Download From Capital Control to Capital`s Control : Political Economy of

Goodbye Capital Controls, Hello Capital’s Controls
: political economy of capital decontrols and the crisis in Korea
Kangkook Lee
I. Introduction
Financial liberalization and capital account liberalization has been argued to lead to economic
efficiency and development. Based on the belief that the market is always efficient, the
government intervention in every realms of the economy has been under attack and the financial
sector is no exception. Accordingly, neoclassicals recommend reduction of government control
over financial market, and incorporation into the international financial market by financial
opening. However, in theory financial market suffers from serious market failure and in reality it
is hard to find the evidence that shows capital account liberalization goes along with economic
development. Rather, some countries achieved rapid economic development with financial
control by the government and capital controls were important measures in this system. Recent
series of financial crises including the Asian financial crisis raise a concern that careless financial
liberalization may cause instability in globalized financial market. The Asian crisis shed light on
the danger of international short-term capital and the importance of its control.
Korea was one of the most successful developing countries that achieved rapid economic
growth since the 60s. Its base was strong industrial policy and most of all government control
over finance. In this process, the government also adopted strong capital control over foreign
capital flow to allocate it to strategic sector, which continued up to the late 80s. Since the 90s,
several measures for financial opening like deregulation on portfolio capital inflow and foreign
borrowing were implemented due to interests like big business and international capital. But it
just led to huge surge of foreign short-term debt and at last the financial crisis coupled with
bankruptcies in industrial sector and contagious effect. After the crisis, the government promoted
further capital market opening along with the IMF program which may aggravate instability in
Korea.
This paper examines the experience of capital controls and demise in Korea. In so doing, we
can see the importance of capital controls for economic development and danger of capital
decontrol to lead to the instability and crisis. In particular, we focus on the politics around
financial liberalization, which will help us understand the capital controls and their demise better
in reality. The first section will survey arguments about capital controls, emphasizing its
importance for broad national economic management or development. The next section will show
the experience of Korea in which economic development was achieved with strong capital
controls and rapid decontrols led to the crisis. We also examine the further opening and its result
after the crisis and discuss some alternative policies including of capital controls.
II. Capital Controls and Economic Management
1. Pros and Cons on Capital Controls
By ‘capital controls’ we mean various measures to restrain or explicitly and implicitly tax
broad categories of international movement of capital. Thus, they include controls on foreign
direct investment, portfolio investment, international borrowing and lending, transaction through
deposit accounts and others, both of inflows and outflows (Rajan, 1998). While capital controls
are mostly adopted by national government, there can be a global cooperation for controls like
Tobin Tax.1
In history of international finance after Brettonwoods system was established, most of
countries adopted extensive capital controls, which enabled them to manage the national
economy. But since the 80s, the controls started to be repealed with financial deregulation
including developed and developing countries some later. However, still lots of developing
countries have kept the controls in reality against the tide of deregulation and liberalization. And,
as the effect of capital account liberalization on economic growth is ambiguous and recently
financial crises broke out all over the world, argument about capital controls has gained a great
momentum. In particular, the Asian crisis in 1997 backfired hot debates among prominent
economists. Many economists now think that the crisis was mostly due to careless financial
opening policy and dangerous international short-term capital movement (Furman and Stiglitiz,
1998; Radelet and Sachs, 1998). Accordingly, many support controls over, at least, volatile
international short-term capital against major neoliberal argument (Krugman, 1998; Rodrik, 1999;
Bhagwati, 1998). It is still hard to imagine that some concrete measures will be taken in the near
future because the interest of international capital and the U.S. government are quite conflictual
with it.2 And yet recent vivid arguments about capital controls may change the policy trend and
lead to a new international financial architecture (Eichengreen, 1999). We will survey arguments
for and against capital controls below.
(1) Neoclassical rejection to capital controls and its problem
Major neoclassical arguments emphasize gains from financial liberalization and international
capital mobility based on the belief in efficient market. According to them, the incorporated
world financial market can contribute to enhancing efficiency in resource allocation all over the
world, the capital will move into the country where the return or interest rate is higher. It is
natural they strongly support capital account liberalization, thus against any of capital controls.3
They maintain capital account liberalization and free international capital movement increase the
availability of foreign savings to supplement domestic resources to produce economic growth of
host country. Another benefit is from the fact that it can reduce the costs of the intertemporal
misalignments and enable investors to diversify risks around the world (Guitian, 1997; Edwards
ed., 1995). To them, capital controls limit international market opportunity and restrict domestic
financial market competition, which introduces distortion and inefficiency in the financial system
and economy as a whole (Dornbush, 1998). In addition, capital controls may allow governments
to sustain imbalance of the economy and bad economic policies. Capital account liberalization is
expected to reduce the budget deficit, with international capital market disciplining the national
government (Kim, 1999). Besides, capital controls are neither good nor effective because in most
of cases controls over capital flows failed and private capital can evade the controls almost
always (Edwards, 1999).
But these arguments are valid only with the assumption of ‘efficient’ financial market. Unlike
the dogma, many theorists postulate it is not true due to information problem, irrational behaviors
like herding and other market distortions. It leads to support for capital controls, at least in part, as
1
The Tobin tax is a permanent, uniform, ad-valorem transaction tax on forex transaction about 0.1-0.25%.
Many argue it must be implemented globally because unilateral imposition would drive investors to trade
forex in offshore market. Haq et al., eds(1996) includes extensive studies about the Tobin Tax.
2
Recent debate between G7 shows this very obviously. In Davos Forum of 1998, the theme was
‘responsible globality’ under which many arguments against international short-term capital flow and
several measures of regulation were presented. However, while Japan and European countries pointed out
the importance of regulation the U.S. government was quite against the idea of regulation or any control.
The IMF still sticks to capital account liberalization in principle with some prudential regulation measures,
though recently it makes efforts to study the capital control measures very extensively (IMF, 2000).
we will examine next section. In addition, capital controls have been implemented effectively in
reality even in the 90s in Chile and Malaysia.4
Of course, faced with this critic and reality that mere financial opening and international
capital flows are apt to destabilize economies, neoclassicals also point to the importance of
several preconditions for capital account liberalization (Mckinnon, 1991; Williamson, 1993). So
there is some consensus about capital account liberalization including the preconditions and
sequence for that. Several conditions like macroeconomic stability and establishment of sound
financial sector with strong supervision system are considered essential for the successful
liberalization. And it should be the last step after trade liberalization and domestic financial
liberalization, and must be developed gradually. Now, this line of argument, so-called ‘orderly
financial opening’, has been in fashion and most of international organizations and policy makers
follow this argument (Eichengreen and Mussa, 1998; Fisher, 1998). But, their argument doesn’t
go far to support capital controls.5 Though recent financial crises show instability of international
financial market and danger of financial liberalization so clearly, it is still not the capital controls
but the prudential regulation along with the financial opening that must be adopted. However, as
Rodrik argues the prudential regulation cannot be established overnight, in particular in
developing countries (Rodrik, 1999). In this regard, proper capital controls are needed at shortest,
till the developing countries set up good institutional framework for prudential regulation.
