Chaebol Capitalism and the Currency-Financial Crisis in Korea

Comment

Jorge Braga de Macedo

OECD and NBER

Anne Krueger, one of the world experts on Korea, has joined forces with Jungho Yoo to understand the factors leading to the financial crisis of late 1997. The authors suggest a chain of causation going from "chaebol capitalism" to the collapse of the won, via weak banks and excessive foreign borrowing: as stated in the conclusion, the "chaebol were in weak financial condition long before the crisis", the extreme vulnerability of the system being due to the fact that "banks were 'evergreening' the chaebols' outstanding debt". In short, "the Korean crisis was a disaster waiting to happen".

In terms of diagnostics, Krueger and Yoo conclude that there was no currency trigger for crisis but rather that the increase in interest rates made chaebols' debt to banks harder to service. Since exports helped recovery, they surmise that the path of stabilization was probably appropriate. The paper ends with the argument that "the necessity of restructuring the finances of the chaebol first" made "the post-crisis workout of the banking system extremely difficult". Depending on whether the difficulty is overcome or not, then, future prospects will be better or worse.

While Krueger and Yoo do not attempt to measure the relative importance of each one of the four factors they mention, Dekle and Kletzer in this volume show a fairly consistent pairing of Korea and Thailand on the one hand and Singapore and Taiwan on the other in terms of rising financial reputation. Malaysia is somewhere in between, and the debate continues on whether its response to the crisis was special. In this volume Rudi Dornbusch shows convincingly that this is not so, while Kaplan and Rodrik present evidence in defense of the Malaysian way.

According to the latest OECD country survey, the sustained recovery of the Korean economy is threatened by the possibility that reforms may stall. Since then, of course, the rise in the price of oil and the slowdown of world growth have also taken toll as output fell in the fourth quarter of 2000. In this comment I plan to elaborate on this point and assess whether the crisis helped bring about structural reforms which could prevent future crises. In so doing I will go back in time and I will follow the historical and institutional approach Krueger and Yoo but giving a perhaps greater weight to the ambiguity of domestic liberalization in Korea, following the common description of the country as "permit kingdom".

With respect to the "currency-financial crisis" itself, it is generally ackowledged that a financial crisis with severe real consequences on the economy typically involves a combination of exchange rate devaluation, debt service difficulties and banking failures (Dornbusch in this volume, Macedo 1999) and that the three elements were undoubtedly present in Korea. Moreover, recalling earlier NBER work on the Korean financial crisis, summarized in Mc Hale (2000), it is evident that noted Korean economists tend to see this crisis as a good example of contagion through herd behavior, rather than a "disaster waiting to happen".

Hopefully, bringing the analysis back in time and giving greater weight to domestic distortions will help promote consensus on the Korean pattern of development, which was once described as a "miracle" but has recently come under closer scrutiny, notably through the regular OECD peer reviews.

KOREAN MIRACLE?

Korea can certainly be seen as one of the best examples of what was called "Asian miracle". Not only was its1960 GDP per capita was about the same as Sudan's but growth expectations at the time were also higher for Africa than for south east Asia. Krueger and Yoo coin the elegant phrase of an "export theory of value" held by Korean policymakers over the last four decades, illustrating the power of export-led growth over import-substituting industrialization.

This power has been recognized since at least the work of Ian Little, Tibor Scitovsky and Maurice Scott at the OECD Development Centre in the late 1960s. Anne´s Stanford colleague Ron McKinnon (1973) pointed out, however, that financial development was often neglected in the assessment of experiences of export-led growth, which often focused on trade in goods and services rather than in assets. International trade theory shows that value comes from imports not exports so that the export theory of value is bound to tolerate or even to create domestic distortions. The distortions may pertain to domestic factor mobility between sectors, as captured by the traditional Fei-Ranis two-sector model of domestic labor mobility from agriculture to manufacturing. This model was taught for many years at the Yale Economic Growth Center as a rationalization of the Asian miracle. But there are many other sources of distortions, from imperfect competition in goods markets to financial repression.

