The Outbreak of the 1997 Financial Crisis and Its Recovery Doowon Lee Professor of Economics Yonsei University, Seoul, Korea Doowon Lee, School of Economics, Yonsei University

I. Outbreak: Causes of Crisis IMF Bail Out & Sharp Depreciation of e Absence of International Crisis Management System Korean Gov.'s Effort to Defend Exchange Rate Failed Failure to Roll over Short- Term Foreign Debts (kind of Bank run) Losing International Credibility Financial Sector Corporate Sector External Sector *Mounting Bad Loans *Losing Competitiveness *Excessive Investment (I>S) *Poor Corporate Governance System *Current Account Deficits Financed by Foreign Borrowing (carry trade?) *Unprepared Financial Market Liberalization

Doowon Lee, School of Economics, Yonsei University I. Outbreak: International Comparison of Debt-Equity Ratios of Mfg Industry South Korea (1997) (2004)Germany(1966)Japan(1999) Taiwan province of China (1995)U.S.(1999) * Sources : Krueger and Yoo (2001). Bank of Korea, Bank of Korea Information (June, 2001, p.66) Bank of Korea, Bank of Korea Information (June, 2001, p.66)

Doowon Lee, School of Economics, Yonsei University * source: The Bank of Korea website ( I. Outbreak: Debt Service Burden of Manufacture Company

Sources : Korea Financial Supervisory Service ( ; The Banker (July 2000, July 2001), recited From (2001.6) and Sources : Korea Financial Supervisory Service ( ; The Banker (July 2000, July 2001), recited From (2001.6) and Note : * Average of all the commercial banks NPL. Note : * Average of all the commercial banks NPL. Korea has changed its criteria of NPL in 1999 according Korea has changed its criteria of NPL in 1999 according to international standard. The ratio of NPL to total loans to international standard. The ratio of NPL to total loans increased after the adoption.Thus 13.6 is value derived increased after the adoption. Thus 13.6 is value derived from new criteria and 8.3 is based on previous criteria. from new criteria and 8.3 is based on previous criteria. ** Average of ten biggest commercial banks NPL. ** Average of ten biggest commercial banks NPL. *** Average of five biggest commercial banks NPL. *** Average of five biggest commercial banks NPL. Doowon Lee, School of Economics, Yonsei University South Korea (1997) (1999) (June, 01) U.S.**(2000)Japan**(2000) Germany *** (1999)U.K.***(1999) * I. Outbreak: International Comparison of NPL (unit: %)

Corporate and financial sector restructured Corporate and financial sector restructured Three party agreement between labor, manager, and government Three party agreement between labor, manager, and government Export led recovery -> current account surplus Export led recovery -> current account surplus Exchange rate stabilized Exchange rate stabilized Doowon Lee, School of Economics, Yonsei University II. Crisis Recovery

Doowon Lee, School of Economics, Yonsei University II. Recovery: General Review Support by Government Budget Financial Sector Restructuring M&A or Liquidation (Applying BIS criteria) Liberalization Removing Bad Loans Attracting Foreign Capital FDI Portfolio Investment Establishment of Social Safety Net Calm Labor Dispute Create Jobs Help the Unemployed Increase Foreign Exchange Reserve Decrease Foreign Debt Domestic Economy Current Account Surplus External Economy Recovery of Korean Economy Corporate Sector Restructuring Lower Debt/Equity Ratio Improving Corporate Governance M&A

II. Recovery: Summary of Reforms in Four Major Areas Doowon Lee, School of Economics, Yonsei University Note : * BIS(bank of International Settlements) ratio measures the ratio of banks equity over a weighted average of risky assets. The higher this ratio is, the more financially sound is the bank. sources : Bank of Korea website ( Korea Financial Supervisory Commision website ( Korea National Statistical Office website ( Korea Development Institute websitewww.nso.go.kr ( Fair Trade Commission website ( 1) Financial Sector Pre-Crisis SituationReform MeasuresChanges and Achievements 14 of the 27 commercial banks below BIS ratio of 8%* Troubled loans are estimated to be W 118 trillion as of March 1998 Lack of proper supervision FSC and FSS established. Initially W64 trillion of public fund was thought to be needed. As of the end of 2005, total of W168 trillion was injected and W76 trillion retrieved. Number of financial institution dropped from 2,102 to 1,341 between 1997 and Impaired loans (substandard or below) as of June 2001 estimated to be W 65 trillion, estimated to be W 49.8 trillion.

