Behind Korea's Plunge

By Alice H. Amsden and Yoon-Dae Euh, The New York Times, 27 November 1997

[S] outh Korea has competed brilliantly in basic industries like steel and semiconductors, and has moved ahead quickly in high technology. Yet financial markets are teetering, the Korean currency has nose-dived, and International Monetary Fund officials are considering South Korea's request for a $20 billion bailout loan.

Economic experts have blamed too much Government regulation and oversight for South Korea's problems. But it isn't that simple. When the Government controlled the financial markets in the 1970's and 1980's, Korea's growth was stupendous. Not until the early 1990's, when financial markets were deregulated, did the economy sink. Indeed, it was the Government's decision to allow banks and other financial institutions to borrow and lend without interference that created the current crisis.

In the 1970's, the Government decided how many financial institutions could exist and what they could do. But in the 1980's the world's leading financial institutions expanded internationally, and, in order to compete, South Korea had to loosen its rigid controls. The Government allowed banks to have more say on interest rates and to have overseas operations.

But the Government went too far. In 1995, South Korea made a Faustian bargain with the United States. In exchange for membership in the prestigious Organization for Economic Cooperation and Development, it agreed to loosen almost all controls on financial institutions, both international and domestic.

Foreign banks were no longer barred from buying and selling large amounts of foreign currency; that enabled them to speculate against the Korean currency, the won. The result? When Southeast Asian currencies fell this year, the won also weakened, but speculation made the currency's slide even more dramatic.

South Korea also didn't monitor its own banks as they ventured farther afield. Merchant banks, which can engage in most financial transactions, lent recklessly. They took out loans from international institutions, but gave out loans to risky ventures, like finance companies in Southeast Asia. When many of these businesses went bust earlier this year, South Korea's merchant banks were stuck with bad loans totaling $3 billion.

The Government's looser restrictions on manufacturing companies were also harmful. Companies became free to take out loans from foreign banks -- and many of them overindulged. They borrowed lots of money, yet they didn't turn these loans into sensible long-term investments.

The companies defaulted on loans, partly because the won had weakened. These bad loans helped create a crisis for South Korea's entire commercial banking system. Not only were companies unable to pay back their foreign loans, but they couldn't pay back their old loans to South Korea's commercial banks, either.

When word got around that some financial institutions were failing, there was an old-fashioned run on the banks. Businesses and individuals withdrew their money, and banks were forced to call in their loans to companies that were highly leveraged but profitable. These companies were innocent victims; because of the panic, they went bankrupt. Hoping to avoid future crises, international economists and regulators are calling for an overhaul of South Korea's manufacturing and financial sectors. Certainly, the Government must reform its banking system and revamp some of its industries.

But the crisis also shows that the United States, acting out of self-interest, was wrong to push the South Korean Government to open up its financial system so quickly. The Government and its financial institutions didn't have time to develop adequate ways to control and monitor this brave new world.

As the international experts set the terms for South Korea's bailout, they would do well to remember this mistake. Alice H. Amsden is professor of political economy at the Massachusetts Institute of Technology. Yoon-Dae Euh, a professor of international finance at Korea University, is a former member of the South Korea's Monetary Board.