At the Growth Center's 25th anniversary conference, McKinnon introduced macroeconomic instability as an additional distortion and showed how this distorsion exacerbated the Stiglitz-Weiss equilibrium credit rationing brought about by the inability of banks to perfectly monitor project returns. Indeed, McKinnon (1988, p. 390) noted that, compared to Japan, Taiwan and Singapore, Korea in 1980 "had a much lower ratio of M2 to GDP (0.34) and had to make up for this shortage of domestic loanable funds by borrowing heavily abroad". Again, the Singapore and Taiwan pair is close to the Japanese benchmark.

The interaction between macro instability and the covariance of returns is bad enough. In Korea, though, the determining factor of the crisis may have been the interaction between industrial and financial structure associated with the export theory of value thought to be behind the Korean miracle.

INDUSTRIAL AND FINANCIAL STRUCTURE

The latest OECD survey summarizes Korea's industrial structure as follows. "One dilemma for Korean policymakers, both before and after the crisis, has been setting appropriate policies to deal with the chaebols, which have played a key role in the country's economic development. Chaebols are large conglomerates linking many individual companies - an average of 27 in 1997 - that are diversified across a wide range of industries. The companies are linked by centralized family control and management, ownership links and mutual debt guarantees that facilitate high levels of leverage. At the beginning of the 1980s, the autorities were faced with two possible methods of dealing with the chaebols, a transition to a free-market economy in which the pressure of stakeholders, competition, both domestic and international, and the threat of bankruptcy would discipline chaebol behavior; or the use of various regulations on financing, investment and loan guarantees to control the chaebols.

The authorities relied primarily on the latter approach to limit the role of the conglomerates. This choice, however, has had several negative consequences. First, it implied considerable government intervention in the private-sector's economic decision-making, thus limiting the role of market forces. The negative impact was compounded by the lack of an effective corporate governance framework to guide management decision-making. Second, it created considerable moral hazard for chaebols, which were essentially protected from bankruptcy. Policies to limit the role of the conglomerates were accompanied by measures to assist small and medium sized enterprises (SMEs), which, nevertheless, remained a relatively backward part of the Korean economy.

Korea's industrialisation was led by large firms affiliated with the chaebols. During the 1960s and 1970s, SMEs accounted for only a third of growth in value-added and less than half of the rise in employment. Since the end of the Heavy and Chemical Industry drive of the 1970s, government policy has gradually shifted to place more emphasis on assisting SMEs in ways that have not always been market-conforming".

As the literature on financial structure in Japan and Germany quoted by McKinnon (1973 and 1988) emphasizes, the preference for conglomerates including financial institutions (called grupos in Latin America) has disadvantages that become apparent during the process of economic development. The effects of a financial structure linked too closely with the industrial structure go beyond the efficiency with which savings is transformed into productive investment. Under the grupos system, no domestic constituency for financial freedom arises, and that bail out guarantees become part of corporate culture. As illustrated by Macedo (1996) for the Portuguese change in economic regime towards stability in convertibility which preceded the creation of the euro, all of this makes the combination of political and financial freedom appear less relevant, thus threatening the growth of civil society.

Other examples can be gathered from Latin America and Europe. Perhaps the most celebrated case is the bailout of Banco Osorno in 1997 by Chilean authorities, to which Carlos Diaz Alejandro attributed the banking crash of a few years later. Some work along these lines has been carried out for European countries in the process of development (Macedo, 1988) and the role of the curb market in Korea and Turkey was investigated in Sweder van Winjbergen's Ph.D. dissertation at MIT in the late 1970s. Recently Bradley (2001) contrasted the Korea to the Irish model, with the latter encouraging "export-oriented foreign investment inflows", in contrast to the former's exclusive objective of "capturing greater export market share".

In other words, to understand "chaebol capitalism"it is essential to go back to the heavy and chemical industry period in mid-1970s, which not coincidentally was used as model for Portuguese nationalization of banks and insurance companies in 1975 by the industry minister João Cravinho

Note that chaebols are not allowed to own banks -- the 4% limit on bank ownership is designed specifically to exclude them. However, they have been allowed to own non-bank financial institutions and have used them as cash cows, with the result of a falling market share for banks. In sum, when the Korean administration embraced globalization in early 1990s, it did not put in place the appropriate governance structures, and the question is whether this contradiction remained after the crisis.

