INFORMATION TO USERS This manuscript has been reproduced from the microfilm master. UMI films the text directly from the original or copy submitted. Thus, some thesis and dissertation copies are in typewriter face, while others may be from any type of computer printer. The quality of this reproduction is dependent upon the quality of the copy submitted. Broken or indistinct print, colored or poor quality illustrations and photographs, print bleedthrough, substandard margins, and improper alignment can adversely affect reproduction. In the unlikely event that the author did not send UMI a complete manuscript and there are missing pages, these will be noted. Also, if unauthorized copyright material had to be removed, a note will indicate the deletion. Oversize materials (e.g.. maps, drawings, charts) are reproduced by sectioning the original, beginning at the upper left-hand comer and continuing from left to right in equal sections with small overlaps. Photographs included in the original manuscript have been reproduced xerographicaHy in this copy. Higher quality 6” x 9” black and white photographic prints are available for any photographs or illustrations appearing in this copy for an additional charge. Contact UMI directly to order. ProQuest Information and Learning 300 North Zeeb Road, Ann Arbor, Ml 48106-1346 USA 800-521-0600 UMÏ STRUCTURAL WEAKNESSES OF THE KOREAN CHAEBOL: MORAL HAZARD AND THE KOREAN FINANCIAL CRISIS by Yong Soon Kim B A., Korea University, 1996 THESIS SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIRMENTS FOR THE DEGREE OF MASTER OF ARTS in INTERNATIONAL STUDIES © Yong Soon Kim, 2001 THE UNIVERSITY OF NORTHERN BRITISH COLUMBIA September, 2001 All rights reserved. This work may not be reproduced in whole or in part, by photocopy or other means, without the permission o f tlie autlior. M National Library of C anada Bibliothèque nationale du Canada Acquisitions and Bibliographic Services Acquisitions et services bibliographiques 395 WeMngton Strsat Ottawa ON K1A0N4 Canada 395. rue WaDington Ottawa ON KtA0N4 Canada /ourWf V em M n net O urUi N o m M ttm c t The author has granted a non­ exclusive licence allowing the National Library of Canada to reproduce, loan, distribute or sell copies of this thesis in microform, paper or electronic formats. L’auteur a accordé une licence non exclusive permettant à la Bibliothèque nationale du Canada de reproduire, prêter, distribuer ou vendre des copies de cette thèse sous la forme de microfiche/film, de reproduction sur papier ou sur format électronique. The author retains ownership of the copyri^t in this thesis. Neiüier the thesis nor substantial extracts from it may be printed or otherwise reproduced without the author’s permission. L’auteur conserve la propriété du droit d’auteur qui protège cette thèse. Ni la thèse ni des extraits substantiels de celle-ci ne doivent être imprimés ou autrement reproduits sans son autorisation. 0-612-62539-7 CanadS APPROVAL Name: Yong Soon Kim Degree: Master o f Arts Thesis Title: STRUCTURAL WEAKNESSES OF THE KOREAN CKAEBOL: MORAL HAZARD AND THE KOREAN FINANCIAL CRISIS Examining Committee: Chair: Dr. fu te L a w s o ^ T Associate Professor & Cfertf; English Program UNBC Supervisor; Dr. Paul Bowles Professor & Chair • Economics Program UNBC nmittee Member: Dr. Towhidul Islam Assistant Professor, Business Administration Program UNBC Com m itteejvtm ber; Nancy Carson, MA Lecturer, Economics Program UNBC External Examiner: Dr. Kwong-leung Tang Professor & Chair, Social Work Program UNBC Date Approved: ABSTRACT The Korean financial crisis in 1997 must be seen in light o f the structural weaknesses o f Korean businesses, which developed with the Korean economy for decades. Since the early 1960s, large Korean business conglomerates {Chaebols) have played an essential role in the process o f rapid economic development. Chaebols expanded dramatically, pooling scarce resources such as entrepreneurship, capital and technologies as well as business risk through cross-subsidization among the subsidiaries. However, Chaebol growth occurred on a very shaky base, critically vulnerable to external shocks. The Chaebol's structural weaknesses include high corporate leverage, investment inefficiency and extensive diversification strategy resulting low profitability and productivity. The moral hazard o f the Chaebol resulted from their expectation that the government would not let these large Korean business conglomerates go bankrupt. As a result, large Chaebols were considered ‘too big to fail’. This belief was nurtured through the government’s extensive intervention in the financial sector, bailout packages for ailing industries as well as industrial targeting and other promotion policies. Thus this study examines the structural weaknesses o f the Chaebols in the context o f the moral hazard, which is the core o f the Korean financial crisis. TABLE OF CONTENTS Abstract ii Table o f Contents iü List o f Tables v List o f Figures vii Acknowledgements viii Chapter One: Introduction 1 1.1 Background l 1.2 Conceptual Framework 8 1.3 Characteristics o f Chaebol in Comparison to Japanese Zaibatsu 10 Chapter Two: Korea’s Development Strategy and Chaebols: An Overview 11 2.1 Rhee’s Regime - The First and Second Republic (1945-1961) 13 2.2 Park’s Regime - The Third Republic (1961-1972) 14 2.3 Park’s Yushin Regime - The Fourth Republic (1972-1979) 17 2.4 Chun’s Regime - The Fifth Republic (1980-1987) 20 2.5 Financial Liberalization in the 1990s 24 2.5.1 Interest Rate Liberalization 24 2.5.2 Foreign Exchange Liberalization 26 2.5.3 Capital Account Liberalization 27 Chapter Three: The Origin o f the Crisis: An Theoretical Review 31 3.1 Financial Panic 31 3.2 Moral Hazard 38 Chapter Four: Structural Weaknesses o f the Chaebols: Cause o f the Crisis 4.1 High Indebtedness 41 41 4.1.1 Motives for the High Indebtedness lU 45 4.1.2 Indebtedness T rends o f the Chaebols 4.2 Investment Inefficiency 48 54 4.2.1 Motives for the Excessive Investment 55 4.2.2 Investment Trends o f the Chaebols 59 4.3. Extensive Diversification 63 4.3.1 Motives for the Extensive Diversification 67 4.3.2 Diversification Trends o f the Chaebols 69 4.4. Low Productivity and Profitability 74 4.4.1 Low Productivity 78 4.4.2 Low Profitability 81 Chapter Five: Conclusion 85 Bibliography 88 IV LIST OF TABLES Table I-l Recent Trends in Key Macroeconomic Indicators 2 Table 1-2 Cases o f Bankruptcies in the 30 Largest Chaebols 3 Table 1-3 Non-performing Loans in Korean Financial Institutions 3 Table 1-4 Inflows and Outflows o f Foreign Portfolio Investment in Korea 4 Table II-1 Economic Structure o f Korea, 1962-1991 11 Table 11-2 Year o f Establishment o f the 50 Largest Chaebols 13 Table 11-3 Major Interest Rates on Loans and Discounts o f the Commercial Banks 15 Table II-4 Investment by Heavy and Light Industries, 1976-79 18 Table II-5 Basic Indicators o f the 10 Largest Chaebols, 1971-1980 19 Table II-6 Year o f Establishment o f Subsidiaries o f the 10 Largest Chaebols, 1984 19 Table 11-7 Interest Rate Liberalization 25 Table 11-8 Foreign Exchange Liberalization (Phase III Plan) 26 Table II-9 Capital Accounts Liberalization (Phase III Plan) 29 Table III-l Capital Flows in Selected Economies prior to the Crisis 32 Table III-2 Current Account Balance, 1994-1998 34 Table HI-3 External Debts by Sector in Korea 35 Table IV-1 Capital Structure o f the 30 largest Chaebols, 1997 49 Table IV-2 Top 30 Chaebols ' Debt/Equity Ratios 50 Table IV-3 Total Borrowing to Sales o f the Bankrupt Chaebols, 1997 51 Table IV-4 International Comparison o f the Average Debt/Equity Ratios 51 Table IV-5 Details o f Korea’s Foreign Debt before the Crisis 53 Table IV-6 Cycles o f Facility Investment 60 Table IV-7 Tangible Fixed Assets o f the 35 Largest Chaebols 62 Table IV-8 Diversification o f the Top 30 Chaebols, 1987-1997 64 Table IV-9 International Comparison o f Diversification by Big Businesses 64 Table FV-IO Number o f Subsidiaries o f the 30 Largest Chaebols 69 Table IV-11 Number o f Business Lines o f the 30 Largest Chaebols 71 Table IV-12 Industry Specialization Ratios o f the 35 Largest Chaebols 72 Table IV-13 Berry Index o f the 35 Largest Chaebols 72 Table IV-14 Business Performance o f the 30 Largest Chaebols, 1995-1996 75 Table IV-15 Wage and Labour Productivity Increase 76 Table IV-16 Hourly Wage in the Manufacturing Sector and Per Capita Income 76 Table IV-17 Corporate Profitability in Manufacturing, 1989-1993 77 Table IV-18 Profit (Net Income) to Equity Ratio by Size o f the Firms 82 Table IV-19 Changing Profitability o f the Chaebols 83 Table IV-20 International Comparison o f Business Performance in the Manufacturing Industry 84 VI LIST OF FIGURES Figure IV-1 Debt/GDP Ratios by Sector 42 Figure IV-2 International Comparison o f Debt/Equity Ratios 42 Figure IV-3 Terms o f Trade (Index) 43 Figure IV-4 International Comparison o f Corporate Debt Service Costs as Percentage o f Sales 52 Figure IV-5 Productivity Comparison 74 Figure IV-6 Capital allocation and Capital Productivity, 1995 75 Figure IV-7 Components o f Value Added in the Manufacturing Industry 79 Figure IV-8 Major Productivity Indicators in the Manufacturing Industry 80 Figure IV-9 Major Profitability Indicators in the Manufacturing Industry 81 vu ACKNOWLEDGEMENTS I could not have completed my thesis without the loving assistance o f many people. Firstly, I am deeply indebted to for Professor Paul Bowles for his kindness, encouragement, teaching and patience. Professor Bowles intellectually nurtured me with his deep knowledge o f the Asian economy, allowing me to develop an interest in and understanding o f the exciting discipline o f economics through his lectures. As my supervisor, he has been the most reliable guiding light for me with his enthusiasm and intellectual profundity. Also, 1 would like to extend my deep appreciation to Professors Towhidul Islam and Nancy Carson for their enlightening teaching and valuable comments. Secondly, I am indebted to my colleagues at the Graduate School o f International Studies who encouraged me when I was sometimes off the track. Special thanks should go to my friend Johan Boyden for reviewing the successive drafts o f this thesis. Finally but most importantly, I would like to thank my family for their unconditional love, trust, patience and support. Their unwavering emotional support has kept me on track and sustained me through the inevitable lonely period as an international student in Canada. VUl I. Introduction 1.1 Background During the past several decades, the rapid economic development o f South Korea (Korea hereafter) has attracted worldwide attention. The country’s rapid economic growth has been cited as an exemplary model o f successful economic development and termed an economic miracle (World Bank, 1993). Indeed, Korea’s growth performance was remarkable; its nominal Gross National Product (CNF) per capita increased by more than 120 times, from less than USS 80 in I960 to USS 10,543 in 1996 (Bank o f Korea, 1998). As a result o f this dramatic economic development, Korea joined the Organization for Economic Cooperation and Development (OECD) in October 1996, becoming the second Asian member after Japan. The impact o f the Asian financial crisis, however, starting with the plunge o f the Thai Baht early in July 1997, was dramatically reflected in the Korean currency market at the end o f 1997. The Korean Won dropped 50 percent in value between the end o f 1996 and the end o f 1997. This financial crisis quickly degenerated into a full economic crisis. Real Gross Domestic Product (GDP) growth plunged following the fourth quarter o f 1997, and remained negative throughout 1998 (See Table I-1). In particular, private consumption and fixed investment declined dramatically, mainly due to a severe credit crunch as well as increased market uncertainty. Reflecting both this dire growth performance as well as the fallout o f economic restructuring, the unemployment rate sharply rose to over seven percent in 1998, up from a pre­ crisis level o f two percent. Stagnant domestic demand worked as the major contributing factor to the improved current account as it reduced import demand dramatically. In addition, dramatic devaluation o f the domestic currency after the crisis increased consumer price inflation to 7.5 percent in 1998, from 4.5 percent in 1997. I Recent Trends in Key Macroeconomic Indicators (year on year growth rates, percent) 1994 1996 1997 1998 1995 8.6 8.9 7.1 5.5 -6 .8 Gross Domestic Product 7.6 8.3 6.8 3.1 -12.0 Private consumption 7.1 Fixed Investment 11.8 11.7 -3 .5 -29.3 13.0 23.6 Exports 16.5 24.0 8.9 21.7 22.0 14.8 3.8 -20.9 Imports -3 9 -8 5 -230 -8 2 97 Current Account (USS lOOmillion) 7.4 2.4 2.0 2.0 2.6 Unemployment 0.17 0.20 0.17 0.52 0.55 Dishonoured Bill Ratio Source: National Statistical Office: Quoted in Nam et al (1999, p.4). As a consequence o f this disastrous economic situation, the Korean government turned to the International Monetary Fund (IMF) to request bailout loans on November 21, 1997. A request by the government for a financial aid package from the IMF amounting to about USS 57 billion', the largest in IMF’s history, was approved on December 3, 1997. This initial program required tight macroeconomic as well as comprehensive adjustments in the corporate and financial sector, including the suspension o f nine insolvent merchant banks.* Why did Korea find itself in both currency and financial crises? The Korean financial crisis was initiated by a series o f large-scale corporate bankruptcies, starting with Hanbo Group in early 1997. For a decade preceding this crisis, none o f the 30 largest Korean conglomerates {Chaebols^) had gone bankrupt, convincing Chaebol owners and international investors that they were ‘too big to fail’. Therefore, these massive corporate failures were shocking in Korea. At least ten o f the 30 largest Korean conglomerates ran into serious liquidity problems before the currency crisis hit the country in late 1997 (See Table 1-2). ‘ USS 21 billion from the IMF, USS 10 billion from the World Bank, USS 4 billion from the Asian Development Bank, and the rest from bilateral loans (Corsetti et al, 1998). ’ For more details, see Corsetti et al, “What caused the Asian currency and financial crisis? Part D: The Policy Debate” Table 58,1998. ^ See definition at the end o f this chapter. 2
Cases of Bankruptcies in the 30 Largest Chaebols Forms of Forms of Date Date Chaebol Bankrupt Bankruptcy Bankrupt Bankruptcy C.A. 96-I-I9 97-5-31 C.A. Woo-Seong Hanshin S.L. 97-7-18 97-1-10 C.A. Dong-Ah Kia C.A. 97-9-11 97-1-28 S.L. / C.A. Hanbo Dae-Nong S.L. / C.A. 97-10-20 97-3-20 S.L. / C.A. Jinro Ssang-Bang-UI C.A. 97-3-20 97-11-1 C.A. Sammi Haitai Note: 1) S.L. means “Cooperative Syndicated Loans”, which is to give emergency loans for the de facto bankrupt firms in the form o f syndicated loans by the involved banks. In some cases, the initial S.L. led to the C.A. latter. In other words, the cases are often mixed. 2) C.A. means “Court Administration”. Firms that are assessed to be hopeless even with cooperative syndicated loans were directly subject to court administration. 3) All firms belong to the 30 Chaebols in terms o f the asset values as o f the end o f 1996, assessed by the Bank Supervision Authority o f Korea. Source: Bank o f Korea, 1999: Quoted in Lee (1999, p. 14). Chaebol These series o f large corporate insolvencies inevitably undermined the soundness o f domestic financial institutions (See Table 1-3). Non-performing loans (NPLs) o f commercial banks as o f the end o f 1996 stood at 12.2 trillion ff'on, which is 3.9 percent o f the total credit. These bad loans almost doubled to 21.9 trillion IFon in the next nine months to September 1997. At the same time, merchant-banking corporations - whose functions are broadly similar to those o f commercial banks - recorded NPLs o f 3.9 trillion fFbn at the end o f September 1997, three times larger than the 1.3 trillion ff^on recorded at the end of 1996.
Non-performing Loans in Korean Financial Institutions (trillion fFon, percent ) 1996 Jun. 1997 Sep. 1997 21.9 Commercial Banks 12.2 19.2 (6.4) (3.9) (5.8) 3.6 3.9 Merchant Banking Corporations 1.3 (2.9) N/A N/A 22.8 25.8 Total 13.5 Note: end o f period, figures in parentheses indicates ratios to total credit. Source: Bank o f Korea, 1998. p.20-2l These massive corporate bankruptcies, followed by the domestic financial institutions’ insolvency problems, severely undermined international investors’ confidence. Moreover, Korea was a victim o f a financial epidemic originating from Southeast Asia, as the financial crisis in Thailand and Indonesia shifted the negative market sentiment on to other Asian economies. This financial crisis in Thailand and Indonesia made international bankers and investors more closely examine any potential risks in Asian markets. In Korea, Ahn (1999) argues that (besides an aggravated corporate profitability and liquidity squeeze) international bankers and investors found a lack o f transparency in foreign debt and foreign exchange reserve situations as well as unreliable corporate accounting standards and disclosure practices. These weaknesses were well known to international bankers and investors even before the crisis, but were overlooked in their belief that Korean Chaebols and banks would not go bankrupt. Nam et al (1999) argue that a sudden shift in international creditors confidence in Korean firms and financial institutions occurred, prompting these investors to leave the market by cashing their investment and refusing to roll over their short-term lending, which directly triggered the Korean financial crisis (See Table 1-4).
