In October 1997, the Korean Stock Exchange began to plunge followed by a sharp fall of the Korean won against the U.S. dollar. Economies in Southeast Asia such as Thailand and Indonesia have already developed instabilities in their markets to "crises" and the changes occurring in Korea were seen as part of a regional contagious effect deriving from the Southeast Asian crisis. By November 21, 1997 Korea's foreign reserves were nearly depleted, and to prevent the total collapse of the economy, the government announced that it would seek emergency loan from the International Monetary Fund (IMF) to overcome the difficulties in the financial and currency markets.


Causes of the Economic Crisis

Throughout the 1990s, the structure of the Korean economy has become increasingly vulnerable to unfavorable shocks. The vulnerability came from two sources. First was the overly short-term oriented external debt structure and insufficient foreign exchange reserves. Korea's external debt to GDP ratio has been rising rapidly and continuously since 1994 as comprehensive financial deregulation proceeded. Rapid increases in private sector borrowings including both direct borrowings of corporations and bank borrowings to finance the corporate investment, accounted for most of the external debt increase.

While the external debt to GDP ratio reached approximately 25%, not an unsustainable level given Korea's economic growth potential, the rapid increase of short-term debt and the term-mismatches were clearly signs of possible external liquidity problems. By the end of 1996, the share of short-term debt out of the total external debt peaked at 58%, while the foreign exchange reserve remained low.

The second factor behind Korea's economic vulnerability was the highly leveraged corporate financial structure. The corporate debt relative to nominal GDP ratio was at the lowest in 1987-1988 when Korea enjoyed current account surpluses. However, since then, the ratio increased substantially to reach over 1.6 in 1996. Due to the highly leveraged financial structure, largely driven by the over-investments of Korean conglomerates, chaebol, the corporate sector has become increasingly vulnerable to unfavorable shocks.

Such deficiencies in Korea's economic structure were the legacies of its past development process. The 30 years of government-led growth process created a close and collusive relationship between the government and chaebol. Chaebol were often engaged in projects at the government's bidding and the government, in turn, implicitly provided insurance against project failures. The society as a whole came to accept the so-called "too-big-to-fail" expectation. Under such a belief, the business firm's main concern became expansion in size rather than to earn profits. To finance the expansion of businesses, firms chose the option of debt-financed growth rather than equity-financed growth. The high debt-equity ratio that resulted from such strategy exceeded 400% by the end of 1997, and the average ratio for the 30 largest chaebol reached 518%. These figures are approximately twice the rate of Mexican firms and four times the rate of Thai firms at the time of their crises.

Unfavorable terms of trade shocks in 1996 severely damaged profits of Korean corporations in 1997. A series of corporate bankruptcies, even among the major chaebols, including Hanbo, Kia and Yuwon, increased the size of outstanding non-performing bank loans at an astounding speed. The deterioration of the corporate sector translated into the weakening of the financial sector. The stringent lending policies adopted by financial institutions in an attempt to minimize the effects of a worsening economic situation, resulted in the shortage of capital which further increased the number of bankruptcies.

Responding to the precarious economic situation, the government launched the Presidential Commission for Financial Reform to begin a comprehensive reform of the financial market. In the labor market, a separate Labor Reform Commission was launched in early 1997. But such early actions taken to prevent further economic deterioration failed to avert an impending crisis. Conflicts soon surfaced between the Presidential Commission for Financial Reform and the Labor Reform Commission in implementing sectoral reform measures.

At the time, the administration of President Kim Young-sam, who was also nearing the end of his term in office, could not provide necessary leadership to aid those reform efforts. The government's unwarranted heavy-handed actions subsequent to the bankruptcies of Hanbo and Kia disappointed foreign investors. Finally, the Ministry of Finance and Economy's inadequate handling of the developing foreign exchange crisis finally brought in a bailout fund from the IMF.

In other words, insolvent corporations and financial institutions damaged Korea's credibility abroad, leading to foreign capital flight. The vicious cycle of foreign exchange shortage and deterioration of Korea's credibility developed into a full-fledged foreign exchange crisis at the end of 1997.



