Tuesday, July 19, 2011

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

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It has been very long -- more than a year in fact. But after much badgering of the guest blogger Wangkon936, the IMF Bailout of Korea series is back. And just in time -- the Financial Times cited Part I of the series as an illustrative example of national bailouts. Below is Part II of the series.

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In 1996 South Korea was a nation on the move.  Less than 10 years ago in 1988, South Korean protests and demonstrations helped topple the authoritarian regime of President Chun Doo-hwan, and became a democracy.  That same year they hosted the Summer Olympics.  By 1996 their GDP was growing at an aggressive 7% a year clip and according to the World Bank, it had become the world's 11th largest economy.  

As the nations of Thailand, Indonesia, Malaysia and the Philippines were facing devaluations and severe stress to their economies in early and mid-1997, few thought the contagion would spread to South KoreaAlan Greenspan, the then U.S. Central Banker, said of the Korean economy:

“...A symbol of Asia’s remarkable growth, South Korea was now the world’s eleventh-largest economy, twice the size of Russia…. And while market watchers knew that there had been problems recently, the economy by all indications was still growing solidly and fast.”

Even the IMF board members' country report indicated that South Korea, as of November 1996:

“[The]... Directors praised the authorities on their enviable fiscal record and... welcomed Korea's continued impressive macroeconomics performance.”

Doubtful Foreign Currency Reserves

Why did the contagion spread to Korea?  The simple answer is that Korea had inadequate foreign currency reserves when foreign currency investors tested the Korean currency, the won.  Yet, problems of this extreme nature generally have more complex answers.  If we were to use a medical analogy, the state of Korea's reserves may have been the cholesterol in the blood vessels that caused the heart attack, but there were other factors that caused the overeating and unhealthy lifestyle that got it to the high level of cholesterol in the first place. 

(More after the jump)

Got a question or a comment for the Korean? Email away at askakorean@gmail.com.

Unlike Thailand, Korea was thought to have sufficient foreign currency reserves to support an attack on its currency by speculators.  As Alan Greenspan said in his book Age of Turbulance:

Korea's central bank was also sitting on $25 billion in dollar reserves- [we believed were] ample protection against the Asian contagion...”

So, what went wrong?  Evidently, only $9 billion of the supposed $25 billion was actually liquid and available for use as actual reserves.  Much of it was already dispersed to smaller Korean banks and tied up to support short-term foreign debt obligations.  Foreign currency reserves are meant to be saved to be used in case of an emergency -- that’s why they are called reserves.  However, in this case they were not available for the upcoming economic crisis.  So, when currency speculators attacked the won, the South Korean central bank could not come up with a sufficient answer and speculators were able to devalue it.  Yet, how did the won get so weak and vulnerable in the first place? 

The Chaebols - Fueled by Debt

Similar to Thailand, where there was an over investment in commercial real estate, Korea had an over investment in non-real estate means of production like factories, machinery, overseas acquisitions, etc.  The main drivers of Korean economic growth were the chaebols, huge family-owned conglomerates that produce anything from cars to ships to missiles to noodles.  These conglomerates enjoyed a very close relationship with the Korean government, who encouraged their growth with very favorable economic policies and access to cheap debt.  That access to cheap debt soon became an addiction and many of the chaebols had loaded themselves up with an enormous of amount of debt obligations.  When growth is strong, the chaebols can maintain high debt loads.  However, when growth starts to slow and plateau, it becomes difficult to maintain a high debt load and it's at this stage where problems can develop.

By early 1997, the top 30 largest chaebols had debt to equity ratios of an unheard of 600 percent, compared to 420 percent in 1989.  For a perspective, in the U.S., a debt to equity ratio of 150 percent would be considered high.  In fact, most American companies would consider this a seriously high level and certainly a level where the company's lenders would start to worry.  In most cases, foreign investors and debt holders did not invest directly into the chaebol, but into the South Korean government and select Korean banks, which parcelled out the capital to the private companies and offered implicit guarantees to overseas lenders that they would be paid back.  The Korean government had used some of their currency reserves to back the debt of the chaebols, which thus made that capital unavailable to defend their currency against speculators.

