JPRI Working Paper No. 46: May 1998
Fashioning a New Korean Model Out of the Crisis
by John A. Mathews

The financial meltdown of East Asia in 1997 has had dramatic effects not only on the region itself, but on the debates over the sources of the "East Asian Miracle." The achievements of the fast-growing East Asian economies are not in question: as Joseph Stiglitz put it in the Asian Wall Street Journal (Feb. 2, 1998), the East Asian Miracle was real. But the methods used by the East Asians in constructing this miracle have been cast in a pitiless spotlight through the financial chain-reactions of 1997, and in many cases, been found wanting. This forces us to revaluate the intellectual underpinnings of the coordinated market systems that fashioned the East Asian Miracle.

That Southeast Asian countries like Thailand and Indonesia were the first to suffer can be explained by these countries' well-known propensities for cronyism and loose financial supervision. But when Malaysia and Singapore were dragged in, followed by the Northeast Asian miracle economies of Hong Kong and Korea, it was clear that something more than mere cronyism was at fault. As the crisis deepened, it also became clear that some countries were much worse affected than others. South Korea came very close to a complete meltdown in December 1997, while Taiwan has escaped relatively unscathed. There are clearly institutional factors involved in their differential experiences. China of course has been building its own miracle behind firmly closed borders, and the experience of 1997 has no doubt reinforced the conviction that this is a very sound way in which to develop.

While some consensus was emerging in the latter half of the 1990s over the ingredients of what might be called "the East Asian Miracle process"--to distinguish it as an intellectual construct from the actual countries where it happened--the burning question now has become: what were the ingredients of its meltdown? What were the features of the growth and development models of Southeast Asia that contributed to the financial collapse, and how did they spread so easily? What were the economic institutions of Northeast Asia that stood up to the ravages of 1997, and what were the features that succumbed, bringing down the rest of the edifice?

The case of Korea is particularly pertinent, since Korea deployed the most high risk development model in East Asia. It grew so fast, and diversified so broadly--and then it fell so hard. Over three-and-a-half decades, from 1961 to 1996, it grew from a war-torn wreck to become the world's 11th largest economy, with a gross domestic product exceeding $10,000 per capita, and to become a member of the rich nations' club, the OECD. But it all fell apart in 1997, even before the ravages of the financial crisis in Southeast Asia.

Korea experienced a shattering series of corporate bankruptcies and financial disasters in 1997 that led to a total unraveling of the country's economic system in the fourth quarter, as its currency plunged, stock markets melted, and firms found themselves trapped in liquidity crises. High debt levels that had seemed smart when external conditions were relatively favorable, allowing interest charges to be covered by growing levels of export earnings, looked very different and appeared foolhardy when external circumstances turned less favorable, and corporations' cash flow contracted to the point that repayment obligations could not be met. Smaller affiliates of conglomerates had their debts guaranteed by the rest of the corporate group, so that when they fell into difficulties they brought down the whole group with them. This happened repeatedly in 1997 with conglomerates like Hanbo, Kia, Jinro, Dainong, and Halla.

Meanwhile, banks in Japan and Hong Kong, which had granted most of the short-term debt to Korea's corporations, started to call in their loans in the fourth quarter, in order to repair their own damaged balance sheets. Out of Korea's total outstanding debt of $105.8 billion owed by domestic financial institutions on September 30, 1997, no less than $16 billion matured and was redeemed by foreign banks in October and November. This is capital drain on a major scale. It was this short-term capital outflow, when combined with investor withdrawals, that proved to be the last straw. It was not so much the size of Korea's foreign debt as its sudden contraction that triggered the default crisis at the end of November. The Institute for International Finance, in its 1998 issue of Capital Flows to Emerging Markets, reported that net private capital flows into the five economies most affected by the East Asian crisis (Indonesia, the Philippines, Malaysia, Thailand, and Korea) were reversed from an inflow of $93 billion in 1996 to an outflow of $12 billion in 1997. In Korea a moratorium on debt repayments was imminent.

At this point the IMF stepped in and hammered out a bailout package amounting to $57 billion in immediate advances and longer-term guarantees. While this had an initial calming effect internationally, it further tightened the liquidity squeeze in Korea, and bankruptcies continued apace. Foreign banks continued to refuse to roll over short-term loans, and a further $20 billion was extracted from Korea's domestic financial institutions by foreign lenders in December--not in interest charges but in redemption of short-term (and some long-term) loans. This was the final blow for a now seriously damaged economy. The shattering loss of confidence that this capital withdrawal created saw the exchange rate plunge, the stock market collapse, a now soaring rate of bankruptcies, with whole sectors like the travel industry being virtually wiped out--and all this further exacerbated the demands for debt repayment. By the third week of December the Korean economy was out of control, tossed like a cork on the seas of international finance. This was the final, inglorious end of the Korean economic miracle.

Since then, dramatic efforts led by President-elect, now President Kim Dae Jung have been mounted to reschedule the country's debts and restore some economic order. It was Kim's victory in the December 18 election, and his stated determination to abide by IMF commitments and force some bitter medicine on the Korean economy, that provided the trigger for a renewed IMF intervention. This time actively brokered by the U.S. government, a second IMF package was announced on December 24, which had the effect of halting the slide in the country's foreign exchange and currency markets. This opened the way for serious negotiations over debt-restructuring in January, which culminated in a successful rescheduling of $24 billion in short-term debt by the end of the month. This, in turn, gave Korea's beleaguered financial institutions and corporations time to restructure.

While the world's press has reported these events in great detail, very little has been written about what the Koreans themselves are doing to rebuild their industrial and financial institutions. The case can be made--as I will argue here--that the IMF agreements provided the essential cover for Korea's restructuring, which was long overdue after three-and-a-half decades of rapid growth. A new model, or "new skin" for the country's further development was needed, but it had proven to be politically impossible to drive through the necessary reforms that would inflict loss of power on banks and corporations as well as ministries. The December 1997 financial upheavals provided the crisis that the country "had to have" in order to fashion a new economic model.

There have been dimensions to the IMF agreements in Korea that critics of its imposition of austerity have missed. While an important element was certainly the IMF's usual calls for monetary and fiscal responsibility (which in any case were not lacking in Korea), and calls by the U.S. government for further opening up of Korea's financial and stock markets, there were also important structural reforms embedded in these agreements, at the behest of the Koreans themselves. For example, they call for the restructuring of financial institutions of supervision, such as the creation of a powerful new office for financial supervision separate from both the Bank of Korea and from the Ministry of Finance, to be located in the Prime Minister's office. They call for substantial reforms in the practices of corporations, requiring them to produce consolidated balance sheets that will reveal the affairs of the entire group, and reducing their ability to diversify through cross-affiliate debt guarantees. They call for substantial changes to Korea's political economy, introducing procedures for the normalization of bankruptcies, and labor layoffs by firms facing market downturns. These are structural reforms that go to the core of the problems of the "old" Korean model, and are laying the foundations for a new model.

The new Korean model is likely to prove more resilient and competitive. It will not demonstrate the tearaway growth rates of previous decades, because it will be too mature for that, like the Japanese economy with which it still compares itself. It will not be a liberalized and open economy on the Anglo-American model--or IMF model--despite the major moves made towards greater levels of transparency and openness. It will continue to demonstrate resilience because of the industrial groupings that dominate its core--the Top Five chaebol--which have used the crisis to streamline themselves, pare back unwanted diversifications and reduce their debt burdens. In any case, it was not the Top Five chaebol that precipitated the recent crisis with excessive indebtedness, but the middle ranking chaebol like Hanbo, Sammi and Halla with their exorbitant debt-to-equity ratios.