II. Recovery: The Number of Financial Institutions Doowon Lee, School of Economics, Yonsei University Fianacial SectorEnd of 1997March, 2007Change Commercial Banks Specialized and Development Banks75-2 Merchant Banks Securities Firms* Insurance Companies Investment Companies Leasing Companies Mutual Savings & Finance Companies Credit Unions (Credit Cooperatives)1,6661, Total2,1021, Note : * The number of security firms increased due to the establishment of foreigners-owned security firms. Also, some merchant banks are transformed into security firms. Sources : Recited from Figure 5 of Jones (2002), Financial Supervisory Service of Korea

BIS ratio of Commercial Banks in Korea Doowon Lee, School of Economics, Yonsei University * Sources : Bank Management Statistics of Financial Supervisory Service of Korea

ROE ratio of Commercial Banks in Korea Doowon Lee, School of Economics, Yonsei University * Sources : Bank Management Statistics of Financial Supervisory Service of Korea

ROA ratio of Commercial Banks in Korea Doowon Lee, School of Economics, Yonsei University * Sources : Bank Management Statistics of Financial Supervisory Service of Korea

II. Recovery: Summary of Reforms in Four Major Areas Doowon Lee, School of Economics, Yonsei University 2) Corporate Sector Pre-Crisis SituationReform MeasuresChanges and Achievements Highly leveraged firms with debt/equity ratio of 396.3% for manufacturing firms in the end of 1997 Poor corporate governance : cross-debt guarantees, cross- shareholdings Lack of transparency and tricky accounting practice Five guidelines Big Deals Debt/equity ratio dropped : 100.9% for manufacturing firms by Cross-debt guarantee decreased from W 11 trillion of 1998 to W 0.2 trillion of 2001 for the largest 5 conglomerates sources : Bank of Korea website ( Korea Financial Supervisory Commision website ( Korea National Statistical Office website ( Korea Development Institute websitewww.nso.go.kr ( Fair Trade Commission website (

Doowon Lee, School of Economics, Yonsei University II. Recovery: International Comparison of Debt-Equity Ratios of Mfg Industry South Korea (1997) (2005)Germany(1996)Japan (1999 -> 2003) Taiwan provinc e of China (1995)U.S. (1999 -> 2004) > > 1.41 * Sources : Krueger and Yoo (2001). Bank of Korea, Bank of Korea Information (June 2001, Sep 2005) Bank of Korea, Bank of Korea Information (June 2001, Sep 2005) Bank of Korea, Principal Economic Indicators (May 2007) Bank of Korea, Principal Economic Indicators (May 2007)

Average of 1990~ Corporate Finance Internal Source 33.9 (29.3) 31.6 (53.0) 62.9 (48.9) 83.9 (50.2) (62.7) External Source 82.0 (70.7) 28.0 (47.0) 65.8 (51.1) 83.3 (49.8) 65.8 (37.3) The Volume and Composition of Corporate Finance * Note : Numbers in parentheses are % ratios. * Source : A periodical, (in Korean) No.112, Samsung Economic Research Institute (Unit : bn Kr\, %) Doowon Lee, School of Economics, Yonsei University

Proportion of Direct Finance Out of External Sources Doowon Lee, School of Economics, Yonsei University Source : Hahm, Joon-Ho(2007), presented at A Decade after Financial Crisis : Process and Problem, 2007 Seminar of Korean Economic Association (June 11 th, 2007)

II. Recovery: Summary of Reforms in Four Major Areas Doowon Lee, School of Economics, Yonsei University 3) Labor Market Pre-Crisis SituationReform MeasuresChanges and Achievements Rigid and militant labor union Average nominal wage increase rate (13.45%) higher than average labor productivity growth rate(10.37%) from 92~96 Absence of social safety net Tripartite Commission established. Social safety net hastily set up (employment insurance system, public works program, national basic livelihood security act). More flexible labor market Average labor productivity growth rate (18.73%) higher than average nominal wage increase rate (5.87%) from 98~00. Productive welfare system sources : Bank of Korea website ( Korea Financial Supervisory Commision website ( Korea National Statistical Office website ( Korea Development Institute websitewww.nso.go.kr ( Fair Trade Commission website (

Painful Process of Laying-Off Doowon Lee, School of Economics, Yonsei University * Sources : Recited figure 3 of An article on East Asian Economies Gold from the Storm, Economist, June 28 th 2007

II. Recovery: Unemployment Rate Doowon Lee, School of Economics, Yonsei University * source : Bank of Korea (

II. Recovery: Summary of Reforms in Four Major Areas Doowon Lee, School of Economics, Yonsei University 4) Government Sector Pre-Crisis SituationReform MeasuresChanges and Achievements Regulation Inefficient public enterprises Administrative reform Deregulation Privatization Total number of civil servants decreased from 919,404 to 885,164 between Feb 1998 and Feb Number of regulations decreased from 10,717 of August 1998 to 7,156 of July Privatized 6 public enterprises and plan to privatize 5 more as of Jan sources : Bank of Korea website ( Korea Financial Supervisory Commision website ( Korea National Statistical Office website ( Korea Development Institute websitewww.nso.go.kr ( Fair Trade Commission website (

