Regulatory Lessons from the South Korean Currency Crisis: A Reply to Jai S. Mah. (Notes and Communications)

By Zalewski, David A. | Journal of Economic Issues, September 2002 | Go to article overview

Regulatory Lessons from the South Korean Currency Crisis: A Reply to Jai S. Mah. (Notes and Communications)


Zalewski, David A., Journal of Economic Issues


Professor Jai S. Mah criticizes my "Brothers, Can You Spare $58 Billion? Regulatory Lessons from the South Korean Currency Crisis" (henceforth, "Brothers") for failing to describe the underlying causes of the crisis and for neglecting to recognize the International Monetary Fund's contribution to South Korea's unexpected economic recovery. Although Mah correctly points out some minor faults in my paper, I argue below that the basic lessons described in "Brothers" were not only relevant at the time it was written but remain so today.

What Caused the Crisis, and Could It Have Been Prevented?

"Brothers" began by evaluating Thomas F. Cargill's (1998) claim that regulatory forbearance, moral hazard, and excessive risk taking were the primary causes of the South Korean crisis. According to Cargill, these problems resulted from the government's unwillingness to completely liberalize the financial sector. Although my paper acknowledged the solvency problems stressed by Cargill such as the increase in nonperforming loans and rising chaebol bankruptcy rates in early 1997, it also stated: "Equally troublesome, however, was the fact that the financial system had become increasingly fragile and susceptible to a liquidity crisis" (360, emphasis added). "Brothers" observed that this condition developed after the liberalization of short-term capital inflows in 1993 enabled bankers to respond to increasing global competition by financing long-term domestic loans with short-term, foreign currency-denominated liabilities. This exposed banks to shocks that could impair their ability to meet cash flow obligations, potentially leading to the type of debt/deflation spiral described by Hyman Minsky (1986). (1) Thus, "Brothers" concluded that South Korea suffered from both solvency and liquidity problems at the time of the crisis and that the latter resulted from the misguided decision to liberalize short-term capital flows while the banking sector was weak and before effective regulatory institutions were established.

Although Mah argues that the "root cause" of the crisis was an increase in nonperforming loans, his criticism of excessive short-term borrowing suggests that he also believes liquidity problems played a role. Therefore, Mah's claim that I "did not reveal the deep-rooted causes" of the crisis is inappropriate since we only disagree about the relative importance of these factors. The events that Mah considers to be responsible for the onset of the crisis--chaebol failures, the government's bailout of Kia, and the Hong Kong stock market crash--worried lenders and motivated many of them to withdraw their loans. Because any of a variety of shocks could have triggered the crisis, however, the type of initiating impulse is less important than the underlying susceptibility of the financial system.

Based on this interpretation, "Brothers" recommended that regulators should strive to prevent financial fragility, especially since global deregulation has forced bankers to assume greater risks to maintain profitability. This implies that financial liberalization should be delayed until regulators adopt some variation of Minsky's (1975) cash flow-based bank examination procedure that focuses on preventing financial crises by gauging the potential impact of macroeconomic developments on banking conditions. My paper also encouraged bankers to adopt risk management practices to supplement regular bank examinations by government auditors. Although Mah claims that I neglected to propose the development of an early warning system, I believe these reforms would have performed this function.

Was the IMF's Response Appropriate?

Responding to South Korea's request for assistance as it depleted its foreign exchange reserves in defense of the won, the International Monetary Fund (IMF) approved approximately US$58 billion in standby credit on December 4, 1997. …

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