Korea's Economic Adjustments Under the IMF-supported Program--Presentation by Kunio Saito
January 21, 1998Presentation by Kunio Saito
Regional Office for Asia and the Pacific
International Monetary Fund
Sogan University/Korea Economic Daily Conference, January 21, 1998
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Ladies and gentlemen:
It is an honor and a pleasure for me to be here and speak to this gathering of distinguished businessmen. I am grateful to the Korea Management Association for inviting me to Seoul and giving me the opportunity to participate in this Conference.
After accepting this speaking engagement, I realized that I am a very brave person--or a complete fool. Everybody in this audience not only knows about Korea much more than I do but has lived through the recent events that I am going to talk about. I am sure that you all have strong feelings and views about the way the Korean economy has been managed over the last few months. At the same time, I realized that there are different ways of looking at the recent events, and I know that you are all interested in an outsider’s view. So I will put together all my courage and make a presentation, including my views. Your comments, after my presentation, are most welcome. I will, of course, answer questions at that time.
Mr. Chairman. Today, I will speak on the subject of "Economic Adjustments to the recent financial crisis under IMF-supported programs". The focus will be on Korea, although I will make reference to other countries in the region, especially Indonesia and Thailand. But, before coming to this subject, I think I should put the recent crises in historical perspective. So let me very briefly go over Asia’s economic developments over the last 50 years which can be succinctly characterized by three widely used expressions--Asian poverty and stagnation, Asian miracle, and Asian crisis.
- First, until the late 1950's and the early 1960's, Asia’s economies were characterized for their poverty and stagnation. Although frustrating, this was the reality and in many cases, the outlook that those of us in the region had to accept. On my part, I remember studying, as an economics student in Tokyo in the early 1960's, the works of G. Myrdahl, J. Myint, etc. who seemed to have believed that Asian economies would continue to stagnate and remain poor for historical, social, and cultural reasons. Later, when I joined the IMF, I learned that many of my predecessors in international organizations had held similar pessimistic views.
- Second, beginning in the mid-1960's, the process of the Asian miracle began, with economies of the region taking off one after another, achieving strong economic growth, and steadily catching up with industrial countries. Although the struggle to overcome poverty continued, the region was no longer stagnant; in fact, it was one of the most dynamic in the world. Underlying this process were the ingenuity and hard work of the people. Korea was certainly a leader in the process, in which many other countries in the region participated with considerable pride.
- Third and finally, in mid-1997 the Asian miracle came to a halt, at least temporarily, as the Asian financial crisis began. To our great frustration and dismay, the crisis came rather suddenly, and deepened and widened beyond anybody’s expectations. Two years ago, very few, if any at all, foresaw a regional crisis. Even six months ago, few envisaged that the crisis would expand to the magnitude we have seen in the last few weeks.
As on previous occasions, the IMF is being criticized from all directions regarding the adequacy and effectiveness of the programs it supports. Some consider IMF-supported programs to be too loose, while others argue that they are too tight. Some criticizes the IMF for dispensing money too easily, while others complain the IMF being too stringent. Apart from these explicit criticism, questions regarding the IMF-supported programs and their effectiveness remain in the minds of many people. I am sure that this audience is no exception.
Mr. Chairman, what I would like to do today in my presentation is to address some of these questions, more specifically, three broad questions. These are:
- How (why) did the crisis occur?
- What are the key elements of the IMF-supported program for Korea? How does it compare with other programs (especially those for Indonesia and Thailand)?
- Will the program work? How does it work? When will we see clear signs of stabilization in financial markets? When will the recovery start?
So, let me start with the first question: how did it happen? As Joseph Stiglitz of the World Bank noted in his recent speech in Kuala Lumpur, most Asian countries were doing well, avoiding both fiscal profligacy and high inflation. Savings were over 30 percent of GDP, and both the skills and work ethic of people were impressive. These are outward-looking economies, with a very dynamic and competitive private sector. So why did they get into trouble?
