Asian Financial Crisis, Volume 1: Financial, Structural, and International Dimensions (International Finance Review)

LIST OF CONTRIBUTORS Zafar U. Ahmed

Professor of Marketing and International Business, Office # East Hall 245, College of Business, Sacred Heart University, Fairfield, Connecticut 06432-1000, USA. Fax: 203-365-7538. E-mail: ahmedz @sacredheart.edu

Ilan Alon

Assistant Professor of International Business, Department of Economics and Business, 221 Netzer Administration Building, State University of New York College at Oneonta, Oneonta, NY 13820, USA. Fax: (607) 436-2543; E-mail: [email protected]

Frank L. Bartels

Deputy Director, MBA Program in Intemational Business, Nanyang Technological University, Singapore. Fax: 65-791-3697; E-mail: aflbartels @ntu.edu.sg

Anindya K. Bhattacharya Assistant Professor of Business, Department of Economics, Brookly College, The City University of New York, 2900 Bedford Avenue, Brooklyn, New York 11210, USA. Fax: 718-951-4867; E-mail: abhattao @stern.nyu.edu Christopher Bilson

Assistant Professor, Faculty of Economics and Commerce, the Australian National University, Canberra 0200, Australia. Fax: 61 2 6 249 5005; E-mail: Chris.Bilston @anu.edu.au ix

S. J. Chang

Professor of Finance, College of Business, Campus Box 5480, Illinois State University, Normal, IL 61790-5480, USA. Fax: 309-438-5510; E-mail: [email protected]

Tung-lung Chang

Assistant Professor of Management, School of Business, Long Island University, 720 Northern Boulevard, Brookville, NY 11548, USA. E-mail: [email protected]

Woon- Youl Choi

President, Korea Securities Research Institute, 33 Yoido-Dong,Youngdungpo-Ku, Seoul, Korea, 150-010. Fax: 822-786-6154; E-mail: ksril @ksri.org

Young Back Choi

Associate Professor of Economics, Department of Economics and Finance, St. John's University, 8000 Utopia Parkway, Jamaica, NY 11439, USA. Fax: 718-990-1868; E-mail: [email protected]

James W. Dean

Professor of Economics, Simon Fraser University (since 1969) and Kaiser Professor of International Business, Western Washington University, Bellingham, WA 98225-917, USA. E-mail: [email protected]

John R. M. Gordon

Professor and Alcon/NSERC/SSHRC Chair in Management and Technology, Queens School of Business, Queens University, Kingston, Ontario, Canada K7L 3N6. Fax: 613-549-5679; E-mail: gordonj @qucdn.queensu.ca

Vince Hooper

Senior Lecturer, School of Banking and Finance, University of New South Wales, Kensington, Sydney, Australia. Fax: 61 2 9385 6730; E-mail: [email protected]

xi M. Faizul Islam

Adjunct Associate Professor, Department of Management Studies, Southeastern University, 500 1 Street, S.W. Washington, D.C. 20024, USA. Fax: (202) 488-8093

Martin Jaugietis

Financial Analyst, Towers Perrin, Level 10, 101 Collins Street, Melbourne, Australia. Fax: 61 3 9270 8199; E-mail: [email protected]

Sung-Hee Jwa

President of Korea Economic Research Institute, FKI Building, 28-1, Yoido-dong, Youngdeungpo-ku, Seoul, Korea, 150-756. Fax: 82-2-785-0270/1.

Hisanori Kataoka

Researcher, Columbia University's APEC Study Center, 3-16-19-303 Naka-cho, Musashino-shi, Tokyo 180-0006, Japan. Fax: 81-422-60-2828; E-mail: kataoka @qg7.so-net.ne.jp

Edmund A. Kellerman

Lecturer in Speech Communication, William and Grace Dial Center for Written and Oral Communication, Rolfs Hall 414, P.O. Box 113072, The University of Florida, Gainesville, FL 32611. Fax: (352) 392-5420; E-mail: [email protected]

Daesik Kim

Professor of Finance, Department of Business and Economics, Hanyang University, Seongdong-Ku Haengdang-Dong 17, Seoul, 133-791, Korea. Fax: (822) 2296-9587; E-mail: [email protected]

Phil Sang Lee

Professor, School of Business Administration, Korea University, 5-1 Anam-dong, Sungbukku, Seoul, Korea 136-701. Fax: 822-922-7220; E-mail: phillee @kuccnx.korea.ac.kr

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Ungki Lim

Professor of Corporate Finance & Securities, Department of Business Administration, Yonsei University, Seoul, Korea 120-749. Fax: 2-2648-0314; E-mail: ungkilim @base.yonsei.ac.kr

Christopher Lingle

Professor of Economics, Universidad Francisco Marroqufn, Apartado Postal 632-A, Guatemala 01010. Fax: (502) 334-6896; E-mail: [email protected]

ReuvenMondejar

City University of Hong Kong, Tat Chee Avenue, Kowloon, Hong Kong

Jaeha Park

Associate Professor, Department of Marketing, Korea Institute of Finance, Myung-Dong 1 Ga 4-1, Chung-ku, Seoul, 100-021, Korea. Fax: 82-2-3705-6304; E-mail: jhpark @sun.kif.re.kr

Kyung Suh Park

Associate Professor, School of Business Administation, Korea University, 5-1 Anamdong, Sungbuk-ku, Seoul, Korea 136-701. Fax: 822-3290-1950; E-mail: kspark @kuccnx.korea.ac.kr

Peter Ping Li

Assistant Professor of Management, School of Business Administration, California State University, Stanislaus, 801 West Monte Vista Avenue, Turlock, CA 95382, USA. Fax: (209) 667-3020; E-mail: [email protected]

Jung-Hwan Seo

Research Fellow, Korea Economic Research Institute. Fax: 82-2-785-0273; E-mail: [email protected].

Tan Teng-Kee

Nanyang Business School, Nanyang Technological University, Singapore

xiii

Yeong-Ho Woo

Vice President, Korea Securities Research Institute, 33 Yoido-Dong,Youngdungpo-Ku, Seoul, Korea, 150-010. Fax: 822-786-6154; E-mail: [email protected]

Jiawen Yang

Associate Professor of International Business, School of Business and Public Management, The George Washington University, 2023 G Street, N.W. Washington, D.C. 20052, USA. Fax: (202) 994-7422; E-mail: [email protected]

ABOUT THE EDITOR J. (Jongmoo) Jay Choi is Laura H. Camell Professor of Finance and International Business at Temple University. He is a graduate of Seoul National University (BBA) and New York University (MBA, Ph.D.). Previously on the faculty of Columbia Business School, and an international economist at Chase Manhattan Bank. Visiting faculty at Pennsylvania (Wharton), NYU (Stem), Korea Advanced Institute of Science and Technology, and International University of Japan. He teaches corporate finance, capital markets, and international finance, and is a doctoral director of international business and a former chair of finance at Temple. He is a recipient of Musser Aaward for Excellence for Leadership, a former president of Korea-America Finance Association, and a trustee of Multinational Finance Society. He has over fifty books and articles in major journals. In addition to his work as a series editor of International Finance Review (JAI/Elsevier), he is a section editor of Journal of Economics and Business, and is on editorial boards of six journals. Listed in Harvard Business School Directory of International Business Scholars, and others.

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EDITORIAL ADVISORY BOARD Michael Adler, Columbia University Warren Bailey, Cornell University Ian Cooper, London Business School John Doukas, Old Dominion University/European Financial Management Gunter Dufey, University of Michigan Vihang Errunza, McGill University Robert Grosse, Thunderbird Business School Campbell R. Harvey, Duke University Yasushi Hamao, University of Southern California Robert Hawkins, Georgia Institute of Technology James E. Hodder, University of Wisconsin, Madison Maurice Levi, University of British Columbia Dennis E. Logue, Dartmouth College James Lothian, Fordham University/Journal of International Money and Finance Richard Marston, University of Pennsylvania Richard Roll, University of California at Los Angeles Anthony Saunders, New York University Richard Sweeney, Georgetown University

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THE ASIAN FINANCIAL CRISIS" MORAL HAZARD IN MORE WAYS THAN ONE Jongmoo Jay Choi The Asian financial crisis of 1997 jolted the world economy like no other economic event since the World War II. The effect of the crisis was both deep and broad. Countries used to decades of 8 - 1 0 % positive annual real economic growth saw their growth plunge up to a negative 15% (Table 1). Hundreds of

Table 1.

Economic Growth of Asian Countries (% Real G D P Growth Rates)

Country

t995

1996

1997

1998

Indonesia Korea Thailand Malaysia Philippines Singapore Hong Kong Taiwan China Japan

8.2 8.9 8.8 9.5 4.8 8.7 3.9 8.0 10.5 2.4

8.0 7.1 5.5 8.6 5.7 6.9 4.6 5.7 9.6 1.7

4.6 5.5 -0.4 7.8 5.1 7.8 5.3 6.9 8.6 0.9

-15.3 -5.8 -8.0 -7.5 -0.5 1.5 -5.1 4.0 7.8 -2.9

2.3

3.4

3.9

3.5

USA

Source: IME International Financial Statistics; Hong Kong Monetary Authority; CEPD for Taiwan

Asian Financial Crisis, Volume 1, pages 3-14. 2000 by Elsevier Science Inc. ISBN: 0-7623-0686-6

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Table 2.

JONGMOO JAY CHOI Devaluation in Stocks and Currencies: Asian Financial Crisis 1997

Country Indonesia Korea Thailand Hong Kong Japan

Stock

Currency

-44.7% -33.3% -35.4% -42.8% -16.7%

-69.3% -44.7% -51.9% 0.0% -10.9%

Source: Institute of International Finance, Inc.

firms and factories closed shops and millions of people lost their jobs. Stock prices as well as currency values plunged by half within days after the crisis (Table 2). Thus a minor currency crisis that started with an attack on the Thai Baht in July 1997 quickly consumed the entire country and precipitated a global contagion not only in Asia but also well beyond. There is an ongoing debate as to the role of finance in both economics and business. The literature on macroeconomic policy, for instance, relegates the role of financial markets to the background on the ground that only real factors matter. Similarly there is a tendency in business literature to afford a predominant role to operational or strategic factors, with finance playing only a subordinate role. Ironically, the Asian financial crisis is an incident that 'proves' that such a view is wrong and that finance is essential for country as well as for business. To describe the crisis, a popular magazine has carried a cover page containing a picture of people demonstrating in the street of Bangkok, carrying a banner of 'finance closed', 'industry closed', and 'country closed'. The banner succinctly summarizes the nature of the crisis: it started as a financial crisis but became of a crisis of industry and country as a whole in no time. In Korea, the economic planning minister pronounced, as late as November 1997 - several months after Southeast Asia has already fallen and less than a month before Korea had to seek assistance from the IMF - that Korea would not fall because of strong macroeconomic 'fundamentals'. Confident in the apparent relative strength of such traditional fundamentals such as growth or inflation, he did not take such financial or liquidity indicators as high shortterm borrowing and dwindling international reserve assets seriously. In a peculiar way, this episode suggests an important lesson that just like a firm squeezed by cash flow problem, nations should ignore finance at their own peril.

The Asian Financial Crisis: Moral Hazard in More Ways Than One

5

The crisis was as unpredictable as it was painful. Government officials could not imagine how their own tiger economies could not simply ride out any of the problems that may come in their path of continued high growth and economic success. Or perhaps that was the reason. The over-confidence and complacency brought about by success may have caused them to be blind to what is actually going on in the outside world and thus they were unable to innovate and change even when the world market environments are fundamentally changing because of globalization and technology.

MULTI-FACETED REASONS FOR THE CRISIS Given the scarcity of an international finance specialist with an Asian background, I was asked to speak on this topic on various occasions. One question I almost never fail to get is: since there are so many smart (Westerntrained) people in these countries, how did they all fail to see it coming and how come did they all let it happen? In answering the question, I often refer to a case of a firm that shows positive earnings yet went into bankruptcy (See Fig. 1). Despite positive earnings and equity, a firm can go under if it does not have cash flows to meet upcoming debt

"Profitable"

+

Bankruptcy

Transparency

I Liquidity/ Cash Flow

St~al

I FX Reserves ST Debt

Ri~dityl

Fundamental Factors

Fig. 1.

6

J O N G M O O JAY CHOI

obligations. It can attempt to obtain credit, but the lender may not be so inclined when the financial conditions of the firm is deteriorating. I then point out that the cash flow or liquidity problem is usually an indication of structural problems, which must be addressed to save the firm. Of course, it is also possible that earnings or equity reported in financial statements may not be transparent or even distortive, so it is important to investigate accounting as well. I then conclude that a basic answer for bankruptcy is simply management failure. This example of corporate bankruptcy suggests a lot about the causes of the Asian financial crisis. Just like a case of corporate bankruptcy, financial factors are at the forefront. However, the causes of the Asian financial crisis are also multi-faceted. They include structural and management problems as well as finance. In addition, there is a question of transparency and the role of capital markets in disciplining the management. Regarding the question of whether smart people should have predicted it, the predictability of the Asian financial crisis is an open issue that requires further empirical investigation. Some western observers such as Paul Krugman, however, sensed - as early as 1995 - that the Asian economic miracle was rapidly losing steam. The traditional source of economic growth - the availability of relatively low-cost high-quality labor was disappearing fast in Asia, and new source of growth such as technology was not easily in sight. The average hourly wage rate in Korea, for instance, has risen by 502% over the period of 1985-95 while it has increased only by 32% in the U.S. for the same period (Table 3). Clearly the resulting decline in international competitiveness had something to do with the crisis. Of course, the basic premise of Asia having many 'smart' people may not hold up upon close examination. However, if the premise is accepted (the Asian countries consistently rank highest in the number of students studying in U.S.

Table 3. Country Korea Taiwan Singapore Japan U.S.A. Source: Wall Street Journal

Hourly Wages in Manufacturing Sector 1985 $1.23 1.50 2.47 6.34 $13.01

1995

% Change

$7.40 5.82 7.28 23.66 $17.20

502 288 195 277 32

The Asian Financial Crisis: Moral Hazard in More Ways Than One

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universities after all), then the only plausible answer is that it did not matter. Apparently, the presence of many smart Western-trained engineers, MBAs or economists in corporations, government or universities did not help the countries in preventing the crisis. In Indonesia, Korea and Thailand (three countries who received assistance from the IMF), the government is run by domestic elites who passed highly competitive civil service exams and westerntrained officials are often cast outside of its inner circle. In corporate settings, top decision-makers do not consult the views of western-trained MBAs because of an organizational rigidity that does not promote broad, open participation. Asian firms have rigid hierarchy and a top person exercises exclusive authority on all major decisions. Moreover given the family control of a business conglomerate, major decisions are deferred to the group 'owner' beyond the chief executive office of a single firm. In the West, capital markets and institutions monitor and discipline the management in the case of poor performance. However, given the underdeveloped capital markets and institutions, investors or creditors are unable to play such a role. Hence, there is nothing that can effectively monitor, influence or discipline the management or group owners either internally or externally. Then the fortune of the firm depends on the vagary and wisdom of the group owner. Of course, the Asian managers do not necessarily have greater or smaller proclivity to make bad decisions than Western ones. However, they are more susceptible to make overly ambitious suboptimal investment decisions because of their reliance on debt capital (as well as the lack of market discipline). Korean finns had a debt-equity ratio of over 300% on the average (some even more than 1000%) before the crisis (Table 4). Corporate finance theory indicates that a firm heavily leveraged with debt capital tends to make overinvestment decisions well beyond the optimal level. If the firm is heavily debt-financed, there is a built-in incentive to 'gamble' with other people's

Table 4.

Financial Leverage of Asian Firms

Country

Debt to Equity

Korea Taiwan Japan

317.1% 85.7% 206.3%

U.S.A.

159.7%

Source: Chosun Ilbo, 1997

8

JONGMOO JAY CHOI

money when the firm is facing potential bankruptcy risk, which will rise with leverage. Easy bank loan made available by 'relationship banking' and the government-guided 3B trilogy (bureaucrats, bankers, and businessmen) of 'the Asian business model' is also a major contributing factor. An interesting related issue pertains to the quality of information. Some of the statistics on external debt and international reserves released by the Korean government prior to the crisis was wrong or misleading, as it was forced to revise them later. Similarly the financial statements released by firms massage the real effects of cross-stock ownership, intra-group transactions and the like and are much removed from mark-to-market accounting. To sum, there is no shortage of suggestions for the reasons of the Asian financial crisis. In the spirit of David Letterman's top 10 - or should it be 21 quizzes since there are so many: Reasons for the Asian Financial Crisis (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (15) (16) (17) (18) (19) (20) (21)

Victims to international speculative capital Victims to conspiracy Crony capitalism and corruption Decline in international competitiveness Failure of the Asian business model Government control and interference (including bailing out of bankrupt institutions) Inadequate government monitoring and regulation Lack of transparencies regarding government policies and accounting Family control of business groups Excessive corporate borrowing Underdeveloped domestic capital markets and institutions Current account deficit and excess consumption Rising external debt Low international reserve assets Liquidity problem due to high ratio of short-term debt Non-sustainability of 'fixed' exchange rate policy International contagion Lack of global perspectives Authoritative decision making structure Ego and stupidity of top business and government officials in charge Moral hazard problems.

Reflecting the multi-faceted nature of the crisis, the list is diverse and multidimensional. The first two are suggestions based on victimhood and represent

The Asian Financial Crisis: Moral Hazard in More Ways Than One

9

views often heard in the Asian media. Reasons 3-6 regarding the shortcomings of the Asian business are ones often suggested by Western analysts and media. Next two questions, 7 and 8, are suggestions from a regulatory standpoint. Corporate finance provides reasons 9-11. Items 12-17 cover the international dimensions, while culture provides items 18-20. The challenge for research is sorting them out in terms of their relative importance. A holistic issue is whether it is possible to put all these factors together in some coherent conceptual framework. Moral hazard - the last item 21 - provides such a possibility. It provides a general conceptual framework since it encompasses financial and real factors as well as questions regarding transparency and management.

MORAL HAZARD IN MORE WAYS THAN ONE Moral hazard is a jargon in finance and microeconomics that refers to an inefficiency created by an inability of insiders to convey accurate information to the market or outsiders because of uncertainty and information asymmetry. This inefficiency is an increasing function of leverage beyond a certain optimal level. A firm financed by debt is likely to make suboptimal investment decisions. As applied to the Asian financial crisis, moral hazard highlights the fact that the origin of the crisis is financial, but the eventual cost of such outcome is magnified by structural factors. And the impacts are society-wide beyond economics. Elementary financial theory suggests that while the use of leverage can be beneficial at good times, the potential loss is far greater with leverage at bad times. Hence, the leverage increases the level of risk in all cases. This simple rule is violated in Asia, and the Asian financial crisis is a natural outcome. At the macro level, it is clear in Table 5 that three countries that sought assistance from the IMF (Indonesia, Korea, and Thailand) as well as other countries that suffered severely in the crisis (Malaysia, Philippines) had much higher level of current account deficit and external debt - and much of it is short term - relative to the size of their economies than others that escaped the crisis (Hong Kong, Singapore, China and Taiwan). The level of international reserve assets is also very low for these countries, while, unlike Mexico and other Latin American countries that faced crises earlier, they did not have deficit in government budget. (The latter factor illustrates that the origin of the Asian crisis was more in the private sector than public although the government might have wielded its influence behind the scenes.) At the same time, the government basically maintained a fixed exchange rate system, which may be untenable with domestic and external financial constraints they faced.

JONGMOO JAY CHOI

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Table 5. Country

Indonesia Korea Thailand Malaysia Philippines Singapore Hong Kong Taiwan China Japan

Financial Constraints of Asian Countries, 1996

Current account (% GDP)

-3.4 -4.8 -7.9 -4.9 -4.7 15.0 -2.5 3.8 0.9 1.4

Government budget (% GDP) 0.0 ~).2 2.3 0.7 0.3 13.9 1.5 1.6 ~.8 -3.9

Externald e b t (% GDP)

International Reserves (months of imports)

38.9 11.2 19.8 28.8 50.9* N/A N/A 0.1 15.0 N/A

6.1 2.8 6.6 4.3 4.4 7.0 10.9 10.3 9.1 8.5

N/A =not applicable. * 1995 figure. Source: Hong Kong Monetary Authority; CEPD for Taiwan, APEC.

At the micro level, many Asian firms borrowed heavily from home and abroad. The debt ratios of major industrial firms are often several times higher than either the norm in the U.S. or any calculation of optimal leverage ratios. Thus, it is a matter of elementary finance that these firms faced severe financial risk, and it is a matter of market conditions whether any of them will fail. Of course it is possible that financial leverage will actually be beneficial if market conditions are favorable. However, if the market turns unfavorable, the firm that has expanded with borrowed funds will face the risk of bankruptcy. Clearly the global business expansion will not work as a risk management strategy, as the failed Daewoo Group in Korea has painfully found it out. Much of the borrowing is made available in a system of the 'Asian business model' that cements the relationship between bureaucrats, bankers and businessmen. Bureaucrats provide directives to bankers so that they can lend out m o n e y to business on the basis of relationship, collateral or government guidance rather than an analysis of risk or business potentials. Firms in turn make political contributions and other payments to win friends and to facilitate transactions. Bankers find no reasons to innovate or to be competitive. In this system, the risk of bankruptcy of a particular firm can be shifted to the group (such as the Korean chaebol) if another company in the group provided a collateral or repayment guarantee. The risk of bankruptcy can also be shifted to the bank since bank loans provide a bulk of outside financing. The

The Asian Financial Crisis: Moral Hazard in More Ways Than One

11

result is the weakening of the group as well as the bank. The risk of failure of the group or bank, in turn, can be shifted to the government by implicit social contract ('too big to fail', or 'banks do not fail') or by an explicit injection of public money. However, the risk shifted is not the risk eliminated. It only reduces the risk perceived by one firm; it does not reduce the actual risk for the system as a whole. Sooner or later there is a day of reckoning, and the reckoning will come when the market environments worsen. Leverage raises bankruptcy risk, but the finn does not perceive it as so because of the belief that it will be bailed out - by the group, the bank or the government. In this situation, the perceived risk is much lower than actual risk. Even though the risk is very large for the country as a whole given the deteriorating macro financial indicators, any individual decision maker in a firm or a bank would not behave as if the risk is big. Ultimately the risk is shifted to the government or people as a whole. Clearly it is possible that some of the risk can be shifted overseas if additional financing can be arranged abroad. However, if foreign creditors refuse to provide credits, or even to renew existing ones, because of worsening economic conditions of the country or unfavorable world market conditions, the massive collapse of those overly leveraged firms would be inevitable. Moral hazard is also harmful because it leads to overly ambitious suboptimal investment decisions. Levered firms on the verge of bankruptcy will have an incentive to expand even when such decision is not warranted objectively by business potential. The reason is asymmetry of the reward to risk structure. If the project is a success, it will save the company and the manager/owner from bankruptcy. If the project is a failure, it just means that creditors will suffer more. The value of equity is zero regardless of whether the firm undertakes the project or not if the firm goes into bankruptcy. The moral hazard problem is present in the case of levered firm in any country. However, it is a much larger problem in Asia because of the Asian business model that encourages excessive use of leverage, because of industrial organization that is controlled by family owners, and because of the lack of market discipline. The problem is exacerbated by the lack of transparency and insufficient regulatory monitoring. More importantly, the cost of moral hazard in Asia is not confined to economics. It permeates the entire society. The system of awarding business based on relationship or government directives (rather than merit) raises the question of integrity and fairness. It encourages factionalism and perpetuates the family control of business. It legitimates corruption and questionable payments as an accepted norm. It destroys incentive to innovate and hinders open, democratic decision-making. It thereby permeates the societal culture

12

JONGMOO JAY CHOI

and undermines the fabric of a civic society. In that sense, moral hazard though created in a technical economic context - if unchecked, can lead to a crisis of moral decay in the society. An interesting dimension of moral hazard is related to asymmetry of information. It is generally assumed in corporate finance that insiders would have superior access to relevant information pertaining to the firm. However, the situation may be the reverse in the case of the Asian financial crisis. As it turned out, foreign analysts and media were correct on their judgment of the risk of the Asian borrowers while the government officials in Asia - the ultimate insider - failed to assess the situation accurately. This, however, may be more a function of whether they have an access to quality information rather than whether they are 'smart'. Anybody who has traveled in these countries more than casually would be struck by the fact that timely international news is generally hard to come by. Local news media often provides only a cursory (and sometimes biased) treatment to major international economic and political developments. If so, it is reasonable to suppose that even the 'smart' Western-trained economists or government officials may lack an access to objective, international viewpoints because they are not easily available from local sources. It is true that, in the immediate pre-crisis period, local talents were generally unaware of critical commentaries reported overseas. I hasten to add that the global information technology innovation that is now going on may reduce the extent of information asymmetry in the post-crisis period.

RESEARCH QUESTIONS Research on the causes, consequences and implications of the Asian financial crisis has just begun. Given the nature of empirical research that requires historical data, the minimum level of historical data are now available which should encourage research and investigation of many facets of the Asian financial crisis. Consistent with the previous list of 21 questions regarding the causes of the Asian financial crisis, here goes another 21 regarding the potential research issues pertaining to the Asian financial crisis. Research Questions on the Asian Financial Crisis (1) Was the Asian financial crisis predictable? (2) How did the crisis spread? (3) Is the pattern of internal or external transmission consistent with market integration? (4) To what extent is the contagion motivated by economics or psychology?

The Asian Financial Crisis: Moral Hazard in More Ways Than One

13

(5) How is the Asian financial crisis similar or different from other financial crises such as the Latin American crisis (or the U.S. savings and loan crisis)? (6) What differentiates the crisis-stricken Asian countries from non-crisis countries? (7) Could the crisis have been averted if the flexible exchange rate system had been in place? (8) To what extent is foreign speculative capital to blame for the crisis? (9) To what extent are different economic sectors of the country (household, business, government) responsible for the crisis? (10) What is the role of capital markets in the crisis? (11) Was the crisis financial or real? (12) Was the cause of the crisis domestic or international? (13) Was the cause of the crisis transitory or permanent? (14) What role did the Asian business model play in the crisis? (15) Who bore the burden of the crisis? (16) Was the IMF policy prescription appropriate? (17) Could the currency board have worked in Asia? (18) Could they have recovered without the IMF assistance? (19) How do you prevent and cure moral hazard problem without letting the country fall? (20) How do you develop early warning and risk management systems? (21) To the extent that corruption and the lack of transparency had been the norm, what is the sense in which it 'caused' the crisis?

LESSONS FROM THE ASIAN FINANCIAL CRISIS To summarize, the following points can be drawn: including the perils of financial leverage, the importance of liquidity, transparency, the role of markets, open and democratic decision-making, inefficiencies of family control, and moral hazard. By implication, we can also add the need for risk management, innovation and specialization, as well as global perspectives. Finally, the political leadership is essential if any reform can be carried out effectively. Given the resistance of the affected groups as well as natural inertia, it is essential that the leadership can transcend narrow political considerations and appeal to the people directly about the need to reform. It is also important that the reforms are carried out in a timely manner, so that the momentum for reform is not buried in a sea of convention, bureaucracy, and self-interests. Thus, we have a top ten list for the lessons from the Asian financial crisis: Lessons from the Asian financial crisis

14 (1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

JONGMOO JAY CHOI Perils of financial leverage An importance of liquidity Transparency in policy and numbers Market rather than relationship Open, democratic decision making in business and government Inefficiencies of family control Beware of Moral Hazard Need for risk management, innovation, and specialized training Global perspectives Political leadership is paramount.

Does this mean that the Asian business model is obsolete? Not necessarily. It is true that the Asian business model has contributed to the creation of many problems of moral hazard. However, it can be reasonably argued that a few years of crisis experience must be judged against decades of economic success that these countries have been able to achieve. Clearly, there are aspects of the Asian model that are good such as hard work, cooperative rather than a confrontational stance, and an emphasis on education, and so forth. The challenge is to sort out the good and bad aspects of the Asian model and to keep the good and throw out the bad. Whatever the specifics of the necessary reform, given the omni-presence of factional self-interest groups, the quality of political leadership appears to be paramount at the present time.

WHICH FAILED: ASIAN CAPITALISM OR INTERNATIONAL CAPITAL MARKETS? James W. Dean ABSTRACT This chapter asks whether the Asian crisis was a failure of Asian capitalism, or a failure of market capitalism. It begins with a stylized chronology of events that is broadly consistent with either hypothesis. It then re-tells the story, first through a 'government failure' lens, and next through a 'market failure' lens. The chapter concludes by reporting what theoretical and policy consensus has so far emerged within the economics profession, as well as the quandries that remain.

1. INTRODUCTION Since the humiliation of Asia, economists may or may not be on the road to Damascus, but as yet, no divine revelation has come their way. On the contrary, they see at best "through a glass darkly. ''1 Worse, they see the Asian crisis through disparate lenses. Some see that Asian 'crony' capitalism has dramatically failed, and interpret the past two years' financial chaos as a final vindication of the West. But others see the very same events through a radically different lens, with Western market capitalism the villain and Asian capitalism

Asian Financial Crisis, Volume 1, pages 15--43. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0686-6

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JAMES W. DEAN

the victim. In short, where some see a failure of Asian capitalism, others see a failure of Western capitalism. 2 The collapse in currency values suffered by half-a-dozen Asian economies between July and December 1997 was unprecedented in modern history. It was preceded by collapses in other asset values - notably in equities and real estate in Japan a decade earlier - that were almost as dramatic. None of these events was even remotely anticipated by the world's leading financial analysts (Irvine, 1997). Such lack of precedence, drama and surprise all call into question the carefully crafted theories of efficient markets that dominate our profession. The existence of efficient markets in Asia is easy to dismiss, given the murkiness of information and absence of arms-length dealing that seems to characterize the region. But the murkiness and arms-on-dealing was more or less known in advance, and thus we would have expected financial markets that were rational and forward-looking - in other words, that incorporated rational expectations - to have reacted smoothly and gradually as new information was revealed. As I have suggested elsewhere (Dean, 1998a, b), there was no obvious external trigger for the events that followed collapse of the Thai baht in mid-1997. Asian currency and equity markets seemed simply to collapse of their own accord. But as Krugman (1997) has acknowledged, even the most recent theoretical literature on self-sustaining currency crises does not do the job. The existence of efficient international capital markets is also easy to dismiss. Conventional analysis based on open-economy macroeconomics more or less did do the job for the Mexican crisis of 1995-6. When Cline (1995, p. 13) stated that "[t]he Mexican mixture of the sheer scale of the currentaccount imbalance, the short-term nature of the debt, and quasi-fixed exchange rate was unique," he was correct in that none of the Asian crisis economies exhibited these factors in combination on quite the scale as did Mexico. Indeed, in a speech delivered in Mexico City in 1994, Krugman, alone among his peers, actually predicted a Mexican crisis unless the exchange rate was unpegged. But neither Krugman nor Cline nor anyone else predicted the Asian crisis. Cline, in fact, went so far as to assert that "[t]he surprise factor of the [Mexican] peso crisis as the first jolt to the post-Brady capital market cannot, by its very occurrence, be repeated" (Cline, 1995, p. 13). In late 1997 and early 1998, Krugman (1997, 1998a, b) was the first to articulate a revision of the conventional view, which could be characterized as the Asian-failure view, and which I will characterize later in this essay more generally as the government-failure view. Krugman suggested that the missing piece in our ex ante analysis of the Asian economies was their internal financial intermediation. Asian banking systems, as the world now belatedly knows, are

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rife with insider lending and government quasi-guarantees - far rifer than their far-from-pure Western counterparts - and this led to extreme moral hazard and adverse selection. These factors prompted 'Panglossian' valuations of asset values, until, that is, the funds for government subsidization and bailouts simply ran out. At that point the dynamics that had led to overvaluation went into reverse. It is perhaps safe to say that by late 1998, Krugman's lens for viewing the Asian crisis was widely enough shared among professional economists, at least in the West, that his version of events had become neoconventional. By early 1998, a radically different view of the Asian crisis was also being articulated, notably (though by no means exclusively) by Wade (1998) and Wade & Veneroso (1998). The view holds to a model of Asian development that starts from extraordinarily high household savings and relies heavily on intermediation through the banking system. This system, they claim, necessarily led to debt-equity ratios in the real sector that far exceed Western norms. Such a mode of finance was too vulnerable to be left to the vagaries of armslength capitalism. It had to be complemented by a set of triangular, mutually supportive and symbiotic relationships between government, banking and industry - what neo-conventional commentators now call 'crony capitalism'. Subscribers to this view argue further that unrestricted inflows of foreign capital upset this symbiotic system and caused it to come unstuck. This could be characterized as the Western-failure or market-failure lens, through which the Asian crisis is seen by a growing minority. This chapter begins, in Part 2, with a stylized series of events that might be used to organize thought about the 'causes' of the crisis. While greatly simplified and shorn of detail, none of these assertions is, by itself, remarkably deviant from the conventional wisdom that prevailed before the crisis. But conventional wisdom did not predict the crisis because these components were not synthesized into a coherent, semi-chronological story. Although this chronology itself necessarily embodies a point of view, I have attempted to cast widely and neutrally enough that it is broadly consistent with both the Asianfailure and Western-failure versions of events. In Part 3, the chapter proceeds to assess the above chronology twice, first through an Asian- or government-failure lens, and then through a Western- or market-failure lens. Part 4 addresses a critical policy quandary - whether or not to re-regulate capital flows - that arises directly from the two conflicting views, and Part 5 reports the fragile consensus, such as it is, that is now emerging about what national and international policies might avert crises in future. Part 6 concludes.

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2. A STYLIZED CHRONOLOGY OF EVENTS LEADING TO THE ASIAN CRISIS HIGH DOMESTIC SAVINGS RATES LED TO RAPID PHYSICAL AND HUMAN CAPITAL FORMATION AND HIGH GROWTH It is probably safe to surmise that by the late 1990s, conventional wisdom among informed economists no longer held to the 'myth of the Asian miracle', if it ever had. Extravagant popular projections such as John Niasbitt's Megatrends Asia (1996), and equally extravagant claims for a neo-Confucian productivity advantage, had been put to rest rather decisively by Paul Krugman's (1994) widely-read article entitled 'The Myth of Asia's Miracle'. Based on empirical work by Alwyn Young (1992, 1994a, b), Krugman argued that the Asian tigers' growth rates could be accounted for almost entirely by growth in inputs of physical and human capital, and thus that rumors of a mysterious unexplained Asian "residual" were false. Put another way, Young and Krugman purported to document that Asian growth had involved no appreciable increases in total factor productivity. Superior technology, innovation, organizational or managerial methods, cultural kinship - none of these seemed to have played a role. Naturally, this message - that growth had been achieved by "perspiration, not inspiration" - was unpopular in Asia. But it made sense to most Western-trained economists. Hence economists, lead by Krugman, at least had it half right based on conventional theory and empirical technique: Asian growth was no miracle and would ultimately slow down because it would be subject to diminishing returns. Nevertheless, Asian growth was an achievement unparalleled in human history. Neither Britain nor America nor any newly industrialized country had in the past grown so rapidly. What Japan followed by the 'tigers' achieved in decades or less took Britain and America half a century or more. The combination of very high savings rates, long hours of hard work, and a strong emphasis on education (at least in the Chinese and Japanese communities) translated into high rates of investment in physical and human capital. In fact to deny that this mobilization of capital was aided and abetted by culture, organization and the like is to deny credit where credit is due. The lasting legacy of the Young and Krugman message is not that nothing remarkable happened, but rather that no endogenous productivity enhancement was evident once all inputs had been measured. In fact in some cases, notably Singapore, when the very high investment rates were compared with real GDP growth, the

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productivity of capital appeared to be very low by the standards of developed economies. This suggested that capital might be both misallocated and overinvested, a theme that is expanded below. Asia's growth, based as it was on capital accumulation, might have slowed down naturally and gradually in the early 1990s as the large but nevertheless limited supply of domestic savings confronted diminishing returns to capital. Interest rates might have risen and marginal returns to investment projects fallen until the rate of investment equilibrated at a lower rate than it actually did. But this did not happen. Interest rates did not rise to choke off investment because foreign capital was readily available. And expected returns to investment did not fall because of a perception - by both domestic and foreign lenders - that they would be bailed out by domestic governments, and if not, by the IME In the 1990s, capital inflows accelerated in part because of widespread deregulation of capital accounts. Perceptions of domestic bailouts were an intrinsic part of what I will call Asian capitalism. The next three sections deal with these topics.

CAPITAL A C C O U N T L I B E R A L I Z A T I O N A D D E D TO H I G H G R O W T H E N C O U R A G E D R A P I D CAPITAL INFLOWS 3 Deregulation of capital flows to and from developed countries - notably Western Europe and to a lesser extent Japan - was complete by the early 1980s, after a post-World War II legacy of exchange rate inconvertibility and capital movement restrictions that took more than four decades to dismantle. Similar liberalization came to Eastern Europe and the Former Soviet Union after the fall of the Berlin Wall in 1989. The spread of liberalization to developing countries was sporadic and often serendipitous. Small island economies were frequently induced to open up their external and financial sectors by the twin carrots of membership in free trade agreements and potential for offshore banking (Dean, 1993). Others were prodded or even panicked into liberalization by balance of payments crises (Haggard & Maxfield, 1996). In the 1990s, increased opportunities for cheap foreign money and high domestic returns prompted both borrowers and lenders to push for deregulation. On the surface, rapid and early deregulation by certain developing countries is puzzling, as it proceeded further than in most developed countries at the time, and in retrospect was often premature. For example Argentina, Chile and Uruguay all liberalized during the late 1970s, and later suffered dire consequences (Edwards & van Wijnbergen, 1986; Corbo & de Melt, 1985).

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More recently, in late 1994 and early 1995, Mexico's liberalization seemed to some as premature. Although the appropriate sequencing of economic de-control may even then have been clear to those with common sense and no self-interest in the outcome, and although the lessons for sequencing are by now well documented (for example, McKinnon, 1991; Sachs, Tornell & Velasco, 1996), deregulation in practice is subject to pressure from the forces of realpolitik. Of course realpolitik often operates in opposing directions. Freeing up capital flows stands to harm private sector lenders and dealers in black market foreign exchange whose rents would be eroded by foreign competition (Grosse, 1994). Governments often have even more to lose, benefiting as they do under capital controls from the ability to run fiscal deficits financed by monetary creation without discipline from international lenders. Governments also stand to lose powers of patronage toward sectors of the economy they may, for good reasons or bad, care to favor. On the other hand as liberalization in the developed world proceeds, with the consequent increase in global economic integration, the balance of realpolitik begins to shift. The opportunity cost of controls on the private sector increases, as do opportunities for evading such controls. Increased external trade leads to greater incentives and occasions for under- and over-invoicing. Banks in their turn see opportunities for tapping international sources of savings, and are tempted to open branches or subsidiaries abroad, particularly in New York and in the London Eurocurrency market. Over the last decade, Korean banks, for example, have engaged in this process with a passion. Governments find such operations increasingly difficult to monitor. Witness the South Korean government's apparently honest confusion, in October and November of 1997, over the external liabilities of overseas branches of Korean commercial banks. These monitoring difficulties are exacerbated by enhanced communications and travel possibilities. Indeed cheap air travel alone has made the enforcement of capital controls on individuals almost impossible. Finally, foreign firms and financial institutions see opportunities for profit in markets that are as yet relatively closed, and begin to lobby for looser controls on entry. Although these trends might ultimately lead to liberalization in and of themselves, their force has typically been strengthened by a balance of payments crisis. This might seem paradoxical, since a crisis should surely prompt government to tighten capital controls rather than loosen them. Yet between 1985 and 1990, when much of the developing world was mired in sovereign debt crisis, developing countries consistently and increasingly liberalized their capital accounts: the number of liberalizing measures increased from twenty-two in 1985 to a peak of sixty-two in 1988 before falling

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off to forty-nine in 1990 (Haggard & Maxfield, 1996). To be sure, in some cases (for example in Argentina, Mexico and Venezuela) the initial response to the debt crisis in 1982-83 was to tighten controls against capital flight, but these responses were soon reversed. Why should a balance of payments crisis prompt loosening, rather than tightening, of capital controls? The answer is that the political position of those interests that favor liberalization is suddenly strengthened. Such interests include holders of foreign exchange, exporters, foreign creditors and investors, foreign financial intermediaries, and the international financial institutions (IFIs): in short, the owners, earners and potential lenders of foreign exchange. Only if the capital account is liberalized will foreign exchange holders desist from (illegal) capital flight, exporters desist from false invoicing, and potential creditors be prepared to resume lending. The extended balance-of-payments-cum-debt crisis of the 1980s was resolved by the Brady Plan, under which from 1989 - 95, creditor commercial banks essentially wrote off about one third of the $211 bn long term debt of some twenty four severely indebted middle income countries, mostly but not exclusively in Latin America. 4 The Brady Plan triggered an abrupt end to the prolonged international debt crisis in the sense that by 1990 capital flows to Latin America had resumed with a vengeance. And the inflow to East and Southeast Asia was already well underway. Lenders were motivated by the alluring triple prospects of high returns, sharply lowered country and exchange rate risks, and deregulated and privatized domestic environments. Borrowers for their part chose foreign over domestic sources of funds because on the margin (and the margin was large), foreign funds carried substantially lower interest rates. Where capital account liberalization was not complete, particularly in Asia, such prospects for profit motivated both lenders and borrowers to push for closure, with strong encouragement from the IFIs. As Wade (1998, p. 9) puts it, " . . . [in East and Southeast Asia during the 1990s] firms and banks, both national and international, pressured governments to undertake financial deregulation, their pressure converging with that of the IMF and the World Bank." Why was foreign capital so cheap? Two factors were paramount. First, contrary to conventional opinion, which focuses solely on low inflation, monetary policy in the developed world has been rather expansionary. In Japan and Europe this reflected largely unsuccessful attempts to revive lagging growth; in the U.S. it reflected Alan Greenspan's concern to keep the good times rolling. With slow real growth and low inflation in Japan and Europe, excess funds flowed into financial assets around the world: into the fabled U.S. stock market, of course, but also into Asia. The bulk of foreign bank claims on

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the crisis Asian economies are from Japan and Western Europe, not the U.S. But from the U.S., where nominal growth throughout its sustained boom has rarely exceeded 4%, broad money growth of 10% and above has flowed substantially into asset markets, including Asia's. Of course lenders ignored default risk, for reasons that we will attend to shortly. The second reason that foreign capital was so cheap in Asia is that borrowers ignored foreign exchange risk. As any beginning student of international finance knows, interest rates on yen- or dollar-denominated loans can only be different from those denominated in domestic currency if expected changes in exchange rates are ignored. Otherwise, if international capital markets are deregulated and otherwise unencumbered, perfectly mobile capital will ensure that expected (risk adjusted) interest rates equalize internationally (uncovered interest parity), or that actual (risk adjusted) forward-hedged interest rates equalize (covered interest parity). Asian borrowers in effect assumed that exchange rates would not be devalued.

FIXED EXCHANGE RATES ADDED TO RAPID CAPITAL INFLOWS LED TO RAPID MONETARY GROWTH Most East and Southeast Asian countries (with the notable exception of Japan) pegged their currencies to the U.S. dollar, or to a basket of currencies dominated by the U.S. dollar. This had two consequences. First, net capital inflows (unless 'sterilized', a losing proposition in the long run 5) were automatically added to foreign exchange reserves, and thence monetized turned into domestic currency. In short, rapid capital inflows led to rapid monetary growth. The second consequence followed from the first. Monetary growth in excess of real output growth was translated into inflation. Hence real exchange rates rose even though nominal exchange rates were pegged. Overvalued real exchange rates then led to widening trade deficits. Added to growing debt service on accumulating foreign debt, this meant widening current account deficits, financed of course by ever-larger capital inflows: that is, ever-larger capital account surpluses. This process proceeded much further in Thailand, Indonesia and Malaysia than it did in South Korea, although it was underway there too. Conventional wisdom circa 1996, at the end of the Mexican crisis, was that this circumstance alone - fixed exchange rates and easy money - was necessary but not sufficient to precipitate an exchange rate crisis. Conventional wisdom was right in principle, but wrong in practice. The implicit assumption behind the comfort accorded countries like Thailand, Indonesia, Malaysia and Korea was that, unlike most of their Latin American counterparts, these were

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economies that invested rather than consumed borrowed funds, and furthermore that invested funds wisely and productively. Hence current account deficits of the order of 8% of GDP were sustainable since GDP would continue to grow and debt-to-GDP ratios would stabilize or decline. In practice this assumption was at least half-wrong. To be sure, these were economies that invested heavily; but in retrospect they over-invested. Worse, they misallocated their investment: a large part of it proved unproductive. The reasons for both over-investment and misallocation are intimately related to imperfect financial intermediation.

IMPERFECT FINANCIAL INTERMEDIATION ADVERSE SELECTION AND MORAL HAZARD ADDED TO RAPID MONETARY GROWTH, LED TO BOTH MISALLOCATION AND OVER-INVESTMENT OF CAPITAL 6 Financial intermediation is necessary because some direct financial markets are imperfect, even in the most advanced economies. Were direct financial markets universally efficient, intermediation would be unnecessary to transfer funds from savers to borrowers: equity and bond markets would suffice. But given that intermediation is often necessary, its efficiency can in principle be improved via judicious supervisory and regulatory systems. Yet in practice no economy has yet devised, let alone implemented, banking or other intermediation systems that align the incentives of lenders and borrowers as closely as do the world's major and more efficient equity and bond markets. We begin this section by reviewing very briefly the reasons that all monetary economies employ financial intermediation, and the reasons that it is by nature imperfect. We then examine the nature of financial intermediation in the Asian crisis economies. Finally, we draw the connection between imperfect financial intermediation, capital inflows, and misallocation and over-investment of capital in these economies. Why All Economies Employ Financial Intermediation

Financial intermediation is a response to asymmetric information. Borrowers usually know more about the risks and returns associated with the projects in which they wish to invest than do savers. Banks and other intermediaries capitalize on economies of scale to pool risks as well as investigate and monitor both risks and returns. Banks thus act as agents for depositors. Hence all economies employ financial intermediation in order to reduce the costs of

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asymmetric information below what they would be were the task of matching savers and borrowers left solely to direct financial markets. But however diligent bankers may be in pooling, investigating and monitoring risks, they are never in practice completely successful in eliminating two consequences of asymmetric information: adverse selection and moral hazard. Why Financial Intermediation is Imperfect

Adverse selection (Stiglitz & Weiss, 1981) refers to the fact that riskier borrowers self-select themselves. Banks and other financial intermediaries attempt to limit adverse selection ex ante by discriminating among borrowers and pricing loans accordingly (Diamond, 1984). But even with the best ex ante discrimination in the world, enough asymmetric information remains that banks are unable to set interest rates on bank loans that fully discriminate according to risk. Hence, among bank borrowers, inferior investment projects are over-represented, and superior projects under-represented. Lower risk borrowers disproportionately choose to obtain direct finance, or finance themselves, because bank loans are overpriced from their point of view. All this derives from asymmetric information between borrowers and savers. A second consequence of asymmetric information is moral hazard. This refers to the fact that ex post, after a contract is in effect, the insured have incentives to act against the interests of the insurer. In order to attract savers, borrowers must offer them some compensation for risk. In an ideal world of symmetric information, savers know as much about investment projects as do borrowers and thus they are able to price risk accurately by charging riskier borrowers appropriate risk premiums. As we have seen, in our less than ideal world of asymmetric information, banks and other financial intermediaries are able to add value over and above direct financial markets because they are better able to act as agents for savers. They do this ex ante by discriminating among borrowers, charging them appropriate risk premiums, and passing these risk premiums on to depositors (savers) as higher interest rates. They also act as agents ex post by monitoring and influencing borrowers' behavior (Stiglitz & Weiss, 1983). Hence they are able to combat moral hazard as well as adverse selection. Nevertheless, in the real world, banks' ability to monitor is limited. In practice, moral hazard remains because borrowers know more about projects than banks. Government

Notably, we have yet to mention government. In a nutshell, current conventional wisdom has made government indulgence of banking the primary

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scapegoat for Asia's crisis. Conventional wisdom would have it that Asian governments greatly exacerbated adverse selection by underwriting foreignexchange-risk-free interest rates, and moral hazard by implicitly assuring banks and bank depositors of bailouts. 7 It is hard to dispute this view, either on factual or theoretical grounds. Yet it may be a half-truth: all governments indulge commercial banking and for good reason. Ideally, governments should intervene so as to reduce rather than exacerbate the adverse selection and moral hazard inherent in financial intermediation. Unfortunately this is not necessarily the case, even in the arms-length Anglo-American systems that have come so much into vogue in the 1990s, when continental Europe and now Asia demonstrably under-performed America. The reason that government intervention in banking faces a dilemma is that banks not only play the role of reducing information asymmetries between savers and borrowers, they also provide the economy's money supply. Commercial banks supply economies with highly liquid deposits. Thus added to the value that commercial banks add to economies by reducing information asymmetries is the value that they add by providing liquidity. The reason that commercial banking attracts government assurance is that this liquidity acts as the economy's means of payment, and is thus a public good. Governments are mandated to ensure the economy's supply of public goods. The supply of bank deposits is vulnerable because deposits are contractually redeemable at par whereas their value derives largely from assets that at short notice can be cashed only at a discount. Hence a bank's contract with depositors is good only as long as net withdrawals of deposits do not exceed its liquid assets. As long as net withdrawals proceed within statisticallypredictable boundaries, bank deposits can be backed up by a statistically-predictable quantity of liquid assets. But if there is a shock to depositors' confidence, and withdrawals accelerate beyond those boundaries, and if depositors are denied cash, it becomes rational for any and all individual depositors to try to withdraw as well. Thus the initial shock develops into a run and not only a run on the original bank but a run on other banks that might otherwise have been sound. A useful abstraction is to consider that before the run, deposits retained value because each individual depositor was able to free ride on the willingness of other depositors to refrain from withdrawing. Conversely, after the run, deposits lose value because free rider behavior goes into reverse. This phenomenon has of course been long understood, although the modern literature has analyzed it in new frameworks with new names. 8 The supply of bank deposits is thus not only a public good - in fact a market economy's most fundamental and valuable public good - but a public good that

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is vulnerable to disruption. Thus governments in all developed economies underwrite commercial banks: implicitly by proffering lender of last resort facilities from a central bank, and sometimes by limiting competition, and often explicitly as well, by providing deposit insurance. However, such comfort from government is a double-edged sword. While on the one hand it is designed to preserve the economy's liquidity, on the other hand it increases banks' susceptibility to adverse selection and moral hazard, the former by suppressing risk premiums on interest rates, and the latter by interfering with banks' role as agents who transmit the true riskiness of loans to depositors. As a consequence, governments' assurances to banks typically lead them to over-allocate funds to risky projects; it may lead them to over-investment in the aggregate as well. Our argument thus far has run as follows. The Asian 'miracle' economies translated high savings rates into high investment rates and high growth. This was complemented in the late 1980s and early 1990s by rapid liberalization of their external capital accounts, which led in turn to rapid capital inflows. Throughout this period, these Asian economies by and large ran fixed exchange rate regimes; thus capital inflows were mostly translated into monetary growth. This monetary growth had two negative consequences. First, it was intermediated (from savers to borrowers) imperfectly; adverse selection and moral hazard led to misallocation of capital as well as over-investment in the aggregate. Second, moral hazard in conjunction with rapid growth in credit led to asset inflation, as will now be explained.

CEILINGS ON PRICE INFLATION ON FLOWS OF GOODS AND SERVICES, ADDED TO RAPID MONETARY GROWTH AND MORAL HAZARD, LEADS TO ASSET INFLATION Consistent with the above remarks, Krugman (1998b) tells a tale of misallocation and over-investment under conditions of rapid capital inflows that confront adverse selection and moral hazard once they are intermediated through the banking system. His tale assumes that the supply of capital goods is perfectly elastic. Krugman then continues his story by reversing this assumption and replacing it with one of complete price inelasticity in the supply of assets. Assets in this context refer not only to capital goods in quasifixed supply but also to financial instruments such as equity shares, real estate, works of art and any other assets that readily attract investment and are in fixed supply for significant periods of time. The assumption of price inelasticity, in conjunction of course with the unrealistic "Panglossian" assessments of returns

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that are induced by moral hazard - what Krugman calls "Panglossian" expectations - adds price-inflation in fixed assets to quantity-inflation in reproducible assets. In short, it leads to asset price bubbles. Asset price inflation can be thought of as produced by an inelastic supply of assets in conjunction with an elastic supply of money. Only if money and credit expands readily to the Panglossian demand for investment can the latter be translated into asset bubbles. Why wasn't the supply of money checked? We have already given part of the answer: unrestricted capital inflows together with a credibly pegged exchange rate lead to rapid monetary growth. But why didn't the Asian economies check their monetary growth? A partial answer is that they tried but failed. Sterilization efforts were largely abandoned by 1995 because of their quasi-fiscal costs (Dean, 1996). But a deeper answer is that there seemed no need. Inflation in goods and services prices was low - at least under 10% - and well within 'Washington consensus' limits. Central banks have learned to target product inflation but not asset inflation. Moreover Asian central banks faced the dilemma that under fixed exchange rate regimes, tightening credit and raising domestic interest rates would have drawn in more foreign capital and imposed quasi-fiscal costs of sterilization. The second dilemma that they faced was that raising rates would have risked bringing down financial institutions and also pricking the stock-price bubble, as Thailand was already discovering to its dismay by early 1997. Hence monetary growth and asset inflation proceeded more or less unchecked. 9

FISCAL LIMITS ON BANK BAILOUTS TURNS ASSET INFLATION INTO ASSET DEFLATION The next step of Krugman's argument is crucial. Asset inflation proceeds only so long as banks maintain their Panglossian views. As the likelihood of bailouts declines, so too do asset prices. This outcome is fairly obvious if the change in the bailout regime is-assumed to be exogenous: the election of a new government that no longer tolerates 'crony capitalism', or intervention by the IME The outcome is less obvious when change is endogenous. Krugman (1998b) models this by assuming that implicit guarantees continue only until they turn out to be too expensive. In the context of a simple three period model, this is tantamount to the proposition that creditors of financial intermediaries will be bailed out only once. If asset returns are 'bad' (less than Panglossian) in period 2, bank depositors will have to be bailed out, and future depositors can no longer expect the same. Hence the banks will collapse immediately, in

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period 2, because the book value of their assets now exceeds its market value, and they will be able to attract new depositors only up to market value. If, however, asset returns in period 2 are 'good' (that is, Panglossian hopes are indeed realized), the one-time bailout option will not be exercised, implicit government assurance will continue, as will inflated land values and the ability of banks to attract deposits up to these values. Banks will not fail. The most interesting possibility is that despite good returns in period 2, depositors' expectations about bailouts change: they no longer expect future bailouts in case of less-than-Panglossian realized asset values. In that case banks will no longer be able to attract funds beyond the assets' actual market values, and thus they will fail. This outcome is what Krugman characterizes as 'self-fulfilling' and uses it as the basis for a story about self-fulfilling financial crises. It is an important story because it differs fundamentally from previous stories about self-fulfilling financial crises based on self-fulfilling currency crises (reviewed in Krugman 1997, 1998a). This is, by contrast, a story that is based on self-fulfilling asset crises that result from diminished expectations about bailouts. As Krugman points out, the story nicely addresses several puzzles associated with the Asian crisis: the absence of macroeconomic or external-account indicators of unsustainable currency pegs; the boom-bust cycles in asset prices that preceded the crises (particularly in Thailand); the absence of sharp external (or internal) shocks; and apparent contagion to countries not strongly linked through trade or capital flows. That the crisis hit several economies almost simultaneously with neither a common external shock nor contagion is consistent, Krugman argues, with the view that they were already "in a sort of 'metastable' state . . . highly vulnerable to self-fulfilling pessimism" (1998b, p. 9).

HIGH DEBT RATIOS ADDED TO ASSET DEFLATION LEADS TO DEBT SERVICING DIFFICULTIES AND EXACERBATES CURRENCY CRISES The story that burst asset bubbles and collapsed financial institutions leads to currency crises is missing a link. The link is high ratios of external debt, and debt service obligations, to export earnings. If the asset and investment boom was sustained in part by an inflow of foreign capital that was mostly borrowed by domestic banks, which have now failed, the inflow will slow down or perhaps turn into an outflow. If in addition the inflow had been sustained for some time, it would have resulted in a considerable accumulation of external

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debt, with associated debt service obligations. Thus the likelihood that an inflow turns into an outflow is enhanced. The depth of the affected countries' currency crises should be related to their debt ratios, both internal and external, including, crucially, the debt-equity ratios of private firms, especially large conglomerates. Moreover, such countries are vulnerable to a dilemma: if interest rates are raised to stem capital outflow, they will simultaneously increase the debt service burden. But if interest rates are not raised, currency values will drop and the debt service burden will increase in local currency terms. Our stylized 'explanation' of Asia's crisis is now complete. The essence of the story is that Asian capitalism and unrestricted capital flows did not mix well. In fact they proved to be an extremely volatile combination, much more volatile than anyone had suspected. A basic issue not yet addressed is whether it is Asian capitalism that must go, or unrestricted capital flows. This issue has, over the past year, become a litmus test that rather reliably divides 'salt water' from 'fresh water' economists. 1° But before addressing it, let me attempt to classify economists' perceptions of East Asia more fundamentally: according to whether they perceive the tale I have just told through a lens of government failure, or one of market failure.

3. GOVERNMENT FAILURE OR MARKET FAILURE? GOVERNMENT FAILURE Those who attribute the crisis to government failure see unwarranted intervention by the state at every stage of the logical chronicle just recounted. Savings rates were too high in Asian countries because of extra-market government policies that encouraged or even forced savings. In fact Singapore's 'Provident Fund' and its counterpart in Malaysia not only forced savings (for retirement), it also forced government investment of the proceeds. This phenomenon was often cited to rationalize Alwyn Young's (1992) findings that Singapore's average growth rate was no higher than Hong Kong's, even though the latter has had substantially lower rates of saving and investment. Hong Kong's higher returns on investment are rationalized as the result of its heavier reliance on mobilization and allocation of savings by the private sector. Rapid capital inflows were the product of easy money in the developed world combined with government guarantees of investment outcomes in the developing world. Although developed-world inflation rates have been low throughout the 1990s, so have interest rates. This has prompted an exodus of

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investment funds to emerging markets. Attractive nominal rates of return in emerging markets partly reflected attractive real and risk-adjusted returns, but were partly illusory because they failed to take account of both exchange rate and default risk. Both types of risk were masked by implicit but widelycredited government guarantees: guarantees of exchange rate pegs, and guarantees to financial intermediaries. Imperfect financial intermediation was the result of government interference with banking at every level. Ultimate borrowers, typically large conglomerates, were prompted and implicitly underwritten by national industrial strategies. The banks through which they borrowed were comforted by assurances of government bailouts, or at least lax supervision and regulation. This led to moral hazard and its classic consequences. One consequence was overinvestment in the aggregate, since down-side risks were discounted. A second was misallocation of investment, since funds were directed by government plan or, worse, by 'cronyism' between borrowers and banks. Both over-investment and misallocated investment meant that risk-adjusted rates of return were bound to be sub-normal. Asset inflation was the combined product of rapid capital inflows, government's failure to sterilize the impact of those inflows on domestic money supplies, and implicit government assurances of bailouts. Rapid monetary and credit growth, combined with Panglossian expectations, resulted not only in high rates of expenditure on reproducible capital, but also in speculative spending on fixed and quasi-fixed assets such as real estate and equity shares. The result was overvalued real estate and stock markets: bubbles that were set to burst at the first sign the river of money was about to dry up. This phenomenon, not incidentally, had already manifested itself in Japan in the late 1980s, but in that case as a result of easy money that was domestically generated rather than the product of capital inflows from abroad. Asset deflation was the result of government's unwillingness, and ultimately inability, to bail out banks and borrowers under on-going regimes of misallocation and over-investment, combined with inflated asset prices. The trigger for the Asian crisis was Thailand, where asset prices began to sag once the first financial intermediaries failed, or even before, when borrowers in default were first held to account and easy credit ceased. Currency collapse, in the view of those who ascribe Asia's crisis to government, was a culmination of the above factors, and was triggered by the banks' inability to meet their foreign currency obligations. Borrowing banks' illiquid assets and short-term liabilities combined with lending banks' reverse free rider behavior turned what might have been temporary illiquidity into virtual bank insolvencies. Short term lines of credit from foreign lenders were

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simply not rolled over. As the net flow of foreign funds into East Asian economies turned increasingly negative, currency values plummeted below any conceivable long term equilibria. Finally, IMF intervention, in this view, has exacerbated the crisis and sowed the seeds for yet more moral hazard in future by bailing out both delinquent borrowers and imprudent lenders.

MARKET FAILURE Those who see the Asian crisis through the lens of market failure rather than government failure see these phenomena quite differently. Savings rates are seen as endogenous, cultural phenomena rather than the result of exogenous government dictate. Government schemes to encourage household saving were expressions of a popular consensus, a consensus that individual free choice is properly subordinated to the national interest. Indeed, East Asia's extraordinary savings and investment rates translated for several decades into a 'growth miracle' that was the envy of the Western world. When properly managed, as in Singapore and Taiwan, domestic saving eventually exceeded domestic investment, leading to net capital outflows rather than inflows, and thus relative immunity from the current crisis. Rapid capital inflows are seen as an unfortunate by-product of premature capital account liberalization: that is, too little government intervention rather than too much. In the 1980s, external liberalization was often adopted under duress by developing countries when they were under the knife of balance of payments crises. Both then and in the 1990s, liberalization was encouraged by advice and pressure from the International Financial Institutions, particularly the IME As well, indirect pressure came from such underwriters and bastions of free market capitalism as the U.S. Treasury and Wall Street investment banks: what has been described by some as the "IMF-[U.S.] Treasury-Wall Street" complex. The alleged market failure that is encouraged by rapid capital inflow could be classified into two types. What might be defined as first-order failure refers to misallocation and over-investment. On the demand side this results from the inability of underdeveloped, under-regulated and under-supervised financial intermediaries to absorb and allocate funds efficiently or even honestly. On the supply side it results from the blindness of foreign investors to the fact that borrowing banks cannot allocate funds efficiently, as well as the tendency of such investors toward herd behavior. Second-order failure could be defined as vulnerability to capital outflows. It too results from tendencies toward herd behavior and related 'inefficient' market phenomena.

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tmperfectfinancial intermediation is seen as a given that invites government intervention, rather than the other way around. This stems from the view that even in advanced economies, financial markets are subject to failure because borrowers and lenders have asymmetric information, leading to adverse selection of borrowers ex ante as well as moral hazard ex post. Compounding this is the risk of a systemic deposit run on the banking system, a risk that almost inevitably prompts government to provide guarantees on bank assets or bank deposits or both, thereby adding to moral hazard. Financial market imperfections are typically so endemic in emerging markets that they turn to hands-on intermediation between lenders and borrowers through the banking system rather than the impersonality of direct financial markets, which operate by trading claims and contracts such as stocks and bonds. But relying on banks does not magically generate the necessary infrastructure of supervision and regulation; nor does it magically generate qualified human capital. In practice the failure of financial markets in Asia has led to a call for more government intervention rather than less, and not just from those who were previously suspicious of markets. The call for stronger bank supervision and regulation is particularly widespread. Interestingly, the private sector in Asia is also calling for advice and intervention and advice from government, think tanks and academia, since the need for analytical skills in risk management and the like, notably absent from the banking sector, is more available in the better-educated public sector.

COUNTERING THE CONVENTIONAL WISDOM ASIAN CRONY CAPITALISM: FINANCIAL INTERMEDIATION IN ASIA

ON

A view of the need for government intervention in emerging market financial systems that is at once more radical and specific to Asia is that there, economic success is derived directly from a symbiotic system that worked well until it was ruptured with the liberalization of its external and internal financial markets. Financial intermediation in the Asian crisis economies differs from that in Anglo-American economies in two important respects. First, there is far more of it, relative to GDP. And second, both the relationships between government and banks, and those between banks and industry, are far more intimate. Since the onset of the Asian crisis, it has become fashionable to refer pejoratively to the Asian system as 'crony capitalism', and to bask in the glory of our 'armslength' financial markets. It is easy to forget that this recently-reviled system is one that produced, or at very least was consistent with, a decade of high and

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sustained real growth such as Western capitalism has never seen. Indeed, it is possible to paint the Asian financial system in a positive light by considering it as a set of reinforcing components. Wade & Veneroso (1998, p. 6) have succinctly described these components as "[h]igh household savings, plus high corporate debt/equity ratios, plus bankfirm-state collaboration, plus national industrial strategy, plus investment incentives conditional on international competitiveness... [that add up to] the 'development state'." Their analysis ~ begins with the observation that saving rates in Asia are much higher than in western economies: one third of GDP or more in Asia, versus 15 or 20% in the west. Moreover the bulk of this saving is done by households and held in bank deposits, rather than in bonds or equities. ~2 Since neither households nor governments are major net borrowers, most of this household saving is channeled, through banks, to firms. This, in combination with relatively undeveloped equity markets, means that firms in East and Southeast Asia have very high debt/equity ratios, especially in Japan and Korea, where the ratios are often two to one or more (in contrast to a norm of less than one in the west). High ratios of financial intermediation (bank deposits and loans) relative to GDP, as well as high debt/equity ratios, make the entire financial system very vulnerable to shocks: for example, reductions in rollovers of bank deposits or increases in interest rates. Until the 1990s, Asian financial systems insulated themselves against such shocks by imposing external and internal controls: externally, restrictions on inflows and outflows of portfolio capital, and internally, ceilings on interest rates. For further insulation, Asian systems enveloped close cooperation between banks and firms, and between both and government. Borrowing from abroad was restricted or at least orchestrated by government, but as a quid pro quo government bailed out banks and firms whose costs or revenues were buffeted by systemic but temporary shocks. Government's intimacy with finance and industry also had a long-term dimension: national industrial strategy. Thus Japan's famous MITI, and to some extent their counterparts in Korea and elsewhere, guided the growth or decline of entire industrial sectors, particularly with an eye to export performance. According to Wade (1998), this system began to unravel when the soon-tobe-crisis-economies rushed to liberalize their external capital accounts in the early 1990s. Wade suggests that blame falls equally on national governments and international organizations. As suggested in Part II, a myriad of domestic interest groups stand to gain from liberalization. So do foreign banks and other lenders: in fact Wade & Veneroso (1998, p. 8) state baldly that "In Korea key people were bribed by Japanese and western financial institutions . . . to do

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something that was counter to the whole thrust of Korean development policy for decades past." The Korean government, eager to join the OECD club of industrialized countries, abolished the Economic Planning Board, which had been the main body for making economic strategy since the 1960s. Once the system of control and coordination was liberalized - or unraveled if one accepts the Wade and Veneroso interpretation - the Korean chaebol and corporate and bank borrowers elsewhere, discovered that they could borrow abroad much more cheaply than at home. This was possible, of course, only so far as potential devaluation of domestic currencies was kept out of the calculation: i.e. the perception of cheapness depended on an assumption that exchange rates were truly fixed. Most of the debt incurred was short term perhaps because of a lingering suspicion that exchange rates just might fall in the long run - and most of it was private. For example, Korea ran up its foreign debt from $39 billion in 1989 to over $160 billion by late 1997. 4. S H O U L D

CAPITAL

FLOWS

BE RE-REGULATED?

Those who argue for what Emmerson (1998) calls (but does not fully endorse) "Americanizing Asia," suggest that the intimacy between finance, industry and government characterizing Asian capitalism must be replaced by AngloAmerican arms-length relationships. But the intimacy of Asian capitalism worked for decades in Japan, and more recently in the 'tigers', to produce the most rapid sustained growth in human history. According to analysts such as Wade & Veneroso, this intimacy was comprised of symbiotic relationships which worked on balance to produce rather than inhibit growth: not, perhaps with ideal allocative efficiency, or a maximum of individual liberty (to save or not to save, for example), but compensated by high investment rates. In this view, the cozy success of Asian capitalism was rudely interrupted by capital liberalization. First-order benefits from foreign capital inflows were minor at best since they were not necessary to finance investment, given the Asian economies' very high domestic saving rates. In fact on balance any benefits turned into net costs due to over-investment and misallocation due to moral hazard. In addition, capital inflows engendered second-order costs given the recipient economies' vulnerability to sudden reversals. This cannot be a universally compelling argument, since some economies are more vulnerable than others. Few, and not Wade & Veneroso I suspect, would argue that the U.S. should restrict capital inflows, or that Japan should restrict capital outflows. Indeed, not all East Asian economies do have dangerously high debt-equity ratios: Taiwan's, for example, is well below 100%, and, not incidentally, Taiwan has weathered the Asian crisis better than

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any economy in the region. The more fundamental basis for Wade and Veneroso's argument is that the highly debt-leveraged keiretsu, chaebol, and konglomerat of Japan, Korea and Indonesia are far more vulnerable than the less leveraged firms of America and Western Europe. In the case of Japan, which is a net exporter of capital, this vulnerability has been buffered by indulgent domestic banks backed by passive domestic depositors, but in the cases of Korea and Indonesia, which are capital importers, the vulnerability was quite naked. This line of reasoning leads Wade & Veneroso to endorse Jagdish Bhagwati's recent (1998) call for a halt to capital liberalization, at least in Asia. Notably, his prescription for India, which remains relatively closed at least to portfolio capital inflows and outflows, is to keep it closed. Similar reasoning, as well as the simple observation that China has thus far weathered the storm that has engulfed its neighbors, is persuading other Western observers to endorse China's longstanding policy of restricting capital flows and currency conversion. Bhagwati's position is startling as he is a highly respected mainstream economist, who endorses free trade. His argument, as well as that of another eminent international economist, Dani Rodrick (1998), is that the logic for free trade in goods and services does not carry over to free flows of capital. The logic for free trade rests on the gains that ensue from specialization in lines of production coincident with comparative advantages. The logic for free capital flows rests on gains that ensue from moving capital to projects and regions with higher than average rates of return. Although neither Bhagwati nor Rodrick spell it out, the argument against free capital flows in light of Krugman's story is presumably that ex p o s t these returns may turn out to be lower than expected because of the misallocation and over-investment biases introduced by asymmetric information. Ex ante, domestic borrowers and lenders expect higher rates of return than are actually realized because they expect private 'Panglossian' returns rather than the true returns that net out either the costs of publicly-funded bailouts for as long as they continue, or the costs of higher interest rates or bankruptcy once they cease. Foreign lenders expect rates of return that are higher ex ante than ex post because they too expect bailouts, whether from the governments that they presume will stand behind domestic borrowers, or from international institutions like the IME It may also be that foreign lenders are less well informed about the creditworthiness of domestic borrowers than are domestic lenders. To this view may be added the Krugman argument that unrestricted access to foreign capital greatly compounded the Asian financial system's potential for moral hazard, and led to Panglossian over-investment in reproducible capital

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and over-valuation of fixed assets. But this does not necessarily lead to the Bhagwati/Rodrick/Wade conclusion that capital inflows should be restricted; rather, it leads more readily to the conclusion that cozy, comfortable relationships between government, financial intermediaries and industrial conglomerates should be ruptured. To do so strikes~ at the heart of Asian capitalism, since the extraordinary debt-equity ratjo~ would be unsustainable were government quasi-guarantees to be withdrawn. In fact whether or not to restrict capital flows into countries where liberalization is a done deal may well be moot, since capital liberalization may be irreversible. Once the river of foreign funds has begun to flow, those with an interest in keeping it flowing - not least, those who have borrowed heavily and contracted high debt loads - will strongly resist re-regulation. Moreover, capital inflows are likely ultimately to force the dismantling of non-arms-length financial relationships. If capital liberalization so severely exacerbates adverse selection and moral hazard that financial crisis ensues, reform is almost inevitable. Cold-eyed capitalism will prevail. Hence the Asian economies that did enthusiastically liberalize portfolio flows in the 1990s - Indonesia, Thailand and, to some extent South Korea - are those most likely to continue the course, both because they are now reliant on continued inflows, and because the damage to their financial intermediaries, and to the government fiscal accounts dedicated to supporting them, has been so profound that reversion to the ancien regime is unthinkable. Should the idea even be mooted, it is probable that IMF, World Bank and other official emergency lending would be cut off; more importantly, so would private capital inflows. Malaysia, which has thus far avoided (or at least postponed) submission to an IMF program as well as bank and corporate restructuring, is also likely to retain its liberalized regime in the long run, despite its imposition of short-term capital controls in September 1998. In contrast to the crisis economies, Japan postponed full liberalization until the late 1990s, with its 'big bang' (which will, inter alia, allow unrestricted access to foreign financial institutions) just now underway. Yet Japan pioneered the Asian financial crisis with its- asset bubble that burst in 1989. Throughout the period both before and after the bubble burst, Japan was a capital exporter, not importer; hence it was not the free availability of foreign capital that exacerbated moral hazard and led to the bubble and burst. This suggests that capital account liberalization was not the root cause of Asia's crisis, but rather that it was cozy 'crony' capitalism. Capital from domestic saving was available in sufficient abundance to swamp the system with misallocated capital without help from abroad. Non-performing loans at Japanese banks are of the same order of magnitude as those in the crisis economies. That Japan avoided

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banking and currency crises for nine years after its asset bubble burst was due to its prolonged ability as an extremely affluent nation to subsidize bleeding banks and the like, as well as its decision (at least de facto) to let the yen float and thus fall gradually. Indeed, the yen has depreciated by over 40% since 1995, more than the net depreciation of all but Indonesia of the 'crisis' economies since July 1997; but 40% over four years rather than a few months does not constitute a currency crisis or precipitate a banking crisis. Although it is unlikely that the Asian economies which liberalized will revert to closed capital accounts, those which did not are equally unlikely to liberalize in the near future. Neither India nor China has yet moved to fully convertible currencies or to unrestricted capital accounts, nor, in practice, has Taiwan. While China, dramatically for some decades now, and India more tentatively and more recently, have welcomed and received foreign direct investment, they have not opened themselves to the volatility of unrestricted portfolio flows. It is likely that the lesson they will learn from the Asian crisis is to postpone liberalization for the foreseeable future. Whereas the IMF, as part of its efforts to promote capital account liberalization under its newly amended Articles of Agreement, might have pressured them in the recent past, its official stance is now, in the words of its First Deputy Managing Director, Stanley Fischer at the September, 1997 annual IMF/World Bankd meetings, " . . . t o phase capital account liberalization appropriately - which means retaining some capital controls in the process." It should be apparent from this discussion of capital liberalization that the pure and polar visions which divide economists on a priori ideological grounds - government failure versus market failure - become much less pure, polar and divisive in the afortiori world of practice. Indeed, in offering practical advice about what should have been done then, and, especially, what should be done now, economists on both sides of the ideological divide have proved uncharacteristically confused. They seem to see through a glass darkly, with their previous ideological clarity badly blurred. 5. I F N O T A V I S I O N

ON THE ROAD TO DAMASCAS,

HAS A N Y C O N S E N S U S E M E R G E D ? WHAT S H O U L D HAVE BEEN D O N E B E F O R E D I S A S T E R STRUCK Hindsight is cheap wisdom; nevertheless the Asian crisis has probably clarified the minds of many analysts about what should have been done well before

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disaster struck. Although there is no complete consensus, more economists than before agree that far better domestic financial disclosure, supervision and regulation should have been put in place in the borrowing countries. The reasons this did not happen had much to do with interest group obstacles in the context of win/win high-growth economies. But it also had to do with the prevailing ideology of de-regulation, an ideology that overarched itself when it came to the banking sector. One might suppose also that consensus has moved further toward the merits of flexible exchange rates for borrowing countries that, like the Asian crisis economies, had their inflation rates well under control and therefore had no need for the monetary discipline that fixed rates provide. After all, since an exchange rate crisis is, almost by definition, the involuntary relinquishment of a fixed exchange rate, flexible rates should preclude such crises. However, the extreme volatility in the baht, won, rupiah and ringhit since they were floated amounting in the case of the rupiah to a virtual free-fall throughout the second half of 1997 and first half of 1998 - has led some to call for a return to fixed rates, hardened, perhaps, by currency boards. Dornbusch (1998) calls for currency boards in Indonesia and Russia, and more recently in Brazil; but others (see Roubini, 1998) warn of the "myths" surrounding such an arrangement. If there is any consensus, it is that "automaticity" - pure flexibility or a strict currency board - is preferably to a managed-rate or even fixed-rate system that is prone to government intervention. It is probably safe to say that economists have become more sensitive to safe sequencing of deregulation: cautious phasing out of capital controls seems to be the order of the day, even at the IME implying that liberalization may have been too rapid or too wholesale in the past. In fact economists who never did so before have begun to talk about taxes on international capital flows: the debate about foreign exchange turnover taxes like the Tobin tax has revived, and attention has turned to Chile's reserve requirement on short-term foreign deposits. Nevertheless throwing sand into the wheels of international finance remains intensely controversial; undoubtedly, there is much less consensus surrounding this measure than the other three. -

What Was Done Wrong When the Crisis Broke There is less consensus about how the crisis was managed. Criticism has focused on the IMF. At least two eminent economists have called for its abolition (Schultz, 1998; Schwartz, 1998), primarily on the grounds that it generates moral hazard among both developing-country borrowers and developed-country lenders. Less extreme judgments are that the IMF acts well

Was Capitalism or Cronyism the Cause of Asia's Economic Crisis?

39

beyond its mandate by imposing surrogate government on independent countries (Feldstein, 1998), or that it relies too readily in crisis on restrictive monetary and fiscal measures, in particular high interest rates, to arrest currency decline (Sachs, 1997; Stiglitz, 1998). Others, notably representatives of the IMF itself, defend its past and present roles and call urgently for renewed funding from its shareholders (Fischer, 1998). These disparate views of the IMF's role are manifestation of the disparate lenses through which equally eminent economists view international financial markets. What Should Be Done Now

If the emerging consensus about what went wrong and what was done wrong is fragile, any consensus about what should be done now is even more so. To be sure, most policy-makers at both domestic and international levels agree that financial disclosure, supervision and regulation should be enhanced - indeed, standing committees of the BIS, IMF and G-10 have been studying such measures since the Halifax G-7 summit of 1995, and in June, 1998, Canada took a proposal for international 'peer supervision' to the G-22 meetings - but both the political and practical impediments to achieving financial reforms remain profound. As for exchange regimes, the 'Washington consensus' that developing countries should adhere to fixed rates had about run its course at the IMF well before the crisis broke, but it remains to be seen what new conventional wisdom will emerge should inflation pose a problem in Asian countries where currencies have depreciated sharply. Jeffrey Sachs, perhaps the world's the most prominent critic of the IMF's part in this (and previous) crises, advocates fully flexible rates (Sachs, 1998b). At the other extreme, Rudiger Dornbusch, equally eminent and Sach's former mentor, one high profile economist advocates currency boards for Indonesia, Russia and Brazil. However, it was abundantly clear that the IMF would not condone a currency board for Indonesia when President Suharto flirted with the idea in early 1998, shortly before his political demise; as of early 1999, Russia is out of the question, given its lack of reserves, pariah status with both private and official lenders, and de-capitalized banks; Brazil is perhaps a better candidate, but it currently lacks sufficient reserves to back its monetary base. Moreover, none of the other crisis countries seem remotely interested in, or indeed positioned, even to peg their exchange rates given continued turbulence in exchange markets as well as their depleted reserves. On the other hand the economies that have held their pegs - Hong Kong, China and Taiwan, - are well aware that to be forced to

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devalue would invite loss of control - currency crises - that could infect the banking and then real sectors and escalate into full-blown financial and economic crises. And so far, these three economies have avoided crisis. What about capital controls, or at least 'sand in the gears of international finance'? Prominent economists such as Dani Rodrick and Jagdesh Bhagwati have questioned the merits of free capital flows. It is likely that skepticism from them and other reputable quarters will lend moral support to countries that have yet to liberalize their capital accounts and are not so inclined- notably India and China. It is also likely that such skepticism in professional quarters will slow down the IMF's campaign to liberalize capital flows under an extension of its Articles of Agreement. Countries that have already liberalized are studying techniques for throwing sand in the wheels, and Malaysia has already implemented such measures. On balance, it is unlikely that any country will eschew capital inflows on a blanket basis. Distinctions will be drawn between direct and portfolio investment, and between long term and short-term flows. China, for example, has thrived for two decades on massive inflows of direct investment (mostly as joint ventures, and more recently as 'Build Operate Transfer' and similar arrangements), despite severe restrictions on both the inflow and outflow of portfolio capital and without even a convertible currency. Similarly, no country in its right mind would advocate restrictions on short-term trade capital.

6. CONCLUSION In short, there is a consensus about Motherhood measures, but no consensus about most measures. Economists still see Asia's convulsions through a glass darkly, and no divine revelation has descended upon them. What follows is a summary of prevailing opinion, in declining order of broad consensus. All agree on better international disclosure and supervision but the practical obstacles are formidable. Few advocate re-regulating capital flows to the crisis economies but many now advocate slowing down de-regulation of non-crisis economies. Some now toy with the idea of slowing down the turnover of short-term capital flows via taxes or other means of 'throwing sand in the gears'. Many now argue that the role of the IMF should be re-examined, although opinions run the spectrum from those who would see it abolished to those who advocate both increased funding and increased powers. Among the increased powers that are being mooted are authority to disclose unfavorable information about member countries without their permission, and increased authority to mobilize private lenders to restructure debt and debt payments.

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On exchange rates there is no consensus whatsoever. W h i l e some maintain that the crisis economies should keep the flexible exchange rates regimes circumstances have chosen for them, others argue for the opposite, credibly fixed-rate regimes underpinned by currency boards. Between the two extremes, proposals are now afoot to create a 'snake in the lake' for East Asia, m o d e l e d on the 'snake in the tunnel' that Western European economies engineered after the collapse o f the Bretton Woods fixed-rate regime in 1971. Most observers do agree that the non-crisis Asian economies should stick to their fixed rate regimes, if only because the potential for precipitating more regional instability, were China and/or Hong Kong to relinquish their pegs, is too horrible to contemplate.

NOTES 1. In 1 Corinthians 13, verse 12, St. Paul writes, "For now we see through a glass darkly, but then face to face . . . . " 2. For an argument that East Asia's crisis was primarily a 'liquidity' or capital market failure, see Dean (1998a, b and 1999). For a related argument applied to China, see Dean (2000). 3. The first half of this section draws on Dean (1997). 4. See Dean (1992) and Dean & Bowe (1997) for extensive reviews of the 1980s debt crisis and its resolution. 5. See Dean (1996). 6. Parts of this section draw on Crockett (1997). 7. The best articulation of this view is Krugman (1998b). 8. See for example Diamond & Dybvig's (1983) analysis of bank values subject to multiple equilibria. The combination of illiquid assets, short-term liabilities and free rider behavior that they model would be useful to analyze the Asian crisis if it were extended to an international context with countries taking the place of banks. 9. The parallel to the U.S. economy in mid- to late-1998 is hard to ignore. See The Economist magazine of May 8, 1998, as well as the three previous issues. 10. Several years ago, the New York Times these epithets to distinguish the noninterventionist, pure market economists, who mostly seem to hail from institutions located on fresh water, like the University of Chicago, from their less-than-pure brethren who preach and practice at places like Harvard, MIT and Stanford, on the salt water East and West coasts. 11. In addition to Wade (1998) and Wade & Veneroso (1998a) see the succint summary of their view in Wade & Veneroso (1998b). 12. The direction of cause and effect is not clear here. The absence of alternatives to bank deposits could be because (Asian) household savers are risk averse and value liquidity, or it could be that Asian savers are forced to rely on bank deposits because equity and bond markets are underdeveloped and thus excessively risky and illiquid.

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REFERENCES Bhagwati, Jagdish (1998) The Capital Myth, Foreign Affairs, May/June, Vol. 77, No. 3, pp. 7-13. Bowe, M., & Dean, J. W. (1997). Has the Market Solved the Sovereign Debt Crisis? Princeton Studies in International Finance No. 83, August, 66 pages. Cline, W. (1995). International Debt Reexamined, Institute for International Economics, Washington, D.C. Corbo, V., & de Melo, J. (1985) Liberalization with Stabilization in the Southern Cone of Latin America: Overview and Summary. World Development, 13, 836-866. Crockett, A. (1997). The Theory and Practice of Financial Stability. Essays in International Finance, International Finance Section, Princeton University, No. 203, April. Dean, J. W. (1992). The Debt Confessional. World Competition, 15, March. Dean, J. W. (1993). Will Financial Deregulation be Good for Malta? Bank of Valletta Review, 8 (Autumn), 1-12. Dean, J. W. (1996) Recent Capital Flows to Asia Pacific Countries: Trade-offs and Dilemmas. Journal of the Asia Pacific Economy, 1(3), 287-317. Dean, J. W. (1997) Can Financial Liberalization Come Too Soon? Jamaica in the 1990s. Social and Economic Studies, 47(4), 47-59. Dean, J. W. (1998a). Why Fiscal Conservatives and Left Wing Academics are Wrong About Asia. Challenge, 41 (March/April). Dean, J. W. (1998b). Asia's Crisis in Historical Perspective. Journal of the Asia Pacific Economy, 3(3), 267-283. Dean, J. W. (1999). Is East Asia Illiquid or Insolvent? Multinational Business Review, Fall. Dean, J. W. (2000). Why Financial Crisis May Come to China but not Taiwan. In: A. Chowdhury & I. Islam (Eds), Beyond the East Asian Crisis: The Path to Innovation and Economic Growth. Cheltenham, UK: Edward Elgar. Diamond, D. W. (1984) Financial Intermediation and Delegated Monitoring. Review of Economic Studies, 51,393-414. Diamond, D. W., & Dybvig, P. (1983). Bank Runs, Deposit Insurance and Liquidity. Journal of Political Economy, 91,401-419. Edwards, S., & van Wijnbergen, S. (1986). The Welfare Effects of Trade and Capital Market Liberalization. International Economic Review, 27(1), 141-148. Donald K. E. (1998) Americanizing Asia? Foreign Affairs, May/June. Feldstein, M. (1998). Reforming the International Monetary Fund. Wall Street Journal, Oct. 6. Grosse, R. (1994). Jamaica's Foreign Exchange Black Market. Journal of Development Studies, 31(1), 17-27. Haggard, S., & Maxfield, S. (1996). The Political Economy of Financial Internationalization in the Developing World. International Organization, 50(1), 35~8. Irvine, S. (1997). Asian research: worth the paper it's printed on? Euromoney, December. Krugman, E (1994). The Myth of Asia's Miracle. Foreign Affairs, Nov/Dec, 62-78. Krugman, E (1997). The Currency Crisis, prepared for NBER conference, October, http:/ /web.mit.edu/krngman/www/crises.html. Krugman, P. (1998a). What Happened to Asia? for a conference in Japan, January, http:/ /www.mit.edu/people/krugman/index.html. Krugman, P. (1998b). Bubble, boom, crash: theoretical notes on Asia's crisis, http://web.mit.edu/ krugman/www.html.

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McKinnon, R. (1991). The Order of Economic Liberalization: Financial Control in the Transition to a Market Economy. Baltimore, Md.: Johns Hopkins University Press. Naisbitt, J. (1996). Megatrends Asia: eight Asian megatrends that are reshaping our worm New York: Simon & Schuster. Roubini, N. (1998). The Case Against Currency Boards: Debunking 10 Myths about the Benefits of Currency Boards, http://www.stern.nyu.edu/~nroubini/asia/CurrencyBoardsRoubini.html Rodrick, D. (1998). Should the IMF Pursue Capital-Account Convertibility? In: S. Fischer, R. N. Cooper, R. Dornbusch, P. N. Garber, P. B. Kenen, C. Massad, J. J. Polack, D. Rodrick, & S. S. Tarapore (Eds), Essays in International Finance. International Finance Section, Princeton University, No. 207, May. Sachs, J. D. (1996). Financial Crises in Emerging Markets: The Lessons from 1995. In: A. Tornell & A. Velasco (Eds), Brookings Papers on Economic Activity (pp. 147 - 215). Sachs, J. D. (1997). IMF is a power unto itself, Financial Times, Dec 11. Sachs, J. D. (1998). The Economist, October. Schwartz, A. J. (1998) International Financial Crises: Myths and Realities. The Cato Journal, 17(3), http://www.cato.org/pubs/journal/cj 17n3-3.html. Stiglitz, G., & Weiss, A. (1981 ). Credit Rationing with Imperfect Information. American Economic Review, 71,393-410. Wade, R. (1998). The Asian Debt-And-Development Crisis of 1997: Causes and Consequences. World Development, August. Wade, R., & Veneroso, E (1998a). The Asian Crisis: The High Debt Model vs. The Wall StreetTreasury-IMF Complex. New Left Review, March-April. Wade, R., & Veneroso, E (1998b). The resources lie within. The Economist, Nov 7. Young, A. (1992). A Tale of Two Cities: Factor Accumulation and Technical Change in Hong Kong and Singapore. NBER Macroeconomics Annual, MIT Press. Young, A. (1994a). The Tyranny of Numbers: Confronting the Statistical Realities of the East Asian Growth Experience. NBER Working Paper No. 4680, March. Young, A. (1994b). Lessons from the East Asian NICS: A Contrarian View. European Economic Review Papers and Proceedings, May.

ORIGINS AND POLICY IMPLICATIONS OF THE ASIAN FINANCIAL CRISIS Phil Sang Lee and Kyung Suh Park 1. INTRODUCTION The financial and currency crisis that has rocked the Asian countries during 1997 and 1998 is going to be another history as the subject economies are more or less recovering from the worst states of the crisis. However, not many people had expected the currency crisis, which started in a small Asian country, would have so much impact on other countries. An immediate concern was whether China could remain stubborn with regard to its foreign exchange policy despite rising unemployment, high inflationary pressure, and failing financial and real sectors. The collapse of the Russian economy also portended a possible worldwide depression. During the turmoil, the asset prices in the crisis countries experienced huge drops, roughly ranging from 40 to 60%, and helped worsen the financial status of local firms and financial institutions, leading to liquidity crunch and a series of corporate failures. The financial crisis also turned into a social crisis with rising unemployment and mounting social instability, and threatened the political regimes in the region. This article overviews the contents of the individual crises these Asian countries have gone through, analyses their similarities and differences, and provides policy implications. It focuses on why the Asian crisis had happened and evaluates the properness of the international assistance programs including those of the IME Then, it proposes policy remedies to prevent the occurrence

Asian Financial Crisis, Volume 1, pages 45-78. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0686-6

45

46

PHIL SANG LEE & KYUNG SUH PARK

of another crisis. Since the crisis is not totally yet over, suggested policy remedies should be interpreted with limited applicability.

2. ORIGINS OF THE CRISIS 2.1. Overview

The Asian crisis originated from multiple sources of problems that were of course closely interrelated, and showed several different features from the previous ones. 1 Originally, the crisis started from the currency crisis in Thailand in April 1997, which spread to neighboring countries of Indonesia, Malaysia, and to South Korea with the lags of a few months. However, in the background of the currency crisis lie a basketful of other factors that stem from micro- to macroeconomic problems of the region. Interestingly enough, these economic factors that caused the crisis are quite similar among the crisis countries with minor diversity. The dominating common feature of the Asian crisis, partly differentiating itself from other ones, is the extreme form of moral hazard on the part of the interested parties whether they being the government, firms, financial institutions, investors, or depositors. Accordingly, the market discipline that usually forces any economy to maintain efficiency through competition was non-existent in critical ways in these economies, z The moral hazard problem led to overinvestment in real sectors that relied on highly leveraged financial structure, and to reckless credit extension to those finns by financial sector. Other factors that helped to exacerbate the problems by camouflaging and postponing their early exposure include huge influx of global liquidity, outrageously insufficient financial regulatory system, and political and social cultures that set the stage for the moral hazard problem. Increasing interconnection among global economies and the flux of short-term capital also expedited the vicious contagion that started from Thailand and spread to other economies in the area. In the following, we diagnosis the origins of the crisis in more detail, trying to derive the similarities and differences among the groups. 2.2. Real Sector Problems 2.2.1. Overinvestment It would not be an easy task to define a certain level of investments by an economy as excessive or not. In the case of the Asian countries that had achieved high growth over the past decades or so, highly leveraged investment

Origins and Policy Implications of the Asian Financial Crisis

47

strategy was viewed as a necessity to exploit the growth potentials of those economies. However, in retrospect, too much of their investment was channeled to the areas with the worries of over-competition, or to speculative activities, and these investments produced returns that could not justify their financing costs. In the case of Korea, the average annual returns on assets of manufacturing firms were below 1% during the 1990s, and the average return on equity were just over 5%. Their average debt to equity ratio deteriorated from 302.5% in 1994 to 397.3% in 1997, and EBIT-to-Sales ratio was --0.3%, which showed a stark contrast with 8.3% of the U.S., 5.1% of Taiwan, and even with 3.4% of Japan. In terms of industrial productivity, the growth rates of value added per employee had decreased from 18.1% of 1994 to 4.7% in 1997. Macroeconomic variables also support the over-investment hypothesis. During the 1990s, investments as a proportion of GDP in the crisis countries showed rising trends, and remained much higher than those in the 1980s. Except Indonesia, the investment over GDP in those countries used to be less than 30% during the 1980s, but approached or exceeded 40% level during the first half of the 1990s. The countries that showed highest growth in investment were Malaysia and Thailand as their governments followed expansionary growth policies. On the other hand, Indonesia and Philippines followed a more conservative macroeconomic policy and their investment growth rates remained pretty much same as in the 1980s. Higher investment rates would not be a problem as long as domestic savings can support such level of investment. However, the savings as a proportion of GDP of those countries remained 2 to 6% below the investment rates, and the gap widened during the 1990s. 3 The countries that showed the biggest investments-savings gap were Malaysia and Thailand again, whose gaps approached 10% level on average during the last decade. In both of Malaysia

Table 1.

Korea Indonesia Malaysia Philippines Thailand

Investment over GDP (%)

1987

1990

1991

1992

1993

1994

1995

1996

29.8 31.4 23.2 -27.9

36.9 36.1 31.3 24.2 41.1

38.9 35.5 35.8 20.2 42.2

36.6 35.9 33.6 21.3 40.0

35.1 29.5 37.8 24.0 41.9

36.1 31.1 40.4 24.1 43.4

37.1 31.9 43.2 22.2 46.6

38.2 32.1 43,0 24.2 42.8

Sources: IMF, International Financial Statistics, various issues; DRI, World Markets Executive Overview, fourth quarter 1996.

48

PHIL SANG LEE & KYUNG SUH PARK

and Thailand, it was mainly the sharp increase in investments that drove the widening gap despite the stable or increasing savings rates, while it was decreasing savings in case of Indonesia. Stiglitz (1998) argued that the marginal productiveness of an economy at this rate of investments cannot be so high as to justify the foreign debts they incurred to fill the investments-savings gap. Not only the quantity and contents of the investment in the region mattered, but also how the investment was funded was another factor that affected the course of the crisis. Most private sector investments relied on debt-form financing either from domestic or foreign sources. Korean Chaebols, for example, maintained debt ratios over 400% and their interest payment costs out of sales exceeded 6% as compared with 2 to 3 % of competing firms of other countries. The high debt service burden rendered these companies vulnerable to minor changes in the market conditions, and as the international competitiveness of Korea wanes, it fell as a heavy burden on the economy. The huge non-performing loans provide another evidence of the inefficient investments in those countries. As of June 1998, the Non-performing Loan (NPL) ratio for Thailand was 30%, and was expected to increase to 35% by the end of the year, while other crisis countries showed a similar level of financial deterioration, which implied a possible collapse of the industrial bases of those economies. In Indonesia and Thailand, domestic and external credits were channeled to non-traded goods sectors which usually contained high risk but do 1 0 a, - -

Korea

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I

1990

I

1991

I

1992

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Fig. 1. Savings-Investments Gap of the Crisis Countries. Sources: IMF, International

Financial Statistics, various issues; DRI, World Markets Executive Overview, fourth quarter 1996.

Origins and Policy Implications of the Asian Financial Crisis Table 2.

Korea Indonesia Malaysia Thailand

49

Non-performing Loans of the Crisis Countries (Loans overdue by 3 months)

End of 1997

June 1998

End of 1998 (estimates)

9% 15% 7% 18%

13% 25% 10.6%~ 30%

21% 35% -35%

Note: ~As of April 1998. Sources: Bank of Indonesia, Financial Statistics, various issues; Bank of Korea, Monthly Bulletin, various issues; Bank Negara Malaysia,Annual Report 1996; Bank of Thailand, Annual Economic Report 1996.

not contribute to improving external debt problems. In Korea, large portions of loans by non-bank financial institutions were extended to failing conglomerates. 4 The high leverages and non-performing loans of the crisis countries were also closely related to their financial systems and government's economic policy. Their capital markets are still underdeveloped and private sector firms had relied on loan credits from financial institutions as their main source of funds. With the government's interest rates control and high inflation rates during the growth periods, bank credit was a cheap source of funds and ensuing financial distress cost of debt was not so high since the governments protected large conglomerates or firms with connection to political power.

2.2.2. Corporate Governance and Managerial Transparency We need to point out the crippled corporate governance structure in those countries as the critical source of mismanagement. Basically, the majority of shareholders could not monitor or influence the management of large corporations in those countries as their management was controlled by a few monopolistic owners who were usually connected to political powers. Investment decisions were made not based on economic feasibility, but based on private interest of the owners whose main objective was to expand their kingdoms. The management of a large conglomerate was monopolized by a dominant shareholder (so called 'owner-manager') who solely appointed the members of the board of directors. Minority shareholders were generally silent and ignored partly due to their lack of concern on long-term performance of their firms, and due to prohibiting

50

PHIL SANG LEE & KYUNG SUH PARK

legal procedures against mismanagement. Externally, the market for corporate control was still at the burgeoning stage of development due to the government's policy to protect the existing management, low labor market flexibility, and the traditional corporate culture of identifying firms with their founding fathers. In addition to the extreme forms of the conflict of interests between ownermanagers and minority shareholders, flimsy accounting standard and auditing system lowered the level of management transparency, and hindered the sound development of capital markets. The underdevelopment of capital market increased firms' dependency on banking credits as the major source of funds, and raised the instability of the economies.

2.3. Financial Sector Problems 2.3.1. Runaway Credit Expansion The overinvestment problem of the real sector would not have occurred if the financial sector had shown some discretion in their credit allocation. The driving power that supported the overinvestment of affected countries was the credit expansion either through domestic financial institutions or through foreign sources. During the 1990s, the growth rates of bank and non-bank credits to private sector well exceeded the growth of real sector in the Asian economies. Table 3 shows that banking credit as a proportion of GDP had increased sharply in the crisis countries. Korea recorded 65% increase and Thailand 92.9% over the 3 year period from 1993 to 1996, while Singapore and

Table 3.

Korea Indonesia Malaysia Philippines Singapore Thailand Hongkong

Bank Credit over GDP (%)

1993

1994

1995

1996

13.6 23.5 25.0 12.2 400.2 27.8 356.2

16.0 23.5 20.0 10.2 349.1 38.0 377.6

18.2 24.2 21.5 10.9 330.2 55.0 366.1

22.4 24.9 26.3 15.9 305.1 53.6 301.3

Sources: DRI, World Markets Executive Overview, fourth quarter 1996; Bank of Indonesia, Financial Statistics, various issues; Bank of Korea, Monthly Bulletin, various issues; Bank Negara Malaysia, Annual Report 1996; Bank of Thailand, Annual Economic Report 1996.

Origins and Policy Implications of the Asian Financial Crisis

51

Hongkong showed decreasing proportions. Unfortunately, these credit increases were directed to risky assets such as real estate investment and to financially shaky firms with no economic prospects. 2.3.2. Regulatory and Supervisory Blunder The lack of discretion on the part of financial institutions as resource allocators was partly attributed to government's involvement in the management of financial institutions and the implicit safety nets. Governments usually involved in allocating financial resources and maintained strong control both on the financial and real sector until the crisis fell upon them. They controlled interest rates, specified the business scopes of financial institutions, and even specified their manpower levels, branch networks and capitals, naming a few. Even after going through extensive financial reform process in the 1990s, those governments still maintained their influence on financial institutions through implicit guidance channels. Worried about the destabilizing effect of financial deterioration, supervisory authorities of those countries had applied lax loan classification and loss provision requirements on non-performing loans, which delayed but amplified the financial crisis of the region. There was also an incentive problem of the government officials dealing with financial institutions. They benefited from the controls and red tapes during their incumbency and even after retirement, since they could safely landed on the management jobs of the financial institutions they used to control. To perpetuate the benefit, the control on financial institutions tended to persist and financial reform measures were superficial in contents. Therefore, it is not surprising that the extensive financial reforms implemented during the 1990s turned out to be failures, leading to the financial crisis. Not only these reform measures were perfunctory, but also they critically underestimated the importance of supervisory functions and prudential regulations that should have accompanied any financial deregulation. Whatever prudential regulations existed usually aimed at restricting specific behavior of financial institutions, but did not add up to maintaining a sound level of capital adequacy that would protect the institutions. Furthermore, these prudential regulations were mostly based on ex-post approaches so that authorities intervened in problematic institutions only after their financial conditions became out of control. The results of the paternalistic policy of the governments were the mounting non-performing loans of financial institutions including commercial banks as shown earlier. On the other hand, under the governments' safety umbrella, financial institutions pursued high-risk-highreturn strategies, and did not worry much about the credit conditions of their corporate customers.

52

PHIL S A N G LEE & K Y U N G SUH PARK

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The excessive intervention by the regulatory authorities basically hurt the governance of financial institutions. Political connections usually played an important role in the appointment of the management of financial institutions, and managers were obliged to offer favored loans to the firms that were connected to those proteges. Such misconduct was closely related with the government's exclusion of shareholders in the governance of commercial banks. The government played the role of the de facto owner of commercial banks, and shareholders were excluded from exercising their ownership rights. In Korea, it was only in 1997 that the outside directors representing shareholders could sit on the Board of Directors of commercial banks and large shareholders could influence the appointment of the members. In the absence of shareholder monitoring, management of banks was generally ready to provide 'policy-directed' or 'politically favored lending' to corporate customers. Depositors also never worried about their savings since there existed general belief that financial institutions would never fail. They even shifted their funds to failing financial institutions which offered high interest rates to avoid liquidity problems after the financial crisis broke out. Such lack of market discipline also worked to bolster the moral hazard of the management of financial institutions to pursue high risks.

2.3.3. Misguided Financial Deregulation In the 1990s, financial reforms were undertaken for the purpose of increasing the efficiency in financial sectors in those countries. They commonly included interest rates deregulation, new entries of financial institutions, increased degree of managerial discretion, expanded business scopes of each financial institution, and so on. Without exception, external opening was implemented on a relative short period of time partly due to the urge of foreign investors. One critical phenomenon that accompanied the financial deregulation process in those countries was the growth of non-bank financial institutions such as savings and loans, merchant banks, finance companies, and investment trust companies, etc. They grew under the less stringent regulatory controls than those on commercial banks. Their business lines included loans to private sectors and their shares in the loan market grew rapidly through aggressive credit policy. On the other hand, the prudential requirements were almost nonexistent for nonbank financial institutions. For example, in Thailand, while the regulatory authority tightened its control on the banking sector, it allowed the establishment of finance companies during the 1990s that were not subject to the strict loan control applied to commercial banks. Most of their funds were flowed into the real estate and development sector, but as their mortgage value

54

PHIL SANG LEE & KYUNG SUH PARK

dropped, these finance companies went bankrupt causing credit crunch in the market. 5 Later on, these NBFIs contributed to the onset of the financial crisis through their shaky financial conditions. It was finance companies in Thailand and merchant banks in Korea that started the credit crunch and triggered foreign investors' run on those economies. The Thai government's effort to reshape Bangkok as the financial center in East-Asian area, which led to the establishment of 'Bangkok International Banking Facilities(BIBF)' in 1993, is evaluated as another policy blunder. The institution worked as a main intermediary for foreign capital inflows that were channeled to real estate and property sector. One notable feature of any financial crisis observed during the past decades is that they were usually preceded by a series of financial deregulations. 6 Experience shows that financial reforms were mainly directed at a larger degree of managerial freedom, but did not properly dealt with the incentives of the management or owners of financial institutions, which were critical to the stability of financial systems. Regulatory authorities which implemented financial deregulation were not usually ready for a new set of rules they imposed on the market. Prudential regulations did not catch up with the new paradigm, and the implicit safety net of old regimes persisted in the minds of regulators and other economic agents. People usually changed only after they faced a financial crisis.

2.4. External Sector Problems 2.4.1. Inflexible Foreign Exchange Control System Those countries in crisis had adopted fixed exchange rate system, or a floating system with a band. Maintaining stable foreign exchange rates, usually pegged to U.S. dollars, was an important policy imperative to those countries to attract foreign capital, and was more or less successful. During the 1990s, the Korean won depreciated only 2.2% per annum, and the Thailand's Baht slightly appreciated. Such movements in the exchange rates of the crisis countries were surprising considering the differences in interest rates between domestic and foreign money markets of those countries, and reflected the monetary authorities' sticky exchange rate policies. Korea had maintained a floating rate system with a band ever since 1990. Under its Market Average Exchange Rate (MAR) system, the Korean won has supposedly been allowed to move freely against the U.S. dollar according to market forces, with the maximum movements of plus minus 2.25% against the previous day's closing price during the most of the period. 7 However, the economic policy that put the first priority on the competitiveness of its export

Origins and Policy Implications of the Asian Financial Crisb~ Table 4.

Exchange Rates against the U.S. dollar (annual average) 1990

Korea Indonesia Malaysia Philippines Thailand

55

707.8 1842.8 2.7 24.3 25.6

1991

1992

1993

733.3 780.7 802.7 1950.3 2029.9 2087.1 2.8 2.6 2.6 27.5 25.5 27.1 25.5 25.4 25.3

1994

1995

803.5 771.3 2160.8 2248.6 2.6 2.5 26.4 25.7 25.2 24.9

1996 804.5 2342.3 2.5 26.2 25.3

Sources: IMF, InternationalFinancial Statistics, various issues.

sector forced the monetary authority to frequently intervene in the market and to maintain stable exchange rates. During the first of half of the 1990s, the real effective exchange rate of the Korean won had depreciated unlike the other crisis countries, partly due to the appreciation of the Japanese yen during the period and mainly due to the government's policy to support the export sector. However, the sticky exchange rate policy of the Korean government needed to be complemented by higher volatility in domestic money markets. The mounting balance of payments surplus due to the increasing exports and the inflow of capital forced the monetary authority to involve in a massive sterilization operation by issuing Monetary Stabilization Bonds (MSBs) in large scale, leading to a circle of higher interest rates and larger inflow of foreign capital. The overflow of liquidity helped to cause asset bubbles in the economy and increased its overall risk with rising debt dependency. Thailand had maintained a multiple currency basket system, mainly pegged to the U.S. dollar, from mid 1984, and relatively large interest rate differentials to induce foreign capital inflows needed for its economic growth. However, as the U.S. dollar appreciated during the period, the Thailand Baht got overvalued, exposing it to a potential currency attack. The high domestic interest rates helped to control the overgrowth of domestic credit, but the credit expansion in external sector was inevitable. The critical blow to the Thailand's economy was the emergence of China as its main competitor in the export sector since mid 1990s. As a result, its export in 1996 recorded 0% growth rate and the amount of foreign debt increased sharply. Unlike Thailand, Indonesian monetary authority had maintained more flexible foreign exchange policy by adjusting its currency according to its current account deficit levels. Its 'crawling peg' system allowed the Indonesian Rupiah to depreciate 3 to 4% every year. Anyway, the currency adjustment was not enough to correct the productivity gap between Indonesia and other

56

PHIL SANG LEE & KYUNG SUH PARK

competing countries. Its real effective exchange rates appreciated despite the nominal depreciation, and its export markets depending on imported raw materials and cheap domestic labor was eroded by the emergence of China and Vietnam as its main competitors ever since the early 1990s. With the Thailand's currency crisis and the limited foreign reserves, the Indonesian government had to convert to a floating rate exchange system in August 1997 facing currency attack by currency speculators. Malaysia provides an interesting case among the crisis countries in that it had tried to contain the possible adverse effect of foreign capital inflows well before the financial crisis broke out in Asia. The reaction of the Malaysian government to the inflows of foreign capital prior to the crisis showed some difference from those of Thailand or Indonesia. Worried about the increasing portion of short-term inflows during the early 1990s, the Malaysian government adopted a floating exchange rate against U.S. dollar in 1993, and later used a currency basket weighted to the currencies of its major trade partners. In 1993 and 1994, the Malaysian monetary authority engaged in massive sterilization operations to prevent a rapid increase in money supply due to the increase in foreign reserves, by issuing 'Bank Negara Bills'. It also reduced domestic credit expansion by transferring government deposits from commercial banks to the central bank, raised reserve requirements including those on foreign capital inflows, limited net open foreign currency positions and prohibited any non-trade related swaps and forward transactions, among others. As the result of the active external policy, the Malaysian economy showed a better shape in this area; lower foreign debt to GDP ratio, lower short-term debt proportion and short-term debt to reserve ratio, However, it could not avoid the financial crisis. In general, the interest rate differentials between domestic and foreign assets remained high due to its high expected growth rates and probably due to imperfect financial market conditions. This was despite the stabilizing inflation rates in the 1990s, low government deficits and the stable exchange rates that were pegged to major currencies. When these governments partly liberalized capital account flows, it was usually large sized corporations of international recognition that were allowed to tap the foreign capital and credit markets. The resulting deterioration in average credit rating of the pool of corporate borrowers, who mainly resorted to domestic credit, left upward pressure on domestic interest rates, in addition to the credit squeeze by the sterilization operations. One group of victims of external opening of an economy was the small-sized firms that could not benefit from the low cost foreign sources of funds, and suffered from domestic credit squeeze due to sterilization policy. An important lesson from the Asian experience is that, unless the differential in

Origins and Policy Implications of the Asian Financial Crisis

57

economic growth rates disappears, inflows of foreign capital do not help to lower domestic interest rates. Other way to dissipate the interest rate differential is to let its domestic currency appreciate, which would undermine the competitive edge of its exporters. There seem to be no free lunch again. 2.4.2. Increase in Current Account Deficit The most conspicuous commonality among the affected countries was the increasing level of current-account deficits in recent years. The current-account deficits in those countries, ranging 3.41 percent of GDP in Indonesia to 9.18 percent in Thailand, were viewed as benign since they were used to fill their investment-savings gap, rather than consumed. As long as those countries with rising trade gap maintain sound fundamentals such as manageable budget deficit, low inflationary pressure, and competitive export sectors, no immediate shift of foreign capital out of the economy was expected and currency attacks did not occur. However, the situation during the mid 1990s attracted some worries since the deficit widened further with the sudden decrease in export growth rates, which is supposedly interpreted as the waning competitiveness of those countries after a decade of rapid growth. 8 One of the driving forces behind the export slowdown was the rising costs of production. Wage growth, above all, exceeded productivity growth in general. Above all, relatively higher inflation rates under sticky foreign exchange forced their real effective exchange rates to rise. The ASEAN 4 countries generally experienced appreciation in real effective exchange rates, which hurt the competitiveness of their exporters. Korea, unlike the other countries of the region, showed depreciating real effective exchange rates and modest inflation rates during the 1990s, but in retrospect, the improbable is interpreted as having reflected the undermining fundamentals of the economy. Behind the scenes lies the Chinese factor, which had worked to disturb the competitive balance in the region. The late starter China, armed with its cheap labor, caught up fast with the ASEAN 4 economies. Korea, nutcracked between these developing countries and Japan, struggled to establish competitive positions in autos, semiconductors, petrochemicals, etc., only to find overcompetition in the world markets. 2.4.3. Massive Inflows of Foreign Capitals On the other hand, the protracted current account deficits in those countries needed to be supplemented somehow, and maintaining commensurate capital account surplus was a natural choice. Capital inflows in credit forms rendered the countries to accumulate stocks of foreign debts, which more than doubled

58

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Korea Indonesia Malaysia Philippines Thailand

59

Inflation Rates (%)

1987

1991

1992

1993

1994

1995

1996

3.0 9.3 0.8 -2.5

9.3 9.4 4.4

6.2 7.6 4.7

4.8 9.6 3.6

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18.7

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7.6

9.1

8.1

8.4

5.7

4.1

3.4

5.2

5.7

5.9

Sources: IMF, International Financial Statistics, various issues.

for the crisis countries during mid 1990s. Malaysia showed the largest increase in foreign debt in relative terms during this period. Not only the scale but also the contents of debt also mattered. As of mid1997, Korea showed the highest short-term dependency in the debt structure, with 67.9% of total debt consisting of debts with maturities of less than 1 year. The numbers for other countries also ranged high from 56.4% of Malaysia to 65.7% of Thailand. The short-term dependency reflected the risk-taking attitude of the financial institutions in concern, which preferred low cost borrowings. However, those economies could not deliver the debt service requirements under waning international competitiveness. 9 Of course, the capital account liberalization reflected the countries' desperate need for foreign capital. One thing to note with respect to the external sector management of the crisis countries was their level of liberalization in both financial and investment flows. In all countries, with minor exceptions, capital account flow as well as foreign direct investment was almost fully liberalized. Stock markets were open, with some limits on the maximum foreign ownership of local firms, and most of financial sectors including asset management industry were open to foreign financial institutions. Only the short-term money markets and bond markets remained partially accessible to foreign portfolio investors. Accordingly, countries in the region observed influx of foreign capital, supported by large interest rate differentials and stable foreign exchange rates. For example, the net portfolio flows of Korea rose from an average of 2% of GDP in 1990-1992 to 2.8% in 1995-1996. They rose from -0.1% to 2.3% in Indonesia, from 0.1 to 2.6% in Malaysia, and from 0.2% to 2.2% in Thailand. Such rise also reflected the huge accumulations of financial resources in pension funds and mutual funds of developed countries, which have overflowed to those developing countries. 1° Adding both the foreign direct investments,

60

PHIL SANG LEE & KYUNG SUH PARK

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Origins and Policy Implications of the Asian Financial Crisis

61

portfolio investments and banking credits, the total capital account flows amounted 6-10% of GDP in those countries, which were more than enough to finance the current account deficit gaps. However, this extra liquidity incurred overinvestment on the part of the host countries and portended the possibility of the crisis. Anyway, the crisis countries showed some difference in how and where the inflows of foreign capital was channeled. With the capital market opening, the proportion of cold money flows such as foreign direct investment tended to decrease while that of portfolio investment, corporate or bank borrowings has increased. Major source of foreign capital inflows for Korea was the portfolio investment, while it was syndicated loans for Thailand, and foreign direct investment for Malaysia. 1~ Unlike the ASEAN countries in crisis, most of the capital inflows in Korea were channeled into manufacturing sectors. It was mainly large conglomerates with international reputations that could access the foreign financial market, and the foreign capital raised by financial institutions were also mostly supplied to medium to small sized exporters for their trade financing. On the other hand, inflow of capital in Thailand was channeled to either non-traded sector or consumed away. ~2 However, in retrospect, the difference in the final user of capital inflows among the crisis countries did not matter since the overall efficiency and profitability of investments has seriously deteriorated.

