Public Sacrifice Serves as Driving Force for Recovery - A Commentary
November 30, 1998
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By Hubert Neiss
Director of the International Monetary Fund’s (IMF’s)
Asia and Pacific Department
Having been closely associated with recent events in Korea, the anniversary of the outbreak of the crisis in Korea evokes a number of thoughts and reflections, in particular: the hectic atmosphere of the initial phase; the success in restoring stability; the seriousness of the recession; and the unfinished agenda ahead.
The outbreak of the financial crisis was sudden and vehement. Foreigners and Koreans lost confidence in the strength of many banks, concerns about the health of the economy grew, and in a panic, huge funds were moved out of the country.
The Bank of Korea had lost most of its foreign exchange reserves. Under this shock, negotiations for a large IMF credit had to be conducted at utmost speed to prevent the country from becoming bankrupt and declaring a default on its debt.
This would have caused serious chaos, not only in Korea but also in the region. Fortunately, the government's crisis management team, led by Deputy Prime Minister Lim Chang-yuel was first-rate.
With a strong common objective, Korea and the IMF quickly reached an agreement on a policy package and the IMF started to disburse its largest loan ever (about $21 billion).
As an emergency measure, interest rates were increased sharply to help stem the outflow of funds and stop the depreciation of the exchange rate.
This step has been controversial from the beginning.
Here is my view: At the outbreak of the panic, there were two extreme choices: either prevent the won from depreciating, which would have required sky-high interest rates; or keep interest rates low and let the won depreciate without limit, which would have escalated the cost of servicing the foreign debt.
Both extremes would have caused havoc to the corporate sector.
The intermediate strategy that was actually followed allowing for limited depreciation and also keeping the increase in interest rates within limits was the only reasonable choice under the circumstances, and it was successful in restoring stability.
Confidence slowly returned, helped by a smooth transition to a new government and an agreement with foreign banks to roll over the short-term debt of Korean banks.
Nevertheless, an atmosphere of pessimism remained, but there was also a sense of common purpose.
Koreans of all walks of life lined up to donate their gold jewelry to help refill the government's empty foreign exchange coffers. When I saw this, I was not only deeply moved, but also convinced that Koreans had the determination to overcome this crisis, just as they had overcome other crises in their history.
And the situation improved significantly in the early months of the year: the balance of payments swung from deficit into surplus; the BOK's foreign exchange reserves were replenished; the won stabilized and started to appreciate; an outburst of inflation was prevented; and interest rates started to come down.
These are remarkable achievements.
But can we already declare victory and relax our efforts? Definitely not!
The country is still in a serious recession that has brought great hardships to many people. And this recession turned out to be much deeper than we had feared a year ago.
No doubt, getting out of the recession is now the number one priority of economic policy.
To some extent, a recession was sooner or later unavoidable. To cut a complicated story short, the panic brought to the surface deeper problems in the corporate and banking sectors.
For too long corporations had expanded investment into less and less profitable areas and created excess capacity. Banks financed these investments on a large scale and increased their own resources by stepping up short-term borrowing from banks abroad.
At some point, this process would have to end, and corporations would be unable to repay the loans. The bankruptcies earlier in 1997 were a warning that this point was being reached. Banks ended up with more and more bad loans, and their situation had similarities with other countries in the region.
This undermined public confidence, and when foreign banks failed to roll over their loans and cut back new credit, a panic was triggered.
I have elaborated on this part of the story to make an important point: To get out of this recession, a two-part strategy is required: it is not only necessary to use the traditional means of expanding government spending and lowering interest rates which is being done, but also to repair the banking system and to restructure the corporations which is a major unfinished agenda.
As regards the first part of the strategy, Korea's long record of fiscal prudence has created some breathing room now to allow an increase in government spending and in the fiscal deficit in order to cushion the impact of the recession.
The government's plans for increased spending to finance an extension of the social safety net are particularly timely.
As regards the second part, there is no way to avoid the pain of restructuring: Korea is an advanced economy and firmly integrated into the global economy.
In this environment, the economy must continuously adapt to remain competitive and reap the benefits from globalization.
Right now, this requires a major restructuring of the banking and corporate sectors to eliminate the weaknesses accumulated over the past years, and bring these sectors up to the standards of a modern developed economy.
While this sounds logical, there are great political obstacles in practice. Restructuring requires changes in established ways of conducting the nation's business, as well as accepting temporary unemployment, and both is not easy.
Unions are right in arguing that sacrifices must be shared equitably, but I believe they also realize that restructuring is necessary to ensure new employment opportunities in the future.
For the government, it is important to create a fair and efficient system of social protection in order to minimize the human costs of structural change.
With this unfinished agenda ahead, I expect that 1999 will still be a difficult year for Korea.
However, I don't doubt for a moment that further progress will be made and that the recovery will begin in the coming year.
If the right lessons from the recent unhappy experience will be drawn by everybody, Korea will emerge as a stronger economy, and the sacrifices of the Korean people will not have been in vain.