Download 3 – The East Asian Crisis - Utrecht University Repository

Dr. IMF
An analysis of the response to the East Asian Financial Crisis in South Korea
Master thesis by:
Jochem Arnold
Student number: 0019933
Thesis supervisor:
Prof. dr. J.L. van Zanden
Thesis co-examiner:
Dr. E. Nijhof
Universiteit Utrecht
Faculty of Humanities
August 20, 2007
Table of contents
1 – Introduction .......................................................................................................................... 3
2 – The IMF and South Korea before the crisis ......................................................................... 7
2.1 – The economy of South Korea ........................................................................................ 7
2.2 – Back to basics: the IMF and U.S. Treasury................................................................. 11
2.3 – From debt crisis to Tequila Crisis: Latin America in the 1980s and 1990s ................ 13
3 – The East Asian Crisis ......................................................................................................... 19
3.1 – The summer of 1997: currency attacks in Asia ........................................................... 19
3.2 – The crisis hits Korea .................................................................................................... 20
3.3 – The IMF deals under close inspection......................................................................... 26
4 – The Korean economy during and after the crisis ............................................................... 33
4.1 – The economy of Korea after the events of December 1997 ........................................ 33
4.2 – The financial sector ..................................................................................................... 36
4.3 – The corporate sector .................................................................................................... 38
4.4 – The labour market ....................................................................................................... 41
4.5 – The reforms and the IMF ............................................................................................ 43
5 – Conclusions ........................................................................................................................ 46
6 – Sources ............................................................................................................................... 49
Picture on front page: Kim Dae Jung (© Reuters)
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1 – Introduction
Not many organisations have been the subject of so much controversy as the International
Monetary Fund (IMF). Numerous highly acclaimed academics such as Jeffrey Sachs and
Joseph Stiglitz have accused the IMF of being incompetent, secretive and a pawn of the
United States Government.1 People in poor countries have been said to see the IMF as a
Western imperialistic organization that takes advantage of governments that face difficult
economic circumstances in times of crisis.2
The criticism that the IMF receives is inherent to the role that it was designed for. In
1944, it was established at Bretton Woods together with the International Bank for
Reconstruction and Development, better known as the World Bank. These organisations have
therefore often been referred to as the ‘Bretton Woods institutions’. The World Bank was set
up to provide funds for the ravaged allies of the United States, while the IMF had tasks more
in the sphere of monetary stability and cooperation between its member states. It was
therefore logical that that membership of the Fund did not lie with the government but with
the central bank.
The catastrophe of the Great Depression had made it clear that international
cooperation was necessary to prevent individual protectionist and inward remedies by nations
in the face of an economic crisis. An important role of the IMF, therefore, was to provide
funds when countries faced an economic downturn so that aggregate demand could be
prevented from dropping to critical levels. It became the ‘international lender of the last
resort’. Another important initial task of the Fund was to coordinate the system of fixed
exchange rates to the U.S. dollar and the gold standard. After this system broke down in 1973,
the role of the IMF became somewhat less clear. However, it has still been active at times of
exchange rate crises, when a fixed exchange rate threatened to be untenable. As the IMF was
active in times of economic panic, it would be inevitable that it would be given criticism.
Panics are usually only predictable with the necessary hindsight, so it often did not see the
crises coming. Furthermore, markets work imperfect in a time of panic causing huge
imbalances which reduce confidence and scare away investors and capital. The IMF often
steps up as a crisis manager, providing funds to support a currency and demands the country
to change a number of economic fundamentals, such as the government budget or the interest
1
2
See for example Stiglitz’ Globalization and Its Discontents and Jeffrey Sachs’ The End of Poverty.
Stiglitz, Joseph E., Globalization and Its Discontents (London 2002), p. 40.
3
rate. As a panic is often self-enforcing, these measures often do not pay out as they should and
the crisis happens anyway. The choices the Fund makes in these times of panic are therefore
the spear point of the criticism that it receives. When it demands countries to adopt austere
measures to avoid the worst, it is almost certain that they will plunge into a recession anyway.
Quite a few people, therefore, see the IMF specifically as the cause of the crisis or blame it for
mishandling it and making it worse.3
The biggest economic crisis since the Great Depression has been the East Asian crisis
of 1997 and 1998, which spread not only through the region of East Asia, but also planted its
seeds in Russia and the very distant Brazil. The crisis began on the 2nd of July, 1997 when the
authorities of Thailand decided to let their currency, the baht, go and float against the dollar.
This should not have created such a panic as was about to unfold. Sometimes the value of the
currency differs too much from the value that the fixed exchange rate assigns to it, and an
adjustment is necessary. However, a panic did occur because the true value of the baht was
allowed to drop to such depths that made holding on to baht a sure, but also huge, loss.
Why did the value of the baht fall by so much anyway? Thailand had allowed a
speculative boom of high economic growth to create a huge trade deficit that made foreign
investors become wary. When the economic tide just turned a little bit, loans started to turn
bad and credit started to flow out of the country. It became apparent that the baht was priced
too high and the fixed exchange rate could not be maintained, causing a great incentive to get
rid of baht, further depressing its value. However, a fall of the magnitude that was necessary
to reflect the baht’s true value would cause havoc on the Thai economy in which companies
had large amounts of foreign debt. These debts would show a spectacular rise in value would
the exchange rate be allowed to float, resulting in insolvency for many companies. In the end
the currency run was too large for the authorities to cope with and the exchange rate was
allowed to float. Although the economic shock was severe, the huge boost in competitiveness
of Thai products would allow the economy to eventually come out of the crisis with an export
surge.
Why the baht devaluation in Thailand led to a regional crisis in the rest of East Asia is
another question. A feeling among investors started to emerge that what could happen to
Thailand could also happen to the other booming economies of East Asia. While economic
growth records were impressive to say the least, once investors would start to withdraw
3
Krugman, Paul R., The Return of Depression Economics (New York 1999), pp. 114-115.
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money, a self-perpetuating motion would inevitably cause a currency devaluation. In this way,
the crisis spread to Indonesia, Malaysia, the Philippines and South Korea.
As with every major economic crisis, the IMF was actively involved in the countries
where trouble started. It provided huge amounts of funds to the countries that faced pressure
on their currency, and combined these funds with conditions that were meant to restore
confidence, and reform the economies to make them healthier. However, its emphasis on
austerity by demanding governments to cut in their budgets and raise interest rates, thus
deepening the recession by trying to restore confidence in the currency, could actually have
attributed to the spread of the crisis. Austerity drives down imports, creating a more balanced
trade balance, but also results in other countries exporting less. Economic growth came,
therefore, under pressure in the whole region. The Fund’s conditions and provision of loans
itself came under severe criticism from economists that advocated Keynesian measures of
aggregate demand stimulation as a better way of dealing with the crisis. 4 Many question
marks were raised on what the true intentions of the IMF really were. It pushed far reaching
reforms through in countries that hardly had any choice but to accept these as part of the funds
provided.
South Korea (hereafter Korea) was one of the countries that received a huge loan from
the IMF when the crisis spread there. Korean growth was largely based on national
companies, most notably the chaebol, which were huge business conglomerates. These were
made up out of several firms operating in different branches, but under one name, and usually
family owned. They prospered since the 1960s with help of government financing and were a
big part in Korea’s overall outstanding economic performance until the East Asian Crisis.
American business did not have much influence in Korea as the conglomerates enjoyed
special privileges from Seoul. During the crisis, the United States Department of Treasury,
which was said to have great influence on the Fund, began to label Korea’s economic
structure as being under the influence of ‘crony capitalism’, describing its tendency towards
corruption and inefficiency.5 The crisis provided an opportunity to fight the crony capitalism
– which had strangely provided GDP growth rates of nearly seven percent per year since 1963
– and force Korea to accept foreign enterprises obtaining improved access to the economy.6
Crotty, James & Kang-Kook Lee, “Is Financial Liberalization Good for Developing Countries? The Case of
South Korea in the 1990s,” The Review of Radical Political Economics, Vol. 34, No. 3 (Summer 2002), 327-334,
among others.
5
Stiglitz, Globalization, p. 90.
6
Krugman, The Return, p. 24.
4
5
The questions that are central to this thesis is whether the IMF tackled the economic
crisis in South Korea with sound economic solutions and stayed true to its mandate. Naturally
it follows to ask the question whether the proposed solutions resulted in a prosperous growth
path for Korea in the years after the crisis.
This paper tries to answer these questions by first studying the operations of the IMF
before the crisis that hit in 1997 and its influence on Korea. Next, its role in the crisis itself is
examined. Besides looking at the Fund’s role, special attention is given to the U.S.
Department of Treasury, which is responsible for promoting U.S. business interests around
the world. Lastly, the period after crisis until the present moment is briefly looked into to see
whether IMF policies had beneficial effects on the Korean economy and whether the Korean
government actually adopted IMF style policies after the crisis.
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2 – The IMF and South Korea before the crisis
This chapter deals with the IMF policies before the crisis. First, the Korean economy is
looked into, taking special notice of and its unique economic structure of state
interventionism. Thereafter, the main purposes of the IMF and United States Treasury as
organisations and their response to the Latin American Debt Crisis of the 1980s and the
Mexican ‘Tequila’ Crisis of 1995 is shortly studied. With these areas covered, a clearer
picture can be given on how the IMF operates in and out of times of crisis and how the crisis
affected Korea in particular.
2.1 – The economy of South Korea
South Korea’s economic success since the Korean War has amazed many. Showing GDP
growth rates of seven percent since the 1960s, Korea changed from a poor country with a
population of mostly peasants to the tenth largest economy in terms of GDP just before the
East Asian crisis.7 Many Korean companies like Samsung and Hyundai were competing
internationally in high-tech sectors. Its stunning performance was rewarded and Korea
received an OECD membership in 1996. Before growth took off in the 1960s, things did not
look very hopeful:
Experts wrote off South Korea in the early 1960s as having one of the dimmest economic
futures of East Asia; Burma and the Philippines looked as if they would be the region’s
stars. Cambridge University economist Joan Robinson hailed the industrial development
of Communist North Korea as a miracle and predicted it would overwhelm the
degenerating South.8
Economic growth in Korea was centred around the chaebol. The state created the chaebol by
controlling credit in the financial system. By controlling the financial system, the state could
steer companies to investments that were of national importance. The military regimes that
governed South Korea since the Korean War could pursue an industrial policy that enlarged
7
Blustein, Paul, The Chastening: Inside the Crisis That Rocked the Global Financial System and Humbled the
IMF (New York 2003), p. 119; Krugman, The Return, p. 24.
8
Blustein, The Chastening, p. 119.
7
the power base of the state, which was of no small importance because Korea had often been
unable to resist foreign occupation. Being protected from foreign competition and obtaining
cheap credit from the state, the chaebol turned into industrial conglomerates, employing
thousands of workers. They became very diversified, with the same chaebol engaging, for
example, in shipbuilding, microchips, cars and hotel resorts. Their interest was not to
maximise profits but to maximise market share.9 Although the state had succeeded in building
strong companies, the chaebol were growing out of control with annual growth rates of
sometimes 35 percent!10 The result was corporate inefficiency, overinvestment and excessive
risk taking. In the late 1970s huge excess capacity in the economy culminated in a recession.
In trying to have the chaebol stick to a core business to increase efficiency, the government
imposed a number of laws in the 1980s, but these failed to rein in the chaebol. During the
same period, however, external forces of free-market thinking and liberalisation were entering
Korea. Non-bank financial institutions were appearing that could circumvent government
influence and foreign banks were increasingly willing to lend to Korean companies. The
Korean conglomerates gratefully excepted other sources of finance as they increasingly felt
strangled by the government in their aims of increasing market share. The efforts of the
government to rein in the chaebol, therefore, proved futile as these companies used other
sources of finance to maintain their enormous levels of investment. The government itself
also became under the influence of free-market ideology and it slowly started a process of
liberalisation. From 1993, the process was accelerated when the first civilian president Kim
Young Sam enacted a five-year liberalisation plan.11 Most notably the plan included interest
rate and capital account liberalisation. Although the relationship between chaebol and
government loosened up a bit, it was still strong. Companies could still enjoy preferential
treatment if the government decided so. This meant that the chaebol still had the incentive to
largely stick to government policy.