This question has been answered in many different ways, but the one I like most was given by Professor Dornbusch of MIT. He spoke recently in Tokyo and noted that east Asian economies were like a drunk driver. There were a yellow traffic signals, warning of possible danger ahead, but east Asian economies, like a drunk driver, paid no attention to the yellow lights and drove straight into the danger.
In this analogy, I believe the countries were intoxicated by their own success, and enjoying it a little bit too much and too long, while increasingly strong signals were sent to warn of precipitous dangers. For enterprises, the warning signs were excessive, and at times unwise, investments, and the related excessive borrowings, particularly short term. For banks and other financial institutions, the warning signs were excessive lending, increasingly high levels of risky and questionable assets, and the weakening of their balance sheets.
There were also warnings in terms of the need for structural reforms to keep the system in line with the enlarged and much more sophisticated economy. The need for reform and restructuring was greatest in the financial sector, and included reforms both of corporate governance and of business practices.
These warning signs were ignored, at least for a while. No actions were taken to address corporate excesses and the resulting economic overheating. Structural reforms were delayed. When export demand slowed, first from outside the region and then from within, the yellow light changed to a red light, uncovering all the underlying problems. Excessive investments turned into unutilized capacity, lower profits, and business failures. Excessive lending on the banking side meant higher non-performing assets, and a further weakening of balance sheets.
These problems and the authorities’ inaction, including in the area of systemic reform resulted in a loss of confidence in the financial markets. The currencies depreciated and stock market prices declined. We all know that once confidence is lost, it is very difficult to restore it. Also, financial market deterioration negatively affects investment and other productive activities, generating a vicious cycle, unless strong policy actions are taken to stop it.
Let me now address the same question in the Korean context: how did the crisis occur in Korea? As I mentioned at the outset, this is one question you can answer much better than I can. But please be patient and listen to my views. My answer to this question entails many of the points I just made in the regional context, on the sides of both enterprises and banks.
First, on the enterprises’ side. As you will all recall, through 1995 and early 1996, Korea’s economy was booming, enterprises’ profit positions were strong, investments were large, and productive capacity were expanding, although with some time-lags. Then, in the course of 1996, a cyclical downturn came. Export growth slowed from 33 percent in 1995 to 3 percent in 1996. Among the factors responsible were a weaker external demand, the collapse of computer chip prices, and the loss of competitiveness resulting from the Yen depreciation. Investment growth also slowed, partly reflecting the political uncertainty prevailing ahead of the Presidential election. But productive capacity became increasingly underutilized, raising costs when sales were already weakening. Consequently, enterprises’ profit positions deteriorated. Some even incurred losses and encountered cash flow problems, including for servicing the debts accumulated during the boom years to finance large investments. When new bank loans were no longer available, some of these firms went bankrupt, including large conglomerates--Hanbo Steel, Jinro, Dianong, New Core Group, and KIA motors.
Second, on the banks’ side. As these and other ailing enterprises delayed and eventually stopped servicing their debt, banks’ nonperforming assets rose and their balance sheets weakened. This affected adversely overseas creditors’ confidence in Korean banks. The Korean premium for overseas borrowing rose and it became increasingly difficult to raise new money--initially for merchant and commercial banks but subsequently even for government-owned policy banks. By mid-November, confidence became so low that foreign banks started declining requests to roll over maturing debts. At the same time, a number of banks, mostly merchant banks, faced serious liquidity problems, as well as a situation close to virtual insolvency.
The Government and the Bank of Korea responded to these problems by injecting liquidity and introducing measures to facilitate liquidity flows to ailing enterprises. They also made announcements to boost confidence. These measures and announcements were largely ineffective in restoring confidence and stopping the deteriorating trend.
Questions may be asked: Why, this time around, were there so many business failures and problem banks? Why, this time around, couldn’t the Government save them? After all, this is not the first time for Korea--and a number of countries in the region--to go for an aggressive investment strategy. In the past, this strategy usually worked and when difficulties arose, the Government worked successfully with banks and enterprises and avoided a disaster. So what makes this investment cycle different from previous ones?
