the crux of the weakness of the Korean economy are its rigidity and overprotective governmental intervention, which impede the natural workings of market mechanisms. This longstanding policy has had a direct effect on the reluctance of foreign investors to look once again at Korea, despite some recent reforms, and is naturally having serious repercussions on the effort to restore the Korean economy in the wake of the 1997 economic crisis.


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3.

Long-term growth prospects

In this section, we examine two sets of long-term growth projections for the Korean economy over the next twenty years, with each estimate based on a somewhat different approach. The first approach deals with expected growth in strictly conventional production factors such as the labor force, and capital and technological advances according to the traditional growth accounting method. The second estimation is formed through an institutional approach, suggesting that various reform measures now under consideration will have a discrete efficiency-enhancing effect if they are successfully implemented and will hence boost future growth prospects. According to the first approach, the most important factor in estimating long-term growth prospects for the economy is how much the economy can grow through technological improvements. For this reason, we project the future performance of the Korean economy by relying on the experiences of advanced industrialized countries. These seem to indicate that as the economy comes to maturity and then enters the low-growth stage, the contribution of technological advances to economic growth increases while the traditional factor inputs play a relatively less important role. We expect that early during the first decade of the next century the Korean economy will have reached maturity and entered the low-growth stage in the same way as seen in the advanced countries. As shown in Table 10.1, it is also expected that, based on the experience of advanced economies, technological advances will contribute to the increase in productivity at a rate of 1.2 per cent over the next two decades in the Korean economy. The rate of Korea’s economic growth through factor inputs is stable at 3.8 per cent on average during the period 1992–2000. However, this growth rate is likely to fall to 2.7 per cent and 1.9 per cent in the first and the second decades of the twenty-first century as the rate of population growth stagnates and labor hours are shortened. Growth caused by capital inputs will also drop from 1.9 per cent during the period 1992–2000 to 1.0 per cent and 0.4 per cent during the first and the second decades of the twenty-first century respectively. In the same way, economic growth due to economies of scale and the reallocation of resources show a similar decreasing tendency. It is expected, however, that economic growth through technological innovations will maintain an average rate of 1.2 per cent up to year 2000 and later


260

Table 10.1

Projections of potential growth rate thorough contribution by factors (%, period averages) Projections 1972–1982

Actual growth rate Irregular factors Potential growth rate Factor inputs Labor Capital Increases in productivity Reallocation of resources Economies of scale Technological innovations (contribution rate to growth)

7.1 –0.9 8.1 5.2 3.2 2.0 2.9 0.7 1.5 0.7


1982–1992 9.5 1.3 8.1 4.4 2.5 1.9 3.7 0.9 1.8 1.0

1992–2000 — — 7.2 3.8 1.9 1.9 3.4 0.7 1.5 1.2 (17)

2000–2010

2010–2020

— — 5.5 2.7 1.0 1.7 2.8 0.5 1.1 1.2 (22)

— — 4.0 1.9 0.4 1.5 2.1 0.2 0.7 1.2 (30)

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years. Moreover, that the contribution rate of technological improvements to economic growth will gradually increase to 17 per cent in 2000, 22 per cent in 2010, and 30 per cent in 2020. Simply put, technological innovations will play a critical leading role in future growth. As a result, long-term projected growth rates range from 4.0 per cent (2010–2020) to 5.5 per cent (2000–2010). Now, we take a look at the expected changes in industrial structures based on the projections above. We can anticipate that as a proportion of the total sum of value-added of all industries, the weight of the agricultural, forestry, fisheries and manufacturing sectors will decrease. In addition, the share of the service sector will continue to grow. As the economy enters the maturity stage, specialization will be enhanced so that marginal returns on capital will decrease. Moreover, the decreasing population growth rate will augment the scarcity of labor so that the wage rate will rise. These conditions are likely to encourage overseas production so that the domestic manufacturing sector – particlarly domestic light industries – is likely to fall on hard times. Table 10.2 helps in understanding this observation. It is expected that the share of the manufacturing sector will be 26.8 per cent in 2000, 25.8 per cent in 2010 and 25.0 per cent in 2020, and that of light industries will decline rapidly – from 19.4 per cent in 2000 to 11.6 per cent in 2020. However, in the case of the service sector, although its productivity is relatively low, both the income elasticity of demand and the proportion of non-trade sectors are high enough to cause its relative share. More specifically, the development of information technology will help industries such as telecommunications, finance, sanitation, medical services and motion pictures make rapid progress.

Table 10.2

Projection on industrial structures (%) [Year]

Sector Agricultural, forestry and fisheries sectors Manufacturing sectors Light industries Heavy industries Service sector

1995

2000

2010

2020

6.6

4.1

3.0

2.5

26.9 (6.4) (20.5) 66.2

26.8 (5.2) (21.7) 68.8

25.8 (3.8) (22.0) 71.0

25.0 (2.9) (22.1) 72.3



By contrast, the second approach, which is an institutional one, emphasizes the importance of economic reforms in promoting technological innovations. According to this approach, technological improvements in Korea might depend on how successfully the government is able to carry out economic reforms that provide an environment more suited to technological innovations to take place. The analysis, based on the new-institutional economic approach, suggests that the Korean economy has the potential to grow at a rate of between 4 and 5 per cent until 2015. This study looks for the motives driving technological advances and thus responsible for increases in institutional devices productivity. In other words, economic agents can maximize their will to economize when institutional reforms successfully implement fair rules of the game in the economy and create a free economic environment. Consequently, we might say that reforms of the economic, political and social institutions would make a great contribution to economic growth. The Korean economy may stagnate at a growth rate of between 2 and 3 per cent on average until 2015 if it is entirely dependent on factor inputs. By comparison, if economic, political and social institutions up to the standards of advanced countries are successfully introduced, the growth rate may reach between 4 and 6 per cent.

Table 10.3

Korea’s long-term growth projections through economic reforms Long-term projections of GDP growth rate, 1995–20151

1990–1995 Average GDP growth rate (%)

No reform scenario2 (%)

Economic reform scenario3 (%)

6.8

2.7

4.8

Notes: 1. These projections are drawn on the basis of the regression equation that has GDP as a dependent variable and some economic institutional variables as independent variables. The institutional variables are the index of individual property rights protection, government expenditures as a proxy for the degree of government intervention, the foreign exchange market premium as a proxy for the degree of market distortion by government regulations. Additionally, it has economic variables such as per capita GDP, the investment rate, the terms of trade, and the M3/GDP ratio as independent variables. 2. The assumption for the ‘no reform scenario’ is that present economic institutions remain the same in the future. 3. The ‘economic reform scenario’ assumes that institutional reforms are implemented, at best, to the standard of advanced countries.


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Namely, institutional reforms should help maximize the inducement for technological advances and allow all economic agents to perform at their best. In this way, the economy can grow at an extra rate of between 2 and 3 per cent through increased productivity.


Notes 1

Overview of Korea over the Past Thirty Years

1. The Korean government undertook three rounds of investment adjustments in the HCI sector during the period from 1979 to 1983. The main purpose of the adjustment was to promote mergers among the competing HCI firms or to scale down the planned capacities in some cases so that the problem of excess capacity might be resolved while, simultaneously, economies of scale might be realized through product specialization. At the same time, the export market environment for businesses was also changed drastically by the Plaza Accord. The Plaza Accord supported the strong Japanese yen, which substantially boosted the price competitiveness of Korean exports. It was thanks to these reforms and the favorable turn-around of the export market environment that most of the troubled HCI firms were later able to increase their output and exports, thereby raising their capacity utilization rates and profitability. 2. This section was drawn from Jwa and Seo (1999) ‘Asian Crisis and Implications for Industrial Policies’, which was presented at the UNIDO Conference (3 March 1999, Bangkok). Refer to Appendix 1.1 for a fuller treatment of the issues discussed. 3. The following offers a brief overview of developments in industrial policy over the last thirty years. For a more detailed treatment, see the Appendix to this chapter. 4. Five Year Economic Development Plans were implemented from 1961. However, from the 1980s, the plans merely served as a broad profile of the government’s economic objectives. 5. The main reason for this policy appears to be security concerns raised by the reduction of US troops stationed in Korea. The Korean government felt the need to build up certain industries for national defense (Yoo (1989)). 6. A further reason was that the heavy and chemical industries required production on a large scale and therefore large amounts of money, giving a relative advantage to the big enterprises that had financial and managerial experience and ability. 7. In the same year, heavy and chemical industry output accounted for 42 per cent of the nation’s total exports. 8. Lee (1988), Lee (1998), Yoo (1991).