Inflows and Outflows of Foreign Portfolio Investment in Korea Inflow Outflow (-) Net Inflow 1992 0.7 2.0 2.7 1993 1.9 5.7 8.6 1994 8.6 6.6 2.0 1995 lO.O 7.8 2.2 1996 12.4 8.0 4.4 1997 12.6 II.8 0.8 (USS billion) 1998 0.8 3.3 -2.5 Source: Bank o f Korea, Monthly Bulletin, Various years. Many theories have been offered to explain the causes o f the Asian financial crisis in 1997. Broadly speaking, however, there are two dominant and contrasting streams o f thought 4 describing the origin o f the Asian financial crisis. One approach, financial panic theory, focuses on external factors — such as the self-fulfilling panic o f foreign investors — to interpret the cause o f the Asian financial crisis. An alternative explanation, moral hazard^ theory, emphasizes internal factors — such as the fundamental weakness of the corporate and banking sectors — to portray the origin o f the crisis. Nevertheless, it is important to note that singling out one or two causes inadequately explains the financial crisis. Similarly, it is difficult to indicate the relative importance o f different crisis causing factors (Lee, 1998). A balanced explanation o f the Korean financial crisis considers both the sudden reversal o f foreign capital flows (external factor) and the subsequent illiquidity o f the corporate sector and financial institutions (internal factor) simultaneously since they are deeply inter-related. The fundamental aspect o f the Korean financial crisis, however, lies in the Chaebol’s many moral hazard-driven structural weaknesses, which developed with the Korean economy for decades. It is true that international investors’ panicky behavior triggered the financial crisis. Nevertheless, without the domestic problem o f moral hazard, the crisis could have been avoided. Regardless o f the external circumstances, the economy had a serious moral hazard problem, which was potentially vulnerable to any kind o f external shock. In other words, the moral hazard was a built-in potential explosive; external circumstances, the irrational panic o f foreign investors, lit its fuse. The purpose o f this study is, therefore, to argue that the moral hazard-driven structural weaknesses o f the Chaebols, which developed with the Korean economy, are the fundamentals o f the Korean financial crisis. Krugman’s (1998) moral hazard approach will provide a theoretical background for this study. However, since Krugman’s argument tends to generalize * See définition at the latter section o f this chapter. 5 the cause o f the Asian crisis by focusing too much on moral hazard, this study will attempt to examine the unique causes o f the Korean crisis by analyzing the structural weakness o f the Chaebol in the context o f moral hazard. Thus this study’s biggest contribution is its holistic interpretation o f the Korean crisis in the context o f moral hazard. By examining the structural weaknesses o f the Chaebol, driven by the moral hazard, this study will demonstrate that Chaebols were already on the path to an economic turmoil years before the actual financial crisis hit the country. The Chaebols' four moral hazard-driven flaws, which eventually triggered the Korean crisis, were: investment inefficiency; high indebtedness; extensive diversification; resulting low productivity and profitability. The central concepts, Chaebol and moral hazard, and the characteristics o f the Korean Chaebol in comparison to the Japanese Zaibatsu are briefly addressed in the latter section o f this chapter. Following the Introduction, Chapter 2 addresses the influence o f political factors on Korean economic development in a historical context to reveal the cause o f the financial crisis. Chapter 3 reviews the two dominant theories interpreting the Asian financial crisis. By doing so, this chapter will show how the moral hazard theory explains the fundamental aspect o f the Korean financial crisis. Chapter 4 reviews the moral hazard-driven structural weaknesses o f the Korean Chaebol uncovering the fundamental cause o f the Korean financial crisis. Among many possible factors, this study focuses on four major problems that many scholars deem significant^. This study will prove that these four major problems are caused by moral hazard in the corporate sector. Finally, various trends and conclusions drawn firom this study will be summarized in Chapter 5. ^ For example, see Hwang, I., (2000), "Diversification and Restructuring o f the Korea Business Groups” for the extensive diversification strategy of the Chaebol. Before addressing the two central concepts and characteristics o f the Chaebol in comparison to the Japanese Zaibatsu, a key limitation o f this study must be acknowledged. Due to the complexity o f the Asian financial crisis, it is difficult to find a general explanatory theory. Obviously, each affected Asian country uniquely faced the crisis because o f their different economic situations^. This study, however, concentrates on the internal problems o f the Chaebol; if I were to extend my analysis, it would be useful to look at the structure and efficiency o f the Chaebol in a comparative context, while this study provides some comparative data - specifically, an International Comparison o f the Average Debt/Equity Ratios - more comprehensive relative data (including a wider range o f Chaebol's efficiency indicators in a comparison to other countries’ business corporations) would be required for such research. This is an area for further study. Instead o f trying to find a general cause (or causes) o f the Asian financial crisis, this thesis descriptively focuses on Korea, revealing the country’s unique causes o f the crisis. My conclusion is, therefore, restricted to the Korean context. " For example, Thailand incurred a USS 144 billion trade deficit before the crisis, while Taiwan recorded a USS 100 billion trade surplus during the same period. In terms o f the impact o f the crisis, Indonesia’s aimual real GDP growth rate was negative 15.0 percent in 1998, while Singapore recorded 0.0 percent real GDP growth in the same year. Besides, although the crisis hit almost every country in the region, not all Asian countries were affected by the crisis. Regarding the aimual average growth rate of real GDP o f China and Taiwan, they were hardly affected by the crisis. China and Taiwan’s real GDP growth rate was 5.5 and 5.0 percent respectfully in 1998 (Asian Development Bank, 1999). 7 1.2 Conceptual Framework Chaebol In the academic arena, several definitions o f Chaebol are available. Kang (1995, p3) defines Chaebol as “a group o f firms that has emerged during rapid economic development, which is largely controlled by the owner and the family members, and is working in many diversified business areas.” Similarly, Kim (1997, p 5 l) defines Chaebol as “family-owned and family-managed large business groups, which formed a tight alliance with the Korean government and spearheaded its rapid economic growth based on exports.” Jones and Sakong (1980) define Chaebol as a family-controlled organization managed centrally through a holding company. The organization is a business group managed by the owner and his family with business diversification. The business group is heavily dependent on outside money and pursues growth through its export drive and its close relations with government. Besides these academic definitions, there is a technical meaning o f Chaebol for the purpose o f government regulation and empirical studies. According to Lee (1999, p3), the Korean Fair Trade Commissions (KFTC) legally define Chaebol as “a group o f companies, more than 30 percent o f whose shares are owned by some individuals or by companies controlled by those individuals.” Although the definitions o f Chaebol are slightly different from one another, some common elements emerge from these various definitions including; large business group structures; family control and ownership; diversified management in conduct; and government support in environment (Lee, 1999). Therefore, this study will define Chaebol as a large, diversified business group that is managed by the owner and his family members, and has grown under the active support o f the government. The terms, companies or subsidiaries will be interchangeably used to refer to individual firms belonging to a business group, Chaebol. 8 Moral Hazard The term moral hazard originated from the insurance sector. Bannock et al. (1992, p295) define moral hazard as “presence o f incentives for individuals to act in ways that incur costs that they do not have to bear” which is a typical case for insurance. For instance, once someone has insured their house against burglary they do not have the incentive to be careful to protect their property. Therefore, the tendency o f insured people to take more risks or use more o f the service is the subject o f the moral hazard. This narrow definition o f moral hazard, according to Leipziger (1998, pi), refers to “actions o f economic agents maximizing their own utility to the detriment o f others in situation where they do not bear the full consequences o f their actions because o f uncertainty, incomplete information or the nature o f the particular contract in force”. Some economists, such as Krugman (1998), argue that the Asian financial crisis was led by moral hazard. They argue that corporations, financial institutions and foreign investors sought to profit by building, financing or serving targeted industries, while believing they were protected by government, at least to some extent, from loss^. In the case o f Korea, Chaebols over-invested and domestic/international banks over-lent because all assumed that if crisis struck, the government would bail them out. In other words, it was believed that Chaebols were always backed by the government due to its concern with the socioeconomic impact o f any failure within the big conglomerates. In this study, therefore, moral hazard is used to indicate the Chaebols' and domestic/international financial institutions’ mind-set that they are somehow protected from loss by governments if things go wrong. ’ Corsetti et ai (1998) postulate three different kinds o f strictly interrelated tnoral hazards: corporate, financial and international level. For more details, see Corsetti et al, “What caused the Asian currency and financial crisis? Part II: The policy debate", 1998. 9 1.3 Characteristics of the Chaebol in Comparison to the Japanese Zaibatsu The Korean Chaebol shared many features with the pre-World War II Japanese Zaibatsu First, the Chaebol and the Zaibatsu are both family-owned and family-managed. model. Majority shares in the various enterprises are held by the chairman and his immediate relatives. Second, their business diversified into a wide range o f unrelated sectors. In Japan, the large Zaibatsu were prominent in industrial manufacturing as well as in banking. In Korea, the large Chaebol have also diversified into unrelated sectors in manufacturing and service, except banks. On the other hand, according to Kim (1997), there are two significant differences between the Chaebol and the Zaibatsu. First, the Chaebols do not own banks. In Korea, banks were nationalised by President Park in 1961, even after privatization in the early 1980s, and the Chaebol were prohibited from owning majority share in banks. The nationalisation o f banks in Korea by President Park in 1961 assured more room for state intervention in the market, since the Chaebol had to rely on the state for domestic loan capital. Unlike the Zaibatsu, therefore, the relationship between the government and the Chaebol was vertical rather than equal. Second, despite the prohibition o f the Chaebol from owning banks, the government actively supported the Chaebol's expansion. The state provided so-called ‘policy loans’ targeted for export firms dominated by the large Chaebols. Thus, unlike Japan, the largest share o f export products is manufactured by large companies that are members o f the Chaebol. In further comparison, according to Kang (1995), the Japanese government usually supported the Zaibatsu only after they survived in the severe internal competition o f the free market. Thus, the Zaibatsu had already developed high technological and managerial skills through internal competitions and had garnered support from the government. In this situation, Zaibatsus could be autonomous in their economic ventures even when cooperating with the state. 10 II. Korea’s Development Strategy and Chaebols: An Overview This chapter explores the influence o f political factors on Korean economic development in a historical context to reveal the root o f the financial crisis in Korea. Korea’s rapid economic development since the 1960s, based on export-oriented industrialization, has been hailed as one o f the Third World’s most successful such cases. During 1962-1991, the Korean economy expanded an average annual rate o f nearly nine percent (Sakong, 1993). Nominal per capita GNP during the period grew from USS 87in 1962 to USS 6,498 in 1991, with real per capita GNP increasing nearly eightfold (See Table II-1). At the same time, the proportion o f GDP originating from the mining and manufacturing sectors increased from 16.4 percent in 1962 to 27.9 percent in 1991. Commodity exports rose from USS 54.8 million in 1961 to USS 71.9 billion in 1991, making Korea one o f the world’s major trading partners.
Economic Structure of Korea, 1962-1991 1962 2.3 1972 10.7 1977 36.8 1987 128.9 1991 280.9 GNP (Current USS Billion) Per capita income 87 319 Current USS 1,012 3,110 6,498 Thousands o f Korean fVon* 423 850 1,269 2,403 3,273 Export 2.4 15.0 Percentage o f GNP 27.2 36.7 25.6 1,624.1 Millions o f current USS) 54.8 10,046.5 47,280.9 71,870.1 Import Percentage o f GNP 18.3 23.6 29.4 31.8 29.0 Millions o f current USS 2,522.0 421.8 10,810.5 41,019.8 81,524.9 Industrial Structure (%) Agriculture, forestry and fishing 37.0 26.8 22.4 10.5 8.1 Mining and manufacturing 16.4 23.5 28.9 33.0 27.9 Other 46.6 49.7 48.7 64.0 56.5 4.5 8.2 3.8 3.1 2.6 Unemployment (%) Note: * 1985 constant Source: Bank o f Korea, “Economic Statistics Yearbook”, various years: Quoted in Saknog (1993, p.8). 11 This rapid industrialization o f Korea during the last three decades was primarily due to strong authoritarian government intervention in business activities through planning the country’s economic direction, selecting strategic Industries, and allocating/distributing capital. This strong government intervention in the private sector, however, created a close govemmentbusiness relationship, which eventually caused the moral hazard problem in the Korean economy. Recent Korean government development strategy has favoured the expansion o f a few large Chaebols. The government’s price control and exchange rate control, allocation o f foreign capital to some large export-oriented companies with low interest rates, and special favours and subsidies for businesses, together with the high rate o f chronic internal inflation, increased the fortune o f a few large Chaebols (Kim, 1997). In this way, the government played the dominant role in promoting economic venture in the business sector, while private enterprises expanded their wealth rapidly under the government’s favour and subsidies. The development process o f the Korean economy, therefore, cannot be explained without understanding the development policy o f the government in relation to the Chaebol. In light o f this situation, it is meaningful to divide the period o f Chaebol development process according to the change in political regimes. The development processes o f Chaebol can be divided into four periods: the Korean emancipation to the end o f Second Republic (1945-1961); the military coup in 1961 to the end o f the Third Republic (1961-1972); the Yushin government (1972-1979); finally the Fifth Republic (1980-1987). In addition, the financial liberalisation o f Korea in the 1990s will be briefly addressed in the latter section o f this chapter. 12 2.1 Rhee’s Regime - The First and Second Republic (1945-1961) Korea has been involved in the world economy since the country’s emancipation from Japanese colonial rule in 1945. However, real industrial development began after the Korean War (1950-1953). During 1953-1957, for example, GNP in real terms grew at about 5 percent per year (Jones and Sakong, 1980). In this period, foreign aid from the West (especially from the U.S.) was an important source o f funds for the reconstruction and rehabilitation o f the economy. For example, more than 70 percent o f imports were financed by foreign aid during the reconstruction period o f 1953-1960, indicating how dependent the Korean economy was on foreign aid (Sakong, 1993). Through the reconstruction boom in this period, many o f the current Chaebols accumulated capital. Among the 50 largest Chaebols ranked by sales in 1984, 70 percent (35 Chaebols) were established during 1945-1960 (See Table II-2).
Year of Establishment of the 50 Largest Chaebols in 1984 -1945 1946-1960 1961-1971 1972-1979 1 8 I 0 Top 10 2 5 2 1 Top 11-20 9 0 0 I Top 21-30 6 I 3 0 Top 31-40 7 0 2 1 Top 41-50 35 5 8 2 Total Source; Daily Economic Newspaper Co. 1986: Quoted in Kim (1997, p.24). 1980-1984 0 0 0 0 0 0 In this period, a group o f entrepreneurs rapidly grew up as large capitalists, with both political favors and government subsidies, by increasing their connections with some powerful bureaucrats and/or politicians rather than investing in the development o f productive industries. The role o f government remained essentially a mechanism to create a few large entrepreneurs 13 who accumulated capital with illicit fortune by gaining more political favours and subsidies. Therefore, the close relationship o f these large capitalists with the government was one o f the most important sources for early capital accumulation. This paved the way towards the rise o f first top 10 Chaebols during the 1950s (Jones and Sakong, 1980). In summary, throughout this period, social stability mostly rested on foreign aid. At the same time, the government played an important role in the initiation and development o f modem entrepreneurial elites (or capitalists) by arranging and distributing resources in the form o f foreign aid from the West, especially from the U.S. Given the government’s lack o f focus toward economic activities, the Chaebol had relative freedom in their economic activities as long as they had familiar connections with government officials. Thus, from the initial period of Korean industrialization in the 1950s, the development o f Chaebols depended highly on their connection with politicians and/or government bureaucrats. 2.2 Park’s Regime - The Third Republic (1961-1972) The govemment-business relationship entered into a new era after the military coup on May 16, 1961. The passage o f ‘A Law for dealing with Illicit Wealth Accumulation’ prescribed the further relationship between the government and Chaebols in the 1960s (Jones and Sakong, 1980). Park’s regime demonstrated its power to the private sector with charges o f illicit accumulation o f wealth. As a result, most former Chaebol founders were arrested and threatened with confiscation o f their assets. These charges were meant to bring a clean sweep o f both the government and the businesses. According to Kim (1997), however, the basic pattern o f close govemment-business relationships was set at this time, and the business community was subordinated to the government through the 1960s and thereafter. 14 In Park’s regime, one o f the most important means o f controlling the business sector was financial monopolization. Monopolization o f domestic capital was achieved by nationalizing all Korean private banks in October 1961. Kim (1997) argues that these nationalized banks were used by the Park government as a carrot to attract private businesses to conform to the state’s directives in the economy and as a stick to punish those that did not follow by threatening a withdrawal o f capital assistance. So-called ‘policy loans’ were offered to Chaebols at an interest rate substantially lower than regular banks loans (See Table 11-3).
Major Interest Rates on Loans and Discounts of the Commercial Banks (percent per annum) Elective Year Discount on Bills Loans for Exports Loans on Other Bills 14.0 8.0 16.0 1964 24.0 26.0 1965 6.5 1967 24.0 6.0 26.0 1968 26.0 6.0 25.2 1971 22.0 6.0 22.0-23.0 15.0 6.0 1972 15.5-16.5 1974 15.5 9.0 15.5 1976 17.0-18.0 8.0 17.0-19.0 1978 18.5-19.0 9.0 18.5-20.5 1981 16.5-20.5 15.0 16.5-22.5 10.0 lO.O 100 1982 1983 10.0-11.5 lO.O 10.0-11.5 1984 10.0-11.5 10.0 10.0-11.5 10.0-11.5 10.0 10.0-13.0 1985 Source: Economic Statistics Yearbook, Bank o f Korea: Quoted in Sakong (1993, p.34). Foreign capital, the most important source o f capital in the 1960s, was also put under the government’s strict control. Since there was very little accumulation o f domestic capital, it was necessary to borrow capital from other countries to pursue economic development. However, the government sought foreign capital in which the responsibility o f distribution and management was in the hands o f the borrower. Thus, the government’s financial monopolization 15 established a centrally managed and powerful set o f instruments to carry out the government’s industrialization policies. In the 1960s, the economy took o ff due to the government’s efforts to earn public support and political legitimacy by promoting economic development via an export-led growth strategy. The government believed that developing an outward-oriented economy, with growth as the top priority, would not only promote growth but also lay the foundation for enhancing equity and a faired income distribution. The government also believed that export-led growth and industrialization, financed by foreign debt, would eventually generate a debt-serving capability in the economy and stimulate domestic savings (Amsden, 1989). To achieve export growth, the government initially financed the necessary funds required for the increase o f exports. While promoting the use o f foreign capital, an export orientation included many specific policies, such as the devaluation o f the Korean the reduction o f tariffs on inputs used for manufacturing exports, and other forms o f export subsidies (Yoo and Moon, 1999). The rise and fall o f Chaebols in the 1960s was, however, still decided in large part by political connections, because the state intervened in business activities through arrangement o f projects, allocation o f foreign capital and monopolization o f domestic financial institutions. Kim (1997) argues that the government’s economic policy in this period was oriented to reduce risks by decreasing any internal competition and supporting large government-favoured entrepreneurs. In this situation, most large Chaebols depended more on the political game by connecting with powerful politicians or bureaucrats. Even though the Korean economy recorded rapid economic growth and industrialization in the 1960s, the financial dependence o f Chaebols on the government increased (Kim, 1997). Conclusively, the fundamental relationships between govenunent and Chaebol were not changed from the previous regime. 16 2.3 Park’s Yushin Regime - The Fourth Republic (1972-1979) In the early 1970s, the government thought it imperative to develop the heavy and chemical industries (HCls), including the iron and steel, non-ferrous metal, shipbuilding, general machinery, chemical and electronic industries. Several internal and external factors contributed to this change in perspective (Sakong, 1993). As an external factor, the declaration o f the Nixon Doctrine* toward the end o f the Vietnam War compelled nations like Korea to re-evaluate the development o f a defense industry. Under these circumstances, the government thought that promoting the HCls would strengthen Korea’s defense capability and upgrade its industrial structure. Internally, Korea’s comparative advantage in light industries declined sharply as the industrialized nations raised protective barriers against light-manufactured goods and services from developing countries. The HCl policy was, therefore, designed to build a self-sufficient economy to cope with the intensified trade protectionism o f the developed countries. In addition, domestic political conditions also changed in the early 1970s giving President Park additional rationale for promoting HCl (Kim, 1997). Park won a narrow victory against a leading opposition leader in the 1971 presidential election. This precarious victory, amid rumours o f extensive vote-buying, caused Park to announce the Yushin Reformation in October 1972, changing the constitution to allow himself a life-term presidency. To earn public support and appease the public prior to the promulgation o f the draconian Yushin Reformation, Park announced the economic goals to be achieved by 1981 as “GNP per capita o f US $1,000, and US ^ International geopolitical conditions changed when President Richard Nixon o f the U.S. made an announcement regarding the defense o f the Pacific during his visit to the Guam Islands in 1969 and with the defeat o f the U.S. in the Vietnam War. President Nixon aimounced that the defense o f the Pacific must lie in the hands o f the people in the Pacific and declared that U.S. troops would gradually be withdrawn &om various bases in Asia, including Korea. (Kim, 1997) 17 $10 billion in export.” (Kim, 1997, pl40). Once again, this was another attempt to earn public support and political legitimacy with economic delivery, as in the aftermath o f the 1961 military coup. In January 1973, President Park urgently called for the development o f the nation’s heavy and chemical industries. However, the private sector was not capable o f investing in the HCls due to the lack o f the capital and technology and thus Korean firms could not join the HCl policy without the government’s strong support. The government presented, therefore, various advantages for large companies to join the HCl policy through preferred support given by the tax, trade and credit policies. Due to the state’s strong and concerted support, manufacturing investment during the late 1970s was predominantly directed to HCls (See Table II-4).
