Korean crisis caused by financial liberalisation and economic deregulation

Contrary to the view put forward by many Western commentators, the Korean crisis was due not to the over-regulation of the economy by an intrusive state, but to deregulation. This, coupled with a policy of financial liberalisation which permitted a reckless spree of foreign borrowing, caused the current financial crisis in that country.

by Ha-Joon Chang

WHEN the Korean crisis first broke out, many commentators argued that it was the result of an intrusive state forcing banks to lend to unprofitable firms.

The 'medicine' to cure the country's economic ill, it was argued, is to ditch the now-defunct dirigiste system, which was linked to those of the Soviet Union or East Germany by some, and create a 'genuine' market economy through an extensive liberalisation of finance, international trade and labour market.

Although dissenting views are increasingly voiced - even right from the heart of the Bretton Woods system such as the World Bank chief economist Joseph Stiglitz and the Harvard professor Jeffrey Sachs, who was the main architect of a number of IMF-style 'reforms' in Latin America and Eastern Europe - this is the view that still prevails in the international media. Is this true?

The first thing to point out is that the current Korean crisis is essentially a financial crisis, rather than a crisis of the 'real economy'. Most of the country's manufacturing firms are able to make products that can sell even in the most demanding markets, if the exchange rate is right.

During the last couple of years, the currency was clearly overvalued by 10-20%, but even then its current account deficit was just over 3% of GDP on the eve of the crisis (and is falling after the recent devaluation). This is not much compared to current account deficits of 8-10% that we saw in countries like Thailand and Mexico before their recent crises. Indeed, Korea itself had a current account deficit of nearly 9% of GDP in its earlier crisis in 1980.

It is believed that most, if not all of the foreign loans were financing investments in tradable sectors (although sometimes duplicative), rather than real estate development or imports of consumer goods, as it was the case in Mexico and South-East Asia. The government budget is largely in balance and gross public debt equivalent only to 3% of GDP - described as the second best budgetary position amongst the OECD economies, according to the Financial Times columnist Mr Martin Wolf - and there has been no other significant inflationary pressure in the economy. Then why did Korea end up where it is now?

It should be noted that there were certain 'external' causes to the current Korean crisis. The crash in the South-East Asian economies earlier this summer reduced demands for Korean exports and dealt a blow to some Korean financial companies which were speculating in their stockmarkets. The entrance of new Taiwanese semiconductor manufacturers drove down the prices of memory chips, which accounted for nearly 20% of Korean exports when their prices were high, to a critical point (from nearly $50 to $4). However, the current crisis is largely the result of policy failure by the current government of Mr Kim Young Sam, and that of under-regulation, rather than of over-regulation as the popular view holds.

Relaxation of state control

Deregulation has been the proclaimed policy objective of Mr Kim's government, and although no radical deregulation was attempted, enough relaxation of state control has happened during the last five years or so to make important differences.

Firstly, the current government abandoned its traditional role of coordinating investments in large scale industries, thus allowing excess capacities to emerge in industries like automobile, shipbuilding, steel, petrochemical, and semiconductors. These eventually led to the fall in export prices and the accumulation of non-performing loans.

Secondly, in the name of financial liberalisation, it failed to properly monitor the foreign borrowing activities, especially by the inexperienced merchant banks. This has resulted in a rapid buildup of debts totalling $100 billion with a very poor maturity structure - 70% of these debts are with less than a year's maturity.

Finally, it was sold to the monetarist idea that inflation control is the most important objective of government policy and that exchange rate should be used as an 'anchor' in inflation control. This led to a significant over-valuation of the currency, which has hurt export performance.

The actions that the current Korean government took at the first signs of economic trouble were also confused and incompetent. It dithered so much about the fate of the third largest car manufacturer, Kia, that it has unnecessarily undermined confidence in the economy. Moreover, in the wake of the currency crisis, it wasted $10 billion, over one-third of its dwindling foreign exchange reserve, trying to defend on an indefensible exchange rate, further exacerbating the foreign exchange shortage.

