Download South Korean Financial Marketization -- A Mirror to China

South Korean Financial Marketization -- A Mirror to China
FANG Fang
School of Economics, Renmin University of China, P.R.China, 100872
[email protected]
Abstract: In 1980, South Korea initiated a planned, gradual and orderly financial marketization
campaign, that is, to gradually adopt market-oriented interest rate, fluctuating exchange rate regime and
open capital accounts. This paper analysis the process of South Korean’s reform and drew some
enlightenment for China’s financial reform.
Keywords: Financial liberalization, Credit culture, Financial Supervision
．Introduction
1
South Korea started its financial liberalization in early 1980s. After some 30 years restructuring and
opening up, South Korea’s financial sector has been transformed from a government led monopoly,
serving only to government economic policy and large firms to an independent service industry, opening
to the global economy. The issues revealed in this process of transformation, such as “credit culture”,
foreign control of domestic financial institutions and overall financial supervision undoubtedly provides
a good reference to China’s financial industry development.
The paper is organized as follows: Section 2 and section 3 reviews South Korean Financial
Marketization in the 1980s and late 1990s. Then we outline some inspiration for China’s financial
reform in section 4.
2. South Korean Financial Marketization in the 1980s
2.1International and Domestic Backgrounds
The international community has been exerting tremendous influence and pressure on South Korea
during its financial liberalization process. As a small country with limited resources, South Korea
adopted an export-oriented economic development strategy, making the integration into the international
community a particularly important task for the country. It participated in the Uruguay Round of trade
negotiations on the General Agreement on Tariffs and Trade (GATT) and the establishment of WTO, and
became a member of Organisation for Economic Co-operation and Development (OECD) in 1996. In
this process, international organizations have been pressing the country to open its financial sector. In
the 1970s, South Korea implemented the government-led plans for development of its heavy chemical
industry. Prior to the 1980s, the country’s financial sector was completely government-driven, serving
the Korean government’s economic development strategy. Banks were tools for the implementation of
government economic policies, loan issuance under government guidance, and adoption of
government-stipulated flat interest rate. In addition, the government also controlled foreign loans and
various types of institutional credit. The South Korean government, in a bid to collectively capitalize on
all of its financial strength, directly intervened with operation of the financial market and instructed
banks to provide low-interest loans to government-picked consortiums in the heavy chemical industry.
Such direct government control over the financial sector distorted capital prices and inhibited
competition, moreover, it undermined the country’s export competitiveness. In 1979, the South Korean
government came to recognize the hazards brought about by economic imbalances and launched a
comprehensive scheme to stabilize the economy, reform the financial sector and optimize resource
allocation through the domestic financial liberalization and the introduction of a competition
mechanism.
2.2 Financial Marketization Process in South Korea
In 1980, South Korea initiated a planned, gradual and orderly financial marketization campaign, that is,
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to gradually adopt market-oriented interest rate, fluctuating exchange rate regime and open capital
accounts. It wasn’t until after the 1997 Asian financial crisis that South Korea turned to a “one-go”
complete marketization and globalization of its financial sector.
2.2.1Market-oriented Reform of Interest Rate
In the early 1980s, South Korea began to privatize its national commercial banks and lifted government
restrictions on banking operations. In June 1982, the country halted the prime rate for most of its
policy-related loans. In 1984, it began to permit financial institutions to adopt self-regulated lending
rates within certain limits. In December 1988, the government announced the removal of control over
bank and non-bank lending rates. However, the scheme was dropped in 1989 as a consequence of
domestic pro-democracy movement, economic downturn and rising interest rates inflicted by frequent
strikes and didn’t resume until August 1991. In a bid to promote competition among financial
institutions, the South Korean government relaxed the threshold to financial businesses including
banking, life insurance, securities, leasing and investment trusts in 1988.
