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Korean Economy -
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Korea's Economic Crisis of 1997
On October 1997, the Korean Stock Exchange began to plunge followed by a sharp fall of the Korean Won against dollar. Economies in Southeast Asia such as Thailand and Indonesia have already developed instabilities in their markets, to termed "crises", and the changes occurring in Korea was seen as a part of a regional contagion effect deriving from the Southeast Asian crisis. However, by November 21, Korea's foreign reserves were nearly depleted, and to prevent the total collapse of the economy, the government announced that it would seek emergency loan from the International Monetary Fund (IMF) to overcome the difficulties in the financial and currency markets.
Causes of the Economic Crisis
Throughout the 1990s, the structure of the Korean economy has become increasingly vulnerable to unfavorable shocks. The vulnerability came from two sources. First was the overly short-term oriented external debt structure and insufficient foreign exchange reserves. Korea's external debt to GDP ratio has been rising rapidly and continuously since 1994 as comprehensive financial deregulation proceeded. Rapid increases in private sector borrowings including both direct borrowings of corporations and bank borrowings to finance the corporate investment, accounted for most of the external debt increase.
While the external debt to GDP ratio reached approximately 25%, not an unsustainable level given Korea's economic growth potential, the rapid increase of short-term debt and the term-mismatches were clearly signs of possible external liquidity problems. By the end of 1996, the share of short-term debt out of the total external debt peaked at 58 %, while the foreign exchange reserve remained low.
The second factor behind Korea's economic vulnerability was the highly leveraged corporate financial structure. The corporate debt relative to nominal GDP ratio was lowest in 1987-1988 when Korea enjoyed current account surpluses. However, since then, the ratio increased substantially to reach over 1.6 in 1996. Due to the highly leveraged financial structure, largely driven by the over-investments of Korean conglomerates, chaebol, the corporate sector has become increasingly vulnerable to unfavorable shocks.
Such deficiencies in Korea's economic structure were the legacies of its past development process. The 30 years of government-led growth process created a close and collusive relationship between the government and chaebol. Chaebol often engaged in projects at the government's bidding and the government, in turn, implicitly provided insurance against project failures. The society as a whole came to accept the so-called "too-big-to-fail" expectation. Under such a belief, the business firm's main concern became expansion in size rather than to earn profits. To finance the expansion of businesses, firms chose the option of debt-financed growth rather than equity-financed growth. The high debt-equity ratio that resulted from such strategy exceeded 400 % by the end of 1997, and the average ratio for the 30 largest chaebol reached 518 %. These figures are approximately twice the rate of Mexican firms and four times the rate of Thai firms at the time of their crises.
Unfavorable terms of trade shocks in 1996 severely damaged profits of Korean corporations in 1997. Series of corporate bankruptcies, even among the major chaebols, including Hanbo, Kia and Yuwon, increased the size of outstanding non-performing bank loans at an astounding speed. The deterioration of the corporate sector translated into the weakening of the financial sector. The stringent lending policies adopted by financial institutions in an attempt to minimize the effects of a worsening economic situation, resulted in the shortage of capital which futher increased the number of bankruptcies.
Responding to the precarious economic situation, the government launched the Presidential Commission for Financial Reform to begin a comprehensive reform of the financial market. In the labor market, a separate Labor Reform Commission was launched in early 1997. But such early actions taken to prevent further economic deterioration failed due to several reasons. First, conflicts soon surfaced as the Presidential Commission for Financial Reform and the Labor Reform Commission began implementing sectoral reform measures.
At the time, the administration of President Kim Young Sam, who was also nearing the end of his term in office, could not provide necessary leadership to aid those reform efforts. Second, the government's unwarranted heavy-handed actions taken subsequent to the bankruptcies of Hanbo and Kia disappointed foreign investors. Finally, the Ministry of Finance and Economy's inadequate handling of the developing foreign exchange crisis finally brought in a bailout fund from the IMF.
In other words, insolvent corporations and financial institutions damaged Korea's credibility abroad, leading to foreign capital flight. The vicious cycle of foreign exchange shortage and deterioration of Korea's credibility developed into a full-fledged foreign exchange crisis at the end of 1997.
Information provided by the Korean Embassy