Financial Sector Reform

In compliance with the agreement reached between the Korean government and the IMF, the economic reform program focused on macroeconomic stability. The macroeconomic policy aimed to achieve stabilization by requiring acquisition of sufficient foreign reserves, reforming the corporate and the financial sectors, and laying a foundation for enhancing the country's long-term growth potential.

The Bank of Korea maintained a tight monetary policy stance since 1997, reflected in the market interest rate hike that at one point reached as high as 20%. In the public sector, a stringent government budget was implemented with a 3.8% growth rate, which is lower than the nominal GDP growth. The organization and staff of government agencies were reorganized and paired down while local government budgets were reduced.

To reform the ailing financial sector and to restore public confidence in the system, resolution of unsound financial institutions was pursued as a top reform priority.

Banks that failed to meet the BIS capital adequacy ratios submitted rehabilitation plans to the Financial Supervisory Commission (FSC). Thorough evaluation was conducted and an appropriate restructuring of the entire financial sector took place involving acquisition, merger, purchase, and assumption.

Several unviable commercial banks that were not able to clear off bad loans through an increase in capital ratio were shut down. while licenses of unsound insurance companies and investment trust companies were revoked. Investigations were carried out for the management of non-bank financial institutions, such as leasing and life insurance companies.

The Nonperforming Asset Resolution Fund, set up in November 1997 to clear bad loans from the books of financial institutions, bought bad loans with a book-value of 16 trillion won (US$12.3 billion). Financial supervision has been strengthened through improved supervisory system and raised standards of prudential regulation. In April 1998, the Financial Supervisory Commission was launched to integrate supervisory mechanisms over banking, securities, and insurance industries. In an attempt to enhance the transparency in the financial sector, statistics on nonperforming loans of banks, including substandard loans, were released every six months.

Prudent standards were made stricter by requiring financial institutions to set aside provisions of 100% loan losses and securities valuation losses. Meanwhile, in order to resolve the problem of financial insolvency as it applies to depositors, the coverage of deposit protection was readjusted. In November 1997, the government announced that the principal and interest on all types of deposits at financial institutions would be insured in full, for an interim period up until the end of year 2000, in order to prevent bank-runs.

From 2001, however, the government guarantees up to 50 million won (US$40,000) in deposits of the principal and interest at the average rate for time deposits with commercial banks.



Corporate Sector Reform

The corporate sector reforms aimed to achieve two objectives; to reduce the size of corporate debt, and to institute a new corporate governance structure that induced better and more transparent management. Unlike in the past, the government did not intervene directly in the restructuring of the corporate sector. Instead, the government focused on improving legal and institutional environment to facilitate and monitor the process and supported the financial sector to expedite its restructuring efforts by providing funds for recapitalization and liquidate all nonperforming bonds. Korea's 30 largest chaebol accounted for about one-third of total value added in addition to fixed assets in the manufacturing sector. Although these chaebol were the primary engine of economic development in the past, their highly leveraged financial structure and unprofitable expansion made the entire economy vulnerable to the economic downfall.

Corporate restructuring became necessary because the over-extended and overlapping businesses among the chaebol were an obstacle to economic recovery.

Big corporations led by Hyundai, Samsung, Daewoo, LG and SK groups agreed to realign their businesses in seven areas - semiconductors, petrochemicals, automobiles, aircraft, rolling-stock, power generating facilities, ship engines and petroleum refining. Their efforts to merge companies in the same line of business to cut the number of companies in each field reduced the number of subsidiaries from 804 in April 1998 to 544 in 2000.

As the government implemented a ban on corporate cross-payment guarantees in April 1998, corporations could no longer finance their subsidiaries with credit or payment guarantees. In order to enhance the reliability of corporate financial statements, the Financial Supervisory Commission set new accounting and auditing rules in line with internationally accepted standards. In addition, all listed companies were required to establish a committee of external auditors. Upon implementation of these new guidelines, the quality and reliability of key financial information provided by banks and corporations were improved, thus proving regulators, shareholders, and the general public with a more credible basis for performance evaluation.

