The Korean Currency Crisis

A Report on the Third Country Meeting of the NBER Project on
Exchange Rate Crisis in Emerging Market Countries

John McHale
February, 2000

Meeting Organizers: Jeffrey Frankel, Jong-Wha Lee and Yung Chul Park
Project Director: Jeffrey Frankel
Advisory Board: Martin Feldstein, Paul Krugman and Jeffrey Sachs

The third in a sequence of country-specific meetings of the NBER Project on Exchange Rate Crisis in Emerging Market Countries was held in Cambridge on February 2, 2000. Following successful meetings on Mexico and Thailand, the subject this time was Korea. Jeffrey Frankel, Jong-Wha Lee and Yung Chul Park organized the meeting, bringing together a wide range of participants. In addition to academic researchers, the participant list included high-level past and current officials of the Korean and US governments, as well as key personnel from the IMF, World Bank, and financial community. As outlined in introductory remarks by National Bureau President Martin Feldstein, a key purpose of the meeting was to further self-education by listening to different perceptions of what happened in Korea, and, hopefully, to leave with a better understanding of the crisis. (1)

The day's proceedings were organized into four sessions, focusing on the build up to the crisis, macroeconomic adjustments, restructuring efforts and economic recovery, and finally lessons and prospects for the future. The format for each session was a number of short presentations by various experts followed by a general discussion. In what follows I provide a brief summary of the presentations and report on the main themes of the discussion. Many of the differences in analysis that have surfaced in previous meetings in the NBER series arose again and led to some lively exchanges. Was the crisis due to deep structural flaws or to a combination poor short-term balance sheet management and contagion? How appropriate were the structural reforms and the macroeconomic retrenchment policies demanded by the IMF? What role did the exchange rate regime play in the crisis and what is the appropriate regime for the future? For those who could not make it to the meeting, I hope that the report conveys the main elements of what was a fascinating discussion.

Session 1: Build up to the Crisis in 1997

Martin Feldstein, Harvard University and NBER

Bohn Young Koo, Korean Center for International Finance
Nouriel Roubini, U.S. Department of Treasury and NBER
Jeffrey Shafer, Saloman, Smith, Barney
Wanda Tseng, IMF

What caused the Korean crisis? In common with much of the discussion of the Asian crisis, there was an evident split on the panel between those who see the crisis as the product of severe structural weaknesses in the economy and those that see it as a mainly a liquidity crisis. To those who hold the first view, the crisis was an almost inevitable punishment for the sins of "crony capitalism." Those who hold the second view typically admit that there were mistakes in economic management, but they also point to such factors as contagion effects from other countries and the herding behavior of foreign investors.

Nouriel Roubini was the clearest exponent of the structural weakness view. He highlighted twelve vulnerabilities already apparent in early 1997.

  • 7 out of 30 chaebol were effectively bankrupt.

  • Large terms of trade shock in 1996, especially in the semi conductor sector.

  • Economy was already in recession in early 1997.

  • Non performing loans (NPLs) were already a high share of total loans, meaning that many financial institutions were effectively bankrupt. (Even though the budget deficit was low, the poor state of the financial sector implied significant government liabilities because of implicit guarantees.)

  • Excessive (directed) investment in early 1990s concentrated among the chaebols.

  • Corporate leverage was already high.

  • Low return on invested capital

  • Large and growing current account deficit together with a large stock of short-term foreign-currency denominated debt.

  • Real appreciation under the semi-fixed exchange rate peg to the dollar. Under the currency peg investors discounted the possibility of devaluation and underestimated the cost of capital.

  • Capital inflows biased toward short-term capital and against foreign directed investment.

  • Lack of transparency. For example, there was poor information on the country's short-term foreign liabilities.

  • Substantial political uncertainty, exacerbated by the government's credibility problem.

  • Roubini concluded by observing that although the data suggest a bank run, liquidity crises don't appear from no-where.

Offering the perspective of a former government official, Bohn Young Koo argued for the liquidity crisis view, although he admitted existence of structural weaknesses. The essence of this crisis, he contended, was that foreign bankers refused to role over short-term debt. He offered four reasons for their unwillingness. First, foreign exchange reserves were insufficient. Officials mistakenly believed that they had access to international capital markets always and, as short-term debt increased, they underestimated Korea's vulnerability. Second, there was an inadequate response of the government to the deteriorating situation, particularly towards the onset of the crisis; a complacency bred by the success of the economy. Third, the political scandals and uncooperative legislature made it difficult for the already lame-duck president to work effectively. Financial reform was thought essential, but with elections coming there wasn't a will for immediate reform. Finally he noted that other structural factors highlighted in much of the discussion played a role of increasing vulnerability, including banking, financial and corporate sector problems, and the spreading effects of the Asian crisis.