2.2.2 Exchange Rate System Reform
Another integral part of the country’s financial liberalization is the adoption of floating exchange rate
regime. In February 1980, South Korea transformed its USD-pegged fixed exchange rate to
multi-currency basket-based floating rate. The country maintained current account surplus between 1986
and 1989, providing a golden opportunity for the liberalization of foreign exchange. It seized the chance
and relaxed foreign exchange position management and transaction management such as exchange
procedures and international use of KRW. In November 1988, South Korea accepted IMF terms and
achieved free convertibility of recurrent items. In March 1990, the country took another major stride
forward in exchange rate liberalization by introducing the market-average foreign exchange rate system,
allowing the exchange rate to float within a certain range.
2.2.3 Opening up of Capital Account
The reform scheme of foreign exchange system helped develop a framework for the country’s capital
market liberalization in late 1990s. According to this scheme, South Korea will gradually achieve
complete liberalization of its capital market by first liberalizing the current account and then capital
account; it will allow very free capital inflows by the year of 2000 and gradually relax restrictions on
credit inflows and advance payment to the international standards; relax constraints on securities
investment by foreign investors; allow enterprises to issue stocks overseas and access commercial loans
for equipment spending. In capital outflows, the scheme allowed the liberalization of overseas direct
investment and portfolio investment. It also allowed enterprises to make overseas real estate investment,
a potential channel of capital flight much feared by policy-makers. However, the capital account
liberalization process was gravely impacted by the 1997 Asian financial crisis, and South Korea later
chose the “one-go” financial liberalization strategy.
2.3 Assessment of South Korean Financial Marketization
Although South Korea took a cautious and gradual financial liberalization route, it ultimately failed to
get spared in the Asian financial crisis erupted in 1997. Clearly, the financial liberalization it adopted has
certain limitations, which can be summarized in the following four aspects:
2.3.1 Economic Structure under Financial Marketization
A careful study of South Korea’s financial liberalization process reveals the fact that its new reform
measures were almost invariably taken in time of slumping economic growth rate or ailing economy.
Those measures helped increase liquidity in the short term, bringing incremental investment,
consumption and exports and stimulating its economic growth. Financial liberalization relaxed liquidity
constraints in the short term, but triggered structural problems, resulting in greater KRW appreciation
pressure. With the heightened financial liberalization, the country saw marked investment growth in
1994-1995, leading to excessive investment in a number of key sectors and consequently overcapacity.
A more grave consequence is the heavy dependency of the entire economy on short-term low-interest
financing resulted from the government prime rate policy for key industries, producing countless
mismatches of assets and liabilities, and getting the government stuck in a vicious cycle of
overinvestment of massive short-term external debt into low-profit heavy industry.
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2.3.2 Competition under Financial Marketization
A key initiative of financial liberalization is to lower the threshold to the financial industry. This has led
to an upsurge in the number of financial institutions in the country. Prior to the financial liberalization,
there were only a small number of banks and other financial institutions. In the mid 1980s, South Korea
only had five privatized commercial banks and two share-holding city banks. But by late 1980s, South
Korea has developed its financial sector into one with all types of commercial banks, securities markets
and many secondary financial institutions, with the number of banks continuing to increase along with
economic development. Toward the end of 1987, there established 961 commercial bank branches with
local banks in each province. Along with a greater number of financial institutions came intensified the
industry competition. To survive the competition, financial institutions unceasingly expanded the
amount of borrowing and neglected risk prevention.
2.3.3 Financial Supervision under Financial Marketization
During the process of financial liberalization, there lacked real-time government supervision over the
financial sector. One of the major threats to the country’s economy is the lack of transparency. Released
government and business data did not reflect the true state of the economy, and macroeconomic
indicators could not track the deterioration of the financial situation. Before the advent of the financial
crisis, South Korea’s macroeconomic indicators still looked normal. At the outbreak of the financial
crisis, financial institutions in the country underestimated the scale of bad debts inflicted by the
corporate cross border payment guarantee and the government overestimated the profitability of
financial institutions and was unable to make appropriate countermeasures. As the
government-controlled financial institutions didn’t carry out sound supervision over capital use, and the
government bestowed “private” banks too much protection, the banks did not operate on the principle of
effective risk control and profit maximization. The entire financial sector lost supervisory control over
inefficient or duplicate corporate investment, which eventually accumulated so many bad debts.