The best 'medicine'

Having met the crisis, is the IMF programme the best 'medicine' for Korea? There are a number of important problems with the IMF programme.

Firstly, as many people have argued, its strong deflationary bias may make the credit crunch that firms are facing even worse, possibly leading to a chain of bankruptcies and driving the economy into a depression. It is indeed curious that those commentators who criticise the Koreans for organising campaigns against luxury consumption, which they point out will deepen the recession by reducing the already failing demand, fail to see that the IMF programme will do the same, only on a larger scale.

The IMF's 5% inflation target is already too deflationary when it was set, given that the economy was to deal with a big rise in import prices due to devaluation and with the excess liquidity released by financial sector bailouts. But given the further fall of the currency since the signing of the agreement, it seems indefensible. The budgetary target, which aims for a small surplus, also needs to be flexibly adjusted, if it is not going to add unduly to the deflationary pressure.

What is more worrying than its deflationary bias about the IMF programme in the long run is the IMF's insistence on financial liberalisation and opening-up. It is actually better financial regulation, rather than less financial regulation, that Korea needs. The country needs to strengthen its prudential regulation system, especially over the non-bank financial institutions such as merchant banks. The country also needs to train people and set up institutions to develop its creditworthiness assessment capabilities. Bad debts in the financial system need to be cleaned up before the banks can be granted more freedom.


Moreover, we need some time before we know which are the really viable financial institutions and which are the ones which have to be closed down, as at the moment the relative prices are all mixed up (unless one thinks that whatever exchange that the financial market dictates is the 'equilibrium exchange rate'). All these require time, but the IMF programme does not allow that.

Drastically relaxing the already inadequate financial regulation, especially drastically opening up the financial market to foreign participation, exposes the economy to a much higher volatility in the future. What such volatility can do to an economy is clearly shown by Chile in the last 1970s and the recent experiences of Mexico and South-East Asia.

There is a growing opinion around the world that the global financial system needs to be restrained for the sake of global economic stability - a view even someone like the legendary currency trader George Soros advocates. Moreover, even if one believed that financial deregulation is good, this is not the time to pursue it. The economy has to recover first before it can withstand the strain of restructuring in the financial sector, as the Korean financial institutions are notoriously over-manned, and thus will have to shed a lot of labour, which will become economically and politically difficult to manage in a crisis situation.

Finally, at the moment there is a widespread feeling among the Korean people that they were not properly consulted in the negotiation with the IMF - there is a widespread talk of 'national humiliation' and 'foreign trusteeship'.

Lack of popular consultation may not be possible in an emergency situation but this makes it no less controversial. As a result, if the IMF programme, with its heavy deflationary bias and penchant for mass redundancy, results in a sharp rise in unemployment, there will be a massive political resistance. The IMF itself implicitly recognised this danger when it said in the programme document that the country needs to strengthen its unemployment insurance system, although it is not clear how this can be achieved in a time of fiscal retrenchment and mass redundancy. Anyhow, if there is a political backlash, the programme itself will be jeopardised. As even the researches by the World Bank and the IMF themselves show, the success of a reform programme is maximised when the government and population has a sense of 'ownership'.

In this sense, the new government of Mr Kim Dae Jung, with its due scepticism about the current IMF programme and its stronger ties with those who are going to hurt the most in the process - such as small firms and trade unions, may be better placed than any other alternative government to pull the country through a period of deflation and job losses and put the economy back on a robust growth path - that is if it finds new ways to maintain the coordinatory and regulatory roles of the government than the previous Korean government, but without the negative features of the old system such as corruption, nepotism and excessive bureaucratic rigidities. (Third World Resurgence No.89, January 1998)

Ha-Joon Chang is a well known Korean economist and teaches at the Faculty of Economics and Politics, University of Cambridge. The above article was written by him specially for the South-North Development Monitor (SUNS).