The Number of Public Officials by Successive Administrations Doowon Lee, School of Economics, Yonsei University * Sources : Maeil Business Newspaper, July 11 th (unit : persons) The Total Number of Public Officials 5 th Administration 6 th CivilianA PeopleParticipation

II. Recovery: Growth Rates of Macroeconomic Indices Doowon Lee, School of Economics, Yonsei University Note : * The growth rates are compared to the same quarter of the previous year. ** Figures for 2000 and 2001 are annual figures. sources : Major Indicators of Korean Economy, Korea Development Institute, , p.41 Bank of Korea website ( /42/43/44/41/42/43/44/4 Growth Rate(%) * GDP Consumption Investment(equipment) Investment(construction) Consolidated budget / GDP(%)** Current account balance (bn $) Inflation rate Unemployment rate

Doowon Lee, School of Economics, Yonsei University II. Recovery: Exports Have Been the Main Driver for Growth Sep- 02 Dec- 02 Mar- 03 Jun- 03 Sep- 03 Dec- 03 Mar- 04 Jun- 04 Sep Merchandise Exports (Percent change, y/y, two-month average)

II. Recovery: Exchange Rate Fluctuation (monthly)

II. Recovery: Exchange Rate Movement (annual) Doowon Lee, School of Economics, Yonsei University * source : Bank of Korea (

II. Recovery: Movement of KOSPI after the Crisis

Withdrawal of foreign capital, but in what channel? Withdrawal of foreign capital, but in what channel? - Little FDI before Stock market partially opened - Borrowing from foreign banks - Especially the loan from the Japanese banks Doowon Lee, School of Economics, Yonsei University III-1. Role of Foreign Capital in the Outbreak of Crisis

Inflow & Outflow of Portfolio Investment Doowon Lee, School of Economics, Yonsei University * Source : Economic Statistic System, Bank of Korea

Composition of Foreign Liabilities Doowon Lee, School of Economics, Yonsei University * Source : Economic Statistic System, Bank of Korea (mn, US$) Total Foreign Liabilities Government Monetary Authority Commercial Banks Excetra (NBFI)

Were there no crisis if capital market was not liberalized? Were there no crisis if capital market was not liberalized? Even before capital market liberalization, there existed insatiable demand for capital by conglomerates. Even before capital market liberalization, there existed insatiable demand for capital by conglomerates. Excessive investment caused chronic trade deficit and increasing NPLs Excessive investment caused chronic trade deficit and increasing NPLs Foreign exchange crisis could have been avoided if e was allowed to depreciate, which was politically difficult Foreign exchange crisis could have been avoided if e was allowed to depreciate, which was politically difficult Even if capital market was not liberalized, mounting NPLs would have caused domestic financial crisis. Even if capital market was not liberalized, mounting NPLs would have caused domestic financial crisis. Doowon Lee, School of Economics, Yonsei University III-1. Role of Foreign Capital in the Outbreak of Crisis

Initially, it provided much-needed liquidities. Initially, it provided much-needed liquidities. It boosted stock market, and partially eliminated the so-called Korea Discount It boosted stock market, and partially eliminated the so-called Korea Discount Structural reforms and improved profitability Structural reforms and improved profitability Protection of minority shareholders right Protection of minority shareholders right Improved transparency (case of SK) Improved transparency (case of SK) Doowon Lee, School of Economics, Yonsei University III-2. Role of Foreign Capital in the Recovery: Positive Aspect

Inflow of Foreign Capital Doowon Lee, School of Economics, Yonsei University * Source : Economic Statistic System, Bank of Korea

Doowon Lee, School of Economics, Yonsei University Price Earning Ratio (PER) MSCI World Average PER (left scale) MSCI Korea PER (left scale) ( times) year Korea PER / World PER (right scale) * source : Maeil Business Newspaper (June the 4 th, 2007)

Proportion of Foreign Possession in Stock Market Doowon Lee, School of Economics, Yonsei University * Sources : A Periodical Securities & Futures, the May 2007 issue, Korea Exchange (%) Institutes Corporate Individuals Foreigners

Consumer loans increased, and HH debt (fueled by the government policy of easy credit) accumulated that dampened consumption Consumer loans increased, and HH debt (fueled by the government policy of easy credit) accumulated that dampened consumption Doowon Lee, School of Economics, Yonsei University III-3. Role of Foreign Capital in the Recovery: Negative Aspect 1

Proportion of Corporate Loan and Household Loan Out of Commercial Bank Credit Doowon Lee, School of Economics, Yonsei University Corporate Loan Household Loan Source : Hahm, Joon-Ho(2007), presented at A Decade after Financial Crisis : Process and Problem, 2007 Seminar of Korean Economic Association (June 11 th, 2007)