The liberalisation policies in the 1980s and 1990s were of great concern to the United
States. Since the end of the Cold War, the Asian political allies had turned into economic
competitors, which were largely impenetrable to U.S. business due to their mercantilist trade
policies. The goal of the U.S. was to make the countries economically strong but still weak
Woo-Cumings, Meredith, “The State, Democracy, and the Reform of the Corporate Sector in Korea” (1999), in
Pempel, T.J. (ed.), The Politics of the Asian Economic Crisis (Ithaca 1999), p. 122.
10
Woo-Cumings, Meredith, “Miracle as Prologue: The State and the Reform of the Corporate Sector in Korea”
(2001), in Stiglitz, Joseph E. & Shahid Yusuf (ed.), Rethinking the East Asian Miracle (New York 2001), p. 353.
11
A list of major liberalisation measures can be found in: Chang, Ha-Joon, Hong-Jae Park & Chul Gyue Yoo,
“Interpreting the Korean Crisis: Financial Liberalisation, Industrial Policy and Corporate Governance,”
Cambridge Journal of Economics, Vol. 22, No. 6 (November 1998), 735-746, p. 737.
9
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enough to resist American capital and political influence. A sort of ‘Clinton Doctrine’ was
developed in 1993 that was “one of aggressive foreign policy designed to promote exports
and to open targeted economies to American goods and investment […] while maintaining the
Cold War positions that gave Washington a diffuse leverage over allies like Japan and
Germany.”12 The Treasury department was especially active in promoting U.S. interests by
pressuring countries to liberalise trade flows and the capital account. Larry Summers,
Treasury undersecretary during the Asian crisis, said on the latter that “financial liberalisation,
both domestically and internationally is a critical part of the U.S. agenda.”13 Besides being
beneficial to U.S. companies, the reasoning was that it would promote efficiency and reduce
corruption in those countries, because international competition would increase after
liberalisation, a view shared by the IMF. Often clashing with Treasury was the Council of
Economic Advisors (CEA) under Clinton that warned about the dangers of short-term
financial flows. They thought that the IMF and Treasury were often overestimating the
advantages of capital account liberalisation and underestimating the dangers. 14 Several
economists, including Joseph Stiglitz, who was in the CEA from 1995 to 1997, made another
point that empirical evidence on capital account liberalisation did not point to any advantages.
Neither would it produce higher growth nor investment rates.15 In defence to the critics,
Stanley Fischer, First Deputy Managing Director of the IMF from 1994 to 2001, actually did
admit that empirical evidence did not support financial market liberalisation. He argued,
somewhat with simplicity, that all advanced countries have open capital markets, which
suggests that it must be the eventual goal for other countries.16
South Korea did not form an exception in American policy. Since Ronald Reagan’s
presidency, Korea was put under pressure to adopt free market reforms. Kim’s five-year plan
that began in 1993 was the result of bilateral talks held in March 1992. His decision to apply
for OECD membership in 1993 subjected Korea to further demands and greatly accelerated
the process of liberalisation. Joseph Stiglitz later mentioned how Treasury was pushing
vigorously for faster reforms in Korea during this time. Faster reforms were of great
importance to Wall Street, but of little importance to U.S. national interest. The CEA
developed a plan of prioritisation that would look specifically at which market opening
Cumings, Bruce, “The Asian Crisis, Democracy, and the End of “Late” Development” (1999), in Pempel, T.J.
(ed.), The Politics of the Asian Economic Crisis (Ithaca 1999), p. 20.
13
Kapur, Devesh, “The IMF: A Cure or a Curse?” Foreign Policy, No. 111 (June 1, 1998), 114-129.
14
Blustein, The Chastening, p. 48.
15
Stiglitz, Globalization, p. 66.
16
Fischer, Stanley, “On the Need for an International Lender of the Last Resort,” Journal of Economic
Perspectives, Vol. 13, No. 4 (Fall 1999), 85-104, in Fischer, Stanley, IMF Essays from a Time of Crisis: The
International Financial System, Stabilization, and Development (Cambridge 2004), p. 19.
12
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measure would be most vital to U.S. national interests. Robert Rubin, who later became
Treasury Secretary in January 1995, of the National Economic Council, which decided what
proposals of the CEA reached the president, rejected the plan and Treasury’s view became
U.S. policy.17
Kim Young Sam began his five-year liberalisation plan in 1993, but at the same time
he abolished the practise of a five-year industrial policy plan. The state ceased to coordinate
investment decisions by the chaebol and stopped implementing industrial policy measures in
most sectors. As industrial policy almost disappeared, the government started to support ad
hoc investments by the chaebol. Hanbo, a medium-sized chaebol, was allowed to enter into
steelmaking while just before, Hyandai was refused entry. As it turned out, Hanbo had bribed
politicians close to Kim for support.18 Also questionable was the government’s support for
Samsung’s decision to enter the overcrowded car industry in 1993. The project was looking
like a failure from the beginning, but Samsung saw a solution by acquiring the then third car
manufacturer and big chaebol, Kia. However, the government suddenly reversed course and
nationalised Kia in an attempt to block Samsung from the acquisition.
Investment coordination used to limit competition and prevent overcapacity. Now that
this was absent, overcapacity started to become a serious problem in the Korean economy.
Profits were falling and companies, wanting to invest heavily in the liberalising economy,
started to borrow large amounts of short-term credit, both domestic and foreign. There were
two reasons for the fact that short-term borrowing increased far more than long-term
borrowing. First, the government had liberalised short-term financing more extensively than
long-term financing. Companies that wanted to obtain long-term loans had to provide
information and obtain permission from the Ministry of Finance and the Economy. Secondly,
companies preferred short-term credit, because they faced uncertainty over the exact time
schedule of the announced liberalisation measures and thought Korean credit ratings would
keep on improving in international financial markets as Kim’s government reform process
continued.19 The share of short-term borrowing in the financial structure of the top 30 chaebol
increased from 47.7 percent in 1994 to 63.6 percent in 1996. Total foreign debt was $43.9
billion in 1994 and exploded to $120.8 billion – of which 60 percent was short-term – in
1997.20 In the period 1988-1996, the debt to equity ratio of Korean companies was the highest
in a group of about 50 countries. Korea’s ratio was an enormous 348 percent followed by
17
Stiglitz, Globalization, pp. 102-104.
Chang, Park & Yoo, “Interpreting,” p. 740.
19
Chang, Park & Yoo, “Interpreting,” p. 739.
20
Crotty & Lee, “Is financial,” p. 330.
18
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Japan with 230 percent. The ratios for the United States and Germany were 103 and 151
percent respectively.21 The Korean ratio actually did not change much over time, also being
between 300 and 400 percent in the 1970s. This amount of leverage was also present in Japan
during its period of high growth from 1955 to 1973.22 However, as the share of short-term
capital increased in Korea, the high ratios were a sign of danger.
In 1997, things started to go from bad to worse in Korea. Even before Thailand
entered a recession in July, certain chaebol started to have serious financial problems ending
in a few bankruptcies. Then as the crisis spread from Thailand, to Malaysia, to Indonesia and
Hong Kong and Taiwan came under attack from speculators, Korea would find itself in such
trouble that it requested IMF help, a national humiliation. But before the crisis is looked into
in the next chapter, it is necessary to study the IMF and Treasury in greater detail.
2.2 – Back to basics: the IMF and U.S. Treasury
To not only understand the response of both the IMF and the U.S. Treasury before, during and
after the East Asian Crisis, but also to assess their actions, it is vital to delve into the nature
and history of the organisations. Section 2.3 will deal with recent history, while this section
will look at the Fund’s foundation and both organisations’ purposes.
The IMF was founded in the summer of 1944 by 45 countries that sought to build a
framework of economic cooperation that would ensure global economic stability after the war
and prevent destructive policies that could lead to another Great Depression. A combination
of protectionist and unhealthy competitive measures proved to be self-inflicting and caused a
massive fall in world trade. The Fund would ensure a healthy and stable international
monetary system without (heavy) exchange rate fluctuations and harmful devaluations, and
encourage member countries to adopt policies that would remove barriers to trade. The
organisation was given six purposes of which the most important for this thesis were:
To facilitate the expansion and balanced growth of international trade, and to contribute
thereby to the promotion and maintenance of high levels of employment and real income
and to the development of the productive resources of all members as primary objectives
of economic policy; to promote exchange stability, to maintain orderly exchange
21
22
Woo-Cumings, “Miracle,” in Stiglitz & Yusuf, Rethinking, p. 357.
Chang, Park & Yoo, “Interpreting,” p. 744.
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arrangements among members, and to avoid competitive exchange depreciation; to assist
in the establishment of a multilateral system of payments in respect of current
transactions between members and in the elimination of foreign exchange restrictions
which hamper the growth of world trade; to give confidence to members by making the
general resources of the Fund temporarily available to them under adequate safeguards,
thus providing them with opportunity to correct maladjustments in their balance of
payments without resorting to measures destructive of national or international
prosperity; in accordance with the above, to shorten the duration and lessen the degree of
disequilibrium in the international balances of payments of members.23
From the above, it is clear that the IMF does not only act as a crisis solver – although it avoids
the word ‘crisis’ in its purposes in favour of the milder disequilibria or maladjustments – but
also as an institution that promotes economic growth through promoting trade. As a crisis
solver, it restricts itself by not being willing to resort to measures harmful, or “destructive”, to
both national and international prosperity. Of course, during a crisis, prosperity will be under
pressure so the effect of possible measures put forward by the Fund might be hard to
distinguish from the effects of the crisis itself. The IMF puts forward another buzzword of an
economic crisis: confidence. Its purposes tell that funds will be available to correct
maladjustments in the balance of payments. Other disequilibria are not mentioned in
combination with either restoring confidence or the availability of its funds. What is
furthermore apparent from the Fund’s purposes is that it emphasises its role in fighting
government interventionist measures in the capital market such as competitive devaluations
and exchange rate barriers. It does not mention that it fights other interventionist measures
such as trade barriers, only that it promotes the expansion of international trade. Compared to
trade liberalisation, its purpose in capital market liberalisation is therefore more focussed and
specific.
The U.S. Treasury does not have a set of purposes but it does have a mission statement
that is, however, much less specific than IMF’s charter: “The mission of the Department of
the Treasury is to promote the conditions for prosperity and stability in the United States and
encourage prosperity and stability in the rest of the world.”24 The elaboration that Treasury
gives to its mission statement with respect to its position in the international arena is very
clear. Recognizing the United States is an important international player, it seeks to “influence
global financial and economic issues whenever possible” to promote both national and global
23
24
International Monetary Fund, “Articles of Agreement, Article I – Purposes” (Last amended: November 1992).
United States Department of the Treasury, “Education: Duties & Functions.”
12
prosperity and stability.25 At first glance this might seem as another international organisation
such as the World Bank and IMF, but looking closely at the description of the mission
statement reveals that it first and foremost serves U.S. citizens, which, after all, is only natural
for a governmental department. It reasons that when world prosperity and economic stability
is promoted, this will automatically benefit the prosperity and stability of the U.S. economy.
2.3 – From debt crisis to Tequila Crisis: Latin America in the 1980s and 1990s
Up to the 1980s, Latin American countries have always been known to be inward orientated
by imposing protectionist barriers.26 This was not so much of a problem during the 1950s and
1960s when the region could profit from global economic prosperity. In the 1970s, this began
to change due to an oil crisis and the collapse of the Bretton Woods system of fixed exchange
rates. Global economic growth slowed down and Latin American politicians resorted to
money printing and lending from foreign creditors to finance their political programs and
campaigns.27 This resulted in hyperinflation and a huge increase in foreign debt levels. The
economic situation of many Latin American countries became even worse when the U.S.
became committed to fighting inflation at home. Interest rates were raised to bring down
inflation, which pushed the world into a recession in 1981. Countries that had large amounts
of dollar-denominated debt saw an increase in their interest burden, while global demand fell
and put their economies under stress. On top of that, the dollar appreciated, increasing the
debt burden even further, and primary commodity prices collapsed, decreasing export
revenues.28
In 1982 it became apparent that Mexico was not able to service its foreign debt
payments. As it became clear that Mexico was not the only Latin American country that had
large amounts of dollar-denominated debt, creditors began demanding repayment on loans
from countries such as Argentina, Brazil and Chile. These countries ran into similar problems
as Mexico and the whole continent was pushed into a debt crisis.