Moreover, considering the crises took place even in countries with relatively good regulation like
Sweden and Finland, they quite underestimate the problem of international financial market and
limit of national regulation after financial opening.
(2) support for capital controls for crisis prevention and national economic management
In theory, since the financial market suffers from serious market failures due to incomplete
information, capital account liberalization can just lead to more instability. Most of all, investors’
3
For extensive survey on the debate about capital controls including neoclassical arguments, see
Rajan(1999) and Cooper(1999).
4
There are already many empirical and case studies about capital controls. Neoclassicals argue that studies
show the controls over outflows mostly failed and inflow controls are not that effective (Edwards, 1999).
But, using the new indices for capital controls, Rossi concludes controls over capital inflows reduce the
possibility of currency crisis and outflow control can increase growth rate (Rossi, 1999). Interestingly,
capital controls over outflow increases the possibility of banking crisis and controls over inflow tend to
reduce growth rate according to him. Also, the recent extensive case studies show capital controls are
indeed successful in some cases though without costs (IMF, 2000).
5
They even say temporary controls to restrain speculative short-term foreign capital are not incompatible
with broad process of capital account liberalization in this respect (Eichengreen et al., 1999). But for them
capital controls are still something that should be hopefully lifted as soon as possible.
‘herd’ behavior brings out serious volatility, not related to the real economic fundamentals (Luxx,
1995; Kim and Wei, 1999) and the problem of moral hazard can give a rise to ‘overborrowing’ or
‘overlending’ (Mckinnon and Pill, 1999). This means financial opening and free movement of
international capital has a tendency to generate not efficiency but more instability, aggravating
boom-and-bust cycle, not diversifying but concentrating risk, as shown in recent financial crises.
The crises are explained by models with ‘self-fulfilling’ character associated with attack on
specific currency, and the contagion effect through the international financial market is
considered so strong (Eichengreen et al., 1997). These theories can support capital controls to
address the economic instability due to rapid movement of short-term capital.
And besides, since all of the markets are not perfect and efficient in reality, the positive
relationship between the capital account liberalization and economic efficiency is hard to be
justified. When there is a trade barrier free movement of international capital can result in
misallocation of capital and difference in tax rate on capital generates capital movement to evade
tax, not enhancing efficiency at all (Brecher and Diaz-Alejandro, 1977; Cooper, 1999). That is,
according to ‘theory of the second best’ there is no reason that free international capital
movement will enhance the efficiency. 6 Empirical studies also show it is hard to justify the
neoclassical argument about the capital account liberalization and economic growth (Rodrik,
1998).
Meanwhile, other important support for capital controls concerns macroeconomic
management of national economy. With open capital market incorporated into the international
market, national governments cannot help losing the autonomy of macroeconomic policy (Crotty,
1989). In particular, it is difficult to adopt expansionary monetary policy with freedom of capital
movement due to the possibility of capital outflow and attack on the currency, which leads
governments to resort to restrictions. Progressives go further to consider these measures as a way
of promoting national economic management and development, in terms of broader national
strategy. Some emphasize the necessity of capital controls for government to implement fullemployement policies and egalitarian policies as well (Crotty and Epstein, 1996). Actually, the
‘golden age’ of capitalism was based on strong capital controls that enabled them to adopt
Keynesian macroeconomic management cooperatively (Helleiner, 1994). The history since the
80s saw a sea change that the government can hardly manage national economy to attain full
employment. International capital mobility has a detrimental effect on workers in developed
countries with the threat of capital retreat, which blocks egalitarian policies (Crotty et al., 1994).
6
In practice, huge international capital was invested in industries with very low return of rate ore even
unproductive industries, usually after financial liberalization and opening like the East Asian crisis showed.
Their argument strongly emphasizes the political will for capital controls and its feasibility in
practice.
As we examined, there are enough arguments for capital controls, with the gamut from the
concern about instability to broader national management. While the former limitedly focuses on
volatile international capital flow underscoring the inherent problem of the financial market, the
latter doesn’t consider capital controls separately from other policies. It is important progressives
pay attention to capital controls in view of broader national management and political effect. We
need to focus more on the political economy of the capital controls and decontrols like the power
relationship among government and social groups (Louriax, 1997; Lee et al, 2000).
2. Capital Controls and Economic Development
(1) Capital controls for economic development
Traditionally, most developing countries have kept strong capital controls due to several
reasons including balance of payment problem, macroeconomic stability, and national
development (Johnston and Tamirisa, 1998). Among others, it is interesting that capital controls
can be used for economic development in some cases. Several countries like Japan and Korea that
achieved rapid economic development intentionally adopted capital controls in line with broad
national development strategy and planning (Collier and Mayer, 1989). In those countries, capital
controls were an essential part for government intervention in conjunction with credit control and
national plan, called ‘government intervention triad’. In this case, capital controls could be very
useful policy measures for development when implemented by capable government, in particular
with the other complementary policies to promote investment (Nembhard, 1996).
Proper capital controls can lead to economic development through several channels. First of
all, control over capital flows can increase available capital and preserve capital in domestic
economy. If capital outflows are strongly controlled then it would obviously help to increase
savings and thus investment. And they are more important because capital inflows are not that
much in the early period of development. The government as well can earn revenues from capital
controls, which enables it to implement expansionary policy. Rather, controls over capital inflow
may decrease available capital, but economic development itself based on proper capital controls
can contribute to increasing foreign capital inflow into the economy. Besides, capital controls as a
form of exchange rate control are likely to manage exchange rate in such a way that it would
maintain foreign reserves, manipulate terms of trade for trade growth, and stabilize
macroeconomy. Thus, capital controls can establish good conditions to encourage private
investment. Several regulations to control capital flow can also helpful to national development
by encouraging domestic acquisition of developed technology and management skill, especially
in the process of foreign direct investment.
Of course mere preservation of capital is not enough at all. It is essential that capital must be
invested productively as well as controlled, and the government should manage this process when
the financial market is not yet developed. That is, capital controls must be coupled with other
proper government effort in financial market that guarantees the productive use of domestic and
foreign capital. The developmental states succeeded in it with preferential allocation of capital
into specific sectors by directed credit, enhancing economic performance. In this process, capital
controls provide the government an effective tool to discipline private business. Because private
business needs more capital with lower interest rates foreign capital is the most attractive channel
of finance, and since foreign borrowing is possible only with government guarantee private
business has no choice but to depend on the government. The government can provide this
preferential foreign capital for business in exchange for economic performance, so that capital
controls can be measures for this ‘carrot and stick’ strategy with discipline and support (Amsden,
1989). This process can minimize unproductive rent-seeking and create ‘contingent’ rents that are
rather productive for the economy (Cho and Kim, 1997). In most countries, financial control is
commanding heights for developmental state to do this job and capital controls were an essential
element (Zysman, 1983). Thanks to the controls, the power relationship between the government
and business is specifically that that the government is predominant over private business, which
gives strong autonomy to the state. Surely, strong autonomy and capacity of the state may be
necessary for the government to control foreign capital flow and private business effectively
(Leftwich, 1995; Ahrens, 1998). Actually lots of developing countries just saw serious rentseeking and corruptions related with capital controls which hindered economic development.
