Lessons of Korean Financial Crisis: A Challenge to Redirect Public Policy

Abstract

This study examines the causes and consequences of the South Korean financial crisis of late 1990s and considers efficacy of the reforms undertaken by the Korean government to recover from crisis as well as discusses what measures could be taken to enforce public economic policy and to prevent happening of the financial crises in South Korea in future. Within the study the economic and political state of Korea before crisis was viewed, two dominated views on the nature and causes of the crisis were discussed, financial reforms aimed at stabilization of Korean economy witnin post-crisis period were analyzed. The study ascertained that both the export-oriented structure of the main industries and the swift adjustment of macroeconomic policies by the government after the crisis contributed to the fast recovery of economy of South Korea.

The study revealed that the crisis is due in no small measure to the unbalanced nature of the economic policies carried out by Korea’s government – extensive external liberalization combined with insufficient domestic liberalization. On the basis of this conclusion it is evident that the key to Korea’s recovery lies in redirecting public policy toward in-depth restructuring of financial institutions of the country.

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Lessons of Korean Financial Crisis:

A Challenge to Redirect Public Policy

Financial panics or crises are as old as capitalism itself and can be traced at least to the Dutch tulipmania of 1636–1637, and the South Sea Bubble of 1719–1720 (Jao, 2001, p. 13). But while such crises of the past were emerging and resolving locally, in our time due to globalization factors and close interrelations among economic systems of various countries they spread rapidly and affect vast territories. The Asian Financial Crisis (AFC) carried exactly such a character. It broke out in full force on July 2, 1997 in Thailand and quickly spread to other countries in Southeast and East Asia being one of the most traumatic and economically devastating events affecting most of Asia since the end of World War II (Clark, 2002, p. 10).

The countries or territories most affected by the AFC are located in the eastern part of Asia: Indonesia, Malaysia, South Korea, Philippines, Singapore, Thailand, Vietnam, China, Hong Kong, and Taiwan. In the wake of collapsing currencies, banking institutions, and asset markets, their economies were crippled by negative growth and rising unemployment (Cooper, 1999, p. 19). Other countries of East Asia, such as Cambodia, Laos, Mongolia, Myanmar, and North Korea, were either too isolated or too marginal to play any important part in the Asian Financial Crisis (Jao, 2001, p. 3).

Thus, during 1997–1998, until then much vaunted 'Asian Miracle' gave way to a nightmare of disenchantment and despair. The Asian Financial Crisis has dramatically changed the world's perception of this region (Clark, 2002, p. 2). Asian economies have gone from 'miraculous' to 'problematic'. As the wealth and relative incomes of these economies have diminished, many observers have concluded that international and Asian capital markets have failed (Pyo, 1999, p. 152).

As an important international financial and business center in the Asia-Pacific region, South Korea could not, of course, avoid being buffeted by the AFC. In just a few months after Thailand, in November 1997, Korea faced a severe currency crisis that culminated in a sharp economic contraction in 1998. Although for three decades before the AFC, Korea had experienced very high growth rates and this had transformed it from one of the poorest countries in the world into the 29th member country of the OECD in December 1996, less than a year after its admission to the OECD Korea had been down on its luck and its economy had crashed (Chopra et al., 2002, p. 15). Such state of things had been in a stark contrast to South Korea's remarkable achievements for a few decades before.

The purpose of this study is to scrutinize the special nature and causes of the Korean financial crisis as well as to evaluate efficacy of the reforms undertaken in the country to recover from it. It is very important for both diagnostic and prognostic purposes, as comprehension of the factors resulted in this crisis gives the basis for development of correct and effective reforms and policy measures in South Korea to be adopted to prevent such a catastrophe from happening again, while through analysis of the reforms having been carried out after crisis allows to consider what improvements in policies could be made to attain better performance for Korean economy. Toward this end we will discuss the economical and political state of South Korea before crisis, examine external and internal factors and forces – both political and economical – which contributed to crisis outburst, evaluate various views by observers on these factors' contribution and relevance, analyze efficacy of the policies implemented by the government to overcome the crisis, and make the conclusion with respect to possible enhancements of public policy which take proper account of the lessons of Korean financial crisis.

Economic and Political State of South Korea in 1990s

Obviously, it is not possible to understand what went wrong with Korea's economy in the late 1990s without analyzing the economical and political situation in this country and realizing the nature of the institutions and policies that generated Korea's economic 'miracle' in the three decades that led up to the crisis.

Rapid economic growth of South Korea since the 1960s looked like a marvel. The world had witnessed how young Asian developing countries, and Korea among them, demonstrated 'economic miracle' on their way toward industrialization. Those were called a group of 'new industrializing countries' incorporating about 15 countries and territories (Krugman, 1994, p. 65). Korea occupied a fitting place in this group. Over three decades from 1960s till 1990s annual real GDP growth rate here had been more than 8% (Chopra et al., 2002, p. 17), and during the period of 1990-1997 – 7,5% (Harvie, 2000, p. 60). For a couple of decades the country transformed from traditionally agrarian into industrialized one (Harvie, 2000, p. 58) with GDP per capita amounted to $5000 (Chopra et al., 2002, p. 18). By the mid 1990s it occupied the 11th place in the list of leading trade nations of the world (Harvie, 2000, p. 58). In fact it was a tremendous achievement for the country with population of nearly 50 million people .

