Download Economic Growth Controlling Capital : focusing on the 1960s

Economic Growth Controlling Capital: focusing on the 1960s’ experience in Korea
Kang-Kook Lee (Ritsumeikan University)
Abstract
The political economy of capital controls, liberalization and crisis in Korea are
examined from institutional and historical perspectives. We analyze how capital
controls helped economic growth under the developmental state. The experience with
capital controls in Korea points to the importance of the specific institutional structure
for success. We then examine the process of the demise of the developmental state and
the mismanaged process financial liberalization and financial opening. We describe the
change in the financial system and the government-business relationships. The broad
change of institutions and liberalization led to serious vulnerability in the economic
system and the financial crisis. After the crisis, the government introduced further
opening as part of neoliberal economic restructuring. This raises concerns of foreign
dominance, lower investment and higher instability. The Korean experience
demonstrates that it is essential to consider the broad issues of political economy in
order to understand the effectiveness of and changes in capital account regimes.
Key Words: Capital Controls, Capital Account Liberalization, Financial Crisis,
Economic Restructuring, Korea
JEL Classification: O16, O53, P45
I. Introduction
The Korean economy was awe to economists in many ways. It was applauded as an
economic miracle for its great economic growth. Thus, there have been lots of studies
on this success. Recently the 1997 economic crisis triggered another hot debate about
the cause of the Korean economy. In understanding the Korean success and crisis, it is
very important to study the foreign capital management policy. The miraculous growth
was based on the strong capital controls, and the crisis was mainly due to the careless
financial opening policy.
In this study, we examine the Korean experience of the foreign capital management
policy in the 60s’. In fact, the dominant mainstream argument is that liberalization and
opening of the market provides the economic success and the liberalization is
recommended to all over the world. However, it is not clear about the financial market.
Still most empirical studies report that there is no evidence that capital account
liberalization spurs growth in developing countries. Rather, capital account
liberalization tends to cause instability and in some cases, capital controls may help
economic development like in Korea. Thus, more extensive study about the case of
capital controls, in particular about how it can be helpful to the economy, is called on.
In this regard, the Korean experience of capital management is very interesting. Based
on the specific institutional structure of developmental state, the government
successfully implemented the controls as one of important part of the development
strategy.
This paper consists of 4 parts. In the first section, we examine the current arguments
about capital controls, we review the mainstream and heterodox arguments and show
how capital controls may help growth under some conditions called the developmental
state. The next section deals with the institutional structure of the developmental state
such as the specific government-business relation and state-led financial system. We
examine the experience of foreign capital management in Korea in the third section. The
strong capital control regime was established as early as in the 60s’ and continued up to
late 80s’, however the government was also active to encourage foreign borrowing with
its guarantee. We study how specific institutional structures and political economy are
interrelated with the successful controls in the 60s’ in Korea. Also, we shed important
light on how the controls are related to other policies such as the industrial policy and
domestic financial controls for economic development. In so doing, we can get
important lessons of the capital controls policy for other developing countries.
II. Political economy of capital controls, decontrol and economic development
1. Capital account liberalization, controls and economic development
(1) Pros and cons of capital account liberalization and controls
Mainstream economists emphasize gains from the international capital movements
made possible by capital account liberalization; their arguments are base on belief in
efficient markets.1 They argue that the integrated global financial market enhances
efficiency in resource allocation, reduces the costs of intertemporal misalignments and
helps investors diversify risks. They also maintain that liberalization and international
capital movement increase the availability of foreign savings to supplement domestic
capital in the host country, and thereby encourage investment (Guitian, 1997; Edwards
ed., 1995; Prasad et al., 2003). In addition, the international capital market disciplines
national governments and liberalization reduces budget deficits (Kim, 2003). According
to these arguments, capital controls limit the opportunities afforded by the international
market, restrict financial market competition, and introduce distortions and inefficiency
(Dornbush, 1998). They are both inefficient and ineffective because in most cases
private capital can evade these controls (Edwards, 1999).
However, these arguments are valid only with the assumption of an ‘efficient’
financial market. It is hard to support efficiency of markets either theoretically or
empirically. Financial markets suffer from serious market failures due to information
problems, with investors displaying ‘herd’ behavior (Luxx, 1995; Kim and Wei, 1999),
and they are rife with moral hazard problems, giving a rise to ‘overborrowing’ or
‘overlending’ (McKinnon and Pill, 1999). Furthermore, from the perspective of the
‘theory of the second best’, the benefit of liberalization is hard to justify coexisting trade
barriers and differential tax rates (Brecher and Diaz-Alejandro, 1977; Bhagwati, 1998).
Financial opening may generate more instability, aggravating boom-and-bust cycles and
concentrating risk, rather than diversifying it. In fact, recent financial crises are
1
For an extensive survey on the debate about capital controls, including neoclassical arguments, see
Rajan (1999) and Cooper (1999).
explained by self-fulfilling expectations models with strong contagion effects
transmitted through the international financial market (Eichengreen et al., 1997).
Faced with the critique that financial opening may destabilize the economy,
economists point to the importance of several preconditions and proper sequencing for
the success of liberalization (McKinnon, 1991; Williamson and Mahar, 1998).