CRISIS AND RECOVERYIn spite of the distortions in the industrial and financial structure, there was no sense of vulnerability, instead complacency was widespread in policy circles as the 1997 presidential election neared. No one thought of calling the IMF in the summer of 1997 (notwithstanding the gloom Anne observed then). Indeed, during the NBER meeting on Korea's crisis, Jeff Shafer made it clear that banks were not asked to coordinate a response in November. Dooley-Shin (2000) note that central bank deposits in foreign currency rose from zero to $ 5b in the week of 17 November and to $10b in the week of 24 November: this rate would have exhausted reserves by the time IMF program was announced. Dooley-Shin (2000) also report that the rollover of credits falls to 24% in first week of December from a 50% average in October. As they note, the lack of reliable figures on useable foreign exchange reserves, foreign debt, non performing loans, etc. was astonishing. Whatever the initial complacency, once the debt/banking crisis hit, combinig the end of the passive dollar peg with tight money my have been the only viable alternative, even though there is still a huge controversy in Korea about the appropriateness of the IMF's monetary conditions.It is widely recognized that the Korean recovery was faster than that of other OECD economies which were hit by financial crises, namely Mexico, Turkey, Sweden and Finland. The main reason noted in the OECD survey is that import compression was greater in Korea than in the other countries, to the point that the current account balance moved into a surplus which reached 13% of GDP. The increase in reserves was sterilized, so that there was no increase in inflation. Wage flexibility is another reason for the subdued response of inflation to the sharp fall in the currency. The decline in nominal wages in 1998 prevented a wage-price spiral. The central bank was given independence in matters of monetary policy, with a regime which can be characterized as "quasi inflation targeting" at a rate set around 2.5% p.a. But the monetary regime remains ambiguous because there is the objective of seeking a current account surplus, which may confuse the market. In addition, an activist fiscal policy towards SME is being implemented and there is a tradition of government handouts to enterprises which may not have been fully overcome yet, even though the stated objective is to promote the new economy. This explains part of the debt buildup (with debt reaching 40% of GDP), even though much of that is government-guaranteed debt related to financial-sector restructuring. The danger of expenditure rises due to social safety net, North Korea and tax reform may be lesser now than it was in 2000, but, on the other side, Korea is set to have the most rapid ageing process of any OECD country. The structural reforms brought about by the crisis pertain therefore to the macroeconomic regime, including the independence of the central bank, more effective financial supervision, the beginning of public debt management and more transparent budgetary procedures. As a new government framework cannot change the industrial and financial structure, more progress is to be expected in areas related to the issue of how the government is dealing with the chaebols, such as competition policy, regulatory reform and corporate governance. Until then, there are conflicting signals. On the one hand, the government limits and controls the chaebols through the Fair Trade Commission, which enforces rules on intra-group dealing, cross-ownership, debt guarantees since the late 1980s. On the other hand, the government is involved in guiding companies' decisions. COMPETITION One measure of competition, the degree of mark-up of prices over costs for manufactured goods, suggests that - before the crisis - competition was relatively weak in Korea compared to other OECD countries, since it was found to be 36 per cent in Korea compared with 25 per cent in Japan, 20 per cent in Germany and 15 per cent in the United States. After recent initiatives to promote competition through reforming government regulations, strengthening competition policy, reducing trade barriers, encouraging inflows of direct foreign investment and privatizing state-owned enterprise, it can be said with the OECD regulatory review that "the competition law and competition authority are well designed, consistent with good international practices. The most serious kinds of horizontal agreements are now treated more harshly and the Fair Trade Commission is moving away from a purely structural approach to abuse of dominance. Most statutory exemptions have now been eliminated. Enforcement processes are adequate, although more power to collect evidence would be welcome, and criminal sanctions may not be effective. Consumer protection is also the responsibility of the competition agency, helping ensure that consumers see the benefits of market-based reforms. Competition authorities have also been responsible for chaebol