Many observers ascribe this success to positive state intervention in resource allocation and correct industrial policies implemented by the government which involved a combination of import protection, export subsidies, preferential government procurement, investment promotion, tax breaks, state equity, loans and grants. Such policies helped to overcome technological barriers and facilitated main industries’ smooth entering into international marketplace (Dean, 1999, p. 63).

Modernization deployed extensively in South Korea after the World War II and its liberation from Japanese colonial dependence since its beginning became closely connected with formation and enhancement of the system of government regulation. The state authorities staked on creation and application of such system as mobilizing, coordinating and guiding force of economic development due to paucity and small-scale of private industrial sector (Mako, 2002, p. 209). The process of formation and development of Korea's economic system since 1960s can be divided into several phases. The first one, from 1960 till 1970, was characterized with policy of import-substituting development of industries facilitated by foreign investments and low-interest loans sponsored by the government. During this period various industrial, transportation and communication facilities had been built which improved economic infrastructure of the country (Cho, 2003, p. 85). The state supported big private businesses by means of creating favorable starting opportunities for them, and such monopolistic conglomerates as Samsung, Lucky Goldstar (now LG), Daewoo, Hyundai, and Ssanyon emerged and developed just at that time. Since this phase the government has paid much attention to implementation of financial instruments favoring development of corporate sector – priority subsidizing, tax preferences and other tools of encouragement for perspective industries and big companies, on the one hand, while it has imposed limitations with regard to crediting and applied tax screw for the other sectors of economy which did not fit in the state developmental policy, on the other hand (Mako, 2002, p. 211). South Korean economists evaluated this policy with ambiguity as they considered such approach to be unfounded and fraught with negative consequences for sustainable development of economy.

But there was no alternative strategy for carrying out accelerated industrialization in economically lagging country anywhere in the world at that time (Cho, 2003, p. 87). The second phase, from 1970 till 1979, was realized by the government headed by Park Chung Hee. He set a goal to achieve economic prosperity by means of implementing export model of development. During this period system of sanguineous government regulation had matured. Ministries and state agencies had been working out common approach and joint variant of perspective plan which then had to be executed by all enterprises – both state-owned and private (Cho, 2003, p. 89). 1970s demonstrated substantial economic progress. South Korea enhanced its prestige abroad, its businesses put into practice expansion in the foreign markets, economy became more open, private corporations gained strength and intensified their activities, and big monopolies able to meet international competition emerged in the country. But bureaucracy's striving for full control and subordination of all aspects of economy evoked growing resistance of businesses which undermined efficacy and mobility of economy (Dean, 1999, p. 64). Nevertheless, the next phase, during 1980s, was characterized by further reinforcement of state economic system. Only in the next decade the system of government control of economy had started to diffuse, and the government took substantial measures for financial liberalization of domestic economy (Cho, 2003, p. 90).

The scholars argue that the economic system which Korea had by early 1990s was created by General Park Chung Hee's military government that came to power in 1961 through a military coup and propelled the country's economic development for the next few decades (Cho, 2003, p. 92). This system was based on a close collaboration between the state, banks, and the chaebols, with the state as the dominant player (Hong ; Lee, 2000, p. 208). However, slowly from the 1980s, and in particular from the mid-1990s, there have been moves to rewire the system by reducing the role of the state, deregulating finance, and reining in the chaebols Scott, 1999, p. 339). The latter had constituted the backbone of the traditional Korean economic system. Chaebols are the special South Korean business establishments – big family-owned financial and industrial conglomerates. They formed a skeleton of the nexus between the state, the banks and the chaebols that operated on a close cooperation and consultation among the government, commercial banks, and big businesses (Pyo, 1999, p. 156). The strength of this system laid primarily in its ability to mobilize large amount of financial and other resources and thereby engage in investment competition in large-scale projects by utilizing economies of scale and scope (Hunter, 1999, p. 129).

Besides, in Korean economy during these three decades government had demonstrated intensive activity in controlling resources formation and allocation among the branches of industry. Thus, since 1970s seven industries had been designated by the special laws as the branches of top-priority: machine-building, electronics, textile industry, ferrous metallurgy, non-ferrous metallurgy, and shipbuilding (Mako, 2002, p. 207). These industries were given substantial preferences in financial resources supply; they were subjected to preferential tax treatment and made use of other preferences (Chopra et al., 2002, p. 23). Observers reasonably argue that corporate sector preferences favoring low interest rates, preferential finance as well as controls over foreign investors were underpinned by the dominant position of the chaebols in the economy, their ownership controls over most non-bank financial institutions and close bank-industry relations (Scott, 1999, p. 341). Scholars define such model of economic management as a 'substituting strategy' or a strategy where late-developing countries pursue an 'independent' developmental path by finding functional substitutes for the institutions used for industrial financing by the forerunners. In case of Korea the state-banks-chaebol nexus demonstrates evident features of such an institutional substitute (Dean, 1999, p. 62).

