Was East Asia Illiquid or Insolvent? with Special Reference to South Korea
Dean, James W., Multinational Business Review
This paper argues that since mid-1997, East Asian crisis countries have suffered from a withdrawal of international capital flows well beyond any fundamental weakness in their economies. This has resulted in good part from "reverse free rider" behavior by foreign lenders. Hence East Asia has been "illiquid" but not "insolvent". The paper argues further that IMF "bailout" lending, although not always the conditions that have gone along with it, has been unjustly maligned. This argument is illustrated with reference to South Korea.
The 1980s saw an "international debt crisis" that began in Mexico and quickly spread throughout Latin America and to parts of Asia and Eastern Europe. The crisis was triggered in mid-1982 and took seven years to resolve. Central to the resolution process was a distinction between illiquidity and insolvency, first emphasized by Cline (1983). If sovereign borrowers were simply illiquid, it was argued, policy should center on "liquidity relief': rescheduling and new lending. If they were insolvent, it should center on "debt relief": permanent reduction of debt obligations. Ultimately, liquidity relief proved insufficient, and the crisis was resolved with the so-called "Brady Plan," that involved substantial debt reduction by commercial bank creditors. For extensive reviews of the 1980s international debt crisis, see Bowe and Dean (1997b), Cline (1995), and Dean (1992).
1994-95 saw a second Mexican crisis that was correctly deemed to be a liquidity crisis, and rather adeptly resolved via a massive and unprecedented infusion of funds from the US Treasury and the IMF. That crisis was more or less confined to Mexico, albeit with some tremors transmitted to Argentina. In short the crisis proved both transitory and local.
Mid-1997 saw a currency crisis in Thailand that spread almost overnight to Malaysia, and then Indonesia. But it was not until November of 1997 that the crisis hit Asia's third largest economy, South Korea. When it did the impact was far more dramatic than expected. The won fell repeatedly by 10% per day, the limit of its trading band; several major firms were declared insolvent, and by mid-December smaller firms were failing at the rate of 50 per day. Short term interest rates soared to 30% and above. The IMF, World Bank, Asian Development Bank and governments of 11 countries committed $57 billion to a rescue package, dwarfing the packages already committed to Thailand and Indonesia, not to mention the record-setting 1995 Mexican bailout.
As is its practice, the IMF attached strenuous conditions to its Korean loan package, including the closure of firms and financial institutions deemed to be insolvent, and sharp hikes in interest rates. This latter part of the package is highly controversial (see for example Sachs, 1997). While substantially higher interest rates should attract and retain capital inflows from abroad (although they palpably did not during the first weeks of the crisis), they will also substantially increase debt service obligations on outstanding stocks of debt. In some cases, such increases might be sufficient to render firms and financial institutions that were hitherto simply illiquid over the brink into insolvency, especially since the debt-equity ratios of Korean firms are extraordinarily high by almost any international standard. This line of argument suggests that the macroeconomic conditions being imposed by the IMF were dead wrong. It may also suggest that other harsh (but necessary) aspects of the program, such as closures of insolvent banks and firms, should have been subordinated to its "bailout" dimension, at least for the moment. Indeed the chief economist of the World Bank, Joseph Stiglitz, was remarkably critical of his sister institution's policies in Asia: "You don't want to push these economies into severe recession. One ought to focus on the things that caused the crisis, not on things that make it more difficult to deal with. …