South Korea’s Financial Crisis in 1997: What Have We Learned?

Abstract

The South Korean bang in was triggered by both endogenous factors such as moral hazard effects and suboptimal foreign debt management, and negatively affected exogenous factors such as contagion effects of the Asian crisis, co-ordination failure effects and terms of trade shocks. An analysis of the South Korean episode implies that: (1) both sustainability and liquidity ought to be considered for an optimal foreign debt policy, particularly during the liberalization of capital markets; (2) a proper corporate governance, coupled with transparency and increased foreign competition, are important to increase the efficiency of big conglomerates; (3) a mechanism for effective global co-ordination is required to cope with the contagion effect, and to promote integration of developing economies into the world market. I. Introduction The South Korean economic turmoil in 1997 provides an interesting research question: why did the crisis happen in late 1997 and not before? In fact, the South Korean economy has been among the most rapidly growing nations over the period, despite the devastations of the Korean War.1 Trends in overall macroeconomic indicators prior to the crash failed to give any significant warning about the episode.2 In addition, economists, including the Organization for Economic Co-operation and Development (OECD), forecasted that South Korea would continue its economic growth and that the level of per capita income (in current price) would double by 2001 from the level of 1995. In contrast to this forecasting, the South Korean economy experienced severe turmoil in late 1997, and therefore a severe recession is expected. The won, which was relatively stable at around 860 per dollar, depreciated rapidly. As of early March 1998, the reduction of the won's value by about 46 per cent brought about various shocks across the economy (Min 1998).3 With the sharp devaluation of the won and capital flight, South Korea experienced a credit crunch. As a result, it resorted to a bailout by the International Monetary Fund (IMF) and switched its foreign exchange rate system from a Market Average Exchange Rate System (MARS), under which the won-dollar exchange rate changes within a daily trading margin, to the free floating exchange rate system.4 This article aims (1) to analyse the economic causes of the turmoil, and (2) to find some implications both for domestic industry policy and for international economics. South Korea experienced negative growth and a high debt ratio in the early 1980s without a capital flight. Thus, special attention will be placed on the different economic environments of the current crisis and the early 1980s, and how these differences precipitated the crisis. Section II describes the analytical framework for the study. Sections III and IV analyse various causes of the turmoil and economic effects. The final section is a summary and conclusion. II. An analytical framework Various economic models and hypotheses have been put forward to explain financial crises.' Among these, and of particular relevance to the South Korean situation, are the crisis zone model (Cole and Kehoe 1996) and the moral hazard argument (Krugman 1998). The basic mechanism of the crisis zone model is that a self-fulfilling debt crisis occurs if the initial level of government debt is above some critical level, and a random variable not connected to the fundamentals of the model is below another critical level. A crucial feature of the model is the ability of the government to roll over old debt into new under different debt maturity scenarios without losing the confidence of international bankers. If this is the case, an optimal management of the composition of debt is highly dependent on the average length of maturity of government debt. Another implication of the model is that the absence of prudential regulation while an economy is liberalizing its capital markets will hinder optimal foreign debt management. …