A debt crisis does not only affect the country with the debt burden. The creditor
country can also be affected because the loans that its financial companies have provided can
United States Department of the Treasury, “Education: Duties & Functions.”
Krugman, Paul R. & Maurice Obstfeld, International Economics: Theory and Policy, 5th Edition (Reading
2000), p. 691.
27
Krugman, The Return, p. 38.
28
Krugman & Obstfeld, International, p. 696.
25
26
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turn bad, creating the risk of bankruptcy. When this happens on a large scale, healthy
economies can run the risk of economic crisis as banks start to collapse. Because the Latin
American Debt Crisis involved relatively large economies such as Mexico, Brazil and
Argentina, there was a risk of a global economic meltdown. The IMF and the United States
quickly provided emergency funds to prevent outright default and the subsequent possibility
of a world recession. These and subsequent funds were provided with conditions of economic
restructuring that were based on neoliberal economic theory that became known as the
‘Washington consensus,’ called after three Washington D.C. based institutions: the U.S.
Treasury, the World Bank and the IMF itself. This economic way of thinking placed high
emphasis on markets and saw governments as a distortion in the market system. Economic
efficiency became the predominant value. Besides stressing efficiency as important, the Fund
advocated a monetarist approach to balance of payments problems.29 In the face of a current
account deficit, a country would need a contractionary monetary policy that would bring
down aggregate demand so that it would not need to import as much as before, thus correcting
the deficit.
As the IMF provided funds for the countries only if they agreed to implement IMF
conditions, countries agreed to the demands. Although balance of payments problems were
resolved, Latin America entered a recession anyway. The affected countries generally
implemented a set of measures that would include one or more of the following: raising
interest rates, reducing government spending, eliminating price and wage controls, liberalising
international trade practises and devaluing the domestic currency. 30 However, because the
IMF demanded these measures to be implemented on short notice, countries saw themselves
applying ‘shock therapy’ on their economies, which tended to strengthen the recessionary
nature of the Fund prescriptions. It was clear that the IMF could help resolve balance of
payments problems and prevent default by providing credit, but it did also bring Latin
America in a decade of recession. The IMF was true to its purposes by providing funds to
correct balance of payments disequilibria, but in doing so it resorted to measures harmful to
economic prosperity. Of its purposes it was clear that restoring equilibrium in financial
markets had a higher priority than not resorting to harmful measures. It can be argued though,
that the Fund’s austerity conditions were only meant to do harm in the short term to enable
higher and healthier economic prosperity in the long run.
Woller, Gary M., “Latin American Debt, the IMF, and Adam Smith: A Proposal for Ethical Reform,” with
David Kirkwood Hart, The Journal of Socio-Economics, Vol. 24, No. 1 (Spring 1995), 1-20, p. 5.
30
Woller, “Latin American Debt,” p. 5.
29
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As the debt problems lingered on with the struggling of Latin America, the U.S.
Treasury intervened in 1989 with the Brady Plan, named after Treasury Secretary Nicholas
Brady, who, in a speech, declared that Latin America’s debt could not be fully repaid. 31 He
orchestrated a deal in which the outstanding debts were converted to Brady bonds, which had
a smaller face value. Besides a decrease in the debt value, the plan provided a psychological
turning point and foreign investors began to provide new sources of capital to Latin America.
The Brady Plan turned out to be a success by finally enabling countries to shift
attention away from the debt burden. However, the Fund’s austerity measures could be partly
blamed for the economic misery of the 1980s in Latin America. In this decade, the region’s
economy shrank by an average of 8,3 percent, real wages fell, inflation actually skyrocketed
and investment levels declined considerably.32
After the ‘lost decade’ economic growth began to take off once more. This was
sustained to the end of 1994, when Mexico plunged into yet another crisis, dragging
Argentina with it. The ‘Tequila Crisis’ saw a renewed interest in Mexico by the U.S. Treasury
and IMF. Before the crisis hit, Mexico had imposed numerous reforms on the economy,
including trade liberalisation and the privatisation of large amounts of state enterprises and
banks. Simultaneously, its currency, the peso, was pegged to the dollar, spurring foreign
investors to provide new credit. Inflation dropped to tolerable levels and the government
budget was in balance. Although things looked a lot better in the 1990s than in the 1980s,
economic growth was still not up to the level that was to be expected with the reforms. In the
1980s, yearly growth was 1.3 percent a year on average – still relatively high for the sluggish
Latin America – but from 1990 onward, it reached a disappointing 2.8 percent a year, only
slightly above population growth.33 The low growth rates were essentially the result of the
exchange rate peg and a higher inflation rate in Mexico than in the U.S., which created an
imbalance between the real exchange rate and the fixed exchange rate. The peso became
overvalued, hampering exports, but promoting imports. The trade deficit reached eight
percent of GPD in 1993 and did not seem to decrease.34 To sustain the peg, Mexican
authorities traded their foreign exchange reserves for pesos. Another leakage of foreign
reserves came from a continuing provision of credit to banks that experienced loan losses.
Banks had been privatised rapidly and the capital account opened up without real regulatory
safeguards in place, creating a highly volatile and vulnerable financial sector. Reserves fell
31
Krugman, The Return, p. 43.
Woller, “Latin American Debt,” pp. 3 & 9.
33
Krugman, The Return, p. 50.
34
Krugman, The Return, p. 49.
32
15
from $30 billion in early 1994 to a mere $5 million in November 1994.35 To make matters
worse, the Mexican government and commercial banks had rolled over $23 billion of shortterm peso denominated debt to so-called tesobonos, short-term dollar-denominated securities,
to signal the government’s commitment to the pegged exchange rate. As foreign exchange
reserves fell, Mexico’s mismatch with short-term foreign debt began to grow to very uneasy
levels.
Besides the problem of the overvalued peso, there was civil unrest and a political
election in 1994. The latter instigated a spending spree by the ruling party creating a massive
budget deficit. In late 1994, the economic problems became too severe and action was needed.
The orthodox policy would have been to raise interest rates, which would increase demand for
pesos but would kill off the growth rates that Mexico had fought for such a long time. The
alternative was a devaluation that would inevitably hurt the financial sector and the
government who had large amounts of dollar-denominated debt. Mexico chose the last option
and devalued the currency by 15 percent. The peso immediately came under attack because
investors considered the devaluation to be far from sufficient, and Mexico had no other choice
but to let the peso float on December 20. As panic around the currency spread, it dropped to
half its original dollar value.
Not only Mexico was infected. Another major victim of investor panic was Argentina
which had few links with Mexico and possessed huge amounts of dollar reserves. As investors
became wary of Mexico, they became wary of the whole of Latin America and the Argentina
peso came under attack, moving the economy into a credit crunch because credit was pulled
out and interest rates rose.
The currency crisis in Mexico became another debt crisis as the value of dollardenominated debt suddenly exploded. International emergency aid was necessary to prevent
default, just like in the previous crisis in 1982. Although the U.S. Congress actually rejected
the proposal for a bailout, Treasury provided Mexico with a $20 billion emergency loan
through a loophole in U.S. legislation that did not make Congress approval a necessary step.36
The IMF provided an additional $17.8 billion and others raised the total loan package to about
$50 billion.37 The loan enabled Mexico to fulfil its short-term tesobono obligations and the
devalued currency converted the trade deficit to a surplus as Mexican products became
Butler, Steven, Thomas Omestad & Kenneth T. Walsh, “The Year of the IMF,” U.S. News and World Report,
Vol. 124, No. 1 (January 12, 1998), 42-43, p. 46.
36
Krugman, The Return, p. 56.
37
Boughton, James M., “From Suez to Tequila: The IMF as Crisis Manager,” The Economic Journal, Vol. 110,
No. 460 (January 2000), 273-291, p. 276.
35
16
cheaper. Although the recession was severe – GDP in 1995 was seven percent below that in
1994, inflation soared and unemployment rose – it was also relatively short. In 1996, Mexico
was once again showing positive growth rates. Because Argentina was probably of less
interest to the U.S. and the crisis there was somewhat less severe, Treasury did not provide it
with a rescue package. It received $12 billion from the World Bank to support its banks.38
The bailout package to Mexico came under severe criticism from German and British
officials, because they had not been consulted about the IMF bailout. Besides, the Germans
argued that the bailout was essentially a bailout for Wall Street, providing Mexico with the
necessary hard currency to repay American holders of tesobonos, of which there were plenty.
By bailing foreign investors out now, they would continue reckless lending as they could
expect the IMF to bail them out in the future. This was the problem of ‘moral hazard’ in
which one changes its behaviour, becoming more risky, because one is insured from any
trouble that one can be exposed to with this changed behaviour. American officials actually
did not deny the bailout largely served American business interests.39 The American defence
was that a Mexican default could prove disastrous for the U.S. and conceivably also to the
world economy, so a bailout was the most sensible thing to do. Treasury held true to its
mission statement.
There were important lessons to be drawn from the two crises in Latin America. It
signalled to countries with a fixed exchange rate that short-term debt denominated in a foreign
currency could be a major crisis precipitator, especially with an open capital account without
adequate safeguards in place against capital flight. To the IMF, responsible for international
cooperation in the wake of an economic crisis, it also provided some interesting insight.
Bailouts had proven their worth preventing governments from going bankrupt and easing their
liquidity problems. However, bailouts did not help to cure what really was the problem in the
economies of the countries hit, and they hardly invoked confidence for international investors.
The latter point was a very valuably lesson to the IMF, considering that giving confidence to
member countries was one its main purposes as an organisation. The economies in Latin
America that were hit by the crises had certain characteristics. They had high levels of shortterm foreign debt, their currency was overvalued and they had inadequate safeguards. In the
specific case of Mexico, the country hit hardest, the government was not committed to a
balanced budget and it drained its foreign reserves to defend an unsustainable currency peg.
The tough conditions that the IMF imposed on countries which needed its help could
38
39
Krugman, The Return, p. 57.
Blustein, The Chastening, p. 173.
17
somewhat be justified by the governments’ profligacy. Although the population suffered, the
authorities learned to live within their means – although one could see that Mexico had not
really learned that well when elections came near in 1994.
Investor confidence was not restored with a bailout because investors believed the
currency would devalue anyway. By having open capital markets, they could easily sell the
affected country’s currency thereby causing an inevitable currency crisis that would justify
the panic. In other words, capital flight became a self-fulfilling prophecy. It was clear that
open capital markets without adequate regulation would pose a tremendous risk for
developing countries. A last lesson from the crises was that the occurrence of contagion in the
region had a high probability as investors began to look more carefully at their portfolios.
After the Tequila crisis of 1995, the IMF and the U.S. Treasury did not back away
from their stance on capital market liberalisation. The IMF even went further to add that
capital account liberalisation was to be included in the IMF’s mandate. According to the
Frenchman Michael Camdessus, the managing director of the Fund at that time, “The benefits
of an open and liberal system of capital movements – for individual countries and investors,
and for the world economy at large – are widely recognized. But in order to have full access
to private capital, countries have to open their capital accounts.”40 This was a rather bold
statement because open capital markets helped to invoke the crisis in Mexico. He, however,
added that capital controls should not be removed prematurely. He did not mention if he
thought that Mexico had done just that with IMF support after the debt crisis if the 1980s.
Treasury paid special attention to banking regulation and supervision after the Mexican crisis.
It wanted the IMF to increase its surveillance capacities of national financial systems and to
play a more active role in addressing financial system vulnerabilities.41 With the lessons of the
crises in Latin America in mind, the East Asian economic crisis can now be dealt with.
International Monetary Fund, “Remarks by Camdessus at the Economic Club of New York” (June 6, 1997).
International Monetary Fund, “Remarks by Summers to the Fifth Annual Conference on the Americas”
(October 8, 1996).
40
41
18
3 – The East Asian Crisis
In the summer of 1997, an economic crisis hit Thailand. A few months later, South Korea was
trying to avert a national default. This chapter first describes how the crisis spread across East
Asia, followed by an analysis of the attempt by the IMF and the international community to
rescue Korea from disaster. How the IMF tackled the crisis in Korea is looked in with great
detail, giving attention to the U.S. Treasury’s role as largest shareholder of the IMF. By
studying the Fund’s way of handling the crisis, a conclusion can be reached to see whether the
IMF handled independently and economically responsible.