Probably the best way to capture the spirit of the new Korean model being fashioned is to compare it with the pre-war Japanese model and its zaibatsu. These have all along been the model for Korea--but in the 1960s, 1970s and 1980s it was not a feasible model since financial institutions were run by the state, not by the industrial groups. Now this is changing. As a result of the structural reforms, each of the Top Five chaebol will emerge as a set or cluster of strong industrial companies complemented by financial institutions such as securities houses, insurance companies, and ownership stakes in major banks, both retail and merchant. The best among them, like Samsung, are likely to develop equally along the three dimensions of manufacturing (e.g., heavy machinery, automotive, electronics and semiconductors), services (e.g., retail distribution, transport) and finance (banking, insurance, securities). Samsung is likely to emerge as Korea's equivalent of the Mitsubishi group--Japan's oldest zaibatsu and in the postwar era, one of its most vigorous keiretsu. Indeed Mitsubishi has all along been Samsung's model, even to the point of Samsung adopting a company name ("Tri-star") and logo that emulates the Mitsubishi triple diamond.

The Unraveling of the 1997 Korean Model

The year 1997 is certainly not the first time that Korea has fallen into the arms of the IMF. In 1971, just ten years after the unleashing of the export-oriented growth model, and again in 1980-1983, at the stormy conclusion to the crash-through program of heavy and chemical industrialization, the pattern was strikingly similar. A period of breakneck expansion of industrial capacity and output, fuelling exports and capitalized by borrowed funds, ended in an overheated blowup as external conditions turned adverse and made interest and capital repayments problematic. In each case IMF intervention calmed things down, stabilized the economy, and domestic "rationalization" cleaned out the weaker corporate players, preparing the system for its next period of breakneck expansion. It's a remarkably simple, remarkably effective model of accelerated economic catch-up. The catch is that there has to be some institution to salvage the wreckage when the process gets overheated--otherwise the foreign borrowings that drive it will dry up and capital investment will henceforth be dependent on national savings. These are not inconsiderable in Korea (as in Japan and other east Asian countries such as Singapore)--but they would not on their own provide the leverage for the accelerated growth that Korea has enjoyed.

The immediate antecedent to the 1997 crisis was the boom of the mid-1990s, when it appeared that the Korean economy could do nothing wrong. The years from 1993 to 1995 saw continuous economic expansion, with growth rates exceeding 8 percent in both 1994 and 1995, exports rising (fuelled by knowledge-intensive exports like semiconductors) and gross domestic investment rates exceeding 35 percent each year. The capital needed for such high levels of investment was found by companies and newly deregulated banks by borrowing abroad. By the end of 1996, Korea's top 30 chaebol had run up external debts on their own of 275 trillion won (around $30 billion), to finance sometimes extravagant diversifications, many of which turned sour. The Ssang Bang Wool Corporation, for example, turned from knitting and woolen garments to building ski resorts--but could not sustain the debt payments and collapsed under the effort.

The banks too enjoyed new opportunities. Under the Kim Young Sam administration, from 1994 onwards, financial liberalization and deregulation proceeded apace. No fewer than 24 new merchant banks were allowed to form, in addition to the six established banks--and they immediately looked aggressively abroad for cheap, short-term loans, which they could then use to lend at higher rates of interest to domestic Korean firms. (They could also "rediscount" the loans with the Bank of Korea, for an interest premium of 2 percent, when lending to policy-approved sectors.) Thus profits were easy to come by as long as external conditions remained more or less supportive--for example, for as long as Korean exchange rates remained in line with movements of the U.S. dollar. If the won began to depreciate vis-à-vis the dollar, it would be harder to repay loans and meet interest charges, but this was not seen as a problem in those heady days.

By the crisis year 1997, Korea's rapid industrial development through borrowed capital was nearing the end of its fourth decade. The government-induced "policy loans," which had made so much sense in the years of heavily regulated finance, made less and less sense as the financial system was slowly liberalized and deregulated. Indeed, the continuation of strong policy direction over investment and open-market sourcing of capital borrowings, made for an explosive mix in which cronyism and corruption could--and did--flourish. Nonetheless, an external crisis that no one foresaw brought the system down. How it happened is a matter of great interest, since it also affects how the new model is being fashioned, in 1998, out of the ruins of the old.

The Korean crisis of 1997 had many elements, but there were at core three processes whose interactions catapulted the country to the brink of insolvency. There was a debt default crisis, triggered by adverse external circumstances that made it difficult for companies and banks to service their loans. Korea has always lived with high debt levels, making it vulnerable to external downturns. But this crisis saw company collapses imposing huge losses on domestic banks, which in turn created a liquidity crisis as letters of credit could not or would not be honored. The liquidity crisis forced further companies and banks into difficulties, so that foreign banks and investors started to withdraw, and external credit rating agencies downgraded Korean stocks and bonds. This created a run on the currency, which had been gently devaluing after two years of appreciating along with the US dollar.

All these factors came together in a downward vicious spiral in November and December. The more the exchange rate fell, the more companies had to hedge their foreign operations, and withhold their foreign earnings, putting further pressure on the exchange rate, and exacerbating the debt repayment problems (since the external debts were largely denominated in U.S. dollars). In this way, a crisis feeds on itself and amplifies processes that would normally be self-correcting.

It is important to recognize the real character of this Korean crisis. It was not triggered by fiscal imbalance or balance of payments problems, which are the usual culprits in discussions of international financial crises, particularly from the perspective of the IMF. Nor can it be ascribed to over-reliance on debt, as opposed to some other form of capital, since the Korean model was essentially one of debt-leveraged accelerated development. Companies ran high debt/equity ratios in order to catch up quickly. Generally speaking, this worked well--so long as it was managed sensibly. But when middle-ranking companies pursued grandiose diversification schemes with little business justification or depended on bribery and corruption for the financing of suspect deals, then the model became rotten at its core. More stringent regulation was called for, at the very time that controls were being relaxed in the name of liberalization and deregulation.

As the crisis unfolded, data were released that allow us to piece together the elements in its creation. First of all, the external debts rose, driven not by public sector borrowing, but through the actions of Korean corporations and banks. As shown in Table 1, at the end of September 1997, Korea's external debts had ballooned to $170 billion (or around 24 percent of GDP)--a large amount, but proportionately much lower than in Southeast Asian countries such as Thailand. Who was doing all this borrowing? It was certainly not the public sector, as had been the case in earlier Latin American debt crises. In the case of Korea, it was banks and corporations, which had raised external borrowings of $105.8 billion and $42.7 billion respectively by the end of September. Public debts were by comparison a minuscule $2 billion. It is this character of the Korean problem that makes conventional measures of "vulnerability," such as foreign debt to reserves ratios (as used by publications like The Economist) virtually meaningless.

Korean indebtedness was "vulnerable" because of the large debt servicing burden it imposed on private corporations and banks, and because of its composition. It was largely made up of short-term debt (i.e., maturing within less than 12 months), although it was being used to finance largely long-term investments. As shown in Table 2, at the end of September 1997, short-term debt accounted for $104 billion, and long-term liabilities for $66.6 billion--a highly skewed and unstable situation, that could be toppled by an adverse turn in external circumstances. As some corporations stumbled in 1997, due to their inability to meet the heavy debt servicing charges, and their creditor banks followed them into virtual insolvency, the Bank of Korea stepped in with emergency loans that propped them up--but at the cost of dissolving confidence on the part of external lenders. It was the demands that short-term debts be redeemed--rather than being rolled over, as was normal practice--that really triggered a wholesale crisis in Korea.