2.4.4. Inadequate Levels of Foreign Reserves The mounting current account deficits and the ensuing capital inflows do not necessarily sets the stage for currency attacks by speculators. The capability of host countries to deal with their external debt burdens can be measured by their relative magnitude to GDP or foreign reserves. The crisis countries without

Table 6.

Indonesia Korea Malaysia Philippines Thailand

Debt to Foreign Private Creditors and the Proportion of Short-term Debt (Billion U.S. dollars, %) 1992

1993

1994

1995

1996

mid-1997

28.4(60.5) 38.7(71.4) 8.5(48.1) 6.9(45.7) 23.0(69.0)

30.5(61.7) 41.2(70.8) 13.0(56.8) 5.8(40.0) 29.6(72.1)

34.2(61.8) 56.5(71.1) 13.5(48.8) 6.5(47.4) 43.4(71.0)

44.5(61.9) 77.5(70.0) 16.8(47.2) 8.3(48.8) 62.8(69.4)

55.5(61.7) 100.0(67.5) 22.2(50.3) 13.3(58.2) 70.1(65.2)

58.7(59.0) 103.4(67.9) 28.8(56.4) 14.1(58.8) 69.3(65.7)

Source: IMF, International Financial Statistics, various issues. Numbers in parentheses are the short-term debt ratios.

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PHIL SANG LEE & KYUNG SUH PARK

exception showed very high levels of debt compared with the sizes of their economies. The Debt-to-GDP ratio of Thailand was 38.1%, 29.3% for Malaysia, and 16.2% for Philippines. These numbers are well compared with 9.2% of Taiwan and 7.1% of China. Their short-term debt to reserves ratio were also much higher than those of other Asian countries that have avoided the currency attack. Korea recorded the highest level of 210.6%, Indonesia 162.9%, Thailand 141.1% and Malaysia 60.9%, which are well compared again with 24.3% of Taiwan or 23.4% of China. Considering that Korea could not avoid the crisis despite its strong fundamentals, the Korean case suggests the importance of foreign reserves as a buffer against any currency attack. The foreign reserve of a country versus its foreign debt has a kind of built-in safety mechanism since the government's effort to maintain a stable exchange rate, usually pegged to the U.S. dollar, renders the central bank to accumulate foreign reserves as capital inflows increase. However, in the crisis countries, such system did not work since the weakening competitiveness of their real sectors tended to depreciate their currencies, reducing the needs for currency purchases. During the 1990s, the accumulation of foreign reserves of the crisis countries did not match the increase in foreign debts. The foreign reserves either doubled or tripled during the period while their debts almost quadrupled. As the currency attack mounted on, the Thailand government poured in 6 billion some U.S. dollars to protect its currency, but only to accept a floating exchange rate system and to apply for the IMF rescue program. Korea's foreign reserves shrank by more than 20 billion U.S. dollars throughout the crisis period as its central banks bailed out domestic financial institutions from defaults on maturing foreign debt.

Table 7.

Indonesia Korea Malaysia Philippines Thailand Taiwan China

Debt Burdens of the Asian Countries (June 1997) Debt to GDP Ratios (%)

Short-term Debt To Reserves Ratios (%)

26.5 21.3 29.3 16.2 38.1 9.2 7.1

162.9 210.6 60.9 72.6 141.1 24.3 23.4

Source: IMF, International Financial Statistics.

Origins and Policy Implications of the Asian Financial Crisis Table 8.

Korea Indonesia Malaysia Philippines Thailand Singapore Taiwan

63

Foreign Reserves (Billion U.S. dollars as of end year) 1991

1993

1995

mid-1997

13.7 9.3 10.9 3.2 17.5 34.1 82.4

20.2 11.3 27.2 4.7 24.5 48.8 83.6

32.7 13.7 23.8 6.4 36.0 68.7 90.3

34.1 20.3 26.6 9.8 31.4 80.7 90.0

Source: IMF, International Financial Statistics, Vol. L, No. 12, 1997.

2.4.5. A Lesson: No Free Lunch in an Open Economy Facing the rising capital inflows, the governments of the affected countries had used combinations of economic policies to dampen the adverse effects the inflows could have. In order to avoid the pressure on exchange rates appreciation due to capital inflows, monetary authorities generally intervened in the foreign exchange market by selling local currencies. The ensuing credit expansion in foreign sector was partly absorbed through credit shrinks in domestic sector, by government bond issues, increases in reserve requirements, shifts of funds from banking system to the central banks, etc. However, the sterilization policy inevitably resulted in high domestic interest rates, imposing extra costs on both the public and private sectors. Issuance of government bonds on large scale, of course, nurtured inflationary expectations on the longer term and narrowed the government's capability for fiscal maneuver. The experience of those countries suggests that any combination of macroeconomic and foreign exchange policies cannot possibly deal with chronic imbalances in real and financial sectors in an open economy. It either immediately hurts the real sector through foreign exchange appreciation, or in the medium to long run through rising inflationary pressures.

3. ONSET OF THE CRISIS AND RESPONSES In retrospect, the Asian crisis seems to have been inevitable with all the structural weaknesses of those countries. However, past history shows that some countries with similar characteristics with those crisis countries still avoided the mishaps. It is also interesting to compare how the crisis fell upon those countries. As for the final stage of the crisis, two paths had worked that cornered those countries into crisis. One starts from the external sector where

64

PHIL SANG LEE & KYUNG SUH PARK

balance-of-payments problem causes a speculative attack on the local currency, and forces the central bank to deplete its reserves to defend the exchange rates. In the process, local banks have problems in rolling over their maturing debts, and may go bankrupt, which results in credit crunch and adversely affect real sectors.13 Another path to a financial crisis starts from a problem in domestic financial sector where troubled financial institutions with foreign debts cannot meet their debt service and the central bank spend its reserves to bail-out those institutions. While the crisis countries commonly shared both of these aspects in their paths to crisis, Indonesia and Thailand, with their external openness and enormous balance of payments, fitted with the first case, while Korea, with the limited extent of financial market opening, better fitted with the second case. Korea had presented a very interesting case in that it had set up an example of how an underdeveloped economy could change into an economy with 1 lth largest GDP and trading volumes in the world, at least before the crisis. It was recognized to have world-class competitiveness in semi-conductor, shipbuilding, car manufacturing, and chemicals. Highly educated labor, sound social infrastructures including the smooth transition from a military to a democratic government and tendency for hard working and austerity worked to make it an OECD member country in 1996. However, it could not avoid the financial crisis that swept the East-Asian countries mainly due to its rising foreign debt, evaluated at over 200 billion U.S. dollars including private sector debt. Unlike other cases, there was no massive currency attack on Korean won by currency speculators throughout the contagion of the crisis in the area, partly due to its underdeveloped foreign currency market. 14 It was rather the financial institutions with poor financial conditions, especially in foreign debt structures, that triggered the financial crisis. From mid-October 1997, a couple of merchant banks and commercial banks faced severe liquidity crunch in foreign accounts partly due to the frozen investments in East-Asian countries, and could not rollover short-term debts. With the limited foreign reserves, what the Korean monetary authority could do was to expand the daily band for currency movements from + 2.25% to 10%. Understanding the multi-layered backgrounds for the crisis, the Asian countries have mounted comprehensive effort to solve their problems. With some confusion and delay, the countries in crisis more or less faithfully followed the prescriptions imposed by the IMF. The main policy imperative was directed to fixing the structural problems in the financial sector. Insolvent financial institutions including commercial banks of substantial scales to nonbank financial institutions such as finance companies and securities firms had been closed or under recapitalization process. Most surviving financial

Origins and Policy Implications of the Asian Financial Crisis

65

institutions are also going through a painful process of organizational restructuring. In the meantime, shareholders, debtors and management as well as employees paid their shares of mistakes, which were unprecedented in the financial sector of those countries. As a part of the conditionality of the IMF rescue program, the Thailand government implemented a couple of financial reform plans. Major changes include the establishment of 'Financial Reconstruction Authority' that replaced the existing financial supervisory authorities. To facilitate the restructuring of financial institutions, 'Asset Management Company' funded by public and private sources was also established. Fifty-eight finance companies with the total assets of 10 billion U.S. dollars were closed. To prevent the increasing instability in the financial market, deposit protection program was reinforced. The limits on foreign participation in domestic financial institutions were relaxed while the minimum capital requirements on banks and finance companies were raised. Faced with the crisis, the Indonesian government closed 16 banks, some of which were closely connected to the dictator or his relatives, introduced a special deposit insurance program, and removed the investment limits on foreigners in its stock market. One criticism on the crisis management of the subject countries is on the pace of the structural reform. Most countries are evaluated to have wasted critical months after the crisis delaying the closing of failed financial institutions and subsidizing private sector firms with no chances for survival. Such delay in restructuring made it hard for domestic and foreign financial institutions to draw the line between good firms and bad firms, and expanded credit crunch in the economy. Exports, the locomotive for recovery for the countries in this region, had also slowed down partly because of the reduced export financing in the turmoil of the restructuring in the financial sector, which led to more defaults of private firms in a vicious circle. The painful reality of structural reform also dragged the reform process. Despite the rescue package of the IMF that amounts to $100 billion in total, the GDP growth projections for the year 1998 ranged from 1.8% for Malaysia to -9.0% for Indonesia, much worse than the projections at the beginning of the crisis. In Indonesia, Suharto's dictatorship was toppled down in the aftermath of the crisis, and the similar threats to those in power were present in other countries. The exchange rate depreciation ranged from 53.4% of Philippines to 129.0% of Indonesia, and stock market indices were also more than halved in most cases. Unemployment rates had doubled or tripled in those economies, rising to a level that threatened the stability of the societies. Given the inflexible labor

PHIL SANG LEE & KYUNG SUH PARK

66

Table 9.

Shocks in Exchange Rates and Stock Market Index Exchange Rate

Indonesia Korea Malaysia Philippines Thailand

Stock Market Index

25 June 1997

30 December 1997

%A

30 December 1996

30 December 1997

%A

2,432 888 2.52 26.4 25.3

5,570 1,635 3.89 40.5 47.0

129.0 84.1 54.4 53.4 85.8

637 651 1,238 3,171 832

401 376 589 1,869 366

-37.0 -42.2 -52.4 -41.1 -56.0

Source: IMF, International Financial Statistics, various issues.

markets and the dire economic conditions of the countries, the laborers seemed to have no other choice but to go for a suicide strategy. To secure the resources necessary for the restructuring was not an easy task, either. In financial sector alone, the problem loans, which were evaluated to be around 20% of the total domestic credits or more than the total annual budget of crisis countries, were too burdensome. The governments relied on fiscal money or government bond issues, but domestic markets for bonds were not well developed enough to absorb the bond issues of unprecedented scales. Allowing foreign capital to own and manage domestic financial institutions was another option the governments had tried. But it took some time before we could observe major M&A deals since foreign investors were afraid of too much uncertainty about the economic prospects in these areas. Other than the financial reforms, reforms in political and private sectors are also under progress, but, as yet, without tangible results. A comprehensive overhaul of the corporate management practices is under progress in the crisis countries, including measures to increase the transparency of corporate management. In Korea, for example, the government enforced the compulsory appointment of outside board members on the board of directors of listed firms, strengthened the legal duties of the owner-mangers, and imposed the 'combined financial statements' on Chaebols. More restrictive accounting and public disclosure standards were also introduced. However, the hindering blocks to the recovery of the Asian countries came from the external factors rather than internal reform failures. Japan, the growth engine of Asia, could not play a leading role due to its prolonged economic sloughs and soaring debt problem exacerbated by the Asian crisis. Its devaluating yen hurt its neighbors such as Korea. China, which barely avoided

Origins and Policy Implications of the Asian Financial Crisis

67

the currency crisis, also suffered from mounting bad loans in financial sector, inefficient state owned enterprises, and threateningly high unemployment rates. Devaluation of the RMB to support its exporting industries as a way out was expected to call for another round of currency and financial crisis in this area, critically hurting the already fizzling reform efforts of other crisis countries. Another phenomenon that worried the governments was the flight of capital from the crisis countries. Money that left the Asian countries including Japan during 1998 was estimated to exceed 120 billion U.S. dollars, which was almost the double the amount of 1997. The on-going financial deregulation that was expedited after the crisis and allowed the local investors larger discretion to invest in foreign assets contributed to such capital outflows. They were not only destabilizing the subject economies, but also nurtured room for another financial crisis by creating bubbles in the asset prices of subject countries.

4. RESCUE PROGRAMS AND CRITIQUES Ever since the IMF got involved in the Asian crisis, there have been cons and pros on the role of the organization. The IMF's conditionality for the financial support ranged from macroeconomic policy frameworks to structural policies including financial and real sector reforms, and the criticism mainly fell on the macroeconomic targets set for the economies. The IMF demanded low growth rates, budgetary austerities, high levels of interest rates and reduced current account deficit among others, whose main purpose was to enforce swift structural adjustments while providing an environment to recover the foreign investors' confidence. The criticism on the IMF program was based on the argument that the Asian countries had maintained sound budgetary policies different from those of Mexico or European countries. In other words, they were basically suffering from private debt problems and microeconomic problems, not from public debt or macroeconomic problems as in Mexico, and half the IMF's conditionality was out of point in the short run, and could be detrimental in the longer run at worst. The fact that the economies in crisis countries experienced severer contractions than even the IMF had expected at the time of its assistance also cast doubt on the properness of the program. Under the IMF program, the financial markets of the crisis countries observed steep rises in interest rates, negative growth rates, and a series of corporate bankruptcies of unprecedented scale. The control on domestic credit growth was especially dubious considering the fact that the economies already began to contract even before the crisis, and many firms with sound financial prospects faced credit crunches

68

PHIL S A N G LEE & K Y U N G SUH PARK

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Origins and Policy Implications of the Asian Financial Crisis

69

after t h e o n s e t o f the crisis. T h e p r e c i p i t a t e d a s s e t p r i c e s m a d e it h a r d e r f o r the private s e c t o r s to r e s t r u c t u r e t h e m s e l v e s t h r o u g h the s a l e s o f t h e i r b u s i n e s s lines. A s the e c o n o m i e s o b s e r v e d a s e r i e s o f b a n k r u p t c i e s , i n c r e a s i n g s o c i a l i n s t a b i l i t y d u e to i n c r e a s i n g u n e m p l o y m e n t also t h r e a t e n e d t h e p o l i t i c a l

Table 10.

Macroeconomic targets

Financial Sector Reforms

Real Sector Reforms

T h e I M F C o n d i t i o n a l i t y f o r the Crisis C o u n t r i e s Indonesia

Korea

Thailand

-reduced public subsidies and tax privileges ~tivestiture of state enterprises -cancellation of some infrastructure projects -macroeconomic targets for 1998 • inflation 20% • GDP growth 0% • budgetary deficit of 1% of GDP • current a/c deficit of 2.2% of GDP • official reserves of 5.2 months of imports -comprehensive financial restructuring including closure of troubled banks -strengthening regulatory framework ~teposit guarantees for small depositors

-selective increase in income and corporate taxes -broadening of VAT base -macroeconomic targets for 1998 • inflation 5.2% • GDP growth 2.5% • budgetary surplus of 0.2% of GDP • current account deficit of 2.3% of GDP

-VAT increase -reduced subsidies ~tivestiture of state enterprises -flexible exchange rates -macroeconomic targets for 1998 • inflation 5.0% • GDP growth 3.5% • budgetary surplus of 1% of GDP • current a/c deficit of 3.0% of GDP • official reserves of 4 months of imports

--comprehensive financial restructuring including closure of troubled financial institution -improving accounting and disclosure rules -consolidated supervisory function -elimination of traderelated subsidies -removal of restrictive import licensing and FDI rules -promotion of labor market flexibility

-restructuring of financial institutions -improving accounting and disclosure rules -removal of unconditional financial support to insolvent institutions

-removal of state regulated monopolies and cartels -abolition of restrictions on marketing arrangements

Sources: IMF Press Releases Nos. 97/37, 97/50 and 97/55.

-enhancing export sector competitiveness through emphasis on education and training

70

Table 11.

PHIL SANG LEE & KYUNG SUH PARK Changes in Economic Environment after the IMF Rescue Program

Agreement Date Total IMF support ($ billion) GDP growth rates CPIs Unemploymentrates Foreign Reserves ($ billion) Total foreigndebt ($ billion) Interest Rates

Korea

Thailand

Indonesia

12/3/97 57.0 -7.7%p + 3.9%p + 4.1%p + 28.7 -6.6 Stabilized after a hike

8/20/97 17.2 -5.4%p + 1.8%p + 2.7%p + 0.9 -2.1 minorincrease

11/5/97 40.0 -14.6%p + 48.0%p + 9.6%p -3.1 + 25.9 Sharpincrease

system, further delaying the implementation of any determined reform plans by the govemments. Another criticism on the IMF program was its fairness in cost sharing. The rescue programs were mostly focused on domestic issues such as enhanced transparency of the overall economy including corporate sectors, removal of public subsidies to private sectors, further financial deregulation including external opening, etc. However, there was less concern or lack of action to deal with the external factors that triggered the financial crisis. The funds provided by the IMF were used to pay back the foreign debts or to guarantee future debt payments, thereby protecting foreign creditors despite de facto bankruptcy of the subject economies or financial institutions. While asking for fairness in cost sharing among the involved parties of the crisis countries for an incentive reason, the IMF was neglectful in dealing with the moral hazard of foreign creditors. 15. Many observers had pointed out the short-term capital that sloshed around the world as the major culprit of the crisis. Negative role of the short-term capital was emphasized by scholars and journalists, who even doubted the role of the market capitalism as the best way to govern the world economy. The criticism of the biased approach to the Asian problems takes more ground since other countries with much less transparency, more political corruption and regulatory intervention, and less external opening avoided the crisis. Finally, and probably the most critical aspect of the IMF's approach to a financial crisis including this one was its ex-post concept of intervention. Any international support programs in the past including those of the IMF had been implemented only after the situation got pretty much out of control in a subject country. This was partly due to the lack of authority and information on the part of rescuers to intervene in local economic issues including debt control. Such

Origins and Policy Implications of the Asian Financial Crisis

71

ex-post intervention tends to create moral hazard of related parties and costs a lot more resources of international society.

5. POLICY IMPLICATIONS OF THE CRISIS 5.1. Management of International Capitals Flows Debates on whether to control the movement of short-term money abound. The key to understanding the nature of short-term money in terms of setting international regulation is to understand the difference between financial assets and real assets, especially the higher barrier to movements of real assets in an international context. Financial assets show much faster mobility by definition, and affect asset prices that cannot be matched fast enough by real sectors. In a world of debt financing, bankruptcy mainly due to the lack of liquidity are not rare, which hurt the financial institutions and worsen the credit crunch problem in real sector in a vicious circle. Informational asymmetry aggravates the problem further in financial markets. Depending on the movements of major players with certain information or economic purpose, markets jolt from one state to another, resulting in extreme instability in an economy. The situation gets worse in an international market that includes cross-border capital flows since the positive boomerang effect of capital shifts and their influence on other sectors of a market takes more time to happen or would never occur. Good examples are currency markets that connect the domestic economy with external economies. With the value of a currency swings so fast with capital shifts, no economy can possibly reallocate their resources instantly and adjust to the changing environment while it takes time before lower interest rates, for example, in other countries where capital shifted into have positive effects o n your economy. In the meantime, the domestic economy goes through serious credit crunch, and economy wide corporate failures follow. As the world's financial markets gets integrated further, and the mobility of funds gets faster, there is a mounting need for an architecture that can deal with international financial issues. Understanding that cross-border capital flows have severe externalities on the world economy, monetary authorities need to strengthen the measures to monitor and control these flows. First, on an international level, an improved reporting system on the size, maturity structure, repayment schedule, currency composition, creditor and debtor information, external debts and foreign reserves of debtor countries should be in place. The establishment of an international organization or a function in existing institutions to monitor and control capital flows should be considered.

72

PHIL SANG LEE & KYUNG SUH PARK

Not only it has the authority to monitor international capital flows, it should be able to set and implement an international rule, like the BIS rule, that controls the external debt levels of member countries. Such idea reflects the negative externality a credit extension by private creditors to member countries has. Second, they need to see to it that capitals are properly allocated to private sectors. Excessive investment in risky assets such as real estate needs to be controlled. Rising asset price would be an indicator to evaluate the impact of capital inflows. Third, they need to monitor the financial soundness of intermediaries in foreign exchange dealings including their currency net positions, maturity gap, short-term dependency, overall credit conditions, etc. Even the financial soundness of institutional investors including hedge funds need to be under the control of an international monitoring and regulatory agency. Fourth, there is an urgent need for strengthening the role and capability of the IMF as a lender of last resort. The capital base of the IMF should be expanded and possibly additional funds can be obtained from the international investors, who are criticized more or less for their imprudent investment behaviors. Worries about increasing moral hazard on the part of the crisis countries are not substantive considering the severe pains these countries have gone through. The Asian crisis needs to be tackled through an international cooperation that spans not only major countries and international organizations, but also private financial institutions. One immediate concern is the need for a more aggressive approach to the underlying problems of debts of the crisis countries. It is not too late to impose proper costs on those private creditors considering that the existing program failed to correct the moral hazard problem of the private creditors. Understanding that the Asian crisis occurred due to the mistaken judgements of both the subject countries and the international creditors, the share of the latter in the costs of the restructuring needs to be increased. Such adjustment would also be appropriate to prevent the occurrence of a similar crisis in the future by heightening the awareness of the international financial society. Capital that looks for high returns in the international financial markets are more or less free riding on the global safety nets such as the IMF and other international mechanism that work to support the stability of the markets. 16As in the case of domestic depositors and creditors who share in the implicit and explicit costs for deposit insurance mechanism, these international investors also need to share in the costs of maintaining system stability. Certain portions of the international investment funds that move across borders should be earmarked as an insurance fund whether it being called

Origins and Policy Implications of the Asian Financial Crisis

73

Tobin's tax or whatever, to be used as a rescue fund for both investors and subject countries. In the short run, one way to solve the external debt problems of the crisis countries without incurring too much cost on the creditors would be debt-equity swaps. As long as a debtor has a positive equity basis, such a scheme could work with some technical difficulties in valuation.

5.2. Need for Market Discipline Since the integral part of the financial crisis in Asia originated from the moral hazard on the part of corporations, financial institutions, the government, reform measures to bolster competition among the economic agents should be strengthened. During the restructuring process, those related parties, whether they being the management, employees, shareholders, depositors or the government should be accountable for their lack of prudence in the past. One critical area that needs restructuring but has the power to resist is the government sector. An overall review of government's role in an economy is in order since the origin of the moral hazard lies in the paternalistic government and its control of markets. The corrective program should be aimed at, above all, downsizing government organizations and privatizing state owned corporations. To correct the tendency to delay any substantive financial reforms, a legislation to prohibit government officials from obtaining jobs in the financial institutions under their control needs to be seriously considered. On a more fundamental level, the corruptive social structure should be reformed too. Without abolishing the cronyism that connects politicians, regulators, corporate firms and financial institutions, the current effort of the crisis countries would lead to another round of crisis. Measures to increase the transparency and the accountability of each sector including public as well as private sectors should be implemented. Legal measures such as minority shareholder rights and class action suits to support the working of market discipline also need to be complemented. Industrial reforms that would remedy over-capacity and over-debt problems of firms also need to be implemented.

5.3. Overhaul of Financial Supervisory Structure Removing moral hazard problems in the real and financial sector through introduction of stronger market discipline needs to be accompanied by the restructuring of financial supervisory functions too. As noted earlier, the crisis could have been avoided if an early warning system in financial sectors had worked to prevent the reckless loan practices of financial institutions. This calls for an improved monitoring of financial institutions. Risk adjusted capital

74

PHIL SANG LEE & KYUNG SUH PARK

requirement system of the BIS type should be introduced and strictly implemented in developing countries. Actually, the need for stricter regulatory and supervisory requirements is stronger in those countries due to the overall opaqueness of the economies from corporations to financial institutions. Understanding the limits of the BIS rule, the supervisory authorities also need to complement it with the CAMEL (Capital, Assets, Management, Earnings and Liquidity) approach of the U.S. federal reserve system. In this regard, the crisis countries need to accept the Basle Core Principles of Effective Banking Supervision, which has been recently agreed among the key member countries. One important area that needs increasing attention of supervisory authorities is the non-bank financial sector. In the crisis, it was the NBFIs that mainly channeled capital inflows into risky investments and contributed to losing confidence of foreign creditors with their credit crisis. With increasingly blurred business lines between banks and non-bank financial institutions, and the latter's increasing role in the financial market, a capital requirement rule similar to that of banking sector needs also to be applied to NBFIs. In addition to the regulatory requirements on financial soundness, a workable internal risk management system should be in place in financial institutions, partly enforced by regulatory authorities as a part of the restructuring process. Whether it being an ALM system or VaR (Value at Risk) system, the internal organization for risk management should be revamped and a risk-based management system should be introduced. More importantly, abreast with the strengthened prudential regulations, additional degree of freedom in the area of the governance of financial institutions should be allowed. Regulators should abstain from their desire to intervene in and affect the management of financial institutions. 5.4. Lessons on Financial Deregulation and Market Opening

The financial deregulation and capital account liberalization in the crisis countries helped to expand the quality and availability of financial services to domestic customers, but at the same time they entailed significant costs by exposing domestic markets and participants to external risks without proper readiness. Many researchers report positive correlation between financial deregulation and ensuing financial instability. ~7Their experience suggests that sound macroeconomic conditions such as low current account deficits, fiscal austerity, and low inflation rates need to precede major financial liberalization. A prolonged capital account surplus cannot be maintained unless strong

Origins and Policy Implications of the Asian Financial Crisis

75

economic fundamentals and proper measures to manage external accounts accompany this. In the crisis countries except Korea, large capital inflows resulted in currency appreciation in real terms and high inflation led by asset and factor price bubbles, which tended to hurt the competitiveness of their export sectors. Their experience also shows that sterilization of capital inflows to contain nominal exchange rate and inflationary pressure has adverse pressure on domestic interest rates, which tends to bring in more foreign capital, and imposes additional fiscal burden on the government and private firms. In conclusion, an attempt to control both the exchange rate and the inflation rates is successful only in the short run, and is almost impossible to be maintained in the longer run.

Another prerequisite for external liberalization is the sound financial status of domestic financial institutions, which would operate as the intermediaries of capital account flows. It is usually financial institutions, not real sector firms, that provide the initial trigger for the adverse movements of short-term capital. Once in a crisis, they tend to shrink their credit supplies for their own survival and worsen the situation. In the same vein, a well developed domestic financial market prior to the external opening would help. The crisis countries in general had weak government bond markets among others, which narrowed the monetary authorities' span for open market operations prior to the crisis, and limited the government's financing capability for restructuring the economies.

6. CONCLUDING REMARKS If economic history tells us anything, it would be that arguing for a system against another could be a very risky bet. The Asian crisis, as its another byproduct, set the stage for disputes over the superiority of economic systems. Such disputes are of course heavily affected by recent performances of the economies that adopted a certain form of an economic system. It has been only a decade that the Japanese system based on its closely intertwined relationship among firms, banks, and the government had been applauded as a model case for western economies that were going through economic slowdowns. Other Asian countries also emerged as world competitors out of dire poverty only in a couple of decades based on their government driven economic development programs. Considering that the western countries took more than a century to achieve the current success, such performances and the values lying behind them do not seem to deserve such a barrage of criticism as observed these days.

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After diagnosing the common features of these crisis countries, we may have to be careful in our definition of the Asian crisis. We usually call it a financial or currency crisis, mainly because it started from the currency attacks on the countries with increasing current account deficits, large inflows of short-term foreign capital, shaky foreign reserves and weak financial institutions which were unable to service their foreign debts. However, it is our understanding that behind these financial deficiencies existed the real problems of an old history. Many papers had pointed out the weak financial system as a main culprit for the crisis, especially the role it played during the development of the crisis. It is true that a healthier financial system would have helped the economies avoiding the difficult situation they are going through now. However, such arguments are sometimes confused about the causality of the events. The main reason for the shaky financial system at the time of the crisis in these countries was the collapsing real sector, which had started well before the crisis. Mounting non-performing loans and loan losses had weakened the financial system, and eventually led to the financial and currency crisis. A sound financial system, by definition, does not coexist with failing real sector, and the hypothesis that a healthier financial system could have saved those economies loses its logical basis. Overinvestment based on high leverage has pervaded the economies, but the quality of the investment and the leverage worsened over time. The fundamental reason for rising domestic and external debt was the decreasing competitiveness of those countries; private sectors in those countries could not produce enough returns to sustain the level of debt. However, we may still call it a financial crisis because the allocational role of financial institutions failed to work to tell good investments from bad investments. Finally, we need another caveat in interpreting the result of analysis in this chapter. Individual items listed above as the causes for the financial crisis do not necessarily qualify for necessary or sufficient conditions for the crisis. Countries with much less corporate transparency still avoid a crisis, while countries such as Sweden and Finland with much more transparency and stronger market discipline plunged into a financial crisis. The amount of external debts is not a major factor either, since Korea, e.g. used to have much higher external debt to GDP ratios in the early 1980s. Only the combination of the local problems seems to add up to a financial crisis, but we do not know the exact combination since otherwise we would be in a much better position to predict and to take actions well before any crisis realizes. Finally and most importantly, there remains the important issue of controlling international investment capital such as hedge funds that played a

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key role in triggering the crisis. In this sense, the term 'the financial crisis' fits the case. They have grown up to sizes that are big enough to j o l t any economy, let alone those o f Asian countries. Unlike in a real sector, we m a y now have to define the concept o f monopolistic power in international financial markets in a different way. For example, the size o f capital an investor can mobilize within a certain period o f time relative to the size o f the existing market should be a new criteria for monopolistic power. Understanding that financial markets are very different from other markets is the key to the solution o f the issues.

NOTES 1. The Asian crisis is the third major currency crisis of the 1990s after the crisis in the European Monetary System in 1992-93 and the Mexican peso crisis of 1994-95. 2. Several authors rightfully pointed out the moral hazard issues as the core of the Asian crisis. 3. On the other hand, Asian countries that avoided the financial crisis generally recorded positive savings-investment gaps. 4. Even before the financial crisis, 5 conglomerates out of the 30 largest went bankrupt creating $2 billion of bad loans that amounts to almost two thirds of the total capitals of commercial banks in Korea. 5. See Bhanupong(1998). The finance companies' lending exhibited higher degree of concentration compared with that of commercial banks. 6. See Johnson et. al. (1997) for a detailed analysis. 7. With the onset of the crisis, the band has been expanded to plus minus 10%. 8. Coupled with the increasing trade deficits, increased remittance of earnings by foreign capital also contributed to the widening current account deficits over the periods. 9. The short-term dependency also limits the monetary authorities' room for maneuver facing speculative attacks. Precarious capital movement forces the central bank to maintain higher reserves than is normally required. 10. Economic and Social Survey of Asia and the Pacific 1998, ESCAP, United Nations. 11. See Park (1998) for more details. 12. Thailand shows the highest investment-savings gap, Malaysia and Philippines following next. 13. See Kaminsky & Reinhart(1996), and Stocker(1995) for a detailed explanation. 14. The amount of the local currency foreigners could mobilize was pretty much limited to their investments in Korean stocks that was barely over 13 billion U.S. dollars at the maximum at the time the currency crisis started. 15. See Camdessus (1998) for an argument. 16. The recent episode of rescuing the Long Term Capital Management provides a good example of how hedge funds are free riding on the institutional safety net. 17. See Johnston et. al. (1997) for example.

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REFERENCES Bank of Indonesia, Financial Statistics, various issues. Bank of Korea, Monthly Bulletin, various issues. Bank Negara Malaysia (1996). Annual Report. Bank of Thailand (1996). Annual Economic Report. Bhanupong, N. (1998), Improved Management of the Financial Sector: A Case Study of Thailand. Presented at the Seminar on Improved Management of the Financial Sector held at ESCAP, 20-22 May 1998. Camdessus, M. (1998). Reflections on the IMF and the International Monetary System. Address to the Economic Club of Washington, March 12, 1998, Washington, D.C. DRI (1996). World Markets Executive Overview, fourth quarter 1996. Howell, M. (1998). Asia's ~ctorianfinancial crisis. Paper presented at the conference on the East Asian Economic Crisis, Institute for Development Studies at the University of Sussex, 13-14 July 1998. IMF, International Financial Statistics, various issues. 1MF (1997). Press Releases Nos. 97/37, 97/50 and 97/55. Johnston, R. B., Darbar, S. M., & Echeverria, C. (1997). Sequencing Capital Account Liberalization: Lessons from the Experience in Chile. Indonesia, Korea, and Thailand, IMF WP/97/157, November 1997. Kaminsky, G. L., & Reinhart, C. M. (1996). The twin crises: The causes of banking and balanceof-payments problems. International Finance Discussion Paper, Board of Governors, 1996. Park, Y. C. (1998). Financial Liberalization and Opening in East Asia: Issues and Policy Challenges. Korea Institute of Finance. Stiglitz, J. (1998). The role of international financial institutions in the current global economy. Address to the Chicago Council on Foreign Relations, February 27, 1998, Chicago, Illinois, U.S.A. Stoker, J. (1994). lntermediation and the business cycle under a specie standard: the role of the gold standard in English financial crises, 1790--1850. University of Chicago, Chicago, U.S.A.

KOREAN FINANCIAL CRISIS AND REFORM: AN OVERVIEW Daesik Kim and Jaeha Park 1. INTRODUCTION A s more and more dismal economic figures 1 come in, it becomes clearer that the Korean economy is in turmoil. The jobless rate hit 7.6% in July 1998, the highest level in 31 years, leaving 1.65 million 2 people out of work. The GDP shrunk 5.3% during the first half of 1998, the largest drop in Korean history. 3 The inflation rate was 7.3% year-on-year in July. These numbers are expected to worsen as the IMF's bailout program continues. Currently, Korea is pushing hard to restructure the economic system, while simultaneously analyzing the causes of the current crisis. This chapter first summarizes the causes of the current crisis on which diverse opinions has been expressed, and then describes financial reform measures taken so far. Since a huge body of literature on the causes of crisis already exists, our focus is on the financial sector reform in Korea. 4 We also present our own interim evaluation and expectations. Many economists have tried to evaluate the causes of the recent currency and financial crisis in Asia. Although no consensus has been reached, there are two competing views in the literature: the 'weak fundamentals hypothesis', which emphasizes weak macroeconomic conditions and policy inconsistencies, and the 'financial panic hypothesis', which emphasizes rapid shifts in market sentiment and expectations. We examine these hypotheses in light of the precrisis situation in Korea. Our tentative explanation emphasizes the lack of

Asian Financial Crisis, Volume 1, pages 79-122. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0686-6

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proper policy responses to external shocks as well as instability inherent in the international financial markets as a triggering event for the Korean crisis. Next we describe the ongoing resolution process of the crisis. In this section, three main challenges faced by policy makers are described. The first problem is resolving the liquidity crisis by slowing down massive capital outflows. Another is reforming the institutional framework, including the financial regulatory structure for the soundness and safety of the financial system. The last is restructuring the whole financial industry by closing, merging, or recapitalizing institutions to improve the financial efficiency. As of the end of September 1998, the Korean government has finished the first round financial restructuring and provided a fiscal support of 37.7 trillion won out of the planned 64 trillion won that amounts to 15.2% of the 1997 GDP of 421 trillion won. The second round is being completed by June 1999, aiming at clean financial institutions. The structure of our analysis is as follows: Section 2 addresses the first and second issues, Section 3 describes the financial sector reform process in brief and Section 4 includes concluding remarks. The Appendix II summarizes the restructuring progress in corporate, labor and public sector.

2. CAUSES OF THE KOREAN FINANCIAL CRISIS 1. Theoretical Models of Crisis Quite a few studies have tried to examine the causes of financial crises. They include Krugman (1979), Obstfeld (1994), Radelet & Sachs (1998), Corsetti, Pesenti & Roubini (1998), Esquivel & Larrain (1998), among others. The literature, however, is separated into two groups: the traditional theory (weak fundamentals hypothesis), and the self-fulfilling model (financial panic hypothesis). The traditional theory asserts that currency crises are caused by weak economic fundamentals, while the self-fulfilling model argues that crises can occur independently of any fundamental economic failings, but are strongly correlated with the expectations of market participants. Krugman (1979) represents supporters of the former theory, and Obstfeld (1994) champions the financial panic model. A brief summary of these two views is stated below.

Weak Fundamental Hypothesis This theory of balance-of-payment crises was put forward by Krugman (1979), who argued that crises occur when a continuous deterioration in economic

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fundamentals becomes inconsistent with the exchange rate system. This inconsistency would induce gradual capital outflows and loss of foreign exchange reserves. Once reserves reach a certain threshold level, speculators' attack the currency to avoid capital losses, exhausting the reaming reserves within a short period of time. Supporters of this view are consequently close observers of macroeconomic indicators such as the exchange rate. Krugman (1979) cites two approaches to this conventional theory based on the method of prediction used to forecast the crisis. The first approach is a 'Model Diagnosis Hypothesis', which forecasts crises by estimating the probability of investor's speculative attacks based on the deterioration of the current account balance and stock of reserves. Econometric models for this analysis are the Probit or Logit models, used by Frankel & Rose (1996) and Agenor, McDermott & Ucer (1997) respectively. The second approach is the so-called 'Indicator Hypothesis', which estimates whether the indicator variables are overheated beyond the critical point or not. Goldstein (1998) and Kaminsky & Reinhart (1996) set this critical point at 10%, whether it be current account deficit or budget deficit. The more indicator variables beyond this critical point, the greater the likelihood of a crisis. Indicators often used are the real exchange rate, the current account balance, stock prices, M2/foreign reserve, real production, money multipliers, number of banking crises, real interest rates, foreign reserve levels, terms of trade, demand for M l, domestic credit/GDP and so on. Financial Panic Hypothesis

According to this theory, a currency crisis can break out with a sudden shift of market expectations and investor confidence. For example, a country receives a shock when its neighbor devaluates. Market observers expect the home government to depreciate its currency to soften or avoid the shock. This expectation alone can cause investors to attack the currency, even if the economic fundamentals are perfectly sound. According to this view, crises are generated by a panic of the market, that can be triggered by an event as trivial as a bad rumor about the level of reserves. Such a rumor could prove to be selffulfilling. Obstfeld (1986,1994), Calvo & Mendoza (1996), Sachs, Tornelt & Velasco (1996), and Sachs & Radelet (1998) support this idea of panic. There are two approaches to the financial panic theory. The first states that expectations will only translate into a full-blown currency crisis if economic fundamentals were already weak. The second approach says that expectations can cause a crisis even if fundamentals are perfectly sound.

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The main points of the financial panic theory are the following: (1) a currency crisis can only occur if there are external shocks, and no currency crisis occurs without external shocks, (2) a currency crisis can be avoided even in the presence of external shocks if the initial symptoms of a crisis are controlled by the proper policies, and (3) the exact time when external shocks break out cannot be estimated with any accuracy. In essence, the difference between the two models is that deterioration of economic fundamentals is a necessary but not a sufficient condition for a currency crisis in the financial panic hypothesis, while it is both a necessary and sufficient condition in the fundamental hypothesis.

2. Symptoms of Crisis 2.1. Current Account and Exchange Rate during the 1990s Until 1995, the ratio of current account balance to GDP in Korea was at a reasonably low level, between 0.3% surplus in 1993 and 2.8% deficit in 1991. Since 1996, however, current account deficits have grown significantly, and the ratio reached 4.9% in 1996. The widening of current account deficits was mainly due to the drastic fall in the international prices of Korea's major exporting products, such as semi-conductors, automobiles, steel, and petrochemical products. The price of the 16 Megabyte DRAM memory chip, for example, had plummeted from fifty dollars in January 1996 to less than two dollars by October 1997. Prices of petrochemical products have also declined, though less dramatically. This fall in w o r d prices, as can be seen in Table 1, caused the terms of trade 5 and current account balance to degenerate rapidly. The terms of trade fell from 103.7 in 1994 to 87.7 in 1996, and the ratio of current account deficit to GDP

Table 1.

Current Account and Terms of Trade

(%)

Current Account/GDP Terms of Trade Real ExchangeRate (Won/Dollar)

1991

1992

1993

1994

1995

1996

-2.8 97.7 98.4

-1.5 98.2 100.5

0.3 102.5 100.0

-1.0 103.7 95.0

-1.9 100.0 91.3

4.9 87.7 98.3

Source: The Bank of Korea, National Income, Balance of Payment, various issues Park & Rhee (1998)

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soared from 1.0 to 4.8% during the same period. The cumulative trade deficit from 1994 to the third quarter of 1997 totaled a tremendous 49.7 billion dollars. In contrast to the current account deterioration, the won/dollar exchange rate appreciated significantly in real terms during the 1990s. If the real exchange rate index 6 is set at 100 in December 1993, it fell to 95 in December 1994, and 91.3 in December 1995, but increased to 98.3 in December 1996. The degree of appreciation in Korea, however, was relatively mild compared to other Southeast Asian nations. 2.2. Growth of External Debts and its Structure Since the early 1990s, the Korean government has accelerated financial market deregulation and market opening. With the financial liberalization, financial institutions were allowed greater freedom in managing their assets and liabilities, especially in borrowing foreign capital. As can be seen in Table 2, capital inflows increased continuously throughout the 1990s, jumping drastically after 1994. Thus capital inflows far exceeded the current account imbalances, leading to the accumulation of gross external liabilities in excess of financing needs for current account deficits. Total external liabilities, measured according to a new definition agreed upon by the Korean government and the IMF, 7 reached 157.5 billion dollars at the end of 1996, which grew by 250% compared to the volume of 1992. As can be seen in Table 3, the debt to GDP ratio reached 34.9% in December 1997 from 20.4% in 1992. Not only the size of the external liabilities, but also the maturity structure showed dramatic change. That is, the bulk of capital inflows were made up of short-term external financing with maturity of less than one year. Table 3 shows that 63.5% of total liabilities had maturity of less than one year in 1996. The

Table 2.

Capital Inflows and Current Account (US$100 million) 1990 1991 1992 1993 1994 1995 1996 1997.1-10

Capital Inflows (A) Capital Outflows (B) Net Capital Inflows(A-B) Current Account Source: Bank of Korea

51.5 101.0 97.1 83.0 201.9 14.2 32.2 28.4 48.6 85.8 37.3 68.8 68.7 34.4 116.1 -21.8 -87.3 -45.3 3.8 -45.3

309.6 135.4 174.2 -89.5

387.3 155.1 232.2 -273.2

235.2 92.2 143.0 -132.0

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Table 3.

Long-term (A) (A/C: %) Financial Institutions Domestic Firms Public Short-term (B) (B/C: %) Financial Institutions Domestic Firms Total Liabilities (C = A + B) DebffGDP (%) Short-Term Liabilities Usable FX Reserves (%)

Korea's Foreign Liabilities and Assets (US$ billion) 1992

1993

1994

1995

1996

1997

26.0 (41.2) 13.9 6.5 5.6 37.0 (58.8) 29.8 7.2 63.0 20.4 216

26.7 (39.9) 15.0 7.8 3.8 40.3 (60.1) 32.5 7.8 67.0 20.2 199

30.3 (34.2) 17.7 9.0 3.6 58.4 (65.8) 47.4 11.0 88.7 23.3 228

41.0 (34.3) 27.5 10.5 3.0 78.7 (65.7) 63.1 15.7 119.7 26.3 268

57.5 (36.5) 41.5 13.6 2.4 100.0 (63.5) 78.0 22.0 157.5 32.5 340

86.0 (55.7) 50.3 17.6 18.1 68.4 (44.3) 43.8 24.6 154.4 34.9 769

Source: The Bank of Korea, Foreign Currency Statistics Yearbook, 1998

ratio of short-term liabilities to usable reserves was 216% in 1992, and the figure climbed to 340% in 1996 and 769% in December 1997. The increase of short-term capital was brought about by several factors: the rapid growth in imports and export-related credits; the lower cost of short-term borrowing compared to long-term borrowing; and lifting the ban on short-term foreign borrowing but not easing bans on medium and long-term borrowing in 1994. In particular, regulations on medium and long-term borrowing, intended to control total domestic liquidity, inevitably forced financial institutions to raise short-term credit to finance domestic foreign-currency denominated lending. Domestic banks borrowed heavily from foreign banks and lent mostly to domestic investors. Since banks can usually roll-over foreign liabilities, in normal times the high ratio of short-term debt may not be a concern, yet when combined with a rapid currency depreciation, such an imbalance may lead to severe financial vulnerability. In such a situation, a panic could cause serious liquidity problems. To make the situation worse, financial institutions, especially merchant banking corporations, were investing recklessly in foreign securities, offshore funds, and derivatives, without any international experience. As a result, these institutions have lost heavily in Malaysia, Ireland, and France in recent years. Eighty-nine offshore funds were leveraged by two to five times their capital

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base. Altogether, disguised as foreign institutional investors, these domestic financial institutions invested heavily in Korean stocks and high-risk securities throughout Southeast Asia. By the end of October 1997, merchant banking corporations had borrowed US$ 20 billion in short-term capital, 5% of which was sunk into non-performing assets. The Korean government, unfortunately, had never supervised these financial institutions' behavior properly in spite of liberalization.

2.3. Over-Investment and Deterioration of Balance Sheets of Corporations From early 1997, large conglomerates in Korea began to go bankrupt, largely due to high debt-equity ratios and low profitability, a necessary result of overinvestment. Among other reasons, political intervention gave firms easy access to the financial market, and encouraged over-investment regardless of low profitability. Large conglomerates thus had an advantageous position in a secured loan market. The low profitability problem was concentrated, especially, in the manufacturing sector of traded goods. To some extent, excessive borrowing from domestic banks and financial intermediaries in international capital markets facilitated and fueled the over-investment. When, in 1997, large losses and outright defaults emerging in the corporate sector signaled a profitability problem, the firms, banks, and investors that had relied heavily on external borrowing were left with a large amount of short-term foreign debt that could not be easily repaid. The currency crisis that ensued exacerbated the problem, since the currency depreciation dramatically increased the real burden of dollar denominated debt and led to further financial woes. Several indicators show over-investment and highly risky investment by Korean corporations. First, efficiency of investment as measured by the incremental capital output ratio was decreasing. Second, the number of nonperforming loans before the crisis was above 15% of the total. Third, by mid- 1997, eight of the thirty large conglomerates were either de facto or de jure bankrupt. Fourth, in 1996, 20 of the largest 30 conglomerates showed a rate of return on invested capital below the cost of capital. Fifth, the debt-equity ratio for Korea's top 30 conglomerates averaged over 900% at the end of 1996. 2.4. Moral Hazard of Governmental Implicit Guarantees As is widely known, commercial and merchant banks in Korea have long operated under an implicit governmental guarantee, though it is not legally codified. Few believed that the government would allow these institutions to go bankrupt. The implicit government guarantee encouraged domestic financial institutions to borrow larger amounts of funds abroad and invest in riskier

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projects than they otherwise would, believing that the government would bail them out if they incurred serious losses. As the process of financial market liberalization proceeded in the 1990s, the severe deficiency of domestic financial markets increased the risk of financial crises in Korea. By international standards, many financial sector features were inadequate, including the transparency of public and private financial institutions, bank capital requirements, banking supervision, and bankruptcy procedures. The presence of financial insurance without proper prudential supervision created a clear moral hazard problem, reducing the incentive to carry out a proper risk assessment of potential projects. The economy as a whole ended up investing too much, and taking on excessive risk. Even before the onset of the currency crisis, the financial system was in dire straits because of excessive lending to large trading-sector conglomerates, many of that went bankrupt even before the currency crisis hit the economy in late 1997. It should be noted that often private banks in Korea were effectively controlled by a chaebol, and thus often gave such conglomerates privileged access to credit, exacerbating the moral hazard problem. This moral hazard problem appears to have affected the behavior of foreign financial institutions lending to Korean banks as well as other financial institutions and corporations. Since foreign banks were aware of the government guarantee, they did not feel the need to conduct careful credit analyses of Korean financial institutions and finns to which they were lending vast sums of money. When the crisis began to surface, however, foreign banks and investors abruptly withdrew their investments, making no serious efforts to reschedule their loans to troubled Korean banks.

3. Triggering Events 3.1. Asian Crises and the Contagion Effect There are several channels of contagion: the stock market: the foreign exchange market; other trade spillovers; and investment and real links that transmit the real shocks of one country to the asset values (stocks, exchange rate) of other countries. Late on October 23, 1997, the Hong Kong stock market crashed and sparked the exodus of foreign capital out of Asia, including Korea. The stock market crash was also transmitted to Korea via the foreign exchange market. In Asia, as the currencies of countries competing in the same world markets came under attack and depreciated sharply, the fundamental value of other currencies that

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had not yet depreciated started to deteriorate. These competitive devaluations explain part of the contagion and are called 'beggar-thy-neighbor' policies. By the end of October 1997 in Korea, the effective real appreciation of the won caused by the collapse of several other currencies was quite large. The Korean won had depreciated by only 14%, relative to December 1996, implying that the won had appreciated in nominal terms by 37, 36, 20 and 15% relative to the currencies of Thailand, Indonesia, Malaysia and the Philippines respectively. Since Singapore and Taiwan competed directly with Korea in a wide range of export products, the fact that they had allowed their currencies to depreciate put Korea at a more serious competitive loss. By November, the Korean won was falling rapidly (by 25% during the month and 39% over the year). The financial turmoil in the Hong Kong stock market in late October, in particular, created a sharp depreciation of the Korean won, exacerbating Korea's credit crunch problem in the international capital market. This crunch in turn caused a currency crash and liquidity crisis in an economy with unhedged and short-term foreign liabilities. Since the Korean economy was the largest economy in Asia besides Japan, the fall of the won implied a real depreciation that negatively affected the competitive position of the other countries in Asia. Thus the fall of the won resulted in further competitive devaluation throughout East Asia. 3.2. A Series of Corporate Bankruptcies and Financial Distress of the Financial Institutions In 1997, the crisis was triggered by a series of bankruptcies of large conglomerates, or chaebols, that had borrowed heavily to finance their investment projects. Eight of the thirty conglomerates failed, sending shocks throughout the real and financial markets. These bankruptcies were mainly a result of overly aggressive diversification, excessive investment in certain industries such as steel, autos, and retail, and the decline in corporate profits brought about by the prolonged economic downturn. The recent and rapid deterioration in the terms of trade especially hurt corporate profits, since many Korean export firms imported raw materials. Table 4 shows the major bankruptcies in 1997. The series of bankruptcies started in December 1996 when 'Hanbo' was unable to meet the payments of the principal and interest on its loans, and was placed under court receivership. Then, in March, 'Sammi Steel' also sought court receivership, followed by the 'Jinro' Group in April, the 'Daenong' group in May, the 'Kia' group in July, the New Core Group in November, and so on. Among these, the bankruptcy of 'Kia' in July was the most injurious shock to the Korean

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Date Jan. 23 Mar.19 Apr. 21 May 19 July 17 Nov. 1 Nov. 4 Dec. 8

Table 4.

Eight Bankruptcies of Conglomerates in 1997 (in billion won)

Group

Major Business

Hanbo Steel Sammi Steel Jinro Retail Daenong Retail&Textile Kia Autos Haitai Food &Electronics NewCore Retail Halla Heavy Industry Total

Rank Debt/Equity Loansby Ratio (%) Banks 14 26 19 34 8 24 25 12

3,245 8,598 523 658 1,224 2,067

4,627 811 1,340 699 4,440 1,310 938 3,036 17,201

Loansby Non-banks 968 36 895 603 5,035 1,971 377 3,440 13,325

Note: (1) The national ranking figures indicate firm size in terms of assets in 1997. (2) Debt-EquityRatio as of the end of 1996 Source: Press release of Financial SupervisoryCommission(FSC)

economy. By the end of the 1997, 72 corporations listed on the Korean Stock Exchange had failed. After this, more high-profile bankruptcies followed. After this string of bankruptcies, the non-performing loans of financial institutions amounted to 28.5 trillion won as of September 1997, which was equivalent to 6.3% of all outstanding loans. Merchant banks held an additional 3.9 trillion won of bad loans as of October 1997, equivalent to 2.9% of all outstanding loans. These corporate bankruptcies which occurred in 1997 saddled the nation's commercial banks with an extremely heavy burden of non-performing loans, or a ratio of 14.9% of non-performing loans to total loans by December 1997, compared with 3.9% in December 1996. By the end of 1997, commercial banks held 82.5% of all non-performing loans among banks, and about 78% among financial institutions. With these unfavorable ratios, banks were highly vulnerable to financial crisis. At the end of 1997, only 12 of 26 commercial banks satisfied the required 8% capital adequacy ratio.

3.3. Korean Government's Policy Mismanagement Just before the onset of the currency crisis, Korean policymakers made a series of erratic judgements and policy errors. First, policymakers judged that Korea's strong economic fundamentals would sustain the economy and safeguard it from the Southeast Asian currency crisis. Therefore, they did not take any

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strong measures to deal with the extemal financial situation. This arrogance and secrecy on the part of the government was pivotal in allowing the economy to slide into crisis. Second, on August 25, 1997, the government issued a statement that the Korean government would ensure the payment of foreign debts by Korean financial institutions. And on October 23, 1997, the Korean government decided to save the Kia group from bankruptcy with a Korea Development Bank contribution. These guarantee announcements increased moral hazard problems and made the bankruptcies of private financial institutions a national concern. Third, confidence was eroded further when it became apparent that monetary authorities had lied about foreign exchange reserve levels. The government insisted that the Bank of Korea held about US$ 30 billion in reserves in November. However, simple calculations revealed that this claim could not be true, and only about US$15 billion remained. Thus foreign investors deduced that the Korean government could not effectively manage currency problems. The fourth critical mistake was inherent in the government guarantee. As noted above, the underlying source of moral hazard was the implicit government guarantee on external borrowing by financial institutions and corporations. However, this guarantee was not legally authorized, only traditional and implicit. The ratio of short-term foreign liabilities to total domestic loans was 13.3% at the end of December 1996. Foreign creditors assumed that these loans had governmental protection, even though this guarantee was only implicit. The failure of the Financial Reform Act, diminished usable reserves and rising non-performing loans made the implicit guarantee no longer credible. When the crisis erupted, abrupt speculative outflows occurred, exacerbating the currency crisis. The fifth and the most serious policy mistake by the Korean government was poor management of foreign reserves. Already in July 1997, foreign capital inflows began to diminish due to the South East Asian crisis. From August, central bank reserves began to fall rapidly as private capital inflows virtually vanished. Under these circumstances, the optimal policy was to allow the Korean won to depreciate, reflecting market forces. Instead, the Bank of Korea continuously intervened in the foreign exchange market, rapidly depleting foreign reserves. Finally, although market fears were rising and Korea's external financial situation had become markedly worse in late October, it was not until November 21 that the government finally approached the IMF for assistance. This move clearly should have been made at least several weeks earlier, since

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Table 5.

1997.8 1997.9 1997.10 1997.11 1997.12

Movements of Foreign Stock Investments (US$ million) Inflow

Outflow

Net Flow

788.2 757.9 760.8 1,530.9 1,045.0

835.5 1,146.2 1,547.1 1,807.5 707.2

-47.3 -388.3 -786.3 -276.6 337.8

Source: Press release of Korea StockExchange(KSE) by then market sentiment had become overwhelmingly negative that aid could not be organized fast enough to avert a crisis.

3.4. Degradation of Sovereign Credit Rating and Herding Behavior Just after the Hong Kong stock market crash, on October 24, 1997, S&P downgraded Korea's short-term rating from A + to AA-, and long-term grade was changed to 'negative'. Because of this development, the exodus of foreign capital from Korea as well as Asia was certain. As we see in Table 5, at least US$1.1 billion was removed from the country in October and November alone, while US$ 76 million exited the stock market in October. Prices of bonds issued by the Korea Development Bank fell to that of junk bonds, and the spread was widened from 128bp to 269bp only 10 days later. Altogether, the roll-over rates of Korean banks' external debt with foreign debtor were merely 58.8% in November and 32.2% in December. Considering all the circumstances, the 1997 crisis does not seem to have been caused by failing economic fundamentals alone. Rather it seems to have been triggered by a combination of domestic and foreign factors such as a heavy chain of corporate bankruptcies, distress of financial institutions, policy mismanagement by the Korean government, the South East Asian crisis, degradation of Korea's sovereign credit rating and so on. On the other hand, an overridden corporate debt ratio, weak financial institutions, and the bureaucratic financial market were not recent phenomena, rather they were unfortunate by-products of a high growth economy and features well-known by both resident and non-resident investors for years. Yet these background problems made the Korean economy particularly susceptible to the crisis sweeping across East Asia. A series of policy mismanagement and downgrading of Korea's sovereign credit rating, combined with other destabilizing factors, made the eventual crisis inevitable.

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3. RESOLUTION OF KOREAN FINANCIAL CRISIS Although the Korean financial crisis was apparently caused mainly by foreign exchange liquidity problems, it is deeply rooted in the inefficient and distorted financial system. The government-led development strategy of the past 30 years has involved routine government intervention in financial sector, preventing the development of market disciplines. Selective credit allocations and prolonged interest control, which were used as primary tools of economic development in Korea, have resulted in an inefficient and distorted financial system. Strict segmentation with the financial industry and high entrance barriers have limited the initiative and innovation of financial institutions. Extensive government involvement in the internal management of financial institutions has undermined the autonomy and accountability of the management. On the other hand, a lack of effective supervisory system failed to prevent the excessive risk taking and moral hazard problems plaguing the industry. Over the years, the negative effects of government-led economy have accumulated to the point of explosion. In recognition of the structural problems, there have been intermittent attempts 8 to overhaul the outmoded financial system toward a market-oriented one. However, those government-initiated reform efforts were often faced with political barriers and the scope was too limited to eradicate the distortions deeply rooted in the financial sector. According to the Letters of Intent submitted to the IMF, the Korean government's strategy for overcoming the financial crisis can be classified into two parts: first, aggressive measures to facilitate the ease of imminent liquidity problem as well as financial market liberalization for relatively long-term purpose. Second, measures for an extensive restructuring of the financial and corporate sectors toward a market-oriented system, including reforms of the financial regulatory structure and the labor market. These issues are not new, but have been discussed for a long time before the crisis with little implementations. The only true remedy for the crisis is to establish a new economic order ruled by market principles. This new order, in turn, will necessarily require painful structural reforms across the board. Due to the IMF program and the government's aggressive efforts to facilitate external financing, the initial foreign exchange problems have been ameliorated to some extent. However, the Korean economy suffers from the most painful economic contraction since the Korean War. Nearly 3,000 firms have filed for bankruptcy every month during the first half of 1998, which led to a mounting non-performing loans and a rapid erosion of the capital base of banking sector. The capital base erosion and a highly uncertain real sector situation has led to

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a credit crunch in the financial market, which again aggravating the real sector and the financial sector. Without prompt resolution of insolvent financial institutions, credit crunch can not be ameliorated. Further delays in financial sector restructuring would undermine the soundness of the whole financial system and the core economic base of the nation could be seriously damaged. Although the Korean government has just finished the first round of financial sector restructuring to ultimately break off the vicious cycle, the on-going restructuring needs to be further accelerated. In this section, the process of resolving the imminent foreign exchange liquidity problems and the recent financial sector reform efforts in Korea are reviewed, including the description of the government policy directions and progress up to date.

1. Resolving Foreign Exchange Liquidity Problem 1.1. Facilitating the External Financing At the onset of the currency crisis in November 1997, the most urgent national task to resolve was the foreign exchange liquidity problem to stabilize the market. The primary goal of the government therefore has been how to stop capital outflows and to facilitate external financing. The major factors easing the liquidity problems include: (1) The bailout fund from the international organizations has greatly eased Korea's short-term liquidity problems at the early stage of the crisis. As of the end of August 1998, a combined total financial assistance from the IMF, IBRD and ADB has reached around US$ 26 billion9 out of a total package of US$ 58.4 billion. (2) The short-term debt problems of Korean financial institutions were eased by the conversion of US$ 21.8 billion short-term external debt into longerterm government-guaranteed loans in April 1998.1° The Korean government was able to get access to the international financial market by issuing inaugural global bonds 11 totaling US$ 3.9 billion. Reflecting an overall improved investors' confidence in Korea, the roUover rate of maturing external debt rose from 32.2% in December 1997 to 92.7% in May 1998, followed by 100.2% and 86% in June and August respectively. (3) The current account surplus after the crisis has substantially improved although it is mainly due to a drastic decline in the import demand. Over the period of January to August, 1998, the current account surplus reached a historical record of around US$ 27.5 billion, 12 drastic change from a deficit of US$ 23 billion in 1996 and a deficit of US$ 8.6 billion in 1997. The foreigner's net security investment of around US$ 3.2 billion over the same period was another important factor.

Korean Financial Crisis and Reform Table 6.

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Official Foreign Exchange Reserves (in US$ billion)

1998 Dec. Dec. 1996 1997 Jan. Feb. Mar. Apr. May June July Aug. Sept Foreign Reserves(~ 33.2 20.4 23.5 26.7 29.8 35.5 Overseas Deposits ® 3.8 11.3 10.9 8.0 5.4 4.6 Others ® --0.2 0.2 0.2 0.2 Usable Reserves 29.4 8.9 12.4 18.5 24.2 30.8 (®-®-®) Won/US$ 839 1,484 1,706 1,623 1,505 1,391

38.8 40.9 43.0 45.1 46.9 4.2 3.7 3.6 3.5 3.4 0.2 0.2 0.2 0.2 0.2 34.4 37.0 39.2 41.4 43.4 1,394 1,397 1,227 1,351 1,391

Note: Reserves at the end of each month and Won/US$rate at the monthlyaverage Source: Press release, The Bank of Korea

The emergency fund from the international organizations, followed by gradual improvement in investor's confidence and a record level of current account surplus, has successfully halted the capital outflows and substantially increased the usable foreign exchange reserves as shown in Table 6. The usable foreign exchange reserve has increased from a record low level of US$ 8.9 billion in December 1997 to US$ 43.4 billion in September 1998 and the foreign exchange rate has stabilized around 1,350 to 1,400 won per dollar in spite of the recent turbulent international market situations. Improvement of external financing environment and stabilized foreign exchange market have enabled the government to turn to the economic restructuring issues in Korea.

1.2. Capital Market Liberalization Since foreign capital inflows are of crucial importance to the Korean economy, the previous schedule for capital market opening has been drastically accelerated. The newly introduced market-opening measures toward liberalizing capital flows include the adoption of the fully floating exchange rate system well in advance than scheduled,13 and a complete removal of restrictions on foreign ownership of listed stocks and bonds with minor exceptions 14 The short-term money market instruments of CPs, RPs and trade bills were also opened to foreigners with no restrictions. Facilitating foreign exchange transactions, a new law was legislated and will be put into effect in two stages starting on April 1, 1999. One of the most significant changes is the adoption of the negative list system, which will

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completely deregulate the foreign exchange market and capital flows. In addition, to promote the foreign direct investment, the government has fully liberalized foreign hostile M&A of domestic firms in May 1998, and allowed both foreign residents and non-residents to purchase land in Korea without any restriction through the amendment of 'Foreigner's Land Acquisition and Management Act' in April 1998. New FDI Promotion Act opened 9 additional industries for FDI in May. As a whole, Korea becomes literally a free open economy. The market-opening deregulation measures undertaken so far are quite drastic in their scope and scale. However, thus far, sufficient inflows of foreign capital have yet to materialize in Korea. The amount of foreign direct investment recorded only US$ 4.1 billion ~5 and the financial investment US$ 3.16 billion over the first 8-month period of 1998. Given the level of the current capital market liberalization, it could have been larger and is expected to grow as the uncertainty arising from the on-going economic restructuring process decreases.

2. Reshaping the Institutional Framework Financial sector restructuring is crucial for economic recovery, and thus has been at the center of reform efforts. Swift and prudent reform has necessitated the establishment of an institutional framework to coordinate and monitor the reform process. To this end, major financial reform bills were legislated to provide a legal basis for required institutional reforms. On December 29, 1997, the National Assembly passed a package of the long-awaited 13 financial reform bills designed to facilitate financial restructuring, improve prudential regulation, and accelerate capital market liberalization. The package contained bills to correct the built-in inefficiency of financial market by enhancing the independence of the central bank, establishing a neutral consolidated Financial Supervisory Commission (FSC), and liberalizing foreign ownership of Korean securities. Enhanced independence of the central bank for monetary policy and establishment of the FSC for a neutral supervision implies a shift from a MOFE-monopolized financial policy making structure to a decentralized one with a check and balance system working. The passage of the package signaled the end of government-controlled financial resource allocation and has provided the legal basis for financial reforms.

The Central Banking. According to the new Bank of Korea Act, the independence of the central bank has been substantially enhanced. The Governor of the Bank of Korea (BOK), previously appointed by the Ministry of Finance and Economy (MOFE), is now appointed by the President on the

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deliberation of the State Council. The Governor of BOK, instead of the Minister of MOFE, now chairs the Monetary Board that is the supreme policy making body of the BOK. In addition, the previous dual objectives of the central bank, maintaining the stability of currency value and the soundness of the banking and credit system, are replaced by maintaining price stability. Escaping from the direct influence of the MOFE, the Monetary Board is expected to carry out more advanced central banking for the unified goal of price stability. Instead, its responsibility for supervising banking industry is transferred to the newly established FSC. A Consolidated Supervisory Body: The FSC. Inefficiency and ill-use 16 of financial supervisory system of Korea has been a target of criticism since the early 1980s. Ending the controversy over the right structure, the Financial Supervisory Commission (FSC) has been newly established in April 1998 under the Office of the Prime Minister to function as a neutral and independent agency. It replaced the MOFE which had previously the de facto supervisory power through four legally independent agencies. For efficient financial supervision with a well-defined goal, the four existing supervisory bodies ~7will be merged into a new Financial Supervisory Board by the end of 1998, and the Board will be directly superintended by the FSC. In addition, the FSC established a sub-committee, the Securities & Futures Commission (SFC), which is responsible for orderly functioning financial market. The FSC currently plays a key role in restructuring the financial and corporate sectors, which will be described in the next section. Under the new structure, the Bank of Korea no longer has its supervisory power over the banking sector although it has a limited bank inspection power. The rationale for consolidating supervisory powers was basically two: (1) separating the supervisory power from the MOFE is a necessary condition for neutral and independent supervisory function (established under the Prime Minister's Office), and (2) a reality that distinguishing financial institutions is increasingly meaningless due to accelerating financial deregulation will necessitate a consolidated supervisory body for effective supervision. Although its effectiveness needs to be tested, it is a reality in Korea. This means the end of a de facto concentration of power to the MOFE. A potential check and balance among MOFE, FSC, and BOK is expected to help the industry be more competitive and viable. A Consolidated Deposit Insurance: The KDIC. Another important change is strengthening the deposit insurance function. The Korea Deposit Insurance Corporation (KDIC), the consolidated deposit insurance body, is established under the MOFE according to the financial reform bill in December 1997. The

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KDIC, which was originally set up for commercial banks in 1996, was expanded to serve all the financial institutions by absorbing the other five existing separate insurance funds. 18They do not have a supervisory power over the institutions although it has a limited joint inspection power with the FSB. Due to its short history, the KDIC does not have enough reserve and issues its own bonds to finance the need, which was authorized by the Assembly. The amount of authorized bond is currently 31.5 trillion won, which is being used for capital injection and deposit loss coverage of ailing financial institutions. In November 1997, the MOFE announced, to prevent a collapse of banking system in the middle of currency crisis, that he government would guarantee the principal and interest of all deposits fully until the end of year 2000. After the announcement, a serious moral hazard problem has emerged such that the government scaled down the protection level to 20 million won for the deposits made after August 1, 1998. This change is a right step toward a market-driven restructuring of the financial system.

The Korea Asset Management Corporation (KAMCO). The KAMCO was first established in 1962 to manage bad loans of the state-run Korea Development Bank. On November 24, 1997, KAMCO has completed a major reorganization to carry out the main objectives of acquisitions and dispositions of the nonperforming Loans in a more efficient manner, under the control of the MOFE. For this purpose, KAMCO, as a Bad Bank, is adopting the divisional structure based on the organizational structure of the Resolution Trust Corp. When KAMC was reorganized, the size of NPLs was 38 trillion won and the size of the Non-Performing Asset Management Fund was 10 trillion won, that increased to 32.5 trillion won now. The bailout fund is used to buy nonperforming loans of financial institutions and the assets of ailing business firms. The KMACO resources are financed by issuing its own bonds of 32.5 trillion won and by disposing purchased assets through direct sale or asset-backed securities. The KAMCO bailout funds, ~9 along with the KDIC, constitute the fiscal support needed to facilitate the financial sector restructuring process. Improvement in Standards in Prudential Regulation and Supervision. Along with institutional framework changes, a new system of prudential regulation and supervision has been established. In accordance with the 5th agreement with IMF last May, FSC announced a plan to strengthen the regulatory standard so as to conform to an internationally acceptable level. Some of the measures undertaken include marking-to market for securities (June 1998), more bank information to be disclosed to meet the international accounting standard (April 1998) and more conservative loan classification and loan provisions (July 1998). Under the new loan classification scheme, effective July 1, the

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Precautionary classification is applied to loans whose interest payments are 1 month to 3 months in arrears, while the old standard was 3-6 months in arrears. The Substandard includes loans with longer than 3 months of interest payments in arrears instead of the old standard of 6 months. And Loan loss provision for precautionary loans is increased from 1% to 2. In addition, to improve BIS capital ratio calculation, of all provisions except those with respect to assets classified as normal and precautionary will be deducted from Tier 2 Capital to be implemented in January 1999. Measures are also being taken for improving bank management's accountability. In the absence of well-functioning monitoring system, the existence of major shareholders is needed to discipline the management. 2° The government is working on the revision of the bank law within this year, including a reform in banks' ownership structure. To improve the accountability of bank managers, the law suggests a removal of the individual equity ownership ceiling of the current 4% for national banks and 15% for provincial banks starting in January 1999. Thus, so-called 'reverse discrimination' against localities that only foreigners may go over 4% is expected to disappear. At the same time, a recent rise in minority shareholder's activism21 will play a key role in enforcing bank management's accountability. 3. Restructuring the Financial Sector

Despite the seemingly successful currency crisis management, Korea's economy has yet to emerge from the current recession, and there are fears that the economy may slide further into a vicious circle of a vulnerable financial system ridden with accumulated bad loans, a credit crunch problem, and a realsector recession. Against this backdrop of ailing financial and corporate sectors, widespread moral hazard phenomenon and economic uncertainties, a quick-fix solution of liquidity injection and partial restructuring is insufficient. Recognizing the gravity of the problem we face, the government has been actively implementing comprehensive reforms in the corporate and financial sectors. This reform, begun in April 1998, reflects the government's serious commitment to bold reform. Since the main body of restructuring must be the Korean government, it will be necessary to review the government actions to understand the restructuring process. 3.1. Basic Framework of Financial Sector Restructuring The ultimate goal of financial restructuring lies in achieving a sound and stable financial system. The government, on April 14, 1998, announced the basic f r a m e w o r k o f 22 financial sector restructuring. Before this date, the Korean

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government didn't have a blueprint for financial restructuring. Occupied by currency crisis management, the government has taken quick-fix and partial measures against ailing institutions such as merchant banks or Korea First Bank and Seoul Bank. It was too busy to design a consistent and extensive restructuring plan conforming to the ultimate goal. In April, a complete plan was suggested for the first time. The basic principles, announced by the government, to facilitate the financial sector restructuring can be summarized as follows: • • • •

Stabilize financial markets through swift and extensive reform. Provide timely and sufficient fiscal support. Set transparent principles for accountability among parties concerned. Confirm internationally accepted standard.

The first and second principles aim at normalizing the financial system as soon as possible through swift and extensive reform with extensive fiscal support. It is based on other countries' experiences that delayed actions increase the costs of restructuring and decrease the success probability. Specifically, non-viable financial institutions must be distinguished from viable ones. Once this is done, the government will act swiftly to bolster viable institutions through equity participation and the purchase of non-performing loans. To qualify for this assistance, banks are required to downsize their branch network and layoff employees such that fiscal support will be linked to their self-rehabilitation efforts to minimize the taxpayers' burden and eliminate the moral hazard problem. Equally swift action will be applied to those institutions judged as 'non-viable'. The government is creating a firm exit strategy to close these institutions, thereby stabilizing the financial market and protecting depositors and creditors from potential defaults. The third one indicates transparent burden sharing rules in the resolution process of insolvent institutions. The fourth asserts that the structural reforms will be made in accordance with market principles and international standards and practices. Under those principles, the government decided that the financial sector restructuring would be pursued in two phases. • In Phase 1, normalization of the banking sector has been given a top priority before non-bank financial institutions. • In Phase 2, the reform measures for non-bank financial institutions will be carried out in line with the financial market situations. Reflecting the priority, the FSC announced the time schedule of financial sector restructuring on April 14 and a revised one on June 19, 1998. According to the schedule, the first round of financial restructuring is scheduled to be completed

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for c o m m e r c i a l banks by the end o f A u g u s t 1998 and for m o s t n o n - b a n k institutions b y the e n d o f S e p t e m b e r 1998, w h e r e a s restructuring o f financial institutions that w e r e not i n c l u d e d in the first r o u n d will be dealt after October, 1998.

3.2. The First-round Financial Sector Restructuring A s o f S e p t e m b e r 30, 1998, the g o v e r n m e n t finished the first r o u n d restructuring f o c u s e d on banks and i n s u r a n c e c o m p a n i e s as planned. T h e p r o g r e s s up to date is first s u m m a r i z e d in Table 7. M o s t o f the financial institutions w e n t t h r o u g h r e v i e w process a c c o r d i n g to the s c h e d u l e and are subject to c o r r e c t i v e actions taken by the g o v e r n m e n t . T h e detailed procedures, c o m m o n to all, are d e s c r i b e d in the next section for c o m m e r c i a l banks. E v e n t h o u g h all the institutions shared the s a m e appraisal process, the actions for a c o n d i t i o n a l l y a p p r o v e d institution w e r e different d e p e n d i n g on

Table 7.

S u m m a r y o f the F i r s t - r o u n d R e s t r u c t u r i n g (as o f S e p t e m b e r 30, 1998)

Institutions

Major Actions

Banks (26)

• Equity write-offs of 2 banks put into sale • Announce 12 undercapitalized Banks -P&A of 5 disapproved banks ~Conditional approval of 7 banks • Three pair-mergers announced (6 banks) • Revoke license of 16 banks under resolution • 14 under rehabilitation plan 1 merger with a bank • 2 licenses revoked • 4 operation suspended • 2 conditional approval • close 4 life insurance companies • 16 under management improvement measures • 2 surety ins. to be merged • 1 license revoked • l suspended operation • 10 liquidated or acquired • 15 under rehabilitation plans • 1 suspended • 20 under management control • 11 under management guidance • 12 to be liquidated • 27 under management guidance

Merchant Banks (30) Securities Companies (34)

Insurance Companies (50)

Investment Trust (8) Leasing Companies (25) Mutual Savings & Finance Co. (230)

Credit Unions (1,653)

The number within parentheses is the total number of institutions

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whether it is a bank or a non-bank. For banks, fiscal support were selectively provided only when rehabilitation plans were approved by FSC and implemented. And voluntary merger between banks and the inducement of foreign investment were encouraged through support measures such as the KAMCO's purchase of NPLs or through recapitalization provided by KDIC for the purposes of covering the deterioration of BIS ratio upon acquisition of a troubled bank. For non-banks, as they have majority shareholders, self-driven rehabilitation through recapitalization was encouraged under the responsibility of major shareholders. In the first round, targeted non-banks were merchant banks, securities companies and insurance companies. However, when a recovery was deemed unrealistic, those institutions were closed and their business was transferred to other institutions with fiscal support covering the difference between assets and liabilities. No immediate industry-wide actions against institutions like investment trusts, leasing, mutual savings and credit unions are scheduled yet although individual rehabilitation efforts or mergers are encouraged. 3.2.1. Commercial Banks The general restructuring strategy described in the previous section was strictly applied to 26 commercial banks, 16 nationwide banks and 10 provincial banks. The detailed procedure is worth reviewing to understand how the restructuring process has been. (1) The government recapitalized two banks, Korea First and Seoul, which proved insolvent last year before the blueprint was ready last April. The government and the KDIC invested 1.5 trillion won in each bank on January 30, 1998 after reducing their paid-in capital from 820 billion won to 100 billion won each. The two banks will be sold in an open auction at the earliest possible date. (2) For the rest of banks, the Financial Supervisory Commission (FSC) examined the capital adequacy as of December 1997. Twelve banks that fell short of BIS capital adequacy ratio of 8% were required, on February 5, 1998, to submit self-rehabilitation plans until April 30, 1998. For the other 12 banks that satisfy the BIS ratio, upon completion of due diligence reviews by the end of August, troubled banks are subject to forceful corrective actions. (3) Accounting firms conducted due diligence review of the banks during May 1-June 8, 1998, in accordance to the internationally accepted criteria 23 agreed upon with the IBRD. The review results turned out to be much

Korean Financial Crisis and Reform Table 8,

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Due Diligence Results o f 12 Undercapitalized Banks (Billion Won %) Assessment Results (As of March 1998)

Banks

Adjusted Assets

BIS Ratio

ChoHeung Commercial Hanil KoreaExchange ChungCheong KyungKi DongWha DongNam DaeDong Peace KangWon ChungBuk Total

44,280 1.49 6,926 19.2 38,004 1.81 7 , 2 4 9 24.3 43,508 4.53 6 , 7 7 2 20.2 47,174 2.13 10,792 28.6 3,770 -5.97 1,619 36.3 7,239 -9.61 2 , 8 6 2 49.0 9,556 -3.72 2 , 2 5 4 28.5 7,115 -5.81 1,118 20.9 5,563 -6.75 1,735 34.1 6,517 -1.57 602 12.9 2,969 -16.0 1,034 45.8 2,487 -5.52 801 28.5 218,182 43,764

NPL

NPL Ratio

Rating C C C C D D D D D C C-~9 C

As of Dec. 1997

Asset

NPL

55,600 2,623 48,552 1,451 53,853 1,324 62,319 2,518 4,829 425 8,894 590 12,968 602 10,055 293 7,715 487 8,359 228 3,869 443 3,139 249 280,152 11,233

NPL Ratio 7.0 4.8 3.6 5.7 12.5 9.7 7.9 5.7 9.6 4.5 18.3 11.3

Note: 1. Assessment is based on new criteria applied to numbers as of March 1998, while the number as of Dec. 1997 on the old BSB criteria 2. NPL: Precautionary and lower 3. Ratings (C: Conditionally Approved, D: Disapproved) assigned by FSC Source: Press Release of FSC (July 1, 1998) & Bank Statistics (1998)

worse than expected as shown in Table 8. Comparing the self-reported N P L ratios as o f D e c e m b e r 1997 with the ratios from due diligence review, utilizing the numbers as o f March 1998, indicates how distant the officially announced bank data is from the reality. Even after considering the fact that a stricter standard in evaluating loans and other assets was applied and 3-month time difference between the measurements existed, it shows how seriously distorted the bank data have been so far. (4) The 12-member Bank Appraisal Committee evaluated the plans during June 20-27, 1998, and submitted the suggestions 24 to the F S C on June 28th. The reviewed items were capital adequacy, recapitalization plan, asset quality classification, reduction plan for risky assets, cost reduction scheme, management improvement plan etc. (5) With the input from the Bank Appraisal Committee, the F S C evaluated the prospects for viability and arrived at either an ' a p p r o v a l ' , 'conditional approval 'or 'disapproval' classification 25 for each bank on June 29, 1998.

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DAESIK KIM & JAEHA PARK The FSC's final decision was: (1) None of the 12 banks received 'Approval', (2) 7 banks received 'Conditional Approval', and 5 banks received 'Disapproval'.

The 7 conditionally approved banks were ordered to submit revised implementation plans containing forceful management reform and recapitalization plan through outside funds inducement or merger by the end of July, and are being reviewed on a quarterly basis. In the event of disapproval of the implementation plans, a mandatory merger or transfer of business order is to be imposed. So far, while two of these banks, Commercial Bank and Hanil Bank, decided to merge with each other, others are under self-rehabilitation process. The 5 disapproved banks are ordered to be liquidated and to have their good assets and liabilities transferred to relatively stronger banks under a P&A arrangement. 26This P&A order was a historical event in Korea since a bank had never been closed before, and gave a clear signal that unconditional protection of financial institutions was no longer valid. However, a few conditionally approved banks were too big to fail. While the Korea First Bank and the Seoul Bank were allowed to continue their operations, the 5 closed banks' assets constituted only 7.3% of the 12 undercapitalized banks Three bank mergers were announced so far, which was encouraged by the FSC's promise of purchasing NPLs or supporting recapitalization. They include a Commercial Bank of Koera and Hanil Bank merger, which were conditionally approved, a Hana and Boram bank merger, and a Kookmin and Korea Long-term Credit bank merger. Given the incentives, more merger attempts are expected. 3.2.2. Non-Bank Financial Institutions Merchant Banks. The increasing bankruptcies of business firms and foreign currency crisis led to the suspension of operations of 9 merchant banks on December 2, 1997 and another 5 banks on December 10, 1997 until the end of January 1998. They were ordered to submit the rehabilitation plans until the end of 1997. After due diligence review 27 during December 19-27 and Appraisal Committee's review 28 for a month starting December 29,1997, the MOFE ordered 10 banks to transfer business to a newly set-up bridge bank on January 30, 1998. After several rounds of the similar process, for now, out of total 30 merchant banks, 16 troubled merchant banks 29 had their licenses revoked and are currently undergoing closure procedures. In the process, the funds to pay depositors are expected around 1.27 trillion won to be financed by

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the KDIC bond issuance. 3° The remaining 14 merchant banks are monitored to insure that they implement their rehabilitation plans and achieve a BIS ratio of 8% by June 1999. Insurance companies. Out of total 50 companies, 22 domestic insurance companies, which didn't meet the solvency margin ratio or had assets lower than liabilities as of March 1998, were singled out and ordered, on May 11, to submit the rehabilitation plans by June 20. A due diligence review was completed over June 20 to July 20, and revised plans were submitted on July 28. The Appraisal Committee reviewed the assessment reports during August 6-11. The FSC announced the final results on August 11. Four life insurance companies (Kukje, BYC, Taeyang, Korea) ordered to close on August 21, 1998 will have their assets and liabilities transferred to relatively stronger insurance companies after a due-diligence review in late October. Among these assets and liabilities, 4 billion won is required to purchase the non-performing assets, and 1.2 trillion won is needed to compensate for the gap between liabilities and assets. Sixteen insurance companies currently subject to management improvement measures are being monitored to insure compliance on quarterly basis. Two surety insurance companies (Daehan and Hankuk), 31 vital to small business financing, are scheduled to merge by November 1998. The purchase of non-performing assets at these companies, totaling 5 trillion won, requires KAMCO 1 trillion to purchase face value of 3 trillion won and was completed in late September. Securities companies. Out of total 34 securities companies, two securities companies (DongSuh, Korea) had their licenses revoked on May 22, 1998 after five extensions of suspension period. Four companies with operational net capital ratios of less than 100% were ordered to submit management improvement plans. After diagnostic reviews by evaluation committee during September 20-23, 1998, two (Dongbang Peregrine and KLB) were suspended in addition to already two suspended companies (HanNam, KDB in July). Other two (Sangyong, SK) was conditionally approved of their rehabilitation plans on September 25, 1998, and ordered to submit a revised rescue plan until October 24, 1998. Other Non-Banks. Ten of 25 leasing companies will be either liquidated or acquired, by decision of their major shareholders. Those not undergoing liquidation are having their assets and liabilities transferred to other institutions

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by means of a bridge leasing company. The remaining 15 leasing companies will be monitored to insure implementation of rehabilitation plans. Although a concrete restructuring plan is not yet set, for the six existing investment trust companies, the government is continually inducing management improvement and monitoring the implementation of rehabilitation plans. Sinseki Investment Trust had its license revoked, and Hannam Investment Trust, currently under suspension, will transfer its business to Kookmin Investment Trust by the end of September and undergo liquidation procedures. One Investment Trust Management Company (Dongbang-Peregrine) has dissolved of its own accord, and five companies are seeking dissolution. The restructuring process will begin as the capital market stabilizes. Out of 230 companies, the Non-Bank Supervisory Authority is imposing management control on 20 companies, and management guidance on 11 companies, with the goal of inducing rehabilitation. Companies deemed incapable of recovery will be closed either through a business transfer, sale or liquidation. One business transfer order was issued so far. A bridge company created on September 16, 1998 specifically for mutual savings and finance companies will manage the closure process. Twelve credit unions were determined to be liquidated, and 27 subject to management guidance measures. Troubled unions will be required to pursue individual efforts or undergo mergers to induce rehabilitation. The MSFC and CU industries were not given a priority during the first round financial restructuring. 4. F I N A N C I N G T H E F I N A N C I A L R E S T R U C T U R I N G Two critical questions in the process of economic restructuring are how to share the costs among the parties concerned, and how to mobilize the necessary resources. The government made it clear that the cost of economic restructuring must be met primarily by the financial institutions so as to minimize both the burden on taxpayers and the risk of moral hazard. The government's fiscal support will only be provided as a supplementary measure to these institutions' own restructuring and financing plans. The fiscal support is provided for the purchase of non-performing loans, recapitalization of viable institutions, and possible deposit payoffs in the event of closure only when the self-rescue plans of ailing institutions are successfully implemented. The needed resources are raised mainly by the bonds of the Korea Asset Management Corporation (KAMCO) and the Korea Deposit Insurance Corporation (KDIC), whose interest payments are absorbed by the budget.

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Table 9. Non-Performing Loans of all Financial Institutions (in trillion won, as of the end of March and June 1998)

Banks Non-Banks Total End of June %of total loan

Bad Loans ~

Precautionary Loans ~2~

NPLs

40 28 68 63.5 10.1%

46 4 50 72.5 11.6%

86 32 118 136 21.7%

Disposal Target

100

~t~Sum of Estimated Loss, Doubtful, and Substandard ~z~Collateralized loans with 3 to 6 month interest payments in arrears 4° Source: MOFE Press Release (May 20, 1998)

4.1. The Estimated Amount of Non-Performing Loans (NPLs) The main task in financial sector restructuring is the disposal of nonperforming loans. According to the government estimate 32 on May 20, the total of non-performing loans (NPLs) of all financial institutions was 118 trillion won as of the end of March 1998, as shown in Table 9. It consists of 86 billion won from banks and 32 billion won from non-banks and became the basis for the financial restructuring plan. This figure includes loans of 50 trillion won which are classified as 'precautionary'. The Korean government targeted 100 trillion won worth of NPLs for immediate disposal as of March 1998, including the core NPLs, bad loans, of 68 trillion won. The rest of 32 trillion won reflects the fact that a portion of the precautionary loans can become sour, on one hand, and the NPLs can be reduced due to business firms' rehabilitation efforts, on the other hand, as corporate restructuring continues. The government estimated that the total market value of these NPLs averages out at only 50% of their book value. Therefore, the realized loss borne by financial institutions will be approximately 50 trillion won, which will eventually result in the erosion of their capital base. The rest is filled with fiscal support. The targeted 100 trillion NPLs would be disposed through two channels. First, financial institutions will dispose on their own accord half of their respective total of NPLs by either selling off collateral or calling in loans. Second, KAMCO will purchase the remaining half from the financial institutions at an estimated market price of 50% of the book value. In accordance with the agreement with the IMF, any disposal of NPLs by KAMC

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is made only for those financial institutions whose rehabilitation plans are approved by the FSC. According to the subsequent estimate as of June 1998, the total NPLs have increased from 118 to 136 trillion won (21.8% of total loan), with bad loans from 68 to 63.5 trillion won (10.9% of total loan) and precautionary loans with from 50 to 72.5 trillion w o n . 33 The government asserts that the new numbers are within a reasonable range and that it is not necessary to change the restructuring plan set previously. Nonetheless, due to the tightened loan classification standards effective July 1, 1998, a substantial portion of precautionary loans will migrate to the 'substandard' category before the end of this year. Furthermore, the quality of some of the precautionary loans may deteriorate over the course of on-going corporate restructuring process. In light of this, the bad loans are expected to peak at 100 - 120 trillion won by the end of this year. On the other hand, the ongoing corporate workouts will significantly reduce the amount of precautionary loans. Moreover, the FSC's strict supervision will diminish the likelihood of new NPLs from developing.

4.2. Fiscal Support up to September 30,1998 The first round of its financial sector restructuring ended on September 30, 1998 aimed at revitalizing the troubled banks. As noted before, the government's basic principles of fiscal support are: (1) it will not financially support the financial institutions unless appropriate self-rehabilitation efforts and fair loss sharing among concerned parties 34 are undertaken, and (2) fiscal support should be sufficient enough to return solvency of the troubled financial institutions. Under these principles, the Korean government, 35 on May 20, has announced to spend a total of 64 trillion won to facilitate financial restructuring until June 1999. This total public fund is approximately 15.2% of 1997 GDP of 421 trillion w o n , 36 which is rather burdensome compared to other c o u n t r i e s 37 that have experienced similar financial crisis. Among this, 32.5 trillion won would be used to finance the purchase of non-performing loans while 31.5 trillion won for recapitalization and deposit payment of ailing institutions. Among the total 64 trillion won, 37.7 trillion won has been injected by the end of September 1998, of which, interestingly enough, 21 trillion won was spent in September only, particularly, on the last three days of September. Presumably, this is done to meet the tight schedule announced on April 14, which signals the government's strong will to meet the original schedule. As shown in Table 10, 39 trillion won worth of bad loans has been purchased from banks, merchant banks, and surety insurance companies with the

107

Korean Financial Crisis and Reform Table 10. Schedule o f Fiscal Support (In trillion won, as o f September 30, 1998) September 1998

NPLs~l)

Book Purchase Capital Injection Loss Coverage Total

Total up to Oct-Dec. Sept. 1998~5~

Nov.97Aug. 98

Bank

Insurance

1st half 1999~6~

16.0 8.612~ 1.5~3~ 6.614)

20.0 8.1 4.9 5.8

3.0 1.0 0 1.2

39.0 17.7 6.4 13.6

25-30 9.8 1.9

12-17 5 6.5

16.7

18.8

2.2

37.7

11.7

11.5

Total 76-86 32.5 28 "417~ (31.5) 60.9 (64.0)

m NPLs: substandard or lower loans ~2)Purchases from 30 commercial and specialized banks, 30 merchant banks and 2 surety insurance ~3)Capital Injection to Seoul and Korea First banks ~4)Deposit payment for suspended merchant banks, MSFC, and credit unions ~5~For the 2nd round restructuring of special banks, a few sound banks, merchant banks, security companies and trust companies ~6)Set aside for newly realized NPLs in the 1st half of 1999 ~7~Do not include the expected loss from sale of Seoul & Korea First Banks and from put-back option exercises on assumed loans of 5 acquiring banks: ( ) is available amount Source: MOFE press release (Sept. 20, 1998), 'Progress in Financial Restructuring and Future Tasks'

K M A C O bond o f 17.7 trillion won by the end o f September 1998, which amounts to approximately 45% o f the book value. A n d 25 to 30 trillion won worth o f NPLs will be purchased from specialized banks, sound banks, merchant banks, securities companies, mutual savings & finance companies with 10 trillion won, starting from October 1998 until the end o f 1998. Additional non-performing loans realized in the future will also be purchased by the K A M C O to make a cleaner banking system Support for recapitalization and loss compensation has been provided to banks acquiring ailing banks and merging banks. The K A M C O purchases the NPLs o f 5 acquired and acquiring banks, and capital was injected so as to prevent the deterioration o f acquiring banks' BIS ratio. New banks created by the merger o f a sound bank and troubled bank is given enough fresh capital to bring their BIS ratio up to standards o f sound banks. New banks resulting from a merger between two troubled banks were given a capital injection sufficient to bring their BIS ratio up to 10%, reflecting the potential bad loans before the

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end of 1998. The total support for recapitalization and loss coverage up to September 1988 amounts to 6.4 trillion won and 13.6 trillion won respectively, totaling 20 trillion won. The government uses the public bonds to finance the projected fiscal support. The Korea Asset Management Corporation (KAMCO) would issue the bonds of total 32.5 trillion won to purchase the NPLs of 50 trillion won or more. And the Korea Deposit Insurance Corporation (KDIC) would issue the bonds of total 31.5 trillion won for equity participation and for compensation of the differential between liabilities and assets to have a margin of 3.1 trillion above the expected 28.4 trillion won. All the issued public bonds are provided 'in kind' to the ailing institutions rather than sold in the market to minimize the possible crowing out effect. Considering that banks have enough liquidity now and the BIS risk weight of public bond is 0%, not much of bonds is expected to cash in. The government provides a guarantee on these bond issues and will bear interest costs. These interest costs are estimated to be 3.6 trillion won for 1998, and 8 to 9 trillion won for 1999. Most of the fiscal support is expected to be recouped over time by the sales of collateralized assets, the divestment of acquired equity shares of financial institutions, and by the liquidation of insolvent financial institutions. Thus, the burden on taxpayers will be minimized to the interest costs related to public bond issues, which will correspondingly decline over time. In addition, assetbacked securities 38 will be issued against collateral to render KAMCO greater flexibility in its financing for the disposal of NPLs. Reviewing the resources allocated in September 1998 in Table 11 may help better understand the fiscal support plan. As noted before, the fiscal support provided in September only amounted to 21 trillion won, resolving the problems of 23 banks and 2 surety insurance companies. 21 trillion won financed by KAMCO and KDIC bonds consists of the NPL purchase of 9.1 trillion won, the capital injection of 4.9 trillion won, and the loss coverage of 7 trillion won. According to the announced principle, the institutions eligible for NPL purchase are limited to those planning a merger or those whose rehabilitation plans have been approved by the Financial Supervisory Commission (FSC). They are to date the resolved and acquiring banks (5 each), 4 merged banks, 9 banks under self-rehabilitation plan, and 2 surety insurance companies under merge. And the eligible bad loans are those classified as 'Substandard Loans' with interest payments longer than 3 months in arrears. The bad loans are exchanged for the KAMCO bonds at an average price-to-book ratio of 24%. Banks with the BIS ratios exceeding 8% as of December 1997 are being under review completed August 31. Banks which deemed to be in danger will

Korean Financial Crisis and Reform Table 11.

109

Contents of Fiscal Support in September 1998 (in trillion won) Purchase of NPLs Total NPLm

Institutions 5 Resolved banks 5 Acquiring Banks 4 Merged Banks 9 Self-rescue Banks 23 Bank total 2 Surety Insurance Total (25) Financing

7.3 6.7 7.4 11.5 32.9 5.0 37.9

Size of Price of Capital Loss Purchase Purchase Injection Coverage

4.6 1.0 2.7 1.2 5.0 2.4 7.8 3.5 20.0 8.1 3.0 1.0 23.0 9.1 KAMC Bonds (9.1)

0 -1.3 5.8 3.6 0 0 0 4.9 5.8 0 1.2 4.9 7.0 KDIC Bonds(11.9)

BIS Ratio after Support -11-13% 10-13.3% ---

Total NPLs equal to substandard or lower on the new standard, as of June 1998 Source: MOFE press release (Sept. 29, 1998)

be subjected to a management appraisal during September. And at the end of this appraisal, targeted banks are required to comply with management improvement recommendations. There is no concrete actions taken against them yet. The next stage in the restructuring process will address non-performing loans at specialized banks and non-bank financial institutions. The government will commence purchasing these non-performing loans starting October 1998. Depending on the progress of financial restructuring, the government will complete implementation of the corporate work-out plan, an important element of the corporate restructuring plan, by the end of 1998.

4.3. Recapitalization by Financial Institutions In addition to the government's fiscal support, financial institutions are called on to recapitalize on their own accord by means of issuing equities and subordinated debt instruments, as well as by inducing foreign capital. In domestic market, despite extremely sluggish stock market conditions, 4 banks raised equity capital of more than 0.8 trillion won as of the end of June. Also, banks and securities companies raised 5.4 trillion won in capital by issuing subordinated debt instruments in the first quarter o f 1998. As for foreign capital inducement, capital inflows for joint ventures with domestic financial institutions increased during the first half of 1998. By the end of July,

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approximately US$1.75 billion was invested or committed by foreign investors in Korean financial institutions, including 0.67 billion to 5 banks and 1.08 billion to 8 non-bank institutions. Although the amount, so far, is minimal, it is expected to grow as the economic uncertainty decreases.

5. CONCLUDING REMARKS We have examined the causes of Korean financial crisis and described the financial sector restructuring process. As to the causes, we reviewed the fundamental weaknesses in Korean economy that might have resulted in loss of foreign investors' confidence in Korea. We agree with those asserting that the weaknesses could be necessary but not sufficient conditions for the Korean crisis. Without question, such flaws of Korea have been known for years to international markets. In transforming such factors to crisis, the contagious effects from other Asian countries and a series of policy missteps were critical. However, it doesn't mean that Korea has no need for correcting structural flaws. In fact, there is nothing new in the contents of the current restructuring efforts requested by the IME They have been discussed for years with little implementation in Korea, mainly due to selfish internal politics among various interest groups. Although the current situation is painful, it will be a good opportunity for Korea to build a sound economy without major resistance. From the financial crisis, we have learned how important an efficient and sound financial system is to maintain a healthy economy. Korean financial sector has had absolutely no ability of and no incentive for monitoring the real sector and preventing misallocation of resources, which made the economy vulnerable to external shocks. The most urgent task in Korea is to build a system for a competitive and resilient financial sector. And Korean crisis41 suggests that a small open economy should pay attention to possible contagious effects by adopting stricter policy measures than its fundamentals require. Such policy measures may include bank supervisory standards stricter than usual, defined rules to correct possible problems swiftly and maintenance of adequate level of foreign currency reserves. However, unless the current international financial order changes, a small economy, no matter how hard it tries, is being forced to pay more than due costs, by either experiencing crisis or putting too much resources to prevent it, to be a member of the global economy. Inventing measures to correct the inherent problem emerges as an urgent task of international society. As to the financial sector restructuring, we tried to describe the process. As of today, it must be too early to evaluate the reform process and predict the

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results with confidence. However, a few concerns remaining after the first round financial sector restructuring and future challenges can be presented. • The essence of the first round restructuring is the disposal of NPLs, where an accurate estimation of NPLs as well as securing fiscal support is crucial. The amount of NPLs could become much larger than the government's estimate, depending on both future economic conditions and the applied classification criteria. As the corporate restructuring gain momentum under mounting international market uncertainties, bad loans may be much more than expected. And the government's estimate is based on loan classification scheme such that an application of new rule, effective July 1, would make the NPLs much larger. In addition, even after the KMACO purchase, the nonperforming loan ratio still remains at 3.52%, based on the figures as of June 1998, which is higher than the goal of 1% set by the government. It seems necessary to secure more fiscal resources enough to restore the domestic and international market confidence in the government's willingness and ability to resolve ailing institutions' problems. • The government plan for recapitalization assumes a half of 39 trillion won to be raised by financial institutions through new stock issuance, foreign capital inducement and subordinated debt. Considering the sluggish domestic financial markets, only feasible alternative is foreign capital. If the foreign capital inflow is slower than expected, the restructuring process may take longer and the current credit crunch may continue. • Disposal of bad loans to meet the BIS ratio is not the fundamental solution to the financial crisis. The deep-rooted problem in Korea is a long history of government intervention in private sector. With the current fiscal support, the government became the largest shareholder of almost all the banks. In addition to disposal of bad loans, supplementary measures for autonomous and accountable management are necessary for laying ground for a competitive financial industry. • The government aims at swift and extensive restructuring and is so far in control. However, it is possible that the policy makers may lose their decisiveness and enthusiasm toward reforming the financial sector for political or economic reasons. 42 Maintaining the current policy stance of accelerating the restructuring process is a challenging issue in Korea.

NOTES 1. Refer to the trend of Korean macro economic variables in the Appendix I. 2. The rate was 4.5% in January 1998 (0.93 million). As restructuring continues, it is expected to reach 8.2% by the year-end and 10% in early 1999. 3. The IMF's bailout program settled in December 1997 required a 2% GDP growth and 5% inflation rate in 1998, which proved to be too optimistic.

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4. For corporate sector, refer to Appendix lI. 5. Terms of Trade are calculated by dividing the export price index by the import price index and multiplying the result by 100. 6. Real exchange rate is calculated as the multiple of the nominal exchange rate and the CPI of the foreign country, divided by the CPI of Korea. It is normalized so that the real exchange rate in December 1993 is equal to 100. 7. A new definition of total external liabilities agreed by the Korean government and the IMF adds the offshore borrowing of Korean banks and their overseas branches and subsidiaries to the external debt as defined by the World Bank. 8. The most recent attempt was the proposal made by the Presidential Commission for Financial Reform (PCFR). Recognizing the urgency of the financial reform, the government established the 31-member PCFR in January 1997 to prepare a comprehensive set of reform measures to overhaul the financial system. Most of the Commission's recommendations were enacted into the 13 financial reform bills only on December 29, 1997, after the IMF Letter of Intent required it, which was too late to prevent the financial crisis. 9. So far, the IMF only has provided a total of US$18 billion out of the promised US$ 21 billion after the 7th reimbursement of US$1 billion on Sept.2. If we look at the period of Jan.-Aug. 1988, a total of US$ 8.2 billion has been rendered: US$ 6.2 billion from IME 0.99 billion from IBRD and 1 billion from ADB. 10. A total of 134 banks of 32 countries accepted terms agreed in the New York negotiations in January 1998. The Korean National Assembly approved a government guarantee of $27.7 billion for this purpose, effective April 8. The roll-over ratio of maturing loans of $22.6 billion was 96.5%. 17.2% of the maturing loans were converted into 1-year maturity, 45% into 2 years, and 37.9% into 3 years. 11. The global bonds consist of US$1 billion of 5-year maturity and US$ 3 billion of 10-year maturity. The issuing rates were US TB rate + 345 b.p and US TB rate + 355 b.p. respectively. As of the end of September, the premium rate was 710 basis points. 12. This figure includes the US$ 1.99 billion export of gold collected through the unprecedented nationwide gold collection campaign. 13. In fact, the market situation in December 1997 left the government no choice but adopting it. 14. The ceilings on foreigner's stock ownership have changed from 26% to 50% on December 11, 1997, to 55% at the end of the same month, and is abolished completely in June 1998. The only exception is for public company stocks with aggregate ceiling of 30% and individual ceiling of 3%. On December 23, 1997, the aggregate foreign bond holding limit of 30% and the 10% limit on individual holdings were abolished. 15. This figure represents an actual decline in FDI flows by 18.7%, compared to the same period of 1997. 16. The regulatory and supervisory tools have been frequently used for governmentcontrolled resource allocations or even for corruptive and political reasons, rather than for the soundness of financial industry. 17. They include the Banking Supervisory Authority, the Securities Supervisory Board, Insurance Supervisory Board, and Non-bank Supervisory Board. 18. The Fund is composed of 6 accounts: Bank Account, Securities Company Account, Insurance Company Account (Insurance Company Account is divided into life and non-life insurance), Merchant Banks Account, Mutual Savings and Finance Company Account, and Credit Union Account.

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19. On November 26, 1998, the KAMC started its operation by purchasing the combined face total of 4.39 trillion won in non-performing loans at Korea First Bank and Seoul Bank at the discounted price of 2.91 trillion won. The average discount rate was set at 66.3%. Refer to the next section for details. 20. For non-bank institutions, there is a major shareholder who is typically one of

Chaebols. 21. Minority shareholders of Korea First Bank that went belly up last year successfully filed a derivative suit against two ex-presidents and two ex-directors of the bank for their misdeed, and the court fined them 40 billion won. 22. Press release of the MOFE on the 4th National Economic Council Meetings (04/14/1998). 23. Precautionary & Substandard are based on new standard. In addition, the asset size was adjusted by evaluating bond holdings on market value rather than book value and loans by subtracting the estimated loss (20% of Substandard+75% of Doubtful + 100% of Estimated Loss) from the book value. 24. The Committee's suggestion was 4 Approval, 2 Conditional Approval and 6 Disapproval. 25. According to the FSC, an 'Approval' rating leads to submission of detailed quarterly implementation plans, which will be monitored on an ongoing basis. A 'Conditional approval' requires a submission of implementation plans within one month. In the event of disapproval of an implementation plan a mandatory merger order or transfer of business order will be imposed. A 'Disapproval' leads to mandatory merger or transfer of business under a purchase & assumption arrangement. Banks identified as being conditionally approved or disapproved that on a voluntary basis pursue mergers with sound banks is exempt from mandatory exit. 26. To ensure the soundness of acquiring banks, only high-grade assets of the liquidated banks were transferred. Non-performing assets classified as 'substandard' or lower were excluded. Additional safeguard measures were taken to prevent inherent risks involved in P&As: • KDIC has covered for any shortfalls in net worth of transferred assets and liabilities; ° KAMC and KDIC are supporting the disposal of NPLs by the acquiring banks, and their recapitalization; • within a certain period after P&A transactions, the acquiring banks can exercise a put-back option by requesting KAMCO to purchase acquired assets if these are later found to be non-performing. 27. As of October 31, 1997, the outstanding non-performing loans of 30 merchant banks amounted to 3,898 billion won and the ratio of non-performing loans to total loans was 2.90%. The BIS ratios of suspended 10 banks were all negative. 28. The MOFE announced that the top priority was given the feasibility of achieving the BIS ratio of 4% by March 1998, 6% by June 1998, and 8% by June 1999. 29. 10 banks in Feb. 1998, 2 banks in April 1998, and 2 banks in July 1998. 30. Refer to Press release of the MOFE (02/26/1998). 31. The cumulative losses of Daehan and Hankuk, as of May 1998, were 1.6 and 0.9 trillion won respectively. A due diligence review was carried out during June 20 to July 15. 32. Refer to the press release of MOFE on the 6th national Economic Council Meetings(05/20/1998). 33. In the new announcement, the numbers as of March 1998 are different from those in Table III.4. Bad loans are 59.6 trillion won instead 68 and precautionary loans are 57.7 instead of 50. No explanation for the differences was however provided.

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34. Examples of the rehabilitation efforts include cost reduction such as layoffs and branch network downsizing and recapitalization efforts through major shareholder or foreign investment. Those of loss sharing include writing down existing equity and forcing management to take responsibility for their misdeeds. In the process, the depositors took little loss. 35. Refer to Press release of MOFE(05/20/1998). 36. At an exchange rate of 1,350 won/US$, 1997 GDP is US$ 211.8 billion. 37. It is known that the ratios of restructuring cost w.r.t. GDP are 6% of U.S.A. (1991-1995), 4.7% of Sweden (91-93), 8.3% of Finland (91-93), 4.3% of Japan (estimated after 98). 38. In fact, in early September, KAMC sold to Goldman Sachs approximately 255 billion won (in book value terms) of acquired NPLs, most of which were uncollateralized. The sale of these NPLs was made in the form of asset-backedsecurities (ABS). 39. Despite the highest NPL ratio, KangWon Bank got a Conditional Approval since a merger was announced with Hyundai Merchant Bank. Both are affiliated companies of Hyundai Group. 40. The loan classification standard has changed on July l, 1998: 'Substandard or lower' from longer than 6 month interest payments in arrears to longer than 3 months, and 'Precautionary' from 3-6 months to 1-3 months interest in arrears. 41. Refer to Shin & Hahm (1998) for this argument. 42. Facing worsening macro economic situation and credit crunch, the government announced an economic stimulus package on September 2, which aims at boosting consumption through money increase and interest rate reduction. The package can be understood as a policy priority shift from a painful fundamental reform to real sector revitalization by announcing recapitalization of all banks up to a BIS ratio of 10% with fiscal resources. It implies no more bank closures.