However, capital controls can be helpful to economic development, when the government
establishes well-operating state-controlled financial system in line with effective industrial policy,
in which the active role of the government is essential.
(2) Role of the government in financial market and capital controls
The important role of the government in financial market for economic development including
capital controls, has been already well acknowledged by many theorists (Stiglitz, 1994). Since
classical argument by Gerschenkron underscored so-called ‘forced saving’ essential for late
industrialization (Gerschenkron, 1966), there has been so many arguments for it.
Even if financial repression theories believe that the financial repression is 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 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 development, 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. For these 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).
In this regard, the government should play an essential role in the financial market to
overcome market failure and boost economic development. Developmental states like Korea
successfully played this role of controlling and allocating capital directly into specific sectors and
firms in order to promote investment. 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. This state-controlled financial system
played roles to mobilize and allocated capital selectively, and to take on the risk of investment
failure in the industrial sector. 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. In this system, foreign capital controlled by the
government was crucial for mobilization of capital and selective allocation in line with industrial
policy.
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 overgrowth of big business with bad capital structure depending on high
debt. 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
case of Korea.
III. Korea : Capital Controls and Development to Decontrol and Crisis
1. Capital Control System and Development in Korea
(1) Strong capital controls in state-controlled financial system
The financial sector in Korea had been strongly controlled by the government during the 60s
and 70s for the purpose of economic development. The government established ‘state-controlled
financial system’ to mobilize capital to utmost and allocate it to priority sectors and firms using
directed credit, in line with industrial policy for the purpose of stimulating investment and thus
growth rate. 7 Extensive capital controls over foreign capital flows were actively used by the
government, incorporated into this state-controlled financial system (Nembhard, 1996). Since
1965, the government made a great effort to mobilize foreign capital with low interest rate,
complementing domestic saving for high investment. Whereas, capital outflows from Korea were
tightly controlled for several decades in order to enhance domestic investment. The capital
controls in Korea which covered all of the capital flows, were long-term one embedded in the
specific financial system and must be understood in this broad economic development strategy
and planning.
The Capital controls in Korea were legally set up under the Foreign Capital Inducement Act in
1961, lied in a broad gamut including current account restrictions, foreign exchange and currency
restrictions, foreign direct investment and foreign borrowing. 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
7
The state-controlled financial system began with an effective nationalization of commercial banks and
establishment of government power to manipulate monetary policy in the early 60s. It even took the role of
share the risk in the industrial sector with financial support. The so-called government discipline
mechanism on private business was also possible due to this financial control. For further analysis, see
Woo(1991), and Cho and Kim(1995).
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 really 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. As a result, foreign direct investment had a minor role in capital formation with its
share about 5.6% between 1962 and 1985, which was very low compared to other developing
countries (Mardon, 1990). The residents’ direct investment abroad was also restricted to a great
extent in the 60 and 70s and there was no outward investment by Korean firms at all till 1967.
As far as foreign borrowings were concerned, they were not hindered but promoted and
managed by the government itself. The government aimed at mobilizing foreign capital for a
rapid industrialization to complement scarce domestic savings. Accordingly, foreign borrowing
was encouraged and banks were permitted to guarantee foreign currency loans to private sector
with the amendment of ‘Foreign Capital Inducement Act’ in 1966 after normalizing diplomatic
relationship with Japan. Since then, 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 ratio of foreign debts to GNP also soared from 6.1% in 1964 to 15.1% in 1967,
27.1% in 1969, 33.9% in 1972 and 41.8% in 1979. The share of foreign saving in GNP between
1962 and 1981 was so high as almost 8% and it played a crucial role to finance high investment,
accounting for 33% in domestic investment. However, because foreign borrowing was possible
only on approval of the ‘foreign capital inducement committee’ of the government, it could
control and allocate them to specific industries like heavy and chemical industries in the 1970s.
Because foreign capital offered lower interest rate than domestic capital control on foreign
borrowing was a great tool for industrial policy (Cho and Kim, 1995).
This experience of Korea shows how the government can not only control but also manage
foreign capital for economic development, coupled with strong and effective financial control and
proper industrial policy. The Korean government did not just blocked foreign capital inflow.
Indeed, investment and economic growth depended highly on foreign loan in the early period of
development but the government was so successful in managing it in the state-controlled financial
system. Besides, it regulated foreign direct investment effectively with clear purpose of domestic
development and strongly controlled other capital flows like capital flight. Surely, the
institutional factors and politics so-called ‘developmental state’ related to capital controls were
important, the capacity of the government to implement those policies and strong autonomy from
domestic and international capital as well, were crucial for the success (Amsden, 1989; Ahrens,
1998).8
(2) Maintained capital controls in the 80s
In the 80s, financial liberalization developed in Korea to some extent. After the serious
recession in 79-80 due to overcapacity in heavy and chemical industry and foreign debt problem,
several financial liberalization measures were executed, such as privatization of commercial
banks, interest rate deregulation, and reduction of policy loans (Corbo and Suh, 1992). But the
measures were just formal and the government still continued to control the financial sector to
manage the economy using banks as a tool of economic policy (Choi, 1993; Amsden and Euh,
1990). 9 Particularly, capital account opening was developed little and the government did
maintain to manage foreign capital flows still tightly though there was some progress in external
liberalization.
The trade liberalization in this period naturally led to decontrol on current account restricted
strongly before. The government also adopted some deregulation measures about portfolio capital
flows. Since the capital market was not developed yet in former period there was no need to
concern about portfolio capital flows but in the 80s their importance grew bigger. The
government started to allow foreigners to invest and trade stocks in the Korean stack market
indirectly after 1981. Also, domestic firms were permitted to issue convertible bonds and bonds
with warrants and depository receipts from 1985. As Korean firms credibility increased thanks to
8
Many researchers argue that capital controls are related to politics like leftist power in government and
income distribution which has something to do with power relationship between classes (Epstein and
Schor, 1992). In developing countries, the strong will of the government for economic development and
capacity seem to be more essential for it. Since there were no strong workers, we should probe the
relationship between government and capitalists.
9
However, financial market structure itself and finance of business changed that government control over
finance and business grew weaker around the late 80s with the growth of nonblank financial institutions
less controlled by the government. Though the government policy loan continued the composition changed
in direction that financial subsidy for big business significantly decreased. It means the strong government
financial control, especially over big business, was already coming to an end then (Lee, 1998).
economic development, private firms started to issue their own bonds in international financial
market since then.10 The control on foreign direct investment was gradually weakened too in the
1980s. The minimum two years period before repatriation of capital disappeared in 1980 and the
range of eligible industry and project continuously expanded with more simplified procedures for
FDI. Outward direct investment was also encouraged from 1981 by the simplification of
procedure and abolishment of government approval and so on. With huge trade surplus from
1986 to 1989, the government eased all restrictions on residents’ foreign direct investment below
$ 1 million.
