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Financial and Corporate Restructuring in South Korea

June 20, 2003
Hiroshi Akama*1
Kunihisa Noro*2
Hiroko Tada*3

Click on ron0306b.pdf (281KB) to download the full text.

The views expressed in this paper are entirely the personal opinions of the authors and do not reflect the official views of either the Bank of Japan or the International Department.

  • *1Bank of Japan International Department, Global Economic Research Division (e-mail: hiroshi.akama@boj.or.jp)
  • *2Bank of Japan International Department, Global Economic Research Division(e-mail: kunihisa.noro@boj.or.jp)
  • *3Bank of Japan International Department, Global Economic Research Division (e-mail: hiroko.tada@boj.or.jp)

Preface

In 1997, a series of bankruptcies of the chaebols destabilized the financial system and triggered a currency crisis. President Kim Dae-jung who took office in February 1998 showed his strong leadership to move forward with swift and bold structural reforms, which restored high economic growth in 1999. This paper reviews the reforms of the past five years and discusses their implications for Japan 1.

  1. For details on financial, corporate and labor market reforms in Korea, see the International Department Working Paper Series available on the Bank of Japan web site, particularly, "Financial Restructuring in South Korea: Outline and Comparison with Japan"(October 2002), "Corporate Restructuring in South Korea: Transition from Government-led to Market-led Reform"(March 2003), and "Labor Market Trends in South Korea since the Currency Crisis: The Mechanism of Rapid Adjustment and Recovery"(December 2002) , these papers are Japanese only.

Summary

The Currency crisis and its causes

1. During the 1990's, the chaebols overextended their business scopes and investments, leading to a surge in corporate debt and causing the current account deficit. Under the strict capital controls on inward direct and portfolio investments, the current account deficits were financed mostly through short-term borrowings by the domestic financial institutions from foreign banks, which resulted in accumulation of unstable, short-term external debts. Once non-performing loans held by the domestic financial institutions soared due to successive bankruptcies of medium-sized chaebols in 1997, foreign banks pressed en masse for repayment, leading the country into a currency crisis.

2. The excessive investment and indebtedness of the chaebols were attributed to inadequate governance not only by shareholders, characterized as lack of separation between ownership and management, but also by creditor financial institutions. The "overly cozy relationships" between the chaebols and the government, which intervened in banks' management, caused the banks to maintain easy lending towards the chaebols. And liberalization of non-banks' ownership by chaebols in the 1990's spurred excessive investments and indebtedness.

Financial Sector Restructuring

3. The government responded to the banking crisis by injecting fiscal funds, equivalent to 30 percent of GDP, including capital injections, non-performing loan purchases, and depositor protections. The under-capitalized banks received capital injections, while the ailing non-banks were closed and their depositors were protected. The government also actively invited foreign capital to recapitalize banks and strengthen banks' governance.

4. There are three features characterizing the injection of public funds into the banks: 1) it is accompanied by the resignation of the existing management and capital reductions; 2) the government is involved in management by imposing numerical targets; and 3) the government collects public funds by selling its shares of nationalized banks to private investors. This framework gives the government an incentive to increase banks' values to minimize ultimate costs. At the same time, the government has adopted stricter standards for asset classification in order to inject sufficient public funds and restore investors' confidence towards the banks.

5. The government-run assets management company (AMC) has purchased non- performing loans worth more than 20 percent of GDP, at market value, and has disposed of them by various methods including issuance of asset backed securities (ABS) and direct sales. This centralized AMC created a market for non-performing loans, and encouraged banks to sell off non-performing loans in the market.

6. These programs resulted in significant improvements in the financial situation and corporate governance of banks. Switching over profit-oriented management, banks have reduced lending to the chaebols, and increased lending to households and small and medium-sized enterprises, particularly in the service sector, which yield higher profits. Combined with policies to bring greater flexibility to the labor market, these changes transformed the economic structure, which had been overly centered around the chaebols.

Corporate Restructuring

7. The government was directly involved in corporate restructuring as well. It imposed numerical targets for debt reduction on the chaebols and required them to select core companies. The government also required the creditor banks to sort out financially ailing companies either as viable or nonviable. As a result, a number of nonviable companies were liquidated while the viable ones were revitalized under out-of-court private workout procedures.

8. The then President Kim Dae-jung called on the chaebols and labor unions to form "Tripartite committee", in which the unions accepted employment cut to overcome the crisis. Together with introduction of foreign capital by swift capital account liberalization, this facilitated companies to sell off their non-core businesses and improve capital base. In addition, the government adopted institutional frameworks to strengthen corporate governance.

9. The chaebols have made steady progress in restructuring; the ratio of corporate debt to GDP has been declining and paving the way for listed companies to set record-high profits in 2002. However, a handful of blue-chip companies were responsible for the improvement in aggregate profits. There are still many companies that are slumping and continue to carry excessive debts.

10. The corporate restructuring is becoming more market-driven. The banks with sufficient capital and good governance and the stock market more driven by foreign investors are becoming more selective about companies to invest in. As a result, slumping companies are forced to restructure, by selling off non-core businesses in order to make interest and principal payments.

Implications

11. The first feature of Korea's structural reforms is the active involvement of the government, particularly in the early stage, and the comprehensiveness of reforms, including financial, corporate and labor market reforms, and capital account liberalization. It is noteworthy that the government tackled corporate governance problems, which were the root of the crisis. The second is that the comprehensive reforms have increased flexibility of the economy. Korea has quickly restored financial intermediary functions, enhanced and developed its capital markets including the ABS market, brought more flexibility to its labor market, and attracted foreign capital. These efforts facilitated the reallocation of resources and even relieved the deflationary pressures of reform. The third is related to sequencing of reforms. Korea restored the soundness of the banking system in a short period, while corporate restructuring is still in progress. This sound banking system laid a foundation for continuous corporate reform, by putting pressures on the chaebols to restructure.

12. The experience of Korea has implications for the Japanese structural reform, although the nature of underlying problems are different in the two countries. With respect to broad government involvement: 1) in the Korean episode, the serious crisis requiring IMF support warranted government intervention; 2) Korea had the fiscal soundness which enabled injection of massive public funds; and 3) the Korean presidential system was able to respond more quickly to the crisis. We should also note differences in the degree of complexity involved in structural reforms: 1) Korea had fewer factors exacerbating instability of financial system, it experienced no asset price bubble in the pre-crisis period and banks held fewer stocks; 2) the Korean economy was centered around a small number of chaebols; and 3) the Korean economy had a relatively small employment mismatch against a background of younger demographic structure and no "lifetime employment" system. Structure problems were therefore much less complex than those in Japan. Third, with respect to short-term conflicts between structural reform and economic growth: 1) Korea had room for fiscal expansion as well as high export dependence, which propped up the economy owing to significant exchange rate depreciation; and 2) Korea had a greater scope for reorientation towards services and growth potential among its small and medium-seized enterprises, which led to early creation of new demand and recovery of bank lending.