REFERENCES Agenor, E, McDermott, J., & Ucer, M. (1997). Fiscal Imbalance, Capital Inflows, and the Real Exchange Rate: The Case of Turkey. European Economic Review, 41,819-825. Bank of Korea (1998). Foreign Currency Statistics Yearbook. Bank of Korea. National Income, Balance of Payment, various issues. Bank of Korea. Bank Statistic. Bank of Korea. National Income, Balance of Payment, various issues. Bank of Korea. Various press releases (www.bok.or.kr). Calvo, G., & Mendoza, E. (1996). Mexico's Balance-of-PaymentsCrisis: A Chronicle of a Death Foretold. Journal of International Economics, 41,235-264. Corsetti, G. Pesenti, E, & Roubini, N. (1998). What Caused the Asian Currency and Financial Crisis?. NYU Stern School Internet Site, (March). Eaquivel, G., & Larrain, E (1998). Explaining Currency Crises. NYU Stern School Internet Site, (June). Financial SupervisoryCommission(FSC) of Korea. Various press releases (www.fsb.or.kr). Frankel, J., & Rose, A. (1996). Curency Crashes in Emerging Markets: An Empirical Treatment. Journal of International Economics, 41,351-366.

Goldstein, M. (1998). Early WarningIndicators and the Asian Financial Crisis, mimeo.

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Im, J. (1998). Management of Financial Crisis in the Post-Crisis Period, mimeo. Korea Institute of Finance. Kaminsky, G., & Reinhart, C. (1997). The Twin Crises: The Causes of Banking and Balance-ofPayments. Problems. International Finance Discussion Paper, NO.544, Board of Governors of the Federal Reserve System. Korea Institute of Finance (1998). Current Developments in the Korean Financial and Labor Markets, May 20. Korea Stock Exchange (1998). Equity Bulletin. Krugman, P. (1979). A Model of Balance of Payments Crises. Journal of Money, Credit and Banking, 11, 311-325. Krugman, E (1998). What Happened to Asia? NYU (Stern School) lnternet Site, January. Lee, J. (1998). Korean Currency Crisis. Crisis in Asia: Differences and Similarities, The SJE-KIF International Symposium, Seoul, Korea, August 21. Lee, S. (1997). The Financial Crisis in Korea, mimeo. Yale University, December 1997. Ministry of Finance and Economy (MOFE) of Korea. Various press releases (www.mofe.or.kr). Obstfeld, M. (1986). Rational and Self-fulfilling Balance-of-Payments Crises. American Economic Review, 76, 72-81. Obstfeld, M. (1994). The Logic of Currency Crises. Journal of Evolutiona~ Economics, 43, 115-213. Park, W. (1998). The Causes and Predictability of Currency Crisis in Korea, mimeo. Korea Institute of Finance, April 1998 (in Korean). Park, D., & Rhee, C. (1998). Currency Crisis in Korea: Could B Have Been Avoided?. Park, Y. (1998). Financial Crisis and Macroeconomic Adjustments in Korea, 1997-1998, Financial Liberalization and Opening in East Asia, Korea Institute of Finance, March. Radelet, S., & Sachs, J. (1998). The Onset of the East Asian Financial Crisis. NYU Stern School Internet Site, March. Rhee, Y., & Lee, J. (1998). Was the Currency Crisis in Korea Predictable?, mimeo, February (in Korean). Sachs, J., Tornell, A., & Velasco, A. (1996). The Collapse of the Mexican Peso: Sudden Death or Death Foretold. Journal of International Economics, 41,265-283. Shin, I., & Hahm, J. (1998). The Korean Crisis: Causes and Resolution, Korea Development Institute. Presented at the East-West Center/KDI Conference on Korean Crisis, July 28.

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APPENDIX I T R E N D IN E C O N O M I C INDICATORS IN K O R E A 1996 GDP (trillion won) G D P Growth (%) Consumption (%)

Investment(%) Unemployment Rate (%) Current Account (US$b) Foreign Debt (US$b) FX Usable Res. (US$b) M2 Growth (%)

CPI (%) 3-yr Corp.Bond Rate (%) KOSPI(1980=100) Won/US$

Defaulted Bill Rate (%)

1997

Jan. 98

389.8 420.9 -7.1 5.5 -6.9 3.5 -7.1 -3.5 -2.0 2.6 4,5 -23.1 -8.2 3.1 157.5 154.4 151,3 29.4 8.9 12,4 15.8 14.1 15.4 4.9 4.5 8.3 12.6 24.3 23.4 833.4 654.5 475.2 839 1,484 1,706 0.17 0.52 0.72

Feb

Mar

Apr

May

-62.6 ----3.9 ----9.7 ----23.0 --5.9 6.5 6.7 6.9 4.1 3.6 3.6 4.1 150.3 151.3 155.2 155.0 18.5 24.2 30.8 34.4 14.6 12.1 12.9 18.3 9.5 9.0 8.8 8.2 20.0 18.7 18.0 17.0 525.2 523.0 444.0 356.3 1,623 1,505 1,391 1,394 0.83 0.62 0.57 0.62

June

July

Aug

66.0 -6.6 ---12.2 ---29.8 --7.0 7.6 7.4 3.2 3.7 2.3 153.8 152.3 150.8 37.0 39.2 41.4 16.3 21.1 20.9 7.5 7.3 6.9 16.1 13.2 11.9 313.3 327.8 312.8 1,397 1,227 1,351 0.58 0.69 0.55

A P P E N D I X II PROGRESS IN CORPORATE, LABOR, PUBLIC SECTOR RESTRUCTURING [ 1 ] Corporate Sector Restructuring 1. Basic Principles Restructuring of the corporate sector was launched following the January 13 agreement between then-president-elect Kim and heads of Chaebol, which set forth five key goals: • Enhancement of transparency of corporate management. • Dismantling of cross guarantees among corporations. • Significant improvement of capital structure. • Singling out core businesses and strengthening cooperative relationship with SME. • Enhancement of accountability of controlling shareholders and management. To effectively pursue the goals, implementation principles were developed; Corporate restructuring will be driven by creditor financial institutions; The work

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out concept will be at the center of the overall process; Non-viable firms will be subject to exit; Develop a scheme to provide full support to sound SMEs

2. Progress to date 1. Capital Structure Improvement and Business Restructuring Creditor banks have been assessing the viability of their client firms, and are taking necessary actions to apply workout programs or to force the exit of insolvent firms. Exit of Non-Viable Firms In May, creditor banks established a formal review committee to assess the viability of 313 client firms showing signs of financial weakness. Upon the completion of their evaluation, creditor banks classified 55 corporations as nonviable. Out of those classified as non-viable, 52 corporations are affiliated with Korea's top 64 business groups. Specifically, 20 of the 52 are affiliated with the 5 largest business groups. The remaining 3 corporations do not have any affiliation with business groups. The outstanding loan amount of the 55 nonviable corporations totaled approximately 5 trillion won. To facilitate the exit of those non-viable corporations, no new credit has been extended by their banks, and financial assistance across affiliate companies for the purpose of bailout has been disallowed.

Corporate Workout Programs Workouts are a more effective means for corporate restructuring than legal proceedings, such as court receivership or composition proceedings, in that historically, these practices have not met with much success in Korea due to lack of expertise and a proper institutional framework. In February, legal procedures pertaining to corporate rehabilitation and bankruptcy filing were simplified so as to facilitate rulings on the exit of nonviable firms and to ensure better representation of creditor banks in the resolution process. In effect, the improved procedures reduced what had previously been legalistic exit barriers. Workout programs will be applied only to those viable firms that have voluntarily entered into negotiations with creditor banks. It is expected that the process of negotiation and the actual make-up of the plans will be completed by the end of this year. The FSC will monitor the proceedings from a prudential regulation standpoint. A portion of the Technical Assistance Loan (TAL) of US$ 33 million, provided by the IBRD, will be used to employ outside experts as advisors not only for the design of corporate workout programs but their implementation as well.

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Workout Programs for Large Corporations. At present, more than 200 financial institutions have signed the 'Corporate Restructuring Agreement' to carry out corporate workouts with the top 6-64 business conglomerates, known as chaebols. Also, workouts are being applied to non-chaebol corporations, identified as financially weak but viable by their creditors. Currently, creditor banks are evaluating the financial status of 35 subsidiaries of 13 chaebols, and 16 non-chaebol corporations that have been selected as possible workout candidates . Upon the completion of the evaluation, creditor banks and the corporations will devise detailed workout programs, including debt-equity swaps and debt rescheduling, based on the rehabilitation plans submitted by corporations. Workout Programs for Small and Medium Enterprises (SME). The scope of corporate workout programs is being expanded to include SMEs. Creditor banks have evaluated the financial status of approximately 22,000 SMEs with outstanding loans of 1 billion won or more, and classified about 13,000 of these as viable. These viable SMEs were selected as candidate firms for workout programs. A special task force unit within each bank is reviewing the feasibility of rehabilitation plans and will soon devise specific measures and schedules for workout programs. Business Restructuring of Chaebols Most important in Korea's corporate sector restructuring is the large-scale reform of the five largest chaebols, given the preponderance of their market share and economic influence. Their restructuring should involve not only capital structure improvement but also business restructuring. The five largest chaebols and their creditor banks have already reached an agreement on debt reduction and other restructuring measures based on the agenda for chaebol reform announced early this year. Recently, the government and the top five chaebol leaders announced a framework for mergers and business swaps, referred to as 'big deals'. The big deals represent an expedient way for corporations to focus on their core competencies,, reduce over-capacity in key industries, reduce overlapping investments, and create management efficiencies. To date, 10 industries have been identified as having the highest levels of over-capacity in terms of excess or duplicate investments. Current discussions on the big deals are focusing on seven of these industries: semi-conductors, petrochemicals, automobiles, aerospace, train car manufacturing, power plant equipment/vessel engines, and oil refining. The discussion stage will be followed up with a concrete outlining of particulars related to actual

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Industry Semiconductor

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Big Deal Plan among the Top Five Chaebol (as of September 1998) Contents

Details & Pending Problems

• Hyundai & LG

° Joint venture with ownership Structure under discussion • Consortium with foreign partner • Samsung + Hyundai, Petrochemicals • To be discussed • SK+LG • Hyundai + Daewoo + Samsung • To be discussed after Kia auction Automobiles • Samsung + Daewoo + Hyundai • Consortium with equal share Aircraft • Consortium with foreign partner • Hyundai + Daewoo + Hanjin Railroad Cars • Under discussion Power Plant Facilities • Hyundai+ Samsung + -Consortium of Hyundai & Korea • Korea Heavy & Ship Engines -Korea to take over Samsung • Hyundai to take over Hanwha Oil Refinery • Hyundai + Hanwha

implementation, which is expected to take place by the end o f this year, if not earlier. The chaebols involved in big deal discussions have requested extensive tax benefits and financial support, such as debt-to-equity swaps, debt restructuring and lower interest rates. The government has already prepared a revised tax bill, which will eliminate major tax-related hurdles. Discussions with respect to financial support have yet to conclude, but it is certain that creditor banks will only provide support conditional upon strong rehabilitation measures taken in line with market principles and international standards. Just as is the case with the workout programs for other firms, any financial support for business restructuring o f the 5 largest chaebols will be devoid o f moral hazard. The F S C will monitor all proceedings from the prudential regulation standpoint. One remaining concern with the big deals is the potential that they m a y result in concentrations of power and subsequent unfair business practices, such as monopolies, or other similar price-fixing vehicles, etc. For this reason, the Fair Trade C o m m i s s i o n will strengthen its market monitoring and investigation o f any potential unfair trade practices.

2. Improving Standards in Corporate Governance Transparency and accountability in corporate governance are being facilitated by the following measures.

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Table 13. Tasks Transparency

• • • • • Cross Debt • Guarantee • Capital Structure • • Business Activities • • • • Accountability • • •

A g e n d a for Reform Measures

Adoption of Combined Financial Statements International Accounting Principles Strengthening Voting Rights of minority shareholders Appointment of outside directors for listed companies External auditors committee No new cross debt guarantee between subsidiaries Resolution of existing cross guarantee Agreement with creditor banks to reduce debt ratio Exclusion of tax shield on excessive borrowings Adoption of corporate-split system Liberalizing foreign ownership of real estate Full liberalization of M&A Streamlining bankruptcy procedures Strengthening legal liability of controlling owners Introduction of cumulative voting system Allowing voting rights of institutional investors

Time Schedule To be in 1999 Oct. 1998 May 1998 Feb 1998 Feb 1998 April 1998 April 1998 April 1998 In 2000 June 1998 June 1998 May 1998 Feb 1998 June 1998 Oct 1998 June 1998

These new standards are and will continue to be strictly enforced. A recent case in point is the penalty i m p o s e d by the Fair Trade C o m m i s s i o n on chaebol subsidiaries found to be involved in insider trading. Indeed, measures for improving standards in corporate governance are already inducing greater transparency in business practices and a generally more open corporate culture. Recently, a court ruling was handed down in favor o f minority shareholders in a suit against the m a n a g e m e n t o f the Korea First Bank. The executives were held responsible for lending money in defiance o f the shareholders' objections. This unprecedented ruling is expected to open the door for other small shareholders of corporations under financial difficulties to follow suit. [2] Labor Market Reform Enforcement o f New L a b o r Standards: L a b o r market flexibility was legally instituted with the revised L a b o r Standard Act passed in February, which allowed layoffs due to managerial difficulties. The resolution of the Hyundai M o t o r strike in September represents a test case with respect to the new Labor Standard Act, in that it was the first application o f the law at a large industrial plant.

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Although the employment adjustment at Hyundai did not proceed as smoothly as hoped, for Korea it represents a significant first step away from the conventional practice of providing life-time employment. Despite the prolonged strikes and the difficulty the two sides had in reaching an agreement, Hyundai was able to achieve its targeted employment adjustment by layoffs, unpaid leave, and early retirement. Yet there is still room for further improvement in business-labor relations and corporate culture. For this reason, the Tripartite Commission is drawing lessons from the recent settlement of the Hyundai strike, and will devise measures for enhancing a new business-labor culture. Any layoffs in Korea are critical at this time given that the government has only recently begun work on its plan to expand the social safety net for displaced workers. Once unemployment benefits are more commensurate with the recent increase in need, labor management conflicts are likely to ease. [3] Public Sector Reform Public sector reform is urgent for two related reasons. First, productivity in the public sector, including state owned enterprises (SOEs), has been far from exemplary, and hence, mandates immediate betterment. Second, the public sector must show itself to be a leading model of efficiency, given that it is the government that is both coordinating and promoting reform in the private sector.

Government Reform. In order to build a small but efficient government, the central government streamlined and reoriented its organizational structure in February with strategic employment cuts. It plans to further reduce its employment by 11% (approximately 17,600 employees) by the end of the year 2000. Local governments will also consolidate their organizations and labor force. At present, related rules and regulations are being revised in order to achieve a targeted employment cut of 12-13% (approximately 35,000 local government employees in total). In conjunction with government reform, the quasi-government sector, including public institutions and various associations, will be streamlined. Reform of State Owned Enterprises (SOEs). The Korean government has decided to overhaul SOEs by either privatizing them or enforcing drastic management reform, depending on their business orientation. The more commercially-oriented SOEs will be privatized. Out of 24 non-financial SOEs (mother companies), 5 SOEs will be privatized immediately within this year, and 6 SOEs gradually by the year 2002, while the

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remaining SOEs are targeted for managerial reform and consolidation. The 82 subsidiaries of these 24 mother companies will also be subject to privatization or management reform: The future status of 27 subsidiaries of those SOEs to be immediately privatized will be determined by the new private management; Among the remaining 55 subsidiaries, 40 will be privatized immediately or gradually, while 15 will undergo restructuring or be consolidated.

THE ASIAN FIVE: FROM FINANCIAL CRISIS TO ECONOMIC RECOVERY M. Faizul Islam ABSTRACT The financial crisis erupted when Thailand delinked its baht to the dollar on July 2, 1997. The contagion affected Malaysia, South Korea, Thailand and the Philippines subsequently. These countries slid into recession in 1998. The crisis also exposed the weaknesses that were inherent in their economies. The International Monetary Fund rushed to rescue them financially in exchange for reforms. Thanks to the reforms that were taking place, all countries except Indonesia pulled out of recession by 1999.

1. INTRODUCTION The financial crisis in the Asian Five (Indonesia, Malaysia, Philippines, South Korea and Thailand) was triggered on July 2, 1997 when the government of Thailand announced that it was abandoning the baht's peg to the U.S. dollar. Instantaneously, the baht fell 15% against the dollar. This unprecedented action ignited the regional financial crisis. The currencies and stock markets of the Asian Five tumbled in tandem. Immediately preceding the crisis, economic conditions apparently appeared to be strong. All of a sudden, the financial meltdown took place. According to the Washington-based Institute of International Finance April 1998 Report, investors lost $80 to $100 billion in equities in the second half of 1997. The Asian Five slid into recession in 1998. A year later, the Asian Five excluding Asian Financial Crisis, Volume 1, pages 123-146. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0686-6

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Indonesia had been experiencing a positive economic growth. This unexpected U-turn had caught even the optimists by surprise. Increased attention had been drawn by policy-makers, investors, academia, international agencies and others to examine the causes of the financial crisis, the road to economic recovery and the lessons learnt from erstwhile 'Asian Tigers'. The objective of this chapter is to analyze the causes of the financial crisis and assess their march towards recovery. The rest of the chapter is as follows. Section 2 analyzes the causes of the crisis. Country analysis is presented in Section 3. Section 4 concludes the chapter.

2. THE BACKGROUND OF THE CRISIS 1. Mismanaged Exchange Rate Policy Over the past decade, Thailand, the Philippines, Indonesia and Malaysia linked their currencies to the U.S. dollar for currency stability. Their choice or decision to link their currencies to the dollar was not irrational. However, once the choice was made, they failed to follow the consistent rules and policies. They intervened to tamper with the inherent adjustment process. We know from exchange rate economics that a currency can have either a fixed or flexible exchange rate. Each system has its merits and demerits. Under a flexible system, the money supply is exogenous whereas in the fixed, it is not. That is, if a country chooses a flexible exchange rate, any balance of payments adjustment takes place through changes in the exchange rate. In this case, the central bank retains control over the monetary policy. With a fixed exchange rate, money supply automatically adjusts to changes in international reserves. In other words, money supply becomes endogenous. Its monetary policy works like an auto-pilot, emasculating the central bank or politicians of any authority. As such, at times the central bank may be tempted to intervene in the market to thwart the effects of external imbalances through sterilization. Such an interventionist policy does more harm than good. This is exactly what their central banks did. As a result of their dollardenominated currencies, there had been an increased capital inflows freed of exchange-rate risk. In turn, they ran balance-of-payments surpluses. This created too much liquidity and credit resulting in an equity and real estate bubble, higher growth and fear of inflation. The central banks intervened and started issuing debt to sterilize the excess liquidity. This futile sterilization pursuit was finally abandoned with the delinking of the baht in early July 1997. The contagion affected the rest of the Asian Five.

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2. Lax Banking Rules

The banking crisis has been aggravated by the failure of regulators to supervise lenders properly and safeguarding the integrity of the financial system. The regulatory environment under which the financial institutions operated was weak. Poor banking standards resulted in overinvestment in some industries (ex. real-estate in Thailand, physical infrastructure in Malaysia, tradeables in South Korea). Some of the banking irregularities were as follows: (I) Money was lent on the basis of collateral whose value plummeted instead of cash-flow basis generated by projects they financed. (2) Loans were made at a slight premium over what U.S. government bonds paid. (3) The standard capitalreserve was not maintained. The Basel-based Bank for International Settlements prescribes under a risk-weighted capital structure, an adequacy ratio of at least 8%. (4) Long-term projects were financed out of short-term debt. Bankruptcy laws were either obsolete (ex. Indonesia), non-existent (Thailand) or unforceable (ex. Philippines). Whatever bankruptcy law existed, it was totally different from that of other countries. For example, when an American company is unable to pay its debt, its creditors force it into bankruptcy. The bankruptcy judge draws a payment plan or liquidates the firm and divides the assets. On the contrary, the creditors in these troubled economies were the losers. In Indonesia, it was almost impossible to force a debtor into bankruptcy. In South Korea, filing bankruptcy papers was easy. The decision-making was time consuming. Although the commercial banks in South Korea were privatized in the 1980s, the management were selected by the government who were driven by political pressure and not shareholders' interests. 3. Globalization of Financial Markets

The financial markets were getting highly integrated in the 1990s. Realizing that the returns in the mature economies had already peaked, foreign investors went on a buying frenzy in search of higher returns in the Asian Five. They disregarded the concomitant potential risks. As long as it was an Asian company, the stock was bought. Eventually, their investment went bust. As soon as they became disappointed with the returns, they exited the market. Any economy is certainly impacted through financial integration. It multiplies the benefits of good policies and institutions on the economy or inflicts huge costs because of bad policies and weak institutions.

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4. Corruption Corruption was rampant too. The level of corruption is directly related to the degree of government size and intervention. As long as government continued to enjoy discretionary powers in the economy and the liberalization process, bribery was prevalent. When a bribe was given, it increased the transaction cost and subsequently raised the price of a good. The problem arose when the bribe became unpredictable. In the end, prices became distorted which could not be relied to serve as a signaling mechanism in the economy. Berlin-based Transparency International (TI) in its annual publication ranks several countries on the basis of corruption. In its 1997 report, it ranked Indonesia 7th, Philippines 13th, Thailand 14th, South Korea 19th and Malaysia 21st as most corrupt out of 52 countries surveyed. It is the conviction of TI that corruption stops development in countries where it is present. In South Korea, two former presidents and several business tycoons were jailed or fined for graft. Beginning in 1997, the Korean government was embroiled in a bribe-for-loans scandal. Former Philippines President Ramos came under severe attack in 1997 when his critics claimed that his party and government officials received kickbacks from a $2.3 billion Manila Bay landdevelopment project. In Malaysia and Indonesia free press did not exist. Political parties UMNO and GOLKAR have ruled Malaysia and Indonesia respectively for many years. Few high-level corruption cases reached courts or ever get convictions in these two countries. In the Asian Five, the politicians and bureaucrats used state-controlled banks to channel money to friends, families and entrepreneurs who had close ties with them. The beneficiaries reciprocated by campaign contributions and personal gratuities. Capital was allocated not to those who deserved it, rather who were in a position to demand it. Markets did not play a major role in allocating resources. For instance, it was widely believed that Hanko, South Korea's 14th largest conglomerate got special treatment for assisting to bankroll the 1992 election campaign of then President Kim Young Sam. Hanko received special favors from the government to build a massive new steel mill. Hanko's founder Chung Soo allegedly bribed legislators and bankers to fund the project. He borrowed a hefty $6 billion which ultimately pushed the company into bankruptcy. Politicians used tax money to finance mega public projects and physical infrastructures. Businesses speculated in real estate investment and built enormous overcapacity in automobiles, computers, steel, textiles and electronics. The infusion of billions of dollars into a corrupt crony-capitalist system was partly responsible for the economic turmoil.

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5. Regulated Economies

Given their colonial past, the Asian Five economies still remain insulated and regulated - of command and control. The Heritage Foundation and the Wall Street Journal publish annually an Index of Economic Freedom. They rank each nation on the basis of 10 key areas: trade policy, taxation, government intervention, monetary policy, capital flows and foreign investment, banking policy, wage and price controls, property rights, regulation and black market activity. In its 1998 index, South Korea ranked 24th, Thailand and Malaysia 28th, Philippines 44th and Indonesia 62nd out of 154 countries. Not that there were walls between nations, but walls existed within. In South Korea, a handful of companies or chaebol control 50% of Gross Domestic Product (GDP). They operate under a centralized and bureaucratic leadership. Businessmen in South Korea complained that they are required to get as many as 2000 government seals of approval before starting a new business enterprise. For more than three decades, the Indonesian economy has been largely controlled by then-President Suharto's family, close associates and political party. Despite IMF's request to diminish the dominant influence of friends and families in the economy, President Suharto following his (short-term) victory as the head of state for the seventh term, appointed his family members and close acquaintances to key positions in the new cabinet.~ He vowed to back a controversial national car project owned by his son and a state-owned jet company. In Thailand, there was a very close relationship between the Bank of Thailand and the powerful cartel formed by the big five commercial banks. Many senior officials at the central bank and commercial banks switched positions back and forth. The Asian Five has shown aversion to foreign investment, ownership or participation. For example, South Korea companies have invested roughly twice ($13.4 billion) abroad as foreigners in South Korea ($6.9 billion) in 1996. 2 Given their monopoly-type economies, the businesses in the Asian Five operate within the fortress erected by tariff walls. The combination of protected home markets, state enterprises, government-directed financing and subsidies resulted in a glut from computers to ships. The Asian Five economies had not only failed to reap the maximum benefits of a fully unrestricted market system but faced the enormous costs of avoiding it. The regulated economies which had been rigid in structure remained indifferent in adjusting to the rapidly changing global environment.

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3. COUNTRY ANALYSIS This section examines the pre-crisis economic conditions in each of the Asian Five. It also traces the reforms and economic developments taking place in each individual country since the crisis erupted.

Thailand Thailand was the first country where the financial crisis surfaced. On July 2, 1997 the Bank of Thailand allowed the baht to float freely. The baht fell 15% against the dollar within days. Thailand pegged its currency to the dollar at a time when its current account deficits were increasing. Pegging the currency resulted in a huge influx of foreign money. People borrowed cheap U.S. dollars in exchange for the expensive baht. Money was cheap and plentiful. During the heyday of 1993, Thai firms issued convertible bonds. Investors seized the opportunity of buying shares at bargain prices. Due to the easy availability of credit, political patronage and fledgling financial sector, money was used to build commercial and residential real estates (luxurious condominiums) instead of investing in physical and human capital. The speculative increase in the property and equity values precipitated the financial sector meltdown. The government ran down reserves unsuccessfully to defend the value of the baht.

IMF Rescue Package On August 21, 1997, the IMF and other Asian donors approved $17.2 billion for Thailand to pay for the financial sector debt, shore up reserves and stabilize the baht. The IMF stipulated that the government: • Raise excise taxes in order to create a budget surplus of 1% of GDP. • Declare bad loans as non-performing after 6 months instead of 12. • Allow foreigners to own majority shares in financial institutions for at least 10 years. • Set up New Financial Sector Restructuring Agency (FRA) by royal decree. • Increase capital requirements from 8.5% to 12% for all financial institutions. • Audit standards as a condition for reopening. • Set up asset-management company to dispose of non-performing assets. • Bank of Thailand (BoT) suspend infusion of liquidity to the ailing financial institutions and disclose the size of the reserves every two weeks. BoT was further denied of easy monetary policy.

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Short-term corporate foreign debt was $67.3 billion at the end of December 1997. Since the crisis, it was clear that increased foreign participation, bank recapitalization and effective corporate restructuring were essential to an economic recovery. To begin with, the government set up the FRA modeled on the U.S. Resolution Trust Corporation to liquidate the assets (cars, property, furniture) of 58 insolvent finance companies. The government eased regulations allowing foreign control in banking, financial, real estate ownership and manufacturing sectors. In response to IMF's requirements, Thailand began to formulate a legal procedure for bankruptcy. A year later after the crisis occurred, the government formulated a reform package to revitalize financial institutions and inject money into the cashstarved economy. Instead of nationalizing big banks that have failed to raise new capital, the plan would recapitalize them through an exchange of securities. Thus, the government issued as much as 300 million baht ($7.18 billion) in government bonds in exchange for preferred shares or subordinated bonds issued by the banks. The banks had to issue payments for their shares and bonds in excess of 1% than the interest on government bonds. This plan called for a reduction in the number of commercial banks from 15 to 12, closure of five more insolvent companies and protection of depositors and creditors. Out of 91 ailing finance companies, FRA closed 58 of them in 1998. Following the passage of bankruptcy and foreclosure laws in early 1999, the FRA liquidated the remaining 58 bust companies. Six banks have been nationalized for merger and sale. Four state banks are to be sold by the end of 1999 to the highest bidders. The new law is expected to streamline the bankruptcy procedures, facilitating creditors to dispose of bad loans. Responding to critics about the nature and the impact of its rescue packages, the IMF toned down some of its prescriptions for Asia's troubled economies) In 1999, Thailand was allowed a budget deficit equal to 6% of GDP and a relaxed tax policy. The Thai government expects that its 1999 stimulus package of 130 billion baht ($3.5 billion) would further boost the economy. Following the crisis, interest rates had to be raised to fight inflation and prop the value of the baht. Short-term interest rate was around 17% before the crisis. It peaked above 20% and has fallen to 3% in September 1999. Inflation which rose after the crisis has receded too. Thailand has built up a sizeable trade surplus with the world. This was the result of a reduction in imports and an increase in exports. A surplus in Thai's trade balance has also boosted reserves. At the depth of the crisis, reserves fell to nearly zero from $25 billion. In August 1999, Thailand had a $32 billion in foreign reserves. With trade balance

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in surplus (Fig. 1), soaring reserves and subdued inflation, the baht has appreciated about 31% vis-a-vis the U.S. dollar (in nominal terms) since bottoming out in early 1998, (Fig. 2). Improvements in economic fundamentals have lifted the Thai's stock market from its trough. However, the market was still below its pre-crisis level by 20%

(U.S. D o l l a r p e r Baht, N o m i n a l ) 0.045

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in September 1999. The Standard & Poor Ratings services has revised its ratings of Thai securities from negative to stable in July 1999. The economy is expected to grow 4% in 1999 after shrinking 9.4% in 1998. In sum, the national elections in late 1997 provided the new reform-minded Premier Leepkai an excellent opportunity to take bold, necessary and unpleasant measures to revive the country's economy and restructure the financial industry. Many foreign investors are making their presence in Thailand's financial, retail, automobile and cement industry. The economy which is now out of recession, so far has been driven by domestic demand and renewed growth in exports. It appears that the government is relying on a relatively weak baht to boost exports. Non-performing loans still account for 46% of the total lending in the financial system. Continued efforts are required to restructure thousands of struggling companies and the debt overhang. Few completed deals have mostly involved deferred payments rather than debt-for-equity swaps. Business recovery hinges on renewed access to traditional sources of capital. Malaysia

Pressured by the Thai baht, Malaysia delinked their dollar-denominated currency on July 14, 1997. The ringgit fell 2% to 2.55 against the dollar. For several days earlier, Malaysia's central bank, Bank Negara bought $1 billion in vain to defend its currency. There was a surge in real estate values and investment in mega-projects diverting money away from manufacturing. Malaysia was also having currentaccount deficits problems. Sensing opportunities to make profits, currency traders 'sold short' on the ringgit. Prime Minister Mahathir Mohamad accused currency traders of undermining the ringgit. On August 2, 1997 Bank Negara banned 'short selling'. His constant barrage against the currency speculators simply made the matter worse. He later on lifted the ban on short-selling. His policy gyrations confused foreign investors even more. An expansionary budget was presented in October 1997. It was possible because she had a budget surplus. During the 1990s, the economy was domestic demand-driven. She spent billions of dollars in physical infrastructures. Immediately after the crisis, investments on mega-projects were put on hold. Because of dwindling reserves, Bank Negara was not in a position to defend the currency through buy backs, rather allowed interest rates to rise to do the job.

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Recognizing that the economy was slowing down from 8% in 1997, the central bank eased monetary policy by lowering the reserve requirement from 13% to 10% thereby injecting 14 billion ringgit into the banking system in early 1998. Because of relatively little foreign debt, Malaysia tried to remedy the problem without external assistance. Since the crisis began, Primier Mahathir opposed IMF-style reforms because he believed, it would make the situation even worse. Malaysia's financial problems were not as severe as Thailand, because the former had a reasonably efficient regulatory system and a relatively independent central bank. The Bank Negara had an early warning system to identify any potential problem. Once detected, it tried to assist the potentially troubled institution. Despite deregulation and liberalization of the financial sector, its expansion remained relatively conservative. No new bank license has been issued since 1980s, The capital ratio was well above 8% - the highest in Southeast Asia. In a very unusual move in March 1998, the government took over the management of Halim Securities-a troubled stock brokerage, and gave eight others to act up. This action reflected the government's determination of restructuring the battered brokerage industry. On September 1, 1998, to stem excessive capital outflow, Malaysia imposed currency controls - outlawing trade in the ringgit and imposing onerous curbs on foreign stock investors. The ringgit was also pegged to the U.S. dollar: 3.8 ringgit per U.S.$, (Fig. 3). The Mahathir government unveiled another expansionary budget in October 1998 to stimulate the economy. Monetary policy was also loosened by slashing interest rates and lowering the statutory reserve requirements. The default period for non-performing loans was extended from 3 to 6 months. Banks were directed to resume lending to stock and property markets. Two agencies Danamodal and Danaharta - were set up to shore up the banking industry. After contracting 7% in 1998, the Malaysian economy is expected to grow 2.4% in 1999. Malaysia's long-term openness to trade has made it easier to boost exports. She accumulated a surplus in trade by higher exports and reduced imports, (Fig. 4). Reserves have increased to $32 billion by July 1999. Inflation and interest rates are below their pre-crisis levels. The Kuala Lumpur Stock Exchange Index has risen from 350 in September 1998 to over 700 a year later. The stock market is still below the pre-crisis level of 1100. In August 1999, the stock market rallied when Morgan Stanley Capital International decided to reinstate in February 2000, the Malaysian market in its international index in response

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Fig. 3. Malaysian Ringgit.

to the government's decision to ease currency controls imposed in September 1998. With the help of the investment bank Solomon Smith Barney, the Malaysian government was able to raise $1 billion in the international bond market in May 1999.

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Capital controls controversy A controversy has surfaced whether the controls on capital helped the economic recovery. The rationale for the government's imposition of capital controls was to stern the capital outflow, despite efforts at checking its flight through higher interest rates. Premier Mahathir believed that such selective exchange controls were undertaken to stop currency and stock market speculators from causing financial turmoil which had disrupted the Malaysian economy.4 Eminent economists like Robert Barro, Paul Krugman, Jeffrey Sachs and World Bank economist Joseph Stiglitz criticized IMF's policies in addressing the financial crisis. Economists Krugman, Barro and Jagwadish Bhagwati even supported some limited form of capital controls, from the devastating impact of investor stampedes when the country is under a financial siege. They believe that the IMF's policy of sterilized intervention coupled with high interest rates is worse than (temporary) capital controls. When the controls were placed in September 1998, the critics thought Malaysian defiance of economic orthodoxy would prove to be a blunder. The government was using it as a ploy to delay restructuring the financial sector. Controls would drive away foreign investors. A year later, given the economy's spectacular turnaround, the IMF conceded in its (September 1999) Annual Review of Malaysian economy that controls over capital have produced positive results. A consensus is building that imposing controls may be justified when there is a potential for risk. At least for now, the government has minimized the control's adverse impact on investors. Some observers think that good macroeconomic policies and significant progress in restructuring the financial sector were largely responsible in terms of economic recovery. If the controls remain in place for too long, the greater will be the likelihood of distorted exchange-rate and interest-rate levels resulting in an inefficient use of capital.

South Korea South Korea, the world's tenth largest economy, became the twenty-ninth member of the Organization for Economic Cooperation and Development in 1996. Several months later, the financial crisis erupted in South Korea. About half a dozen conglomerates (including Hanbo, Sammi) had collapsed. The merchant banks lent money to the already highly leveraged conglomerates. They also made huge, leveraged bets on risky bonds at times from short-term borrowing from abroad. The average South Korean company was leveraged four times its equity. The debt-to-equity ratio rose from 330% in 1996 to 450%

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in 1997. Lack of market forces to determine efficient allocation of resources led to the creation of some conglomerates. South Korea experienced current-account deficits since 1990 (with a minor surplus of $1013 million in 1993). The deficit hit a record of $23.7 billion in 1996. Bad bank loans were estimated to be over $300 billion because of Korean's banks heavy exposure to troubled conglomerates. Problems of banking regulations existed which were similar to Thailand. Corporate debt stood at $470 billion in 1997. The culmination of all these financial troubles resulted in the won's depreciation. The long-term factors responsible for the crisis were that the South Korean economy remained protected and regulated and the governments were corrupt. IMF Rescue Package

In December 1997, the IMF agreed to provide South Korea with $55 billion to address the crisis. In return, South Korea had to: • Slash growth to 3% (down from the 1997's 6% growth rate) • Cap inflation at 5% (through raising interest rate) • Reduce current-account deficit to be equal to 1% of GDP (down from 1997's 3% level) • Produce a balanced budget by raising taxes and reducing spending The following measures had been undertaken since the crisis. • The amendment of the General Banking Law and the Financial Industry Act of 1997 raised foreign ownership to 100%. This amendment had: (1) made it easier for the acquisition of, and greater ownership in, domestic companies by foreigners, and (2) completely opened financial markets where even hostile takeovers are permitted. • The government had lowered the capital requirements for financial institutions setting up brokerage houses in South Korea from 300 billion won to 200 billion won. This was an effort to attract foreigners to invest in Korea. • To make business firms more transparent, the government required conglomerates to publish consolidated statements and reduce crosssubsidiary grantees. • In response to economic slump, chaebol reduced its workforce to make it more efficient. When IMF's help was sought in December 1997, many market observers thought the country would not recover. It was assumed that the government did

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(Merchandise, Billions of Dollars)

t5 (RHS) 14 .................................. 13~ 2H LS )(1 m ~ P ° ~ 12 11 10 9 8 7 ...................... 6 Balance

Source:

4 031 -1 -2 -3 -4 -5

IMF Fig. 5. internationalTrade.

not have the political will to introduce the necessary reforms. To utter surprise, South Korea's impressive economic turnaround took place by December 1998. Two years after the crisis, inflation and interest rates have fallen below precrisis levels. Foreign investment and trade surpluses are up (Fig. 5). Reserves have soared from its bottom of $20 billion in December 1997 to $65 billion in July 1999. Improvements in economic fundamentals and bargain hunting by (foreign) investors have pushed the stock market to rise above the pre-crisis level. By August 1999, the won has appreciated nearly 30% against the U.S. dollar (in nominal terms) since bottoming out in January 1998. In January 1999, two credit-rating agencies - Standard & Poor and Fitch IBCA - have raised South Korea's sovereign-debt rating to investment grade from the junk-bond category. The credit agencies pushed Korean debt into the junk-debt status when the debt crisis swept the country. South Korea began to pay off the IMF beginning in December 1998, and since mid-1999, the government has stopped borrowing the remainder of the funds. After a negative growth rate of 6% in 1998, the Korean economy is expected to grow 6.5% in 1999. How did the South Korean economy recover so quickly? It was due primarily to the newly elected President Kim Dae Jung in December 1997 who introduced and implemented the reforms from the outset. Chaebol and the labor unions who vehemently opposed those changes are surely but slowly yielding to President Jung's reform plans. As mentioned earlier, the

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(UoS. Dollar per Won, Nominal) 0.0014

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government took very bold and timely steps in restructuring the economy based on market principles and IMF-mandated prescriptions. 5 The economic growth has been partly fueled by deficit-financing which is expected to be about 5% to 6% of GDP in 1999. Record levels of foreign investment in 1998 and 1999, and higher exports have also aided in the economic recovery. Philippines

Philippines delinked peso from the U.S. dollar on July 11, 1997. As soon as this switch was announced, the peso fell 9.8% from 26.4 to the dollar to 29 per dollar. The earlier strength in the peso was the result of capital inflows - equity and physical investment and foreign remittances. The central bank, however, failed to recognize that the strong or at times overvalued peso was hurting exports. Oil accounted for 95% of overall imports. With earlier deregulation of the oil business, a weak peso and dollar-denominated oil price, the prices skyrocketed at the gas pumps. This had resulted in street protests. Also, the 'E1-Nino' phenomenon had hampered agricultural output in 1997. Unlike Thailand, the Philippines banking sector remained strong. Like Malaysia, the Philippines did not seek IMF's assistance. Had it not been for the natural calamities, the economy could have avoided a recession in 1998. Following the crisis, both inflation and interest rates shot up. Two years after the crisis, these economic variables have fallen to pre-crisis levels. As a result of lower imports and higher exports, the Philippines is having a trade surplus since mid-1998, (Fig. 7).

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The economy continued to benefit from more than $6 billion in annual remittances from Philippinos abroad. Foreign reserves rose to $14 billion in August 1999, an all-time high. The peso has merely increased 8% against the U.S. dollar (in nominal terms) since bottoming out in early 1998, (Fig. 8). Because exports play an important role in the economy, a weak peso is good because it is likely to make Philippino goods more competitive. The economy is expected to grow 2.2% in 1999. (U.S. Dollar per Peso, N o m i n a l ) 0.045

0.04 0.035 0.03 0.025 0.02

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1997

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Fig. 8. Philippines Peso.

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The Philippino economy has held up relatively well in the face of the regional economic crisis. The economic recovery is dependent on weather, exports and remittances from Philippinos working overseas. Indonesia

On July 8, 1997 the Jakarta stock index was at an all-time high of 740 reflecting Indonesia's sound economic fundamentals. The Thai's financial problem started to affect the Indonesia's rupiah. The central bank responded by raising the interest rate. The overnight loan rate was 20% and 49% for small banks. There was a flight out of equities. The stock market dropped and so did the value of rupiah precipitously. The rupiah was allowed to float on August 14, 1997. The central bank governor Djiwandono pursued 'moral suasion'. He invited and asked foreign and local bankers not to listen to rumors. When currency traders were 'short-selling', the central bank spent U.S.$500 million to defend the rupiah in vain. On September 3, 1997 the government announced a plan to respond to the crisis. It called for revising the budget, postponing spending on some capital projects, raising taxes on luxury import items, liquidate insolvent banks and increase foreign ownership. These announcements had a mild but temporary effect on the stock market. The rupiah declined continually. The fall in the value of the rupiah had made many unhedged loans much too expensive to repay. Lack of transparency in corporate financial affairs was compounding the problem. Corporate debt was estimated to be $70 billion in 1997. Bad loans were estimated to be over 70% of total loans. On October 8, 1997 Indonesia approached IMF for assistance. A $43 billion rescue plan was prepared for Indonesia. Indonesia rejected IMF's austerity measures of raising taxes and reducing expenditures (including slashing subsidies on staples). The people lost confidence in then President Suharto's ability to handle the crisis and the economy. The lack of action pushed the rupiah to fall to as low as 11000 to the dollar. Investors were selling rupiah to buy U.S. dollars at any price. Suharto's dismissal of key high-ranking central banks officials did not help in restoring confidence among the investors. A 50-point second letter of agreement was signed with the IMF in January 1998. It did not even restore the confidence on the rupiah. Prices of essentials were rising and the poor were the hardest hit. Social unrest became widespread. The pace of reform bogged down because of pending presidential election and Suharto's toying with the idea of currency-board. 6

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As expected, Suharto was elected president for a five seventh-year term on March 11, 1998. As before and much to IMF's chagrin, he appointed his friends and family members in the government. The government finally abandoned plans for a currency board in March 1998. In accordance with the IMF's plan, the government had agreed to divest 12 state-owned enterprises. The plywood cartel would be dismantled. Then cartel chairperson Bob Hasan stepped down. Fees levied on plywood exports had been removed. With foreign exchange reserves nearly depleted, some Indonesian traders have resorted to barter trade. For example, Australian beef were exchanged for Indonesian beer and cement. On April 4, 1998 the newly created Indonesian Bank Restructuring Agency (IBRA) shut down seven small banks and took control of seven big ones. Some of these institutions were partly owned by friends and relatives of Suharto. This unprecedented move was applauded by observers who were led to believe that it may assist in restoring confidence that Indonesia is serious about banking reforms. The third pact between the IMF and the Indonesian government was signed on April 8, 1998. Both sides tried to narrow their differences. The IMF had agreed to ease its requirements. For example, Indonesia would be able to have a budget deficit of more than 1% in the light of worse-than-expected economic conditions. (Earlier, the IMF mandated that the limit not exceed 1%). Subsidies for food and energy would be allowed if suffering among the poor continues. The $43 billion rescue package called for the termination of government funding for an airport development project, dismantling of plywood monopoly benefitting the President Suharto's associates, ending subsidies for a national car project owned by his son Tommy. The continued economic turmoil, social unrest and political chaos led to the resignation of ex-President Suharto on May 21, 1998. President B. J. Habibe who became the new interim head was faced with a colossal task of rebuilding a devastated economy. At the outset, he urged the IMF to renegotiate a suspended $43 billion bailout, and foreigners to invest in Indonesia. Recognizing that its strict fiscal, monetary and restructuring policies have partly led to the social fallout, the IMF began to waver on its policies. The policy allowed the continuity of subsidy on food, eased interest-rate and exchange-rate targets. The IMF also resumed disbursements of funds. In early 1999, Indonesia also passed an antimonopoly law stamping out monopolies, cartels and other practices. Under IMF pressure, cartels in the paper, cement and plywood industries as well as the monopoly that controlled imports of basic foodstuffs were dismantled.

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Progress on the banking sector reform and corporate debt restructuring

In the first half of 1998, as many as 23 failed banks were shut down, and the Indonesian Bank Restructuring Agency had 54 institutions under its care. As part of the IMF bailout package, the government moved to nationalize much of its ravaged banking system in August 1998. After initial reluctance and delay, the government closed thirty eight banks, took over seven, and agreed to bailout more than nine in March 1999. The banking sector had been hard hit by high interest rates, huge non-performing loans and a big drop in the value of its currency. The mixed signals and inconsistency in its implementation were driven by politics rather than economics. The IMF and WB which had publicly criticized the delay earlier, released additional funds earmarked under the bailout package. Under the terms of the bailout, the government would lend 80% of the money needed to raise capital to at least 4% of its bank's risk-adjusted assets, provided the bank owners come up with the rest in cash. According to Standard & Poors Rating Services, the bank bailout program is expected to cost $87 billion or 82% of the country's annual GDP, making it among the world's costliest banking crises in the last three decades. More than 170 Indonesian companies with a total debt of $22 billion, have entered into debt negotiations under the Jakarta Initiative, sponsored by the World Bank in May 1999. Western bankers have recognized the need to compromise after nearly two years of political and economic crisis. Many lenders fear that the country has fallen in a debt trap. Like other heavily indebted developing countries, a concern has surfaced whether Indonesia will be able to revitalize the economy without debt relief. In this context, the IMF and WB have ruled out any debt forgiveness for Indonesia. Due to a collapse in economic activity, political uncertainty and social unrest, the Indonesian economy contracted 15% in 1998. Following the crisis, inflation and interest rates shot up significantly which have fallen to nearly precrisis levels two years later. The trade surpluses have grown, largely due to a reduction in imports, (Fig. 9). Foreign reserves have risen from as low as $12 billion in February 1998 to $16 billion in August 1999. Two years after the crisis, the stock market was 25% below its pre-crisis level. Before the crisis, 2439 Indonesian rupiah was exchanged for US$1.00. The rupiah depreciated steeply and then recovered. In September 1999, a U.S. dollar could buy 7692 rupiah. In other words, the rupiah-dollar exchange rate was still 96% below its pre-crisis level, (Fig. 10). The economy is expected to be in recession for the second consecutive year in 1999.

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To sum up, Indonesia's financial crisis has been the worst in the region. The problem has been compounded by the government's reluctance to introduce and implement the much-needed reforms expeditiously. Social unrest and political uncertainty - the fall of Suharto regime, the subsequent formation of President Habibe's new interim government, the June 1999 parliamentary

(Rupiah per U.S. Dollar, Nominal) 0.0005 0.0004 0.0003 0.0002 0.0001

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Fig. 10. Indonesian Rupiah.

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elections, referendum for East Timor's independence, and the election of the new President Abdurrahman Wahid - have certainly slowed the recovery process. Due to lack of commitment in implementing IMF policies, the disbursement of aid was sporadic. Corruption continued to flourish even under the interim government which sapped the vitality of the economy. 7 The road to future recovery will depend whether the new President Abdulrahman Wahid will have the mandate, and the boldness to expedite the implementation of the stipulated reforms. The banking sector needs to be revitalized. The government and corporate debts have to be rescheduled or restructured and consolidated with greater supervision. Corruption should be checked by downsizing government and by making the economy more market-based. Transparency and accountability have to be introduced.

4. CONCLUSION Before the crisis, the Asian Five had a hard-working, well-educated and welltrained labor force, entrepreneurial spirit, small public debt and enjoyed robust economic growth. However, crony capitalism, poor governance, corruption, mismanaged exchange rate policy, regulated economy, laxed banking rules, weak domestic institutions in a globalized financial market, and lack of competition, or in broad terms, deviation from market-principles, led to the financial crisis. Clearly, the solutions in resolving the crisis lie in addressing the causes of the crisis. These former Asian tigers are now on the path to economic recovery. The speed and extent of recovery have taken even optimists by surprise. Except Indonesia, the other four countries will be out of recession in 1999. The rate of economic recovery among the Asian Five has been uneven. Between 1998 and 1999, foreign direct investment has been increasing in South Korea, Thailand and the Philippines but falling in Malaysia and remaining negative in Indonesia. The South Korean economy has shown a spectacular recovery because the new head of state was very bold in implementing the IMFmandated and market reforms as quickly as possible. The task is not over as yet. Much depends on whether the chaebol and labor unions will allow the market forces to prevail in the economy. Thailand, under the leadership of Premier Chuan Leekpai, had also made a reasonable progress. Banking sector reform and corporate debt restructuring remain incomplete. A healthy banking system is essential before these institutions can start pumping money to finance economic activities. 8 The Indonesian economy appears to have bottomed out. The IMF-mandated reforms are being implemented very slowly. The delay in

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implementing the reforms has increased the economic and social costs. The course of the Indonesian economy in future will largely depend whether President Abdurrahman Wahid will proceed with these IMF-mandated and market-reforms boldly and expeditiously. The Malaysian economy has also rebounded very well. Apparently, Premier Mahathir's self-devised policies including capital controls are producing positive results. However, the longer these controls remain in place, the greater the likelihood of distorted exchangerate and interest-rate levels leading to an inefficient use of capital. The Asian Development Bank, IMF, WB and other donor countries had been playing an important role in the economic recovery process. Recognizing the mistakes, the IMF and WB have adjusted their policies accordingly at different times, to ensure that their policies do not become too painful. To avoid such contagion in future, the IMF has established the Contingent Credit Line for qualified member countries in 1999. It is essential for the international community to evolve some safeguards to ensure that investors do not stampede out of emerging economies on rumors of a crisis.9 The institutions are either not developed or sophisticated in emerging markets when compared to the developed countries to deal with the instantaneous (out)flow of huge amounts of (short-term) capital. Where reforms come slowly, crisis can help. It is true in several of these crisis countries. The sooner the market and IMF-mandated reforms are being implemented, the faster has been the economic growth.

NOTES 1. The Wall Street Journal, March 16, 1998, p. A18. 2. Far Eastern Economic Review, March 26, 1998, p. 12.

3. When IMF's initial stringent budget constraints were implemented, it created social unrest. With taxes raised and subsidies withdrawn, the poorest had been hard hit. Unemployment shot up. (In 1998, the World Bank stepped in with $300 million to assist those hardest hit). 4. The controls which were narrow in scope, were imposed a year after the crisis took place. The objective was to discourage short-term portfolio investors to gain from its trading, and for offshore hedge funds to exert downward pressure on the ringgit. The ban on remitting the proceeds of share sales imposed in September 1998 was replaced by a graduated exit tax later in February 1999. After September 1, 1999, money that was in the country for at least a year could be repatriated tax free. Critics argue that because the controls were imposed belatedly, it had minor effects on the economy. 5. Daewoo - the second largest chaebol deserves illustration. It epitomized the best and worst of the Korean economy. Because of their close ties to government and access to capital, the conglomerates had a clear incentive to expand imprudently causing moral hazard. Daewoo piled up a corporate debt of $47 billion, more than the national foreign debt of Poland or Malaysia. On August 16, 1999 creditors of Daewoo group approved

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a restructuring plan that shrinks the failing conglomerate from 25 affiliated companies down to six automobile-related units. In sum, the Kim government has made it clear that there would be no more state-directed financing to help chaebol expand into strategic industries. Also, the government would not provide guarantees to support their illconceived and over-ambitious expansion plans. Under his tenure, he is allowing market forces alone to allocate resources, deregulate and open the Korean economy fully to outside participation. 6. In order to put a quick fix to the rupiah, then President Suharto on February 9, 1998 expressed interest in favor of a 'currency board' (pegging the rupiah between 5500 to 6000 to one U.S. dollar). IMF disapproved of it. Critics argued that by having a currency board, he was not serious about addressing the economic fundamentals of the economy. That is, critics viewed that by adopting a currency board, then President Suharto would forgo the much-needed structural, banking, legal and monetary reforms in future. President Clinton even telephoned him to accept IMF's plan. 7. The IMF suspended disbursements early in 1999 after a company linked to Mr. Habibe's Golkar party siphoned $70.5 million out of recently nationalized PT Bank Bali. 8. The economic recovery in the Asian Five has been partly driven by increases in budget-deficits. In the event, government's stimulus spending slows, the consumers and businesses will face difficulty in obtaining credit from a weak banking sector. 9. In an article written by Premier Mahathir and published in the February 11, 1999 issue of the Far Eastern Economic Review (p. 31 ), he has indicated that capital controls will not be lifted until the global community devises a new financial regime that stops speculative activities of currency trader's.

REFERENCES Duca, J. et.al. (1998). What does the Asian crisis mean for the U.S. economy? Federal Reserve Bank of Dallas, (March-April), 1-6. Far Eastern Economic Review, various issues. Goldstein, M. (1998). The Asian financial crisis: causes, cures, and systematic implications, Policy Analyses in International EconomicsNo. 55 Washington:Institute for International Economics. Greenwood, J. (1997). The lessons of Asia's currency crisis. The Wall Street Journal, October 7, A22. Hunter, W. C, et.al. (Eds) (1999). The Asian Financial Crisis: Origins, Implications and Solutions. Boston: Kluwer Academic Publishers. International Monetary Fund (1997). World Economic Outlook: Interim Assessment, December, Washington,D.C. Krugman, P. (1994). The myth of Asia's miracle. Foreign Affairs, November/December,62-78. Lane, T. (1999). The Asian financial crisis: What have we learned? Finance and Development, IMF, September, 44-47. Mahathir, M. (1999). Malaysia: Bouncingback. Far Eastern Economic Review, February 11, 31.

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Malpass, D. (1998). The road back from devaluation. The Wall Street Journal, January 14, A I8. Malpass, D. (1997). Floating into monetary trouble. The Wall Street Journal, July 23, A 18. Ranson, D. (1998). Inflation steals the benefits of devaluation. The Wall Street Journal, April 28, A18. The Economist, various issues.

EAST ASIAN CRISES AND GLOBAL CAPITAL FLOWS: CAUSE OR EFFECT... ? Christopher Lingle and Reuben Mondejar EXPLORING THE CAUSE AND NATURE OF THE CRISES looking for culprits to blame for the economic crises that swept through much of Southeast and East Asia beginning in July 1997, one of the usual suspects is the putative instability of capital markets. An alternative interpretation is that capital flows were only the messenger of bad tidings about the unsustainable nature of the growth experienced by emerging economies in the region. Acceptance of this latter view would mean that the growing demands for capital controls are misguided and perhaps counter-productive in restoring long-term stability to the region. The proposition explored here is that crises that afflict East Asian economies are rooted in the nature of political and corporate governance in the region. While this proposition points to a simple truth, resolution of the problems requires fundamental changes that will difficult to implement. This is because the financial and currency crises are an outcome of deeply-rooted institutions that reflect cultural conditions peculiar to each country. In turn, there can be little hope for speedy implementation of the fundamental changes. Indeed, the choice may be made not to effect change that would be too threatening to the political status quo. Consequently, restoration of stability to the region's economies will not come quickly while recovery may be many years off and In

Asian Financial Crisis, Volume 1, pages 149-173. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0686-6

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will result in a much lower growth trajectory than experienced during their 'miracle' phases. In essence, the recent turbulence in regional markets sharply contradicts the World Bank's 1993 report on East Asia's 'miracle' economies suggesting that their governments "got the basics right." If economic and political fundamentals had indeed been sound in the region, it is unlikely that the discussion of the region would be focusing upon crises. What began as a currency crisis in Thailand spread to other countries where financial crises have sparked recessionary economic conditions (Goldstein, 1998). The thesis offered here is based upon developments in what is known as New Institutional Economics (North, 1990; Alston, et al., 1996) as a means to understand growth and change as well as economic and social interactions. Institutions are systems of rules, conventions, laws or customs that serve as enabling mechanisms discovered through the process of human interaction. Such arrangements emerge and endure inasmuch as they reinforce stability within a community or facilitate change by reducing uncertainty. The rule structure of institutions provides an aspect of predictability in the course of social interplay. This predictability arises from the incentive structures embodied in the institutions that guide individual choices and shape the social impacts of these decisions. This all relates to economics since markets both depend upon and set the stage for the emergence of a contract culture and commercial morality. In turn, institutional frameworks will evolve to reinforce and reward or punish actions in reference to the agreements and the legal institutions that support them. Cultural change and economic growth reflect the speed of learning expressed through the learning process. Entrepreneurial action is the search and application of new knowledge that occurs when there are adequate payoffs from the expense of their quests. As such, institutional arrangements based upon openness and that encourage competition will offer greater opportunities for entrepreneurial innovation. In contrast, the presence and enforcement of monopoly imposed by government mandate will retard learning and put a brake on economic growth. Consequently, a strong case can be made for the linkage between economic liberty, as seen in institutional arrangements that promote free markets, and high growth. Informal institutions of shared beliefs, social norms, moral codes or cultural conditioning may reflect ethnicity or some other common characteristic. An informal arrangement that drives market development as well as being the outcome of market interactions is trust. At the micro level, the development of markets is limited by extent to which trust becomes ingrained in commercial relations. While elements of trust must become implicit at the macro and global

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level, large projects involving a more complex set of parties will require an institutional framework for the non-arbitrary settlement of contract disputes. As market exchange expands, group or ethnic identity becomes less important as the basis for reliable terms of exchange. For most, it will be counter-intuitive that the impersonal nature of markets actually encourages a higher level of trust to emerge. By contrast, institutional arrangements that encourage collective identity will weaken the sense of trust, especially among outsiders. In the end, individualist-based institutions will encourage more equitable treatment of strangers in order to allow for expansion of market exchange. Most governments in East Asia neglected the necessary infrastructural development for their modernization. While there were some steps to provide some elements of physical infrastructure (transportation, communications, educational facilities), intangible infrastructure expenditures and human capital investments were too often neglected. What is lacking is the institutional infrastructure where these countries could more readily mesh into a global market that demands increasing transparency as well as the harmonization of policies, laws and business practices (Lingle, 1998). The presumed successes of an 'Asian model' provided cover for the dysfunctional democracy of one-party or one-family regimes where electoral success was seldom a function of true endorsement by the masses. Too often, political longevity reflected a grip on power based upon either the carrot of cronyism or wielding the stick of fear and repression. More benign methods involved co-opting key elements of civil society through trade unions dominated by supporters of the regime or filling key university posts with sycophants or concocting laws designed to tame the media. Authoritarianism and Economic Growth: A Riddle Unraveled

One casualty of these crises is likely to be the myth that interventionist or authoritarian governments can effectively shepherd economic development. Until recently, advocates of 'Asian values' insisted that the rapid growth in the region was evidence of a superior political system that was responsible for their undisputed economic successes (Mahbubani, 1995). Another related notion was fatally damaged by the regional turmoil that began with the devaluation of the Thai baht in 1997. In the future, suggestions that political connections can inoculate investments against the vagaries of the market will have little credibility. Anyone wishing to stake claims for the salubrious effect of authoritarianism for economic growth will find it difficult to explain

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Indonesia's economic collapse. Likewise, it should be clear that efficient markets eventually punish despotism. It is contestable whether one can speak about a single 'Asian model' behind the earlier meteoric rise of East Asia's economies. Nonetheless, a common thread in the political culture in these diverse countries can be identified that offers insights into their recent precipitous demise. More specifically, the economic and political institutions apparent throughout the region are ill suited for the effective responses required by the demanding climate of the global economy. While the dominant political culture that guided economic and political structures suited the specific agenda of a given ruling party or regime, they also reflected an underlying conservatism inherent to local traditions and culture. It is difficult to offer a simple categorization about East Asia given the wide differences in the national cultures, languages, and historical circumstances. While admittedly this task requires generalizing the ungeneralizable, there is a commonality in the political arrangements in most of East Asia. This is that politics reflect a deeply rooted collectivist approach to governance. As such, the interests of the greater community, mostly as interpreted by some elite, are placed above individual rights and freedoms. In turn, expressions of individualism are deterred by such admonitions as "the exposed nail is hammered down." The sense of the dominance of collective is seen in assertions that Asian governments and regional institutions operate on a principle of consensus building and their strong desire to seek harmony. At the same time, success in life or commerce depended upon personal and political connections. These political and economic arrangements actually have a venerable history and may have served noble purposes in the past. Like institutions in other parts of the world, they emerged from the process of human interaction resulting from local conditions that were appropriate for their times. The institutions that allowed communities to survive and then thrive were kept while others would eventually be discarded. Unfortunately, the current institutional arrangements are in conflict with the requirements of global markets that function best in presence of individualistbased institutions operating within conditions of greater corporate and political openness. In an advanced market context, reliance upon personal relationships tends to limit the extent of economic exchange and opportunities. As complexities in economic conditions grow, it also becomes more difficult for government policy makers to pick 'winners' or choose the 'right' policies. In a modern political context, dependence upon governmental connections invites endemic corruption and may allow for extensive nepotism. At the same

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time, authoritarian regimes attempt to justify repression on the basis of enforcing cultural traditions of harmony and respect for authority. While East Asia has no monopoly on corruption, surveys of business leaders involved in global commerce by Transparency International indicate that their impressions are that some of the most corrupt regimes are in the region. While these institutional arrangements might have worked in the past, they are likely to fail to serve well in the future. This is because the most demanding component of the ongoing process of globalizing markets is the free and generally unfettered international capital flows. Unfortunately, the political culture in most of East Asia has militated against the development of domestic capital markets that might have allowed their economies to weather competitive storms that have washed over the region. Most governments purposely sought to control credit allocation. In tum, there were restraints on the emergence of free and open capital markets because it suited the domestic political agenda. Financial markets in most of the region were underdeveloped, inefficient and weak in that the visible hand of government replaced the invisible hand of market forces. Consequently, there was little disclosure and almost no scrutiny of institutions that were under the protection of the ruling governments. In turn, the real cost of non-economic transactions or unsound loans could be more readily concealed. There were several operational consequences of East Asia's underdeveloped domestic financial markets. First, much of the internal financing of commercial and development project was channeled through the domestic banking system. Second, there was greater dependency upon foreign capital to provide liquidity to the domestic banking system. Government-directed investment sent illusory signals to domestic financial institutions that the projects involved low-risk or no-risk commitments of capital since they would bear the imprimatur of ranking officials. A heavy reliance upon bank lending instead of capital markets is problematic since bank managers or directors can be more easily swayed by political pressure. In contrast, large numbers of independent private investors in capital markets demand greater access to information and require greater accountability before offering up funds. In essence, financial markets in most of East Asia were politicized so that commercial risks were ignored on the basis of promised protection from political connections. This may have worked while growth rates were high over past decades, but it is now painfully clear that political connections cannot protect investors from downside risk. At the same time, countries like Japan, Korea and Taiwan continued to apply outdated restrictions on foreign direct investment. (Others like Singapore welcomed manufacturing finns but limited the activities of foreign banks.)

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Borrowing from abroad supplanted the participation of foreign companies with greater international experience that could offer balance sheets that made sense to the rest of the world. These outsiders could also have injected a bit of competitiveness lacking in their coddled domestic economies. It could be argued that cause and effect is blurred here. Perhaps capital markets in these economies were underdeveloped because of the low levels of their overall development. Yet it can hardly be claimed that neither Japan nor Korea were unable to open up and modernize their markets. As it is Taiwan's total market capitalization, the largest in Asia, is only about $178 billion compared to America's (presumably overstated?) market capitalization of $12 trillion. Most other countries in Asia can barely match the value of a largish company listed on the NYSE. Liberalizing East Asia's Financial Markets: Too Much Too S o o n . . . ?

In the aftermath of the financial deluge sweeping across East Asia and other emerging or transition economies, the search for villains and victims has ignored much of this evidence. Indeed, a variety of longstanding critics of globalization insist that liberalization went too far, too fast (Greider, 1998; Rodrik, 1998). A refrain that has gained momentum is that limits on capital flows be implemented and overseen by international watchdogs. It is unlikely that the end of the Asian 'miracle' was the result of overzealous economic liberalization and deregulation (Rodrik, 1997). Unfortunately, this interpretation has a wide following that may lead to abatement in the process of financial deregulation. Where this message is heeded, markets can be expected to slow down eventually, inviting deepening recession. Following the anti-foreigner rhetoric of Prime Minister Mahathir, Malaysia was first out of the blocks. This decision was apparently spurred on by suggestions of the advantages of capital controls offered by Paul Krngman who later issued an apologetic plea that his proposal should only be implemented under extreme limitations (Krugman, 1998). Limitations that are unlikely to be imposed in an autocratic, single-party state like Malaysia. Many leaders of emerging economies have no wish to shake up the status quo, and there will be an increasing clamor for more regulation of capital markets, especially to restrain short term flows. However, further liberalization of capital markets can yield benefits for them if they take steps to strengthen their banking systems by enhancing transparency and competitiveness. These reforms would make capital flows less erratic. By encouraging more efficient use of capital, growth prospects would likely improve.

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It is true that the currency and financial crises in Thailand, South Korea and Indonesia resulted from a sharp reversal in capital flows that poured in during the early 1990s. But the stampede was not the result of rapid financial liberalization. Nor was it the fault of short-term capital flows, per se. Shortterm commitments of capital are compatible with long-term growth as long as there is a balance between inflows and outflows. Problems arise only when there is a mass exodus and that usually occurs only when there is a loss of confidence in the overall system. Apparently, East Asia's economies suffered from just such a crisis of confidence arising from government policies obstructing market adjustments and limiting competition while banks with nonand under-performing loans were kept in business. Economic And Political Risks In East Asian Emerging Markets

Conventional wisdom often declares that emerging markets, especially those in East and Southeast Asia prior to the emergence of the crises, are an investment play that should not to be missed. This view is not surprising in light of the reported high rates of economic growth in East Asia. The five fastest growing nations in the world in 1996 were in East Asian (Vietnam, China, Malaysia, Singapore and Thailand). From 1990, China grew over 135%, Indonesia 124%, and Singapore experienced 99.8% growth. In the same period Japan grew only 26.8%, its worst period since the early 1950s. Eight of the top ten nations in growth since 1990 were in East Asia (World Bank, 1994). Singapore moved from 18th to 4th in per capita GDP since 1990. That meant it overtook its former colonial master (Great Britain) and the U.S. in this crude measure of standard of living. If it were able to continue on its present course, it would have overtaken Switzerland and Japan by around 2003 to become the world's wealthiest nation. In early 1997, South Korea was awarded membership in the exclusive industrialized club of the OECD. Unfortunately, many of these statistics now look quite hollow. However, the turmoil in East Asian currency and stock markets during 1998 indicate that considerably more caution should have been exercised before international funds were directed there. In all emerging economy plays, prudent investors should look closely into combined economic and political risks in order to avoid being involved in what might turn out to be a crapshoot. Interestingly, even with the recent well-publicized setbacks, it appears that the greatest fear among many potential investors and business interests was missing out on important opportunities in East Asia. This fear seems to be pushing up many of the region's stock market despite few signs of

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improvements in the real side of the local economies and little change in their supporting institutions of governance. It is not surprising that emerging markets exhibit relatively high political risks. This type of risk of the disruption of commercial activity arises out of internal conflict like civil wars or power struggles. However, there are also relatively high risks stemming from actions or policies taken by governments that somehow disrupt or destabilize economic activity. These include policies leading to inflation or hyperinflation, increasing budget deficits, or increasing the likelihood of fraud or default on international loans by sovereign governments. Then there are the run-of-the-mill risks that any business venture may simply fail due to lack of commercial viability. Costs and Benefits of Authoritarianism and Asian Values The authoritarian nature of regimes both raises and lowers political risks. There is a misleading impression of the contribution of authoritarianism to stability since the various one-party or one-family regimes have been in power long enough to perfect political repression. Such stability is likely to be illusory and can only be counted on for the short run. If despots are too severe, they invite coup d'etats or assassination. If they are not strong enough, then the political opposition may sweep them out of office. In all events, the mortality of despots (benevolent or otherwise) ensures that political risks will eventually rise due to uncertainty over the transition of power as evident in China, Indonesia, and Singapore. Dynastic succession or one-party regimes are not an uncommon feature in East Asian politics that is often mistakenly associated with stability. Like other forms of nepotism, intra-family political succession is consistent with the culturally-imbedded commitment to family that is said to define social relations in much of Asia. Of course the most painful example of this is in Indonesia. In terms of the concerns of international investors, both reflect forms of corruption that arise from leadership whose authority is seldom challenged. Where nepotism is prevalent, there are also a variety of costs to the community that should be considered. Political costs arise in the form of losses of political rights. Nepotism also invites economic inefficiency from the diversion of resources towards a single family or cronies in a dominant political party. By interfering with market transactions, nepotism imposes costs upon the greater community and upon potential investors by reducing returns on gross investment. Before acquiring political power, the offspring of rulers often develop their own power base, perhaps as grants of national monopolies over certain

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economic sectors. According to a rating by Transparency International in 1995, Indonesia was considered to then have the world's most corrupt regime. Indeed, 6 of the 10 worst rating were Asian countries. A similar rating for 1996 revealed that Pakistan and Nigeria replaced Indonesia and China as the countries most affected by corruption while 5 of the 10 countries with the worst rating were in Asia (in order, Pakistan, Bangladesh, China, India, and Indonesia). Nepotism and special privileges will distort these markets for insiders as well as for outsiders. Many Asian countries have leaders who seek to impose secular dynasties upon their citizens. Unilateral transfer of political control to family members is often found where there were anti-colonial movements are led by charismatic autocrats. An ill-educated citizenry often faces repression of dissent so Asian autocrats can decide in the best interest of their family regardless of the impact on the country or foreign investments. Another problem with authoritarian regimes in the region is that they interfere with the level of transparency in economic dealings demanded by responsible international investors. For example, in addition to tight controls on domestic news reporting, China recently announced its intention to restrict the flow of financial and commercial information from international news services. While the limits placed upon political debate in Singapore are well known, the ruling party has gone to great lengths to punish individuals for leaking economic data. In 1994, several journalists, a private investment adviser, and a civil servant were prosecuted for publishing quarterly GDP estimates before their official release. This sort of obsessive control of data thwarts the independent corroboration required by long-term investors. Similarly, repression of a free press chokes off an independent source of information about events in these countries that might be relevant to foreign investors.

East Asian Infrastructural Development Requires Long Term International Capital There will be numerous opportunities to invest in East Asia over the next decade. In order to facilitate expanding markets, the countries in the region must undertake massive infrastructural development. A World Bank study suggests a need for a total of $1.5 trillion in expenditures with $600 billion for improving port facilities, roads and other transportation systems. About $500 billion will be spent for expanded power capacity, $250 billion on telecommunication, and about $150 billion for water and sanitation facilities. Prior to the crisis, this would constitute on average expenditures of about 7% of

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average GDP for the region's economies. It would require a substantial increase from 4% that was spent in 1994. Unfortunately, the underdeveloped capital markets of the emerging economies of East Asia are likely to impose limits upon their capacity to grow due to a shortage of long-term capital lending. Despite high rates of household savings, the region's capital markets remain inefficient and far more underdeveloped than their trading systems. Emerging Asia-Pacific economies must develop a more efficient means to channel domestic savings and to attract international capital to provide funding for infrastructural investments in telecommunications as well as power and transport systems. Several problems loom large in the provision of domestic or even regional funds for development projects in East Asia. On one hand, family-owned companies that tend to be narrowly concentrated on trade or property development hold a large proportion of the business assets in the region. On the other hand, widespread government ownership requires that a substantial amount of funding for business expansion will involve the issuance of public debt. Eventually, widespread privatization will allow capital to be raised through the sale of stocks and equities. However, firms based in East Asia will have to shed their preference for secrecy. Potential investors from outside the region will demand greater transparency before lending. Similarly, international investors who wish to participate in East Asia will require increased clarity of risk/return assessments as international transactions extend beyond the range of friends or family contacts. In sum, despite having domestic saving rates of 30% and higher, East Asian economies do not mobilize their capital efficiently. Historical mistrust of financial institutions leads to high demands for liquidity by savers. In turn, the high stock of savings has not been transformed effectively into long-term investment. There are some estimates that the Chinese government has squandered as much as 40% of domestic savings by making 'loans' to the stateowned enterprises. Governments and private borrowers in East Asia must develop more transparent and legally reliable investment frameworks. These include improved corporate governance, better clearing and payment systems, acceptable accounting standards, and modernized credit-rating systems. Risks in Equity Purchases in East Asian Emerging Markets

Problems associated with commitments of long-term capital investment also stem from the volatility of East Asia's emerging markets. This volatility undermines the security of international equity investment. Not unlike the experience of other emerging markets, the stock exchanges in East Asia

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represent a high-risk investment due to their high price volatility. The collapse of the Mexican peso in 1994 led to a simultaneous downturns of most emerging markets, with Latin American markets affected the most. Now, deep currency devaluations in Thailand, the Philippines, Indonesia, Malaysia, and South Korea have been matched by local stock market declines of as much as 50% over the first 18 months of the crises. Despite so many fingers being burned in similar high-risk emerging-market plays in the past, some of the same players found another bitter pill in Southeast Asian markets. In this instance, it was precipitated by the Thai government's refusal to take steps to ease the financial trauma induced by an abrupt abandonment of the baht's peg with the U.S. dollar in July 1997. As early as June 1996, the International Monetary Fund (IMF) advised Thailand to shift to a flexible exchange rate regime to avoid imminent economic problems. The Thai government blithely ignored this advice and risked further damage to its economy by defending the baht in the forward exchange market. This attempted defense failed, and Thailand's foreign exchange reserves fell dramatically as the baht lost about 40% of its value. Much of the rest of Southeast Asia experienced similar problems as ASEANs leaders proved themselves incapable of effective crisis management, both jointly and individually. Thailand and Malaysia imposed a variety of capital controls aimed at halting short selling by foreigners. Unfortunately, these measures irreparably harmed investor confidence and were soon scrapped. Nonetheless, many investment advisers continue to promote portfolio holdings in emerging markets since the stock markets in most of them have outperformed the stock markets in the more developed economies. This is all true, but it means that timing and composition of investments under highly volatile market conditions make for a very risky game. A given portfolio of stocks in emerging economies might fall by 20-50% and not recover for several years. There are numerous reasons behind the volatility of stock markets in East Asia's emerging economies. With their low capitalization, they are susceptible to quick shifts of 'hot capital'. These flows might be movements away from bad news (coup d'etats, drought, strikes, doubts about succession of leaders, inflation, or structural fiscal deficits) or towards good news (deregulation, privatization, reduction of trade barriers, or structural reforms). Most of these countries provide little reassurance in terms of minimizing political risk, the constancy of real interest rate or stable prices. There are also concerns about the imposition of controls over capital movements as well as the maintenance of overall economic freedoms. What can be expected is a vicious cycle where market volatility leads to a greater concentration of 'hot capital' that in turn induces greater volatility that frightens off more long-term investment.

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In light of these problems, it is almost certain that economic growth in the region will be slow to recover. On the one hand, successful financing of necessary public infrastructure may 'crowd out' other domestic investments by forcing up market rates of interest. On the other hand, if the infrastructural projects are not completed then the capacity of these economies to return to positive rates of growth will be severely limited.

Global Capital and Forces of Economic and Political Modernization Successful economic development in the future will depend upon a number of conditions that shape and define the so-called global economy. Perhaps the most important momentum behind the internationalization of economic activities arises from the high degree of capital mobility. The capacity of capital to migrate and reside more or less at will insures that the search for the gains from trade arising from comparative advantage is temporary, elusive, and increasingly contested. It will be increasingly important that countries develop greater flexibility and responsiveness in their economic and political institutions. Otherwise the automatic adjustment mechanisms that contribute to stability and aid growth will be obstructed. Countries wishing to become players in the global marketplace will have to face up to the implications of this simple observation. These observations might be heeded by countries in early stages of development that might wish more to pursue development through the promotion of export-oriented production or more advanced economies that seek to ease higher rates of growth to keep living standards high and unemployment low. Aspirants in the global marketplace that wish to remain competitive and enjoy success will be guided toward policy mixes and institutional arrangements that are flexible and responsive. Otherwise, commercial aspirants will find their market shares lost to competitors and national economies will experience an exodus of capital. In the future of a truly global economy, the institutions of every country will be affected by external shocks generated by repetitive waves of competition. Those that are not flexible will simply break down in face of these challenges. From the micro side, small and medium sized enterprises will be well placed with nimble responses to exploit niche opportunities. This will imply that this will work best in situations where there is extensive domestic competition among firms, including allowing foreign producers in to contest local markets. From the macroeconomic side, policies that are capital friendly combined with liberal trade regime will increase and enhance linkages with international markets that facilitate trade and capital flows.

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There are risks and challenges associated with such arrangements. Not least of these is the upsetting of traditional relationships that may lead to some political instability. However, the political stability associated with the cozy relationships between many Asian governments or politicians and commercial interests has proved to be a recipe for disaster. China: Asia's Next And Biggest B u b b l e . . . ?

After speculative bubbles burst in erstwhile economic powerhouses in Southeast Asia, the damage spread quickly to North Asia. This should not be surprising since many of the East Asian 'miracle' economies pursued similar paths for development. As suggested above, the systems of governance once acclaimed as the basis for rapid growth in East Asia can be seen as the source of their own economic undoing. Now that South Korea and Japan find themselves rattled by the chilling winds of economic reality, China's most recent growth spurt is also stumbling. Economic performance is trailing off and export growth is falling just as nearby Tiger economies with weakened currencies are hoping to export their way back to prosperity. Ironically, China may have contributed to its own misery and that of its neighbors. Following its competitive devaluation of the yuan by about one-third in 1994, the bitter truth is that China may have contributed to the devaluations that now plague much of East Asia. Unfortunately, economic advisers and many enterprise managers in China are too ill acquainted with markets to understand that competitive advantage is a moving target. Consequently, China's manufacturers are beginning to confront the realities of growing mountains of unsold inventory. Township and village enterprises (TVEs), a Chinese hybrid of collective ownership where operations follow limited market principles once served as an important contributor to economic growth. Now they are struggling under excess capacity and increasingly contested markets while they are starved of access to capital that continues to flow from state-run banks to state-owned enterprises (SOEs). Clearing the growing inventories may require another devaluation of the quasi-floating Chinese currency. However, it will be resisted since it will certainly put strains on the ability of Hong Kong to hold its peg against the U.S. dollar and add to the problems of repayment of China's debt burden. Perhaps the weakest link in China's continued economic progress is caused by the lack of transparency within its financial institutions. In keeping with the development approach in much of the rest of East Asia and its own authoritarian legacy, tight controls over capital markets result in a heavy reliance upon bank lending for industrial and commercial developments.

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Avoiding the openness demanded by private investors in bond markets, banks can be obliged to grant loans to meet political ends and so neglect appropriate risk assessment in their lending decisions. Like elsewhere in the region, banks provide a more supple and predictable source of funds. These funds may be for subsidies to support industry policy or to reward political cronies. Additionally, the Bank of China suffers from a complete lack of independence, and it has never carried out the oversight role of a modern central bank. Despite announcements of an intent to reduce subsidies or low interest loans to SOEs and to force them to sink or swim, there is no clear plan of action. In light of the regime's gradualist attitude towards economic transition, change will not come soon. Meanwhile, any attempt to clear up the non-performing loans held by the SOEs hangs like the sword of Damocles over the regime's head. At the beginning of Zhu Rongji's reform program of nearly 300,000 SOEs, roughly 75% were effectively bankrupt and kept going by 'loans' that were essentially grants from state banks. By their own admission, the ratio of bad loans to assets in China's banking is about 20-30% and growing. This figure is likely to mushroom dramatically once property prices and rentals begin to fall in response to the overbuilding in many of China's largest cities. Like in Southeast Asia, a property bubble is looming while infrastructural investments in South China, especially in the Pearl River Delta and Shanghai, provide enormous excess capacity. In turn, the cascading effect on Chinese stock markets and the rest of the economy has already been outlined in stark relief in the experiences of neighboring Southeast Asian economies. There is no easy way out to sort out the ongoing financial crisis. It would be bad enough if banks only had to find a way to unburden themselves from losses arising from lending to property developers and slumping sales by TVEs. However, suggestions to sever the financial lifelines to the SOEs are likely to fall on deaf ears due to the expected social and political costs. All of the solutions require substantial economic pain in the short run. If SOEs are forced to repay their debts they must privatize, restructure or liquidate. Each option requires massive cost cutting which unavoidably translates into drastic cuts in employment as well as reducing workers' benefits that often include cradle-to-grave services. Estimates of job losses range from 20-50 million workers that will be made redundant through downsizing. China's hybrid foreign exchange system will not protect it from the pressures of the economic forces that are disciplining countries with more solid fundamentals. Its growing current account deficit will require changes in the real economy or changes in the exchange rate. Governments around the world have suffered from believing that they can defeat market logic.

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As a first step, it should be made clear that international support for China and other emerging economies will depend upon consistent provision of transparent data in a timely manner. This would allow for more intensive evaluation of their economies and avoid the sort of underestimates of the rot found by the IMF in South Korea's banking sector. As outlined in the new accords, greater foreign competition in the banking systems and formation of an active, aggressive bond market would also provide more external scrutiny. In comparing China's current economic balance sheet to those in Southeast Asia prior to July, it looks like deja vu all over again. However, the result may be worse since China's bubble will burst in the face of over 1 billion people. Zhu Rongji: Helmsman of the Chinese Titanic... ?

As a rising star whose credentials and declarations indicate clear thinking on economic matter, Zhu Rongji's 'election' as China's prime minister is to be applauded. There is a clear consensus that he is a tough taskmaster who can restore discipline among the party faithful and act as an able helmsman for the economy. However, it should be remembered that even exceptional cult figures make little real difference when the tide flows against them. Many of Mao's positive achievements were tarnished by the failure to move the economy forward. Similarly, it is likely that Deng's worthy contributions may be seen as too little, too late. Indeed, Chinese authorities must undertake deep reform that goes far beyond fine-tuning or tinkering with economic policy. It remains to be seen whether Zhu will have the authority or the will to direct the necessary thoroughgoing economic restructuring. Pragmatism, the guiding principal for Chinese modernization, is headed straight into a minefield of immense proportions. Privatization is doomed to failure because the state-owned enterprises cannot be made profitable without shedding millions of workers. Meanwhile, the drying up of foreign capital will put a damper on growth. In all events, official growth rates are misleading that they do not match with other vital economic data such as energy consumption. In sum, the obstacles that Zhu will face are a set of realities defined by a highly competitive global capital market. As such, some basic contradictions of China's 'market socialism' may soon become fatal afflictions. After all, history shows that communist economies cannot reform, they eventually collapse. The bottom line for China's modernization is the privatization of the large number of loss-making SOEs. Political decisions to this end have already been taken. The plan is to scrap those that are loss making - more than h a l f - and

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reorganize the rest into large, highly diversified and profitable corporations along the lines of the Korean chaebol. In the process, the banking system will be transformed so that they are no longer merely agents for distributing government subsidies to cover SOE losses. After reform, the banks are to become profit-making financial institutions to stimulate Chinese growth with an efficient and modem banking system. At least this was the idea when the chaebol looked like something other than the industrial dinosaurs that they are proving to be. But which conditions must be met to make this a policy with any prospect for success? The Chinese capital market is effectively illiquid due to the massive subsidies offered to SOEs. Funding for the privatization program will have to rely on a variety of sources other than domestic savings. The main techniques are incoming foreign investment, a continuing and substantial trade surplus and international loans. These sources are drying up. Even the trade surplus policy does not look convincing after the rounds of devaluation in other export-oriented Asian economies. Every reasonable conclusion from these observations is then that the privatization program can not succeed, for lack of funds. Chinese economic policies will, in a worst case, face a large number of subsidy-demanding firms and half-reformed new corporations that do not generate the expected level of profits. To go on, it will require some more fundamental policy change in China than we have seen so far - or an aggressive devaluation of the renminbi that looks increasingly likely despite continuing claims to the contrary. If the economics of the project looks bad, the political outcomes might be worse. In many Chinese towns a sole SOE is the principal employer. Closing a number of these companies or moving parts of them to a regional center will result in a number of industrial 'unemployment islands'. Political unrest is likely to follow the surge of local unemployment. This is especially so, since China has no social insurance safety net in place to avoid such political reactions to policy changes outside of the employment-linked benefits from SOEs. Unlike peasant unrest, industrial unrest does not tend to stay local. It has always a capacity to be transformed into a national political issue. With 20-25% of the Chinese population affected by the planned privatization project, it difficult to see how deep political consequences can be avoided.

China and The Globalization of the Asian Economies Under Deng Xiaoping, China staked its future on its participation in a new international market order. The forces of the global economy can act as a tidal wave that can easily erase the remarkable gains achieved since the late 1970s.

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Evidence confirming this contention can be found in the financial crises affecting much of East and Southeast Asia beginning in the late 1990s. The institutional demands that shadow the new global investment patterns are not often observed or well understood. China is not in a strong position to accommodate these demands. China's economic growth depends upon foreign capital to carry out ambitious infrastructural development or to gain technical expertise. These activities require transparency in commercial operations and accountability for political choices that do not exist in the economic and governmental institutions in China, or elsewhere in the East Asian region. While the modern globalized capital market builds on centuries of historical development, some recent events have brought about fundamental and perhaps irrevocable changes in its operation. Competitive pressures for investment funds helped stimulate a market for footloose capital. These pressures prompted and were also aided by financial and technical innovations to facilitate movement. At the same time there were policy initiatives, like the deregulation of London's financial markets in 1985. Out of this sequence of events and circumstances, capital markets became both more liquid and more efficient. The efficiency is evident in an everwidening set of financial institutions and innovations in the offering of financial instruments like derivatives and other futures markets instruments. Risk-averse financial actors seek to compensate the inherent risks in the activity of lending money, by being well informed. Whatever the state of evolution of capital markets, they depend, in extremis, upon access to reliable and massive amounts of business-related information. With capital having global reach, efficient new information technologies have followed, making the continuing internationalization of capital markets possible. The endeavor to maximize international information flows had several important political effects. The most visible among these has been the stronger drive towards democratization as more countries turned democratic since the 1980s. A democratic community that reflects the influence of individualistbased institutions puts no (or few) restrictions on generation or spreading of information. Authoritarian or 'corporatist' regimes tend to impose greater restrictions as justified by some specified political concern such as social harmony or consensus. A conflict and competition among institutional arrangements will surface in the latter cases, indicating that democratic pressure can easily build up in countries taking active part in the process of globalization. In an increasingly globalized economy, comparative advantage will be based upon favorable institutional arrangements as much as input costs or resource availability.

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There are various problems with China's political development being put in line with these wider requirements for institutional change. The Tiananmen massacre in 1989 indicated that Chinese politics, under communist supervision, fails to meet the standards of the global community or can contribute to the constantly ongoing institutional development demanded by globalization. Yet, China is basing decisive parts of its long-term financial policy on attracting large commitments of future foreign investments into its economy. This marks a deep conflict in its own internal policy, as well as an unresolved conflict between its rigid and slow-changing economy institutions that contrast sharply with the demands of advanced information markets arising out of the globalization process. China's institutional contradictions also arise from requirements of international investors for greater accountability and transparency and who also require a mechanism for settling contract disputes. All these conditions are influenced by the policy settings among economies throughout the world. Consequently, global capital markets inspire a competition among countries to offer the institutional basis that attracts capital. Countries like China, with a political structure that does not accommodate the demands of borderless capital, will not attract the amount of foreign investment needed for its development plans. Instead, it will suffer a net outflow as capital is attracted to better terms elsewhere. So China will be facing a number of internal contradictions so that changing personalities in leadership positions will be no more effective than rearranging deckchairs on the Titanic. Even if Zhu is able to get the economy right, China will face political pressures that may be overwhelming.

Japan's Big Bang Promises: Rhetoric or Reality... ? Former Prime Minister Ryutaro Hashimoto complained that currency devaluations in Southeast Asia were behind devaluation pressures that were forcing down the value of the yen against the dollar. Soon afterwards, Japan's Ministry of Finance (MOF) officials announced plans to minimize short-selling of the yen, including the screening of market details more closely to seek out 'irregular' transactions which might represent manipulation of market prices. Perhaps the promises to liberalize Japan's financial markets and open its economy to competition deflected the sort of criticism when leaders in Southeast Asian countries tried to blame others for their woes. Nonetheless, the excoriation made by Malaysian Prime Minister Mahathir against George Soros and other speculators was different only in tone, not in substance. With these

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attitudes firmly entrenched among Japan's hierarchy, it shows how difficult it is for its 'Big Bang' financial market deregulation to be fully implemented. Japan's model for modernizing its banking and financial sector was inspired by Margaret Thatcher's reform of the British securities industry in the late 1980s. Beginning in December 1997, Japanese banks and securities firms were able to jointly market investment trust funds. These are essentially mutual funds and are not yet widely used by individual investors. Most Japanese savers hold accounts in low-interest deposits in the postal savings system. While 140 trillion yen goes into securities, only about two percent of total invested assets go into investment trust funds. In April 1998, foreign currency exchange laws were liberalized, allowing any individual or business to make foreign currency transactions without prior approval from the Ministry of Finance. Prior to this change, such transactions could only be made to officially designated banks. Businesses can now negotiate for foreign exchange from Japanese or foreign banks or can make arrangements internally with their own finance departments. Most importantly, individuals are allowed to invest personal assets at higher rates overseas or in foreign currencies through foreign banks in Japan. Other deregulations include securities trades of more than 50 million yen that will allow securities firms to set their own commissions. It is expected that increased competition will lead to an improvement in service and lower trading costs offered by securities firms. If all goes well, it may breathe new life into Japan's sagging equities market. Modernization of corporate structures will allow new holding companies to be formed for the first time in the post-WWII period. New securities firms will not need to apply for government licensing, banks and securities companies will be able to enter each other's businesses without restrictions, and banks and securities firms will be allowed to sell insurance. The crises in the rest of the region require even more urgent action to avert widening problems in Japan. The slide of the Thai baht and subsequent assaults on the currencies of Indonesia and Malaysia prompted Japan's MOF to propose an Asia-based currency fund. This would have replaced the conventional tough austerity measures required by IMF interventions. Most affected countries in Southeast Asia responded favorably to these overtures, but Western governments and their respective banking community were negative. Japanese banks felt the pinch of the crisis affecting South Korea since they were holding about $20 billion of the $100 billion in short-term debt owed by Korean banks in 1998. In total, Japanese banks lent about $123 billion to various enterprises in Southeast Asia. The looming crises with their overseas exposure added to the woes of Japanese banks that were struggling to cope with

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$580 billion (76.7 trillion yen) in domestic loans that were bad or questionable. Despite serious problems threatening Japan's banking system since the beginning of the 1990s, supervisory authorities avoided taking strong remedial actions. Strikingly, the MOF did not require reporting on non-performing loans until 1993. In this regulatory setting, it is no surprise that there were neither requirements to liquidate collateral (property or stocks) held against the bad loans nor were there banks directed to increase their capital to offset losses. Japan's population is rapidly aging due largely to changing demographics and this is also driving reform. Japan has a fertility rate of 1.5 children per woman. That is well below replacement level and considerably lower than in the U.S. (2.1). According to trends, Japan's 'elderly dependency ratio' (proportion of the population aged 65 and over relative to the population aged 15 to 64) will mean that there will a decrease in the number of the work force relative to an increasing number of retirees. Such prospects have focused minds since it directly threatens their social and economic stability. These stark realities require that Japan's capital markets must become more efficient in order to resolve the persistent slump in its domestic economy. In light of the banking crises sweeping through East Asia, it will be important that capital-adequacy ratios be enforced. Banks with operations limited to domestic activities must meet a 4% ratio requirement within a year while banks with international operations must follow the 8% ratio required by the Bank for International Settlements. However, Japanese banks have used different benchmarks for those assets included as capital than their counterparts in other industrialized countries. After April, Japan's banks must reduce the proportion of their capital-adequacy ratio derived from unrealized gains on stock market holdings. There are signs of continued dithering in the enactment of these necessary reforms. However, containment of the crises sweeping East Asia makes Japan the final line of defense. As such, there is an increasing urgency for the rest of the world that Japan implement global financial standards and modernize procedures for corporate accounting and financial reporting.

Japan's Bleak Future Japan's economy accounts for two-thirds of Asia's economy and generates 15% of global economic output. Unfortunately, this powerhouse has experienced a decline in its GDP 0.7% in fiscal 1997 with a further decline of over 2% in 1998. By the end of the first quarter of 1999, the Japanese economy had

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experienced at least five consecutive quarters of economic decline with more bad news likely for the foreseeable future. Japan's role as linchpin in the global economy is in real danger of crumbling under the combined weight of its own looming domestic and foreign crises (Katz, 1998). While various policies have been announced to deal with Japan's long-suffering economy, there is little evidence that there will be the fundamental changes that will be necessary before Japan will experience a restoration of positive growth. A mountain of non-performing loans obstructs Japan's economic recovery. Until these bad loans are disposed of, the economy cannot be stabilized and without stabilization it cannot be revitalized. Along with establishing the political will to accept the bankruptcy of financial institutions, public money will be injected into solvent banks. The extent of Japan's banking problem and the associated numbers is staggering. Estimates of the value of non-performing or under-forming loans are between U.S.$500 billion to U.S.$1 trillion. The latest accord of October 1998 commits a vast amount of public funds, about 60 trillion yen. From this fund, 25 trillion yen will be made available for bank recapitalization, 18 trillion yen will be committed to nationalize weak banks with the remaining 17 trillion yen used for protection of depositors. A shaky alliance was formed when the small Liberal Party and a smaller Buddhist bloc joined with LDP in the upper house to enact a bill forming a 'financial resuscitation committee' that would be empowered to buy bad loans from failed or failing banks. There are three basic options in dealing with problem banks. The first would involve temporary state control through government purchase of common shares while a restructuring plan was implemented for eventual sale to a private buyer. A second option is for liquidation under bankruptcy laws. Finally, struggling institutions could be placed under control of bridge banks. Unfortunately, these proposals contain no silver bullet to solve Japan's problem and have set off a familiar cycle so often observed in response to impending policy announcements from Tokyo. Bullish market sentiment in anticipation of the package can turn rapidly bearish when the details are announced that send world markets soaring skyward one day and to plunge the next day as reality sets in. An important element driving market sentiments is voiced by the Democratic Party whose refusal to support the LDP plan reflects worries about lax controls over cash injections administered by the same old-boy network. Similarly, there is no clear timetable for the process or enough specifics to provide a sense of confidence in the package.

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There is also the question as to how far the liberalization of Japan's financial system will go. In particular, will foreign banks be allowed to take full control over any of the banks that might be temporarily under government control...? If this is not allowed, there will be a continuing lag in services and efficiency for Japan's domestic banks that are unaccustomed to competition. This situation borders on the tragic. Until the banking crisis is resolved, Japan will be doomed to a prolonged recession. No amount of additional Keynesian pump-priming or reflation will induce Japanese consumers to spend their way out of the current slump. The additional tax burden of the current proposal combined with increased job insecurity and shaky pension plans has frightened the Japanese away from being a country with a high propensity to save into a nation of currency hoarders. As policy leaders in Tokyo stumble in seeking their way, advice from foreign friends offers little clarity or consistency. In Washington, the Clinton administration offers advice based upon unreconstructed Keynesian nostrums. Proposals for pump-priming, reflation and temporary tax cuts offer little hope for a recovery in Japan's economic prospects. Japan's domestic problems include a slow-growth or no-growth recession since the late 1980s after the collapse of its 'bubble economy'. During this time, growth had to be supplied by the international sector that cannot continue to keep the rest of the economy afloat. In the early 1990s, while real estate and stock market values plummeted, the yen experienced a sharp appreciation that prompted production and jobs to move offshore. More recently, the imposition of a consumption tax in April 1996 caused a slump in retail sales. Meanwhile, consumer and business confidence is at an all time low over the failure of the government's attempts to revive the economy. In seeking to minimize domestic political resistance, the government is likely to put its hopes on an export-led growth strategy to revive its flagging economy. Unfortunately, regional financial turmoil will make it unlikely that trading partners in Southeast Asia will be able to continue absorbing 40% of Japan's exports. Changing realities of increased competition in the global economy will thwart any significant increase in Western demand. Like other countries that have tied their future to international trade, Japan's future will be molded by the constantly changing nature of the global economy. As waves of competition sweep the globe, they will spark new imperatives for domestic policies to be in synch with free and open market economies. In particular, the return of Japan as an important player in global capital markets will require an extensive deregulation of the banking industry. Japan's financial services sector is burdened by a ceaseless bad debt problem while half-heartedly approaching 'Big Bang' financial deregulation to remove

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anti-competitive practices. After years of being cosseted from foreign competition while serving the government's program of directed development, 'Big Bang' will require Japanese banks to respond to competitive conditions. They will have to measure performance in terms of return on equity instead of concentrating on maximizing asset size. To this end, Japan's banks will have to restructure their balance sheets to reduce non-performing loans through writeoffs or securitization. Japan's banking sector has extensive exposure to the rest of Asia and is enormous as creditor and equity investor. With an estimated loan exposure of about U.S.$300 billion, Japanese banks are the region's largest creditor with about one-third of these loans in Hong Kong and its increasingly precarious property market. Another US$24.3 billion is in Korea, which is an economic domino that fell in the wake of Asia's financial contagion. Compounding Japan's bad debt problem is the drastic fall in the market value of their Asian equity portfolios. Without these 'hidden' reserves to provide the financial cushion needed to absorb loan losses, domestic bank failures will inevitably rise. While some consolidation in Japan's financial sector is overdue, there is a real risk of system-wide implosion owing to government inertia and mismanagement. The Finance Ministry has still not addressed the pressing issue of reforming the mammoth postal-savings system, which accounts for as much as one-third of Japanese individuals' deposits. Regulators still have no legal responsibility to shut down unsalvageable banks as part of their mandate to take 'prompt, corrective action'. Leaving such discretion in the hands of the regulatory bureaucracy insures that resolution of these problems will not be easy or swift. The government's failed attempt to stave off the recent bankruptcy of Sanyo Securities through an arranged merger attests to the tenacity of the government in applying anachronistic remedies in the face of impending deregulation. Despite the conspicuous pattern of problems in the present, the vacillation for Keynesian fine-tuning does not bode well for the future. A demographic Damocles sword is hanging over their head. A misstep today will impose an increasing burden on a shrinking work force that will also find fewer job opportunities. Perhaps the greatest tragedy will be that young Japanese will choose to migrate to countries that offer better opportunities.

CONCLUSION As suggested, inhibitions of domestic capital markets in East Asia were consistent with the political culture of the region. The more interventionist

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governments sought to exercise tight control over the flow of economic information either by dictate or appeal to tradition. Most other countries also followed or enforced traditions of collectivist institutions guided by governance by consensus that often created an illusion of harmony. In these settings, criticisms of economic conditions or policies tend to be suppressed while independent corroboration of government supplied data is unlikely or impossible. Unfortunately, by limiting access by investors and traders to information, markets are prone to greater volatility arising from rumors and misinformation. Faced with deep and perhaps intractable problems in putting their economic and financial houses in order, economies in East Asian face a difficult uphill battle. Most will seek to cut prices to export their way out of their predicament, but other countries both in and outside of the region will increasingly challenge them in their traditional markets. Meanwhile, foreign investors will impose higher standards in assessing commercial and political risk before committing funds to East Asia. With hindsight, the high performance of the economies in the region came more easily than will even lower growth rates in the future. In essence, shared aspects of East Asia's political culture reproduced flaws in the institutional infrastructure of the 'miracle' economies. Consequently, they were ill prepared to sustain external shocks generated by inevitable global capital flows. As such the rigidity of conservative political institutions led to policies that interfered with the self-adjusting mechanisms in their economies. While restoration of stability in East Asian economies will be a difficult road, the slow pace of institutional changes will make recovery an even longer one. Indeed, it may require a generation before some East Asian economies can replicate the required institutional infrastructure for sustainable economic growth that will be required by the increasingly efficient global capital market.

REFERENCES Alston, L. J., Eggertsson, T., & North, D. C. (Eds) (1996). Empirical Studies in Institutional Change. Cambridge: Cambridge University Press. Arogyaswamy, B. (1998). The Asian Miracle, Myth, and Mirage: The Economic Slowdown Is Here to Stay. Greenwood Press. Goldstein, M. (1998). The Asian Financial Crisis: Causes, Cures, and Systemic Implications. Washington, DC: Institute for International Economics. Greider, W. (1998). One World, Ready or not: The Manic Logic of Global Capitalism. Touchstone Books. Henderson, C. (1998). Asia Falling: Making Sense of the Asian Currency Crisis and Its Aftermath. New York: McGraw-Hill.

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Katz, R. (1998). Japan, the System That Soured." The Rise and Fall of the Japanese Economic Miracle. Armonk, NY: M. E. Sharpe. Krugman, P. (1998). Saving Asia: It's Time to Get Radical. Fortune, (September 7). Krugman, P. (1994). The Myth of Asia's Miracle. Foreign Affairs, (November/December), 62-73. Lingle, C. (1998). The Rise and Decline of the Asian Century. Seattle: University of Washington Press. Mahbubani, K. (1998). Can Asians Think? Singapore: Times Editions Books. Mahbubani, K. (1995). The Pacific Way. Foreign Affairs, 74(1), 100-i 11. North, D. C. (1990). Institutions, Institutional Change and Economic Performance. Cambridge: Cambridge University Press. Rodrik, D. (1997). Has Globalization Gone Too Far? Washington, DC: Institute for International Economics. Young, A. (1994). Lessons from the East Asian NIC's: A Contrarian View. European Economic Review, 964-973. Young, A. (1995). The Tyranny of Numbers: confronting the Statistical Realities of the East Asian Growth Experience. Quarterly Journal of Economics, August. Wade, R. (1993) Governing the Market: Economic Theo~ and the Role of Government in East Asian Industrialization. Princeton, NJ: Princeton Univ. Press. World Bank (1993). The Asian Miracle. Oxford University Press.

FINANCIAL LIBERALIZATION, CAPITAL MOBILITY, AND FINANCIAL CRISES Jiawen Yang* Financial liberalization encompasses deregulation of the domestic financial markets and the freedom of capital mobility across economies. While the world has witnessed a long history of foreign direct investment, financial capital flows including portfolio investment and short-term capital movements gained prominence towards the end of the 20th century. Indeed, international financial capital mobility has been at the core of the so called 'international financial liberalization', 'financial globalization', or 'international financial market integration'. The roles of, and the implications for, international investors and the emerging markets have been very different in the liberalization process. Financial liberalization enables international investors move capital swiftly around the world in search of high returns. For most emerging markets, financial liberalization entails relaxation of capital and exchange controls and opening the door to allow for financial capital to flow in and out freely.1 It is often claimed that free capital mobility benefits to the recipients as well as the investors. Like free trade, the free flow of capital across countries can lower the cost of capital and promote economic growth for the recipient countries. While such potential does exist in the long run, the benefits of free capital mobility to many emerging markets have appeared illusionary. Instead, the swirls of large financial flows have brought adverse, and sometimes * School of Business and Public Management, The George Washington University. I thank Huiping Dong and Lili Zhu for their research assistance. Asian Financial Crisis, Volume 1, pages 175-197. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0686-6

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devastating, effects to the recipients' economies. The world debt crisis in the early 1980s, the 1994 Mexican peso crisis, and the financial crises suffered by many emerging markets throughout the world in the late 1990s provide ample evidence of the damages that free financial capital flows can bring to the emerging markets. 2 There has been an enormous literature on the causes and consequences of these financial crises. Much attention has been given to the stability of international financial systems and to risk assessment and management on the part of international investors. To the extent the roles of the emerging markets have been discussed, they are often blamed for lack of transparency, lack of regulation and supervision, and lack of appropriate management of their economies in general. The role of financial capital flows has been at the center of policy debates among academics, policy makers, and market participants. Those who blame the emerging markets for their financial crises, argue that capital liberalization is a good thing and emerging markets are better off improving their financial systems rather than restricting the inflow of capital. Others who believe that even a well managed but small economy might be overpowered the power of vast international capital flows argue that some limits on such flows, particularly the most volatile and pernicious short-term kind, might therefore be warranted. 3 It seems there is some confusion in the debates and the literature. First, while people have become increasingly aware of the adverse effects of short-term capital flows to emerging markets, the distinction among different types of capital flows and their impacts on emerging markets is not laid bare. One hears too often that people argue for free flow of capital on the benefits of free markets and on the basis of improving economic efficiency. However, direct investment, portfolio investment, commercial loans, and capital flows involving financial derivatives enter emerging markets with different objectives and have drastically different impacts on host economies. Second, the time structure in many policy recommendations is not clearly framed. The seemingly contrasting policy prescriptions may have different timing implications. For many emerging markets, financial liberalization and free capital mobility may work for them over time when the appropriate macroeconomic infrastructures are established, while some restrictions are necessary given the current chaotic economic and financial situation. The purpose of this chapter is to analyze the impacts of financial liberalization and financial capital flows on emerging markets. In doing so, the chapter attempts to clarify three points. First, it distinguishes financial capital flows from real investment. These two types of capital flows differ significantly

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in the association between the sources and uses of funds, investor responsibility, and contribution to the host economy. Second, through analysis of the characteristics of financial capital flows and the immature nature of the financial system in emerging markets, the chapter highlights the damaging effects of financial capital flows on emerging markets financial stability and economic welfare. Third, the chapter emphasizes that many alleged problems with emerging markets are inherent and solving these problems takes time. In the interim, different approaches toward financial liberalization and capital flows should be adopted based on the development of the economy and the macroeconomic infrastructure.

DISTINCTIONS BETWEEN DIRECT INVESTMENT AND FINANCIAL

CAPITAL FLOWS

A country's economic growth derives from two ingredients: accumulation of physical capital and more efficient use of resources (Dornbusch & Reynoso, 1989). In a closed economy, domestic savings are the only source of investment and physical capital accumulation. In an open economy, however, domestic investment can be financed by foreign capital. It is generally known that industrial countries are abundant in capital while emerging markets have a constant shortage of capital for economic development. Standard foreign direct investment theories claim that foreign investment helps bring a more efficient allocation of capital across countries and is assumed to be beneficial to both the investors and the recipients. To the investors, foreign investment provides them with more investment opportunities and higher returns; to the recipients, foreign investment affords them lower cost of capital and higher economic growth. Yet the assumed benefits depend crucially on the efficient use (or allocation) of foreign capital. Efficient use of capital involves the employment of technology and management skills. In fact, many emerging markets do not welcome or encourage foreign investment for the sake of money, but for the efficiency that may not be obtained through domestic investment. However, foreign direct investment is not the only type of capital flows today and the major features of foreign direct investment do not necessarily apply to all kinds of international capital flows. According to the classification in the Balance of Payments Statistics published by the International Monetary Fund (IMF), private international capital flows consist of the following three major categories of investment:4 Direct investment - reflecting the lasting interest of a resident entity in one economy (direct investor) in an entity resident in another economy (direct investment enterprise) - covers all transactions between direct investors and

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direct investment enterprises. [...] Direct investment transactions (abroad and in the reporting economy) are sub classified into equity capital, reinvested earnings, and other capital (intercompany transactions). Portfolio investment covers transactions in equity securities and debt securities; the latter are subsectored into bonds and notes, money market instruments, and financial derivatives (such as options) when the derivatives generate financial claims and liabilities. Other investment covers short- and long-term trade credits; loans; currency and deposits; and other accounts receivable and payable. Foreign direct investment has been around throughout the modern history and has been steadily increasing over time. The surge and whirling flows of portfolio investment and other investment have been a relatively more recent phenomenon. As Table 1 shows, net portfolio investment, bank loans and other investment to emerging markets well surpassed net foreign direct investment in the years preceding the Mexican peso crisis in 1994/1995. In 1991, non-direct investment capital flows to emerging markets were almost three time as much as direct investment flows. It is even more striking to note the overwhelming non-direct investment capital flows to Latin America and to the five Asian countries that have been affected by financial crises. Table 2 shows that the non-direct investment to direct investment ratio reached 4.21 in 1993, immediately before the Mexican peso crisis. Net portfolio capital flow in that year was actually more than five times as much as that of direct investment. For the five Asian markets, as Table 3 presents, the non-direct investment to direct investment ratio ranged between

Table 1.

Private Capital Flows to Emerging Markets (In billions of U.S. dollars) 1990 1991 1 9 9 2 1993 1 9 9 4 1995 1 9 9 6 1 9 9 7

Net foreign direct investment 18.4 3 1 . 3 Net portfolio investment 17.4 36.9 Bankloans and other 11.9 55.6 Total net private capital 47.7 123.8 inflows Non-direct investment to 1.59 2.96 direct investment ratio*

3 5 . 5 56.8 82.6 96.7 115 5 1 . 1 113.6 105.6 41.2 80.8 32.7 11.5 -35.5 55.4 16.3 119.3 181.9 152.7 193.3 212.1 2.36

2.20

0.85

1 . 0 0 0.84

1998

140 131 66.8 36.7 -57.6 -103.5 149.2 64.2 0.07

~3.51

Sources: IME International Capital Markets, September 1999. * The ratio is defined as (Net portfolio investment+Bank loans and other)/Net foreign direct investment

Financial Liberalization, Capital Mobility, and Financial Crises Table 2.

179

Private Capital Flows to Emerging Markets in Western Hemisphere (In billions of U.S. dollars) 1990 1991 1992 1993 1994 1995 1996 1997 1998

Net foreign direct investment 6.7 11.3 13.9 12.0 24.9 Net portfolio investment 17.5 14.7 30.3 6 1 . 1 60.8 Bank loans and other -10.5 -2.0 11.7 -10.6 -38.2 Total netprivatecapitalinfiows 13.7 24.0 55.9 6 2 . 5 47.5 Non-direct investmentto 1.04 1.12 3.02 4.21 0.91 direct investmentratio

26.0 39.3 50.6 54.0 1.7 40.0 39.7 33.0 10.6 2.7 -3.1 -18.1 38.3 82.0 87.2 68.9 0.47 1.09 0.72 0.28

Sources and notes: See Table 1.

four to six in the years preceding the so-called Asian financial crisis. There is, however, a sharp contrast in the composition of non-direct investment capital flows to the two groups of countries. Portfolio capital flows dominated the capital flows to Latin American while bank loans and other investment dominated the capital flows to the five Asian countries. Indeed, bank loans and other investment were three or four times as much as direct investment capital flows to the five Asian countries in 1995 and 1996. The surge and the swirls of large non-direct investment capital flows to emerging markets in the 1990s have been unprecedented. This is a result of at least two new developments in the international financial market. First, financial liberalization in many emerging markets paved the way for the free

Table 3.

Private Capital Flows to Five Asian Emerging Markets Affected by Financial Crisis* (In billions of U.S. dollars) 1990 1991 1992 1993 1994 1995 1996 1997 1998

Net foreign direct investment 6.0 6.1 6.3 6.7 6.5 8.7 9.5 12.1 4.9 Net portfolio investment 0.3 3.4 5.3 16.5 8.3 17.0 20.0 12.6 ~i.5 Bank loans and other 17.9 17.3 15.0 8.7 18.4 36.9 32.9 -44.5 -44.5 Total net private capital inflows 24.2 26.8 26.6 31.9 33.2 62.6 62.4 -19.8 -46.1 Non-direct investmentto 3.03 3.39 3.22 3.76 4.11 6.20 5.57 -2.64 -10.41 direct investmentratio Sources and notes: See Table 1. * Indonesia, Korea, Malaysia, the Philippines,and Thailand.

