Managing Economic Crisis in East Asia

7. The Foreign Exchange Crisis in Korea

162 Shin Jang-Sup 7 The Foreign Exchange Crisis in Korea Shin Jang-Sup Introduction The South Korean economy faced a foreign exchange (FX) crisis again during the global financial crisis in 2008–09, a decade after it suffered from a similar disaster during the Asian Financial Crisis in 1997–98. For four months after the collapse of Lehman Brothers in September 2008, Korea saw a massive net outflow amounting to US$46.5 billion of loans held by banks, including domestic banks and foreign bank branches in Korea. The Korean economy virtually came to a “sudden stop” during the period (Rhee 2009). This time around, Korea avoided seeking a rescue package from the International Monetary Fund (IMF), but survived the crisis thanks to the supply of foreign exchange and credit lines provided by emergency currency swap agreements with the United States, Japan, and China, totalling about US$80 billion. As the crisis was unfolding, the Korean won depreciated sharply, with the KRW-USD rate, which started at 937 in January 2008, rising to 1,200 at Foreign Exchange Crisis in Korea 163 the end of September, and further shooting up to 1,500 towards the end of November 2008. It in fact depreciated even more than the currencies of Eastern European countries which actually received the IMF emergency rescue packages. This Korean experience is puzzling, especially in view of the conventional perception that the country underwent one of the most successful IMF-sponsored reforms after the 1997–98 crisis and achieved “financial stability”. The debtequity ratio of its corporate sector, which was over 400 per cent in 1997, was reduced to about 80 per cent in 2008, even lower than that of the United States. Its public finance was one the soundest among the OECD countries. Its FX reserves, nearly depleted in 1997, ballooned to US$240 billion at the beginning of 2008, making the country the sixth largest holder of foreign reserves in the world. The post-1998 Korean economy boasted “strong fundamentals” and it had hardly been expected that the country would face an FX crisis again. This chapter investigates the causes of the crisis and discusses policy implications for Korea and other emerging market economies. It pays attention to the fact that the Korean economy actually became more vulnerable to abrupt international capital flows after the IMF-sponsored reforms. This weakness was not visible when international capital kept flowing into Korea during the first half of 2000s but became evident with the deepening of the global financial crisis in 2008–09. The chapter therefore suggests shifting its economic system to one that can better control capital flows and stabilize its FX rates. 164 Shin Jang-Sup Reassessing the “Successful” IMF Programme The IMF programme instituted in Korea after the 1997–98 crisis consisted of three elements: (1) macroeconomic retrenchment, (2) market opening, and (3) structural reforms (for details, see Table 7.1). Let us put aside macroeconomic retrenchment because it was a shock therapy at the beginning of the crisis and was reversed in the middle of 1998. Let us focus on market opening and structural reforms to assess long-term effects of the programme. In this programme, it is important to note that the market is depicted as a stabilizing force whereas the government is regarded as a destabilizing force. This is why market opening and structural reforms are combined as measures to prevent future financial crises. Therefore, a fuller liberalization of product and capital markets was undertaken while “rigidities” of the economy introduced by government interventions were minimized. All trade-related subsidies were abolished and remaining import barriers were removed. The foreign exchange rate system was changed to a free floating system by abolishing the daily exchange rate band and limiting government’s intervention in the FX market. The upper limit to foreigners’ domestic shareholding was also eliminated, the bond market fully opened, and commercial lending further liberalized. As far as market openness is concerned, Korea became a full First World country after the crisis. At the same time, four major system reforms were carried out to address the alleged “structural problems” that made the economy vulnerable to a financial crisis. In the financial sector, it was thought that the most serious structural Foreign Exchange Crisis in Korea 165 TABLE 7.1 Major Components of the IMF Programme in Korea Category Subcategory Contents Retrenchment Monetary Policy — increase call rates and reduce the...