3.1 – The summer of 1997: currency attacks in Asia
On July 2 1997, Thai officials decided to let the baht float after months of currency
speculation. A devaluation was expected, but the baht entered a free fall, putting Thailand’s
economy under stress by increasing the value of all debt denominated in a foreign currency.
Thailand’s U.S. dollar reserves were falling rapidly as baht were being traded for dollars and
the IMF was asked for help. The Fund provided a loan and demanded measures of austerity.
Interest rates needed to be very high to stop the baht from falling and the fiscal budget needed
some serious cuts. Before the crisis, Thailand had run huge current account deficits, or in
other words, been living beyond its means. Demand had to fall to cut back imports and
lowering the budget deficit was one way to do this. According to the IMF, it would also
restore confidence by showing Bangkok’s seriousness in dealing with the crisis.42 The
question remains why Thailand would need a reduction in aggregate demand when demand
was already falling due to a multitude of companies having the greatest difficulty in dealing
with the currency depreciation. Again, the IMF chose equilibrium in the balance of payments
over maintaining, where possible, short-term prosperity. By doing so, it actually undermined
its own efforts. Raising interest rates could be defended because it would make the national
currency more attractive. Asking for government budget cuts was insensible and undermined
the organisation’s purposes both directly by negatively targeting economic prosperity and
indirectly by aggravating the fall of the baht.
42
Blustein, The Chastening, p. 74.
19
In spite of the IMF remedy, the baht kept falling. The most likely reason was that the Fund
had demanded the Thai central bank to disclose information on the dire status of its official
reserves, showing that the IMF rescue of $17 billion was insufficient to meet the debtors’
obligations. The disclosure was made under pressure from Treasury’s Rubin and Summers,
who insisted that Thailand needed to come clean, because it had brought the crisis upon itself
by being untransparent.43 Only after November 1997 when Thailand’s prime minister
resigned, did the baht begin to appreciate slightly when investors saw a renewed willingness
of Thai officials to implement the IMF reforms.
Shortly after the baht came under attack, Malaysia’s currency suffered a similar fate.
Just like Thailand, neighbouring Malaysia had been running a large current account deficit,
making it a likely candidate for speculation. The currency depreciated and the economy
entered a recession, but unlike Thailand, Malaysia refused to ask the IMF for help. After
Malaysia, Indonesia was the next to be hit be speculators. Indonesia had experienced high
growth rates like Thailand and Malaysia, but did not have a large current account deficit.
However, its companies did have many debts in dollars, making the country look similar to
Thailand. Furthermore, it had a currency band with the dollar that made it vulnerable to a
currency run, which is what happened in August. Not defending the currency for too long,
authorities abandoned the band and let the rupiah float. Because corporate Indonesia was in
deep trouble as the currency dropped, the IMF was called to the rescue and provided a bailout
package with similar conditions as in Thailand. Indonesia entered a recession, made worse by
IMF demands that insolvent banks needed to be closed, causing a bank run on all private
banks.44
3.2 – The crisis hits Korea
That crisis that hit Southeast Asia in 1997 amazed many. For a few decades, the region had
shown spectacular growth rates and its performance became known as the ‘East Asian
Miracle’. South Korea was one of the miracle’s shining stars, and investors generally thought
it was a profitable and safe place to invest. From 1993 to 1997, risk ratings for Korea
improved, indicating the opposite of what was about to unfold.45 When country after country
43
Blustein, The Chastening, p. 80.
Stiglitz, Globalization, p. 117.
45
Radelet, Steven & Jeffrey Sachs, “The Onset of the East Asian Financial Crisis,” NBER Working Paper No.
W6680 (August 1998).
44
20
came under attack in Southeast Asia, Korea was still considered to be safe from crisis. This
was confirmed in October 1997 when the IMF issued a secret country report, a so-called
‘article IV report’.46 Unlike Thailand, Korea’s current account deficit was not very large and
declining, its currency was not overvalued and macroeconomic fundamentals remained
strong.47 The Funds World Economic Outlook estimated growth to be 6 percent for Korea in
1998.48 Besides, Korea was geographically far away from the problems in Thailand, Malaysia
and Indonesia.
With the necessary hindsight, there were indications that the economy of Korea was
starting to sputter in 1997. During 1996 the main stock market index fell 40 percent and
another 20 in the first half year of 1997.49 After a decade without any chaebol bankruptcies,
three chaebol, Hanbo, Sammi Steel and Kia Motors, collapsed in 1997. The financial
soundness of the chaebol was certainly being put into question, but could an OECD country
so easily become a panic victim like Thailand and Indonesia?
The first serious warning sign appeared on October 17 when Taiwan abandoned its
fixed exchange rate with the dollar after it could not defend attacks on its currency. Taiwan, a
wealthy country with a healthy economy, was well known for its towering exchange reserves.
The fact that it could not uphold its currency value signalled to investors that stable
economies like Hong Kong and Korea might experience the same fate. “Taiwan acted as a fire
bridge from Southeast to East Asia. After Taiwan the conceptual category of ‘Asian financial
crisis’ came into being.”50 The same month that the IMF Article IV report was completed, the
attack on the Korean won commenced. Korea’s exchange rate regime was that of a crawling
peg, letting the won slowly adjust to U.S. dollar, while using a day-to-day currency band that
prohibited the won from changing ten percent in value against the dollar. Korea did not have,
in so far, a fixed exchange rate but its flexibility was limited.
What essentially happened in Korea was that foreign creditors of external financing
stopped rolling over their loans and began to demand payback of their loans, because they
began questioning the imbalance between official reserves and the external dollar-dominated
debts. Especially the banks and non-bank financial institutions had been borrowing heavily in
short-term dollar maturities and lending in won with longer payback periods.51 The chaebol,
46
Blustein, The Chastening, pp. 13 & 117.
Feldstein, Martin, “Refocusing the IMF,” Foreign Affairs, Vol. 77, No. 2 (March 1, 1998), 20-33, p. 24.
48
Radelet & Sachs, “The Onset.”
49
Radelet & Sachs, “The Onset.”
50
Wade, Robert, “The Asian Debt-and-development Crisis of 1997-?: Causes and Consequences,” World
Development, Vol. 26, No. 8 (August 1998), 1535-1553, p. 1542.
51
Radelet & Sachs, “The Onset.”
47
21
in turn, largely borrowed from these sources and had less exposure to exchange rate
fluctuations. The private sector was heavily indebted, showing a clear difference with the debt
problem of the Latin American Debt Crisis where the state owned the bulk of debts. The
sudden demand for dollars in Korea had two consequences. First it drained the exchange
reserves of the central bank because it was obliged to trade dollars for won, and secondly, it
resulted in rising interest rates as the won money stock decreased. Economic growth was
slowing down and the country found itself facing a nearing recession.
As people kept buying dollars and selling won, Korea would soon enter a default after
all reserves had been depleted. When an emergency loan request was denied by Japan, Korean
officials of the ministry of Finance and Economy agreed that reaching out to the IMF was the
only option left. The option of default would be devastating for the economy, because it
would probably mean Korea had to live years without adequate sources of credit. A team of
IMF officials under leadership of Camdessus arrived in Seoul on November 16 to negotiate a
rescue package. Camdessus was relieved to hear that Korea’s reserves of $30 billion would
enable it to last, at least, until new year.52 The Korean negotiating party, on its part, was
pleasantly surprised that the Fund did not demand any far-reaching reforms in the Korean
economy. However, the situation was much worse than Camdessus could have imagined. A
large part of the $30 billion of hard currency was deposited in overseas affiliates of Korean
banks and already being used for paying back creditors.53 Besides, the IMF found out that
Korean foreign obligations were actually much higher. In its article IV report, the Fund had
failed to take the debt figures of overseas affiliates of Korean banks and companies into
account. The next year, Korea had a staggering $115 billion in payments falling due. 54 The
situation became even more critical when the IMF deal was voted down in the Korean
National Assembly and the Finance minister was dismissed. The new finance minister openly
rejected an IMF rescue, but later changed his opinion when he found out about the true
situation of the enfolding crisis.
A new IMF team under leadership of Hubert Neiss was dispatched to Korea to
construct another deal with the new Finance minister. With the new numbers in hand, Neiss
realised that Korea would default within several days if nothing was done. Having been
shocked by the condition of Korean reserves, the IMF did demand changes in the economy
this time. However, Korea had a tough team of negotiators and they only agreed to make
52
Blustein, The Chastening, p. 129.
Blustein, The Chastening, p. 130.
54
Blustein, The Chastening, p. 130.
53
22
vague commitments. Dissatisfied with the work Neiss was providing, the U.S. Treasury came
into action and sent Undersecretary David Lipton to Seoul to put Neiss under pressure. The
stakes were high for Washington. First of all, the U.S. feared the possibility of a military
adventure by North Korea after a economic collapse in the South.55 Secondly, they were
afraid the crisis could spread to Japan which would seriously affect the whole world
economy.56 Beside its fears, Treasury also saw opportunities in Korea. The crisis situation
enabled Treasury to make demands that would be ignored otherwise. It thought OECD
reforms were being implemented too slowly and wanted to speed up the liberalisation process.
Foreigners had to gain better access to the Korean stock market and restrictions on
competition from foreign banks had to be lifted.57 Lipton was also told to demand a much
tighter monetary policy, thereby raising interest even further so that demand for won would be
restored. IMF staffers thought tight monetary policy was a sensible option, but they were
displeased with Treasury’s other demands that were essentially outside of the Fund’s borders.
According to an IMF member of the Asia and Pacific Department, “The U.S. saw this as an
opportunity, as they did in many countries, to crack open all these that for years have bothered
them.”58 This was in line with a statement made by the U.S. Trade Representative, Mickey
Kantor, that the Fund should be used as a “battering ram” for U.S. interests.59
To finish the negotiations, Camdessus visited Seoul again on December 3. He was
under pressure from Treasury to strike a tough deal and reject any preliminary arrangements
by Neiss that were considered too weak in the eyes of Washington.60 It is even said that Rubin
called Camdessus shortly after his arrival and bluntly put that the U.S. would oppose a
program that it considered weak.61 Korean newspapers were also aware of Treasury’s pressure
on the IMF. A leading daily newspaper charged that “a senior U.S. Treasury official
backhandedly manipulated IMF negotiators to push for market opening.”62
On December 3, an agreement was reached on the IMF rescue for Korea. The package
included the provision of a massive total of $55 billion in emergency funds of which the IMF
would provide $21 billion. Of the $55 billion, $20 billion came in the form of bilateral loans
that would only be used if the $35 billion of multilateral loans proved insufficient. The
Butler, Steven, Thomas Omestad & Kenneth T. Walsh, “The Year of the IMF,” U.S. News and World Report,
Vol. 124, No. 1 (January 12, 1998), 42-43.
56
Duffy, Michael, “The Rubin Rescue,” Time, Vol. 151, No. 1 (January 12, 1998), 46-49.
57
Blustein, The Chastening, p. 143.
58
Blustein, The Chastening, p. 143.
59
Kapur, “The IMF.”
60
“Korea-IMF deal in sight after tough battle of wills at talks,” Financial Times, 3 December 1997.
61
Blustein, The Chastening, p. 147.
62
Cumings, “The Asian Crisis,” in Pempel (ed.), The Politics, p. 28.
