A Tale of Two Crises: Korea’s Experience with External Debt Management

1. A Tale of Two Crises: Korea’s Experience with External Debt Management Paper Prepared by Professor Yung Chul Park Seoul National University UNCTAD Expert Meeting Debt Sustainability and Development Strategies

2. Korea’s Experience • Small and large financial crises: • 1968-1969; 1974-1975; 1979-1980; 1991-1992; 1997-1998. • In each case the crises were preceded by: • An investment boom • A growing current account deficit in proportion to GDP • A real effective appreciation of the currency

3. Developments leading up to the 1979-1980 crisis • Export promotion strategy • Investment boom • Dramatic rise in inflation in 1980 • Appreciation of the real effective exchange rate • Slowing of growth in 1979

4. Additional Developments • Oil crisis 1979 • Deterioration of Terms of trade • Assassination of President Park in 1979 • Deep Recession in 1980 • Contraction of investment • Poor Harvest • Increase in current account deficit

5. 1979-1980 Crisis • Deep Recession • Large current account imbalance • Crisis in the informal credit market • Total debt as a proportion of GDP rose by more than 10 percent in 1980

6. Crisis Response and Management • Devaluation of the won vis-à-vis the US dollar (27 percent in 1980) • Move to a managed float • Growth-first strategy • Spending out strategy • Expansionary fiscal policy • High growth of M2 and M3

7. Recovery and Shift to Stabilization • Inflation begins to subside in 1981 • Current account deficit shrank to 3.3 percent of GDP by 1982 • Resumption of double digit growth in 1983 • Shift to stabilization policies 1983-1988 • Reversal of monetary and fiscal policies • Total external debt remained over 47 percent of GDP • Heavily laden with short term loans

8. 1997-1998 Capital Account Crisis

9. Investment Boom prior to the 1997-1998 Crisis • Steady economic growth (1994-1997) • Strengthening of the yen • Financial liberalization and market opening • Movement to foreign countries as foreign direct investors • High accumulation of foreign debt of domestic firms

10. Bursting of the Investment Bubble • Depreciation of the yen (Q3 1995) • Deterioration Korea’s of terms of trade • Real effective exchange rate appreciation (Q3 1995) • Slowing of the economy in second half of 1996 • Industrial groups slow to adjusting investment and output • Rising inventories • Accumulation of debt • Commercial Banks less willing to meet credit needs

11. Factors contributing to financial market collapse 1997 • Slowdown of export growth • Deterioration of terms of trade • Soaring levels of corporate bankruptcies • Rapid rise in non-performing loans of financial institutions (Dec 1996-June 1997)

12. Additional factors contributing to collapse • Pending presidential elections (Dec 1997) • Political uncertainties prompt capital flight • Unclear exchange rate policy • Defense of the won under pressure to depreciate • Fall in the Bank of Korea’s reserve holdings • Repeated lowering of sovereign credit rating • Contributed to further the worsening of market sentiment and foreign exchange rate depreciation

13. Management and Recovery of 1997-1998 Crisis • Government reform package (19 Nov. 1997) • IMF Bailout (3 Dec 1997) • Package $21 billion • Conditionality • Response to bailout package • Emergency financing program (24 Dec 1997) • Additional funds ($10 billion) • Government guarantee on private debt • Macroeconomic Policy Adjustments • Initial tightening of monetary and fiscal policy • The consequential increase in interest rates contributed to widespread bankruptcies • Reversal of fiscal and monetary policies in the face of a deeper recession to more accommodative stance.

14. 1997-1998 Crisis • Strong contraction of GDP in 1998 to -6.9 percent growth • Rise in inflation (7.5 percent) • Strong depreciation of the won vis-à-vis the dollar • Rapid Recovery • Expansion of growth by 9.5 percent in 1999 • Current account surplus in 1998 • Large increase in net exports • Decline in import demand

15. Rapid Recovery • Higher level of openness fueled recovery: • Large depreciation • Large trade sector and export orientation • Flexibility of labor market • Wage adjustments • Reallocation of resources from non-tradeables to the tradeables sector • Strong global economy • Improvement in terms of trade in 1999 • Appreciation of the yen

16. Similarities across crises • Crises were in part precipitated by an investment boom financed by foreign borrowing. • Rapid recovery • Similar ratios of external debt to GDP • Rigid foreign exchange rate systems exacerbated the crises • Economic fundamentals • Aggressive export promotion policies

17. Differences between crises • First case 1979-1980 • Capital account transactions were tightly controlled • No capital flight • Continued willingness to finance the CA by international financial market • Spend-out policy adopted • Expansionary monetary and fiscal policy • Second case 1997-1998 • Capital account deregulation and freer movement of capital • Capital flight • IMF package • Tight monetary and fiscal policy in concert with devaluation of the exchange rate

18. Differences between crises • Policy response • (expansionary/contractionary) • Economic environments • Economic liberalization • Market deregulation