The best microcosm of Korea's problems with the chaebol was Hanbo Steel.  Long forgotten in the dust bin of history, Hanbo Steel epitomized what went wrong.  In 1992, Hanbo began construction of what would be the 5th largest steel manufacturing plant in the world on the south coast town of Dangjin. 45 banks lent the company $6.5 billion against only $100 million in equity, a whopping debt to equity ratio of 650 percent.  However, the technology of the plant was old, using coal burning furnaces instead of electrically heated furnaces.  The quality of the steel was inferior and the technology was not good enough to significantly improve it.  The interest payments on the debt alone ate up almost a quarter of Hanbo's revenues.  Hanbo had overestimated the demand for its steel, and actively bribed government officials for contracts and additional loans.  In January 1997, Hanbo defaulted on its loans and declared bankruptcy.

The default of Hanbo Steel, the largest bankruptcy in the history of Korea at the time, really put the nation on the radar screen of foreign investors.  As the contagion spread from Thailand to Indonesia and the Philippines, etc., foreign currency speculators realized Korea had similar macroeconomic weaknesses and made a bet that the won would devalue if was put under pressure.  They were right.  Just a few months later, with the won devaluing and debts rising, other large Korean conglomerates would declare bankruptcy and seek court protection, repeating the same cycle that had happened with Hanbo.  The end result was, of course, sudden and massive layoffs estimated to be as high as 8,000 a day.  Salary men who had jobs all their lives couldn't bring themselves to tell their families that they had lost their jobs so they dressed up and got ready to go to work like any normal day but spent their work days on park benches.  There were enormous strikes held throughout the country by labor unions protesting the closure of their factories.  Stalwarts of the Korean economy that have been household names and took decades of sweat and labor to build, such as Daewoo, Ssangyong and Kia, seemingly disappeared overnight

Returning to the medical analogy, if it was a heart attack of low foreign currency reserves unable to keep currency speculators at bay that struck Korea in 1997, then it was its unhealthy addiction to cheap and seemingly plentiful debt that lead to its arteries being clogged with cholesterol.  However, rapid economic growth is like youth and exercise.  A bad diet can partially be forgiven if you are young and if you exercise a lot.  But if your growth is slowing and your economy matures, as the region appeared to be doing in the early and late 90's, then you can't take as many macroeconomic risks.

Flaws With Korea's Development Model

Developing countries tend to take more risks to sustain their growth.  However, these countries tend to lack a lot of infrastructure, technology, education and sophisticated financial systems.  When they run out of easy ways to grow such as cheap labor, selling simple to make and inexpensive products, low capital intensive manufacturing, etc. they “stretch” to sustain their growth by making increasingly risky investments.  The fact that many of these developing countries have primitive financial systems, governments that may have had a high level of corruption and a lower technology base can make their vulnerability worse.

In Korea's case many of her industrial conglomerates were able to get so much debt relative to their modest level of assets because of their very close relationship with the government.  Since the Park Chung-Hee administration, it was determined that Korea would follow an economic growth model that relied on the close cooperation and collaboration of government and industry.  Analysts have often pointed out that this is the main reason why Korean companies were able to get so much debt.

It may be helpful to compare and contrast Korea to another Asian country, particularly one that was not meaningfully affected by the economic crisis -- Taiwan, a country that was geographically in the mix but seemed completely inoculated from the unfolding events of 1997 and 1998.  Although Taiwan is in East Asia and appears to be in the geographic path of the financial contagion, the Taiwanese dollar did not meaningfully devalue and its economy did not go through undue stress.  The biggest reason was simply that Taiwan does not have a lot of external (i.e. foreigner-owned) debt as a percentage of its GDP.  Whereas Korea had over three times as much external debt than it had foreign currency reserves, Taiwan had almost four times as much foreign currency reserves than it had external debt.  Taiwan had plenty of foreign capital to both defend its currency and pay off any external debt that foreign banks may call-up early.