2 The Role of Government versus the Market for Sustainable Development 1. See Rosen (1997) for an interesting exposition and comparison of the views of the Austrian School to those of the Neoclassicist School, including the overall issue of the role of competition as a discovery procedure and the 264


Notes 265 debate between the Austrian School and proponents of market socialism (Lange). Rosen is expanding on de Soto’s argument when the latter says, ‘I am concerned about those aspects of Austrian economics primarily dealing with the process of competition, and that portion of neoclassical economics primarily dealing with the determination of economic equilibrium. This, in a nutshell, is the main intellectual difference between them’ (Huerta de Soto, 1996). Leland B. Yeager also offers an interesting perspective in his discussion of Rosen’s paper and writes: Where does lack of the Austrian perspective takes neoclassical economics furthest off track? Neoclassicism downplays the reality of fragmentary, scattered, unarticulated, and undiscovered knowledge. Neoclassicials tend to treat information as something objective, bought and sold on the market, in carrying out maximization decisions. They tend to ignore the role of knowledge that simply does not exist before entrepreneurs discover or create it. … The big economic problem comprises of more than just scarcity and choice. Equilibrium is not automatic and in fact is never reached. Entrepreneurs have wide scope and play a central role. All this gets shunted aside by fascination with the maximization of an objective function subject to known constraints. (1997, p. 155) 2. Friedman offers a view that Keynes’s bequest to politics has had far more influence on the shape of today’s world than his bequest to technical economics. In particular, it has contributed greatly to the proliferation of overgrown governments increasingly concerned with every phase of their citizens’s daily lives. Friedman explains the political legacy of Keynes’s view. He writes: An approach that takes for granted that government employees and officials are acting as a benevolent dictators, promoting what they regard as the public’s conception of the general interest, is bound to contribute to an expansion in governmental intervention in economy – regardless of the economic theory employed. A monetarist no less than a Keynesian interpretation of economic fluctuations can lead to a fine-tuning approach to economic policy. 3. According to Amsden, Under such disequilibriating conditions, the state’s role in late industrialization is to mediate market forces. The state in late industrialization has intervened to address the needs of both savers and investors, and of both exporters and importers, by creating multiple prices. Some interest rates are higher than others. Importers and exporters face different prices for foreign currency. Insofar as the state in late industrialization has intervened to establish multiple prices in the same market, the state cannot be said to have gotten relative prices ‘right’, as dictated by supply and demand. In fact, the state in the late industrialization has set relative prices deliberately ‘wrong’ in order to create profitable investment opportunities. (1989, pp. 13–14) 4. According to Amsden, ‘Whatever the relationship between inflation and investment in theory, in practice inflation did accompany Korea’s push into heavy industry under government leadership in the late 1970s. … The


266 Notes

5. 6. 7.

8.

9.

10. 11.

12. 13. 14.

15.

16.

pursuit of fast growth was not restrained in the interest of price stability.’ (Amsden, 1989, p. 100) World Bank (1993), p. 11. Vanberg (1991), p. 179. This lack of a sense of independence characterized by the requests for reregulation on the part of private agents may well be a reflection of rentseeking behaviors. In this case, it would be in the interests of both the government as regulator and the private agents as regulatees to maintain the existing regulations. See literature on public choice theory and regulation theory for a deeper treatment of this discussion. Lao-Tzu, Tao Te Ching, Chapter 1. The very act of attaching names to things may be seen as confining or restricting, and in this sense, results in the reduction of liberty. Or put differently, the impossibility of being confined by a name is a reflection of complete liberty. From henceforth, translations on the quotations may differ slightly from the translations in the reference, Gia-Fu Fang and Jane English (1997), depending on the author’s own translations. Lao-Tzu, Tao Te Ching, Chapter 19. Seeking ‘wisdom’, ‘benevolence’ and ‘justice’ became tenets of the Confucian model of ideal self-cultivation. However, it is clearly seen from this statement that such a civilized outlook was not a universally accepted one in Asia. In fact, adherents to Taoism emphasized the impotence of trying to control things that cannot and therefore should not be controlled. Lao-Tzu, Tao Te Ching, Chapter 29. Lao-Tzu, Tao Te Ching, Chapter 57. The word ‘economy’ is placed in square brackets to signify that the quotation has a parallel interpretation in the economics sense. Lao-Tzu, Tao te Ching, Chapter 48. Hayek (1989, p. 7). A lengthy discussion on the nature and characteristics of the so-called industrial policies in those East Asian economies is found in World Bank (1993). This study suggests that while government intervention was helpful under certain conditions, the most important factors behind the East Asian Miracle are the macroeconomic stability and market-conforming economic policies adopted by the governments in these countries. Oman (1993) identifies the globalization phenomenon as not only a market extension but also a mixture of market deregulation, the spread of new information technologies, the intermeshing of financial markets and the innovation of industrial and production systems. Chapter 5 analyzes the implications of globalization on the optimal industrial organization structure.

3 Legacies and Lessons of Korea’s Macroeconomic Management 1. For example, Korea’s banking sector has relied heavily on the practice of compensating balances to evade the long-standing regulations on the lending rates which was regarded as artificially inflating money supply figures such as M2. The central bank often forced commercial banks to reduce the balance of deposits by canceling compensating balances with


Notes 267

2. 3.

4. 5.

6.

7.

8.

9. 10. 11. 12.

13.

lending balances, thereby intending to control the M2 figures. This is an example of direct multiplier management policy. See Jwa (1988) for related discussion on Korea’s exchange rate policy. There have been a series of five-year economic development plans, with the first one covering the period 1962–1966. The first two plans focused on establishing key industrial sectors such as cement, fertilizer, petroleum refining, chemicals and synthetic textiles. The next two plans (1972–1976, 1977–1981) concentrated on building up heavy and chemical industries. The fifth plan placed emphasis on macroeconomic stabilization. The objective of the sixth plan was to emphasize the social development aspect of the economy, something which had been neglected in previous plans. For discussion on the time inconsistency in economic policies, see Kydland and Prescott (1977). See Lawrence et al. (1994) for a detailed discussion on the possibility as well as the necessity of deeper policy integration in the new world economic order. Despite continuous discussions regarding various policy measures to enhance the managerial autonomy of commercial banks, no substantive changes have taken place as yet. We discuss in detail some related issues in Chapter 5. The IMF fiscal impulse measure is obtained through dividing the difference of the actual fiscal deficit (or surplus) and the cyclically neutral one by the actual nominal GNP where the neutral one is calculated by subtracting the expenditure proportional to the potential nominal GNP from the actual tax revenue proportional to actual nominal GNP, with the proportions given by the ones in the base year. See Cho and Park (1994). Exact figures for the expansion of the band are as follows: 0.6 per cent (2 September 1991), 1.0 per cent (1 October 1993), 1.5 per cent (1 November 1994), 2.25 per cent (1 December 1995), 10 per cent (19 November 1997). See Cukierman (1992) for this international comparison of central bank independence. See Kydland and Prescott (1977), H. Taylor (1985), J. Taylor (1982), Barro and Gordon (1983, 1985) and Fischer (1990) for discussions of this issue. See Jwa (1994) for detailed discussions of Korea’s experiences with capital flow management during the 1980s and the first half of the 1990s. Imperfect substitution is assumed in the portfolio balance models where the investor is assumed to be risk-averse. In this case, non-zero risk premium will be affected by the relative stocks of domestic and foreign currency bonds. On the other hand, perfect substitution is assumed in the monetary models where the exchange rate is assumed to depend on the relative supply of domestic and foreign currencies. Therefore, the exchange rate is not affected by the relative stocks of domestic and foreign bonds. Also since asset holders are concerned only about the total amount of assets held regardless of its composition, no risk premium is required. See OECD (1985), Weber (1986), and Edison (1993) for more detailed discussions. The 8.5 per cent decrease in the money multiplier in 1993 reflects not only the sterilization activities through the multiplier management to counteract the capital inflows but also the real-name system in financial transaction


268 Notes introduced on 13 August 1993, which had a constricting effect on deposits in financial intermediaries. Also, despite the relatively large increase of net foreign assets the positive growth of domestic credit led to a high monetary base increase. This reflects the policy concern of counteracting the economy-wide depressive impact of the real name system, without which we might have witnessed negative growth in domestic credit as a result of the sterilization effort. 14. The issue of the policy mix of monetary policy, exchange rate policy, and fiscal expenditure policy could be discussed within the tradition of the framework provided by Mundell (1968) and Fleming (1962). According to Mundell, in general, under the exchange rate targeting (fixed or pegged exchange rate system), monetary policy is ineffective as a stabilization policy as already seen in the previous section, but fiscal policy become an effective stabilization tool. On the contrary, under the flexible exchange rate system, monetary policy becomes an independent and effective policy, but fiscal policy becomes impotent. Mundell derives these results under the assumptions of perfect capital mobility and perfect asset substitution. Also, Fleming arrives at the similar result that monetary policy will be more powerful relative to fiscal expenditure policy under a flexible than under a fixed exchange rate system.

