Saturday, June 05, 2010

IMF Bailout of Korea During East Asian Financial Crisis (Part I)

Dear Korean,

I've often heard from my parents about the IMF-Korea bail out and how it was "actually" some big conspiracy that pushed Korea further into debt. They also mention how everyone in Korea united and melted their gold jewelry to pay off the debt. As much as I love my parents, I know they have rather slanted views when it comes to Korean history, economics, and/or politics. I would like to know, as objectively as possible, about the IMF-Korea bail out and how Koreans reacted to it and feel about it to this day.

2nd Generation

Dear 2nd Generation,

The Korean always found it a good policy to listen to someone who knows better than you do. So for this question, the Korean consulted with Wangkon936, who is a regular guest blogger at a popular Korea-related blog and far more knowledgeable about the East Asian Economic Crisis than the Korean himself, at least as far as the economics part is concerned.

Since this is a big topic, it will proceed in several parts. Wangkon936 will first discuss the mechanics of how the financial crisis started, followed by the Korean's discussion of the crisis' sociological impact Korean society. Below is Wangkon936.

*                *                *

It is not an exaggeration to say that East Asian Financial Crisis was a traumatic event for Korea. Not too long ago before the crisis, Korea became the 11th largest economy in the world and its per capita GDP had reached a milestone of $10,000.  The reform programs mandated by the IMF was humiliating to the country who had thought that they had turned a corner from decades of economic hardship and struggle and was close to reaching the exclusive club of the advanced economies of the world.

The sudden, almost hurricane or earthquake-like change in fortune was hard for most Koreans to bear, let alone understand.  So in an attempt to explain what they could not many Koreans viewed the crisis as being fueled by foreign speculators driving down the value of their currency, foreign lenders prematurely calling in their loans and a foreign IMF that did not care about the businesses they drove into bankruptcy, the people laid off from their jobs or the dreams of the people that all this sudden hardship destroyed.  Some desperate families, in dire economic straits, left their children at orphanages and these kids were called “IMF orphans.”  The acronym “IMF” in Korea became a symbol of every malaise that the country was going through at the time.  It literally became a new word in the Korean vocabulary as to many IMF stood for “I'M Fired.”

More after the jump.

Got a question or a comment for the Korean? Email away at

East Asian Financial Crisis -- the Challenge of a Developing Economy

Korea was part of what many economists would call a “contagion.”  If you think that sounds a lot like the word “contagious” you are right.  An economic contagion is a situation where the economic problems of one nation, for reasons too complex to discuss in this blog, spread to another.  The crisis started in Thailand, then spread to Malaysia, Indonesia, The Philippines and South Korea.  These countries, to various degrees, fell like dominoes as their currencies were attacked by currency speculators and devalued. 

Developing countries, be it Mexico, Thailand or Korea of the 80's and 90's raised a lot of foreign debt so they could buy the means to develop.  In order for poor countries to raise their standard of living, they need to manufacture, mine or drill and pump out the things that developed countries want.  Sometimes these things are oil (the Middle East), raw diamonds and minerals (Africa), cars (Japan) or consumer products (China).  To extract oil or to make cars and consumer products you need machines and expertise that the developed countries have such as oil drills, metal stamping machines, lathes, sewing machines, injection molding machines, etc. otherwise known as “capital equipment.”  The only way a developed country will sell you capital equipment is if you buy it with their currency.  So, here is the developing country's fundamental challenge: one must borrow money from developed countries to buy their capital equipment then provide the developed countries with the goods they want so they will give you more of their currency so you can in turn raise your own productivity and pay off your debt to them.  A rather simplified model, but correct enough to suit our purposes here. 

The main problem for many developing countries is growth.  They must maintain strong growth rates otherwise it will be harder for them to pay off their debts to the developed countries.  Latin America has has mixed success to meeting this challenge.  For Africa it's largely been a disaster.  However, Japan succeeded spectacularly with this model and it looks like China is making good progress thus far.  From the 80's to the mid-90's the newly developing countries of East Asia were on a tear with annual growth rates between 7-9%, a blistering rate compared to the more sedate growth rates of 2-3% for the typical developed country.  However, by the mid-90's the newly developing East Asian countries were facing some problems.  Their strong grow rates were slowing because they had relied mostly on moving labor from the countryside and into the factories, but not in meaningful improvements in technology and efficiency.  To maintain their growth rates some of these countries started to “stretch” and take unnecessary risks. 

Let's take a step back and consider what this means. Suppose you own a factory with five workers, who make hand-woven baskets by hand. One way to improve your productivity (and create more baskets in the same amount of time) would be to hire additional basket weavers. Another way to improve your productivity would be to find an innovative way to weave baskets faster. East Asian economy grew primarily by adding more people without making as much innovation. (Again, this is all extremely simplified.) So when East Asian economies no longer had additional manpower to throw into the factories, problems began to boil up.

