Regulatory Lessons from the South Korean Currency Crisis: Comment on Zalewski. (Notes and Communications)

Article excerpt

Korea experienced a financial crisis in 1997-1998 after three decades' rapid economic growth. Since most economists thought that the Korean economy had good economic fundamentals, the occurrence of a financial crisis in Korea was surprising. When the International Monetary Fund (IMF) prepared emergency loans for Korea, its policy packages comprising various institutional reform measures as well as a high interest rate policy were imposed as well. Since the financial crisis, the Korean economy has shown a V-shaped recovery.

David Zalewski (1999) tried to explain the causes of the financial crisis in Korea and suggested certain regulatory reform measures. Since the article was written in the midst of the financial crisis and could not fully reflect the reform measures taken in the recovery process, it included certain problems. Some aspects were not mentioned, although they were of importance in explaining the causes of or recovery from the financial crisis. The current paper criticizes and extends Zalewski 1999 in light of the unexpectedly rapid economic recovery. Considering that lots of developing countries are expected to face financial crises in their development processes, this paper draws lessons from the experience of the Korean financial crisis that may be applied to the other countries.

Macroeconomic Situation in 1997

The Korean economy experienced current account deficits during 1990-1997. In the midst of such deficits and economic growth slowdown, the Korean economy showed corporate failures in 1997. Following failures of several chaebols, which denote the large conglomerates in Korea, when the decision was made to bail out the nearly bankrupt Kia and Hong Kong's stock market crashed in October 1997, foreign banks refused to roll over the matured loans. The foreign exchange reserves were nearly depleted at the end of 1997.

On December 4, 1997, the IMF approved a three-year stand-by arrangement with Korea, amounting to US$21 billion. Since the then newly elected president of Korea was firmly supported by major developed countries and international financial institutions, financing was also committed by the World Bank, the Asian Development Bank, and certain developed countries. The financing packages provided by the IMF, the World Bank, and developed countries reached US$58 billion. (1) The foreign exchange reserves, which plummeted to US$4 billion on December 24,1997, began to increase at the end of 1997.

IMF-Mandated Macroeconomic Policies

Together with the emergency loans, the IMF policy package was imposed on the Korean economy. Money supply was tightened quite sharply, and the overnight call money rate, which had averaged 12 percent prior to the crisis, increased to levels between 20 percent and 30 percent in early 1998. Zalewski (1999) argued that economists from across the ideological spectrum blamed IMF-mandated policies for the economic decline and social unrest in 1998.

Zalewski (1999) suggested that the disinflationary impact of such an austerity program would have been mitigated with a program based on an interest rate offset plan; in other words, the Korean government should have required banks to charge low interest rates on business loans to prevent massive bankruptcies and rising unemployment. According to Martin Feldstein (1998) and Zalewski (1999), the Korean government should have reimbursed banks by crediting the bank restructuring fund with the difference between market interest rates and the subsidized loan rates. However, such an argument ignores the institutional characteristics of the World Trade Organization (WTO) system. According to the Agreement on Subsidies and Countervailing Measures of the WTO, the products exported from companies which borrowed at the subsidized loan rates would be subject to the countervailing duties imposed by the importing countries.

Zalewski (1999) predicted no significant recovery before the new millennium, noting high unemployment and negative real GDP growth rate in 1998. …