55
23
austerity measures were to raise short-term interest rates to 25 percent, a number much higher
than was negotiated by Neiss, to contain the money supply to control inflation at around five
percent, and pursue a budget surplus of one percent of GDP by raising taxes. 63 Structural
measures that were included were the establishment of central bank independence, the closing
down of troubled financial institutions, the imposition of certain capital adequacy ratios for
the financial sector, the opening of the financial sector to foreign entry, further trade and the
capital account liberalisation and labour market reform.64
After the deal was announced, there was a glimpse of hope when the won appreciated
slightly in value and the stock market index rose 15 percent. 65 Then, however, things went
back to where they were before the rescue was announced. The won plummeted so heavily
that trade in the won was suspended everyday as the currency dropped below the ten percent
bandwidth. Sometimes this even occurred within minutes after trading began.66 Washington
was quick to point fingers at Seoul when the package did not restore confidence in the
markets. Seoul’s decision to support and recapitalise two ailing banks signalled to
Washington that it was not being serious in implementing the IMF program. On top of that,
the leading Korean presidential candidate for elections on December 18, Kim Dae Jung,
publicly attacked the deal and announced he would renegotiate it after his election.67
Although at a later time and still before the election he would change his mind and support the
IMF program, his initial response, however, did surely have an impact. Criticism on both
sides did not help much to restore confidence, but what really was the issue was that the
markets started to realise that the bailout was simply insufficient to cover all the foreign debt
in Korea. The true state of the official reserves and foreign debt became known to the public
after a Korean leading newspaper published a leaked IMF report, made during the
negotiations. Korea, heading for a default, pleaded with the U.S. Treasury to provide some
emergency cash, but was refused on the grounds that it did not reform fast enough.68 As the
won fell and the Korean economy entered a recession, the IMF still tried to convince markets
that the program was a success by showing that is was pleased with the Korean commitment
to reforms. The course reversal of Kim Dae Jung surely made this kind of statement possibly.
Blustein, The Chastening, p. 148; Bullard, Nicola, Walden Bello & Kamal Mallhotra, “Taming the tigers: The
IMF and the Asian crisis,” Third World Quarterly, Vol. 19, No. 3 (1998), 505-555, p. 524.
64
Bullard, Bello & Mallhotra, “Taming the tigers,” p. 524.
65
Blustein, The Chastening, p. 181.
66
Blustein, The Chastening, p. 8.
67
Blustein, The Chastening, p. 181.
68
Bullard, Bello & Mallhotra, “Taming the tigers,” p. 548.
63
24
Up to the election in Korea, officials of the IMF and Clinton administration realised
that, in spite of the largest bailout in history, Korea would soon be forced to stop all dollar
transactions. The possible consequences that a default would have on the world economy and
North Korea were too severe to consider default a viable option. Instead, a new strategy was
adopted by going to the source of the problem: the international banks and financial
institutions that were asking Korea to pay back its short-term loans. These were simply trying
to save as much as possibly until Korea would default. It was therefore in their common
interest to put a hold on the panic and come to a collective solution that would bear minimum
losses. The IMF realised that when loans would be rolled over and payment by Korean banks
to foreign investors would be delayed, calmness could be restored and capital flight halted.
Such a plan would require a global response of Finance ministers to persuade their national
banks that it was in their interest to carry out this plan. The obvious objection to the ‘bailing
in’ of the international financial sector was one of principle: governments should not meddle
on such scale with the private sector, which would have to bear the consequences of their
actions of lending short-term in East Asia.69 However, by providing the $55 billion bailout,
the government had already meddled with the private sector by providing a bailout for
financial markets.
To make this plan work, the IMF needed Treasury’s support. Uncertainty on the
outcome of the Korean presidential election made a decision only possible after December 19.
A Korean delegation met with Undersecretary Summers and promised that, with the full
backing of the newly elected Kim Dae Jung, the IMF reforms would be carried out faster and
more thoroughly.70 Now that Treasury was in, a meeting with top executives from the
American banking sector was arranged on short notice. Time was of the essence as Christmas
was coming near, so talks began on December 22. Just in time, on December 24, the banking
executives agreed to a debt rescheduling that enabled Korea to survive. In the rest of the
world, similar agreements led to a temporary halt of payments from Korea. Meanwhile,
Lipton was in Seoul, negotiating on the conditions for providing a rescue package ahead of
schedule. The new Korean government promised to close ailing merchant banks and provide
the possibility of foreign takeovers of other merchant banks. The bond market would be
opened by the end of the year and foreign entry in the financial sector would be allowed.71
69
Blustein, The Chastening, p. 188.
Blustein, The Chastening, p. 193.
71
Bullard, Bello & Mallhotra, “Taming the tigers,” p. 525.
70
25
Many were quick to place blame on the IMF for its attempt at a rescue in the
beginning of December. When that deal did not work, Korea had to swallow additional
measures that were only arguably curing the source of the crisis. In the next section, the deal
is studied more in detail, looking closely at the Fund and Treasury’s way of acting.
3.3 – The IMF deals under close inspection
The first observation that comes to mind when looking at the crisis in Korea is that the IMF
did not predict the crisis could and would indeed happen. Korea, with its high foreign and
domestic debt ratios, showed similarities with the Latin American governments that were hit
in the debt crisis of the 1980s. In Korea, the financial sector bore the greatest risks, while
governments were vulnerable to external shocks in Mexico, Argentina and Brazil. Problems
in the financial sector would quickly spread to the whole economy in which the chaebol had
been lending heavily from the Korean banks. The Tequila crisis of 1994-1995 should have
warned the Fund that contagion could occur, even when economies were geographically
distant. At the moment when Thailand, Malaysia and Indonesia had an economic crisis and
the Taiwanese currency was under attack, the IMF believed chances that Korea would enter a
similar crisis to be minimal. It was true that Korean macroeconomic fundamentals were
stronger than most other Asian countries that were hit. The current account deficit was small
and it did not have an overvalued currency. With the necessary hindsight, financial indicators
like debt-to-equity ratios and the levels of short-term foreign debt proved more of a risk
indicator for Korea. Realising the need for better ways of surveillance and crisis prevention,
the IMF worked to improve this area after the crisis. Countries were urged to provide more
and better information to the IMF and the Fund itself moved towards becoming more
transparent.72
When the IMF entered the crisis scene in Korea, it demanded the same measures of
austerity as in Thailand, Indonesia and Mexico. The organisation was facing a trade-off
between a currency slide, which would hurt the financial sector with its high levels of foreign
short-term debt, and high interest rates, which would hurt the heavily indebted corporate
sector, including the chaebol. In choosing between two evils, it stuck to the medicine that it
had so often used. First of all, high interest rates would increase the value of keeping Korean
Fischer, Stanley, “The IMF and the Asian Crisis,” Forum Funds Lecture, UCLA (March 20, 1998), in Fischer,
IMF Essays, pp. 91-92.
72
26
won and secondly, cutting the government budget would decrease the current account deficit,
thus raising foreign currency reserves, and show the seriousness of the Korean government to
prudent policies. Both were needed to stop the capital flight. However, capital flight did not
stop until the fund withdrawers were bailed in with the Christmas Eve package. Why didn’t
the measures work? The most likely answer was that these measures proved to be insufficient
when investors found out that the bailout was simply too small to cover all foreign debt. No
matter the $55 billion, Korea was heading for default anyway, in spite of a prudent
government budget or high interest rates.
When the austerity measures proved insufficient, they only could do more harm than
good. While banks were coming under stress because of a plummeting won, the private sector
was also in difficulty as interest payments rose. Increased government spending on key
sectors would have eased the pain, but the government reduced spending instead to meet IMF
criteria. At the worst point in the crisis in mid December, the IMF kept demanding fiscal
prudence when the economy was sinking lower and lower. Compared to the profligacy of the
Mexican government in 1994, Korea had run a responsible budget up to the crisis.
Furthermore, its current account deficit was not large like Thailand’s, for example, and
already shrinking due to the contractionary force of the crisis. Demanding a balanced budget
was therefore even less sensible than in Thailand’s case. After the crisis, the IMF admitted its
fiscal adjustment policies had been too strong.73
The IMF did not consider its interest rate policies to be wrong after the Asian financial
crisis. Although an extreme devaluation took place nonetheless in Korea, the Fund had made
a clear commitment on preventing a currency plunge, in accordance to its purposes. In his
analysis of the crisis, First Deputy Managing Director Fischer did not only fear insolvency in
companies with large amounts of foreign debt, he also feared an extreme devaluation would
make exports too competitive, thereby increasing the probability of contagion. 74 He fails to
take into account that the recessionary nature of a sharp rise in interest rates would inevitably
mean that imports would be reduced, thus spreading economic hardship on others. The
Koreans put forward another motive for not raising interest rates to high levels. It simply
could not have the desired effect because investment opportunities for foreign investors in the
economy were very limited and, thus, capital would not be lured from overseas. 75 The fact
that the IMF stood firm did not mean there was no considerable internal debate on the issue of
73
Fischer, IMF Essays, p. 68.
Fischer, “The IMF,” in Fischer, IMF Essays, p. 85.
75
Blustein, The Chastening, p. 148.
74
27
high interest rates. The ‘dovish’ IMF staff members often fought heated discussions with their
counterparts about the height of the interest rates. On one side, they were under attack from
economists such as Sachs and Stiglitz, who proposed low interest rates and criticised the IMF
for its lack on internal debate, and on the other side ‘hawkish’ IMF Executive Board members
from the U.S., Great Britain, Germany and other powerful countries, who were asking for
rates to be raised sky-high.76 Because the latter held the votes, the IMF decided to opt for a
policy of very high interest rates.
As noted above, austerity measures were not the only measures that Korea was asked
to implement. Structural changes had to be made to cure the economy of its perceived flaws.
By addressing these, the IMF argued that the country would invoke confidence and, as a
bonus, would be stronger against future shocks.77 The MIT economist Paul Krugman went
further to add that structural reforms did not necessarily need to be economically sound, but
should rather “mollify market sentiment.”78 Demanding structural reforms was not part of the
traditional IMF mandate and it would not necessarily have a direct link with the flight of
capital. However, by insisting on their implementation, ‘crony capitalism’ could be dealt with
and confidence in the Korean economy hopefully rebuilt.
One of the structural reforms that were demanded was the closing of insolvent banks
and the introduction of strict capital adequacy ratios to solvent ones. The closure of 14
merchant banks added to the sense of panic in the financial system and the rapid
implementation of capital adequacy ratios meant that banks had to cut back lending, leading
to a capital squeeze.79 Korea was not entirely committed to this part of the program because it
recapitalised two banks that had liquidity problems. Private merchant banks had weak
government links, however, and they had less chance of a rescue. Closing insolvent banks
could bring long-term benefits to Korea, but since it was demanded during the crisis, it did not
restore confidence among foreign investors. Afraid that loan repayments could not be made,
investors withdrew credit at a faster rate and the fall of the won accelerated.
Other structural measures that were put forward during the crisis were usually
designed to break the link between the state and the chaebol. One of the most politically
sensitive demands was that Korea needed to change the charter of its central bank and make it
more independent. During the crisis, it was told to focus exclusively on inflation, much like
the European model of the central bank. However, before the crisis, Korea did not have a
76
Stiglitz, Globalization, p. 228; Blustein, The Chastening, p. 156.
Fischer, “The IMF,” in Fischer, IMF Essays, p. 87.
78
Krugman, The Return, p. 113.
79
Radelet & Sachs, “The Onset.”
77
28
history of high inflation or monetary mismanagement. Neither was there evidence to show
that an independent central bank would be beneficial for growth and prevent high fluctuations
in the economy.80 Just like the austerity measures, it did not necessarily make economic sense,
but it was demanded to restore confidence. It was argued that an independent central bank
would prevent politicians from using it to lower interest rates to prevent job losses.81
Furthermore, direct influence on chaebol investment decisions through the central bank would
no longer be possible. Full central bank independence, being as sensitive as it was, was
rejected by the Korean parliament during the crisis, but more independence was granted
nonetheless.
The influence of the government on the chaebol was also being tested by new
demands for liberalisation. Foreign entry was allowed in financial markets, proving lucrative
with a very weak won and slumping Korean economy. Capital account liberalisation was
accelerated enabling foreign investors to invest in Korea with greater ease. Again, this hardly
made economic sense when an open capital account had proven to be quite disastrous in the
first place. Confidence was again the buzzword. If foreign investors saw increased
opportunities in Korea in the future, this would maybe make them think twice about removing
funds. Of all structural reform demands, this one was actually part of the Fund’s purposes.
They tell, however, that the IMF would only assist – the word ‘promote’ is not used – in the
implementation of capital account liberalisation
The IMF program also sought to change the labour market in Korea. Up to the crisis,
Korean companies were unable to sack workers. In January 1996, just one year before the
crisis, a bill that allowed the sacking of workers was rejected after heavy protests from the
unions.82 The government and chaebol were very willingly to use the time of crisis to push
through unpopular IMF labour market reforms, enabling companies to fire workers. The
reforms did not address the direct cause of the crisis, but tried to please foreign financial
markets by making foreign entry in Korean markets a lot more attractive.