Summing up the results of numerous studies of the agents contributed to rapid growth of South Korea’s economy, the following factors – objective and subjective, economical and political, external and internal – were defined as promotional: export-oriented and integrative with the outer world strategy of development (Harvie, 2000, p. 60); favorable international economic climate during the period through 1960s till the first half of 1970s which eased access to external sources of financing (Kim ; Park, 2000, p. 82); powerful and effective governance in the person of authoritative governments which postponed democratic and political reformation in favor of economic development ; relatively low maintenance costs for military-industrial establishment (Dean, 1999, p. 64); an influx of foreign investments – both financial and technological such as know how and industrial equipment (Barth ; Zhang, 1999, p. 184); ethnical and cultural homogeneity and Confucian tradition which attach much significance to diligence, education, life success and deep devotion to own nation (Clark, 2002, p. 12; Cooper, 1999; Pyo, 1999; Jao, 2001).

Emergence of Asian Financial Crisis and Korea’s Fate within It

Notwithstanding its speedy movement on the way to prosperity South Korea, in stark contrast to its remarkable achievements, was down on its luck in 1997 when the Asian Financial Crisis burst out. Internationally, the AFC is the most serious regional financial crisis since the European monetary crisis of 1992–1993 and the Mexican peso crisis of 1994–1995. However, for the Asian region alone, the AFC is the most devastating economic and financial catastrophe since the Korean War of 1950–1953 (Jao, 2001, p. 3).

It is commonly known that it was Thailand that paced AFC. It has been over two years since Thailand unexpectedly withdrew its support from the foreign exchange market when on July 2, 1997 the baht dropped dramatically in price relative to other currencies. The consequences were both immediate and dramatic. The baht plummeted, leading to a rapid outflow of foreign capital (Clark 2002, p. 2). Soon thereafter, Malaysia made the same move. Indonesia relaxed its support for the rupee and then decided it could not even hold the relaxed version, effectively withdrawing from the foreign exchange market in October before exhausting its reserves. By late November it became clear that Korea was in difficulty, and the crisis emerged fully in December. Moreover, in August 1998, Russia, in a partly expected and partly extremely unexpected move, withdrew its support for the ruble and ceased payment on some of its government obligations. Brazil came under very strong pressure in October, but the break was postponed until January 1999 by the promise of a substantial international package of financial support in exchange for strong fiscal actions by Brazil (Cooper 1999, p. 17). Those were the main events of AFC.

For the South Korea the crisis of 1997 was the biggest financial crisis in its modern economic history. Many Koreans considered this crisis to be the most national disgrace since the 1910 Japanese Annexation (Chopra et al., 2002, p. 16). In 1997 consecutive bankruptcies of several chaebols coupled with financial crises of foreign exchange instability in most East Asian countries weakened investors' confidence in Korea. Thus, between January and October of 1997, six of the largest thirty Korean chaebol went bankrupt (Cho, 2003, p. 82).  As a result, foreign banks refused to roll over credit lines to Korean financial institutions. The country was on the brink of bankruptcy in November 1997 (Hong & Lee, 2000, p. 211). The crisis led to a sharp contraction of economic activity in 1998 – minus 6,7% growth, the worst in modern Korean history. By mid December of 1997 Korea’s foreign exchange reserves were almost depleted (Kim & Park, 2000, p. 83). Capital flight and the falling exchange rate wreaked havoc on the stock market. Capital market of Korea and its neighbors – Indonesia, Thailand and Malaysia – were devastated too. The aggregate market capitalization of these four countries reduced from $637 billion in 1996 to $188 billion in 1997, a decline of 70 percent (Pomerleano & Zhang, 1999, p. 118). Reduction in exchange rate of won with U.S. dollar for the period from June till December 1997 amounted to minus 47,7%, drop of stock market index – minus 49,5%, real GDP growth dynamics was negative – from 7,1% in 1996 to 5,5% in 1997, and to minus 5,3% in 1998 (Clark, 2002, p. 3).

Korea had no choice but to ask for a rescue package from the International Monetary Fund (IMF). The announcement by the Korean government on 3 December 1997 that it was going to call in the IMF shocked the world (Dean, 1999, p. 65). On December 3 of 1997 South Korea and the IMF signed a three year Stand-By agreement. The arrangement included financing for a total of $57 billion from the IMF, the World Bank, the Asian Development Bank, and a group of countries – the largest rescue package in the history of the IMF (Harvie, 2000, p. 80).

By the spring of 1998, the economy was in free-fall, and many observers feared that the economy would not recover for another couple of years (Sachs & Woo, 2000, p. 3). But after only a year, like a phoenix, Korea managed to restore the main economic indices and to stabilize won. The growth rate of GDP increased from a negative rate in 1998 to 9,4% in 1999 (Sachs & Woo, 2000, p. 3); in 1999 inflation was very low, less than 2%, unemployment has been reduced sharply, from 8,6% percent in February to 6,2% in September 1999 (Clark, 2002, p. 5). During the first half of 1999, stock markets in seven of the eight East Asian countries, including South Korea, raised 30–50%. As a result, stock market indices in these countries almost recovered their devastating falls during the second half of 1997. Exchange rates had rebounded by mid 1999 too, although their upturn did not go as far toward achieving pre-crisis levels as the stock market 'miracle'. Besides, exports, consumer spending, and investment have all increased substantially all through the region, assuming that the recovery was well under way (Clark, 2002, p. 4). In South Korea, in December 1999 President Dae Jung Kim proclaimed that the financial crisis was over (Koo & Kiser, 2001, p. 33).