Successful capital account liberalization needs macroeconomic stability and the
establishment of a sound financial sector with a strong supervision system, and it should
be developed gradually, only after trade liberalization. This so-called ‘orderly financial
opening’ rubric has become the new conventional wisdom (Eichengreen and Mussa,
1998; Fischer et al., 1998).2 However, although these economists recognize the
importance of regulation and institutional development, their main thrust is still toward
liberalization. They underestimate problems of international financial markets and the
limits of national regulation following opening. Setting up prudential regulation in
developing countries takes years, and even developed countries with relatively good
regulation suffer from crises (Rodrik, 1999). Moreover, it is not easy to distinguish
between capital controls and prudential regulation since prudential regulation also limits
the free capital movements. Hence, more skeptical views have prevailed recently. In
particular, after the Asian crisis in 1997, many prominent economists have argued that
the crisis was due to careless financial liberalization and opening, and called for controls
over short-term capital flows (Furman and Stiglitz, 1998; Radelet and Sachs, 1998;
Krugman, 1998). However, it should be noted that they remain focused on the volatility
of short-term capital, and do not examine capital controls in the broader context of
management of the economy and the development process.
To resolve this controversy, a large number of empirical studies have been done
recently. They show only mixed results; there is no strong evidence that capital account
liberalization spurs economic growth (Prasad et al., 2003).
(2) Capital controls, economic development and political economy
2
These economists even say temporary controls to restrain speculative short-term foreign capital are not
incompatible with a broad process of capital account liberalization in this respect (Eichengreen et al.,
1999).
Heterodox economists understand capital controls and liberalization in relation to
the broader context of economic management and growth. They argue that controls are
helpful to implement full employment and egalitarian policies. National governments
may lose policy autonomy under an open capital market because of the possibilities of
capital outflow and currency attacks (Crotty, 1989). The ‘golden age’ of capitalism was
based on capital controls that enabled the adoption of Keynesian macroeconomic
management and the promotion of economic stability (Helleiner, 1994). Financial
globalization, starting in the 1980s, has made it harder for countries seeking full
employment to manage their economies, and has done harm to workers with a threat of
capital outflows.
Heterodox economists argue that capital controls, if effectively adopted under a
proper development strategy, can be an important tool to promote national economic
development in developing countries. In particular, they emphasize political will and the
feasibility of controls in practice (Crotty and Epstein, 1996).3 Historically, developing
countries have kept controls for various reasons, including avoiding balance of
payments problems and ensuring macroeconomic stability (Johnston and Tamirisa,
1998). The experience of East Asian countries deserves special attention with regard to
the important role of controls for growth. They achieved rapid development with strong
capital controls that worked in conjunction with credit controls and national
developmoent plans (Nembhard, 1996).
Proper capital controls may spur growth through several channels. First, controls
can keep capital in the domestic economy and hinder capital flight, which can increase
domestic savings and investment. Several African and Latin American countries have
suffered from huge capital flight (Ndikumana and Boyce, 2002). One may argue that
controls repress capital inflows that are necessary in the early stage of development, but
this is not self-evident. For instance, selective controls may change the structure of
foreign capital inflows towards longer term so as to encourage economic growth, as in
the case of Chile. A proper management of foreign capital, such as guarantees for
3
Mainstream economists argue that controls over outflows mostly failed and controls over inflows are not
very effective (Edwards, 1999). However, recent extensive case studies show capital controls are indeed
successful in some cases and need not have significant costs (IMF, 2000). The experience of capital
controls that were implemented effectively in Chile and Malaysia in the 1990s support heterodox
economists.
foreign debt, may encourage foreign capital inflows.4 Foreign investment is indeed
more affected by the country’s growth potential rather than by regulation itself (Mody
and Murshid, 2002). Capital controls are likely to maintain foreign reserves, allow for
the manipulation of the terms of trade for trade growth, and, most importantly, stabilize
the economy, thereby further boosting economic growth (Ramey and Ramey, 1995;
Prasad, et al., 2003). Measures to regulate foreign direct investment (FDI) may be also
needed for the growth of domestic firms and autonomous national development.
Though FDI is said to be more beneficial than other flows, some regulations are
essential to reap the spillover effects and acquire advanced technology and modern
management skills (Mardon, 1990).5
Of course mere controls are not a sufficient condition for growth; it is necessary that
controls be incorporated in policies designed to promote productive investment. Thus,
they should be coordinated with appropriate efforts by the state in capital allocation
(Stiglitz, 1994).6 While financial liberalization in developing countries usually fails to
promote long-term investment and growth, effective financial control can achieve
success, as seen in East Asia. (Dimitri and Cho, 1996; Hellman et al, 1997). Capital
controls were an essential part of the state-led financial system that mobilized capital
and allocated it into priority industries. However, financial and capital controls may
hamper growth, unless rent-seeking and corruption are minimized in the process, as
seen in the failure of intervention in other countries. In fact, the East Asian success was
in large part due to an institutional structure called the developmental state (Evans,
1995; Louriax et al., 1997). We examine this specific context and political economy in
which capital controls can be successful in the next section
In this regard, capital controls must be understood in a broader sense and the term, ‘foreign capital
management policy’ could be more relevant (Epstein, Jomo and Grabel, 2003).
5
Some studies show that FDI spurs growth in developing countries under some absorptive capacity such
as the higher level of education (Borensztein et al., 1998; Bosworth and Collins, 1999). However, others
studies refute this and microeconomic studies to analyze ‘spillover effects’ show only mixed results
(Carkovic and Levine, 2001; Aitken and Harrison, 1999. For a survey, see Hanson, 2000. Some even
argue that the share of FDI is higher in riskier countries with less developed institutions (Hausmann and
Fernandez-Ariase, 2000).
6
Since Gershenkron emphasized forced saving to encourage investment, the government role has been at
the center of the debate (Gershenkron, 1966). Mainstream economists have long criticized financial
repression but a recent theory of financial restraint points to the positive role of government regulation on
interest rates and entry in banking. It can promote financial deepening by creating a rent that is beneficial
to growth and stability (Stiglitz and Uy, 1996; Cho, 1997).