So far, only the Fund’s dealings have been studied in detail. The United States, being
the largest shareholder of the IMF, tried to greatly influence the parties at the negotiating
table. Before the deal of December 3, this became apparent when Treasury sent Lipton to
defend American interests and prevent a program that did not address the structural problems
of the Korean economy well enough. In separate talks with the Koreans, Lipton tried to win
80
Stiglitz, Globalization, p. 45.
Butler, Omestad & Walsh, “The Year.”
82
Bullard, Bello & Mallhotra, “Taming the tigers,” p. 536.
81
29
concessions by threatening with the withdrawal of American support to a weak IMF program.
The political ties between the countries and the threat that hard dollar cash would be lost led
the Koreans to accept terms dictated by Washington. The IMF team was very unhappy with
Lipton’s attempts to open up the Korean economy to foreign entry and the fact that Neiss was
often unreachable because he needed to have private meetings with Lipton.83 When hands
were shaken on December 3, Lipton and the U.S. Treasury could be pleased, because bilateral
funding by the U.S. had been reduced to an ‘in case’ second-line bailout. This bilateral loan
pledge was however far more shaky than it appeared. Treasury actually never intended to use
it, except for in extreme circumstances, and hoped that the signal of the inclusion of a secondline defence, in case the first-line bailout did not prove sufficient, would be enough to bring
calmness to the markets.84 Treasury’s trick to use its funds without Congress approval to bail
out Mexico just a few years earlier had made it hesitant to use it again. It had therefore made
the second-line defence conditional on Korea’s willingness to reform.85 When Korea was
pleading the U.S. for an emergency cash injection after the initial IMF deal proved futile,
Treasury was therefore quick to point fingers at Seoul for not being serious enough in
implementing the reforms it asked for.86 The second-line defence could thus be used to
demand a new set of reforms that served U.S. interests, including faster implementation of
measures that enabled improved foreign entry and foreign takeover possibilities of Korean
banks. Treasury was clearly thinking long-term, because the accusations that Seoul was not
serious in reforming its flaws, was not a signal that would restore confidence among foreign
investors. Unlike Treasury, the IMF tried its best to compliment the Korean government in
public statements on its commitment for tackling the causes of the crisis.87
The United States had considerable power in the IMF as its largest shareholder. When
the Fund’s role was put into question by the Japanese proposal of the establishment of an
Asian Monetary Fund (AMF) in September 1997 to provide cash for stimulative measures in
Thailand and Indonesia, Treasury was quick to react and sided with the IMF to defend the
monopoly position of the latter. The AMF as a competitor of the IMF would greatly reduce
American influence in the region. On the other hand, the effectiveness of the IMF rested on
the fact that it was the hallmark of the international financial system. The establishment of the
83
Blustein, The Chastening, p. 145.
Blustein, The Chastening, p. 179.
85
United States Department of Treasury, “Statement of Treasury Secretary Robert E. Rubin,” December 3, 1997
(RR-2091).
86
Blustein, The Chastening, p. 181.
87
Blustein, The Chastening, p. 184.
84
30
AMF would surely reduce the effectiveness of IMF remedies because markets would look less
at the Fund’s ‘seal of approval’.
Treasury could also use its influence as largest shareholder of the IMF in other ways.
“In the face of increasing resistance at home to its free-wheeling liberalisation agenda, the
U.S. government [had] to rely even more on bodies such as the IMF and APEC [Asia-Pacific
Economic Cooperation] to push its trade objectives.”88 Charlene Barshefsky, a U.S. trade
representative said that “[IMF] programs will complement and reinforce our trade policy
goals.”89 The already mentioned ‘battering ram’ statement by Mickey Kantor gives the same
picture. One example of Treasury hiding behind the IMF was the demand for sky-high interest
rates. A former IMF economist said that Treasury “hid behind our skirt. They were willing to
let the Fund get all the blame, and never made it clear that when things were left to them,
interest rates would have been raised substantially higher.”90
The U.S. Treasury used its negotiating power to win concessions from Korea that
served U.S. interests. Although its mission statement states it encourages global stability and
its elaboration even mentions it promotes global stability, Treasury’s behaviour often showed
the opposite. It thwarted the attempt by the IMF to restore confidence by openly criticising
Korean officials and demanding full transparency of Korea’s dire situation. These actions
deepened the crisis and obviously decreased global economic stability. Furthermore, they
were not in the interest of the U.S. economy, except perhaps by, unintentionally or not,
worsening the crisis and thus creating more negotiating power.
The IMF faced a huge problem during its mission in Korea. It was called to the rescue
to a country that could not be rescued after the panic had set in. The bailout that was needed
to prevent default could never be scrambled together on such short notice. Instead, the IMF
opted to play the confidence game, but this proved futile when foreign creditors found out
about the true status of Korean reserves. By imposing unpopular measures and meddling with
the Korean economy beyond its mandate, it came under severe criticism from all directions.
On top of that, it was pressured, much against its will, by the U.S. Treasury to demand market
opening in the interest of American companies. The IMF still functioned as an organisation
that sought to cure the crisis with the most sensible set of policies. That it did not work out
very well in the case of Korea up to the Christmas Eve package can, with the necessary
hindsight, be blamed on the IMF. However, a different approach would probably steer Korea
Bullard, Bello & Mallhotra, “Taming the tigers,” p. 541.
Bullard, Bello & Mallhotra, “Taming the tigers,” p. 541.
90
Blustein, The Chastening, p. 157.
88
89
31
in the same direction: default. How the reforms in the Korean economy worked out in the
years after the crisis is studied in the next chapter.
32
4 – The Korean economy during and after the crisis
This chapter continues where the last chapter ended: the Christmas Eve package for South
Korea. Although a default had been averted, the country entered a recession in 1998. This
chapter shows how economic restructuring took place in 1998 and how the Korea economy
performed in the years after the crisis. This is done by distinguishing between the labour
market, the financial sector and the real sector. In this way a general judgement can be made
about IMF reforms and their impact on the economy.
4.1 – The economy of Korea after the events of December 1997
During the talks in late December, it was agreed to maintain credit lines up till March 1998.
This resulted in a sharp increase of loan rollover rates in January. Finally, on March 31, a
final agreement was reached with a total of 134 creditor banks from 32 countries, in which
$21.8 billion of obligations were converted to government-guaranteed debt.91 As a result
Korea’s short-term debt declined from $61 billion in March to $42 billion in April 1998.
As pledged to the IMF, Korea began reforming the economy in 1998 while trying to
pursue macroeconomic stabilisation. Reforms were being implemented in all levels of the
economy, from the chaebol and the labour market to the financial sector and the capital
account. Reforms were generally of a liberal nature, which implied less state control and an
opener economy. The restructuring efforts were carried out vigorously by the new president
Kim Dae Jung. He was elected partly because he promised to reduce the economic power of
the chaebol. Due to the severity of the crisis, the chaebol were in no position to bargain and
tough reforms were forced upon them. Kim, a lifetime liberal, was a great supporter of the
measures that were negotiated in the IMF package.92
As mentioned in chapter 3, the remedy for the crisis involved restrictive
macroeconomic policies such as raising taxes, cutting back government spending, and raising
interest rates. Raising interest rates would stabilize the currency and a budget surplus would
enable a current account surplus which was necessary to provide foreign exchange and, thus,
Lane, Timothy et al., “IMF-Supported Programs in Indonesia, Korea, and Thailand: A Preliminary
Assessment,” International Monetary Fund Occasional Paper 178 (1999), p. 22.
92
Crotty, James & Kang-Kook Lee, “Economic Performance in Post-Crisis Korea: A Critical Perspective on
Neoliberal Restructuring,” Political Economy Research Institute working paper, University of Massachusetts,
Amherst (2001).
91
33
restore some level of confidence with foreign investors. The depth of the crisis was vastly
underestimated by the IMF and the remedies did not work. The IMF agreement was
constantly amended in the light of worsening conditions. The amendment of May 1998 still
showed a GDP growth forecast of -1.75 percent for 1998 while it turned out to be -6.9
percent.93
With the economic downturn underway in 1998, the government changed to a more
expansionary fiscal policy. Funds were injected, especially, to ailing but viable banks.
However, by that time, the economy was already in a disastrous shape. Looking at table 4.1, it
can be seen that unemployment rose as firms and banks ran out of business. Besides, real
wages were falling and consumer confidence was dropping. The current account climbed to a
surplus as domestic demand declined, making a government budget surplus superfluous. As a
result the country began collecting foreign exchange reserves again. In combination with
programs to lower foreign debt levels, net external assets turned positive in 2000, effectively
signalling that the possibility of national default had become impossible. The trade surplus
and rising foreign exchange reserves caused a dramatic turnaround in economic growth. The
ensuing economic boom showed growth rates of 9.5 percent in 1999 and 8.5 percent in 2000.
Unemployment dropped from crisis levels above 8 percent to a little more than 4 percent in
2000.94
Table 4.1: Economic indicators
1991-1995
1996
1997
1998
1999
Real GDP growth rate (%)
7.5
6.8
4.7
-6.9
9.5
8.5
4.5
Unemployment rate (%)
2.4
2.0
2.6
7.0
6.3
4.1
3.7
CPI growth rate (%)
6.0
4.9
4.4
7.5
0.8
2.3
3.3
-1.4
-4.1
-1.6
11.7
5.5
2.4
2.3
774.7 844.9 1,695.0 1,204.0 1,138.0 1,264.5
1,011.6
Current account balance (% of GDP)
Exchange rate (won/US$)*
2000 2001-2005
Foreign exchange (bln US$)*
23.4
29.4
8.9
48.5
74.1
96.2
210.4
Net external assets (bln US$)
-21.8
-46.2
-68.1
-34.5
-6.8
18.8
120.7
0.3
0.2
-1.4
-3.9
-2.5
1.1
1.2
Gross domestic investment ratio (%)
37.5
39.0
36.1
25.2
29.3
31.1
29.8
Gini coefficient
0.28
0.29
0.28
0.32
0.32
0.32
0.33
Government balance (% of GDP)
Source: Bank of Korea; Korea National Statistical Office (gini coefficient)
* end of period
Lee, Young, Changyong Rhee & Taeyoon Sung, “Fiscal Policy in Korea: Before and After the Financial
Crisis,” International Tax and Public Finance, Vol. 13, No. 4 (August 1, 2006), 509-531, p. 520.
94
Crotty & Lee, “Economic Performance.”
93
34
The IMF understandably emphasised the dramatic turnaround after the economic decline in its
reports because its rescue package with its structural reforms had clearly showed signs of
success. However, the economy has to be studied in more detail to see what the effect of the
crisis and liberal restructuring really was. James Crotty and Kang-Kook Lee (2001) of the
University of Massachusetts gave a decent analysis of the reform program. They based their
negative conclusions on economic data on only two years of economic growth: 1999 and
2000. This thesis provides a more thorough analysis by using data up to and including 2005. It
is still a preliminary analysis however. More in depth analysis is needed to provide proof of a
causal relationship between the reform program and the economic indicators.
In spite of the rapid recovery after the crisis, Korea is now on a lower growth
trajectory than before the crisis. A possible explanation can be that Korea is converging to
OECD GDP per capita levels and it is thus only natural that the growth rate is converging too.
However, the data also shows that investment to GDP – the gross investment ratio – is
substantially lower in the years after the crisis. This could possibly explain the lower GDP
growth rate. The world slump of 2001 and 2002 must also have had a negative influence on
growth as it lowered exports. The current account surplus shrank considerably after the crisis,
but it has turned from negative before 1998 to consistently positive. In 2002, it showed a little
dip by reaching 1 percent of GDP, and since then, it has been higher.
