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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) 2 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. 4 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. 6 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 8 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 9 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 10 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. 11 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 13 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 14 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. 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