4
2. Political economy of capital controls and decontrols
(1) Developmental states and capital controls
The institutional structure was crucial to economic growth in East Asia. Opposed to
neoclassical arguments emphasizing free market operations (Balassa, 1988; World Bank,
1993), heterodox economists stress the important constructive role of the state. They
point to several active government policies that were essential for the success of the
region, including the selective promotion of industry, credit allocation programs,
various trade protection measures, and capital controls (Amsden, 1989; Wade, 1990;
Chang, 1994).
Specific institutional structures such as ‘embedded autonomy’ and high state
capacity, along with a distinctive state-society relationship helped intervention succeed
(Leftwitch, 1995; Evans, 1995; Ahrens, 1998). States in East Asia had strong autonomy
and a large administrative capacity because no strong economic interest groups existed.
A second important feature was the close and cooperative government-business
relationship, and the discipline that states maintained over businesses. These mitigated
information problems and limited rent-seeking (Weiss, 1998). Although not often
considered, external threats and international geopolitics played an important role
(Vartiainen, 1995). On this basis, the region developed a state-led financial system and
developmental regime, combining market and state mechanisms in a unique way
(Pempel, 1999). This system, which some have called ‘quasi internal
organization’(QIO) included large enterprises and banks that operated with coordinating
hierarchical relations based on financial control (Lee, 1992).7 An outward-oriented
strategy played a role since export performance provided criteria the government could
use to support and discipline the corporate sector, while the government simultaneously
introduced import substitution and protection.8
7
Internal organization could be efficient in handling information imperfections in that the bounds of
rationality are extended due to its hierarchical structure. This removes uncertainty through coordination of
decisions (Williamson, 1975).
8
Sum argues that the mode of regulation of the developmental state was ‘embedded exportism’ from the
perspective of ‘Regulation Theory’ (Sum, 1997).
How do capital controls function under the developmental state, and what is the
interaction between them? The effective execution of controls is only possible with
significant government capacity and relatively little corruption. More importantly, the
growth-oriented state encourages the corporate sector to make use of borrowed capital
productively by enacting industrial policies and controlling domestic finance. Foreign
capital was an important source of preferential policy credit to encourage priority
investment (i.e. the ‘carrot and stick’ strategy of discipline and support) (Amsden, 1989).
Hence, capital controls worked as an essential component of the developmental state.9
Controls also helped the government discipline businesses because they relied on
external finance and foreign capital, all of which were controlled by the government.
Developmental state theory helps us understand the importance of institutions for
successful capital controls in this regard. However, the ‘relational’ nature of the state
and the social influence on policies should be considered further. Important aspects of
institutional change or evolution have not been studied until recently (Jessop, 2000;
Chan et al., 1998; Cho and Kim, 1998).10 Ironically, the success of the developmental
state may engender its own demise as the growth of private businesses undermines state
autonomy and international pressure to liberalize increases (Lee, 2004). The change of
the developmental state and capital account regimes are another important issue that
should be studied extensively.
2) Role of the government in financial market and capital controls
While the liberalized financial market in developing countries fails to promote longterm investment and growth, the effective financial control does the job successfully,
seen in East Asia. (Dimitri and Cho, 1996; Hellman et al, 1997). Under this state-led
financial system to mobilize capital and allocate it into priority industries, capital
controls were an essential part………..
9
Domestic financial control, industrial policy and capital controls were argued to be trilogy of effective
government intervention to enable economic development (Nembhard, 1996). The three must work
together to be effective, and the demise of one element can make the system dysfunctional.
10
Another limit is that they think of the state as monolithic. Some point out corruptions and internal
conflicts even within the developmental state (Bello and Rosenfeld, 1990; Kang, 2002).
Before turning to the institutional view, we discuss the important role of the
government in financial market for economic development. It has been already well
acknowledged by many theorists (Stiglitz, 1994). Since the classical argument by
Gerschenkron underscored so-called ‘forced saving’ essential for late industrialization
(Gerschenkron, 1966), there have been so many theoretical and case studies for it.
Even if financial repression theories believe that it is always bad for economic
development, recently many contend a mild form of financial repression may be helpful
for economic development. The financial restraint hypothesis contends that the state
intervention in the financial sector such as regulation of interest rates and entry of
banking, and allocation of finance, may promote financial deepening and economic
growth, by creating a kind of rent beneficial for the stability of the banking system and
the firms (Stiglitz and Uy, 1996; Cho, 1997). As we mentioned, financial markets are
naturally incomplete because of incomplete information to raise the credit rationing,
which is more serious in developing countries. Besides, long-term dynamic efficiency
related to the performance of firms is more important than short-term allocative
efficiency for economic development. In this regard, encouraging the stable and longterm investment is crucial for economic growth, which cannot be achieved by mere
liberalized financial market in developing countries. For several reasons, the
government intervention in the financial market like directed credit can be efficient, and
it was true in the East Asia (Dimitri and Cho, 1996). They apply this perspective to the
experiences of East Asian countries including Japan and Korea (Hellman et al, 1997;
Demetriades and Luntiel, 2001).