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flow of non-direct investment capital across countries. Second, financial innovation and the development of information technology have made it possible to transfer capital across countries with many more sophisticated financial instruments and at an ever-increasing speed. Because of their nature and for ease of expression, non-direct investment capital flows will be referred to as financial capital flows hereafter in this chapter. While there has been an enormous literature on foreign direct investment and the economic growth in emerging markets, serious studies of the role of financial capital flows in the economic development of emerging markets are still lacking and lagging. Proponents for the free flow of financial capital use more or less the same arguments for free trade and for foreign direct investment. Application of these arguments to financial capital flows is at best being farfetched if not misleading. There are fundamental distinctions between direct investment and financial capital flows. Table 4 attempts to present a summary comparison of the basic features between direct investment and financial capital flows. As financial capital flows are very much diversified, two major categories - equity securities and debt (securities and bank loans) - are singled out for comparison with direct investment. Features for each category of capital flows are related to each other and are therefore not mutually exclusive. One caveat is in order. Due to the complexity of both direct investment and financial capital flows, the summary can only provide some highlights without being able to cater to much details or specifics. As manifested in Table 4, many important features whereby foreign direct investment contributes to the host economies' efficiency and growth do not exist with financial capital flows. The first and natural dimension that sets financial capital flows apart from direct investment is how the foreign capital is allocated. In direct investment, the foreign investor bypasses financial market intermediation and outlays the budgeted capital to selected projects and operations. It is assumed that the investor has done all the necessary studies and investigations of the investment environment and the specific projects before the capital commitment. On the other hand, financial capital flows enter the host country through financial market intermediation. Financial markets, including the banking sector, are very immature in many emerging markets and may not have the capacity to allocate foreign capital to the most productive uses. It is now well known that many emerging markets suffering from financial crisis bear much blame for problems including weak financial sectors and lack of banking regulation and supervision. Misallocation of foreign capital may also due to government intervention or corruption that are prevalent in some emerging markets.

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Another major distinction between direct investment and financial capital flows is in efficient use of capital. To turn good investment opportunities into economic success requires not only capital, but also the appropriate technology and management skills. Direct investment often brings in technology and management skills as well as capital. The host economy benefits (or has the possibility to benefit) from direct investment through technology transfers and other spillover effects. For many emerging markets, the need for better technology and improvement management is more urgent than pure monetary capital. But there is no technology contents or management skills in financial capital flows. Direct investment and financial capital flows also differ in how the investor is linked to the performance of the end use of capital. For direct investment, investors are at both ends of the investment process - from sources of funds to the end uses of funds. They are the owners of capital and end users of capital at the same time. They are also responsible for the success or failure of the invested projects. On the other hand, the sources of funds and uses of funds are separated in the investment chain for financial capital flows. The owners and end users of capital are different parties. Owners of capital have no direct or immediate control over the uses of capital. For investment in equity securities, the investment return does depend on the performance of the end users (invested companies) and the stock market in general. However, it can withdraw from the market very quickly. Therefore, capital flows to emerging markets through equity market have no strong or long-term commitment. For capital flows in the form of debt securities or bank loans, the debtor has the obligation to service the debt irrespective of the performance of the invested capital in its end use. Very often the debt service is guaranteed either explicitly or implicitly by the debtor's government or international institutions. With debt service guarantees, international lenders have no incentive to care about how the funds are eventually used. In this case the sources of funds and uses of funds are basically severed. The owners of funds (the lenders) may not even know who the end users are. The international lenders bear no commitment to or responsibility for the efficient use of their capital. Moreover, official guarantees of debt service may breed moral hazard and promote opportunistic or reckless lending across countries. As mentioned earlier, bank loans were a predominant component of capital flows to the five Asian countries in the years before the financial crisis broke out in 1997. In retrospect, people now realize that these loans were not properly allocated or used efficiently. Financial institutions in these emerging markets borrowed money abroad and re-lent the borrowed funds domestically without scrutinizing the end users or the projects involved. In a well-developed and

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well-regulated financial market, the banking sector should have the ability to efficiently channel the sources of financial capital to the end uses of funds. First, it is equipped with information and the sophistication for project and credit evaluation. Second, its lending decision is based on market conditions. Third, in case of default, the legal infrastructure provides some recourse of the invested funds. The financial and legal infrastructure in many emerging markets is not yet as developed to affect efficient allocation of financial capital or monitor its performance. FINANCIAL

CAPITAL

FLOWS

AND ECONOMIC

GROWTH IN EMERGING MARKETS: A M I S M A T C H Suffice it to say that the basic theories of foreign direct investment do not apply to financial capital flows given their fundamental differences outlined in the previous section. Can financial capital flows contribute to the economic development in emerging markets then? Whether or not foreign capital can contribute to the recipient country's economic growth depends on whether the sources of funds match the uses of funds in at least two aspects: the investment horizon and the investment return. The time horizon for which the funds are committed by the foreign investor can be different from investment horizon needed by the end users of funds. The required rate of return by the foreign investor may also be different from the return generated from the investment project. In case of direct investment, the foreign investor is responsible to match the investment horizons and the returns. For financial capital flows to contribute to the recipient country's economic growth, it has to meet at least two minimum conditions. First, there has to be a steady and constant inflow of funds. This condition is based on the fact that most financial capital flows are short term in nature while the economic development in emerging markets needs long-term capital commitments. If there is a constant inflow of financial capital, short-term investment can be rolled over to finance long-term projects. This is analogous to the short-term borrowing and long-term lending by commercial banks. Liquidity crisis will occur if the short-term capital inflows stop and reverse. Second, the return generated from investment projects financed by the financial capital inflows has to be high enough to service the foreign liability. In direct investment, the foreign investor bears the losses if the return on the investment falls short of the cost of capital. In financial capital flows, particularly in the case of foreign debt, the required interest rate by the foreign lender is either fixed or floating based on a particular reference rate. The stream of cash flows generated from the invested funds may not be able to meet the

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periodical debt service requirements. Default occurs when the borrower is unable to service the debt. Failure to meet the debt service requirement may be due to liquidity problems or to misuse of funds or mismanagement of the investment projects. Prevalence of such defaults or the threat of such defaults can lead to financial crisis and cripple the domestic economy. International financial capital flows can potentially make contributions to the economic growth of emerging markets if these two conditions are met. Unfortunately, they have not been met in the experience of many emerging markets. First, due to the features described in the next section, the supply of financial capital to developing countries is anything but steady. Internal and/or external adverse events can cause financial capital flows to a sudden stop or even a reversal, thus derailing the investment projects. Second, both the internal and external factors have often made debt servicing difficult for emerging markets. Internally, it is believed that financial capital inflows have not been allocated or used efficiently in many emerging markets. Externally, interest rate and foreign exchange rate risks, commodity prices for the exports by many emerging markets, and the general economic situation in the industrial world all have often aggravated the debt-servicing burden. Generally, interest rate risk is a major source of cash flow mismatch of shortterm capital financing for long-term development. In a domestic setting, investors (depositors) put their money into a bank in part because they require the flexibility that short-term deposits provide, while companies borrow from banks because they want the peace of mind that longer-term loans offer (Dufey & Giddy, 1994, p. 223). When rates rise, the bank's profits are squeezed because the cost of funds rises more rapidly than the return on earning assets. The result is negative profits and declining net worth that threaten the bank's solvency. Two problems exist: (1) the funds may not be rolled over because of disintermediation (the 'silent run'), and (2) if they are rolled over, it is usually at a higher rate. The latter combined with the fixed rate mortgage creates the interest-rate risk that leads to a squeeze on profits and eventually on net worth (Sinkey, 1992, p. 373). Similarly, international investors put their financial capital in developing countries on a short-term basis because they want to retain flexibility while taking advantage of higher interest earnings. Floating rate long-term lending is equivalent to short-term capital as interest rates are set periodically based on contemporaneous interest rates. For a recipient country that uses the short-term funds or floating rate long-term debt to finance long-term development, the income stream and interest payment stream may diverge as they are determined by two different sets of factors. When short-term interest rates rise in the international money market and/or income declines, debt servicing becomes

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difficult. This is what happened when the world debt crisis occurred in the early 1980s. Most of the developing countries debt was denominated in U.S. dollars and set at floating interest rates. The debtor countries export earnings declined due to both a reduction in export volume and a deterioration in their terms of trade as a result of the industrial countries' economic recession. At the same time, U.S. interest rates exhibited a series of spikes and the U.S. dollar appreciated persistently. The simultaneous increase in debt service burdens and decrease in export earnings eventually brought the debtors countries to default. The creditors, mainly commercial banks in the international money centers, were unwilling to roll over their loans. Capital inflows to the debtor countries came to an abrupt stop and then a reverse flow of capital ensued in the years that followed. Misallocation and inefficient use of the borrowed capital may also be the major reason for many emerging markets to fail to generate the necessary cash flow to meet the debt-servicing requirement. First, the foreign capital may be used in non-productive sectors. For example, the borrowed funds may not generate any cash flow if they are used to finance government deficit or domestic consumption. Second, the foreign capital may not be allocated to most viable projects either due to incompetence of financial market intermediation or to government policy. Third, the investment may lack the technology and management skills that are often embedded in foreign direct investment. Although other financial capital flows, including investment in equity securities, may not require contractual returns from the recipient countries, they do exert undesirable pressures on the recipient country's financial systems. The capital markets in many emerging economies have a relatively small investor base and market capitalization. Therefore, they may not be able to absorb unduly large capital inflows. While large inflows may fuel the stock prices, large capital outflows can exacerbate the pressure for market crash. CHARACTERISTICS

OF FINANCIAL INFLOWS

CAPITAL

The analysis in the previous section concludes that financial capital flows do not meet the two minimum conditions for contribution to the economic development in emerging markets, and hence there is a mismatch between financial capital flows and the emerging markets' long-term development strategies. To further understand this point, this section examines the characteristics of international financial capital flows.

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Financial Capital Inflows Are Driven by Excess Liquidity in the International Market Kaufman (1996) compares the contemporary financial capital inflows to emerging markets with those in the 1920s and states, "Then as now, the dilemma is that foreign investing in emerging countries is a fair-weather tactic, mainly driven by the industrial world's excess liquidity" The oil shocks in the 1970s generated tremendous surplus funds from the oil exporting countries. As was observed by Killick & Sutton (1982, p. 51), the overriding objective of these countries was to invest their surpluses in a portfolio of fairly liquid assets that would yield a positive real rate of return or would at least avoid any erosion of real asset values. Commercial banks in the international money centers played an important role in the large-scale recycling of petro-dollars. The banks had effectively increased their international financing as a means of increasing profits and the volume of business (O'Brien, 1982, p. 143). In the early 1990s, lower interest rates in a few industrial countries created a supply of money that was "itching to invest overseas" (Wysocki, 1995). The key point here is the exogeneity of the supply of capital flows to the emerging markets. Many discussions of foreign borrowing, indeed, assume that the accumulation of foreign debt is driven entirely by the borrowing nations. Frieden (1991, p. 53) argues that the possibility of foreign financing is not constant. It is generally the international lenders who set the timing, the amount, and the price at which emerging markets can extract financing externally. Therefore, there is no guarantee that there will be a constant or steady flow of capital to finance long-term economic growth.

Financial Capital Inflows are Subject to Sudden Reversal Since financial capital is liquid in nature, while it is provided quickly, it is also withdrawn quickly when the warning signals are seen (O'Brien, 1982, p. 144). Such warning signals may be any major adverse events, or expectations of such events, be they internal or external, political or economic. In these cases, international investors may be quick to withdraw from the emerging markets and cease to provide future funding or credit. Moreover, with capital mobility, domestic residents as well as foreign investors try to move their capital (or savings) out of the country in panic. Indeed, in the Mexican financial crisis in 1994, local residents put the most pressure on the peso as the crisis approached (Whitt, 1996), thereby accelerating the financial problems and accentuating the costs.

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Financial Capital Inflows Can Become Sources of Speculative Attacks on the Domestic Currency A speculative attack on a fixed or managed exchange rate is a sudden and massive restructuring of portfolios in which market participants attempt to reap gains or prevent losses from an expected change in the exchange rate regime (IMF, 1995, p. 70). It is often regarded as a market's rational response to a perceived inconsistency in economic policies. Calvo & Mendoza (1996) and others argue, however, that a speculative attack can topple an exchange rate peg even when economic 'fundamentals' are sound, if investors display a herding behavior and the country is financially vulnerable with large amounts of shortterm debt. Emerging markets are not alone in being vulnerable to the speculative attacks by international financial investors. In response to the 1992 ERM crisis, the Committee of Governors of the Central Banks of the member states of the EEC stated (Temperton, 1993, p. 301): As the crisis developed, it became evident that the liberalization and deregulation of financial markets and their growing integration - which had greatly facilitated the flow of private capital to Communitycountries with financing needs - had also provided scope for capital movementsof an unprecedented size. Within these capital movements,speculative operations proved at times to be a notable destabilizing force giving rise to serious problems also for currencies of countries with sound economic fundamentals, thereby imposing sizeable costs on the countries concerned. Speculativeoperations also imposed a disproportionate burden on currencies of small countries.

Financial Capital Inflows Are Influenced by Interest Rates in Industrial Countries Studies have shown that interest rates in industrial countries, particularly the U.S. dollar interest rates, have profoundly affected the financial capital inflows and outflows in emerging markets. In the early 1990s, with U.S. interest rates so low, investors were unusually willing to consider moving funds to Mexico and other developing countries in hopes of earning higher returns (Whitt, 1996). Calvo, Leiderman & Reinhart (1993) and Dooley, Fernandez-Arias & Kletzer (1994) suggest that while capital inflows to emerging markets during this period can be attributed partly to policy reforms in those countries, they were also a response to the low interest rates in the United States. In a study of U.S. interest rates and portfolio investment in Latin America, Yang (1997) finds a statistically significant negative relationship for Mexico, Brazil and Argentina. The impact of U.S. interest rates may be best described in a Wall Street Journal article (Wysocki, 1995):

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When U.S. rates drop, they encourageAmericaninvestorsto seek higher rates abroad. That happened in 1990 to 1993, when more than $150 billion flooded the securities markets of Latin America,Asia and Eastern Europe. But when U.S. rates rise, the investmentstend to flow back home. That is what occurredin 1994, in the sell-offof stocks and bonds in many emerging countries. In Mexico, the outflow was a fundamental cause of the financial crisis last December.

Loan Guarantees and Bailouts Bred Moral Hazard in InterNational Lending As pointed out in an IMF report, an important issue in understanding the surges in capital flows and financial crises is the extent to which private investors are encouraged to undertake imprudent risks on account of the expectation of official support (IMF, 1998, pp. 6-7). International lenders sometimes have double or triple protection for their lending to emerging markets. First, their loans are often secured or guaranteed by the governments of the borrowing countries. Second, the governments of the lenders themselves may bail them out if debt crisis occurs since they are too big to fail. Third, international organizations like the IMF may bail them out as they worry about the stability of the international monetary system. These institutional arrangements encourage financial institutions to take excessive risk. In fact they are sometimes too eager to lend when there is excess liquidity in the domestic money market. The excess lending (or excess borrowing on the part of emerging markets) is not readily turned into productive capacities in recipient countries due to reasons discussed earlier. When the bubble bursts and the borrowers default, the international investors are bailed out by international organizations and/or the governments of the industrial countries, who are eventually, at least partially, reimbursed by the taxpayers in the affected emerging markets.

LONG-LASTING DAMAGING EFFECTS OF FINANCIAL CRISES Given the characteristics of financial capital flows and their mismatch with the long-term development strategies of emerging markets, the free flow of financial capital may not render benefits to the emerging markets. In fact, financial capital flows have brought crises rather than developments to emerging markets in the last quarter of the 20th century. By their very nature, emerging markets are more prone to capital-flow-related financial crises. Financial capital flows to industrial countries have been far greater by volume than those to emerging market. Yet the capital-flow-related financial crises with

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emerging markets have so far been much more frequent and severe. Although the overall adverse effects of financial crises on developing countries are hard to gauge and few studies have made strenuous efforts to do so, the setbacks for emerging markets have been sporadically observed in the literature and shown by empirical evidence. The long-lasting damages incurred by the crises-ridden countries include painful economic adjustments, income transfer, high costs of returning to the world capital market, and slower economic growth.

Painful Economic Adjustment and Welfare Deterioration Financial crises often force countries involved to make unusually strong efforts toward austerity such as cutting government spending, tightening monetary control, and devaluing the domestic currency. These contractionary adjustment measures lower imports and thus free foreign exchange to service their external liabilities. However necessary these belt-tightening measures may be, they take a painful toll on their income and standard of living. In evaluating the world debt crisis of the early 1980s, Dornbusch (1984, p. 210) observes, "The duration and magnitude of the income decline are frightening in themselves. Adjustment has gone far beyond cutting fiscal extravagance." Between 1981 and 1983, merchandise imports for Latin America fell 45% in dollars; the current account deficit of the region fell from U.S.$38 billion to U.S.$18 million in the same period. Per capita income in 1983 was 15% lower than it was in 1980 (Kuczynski, 1984, p. 86). By 1990 per capita income in Latin America was still below 1975 levels (Frieden, 1991, p. 3). In evaluating the impact of the Asian financial crisis toward the end of the 20th century, Joseph Stiglitz (World Bank, 2000, p. vii) stated: [...] the crisis has increased povertyin the EastAsian crisis countries, in Brazil and Russia. Not only has the increase in poverty been significant, whether measured by levels of income or consumption, but the crisis has engendered large costly movements of populations and sharp declines in standards of living for the middle classes. Urban poverty increased in all countries, particularly the Republic of Korea. Although efforts were made to maintain spending on social services, real public expenditures on health and education fell in the crisis countries, with a particularly severe impact on access to services in Indonesia.

Resource~Income Transfer In the aftermath of a developing country financial crisis, debt service becomes the focal issue while fresh capital inflows slow down or stop, leading to a net resource outflow. This was clearly manifested for the debtor countries in the 1980s. Dornbusch (1984, p. 210), again, observes, "The large debts due to past

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policy mistakes of the debtors and events beyond their control combine with high interest rates due to U.S. policy mistakes today. The result is a vast transfer of income from poor people in poor countries to wealth holders in rich countries." Kuczynski (1984, p. 87) also observes "Latin America is now transferring to the commercial banks systematically more than it receives from them, a sharp reversal of the trend which prevailed until 1980."

High Borrowing Cost Financial crises often stigmatize developing countries as risky borrowers and the international financial markets demand high premia for new lending to these countries. This further aggravates the difficulties of debtor countries. Bolstered by the joint efforts of the United States and the International Monetary Fund, Mexico was able to come back to the world financial markets to borrow after the peso crisis. However, its new debt issue in July 1995 carried a 5.375% spread over LIBOR (London Interbank Offered Rate) or about 11% on the date of the sale, while similar issues by Korean institutions carried spreads that were well below 1% (World Bank, 1996). Yet the borrowing costs for the Asian economies rose significantly after financial crisis befell upon them as well. By early October 1998, spreads for most Asian and Latin American emerging markets had risen to over 800 basis points (BIS 1999, pp. 35-36).

Slow Economic Growth The most obvious effects of financial crises are on the economic growth of the countries involved. The aftermath of the world debt crisis is alarmingly thought provoking. As Table 5 shows, the average annual GDP growth rate of the Latin American countries (indicated as Western Hemisphere in the table) between 1969 and 1980 was about the same as that of the Asian developing countries. But since world debt crisis, a wedge between the two series of growth rates emerged with Asia growing at higher rate throughout the 1980s and much of the 1990s. Gibson & Tsakalotos (1992) observe that the 1980s was a period in many less developed countries of falling living standards, rising unemployment and poverty and slow, if not negative, growth. Till today several debtor countries have not fully emerged from the shadows of the debt crisis. The divergence in growth rates between the two regions at least in part reflects the difference in financing strategies they had followed in the past few decades. Most Asian countries until the 1990s pursued internally oriented financing strategies. That is, much of the capital needed to finance domestic

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investment had been provided by domestic savings. On the other hand, most Latin American countries adopted a development strategy of externally financed growth under which much of the funding for domestic investment came from foreign lenders and investors. The funds to repay these lenders and investors were expected to come out of the profits derived from the investment projects (Espinosa & Russel, 1996). It seems clear today that the external financing strategies failed to contribute to the economic growth in Latin America. To the extent that developing countries in Asia had also been a major recipient of international capital, the capital inflows to Asia in the past differed from those to Latin America in two aspects. First, it was observed that investments in Latin America were dominated by debt before the world debt crisis and by portfolio and privatization-related financial flows in early 1990s, while those into Asia had mainly taken the form of direct investment capital (BIS, 1994). Second, it was also observed that during the 1982-91 period, capital inflows had grown relatively steadily in Asia, had been poor in Africa, and had fluctuated sharply in Latin America (Culpeper & Griffith-Johns, 1992). The erratic financial capital flows seem to have retarded rather than helped the economic growth in Latin America throughout the 1980s. The impacts of the more recent financial crises on the economic growth in emerging markets are also obvious. During the late 1980s and early 1990s, Mexico had chosen (intentionally or unintentionally) a development strategy of externally financed growth (Espinosa & Russell, 1996). As Table 5 shows, Mexico's economic growth did pick up speed in the three years from 1989 to 1991 (GDP grew more than 4% each year), but crashed heavily following the peso crisis. Mexico's GDP declined by 6.2% in 1995. Some Asian emerging markets made dramatic changes in their policies toward international financial capital in the 1990s. They took fast steps to open up their capital account and to allow currency convertibility) Indonesia lifted capital controls very early on, allowing short-term capital to move in and out of the country with little impediments. Thailand established in 1993 operations similar to those of international banking facilities in industrial countries to help attract foreign financial capital. Malaysia eased controls on short-term (portfolio) movements in 1996. Korea had been under pressure to allow a higher degree of capital mobility in its negotiations to join the OECD. In spite of the reluctance to open the stock market to foreign funds, Korea allowed its banks to borrow heavily and at very short maturities from international banks (Edwards, 1999). The turmoil in the financial markets in Asia towards the end of the 20th century is a direct result of the premature capital account liberalization by the affected countries. The consequences are severe. Gross domestic product declined 0.4%

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for Thailand in 1997, the year Thailand entered into financial crisis, which was followed by a further 10.2% decline in 1998. GDP dropped by 5.8% and 13.7% for Korea and Indonesia respectively in 1998.

THE T R E N D O F G L O B A L I Z A T I O N AND POLICY IMPLICATIONS FOR EMERGING MARKETS Financial liberalization and financial capital mobility across countries can be seen as part of what is fashionably called the globalization trend. In fact, this trend has gone through several stages. Liberalization in international trade has been going on for hundreds of years and the war for free trade has been carried out in all fronts: economic, political, and battle fields. There have been many rounds of multilateral trade negotiations under the General Agreement on Tariffs and Trade, a forum set up after World War II, and more recently under the World Trade Organization. Tariff and non-tariff barriers have been torn down substantially, rules have been promulgated, but the fight between free trade and protection is still going on, particularly among the major economies in the world. Traditional international trade theories assume factors of production capital and labor - are mobile within a country but immobile across countries. Free trade substitutes for the movement of factors of production in efficiently allocating resources. However, capital did gain mobility a long time ago, but basically in the form of direct investment. Direct investment, like merchandise trade, has increased steadily in the past few decades. According to a report by The Wall Street Journal in 1995, foreign direct investment had grown twice as fast as international trade over the past 25 years, while trade in turn had grown twice as fast as world output (Whitman, 1995). It seems that international liberalization has gained both scope and speed toward the end of the 20th century. In scope, free flow of financial capital has been added to free trade and direct investment. In speed, what took many industrial countries several decades to accomplish has been done in a few years in some emerging markets. Many industrial countries did not liberalize their capital account until the decade of 1980s. But by mid-1990s, many emerging markets removed their exchange and capital controls. At the end of the 20th century, the push for liberalization in services in telecommunication, information, banking, and insurance is gaining momentum. What next then? Are we moving in the direction of free movement of human labor across countries? If free capital mobility can promote efficient allocation and use of resources, one can also argue for free mobility of labor along the lines of efficient allocation and use of an equally, if not more, important factor of

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production. In fact, in high levels of economic integration, such as in the Europe Union, labor mobility is allowed. Arguments for free trade in classical international trade theories are based on comparative advantage. It is often believed that industrial countries have a comparative advantage in capital-intensive goods while developing countries have a comparative advantage in labor-intensive goods. So free trade allows each trading nation to specialize in where its comparative advantage is and benefits from trade with other countries. 6 But what roles do emerging markets play in financial liberalization and liberalization in services? What do emerging market gain or have to offer except for granting market access to international investors and service providers? One has to admit that the pressure for liberalization and globalization has imposed unprecedented challenges to many emerging markets. The issue is not whether emerging markets should liberalize and be integrated into the world economy. Globalization as a trend is irresistible. The issue is how and at what pace to liberalize and be integrated into the world economy. It may be stated as a general rule that hasty liberalization may lead to peril and proactive opening may lead to prosperity for emerging markets. Although there is no consensus on the causes and policy implications of the financial crises in emerging markets in the last years of the 20th century, it is widely agreed that financial liberalization and capital mobility are at the core of the debate. One side of the debate is that there is nothing wrong with capital mobility and the cause of crisis is the weak financial sector in the emerging markets. The policy implication is that emerging markets improve their financial sector and the general macroeconomic infrastructure. The other side of the argument is that reckless financial capital flows can topple even a sound but small economy. Therefore, some capital control is necessary. Two clarifications seem in order in the debate. First, the act of improving the financial sector itself may in effect contain the flow of financial capital. For example, improved banking regulation may stop reckless lending by the banking sector and therefore limit the flow of financial capital from abroad. Second, what should emerging markets do with capital mobility in the interim of their problems being solved? Should they allow financial crises to keep pounding at them in the process? Many problems that the emerging markets are criticized for are inherent with the current stages of their economic development and will take a long time to solve. In the interim, some capital control is needed to avoid or limit the adverse effects of financial capital flows. Financial liberalization should be paced to the improvement of financial sector and the overall macroeconomic infrastructure.

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Economic development and welfare improvement are the long-term goals for emerging markets and for any other country in the world, for that matter. Domestic savings are the ultimate sources of investment financing. Reliance on foreign capital to finance domestic investment is not viable for long-term economic growth. Inadequate domestic savings will eventually pull down investment rates, either directly or through constraints on the continued buildup of foreign liabilities, which must eventually be repaid from domestic savings (World Bank, 1993).

CONCLUDING REMARKS With a basic framework to analyze the sources of funds and uses of funds, this chapter argues that financial capital flows are not viable for long-term economic growth in emerging markets. Premature financial liberalization is the major cause of the financial crisis in many emerging markets at the end of the 20th century. While there has been an enormous literature on the financial crisis in emerging markets, a systematic and coherent theoretical framework to analyze the impact of financial capital flows on emerging markets is still missing. It is hoped that this chapter has started an effort in this direction. On the empirical side, more research is still needed. As IMF points out, the empirical literature has, unfortunately, had only limited success in shedding light on the causes of the surges in capital flows and reasons for the sharp changes in the terms and conditions of market access (IMF, 1998, p. 6). Studies on the absorption capacity of foreign capital and the capital allocation mechanism in emerging markets should also prove valuable in policy analysis.

NOTES 1. The term 'emerging markets' includes the IMF's World Economic Outlook classifications of 'developing countries', 'countries in transition', and the advanced economies of Hong Kong Special Administrative Region (SAR) of China, Israel, Korea, Singapore, and the Taiwan Province of China (IMF, 1998. p. 1). 2. The financial crises that started in Thailand in summer 1997 and spread to other countries in Asia have been often called the 'Asian financial crises'. In fact, the crises have expanded well beyond Asia to include countries in Latin America and the transitional economies in Europe. 3. The former view is represented by Lawrence Summers, the U.S. treasury secretary, and latter is led by Joseph Stiglitz, chief economist at the World Bank. See The Economist (1998) for a more detailed description of the debate.

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4. IME Balance of Payments Statistics Yearbook Part 1: Country Tables 1998, p. xxvii. 5. There has been a change in the IMF definition of capital account in the late 1990s. The traditional 'capital account' is now represented by the 'capital and financial account' in current IMF balance of payments presentations. The term used here corresponds to the traditional definition. 6. Of course the real world is much more complicated and there are many new and sophisticated trade theories for and against free trade.

REFERENCES BIS (1994). 64th Annual Report. Bank for International Settlements, Basle. BIS (1999). 69th Annual Report. Bank for International Settlements, Basle. Calvo, G. A., & Mendoza, E. G. (1996). Mexico's balance-of-payments crisis: a chronicle of a death foretold. Journal Of International Economics, 3--4, 235-64 Calvo, G. A., Leiderman, L., & Reinhart, C. M. (1993). Capital Inflows and Real Exchange Rate Appreciation in Latin America: The Role of External Factors, IMF Staff Papers, 40, 108-51.

Culpeper, J., & Griffith-Johns, S. (1992). Rapid Return of Private Flows to Latin America: New Trends and New Policy Issues. Economic Commission for Latin America and the Caribbean (ECLAC), United Nations. Dooley, M. P., Fernandez-Arias, E., & Kletzer, K. M. (1994). Recent Private Capital Inflows to Developing Countries: Is the Debt Crisis History? National Bureau of Economic Research Working Paper, 4792. Dornbusch, R. (1984). Discussion, in Federal Reserve Bank of Boston. In: R. Dornbusch (Ed.), The International Monetary System: Forty Years After Bretton Woods (pp. 208-212). Federal Reserve Bank of Boston. Dornbusch, R., & Reynoso, A. (1989). Financial Factors in Economic Development. American Economic Review, 2, 204-209. Dufey, G., & Giddy, I. (1994). The International Money Market (2nd ed.). Prentice Hall International. The Economist (1998). Of take-offs and tempests. The Economist, (March 14), 88. Edwards, S. (1999). On Crisis Prevention: Lessons from Mexico and East Asia. NBER Working Paper, 7233. Espinosa, M., & Russell, S. (1996). The Mexican Economic Crisis: Alternative Views, Economic Review (Federal Reserve Bank of Atlanta), 1, 21-44. Frieden, J. A. (1991). Debt, Development, and Democracy: Modern Political Economy and Latin America, 1965-1985. Princeton University Press: Princeton, New Jersey. Gibson, H. D., & Tsakalotos, E. (1992). The International Debt Crisis: Causes, Consequences and Solutions. In: T. Hewitt, H. Johnson & D. Wield (Eds), Industrialization and Development (pp. 41-65). Oxford University Press: Oxford. IMF (1995). International Capital Markets, Developments, Prospects, and Policy Issues. August. IMF (1998). International Capital Markets - Developments, Prospects, and Key Policy Issues. September. Kaufman, H. (1996). Today's Financial Euphoria Can't Last. The Wall Street Journal, November 25.

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Killick, T., & Sutton, M. (1982). Disequilibria, Financing, and Adjustment in Developing Countries. In: T. Killick (Ed.), Adjustment and Financing in the Developing World (pp. 4872). International Monetary Fund: Washington, D.C. Kuczynski, P.-P. (1984). International Emergency Lending Facilities - Are They Adequate? In: Federal Reserve Bank of Boston (Ed.), The International Monetary System: Forty Years After Bretton Woods. Federal Reserve Bank of Boston. O'Brien, R. (1982). Roles of the Euromarket and the International Monetary Fund in Financing Developing Countries. In: T. Killick (Ed.), Adjustment and Financing in the Developing World (pp. 136-54). International Monetary Fund: Washington, D.C. Sinkey, J. F. Jr. (1992). Commercial Banks Financial Management (4th ed.). Macmillan Publishing Company. Temperton, P. (1993). Official responses to the ERM crisis. In: Temperton (Ed.), The European Currency Crisis (pp. 299-316). Probus Publishing Company: Cambridge, England. The World Bank (1993). The East Asian Miracle: Economic Growth and Public Policy. Oxford University Press. The World Bank (1996). Worm Debt Tables (lst ed.). The World Bank: Washington, D.C. The World Bank (2000). Global Economic Prospects. The World Bank: Washington, D.C. Whitt, J. A. Jr. (1996). The Mexican Peso Crisis. Economic Review. Federal Reserve Bank of Atlanta, 1, 1-20. Whitman, M. V. (1995). Domestic Myths on Globalization. The Wall Street Journal, (October 27). Wysocki, B. Jr. (1995). Some Painful Lessons On Emerging Markets. The Wall Street Journal, (September 18). Yang, J. (1997). U.S. Interest Rate and Portfolio Investments in Latin America. Global Business and Financial Review, 1, 37-42.

THE IMPACT OF LIBERALIZATION AND REGIONALISM UPON CAPITAL MARKETS IN EMERGING ASIAN ECONOMIES Christopher Bilson, Vince Hooper and Martin Jaugietis ABSTRACT This chapter examines the trend towards regionalism upon stock market returns for a sample of Asian countries. We find that stock markets are becoming regionally integrated at a faster rate than globally. This finding reflects the growing co-operation between Asian countries. This study focuses upon Indonesia, Malaysia, the Philippines, South Korea, Taiwan and Thailand. These markets suffered severe contagion effects in relation to the Asian financial crisis that occurred during 1997. In addition, this study reports on the significant economic and political events that occurred in Asian economies from 1980. This study concludes that increases in liberalization coupled with stronger 'regionalism' in South East Asia contributed to the Asian financial crisis in 1997, in addition to the structural weaknesses in their financial systems. Policy setters may consider reducing the amount of intra-regional dependence in order to reduce the impact of financial crises and improve stability of the financial system.

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1. INTRODUCTION The purpose of this chapter is to investigate financial liberalization and the trend towards 'regionalism' in Asia upon stock market returns. However, it is not an objective of this study to examine whether the growth in regionalism and liberalization is good or bad from a socio-economic perspective but rather to suggest some policy-relevant questions for the governments in light of the recent financial crisis in Asia. It is argued that 'regionalism' combined with unsustainable levels of liberalization may have contributed to the Asian financial crisis. We conclude that the move towards greater regionalism in Asia may mean greater contagion effects in the future. We endorse the International Monetary Fund's call for increased transparency; good governance and intensification of the fight against corruption; strengthening of financial and banking systems; effective regional surveillance; continued liberalization of international capital flows and the strengthening of multilateral institutions. The ascendancy of stock markets in the rapidly emerging economies of Asia is due to a continual process of liberalization. Many Asian nations realised the virtues of capital markets and their contribution to economic development. Developed nations capitalised upon the opportunities for profit from investments and portfolio diversification in emerging stock markets, and found that they could hedge against potentially damaging domestic equity market shocks. These opportunities arose because of low correlations of emerging stock markets with other markets, caused by market segmentation. The market movements of developing and developed markets have become more closely related in the past decade. The forces driving globalization are faster global communication and transportation infrastructures, and the homogenization and convergence of consumer demands. This process has been reinforced by a reduction in barriers to investment in emerging equity markets. However, within the paradigm of globalization is a more potent driver of economic development - regionalism. Within Asia there has been a shift towards regionalism from the doctrine of multilateralism (Tussie, 1998). There are two major forms of regionalism in existence in Asia. The first is a relatively restrictive grouping of countries known as the ASEAN (Association of South East Asian Nations) bloc and the second is the less restrictive APEC (Asia Pacific Economic Co-operation) affiliation. The rapid industrial expansion of East Asia has been a significant contributor to the strong association and inter-dependence between their economies and the west under the concept of 'open regionalism.' (Elek, 1992). Regional trading agreements began to proliferate during the 1980s. Most countries now belong to a regional trade group. The United States has

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traditionally taken a multilateral stance and was founder of the principles driving the General Agreement on Tariffs and Trade (GATT), is a member of the North American Free Trade Agreement (NAFTA) and also the Asia-Pacific Economic Cooperation (APEC) group. The trend toward regionalism is likely to dominate the trade agenda during the 21st century. The growth in regionalism may be viewed as a progression from highly protected domestic markets towards complete globalization. The process of globalization seems to undermine the nation state as well as liberal democracy. In consequence, the need to establish democratic structures on an international level is widely accepted. However, such institutions are viewed upon with a high degree of scepticism and sometimes as instruments of economic imperialism. It may also be argued that countries that promote multilateralism are those that will benefit most from such a system. Thus regionalism could be viewed as the response to economic imperialism. Game theoretical analysis suggests that it is less costly and more beneficial to negotiate trade on a regional as opposed to a multilateral basis. A potential criticism of regionalism is that free trade areas are especially harmful because associated rules of origin offer a vehicle for increasing protection toward non-members. In addition, there could be a danger that regional trade agreements will distort trading patterns, complicate trade regulation, and hinder rather than promote progress toward multilateral liberalization. In this chapter we argue that regionalism was in part responsible for the Asian financial crisis. Within Asia, other than the Association of South-East Asian Nations, established in 1967 involving Thailand, Malaysia, the Philippines, and Indonesia, no other trading alliances have been created that may explicitly be defined as a trading bloc (Hodder, 1994). Although foreign direct investment had undergone substantial reforms especially through the relaxation of foreign exchange controls, ASEAN's intra-regional trade only constituted 12% of its total exports and imports in 1994 (Hodder, 1994). However, this had risen significantly in the past five years. Intra-regional trade amongst ASEAN countries is stronger than for any other trading bloc (Garnaut, 1998). Portfolio flows of capital also show evidence of regional patterns emerging through intense competition (Langhammer, 1995). We believe that the substantial growth in regional trade harnessed an over dependence upon the fortunes of the region. This growth in regionalism within ASEAN has been due to similar cultures, traditions and geographic proximity to one another. Geographically it is a series of islands and peninsulas that is controlled by national governments each with widely different political orientation (Hodder, 1994).

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Economic development is inherently endowed with a spatial dimension, which derives from the important cumulative effects of synergy and feedback which are activated by spatial proximity...

[Pompili, 1994]

Regional integration has both economic and political connotations. It is not necessarily just an economic union. Rather, regionalism involves the elimination of various forms of disagreement and discrimination between participating countries (Balassa, 1982). Agreements range from the removal of internal tariffs and quotas to the total unification of political and super-national institutions. Nationalistic tendencies may prevent the loosening of trade barriers because of a country's desire to maintain their own political sovereignty. For developing markets, there is a perception that developed countries close off their markets to the exports from developing countries while still wanting to establish their own markets in developing countries. Sociological analysis suggests that developing nations have been lured into a state of dependence upon Western nations (George, 1988). The regionalism trend is so strong that the decline in multilateral world trade may cause the emergence of three distinct and separate trading blocs centred around the European Community, the Americas, and Asia (Kim, 1992). The acceleration of international economic interdependence during the 1970s and 1980s is not a phenomenon solely characteristic of industrialised nations: GIobalization of economic activity is evident not only in industrialised regions but also in less developed countries

[Michalak, 1994]

2. SUMMARY OF ECONOMIC AND POLITICAL EVENTS IN ASIA LEADING UP TO THE CRISIS In the appendices, a chronology of critical economic and political events is reported for Indonesia, Malaysia, the Philippines, South Korea, Taiwan and Thailand. Prior to the early 1980s the laws governing the access to capital markets by foreigners were restrictive. This phenomenon was not only apparent in Indonesia but other countries within ASEAN. Throughout the 1980s there was a change in global political dynamics occurring in developed countries like the U.K. and U.S. which spilled over into other countries. Whereas, many Latin American countries had been severely affected by their inability to repay loans to Western banks, ASEAN countries were embarking upon a relatively stable economic trajectory. Towards the late 1980s marked a period of privatization of

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former inefficient state run industries and the 1990s. The High Performing Asian Countries (HPAE) were successful because of their high levels of private domestic investment, better educated labour force, rapidly growing human capital and rapid growth in output and productivity. In this sense there is little that is 'miraculous" about HPAEs superior record of growth; it is largely due to superior accumulation of physical and human capital • . . productivity growth in the HPAEs exceeds that o f most other developing and industrial economies. The superior productivity performance comes from the combination of unusual success at allocating capital to high-yielding investments and at catching up technologically to the industrial countries.

[World Bank, 1993].

The growth in the HPAEs considered in this chapter came about due to intensive and extensive growth. With intensive growth the economy grows because it uses new technologies and becomes more efficient, creating more output per unit of inputs. Extensive growth of the economy is due to the use of more resources as inputs, such as more factories, buildings and machines, and has higher participation rates in the labour force. It is generally considered that intensive growth is sustainable, however extensive growth can only be attained in the short-run. • . . Asian growth, impressive as it was, could mostly be explained by such bread and butter economic forces as high savings rates, good education, and the movement of underemployed peasants into the modern s e c t o r . . , if you like . . . . Asian growth has so far been mainly a matter of perspiration rather than inspiration - of working harder, not smarter.

[Krugman, 1997]

As Krugman himself says, this conclusion is controversial. In terms of the crisis, the International Monetary Fund (IMF) viewed these important dates: ~ Phase I (January - April 1997): Lead up to Crisis in Thailand. Phase II (May - beginning July 1997): Thai Crisis. Phase III (Beginning July - mid-October 1997): Crisis engulfs ASEAN--4. Phase IV (Mid-October 1997 - Present): Spillovers across global financial markets. The Asian financial crisis was very different from past occurrences in other regions, for example Latin America. All governments were more or less in fiscal balance; there was no irresponsible credit creation, or runaway monetary expansion; also inflation was low. In addition, there was no substantial unemployment when the crisis began. However, there was an over reliance upon financial intermediaries as central players in the economies of many

204

CHRISTOPHER BILSON, VINCE HOOPER & MARTIN JAUGIETIS

South-East Asian nations. Thai finance companies tended to borrow short and lend to speculative investors, largely in real estate. It was these financial intermediaries that contributed to the inflating of a speculative 'bubble'. The following outlines Paul Krugman's 'Bubble Story': The first act was the story of the bubble. It began, we now think, with bad banking. In all of the countries that are currently in crisis, there was a fuzzy line at best between what was public and what was private; the minister's nephew or the president's son could open a bank and raise money both from the domestic populace and from foreign lenders, with everyone believing that their money was safe because official connections stood behind the institution. Government guarantees on bank deposits are standard practice throughout the world, but normally these guarantees come with strings attached. The owners of banks have to meet capital requirements (that is, put a lot of their own money at risk), restrict themselves to prudent investments, and so on. In Asian countries, however, too many people seem to have been granted privilege without responsibility, allowing them to play a game of "heads I win, tails somebody else loses".

Inflating the Bubble The bubble was inflated still further by credulous foreign investors, who were all to put money into faraway countries about which they knew nothing (except that thriving). It was also, f o r a while, self-sustaining: All those irresponsible loans boom in real estate and stock markets, which made the balance sheets of banks clients look much healthier than they were.

too eager they were created a and their

The Bubble Bursts "Soon enough, Asia was set up for the second act, the bursting of the bubble. The bursting had to happen sooner or later. At some point it was going to become clear that the Panglossian values Asian markets had placed on assets weren't realistic in this imperfect world, that Asian conglomerates are no better than their Western counterparts at trying to be in every business in every country. But the collapse came sooner rather than later because speculative bubbles are vulnerable to self-fulfilling pessimism: As soon as a significant number of investors begin to wonder whether the bubble will burst, it does"

Start of Downward Spiral What actually started this downward spiral? Who cares,t Any little thing can set off an avalanche once the conditions are right. Probably the proximate causes were a slump in the semiconductor market and a rise in the dollar-yen exchange rate, but if they hadn't triggered the crisis, something else would have.

The Impact o f Liberalization and Regionalism upon Capital Markets

205

Downward Spiral So Asia went into a downward spiral. As nervous investors began to pull their money out of banks, asset prices plunged. As asset pricesfell, it became increasingly doubO~ul whether governments would really stand behind the deposits and loans that remained, and investors fled all the faster. Foreign investors stampeded for the exits, forcing currency devaluations, which worsened the crisis still more as banks and companies found themselves with assets in devalued baht or rupiah, but with liabilities in lamentably solid dollars.

[Krugman, 1998]

The IMF's view was that structural factors were at the heart of the economic problems. First and foremost, the crisis was a financial sector crisis. There were several weaknesses. The financial sectors in Indonesia, Korea, and Thailand lacked proper prudential standards and supervision. For instance, financial institutions had been allowed to borrow from abroad because of inadequate prudential controls on their foreign exchange exposure. The sizeable capital inflows had given rise to investment in equity and property and the risks associated with price bubbles. In the case of Korea, foreign borrowing, channelled through the bank had financed excessive investment of the conglomerates, the so-called 'chaebol'. These conglomerates suffered from very high debt/equity ratios. In addition, a large trade decline during 1996-97 hurt the profitability of the conglomerates and resulted in a string of bankruptcies in 1997 to the detriment of the financial sector. The authorities had in some instances come to the rescue of insolvent financial institutions and prevented them from being liquidated. In all the Asian economies affected by the crisis, there is a need to review the close relationship among the government, banks and the enterprises and ensure that it reflects market conditions and is subject to greater transparency about the financial relations between the partners. 3. D A T A A N D M E T H O D The monthly total U.S. dollar ($U.S.) 2 returns used in this study are derived from Morgan Stanley Capital International (MSCI) and the International Finance Corporation (IFC) indices maintained on the Datastream International Equities Database. The use of $U.S. may be criticised on the grounds that capital controls and restrictions on foreign investment, well known to exist in emerging markets, may reduce the meaningful explanatory power of $U.S. returns. However, evidence suggests that domestic currency returns are similar to those of real currency returns, and so justifies the use of $U.S. returns. Furthermore, by using $US returns, cross-country comparability of results is ensured (Harvey, 1991). 3

206

CHRISTOPHER BILSON, VINCE HOOPER & MARTIN JAUGIETIS MSCI Return Indices

The MSCI international indices consist of value weighted, dividend inclusive data of a broad representation of stocks in different countries. Non-nationals can readily purchase almost all these stocks. However, much criticism has been levelled at MSCI indices because they are weighted towards larger capitalization stocks. The results are thereby biased towards a somewhat more stable return series, characteristic of 'Blue Chip' stocks. 4 The MSCI World index covers 80% of the world market capitalization (U.S.$12.1 trillion) in both developed and emerging markets, and thus is a reasonably accurate proxy for the true market portfolio. 5 IFC Indices For the returns on Asian stock markets, the data used is provided by the IFC from the Emerging Markets Data Base (EMDB) available on Datastream. It includes information on more than 1,800 stocks in low and middle income nations totalling U.S.$1.2 trillion in market capitalization. This represents approximately 10% of the MSCI world market portfolio. Similar to the MSCI, the IFC uses a subset of stocks in each country based on a target market share of 60% to 75% of total market capitalization. The indices are intended to represent performance measures of the most actively traded stocks across a diversified range of industries. The data is calculated from monthly, value weighted index returns, with dividend reinvestment, and adjusted for stock levels (new shares, rights issues, and splits), and market capitalization. A detailed description of the IFC indices definitions, methodologies, and their construction is contained in 'The IFC Indexes' manual (IFC, 1997). Information on six Asian markets was collected: Indonesia, Malaysia, Philippines, South Korea, Taiwan and Thailand. 6 Regional Indices In this study we construct our own Asian aggregate index. Regional indices could be criticised in testing the relevance of regional returns to the country in question. This is especially the case for countries with a large market capitalization. To measure the true association of returns in a country to its region, this study constructs an equally weighted regional index that removes the returns of the country being analysed, respectively. With this innovation, one may accurately assess the relationship of returns within the region.

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207

Return Construction The time series data from MSCI and IFC are not provided in a total return form. Thus, the total percentage return (TR%) series is calculated by:

TR% =

( P t - P, ,)

(100)

(1)

et-- 1

where P,=price index value at time t; P,_ ~=price index value one month prior.

Survivorship Bias The early data is problematic because of a survivorship or look-back'. A question that can never be answered is whether the IFC would have chosen the same portfolio of assets throughout the life of the index. Indeed, some of the stocks may have 'dissolved' during the time span of this study. Hence, there may be evidence of survivorship bias. A study has examined the potential for damaging effects of look-back bias by splitting the sample to include and exclude data to test for survivorship bias. These tests showed that look-back' bias did not effect the results enough to damage the significance of outcomes (Harvey, 1995). Another source of bias occurs in both the IFC and MSCI data where the stocks included in the respective indices are chosen on the basis of historical and expected future performance, size, and liquidity. This implicitly reveals information about a firm's past history and is evidence of another form of bias.

Correlation Measures There is evidence in the past literature to suggest that total equity returns in emerging stock markets are less correlated with the world market portfolio than industrial markets (Harvey, 1995). However, there is also evidence to suggest that Asian emerging stock markets are becoming increasingly correlated with the world market portfolio over time] Observing Fig. 1 shown above which reflects the average correlation a regional and world index for the six Asian countries, there is definite evidence that the regional equity market relationship in Asia has become stronger since 1991. Prior to the intense liberalization phase in Asia, equity markets were positively closely correlated with the rest of the world (i.e. the world market portfolio) and simultaneously regional correlations were negative, but of

208

CHRISTOPHER BILSON, VINCE HOOPER & MARTIN JAUGIETIS

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O ca) ;.=

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The Impact of Liberalization and Regionalism upon Capital Markets

209

similar magnitude. This correlation with regional markets was high and increasing directly after the liberalization phase that occurred from 1991. Throughout the 1980s regional correlation between the Asian markets in this study were very low compared to the world. Overall the correlation results are, thus, direct confirmation that liberalization has had a direct impact on an increasing regional relationship between proximate stock markets. It may have been the very strong growth in regionalism coupled with dramatic liberalization that increased the impact of the recent Asian financial crisis. This was in addition to the lack of regulatory framework and prudent financial surveillance. 4. C O N C L U S I O N The purpose of this chapter was to examine the way in which stock markets in Asia vary over time in terms of their correlations with world and regional indices. Prior to the liberalization of markets in the early 1990s in Asia, equity markets tended to exhibit higher correlations with respect to a world index and lower regional correlations. Asian countries embarked upon a radical programme of reform throughout the 1980s and 1990s which was aimed at encouraging inflows of portfolio equity capital. However, whilst liberalization brought about an influx of funds many economists now argue that economic reforms lagged behind reinforcing financial stability and the mitigation of systemic financial risk. We believe that the Asian financial crisis was brought about by a combination of unsustainable liberalization, over extended regional dependence and a lack of prudent surveillance of financial institutions. We argue that financial contagion effects may be reduced by encouraging Asian country governments to adopt a portfolio approach to their trade patterns rather than strengthening intra-regional trade which increases contagion. A future extension of this research may be to examine in more detail the theory underlying 'regional integration' and its impact upon the dissipation of exogenous financial and economic shocks amongst neighbouring countries. ACKNOWLEDGEMENT We thank Professor Campbell Harvey for his assistance in providing the political and economic event data. NOTES 1. See Section III of the IMF World Economic Outlook: Interim Assessment, December 1997.

210

CHRISTOPHER BILSON, VINCE HOOPER & MARTIN JAUGIETIS

2. The IFC and MSCI use the World Market/Reuters Closing Spot Rates Service as well as the Wall Street Journal to calculate U.S. dollar index levels. 3. Harvey (1991) provides a recent summary of countries included in the MSCI portfolio and their weightings. Regressions run by Harvey incorporating exchange rates into a two factor world model showed that exchange rates did not enhance the explanatory power of results by more than 5% 4. The returns on the Morgan Stanley Composite Index (MSCI) data are similar to widely quoted country index returns such as the Centre for Research in Security Prices (CRSP) at the University of Chicago (UC) which is widely regarded in much of the finance literature as the premier source of data for high class publication. Yet, it is largely inaccessible to the academic world outside the closed doors of UC. Harvey (1991) shows that there is a 99.1% correlation between the MSCI U.S. returns and the New York Stock Exchange (NYSE) value weighted return calculated by CRSP, and thus may be thought of as an accurate measure. 5. Whereas the MSCI U.S. represents only 30% of the world portfolio. Numerous papers have, however, found that the U.S. is a significant driver of world stock markets, especially in developed nations. 6. The inclusion of countries in our sample of Asia is restricted by the fact that data is not available for every Asian country over the time period. Thus our analysis is a broad appraisal of regional integration in Asia. Singapore and Hong Kong are omitted from our sample because these markets have long been established to have highly integrated capital markets. 7. For example, Buckberg (1995) finds that data from 1976-84 shows that the correlation between returns in emerging equity markets and the MSCI World Index had no country above 0.20. In the later data set from 1985-91, Buckberg (1995) found that only seven emerging markets exhibited a correlation measure above 0.25.

REFERENCES Balassa, B. (1982). The Theory of Economic Integration (Greenwood,Westport). Bekaert, G., & Harvey, C. R. (1994). Time-VaryingWorld Market Integration.National Bureau of Economic Research Working Paper." 4843, August. Bekaert, G., & Harvey, C. R. (1995). Time-varying world market integration. The Journal of Finance, 50, 403 444. Buckberg, E. (1995). Emerging Stock Markets and InternationalAsset Pricing. The World Bank Economic Review, 9, 51-74. Elek, A. (1992). Trade Policy Options for the Asia-PacificRegion in the 1990's: The Potential for Open Regionalism.American Economic Review, 82, 74-78 Garnaut, R. (1998). ASEAN and the Regionalizationand Globalizationof World Trade. ASEAN Economic Bulletin, 14, 215-222. George, S. (1988). A Fate Worse than Debt (Penguin Books, London). Harvey, C. R. (1991). The World Price of CovarianceRisk. Journal of Finance, 46, 111-57. Harvey, C. R. (1995). The Risk Exposure of EmergingEquity Markets. The World Bank Economic Review, 9, 19-50. Hodder, R. (1994). The West Pacific Rim. In: R. Gibb & W. Michalak (Eds), Continental Trading Blocs: The Growth of Regionalism in the World Economy (pp. 231). John Wiley & Sons: New York.

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International Monetary Fund (IMF) (1997). World Economic Outlook: Interim Assessment, December. Kim, D. C. (1992). Open Regionalism in the Pacific: A World of Trading Blocs? American Economic Review, 82, 79-83. Kim, E. H., & Singal, V. (1993). Opening up of Stock Markets by Emerging Economies: Effect on Portfolio Flows and Volatility of Stock Prices. In: S. Claessens & S. Gooptu (Eds.), PorOrolio Investment in Developing Countries, World Bank Discussion Paper 228. World Bank: Washington, D.C. Krngman, P. (1997). What Ever Happened to the Asian Miracle? Fortune, August 18th. Krugman, P. (1998). Asia: What Went Wrong. Fortune, 2nd March. Langhammer, R. J. (1995). Regional Integration in East Asia. From Market-Driven Regionalization to Institutionalised Regionalism?. WeltwirtschaftlichesArchiv, 131, 187-9. Michalak, W. (1994). The Political Economy of Trading Blocs. In: R. Gibb & W. Michalak (Eds), Continental Trading Blocs: The Growth of Regionalism in the World Economy (pp. 52). John Wiley & Sons: New York. Pompili, T. (1994). Structure and Performance of Less Developed Regions in the EC. Regional Studies, 28, 679-693. Tussie, D. (1998). Globalization and World Trade: From Multilateralism to Regionalism. Oxford Development Studies, 26, 33-45. World Bank (1993). The East Asian Miracle: Economic Growth and Public Policy.

APPENDIX INDONESIA Dme

M~or Political and Economic Events

7400

Foreign Investment Law ensures eventual majority ownership for Indonesian national in joint ventures. Wholly foreignowned enterprises are permitted only in very special cases. Permits for investment projects are valid for 30 years. Central Bank certificates issued through auctions to stimulate money markets. Incentives granted to Foreign Investment under the Income Tax Law. Security houses established to serve as market makers in money market instruments. Bankers' acceptances introduced. Government introduces measures to allow foreigners to purchase shares in eight non-joint venture companies. Full Financial sector liberalization. Established over-the-

8400 840101 8500 8712 8800

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CHRISTOPHER BILSON, VINCE HOOPER & MARTIN JAUGIETIS

8901 8903 8903 8905 8909 8909

counter market to encourage firms to go public. Malacca Fund (Cayman) Ltd launched as the first Country Fund. Some minor foreign exchange restriction still in place.

Buckberg Liberalization date. Accepted IMF's obligations for convertibility.

IFC Liberalization date. Minister of Finance allows foreigners to purchase up to 49% of all companies listing shares on the domestic exchange excluding financial finns.

8909 8909 9000

Bekaert/Harvey(1995 ) Official Liberalization date]. Kim and Singal Liberalization date.

9009 9105

Bekaert/Harvey Official Liberalization date. [NBER version].

9201 9202 9207

9210 9310 9406

9409 9410 9411 9412

9503

Drastically reduced central bank, refinancing facilities and revised interest rates under the program to approach market rates. First privatization took place with issue of 40 million shares of the cement company PT Semen Gresik. Government announces it will allow foreign shareholders to invest up to 49% of bank stocks. First ADR launched. Capital market supervisory board creates a foreign board for trading stocks by foreign investors. Standard and Poor's assigned a first time rating of BBB- to sovereign debt. Implementation of Bank Act of 1992 allowed foreign investors to own 49% of private national banks. Liberalization package was unveiled by the government which included a reduction in import tariffs. State owned electricity company Pernsahaan Umum Listrik Negara is converted into corporate entity and is regarded as a leading candidate for a privatization program. Indosat, Asia's largest IPO ($1 billion) offered 25% in overseas markets in the form of ADRs. Indosat begins trading on NYSE. APEC agreed to open the region's markets to trade and investment by 2020. Announcement that Jakarta Stock Exchange will split its listings into 2 boards in 4/95. One for blue chips and the other for smaller companies. Standard and Poor's boosted Indonesia's country rating to

The Impact of Liberalization and Regionalism upon Capital Markets

9507

9510

9512

9703 9705 9707 9708 9709

9710 9711

213

investment grade making fixed-income investments more attractive. Concern over the devaluation of the rupiah, but lowinterest loans from governments and institutions from World Bank will 'unlikely' force a devaluation. International consortium agreed on a $2.5 billion financing deal for Indonesia's first large-scale private power project. Foreign investment approvals surged to $27.7 billion. Approval for investments in textiles and chemicals. IPO of PT Bimantara Citra. Shares available to foreigners were oversubscribed 45 times. Central bank intends to increase bank capital adequacy ratios from 8% to 10% in the next 2 years, hurting bank stocks. A new capital markets reform bill was approved which features firm penalties for offences such as insider trading, share manipulation, and failure by individuals and group to declare significant stakes in publicly-listed companies. Government announced in its budget that it would increase its spending on roads and other infrastructure. Foreign investors bought Indonesia's largest and most liquid stocks. A deregulation package by the government included cuts in import tariffs on capital goods, but did not give any mention to an expected liberalization in the plywood and textile industries. Anticipation of a government announcement liberalizing regulations in the plywood industry. The government asked bank to limit loan growth to 17%. A decisive victory by President Suharto's Golkar Party in the national elections. Devaluation of the Thai Baht. Rupiah plunged nearly 7%, a record low against the dollar. Rupiah posted a 39.8% loss in dollar terms. Government announced plans to scrap the 49% foreign limit on IPO shares. Interest rates on short-term SBI government bills and import tariff were cut. The rupiah continued plunging to an all-time low against the dollar. Moody's cut the country's sovereign credit rating. IMF-led aid package was formally announced. 16 insolvent banks were closed. President Suharto's son withdrew a lawsuit against the government related to the closure of his bank, Bank Andromeda. President Suharto had urged state-owned companies to invest 1% of profit in equities.

214

9712

9801

9802

9803

9804

9805

9806

CHRISTOPHER BILSON, VINCE HOOPER & MARTIN JAUGIETIS However, the closure of Yamaichi Securities in Japan triggered the sharp decline in Jakarta market. Concerns about the health of President Suharto and a shortage of dollars triggered sharp declines in the rupiah. The country's Capital Market Supervisory Agency (Bapepam) suspended 16 brokerages for being undercapitalized. The government announced 15 new capital markets regulations. S&P downgraded the rating of 15 Indonesian banks. The currency tumbles to more than 10,000 (from 2,400 in July). The country's two largest private banks merged. President Suharto accepted the nomination for a seventh term. The Indonesian Bank Restructuring Agency was unveiled as a new oversight body. Indonesia pledged to open up the banking sector to foreign ownership. The government had reported it will guarantee all deposits and debts owed by banks. President Suharto studied the issue of a currency board system with a fixed peg. The IMF and the World Bank cautioned against the system at this stage. Indonesia has decided to put aside the controversial plan to implement a currency board for a fixed exchange rate. A 5% tax on the purchase of foreign currencies was imposed to curtail speculation. On March 23, rates on one-month SBI government bills were doubled to 45% from 22%. Government closed 7 banks and seized control of seven more banks faced with loan defaults. Government persisted in maintaining a clove monopoly, run by the president's son, Tommy Suharto. The IMF ceased disbursing aid on March 15, and will not begin again until the government carries out previously agreed reforms. On May 5, the governments cancelled subsidies on fuel and food in compliance with the IMF agreement for a $40 billion international bailout package. Riots in Jakarta escalated and culminated on May 21 with the resignation of President Suharto, who had ruled the country for 32 years. Vice President B. J. Harbibie replaced him and has pledged new general elections next year. Deposit rates have reached as high as 72% while annual inflation as of May was 52%. The IMF will resume aid in July. Indonesian negotiators and international creditors reached agreement on $78.2 billion in corporate foreign debt.

The Impact of Liberalization and Regionalism upon Capital Markets

215

MALAYSIA Date

M~or Politic~ and Economic Events

7100

Government began a discrimination program in an attempt to reduce foreign held shares of the Malaysian economy. In 1970 foreigners held as much as 55%. The govemment plans to reduce this share to 30% by 1990. The target is overshot dramatically by the end of 1990 when foreign ownership is estimated at 25%. Amount of Malaysian banknotes travelers were allowed to bring into or take out of the country was raised. Restrictions on the export of foreign currencies was lifted. Paddy farmers riot for a higher rice support price. Fixed exchange rate abandoned and a controlled, Effective Exchange Rate was established, linked to the SDR in combination with a 'basket of currencies'. More exchange controls eased. Traders in commodities futures were allowed to maintain foreign currency accounts in Malaysia. Commercial banks ordered to stop lending to Malaysian companies for investment abroad, especially in property and equity shares. Foreign exchange controls loosened. Banks allowed to lend foreign currency to residents and borrow funds from abroad. Introduction of base lending rate. Corporatization Policy whereby approved financial institutions, including foreign brokers, were permitted to acquire up to 30% of local brokerage houses. Malaysian government securities with market-based coupon rates introduced. Foreign institutions limit on brokers raised to 49%. Malaysia Fund, Inc launched on the NYSE with a net asset value of $98.3 million as of December 1991. Budget calls for liberalization of foreign ownership policies to attract more foreign investors.

790423

8001 800227

8010

8108

8200 8300 8603

8700 8707 8712 8810 8812 8812

IFC Liberalization date. Bekaert/Harvey Official Liberalization date. [Final and NBER version].

216 9100 9102

9103

9106

9108 9205 9208 9209

9300

9303 9310 9401 9402 9409

CHRISTOPHER BILSON, VINCE HOOPER & MARTIN JAUGIETIS Removal of base lending rate. Privatization Master Plan was released. Large automotive company, Proton, and the national electricity company, Tenaga National, are to be privatized in 1992. Malaysia issued 190 million in bonds that are convertible into shares of state owned communications firm. This marked the first placement of a convertible sovereign bond in the international market. New economic plan termed the Outline Perspective Plan is passed. The plan emphasized economic growth and encouraged private, including foreign, investment. This plan served as a successor to New Economic Policy of 1971. Government stated that future regulatory process governing foreign investment would be decided on a case by case basis. However, a 30% foreign ownership restriction was still in affect so that the policy might not have been fully commensurate with a liberalization of the capital account. Government imposed restrictions on automobile loans and consumer credits. Central bank raised the statutory requirement reserve for financial institutions from 7.5% to 8.5%. First ADR announced. Ministry of Finance approved creation of Kuala Lumpur Options and Financial Futures Exchange to be opened in near future. Also, Malaysian cabinet approved the formation of a SEC to be designed along the lines of the Australian SEC. In early 1993 Malaysia lifts its foreign ownership limit of 30% on manufacturing firms. Malaysian central depository begins operating a scriptless trading system through computerized clearing and settlement process. Moody's upgraded Malaysia's rating from A3 to A2. Resignation of deputy Prime Minister Ghafar Babar is well received by the market. Adopt capital control measures to curb short-term capital inflows. Ban implemented preventing British firms from participating in public sector contract bidding. Malaysian cabinet lifted its 7 month old ban preventing British firms from participating in public sector contract bidding. Prime minister Mahathier Mohammad dissolved the current

The Impact of Liberalization and Regionalism upon Capital Markets

9410

9501

9506

9510

9511

9512 9609

9611

9701

9702

217

government and called for a general election. Perception was that several companies would benefit from government contracts in an effort by politicians to raise funds. Kuala Lumpur Stock Exchange limits the suspension period for listed companies to no more than 10 business days. Improves the image of the exchange and curbs speculation. Government would amend legislation related to corporate disclosure to ensure that company information is more reliable and timely. Tax cut implemented: maximum personal income tax lowered from 34% to 32% and corporate rate is lowered from 32% to 30%. Tax cut abolished import duties on more than 2600 items, including 600 food and 1400 raw material. Warrants on stocks are allowed by the securities commission. Kuala Lumpur Stock Exchange regulations revised the commission structure. Foreign brokers cannot be exchange members. Foreign brokers complained that even the new schedule would slash profits on large transactions. Local brokers noted that foreign investors were moving money into Hong Kong equities and ignoring the Malaysian market. The 1996 Budget proposal: slow the pace of spending on large government construction projects and new restrictions on foreigners' purchases. Central bank raised the requirement on statutory reserves funds that banks keep interest free with the central bank - from 11.5% to 12% of liabilities. Kuala Lumpur Options and Financial Futures Exchanged opened on 12/15/95. Short sales regulations put into place. Announced plans to establish an Islamic Index for stocks that comply with Islamic business practices. Public Bank cut its base lending rate. Central Bank wanted major banks to acquire smaller banks. Banks gained more ground on expectations of more mergers and acquisitions in the industry. Foreign and domestic investors poured funds into banks after Rashid Hussain announced that it will acquire Malaysian Banking's 75% share of Kwong Yik Bank. Government approved higher electricity rates. Bank loans grew at 28% in 1996. Government licensed another company to distribute power in an industrial area. Government announcements that it will accelerate its deregula-

218

9703

9704

9707

9708

9709

9710

9711 9712

CHRISTOPHER BILSON, VINCE HOOPER & MARTINJAUGIETIS tion of the banking industry and encourage mergers gave an added boost to the sector. Government also revealed plans to establish an over the counter market, modeled after the NASDAQ. Government introduced its plan at the World Trade Organization to open Malaysia's telecommunications industry to international competition. Central bank regulations limit to 20% the proportion of all bank loans to the property industry, effective April 1. Regulations limit the lending of stock purchases to 15% of total loans by commercial banks and finance companies. Central bank has exemptions to the new lending curbs. Loans made for the purchase of owner-occupied houses will be exempted from the lending curbs. Kuala Lumpur Stock Exchange chairman said the exchange will add 200-300 listed firms by year 2000. Devaluation of the Thai Baht. Ringgit drops to 38-month lows against the dollar. A sign that Bank Negara has given up its strategy of vigorously defending its currency. Prime minister Mahathir Mohamad's announcement that the government would not take steps to defend the currency weakened the ringgit. Finance Ministry plans to bolster the ringgit indirectly by cutting imports and scaling back on public projects. Standard and Poor's downgraded the country's credit rating. Kuala Lumpur Stock Exchange imposed trading controis on benchmark stocks. To curb speculation, investors required paying full price for a stock and sellers to deliver all shares before signing the contract. Elimination of short selling which causes panic among investors wanting to hedge positions. S&P downgraded the country's long-term outlook to 'negative' from 'stable'. Prime minister Mahathir called for currency trading control. Prime minister Mahathir Mohamad renewed calls for tighter restrictions or a ban on foreign exchange rate. Malaysia shares tumbled to a four-year low due to the regional weakness. Concern about corporate transparency. The closure of Yamaichi Securities in Japan impacted the market. Moody's and S&P lowered the country's foreign currency rating and also lowered the debt ratings for several leading banks and companies.

The Impact of Liberalization and Regionalism upon Capital Markets

9801

9802 9803

9804 9805

219

The government planed to combine 39 finance companies into an 'anchor' group of five or six large companies. IMF commented that the country does not need an emergency aid package. A sharp drop in the Indonesian rupiah triggered speculation against the Malaysian ringgit. The Central Bank would reduce the reserve ratio of Malaysian banks. The government forecasted 2-3% growth for the year 1998, down from the previous estimate three month ago o 4-5%. Non-performing loans had risen to 8.7% at end-February. Finance Minister Anwar Ibrahim stated that the rules regarding foreign ownership of Malaysian banks would remain unchanged. Foreigners can hold up to 61% of local telephone companies on a case-by-case basis, up from 49% ceiling. Japan's recession could slow down the Malaysian export. Nonperforming loans were predicted to more than 20% of banks. The reserve requirements were lowered to 8% of commercial banks eligible liabilities from 10, effective July 1.

PHILIPPINES Date

Major Political and Economic Events

8000 8101

The Philippines becomes member of the GATT. 10% Capital-gains tax on share transactions to discourage speculation in the Manila Stock market. Export of foreign currency was forbidden without prior approval. Residents working abroad have to show proof that proper remittances of earnings were made before their passports could be renewed. Benigno S. Aquino, political opponent, assassinated at airport after returning from the United States. Beginning of large capital flight. Commercial banks instructed to surrender 80% of foreign exchange earnings to the Central Bank and a ban was placed on

811215 8302

830821

831005

220

8311

8400 840606 841010

8505 8508 8511 8602 8603 8605

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CHRISTOPHER BILSON, VINCE HOOPER & MARTINJAUGIETIS nonresident imports. Commercial banks must surrender all their foreign exchange receipts to the Central Bank. Foreigners were permitted to own up to 100% of certain Philippine enterprises to attract hard currency. Letter of intent signed with IMF, including standby credit. Exchange rate system revised. Multiple rate structure created. Multiple rate structure abolished. Effective exchange rate determined by market forces with periodic Central Bank intervention. 1% tax on all purchases and sales on foreign exchange. Bank debt restructuring agreement. IMF targets missed. $2.9 billion of public debt rescheduled. Marcos overthrown. Kim and Singal Liberalization date. Country Fund liberalization. First Country Fund launch of 1980s is Thorton Philippines Redevelopment Fund Ltd with net asset value of $0.9 million as of December 1991. The first larger scale Country Fund followed in May 1987. Import restrictions lifted. Talks open with IME Import controls lifted. Paris Club debt rescheduling of $870 Million. Few restrictions left governing repatriation of capital income by foreigners. $10.5 billion structural adjustment loan. Debt rescheduling. Philippine Long Term Equity Fund Ltd launched (unlisted) with net asset value of $44.3 million as of December 1991. This is the first Country fund of substantial size. Agrarian land reform plan is approved. Coup attempt. Bombings of business in Makati. Bank debt restructuring agreement. IMF approves stabilization plan. Debt rescheduling $2.2 billion. Brady Deal reached in principle. IFC Liberalization date. Buckberg Liberalization date. Coup attempt. Bank debt restructuring agreement. Reintroduction of official debt/conversion program.

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First ADR announced. Ayala Land Inc. becomes the first equity transaction in Philippines to have formed an international syndicate. A Foreign Investment Act is signed into law. The Act removes, over a period of three years, all restrictions on foreign investments. Under the provisions, foreign investors are required only to register with the Securities and Exchange Commission, and most sectors of the economy are opened to 100% foreign ownership.

Bekaert/Harvey Official Liberalization date. [Final version]. Bekaert/Harvey Official Liberalization date. [NBER version]. Manila Electric (Meralco) is privatized. This is the first privatization to involve an equity issue. The Central Bank liberalizes rules governing foreign exchange transactions. The IMF approves an extension of 18-month standby credit. Mr. Fidel Ramos elected as president. Buy/back option of July 1992 debt restructuring agreement was completed. Bank debt restructuring agreement. The government lifted all foreign exchange restrictions allowing foreign investors to freely repatriate their capital. By end of 1993 residents can freely own foreign securities. Philippines return to international capital markets for the first time since 1983 with the flotation of a $150 million three year government bond. Philippine government announced that foreigners can repatriate cash dividends without central bank approval. The move follows the more general relaxation of foreign ownership restrictions in 1992. Moody's assigns first time rating to sovereign debt of Ba3. Standard and Poor's assigned first time rating to sovereign debt of BB-. A computer link-up is established integrating the exchanges in Manila and Makati. The Philippine central bank tightens money supply growth. Local interest rates reduced. The new Senate leadership pledged its support for a tax reform package. New tax measures designed to reduce the budget deficit and boost the Philippine's credit ratings are applied. Philippine Stock Exchange proposed scrapping a tax on initial

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CHRISTOPHER BILSON, VINCE HOOPER & MARTIN JAUG1ETIS public offerings to encourage firms to go public. Interest rates raised by 2%. Central bank announced that the currency could trade in a wider range. Devaluation of the Thai Baht. Peso declines. Central bank decided to raise bank liquidity reserves, indicating a rise in interest rates. The Central Bank relaxed country's monetary policy. President Fidel Ramos officially indicated he would step down when his term ends. Overnight borrowing rates reached as high as 71%. On September 3, the reserve requirements were cut to 6% from 8%. Cut in liquidity reserve requirements form 6% to 4%. The peso lost 5%. The bank reserve requirements were decreased 1%. The Board of Investment announced that equity investments in the first nine months of 1997 rose 396% to around $4.7 billion form roughly $952 million last year. The Supreme Court declared the country's oil deregulation law unconstitutional. The peso lost 1.9% over a three-day period, following the Korean won's abrupt slide. The Philippine Congress passed a crucial new tax reform bill that would free the country from 35 years of IMF supervision. The Monetary Board agreed to enter into non-deliverable dollar forwards with banks whose clients are unhedged in foreign exchanged exposure and to provide at least $100 million in the spot foreign exchange market every day. The government economic policy of containing peso in an environment of high interest rates. The implementation of nondeliverable forward contracts (NDF) to exports. Allowing foreign funds to purchase 'A' shares-to date reserved only for Filipinos. The central bank announced it would boost forex reserves by $3 billion and reduce the overnight lending rate to 15.7% from 16%. The Energy Regulatory Board forced electricity provider and Meralco to roll back power prices and refund its customers half of the rate increase it charged them in 1994. A reduction in prime lending rate to an average of 23.35%. S&P downgrade country outlook from 'stable' to 'negative'. An agreement reached with the IMF on a new two-year economic program worth $1.6 million. The central bank committed to reducing interest rates. It had

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promised to lower bank's borrowing costs by adjusting the mix of their different reserve ratios. A 20% plunge in the Indonesian rupiah sparked renewed concerns of currency depreciation throughout the region. A 20-month high inflation rate in April. The slowest firstquarter GDP growth in five years (1.7%). Relatively peaceful presidential elections. Yen's depreciation. President-elect Joseph Estrada was sworn in as the country's 13th president. The peso lost 6.6% against dollar.

SOUTH KOREA Date

Major Political and Economic Events

750821

Controlled Effective Rate was linked to a 'basket' of unspecified currencies. Liberalization of foreign-investment rules. Abolished credit ceilings and reduced scope of direct-credit activities. Most preferential interest rates abolished as well. Computerized exchange trading system put in place. Minimum and maximum bank interest rate ranges introduced. Interest rate restrictions on interbank lending abolished. Banks allowed to issue CDs at rate higher than for time deposits. Amendment to the Foreign Capital Inducement Act, a negative list system was introduced which permitted foreign investment in all areas not on the list. Foreign equity participation of up to 100% is allowed in a limited number of industries. Korea Fund launched on NYSE with a net asset value of $235.9 million as of December 1991. Foreign banks granted access to Central Bank's discount rate. Set up an OTC market for equities. Trade liberalization measures announced. Korean government outlines plan for liberalization. However, after the announcement the liberalization plan was put on hold due to an increase in money supply. The liberalization plan defined two categories of industry, Limited and Non-Limited.

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CHRISTOPHER BILSON, VINCE HOOPER & MARTIN JAUGIETIS Non-Limited industries will have foreign investment limits of up to 10% of market capitalization. Limited industries will have foreign investment limits of up to 8% of market capitalization. Furthermore, a limit of 3% is imposed for any single investor for any industry.e Most bank and non-bank financial institution lending rates and long-term deposit rates liberalized. Bank of Korea still controls short-term deposit rates, total volume of credit, and minimum credit guidelines to small and medium finns and conglomerates.

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Bekaert/Harvey Official Liberalization date. [NBER version]. Korea accepted the IMF's obligations of convertibility. Unified the call money market, previously divided between the banking and non-bank sector, s Foreign exchange controls phased out. Passed legislation to convert investment finance companies to security houses. Effective exchange rate replaced by a Market Average Rate determined in the interbank market based on a weighted average of rates for WON/U. S. spot transactions and allowed to vary within a narrow band. First ADR is announced. Ministry of Finance announced guidelines governing the opening of the securities industry to foreign institutions. The regulations call for a high entry fee and a required commitment of at least 10 years. No more than ten licenses are expected initially. Market opening to foreign investors. Notification System makes authorization of foreign investment subject to approval or notification. Foreign participation will be easier under new law. Repatriation of capital freely permitted. Government orders the thirty largest industrial conglomerates, whose sales account for 90% of Korean GDP, to focus on three core businesses. (Tight industrial policy). Announcement that stock market will open to investors in January of 1992. The announced regulations are that a foreign investor cannot own more than 3% of a company's shares and foreigners cannot own collectively more than 10% of a company. The government later raised the limit to 25% for 45 companies that already had more than 10% ownership by foreigners. The announcement is not well received by foreign

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investors. Korea admitted into the United Nations. Samsung, largest conglomerate, announced 2 subsidiaries would be separated from the group. Republic of Korea and Democratic People's Republic of Korea concluded an agreement covering political reconciliation, military nonagression and economic aggression.

IFC Liberalization date. Bekaert/Harvey Official Liberalization date. [Final version]. Kim and Singal Liberalization date. Partial opening of the stock market to foreigners. Foreigners can now own up to 10% of domestically listed firms. 565 foreign investors registered with the Securities Supervisory Board. Government approves lifting of foreign ownership restrictions on Korea Electric Power and Pohang Iron and Steel. Korea Electric Power lifts foreign ownership restriction from 8% total and 1% per individual to 10% total and 3% per individual. Pohang Iron and Steel lifts foreign ownership restriction from 8% total and 1% per individual to 10% total and 3% per individual. Kim Young Sam from the Democratic Ruling Party is elected as President. Implementation of a growth oriented 100-day economic stimulus package. President Kim implements the Real Name Financial System to help cut down on corruption by government officials and private recipients of government favors. Implementation led to panic by small investors. False name accounts were given 60 days to transfer funds to real name accounts to avoid maximum penalty of up to 60% of total account value. Sixty day amnesty period concluded in implementation of the Real Name Financial System. Panic quells as uncertainty over the business climate abates. By the end of 1993 foreigners own up to 9.8% of market capitalization and close to 9% of shares outstanding. Most companies have reached their 10% limit of foreign ownership restrictions. Cash deposits for buy orders put into effect. The limit was quickly increased to 40% of purchase value for institutional investors and 80% of purchase value for individual investors. Later the deposit amounts were reduced by half to 20% for

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CHRISTOPHER BILSON, VINCE HOOPER & MARTIN JAUGIETIS institutional and 40% for individual investors. The stock transactions tax was decreased from 0.35% of sales value to 0.2%. Finally, several IPOs hit the market including Samsung Heavy Industry, Goldstar Industrial System, Citizens National Bank, and Industrial Bank of Korea. Government approved ADR listing of POSCO on NYSE. (First ADR on NYSE, previous were 144As). IPO of Industrial Bank of Korea ($2.7 billion) and the last round of auction for Korea Telecom ($1.7 billion). Government announced that institutional investors would be exempt from the cash deposits of 20% for buy orders as of January 1995. Limit of foreign ownership of domestically listed firms raised from 10% to 12%. KEPCO and POSCO retain their limits of 8%. Government announces its intention to raise the overall limit from 12% to 15% sometime in 1995. Of the Korean Stock Exchange had 702 listed firms, 98 have reached their 12% foreign ownership limit. Overall, 8.6% of the total market capitalization was owned by foreigners. Ministry of Finance lowered the margin requirements for stock purchases from 40% to 20%. Individuals will be able to borrow up to 100 million won from brokers for purchases. Brokerage firms can lend individuals up to 25% of their capital compared to the current 18%. KSE trading in KOSPI 200 Index futures began. Announcement that stock options index will be launched in 1997. Announcement that foreign ownership limits will be raised from 12% to 15% in July. Government raised foreign stock ownership limit from 12% to 15% and raised the limit for single investors from 3% to 5%. KEPCO and POSCO limits' raised to 10%. $1.3 billion of fresh foreign investment entered the market. Ministry of Finance plans to deregulate the securities business by lifting interest rate controls on margin accounts, easing government control on the international activities of securities firms, and permitting local securities firms to borrow from the cheap foreigncurrency funds in order to underwrite overseas securities. Most importantly, the registration period for foreign investment will decrease from 14 to 5 days. Government announced plans to tax fixed income instruments beginning in 1996. Investor confidence responded positively to

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the news. Government announced that foreign firms will be able to list on the Korean Stock Exchange as of 1996. Rumors fly that former President Roe Tae Woo amassed an illegal political fund worth $650 million. Investor confidence wanes. Most of the money is thought to be held under false names in various financial institutions. Former President Chun Doo-hwan is taken into custody for his role in a 1979 coup. This arrest followed the arrest of former President Roe Tae Woo for his accepting bribes from most of the CEOs of Korea's leading companies. The stock markets plunge. Limit of foreign ownership of domestically listed firms raised from 15% to 18%. Futures begin trading on the Korean Stock Exchange on the KOSPI 200 Index. Short term abolition of the capital gains tax. Government relaxes foreign ownership restrictions from 18% to 20% and from 12% to 15% for state owned enterprises. South Korea opens its first won-yen exchange market, which aims to reduce transactions cost for market traders. Government announced that in two years it will relax foreign ownership restrictions of telecommunications industry to 33%. Government IPO of Korea Telecom. Government announced plans to lift foreign ownership restrictions from 20% to 23% in May 1997. Government raised foreign ownership restriction from 20% to 23%. Trade surplus of $97.6 million, the first monthly surplus since December 1994. Kia's group faced financial problems. The August trade deficit was $381 million, down from July's $806 million. Government would raise the foreign share-holding limit to 26% from 23% while state-run firms' limits would be raised to 21% from 18%, effective November 3. Foreign investors unload a $93.6 million worth of shares on October 21. The government abandoned its defense of the won and sought a $20 billion loan form the IMF. Korea got a $55 billion bailout package from IMF. Won depreciated to 1,695 at the end of the month. The government announced a new 50% foreign investment ceiling, effective December 11. IMF and G-7 nations had pledged to expedite

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CHRISTOPHER BILSON, VINCE HOOPER & MARTIN JAUGIETIS $10 billion in aid to Korea. Foreign net inflow of $457.7 million in 1998 helped stabilize the won against dollar. S&P upgrade credit rating of select Korean bourse companies. S&P upgraded the country's foreign currency debt rating by three notches, one grade below investment grade. The government lifted all restrictions on listed companies' right offerings from February 20. The Emergency Economic Committee agreed to let foreigners buy up to one-third of a company's shares without prior approval of the target firm's board of directors. Korean equities will be permitted to fluctuate within a 12% band beginning March 2. The Japanese lenders agreed to support a plan to reschedule $24 billion in short-term Korean debt. Creditor banks will extend $21 billion of maturing bank debt up to three years, in exchange for government guarantee. A weaken yen undermined Korean exporters' price advantage over their Japanese counterpart. The jobless rate hit a 12-year high of 6.7%. Foreign investment limit on Korean securities was raised to 55%. Foreign investment ceiling on state-run corporations, Pohang Iron & Steel as well as Korea Electric Power was boosted to 30% from 25% cap. The government committed to write off $70 billion in bad loans and to take controlling stakes in commercial banks that are unable to find outside investors.

TAIWAN

Date

Major Political and Economic Events

7600

Established open money market with market-determined interest rates. The United States formally recognizes the People's Republic of China and breaks off relations with Taiwan. Effective Rate was placed on a controlled, floating basis with its exchange determined against a 'basket' of currencies. Liberalized CD rates. In the Spring, Taiwan was expelled from

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the IMF and the World Bank. Ministry of Finance began policy of gradual liberalization.e The plan has three phases. The first phase will allow indirect investment through trust funds established in the Republic of China. The second phase will allow direct investment by foreign institutions. The third phase will allow free access to foreign capital. Taipei announced the gradual opening of local stock market to foreign investors via 'beneficial certificates' issued by local investment companies. Foreign investors were to be allowed to buy shares in companies in Taiwan. Implementation date of phase one of the liberalization plan. The International Trust Company Limited is established. The Taiwan Republic of China fund raises $41 million in Europe and Japan for investment in the Taiwan stock market. This fund is made possible by the International Trust Company Limited. Flexible maximum and minimum lending rates introduced. Commercial banks allowed to set prime rate within centralbank administered range. Revoked regulation prohibiting maximum deposit rates from exceeding minimum lending rate.s Offshore banking operations begin in Taiwan. Taiwan continued to dismantle its foreign exchange control system. Allowed foreign-invested firms to remit capital gains as well as all of their investment after one year instead of several; reduced tariffs on 1841 items, freed restrictions on transactions in gold; permitted residents to hold or export up to U.S.$5 million in foreign exchange and allowed residents to buy foreign exchange certificates of deposit at minimums of U.S.$10000. Value Added Tax of 5% was instituted (15% for entertainment facilities and 1% for small businesses). Taipei Fund launched on the London Stock Exchange with net asset value of $88 million as of December 1991. Liberalization of foreign capital account. At mid-1987 the 38-year period of martial law was ended, the ban on strikes was lifted and a constitutional democracy was to be instituted. Practically all foreign exchange controls were lifted. Later in the year, import tariffs on 3500 items were cut. President Chiang Ching-kuo died, bringing an end to Chiang

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CHRISTOPHER BILSON, VINCE HOOPER & MARTIN JAUGIETIS family rule which lasted four decades. Vice President Lee Tung-hiu was sworn in as his successor, followed by massive public unrest. At mid-year, the Minister of Economy and eight other officials faced impeachment charges over a scandal involving Taiwan's top automobile manufacturer. Liberalizations continued. Foreign stockbrokers could open branches in Taiwan and import tariffs were being reduced. It was announced that the income tax on capital gains would be reimposed at the start of 1989. Foreign Exchange Rate liberalization. Complete deregulation of interest rates with advend of a new Banking Law. Relaxed the requirenment for entry into the banking system and the establishment of new branches including international offices. Government set to allow foreign investmen in the stock market in local companies. Central Bank lifted the U.S.$5 million annual limit for financial institutions making remittances and overseas investments with specified trust funds. Taiwan recognizes the Government on the Mainland and sanctioned indirect investment in China through affiliates or subsidiaries. President Lee Teng-hui reelected by the national assembly.

IFC Liberalization date. Implementation date of phase two of liberalization plan. Eligible foreign institutional investors may now invest directly in Taiwan securities if they have applied for and received SEC approval as a qualified foreign institutional investor (QFII).e Outward remittance is not allowed until three months after initial investment. Each foreign institution is limited to holding a maximum of 5% of any listed stock and total foreign holdings in any listed companies may not exceed 10%. Bekaert/Harvey Official Liberalization date. [Final and NBER version]. Kim and Singal Liberalization date. First ADR announced. Central bank halts (temporarily) inward remittance of QFII funds. China Steel Corporation plans to place 18 million shares of GDRs worth $400 million marking the first time foreign investors will be allowed to directly purchase equity of a

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Taiwanese company. Until this time investors were restricted to Euroconvertible bonds and country funds. Asia Cement tapped international market with a $60 million issue. Authorities approve purchase by domestic investors of futures traded on international exchanges as a part of a three stage program to develop domestic futures and options trading facilities. China Hsin raises $72 million through GDR issue on NYSE. New Taiwan Dollar fell 3.5% against the dollar. The government lowered the interbank rate to 4.8%. Parliament reinstates a capital gains tax of 10-14% on stock market profits. Executive Yuan increased the ceiling on foreign ownership of total market capitalization from 15% to 20%, raised to 25% in December. Presidential election won by incumbent Lee, Teng Hui. The benchmark short-term interest rate fell to a 22-month low of 4.5%. Central bank allowed money market rates to rise. Interest rate hike. The government encouraged large state-run commercial banks to sell shares. M1 money supply increased 14.4% since March. Government took steps to give greater access to foreign banks in domestic markets. Currency fell to a nine-year low against the dollar; the central bank raised its rediscount rate to 5.25% from 5.0%. Devaluation of the Thai Baht. Stocks rallied to a seven-and-a-half-year high amid strong interest for Chiao Tung Bank. The limit on how much of the net worth commercial banks can invest in stocks was raised to 20% from 15%. The central bank announced that foreign institutions investing less than $50 million no longer require central bank approval. President Lee Teng asserted the island's right to govern itself and seek international recognition in Panama. The government spent $5 billion defending the currency since the East Asian currency turmoil began on July 2. The central bank capped a rise in interest rates to a seven-year high on

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CHRISTOPHER B1LSON, VINCE HOOPER & MARTIN JAUGIETIS October 8, pulling overnight rates down to 9.5% from 11.5%. Cut in bank reserve requirement. The foreign limit on shares was raised to 30% from 25%. The predicted year growth was 6.6%. The local currency trading at 10-year low. The government has permitted the currency's depreciation as an export-boosting measure. The weak in Korean won pressured competition for the Taiwan's technology firms. The Yamaichi collapse. The poor election performance by Kuomintang Party in the local government elections on November 30 and the strong outcome for the opposition DPP. On December 3, the government decided to allow mutual fund companies and stock consulting firms to manage accounts for investors in 1998. The companies were allowed to buy back up to 10% of their shares. Exports reached an all-time high of U.S.$11.41 billion in November. The government signaled to liberalize the financial markets. The currency fell to an 11-month low. Foreign net outflow was U.S.$85 million. International optimism over the outlook for Asia. Foreign funs had a net inflow of U.S.$ 692 million from Feb 1-9. Central Bank Governor Sheu Yuan-dong died and Patrick Liang was appointed acting governor. Government asserted that it would not lift restrictions on foreign ownership of property. On February 21, the Finance Minister announced new rules that lower the minimum deposit for borrowing stocks to 70% of their values from 90%. The Taipei government will rezone land for commercial use. Weakness of the Japanese yen overseas. Warmer U.S.-China ties could have an adverse effect on local economy. The futures exchange will begin trading in May, subject to parliamentary tax-exchanges. Concern about weak foreign demand for personal computers. The NT dollar weakened to $34.1. The weakening Japanese yen. The finance ministry lowered the collateral required on margin loans to 120% of the deposit before a margin call is triggered. S&P affirmed its AA + sovereign credit rating, citing foreign reserves that exceed total short-term debt by about three to one.

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THAILAND Date

M~or Politic~ and Economic Events

770429

Foreign Promotion Act, guarantees that no private business will be nationalized. Tax exemptions are granted for three to eight years, as are tariff exemptions and reduction in income taxes. Free repatriation of profits and dividends. Interest rate ceilings for financial institutions from 15 percent limit imposed by usury law. Board of Investment criteria are changed to facilitate exportoriented investment. While new criteria require majority local ownership for firms producing in the domestic market, they permit majority foreign ownership of export-oriented firms; plants whose output is wholly exported are permitted to be owned 100 percent by foreigners. Banking crisis. Thailand abandons fixed exchange rate vis-h-vis the dollar. General credit restrictions abolished but restrictions on bank lending rates reimposed. Ceilings for loans to priority sectors lowered. IMF stand-by credit. Bangkok Fund Ltd launched on the London Stock Exchange with net asset value of $163.5 million (in December 1991). Morgan Stanley launches $30 million Thailand Fund. General Yongchaiyut called for reforms. ASEAN free trade agreement extended. Inauguration of the Alien Board on Thailand's Stock Exchange. The Alien Board allows foreigners to trade stocks of those companies which have reached their foreign investment limits. Thais continue to trade stocks on the Main Board. Bekaert/Harvey Official Liberalization date. [Final version]. Chartchai Choonhavan takes office. Kim and Singal Liberalization date. IFC Liberalization date. Bekaert/Harvey Official Liberalization date. [NBER version]. Ceiling on foreign borrowing raised. Abolished deposit rate ceilings on commercial bank time deposits greater than one year. U.S. imposes restrictions on imports from Thailand.

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CHRISTOPHER BILSON,VINCE HOOPER & MARTINJAUGIETIS Accusations of corruption. Strikes protesting privatization. Domestic firms no longer need to get approval to pay dividends to foreigners. Ceiling on loan rates raised. Thai citizens gain access to foreign bank accounts. Twenty ministers sacked in corruption scandal. First ADR announced. Coup overthrows government. Investability Index jumps 35 percent. Prime Minister Chatichai ousted. Announcement of the loosening of foreign exchange controls and the introduction of the value added tax system in January of 1992. Controls and reporting requirements for the repatriation of dividends, capital gains, foreign currencies, and share certificates are partially removed. Controls and reporting requirements for the repatriation of dividends, capital gains, foreign currencies, and share certificates continue to be partially removed. The Thai prime rate stands at 13.75%, the highest in several years. The Bank of Thailand said it would pump more funds into the market by intervening in the foreign exchange and repurchase markets. The government unveiled a tax-cut package aimed at stimulating exports and reducing the current account deficit. The government planned to reduce interest rates. The overnight rates rose to 25%. The baht fell to its lowest level in 10 years. The central bank boosted short term rates. Thai officials refused to join the World Trade Organization agreement to liberalize the telecom industry. The Financial Minister pledged to reduce interest rates by 2% by year-end. Devaluation of the Thai Baht. The central bank ordered 42 finance companies to suspend operations. S&P cut the ratings of seven financial institutions. Thomson Bankwatch downgraded its sovereign risk rating for Thailand to 'BBB' from 'A-'. Thailand was meeting conditions for a $17.2 billion rescue package from IME

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Economic growth estimate for 1997 was cut to about 1% from 3% by the central bank. Finance Minister Thanong Bidaya resigned from his post. Prime minister Chavalit resigned. Chuan Leekpai, Democratic party's leader, was named the country's new Prime minister and Tarrin Nimmanaheminda was appointed to the finance minister post. The Stock Exchange of Thailand (SET) will allow short-selling of the 50 issues in the SET 50 Index starting January 1. Thai Farmers Bank announced that non-performing loans comprised about 18% of total loans. 58 finance companies were suspended, 56 of which would be closed. Moody's lowered government debt and he debt of 11 banks and financial companies to 'junk' status. Fitch IBCA cut the debt rating of ten banks. A new state-owned commercial bank was launched to manage assets of 56 finance and securities firms closed by the government in 1997. The 49% foreign ownership limit for securities companies was scrapped. Creation of two-tier baht exchange market (domestic and offshore). Decision to dismantle currency controls was made on January 30. Definition for 'bad loans' changed to -those in which no interest has been paid for three consecutive months, compared with the current standard of six months. Interest rate in Thailand was at six-year highs. The government nationalized seven finance companies, including two publicly traded firms (Union Asia Finance Pcl. And Nava Finance Pcl. S&P downgraded the long-term foreign currency rating of the country's five biggest banks. (Thailand has $90 billion in foreign debts, largely in US$)

TWO YEARS AFTER FINANCIAL REFORM: CAPITAL MARKET DEVELOPMENTS IN KOREA Woon-Youl Choi and Yeong-Ho Woo 1. INTRODUCTION The financial crisis in late 1997 showed how Korea had failed to modernize its financial system. Since the crisis Korea has been undergoing the most painful financial as well as corporate restructuring process never experienced in its economic history. Just after the crisis the Korean government has taken prompt and drastic actions to reform its financial and corporate sector to restore a stable and sound economy. As a result, after two years, the Korean economy is gradually turning around much faster than expected. The financial crisis stemmed from the currency crisis that threatened almost all financial institutions and corporations with bankruptcy. Because the market mechanism was not functioning, the government stepped into the restructuring process. The government started to restructure the financial system with public funds. Once the major financial restructuring was largely implemented, the government moved to focus on the corporate restructuring. Behind the financial crisis, financial institutions and large corporations, especially chaebols, have been fingered as the culprits. Most financial institutions including commercial banks and merchant banks had not managed their businesses according to global standards. Although most commercial banks maintain well-designed rules and guidelines internally, their loan

Asian Financial Crisis, Volume 1, pages 239-262. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0686-6

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appraisal system did not work. Sometimes they made loans without proper loan evaluation because of political pressures. Merchant banks that can engage in foreign currency business have conducted business recklessly in their overseas operations. They borrowed short-term foreign funds and invested in long-term products denominated in Asian currencies. Once the crisis arose, merchant banks defaulted since they could not cover their losses from the long-term investments and commercial banks became bankrupt as corporations became bankrupt. Large corporations have focused primarily on their sales growth and have heavily borrowed to maintain unprofitable businesses or affiliates as well as to expand into new ventures. Because of the high leverage and low profitability, such corporations are greatly exposed to high risk with the economic fluctuations. After the financial crisis the mounting problems of chaebols stemming from heavy borrowing and opaque management have begun to surface. For instance, the structural weaknesses of the financial institutions were exacerbated by the default of several chaebols. In principle, the government has been keeping the position that the financial institutions in line with the market principle have driven the corporate restructuring process. Thus, the creditor banks took the initiative to resolve non-viable corporations, and financially distressed but viable corporations entered into workout programs. Moreover, the government set a general guideline that large chaebols must reduce their leverage ratio to less than 200 percent. The most plausible way to attain this goal is to increase the equity level through offering equity. Therefore, in the process of financial and corporate restructuring, a great emphasis has been given to the development of the capital market. Because in the intermediation market commercial banks and other intermediaries lost their ability to mobilize loanable funds and more importantly they lost their credibility, it was very essential to develop the capital market. As a result, huge amount of funds, for instance, were moved from bank deposits to collective investment schemes since late 1998. In developing the capital market the key issue is to expand the demand base for the securities. Therefore, the government has been trying to create new means of investment vehicles and to modify creaking systems of corporate governance and dubious business practices in order to attract domestic as well as foreign investors. That is, the government has taken a series of structural reform measures to develop the corporate type collective investment scheme and to improve standards of corporate governance and to enhance transparency in corporate management.

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This chapter reviews the developments in the Korean capital market since the financial crisis struck two years ago and suggests several agenda for change in the future. Many improvements have been made to enhance the capital market demand and strengthen the prudential regulations on financial institutions. This chapter consists of five sections. The next section addresses reform measures that had been taken after the financial crisis and the third section deals with the phenomenon that resulted from these reform measures. The fourth section discusses reform measures that have to be taken in the future to strengthen the capital market followed by the summary and conclusion.

2. REFORM MEASURES TAKEN AFTER THE CRISIS 1. General Background

Efficient capital allocation needs something more than can be attained by restructuring financial institutions. The existence of an invisible pricing function through trades among many rational market participants is the most effective vehicle to achieve efficient capital allocation, which oversees investment activities by financial institutions and eventually ensures the capital allocation efficiency. In all, an efficient capital market is one of the necessary conditions for efficient capital allocation. An efficient capital market should be endowed with at least two prerequisites. The first is operational efficiency of the market, maintaining a fast information gathering and an efficient price discovery function and keeping transaction costs low. The other is informational efficiency, guaranteeing fair trade among market participants, ensuring credibility of the market, providing confidence to the participants, protecting investors and eventually inducing investors into the market. The capital market in Korea was far behind the global standard in terms of the prescribed operational and informational efficiency. With the purpose of enhancing the efficiency of the capital market, the government has been actively implementing comprehensive reforms of rules and regulations. For instance, governing rules and regulations on the market architecture, the regulatory system, corporate governance, the disclosure system, accounting standards, institutional capital adequacy and market opening for foreign investors have been reformed to make the market more efficient and transparent.

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2. Integration of Financial Supervisory Organizations Financial Supervisory Commission The Act for the Establishment of Financial Supervisory Organizations was enacted on December 31, 1997 to integrate the responsibilities for financial supervision into the Financial Supervisory Commission (FSC). The FSC is responsible for the promulgation and amendment of financial supervisory rules and regulations, the approval and permission for the business of financial institutions relating to their operations and for the deliberation and resolution of agenda with respect to any inspections, examinations and sanctions on financial institutions, etc. The Securities & Futures Commission (SFC) was established under the jurisdiction of the FSC. It is in charge of deliberating matters related to securities and futures markets prior to the FSC's deliberation and investigating market abuses such as insider trading and market manipulation. The Financial Supervisory Service (FSS) was established as an executive body of the FSC and the SFC on January 1, 1999. The FSS has the power to inspect the assets and business conditions of financial institutions and impose penalties on the perpetrators. A special team shall be organized within the FSS to mediate financial disputes between financial institutions and customers.

Establishment of the KOSDAQ Commission In October 1998, the KOSDAQ Commission launched as one of the measures to vitalize the KOSDAQ market. The roll of KOSDAQ Commission shall be to supervise and maintain surveillance over the KOSDAQ market, and also to implement and revise related regulations. This commission holds nine commissioners, with representatives from venture companies, institutional investors and academia. The establishment of the commission is expected to ensure fairness of the market operation, to protect investors more effectively, and eventually to bring increased trading volume into the market with investors' confidence.

3. Expansion of the Capital Market Demand Deregulation of Foreign Investment in Korea In order to overcome the foreign exchange shortage the FSC lifted most restrictions on foreign investment in the Korean securities market from May 25, 1998. That is, the foreign portfolio investment ceiling of 55% on stocks listed on Korea Stock Exchange (KSE) and registered on KOSDAQ has been eliminated completely. As for the government-controlled corporations, the

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aggregate and individual investment ceiling increased from 25% to 30% and from 1% to 3%, respectively. Also, the FSC allowed foreigners to acquire stocks in the primary market. Accordingly, foreigners can subscribe publicly offered shares of KSE-listed and KOSDAQ-registered companies. Foreigners have been allowed to invest in short-term money market instruments such as certificates of deposit, and repurchase agreement since May 25, 1998. Moreover, under the measure, the market opening for foreigners was accelerated, allowing to purchase all types of corporate bonds even guaranteed bonds, convertible bonds, bonds with warrants and exchange bonds. In all, investment in the bond market has been totally opened to foreigners.

Introduction of Securities Investment Company (Mutual Funds) In order to vitalize the capital market by expanding the demand base, the government introduced the corporate-type investment trust fund into the Korean securities industry) The Securities Investment Company Act (SICA), which was recently enacted, is the unitary statute regulating mutual funds. The SICA basically stipulates structure and operations of mutual funds, and contains provisions regarding securities investment companies, asset management companies, custodian companies, sales companies, and back office companies. 2 Traditionally, the contractual-type investment funds have been the most well known form of indirect investment in the Korean stock market. Although individual direct investment in the equity used to be unusually high in the Korean market, individuals with lack of information have performed poorly compared to professional asset managers as the market becomes more efficient. As a consequence, it is expected that a shift from direct investment accounts to indirect investment accounts is on the way. The traditional investment trust companies (ITCs) are known to have suffered a huge loss. This is the reason why the government has carved out the sales function from newly established investment trust management companies (ITMCs). ITMCs can manage contractual funds as well as corporate funds, but their funds are sold through securities houses' sales networks. As a result, recently launched investment companies and ITMCs are generally known to have more transparency in fund management which together with the surge in the stock market brought early success. The healthy competition among the ITCs, ITMCs and securities investment companies is expected to raise the overall demand toward the stock market through indirect investment vehicles. The new securities investment companies (or mutual funds) are modeled on U.S. investment companies set up under the Investment Companies Act, 1940.

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So far these can only be closed-ended and can be started by any management company with more than 7 billion won. Up to now most of them have been restricted to one year operating licenses. Nevertheless they have grown rapidly since they started in December 1998 to a size of 4.3 trillion won (54 funds) as of August 31, 1999.

Enactment of the Special Purpose Companyfor Asset Backed Securities The government enacted, on September 1998, the Act for Asset Backed Securitization. By introducing the Special Purpose Company (SPC), the government expects it to contribute to securitization of financial assets held by various financial institutions. Also, on October 1998, the government promulgated the Special Securitization Company for House Mortgage Loans Act. By introducing the SPC for house mortgage loans, the government expects it to contribute to supplying stable housing loans and enhancing the efficiency of house financing. At the time that the SPC takes over mortgage loans, it is required that the SPC register the fact to the FSC. This registration shall be considered satisfying a requisite against a claim-transfer under the Civil Code or as a transfer of the mortgage. The company lies under the supervision of the FSC. 4. Corporate Governance General Background Beginning in November 1997, Korea has undergone the most painful financial crisis in its history. While chaebols have contributed to the country's huge economic growth, they stand accused of sacrificing profits and strategic focus in their pursuit of sales growth, competing against each other in the domestic market. Blame is also laid for ignoring other shareholders' interests and contributing to the financial crisis through its highly leveraged borrowing to finance excess capacity and maintain unprofitable businesses. Since the financial crisis various related regulations have been amended to improve the efficiency in corporate governance. Because a chaebol owner possesses ultimate authority in the corporate decision-making, the check-andbalance system of management has not been able to function properly. As such, changes in corporate governance have been proposed and enacted to improve the monitoring mechanism of a corporation and to protect minority shareholders' interests. Reform Measures in 1998 In February 1998, the KSE's regulation on listing requirements was amended so that listed corporations were obliged to elect independent directors to

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improve the transparency in corporate management and the corporate governance structure. It is required for listed corporations to have at least one independent director on their board before their Shareholders' General Meeting (SGM) is held in 1998, and have one-quarter of the board filled by independent directors starting in 1999. Election of outside auditors for a listed corporation was seriously considered when the issue of having compulsory independent directors was discussed. However, it was later decided that such an appointment should be a recommendation rather than an obligation for listed corporations, in accordance with the KSE regulations. A corporation not abiding by this recommendation will have its name published in the KSE's daily information paper, Securities Market Paper. An independent director must meet the set qualification standards, and must possess sufficient professional knowledge and experience in management, economics, accounting, law or other related fields. Such a person should not be a majority shareholder, be specially related in any way to the corporation, be a spouse, be blood-related to a director or be a director or an employee of an affiliate. Listed corporations without an outside director may be disciplined since such a requirement is one of the delisting criteria. Such a corporation will then be assigned to the supervisory listing section and possibly face delisting in two years by the KSE. From April 1st of this year, all listed corporations and those corporations both which belong to the 30 largest business groups and which are subject to external audit are obligated to form a nomination committee for selecting an outside auditing firm to enhance their audit credibility. 3 Also, rights of minority shareholders are strengthened. For listed corporations, from April 1st of 1998, shareholders holding at least 0.05% of outstanding shares can file a derivative suit. The move to have a director or an auditor dismissed or to have a director's illegal action suspended can be brought about by shareholders holding at least 0.5% (or 0.25% for large corporations with total assets exceeding 100 billion won) of outstanding shares. Shareholders holding at least 1% (or 0.5% for large corporations) have the right to inspect accounting books or move to convene the SGM. (Shareholding requirement for filing a derivative suit was further relaxed to 0.01% with a later amendment on May 25th.) In order to allow hostile takeover activities in the secondary market and promoting foreign investment in local corporations, the mandatory tender offer system was removed on February 24, 1998. Under the mandatory tender offer system, shareholders wishing to hold 25% or more of outstanding voting shares were obligated to acquire them through tender offer. Furthermore, the number

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of shares for tender offer should be more than 50% of outstanding voting shares including their own. Corporate Governance Committee established in 1999 In March 1999, in order to raise the corporate governance structure to the wodd standard, the Committee on Corporate Governance (CGC) was organized with 14 committee members and 14 advisory fellows, respectively. This committee produced a code of best practice for corporate govemance mainly applicable to listed corporations and had an open discussion with the public. In the final report distributed on September 22, 1999, the Committee suggested many important recommendations. The final report consists of five chapters as follows. The first chapter of the code is about shareholders. It explicates that shareholders' rights must be protected so that they can exercise their rights accordingly. For this, it is recommended that the dates of SGM should be scattered to give minority shareholders the opportunities to attend the meeting. Currently, most listed companies hold their SGM on the same day. Under the principle that all shareholders should be treated equally, the Committee recommends that the limitation of ownership in the financial sector should be justified if and only if there is any evidence of misconduct stemming from the ownership structure. In order for shareholders to get timely and sufficient information, it suggests that shareholders holding at least 0.5% (or 0.25% for large corporations) have the right to inspect accounting books. In addition, it is recommended that majority shareholders should have responsibilities if they influence the management decisions without any position in the corporation. The second chapter deals with the Board of Directors (BOD). In order to enhance the functions of BOD it is recommended that the BOD have appropriate subcommittees consisting of qualified professionals. For instance, it is recommended that a nomination subcommittee nominate new independent directors. For large listed corporations with total assets above one trillion won, it is recommended that more than one half of their board members should be independent directors. Independent directors must submit a certificate of no conflict of interest to the BOD and it must be disclosed, and they must have their own meeting regularly. It also recommends that the board meeting be held at least once a quarter and the minutes be recorded. Directors must hold their responsibilities for the fulfillment of obligations, and they must be fairly evaluated and compensated accordingly. The third chapter concentrates on auditing. The Committee recommends that large listed corporations, govemment owned or partly owned corporations and

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financial institutions should establish an auditing subcommittee. This subcommittee must consist of more than three directors of which more than two-thirds are independent directors and at least one member is an auditing professional. Outside auditors must be independent from the corporation and responsible for their activities. The fourth chapter relates to stakeholders. Debtors must be protected when there are major changes in the management such as M&A, reduction of capital, etc. The corporation must observe the labor related laws and regulations, and must make efforts to maintain good working conditions. Also, the corporation must pay attention to consumer protection and environment. It is recommended that employees should be able to participate in the management of the corporation according to the laws and regulations such as employee stock ownership program and stock option program. The last and fifth chapter recommends the monitoring activities by the market. It is secured that the M&A market can be formed to help improve the managerial efficiency and increase the value of a corporation. In this context, the management activity to defend the M&A should not harm shareholders' interests. Also, the corporation must positively disclose material information to stakeholders. For instance, corporations whose foreign ownership is more than 20% or more must prepare English versions of audit reports as well as material ongoing disclosure requirements. Moreover, corporations must disclose their corporate governance structure in their annual reports, in which they must include the comments on the difference of their corporate governance with the code developed by the CGC and their future plans to modify the governance structure. 5. Disclosure Requirements Registration Statement In April 1997 regulations were amended to expand exemptions from filing a registration statement with the FSC. Securities options, beneficiary certificates issued by foreign investment trust companies, corporate bonds issued by securities companies and debentures issued by the securities finance corporation were newly classified as securities exempt from filing a registration statement. When the issuing amount of securities is less than one billion won, the filing with the FSC of a registration statement may be exempted. The following securities are also exempted from such filing when they are sold through public offering: securities issued and owned by the national government, municipal governments, government-owned corporations, and FSC-designated corporations.