Investment by Heavy and Light Industries, 1976-79 (as a share o f total investment) 1979 1976 1977 1978 24.6 18.1 25.8 17.5 Light Industries 81.9 75.4 74.2 82.5 Heavy Industries Source: Korea Development Institute, 1981: Quoted in Sakong (1993, p.58) With the government’s support, many Chaebols invested a massive amount o f capital to HCls, which caused the massive concentration o f wealth and the growth o f the Chaebol. Table II-5 and Table II-6 show a great deal o f business expansion o f large Chaebols in the 1970. According to the Table H-6, among the 191 subsidiaries o f the top 10 Chaebols, excluding the IS missing cases, 114 were established or incorporated during the 1970s while only 34 were established or incorporated in the 1960s and only 20 were established or incorporated before 1960. Furthermore, although most o f the top 10 Chaebols except Daewoo were established before 1960, they were able to develop rapidly during the 1970s following the government’s HCl policy. However, not all the Chaebols could grow dramatically. According to Jones and Sakong 18 (1980), seven o f the top 10 Chaebols in the mid-1970s ranked by sales were new ones compared with those o f mid-1960s. In other words, many o f the previous Chaebols that could not follow with the new government’s development plan were excluded from the chance to grow more.
Basic Indicators of thelO Largest Chaebols, 1971-1980 Total Assets Foundation Year 1971 1980 1947 158,261 2,874,114 Hyundai 1951 415,978 1,901,127 Samsung 1947 437,060 1,825,429 Lucky-Gold Star 1967 34,679 1,663,400 Daewoo 310,424 1954 1,255,876 Ssangyong 83,734 1,085,337 Hanjin 1945 1949 153,489 772,993 Kukje 64,522 748,795 1939 Dae Lim 256,424 1952 695,363 Korea Explosives 40,049 666,359 Sunkyong 1953 Note: 1. Rank order based on total assets in 1980. 2. Foundation year o f mother firm. 3. Total assets in 1980 constant Korean million Won. Source: Kim, 1997 p.l53. Chaebol Average Annual Growth Rate of Total Assets (%) 38.0 18.4 17.2 53.7 16.8 32.9 19.3 31.8 11.7 36.7
Year of EsiauUshment of Subsidiaries of the 10 Largest Chaebols in 1984 Chaebols 1970-79 Total -1949 1950-59 1960-69 1 11 30 3 6 Samsung 4 32 I 2 20 Hyundai 24 1 2 5 10 Lucky-Gold Star 0 24 0 0 21 Daewoo 0 14 I I 7 Sunkyung 14 2 1 3 6 Ssangyong 0 18 I 5 8 Korea Explosives 18 I 0 13 Kukje 0 12 I 0 7 Hanjin 5 20 I 12 Hyosung 2 5 191* 8 34 114 Total 12 Note: * Missing 15 subsidiaries were excluded from the total. Source: Hankook Newspaper Co. 1985 p.343. 19 1980-84 8 1 3 3 3 2 3 0 0 0 23 Missing 1 4 3 0 2 0 1 4 0 0 15 However, such disproportionate incentives - along with over-optimistic assumptions regarding world trade prospects - led to excessive investment in some industries (Kim, 1997). In addition to creating inefficiencies in investment, the HCl promotion policy gave rise to serious sectoral imbalances. As the government-favoured HCl projects preempted limited financial resources, credit to other industries - such as light manufacturing - was dramatically squeezed. In summary, fi-om 1973 to 1979, the government was deeply involved in the allocation o f resources to promote the development o f specific industries. The government policy o f long­ term economic planning with the aggressive entrepreneurship o f the Chaebol transformed the Korean industrial structure and secured the dominant position o f the Chaebol. Moreover, because o f huge capital requirement and weak business position o f small and medium-seized firms, the new HCl projects were granted exclusively to large Chaebols, contributing to the concentration o f economic power among a few large business conglomerates. 2.4 Chun’s Regime - The Fifth Republic (1980-1987) The political turmoil o f Korea from the assassination o f President Park in 1979 resolved with the emergence o f the Fifth Republic. In 1980 the Korean economy was faced with some serious problems that had their origin in external factors as well as certain past industrial policies. First, a worldwide recession following the second oil shock in 1979 harshly affected the state. Second, the country suffered from domestic inflation and political instability following President Park’s assassination. Finally, according to Amsden (1989), industrialized countries began to lose their comparative advantage in many o f their traditional manufacturing industries and grew more protectionists, while developing countries, such as China, began their rapid industrialization, specializing in the production o f low-skilled, labour-intensive items. 20 Facing these circumstances, the new government under President Chun adopted several stabilization policies (Lee and Yamazawa, 1990). First, the macroeconomic policy implemented in 1980 that aimed at stabilizing inflation, galloping at an average annual rate o f 19.7 percent measured in terms o f the whole price index. Second, policy involved a structural readjustment o f the heavy and chemical industries. Due to overlapping and excessive investments in the 1970s and a lack o f demand caused by the world recession, most o f the Arms suffered large losses. Third, policy introduced to help reshape the economy was a revocation o f the large incentives given the HCls in the 1970s. Loans no longer carried preferential rates o f interest. As the last four rows o f Table 11-2 show, the government took steps, abolishing preference loans by eliminating interest rate differentials. The forth measure involved the promotion o f market competition and the elimination o f various factors inhibiting a competitive environment including flnancial liberalization, mitigating the effects o f excessive concentration o f wealth in the Chaebols, and improving the decreasing level o f capital efficiency. At the same time, the government diversified its equity shares in all nationwide commercial banks, transferring ownership to private hands. Financial services provided by different types o f intermediaries were diversified and made increasingly to overlap, while entry barriers into financial markets were lowered. Progress was also made in the area o f monetary and credit management as a result o f the relative decline in policy loans and phased interest rate deregulation (Kim, 1997). Finally, the fifth measure was the government’s emphasis on the growth o f the small and medium-sized firms. To this end, the government promoted the manufacture o f technology­ intensive or skilled labour-intensive products. Despite these readjustments policies, the current economic situation made the government continue its intervention in business activities. Many large enterprises in the early 21 1980s were on the edge o f bankruptcy because o f the unfavorable external and internal economic situations. The rapid increase o f labor wages, the over-and-duplicated investment on the HCls, the worldwide recession in the early 1980s and increasing foreign debt made many Chaebols vulnerable in their international competitions. In order to correct this situation, the government intervened and coordinated negotiations among firms for the relinquishing o f project or reduction o f capacity with mergers in some cases’. Although the government’s readjustment policies began the process o f institutionalizing more efficiency in the corporate sector, the government failed to eliminate the state’s implicit guarantee to the Chaebol. The government cushioned the industry so that if the Chaebol needed help, the government was there to rescue. It was thus the state guarantor o f private debt, thereby underwriting risk. This guarantee led to the strong belief in Korea that the state would insure their survival, because the Chaebols were “too big to fail”. In other words, the country could not help adverting the moral hazard problem in the corporate/financial sector even after the massive economic reform in the early 1980s. One critical question may be asked at this point. If the moral hazard is the cause o f the Korean financial crisis, why did the crisis not occur until 1997? Since the moral hazard o f the country had existed for decades, it could have happened anytime, including this readjustment period. According to Click (1998), rapid economic growth masked much o f the extent o f risky lending and the structural weaknesses o f the corporate/financial sector. Financial liberalization ^ There were two more rounds o f massive industrial restructuring and bailouts in the 1980s. One was the restructuring o f two ailing industries in the mid-1980s; overseas construction and shipping. The restructuring packages included mergers, capacity reduction, debt rescheduling and ftesh bank loans. The other industry rationalization was made under the Industrial Development Law o f 1986 involving such industries as automobiles, diesel engines, heavy electrical equipment, heavy construction equipment, textiles and shoes. Included in the rationalization packages were inducement o f specialization, capacity reduction, long-term supply contracts together with such financial support as long-term loans at subsidized interest rates, loans loss compensation and debt write­ offs. About lialf o f ilie coumiercial bank loss was replenished by subsidized central bank loans (Lee, 1999). 22 in the 1990s, therefore, should be seen as having exacerbated the structural weaknesses o f Asian economies and increased their vulnerability to a critical level. Through the 1990s financial liberalization, Korea was much more closely integrated with world financial markets in the 1990s than they had been in the 1980s, so that the country’s susceptibility to changes in market sentiment increased'®. What is different is that international funds flow much more easily to the country because o f the liberalization o f the financial market. Closer integration with world financial market adds additional dimensions o f vulnerability that are not present in a closed economy such as China (Moreno et al, 1998). Thus domestic financial liberalization and the increased volume and volatility o f international capital flows combined to exacerbate structural weaknesses arising from moral hazard in under-regulated Asian financial market (Click, 1998). From the late 1980s, Kim (1997) argues that the businesses surpassed the government in certain technological areas and no longer need government subsidies to survive. The government lost its bargaining power when the Chaebol found other ways to raise capital investment. The government was able to make credible demands on the Chaebol when it was the sole dispenser and distributor o f credit. However, Korean conglomerates had alternative investment methods to line up credit and raise capital through bond or stock offering. As a result, the government was weakened in its ability to control the private sector from the late 1980s. In summary, modem Korean industries and entrepreneurial elites could accumulate capital by industrial monopolization under the state’s protection. They established industrial bases during the 1950s and 1960s by foreign aid and foreign borrowings, and expanded their wealth rapidly during the 1970s under the government HCl development plan. Moreover, the Kuteau llimucml libcralizalion in ihe 1990s will be addressed in the latter section o f this chapter. 23 direct state intervention in the 1970s and 1980s created moral hazard. In other words, because o f implicit government guarantees, the Chaebol no longer felt compelled to fulfill their obligations to their respective banks. In the financial sector, banks lent to the Chaebol after the state guaranteed the loans, instead o f fostering an innovative banking industry that applied financial tools to evaluate firms, minimize risk and gauge the Chaebols. Banks did not need to use complicated tools to evaluate firms when the safest bet was to give loans to state-backed Chaebols. Chapter 3 and 4 will cover the moral hazard problem o f the Korean economy as a fundamental cause o f the crisis. 2.5 Financial Liberalization in the 1990s Financial reform in Korea has been progressing on many fronts since the early 1990s. This has resulted in many changes and new challenges, particularly in the financial sector. 2.5.1 Interest Rate Liberalization To bring interest rates more in line with financial markets’ fluctuations, the Korean government launched a four-staged interest rate liberalization plan in November 1991 (See Table II-7). This plan applies to interest rates on all deposits and loans. The state hoped that the new deregulated interest rate would accurately represent the way capital was moving through the domestic financial market; in this way it aimed to promote the efficient distribution o f capital and improve the competitiveness o f the financial sector (Bank o f Korea, 1994). However, liberalization o f interest rates does not guarantee efficient capital distribution. Rather, there have to be other institutional settings for a rational decision-making process. It is now apparent that while the government made gradual gains in interest rate liberalization, it continued to direct the 24 nation’s commercial banks and other financial institutions toward making investment in certain strategic industries that would latter prove to be inefficient (Haggard and Mo, 2000).
Interest Rate Liberalization Stage Lending Rates Deposit Rates Bond Issue Rates Objects 1" November 1991 - Bank overdraws and discounts on commercial bills, apart from loans assisted by BOK* rediscounts • Discounts on commercial paper and trade bills o f investments and finance companies, etc - Overdue loans - Short-term, large denomination deposit instruments such as certificates o f deposit, trade bills, commercial paper and repurchase agreements - Long-term time deposits and money-in-trust with a maturity o f at least 3 years - Corporate bonds with a maturity of at least 2 years - All loans of banks and non-bank financial institutions, apart from those provided through government or BOK rediscounts - Long-term deposit with a maturity o f 2 years or more - Corporate bonds with a maturity of less than 2 years and all bank debentures - Monetary stabilization bonds and all government and public bonds < 1994- 1995> - Loans financed by BOK rediscounts such as discount bills <1996> - Loans with banking funds compensated for interest rate gap by government funds (special equipment loans, etc) - Further deregulation of short-term marketable products -> Phasing out regulations on issues and matiuities - Deposit excluding demand deposit -^Introduction of financial products linked to market rates 2nd November 1993 3'“ 1994-1995 4'* During 1997 - Setting up plan for gradual deregulation of demand deposit - Reviewing an abolition o f restrictions on short­ term marketable instruments Note: * Bank o f Korea. Source: Bank o f Korea, 1994 p.5 25 2.5.2 Foreign Exchange Liberalization The Phase III Plan o f foreign exchange liberalization in November 1997 achieved two major objectives: First, it brought Korea closer to a free-floating foreign exchange system by widening the band at which currency exchange may vary from the standard rate; second, it deregulated foreign currency transactions within a preset limit by eliminating documentation requirements (See Table II-8). Since adopting a market average exchange rate system in March 1990, the government had been incrementally widening the foreign exchange fluctuation band from 0.4 percent to 1.0 percent in October 1993, to 1.5 percent in November 1994 and finally to 2.25 percent in December 1995. The Phase III Plan further expanded the band to 10 percent in November 1997. This last increase was a defensive response to the extreme destabilization o f the Korean currency, a situation that was taking the economy toward a financial crisis (Cho, 1999a).
Foreign Exchange Liberalization (Phase III Plan) Stage 1st Starting Year 1993 Liberalization Contents - From October I, the daily fluctuation band o f the interbank foreign exchange rate will be widened to plus and minus 0.8 percent. - From July I, the overall foreign exchange oversold position limit will be raised to 30 percent o f the bills bought in the previous month or USS 20 million, whichever is larger, from the current 20 percent or USS 10 million limit. - From July I, firms can hold foreign currency deposits o f up to USS 300 million in exchange for won currency without presenting underlying documents, compared with the current USS 200 million limit. - From July I, underlying documentation will be required for all foreign exchange forward deals 45 days after signing o f contracts, compared with the current 30 days. - Import or export settlements in Korean currency up to USS 100 thousand will be permissible from October I. - From October I, non-residents will be permitted to open free won accounts (demand deposit accounts). 26 2nd 19941995 - The daily fluctuation band o f interbank rates will be further expanded. - Criteria for monitoring foreign exchange position o f banks will be shifted from controlling only the overbought position to weighing both the overbought position and capital size. • The limit for oversold spot FX position will be readjusted after taking into consideration the development o f the foreign exchange market. • Underlying documentation requirements for foreign exchange forward contracts will continue to be softened so that both industrial and financial institutions will be fully responsible for their own exchange risks. - A full exemption on underlying documentation requirements for foreign exchange forward contracts between foreign currencies ( 1994). - Firms can hold foreign currency deposits without limit in exchange for won currency without presenting underlying documentations (1994). • The scope of exemptions on underlying documentation for forward transactions between won and foreign currencies will be widened ( 1994). - The maximum limit for exports and imports settlement in won will be raised beyond USS 100 thousand. 3rd 19961997 • To pursue the establishment o f a free-floating foreign exchange rate system as used by advanced countries. - Focus on foreign exchange position management will be shifted from monitoring exchange market to promoting sound business managements of foreign exchange banks. - Underlying documentation requirements for normal and ordinary transactions will be waived but the principle of real demand use in foreign exchange forward contracts will be maintained. - Invisible trade, in addition to visible trade, will be permitted to be settled in the won currency on a step-by-step basis. Source: he Korea imes, June 30,1993 p.9. 2.5.3 Capital Account Liberalization In 1981, the government announced a long term plan that would open the nation’s securities markets to foreigners. As a first step, onshore investment trust funds (exclusive to foreign investors) were established to provide opportimities to invest in Korean securities (The Korea Times, June 30, 1993). In 1991, the Korean stock exchange began allowing membership to foreign securities houses, and on January 3, 1992, the Korean stock market was opened to direct foreign investment with certain restrictions: a ceiling o f 10 percent on the aggregate foreign positions in any class o f shares o f a company, and a ceiling o f 3 percent for a single foreign investor. 27 These ceilings were raised in June 1993 with phase III o f the capital market liberalization plan (See Table 11-9), launched as part o f the government’s blueprint for financial market liberalization. As well as opening its own markets to foreign investors, Korea paved the way for domestic investors to invest directly in foreign securities in 1994. Beginning with Sammi Steel Corporation’s overseas bonds with warrants in November 1989, and Samsung Corporation’s overseas depositary receipts in December 1990, listed companies in Korea began actively working towards global securitization. In May 1998, the Korean equity and debt securities markets were further liberalized with the elimination o f ceilings on foreign positions and the opening of the short-term debt securities markets to foreign investors. Capital accounts liberalization in a broad sense refers to any action that releases or removes legal obstacles laid upon the international movement o f capital. The most common first step to capital accounts liberalization is the opening o f the domestic securities market to foreign investors. From this initial step, cross-border transactions o f assets with maturities o f one year and over are liberalized. In the advanced stages, the short-term assets market is open. Capital liberalization is complete when deregulation extends beyond the asset markets to direct investments, real estate, non-securitized rights, credits related to international trade, financial collateral and insurance, foreign currencies, savings accounts transaction, life insurance and similar financial transactions (Cho, 1999a). In Korea, large banks were able to raise short-term fimds from overseas under an arrangement that gave them a virtual monopoly on foreign commercial loans. The resulting unhedged exposure to foreign exchange volatility left the economy highly vulnerable to the liquidity crunch that arrived in late 1997. The Korean government has since been condemned for its loose supervision o f domestic banks and their portfolio structure. 28
Capital Accounts Liberalization (Phase III Plan) Stage 1st Starting Year 1993 Liberalization Contents (Direct Investment) - The notification system for direct foreign investment in Korea has been adopted in principle. - The pre-notice plan for opening o f dom estic industries to direct foreign investments was announced. - Korean firms will enjoy simplication o f application procedures and easing o f restrictions for overseas direct investments. (Outbound Portfolio Investment) - Both the scope o f institutional investors and their investment limits will be expanded or raised. From October I , securities and insurance companies will be permitted to expand their overseas portfolio investment ceiling to USS 100-200 million, compared with the current limit o f USS 50-100 million. - Individual investors will be able to make indirect portfolio investment overseas through investment trust companies and their investment ceiling will be expanded as demand increases. (Inbound Portfolio Investment) - From August I , the cument 10 percent foreign ownership ceiling will not be applied to joint venture listed companies in which foreigners control more than 50 percent o f the equities. But prior consent from these companies is required. (Overseas Fund Raising by Firms in Korea) - The notification system has already replaced the prior approval system. For Korean companies seeking to raise overseas capital through issuance o f equity linked bonds including convertible bonds, bonds with warrants and depositary receipt. - The deferred payment period for imports o f raw materials for export purposes has already been extended to 120 days from the previous 90 days. - From July I, foreign firms or joint venture hi-tech services com panies will be permitted to introduce offshore short-term capital. Foreign hi-tech manufacturing companies have already been given access to offshore short-term capital. 2nd 19941995 (Direct Investment) - In accordance with the pre-notification plan for opening direct foreign investment in Korea, the scope o f industrial sectors eligible for foreign investment will be expanded and the investment procedures will be simplified. - Projects eligible for notification to the government for investing overseas will be expanded. (Outbound Portfolio Investment) - Institutional investors will be given full freedom in investing in offshore bonds and equities. - The scope o f the allowable limit for individual investors to invest in overseas bonds and equities will be expanded. (Inbound Stock Investment) - The foreign stock ownership ceiling in Korean stocks will be raised. - Foreigners, who have stayed in Korea for more than six months but are defined under the Securities Exchange Act as foreigners, will be given national treatment for Korean stock investment (1994). (Bond Market-Opening) - International organizations such as the W orld Bank and Asian Development Bank will be authorized to issue w on-denominated bonds in Korea (1995). - Foreigners will be authorized to invest directly in equity-linked bonds and convertible bonds issued by sm all-and medium-sized companies (1994). - Foreigners will be allowed to underwrite government and public bonds o f which yields are sim ilar to international rates (1994). - Foreign firms will be able to invest in bond-type beneficiary certificates as a w ay o f indirectly opening the domestic bond market (1995). (Overseas Fund-Raising By Firms in Korea) - Foreign firms o f jo in t venture general m anufacturing com panies will be allowed to introduce offshore short-term capital. - The period for imports on a deferred payment basis will be further extended.__________________________ 29 (Direct Investment) - The notification system for direct foreign investments in Korea will be widely implemented. - The notification system will be introduced to liberalize overseas direct investments by Korean companies. (Inbound Stock Investment) - The foreign stock investment limit will be raised again. (Bond Market Opening) - Foreigners will be authorized to invest directly in non-guaranteed long-term bonds issued by sm all- and medium-sized companies (1997). (Access to Foreign Capital) - In keeping with the maturity o f macroeconomic conditions including balance o f payments equilibrium and narrowing o f interest rate differentials between domestic and international markets, imports o f commercial loans will be authorized and the period for deferred imports will be extended in parallel with intemational standards. (.Additional Opening of Securities Industry) - Requirements for opening branches by foreign securities companies will be soffened ( 1994). - Capital requirements for branches o f foreign securities companies will be lowered from 10-20 billion won (1996). - Foreign credit rating agencies will be able to establish liaison offices in Korea and have equity participation in local credit rating agencies (1994). - Foreigners can expand their equity participation ceiling in Korea investment trust companies and investment advisory companies (1995). - Foreign credit rating agencies can raise their equity participation ceiling in dom estic rating companies (1996).________________________________________________________________________________________ Source: The Korea Times, June 30,1993 p.9. 30 Chapter III. The Origin of the Crisis - Theoretical Review Numerous research papers, statements and speeches attempted to decipher the origin o f the Asian financial crisis. Broadly speaking, however, there are two dominant streams o f thoughts explaining the origin o f the crisis in contrasting ways: the 'financial panic’ and the moral hazard’ theories. This chapter reviews these two popular theories, and argue that the moral hazard theory best interprets the fundamental cause o f the financial crisis in Korea. The following sub-section will, therefore, theoretically review these two explanations o f the crisis in 1997. Finally, this chapter will explain the Korean financial crisis assuming that the moral hazard was the fundamental cause o f the crisis. 1. Financial Panic The financial panic theory argues that the main cause o f the financial crisis was an irrational panic among speculative investors. According to Radelet and Sachs (1998a, 1998b), for example, there was nothing wrong with the fundamentals o f the Asian economies prior to the crisis. The Asian financial crisis was caused not by any weakness o f the Asian countries’ economic fundamentals, but by intemational investors’ panicky behaviour; such behaviour primarily involved in a sudden shifi in market confidence and disrupted capital flows to Asia (Radelet and Sachs, 1998a). In other words, at the core o f the Asian financial crisis were largescale foreign capital inflows into financial system that became vulnerable to panic. Therefore, Radelet and Sachs suggest that the structural deficiencies o f the intemational capital market is the prominent culprit o f the rapid economic meltdown in East Asia and its spread to the rest o f the region, and that the affected countries’ economic fundamentals became vulnerable to extemal shock prior to the Asian financial crisis. 31 It is true that during the 1990s, many Asian economies enjoyed a drastic increase in capital flows compared with the 1980s, resulting from their market opening and good market forecast, even though the institutional weaknesses o f these economies were well known for decades" (See Table III-l). The volume o f capital inflows into the region averaged over 5 percent o f GDP between 1990 and 1996. Most notably, capital inflows into Thailand and Malaysia were equivalent to 13 percent in 1995 and 16.8 percent in 1993 o f those year’s GDPs, respectively.