In this regard, the government should play an essential role in the financial market
to overcome market failure and boost economic development. In Korea, the financial
control was the most important tool for the government to encourage national
development (Patrick and Park, 1994). The Korean government successfully played this
role of controlling and allocating capital directly into specific sectors and firms in order
to spur investment (Cho and Kim, 1997). Moreover, the government made a great effort
to create a new financial market like the second financial sector or capital market to
mobilize public financial resources to the fullest. In some cases, it is also the
government that shifted risk in industry to financial sector based on financial control. It
should be noticed that discipline mechanism over private business by the government is
prerequisite for effective state controlled financial system to promote growth, as we
already mentioned.11 In this system, foreign capital controlled by the government was
crucial for maximum mobilization of capital and its selective allocation in line with
industrial policy, when the financial market is underdeveloped and available capital is
scarce. The Korean economic growth indeed depended a lot on foreign capital with
huge foreign debt, but the government successfully managed the attraction and usage of
the foreign capital to maximize its benefit.
But although the financial control with capital controls can succeed in promoting
economic development by promoting and managing investment, it could raise problems
like too much burden on banks and bad capital structure of firms. Meanwhile, the initial
strong government control may get weaker due to the change of financial market and
the growth of business that would dominate financial market. This change of power
relationship between the government and business may well lead to dismantle capital
controls as private business requests more deregulation, that will give more power to
capital against the state. Thus, there is a kind of interaction between capital controls and
decontrol, and power relationship between the state and capital, which we will examine
in the next section in terms of ‘developmental state’.
11
Demetriades and Luntiel (2001) shows that the government control over the financial system and
lending rate regulation led to financial deepening in Korea from the perspective of financial restraints
theory. However it should be noted that the original theory of financial restraint is based on the Japanese
case and the role of the government was much more in Korea. It is essential to analyze how the control
works in relation to other policies.
III. Korean Developmental state
1. Institutional structure of the developmental state
Nobody would disagree that Korea is a one of the best cases of a typical
developmental state. The Korean government built a specific institution and financial
system in which it allocated financial resources in line with industrial policies, and
succeeded in spurring investment, exports and economic development (Amsden, 1989;
Chang, 1994; c.f. Pack, 2001). The government was a headquarters of a company using
banks like a financial department and firms were like an operation division of so-called
the Korea Inc.
The first character of the Korean state was strong autonomy from interest groups.
Behind it were socio-historical conditions such as weakness of interest groups due to the
land reform and relatively equal distribution (Leftwitch, 1994; Ahrens, 1998). The state
also had relatively strong capacity thanks to the bureaucratic tradition and reform efforts,
and was oriented toward national development based on administrative guidance
following Japan (Woo, 1999). Secondly, though it was autonomous, it was not
predatory at the expense of the whole economy, but well embedded in the society,
coordinating closely with the private business (Evans, 1995; Weiss and Hobson, 1995;
Weiss, 1998), and this ‘embedded autonomy’ or ‘governed interdependence’ was
essential for successful intervention, by constructing a specific government-bankbusiness relationship. External threat and international geopolitics helped it further
(Gunnarson and Lundahl, 1996; Vartiainen, 1995). The ‘Cold War’ situation made
supports from the U.S possible, and the regime competition between North and South
was crucial for national mobilization with a development-oriented and anti-communist
ideology (Cho and Kim, 1998). The equal distribution called ‘shared-growth’ principle
is also argued to contribute to preventing excess representation of demands of social
groups and effective mobilization (Campos and Root, 1996; Rodrik, 1998). But we
should notice that the government repressed labor strongly so that mobilization was
compulsory and the embeddeness was mostly in capitalists, in particular big ones.
All of these features were established in the 1960s, after the military coup broke out.
The government………….. On the basis of this institutional feature, the government
actively carried out active industrial policies to support priority sectors, with controls
over domestic and foreign capital. The government endeavored to promote and manage
investment with strong investment coordination among businesses to prevent excessive
competition and encourage competitiveness (Amsden, 1989), and with industrial
restructuring if needed. Big businesses grew rapidly with tremendous financial supports
and guide from the government. Chaebols, Korean conglomerates with a diversified
structure and centralized ownership, entered into priority industries and increased
investment following the government promotion of the export and HCI sectors (Lee,
1997). They have increased competitiveness by competition in the export market,
internalization of deficient productive factors, and disciplines by the government.12 The
government made a cooperative and disciplinary relation with them, with the intimate
consultation through the deliberation council and the support in return for the export
performance (Fukagawa, 1997).13 Though the internal corporate governance and
monitoring by the financial market was weak, the government itself monitored debtridden businesses, controlling banks (Nam, 2001; Chang, 2003).14 Meanwhile, banks
were in effect agencies of the government to implement policies to mobilize and
allocate capital under strong regulation, and help from the central bank. Their
management autonomy and monitoring through loan examination were limited, but it
was ok as long as the government control was effective. Based on this governmentbank-business relation the developmental state worked well, at the center of the whole
process was financial control.
2. State-led and bank-based financial system
12
Government’s discipline mechanisms are found in several cases. They include the export loans
exchanged for the export performance, the rigorous examination of investment project in the HCI
program, the regulation to make the firms in the import substitution industry supply materials for the
export industry at the international price, and various state-led merger programs. Most of them were
implemented with financial measures.
13
The state intervention was not to replace the market but to build specific institutions compounding the
state and the market mechanism. This mechanism is called ‘contest’ mixing competition and test (World
Bank, 1993; Aoki et al., 1997).
14
It was easier since they relied on external finance a lot, called ‘high debt model’ (Wade and Veneroso,
1998). The debt ratio in the manufacturing sector increased so fast from less than 100% in the early 60s’
to over 300% in the early 70s’ and it continued high over 300% up to the 1997 crisis.
