Major Causes for the Korean Financial Crisis in 1997

Article excerpt

Our study investigates the major causes of the Korean financial crisis in 1997. In a later paper, we will identify the reforms implemented to recover from the crisis. The Korean government believes that the main cause of the financial crisis in 1997 was a lack of market discipline and the malfunctioning of the market system rather than macroeconomic imbalance. Changes must be made in many areas including 1) fiscal and monetary policies, 2) the public sector and 3) the corporate sector. Korea's bank failures and the ensuing foreign exchange crisis are unique in that the failures were neither attributable to depression in any particular industry, nor to weakness in the real economy. Many indicators of macroeconomic performance (e.g. production, consumption and savings) had been normal until the financial crisis.

Background

In this paper, we examine the major causes of the Korean financial crisis in 1997. Most financial crises start with bank failures. The causes of bank failures, however, differ from country to country. In the U.S. for example, bank failures between 1982 and 1992 were due partially to a depression in agriculture, energy and real estate businesses. In Japan there have been many cases of bank failure since 1994. The major cause of these bank failures was the collapse in the price of land and stocks in the early 1990s.

However Korea's bank failures and the ensuing foreign exchange crisis are unique in that the failures were neither attributable to depression in any particular industry, nor to weakness in the real economy. Many indicators of macroeconomic performance (e.g. production, consumption and savings) had been normal until the financial crisis started. In November, the MOFE (Ministry of Finance and Economy) Minister argued that economic fundamentals were strong and the financial instability would be a passing phenomenon. Korea's banking system collapsed due to the loss of confidence of foreign creditors. The structural malady of Korea's financial system came to the surface in the course of democratization and globalization. The Korean economy was also affected by the financial crisis in the Southeast Asian countries and Japan.

In response to globalization, Korea gradually opened up commodity markets beginning in the early 199Os. The domestic industry was not well prepared to compete with foreign products at home as well as abroad because of so-called "4 highs and 3 lows". The four highs were the high wage rate, the high interest rate, high land values, and high transportation costs. The three lows were low technology, low value-added, and low managerial efficiency. Unfortunately there had been little progress in remedying these structural weaknesses in the years before the crisis. For example, the frequent replacement of the MOFE minister made it almost impossible for the MOFE to pursue needed policy adjustments in a consistent and sustained manner.

Korea's financial system is characterized by the lack of independence from the business conglomerates as well as from the government. For example, in making credit decisions to the business conglomerates known as chaebols, in most cases the Korean banks did not ask the chaebols to present consolidated financial statements to assess the financial positions and performances of the business groups as a whole. Individual financial statements were the primary financial statements. The chaebols were mandated to file consolidated financial statements with the Korean SEC. However other financial users including banks and investors did not use consolidated financial statements to make financial decisions. Korean companies are listed as individual companies and not listed as the entire business group as is the practice in the United States. For example, General Motors is listed as a single company on the New York Stock Exchange. Divisional units including Chevrolet and Cadillac are not listed individually even though each could be considered a separate business entity. …