4 The Evolution of the Chaebols: The Property Rights System and Economic Organization in Korea 1. Clague et al. explain their choice of variables in the following way: In environments in which third-party enforcement of contracts is reliable and where property rights facilitate the pledging of assets as security for loans, banks and other financial intermediaries will profit from providing retail banking services at low cost. If the public can rely on institutional stability and third-party enforcement of contracts, they can be confident that the banks or government will not confiscate their deposits. Thus the rationale for this measure is that those forms of money such as currency that rely least on the fulfillment of contractual obligations by others will be preferred when property and contractual rights are insecure, whereas other forms of money are more advantageous for most purposes in environments with secure contract-enforcement and property rights. 2. In terms of other measures such as total shipment or value-added production, chaebols invariably dominate over small and medium-sized firms. However, the degree of dominance is comparable to that found in developed economies. See Chapter 6 for related discussion. 3. See Appendix 5.1 for a breakdown of the data. 4. See Appendix 5.2. 5. Information on the IPR system index is obtained from Robert J. Barro and Xavier Sala-i-Martin (1995, Chapter 12). 6. For a concurrent western observer’s perspective on the ill-effects of the irregular tax system on farmers during the late nineteenth century, their


Notes 269 subsequent disincentive to economize and the country’s poor economic development in general, see Bishop (1970). 7. The deferment measure included cutting the curb market rate from an average 3.84 per cent monthly market rate to a 1.35 per cent monthly rate and a three-year deferment with installment payment for five years thereafter. 8. For example, in the run-up to the 1997 presidential elections, an official of the Grand National Party released details from the personal bank accounts under a pseudonym of the then leading opposition party’s candidate, Kim Dae-jung, as well as those of his relatives in an attempt to discredit him. It was suggested that Kim Dae-jung had received illegal political contributions.

5 Globalization and the Diversification Behavior of the Chaebols 1. Recently, Oman (1993, 1994) endeavored to define the complex phenomenon of globalization along similar lines. 2. See Oman (1993, 1994) for further discussion of this point. 3. See East–West Center (1994). Longer discussions on various aspects of globalization and the structures of industrial organizations in major developed countries can be found in the volume compiled by the East–West Center of the University of Hawaii. However, to some extent, our own focus stems from dissatisfaction with the approaches taken by the various authors in this volume. 4. In general, the source of scope economies is the existence of public inputs, which are similar to public goods in consumption. ‘Information’ is intrinsically of a public-input nature; therefore, diversification across different industrial activities utilizing the same information will benefit from economies of scope. In addition, improvement in computer and automation technologies will help develop multifunctional machinery that will become a public input to various related industrial activities, thereby creating or increasing economies of scope among those activities. All these possibilities suggest that economies of scope among economic activities will be strengthened as the result of technological innovations in the information industry. 5. This hypothesis may sound a little unlikely if one insists, for example, that the non-tradable sector will continue to be large and differences in resource endowments among economies will not easily disappear even in a fully globalized environment. However, what this hypothesis really intends to establish is that as firms in different economies face the same economic environment, the fittest survivors in these economies will have similar characteristics. In this sense, it can easily be understood that the persistent differences in economic environments will entail persistent differences in industrial organization. Therefore, the hypothesis amounts to assuming that economic environments, including such aspects as non-tradable sector sizes and resource endowments, will converge among different economies as they become more globalized. 6. In Korea, chaebol diversification behavior has been nicknamed ‘octopus-like business expansion’, emphasizing the excessive degree of diversification of these organizations.


270 Notes 7. Strangely enough, there is a widely held opinion among Korean policy makers that business expansion through specialization improves competitiveness but expansion through diversification does not. 8. Yang (1992) has tested an implication of portfolio theory on the behavior of business diversification – that the possibility of reducing the variance of total profits of a business group by diversifying business activities can act as an incentive for diversification – but has found that the empirical evidence is not consistent with this implication. 9. During the 1970s, when Korea was pursuing its so-called heavy and chemical industry (HCI) promotion policy, the government actively intervened in selecting the firms or entrepreneurs to do business in specific areas and in providing the means to support them. If those selected firms were in danger of going bankrupt, the government intervened in arranging additional financial assistance or merger and acquisition procedures to save them. Since the 1980s, this pattern of government intervention has been mitigated, but it remains effective to some extent in a weaker form. The government still maintains a strong influence over who can enter the business in the case of important industries such as automobiles, steel, and so on. Concerning exit policy, the government has become much more lenient in allowing non-competitive firms to go bankrupt in recent years, but is still very reluctant to see big firms in important industries fail. Therefore, although the perception that ‘once allowed to enter, then it’s easy to survive’ has lessened it is still very much in existence. 10. A lengthy discussion of the nature and characteristics of industrial policies in these East Asian economies is found in World Bank (1993). This study suggests that while government intervention was helpful under certain conditions, the most important factors in advancing the East Asian Miracle were macroeconomic stability and the market-conforming economic policies followed by these economies. 11. See Stigler (1968, p. 133): Certain processes are subject to increasing returns; why does the firm not exploit them further and in the process become a monopoly? Because there are other functions subject to diminishing returns, and these are, on balance, at least so costly that the average cost of the final product does not diminish with output. Then why does the firm not abandon the functions subject to increasing returns, allowing another firm (and industry) to specialize in them to take full advantage of increasing returns? At a given time these functions may be too small to support a specialized firm or firms. The sales of the product may be too small to support a specialized merchant.

6

Reform Prospects for Korea’s Financial System

1. For a discussion of potential problems of allowing commerce–banking cross-over, see Corrigan (1986). 2. Litan (1987) offers a comprehensive overview of potential costs and benefits of removing the separating wall between the two types of financial businesses – that is, banks and non-bank financial businesses.


Notes 271 3. The Farmers Cooperation and the Industrial Bank for Small and Medium Industries were established in 1961 to focus on rural areas and the funding of small and medium businesses, respectively. The Kookmin Bank was established in 1963 to deal with both the general public as well as small businesses. In 1967 the Housing Bank and Korea Exchange Bank were set up to deal with the issues of housing finance and international trade, respectively. The Korea Development Bank, established in the early 1950s, focused on long-term large investment projects. 4. In addition, a potential breach of confidential business information is another concern. A chaebol-affiliated bank might leak key business information of a client firm to a competitor who is affiliated with the same chaebol. 5. The Korea First Bank, with capital of 1.2 trillion won at the end of 1996, was greatly exposed to the Hanbo Group in its role as its main bank. The total amount of loans to the Hanbo Group businesses that failed in early 1997 was 1.8 trillion won. A series of business failures that followed the Hanbo case in the remainder of 1997 has put more banks in dire straits. The Korean government had to step in to prevent insolvency at the Seoul Bank as well as at the Korea First Bank. 6. One immediate problem resulted from such a reality is the so-called crossguarantee system. Lending to firm A belonging to chaebol group X, banks demanded a third party credit guarantee in lieu of collateral. Typically firm B, which also belonged to the same group X, offered such a guarantee. Since firms A and B are legally independent entities, this guarantee was legitimate as far as the banks were concerned. However, the economic reality is that since both firms A and B belong to the same group X, such a credit guarantee is meaningless against the potential failure of firm A. The failure of firm A will most likely involve overall business difficulties of group X and the affiliated firm B. This was indeed the case of the Hanbo Group that failed early 1997. Related to this, it might make more sense to acknowledge the reality by allowing the creation of a holding company that can make the ownership structure explicit. This would have the beneficial effect of establishing transparent managerial accountabilities. 7. This number for the global big players is likely to change in the direction of large banks as a result of the recent series of mergers between large US banks. 8. For more details, refer to Appendix 5.1 at the end of Chapter 5 regarding the integrated theory of endogenous economic organization.

7 Experiences of Economic Reforms in Korea and Future Challenges 1. Jwa (1988) showed that the power of domestic monopolies and sectorspecific interest groups as well as other political-economic factors significantly affected the pattern of Korea’s trade liberalization. Broadly speaking, the results were consistent with the implications of the literature of public choice theory on rent-seeking behavior. 2. See McKinnon (1991).


272 Notes 3. See Evans et al. (1996). 4. See Seong Min Yoo and Sung Soon Lee (1997), ‘Evolution of Industrial Organization and Policy Response in Korea 1945–1995’, in Dong-Se Cha et al. (eds), The Korean Economy 1945–1995: Performance and Vision for the 21st Century. Seoul: Korea Development Institute, pp. 426–67. 5. For a thoughtful and well-researched study on the subject of income gaps, refer to Kwang Choi and Soonwon Kwon (1997), ‘Social Welfare and Distribution Policies’, in Cha et al. (eds), The Korean Economy 1945–1995, Performance and Vision for the 21st Century. Seoul: Korea Development Institute, pp. 541–85.