3. South Korean Financial Liberalization in Late 1990s
3.1 South Korean Financial Crisis
South Korea’s external debt has risen sharply since the 1990s, which ultimately pushed the country into
the Asian financial crisis in November 1997. To halt discontinued production and bankruptcy and to
prevent complete collapse of the economy, the Korean government pleaded to the International
Monetary Fund (IMF) for help on November 21, 1997 and signed a rescue plan of USD21 billion
stand-by credit with IMF on December 3 that year. Financial assistance to the country also included
USD10 billion from the World Bank, USD4 billion from the Asian Development Bank and USD20
billion from other groups of industrial countries. Conditions for such assistance are immediate
comprehensive economic restructuring and reform, including full liberalization of the financial industry.
3.2 Post-crisis Financial Reform and Liberalization in South Korea
In the post-crisis period, the financial supervision system in South Korea underwent a series of reform
and liberalization, and a unified financial supervision model was adopted. The Financial Supervisory
Commission (FSC) directly under the State Council was established in 1998, and as a government
agency in the nature of a commission with members designated by relevant government supervisory
departments, FSC was responsible for centralized and unified supervision over the capital market and
financial institutions. In 1999, the Financial Supervisory Service (FSS) jointly funded by financial
institutions was established, whose primary functions were to conduct specific financial supervision,
regulation and inspection in accordance with FSC directives. According to IMF requirements, the
Korean government needed to pursue full economic liberalization. Prior to the financial crisis, it had
already achieved banking interest rate liberalization and gradually opened capital account; nonetheless,
it still had many restrictions on foreign capital. Therefore, after the crisis, the government accelerated
liberalization of foreign exchanges and capital account transactions and fully relaxed restrictions on
foreign capital injection into stock ownership.
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3.3 Assessment of Financial Reform and Liberalization in South Korea
Post-crisis financial reform in South Korea brought unprecedented changes:
3.3.1 Greater Concentration in the Financial Industry
The economic and financial reform contributed to more orderly market competition and enabled
financial institutions to have greater profitability. The reform changed the way banks operate and also
changed corporate finance pattern, realizing fully market-oriented banking operations and gradual
abandonment of high-lending and highly leveraged corporate business model. Capital structure
adjustment and solvency of large amounts of bad debt helped enhance the profitability of financial
institutions.
3.3.2 Transition of the Government Role
The government completed its role transition from a participant in financial activities to a referee. It no
longer directly interfered in the banking business, enabling financial institutions to independently
participate in market competition in line with the market principles.
3.3.3 Rationalized Regulatory System and Strengthened Financial Supervision
South Korea chose the British model of financial supervision, that is, to conduct unified supervision
over the financial sector and avoid poor efficiency resulted from duplicate regulation and regulatory
inconsistencies found in separate regulation systems, thus complying with the trend of mixed operation
in the financial industry. Meanwhile, the country redoubled supervisory efforts over financial
institutions in the following aspects: (a) access review; (b) large shareholder restrictions; (c) principle of
prudence; (d) immediate corrective actions; (e) double supervision -- both field and remote supervision;
(f) supervision over corporate governance, etc.
3.3.4 Foreign-controlled Korean Financial Industry
After full liberalization of the financial sector, foreign investment poured into the country. On the one
hand, the Korean financial industry achieved globalization in a very short time; on the other hand, the
country lost control over its financial industry. Currently, almost all commercial banks in South Korea
are foreign controlled, and there exists not a single Korean commercial bank in the true sense.
4. South Korean Financial Reform -- A Mirror to China
An open financial and economic system inevitably invites external shocks, and South Korea, without
exception, is gravely impacted by the global financial crisis triggered by the U.S. subprime loan crisis.