More worrisome is the higher average unemployment rate after the crisis. Before the
crisis, Korea had rigid labour laws and unemployment was a rare phenomenon because firms
were not operating at maximum efficiency. During 1998, a number of laws were passed that
increased labour flexibility and allowed chaebol to initiate a number of mass layoffs. For the
time being, it appears that reforms have caused a consistently higher unemployment rate. Also
consistently higher, but more on a positive note, is the budget surplus, which used to be
negative before the crisis erupted. It has stayed positive, even when world output growth rates
declined. The result is commendable because in the beginning of 1999, the government
projected the first balanced budget after a series of deficits to take place as late as 2006.95
Only in 2005 did Korea record a minor deficit of 0.4 percent of GDP. Inflation numbers are
also reason to celebrate. The traditional emphasis by the Fund on low inflation can be found
in table 4.1, where after a peak in 1998, the consumer price index (CPI) averaged 3.3 percent,
almost twice as low as before the crisis.
International Monetary Fund, “Korea Letter of Intent and Memorandum of Economic Policies” (March 10,
1999).
95
35
With a higher level of unemployment also came a higher level of inequality in the
Korean economy. This had been general trend in all modern economies, but the Korean gini
coefficient rose 4 percent since 1997, compared to an increase of less than 1 percent for
countries such as the United States and Canada.96 The Korean experience was even more
dramatic because “inequality [was] rising not just because the rich [were] getting richer: lower
incomes in Korea [fell] substantially in absolute terms despite rapid economic growth.”97
Inequality is dealt with further in section 4.4.
4.2 – The financial sector
Already in 1985, the new president of Korea in 1997, Kim Dae Jun, wrote in his book that
“financial markets must be allowed to operate completely free of government interference in
credit allocation and interest determination.”98 This gave some clue into which direction he
would steer the financial sector after the talks in December 1997. In 1998, government
immediately began to close down unsound financial institutions and revitalise viable ones.
The institutions themselves pledged to the government to reduce staff levels by an enormous
32 percent.99 The rescue of viable banks took a toll on the government budget but was partly
paid by the IMF rescue package. Two state-owned corporations, the Korea Asset
Management Corporation (KAMCO) and the Korea Deposit Insurance Corporation (KDIC),
were reorganised to clean up non-performing loans – mostly caused by the interest rate hikes
around New year – and provide the necessary capital to strengthen viable banks. The figures
of the institutions were not included in the official budget balance. Would they be included,
talking about a contractionary policy would seem ridiculous, because it would raise deficit
figures from about 4 percent to 15 percent of GDP.100 This does not take away the fact,
however, that the IMF demanded other budget cuts around New Year 1998. Total government
debt also grew considerably, from 9 percent in 1996 to 23 percent in 2000.101 The result was
that financial institutions slowly came under government control and were, in fact,
nationalised. This was a completely different picture from the one the citation gives at the
International Monetary Fund, “Republic of Korea: Article IV Consultation,” IMF Country Report No. 06/380
(October 2006).
97
International Monetary Fund, “Republic of Korea: Selected Issues,” IMF Country Report No. 06/381 (October
2006).
98
Kim, Dae Jung, Mass Participatory Economy (1985), as quoted in Crotty & Lee, “Economic Performance.”
99
International Monetary Fund, “Korea Letter of Intent” (November 13, 1998).
100
Lee, Rhee & Sung, “Fiscal Policy,” p. 520.
101
Crotty & Lee, “Economic Performance.”
96
36
beginning of this paragraph. The Korean government therefore notified the IMF that these
nationalised institutions would be privatised immediately “as soon as market conditions
[would] permit.”102 With the injection of funds, the financial sector calmed and interest rates
were slowly lowered. In June interest rates were 16 percent and by the end of September, they
reached 7 percent.103 The central bank, the Bank of Korea, saw a changed mandate in which it
got independence with price stability. In the years after the crisis there was a much lower and
more stable level of inflation – hovering around 3 percent – than before the crisis.
Figure 4.1: flows to the business sector
Source: Bank of Korea
Meanwhile supervision of the financial sector was being adjusted to higher levels, and extra
regulation was introduced to prevent banks in taking excessive risks. However, the
requirements that banks had to fulfil were very stringent and higher than before. In the middle
of 1998 already, commercial banks had to meet the Bank for International Settlements (BIS)
capital adequacy ratios that required assets to be 8 percent of loans. 104 Merchant banks were
International Monetary Fund, “Korea Letter of Intent” (November 13, 1998).
“South Korea’s Alarming Recovery,” The Economist (July 31, 1999).
104
International Monetary Fund, “Korea Letter of Intent” (May 2, 1998).
102
103
37
handled more carefully with adequacy ratios of 6 percent during the second half of 1998 and
first half of 1999.105 Starting the second half of 1999, these banks had to comply to the 8
percent ratios as well. During this time of economic hardship the stringent capital adequacy
ratio criteria resulted in a decrease in the supply of loans as banks tried to raise their capital to
outstanding loans ratio. Both the financial and corporate sector were thus hampered in their
recovery. At the same time, the quality of supervision was not considered appropriate, even as
late as 2003. The World Bank judged that “[d]espite notable progress in prudential
supervision, concerns remain about the regulator’s ability to supervise certain risks in an
integrated, coherent manner and to respond to new challenges.”106 However, because prudent
supervision was almost absent before 1998, this was a much desired improvement.
In figure 4.1 the credit crunch of 1998 and 1999 that resulted from the economic chaos
is visible. The total flow of loans from financial institutions to the business sector turned
negative in 1998 and barely positive in 1999 after a disastrous second quarter that year. Total
flows dropped from about 140 trillion to little less than 30 trillion won. This drop was, among
others, caused by a drop in short-term securities. These bonds were one of the causes of the
crisis and the flow never fully recovered until 2005. The amount of loans from the financial
sector stayed volatile in the ensuing years, but showed a gradual rising trend. A similar trend
could be seen in the total amount of funds that reached flowed to the business sector.
During the credit crunch of 1998 and 1999, other means of finance were sought by
companies. In 1998, the issuing of long-term securities was especially popular while stocks
were a valuable source of finance in 1999. One third of the long-term securities that was
issued in 1998, was issued in the first half of the year when interest rates were still very high.
As soon as the flow of loans from financial institutions recovered somewhat, the issues of
stocks and bonds declined.
4.3 – The corporate sector
In the corporate sector, a number of ailing firms has also been forced to close down, and with
help of creditor banks, viable companies were helped back on their feet again. Reform in the
corporate sector was based on five principles:
International Monetary Fund, “Korea Letter of Intent” (May 2, 1998); International Monetary Fund, “Korea
Letter of Intent and Memorandum of Economic Policies” (March 10, 1999).
106
World Bank, “Financial Sector Assessment Korea,” Report no. 26176 (June 2003), p. 2.
105
38
The enhancement of transparency in corporate management; dramatic improvement in
capital structure; the abolition of cross payment guarantees; the selection of core sectors
and the strengthening of cooperative link-ups between large enterprises and SMEs; and
heightening the accountability of majority shareholders and management.107
The above-quoted measures reduced chaebol power by forcing sales and mergers of sub
companies, new financial transparency standards and greater accountability for chaebol
management. The government could effectively steer their activities because it had
nationalised the big banks on which the chaebol were dependent. The creditor banks forced
them to redirect their business activities and cut down debts. Firms had to cooperate with the
banks with business swaps or their credit line would be cut off.108 This was not an empty
threat because Daewoo, the third largest chaebol, was forced into bankruptcy in August 1999
after it increased its debt by 40 percent in 1998 when other big chaebol were cutting back.109
By the end of 2000, more than a hundred firms went bankrupt when government controlled
banks refused to provide any more credit.110
Chaebol power was limited further by allowing foreign hostile takeovers and new
capital account liberalising measures. The latter was carried out in two stages. The second
stage was carried out at the end of 2000 after enough progress in strengthening the financial
sector had been made and, thus, entailed measures that were still restricted after the first stage.
Still, after the second stage a number of restrictions were kept in place, such as the prohibition
of short-term borrowing by “unsound” companies.111
Kim believed that more foreign influence in the Korean economy would lead to
modernisation.112 One of the most drastic measures was to force firms to give half of the seats
on the board of directors to foreigners. Decision-making would, thus, be less controlled by
insiders and become more transparent. By 2000, the situation was not yet as it had been
envisioned by the government, although improvements had been made. Outsiders were often
absent at board meetings and voted affirmatively in almost all management decisions.113
Bank of Korea, “The Korean Economy” (December 2006), p. 14.
Crotty & Lee, “Economic Performance.”
109
“The Death of Daewoo,” The Economist (August 19, 1999).
110
Crotty & Lee, “Economic Performance.”
111
International Monetary Fund, “Korea Letter of Intent and Memorandum on Economic and Financial Policies
for 2000” (July 12, 2000).
112
Crotty & Lee, “Economic Performance.”
113
Crotty & Lee, “Economic Performance.”
107
108
39
Figure 4.2 gives an overview of the main business indicators of Korea. The picture
that it gives is generally very positive and it seems that reforms have resulted in real change.
One of the fundamental weaknesses that enabled the panic of late 1997 was the high debt ratio
of firms in Korea. When banks started to experience difficulties, firms were asked to pay back
loans and the credit crunch was born. Furthermore, the interest hikes in the beginning of 1998
became an enormous burden on the highly leveraged companies. With the exception of,
notably, Daewoo, firms cut back debt and the debt ratio plummeted from a sky-high average
of 425 percent in 1997 to 235 percent in 1999 and 111 percent in 2005. Firms are now less
sensitive to a credit crunch or big interest rate increases.
Figure 4.2: industrial financial statement indicators
Source: Bank of Korea
The current ratio, a measure that serves as an indicator of short-term financial health used to
be below 100 percent till shortly after the crisis, indicating that short-term, or current
liabilities were higher than current assets. This was an indicator that companies could get in
trouble over their short-term obligations, which they, of course, did. In 2001, the ratio reached
100 percent and climbed steadily to a healthy 122 percent in 2005. Corporations have become
financially healthier with respect to the short-term.
40
Have corporations become more profitable after the crisis? Operating income (or
profit) has stayed roughly similar to pre-crisis levels. Ordinary profit has risen considerably
but this can simply be attributed to lower interest payments. The interest rates also explain the
sharper drop in ordinary profit than in operating profit during the crisis years. Looking at
figure 4.2, the debt ratio and ordinary profit to sales ratio move in opposite direction. This
shows how much profit rates of Korean industry were dependent on interest payments.
Interest payments to sales ratio dropped from an average of about 5 percent before 1998 to a
little more than 1 percent in 2005. In this respect, firms have also become financially more
healthy by structurally reducing debt levels.
Overall, firms have become more healthy and less prone to outside risks. Transparency
and accountability increased so a similar crisis is less likely to happen in the future. The only
worrisome development, as stated before, is the lower investment ratio in the Korea economy.
However, it is still much higher than, for example, the investment ratio of the Netherlands
which hovers around 20 percent, and that of the United States which hovers between 15 and
20 percent.114
4.4 – The labour market
Before the crisis, labour laws in Korea were relatively rigid, unemployment levels were low
and unions considered militant.115 Korea was thought to be in a state of full employment were
laying off workers was extremely cumbersome. The rescue packages of December 1997
argued that it was necessary to break the power of the unions and increase labour flexibility to
stimulate more foreigners to invest in Korea. Because of the severity of the economic crisis
and high unemployment in 1998, unions lost considerable bargaining power and excepted
most of the changes in labour law put forward by the Kim administration.116
The year 1998 saw, therefore, two important events: the unemployment rate rose
steeply and far reaching reforms increased labour flexibility. For the chaebol, increased
flexibility was not necessarily a bad thing because it enabled them to fire workers in great
numbers during the time of economic hardship. Increased flexibility probably contributed to
an increase in the unemployment rate in the short-run and it led to an increase in the number
114
Centraal Bureau voor de Statistiek, Macro-economische Saldi; United States Department of Commerce,
Bureau of Economic Analysis, National Economic Accounts.
115
Crotty & Lee, “Economic Performance.”
116
Crotty & Lee, “Economic Performance.”
41
of temporary jobs. Agencies that specialised in helping people find temporary work were
legalised in the summer of 1998.117
Rising unemployment and increased worker insecurity forced the government to
reform the welfare system. Social spending used to be very low before the crisis, but rose
substantially after. In figure 4.3, it can be seen that social benefits in cash were less than 5,000
billion won in 1997 and rose to about 16,000 billion won in 2005. A better measure is to
compare benefits to the GDP level. With respect to this indicator, one can, arguably, speak of
a permanent increase as well.