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Also, the reference system was introduced in the registration in April 1997. If a part of the registration statement or attached documents is the same as those documents already filed, it could be referred to the previous documents under the reference system.

Introduction of the Combined Financial Statements The Korean accounting standards require finns that have subsidiaries to prepare consolidated financial statements. However, because of the unique chaebol ownership structure in Korea, several consolidated financial statements are issued within the same chaebol. Further, a parent-subsidiary relationship exists when a company as the largest shareholder directly or indirectly owns more than 30% of another company's voting interest. In contrast, an affiliate is any company that belongs to a chaebol regardless of the ownership relation. Therefore, an affiliate that is not a subsidiary of another affiliate is excluded from consolidated financial statements although it is under the common control of the chaebol. In order to address these issues, the Korean Congress passed a bill that requires combined financial statements for chaebols for fiscal years starting from January 1, 1999. The objectives of combined financial statements are to present financial positions, operating results, and cash flows of chaebols as a whole under the assumption that chaebol-affiliated companies constitute a single economic entity. That is, according to the External Audit law and its decree, the 30 largest chaebols designated by the Fair Trade Commission are required to issue audited combined financial statements. The combined financial statements should include all domestic and foreign affiliates that are under effective control and be consistent with International Accounting Standards and other international best practices. Financial Reports From April 1997, more corporations must file their annual and semiannual reports with the FSC. Before the amendment, corporations - whose shares or bonds (excluding guaranteed bonds) are listed or whose registration for issuing shares or bonds (excluding guaranteed bonds) is effective - were required to submit annual and semiannual reports. The regulation was revised so that more corporations must submit annual report and semiannual reports. For instance, it includes corporations whose shares are KSE-listed or KOSDAQ-registered, whose non-guaranteed bonds or convertible bonds are listed on the KSE, whose registration for issuing shares, non-guaranteed bonds or convertible bonds is effective, or whose number of shareholders is 500 or more.

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In June 1997, the format of the annual reports was changed according to industrial classification. Previously, a single format was applied to all listed corporations. But at the moment there are six types of reporting format for six different industries, respectively: manufacturing, banking, securities, insurance, construction and wholesale & retail. Disclosure of segmented financial information was also introduced in June 1997. If a specific business division accounts for more than 10% of total sales, operating revenue or loss, or assets of the corporation, segmented financial information should be separately reported for the division. Some measures will be introduced to reinforce the disclosure system in the secondary market. Quarterly reports are to be filed with the FSC and KSE by listed corporations from the year 2000. Currently, it is proposed that listed companies must file quarterly reports confirmed by the auditor of the company. For quarterly reports external auditing is not required. Ongoing Disclosures The ongoing disclosure system was also improved in 1997 and in the following year. The scope of information and the reporting method by listed corporations for ongoing disclosure materialized in April 1997. Material management information for ongoing disclosure was classified into 45 items, and the contents of the disclosure were clarified for each item. The disclosure of a corporation's projects, such as new business plans and others, was required from November 1997. The corporation should disclose a detailed schedule of the project and any obstacles to the project. It should disclose the progress of the project in its annual report, as well as its semiannual report, to confirm whether the project is being completed according to its disclosed schedule. Penalties against violation of the disclosure requirement were strengthened in November 1997. When a corporation makes an unfaithful disclosure of material information for possible insider trading, a conviction is made and the issue of new securities is restricted. The standard of discipline is clearly set according to the type of violation incurred to ensure procedural transparency. The scope of disclosure regarding off-balance sheet transactions was expanded in February 1998. Disclosure requirements for trading derivative products, such as futures, as well as providing payment guarantee, were reinforced. The corporation concerned must report to the FSC and KSE when open interests of the derivative products amount to over 2% of total assets, and when, thereafter, changes in open interest exceed 0.5% of total assets or 20% of outstanding commitment. When the value of collateral provided in a fiscal year or accumulated payment guaranty for an entity exceeds 10% of its paid-in

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capital, the corporation should report on a case-by-case basis to the FSC and KSE. In April 1997, the filing system was changed for tender offers, transfer or takeover of material business, and repurchase or sale of a corporation's own shares. Previously, a tender offer statement had to be filed and accepted by the authorities concerned. Following the change, the tender offer statement still has to be filed but need not be accepted. Previously, transfer or takeover of material business was only to be disclosed. But as a result of the revision, a report must now be made, as it is similar to the merger in reality and appraisal rights of dissenting shareholders are also applied. While in the past a corporation had to submit a statement on nothing but repurchasing its own shares, now a statement must also be submitted on the sale of its shares. 6. Mark to Market System

One of the major impediments which has been hindering the sound development of the investment trust industry in Korea is the historical valuation method of fixed income funds. Traditionally, ITCs have used the historical valuation method so that the value of a fixed income fund never changes even though the market yields of various bonds fluctuate. Then during a period of rising interest rates investors can benefit from the mispricing when they want to redeem funds early. However, ITCs and/or unredeemed remaining investors take the loss from the mispricing. This practice prevents ITCs from rebalancing their funds' portfolio and encourages them to just hold bonds until maturity. In order to correct this practice, the government has announced the introduction of the mark to market system in November 1998. The new system will be applied to the new funds that are established after November 1998 and all the remaining funds as of July 2000. Therefore, it is very essential for ITCs to absorb the impact from the actual implementation of the mark to market system. If those who hold all the remaining fixed income funds ask for redemption all at once in order to avoid the probable loss from the mark to market system just before July 2000, old ITCs would be confronted with a liquidity drain. Therefore, it will be desirable that those fixed income funds with historical valuation are transformed to the new funds with mark to market system gradually by July 2000. In order to implement the mark to market system successfully it is essential to find fair prices of bonds. In reality, the Korea Securities Dealers Association provides a price matrix for market valuation everyday but some adjustments of the price matrix are needed to find out the fair market price of each bond. An

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evaluation committee, credit rating agency, and/or independent bond valuation firm can contribute to finding fair prices of bonds. 7. Bond Market Development In order to promote the government bond market the primary dealer system was introduced in July 1999. If large financial institutions can actively participate in government bond underwriting as primary dealers, there is a good chance that they can smoothly take the market makers' role. However, some skepticism still exists for this change due to the size and capability of Korean financial institutions as primary dealers. The compulsory placements of government or government agency bonds still exist and people simply consider these bonds as a quasi tax. This is an unhealthy practice, which undermines the establishment of proper bond prices. Also, the government often creates various types of special bonds, such as monetary stabilization bonds and restructuring bonds, to meet temporary financial needs. It is important to issue standardized bonds regularly and reduce the issuance of temporary bonds that would be off-the-run soon after the issuance. It seems that there is a strong demand for Korean government bonds and top rated corporate bonds among foreign investors. If foreign exchange risk can be hedged at reasonable cost, it will induce a large inflow of foreign capital. It is expected that the Korea Futures Exchange may provide foreign exchange risk hedge instruments as well as interest rate hedge instruments for the bond market. To cultivate the bond market, it is also essential to have a potential buyer and seller. However, for a securities house to play as a market maker, it should have enough cash as well as stocks of bonds to meet customer needs. In reality, the size of securities houses' capital is too small to accumulate bond portfolios, and the securities houses cannot raise necessary funds with their bonds in hand since the short selling and repurchase agreement (RP) market have not been adequately developed. If RP and short selling become readily available, it will not only increase the demand for bonds, but also help the securities houses to be market makers. For all kinds of financial instruments the ultimate beneficiary is the individual investor, and therefore the instrument has to be attractive to individual investors. While liquidity is the most important condition to attract any kinds of investors, tax incentive is also important to raise individual demand for bonds or for bond investment funds. It is suggested by the securities industry that tax incentives for government and municipal bonds,

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inheritance tax exemption for long-term bonds, and tax exemption for capital gains of foreign investors are needed to enhance demand for bonds. Before the financial crisis, financial institutions have guaranteed most corporate bonds. However, as the non-guaranteed corporate bond issuance is becoming popular after the crisis, the role of credit rating agencies will become very important. Currently, each firm that wants to list its bonds on the exchange should receive credit ratings from at least two rating agencies. The high professional standards of rating agencies and lower cost of receiving frequent or regular ratings should be provided for the rating to be more reliable one. In the secondary market 97% of bond trading is conducted through the overthe-counter in which the price quotation and deal is made by telephone inquiry. The Korean bond market needs a reliable price provider. Maekyung-Bloomberg is trying to be a market index provider to become a generic price provider in the long run, but is not yet established as a reliable information provider. 3. R E C E N T

CHANGES

IN THE CAPITAL

MARKET

The reform measures taken since the financial crisis have driven the Korean capital market to recover dramatically. Most of all, the expansion of demand forces and the enhancement of transparency in the market attract foreign as well as domestic investors. Noticeably, as of June 1999 the collective investment funds (investment trust funds and securities investment companies) have increased to 250 trillion won from 94 trillion won at the end of 1997. 4 A most distinct recovery has been shown in the stock market. The KOSPI at the time of the currency crisis was 350 points. It has decreased to 276 points in the second quarter of 1998, but has surged to over 1000 points in the second quarter of 1999. (The trends of the KOSPI are plotted in Fig. 1). In the stock market the deposits waiting for investment in stocks amount to nearly 9 trillion won, which was only 2 or 3 trillion won before the crisis. And the equity type investment funds has increased to 34 trillion won as of June 1999 from the lowest level of 9 trillion won at the end of 1998. The recovery of the stock market contributed to corporate restructuring by way of increasing the equity level of listed corporations. As shown in the Table 1, after the crisis, listed corporations raised funds through equity offerings at the amount of 32.8 trillion won, and through corporate bond offerings for the amount of 76.6 trillion won. Although the target leverage ratio of 200% set by the government for chaebols is very crude, the bullish stock market has helped corporations raise their equity from the market. Table 2 shows how 30 chaebols reduced their debt to equity level from 448% (at the end of 1997) to 252% (at the end of the first

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4. FURTHER DEVELOPMENT NEEDED 1. Defined Contribution Type Corporate Pension Scheme General Background In Korea, under the current Labor Law, a company must pay its employee on severance or retirement a lump sum retirement benefit equivalent to one

Table 1.

Proceeds from Corporate Securities Offerings (Unit: billion won) Stocks

1991 1992 1993 1994 1995 1996 1997 1998 1999(6mos)

Corporate Bonds

Cases

Amount

Cases

Amount

Total

158 159 210 198 219 210 190 154 153

2,687 2,350 3,259 6,248 6,267 5,286 3,389 14,158 18,620

2,797 2,382 2,681 2,710 2,819 3,206 2,246 1,096 588

12,741 11,137 15,599 20,033 23,581 29,902 34,322 55,970 20,609

15,428 13,487 18,858 26,281 29,848 35,188 37,711 70,128 39,310

Note: 1. When the same company makes public offerings of both new issues and outstanding shares, the larger amount is counted in the entry for 'case' 2. In the case of public offering of unlisted companies or incorporation by subscription. 3. From 1992, bonds issued by the leasing corporations were excluded (figures in parentheses include those bonds of 1992). 4. Corporate Bonds issued by Merchant Banks were added from Jan. 1990 to Apr. 1996. Source: Financial Supervision Service, Monthly Financial Statistics Bulletin, July 1999.

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month's pay for each year served. Most companies are used to providing this as allowance by using the book entry system whereby each employee becomes an ordinary creditor. Or, from 1998, a company is able to buy a retirement insurance plan from an insurance company, which is a defined benefit scheme. However, defined contribution schemes are not allowed yet. Currently, a company enjoys a tax deduction up to 40% 5 of the estimated amount of retirement benefits payable to all employees. And if it has a contract with an insurance company, then 100% of premiums paid to insurance companies within the estimated amount are tax-deductible. Most companies rationally accumulate up to the 40% internally for utilizing the fund as working capital as well as getting a tax deduction, and then build up the excess over the 40% in the insurance companies for additional tax benefits. However, some companies build up the entire plan in insurance companies to get more loans from the insurers. However, the legal beneficiary of this contract is the company instead of employees, it is often used as collateral for the corporate debt. This practice is very far from the spirit of retirement pension plans that should be safe until retirement. Therefore, it is necessary for employees to keep their pension plan outside of the company and keep it safe until their retirement. Defined Contribution Scheme As a corporate pension plan, the U.S. 401(k) plan has received lots of attention in Korea. The 401(k) plans are defined contributions schemes, for whose final value the employer bears no responsibility. In order to emphasize the responsibility of the employee, the employer offers the employee a choice of ways in which his or her plan can be invested, usually in a selection of mutual funds, which have been chosen by the employer. Such schemes are flexible and portable, and can be added to by either employer or employee individually or collectively without disturbing the balance of the whole scheme. However, in the early stage of introducing a defined contribution scheme, it should be noted that the complex system like the U.S. system is not desirable for employees. Most of 401(k) plan specialists recommended that the scheme should be made of a few very simple products for employees. Also, in order to satisfy those employees who will worry about the reduction of their principal, one such scheme would have all contributions initially invested in government bonds, and then all accrued interest invested in stocks. This scheme may guarantee the principal for employees if they hold those government bonds till maturity. It should be made clear that the employee cannot receive any of the accumulated funds until retirement age without suffering some tax penalty. If

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he loses his job before retirement age, he can either leave the money due to him in the fund to continue to accumulate or transfer it to another approved scheme. It should be emphasized that, although it looks to be simple, such schemes are complicated to administer since each employee has a separate account, which may contain different investments, as if it were a personal pension plan.

2. Open-End Mutual Funds The securities investment companies are very popular in Korea although they only came to the market in December 1998. However, so far they are only permitted to be of the closed-end type. Also, the majority of the investment companies established so far have limited lives of one year, which may be to avoid illiquidity - the classical problem of closed-end funds. In order to cure this problem their shares are listed on an exchange and their trade encouraged, but this is likely to create a greater problem, as the shares will trade at a discount to the net asset value. The elimination of the discount requires liquidation of the fund. Therefore, closed-end funds are not ideal vehicles for participation by the general public in liquid assets. They are suitable for participation in less liquid assets such as smaller companies or venture capital, for which purpose they are quite widely used in many countries. For ordinary investors, however, the openend is much more suitable, provided that the underlying portfolio assets are sufficiently liquid to allow proper valuation and pricing for the purposes of sales and redemption. Specially, for those open-end funds that are designed to invest predominantly in listed stocks, it seems that there is no problem in permitting their introduction.

3. Stricter Supervision General Background It is very important to supervise the capital market and its participants in order to maintain a fair and orderly market. In Korea, however, its importance has been neglected for a long time since both regulators and participants were interested only in the quantitative growth of markets. Due to dramatic failures of financial intermediaries since the crisis, investors as well as regulators need to pay more attention to prudential regulations. The lack of prudential regulations is one of the major reasons why the Korean securities and asset management industries have failed. Prudent management and effective internal control would have contributed to preventing the crisis.

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Prudential Regulations on Investment Trust Companies In order to make the investment trust industry more competitive two major issues should be solved. One is the issue of firewalls between clients' funds and a proprietary trading account, and among investors' funds. In Korea, an old ITC is very unique so that it can manage and sell funds as well as engage in its own proprietary trading. Also, in new ITMCs there seems to be few firewalls between fund operators and distributors. This is similar to the previous issue in that the distributor's account is the proprietary account of old ITCs. Therefore, it is recommended that the investment trust industry be strongly supervised as guided by laws and regulations. The other issue is the corporate governance of securities investment companies. The most important advantage of a securities investment company is the transparency of its management. However, some investment companies abuse the corporate governance structure by selecting biased independent directors, which might be a stumbling block to the successful settlement of securities investment company. Compliance Programs Many ITCs (and ITMCs) in Korea generally do not understand the purpose and function of compliance programs yet. Although several ITCs have established compliance programs, they still remain at a nascent stage of development. Most other ITCs do not accurately comprehend the functions of compliance, and in fact confuse the purpose of compliance programs with the functions of audit departments or, more recently, that of risk management. Therefore, overall, at present, it would be fair to assess that Korean ITCs do not have even a general understanding of the functions of preventive compliance programs or do not know how to operate them. In case of securities companies, at present, only a handful of companies appear to employ full-time personnel that conduct compliance-type functions. Korean securities firms continue to rely upon after-the-fact audit departments much like the ITCs. As for the internal audit departments in Korean companies, they themselves have been virtually ineffective. Moreover, further compounding the situation, most companies are plagued with a lack of effective corporate governance. Against this background, Korean securities firms have yet to establish preventive compliance that seeks to detect improprieties before they pose serious risks. No securities firm could be found that has a full-fledged compliance department meeting international standards. The need for compliance functions within investment trust companies and securities companies is apparent. Weak regulatory systems compounded by lenient enforcement of violations and lack of qualified personnel, have all led

260

WOON-YOUL CHOI & YEONG-HO WOO

to a general lack of preventive compliance programs in ITCs and the securities industry. Investment funds, in the form of both investment trust funds and investment companies, and securities companies should be able to demonstrate that they have an effective compliance program before being allowed to come into existence. Therefore, financial fiduciaries in charge of investment decisions must provide their services based on strict adherence to relevant laws and ethical standards.

Legal Remedies In Korea the private enforcement schemes (traditional judicial scheme and new alternative dispute resolution scheme) are not well developed for investors. The developments of judicial scheme and alternative resolution scheme are closely related. Unless the judicial scheme is well developed and more legal actions occur, securities companies and investment trust companies do not have a strong incentive to resolve disputes using alternative dispute resolution methods. If the judicial scheme cannot be readily improved in a short period of time, there would be even greater need to develop a compulsory alternative scheme such as an ombudsman system in the U.K. Recently, there are debates to introduce class action suits in the securities market. Among others, a bill has been proposed to maintain a class action suit if the issuer of securities files an untrue registration statement, annual report or semiannual report, or if a bidder files an untrue tender offer statement. It has been suggested that in order to prevent the filing of false statements the violator would be subject to pay severe penalties. For instance, it is proposed that those who make any untrue statement of a material fact or omit any material fact should be fined not more than 800 million won. However, it is generally said that the penalty levied is so small that everybody has an incentive to violate laws and regulations. In order to keep an orderly and fair market principle more severe penalties are necessary.

5. SUMMARY AND CONCLU.S.ION The very recent Daewoo crisis has changed the climate of the capital market. Since the financial crisis in late 1997, Daewoo group companies raised their required capital through issuing corporate bonds and commercial papers. From July 1997 when the Daewoo group announced that it became insolvent and needed help to relieve its financial situation, the capital market as a whole has had problems. First of all, the ITC industry entered into financial distress since most ITCs hold Daewoo's bonds and/or commercial papers on average 7.5% of their assets. In order to prevent the early redemption, on August 12,

Two Years After Financial Reform: Capital Market Developments in Korea

261

1999 the association of ITCs promised to redeem a certain proportion of Daewoo's non-guaranteed bonds and commercial papers according to the holding period of investors. That is, bonds can be redeemed for 50% within 90 days, 80% between 91 to 180 days, and 95% between 181 to 270 days. Although the government has been trying to delay the early redemption of most ITCs, the corporate bond as well as commercial paper markets suffer from sharp reduction in the demand base. Therefore, in order to mitigate the Daewoo effect on the capital market the government took several measures. First of all, on September 1999 the government announced the establishment at a Bond Stabilization Fund that is designed to buy those bonds held by ITCs. And the government confirmed the promise made by ITCs on August 12, 1999. It is very critical to restore the credibility of the investment trust industry, which may hinder the corporate restructuring in the future. In general, it is believed that the uncertainty will gradually disappear if the Daewoo problem can be settled in a clear and transparent manner and the government prepares the concrete measures to solve the ITC problem. In order to develop the capital market one step further, it is necessary to restructure the investment trust industry completely to maintain a very strong demand base. Together with this, it is necessary to make the capital market more transparent and fair. In this sense, recent changes in regulations concerning the capital market and corporate governance are expected to contribute to the transparency of the capital market and to provide greater investor protection. As more detailed information becomes available to public investors, efficiency of accessing information in the capital market will be enhanced and illegal transactions, such as insider trading, will be prevented more effectively.

NOTES 1. Before the introduction of the corporate-type investment company, the investment funds are contractual-type, similar to German Investment funds and Japanese Investment Funds. There are two types of management companies in Korea. One is called the investment Trust Company (ITC) which is able to invest its own money, manage funds and sell those beneficiary certificates to investors. The other is Investment Trust Management Company (ITMC) which is a reformed contractual type and is not able to invest and sell. 2. The minimum paid-in capital for a SIC is 8 hundred million won for SIC and 7 billion won for an AMC. Mutual funds are expected to enhance the efficiency of investment trust industry and attract institutional and foreign investors' capital to corporate restructuring. 3. Fair Trade Office designates large business groups under the Fair Trade Law.

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WOON-YOUL CHOI & YEONG-HO WOO

4. See Korea Investment Trust Companies Association, Investment Trusts, July 1999. 5. It has been 50% until the end of 1998 and changed to 40% in 1999.

REFERENCES Chunsoo Lim (1999). Debt to Equity Swap in Korea: A Financial Analysis. Paper presented at the InternationalWorkshop on the Role of Debt, Equity Swap in the Corporate Restructuring Process held on September 2-3, 1999, Seoul, Korea. Committee on Corporate Governance (1999). Code of Best Practice for Corporate Governance, September 1999, Seoul Korea Financial SupervisionService (1999). Monthly Financial Statistics Bulletin. Korea InvestmentTrust CompaniesAssociation(1999). Investment Trusts.

KOREAN BANKING REFORM FOLLOWING THE ASIAN FINANCIAL CRISIS Hisanori Kataoka

INTRODUCTION Korea has experienced amazing growth since the 1960s, joining the OECD in 1996. However, the financial crisis, which surfaced in 1997, has forced Korea to ask the IMF for a $57 billion bailout for the first time since the early 1980s. Although the contagion effect spread from the crisis in Southeast Asia, the root of the crisis was the failure of the Korean financial system. The highly regulated and uncompetitive banking system, imprudent provision of loans funded by short-term borrowing in the international market, and the lack of transparency in the accounting and management of financial institutions are all evidence of the structural problems of the Korean financial system which saw little change for more than thirty years until the crisis. Since the collapse of its financial system in 1997, the Korean government has begun an extensive economic program focused on macroeconomic stability and structural reform of the financial sector. Individual banks, too, have been carrying out efforts to restructure their management systems. This chapter focuses on restructuring efforts in the Korean banking system and evaluates the progress and effectiveness of the reform.

Asian Financial Crisis, Volume 1, pages 263-292. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0686-6

263

264

HISANORI KATAOKA

BACKGROUND TO THE FINANCIAL CRISIS Korean financial institutions are categorized into two groups: banking institutions (commercial and specialized banks) and non-bank institutions (development, savings, investment, insurance and other institutions) as in Fig. 1. The Korean financial system has been privatized over the past fifteen years. However, traditionally heavily controlled but poorly regulated in the prudential sense, Korean financial reform was far behind the liberalization and internationalization occurring in real sectors. ~ After Park Chung Hee became president in 1961, he organized a highly centralized government and nationalized all banks, taking control of all forms of institutional credit. 2 Government-led development lending from banks to focused industries (heavy and chemical industries), no matter the risk, hindered the development of risk analysis in banks. 3 Even after the emergence of privately owned commercial banks by the mid-1980s, persisting government control4 limited banks' incentive to control their credit risk. The existence of insider relationships among banks, companies and the government, 5 resulted in regulatory forbearance on the part of the authorities and indiscriminate lending, regardless of the rate of return, on the part of the banks. The Korean government was also very sluggish in opening money and capital markets, as these markets were not well-equipped to compete against foreign institutions or investors. 6 In addition to accumulating large concentrations of lending to the highly leveraged top business groups, or chaebol, the Korean government also pressured banks to lend to small and medium-sized companies. Some Korean banks 7 lent up to 45% of their capital to a single borrower, compared with more conventional limits of 15-25%. Some banks lent up to 300% of their capital to one chaebol group. This created significant potential systemic risk, 8 and also led to 'financial repression,' which was reflected in the low average rate of return on bank assets, a rate which is among the lowest in emerging economies. 9 In its '1993-97 Financial Sector Reform Plan', the government allowed greater freedom in setting interest rates and allocating loans to financial institutions, authorizing foreign participation in the banking system. While the government now gave greater discretion to banks to set interest rates and loan amounts, government control over the banking system continued. The government voided bankruptcies of large corporations by directing banks to provide rescue loans, and the central bank provided subsidized re-discounts to the banks. 1° Nor did the government require banks to make full provision for investment securities losses. It allowed the deferral of foreign exchange losses for Korean corporate accounts. All of this made their financial reporting

265

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'crooked'. Under the safety net provided by the government, and with the lack of prudent regulation, commercial banks' lending continued to be aggressive H and merchant banks increased their foreign currency denominated loans. The introduction of a deposit insurance scheme in 199212 also removed the incentive from depositors to monitor bank management. Thus, there was enough background to create moral hazard on the part of both lenders and borrowers. Immediately following 1992, a sharp deterioration in the quality of loans was observed (Tables la and b). Under the guidelines of the government in 1995, commercial banks' capital adequacy ratios (CAR) all met the Bank for International Settlements (BIS) standard, which since 1988 has required the CAR to be above 8% for all internationally operating banks, 13 and their provisions for bad loans seemed quite sufficient. However, the actual CAR for Korean commercial banks was 7% on average, given their definition of 'bad loans' was much narrower than that of other OECD countries. 14 Fourteen commercial banks, including Korea First Bank and Seoul Bank, had CARs lower than 8%. 25 When the economy started to slow and several large companies such as Hanbo Steel failed in 1997, Korean banks were hit further. Ten of Korea's 26 commercial banks posted losses in the first half of 1997. By the end of October 1997, the total amount of bad loans held by suspended merchants banks was $4.2 billion, or 51% of their total l o a n s . 16 Banks tried to call in their short term loans to companies, but they were instructed by the government to extend maturity to help corporations and merchant banks. The non-performing loans (NPLs) of banking institutions as of September 1998 became 47 trillion KRW, or 7.6% of total loans. Including non-bank sectors, 71 trillion KRW, about 11% of total loans, was classified as non-performing at that time. The government estimates that NPLs will peak at 100 to 120 trillion KRW (18-20% of total loans) in 1999, with an asset recovery rate of 40%, translating into net system losses of 60-72 trillion KRW. However, IBCA, Ltd. (IBCA), a rating company believes that this estimate is somewhat optimistic, given the potential fallout from corporate restructuring, with its consequent impact on the number of insolvencies. 17Under consultation with the IMF, which stepped in beginning in November 1997 to bailout the economy, the Korean government is now trying to rehabilitate banks and revitalize the financial system through several reforms.

PROGRESS IN BANKING REFORM Financial sector restructuring is to be conducted in a way to compel unsound financial institutions to leave the market, resolving the overhang of bad loans,

Korean Banking Reform Following the Asian Financial Crisis

267

strengthening institutions' capital base, and ensuring the transparency of management.

TM B o t h

the Korean government and individual banks have made

m a j o r p r o g r e s s i n b a n k r e s t r u c t u r i n g in t h e p a s t t w o y e a r s . H o w e v e r , t h e o p t i m a l s o l u t i o n h a s y e t to b e f o u n d . It is i m p o r t a n t f o r s u c c e s s f u l

Table 1.

a a n d b: P e r f o r m a n c e o f K o r e a n B a n k s

la. Return on Assets (%)*

Korea** U.S.*** Japan****

1991

1992

1993

1994

1995

1996

0.55 0.53 0.15

0.68 0.93 0.09

0.51 1.20 0.08

0.54 1.15 -0.02

0.34 1.17 -0.43

0.27 1.19 -0.01

* ROA; **Commercial banks; ***FDIC member banks; ****City banks Source: Bank of Japan, 'Korean Financial Crisis and its Aftermath' lb. Non-performing loans of Korean Commercial Banks (trillion KRW)

Year 1990 1991 1992 1993 1994 1995 1996 6/97 12/97 3/98 6/98 9/98 12/98

Bad Credit* (% of total loans) 1.9 2.1 2.4 2.9 1.9 2.3 2.5 5.1 10.1 12.4

(2.0) (1.6) (1.6) (1.7) (0.9) (0.9) (0.8) (1.5) (2.7) (3.4) na

10.2 10.1

(3.4) (3.2)

Non-Performing Credit** (% of total loans) 7.2 8.3 10.3 12.1 11.7 12.5 12.2 17.3 22.6 28.0 29.1 22.4 22.2

(7.5) (6.6) (6.7) (7.0) (5.6) (5.2) (3.9) (5.2) (6.0) (7.7) (8.6) (7.1) (7.4)

* Bad credit includes credit classified as 'Doubtful' or 'Estimated Loss'. Doubtful Credit is that in excess of the portion collateralized to customers in arrears for more than six months, or to issuers of dishonored bills and checks, or to companies under court receivership. The Estimated Loss category is equivalent to customers in Doubtful Credit, but the loss has been realized. ** Non-Performing Credit includes Bad Credit and Substandard Credit. Substandard credit is the credit due to customers classified under Doubtful Credit, but covers the coltateralized portion. Sources: Bank of Korea, http://www.fsc.go.kr/kfsc/board/ll/pt_0303.html; Bank of Japan, 'Korean Financial Crisis and its Aftermath'

268

HISANORI KATAOKA

implementation of the policies that the government first specify what kind of system it is trying to establish in the long run. Basically, a banking system is to be considered sound if the system adopts the features in Fig. 2 in both policy and individual management aspects. The Korean banking system is no exception. All reform should target the 'ideal banking system' in the long run. In this section I describe the specific reforms the Korean government has enacted and then evaluate reform, revisiting the ideal banking system in the next section.

Fiscal Support for Financial Restructuring According to the Bank of Korea, public funds injection is unavoidable in the reform of the Korean banking system due to "the real possibility that turmoil in the financial system could trigger a crisis in all sectors of the economy, and the great difficulty for the financial institutions themselves to raise funds in the bearish stock and real estate markets.''19 The government announced a reform package in July 1997 that included a public fund injection of $4.4 billion into the banking system. By the end of December 1998, the government raised 64 trillion KRW, equivalent to 15% of Korean 1997 GDP, for financial sector restructuring. :° Roughly half will be used to finance the purchase of NPLs, and the remainder will be spent on recapitalization, deposit payments, etc. 2~ In November 1997, the govemment established the Korea Asset Management Corporation (KAMCO) to buy NPLs from banks planning mergers or carrying out self-rehabilitation plans. KAMCO buys the NPLs at an appropriate discount22 and injects new capital into the banks in the form of interest-bearing government-backed securities. By the end of September 1998, KAMCO had purchased 16 trillion KRW of NPLs with a face value of 36 trillion KRW from banks and insurance companies (Table 2). For commercial banks, the amounts purchased by KAMCO by the end of December 1998 were more than 60% of the overall NPLs of these institutions. The government has also established a program to inject public funds into the recapitalization of newly merged banks and to make up the losses arising from the acquisition of resolved banks. The government fills the shortfall between the assets and the liabilities of the acquired banks to prevent deterioration in the assets of the acquiring banks. It also injects capital into newly merged banks to bring their BIS CARs up to 10%. Before December 1998, 19.8 trillion KRW was spent for the purchase of NPLs, 13.2 trillion KRW was spent to recapitalize banks, including Korea First Bank and Seoul Bank, and 7.8 trillion KRW was spent for the repayment of deposits with resolved

Korean Banking Reform Following the Asian Financial Crisis

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Table2.

271

KAMCO's Non-performing Loans Purchase Schedule (trillion KRW)*

NPLs Purchase Price

11/97-9/98

10/98-12/98"*

1/99-6/99"**

Total

36.0 16.5

28.0-33.0 11.0

12.0-17.0 5.0

76.0-86.0 32.5

* including commercial banks, specialized banks, merchant banks, security companies, insurance companies and mutual savings companies ** estimation *** projection Source: Bank of Korea, http://www.fsc.go.kr/kfsc/board/11/pt_0303.html

An additional 23.1 trillion KRW is expected to be used in 1999, including the redemption of deposits of merchant banks, mutual savings companies, credit unions and other non-banks (Table 3). The Bank of Korea estimates that additional funds will be needed to cover losses resulting from the sales of the government's stakes in Korea First Bank and Seoul Bank to foreign investors, and exercise of the asset put-back option by the five banks, 24 which acquired the resolved banks earlier. 25

b a n k s . 23

Restructuring Bad Banks and Reshaping the Banking Sector In April 1998, the government established a new agency, the Financial Supervisory Commission (FSC), which succeeded the bank supervisory function from the BOK, 26 to force bank restructuring, ensure that capital adequacy guidelines are met and tighten up risk management and accounting standards. 27 FSC's medium term strategy is to strengthen liquidity and improve

Table 3.

Capital Injection Experience and Its Projections (trillion KRW)

Purchase of NPLs Recapitalization and Loss Coverage Deposit Payment Total

11/97-12/98

1999

Total

19.8 13.2 7.8 40.9

12.6 4.3 6.2 23.1

32.5 17.5 14.0 64.0

Source: IBCA, http://www.chosun.com/special/9901/ibca_report5.html

272

HISANORI KATAOKA

the quality of risk management in the banking system. Nationalization and mergers have been developed as the principal short-term strategy to stabilize the system and prepare it for restructuring. 28 However, the govemment intends to undertake rapid privatization, and the participation of foreign banks is viewed as essential to achieve these goals. 29 Korea First Bank and Seoul Bank were the hardest hit among twenty-six commercial banks in crisis. Korea First Bank's CAR, which was already below 8% in December 1997, stood at 0.98%. However, based on the assumption of full provisioning for loan losses and for unrealized securities losses, the ratio dropped to -2.70%, a negative net worth. At the same time, Seoul Bank had a 6.39% BIS ratio, but this would have fallen to 0.97% if unrealized securities losses had been included. 3° In December 1997, both banks were directed to carry out measures to improve their management. In January 1998, they were ordered to reduce their paid-in capital from 820 billion KRW to100 billion KRW, and shareholders were forced to bear the loss of the banks' mismanagement. Then, both banks were nationalized through subscriptions of 1.5 trillion KRW securities purchased by the Korean government and the Korean Deposit Insurance Corporation (KDIC) 31bringing their capital up to 1.6 trillion KRW in each case. 32 The Korean government agreed with the IMF that the two banks would be sold to the private sector, following their recapitalization, by November 15, 1998, 33 but this was postponed to the end of January 1999, due to the absence of a suitable buyer. However, in December 1998, the government settled a deal to sell a majority stake of Korea First Bank to a consortium of American institutions, Newbridge Capital, by April 1999, a transaction with an expected cost of 600 million to 1 billion KRW. 34 On February 22, 1999, the government announced the sale of Seoul Bank to HSBC Holdings for $900 million, including an initial 70% stake for the bank and a call option, which provides 51% of the new entity shares. The sale capped off a $27 billion bad loan buyback 35 and recapitalization effort, which should go a long way toward normalizing commercial bank operations. 36 In February 1998, the Bank of Korea (BOK) ordered management improvement in twelve other commercial banks (Table 4) which had BIS CARs below 8% at the end of 1997. The BOK required them to submit rehabilitation plans, including capital enhancement, by April 1998. The FSC, which succeeded the BOK's bank supervisory function, selected six domestic accounting firms associated with intemationally recognized accountants to inspect the Assets and Liability Management (ALM) and feasibility of the rehabilitation plans of the twelve troubled commercial banks. The Management Evaluation Committee (MEC), consisting of experts from the private sector, was then established by the FSC in June 1998 to deliberate on the basis of the

Korean Banking Reform Following the Asian Financial Crisis Table 4.

8% or more 6-8% less than 6%

273

BIS Capital Adequacy Ratios of Korean Commercial Banks as of End of 1997 12 banks: Kookmin;Housing & Commercial;Shinhan; Koram;Hana; Boram; Daegu; Pusan; Kwangjoo;Jeonbuk;Cheju; Kyongnam 6 banks: Chohung;CBK; Hanil; KEB; Chungchong;Kyungki 6 banks: Donghwa;Daedong;Peace; Kangwon;Chungbok

Source: Bank of Korea,http://www.fsc.go.kr/kfsc/board/11/pt_0303.html accountants' assessment as to whether the rehabilitation plans should be approved. 37 Based on the inspection, in June 1998 the FSC decided to order the exit of five commercial banks 38 through the Purchase & Assumption (P&A) method, for the first time in Korean history. The sound assets of those banks were purchased by five banks 39 which had more than 9% BIS ratios at the end of 1997, following public funds injection and put-back options granted by the government. 4° The bad assets of the resolved banks were sold to KAMCO with a book value of 4.16 trillion KRW in September 1998. KDIC put up the 5.78 trillion KRW by which the liabilities of the resolved banks exceeded their assets in September 1998. 41 Seven commercial banks 42 were designated conditionally-approved banks; their BIS CARs were below 8%, but their turnaround plans were approved by the MEC. The FSC is promoting restructuring of these banks through mergers, attracting foreign capital, consolidations with subsidiaries, and partial limitation of their banking business. 43 The FSC required some banks to change their management by appointing outside directors, including foreigners.44 In 1999, additional mergers among those conditionally approved banks took place. 45 Reform in Prudential Regulatory Standards - Increasing Transparency In order to improve bank supervision, the Korean government pursued several reforms to strengthen prudential policy. In January 1998, the government amended the 'General Banking Act' to enable supervisory authorities to carry out 'fit-and-proper' tests of shareholders and senior management by inspecting the adequacy of the composition of shareholders, the source of funds used in the acquisition of stocks, and the integrity and suitability of management teams. 46 The 'Act Concerning the Structural Improvement of the Financial Industry' was also amended in January 1998, so that the government can order the destruction of the equity of shareholders deemed responsible for the insolvency of banks that the government has recapitalized or decided to recapitalize. 4v In April 1998, the related legislation was changed so that the

274

HISANORI KATAOKA

FSC can demand management changes, capital reduction, merger, business transfers and third party acquisitions in banks whose CAR is below the 8% BIS standard. Thus, a new early warning system based on the BIS CAR was introduced (Korean Prompt Corrective Action). 48 Following the accumulation of NPLs and deteriorating banking profits, prudential regulation was tightened further in July 1998 by introducing a stricter definition of NPLs to include loans in shorter period arrears, so that potential NPLs could be captured early.49 The government also introduced a system requiting banks to match the gap between foreign currency assets and liabilities5° and minimize possible foreign exchange shortage risk in the banking system. The evaluation of marketable securities held by banks was changed to mark-to-market in 1998. In January 1999, new asset quality classifications were introduced, based on the assessed future repayment ability of borrowers. 51 Disclosure rules are also being improved. Lack of transparency is one of the major causes of the financial crisis, because foreign investors could not capture the real shape of Korean banks' losses, and therefore lost confidence in them. Korean banks' disclosure of information utilized neither mark-to-market in evaluating the loss of bank-held securities, nor included the broad base of NPLs. 52 The FSC has improved disclosure requirements toward the regular disclosure items in accordance with the internationally accepted standard, with additional disclosure mandated in risk management, off-balance sheet activities, asset classification, etc. 53 The requirements for minority shareholders' tight to initiate class action were eased in February 1998, and listed banks are now forced to appoint external auditors at the request of a nomination committee consisting of internal auditors and outside directors representing shareholders and creditors. 54

Improving Efficiency of Banking Management All Korean banks are being forced to improve their management in order to survive. Conditionally approved banks are drastically downsizing their organization and staff. By December 1998, many banks had cut more than 32% of their workforce, despite strong protest by unionized employeesY The banks also shrunk head offices and closed many branches (Table 5). 56 However, the FSC declared that conditionally approved banks would be required to trim their workforces by an additional 10% to 25% in order to continue to receive financial aid from the governmentY Restructuring the managing board is also important for appropriate corporate governance. It is necessary to enlarge the numbers of non-executive directors,

275

Korean Banking Reform Following the Asian Financial Crisis Table 5.

Bank Korea First Seoul Choheung Korea Exchange Hanvit Korea Housing Peace Kookmin & KLB* Shinhan Hana & Boram* Koram

Downsizing Figures for Korean Banks in 1998 Employees % change over 1997

Branches % change over 1997

Net Income change in billion KRW over 1997

-39.1 -35.9 -35.3 -32.2 -32.1 -30.1 -27.7 -18.2 4)2.9 15.7 29.0

-19.5 -20.3 13.9 -18.3 -12.7 08.3 -20.4 05.6 08.5 31.5 73.4

-2,600 -840 -1,970 -840 -3,350 -450 na 74 59 110 53

* merged Source: HennySender, 'New Kid in Town', Far Eastern Economic Review,February 1999

to expand the coverage of external audits, and to strengthen the surveillance function of interested parties such as shareholders, depositors, etc. According to the FSC, 58 as of March 1999, the number of total directors of 19 commercial banks decreased by 36.4% from the year before. The share of non-standing directors to total directors increased from 59.4% to 70.7% in the same period. However, the number of executive officers increased in many banks in order to fill in the gap created by the decrease in standing directors. Eighteen of nineteen banks elected outsiders as auditors with the aim of enhancing their independence and professionalism. Five banks now differentiate between bank president and chairman of the board of directors, possibly to implement more objective corporate policy and to reduce the risk of autocracy on the part of the president in bank management. Thirteen banks now use stock options as part of their incentive plan for directors.

REMAINING TASKS FOR KOREAN BANKING REFORM: POLICY RELATED ISSUES To date, the Korean government has implemented reforms swiftly and banking consolidation has been carried out on a relatively large scale. However, many tasks remain that should be carried out without delay to establish a better banking system.

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More Efficient Public Funds Injection Prompt injection of public funds is a must for successful restructuring and was executed as early as July 1997, the year when the Korean financial crisis began. Timely restructuring with huge public funds injections put the U.S. financial system in the strongest position in the world, while the hesitant and protracted Japanese action aggravated its financial crisis. 59 Korea seems to have handled the issue relatively well, at least in terms of its prompt action. 6° However, although public funds injection is no corporate project to be evaluated via the Net Present Value method, it should be used with care, particularly because any losses incurred are paid ultimately by taxpayers. IBCA worries that the Korean government may be overestimating the banks' capacity to enforce a workout in the face of chaebol intransigence and the banks' own very limited experience with commercial risk management. Therefore, IBCA expects government expenditure on financial reform will likely be increased in the future. 61 The government must consider how to effectively minimize the cost of public funds injection. The disposal of KAMCO's acquired NPLs, for example, remains superficial, due to the economic depression and a subdued real estate market, 62 yet the government is planning to inject more than half its public funds into KAMCO in 1999 to support its NPL purchases. Given the current government budget deficit,63 it is expected that unless land prices go up and the price of collateral increases, the loss in resale of the loan will probably increase, and must ultimately be borne by taxpayers. Strategies such as reducing real estate taxes to revitalize the real estate trade, or developing a badloan securitizing market (referred to in a later section) would be a more appropriate policy to minimize budget loss. Also, the government should recognize the risk that public funds injections may promote moral hazard in private banks. As was demonstrated in the closure of Korean First Bank and Seoul Bank, the government should request of each fund-injected bank, a reduction of net worth, a management purge, and business restructuring to clarify the responsibilities of management, employees, and shareholders. In order to minimize government spending, the government should inject funds into viable banks only - those which have the potential to recover and gain a competitive edge in the domestic or international sector in the future.

Improvement of Disclosure Rules and Enhancement of Market-Based Monitoring It is an urgent task to establish a general practice of allowing market forces to monitor and resolve bad financial institutions in order to reduce moral hazard

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and reduce the cost of bailing-out banks. At a minimum, disclosure should include specific, timely information on: (1) financial performance, (2) financial position (including capital, solvency and liquidity), (3) risk management strategies and practices, (4) risk exposure, including credit risk, market risk, liquidity risk as well as operational, legal and other risks, (5) accounting policies, and (6) basic business, management and corporate governance. 64 Establishment of an accounting system and practices congruent with international standards, in addition to a fair and transparent tax system are also key issues. 65 Also, a clearer definition of NPLs is desirable, so that individual banks cannot 'cook their books'. NPLs are decreasing in nominal terms, but the definition of NPLs is still ambiguous. Since it seems the disclosed NPLs do not include renegotiated loans, in which banks' re-discounted interest rates and other similar conditions allow borrowers to survive, and as the renegotiated portion is supposedly the largest proportion of bad debt (as was the case in the Japanese banking crisis), the disclosed NPLs are not credible; they do not show the true state of Korea's banking health. Moreover, by re-lending to borrowers, and having them repay interest payments, banks can significantly reduce the disclosed portion of the loans past due more than six months. 66 As Korean chaebols begin to restructure in the next few years, bankruptcy of these companies will likely increase and therefore, the bad debt of Korean banks will also rise. Thus, promptly establishing guidelines for disclosing NPL figures is extremely important for both the government and investors. Banks should disclose information on a consolidated basis. Affiliate leasing companies of banks are also in financial crisis, but there is no legal way to force the shutdown of insolvent companies. Nevertheless, nine troubled leasing companies out of a total 25 were closed in July 1998. 67 Considering that the failure of these affiliates aggravates the parent banks' balance sheets when banks write-off their loans, and considering the possibility that those banks may be forced by the government to rescue their affiliates through acquisitions, all relevant information, including all NPLs, should be disclosed.

Reforming the Safety Net System Limiting deposit insurance protection to small savers, putting uninsured depositors and large creditors at the end of the line for any recovery following resolution of a failed bank, and wiping out shareholder equity when a bank fails, are key success factors in increasing market discipline and investors' monitoring incentives over bank management in Korea. In fact, the interim blanket guarantee, which was introduced after November 1997 to cover

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deposits and interest payments in full until the year 2000, was partially removed. If deposits made after August 1, 1998 amount to more than 20 million KRW per depositor, only the principal is guaranteed. From the year 2000, a maximum insurance limit of 20 million KRW per depositor will apply to all deposits, in order to reduce moral hazard. 6s However, a more sophisticated deposit insurance system, such as that which charges a deposit insurance premium based on the risk of the banks, is crucial. Flat-rate premium systems still cannot resolve problems of moral hazard, because risky banks take greater chances knowing there is no difference in insurance premiums regardless of the amount of risk they take. Charging higher premiums based on banks' NPL size, CAR or credit rating will effectively reduce the risk of moral hazard and the cost of the deposit insurance system.69 More Large-Scale Financial Consolidation with Clear Exit Rules Although the total number of commercial banks declined from 27 to 14 in 1998, further consolidation and exit of banks should be promoted strongly. The Korean banking system still appears 'over-banked'. The number of financial institutions, including the non-bank sector, is excessive when compared with the U.S. or Japan. This over-banking, combined with banks' poor credit risk quantification skills, has forced Korean banks to earn relatively thin interest rate margins. Byong Ho Kang shows that Korean commercial banks currently charge 3.57% interest rate margins, which is far narrower than those in the U.S. 7° In ratios to average loan interest rates, Korean interest rate margin is the lowest among the countries compared (Table 6). 71

Table 6.

Comparison of Interest Margins (%)

Average Loan Interest Rate (A) Average Deposit Interest Rate (B) Average Interest Margin (C = A - B) Ratio of Interest Margin (C/A)

Korean Banks* 11.43 7.86 3.57 31.20

U.S. Banks** 9.10 4.02 5.08 55.80

Japanese Banks*** 2.53 0.42 2.11 83.40

* Korean banks include 26 commercial banks for 1997; ** U. S. banks include all commercial banks for 1996; *** Japanese banks include all nationwide banks for 1996 - - Average deposit interest rate of 3 major amount ranges of nationwide banks Source: Byong Ho Kang, 'Restructuring of Financial Institutions and the Corporate Sector in Korea'

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The possible reasons for this thin spread are: (1) Korean banks didn't establish the appropriate risk-quantifying skills to charge higher interest rates on riskier loans; and/or (2) this over-banking situation forced Korean banks to charge lower interest rates on their loans due to the severe competition.7z It is expected that any over-guaranteed and poorly regulated financial system, under the pressure of disintermediation, led to over-lending in risky projects. 73 If the over-banking situation forces Korean banks to charge inappropriately low loan rates, then the banking system definitely has to be further consolidated in order for viable banks to earn appropriate profits. 74 The head of the FSC stated in a recent report by Mackenzy Consulting, that four or five leading banks would be enough for Korea's economic scale. 75 As a means of consolidation, the government is promoting the acquisition of insolvent banks by viable banks, particularly restructuring upper-class banking institutions (commercial banks). According to the Bank of Korea, public funds were used to nationalize the banks, rather than force them to exit the system, because "if the two banks were liquidated, all remaining banks would have faced bank-runs with severe systemic risk for the financial industry.''76 This acquisition system seems not only to ignore the strategy of the acquiring, healthy banks, but is also opaque from the outside. These acquisitions of commercial banks definitely expand the asset and equity size of the acquiring banks and reduce their profitability figures (ROA or ROE), which are becoming more important in evaluating the efficiency of bank management under international standards. Nor can the acquiring banks focus their strategies (e.g. concentrate on sectors in which they hold comparative advantage, be it wholesale, retail, international, or domestic markets), if they are forced to acquire weak banks. Although the government is supporting acquisitions financially, in order to allow the acquiring banks to maintain the appropriate BIS CAR, the room for banks to acquire an insolvent bank is growing slim due to the declining profits of many banks. In the worst case scenario, it is conceivable that some of the acquiring bank's shareholders may file lawsuits against the government (or the managing board of the acquiring bank) over the forced acquisition. The moral hazard problem of insolvent banks cannot be eliminated (not only on the part of managers of insolvent banks, but also for depositors and borrowers) when rescue via acquisition, and therefore continuity of business, is anticipated. The government should announce clearly that the insolvent banks are to be closed77 and deposits to be paid-off, while good borrowers can continue their borrowing through bridge banks. TM In order for the pay-off to function effectively, increasing the available fund of deposit insurance is also needed. Clear exit rules in the banking system should be established, including effective

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bankruptcy laws, so that banks are seized by their creditors and the collection of debt is facilitated. The shutdown of troubled banks could lead to a credit crunch. To complement the credit reduction of commercial banks or non-banks, government should use a bridge bank, and/or specialized banks or development institutions, such as the Industrial Bank of Korea or Korea Development Bank, to maintain or initiate the loans to borrowers with solid credit records.

Development of a Bad-Loan Securitizing Market Currently, the major source for purchasing the NPLs of Korean banks is KAMCO, which, as discussed earlier, is accumulating such debts. In order to liquidate the NPLs more easily and effectively, a secondary loan trading market, including an Asset Backed Security (ABS) market must be established and organized. 79The legislation for establishing a basis for ABS was enacted in September 1998. 80These securities will be sold to domestic or foreign investors through the Special Purpose Company established for this purpose. Historically, Korea has had a very high household savings rate, but households may not be the appropriate buyers of securities, given the financial crisis. Potential buyers should be sought overseas. The Korean government should permit the creation of intermediate institutions, such as professionally managed mutual funds or pension funds to enhance the bad-loan security market and introduce foreign investors to the market.

A Sophisticated Early Warning System Prompt corrective action has been established to reduce the possibility of bankruptcy of financial institutions and to decrease the social costs of terminating unsound banking operations. However, the government should establish a more sophisticated risk-adjusted CAR than the simple BIS ratio as quickly as possible. 8t Current calculations of BIS CAR do not differentiate risk among borrowers, so long as borrowers are in the same category (e.g. no matter how risky the company, the risk weight of a corporation is only 100%). More sophisticated risk-adjusted measures should be introduced, such as a ratio based on the FSC's bank asset classification through on-site examination. Also, in addition to the CAR, other indicators such as value-at-risk (VAR), liquidity, maturity-gap, etc., should be taken into account in evaluating overall bank soundness at an early stage.

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Restructuring the Relationship among the Government, Banks and Corporations - Abolishing Connected Lending and Regulatory Forbearance Bank restructuring must be linked closely to the reform, not only of the corporate sector, but also of the government sector. The restructuring process is progressing within the top business groups, or chaebol, under the Big Deal. Workout programs for weak, but viable company groups are also being put in place by creditor financial institutionsY However, reforming the connections among governments, banks and corporations is crucial. Arbitrary government guidance in allocating loans resulted in connected lending between banks and corporations. The government's role should be limited to supporting the effective functioning of the market mechanism in the banking system. If bank examiners know they may be invited to positions at the top of banks after their retirement (a system referred to as amakudari in Japan), they have no incentive to demand reform. As there is no evidence that the amakudari improve bank management, 83 a strict firewall should be established between the government and banks and corporations in human resource management. 84 The Korean government should also limit its control of the banking industry. Specifically, the government should re-privatize troubled banks promptly once they've been nationalized. Before the sell-off of Korea First Bank and Seoul Bank, 29% of the Korean banking system, including development institutions such as Korea EXIM Bank, was under government control. 85 It may be necessary to nationalize troubled banks in an emergency situation, in order to limit the systemic risk of bankruptcy, but in light of the nightmare of dictatorship in the 1960s and 1970s with a nationalized banking system, the government should show a clear and credible path to privatize nationalized banks. In order to establish a principle of self-responsibility in banks and to implement better, cutting-edge management skills in operating banks, nationalization should be of limited duration.

TASKS REMAINING TO BANKS Viable banks whose management rehabilitation plans were authorized by the FSC review team in September 1998 are currently carrying out their plans through merger, capital increase via the inducement of foreign capital investment, consolidation with subsidiaries, and partial limitation of their banking activities. Several improvements, however, should be carried out in future. 86

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CAR Improvement The requirement to meet BIS CAR standards (8%) before the year 2000 adds a new dimension to Korea's credit squeeze. Fourteen commercial banks (including Korea First Bank and Seoul Bank) did not meet the 8% requirement in 1997. Now, banks will be forced to increase their equity capital, issue subordinate bonds and increase capital through asset revaluation. CAR is the best means to reduce banks' moral hazard and increase financial soundness. However, an 8% CAR is an inadequate benchmark under today's highly volatile global market. George Fane advises other troubled economies in Asia to adopt a minimum 20% CAR, given their volatile banking systems. 87 Although the severity of the financial crisis in Korea is less than that in Indonesia, Korea, too, should consider a CAR of at least 15% in order to reduce moral hazard and acquire international credibility. Introducing foreign investment should also be an option in raising capital. 88At the same time, banks need to recognize that there is a trade-off between CAR and ROE (the denominator increases when capital rises), unless ROA is improved appropriately through increasing earnings or decreasing assets. Therefore, banks should restructure their management further, cutting assets which do not produce appropriate returns and streamlining their operations.

Establishing Managerial Responsibility To prevent moral hazard arising in the course of resolving troubled banks, shareholders, employees and managerial staff must share the pain and responsibility of the trouble they created. As was seen earlier, many banks are increasing the number of non-executive or external auditors. It is necessary to establish strong corporate governance systems and management empowerment mechanisms in bank management. Ultimately, each bank should concentrate on operating efficiency on the basis of maximizing shareholder value.

Establishing Loan Risk Quantifying Measures via Default Probability Korean banks are particularly encouraged to adopt an advanced management system grounded in proper credit risk analysis. As of the end of 1996, the collateralized loans of 25 commercial banks were only 32% of overall loans, or 68 trillion KRW (Table 7). 89 Korean banks expanded non-collateral based loans on the credibility of chaebols (considered to be 'Too Big to Fail') due to political pressure by the government and were burdened with huge NPLs following the chaebols' collapse. The passive attitude of Korean banks in

Korean Banking Reform Following the Asian Financial Crisis

Table 7.

283

Korean Commercial Bank Loans (year end, trillion KRW) 1990

Collateralized Loans (share %) Real Estate Moveable Properties Securities Others Guarantees (share %) Non-Collateralized Loans (share %) Total Loans

1995

1996

32.0 (42.2)

67.0 (37.6)

67.8 (32.0)

26.5 0.9 3.3 1.3 4.8 (6.4) 39.0 (51.4) 75.8

54.4 3.4 7.0 2.2 11.8 (6.6) 99.6 (55.8) 178.3

54.6 2.2 9.3 1.6 12.9 (6.1) 131.2 (61.9) 211.9

Source: Takuma Takahashi p. 179

examining loans spoiled their credit analysis skills. As discussed previously, Korean banks' thin interest margin is due partly to inappropriate credit analysis the failure to charge sufficient spread on their loans. It is crucial that banks improve their credit screening skills and develop risk management techniques, including their ability to quantify credit risk. 9°

-

Adopting a Strategic Approach Formerly, operating under the government's protection, there was little room for Korean banks to form a business strategy. Traditional trade theory (emphasizing comparative advantage) and financial theory (stressing the importance that investors diversify, but companies focus their energies) affirm the importance for banks of choosing the right strategy, focusing on their strengths and nurturing their business competencies. It is still unclear where individual Korean banks will head once the current crisis is overcome. Without a blueprint for their future, banks will never achieve independence from government control. CONCLUDING

REMARKS

Korean bank reform entails many adjustments, both in government regulation and in the bank's individual operations. For the past 30 years, the basic functions of the financial industry, including credit analysis and corporate governance, have been largely neglected. The financial sector was able to

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survive previously, avoiding international competition and managerial innovation by taking shelter under government protection and control. However, the current financial crisis is forcing both the government and the banks themselves to implement painful changes in order to improve competitiveness and efficiency. The crisis provides an excellent opportunity for Korea to establish a real, open financial system. While many tasks remain for the future, the historical gradualism of reform is facing pressure from the international market. Indeed, some banks are now controlled by international organizations. Banks are being forced to abandon practices that encourage moral hazard and are beginning to operate their businesses in accordance with "market discipline, which requires transparent, profit-oriented, sound and accountable management. ''91 Globalization and deregulation in finance is now an irrevocable trend in the Korean economy. The next year or two are a crucial time for Korea to seize the opportunity to advance reform. If successful, Korea will establish an internationally competitive banking system and possibly assume the role of a regional financial center in Asia, effectively completing the real 'Korean Big Bang', in which the financial sector becomes the leading, rather than dragging force in the Korean economy.

NOTES 1. The description in this section is based largely on Heather Smith, 'Korea' in East Asia in Crisis: From Being a Miracle to Needing One?, eds. Ross H. McLeod and Ross Gamaut. (New York: Routledge, 1998). 2. http://icweb2.1oc.gov/cgi-bin/query/ 3. The cost of these heavy controls and financial repression exceeded the benefit in the 1970s. See Eduardo R. Borensztein and Jong-Wha Lee, 'Credit Allocation and Financial Crisis in Korea', Working Paper WP/99/20 (Washington, DC: IME February 1999). 4. Such as lending limits applied to large companies, subsidized lending from the central bank, etc. 5. Even after privatization, the five largest commercial banks invited their presidents from either the government, or the central bank. In the failure of Kanpo Steel, many politicians of the Kim Young Sam cabinet were arrested for forcing connected lending. See Yukiko Fukawa, Industrialized Korean Economy, (Tokyo: Nihon Keizai Shinbun, April 1997), p.188. (In Japanese). 6. According to the IBCA's rating report, which was released at the end of 1998, "Even after so called privatization the influence of the state remained pervasive, manifesting itself in directed lending, regulation of interest rates and state interference in the appointment of top personnel." http://www.chosun.com/special/9901flBCA_ reportS.html 7. Lending limits to chaebols only applied to commercial banks, not to merchant banks. Therefore, chaebols utilized merchant banks to exploit loopholes in the

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regulation. 'Korean Financial Crisis and Its Aftermath', (Tokyo: Bank of Japan, May 1998) 7. (In Japanese) However, chaebols are now required to reform their high financial-leverage structure by the government. They must reduce their debt-equity ratio to 200% by the end of 1999 and eliminate cross-subsidiary debt guarantees by March 2000. Korea Economic Update, (Seoul: Ministry of Finance and Economy, December 1998) 8. http://www.chosun.com/special/9901/IBCA_report5.html 9. Marcus Noland, 'Restructuring Korea's Financial Sector for Greater Competitiveness', APEC Working Paper 96-14 (Washington, DC: Institute for International Economics, November 1996), I. 10. The implicit co-insurance scheme existing among government, banks and industry, combined with lax prudential supervision standards, allowed banks to take excessive lending risks. Smith, 74. l l. Between 1990 and 1996, the financial industry's lending to the private sector increased by 17% annually. This is well above Korea's nominal GDP growth rate. Smith, 74. 12. Actually, a deposit insurance scheme for non-bank financial institutions in Korea has been operated by the Korea Non-Bank Deposit Insurance (KDIC) since the early 1980s. However, there has never been a deposit insurance scheme for banks. The plans for a bank deposit insurance scheme were first introduced in 1992 as part of the government's 1993-97 Financial Sector Reform Plan. Dong Won Ko, International Financial Law Review 16, Issue 4, April 1997. 13. Today, well-known, internationally operating banks have more than 10% CARs this is now considered a minimum requirement for banks to gain international confidence. In Hong Kong, for example, the consolidated CARs for locally incorporated institutions were above 17.7% in September 1996. In the U.S., the average CAR of banks with sound ratings is 16-20%. George Fane, 'The Role of Prudential Regulation', East Asia in Crisis, 299. 14. In Korea, there were three categories of NPLs: 'substandard' loans, which are loans past due more than six months, or loans to customers in bankruptcy court which are covered by collateral; 'doubtful' loans, loans to customers which are substandard, but not covered by collateral; and 'estimated losses', loans that are uncollectible for the foreseeable future. Until late 1997, substandard NPLs were not disclosed. Moreover, until 1998, NPLs did not include 'past-due' credits, loans which are in arrears of three to six months. This was true primarily because the government tolerated a common financial practice in Korea, in which customers generally do not take prompt payment of interest as seriously as borrowers in developed economies like the U.S. The collection ratio of past-due credits was also relatively high in Korea, because of the use of collateral. U.S. SEC base disclosure includes all the aforementioned requirements, including loans 90 days past due and renegotiated loans where rates were discounted. http://www.bok.or.kr/cgi-bin/nph-hwp2html.data/eng8/UP/ press5.hwp. 19980227182443 15. The definition of bad loans included only 50% of unrealized securities losses. 16. Smith, 77. 17. Recovery rate to date has passed 40%. http://www.chosun.com/special/9901/IBCA_report5.html -

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18. 'Bank Restructuring in Korea', (Seoul: Bank of Korea, December 1998) 2. Written for Deputy Governors' Meeting on Bank Restructuring held by BIS in Basle, Switzerland. 19. Ibid. 20. Those funds are raised by issuing bonds for the Non-Performing Asset Management Fund, run by KAMCO and the Deposit Insurance Fund, run by KDIC. Ibid., 19. 21. Including 12 trillion KRW injected into a number of newly merged banks to strengthen their capital base, resulting in BIS ratios of approximately 10% for these institutions, http://www.chosun.com/special/9901/IBCA_report5.html 22. The discount rate was 30% for loans with collateral and 80% for those without. Ibid. 23. Ibid. 24. Daedong, Dongnam, Donghwa, Kyungki and Chungchong. 25. 'Bank Restructuring in Korea', 22. 26. In April 1998, the Bank of Korea Act was also revised to guarantee the neutrality of BOK monetary policies through its independence. 27. http://www.chosun.com/special/9901/IB CA_report5.html 28. As the BOK indicates, the government believes "mergers increase the competitive edge of the Korean banking industry through economies of scale and remove the inefficiency caused by the presence of many relatively small banks." In September 1998, the amended Act Concerning the Structural Improvement of the Financial Industry came into force, simplifying merger procedures and tax incentives for mergers among financial institutions. 'Bank Restructuring in Korea', 14. 29. As discussed earlier, the recent decision to sell Korea First Bank and Seoul Bank to foreign institutions signals a commitment to reform and openness to overseas capital that is unprecedented in Korea. 30. http://www.bok.or.kr/cgi-bin/nph-hwp2html/dataleng8/UP/ press4.hwp. 19980226194218 31. In December 1995, the Korean National Assembly passed the Bank Deposit Insurance Act (Law No. 5042, the BDIA). Under the BDIA, the KDIC, which manages the bank deposit insurance scheme, was established in June 1996. It was modeled on the US FDIC. 32. 'Bank Restructuring in Korea', 8. 33. Coopers and Lybrand was selected as the accountant responsible for evaluating the two banks' assets. Morgan Stanley was chosen as lead manager for the sale. 34. The government will retain 49% interest in KFB, but will delegate its voting rights to Newbridge for two years, subject to an undertaking by the latter to keep the bank open, hold the capital structure in place and uphold the govemment's interest. The sale is conditional on the government writing down all existing bad loans and assuming responsibility for any loans that go bad the first year, and a certain portion that go bad in the second year. 35. The Korean government promised to take responsibility for all existing loans that turn out to be bad in 1999, and for a portion of such loans in 2000. 36. Dow Jones Newswire, March 3, 1999. 37. 'Bank Restructuring in Korea', 10. 38. Daedong, Dongnam, Donghwa, Kyungki, Chungchong 39. Kookmin, Housing & Commercial, Shinhan, Korea and Hana

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40. Under the option, bad assets could be sold back to KAMCO within one year after the acquisition turned sour. 41. In the non-bank sector, the Korean government revoked the foreign exchange licenses of eight merchant banks (Gyongnam, Samyang, Hangil, Coryo, Yeungnam, Daehan, Samsam and Kyungil that were unable to meet their liabilities at the time IMF negotiation began in November 1997. Nine merchant banks (Samsam, Hansol, Gyongnam, Coryo, Hangdo, Sangyong, Shisegae, Chongsol and Kyungil, owing to liquidity shortages, were ordered to suspend business on December 2, 1997. Five additional merchant banks (Daehan, Central Banking, Shinhan, Hanhwa, and Nara) were ordered suspension ten days later. In total, 18 merchant banks' operations were suspended, of which 16 had their licenses revoked. Only 14 merchant banks were operating as of December 1998 compared to 30 before the crisis. In addition, four security companies (Dongsuh on December 2, 1997; Coryo on December 5, 1997; KLB Securities and KDB Securities on July 25, 1998) out of 58, one investment trust management company (Sinseki Investment Trust on December 19, 1997) out of 31; 31 mutual savings and finance companies out of more than 200; and 50 credit unions out of 1700 were ordered to suspend business by January 1999. 'Bank Restructuring in Korea', 7-11 and http://www.mofe.go.kr/cgi-vin/e_mofe/body.txt 42. CBK, Hanil, Chohung, KEB, Peace, Kangwon and Chungbuk 43. 'Bank Restructuring in Korea', 12. 44. KEB appointed two directors from Commerz Bank in July 1998 in line with the FSC order. Ibid. 16 45. Mergers between CBK and Hanil, Hana and Boram, and Kookmin and Korea Long-Term Credit Bank were already approved, and another merger between Chohung Bank and Kangwon Bank, together with Hyundai International Merchant Bank would create a new bank in March. Government also injected public funds to prevent the possible deterioration of those merged banks' capital adequacy ratios, with the condition of reducing their capital and turning themselves around. 46. 'Bank Restructuring in Korea', 16. 47. Ibid. 48. The legal basis for Prompt Corrective Action was established by the Act Conceming the Structural Improvement of the Financial Industry in 1997. Corrective actions are described as "the step by step imposition of obligatory corrective measures by supervisory authorities on unsound financial institutions that fall below a certain level of capital adequacy." Three levels of corrective measures are used, based on the soundness of the bank's management: management improvement recommendations, management improvement measures and management improvement orders. The last applies to the worst managed banks, and includes orders of merger, lay-off, manager transfer, etc. by BSA. 'Update on Progress of Strengthening Prudential Supervision & Regulations', Team for Improving Supervisory Regulations of the Financial Supervisory Commission (Seoul: Bank Supervisory Authority, December 1998), 3. The FSC also altered the bank management evaluation system from CAMEL to CAMELS, which incorporates market risk assessment, in January 1999. The FSC also began to develop an electronic checking system for financial institutions in 1999, using some indicators to identify the symptoms of problems in the early stages. 'Bank Restructuring in Korea', 17. 49. The government began to classify loans in arrears for three months or more as 'substandard' instead of 'precautionary', and those for one to three months as

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'precautionary' instead of 'normal'. The required provision rate for precautionary loans was raised from 1% to 2%. The criteria for calculating BIS capital adequacy ratio was also revised to deduct the provisions of those classified as substandard or lower from Tier 2 capital. 'Update on Progress of Strengthening Prudential Supervision & Regulations'. 50. Net foreign exchange assets is regulated to be more than 0% to total foreign exchange assets for the maturity of 0-7 days, less than-10% for 7-30 days and less than-20% for one to three months. 51. At the request of the IME the FSC decided to introduce mark-to-market accounting in financial institutions, but only gradually, in order to minimize the negative impact. Banks, security companies, investment trust companies, lending specialized companies and credit unions have implemented the program from the settlement of the first half of fiscal year 1998 and fiscal year 1999. 'Update on Progress of Strengthening Prudential Supervision & Regulations', 6. 52. The Korean government only disclosed so-called 'bad credit', which was the portion not covered by the collateral of commercial banks. Neither NPLs covered by collateral, nor bad debt of merchant banks, which actually were in crisis (14 of 16 merchant banks were shut down in the first half of 1998), was disclosed. In November 1997, the government disclosed NPLs (including those past due more than six months, with collateral) of commercial and merchant banks for the first time. 'Korean Financial Crisis and its Aftermath', 10. As the FSC admitted, "disclosure contents have not been up to the minimum level of public disclosure requested by International Accounting Standards" (IAS). 'Update on Progress of Strengthening Prudential Supervision & Regulations', 7. 53. The FSC also increased the frequency of regular disclosure from once to twice a year from 1998. 'Update on Progress of Strengthening Prudential Supervision & Regulations', 7 and 'Bank Restructuring in Korea', 5. 54. 'Bank Restructuring in Korea', 18. 55. They also protested because the downsizing decision was government-led, not bank-led and they objected to the compensation package. 'Several Hurdles Remain in Banking Reform', Business Korea 15, Issue 10, October 1998. 56. 'Bank Restructuring in Korea', 18. 57. 'Several Hurdles Remain in Banking Reform' 58. 'Shareholders' Meeting Results at Commercial Banks', by FSC, March 1999. 59. In Japan, public funds injection had been a touchy issue for some time after the failure to convince the public of the need to inject funds into insolvent banks when the Jusen collapsed in early 1996. The 685 billion yen finally injected to write-off the Jusen was essentially used to rescue agricultural cooperatives, a large constituency for the LDP. Tax payers felt the bailout was improper. The Japanese government could not open public funds injection to debate until the end of 1997, although the banking system was very fragile. 60. Perhaps this is related to the difference between the presidential system, where the president is elected directly by the public and the cabinet system, where the prime minister is only indirectly elected by the public. The president may be able to take more drastic steps toward public funds injection. 61. http://www.chosun.com/special/9901/IBCA_report5.html 62. KAMCO could sell only 240 billion KRW by the end of September 1998. 'Bank Restructuring in Korea', 20.

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63. At the end of December 1998, the government budget deficit was already 5% of Korea's GDP. 64. http://www.bis.org/publ/bcbs41.html 65. Byong Ho Kang, 'Restructuring of Financial Institutions and the Corporate Sector in Korea', Journal of Asian Economies 9 (4) 1998. 66. Some Korean analysts argue the true bad debt of Korea's financial system is 200 trillion KRW, which is twice as large as the current worst case estimate. Catherine Lee, 'The Wrong Medicine: Nationalization of Commercial Banks in South Korea', The Banker, December 1998. Morgan Stanley estimates Korean NPLs will peak at 30% of total loans, an amount more than four times larger than today, by the end of 1999. Henny Sender, 'New Kid in Town', Far Eastern Economic Review, February 11, 1999. 67. Byong Ho Kang, 659. 68. 'Bank Restructuring in Korea', 18. 69. In the U.S., until the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) introduced a risk-based premium scheme, the deposit insurance system regularly led to moral hazard because it charged all member banks a uniform rate. 'Recommendations', International Financial Law Review 16, Issue 4, April 1997. 70. Japan's interest margin is lower than Korea's. Many analysts indicate Japanese banking system is overcapacity, which forced Japanese banks to charge lower interest rates than they should have according to risk profiles. Hidehiro Kikuchi, Ginkou Big Bang - Big Bang in Banking, (Tokyo: Toyo Keizai, October 1997). (In Japanese). 71. Byong Ho Kang, 660. We must be cautious in using this figure. Considering the crisis, the loan interest rate to troubled companies should be reduced to an extraordinarily low level, thus nominally lowering the loan interest rates. 72. The bottom line is that due to the progress of disintermediation and greater competition with non-banks, traditional banks had to either go into non-bank fields (e.g. securities, insurance, etc.) or loan to riskier borrowers unable to go to the market due to their risk profile without charging sufficient interest. In Korea, non-bank financial institutions were long allowed relatively greater freedom in their management of assets and liabilities, and most importantly, permitted to apply higher interest rates on deposits and loans than banking institutions. The market share of banking institutions in terms of deposits dropped from 71% in 1980 to approximately 30% in 1997, while that of non-banks increased from 29% to 70% in the same period. As for loans and discounts, the market share of banking institutions dropped from about 63% to 41%, while that of non-banks expanded from 37% to 59% in the same period. See 'Financial System in Korea' in the BOK website, http://www.bok.or.kr/kobank/owa/ 73. Some researchers have used regression analysis to argue this was not true in Korea. Borensztein and Lee, for example, found no evidence that credit flows were directed to the relatively riskier projects in the last three decades. 74. The Korean commercial banks posted a combined loss of 14.48 trillion KRW in 1998, far higher than the 3.88 trillion loss in 1997. A banking analyst at ABN Amro Asia estimates the loss in the sector could reach a maximum of 10 trillion KRW in 1999 with potential NPLs realized. Michael Schuman, 'South Korean Banks Post $12.32 Billion Loss - Results Are Sharply Worse Than in 1997, and Pain Is Likely to Continue', Wall Street Journal Feb 10, 1999, p. A14.. In game theory, when a financial sector is monopolized, the system is considered safer because the large financial institutions have incentive to keep the system from failing, in order to continue to benefit from their

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monopolistic rents. However, empirical studies do not support this argument and there is little evidence that large banks are necessarily safer. 75. 'Several Hurdles Remain in Banking Reform'. 76. 'Bank Restructuring in Korea', 8. 77. Some papers indicate Purchase and Assumption (P&A) should work better to minimize the length of takeover process and the damage to depositors, borrowers, buyers and the government. Normally, it takes 3 years for liquidation to be completed, 6-9 months for merger, but two months for P&A in Korea. Byong Ho Kang, 657. However, key to reducing moral hazard is letting the interested parties bear the cost of bank failure, and to monitor bank management preemptively. Therefore, the cost of the process should be maximized. Moreover, if P&A is the method used to close banks, there is no need for a deposit insurance system. 78. A 'total plan' was introduced in the Japanese Financial System Reorganization Plan and passed the Upper House on October 12, 1998. Failed banks are nationalized when their stock is transferred to the bridge bank established by the Deposit Insurance Corporation (DIC), and their NPLs are sent to the collecting bank (Japanese version of RTC). The DIC supports and loans the nationalized banks' operating capital. This protects creditworthy borrowers left in the lurch by failed banks while a merger partner is sought. The nationalized bank's good assets are sold or its operations are merged with a commercial bank within one year. The time limit can be extended to 3 years if approved by the DIC. 79. For example, the secondary loan market has just emerged in Japan with the newly established SPC rules and the initiative of some foreign investment banks. The government could utilize RTC rules, as happened in the S&L bailout in the U.S., or use existing public institutions to promote the liquidation of loan assets. The Resolution Trust Corporation (RTC) was a state-owned enterprise created to resolve the S&L crisis in the late 1980s. From its start in August 1989 until its end in 1995, RTC acted as the receiver of the assets of failed S&Ls, most of which were sold or liquidated. It resolved 747 failed financial institutions with a book value of $458 billion. Including the capital loss of $61 billion in the resale of the assets, RTC incurred a cost of $81.9 billion dollars, ultimately borne by U.S. taxpayers. RTC actually took control of failed S&Ls, using private contractors to manage and liquidate S&L assets. If Korea were to establish a similar institution, experts recommend that it hire a competent, full-time staff with strong financial background who can also serve as educators in management training for the reformed Korean banks. Edward M. Graham, 'A Radical but Workable Restructuring Plan for South Korea', Institute for International Economics, a speech translated into Korean and printed in The Korean Economic Daily on October 15, 1998 and Frederic S. Mishkin, The Economics of Money, Banking and Financial Markets, 5th edition (NY: Harper Collins, 1997) chapter 12. This should reduce the bad loans purchased by KAMCO in the Korean case. 80. Byong Ho Kang, 661. 81. Minimum CARs have three weaknesses if used in an early warning system: (1) measured capital adqequacy responds on with long lags to true capital adequacy. (2) enforcing CARs when banks are in crisis can worsen panic among depositors and creditors (3) banks try to conceal NPLs by rolling them over so that their CAR looks better. See Fane, 1998. 82. 'Bank Restructuring in Korea', 24. 83. Akioshi Horiuchi, 'Japan', East Asia in Crisis.

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84. Kim Woo Choong, the founder and chairman of Daewoo, intends to set up an international bank owned by chaebols. Currently, chaebol ownership in banking is limited to 4% in nationwide commercial banks and to 15% in regional banks. However, the ruling party is revising banking laws to abolish the ceiling. This will further aggravate the connected lending situation. Catherine Lee, 'Vicious Circle Continues', The Banker, July 1998. 85. Catherine Lee, 'The Wrong Medicine'. 86. 'Bank Restructuring in Korea, 13. 87. George Fane, 299. 88. The government eased limitations on bank shares in the General Banking Act, and allowed 25-30% of voting stock holding by non-residents for the 'conditionally approved' commercial banks (CBK, Hanil, Chohung, KEB, Peace, Kangwon and Chungbuk). Actually, Commerz Bank of Germany purchased 350 billion KRW shares in KEB. By the end of October 1998, those conditionally approved banks sold 9.33 trillion NPLs to KAMCO. 89. Takuma Takahashi, Asian Financial Crisis (Tokyo: Toyo Keizai, August 1998) (In Japanese) 178-9. 90. Banks' lending decisions concerning large companies have been based on a notion they were 'Too Big to Fail'. Banks did not analyze fully the profitability of a firm's investment project, but believed the government would ultimately rescue a company, given repercussions of failure. When lending to small and medium-sized companies, banks' lending decisions relied on the collateral offered. 'Bank Restructuring in Korea', 5. Reform is progressing. According to the Bank of Korea, "much of the discretionary authority concerning loan decision making formerly given to presidents and branch managers has been removed, and banks have now generally established credit appraisal committees whose main function is to assess the status of would-be borrowers before providing any large-scale loans." 'Bank Restructuring in Korea', 18. 91. 'Bank Restructuring in Korea', 27.

REFERENCES Bank of Japan (1998). Korean Financial Crisis and its Aftermath. Tokyo: Bank of Japan (not published) (In Japanese). Bank of Korea (1998). Bank Restructuring in Korea. Seoul: Bank of Korea. Borensztein, E. R., & Lee, J.-W. (1999). Credit Allocation and Financial, Crisis in Korea, Working Paper Wp/99/20. Washington, DC: IME Business Korea (1998). Several Hurdles Remain in Banking Reform. Business Korea, 15(10). Dow Jones Newswire (1999). Fane, G. (1998). The Role of Prudential Regulation. In: R. H. McLeod & R. Garnaut (Eds), East Asia in Crisis: From Being a Miracle to Needing One? New York: Routledge. Financial Supervisory Commission (1999). Shareholders' Meeting Results at Commercial Banks. Fukawa, Y. (1997). lndustrial&ed Korean Economy. Tokyo: Nihon Keizai Shinbun (In Japanese). Graham, E. M. (1998). A Radical but Workable Restructuring Plan for South Korea. The Korean Economic Daily.

Horiuchi, A. (1998). Japan. In: R. H. MeLeod & R. Garnaut (Eds), EastAsia in Crisis: From Being a Miracle to Needing One? New York: Routledge.

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International Financial Law Review (1997). Recommendations. International Financial Law Review, •6(4). Kang, B. H. (1998). Restructing of Financial Institutions and the Corporate Sector in Korea. Journal of Asian Economies, 9(4). Kikuchi, H. (1997). Ginkou Big Bang-Big Bang in Banking. Tokyo: Toyo Keizai (In Japanese). Ko, D. W. (1997). International Financial Law Review •6(4). Korean Bank Supervisory Authority (1998). Update on Progress of Strengthening Prudential Supervision & Regulations. Seoul: Bank Supervisory Authority. Korean Ministry of Finance and Economy (1998). Korea Economic Update. Seoul: Ministry of Finance and Economy. Lee, C. (1998). Vicious Circle Continues. The Banker. The Wrong Medicine: Nationalization of commercial Banks in South Korea. The Banker. Mishkin, E S. (1997). The Economics of Money, Banking and Financial Markets (5th ed.). NY: Harper Collins, 1997) chapter 12. Noland, M. (1996). Restructuring Korea's Financial Sector for Greater Competitiveness, APEC Working Paper 96-14. Washington, DC: Institute for International Economics. Schuman, M. (1999). South Korean Banks Post $12.32 Billion Loss - Results Are Sharply Worse Than in 1997, and Pain Is Likely to Continue. Wall Street Journal, Feb 10, A14. Sender, H. (1999). New Kid in Town. Far Eastern Economic Review, February 11. Smith, H. (1998). Korea. In: R. H. McLeod & R. Garnaut (Eds), EastAsia in Crisis: From Being a Miracle to Needing One? New York: Routledge. Takahashi, T. (1998). Asian Financial Crisis. Tokyo: Toyo Keizai (In Japanese). http://www.bis.org/publ/bcbs41.html http://bok.or.kr/cgi-bin/nph-hwp2html.data/eng8/UP/press5.hwt. 19980227182443 http://www.bok.or.kr/cgi-bin/nph-hwp2html/data/eng8/UP/press4.hwp. 19980226194218 http://bok.or.or.kr/kobank/owa/ http://www.chosun.com/special/9901/IBCA_report5.html http://www.fsc.go.kr/kfsc/board/11/pt_O303.html http://icweb2.1oc.gov/cgi-birdquery/ http://www.mofe.go.kr/cgi-virde_mofe/body.txt

THE ASIAN FINANCIAL CRISIS: AN EVALUATION OF MARKET INTERVENTION POLICIES BY HONG KONG REGULATORS Anindya K. Bhattacharya ABSTRACT This chapter examines the rationale behind the imposition of stock market controls in Hong Kong and evaluates the effectiveness of this market intervention policy by the Hong Kong regulators during the Asian currency crisis of 1997. The chapter finds that the Hong Kong authorities invoked such a controversial policy measure only when containing the crisis through traditional policy instruments such as informal agreements with banks was no longer feasible. From their viewpoint, the crisis bore no relationship to Hong Kong's economic fundamentals and was dictated instead by the 'herd like' behavior of foreign portfolio investors. They viewed stock market controls as necessary instruments to fend off dual speculative attacks on both the Hong Kong dollar and stock market. The chapter concludes that the imposition of stock market controls yielded positive results in that they stabilized the Hong Kong dollar and stock market, thereby improving economic growth prospects in Hong Kong.

Asian Financial Crisis, Volume 1, pages 293-303. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0686-6

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INTRODUCTION The Asian currency crisis that began in Thailand in the spring and summer of 1997 spread rapidly to other Asian emerging markets, including Hong Kong the financial hub of Asia. 1The currency crisis quickly turned into a full-fledged financial crisis, affecting particularly the exchange rate, banking sector, and stock and property markets in Hong Kong. It also became an economic crisis engulfing the Hong Kong real economic sector, as evidenced by declining growth in Gross Domestic Product (GDP), growing unemployment, and falling asset prices. The responses of the Asian regulators to the crisis varied considerably, ranging from the use of conventional policy instruments like interest rates and exchange rates in Thailand and the Philippines to unconventional market intervention policies like capital and stock market controls in Malaysia and Hong Kong. 2 The purpose of this chapter is to evaluate the effectiveness of unconventional and controversial market intervention measures invoked by the Hong Kong regulatory authorities in coping with the crisis. The policy instruments discussed in this chapter are essentially stock market controls.

THE HONG KONG CURRENCY CRISIS AND REGULATORY POLICY RESPONSES The currency crisis that began in Thailand spread quickly to Hong Kong in the summer of 1997. The floating of the Thai baht in July 1997 set off a wave of currency devaluations in the region. The currency turmoil reached its peak in Hong Kong in October 1977 when the Central Bank of Taiwan abandoned its exchange market intervention in support of the New Taiwan Dollar. This led to speculation that the Hong Kong dollar's peg to the U.S. dollar was unsustainable. Speculative selling of the Hong Kong dollar intensified and resulted in banks selling more local currency to the Hong Kong Monetary Authority (HKMA) than they could settle. 3 Similarly, the Hong Kong stock market lost 23% of its value over four days of selling pressure. In response to the extensive shorting of the Hong Kong dollar and Hong Kong shares, overnight interest rates rose from 7% to around 280% briefly on October 23. On that day, the Hang Seng Index fell by more than 10%.4 International investors saw some of the same problems in Hong Kong that had beset Thailand, the Philippines, and Malaysia earlier on. In 1997, Hong Kong had a high economic growth exceeding its trend growth, overheated

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equity and property markets, a banking sector heavily dependent on loans to the speculative property and equity sectors, and a slowdown in services exports. 5 These warning signals made Hong Kong all the more susceptible to the regional contagion effect. Weakening investor confidence triggered a series of speculative attacks on both the currency and equity markets in Hong Kong. Asset prices fell sharply in the fourth quarter of 1997 as interest rates rose and domestic credit contracted since Hong Kong banks adopted more cautious lending policies. Interest rates rose substantially in the aftermath of the currency crisis. Thus, the 3-month Hong Kong Interbank Offer Rate (HIBOR) increased from 6.4% in July to over 9% at the end of 1997. Interest rates for time deposits also went up to around 6.5%. As the cost of funds for banks rose, the best lending rate of Hong Kong banks was raised to 10.25% by January 1998. The Hang Seng stock index fell by 47.8% in October from its all-time high recorded in August. Similarly, property prices declined sharply, with residential prices falling by 20 to 3 0 % . 6 The impact on the real economy was substantial, Hong Kong's economy contracted due to higher interest rates and asset price deflation. GDP growth declined from 6.4% in the first half of 1997 to 4.0% in the second half and to negative 2.7% and 5.2% in the first and second quarters of 1998 respectively. Both private consumption and business investment slowed substantially as interest rates rose. Due to a slump in exports of services, the overall trade deficit widened to $51 billion in 1997. The unemployment rate rose from 2.5% in the fourth quarter of 1997 to 5.3% in the first quarter of 1998. 7 The magnitude and speed of the contagion caught Hong Kong regulators by surprise. The Hong Kong dollar came under sharp speculative pressure since July 1997 as institutional investors engaged in speculative currency shorting. As the currency was sold heavily, under the automatic adjustment mechanism of Hong Kong's currency board system, interest rates rose automatically and substantially, with ovemight interbank offer rate reaching an all-time high of nearly 300% on October 23, 1997. 8 Even though interest rates stabilized within a short period of time, they still stayed at relatively high levels compared with where they were at the beginning of the crisis. In line with the currency board discipline, the initial response of the HKMA was to passively sell massive amounts of U.S. dollars. 9 Because of the heavy selling of the local currency by institutional investors, there was an acute shortage of Hong Kong dollar liquidity that caused interbank and other interest rates to go up substantially. Even though interest rates eased shortly, the selling pressure on the Hong Kong dollar continued and ignited again in January 1998 when the Indonesian rupiah depreciated sharply. 1°

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From the viewpoint of international investors, high interest rates were not sustainable in Hong Kong. They were hoping that the regulators would give in to currency pressures and abandon the linked exchange rate system." However, when it did not happen, capital outflows continued, creating a vicious circle of exchange rate pressures and declining property and stock prices. The Hong Kong dollar depreciated from 7.736 at the end of 1996 to 7.746 at the end of 1997, and the Han Seng stock index declined from 13,451 to 10,723 over the same time period. The sharp decline in property and equity markets severely dampened consumer spending, which declined for the first time since the 1974 oil crisis. 12

Table 1 shows the key economic indicators in Hong Kong during 1996-1998. Particularly noteworthy are the merchandise trade account deficit and declining GDP growth. The Hong Kong regulatory authorities responded to the crisis by invoking standard economic stabilization measures during July 1997-October 1998. Under the currency board's automatic adjustment mechanism, U.S. dollars were sold to defend the local currency, money supply declined, and interest rates rose sharply. The Hong Kong authorities also took several other steps such as asking banks to limit loans to the speculative property and stock markets, strengthening prudential standards for non-performing loans of banks, increasing bank reporting requirements, and insisting on greater transparency of the banking sector. 13 Table 2 shows that key interest rates rose sharply in Hong Kong between 1996 and 1997. Irrespective of these policy responses by the Hong Kong authorities, the financial crisis continued unabated with continued selling pressures on the

Table 1.

Key Economic Indicators for Hong Kong, 1996-98

Real GDP growth (annual percentage changes) Inflation rate (annual percentage changes) Merchandise trade balance (HK$ billion) Fiscal balance (HK$ billion) Unemployment rate (annual average,%) Foreign currency assets (US$ billion) Exchange rates (HK$/US$, end of period) Hang Seng index (end of period)

1996

1997

1998

5.0 6.0 -141.9 173.6 2.8 63.8 7.736 13,451

5.2 5.7 -163.5 445.5 2.2 92.8 7.746 10,723

3.5 4.5 -147.8 456.3

Source: Hong Kong Monetary Authority, Annual Report 1997, pp. 117-118.

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The Asian Crisis in Hong Kong Table 2.

3-month interbankrate Savings deposit 1-month time deposit Banks' best lending rate

Interest Rates in Hong Kong (end of period %) 1996

1997

5.50 3.75 4.69 8.50

9.13 4.75 7.08 9.50

Source: Hong KongMonetaryAuthority,Annual Report 1997,p. 118.

currency, major declines in stock prices, weaker investor confidence, and a sharp dampening of economic growth. When the Hong Kong regulatory authorities could not contain the crisis through conventional means, they turned to unconventional market intervention methods. In August 1998, the Financial Secretary of Hong Kong decided to intervene in the stock and futures markets to deter currency manipulation by those who had built up large short positions in the Hang Seng Index futures, t4 The Hong Kong Stock Exchange introduced measures to restrict the short selling of Hong Kong shares. 15The HKMA spent an estimated $15 billion on buying stocks to deter currency speculators from what it called 'unfair attacks' on the Hong Kong dollar. 16They also introduced seven technical measures to strengthen the currency board arrangements. 17 The decision by the Hong Kong regulators to intervene in the stock and futures markets sent shock waves throughout the international financial world and prompted Dr. Milton Friedman to characterize such a major departure from the free market philosophy of Hong Kong as 'insane'.+8 EVALUATING KONG

THE POLICY RESPONSES BY HONG REGULATORY AUTHORITIES

The Hong Kong regulatory authorities were clearly taken by surprise by the magnitude and speed of the Asian contagion. From their viewpoint, the situation in Hong Kong was different from that in Thailand and the Philippines in that the economic fundamentals were strong in Hong Kong. Hong Kong enjoyed a high economic growth averaging more than 6% for over a decade; its foreign exchange reserves were sizable amounting to $92.8 billion at the end of 1997; it consistently ran budget surpluses averaging 2% of GDP per year; its unemployment rate stood at a low level of 2 to 3% for a long time; its inflation rate was moderate; it possessed sophisticated manufacturing and financial

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sectors; and its economy was characterized by the lowest level of government intervention in the worldJ 9 Yet, despite all these positive fundamentals, its currency was subjected to speculative manipulation by hedge funds that threatened local interest rates, asset prices, job creation, and the very fabric of Hong Kong's free economy. 2° The Hong Kong Government carefully weighed the pros and cons of market intervention and concluded that it was in the best interest of the people of Hong Kong to intervene in order to ward off a serious recession and its impact on local unemployment. The Hong Kong regulators were convinced that currency speculators, particularly hedge funds, engineered extreme speculative conditions in the interbank market in order to profit from large short positions they had taken in stock index futures. They accused the speculators of engaging in 'double play' of both the currency and stock futures markets that was responsible for a significant part of the interest rate premium in the Hong Kong dollar over the U.S. dollar.21 The Hong Kong regulators believed that the massive selling of Hong Kong dollars by currency speculators was clearly out of line with the economic fundamentals of Hong Kong. They concluded that it was in the best interest of Hong Kong to intervene in the market to frustrate the 'double play', and that this intervention did not represent a major departure from the traditional policy of non-intervention. Instead, the regulators wanted to send a clear message to currency manipulators that the government would not stand idly by.22 The Hong Kong regulators accused the hedge funds of borrowing large amounts of Hong Kong dollars to the tune of HK$ 30 billion raised through swapping U.S. dollars for Hong Kong dollars in the debt market with multilateral institutions. Thus, the hedge funds pre-funded themselves in Hong Kong dollars. At the same time, they accumulated large short positions in the stock exchange futures market. They then shorted the Hong Kong dollar in a big way causing a sharp interest rate hike in the money market. Higher interest rates would put downward pressure on stock prices, enabling them to reap substantial profits from the futures contracts they held - potential profits of an estimated HK $ 4 billion for every 1000 points decline in the Hang Seng Index. They would gain from both higher deposit rates in the money market and cheaper prices for stocks, which they would then buy, even if they could not break the exchange rate link. 23 The Hong Kong authorities estimated that the hedge funds accumulated over HK $30 billion in currency borrowings, at an interest cost of about HK $4 million per day. They also held an estimated 80,000 short stock index futures contracts. They waited for an opportune time to sell Hong Kong dollars, drive up interest rates, and engineer a fall of the stock market.

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The Hong Kong Government had no intention of being the 'sitting duck' that the market participants perceived them to be. The regulators took the view that free markets did not mean manipulated markets, and that they had a responsibility to avoid serious market distortions. They wanted to prevent the 'herd mentality' of institutional investors from developing into a full-blown currency and stock market crisis. Thus, in August 1998, the Hong Kong regulators bought some U.S. $15 billion worth of stocks, forcing the hedge funds to close out their short positions with heavy losses. At the same time, they introduced seven technical measures to make the money market less susceptible to currency manipulation. 24 From the viewpoint of Hong Kong regulators, their preemptive actions in the market place were successful in that the hedge funds were forced to unwind their short positions in the Hong Kong dollar with considerable losses incurred in the process. The Hong Kong dollar link survived. Since the end of April 1998, the Hong Kong dollar returned to stable levels vis-a-vis the U.S. dollar.25 Much of the interest rate premium of the Hong Kong dollar over the U.S. dollar disappeared, and asset prices stabilized. 26The overall favorable result was that Hong Kong's economy grew by 3.5% in real terms in 1998. Although this was below the growth rate of 5.2% recorded in 1997, it was still a respectable performance in light of the Asian crisis. 27

THE ROLE OF INSTITUTIONAL INVESTORS AND HEDGE FUNDS IN PRECIPITATING THE HONG KONG FINANCIAL CRISIS The role played by international institutional investors and hedge funds in the financial crisis of Hong Kong was controversial, to say the least. One school of thought, led by the IMF, maintains that there does not appear to be any evidence of a concerted strategy by institutional investors and hedge funds to short the Hong Kong dollar and equity markets simultaneously. The IMF argues that direct short sales of equity accounted for less than 3% of total stock market turnover in Hong Kong. 28On the other hand, as stated earlier, the Hong Kong regulators were convinced that institutional investors, particularly the hedge funds, were engaging in 'double market play' involving short selling of both Hong Kong dollars and Hong Kong stocks. Lured by high returns, strong economic growth and financial sector liberalization in Asia, institutional investors and hedge funds had poured billions of dollars into the emerging markets of Asia during the early 1990s. Total net private capital inflows (including foreign direct investment, portfolio investment, and bank lending) to the Asian emerging markets increased

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substantially, from $19 billion in 1990 to $110 billion in 1996. In the aftermath of the Asian crisis, however, they fell to $13.9 billion in 1997, representing a decline of about $67 billion. In Thailand, Malaysia, Philippines, Indonesia, and Korea, net inflows of $73 billion in 1996 were replaced by net outflows of $11 billion in 1997. 29 In the fourth quarter of 1997, international banks reporting to the BIS reduced their outstanding claims to Asia by $27 billion, and international bank loans to non-banks in Asian emerging markets fell by more than $9 billion. 3° A study by the IMF suggests that hedge funds as a group were not actively involved in taking short positions against Asian currencies, except the baht, during the summer of 1997. 31 Similarly, George Soros states that hedge funds managed by his group sold the baht short, but not other Asian currencies during the height of the Asian currency crisis. Soros states that institutional investors were caught off-guard by the discovery of new credit risk involved in interest rate swaps that they had engaged in Hong Kong. Soros also maintains that banks played a far more critical role than hedge funds in the Asian currency markets. 32 Particularly noteworthy in this context are the arbitrage and derivatives activities of international banks. 33However, others maintain that the derivatives activities of hedge funds may have been active catalysts in the Asian c r i s i s . 34

CONCLUSIONS The policy responses to the crisis by Asian regulators varied considerably, ranging from the conventional to the market interventionist approach. In Hong Kong, the regulatory authorities intervened in the stock and futures markets because they were convinced that the currency crisis was externally induced by hedge funds that hoped to profit from 'double market play' .35 They concluded that such speculative actions went far beyond what was justified by economic fundamentals and had the potential to create massive distortions in the economy by way of sharp wealth loss, sudden capital flight, asset price collapses, and threats to currency and banking stability. The authorities had no intention of sitting by idly and watching the speculators create a vicious circle involving the stock market, the currency and interest rates. 36 The decision by the Hong Kong authorities to buy stock and futures contracts in a big way came as a surprise to market participants who did not take kindly to such an active intervention policy. The Hong Kong Government claimed, however, that the emphasis of their market action was not on intervention, but on 'facilitation'. From their viewpoint, the actions undertaken in August 1998 were both necessary and effective. These actions did not represent an end of

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Hong Kong's traditional 'laissez-faire' policies. Rather they were measures undertaken to ensure that free market principles would prevail. They proclaimed that free markets did not mean that small markets could be manipulated by large players. 37 Thus, the market intervention by the Hong Kong authorities can hardly be interpreted as 'insane'. Rather, it was a limited, one-time intervention that yielded expected favorable results.

NOTES 1. For an analysis of the contagion, see Taimur Baig and Ilan Goldfajn, 'Financial Market Contagion in the Asian Crisis', IMF Working Paper WP/98/155 (November 1988), Washington, D.C. 2. For an analysis of monetary and exchange rate policies pursued by Asian regulators, see Ilan Goldfajn and Taimur Baig, 'Monetary Policy in the Aftermath of Currency Crises: The Case of Asia', IMF Working Paper WP/98/170 (December 1998), Washington, D.C. 3. Hong Kong Monetary Authority, Annual Report 1997, p. 9. 4. IMF, International Capital Markets: Developments, Prospects, and Key Policy Issues, September 1998, pp. 16, 49, 51. 5. Hong Kong Monetary Authority, Annual Report 1997, op. cit., pp. 15-18. 6. Ibid., pp. 15-24. 7. Ibid., pp. 15-17, and Hong Kong Monetary Authority, Quarterly Bulletin (November 1998), p. 110. For 1998 as a whole, Hong Kong's real GDP contracted by 5.1%. See The Wall Street Journal, June 9, 1999, p. A29. 8. The currency board system of Hong Kong comprises a linked exchange rate system, which requires the monetary base (the sum of banknotes in circulation and bank balances with the central bank) to be fully backed by the foreign currency to which the domestic currency is linked. The currency board system operates with a self-adjustment mechanism to restore exchange rate stability when it comes under pressure Thus, when there is an outflow of funds and the domestic currency is sold to the currency board, the monetary base will contract and interest rates will rise automatically. See Hong Kong Monetary Authority Annual Report 1997, op. cit., p. 31. 9. The currency board system in Hong Kong is a fixed exchange rate system that requires the monetary base, defined as bank notes in circulation and clearing balances of banks with the central bank, to be fully backed by U.S. dollars at a fixed exchange rate of HK $7.80 = U.S. $1.00. Thus, any change in the monetary base has to be matched by a corresponding change in the amount of U.S. dollar reserves held by the HKMA. The automatic adjustment mechanism would require, for example, local interest rates in the interbank market to go up in the event of a capital outflow, which would take the form of Hong Kong banks selling Hong Kong dollars to the HKMA for U.S. dollars at the fixed exchange rate. See the Keynote Address by Joseph Yam, Chief Executive, Hong Kong Monetary Authority, on 'The Hong Kong Dollar Link' before the Hong Kong Trade Development Council Roadshow in Tokyo, March 3, 1998. 10. Ibid., pp. 31-35

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I 1. 'Reflections on the Global Financial Landscape', Lecture by Joseph Yam, Chief Executive, Hong Kong Monetary Authority, at the Institut Etudes Bancaires et Financiere, Paris, December 8, 1998. 12. Ibid., p. 118. 13. Ibid., pp. 37-52. 14. Hong Kong Monetary Authority, Quarterly Bulletin, op. cit., p. t. 15. Short selling is selling borrowed stock in hopes that the stock price will fall before the stock has to be returned. See The Wall Street Journal, September 3, 1998, p. A19. 16. Under Hong Kong's currency board system, when speculators sell the Hong Kong dollar, local interest rates automatically go up hurting the economy and share prices. See The Wall Street Journal, ibid. 17. For details of these technical measures, see Hong Kong Monetary Authority, Quarterly Bulletin, op. cit., pp. 7-11. 18. The Wall Street Journal, September 3, 1998, op. cir. 19. Keynote Address on 'The Hong Kong Dollar Link' by Joseph Yam, March 3, 1998, op. cit.. 20. Hong Kong Monetary Authority, Quarterly Bulletin, op.cit., p. 4. 21. Ibid., p. 2. 22. Ibid. 23. Ibid., pp. 76-77, 115; and 'Coping with Financial Turmoil', Lecture by Joseph Yam, Chief Executive, Hong Kong Monetary Authority, organized by The Australian, Sydney, November 23, 1998. 24. 'Coping with Financial Turmoil', Lecture by Joseph Yam, Ibid. 25. BIS, 'International Banking and Financial Market Developments', Quarterly Review, November 1998, p. 13. 26. Hong Kong Monetary Authority, Quarterly Review, op. cit., pp. 78-79. 27. Keynote Address on 'The Hong Kong Dollar Link' by Joseph Yam, March 3, 1998, op. cir. 28. IMF, International Capital Markets, op. cit., p. 51. 29. Ibid., pp. 12-14. 30. BIS, 68th Annual Report, op. cit., p. 133; and BIS, International Banking and Financial Market Developments (May 1998), p.8. 31. IMF, Hedge Funds and Financial Market Dynamics, Occasional Paper 166 (May 1998). 32. George Sorts, The Crisis of Global Capitalism, New York: Public Affairs, 1998, pp. 136-145. 33. Martin Mayer, The Asian Disease: Plausible Diagnoses, Possible Remedies, Public Policy Brief No. 44 (1998), The Jerome Levy Economics Institute, pp. 7-8, 16, 19, 29-31. 34. See for example, J. A. Kriegel, 'Derivatives and Capital Flows: Applications to Asia', Working Paper No. 246, The Jerome Levy Economics Institute (August 1998), p. 2 35. 'Causes and Solutions to the Recent Financial Turmoil in the Asian Region', Speech by Joseph Yam, Chief Executive, Hong Kong Monetary, before a Symposium of Central Banking in the Philippines, Manila, January 5, 1999. 36. Hong Kong Monetary Authority, Quarterly Bulletin, op. cit., p. 79.

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37. "I am convinced that much of the difficulty over the past year or so in Hong Kong arose not out of any problem in our economic fundamentals, but because, by being small, open and predictable, we are vulnerable to market manipulation. We had to resort to doing something unpredictable to defend ourselves." See 'Coping with Financial Turmoil', Lecture by Joseph Yam, November 23, 1998, op. cit.

REFERENCES Baig, T., & Goldfajn, I. (1998). Financial Market Contagion in the Asian Crisis, 1MF Working Paper WP/98/155. Washington, D.C. Bank for International Settlements (1998). 68th Annual Report, April 1, 1997-March 31. Basle, Switzerland. Bank for International Settlements (1998). International Banking and Financial Market Developments. Quarterly Review. Basle, Switzerland. Hong Kong Monetary Authority (1997). Annual Report 1997. Hong Kong. Hong Kong Monetary Authority (1998). Quarterly Bulletin. Hong Kong. Goldfajn, I., & Baig, T. (1998). Monetary Policy in the Aftermath of Currency Crises: The Case of Asia, IMF Working Paper W/P/98/170. Washington, D.C. International Monetary Fund (1998). International Capital Markets: Developments, Prospects, and Key Policy Issues, World Economic and Financial Surveys. Washington, D.C. International Monetary Fund (1998). Hedge Funds and Financial Market Dynamics, Occasional Paper 166. Washington, D.C. Kriegel, J. A. (1998). Derivatives and Capital Flows: Applications to Asia, Jerome Levy Economics Institute Working Paper No. 246, New York. Mayer, M. (1998). The Asian Disease: Plausible Diagnoses, Possible Remedies, Jerome Levy Economics Institute Public Policy Brief No. 44, New York. Soros, G. (1998). The Crisis of Global Capitalism. New York: Public Affairs. The Wall Street Journal (1998) and (1999). Yam, J. (1998). The Hong Kong Dollar Link. Keynote Address before the Hong Kong Trade Development Council Financial Roadshow, Tokyo. Yam, J. (1998). Coping with Financial Turmoil. Lecture organized by The Australian, Sydney. Yam, J. (1988). Reflections on the Global Financial Landscape. Lecture at the Institut Etudes Bancaires et Financiere, Paris. Yam, J. (1999). Causes and Solutions to the Recent Financial Turmoil in the Asian Region. Speech before a Symposium of Central Banking in the Philippines, Manila.

ASIAN CRISIS AND IMPLICATIONS FOR INDUSTRIAL POLICIES Sung-Hee Jwa and Jung-Hwan Seo* I. INTRODUCTION The financial crisis that started with the devaluation of the Thai baht in July of 1997 severely hit East Asian countries, especially Thailand, Indonesia, South Korea, and Malaysia. As a response to the crisis, the governments in these countries implemented emergency measures to rescue their economies, and since then they have been going through drastic economic restructuring programs, never before seen in Asia. Throughout the crisis, the East Asian countries have increased the standards and legal framework of their economy to global levels. In this process, they almost completely opened their economy to the world. As a result, the domestic economic environment has dramatically changed. Moreover, the world economy has been rapidly globalizing, which is a great challenge to the resuscitating East Asian economies. Recently, major economic indicators in these countries have been showing signs of recovery, especially in Korea. However, it is yet controversial whether the economic recovery is a result of economic restructuring and what effects it will have in the long run. It is a well-known fact that extensive government intervention has prevailed in East Asian economies for the last 30 years. This strategy of government-led economic management has contributed to economic growth in the early phase of economic development. However, extensive government intervention has brought about problems to the smooth operation * President and Research Fellow of Korea EconomicResearch Institute, respectively.The views expressedin this paper are the authors' and do not reflectKERI's position. Asian Financial Crisis, Volume 1, pages 307-355. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0686-6

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of the market economy. With the rapidly changing domestic and international economic environment, those policies and the recent restructuring policies should be reevaluated in searching for appropriate policies in the new environment. In this chapter, we look back and evaluate the past industrial policies of East Asian countries and then attempt to propose an appropriate framework for industrial policies in the new environment. The rest of the chapter is organized as follows: Section 2 presents the restructuring processes and the impact of the crisis on the industrial sector. The industrial policies that have been adopted by some of East Asian countries will be discussed in Section 3. We will compare the industrial policies of each country and take a close look at Korea's experience. An evaluation of their industrial policies will be presented at the end of each section. We consider interventionist industrial policies to be one of main causes of the crisis. In particular, Section 3-3 presents a specific case of industrial policy lifecycle. This case will show how an interventionist industrial policy was implemented and how it has affected the economy. Section 3 presents the economic environment that the East Asian countries will confront and proposes a framework for new industrial policies.

2. ECONOMIC RESTRUCTURING AND IMPACT ON INDUSTRIES 1. Economic Restructuring East Asian countries undertook a comprehensive economic restructuring program to survive the crisis. Their responses to the crisis have two parts: the restructuring plan and its implementation. Most countries introduced unprecedented economic plans calling for financial and corporate restructuring. Since those plans were made under the supervision of the IMF, the restructuring processes have common features. First, in the field of financial restructuring two government agencies were established - one for discriminating between viable and non-viable financial institutions and the other for handling NPLs. Second, one or two agencies were set up to deal with corporate debt restructuring (see Table 1) and bankruptcy-related laws were revised. In order to implement the plans, the government has supported restructuring with huge amounts of public money. In the financial sector, restructuring has typically included closures and/or takeovers of insolvent financial institutions, the transfer of non-performing assets to a central agency, and the recapitalization of the remaining financial institutions. These procedures have been carried out by the newly established

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Table 2.

Financial Sector Restructuring: Comparison Content

Thailand

Focused on financial firms and banks Financial firms (total number: 91) 56 were closed (by 1997) and 35 were induced to recapitalize themselves. Banks (total number: 15) Reduced to 11 through nationalization, closures and M&As Strengthening of standards Legal minimum for capital adequacy ratios: 8.5% for banks and 8% for financial firms (deadline of Jan. 15, 1999) Disclosure of NPLs after 6 months (3 months from 2000) Plans (announced on Aug. 1998) Privatize 4 nationalized banks Inject public capital into banks prepared to restructure themselves and their corporate debt and to start lending again Set up a framework for private asset companies

Indonesia

Focused on banks Banks 61 banks were closed and 7 banks were taken over by the government (by March 1999) 73 banks with capital asset ratios equal to or greater than 4% remain open 4 state banks were absorbed into a newly formed bank (Bank Mandri) Strengthening of standards Increased capital requirement for banks Tightened loan classification criteria Plan Government will issue bonds to provide up to 80% of the financing for the recapitalization of 9 banks (remaining 20% will be provided by the owners of the banks) Prospects Political uncertainty and political interference in IBRA decision-making impedes progress

Korea

Banks (total number 33) Banks with BIS ratios less than 8% were closed. As a result 8 banks were closed or merged Other financial institutions 16 out of 30 merchant banks were closed 3 out of 37 securities companies were closed Strengthening of standards Revision of loan classification criteria Banks are required to disclose connected lending information More conservative calculation of capital asset ratios

Asian Crisis and Implications for Industrial Policies Table 2.

311

Continued Content

Malaysia

Strengthening and subsequently relaxing of standards 10/97-9/98: Tightened regulations on loan classification and capital adequacy ratios Tightened loan-loss provision standards to 3 month classification Raised capital adequacy ratio for financial firms 9/98: those regulations were relaxed Unsuccessful consolidation of 40 financial firms into eight Prospects Without firmer government stand on closures, Danamodal could end up bearing more of the burden of capitalization than shareholders

The Philippines

Strengthening of standards Set minimum capital adequacy ratio at 10% Set the limit of loan to a same entity at 25% of bank's own capital Banks are required to disclose NPLs Strengthened banking sector entry prerequisites Plan Privatization of Philippine National Bank Strengthening of prudential standards and operational discretion

Source: Kim (1999), Jwa and Yi (1999), Shirazi (1999)

government agencies mentioned above. Along with restructuring, most countries strengthened their prudential standards in the financial sector and their legal framework: loan classification, minimum capital-adequacy ratios, and regulations to supervise financial activities. Table 2 shows the financial restructuring process in these countries. Malaysia took a different approach from the other countries. Before the crisis, Malaysia's banking sector was relatively sounder than that of other countries. The risk-weighted capital adequacy ratio of commercial banks was 10.8% at the end of 1996. However, as the crisis unfolded along with a recession, NPLs rose from 8% of total loans at the end of 1997 to 13.6% at the end of 1998 (measured using a three-month classification standard). As a result, the overall capital adequacy ratio at the end of 1998 had fallen to 8.7%. Between Oct. 1997 and March 1998, the authorities tightened regulations regarding loan classification and capital adequacy ratios for banks and financial firms. However, these regulations were subsequently relaxed in Sept. 1998 to reduce the credit crunch that was believed to be caused by the new regulations. 1 The policy switch from tightening to relaxation probably contributed to the sluggish restructuring pace. 2

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In the area of corporate sector restructuring, Indonesia, Korea, Malaysia and Thailand all revised their bankruptcy-related laws and processes to expedite the bankruptcy and reorganization process. However, for some countries (especially Malaysia), those revisions looked suspicious, implemented so as to resuscitate non-viable firms. In addition, these countries privatized state corporations by selling shares to foreign investors in order to finance the cost of restructuring. For example, Indonesia expects to bring in US$1.5 billion in government revenues through the privatization of public enterprises by 2000. 3 Corporate restructuring plans are presented in Table 3. In general, restructuring so far has been going in the right direction. Results, however, are far from what was expected.

