The Prologue: Before the Crisis
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Korea's Pre-Crisis Economy
Before the crisis hit Korea in July, the East Asian economies were some of the fastest growing in the world, and as such they were drawing in a high proportion of international aid and investment capital. To fully understand how Korea and the other East Asian economies fell so hard, one must first look at their economic policies before the crisis hit.
Korea's pre-Crisis economy had several important characteristics. First, the growth that occurred in the decades leading up to the crisis was lead by policies of Export-oriented Industrialization (EOI). This concept is often employed by developing countries, to facilitate rapid economic growth. Essentially, EOI policies encourage a lowering of tariff barriers and artificially manipulating local currencies help to increase international investment. This increase in capital inflow should lead to a boom in exports, which are always products for which the country has a relative advantage at producing (1). In Korea’s case, this led to the establishment of several heavy industrial companies known in Korea as chaebols, such as automobile manufacturing, metal refining, machine fabrication and petrochemical production (1). The bankruptcy of several of these industries exacerbated the collapse in early 1997, and propelled Korea’s situation into a full-blown crisis.
Over the longer term, the idea was for the economic growth caused by EOI to help make the economy less dependent on external investment, which will make the economy more stable in general. In the case of the Korean economy in the years leading up to the crisis, they were in the middle stages of this process, where outside investment was very high, but the economy was not yet stable enough to survive any fluctuations in the capital inflow. By 1994-96, however, the EOI policies that had been adopted more than twenty years before appeared to be having unforeseen effects. Domestic savings could not keep up with external capital inflows, and Korea soon began to run what is known as a current-account deficit. This deficit grew to 5% of GNP by 1996, and represented a slowing of export growth that eventually led to the overall collapse (2).
The second main characteristic of Korea’s pre-crisis economy – particularly in the few years before – was a liberalization of both the financial and the monetary institutions that existed (3). The liberalization of financial institutions meant that the system had made certain guarantees about backing investment, which became harder and harder to meet. The liberalization of monetary institutions meant that the system had been based off of a relatively fixed rate of exchange for the Korean won, which was essentially pegged to the US dollar. The fact that internal savings could no longer match external cash-inflows coupled with liberalized fiscal and monetary institutions set the Korean economy up for a serious economic crisis.
Many economists see this pre-crisis economic situation and argue that it was a standard currency crisis that brought about the fall of the Korean economy. Others, however, argue that the Asian economic crisis was unlike any other currency crisis, for several reasons. Paul Krugman’s 1998 article, “What Happened to Asia?” outlined the characteristics of the Asian collapse, and how these characteristics differed from other observed currency crises. First of all, the Korean economy was for the most part well balanced, with low inflation rates and low rates of unemployment (4). Typically, those economies that are forced to abandon a fixed exchange rate – and thus suffer a currency crisis – are marred by very unstable investment and high unemployment. In addition, the country’s financial players appear to have been central players in the increasing vulnerability, whereas in past crises, it is the financial players which try to balance out the effects.
The Organisation for Economic Cooperation and Development
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It is important to note that in 1996, Korea joined the Organisation for Economic Cooperation and Development (OECD). This international organization was originally designed to coordinate reconstruction efforts and Marshall Plan distribution in post-WWII Europe. In recent decades, the organization has transformed to coordinate international trade policies and offer fiscal and economic advice to its members. The OECD also publishes huge statistical reports which are used as references for policy management and international economic cooperation. Unfortunately for Korea, by 1996, there was not much aid the OECD could offer, in part because the vulnerability of much of the investment was not known and in part because it was too late for some of the necessary changes to take place in time to ward off a collapse.
The Catalyst
Having seen what the pre-crisis economy looked like, it is not hard to see where the problem could have originated. What struck Korea at this point has been seen by economists as either a financial crisis, a currency crisis, or a terrible combination of the two. The two arguments can be viewed in the following manner.
Financial Crisis
Krugman's 1998 paper goes on to argue that the real beginning of the collapse centered around those financial institutions which falsely promised to back investments This led to increasingly risky investments, none of which the banking system could really back, which in turn drove up inflation of asset prices (4). Finally, at the moment of collapse, investors realized the vulnerability of their investments and the true nature of the financial guarantees, and quickly pulled all their capital out. From here, the cycle reversed, and upon seeing the true vulnerability of the system, financial institutions retracted their capital and investment insurances.
Currency Crisis
In contrast to this financial view of the crisis, there are still the economists who argue that the currency crisis is really what caused most of the problems in 1997. The bankruptcy of several key companies who had flourished in the preceding decades was caused by either dishonest business practices or an overestimation of the international market for the industries which Korea was trying to develop, and this caused foreign investment to plummet (5). From here, the currency crisis argument takes shape; falling investment led to a drop in the exchange rate of the won, despite the efforts of the government and a few other financial institutions. This currency depreciation led to further bankruptcies, which led to the end of the fixed exchange rate of the won and the downward spiral quickly continued into a full collapse.
Conclusion
What is important here is the interplay between the financial crisis and the currency crisis. There exists several links between the two, including the withdrawal of external investment, and it is easier to explain why the 1997 collapse was so severe when both aspects of the crisis are considered.
In either case, the crisis which occurred in the East Asian economies in 1997 had serious effects on the region’s lasting stability. Seven of Korea's biggest chaebols - including Kia motors - went bankrupt, the Korean stock market dropped by over 50% of its pre-crisis status and the worth of the Korean won fell as much in only three months. By the time the IMF and the United States responded to the crisis, Korea's thriving economy had been decimated; which coupled with the wider regional depressions which were going on at about the same time, held serious consequences for regional and global trade for several years after.
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