Case in pointThailand decided to build a lot of commercial buildings to encourage the development of business services such as a strong financial services sector like those that existed in Hong Kong and Singapore.  However, it wasn't working and all those newly built commercial properties had too many vacancies.  Thailand did try to “liberalize” its financial systems to help them develop faster and the get foreign financial institutions to move operations into their country, but that didn't work either. The Thais just didn't have the education base, experience or track record to develop a competitive financial services sector.   Because Thailand had a lot of real estate that was not bringing in revenue, their economy was full of what was called “non-performing loans" -- essentially, the loans that were not getting repaid by the borrowers. With a lot of overvalued properties and rising portfolio of non-performing loans the Thai economy slowed down. Thus, the Thai baht looked overvalued to currency speculators and they attacked, betting that the Thai government wouldn't have enough foreign currency to defend the baht. 

Currency Under Siege

Here, we need to understand a couple of concepts. One is short term loans.  Developing countries took on a lot of short term loans because they were considered riskier investments by the lenders of the developed world and are thus easier for developing countries to get.  The term of these loans are 12 months, meaning technically these loans need to be completely repaid within a year.  Most short-term loans are merely refinanced every year.  However, if the economic situation is unstable, given the greater risk of these short-term loans, banks can decide to not renew them and/or call them up early.

The other is foreign currency reserves, which are funds held by a nation's central bank (their version of a Federal Reserve) to stabilize their nation's currency.  For the purposes of understanding the concepts in this post, there is another function of foreign currency.  Think of it as the last reserve of having just in case your lender suddenly wants to its debt repaid ahead of schedule.  In other words, it's the last resource that a nation's central bank has in order to pay off their foreign debts if those debts suddenly and unexpectedly become due.  Think of it as a family's chest of jewelry that has quickly exchangeable value anywhere, at any time, just in case of an emergency to get you out of a pinch. So if the Thai baht or Korean won's value plummets, those respective countries can meet their short-term obligations to foreigners through their foreign currency reserves. 

Let us apply this to the Thailand situation. For ten years the Thai economy had enjoyed an average of 9.4% annual growth with only 4.7% inflation.  It looked like Thai was pulling an economic rabbit out of its hat.  But they weren't.  As mentioned before, the Thai economy by late 1996 had shown signs of strain.  It grew quickly and tried to maintain the fast growth rates, but had precariously stretched themselves which resulted in a commercial real estate bubble.  As the Thai economy slowed and strained its currency was attacked by currency speculators.

So, what's a currency speculator and why do they attack currencies?  To begin to answer these questions, we have to explore the question of what money really is.  Money nowadays has “intrinsic” value.  A dollar bill has no value in itself.  It's just paper and ink.  The value of money in the modern age is essentially what the market thinks it is.  Yes, this concept is strange when you sit down and think about it, but it wasn't always like this.  Up to about the  late 1970’s, the world had a “gold standard” where a unit of a country's currency was theoretically worth a declared amount of gold redeemable by the government.  The government's central bank would promise that an X amount of their currency would be worth a Y amount of gold.  Well, that ended in 1971.  So, since then a country's currency is whatever people think it is.  Alright, that might be a little bit of an exaggeration, but theoretically it is “guaranteed” or made “legal tender” by the country's ability to raise tax revenue, or in other words, reap productive and valuable resources from its citizens and businesses.  It's almost like a publicly exchangeable stock on an entire country.  My old college economics professors probably won't like that analogy, but it will suffice for now.

Currency speculators are needed in the marketplace.  They enable developing countries, like Thailand, to get foreign currency to buy foreign goods.  Likewise, they are needed to help foreign companies buy Thai currency so they can buy Thai products.  However, currency speculators are not around to just help people.  Like any financially minded commercial institution, they are around to make a profit.  Currency speculators make money on manipulating the “spread” or “arbitrage.”  In other words, buy one currency cheaper and sell it for a higher price.  They use derivatives and leverage to “amplify” their returns.  It took me a semester of international finance to figure out how they make massive amounts of money on derivatives based on currency fluctuations so there is no way I can explain it in a few sentences.  It is sufficient to know that foreign currency speculators can make a lot of money if it makes a lot of correct “bets” on a nation's currency.  If the bet is against a currency then this can accelerate the decline of that currency.  Although this concept may be difficult for many lay people to immediately comprehend, it's something that needs to be understood to some degree before one can properly appreciate what happened to Korea and the other newly developed East Asian economies at the time.

So, in any stock market, who determines the price?  Demand does.  The higher the demand the more “valued” the currency is.  What determines demand?  Investor confidence in the country.  Why would investors lose confidence in a country?  The same reason all investors lose confidence.  They lose confidence because the country may have a declining ability to meet its debt obligations.  So, in Thailand's case its debt rises, its economy slows and its real estate bubble begins to pop.  With those things going on people begin to doubt if the nation can pay its debt obligations to foreign lenders.