However, still informal regulation remained and so many requirements should be met in
foreign direct investment, and faced with current account deficit, the Korean government again
resorted to tight control over residents’ overseas investment in the early 1980 (Park, 1996). As for
the foreign exchange control, though strong restrictions on foreign exchange started to be
liberalized after 1979, when the government allowed domestic banks to lend to nonresidents and
residents to hold foreign currency accounts to some amount, the 80s saw rather strong controls on
foreign exchange. Most of all, controls on foreign borrowing, most important source of foreign
capital, were strengthened due to the serious foreign debt problem. Although share of foreign
saving decreased in the 80s, skyrocketing foreign debt made Korea the third world largest debtor
by 1985, with its ratio to GNP over 40% in the early 80s.11 In 1986, requirements for approval of
new foreign loans were tightened including increase of minimum maturity to 8 years and
reduction of maximum interest rate. The government even stopped financial institutions from
guaranteeing foreign commercial loans for private sector this year. Hence, commercial loans by
domestic firms were still under strong controls. And several regulations also continued in
issuance of bonds throughout the 1980s despite liberalization.
To sum up, the Korean government managed the foreign capital flows mostly in response to
current account balance, and strong capital control system was sustained in the 80s. The domestic
financial liberalization then was limited and external liberalization was more so (Park, 1996).
Thus, the Korean financial system was still relatively closed one and foreign capital flow was in
visible hands of the government.
2. Capital Decontrols in the 90s and the Crisis
10
The first private firm that issued its own bonds in international financial market was Samsung electronics
company in 1984 with $ 30 million and total amount between 1985 and 1994 amounted to $ 4.9 billion
11
The ratio of foreign debt/GDP in Korea was 32.4% in 1979, 49.6% in 1982, 41.0% in 1986 and
decreased to 29.2% in 1987 and 14.8% in 1989. This change is related with huge current account surplus in
(1) Demise of capital controls in the 90s
It is only after the 90s, the Korean government opened its capital market significantly and
lifted most regulation on foreign borrowing first time in history, which dismantled the relatively
closed Korean financial system with capital controls.
First, in 1990 current account balance turned to serious deficit and the government was forced
to liberalize the capital account with amending Exchange Management Act in 1991. Under this
law, residents’ could issue securities abroad under some conditions and some regulations on
nonresidents’ direct investment were lifted. Most of all, from January 1992, foreign investors
were allowed to invest in the Korean stock market directly, with 10% limit to the ownership of
the stock for group and 3% for individuals. This opening led to a surge of foreign portfolio capital
inflow after 1991. Net foreign capital inflows went up to $ 9.6 billion in 1993 and $ 5.7 billion in
1991 from only $ 1.3 billion in 1990, which raised a large surplus in the overall account offsetting
the deficit in current account.
Far-reaching and radical financial opening was promoted after 1993 with the new Kim
government. In 1993, the government announced ‘the Blueprint for Financial Liberalization and
Market Opening’, a new ‘Plan for Foreign Exchange System Reform’ in December 1994 and
‘Plan for Financial Opening and Capital Account Liberalization with consultation with the OECD,
which stipulated current and capital account would be completely liberalized and efficient
domestic foreign exchange market would be developed by 2000 (Dalla and Katkhate, 1994).
Along with these schemes, further deregulation for foreign portfolio investment went on.
Foreigners’ investment in the stock market were encouraged by allowing more foreign stock
ownership, their investment in stock fund in 1996, forward and option trade in 1996 and 1997 and
so on. 12 Bonds market was not developed yet that the government took a careful stance. But
foreign investors were allowed to directly invest some domestic bonds after 1994 and indirect
investment through security became possible in 1995. Several restrictions on issuance of foreigncurrency bonds by domestic firms and financial institutions were eased in 1993 and limit to the
amount of stock related bonds were further scrapped.
the late 1980s as well as this tight control on foreign borrowing. It increased again after 1994 with the
financial opening after 1993.
12
It was raised to 12% in December 1994, 15% in July 1995, 18% in April 1996, 20% in Octover 1996,
23% in May 1997, 26% in November 1997. As for individual foreign investor the ceiling was changed
from 3% in January to 5% in October 1996, 6% in May 1997, 7% in November 1997.
For foreign direct investment, eligible industries expanded annually from 1993 and investment
procedure got more simplified. In 1997, non-hostile M&A and long-term borrowing from foreign
mother company were permitted. The government also promoted extensive deregulations on
foreign borrowings of financial institutions and firms in Korea after 1993. Controls on trade
credit were continuously lifted during this period and foreign borrowings started to be permitted
from 1995 limitedly for certain firms, with more deregulations in 1997 (Kim, 1997). The
government also abolished annual ceiling on foreign-currency loans by financial institutions in
1993 and lowered long term borrowing requirement from 70% to 50%. On top of that, 24 new
licenses for merchant banks to run business mostly in foreign borrowings, were granted to smaller
financial institutions in 1994 and 1996.
For capital outflow, residents’ foreign direct investment was encouraged from 1993 with
reduction of regulated industries, this limit was lifted in 1996. Ceiling on the amount of residents’
investment of foreign bonds disappeared, for financial institutions in 1993 and for firms in 1994.
Also nonresidents were further allowed to issue bonds in domestic currency from 1995 and in
foreign currency in 1997, and foreign firms could be listed in the Korean stock market in 1995.
It is interesting that still the Korean government took mostly gradual stance on deregulation of
foreign portfolio capital flows. The limit to foreign investors’ ownership of Korean stock was
sustained though it was continuously raised and portfolio inflow grew stagnant after 1994. 13 .
However, the deregulation in foreign borrowing was really careless and dangerous, when
domestic financial sector and industrial sector had serious problems. In fact, it is a foreign shortterm borrowing was a major source of capital inflow from 1994 to 1997 and the crisis was
triggered by a refusal to rollover. This has much to do with the asymmetric character of the
opening program, while long-term commercial borrowing and issuance of long-term bonds, albeit
deregulated, were still subject to volume restrictions, short-term borrowing had met no effective
restriction or monitoring (Chang et al., 1998) 14 Even worse, despite this extensive deregulation,
regulatory system over financial sector and foreign capital flow was never effective due to
ununified supervision system and complicated monitoring structure with many loopholes (Balino
and Ubide, 1999). The problem was especially serious for newly licensed merchant banks that
The share of residents’ issuance of securities in international capital market was higher than foreign
investment in domestic stock market in the early 1990s. Park reports, at least, from 1990 to 1995 it is hard
to find any serious increase of instability in net capital inflow in Korea in GARCH variance analysis. He
also shows that foreign investors behavior was not that speculative or unstable compared to domestic
investors and the capital account liberalization didn’t lead to the higher instability in the Korean stock
market (Park, 1996).