Why was Taiwan's financial situation so much better than Korea's?  Taiwan followed a different economic path where they did not seek growth via pouring a lot of debt through industry conglomerates.  Taiwanese businesses are much smaller and generally not conglomerate in scope.  Taiwanese companies never grew to a size where they had enough influence to persuade the government to take on so much foreign debt on their behalf and then compound that problem by offering implicit guarantees on that debt to foreigners. 

So, when one looks at the dynamics of why certain countries go through financial crises and certain countries do not, we see there are generally solid macroeconomic reasons.  Currency speculators do not attack a currency unless there are recognized vulnerabilities.  Short-term foreign lenders don't call in their debt early if they don't think there is a risk they won't get paid back.  So, in these cases, where a developing country doesn't have a sufficient ability to defend itself against external debt, currency and liquidity issues, where do they have to turn to?  Theoretically, they have the IMF to turn to. 

The IMF- the World's Lender of Last Resort

One of the major reasons why the IMF was established was to stabilize world markets around the end of World War II.  The memory of the Great Depression, which affected Europe as much as it affected the U.S., was fresh in the minds of the people who established the IMF.  They wanted to create an organization that would help build an economically stable post war world. 

One of the major reasons why the stock market crash of 1929 grew into an economic depression was that there was no central financial institution to be the “lender of last resort” that filled the void of confidence to stop a panicked “run” at banks.  You see, no bank in the world has all the money that was deposited into it immediately available at all times.  Banks make money by lending out what others deposit into it.  When depositors get nervous about a deteriorating economic situation, they make a run at the bank to withdraw their money before other depositors get their money out first.  It's a game of financial musical chairs formally called “moral hazard.” A “lender of last resort” eliminates moral hazard and helps keep banks solvent by providing capital in emergency situations, thus filling them with liquidity, raising confidence in the marketplace and thus getting rid of the main rationale to make a run at them.

In the United States the lender of last resort is the Federal Reserve, which, if it cannot support the dollar with the currency of foreign countries, has the ability to print dollars and literally create assets “out of thin air” via the fiat power of money.  Very few countries on earth can do this to the degree that the U.S. can, so they rely on keeping reserves of dollars (as well as euros and yen) in their nation's central banks.  When they do not have enough of these reserves to stave off an economic crisis, as Korea did not in 1997, they need to rely on the IMF.

The IMF has gotten involved in lending during crises a number of times before and after 1997.  For example, there was Argentina in 1991 and Mexico in 1995.  It was not a great experience for these Latin American countries either.  After 1997, Russia needed emergency loans and most recently, the IMF had to get involved in Greece in 2010.  For pretty much every country that has turned to the IMF for help in crisis situations, they have been less than pleased with the results.

As with Thailand and Korea, the IMF asks for quite a few changes in a country's economy in exchange for being their lender of last resort.  Before I go on, it must be said that there isn't anything wrong with a lender asking for requirements from a lendee.  However, many lendee countries thought that the IMF requirements were too onerous and unfair and lacked knowledge that directly applied to the unique differences in their economies. 

The IMF's Mistakes

What the IMF asks for generally follows a recognizable pattern such as fiscal government budget cuts, wage freezing, credit tightening, liquidation of certain assets, increased government transparency, etc.  In all, what the IMF asks for requires immediate austerity, particularly to the rank and file population.  Thus, many people from these lendee countries believe that it's a type of austerity that the lender nations themselves wouldn't ask of their own country.  This is a controversial view and by no means is it automatically the correct view.  However, those that share it believe that since the bulk of the IMF's board of director's voting power are from North American and Western European countries, the IMF is less concerned with the impact that their policies will have on the population of a non-North American or non-Western European countries.  The thought is that it is easy for them to dictate changes that will create severe austerity to populations they are not directly accountable to.

