Bailout of South Korea Raises Stakes for U.S.

By David E. Sanger, in the New York Times
22 November 1997

[W] ASHINGTON -- As Thailand's economy imploded during the summer, the International Monetary Fund rushed in to try to confine the problem to one of Asia's most promising -- but still small -- economic powers.

It failed. Investors quickly turned their attention to other Asian nations plagued with wildly overextended banks, corruption and collapsing financial institutions. After a two-month hiatus, Indonesia erupted, requiring a far, far larger bailout, one that included for the first time billions of dollars in backup financing from Washington.

But the Asian contagion still could not be stopped. And now the impending bailout of South Korea -- a rescue plan that could easily exceed the $48 billion, American-led bailout of Mexico in 1995 -- raises the stakes for the United States and for investors around the world.

Korea is a critical fire wall in the effort to keep the contagion from engulfing the world's second-largest economy: Japan. The fear is that Japan's own teetering financial system -- one of its largest securities houses, Yamaichi Securities, is reported to be on the verge of liquidation -- could not withstand the collapse of one of Japan's biggest trading partners.

"We simply don't know where this goes next, and can't predict it," one senior Clinton administration official said Friday. And if Japan heads into a precipitous decline, it would be all but impossible to prevent the United States from catching the Asian flu. Exports to virtually all the Asian markets would slow, and the effects would be felt from Wall Street to the factory floors of companies that have thrived in America's export boom.

It is for all those reasons that inside the Treasury Department, where Asia's woes have become as large a preoccupation as Iraq is in the Pentagon, few doubt that South Korea's troubles raise the Asian financial crisis to a new level.

South Korea is the world's 11th-largest economy, roughly the size of Indonesia's, Malaysia's and Thailand's rolled into one.

"Korea makes this an entirely different ball game," David Hale, the chief economist at Zurich Kemper Investments, said recently as economists tried to take the measure of a Korean meltdown. He estimates it could take $50 billion to $100 billion in outside assistance to aid Korea; the IMF considers $30 billion an accurate estimate, though officials concede the sum could total more than that.

One thing is clear: Whatever it takes, the Clinton administration will push to make sure that the size of the bailout is large enough to persuade investors to return. Part of the reason is strategic: Korea is a major American ally, with 36,000 American troops stationed along the demilitarized zone, and no one wants it to appear weak at a time of tense negotiations with the North. In fact, for Seoul it was a cruel coincidence that international help came on the same day that North Korea agreed to begin talks over a formal ending of the Korean War -- a concession that on any other day would be viewed as a victory for the South.

But the talks with North Korea will drag on for months; insulating Japan from the worst of the "contagion effect" is a far more immediate problem.

The worst case runs something like this: Even with the IMF's help, Korea's pain spreads quickly across the Sea of Japan, reaching banks that lent to Korean financial institutions and cutting off business to Japanese companies that are major suppliers to what was once a Japanese colony. The Japanese institutions, already teetering, are forced into bankruptcy. Japanese exports fall. And with the Korean won sharply devalued -- it has already dropped about 20 percent this year, Japan feels compelled to let the yen slide as well, so that its cars and computer chips remain competitive with Korea's on overseas markets.

"This is the scenario that could bring the Nikkei to 12,000 or lower," an investment banker in Asia speculated recently about Japanese stocks. And that in turn, would lead to the failure of more Japanese banks, which have long been permitted by Japanese authorities to count their unrealized stock market gains as capital. With the Nikkei index that low, there would be no gains, and, thus, far less capital. The banks would have to merge or be permitted to liquidate, as Japan's 10th-largest bank, the Hokkaido Takushoku Bank, did earlier this week.

Japan's pain, of course, would quickly become America's. The trade deficit with Japan would soar, and Japanese imports, made less expensive by a declining yen, would displace American products. Political tensions would rise geometrically. This is why Treasury Secretary Robert Rubin has been escalating his warnings to Japan that it must pull itself out of its trouble by stimulating domestic demand, rather than exporting more and more goods. Of course, that is the worst case. If Japan moves quickly to confront its problems -- injecting taxpayer dollars into its banking system to ward off collapse, finding innovative ways to bolster the domestic economy -- it could ward off much of the contagion from Korea. American officials are busily trying to come up with reliable estimates of how much Japanese banks are exposed to Korea. The early answer, officials say, is that they are not as vulnerable in Korea as many first thought.

"This is a case where the Korean enmity toward Japan may actually pay off for the Japanese," an Asian diplomat in Washington said recently. "The Koreans don't especially like the Japanese, and so they often went out of their way to cut out Japanese banks and companies."

And the best-case outlook is that South Korea will respond to the medicine the way Mexico did. In the Mexican case, a huge rescue package was organized, totaling more than $52 billion. But in the end, the Mexicans only used about half of that amount.

The rest served as a psychological prop to investors, who knew that the country had a cushion of loans to fall back on in case the problems took a turn for the worse. And because the cushion was there, private investment quickly came back.

It is, in short, the financial equivalent of the Powell Doctrine, which was Gen. Colin Powell's insistence on the need to use "decisive and overwhelming force." It is a doctrine well understood in Korea, a country that has been focused on military security for a lot longer than it has been focused on economic security.