Jeffrey Shafer opened his presentation by agreeing that the Korean crisis was fundamentally a liquidity crisis: there were insufficient reserves and insufficient access to funds leading to the possibility of debt default by banks. But there were also long standing structural weaknesses, including current account deficits, politically directed lending and government guarantees, policies that limited long-term borrowing while encouraging short-term borrowing, and the distorted incentives of the mangers of foreign banks to seek current returns and avoid focusing on the downside risk.

Shafer emphasized that these problems had been there for a while. Why, then, did the crisis happen when it did?

He described the slide towards crisis. The exposure of individual cases of corporate financial weakness in Korea, the eruption of the Thai crisis, the exposure of Korean banks to emerging markets, and the realization that problems elsewhere would impact Korea. As investors began to pull money out, the government lowered short-term interest rates. As interest rates available from foreign sources rose, domestic borrowers tried to finance domestically. Even after the IMF program of December 1997, Korea was still judged to have market access. But Korean officials were evasive in a key conference call with investors, leading to a loss of confidence. As the bank outflow accelerated, resources were not there to cover short-term liabilities. The deprecating exchange rate did increase domestic currency debt burdens, but, in Shafer's view, the exchange rate was not the major problem.

In closing, Shafer offered two conclusions. The first was that although structural problems created the conditions, they did not cause the crisis. The second was that it is wrong to avoid tight money as a crisis threatens.

Wanda Tseng began by pointing to the difference between the Korean case and previous crisis situations that the IMF had faced. The key problem was not current account imbalances but rather structural weaknesses, including weak financial sector balance sheets and poor corporate governance. These weaknesses made Korea vulnerable to contagion. The situation was made worse by impact of corporate failures on the balance sheets of financial institutions. Ironically, the diminishing cronyism might also have contributed to the vulnerability, as doubts were cast over previously assumed government guarantees. (Koo also referred to this possibility in his presentation.)

The problems in Thailand and Hong Kong made people focus on Korea. What the published data had not previously revealed was that a large portion of apparent reserves were unusable, having been already been lent to the banks.

Korea did experience a liquidity crisis: the debt had to be extended. But major fundamental weaknesses underlay the loss of investor confidence. The policy content of the IMF programs was aimed at the structural weaknesses.

General Discussion

The nature of the crisis--fundamentals or liquidity--was also the major theme running through the general discussion. Martin Feldstein asked if the crisis would have occurred if reserves were large relative to short-term debt, even assuming all the structural weaknesses listed were present. Jeffrey Shafer responded that the crisis would not have happened with sufficient reserves. On the other hand, it wouldn't have happened if there had been a strong banking system either.

Responding to Roubini's presentation, Yung Chul Park pointed out that all emerging markets have structural problems. He also questioned the evidence for excess investment prior to the crisis, noting that capacity utilization rates are now high. (Stign Claessens commented later that high levels of capacity utilization were not all that significant, given evidence of low intensity use.) Park also questioned the significance of the high short-term borrowing, arguing that emerging economies have very little opportunity to borrow long. He agreed that Korea did limit FDI inflows, but added that Korean companies were inverting abroad. He asked, "In what industries should FDI have been liberalized." Finally he questioned whether there was any significant difference between portfolio capital and FDI in the speed with which money can flow out.

Roubini responded by saying that his view is not that there was not an element of a liquidity crisis. In the US and many European countries foreign short-term debt is high relative to reserves, but we don't observes crises. The difference, he argued, is the structure of the economic system.

At another point in the discussion Paul Krugman referred to the scare literature about financial weakness in Britain--" hedge fund Britain." But he said we don't believe it. And even if we did we would not say that Britain should have huge foreign exchange reserves.

Caroline Atkinson did not agree that a consensus had formed that Korea had suffered only from a liquidity crisis with no fundamental problems involved. Responding to Krugman, she said that people do distinguish Britain (and other industrialized economies) from emerging markets: "The economy simply operates differently."

Enrique Mendoza took up the point about the difference between Korea and an economy like Austria. The difference, he stated, is volatility. Many developed countries have high ratios of short-term liabilities to reserves but significantly less volatility. He added that we must stop thinking about fundamentals and liquidity as different issues.

Susan Collins wondered why investors thought Korea would not be next. During the debt crisis of the 1980s, she noted, Korea responded with timely policy adjustments.

Session 2: Crisis and Macroeconomic Adjustments

Yung Chul Park, Korea University

Kang-Nam Lee, Bank of Korea
David Lipton, Moore Capital Strategy Group
Timothy Lane, IMF
David Pflug, Chase Manhattan

The second session moved on to consider how the creditor panic of late 1997 and early 1998 was resolved. Among the questions to be considered: How did the late-December 1997 program differ from the earlier December 4 program? What was the effect of the initial IMF programs? Would some combination of devaluation and expansionary monetary policy have avoided the recession?