Causes of Korean Financial Crisis

During the first years after the Asian Financial Crisis the debates around its causes had been vigorous, and they have been continuing until now. South Korea as a country which was among the severely affected by the crisis has been in the focus of discussions as well. Scholars and experts which take part in such debates, although expressing various views on this issue, have something in common: they agree that Korean financial crisis, like crises in other East Asian countries, was caused by a combination of certain external and internal factors, an unfortunate outcome of confluence of weak domestic financial system and volatile international capital movements brought about by the globalization of financial markets (Dean, 1999, p. 66).

External factors

An explanation of the origins and development of the crisis in the East Asian region involves a complicated interplay among numerous economic and social factors. Like crises in South Korea's neighboring countries, the Korean financial crisis evidently owes its outburst to the mounting volume of short-term, foreign currency-denominated borrowings by large and already highly leveraged domestic chaebols and banks (Hunter, 1999, p. 128), but what triggered crisis and deepened it to huge losses for Korean economy, were external factors – losing of investors' confidence and foreign exchange instability (Scott, 1999, p. 335).

The development of Western economies has demonstrated that financial systems will not function properly unless they contain some basic elements of an appropriate market infrastructure. Banks must be supervised effectively to ensure that they do not take excessive risks and that they maintain the resources to pay back depositors. Markets will not allocate funds to worthy borrowers unless investors have accurate and timely information about them and use that information effectively. Corporations must follow appropriate rules of governance to ensure that managers, as agents for shareholders, act responsibly and do not waste resources. When these elements of a financial system are not in place, it is more than likely that eventually too much money will be sent to the wrong destinations and that economies will become vulnerable to a sudden collapse of confidence among firms and foreign investors (Pomerleano & Zhang, 1999, p. 153). That, of course, is exactly what happened in South Korea.

It comes as no surprise that the difficult situation in foreign capital markets affects the stability of domestic financial system of any given country. Given the technological advances in information and communications of the late twentieth century, globalization of financial markets was perhaps inevitable although its rapid progress since the 1980s was abetted by a widely accepted notion that free capital movements were better than restricted capital movements (Barth & Zhang, 1999, p. 183). But, as it turned out from the lessons of the AFC, this notion, which is based on a simple extension to financial markets of the cliché that free trade in goods increases economic efficiency and thus improves economic welfare, requires many qualifiers to be valid. The Korean economy, like those of other East Asian countries, was a victim of this naive notion about free capital movement (Cho, 2003, p. 86). Analyzing the evolution of the AFC, scholars and economists revealed that if a country is to benefit from free international capital movement it must have a sound and strong financial system that can deter panic capital movement and withstand systemic shocks from such a movement, if it is to occur (Pomerleano & Zhang, 1999, p. 128).

Thus, in the case of South Korea, the financial crisis was caused not by the reversal of foreign portfolio investment as it could be assumed from the first sight, but by the refusal of foreign creditors to roll over their short-term credit to Korean commercial banks and merchant banking companies (Pyo, 1999, p. 158). In addition, the international currency market disorder swiftly crushed the banking sector when by early 1998 most banks and other financial institutions were in technical default (Koo & Kiser, 2001, p. 26). As Cooper (1999, p. 22) explains, the rapid outflow of funds of the bank triggered collapse in the value of Korean currency won on world markets and, in turn, steep decline in real output in the country. The crisis was especially dramatic because Korea had been following sound macroeconomic policy by contemporary international standards: government budget was not unbalanced, while monetary policy was not generating disturbing rates of inflation (Chopra et al., 2002, p. 19). But the country experienced a crisis of confidence of foreign investors because it had significant shortcomings in its banking and financial markets, as well as in its systems of corporate governance.

Internal factors

What is ironic about the Korean financial crisis is that it took place in the country belonging to the group of so-called Asian 'miracle' economies, which had been held up in numerous writings on Asia's economic success as an exemplary case of sound economic policies leading to rapid economic growth. As generally reported in those pre-crisis writings Korean economy maintained sound macroeconomic policy and carried out financial liberalization, presumably removing government intervention and its distorting effects from domestic financial market (Krugman, 1994, p. 66). Later the same economy was accused of having weak financial system.

Although such accusation was in sharp contrast to pre-crisis write-ups, it was true. Scholars admit that there were a number of factors behind this rapid erosion in foreign creditors' confidence in the Korean banking sector, including the contagion effect from other East Asian economies; however, the most critical factor was the rapid increase in nonperforming assets of Korean banks (Koo & Kiser, 2001, p. 26). In Korea, unlike in the case of many other Asian developing countries, the rapid increase in nonperforming assets was not caused by the burst of an asset bubble, but rather by a widespread debt problem in the corporate sector, in particular, that of the large chaebols (Hong & Lee, 2000, p. 209). The chaebols were blamed as excessively diversified unions of ineffective companies staying alive on low profit only due to the opportunity to incur debts more than they deserve on the ground of their collusion with the state and banks, and non-transparent intra-union dealings (Kim & Park, 2000, p. 84). It was also assumed that such inadequacy was possible only due to the fact that South Korea had a primitive corporate governance system (Pyo, 1999, p. 157), although the latter argument looks not well-grounded.