Capital Flows in Selected Economies prior to the Crisis (percent o f GDP) Country 83-89 90-95 90 91 94 92 93 96 95 -0.8 3.0 1.1 Korea 2.3 2.3 1.0 2.8 5.0 8.5 4.0 3.9 3.9 4.4 4.4 3.6 2.2 5.1 N/A Indonesia 10.7 4.6 10.2 12.0 8.5 8.4 10.7 Thailand 8.4 13.0 9.7 3.6 4.2 11.7 15.1 16.8 1.8 N/A Malaysia 8.5 6.4 1.2 4.6 6.4 6.1 6.0 8.0 Philippines 7.2 N/A 4.9 -0.2 10.5 5.4 3.6 -1.9 -16.1 -2.9 0.6 Singapore Note: The financial capital flows in this table includes portfolio investment and direct investment by the government. Source: Bank o f Korea, Various years: Quoted in Rhee and Lee (1998, p.9). This massive capital inflow started to reverse when the Thai Baht plummeted in value after the Thai government abandoned its pegged exchange rate, given the country’s huge trade deficit in July 1997. According to Bowles (1999), once Thailand was forced to devalue its currency, it reinforced intemational investors’ self-fulfilling expectations and made them look for ‘similar’ countries. Thus, Bowles argues that countries with fixed exchange rates, low " As Corsetti et al. (1998) point out, Asia’s consumption and investment boom might have resulted from the region’s overly-optimistic beliefs that the economic expansion would persist unabated in the future. These large capital inflows make it easy to Hnance the increasing demand. In such circumstances, Corsetti et al. argue that a sudden change in expectations in response to an extemal shock can cause a rapid reversal o f capital flows and in turn trigger a currency crisis. 32 foreign exchange reserves, high trade deficits and soaring inflows o f short-term capital were potential targets for investor panic and currency flight. As a result, between 1996 and 1997, Thailand experienced a sudden reversal o f capital inflows equivalent to approximately 20 percent o f that year’s GDP. For the five troubled economies - Indonesia, Korea, Malaysia, Philippines and Thailand - net capital inflows plummeted from USS 97 billion to negative USS 12 billion in 1997. This turnaround o f USS 109 billion in a year is equivalent to about 10 percent o f pre-crisis GDP o f these five countries (Radelet and Sachs, 1998a). This sudden withdrawal o f foreign capital had significant economic effects in Asia. As Radelet and Sachs (1998b) argue, the withdrawal o f foreign credit resulted in a rise in domestic interest rates, which in turn led to a tightening o f domestic credit conditions while the nominal and real exchange rates sharply depreciated. In the case o f Korea, the Won currency dropped in value by 50 percent and the domestic interest rate doubled between the end o f 1996 and the end o f 1997. The real exchange rates depreciation and much higher domestic interest rates led to a rapid rise in non-performing loans and a sudden loss o f bank capital in the crisis-hit economies, where banks borrowed short-term, unhedged and US dollar denominated loans to finance long term domestic investment. Similarly, Wade and Veneroso (1998) contend that the Asian economies were relatively healthy and efficient prior to the crisis. High savings in Asian countries naturally led to high debt/equity ratio o f industrial firms, which worked as the engine o f strong economic growth. They argue that Western and Japanese banks and investment houses were responsible for the crisis. These intemational bankers, who usually had a powerful incentive to follow the herd, ignored their own pmdential limits and lent heavily to Asian companies over the 1990s, assuming that high growth would continue and the exchange rate would remain stable. 33 It is one thing, however, to point to the irrational behaviour o f intemational investors as the source o f the problem, and another to argue that the fundamentals o f the Asian economy were strong prior to the crisis. According to Radelet and Sachs (1998a, 1998b), there was nothing wrong with the fundamentals o f the Asian economies prior to the crisis. However, the Korean economy was already on the path to a crisis years before the actual financial crisis hit the country. The symptoms o f the impending financial crisis in Korea started to appear when the economy began to slow down in 1996. As Table IU-2 shows, the current account deficit widened from USS 8.5 billion in 1995 to USS 23 billion in 1996. The ratio o f the current account balance deficit to GDP rose to 4.7 percent in 1996 from below 2 percent in the two preceding years. This widening current account deficit was brought by the deceleration o f export growth due to the fall in the prices o f Korea’s major export items, especially computer memory chips, coupled with a rapid expansion o f imports, most notably o f capital goods and consumer goods, which eventually caused the massive corporate bankruptcy in the early 1997 (Nam et al., 1999).
Current Account Balance, 1994-1998 (year on year growth rates, percent) 1994 1995 1996 -3 .9 -8.5 -23 Current Account (USS billion) -1.0 -1.9 -4.7 Current Account /GDP Source: National Statistical Office: Quoted in Nam et al (1999, p.4). 1997 -8 .2 -1.9 1998 9.7 2.1 Radelet and Sachs (1998b) hardly mention the continuous bankruptcies o f many Korean Chaebols during the period firom early 1997 to the onset o f the crisis. They also fail to acknowledge that the Korean banking sector was burdened with huge amounts o f nonperforming loans due to inefficient banking practice even before the financial crisis in the late 34 1997. Instead, they argue that exchange rate depreciation, precipitated by sudden withdrawal o f capital and the improper IMF macroeconomic policies, was the major cause o f the debt problems in Korea. To be sure, foreign exchange depreciation and high interest rates since December 1997 added to the debt burden o f Korean firms. It is also critical to point out that, however, huge amounts o f inherited extemal debts, plus additional debts imposed on the banks by the unprecedented number o f bankruptcies o f Chaebols since the early o f 1997, were important causes o f the crisis (See Table 111-3). The ratio o f external debts to GNP rose to 21.8 percent in 1996 from 14.0 percent in 1992, where the major debt holders were financial institutions.
External Debts by Sector in Korea 1992 5.6 Public Sector 13.7 Corporate Sector 23.5 Financial Sector 42.8 Total 24.3 Long-Term 18.5 Short-Term 14.0 Total/GNP (%) Source: Cho, 1999a p.20. 1994 3.6 20.0 33.3 56.8 26.5 30.4 15.1 1993 3.8 15.6 24.4 43.9 24.7 19.2 13.3 1995 3.0 26.1 49.3 78.4 33.1 45.3 17.3 (Unit: USS billion) 1996 1997 2.4 18.0 35.6 42.3 66.7 60.5 104.7 120.8 43.7 69.6 61.0 51.2 21.8 27.5 As a result, many domestic banks - such as Seoul Bank and First Bank - were already close to the point o f bankruptcy even before the crisis: this led negotiators firom the IMF and the government to decide to liquidate these troubled banks in negotiations leading to the first IMF bailout (Yoon, 1998). In this way, Radelet and Sachs see only what happened after the crisis and disregard prior events. Furthermore, Radelet and Sachs argue, "the crisis involved considerable lending to debtors that were not protected by state guarantees” (1998b, p5). However, in the case o f Korea, 35 all the domestic financial institutions were explicitly and/or implicitly guaranteed by the government'": at least financial institutions and foreign investors thought that they were protected from possible loss by the government. This moral hazard certainly worked as an incentive for foreign banks to make loans excessively to Korean financial institutions. When the Hanbo Group collapsed in February 1997, for example, the Secretary o f Economic Affairs announced that the Korean government would not guarantee Korean banks' foreign debts. This resulted in enormous panic among intemational investors, and the official retracted the statement in less than a week (Ahn, 1999). Wade and Veneroso (1998) seem to agree with Radelet and Sachs that there was nothing fundamentally wrong with the Korean economic model. For instance, according to Wade and Veneroso, Western commentators who dismiss the system as ‘crony capitalism’, seeing only its corruption and favouritism, miss (1998, p7) "...the financial rationale for cooperative, long-term, reciprocal relations between firms, banks and government in a system which intermediates high savings into high corporate debt-equity ratios. (They also miss the cronyism o f U.S. capitalism, generated by the electoral finance regime.)” However, according to Yoon (1998), Wade and Veneroso do not recognize that this ‘cooperative, long-term, and reciprocal relations between firms, banks and govenunent’ also provided politicians and Chaebol owners with the opportunity to seriously distort Korea’s political and There seem to be a number o f studies that back up the Korean government’s explicitly and/or implicitly guarantee towards the domestic financial institutions. See Amsden (1989), “Asia's Next Giant: South Korea and late Industrialization”, New York: Oxford University Press as well as Roubini (1999), "What caused Asia's Economic and Curreucy Crisis and Its Global Contagion? " for more details. 36 economic structure. The slush fund scandals o f former presidents Chun and Roh, and the Hanbo collapse, vividly show how seemingly benign trilateral relations could be turned into ugly relations. This moral hazard phenomenon was nothing but the mirror image o f these 'cooperative, long-term, and reciprocal relations’. In summary, from the perspective o f the financial panic theory, the region’s economies were inherently sound and could have continued functioning well, but an arbitrary shift in market expectations that interrupted capital flows to Asia triggered the financial crisis in 1997. To be sure, the financial crisis was triggered by the investors’ irrational panic. However, given the empirical evidence above, it is hard to believe that the fundamentals o f the Korean economy were sound. The economy was already on the path to a crisis years before the actual financial crisis hit the country. The economy suffered from a string o f major corporate bankruptcies followed by unbearable burden o f non-performing loans in the financial sector, which in turn, greatly undermined intemational confidence and hence caused a massive pullout by foreign investors from the country. 37 2. Moral Hazard An alternative explanation, which this study favours, emphasizes internal factors as the cause o f the East Asian economic crisis. This hypothesis focuses on the moral hazard problem in the debtor countries' financial and industrial sectors as having the leading role in the crisis. For instance, Krugman argues (1998, p3) ‘T he problem began with financial intermediaries - institutions whose liabilities were perceived as having an implicit government guarantee, but were essentially unregulated and therefore subject to severe moral hazard problems. The excessive risky lending of these institutions created - inflation not o f goods but o f asset prices. The overpricing of assets was sustained in part by a sort o f circular process, in which the proliferation o f risky lending drove up the prices o f risky assets, making the financial condition o f the intermediaries seem sounder than it was." This interpretation emphasises the role that governmental guaranties played in the birth of the crisis, through moral hazard. According to this approach, the loans borrowed by domestic banks from abroad are supported by government. The banks, whose obligations are guaranteed, like “investments that could yield high returns if it gets lucky, even if there is also strong possibility o f heavy losses” (Krugman, 1998, p4). That is, foreign capital deviates towards less efficient and riskier projects than those the projects non-guaranteed intermediaries would invest it in. On the other hand, according to Krugman (1998), moral hazard leads to over-investment. When granting a loan, guaranteed intermediaries do not consider the expected profitability o f the project but the highest profitability possible for such project (so-called ‘pangloss value’), so for 38 these intermediaries there are more profitable projects to invest it (Garcia and Olivie, 1998, p i I). This is why investors receiving loans from guaranteed intermediaries will be willing to pay more than others for certain assets, thus pushing up the price o f those assets. Roubini (1998) also argues that most banks in East Asian economies had been implicitly and explicitly guaranteed by governments. Thus, international investors made excessive loans to the banks in East Asian countries, which in turn transferred capital to firms involved in risky projects. In the case o f Korea, it is noteworthy that the number o f firms belonging to the Hanbo Group increased while an unsound investment in a steel plant occurred. This means that bank loans were diverted for the purpose o f increasing the number o f companies in the group (The Joong-Ang Newspaper, February 3, 1997). Most Chaebol owners in Korea would have thought, as did Chung Tae-soo (Chairman o f the Hanbo Group) that the safest way to avoid collapse would be to increase the number and the size o f their companies and take the national economy and creditor banks as their own hostages. As Park Young Bae, President o f a commercial bank, complained, ‘T h e attitude o f the Chaebol owners, with the help o f politicians and high-ranking bureaucrats in the Ministry o f Finance and Economy (MOFE), would suddenly become arrogant when their bank loans exceeded certain levels.” (The Dong-Ah Newspaper, May 16,1997). This Chaebol owners' strategy o f taking the national economy hostage usually worked as they expected. Even the former deputy prime minister Kang Kyung-sik, who has been known as a believer o f market principles, could not let the Chaebols collapse as market mechanisms would dictate. After the collapse o f the Hanbo and the Sammi Groups, his ministry (MOFE) directed creditor banks to make an agreement to keep providing additional emergency loans to these Chaebols (The Dong-Ah Newspaper, April 23,24, May 19,1997). 39 On the other hand, the problem o f moral hazard made regulation o f the financial system lax, which contributed to excessive inflows o f foreign capital and Anally to the occurrence o f the currency crisis (Balino and Ubide, 1999). International investors believed that the Korean government or the IMF would bail them out if something went wrong. Thus, they did not feel it was necessary to carefully examine the soundness o f Korean firms and financial institutions to which they made these excessive loans. Similarly, domestic financial institutions tended to think that the government would rescue business firms if problems arose (Corsetti et al., 1998). They had no incentive to be prudent when borrowing from international investors and lending to domestic industrial firms. This moral hazard driven situation was worsened by the government, to whom the final responsibility o f monitoring international financial transactions fell. Cho (1999a) argues that this was because the government had no experience o f monitoring international capital transactions and providing the financial system with proper safeguard measures in order to contain risks while opening market. Indeed, the moral hazard o f the Korean economy resulted in excessive investment, high indebtedness, over diversification and low productivity and profitability o f the corporate sector, which eventually caused the financial crisis. Chaebols will be examined in the next chapter. 40 These moral hazard driven problems o f the IV. Structural Weaknesses of the Chaebol: Cause of the Crisis This chapter analyses the cause o f the Korean financial crisis, which can be attributed to the structural weaknesses o f the Chaebol in the context o f the moral hazard. The moral hazard caused high indebtedness, investment inefficiency and extensive diversification resulting low productivity and profitability leading to massive bankruptcies o f the Chaebols. This massive corporate insolvency problem translated into a domestic financial crisis making the economy extremely vulnerable and eventually contributing to the financial crisis. By examining these structural weaknesses o f the Chaebol in the context o f the moral hazard, this chapter will demonstrate that these four weaknesses were the fundamental cause o f the crisis. In addition, this chapter will try to explain that the Chaebols were already on the path to a crisis years before the actual financial crisis hit the country, due to their moral hazard-driven structural weaknesses. 4.1 High Indebtedness The high exposure to debt financing o f large Korean conglomerates was one o f the most critical factors on the path to the financial crisis. In 1997, the gross debt o f the top 30 Chaebols amounted to 357 trillion Won, equivalent to 85 percent o f that year’s GDP (Gobat, 1998). The total debt owned by Korean firms amounted to 811 trillion Won, equivalent to 190 percent o f that year’s GDP (See Figure IV-1). This debt was also highly concentrated: the top 5 Chaebols accounted for roughly two-thirds o f the top 30 Chaebols’ debt and 45 percent o f Korea’s corporate debt. The financial vulnerability o f Korean firms can also be seen from the high debt/equity ratios. The average corporate debt/equity ratio in Korea is about 5 times higher than that o f Taiwan (See Figure IV-2). By the end o f 1997 the average debt/equity ratio o f the 30 largest Chaebols reached 519 percent, about 130 percent points higher than a year earlier. 41
Debt/GDP Ratios by Sector 1 I* 1 .o- O .tl Source: Bank o f Korea: Quoted in Nam et al (1999, p.6).
International Comparison of Debt/Equity Ratios (%> U .S., U .K . Note: For the manufacturing sector in Korea, Japan and Taiwan. Source: Bank o f Korea, Financial Statement Analysis: Quoted in Nam et al (1999, p.6). Furthermore, Chaebols ' high indebtedness problem was worsened by domestic banks’ excessive exposure to short-term external debt. During 1994-96, Korean firms undertook a major capacity investment financed mainly through borrowing from domestic financial institutions. Korean banks met this increased demand for funds by increasingly turning to 42 foreign borrowing, often at short maturities (Balino and Ubide, 1999). The share o f short-term foreign debt, which amounted to 58 percent o f the total external liability o f Korea in 1995, increased to 62 percent in 1996, adding up to US $ 100 billion (Yoo and Moon, 1999). This heavy reliance on the short-term debt exposed the country to the risk o f a bank crisis. Corsetti et al. (1998) argue that banks would not have been able to liquidate assets rapidly without huge losses if foreign lenders had suddenly refused to roll over short-term debt to domestic banks, precipitating a credit crisis. Due to the high financial leverage and excessive short-term debt, the corporate sector had been faced with high default risk over the business cycle. Such inherent vulnerability was worsened by both a large negative shock in terms o f trade and weak domestic demand in 199697 (See Figure lV-3). During this period, Korea’s terms o f trade deteriorated by more than 20 percent due to the collapse o f export price in international market, particularly the price o f semiconductors the biggest single Korean export item.