As the Southeast Asian crisis started to bite in the third quarter of 1997, banks in Japan and Hong Kong in particular (which had high exposure in Korea) started to call in their loans. As their confidence in the Korean system itself started to dissolve, these demands accelerated in the fourth quarter. Figures released by the Korean Ministry of Finance and Economy this year and reproduced in Tables 1 and 2, tell the sorry story. The thing to focus on in these Tables is not the absolute levels of debt, but the contraction in debt in October and November, which triggered the first IMF intervention at the beginning of December, and the further contraction in December, which triggered the second IMF intervention. Thus Korean domestic financial institutions were required to redeem $10.5 billion in debt in October and November, and a further $20.1 billion in December--making for a remarkable redemption of $30.6 billion in the final quarter (with debt contracting from $105.8 billion to $75.2 billion over this period). Over the same period, debt owed by foreign bank branches in Korea changed little, as did debt owed to foreign banks by Korean corporations. Table 2 shows that most of the debt redeemed was short-term, while long-term liabilities over the same period actually increased. (It could be that some of this increase represents conversion of short-term debt to long-term debt, as a concession by some banks in advance of the January 1998 collective negotiations on this issue.)

It was the redemption of $30.6 billion in debts out of a total external debt for domestic financial institutions of $103.2 billion, that encapsulates the core of the Korean crisis. This on its own would have been bad enough, but in conjunction with the liquidity crisis and then the currency crisis, it was simply unsupportable. Korea nearly defaulted at the beginning of December, and certainly would have defaulted at the end of December, were it not for IMF intervention. To put it crudely, the Korean crisis was not a "run on the banks" by private depositors but rather a run by international banks on their Korean counterparts. This was the "crisis of confidence" that the Koreans were fighting against--a crisis created by the precipitate demands for debt repayment by foreign banks alarmed by the effects of the financial dislocations in Southeast Asia and by the spate of corporate collapses in Korea.

Who was lending the banks and corporations all this short-term finance? Foremost in offering heavily discounted loans were Japanese banks, anxious to increase their business in Asia generally, and in Korea in particular. European banks were also aggressively offering low-interest, short-term loans. U.S. banks such as Chase Manhattan, J.P. Morgan and Citicorp were also involved, but not to the same degree in short-term finance (see Table 3).

The involvement of Japanese banks in Korea, and their contribution to the financial crisis, is probably understated by the Table 3 figures. Some of the lending from Germany and France to Korea, for example, is attributed to European subsidiaries of Japanese banks. Likewise much of the lending channelled through Hong Kong is thought to emanate from Japanese banks. The proportion of short-term loans in Japan's exposure in Korea is thought to be high. Japanese banks were also among the most pressing in their demands for capital redemption, claiming back an estimated $8.4 billion in non-rolled over loans in the second half of 1997. Japan's own financial turmoil thus contributed to the catastrophic capital withdrawals imposed on neighboring countries like Korea.

How did Korean corporations get themselves into a level of indebtedness that made them critically vulnerable to any economic downturn or demands for capital redemption from creditor banks? This is easily answered. They simply continued to do what they had always done. High levels of debt to equity ratios, and high levels of cross-divisional debt guarantees by one affiliate supporting fellow affiliates, have always been a part of the "Korean model." In the 1990s, it was merely being practiced on a larger and riskier scale, and by smaller and less experienced chaebol, anxious to become players in the international Big League.

Across the board, Korea's top 30 chaebol were leveraged to the extent of debt exceeding shareholders' equity by nearly four times (actually, a ratio overall of 3.87). Compared with the situation in other countries, such as Taiwan (0.85), Japan (2.0) and the U.S. (1.6), such a degree of leveraging might be dismissed as foolish. Yet it sustained Korea's rapid growth in the 1980s and 1990s very nicely, particularly in the case of the top five chaebol, which fluctuated around this average (Hyundai being the most daring, at a ratio of 4.4, and Samsung the most conservative, with a ratio of "only" 2.7--as shown in Table 4). The high ratio reflects not imprudence on the part of the top chaebol, but the structure of capital institutions in the country, with banks supplying much more developmental capital than equity markets. Moreover, the Korean debt/equity ratios are far from unknown in advanced industrial countries. In the case of leveraged buyouts, where debt is involved far more than shareholder equity, such ratios would be considered conservative. So the problem was not the high debt-equity ratios in themselves, but the abuse made of this system by some of the smaller and medium-sized chaebol, who were anxious to grow and move up the ladder by whatever means available.

Worst offenders in this regard were Hanbo, whose collapse in January 1997 signalled the start of the souring of the Korean miracle, and other chaebol such as Halla, Kia, Jinro and New Core. Moreover, these worst offenders raised loans using their existing operations as security. This system, known as "cross-group debt guarantees," was a powerful weapon in the hands of Korean firms when used responsibly, enabling them to expand rapidly--but when abused it could trigger a group-wide collapse when a marginal business faced debt servicing difficulties. Halla, Kia, Jinro and New Core were all victims of their excessive use of cross-group debt guarantees for the launching of new, marginal businesses. A catastrophic series of corporate bankruptcies in 1997 revealed how vulnerable firms with high debt/equity ratios and high levels of cross-group debt guarantees could be.

Hanbo Steel folded in January 1997, with debts totalling more than 5 trillion won ($5.85 billion)--the largest collapse in Korea's history. But this was only the beginning. Other affiliates of the Hanbo group, which had been forced to act as guarantors of Hanbo Steel's debts, also collapsed, effectively bringing down the entire group, Korea's 14th largest chaebol. Hanbo Steel and Hanbo Construction were badly affected by a downturn in the building industry in Korea, but the default was actually on debt raised to build a huge steel mill. In 1988, Hanbo Steel had raised 2.7 trillion won to build the mill, when it had an equity base of 90 billion won, giving it a debt to equity ratio of 30 to 1. Costs ran well over the original estimate, and banks were continually pressed for more funds, rising by 1998 to more than 5 trillion won, against the company's equity base in January of 224 billion won, a debt to equity ratio of 22 to 1.

Why the banks continued to lend to such a poor risk subsequently became clear: they were being bribed by Hanbo's founder, Chung Tae Soo, to do so. Chung, it turned out, had been indicted twice before for bribery, but somehow had managed to stay in business. Eventually he was forced to default because even the banks, despite the bribes, refused to go on lending to him, and demanded his removal from the company's management. But instead of bankruptcy being declared, and the banks wearing the losses, Hanbo filed for--and was granted--court protection from its creditors. The government stepped in with plans to protect Hanbo's subcontractors, and even the purchasers of apartments in blocks being built by Hanbo. The banks--led by Korea First Bank, Korea Development Bank, Cho Hung Bank and Korea Exchange Bank--were forced to carry the bad loans, while the company was "restructured" under court protection. Mr. Chung was eventually removed, and Korea's premier steel company, POSCO, was brought in to oversee the final stages of construction of Hanbo's steel mill.

Korea First Bank never really recovered from this setback and was one of the banks forced by the government to close its doors in December (the government is currently trying to sell the bank, probably to a foreign buyer). But the ramifications did not end here. Investigations by the Prosecutor's office led to the arrest of officials and legislators alleged to be on the receiving end of bribes from Hanbo. By the end of February, a total of 10 businessmen, politicians and government officials had been indicted. They included: Chung Tae Soo, founder and chairman of Hanbo group, on charges of embezzlement, fraud and bribery; the presidents of Korea First Bank and Cho Hung Bank, Shin Kwang Shik and Woo Chan Mok respectively, on charges that they received personal bribes to extend loans to Hanbo Steel; plus Lee Chul Soo, a former president of Korea First Bank, on similar bribery charges; legislators Hong In Kil and Hwang Byung Tae, both members of the President's New Korea Party, on charges of influence-peddling; former Cabinet minister Kim Woo Suk, on bribery charges; and legislator Chung Jae Chul, on charges of money passing on behalf of Chung; and even an opposition legislator, Kwon Ro Gap, on charges of bribery and influence peddling (he was alleged to have been asked by Chung to prevent parliamentary hearings on Hanbo).

The entire cabinet eventually resigned to take responsibility for the scandal. In March 1997, President Kim Young Sam accepted the resignations of the prime minister and eight ministers, and ushered in a new cabinet, headed by a new prime minister, Koh Kun. President Kim Young Sam's effort to reestablish confidence in his government was rudely shattered, however, when his own son, Kim Hyun Chul, was also caught up in investigations over bribery and influence peddling. Although cleared of involvement in the Hanbo case, the son was arrested in May on bribery and tax evasion charges. This was a blow from which President Kim Young Sam's administration never really recovered, its ability to deal with the economic crisis shattered even before the crisis had really begun.