8 Korea’s 1997 Currency Crisis: Causes and Post-crisis Macroeconomic Developments 1. On the other hand, some offer explanations that do not pay attention to structural misalignments of the domestic economies in the affected countries. For example, Huh and Kasa (1998) offer an explanation of the simultaneity of the crises based on a game-theoretical consideration on the part of the monetary authorities of the affected countries trying to avoid competitive devaluation in the face of a common adverse shock. 2. It is interesting to note that preventing the Korean corporate sector from borrowing directly from international financial institutions had a distinct drawback that has been overlooked. Typically, large international financial institutions have to justify their lending decisions based on their objective creditworthiness analysis. This means asking many questions about the prospective projects – general level of financial obligations, profitability of the project to be funded, and so on. In comparison, Korean businesses did not have to answer many of these kinds of questions when they dealt with Korean banks. Thus, the policy that blocked the Korean corporate sector’s direct foreign borrowing might have had more adverse consequences than the benefits envisioned when the restriction was initially applied. 3. For some reason, the Korean government discouraged long-term borrowing. For example, financial institutions needed to clear a much higher level of bureaucratic permission to raise long-term funds opposed to raising shortterm funds. 4. It is difficult to quantitatively capture this conjecture in a succinct way. However, one could use indicators of concentration of firms in a particular industry as a proxy for the degree of competition. One such measure is the so-called ‘concentration ratio of k’, denoted as CR, which measures the share held by k largest firms in a particular product market. For example, CR4 for the soft drink market measures the share of the four largest firms in the soft drink market. According to Shepherd (1982), about 76 per cent of GNP in the United States was produced by industries with CR4 of less than 40 per cent until 1980. In comparison, only about 44 per cent of Korea’s GDP were produced by industries with the CR3 of less than 40 per cent (Whang, 1998). There are different views regarding the relationship between market structure and economic efficiency. The fact that only a


Notes 273

5.

6.

7.

8.

9.

10. 11.

small number of firms are present in a particular market does not necessarily lead to economic inefficiency, as it does when a few dominant firms exhibit rent-seeking behavior. For a more detailed discussion of this issue in Korean setting see Whang (1998). Inflation reduces the real value of a debt burden. The Korean corporate sector benefited from high inflation in the past since a high leverage ratio has been common to most large businesses. For a comprehensive discussion of international comparisons, see Kaminsky and Reinhart (1996). For further discussion on the Korean banking sector, see Chapter 6. There is a strong positive correlation between the size of firms (in terms of number of workers) and the degree of union formation at work places. For example, for firms with 100 to 999 workers, the union organization rate, which measures the proportion of workshops to organized unions, was about 30 per cent. In 1993, the unionization rate stood at 76 per cent for firms with more than 15 000 workers. Unions at large firms in general tend to be more militant. One interesting explanation for this phenomenon focuses on the nature of the Korean industrial organization. As mentioned earlier, large firms faced inelastic demand in goods market due to a monopolistic or oligopolistic industrial structure. This, in turn, increases the margin for rent-sharing behavior on the part of the employees. There is also some evidence to suggest the presence of a ‘large’ firm premium. In the late 1980s, wage increases were more rapid for employees of large firms compared to wages for employees of smaller firms (Lee and Kim, 1997, in Korean). An interesting survey regarding worker overhang was conducted by the Korea Federation of Employers in 1997 using a sample of 233 firms with over 100 employees. 37.5 per cent of responding firms with 1000 or more workers said that they have too many workers. Respondents pointed to middle- and upper-level management ranks as the most saturated. About 80 per cent of the firms that responded that they have too many workers indicated that they need to shed 5–15 per cent of employees to achieve the appropriate level (KFE, 1997). One factor that might have negatively affected profitability of Korean businesses is the high cost of transporting and distributing goods. Surface road transportation made up some 50 per cent to 70 per cent of the total physical distribution in a typical year in the early 1990s. By some estimates, the distribution cost in Korea was about 15 per cent of the Korean GDP in 1993, compared to 10 per cent in the United States. Basically, poor road conditions, due to a prolonged period of low investment in social infrastructures, and increased traffic appear to have raised the distribution cost in Korea. Some policy makers viewed this as a very important issue for improving Korea’s competitiveness in the long term. Although the Korean government did not expend any of its budget on building housing units, policy measures were taken to facilitate such goals. For example, land for new construction projects was readily made available. Several medium-sized new satellite cities that house about half million each were constructed around the Seoul metropolitan area as a result.


274 Notes 12. See Choi (1998) for a comprehensive overview of the external developments in the period leading up to Korea’s crisis. 13. The policy prescription by the IMF can perhaps be better understood from the perspective of a creditor who is lending a sizable part of his scarce capital to a troubled debtor. The IMF has to make sure that it can recoup the financial resources committed to Korea on an emergency basis. To do this, it starts by stipulating adherence to the most conservative sets of policy prescriptions, which have been implemented successfully many times before. In this instance, the IMF decision-makers ignored the possibility that the Korean illness may have needed a different medicine from the one that had a record for curing the economic ailments of various Latin American countries. 14. For an interesting insight into the Korean industry’s response to the stringent measures imposed by the IMF as part of its policy prescription, see Appendix 8.2. This includes a letter addressed to Michel Camdessus, the Managing Director of the IMF, from a group of Korean industry leaders and Mr Camdessus’s response. The letter to Mr Camdessus was originally drafted by the author. 15. Cho Dongchul (1999). According to his analysis, of the GDP decline of –5.8 per cent, no less than 5 per cent can be attributed to the aggregate demand shock. The implication of this decomposition is that an aggregate demand-driven recession can be cured rather easily through expansionary fiscal and monetary policies. 16. We follow the reasoning and application of a VECM model to the US data by Huh and Trehan (1996). The data used were: total compensation (including benefits), total output divided by total hours, and the consumer price index for nominal wages, productivity, and prices, respectively. Series were logged first then adjusted by multiplying by constant numbers to scale them to be comparable to each other. Growth rates were calculated by first differencing each series. 17. The first sample period was chosen based on the discussion given in the previous section regarding the late 1980s. Namely, there was a clearly identifiable shift in the social and political environment in Korea.

9

Kim Dae-Jung’s Structural Reforms and Some Evaluations

1. The newly established Korea Investment Service Center (KISC) at the Korea Trade Investment Promotion Agency (KOTRA) now provides a convenient one-stop service for all prospective foreign investors. 2. High-tech industry FDI, for example, is given full exemption of corporate and income taxes for the first seven years and an additional 50 per cent reduction for the next three years after that. 3. The Tripartite Commission was formed on the basis of the Social Agreement concluded among labor, management and the government on 6 February 1998 in order to establish a tripartite cooperative system for the overcoming of the economic crisis and to pursue a restructuring of social cohesion via institutionalizing participation of workers’ and employers’ organizations. The basic goals of the Tripartite Commission are: (i) the reinforcement of


Notes 275 national competitiveness; (ii) the improvement of international credibility; (iii) the continuous reform of overall state affairs; and (iv) the early realization of national cohesion. The Tripartite Commission adopted the ‘Tripartite Joint Statement on Fair Burden-Sharing in the Process of Overcoming the Economic Crisis’ and the ‘Social Agreement for Overcoming the Economic Crisis’. The ‘Tripartite Commission Rules’ were enacted as the Presidential Decree on 28 March 1998. The major agreed matters in the first and second Tripartite Commission were: (i) an agenda on employment stability and unemployment measures; (ii) the expansion of the social security system; (iii) the stabilization of wage and the improvement of labor–management cooperation, including the securing of basic labor rights, the enhancement of the labor market flexibility, and the securing of management transparency; (iv) the acceleration of the process of restructuring, and the stabilization of prices; (v) the increase of export and improvement of international balance of payments, and (vi) the proposal for great social cohesion. 4. For a deeper analysis of the labor market situation in Korea, refer to Ju Ho Lee and Dae Il Kim (1997), ‘Labor Market Developments and Reforms in Korea’ (paper), Korea Development Institute.

10

A Final Word: The Future of the Korean Economy

1. For related discussion, see Yoo (1998). 2. A more systematic treatment of this issue and related discussion can be found in Chapter 4 of this volume. 3. See Hayek (1984) for the importance of competition as a discovery procedure in the imperfect information world. Competition can also be depicted as the driving force behind the development of Hayekian spontaneous market order.