policy, though many chaebol policies deal with corporate governance and financial prudence rather than with competition policy. Chaebol reforms may also involve conventional competition policy issues such as market domination, exclusion, and discrimination, that can be dealt with using consistent economy-wide principles".After the crisis, the Korea Asset Management Corporation was created to buy bad loans, and it has been very successful in selling those loans to private investors. However, there have been no sales of the government shares in re-capitalised banks held by the Korean Deposit Insurance Corporation. . There also remains considerable ambiguity about the extent of government involvement in enterprises. This is especially worrying in view of likely political paralysis towards the end of the year with both presidential and local elections scheduled in 2002. Since the crisis, the chaebols have restructured by reducing debt-equity ratios and cutting the number of affiliates. Hyundai, in particular, will soon become three separate chaebols, as shareholding ties are cut. This is a positive development since it limits the risk of chain insolvencies. Nevertheless, the chaebols as a group remain highly indebted (they increased equity more than cutting debt during the sharp 1998-2000 upturn). REGULATORY REFORM Quoting the survey, "the conglomerates' measures to reduce the number of affiliates and sell assets created competitive opportunities for SMEs. In addition, the requirement that chaebols lower their debt to equity ratios to 200 per cent reduced their borrowing from banks, improving loan availability for smaller firms. Indeed, SMEs accounted for 46 per cent of the increase in bank lending in 1999".According to the review, new disciplines of transparency and market principles are needed throughout the entire policy apparatus, at all levels of government. Massive deregulation was accomplished in 1998-99, when the number of government regulations was cut by nearly 50%. Reforms are now shifting to more pro-active and comprehensive attention to regulatory quality and institution-building. Institutions have been established to promote regulatory reform at political and administrative levels. Korea has taken steps to improve regulatory transparency, though representation of stakeholders in decision-making should be broadened. Korea's programme of regulatory impact analysis (RIA) is well conceived, though implementation by the ministries remains weak and new legislation proposed by the members of parliament is not subject to RIA. Transparency and accountability would be boosted by establishing independent sectoral regulators. Implementation is a high priority now to embed new practices throughout the public administration, since, as President Kim Dae-Jung said, "Reform must begin with the government".CORPORATE GOVERNANCE In spite of the reforms induced by the crisis, the survey argues that the creation of a strong corporate governance framework will require significant changes in Korea's corporate culture. To hasten such changes, detailed, prescriptive legal measures that in some cases go beyond those found in other countries are needed to achieve fundamental change. For example, while outside directors are required to make up at least 50% of the boards of directors at listed companies, there is a big doubt how independent these "independent" directors are.To promote further improvements in this area, the Ministry of Finance and Economy established the Committee on Improving Corporate Governance in March 1999. The committee, which consisted entirely of private-sector experts, issued a "Code of Best Practices" in September 1999. The recommendations of this committee, in line with OECD principles for corporate governance, are voluntary. However, the Korea Stock Exchange has required listed companies to provide information to their shareholders about the extent to which they conform with the Code. The efforts of Jang Hasung, who participated in the OECD Development Centre´s workshop on corporate governance in the Spring of 2000, have been well publicized as can be seen, e.g. in Economist, Hamlin, Larkin, Lee and Scott. A recent example of improved corporate governance is the refusal of other chaebols to assist Hyundai Engineering and Construction when it teetered on the edge of bankruptcy, in spite of the government's encouragement. The other chaebols were afraid of being sued by minority shareholders.CONCLUSIONThe Korean case suggests four possible lessons for crisis prevention1. Even with a crisis, you can't import credibility, instead you need to earn it in domestic market institutions. 2. There are many exchange rate/convertibility options besides the two corner solutions of a currency board and pure float, and the exact solution should recognize that financial freedom interacts with political freedom and therefore that a constituency for capital account openness cannot arise unless financial supervision is operative. This is developed in Macedo, Cohen and Reisen (2001).

