Comment on “Crisis and Recovery: What Have We Learned from the South Korean Experience?”

Abstract

Lee and Rhee's paper (2007) is very good at what it sets out to accomplish. I would like to step back and raise some issues that are not considered in this paper; consequently, these comments should be interpreted as supplementary or complementary in nature. The paper disposes with the background to the crisis rather perfunctorily in the opening paragraphs, vaguely alluding to institutional weaknesses and panic. Although this can be justified in terms of focus on the ex post“lessons,” the neglect of any deeper consideration of the sources of the crisis limits eliciting broader lessons for either South Korea or other countries. During its period of rapid growth, South Korea pursued a policy of financial repression as part of a state-led development strategy. Problems arose as the country approached the international technological frontier and opportunities for easy technological catch-up attenuated. The disappearance of straightforward paths for industrial upgrading based on imitating the prior trajectories of more advanced economies put a heightened premium on the ability of corporate managements and their financiers to discern emerging profit opportunities. Decades of state-led growth had bureaucratized the financial system, however, and created a formidable constellation of incumbent stakeholders opposed to liberalization and transition toward a more market-oriented development model. As the paper observes, alternative sources of corporate finance were suppressed: the development of money markets and bond markets was retarded and issuance was effectively dependent on bank-guarantees. The government discouraged the development of an efficient auction and secondary market for bonds, and no swap, bond, or interest futures markets existed. As for the stock market, in 1990, the government established a quarterly quota on new issues and criminal proceedings documented how firms resorted to bribing officials to bring their initial public offerings to the market. Comprehensive capital controls were used to insulate the domestic financial market from the global market (Noland 2007). Portfolio flows and even direct investments were discouraged through various prohibitions and limitations. Interventions create their own constituencies, and the liberalization undertaken in the early 1990s was a function of political competition among domestic financial and corporate institutions over declining rents and foreign financial service providers seeking to enter South Korea. A combination of South Korean policy, its accession to the Organization for Economic Cooperation and Development, and the Basel Accords on capital adequacy created unintended incentives for short-term bank borrowing. The highly leveraged nature of the economy, together with the currency and term mismatches embodied in the mid-1990s surge of foreign debt exposure, left the economy vulnerable to a variety of negative shocks. In 1997, in the context of the broader Asian upheaval, South Korea experienced a financial crisis. South Korea seemingly recovered quickly, yet the “dumbing down” of the financial system produced by decades of financial repression may have left lingering effects. Concerns center on the apparent difficulty of changing the lending culture of until recently bureaucratized financial institutions and the counterpart challenge of improving the quality of market-oriented financial oversight by regulators more experienced in systems of greater direct control. As the paper notes, prudential regulation has been consolidated and strengthened through the creation of the Financial Supervisory Commission and the introduction of new regulatory practices, approaches, and standards. Competition was injected into the financial sector by the increased role of foreigners through a variety of institutional arrangements. The lending culture appears more resistant to change. In the aftermath of the crisis, lenders went from bingeing on corporate lending to bingeing on household lending: South Korean household debt registered the fastest growth in the world, increasing 18 percentage points of the gross domestic product in 2 years, before ending in crisis with the insolvency of the country's largest credit card issuer. A current challenge involves the extensive use of financial derivatives by South Korean financial institutions and the concern that the regulatory regime may not have kept pace with financial innovation. Institutional investors tend to be affiliated with the major chaebol. Independent institutional investors capable of monitoring management have been slow to develop, and although some foreign institutional investors and the nascent shareholder rights movement have exerted a salutary influence, the country still lacks a real market for corporate control. An open question is whether the crisis was avoidable: was there a politically feasible alternative path out of the state-led model, or was the constellation of incumbent stakeholders such that a crisis was needed to reform the system? I am skeptical that a smoother exit path was feasible: neither government officials nor the intelligentsia evinced much commitment to the notion of freer financial markets, and perhaps more importantly, there were some large and powerful interest groups opposed to liberalization.