Korea's Economic Adjustments Under the IMF-supported Program--Presentation by Kunio Saito

IMF News, January 21, 1998

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Korea's Economic Adjustments Under the IMF-supported Program--Presentation by Kunio Saito

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• Published: January 21, 1998

I. Introduction

• Presentation context: Sogan University/Korea Economic Daily Conference, January 21, 1998.
• Scope:
  • Focus on "Economic Adjustments to the recent financial crisis under IMF-supported programs", primarily Korea, with references to Indonesia and Thailand.
  • Three guiding questions:
  • 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?
  • Will the program work? How does it work? When will stabilization and recovery begin?

II. Problems (Drivers of the Crisis)

• Regional framing:
  • Asia’s development characterized as: Asian poverty and stagnation; Asian miracle; Asian crisis.
  • Rapid turnaround from boom to crisis in mid-1997; crisis deepened and widened unexpectedly.
• Scale of international support packages:
  • Packages (including multilateral and bilateral contributions): $57 billion for Korea, $40 billion for Indonesia and $17 billion for Thailand.
  • IMF contributions alone: $21 billion for Korea, $10 billion for Indonesia, and $4 billion for Thailand.
• Common warning signs (regional and Korean specifics):
  • Excessive and sometimes unwise investments financed by short-term borrowing.
  • Banks: excessive lending, high levels of risky and questionable assets, weakening balance sheets.
  • Delayed structural reforms, especially in financial sector, corporate governance, and business practices.
• Korea-specific chronology and mechanics:
  • 1995–early 1996: booming economy; 1996 cyclical downturn.
  • Export growth slowed from 33 percent in 1995 to 3 percent in 1996.
  • Contributing factors: weaker external demand, collapse of computer chip prices, loss of competitiveness due to Yen depreciation, political uncertainty ahead of Presidential election.
  • Resulting corporate failures: Hanbo Steel, Jinro, Dianong, New Core Group, and KIA motors.
  • Banking consequences: rising nonperforming assets, weakened balance sheets, higher foreign borrowing premia.
  • By mid-November, foreign banks began declining rollovers; merchant banks faced liquidity problems and virtual insolvency.
  • Political setback: failure to obtain parliamentary approval of 9 financial sector reform bills in mid-November.
  • Exchange rate and stock market: sharp declines; daily exchange rate band widened to 10 percent on October 20.

III. IMF-supported Program — Key Elements and Implementation

• Timeline and financing:
  • Government requested IMF support on November 21.
  • IMF program approved on December 4.
  • IMF Board reviews: December 18, December 30, and January 8.
  • IMF disbursed loans totaling SDR9.7 billion so far.
• Three broad program pillars: Exchange market stabilization; Financial policies; Structural reform.

H3: Exchange Market Stabilization

• Immediate priority: stabilize the foreign exchange market.
• Instruments: interest rate and exchange rate policies, external financing strategy, financial sector restructuring.
• Roll-over efforts in December: initial low roll-over ratios that rose substantially by month-end; coordination among creditor-country governments to encourage rollovers and monitor progress.
• Alternatives discussed: conversion of short-term private debts to longer-term government bonds; government guarantees for rolled-over debts.
• Bank of Korea interventions:
• Provided foreign-exchange loans through a special window when maturing debts were not rolled over.
• Premium on this window progressively raised—to over 1,000 basis points—to encourage banks to seek other foreign exchange sources.
• Source of foreign exchange for the window: reserves, including borrowing from the IMF and other international organizations.
• Exchange rate policy:
• Market-determined; no particular level targeted.
• Intervention limited to smoothing intra-day volatility.
• Once stabilized, intervention will shift toward accumulating usable foreign exchange reserves.
• Interest rate rationale:
• High interest rates used to encourage holding domestic currency and increase foreign exchange supply.
• Rates do not need to remain high indefinitely; they will be lowered once exchange market stabilizes.
• Korea’s money market rates more than doubled during December to about 27-30 percent.
• Legislated interest rate caps have been removed; authorities prepared to allow rates to move higher if necessary.

H3: Financial Policies

• Dual objectives: ensure credit access for sound enterprises and maintain monetary conditions consistent with macro prospects.
• Measures to support liquidity and capital adequacy:
• Issued subordinated debt of W 4.4 trillion (1 percent of GDP) to improve liquidity of bank assets and raise capital adequacy ratios.
• Provided short-term financing through a W 11.3 trillion liquidity support facility at the average call rate.
• Increased the ceiling on official export guarantees by W 3 trillion.
• Importance of prompt financial restructuring, improved corporate governance, and accounting to aid credit risk evaluation.
• Monetary program targets:
• Aim to reduce broad money growth (M3) somewhat from about an annual 16 percent registered during the last quarter of 1997.
• Reserve money growth to be contained at about the same level.
• Open market operations to be used after targeted liquidity injections are completed.
• Fiscal policy:
• Automatic fiscal stabilizers to be permitted given a likely considerable output gap.
• 1997 budgetary deficit estimated at about 0.5 percent of GDP (W 2 trillion).
• 1998 deficit currently estimated to be 1-1.5 percent of GDP.
• New tax measures (special excises and transportation excises) implemented beginning January 10; later strengthened to include gasoline and broaden the special excise tax base.
• Revenue gains expected to be more than offset by fiscal cost of financial sector restructuring, exchange rate depreciation, and automatic stabilizers.