2. Impact on Industries The large amount of short-term debts denominated in foreign currencies in the private sector was difficult to roll over, leading to many bankruptcies. For example, in Korea nearly 9,500 corporate bankruptcies were reported in the first quarter of 1998. 4 The traditional export sectors benefited from the devalued currencies throughout the region. However, the advanced export sectors relying on imported parts and components suffered from the capital shortage in addition to the currency devaluation causing a rise in input costs. 5 High interest rates, inflation and income losses due to massive layoffs and salary cuts had a deep impact on industries dependent on domestic demand. In addition, small and medium enterprises supplying parts and components to larger firms that went bankrupt suffered severely. Since detailed industrial statistics are not available, the World Bank survey data will be briefly reviewed in this section. 6

2.1. Capacity Utilization and Expectations The crisis severely affected capacity utilization throughout the region. During 1996-1998, the decline in capacity utilization was more than 10% (except the Philippines). Indonesia experienced the most severe decline, 20.8%. Moreover, Indonesia's capacity utilization in the first half of 1998 is the lowest (59.2%). Korea, whose capacity utilization declined by 12.7% during 1996-1998, had the highest level, 72.1%, among the five countries in 1998 (See Table 4). Among industries, the auto-parts and electronics industries, which are the main exports of those countries, experienced the largest drops in capacity utilization during 1997-1998, 21.7% and 23%, respectively.

Asian Crisis and Implications for Industrial Policies Table 3.

313

Corporate Sector Restructuring Content

Thailand

Law revisions bankruptcy laws: Incorporated reorganization process, enlarged the range of out-of-court workouts, set up special bankruptcy court foreclosure law: strengthened creditor's rights Private sector 67 firms have completed debt restructuring (by March 1999) 200 more firms are expected to complete debt restructuring by the end of 1999 Public sector Revised corporate laws to promote privatization Privatization of natural gas industry is in progress Private sector participation in Rachaburi Power Plant was approved Privatization of Airport Authority and private sector participation in water services are under consideration

Indonesia

Revision of bankruptcy laws Simplification of bankruptcy process Establishment of special bankruptcy court Private sector INDRA program for corporate debt restructuring Government relaxed the regulation on debt-equity swaps Public sector IMF and ADB reevaluated the expenditures and investments of the public sector by June 1998 3 public corporations were privatized in 1999/8/23 Government plans to privatize 150 public enterprises by March 2000

Korea

Revision of bankruptcy-related laws Establishment of management committee in reorganization process to alleviate the court's burden Government introduced out-of-court workout process Private sector Big-deals (large business swaps) for the big 5 chaebols Out-of-court Workout programs for others (83 firms under program as of June 1999) Public sector Govemment issued Depository Receipts (DR) for POSCO and KEPCO and listed the stocks of Korea Telecom Government plans to privatize 11 public enterprises including POSCO, KEPCO and Korea Heavy Industries and Construction Co.

Malaysia

Focused on reorganization Private sector 47 firms applied to CDRC for restructuring US$ 6.6 billion debt Government makes use of public corporations to support incompetent private corporations: government diverted the Employment Provident Fund of Petronas to support financially distressed private firms

Source: Kim (1999)

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Table 4.

Capacity Utilization Levels %

Country

1996

1998 (lst halt)

1996-1998

Indonesia Korea Malaysia Philippines Thailand

80.0 84.8 81.9 77.7 79.4

59.2 72.2 66.3 68.8 61.8

20.8 12.7 15.6 8.9 17.6

Average

81.1

65.7

15.4

Source: Waiquamdee (1999)

In Thailand, manufacturing accounts for 81% of export earnings. The excess production capacity in the manufacturing sector was over 50% in 1998. Production in the automobile industry fell by 56% in 1998. Import-intensive industries such as canned seafood and electronics had accounted for 30% of total manufacturing export earnings before the crisis. Since in those industries imported inputs account for more than 80% of total content, the currency devaluation raised production costs by about 35% and as a result they contracted sharply. Input costs have risen 25-30% for computers and parts, 15-17% for textiles, and 15% for footwear in 1997. In Indonesia, the automobile industry was the most severely hit by the crisis. The production index of motor vehicles declined by about 72% in 1998. In other industries, the production index in 1998 fell by 42.5% for footwear, 31.5% for radios and television sets, 39.5% for chapter, and 39.4% for plastics. Exporters experienced a smaller decline in capacity utilization than nonexporters. For exporters, the smallest decline in capacity utilization occurred in the garment, textile, and food industries. Expectations for capacity utilization over the next 6 months vary among countries. According to the World Bank Survey, more than 35% of Korean firms expect an improvement compared to only 16% for Indonesian firms. The figure for other countries ranges between 22% and 27% of firms.

2.2. Export Performance An improvement in export performance was most common for Korean exporters. However, still a significant proportion of exporters reported that their performance had slipped during 1996-1998. A large proportion of Thai and Malaysian exporters reported a worsening performance for the period 1996-1998.

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However, proportionately more exporters expected improved performances this year rather than worsening or stagnant ones: above 50% of Korean exporters expected an improvement this year. For Malaysian and Thai exporters, the figure is 39% and 37% respectively. Exchange rate effects and subsequent price competitiveness were the main factors leading to expectations of an improved performance, whereas poor demand and unstable conditions in export markets led to expectations of a worsening performance. 2.3. Expansion Plans The number of expansion plans has been decreasing since the crisis. In 1997, 44% of firms reported that they considered expanding. This figure dropped to 15.4% in 1998. Most firms without expansion plans in 1997 still did not have any in 1998. Moreover, only half of the firms that had expansion plans in 1998 carried them through. However, the proportion of firms having expansion plans has increased from 15.4% in 1998 to 22.2% in 1999.27.2% of Indonesian firms expect to expand in 1999, 18.9% in Korea, 23.6% in Malaysia, 25.9% in the Philippines and 15.5% in Thailand. 3. Constraints on Recovery

In late 1998 macroeconomic indicators started to show signs of stabilization and recovery in the East Asian economies. Real GDP and industrial production figures improved, notably in Korea. The local currency regained some strength in Korea and Thailand. Foreign investors' confidence has improved, and private capital inflows have resumed. The relaxed monetary policies adopted in these countries have resulted in lower nominal interest rates (see Table 5). However, it would not be safe to conclude that these economies are on the sustainable recovery path. Particularly, there are no signs of improvement in the high unemployment rates, depressed demand, and still large size of NPLs. In Korea and Thailand, recent GDP growth was mainly due to a decrease in inventory investment. During the crisis, large interest expenses, exchange rate depreciation, and the lack of cash flow must have forced the disposal of existing stock. After the crisis, inventory investment increased from -15% of GDP to almost 0% of GDP, which was the main factor behind the recent increase of the real GDP growth rate. In 1999, capacity utilization levels have risen rapidly and exchange rates have been stable. However, the composite Stock Price index has experienced ups and downs during the last six months. The current account surplus is most likely to be less than what was expected at the end of 1998.

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Table 5.

Recent Macroeconomic Indicators of East Asian Countries

Nation

Year

Korea

96 97 98 99 1Q

Indonesia

Growth

Exchangerate

Stock Market

InterestRate

7.1 5.6 -5.8 4.6

804.5 949.9 1403.8 1197.6

819.6 630.7 420.0 570.2

12.1 15.3 14.1 8.3

96 97 98 99 1Q

7.8 5.0 -13.6 -13.7

2342.3 2909.4 10688 8788

N.A 599.8 418.5 400.5

14.93 27.85 62.79 119.87

Malaysia

96 97 98 99 1Q

8.3 7.8 -7.1 -1.3

2.5159 2.8132 3.9245 3.8000

1142.6 949.1 521.1 545.5

7.82 7.98 8.83 6.17

Philippines

96 97 98 99 1Q

5.8 5.2 -0.4 N.A

26.216 29.471 40.608 N.A

N.A 2531.8 1847.0 1982.5

12.305 13.43 14.52 N.A

Thailand

96 97 98 99 1Q

5.5 -0.4 -9.5 1.2

25.36 32.12 40.75 37.31

N.A 575.3 356.1 N.A

10.10 17.26 12.24 2.69

Source: Cho and Rhee (1999)

For Indonesia, there is no sign yet of recovery. The foreign debt is still US$140 billion, and the inflation rate is more than 30%. Uncontrolled monetary expansion contributed to economic uncertainty: The growth rate of M2 was 80% in the second quarter of 1998. Relaxed macroeconomic policies without structural reform and political uncertainty can aggravate the state of the economy. Until mid-1998, a credit crunch and a persistent recession due to a tight monetary policy led Malaysia to switch to an expansionary policy, which began to show some signs of economic stabilization. However, the implementation of capital controls and continued policy inconsistency have increased uncertainty so that foreign investors hesitate to invest in the country. Moreover, the reluctance to restructure the financial and corporate sectors contributes to the stagnant pace of economic recovery.

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The steady structural reforms pursued by the Philippines from the early 1990s protected that country from the crisis, even though its extemal debt/GDP ratio was the highest among the five countries. However, there are still ongoing problems, including a high budget deficit, rising inflation, and increasing poverty. The currency's depreciation will increase debt-servicing costs, which could delay recovery. Overall, sustained economic recovery and further economic development require political stability and the completion of the financial and corporate restructuring processes. One more condition for recovery is the clarification of the government's role in economic management. Throughout the crisis, the government has made its presence felt in private sector matters by injecting public funds to help the financial and corporate restructuring processes. In addition, Throughout the crisis, the East Asian countries upgraded their economic institutions and the legal frameworks of their economy to global standards. Seeing the changes of economic environment due to restructuring and on-going globalization, we should review and evaluate past policies in order to propose appropriate policies for the future. The next section will discuss the trade and industrial policies of East Asian countries.

3. INDUSTRIES AND INDUSTRIAL POLICIES 1. Overview of the Debate on the Role of Government in Economic Growth

There is an interesting debate about whether or not the government in an underdeveloped capitalistic market economy can improve upon the market outcome of resource mobilization and resource allocation. The debate is ultimately reduced to measuring the importance of market failure (or absent market mechanisms) versus government failure (or government's inability to assume the role of markets or to introduce market institutions), While observing the remarkable success of economic development in East Asian countries such as Japan, Korea, and Taiwan over the past thirty years or so, adherents to the neoclassical view v feel that one important lesson should be learned from the East Asian experience. In short, this lesson, as far as economic policy is concerned, is to get the basics right. They argue that the government should provide a stable macroeconomic environment and a reliable legal framework in order to create an environment where market forces can act unhindered. Minimum intervention with the lowest degree of relative price distortion is a virtue. They believe that Asian economies benefited most from a strategy where the government more or less followed the lead of the market rather than tried to actively direct it.

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On the other hand, a group of economists known as the revisionists attribute greater significance to other aspects of East Asia's success, aspects that have gone relatively unnoticed by neoclassicists. 8 They observe that the government has taken a much more active role in the economic development process than the one envisaged by neoclassicists and thus argue that despite efforts to do quite the opposite, the government has actually been leading the market. Revisionists even go on to argue that during the late industrialization stage, the state should set relative prices at deliberately 'wrong' levels in order to create profitable investment opportunities. 9 Also emphasized is the existence of market failures in developing economies due to market imperfections such as a lack of relevant markets. It is thus contended that a positive role of the government is necessary for the treatment of these failures as markets consistently fail to guide resource allocation toward the highest growth areas in the economy. Amsden, one of the staunchest revisionists, even suggests that the central bank may support priority industries at the cost of macroeconomic stability, l°. The World Bank (1993) answered the revisionists' argument with the reassertion of an obvious truth. "For interventions that attempt to guide resource allocation to succeed, they must address failures in the working of markets. Otherwise, the market would perform the allocation function more efficiently."1 In sum, the debate on the role of the government in economic development seems to center around the issue of market failure versus government failure. In this regard, it may be useful to remember that market failure generally reflects the failure of institutions, another form of government failure. This time the failure lies in the government's inability to set up the right institutions or, in other words, the rules of the game in the economy. Therefore, market failures on their own cannot be considered as an automatic justification for direct government intervention. Rather, the government should try to introduce 'right' institutions to provide an optimal environment for an improved economic performance. 12Furthermore, in most cases of apparent market failure, it should not go unnoticed that government regulations or preferential treatment usually turn out to be the major causes of those failures. In this section, we will look over past industrial policies of some East Asian countries. They will demonstrate that the governments in these countries tended to substitute for market operations and to manage the economy in a nontransparent way rather than through the rule of law, which weakened their ability to adapt to the changing economic environment. It will provide some clue as to the new paradigm of economic management that should substitute for interventionist industrial policies.

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2. Pre-Crisis Industrial Policies in East Asian Countries It is a well-known fact that all East Asian countries have adopted an exportoriented development model. This model is considered as the main factor behind their rapid growth up until the crisis. 13 The policy tools accompanying the promotion of exports were export-credit schemes and the protection of domestic industries. In addition, most East Asian countries implemented policies especially targeting strategic industries or firms. Korea adopted such a policy throughout the 1970s but this led to over-investment in heavy and chemical industries (HCIs) and to an unbalanced industrial structure. Malaysia followed suit in the early 1980s but reversed its course in the mid-1980s. Indonesia attempted to shift from labor-intensive to hi-tech industries but was unsuccessful. The main policy tool was the direct-credit program. Table 6 shows the profile of economic policies in those countries. Export credit schemes included interest rates subsidies and the rediscounting of export bills. In Malaysia, the Export Credit Financing facility discounted export bills for post-shipment financing and refinanced pre-shipment export credits at subsidized rates for eligible exports, based on letters of credits (LCs).

Table 6.

Policy Profile of Some of East Asian Countries

Country

Policy Profile

Indonesia

1973-1980: Oil and commodityboom, growing inward orientation 1974: program of direct credit control and allocation 1979: 1st big devaluation 1982-1988: adjustment period 1983: 2nd big devaluation 1985-1986: tax Reform 1988: full financial sector liberalization

Malaysia

1970-1980: state-led development 1981-1985: Heavy Industrialization path 1981: creation of HICOM 1983: pfivatizationpolicy begins 1978-87: financial and capital liberalization

Korea

1962-1972: Export Promotion 1973-1979: Industrial Promotion 1980-1993: Adjustment and Deregulation

Source: Choi (1998), World Bank (1993)

320

Table 7.

S U N G - H E E JWA & J U N G - H W A N SEO

Effective Rates of Protection, Indonesia and Thailand, Selected Years (%)

Country/Sector Indonesia Manufacturing total (excluding oil sector)

77.4 (1981)

67.4 (1983)

66.3 (1985)

Thailand Manufacturing

74.1 (1975)

68 (1987)

59 (1990)

Note: The effective rate of protection is the percentage by which value added at domestic prices

exceeds value added at world prices Source: World Bank (1993)

In Thailand, the Bank of Thailand rediscounted 50% of the value of loans to exporting firms by commercial banks at subsidized rates. Korea rediscounted pre-shipment credits based o n L C s . 14 Indonesia, Malaysia and Thailand all went through periods of domestic market protection. The level of protection in Indonesia and Thailand were particularly high, while that in Malaysia was relatively low (see Table 7). Korea selectively protected HCIs (Table 8). Effective protection rates have been declining but in Indonesia and Malaysia they remained high until 1990. The same is true for HCIs in Korea. Interventionist Industrial policy was motivated by the belief that shifting the industrial structure toward newer and more modem sectors increases the

Table 8.

Selected Effective Rates of Protection, Korea (%)

Food Products Manufacture of beverages and tobacco products Construction material Non-durable consumer goods Durable consumer goods Machinery Transportation Equipment Manufacturing Source: Hong (1998)

1975

1980

1985

1990

1995

17.4 -24.5 -3.8 -27.6 52.6 -0.1 25.6 -3.8

-52.2 --6.4 44.9 36.1 55.3 62.6 99.1 22.8

-48.1 -13.0 34.0 33.0 13.1 23.2 46.7 11.1

~40.1 -21.7 34.0 11.2 25.1 24.2 49.3 10.0

-32.4 -29.0 26.9 63.4 10.8 10.9 18.8 4.4

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321

opportunities for capturing economies of scale. Korea, Malaysia and Indonesia all used interventionist industrial policies. Among them, Korea had the most systematic set of policies (details in Section 111-2). Malaysia started promoting HCIs in the 1980s, following the same path taken by Korea and Japan earlier. However, the key difference is that the Malaysian govemment led the industrialization drive by expanding the number of state finns out of the conviction that the government could speed development. The government established the Heavy and Chemical Industries Corporation of Malaysia (HICOM). HICOM started a number of large-scale, capital-intensive projects including iron and steel, nonferrous metals, machinery and equipment, paper and paper products, and petrochemicals. In 1988, HICOM had set up nine companies involving steel, cement, motor vehicles, and motorcycle engine manufacturing. A well-known project was the PROTON car project, a joint venture with Mitsubishi. However, the performance of state firms, including HICOM, was lower than expected. In 1984 the deficit of public enterprises reached 3.7% of GNP.~5 Poor management and low profitability made the treasury bail out incompetent enterprises. Moreover, the government could not endure rising fiscal deficits and declining terms of trade. In the late 1980s it shifted its policy to the privatization of public corporations and the development of the private sector. Out of the more than 800 state enterprises in the mid-1980s, about 100 were sold by 1990. However, the privatization process has been slow, even after the crisis. Indonesia's approach was a little different. The government used public funds to shift from labor-intensive manufacturing to high technology industries such as aircraft and electronics. The government decided to support the private sector's efforts to upgrade their technological capabilities. However, public sector research facilities and strategic industries have few links with the private industrial sector. 16Moreover, the efficiency of public investments was low. For example, the Indonesian aircraft producer, Industri Pesawat Terbang Nusantara (IPTN), has absorbed $1 billion in government funds since its establishment in 1979. The strategy was to absorb foreign technology through licensing and coproduction and eventually to design and produce aircraft with domestic technology and then export them. However, the domestic market was too small to capture economies of scale. Moreover, the company has had little exposure to the world market. 17 During the industry-targeting industrial policy period, the East Asian governments directed large amounts of money toward HCIs (Korea and Malaysia) or toward high technology industries (Indonesia). For example, Korea allocated more than 50% of total credits to HCIs.

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The financial markets in East Asian Countries were immature. In fact, even though the growth o f financial assets in East A s i a was very rapid, 18 the equity and bond markets developed slowly. Thus, banks have p l a y e d an increasingly important role in allocating capital. Because banks lacked the ability to select borrowers and to monitor their performance, the government intervened in the process of capital allocation. In addition, the government influenced banks' lending decisions through the allocation o f savings deposits that it directly held. Indonesia, Korea, M a l a y s i a and Thailand used their state-owned banks to finance priority projects. In these countries, a very large share o f the financial system's total deposits was held in publicly owned commercial banks (see Table 9). In Korea, the government put private banks under its control by revising some laws (see Section 111-2). Indonesia, M a l a y s i a and Thailand had started financial and capital liberalization in the 1970s before they deregulated their real sectors, which,

Table 9.

Proportion o f Total Deposits in Financial Institutions in East A s i a

(Percentage of Total Deposit)

Economy/year

With government or postal savings institutions

With personal/provident insurance funds

With public commercial and specialized banks

Total

N.A N.A N.A --

N.A N.A N.A N.A

-79.9 71.7 61.3

-79.9 71.7 61.3

4.8 1.0 2.2 1.1

N.A N.A N.A N.A

80.7 80.0

85.5 81.0

57.9

60.1

32.1

33.2

4.1 3.6 2.0 1.5

30.8 24.7 24.9 30.4

-----

34.9 28.3 26.9 31.9

12.7 10.0 8.2 7.6

N.A N.A N.A N.A

1.1 3.7 1.6 2.2

13.8 13.7 9.8 9.8

Indonesia 1971-76 1976-80 1981-85 1986-90 Korea Rep. of 1971-75 1976-80 1981-85

1986-90 Malaysia 1971-75 1976-80 1981-85 1986-90 Thailand 1971-75 1976-80 1981-85 1986-90 Source: World Bank (1993)

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according to many researchers, was a key factor leading to the crisis) 9 Korea had been reluctant to liberalize. It only liberalized its economy from the early 1990s. z° Industrial policies that target certain industries and firms have generally not been very successful in changing industrial structures and raising productivity.21 The Malaysian government had no choice but to get involved in the business of bailing out unprofitable state firms. Also privatization was sluggish. The Korean government had closely monitored and even guided the HCI restructuring process in the 1980s. In addition, the cost of large, highly subsidized credits to firms operating in targeted industries was substantial. Those credits burdened banks with NPLs and interfered with financial resource allocation. Economies with closed capital markets under government control, such as Korea until the early 1990s, could have sustained those costs. But in the world of open capital markets and competition in international capital markets, targeted credit programs are not viable options. The order of liberalization may also have mattered. It is conventional wisdom that governments should deregulate the real sector before the financial sector. Otherwise, banks and other financial institutions will be saddled with NPLs given out to protected enterprises that would fail with liberalization. Indonesia, Malaysia, Thailand and Korea liberalized their financial and capital sectors before their real sector. The huge amount of NPLs after the crisis probably reflects the results expected from conducting liberalization in the reverse order. 3. Korea's Experience 3.1. Industries and Industrial Policies before the Crisis Schematically, the pattem of Korean industrial policies during the last 30 years could be depicted as a cycle of: (i) government selection of industries and corporations to be supported ---* (ii) mobilization of tax and financial resources and drafting of trade policies to support the selected industries ---, (iii) government-led restructuring of industries and corporations in distress. The government actively intervened into every phase of the cycle. Entry and exit barriers, and financial and tax supports were the tools of industrial policy. Entry barriers basically allowing only the existing large corporations to enter the targeted industries and policies designed to support these corporations contributed to the rise of big diversified enterprises, the Korean chaebols. Moreover, exit barriers erected as a result of active governmental intervention in industrial and corporate restructuring inhibited the natural flow of economic resources form non-viable firms to viable ones. Financial support included

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loans of scarce financial resources at preferential, subsidized rates, with long maturity periods to corporations chosen to operate in selected industries. These practices resulted in biased resource allocation. Meaningful industrial policies in Korea were first implemented in the 1960s, at which time the First Five-year Economic Development Plan = was launched. The government targeted the construction of key industries through importsubstitution. It selected several industries including fertilizer and refined oil as strategic industries to be supported. Laws supporting these industries were enacted. The government allocated most investment resources, which were procured mainly through foreign loans, to firms operating in these industries. The most extensive government intervention took place in the 1970s when it carried out 'the heavy and chemical industrialization drive'. The government designated certain industries as key industries. These included iron and steel, non-ferrous metals, shipbuilding, general machinery, chemicals and electronics. Tax and financial resources as well as trade policies were used to promote the development of these industries. Entry barriers were set up, contributing to the rise of the chaebols. During this period, the size of HCIs grew large. In the 1980s, the problems of the previous decade's industrial policies started to come out. Over-investment in HCIs and the expansionary monetary policy that caused high inflation led the government to refrain from active industrial promotion policies. The industrial policy was redrawn to support technologyintensive industries. The underlying motive for this shift was to correct the structural imbalance that started to appear in the manufacturing sector in the late 1970s. Massive inflows of fund in HCIs were cut off, leaving many of these industries with severe overcapacity. Moreover, the government closely interfered in industrial and corporate restructuring. In the 1990s, the government's economic policy emphasized deregulation. The government rescinded many existing regulations, but sometimes revived the once repealed ones. The government's interventionist 'habit' and the private sector's persistent expectations of government initiation/intervention in the market have kept impeding the development of a market economy. 3.1.1. Selective Nurturing of Industries by the Government For the sake of rapid economic growth, the government set up economic development plans and selected strategic industries. Furthermore, in the course of promoting these industries, the government restricted entry through regulations, contributing to the growth of a few large corporations. In the early 1960s, fertilizer, refined oil, steel, synthetic chemical fibers and electric machinery were selected as the industries to be supported. The government also set up a division of labor: The government was supposed to

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build the oil refineries while the private sector was in charge of the other industries. During that period, 60% of total investment was procured through foreign loans, 55% of which was used for the fertilizer, refined oil, cement and textile industries. Moreover, 25% of foreign loans were spent on SOC such as electricity, telecommunication and transportation. In the second half of the 1960s, the government targeted the steel, petrochemical, and general machinery industries. These three industries absorbed 60% of total investment in the manufacturing industry and 77% of foreign loans. In the 1970s and early 1980s, the HCIs were targeted as strategic industries. 23 They included iron and steel, nonferrous metals, shipbuilding, general machinery, chemicals and electronics. Once again, tax and financial resources as well as trade policy were used to support these industries. The government allowed only existing large corporations to enter the targeted industries, and as a result they enjoyed the benefits emanating from the government's support of these industries. The government allowed foreign loans for firms in the targeted industries on a preferential basis. 3.1.2. Entry and Exit Barriers Once the strategic industries were selected, the government decided which ones it would take care of and which ones it would delegate to the private sector. There was fierce competition in the private sector to get permission to enter these industries. However, once the entry permission was obtained, the selected firms were protected by entry restrictions and supported through tax and financial policies. After industrial capital began to be accumulated in the 1960s, the government recycled the corporations i.e. those that had been selected in the 1960s were selected again to participate in the HCI drive of the 1970s. For example, 'the Promotion Plan for Heavy and Chemical Industries', announced in June 1973, stated that the companies wishing to enter the HCIs must procure 30% of total investment with their own capital. This was a way to ensure that only those enterprises that had been selected in the 1960s were selected again. These companies were the only ones able to put out such a large amount of capital, based on their capital accumulation experience of the 1960s. 24 Along with the promotion of HCIs, the government in the 1970s adopted an exportoriented policy. For that purpose, it sought economies of scale in export industries, resulting in the establishment of the so-called 'General Trading Companies'. These companies were private enterprises specializing in the

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export of Korean goods with government backing. Because the general trading companies were given permission to enter the HCIs, they were therefore also deeply involved in those industries. Trade policy also supported the selected industries and corporations. It was almost impossible to import foreign products if similar goods were produced domestically. However, if the exporter needed to import inputs for the production of export goods, it was exempted from this rule and moreover benefited from the tariff rebate system. As such, the general trading companies engaged themselves in the export and import businesses as well as in the HCIs through their subsidiaries, and benefited greatly from the system. As a result, HCI output accounted for 57% of the general trading companies' total exports in 1980.25 In addition to entry selection, the government actively intervened in the corporate restructuring process, including the liquidation and M&As of private firms. Table 10 shows the main content of industrial and corporate restructuring that took place during Korea's rapid economic development period. Throughout the 1960s, the country's export-oriented economic development strategy, financed by large investments, generated many incompetent firms due to their lack of experience and managerial skills. The funds needed to finance the projects of the 1960s were mainly procured through foreign loans under government guarantees and were allocated by the government. The government worried that the emergence of many non-viable firms could lower the nation's credit status in international financial markets, which would impede economic growth greatly dependent on foreign loans. The government, despite criticism that it was itself partly responsible for failures in resource allocation, actively intervened in the corporate restructuring process. Between 1969-1971, one hundred and twelve incompetent firms were either liquidated or acquired by other firms. The government's corporate restructuring strategy was to transfer ownership without liquidation. However, problems of high financial costs and capital structure vulnerability persisted in all firms. The tight monetary policy recommended by the IMF in the early 1970s and sharp currency devaluation aggravated those financial problems. Thus, the government took comprehensive measures and applied them uniformly to the remaining firms in order to alleviate their financial difficulties. Those measures included transforming short-term debt into long-term debt, lowering interest rates, and tax exemptions. From the late 1970s, the main problems of the Korean economy were overinvestment and persistent inflation caused by the expansionary monetary policy. From 1979, the government switched the target of economic policy to the stabilization of the economy and the scaling-down of investment in HCIs.

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In 1979, the government set the M 2 growth rate at 25%, 10% lower than the rate in 1978. It also diverted financial support toward the expansion of consumer goods industries, which led to a reduction o f investments in HCIs. Throughout the 1980s, the government reorganized the HCIs to raise their competitiveness through the creation of economies o f scale and to reduce the social costs associated with massive corporate bankruptcies. The restructuring process covered the electricity generation, heavy construction equipment, automobile, and diesel engine industries. In addition, the government carried out a p r o g r a m o f industrial rationalization. It revised the tax reduction regulation law. The revision states that: (i) the government sets the industry rationalization criteria and (ii) firms going through rationalization according to these criteria will get tax reductions or exemptions. Until 1988, seventy firms were classified as firms necessitating rationalization. A m o n g them, sixty-seven

Table 10.

Content of Industrial and Corporate Restructuring Content

1969-1971

112 insolvent finns in the PVC, automobile, steel, chemical and textile industries were liquidated or acquired by other firms

1972: Industrial Rationalization

Due to a tight monetary policy recommended by the IMF and a sharp devaluation, firms took out loans at high interest rates and with short maturity. Those firms' financial problems worsened. Industrial Rationalization - Covered 61 firms, including 30 in heavy industries, 8 in chemical industries, and 10 in light industries. Self-rationalization through specialization, M&As and R&D supported by the government through financial and tax support -

Late 1970s-early 1980s Restructuring of HCIs

The government decreased the flow of money to HCIs to correct over-investment in those industries. The electricity generating, heavy construction equipment, automobile, and diesel engine industries were covered. Main restructuring tools were M&As. The government supported restructuring with bail-out financing and interest rate subsidies

1990s Business Specialization Inducement

Induce the big 30 business groups to specialize Regulations on the core business areas chosen by individual business groups will be eased

Source: KERI (1998)

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firms were disposed of through government-led M&As, two firms went through a reorganization process and one firm was liquidated. Note that most firms were merged with or acquired by third parties based on criteria set by the government, not through market discipline. 3.1.3. Financial and Tax Support The govemment allocated financial resources and provided tax support to the corporations given the permission to enter the industries it deemed economically strategic. During the 1960s, the government put almost all domestic financial resources under its control: It revised the Korea Central Bank law as well as the Bank Law, took over the stocks of commercial banks owned by private enterprises, and established special-purpose state banks such as Kookmin Bank for the general public and the Industrial Bank of Korea for small and medium firms. In the early 1960s, the government allocated 55% of foreign loans to the strategically selected industries. In the second half of the decade, 60% of investments in the manufacturing sector were allocated to three strategic industries, petrochemical, steel, and machinery. In addition, the government applied low interest rates on loans to firms entering the selected industries, reinforcing private sector dependency on the government. Even after the industrial restructuring program of the late 1960s, many of the surviving firms (selected and helped by the government) experienced financial difficulties. The government relieved them with comprehensive and uniformly applied measures. It allowed short-term private-sector debt to be changed to long-term debt, lowered interest rates (from 19.0% to 15.5% for the discount rate of commercial bills), issued special bonds (30% of which were changed into long-term low interest rate loans), raised the depreciation rate of fixed facilities from 30% to 40-80%, and raised the corporate exemption rate from 6% to 10%. In the 1970s, the government got deeply involved in the allocation of investment funds not only to strategic industries but also to individual investment projects. To provide large investment resources into the heavy and chemical industries, the government established the National Investment Fund in 1974, and commercial banks, virtually controlled by the government at that time, were told to give out loans to targeted investment projects. In addition, the government gave priority to companies operating in the heavy, chemical, and export-oriented industries to introduce foreign loans. The loans to these companies and other earmarked loans were called 'policy loans'. The interest rate on the policy loans were kept low (see Table 12). Table 11 shows the share of policy loans compared to total domestic credit during 1975-1985. The

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foreign trade loans were used to finance exports in general. The earmarked loans were for the agricultural sector, small and medium firms, residence construction, and so on. Hence, loans that were not earmarked were the most likely source of investment funds for the heavy and chemical industries. More than half of total investment funds were under government control and more than 2/3 of them were allocated to HCI firms and exporters. In the late 1980s, more than 93% of national investment funds and 42% of the Korea Development Bank's loans were allocated to those industries. Table 12 shows the gap between the preferential interest rate and other interest rates. The difference between the earnings rate of commercial bills and the interest rate on loans for equipment grew from 3.0% in 1965 to 12.6% in 1970 to 15% in 1980. The difference between commercial bills and loans for foreign trade is even greater. Those differences grew smaller after 1985. Furthermore, since the inflation rate ranged between 10-28.7% during 1975-1985, real interest rates on policy loans were negative.

Table 11.

1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985

Share of Policy Loans in Domestic Credit

(%)

Not earmarked

Foreign Trade

Earmarked

Total

27.67 26.98 29.52 32.14 33.05 32.76 31.52 29.65 27.7 25.73 25.03

8.86 9.84 10.20 10.62 10.49 11.15 12.56 12.16 12.56 12.62 12.75

18.52 17.78 18.03 19.17 16.34 15.44 16.24 14.25 15.98 16.94 16.98

55.04 54,61 57.76 61.93 59.88 59.35 60.31 56.05 56.24 55.29 54.76

Notes: (1) Domestic credit includes all loans and discounts to the private sector by deposit money banks (commercial banks and special banks) and two development institutions, the Korea Development Bank and Korea Export Import Bank (2) 'Not earmarked' includes loans from the National Investment Fund, Loans denominated in Foreign Currencies, all loans by the Korea Development Bank, and other miscellaneous items. (3) 'Foreign Trade' includes loans for foreign trade by deposit money banks and all loans from the Korea Export and Import Bank (4) 'earmarked' includes loans for agriculture, small and medium firms, and residence construction Source: Yoo (1989)

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In sum, until the mid-1980's the export sector and the heavy and chemical industries enjoyed easy access to financial resources at low interest rates. In general, tax support to corporations operating in the selected industries included tax reductions on export sales, reductions of indirect and customs taxes on inputs for export goods, reductions of corporate tax, and a high rate of depreciation. Table 13 shows the trend of corporate tax reduction. The reduction rate slowly increased until the 1970s, but then started to increase very sharply in the late 1970s and early 1980s. Table 14 shows the effective marginal tax rate for selected industries. The favorable tax treatment for these industries lowers the tax rate to around 3/4 of what it would otherwise have been. In addition, the effective tax rate on HCIs during the 1970s was 20%, while that of light industries was almost 50%. 26 3.1.4. Productivity Trend: Evidence of the Effects of Industrial Policies Governmental control over the financial sector contributed to the mobilization of capital, but not necessarily to an increase in productivity. In addition, loose supervision of the financial sector contributed to the loose corporate governance structure. These factors gave rise to inefficient resource allocation. Studies 27 show that the quantitative growth of inputs rather than the growth of input productivity promoted the growth of the Korean manufacturing sector.

Table 12.

Commercial bills Loans for Equipment Loans for Foreign Trade

Various Interest rates (%)

1965

1970 1975 1980 1985 1 9 9 o 1 9 9 2

1993

14.0 11.0 6.5

24.6 12.0 6.0

12.6 9.5 8.5

20.1 12.0 9.6

30.1 20.0 15.0

14.2 12.0 10.0

16.5 12.0 10.0

16.2 12.0 10.0

Source: Lee (1998b)

Table 13,

Reduction of Corporate Tax (%)

1966 1967 1971 1976 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 Reduction rate 23.1 20.4 21.5 35.2 64.8 82.7 61.3 34.4 14.2 13.7 15.1 15.6 12.2 16.8 Source: Lee (1998b)

Asian Crisis and Implications for Industrial Policies

Table 14.

Effective Marginal Tax Rates Basic Metal and Product

Chemical Products

1973 1975 1978 1980 1981 1982 1983

331

Electrical and Electronic Machinery

general

special

general

special

general

Special

48.90 54.20 41.10 45.30 55.80 57.10 37.60

46.30 38.80 29.50 32.00 42.40 50.80 34.80

49.00 53.20 41.20 45.50 55.00 56.40 38.10

46.90 38.70 31.00 32.90 42.60 50.80 35.80

49.30 53.70 42.00 45.80 55.60 57.00 38.40

47.10 39.10 30.90 33.00 43.00 51.20 36.00

Notes: 'General' rates are applicable to firms that are not qualified to get special tax treatment and 'special' rates are for qualified firms Source: Kwack (1984)

Table 15.

Increase of Total Factor Productivity (%)

1967-1970 1970-1975 1975-1980 1980-1985 1985-1990 1990-1996 Increasing rate of TFP

3.30

1.56

-3.10

4).26

0.76

2.43

Source: Lee (1998b)

During 1975-1980, there were massive investments in HCIs. The yearly average growth rates of capital intensity were 24.6% in general machinery, 18.5% in the steel industry, and more than 10% in the other HCIs. The increase in capital investments combined with technological progress and increased managerial skill result in capital efficiency, In Korea, R&D and managerial skills did not catch up with the increase in capital investment, i.e. resource allocation was inefficient. As a result, factor productivity decreased. In particular, the input productivity of most HCIs decreased between 1970-1980 (and some of them did so between 1970-1985). These results imply that the government's interventionist industrial policy, together with the two oil crises of the 1970s, generated inefficient resource allocation. For example, Table 15 shows that total factor productivity in the manufacturing sector decreased during 1975-1985 and started to gradually increase from the early 1990s.

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Table 16.

Distribution o f Total Factor Productivity

1967-1970 1970-1975 1975-1980 1980-1985 1985-1990 1990-1996 Below -4% -3 - -3.9 -2 - -2.9 -1 ~ - 1 . 9 --0.9 ~ 0 0 - 0.9

0 0 1

1 1 0

3 0 0

1 1 1

0 0 1

2 0 3

0

1

1

3

3

0

l 2

1 0

3 5

3 5

7 9

1 2

1 - 1.9

4

1

2

3

5

6

2 - 2.9 3 ~ 3.9 Above 4%

5 2 13

2 4 17

2 5 7

6 4 1

1 0 2

5 6 3

Source: Lee (1998b)

Moreover, the number of industries whose input productivity decreased rose between 1970-1990 (See Table 16). Additionally, the government's system of financial and tax support to selected firms in the targeted industries was not effective. Some studies show that it did not statistically contribute to the increase in input productivity. 28 3.1.5. Growth of the Chaebol The strategy of government-led economic development set the ground for the growth of business conglomerates called chaebol. In the early stages of economic development, the government allowed a few corporations to enter the targeted industries. Since those industries were HCIs subject to economies of scale, the size of the corporations involved could not but grow larger. Afterwards, the government continued to make use of their experience and managerial skills in the course of economic development. The government gave those large corporations preferential entry into the targeted industries, which hindered competition. Moreover, the government offered financial and tax inducements to the chosen firms. Thus, the large corporations had every incentive to diversify their operations according to the government's industry targeting policy. They became large business groups. Furthermore, in disposing of insolvent firms, the government reorganized the industrial structure by transferring their ownership to the big business groups, reinforcing the growth of the chaebol. In addition, the government, to minimize the huge potential social cost of chaebols bankruptcies, resuscitated insolvent chaebols or their subsidiaries through preferential measures. As a result, the big business groups

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had little chance to restructure themselves according to market discipline. The formation and growth of the chaebol was the result of the interaction between industrial policies and the chaebol's responses to them. Chaebols had a distinguishable management system. The controlling shareholder, the chairman, controlled the management of all of its affiliates. The chairman of a chaebol has maintained control rights over its subsidiaries through cross shareholding. Consequently, the boards of directors and supervisors of all subsidiaries do not function as they are supposed to do (for example, monitoring management). In fact, board members may be expelled from the board if they oppose the chairman. The growth of the chaebol became a burden to economic policy. Since the chaebols were accountable for a large share of the Korean economy's assets, sales and debts, most industrial policy measures were inevitably connected with them. The chaebols, as leading companies in major export-oriented industries such as petro-chemicals, automobiles, and semiconductors had initiated large-scale projects and were exposed to harsh international competition. Moreover, strategic concerns in oligopolistic markets forced them to expand their capacity. They became larger and larger with little experience of how to restructure, generating the notorious 'too-big-to-fail' legacy of the chaebol. In addition, Korea's financial system was heavily skewed toward indirect financing through banks, compared to direct financing through the stock market. Moreover, the government controlled the banking system. It allocated financial resources so as to support big businesses and sometimes to resuscitate them. As a result, through over-expansion as well as the given Korean financial structure, the chaebol ended up with high debt/equity ratios. Figure 1 shows the debt-equity ratio trend of the big business groups. From the early 1980s, the anti-monopolist policy began to focus its attention on regulating economic concentration. The 'Regulation on Monopoly and Fair Trade Act' ('The Fair Trade Act' hereafter) was enacted in 1980. The regulations on M&As and big business groups were introduced in 1986. The regulations on market concentration and cross-debt guarantees among chaebol subsidiaries were introduced in 1990 and 1992, respectively. Table 17 presents the main regulations regarding economic concentration in 1990. The Fair Trade Commission selected the top 30 chaebols, based on the size of their assets, as its main target of regulation. In addition, the government put restrictions on loans to the chaebol to prevent leveling concentration. During the 1990s, it introduced the business specialization policy to induce the chaebol to limit diversification to 2-3 specialized business lines. These regulations were not as effective as expected. Both the net assets and cross holdings of the chaebol have increased by 2.1 times during 1993-1997.

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Asian Crisis and Implications for Industrial Policies Table 17.

335

Regulations on Economic Concentration in 1990 Content

Market Structure

Suppressionof economic concentration Restrictions on M&A.s

Corporate Behavior

Restrictions on exercising market power Restrictions on collusion Restrictions on Unfair Transactions

holding companies are prohibited Restrictions on total investment in subsidiaries Restrictions on cross-debt guarantees Restrictions on voting rights of financial and insurance companies having shares of affiliates anti-competitive M&As prohibited Unfair M&A is prohibited Restrictions on unjust price determination and change Restrictions on entry barriers Restrictions on hindering other firms' operations Restrictions on collusive determination of prices and sale conditions Restrictions on regional demarcation and exclusive dealing Maintaining resale prices is prohibited Restrictions on unfair international contracts

Source: KERI(1995)

Market concentration is still high - the top thirty chaebols accounted for 46.88% and 46.62% of total sale in 1988 and 1997, respectively. 29 The top thirty accounted for 24.2% and 21.5% of total financial loans in 1990 and 1995, respectively. There are several reasons for the failure of regulations on economic concentration. First, restrictions on competition including entry barriers and price regulations were still effective. Second, the government could not commit the fate of incompetent chaebols to the care of market mechanisms because of the potential social cost of their financial problems and bankruptcies. So the government kept incompetent chaebol subsidiaries alive with public money or merged them to other chaebol subsidiaries. Furthermore, the M & A market was inactive and the bankruptcy laws including reorganization processes which were inadequate were usually ignored. Third, The financial industry was too immature to exercise its role to check chaebols' overexpansion. Korean banks did not perform their duty of loan screening thoroughly because they were used only as tools to support the government's industrial policies in the so called 'government-managed financial system,' a product of excessive government intervention in the banking sector. Banks and other financial institutions got

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used to governmental guidance and coordination. They hardly needed and so lacked the requisite ability to conduct credit and project analyses. Since they lacked such ability, for every loan they provided, even for credit loans, they required debt guarantees or collateral to reduce risks. So the chaebol satisfied the banks with cross-debt guarantees among subsidiaries, with which they could obtain as much money as needed for expansion. All of these factors made regulating the chaebol ineffective and possibly led to the erosion of their competitiveness. 3.1.6. Evaluation: Interventionist Industrial Policies as A Cause of the Crisis The government-led interventionist industrial policy strategy generated various structural problems. First, industry- and firm-targeting industrial policies greatly distorted resource allocation. They frequently tended to substitute for the price mechanism. It resulted in over-investment in and subsequent restructuring of the HCIs. Preferential industrial policies have worsened economic concentration, resulting in structural imbalance between big and small-and-medium firms and a monopolistic economic structure. Second, government control of the financial sector as a tool to support its industrial policy undermined financial institutions' ability to discriminate between competent and incompetent firms and projects and to monitor the performance of borrowing firms. It eventually led to the underdevelopment of the financial sector. Third, persistent government intervention destroyed private sector incentives for creative economic ventures. State support of selected industries and firms, and government control of the financial sector made the private sector dependent on governmental guidance and coordination. In addition, since the government helped the large enterprises, especially the chaebol, survive financial difficulties by showering them with preferential measures, the too-big-to-fail legacy emerged and moral hazard ensued. Lastly, in political economic sense, the government's ability to select and support strategic industries and to enforce restructuring programs generated room for rent seeking. The corporations lobbied government officials, which raised suspicions of corruption. It also contributed to the prevalent anti-chaebol sentiment. By and large, interventionist industrial policies greatly contributed to the development of the crisis. They frequently substituted for market operations, nourishing the private sector's dependence on the government, which lead to a decrease in the private sector's autonomy and creativity. As a result, the effectiveness of market mechanisms declined. All of the results also had moral hazards prevail in the economy. Due to moral hazards, the necessity for economic restructuring to allow market mechanisms to work was likely to be

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unrecognized. The agents in the economy didn't have many incentives to exert themselves to adapt to the changing economic environment. All of them provided the environment for the crisis. The economy's lack of market flexibility and ability of adaptation could not avoid the crisis. Moreover, economic agents had to resort to another great government intervention to respond to the crisis, i.e. they had to depend on the government in clearing up all the vestiges of the government's past interventionist policies. Industrial policies are based on the belief that the government has sufficient information about the changing economic environment and the ability to fully anticipate the optimal industrial structure. However, the economic environment has been changing rapidly of late. It is getting more dynamic and therefore more uncertain. Market participants have more information about changes in the economic environment than the government. In addition, as the economy grows in size and complexity, it is getting less and less possible for the government to absorb these changes and determine the optimal industrial structure over time on behalf of the private sector. It is thus safe to say that Korea's industrial policies should adapt to the changing economic environment. 3.2. Post-Crisis Corporate Restructuring 3.2.1. Corporate Restructuring The direct cause of the crisis in Korea was a combination of measures undertaken by the Korean government in 1997 that triggered the blowout and the Korean government's policy of overvaluation of the exchange rate. The poorly implemented financial liberalization measures were also responsible for weakening the corporate financial structure. Furthermore inadequate prudential regulations and supervision were responsible for accelerating the crisis during the inappropriate sequencing of the liberalization of the domestic financial market9 For the corporate sector, the IMF pinpointed the Korean chaebol as the culprits of Korea's structural weakness and stressed the need for rigorous corporate restructuring. High debt-equity ratios and a very poor use of capital in the corporate sector prior to the crisis aggravated the impact of tightening liquidity on corporate cash flow and investment activities under the tight macroeconomic policy stance of the IMF program. Cross-debt guarantees between chaebol affiliates, which was a strategy used by the chaebol to increase the amount of loans they were getting, helped create high debt levels among the large Korean chaebol. As for the top thirty chaebols, the new D. J. Kim government presented five guidelines for chaebol reform in Jan. 1998 as shown in Table 18.

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Table 18.

Five Principles for Chaebol Reform

Objectives

Measures

Schedule

Enhanced Transparency

• Adoption of consolidated financial statements • Adoption of international accounting principles • Strengthening the voting rights of minority shareholders • Compulsory appointment of outside directors • Establishment of external auditors committee

• FY 1999 • Oct. 1998 • May 1998

Strengthening Accountability

• Strengthening the legal liability of controlling owners • Allowing voting rights of institutional investors • Introduction of cumulative voting system

• Jun. 1998 • Sept. 1998 • Dec. 1998

Resolution of Cross-debt Guarantees

• Elimination of existing cross guarantees • Prohibiting new cross guarantees between affiliates • Prohibiting financial institutions from demanding crossdebt guarantees

• Mar. 2000 • Apr. 1998 • Apr. 1998

Improvement of Financial Structure

• Agreement with banks to improve the capital structure • Removal of restriction on capital infusion to affiliates with consideration to defend against hostile takeovers (this restriction to be re-enforced by April 2000) • Exclusion of income tax deduction on interest payments on excessive borrowings • Introduction of asset-backed securities • Requirement of 200% debt/equity ratio (added later)

• Apr. 1998 • Feb. 1998

Streamlining Business Activities

• • • • •

Adoption of corporate-split system Improving M&A procedures Liberalization of foreign ownership of real estate Full liberalization ofM&As Streamlining bankruptcy procedures

• Feb. 1998 • Feb. 1998

• FY 2000 • Sept. 1998 • Dec. 1999 • • • • •

Jun. 1998 Jun. 1998 Jun. 1998 May 1998 Feb. 1998

T h e s e p r i n c i p l e s c o n s i s t o f t h r e e c a t e g o r i e s . T h e first o n e s e e k s to i m p r o v e c o r p o r a t e g o v e r n a n c e s t r u c t u r e a n d m a n a g e r i a l t r a n s p a r e n c y . It r e q u i r e s t h e adoption of consolidated financial statements and international accounting p r i n c i p l e s . I n a d d i t i o n , t h e a p p o i n t m e n t o f o u t s i d e d i r e c t o r s is n o w r e q u i r e d b y law. L i m i t s o n t h e v o t i n g r i g h t s o f i n s t i t u t i o n a l i n v e s t o r s w e r e lifted, a n d t h e r i g h t s o f m i n o r i t y s h a r e h o l d e r s w e r e s t r e n g t h e n e d . O n t h e o t h e r h a n d , t h e legal l i a b i l i t y o f c o n t r o l l i n g o w n e r s w a s also s t r e n g t h e n e d . T h e s e r e f o r m s in all will h e l p i n c r e a s e a c c o u n t a b i l i t y o f the o w n e r - m a n a g e r s , s o - c a l l e d the g r o u p chairmen, and decrease the hold on power that they currently have. One of the

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problems in the chaebol has been the absolute dominance of the chairman over all affiliated firms. The chairman of a chaebol has the power to fire members of the Board of Directors, who should be the ones keeping the chairman in check. The reforms should help reverse this situation and create a Board with more power. The second component seeks to improve financial conditions and the capital structure of firms and includes the elimination of cross-debt guarantees among group affiliates by March 2000. It also covers a reduction in debt-equity ratios to 200% by the end of 1999. An agreement to improve the financial structure of the business sector was signed between creditor banks and their corporate clients under government guidance, and the process of financial restructuring is being closely monitored by the government. Progress has been made in financial restructuring. Debt-equity ratios have decreased from 477.08% in 1997 to 390.64% at the end of 199831 and to the level lower than 200% by the end of 1999. Most of the top 5 chaebols' cross-debt guarantees have been resolved as of January 2000. The third category aims to improve business competitiveness by streamlining business activity. To facilitate the exit or reorganization of insolvent firms, the bankruptcy and corporate reorganization laws have been revised. On the other hand, 55 non-viable firms belonging to the 30 largest chaebols have been forced to close down. In particular, as part of the efforts to streamline business activity, the top five chaebols agreed to decrease the number of their affiliates and to concentrate on three to five core businesses in order to solve the problems of over-diversification and over-investment. 32 They will reduce the number of affiliates by up to 70% by the year 2000 in return for comprehensive tax breaks and other benefits, including debt-equity swaps by creditors. The government has also strongly encouraged big deals among them. The big deals, or more precisely business swap deals, have been taking place in eight major industries including the semiconductor and automobile industries (see Table 19). The big deals, however, are controversial and run counter to the liberalization trend in that they represent government intervention. At the same time they do nothing to improve the situation of property rights in Korea as they involve the forced merger or acquisition of companies. To improve corporate governance and accelerate the corporate restructuring process, measures to revitalize the domestic M&A market were introduced. M&A activities involving foreign firms have been encouraged through the amendment of the Foreign Capital Inducement Law. For the top 6--64 chaebols and other mid-size corporations, an out-of-court workout program was introduced by an association of financial institutions. The Workout program is a kind of private corporate reorganization process

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Table 19,

P r o g r e s s in B i g D e a l s

Industry

Before Big Deals

Progress

Semiconductor

• Samsung Electronic Co. • Hyundai Electronic Ind. • LG Semicon Co.

• Samsung Electronic Co. • Hyundai and LG merged into one company (Equity Shareout to be discussed later)

Petrochemicals

• Samsung General Chemical Co. • Hyundai Petrochemical Co. • Hanwha Petrochemical Co. • Daelim Petrochemical Co.

• Samsung and Hyundai merged in to one company (foreign investment is under negotiation) ° Hanwha and Daelim merged into one company

Aircraft Parts

• Samsung Aerospace Industries Co. • Daewoo Heavy Industries Co. • Hyundai Space & Aircraft Co.

Form a new, joint company and introduce foreign capital

Rolling Stock

• Hyundai Precision & Ind. Co. • Daewoo Heavy Ind. Co. • Hanjin Heavy Ind. Co.

Unified into one company

Power Generation Equipment

• Korea Heavy Industries & Construction Co. (Hanjung) • Samsung Heavy Ind. Co. • Hyundai Heavy Ind. Co.

• Unified into one company • Hanjung takes over Samsung's Business

Ship-Engine

• Samsung Heavy Ind. Co. • Hyundai Heavy Ind. Co. • Hanjung

Hanjung takes over Samsung's Business

Oil Refining Auto

Hanwha Energy Co, • Hyundai Motor Co. • Kia Motors • Daewoo motors • Samsung Motors

Acquired by Hyundai Oil Co. • Daewoo motors failed to take over Samsung motors • Hyundai Motor Co. took over Kia Motor Co.

* As of November, 1999.

b e t w e e n d e b t o r - f i r m s a n d c r e d i t o r - b a n k s . It a i m s to r e s t r u c t u r e d e b t o r - f i r m s before they b e c o m e n o n - v i a b l e so that firms and b a n k s can avoid the a g o n y of c o r p o r a t e b a n k r u p t c y . A s o f S e p t e m b e r 1999, 5 9 affiliates o f t h e t o p 6 - 6 4

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chaebols and 42 other mid-size finns were under the workout program. In this workout program, the creditor banks allow a grace of payment and enforce debt-equity swaps as shown in Table 20. 3.2.2. Evaluation Post-crisis corporate restructuring has proceeded under strong government guidance. There has been progress in corporate governance and financial and business structures. The reduction of firms' debt/equity ratios and cross-debt guarantees, the introduction of outside directors, and the closing-down of nonviable firms are among others. However, the process of restructuring is reminiscent of the interventionist industrial restructuring attempts of the 1970s and 1980s. For example, in the big deals, the government forced M&As upon firms and gave them deadlines by which they must be completed, and determined the acquiring and acquired firms in advance. However, the government underestimated the transaction costs of M&As as well as the differences in production technologies and the technological levels of the merged firms or the acquired

Table 20.

Debt Restructuring Plan and Accomplishment of the Workout Program (100 million Won, %) Grace of Payment Reduced Normal Debt-Equity Interest Interest Swaps Rate Rate (Value)

Others

Total

New Loans

Top 6-64 Plan 204,228 33,119 chaebols Accomplished 194,914 30,533

40,495 31,696

18,995 19,602

296,897 14,744 276,745 13,795

Mid-size Plan 28,773 15,452 finns Accomplished 2 8 , 5 0 8 14,611

2,798 1,985

5,126 5,613

5 2 , 1 0 9 5,505 5 0 , 7 1 7 3,745

Total

Plan (composition ratio) Accomplished (% to the plan)

233,021 48,571 (66.8%) (13.9%)

43,293 (12.4%)

24,121 349,006 20,249 ( 6 . 9 % ) (100%)

223,442 4 5 , 1 4 4 (95.9%) (92.9%)

33,681 (77.8%)

25,215 327,462 17,450 (104.5%) (93.8%) (86.6%)

Source: Financial SupervisoryService, 1999. 11.

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and acquiring firms, leading to a time-consuming negotiation process. In addition, the government infringes on the property fights of the companies participating in the restructuring programs. With the pre-set deadlines and strong governmental pressure, the participating companies had to go ahead with the forced M&As without having enough time to think about their soundness. The big deals could raise doubts as to the consistency of government policy: first, they may lead to a significant increase in market concentration, which could be in conflict with governmental policy regulations on economic concentration. Second, after the deals are over, would the government prohibit new entry in the industries affected by the big deals? What if the potential entrants are foreign investors? Another example is the reduction of debt/equity ratio uniformly applied to each of the big five chaebols. The government did not take into account the diversity of economic agents. Considering that each of these chaebols has different managerial styles and business outlooks, their debt management plans and/or capability cannot but be different. The policy of lowering the debtequity ratio might be right, but it is unclear whether the same numerical target and deadline must be applied to all chaebols uniformly. The government announced to stick to 200% debt/equity ratio policy in 2000. However, it will restrict the freedom of the corporate sector in managing financial options, especially in the normal economic situation after the crisis. It looks as if this restructuring process has paid too much attention to changing outward symptomatic characteristics rather than setting the correct underlying institutional and incentive structures. Government-led restructuring without providing appropriate institutional foundation will not have a lasting effect. A systematic approach such as establishing an economic environment encouraging voluntary restructuring in the process of competition is more favorable to the economy. Broadly speaking, there are two distinct systems for disciplining corporate behavior, the market-based system and the internal discipline-based system. (see Fig. 2). The market-based system can be further broken down into the product market, direct financing market, and market for managers. Through competition in the product market, consumers choose efficient and competitive businesses that produce good products. In the direct financing market, shareholders, through their oversight rights as well as the threat of mergers and acquisitions, discipline incompetent corporate managers. In the indirect financing market, creditors keep close checks on corporate managers, not only by means of close analyses of creditworthiness before extending credits to

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finns, but also by closely monitoring firms' use of funds. The competition among professional managers in the market for managers contributes to improving overall managerial efficiency by sorting out managers with poor managerial performances. On the other hand, the internal discipline system of oversight relies on inside organizations, such as holding companies, coordination offices, and the board of directors for providing checks and balances on managers. In addition, there is the hybrid approach through which institutional investors appoint outside directors to oversee managers. The proper role of the government is to change laws and institutions and enforce them so as to provide corporate management with an external environment that will ensure the normal functioning of the various disciplinary systems. Then, as these systems begin to operate, firms will start restructuring at a faster pace as they realize that their survival depends on it. This system is far more favorable to the market economy than the government-led restructuring system.

4. An Example of Industrial Policy Lifecycle : Samsung Motor Company This section will discuss the rise and fall of Samsung Motor Company and the government's role in the process. This is a typical example of how the government influenced a firm's activity from entry to exit. Recently, the big deal so awaited for in the automobile industry fell through. The Samsung Group decided to seek court receivership for its automobile unit, backing off from its earlier plan to sell the debt-laden unit to the Daewoo Group. The life of Samsung Motor Company, a subsidiary of the Samsung Group and a participant in the big deal, is an example of the government's interventionist industrial policy. Samsung group, one of the largest chaebols in Korea, signed a 'technology import contract' with Nissan Motor Company, Japan on April 26, 1994. It was Samsung's first step toward participating in the automobile industry. However, before the contract was signed, the government had undertaken an economic analysis of Samsung's entry into the Korean automobile industry. As a result of this analysis, on April 28, 1994, the government had decided not to allow Samsung entry into the automobile industry. The reasons for this decision were: (i) duplication and over-investment in the automobile industry, (ii) exhaustive competition in the limited domestic market, 33 and (iii) delay of technological independence caused by the introduction of foreign technology. But suddenly,34 on November 30, 1994, the government allowed Samsung to enter the automobile industry. Subsequently, Samsung submitted the report of

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technology import and the government accepted it. Samsung Motor Company (SMC hereinafter) was established on March 28, 1995 and operation of the production line began on May 12 1997. SMC introduced its first model into the market on February 17, 1998. However, there were numerous debates among economists and social reformers on SMC's competence, profitability and excessive amount of debt. On December 7, 1998, a big deal between Daewoo Motor and SMC stipulating that Daewoo would acquire SMC was announced and on March 22, 1999, the CEOs of both groups agreed on the principles of the big deal. 35 There were various conflicts of interests in the process of making the big deal. Most of all, handling SMC's more than 4 trillion Korean Won debt, which is estimated to be more than four times the value of its equity, was a headache to the government as well as to both companies. Eventually, the big deal negotiations fell through and SMC filed for the Corporate Reorganization Process on June 30, 1999. Under that process, the court must decide on whether the filing firm is worth reviving through reorganization, and if the court makes a decision for reorganization, the creditors and the filing firm set up a reorganization plan including debt adjustment. After the filing, the government, along with the subcontractors and the community where SMC is located, insisted on keeping SMC alive regardless of its economic viability. Furthermore, the creditors and the government have pressured the CEO of SMC to solve SMC's debt problem using his own private wealth. SMC's case shows the typical features of interventionist industrial policies. First, the government controlled a private company's entry into a market - the government determined SMC's entry into the automobile industry. Second, the government closely interfered with the private sector's restructuring process. It decided on whether a firm should go bankrupt or be acquired by another firm. The government even determined which firm should acquire the other - the government determined that SMC should be acquired by Daewoo Motor. The life of SMC also reveals how uncertainty arises from intervention. First, what made the government reverse its decision about SMC's entry into the automobile industry? After all, there were reasons given for disallowing SMC's entry, but not for the abrupt decision reversal afterwards. As such, nobody knows why the government changed its decision. Consequently, the qualifications required to enter the automobile industry remain unknown. Second, what is the cause of SMC's failure afterwards? Is it duplication and over-investment in the automobile industry, exhaustive competition in the limited domestic market, or management failure? If it is one or both of the first two, then the questions regarding the government's policy reversal, from barring Samsung's entry to allowing it, remain. If the cause is management failure, the court and

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Table 21. 1994.4.26 4.28 11.30 12.3 12.7 1995.3.28 1997.5.12 1998.2.17 12.17 1999.3.22 6.30 10. 12.30

Diary of SMC's Life

Contract of technologyimport with Nissan Government disallows Samsung'sentry into the automobile industry Government allows Samsung'sentry into the automobile industry Samsung submits its request for technologyimport Government accepts the report SMC was established The productionline began SMC introduces its first model into the market The big deal between DaewooMotror and SMC is announced The CEOs of DaewooMotor and SMC agree on the principles of the big deal Collapse of the big deal. SMC files for the Corporate ReorganizationProcess The part of SMC's production line re-started operation with creditor banks new loans Corporate ReorganizationProcess began. Renault(a French motor company)started the negotiationto acquire SMC with creditor banks.

the creditors should decide on how to handle SMC. But then, why did the government insist on the continuation of SMC's operations and why did it intervene in the debt-handling process? Persistent government intervention undermined private sector autonomy and nourished dependence on the government. At this point one has to wonder whether creditors have responsibility for lending money to firms. Why did they wait for the government's decision instead of actively trying to solve the debt problem? Governmental control of the banking sector during last 30 years has made the creditor banks dependent on government guidelines or coordination. Sometimes, government intervention creates conflicts with the system of private property rights. What allows the government to pressure the CEO of SMC into paying a corporate debt using his own private wealth? There are neither laws nor regulations in Korea about CEOs surrendering private property except for shareholders giving up their shares in the case of a business failure. The SMC case shows the legacy of governmental discretion in policy/ decision making, determining the rise and fall of private firms and creating uncertainty due to inconsistent policy making, private sector lack of autonomy in decision making, and governmental infringement on private property. Should this kind of industrial policy continue in the 21 st century? The next section will

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provide a direction for industrial policy in the changing economic environment. 5. New Industrial Policy in the Changing Environment 5.1. Changes in the Economic Environment IMF Programs for the financially distressed Korean economy entailed the implementation of global standards and the liberalization of the economy. Throughout the crisis, Korea strengthened the standards and legal frameworks of the economy to global levels. In addition, after the crisis the Korean economy almost completely opened to the world. These results imply that the government's ability to intervene in the economy will greatly diminish. 36 As such, the economy will follow global standards. In addition to this change in the domestic economic environment, we should also pay attention to the rapidly changing world economic environment. During the last 50 years, the world economy has been globalizing (economically integrating) because of increasing inter-dependence between countries, a process made possible by breakthroughs in transport and communication technology and the liberalization of trade and capital. What will be the effects of rapid globalization on the economic environment? First, globalization implies the expansion of economic activity across politically defined national and regional boundaries through the increased movement of goods, services, factors of production and economic agents via trade and investment. Preferential and discriminatory policies will become increasingly ineffective under an economic environment that is moving towards globalization. As a result, government-led economic development strategies and policy instruments will also become ineffective. It is easy to see how direct regulations to promote or protect targeted industries would eventually constitute obstacles to further economic development. Generally speaking, globalization will ensure that economic policy-making and implementation will proceed according to the principle of non-discrimination and market mechanisms. Second, in the process of globalization, knowledge, information, and technology will be the most important forces behind economic development. A few industries in the traditional sense do not constitute a sufficient basis for economic growth. Technology and industries are intermeshed with each other and no technology is industry specific. In the 21st century, networking, systemization, and intellectualization of economic activity will be a fact, and the cycle of technological innovation will be shorter. These changes will greatly affect production systems and market structures.

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Third, rapid globalization implies the advent of an age of uncertainty. Successful economic strategies in industrial societies are not necessarily applicable to the new society of globalization and information. Additionally, rapidly increasing integration and a shorter technological innovation cycle would make the search for an appropriate industrial structure for this new society somewhat fruitless. 5.2. New Industrial Policies

5.2.1. Philosophical Background It has been generally accepted that the critical factor behind Asia's (including Korea) rapid growth was 'Asian Values'. But at the onset of the crisis in 1997, these same 'Asian Values' were blamed for causing the crisis. Asian Values are understood as based on Confucianism. Confucianism stresses the fulfillment of human morality through learning and training. It emphasizes that elite groups, who are supposed to have moral superiority, should lead the morally lacking general public using principles and rules that they have chosen themselves. Adherents to Asian Values insist that the government and the elite group of officials should manage the economy. Some political leaders in East Asian countries have supported the maintenance of Asian Values. Their argument is that the government and its officials have been capable of generating rapid economic growth and therefore future prosperity should depend on the government. However, it seems as if political leaders make reference to Confucian Asian Values mainly to justify their almost authoritarian political systems. 37 Moreover, 'Asian values', as used by political leaders and scholars, are taken mostly from Confucianism and therefore can mislead people into thinking that it is the only value system in Asia. In traditional Asian philosophy, there exists another school of thought, Taoism, which has been widely ignored in the process of industrialization. Taoism is skeptical about confining people within specific moral values and an artificial order. It emphasizes the spontaneity and the accommodation to being natural. The central theme of Taoism is "being natural without coercion." Give up the desire to be sage and throw awayintellectuality,then the payoffsto the people will be much larger. Give up the desire to master perfect virtue and throw away the arrogance to be just, then the welfareof the people will be greatly enhanced. Give up the desire to be ingeniousand throw away cleverness,then there will be nothing to steal...38 In applying Confucianism and Taoism to the economic context, Confucianism will emphasize government-led economic management while Taoism tends to stress the importance of natural and spontaneous market order.

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Government-led economic m a n a g e m e n t based on Confucian Asian Values may have contributed to the growth of East Asian economies. However, emphasis on the leading role of the government and its officials resulted, in general, in more regulations and restrictions on economic activity than in Western countries. In addition, emphasis on the elite group as a leading social force resulted in non-transparent governance relying on government arbitrary and discretionary decisions rather than the rule of law. Due to the complexity and diversity of the real world economy, governments will come across great difficulties in playing the role of an omnipotent and objective economic system manager. To cope with the changing economic environment, it will be wiser to follow the spontaneous market order and principles of competition rather than artificially managing the economy. In the widely open world economy ruled according to global standards, a new paradigm of economic management should be presented. The economy is a system in which diverse agents interact with each other. It rises above artificial manipulation. The government, recognizing the complexity and diversity of the economy, should adapt to its nature. The economy is not a system that can operate by control. It is a system in which continual search and evolution take place. The one who tries to possess the world in a forced way will lose it. The world is a mysterious thing that cannot be controlled in an artificial way. The one acting contrary to being natural will fail and the one trying to hold with force will lose.. 39 Taoism in economic sense is similar to neoliberalism. Hayek, the leader of the Austrian School and neoliberalism, stresses the spontaneous market order and competition as a discovery process rather than government intervention in resource allocation. Governments should nurture the economy by providing proper surroundings for market mechanisms to operate. We are only beginning to understand on how subtle a communicationsystem the function of an advanced industrial society is based - a communicationsystem which we call the market and which tums out to be a more efficient mechanism for digesting dispersed information than any that man has deliberately designed. If man is not to do more harm than good in his efforts to improve the social order, he will have to learn that in this, as in all other fields where essential complexityof an organizes kind prevails, he cannot acquire the full knowledge which would make mastery of the events possible. He will therefore have to use what knowledgehe can achieve, not to shape the results as the craftsman shape his handiwork, but rather to cultivate a growth by providing the appropriate environment, in the manner in which the gardener does this for his plants.4o

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5.2.2. Direction of New Industrial Policies Due to the rapid pace of globalization and the adoption of global standards, governments' ability to effectively intervene in the economy is declining rapidly. What should be the direction of industrial policy in this environment? Before the crisis, a group of economists called 'revisionists' suggested that the implementation of an industrial policy similar to the ones adopted by successful East Asian economies such as Japan, Taiwan, and Korea would be a good strategy. The tendency was even more conspicuous when discussing the possible policy responses to the so-called 'unlimited competition' resulting from globalization. An increasingly common view seems to be that the government should help firms compete successfully in the international market and that it should intervene, to a large extent, in adjusting the industrial structure to the globalized competitive environment. This paper's implications are diametrically opposed to the revisionists' industrial policy proposal. Above all, globalization is basically a diversified and sometimes conflicting phenomenon that has different economic implications depending on the context. 41Therefore, it is especially difficult for a government to design a particular industrial structure that is supposed to be optimal for its economy. In this sense, the economists' search for an alternative industrial organization will not yield any definitive, single structure of industrial organization. For example, the Fordist mass production system was thought of as the optimal production system in the early 20th century. However, changes in the market environment, such as demand diversification and technological flexibility supported by microelectronics, called for a more flexible production system. As a result, from the late 1970s the German and Japanese lean-andflexible production systems (Just-in-Time system of Toyota Motors is a typical example) emerged and seemed to have surpassed the Fordist mass production system. But in the late 1980s and 1990s, the German and Japanese systems were in turn being challenged by new American systems such as the selfmanaged team or self-directed work team systems. Therefore, instead of adopting an active interventionist industrial policy that requires a tremendous volume of information and is not guaranteed to produce the correct solutions, an effective response to globalization may be to let the market order prevail in discovering an optimal business and industrial structure. 42This entails allowing the private sector maximum freedom to make structural adjustments in response to the globalization of market competition. The role of the government should be confined to preserving the spontaneity and endogeneity of the market order and to cultivating a better economic environment for its

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smooth operation. The government should determine exogenous variables for the market order while the determination of endogenous variables should be left to market competition.

NOTES 1. Shirazi (1999). 2. Kim (1999). 3. Kim (1999). 4. ESCAP (1998). 5. For example, Thai exports contain on average 60% imported components and raw materials. 6. The survey was conducted in Indonesia, Korea, Malaysia, the Philippines and Thailand between late 1998 and early 1999. The sample includes 816 individual firms from Indonesia, 857 from Korea, 814 from Malaysia, 564 from the Philippines and 659 from Thailand. The industries covered are food, textiles and garments, electronics and electrical machinery, chemicals, and auto-parts. The survey results were presented in 'the Asian Corporate Recovery Conference' organized by the World Bank between March 31-April 2, 1999. 7. For example, Krueger (1985), Balassa (1987). 8. For example, Wade (1990), Amsden (1989). 9. "Under such disequilibriating conditions, the state's role in late industrialization is to mediate market forces. The state in late industrialization stages has intervened to address the needs of both savers and investors, and of both exporters and importers, by creating multiple prices. Some interest rates are higher than others. Importers and exporters face different prices for foreign currency. Insofar as the state in late industrialization stages has intervened to establish multiple prices in the same market, the state cannot be said to have gotten relative prices 'right', as dictated by supply and demand. In fact, the state in late industrialization stages has set relative prices deliberately 'wrong' in order to create profitable investment opportunities" Amsden (1989), pp. 13-14. 10. "Whatever the relationship between inflation and investment in theory, in practice inflation did accompany Korea's push into heavy industry under govemment leadership in the late 1970s... The pursuit of fast growth was not restrained in the interest of price stability" Amsden (1989), p l00. 11. World Bank (1993). 12. Vanberg (1991). 13. Baghwatti (1999), Balassa (1991), World Bank (1993). 14. For details of export credit schemes, see World Bank (1993). 15. World Bank (1993). 16. World Bank (1993). 17. Of the 230 aircraft that IPTN has manufactured since its creation, about 90% have been sold domestically (World Bank (1993)). 18. World Bank (1993). 19. Rasiah (1998), Vajragupta & Vichyanond (1998), Sachs (1997). 20. For details of financial and capital liberalization in East Asian Countries, see Choi (1998).

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21. World Bank (1993). 22. Five-Year Economic Development Plans were implemented every five years starting in 1961 during the 1960s and 1970s. However, from the 1980s on, the plans have merely been a broad profile of government economic objectives. 23. The main reason for this policy appears to be security concerns raised by the reduction of US troops stationed in Korea. The Korean government felt the need to build up certain industries for national defense (Yoo, 1989). 24. One more reason was that the heavy and chemical industries required a large production scale and therefore large amounts of money, giving a relative advantage to the big enterprises that had financial and managerial experience and ability. 25. In the same year, heavy and chemical output accounted for 42% of the nation's total exports. 26. Lee (1988), Lee (1998b), Yoo (1991). 27. Lee (1998b), Moon (1991). 28. Lee (1994), Lee (1998b). 29. Hwang (1999). 30. Jwa &Yi (1999). 31. Some economists, however, point out that debt has simply been transformed into bonds and that although formal debts have decreased, the actual amount of money owed has not decreased and may in fact have increased. Along this line, it is also criticized that the achievement of 200% debt/equity ratio is simply nothing more than a kind of an accounting gimmick. 32. In the turmoil of corporate restructuring, the Daewoo group, which was the 4th largest chaebol in Korea, has collapsed in 1999 and has entered the Workout program. 33. There were three automobile manufacturing companies in Korea, Hyundai Motor Company, Daewoo Motor and Kia Mortors. The production capacity of the first two companies was more than two million cars in 1997. 34. There are various political behind-the-scene stories and rumors regarding this event. For example, Pusan, where SMC's manufacturing unit is located, is the then President's hometown. It is said that the President decided to allow SMC's entry into the automobile industry to boost the economy of his hometown. Since those stories cannot be corroborated, it is impossible to know whether they are tree. 35. The reason for SMC's participation in the big deal remains unclear. Since the government has strongly pushed the big deals, it probably intervened in the determination of SMC's exit from the automobile industry. 36. Some worry about the increase in the government's share of the economy after restructuring. As a result, it is in an even better position to intervene in the economy. For example, in Korea, the government's share of total stock has increased from 7.4% in 1996 to 17.3% in 1998. Since it injected public money into most private banks to recapitalize them, its actual share will be higher than 17.3%. Thus, the government now carries more weight in the private sector than before. However, it can be expected that with liberalization and globalization, the economy will leave increasingly little room for government intervention. 37. Lim (1999) discussed about the Asian Values debate in a more philosophical context. His main point is that: (i) Confucianism is not inherently conducive to economic development, and actually contains many elements that are hostile to capitalism; and (ii) Asia's crisis has more to do with the economic logic of Asia's development than defective elements in the Asian Value system.

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38. Lao-Tsze, Scriptures on Morality. 39. Lao-Tsze, Scriptures on Morality. 40. Hayek (1989), p7, 41. Oman (1993) identifies the globalization phenomenon as not only a market extension but also a mixture of market deregulation, the spread of new information technologies, the intermeshing of financial markets and the innovation of industrial and production systems. 42. Jwa (1997) presents theoretical and empirical analysis about spontaneous evolutions of industrial organizations. It shows that, due to globalization and the progress of information technology, industrial policies based on Hayekian competition should be accepted whatsoever.

REFERENCES Amsden, A. (1989). Asia's Next Giant. Oxford University Press. Balassa, B. (1987). The importance of Trade for developing Countries. Banca Nazionale del Lavoro Quarterly Review, 163,437-469. Bhagwati, J. (1999). From Miracle to Debacle: The Asian Economic Crisis in Perspective, presented in 32th International General Meeting: the Challenges of the Next Century for the Pacific Basin, Pacific Basin Economic Council. Camdessus, M. (1999). Governments and Economic Development in a Globalized World, presented in 32th International General Meeting: the Challenges of the Next Century for the Pacific Basin, Pacific Basin Economic Council. Cho, Y., & Rhee, C. (1999). Macroeconomic Views of the East Asian Crisis: A Comparison, presented in Conference on Asian Corporate Recovery: Corporate Governance & Government Policy. Chang, E. (1998). The World ofTaoism. Dong Nam Poong (in Korean). Choi, D. (1998). Causes and Development of East Asian Crisis. KERI (in Korean). Drucker, P. (1999). Management challenges for the 21st Century. Harperbusiness. ESCAP (1999). The East Asian Crisis: Implications for Sustainable Industrial and Technological Development in the Asia Pacific Region. Hallward-Driemeier, M., & Dwor-Frecaut, D. (1999). Asian Corporate Recovery: A Firm Level Analysis, presented in Seminar on Asia Financial Crisis: Evaluation and Problems. Hayek, E (1989). The Pretence of Knowledge. American Economic Review, 79(6), 3-7. Hwang, I. (1999). The Ownership and Control of Chaebols, in Direction for Corporate Governance Structure of Korea Toward 21st Century (in Korean). Hwang, I. (1998). Understanding Economic Concentration, in Open Economy and Economic Concentration, Korea Economic Research Institute (in Korean). Hong, S. (1998). Structural Changes in Nominal and Real Protection Rates: 1975-1995. Korea Development Institute. IMF (1999). Indonesia: Statistical Appendix, IMF Staff Country Report No. 99/39. Jwa, S. (1999a). An Evolutionary Theory of Chaebol. Beebong Publishing Co., Korea (in Korean). Jwa, S. (1999b). Command Eocnommy? Not Any More. Nanam Publishing Co. (in Korean). Jwa, S. (1997). Globalization and Industrial Organization: Implications for Structural Adjustment Policies, Regionalism vs. Multilateral Trade Arrangement, NBER-East Asia Seminar on Economics, Vol. 6.

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Jwa, S. & C. Huh (1998). Korea's 1997 Currency Crisis: Causes and Implications. Korea Journal, 38(2). Jwa, S. & Yi (1999). Korean Financial Crisis: Evaluations and Lessons, presented in Australia and Korea into the New Millenium: Political, Economic and Business Relations organized by Australian Center for Korean Studies, Griffith University. Krueger, A. O. (1985). In: Corbo et. al. (Eds), The Experience and Lessons of Asia's Super Exporters. KERI (1995). Business Groups in Korea. Korea Economic Research Institute (in Korean). KERI (1998). Policies for Corporate Restructuring: Review and Problems, Policy Report 98-433, Korea Economic Research Institute. KIET (1997). Regional Information: Southeast Asia. Real Economy, 114, Korea Institute for Industrial Economics and Trade (in Korean). Kim, W. (1999). Financial and Corporate Restructuring in Southeast Asia Countries, World Economy, Korea, Korea Institute for International Economic Policy (in Korean). Kwack, T. (1984). Industrial Restructuring Experience Policies in the 1970s, presented in Workshop: Industrial Restructuring Experience and Policies in the Asian NICs, East-West Center, Honolulu. Lao-Tsze. Scriptures on Morality. Lee, B. (1998a). Debt Guarantee of Business Groups, in Open Economy and Economic Concentration, Korea Economic Research Institute (in Korean). Lee, B. (1998b). Factors of Korean Economic Growth and Roles of Industrial Policies, Korea Economic Research Institute (in Korean). Lee, J. (1999). Corporate Restructuring in Korea: Experience and Lessons, presented in a Policy Workshop organized by Korea Money and Finance Association. Lee, K. (1994). Policy Loans: Effects and Problems. Korea Institute of Public Finance (in Korean). Lee, S. (1988). Government-led Industrial Organization Policies: Accomplishment and Problems, Federation of Korean Industries (in Korean). Lee, Y. (1999). Implications of the Financial Crisis on Industrial Development in Korea, K1ET Occasional Paper 031, Korea Institute for Industrial Economics and Trade. Lim, P. (1999). The Asian Values Debate Revisited: Positive and Normative Dimensions, mimeo. Moon, H., Cho, B., Hwang, H., & Kim, H. (1990). Measurement of Total Factor Productivity: 27 Industries in Manufacturing. Korea Productivity Center. Oman, C. (1993). Globalization and Regionalism: the ChaUenge for Developing Countries, OECD Development Center. Rasiah, R. (1998). Busting the Bubble: Causes and Consequences of the Southeast Asian Financial Crisis, European Institute for Asian Studies Briefing Paper, No. 98/01. Sachs, I. (1997). The Wrong Medicine for Asia, mimeo. Shirazi, J. (1999). The East Asian Financial Sector Restructuring: Progress and Issues, presented in Conference on Asian Corporate Recovery: Corporate Governance & Government Policy. Sohn, C., Yang, J., & Yim, H. (1998). Korea's Trade and Industrial Pollicies: 1948-1998, KIEP Working Paper 98~)5, Korea Institute for International Economic Policy. Vajragupta, Y., & Vichyanond, P. (1998). Thailand's Financial Evolution and the 1997 Crisis, Thailand Development Research Institute Foundation. Vanberg, V. (1991). Spontaneous Market Order and Social Rules: A Critical Examination of E A. Hayek's Theory of Cultural Evolution. In: J. Cunningham Wood & R. N. Wool (Eds),

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Friedrich A. Hayek: A critical Assessments (pp. 177-201) (Vol. IV). Routledge: London and New York. Wade, R. (1990). Governing the Market: Economic Theory and the Role of Government in East Asian Industrialization. Princeton University Press. Waiquamdee, A. Krairiksh, S. & Phongsanarakul, W. (1999). Corportaes' Views of the Constraints to Recovery, presented in Conference on Asian Corporate Recovery: Corporate Governance & Government Policy. World Bank (1993). The East Asian Miracle, A World Bank Policy Research Report. Yoo, I. (1999). The Role of Korean Government in Crisis, presented in Conference on Economic Crisis and the Role of Government, Korea Public Finance Association. Yoo, J. (1991). Effects of Heavy and Chemical Industrialization Policy in 1970's on Capital Efficiency and Export competitiveness. Research on Korea Development, 13(1), Korea Development Institute. Yoo, J. (1989). The Government in Korean Economic Growth, KDI Working Paper No. 8904, Korea Development Institute.

FINANCIAL CRISIS AND PERSPECTIVES ON KOREAN ECONOMIC DEVELOPMENT Young Back Choi 1. INTRODUCTION On November 21, 1997, South Korea's Finance Minister announced that the government was officially seeking an IMF rescue package. This was a desperate move to prevent a complete collapse of the economy from a rapid depreciation of currency and credit crunch. During the subsequent period of uncertainty - protracted negotiations between Korea and IMF, negative reactions to the terms of the IMF rescue package, and the threat of impending banking insolvency, etc. - the situation became much worse. The currency continued to depreciate rapidly, accompanied by a severe credit crunch and mounting bankruptcies before it became stabilized from April 1998. ~ The crisis came as a complete surprise to many. Until the last moment, Korean government officials insisted that everything was under control and denied the possibility of the Southeast Asian financial crisis spreading to Korea. Moreover, in August, the Korean government had committed $0.5 billion to the IMF rescue plan for Thailand, and actually paid in $0.2 billion in November, only 10 days before Korean government requested an IMF rescue of its own! 2 Until the last moment, Korean firms were also busy expanding both domestically and internationally through debt financing and Korean consumers were busy enjoying imported goods and foreign travels.

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Caught off-guard were not only Koreans. Foreigners had also regarded the situation in Korea as good, or fundamentally sound. In 1996 the World Bank issued a book on the 'Asian Miracle', in which Korea was used as an exemplary case. As late as June 1997, the World Economic Forum rated Korea the 5th best place in the world to invest. 3 Before the crisis foreign lenders eagerly lent to Korean banks at favorable interest rates. For example, before the bankruptcy of Hanbo Group in March 1997, the terms of borrowing were most favorable, at LIBOR + 0.08%. 4 After the crisis in November, the rates demanded jumped to LIBOR + 5%, with government guarantees. In retrospect, there were signs of looming trouble. The earlier crises in Thailand, Indonesia and Malaysia, where Koreans had invested much and whose products were increasingly competing against Korean products, should have been taken much more seriously. A series of massive corporate failures that threatened the solvency of many banks - e.g. the Hanbo Steel in January and the Kia Group in October, among others - should have been seen as dangerous developments. The downgrading of Korea's credit rating to a junk bond grade in September 1997 should have been taken as an expression of serious doubts about the state of the Korean economy in the international capital market. Indeed, within Korea itself warnings had been issued about this dangerous development. For example, in March 1997 a report warned of an impending currency crisis. 5 Another report in March described a serious deterioration of economic conditions in Korea. 6 In July yet another report described the Korean economy in a 'banking crisis'.7 However, most people in and out of Korea, including the ones who clearly perceived the worsening conditions, did not interpret the situation as grave as it actually turned out to be. 8 The aim of this chapter is to present a perspective on Korean economic development in light of the November 1997 financial crisis. Obviously, many of the erstwhile popular views on Korean economic development, e.g. 'Asia's Next Giant', etc., have become less convincing. The recent experience calls for a reevaluation of the Korean economic development experience. To that end, I examine prevailing perspectives on the Korean economy. For example, some argue that the crisis was an aberration due to contagion or speculative attacks, or that the crisis could have been avoided if Korea liberalized her financial market more cautiously with proper regulatory mechanisms in place. Implicit in these arguments is the view that the economy is basically sound. Others argue that the economy is so ridden with corruption that the crisis could not have been avoided. The presumption here is that the Korean economy is fundamentally unsound. Clearly, how one responds to a situation depends on

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how one understands the situation. Then, I will try to present a perspective on Korean economic development that is more defensible in light of experience. The outline of the chapter is: (1) to evaluate various views on the cause of the crisis, (2) to advance reckless expansionism as the fundamental cause of the crisis, and (3) to present a perspective on the Korean economic development experience in light of the thesis presented. The chapter ends with an overall assessment and some thoughts on what needs to be done.

2. PREVAILING VIEWS There are five prevailing views (which are not necessarily mutually exclusive) about the causes of the financial crisis with some relevance to a perspective of economic development - speculative attack, contagion, premature liberalization, policy mistakes, and corruption. I will try to evaluate them briefly with the aim of identifying the fundamental causes of the crisis. (1) Speculative Attack Some have argued that the financial crisis was a result of spreading speculative attacks on currencies, starting from Southeast Asian Countries in early 1997. This view implies that the Korean economy was basically sound 9 and perhaps a set of proper policies to monitor and regulate capital flows could have prevented the crisis. 1° Attributing the currency crisis in Korea in November 1997 to speculative attack, however, is not quite correct for the following reasons: (1) For a speculative attack to occur (international) speculators must have been able to short the Won on a big scale. But the Korean government had regulations preventing foreign entities from borrowing the Won.11 Therefore, a speculative attack on the Won by international speculators could not have been possible. (2) The disintermediation by foreign lenders is sufficient to explain the currency crisis leading to subsequent liquidity crisis, etc. As the foreign lenders became concerned about Korean borrowers' ability to repay, they refused to make any new loans, including roll-overs. Given that Koreans had a very large external debt, standing at $153 billion at the end of 1997, (of which $82 billion was short-term debts due within a year), ~z it is easy to see how foreign disintermediation can drastically increase the demand for dollars sufficient to cause a currency crisis. Consider the following: Since March 1997, soon after the bankruptcy of the Hanbo group in January, there were no new medium- to long-term loans. ~3 Moreover, since the announcement of the insolvency of the Kia Motor Co. in

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August 1997, even short-term loans dried up completely. Assuming that the average duration of the long-term loans was three years and that all the loans were evenly spread out and interest payments are duly made, Koreans had to repay foreign loans at the rate of roughly $11.6 billion dollars a month from September) 4 The attempt on the part of the Bank of Korea to prevent massive bank failures by providing emergency loans, to the tune of W 32 trillion, 15 enables the Korean banks to sustain the demand for dollars. Official reserves stood at $22.3 billion at the end of October 1997, but were reduced, in vain attempts to defend the Won, to $7.3 in a m o n t h . 16 There was not much the Korean government could do to contain the radical depreciation of its currency. Therefore, it would be incorrect to identify currency speculation as the cause of the Korean financial crisis. Rather the cause should be found in the underlying economic conditions, including unprofitable investments. (2)

Contagion

Alternately, one may still maintain that it is the spread of panic among foreign lenders and investors that brought about the crisis to an otherwise sound economy, an economy that would have been viable without the panic attack. As evidence, proponents of this view might point to the indicators of sound fundamentals - e.g. high savings, high level of human capital, high level of investment, balanced government budgets, etc. The Panic may have been caused by a belated realization, triggered by a series of large bankruptcies in Thailand and then in Korea, that borrowers in Korea may not be in as good a financial shape as previously believed. Or it may have been due to a belated realization - after seeing the ineptitude of the Korean government in handling corporate failures - that the loans to Koreans were no longer safe, contrary to the lenders' prior beliefs. Or it may be even that the disintermediation by troubled Japanese banks spooked other lenders as well, precipitating a stampede) 7 There is no way to establish precisely the timing and the way in which the lenders revised their expectations. What is important to notice, however, is that the panic seemed to have been rather selective in doing most damage to the countries with large debts - e.g. Korea, Indonesia, Thailand, etc. - exempting those countries without large debts - e.g. Taiwan and Singapore. The debt-equity ratio of 3:1 is common in Korea. Large conglomerates, jaebol, have much higher debt-equity ratios (the thirty largest jaebol have the average debt-equity ratio of more than 3.8:1.) 18 Some have higher ratios, as in the case of Daewoo with 5:1. For Hanbo Steel Co., which became insolvent in January 1997, the ratio was close to 6:1. The

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comparable figure for Japan is 2.1:1, which is regarded as high by Western standards. The comparable figure for the U.S. is 1.7:1. Interestingly enough, the ratio is 0.87:1 for Taiwan which has been largely exempt from the financial crises embroiling many Asian countries. The vastly different states in which Korea and Taiwan find themselves, I believe, stem from the differences in the degree of leverage. ~9An economy so precariously exposed to the swings of the international lenders' mood cannot be called sound. The indicators of sound fundamentals - viz., high savings, high investments and high level of human capital, etc. - were misleading. As for the high savings, savings are apparently not high enough in Korea, thanks to unrestrained expansionism and the attendant insatiable demand for capital. As for the high investment, excessive investments have led to extremely low rates of return, i.e. a waste of capital. And as for the high level of human capital, it may have been extremely high for a country with a per capita GNP of, say, $500, but not for a country with a per capita GNP of, say, $10,000, as evidenced by the constant complaints about the lack of skilled manpower. (3) Premature Liberalization Some argue that premature liberalization of financial markets in Korea contributed to the crisis. That is, if liberalization had been more cautious, implementing proper mechanisms for supervision and regulations - preventing Korean entities from borrowing too much from overseas and therefore immunizing the Korean economy from the swinging mood of international lenders - the crisis could have been avoided. This argument, however, is not entirely persuasive. In the first place, before the recent liberalization of financial markets, and under regimes of the strictest control of the flow of international capital, the Korean economy faced severe financial crises twice - in the early 1970s and the early 1980s - in both cases, from unprofitable investments on a massive scale. Therefore, one must conclude that a financial crisis is possible with or without financial market liberalization. One may still argue that the liberalization led not only to a larger amount of external loans, but also to a higher proportion of short-term loans. This change in the composition of loans caused the effects of disintermediation by foreign lenders to be much more drastic than if the composition of loans had a higher proportion of long-term loans, or if a higher proportion of capital took the form of foreign direct investment (FDI). Therefore, one may argue that if there were regulations discouraging short-term borrowing from overseas, the Korean

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economy would have been able to soften the blow of foreign disindermediation. But an alternative interpretation of the event is possible by inquiring about the causes of the change in the debt composition in the first place. Both the higher debts and the higher proportion of short-term debts have to do with the eagerness of Koreans firms to expand regardless of profit prospects, often in the face of mounting losses. Only by borrowing from overseas on an ever-greater scale could Korean firms have postponed the day of reckoning, even creating an impression of a boom This is contrary to the common view that the Korean economy was making fine progress toward industrialization. For example, in 1993 Korean semiconductor producers benefited much from the increase in the demand for DRAM chips and recorded profits of billions of dollars. Korea, which was already the second largest shipbuilding nation in the world, (closely behind Japan), and becoming a more important exporter of automobiles, therefore, seemed to have graduated from the status of a LDC. Industrialized nations recognized Korea's growing stature in the international community by admitting it to the OECD. The so-called 'semi-conductor boom', which has often been interpreted as a sign of the successful transformation of Korean economy from labor-intensive industries to high-technology industries, however, was short-lived. Korean economic conditions had already begun growing worse since 1990. This was a reflection of Korean firms becoming increasingly less competitive due to inefficiencies caused by over-investment and concessions made to militant unions and by increasing foreign competition. 2° Between 1995 and 1996, Korean terms of trade deteriorated by about 25%. 21 The result can be seen in the worsening current account in Table 1. A recent study shows that Korean firms as a whole have had a negative cash flow every year since 1991. Even through the so-called semi-conductor boom, the cumulative negative cash flow was estimated at W144 trillion. 22 Therefore, one may plausibly argue that, if not for the chance of rolling-over debts and postponing the day of reckoning, made possible by the financial liberalization, the Korean economy would have faced an earlier crisis. The crisis was a manifestation of the weakness of the Korean economy generated by the drive to invest even in the face of falling profit, or even losses. (4) Policy Mistakes Some have argued that a set of prudent policies might have enabled the Korean economy to avoid the crisis. For example, despite increasing competition from

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China and the South East Asian countries and the relative devaluation of Japanese and Chinese currencies, the Korean government did not undertake measures to improve the competitiveness of its industries, e.g. competitive d e v a l u a t i o n . 23

Some have blamed the obsession to become a member of the OECD and an unreasonably euphoric expectation about its beneficial consequences. 24 One of the chief benefits of joining the OECD was understood to be easier access to international capital. Given that interest rates in Korea were much higher than in overseas markets, Korean policy makers expected a flood of capital inflow after the liberalization of Korean financial markets as a precondition for joining the OECD in 1996. Indeed, foreign capital did flow in on a massive scale. A consequence is that the Korean currency appreciated and Korean products became priced out of the market. To most, including businessmen and government officials, however, the sudden availability of cheap money was a sign of good times. Many Koreans Table 1. 1990 1991 1992 1993 1 9 9 4 GNP (billions of dollars) Current account (billions of dollars) External debt (Long term) External debt (Short term) Total Non-performing Loan rate 5

1995

1996

197

1998

5,883 6,757 6,988 7,484 8,467 10,037 10,543 9,511 6,4621 -2.2

7.5

-8.7

6.6

~J~.5

0.4

-4.5

-8.9

-23.7

-8.6

31.92

26.4 33.9 60.3 5.6

33.1 45 78.1 5.2

43 69 1123 3.9

71 82 153 6.0

112.8 37.9 150.74

6.7

24.7 19.1 43.8 7.0

t. Estimated 2. The figure is through October 1998. The government estimate through the end of the year is $40 billion. 3. When borrowings of overseas branches and subsidiaries of Korean banks and borrowings of domestic banks are included, as agreed between the IMF and the Korean government in December 1997, the figure increases by $41 billion to the total of $157 billion. 4. Preliminary estimates of the Ministry of Finance and Economics at the end of August 1998. Chosun Ilbo, Oct 1, 1998. $40 billion (= $31 billion principal + $9 billion interest) comes due in 1999 according to the Bank of Korea, including $9.5 billion (to IMF), $0.5 billion (from governmental agencies), $17 billion (from financial institutions), and $4 billion (from corporations.) 5. News Brief: Problem Credits of Korean Commercial Banks. Feb. 26, 1998, Bank of Korea. The Korean definition of non-performing loan is much more relaxed compared to the Japanese standard, which in turn is much more relaxed than that of the U.S.

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took advantage of the situation by increasing both investment and consumption, financed by borrowing from overseas. Debts grew bigger and bigger as Korean firms found it easier to borrow more to pay even interest on existing loans. The populist Korean government encouraged imports, foreign travel, and overseas investments, in the face of chronic current account deficit and deteriorating terms of tradeY As the financial markets began to deteriorate rapidly in mid-1997, the Bank of Korea pursued two contradictory goals - to keep the interest rates low so as not to burden the debt-ridden Korean firms, and to keep the exchange rate stable so as not to expose them to foreign exchange risk. Once the foreign exchange reserve was depleted, of course, the Bank of Korea had to abandon the conflicting policies, with a result of high interest rates (to more than 30% from about 10% a year earlier), and drastic devaluation of the Won. One can go on and on. Of course, there have been some obvious mistakes and others not so obvious. With the help of hindsight, we can find many mistakes in the past. 26 But, as we saw above, the crisis came as a complete surprise to many, including international lenders and speculators. It is unreasonable to expect policy makers and bureaucrats to command information and prudence superior to those of the most seasoned investors. If the health of an economy depends on wise policy makers who make no mistakes, few economies would be safe. (5)

Corruption~MoralHazard~Crony Capitalism

Many have identified corruption as the root cause of the current economic difficulties in Korea. 27 The charges of corruption ring true like nothing else and hit a sympathetic chord among Koreans. But as a perspective on Korean economic development it is deficient. For the prevalence of bribery and graft in Korea is nothing unusual; it is so in any country with absolute concentration of political power. 28 Moreover, it is a time-honored tradition in Korea to blame corruption whenever there is a crisis, to have a f e w showy trials of political enemies or scapegoats, but then in good time to resume the old ways. In June 1996, James Buchanan traveled to Korea and gave talks on the topic of rentseeking. I am told that the general reaction of Koreans was: "What's new? With all the rent-seeking, we Koreans have not done badly over the years!" Indeed, the Korean economy, despite the widespread corruption, had managed to grow respectively since the early 1960s. Therefore, pointing out corruption as the cause of the current crisis is insufficient. Rather, corruption is largely a manifestation of the depth of government involvement in regulating the economy.

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In this section, I briefly reviewed various explanations of the current crisis currency speculation, contagion, premature liberalization, policy mistakes, and corruption. Each focuses on some contributing factors, or symptoms, but ignores the most important causes - misallocation of resources through reckless expansions. The massive disintermediation by foreign lenders, and the resulting currency crisis and liquidity crisis was, fundamentally, a reaction to the worsening economic conditions in Korea in the preceding years, made worse by the financial crises in Southeast Asia and the banking crisis in Japan. The worsening of Korean economic conditions, in turn, was caused by excessive and imprudent investments by Korean firms, within a set of institutions and incentives created by the intrusive government bent on attaining hasty economic development.

3. EXPANSIONISM The fundamental cause of the magnitude of the current financial crisis in Korea is the persistence of the business propensity for reckless expansion in a situation substantially altered by financial liberalization. Leveraging to the highest degree possible has been the way to do business in Korea for over three decades. That is how jaebol have come to dominate most industries - the ten largestjaebol producing around 27% of all manufacturing shipments in 1989. 29 The prevalence of high leveraging in part reflects the growth potential of the Korean economy and the entrepreneurial drive. But it is mainly a reflection of what may be called a system of 'privatized gain and socialized losses' that was put in place in the 1960s, under the system of preferential loans for industrial promotion. In this system those who borrow money to invest can keep the gain if the investment is successful, but are bailed out if the investment is a failure. Borrowing was the way to get rich. Under the system, successful rent seeking is one of the more important factors in entrepreneurial success. When Koreans kept following the path of getting rich through leveraged growth, even after the system had been substantially altered through a liberalization of the financial markets, a seed for a massive contraction had been sown. The economic logic of the expansionism is clear. In a system of privatized gain and socialized loss, borrowing is subsidized. Therefore, those who can would try to borrow as much as possible. The more you borrow, the larger the gain. Three decades of subsidized gambling has produced a propensity for reckless expansion among Korean businessmen, especially thejaebol. A typical jaebol has business involvement in several unrelated areas, e.g. insurance, brokerage, steel, newspaper, refrigerators, shoes, construction, department stores, shipbuilding, computers, and semi-conductor chip fabricating, etc. In

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each of the industries in which they are involved, Korean conglomerates have raced to expand their market shares, into industries they know next to nothing about, with little respect for profitability. Their attitude is often characterized as: 'damn the torpedoes!' The system of subsidized gambling in Korea was based on two components, viz., credit rationing by government and feeble corporate governance. (A) Credit rationing The banking sector in Korea has been heavily regulated. For over two decades since the early 1960s, Korean banks had been nationalized. During that period, even foreign loans had been channeled through government run banks. The government, intent on promoting economic development through export and the growth of certain strategic industries, used policy loans, i.e. subsidized loans to firms in the targeted industries. Not only were policy loans below the market interest rates, but they carried negative real interest rates during periods of high inflation. 3° Since policy loans were made without regard to profitability, (and banks merely rubber stamped the political decisions), when firms ran into difficulties, governmental bailout became a necessity - through debt cancellations, or additional subsidized loans, etc. Considering that the low rates charged for policy loans did not account for the risk involved in the proposed investments, the implied subsidies were substantial. The policy loans were give-aways. Who would not try to borrow under such a circumstance? A permanent shortage of credit was the result. Given the shortage, the chief means of competing for the subsidized loans was bribery to politicians and their advisors. A significant part of corruption in Korea has been aimed at influencing governmental loan decisions. In the process banks were forced to carry substantial bad loans on their books. Since the 1980s, Korean banks became denationalized and policy loans were somewhat de-emphasized. Even so, the Korean government has exercised much influence over banks through regulations and access to policy loans has remained an important source of funds for many Korean finns, as in the example of Hanbo Steel. 31 (B) Feeble corporate governance Korean businesses preferred debt financing over equity financing for investment given the existence of subsidized loans and preferential tax treatment of interests over dividends. The public also preferred to deposit their savings in the bank or lend in the 'curb money market' because of the paucity and unreliability of information about finns' operations. 32 Nevertheless, the stock market has grown in Korea over time through government encouragement. Beyond buying and selling stocks, however, "shareholders in Korea have had

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little ability to know, let alone to influence, how the firm in which they invested is run. Founders of firms, though they may be minority shareholders in some cases, have had complete reign on the operation of firms under their control and have used their influence to further their own interests at the expense of shareholders." They use funds from company A, for example, to further their interest in company B. Founders could structure the finance of the firms under their control to cash in on the upside gain, by forcing the firms to make an investment in a risky venture from which they, and not the shareholders, stood to gain the most. 33 Reckless Expansionism The system of subsidized gambling, therefore, has led to reckless expansionism. With subsidized loans and feeble corporate governance, entrepreneurs can create empires through relentless (and reckless) expansions and acquisitions. Even marginally profitable investments (that would not be undertaken if one had to pay fair market interest rates) would become profitable from the entrepreneur's point of view, given high leveraging and subsidized loans. No wonder that in Korea anyone who can have access to credit, (and people have gained the access through bribery), have tried to build a business empire by investing in anything and everything. There may be some economic rationale for the expansionism, i.e. diversification or the minimum efficient size. But when a real-estate developer expands into major steel production, or a confectioner, into construction and investment underwriting, more direct considerations have been to magnify the gains through leveraging, and to grow big enough so that government cannot but bail out when things go wrong. With such an attitude toward business, the urge to innovate and improve efficiency must be less keen. For what really decides the fate of one's venture is access to credit, which depends on political patronage, on the one hand, and the authoritarian domination in the firm, on the other hand. Despite their seemingly fantastic growths until recently, the reckless expansionism has led to the general inefficiency of Korean firms and a crippled banking sector, (that has been the handmaiden of the Korean government in supporting the system of subsidized gambling all these years.) Liberalization and the Persistence of Expansionism In the 1980s, the Korean economy began to liberalize gradually, leading to even some liberalization of financial markets in the 1990s. Liberalization became a viable alternative policy as a backlash against the failed attempts to promote heavy industries in the 1970s. That the U.S. government applied pressure on Korea to open its markets when Korea ran current account surpluses in the late

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1980s brought additional weight to the issue. Faced with increasing criticism against privileges granted to jaebol, and increasing difficulty of containing the militant labor under a more democratic regime, and sensing that to satisfy the growing thirst for credit - even to just stay afloat - they must have free access to the international capital markets, business interests argued strongly for financial liberalization. One reason business interests so eagerly supported Korea's membership in the OECD was that financial and other market liberalization was a precondition. Through the late 1980s and 1990s, tariffs were lowered across the board, and a fairly free access to foreign capital had been granted. However, certain markets such as the automobile, machines, and banking, which certain jaebol regard as crucial to their interests, have been protected through tariff and nontariff barriers and regulatory mazes. Rent-seeking bureaucrats were only too eager to create barriers, justifying their actions based on nationalistic sentiments. 34 A similar posture was assumed against foreign direct investment (FDI), despite the expressed interest in attracting FDI. The result was that most of the foreign capital flowed in as loans, and much of it in the form of shortterm capital, rather than FDI. This development seemed to serve jaebol interests well. Their important domestic markets were largely protected from foreign competition, and they had unlimited access to foreign capital, either directly or through Korean intermediaries, to satisfy their drive to expand. Timing seemed impeccable; as jaebol gained access to international capital, the U.S. and Japan kept interest rates low. Korean banks and non-bank financial institutions borrowed huge sums of short-term loans and lent to Korean firms to invest at higher interest rates. (This was still much lower than the rates available on traditional Korean bank loans.) With so much (of what they thought was) arbitrage profits, the sting of being out-competed in the market was much softened. Korean firms were less inclined to fight wage demands far in excess of productivity increases. Without much fight, they conceded to higher wages. Industrial peace and prosperity seemed to go together. At the same time, jaebol trotted the globe to acquire assets and businesses not only in Southeast Asia or Central Europe or former USSR, but also in Western Europe and North America. As a consequence, Korean FDI overseas far exceeded FDI in Korea by foreigners. It was a puzzling phenomenon. Korean FDI is seldom based on superior products, or managerial or marketing abilities, but is based on a lower cost of borrowing. But how is it possible? Koreans were not generating excess savings; on the contrary, throughout the 1990s Koreans ran current-account deficits which were financed by borrowing. How can Koreans have an advantage in

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Table 2.

Total inflow Inward FDI Outward FDI (in billions of US dollar)

1990

1991

1992

1993

1994

1995

1996

1997

2.9 0.8 1.0

6.7 1.4 1.1

6.9 0.9 1.2

3.1 1.0 1.3

10.6 1.3 2.3

17.2 1.9 3.0

24.0 3.2 6.2

6.9 5.6

financing investment over others when they themselves have to borrow from the money-center banks to which others have equal access? The secret is that Koreans tended to borrow short-term to invest long term on a great scale, a practice others would regard as too risky, both to the run on the bank (or rather to the disintermediation by foreign lenders) and foreign exchange fluctuations. Moreover, many became bolder and began to hatch schemes in which borrowing is pain-free by borrowing even more even to pay interest. This was the highest expression of reckless expansionism. The scruples that Koreans have been conditioned to ignore as 'unnecessary', however, have turned out to be not so unnecessary.

4. A PERSPECTIVE ON KOREAN ECONOMIC DEVELOPMENT An objection may be raised against the preceding argument: The system under criticism, nevertheless, has brought much improvement in the Korean standard of living in the past three decades and has produced some world-class Korean producers, e.g. memory chips, or LCD, etc. Indeed, the Korean economy has grown tremendously since the 1960s by any measure - per capita GNP, trade volume, number of automobiles or telephones per person, infant mortality, etc. But the temptation to self-congratulate, somewhat mollified since the crisis, must be further tempered by the following considerations: (l) What are the factors that made Korean economic development possible and are they still present? (2) Is Korean economic development special compared to others? (3) In what ways is the development of some heavy industries or high-tech industries uniquely beneficial? and (4) What have been the costs of Korean economic development methods?