Select Bibliography 1

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2 The role of Government Versus the Market for Sustainable Development Amsden, Alice H. (1989) Asia’s Next Giant. Oxford University Press. Feng, Gia-fu and Jane English (trs.) (1972) Lao-tzu: Tao te Ching. New York: Random House. Friedman, Milton (1993) ‘John Maynard Keynes’, Economic Quarterly, Federal Bank of Richmond, (Spring), pp. 1–23. Hayek, F.A. von (1948) Individualism and Economic Order. London and Chicago: Chicago University Press, pp. 92–106. Hayek, F.A. von (1984a) ‘Competition As a Discovery Procedure’, in Nishiyama Chiaki and Kurt R. Leube (eds), The Essence of Hayek. Stanford, CA: Hoover Institution Press, pp. 254–65. Hayek, F.A. von (1984b) ‘The Use of Knowledge in Society’, in Nishiyama Chiaki and Kurt R. Leube (eds), The Essence of Hayek. Stanford, CA: Hoover Institution Press, pp. 211–24. Hayek, F.A. von (1989) ‘The Pretence of Knowledge’, American Economic Review, 79(6). Huerta de Soto, Jesus (1996) ‘The Ongoing Methodenstreit of the Austrian School’. Comment on papers by Sherwin Rosen and Erich Streissler, presented at the Meeting of the Mont Pelerin Society, Vienna. 276


Select Bibliography 277 Jwa, Sung-Hee (1997) ‘The Role of Government in Economic Management: Korea’s Experiences and Lessons’, Korea Journal, 37 (4) (Winter) pp. 5–14. Lao-Tzu, ‘Scriptures on Morality’ Oman, Charles (1993) Globalization and Regionalization: the Challenge for Developing Countries. Paris: OECD Development Centre. Rosen, Sherwin (1997) ‘Austrian and Neoclassical Economics: Any Gains From Trade?’, Journal of Economic Perspectives, 11(4), Fall, pp. 139–52. Vanberg, V. (1991) ‘Spontaneous Market Order and Social Rules: a Critical Examination of F.A. Hayek’s Theory of Cultural Evolution’, in John Cunningham Wood and Ronald N. Woods (eds), Friedrich A. Hayek: a Critical Assessment, vol. IV. London and New York: Routledge, 1991, pp. 177–201. World Bank (1993) The East Asian Miracle. Oxford University Press. Yeager, Leland (1997) ‘Austrian Economics, Neoclassicism and the Market Test’, Journal of Economic Perspectives, Fall, pp. 153–66.

3 Legacies and Lessons of Korea’s Macroeconomic Management Barro, Robert J. and David B. Gordon (1993) ‘A Positive Theory of Monetary Policy in a Natural Rate Model’, Journal of Political Economy, 91(4), 589–610. Barro, Robert J. and David B. Gordon (1985) ‘Rules, Discretion and Reputation in a Model of Monetary Policy’, Journal of Monetary Economics, 12, 101–21. Cho, Yoon Je and Jongkyu Park (1994) Financial Deregulation, Capital Market Opening and the Changing Role of Fiscal Policy in the Korean Economy. Working paper 94-07. Seoul: Korea Tax Institute. Cukierman, Alex (1992) Central Bank Strategy, Credibility, and Independence: Theory and Evidence. Cambridge, MA: MIT Press. Darby, Michael R. (1985) ‘Monetary Policy in the Large Open Economy’, in Albert Ando, Hidehazu Eguchi, Roger Farmer and Yoshio Suzuki (eds), Monetary Policy in Our Times. Cambridge, MA: MIT Press, pp. 143–67. Edison, Hali J. (1993) The Effectiveness of Central-Bank Intervention: a Survey of the Literature After 1982. Princeton, NJ: Department of Economics, Princeton University. Fischer, Stanley (1990) ‘Rules Versus Discretion in Monetary Policy’, in Benjamin M. Friedman and Frank H. Hahn (eds), Handbook of Monetary Economics, vol. 2. Amsterdam and New York: North-Holland, pp. 1155–84. Fleming, J. Marcus (1962) ‘Domestic Financial Policies Under Fixed and Under Floating Exchange Rates’, IMF Staff Papers, vol. 9, pp. 369–80. Glick, Reuven and Ramon Moreno (1994), Capital Flows and Monetary Policy in East Asia. Pacific basin working paper 94-08. Federal Reserve Bank of San Francisco. IMF (1993) Recent Experiences with Surges in Capital Inflows. Washington: International Monetary Fund. Jwa, Sung-Hee (1988) Korea’s Exchange Rate Policy: System, Effect and Issues. KDI Working Paper 88-02. Seoul: Korea Development Institute. Jwa, Sung-Hee (1994) ‘Capital Mobility in Korea since the Early 1980s: Comparison with Japan and Taiwan’, in Tahatoshi Ito and Anne Krueger (eds), Macroeconomic Linkage, NBER East Asia Seminar on Economics, vol. 3, pp. 123–64.


278 Select Bibliography Jwa, Sung-Hee (1998) ‘Reorganization of Korea’s Macroeconomic Management’, in Lee-Jay Cho and Yoon Hyung Kim (eds), Korea’s Choices in Emerging Global Competition and Cooperation. Seoul: Korea Development Institute, pp. 1–56. Kim, Kwang Suk and Sung Duk Hong (1997) Accounting for Rapid Economic Growth in Korea, 1963–1995. Korea Development Institute. Kim, Kwang Suk and Joon-Kyung Park (1985) Sources of Economic Growth in Korea, 1963–1982. Seoul: KDI Press. Kydland, Finn E. and E.C. Prescott (1977) ‘Rules Rather than Discretion: the Inconsistency of Optimal Plans’, The Journal of Political Economy, 85, 473–91. Lawrence, Robert Z., Albert Bressand, and Takatoshi Ito (1994) A New Vision for the World Economy, Brookings Project on Integrating National Economies. Washington DC: Brookings Institution. Lee, Byoung Ki (1998) Factors of Korean Economic Growth and Roles of Industrial Policies. Korea Economic Research Institute (in Korean). Mundell, Robert A. (1968) International Economics. New York: Macmillan. Nam, Sang-Woo (1988) The Role of Exchange Rate Policy in Four East Asian Countries, Internal discussion paper 15, Asia regional series. Washington DC: World Bank. OECD (1985) Exchange Rate Management and the Conduct of Monetary Policy. Paris. OECD (1990) Liberalization of Capital Movements and Financial Services in the OECD Area. Paris. Perkins, Dwight H. (1997) ‘Structural Transformation and the Role of the State: Korea 1945–1995’, in Dong-se Cha, Kwang Suk Kim and Dwight H. Perkins (eds), The Korean Economy 1945–1995. Seoul: Korea Development Institute, pp. 57–98. Taylor, H. (1985) ‘Time Inconsistency: a Potential Problem for Policymakers’, Business Review, Federal Reserve Bank of Philadelphia (March–April), pp. 3–12. Taylor, John B. (1982) ‘Establishing Credibility: a Rational Expectations Viewpoint’, AEA Papers and Proceedings 72(2), pp. 81–5. Weber, Warren E. (1986) ‘Do Sterilized Interventions Affect Exchange Rates?’, Quarterly Review of the Federal Reserve Bank of Minneapolis, 10, 3, pp. 14–23.

4

The Evolution of the Chaebols

Alchian, Armen A. (1961) Some Economics of Property. RAND P-2316. Santa Monica, CA, RAND Corporation, reprinted in Armen A. Alchian as Economic Forces at Work. Indianapolis: Liberty Press, 1977. Alchian, A.A. and Demsetz, H. (1972) ‘Production, Information Costs, and Economic Organization’, American Economic Review, 62, 5, pp. 777–95. Barro, Robert J. and Sala-I-Martin, Xavier (1995) Economic Growth, McGraw-Hill International Editions. Bishop, Isabella Bird (1970) Korea and her Neighbors. London: John Murray. Buchanan, J.M. and R.D. Tollison (eds) (1972) The Theory of Public Choice: Political Application of Economic. Ann Arbor: University of Michigan Press. Clague, Christopher, Philip Keefer, Stephen Knack, and Mancur Olson (1996) ‘Property and Contract Rights in Autocracies and Democracies’, Journal of Economic Growth, June, pp. 243–76.