In response, I can make a few points. First, the sheer magnitudes of investment and the related external short term borrowing undertaken during the boom years. Korea had never before gone into a cyclical downturn with external short-term debts amounting to almost $100 billion or about one-third of GDP. The servicing difficulties experienced in the last few months indicate that the investments that these debts had financed were perhaps excessive. Perhaps, business leaders, accustomed to rapid growth, became overly ambitious in their investment decisions during the boom years. Perhaps, Professor Dornbush is right in his analogy of a drunk driver.
My second and probably the most important point is that Korea is now integrated into the globalized market system, where confidence factors play a crucial role. In such an environment, policy responses have to change--for example, closing troubled banks rather than saving them usually helps boost confidence and facilitates the country’s external financing. This explains the limited effectiveness of the traditional policies undertaken during most of 1996.
Finally, the political uncertainties that prevailed during the last several months did not help boost confidence and facilitate economic management. In particular, the failure to obtain parliamentary approval of 9 financial sector reform bills in mid-November was most unfortunate.
This triggered Korea’s financial crisis, intensifying the pressures that the market had already been facing following the decline in Hong Kong stock market prices in late October. The exchange rate of the won declined sharply in a chaotic market, as did stock market prices. The declines continued even after the daily exchange rate band was widened to 10 percent on October 20.
III. IMF-supported Program
On November 21, the new Deputy Prime Minister, Mr. Lim, announced that the Government had requested the IMF’s support for an economic stabilization and reform program. As has been reported widely, this program was brought to the IMF’s Executive Board and approved on December 4. The Korean authorities have since strengthened the program, and the IMF Board has reviewed the situation three times--on December 18, December 30, and January 8. After each Board meeting, the IMF disbursed its loans-- a total of SDR9.7 billion so far.
This brings me to the next question: What are the key elements of the IMF-supported program? How does it work? I will respond to these questions under three broad headings--exchange market stabilization, financial policies, and structural reform.
(1) Exchange Market Stabilization
The immediate priority of the IMF-supported program is to stabilize the foreign exchange market. Interest rate and exchange rate policies, supported by an external financing strategy and financial sector restructuring, are the key instruments to secure this goal.
During the month of December, considerable efforts were made to roll over external short-term debts. Initially, foreign banks remained nervous, accepting to roll-over only a small portion of maturing debts. However, as the month progressed, the roll-over ratio rose substantially, and, at the end of the month, understanding was reached among the Governments of countries with major creditor banks to encourage them to rollover Korean debts and monitor progress on their sides. Discussions have also begun regarding a possible alternatives, including a conversion of short-term private sector debts to a longer-term government bond or government-guarantees for rolled-over debts.
When the maturing debts were not rolled over, the Bank of Korea provided foreign exchange loans to the commercial banks in need through its special window. This window remains open, but the premium charged (over LIBOR) has been progressly raised--to over 1,000 basis points--to encourage banks to find the needed foreign exchange elsewhere. On the part of the Bank of Korea, the source of foreign exchange provided through this special window has been its reserves, including borrowing from the IMF and other international organizations.
The exchange rate has been market determined. As such, the Bank of Korea does not target any particular level of the currency, and its intervention in the foreign exchange market has been limited to smoothing excessive intra-day exchange rate volatility. Once the foreign exchange market stabilizes, intervention to accumulate usable foreign exchange reserves is expected.
When the exchange market is under pressure, interest rates must remain high to encourage the public to hold assets in domestic currency and to increase the supply of foreign exchange to the market. High interest rates, of course, adds a burden to enterprises and banks that are in debt and reduces investment. But, clearly, priority has to be on the exchange market stabilization. Interest rates, of course, do not need to remain high for ever. Once the exchange market stabilizes, interest rates can be lowered to address other pressing needs and facilitate economic recovery. Questions have often been asked about the appropriateness of high interest rates in IMF-supported programs. The answer is that in a situation in which these programs are formulated, the initial priority has to be given to stopping the free fall of the currency, as was the case in Korea. It is not that the IMF is not aware of the trade off--in fact, all IMF-supported programs envisage interest rates coming down as soon as the exchange rate market stabilizes.
Korea’s money market rates more than doubled during December to about 27-30 percent. The authorities are prepared to allow these rates to move higher should that prove necessary. Toward that end, the legislated interest rate caps have been removed.