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YOUNG BACK CHOI (1) Source of Economic Development

Students of Korean economic development almost unanimously credit President Park for starting the process of economic development in the early 1960s and making substantial progress for nearly two decades since. Indeed, anyone would marvel at the difference in economic performance before and since President Park. But what was the nature of his contribution? His main contribution, at least initially, was encouraging exports - most importantly by eliminating the thicket of regulatory red-tape and providing compensatory measures to counter disadvantages exporters suffered from tariffs and other cost raising factors. This measure had salutary effects in the then very favorable environment - low wages in Korea, open trade, and little competition. Given the dire economic conditions and correspondingly low wages in the early 1960s, many declining industries in more developed countries could become economically viable, or even profitable, when transplanted in Korea. Korean businessmen imported all necessary inputs for production - raw materials, machinery, and even foreign technicians and engineers to teach them how to produce, most of which were obtained on credit - hired local labor, and exported the finished products to the largely known markets in the West. Much of what Koreans did was arbitrage, pure and simple. The fact that many LCDs at the time were still enchanted by the socialist ideology and were, contrary to their rhetoric, hostile to development meant Korea could acquire technologies inexpensively, sell cheaply and still make profit. 35 Over time, however, the situation was altered substantially by rising wages within, and rising competition without. Other LDCs began to notice the benefits of export promotion. That over the years labor intensive industries in Korea have been increasingly out-competed by such late comers as China, Indonesia, Thailand, Malaysia, Bangladesh, Sri Lanka, and India is telling evidence that it took no genius to embark on industrialization in the manner of Korea in the 1960s. Increasing wages in Korea and increasing competition overseas led to declining profits from the late 1960s. 36 Instead of allowing unprofitable firms to fold and entrepreneurs to discover new profit opportunities, the Korean government used extreme measures to rescue firms from financial burdens 37 and soon began to promote heavy and chemical industries, by means of subsidized loans and protected markets. However, it turned out that promoting heavy industry was much more difficult than slapping together various inputs purchased in the open market to make light manufactured goods. For a state-sponsored expansionism fueled by subsidized loans is no substitute for the entrepreneurial drive to earn profit in the market. The result of industrial promotion was much waste. When many

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massive development projects were completed in the late 1970s, they remained idle for lack of demand. There followed high inflation, high unemployment, crushing burden of unserviceable debts, and nation-wide riots. It is ironic that the ambitious economic plans of President Park thoroughly undermined his own legitimacy, which he himself placed exclusively on economic success, and even claimed his life at the hand of his trusted Chief of the Korean Central Intelligence Agency (KCIA). In reaction to the excesses of industrial promotion in the preceding decade, liberalization and stabilization came to be valued in the early 1980s. Even so, most of jaebol that participated in the industrial promotion, in large part at government prodding, were bailed out in a restructuring orchestrated by government. The policy seemed to have worked. Beginning in late 1985 through 1989, Korean firms enjoyed an unprecedented boom, thanks to the socalled 'three-lows' - rapid appreciation of the Yen in the aftermath of the Plaza Accord in September 1985, low price of petroleum, and low interest rates. The boom brought unprecedented trade surpluses for four years, a rapid increase in asset prices, and even a revisionist view that the industrial policy of the 1970s was paying off after all. The 1988 Seoul Olympic Games provided a showcase for the new Korean prosperity. Flushed with success, jaebol went all out on expansion. The boom also brought an increasing American demand for open markets and increasing militancy of the labor demanding a greater share of prosperity. The combination of intensifying competition abroad, labor disputes and rising wages, and the race to expand on high leverage, however, soon led to a recession beginning 1990 which became worse as time passed. A recent study shows that Korean firms as a whole have had a negative cash flow every year since 1991, even through the so-called semi-conductor boom. The cumulative negative cash flow estimated at W144 trillion, (which translates into roughly $150 billion debt, using then prevailing exchange rates.) 38 For the cash flow of Korean firms in 1996 and 1997 was only 1.89 times the interest payment obligations, excluding principal that came due. In 1997, the cash flow was not enough to pay interest and principal that came due. If short-term debts are included, the cash flow in 1997 amounted to only 25% of what is needed to pay interests and principal that came due! During the period, incredibly, Korean firms went full speed ahead with their expansions, domestically and overseas, in automobiles, memory chips, steel, etc. - ignoring over-capacities and mounting losses. Perhaps, their custom of playing a subsidized gamble helped them to remember the successes, but discount failures. The liberalization of financial markets in Korea enabled jaebol to persist in their expansions. The jaebol expansionism, therefore, increasingly began to resemble a Ponzi

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scheme. One begins to wonder why the financial crisis did not come any sooner. (2)

Comparative Performance

While it is true that the Korean economy has grown very much by any measure, it is nothing special, even before the current crisis, if compared to other countries in the area, e.g. Taiwan, Hong Kong, and Singapore. 39 Until recently, these countries have done as well as Korea, even after accounting for the fact that they started their development processes earlier than Korea. Moreover, Koreans had achieved the results only by working longer hours than anyone else. Since the crisis, the Korean performance looks distinctly inferior to other 'Asian Dragons'. Moreover, the expansion driven and jaebol dominated development of the Korean economy has produced a number of factors that are less conducive to the long term development prospect. They include, briefly, greater volatility, less adaptability, and generally higher transaction costs. As jaebol dominated economy is characterized by a few large scale industries, it tends to be more prone to external shocks, good or bad, and fluctuates more than a more diversified economy with less government cultivated concentrations. By the same token, the Korean economy has become less adaptive to changing conditions. One cannot characterize this as a reflection of greater risk-taking by Koreans since jaebol risk-taking has been subsidized by policy loans and bailouts, etc. Finally, as an increasing proportion of economic agents, i.e. jaebol, labor, etc., has come to play brinkmanship - or the game of chicken - even in (what should be) mundane businesses, transaction costs in general have risen significantly to the detriment of future development. (3)

Significance of Heavy Industry and High-tech Industry

Koreans often boast this or that world class heavy industry or high tech industry. But what counts in business is profitability, not technical sophistication. Russians had truly marvelous technological feats in sending Sputnik to the orbit and operating a fleet of the largest nuclear submarines in the world, but they did little good for the Russians! Without resorting to the all-out promotion of heavy and chemical industries as in Korea, other Asian Dragons have achieved the standard of living that compares favorably to those of industrialized nations. Some may observe that there have nevertheless been some spectacular successes in steel, automobiles, and memory chips. Even if these have been as

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much success as people claim, it is like counting, as it were, the number of home runs without counting the number at-bats. While the system allowed the owners of jaebol to have disproportionately large number of at-bats and produced a few home runs, it has prevented many others from having a chance (perhaps to score more through an assortment of home runs and timely hits). Moreover, fancy factories that turn out some industrial products are worse than useless if they are not profitable, requiring massive subsidies, repeated bailouts, and protection. The system has to a large extent crowded out innovative entrepreneurs. (4) Costs of Industrial Promotion The apparent benefits of industrial policies must be judged against the harm they have caused. The industrial policies planted a cancer that is killing the social covenant. Too many sacrifices had been forced upon the ordinary citizens in the name of economic development while conferring disproportionate gains to the politically connected. For example, when inflation was high, government forced citizens to buy, in lieu of government stamps, long term government bonds that quickly became worthless, while giving favored businesses loans at negative real interest rates. When reckless expansion threatened to drive firms to insolvency in the early 1970s the government declared a moratorium on all private loans to corporations for three years, forcing citizens to give firms practically interest free loans. In addition, Koreans have been forced to pay exorbitant prices for shoddy products in the protected consumer markets dominated by government sanctioned oligopolies. At the same time, the ruling elite claimed a lion's share of the fruits of economic growth, while forcing the public to bear the costs of adjustments and their mistakes. Members of the ruling elite enriched themselves by taking bribes in awarding lucrative government contracts and doling out policy loans. They have also sold to themselves large tracts of land, for next to nothing, knowing full well that planned government projects would drive up the value of the properties. Over two decades of the shady side of industrial policy made many men and women, many of whom without visible means of earning a living, very wealthy. People are not stupid when it comes to the issue of someone getting rich at their expense. When people protested the unfairness of the way the economy was managed, they were often brutally suppressed on the charges of sedition and even treason. Even after the nominal democratization since 1988, political power has been the main source of wealth in Korea. Consequently, many people come to either deny any legitimacy to wealth, or have co-opted to

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exploit the system of patronage and rent-seeking to the fullest. 4° Neither contributes to a hospitable environment for the entrepreneur.

5. CONCLUDING REMARKS An economy driven by reckless expansion is precarious. It is viable only under the most favorable conditions. That is why in the past Korean government had to periodically bail out jaebol on a massive scale. When the Korean economy was relatively small, the government could bail out firms by forcing others to share the losses as in 1972. As the economy grew, governmental attempt to bail out over-leveraged firms in distress became much more difficult, as in the early 1980s, and had to involve foreign governments, viz. U.S. and Japan. That was when the size of the Korean economy was a fraction of what it is now and the majority of involved financial institutions were under tight government control. Today, the Korean economy is too large and complex for the government to attempt to manage, and many financial institutions involved are beyond the control of the Korean government, especially foreign lenders. That is why the Korean government resorted to seeking the IMF bailout in the unprecedented sum of $58.4 billion, pledging to carry out terms dictated by it. Not only is a Korean economy driven by reckless expansionism precarious, but it became inefficient and less innovative. In trying to address problems in business mainly from the perspective of acquiring 'cheap' financing - from government, shareholders, or foreigners - entrepreneurs and managers have become less inclined to solve them by addressing the issue of inefficiency or by innovation. Indeed, any casual observer from the U.S. may notice much wasteful practices in business, especially in management. What is to be done? Some wish the situation to return to the way it was, presumed sound, by regulating Korean access to international capital. That may increase the stability of the economy, but at the expense of perpetuating the system that encourages rent-seeking, not innovation. Restoration of the old Korean economic system is not desirable. Nor is it possible. For good or bad, the Korean government has agreed to carry out the reforms dictated by the IMF including drastic deregulation of financial markets, elimination of much rigidity in the labor market, and drastic reduction of trade-barriers. It is unfortunate that the reforms are forced upon Koreans, instead of being initiated by Koreans themselves. But there is no need to speculate about the motives behind the reforms dictated by the IMF. Whatever the motivates of IMF, most of the reforms forced upon Koreans are what Koreans themselves should have undertaken on their own for long-term prosperity. Koreans should take one step further and aim to level the playing field by eliminating all subsidies and

-

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privileges. When it is understood that there is no short-cut to business success (such as getting privilege through bribes or through brinkmanship), many Koreans will exercise their ingenuity to innovate. I believe that the potential, even in the short term, is great. It is because, paradoxically, there is so much inefficiency that can be easily corrected by just trying. The road to reform will not be easy or painless. It will involve much adjustment and redeployment of resources with all that entails - bankruptcies, layoffs, and change of ownership, even much foreign ownership. There will be much temptation to take a short cut. But Koreans must see through nationalistic rhetoric used by interest groups to secure privileges or retain ownership of assets, at public expense. The reckless expansionism in Korea must be exposed for what it is - a sham to get rich quick at others' expense. It will survive in a modified form unless all unprofitable firms are allowed to be liquidated, or reorganized, within a short period. Politically well connected jaebol interests are major hindrance to the road to change. The most important task for change is building a consensus: (1) to decentralize the political power, (2) to get rid of most of the regulations that are selectively used by politicians and bureaucrats for extortion and by businessmen to secure privileges, and (3) to build a society in which individuals compete by all fair means, in pursuing their dreams. ACKNOWLEDGMENT The paper was written during my stay as a visiting scholar at the Social Philosophy and Policy Center, Bowling Green State University, Fall 1998. The paper was presented at a KAEA session during the ASSA conference in NYC, January 1999. I wish to acknowledge the generous support of SPPC and helpful suggestions from my colleague Joseph Giacalone. NOTES 1. There were 123 bankruptcies per day in December 1997 and 151 per day in January 1998. Chosun llbo, Feb 27, 1998. 2. Chosun llbo, Feb. 13, 1998. Even when M. Camdessus, the Managing Director of IMF, made a clandestine visit to Korea on November 16, 1997 to urge an IMF intervention in view of its deteriorating economic conditions, Korean officials did not take him seriously. Wall Street Journal, March 2, 1998. 3. Dean (1998). 4. Foreign lenders assumed that loans to Korean private banks or other non-bank financial institutions are implicitly guaranteed by the Korean government. Korean financial institutions themselves assumed that loans to large firms were guaranteed by government. The assumption was proven unfounded when the depletion of the official

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foreign exchange reserve forced the Bank of Korea to abandon the attempt to bolster both borrowers and the lenders. 5. Kwon (1997). 6. Choi, et al. (1997). The report expressed concern over the growing expectation of impending devaluation of the Korean currency. 7. Kang & Shim (1997). 8. If anyone truly had truly foreseen what was coming and yet if he did not act on his superior sagacity, he threw away a chance of creating a fortune comparable to that of George Soros on shorting the British Pound! 9. See Radelet & Sachs (1997) and Wade (1998). 10. Kim (1998). Joseph Stiglitz (1998) argues similarly. 11. Kang & Shim (1997, 23). 12. The comparable figure at the end of 1996, was $157 billion, (of which $100 billion was short term.) The comparable figure at the end of January 1998 was $151 billion (of which $63.8 billion was short term loans, thanks to the conversion of some short-term loans from foreign banks to long-term loans from IMF and ADB, etc.) 13. Chosun Ilbo, Jan 30, 1998. 14. This is assuming that the debt amount is as of the end of November and interests on loans were being paid. A rough calculation leads to $2.6 billion a month to repay long-term debts and an additional $9 billion a month to repay short-term debts. Of course, The situation was made worse by currency substitution by Korean exporters and disinvestment by foreign portfolio investors. 15. Chosun llbo, Jan. 23, 1998. 16. The change can be largely accounted for by our simple calculation above, between the reduced supply of dollar and the currency substitution. 17. The earlier financial crises in Southeast Asia contributed to a degree by awakening the foreign lenders and investors to the possibility of a similar crisis in Korea. A series of bank failures in Japan (the major creditor to Korea with more than 30% of Korean external debt), resulted in higher costs of fund for Japanese banks, (the so-called Japan premium), and brought about a turn to a more conservative lending practices, i.e. disintermediation. 18. 'Financial Instability and Industrial Restructuring: How will Korea Overcome the Current Economic Challenge?' Korea Institute of Finance. September 22, 1997, p. 20. The ratios have become much worse since the crisis that has much reduced asset prices - e.g. stocks, real-estates, investment holdings in Southeast Asia, etc. 19. See also Ranis (1998). Also Gargan (1998). 20. The Japanese currency depreciated from about 90 Yen to a dollar in 1995 to 125 Yen in 1997. 21. Choi et al. (1997, 18). 22. Oh, Jinwook & Lee, Handk (1998). For example, it was revealed in August 1998 that Kia Motor Co. alone had a cumulative loss o f W 3 trillion between 1991 and 1997 and covered up by doctored books. The cumulative sum of W144 trillion would be equivalent to about $150 billion, using contemporary exchange rates. 23. Nam (1998). In January and February 1998, the transition teams of the newly elected president seemed to come to similar conclusions. 24. The obsession, it is alleged, had much to do with President Kim's desire to make his mark in history. No less significant, perhaps, was the bureaucrats' desire to hobnob in prestigious international circles.

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25. See Dean (1996 and 1998). 26. In Korea, some key officials, indeed, have been imprisoned on the ground of making mistakes! 27. In addition to numerous Korean sources, see Wolf (1998) and Ranis (1998). 28. The reputed grafts by two former presidents of Korea, Chun and Rho, is over $1billion between them. In the process of amassing their fortunes (and fortunes of their followers as well), they dispensed lucrative privileges to contributors. 29. Cho Soon (1994, 69.) The share was down from some 30% in 1985. 30. Sakong 1993. 31. See 'Political Power Ruled Banking Behind the Facade of Financial Liberalization' and 'Jung Tae-Soo and the Mysterious Money' (in Korean) Shin-Dong-A, March 1997. The proportion of policy loans in total domestic credit remained above 50% since 1975 and reached above 70% in 1985. (Cho 1994, 118) Even after 'liberalization' policy loans has remained around 40%. 32. It is alleged that the accounting systems in Korean finns are so unreliable that during the current crisis jaebol themselves have had to rely on unofficial sources. 33. Only recently shareholders have begun to try to excretes their rights as shareholders. 34. For example, based on the number of vehicles produced, Korea is the 5th largest producer in the world. But as of 1996, foreign vehicles have a negligible presence in Korea - about 1.5% market share, compare to Japan's 6% and U.S.'s 25% in the market shares of foreign vehicles. Non-tariff barriers include the threat (perceived or imagined) of selective tax audits and even vandalism targeted against the ownership of foreign made cars. 35. There were few exceptions in East Asia, e.g. Taiwan, Hong Kong, and Singapore, in addition to Japan that was much further ahead in the game. Of course, Korean leaders were stimulated to imitate the successful development in neighboring countries. 36. Cho Soon (1994, 119). 37. The presidential Decree for Economic Stability and Growth of August 1972, to save the over leveraged firms, imposed a price ceiling on all non-governmental loans and converted short term governmental loans to long term loans. Cho Soon (1994,

119). 38. Oh, Jinwook & Lee, Handk (1998). 39. This excludes other countries that never tried because of their commitment to socialist ideology, or those that only belatedly tried when the environment became much more competitive. 40. I am told that a good 40% of the students at the top engineering school are preparing for the bar or civil service exams.

REFERENCES Aliber, R. Z. (1994) Financial Reform in South Korea. In: L. J. Cho & Y. H. Kim (Eds), Korea's Political Economy: An Institutional Perspective (pp. 341-358). Boulder, CO: Westview Press Cho, S. (1994). The Dynamics of Korean Economic Development. Washington,DC: Institute of InternationalEconomics.

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Choi, G. E, Lee, C., & Lee, C. (1997). 1997 Economic Prospects and the Trends in Financial and Foreign Exchange Markets (in Korean), March, Korea Institute of Finance. Choi, Y. B. (1994). Industrial Policy for Economic Development: Lessons from South Korean Experience. Human Systems Management, 13(2), 111-121. Clifford, M. L. (1994). Troubled Tiger: Businessmen, Bureaucrats, and Generals in South Korea. Armonk, NY: M. E. Sharp. Dean, J. W. (1998). Asia's Financial Crisis in Historical Perspective, unpublished manuscript. Jones, L. P. (1994). Big Business Groups in Korea: Causation, Growth, and Policies. In: L. J. Cho & Y. H. Kim (Eds), Korea's Political Economy: An Institutional Perspective (pp. 499-521). Boulder, CO: Westview Press. Kang, B., & Shim, J. (1997). Prospects of the Currency Crisis in South East Asia and Its Relevance to Korea (in Korean), July, LG Economic Research Institute. Kang, K. S. (1997). Repositioning the Korean Economy for the 21st Century (speech given on September 22, in Hong Kong.) Kim, K. (1997). Korea's Economic Reforms. Korea Economic Update, 8(5), September. Kim, P. J. (1994). Financial Institutions. In: L. J. Cho & Y. H. Kim (Eds), Korea's Political Economy: An Institutional Perspective (pp. 273-319). Boulder, CO: Westview Press. Kim, S. (1994). Korean Labor-Management Relations. In: L. J. Cho & Y. H. Kim (Eds), Korea's Political Economy: An Institutional Perspective (pp. 623-661). Boulder, CO: Westview Press. Kim, Y-S. (1988). Korean Capital Market under IMF System (in Korean), Maeil Kyungje, January 26. Kwon, S. W. (1997). Symptoms of Currency Crisis and Prescriptions (in Korean), Weekly CEO Information, March, Samsung Economic Institute. Nam, D.-W. (1998). The Financial Crisis in Korea. Korea Economic Update, 9(1), January. Leipziger, D. M., & Peter A. P. (1994). Korean Industrial Policy. In: L. J. Cho & Y. H. Kim (Eds), Korea's Political Economy: An Institutional Perspective (pp. 581-619). Boulder, CO: Westview Press. Nam, S-W. (1994). Institutional Reform of the Korean Financial System. In:L. J. Cho & Y. H. Kim (Eds), Korea's Political Economy: An Institutional Perspective (pp. 321-339). Boulder, CO: Westview Press. Oh, J., & Lee, H. (1998). The Nature of Corporate Debt Crisis in Korea (in Korean). Weekly Economics, No. 489. October 21. LG Economic Research Institute. Oum, B. (1997). Korean Economy: Issues and Prospects. Korea Economic Update, 8(6), October. Ranis, G. (1998). Miracles that Don't Cease. Financial Times, Feb. 19. Radelet, S., & Sachs, J. (1997). Asia's Reemergence. Foreign Affairs, Nov/Dec. 44-59. Sakong, I. (1993). Korea in the World Economy. Washington, DC: Institute of International Economics. Stiglitz, J. (1998). What Caused Asia's Crash? Bad Private-Sector Decisions. The Wall Street Journal, Feb. 4. Strom, S. (1998). Korea's Other Big Problems: $300 Billion in Domestic Debt. NY Times, Feb. 10. Wade, R. (1998). The Asian Debt-and-Development Crisis of 1997-9? March. unpublished manuscript. Wolf, C. Jr. (1998). What Caused Asia's Crash? Too Much Government Control. The Wall Street Journal. Feb. 4.

OWNERSHIP STRUCTURE AND FAMILY CONTROL IN KOREAN CONGLOMERATES Ungki Lim ABSTRACT The Korean enterprise group, known as chaebol, is unique for its corporate form consisting of a pyramid of subsidiary firms operated by a single line of family. This study investigates how the family of chaebol system has been able to exert its control over a wide range of businesses with its limited resources. It finds that the chaebol families, for the attainment of proper control, have maintained a certain amount of inside shareholding in various forms; share ownership by family itself affiliate firms, non-profit organizations, and employees. At the same time, families of conglomerates have created intricate web of ownership network to grip the control in different styles; direct family control, indirect family control via a base company, indirect family control via non-profit institutions, and indirect family control via a combination of base company and outside institution. This study is conducted on the basis of support from The Asia Research Fund.

1. INTRODUCTION The chaebol, the large conglomerates in Korean version, have played the main role of the Korean economic development (Chung, Lee, & Jung, 1997). 1 It is a Asian Financial Crisis, Volume 1, pages 379--410. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0686-6

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form of corporate organization similar to Japanese keiretsu in the sense that both are a kind of enterprise group which holds a set of firms in a wide range of business fields. They, however, are greatly different in the way of how the ownership is structured and how the management is carried out (Fukuyama, 1995). 2 To a great extent, the Korean chaebol is owned and operated by the family whereas the Japanese keiretsu is largely owned by the group's member companies and run by the professional managers. The purpose of study is to investigate how the chaebols have operated their strategic efforts in the construction of the groups' overall ownership distributions for management control by the family. Specifically, this study includes three detailed topics. First, it will investigate the components of group ownership and their interrelationship between each other. Second, it is going to categorize the patterns of family control via shareholding strategy. Third, it will examine the factors that have contributed to the differences in control formats.

2. DESCRIPTION OF DATA The Korean 'Fair Trade Law' defines an enterprise group as a set of business units, each of which is owned by the group's controlling shareholder and its affiliate companies by as much as 30% or greater of the total outstanding shares. Each year, the Fair Trade Commission of the Korean government selects the 30 largest enterprise groups in the order of asset size, and regulates them to follow a series of guidelines according to the amounts of the company's borrowings and shareholdings in other companies. This study takes all of the 30 largest groups selected by the Fair Trade Commission for the analysis. Table 1 shows a brief description of each of the 30 Chaebols as of the end of December, 1995. Daewoo is found to be the largest group in terms of the total capital, whereas Samsung is the largest in the number of the group's member finns. Hyundai has the largest number of listed companies while Ssangyong shows the largest ratio of listed companies to the total member companies in the group. The total number of member firms of the 30 largest Chaebols is known to be 669, of which 171 companies are the listed firms. As of the end of 1993, these companies accounted for 33.9% of the nation's total amount of value added, 42.6% of the total corporate assets, 39.7% of the total production, and 16.8% of the total employees. The ownership distribution data of affiliate companies of the 30 largest Chaebols, as of the end of 1995, are obtained from the official list of shareholders registered at the Korean Securities Depository in the case of listed

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companies and the annual business report submitted to the securities authorities in the case o f unlisted companies. The list o f affiliate companies of the 30 Chaebols is based on the data constructed and supplied by the Korean Fair Trade Commission. There are total of 669 m e m b e r firms in the 30 conglomerates, but 12 unlisted companies are excluded from the analysis because of the difficulties in collecting the necessary data.

Table 1.

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30.

Hyundai Samsung LG Daewoo Sunkyung Ssangyong Hanjin Kia Hanwha Lotte Kumho Doosan Daelim Hanbo Dong-A Halla Hyosung Dongkuk Jinro Kolon Tongyang Hansol Dongbu Kohap Haitai Sammi Hanil Keukdong New Core Byucksan

Descriptions of 30 Largest Chaebols : D e c e m b e r 1995 Total Assets (bill. won)

Total Capital (bill. w o n )

No. of MembersFirm

No. of Listed Company

43,743 40,761 31,395 31,313 14,501 13,929 12,246 11,427 9,158 7,090 6,423 5,756 5,364 5,147 5,117 4,766 3,574 3,433 3,303 3,129 2,995 2,990 2,935 2,924 2,873 2,475 2,180 2,158 1,996 1,853

3,307 3,395 3,113 4,013 1,060 1,311 884 951 1,008 1,438 862 302 404 479 424 245 243 312 265 311 514 327 325 299 217 390 296 430 144 154

46 55 48 25 32 23 24 16 31 28 27 26 18 21 16 17 16 16 14 19 22 19 24 11 14 8 8 11 18 16

16 14 11 9 5 11 9 5 8 4 4 9 5 2 4 3 2 7 4 4 4 6 8 2 5 2 2 2 0 4

Source: Korean Fair Trade Commission

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3. THE COMPONENTS OF FAMILY-CONTROLLED SHAREHOLDINGS A certain amount of shareholdings are needed to attain proper control in a company. The share ownership needed for managerial control can be in many different forms. In the case of Korean conglomerates, there exist a set of inside shareholders who own enough shares of each affiliate companies to exert control power over the entire business. The inside share ownership can take on many different forms. For example, it can be achieved by shareholdings of a fleet of family members including an individual representing the family and his relatives, shareholdings of the affiliate companies, and in some cases shareholdings of a non-profit organization under the control of a family. In this section, we are going to establish a specific definition of the inside shareholdings of a conglomerate and discuss the way it is composed. (1) The Definition of lnside Shareholdings of the Industrial Group In this study, the inside shareholdings of an industrial group are divided into two types; (1) the family shareholdings that are the share ownerships of family members and their specially related parties such as the non-profit organization under the influence of family and the employees who are expected to side with the interests of the group's family, (2) the member firm shareholdings which are a kind of interlocking share ownership undertaken among the member companies of the group. In other words, in this analysis the components of inside shareholdings are the six different types of shareholdings undertaken by (1) member firm, (2) owner (the representative family member), (3) owner's family,.(4) non-profit organization, (5) ESOP (employee share ownership plan). Accordingly, for the computation of an individual group's inside shareholdings, we measured each component shareholding proportions separately and summed them up. Moreover, each figure of component shareholding is obtained by computing the average of shareholdings of the individual member firms of a conglomerate, weighted on the basis of the firm's capital. Consequently, the inside shareholding of an individual chaebol can be expressed by the following equation: ISk = ~i[Y-,j (CSij - X)] where

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ISk: the inside shareholding of chaebol-k CSij: the component shareholding-i of member company-j Xj: the weight of member company-j's capital in chaebol's total capital (EXj = 1.0) Ej (CSij - Xj): the weighted average of component shareholding-i Table 2 is the summary of those shareholdings in the 30 largest conglomerates of the Korean economy. In addition, as shown in Table 3, we computed a different measure of share ownership by dividing each component shareholdings by the total inside shareholdings. We are going to examine the distributions of each item of component shareholdings across the sample conglomerates and discuss their implications. With respect to the inside shareholdings, their distribution across the 30 sample groups shows a great deal of deviation. The five largest values of the inside shareholdings are found in New Core (93.54%), Hanbo (82.59), Hyundai (62.18%), Samsung (61.27%), and Tongyang (59.32%). The five smallest values are found in Lotte (22.58%), Keukdong (25.19%), Haitai (31.04%), Kia (32.27%), and Daelim (33.42%). The average of inside shareholdings of the 30 sample chaebols is shown to be 47%. The top five groups tend to have greater inside shareholdings on average when they are compared to the other groups with smaller asset size. Within the 10 largest groups in particular, it appears that the key contributing factor to the magnitude of the inside shareholdings is the size of group's business: the greater the size of group's total assets, the larger is the size of the group's inside share ownership. For instance, the largest two chaebols, Hyundae and Samsung show their inside shareholdings as high as 62.18% and 61.27% respectively whereas the groups ranked 9th (Hanwha) and 10th (Lotte) show their inside share ownership as low as 34.77% and 22.58% respectively. One possible explanation for this phenomenon is that the group with large amount of investments is more likely to diversify its business in many different industries and therefore is expected to have greater number of member finns. And, it is more probable that many of the affiliate companies are not listed on the exchange so that most of their shares are held by the inside shareholders such as family and member companies. The other possible candidates, besides business size, as the explanatory variable for the variations of inside shareholdings are believed to be many (Demsetz & Lehn (1985), Williamson (1985), and Lim (1994)); the characteristics of the group's business engaged, the accessibility to the capital market, the number of business years in the industry, the nature of business diversification, and so on. 3

384

Table 2.

U N G K I LIM The Components of Share Ownership of 30

Chaebols: D e c e m b e r

1995 Inside Shareholdings

1. Hyundai 2. Samsung 3. LG 4. Daewoo 5. Sunkyung 6. Ssangyong 7. Hanjin 8. Kia 9. Hanwha 10. Lotte 11. Kumho 12. Doosan 13. Daelim 14. Hanbo 15. Dong-A 16. Halla 17. Hyosung 18. Dongkuk 19. Jinro 20. Kolon 21. Tongyang 22. Hansol 23. Dongbu 24. Kohap 25. Haitai 26. Sammi 27. Hanil 28. Keukdong 29. New Core 30. Byucksan Average

Family Shareholdings

Inside Shareholdings

Member Finn

Family

Owner

Owner's Family

Non-Profit Orga.

ESOP

0.6218 0.6127 0.3971 0.4856 0.5233 0.3740 0.5367 0.3227 0.3477 0.2258 0.4426 0.3364 0.3342 0.8259 0.4222 0.5820 0.4295 0.4731 0.4982 0.5108 0.5932 0.5328 0.4275 0.6668 0.3104 0.2926 0.4244 0.2519 0.9354 0.3640 0.4700

0.4654 0.5574 0.3309 0.4120 0.3225 0.3218 0.2909 0.2457 0.2880 0.1918 0.4091 0.1980 0.2467 0.0582 0.2387 0.3465 0.2981 0.3230 0.3339 0.3766 0.4864 0.4496 0.2868 0.5538 0.2747 0.1553 0.2689 0.1897 0.5803 0.2121 0.3231

0.1564 0.0554 0.0662 0.0736 0.2008 0.0522 0.2459 0.0770 0.0796 0.0340 0.0336 0.1384 0.0875 0.7678 0.1835 0.2354 0.1313 0.1500 0.1643 0.1342 0.1068 0.0832 0.1407 0.1130 0.0357 0.1373 0.1555 0.0622 0.3550 0.1519 0.1469

0.0393 0.0112 0.0035 0.0478 0.1017 0.0298 0.0697 0.0012 0.0392 0.0097 0.0079 0.0277 0.0253 0.4662 0.0985 0.0071 0.1215 0.0438 0.1201 0.0197 0.0170 0.0218 0.0855 0.0562 0.0274 0.0653 0.1441 0.0153 0.1291 0.0380 0.0630

0.1118 0.0140 0.0541 0.0018 0.0598 0.0087 0.1231 0 0.0167 0.0166 0.0246 0.0736 0.0476 0.2982 0.0119 0.2003 0.0098 0.0884 0.0441 0.0927 0.0831 0.0596 0.0480 0.0380 0.0083 0.0478 0.0107 0.0469 0.2259 0.1139 0.0660

0.0053 0.0019 0.0066 0.0218 0.0063 0.0018 0.0021 0.0004 0.0033 0.0077 0.0011 0.0286 0.0146 0 0.0672 0.0182 0 0.0178 0 0.0082 0.0032 0.0017 0.0061 0.0136 0 0.0243 0 0 0 0 0.0087

0 0.0282 0.0020 0.0022 0.0329 0.0119 0.0510 0.0753 0.0205 0 0 0.0085 0 0.0124 0.0058 0.0099 0 0 0 0.0137 0.0035 0 0.0010 0.0053 0 0 0.0008 0 0 0 0.0095

(2)

The Components of Inside Shareholdings

(i) Member Firm Shareholdings T h e l a r g e s t p o r t i o n o f t h e i n s i d e s h a r e h o l d i n g s in a t y p i c a l c o n g l o m e r a t e is m a d e o f t h e g r o u p ' s m e m b e r firm s h a r e h o l d i n g s . A s s e e n f r o m T a b l e s 2 a n d 3,

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385

t h e a v e r a g e o f t h e i r v a l u e s a m o n g t h e 3 0 chaebols t u r n e d o u t to b e 3 2 . 3 1 % , a n d this figure a c c o u n t s f o r 7 0 . 7 8 % o f t h e t o t a l i n s i d e s h a r e h o l d i n g s . T h e h i g h e s t l e v e l o f m e m b e r f i r m s h a r e h o l d i n g s is f o u n d in N e w C o r e ( 5 8 . 0 3 % ) , a n d t h e l o w e s t is f o u n d i n S a m m i ( 1 5 . 5 3 % ) . I n t e r m s o f t h e m e m b e r firm s h a r e h o l d i n g s

Table 3.

T h e C o m p o n e n t s o f S h a r e O w n e r s h i p as t h e P r o p o r t i o n o f I n s i d e S h a r e h o l d i n g : D e c e m b e r 1995 Inside Shareholdings

1. Hyundai 2. Samsung 3. LG 4. Daewoo 5. Sunkyung 6. Ssangyong 7. Hanjin 8. Kia 9. Hanwha 10. Lotte 11. Kumho 12. Doosan 13. Daelim 14. Hanbo 15. Dong-A 16. Halla 17. Hyosung 18. Dongkuk 19. Jinro 20. Kolon 21. Tongyang 22. Hansol 23. Dongbu 24. Kohap 25. Haitai 26. Sammi 27. Hanil 28. Keukdong 29. New Core 30. Byucksan Average

Family Shareholdings

Member Finn

Family

Owner

Owner's Family

Non-Profit Orga.

ESOP

0.7485 0.9097 0.8333 0.8484 0.6163 0.8604 0.5420 0.7614 0.8283 0.8494 0.9243 0.5886 0.7382 0.0705 0.5654 0.5954 0.6941 0.6827 0.6702 0.7373 0.8200 0.8438 0.6709 0.8305 0.8850 0.5308 0.6336 0.7531 0.6204 0.5827 0.7078

0.2515 0.0904 0.1667 0.1516 0.3837 0.1396 0.4582 0.2386 0.2289 0.1506 0.0759 0.4114 0.2618 0.9297 0.4346 0.4045 0.3057 0.3171 0.3298 0.2627 0.1800 0.1562 0.3291 0.1695 0.1150 0.4692 0.3664 0.2469 0.3795 0.4173 0.2941

0.0632 0.0183 0.0088 0.0984 0.1943 0.0797 0.1299 0.0037 0.1127 0.0430 0.0178 0.0823 0.0757 0.5645 0.2333 0.0122 0.2829 0.0926 0.2411 0.0386 0.0287 0.0409 0.2000 0.0843 0.0883 0.2232 0.3395 0.0607 0.1380 0.1044 0.1234

0.1798 0.0228 0.1362 0.0037 0.1143 0.0223 0.2294 0 0.0480 0.0735 0.0556 0.2188 0.1424 0.3611 0.0282 0.3442 0.0228 0.1869 0.0885 0.1815 0.1401 0.1119 0.1123 0.0570 0.0267 0.1634 0.0252 0.1862 0.2415 0.3129 0.1279

0.0085 0.0031 0.0166 0.0449 0.0120 0.0048 0.0039 0.0012 0.0095 0.0341 0.0025 0.0850 0.0437 0.0000 0.1592 0.0313 0 0.0376 0.0000 0.0161 0.0054 " 0.0032 0.0143 0.0204 0 0.0830 0 0 0 0 0.0213

0 0.0460 0.0050 0.0045 0.0629 0.0318 0.0950 0.2333 0.0590 0 0 0.0253 0 0.0150 0.0137 0.0170 0 0 0 0.0268 0.0059 0 0.0023 0.0079 0 0 0.0019 0 0 0 0.0218

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measured as a proportion of the total inside shareholdings, the largest value is found to be 0.9243 in Kumho, and the smallest is 0.0705 in Hanbo. The group size seems to be an influential factor in determining the magnitude of the group's inter-firm share ownership: the larger the size of group's business, the higher is the group's member firm shareholding. For instance, the four largest groups (Hyundai, Samsung, LG, Daewoo) show their member firm shareholdings much greater than the average; 46.54%, 55.74%, 33.09%, and 42.20%, respectively. Also, in terms of the proportion of the total inside shareholdings, these four largest conglomerates have significantly large portion of member firm share ownership; 0.7485, 0.9097, 0.8333, and 0.8484, respectively. The reasoning behind this interpretation is that a group with a large asset investments has to rely on the indirect form of share ownership through member companies because of the limited amount of family endowments for the expansion. (ii) Family Shareholdings The average value of family shareholdings is shown to be 14.69% which accounts for 29.41% of the total inside shareholdings. The highest level of family shareholdings is found in Hanbo (76.78%), the lowest is found in Kumho (3.36%). With respect to the family shareholdings computed as a proportion of the total inside shareholdings, the largest figure is also found in Hanbo (0.9297), and the smallest is also found in Kumho (0.0759). One may expect that those groups with a large amount of asset investments would have a low level of family shareholdings since the amount of family wealth for the group's investments should be limited so that the family has to rely on external equity financing and eventually ends up with the dilution of ownership. However, our actual data do not provide any evidence to confirm this argument. Although there exist some differences in the averages of the family share ownership between the set of 10 largest chaebols (10.41%) and the set of 10 smallest chaebols (13.41%), its difference is found to be statistically not significant. It would be worthwhile to have a closer look in the cases of the 10 largest conglomerates in particular, considering the controversial issues on their magnitude of wealth concentrated in the hands of the families and the debates on their social, economic implications. For instances, Hanjin, Sunkyung, and Hyundai show a substantially high level; 24.59%, 20.08%, and 15.64%, respectively. On the other hand, Kia, Ssangyong, and Samsung have a relatively low level of family shareholdings; 0.16% (excluding 7.53% of the ESOP ownership), 5.22%, and 5.54% respectively. What have caused all these differences? The high level of family shareholdings observed in Hanjin, for

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387

instance, is an expected result since the family in this group directly owns a significant number of member companies. The other two cases of large family shareholdings can be explained by the unique characteristics of the family and its management style. Specifically, the Hyundai family is famous for its large number of offspring participating in the ownership as well as the management of group businesses. Sunkyung is very well known for its group structure with a limited number of public companies: only 5 out of 32 member firms are listed on the exchange. On the other hand, the 3 cases with a relatively low level of family shareholdings can be explained by the unique situations each group has faced. Kia, for example, is known to be the only large size business organization under the management control in Korea, with a negligible amount of family shareholdings. The Samsung family has a reputation of economizing in controlling member companies with the least amount of family ownership. For the Samsung family to attain group control, all it needed was to maintain majority share ownership in one key company, the Samsung Life Insurance. Finally, Ssangyong has had a very high ratio of listed firms to unlisted firms (11:12) among its member companies and thereby the group has followed a process of dilution in family shareholdings to a greater extent than most of the other groups. (iii) Owner Shareholdings and Owner's Family Shareholdings The family shareholdings were further decomposed into four different kinds of share ownership: owner shareholdings, owner's family shareholdings, nonprofit organization shareholdings, and ESOP shareholdings. The 'owner' in this case is an individual who represents the whole family members of a conglomerate: Jooyoung Jung in Hyundai, Kunhee Lee in Samsung, Bonmoo Ku in LG and so on. On the other hand, 'owner's family' means those individuals in the special relations with the owner himself such as owner's immediate offspring, relatives, and company-executives who are believed to be under the influence of the owner. The average sizes of the owner shareholdings and the owner's family shareholdings are not much different; 6.30% and 6.60%, respectively. The same is true in the case of their shareholdings measured in terms of the proportion of total inside shareholdings; 0.1234 in owner shareholdings, and 0.1279 in owner's family shareholdings. In the owner shareholdings of the 10 largest chaebols in particular, Sunkyung and Hanjin shows 10.17% and 6.97%, respectively, and all the rest show the shareholdings less than 5%. Of the next 20 largest chaebols, Hanbo, Hanil, New Core, Hyosung, and Jinro have a relatively high value of the owner shareholdings; 46.62%, 14.41%, 12.91%, 12.15%, and 12.01%, respectively.

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There is no sign that the size of chaebol's business affects the size of the owner's share ownership. In the owner's family shareholdings, two out of the 10 largest groups demonstrated relatively high values; 12.31% in Hanjin and 11.18% in Hyundai. Three out of the next 20 largest chaebols reveal substantially high values; 29.82% in Hanbo, 22.59% in New Core, and 11.39% in Byucksan. There is no sign of any relationship between the size of the group's business and the size of the owner's family shareholdings. (iv) Non-profit Organization Shareholdings and ESOP Shareholdings The shareholdings by non-profit organization as well as ESOP were interpreted as a part of the family share ownership since they are a kind of shareholdings which are mostly under the domain of family control. In the non-profit organization shareholdings, the average of 30 chaebols is 0.87%, and this amounts to 2.13% of the total inside shareholdings. Among all sample conglomerates, Dong-A shows the largest, as high as 6.72% which accounts for 15.92% of the group's total inside shareholdings. Besides Dong-A, there are only three groups which have the non-profit institution with its shareholdings greater than 2%; Doosan (2.86%), Sammi (2.43%), and Daewoo (2.18%). With respect to ESOP shareholdings, its over-all average among the 30 groups is found to be 0.95%, and this is equivalent of 2.18% of the total inside shareholdings. There are 5 conglomerates whose ESOP share ownership is found in excess of 2%, and all of them are ranked within the top 10 among our 30 sample chaebols; Kia (7.53%), Hanjin (5.10%), Sunkyung (3.29%), Samsung (2.82%), and Hanwha (2.05%). In the case of Kia, the share ownership on the behalf of employees adds up to 23.33% of its total inside shareholdings. It is evident that the size of group's business definitely affects the magnitude of the group's ESOP shareholdings. For instance, the average value of ESOP shareholdings is 2.24% in the first 10 largest chaebols, 0.50% in the second 10 largest, and 0.11% in the third 10 largest.

4. THE PATTERNS OF FAMILY CONTROL IN 30 CHAEBOLS We have observed in the preceding discussions that the families of Korean conglomerates, regardless of their size, have utilized various forms of share ownership to maintain their grip on the management. It appears that one of the key criteria the chaebol families have applied in establishing their corporate ownership structure is to minimize their stakes in the asset investments while maximizing the family's power basis in running the businesses. It is attempted

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389

in this section to categorize the patterns of family control by means of shareholding strategies, and to identify the contributing factors to the distinctiveness of control patterns.

(1) Hattori Study Based on his observations of Korean conglomerates in early 1980s, Hattori (1989) suggested that the pattern of family control could be classified into three different types. The first type is the 'direct family control' in which the family itself owns a substantial portion of shares and becomes the controlling shareholder in group companies. The second is the 'indirect family control via base company' in which family is the controlling shareholder of a strategic company (or companies). This firm has enough equity participation in each of the subsidiaries so that the family is able to exercise its influence over the member companies on a group basis. The third is the 'indirect family control via cross shareholding' where a base company retains a significant portion of shareholdings in its subsidiary firms, and at the same time, the subsidiaries hold each other's shares to the extent that the family is provided with substantial control over member firms. With the classification of the Chaebors control pattern into three different types, Hattori made an observation that the pattern of family control in a Chaebol had something to do with the size of a Chaebol's business. His finding was that as the size of Chaebol's business operation got bigger, it was more likely for the Chaebol family to rely upon the indirect form of control. His interpretation for the finding was that as a group expands its business size, it would face more difficulties in raising enough funds through the family's own wealth and have to depend on the external financing sources such as new share issues and borrowings. As the borrowing capacity of a group is exhausted and the use of external equity financing is not a viable source any more because of the family's concerns about group control, the family would be led to adopt a control device other than the direct form of control. He referred to Hanjin and Kumho group as examples of direct family control, Daewoo group an example of indirect family control via base company, and Samsung and LG group as examples of indirect family control via cross shareholding. (2) Control Pattern of 30 Largest Chaebols It has been suggested that Hattori's method of dividing Chaebors control pattern into three types would no longer be acceptable because the business environment should have changed substantially since the time his observations

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about Korean conglomerates were made (Kong, 1995). 4 Yet this study finds that his interpretation of the business size as the determinant of control pattern is still valid and applicable to our analysis of the 30 largest Chaebols. Accordingly, Hattori's approach is used as our basic methodology with a slight modification such that the Chaebols' control pattern is classified into five types, instead of three as was suggested by Hattori: (1) direct family control, (2) indirect family control via base company, (3) indirect family control via nonprofit organization, (4) complex family control, and (5) management control. (i) Direct Family Control It is the simplest form of family control which is illustrated in Fig. 1. This is the case where the control power exercised by a family is based on the family's direct ownership of the shares in most of the major business units. It is characterized by a simple ownership network with a set of major member firms positioned at the front line. Accordingly, the group's ownership network is typified by a small number of layers of member companies, usually in single or double-layer form. Some of the front-line business units may operate a certain number of subsidiary companies, but in most of the cases they are in the related business fields. It is quite possible to see a situation that the number of front-line member firms owned directly by the family are large, but the relative size of their businesses in the group as a whole is not so significant. Such a case is not going to be classified as the direct family control in the analysis. To make a distinction between the case of direct family control and the case of indirect family control more consistent, we are going to evaluate the significance of the front-line business units on the basis of a rather objective measure. Specifically, a chaebors ownership structure is to be grouped as the direct family control

I

000

Family

I

000 Fig. 1. Direct Family Control Type.

Ownership Structure and Family Control in Korean Conglomerates

391

type if the sum of capital of each family-owned company exceeds half of the total capital of the chaebol: otherwise, it will be classified as a type of indirect family control. The example of this type of family control is found in Hanjin and Lotte out of the 10 largest groups. Their proportions of the front-line firms' capital to the group's total capital (hereafter, 'family-owned firms' capital ratio') are 58.27% and 72.66%, respectively. The direct family control type is also found in Hanbo, Dong-A, Sammi, New Core, and Byucksan out of the next 20 largest groups: their family-owned firms' capital ratios are shown to be 95.25%, 78.93%, 85.32%, 73.67%, and 69.76%, respectively. Take Hanjin as a specific example, which is illustrated in the Fig. 7 of Appendix. This group is ranked 7th among the major Korean Chaebols in terms of business size and has concentrated its efforts on transportation industry with a few peripheral business fields such as tourism & leisure, construction, and finance. With its relatively simple line of business, the group shows a simple and direct form of family control. For instance, its family stands as the majority shareholder in almost every core company of the group (including KAL and Hanjin Corp.) as well as several other peripheral business units (including Hanjin Development, Hanjin Travel Service, Hanjin Investment & Securities, etc.). Those front-line business units tend to own a series of their own subsidiary firms mostly in the related line of business. Accordingly, the ownership netwok of this group shows a double-layer structure of affiliate companies. Another good example of direct family control is found in Lotte group, illustrated in the Fig. 10 of Appendix. It is ranked 10th as a Chaebol group and its line of business is not so diverse as the other leading industrial groups, concentrating in retail, hotel, and food industry. It has a reputation for being the most conservative group among the major Korean conglomerates, and uses a minimum amount of debt financing and maintains a tight family control over the group business. The group's family, including Japan-based corporate shareholders, directly owns the core companies (Hotel Lotte, Lotte Confectionery, and Lotte Shopping) as well as a series of peripheral business units (Lotte Electronics, Pusan Finance, Lotte Engineering & Machine, etc.). Some of those front-line companies hold their own subsidiaries mostly in the related business area. Like Hanjin Group's case, its ownership network has a doublelayer structure. In the examples of the next 20 largest groups, Hanbo (Fig. 14 of Appendix) family owns directly 19 out of the 20 member finns. Dong-A (Fig. 15) family is the largest shareholder only in five subsidiary firms out of total 16 member firms, yet the capital of those family-holding companies takes almost 8/10 of

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UNGKI LIM

the group's total capital commitment. Sammi (Fig. 26) family has a direct form of shareholdings in three key business units out of total seven member companies. The family of New Core (Fig. 29) group holds directly 15 subsidiaries out of 18 member firms. And, in the case of Buycksan (Fig. 30), its family is the largest shareholder only in five out of 16 subsidiaries, but the capital of the family-owned firms amounts to almost 7/10 of the group's total capital. (ii) Indirect Family Control via Base Company This is the case where the family does not own many business units as the front line companies in its ownership network. Instead, the family only owns a limited number of strategic, core businesses. The family uses these finns as the holding company of a fleet of group businesses in related as well as non-related areas. The control of group, therefore, is achieved not through the direct ownership of member firms but through the operation of holding company, as summarized in Fig. 2. Thus, it is characterized by a multiple number of layers of member companies in the hierarchy of ownership network. Out of 10 largest Chaebols, Sunkyung, Ssangyong, and Hanwha are found to be the examples of this type; their family-owned firms' capital ratios are 41.32%, 16.02%, and 23.84%, respectively. And, of the next 20 largest conglomerates, all but five groups are found to be the cases; Kumho (15.30% in the family-owned member firms' capital ratio), Doosan (36.68%), Daelim (48.89%), Halla (35.42%), Hyosung (36.99%), Dongkuk Steel (45.46%), Jinro (47.56%), Kolon (26.00%), Dongyang (21.63%), Hansol (31.42%), Dongbu

I

Family

[ Base Company

I I

,O, o o,o, 000

000

Fig. 2. Indirect Family Control via Base Company Type.

Ownership Structure and Family Control in Korean Conglomerates

393

(50.20%), Kohap (9.33%), Haitai (20.52%), Hanil (38.02%), and Keukdong (19.14%). As a specific example out of the 10 largest chaebols, Sunkyung family is directly involved in owning 10 companies as a controlling shareholder. Of the 10 companies, Sunkyung Corporation, SKC, and Sunkyung Industry are the group's core business units, and the rest of the firms are peripheral. Sunkyung Corp., in particular, owns three subsidiaries and one of the three subsidiary companies is Yukong Refinery. This refinery firm is one of the group's most essential business unit and operates a fleet of 14 subsidiaries. Hence, the Sunkyung family is given the power to control 17 firms, which cover 58.34% of the group's total capital, by owning just one core company. Sunkyung's control strategy of this kind produced a triple-layer ownership hierarchy. In the case of Ssangyong (Fig. 6 of Appendix), the family is the largest shareholder of Ssangyong Cement & Industrial, the group's holding company. The Ssangyong family has utilized this company as a base ground to expand into 21 new business units whose capital amounts to 83.98% of the group's total capital. In detail, the cement company is the parent company of 10 major member firms, including five listed companies such as Ssangyong Corp., Ssangyong Oil Refining, Ssangyong Heavy Industry, Ssangyong Investment Securities, Ssangyong Paper, and five non-listed companies. Also, five out of 10 member companies operate their own subsidiaries. For example, Ssangyong Oil Refining, a subsidiary of the cement company, has two firms with majority share ownership; Ssangyong Motor and Bum-A petroleum. Further, Ssangyong Motor holds as many as three of its own subsidiaries. The result is that Ssangyong has four layers in its pyramid of member firms. Hanwha (Fig. 9 of Appendix) group is another example of indirect family control through base company. Its family is a majority shareholder in nine companies. Of those nine firms, Hanwha Corporation is the group's representative company and owns three subsidiaries, including Hanwha Chemical. This chemical company then operates a dozen of sub-subsidiaries. Consequently, the family was able to reign over 17 member firms, which covers 71.55% of the group's total capital, through the operation of a base company. Hanwha thus shows a triple-layer form of ownership structure. The situations are very similar in the cases of the 15 examples from the next 20 largest conglomerates. Kumho (Fig. 11 of Appendix) group, as an exemplified case of these, operates Kumho Tire Co. as its head company through which the family is able to exert its control power over most of the business units. All chaebols but one in this category have their capital ratios of family-owned subsidiaries lower than 50%: Dongbu (Fig. 23), as an exception, shows its figure as high as 50.2%. Nevertheless, Dongbu is classified as the

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UNGKI LIM

type of indirect family control via base company because this group has utilized very extensively the network of interlocking shareholdings centered at a base company, showing as many as 6 layers in its pyramid of subsidiary firms. (iii) Indirect Family Control via Non-profit Organization This is another type of indirect family control and its example is found in Daewoo group (Fig. 4 of Appendix). This group is quite unique in the sense that no family member engages in owning shares of group companies except for a minor portion of group businesses. The group consists of two head companies, Daewoo Electronics and Daewoo Corporation, and the group family does not participate in the ownership of either of the two companies. Daewoo Electronics has four subsidiaries, one of which, Daewoo Telecom, holds two units of sub-subsidiaries. At the same time, Daewoo Corporation possesses a majority shareholder position in three key business units such as automobiles, heavy industries, and constructions, and eventually results in operating seven subsidiaries. It was seen from the previous discussions that a non-profit organization, The Daewoo Foundation, is the majority shareholder of the group's two head companies. However, the ultimate control remains in the hands of the group family since the foundation is run under the authority of the family. Thus, as summarized in Fig. 3, Daewoo group is seen to be a rare case of control pattern where a non-business organization is utilized to preserve family control over group businesses. (iv) Complex Family Control This is a combination of all three types of control method described above, as illustrated in Fig. 4. Its example is found in the top three conglomerates among the 10 largest Chaebols; Hyundai, Samsung, and LG. Hyundai (Fig. 1 of Appendix), the largest industrial group in Korea, is basically composed of three head companies; Hyundai Heavy Industries, Hyundai Engineering & Construction, and Hyundai Shipping. The majority shareholder of the heavy industry unit and the marine transportation unit is the Jung family, the group's owner, whereas the controlling shareholder of the construction unit is a non-profit organization, The Asan Foundation, which is believed to be under full control of the group family. Those three base firms serve as the parent company for the most of the group's influential business entities while they carry on their own business. Hyundai Heavy Industry in particular holds 20 firms including the group's core business units such as Hyundai Motor (in the form of subsidiary) and Hyundai Corporation (in the

395

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form of sub-subsidiary). In some cases, for the enhancement of control base, the family itself joins in owning a subsidiary company in part held by a head company. For instance, Hyundai Oil Refinery, a subsidiary of Hyundai Heavy Industry, has the group family as the second major shareholder. In recent years, although not shown in the chart discussed in previous section, Samsung (Fig. 2 of Appendix) has gone through a process of splitting up the business units with different members of the family.5 Specifically, Cheil Jedang and Shinsegae business units have departed from Samsung group and formed separate, independent enterprise groups. If we focus on the remains of the group business after those two family members separated out, the control structure of Samsung would be rather straightforward. Now, Samsung Life Insurance, an unlisted firm strictly controlled by the family, commands the entire fleet of group companies. This insurance firm is virtually a holding company of nine core business units in the group. Of those nine firms, Samgsung Corporation, Samsung Electronics, and Cheil Textile are the backbone of the group business, providing the family with the power basis to control the rest of the member companies. In addition to this type of indirect control, the Samsung family has employed a direct way of control by holding a substantial portion of shares of those three key companies to strengthen its control basis even further. Finally, unlike other major Chaebols, its family is not using non-business institution as a basis to control member companies. Instead, this group has utilized the employee share ownership, rather extensively in some cases. For instance, Samsung Heavy Ind. and Samsung Engineering have their employee's shareholdings at 12.9% and 13.6% respectively. In the case of LG (Fig. 3 of Appendix), the family's control power originates from the ownership of one core company, LG Chemicals which has the group family as the first major shareholder and the group's non-profit institution (LG Yonam Foundation Institute) as the second major owner. This company is the controlling shareholder of many key member firms. One of its subsidiary companies is LG Electronics which owns another set of business units as its own subsidiaries. The ownership base of this electronic firm is reinforced by the family's direct holding of its shares. (v) Management Control Kia (Fig. 8 of Appendix) group is an exceptional case of Korean conglomerates for its unique ownership distribution not having any family member as the controlling shareholder, as depicted by Fig. 5. At the same time, in the business culture stereotyped by the familistic management style, this group has been regarded as an exemplified model of future Korean business. It is composed of

Ownership Structure and Family Control in Korean Conglomerates

397

Diversified Owners

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Fig. 5. Management-Control Type. a head company, Kia Motors, and 14 subsidiaries. The head company has a list of company-related shareholders such as an employee share ownership plan (ESOP), the ESOP's subsidiary (Kisan Corp.), and a couple of foreign joint firms (Ford and Mazda). And their portion of equity amounts to about one third of the total outstanding shares. The rest of the shares are spread over small individual investors and various types of institutional investors. Although employees could have been an influential group with its substantial portion of the head company's equity (about 16%), it has never been the case. Instead, it has always been the management controlling the group. The management has been empowered with an un-checked authority to run the group business. (3) Contributing Factors to the Different Patterns of Family Control It has been shown that majority of the Korean conglomerates have adopted an indirect form of family ownership and control via the core, strategic business unit (s), while a handful number of chaebols have established a direct form or some other special type of family control. We may wonder then what had contributed to the different types of family control observed among the Korean conglomerates. Hattori suggested the size of chaebol's business operations was an influential factor determining the ways undertaken by the chaebol families to reign over their business empire. His observations made in the early 1980s was that it was more likely for a chaebol of a large business size to employ an indirect form of family control rather than direct form. In our observations of chaebols' behavior in the 1990s also, the size factor has contributed to the various forms of family control scheme. For instance, of the 30 chaebols, the top three groups, Hyundai, Samsung, and LG, showed a complex type of family control whereas the two smallest groups, New Core and

398

UNGKILIM

Byucksan, had a simple and direct type. However, it appears that the size of the business is not enough to explain the various ways our chaebols have formed their control structure. For example, some of the fairly large chaebols such as Hanjin and Lotte which would have adopted an idnirect type of family control device have utilized a direct form of family contol while a substantial number ofr groups with a relatively small business size in which a direct form of family control was expected have developed an indirect type of control network. The nature of business diversification, besides the size of business, explains some aspects of chaebols' strategic behavior of ownership and control. Those chaebol groups with an operation of businesses less diversified would show a direct form of family ownership and family control. This is an obvious point because it would be less probable to rely on an indirect way of shareholding through a base company for those chaebols that have confined their business expansion within a limited number of business areas. An example of this among large size chaebols is found in the case of Lotte which has maintained a portfolio of businesses focused on its main field, hotel and department store: Its capital invested in this single industry amounts to 57% of the group's total capital. Sammi is the example of this sort found among the small size chaebols: almost three quarters of the group's total capital has been allocated in its major field, the metal and ceramic material manufacturing. The length of business life appears to be another relevant factor influencing the formation of family control strategy. The Korean conglomerates with a business life relatively short tend to have a direct form of control scheme because they have not yet grown enough to expand into new business fields. As specific examples, Hanbo and New Core are the two youngest groups (21 and 16 years old years old, respectively) among the 30 sample chaebols, and attains its family control through direct way of share ownership. The business characteristics of a chaebol can be viewed as a determinant factor of control pattem. For instance, Hanjin has its main business in air line industry which requires a relatively large amount of capital investments: the capital of one company, Hanjin Air Line, alone accounts for 29% of the group's total capital. The situation of Sammi is very similar: the capital invested in a single company of the group, Sammi Special Metals, amounts to 62% of the group's total capital. The requirements of large sum of investments in one leading field would prevent chaebol families from venturing into many different industries so that they have to settle for a business structure focused on a limited number of industries and its corresponding ownership and control network should be in a simple and direct form. Finally, the non-business factors as well could have contributed to the establishment of some form of family control. In the case of Daewoo, for

Ownership Structure and Family Control in Korean Conglomerates

399

example, a non-profit organization instead of an individual owner is the majority shareholder of the group's core business units, but the group's founding family still has the full grip on the operation of businesses since the non-business institution is under the control of family. This type of family control structure is very unique and was created through a political arrangement between the group's founding family and the government. The management control shown in Kia is another example of the special case which can not be readily explained by the traditional economic factors. It is an atypical case for the Korean business culture and needs to be analyzed more thoroughly in a separate study. 6

5. SUMMARY AND CONCLUSION The chaebol is a unique form of business organization not seen in other parts of the world economy. It is a type of enterprise group consisting of a pyramid of subsidiary firms, operated by a single line of family members. This study has tried to investigate how the family of chaebol structure has been able to exert its control over a wide range of businesses with its limited resources. Primary task was to examine how the family of chaebol attained its ownership base for the management control. We found that the total amount of share ownership under the influence of family, the inside shareholdings (as much as 47% of the total equities, as an average among the 30 largest conglomerates), was composed of two parts. One was the portion of shareholdings undertaken in the form of indirect share ownership through the affiliate companies, which accounted for 32.31% of the total shares (or 70.78% of the total inside shareholdings). The other one was the portion of shares acquired in the form of direct ownership of the family, which amounted to 14.69% of the total equities (or 29.41% of the total inside shareholdings). The share ownership of the family could be further decomposed into four different kinds; the shareholdings of the owner himself as much as 6.3% (i.e. 12.34% of the total inside shareholdings), shareholdings of the owner's family as much as 6.6% (i.e. 12.79% of the total inside shareholdings), the shareholdings of nonprofit institutions as much as 0.87% (i.e. 2.13% of the total inside shareholdings), and the shareholdings of employees as much as 0.95% (i.e. 2.18% of the total inside shareholdings). There were evidential signs that these different types of shareholdings were used as the competing devices of share ownership by the group's family to attain its management control. Families of Korean conglomerates have created intricate web of ownership network as a device to grip control over affiliate companies. The pattern of their family control in the network of share ownership could be classified into five

400

UNGKI LIM

different types: direct family control, indirect family control via a base company, indirect family control via non-profit institutions, complex family control, and management control. Majority of the sample conglomerates, as many as 18, were found to have an indirect form of family control via a base company. This is an expected result, given the fact that chaebols are mostly run by a single family whose goal is to maximize its business base by expanding into a wide range of industries, and one practical way to own a new business with only a limited amount of capital is to have its core companies own subsidiaries. The direct form of family control was seen to be rather uncommon: only two out the 10 largest chaebols, and only five out of the 20 next largest chaebols. This type of family control was found among the conglomerates whose business portfolio were less diversified (such as Lotte and Sammi) and whose main line of business was characterized by the requirement of the large amount of capital investments (Hanjin, as an example). The direct family control was also found in chaebols which have not been in the industries long and therefore did not grow large enough to expand into new business field (such as Hanbo and New Core). Hyundai, Samgsung, and LG were the groups with a large asset size and a high degree of business diversifications, and thereby have ample reasons to have a complex type of family control. Daewoo, which showed an example of indirect family control via non-profit organization, was the case where the relationship with the public and the government influenced the pattem of family control. In Kia's case, it could not be categorized as a chaebol structure in the first place because no family had controlling share ownership. Yet, thanks to the lack of meaningful monitoring devices, its managers have exercised control power not much differently from the family in the chaebol system. Although there were some exceptions, most of the inter-company shareholdings among the affiliate firms were taken place between the unrelated business units. An implication from this kind of ownership network would be that the purpose of inter-firm share ownership in many cases was to establish a ground for the family control. These findings, after all, led us to believe that some degree of economic efficiency had been sacrificed in exchange for the family control power. 7 NOTES 1. For an insightful analysis of the cultural background of Korean conglomerates on a comparative basis, see Francis Fukuyama, Trust: The Social Virtues and the Creation of Prosperity, The Free Press, New York, 1995, pp. 127-145.

Ownership Structure and Family Control in Korean Conglomerates

401

2. For more details, see Kae H. Chung, Hak Chong Lee, & Ku Hyun Jung, Korean Management: Global Strategy and Cultural Transformation, Walter de Gruyter, 1997, p. 57. 3. When we regressed the four potential explanatory variables against the inside shareholdings across the 30 chaebols, following results were obtained. Explanatory Variables (1) (2) (3) (4)

Capital Number of Years in Business Fixed Assets/Total Assets Proportion of Listed Co. To Total Member Co.

Coefficients

t-Value

Other Statistics

0.0003 -l° 1.958" -2.191"* Degree of Freedom=26 -0.0024 0.0030 2.349** A~usted R-Square=0.769 -6.039*** -0.0047

Notes * significance at the level of 10%; ** significance at the level of 5%; • ** significance at the level of 1% 4. The only significant empirical research on the ownership structure of Korean conglomerates since the Hattori (1982)'s has been the Kong (1995)'s study which was based on the corporate ownership information of 1989, borrowed from the previous survey work, Report of Chaebol Analysis, Korean Credit Evaluation Corp., 1990. Kong classified the ownership networks of Korean conglomerates into 5 different types; family control, holding company control, complex control, family control via base company control, and family control via cross-shareholding. The result of our study (using only 10 largest chaebols as of 1995) differs from Kong's (using all 30 chaebols as of 1989) in two respects: this study employs no straightforward form of holding company control, and this study finds none of sample chaebols using crossshareholdings as their control device. 5. For more details, see Young Wook Kim, 'A Study on the Diversification Process and Control Structure of Samsung', Ph.D Dissertation, Dept. of Economics, Seoul National University, 1993. 6. Besides those variables employed for the explanation of the different patterns of ownership control in this study, there can be other factors worth contemplating. For instance, one of the theories on the ownership structure of conglomerates recently introduced (e.g. Wolfenzon (1999)) suggests that it is more probable for an entrepreneur to seek more indirect or pyramidal type of family control when he faces a business setting with poor shareholder protection whereas a direct or horizontal type of control network is expected in a business environment with a better protection system. Another theory (Bebchuk, Kraakman & Triantis (1999)) predicts that the styles of ownership control undertaken by an entrepreneur may have something to with the availability of 'cross shareholding' as well as 'non-voting shares' because they all are the alternative means of separating control rights from the cash flow rights. In this study, however, these potential candidates of explanatory variable are not taken into consideration either because of the difficulties finding appropriate proxies or because of the lack of relevant data. 7. 'The chaebols' philosophy is to increase wealth for the family. They do not care about this quarter or the next; indeed near-term profits are bad, because they are taxed'.: Quoted from 'South Korean manufacturing-the giants stumble', Economist, October.

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18th, 1997, p. 82. Our argument is that the objective of chaebol family to 'maximize its wealth' is not always consistent with the maximization of corporate value. In the course of maximization of the group's overall wealth, the intra-group transactions and transfers of wealth between the member firms have been common practices among the chaebols, and these have caused a great deal of inefficiencies in the allocation of resources. There has been a general consensus that one of the main causes for the recent IMF crisis of the Korean economy should be the miss-management of corporate assets in pursuit of the interest of the group as a whole rather than the corporate value of an individual business unit on a separate basis.

REFERENCES Bebchuk, L., Kraakman, R., & Triantis, G. (1999). Stock Pyramids, Cross-Ownership, and Dual Class Equity: The Creation and Agency Costs of Separating Control from Cash Flow Rights. National Bureau of Economic Research, Working Paper 6951. Chung, K. H, Lee, H. C., & Jung, K. H. (1997). Korean Management: Global Strategy and Cultural Transformation. Walter de Gruyter: New York. Demsetz, H., & Lehn, K. (1985). The Structure of Corporate Ownership: Causes and Consequences. Journal of Political Economy, 93, 288-307. Fukuyama, E (1995). Trust: The Social Virtues and the Creation of Prosperity. The Free Press: New York. Hattori, T. (1989). Japanese Zalbatsu and Korean chaebols. In: K. H. Chung & H. C. Lee (Eds.), Korean Managerial Dynamics (pp. 79-95). Praeger: New York. Kim, Y. W. (1993). A Study on the Diversification Process and Control Structure of Samsung. Ph.D Dissertation. Dept. of Economics, Seoul National University. Kong, B. H. (1995). A Study on the Ownership Structure of Korean chaebol. Economic Studies, Korean Economic Association, 42 (3), 307-330. Korean Credit Analysis Corporation (1990). A Report ofchaebol Analysis. Lim, U. (1989). Corporate Ownership Structure and Development of Capital Market, Korean Credit Evaluation Corporation. Lim, U. (1994). Corporate Ownership Structure and Corporate Governance Mechanism: with Experiences of Korean Firms. Advances in Pacific Basin Business, Economics, and Finance, 1, JAI Press. Williamson, O. (1985). The Economic Institutions of Capitalism. The Free Press: New York. Wolfenzon, D. (1999). A Theory of Pyramidal Ownership. Harvard University mimeo.

APPENDIX T h e tables that m a k e up the A p p e n d i x are s h o w n on the f o l l o w i n g pages.

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THE ASIAN PARADOX OF MIRACLE AND DEBACLE: AN EXPLORATORY STUDY Peter Ping Li and Tung-lung Chang ABSTRACT The Western scholars have always been puzzled by Asia's unique economic system and management practice, particularly by the dramatic swings of Asia's economic performance. To shed some light on this issue, this chapter focuses on two important questions: (1) what have been the causes of success and failure of the Asian firms in the recent past; and (2) what may be the solutions to enhance the competitive advantage of the Asian firms. As a longitudinal case study, this chapter argues that any narrow or static views are problematic; the best approach is to adopt a holistic, dynamic and paradoxical perspective. The case evidence suggests that Asia's economic systems and management practices have both weaknesses and strengths; paradoxically, its major strengths could also be its major weaknesses, contingent upon the transition of different stages of economic and social development in Asia. The real challenge for Asia is to find a way to correct its weaknesses while preserving its strengths.

How to explain the economic performance o f A s i a has long been a thorny issue for the Western scholars (Economist, 1998a, b, c). They have always been

Asian Financial Crisis, Volume 1, pages 411-435. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0686-6

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PETER PING LI & TUNG-LUNG CHANG

puzzled by Asia's dramatic swings of economic performance, as illustrated by the economic miracle not long ago and the economic debacle in the recent past. Consequently, the prevailing views of the Western scholars have also swung dramatically accordingly. Before the 1980s, the popular view in the West was that Asia's cultural values and institutional systems posed major obstacles to economic development and institutional modernization, so a wholesale Westernization was necessary (e.g. Balasz, 1964; Levenson, 1958; Wright, 1957). During the 1980s, a positive view about the Asian values and systems emerged (e.g. Hofstede, 1991; Vogel, 1990). However, after the outbreak of Asia's crisis, the negative view was popular again (e.g. Economist, 1998c; Pfeil, 1998). The Asian puzzle has been brought into the focus of a scholarly debate by the Asian crisis (cf. Ching, 1998; Economist, 1998a, b; Pfeil, 1998; Tyson, 1998; Vatikiotis and Daorueng, 1998; see Economist, 1998c for a survey). Some believe that the real causes of the Asian crisis lie in Asia's cultural values and institutional systems, so their prescription for Asia is to undergo a wholesale Westernization (e.g. Pfeil, 1998). Others claim that the Asian crisis has little to do with its cultural values and institutional systems; rather, it is related to Asia's immature stage of economic development as a latecomer, or the policy and strategy failures of Asia's complacent governments and corporations. Thus, the right prescription is to take a natural path of evolution, or to adopt new policies and strategies, so as to address the changed external environment (e.g. Economist, 1998b). Still others argue that the Asian crisis is actually caused by not sticking to Asia's traditional cultural values, so the prescription is to go back to the cultural roots of Asia's traditional values (e.g. Vatikiotis & Daorueng, 1998). To shed light on the above debate with empirical evidence, this study focuses on two key questions: (1) what have been the causes of success and failure of the Asian firms in the recent past; and (2) what may be the solutions to enhance the competitive advantages of the Asia firms. We intend to extract the complementary elements from the diverse diagnoses and prescriptions regarding the Asian crisis so as to develop an integrated model. Our theme is that any narrow or static views are problematic; the best approach is to adopt a holistic and dynamic view. To do so, we need to recognize and appreciate the paradoxical nature of complex social issues (paradox refers to the interdependence, interaction and interchange of opposing elements in a social phenomenon, see Li, 1995 for a review). This is part of a trend toward studying social issues from a holistic, dynamic and paradoxical perspective (Li, 1995, 1998a, b).

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ANALYTICAL FRAMEWORK The Links between Cultural Value, Institutional System, and Strategic Choice There are three seemingly competing explanations of the differences in economic performance between nations and between companies: (1) Strategic Perspective (Child, 1972); (2) Institutional Perspective (DiMaggio & Powell, 1991); and (3) Cultural Perspective (Hofstede, 1991). Strategic Perspective emphasizes the role of rational and contingent decision-making in determining the internal profile of nations and companies as well as the fit between their external contexts and internal profiles (Andrews, 1971). Institutional Perspective emphasizes the role of institutional systems in shaping the external context of nations and companies (Whitley, 1992). Cultural Perspective emphasizes the role of cultural values in affecting how each of external context, internal profile and strategy, as well as their overall fit, is perceived, evaluated and reconstructed (Hofstede, 1991). Strategic Perspective is rooted in the field of Economics; Institutional Perspective in the field of Sociology, and Cultural Perspective in the field of Psychology. What is missing is an interdisciplinary, overarching framework that links all the three perspectives. As a result, there are serious confusions about the links between culture, institution, and strategy. Given the length limit of this chapter, it is not possible to evaluate the above three views in detail. For the purpose of this chapter, we make three assumptions (Li, 1993, 1998a). First, we assume that none of the three perspectives alone is sufficient for explaining economic performance because none is complete by itself, thus necessary to integrate them. For instance, Strategic Perspective takes rationality as given, but it fails to explain where rationality comes from; Institutional Perspective takes authority as given, but it fails to explain where authority comes from; Cultural Perspective takes value as given, but it fails to explain where value comes from. Second, we assume that the three perspectives are complementary to each other as each starts from where others stop, thus feasible to integrate them. For instance, Cultural Perspective offers a unique insight into the sources of rationality and authority; Strategic Perspective and Institutional Perspective provide a unique insight into the sources of value. Third, we assume that an integration of the three perspectives will be sufficient for explaining economic performance, provided that such an integration will incorporate situational factors such as natural endowment, developmental level and international involvement as well as the evolutionary dynamics of these situational factors. For instance, Cultural Perspective and Institutional Perspective, together with the situational factors,

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PETER PING LI & TUNG-LUNG CHANG

define the external context for the economic performance of nations and companies, while Strategic Perspective defines the internal resources and policy/strategy choices of governments and companies. The Links between Asia' s Value, System and Choice

In this section, we introduce four major explanations about Asia's economic performance and discuss their policy and strategy implications. For the purpose of this study, we focus on the Confucianism in our analysis of Asia's cultural values and institutional systems since we believe that the Confucianism best represents Asia's values and systems. There are two reasons for such a claim. First, despite the cultural diversity in Asia, the Confucianism is the most widely shared cultural root, upon which the Asian systems are built, especially in the East Asia (Gibney, 1993; Hofstede, 1991; Rozman, 1991; Vogel, 1990). Second, though various versions of Confucianism exist in Asia, they all share a common core (Morishima, 1982). Similarly, for our purpose, we focus on the common policies of Asia's governments, and the common strategies of Asia's firms, since we believe that they represent the mainstream in Asia and also best reflect the boom-bust cycle of Asia's economic performance. The Classic View Following the tradition of Max Weber (1964), most Western scholars before 1980s claimed that Asia's cultural values and institutional systems posed major obstacles to economic development and institutional modernization (e.g. Balasz, 1964; Levenson, 1958; Wright, 1957). This was a natural view for the Western scholars because they tended to equate industrialization or modernization to a wholesale Westernization. They believed that success in industrialization was related to a special ethos found in Protestantism or other qualities unique to the Western civilization (Weber, 1964). According to the Western theories, the Asian models of economic development and corporate management get almost everything wrong (Biggart & Hamilton, 1992; Economist, 1991). This view implies that the nations and companies in Asia are doomed if they do not Westernize, and the best solution was a wholesale Westernization. The Anti-Classic View In the 1980s, due to the economic success in Asia, many scholars in the West began to challenge the classic view so as to cast a positive view about Confucianism (Hofstede, 1991; Gibney, 1993; Redding, 1990; Vogel, 1990). They highlighted the values of reverence for education, willingness to delay

The Asian Paradox of Miracle and Debacle: An Exploratory Study

415

gratification, attachment to family, respect for authority and discipline, and social harmony as the key factors for the Asian miracle. Related to these values, the Asian success was built upon hard work, high saving rate, and effective government (Leger, 1994). The policies of Asia's governments had been to promote economic development by creating a modern infrastructure, providing a stable incentive system for corporations; ensuring a relatively equal distribution of income; and promoting export-oriented economic growth. Some even argue that not sticking to the traditional cultural values is the real cause of the Asian crisis, so they prescribe that Asian firms go back to their traditional cultural values (Vatiotis & Daorueng, 1998). The implication of this view is that Asia's nations and companies can succeed in the global competition on their own terms without a wholesale Westernization. The Neo-Classic View After the current Asian crisis erupted, the classic view has revived in a new fashion (e.g. Economist, 1998c; Pfeil, 1998). In a recent survey, six deadly sins or myths of Asia have been identified (Economist, 1998c): (1) The virtue of high investment: High investment is desirable only if the money is well spent. In recent years, East Asian companies had enjoyed an artificially low cost of capital for three main reasons - government subsidies, foreign banks' eagerness to lend, and cheap dollars thanks to managed exchange rates. Moreover, money had been poorly allocated by bureaucrats or by banks that put too much weight on personal connections; (2) Small government: It is true that government spending in Asia had been rather low, but Asia's governments had intervened extensively, leaving their economies riddled with many distortions. For instance, subsidies and tax breaks for selected industries and government-protected monopolies had been widespread in Asia; (3) Flexibility: Except for Taiwan, there had been serious rigidities in labor markets and financial markets in Asia. These structural rigidities had mattered less in the early stages of Asia's economic development, but they had become serious problems for Asia later; (4) Good governance: Asia's major institutions had not kept pace with its economic growth such as Asia's unreliable legal systems, inadequate bank regulations, insufficient corporate transparency, and widespread corruption; (5) The virtue of long-term relationship: The long-term good relationship between governments, banks and companies had encouraged cronyism and corruption;

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PETER PING LI & TUNG-LUNG CHANG

(6) Education: There had been a serious shortage of skilled labor in the second-tiered Asian tigers. Besides, the high-tech industries in Asia had not contributed enough to the overall economy. Further, six problematic Asian values have also been identified (Pfeil, 1998): (1) (2) (3) (4)

Asians are group-oriented; Asian societies are vertical structures; Harmony commands a high premium in Asia; Asians' thinking process is governed more by intuition than by rationality; (5) Social progress is not valued in Asia as highly as in the West; (6) Prosperity doesn't command the premium in the East than it does in the West. In sum, those in the neo-classic camp believe that capitalism is built on the basis of the Western cultural values and institutional systems, so the Asian values and systems are incompatible with capitalism. This view implies that Asia's nations and companies can never develop any sustainable competitive advantages if they stick to their traditional values and systems, even though they may gain some short-lived competitive advantages from their traditional values and systems. The solution prescribed by this view is similar to that of the classic view (i.e. Asia has to Westernize).

The Contingent View Different from the above views which either reject or endorse the Asian values and systems in a wholesale fashion, many scholars adopt a contingent view (e.g. Chanda, 1998; Dumaine, 1997; Economist, 1998b, c; Katz, 1998; Shender, 1989). The basic premise of this view is that Asia's values, systems and choices should be evaluated in the context of Asia's special conditions. The primary condition of Asia is its specific stage of national development and corporate development. What appears to be bad at the current stage might not be bad at an earlier stage, or may not be bad at a later stage. Similarly, what appears to be good at the current stage might not be good at an earlier stage, or may not be good at a later stage. This happens simply because the overall environment at one stage differs fundamentally from those at other stages. Some argue that the current Asian crisis is caused by the turn of positive values and systems into negative ones in Asia (Ching, 1998; Economist, 1998b). For instance, the attachment to family became nepotism; the important of personal relationships rather than formal legality became cronyism; consensus became wheel-greasing and corrupt politics; conservatism and respect for authority became rigidity and an inability to innovate; and

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much-vaunted educational achievement became rote-learning and a refusal to question those in authority (Economist, 1998b). Others argue that the current Asian crisis is caused by the turn of positive policies and strategies into negative ones in Asia (Economist, 1998a). For instance, the bank policies of Asian governments led to an over-guarantee but under-regulation of the banks in Asia, which distorted investment decisions by encouraging bankers to finance risky projects in the expectation that they enjoy profits while the governments cover losses (Economist, 1998a). In addition, the strategy of emphasizing market share over profits adopted by most Asian firms led them to add capacity in already crowed fields, while the governments encouraged such a strategy with their own outsized ambitions (Sender, 1998). The above argument is not complete without addressing the question why those positive values, systems, policies and strategies suddenly turned negative. The catalysts to the turn of events are the fundamental changes in Asia's external environment due to globalization and Asia's internal situation due to complacency, so the root of the Asian crisis is the interplay of globalization and complacency (Chanda, 1998; Dumaine, 1997; Economist, 1998c; Sender, 1998; Tyson, 1998). Globalization had exposed Asia to the fluctuations of global markets; such an exposure became a serious problem when Asia's overconfidence led to an over-hasty opening of their economies to short-term global capital flows. The free flow of global financial capital first provided an easy access to cheap money (which led to Asia's bubble in terms of over-expansion and over-leveraging), and later resulted in a credit crunch in Asia (which triggered the burst of the Asian bubble). For instance, the Asian crisis actually started in the early 1990s when, boosted by financial liberalization, Asia attracted vast inflows of foreign capital, much of which was speculative and lent or invested with little or no due diligence. Easy money engendered the bad habits of some governments and companies in Asia, paving the way to overleveraging and over-expansion. Besides, the intensified global competition made the traditional advantages of Asian firms, such as cheap labor, less important than before (Dumaine, 1997). In addition to the pull of globalization, there was a push of Asia's complacency. False expectation of high future growth, coupled with easy credit, fixed and often over-valued foreign exchange rate, and virtue monopolies granted by governments to elite companies, led to a rapid growth of speculative investment in Asia's property and stock markets as well as Asia's industrial over-capacity (Sender, 1998). Continued rapid growth and lack of transparency in Asia also concealed the emerging crisis so that Asia's governments and companies reacted slowly when the first signs of trouble emerged. Even after the outbreak of the Asian crisis, many Asians still suffered

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from a denial syndrome (Chanda, 1998). However, some suggest that Asia is still at an earlier stage of economic and social development compared to the West, so are the Asian firms. Since they are still immature, it is inevitable for Asian firms to make many mistakes (Economist, 1998c), just like teenagers who struggle during their adolescence. In sum, the contingent view argues that the root of Asia's problems is that Asia is trapped in the straitjacket of obsolete values, systems, and choices that proved effective in the past. The above factors did help a backward Asia industrialize, but then turned negative after Asia's rapid industrialization (Katz, 1998). The current Asian crisis reflects the incompatibility of traditional cultural values, institutional systems and strategic choices with the emerging economic reality in the global marketplace. According to the contingent view, the proper prescription for Asia is to update its values, systems and choices, which have fallen behind the economic transformation in Asia. This implies that Asia need to learn from the West, not because the latter is culturally superior, but because the latter is more experienced with post-industrialization and globalization.

A Working Model for Firm-Level Analysis To shed light on the debate about what caused Asia's current crisis, we need to provide some empirical evidence through a firm-level analysis. To do that, we have to develop a model that is capable of describing, explaining and prescribing both the content (i.e. the 'spatial' factors such as antecedent, activity and consequence) and the process (i.e. the temporal factors such as simultaneity, directionality and rhythm) of corporate evolution from the preCrisis period to the post-Crisis period. We propose a model for firm-level analysis as follows (see Fig. 1).

The 'Spatial' Content of Corporate Evolution By integrating all the three perspectives about economic performance (i.e. Strategic Perspective, Institutional Perspective, and Cultural Perspective), we can identify five essential 'spatial' variables concerning corporate evolution: (1) external context; (2) internal profile; (3) ultimate intent; (4) strategic choice; and (5) market effect (Li, 1994, 1998b). External context refers to the set of location-specific and industry-specific environmental factors. Internal profile refers to the set of firm-specific factors. Ultimate intent refers to a firm's mission, which is the core of corporate culture. Strategic choice refers to a

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firm's key decisions and actions to achieve its ultimate intent by matching its external context and its internal profile. Market effect refers to a firm's performance in the marketplace as the direct result of its strategic choice. We use the above five variables to define the antecedent, activity and consequence of corporate evolution (Li, 1998b). For the purpose of this study, we focus on the impact of external factors (as measured by External Context in terms of cultural value and institutional system to define unique social norms as well as situational factors to define unique opportunities and threats) and internal factors (as measured by Ultimate Intent and Internal Profile to define unique corporate strengths and weaknesses as well as Strategic Choice to define corporate decisions) upon corporate performance (as measured by Market Effect in terms of corporate success or failure).

The Temporal Process of Corporate Evolution Synthesizing the contingent view about the Asian crisis with the Evolutionary Theories (Barnett & Burgelman, 1996; Riegel, 1979), we can identify three basic temporal variables: (1) simultaneity - the measure of absolute time when events occur concurrently; (2) directionality - the measure of absolute time when events occur sequentially; and (3) rhythm - the measure of relative time when events recur at different intervals. We use these three variables to define the concurrent, sequential and recurrent relationships between the 'spatial' content variables as the temporal process of corporate evolution (Li, 1998b). For the purpose of this study, we focus on the impact of evolutionary stage (as measured by Directionality in terms of the 'infant', 'teenager' and 'adult' stages) on market performance (as measured by Market Effect in terms of corporate success or failure). In sum, we have a model delineated by the dimensions of content and process of corporate evolution. This model is holistic (as it integrates various views), dynamic (as it emphasizes the role of time), and paradoxical (as it reveals the interdependence, interaction and interchange of opposing elements such as success and failure) (Li, 1995, 1998a, 1998b).

METHODOLOGY Many scholars have called for more and better-guided longitudinal case studies at the corporate level (e.g. Andersen, 1993; Parkhe, 1993). Different from the method of cross-sectional study, the method of longitudinal case study offers the best prospect for advancing our knowledge about organizational process

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(Eisenhardt, 1989; Numagami, 1998; Yin, 1994). For the purpose of this study, we chose to adopt the case study method. Case Selection

The case for our study is Hong Kong's Peregrine. We considered several criteria in selecting this case. First, we limited our selection to those Asian firms who competed in global industries because they offer the best prospect for studying the impact of globalization on the Asian firms. Second, we limited our selection to those Asian firms who had succeeded early but failed later so as to compare those factors that caused the initial success and subsequent failure. Third, we limited our selection to those Asian finns whose success and failure paralleled the boom and bust of Asia in general. Fourth, we limited our selection to those Asian firms who had a high profile so as to be a recognized symbol of the Asian miracle as well as that of the Asian debacle. We selected Peregrine because it met all the above criteria. Besides, Peregrine was widely viewed as a model of the Asian way of doing business, and its story of astonishingly rapid rise and even more abrupt fall is being cast as a morality tale for global capitalism (Hirsh, 1998; Sender, 1996). Data Collection

We collected data for this study from archival documents including corporate brochures, corporate annual reports, books, newspaper/magazine reports and case studies. Approximately 300 pages of archival data were collected. Data from various sources were coded using typical content analysis procedures (Yin, 1994). First, we identified specific events as the basic unit of analysis. Second, we coded the events into five groups according to the five 'spatial' variables in the working model. Third, we re-coded the events into three groups according to the three temporal variables in the working model. Finally, we regrouped the 'spatial' and temporal events into four camps according to the dimensions of external/internal factors and infant/teenager stages. The four camps are: (1) the external factors at the infant stage; (2) the internal factors at the infant stage; (3) the external factors at the teenager stage; and (4) the internal factors at the teenager stage. The adult stage is not included in this study since Peregrine failed in its teenager stage before reaching its adult stage. It is important to note that only those data that were corroborated from multiple sources were used in this study.

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PETER PING LI & TUNG-LUNG CHANG CASE EVIDENCE

Background Almost swooping in from nowhere, Peregrine Investment Holdings in a decade became Asia's largest homegrown investment bank outside Japan. Founded in 1988 with a capital base of $38 million registered in Bermuda, Peregrine had been a huge success story in Asia before it suddenly collapsed in early 1998 during the Asian crisis. The key figure in the story of Peregrine was Philip Tose, the Chairman and Co-founder of Peregrine. Mr. Tose began his career as a racing car driver in Europe. After a car crash in 1968, he jumped into the equally challenging and exciting field of finance. He was dispatched to Hong Kong in 1972 by his father (a senior executive at a London-based brokerage) to open a Hong Kong office. Tose did a great job, attracting Hong Kong's best brokers, and established his firm as one of the most successful security firms in Hong Kong. In 1987, the brokerage was bought over by Citicorp. Mr. Tose stayed on to supervise the unit for Citicorp until 1988. Out of his discussions with two of his brightest and most frustrated subordinates - Francis Leung (who became the other co-founder of Peregrine) and Francis Yuen (who later headed the Stock Exchange of Hong Kong), Mr. Tose decided to start a firm of his own. Backed by Li Ka-Shing and other local tycoons, Peregrine was set up. Tose chose the name of Peregrine since he liked the symbol of fast and agile bird. Tose and Leung each owned 17.5% of the initial shares of Peregrine, with the rest shared by 18 local tycoons, all connected to Li Ka-Shing. To strengthen its capital base, Peregrine took over one of Li's publicly listed firms, Kwong Sang Hong, as the first Asian-style leverage buyout in 1989. From then on, Peregrine took off as one of the fastest growing companies in Asia. Peregrine started with security trading and underwriting, and later involved in the areas of bond trade, asset management, direct investment, and property development. At its peak, Peregrine had its offices in sixteen countries, including European countries and the United States, with an asset base of over $5 billion. However, after the Asian crisis erupted, Peregrine collapsed and was liquidated on January 12th, 1998 (see Tables 1 and 2 for summaries of the case evidence).

Peregrine at Its Infant Stage: The External Factors Peregrine was extremely successful at its infant stage (from its birth in 1988 to its initial peak year of 1996). Supported by Li Ka-Shing, Peregrine was

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Table 2.

Summary of Peregrine's Financial Information

In HK $ Million

1991

1992

1993

Revenue Profit before Tax Net Profit Total Assets Shareholders' Equity Earning per Share # Asset/Equity Ratio @

1,855 4,238 11,438 360 778 1,028 318 676 856 4,181 6,259 7,263 3,065 3,460 4,101 1.026 1.313 1.647 1.36 1.81 1.77

1994 28,901 779 651 13,841 4,699 1.208 2.95

1995

1996

1997"

84,389 175,524 224,262 1,102 1,024 748 1,010 856 387 14,602 24,190 -5,889 6,690 -1.657 1.358 0.613 2.48 3.62 --

*, The first ten months of 1997 #, in HK$1

@, as a ration number

established with a capital base of $38 million in 1988, and its annual turnover grew 150% per year from 1991 to 1996. Peregrine's initial success was due to a mix of favorable external factors and internal factors. In this section, we discuss those external opportunities and internal strengths in detail.

Unique Opportunities When Peregrine was established, Asia's economies were at the middle of its take-off period. As the fastest growing region in the world, Asia had an insatiable need for capital and financial services. Such a need became more acute as Asia's capital markets were underdeveloped and inadequate. For instance, Asia's greatest need for capital was in the area of infrastructure. The financing of infrastructure projects had traditionally been funded through governments. When the governments in Asia found it impossible to finance all the necessary projects, they turned to the private market. In addition, when the private firms found it impossible to help all the needed financing from the governments, they also turned to the private markets. There was a tremendous demand for debt issues in Asia because the equity market was not in a position to meet the demand. There were two specific growing appetites for debt issues in Asia: (1) the hunger of rapidly growing Asian firms for cash, and (2) the demand of growing Asian banks for high-yield instruments. However, Asia never developed an adequate bond market, partly due to the lack of pension funds that might have spawned more interest in long-term debt instruments, and partly due to the heavy regulation over the financial business and an overreliance on credit and equity markets for capital in Asia. The size of Asia's bond market was tiny by any standards. By the end of 1995, the bond market

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of East Asia (excluding Japan) was as small as 20.4% of the region's GDP, while the U.S. bond market was as big as 110% of its GDP and the German bond market as 83% of its GDE Besides the acute demand for capital in Asia, globalization of financial markets provided Asia with an easy access to foreign capital. Further, there was a huge gap between the unique demand of local firms and the general services provided by the Western investment banks. For instance, as late as the 1980s, Hong Kong was ruled by the British investment banks, which dealt only with other Europeans. As they had done for a century and a half, ever since Britain expropriated Hong Kong from China, these waist-coated lords of the colony largely ignored the need of those local Chinese businessmen even though many of them were quietly becoming extremely rich. These local Chinese businessmen had a hard time even getting in the front doors of those British investment banks. Besides, all the foreign investment banks in Hong Kong were not aware of the potential of the Mainland China. After more than a decade of economic reforms, China was ready to take off economically. What was needed was a local investment bank that would understand the special need of local firms, and provide them with customized products and services. Peregrine seized this golden opportunity. Finally, the situations in the Mainland China also offered some rare opportunities for Peregrine. For instance, China's political crisis in 1989 caused the Hong Kong's stock market and property market to collapse, which gave Peregrine the opportunity to expand. Peregrine acquired Kwong Sang Hong and Tai Shing, both as publicly listed companies in Hong Kong. Again, during China's economic boom in the early 1990s, Peregrine was given the opportunity to develop the so-called 'red-chip' market, which earned Leung, the co-founder of Peregrine, the reputation of the 'father of red-chip'. In 1991, only five firms from the Mainland China were listed in Hong Kong, but 73 firms were listed in 1996, which accounted for about 12% of the total value of Hong Kong stock market. Peregrine was the most creative and aggressive in this special segment of investment banking in Asia, and it benefited tremendously. Unique Social Norm The primary social norm in Asia was to maintain a good personal relationship, not only because the Asians emphasized personal trust rather than institutional trust, but also because they regarded maintaining good personal relationships as a social ideal. As a result, the core of the Asian way of doing business was cronyism (the critical role of personal connection in business dealings). The specific features of this cronyism included government patronage, preferential

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treatment, opaque deal-making, risk-taking, instantaneous decision-making, conglomerate diversification, family-control, inter-firm network, informal structure, and authoritarian leadership. For instance, it was not uncommon for the Asian clients to expect their investment banks to invest directly in a venture without any form of guarantee, or take a position in securities with its own money for those clients who had critical political connections. Besides the cronyism, another key Asian norm was the typical corporate strategy of putting market share above profit margin, which was triggered by the over-sized national and corporate ambitions to catch up with the developed world as Asia was a late comer to the game of global competition. In fact, Peregrine could not have been established or survived without the personal support of the local Chinese tycoons such as Li Ka-Shing and his business partners.

Peregrine's Infant Stage: The Internal Factors Unique Strengths The unique strengths of Peregrine included its foresight and vision about Asia's opportunities, its good Asian connections, and its entrepreneurial style. Tose was British, but he did not think and act like a typical British. He understood the local mentality. He was a European who acted as a bridge between Western investors and Chinese tycoons. In the mid-1970s, Tose was one of the first to recognize what later became so obvious: that the days when Hong Kong business meant a small group of British colonial companies were numbered, and that the future of Hong Kong belonged to the Chinese, not the British. He wrote a glowing report about virtually unknown property developer Cheung Kong, probably the first report by a Western brokerage on a Hong Kong Chinese company. Two decades later, Cheung Kong boss Li Ka-Shing became the biggest tycoon in Hong Kong and one of the richest man in the world. Not until 1990s did the Wall Street, London and Tokyo discover what Tose had long known. Tose was right to see Asia's debt market as a niche desperately needed to be filled, and he was also right to see the potential of serving the needs of Asia's local firms rather than those of large multinational firms and institutional funds. Besides, Leung was among the first to realize the potential of the Mainland China's capital market. Another strength of Peregrine was its good personal connection in Asia. Tose was the first Westerner to master the art of Asia's crony capitalism. For instance, Tose realized the potential of the local Chinese businessmen in Hong Kong, so he cultivated good relationships with them, perhaps because he was a rebel and an outsider to the British elite in both U.K. and Hong Kong. Tose was more interested in socializing with the local businessmen in Hong Kong

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than with the British colonial establishment. Tose had a special connection with the group of Hong Kong tycoons who were of Chiu Chow origin such as Li KaShing, Gordon Wu and the Lau brothers, and through them to the new tycoons from the Mainland China such as Larry Yung, the son of the former Vice President of China. Due to the connection with Larry Yung, Peregrine received the first claim on the business of raising money for the Chinese state-controlled firms, which later turned into the 'red-chip' market. As the major shareholders, Li Ka-Shing, Gordon Wu and Larry Yung also became Peregrine's initial clients. Peregrine had a insider track on many of the local tycoons and China's 'red capitalists'. Peregrine would go the extra mile for its major shareholders and its favored clients by investing directly in the ventures without any form of guarantee, and taking positions in securities with its own money for those clients who had critical political connections. Peregrine's initial success had a lot to do with its mastery of Asia's crony capitalism. Peregrine took off on what made Asia successful. The third strength of Peregrine was its entrepreneurial style. Tose liked the Chinese style of entrepreneurial management. He often boasted that Peregrine become a model of the Chinese way of doing business. At the core of its entrepreneurial style were Peregrine's stomach for risk and its informal control. Peregrine often went first for the riskiest deals in Asia. For instance, it targeted riskier markets in Asia such as Burma, China, North Korea and Vietnam, which were shunned away by its more established rivals. It pioneered China's 'redchip' market long before anybody else, and it gambled with the underdeveloped bond markets in Asia. Peregrine would also go the extra mile for its major shareholders and its favored clients by investing directly in the ventures without any form of guarantee, and taking positions in securities with its own money for those clients who had critical political connections. Further, Tose often boasted that one of Peregrine's strength was that they did not hang around waiting for committees to commit to a deal. Peregrine could make decisions instantaneously, so many of its deals were done through telephone instantaneously by one person, often Tose himself. Unique Strategy Peregrine's strategy was unique in its choice of client, location, product and mode. In terms of its clients, Peregrine first served its major shareholders, and later expanded to other local businesses across Asia, instead of serving the needs of foreign multinational firms and large institutional funds. In terms of its location, it first focused on Hong Kong and China, and later expanded to the rest of Asia, including even Burma, North Korea and Vietnam. In terms of its products, Peregrine first concentrated on the equity market, and later expanded

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into bond operation and other businesses. In terms of its mode of operation, Peregrine often adopted the mode of joint venture in its overseas expansion. Peregrine's overall strategy was to position as the primary conduit between the Western investor and the Asian clients. For instance, Tose hired Andrew Lee from Lehman Brothers to build the debt business from scratch. Lee adopted a strategy of doing grassroots business in local currencies; it worked well initially; the bond department in Peregrine became one of the largest operations in Asia in just few years. In 1996, it accounted for 45% of Peregrine's total operating profit. Born in New York to a Korean father and a Canadian mother, Mr. Lee moved to South Korea when he was five and remained there for thirteen years until he attended Colgate University in the state of New York, where he studied philosophy and religion. After his graduation, he soon went to work selling sewing machines for a Japanese firm. He had little interest in that job. By 1989, the ambitious young man landed a job as a retail-broker trainee at a firm then called Shearson Lehman Hutton. He quickly made use of his contacts at Korean banks to sell them bonds. Though he did not know much about the bond business, his Korean contacts helped him to conclude big deals. Later, he was transferred to Hong Kong, where he worked for Lehman Brothers Asia until 1994, when about a dozen of other young bond traders were recruited by Peregrine to build an Asian bond business. Within two years, Peregrine's bond department became the largest operation in Asia. Another example of its unique strategy was Peregrine's fast-paced, island-hopping regional expansion. Unlike its more established rivals, Peregrine sought to serve the local needs by hooking up with local partners to set up joint ventures. In this way, Peregrine established its large global distribution network that was dedicated solely to the sale of Asian securities.

Peregrine's Teenager Stage: The External Factors Peregrine started to show some signs of trouble and finally collapsed at its teenager stage (from its initial peak in 1996 to its fall at the beginning of 1998). Peregrine's turnover only grew about 6% in 1997, in sharp contrast to the average annual growth of 150% from 1991 to 1996. Peregrine's failure was due to a mix of negative external factors and internal factors, especially the timing when Peregrine tried to transform from a regional player to a global player, and when Asia underwent its worst economic crisis. In this section, we discuss those external threats as well as internal weaknesses in detail.

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Unique Threats Paradoxically, Asia's unique opportunities contained the seeds of its destruction. The growth of Asia's markets was an opportunity, but any slowdown of such a growth would hurt Peregrine's business. The Asian crisis, which started in the middle of 1997, was directly responsible for the sudden collapse of Peregrine since it had heavy exposure to all the hard-hit economies in Asia, especially Thailand and Indonesia. For instance, Peregrine's operations in Thailand and Indonesia accounted for 20% and 38% of its total corporate turnover in 1996 respectively, followed by Hong Kong and China (15%), South Korea (5%) and Malaysia (4%). The insatiable demand for capital in Asia was an opportunity, but it could also turn into a threat. For instance, when the raised capital was not invested properly (e.g. when the capital was speculated on the property markets and stock markets in Asia), a serious problem would occur. In addition, the underdevelopment of capital markets in Asia, especially the bond market in Asia, was an opportunity for Peregrine, but it could also be one of its biggest threats. For instance, the inactive bond market strongly contributed to the miscalculation of financial risk, thus mis-pricing of capital, which was partly responsible for the Asian crisis and the fall of Peregrine. Besides, the rules regulating investment banking were far less strict than those for commercial banking. Further, the Asian cronyism was not only an opportunity but also a threat to the Asian firms. For instance, Peregrine was hurt very badly by its crony deal with an Indonesian taxi firm, Steady Safe. Largely due to the firm's connection to the family of former Indonesia President Suharto, Peregrine decided to provide the firm with a funding equivalent to a third of Peregrine's total capital. When the taxi firm failed to repay the debt, Peregrine started to collapse. Further, globalization offered an opportunity for Peregrine to reach its goal of being a conduit of international capital to Asia, but globalization might also hurt Peregrine as the global financial market became far more impersonal and calculating than before. For instance, the 24-hour trading threatened the traditionally stable and special relations between cronies). Moreover, Peregrine had to compete against those well-established investment houses out of its home turf. Finally, the lack of adequate regulation over international investment banking industry in general could be both an opportunity and a threat to investment banks such as Peregrine since sudden rise and sudden fall were both made possible. It is important to note that the point for Asia's unique opportunities to turn into unique threats was the time when the global forces favoring impersonal calculation trumped the local forces that prefer personal cronyism.

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Peregrine's Teenager Stage: The Internal Factors Unique Weaknesses Paradoxically, Peregrine's unique strengths contained the seeds of Peregrine's destruction. The vision about the take-off of Asia's bond business was not realized largely due to the overall underdevelopment of Asia's financial markets, but also due to the risky nature of bond business. The art of mastering Asia's cronyism also became a problem. Tose bought too much into the idea that business in Asia was just a matter of personal connection. Because of that conviction, Peregrine involved into many risky deals, such as that with Steady Safe, which struck fatal blows to Peregrine. Peregrine seriously underestimated the inherent dangers in the lack of transparency that was characteristic of the Asian cronyism. The go-go style that had once helped propel Peregrine was not necessarily an asset when Peregrine aimed to transform itself from a local equity boutique into a full-service global player. Its global success had to depend on battling effectively against well-established international investment houses outside its home turf. It also meant running Peregrine more like a global heavyweight rather than like a daring, opportunistic and centralized Chinese-style company. The go-go style earned Peregrine a cowboy image. There was always a suspicion that Peregrine sometimes manipulated the markets for the interests of their shareholders and major clients (in 1993, it was disciplined for that). Due to Peregrine's direct stake in the firms it brought public, there were often claims of conflict of interest. To make it to the major league of international investment banking, Peregrine had to erase any traces of its poor reputation. For instance, despite Peregrine's aggressiveness, many of Asia's most soughtafter deals often went to more established investment houses, whose reputation rested on financial expertise rather than personal connection. Even Li KaShing, who was Peregrine's most supportive backers and one of its major shareholders, turned to Goldman Sachs (an American investment house) when he needed more complicated advice for the listing of his British telecom venture. As the market and the company grew, Peregrine had to turn what had been a successful entrepreneurial culture into a more institutionalized one, which it failed to do. According to one analyst, Peregrine 'rode on the business practices of what made these Southeastern Asian countries successful, and in these practices were the seeds of destruction' (Hirsh, 1998). The lack of adequate capital was also to blame for the failure of Peregrine at its teenage stage of corporate evolution.

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Backfired Strategy The strategy that used to work so well for Peregrine also hit a wall. Due the lack of adequate capital base, Peregrine had to target smaller markets in Asia, which were also riskier. Peregrine's strategy of doing grassroots business in local currencies, which worked well initially, also went sour when the foreign exchange rate fell. Peregrine also had a hard time replicating its successful strategy of building personal connections with local players. This strategy served it well in Hong Kong and China, but it did not work as well as planned in other part of Asia. Many joint ventures went sour and often dragged Peregrine into lawsuits brought by its local joint venture partners. Further, the rapid opening of offices worldwide contributed to the creation of fiefdom, internal bickering, and inefficiency within Peregrine. Peregrine's fast-paced expansion into unfamiliar countries and businesses, coupled with the lack of internal control was a recipe for disaster. The strategy of blindly seeking market share with little concern for profits (a strategy that mirrored the mindless expansionism across Asia) also hurt Peregrine dramatically. Similarly, the entrepreneurial style that helped push Peregrine to the top and also helped bring it down to the bottom. Tose never stopped thinking like a cowboy capitalist, even after Peregrine became a huge multi-business operation. A longtime acquaintance of Tose noted that Tose 'hated all the memos and checks and balances'. Tose loved the deal-based Chinese style of intuitive thinking and informal control. Only belatedly did he put into place the kind of risk assessment and control procedures like stringent credit checks and daily reevaluation of holding positions, which were standard practices among major investment banks. Peregrine's reliance on personal connection as the sole measure of control made itself extremely vulnerable to any financial troubles. Further, the lack of internal transparency and communication hurt Peregrine. The sharp division between Tose and Leung in their responsibilities as two separate fiefdoms exacerbated the internal politics. Finally, the lack of corporate control over the bond department was another fatal mistake. Established in 1994, the bond department headed by Andrew Lee grew from a staff of 20 at the beginning to a staff of 270 at its peak in the middle of 1997. During that period, the total revenue of the bond department grew from HK$16.8 billion in 1994 to HK$128.3 billion for the first half of 1997, and its profit as a percentage of Peregrine's total profit grew from -7% to 22% during the same time. Tose and Lee realized the potential benefits of the Asian bond market, but they largely ignored the potential risks of that market. Simply because of the size of its profit and the speed it brought in the profit to Peregrine, Tose decided to delegate all his control to Lee for the bond

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PETER PING LI & TUNG-LUNG CHANG

department. Lee could bypass all of the internal control measures since he directly reported to Tose who gave Lee a free hand. Lee had almost unlimited credit facilities, even exceeding that of Leung, the co-founder and deputy chairman of Peregrine. Consequently, the top management of Peregrine did not know what was going on in the bond department. Further, the personality of Lee as a gambler made such delegation even more dangerous. In sum, the internal factors that used to work so well for Peregrine at its infant stage of corporate evolution had turned against it at its teenage stage. The trigger seemed to be the forces of globalization, whose impact on Asia became disastrous largely due to the complacency of Asia's governments and corporations who indulged too much in their past successes.

CONCLUSION This case study provided some evidence for us to address the two research questions. For the first question (i.e. what have been the causes of success and failure of the Asian firms in the recent past), the evidence seems to suggest paradoxically that those factors that were responsible for the success of the Asian firms were also largely responsible for their failure. The Asian firms were pushed across the fine lines between success and failure by the factors associated with the stage of economic development at the macro level (e.g. the new role of government in the new context of globalization and technological revolution), and the stage of organizational evolution at the micro level (e.g. the impact of complacency and cronyism in the context of being global players). As the case of Peregrine illustrated, a dazzling symbol of strength and success of the crony capitalism in Asia could also be an alarming sign of weakness and failure. Peregrine rode on the practices that made Asia successful, but it was those same practices that brought down both Peregrine and Asia. We may call this paradoxical phenomenon (i.e. the same set of factors leading to both economic miracle and economic debacle in Asia) as 'the Asian Paradox'. This paradox bears critical implications for the direction of Asia's future development. For the second question (i.e. what may be the best solutions to enhance the competitive advantages of the Asian firms), the case evidence seems to suggest that the Asian firms have to adapt to the new reality of global competition. They need to update their management practices so as to compete effectively in the global marketplace. They also need to update their cultural values, institutional systems and strategic choices in order to support those new management practices. However, it is still an open question how the Asian firms should upgrade. The case evidence does not suggest a wholesale Westernization. It is

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reasonable to argue that a wholesale Westernization is as ineffective as a wholesale preservation of the Asian traditions. For instance, personal connection may always play a key role in Asia, not only because nothing is inherently wrong with personal connection per se but also because personal connection is becoming more significant in the future, as illustrated by the increasing popularity of network organization (Li, 1998a). Asia need to learn from the West not because of the latter's superior culture but because of the latter's rich experience with modernization and globalization. The best solution for Asia is to blend the best of the East with the best of the West (Mahbubani, 1998). The most significant implicatioh of this study for future research is that scholars need to pay a special attention to the issue of paradox. As indicated by the case of Peregrine, paradox is at the core of social issues, such as the paradoxical relationship (i.e. interdependent, interactive, and interchangeable relations) between opportunity and threat, strength and weakness, success and failure as well as miracle and debacle. More case studies should be conducted to shed more light on the issue of paradox so as to build complete and consistent theoretical models.

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Eisenhardt, K. M. (1989). Building theories from case study research. Academy of Management Review, 14, 532-550. Gibney, E (1993). Pacific Century. Scriners: London. Hirsh, M. (1998). A high flier falls to earth, Newsweek January 26, 46-47. Hofstede, Ge. (1980). Culture's Consequences. Sage: Beverly Hills, CA. Hofstede, G. (1991). Cultures and Organizations: Software of the Mind. McGraw-Hill: Cambridge, U.K. Hofstede, G, (1996). An American in Paris: The influence of nationality on organization theories. Organization Studies?, 525-537. Leger, J. (1994). The Boom. Far Eastern Economic Review, November 24, 43-49. Levenson, J. (1958). Confucian China and Its Modern Fate. University of California Press, Berkeley, CA. Li, R E (1998a). Towards a geocentric framework of organizational form. Organization Studies, 19, 829-861. Li, E P. (1998b). The evolution of multinational firms from Asia. Journal of Organizational Change, 11,321-337. Li, E E (1997). The unique nature of international joint ventures in the People's Republic of China. In: S. Steward & A. Carver (Eds), Advances in Chinese Industrial Studies, 5. JAI: Greenwich, CT. Li, E E (1995). Inevitability, desirability and resolvability of paradox. Presentation at the Annual Meeting of the Academy of Management. Vancouver, Canada. Li, E E (1994). Strategic profile of indigenous MNEs from NIEs: Case of South Korea and Taiwan. The International Executive, 34, 525-537. Li, P. P. (1993). How national context influences corporate strategy. In: S. B. Prasad & R. B. Peterson (Eds), Advances in International Comparative Management, 8. JAI: Greenwich, CT. Lincoln, J., & Kalleberg, A. (1990). Culture, Control, and Commitment: A Study of Work Organization in the United States and Japan. Cambridge University Press: Cambridge, UK. Katz, R. (1998). Japan: The System That Soured. Sharpe: New York. Mahbubani, K. (1998). Can Asians Think?. Time Books International: Singapore. McVey, R. (1992). Materialization of the Southeast Asian entrepreneur. In: R. McEvoy (Ed.), Southeast Asian Capitalists. Cornell Southeast Asia Program: Ithaca, NY. Morishima, M. (1982). Why Has Japan 'Succeeded'? Cambridge University Press: Cambridge, London. Numagami, T. (1998). The infeasibility of invariant laws in management studies: A reflective dialogue in defense of case study. Organization Science, 9, 2-15. Parkhe, A. (1993). 'Messy' research, methodological redispositions, and theory development in international joint ventures. Academy of Management Journal, 18, 227-268. Pfeil, E. (1998). Can Asia want capitalism? Far Eastern Economic Review, October 1, 73. Redding, G. (1990). The Spirit of Chinese Capitalism. de Gruyter: New York. Riegel, K. E (1979). Foundations of Dialectic Psychology. Academic Press: New York. Rozman, G. (Ed.) (1991). The East Asian Region: Confucian Heritage and Its Modern Adaptation. Princeton University Press, Princeton, NJ. Sender, H. (1998). Asian indigestion. Far Eastern Economic Review, October 1, 10-13. Sender, H. (1996). Peregrine's great leap. Far Eastern Economic Review, May 9, 70--74. Tyson, L. (1998). The global meltdown: What to do next. Business Week, October 26, 22.

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Vatikiotis, M., & Daorueng, E (1998). Survival tactics. Far Eastern Economic Review, February 26, 42-45. Vogel, E. E (1990). The Four Little Dragons. Harvard University Press: Cambridge, MA. Weber, M. (1964). The Religion of China. Free Press: New York. Wright, M. (1957). The Last Stand of Chinese Conservatism. Stanford University Press: Stanford, CA. Whitley, R. D. (1992). Business systems in EastAsia. Sage: London. Yin, R. K. (1994). Case Study Research: Design and Methods (2nd Ed.). Sage, Thousand Oaks, CA.