Terms of Trade (Index) tlO- 1oo ^*70'y i ■yâ'Tri' r Source: Nam et al., 1999 p.5. 43 w a V As a result, a number o f highly indebted Korean conglomerates ran into serious liquidity problems before the actual crisis hit the country in late 1997. These major bankruptcies directly increased the fragility o f the financial institutions that had excessive exposure to these business groups, and undermined foreign investors’ confidence and eventually made them rush out o f the country. The rest of the sub-section is organized into two parts. The first part is an introduction to the motives for the heavy indebtedness o f the Chaebols. This sub-section will prove the fact that the essential aspect o f the crisis lies at the moral hazard o f the corporate sector. The second part analyzes the Chaebols ’ indebtedness trends. By doing this, this sub-section will explain that the Chaebols were already on the path to an economic disaster years before the actual financial crisis hit the country. 44 4.1.1 Motives for high Indebtedness There are several factors encouraging the Chaebols' high debt financing business practice. First, the government’s implicit risk sharing with Chaebols, which resulted in the serious problem o f the moral hazard, was one o f the most critical motivations for the heavy indebtedness o f the Chaebol. The large conglomerates could pursue heavily indebted growth under the impression that the government would bail them out when their businesses were in trouble. In fact the government was heavily involved in massive bailouts on numerous occasions during the past decades, including the emergency debt freeze in 1972 and restructuring o f major heavy chemical industries in the early 1980s'\ These government bailouts eliminated the fear o f bankruptcy and encouraged Chaebols to increase their dependency on government-backed loans. The frequent government bailouts o f troubled and insolvent firms, therefore, caused the moral hazard, which encouraged large corporations to have large amounts o f debt. Second, the history o f government involvement in bank lending decisions also promoted the Chaebols ’ heavy debt financing. As a result o f a tradition whereby the government implicitly underwrote banking risks, banks developed limited skills in credit analysis and risk management. Although the government greatly reduced its involvement in bank lending decisions, substantial moral hazard remained, reflecting the implicit guarantee that Korean banks had never been allowed to fail (Balino and Ubide, 1999). The moral hazard within the banking system made it easy for the conglomerates to access money that invested in various fields without adequate scrutiny. Thus, the Chaebols were able to indulge in risky moral hazard-driven lending from these institutions. The government bailed out many insolvent companies to protect workers from being unemployed, the adverse effect o f big business failures on the entire economy, and protect the overseas financial reputation o f Korean firms (Lee, 1999). 45 Third, Chaebols preferred bank loans because they could enjoy the interest differential rent. Interest differentials arise from the dual structure o f interest rates - in other words, the difference between the market rate and the government-regulated rate***. Capital was usually under-priced throughout the rapid growth period. In the 1960s and 1970s, by means o f promoting the economic development plan, the government chose a financial repression policy to achieve various kinds o f industrial policy goals (Kim, 1997). As the interest rates from commercial banks were historically attractive to borrowers as compared to time deposit rates or inflation rates, the Chaebol financed investments with borrowed funds from the commercial banks (See Table 11-3). Fourth, the higher dependency on debt financing made it possible for the Chaebol families to control a large business group with a relatively small amount o f shares through circular share holdings. For example, according to Lee (1999), firm A i n a Chaebol group owns a share o f firm B worth 1 million dollars, firm B owns a share o f a share o f firm C worth 1 million dollars, and finally firm C owns a share o f firm A worth 1 million dollars. This 1 million dollars does not represent a real asset and it is a paper asset existing only in the accounting system. On average, the owner and relatives own only about 10 percent o f the Chaebol group’s stock in the top 30 business groups. However, circular share holdings by other affiliated firms that own an additional 30 percent o f shares enable the largest shareholder to control the firms. In other words, although family owners hold 10 percent o f the shares o f several core companies within the group, these companies themselves posses holding in other companies in the group. This means that Chaebol families contribute a relatively small amount o f their wealth to the total " The borrowing cost differential between protected and unprotected industries was about 2-3 percentage points during 1972-1984, at a time when nominal lending interest rates averaged 16 percent. Under these conditions, the Chaebols could exploit quasi-rents accompanying loan market disequiiiforia (Balino and Ubide, 1999). 46 capitalization o f their business groups and yet exercise absolute control over their business groups by means o f circular share holdings and debt financing. Fifth, debt financing was also encouraged by internal financial arrangement, namely the cross debt guarantee system, within Chaebols themselves. The conglomerates were able to guarantee bank loans and other forms o f corporate debt among their affiliates because those mother companies were “too big to fail”. In other words. Chaebols ’ subsidiaries were able to get bank loans due to their mother companies’ debt guarantees. The total value o f the debt payments guaranteed by the affiliates o f the top 30 Chaebols amounted to 91 percent o f their total equity capital in the mid-1997 (Gobat, 1998). The practice o f providing cross debt guarantees among affiliates o f business groups, therefore, allowed firms to borrow more easily, and this easy credit led to high leverage in the corporate sector. Finally, the debt ratio also increased due to low retained earnings and the long-term stagnation of the stock market, making it difficult for Chaebols to raise capital. After the boom period o f the stock market from 1987 to 1989, the Korean stock market declined except for a few years o f transient recovery (Nam et al., 1999). Therefore, firms met their capital needs with debt, mainly credits from bank and non-bank financial institutions. The fundamental aspect o f the Chaebols' motivations for high indebtedness lies, however, in the moral hazard, reflecting the implicit assumption that large corporations were “too big to fail”. The Chaebols were not allowed to go bankrupt due to their massive socio­ economic impact. In such an environment, the Chaebols’ incentive structure with regard to corporate financing was seriously distorted: the more they borrow, the safer they are. These fault lines made the corporate sector extremely vulnerable to unfavourable shock and increased financial market’s fragility. 47 4.1.2 Indebtedness Trends of the Chaebols The promotion o f heavy chemical industries in a country with a credit based financial system resulted in the extremely high financial leverage o f industrial companies. There is no doubt that the high debt levels o f the Korean corporate sector led to massive insolvency and bankruptcies o f the Chaebols, and eventually to the economy’s vulnerability. The financial vulnerability o f Korean firms can also be seen from the high debt/equity ratios (See Table IV-1 and Table IV-2). By the end o f 1997, the average debt/equity ratio o f the 30 largest Chaebols reached 519 percent, about five times higher than that o f Taiwan (Gobat, 1998). A striking point is that such extremely high debt/equity ratios had shown for several years before the crisis. In 1995, the debt/equity ratios o f several Chaebols were already at super-high levels: Hanbo Steel Co. (675 percent). New Core Group (924 percent), Jinro Group (2,441 percent), Halla Group (2,885 percent), and Sammi Group (3,245 percent). In 1997, the ratios o f total borrowings to sales for those bankmpt Chaebol groups were extremely high as well: Hanbo Steel Co. (1,112.9 percent), Jinro Group (169.4 percent), and Sammi Group (116.5 percent) (See Table IV-3). As a result, before the financial crisis all o f the above Chaebols either went bankrupt or were subject to legal procedures related to composition or reorganization. To be sure, all the Chaebols that ran into trouble in 1997 had already been experiencing considerable financial stress, and thus were vulnerable to the shocks that occurred over the course o f 1997. These troubled Chaebols were much more indebted than the average o f the top 30 Chaebols, Furthermore, these Chaebols had been posting operating losses since 1993 (See sub-section 4 at the end o f this chapter). deteriorating financial health. Many Chaebols had shown signs o f rapidly The Chaebols were, therefore clearly already on the path to economic disaster years before the actual financial crisis hit the country. 48
Capital Structure of the 30 largest Chaebols, 1997 Assets Sales Equity 72,415 10,670 78,690 1. Hyundai 63,536 66,939 13,492 2. Samsung 51,791 49,570 9,055 3. Daewoo 8,491 51,435 58,344 4. LG 29,019 30,167 5,109 5. SK 19,037 10,408 1,889 6. Hanjin 14,930 2,988 20,812 7. Ssangyong 12,056 11,192 917 8. Hanwha 10,232 980 9. Kumho 5,163 8,770 4,508 1,907 10. DongAh 8,842 2,794 7,873 11. Lotte -570 8,552 6,158 12. Halla 6,688 1,090 6,574 13. Daelim 6,585 954 3,690 14. Doosan 6,094 1,219 15. Hansol 3,183 5,244 6,283 928 16. Hyosung 901 5,155 3,256 17. Kohab 4,812 4,915 902 18. Kolon 4,594 3,280 1,084 19. Dongkuk 4,375 3,572 998 20. Dongbu 4,300 269 2,446 21. Anam 4,253 1,618 -536 22. Jinro 3,152 2,280 625 23.Tongyang 234 3,747 3,259 24. Haitai 3,045 392 1,932 25. Shinho 2,842 1,598 380 26. Daesang 2,845 2,478 151 27. New Core 2,626 488 28.Keopyong 1,373 2,665 3,381 561 29. Kangwon 2,659 512 1,603 30. Saehan 462,296 68,874 Total 406,545 Source: Fair Trade Commission: Quoted in Gobat (1998, p.34). 49 (billion Won) Debt 61,745 50,044 42,736 42,944 23,910 17,148 11,942 11,139 9,252 6,863 6,048 9,122 5,598 5,631 4,875 4,316 4,254 3,910 3,510 3,377 4,031 4,789 2,527 3,513 2,653 2,462 2,694 2,138 2,104 2,147 357,422
Top 30 Chaebols’ Debt/Equity Ratios (percent) 1995 Debt/Equity Chaebols Ratio 1. Hyundai 2. Samsung 3. LG 4. Daewoo S. SK 6. Ssangyong 7. Hanjin 8. Kia 9. Hanwha 10. Lotte 11. Kumho 12. Doosan 13. Daelim 14. Hanbo 15. DongAh 16. Halla 17. Hyosung 18. Dongkuk 19. Jinro 20. Kolon 21.Tongyang 22. Hansol 23. Dongbu 24. Kohab 25. Haitai 26. Sammi 27. Hanil 28. Kukdong 29. New Core 30. Byucksan 376.4 205.8 312.8 336.5 343.3 297.7 612.7 416.7 620.4 175.5 464.4 622.1 385.1 674.9 321.5 2,855.3 315.1 190.2 2,441.2 328.1 278.8 313.3 328.3 572.0 506.1 3,244.6 936.2 471.2 924.0 486.0 Average 347.5 1996 Chaebols Debt/Equity Ratio 1. Hyundai 2. Samsung 3. LG 4. Daewoo 5. SK 6. Ssangyong 7. Hanjin 8. Kia 9. Hanwha 10. Lotte 11. Kumho 12. Halla 13. DongAh 14. Doosan 15. Daelim 16. Hansol 17. Hyosung 18. Dongkuk 19. Jinro 20. Kolon 21. Kohab 22. Dongbu 23.Tongyang 24. Haitai 25. New Core 26. Anam 27. Hanil 28.Keopyong 29. Miwon 30. Shinho 436.7 267.2 346.5 337.5 383.6 409.4 556.6 516.9 751.4 192.1 477.6 2,065.7 354.7 688.2 423.2 292.0 370.0 218.5 3,764.6 317.8 590.5 261.8 307.8 658.5 1,225.6 478.5 576.8 347.6 416.9 490.9 386.5 1997 Chaebols Debt/Equity Ratio I. Hyundai 2. Samsung 3. Daewoo 4. LG 5. SK 6. Hanjin 7.Ssangyong* 8. Hanwha* 9. Kumho 10. DongAh* 11. Lotte 12. Halla+ 13. Daelim 14. Doosan 15. Hansol 16. Hyosung 17. Kohab* 18. Kolon 19. Dongkuk* 20. Dongbu 21. Anam* 22. Jinro+ 23.Tongyang 24. Haitai+ 25. Shinho* 26. Daesang 27.New Core* 28.Keopyong* 29. Kangwon 30. Saehan 578.7 370.9 472.0 505.8 468.0 907.8 399.7 1,214.7 944.1 359.9 216.5 -1,600.4 513.6 590.3 399.9 465.1 472.1 433.5 323.8 338.4 1,498.5 -893.5 404.3 1,501.3 676.8 647.9 1,784.1 438.1 375.0 419.3 519.0 Note; * denotes business groups whose subsidiaries were subject to corporate workout after the financial crisis o f 1997 and + denotes the business groups that became insolvent. Source: Fair Trade Commission: Quoted in Nam et al. (1999, p.25). 50
Total Borrowing to Sales of the B ankrupt Chaebols, 1997 Groups Total Borrowing Total Sales 50,970 Hanbo 4,580 17,390 Sammi 14,923 25,257 Jinro 14,910 97,398 Kia 121,440 29,329 Haitai 27,157 12,843 New Core 18,276 54,528 Halla 52,973 Source: Samsung Economic Research Institution, 1999 p.2. (100 million fVon, percent) Total Borrowing to Sales 1,112.9 116.5 169.4 80.2 108.0 70.3 102.9 The debt/equity ratios o f the Korean Chaebols were also excessively high compared to business groups in other countries (See Table IV-4). The average debt/equity ratios o f these 30 Chaebol groups in 1996 was 450 percent, which is approximately 3 times those o f American groups, 2.5 times Japanese Zaibatsu, and 5 times Taiwanese groups. This ratio is also high not just for Chaebols but for the manufacturing industry as a whole compared with other industrial countries. These high debt/equity ratios o f the Chaebols reduced flexibility and increased vulnerability o f the corporate sector’s cash flow, because debt payments have to be paid even if in bad times while equity payments do not.
International Comparison of the Average Debt/Equity Ratios Korea United States Manufacturing 30 Chaebols 307 403 1991 147 319 426 1992 168 295 398 1993 175 303 403 1994 167 287 388 1995 160 317 450 1996 154 Note: Non-flnancial subsidiaries o f 30 largest Chaebols. Source: Fair Trade Commission: Quoted in Gobat (1998, p. 15). 51 Japan Taiwan 209 202 202 196 196 187 98 93 88 87 86 The high debt burden also resulted in high debt serving costs (See Figure IV-4). Interest expense in the manufacturing sector averaged 5-6 percent o f sales, roughly three times as large as Japan and Taiwan. Given the high debt leverage o f the corporate sector, a large share of operating earnings went to servicing their debts. The more debts the Chaebols had, the more interest payments were made to service the firm’s debt.
International Comparison of Corporate Debt Service Costs as Percentage of Sales (%> 1w n I no Note: Manufacturing sector. Source: Bank o f Korea, Financial Statement Analysis: Quoted in Nam et al., 1999 p.7. Moreover, the Chaebols ’ high leverage problem was worsened by the excessive exposure to the short-term external debt. During 1994-96, Korean companies implemented gigantic facility expansions, which relied heavily on borrowing from domestic financial institutions. Korean banks met the increased demand for funds by turning to foreign borrowing, often at short maturities'^. As a result, in Korea, short-term debt with a maturity o f less than one-year accounted for 62.2 percent o f the total foreign debt o f US$ 100 billion at the end o f 1996 and Several factors explain the reliance on short-term capital inflows. For details, see Balino and Ubide, ‘T he Korean Financial Crisis of 1997 - A Strategy of Financial Sector Reform”, IMF, 1999. 52 61.0 percent o f USS 104.0 billion as o f September 1997 (See Table IV-5). Over the course o f capital account liberalisation occurring since the early 1990s, short-term capital inflows were liberalised in advance o f long-term inflows (Nam et al., 1999). Consequently, Korean banks borrowed from abroad in the short-term, and lent funds in the long-term. In other words, domestic banks channelling external short-term funds to long-term loans that financed facility investments by the corporations caused a serious maturity mismatch problem'^. This maturity mismatch resulted in the inability o f the financial institutions to roll over their short-term foreign borrowings which, in turn, eventually triggered the financial crisis.