Figure 4.3: social benefits in cash paid by the government
Source: Bank of Korea
Before the crisis, labour costs had been gradually declining. With new laws on more labour
flexibility in the economy, the cost of labour showed an even bigger decline as companies
began to hire more temporary workers to cut costs. They did this with such vigour that the
OECD reported in August 2003 that Korea had the highest number of non-regular workers.118
Crotty & Lee, “Economic Performance.”
International Monetary Fund, “Republic of Korea: Selected Issues,” IMF Country Report No. 04/45
(February 2004).
117
118
42
Labour costs to sales declined from 12.5 percent in 1996 to 9.6 in 1998, and labour costs to
operating costs declined from 18.8 percent in 1996 to 14.7 percent in 1998.119 After 1998,
labour costs to operating costs stayed roughly constant and labour costs to sales actually
increased slightly. The trend in labour costs was of a dual nature. Regular workers saw their
wages rise near “double digits” after the crisis while non-regular workers saw their wages
stagnate, causing rising inequality in society.120 The IMF was happy with the reforms of 1998
but witnessed a decline in the enthusiasm for labour reforms afterwards. As a result, Korea
kept having the second highest strict labour laws with respect to regular workers of the
OECD.121 Simultaneously, safety nets for non-regular workers have been inadequate, despite
an improvement during the recession.
4.5 – The reforms and the IMF
The majority of the above mentioned measures that were taken during the economic recession
in Korea were made with the approval stamp of the IMF. The multitude of Korean Letters of
Intent that were sent to the IMF up to the end of 2000 showed that Korean officials had to
continuously account for the implementation of their economic policies. Especially the
restructuring of the financial sector was in close cooperation with the IMF, while the World
Bank participated more in the field of corporate restructuring.122
Chapter 3 showed the short-term implications of the IMF package. They obviously did
more harm than good in 1998 but nonetheless cured the balance of payments disequilibrium
that resulted from the outflow of funds from Korea. This chapter focuses more on the midterm performance of the Korean economy. The IMF was involved for many years in
restructuring the Korea economy and often meddled with affairs outside its traditional
purposes.
After the currency plunge debacle of late 1997, the IMF sought to stabilise the
currency. The insistence that the central bank of Korea should obtain more independence
resulted in lower and more stable inflation rates after the crisis. This, in turn, was a
119
Bank of Korea, Economic Statistic System, Financial Statement Analysis.
International Monetary Fund, “Republic of Korea: Selected Issues,” IMF Country Report No. 04/45
(February 2004).
121
International Monetary Fund, “Republic of Korea: Selected Issues,” IMF Country Report No. 04/45
(February 2004).
122
See, for example, International Monetary Fund, “Korea Letter of Intent and Memorandum of Economic
Policies” (March 10, 1999).
120
43
prerequisite for a stable exchange rate and macroeconomic environment, but would not
necessarily lead to high economic growth rates, because higher inflation before the crisis went
hand in hand with high GDP growth. Promoting exchange stability was one of the main
purposes of the fund and it did achieve some level of stability after the plunge of 1997.
The rebound of the financial sector after the losses of 1998 took a couple of years.
Only since 2002 did flows from the financial sector to the corporate sector stay positive for a
longer period. With help of IMF funds and extra government budgets viable banks were
helped to keep afloat so that a full collapse of the financial sector was averted. Funds were
thus effectively used to cure the capital account disequilibrium and prevent full disaster.
However, the demands to financial institutions for financial prudence during the recovery
were timed too early, which led to a capital squeeze and unnecessary panic. In the medium
run these demands made more sense and the financial sector evolved into a healthier one.
Combined with measures that provided more transparency and accountability, the financial
sector improved after the crisis. The IMF was especially committed to restoring the financial
sector because of its financial expertise and because a healthy sector was a condition of future
repayment of the Fund’s loans. The IMF purposes stated that its sources were only available
under adequate safeguards, and the reforms that it demanded in the financial sector could be
seen in this light.
Another area of expertise of the IMF was the liberalisation of the capital account, or
the elimination of foreign exchange restrictions. Wisely, short-term transactions to unviable
companies were kept restricted for a longer period. Next to these liberalising measures,
foreigners were provided with more and better opportunities in the Korean economy. From
the viewpoint of the IMF, there was no clear economic rationale available for demanding
these latter measures to be undertaken, let alone that it was mentioned somewhere in the
Fund’s purposes. These were demands from the U.S. Treasury and were willingly
implemented by a reform-minded and liberal Korean government. The value added of these
measures to the Korean economy is regrettably beyond the scope of this thesis.
The above mentioned reforms were implemented by Seoul to break the power of the
chaebol. With help of especially the World Bank, corporate restructuring plans were
formulated. These did not necessarily attack the root causes of the crisis and were often
politically motivated. In spite of economic disaster, president Kim scored approval ratings of
80 percent in 1998 by attacking the hated chaebol.123 Shareholders obtained greater power
123
Crotty & Lee, “Economic Performance.”
44
and the business activities during and shortly after the crisis were controlled by the big
creditor banks that had been effectively nationalised. The government went as far as to
announce to the IMF that “the dismantling of Daewoo [was] a major breakthrough” in the
process or corporate restructuring.124 Reforms that did tackle the root causes of the crisis were
also implemented. Most important was the emphasis on lowering debt to equity ratios. From
1998 onwards, the average debt ratio of the Korean economy declined year by year while
profits to sales grew. A rising current ratio also showed that short-term financial health
increased. These results have greatly increased the possibility to use high interest rates to
defend the currency in a future currency attack, without doing severe harm to the corporate
sector.
The demands of the IMF for reforms in the labour market were perhaps the most
controversial of all in the rescue packages of December 1997. These reforms had no direct
link with the crisis and were outside of the Fund’s purposes. Indirectly, labour reforms could
encourage foreigners to invest more in Korea, but this claim was, most of all, relevant to the
longer term. To the Fund’s annoyance, labour reforms were only carried out half-heartedly so
that permanent workers kept enjoying their privileges while the group of temporary workers
exploded in numbers and became relatively underpaid.125 The IMF voiced its concern on fast
rising inequality but by that time it had lost its big influence on the Korean economy. 126
Regrettably, more flexibility actually led to higher unemployment levels after the crisis but
they still compared relatively well to the OECD average
, which was 6.6 percent in 2005.127
The IMF asked the Korean economy to be treated by the so-called ‘shock therapy.’
New rules and standards were implemented on very short notice and did not all create shortterm benefits. In the medium run the economy recovered fairly well. There is now more
oversight and transparency, and the chance of another crisis of similar nature has been
reduced greatly because corporate debt ratios have been lowered and net external assets have
turned positive with the help of a current account surplus. Now, the central question that was
posed in the introduction of this thesis needs to be answered to see whether the IMF has truly
been of help to Korea in the short and medium run and stayed true to its organisation’s
mandate. This is done in the next chapter.
International Monetary Fund, “Korea Letter of Intent and Memorandum of Economic Policies” (November
24, 1999).
125
International Monetary Fund, “Republic of Korea: Selected Issues,” IMF Country Report No. 06/381
(October 2006).
126
The IMF standby agreement ended on December 3, 2000.
127
Organisation for Economic Co-operation and Development, Statistics Portal.
124
45
5 – Conclusions
In the introduction, the main purpose of this thesis was sketched. I wanted to find out whether
the International Monetary Fund handled the East Asian Crisis in South Korea economically
sound in both the short and medium run, and whether it acted according to the organisation’s
purposes. First of all, the thesis elaborated on the structure of the Korean economy, the recent
history of the IMF, and the history of, to a lesser degree, the United States Treasury
Department. Subsequently, the crisis itself was studied, focussing on the negotiations, the
results and the IMF rescue package. Finally, the Korean economy and reforms in the years
after the rescue package were examined to see whether the rescue package and reforms
benefited Korea. Chapter 3 and 4 repeatedly fell back on the historical background that was
given in chapter 2 to explain the behaviour of the IMF and test its dealings with respect to its
purposes.
The IMF did not, but could have foreseen the Korean currency crisis. Short-term
foreign denominated debt had already caused two crises in Mexico and did so again in Korea.
Probably because the crises looked similar, the Fund’s demands were comparable. The main
purpose of the IMF should have been correcting the balance of payments disequilibrium, or in
other words, reversing the outflow of funds from Korea. Through the standby agreement, the
worst was avoided. The disequilibrium was still there in theory, though. Before the agreement
expired, the disequilibrium had to be corrected. As could be seen in chapter 3, this happened
at large cost. The short-term effects were disastrous and GDP fell by 7 percent in 1998.
However, through the fall in aggregate demand, the balance of payments disequilibrium
disappeared when the current account turned into a huge surplus. The traditional IMF
demands for high interest rates could be defended, but demanding a balanced budget to build
up foreign currency reserves did not make economic sense when demand was falling and the
won was depreciating. As in Latin America, the IMF initially chose to prevent default by
defending the currency and make preventing harm on national prosperity of secondary
importance.
Measures that had to restore confidence hardly worked in Latin American and surely
did not work in Korea after a leak showed the true status of the Korean official reserves.
These measures, however, did have far reaching implications on the Korean economy because
they were often of a structural nature. A number of these measures neither had any direct link
to the crisis nor should have been demanded by an organisation as the IMF. That they would
46
quickly restore confidence in the Korean economy was doubtful; that they had long-term
implications was certain. Especially the demands to open up the Korean economy to
foreigners and reform the labour market would not cure the balance of payments equilibrium
and benefit the Koreans in the short run. They were furthermore not part of the Fund’s
purposes and should not have been demanded because of the long lasting effects. The
annoyance of IMF staff to these reforms being demanded showed that Treasury had
considerable power in negotiating the IMF rescue package.
Other structural measures can be defended better. The reforms in the corporate sector
were more nationally motivated and conducted in close cooperation with the World Bank.
These resulted in a healthier business sector with higher profits and less reliance on debt
finance. The IMF was committed to reforming the financial sector. Although it can be argued
that it should have stuck to a short-term medicine that would cure the capital flight and
currency plunge, the reforms in the financial sector served as a safeguard for the repayment of
the IMF loan. Asking financial institutions for financial prudence should have been timed
later after the worst of the recession had been over, for it only added to the sense of panic. In
the longer run, better oversight and more transparency have made the financial sector better
off. Further reforms of the capital account were part of the IMF purposes although these did
not state that it should involve more liberalising. These measures were probably a long wish
of the IMF because its inclusion in the rescue package could only send signals to foreign
creditors that they might benefit in the medium run, instead of reducing the balance of
payments disequilibrium in the short run. Although the open flow of short-term capital had
caused the crisis, the liberalising of the capital account was done responsibly in steps. The
final liberalising reforms were put into place after the net external assets position of Korea
had turned positive.
At the end of the researched period, the year 2005, Korea has definitely become less
prone to crises. The crisis, a reform minded government and the IMF improved parts of the
economy that have made it safer from negative investor sentiments. The years after the crisis
also brought bad things. Unemployment and inequality were structurally higher and
investment to GDP structurally lower. Nonetheless, these benchmarks still compare very
favourably to other OECD countries.
Has the IMF acted economically sound and stayed true to its purposes? Both yes and
no. It stayed partly true to its purposes because during the currency crisis, fighting for both
exchange rate stability and bringing no harm on national prosperity was impossible. When it
did go beyond its purposes by demanding far reaching reforms, it was usually pressured by its
47
biggest shareholder, the U.S. Treasury. Economically speaking, the argument also goes both
ways. The standby agreement was a very sensible thing to do although it came rather late. The
high interest rates could be justified as could the idea of financial sector reforms. The latter
was timed too early which resulted more panic. Initially asking for a budget surplus was
insensible and the IMF later admitted it had been wrong in this field. With respect to the cause
of the crisis, the reforms demanded by Treasury could not be explained economically.
Thinking away the influence of the U.S. Treasury, the IMF did not perform as bad in Korea as
some economists have written to their readers. Although real changes are unlikely, it would
be wise to reduce the influence of the economic agendas of the Fund’s shareholders and let it
stay true to its economic principles.
48
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51