Kang-Nam Lee started off the session with a central banker's perspective on the turnaround. He stressed the importance of international funds in overcoming the crisis, and the importance of getting the private sector on board. Echoing themes from the first session, he said that the crisis was caused by a sort of herd behavior. To regain investor confidence it was necessary to push for wide ranging economic reforms. Fiscal and monetary austerity was needed in the early stages to stabilize the exchange rate. However, Korea's history of fiscal prudence allowed for the earlier relaxation of the fiscal stance. Also it was possible for interest rates to fall sharply, though a credit crunch continued due to increased capital requirements on the banks. The improving conditions allowed for a stock market recovery, and paved the way for a recovery of consumer confidence.

David Lipton offered the perspective of someone who had been a key US Treasury official during the Korean crisis. He began by admitting that not much attention was being paid to Korea in November 1997. But by the end of the month information came in that the usable reserves were very low. Helping Korea was seen as an extremely important objective for the US. The question of whether the crisis was due to fundamentals or liquidity was posed, but there wasn't time to dwell on this. The mandate from Secretary Rubin was to put together a big package--provided that Korea was willing to make decisive macroeconomic and structural changes. Among the requirements were the need to put in place policies to restore currency stability and to prevent an internal run, structural changes in the banking system, improvements in corporate governance including bankruptcy procedure, and a new regime of transparency. At this time, decentralized efforts by foreign banks to give coordinated relief were not going anywhere, leading Lipton to assume that a voluntary freeze was unlikely. With significant bad news coming out (a result of the previous limited transparency), the Treasury decided to push the new government for an affirmation of commitment to reform in mid-December. Officials were impressed that the president-elect had a clear strategy for dealing with the problem, including an active role for government, a commitment restructuring the chaebol, and a plan to include labor in the reform process. Lipton noted that the process of institutional restructuring has begun, but has a long way to go.

Lipton concluded with four lessons for similarly affected countries. First, there is a need for a firm monetary stance to lean against pressures on the currency. Second, there is a need to start deep reforms. This enhances the prospects for long-term growth and is needed to impress the markets and restore confidence. Third, macroeconomic stimulus does have potency: the weak won and fiscal expansion have powered the recovery. Finally, and more speculatively, sustained high growth will depend on pushing on with the reforms.

Timothy Lane, filling in for Michael Mussa, offered the perspective of the IMF. While he was not an active participant in the crisis management, he was responsible for an ex post assessment of what the IMF was trying to do, and why it did not initially turn out as well as expected.

Lane began by noting the two major problems. First there was the arithmetic of the ratio of reserves to the un-hedged exposure to foreign currency debt. But there also were major structural weaknesses in the financial system. It was clear that the approach to designing a program would need to be different from what the Fund had used elsewhere. In particular, there was a need to address weaknesses in the corporate sector as well as in the financial sector. At the same time, he argued, however, the claim that everything was demanded at once by the Fund is exaggerated. Many reforms-such as prudential standards for financial institutions - were to be phased in. The Fund considered that Korea's capital investment was hugely vulnerable -- including to domestic residents moving their money out--unless credible commitments to reform could be made.

On fiscal policy, Lane noted that adjustment elsewhere in the budget made room for the financial sector bail out costs, with no real overall change in the balance. However, the original estimates were based on too optimistic a target for real growth and the actual result was a much larger deficit than envisioned. On the exchange rate, he noted that the intention was not to stabilize it completely, but to "lean against the wind."

It took time for the policies to have the desired effect, and market participants were not sure at first that the policies would be implemented. Moreover, the "iron logic of a funding crisis" took hold - as usable reserves fell to a tiny fraction of short term debt. When an agreement among private creditors was reached, and a political consensus for reform arose, the package became credible.

Lane closed with a remark about bailing private creditors in. This, he noted, was important to pursue, but was extremely difficult to do without frightening investors in other markets.

David Pflug was one of the participants involved in the process of restructuring of the maturity of the debt. Drawing on this experience he raised a number of questions and points.

  • What is the effect on market participants of an event like the Asian crisis? What is the effect on market psychology of a continuum of sub-crises?

  • There is a need to distinguish between investors. Who left? And when? He stressed the importance of distinguishing between different banks in their response. "Not everyone was heading for the door." Chase, he noted, put in new money. In a similar vein he later pointed out that a very high percentage of the debt did get restructured. But added that the "small guys headed for the hills."

  • What is the effect of the Basle requirements? The international banks lending to Korea had put up very little capital.

  • What is the role of the stock market? He noted that it acts as a "load bearing wall"--when it falls it makes people ask, "What don't I know."