Details of Korea’s Foreign Debt before the Crisis Total Foreign Debt Short-term Debt/Total Foreign Debt Source: Yoo and Moon, 1999 p. 11-12. 1995.12 45.3 57.8 1996.12 100.0 62.2 (US$ billion, percent) 1997.9 104.0 61.0 In summary, moral hazard-driven high financial leverage and heavy exposure to short­ term debt o f the Chaebols were both extremely vulnerable to cyclical shocks as well as to changes in market expectations. Such vulnerability was worsened by an adverse shock in terms o f trade occurring in the first half o f 1996. As a result, 14 out o f the top 30 largest Chaebols ran into serious liquidity problems before the financial crisis hit the country in late 1997. These large bankruptcies significantly damaged the asset position o f financial institutions and undermined foreign investors’ confidence making them rush out o f the country. The corporate insolvency problem, driven by the high indebtedness o f the Chaebols, translated into domestic financial crisis, and ultimately caused the external liquidity crisis. For more details, see Nam et ai, “Corporate üovemance m Korea", Korea Development Institute, 1999. 53 4.2 Investment Inefficacy Investments by the Chaebols into high-risk business projects are also regarded as one o f the key factors that caused the Korean financial crisis. During 1994-96, Korean corporations undertook a major investment expansion, particularly in the manufacturing sector. An example o f this is the chemical industry, where Korea added almost as much new capacity between 1990 and 1997 as the whole o f Western Europe with a goal o f increasing their market share in the markets, even though world markets for many products were already glutted (The McKinsey N o .4 ,1998). This huge capacity expansion o f Chaebols was manageable so long as the economy was growing, even though returns on investment were often low '’ due to their over capacity, driven by the moral hazard and ruthless competition among large Chaebols. The investment boom during 1994-96, however, turned out to be unsustainable when the terms o f trade deteriorated about 20 percent in the first half o f 1996, the largest drop since the first oil shock o f 1974 (Haggard and Mo, 2000). The sharp fall in export prices, mainly reflecting the oversupply in the semiconductor market and a decline in foreign demand, resulted in substantial losses in the export sector. This huge deterioration o f the terms o f trade severely damaged Chaebols ' profitability, which was potentially dangerous given the over leveraged and over invested structure o f the Korean corporate sectors. As a result, starting ft'om the beginning o f 1997, a number o f the highly leveraged Chaebols went into bankruptcy dragged down by a substantial debt burden. These massive bankruptcies inevitably undermined the soundness o f financial institutions, and the financial crisis quickly degenerated into a full economic crisis. According to Corsetti et ai. (1998), with a prime rate in local currency that before the crisis was as high as 12 percent, the return on invested capital (ROIC) for Korean Chaebols was well below the cost o f capital in the 199296 period. For example, in the case o f Hanbo, Sammi and Jinro (the first Chaebols to collapse in 1997) the ROIC at the end o f 1996 was as low as 1.7 percent, 3.2 percent and 1.9 percent respectively. 54 4.2.1. Motives for Excessive Investment There are six factors that encouraged the Chaebols' excessive investment business practice. First, the government’s implicit risk sharing with Chaebols, which resulted in a serious problem o f moral hazard, was one of the most critical motivations for the excessive investment o f the Chaebol. The consequence of this close govemment-business relationship induced the investment inefficiency o f the Chaebols. In other words, the myth o f “too big to fail” allowed the Chaebol groups to set a goal o f size maximization at the expense o f more rational management objectives. Even with low expected returns, risky investment became inevitable when the Chaebols determined that they were protected from the risks o f investment losses. Due to their ability to simply walk away from failure. Chaebols indulged in over investment behaviour. Second, in Korea, the government policy had always been devoted to the growth o f Chaebols with the belief that large-scale firms had an advantage in global competition. Accordingly, business firms pursued size-oriented business strategies to meet the government’s need. Business decisions were predicted, therefore, on the company being either ‘strong’ or ‘big’ enough to survive, instead o f making the rational or right business decision (Kim, 1997). Thus, the management goals o f firms were focused on size and volume, instead o f achieving technological development for productivity growth. The result o f Chaebol's expansion strategy was over investment in the economy, especially in the manufacturing sector (Haggard and Mo, 2000). The Chaebols were eager to expand plant capacity in the hope o f having more market share and achieving lower production costs due to economies o f scale'\ Economies of scale is achieved when average costs are reduced through the production of a single item in large quantities (Liiu, Î99S). 55 According to Park (1999), the Chaebols ’ focus on size was the result o f two factors. One is the regulation o f price and entry to markets, and the other is the existence o f huge demand in the economy. Price regulations were implemented based on the cost plus pricing that essentially guaranteed a fixed margin on product sales. Consequently, an increase in business volume in times o f high demand, entry barriers, and price regulation automatically guaranteed an increase in operating profits to the Chaebols. Third, the high competition among the Chaebols to have more market share and not to fall behind rivals stimulated their investment. The Chaebols considered an increase o f market share to be more important than the rate o f profit. As a result, two or more groups often simultaneously made large-scale investments in the same industrial fields in order to increase their own market share. Fourth, the cost o f capital below market price encouraged Chaebols ' investment in the capacity expansion. Large Chaebols had more chance to get the favourable credit from the government due to their gigantic size. Thus, credit was particularly distributed to the Chaebols in several o f the government’s strategic industries, including semiconductors, consumer electronics, steel, automobile, and petrochemicals. For example, during the heavy chemical industry promotion drive by the government in the 1970s, the government directed banks and non-banking financial institutions to supply more than SO percent o f total domestic credit as a heavily subsidised loan (Nam et al., 1999). In Korea, the problem was compounded by the government’s attempt to pick winners by directing cheap credit toward favoured large industries (The Economist, 1997). Fifth, managerial desire for maximization o f the size o f their firm induced Chaebols ’ investment. According to Lee (1999), one o f the most important causes for the decline o f the 56 firms has to do with wrong strategic business decisions made by the owner, especially by the second-generation owner-manager who inherited the company from his father. The typical behaviour and motivation o f the second-generation owner-manager includes a very aggressive mind-set and desire. A new manager-owner feels he must prove not only that he is as good as his father but also that he can achieve something new and different. Such a mentality leads to careless expansion into new business areas, often putting the whole group into jeopardy. Samsung’s decision to enter the automobile business in 1995, when the domestic market was already oversupplied by four established manufacturers, is one good example. Under the second-generation owner-manager President Lee’s control, nearly USS 2 billion was poured into the new business. However, due to the already glutted domestic market situation, Samsung Motors bankrupted with USS 1.4 billion debt in 1998. Finally, the Chaebols often made huge speculative investments in real estate for either business or non-business use, because it is often possible in Korea to achieve enormous amounts o f profit from increases in real estate prices. In this manner, according to Kim (2000), the owners can earn large margins from the rise in real estate price. They argue that according to the closing account at the end o f 1997, the listed book value o f real estate possessed by business firms was approximately 31.8 trillion Won. Since the official price o f that real estate was about 53.8 trillion Won, if their assets were to be re-estimated, they would be expected to have a margin o f about 22 trillion Won. Unlike other East Asian countries, however, this real estate bubble in Korea had a relatively small impact on the onset o f the crisis. There are many factors that caused investment inefficiency o f Chaebol, but the fundamental aspect o f the Chaebols’ motivations for over-investment lies in moral hazard, reflecting the implicit assumption that large corporations were “too big to fail”. In other words, 57 the myth o f “too big to fail” allowed the Chaebol groups to set a goal o f size maximization, at the expense o f more rational management objectives. Even with low expected returns, excessively risky investment became inevitable when the Chaebols determined that they were protected from the risks o f investment losses. Due to their ability to simply walk away from failure. Chaebols indulged in over investment behaviour. 58 4.2.2 Investment Trends of the Chaebols The Chaebols ’ investment inefBciency problem can be narrowed down into excessivecapacity and declining profitability. In terms o f excessive-capacity, first o f all, too much investment led to excessive capacity in many industrial sectors. For example, makers o f rolled aluminium suffered from about 60 percent over capacity in 1997. Korean automakers, meanwhile, used just 40 percent o f their 4.5-million-unit annual capacity at the same period (McKinsey Quarterly 1998 No.4, 1998). In terms o f the profit rate, second o f all, the ratio of equity o f the manufacturing firms in 1996 fell dramatically to 2.0 percent as against 11.0 percent the year before, and deteriorated further to register negative 4.2 percent in 1997 (Lee, 1999). According to Haggard and Mo (2000), the Korean firms’ subsequent insolvency is to be found in the investment boom o f 1994-1996. During these three years, facility investment in manufacturing rose by 38.5 percent per year (See Table IV-6). Investment was particularly robust in 1994 and 1995, when it grew at rates o f 56.2 and 43.5 percent respectively. The majority o f investment (65.7 percent) went to expand existing production lines, and a relatively small amount was allocated to other sectors, such as corporate restructuring and rationalizing. Moreover, investments in the heavy chemical industry grew at the annual rate o f 43.1 percent while the rate growth for light industries was only 15 percent. In terms o f firms size, large firms - rather than small and medium-sized firms - set the pace. Investments by large enterprises grew 45.7 percent while small and medium-sized enterprises increased their investments by 17.7 percent. In summary, this was a boom dominated by real manufacturing investment on the part o f the large Chaebols in heavy industries: automobiles, petrochemicals, steel and electronics. 59
Cycles of Facility Investment (percent) 19721979 19801982 19831991 19921993 19941996 19971998 Average Growth Rate All Industries 41.8 20.0 -1.0 1.3 30.1 -18.8 Manufacturing 41.3 29.6 -8.9 -11.3 38.5 -29.0 Heavy and Chemical Industry 39.9 32.0 -10.8 -11.2 43.1 -28.6 Light Industry 46.8 0.9 -8.2 22.5 15.0 -32.0 Large Enterprises 39.6 28.7 -7.6 0.3 45.7 -11.6 24.0 Small Medium Enterprises 53.2 -22.0 -10.5 17.7 10.5 Non-Manufacturing 42.7 21.8 10.0 15.5 17.3 1.1 Reason for Investment (Manufacturing) 62.9 62.9 Capacity Expansion 69.6 61.2 65.7 66.5 Rationalisation 20.7 20.7 17.3 20.1 15.5 14.7 Pollution Control 4.1 1.1 4.1 2.5 2.5 1.7 3.6 3.6 Research and Development Facilities 4.3 6.6 6.2 8.4 Others 8.6 8.6 8.5 9.7 10.1 8.9 Sources of Funds (Manufacturing) 76.4 76.4 External Financing 65.8 68.7 71.7 72.7 Bank Loans 20.1 20.1 31.0 31.5 29.5 32.6 12.9 Foreign Currency Borrowing 12.9 12.1 10.3 20.4 11.4 23.6 Internal Financing 23.6 34.2 31.3 28.3 27.3 Source: Korea Development Bank, Survey o f Facility Investment Plans (Seoul), various issues: Quoted in Haggard and Mo (2000, p.201). Haggard and Mo (2000) argue that compared with the two previous episodes o f rapid investment growth (1972-79, 1983-91), the 1994-1996 period displays two distinguishing features. First, the emphasis on manufacturing and large enterprises was even more marked than in the past. Second, dependence on foreign capital was much higher in 1994-1996 (20.4 percent) than it had been during 1972-1979, when it accounted for only 12.9 percent o f tlie total investment, or 1983-1991, when it financed 12.1 percent. There are some studies analyzing Chaebol investment trends. For example, Hahn's (1999) argues that Chaebols ’ over investment behaviour is based on moral hazard. Using data from the financial statements o f 586 listed companies in Korea during the 1992-1997 period, he 60 analyses the investment behaviour o f firms. By using a modified sales accelerator model, this study shows that firms with the expectation o f government protection invested more than those firms without such expectation. It also shows that firms with such expectations are more likely to increase investments as the degree o f uncertainty increases rather than those that cannot be protected from investment losses. The top ranking Chaebols maintain higher investment rates than those o f other group-affiliated firms or independent firms. Thus, the results obtain consistency with the story o f the excessive risk-taking behaviour o f top ranking Chaebols, in so far as the firms are grouped according to the characteristic that reflect the extent o f government protection'^ Another study, Eo (1999) runs a regression analysis using both a logit model and a probit model with the 1993-1997 data o f 35 Chaebol groups including eighteen bankrupt groups in order to analyse Chaebols ’ over investment behaviour. In his study, the dummy variable o f bankruptcy/non-bankruptcy is used as a dependent variable while the average annual growth rate o f tangible fixed assets (GTEA) is used as one o f the independent variables. From the analysis, GTFA is shown to be positively related to the probability o f bankruptcy and that the variable is also highly significant (See Table lV-7). The rate o f increase in tangible fixed assets for the top 35 Chaebols in two years from 1995 to 1997 are much higher than the rates o f increase in the previous two years from 1993 to 1995. There are no exceptions even if the Chaebols are categorized into three different groups according to their rankings. By looking at this sharp rise in the rate o f increase in the latter two years, compared with former two years, it can then be said that the Chaebol groups aggressively increased their investment. ” See Hahn, C H., “Implicit Loss-Protection and the Investment Behaviour o f Korean Chaebols”, Korea Dcvclupiiieul luslilulc, 1999. 61 Tangible Fixed Assets of the 35 Largest Chaebols Total Top 5 Average % Total Top 6-10 Average % Total Topll-35 Average % Top 35 Total Average Source: Eo, 1999 p.23 1993 1995 1997 31,985 6,397 51.6 14,558 2,912 23.5 15,412 616 24.9 61,955 1,770 44,609 8,922 52.0 19,106 3,821 22.3 21,995 880 25.7 85,710 2,449 75,826 15,165 53.9 28,384 5,677 20.2 36,442 1,458 25.9 140,652 4,019 Growth Rate (%) (93-95) (billion Won) Growth Growth Rate (%) Rate (%) (95-97) (93-97) 16.6331 26.5254 21.5792 13.5918 19.7913 16.6915 17.7839 25.2448 21.5144 16.2277 24.7659 20.4968 In summary, the massive capacity expansion o f the large Korean conglomerates made Chaebols extremely vulnerable to cyclical shocks as well as to changes in market expectations. This massive capacity expansion o f the Chaebols was conducted under the impression that the government would do whatever was needed to facilitate the expansion, since the government policy had always been devoted to the growth o f Chaebols with the belief that large-scale firms have an advantage in global competition. Krugman (1998) argues that this implicit guarantee o f government to the corporate sector and the inadequate regulation o f financial intermediaries in Asian countries lead to moral hazard driven over-investment and asset bubbles, so that Asian countries under those conditions were inevitably vulnerable to the financial crisis. 62 4.3 Extensive Diversification The extensive diversification strategy o f the Chaebols, often described as the “octopus tentacles” strategy in the Korean media, was also one o f the main culprits leading to the outbreak o f the financial crisis in Korea. Many critics argue that the diversification strategies o f the Chaebols failed to consider economic efficiency and resulted in excessive, debt-fueled diversification unsustainable in economic downturns (The Business Week, 1998). The Chaebols operate in a wide series o f businesses ranging from electronics, shipbuilding, and construction to publishing companies, baseball teams, ski resorts, and hotels. Table IV-8 provides the summary statistics about the largely diversified top 30 Chaebol from 1987 to 1997. On average, the top 30 Chaebols own about 27 subsidiaries in 20 different industries in 1997. Moreover, the top 5 Chaebols are particularly diversified in that they had on average 52 affiliates competing in 30 different industries in the same year. The number o f affiliates belonging to each Chaebol exceeds the number o f lines o f businesses because they diversify through the creation o f new firms and the acquisition o f existing firms. Nevertheless, the Korean Chaebol is not the only conglomerate in the world market engaging in multiple-line businesses which have a significant effect in economic activity. Montgomery (1994) shows that, on average, the top 500 U.S. firms engage in 10.9 industries, and among them, 40 companies engage in more than 30 industries. Thus, diversification o f large corporations is even pronounced in the developed countries. Despite this fact, the level o f diversification in the Chaebols is rather high compared to that in the U.S., taking into consideration the differences between the 2-digit and 4-digit level o f industry classification'”. For more details, see Hwang, I.H., “Diversification and Restructuring o f the Korean Business Groups”, Korea Economic Research Institute, 2000. 63 What is unusual about the Chaebols compared with their foreign competitors is that Chaebols are more diversified into unrelated sectors (See Table IV-9). In other words, Korean Chaebols tend to go into unrelated areas whenever possible in the name o f diversification, even though the new area is not related to the group’s core competence.
Diversification of the Top 30 Chaebos, 1987-1997 Average Numbers of Affiliates 1987 16.4 1993 20.1 1994 20.5 1995 20.8 1996 22.3 1997 27.3 N/A <41 6> <4l.6> <4l.4> <4l.2> <52.4> 18.8 19.1 18.5 18.8 19.8 Average Numbers of Industries Engaged N/A (31.2) (30.4) (29.8) (29.6) (30.2) Total Number of Affiliates 509 604 616 623 669 819 Note I . The figures in < > denote the number o f affiliates that the top 5 Chaebols own. 2 The figures in ( ) denote the number o f industries that the top 5 Chaebols engage in. Sources: Hwang, 2000 p.5.
International Comparison of Diversification by Big Businesses Types of Korea Japan US. Italy France U.K. (percent) West Germany Diversification (1989) (1973) (1969) (1970) (1970) (1970) (1970) Specialized 8.2 16.9 6.2 lO.O 16.0 6.0 22.0 Semi-specialized 28.6 36.4 29.2 33.0 32.0 34.0 22.0 Related 6.1 39.9 45.2 52.0 42.0 54.0 38.0 Unrelated 57.1 6.8 19.4 5.0 lO.O 6.0 18.0 Note: I. Forty-nine Chaebols for Korea, 118 firms for Japan, 100 firms for the other countries. 2. The sources above are not the latest due to the limitation o f my research. Yet, this table clearly shows that Chaebols are diversified into unrelated sectors in a comparative way. Sources: Yoo and Lim, 1997: Quoted in Gobat (1998, p.9) 64 There are many different theories and arguments on the reasons for diversification of business corporations. Firstly, according to the agency view, motives for diversification lie in the manager’s pursuit o f private benefit (Jenson, 1986). Unlike stockholders who pursue firm value or profit maximization, managers tend to maximize their profit by increasing the size o f the firm through investment in various business areas. Secondly, the market power view (or the monopoly power hypothesis) stresses that the motives for diversification encompass a desire to limit any potential competitions with other firms (Hwang, 2000). In other words, the Chaebols want to monopolize their market power by using all possible anti-competitive ways such as cross-subsidization, mutual forbearance, and reciprocal buying. Thirdly, the transaction cost hypothesis argues that firms diversify to internalize the high costs involved with market transaction resulting from market imperfection, and thus may predict the positive linkage (Hwang, 2000). By doing so, firms are able to achieve greater allocative efficiency and competitive advantage vis-à-vis other firms in the same market. Under certain circumstances, transactions within a group o f firms are more efficient than transactions through the market or transaction through the internal organization o f the firm. Finally, the resource-based view argues that diversification is pursued to utilise unused resources effectively by expanding their business to earn more profit (Song and Cho, 1999). Imperfections in the market’s ability to allocate resources efficiently causes business groups to diversify. Given an imperfect market, business groups can facilitate the resource allocation process using a diversification strategy. Since the Korean market is relatively small, a successful company that enters a saturated market with a relatively small scale o f operation must soon find new business opportunities. 65 Some o f these above theories may explain the reasons for diversification o f Korean Chaebols. For example, Hwang (2000, p i 2) argues that the transaction cost and the resourcebased view deserve special attention when explaining why Korean conglomerates are so extensively diversified. “Due to the relatively short history o f capitalism and the discretionary policy o f the government in Korea, market institutions for economic activity has been distorted. In addition, most o f the firms have not as yet accumulated productive factors having high specificity that is sufficient enough to make it possible for them to yield high rates o f return.” However, these theories are inadequate to see the overall picture o f the diversification of Chaebols. The above arguments may be able to explicate the reasons for the diversification of the Chaebols, but they still cannot explain why Chaebols intended to diversify beyond their optimal limit. An often-cited criticism about the Chaebols is not just they pursue extensive diversification but that they pursue excessive diversification. What factors played a primary role in the Chaebols ' diversification strategy? This sub­ section will prove that the essential aspect o f the diversification o f Chaebols lies in the moral hazard o f the corporate sector. Then the Chaebols ’ diversification trends will be discussed in order to prove that the moral hazard driven Chaebols' extensive diversification was one o f the structural weaknesses, which eventually caused the Korean financial crisis. 66 4.3.1 Motives for Extensive Diversification There are many factors that encouraged the Chaebols ' extensive diversification. First o f all, the government’s implicit risk partnership with business groups, resulting in the problem o f the moral hazard, played a primary role in the Chaebols ' extensive diversification. In Korea, the government pursued the Chaebols ' diversification as a part o f the national economic policy over the past three decades. Both the government and the Chaebol strove to create world-class large business groups that could effectively compete in the international market. As a result, the Chaebols could increase their size by means o f diversification while under the impression that the government would support and protect the big businesses fiom both domestic and foreign competition. In other words, because o f the government’s implicit guarantees, the Chaebols could diversify in various industries without due regard to the level o f risk. Therefore, the government’s implicit guarantees, driven by the moral hazard, encouraged the Chaebols to diversify into many industries with little risk to themselves. Furthermore, diversification had been a strategy for gaining independence and autonomy from the state (Kim, 1997). Many Chaebols have undergone ownership changes in the past due to the government actions in the name o f industry rationalization policy^'. Given this political threat. Chaebols have exerted great effort to achieve maximization to make it difficult for the government to declare them bankrupt or to dismantle their groups, due to the economic sideeffects that would follow such government action. Thus, the Chaebols diversified into non­ banking financial institutions (NBFI), such as insurance, securities, and short-term finance In fact, many Chaebols had undergone ownership changes due to the government’s industrial rationalization policy in the past three decades. For instance, Kulge group, the seventh-largest Chaebol in 1985, disbanded for reasons including “reckless management”, and “exceedingly high rates o f debt" (Kim, 1997 p20I). Hanil, which took over the Kukje companies, jumped from the twenty-third to the fourteenth-largest Chaebol as a result o f the takeover. 67 companies, in order to become less dependent on the government for capital. Historically, Chaebols depended on the government for their necessary capital, because the banks belonged to the state. The state controlled the private sector by controlling the financial institutions. Chaebols were prohibited from owning banks during the 1960s and 1970s. In other words, business conglomerates had to listen to the government in order to get their capital for the business. This policy remained in effect until 1981, when the Chun regime announced partial privatization o f banks (Kim, 1997). By diversifying into NBFIs, therefore, the Chaebols could use their affiliated NBFls to finance the activities o f other subsidiaries within their group in various ways: direct provision o f funds, priority underwriting o f securities issued by related subsidiaries, and other forms o f unfair inter-group transaction. In other words, the NBFIs o f the Chaebols allowed flexibility in cash flow for member companies and ready access to loans within the group. The Chaebols were able to become less dependent on the government by diversifying into NBFIs (Kim, 1997). 68 4.3.2 Diversification Trends of the Chaebols Unlike the specialization trends o f world-class firms, Korean Chaebols tended to go into unrelated areas whenever possible in the name o f diversification, even though the new area was not related to the group’s core competence. Such extensive diversification not only prevented a Chaebol group from developing core competence in the new business area, but also weakened competence in their existing business areas (Lee, 1999). Despite enforcement o f the government’s Chaebol specialization policy, the number of the subsidiaries o f the thirty largest Chaebols did not change considerably until 1995. As Table IV-10 reveals, the average number o f subsidiaries o f the 30 largest Chaebols in 1995 was 20.8, with a total number o f 623 subsidiaries. Number of Subsidiaries of the 30 Largest Chaebols T ops Top 6-10 Topi 1-30 Top 30 Total 1993 208 1994 208 1995 207 1996 206 1997 262 1998 257 1999 234 Average 41.6 41.6 41.4 41.2 52.4 51.4 46.8 Total 115 116 117 122 138 132 122 Average 23.0 23.2 23.4 24.4 27.6 26.4 24.4 Total 281 292 299 341 419 415 330 Average 14.1 14.6 15.0 17.1 21.0 20.8 16.5 Total 604 616 623 669 819 804 686 Average 20.1 20.5 20.8 22.3 27.3 26.8 22.9 Source: Bank o f Korea, various years The number o f subsidiaries started to increase in 1996 and 1997. In 1996 alone, the total number o f subsidiaries o f the 30 largest Chaebols increased to 669 fi*om 623 in the previous year. In 1997, the numbers o f subsidiaries o f the 30 largest Chaebols drastically increased to 819 69 from 669. The greatest increase was found in the number o f the subsidiaries in the top five Chaebol groups; the average number o f subsidiaries increased by approximately 20 percent in 1997. This number, however, slowly decreased from 1998 as a result o f the massive Chaebol bankruptcies and the corporate restructuring program. During 1999, in particular, the number o f subsidiaries o f the 30 largest Chaebols sharply dropped to 686, from 804 in 1998. The number o f business lines" o f the 30 largest Chaebols is shown in table IV-11. As can be seen, the number o f business lines has gradually increased every year. In 1998, the top 5 Chaebols had an average o f 31 business lines, top 6 to 10 Chaebols had an average o f 22.6, and the rest o f the lower ranking 20 Chaebols had an average o f 16.5 business lines. The 30 largest Chaebol groups had operated in 20 different industries in average. Just by observing the numbers in table lV-11, it can be said that larger Chaebol groups are more diversified than smaller Chaebol groups. The top 5 Chaebols had twice as many different business lines, when compared with the 20 Chaebols from the ranking 11 to 30. Simple indexes such as the number o f subsidiaries or the number o f business lines are not enough to properly measure the degree o f diversification. Since only a few subsidiaries and industries account for most o f the total sales o f a Chaebol group‘d, there is a need to examine the “ According to Hwang (2000), the number o f business lines is the simplest o f diversification index. It disregards the relatedness o f industries and the relative importance o f a particular commodity in a business group, and directly shows the degree o f diversification. ^ Although Chaebols own a lot o f subsidiaries operating in many different industries, most o f their sales revenues are generated by a few core firms. Between 1988 and 1995, according to Chang and Park (1999), the four largest subsidiaries o f the top 4 Chaebols generated an average o f 79.0 percent o f their total sales. Especially in the case of Samsung, the four largest firms, two o f which were in the same industry (electronics), alone accounted for about 90 percent o f sales - a striking concentration (rather than diversification) o f activities given the number o f its subsidiaries (55 as o f 1995). Chang and Park (1999) argue that the same can be said o f the smaller Chaebols, because the reliance on a small number o f subsidiaries tends to increase as their size diminishes. For instance, in 1994, the Chaebols that ranked between the 6 and the 10 generated 72.6 percent o f their sales from the 4 largest subsidiaries. In the case o f the Chaebols ranking between the 11 and the 20, the 3 largest subsidiaries generated 72.1 percent o f their sales, and in the case o f the Chaebols that ranked between the 21 and the 30, as much as 72.3 percent o f the sales were generated by the 2 largest subsidiaries. For more details, see Chang and Park, “An Alternative Perspective on Post-1997 Corporate Reform in Korea”, Korea Economic Research Institute, 1999. 70 industry specialization ratio"'* and the Berry index‘d, to realize the diversification situation o f the Chaebol groups and their characteristics.