Although the Hanbo case was the worst, it was by no means the only bad case of over-extension on the part of a corporate group. Also in January, the Ssangyong Motor Company, part of the influential Ssangyong chaebol, found itself unable to meet debt charges, and sought emergency financial assistance from government-backed banks. At the time, Ssangyong Motor was a manufacturer of four-wheel drive vehicles, but it was gearing up for entry into the passenger car market and had debts of 3.5 trillion won. It survived through emergency relief for another six months, but in July 1997 had to call for assistance again, this time with two of its creditor banks, Cho Hung and Hanil, stepping in to purchase commercial paper issued by Ssangyong. The Ssangyong group was eventually forced to sell its Motors affiliate, with Daewoo emerging as surprise purchaser in 1998. The repercussions for the rest of the group were profound; Ssangyong was also forced to sell its energy affiliate, to a foreign buyer rumored in January 1998 to be Shell.

Other collapsing chaebol seeking court protection included Sammi (through its steel business, eventually taken over by POSCO); the retail group New Core, which had diversified into 18 affiliated activities; the fermented beverages group Jinro, which struck a bankruptcy prevention accord with its creditor banks; the construction group Hanshin; the Dainong group; then the Kia group in July; the Ssangbang wool group in October; followed by the Haitai group, the country's 24th largest chaebol; and then also in November, the shock collapse of the Halla group, the 7th largest in Korea.

In each case it was not the core business of the group that was caught by high debt repayment provisions, but the marginal businesses that had been started on the strength of cross-affiliate debt guarantees. This was particularly so in the case of Kia, where Kia Motors and its affiliate Asia Motors, were tripped up by the default of their affiliates in non-related activities, particularly in the steel industry (which was suffering from the downturn in demand from the construction industry). But Kia too filed for court protection from its creditors, leading to a long drawn-out battle over management control of the group that has still not been resolved.

Toward the end of 1997, bankruptcies were being registered in businesses that were otherwise healthy but that simply could not meet repayments on foreign debts because by then the currency devaluations and loss of value in their own stocks had reduced their credit ratings. Deeply distressed banks and merchant banks were cutting back on their credit lines to local enterprises, driving these healthy firms into insolvency. Halla was a victim of this kind. An otherwise excellent automotive components producer (Halla Climate Control is the leading producer of heaters and air conditioners for the automotive market), it too had diversified using loans that at one point stood at 50 times the company's equity. Again, it was the marginal businesses that brought down the core components business through the operation of cross-affiliate guarantees.

What was being done to stem the tide of the financial crisis? After so many years of relatively easy success, no one in Korea had much experience in managing a recession, and in particular, a savage externally-induced and debt-sourced recession. The Korean domestic banks, which were hit hard by these collapses, launched a rescue plan of their own in April in the form of a "bankruptcy prevention program." A company threatening to default was to receive emergency financial aid, in return for which the company's management would hand over day to day control to the banks. Naturally the chaebol were not too happy with this arrangement, and strongly resisted being brought into the program, which eventually fizzled out as the banks were overwhelmed by the scale of their losses.

As for the government, it was too busy denying the reality of the crisis and arranging for palliative actions to cope with the consequences of corporate collapses. In the middle months of 1997, the finance ministry appears to have been obsessed, along with the banks, with "bankruptcy prevention" measures, which delayed settlement of the Hanbo and Kia crises, and generated enormous uncertainty as well as ruining the creditor banks caught up in these corporate collapses. The ministry was also making attempts to maintain the value of the currency by intervening in the foreign exchange market. But even this option became problematic as foreign exchange reserves dwindled, and the country's credit rating was reduced to "junk bond" status. In terms of classical economic theory, a depreciating currency enhances competitiveness for exporters; but in a highly indebted country like Korea it translates rapidly and brutally into higher debt repayment and interest charges that overwhelm any putative enhancement of export competitiveness.

As November wore on, and foreign banks were demanding the redemption of all short term loans as they matured (i.e., a 100 percent redemption rate), with the currency sliding and repayment of interest and capital becoming more and more difficult as the currency weakened, the government was faced with the unbearable prospect of having to surrender its authority, and call in the IMF. This moment was postponed through several extremely damaging days, during which the press was rife with speculation and the foreign exchange markets played havoc with the won. A last ditch effort to retrieve the situation through reform was tried with some financial restructuring bills presented to the National Assembly--but they were voted down. At this point, the government had run out of options. Negotiations, which had been conducted in secret with the IMF, were made public, and on December 3rd a memorandum of agreement between Korea and the IMF was issued. The international body lined up a bailout package for Korea of $57 billion.

But the IMF agreement, with its upfront austerity measures, did little to address the underlying fundamentals of the Korean crisis--the short-term debt redemptions at a time when companies and banks could not repay due to currency depreciation and cashflow shortages. The key was debt rescheduling, which was not mentioned in the IMF agreement, nor addressed in the negotiations. And so the hemorrhaging went on throughout December. While the Korean government moved to implement some aspects of the IMF agreement rapidly--such as suspending operations at many of the technically insolvent banks--these actions only exacerbated the economic situation, precipitating more companies into bankruptcy.

The only positive element in Korea at this time was the presidential election, called fortuitously for December 18. When it was learned that Kim Dae Jung had been elected (on his fourth attempt) the powerbrokers of the U.S. government moved in to ensure that he would abide by the international commitments. At a meeting with U.S. Treasury official David Lipton at his home just two days after his election, Kim Dae Jung gave assurances that he understood the gravity of the problems and the solutions needed, including radical overhaul of chaebol structures and procedures, reformed bankruptcy provisions, labor market flexibility (meaning facilitation of layoffs) and opening up of stock and bond markets to foreign investors. These assurances were relayed rapidly to Washington, where the IMF moved to advance an emergency $10 billion infusion of cash to prevent a second imminent default on maturing loans. A second memorandum of understanding with the IMF was released on December 24, reinforcing the points made in the first agreement, just before the markets closed for the Christmas holiday break. When they reopened, the crisis had passed. Now the time had come for serious negotiations over debt restructuring. This time, the negotiations would be conducted by the new team ushered in by Kim Dae Jung, who was not even due to take office until February 25. But Kim Dae Jung was by now master of the political stage, and his lifelong political rival, Kim Young Sam, was already a forgotten man.

The Multiple Agendas of the IMF Agreements and Their Effect

There were three agendas at work in the twin IMF agreements signed with Korea on December 5 and 24, 1997. First, a conventional IMF agenda called for monetary rectitude, some financial austerity, and fiscal responsibility. These points, covering monetary policy and exchange rate policy, and fiscal policy, were focused on such macroeconomic objectives as narrowing the external current account deficit to below 1 percent of GDP in 1998 and 1999, containing inflation below 5 percent, and limiting deceleration of GDP growth to about 3 percent in 1998. (In the event, the turnaround in the current account was quite extraordinary, registering a surplus in December 1997 and January 1998, due not so much to the IMF measures, as to the drastic decline in imports of luxury goods.) While the macroeconomic measures in themselves were relatively pointless, what the IMF austerity measures achieved was a tightening of liquidity and the raising of interest rates--both of which have directly impinged on Korean businesses' survival capacity, and contributed to the extraordinary rate of bankruptcies that continued through December 1997 and January 1998. The IMF argued that the tightening of liquidity was necessary to restore "health" to the banking sector. While this is no doubt true, it also further tightened an economic noose that was already squeezing healthy businesses, which not only could not make the investments needed to remain competitive, but could not even secure the working capital needed to cover foreign transactions and export activity.