The control of the financial sector is key feature of the Korean developmental state,
and crucial to understand success of capital controls. Since the early 60s’, the
government adopted various measures to control finance including the takeover of the
monetary policy from the central bank in 1961, effective nationalization of commercial
banks in 1962, and establishment of special financial institutions (Park, 1994; Cho,
2002). The control was the essential government plan itself, and each 5-year plan
stipulates how much funds should be mobilized and where to be invested extensively
(EPB, 1962; EPB, 1967). Establishing the control, the government first endeavored to
mobilize the financial resources to the utmost. Even the interest rate liberalization in 65,
almost doubling the rates, which increased the domestic saving a lot, was another
measure for the control since the banking sector was under the government control
(Harris, 1988).15 Besides, it encouraged the nonblank financial institutions (NBFIs) and
capital market since the 70s’ in an effort to attract capital from the curb market and
address corporate debt problems (Lee, 1998).
To promote investment, various policy loans with preferential interest rates were
utilized in the allocation of capital. The government had the banking sector provide a
huge policy loan, backed by the central bank, and set up special funds like and the
National Investment Fund established in 1973, with most of it lent to the HCI sector.
The bank-lending rate itself was much lower than the curb market, and the policy loan
rate was with even lower rates, which helped to increase investment in priority sectors.16
The subsidy worked as a monitoring mechanism creating ‘contingent rent’ like in the
case of the export loan.17 From 1961 to 1970 the ratio of policy loan to all loans was as
high as above 65% in bank loans, and even from 1973 to 1991 the policy loans out of all
deposit banks loan was around 61% (Choi, 1996). Its structure evolved in line with the
15
It was so successful that private savings and bank loans soared rapidly over the next four years, the
growth rate of bank loans rose from 10.9% during 1963-64 to 61.5% during 1965-69 (Choi, 1996). But
the general trend of the policy was ‘low interest rate’ and the government turned to low rate policy in the
recession of the early 1970s.
16
In the 60s, the average curb market lending rate was more than 50%, while the general bank lending
rate was about 25% and the export loan rate was mere 6%. In the 70s, the average curb market rate was
about 40%, while the bank lending rate and export loan rate were around 18% and 8% and the NIF rate
was 14%. Average inflation rate was around more than 15% for the period. (Cho, 2002).
17
Among various measures including pecuniary incentives like depreciation of the exchange rate, subsidy
in tax, tariff etc., financial support was the most important. In 1967, the ratio between financial and fiscal
subsidies to export was about 7:3 from 1965 to 1980 (Cho and Kim, 1997). The rent created in export
loans increased from 0.3% of GNP in 1963 to 1.7% in 1970, 3.0% in 1975 and 4.7% in 1980 (Cho, 1997)
industrial policy, with export loans the largest share, and others including loans for
machinery, special equipment funds, and foreign currency loans mainly allocated to the
HCI sector large up to the mid 1980s’ (Lee, 1998).
Table 1. here.
The system took another role to share the risk of the corporate sector investment,
and the government actively managed it ex post, as well as encouraged it, establishing a
distinctive coinsurance mechanism (Cho and Kim, 1997; Lim, 2001). It frequently
intervened into the corporate restructuring process whenever the economy was faced
with a crisis, based on financial control, though it’s later period. In 1972, the 8.3
measures announced a moratorium on the payment of all corporate debt to the curb
market and extensive rescheduling of bank loans at a reduced interest rate to bail out the
debt-ridden corporate sector. After the economic recession of 1979-80, the government
again led corporate merger programs with financial measures like special loans,
guarantee of payment and debt-equity swaps and even a moratorium on bank-loan
repayment. Thus, the financial system played a role of mobilizing capital to utmost,
allocating it into specific sectors, and managing the risk, to promote and manage
investment (Cho and Kim, 1997).18 It maximized the benefit of the bank-based system
of promoting long-term and stable investment, not possible left to the market (Zysman,
1983).19 In fact, the saving rate increased so much from around 10% of GDP in 1960 to
20% in late 1960s’ and 30% in late 1970s’, and investment increased even further.
Naturally, the government needed to attract foreign capital to finance the gap, and it
successfully managed it based on capital controls under the financial system.
18
Demetriades and Luntiel (2001) shows that the government regulation led to financial deepening in
Korea from the perspective of recent financial restraints theory.
19
In comparison with the capital market-based system, it is argued that the bank-based system is better to
encourage long-term and the close bank-business relationship is helpful to better monitoring like the
Japanese main bank system (Allen, 2000; Aoki et al., 1994). In Korea, banks were repressed and
controlled, and all process was managed by the state.
IV. Capital Controls under the Developmental state in the 1960s
1. Active capital management policy in the 1960s
Extensive capital controls over foreign capital flows were actively used, exactly
incorporated into this state-controlled financial system (Nembhard, 1996). It is the
1960s that the strong capital controls system was built in place by the military
government. As early as 1962, the government transferred the control over the foreign
exchange from the central bank to the ministry of finance (MOF), and the Foreign
Capital Inducement Act in 1961 legally stipulated the strong capital controls in a broad
gamut from current account restrictions, foreign exchange and currency restrictions,
foreign direct investment to foreign borrowing.
The Capital controls in Korea were legally set up under the Foreign Capital
Inducement Act in 1961, lied in a broad gamut including exchange and other controls.
With several revisions of the act, the government made a great efforts to manage the
foreign capital flows. First of all, the foreign trade, especially import was strongly
controlled by the government, which naturally led to the control in current account.
Foreign exchange transaction had also long been in strong control of the government
from the 50s’ before the industrialization started, that residents could neither own
foreign currency nor foreign securities. The strict exchange restrictions were applied to
almost all capital outflows till the 1980s.