3. Peer pressure mechanisms are useful to intermediate the process of earning credibility and this can be facilitated by regional surveillance. In addition to the worldwide surveillance provided by the IMF and of the peer pressure derived from OECD membership, the mechanism adopted by the EU can be helpful. This is evident in the ASEAN+3 swaps (also called the Chiang Mai initiative). The alternative chosen by Taiwan, stressing bilateral rather than multilateral surveillance mechanisms, implies a high standard as pointed out at the outset. The caveat aboiut peer pressure suggested by the European experience, as reviewed in Macedo (2000) and in Macedo, Cohen and Reisen (2001) is that entry conditions may not be as effective in earning credibility as accepted norms. This is the difference between the so-called Maastricht criteria and the stability pact approved in 1996. In Korea, the liberalization brought about to qualify for OECD membership was defensive rather than cooperative, so that additional measures must be agreed upon domestically. See.

4. There was a myth about "Asian values" which were often contrasted to Latin American ones when in fact policies and institutions that are appropriate for one stage of development may not be appropriate for another. This is like the comparison made at the outset between Korea and Sudan at a time when Africa was seen as having a greater potential than Asia. The importance of comparisons, is of course, that they are essential prerequisite of peer pressure. The comparison between the Korean and the Irish model, for example, suggests that domestic taxation and policies towards foreign investment can go a long way towards differentiating the two experiences of export promotion, with a clear advantage for Ireland's.

References

Bradley, John Cohesion and transition: comparing the Irish experience with the prospects of the Central and eastern european countries, University of Antwerp conference on An expanding Europe?, February 2001

Dekle Robert & Kletzer Kenneth, Domestic bank regulation & financial crises: theory & empirical evidence from East Asia, NBER Conference on currency crises prevention, January 2001

Dooley Michael P. & Shin Inseok, Private inflows when crises are anticipated: a case study of Korea, NBER, Working paper 7992, November 2000

Dornbusch Rudi, Malaysia's: was it different?, NBER Conference on currency crises prevention, January 2001

Dornbusch Rudi, A primer on emerging market crises, NBER Conference on currency crises prevention, January 2001

Economist, Scourge of the chaebol, pg. 78, 23rd March 1999

Hamlin Kevin, Is corporate Asia getting the message?, Institutional Investor, pg. 68, March 2000

Kaplan Ethan & Rodrik Dani, Did the Malaysian capital controls work?, NBER Conference on currency crises prevention, January 2001

Krueger Anne & Yoo Jungho, Chaebol capitalism & the currency financial crisis in Korea, NBER Conference on currency crises prevention, January 2001

Larkin John, Korea's Winter of Discontent, Far Eastern Economic Review, pg. 16, 7th December 2000

Lee Charles S., Fairer Shares, Far Eastern Economic Review, pg. 56, 1st April 1999

McHale John, The Korean Currency Crisis: A report on the third country meeting of the NBER project on exchange rate crisis in emerging market countries, NBER, February 2000

Mc Kinnon, Ronald, Financial Liberalization and Economic Development: Interest Rate Policies in LDCs, The State of Development Economics, edited by Gustav Ranis and T. Paul Schultz, Oxford: Basil Blackwell, 1988

Mc Kinnon Ronald, Money and Finance in Economic Development, Washington: Brookings 1973.

Macedo, Jorge Braga de Comment on McKinnon (1988), pp. 411-415.

Macedo, Jorge Braga de Portugal and European Monetary Union: Selling Stability at Home, Earning Credibility Abroad, in Monetary Reform in Europe, edited by Francisco Torres, Lisboa: Universidade Católica 1996.

Macedo, Jorge Braga de Comment on part VII Financial Markets, in Global Financial Turmoil and Reform: A United Nations Perspective, edited by Barry Herman, Tokyo: The United Nations University Press, 1999, pp. 438-447.

Macedo, Jorge Braga de Financial Crises and International Architecture: a Eurocentric perspective, OECD Development Centre Technical Paper nº 162, August 2000.

Macedo, Jorge Braga de, Daniel Cohen and Helmut Reisen, Monetary Integration for sustained convergence: earning rather then importing credibility, OECD Development Centre, March 2001 (in progress)

OECD Regulatory Reform Review of Korea, OECD, September 2000

OECD Economic Surveys: Korea, OECD, September 2000

Scott Kenneth, The role of corporate governance in South Korean economic reform, Journal of Applied Corporate Finance, Vol. 10, n° 4, Winter 1998

The views expressed are personal and do not reflect positions of the OECD Development Centre or its Member countries. I am grateful to Jose Oliveira Martins and Soogil Young for help and to Randall Jones for detailed comments on an earlier draft, with the usual caveat.

Cravinho does not mention the Korean model in his written remarks at the 1976 international conference on the Portuguese economy but he did make the point while presenting his paper.

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