  • What was the impact of the rating agencies? They initially overrated Korea, and then dropped the rating three times.

  • What were the interactions between the crisis and the IMF quota debate in congress?

  • Finally he raised the conflicted role of the creditor banks being asked to restructure the debt. What is the proper balance between national interest and corporate interest?

General Discussion

Linda Goldberg asked David Pflug if he had a preference for smaller groups in efforts to coordinate creditors. She also asked him to comment on the means for bringing coordination about, including special clauses in the debt contracts. Pflug answered that he would like to see everyone caught in the same net, but as a practical matter what was necessary was to get the "big guys" together in a room. Nouriel Roubini followed up by asking why it was possible to get a roll over agreement at Christmas [of 1997] and not at Thanksgiving. Timothy Lane said that initially the voluntary approach was tried but eventually it was realized that there was no other alternative to coordination. David Lipton added that we will never know if a coordinated approach would have worked initially since it was not tried. Until early December, he added, it wasn't clear the Koreans were going to manage the economy at all well. Lipton ended by saying that next time the process is likely to be accelerated as the market catches on to what the process will be. Jeffrey Shafer argued that the banks had to be asked, but they were not asked early on. Just after the election no senior executive in New York had been asked to focus on the Korean problem, he reported. He also said that a monitoring system is needed to enforce an agreement. "It took machinery to have an enforceable standstill," he said. There had to be someone from the IMF sitting in the Bank of Korea recording the transfer of funds every night. Otherwise there was no check on the drainage of funds. Martin Feldstein asked if the Treasury discussed with the Fed or the Fund getting the banks together. Lipton answered that it was not initially a focus. Emphasis was first on putting a program in place. Caroline Atkinson added there was a great concern not to make contagion worse. David Pflug observed that the lack of trust in the system, even compared to the 1980s, made it hard to make agreements of the sort being discussed work.

Martin Feldstein asked if the Treasury thought about the impact of the elections. No, was David Lipton's response, adding that they [the Korean government] were about to "run out of money." Andrew Berg asked if rumors that that the banks were demanding reform of the financial sector were true. The answer was no. David Pflug admitted that he spent his time trying to get fifty basis points on the roll over--not demanding financial sector reform.

Switching focus, Richard Cooper said there had allegedly been strong demands to open the auto industry. Unlike demands for reform in the financial sector, it was unclear to him why this was relevant. He also asked about what interest rates were being demanded on the roll overs. David Lipton responded that the issue of autos was not discussed. US government officials were very aware that they were there with the IMF, and that any mention of inappropriate bilateral issues would cause difficulties. The question, he contended, was "What was needed to restore confidence?" One element was the need to move to a market-based from a bank-based capital system. Lipton added that he did not believe that it was purely a liquidity problem. There were important structural weaknesses, including labor taking all of the productivity gains. David Pflug then responded to the interest rate part of Cooper's question: 275 basis points (over LIBOR) for one year, and 300-325 basis points for two years.

Turning to the often-heard criticism that the IMF had forced structural changes on Korea and Lipton's claim that the measures were voluntarily adopted by the Korean government, Yung Chul Park contended that the Korean President did not ask for these reforms. "They were imposed," he said. David Lipton responded that the Korean President-elect embraced the concepts in the package.

The discussion then turned to macroeconomics, with David Lipton predicting that the success of the Korean going forward depends on it ability to control inflation. Kang-Nam Lee agreed, and pointed out that Korea was pursuing a medium-term inflation target of 2.5 percent in order to keep expectations of inflation low and to maintain investor confidence. Commenting on monetary policy during the crisis, Timothy Lane stressed interest rates were not pushed to whatever level was needed to stabilize the currency. Since this was not tried, he said, the jury is still out on the effect of high interest rates on the exchange rate in a crisis situation.

Session 3: Restructuring and Economic Recovery

Jong-Wha Lee

Ajai Chopra, IMF
Kap-Soo Oh, Financial Supervisory Service
Zia Qureshi, The World Bank
Caroline Atkinson, United States Treasury

In the third session the focus moved to the actual progress in financial and corporate sector reform. The Chairman also posed two important questions for consideration in the session. First, referring to Korea's famous V-shaped recovery, he asked, "How did Korea recover so fast?" And second, "Do the reforms mean sustainable growth in the future?"

Ajai Chopra opened by stressing the IMF's heavy emphasis on promoting recovery. He observed that the speed and extent of recovery have been spectacular, and there has been a major decrease in external sector vulnerability as reserves have grown relative to short-term debt. In his view, appropriate macroeconomic management and structural reforms brought this improvement about. Even though Korea is now a more open, market-driven economy, he cautioned that there are still structural weaknesses and the economy remains vulnerable to domestic and external shocks.