14
This asymmetric deregulation was related with the fact that government was concerned about the impact
of inflow of long term capital on monetary supply and since roll-over had been customary, the government
went easier with short term borrowing.
13
were inclined toward short-term borrowing and risky investment, connected to chaebols and
exposed to high liquidity and currency risk. 15 Besides, the monitoring over internationalized
financial business was also so bad even in spite of keen exansion of the Korean financiall
institutions abroad in the early 1990s. Since a proper regulatory system was never established
term mismatch and foreign currency risk increased, only to make financial sector in Korea very
vulnerable.
The financial opening in this period was really path-breaking especially for several capital
inflows, which brought a serious rupture to the relatively closed financial system in Korea. It is
certain that this financial opening and capital account liberalization was in line with much broader
financial liberalization scheme including domestic one after 1993. But the financial liberalization
tends to generate more risk and fragility of the financial sector and whole economy, leading to
‘speculation-led development’ (Grabel, 1995). This problem must be more serious in the
economy in Korea where big business dominated the economy, using financial institutions as a
channel of their investment. Financial opening worsened this problem and added currency risk
because international financial market reeks with volatility like herd behavior.16 In addition, in the
90s, the capacity of the government to monitor capital flows was no longer strong at all, which
was related to degeneration of institutional capacity of the government.17
(2) Politics of capital account liberalization and opening
Then, what was the force behind this rapid and even reckless capital decontrol in Korea? It is
obvious the government originally had a plan for internal and external financial liberalization to
make the financial sector more competitive and to enhance economic efficiency. Since the 80s,
the government supposed reduction of the government intervention was necessary to solve the
crisis in 79-80 and to pave the road for market economy, as economic problems got serious which,
15
The chaebol-affiliated merchant banks concentrated their loans to chaebol-affiliated firms, which was
possible since they were subject to less restriction to loans that can given to the same persons (chaebols),
with 150% of equity capital compared with 45% for banks. In consequence, as of March 1997, the share of
loans given to the top 30 chaebols was as high as 51% of total lending of the merchant banks. In addition,
while the maximum amount of domestic short term borrowing by the merchant banks were set to be 100 %,
there was no such limit on the foreign borrowing, quite strange asymmetry. (Lee et al., 1999)
16
International banks as well as institutional investors show this character especially in the crisis situ ation
to plunge into bank-run by stopping rollover, which was a direct cause for the crisis (Radelet and Sachs,
1998).
17
Now it is well known that the conflict went serious between the Bank of Korea and Ministry of Finance
and economy over monitoring rights for financial sector after 1995 and the financial reform plan was
aborted due to conflicts of interest groups in 1997. And change in the government organization like
incorporation of Ministry of Finance and Economic Planning Board further weakened ability to monitor
foreign capital flow (Lee et al., 2000; Moon and Ryu, 2000).
it considered, stemmed from excessive government intervention, so-called ‘governmentdominated economy’. The democratic wave in the late 80s might have contributed this trend
against government-repression on the economy in part since the intervention was thought to be
equal to autocracy. Despite these, financial liberalization was never easy to be developed in the
80s, due to consideration of big business and government intention to manage the economy based
on financial control (Choi, 1993). However, after 1993 with the new private government,
neoliberal ideology predominated the government officials and even the president made an
announcement of national agenda of ‘globalization’ in 1994 (Lee, 1998). Besides, according as
the Korean government was keen on getting a membership in the OECD, capital account
liberalization was thought to be necessary and adopted even sooner than original plan.
However, we should indicate there were strong interests to demand financial liberalization and
capital market opening. First, demand international capital and the U.S. government played a role.
After the late 80s, the U.S. government pressure on Korea to open its financial market got higher,
to which represented interest of international capital. The end of cold war and financial
globalization were backgrounds of this change and at that same time the Korean economy was in
good shape with big trade surplus. In fact, the plan of the government ‘blueprint for financial
market reform’ announced in 1993 was basically originated from the bilateral agreement between
the Korean and U.S. government in 1991.
Among others the interest of domestic big business and financial institutions were the most
important. Chaebols got more freedom from government due to the broad change of financial
system, and demanded more financial deregulation. Although the Korean government succeeded
in disciplining big business, controlling most of financial resources, at the end of 1980s, the
growth of big business and especially decrease of government financial control gave chaebols
advantage against the government (Woo, 1991; Lee, 1998). They didn’t need to rely on the
government in finance due to the growth of nonblank financial institutions not controlled by the
government and tapering of government policy credit. In this process, financial globalization as
such was an important cause of the change of government-business relationship. Chaebols could
issue bonds in international capital market from 1985, which made them bypass the government
in financing foreign capital. In the 1990s, chaebols in Korea continuously requested the
government to liberalize and open financial market much further to capitalize on cheap foreign
capital without any regulation, based on the neoliberal ideology (Lee et al., 2000).18 In addition,
Actually, most of agendas argued in the report, a way of pressing the government, of ‘National Business
Association’ were about financial liberalization and opening. Interestingly, this demand of neoliberal
policies from big business was also a strategy against working class that was getting powerful then. They
18
financial institutions also have an interest in this process because it could give them opportunity
to invest abroad and run business with cheap foreign capital.
The capital decontrol and financial liberalization promoted after 1993 in Korea originated
from the broad change of power relationship among the government, domestic and international
capital as well as the change of economic ideology. The conflict between the government and
chabols over financial regulation went serious from the late 1980s but the chaebol dominated the
government after 1993. The government did surrender itself to strong interests and neoliberal
ideology in the 1990s. That is, capital decontrol in the 90s stemmed from demise of
developmental state in Korea like a weakening of the capacity and autonomy of the government.
(2) From the capital decontrols to the crisis
After all, this capital decontrol without any good monitoring resulted in a spree of short-term
foreign borrowing of financial institutions and firms. It also raised a great surplus in capital
account with $ 5.2 billion in average during 1991-93 and $ 17.4 billion during 1994-96 and shortterm one increased from 37% to 62% for each year.
Table 1. Net Capital inflow into Korea in the 90s (1billion dollars)
Net Capital Inflow (1+2+3)
1. Net Direct Investment
2. Net Portfolio Investment
3. Other Net Capital Inflow (A+B)
A. Assets
B. Debts
Financial Institutions Borrowing
Long-term
Banks
Development Institutions
Merchant Banks
Short-term
Banks
Development Institutions
Merchant Banks
Other debts (Trade Credit et al.)
92
6.99
-0.43
5.8
1.62
-3.3
4.92
2.43
1.2
0.9
0.08
0.22
1.23
0.7
0.59
-0.06
2.49
93
3.22
-0.75
10.0
-6.05
-4.59
-1.46
1.2
0.08
0.15
-0.08
0.01
1.12
0.39
0.56
0.17
-2.66
94
10.73
-1.65
6.12
6.26
-7.37
13.63
8.98
1.95
2.18
0.01
-0.24
7.03
5.38
0.78
0.87
4.65
95
17.22
-1.78
11.59
7.46
- 13.99
21.45
13.40
1.61
2.03
-0.35
-0.07
11.79
8.52
1.56
1.71
8.05
96
23.92
-2.34
15.18
11.08
-13.49
24.57
14.15
1.53
2.49
-0.85
-0.11
12.62
7.19
2.24
3.19
10.42
97
6.03
-1.95
14.76
-6.79
-10.74
3.95
-14.12
0.72
0.66
-0.01
0.07
-14.84
-10.31
-2.43
-2.10
18.07
Source : Bank of Korea, International account table.
thought they could suppress workers’ power with market mechanism like flexible labor market though they
failed to adopt it in the early 1997.
