Why are There Global Imbalances? The Case of South Korea

Abstract

In the 1997 Asian Financial Crisis, South Korea, which had been one of the most successful economies in the world, was forced to raise interest rates and cut government spending by the IMF. These measures caused great economic distress. Because Asian countries are not well represented in the IMF’s governance structure, Korea could not effectively appeal the IMF’s decision. What Korea and neighboring countries learned from this experience was that they had to accumulate their own reserves to self insure against future crises without the need to resort to the IMF. This self-insurance in East Asia has been quite effective, allowing Korea, for example, to navigate the current crisis well. However, the trillions of dollars saved in Asia contributed to the ‘global imbalances’ that have played an important role in causing the current crisis. In terms of resource allocation, holding reserves is a costly and inefficient method. Firstly, one possible method of acquiring reserves is a lowering of consumption in the accumulating countries such as China and Korea, and an increase in consumption in the countries whose assets are being acquired, mainly the U.S. This transfer of consumption from relatively poor countries to the richest is not desirable. Another possibility is to issue long term debt to fund the reserves and invest in short term foreign assets. Here the spread between the long term and short term rates is the cost of reserves. Secondly, the debt securities acquired by Asian countries helped to drive down lending standards and led to an excessive supply of credit in the housing sector in the U.S. Going forward, one of the necessary changes in the international financial architecture is to reduce the need for Asian countries to hold large reserves. Reforming the governance of the IMF will be one of the first steps needed to achieve this goal. If countries could always rely on being treated fairly and equitably, they would not need to accumulate huge reserves. In the medium term this goal seems unlikely to be achieved. Other measures to solve the global imbalance problem are to set up a risk-sharing institution in Asia and for the Chinese to allow the RMB to become a reserve currency.