Select Bibliography 279 Coase, R.H. (1937) ‘The Nature of the Firm’, Economica, 4, NS, pp. 386–405. Coase, R.H. (1960) ‘The Problem of Social Cost’, Journal of Law and Economics, 3, October, pp. 1–44. Demsetz, Harold (1967) ‘Toward a Theory of Property Rights’, American Economic Review, 5, pp. 347–59. Eggertsson, Thrainn (1990) Economic Behavior and Institutions. Cambridge: Cambridge University Press. Fisher, I. (1920) Elementary Principles of Economics. New York: Macmillan. Fukuyama, Francis (1995) ‘Social Capital and the Global Economy’, Foreign Affairs, 74(5), Sep./Oct., pp. 89–103. Fukuyama, Francis (1996), ‘Social Capital and Future of Asia’, Samsung Economic Research Institution, Seminar Paper. Hwang, Inhak (1997) The Myth and Facts of the Korean Economic Concentration. Seoul: Korea Economic Research Institute. Jwa, Sung-Hee (2000) ‘Property Rights and Economic Behavior: Lessons for Korea’s Economic Reform’, in Kenneth L. Judd and Young Ki Lee (eds), An Agenda for Economic Reform in Korea. Hoover Institute and Korea Development Institute pp. 401–30. Knack, Stephen and Philip Keefer (1995) ‘Institutions and Economic Performance: Cross-Country Tests Using Alternative Institutional Measures’, Economics and Politics, 7, pp. 207–27. Lewis, W. Arthur (1955) The Theory of Economic Growth. London: Allen & Unwin. North, Douglass C. (1981) Structure and Change in Economic History. New York, W.W. Norton & Company. North, Douglass C. (1990) Institutions, Institutional Change and Economic Performance. Cambridge: Cambridge University Press. North, Douglass C. (1992) Transaction Costs, Institutions, and Economic Performance, Occasional Papers No. 30. San Francisco, CA: International Center for Economic Growth. Pejovich, Svetozar (1990) The Economics of Property Rights: Towards a Theory of Comparative Systems. Dordrecht: Kluwer Academic. Rapaczynski, Andrzej (1996) ‘The Roles of the State and the Market in Establishing Property Rights’, Journal of Economic Perspectives, 10(2), Spring, pp. 87–107. Redelet, Steven, Jeffrey Sachs, and Jong-Wha Lee (1997) ‘Economic Growth in Asia’, HIID Development Discussion Paper Number 609, November. Wallis, John Joseph and Douglass C. North (1986) ‘Measuring the Transaction Sector in the American Economy 1870–1970’, in Shanleyh, Engerman and Robert E. Gallman (eds), Long-term Factors in American Economic Growth, vol. 51 of The Income and Wealth Series. Chicago: University of Chicago Press, 1986, pp. 95–161.

5 Globalization and the Diversification Behavior of the Chaebol Baumol, William J., John C. Panzar, and Robert D. Willig (1982) Contestable Markets and the Theory of Industry Structure. New York: Harcourt Brace Jovanovich.


280 Select Bibliography East–West Center (ed) (1994) Globalization and Regionalization: Implications and Options for the Asian NIEs. Conference Papers. Honolulu: University of Hawaii. Herrigel, Gary and Charles F. Sabel (1994) ‘Craft production in crisis: Industrial restructuring in Germany during the 1990s’, in East–West Center (eds), Globalization and Regionalization: Implications and Options for the Asian NIEs. Honolulu: University of Hawaii. Jwa, Sung-Hee (1997) ‘Globalization and Industrial Organization: Implications for Structural Adjustment Policies’, in Takatoshi Ito and Anne O. Krueger (eds), Regionalism vs. Multilateral Trade Arrangement. NBER-East Asia Seminar on Economics, vol. 6. Chicago: University of Chicago Press, pp. 313–43. Oman, Charles (1993) Globalization and Regionalization: the Challenge for Developing Countries. OECD Development Centre. Oman, Charles (1994) ‘Globalization and regionalization: Key issues and interactions’, in East–West Center (eds), Globalization and Regionalization: Implications and Options for the Asian NIEs. Honolulu: University of Hawaii. Scherer, F.M. and D. Ravenscraft (1984) ‘Growth by diversification: Entrepreneurial behavior in large-scale United States enterprises’, Zeitschrift für National konomie, Suppl. 4, pp. 199–218. Stigler, George J. (1968) ‘The division of labor is limited by the extent of the market’, in G.J. Stigler (eds) The Organization of Industry. Homewood, Ill.: Irwin, pp. 129–41. Westney, D. Eleanor (1994) ‘The Large Japanese Industrial Firm as a Network Organization’, in East–West Center (ed.), Globalization and Regionalization: Implications and Options for the Asian NIEs Honolulu: University of Hawaii. World Bank (1993) The East Asian Miracle. New York: Oxford University Press. Yang, Won Keun (1992) Deakiup JipDan eui Hyoyulsung Bunsuk (Analysis of the efficiency of large business groups), Research Report no. 250. Seoul: Korea Institute for Industrial Economics and Trade.

6

Reform Prospects for Korea’s Financial System

‘The Top 1000 Banks’, The Banker, July 1997. Corrigan, Gerald E. (1986) ‘Financial Market Structure: a Longer View’, 72, Annual Report, Federal Reserve Bank of New York. ‘The Global 500 List’, Fortune, August 1997. Jwa, Sung-Hee (1995) Endogenous Financial System Seoul: Dasan Publications (in Korean). Jwa, Sung-Hee (1994) ‘Endogenous Financial System: Theory and Evidence’. Seoul: Korea Development Institute, Mineo. Litan, Robert E. (1987) What Should Banks Do? Washington DC: The Brookings Institution.

7 Experiences of Economic Reforms in Korea and Future Challenges Choi, Kwang and Soonwon Kwon (1997) ‘Social Welfare and Distribution Policies’, in Dong-Se Cha, Kwang Suk Kim and Dwight H. Perkins (eds), The


Select Bibliography 281 Korean Economy 1945–1995: Performance and Vision for the 21st Century, pp. 541–85. Evans, Lewis, Arthur Grimes, Bryce Wilkinson and David Teece (1996) ‘Economic Reform in New Zealand 1984–95: The Pursuit of Efficiency’, Journal of Economic Literature, (December), pp. 1856–1902. Jwa, Sung-Hee (1988) ‘The Political Economy of Market-opening Pressure and Response: Theory and Evidence for the Case of Korea and the United States’, Seoul Journal of Economics, 1(14), pp. 387–415. Jwa, Sung-Hee and Jung-Il Kim (1999) ‘Korea’s Economic Reform: Political Economy and Future Strategy’, in Chung-In Moon and Jongryn Moo (eds), Democratization and Globalization in Korea: Assessments and Prospects. Seoul: Yonsei University Press. McKinnon, Ronald, I. (1991) The Order of Economic Liberalization: Financial Control in the Transition to a Market Economy. Baltimore, MD: Johns Hopkins University Press. Yoo, Seong Min and Sung Soon Lee (1997) ‘Evolution of Industrial Organization and Policy Response in Korea 1945–1995’, in Dong-se Cha, Kwang Suk Kim and Dwight H. Perkins (eds), The Korean Economy 1945–1995: Performance and Vision for the 21st Century. Seoul: Korea Development Institute, pp. 426–67.

8 Korea’s 1997 Currency Crisis: Causes and Post-crisis Macroeconomic Development Burnside, Craig, Martin Eichenbaum, and Sergio Rebelo (1998) ‘Prospective Deficits and the Asian Currency Crisis’, NBER Working Paper No. w6758, October. Cho, Dong Chul (1999) ‘Recovering from the Crisis: Where Does the Korean Economy Stand?’, Korea Journal, 39(3), pp. 179–97. Choi, Doo-Yull (1998) ‘The Causes of Korea’s Currency Crisis: with Emphasis on External Environment’ (in Korean), Working paper. Korea Economic Research Institute. Corsetti, Giancarlo, Paolo Pesenti, and Nouriel Roubini (1998) ‘What Caused the Asian Currency and Financial Crisis?’ Mimeo, March. Huh, Chan Gook and Kenneth Kasa (1998) ‘A Dynamic Model of Export Competition, Policy Coordination, and Simultaneous Currency Collapse’, working paper, Federal Reserve Bank of San Francisco. Huh, Chan Gook and B. Trehan (1996) ‘Modeling the Time-Series Behavior of the Aggregate Wage Rate’, Economic Review, Federal Reserve Bank of San Francisco, No. 1, pp. 1–13. Hwang, In Hak (1998) Market Structure and Economic Efficiency. Seoul: Korea Economic Research Institute (in Korean). Jwa, Sung-Hee and Chan Gook Huh (1998) ‘Korea’s 1997 Currency Crisis: Causes and Implications’, Korea Journal, 38(2) (Summer) pp. 5–33. Kaminsky, G. and C. Reinhart (1996) ‘The Twin Crises: the Cause of Banking and Balance of Payments Problems’, Board of Governors of the Federal Reserve System, International Finance Discussion Paper No. 544. Korea Federation of Employers (1997) Surveys on Redundancy and Early Retirement System (in Korean).