In charting the recovery he used Sweden, Finland and Mexico as standards of comparison. Each of these countries underwent difficult adjustments during the 1990s. In addition, he considered Sweden and Finland as especially good standards, since they, like Korea, have large industrial sectors.

Korea's turned around more quickly than all three. Initially, the recovery was in the external accounts, but it has recently expanded to domestic demand. In Sweden the authorities had a weak fiscal position that limited their ability to respond. Korea has had more freedom. Moreover, in Korea it was import compression rather than an export surge that brought about the initial improvement in the external accounts. However, since mid-1998, robust export growth, benefitting from a competitive exchange rate and a favorable international environment, has been a major factor. In addition, the strong balance sheet position of households helped foster a relatively quick rebound in consumption. At the firm level, he noted that fixed investment is recovering and there has been an inventory rebound. More recently, there are also signs of a rebound in the construction sector.

The core challenge, Chopra argued, is to understand the virtuous circle that has underpinned the recovery. He pointed to a number of factors:

  • Moving quickly and aggressively to clean up banks' books.

  • Easy monetary policy after exchange rate stability had been achieved.

  • Wage and employment flexibility.

  • Commitment to political reforms the increased investor and consumer confidence.

  • Positive external shocks such as the upswing in the global electronics market.

Next Kap-Soo Oh offered the perspective of a financial supervisor on Korea's recovery. He pointed to the improved condition of the financial sector, emphasizing such outcomes as the reduced number of banks and investment companies, and the enhanced use of forward looking criteria for judging the credit worthiness of borrowers. Measures have also been taken so that the chaebol cannot use financial institutions as their private banks. Debt-equity ratios have fallen, and there have been a large number of debt workout agreements. In his view, the ongoing structural reform has achieved remarkable progress in improving overall levels of transparency, efficiency and governance of the corporations and the financial institutions. He also sees the strong growth of entrepreneurial firms as a favorable sign.

On a more negative note, Mr. Oh noted that investment has lagged and export growth was to a large extent the result of favorable external conditions. Turning to the difficulties that lie ahead, he pointed to the difficulties that increased loan provisioning will impose on the banks and the danger of complacency will slow down the impetus for reform.

He closed on an optimistic note. The new market environment, he contended, should help avoid the build up of structural imbalances in the Korean economy. He also expressed the conviction that the government will continue with financial and corporatre sector reform. Korea has made a good start and sustained reform will pave the way for continued growth.

The emphasis on structural reform in the financial and corporate sectors continued in Zia Qureshi's presentation. On the depth of reforms, Qureshi believes that Korea compares favorably with other crisis affected East Asian economies and with post-crisis Mexico. In the financial sector, Korea has moved quickly to restructure and recapitalize banks and to strengthen that framework for bank prudential regulation and supervision. In the corporate sector, major progress has been made in reducing debt-equity ratios. Other favorable developments have been the impetus the Daewoo crisis has given to reform, reforms of corporate governance, and the opening up to foreign ownership.

Yet further progress is needed for the current recovery to be translated into sustained growth. He listed seven areas for further effort:

  • A large part of the financial sector has been nationalized. A key issue is how it will be reprivatized (including the role for foreign capital).

  • There is a danger of "regulatory arbitrage." The present crisis in the investment trust industry indeed resulted in part from regulatory arbitrage. With the increase in the assets of the non-bank financial institutions, it will be a priority to extend improved regulation to the entire financial sector.

  • There still needs to be much improvement in such areas as financial institutions' management, supervision and credit evaluation.

  • Debt-equity ratios remain high. New policies and institutions are needed in order to achieve deeper debt restructuring, such as more conducive policies on prudential and tax treatment of restructured debt and private sector based corporate restructuring vehicles..

  • Korea must develop and modernize its bankruptcy and reorganization procedures.

  • Further progress needs to be made in improving corporate governance and enhancing competition. Governance must be redirected to maximizing shareholder value from maximizing corporate size. Improved corporate governance and financial transparency will be essential to developing equity markets and shifting corporate finances away from excessive reliance on debt.

  • The government must remove itself from firm level decisions. Such interference will be seen as increasingly inadmissible under the rules of a global economy.

Caroline Atkinson followed Qureshi by asking if the recovery was a surprise. She offered the example of Mexico as a country that had a sharp turnaround in its current account and a recession, yet also had a fast turnaround in economic activity. Echoing Lipton and Shafer from earlier sessions, she stressed the importance of tight money in turning confidence around.

She next turned to the possibility that the recovery could be a problem if it slows the momentum for reform. She listed three areas where reforms need to be extended. First, the amount of money needed for bank recapitalization may be higher. Second, the government must get out of the banking business. And third, there is a need for "operational restructuring."