The major agents to be responsible for this were financial institutions including merchant banks
dominated by chaebols. Chaebols promoted excessive investment with this foreign capital, in
reality 54.6% of growth of foreign debt between 1993 and 1996 was spent in equipment and
foreign investment by firms and growth rate of both of them was quite high. This means foreign
capital inflow rather worsened the trade deficit because it was spent on import of more capital
goods from foreign countries. Accordingly, foreign debt surged, from $ 44 billion in 1992 to
$ 120 billion at the end of 1997, with external liabilities including the offshore borrowings of the
Korean banks amounting to $ 170 billion. In this process, share of short-term debt grew higher
and liquidity problem grew more and more serious.
Of course, besides this capital decontrol policy, it should be pointed out that change in
international financial market affected foreign capital inflow into Korea. Since the 1990s,
international financial capital increased the investment into the so-called emerging market
seeking for diversification, with the sound economic growth in this region and low interest of
developed countries. It was international commercial banks and investment banks that increased
capital inflow into the Asian countries with loans rather than hedge funds (World Bank, 1998).
But their investment was not based on extensive evaluation on these economies and the herd
behavior might generate serious instability (IMF, 1998).
Table. Foreign debt of Korea and its composition ($ 1 billion)
Total Debt
Long term
Short term
Ext. Liabilities
Long term
Short term
Net Debt
Liquidity Indicator1)
Public Sector
Long term
Short term
Corporate Sector
Long term
Short term
Financial Sector
Long term
Short term
Financial Sector2)
Long term
Short term
1992
42.8
24.3
18.5
62.0
26.0
37.0
1.11
1.00
5.6
5.6
0
13.7
6.5
7.2
23.5
12.2
11.3
43.6
13.9
29.8
1993
43.9
24.7
19.2
67.0
26.7
40.3
0.79
1.44
3.8
3.8
0
15.6
7.8
7.8
24.4
13.0
11.4
47.5
15.0
32.5
1994
56.8
26.5
30.4
88.7
30.3
58.4
1.03
1.25
3.6
3.6
0
20.0
9.0
11.0
33.3
13.9
19.4
65.1
17.7
47.4
1995
78.4
33.1
45.3
119.7
41.0
78.7
1.69
1.07
3.0
3.0
0
26.1
10.5
15.6
49.3
19.6
29.7
90.5
27.5
63.1
1996
104.7
43.7
61.0
157.5
57.5
100.0
3.47
-0..5
2.4
2.4
0
35.6
13.6
22.0
66.7
27.7
39.0
119.5
41.5
78.0
1997
120.8
69.6
51.2
154.4
86.0
68.5
5.57
-0.62
18.0
18.0
0
42.3
17.6
24.7
60.5
33.9
26.6
94.1
50.3
43.8
Source : The Bank of Korea
Note : 1) liquidable foreign currency assets(currency reserve and other foreign assets) – short-term debt
2)
including all foreign debt of overseas branches of financial institutions to show external liablities
This surge of short-term capital inflow and foreign debt was so dangerous in Korea when there
were structural problems in financial and industrial sector like excessive investment of chaebols
without proper rate of return (World Bank, 1998).19 Their corporate governance was so bad that
irrational investment decision of the owner could not be checked and monitored by any way and
externally since the government could not discipline them any more and the ownership structure
was so centralized. Also, their external debt was too high with cross repayment guarantee among
firms included in the same group (OECD, 1999).20 Many chaebols went bankrupt in 1998, which
made the financial sector more vulnerable and exacerbated foreign investors’confidence in the
Korean economy. Finally, with the contagious effect of South Asian countries’ financial crisis and
the government’s several policy mistakes, foreign investors turned their back to Korea, by
refusing to rollover the short-term loan (Chang, 1998; Park, 1998). The Korean economy had no
choice but to plunge into the crisis and danger of default in this situation. Faced with serious
shortage of foreign reserves less than $ 3 billion as of late November 1997, the government
resorted to the IMF emergency loan in December. It was not enough to stop the foreign exchange
crisis, and the escalation of the crisis was stopped only after the promise by the advanced
countries of $ 10 billion emergency loans in December 24, 1997. Extensive capital decontrol
without proper regulation mechanism and radical reform in the economy ended up with neither
the economic efficiency nor growth but the financial crisis.
3. After the Crisis : What Is To Be Done?
(1) Further capital’s control after the crisis
The IMF’s program after the crisis imposed on Korea consists of two broad parts, one is a
restrictive macroeconomic policy with high interest, and the other is a micro restructuring policy
for industrial and financial sector. Already many pointed out that the high interest policy just
19
Korean chaebols seems to have been too optimistic about the future economy. But actually, this high
investment had much to do with competition among themselves, so-called ‘competition-coerced
investment’ (Crotty, 1993). With the end of government’s investment coordination after 1990 they made a
great effort to intrude into new industry to beat others and it became more serious in recession in mid
1990s.
20
This problem got more serious when big business owned and dominated financial institutions. The debtratio was higher for chaebols that owned financial institutions and profit rate of financial institutions owned
by chaebols was lower, which means chaebols used their financial institutions as a channel of finance, not
efficient.
overkilled the economy in recession, skyrocketing bankruptcy and unemployment rate. Since the
Asian countries are different from Latin American ones and at least macroeconomic fundamentals
were sound, this policy was not fit for Korea at all (Furman and Stiglitz, 1999).21 Microeconomic
restructuring policy included corporate reform for chaebols like reduction of high debt and
abolition of cross repayment guarantee, strengthening the management transparency with
combined financial statements etc.22 More importantly, in the financial sector the IMF forced the
government to adopt radical opening measures.
After the crisis, the Korean government brought deregulation to the financial sector along with
the pressure of the IMF and urgent demand of foreign exchange. First of all, it opened domestic
capital market like stocks and bonds to foreign investors so that significant freedom was given to
portfolio capital inflow. The limit to foreign investors’ ownership of Korean stock in aggregate
was continuously raised in the 90 and finally after the crisis, it was lifted up to 55% in December
1997 and abolished in May 1998 finally. Also, in December 1997, regulations on foreign direct
investment of most corporate bonds were lifted. Moreover, foreign investors were now allowed to
own domestic financial institutions during financial restructuring after the crisis and they bought
most of domestic bankrupt banks in 1998 and 1999. Second, foreign borrowings of domestic
corporate were liberalized after the crisis, even if short-term foreign borrowings of financial
institutions were the most important cause of the crisis. The government eased regulation on
firms to borrow foreign capital and issue bonds abroad with term of longer than 1 year in July of
1998.