Thailand's currency, the baht, was under pressure in the early summer of 1997, as currency speculators attacked it by making “bets” that it was overvalued due to the underlying weakness of its economy.  The Thai central bank had no choice but to flood the market with foreign currency from their foreign currency reserves to buy back the baht that the currency speculators were dumping into the market.  They were thus “creating” demand to keep the value of their currency stable.  However, at this time Thailand's foreign currency reserves were modest and not enough to sufficiently counter the bets made against it by speculators.  With Thai's foreign currency reserves exhausted they could no longer maintain the peg to the major developed currencies and the value of the baht fell like a meteor.  With the baht's value dropping in half Thai's short term lenders panicked.  A sudden decline in a country's currency effectively multiplied the debt by how much the currency declines.  So if the currency declines in half, it effectively doubles the debt.  Thus, the mostly foreign short-term lenders either called in their loans early or said they wouldn't refinance the loans.  Thailand was in default and had to get a loan from the IMF to cover their short term debts.

However, the emergency IMF loans that helped the Thais to pay off their short term debt obligations didn’t come without its costs and consequences.  The IMF mandated, as a precondition to obtaining the loan, a balanced government budget, ample foreign currency reserves, controlled inflation, etc.  All these things sound good, but the problem was that the Thai government had to do implement all of this virtually immediately, which caused a good deal of austerity and hardship for its citizens and businesses.

Thus, this similar pattern spread to other formally fast growing East Asian economies as the contagion spread to Indonesia, then Malaysia and ripples were felt worldwide.  The last but largest casualty of the contagion was South Korea. How South Korea fell and what lead to its financial demise, if this demise was “fair” or “unfair,” and if external (i.e foreign) parties like the IMF had an undue responsibility will be the topic of part II.

Got a question or a comment for the Korean? Email away at


  1. This is outstanding. I was in Korea during the IMF crisis, and I remember all the news stories and such, but I still have a really hard time explaining what happened and why. Really looking forward to part II.

  2. The ironic thing is the IMF is the cure, not the problem. They promised to pay off debts that Thailand and Korea could not - in return for reforms that would enable these countries to repay the IMF later on. It's like your mom agreeing to buy you a new car after you wrecked it, but only if you cut back on your lifestyle so you could repay her. You then spend the next several years cursing your mom for your hardships.

  3. None of this is new to me, but it's a good, tidy reference I shall link back to in the future. Thanks for going to the trouble.

  4. "The Chastening" is a good book for an overview of the global crisis.

  5. Bma,

    Yes, the IMF is part of the cure, but sometimes even cures can cause more harm then they should.

    More on that in part II.

  6. The fundamental argument that Koreans have with the "IMF crisis" is not necessarily the manner in which the crisis started, but the manner in which the IMF handled it. The IMF, in exchange for more than $50 billion in loans to rescue the industrial sector from the threat of imminent collapse (the financial sector had essentially already collapsed), the IMF demanded that the Korean banking/government infrastructure lend money at extremely high interest rates. This went counter to the Korean tradition of low interest rates as a means to foster economic growth. As a result, things didn't get much better after the first six months of the IMF "rescue". Finally, Joe Stiglitz at the IMF championed a return to "the Korean way", arguing that Korean economic experts understood the Korean economy better than any outsiders. After the change in IMF demands, Korea recovered dramatically.When we began the process of writing our book "The New Korea", we scoffed at the way Koreans referred to the 1997-98 crisis as "The IMF Crisis". As we researched the period, we understood that the IMF really did screw up and Korea paid the price. The IMF deserves the anger of the Koreans for the way it did more damage to the economy than was necessary. It also deserves a little bit of credit for changing its path.

  7. One more comment/request: During the writing of our book ("The New Korea") we desperately searched for hard data on the real value of the gold jewelry that was contributed to the KCB in the midst of the crisis. We found some sources that claimed it was a made-up media event, with only a few hundred people actually donating their jewelry. We also found sources that claimed that more than $2 billion worth of jewelry was donated. If there's anyone who can point me to a definitive source of the true value of the gold contributions, I'll send that person a free copy of our book. Please post it on this comment thread.

  8. Here's a really good paper for you, WK

    Marcus Noland
    "South Korea's Experience with International Capital Flows"

  9. Linkd,

    Wasssup! Where have you been? Self imposed exile?

  10. sam jaffe,
    my whole family donated our gold at the time. my neighbors and coworkers (who would go on to lose their jobs), too.

    i have no idea how many other koreans gave their gold to save our collective selves at the time, but for us at least, that has been a source of our anger since because we now feel like we gave our jewels away for no good reason. but for what it's worth, i don't know too many koreans who didn't give whatever they had to help rescue our country.

  11. It's important to note that the IMF and the World Bank has never successfully helped ANY nation under is economic noose, moreover they have used these practices to not only cripple the nation in question but to also advance Europe and America (the votes of a nation are proportionate to the size of the economy, to pass something you need 80% vote, America alone held 17%(circa 1993)).
    It's upsetting to say the least but you must realize that they've done the same thing throughout history (you can see what they did to Jamaica in the documentary Life and Debt, on Netfilx).

  12. Where is the part 2? forgot it?


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