11 > Number of Business Lines of the 30 Largest Chaebols Top 5 Top 6-10 Top 11-30 Top 30 Total 1993 156 1994 152 1995 149 1996 148 1997 151 1998 155 Average 31.2 30.4 29.8 29.6 30.2 31.0 Total no 113 118 129 123 113 Average 22.0 22.6 23.6 25.8 24.6 22.6 Total 283 307 289 326 321 331 Average 14.2 15.4 14.5 14.8 16.1 16.6 Total 549 572 556 603 595 599 Average 18.8 19.1 18.5 18.8 19.8 20.0 Source: Bank o f Korea, various years The industry specialization ratio is a ratio o f an industry that has the largest sales proportion in total sales o f a group. The industry specialization ratio becomes I if the Chaebol group is perfectly specialized in one main industry. Smaller numbers indicate the firm is less specialized, or more diversified. Table lV-12 shows that a Chaebol group in a higher rank has a smaller industry specialization ratio, which means a group is less specialized or relatively more diversified. However, the growth rate is higher in the low-ranking groups, which means they are more rapidly diversified than the high-ranking groups. '* The industry specialization ratio is frequently used in empirical studies due to the simplicity o f calculation and feasibility o f gathering data. It fully reflects a group’s dependency on its main industry. However, it does not show the degree o f diversification. For more details on how to calculate the index, see Kim, K.H., “Comparative Analysis o f Diversification and Performance o f the business Groups”, Yonsei Univ. 1993. ^ The Berry index is simply a transformation of the Herfindahl index, which measures market concentration. Its strength is that it reflects the relative importance o f all the industries in addition to the main industry. For more details on how to calculate the index, see Kim, K.H., “Comparative Analysis o f Diversification and Performance of the business Groups”, Yonsei Univ. 1993. 71 Table IV-13 shows that a Chaebol group with a higher rank has a higher Berry index, meaning the degree o f diversification for the Chaebol groups has continued to increase. Although the table shows that high-ranking Chaebols are more diversified than low-ranking Chaebols, the rate o f increase in the Berry index is higher in low-ranking Chaebols than in highranking Chaebols, as in an analysis with the specialization index.
Industry Specialization Ratios of the 35 Largest Chaebols 0.43019 Growth Rate (93-97) -0.444 (percent) Average annual Growth Rate -0.111 0.51980 0.53257 -0.937 -0.235 0.58880 0.53509 0.59446 -18.864 -5.226 0.56141 0.51709 0.56198 -14.874 -4.026 1993 1995 1997 Average Top 5 0.42991 0.43265 0.42800 Top 6-10 0.52472 0.55321 Top 11-35 0.65949 Top 35 0.60744 Source: Eo, 1999 p.34.
Berry Index of the 35 Largest Chaebols 1993 Top 5 0.70318 Growth Rate (93-97) 0.204 (percent) Average annual Growth Rate 0.051 0.60695 0.58513 4.604 1.125 0.54539 0.59548 0.53319 29.817 6.524 0.57015 0.61365 0.56507 19.991 4.556 1995 1997 Average 0.70608 0.69593 0.70752 Top 6-10 0.58024 0.56821 Top 11-35 0.45871 Top 35 0.51141 Source: Eo, 1999 p.37. 72 In summary, the Chaebols intended to diversify beyond their optimal limit based on the government’s implicit risk partnership with business groups, resulting in the problem o f moral hazard. In other words, because o f the government’s implicit guarantees. Chaebols could diversify in various industries without due regard to the level o f risk. Under this “guaranteed” circumstance, business conglomerates subsidized unprofitable subsidiaries by transferring funds across Chaebol groups and provided cross-guarantees on debts among affiliates, which eventually jeopardized the entire group (Lee, 1999). The diversified Chaebol structure acted as an exit barrier to unprofitable businesses in the group and eventually undermined the viability o f the whole system. Therefore, the extensive diversification strategies o f the Chaebols, driven by moral hazard, weakened the entire companies by losing economic efficiency, and eventually caused the financial crisis. 73 4.4 Low Productivity and Profitability The low productivity and profitability o f Chaebols are also critical factors on the path to the Korean financial crisis. In terms o f productivity, although most o f Korea's investment had been directed into manufacturing, giving the country almost as much manufacturing capital stock per capita as the U.S., labour and capital productivity in most Korean manufacturing sectors stood at less than half o f the U.S. levels between 1993 and 1995 (See Figure IV-5 and Figure IV6). Before the financial crisis, Krugman (1994) argued that Asian economic growth is based mainly on massive inputs o f capital and labour rather than productivity growth and thus will not be sustainable over a long period. In this sense, the crisis was structural. In terms o f low profitability, the economic recession and the huge deterioration o f the terms o f trade in 1996, particularly in the semiconductor manufacturing industry, negatively influenced on the profitability o f the Korean business conglomerates. As a result, although total sales o f the 30 largest Chaebol groups increased by 16.2 percent, their net income decreased by more than 90 percent in 1996 (See Table lV-14). Productivity Comparison Productivity comparison l«>c4e>A l i c i i Si>slt*s-19 9 3 — 95 M ih Koffc# ZZI Ei U n ite d S ta te 'S = 1 0 0 v Steel Ill Processed food i P e trflll lïâ rilc iriQ GS : Télécommunications €6 ] O v e ra ll e c o n o m y Source: McKinsey Quarterly 1998 N o .4 ,1998 p.74. 74
Capital allocation and Capital Productivity 1995 Co^sltal ctHocodHon m ndcapHsI prodLactlvity; 199S * # # # —' Mar«ufiaiiOtun»vg” 80 w a m n m m m im m im m Ê Ê m m m m B m m im m m m mtis stcwi Source: McKinsey Quarterly 1998 No.2, 1998 p.3.
Business Performance of the 30 Largest Chaebols^ 1995-1996 Top 10 1995 194.5 Total Sales 1996 Growth Rate 17.4 228.4 Top 30 226.4 263.2 16.2 1995 5.7 5.8 Net Profit 1996 Growth Rate 0.6 -82.7 0.6 -90.1 Note: Except Hanbo and New Core group. The values are based on listed firms only. Source: Samsung Economic Research Institute, 1998. In addition to the economic recession, the rising wage costs in Korea contributed to the eroding profitability o f the firms, so that the corporate sector increasingly suffered from declining competitiveness and profits in the world market*^. Domestic wages grew faster than labour productivity during the last decade (See Table IV-IS), making Korean wages higher than those o f Hong Kong, Singapore and Taiwan (See Table IV-16). As a result, Korean companies’ Korean comparative advantages as a low wage country disappeared with the rise o f new competitors, such as China, in the world market. Besides, Korean products could not afford to compete with the products from an advanced country, such as Japan, in terms o f quality and product differentiation (Lee. 19991. 75 profitability deteriorated much below that o f firms in economies having significantly lower financial costs, such as Japan, Taiwan, and the U .S/^ (See Table IV-17). Therefore, with wages higher than labour productivity and interest rates higher than capital productivity over the past 10 years, companies were unable to accumulate profits. Given the over-leveraged and over-invested structure o f the Korean corporate sector, this decreasing profitability eventually made Korean firms very vulnerable to any shock; low profit decreased the ability to service the high debt that Korean companies accumulated.
Wage and Labour Productivity Increase (percent) Wages Growth 1971-1986 21.2 1987-1995 16.1 26.8 13.1 Productivity Growth Source: Korea Productivity Centre Estimates: Quoted in Cho (1999b, p.6).
Hourly Wage in the Manufacturing Sector and Per Capita Income (USS) U.S. Hong Kong Japan Korea Singapore Taiwan 1985 1.73 6.34 1.23 2.47 1.50 13.01 1990 3.20 12.80 3.71 3.78 3.93 14.91 1995 4.82 23.66 7.40 7.28 5.82 17.20 22,990 39,640 9,700 26,730 12,293 26,980 Hourly wage: Per Capita Income: 1995 Source: U.S. Bureau o f Labour Statistics, 1995: Quoted in Cho (1999b, p.6). Cho (1999b) argues that real profitability, disguised by accounting practices, may have been much lower than the statistics suggest. 76
Corporate Profitability in M anufacturing, 1989-1993 (percent) U.S. 3.06 Current Profit/Sales Japan 3.38 Korea 1.97 Taiwan 3.72 Current Profit/Assets 3.54 1.99 3.50 6.23 Net Profit/Capital N/A 5.03 11.77 N/A Source: Bank o f Korea, “’Corporate Financial Statement Analysis ”, various issues: Quoted in Cho (1999b, p.7). In summary, the fundamental aspect o f the Chaebols' low profitability lies in their structural weaknesses. The huge debt-fueled capacity expansion o f Chaebols was manageable so long as the economy was growing, even though investment returns were often too low to service the cost o f capital. The huge deterioration o f the terms o f trade, however, severely damaged Chaebols' profitability, which was potentially dangerous given the over leveraged and over invested structure o f the Korean corporate sector. The diversification strategies o f the Chaebols often failed to consider economic efficiency causing excessive, debt-fueled expansion unsustainable in economic downturns. Starting from the beginning o f 1997, therefore, a number o f the highly leveraged Chaebols went into bankruptcy, dragged down by excessive investment and a substantial debt burden. The following sub-sections analyze the low productivity and profitability o f the Korean firms in detail. By doing this, the sub-sections will explain that the large Chaebols were already on the path to an economic disaster years before the actual financial crisis hit the country. 77 4.4.1 Low Productivity According to Bello and Rosenfeld (1990), Korea's impressive growth over the past three decades can be explained largely by the fact that its people worked long hours and saved a great deal, leading to the rapid accumulation o f capital. Most o f Korea's investment has been directed into manufacturing, giving the country almost as much manufacturing capital stock per capita as the United States. Yet capital productivity in many manufacturing sectors is only half o f U.S. levels. In semiconductor manufacturing, for example, Korean firms use machines similar to those employed by U.S. companies, but produce low-value DRAM chips instead o f more complex microprocessors. Within the DRAM industry. Micron, the largest U.S. manufacturer, boasts capital productivity 50 percent higher than that o f the average Korean maker. Similarly, Korea's failure to implement lean manufacturing in the automotive industry means its car makers produce only half as many vehicles as their Japanese counterparts in a similar plant (McKinsey No.2, 1998). Factor productivity was low in Korea. The productivity in the manufacturing industry can be seen collectively by analysing the rate o f value added. As can be seen from Figure lV-7, ordinary income began to decrease rapidly after 1995. In 1998, the ratio o f personnel expenses (labour cost) to value added fell to 47.1 percent from 54.5 percent in 1997. However, the ratio o f financial expenses (capital cost from borrowing) to value added jumped suddenly to 31.7 in 1998 from 20.8 percent in 1997 and the ratio o f ordinary income to value added sharply dropped to negative 8.1 percent in 1998 from negative 1.8 percent in 1997. This problem can be attributed to the increase in labour costs and net ftnancial expenses, because the ftnancial expense ratio in Korea was over three times the ratios in Japan and the U.S., due to the high market interest rate (See Figure IV-3). Productivity, however, has not improved equally to back-up these high costs 78 (See Table IV-16). It can be said, therefore, that the business performance o f the firms in Korea continuously worsened as a result o f wages higher than labour productivity and interest rates higher than capital productivity.
Components of Value Added in the Manufacturing Industry 60 50 40 30 20 10 -10 -20 1993 1994 1995 1996 1997 1998 Year —• — O rdinary Income Net Einancial Expen ses —• — Personnel Expenses —a— Depreciation Expenses Etc. Source: Bank o f Korea, May 1998. Korea Development Bank, 1999 p.71. As Figure IV-8 shows, the value added growth rate per employee for the manufacturing sector began to fall sharply from 1995. In 1998, it recorded a stiff drop from 0.99 percent in 1997 to -3.12 percent, due to the heavy losses in ordinary income from lagging sales, slim margins, and a huge amount o f write-offs. The growth rate o f capital productivity (or value added to total liabilities and stockholders’ equity) gradually decreased from 1995 and recorded a slight drop from 18.2 percent in 1997 to 17.1 percent in 1998. This declining productivity can be explained by both the setback in total value added from low profitability in the prolonged economic recession, together with only a 2.9 percent increase in total liabilities and stockholders’ equity. 79
Major Productivity Indicators in the Manufacturing Industry so 70 60 SO 40 30 “ - ? ~ ~ 20 -1 0 1993 1994 1995 1996 1997 1998 Y ear Ratio o f Value A dded to Tangible A ssets —» • G row th Rate o f Labor Productivity G row th Rate o f Capital Productivity Value Added G row th Rate p e r E m ployee Source: Korea Development Bank, 1999 p.66. In contrast, the growth rate o f labour productivity, or value added per employee, slowly rose from 1996 after dropping sharply in 1995. Productivity increased to 11.1 percent in 1998 from 6.5 percent in 1997. However, this was due to a decrease in the number o f employees as a result o f restructuring and downsizing efforts carried out during 1998. In conclusion, although labour productivity showed an increase, the value added growth rate itself showed a drop from 23.0 percent in 1997 to 22.0 percent in 1998. This fall was largely attributed to the huge deficit in ordinary income, reflecting inadequate margins and the negligence o f management on sales receivables. Also, the ratio o f value added to tangible fixed assets, a supplementary ratio to the growth rate o f capital productivity began to fall steeply from 1995 along with other productivity indicators. It reached its highest level o f 66.8 percent in 1995 but fell as low as to 41.0 percent in 1998-®. ^ For more details, see Korea Development Dank, “Analysis o f Financial Data for 1998 ", 1999. 80 4.4.2 Low Profitability In 1997, for the first time ever since the Korea Development Bank began its financial analysis in 1958, Korean firms recorded a deficit in ordinary income compared to total assets (Korea Development Bank, 1999). Figure IV-9 shows that after all three profitability indicators in the manufacturing industry recorded the highest values in 1995 they rapidly began to downturn. The ratio o f ordinary income to sales and the ratio o f ordinary income to total assets began to drop steeply from 1995 and started to record deficits from 1997.
Major Profitability Indicators in the Manufacturing Industry F ig u r e 5 -3 . M a jo r I'ro flta b ilily In d ic a to rs m th e M a n u f a c iu n n g In d u stry ID I Y ear O p e r a t i n g Ine&wnc t o SoScs O r d i n a r y l iK o m c t o S a U*^ ♦ ' O rd in a ry In c o m e to T o ta l A s s e t ' Source: Korea Development Bank, 1999 p.59. The evidence o f low profitability is also available at the firm level. Table IV-18 shows the long-term trend o f the profit rates o f the Korean companies over the 1980 to 1996 period. In general, the table describes the decreasing trend over the concerned period. In particular, for the large-sized firms (including most o f the Chaebol firms) profit rates crashed fi-om 13.3 percent during the 1985-1989 to 0.2 percent during the 1990-1996. 81
Profit (Net Income) to Equity Ratio by Size of the Firms (percent) Y ear Large M edium Small -8.8 -4.4 80 -3.7 81 -0.2 0.8 2.3 -4.5 82 2.5 4.5 7.4 11.5 13.9 83 7.4 9.9 84 10.4 4.0 8.4 85 6.4 16.3 86 13.9 12.1 18.6 14.6 87 15.4 16.0 14.6 88 15.5 11.7 89 14.1 13.0 1.7 90 7.0 8.1 0.4 7.0 91 7.4 -2.0 1.2 1.4 92 2.8 93 3.5 2.9 94 4.6 5.9 5.0 -1.3 0.4 95 2.3 -4.5 -1.6 96 0.3 Averaged by period 0.3 4.1 5.5 1980-1984 12.8 12.8 1985-1989 13.3 0.2 3.3 3.9 1990-1996 4.1 6.3 7.0 1980-1996 S tandard Deviation 9.2 6.6 6.5 1980’s 3.1 3.4 1990’s 3.0 7.9 6.0 1980-96 5.9 Source: Yoon, J. I., “A Study on the Return on Stockholders’ Equity in Korea”, Seoul National Univ., 1998: Quoted in Lee (1999, p. 19). Table IV-19 measures the short-term change o f the profit rates particularly for the 10 and 30 largest Chaebols during the 1994-96 and depicts that over this period all the measures o f profitability declined by a substantial margin for the 30 largest business groups. This trend is more clear-cut for the profitability measured using ordinary income rather than operating income. Ordinary income compared to stockholders' equity rates declined from 8.46 percent in 1994 to a mere 0.75 percent in 1996 for the 10 largest Chaebols. 82
Changing Profitability of the Chaebols A. Profitability of the 10 Largest Chaebols in Korea Operation Profit / Equity 1994 15.37 1995 28.95 (percent) 1996 24.66 Normal Profit / Equity 8.46 10.38 0.75 Operation Profit / Sales Revenue 6.22 6.23 4.7 Normal Profit / Sales Revenue 1.9 2.29 0.21 Operation Profit / Total Asset 6.34 6.74 5.02 Normal Profit / Total Asset 2.16 2.65 0.4 B. Profitability of the 30 Largest Chaebols in Korea Operation Profit / Equity 1994 6.23 1995 1.11 (percent) 1996 0.87 Normal Profit / Equity 0.31 0.42 0.09 Operation Profit / Sales Revenue 0.22 0.23 0.17 Normal Profit / Sales Revenue 0.07 0.09 0.02 Operation Profit / Total Asset 0.22 0.25 0.18 Normal Profit / Total Asset 0.07 0.09 0.02 Source: Cho, S. “The Large Corporate Groups in Korea”, 1997: Quoted In Lee (1999, p.20). Table IV-20 reveals the ratio o f operating income to sales among Korean firms was higher than in the United States, Japan, and Taiwan*^. However, the ordinary income to sales in Korea is exorbitantly lower when compared to these countries. This is because o f the sharp increase in financial expenses firom excess borrowing offset the favourable effect o f foreign ^ The main reason for the sales increase in 1997 was a favourable balance o f trade due to exchange rate appreciatiuu; this led to au increase in operating income as well (Bank, o f Korea, 1998). 83 currency debt translation. Therefore, non-operating income was lowered, although the Korean companies showed similar profitability in operating activities. This resulted in an ordinary income o f-1 .7 9 percent in 1998 compared to -0.42 percent in 1997 (Bank o f Korea, 1998).