As we discussed earlier the Korean model of state regulation in all aspects of economy was justified at those circumstances where Korea was striving for fast industrialization. Until the crisis, rapid expansion of the Korean economy as well as its corporate sector was based on the expansion of debt intermediation with firms operating with a highly leveraged financial structure. This highly leveraged financial structure could be sustained only so long as the government functioned as the corporate sector's risk partner. With its control over credit allocation, the government could intervene whenever it was necessary to save the highly indebted, troubled corporate firms. But once the government relaxed its control over the financial sector – a result of financial liberalization – its role as a risk partner was also weakened (Pomerleano ; Zhang, 1999, p. 139).

A financial crisis is not simply brought about by insolvency of a single enterprise or financial institution. Insolvency can and does persist for years without causing a crisis. This was what had happened many times in Korea prior to 1997. What was different in 1997 was that, because of a changed financial market environment brought about by financial liberalization, the Korean government could no longer contain the insolvency of several troubled firms by forcing financial institutions to roll over their credit. Another difference was that domestic firms and financial institutions had accumulated a large amount of short-term, private foreign debt, and the country suddenly faced a liquidity problem when foreign lenders refused to roll over the maturing debt (Cho, 2003, p. 93).

Thus, inadequate regulation, banking supervision, accounting standards, financial transparency, legal protection and accountability in corporate governance, combined with pervasive market imperfections, government interventions in business, and the common and locally often rational practice of relying on political or personal relationships to advance and protect one's business ventures all led to a high proportion of non-performing loans and overinvestment (Kim & Park, 2000). In the corporate sector weak, but not primitive as some observers argued, corporate governance led to ignoring risk assessment, over-leverage and an excess of foreign borrowing, related-party lending contributing to big external debts, domestic asset bubbles, and excess capacity (Harvie, 2000, p. 76). Attempts by corporations to hedge their external debts by buying dollars after the currency devaluations began only led to more capital flight, deeper devaluations, and higher debt burdens (Pomerleano & Zhang, 1999, p. 154). Despite the fact that the corporate sector's profitability fell to very low levels in 1990s, the banks continued to roll over the chaebols' outstanding debt. When unfavorable situation in international markets materialized, the needed increase in financial resources by the banks was larger than their balance sheets could tolerate (Pomerleano & Zhang, 1999, p. 134). Thus, the chaebols' low profitability, high leverage, and economic dominance meant that the Korean crisis was a disaster waiting to happen. Given the magnitude of leveraging of the chaebols prior to the crisis, the increase in the interest rate, not the foreign exchange crisis in Asia itself, probably triggered the Korean financial crisis (Mako, 2002, p. 216).

Moreover, some scholars argue that financial liberalization in South Korea was not an appropriate policy, as it weakened the role of government in overseeing and supporting private enterprises, which was an integral component of the country's developmental strategy. In the absence of a government agency overseeing the strategies of individual firms and combining it with a broader sector or national strategy, firms over-expanded their capacity, engaging in unrelated and unwarranted diversification. Such expansion, it was argued, became the root cause of the crisis (Cho, 2003). Accordingly, the Korean financial crisis essentially represents a case of market failure and not of government policy failure.

This let us to assume that the primary factors causing the Korean financial crisis were deep-rooted structural weaknesses – notably a weak domestic financial sector with limited ability to access risk and an over-leveraged corporate sector with insufficient attention to profitability – that left the Korean economy vulnerable to external shocks.

Confirming this conclusion from a broader perspective, Cooper (1999) argues that domestic residents put more selling pressure on their currencies than did foreign investors. This is contrary to the view held among many observers in Asia, of course. More broadly, Cooper concludes that the AFC teach us that a healthy financial system is integral to the proper fundamentals of any modern economy. When finance goes wrong, so does the real economy. This is important because, as Cooper argues, financial systems are intrinsically unstable. Savers often want liquidity, while borrowers want assured finance over long periods. Financial institutions and markets are supposed to bridge this gap in maturity preferences, but this process does not always occur smoothly. When it does not, financial crisis can be and often is the result.

Thus, as the current study shown, the 1997 Korean financial crisis was not a direct consequence of the state-banks-chaebols economic system but that of the failure to adjust the system to the new challenges thrown up by the country's economic maturity and by globalization.

To complete the picture, it is necessary to mention that among various views on the issue there have been formed two dominated schools of thought with regard to the primary causes of the Asian financial crisis. The first one associated with Paul Krugman, is best characterized by two well-known in scholarly circles notions – "crony capitalism" and "Asian values" (Sheng, 1999, p. 417). The focus here is on inappropriate domestic policies, ineffective financial resources allotment to the companies which are connected with the government by close personal ties, overborrowing, weak government supervision over bank activities and complacency based on decades of fast growth. Advocates of this school consider the AFC to be a logic consequence of such inadequacies in financial and corporate sectors of the countries affected by it (Sheng, 1999, p. 418). The second school of thought associated with Jeffrey Sachs considers the AFC in less moralistic terms. The crisis as, for example, Sachs and Woo (2000) argue was a classical financial panic: a run on the banks and massive capital flight aggravated with the growing debt/equity ratio of large Asian banks and the currency instability of most Asian borrowers. The financial chaos, as Sachs supporters ascertain, was companioned with speculative attacks on currencies and the fall down of asset values (Pomerleano ; Zhang, 1999, p. 137). Such approach assumes that the Asian economies were in moderately sound state, and that the large-scale of the AFC far surpassed the mistakes of individual countries' financial regulations and policies.