The greatest critic of the IMF's handling of economic crises is developmental economist Jeffrey Sachs.  Sachs was a former Harvard economics professor and is currently with Columbia University.  In 2004 and 2005 he was named among the 100 most influential leaders in the world by Time Magazine.  His basic premise is that during the East Asian Economic Crisis the IMF failed in its job of being a lender of last resort, thus exacerbating the crisis and making the situation much worse than it should have been for the countries involved.

Sachs believes that IMF dictated austerity measures, in exchange for emergency lending, was not necessary.  He believes that if the IMF had acted more proactively, with greater knowledge of the specific needs of the countries involved and focused on preventing a panicked withdraw of liquidity out of those countries, then an economic crisis could have been avoided.  Also, Sachs believes that the IMF's power to dictate the terms of the loans were onerous on the sovereignty and long-term well-being of the countries they were professing to help.  If we are to take the  medical analogy further, Sachs is essentially saying that invasive chemotherapy, or the simple cutting off of limbs, is not always the right course of action in every situation, but he believes that is what the IMF prescribed in pretty much every situation.  Sachs believed that the IMF applied a cookie cutter approach to responding to financial crisis when a more direct, knowledgeable and targeted approach was warranted.

For example, back in the subprime mortgage crisis in 2008, America, by virtue of the fact that it was a developed, sophisticated and enormous economy, had the wherewithal to handle their liquidity emergency with internal resources, thus avoiding a type of austerity that the IMF had requested from the nations they helped over a decade earlier.  Government officials and banking professionals had the ability to rely on those that understood their economy the best to help avoid a complete melt down in their economy.  The U.S. Federal Reserve and the Department of Treasury were at least theoretically accountable to their nominal employers- the American people and their elected representatives.  Thus, they were more careful to avoid measures that advocated an immediate levying of austerity measures to combat an emerging financial crisis.

How would the American people react to an extra-government, foreign authority telling them to make massive government budget cuts, liquidate long standing companies and tighten credit that would naturally lead to long unemployment lines, a hugely undervalued currency, runaway inflation and a severely handicapped economy?  It must be remembered that to combat the subprime crisis the U.S. Treasury and the Federal Reserve relied on none of these measures to protect the economy and keep it from imploding.  On the contrary, they actually did everything they could to expand credit and requested the U.S. Congress to approve massive government spending, via stimulus packages and TARP funds, to spur the economy, again a complete opposite of what the IMF mandated the crisis affected countries to do.

(To be continued on Part III.)

Got a question or a comment for the Korean? Email away at askakorean@gmail.com.


  1. Forgive my ignorance, but who are these "foreign currency speculators", and what does is the actual process of "attacking" a currency?

  2. "One of the major reasons why the stock market crash of 1929 grew into an economic depression was that there was no central financial institution to be the “lender of last resort” that filled the void of confidence to stop a panicked “run” at banks."

    Wasn't the federal reserve created in 1913? Or was it not then a central financial institution which was "lender of last resort?"

  3. kuiwon,

    It is correct that the Fed existed well before the Great Depression. However, the Fed was restricted in its lender of last resort functions by flaws within the Federal Reserve Act which had created the Fed:

    "We trace the Fed’s failure to act as an effective lender of last resort during the Great
    Depression to defects of the Federal Reserve Act and, more broadly, of the U.S. banking system. In particular, the Act failed to recreate the money market conditions and other institutions that enabled the Bank of England and other European central banks to function effectively as lenders of last resort. In addition, the Act created a system that depended critically on the competence of
    the individuals running the system—a point which Friedman and Schwartz (1963) emphasize—
    rather than a set of rules or principles to guide lender of last resort policy. Finally, and perhaps at least as importantly, the Federal Reserve Act failed to replace the crisis-prone U.S. unit banking system with a more stable, concentrated branch banking system, such as those of the United
    Kingdom and Canada."

    From pages 3-4 of: http://research.stlouisfed.org/wp/2010/2010-036.pdf

  4. Lee,

    It would help if you read part I first.

  5. It's about time Wangkon936. I'll see you in a few years for part III :)


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