Century of Turbulence 41 Financial crisis in 1997-98: shock and recovery
By Michael Breen
In late 1997, a currency panic in Southeast Asia mushroomed into a full blown financial crisis that drove Korea and several other nations to the edge of bankruptcy.
A scheduled presidential election a few weeks after the crisis hit led to the first ever democratic transition of power to the political opposition. Kim Dae-jung, more noted for his ability to confront anti-communist dictators and taunt them with ideas of reconciling with North Korea than with economics, took the reins, negotiated a bailout from the International Monetary Fund, sent his people to convince Wall Street that his reforms were serious, and, remarkably, turned the country around more rapidly than any other at that time.
The new captain steadied a ship that, unknown to most, was already dangerously vulnerable when the freak wave hit. How that came to be is a lesson in one of the ironies of national development, the way that strengths can turn with time into weaknesses.
In Korea’s case, for example, to achieve growth in a country characterized by corruption, incompetence and mistrust, the leadership decided to control all banks and depend on a handful of tycoons. While this strategy produced stunning results in the first 15 years, it also led to a staggering level of indebtedness by companies which sucked in available capital and resources and had an effective stranglehold on the economy.
“Everyone knew the problem,” said the vice-president of a company in conglomerate that staggered under a $1 billion debt. But bankers were “very weak,” he said, lending to businessmen on the recommendation of government officials. The businessmen, in turn, “took care” of the officials. “The politicians said we must change this system, but they themselves were dependant on it.
One bad habit was that sales volume, not profitability, determined whether firms got loans. As a result CEOs and chief financial officers of Korean companies lacked the financial management skills associated with companies in competitive free markets. They were good, however, at manipulating the numbers to show record sales growth of 10-20 percent every year.
As a result of this type of credit analysis, unsteady companies got loans and then borrowed more to pay the interest. The debt which most large groups were carrying by the mid-1990s was staggering. In 1996, bad loans were reckoned to account for 8 percent of all lending, around $24 billion which was roughly the value of the banks’ total equity capital. At the time, this was not easy to measure because firms kept different sets of books that did not reflect the level of transactions between affiliates of the same group. By one reckoning in 1997, the internal debt carried by corporate Korea – in other words debt owed to Korean banks by Korean companies – was roughly $350 billion. The country’s total foreign currency debt was $153 billion with just over 50 percent of it due in under a year.
The rapid peddling of the conglomerates to stay upright was invisible. Most Koreans thought they were riding high, their country a proud new member of the OECD. Then in late 1997, the foreign currency wave struck.
The trigger for the lurch into the deeper crisis was the bad loans at the small short-term lending banks. These merchant banks, as they were misleadingly called, began as loan sharks who, in the early 1970s, had been ordered to write off chaebol debts. In exchange they were allowed to set up officially as short-term finance companies. These banks were leveraged up on average ten times. In other words, one bank might have started with $100 million capital, borrowed $1 billion, and then extended loans worth $1.1 billion. Thus they tried to grow, just as the chaebol had, by piling on more debt. They went overseas and invested in Southeast Asian currency. When these currencies collapsed in 1997, the merchant banks were left unable to pay their debts.
The central bank started depositing foreign currency in the merchant banks and foolishly tried to hide the problem. Once word got out, international investors started withdrawing their money from Korea, and as a result the exchange rate went haywire. Then there was further panic.
Rather than let the foreign exchange market fluctuate, the central bank tried to prop up the Won artificially and started selling dollars in its reserves at the prompting of the finance ministry. It reportedly depleted its reserves by 30 percent ($10 billion). The won halved its value in a matter of weeks. By the end of the year, banks had completely stopped giving new loans, even to healthy companies.
Even good small businesses began going under because they couldn’t afford the 13-18 percent monthly interest rates being offered by loan sharks, who had mushroomed in Seoul behind doors with signs on them like “Mountaineering Association.” In December 1997, 1,226 small and medium companies went bankrupt. So did the Halla Group, the 12th biggest conglomerate, which foundered under debts of $5.3 billion.
An increasing number of men were leaving home as usual in their suits, but going off to the mountains where they kept hiking gear in lockers: white collar workers concealing the fact, sometimes even from their families, that they were out of work.
Because Japanese banks held a significant portion of Korean debt, a collapse threatened an already unstable Japanese banking system which in turn alarmed western economies. The International Monetary Fund stepped in with a $57 billion loan, its largest-ever bail-out of a country. But the money came with conditions that require Korea to clean up its act.
Just how severe the crisis was became quickly apparent. The following statistics for January, 1998, all represent the biggest monthly drop ever recorded (compared to previous Januaries): industrial production fell 10.3%, total manufacturing shipments fell 7.2%, domestic manufacturing shipments fell 20.6%, consumer durable goods shipments fell 23.2%, consumer non-durable goods shipments fell 17.0%, machinery imports fell 47.3%. Other records: the composite leading index fell 3.0% (month-on-month), the composite concurrent index fell 3.5%, and capacity utilization fell to 68.3, the lowest level ever recorded.
As they entered what they referred to as the “IMF era,” Koreans went through the gamut of emotions: at first there was a kind of denial, and wounded pride that the country was asking for foreign help. There were angry accusations – it the Kim Young-sam government’s fault. No, it was the fault of the chaebol. No, it was a foreign plot. (This, most notably, from Lee Kun-hee, the head of Samsung, who alleged that industrialized countries had before the crisis already finished “working out a program to punish the Korea Inc. and waited until the time was ripe.” )
Then the Koreans laid down the weapons that they been using to beat one another and sought common cause. After experts announced there was an estimated $20 billion worth of gold kept in Korean homes, tens of thousands got caught up in a gold selling fever launched by KBS TV and the Korea Housing and Commercial Bank to raise dollars to help repay the IMF loans. People queued up to either donate or sell. Couples handed over wedding rings. Old ladies contributed treasured possessions with the conviction that they were helping save their country. (As a result of this campaign, the international price of gold dropped to the lowest in 18 years.)
People stopped drinking coffee because it is imported. In the Ministry of Defense publishing house, for example, secretaries offered visitors local teas instead of coffee and explained it was “because of the IMF.”
In early 1998, laws were passed to permit companies to lay workers off for the purpose of downsizing. To pre-empt future reluctance in implementation, the IMF made these changes, as well as transparent accounting, conditions for receiving more loans.
But, as things turned around, and the IMF loan was paid back, the seeds for future problems were laid. The government, for example, spent billions buying banks. This state ownership felt good and right. The government has not yet sold its stakes to let those banks compete, while at the same time trying to convince the international financial community that the country could become a financial hub.