She also drew some conclusions and raised some questions for the future. Her two major conclusions: (1) the crisis was caused by fundamental problems, including of a structural nature, although the extent of the collapse was larger than could be explained by these problems; and (2) the period of tight money was necessary to restore confidence and stability. And her two major issues for the future: (1) with money flooding back in again, there is a concern that investors who should not be there are coming back in; and (2) care must be taken not to allow an implicit guarantee on the exchange rate to reemerge.

General Discussion

Linda Goldberg opened the comments from the floor by arguing that private-owned banks, and in particular healthy ones, could potentially play a constructive role in facilitating banking sector improvements. She asked about the sentiment in Korea toward allowing healthy foreign banks to operate more extensively within Korea, noting the positive experiences of some Latin American countries. She also noted that small- and medium-sized enterprises (SMEs) are often the hardest hit on the downside of the cycle, implying the need for social safety net arrangements. Zia Qureshi responded that there had been significant progress on developing the social safety net.

Steve Radelet emphasized the importance of liquidity in the recovery. There was a strong push to ease monetary policy and to recapitalize the banks. There was also a roll over of domestic debt. He wondered how this supported the recovery, and asked if it would end up slowing reform. His view is that domestic liquidity has complemented restructuring.

Zia Qureshi responded that there were rollovers for the SMEs but not for the largest borrowers. He said that, in the context of a systemic crisis, it was difficult to achieve workouts for distressed small borrowers individually given their large numbers, and agreed that a draconian approach to restructuring was avoided.

Enrique Mendoza observed that when credit markets have been paralyzed you see a V-shaped response. To what extent was the recession due to a loss of credit? Relatedly, Pierre Oliver Gourinchas queried the rationale for tight money in the early stage of a crisis. Caroline Atkinson answered that there was already a large exchange rate adjustment, and it should not have been allowed to fall any more. The authorities needed to demonstrate that they cared about financial stability. She noted that if you tighten too much you can ease later. You first must obtain credibility for the monetary authority.

Kristin Forbes asked what had happened to poverty levels. Zia Qureshi answered that, following a sharp increase, the unemployment rate had fallen quite rapidly and other measures (e.g. urban poverty) show a similar pattern. So there was an inverted V-shaped pattern, though levels had not returned to their pre crisis values.

Martin Feldstein questioned where the appetite for investing in high technology SMEs came from. Government directed lending, perhaps. Kap-Soo Oh agreed that the government played a role through, for example, favorable tax policies. But he stressed that there was more than just government involved in the investment boom. Not able to lend to the chaebols the banks are seeking new outlets. Feldstein inquired if the banks can invest in equities, and was told yes.

Stign Claessens made the observation that there has been an increase in the inside ownership of the chaebols, and expressed doubts the sustainability of the recovery given this increased ownership.

Yung Chul Park picked up the thread of his earlier critical remarks about how the Korean crisis was handled by noting that Korea had done in thirty years what took three hundred years to do in Europe. He said that listening to the panel he gets the impression there is still much that is wrong. The reforms are supposed to have led to the return of confidence; but if there is such a long way to go, why the return of confidence. He asked if it is so clear that reforms are needed. And if so, why?

Robert Dekle asked what financial system is Korea striving for. Or is the East Asian financial system to be retained in some form.

Session 4: Lessons and Prospects for the Future

Jeffrey Frankel, Harvard University and NBER

Martin Feldstein, Harvard University and NBER
Paul Krugman, MIT and NBER
Rak-Yong Uhm, Ministry of Finance and Economy
Richard Cooper, Harvard University
Lael Brainard, National Economic Council and NBER

Martin Feldstein opened by questioning the wisdom of the IMF and World Bank's drive to reform the economy along multiple dimensions. He asked if they would have done that for any other OECD country. Arguing that there was a need to go back to an older, more narrowly focused approach, he said that the focus should have been on getting the private sector obligations rolled over, paying down the debt and building reserves. The focus should have been on crisis prevention and management--but not on long-term growth in a country that had been as successful as Korea.

Feldstein felt that there had not been enough talk over the course of the day about why the national balance sheet mismatch had been allowed to occur. He asked why the supervision had not been better. And wondered if the poor supervision would have mattered if reserves had been higher.

The banks were in trouble, he noted, because the chaebol were in trouble. But this had happened before and the government had bailed them out. He asked if the markets were alert to the fact that something had changed. He went on to say, however, that this made a banking crisis more likely--but not an external crisis. At the route of the problem again lay the lack of reserves.

Recalling the Roubini list from the first session, Feldstein said that almost everything on the list is wrong with Japan today.