Tight regulations on foreign investment and its enforcement were famous in Korea.
Foreign direct investment inflow was regulated by a ‘positive list’ system up to 1984.
The government inspected investment project very rigidly at first, and limited
foreigners’ ownership of domestic industry. Mostly, only joint ventures between foreign
and domestic capital were permitted and moreover it was compulsory for foreign
investors to resell their share after some years. Also, the government didn’t allow
foreign investment that might compete with domestic firms and attempted to gain the
most benefits, inducing competition among foreign investors. Technology-related
investment was encouraged but the government attached several conditions for transfer
of technology. It established various mechanisms in order that foreign direct investment
was a conduit of advanced technology and managerial expertise for domestic
development, although limiting the foreign penetration. As a result, foreign direct
investment had only a minor role in capital formation, compared to other developing
countries (Mardon, 1990). The table 2 and 3 show its share in the total long-term
foreign capital and total domestic investment was very low. Also, the residents’ direct
investment abroad was also restricted to a great extent in the 60s’ and 70s’ and there
was no outward investment by Korean firms at all till 1967.
As far as foreign loan was concerned, it was not hindered but promoted and
managed by the government itself. 20 The government aimed at mobilizing it for
industrialization to complement scarce domestic savings.21 For the purpose, again it
utilized the state-controlled banks, letting them guarantee long-term foreign currency
loans by the private sector. The government introduced new laws to allow for the
payment guarantee by the government in 1962, and amended ‘Foreign Capital
Inducement Act’ in 1966. With these laws and normalizing diplomatic relationship with
Japan, the foreign loan began to increase. As the private business did not have
credibility to borrow foreign capital directly, the nationalized banks played an essential
role of guarantor. The government was also active to attract the foreign loan from
diverse sources including multilateral lending and international financial markets (EPB,
1967).
Due to these measures, the long-term loan soared since the mid-60s’ as in the table 2,
in particular with the skyrocketing commercial loan.22 The ratio of payment guarantee
on foreign borrowings to total deposit money bank loans increased from 11% in 1965 to
71% in 1967 and 94% in 1970 (Choi, 1996), and the foreign debt increased as in the
table 3. The share of foreign saving in GDP between 1966 and 1982 was as high as
20
In the 50s’ the foreign aid from U.S. was very important source of investment, which was higher than
domestic saving. In particular it accounted for around 30% of the government revenue and a crucial share
for the fiscal investment and loan. The foreign aid flow was still high in the early 60s’ (61-65) with about
$ 200 million, more than long-term loan. But the U.S. government started to cut the aid, and the
government responded to it with efforts to attract foreign loan.
21
Foreign capital inflows consist of long term foreign capital including public loan, commercial loan,
bank loan, bonds, and long-term trade credit, and short term capital including trade credit and refinance.
Bank loan that started from 1968 changed more important since the late 70s’ but other inflows were of no
consequence. We report data for long-term public and commercial loan that were most important for
economic growth.
22
Interestingly, the commercial loan was 5 times bigger than the original plan in the second economic 5year plan period. In the plan (1967-1971), the government attempted to regulate quality of commercial
loan since that with bad conditions came in too much but went to failure to repress the strong demand
(EPB, 1967). It caused the difficulty in the corporate sector in the early 70s.
about 5.5%, only to finance high investment and huge trade deficit. Indeed, investment
and economic growth banked highly on foreign long-term capital in the early period of
development and without it, the growth rate must have been lower taking longer. But
because foreign borrowing was possible only on approval of the ‘Foreign Capital
Inducement Committee’ of the government, the government could control and allocate
them to specific effectively. Controls over foreign capital with lower interest rate
provided a great tool for the industrial policy (Cho and Kim, 1997). However, the
dependence on long-term foreign loan aggravated the foreign debt problem seriously
later in the early 80s, shown in table 3. In fact, Korea was the second-largest borrower
after Brazil, and was one of the riskiest countries in 1980.23 Nevertheless, the
government could overcome the 1980 crisis thanks to the friendly political support from
U.S. and Japan (Woo, 1997). Finally, the huge trade surplus in the late 80s’ could
resolve this problem.
Table 2, 3. here, Figure 1. here
2. Successful controls for growth under the developmental state
Capital controls played important roles in economic development in Korea, which
was possible thanks to the specific institutional feature of the developmental state. First
of all, the strong control over capital outflows were helpful to contain domestic capital
and increase domestic investment. The bloody measures against capital flight in Korea
were very well known and the government emphasized the utmost importance of
available financial resources (Amsden, 1989). Secondly, it is very important that the
government not only controlled the foreign capital flows but also endeavored to attract
foreign capital mostly as a form of borrowing to finance domestic investment.24 At a
23
Euromoney ranked Korea’s country risk 35th out of 67 countries, far beind Mexico (21st) , Brazil
(23rd) and Phillippines (24th). Euromoney, 1980.
24
The government effort to attract foreign capital in the 60s’ was well known. In fact as the international
organization and U.S. government were skeptical about the ambitious industrialization plan, they had
hard time. For example, the Park administration tried to make a long-term loan from the IBRD to build
Pohang Steel Company but rejected, and the commercial loan through the private consortium of
KISA(Korea International Steel Associates) also failed getting loan from American Export-Import bank.
time, it successfully managed foreign capital after borrowing, allocating it into the
priority sector under the state-led financial system. Lastly, the government used a
specific mode of foreign finance. It tried not to rely on foreign investment with strong
regulation, and thus the foreign dominance was limited in favor of rather independent
national development.