Doowon Lee, School of Economics, Yonsei University

HH Debt Suppress Consumption * source : ecos.bok.or.kr

Growth potential deteriorated Growth potential deteriorated Less investment as banks are reluctant to lend Less investment as banks are reluctant to lend Threat of hostile take-over has prevented big companies from making large-scale and long-term investment: cash-hoarding, increased divident payment, buying its own shares. But, it is difficult to generalize. Threat of hostile take-over has prevented big companies from making large-scale and long-term investment: cash-hoarding, increased divident payment, buying its own shares. But, it is difficult to generalize. Increased regulation, rapidly aging population, and instable labor relation are also responsible for deterioration of growth potential Increased regulation, rapidly aging population, and instable labor relation are also responsible for deterioration of growth potential Doowon Lee, School of Economics, Yonsei University III-3. Role of Foreign Capital in the Recovery: Negative Aspect 2

Falling Growth Rate

Five Asian Economies Investment ratio & Growth rate Doowon Lee, School of Economics, Yonsei University * Sources : Recited figure 1 of An article on East Asian Economies Gold from the Storm, Economist, June 28 th 2007

PEF: Short-term speculative gains that were non-taxable: Case of Lone Stars take over of Foreign Exchange Bank of Korea in 2003 PEF: Short-term speculative gains that were non-taxable: Case of Lone Stars take over of Foreign Exchange Bank of Korea in 2003 As part of the banking sector is under foreign ownership, public good nature of banking industry is under threat. Also, it is difficult to carry out the old-style industrial policy (case of The First Bank w.r.t. Hynix), which is not always a bad thing. As part of the banking sector is under foreign ownership, public good nature of banking industry is under threat. Also, it is difficult to carry out the old-style industrial policy (case of The First Bank w.r.t. Hynix), which is not always a bad thing. Some myths about foreign capital: herd behavior? Increased volatility? Increased divident/profit? Some myths about foreign capital: herd behavior? Increased volatility? Increased divident/profit? Doowon Lee, School of Economics, Yonsei University III-3. Role of Foreign Capital in the Recovery: Negative Aspect 3

Invasion of Private Equity Fund Doowon Lee, School of Economics, Yonsei University * source : Maeil Business Newspaper (June the 23 rd, 2007)

Fixed e with capital market liberalization is difficult to maintain Fixed e with capital market liberalization is difficult to maintain After all, it was sound fundamentals of the Korean economy that enabled the recovery After all, it was sound fundamentals of the Korean economy that enabled the recovery Foreign capital is a two-edged sword. Also, it is difficult to define foreign capital in one word as they are not homogeneous. Foreign capital is a two-edged sword. Also, it is difficult to define foreign capital in one word as they are not homogeneous. Sequential liberalization of capital market is necessary Sequential liberalization of capital market is necessary Too much foreign exchange reserve can also be a problem Too much foreign exchange reserve can also be a problem Doowon Lee, School of Economics, Yonsei University IV. Lessons of the Korean Crisis

Low investment growth rate Low investment growth rate Credit bubble and household debt -> weak consumption growth Credit bubble and household debt -> weak consumption growth Government owned financial institutions Government owned financial institutions Ballooning government debt: public fund and budget deficit Ballooning government debt: public fund and budget deficit Worsened income distribution and poverty problem Worsened income distribution and poverty problem Bi-polarization of the economy Bi-polarization of the economy Set back of reforms in labor market and government Set back of reforms in labor market and government Doowon Lee, School of Economics, Yonsei University V. Side Effects and Remaining Agenda

Resulting in Unbalanced Growth Doowon Lee, School of Economics, Yonsei University * source : kosis.nso.go.kr

Private consumption & Export % change Doowon Lee, School of Economics, Yonsei University * source : Bank of Korea (

Recipient of Basic Livelihood Guarantee Doowon Lee, School of Economics, Yonsei University

Gini's coefficient Doowon Lee, School of Economics, Yonsei University * source : Bank of Korea (

Recent movement of Korean labor market: Anglo Saxon to Europe Doowon Lee, School of Economics, Yonsei University

Conflicts between Labor and Capital Doowon Lee, School of Economics, Yonsei University * source: Korea Labor Institute (

Deregulation Index (2004)

Year Regulations Number of Regulations

Korea of 2004 and the reference years of advanced countries CountriesFinlandFranceGermanIrelandItalyJapan Years CountriesNetherlandsNorwaySpainSwedenU.K.U.S.A. Years Reference Years for Advanced Economies Doowon Lee, School of Economics, Yonsei University

Government role and size: G/Y, social security/G, index of aging CountryReference Year Government Size (%, G/Y) Social Security and Welfare out of GDP (%) Index of Agingunemployment rate Japan1) USA Spain Korea (2005) Germany Ireland UK Finland Norway Italy Sweden France Netherlands Doowon Lee, School of Economics, Yonsei University

Decomposition of Sectoral Output per Worker Growth, Average of