International Comparison of Business Performance in the Manufacturing Industry Financial Ratio Sales Growth Korea 11.0 U.S. 6.7 Japan 0.2 (percent) Taiwan 16.4 Tangible Fixed Asset Growth 13.7 3.2 1.5 6.8 Operating Income to Sales 7.9 7.4 3.6 7.3 Ordinary Income to Sales -0.4 8.3 3.4 5.1 Financial Equity Ratio 20.2 39.4 34.1 53.9 Structure Current Ratio 91.8 137.9 130.0 129.4 Financial Expenses Ratio 6.4 - 1.0 2.2 Index Growth Profitability Note: The values are based on 1997 for Korea, 1996 for Japan and U.S., and 1995 for Taiwan. Source: Bank o f Korea, May 1998 p.29-35. Therefore, the Korean economic crisis was a result o f structural weaknesses in the corporate sector. The Korean Chaebols were already on the path to economic disaster, having shown low productivity and profitability years before the actual financial crisis hit the country. With high debt-equity ratios, Korean firms were expected to yield high profitability on their equity. However, the average rate o f return on the equity was lower than the prevailing interest rates for loans. On average, the return on capital was lower than its opportunity cost for almost ten years before the crisis. Thus, the capital used in the corporate sector was generally wasted on unprofitable projects. The high debt level and the low profitability o f Korean firms were unsustainable. 84 V. Conclusion This paper has identified the critical factors underlying the Korean financial crisis. The crisis started with a series o f corporate bankruptcies in 1997. The massive large corporate failure ended with massive non-performing loans in the financial institutes severely affecting the soundness o f the domestic financial institutions. This substantial corporate/bank insolvency problem soon led to a serious loss o f confidence among international investors. A sudden shift in international creditors confidence in Korean firms and financial institutions occurred, prompting these investors to leave the market by cashing their investment and refusing to roll over their short-term lending. As a result, the corporate insolvency problem translated into domestic financial crisis, and ultimately caused the external liquidity crisis. A comparative analysis o f two o f the most prominent arguments explaining the causes of the crisis in Korea, the moral hazard and the financial panic theory, reveals that the moral hazard approach interprets the Korean financial crisis. This moral hazard o f the corporate sector caused four significant flaws, eventually triggering the financial crisis. First, the debt-equity ratio o f the top thirty Chaebols was over 500 percent in 1997, extremely high compared to firms in other advanced countries. Such moral hazard-driven high leverage increased companies’ financial expenses, eventually lowering the Chaebols ’ profitability. Second, large Chaebols undertook a major investment expansion, particularly in the manufacturing sector between 1994 and 1996. However, this moral hazard-driven massive investment boom turned out to be unsustainable when the terms o f trade deteriorated by approximately 20 percent in 1996. This huge trade deterioration severely damaged the Chaebols' profitability, which was potentially dangerous given the over-leveraged structure o f the Korean corporate sectors. Third, Chaebols operated in a wide series o f businesses. Chaebols intended to diversify beyond their optimal limit based on 85 the government’s implicit risk partnership with business groups. This extensive diversification strategy often failed to consider economic efficiency and resulted in excessive, debt-fueled expansion unsustainable in economic downturns, especially financial crisis. Finally, with wages higher than labour productivity and interest rates higher than capital productivity over the past 10 years, companies were unable to accumulate profits. Under the above circumstances, the companies could not accumulate profits. For example, the average rate o f return on equity was lower than the prevailing interest rates for loans. Given the over leveraged and over invested structure o f the Korean corporate sector, profitability decreased making Korean firms very vulnerable to any shock; these low profits decreased the ability to service the high debt that those companies accumulated. The effort o f the government to reform the Chaebol is in process now. The government, however, has not yet achieved enough success to continue the comprehensive Chaebol reform program. For example, the top 5 Chaebols are lagging far behind in the government’s restructuring plan and remained very resistant to government efforts to restructure until recently. Moreover, the government’s concentration on the top 5 Chaebols in its efforts at corporate restructuring, namely “big deals^°”, sent a wrong signal to the market that only the top 5 would be safe in periods o f financial turmoil (Root, 2000). In other words, the government policy created an economy-wide moral hazard by making the power o f the top 5 even greater than before (The Business Week, 1998). The current reform plans in Korea, therefore, ought to focus on cleaning up the remnants o f the past moral hazard. In order to achieve this critical task, the government needs to take a The government called for large Chaebols to engage in what is called “big deals”, wherein they exchange subsidiaries through mergers and acquisitions (M&A) among them as the focus o f the industrial restructuring. 86 more liberal position to the corporate sector. In other words, the government will have to reduce its role as an economic player by desisting from its past habit o f intervening in the corporate sector. If Chaebols are not performing well, for example, the government should not quickly takeover the failing company and hand it over to another Chaebol. The government should let the market decide whether the firm should go bankrupt. However, the government still needs to maintain its role as a neutral umpire, protecting the market principles and providing a legal infrastructure for economic players. In the mean time. Chaebols must try to solve the four given moral hazard drive fiaws by focusing on their core businesses that have a chance o f becoming internationally competitive, and improving their debt/equity ratios for future growth and prosperity. 87 Bibliography Ahn, C., (1999), “Corporate Restructuring and Debt Issues in East Asia: Experience o f South Korea and Other Countries”, Korea Development Institute Akaba, Y., Budde, F., and Choi, J., (1999), “Restructuring South Korea’s Chaebols", The Mckinsey Quarterly 1999 No.4 Amsden, A., (1989), “Asia's Next Giant: South Korea and late Industrialization”, New York: Oxford University Press Asian Development Bank, (1999), “Economic Outlook o f Asia”, Oxford University Press Baily, M. et al., (1998), “The Roots o f Korea’s Crisis”, the Mckinsey Quarterly 1998 No.2 pp7683 Bank o f Korea, (1994), “Monetary Policy and Financial Liberalization in Korea - English Version”, Bank o f Korea Bank o f Korea, Various years. Monthly Statistical Bulletin, Quarterly Economic Review, Economic Statistical Yearbook, Review o f Korean Economy, Seoul, Bank o f Korea Available at www.bok.or.kr Bannock, G., Baxter, R E. and Davis, E., (1992), “The Penguin Dictionary o f Economics”, 5 ^ edition, London, Penguin Book, 1992 Balino, T.J.T. and Ubbide, A., (1999), “The Korean Financial Crisis o f 1997 - A strategy o f Financial Sector Reform”, IMF Working Paper WP/99/28 Bello, W. and Rosenfeld, S., (1990), “Dragons in Distress: Asia’s Miracle Economies in Crisis”, San Francisco, The Institute for Food and Development Policy Bello, W., (1998), “The End o f the Asian Miracle”, Nation, 01/12/98, Vol.266 Issue 2 Bird, G. and Milre, A., (1999), “Miracle to Meltdown: A pathology o f the East Asian Financial Crisis”, Third World Quarterly, April 1999, Vol.22 Issue 2. p. 1 6 ,5p, Ibw Bremmer, B. and Moon, L, (1998), “Can Kim Cut It?”, Business Week June 8,1998 p p I6-l7 Borensztein, E. and Lee, J., (1998), “Financial Distortions and Crisis in Korea”, IMF Working Paper WP/98/20 Bowles, P., (1999), “Regionalism and Development after (?) the Global Financial Crisis”, Paper prepared for the Centre for the Study o f Globalization and Régionalisation Third Annual Conference September 16-18,1999 88 Cho, L. and Yoon, H., (1994), “Korea’s Political Economy; an Industrial Perspective”, Western Press Cho, Y.J., (1999a), “Financial Crisis in Korea: A Consequence o f Unbalanced Liberiasation?”, Sogang University Cho, Y.J., (1999b), “The Financial Crisis in Korea: Causes and Challenges”, Sogang University Chung, M., and Park, J., (1999), “An Alternative Perspective on Post-1997 Corporate Reform in Korea”, Korea Economic Research Institute Chung, U., (1999), “East Asian Economic Crisis - What is and What Ought to be done: The Case o f Korea”, Seoul National University Clifford, M., (1998), “Troubled Tiger: Businessmen, Bureaucrats and Generals in South Korea”, Armonk, NY: M.E. Sharp Corsetti, G., Pesenti, P., and Roubini, N., (1998), “What Caused the Asian Currency and Financial Crisis? Part 1: A Macroeconomic Overview, Part II: The Policy Debate”, available at http://www.stren.nyu.edu/~nroubini/asia/AsiaHomepage.html Eo, W. S., (1999), “Crisis o f the Korean Economic Development Model and the Chaebol System: Focusing on the Chaebol Bankruptcies”, Yonsei University Fischer, S., (1998), “The Asian Crisis: A View from the IMF”, Washington D C, IMF Garcia, C. and Olivie, I., (1998), “The Financial Crisis in East Asia: The Cases o f Japan, China, South Korea and Southeast Asia”, ICE I Working Papers No. 11 Glick, R., (1998), “Thoughts on the Origins o f the Asian Crisis: Impulses and Propagation Mechanisms”, Pacific Basin Working Paer No. PB98-07 Gobat, J., (1998), “Republic o f Korea: Selected Issues”, IMF Staff Country Report No. 98/74, IMF Goldstein, M., (1998), “The Asian Financial Crisis: Causes, Cures and Systemic Implication”, Washington D C, Institute for International Economics Haggard, S., and Mo, J., (2000), “The Political Economy o f the Korean Financial Crisis”, Review o f International Political Economy 7:2 Summer 2000, ppl97-218 Hahn, C H., (1999), “Implicit Loss-Protection and the Investment Behaviour o f Korean Chaebols", Seoul, Korea Development Institute Hankook Newspaper, (1985), “Korea’s 50 Largest Chaebols", Seoul, Hankook Newspaper Co. 89 Hillebrand, W., “Shaping Competitive Advantages: Conceptual Framework and the Korean Approach”, Frank Cass, 1996 Hong, D., (1998), “Theoretical Review and Reconstruction o f East-Asian Model”, Tae-Gu University Press Hyun, 0 ., (1999), “Korea’s Corporate Governance System under the Remedies”, Seoul, Korea Development Institute Hwang, 1., (2000), “Diversification and Restructuring o f the Korea Business Groups”, Korea Economic Research Institute Janelli, R. L., (1993), “Making Capitalism: the Social and Cultural construction o f a South Korean Conglomerates”, Stanford University Press Jensen, M., (1986), “Agency costs o f Free Cash Flow, Corporate Finance and Takeovers”, American Economic Review, 76(2), pp323-329 Jeory, B.H and Yang, Y.S, (1992), “Economic Analysis o f the Chaebol Sector in Korea”, Seoul, Korea Development Institute Jones, P. and Sakong, 1., (1980), “Government, Business and Entrepreneurship in Economic Development: The Korean Case”, Cambridge, Mass: Harvard University Press Kang, M., (1995), “The Korean Business Conglomerates: Chaebol then and now”, CA, Institute o f East Asian Studies, University o f California, Berkeley Kim, E. M., (1997), “Big Business and Strong State”, New York, State University o f New York Press. Kim, E.M., (1998), “The Four Asian Tigers”, Academic Press Kim, K. H., (1993), “Comparative Analysis o f Diversification and Performance o f the business Groups”, Yonsei University Kim, K.H., (2000), “Could a Real Estate Price Bubble have Caused the Korean Economic Crisis?”, Sogang University Kim, S. and Cho, B., (1999), “Korean Economic Crisis: New Interpretation and Alternative Economic Reform”, Paper presented to the Annual Conference o f Studies in Political Economy held in Ottawa, Canada on January 29,1999 Korea Development Bank, (1999), “Analysis o f Financial Data for 1998”, Seoul, Korea Development Bank 90 Krugman, P., (1994), “The Myth o f Asia's Miracle", Foreign Affairs, November / December,Volume 73 (6), pp. 62-78. Krugman, P., (1998), “What Happened to Asia?” available at http://www.stren.nyu.edu/~nroubini/asia/AsiaHomepage.html Kwack, S.Y., (1998), “Factors Contributing to the Financial Crisis in Korea”, Journal o f Asian Economic, Winter 98, Vol 9 pp 611- 615 Kwack, S.Y., (2001), “An Empirical Assessment o f Monetary Policy Responses tp Capital Inflows in Asia before and after the Financial Crisis”, International Economic Journal Vol. 15, No. 1 Lee, E., (1998), “The Asian Financial Crisis: The Challenge for Social Policy”, Geneva, International Labor Office Lee, K., (1999), “Corporate Governance and Growth in the Korean Chaebols: A Macroeconomic Foundation for the 1997 Crisis”, Seoul National University Lee, C.H. and Yamazawa, 1., (1990), “The Economic Development o f Japan and Korea”, EastWest Centre Leipziger, D M., and Petri, P., “Korean Industrial Policy: Legacies o f the past and Directions for the Future”, Washington, D C, World Bank Discussion Papers, 0259-21 OX Leipziger, D M, (1998), “Public and Private Interests in Korea: Views on Moral Hazard and Crisis Resolution”, EDI Working Paper, Economic Development Institute o f the World Bank Lim, H., (1998), “Korea’s Growth and Industrial Transformation”, New York, St. Martin’s Press Maeil Business Newspaper, October 29,1998 Ministry o f Finance and Economy, (1998), “Korean Government’s Economic Reform Progress Report”, Ministry o f Finance and Economy Montgomery, C.A., (1994), “Corporate Diversification”, Journal o f Economic Perspectives, ppl63-178 Moon, C., (1990), “Beyond Statism: Rethinking the Political Economy o f Growth in South Korea”, Moreno, R., Pasadilla, G. and Remo Iona, E., (1998), “Asian Financial Crisis: Lessons and Policy Responses”, San Francisco 91 Nam, D., (1998), “Some Observations on the Reform Policies in Korea”, Annual Meeting Boards o f Governance 1998 Washington D C Nam, I.e., Kim, J.K., Kang, Y.G., Joh, S.W. and Kim, J.I., (1999), “Corporate Governance in Asia: A comparative Perspective”, Korea Development Institute Nam, S., (1999), “Korea’s Economic Crisis and Corporate Governance”, Korea Development Institute Park, S., (1999), “Corporate Governance Reform in Korea”, Paper presented at the 7‘*' International Conference on Regional Cooperation in Northeast Asia, Seoul, Korea Pyo, H., (1999), “The Financial Crisis in Korea and Its Aftermath: A Political Economy Perspective”, SAIS Policy Forum Series No. 9 Ravenhill, J. (1995), “China, Korea and Taiwan”, Aldershot, UK Radelet, S., and Sachs, J., (1998a), “The onset o f the East Asian Financial Crisis”, available at http://www.stren.nyu.edu/~nroubini/asia/AsiaHomepage.html Radelet, S., and Sachs, J., (1998b), “The East Asian Financial Crisis: Diagnosis, Remedies, Prospects”, Available at http://www.stren.nyu.edu/~nroubini/asia/AsiaHomepage.html Radelet, S., and Sachs, J., (1998c), “What Have We Learned so far from the Asian Financial Crisis?”, Available at http://www.stren.nyu.edu/~nroubini/asia/AsiaHomepage.html Rhee, C. and Lee J.W., (1998), “Social Impacts o f the Asian Crisis: Policy Challenges and Lessons”, Paper presented for the United Nation Development Program, UNDP Rhee, J. C., (1994), “The State and Industry in South Korea: the limits o f the Authoritarian State”, London, Routledge Root, H., (2000), “Korea’s Comeback: The Thirst for Funds Drives Change”, Council on Foreign Relations Roubini, N., (1999), "What caused Asia's Economic and Currency Crisis and Its Global Contagion?", available at http://www.stren.nyu.edu/~nroubini/asia/AsiaHomepage.html Sakong, L, (1993), “Korea in the World Economy”, Washington D C, Institute for International Economics Samsung Economic Research Institute, (1998), “98 Business Management Report”, Seoul, SERI 92 Samsung Economie Research Institute, (1998), “Six Months after the IMF Bailout”, SERI Working Paper Song, I. and Cho, J., (1999), “Diversification Strategies and the Formation o f Korean Big Business Groups (Chaebols): Resource based and Institutional Perspectives on the Causes o f Diversification”, APEC Study Centre Discussion Paper No. 9 Stijin, C., Ghosh, S. and Scott, D., (1998), “Korea’s Financial Sector Reforms”, Paper presented at the International Seminar on Korea Economic Restructuring, Korea Institute for International Economic Policy The Business Week, (March 2,1998), “Kim’s War on Two Fronts” The Dong-Ah Ilbo, April 23,24, May 16, 19, 1997 The Economist, (1997), “The Asian Miracle: Is it Over?”, 03/01/97 The Economist, (1999), “Nation Builders”, 07/10/99, The Joongang Ilbo, February 3, 1997 The Korea Times, June 30,1993 Wade, R., (1990), “Governing the Market: Economic Theory and the Role o f Government in East Asian Industrialization”, Princeton: Princeton University Press Wade, R. and Veneroso, (1998), “The Asian Crisis: The High Debt Model vs. The Wall StreetTreasury-IMF Complex” Available at http://www.stren.nyu.edu/~nroubini/asia/AsiaHomepage.html World Bank, (1992), “Korea: Managing the Industrial Transition”, Washington, D C, World Bank World Bank, (1993), “The East Asian Economic Miracle ”, Oxford University Press Yoo, M. and Moon, C., (1999), “Korean Financial Crisis during 1997-1998: Causes and Challenges”, Journal o f Asian Economics, Summer 99, Vol. 10 pp263-278 Yoo, S. M. and Lim, Y.J., (1997), “fl/g Business in Korea: New Learning and Policy Issues", Seoul, Korea Economic Research Institute. Yoon, Y., (1998), “The Political Economy o f Economic Crisis: The Case o f South Korea”, Seoul National University 93