Surely, the institutional factors of developmental state as we mentioned, was
essential. Many researchers argue that capital controls are related to politics like leftist
power in government, weak central bank, and income distribution which has something
to do with power relationship between classes (Epstein and Schor, 1992). In developing
countries, the strong will and capacity of the government are more important. In Korea,
in the beginning, since there were no strong interest groups like domestic who might
want more liberal regime, it’s easier to adopt strong controls. In fact, the strong military
regime could repress any trial of capital flight with the bloody control over the all
features of the economy. Nobody could dare to be against the government when
chaebols leaders were summoned after the military coup and accused of corruption.
Also, the bureaucratic capacity with the strong development-oriented mind with
relatively less corruption could achieve effective controls. In 1961, with the setup of
Economic Planning Board (EPB) as a pilot agency, the special department for foreign
capital attraction was established in it so that the controls can be incorporated into the
economic planning. The autonomy of the state from the international capital and
international geopolitics was crucial in the unique manner of mobilization of foreign
saving.25 The government could sustain autonomy since the form of foreign capital was
not direct investment but mostly multilateral long-term loan, mediated by the
government itself. Thus, successful capital controls were thanks to the institutional
structure of developmental state in many was.
More important is how controls could spur economic development. Most of public
loans like economic cooperation loan from Japan was spent for industrial development
Finally they succeeded in it with foreign capital from Japan, with a different and more ambitious plan (Oh,
2003).
25
With the ‘Cold War’ the U.S. government was a bit permissive on Korea to adopt protective industrial
policy and restrictive capital accounts since Korea was on the front against communism (Cummings,
1999). Thus, Woo concludes the Korean manner of mobilizing foreign savings was unique, in comparison
with that of Japan (which did not rely on foreign savings) and Latin America (which relied on different
sources of foreign savings). (Woo, 1997. p. 59.)
like Posco and other infrastructure (Cho, 2001. pp. 10-13.). And the government
emphasized the extensive examination of incoming foreign capital ex post management
in the 5-year plans (EPB, 1962, 1967). The foreign currency loan from banks was an
important source of the policy loan, and among others, the commercial loan of the
private business, guaranteed by banks, was possible only with the government
examination and permission. Thus, in Korea, capital controls worked within the stateled financial system to encourage productive private investment. It also enabled the
government to discipline and support businesses further, thus contributed to the
government-business relation.26 When private businesses always needed more capital,
and control over attractive foreign capital provides the government with a strong tool to
control them (Haggard and Cheng, 1987, pp 110-113.) Hence, the experience of Korea
shows how the government can successfully control and manage foreign capital for
development with strong financial control and proper industrial policy.27 The
developmental state allowed for the specific manner to mobilize and allocate foreign
saving in Korea. The Korean experience of the 1960s illustrates how the developmental
government can not only control but also manage foreign capital wisely, and how the
national growth dependent on foreign capital is possible in a managed way.28
26
The rent from the foreign loan was very large. It amounted to 10% of GDP, even bigger than that of the
export loan, 3% of the GDP in the 1970s (Cho, 1997).
27
We should mention the friendly international situation also helped its success. For example, in addition
to geopolitics, the development of Euro market helped foreign capital flows into Korea in the late 70s’
when U.S. capital inflow decreased with more concern.
28
We should also mention the friendly international situation. For example, besides international
geopolitics, the development of Euro market helped foreign capital flows into Korea in the late 70s’ when
U.S. capital inflows decreased.
IV. Concluding Remarks: lessons for developing countries
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Table 1 : Share of Policy Loans by Deposit Money Banks and Special Banks (%)
DMB policy loans (A)
Government funds
NIF
Foreign currency loans
Export loans
Commercial bill discounted
Special funds for SMCs
Loans for AFL
Housing loans
Others
Total
Loans by special banks (B)
KDB loans
(NIF)
EXIM loans
(NIF)
Total
(A) / DMB loans
(B) / NBFI loans
(A) + (B) / domestic credit
1973-81
1982-86
1987-91
Average 73-91
7.5
4.3
21.1
21.3
8.0
5.9
6.1
8.0
17.7
100.0
7.4
5.1
19.7
16.9
13.9
5.6
5.3
13.1
13.1
100.0
8.0
3.0
19.4
5.2
16.5
6.5
7.4
14.1
20.0
100.0
7.6
4.2
20.3
16.2
11.6
6.0
6.2
10.8
17.1
100.0
91.9
(25.7)
8.1
(2.5)
100.0
63.0
48.0
48.9
71.7
(18.5)
28.3
(4.7)
100.0
59.4
32.3
40.8
83.7
(7.9)
16.3
(2.3)
100.0
59.5
15.3
30.9
84.8
(19.5)
15.2
(3.0)
100.0
61.2
35.9
42.4
Note :
1) The share of NIF (National Investment Fund, specially for HCI program) is annual
average during 1974-81
2) Others include loans for imports of key raw materials, loans for machinery,
equipment loans to the export industry, special equipment funds, and special long-term
loans.