This IMF agenda was backed by stringent requirements on financial institutions to reach international standards in capital adequacy ratios and other operating measures, with the sanction of closure to be imposed on institutions that could not meet these requirements. The Korean government proceeded softly in implementing this aspect of the IMF's agenda after the first agreement on December 5, but the rapidly deteriorating situation as the month wore on had the effect of making the government much more amenable to closing insolvent merchant banks and imposing the IMF requirements on the remaining financial institutions.

The second component was a conspicuous American agenda to open up the Korean economy to foreign investment. This was contained in the "restructuring and reform measures" clauses of the IMF agreement, calling for accounting standards and disclosure rules to be strengthened to meet international practice and audit standards; acceleration of the schedule for allowing foreign entry into the Korean financial sector, including allowing foreign firms to establish bank subsidiaries and brokerage houses by mid-1998; liberalizing foreign investment in the Korean stock market, increasing the ceiling on aggregate foreign ownership in firms from 26 percent to 50 percent by the end of 1997 and to 55 percent by the end of 1998 (with the ceiling on individual foreign ownership to be raised from 7 percent to 50 percent by the end of 1997); allowing foreign banks to purchase equity in Korean domestic banks in excess of the 4 percent limit requiring supervisory authority approval; allowing foreign investors to purchase, without restriction, domestic Korean money market instruments and corporate bonds; and reducing restrictions on foreign direct investment in Korean industrial and other firms through simplification of procedures. These matters are not normally the subject of IMF agreements, and they reflect a clear concern by the American sponsors of the IMF, who wanted a substantial opening of the Korean market to U.S. investors as quid pro quo for the bail-out. That these matters constitute a U.S. agenda is not hard to prove, the U.S. Congress, and U.S. officials such as the Special Trade Representative, having repeatedly called for these very measures to be implemented, without success, until the financial crisis enabled them to incorporate these points into the IMF agreement.

The Koreans fought these provisions, but not very strenuously, partly because there is a strong lobby within Korea that supports such liberalization and opening up. This Korean agenda, entailing structural reforms that had long eluded the Korean government, was incorporated into the IMF agreement in return for ratification of the U.S. agenda. It is this Korean agenda that has escaped serious discussion in the international press. The Korean side in the negotiations knew exactly what they were doing and made use of the extraordinary opportunity created by the IMF intervention to transform the Korean "model" from a developmental system to a mature, "normal" system. These Korean-instigated reforms (which are not part of any comparable IMF agreement with a country in trouble) cover matters such as: corporate governance and structure (e.g., transparency of corporate balance sheets and full implementation of international accounting standards for Korean chaebol, and consolidated financial statements for business conglomerates); reducing the levels of mutual debt repayment guarantees between affiliates within a single business group; easing restrictions in the labor market over redundancies; opening the way to corporate bankruptcy procedures; and above all, reform of the financial sector, including separation between the Bank of Korea and the Ministry of Finance and the creation of a new office for the supervision of all financial institutions. Taken as a group, these constitute a quite remarkable set of structural reforms, all incorporated into the agreement at the instigation of the Korean side (according to my informants in the Ministry of Finance during extensive discussions in January 1998).

The ramifications of these reforms, all of which are being actively pursued by Korea, will be considerable. The accounting and disclosure reforms cut to the heart of the chaebol's greatest weapon in the past, namely the murkiness of their accounting practices and their refusal to provide consolidated balance sheets. The chaebol acted in this way in their own short-term interests since it enabled them to grow and diversify without effective oversight, while channeling funds from one affiliate to another. This maximized their room for maneuver and accounts (at least in part) for the great success these groups have had in entering new and increasingly sophisticated business areas, such as information technology and semiconductors. But these provisions were certainly not in their long-term interests, nor in the interests of the chaebol as a group--witness the grand failures of 1997 due to excessive risk-taking unchecked by normal corporate fiduciary requirements.

Mutual guarantees were another secret weapon of Korea's chaebol, enabling them to expand rapidly and diversify with minimal collateral. But in the hands of weaker and inexperienced players, they became a trap that could ensnare the entire group when one marginal affiliate stumbled--with Kia and Halla being two of the most spectacular cases of this effect at work. Table 4 reveals that Halla's debt guarantees amounted to 1.38 times its equity base; the situation was even worse for Jinro, whose debt guarantees amounted to 4.6 times its equity base. Total debt guarantees for the top 30 chaebeol amounted to 33 trillion won. Eliminating cross-affiliate guarantees would mean simply that affiliates would have to raise capital on the strength of their own business prospects, rather than through their membership in a wider group.

Korea's unwritten labor guarantee in the larger chaebol was lifetime employment. It was the key to maintaining a precarious balance between highly militant unions and strong managements. But it had also hindered efforts by chaebol in previous years to liquidate unprofitable businesses. The need for labor market flexibility was therefore written into the IMF agreement, but the struggle to implement it will be long and hard.

In calling for normal bankruptcy procedures, the IMF is putting on the agenda something that was never deemed to be politically feasible in Korea. The problem with the corporate collapses of 1997 was not so much that a company threatened to default on its debts, but that elaborate rescue operations were mounted to avoid bankruptcy. While these were motivated, generally speaking, by the best social intentions, their effects were usually to prolong a company's crisis, and further damage its creditor banks. Bankruptcy would be a cleaner operation, particularly in sheeting home the losses to foreign banks, which have been far too indulgent in extending credit.

Reforming the financial sector has also been included in the IMF agreements. Korea rushed pell-mell into financial deregulation in the mid 1990s for questionable motives (chiefly its eagerness to join the OECD), but as stringent and detailed controls were lifted, they were not replaced by the overall or systemic limits needed in any self-regulating system. Thus banks and corporations ran up huge short-term external debts, apparently without the bank supervision office being aware of or able to do anything about it. Reform of the Bank of Korea and creation of a new financial supervisory authority will help solve these problems.

A case can thus be made that the twin IMF agreements of December, 1997, represent a victory for all sides to the negotiations. The IMF will gain Korea's adherence to financial rectitude and macroeconomic stability; the U.S. will realize its agenda of liberalization and market-opening, paving the way for some easy pickings among Korean industrial and financial firms for cash-rich U.S. corporations; and Korea itself will reinvent its economy and enter the next 'mature' stage.

Laying the Foundations for a New Korean Model

Since it was the financial sector and its excesses that generated the Korea crisis, the starting point for building a new Korean model has to be the restructuring of this sector. There are three major elements to this. First, the worst affected and worst performing financial institutions are being closed. The greedy merchant banks that borrowed short and lent long have been singled out for disciplinary action. As part of the December IMF Accords, a total of 14 merchant banks were placed in provisional liquidation by the Kim Young Sam administration. At the beginning of February, the government announced that 10 of these would actually be shut down and arrangements made to provide some protection for their creditors. The ten banks were thinly capitalized and were deemed to face major problems in ever achieving a balanced business, since their liabilities far outweighed their assets. (They were: Gyongnam, Coryo, Samsam, Ssangyong, Hangdo, Cheongsol, Shinsegae, Shinhan, Hanwha and the unlisted Kyungil Merchant Bank. The Ssangyong and Hanwha banks were affiliates of major chaebol.) To minimize the impact on creditors--i.e., the companies that borrowed from these banks--the government set up at the beginning of February a "bridging bank" that would temporarily assume some of the debt held by the 10 merchant banks until they could be liquidated, merged, or sold. This initiative was aimed at averting wholesale bankruptcies among existing borrowers. The remaining 20 of the 30 merchant banks were given until the end of February to devise plans to stay afloat.

