Brothers, Can You Spare $58 Billion? Regulatory Lessons from the South Korea Currency Crisis

Article excerpt

More than one year after the collapse of the Thai baht set the Asian currency crisis into motion, the resulting economic depression in that region reveals the downside of unfettered capital flows. Filling an institutional void, the International Monetary Fund (IMF) offered aid to imperiled countries in exchange for promises to stabilize currencies by raising interest rates and adopting market-based structural reforms. Although economists from across the ideological spectrum blame IMF-mandated macroeconomic policies for the economic decline and social unrest that plagued much of Asia during 1998, they remain divided on how to respond to financial crises.(1)

Does the Asian experience provide any lessons about international financial policy? This paper considers several based on the recent history of South Korea. Unlike Indonesia and Thailand, South Korea did not suffer from chronic current account deficits or an excessively overvalued currency. Rather, the problem was a banking system that weakened during a period of financial liberalization. Economists familiar with the work of Hyman Minsky [1986] would not be surprised that the policies recommended by the IMF in late 1997 to stabilize financial markets worsened banking conditions, resulting in a severe credit crunch that exacerbated recessionary conditions and disproportionately harmed households and smaller firms.(2,3) Because financial crises are difficult to prevent, countries must attempt to cushion their impact by formulating policies to promote financial stability and sustain economic activity.

Financial Factors in the South Korean Crisis

By late 1997, the financial crisis that began earlier in the year spread to South Korea despite policies limiting the inflow of speculative investment.(4) Many economists contend that South Korea was not swept up in a contagion, but was vulnerable because of excessive government involvement in the economy. For example, Thomas Cargill [1998] blames the South Korean currency crisis on incomplete financial liberalization. Although the government privatized large commercial banks in the early 1980s and phased out interest rate controls during the 1990s, Cargill argues that banks were weakened because of regulatory forbearance, moral hazard, and excessive risk-taking.

Solvency problems worsened by early 1997 when 7.6 percent of total loans at eight major banks were considered non-performing and five large conglomerates filed for bankruptcy. Equally troublesome, however, was the fact that the financial system had become increasingly fragile and susceptible to a liquidity crisis. Unlike the solvency problem, this condition arose after financial liberalization increased competitive pressure on Korean banks by raising borrowing costs. Banks responded to these developments by seeking new funding sources and by increasing speculative activity.

It was the decline in Japanese interest rates in the mid-1990s that provided Korean banks with a profit opportunity known as the carry trade.(5) Because restrictions on short-term capital flows were relaxed in 1993, banks exploited the spread between domestic and foreign interest rates by increasing their reliance on short-term, foreign-currency denominated funds. The large Korean conglomerates known as the chaebol also took advantage of this opportunity by borrowing directly, increasing their use of leverage in the process. Despite the associated increase in default risk and opaque financial reporting practices, foreign lenders eagerly provided funds, increasing South Korea's short-term external debt to nearly $80 billion in 1997.

As uncertainty about South Korea's ability to defend the won increased, foreign lenders refused to renew short-term loans, increasing pressure on the currency. Alarmed by the depletion of foreign exchange reserves expended to stabilize the won, Deputy Prime Minister Lira requested IMF support on October 21, 1997. Approximately six weeks later, the executive board approved an assistance program that provided approximately $58 billion in credit to replenish reserves in exchange for South Korea's promise to further liberalize its economy. …