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Korea’s Economic Adjustments
Presentation by Kunio Saito
Under the IMF-supported Program
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
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
Our frustration and dismay notwithstanding, a major crisis has occurred and is still very much with us.
The governments and central banks of the region--including those in Korea, Indonesia, and
Thailand--have been addressing the crisis by adopting comprehensive policy
programs. The IMF, in turn, is supporting the programs with unprecedentedly large
financing packages. Including contributions from other multilateral and bilateral creditors, these
packages amount to $57 billion for Korea, $40 billion for Indonesia and $17 billion for Thailand. The
IMF’s contributions alone total $21 billion for Korea, $10 billion for Indonesia, and $4 billion for
- 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:
These are not easy questions. And I do not pretend I have all the answers. But, in what follows, I would
like to touch on a few aspects of each of these questions and provide a basis for our discussions
- 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
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
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
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
(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
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
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
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
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:
One should add that underlying these macroeconomic projections are large-scale industrial
restructuring and labor redeployment issues. If experiences of other industrial countries are any
guide, a large number of corporate mergers are likely, with the associated downsizing and transitory
- 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
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
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
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.
IMF EXTERNAL RELATIONS DEPARTMENT