HOW CULTURAL FACTORS LED TO RISKY ANTECEDENT MARKET CONDITIONS AND THE 1997 ASIAN ECONOMIC CRISIS Edmund A. Kellerman and Ilan Alon ABSTRACT While a large body of literature lays the blame of the 1997Asian economic crisis on external factors, such as Japan's recession, speculative foreign investors, and non-stringent international bank credit, the body of literature examining the cultural factors is emerging. The purpose of this chapter is to examine the internal antecedents to the Asian crisis by focusing on region-specific cultural conditions leading to the crisis. Important cultural factors of collectivism, authoritarianism, and powerdistance that led to precarious and risky financial practices are explored. This chapter proposes that investors and academics look beyond economic 'hard' data, and examine the values, traits, and customs of a society in order to evaluate the possibility of a financial collapse.

INTRODUCTION In July of 1997 the Asian economic crisis burst to life when Thailand could not maintain its currency exchange rate. The crisis spread throughout Asia with a profound impact on local and global economies (Roubini, 1999). Previously an area of unprecedented and sustained growth, the crisis hit South Korea, Asian Financial Crisis, Volume 1, pages 439--457. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0686-6

439

440

EDMUND A. KELLERMAN & ILAN ALON Table 1.

Country United States Mexico Indonesia South Korea Thailand

Percentage Drop in GDP Crisis year

% drop

1982 1995 1998 1998 1998

-2.1 ~.2 -15.1 -4.3 -7.2

Source: Fortune, 1998

Thailand, Indonesia, Malaysia, and the Philippines hardest (hereafter referred to as 'crisis Asia'). Within several months, the flight of foreign investment, declining currency values, crashing stock markets, large layoffs, contracting GDPs, bank closures and consolidations, and rising prices of staples afflicted the region severely. Table 1 shows the percentage drop in GDP of several Eastern and Western nations in their times of crisis. Furthermore, the area experienced an overall rise in lending rates, inflation, debt repayment problems, and cutbacks on megaprojects. Economic hardships spilled over to the political and cultural realms with the ousting of the Prime Ministers of South Korea, Thailand, and Indonesia's President when labor protests, demonstrations, and public outcry followed. What went wrong? In the midst of such envied growth and prosperity, how could a region go from first to worst in less than a year? The answer has less to do with technical reasons and more to do with cultural values and practices. Myrdal (1968) states that the Asian economy cannot be described solely in economic terms while culture has been increasingly cited as the key determinant of economic and political outcomes (Lohr, 1998). Using the 1997 Asian economic crisis as a case study, this article theorizes that certain cultural factors unique to Asia created conditions that led to the economic collapse. Literature on the Asian crisis has neglected cultural influences on macroeconomic variables (Calingo & Katz, 1999) however, "the cultural value orientations of the affected countries must be embedded in any meaningful, comprehensive analysis of the antecedents of the Asian financial crisis" (p. 160).

HISTORICAL PERSPECTIVE Prior to the 1997 crisis, the 1MF reported growth in ASEAN-5 countries' GDPs (Indonesia, Malaysia, the Philippines, Singapore, and Thailand) as close to 8%

How Cultural Factors Led to Risky Antecedent Market Conditions

441

over the past ten years with ten fold increases in per capita income levels in Korea, five fold in Thailand, four fold in Malaysia, and capital inflows of $100 billion in 1996 alone (Fischer, 1998). The results were vastly increased per capita incomes, foreign investment, and exports of manufactured hightechnology products. These successes led to acclaim for the Asian 'miracle' and recommendations to adopt the 'Asian model'. Table 2 illustrates how Japan and Far East GDP were expected to equal that of the U.S. and Europe by the year 2000. It was the "best-of-both-worlds" achievement: high economic growth without corresponding social ills (Lohr, 1998). However, short term external borrowing, large current account deficits, risky unsecured investments and loans, and other factors, helped sink the economies and currencies of crisis Asia rapidly and precipitously. Figure 1 shows a brief outline of major events to the NIC and crisis Asia. By abandoning the pegged exchange rate, (Thailand on July 2, 1997, the Philippines on July 11, Malaysia on July 14, Indonesia on August 1, and S. Korea on November 17), within one year, the value of the currency of each of these nations nearly halved, with the Indonesian rupiah falling by more than 70% by the end of the year. The causes of the Asian crisis are well known and they range from "punishment for Asian sins or the nefarious work of evil speculators" (Krugman, 1998, p. 76) to overheated economies, large external debts, lax oversight, and reluctance to close insolvent institutions (Fischer, 1998). Also cited is institutionalized corruption leading to less than secure investments as well as allocations to often dubious government-favored entities, extreme corruption and concentration of market power (The Economist, November 11, 1995; November 8, 1997; Long, 1997). Zaman (1998) cites 'excessive borrowing and overbuilding in industries and sectors favored by corrupt officials' (p. 41). Fukuyama's (1998) assessment is the most stark saying that

Table 2.

United States EEC Japan/Far East Other Source: EdwardD. Barlow, 1996

Percentage of World's GDP 1960

1987

2000 (predicted)

39.2% 27.5% 13.7% 19.6%

25.0% 25.0% 18.0% 32.0%

22.0% 22.0% 22.0% 34.0%

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it was cheap, subsidized credit for ambitious expansion projects in South Korea, overzealous speculative investment fueled by cheap credit in Thailand, and lack of openness, regulation, and transparency in Japan while "keeping faltering firms alive at all costs rather than letting mangers and shareholders absorb the consequences of failure" (p. 25).

THEORETICAL BACKGROUND Calingo & Katz (1999) focused on five explanations for the crash: weakness in the Asian model, correction of macroeconomic weaknesses, weaknesses in the banking sector, herd behavior and escalation, and contagion effect. Our research and model as depicted in Figure 2 explains that certain cultural factors (collectivism, authoritarianism, and power-distance) allowed antecedent economic conditions and risky business practices which led to morally hazardous anti-correction policies. For instance, do the seeds of the morally hazardous bailouts have its roots in collectivist or power-distance practices? Clearly yes as Greenspan (1998) stated if "the expectation that monetary authorities or international financial institutions will come to the rescue of failing financial systems and unsound investments clearly engendered a significant element of moral hazard and excessive risk taking." (p. 5). Day after day, Asian newspapers (controlled by governments) and Asian agents (often ruled with Internal Security Acts) trumpeted these risky practices in order to maintain group harmony by keeping the economy growing at any cost. This, combined with the public's lack of resolve to challenge a powerful and well connected businessperson's overreach, proved devastating once the central banks of Thailand, Indonesia, Korea, the Philippines, and Malaysia faced insolvency. Moral hazards are also harmful in that if one member of the transaction alters its behavior in a way that is hidden and costly to the other member. Obviously most governments (Asian or otherwise) explained that they were doing this for the collective good of the people. After all, "a mere rumor that a government is about to impose exchange controls can accelerate capital flight, as residents move money out of the country before the rules go into effect" (Kahn, 1998, p. 79). Indeed, the public relations effort by Asian governments was effective at first, especially governments with Internal Security Acts allowing for capricious and arbitrary arrests of their public critics. When it came to risky investments, governments, businesspeople, and banks throughout Asia (and for many years before 1979), created a system of financial support and ongoing bailouts that allowed them to reap the rewards when things went well, but not to suffer the full consequences when things

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went badly. Conglomerates in South Korea (specifically Hyundai, Daewoo, and Samsung) enjoyed "unlimited access to bank loans and were allowed to borrow and expand without regard to profits or possible consequences in an economic downturn" (Gainesville Sun, 1999, p. B3). Alan Greenspan (1998) explained that this type of reward structure obviously encouraged excessive risk taking. When the full story of how much money governments artificially pumped into their stock markets or propped up prices and valuations of supposedly 'privatized' companies over the years, people across Asia sold everything for cash. Mercedes-Benz sedans sold for pennies on the dollar in Thailand. One executive offered his two sedans for free if someone would buy his private jet. Malaysia's Finance Minister Anwar Ibrihim revised his 1998 budget three times in the first three months to account for downward estimates of GDP; yet none predicted contraction and negative growth until much later. As early as 1968, Myrdal (in Asian Drama) argued the very same premise that economic growth is a function of economic and non-economic factors. Therefore, it is useful and instructive to focus on culture and antecedents of the crisis.

METHOD This research uses an eclectic approach to explain the cultural factors that led to antecedent conditions that increased the sensitivity of Asian economies. Though some external factors (role of IMF, World Bank, foreign investors, and neighboring countries) are recognized, understanding how cultural values and specific factors led government ministers, lending institutions, investors, and the public to ignore sound financial practices is crucial. In the 1970s, research tilted away from cultural explanations of macroeconomic variables (Calingo & Katz, 1999) however, "in our view, East Asian cultural values are the social foundation that generated the critical institutional, organizational, and personal factors that, in turn, created the environment for moral hazard and other opportunistic behaviors that shaped the Asian economic crisis" (p. 160). The central thesis of this chapter will show an influence of cultural values on guarantees that encouraged excessive risk. Previous work in this area showed that both factors (internal economic conditions and cultural values and practices) created risky, unhealthy, and sensitizing antecedent conditions (Alon & Kellerman, 1999) but this newer chapter increases the weight of the influence of culture on economic practices. It is important to remember that in attempting a cultural approach, treating authoritarianism, collectivism, and power-distance as distinct, discrete, and causal variables would be difficult. Cultural variability theories have the

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EDMUND A. KELLERMAN & ILAN ALON

liability of overlapping definitional issues, e.g. where does power-distance begin and authoritarianism end. Nomothetic arguments aside, the framework suggested here may help investors evaluate the possibility of a crisis and may help figure out what changes need to be made in order for Asia's economies to recover. CULTURAL

FACTORS

Joel Kotkin, senior fellow at the Institute for Public Policy at Pepperdine University, explained that culture forms a basis for most of what happens in economic progress and that a "cultural virus" shapes most of what societies do, how they do it in politics, economics, and other areas (Lohr, 1998). This supports an emergent body of literature pointing towards cultural factors that produced antecedent conditions that allowed the economic crisis to happen. Collectivism, authoritarianism, power-distance (status and hierarchical considerations) were cultural considerations of the morally hazardous antecedent conditions that led to the Asian economic crisis. Asian values may have brought Asian countries to the major leagues of the global economy, but they did not adopt Western norms in transparency and democracy issues that could have helped them avoid and prevent the pitfalls (Gardels, 1998). Singapore Senior Minister Lee Kuan Yew and others have said the Asian governments and business community had taken on a type of 'hubris' and lack of humility uncharacteristic of Asians (Hitchcock, 1998). Media in those nations (many of them government-controlled) often touted the Asian model as good as Western business acumen but with Asian values that encouraged long term planning, stability, and a togetherness westerners should envy. Senior Minister Lee has said that "these different values have made for fast growth" (Time International, 1998, p. 24), yet the question is still how could stewards of the Asian tigers' growth become so blind to the growing crisis and so unable to stem the turning tide? The answers may lie in three crucial areas of intercultural communication: collectivism, authoritarianism, and power-distance (status and hierarchical considerations). Collectivism

Cultures differ in their members orientation towards the group and the individual. A 1994 Center for Strategic and International Studies survey of 100 respected observers of Southeast Asia revealed that Asians rated orderly society, group harmony, and respect for authority as highest priorities. These were the lowest rated priorities among Americans who rated freedom of

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expression and resolving conflict through open debate as highest. While the Asian ideals of hard work, respect for learning, collectivism, and lack of individualism brought them unparalleled growth, many analysts now believe that these cultural factors led to the abuses of collusion, lack of transparency, poor banking practices, and corruption that precipitated large weaknesses in many of these countries' economies and continue to forestall recovery (Hitchcock, 1998). Lohr (1998) proposed that this collective ideology, specifically a high work ethic, a respect for family, and a deference to government authority was characteristic of Asian values and called it a type of Protestant work ethic without the Western reverence for individualism. Table 3 rates selected Eastern and Western countries for orientation towards individualism and collectivism. The cultural phenomenon of a collective, familistic and quanxi (personal connections) form of capitalism allowed government and business collusion, corruption and competition-thwarting to exist (Gardels, 1998). The desire for group harmony among economic agents and members of a society increased the 'moral hazard' - banks and conglomerates who feel little need to act fiscally responsible if they believe that a government will ball out the wellconnected. Zarman (1998) asserts that even the IMF failed to warn the world financial markets about Asia's impending collapse to "assure continued cooperation and working relations with the governments concerned!" (p. 38) An editorial in the Economist (January 10, 1998) stated that "this problem of moral hazard is all too familiar to central bankers. To promote safe lending in the long term, some risk must be left with depositors, and far more (it is to be hoped) with owners, but not so much to make them vulnerable to short-term instability. A trade off must be struck, involving guarantees of one kind or another on one side and regulation to curb excessive risk taking" (p. 13). Table 3.

Individualism Orientation for 11 Selected Countres (Out of 50 Countries)

The West U.S.A. Great Britain Canada Netherlands Italy

Source: Hofstede, 1991

Rank

Rating

1 3 4 5 7

91 89 80 80 76

The East The Philippines Malaysia Thailand Singapore South Korea Indonesia

Rank

Rating

31 36 40 41 43 47

32 26 20 20 18 14

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EDMUND A. KELLERMAN & ILAN ALON

The tendency to ignore regulation and bankruptcy laws as a leading cause of the economic crisis was reified in collectivism. Walker (1998) pointed out that the modern business practice of debt protection, liquidation, and bankruptcy so commonly utilized in the West were largely unused in Asia because Asians tend to favor reconstruction and compromise in line with Confucian tradition which can stave off insolvency for only so long. According to Hitchcock (1998), to confront an insolvency issue head on is a Western concept, yet the Asian collectivist practice of indirectness and avoiding public embarrassments by not airing dirty laundry in public led to the moral hazard of bailouts that contributed to the lack of market correction that precipitated the crash. Combined with the cultural practice of 'special' relationships among favored clients for awarding contracts and a lack of oversight (Hitchcock, 1998), collectivism and power-distance (hierarchal considerations and status) precluded the public from asking for transparency even when faced with overwhelming evidence of mismanagement, corruption, and years of insolvency. Perhaps liberalization in transparency practices would have led to stabilization since market correction would have occurred sooner, avoiding such a large boom and bust cycle. This is a concept that former Japanese Prime Minister Kiichi Miyazawa has been recommending for his country saying that "Transparency is a must . . . (this) means sometimes a brutal confrontation, which is not really part of our culture," (Center for Strategic and International Studies Pacific Forum, 1998, p. 1), a view echoed by former dissident and current South Korean President Kim Dae Jung. Corruption that comes from the collectivist desire for group harmony affects a country's economy "by injecting private preferences into public dealings. It cheats members of one group - taxpayers, shareholder or Sunday supplement readers - and distributes the spoils to a privileged group" (The Economist, January 19, 1999, p. 19). Furthermore, developing economies from Indonesia to Russia have been severely hurt by "a corrupt form of capitalism which diverted resources from economically well founded enterprises to those that were merely well-connected" (p. 22). In order to ensure the collective welfare and harmony, East Asian nations developed their economies through: (1) modernization of agriculture, (2) promotion of labor based technologies, (3) increases in literacy, education, science, and technology, (4) industrial policy offering protection to infant industries and, (5) liberalization of trade and capital flows (Zaman, 1998). These investments, however, were often in industries in which these Asian countries had no comparative advantage (for example, Indonesia's aircraft manufacturing) and necessitated large government support to compete globally. It later became clear that many of these policies were implemented to enrich

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select families, companies, and influential figures, a prominent feature of authoritarian governments and the Asian value of 'quanxi' (personal connections). The emphasis on export promotion came at the expense of other industries, leading to sub-optimal allocation of resources. Zaman (1998) pointed out that Asian economic growth was led by rapid exports expansion financed by foreign direct and portfolio investment growth. This required high levels of borrowing and industrial investment in such export oriented industries as auto, shipbuilding, steel, and consumer electronics. Industries tailored to accommodate domestic consumption were given secondary emphasis, thus helping sensitize Asian economies to external economic shocks. Authoritarianism

To say that Asian culture philosophy is heavily devoted to strong authority (government, social, familial, or societal), paternalism, collectivism, and the desire for group harmony would be an understatement. On the surface, the belief in an elite ruling power provides for a measure of certainty and security. On the other hand, authoritarians that promote harmony often produce lax oversight which stems from the concept of keeping group harmony which comes from a strong belief in authoritarianism - a viscious cycle that came back to haunt crisis Asian economies. The respect for an 'elite' ruler ensured that even outrageous allegations against entrenched interests went unheeded. In reality, Sicherman (1998) suggested that the oft touted "Asian model" was an exaggeration of a benevolent autocracy characterized by a modern "free" economy (with much less pain and risk than classic capitalism's "creative destruction"). He explained that these types of governments are not strong enough to compel sacrifice for necessary market corrections nor popular enough to inspire sacrifice voluntarily. In other words, governments were not strong enough to take more out of a paycheck to put into an Employee's Provident Retirement Fund (which the government could then use for more investments) nor ask the citizenry to do so on their own. This untenable situation, combined with a lack of restraint and preference for authoritarans, led to the reckless and irresponsible pursuit of profits and piled risks onto an already fragile financial structure (Zhou, 1998). One major factor which increased the external vulnerability of crisis Asia was the obvious willingness to borrow heavily and on risky terms, leading to high foreign denominated short-term debt which further exaggerated their external vulnerability - another viscious cycle that came back to haunt crisis Asian economies.

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Alan Greenspan (1998) claimed that a high degree of debt to equity leverage was a symptom of excessive risk taking and was aggravated by the fact that these assets were less liquid than the liabilities. He reported that while the average growth in real GDP between 1986 and 1996 of crisis Asia was 7.32%, the rate of credit growth was nearly 17%. Excessive borrowing was also evident in the non-financial sectors. Early indicators of the financial crisis were the payment delays of leading industrial conglomerates in South Korea (Hanbo Steel in January, 1997 and Sammi Steel in March, 1997) and Thailand (Somprasong in March, 1997). These warnings were dismissed by Michael Camdessus, Managing Director of the IMF (Hitchcock, 1998). External short-term debt ranged from just over 13% in the Philippines to nearly 33% in Thailand, with much of that debt in variable-rates and hard currency. As debt began to accumulate, the financial bubble grew. Krugman (1998) suggested that financial intermediaries, whose liabilities were seen as having implicit government guarantees, drove up prices of risky projects making their financial integrity seem more stable than it really was. Each newly funded project became another step in a giant Ponzi scheme (Alon & Kellerman, 1999). To a large degree, this financial bubble was hidden from the eyes of investors and regulators. The authoritarian governments in Asia had no interest in revealing the structural weaknesses in their economy. At the outset of the crisis, the 'official' South Korean bad loan rate was 6.1% of total loans outstanding while Merrill Lynch figured that the rate was more like 15% compared to the U.S. rate of 1-2% (the Economist, November 8, 1998). The Economist also reported that at nine of the largest institutions, bad loans ranged from 94% to 376% of banks' capital and on November 8, 1997, the central bank had to pump 5 trillion won (US$1 billion) into the financial system to keep it afloat. Authoritarian societies, at least on the surface, appear stable because the authoritarians rarely have challenges to their perception of events. Prior to the economic crisis, dire predictions and warnings of financial turmoil often brought accusations of promoting disharmony and seditious attempts at destabilization. Malaysian Prime Minster Mahatir bin Mohammed's jailing of Deputy Prime Minister and Finance Minster Anwar Ibrahim in 1998 for sedition and sexual perversion is a prime example. When charges of nepotism and cronyism against Dr. Mahatir began to surface at the ruling party's general assembly, he told delegates "those who raise issues that may destabilize the party must be accountable for their actions" (The New Straits Times, June 18, 1998, p. 1). Despite denials of a gag order, the threat quelled dissent overnight.

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Authoritarianism often presents a double edged sword. When economies start to fail, denial and efforts to find scapegoats become a dominant public theme, whether or not anyone outside those countries believes even the most outrageous claims. First, the Thais "blamed Americans upset with Thai policy toward Cambodia: the Koreans blamed Westerners who feared they could not compete with Koreans; the Malaysian Prime Minister blamed Jews" (Lewis, 1998, p. 36). Dr. Mahatir blamed such "rogue speculators" as George Soros saying "All these countries have spent 40 years trying to build up their economies and a moron like Soros comes along" (Roubini, 1999). In reply, Soros called Mahatir a menace to his own country. Many Asian governments accused Western nations of trying to buy Asian assets at 'bargain' rates. Serious reform efforts rarely succeeded in authoritarian administrations. Periodic demogoguery associated with authoritarianism had severe repercussions as in Indonesia's periodic burning, looting, and killing members of the Chinese ethnic community whose 4% of the population allegedly controls half the economy. Paternalistic, familial, and authoritarian governments tend to control the information about conditions leading up to, and after a crisis, and this hurts efforts at correction. Cultures who prize authoritarianism in a belief that the leaders will provide for the people (in return for 'quanxi') may have to realize that as Gardels 0998) advocated, adopting Western norms of democracy in the form of individual responsibility, transparency, and accountability may have to be part of economic reform. At first, the IMF insisted on Suharto's removal before approving Indonesian's initial US$43 billion loan because they knew that most of it would end up in the hands of government cronies - Suharto as the 'bagman' in a continuing siphoning off of Indonesia's resources. In reality, much of the progress in crisis Asia in the past decade, especially South Korea and Thailand, were due simply to ongoing bailouts of conglomerates especially after the Japanese real estate market collapse in the early 1990s. Companies continued to speculate widely, building monuments that had little to do with infrastructure and solid economic development. Would they have been so keen if they thought that sometime their government would not bail them out? It took the installation of South Korea opposition leader Kim Dae Jung and revelations of massive insolvency for demoralized South Koreans to finally insist upon ending the chaebol bailouts - an unheard of cultural turnaround. Is authoritarianism good or bad for a developing economy? According to Francis Fukuyama (1998), professor of public policy at George Mason University, "In the absence of adequate feedback mechanisms and institutional controls on state power, it ends up being a matter of luck whether authoritarian

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institutions are turned toward the single-minded pursuit of investment and growth or become vehicles for padding the bank accounts of the politicians in charge" (p. 24). Power-distance

A third factor in cultural variability is what Dutch researcher Geert Hofstede calls the power-distance - the extent to which members of a culture adhere to unequal distributions of power, and the amount of respect accorded people's positions and status in a hierarchy. The United States, a low power-distance country, has laws designed to protect whistleblowers. On the other hand, high power-distance Asians who cause trouble for their superiors may find themselves circumvented or out of a job. Power-distance is an extension of the direct versus indirect communication styles favored by North Americans and Asians, respectively (Gudykunst & Ting-Toomey, 1988), and accounted for a significant amount of lack of transparency throughout the years leading up to the economic crisis. Power-distance is also the degree to which society accepts inequality and considers social and business distance normal. As seen in Table 4, Asian countries are far more power-distant than Western nations and their political and economic institutions embody this value. High power-distance cultures are more hierarchal with strong dependence on authority. Therefore, these societies tend to form authoritarian governments characterized by long periods of stability followed by short and abrupt periods of upheavals (Hofstede, 1991). The 1997 crisis represents just such an upheaval after a long period of growth and stability in crisis Asia. When state banks ran out of money to lend, government ministers, state bank higher ups, well connected business executives, and top loan officers Table 4.

Power-Distance Orientation for 11 Selected Countries (Out of 50 Countries)

The West Italy U.S.A. Canada Netherlands Great Britain

Source: Hofstede, 1991

Rank

Rating

34 38 39 40 42

50 40 39 38 35

The East Malaysia The Philippines Indonesia Singapore Thailand South Korea

Rank

Rating

1 4 8 13 21 27

104 94 78 70 64 60

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encouraged risky short term external borrowing - the very damaging practice that started the currency collapses. Who was going to argue with the Prime Minister's office, the Minister of Trade, the State Bank, or someone with close connections to them? Lohr (1998) pointed out that this form of "crony capitalism" of patronage for well connected business executives is now under great scrutiny and disrepute, not unlike the exploitative system of the American robber-barons in the late 1800s who finally received their punishment through divestiture. When faced with questions involving transparency on insolvency issues, the aforementioned Asian tendency of (1) respect for people in powerful positions, (2) to not confront directly and (3) to go carefully around to local press outlets, friends and associates of the target did not lend themselves to the full and accurate disclosure necessary to correct perilous situations. This lack of confrontation led to ten years of face-value government assurances until July 2, 1997 when the Central Bank of Thailand admitted publicly they were insolvent due to unpaid loans. How bad was the fallout from power-distance related risky borrowing? In late July, word leaked out from the Economist that taxpayers' burden for insolvent banks was 800 million baht, one sixth of the Thai GDP. In addition, both the exchange crisis, and later the debt crisis, were worsened by a reversal of capital flows from private sources. Debt that was denominated in foreign currency, in particular, could not be paid off easily because of the declining purchasing powers of local currencies. This triggered a collapse in asset prices in the banking sector with non performing loans in crisis Asia ranging from 20% in the Philippines to 75% in Indonesia with an average of around 42%. Nearly all banks in Korea, Thailand, and Indonesia were insolvent by current international standards (Sweet, 1999). Jardine Fleming, a Japanese investment company, estimated the Southeast Asian banks were carrying US$73 billion worth of bad loans, representing a staggering 13% of Southeast Asian GDP (compared with the 2-3% of the U.S. GDP to solve the Savings and Loan crisis and 10-12% to solve Mexico's 1994 currency crisis). The Central Bank of New York estimated that the costs of the recent banking crisis of Korea, Thailand, Indonesia were 30 to 35% of their GDPs, twice as high as that of the Mexican crisis, and ten times as high as one of the U.S. Savings and Loan banking crisis of 1984 to 1989 (Sweet, 1999). This cultural value of non-confrontation of elite power in powerful positions promoted some astounding latitude in fiscal practices. The Economist (1998) reported that Thailand's Central Bank allowed banks to claim that a secured loan was performing even if no interest had been paid for a year and that they were spending nearly 100 million baht (US$2.6 billion) a month to stave off

45,1

EDMUND A. KELLERMAN & ILAN ALON

insolvency. The same lack of confrontation occurred in South Korea with Hanbo, a steel group, and KIA Motors, both of whom had been insolvent for a decade. By the middle of 1997, correction was impossible and the effect rippled instantly and throughout the region. Culturally, there could not have been any public or private challenge. Putting one's faith in elites through power-distance values is risky business as seen in the robber baron era of America in the late 1800s or in the Savings and Loans scandals of the 1980s. In Asia, all of its industrial "had been built on a faith in elites. Elites rather than markets had determined who got capital, and therefore who was allowed to succeed in business" (Lewis, 1998, p. 36). Thais and especially South Koreans went through an unprecedented reexamination of cultural values and faith in elite leaders culminating in National Humiliation Day December 3, 1997 - the day the IMF gave the terms of their $57 billion loan to Seoul.

CONCLUSION Government officials and businesspeople throughout Asia have continually stated that Asian values brought them incredible economic progress over the years. Yet another set of values (absolute trust in leaders, tolerance of corruption, lack of confrontation) encouraged risky antecedent conditions that led to the economic crisis. Simultaneously, higher-ups spent considerable time avoiding responsibility which at first played well with the public. On the cultural side, the contention of this chapter that collectivism, authoritarianism, and power-distance brought a false sense of security is well supported. It is too hard to ignore the connection between such corruption as continuing government support for insolvent industries (a type of 'Bailouts for Harmony') and the lack of effort at market correction. Too much respect for hierarchy led to a critical lack of transparency just when Asia needed it most. According to Meuhring (1998) some of the solutions to Asian countries economic woes include such economic practices as new codes of conduct governing fiscal transparency from G-7 and IMF. Some are cultural. The IMF has proposed a new 'tiered response' system including 'yellow card' warning system, perhaps an Asian facesaving way to motivate fiscal responsibility and, as in soccer, one last chance to correct destructive behavior. The causes of the Asian economic crisis are economic (too much growth too fast, too much unsecured credit, too many unworthy ventures and leaders) and cultural (too much confidence in the leaders' grand visions, too little investigation of people and situations who needed scrutiny, and too much insistence on group harmony by the leaders). They provide lessons that Asian

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leaders will have to learn whether it takes IMF restrictions, full scale reform movement, revolution, or merely making laws and economic practices by which they will have to stand resolutely. By examining the suggested cultural factors investors can properly assess financial risks and will take measures to hedge and diversify. Asian governments should increase the level of individual responsibility, become more transparent, and democratize their political institutions to reduce the risk of financial collapse. These governments can ease the pain by helping reemploy resources in more productive industries in which they have a comparative advantage. This study is just the start of what should be a lengthy examination into how Asian cultural values will change to overcome current problems and stabilize future economic conditions. Will they have to adopt "Anglo-Saxon" norms as Gardels (1998) suggested or modify the "familistic and quanxi" form of capitalism with which Asian culture is most comfortable? While there is no lack of educated leaders and population who should be insisting on change, Zhou (1998) reiterated that Asian values and morals are products of thousands of years, and cannot be expected to change quickly and drastically. Walter Russel Mead (1998), senior fellow at the Council on Foreign Relations, said that in the old days, a handshake, customs, and family relationships were strong enough to build as modern social safety net, however, "when modern cities spring up, you need courts of law, unions, and government oversight" (p. 38). This catalysm has already spurred on deep philosophical introspection that will encourage Asian countries to forge economies that are less prone to a wild roller coaster ride so that they enjoy a lengthy boom without this specular and devastating bust. Though Zhou states that Asian values change slowly, in a force-field analysis something has to give - either the forces of change, the forces of resistance, or the standards by which struggle is measured. In July of 1999, one year after the lowest point of the crisis, the South Korean government-run banks forced the managers to sign an agreement to dismantle the Daewoo Group, the second largest chaebol in Korea - the first time a chaebol has been broken up and largely to pay for its estimated $49 billion in debt (Businessweek, May 3, 1999). In the year 2000, nobody in Japan forgave billions of dollars of debt by Sogo, the department store retailer nor extended them any bailout. Businessweek regards this restructuring and asset selloff, notably in South Korea, as positive signs of a recovery and "that Asia appears to be headed out of its economic slump" (p. 24). Asians have been holding their breath over Japan and China because as they go, oftentimes so goes much of Asia. The

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principal cultural value seems to be a worry; for as writer George Washington Lyon once wrote, worry is the interest paid by those who borrow trouble. REFERENCES Alon, I., & Kellerman, E. (1999). Meltdown in Southeast Asia: Internal Antecedents in the 1997 Asian Economic Crisis. Multinational Business Review, 7(2), 1-12. And Southeast Asia Thinks It's All Over (1997). The Economist, 345(8042), 41. Barlow, E. Jr. (1996). The journey toward the next millennium: Doing business in the 1990s. Bethesda, Md: Infospeak. Be Responsible, UMNO Delegates Told (1998). The New Straits Times (Malaysia), 1. Break Up Ordered (1999). The Gainesville Sun, B2. Business Week (1999). Asia: How real is its recovery?, 36(27), 24. Calingo, L. R., & Katz, A. E. (1999). The Cultural and Institutional Antecedents of the Asian Financial Crisis. In: Calingo et al. (Ed), GlobalBusiness in theAge of Technology (pp. 158167). Monterrey, CA: Eighth World Business Congress. Fischer, S. (1998). The Asian crisis: A view from the IME Presentation at the Midwinter Conference, Banker's Associaion for Foreign Trade, Washington, D.C. Fukuyama, F. (1998). Asian values and the Asian crisis. Commentary, 105(2), 23-28. Gardels, N. (1998). Global fusion: Asian ideals and Anglo-Saxon norms. Washington, D.C.: Center for Democratic Institutions. Greenspan, A. (1998). Testimony before the Committee on Banking and Financial Services, Washington, D.C.: U.S, House of representatives. Gudykunst, W. B., & Ting-Toomey, S. (1988). Culture and Interpersonal Communication. Newbury Park, CA: Sage. Hitchcock, D. I. (1998). Asian Crisis is Cultural as Well as Economic. Christian Science Monitor, p. 19 (also available as Pacific Forum CSIS PacNet, no. 15). Hofstede, G. (1991). Culture and Organizations: Software of the Mind. London: McGraw-Hill. Kahn, J. (1998). A Desperate Remedy. Fortune, 138(5), 79. Krugman, P. (1998). Saving Asia: It's time to get radical. Fortune, 138(5), 74-80. Krugman, P. (1998). What happened to Asia? available through http://web.mit.edu/krugmardwww/ DISINTER.html Leaders: Kill or Cure? (Ed.) (1998). The Economist, 346(8050, 13-14. Lewis, M. (1998). The Biggest Going Out of Business Sale. The New York Times Magazine, 37-41, 53, 58--64, 68-69. Lohr, S. (1998). Business, Asian Style: A revaluing of values; Some say market collapse shows democracy is key to growth, after all. New York Times, B9 (col. 2). Long, S. (1997). Suharto's End Game. The Economist, 344(8027), Survey Indonesia section p. 1-18. Mead, W. R. (1998). Asia Devalued. The New York Times Magazine, 38-39. Meuhring, K. (1998). The fire next time. Institutional Investor, Inc., 74. Myrdal, Gr. (1968). Asian Drama: An enquiry into the poverty of nations. Pantheon: NY. Roubini, N. (1999). Chronology of the Asian currency crisis and its global contagion. NYUAsian Crisis Compilation, p. 2, available through http://www.stern.nyu.edu Sicherman, H. (1998). The Asian Panic, Round Two. Washington, D.C.: Foreign Policy research Institute.

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Sweet, L. (1999). Prospects for emerging markets. Presentation at the Federal Reserve Bank, 39th Central Banking Seminar, New York City, New York. Stop the Rot (1999). The Economist, 350(8102), 19 & 22. The Woes of South Korea's Chaebols (1995). The Economist, 337(7940), 61. 'Asian Values' the Crisis: An Interview with Lee Kuan Yew (1998). Time International, 150(29), 24. Walker, S. (1998). Debt 'culture', Asian insolvency regimes feel strain; diversity bankruptcy systems in the region are suddenly forced to deal with a huge debt crisis. National Law Journal, 20(36), C3 (col. 1). Woo, C. (1998). Meltdown. Money Manageemnt: Asia 2000, International Investor Inc., 147. Zaman, M. R. (1998). The causes and consequences of the 1997 crisis in financial markets of East Asia. The Journal of Global Business, 37-43. Zhou, D. R. (1998). Charting the course at the edges of the economic storm. Pacific Forum CSIS, PacNet no. 41.

SOCIOPOLITICAL ANALYSIS OF KOREAN ECONOMIC CRISIS OF 1997 S. J. Chang 1. I N T R O D U C T I O N

-

MIRACLE OR MIRAGE?

Up until late 1997 when South Korea came within an eyelash of national bankruptcy, its unprecedented economic growth since the early 1970s had been the envy of the world. The story was so remarkable that it had been often referred to as an economic miracle. But the abrupt collapse of the world's then eleventh largest economy was by itself a miraculous turnaround. Naturally numerous explanations, arguments, debates, analyses, and postscripts followed since then regarding the causes of this crisis. When all the dust settled, a consensus view seemed to indicate that Korean economy was choked by the flood of easy money that had been grossly misdirected into unhealthy investments and lavish expenditures. While companies borrowed short term to finance long-term investments, banks borrowed in dollars and lent in won without hedging. They simply invested too much too fast. Indeed, the major criticism was directed to Korea's reckless businesses, particularly those infamous chaebol groups, as well as the imprudent lenders entrenched in the lax banking system. Thus, the analysts say that the Korean miracle died when these 'economic bubbles' burst. However, economic bubbles were apparently not the only kind of bubbles that triggered the Korean crisis. Although the crisis was in essence a financial one, it was, in a sense, a combined result of many corroborating factors, including policy blunders, political quagmire, social inertia, cultural rigidity, and even low civility in the society. In fact, a careful look into the crisis reveals Asian Financial Crisis, Volume 1, pages 459-479. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0686-6

459

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S.J. CHANG

that almost every major sector of the nation was full of bubbles that collectively created a crisis-conducive environment. In this context, it can be argued that the Korean miracle was killed when all these political, social, economic, institutional, and psychological bubbles burst - one at a time in a short time period or maybe all at once. Perhaps the miracle itself was a big bubble that was bound to pop. Or was it only a mirage? From this perspective, this chapter takes a holistic approach to the issue of the Korean economic crisis by relating to its politics and government, education and technology, industrial and social infrastructure, and public mentality and civility. The chapter's analysis should bear significance in that the ultimate solution to Korea's problems rests not only on economic and business restructurings but also on politicaL social cultural and psychological reforms. 2. K O R E A N

ECONOMIC

CRISIS -A

TOTAL CRISIS

The first clear sign of the 1997 Korean economic difficulty was the collapse of Hanbo Group in January 1997. Hanbo was the first of a series of chaebol failures. By the end of 1997 seven of Korea's 30 largest conglomerates became insolvent (Beck, 1998). Hanbo's problem was brewing much earlier when it overdiversified its business with excessive borrowing in 1994. Eventually Hanbo accumulated over $6 billion worth of debt - 20 times its equity. More important, the Hanbo case turned into a big political scandal when then president's son and ruling party members were found deeply involved in a collusive tie with Hanbo. Soon, other over-extended, over-leveraged conglomerates went bankrupt including Kia, the eighth largest chaebol in Korea back then. Large commercial banks then became saddled with non-performing loans. By early 1997, the level of non-performing loans was over 70% of banks' equity. By then, a fullscale financial meltdown began. On December 3, 1997, the International Monetary Fund doled out $57 billion, the largest bailout in its history. The bailout imposed on the Korean government a series of restrictive economic programs that focus on restructuring the economy, resolving the large buildup of domestic debt, restructuring the banking and chaebol system, and restoring investor confidence, among others. Korea thus fell on a 'bone-carving' hard time. During the first quarter of 1998 household real income shrank nearly 11% on a year-on-year basis. The unemployment rate, which stood at 3.1% in December 1997, skyrocketed to nearly 9% by early 1999. All in all, the economy experienced a negative growth of 5.8% in 1998. The crisis-induced rapid economic decline can be read from

Sociopolitical Analysis of the Korean Crisis

461

Table 1, which indicates particularly severe deterioration in GNP, unemployment, exchange rate, and stock price. While some specific theoretical explanations are offered for the recent Korean economic turmoil, such as theories of investor panic, bad policies, international capital influx, and Ponzi finance (Aliber, 1998; Oh, 1998; Y. Park, 1998), the direct cause of the Korean economic crisis is essentially the private debt. That is why restructuring the financial sector is widely regarded as the key to an economic turnaround (KIIEP, 1998). It is no secret that Korea's unruly chaebol companies have been snowballing their debt capital to finance their businesses, which range from toilet paper to semiconductors. While these chaebol groups were the kingpins of the once strong Korean export machine, their overexpansion resulted in tremendous financial burdens, low productivity, and inefficient resource allocation. Indeed, the IMF bailout package spells out an explicit chaebol policy that requires them to focus on their core businesses, have greater financial transparency and profitability, and drastically lower their debt ratios from the recent average of 400%. Accordingly, ambitious business reorganization plans, such as the so-called 'Big Deal', have been negotiated between the government and the largest Table 1.

Major Economic Indicators of Korea Surrounding the Crisis

GNP Growth (1990 Price) Per Capita GNP Inflation (1990 Price) Unemployment Exchange Rate (vs $) Current Account Balance (bil.) Foreign Direct Investment(bil.) Foreign Exchange Reserves (bil.) Stock Price (1980 = 100)

1995

1996

1997

1998

8.7%

6.9%

5.9%

-5.8%

$10,037 4.5%

$10,548 4.9%

$9,473 4.5%

$6,823 7.5%

2.0% W774.7

2.0% W844.2

2.6% W 1,415.2

7.9% W 1,375.3

-$8.9

-$23.7

-$9.3

+ $40.0

$1.9

$3.2

$6.0

$3.8

$31.9

$29.3

$8.3

$38.7

882.9

649.2

388.7

342.5

Sources: Compiled from various publications of the Bank of Korea, Ministry of Finance and Economy,WISE Research Institute, and Samsung Economic Research Institute.

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S.J. CHANG

conglomerates in Korea. This is seen as a significant step towards enhancing Korea's battered competitiveness. However, the Big Deal, which is largely regarded as a bureaucratic concept, not a business concept (Mitchell, 1998), can be endangered if the nation's old guards, including labor unions, continue to resist the changes. Yet, the recent collapse of the once powerful Daewoo Group clearly indicates that Korea's chaebol problems were more serious than thought. Thus, the main focus of Korea's economic reforms has been on banks and chaebol. In other words, the crisis analysis has been narrowly focused on banking and chaebol business sectors. Not many people even pay attention to the lack of properly functioning direct financial markets (i.e. markets for stocks and bonds) in Korea. Yet, as Henderson (1998) suggests, the creation of a healthy domestic bond market can be offered as a specific remedy for the ailing banking sector. On the other hand, what need to be changed at a macro level are the government policies. For example, the policy that focused too heavily on exports as the main engine of economic growth or the policy that completely dictated private sector business should now go. More important, it is suggested that the crisis analysis should be more comprehensive, integrative, and holistic in nature. There are numerous formidable challenges to be tackled simultaneously in order for Korea's economic reforms to succeed. Perhaps, as S. Kim (1998) argues, a nationwide purge is needed. Hence, a holistic analysis of the crisis is in order. Figure 1 summarily represents a holistic assessment of the economic problems of Korea. Such a holistic approach can also be structured as a simple formulation of economic development: P=[3'X+e where P = vector of economic outputs that collectively determine economic progress, X = data matrix of variables affecting economic outputs, 13= vector of coefficients, and e = vector of random errors or exogenous shocks. In this structure, X includes not only various economic factors at macro and micro levels but also a variety of non-economic factors that directly and indirectly affect the economic performance. Examples include politics and government, education, science and technology, labor, welfare system, journalism, judicial system, civility, and even public mentality. Traditionally these non-economic factors have been implicitly treated as exogenous noise and thus relegated to random error terms e.

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Sociopolitical Analysis of the Korean Crisis

Government

Businesses

8,

Politics ~R.

Overi~clulation.

C~

~ansion Science 8,

~

e-trainingCo,st(~'lEconomyl 1 Inbreeding

Technology, Cost. Social Infrastructure

Fig. I. A Holistic Approach to Korea's Socio-Politico-Economic Structure.

In the following sections, major non-economic sectors of the Korean society are investigated in relation to their impacts on the economic failure. Such a holistic view will allow us to see the big picture. Namely, when the nation's all major sectors are dysfunctional, its economy finds no place to go but the drain. 3. P O L I T I C S A N D G O V E R N M E N T

- CRONY

CAPITALISM IN A CRONY DEMOCRACY While the global free market capitalism is ever closely linked with liberal democracy, so far South Korea has only produced a crony capitalism entrenched in a crony democracy at best. In the wake of the 1997 economic failure, the Korean bureaucracy is now forever stigmatized as incompetent and corrupt. In Korea, a chronic excess demand for politics driven by excessively high returns on political investments has been producing massive political bubbles which are nothing but a recipe for inefficiency, waste, and corruption. A

464

S.J. CHANG

statistic that quickly draws our attention is the number of elected parliamentary representatives in Korea. Koreans elect one representative for every 150,000 residents, whereas the corresponding numbers are 240,000 and 430,000 people in Japan and the United States, respectively. Political and governmental corruption in Korea has been so pervasive that people even coined such words as the 'Republic of Corruption' and 'Republic of Bribery'. One is even advised to visit jails in order to meet who's who in Korea. According to the Berlin-based Transparency International, South Korea's Corruption Perceived Index has been worsening from the rank of 27th in 1996, to 34th in 1997 and 43rd in 1998 among the 85 countries surveyed. Such political inefficiency, waste, and corruption would no doubt strain the economy. Besides, Korea's economic difficulty is largely attributable to the heavy-handed bureaucracy. The Korean economy had already grown so big and complex that it needed new sets of structure and framework, policies and rules, and tools and devices. Yet, the calls for new structures and policies have been completely neglected by the Korean politics and government. In particular, the call for a free market economy along with a liberal democracy was artfully snubbed by the overpowering majority of incompetent, inept, and corrupt political leaders and government bureaucrats. This is why many researchers point to the structural flaws in Korean economy and the lack of effective government policies as the direct cause of the economic collapse (Aiyer, 1999; Hyun, 1998; D. Nam, 1998; S. Nam, 1998; You, 1999). Maintaining a sticky symbiotic relationship with major chaebol companies, these ruling classes have been mainly looking to illegal means to accumulate wealth. Together, they would turn every creative idea and innovative thought into a heap of dust. Lofty goals are set, ambitious policies are formulated, and numerous committees and task forces are installed, but most of them produce no tangible outcome other than futile lip service. Desperate to upkeep their group interests, these politically motivated economic animals and economically motivated political animals would openly practice and pursue political expediency, nepotism, networking, and even nightclubbing. With all-controlling power and excess discretion, they would manipulate the economy and market at will. As the economy is overly regulated by the government's unmistakably visible and clumsy hands, those businesses without a strong political tie, especially small and medium sized industries, would suffer a great deal (Strom, 1998). For almost every businessman in Korea, the most important job is lobbying politicians, bureaucrats, and bank executives (You, 1999). Politicians accepted bribes from businessmen in return for favors in winning government contracts, and peddled influence in connection with bank loans. In Korea, businesses

Sociopolitical Analysis of the Korean Crisis

465

would have to feed the politics and governments with numerous kinds of politically motivated funds. Labeled as quasi taxes, these monies amounted to W10 trillion or about two percent of the nation's GDP in 1997. As the economy has to roll over unhealthy capital on a consistent basis, corruption inevitably follows in the form of illegal campaign finance, bribery, embezzlement, money laundering, kickbacks, slush funds, and other wrongdoings. The result is an economy that is largely driven by political incidentals rather than economic fundamentals. In this sense, the economic crisis was caused by collusive links among politicians, bureaucrats, banks, and chaebol. Although the Korean government keeps touting its firm commitment to a smaller and less intervening government (D. Han, 1998; MOFE, 1996), many stakeholders in the Korean economy are skeptical and still concerned about how many more wrists and ankles are yet to be unshackled. Some are even worried that the current crisis may induce resurgence of an omnipotent bigbrother government (C. Kim, 1998; Kong, 1998). Due to the preponderance of government bureaucracy in the Korean society, the level of government officials' accountability is pathetically low and the citizens' tax money consciousness is, in turn, all but nonexistent. Calling for a paradigmatic shift in Korean mentality, H. Lee (1998) argues that Korea's value system needs to move away from its long and deeply entrenched political collectivism to individual accountability. Korea must realize that global capital markets are now dominated by private flows, only a fraction of which is government money. More important, while the severance of politics-business ties must happen soon, it must also realize that economic development and stability cannot be achieved without democratic consolidation.

4. E D U C A T I O N , S C I E N C E , A N D T E C H N O L O G Y PSEUDO-COMPETITION

AND ANTI-CREATIVITY

Another bubble area in Korea that greatly stifles its economic effort is education. Education in the recent history of Korea has been simply teaching or preaching social obedience and conformity. It has been taming or domesticating people under a very rigid hierarchy where no flexible education is available for either the gifted or the learning disabled. As a nation, Korea suffers from a severe educational inflation or bubble, which in turn hurts its economy. Korea may have the highest per-capita Ph.D.'s in the world, but no Koreans have won a Nobel Prize yet. In his recently released book 'Criticism on Korea and Koreans', a Japanese writer Ikehara (1999) harshly criticizes Korean education from the very

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beginning. He states that mothers are responsible for teaching their children basic social rules before they enter primary school, but Korean mothers spoil their children with pampering and overprotection. Korean mothers think that everything their children do is okay as long as they get good grades at school, says Ikehara. But once again, the problem is not the lack of ideas but the lack of leadership, political will, and commitment. Noting the far-reaching significance of educational impact, W. Lee (1998) argues that unless and until bold educational reforms are carded out, all the other reform attempts by Korean people may come to naught. He particularly contends that the fatal flaw in the Korean education is the cramming system under which students are almost blindfoldly driven to memorize innumerable bits of 'knowledge' by rote. While rote memorization would lead to crushing of creativity and individual vitality, the cancer of after-school schooling, overly competitive college entrance, rampant corruption in teaching profession, and the influence of money politics would produce costly resource misallocation and social waste. Korean education suffers from misguided and misconceived missions at both parental/familial and governmental levels. The basic driving force behind Korean parents' craze for their children's education is that the diploma from a name value school means success based on future inbreeding of careers. Thus, education has been the foundation of career inbreeding in Korea. Particular concerns are raised over Korea's higher education system where academic inbreeding has been all but killing the competition between universities and between professors. Many researchers (Baker, 1998; M. Han, 1998; West, 1998) cite as major problems in Korean higher education, inadequate specialization or functional education, insufficient resources, rigid faculty hiring practices, and lack of credible accreditation process. In particular, West (1998) points out that their root cause may be found in Korea's Confucian heritage that accords undue prestige and political influence to academics. In Korea, argues West, deference to scholars all too often comes from a shallow credentialism that mistakes the presumptive status of an impressive institutional affiliation for real ability. Many professors, like bureaucrats, live by the 'safety first makes no enemies' principle. Feeling no dire need of honing their competitiveness, universities would mass produce mediocre graduates who are largely functionally incompetent. Businesses, in turn, find themselves re-training these ill-educated college graduates at a very high cost. The 1998 Report of International Competitiveness by the Switzerland-based International Institute of Management and Development (IMD) showed that Korea's productivity as measured by GDP per person employed ranked 30th out of 46 nations.

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Irony is that while voices are being raised against excessive economic intervention by government arms, such as the notoriousMinistry of Finance and Economy, not much substantial criticism is explicitly presented against the equally powerful Ministry of Education or Ministry of Science and Technology, whose whimsical caprice has been practically crippling the autonomy, competitiveness, creativity, and resource development of the Korean education. Apparently, many still do not realize that the most productive and efficient education systems also grow in a free market. So, here too, drastic reforms are needed. For example, Do away with the Education Ministry and free the Korean education. Such is suggested because, when properly fostered and utilized, education will once again enable Korea to share in the advance of global prosperity (Krause, 1999). A critical implication of Korea's dysfunctional education system is directly transpired in its science and technology sector. In a globalizing environment where economic competitiveness is largely dictated by technological edges, the seriousness of Korea's mal-educated science and technology looms large. The World Congress (1998) gives Korea's basic science a score of 4.3, while the U.S. gets a score of 10, Europe 8.2, Japan 8.0, and Taiwan and Singapore 5.1. However, the paucity of research institutes in Korea cannot be a contributing factor for its low ranking. There are some 60-odd major science and engineering research institutes in Korea, more than two thirds of which are government-affiliated. But many of them are nonviable research institutes established and maintained only for keeping mediocre people who are largely incapable of making any serious contribution. As policies are badly coordinated and research institutes squander good money after bad, Korea's science and technology sector also fails to promote individual meritocracy and innovative free market competition. Thus, it has been often said that in Korea bad researchers aren't fired, good ones aren't rewarded, and cronies are often chosen over qualified candidates for top positions in research labs and institutes. Baker (1998) notes that Korea's science and technology development has also been hampered by unproductive investment and inefficient management of R&D. Korea's public and private R&D expenditure was the sixth largest in the world as recently as 1995 but apparently yielded very low dividends. Baker further notes that the problem was aggravated by the previous administration when it churned five science ministers in five years. Right after the crisis Korea has seen the payrolls in public and private research labs drop by 8.7% and 6%, respectively.

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Some even present an argument that Korea's lagging science and technology as well as unproductive education is due in part to the dominant position of Seoul National University (SNU) in Korean politics, government, and education. SNU, Korea's most prestigious university has its graduates at major decision-making posts. For example, at any given time three quarters of Korea's cabinet members are alumni of the university. With a strong, efficient alumni network in every sector of the country, an SNU diploma is a necessary, if not sufficient, condition for success. As such, favoritism runs wild, competition is easily stymied, and efficiency suffers. Yet, a recent attempt to restructure SNU is vehemently opposed by its own faculty, among others.

. INDUSTRIAL AND SOCIAL INFRASTRUCTURE FAILING THE PREREQUISITE TO ADVANCED ECONOMY

-

Korea's economy and business has also been dragged by its severely underdeveloped industrial and social infrastructure. While education as an important pillar of Korea's social infrastructure is seen as highly dysfunctional, a broad spectrum of Korea's economic, industrial, social, and cultural institutions are also considered inferior. Korean businesses' global competitiveness has been hurt by the high social costs they had to share in relation to the nation's inadequate transportation and logistics facilities, pollution control, parks and libraries, and lynching journalism, fledgling social welfare system, and ineffective judicial system. Korea's notorious traffic jam, for example, directly translates into high costs and low productivity for its economy. A free hand estimate of Korea's annual economic loss due to traffic congestion is whopping W18.4 trillion which represents over four percent of its 1997 GDP or more than twice the cost of a new airport being constructed near Seoul. Transportation cost between Seoul and Pusan is 50% higher than that between Pusan and Singapore. Korea's outdated distribution system also drags its competitiveness. Korea has nearly 200 wholesale and retail outlets per 10,000 people compared with 167 in Japan and 100 in the U.S. Its far outdated and insufficient facilities in highways and byways, seaports and airports, labs and warehouses, electricity and gas, water and sewage treatment, information and communication facilities, and social welfare system mean a heavy burden to the economy.

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Already plagued by such environmental hampers as ozone rays, acid rains, and green tides, Korea is recently reported to have the world's highest sulfur dioxide and carbon dioxide concentration in air. Surprisingly or rather understandably, no rainbows have been spotted in the skies of Seoul Metropollutant City over the last four years. With nearly 90% of the population living in urban areas which represent less than 15% of the entire country, the problem of Korea's poor infrastructure looms large. On average Koreans produce 1.3 kg of garbage per day, compared to 1.0 kg for Japan and 0.9 kg for the U.S. All these diseases induced by substandard infrastructure are very costly to treat and cure, and thus pressing the economy as an unbearable dead weight loss. They not only hurt corporate Korea's export competitiveness but also discourage direct investment by foreign businesses. In the first place, Korea has been failing in an important prerequisite to economic viability. Pointing to the fatal collapse of a big bridge and a department store building as well as a series of gas explosion incidents in Korea over the recent years, some even go so far to say that the nation's whole infrastructure is about to crumble. Less visible but equally important is the economic impact of Korea's inferior infrastructure in noneconomic, nonindustrial institutions. For example, while it would be very difficult to figure exactly what negative economic impact Korea's severely dysfunctional journalism is causing on its economy, it is rather surprising to observe this obvious problem go largely unnoticed in Korea. It is Korea's untouchable holy cow, perhaps. In a very homogeneous and implicit society such as Korea, even an isolated anecdotal incident can easily be generalized into a pervasive phenomenon through publication in mass media such as TV and newspaper. Korean mass media have long been exploiting this point and through it they were able to muscle up their undue power and influence over the society. As such, once you fall out of the favor of Korean TVs and newspapers, you are in a very precarious situation where even a small misplay will attract a violent media lynch. Before you go on court trial, you have to go through media trial. To avoid this, therefore, government officials would often withhold truthful facts or sugarcoat press releases, whereas companies would bribe the media to publicize (or unpublicize) business reports. Such undue pressure from the media would mean constrained or even lost efficiency and eventually erode economic productivity. Exaggeration, inflation, over-generalization, and even outright falsification have been widespread in Korean journalism. The situation is partly attributable to Korean media's tendency to write by heart rather than brain. When feelings

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and emotions are put before logic and reasoning, audiences are driven to get angry, happy, sad, or excited very easily, quickly, and unduly. So, it was the media that indicted former presidents, pushed Korean people to host the Olympics and World Cup Soccer, and made the tenure of Korean cabinet members so short. S. Kim (1998) further argues that despite the fact that the freedom of press is upheld in Korea, it seems inordinately difficult to find examples of journalistic integrity, unperverted by commercialism or obvious political orientation. Thus, knowingly and unknowingly, Korea is paying a hefty sum of social cost due to its dysfunctional journalism. Although consensus opinion identifies the inflexibility in the modern segment of Korea's labor market as another stumbling block to its economic reform, not many seem to recognize that the problem is in large part due to the lack of an economically viable social welfare system. S. Park (1999) states that there is a huge 'blind spot' or 'dead zone' in the current social safety net of Korea. Stressing the dualistic and highly segmented nature of the Korean labor market, S. Park also points out the severity of structural unemployment problem due to the re-employment difficulty of displaced mid-career workers in Korea. This particular deficiency in social infrastructure renders Korea's labor market arguably one of the most rigid ones and its labor organizations one of the most militant ones in the world. No doubt, the inflexible labor market has been eating up Korea's economic profits and remains to be a major problem in the recent corporate restructuring campaign. To have a much more flexible labor market, therefore, Korea should work out the right kind of social consensus on the social safety net (Mitchell, 1998; You, 1999). The judicial system in Korea should also draw criticism in that it has not been on a par with the fast moving economy and business. Because of its inherently sticky relationship with the ruling politics and government, the Korean judicial system has often been found applying double standards, wielding too arbitrary and discretionary power, and being unable to function independently of political whims. Driven only by selfishness and popularity, Korea's juridical system has never been seriously conscious about the economic efficiency or business competitiveness in relation to its all-forgotten function as an economic traffic controller. With recurrent corruption scandals that involve judges, prosecutors, and lawyers of all ranks, Korea's judicial system has only been proving that it too is not immune to corruption. Again, the situation is that people willingly forgo efficiency and productivity for juridical and political expediency.

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6. PUBLIC MENTALITY- N O T H I N G I S I M P O S S I B L E , YET NOTHING IS POSSIBLE One characteristic that distinguishes Korean society from most others is its strong spirit of collectivism or comrnunitarianism and the resulting uniform mentality. The spirit of collectivism values and pursues a host of desirable virtues including respect for family and community, deference to authority and leaders, strong work ethic, group consensus and harmony, and sound morality. Some even argue that it is this communal spirit that allowed countries like Korea and Japan to attain high economic growth while avoiding rising crime, broken homes, out-of-wedlock births, and other social diseases commonly observed in the West. Nevertheless, excessive collectivism breeds harmful social bubbles. It not only kills competition but also stifles innovative, entrepreneurial, venturing, and enterprising spirit. The strong communitarianism in Korea has led people to a gross misunderstanding of individualism as selfishness. It has also yielded a social inertia that knows no diversity, flexibility, adaptability, versatility, or proactivity - virtues one dearly needs in today's constantly changing environment. It is notable that for whatever good or bad reasons, from flush toilet to internet and everything in between, not one major innovation in recent human history came out of a uniform society like Korea. Communal societies may produce chaebol and keiretsu but not entrepreneurial businesses such as Microsoft or eBay. They don't even have a good word for entrepreneurship (Dunn, 1998). As long as Korea maintains the mentality of 'Don't stick out, or else you get hammered', its economy will continue to struggle finding competitive edge in this highly innovation-driven global system. Another harmful aspect of Korea's strong group-oriented mentality is the almost incurable favoritism that has been so pervasive in Korea. Many Korean people would readily attest to the statement that in Korea three connections of blood, hometown, and school directly translate into three keys to success. For example, it has been empirically documented that a strong correlation exists between social ties and social advancement in Korea (Hwang, 1997). For those who are on the receiving end of this favoritism, nothing is impossible. However, for those who do not have any of these connections at the right place at the right time, nothing is possible. One may find it very surprising that South Korea, a country even smaller than the size of the State of Illinois, has so distinctively different regional dialects. More startling is that this small country known by its racial/cultural

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homogeneity is plagued by persistent regional prejudices, stereotypes, discrimination, nepotism, and favoritism. While researchers prescribe various normative judgments and moralistic exhortations on this national disease (Korean Psychological Association, 1988; Korean Sociological Association, 1990), Korea's deep-rooted regionalism, particularly between western (Cholla) and eastern (Kyungsang) provinces, persists only to prevent the balanced, integral development of the national economy. I. Kim (1999) argues that there is a strong mistrust among the Korean people which stems from collective rent-seeking behavior based on social ties. People use provincial ties as well as blood ties and school ties to create and maintain social rents for members at the expense of non-members.' Such collective rentseeking behavior tends to make people callous to social justice, and in fact, has been the bedrock of cronyism in Korea, contends I. Kim. On this narrow strip of Korean Peninsula, therefore, the ultimate unification between North and South may have to be preceded by the reconciliation between East and West. Favoritism turns into inbreeding which virtually eliminate real, healthy competition in a society. This, in fact, may be the root cause of Korea's widespread corruption. When true competition is replaced with buddyism and inbreeding, decisions are made haphazardly based on self or group interests as well as personal connections rather than merits and viability. Deprived of fairness and equal opportunities, even rule-abiding, otherwise innocent citizens would try to find a way to get around. Consequently, the whole society would engage in some kind of wrongdoing one way or another. This would, of course, affect the society's ethics, conscience, morality, and justice. Unfortunately, such was the case with Korea. In Korea, relevant contents and essential cores are all too often disregarded in favor of formalities, appearances, namesakes, and face savings. This has planted an extreme short-termism in people's mind. Impatient in realizing visible and tangible outright outcomes, the society is never content with gradual long-term progress or achievement. Kang (1998) is self critical in saying that while Koreans have been blessed with intelligence and stamina, they fall short on the side of vision. Preoccupied with here and now, they often do not see beyond immediate interests and forget easily, which is why they do not learn from their mistakes, laments Kang. According to a national survey conducted by Korea Gallup and Chosun Ilbo (1998), only those showy events like hosting the Olympics, joining the OECD (Organization for Economic Cooperation and Development), and producing the record-shattering golf prodigy Se-Ri Pak are regarded as Korea's most significant achievements over the last 50 years. Few would cite the nation's hard-fought, blood-shed democratic progress as a major achievement.

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Collectivism in Korea has also produced the so-called 'numero-uno syndrome'. Koreans are excessively obsessed with getting the best in everything they eat, wear, drive, or play. This syndrome is so prevalent that it actually turns many people into manias and cults who would pursue only top brands in every aspect of their life at any cost. The result is a vulgar crowd or blind populace who are not only economically irrational but socially dysfunctional. Unable to recognize, accommodate, or utilize the growing diversity in the world, Korea's outdated collectivism thus breeds uniformity, which in turn

produces favoritism, inbreeding, anti-competition, and subsequently formalities, short-termism, and numero-uno syndrome. Such ill-spirited mentality, coupled with quick-found affluence, has also promoted all kinds of unhealthy and unproductive social behaviorism. In fact, the quick-found wealth has turned these historically impoverished, plain-clothed people into the world's best-dressed (in terms of expense) and most golf-loving people. On average, Koreans drive around their cars over 23,000 km a year which is almost twice the Japanese average (12,000 km) and even more than the U.S. average (19,000 km). Korean people's annual eat-out expense averages to nearly 5% of GDP, while the respective figures are 4% and 3% for Japan and the U.S. In Korea 26,000 video rental stores are in operation, whereas the corresponding numbers are only 13,200 and 19,400 for Japan and the U.S. Presumably these are the bubbles that will burst abruptly if and when the economy experiences a sudden downturn. Korea's hard-pressed collectivism also almost naturally extends to a strong nationalism. Unfortunately, it, too, is a narrow minded, unfitting, and often distorted one. It is the kind of nationalism that resorts to people's patriotic emotions to promote socio-political agenda and propaganda. It is the kind of nationalism that would start a gold-collecting drive to ease the nation's foreign reserve crisis and organize a citizens group to save nonviable companies. Even the moniker for a newly-formed shareholder activist group, 'People's Solidarity for Participatory Democracy', seems to resort to such sticky collectivism or nationalism. While in other countries many nationally treasured, but economically nonviable companies, such as Pan Am and Rolls Royce, were let go, in Korea all too often the anti-productive nationalism rears its ugly head only to nullify any economic justification. This, too, undoubtedly has caused costly inefficiency in resource utilization and allocation. Poignantly criticizing all this unhealthy, irrational, and counterproductive mentality and behaviorism in Korea, Ikehara (1999) bluntly states that all in all Korea lags behind Japan by 100 years.

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7. C I V I L I T Y

ERA - STILL A

IN A GLOBALIZING

HERMIT KINGDOM? As shown in Table 2, the aforementioned IMD's 1998 Report of International Competitiveness ranks Korea's overall competitiveness 35th out of 46 nations (38th out of 47 in the 1999 report). The report, which was based on an extensive survey in eight categories covering 223 items, ranked Korea 22nd in human resources, 28th in science and technology, 31st in social overhead capital (SOC), 34th in three categories of government, domestic economy, and business management, 45th in financing, and 46th in globalization which is the dead last. So, Korea's globalization is the lowest in the world! The level of globalization was measured by analysis of various factors, such as protectionism (Korea's rank: 46th), cultural openness (46th), venture business abroad (45th), and immigration laws (45th). Korea is so un-globalized. Although Korean people may like to hear other people referring to Korea as the 'Land of Morning Calm', Korea is still viewed as a country that is tightly shut to the outside. For long, foreign investors and business people have been complaining that they cannot invest or do business easily in Korea because the nation is too closed. They find high barriers and walls in every economic sector in Korea; trade, capital movement, foreign exchange, stock market, labor market, and so forth. Not only that, they are also critical about 'the Korean way of doing

Table 2.

Korea's International Competitiveness: 1994-1998

Ranking out of 46 countries surveyed in eight categories: Human Resources, Science and Technology, Social Overhead Capital, Government, Domestic Economy, Business Management, Financing, and Globalization

1994 1995 1996 1997 1998

Hum Res

Sci & Tech

SOC

Gov

Dom Econ

Bus Mgt

Fin

Glob

Overall

23 21 22 22 22

24 24 25 22 28

36 35 34 34 31

35 18 33 32 34

9 7 4 13 34

37 27 28 26 34

42 37 40 43 45

44 40 43 45 46

32 26 27 30 35

Source: Reports of International Competitiveness - 1998, International Institute of Management

and Development

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business' which is far different from, and far short of, the prevailing global standards. However, it is not just this un-open, un-globalized business environment that has been hurting the Korean economy's overall viability. Equally critical is Korean people's un-open, un-globalized mindset. It is the kind of mindset that judges a thing wrong if it is different from most others. It is the kind of mindset that does not allow Toyota cars to roll on the streets of Seoul. Yet, it is the kind of mindset that believes globalization can be achieved by just going abroad on a back-pack trek, golf tour, language training, or filial sightseeing. Quite possibly, people's rigid, un-globalized mindset has been the single most important deterrent to the growth of Korea's civil society. Living up to their popular slogan, 'body and soil are inseparable', the general civility of Korean society is yet to get off the ground. While those already globalized countries have been reaping the fruits of crosscultural interaction, cooperation, and synergy through global business transactions, Korea has only been experiencing intercultural misunderstanding, conflict, or collision. While the misguided globalization spirit has led Korean consumers to spend millions of dollars through stupendous luxury consumption, we would never know what other costs Korea had to pay all these years due to its low civility. Recognizing this difficulty of 'globalizing Korea', a local intellectual recently has made a suggestion to adopt English as Korea's official language, thereby provoking another round of hot debate over nationalism versus globalism (Y. Han, 1998). But whenever they find a confrontation between the West-based rationalism or pragmatism and the East-based metaphysical value system, most Korean intellectuals seem to be willing to forgo the concept of globalization and refute the ideas of market efficiency, competition, and innovation. Steinberg (1999) argues that Korea has one of the highest levels of nationalistic sentiment and that sentiment often affects its domestic and foreign policies negatively. It is sad to note that all these years Korean intelligentsias, including hard-minded politicians, have turned deaf ears to calls for noblesse oblige of globalizing the people's mind. They have only worked to advance personal and partisan interests, rather than to exercise their power to help other people. Sympathetic with this view, Korean President Kim Dae-jung recently asserted that his government will strive to promote a nationwide reform of spirit to help Koreans adapt to globalization and to discard unfavorable legacies of nationalistic sentiments (D. Kim, 1999). In this context, it is important for Korean people to realize that globalization does not mean Westernization. Never, because neither the Western nor the Eastern system is intrinsically good

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or bad. Rather, it means diversification, interaction, multifunctionalism, mutual understanding, cooperation, assimilation, and unifying. So, it means unity with diversity, not uniformity with division as seen in Korea all throughout its history. After all, it is important to remember that, as M. Han (1998) quips, it takes advanced mentality, cultures, and visions, not the production of DRAM chips, to transform a nation into an advanced one. As Krause (1999) argues, it is clear that Korea cannot revert to the Hermit Kingdom in order to avoid shocks from abroad and at the same time sustain a high level of per capita income. That is because the all-inclusive nature of the ever-growing global system virtually prohibits any economy from opting out of the system. 8. C O N C L U S I O N

- IS THERE A SILVER LINING?

In this day and age of diversity, sophistication, and integration, nothing is totally isolated from others. An economic issue is not just an economic issue. In particular, a national economy can and should be approached from a holistic perspective which incorporates all relevant factors, elements, and resources, whether economic or not. This is consistent with a micro-level integrative approach often seen in business management, such as the total factor productivity. Here, a national economy is viewed as a multifunctioning complex whole whose overall productivity is collectively determined by all of its parts. One should look at the substance and process of satisfying conflicting goals for the whole rather than examine each element separately (Doz & Prahalad, 1997). Optimization is attained when all the resources are simultaneously engaged up to their capacity. Judging from this angle, the Korean economy was almost bound to fall. Every major sector in Korea has been seriously dysfunctional and counter-productive. Fortunately, throughout 1999 the South Korean economy has shown strong signs of quick recovery. While the unemployment rate is expected to remain high, Korea was able to accumulate $74 billion of foreign reserve in late 1999 thanks largely to its record $40 billion current account surplus in 1998. The benchmark yield on 3-year corporate bonds, which once soared over 30% is now tamed down to a 10% level and inflation rate was cut down to a record 0.8% during 1999. All these mean a very healthy and surprising 10% economic growth in 1999. However, difficulties and challenges still abound. Pains from a prolonged high unemployment rate will be felt. Trial and error will be repeated as the

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competition-based true market economy is experimented. Businesses and households will also suffer from financial crunch as capitals are channeled to improving technology, R&D environment, and other industrial and social infrastructure. Groups with strong vested interests in the old system, including organized labor and big businesses will continue to resist changes. Creating a slim and effective government will also face bureaucratic resistance. All these dismal talks notwithstanding, Korea may still have potential for a brighter future. Fortunately, not everything went down the drain. Riding a very steep learning curve, Korea has been able to accumulate some knowledge and experience needed for global survival. It has been able to lay the foundations necessary for building economic resilience and sustainability. But in order to turn this hope and possibility into reality, all-out efforts need to be mobilized from every area. Specifically, for example, Korea should develop a legitimate bond market, more flexible labor market, internationalize its won, develop more competitive and transparent corporate environment, employ stockholders-oriented management strategies, and develop a full fledged futures market for effective risk management. Even at the risk of transitory market turmoil, the government should, once and for all, withdraw its clumsy hand and let the market rule so that those companies that lost competitiveness should go. On other sides, Korea should merge and consolidate research institutes and organizations, reward young creative and innovative minds, and encourage a new research culture. It should make a forceful, and if necessary, artificial effort to diversify success. It should mix all regions of the country, mix as many universities as possible, and mix gender (M. Han, 1998). It should pursue some revolutionary changes in its labor market, journalism, judicial system, and other infrastructural institutions. It should also free the society from the shackles of tyranny, networking, and inbreeding. It is particularly important to ensure efforts be funneled to the growth of civil society by eradicating regionalism, nepotism, cronyism, uniformity, and rigidity from people's mind. Korea and Korean people should seriously think what it means to be a globalized country and a globalized citizen. Total rethinking is needed. Rather than some gradual or incremental changes (K. Lee, 1998), complete reforms and paradigmatic shifts are called for in every major sector in Korea. To succeed, it will take a great deal of moral courage on the part of the nation's leaders, government bureaucrats, banks and businesses, and people in general (You, 1999). Then, only then, hopefully Korea can be born again. This time, not as a miracle, but as a legitimate outcome of well planned, sincere, concerted efforts.

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ACKNOWLEDGMENT D a t a q u o t e d in this chapter w e r e o b t a i n e d f r o m the recent publications o f various institutions i n c l u d i n g Bank o f Korea, BusinessWeek, International

Institute o f Management and Development, International Monetary Fund, Korean Ministry o f Finance and Economy, Samsung Economic Research Institute, Transparency International, U.S. Institute f o r Policy Studies, Wall Street Journal, WISE Research Institute, Worldwatch Institute, as w e l l as K o r e a n newspapers. R e a d e r s are a d v i s e d to note the a p p r o x i m a t e nature o f m a n y o f the q u o t e d n u m b e r s . )

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Kim, I. (1999). Korea's growth potential and crisis management in a changing intemational environment. Korea and the Asian Economic Crisis: One Year Later, Joint U.S.-Korea Academic Studies, 9, Korea Economic Institute of America, 63-82. Kim, S.-h. (1998). Land of the morning clatter. The Korea Times, (October 27). Kong, B.-h. (1998). Government cannot replace the market. Korea Economic Weekly, (August 3). Korea Gallup, & Chosun Ilbo (1998). National Surveys on Korea's 50th Anniversary, (July). Korean Psychological Association (1998). Regionalism from Psychological Perspectives, Sungwonsa, Seoul. Korean Sociological Association (1990). Korea's Regionalism and Regional Prejudices, Sungwonsa, Seoul. Krause, L. B. (1999). The Koran economy in a changing international environment. Korea and the Asian Economic Crisis: One Year Later, Joint U.S.-Korea Academic Studies, 9, Korea Economic Institute of America, 51-62. Lee, H. K. (1998). A paradigm shift in Korean mentality. Korea Economic Daily, (October 31). Lee, K.-T. (1998). Korea's economic transition: a new growth paradigm. Korea Economic Update,, 9--4, 1-4. Lee, W.-s. (1998). Urgent need for educational reform. The KoreaHerald, (June 29). Mitchell, T. (1998). Korea's successes in the great recession. Korea Economic Weekly, (September 14). MOFE (Ministry of Finance and Economy) (1996). Shared Interests, Shared Rewards: The KoreaU.S. Global Partnership, (September). Nam, D.-W. (1998). The financial crisis in Korea. Korea Economic Update, 9-1, 1 4 . Nam, S.-W. (1998). Overview of the Korean economy: Its success and crisis. Building a Global Education Community for the 21st Century. KDI School, 63-84. Oh, J. N. (1998). Korea's financial and corporate restructuring program. Korea Economic Update, 9-2, 1-4. Park, S.-I. (1999). Labour market reform and the social safety net in Korea. Korea and the Asian Economic Crisis: One Year Later, Joint U.S.-Korea Academic Studies, 9, Korea Economic Institute of America, 201-220. Park, Y.-C. (1998). Financial Liberalization and Opening in East Asia, Seoul. Steinberg, D. I. (1999). American perceptions of Korea. Chosun llbo, (March 8). Strom, S. (1998). The perils of being small in South Korea. The New York Times, (September 8). West, J. W. (1998). Korean universities: Shallow credentialism. The Korea Herald, (August 24). WISE Research Institute (1998). Macro-economic trend and forecast for Korean economy. Korea Economic Weekly, (September 14). World Congress, IT World Congress 1998 Press Release (1998). Available at http://www.worldcongress 1998.org/ You, J.-K. (1999). Paradigm shift in Korea. Korea and the Asian Economic Crisis: One Year Later, Joint U.S.-Korea Academic Studies, 9, Korea Economic Institute of America, 9-20.

BUSINESS IN ASEAN'S CORE: POSTCRISIS OPPORTUNITY AMIDST THE ECONOMIC DEBRIS Zafar U. Ahmed, Frank L. Bartels, Tan Teng-Kee and John R. M. Gordon INTRODUCTION 'Much of East Asia's dramatic growth is due to superior accumulation of physical and human capital'. IMF/World Bank It is an article of faith that between 1965 and 1995, the high performance Asia Pacific economies - the so-called 'tiger economies' - out-performed most of the other developing countries of the global economy. The areas of above average economic performance were several, namely: (a) building human and social capital; (b) maintaining the high savings rates; (c) ensuring a highly flexible labour market; (d) absorbing foreign technology; and (e) state promotion of exports in general and specific industries in particular with the help of Multinational Enterprises. The policy environment that created the performance has been framed by public investment averaging 15% of GDP and private investment averaging 15-20% of GDP over the period 1965 to 1995. The regional dimension of the performance, an intra-regional effect, has produced a positive compounding effect on the individual countries.

Asian Financial Crisis, Volume 1, pages 481-501. 2000 by Elsevier Science Inc. ISBN: 0-7623-0686-6

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Table 1.

Basic Regional Economic Indices % ANNUALAVERAGEGDP GROWTH

COUNTRYOR REGION CHINA HONG KONG INDONESIA MALAYSIA PHILIPPINES SINGAPORE S. KOREA TAIWAN THAILAND OECD

GDP/HEAD 1970-96 1996 US$ 3,120 25,400 4,280 9,703 3,060 25,650 12,410 17,720 8,370 22,700

1997 1998 1999 ESTIMATE FORECAST FORECAST

9.1 7.5 6.8 7.4 3.6 8.2 8.4 8.3 7.5 2.7

8.9 5.1 5.4 7.4 4.8 7.6 5.6 6.3 ~).7 2.8

6.3 1.8 -5.2 1.6 1.9 2.7 -2.5 5.0 -4.0 2.6

7.5 3.8 2.9 1.8 4.0 5.0 1.7 5.7 3.7 2.6

Source: The Economist7th March 1998.

A SYMBIOTIC ECONOMIC AND SOCIAL CRISIS ' You don't stabilize the exchange rate by killing the economy. High interest rates and fiscal austerity will impose widespread bankruptcies'. Jeffrey Sachs After the devastation, before the desperation, there was denial by governments of Association of South East Asian Nations (ASEAN) countries that there was anything wrong with their 'economic miracle'. When the currency devaluation, and subsequently the financial and economic crisis, struck South East Asia like a typhoon in 1997, governments were unprepared. While being dealt a stinging blow by the invisible hand of uncompromising global capital markets, ASEAN continued to underestimate not only the scale and scope of the crisis but also the requirements for regional recovery. ASEAN's economic crisis is attributable to the conjunction of rigid macroeconomic policies and imbalances in economic variables with imprudent, politically driven state interventionism in the economy and its concomitant investment policy. Local banks, on the one hand, were poorly regulated and inadequately supervised. On the other hand, often treated as the treasuries of businesses, they were pressured by governments or corrupt connections to lend - the archetype of 'Crony Capitalism'. The result? Too many bad loans in developing Asia Pacific including Japan as well. Asia Pacific had a Nonperforming Loan portfolio of some U.S.$1.781 trillion as at 1997.

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In South Korea, citizens donated 222.3 tones of their own gold, worth U.S.$2.08 billion to the state. In Thailand, there was a 'Thais help Thais' campaign, and 126 kg of gold was collected from members of the public in a pathetic attempt to help the country out of its economic desperation, social deprivation and desolation. The social depravations across Asia Pacific from South Korea (where suicides have shot up 25%) to Indonesia (where hungry folks are rioting and raiding warehouses and crop fields) have not been avoided.

ASEAN'S FIRST TASKS: PSYCHOLOGICAL ACCEPTANCE AND TRANSFORMATION To American executives and business people watching the debacle, these individual efforts are bandages, when what is presumably essential is triple bypass surgery - the conditionalities of Structural Adjustment imposed by the IFM and World Bank. However, these may be abandoned in the face of challenges to authority and the desperate bid to hold the social fabric of civic society together. Can business be carried out across Asia Pacific without civic order? The IMF's U.S.$17.2 billion rescue package for the Thai economy awarded on August 11, 1997, came with its standby and other credit facilities and a strict prescription of frugal government spending, money supply limitations and higher interest rates. These measures were designed to restore the much-needed confidence of foreign and domestic investors. The IMF's prescriptions required ASEAN countries in trouble to completely overhaul their banking and financial systems. The overhaul is required so that these economies, liberalizing and deregulating to take advantage of globalization, are in line with prevailing free-market principles of openness and transparency. IMF's loans are being disbursed in installments, and only when the afflicted countries adjust appropriately. Unfortunately, it is apparent that these structural adjustments are being implemented on a piecemeal basis. Some countries such as Indonesia, still administered by the unhealthy obligations of cronyism, do not appreciate the prerequisites and it has even evoked the constitution to argue against IMF conditionalities. The reward for compliance is somewhat encouraging. Since the IMF brokered the package for Thailand, its stock market and currency have begun to show signs of resilience. The bludgeoned Thai Baht has recovered a little, and is trading in the range of 40 to 45 to the U.S. dollar - a far worse position when compared to June 1997 when 25 Baht could buy a dollar. However, it is healthier than the record 56.70 it plunged to in January 1998. For the IMF, the improved health of Thai economy is proof enough of the efficacy of its cures.

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In Thailand, incentives for corruption have declined with changes to the political system and with banking reforms underway. However, even as these economies struggle to cope with these changes, there is the question, increasingly asked - is it not only the countries themselves that need to reform but also the international financial system.

IMF: A TOUGH TASK M A S T E R Currently, the local feelings across Asia Pacific are that every country has to follow whatever the IMF orders. Some critics are asking how much of the pain of structural adjustment ASEAN can take. High interest rates create more bankruptcies, raise unemployment and deepen already serious social problems (the once touted South East Asian economic miracle in reality was limited to urban Asia - rural Asia is still desperately poor). Others argue that IMF treatment, while it may not be the best, is the only solution for troubled economies. Moral hazard is a key issue that emerges in the problems of governments and their profligate private sectors (the cause of some aspects of the current problems). This issue goes to the heart of the arguments raging about what is best for Asia Pacific. Of the troubled countries, Indonesia is the most virulent in its argument against the IME There are signs of a change albeit far from strong. The IMF has resolved to be flexible, aware of the country's humanitarian concerns, as food riots flare up and ethnic tensions escalate, as price inflation gathers pace and with the looming prospect of ballooning unemployment for millions of impoverished souls. If there is an upside to the crisis, it is that the questionable practices of cronyism and opacity in business (and government) transactions are under greater scrutiny than ever before. The IMF typically decrees that cartels - and businesses linked to government - must be broken up and de-linked from government to allow for greater competition and transparent practices. ASEAN countries, Thailand and Philippines in particular, have agreed to institute transparent management practices, privatize extraneous and inefficient corporations and focus on providing coherent policy and setting the macro-economic climate for investment and growth. Across ASEAN critique of IMF reforms, and its requirement for good governance and transparency in the management of the economy, is leading to the belief that the magic of free market economy works only for those who can afford it. This view is creating a backlash against capitalism.

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FROM FORTUNE TO OPPROBRIUM 'The way they raised standards o f living f o r so many people in a single generation was completely unprecedented'. Vinod Thomas - World Bank

Economist In three decades, the ASEAN economies have taken their masses from postcolonial poverty to the kind of prosperity few believed possible. However, since March 1997, the ASEAN miracle has looked like a mirage. In the 1998 'Year of The Tiger', the Asian currency and financial crisis is arguably the first, and it will be viewed in retrospect as the most significant, 'event horizon' of the post-modern era of globalization and economic inter-dependency. In a few eventful months, the so-called 'tiger economies' have been cut down to size. With hindsight, however, the hubris and iconography had all the hallmarks of the proverbial pride that comes before a fall. Here are a few examples: Thailand: During the early 1990s, the newly rich snapped up luxury cars, built and bought condominiums, and paid extravagantly for golf-club memberships. The skyline of Bangkok had pretensions of rivaling cities across the U.S., Japan and Europe and with the stock market soaring, 'Wall Street bonuses' were commonplace. Of all South East Asian nations, Thailand seems to be taking the structural adjustment prescription of the IMF most seriously with a consistency that is admirable. Although its crisis is far from over, it has not displayed uncertainties and ambivalence towards the foreign investor. Malaysia: Confidence in the economy fuelled a number of exuberant and mammoth prestige projects such as the Pretronas Twin Towers, the world's tallest buildings, now complete, but having only 50% occupancy. To complement the world's tallest building, Kuala Lumpur decided to construct the world's longest building - a linear city but was later scrapped. Since the heady days of pre-June 1997, Dr. Mahathir has taken Malaysia down the road of capital controls. In an attempt to ring-fence the Malaysian economy from the aggression of global capital markets and stem capital flight arising from portfolio investment and Foreign Direct Investment (FDI), investors have been 'locked' into Malaysia unable to make market efficient decisions. Indonesia: The Suharto regime applauded by a World Bank report portraying the country as a model for other developing countries, promised Jakarta more condominiums, more luxury hotels, and more shopping malls crammed with designer boutiques. Over ambitious growth in the number of banks (over 200) and the obsession with the national car project as well as building an aerospace industry further boosted an already over-inflated 'national ego'. A mega bridge - the friendship bridge - across the straits of

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Malacca, promised as a mark of nationhood, has been shelved. Since mid-1997 the scene has completely changed - a new regime is in place but its tenacious links with the previous regime remain strong. Rioting students continue demanding an overhaul of the socio-political system of relationships between the government and the governed. The civil chaos, with its fully exposed undercurrent of ethnic strife, has made foreign investors suspend their investment plans for Indonesia.

THE ROOT CAUSES OF ECONOMIC CRISIS The components of the financial crisis across ASEAN were assembled over the past 15 years on the high-octane fuel of portfolio investments in emerging markets and in-flows of FDI. There are technical and social reasons that have interacted to generate the contagion of the Asian Crisis (see Exhibit #1 for Asian Crisis - Pre and Post Economic Model). The technical explanations focus on asymmetric relationships in globalization and liberalization associated with precipitate deregulation. In short, Asia's financial sectors, which have immature banking systems, were unable to manage efficiently the rapid accumulation of FDI and availability of international and domestic credit. The social reasons involve an unfavourable mix of distorted self-assessment of values by Asian nations - with misconceptions of 'regional cultural theory' that led to uncritical choices for investment, hubris and the excesses of 'crony capitalism'. The distress was manifest by a crisis of confidence in capital efficiencies and government authorities' ability to continue defending their U.S. Dollar pegged currencies. Excessive foreign 'off-shore' borrowing by banks, corporations and investors on short-term basis went into property, stock market speculation and unproductive expansion. Weaknesses in the regulation of national banking systems made reckless borrowing for asset investments possible and this in turn, led to unrealistic accounting practices (which incidentally started in Japan in the 1980s). It is no wonder that Japan's banking bad debts (a significant proportion of which are loans to ASEAN) are some U.S.$1.122 Billion (30% of GDP) twice the previous best estimates! (see Exhibit #2 for diagram of Japan's relationship to the Asian crisis). Borrowing by banks in South East Asia was U.S.$241 Billion or 62 per cent of the Bank of International Settlements (BIS) lending to all of Asia Pacific by the end of year 1997. The sharp rise in regional short-term external debts occurred without accounting for exogenous global macro-economic risks. Table 2 profiles emerging market external debts and debt servicing.

Business in Asean's Core: Post-crisis Opportunity Amidst the Economic Debris

487

A measure of credit available to Asia as a whole is provided by the sobering detail that, as of end-1997, European banks had a loan exposure of U.S.$320 Billion to the region. In comparison Japanese banks had an exposure of

..2 _.J Technical and Social Agitator(s): * • • • • •

Excessive Private Sector Debt Financing Abuse of Closed Private Sector & Government Relations Cronyism & Corruption Poor Banking Reform Aggressive tMF Measures Administration International C u r r e n c y / E q u i t y T r a d i n g

© Economic Rebound:

Banking Reform: • •

•

Write-off Non Performing Loans Bank Mergers

• •

G l o b a l S t a n d a r d Best

Practice:

• • •

Productivity Profitability Quality

•

Shareholders value

• •

Strategic Mindedness Business Process Focus

•

*

Guanxi & Market/ Customer Driven Opportunity

• •

Strategic Alliances with MNCs Korea Supersonic Recovery Thailand Economic Pickup Malaysia Higher Than Expected (7%) Economic Growth Singapore Productivity Gain Increased Japan & Asian Consumer Confidence

Exhibit 1. Asian Crisis - Pre and Post Economic Model.

488

ZAFAR U. AHMED ET AL.

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Business in Asean's Core: Post-crisis Opportunity Amidst the Economic Debris

Table 2.

489

External Debt (US$ Billions) and Debt Servicing (% of GDP) EXTERNAL DEBTS

DEBT SERVICING

Country

1996

1997

1996

1997

Indonesia Malaysia Philippines Thailand

49.8 38.8 50.1 49.0

188.7 68.9 79.7 97.1

5.9 5.4 7.4 4.7

19.1 8.1 10.6 9.0

Source: The Strait Times, Thursday, January 22, 1998 p. 46 Note: 1997 debt burden is computed using exchange rates on January 16, 1998.

U.S.$260 Billion while U.S. banks had an exposure of U.S.$46 Billion. These figures are quite likely to be grossly underestimated (if comparisons with the Mexican debt crisis are a guide). Private sector companies were the main culprits and governments of the emerging countries may be censured for failing to institute 'financial discipline'. External debts and the debt servicing increased in 1996 and 1997 due to explosive growth in bank lending. Lending to the private sector took place in the context of a rapid economic boom in the second half of 1980s that continued until the collapse of investor confidence. The growth in bank lending in these Asian emerging markets between 1994 to 1996 is represented in Table 3. In Thailand, the crisis was precipitated by the discovery of an astounding cover-up on June 25, 1997 by Thailand's Finance Minister: Thailand's reported foreign reserves of over 300 billion Baht were a myth. They had dwindled to

Table 3. Indonesia Malaysia Philippines Thailand Singapore

Growth in Bank Lending 1994-1996 (%) 22.4 23.9 30.2 22.0 15.8

490

ZAFAR U. AHMED ET AL.

1.14 billion Baht, equal to just two days of imports. Clearly, the financial system had become a black hole. The situation had come about because of the growing trade gap. Thailand had been importing more than what it was exporting. This trend translated into falling demand for Baht to pay for Thai goods, compared with the demand for foreign currency. If the Baht had been free-floating, this falling demand would have caused it to decline steadily in value. However, its fixed-exchange-rate policy meant that the government had to keep buying Baht to maintain its demand and thus its value. Meanwhile, observant outsiders - (the world's currency speculators) - a breed interested only in profits, had spotted this fundamental weakness and 'shorted' the Baht. They realized that if they kept selling Baht, the government would keep buying, paying from its foreign reserves. With its growing current-account deficit and declining foreign reserves, Thailand lacked the stamina for a currency war. Finally, on July 1, 1997 bankers and the media were given a wake-up call at 4.30 a.m., summoning them to a meeting at the Bank of Thailand. There, the bombshell dropped: the Baht would be floated. In the after-shock Thailand would be asking the IMF for 'technical assistance'. Almost immediately, the value of the Baht plunged some 15%, from 25 Baht to the U.S. dollar to a record low of 29 Baht. It continued sliding through the rest of 1997, reaching a historic low of 55 to the dollar, before stabilizing only recently at the 40-45 range. These events in Thailand set off a chain reaction. The currency speculators thought, if this was happening to Thailand, what about the other tiger economies - Malaysia, Indonesia and Philippines? Speculators attacked ASEAN currencies. To maintain their values, the respective ASEAN central banks were forced to buy them up, spending their precious foreign reserves in the process and enriching international currency speculators who made huge profits. Before long, the awful truth would hit home: international capital markets were more powerful than ASEAN governments. Malaysia's imposition of currency controls in September 1998 is a reaction to this sentiment widely felt across Asia. According to one Malaysian Central bank Official - "We just kept soaking up the Ringgit, throwing away more and more American dollars, and they had more and more Ringgit to unload." Based in international capital cities, global hedge artists - (the likes of Sloane Robinson, Julian Robertson's Tiger Fund and George Soros' Quantum Fund) - had billions with which to gamble. Along with currencies, global confidence in ASEAN economies crumbled. Nervous foreign investors began seeking other locations for better long-term returns on capital. The London Financial Times in reacting to the meltdown expressed the sentiments of many

Business in Asean's Core: Post-crisis Opportunity Amidst the Economic Debris

491

in the international banking industry.- "the carnage of Asian currencies was a fast spreading plague capable of debilitating any country."

THE SOCIAL COST OF THE CRISIS Across the Asia Pacific region - citizens, wealthy and poor alike, struggle to make sense of what has happened to their 'miracle'. In addition to rising unemployment and shrinking earnings and savings, serious civic and social problems (such as disturbing ethnic and destabilizing racial dimensions in Indonesia) have surfaced across ASEAN to make matters worse. Rising prices of basic necessities in Indonesia, for instance, have sparked off panic buying, hoarding as well as riots and looting of shops (usually the ones owned by ethnic Chinese), crops in the field and warehouses storing everything from timber to coffee. The depreciation of the Indonesian Rupiah (80% at its nadir) has meant that ordinary Indonesians cannot afford to buy rice, sugar, flour, or infant milk. The extreme social dimensions of the Asian Crisis implies that the normal 'investment climate' of ASEAN, made up of the social infrastructure which permits business to be done reasonably, has been all but destroyed. Investors from the U.S., and other sources, view these developments negatively. New investments in most sectors of the Indonesian economy have ceased.

CASE STUDIES OF T H R E E A S E A N C O U N T R I E S T H A I L A N D : FIRST INTO THE CRISIS - FIRST OUT OF THE CRISIS? The Setting

The Chuan government, elected to power in November, 1997 has so far achieved the targets set under the U.S.$17.2 billion IMF package, aimed at tackling the country's current account deficit, improving its cash position, and increasing its foreign reserves. Facing social resistance, the government is sticking to the tough conditionalities of the IMF rescue package aimed at restoring confidence effectively and wooing back foreign investors. Thailand is, in some ways, at the mercy of its neighbors and their management of their economic hardships. Eventually the East Asian Crisis will end. However, when

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it does, Thailand will be able to point to its record of good governance, and IMF compliance, as evidence of its attractiveness to foreign investors. Thailand's Economic Indicators 1991 1992 1993 1994 1995 1996 1997e 1998f Real GDPGrowth(%) 7.89 7.40 7.80 8.80 8.60 6.70 2.00-8.00 Exchange Rate vs. U.S.$ 25.28 25.52 25.54 25.09 25.16 25.61 52.00 50.00 (year-end) Inflation (CPI %) 5.72 4.10 3.40 5.20 5.70 5.90 7.90 13.00 Source: PERC: Note; e - estimated, f - forecast What's Needed

Thailand took action to close down 56 cash-strapped finance companies by December 1997 despite the loss of jobs for 25,000 employees. The government acquired control of four medium-sized commercial banks to pre-empt their possible failure. The Thai government also raised provisions for nonperforming loans to initiate the process of bringing liquidity back into the system. It has already suspended or eliminated unnecessary infrastructure projects. It has also scrapping plans to purchase eight F-18 fighter jets and has gone ahead with the moth-bailing of the recently purchased aircraft cartier. Its other revolutionary measures have included: reducing ministers and civil servants' salaries by 20%, and raising levy/taxes on petrol, liquor and imported cigarettes. However, it ought to open up its economy more by relaxing rules on foreign ownership of Thai companies and property. It could do so by letting foreign investors buy into state-owned enterprises in telecommunications and infrastructure. And the Future?

Current account balance is negative but the deficit is shrinking slowly. Short term debt is about 180% of foreign exchange reserves and unlikely to improve soon. GDP is expected to contract by -8.0% in 1998 and rise to 2-3% in 1999.

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INDONESIA: A M A J O R C A L A M I T Y The Setting

President Suharto was re-elected for a seventh consecutive term in March 1998 but was ousted by May, 1998. In the interim, his 'new-look' Cabinet (including daughter Tutut and long-time pal Bob Hasan) made a mockery of following the conditionalities of the IMF U.S.$45 billion bailout package without any serious commitment to compliance. Prospects for meaningful economic reform under President B. J. Habibie were gloomier than the optimistic statements of government. As far as the foreign investor is concerned, economic policymaking is in free-fall. Events in Indonesia are in crisis with the country descending into a vicious spiral of civil, economic, ethnic and political chaos. No one can be optimistic in the present scenario as Indonesia confronts the most serious socio-political and socio-economic crisis since independence. Portfolio investors have nothing to look forward to - nearly all the listed firms on the Jakarta Stock Exchange are bankrupt. The currency, having plunged to 20% of its value against the U.S. Dollar within a year, oscillates wildly on the international foreign exchange market. The banking and financial system intermediation has collapsed. The civil order is threatened by hyper-inflation, food shortages, hoarding, unemployment and the greatest increase in the poverty rate experienced with 70% of the population below the poverty line.

Indonesia's Economic Indicators 1991 1992 1993 1994 1995 1996 1997e 1998f Real GDPGrowth(%) 6.62 6.10 7.25 7.48 8.20 7.80 4 . 5 0 - 1 5 . 0 0 Exchange Rate vs U.S.$ 1,992 2,062 2,110 2,200 2,308 2,361 5,200 15,000 (year-end) Inflation(CPI %) 9.24 5.00 9.70 8.50 8.60 6.60 11.00 65.00 Source: PERC: Note; e - estimated, f - forecast What's Needed

Indonesia needs a cessation of the economic policy-making free-for-all in which cronies attempt to generate magic formulas for turning around the nation. Indonesian government has already closed 16 banks and merged four ailing state-owned banks. It has also established a 'National Banking Restructuring Agency' to oversee the rehabilitation of other ailing banks. It has

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revised economic forecasts in 1998/99 budget to more realistic levels. It ought to stop financial support for state plane manufacturer, IPTN. It should also cancel major infrastructure projects. It should open up the economy to outsiders by abolishing ownership restrictions and cartels. Last, but not the least, it should get the armed forces out of commerce and business but make them responsible for an unbiased implementation of law and order.

And the Future ? Indonesia does not present an environment in which Multinationals can do business. Current account balance is still negative, but the deficit is shrinking because of the implosion of the import capacity. Short-term debt is running at about 200% of foreign exchange reserves and is unlikely to improve in the near tenn. Investors should take their cue form those who are treading cautiously on committing new investments to Indonesia.

MALAYSIA: A PROBLEM OF CREDIBILITY The Setting The government, in a public display of self-reliance, refusing to go to the IMF, put in place its own style of austerity measures and then imposed an abruptly announced set of regulations on capital controls. In one swoop, it locked in investors to poor returns. Instead of a severe contraction (for example, cutting down on infrastructure projects) the capital controls are meant to enable the reflation of the domestic economy. This might add fuel to the fire of badly overinflated property and financial markets.

Malaysia's Economic Indicators

Real GDP Growth (%) Exchange Rate vs U.S.$ (year-end) Inflation (CPI %)

1994

1995

1996

1997e

1998f

9.20 2.56

9.50 2.54

8.60 2.53

7.00 3.89

2.00 3.90

3.70

3.36

3.35

3.70

8.00

Source: PERC: Note f - forecast

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What's Needed

Banks are being strongly encouraged to merge and some thirty-nine finance companies are to be consolidated into five or six entities. Major infrastructure projects like the Bakun dam and Kuala Lumpur Linear City have been postponed. There is a spending cut of 18% for all govemment units. Civil servants' salaries are to be frozen. In addition, the ceiling on import duties on foreign-built cars is to be raised. Opening the economy by easing Bumiputra rules on investment and ownership, even at the risk of unleashing severe reactions from the grass-roots level, and extending this to foreign investors as well, needs acceleration. And the future ?

Current account is negative and although the deficit may be improving slowly due to import contraction, short term debt continues to be about 100% of foreign exchange reserves and is unlikely to change for the better in the short run.

THE ROLE OF U.S. MULTINATIONAL CORPORATIONS The Chinese ideogram for crisis is a combination of danger and opportunity. This sums up the situation for Multinational Corporations. For leading firms, confidence in ASEAN has remained largely unshaken despite the regional economic crisis. In fact, one in four companies plan to boost their direct investments in ASEAN over the short and medium terms to tap the new opportunities that the crisis has thrown up as it is the right time to buy new business assets when the prices have hit the rock-bottom.

THE CASE STUDY OF MICROSOFT Microsoft intends to invest 'significant amounts of money' in five major initiatives to help make Singapore ONE - billed as the Nation's Revolutionary High-Speed Information Network - the 'digital nervous system' and the 'web lifestyle' a reality for ASEAN. Microsoft is committed to being a partner to, and beneficiary of, Singapore's information technology industry and economy. The five initiatives, being pursued by Microsoft are: • A two year MOU with Singapore Telecom under which Microsoft will help it build a video-on-demand service and develop broad band services; • A letter of intent with Singapore Cable Vision to market advanced set top boxes, enabling users to surf the Internet using their TV sets;

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• An MOU with Television 12 to provide high value-added, consumer-oriented television services based on Microsoft technologies; • An MOU with Times Publishing to set up the Times Online Education Services, to provide a curriculum-oriented service to bring children, parents, and teachers closer; and • A commitment to develop solutions to help the Education Ministry realize Singapore's IT Master Plan for Education.

THE CASE STUDY OF CALTEX A classic American MNC from Texas, Caltex turns over U.S.$17 billion in revenue and has all its operations for marketing in Singapore - an unwavering commitment to Asia Pacific. Its global head-quarters have been moved to Singapore as its center of gravity for managerial decision-making with management of marketing operations enhanced by three vice-presidents for Africa, Middle East and South Asia being relocated in Singapore. With its global head-quarters in Singapore, Caltex will manage its IT network from Cape Town; its transactional services from Manila; its training from Bangkok; and its retail customer consumer credit from Kuala Lumpur in a global division of managerial labor. Caltex, as a world-class trading firm, while not bullish on margins for refining operations improving substantially in the near-term, is very much an enthusiastic Asian operator - it is the only energy company operating in all the major markets of the region.

THE CASE STUDY OF GE GE intends to spend U.S.$40 billion over the next four to five years in Asia. The industrial giant - a conglomerate for servicing jet engines as well as trading financial services - intends to repeat its success of investing in troubled times, as it did in Europe in the early 1990s, to reap benefits from high value-low price assets in troubled ASEAN. GE is looking to make major investments in consumer and business related financial products - insurance, auto-lending, equipment-lending. The locations that are receiving GE's greatest attention are inevitably the most afflicted ASEAN countries Indonesia, Malaysia and Thailand as well as South Korea and China.

THE CASE STUDY OF DUPONT The world's largest chemical business and high-performance engineering plastics and materials firm DuPont, believes that the Asia Pacific region holds

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growth rates of 20% or more for the company. With annual global revenues of U.S.$44 billion and sales from Asia topping U.S.$3.6 billion on a global investment platform of U.S.$11 billion (U.S.$2 billion in Asia-pacific, with U.S.$1.1 billion in Singapore alone), the firm has an indisputable commitment to its Asia-Pacific region comprising Japan and Australia, South-East Asia, and the 'tiger' economies. As Managing Director of DuPont Singapore states "We're not like some of the electronics industries. The things we have here are not moving." However, in response to the Asian Crisis, DuPont has undertaken a restructuring exercise to reduce product development time to a bench-mark close to that of competitors such as Hitachi Chemical and ICI. The firm is looking strategically to the domestic market potential of China and India to spur its growth into the next decade especially in the context of the Asian Crisis shrinking the relatively small domestic markets of ASEAN.

CONCLUDING REMARKS Significantly, in the February 1998 survey of MNCs by UNCTAD-ICC, 62% of firms plan to continue and expand their investments undeterred by the economic turmoil. About 81% of MNCs felt that the long-term prospects for investments were unchanged by the financial turbulence. Another 13% of firms believe that the long-term investment climate had actually improved by virtue of the reduction in assets values. The survey result is a resounding vote of confidence in the long-term economic fundamentals of ASEAN. Exhibit #3 shows the Multi-National Corporations' investment behavior, in general, in ASEAN countries during the Asian Economic Crisis. In the short and medium term however, lower operational costs in the most affected countries including the effect of devaluation - will create immediate incentives for additional direct investment especially for export oriented production and components for integrated international sourcing and production. This is so notwithstanding the difficulties that the financial turmoil has thrown up as far as the credit financing of exports for local companies is concerned. However, companies heavily dependent on regional domestic market sales, are bound to see reductions in their growth performance. As a result, the valuechain of activities of firms and industries servicing ASEAN domestic markets will see deep cuts in investments. There is emerging evidence that this is so especially for Japanese Multinationals. The fall off in new investments to ASEAN is seen to result directly from the economic collapse, the apparent ineffectiveness of regional institutions and the growing political uncertainties.

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In the present circumstances of danger and opportunity, U.S. corporations would be best advised to place less emphasis on cost and book values, and historical Profit and Loss Accounts, when making investments across ASEAN. One key explanation for the Crisis in the first place was the appalling lack of audit transparency in corporate Asia. If a U.S. corporation invests in Asia Pacific, it should not pay more than it could justify based on the prevent value

US MNCs maintained or expanded capacity in ASEAN to support strong home market demand and bought bargainpricing assets during the Asian Crisis.

European MNCs maintained or reduced their plant capacity in ASEAN but did not take the opportunity to purchase cheap Asian assets.

Japanese MNCs reduced their capacities in Asian drastically due to weak International & Home Market demand but kept the investment in ASEAN and Will be able to pick up capacity rapidly during the economic rebound.

Korean MNCs stop some of their factories in ASEAN during the crisis due to home country economic crisis and severe liquidity problems. Many were not able to restart production to take advantageof the economic rebound.

I IIIII

Exhibit3. MNCs Investment Behavior in ASEAN Countries During the Asian Economic Crisis.

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of projections of free cash flows - in dollars, not in local currencies. According to Standard and Poor, the crisis is not going to end quickly and rating U.S. agencies have been downgrading the corporate capacity and capability of Asian banks, conglomerates and even national treasuries right across the region. U.S. corporations viewing ASEAN would need to pay heed to the following scenarios. Act one - the currency crisis is not over by any means. Act two - the crisis as a banking crisis is not moving to its close. Japan has surprised all but the most cynical with an economic clumsiness that is staggering and bad debts amounting to an astonishing U.S.$1.2 Trillion. The non-performing loans of Asia will exceed that of the Mexican Crisis in 1994/95 by at least 20%. Act three - when banking systems have been repaired eventually, the spotlight will shift to micro-economic restructuring involving necessarily a further liberalization of ownership regulations so as to allow foreigners to own assets. At the same time, Asia is beginning to project a virulent backlash against globalization in general and capitalism in particular. The more flexible and strategically minded operators will move in to redeploy assets through mergers and acquisitions and securitization - that is when the real money could be made, a lot of it by the U.S. firms. This is not in the immediate future because laws have not been fully changed to reflect the new realities of the economic recession. Nevertheless U.S. corporations should get ready and position themselves for the unique opportunities of buying into varied but quality assets ranging from security houses to telecom companies, from auto manufacturing to hotel real estate and from energy to water utilities. The first consideration is the privatization programmes that are part of the IMF conditionalities. The second, in the context of South Korea is the ceding to foreign ownership of key industries - petrochemicals, and aerospace - in the restructuring of Chaebols. U.S. firms are well placed in comparison with European companies in this respect. Thirdly, the judicious use of regional centres, such as Singapore, to add-value to existing capability through economies of scale, is already finding expression in the plans of the likes of EXXON and MOBIL Oil in constructing additional polymer plants. With persistent optimism on Wall Street and Asia Pacific in crisis, ASEAN economies have a lot to offer to the U.S. MNCs. Their long-term growth trajectories, 6% to 9% since 1965, suggest that they have solid platforms of labour productivity available to which Multinationals can match their technology and thus competitively serve global markets.. Earlier studies indicating that the growth in the region came purely from accumulation strategies may be ignoring the evidence of stable rather than declining rates of return on investment. Regarding productivity growth, studies by Chang-Tai Hsieh, University of Berkeley has found productivity growth of 2.2% for

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Singapore; 3.7% for Taiwan; 1.5% for South Korea (granted this is lower than previous estimates); and 2.7% for Hong Kong. The World Bank indicates growth in output per worker per year of 2% for Singapore, 1.5% for Taiwan and China, 1.8% for South Korea, 1.3% for Hong Kong. The IMF indicates that growth rates of Total Factor Productivity (TFP) between 1978 and 1996 are 2.3% for Singapore, 2.0% for Thailand, 2.0% for Malaysia, 1.2% for Indonesia. -0.8% for Philippines. In comparison the TFP for U.S.A. for the same period was 0.3%! The argument over accumulation versus technical adaptation is moot. The case of Singapore, with its corruption-free civil service and business climate, remains very much to the fore - a location that has best weathered (by adopting a sober view) the financial typhoon that has whipped the rest of Asia Pacific. To take advantage of the ample opportunities, U.S. firms must get focused, buy assets wisely and expand the range of products and services to their global customers from the now competitive platforms of ASEAN manufacturing. Plenty of prudent examples abound not only in manufacturing with the likes of Ford, General Motors and DaimlerChrysler moving ahead to take greater control over their Asian operations but also service firms such as Citibank. This U.S. bank has invested over U.S.$100 Million in its Singapore data processing centre. This investment commitment enables it to manage over seven million credit card accounts in 24 countries and process over 700,00 credit transactions daily in, and between, the Far East, the Caribbean, the Middle East, Eastern Europe, South Asia and Australasia. In the IT sector, the likes of Compaq and Dell intend to redouble their operational efforts across ASEAN. In the industrial sector, mention has already been made of GE's strategic moves. Globalization, some effects of which the Asian Crisis has demonstrated strikingly, is not for the faint-hearted and, as U.S. firms have been amongst the most aggressive of operators, now is the time to move. ASEAN members need to make a tough examination not only of their economic structures, politics, and business systems but also at their operating assumptions in order to ensure the return of the pre-crisis positive attitudes held by American investors. For the more seriously minded, the hollowing out of the ASEAN economies means the elimination of inefficient capital to be followed by the reappearance of more efficient capital. However, this can only happen in a world favourable to capital flows. Whether these suggestions are adopted depends not only on corporate courage but also on how long ASEAN takes to accept fully the features and disciplines of being integrated with the global economy. The advantages and benefits of hosting MNCs call for hosts to accept the disciplines of globalization. This, in turn, is as much a question of politics as of business.

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SOURCES OF INFORMATION USED TO DEVELOP THIS CHAPTER 1. 'Paralysis in Asia: What to Do', Business Week (Special Report), 10 November 1997. 2. 'The IMF Bailout: What Could It Cost?', Business Week, 17 November 1997. 3. Jonathan Fuerbringer, 'Many Players, Many Losers', New York Times, 10 December 1997, pp. 1 and 4. 4. 'Asian Economic Crisis', Wall Street Journal, 8 January 1998, p.A5.W. 5. 'Asian Economic Crisis', The Strait Times, 22 January 1998 p. 46. 6. 'Who Needs the IMF?', Wall Street Journal, 3 February 1998, op. ed. Page. 7. 'What Caused Asia's Crash', Wall Street Journal, 4 February 1998, op. ed. Page. 8. Lester Thurow, 'Asia:The Collapse and the Cure', The New York Review of Books, 5 February 1998, pp. 22-26. 9. 'Back from the Brink', The Economist, East Asian Economics Survey, 7 March 1998. 10. 'Collapse in Asia: 1997-1998', By George C. Lodge & Anthony St. George, Harvard Business School, 9-798-084, 23 March 1998. 11. Martin Feldstein, 'Refocusing the IMF', Foreign Affairs, March/April 1998, pp. 22 and 23. 12. Julia Lichtblau, 'The Patient Way to Play the Asian Crisis: It's a Ties for Building Ties, Not for Profiteering', Business Week Online, The McGraw-Hill Companies, Inc., 24 August 1998. 13. 'How Small Business Can Play the Asian Crisis: Patiently', Business Week Online, The McGraw-Hill Companies, Inc., 25 August 1998. 14. 'Asia's Recovery Masks a 'Fragility', East Asia News and Features (Australia) Pte. Ltd., Lexis-Nexis Academic Universe, February 2000. 15. Michael Alan Hamlin, The New Asian Corporation: Managing for the Future in Post-Crisis Asia, Jossey-Bass Publishers, ISBN: 0787946060.