Legal protection for the rights of minority shareholders was also strengthened. The revised Security Exchange Act allows any shareholder with at least 0.5% (previously 1%) ownership the right to ask the firms to dismiss a director or an auditor, and with 1% ownership (previously 3%) to review financial accounts of the firm.

Additional measures to improve corporate governance included amending the Commercial Law to simplify M&A; procedures, shortening the appeal period for mergers from two months to one month, introducing a de facto directors system, implementing a cumulative voting system, and bestowing voting rights to institutional investors who previously were been allowed to vote.



Labor Sector Reform

The labor market environment in Korea in the past has been characterized as "rigid." The legal system awarded workers substantial job security by limiting redundancy layoffs and temporary labor contracts. The conditions and procedures of redundancy layoffs, which were not clear, in many ways placed an obstacle to flexible market adjustment, as economic growth slowed in the 1990s, and also as the economy shifted emphasis from quantitative expansion to qualitative enhancement with greater emphasis on knowledge-intensive and high-tech industries. The need for sectoral reallocation and downsizing increased, but businesses often found their ability to do so greatly restricted.

Liberalized union activity since 1987 has increased rigidity in the economy. In the late 1980s, the government failed to control the illegal practices of unions, sometimes resorting to selective intervention for political gains. Furthermore, market forces could not discipline industrial relations in large firms and chaebol, as most people in Korea believed that large firms would never go bankrupt.

In particular, unions in chaebol became stronger and more militant, and dismissals became virtually impossible. The economic crisis of 1997 provided an opportunity to enhance labor market flexibility and restore market mechanisms. There was a need for a more flexible labor market in which labor allocation and wage determination would be efficiently governed through market mechanisms. The government announced that while unlawful layoffs would not be tolerated, economic restructuring would take precedence over job security. In February of 1998, the government passed legislation legalizing redundancy layoffs, and also relaxed the previously restrictive legal provision relating to manpower leasing services. Firms in need of labor can adjust employment more flexibly and at a considerably lower cost, a major step toward economic recovery.

To tackle labor-related issues, the Tripartite Committee was formed among the representatives of labor, business, and government. The committee established rules for an equitable sharing of both economic and noneconomic costs, and attained public consensus for the restructuring. The committee accomplished an accord which contained a considerable number of measures to enhance corporate governance transparency, and to increase unemployment benefits and labor market flexibility.

Unemployment rates increased from 2.6% in November 1997 to 6.8% in 1998, but it has decreased to 6.3% in 1999, 4.1% in 2000 and 3.7% in 2001.



Public Sector Reform

The public sector in Korea has been long criticized for its inefficiency and lack of transparency. It is recognized that competition, market forces, and efficient corporate management are needed to improve the quality of administrative services. In the area of government budgeting, the government has maintained a sound fiscal stance in spite of the relatively low overall tax burden ratio. The budget structure must be changed to cut the portion of nondiscretionary expenditure. There are also inefficiencies in government spending on agriculture, education, and infrastructure. Some investment programs were initiated without the appropriate and rigorous cost-benefit analysis.

Recognizing these problems, the Korean government started to reform the budgeting system in the public sector. Initial restructuring of the central government organization began in February of 1998. To initiate the process of public sector reform, the Government Reform Office was launched in the Planning and Budget Commission, which later became a ministry. A plan for reducing the number of civil servants by approximately 10% was announced. Five ministries were eliminated out of the total number of 22. State-owned enterprises and other government-funded institutes were thoroughly examined and were streamlined to minimize government subsidies and to increase efficiency.

The range of direct government intervention was reduced, and market competition in the public sector was more widely introduced through self-discipline and privatization. The public sector will, in the long run, become a "corporation" financed by taxpayers. Customer-oriented administrative services will be provided with restructured incentive systems for public employees and a widely adopted practice of outsourcing.

Korea's tax system will be streamlined in order to increase transparency in line with international standards and the number of tax items will be reduced by consolidating many earmarked surtaxes and abolishing ineffective tax items. The income tax base will need to be broadened and more property taxes will be imposed.