(2) Financial Policies
While pursuing the immediate objective of exchange market stabilization, the program must address the task of overall macroeconomic and financial management--a difficult and complex task under the present circumstances.
On the one hand, the authorities are concerned about the ability of sound commercial enterprises to secure credit because banks are reportedly closing credit lines without consideration the quality of the borrower. In response to this concern, the authorities have, in addition to the previously announced support it had given to financial institutions, issued subordinated debt of W 4.4 trillion (1 percent of GDP) to improve the liquidity of bank assets and raise capital adequacy ratios; provided short-term financing to temporarily illiquid financial institutions through a W 11.3 trillion liquidity support facility at the average call rate; and increased the ceiling on the provision of official export guarantees by W 3 trillion. These developments in private sector credit underscore the importance of prompt implementation of financial restructuring and improved corporate governance and accounting to help credit risk evaluation. Clarification of the financial restructuring strategy will also help reassure banks regarding the timing of the mandated strengthening of their balance sheets.
On the other hand, there is the need to maintain monetary conditions consistent with macroeconomic prospects and objectives. The recent events indicate a sharp dip in output and a surge in inflation in the months ahead. These developments, along with financial sector restructuring, are expected to see, at least temporarily, a decline in money demand. In these circumstances, the monetary program for the early part of 1998 will aim to reduce broad money growth (M3) somewhat from about an annual 16 percent registered during the last quarter of 1997. Reserve money growth--which has been strong reflecting uncertainty associated with financial sector restructuring--will also be contained at about the same level. Toward these ends, open market operations will be used, especially after the liquidity injection aimed at a particular segments of the system has been completed.
Budgetary policy will also have to be consistent with the overall financial program. But, beyond that, the automatic fiscal stabilizers will be permitted to operate because the economy is likely to be experiencing a considerable output gap. Revenues from profit and income taxes will fall, and expenditures in some social programs will rise.
For 1997, the budgetary deficit is estimated to have been contained at about 0.5 percent of GDP (W 2 trillion) as the Government responded to lower revenues by reducing expenditures. For 1998, the deficit is currently estimated to be 1-1.5 percent of GDP. New tax measures--special excises and transportation excises--have been implemented beginning January 10. More recently, the Government has strengthened these measures by including gasoline in the items covered by the higher mineral oil taxes and by broadening the tax base for the higher special excise tax further by including additional luxury and entertainment items. However, these revenue effects will be more than offset by the fiscal cost of financial sector restructuring and the exchange rate depreciation and, more significantly, by the effect of the automatic stabilizers associated with the emerging output gap.
(3) Structural Reform
The program entails a very ambitious and comprehensive list of structural reform.
In the area of financial sector reform, the authorities have already suspended 14 insolvent merchant banks, placed 2 commercial banks under supervision, and requested other institutions to submit plans for capital restorations needed to meet the Basle standards. The deposit guarantee and asset management schemes have been strengthened by injecting budgetary funds. The Bank of Korea will be given greater autonomy, while the Government is to refrain from intervening in bank management and individual lending decisions. In the corporate sector, improvements are expected regarding the transparency of their balance sheets by enforcing the Generally Accepted Accounting Standards, as well as in risk management by overhauling the system of mutual guarantees within conglomerates.
The program places particular emphasis on measures to improve labor market flexibility, including enlarging the scope for lay-offs. These measures will be supported by improvements in unemployment insurance schemes and labor retraining programs. The Government has formed a tripartite committee which will meet over the next month to address these sensitive problems and produce a tripartite consensus, which in my view is a very important development showing the desire of all sectors, and particularly the labor movement to arrive at effective solutions that distribute the border of adjustment in a fair manner.
The final element of the reform program is the liberalization of capital account transactions and removal of some remaining trade restrictions. This liberalization, to a large extent, represents an acceleration of Korea’s previous commitments under the OECD and WTO frameworks, but does go a bit beyond the earlier schedule. Many of the liberalization measures--like raising ceilings on foreign acquisition of Korean stocks--have already been put in place. Others are on a concrete, time-bound schedule for implementation.