282 Select Bibliography Lee, Chu-ho and Tae-il Kim (1997) ‘Reforms and Changes in Korean Labor Market’, KDI Journal of Economic Policy III, 5–60 (in Korean). Lee, Yung-sup and Jong-uk Lee (1998) ‘Was Korea’s Currency Crisis Predictable?’ (in Korean). Mimeo. Park, Dae-keun and Chang-Yong Rhee (1998) ‘Korea’s Currency Crisis: Developments and Lessons’ (in Korean). Mimeo. Radelet, Steven, and Jeffrey Sachs (1998) ‘The Onset of the East Asian Financial Crisis’, Harvard Institute for International Development, 30 March. Shepherd, William G. (1982) ‘Causes of Increased Competition in the U.S. Economy, 1939–1980’, Review of Economics and Statistics, 64, pp. 613–26.

9

Kim Dae-jung’s Structural Reforms and Some Evaluations

Lee, Ju-Ho and Dae Il Kim (1997) ‘Labor Market Developments and Reforms in Korea’ (paper). Seoul: Korea Development Institute. Ministry of Finance and Economy (1999) Djnomics: a New Foundation for the Korean Economy. Seoul. Mo, Jong-ryn and Jung-In Moon (1999) ‘Korea After The Crash’ Journal of Democracy, 10(3), pp. 150–64.

10

A Final Word: The Future of the Korean Economy

Hayek, F.A. von (1984) ‘Competition as a Discovery Procedure’, in Nishiyama Chiahi and Kurt R. Leube (eds), The Essence of Hayek. Stanford, CA: Hoover Institution Press, pp. 254–65. Yoo, Jungho (1988) ‘The Nature of the National Economy in the Borderless World and the Role of the Government’, in Lee-Jay Cho and Yoo Hyung Kim (eds), Korea’s Choices in Emerging Global Competition and Cooperation. Seoul: Korea Development Institute, pp. 65–85.


Index of Names Alchian, Armen A. 83 Amsden, Alice H. 34, 265n, 266n

Hong, Sung Duk 49 Huerta de Soto, Jesus 265n Huh, Chan-Guk 272n, 274n Hwang, Inhak 108

Barro, Robert J. 98, 267n, 268n Baumol, William J. 117 Bishop, Isabella Bird 268n Bressand, Albert 267 Buchanan, J.M. 86 Burnside, Craig 176

Ito, Takatoshi

267

Jwa, Sung-Hee 124–5, 149, 152, 264n , 267n, 271n

Cho, Dongchul 274n Cho, Yoon Je 61 Choi, Doo-Yull 274n Choi, Kwang 272n Clague, Christopher 91–2, 268n Coase, Ronald H. 84 Corrigan, Gerald E. 270n Corsetti, Giancarlo 176 Cukierman, Alex 267n

Kaminsky, G. 273n Kasa, Kenneth 272n, 274n Keefer, Philip 91, 268n Kim, Dae Il 264 Kim, Jun-il 271n Kim, Kwang Suk 49 Kim, Tae-il 273n Knack, Stephen 90, 952, 268n Krugman, Paul 177 Kwon, Soonwon 272n Kydland, Finn E. 267n

Darby, Michael R. 78 Demsetz, Harold 83

Lao-Tzu 266n Lawrence, Robert Z. 267 Lee, Byoung Ki 24, 26, 50, 264n Lee, Chu-ho 273n Lee, Jong-uk 177 Lee, Jong-Wha 98 Lee, Ju-Ho 264 Lee, Sung Soon 264n, 272n Lee, Yung-sup 177 Lewis, W. Arthur 89 Litan, Robert E. 270n

Edison, Hali J. 73, 267n Eggertsson, Thrainn 83, 85 Eichenbaum, Martin 176 English, Jane 266n Evans, Lewis 272n Feng, Gia-fu 266n Fisher, Irving 86 Fisher, Stanley 267n Fleming, J. Marcus 268n Fukuyama, Francis 88–9, 92, 94, 99

McKinnon, Ronald, I. 271n Mo, Jong-ryn 242 Moon, Jung-In 242 Moreno, Ramon 73 Mundell, Robert A. 268n

Glick, Reuven 73 Gordon, David B. 267n Grimes, Arthur 272n

Nam, Sang-Woo 53 North, Douglass C. 87, 90, 92, 94, 107

Hayek, F.A. 34–6, 43, 266n Herrigel, Gary 116

283


284 Index of Names Oman, Charles Olson, Mancur

119, 266n 91, 268n

Panzar, John C. 117 Park, Jongkyu 61 Park, Joon-Kyung 49 Park, Dae-keun 177 Pejovich, Svetozar 87 Perkins, J.O.N. 50 Pesenti, Paolo 177 Prescott, E.C. 267n

Seo, Jung-Hwan 264n Shepherd, William G. 272n Sherwin, Rosen 264–5n Stigler, George J. 117, 127, 129 Stiglitz, Joseph 177 Taylor, H. 267n Taylor, John B. 267n Teece, David 272n Tollison, R.D. 86 Trehan, B. 274n

Radelet, Steven 98, 176, 178 Rapaczynski, Andrzej 112 Ravenscraft, D. 121 Rebelo, Sergio 176 Reinhart, C. 273n Rhee, Chang-Yong 177 Roubini, Nouriel 176

Vanberg, V.

Sabel, Charles F. 116 Sachs, Jeffrey 98, 176 Sala-I-Martin, Xavier 98, 268n Scherer, F.M. 121

Yang, Won Keun 121 Yeager, Leland B. 265n Yoo, Jung Ho 23, 264n, 275n Yoo, Seong Min 272n


266n

Wallis, John Joseph 90 Weber, Warren E. 73, 267n Westney, D. Eleanor 116 Wilkinson, Bryce 272n Willig, Robert D. 117

Index of Subjects ‘Asian values’ 41 Anti-inflationary policy 7; see also stabilization policy Austrian School 34; see also Hayek, Mises

regulation 29t, 123–5 see also corporate governance, globalization, reform China 89, 186 Cho Hung Bank 140 Chun, Doo-hwan 105 Commercial banks 135–6, 144, 152 Commercial bills 22–3, 24t Confucianism and influence on economic management system 41–2 Competition as a discovery procedure 35, 39, 43, 256 see also Hayek, Taoism Contagion 151, 194 see also financial crisis Corporate governance 230–1, 242 internal versus external disciplinary systems 243t, 243–5 Corporate sector restructuring and reform 227–31, 241–5 Credit rating for Korea 179

Banking Law 22, 240 Bank of Korea 65, 183, 207 Bank of Korea Act 6, 65 Bank Supervisory Board 65 Bank’s monitoring role 142, 161–2, 244 deterioration of 31; see also corporate governance Banking systems specialized versus universal 144–5, 148–50 Big deals 229, 241 BIS (capital adequacy ratio) 222 Board of directors 27, 239–40, 242–4 see also corporate governance Capital mobility 69–70 Camdessus, Michel 214–19 Central Bank Law 22 Chaebol anti-chaebol sentiment 8, 11, 31, 110 characteristics 24–7 cross-debt guarantee 31, 139, 229 cross-shareholding 27 diversification 28, 110–11, 121, 123–6 early growth 10–11, 27 economic concentration 28, 29t, 30t, 120t five principles of reform 228t, 229 ownership and management structure 27 ownership concentration 121, 123t property rights 110 reform and restructuring 227–31

Debt–equity ratio 27, 28f, 242 Depreciation of Korean Won 22, 179, 193, 204 Democracy 55, 58, 241, 246–7 Demographic composition forecast 251 Deregulation 36, 162, 167, 234, 237, 240 see also liberalization De-urbanization 251 Development strategies of Korea Export drive of the 1960s 5–6 HCI drive of the 1970s 6–7, 19–22 stabilization and anti-inflationary measures of the 1980s 7–8, 21 see also deregulation, liberalization Diversification, see also chaebol comparison to other countries 122t excess 131

285


286 Index of Subjects market size 124 to disperse risk 146, 150–2 Economic reform, goal and targets 157t, 157–60 Economic Planning Board 6 Economic policy horizon 54–5, 67 Economies of scale 127–31, 146–8, 152 Economies of scope 124, 127–9, 146, 148, 150–2 Effective marginal tax rate 24, 26t; see Tax Endogeneity and spontaneity of markets 44–5 see also Hayek, Taoism Endogenous economic organizations 127–31, 146–7 Endogenous financial system 143, 147–9 Entry and Exit barriers 17, 19–22, 137 EU 249 Exchange rate policy autonomy of 68–70 maintenance of export competitiveness and control of inflation 53 government intervention 74 Fair Trade Act 28 FDI promotion 227 see also Liberalization Feudalism 90 Financial crisis in Korea background 178–9 debate on causes 176–8 external financing 180–2 high leverage 183 inflexible foreign exchange policy 186–8, 193 short-term macroeconomic factors 188–93 unemployment 204, 207 see also IMF program, labor market, moral hazard Financial sector as tool of industrial policy 11, 22, 142


reform of 223t, 139–42 public support for reform of 224–6 underdevelopment of 145, 239, 244 Financial Supervisory Committee 65, 222 Fiscal policy and macroeconomic stabilization 53 see also Keynesian economics Five-year economic development plans 9, 54 Fordist production system 115, 118–19, 147, 255 see also post-fordist production system Foreign exchange reserves 181 Foreign Exchange Transaction Act 227 Fukuyama, Francis 88–9, 92, 94, 99 GATT 55 ‘General Trading Companies’ 19–20 German craft system 115 Glass–Steagall Act 135 Globalization convergence of economic organization 117–19 implications on economic management 55–7 impact on role of government 45, 57 general implications of 116–19, 157, 249–50 increased uncertainty 255–6 large-scale and small-scale production 118–19 prospects for chaebol diversification 125–6 Government failure as a reflection of institutional failure 33, 36–7 Government intervention to rescue failing firms 22, 124, 170 see also moral hazard Government-led economic management characteristics 39–40 definition 39 ineffectiveness of 35 structural problems of 31