The second element in the restructuring involves separating the Bank of Korea (the central bank) clearly from the Ministry of Finance and Economics, and stripping both of supervisory functions. The Bank of Korea is to be consolidated as the principal instrument of the country's monetary policy--i.e., in charge of setting prime interest rates. The restructured Bank will consist of a Monetary Board as the supreme decision-making organ of the central banking system and an executive body headed by the Governor of the Bank of Korea, who will concurrently hold the position as Chair of the Monetary Board. Such a restructuring is critical to breaking the nexus between monetary policy and supervision of financial institutions, which was one of the sources of the 1997 financial crisis. The independence of the Bank of Korea is thus protected and reinforced, while its supervisory powers are to be diminished and transferred. This is a step towards the "normalization" of the Korean financial system, which along with continued enforcement of reforms, such as the "real names" requirement for financial accounts, should drastically curtail the opportunities for graft and corruption of the Hanbo Steel variety.

The third element involves restructuring completely the mechanisms for supervision of financial institutions, and the creation of a powerful new office for such a purpose, to be located within a strengthened prime minister's office. This is one of the most far-reaching and innovative reforms to emerge from the Korean financial crisis. The new consolidated institution will consist of a Financial Supervisory Board (FSB) and Financial Supervisory Agency (FSA) together with a Securities and Futures Trade Commission. The Board will be responsible for the promulgation and amendment of supervisory rules, licensing of business activities and operations of the financial institutions, other than their establishment. The Financial Supervisory Agency will be the special juridical body responsible for inspecting, auditing and sanctioning financial institutions. Until the new structures are established, an interim Financial Services Commission has been established and began operating in early April 1998 to act as financial watchdog and to direct reforms of the industrial conglomerates. The Ministry of Finance and Economy will retain the authority over macroeconomic and broad financial policy and license the establishment of financial institutions.

The restructuring essentially consolidates these existing bodies into a single and coherent set of institutions, broadening their scope and responsibilities, and severing them from the influence of the Bank of Korea and the Ministry of Finance. The FSB and FSA are likely to become central players in monitoring the future health of the financial sector in Korea and preventing any repetition of the suicidal short-term borrowings that characterized the activities of the newly established and deregulated merchant banks in the mid-1990s that helped trigger the 1997 crisis. The restructuring carries the full mandate of the IMF, and indeed would not have been politically feasible in Korea without its intervention. Bills that were presented to the National Assembly in December and voted down, were re-presented in early January and passed, with Kim Dae Jung's support, and with some amendments owed explicitly to the IMF.

The independence of the FSB/FSA and their powers to demand information from banks and financial institutions (and the requirement imposed on them to publish this information) should go a long way toward ensuring that financial crises stemming from excessive indebtedness, and in particular from short-term indebtedness, will become a thing of the past in Korea. The cycle of borrowing in order rapidly to build industrial capacity, resulting in periodic debt crises--as in 1971, 1981 and 1997--appears now finally to have run its course. In part, this is because the financial restructuring is backed by radical overhaul of chaebol industrial structures and operations.

Restructuring Korea's Industrial Conglomerates, the Chaebol

Underpinning the Korean crisis lay the expansionary practices of the mid-sized chaebol, extending their activities through debts that far exceeded their equity base or their capacity to repay. While these practices had been exposed and denounced by many before, both within and outside of Korea, they went on unchecked--with the disastrous results of 1997, and the bankruptcies of Hanbo, Sammi, Jinro, Halla and many others. So reform of chaebol practices has been near the top of the political agenda for a long time in Korea, but until 1997 the necessary will or sense of crisis was lacking.

The IMF intervention and agreements, and then the election of Kim Dae Jung as president on December 18, changed all that. The IMF Accords contained several clauses explicitly targeted at reforming the structures and operations of the chaebol. They were required to produce consolidated balance sheets, audited to international standards (as a means of identifying clearly what businesses they were in and whether one affiliate was propping up another). They were asked to restructure or divest themselves of their less well performing affiliates. They were ordered to reduce their debt levels with respect to their equity base; and, through reducing their reliance on cross-affiliate debt guarantees, to raise capital on the strength of their own business prospects or assets and not on the fortunes of the rest of the group.

While the IMF accords made mention of these issues, it was up to the Korean government (and Kim Dae Jung's transition team) to act on them and drive through the changes--something that had eluded previous administrations. Kim Dae Jung showed that he meant business by calling a meeting of the country's top five business leaders--the heads of the Top Five chaebol--on January 13, only three weeks after his election and six weeks before his inauguration, to secure their agreement to a binding 5-point undertaking. This historic compact between the chaebol leaders and the President-elect committed them to:

  • producing consolidated balance sheets, prepared according to international accounting standards;
  • terminating the cross-divisional payment guarantee system for raising loans;
  • requiring affiliates to perform profitably, and merging or divesting those that are not profitable;
  • promoting partnerships between the chaebol and small and medium-sized enterprises;
  • placing their personal wealth into their companies to improve their equity base.

This 5-point compact captured the essential reforms needed to rein in the chaebol and give more life to other elements in the Korean economy, particularly small and medium enterprises. While the abuses have generally occurred within the ranks of the middle-sized chaebol, and the Top Five have generally been responsible in their behavior, the Top Five chairmen nonetheless took responsibility for the practices of their colleagues in mid-sized chaebol and for having failed to take the lead in reform.

The key strategic weapon of the chaebol, and the factor that has enabled them to expand so rapidly, has been the lack of transparency in their accounting and shareholding details. Behind the veil of secrecy, owners and their senior managers have been able to manipulate profit and loss flows, channelling profits from one business into another to get it started or prop it up during downturns. This has been a powerful technique for entering new businesses, such as semiconductors--and when it worked, it served the firms, and Korea, very well indeed. But such a system can, and does, lead to abuses. In the case of Hanbo, for example, funds raised to build the steel mill were being siphoned off to start new, unrelated businesses, as well as to bribe bank presidents, legislators, government officials and presidential aides into maintaining the flow of funds. Even in the case of the Top Five chaebol the lack of consolidated balance sheets has presented company presidents with too many temptations for unaccountable diversification and expansion. Samsung, generally reckoned to be the best-managed company in Korea, now berates itself for having entered the automotive industry, at the cost of losses that will last until well into the next century and draining profits from the company's successful operations such as semiconductors.

The complement to insisting on transparent accounting is the elimination of the practice whereby a chaebol affiliate can raise loans backed by the security, indeed the total repayment guarantee, of its associated affiliates. This practice is to be outlawed eventually, with chaebol individually seeking to reduce the level of their guarantees as fast as possible. (On the other hand, too sudden outlawing of the guarantees, as originally demanded, could tip some groups into unnecessary bankruptcy.)

Requiring affiliate management to ensure the profitability of their businesses is code for extensive restructuring of chaebol operations. One after another, the Top 30 chaebol have been making announcements to this effect. The Hyosung group (Korea's 14th largest chaebol) was first off the mark, announcing major restructurings in March 1998. According to the group's chairman, Cho Suck Rai, Hyosung plans to reduce its affiliates from 20 to 4, through sales and mergers, so that it can concentrate on core technological businesses. The group anticipates that this restructuring will net 500 billion won ($316 million), which can be used to pay off debts and bring the group's debt to equity ratio down from 3.70 to 2.9 in the year 2000 and to below 2.0 by the year 2002. The group will introduce consolidated balance sheets in 1999 and will eliminate cross-subsidiary loan guarantees. Other chaebol are likely to follow this lead. The food giant, Daesang, has announced plans to sell as much as one third of its business to foreign firms in order to raise cash and overcome its liquidity crisis. The Hanwha group has announced plans to sell off its energy business, Hanwha Energy. The giant Hyundai group announced that it would give up its plans to enter the steel industry, while Samsung has put its plans to go it alone in the automotive business on hold. (It is reportedly seeking to establish a joint venture with Ford, incorporating the remnants of Kia.) All the major chaebol have put a freeze on their overseas expansion plans.