H3: Structural Reform

• Comprehensive program including financial sector, corporate, labor market, and capital account measures.
• Financial sector actions already taken:
• Suspended 14 insolvent merchant banks.
• Placed 2 commercial banks under supervision.
• Requested other institutions to submit plans for capital restorations needed to meet the Basle standards.
• Strengthened deposit guarantee and asset management schemes by injecting budgetary funds.
• Bank of Korea to be given greater autonomy; Government to refrain from intervening in bank management and individual lending decisions.
• Corporate sector reforms:
• Enforce Generally Accepted Accounting Standards to improve balance sheet transparency.
• Overhaul mutual guarantee systems within conglomerates to improve risk management.
• Labor market reforms:
• Emphasis on measures to improve flexibility, including enlarging scope for lay-offs.
• Support measures: improvements in unemployment insurance and labor retraining programs.
• Formation of a tripartite committee to seek consensus on sensitive labor issues.
• Capital account and trade:
• Accelerated liberalization of capital account transactions and removal of some remaining trade restrictions.
• Many measures implement earlier OECD and WTO commitments on an accelerated schedule; some measures go beyond earlier schedules.
• Examples: raising ceilings on foreign acquisition of Korean stocks already implemented; other measures scheduled with concrete time-bound plans.
• Rationale: reforms depart from traditional government-corporate relationships and management styles to improve efficiency, risk management, productivity, flexibility, and investor confidence.

IV. Economic Outlook (Prospects and Key Projections)

• Overall assessment:
  • Saito’s view: the IMF-supported program "will work" if implemented rapidly and thoroughly; stabilization and a basis for rapid growth will be established, but the adjustment will be long and hard.
• Main macroeconomic projections and indicators for 1998:
  • GDP growth:
  • GDP to increase by no more than 1 to 2 percent in 1998.
  • Domestic demand expected to be sharply lower owing to higher interest rates; net foreign demand to boost growth via a turnaround in the current account.
  • Activity indicators:
  • Machinery orders declined by about 35 percent in November.
  • Consumption growth expected to decrease further due to diminished confidence and declining wage growth.
  • Unemployment has increased to about 3 percent from 2 percent.
  • Inflation and exchange rate pass-through:
  • 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 won-dollar depreciation effects on domestic fuel prices.
  • The depreciation to date implies, on an average annual basis, 25 percent real effective exchange rate depreciation for 1998.
  • Consumer price growth expected to peak in the first and second quarters, tempered by a growing output gap; recent industrial agreements with reductions in nominal wages suggest limited second-round cost-induced price increases.
  • External current account:
  • Movement to surplus of US$3-5 billion (about 1percent of GDP) in 1998.
  • Current account moved into surplus in November due to declining import growth (particularly consumer goods) and growing exports to Eastern Europe and China.
  • Export prospects constrained by domestic financing limits and a backdrop of extremely weak dollar export prices—a 25 percent fall over the past two years—resulting in narrow margins.
  • Structural transition:
  • Large-scale industrial restructuring and labor redeployment expected.
  • Anticipated rise in corporate mergers, associated downsizing, and transitory unemployment.
• Outlook summary:
  • 1998 is projected as a difficult year of consolidation and preparation for future growth.
  • Strong belief that Korea will resume rapid growth once consolidation and restructuring are complete.

V. Conclusion — Key Policy judgments and recommendations

• Three concluding points:
  • The IMF-supported program is the best—and perhaps the only available—means to address the crisis; rapid and thorough implementation by the government will stabilize the economy and restore the basis for rapid growth.
  • Structural measures (financial sector and corporate restructuring, labor redeployment) are painful short-term but serve the nation's long-term interest by strengthening competitiveness and efficiency.
  • Liberalization of the capital account and remaining trade restrictions has been accelerated; improvements in government-corporate relationships, inter-enterprise arrangements, and corporate management styles will strengthen Korea’s—and east Asia’s—approach to rapid economic growth.

Presentation by Kunio Saito, Director, Regional Office for Asia and the Pacific, International Monetary Fund, at the Sogan University/Korea Economic Daily Conference, January 21, 1998.

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