Feldstein closed on the topic of the IMF's role in organizing a roll over of private sector credit. He contended that a "market maker" was needed, and the IMF had played role in the 1980s. So the model was there. "Was the attempt to bring the private banks to the table done early enough?"

Paul Krugman started off his presentation by restating a disagreement that he felt had lurked in the discussion all day: Does the recovery show that the policy response to the crisis was got right? Or, since the economy recovered so quickly, was there a need to have the crisis in the first place? He thinks it is difficult to tell. He also argued that the structural vs. liquidity distinction is not very useful. A better distinction is between the bursting of a bubble and a bank run. Krugman reminded the group that there were conspicuous bad investments. But went on to say that the downturn had been a demand-side slump (lower consumption and investment) and the upturn had been a demand-side recovery (higher consumption, investment and net exports). The structural reforms had apparently not contributed to the recovery, though he thought the performance of the small- and medium-sized enterprises (SMEs) raised interesting questions.

Responding to the argument that high interest rates are needed to avoid a low-level exchange rate equilibrium, Krugman pointed out that with the exchange rate well below the pre-crisis level it is not clear that the low-level equilibrium had actually been avoided.

He closed on the subject of the private sector's involvement in resolving the crisis. Korea, he argued, was in a way fortunate to have underdeveloped financial markets. In the future the changed system will make private sector involvement harder. In the 1980s, he recalled, private sector involvement was a given. Going forward he felt that either we will have to do without private sector involvement or more draconian methods will have to be used to involve it.

In Rak-Yong Uhm's view, the recent Asian crisis was some of the most serious financial events of the last century, with the issues concerning everyone in an increasingly integrated global economy. He argued that there is a need to deal with the vulnerabilities that led to the crisis; both issues related to short-term liabilities and structural weaknesses. A sound financial system backed up by supervision and prudential regulation is essential. There is a need, he said, to enhance transparency in Korean society as a whole. The corporate sector had become convinced of the "too big to fail" myth. "That has changed," he said.

He also pointed to the importance of preserving social cohesion, and emphasized it was not a coincidence that the crisis broke out during a political transition. He said that strengthening the social safety net should be seen as a key element of ongoing reform.

Rak-Yong Uhm also spoke to reforms of the international architecture designed to protect small open economies, mentioning the G20 forum and discussions on mechanisms for bailing in the private sector and reducing the volatility of short-term capital flows.

Addressing future challenges, he warned of the danger of creeping complacency and against the belief that recovery is simply a matter of getting back to the pre-crisis state. Regardless of the reason for the crisis, its occurrence can be seen as an opportunity to make the economy more efficient. He said that the government remains deeply committed to ongoing reform. He closed with a list of five targets.

Inflation checked below 3 percent

  • Getting the fiscal deficit from 3 percent to zero by 2004

  • Push ahead with structural reforms that transform the business culture and financial system

  • Develop a work-based welfare system including vocational training resources

  • Shift in the direct of a knowledge based society

  • Finally he said that Korea remains committed to further integration with the world economy.

Richard Cooper organized his presentation into seven points.

  • Financial systems are intrinsically unstable. Lenders want their claims to be as secure as possible; borrowers want money long term. Financial systems are a balancing act. Every country has to work at creating an institutional system that keeps the balance.

  • During a period of economic growth the economic system outruns its financial system. From 1830 on, the US had a financial crisis once a decade. It took the depression to put the system on a reasonably secure footing.

  • Korea engaged in the standard errors: borrowing short and lending exceptionally long. It also borrowed in foreign currency and lent in domestic currency. The chaebol were assumed to be invulnerable. Referring to a McKinsey report on Korea, he said that the striking thing about the country was how badly capital had been used. It might not be a bad idea for Korea to be a net exporter of capital.

  • The key question in any financial crisis is who bears the cost of the clean up. There are tremendous distributional consequences in this. He added parenthetically that Japan is finds dealing with such distributional issues notoriously difficult.

  • He asked how much have the reforms contributed to Korea's recovery. His null hypothesis is that 90 percent has been due to the exchange rate.

  • Many Koreans feel they have been victimized by the international banks etc. They conclude: no serious changes in habit need to be made. But without reform we can confidently look forward to another financial crisis sometime in the coming decade.

  • We think we understand things when we find a catchy metaphor. But the metaphor of "contagion" is not useful. What was the exact mechanism through which the events in Thailand led to what ensued in Korea?

Lael Brainard made the last presentation of the day. She began by asking why it is possible to see such a rapid decline in a country, and why financial variables are capable of turning around so quickly. She emphasized the importance of psychological factors in the response of the financial system. This emphasis on psychology also raises the importance of politics. In the case of Korea, the ability of President Kim to take difficult steps did turn confidence around. The structural reforms were seen as putting Korea on a sustainable long-run growth path.