Calls for a better relationship between the chaebol and small and medium enterprises are intended to end chaebol predatory practices that have gone on far too long in Korea. Small firms are squeezed out of markets or, when acting as suppliers, are put at the end of the credit queue. In aggregate terms, this simply increases economic concentration in Korea for no good reason, and deprives the economy of the energy and initiative of small and nimble firms, particularly in technology-intensive and knowledge-intensive sectors. Chaebol are being urged to find ways of encouraging small and medium enterprise growth and participation in the economy, either by striking up alliances with selected firms or leaving other sectors of the economy free of chaebol influence.

Finally, president-elect Kim Dae Jung startled the business leaders by demanding that they set an example of self-sacrifice by investing their personal wealth in their companies. This is aimed ostensibly at boosting their equity in the companies and decreasing the debt-to-equity ratio, but its effects on this front are likely to be minimal. Rather, the real purpose is symbolic, demonstrating that the chaebol leaders are sharing in the sacrifices being demanded of the rest of the community. Chaebol leaders were quick to grasp this opportunity for a symbolic gesture and have made announcements of their intent to transfer family wealth into their companies.

These are the most thorough-going reforms to chaebol structures and practices in a generation. And Kim Dae Jung appears to have every intention of driving the changes through. His enforcer is the formidable Park Tae-Joon, founder of the steel giant POSCO, and now a member of the National Assembly and chairman of the United Liberal Democrats, the coalition partner with Kim Dae Jung's National Congress for New Politics. The changes envisaged will make the chaebol more responsible, more prudent, less predatory, and more transparent. Many of their businesses will be sold, in several cases to foreign firms, in order to relieve debt and liquidity problems, as well as to streamline operations. The days of huge investment rates are behind them. They will continue to be formidable competitors in international markets, particularly in areas where they have built up considerable internal knowhow, such as semiconductors, steel, and shipbuilding. But now they move into a long-anticipated "consolidation" phase, after the frantic growth and diversification of the past three and a half decades.

The Korean model ensured that Korea's economy was highly centralized and concentrated, with the Top 30 chaebol accounting for around 50 percent of all economic activity. While this served the country well during its initial decades, it also had a stifling effect on other elements in the economy, particularly small and medium enterprises. This is why Kim Dae Jung also announced steps to boost funding, export support, and services for small and medium enterprises that will bring them into a position of being able to compete with chaebol on their own terms.

The recovery of the Korean economy also calls for measures to facilitate the liquidation or disposal of firms that have become insolvent, rather than the earlier system of the state requiring them to be absorbed into another corporation's operations. Again, this could not be achieved without the mandate of the IMF, but the Kim Dae Jung administration has been moving rapidly to introduce measures for moving companies into orderly bankruptcy, or arranging for their takeover by a foreign investor.

The toughest issue of all concerns labor market flexibility, since this entails abandonment of the implicit foundation of the Korean model, namely employment security. Although this has never been spelled out in law, in practice dismissals in larger firms are almost impossible, due to the lengthy procedures required. Kim Dae Jung and his transition team grasped this nettle and conducted long discussions and negotiations with Korea's unions and union federations. A tripartite negotiating committee (consisting of government, union, and chaebol representatives) was established prior to Kim Dae Jung's inauguration, under the title Tripartite Commission on Fair Burden-Sharing. An agreement was reached early in February, with union federations promising to introduce legal procedures for companies to layoff workers, in return for certain concessions (such as rights for union members to engage in political activities in the workplace; paid leave for union delegates; and recognition of currently outlawed unions representing public employees and teachers). At the time of this writing, it is still unclear whether this agreement will hold, since there is widespread and sometimes violent opposition.

How a "New" Korean Model Is Likely to Work

The "old" Korean model, that died on November 30, 1997, and was finally buried on December 24, 1997, was built on three foundations:

  • strong industrial conglomerates (chaebol) able to penetrate new markets and industrial sectors;
  • a financial system that channelled capital, chiefly through foreign borrowings, to the chaebol ("policy loans");
  • strong "pilot agencies" to set the lead for investment in new sectors and the standards for judging corporate performance (e.g., export levels).

This model must be counted as one of the most successful "engines" of accelerated industrial development ever devised and put into practice. Its strengths were the capacity to move rapidly into new sectors--first into labor-intensive industries in the 1960s; then into capital-intensive heavy and chemical industries in the 1970s; and then into knowledge-intensive industries in the 1980s--and to mobilize the resources necessary to do so. Its weaknesses were, first, its extreme dependence on foreign borrowing, and hence vulnerability to externally generated downturns. Second, the dependence on strong and large industrial firms turned into a fetter as these firms grew ever larger and more powerful. In the 1980s, and increasingly in the 1990s, they became a political force that was in many ways out of control. The concentration engendered by the model threatened to choke off all other forms of development and initiative in the Korean economy. Only something drastic--like a major crisis--could loosen the grip that the chaebol came to exercise over the economy. Third, the role of state agencies in directing development, combined with financial non-transparency, could and did lead to excessive cronyism and outright bribery and corruption, as revealed in the case of Hanbo Steel. The strong "envelope" of regulatory controls and restrictions also became increasingly incompatible with the decision-making imperatives of nimble, high-technology firms competing in international marketplaces, and its dismantling proceeded in a jerky, on-off process of deregulation followed by re-regulation without a clear goal or sense of purpose.

This "old" Korean model, like its counterpart in Japan in the 1930s (which it resembles in many striking ways), threatened to become a political force beyond the control of existing state agencies and newly created democratic institutions. It was unstoppable, or rather, could be stopped only by a major crisis. Hence the perspective amongst the political and business elite in Korea, particularly within the circles grouped around Kim Dae Jung, to regard the 1997/98 meltdown as a "blessing in disguise."

How can the new model, which is being established now, be expected to work? The first point to note is that, in spite of all the "liberalization" and "deregulation" of the financial sector, the Koreans have no intention of replacing their former highly interventionist model of development with an Anglo-American style non-interventionist economy based on unfettered market forces. The former pilot agency, the Economic Planning Board, was abolished (or rather "absorbed" within the Ministry of Finance and Economics) in 1996, in an excess of deregulatory zeal. But a pilot agency of this kind is widely missed in Korea, and discussions are proceeding as to what kind of institution might take its place. One of Kim Dae Jung's initiatives is the creation of a new Office of Planning and Budget to be located in the Presidential Blue House, separate from the Ministry of Finance and Economics. This institutional innovation will go some way to redress the loss of coordination experienced with the demise of the ESB. Other East Asian successes, like Taiwan and Singapore, maintain their pilot agencies--the Council for Economic Planning and Development in Taiwan, and the Economic Development Board in Singapore--adapting them as needed to new circumstances but never abandoning their coordinating and lead-setting role.

In Korea, the role of economic guide is sure to be played in more subtle and sophisticated ways in future, such as through public and private research agencies setting goals for the development of new technologies or new industrial sectors (e.g., flat panel displays), and through continued interaction between trade associations and government agencies. The major point to note is the building of new institutions of state regulation and supervision, such as the Financial Supervision Board and Agency. These will be powerful bodies, able to demand information on lending practices from banks and other financial institutions, and to mount raids on the companies' premises if the information is not forthcoming. The Agency will have powers to shut down any financial institution not complying with the current rules. This is surely a case of strong "re-regulation" rather than deregulation, mandated by the IMF and the World Bank.

The Korean industrial structure is also likely to demonstrate two major new trends that will provide it with great strength and resilience in the 21st century. The first is the emergence of the chaebol as genuine "industrial groups" or clusters, on the Japanese model of keiretsu, or even more closely modeled on the Japanese prewar zaibatsu. Thus the Top Five chaebol are likely to emerge from their restructuring each as a tightly knit group of firms involved in a range of industrial sectors, knitted together by common ownership of financial institutions such as insurance companies, securities firms and (part ownership in) retail and merchant banks. Each will specialize in certain industrial sectors, but each will span manufacturing and service firms, and will have at its core financial institutions that will eventually provide a first preference channel for future capital needs. Such a structure is likely to give the Korean economy great responsive and adaptive capacities.

