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.
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. In Korea individual business divisions are incorporated as single business entities. Each entity is listed on the Korean Stock Exchange. Most bankers are not educated to understand consolidated financial statements. The banks did not bother to check possible misuse of prior loans by some borrowers to create slush funds to politicians. This abnormal situation was rooted in the heyday of economic development during the 1960s through 1980s, when the government heavily intervened in bank management to guide fund allocation in favor of development. As a result, Korean banks have had little incentive to learn advanced bank management techniques.
Even after the reduction of the government intervention in the early 1990s, there has been little change in the financial system. The chaebols comprise not only industrial companies but also various financial institutions. Most chaebol member firms borrow funds from their financial affiliates based on cross-guarantees. This led to lax risk management by financial institutions. Even non-member banks did not use well-founded risk analysis when making credit decisions. After all, banks wanted to maintain good relations with the chaebols in expanding their business volume and earning large fees. This situation encouraged chaebols to prefer excessive diversification of businesses driven by a desire to build a self-contained empire rather than to generate profits.
Another weakness in Korea's financial system related to the weak and poorly planned supervision of financial institutions. There were three independent supervisory bodies for banks, insurance, and security businesses. First, merchant banks were under the direct supervision of the MOFE. However, the MOFE operated without necessary manpower and competence. Still most bank failures were concentrated the merchant bank sector. Moreover, the government did not care in the name of liberalization and deregulation to regulate possible reckless overseas borrowing by banks and enterprises. Second, the insurance industry was supervised and regulated by the Insurance Supervisory Service. Third, security businesses are regulated by the security Supervisory Services (SSS). For example, the SSS set accounting standards, administered Korean CPA exams, reviewed audit reports and generally supervised insurance activities. This financial system environment is mainly responsible for the skewed distribution of loans to chaebols, the existence of many bad debts and non-performing assets by banks.
The weakness of Korea's financial system was first recognized during the democratization process. The civil government, right after it came to power in 1993, identified and published financial irregularities involving two former presidents, several politicians, many chaebol tycoons, and heads of commercial banks. The changing political climate also affected the financial institutions. The bank presidents started to tighten up lending policies driving many financially weaker companies to the verge of bankruptcy. Caught between the need for a hands-off policy toward private business and the call for intervention to avert bank failures and labor unrest, the government was unable to develop proper measures for more than three months between August and October 1997. Kia. Motors declared bankruptcy in July 1997. Labor strikes were particularly severe in September 1997. As a result, the economic climate and the confidence of overseas investors began to deteriorate rapidly.
Foreign investors found that portfolio investment in Korea was attractive given the high interest rate of 12-13% return per annum from 1991 to 1996 in Korea. They also thought that stock prices in Korea were generally undervalued, and overall economic performance was fairly promising. The inflow of foreign portfolio investment, starting from almost none before 1990, increased rapidly and the cumulative total from 1991 to 1996 was estimated at $48 billion. At the same time banks and big companies borrowed short-term loans abroad for long-term physical or portfolio investments abroad. Unfortunately, no policy makers or central bankers in Korea were aware of the danger inherent in the volatility of the short-term capital and no one was able to foresee the foreign exchange crisis just around the comer.
Direct Causes of the Korean Financial Crisis
After posting a small surplus in 1993, Korea's current account deficits started to widen in 1994 and rose to a record high of US$ 23 billion in 1996. In the beginning of 1997. a series of defaults by large private enterprises occurred. After Hanbo Steel, the 14th largest chaebol in Korea, went bankrupt in January 1997, several other corporations failed including the bankruptcy of the 7th largest chaebol, the Kia Group, in July 1997 and the 4th largest chaebol, the Daewoo Group, two years later.
The major problems resulted from the excessive buildup of short-term foreign borrowings by private enterprises and financial institutions. The short-term debt amounted to more than 50 percent of the country's total external debt and twice the size of its total foreign reserves. Furthermore, the increasing trend towards global financial integration in the 1990s created an environment vulnerable to the easy spread of the crisis across countries. The Thailand currency devaluation (late 1997) had a detrimental effect on other countries.
The political and financial scandals, the accumulation of trade deficits, and a series of corporate failures were quickly publicized in the international financial community. The investment community was shaken by these events. This confidence erosion was further precipitated by the foreign exchange crisis in the South East Asia. Many foreign investors started to pull their money out of Korea by dumping stocks and bonds. In addition, some firms refused to roll over the loans to Korean banks and companies. The capital exit helped decrease the Korean stock prices and Korean won. Foreign exchange reserves were rapidly drained during this period.
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. Therefore, until a well-functioning market system is solidly put into place, the government decided to monitor the initial stages of the restructuring process not only for a quick turnaround of the Korean economy but also for significant and sustainable growth. Once the market system functions properly, then the government can reduce their involvement and let market forces prevail. The government's role in the matured market system should be limited to that of surveillance and ensuring that market discipline is upheld.
The restructuring process can be completed when both hardware reform and software reform are successfully implemented. Hardware reforms include structural reforms and the establishment of market-driven institutional frameworks. When the hardware reforms are largely in place, then the software reform should complete the restructuring process. Software reforms should include eliminating the anachronistic attitudes and business practices, rewarding performance and innovation, focusing on profitability, and embracing managerial excellence and advanced lending practices. Only when these software reforms are widely accepted can Korea ensure their competitive position in the keenly competitive global market place.
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Soon Suk Yoon
Chonnam National University
Texas A&M International University