Many of the reform measures represent a departure from the traditional styles of economic and corporate management--with regard to government-corporate relationships, inter-enterprise-arrangements, and management methods of corporations. But these changes are needed to improve the efficiency and risk-management of each corporation. They are needed to enhance the economy’s overall productivity, flexibility, and credibility, as well as to restore the overseas investors’ confidence. They will enhance the Korean economy’s robustness to withstand future shocks, and so help ensure that this crisis is never repeated.
IV. Economic Outlook
I would now like to address the third and final question: Will the IMF-supported program work? What are the prospects for Korea’s economy in 1998 and beyond?
Notwithstanding views to the contrary, my answer, not surprisingly, is: yes, it will work. The program will soon stabilize the economy and establish a basis to resume rapid growth, given the strong commitment and determination of the authorities and the Korean people. But the road to success is likely to be long and hard, partly because it started with a crisis situation associated with an almost complete loss of confidence, and partly because it involves not only short-term stabilization measures but also structural reform measures for the longer term.
In these circumstances, the economic outlook is characterized by the following:
- A sharper than expected downturn in growth; GDP to increase by no more than 1 to 2 percent in 1998. While net foreign demand will boost growth, as indicated by a turnaround in the current account, domestic demand is expected to be sharply lower owing to higher interest rates. Among other indicators of the slowdown that are already visible, machinery orders declined by about 35 percent in November. Consumption growth, already weak reflecting diminished confidence (owing to the weak stock market and corporate sector bankruptcies) and declining wage growth, is expected to decrease further. Unemployment has increased to about 3 percent from 2 percent.
- A rapid feed through of exchange rate depreciation into prices; inflation of 8 to 10 percent and perhaps higher in the first part of 1998. Inflation accelerated to 6.6 percent in December, from about 4 percent, reflecting the effect of the won-dollar exchange rate depreciation on domestic fuel prices. The depreciation that has already occurred so far indicates, on an average annual basis, 25 percent real effective exchange rate depreciation for 1998. Domestic consumer price growth is expected to reflect this exchange rate adjustment with a short lag and thus peak in the first and second quarters. Nevertheless, price growth is expected to be tempered by a growing output gap. Recent industrial agreements, which have included reductions in nominal wages, suggest a limited second round of cost-induced price increases.
- A movement to surplus in the external current account; US$3-5 billion (about 1 percent of GDP) in 1998. The current account moved into surplus in November reflecting declining import growth, particularly of consumer goods, and boosted by growing exports to Eastern Europe and China. These trends are expected to continue although domestic financing constraints are reportedly harming export prospects. The real effective exchange rate depreciation will clearly increase incentives to export. But, exchange rate developments are set against a backdrop of extremely weak dollar export prices--a 25 percent fall over the past two years--that has resulted in narrow margins and reduced incentives to boost capacity.
The outlook for 1998 is certainly not bright. It is going to be a difficult year. But it is a year of consolidation and the year to prepare for the future. I personally believe, strongly, that Korea will resume rapid growth once this consolidation phase is over. The Asian miracle is not over, at least in Korea.
Mr. Chairman. Let me now conclude my rather lengthy presentation. I have three points.
First, the IMF-supported program is the best--and perhaps the only available--means to deal with the present crisis. When implemented rapidly and thoroughly by the governmnet, it will succeed in stabilizing the economy and restoring the basis for rapid growth, given the strong commitment and determination of the authorities and Korean people. The Asian Miracle is not over.
Second, structural measures--entailing financial sector and other corporate restructuring as well as labor redeployment--are painful in the short-run but are in the nation’s best interest in the longer-run. These measures strengthen enterprises’ competitiveness, enhance the efficiency of the economy as a whole, and thereby pave the way for rapid growth.
Third, under the program, liberalization of the capital account and some remaining trade restrictions
have been accelerated. Also, improvements are being made regarding the traditional
government-corporate relationship, inter-enterprise arrangements, and even the management style of
each corporation. These improvements will lead to the strengthening of the Korean--and
the east Asian--approach to rapid economic growth.