Turning to the role of the US government she said there was an unwillingness to commit the second line of defense until after the election. The key issue was how the market saw it. Officials tried to work with the markets, and were also willing to use the influence of the US to act as a market maker (e.g. special relationships with private creditors and influence over other governments.)

General Discussion

Nouriel Roubini began the discussion by questioning Paul Krugman's contention that Korea had experienced a conventional demand-side slump. He also affirmed his belief in the conventional wisdom that high interest rates are needed to stabilize a currency in a crisis situation. He pointed to Indonesia as an example of a country where the monetary response was badly managed and the currency went into free fall. On the other hand Korea and Thailand did stabilize their currencies with their high interest rate policies. He reminded the group of the balance sheet problems caused when a currency goes into free fall.

Eduardo Borensztein expressed sympathy with the idea of a more narrowly focused IMF role, but he said financial sector must be part of its focus. One reason that the financial sector can't be neglected is the large contingent liabilities that can arise because of (implicit) government guarantees. Turning to the exchange rate, he added that he is confident that the exchange rate will not remain permanently lower: when the pace of reserve accumulation falls there will be an appreciation

In June Kim set off a lively discussion by asking the group for their opinion about the best exchange rate for Korea. Richard Cooper responded by casting doubt on the fashionable corner solution advice--i.e. countries should choose a freely floating rate or a truly fixed rate--saying that neither extreme works well everywhere. He added that if you have a floating rate and poorly developed capital markets then you probably need capital controls. It is not good advice, he contended, to float and to completely liberalize your financial system. Paul Krugman speculated the reason the IMF is against a "dirty float" is that it fears it will turn into a peg. Ajai Chopra interjected that the Fund is advocating a managed float. The rationale is to smooth fluctuations and prevent disorderly market conditions, but not resist the trend toward appreciation. He echoed Borensztein emphasis on the accumulation of reserves, citing it as evidence of the managed float. Jeff Shafer later said that fixed exchange rates have served poorly as nominal anchors, and expressed a positive view of inflation targeting as an alternative. He added that he thought Richard Cooper was too pessimistic about the sustainability of a floating exchange without capital controls, noting that there are a number of positive examples from around the world. Nouriel Roubini followed on this theme by saying that there had been many bad experiences with currency pegs in the 1990s. On the other hand, he sees flexible regimes, or more precisely dirty floats, as working well in many countries. Richard Cooper responded that most countries have quasi-fixed rate regimes.

There was another exchange of views on the seriousness of the collective action problem involved in getting creditors to roll over debts. Timothy Lane argued that the collective action problem was more serious than with the debt crisis of the 1980s due to the reduced importance of syndicated loans. Responding to a question by Martin Feldstein, Jeffrey Shafer informed the group that most of the international lending was in the form of bank to bank loans and not bonds.

Not surprisingly, the issue of the international community dictating policy to the Korean government once again led to disagreements. Wanda Tseng stressed that Korea had already embarked on a process of liberalization in the 1990s. She said that it is simply not true that it was imposed by the IMF. Coming up to the crisis political paralysis made it difficult to push through the reforms. The crisis created an opportunity for the political leadership to push the reforms through. Tomas Balino, her IMF colleague, seconded this point. Bohn-Young Koo agreed that most of the reform package was not new and thus accepted by the government as an inevitable course--with the exception of tight monetary policy. In a spirited dissent, Yung Chul Park again argued that the US Treasury had put a lot of pressure on Korea to liberalize and to open up markets in the early 1990s. Korea took on board a lot of the reforms when it decided to join the OECD. He also did not agree that the IMF had not put a lot of pressure on Korea to push through structural reforms. However, he does not think that the reforms were the main reason that the crisis was overcome. The most important development, he contended, was the agreement with the creditors to roll over the short-term debt. Martin Feldstein said he was fascinated to hear that other than the tight monetary policy all terms had the support of the government. He wondered if there was really agreement between the administrative and legislative branches on this. Bohn-Young Koo answered that the liberalization program was much the same as had been planned, but that there was an acceleration of the program in most areas.

1Korea's vulnerability to crisis came as a surprise to some in the international economics community. After all, Korea had a decades long record of impressive growth, a tradition of sound macroeconomic management, and had weathered the debt crisis of 1980s and the Mexican crisis of 1995 with relatively little ill effect. Korea had also recently joined the OECD. Of course, critics have pointed to a number of factors present in 1997 that made the country vulnerable to a sudden reversal of the flow of international capital. These include: a weak financial sector burdened with high short-term foreign currency liabilities; a corporate sector with high debt to equity ratios and low returns on investment; a pegged exchange rate regime that encouraged short-term speculative capital flows; and low official reserves relative to the country's short-term foreign currency liabilities.