Significant more deregulation measures were adopted in March 1999 along with the first stage
of ‘2-stage financial opening plan’. It covers allowance of nonresisdents’ long-term deposit to
domestic financial institutions and issuing bonds in foreign currency in Korea, domestic firms’
direct short-term foreign borrowing and real estate investment abroad. And any financial
institutions that want to do foreign currency transaction are allowed to run the business and
private individuals were enabled to establish foreign currency transaction business. Financial
institutions got more freedom since ‘principle of real demand for foreign currency’ for forward
exchange disappeared, which made it unnecessary to report what the demand is for to the
21
Actually, the government got more permission for low interest rate policy from the IMF and real interest
rate was not that high. However, harsh restructuring in financial institutions played a role to contract
aggregate demand and restrictive policy, despite not that high interest rate.
22
It does not consider the importance of institutions and a proper institution building, just emphasizing the
logic of the market like liberalization and market opening too much. Especially, they lacked the necessary
reforms over chaebols and the consideration of the new relationship building between the bank and
business. It is the reality that the biggest chaebols expanded their business centralizing financial resources
into themselves even after the crisis and the government might allow them to own banks, which would
make the banks’ monitor over chaebols impossible
government. From April, the NDF market where forward exchange is traded also emerged in
Korea. The government was still worried about excessive foreign borrowing of firms and
speculative attack so that it prohibited firms with high debt and bad credibility from borrowing
and continued the regulation on nonresidents’ borrowing in domestic currency. But many people
including private institutes presented concern and institutional frameworks and preconditions for
the capital account liberalization was said to be very immature23 The opening measures adopted
were much ahead of the original plan agreed with the OECD, the government promoted the
opening sooner due to the pressure of the IMF after the crisis.
After the opening measures, the Korean financial sector has got quite open compared to before
the crisis. However, this radical financial opening measures gives serious concern about volatility
of foreign capital flow and problem of macroeconomic management. In reality, after this further
opening, foreign direct investment flow into Korea skyrocketed amazingly after the crisis. In
1998, the amount of FDI inflow was $ 8.9 billion, it increased sharply up to $ 15.5 billion in 1999
and in 2000 $ 5.5billion till April. It is surprising that total amount of 1998 and 1999, $ 24.4
billion, is almost same to total from 1962 to 1997, $ 24.6 billion. This hike is mostly due to
radical deregulation measures adopted after the crisis and lowered asset price in Korea. But the
share of greenfield investment to establish a new factory or firm is tiny and in 1998 M&A related
investment in the restructuring process was the most. Though the share to buy newly issued
stocks is about as high as 86% in 1998 and 1999, the productive effect of FDI is still ambiguous,
considering broad meaning of M&A. 24 Rather, the government supports foreign investors too
much and especially workers’ power is harshly encroached by the FDI.
Portfolio capital flows also increased and fluctuated so much, especially in 2000. In the first
quarter of 2000, foreign portfolio capital inflow amounted to $ 7.3 billion compared to 5.2 billion
in 1998 in total. Actually, foreign capital inflow and outflow as well raise so much up to $ 77
23
Daewoo Economic Institute argued that this much deregulation was not necessary when there was no
emergent need for foreign currency and it would lead to serious volatility with foreign investors’
speculation. Moreover, it is reported that computer network for to gather the foreign currency transaction in
Bank of Korea was not established yet, ‘foreign currency management code’ for firms and financial
institutions was presented so late and manpower of international finance center was scarce in the
government (Korean Economic Daily, 2000. 2.3, 2000. 3.24.)
24
Actually the share of greenfield investment is really tiny in total foreign direct investment in 2000
(Korean Economic Daily, 2000. 4.12). And in the process of foreign direct investment, foreign investors
used P&A (Purchase and Assumption), which means foreign investors buy only good assets of firms and
financial institutions while bad assets and debts were shifted on public institutions. After this procedure,
foreign investors establish a new firm and buy newly issued stocks of this firm. In this case, acquisition of
newly issued stocks is also related to M&A, which means M&A type FDI is much greater than mere
acquisition of outstanding stocks. In reality, M&A type FDI in broad meaning including several asset
acquisitions in 1998 was reported to be about 53% due to the restructuring process after the crisis.
billion in 1999 from $ 28 billion in 1998 and so did foreign exchange transaction up to $ 2.3
billion from $1.0 billion. In consequence, market volatility is getting more and more, considering
foreign investors tend to be a more positive feedback trader, which led to high fluctuation in the
stock market (Wei and Kim, 1999). Financial institutions’ foreign exchange trade also surged by
72.7% in 1999 and especially derivatives’ trade increased most. It is remarkable that the share of
portfolio flow in total foreign currency transaction amounted to 23.5% in the first quarter of 2000
compared to 15.9% a year before, which means portfolio capital flow gets so important in foreign
exchange volatility (MOFE, 2000). Still lots of foreign investors think of the Korean market
attractive and institutional investors like hedge funds are expected to come more. It is not serious
problem yet, but it must become a constraint to an autonomous macroeconomic policy, especially
low interest policy in the near future.
Table. Change in portfolio capital flow by foreigners after the crisis (0.1 billion)
Inflow
Outflow
Net
1998
164.8
117.0
47.8
1999
415.2
362.8
52.4
1/4
67.0
45.5
21.5
2/4
100.3
88.8
11.5
3/4
107.6
135.1
-27.5
4/4
140.3
93.4
46.9
2000 ¼
208.7
135.0
73.7
Stocks and bonds traded, and short-term financial instruments included.
Source : MOFE (2000)
The increase of foreign capital inflow has already given the government a burden of
macroeconomic management. The exchange rate already continuously decreased after the crisis
and capital market opening due to foreign capital inflow, which may be harmful for export
competitiveness. In particular the Korean government has hard time to manage monetary supply
due to huge inflow of foreign capital. Traditionally it has been implementing sterilization policy
to offset the inflow and doing more so after the crisis. Since there is no developed government
bonds market, it just sold ‘Monetary Stability Bonds’ to financial institutions. Already, before the
crisis, sales of MSBs incurred serious cost so that interest payments on them accounted for more
than 70% of increase in the monetary base since 1990 (Park, 1996). The amount of this bond
went up to 61.5 trillion won in the late March of 2000, by 10 trillion won more than a year ago
and interest paid already increased up to 8.6 trillion won in 98 and 99, which gives the
government more difficulty in managing inflation.
(2) What is to be done: prospect for future
Furthermore, the government announced in March 2000 it would open the financial market
totally within 2000, giving unlimited freedom to investors about capital flows (Korea Economic
Daily, 4.23). According to the second-stage opening plan in 2000, all of the capital transaction is
supposed to be deregulated, including residents’ deposit to foreign financial institutions, purchase
of foreign bonds, lending to foreigners, and even any foreign currency payment including cost of
travel abroad. Nonresidents’ issuing of bonds and borrowing in domestic currency will be totally
allowed and limit to residents’ and nonresidents’ purchase of foreign currency will be abolished.