Although these two schools have many similar aspects, they focus on different points in explaining the causes of the AFC. Krugman censures mainly the values, financial institutions and governmental policies of the countries affected by the AFC; his approach is rather country-specific. Sachs' school ascribes the crisis more to defects of the worldwide financial system structure. Its proponents argue that, even if a new industrializing country carries out reasonably sound economic policy, global recurring waves which are not connected with the fundamentals of that country have the ability to devastate its markets and cause financial fall down. This approach is evidently global-specific. Nevertheless, conceivably, the truth lies somewhere in between of these two approaches, and, as our study proves, the crisis owes its severity to both internal weakness of the Korean financial system and external turbulence in global financial markets.

Reforms to Recover from the Crisis

As we discussed above, to overcome this severe financial crisis the Korean government signed the bail-out agreement with the IMF, carried out a wholesale restructuring of the system in the belief that the country's previous economic system was the root cause of the crisis (Pyo, 1999, p. 152).

The condition for financing was that Korea had to agree with the IMF about macroeconomic as well as financial and corporate restructuring policies during 3 years of the program (Hong & Lee, 2000, p. 210). The IMF recommended to the Korean government a short-term macroeconomic policy focused on high interest rates to restore the plummeting confidence of overseas investors during the early months of the crisis (Koo & Kiser, 2001, p. 33). A concerted effort to persuade foreign creditors to roll over short-term debt was also launched in late December 1997, followed by a more comprehensive rescheduling of maturing debt. The IMF also recommended that the government implement various policies to restructure and reform heavily indebted corporate sector dominated by the chaebols and the financial sector saddled with non-performing loans (Dean, 1999, p. 60).

As a result of Korean governments' fulfillment of the IMF requirements under the bail-out agreement, the Korean financial system was, at least at the formal level, remoulded into an essentially Anglo-American one based on minimal state, arm's-length contractual relationships, and focus on short-term financial profitability (Cho, 2003, p. 91). What is notable about the post-1997 restructuring in the international context was that, for the first time in its history, the private corporate sector became the focus of the IMF program (Pyo, 1999, p. 154). It is well known that until the Korean crisis the IMF had blamed the 'spendthrift' public sector for just about every financial crisis in developing countries and still continues to do so, as seen in its dealings with the Argentine crisis that broke out in 2001 (Cho, 2003, p. 92). However, in the Korean case, it identified the private corporate sector, and in particular the chaebols as a main maker of the crisis (Hong & Lee, 2000, p. 211). Thus, it was the corporate sector that became a main focus of the IMF-led program of Korean recovery from crisis.

It is necessary to admit that South Korea demonstrated the most prompt recovery among the East Asian countries hit by the AFC. The IMF and its supporters claim the IMF program was the main force behind the recovery (Koo & Kiser, 2001, p. 25), although it is a moot point. Some scholars argued that the radical neoliberal restructuring of the economy after 1997 was ill conceived and destructive, in large part because it was based on one-size-fits-all neoclassical economic models that bear little resemblance to the institutional structure of South Korea's economy (Shin ; Ha, 2002, p. 106). They evaluated every important aspect of the restructuring program, showing how each one failed to achieve its stated objectives because it failed to take into account then existing economic and political institutions and totally misunderstood the key economic roles they played, and offered a pessimistic assessment of Korea's intermediate economic future with further promotion of such restructuring (Mako, 2002, p. 219).

Anyway, with or without the IMF guidance, the Korean corporate reform after the financial crisis was predicated on the premise that the chaebol-dominated corporate structure brought about overinvestment and excessive diversification because it lacked adequate institutional mechanisms to restrain authoritarian management decisions by the families-owners (Scott, 1999, p. 354).

Based on this premise, the corporate reform program implemented by the Korean government contained the following elements.

1. At the more symptomatic level, a radical reduction of corporate debt was thought necessary in order to reduce financial vulnerability of the chaebols. The 'Big Deal' program which involved the business swaps among the chaebols operating in overlapping industries, and the 'Workout' program which constituted the bank-sponsored rehabilitation program for ailing firms were also implemented in order to reduce over-capacity and the degree of business diversification (Pyo, 1999, p. 162).

2. At the more fundamental level, radical changes in external and internal governance mechanisms were made. Fair trading regulations were stringently applied to check non-transparent or so to say 'unfair' expansion of the chaebols. Financial supervision was strengthened in order to control chaebols' investment through lending institutions rather than through state intervention, as before. Changes in internal corporate governance were introduced in order to reflect more closely the shareholders' point of view in the running of the companies (Hong & Lee, 2000, p. 211). This new system of check and balance among companies, financial institutions, and shareholders was apparently based on the ideal of the Anglo-American economic system promoted by the IMF (Cho, 2003, p. 92).