Source : National Statistics Office, Korean Economic Indicators, various issues;
Bank of Korea, Monthly Bulletin, various issues; in Cho and Kim(1997)
Table 2. Long-term foreign loan and FDI in Korea
Year
FDI/
Public
Commercial Total
(total long
Long-term
Long-term
long-term
Foreign direct term loan +
loan
loan
loan
investment
FDI)
$ million
%
1962
6.3
0.1
6.4
0.6
8.6
1963
24.3
18.9
43.2
2.1
4.6
1964
11.1
19.1
30.2
3.1
9.3
1965
11.2
27.9
39.1
10.7
21.5
1966
62.7
109.6
172.3
4.8
2.7
1967
79.7
137.7
217.4
12.6
5.5
1968
112.1
252.1
364.2
14.7
3.9
1969
148
360.8
508.8
6.9
1.3
1970
146.6
282.9
429.5
25.2
5.5
1971
324.5
319.5
644
36.7
5.4
1972
437.5
298.5
736
61.2
7.7
1973
403.5
460.6
864.1
158.4
15.5
1974
385.2
603
988.2
162.6
14.1
1975
476.8
801.5
1278.3
69.1
5.1
1976
712.9
838.9
1551.8
105.5
6.4
1977
637.9
1241.1
1879
102.2
5.2
1978
817.9
1913.2
2731.1
100.4
3.5
1979
1089.2
1578.4
2667.6
126.9
4.5
1980
1516.4
1402.3
2918.7
96.6
3.2
1981
1679.5
1257
2936.5
105.4
3.5
1982
1868
913.6
2781.6
100.5
3.5
1983
1493.4
973.4
2466.8
101.4
3.9
1984
1424.2
858.4
2282.6
170.7
7.0
1985
1023.7
964
1987.7
250.3
11.2
1986
880
1620
2500
477
16.0
1987
1109
1558
2667
1060
28.4
1988
891
988
1879
1283
40.6
1989
472
860
1332
1090
45.0
1990
418
30
448
803
64.2
Source: Economic Planning Board (EPB), Bank of Korea (BOK), Ministry of Finance
and Economy (MOFE), arrival base
Note:
1) Commercial loans are loans to the private sector, usually with the guarantee from the
banks. Public loans are loans to the government institutions, and ones guaranteed by the
government. The data are for only total inflows.
2) The share of foreign capital in investment in reality must be higher in the early 60s’
considering the big share of foreign aid in the government saving that was high.
Table 2. Foreign debt, long-term loan and foreign direct investment in Korea
Long-term
loan/
Domestic
investment
%
FDI/
Domestic
investment
%
Year
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
Source: Ibid.
0.2
0.5
0.8
2.5
0.7
1.4
1.1
0.4
1.3
1.6
2.7
4.6
2.7
1.1
1.4
1.0
0.6
0.6
0.5
0.5
0.5
0.4
0.6
0.9
1.5
2.6
2.3
1.5
0.8
(FDI + longterm loan)/
Foreign
Foreign debt
GDP
debt
/GDP
%
$ million
%
2.4
0.3
89
3.9
9.4
1.7
157
5.8
7.9
1.1
177
6.1
9.2
1.7
206
6.9
23.5
4.9
392
10.1
24.8
5.5
645
15.4
28.1
7.3
1199
23.1
28.1
7.9
1800
27.7
21.6
5.7
2245
28.1
27.3
7.2
2922
31.1
32.6
7.5
3589
33.9
25.1
7.6
4260
31.6
16.4
6.1
5937
31.6
21.0
6.4
8456
40.1
20.0
5.7
10533
36.4
17.6
5.3
12648
34.1
16.0
5.4
14871
28.6
11.9
4.5
20500
33.1
14.6
4.8
27365
44.0
14.1
4.4
32490
46.7
12.9
3.9
37314
50.2
10.2
3.1
40378
49.1
8.2
2.7
43053
47.5
7.0
2.4
46762
50.1
7.9
2.8
44510
41.4
6.5
2.8
35568
26.3
3.3
1.7
31150
17.2
1.8
1.1
29372
13.3
0.5
0.5
31699
12.6
Figure 1. Investment and saving in Korea (1960-2002)
Investment and saving in Korea
50
40
% of GDP
30
20
10
19
60
19
63
19
66
19
69
19
72
19
75
19
78
19
81
19
84
19
87
19
90
19
93
19
96
19
99
20
02
0
-10
-20
year
domestic saving
domestic investment
foreign saving
Source: Bank of Korea (BOK).
Note: Foreign saving is calculated by domestic investment minus domestic saving.
However, in the 60s’ the share of government saving is more than 30% in the total
saving and the share of foreign capital like aid was very high. Thus, the share of foreign
saving must have been more important. The 5-year economic plan reports show the
share of foreign saving accounted for around 50% of total investment in this period
based on division of the government budget (EPB, 1967).
Table 3. Change of external fund financing in the corporate sector in Korea (%)
Indirect finance
Borrowing from banks(A)
Borrowing from NBFIs
Direct finance
Treasury bills
Commercial paper
Corporate bonds
Stocks
Foreign borrowings(B)
Others
Total
(A) + (B)
1970
39.7
30.2
9.5
15.1
0.1
0.0
1.1
13.9
29.6
15.6
100.0
54.8
1975
27.7
19.1
8.6
26.1
0.8
1.6
1.1
22.6
29.8
16.4
100.0
48.9
1980
36.0
20.8
15.2
22.9
0.9
5.0
6.1
10.9
16.6
24.5
100.0
37.3
1985
56.2
35.4
20.8
30.3
0.8
0.4
16.1
13.0
0.8
12.7
100.0
36.2
1988
27.4
19.4
8.0
59.5
5.3
6.1
7.5
40.6
6.4
6.7
100.0
25.8
1990
40.9
16.8
24.1
45.2
3.1
4.0
23.0
14.2
6.8
7.1
100.0
23.6
Source : The Bank of Korea, Understanding of capital circulation in Korea
Note : Others include government loan and corporate credit.
1992
36.3
15.1
21.1
41.4
3.3
7.6
12.5
15.9
5.0
17.3
100.0
20.1