During the Crisis

The Korean Economic Crisis | The Prologue: Before the Crisis | During the Crisis | After the Crisis | Korean Crisis Works Cited

Background Information

One of the main signs of Korea’s pending economic failure was the rise of the Current Account Deficit. In any country's economy, the interplay between domestic investment and domestic savings is very important. Domestic Investment is defined as expenditure on Plant assets, housing, or equipment, while domestic savings is national income not spent on consumption. The balancing of the two is very important because the excess of domestic investment, over domestic savings is equal to the amount of inflow of capital or investment from abroad. This excess of Domestic Investment is directly related to the excess of imports of goods and services over the exports of goods and services. This excess of the imports is labeled as the Current Account Deficit. When the Current Account Deficit goes up, this means that foreign investors have bought up local currency to invest in the country, which makes the value of the local currency to be higher. This makes exports for this country less attractive and causes a decline in exports and a rise in imports. This either creates a Current Account Deficit or increases it. To combat the valuation of their currency, the government may try to buy foreign currency with their own currency. This forces the government to print more money, causing aggregate demand to go up, causing either prices to go up and or a rise in real income. Both of these effects will decrease exports and increase imports. (3)

Increase in AD due to Government Intervention

Before the economic Crisis, Koreas economic Development was largely based around the Economic policy coined EOI, or export oriented industrialization. This policy maintains that the government Essentially lowers tariff barriers and deliberately depreciates local currencies help to increase international investment. This increase in capital should lead to a boom in exports, which are always products for which the country has a relative advantage at producing. In Koreas case, this policy did drive exports, but also had negative effects. One of these negative effects was the lack of competitiveness in the domestic financial sector, most notably the banks and leasing companies. Instead of scarcely supplying credit, banks over lent and also exposed themselves to junk bonds from other east Asian companies. Also the lack of maturity of the financial sector, mainly in the area of supervision of reserves, exposed Korea’s financial sector to exogenous shocks. Another negative effect of EOI, is that the cooperate sector lacked competitiveness, supporting chaebols(defined below), which focused on poor business strategy, concentrating on increasing market share and diversification rather than profitability and specialization. Businesses excessively borrowed foreign capital to finance these businesses practices, and coupled with poor debt management, lead to both dependence on foreign capital to sustain themselves, with also a strong dependence on the financial market. In conclusion, these poor business practices created debt-laden bloated business empires with little competitiveness that created a unstable dependence between both the business sector and financial sector in Korea.(1)

Important Chaebols

Chaebol:Chaebol refers to the several dozen large, family-controlled Korean corporate groups, assisted by government financing, which have played a major role in the South Korean economy since the 1960s. Some have become well-known international brand names, such as Samsung, Hyundai, and LG. Chaebol= big business (2)

Leading up to the Korean Economic Crisis

Before the Economic crisis, Korea’s government made many policy mistakes that lead to the economic crisis. First the government loosely pegged its exchange rate to the dollar, and did not allow its currency to fully devalue. This policy mistake allowed a rise in the value of the won during Japans economic recession, causing a fall of exports due to a loss of competitiveness. (1)

Second, the government encouraged a high rate of real wage growth, in excess of labor productivity. This made products even more expensive to produce while also companies try to cut wage costs by automating, causing high rates of investment. This investment came from abroad, due to high internal interest rates set by the Korean government.(1)

Labor Productivity vs. Real Wages

Third, the government had tight monetary policy, and set a high interest rate that was much higher than the rest of the world. This encouraged companies to borrow money from abroad, thus increasing debt and also hindering the Korean Banking system.(1)

Cause of Foreign Borrowing

All three of these policy mistakes put a squeeze on corporate profits, causing many to go bankrupt in 1997 which started the run on the Korean economy. These policies increased Korea’s foreign debt, which put the economy at high risk.(1)

Crisis Overview

The first major signs of Economic trouble came in 1996 in the form of the Current Account deficit widening from 2% of the GDP in 1995 to 5% of the GDP in 1996. This current account deficit was higher than any other industrialized nation other than Poland or the Czech republic. This deficit was made possible due to a high foreign investment due to a high exchange rate for the won. This exchange rate could have been higher, had not Korea been in the process of buying dollars with won, gaining a reserve of dollars. . At this same time, the National GDP went from 14.6% growth to 7.1% growth, and Koreas short-term foreign debt skyrocketed from 78 billion to 100 billion Also between 1995 and 1996 the rate of growth of Korea's exports fell from 31% growth to 15% growth. This is largely due to Japans recession, making the won increase in value, thus decreasing the competitiveness of Koreas exports. Also at this time, the prices for computer chips, ships, and automobiles went down, which affected over 50% of Koreas exports. Companies who exported these products were losing money and coupled with high interest rates and high real wages, felt a large squeeze thus resulting in corporate failures and bankruptcies. These bankruptcies caused the Korean stock market to decline rapidly, hitting all-time lows in a short amount of time. This caused the won to decline rapidly as well. Losing 50 % of its value in a two-week span. The last major hit to the economy was the downgrading of Korea’s bond status, going from A1 status to junk bond status, killing any chance of Portfolio investment by any international bank. This final stage caused massive withdrawals of foreign funds, kicking the legs out of the debt ridden, propped up, Korean business and financial structure.(1)

Crisis Walkthrough

Before Crisis

• Korean Companies experiencing High Real Wages, high interest rates due to Government control, Firms unable to raise domestic capital, turn to foreign investment that increases current account deficit.

• Due to high current account deficit, value of the won should increase in value due to foreign investors buying up local currency. Government combats this increase in value by increasing amount of money supply by printing won. This increases aggregate demand, increases prices, and or increase real wages due to increased economic production.

• Result: Korean Companies bloated with high wage costs, high foreign debt, high domestic interest rates, reliant on foreign capital to operate, focused on diversification and increasing marketshare instead of specialization and profitability. Debt Ratio of Korean Companies is on average 3-4, while American competitors average around .8-1.5 debt ratio.

• 1996- exogenous shocks come in the form of Japanese and European recession, value of won increases, exports become less competitive, surrounding countries also experience minor economic crisis’s, Korean exports suffer.

• Major shock- Prices and demand of Major Korean exports, those being computer chips, ships, and cars falls, exports suffer even more. Exports become less profitable, bloated chaebols plagued with debt, high wages, investment and productions costs, fail and

default.

• 1997- Hanbo Steel goes bankrupt

Sammi Group- bankrupt

• Jinso group affliates- default due to debt

• Dainong Retail chain- default due to debt

• Ssanyong- 6th largest chaebol default due to debt

• July 1997- Kia motors, 3rd largest car maker, defaults

• Mid November 1997- Stock market freefall, drops 50% of 1997 high.

• November 19th 1997- won freefalls down 50% of value in two weeks, ends at 25% of value of its 1997 high. (1)

• Korea’s bond status is downgraded to junk status, eliminates chance of International Bank Investment. Foreign Investors pull money out of Korea, trying to convert won into dollars, dropping won value even more. Economy is in severe trouble. Koreas turns to IMF.

Conclusion

Overall, The three major causes of the Korean Economic Crisis were poor business strategy and poor financial management by Koreans big business, tight government economic control that induced high foreign debt, along with exogenous shocks including a Japanese and European recession, coupled with a decrease in demand for Koreas biggest exports.

The Korean Economic Crisis | The Prologue: Before the Crisis | During the Crisis | After the Crisis | Korean Crisis Works Cited