As for reform of financial sector the government undertook various measures to encourage its deep restructuring. First of all, the government reinforced prudential regulations and implemented Bank of International Settlements (BIS) tough standards in the financial sector in an attempt to meet the need in establishing international standards for measuring the healthiness of financial institutions. These measures were aimed at stimulating the banks and other financial institutions to set adequate pressure on chaebols in terms of their debts lessening and restructuring of business activities (Hong & Lee, 2000, p. 211).

In financial sector restructuring Korea adopted a gradual and piecemeal approach to the liberalization of interest rates and credit controls, but took a more liberal position on the deregulation of entry barriers (Barth & Zhang, 1999, p. 213). The government limited the role of commercial banks to implementing industrial policies, but gave greater freedom to non-bank financial institutions, such as finance companies, merchant banking corporations and securities firms, to mobilize savings and stabilize financial system. Among these measures one important area in which Korea liberalized more rapidly was the lowering of entry barriers into financial markets and the tremendous growth of non-bank financial institutions. Hence, as a result of this trend rapid progress was made in the development of the non-bank financial sector and deregulation of entry barriers, whereas interest rate deregulation, policy loan reduction and capital decontrol ran a slow, erratic and selective course (Shin & Ha, 2002, p. 98). In the process of capital market liberalization the government abolished all controls and restrictions by 2000. Most limitations imposed on foreign equity ownership, foreign occupation of management and land ownership had been eradicated. Legislative acts which promoted attraction of foreign investments were adopted. Besides, the government closed many insolvent financial institutions and hold up the transactions of other unprofitable financial institutions. One of the most important objectives was to eradicate non-performing loans (Hong & Lee, 2000, p. 212).

After several years since launching ambitious program of financial sector restructuring the experts admitted that it progressed well on the whole, although some aspects of it were not fulfilled in appropriate volume. Thus, the government's policy of financial restructuring, which focused on the restructuring of the banks with little attention paid, at least initially, to the investment trust companies (ITC), helped to reduce banks' exposure to large corporations, but allowed weak chaebols such as the Daewoo group to issue large amounts of corporate bonds through the ITCs, which were not closely supervised. Although the issuance of these bonds helped avoid a credit crunch in the late 1990s, the proceeds were used largely for further business expansion rather than restructuring. As a result, the corporate bond market faced another credit crunch in 2001, when the bonds matured (Mako, 2002, p. 217).

Nevertheless, government's policy of financial restructuring yielded many positive attainments. The financial reforms reinforced the supervisory and regulatory structure, enhanced the transparency of financial sector by means of public disclosure of information, advanced the financial and fiscal instruments able to deal with unhealthy establishments and to manage bad loans, and promoted the entry of foreign investment and expertise into the Korean financial system (Shin ; Ha, 2002, p. 114). The majority of commercial banks ameliorated their capital adequacy ratio to the level above 10%. Nevertheless, immoderate exposure of the financial establishments to over-indebted corporate sector generated substantial problems in the process of financial restructuring (Hong ; Lee, 2000, p. 213).

As our study demonstrates there are many questions about the nature of the Korean financial crisis and the effectiveness of the policies adopted to resolve the crisis. In the early stage of the crisis the IMF recommendations to Korea sparked heated debates both in Korea and abroad (Harvie, 2000, p. 90). The disparity between arguments and favor of and against the IMF's policy recommendations was as sharp as the contrast between the high-growth period and the crisis. During the crisis and the early post-crisis period it was difficult to judge which side – the critics or supporters of the IMF program – was correct, hence, the full effects of the policies adopted during the program were not yet apparent (Clark, 2002, p. 26). To fill this gap in May 2001 the Korea Institute for International Economic Policy and the IMF organized a conference on the issues of the Korean financial crisis and recovery. The conference aimed at distilling lessons based on analysis of the crisis and recovery, as well as evaluating the effects of the policies implemented in Korea under the IMF-supported program (Chopra et al., 2002). The conclusions of the conference were as follows:

- the initial policy of high interest rate aimed at bringing about investors' confidence in the monetary authority, which was quickly supplemented by the coordinated debt rollover, helped to stabilize the exchange rate and financial market;

- on financial sector reform it was underlined that closures of nonviable financial institutions and reforms of prudential regulations and supervision had positive effect for stabilization of economy, although the government was recommended to privatize its stake in a number of large banks;

- corporate sector reforms made progress in terms of financial disclosure and corporate governance, but Korean corporate sector was censured for remaining highly leveraged and continuing to suffer from low profitability, which indicate the need for more operational reforms (Chopra et al., 2002).

Thus, the conference gave deep appreciation to the IMF program and emphasized its efficacy. At the same time, many experts express differing view. They inferred that the high interest rate policy may have deepened the financial crisis rather than stabilized the exchange rate. They also stressed the problem was that financial restructuring focused primarily on the banks without also improving regulatory oversight of the investment trust companies, and the rapid expansion of the ITCs contributed to the quick recovery in 1999, but delayed corporate restructuring and deepened financial sector problems (Mako, 2002, p. 216).