With a highly liberalized economy and financial sector, many people fear it will repeat the nightmare of
1997. However, so far, Korean financial institutions are operating normally apart from some difficulty in
obtaining foreign currency loans. There is neither outbreak of insolvency, nor large-scale capital
withdrawal by major foreign shareholders or closure of large enterprises, and financial institutions are
well capitalized. At present, we cannot assert that the South Korean financial industry is completely
stable and healthy without possible problems; however, financial liberalization and reform in the country
did not in any way undermine the financial sector’s ability to fend off external risks but on the contrary
strengthened its stability. We can at least draw the following inspirations:
4.1 Enhance Regulation in Time of Financial Liberalization
South Korea gives priority to regulation when it carried out the financial liberalization campaign. The
financial reform actually began with the reform of the regulatory system. In 1998, the Financial
Supervisory Commission (FSC) was established in South Korea to conduct uniform supervision of the
financial industry, adopt prudent regulatory measures and formulate stringent regulations on banks’
capital adequacy ratio, asset classification and provision, credit restrictions, liquidity ratio, foreign
exchange risk and national risk, derivatives and off-balance sheet business, financial disclosure and
external audit. To prevent major shareholders from manipulation of banks, South Korea formulated and
implemented very stringent restrictions on major shareholders, stipulating that individuals and
businesses cannot control over 10% of the shares of national commercial banks and 15% of the shares of
regional commercial banks, and there are strict and specific restrictions on major shareholders’ credit,
bank purchase of stocks issued by major shareholders and undue influence of major shareholders on
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banking operations. The country has stuck to the international standards on the supervision of financial
institutions, and in 2008, it has already begun implementation of the new Basel regulatory standards.
4.2 Conduct Stringent and Comprehensive Financial Supervisions
The FSC is in charge of uniform supervision over banks, non-bank financial institutions, as well as
insurance and securities companies. The country not only supervises financial institutions’ asset liquidity,
debt levels, bad debt ratio, savings ratio, etc., but also directly supervises the lending to the real estate
industry. By doing so, property prices in South Korea didn’t witness major ups and downs in recent
years. Between 2001 and 2007, the average annual growth rate of housing prices in South Korea was
6.9%, and the figure stood at 3.9% in the first half of 2008. The loan-to-value ratio of house mortgage in
the country dropped annually from 52.2% in 2005 to 47.0% in the second quarter of 2008. The home
mortgage loan accounts for only 33.4% of the country’s GDP.
4.3 Avoid Over-concentration of Investment and Pursue Balanced Investment
Following the financial liberalization, foreign capitals poured into the country, breaking close ties
between financial institutions and large enterprise groups, and consequently inducing profound changes
in the lending structure of financial institutions. Bank loans are no longer concentrated in large
corporations and government-supported key industries, and the ratio of loans to individuals, small and
medium-sized businesses increased. The industries receiving loans have become more diversified and
balanced.
4.4 Stringently Supervise Financial Derivative Transactions
Although Korea permits banks to engage in financial derivative transactions, it has taken very stringent
regulatory and supervisory measures. Banks engaged in such transactions are required to not only
formulate relevant transaction and risk management standards, but also set specific transaction amount
and stop-loss limits for each dealer and branch, and establish independent supervision and inspection
systems for dealers and back office personnel. Banks must submit quarterly reports to the FSC on their
derivative transactions. Where there are unusual or large transactions of financial derivatives, banks
must submit monthly reports for the FSC to conduct risk analysis. According to advice of an
international financial regulatory body, as of April, 2004, the FSC began to require banks to make
assessments according to the complexity of financial derivatives and risk exposure, enhance internal
control and risk management, follow market transaction disciplines, disclose all relevant information,
protect the interests of investors and comprehensively introduce derivatives to investors, prevent unfair
transactions, and limit trading of overestimated or underestimated derivatives with potential loss.
5. Conclusion
South Korea’s financial marketization has been full of ups and downs, twists and turns, as well as
opportunities and challenges. The financial market has gone through the gradual changes from 1980 to
1997, felt the impact of the 1997-1998 Asian financial crisis and witnessed the “one-go” globalization,
which ultimately transformed the government-led financial industry into a service sector providing
capital injection for the industry development, and an open, globalized and independent industry. The
experience and lessons in its development history can be of some inspiration to China’s financial
industry. China must enhance regulation in time of financial liberalization.
Acknowledgements:
The dissertation is completed with the support of “Innovation Center of Philosophical and Social
Science Studies on Chinese Economy”, a “985” project of Renmin University of China.
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