Index of Subjects 287 Government-led economic management (continued) resource allocation 28–9 in mobilization of banks 135–6 Government preferential treatment in fostering large corporations 109, 183 see also chaebol Government’s role in corporate governance 244 in economic management 34–7, 44–5, 171 in East Asia’s economic development 36–7 need to distinguish between exogenous and endogenous factors 44–5 see also Asian values, confucianism and influence on economic management system, Taoism Greenspan, Alan 177 Hayek, Friedrich von 34–5, 43, 159 Hanbo Goup 133, 192 Heavy and chemical industry (HCI) drive 170; see also development strategies of Korea IMF recommendations to Korea 21, 166, 179–80, 194, 252 post-crisis structural adjustment program 194–5 Stand-By Agreement 196–200t Inflation; in post-crisis period 204, 208; pre-crisis period 6–7, 21, 137; see also stabilization policies in Korea Indirect macroeconomic management 58–60, 64 Industrial Bank of Korea 22 Industrial policy cycle of Korea 9, 17 Industrial structure under globalized markets 117–19 Informal institutions 84, 88, 90, 107 see also anti-chaebol sentiment, institutions Information technology 250


Informational superiority between government and private sector 39–40 see also socialist economic calculation, government’s role Institutions absence of ‘proper’ institutions in Korea 12, 36, 111 in economic analysis 83–6, 85f see also government failure as a reflection of institutional failure, informal institutions, institutional reform, market failure, new-institutionalism, property rights, reform, transaction costs Institutional reform 161t, 163, 168, 247–8, 253–4 enhancing competition 160, 161t neoclassical interpretation 155–60 see also chaebol ‘insular economy’ 69 Integration of financial and non-financial sector 143–5, 150–3, 183–4 Intellectual capital and economic growth 256–7 Interest rates control and intervention 22–4, 24t, 137–8, 183, 239 see also government preferential treatment International competitiveness 74, 80, 186 Investment banks 144 Investment–savings ratio 49–50 Japan 90, 135, 139 Japanese flexible and lean production system 116 Keiretsu 135 Keynesian economics and countercyclical macroeconomic policy 35, 36, 158 see also stabilization policy Kia Motor Group 133, 177, 192 Kim, Young Sam 161, 185

288 Index of Subjects Korea Asset Management Corporation 224 Korea Deposit Insurance Corporation 224 Korea Development Bank 23 Korea Exchange Bank 140 Korea First Bank 105 Korea Futures Exchange 226 Kookmin Bank 22 KOSPI 180 Krugman, Paul 177 Kukjae goup 105 Kwanchi kumyung (‘governmentcontrolled finance’) 29, 238, 247 Kwanchi kyungche (‘governmentcontrolled economy’) 247 Labor market reform 163, 234–6, 245 Labor market rigidity and labor law 184–5 Land reform 103–4 Lange, Oscar 33–5 Lao Tzu, see also Taoism Legal barriers to financial–industrial interaction 133–4 Legal institution in Korea, nature of 107 Lending concentration 138–9, 176 Liberalization impact on competition 145 impact on economic management 57 of banking industry 240 of capital flow 57–8, 68, 149, 158, 162, 226–7 of foreign exchange 227–8 of interest rates 162 of prices 59 problems of 56–7, 164 M&As 222, 223t, 231, 244 government-led 20–2, 241 Macroeconomic stability as exogenous factor for growth 45 see also anti-inflationary policy, stabilization policy ‘Main bank’ system 139


Market disciplinary mechanism, see corporate governance, bank’s monitoring role Market failure 33, 36–7; see government failure as a reflection of institutional failure Ministry of Finance and Economy 64 Mises, Ludwig von 33 Monetary Board 65 Monetary policy autonomy of 68–70 neutrality of 50–1 theory and practice 60–1 Monetary Stabilization Bonds 74 Monopolistic and oligopolistic structures 11, 40, 145, 183 Moral hazard 11, 178; as cause of financial crisis 11, 31–2; solution toward 169–71 Multi-product firm 118, 127–9 National Investment fund 22 New growth theories 158–9 New-institutionalism 84–6 see also transaction costs, property rights Non-banking financial sector 144–5 Non-performing loans 192, 224, 238 North, Douglass 83, 87, 90, 94, 99, 107 North Korea 252 OECD 63, 234, 240, 252 Oriental liberalism, see Taoism Ownership restrictions in banking sector 136–7, 240 rights 87 see also chaebol, privatization Park Chung-hee 5 Paternal government see confusianism and influence on economic management system, government’s role, Taoism Plaza Accord 188 Policy credibility 55, 66, 155, 171–2, 241

Index of Subjects 289 ‘Policy loans’ 23 Policy mix and macroeconomic management 77–80 Post-fordist production system 115, 118–19 Price controls 38, 53–4 see also liberalization Privatization of public sector 162, 236 of banks 104, 136–7 see also liberalization Property rights attenuation in Korea 102–7, 241, 248 effects on economic behavior 91t, 98–9, 145 effects on economic performance 89–90 implications on economic organization 87–9 implication on size of firm 100–1, 107–11 and tax system 107 see also institutions, new-institutionalism, transaction costs Public choice school 36, 86 Public sector reform 231–4, 236; objectives and strategies 232t Real Name Financial Transaction System 105–6, 162, 163 Reform of central bank system 65–6 of exchange rate policy 62–3 of fiscal policy 61–2 indirect macroeconomic management system 58–60 of monetary policy 60–1 political reform 163–7 price stabilization 155, 159t reaction against 163–5 role of foreign competition 167 sequence of 168–9 see also chaebol, corporate sector restructuring and reform, economic reform, financial sector, institutional reform, labor reform, public sector


reform, state-owned enterprises, tax reform Regulated deregulation 40, 162 Regulation on economic concentration 29t; reason for failure of 28–9 Regulation Reform Committee 234 Restructuring of corporations and industries 20t; government-led 21 Revisionist view of East Asia’s economic growth 36–7 Rule-based economic policy 36, 64, 66–7 Rules of the game 37, 111–12, 160, 163, 262 see also corporate governance, institutional reform, reform Sachs, Jeffrey 176–8 Short-term credit 179 Smith, Adam 127, 158 Socialist economic calculation 35 see also Hayek, Lange Solow growth model 158 Stagflation 35–6 Stabilization policies 7–8, 53, 59 see also anti-inflationary policy, Keynesian economics and counter-cyclical macroeconomic policy, sterilization policies State-owned enterprises (SOEs) 222, 227–8; reform plan 233t; see also public sector reform Sterilization policy as part of monetary policy 70–1 effectiveness of 71–3 Korea’s experience with 73–7 see also stabilization policies Structural adjustment policy of the 1980s 105 Synergy effect 152 see also economies of scope Taoism 41–4 see also Asian values, competition as a discovery process, confusianism and its influence

290 Index of Subjects on economic management system, government’s role, Hayek, endogeneity and spontaneity of markets Targeting policy 77–80 cost and benefits 79t Tax reform 162 Tax regulation and system 21, 107 during the Yi Dynasty 102–3 Tax support to selected industries 9, 17, 21–4, 104 Tax reduction regulation law 21 corporate tax 25t exemption rate 22 Technological efficiency and Korea’s financial industry 149–50, 152–3 Terms of trade 190t Thatcher, Margaret 36 ‘three-lows’ 7 Time-inconsistency 66 see also policy credibility


‘too big to fail’ legacy 11, 27, 110, 134, 170, 184 Transaction costs empirical evidence 94–7 implication on economic institutions 84–6 implications on property rights 86–7, 163 implication on size of firm 92–8 measurement of 90–3 see also new-institutionalism Tripartite Commission 234–5 Unemployment Task Force Vector error correction model Workout program 230 World Bank 37, 44, 180–1 WTO 55, 166, 234, 252 Yi Dynasty

102–3

236 211–14

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