Besides, the empirical studies on the amount of defaulted corporate bonds demonstrated that the bank-focused financial restructuring had large negative side effects for corporate sector, and that short-run liquidity problem is recurring if significant corporate restructuring is absent or if it is insufficient (Mako, 2002, p. 221). For example, the total amount of corporate debt for the year after Korea's recovery remained virtually unchanged as a result of the bank-focused restructuring policy and the associated replacement of bank loans by corporate bonds, not by equities, suggesting that the corporate sector would remain vulnerable to adverse shocks (Koo & Kiser, 2001, p. 30).

Critics of the IMF program also argued that money growth in a crisis-hit country may be affected more strongly by the regulatory actions of the supervisory authorities than by the policies of the monetary authorities, hence the strengthening of regulatory rules may limit money creation by financial intermediaries (Sheng, 1999, p. 118). And finally, some critic reasonably argue that too ambitious reform program such as rapid introduction of global standards into the banking system may not be digestible by the political economy of the country, and hence may backfire (Cho, 2003, p. 93).

Conclusion

The conducted study revealed that the financial crisis which burst out in South Korea in 1997-1998 was caused by the combination of external and domestic factors. The study proved that this crisis was not a direct consequence of the country's financial system but that of the failure to tailor this system to the new challenges thrown up by the country's economic maturity and by globalization. At the same time, the structural weakness of financial sector together with low profitability of the backbone of the Korean economy – the nexus between the state, the banks, and the chaebols that operated on a close cooperation and consultation among the government, commercial banks, and big businesses – contributed substantially to the crisis severity due to extremely high vulnerability to external financial shocks. We learned that the strength of this system laid primarily in its ability to mobilize large amount of financial and other resources, while its weakness was in low flexibility in reaction to external capital markets instability. When the Asian Financial Crisis burst out, Korea had no enough structural and financial resources to resist it. Hence, the financial crisis in Korea had important endogenous origins. Domestic institutional deficiencies and associated political constraints had important bearings on how the crisis developed and was managed. Severe weaknesses in the corporate and financial sectors of Korea resulted primarily from the failed course of market reform, which in turn reflected the organizational and political structures of financial policy.

The impact of the crisis on the viability of the banks and finance companies caused a severe shortage of domestic credit, a credit crunch, which continues in Korea to this day. As for the corporate sector, the crisis revealed that chaebols were vulnerable to international capital movements as well as the ideology and politics of the market economy. It is important to point out here that Korean financial policy-making has two institutional features. Private sector preferences favoring low interest rates, preferential finance and controls over foreign investors were underpinned by the dominant position of the chaebols in the economy, as we discussed in our study, as well as by their ownership controls over most non-bank financial institutions and close bank-industry relations. This structure of private sector preference formation made it difficult for the banking community to assert its stance on financial liberalization having been carried out by the government since 1980s. Such characteristics of financial system stipulate that without deep restructuring of corporate sector South Korea would bury the hopes for the resumption of its economic advance. Basing on peculiarities of Korean economic development model through several decades before the crisis, it is reasonably to assume that such advance requires the support of the developmental state, with the financial sector as its servant, and business enterprises – the chaebols, small and medium businesses – as agents of change.

Our study showed that the Korean government undertaken major steps to overcome the crisis and make progress on the way to such economic advance. The fastest recovery of Korea's economy among the East Asian countries affected by the Asian Financial Crisis is an unbeatable evidence of this. The government's policies of wide restructuring in both financial and corporate sectors enabled such accomplishments as fast ceasing of investors' panic and resumption of their confidence, liberalization of capital market, strengthening of export-oriented branches of industry and betterment of the major macroeconomic indices.

But the swift pace of Korean economy's rehabilitation also evokes anxieties on its sustainability. The success of financial reforms hinges not just on changes within the financial sector itself or on the reduction of the state role in general terms. The corporate sector restructuring including ownership structures, the strengthening of key state institutions, especially the state banks, and a thorough democratization of the political and policy-making processes are mutually reinforcing preconditions for strong and effective national economic governance. These insights are of undeniable relevance for the prospects for sustainable economic growth in the country. In particular, in the case of Korea expansionist macroeconomic strategy management since the late 1998 played a crucial part in facilitating the economy to accomplish prompt recovery. Nonetheless, with the fiscal deficit growing and inflationary pressures becoming stronger, the expansionist policy position should be extenuated in the future. Also, the difficulty in removing a considerable number of bad loans still remains to be tackled. Hence, it is evident, that already substantial transition costs have been incurred in Korea, but if the newly introduced institutional changes are ill suited to the country's needs, the future can be worrying. The complexities on the way to recovery from the Korean financial crisis, like a litmus paper, demonstrated that without keeping on in-depth restructuring efforts directed at financial instutions of the country, the recovery may be short-lived, and the sustainable economic advancement of South Korea may be slowed down.

Internationally, the Asian Financial Crisis convinced the world community that we are dealing with the issue of financial risk management in one world, and in an era of globalization and integration of financial markets no one country in the world can develop without taking into account trends in global financial architecture. To prevent such crises to happen in the future the world has to learn from past mistakes and map out a better strategy for crisis management.

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