Korea and the Asian Financial Crisis

1. Korea and the Asian Financial Crisis

2. The Timeline of the Crisis, 1997 • March-June: 65 Thai financial companies receive secret liquidity support from the government • June: Thailand suspends operations of 16 financial companies, baht depreciates 20% • July: Malaysia, Philippines and Indonesia fail to protect their currencies, an “all currency meltdown”; several Korean banks placed on negative credit rating • November: Korean won falls sharply, KAMCO established (a non-performing asset fund)‏ • December: IMF approves a 3-year standby agreement with Korea

3. Asymmetric Information: the Basics • Asymmetric information is only shared by a limited number of players • Card-playing games • Sellers of second-hand cars • Asymmetric information typically leads to moral hazard and adverse selection • Moral hazard: one party's actions may hurt the other party of a deal, but the other party does not observe these actions • Lazy managers • Adverse selection: one party's type is private information • The riskiness of a project

4. Financial Crisis: the Asymmetric Story • Financial system channels funds from those who want to lend to those who want to borrow • S=I • Asymmetric information in the financial markets that leads to moral hazard and adverse selection may seriously disrupt the operation of this channel • A financial crisis erupts when the problems associated with asymmetric information make it impossible for the financial markets to channel funds from savers to borrowers efficiently

5. Asymmetric Information and Economic Growth • Asymmetric information problems damage the ability of financial intermediaries (e.g. banks) to lend efficiently • Hard to distinguish good borrowers from bad borrowers (good loans from bad loans)‏ • Lack of credit leads to lack of spending and production by firms • Lack of production by firms leads to a decrease in employment and lack of spending by individuals too • A disruption in the savers->borrowers channel will lead to lack of investment and lower economic growth

6. Factors Leading to Asymmetric Information • Deterioration of financial sector balance sheets • Increases in interest rates • Increases in uncertainty • Deterioration of non-financial sector balance sheets

7. Deterioration of Financial Sector Balance Sheets • When banks' balance sheets deteriorate... • Banks raise more capital (difficult)‏ • Banks are lending less (easy and most probable)‏ • Bank runs are a possibility when balance sheets deteriorate • The role of asymmetric information: • Depositors (clients) do not know about the quality of the banks' balance sheets-->withdraw their money • The banks do not know about the quality of their lenders so they lend less

8. Increases in Interest Rates • Credit crunch causes interest rates to rise • Rising interest rates create incentives for: • The prudent borrowers not to borrow • The riskiest borrowers to borrow at a higher interest rate • Banks' loan portfolio quality deteriorates: adverse selection comes into play • Effects on 'borrowing short and lending long' • 'short' interest rates are higher than 'long' interest rates

9. Increases in Uncertainty • Uncertainty makes both moral hazard and adverse selection problems worse

10. Deterioration of Non-Financial Sector Balance Sheets • Deteriorating collateral value • Banks often require borrowers to leave collateral for the loan (e.g. Buildings)‏ • However, when asset prices go down, collateral value does too, so moral hazard problems get aggravated • Deteriorating net worth of the firm • Unexpected changes in the rate of inflation • Disinflation often accompanies crises • When prices go down, firms' liabilities (fixed in nominal interest terms) increase, thus decreasing firms' net worth

11. Stages of the Financial Crisis • Stage 1: run-up to the currency crisis • Stage 2: from currency crisis to the financial crisis

12. Run-Up to the Currency Crisis • Financial liberalization • Lifting up of the interest rate ceilings for the borrowers • Easing restrictions on the type of borrowing • Lending and inflow of international capital increase dramatically • Excessive risk taking • Lack of skills and time to screen the many new loans • Weak regulation systems

13. From Currency to Financial Crisis • Currency crisis results in the deterioration of banks' balance sheets • Central bank finds it increasingly difficult to protect domestic currency against speculative attacks • Raising discount rates makes lending more difficult • Maturity mismatch (long versus short term lending) contribute to the collapse of the banking system • A full-blown speculative attack results in depreciation of the domestic currency • Depreciation results in default on the overseas loans, outflow of capital • Bad balance sheets in both financial and non-financial sectors make it impossible for the financial sector to channel funds from savers to borrowers

14. Five Major Misunderstandings about the IMF Rescue Programs • The IMF failed to predict the crisis • Predictions have been made both by Korean and Western scholars: Krugman (1994) and Choi Jong-Hyon (SK founder) • IMF warned Thai authorities for 18 months before the crisis, same grounds as in Korean case • The IMF instituted high interest rates that stifle businesses by inflating borrowing costs • High interest rates indeed have long-run recessionary effects, but they are necessary to restore the attractiveness of the currency, which was one of the key short-run objectives • The IMF creates moral hazard by bailing out reckless investors • Bailing out of insolvent banks was a short-term measure aimed at restoring international confidence in the Korean financial system • Long-term oriented structural reforms of the financial system are an integral and unconditional part of the IMF rescue package • Korean industry is significantly subordinate to foreign capital • Globalization also means liberalizing international capital flows • Korean economic growth falls far short of its average pre-crisis level • The law of diminishing returns • Initial growth rates always high • “Dead cat jumping”

15. Lessons From the Financial Crisis • Soundness of financial system key to the macroeconomic stability • Pegged exchange rates lull investors into ignoring currency risks • Highly leveraged chaebols financed with short-term debt are a major threat to macroeconomic stability • Globalization makes financial system ever more vulnerable to external shocks (Korea had strong fundamentals before the crisis) • Greater transparency of financial system is key to the early identification of the risky behavior by lenders and borrowers alike • Access to financial expertise is particularly helpful in times of crisis despite the need to incur losses when reforms begin • Bank restructuring provides a key lever for corporate restructuring • Short-term losses were unavoidable under any reform package in 1997 • Foreign expertise and increased foreign participation is crucial to ensure economic safety in an increasingly globalized world