Among those, it raises most concern that any regulation on foreign borrowing of firms will be
repealed and nonresidents will get freedom to borrow in domestic currency.
Once these measures are adopted fully, the government will lose any capability to control
foreign capital flows. Even though the government says it will adopt more prudential regulation
system like monitoring over financial institutions, it will be hard to prevent volatility in the
financial sector. 25 In particular, nonresidents’ borrowing in domestic currency will give
speculators a great chance to attack Korean currency and unstable hot money flows will rise.
Besides, total liberalization in capital account might lead to capital flight of residents and firms’
excessive foreign short-term borrowing will worsen the bad debt structure only to increase risk.
As foreign financial institutions can run business in domestic market, many of uncompetitive
domestic financial institutions will go bankrupt considering their vulnerability. Finally, the
Korean financial market might be dominated by foreign capital and the importance of capital
market compared with banks may well increase in firms’ financing. But then, the character of
relationship-oriented financial system in Korea, led by the government before, will disappear and
it is detrimental long-term investment and economic development. Domestic banks’ role will
reduce and so will the close relationship between business and banks, managed by the
government before for investment coordination.
Further financial opening to aggravate macroeconomic instability, is likely to weake the
government policy autonomy, and dismantle former financial system totally. Considering these
problems, what is needed is not financial opening but proper capital controls. Most of all, because
domestic saving rate is still very high and investment before the crisis with foreign borrowing
was thought to be too excessive, the need of foreign capital is not big. In Korea, we may think of
adopting the Chilean style controls over capital inflows because the problem is increasing capital
inflows. As Chile did, the Korean government may as well have all of the foreign short-term
capital inflows deposit part of it with no interest. Foreign portfolio capital inflow must be tightly
controlled because it seems to be a most important source of financial market volatility. Explicit
tax or implicit levy on foreign exchange transaction could be one of the measures to address the
volatility. And the government should reregulate the foreign borrowings of financial institutions
and firms, by imposing strong regulation or adopting unremunerated reserve requirement like in
Chile. As for foreign borrowings, compulsory rollover agreement for short-term borrowings
could be helpful to constrain capital exit as a form of refusal to rollover. Foreign direct
investment is thought be rather long-term and stable but the Korean government should recover
the various regulation measures to promote transfer of technology and management skill for
domestic development like in former days.26 Of course, at the same time with the capital controls,
necessary reforms over industrial sector and a new relationship between government-businessbanks should be constructed.27
As we have argued, capital controls and decontrols are not implemented in the vacuum of
politics but always depend on the politics or power relationship around them. Since the pressure
of the U.S. government and the IMF with the strong interest of international capital is really
strong, it is never easy to make capital controls come true. For example, the U.S. government
prompted the Korean government to repeal almost all of the remained regulation on foreign direct
investment through the bilateral agreement after the crisis. However, Malaysian case shows the
feasibility of capital controls by individual developing country after crisis and the people’s
pressure can hopefully lead the government to adopt controls on foreign capital. Especially,
progressives and workers in Korea should exert to adopt capital controls because they can be a
base for egalitarian policy. When the workers’ position was significantly weakened after the crisis
due to flexibilization of labor market and high unemployment, capital controls are very crucial to
change the power relationship and bring out alternative policies.
25
As Rodrik argues, the sound regulation and monitoring system in the financial sector takes a long time,
especially in developing countries. He also indicates even some developed countries with prudential
regulation like Sweden suffered from serious financial crisis due to foreign capital flow (Rodrik, 1999).
26
Fortunately, the government stipulated the code that it could implement variable deposit requirement
system(VDR) when there was serious volatility in foreign capital flow in 1999, which must be adopted
right away in Korea.
27
First of all, corporate governance of chaebols must be reformed with workers’ participation and
enhancement of financial institutions in management. For that, radical change of centralized and distorted
ownership structure like abolition of cross stock ownership is essential. And management ability of
financial institutions should be strengthened so that they can monitor big business in giving loans. Based on
these we can formulate parallel and cooperative relationship between business and financial institutions,
called Korean style ‘main bank system’ (Nam, 1996). For that, the chaebols’ ownership and dominance
over financial institutions should be tightly regulated and the government should take a strong role in
investment coordination and financial resource allocation. About the role of the government in the financial
sector, see Kim and Cho(1998).
IV. Concluding Remarks
The issue of capital controls is nowadays ‘hot potato’ for economists who believe the financial
market is always efficient and the government should promote financial liberalization and capital
account opening. The theory and reality refutes this argument, rather we need proper controls
over international capital flows and effective government that can do it. Bottom line is capital
controls are necessary and feasible as well, for crisis prevention and national economic
management. Especially, capital controls should be understood in terms of politics and power
relationship because capital controls and power relationship among the capital, labor and the state
depend on each other and interact.
Controls over foreign capital flow are crucial for economic development too. So-called
developmental state in Korea achieved the rapid economic growth with strong capital control
system. The key to this ‘miracle’ was well-designed state-controlled financial system in which the
government mobilized capital to utmost and allocated it into specific industry in line with
industrial policy, with discipline and cooperation with private business. In this system, capital
controls are an essential element, which made the specific government-business relationship
possible, providing the government an effective tool to discipline business. However, the growth
of big business along with the economic development and globalization brought out financial
autonomy of business from the government and weakened government financial control
significantly. This led to the change of the government-business power relationship in favor of
big business, which raised strong demand of financial deregulation and capital decontrol. Also
faced with demand of international capital, the government adopted the far-reaching financial
opening program in the 90s based on neoliberal ideology. This radical turn to capital decontrol in
Korea especially about foreign short-term borrowings, dismantled the former financial system
with strong capital controls. After all, it generated foreign short-term borrowing spree that was
invested badly by chaebols and skyrocketing short-term debt, only to sow the seed of the financial
crisis.
The Korean experience of capital controls and decontrols clearly shows what the government
in developing countries must do to control foreign capital for national economic development and
how this system finally collapses. Most of all, the power relationship among the government and
domestic and international capital and the strong will of the government are crucial factors for
success of capital controls for economic development. Unfortunately, after the crisis, further
capital decontrol is going on under the IMF restructuring policy as the crisis itself affected the
power relationship in favor of international capital. This change would do much harm to workers
and keep the government at bay with increasing instability and less autonomy to manage it. In
Korea, strong capital control system to promote economic development was gone along with the
increasing power of capital and capital controlled the financial liberalization process. Now, the
stronger capital’s control is emerging after the crisis.
Growth of foreign debt
1400
1200
0.1 billion dollars
1000
800
Total Debt
Long term
Short term
600
400
200
0
1992
1993
1994
1995
1996
1997
year
Composition of foreign debt
1400
1200
0.1 billion dollars
1000
800
Financial Sector
Corporate Sector
600
Public Sector
400
200
0
1992
1993
1994
1995
year
1996
1997
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