The second feature of the new industrial structure is likely to be flourishing small and medium-sized firms, many of which will be based on new and advanced technologies--unfettered or unobstructed by the chaebol. The emergence of such firms has been choked off in the past by the chaebol's concentrated power. In the future, chaebol will stand to benefit by entering into alliances with such small and medium enterprises as they seek to span as many of the emerging technologies as possible.

The new Korean model will use transparency and competitive processes as devices to ensure fairness and to extirpate any remnants of cronyism and corruption. This aspect of the new Korean model will be complemented by a greater reliance on the institutions of democracy in its supervision and its guidance. While Korea has made enormous advances in democratization since the ending of the military regimes in 1988, there is still much to be done to embed the processes of democracy in the institutional fabric of the country. This is precisely what the new Kim Dae Jung regime is dedicated to accomplishing. Extensive reforms are envisaged: a strengthening of the authority of the prime minister's office; a shift towards parliamentary authority and a reduction in direct presidential authority; a streamlining of the bureaucracy, and creation of new agencies such as the Office for Planning and Budget; a revitalization of local government; a renewed mandate for trade unions to engage in political activities, thus inducting them as legitimate members of the Korean body politic. Kim Dae Jung apparently has no intention of rescuing the economy and making it strong only to see it repossessed by an anti-democratic military and industrial elite.

Other analysts are less sanguine as to Korea's prospects. Robert Wade and Frank Veneroso, for example, writing in New Left Review (March-April 1998), argue that Korea's highly leveraged development model needs strong government coordination if it is to work and that this is what is being dismantled at the insistence of the IMF. Their argument does not seem to take into account the positive moves being made towards re-regulation currently underway within Korea. They offer a gloomy outlook for Korea based on consideration of four ways of reducing a mountain of debt--through inflation, through declaring bankruptcy, through repayment of debt out of cash flow, and through debt-to-equity swaps. They see Korea as being precluded by the IMF from acting decisively on any one of these fronts. I disagree with this analysis on two grounds. First, that Korea has been able to use the IMF intervention to attack its debt problem directly, such as in the negotiated roll-over of short-term loans and conversion of some of the short-term debt to longer-term securities. Second, the "solutions" such as inflation are oriented towards public sector debt of the Latin American kind in the 1980s, not to private sector debt of the East Asian 1990s kind. In Korea the chaebol are restructuring so as to reduce their own debt to equity levels, thereby changing the debt structure of the country as a whole. Thus transformed, the firms will try to trade their way out of their difficulties, and eventually retire the present debts. This is the essential ingredient of the current Korean crisis that holds the key to the country's likely emergence from this crisis.

Thus I would argue that while the "East Asian Miracle" as a political economic process, and idea, expired in 1997, another process that might be called the reinvention of the East Asian Miracle is now underway. In some countries, such as Taiwan and Singapore, the institutions of the East Asian miracle were sufficiently strong and resilient to enable the country to weather the storms of 1997 relatively unscathed. These countries did not succumb to rapid financial deregulation in the mid-1990s and did not abandon their governmental "pilot" agencies providing coordination and leadership in times of crisis. But Korea has long been a country of greater extremes. It sought more rapidly accelerated growth rates; it indulged in higher investment rates and it relied more heavily on foreign debt to finance these investment rates than any other country. It thus ran bigger risks than others, and it therefore fell more heavily when the crunch came, as it did in November 1997. But Korea is also picking itself up more rapidly and re-establishing the institutional foundations for more balanced and more responsible growth in future. In other words, it is re-inventing its own national variant of the East Asian Miracle. Those who profess to see in the events of 1997 or 1998 a definitive "end" to the East Asian Miracle, and the triumph of another form of political economy, are simply banking on the fulfillment of their fantasies.

To be sure, the "new" Korean economy will have to ride out one or two very difficult years, in 1998 and 1999, while the full effects of the 1997 financial crisis work their way through. There will be many more bankruptcies of otherwise quite healthy companies; there will be layoffs and upheavals in the labor market; there will be further debt hiccups as the legacy of the past is only slowly dismantled. But these will represent the symptoms of the dying model, not those of the model in the making. The Korean economy will remain under the supervision of the IMF and World Bank until well into 1999. There will be tough negotiations between Korea's economic management team and the IMF over critical matters such as money supply and interest rates that are widely seen in Korea as being impossibly high. These too will be difficult issues to manage and move through. And to be sure, the new Korean model will be more closely integrated into world financial and industrial processes and thus more vulnerable to downturns triggered by forces external to the country. This is unavoidable; to hide from such engagement and vulnerability is to cut the economy off from sources of vitality and innovation. The trick is to establish an institutional framework in which such external shocks can be absorbed, for example through controls on speculative capital movements that do not interfere with the genuine transfer of productive investment capital into and out of the country.

Korea has faced huge crises before and emerged stronger from the experience. In the 1950s, the country faced the ravages of a war that was fought largely for reasons of Cold War politics; it emerged from the ruins of this military convulsion to create its economic miracle. In the late 1980s, it suffered a second national crisis, as the military regime that had dominated public life for nearly three decades was brought down, and a process of democratization was begun. It was out of this political convulsion that the lineaments of a new economic model were sketched--but could not yet be implemented. The third crisis of 1997 has been financial and economic, and out of it is emerging Korea's restructured industrial and financial institutions. The country's history over the past half century would indicate that it will ride out this crisis as well.

JOHN A. MATHEWS is the ACT Government Visiting Professor in the Managing Business in Asia program at the Australian National University. This paper was prepared partly under the auspices of the "Building Institutional Capacity in Asia" project of the Research Institute for Asia and the Pacific at the University of Sydney. The assistance of Ms. Hye-Jin Lee, in Seoul, and of Ms. Elizabeth Thurbon in Sydney, is gratefully acknowledged. The arguments of the paper are based on extensive discussions held in Seoul in January 1998 by the author with business and government officials, ministers and members of the National Assembly, as well as with scholars and researchers. The author's thanks go to these informants for their frank exchanges and comments.

12,510 words

Table 1

Korea's Gross Foreign Debt (by IMF Standards) 1996, 1997 (in U.S. $ billions)


Dec 31 1996

June 30 1997

Sep 30 1997

Nov 30 1997

Dec 31 1997

Gross Foreign Debt







Financial Institutions






·  Domestic Institutions






·  Foreign bank branches






Private corporations






Public sector






* Includes $15 billion from the IMF

Table 2

Short and Long Term Debt in Korea

(in U.S. $ billions)







Total External Debt













Financial institutions






·  Domestic






·  Foreign Bank Branches






Domestic Corporations













Financial institutions






·  Domestic






·  Foreign Bank Branches






Domestic Corporations






Public Sector






Source: Ministry of Finance and Economy; IMF (Feb. 5, 1998)

Table 3

Bank Lending to Korea, by Nationality: end of June, 1997*

(in U.S. $ billions)


Outstanding Loans














Other (including Hong Kong)






* The total of outstanding loans corresponds to the external indebtedness of domestic financial institutions as of June 30, 1997, in Table I, except for a slight discrepancy caused by different data collection methods among agencies.

Source: Bank for International Settlements, The Maturity, Sectoral and Nationality Distribution of International Bank Lending, First Half 1997 (Basle, January 1998).

Table 4

Debt-Asset and Debt-Equity Ratios and Cross-Group Debt Guarantees for the 30 Largest Chaebol


Debt-Asset Ratio (top 20) (billions won)

Debt-Equity Ratio (billions won)

Debt Guarantee (trillions won)

Guarantee-equity ratio (percent)

Number of Subsidiaries (top 20)





































Hanjin (Korean Air)












































































































New Core*




































*Company under court protection
Source: Bank of Korea for debt-asset ratios for top 20; Fair Trade Commission for debt-equity ratios, debt guarantees, and subsidiaries.

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