Commentary Type

Economic Reform in South Korea: An Unfinished Legacy

Paper prepared for the conference "Korea as a 21st Century Power" University of Cambridge



Since 1997 South Korea has been on an economic and political roller coaster. Between 1997 and 1998 forecasts of annual economic growth swung from +7 percent to -7 percent, and the country elected Kim Dae-jung, former dissident, future Nobel Peace Prize winner (and University of Cambridge honoree), and avowed economic reformer, president. However President Kim's weak electoral position-he was with only a plurality of support and forced to form a governing coalition with an ideologically dissimilar conservative party-and the continuing regional nature of South Korean politics have impeded the formation of a stable political coalition in favor of reform.

Today, despite the enormous political power granted to the executive under the South Korea constitution, Kim is effectively a lame duck. Constitutionally limited to a single term, he confronts a hostile national assembly controlled by the political opposition, his personal popularity has fallen below 30 percent, and his party is trailing in public opinion polls in the run-up to December's presidential elections.

Yet in spite of these challenges, a hundred other countries would envy the forecast of 5 percent growth and five percent unemployment in 2002. In the six months between mid-September 2001 and mid-March 2002, the stock market has risen by nearly 90 percent, and the only thing hotter on Wall Street than South Korea funds are…Russia funds (which may say something about Wall Street). Property prices are up in Seoul, credit card lending more than doubled last year, and household debt has risen from 18 percent of GDP to 62 percent in two years, the fastest growth rate in the world, achieving in two years what it took notoriously profligate US households a decade to accomplish.1 Despite such signs of overheating, four interest rate cuts, and two supplementary budgets in the past year, the International Monetary Fund (IMF) has urged the South Korean government to cut interest rates further and spend more money.2 With an election coming up, the government may be all too willing to oblige.

The state-led process of restructuring begun in 1997 has largely run out of steam, and the challenges that South Korea now confronts is less the wolf at the door than the termites in the foundation. And while the IMF and the government sort out whether South Korea is currently in a crisis, a bubble, or macroeconomic nirvana, it is worth recalling the lessons of South Korean economic history.

First, progress in policy reform is the greatest where international involvement is the highest. Over the course of the last 50 years, international trade policy has stood out as the arena of most successful policy reform. It also has been the area in which there has been the greatest consensus about and articulation of international norms (such as free trade in goods) and international institutions such as the World Trade Organization have been the most developed.3 In the financial arena, there is less consensus about best practices either with respect to domestic institutions or external relations, and the international institutions (Bank of International Settlements, the IMF) have been relatively less successful in promoting an international consensus about desirable norms. In areas such as labor policy, there has been little consensus beyond some minimal standards (i.e. prohibitions on forced labor or child labor) and the international institution (the International Labour Organisation) has been, and remains, weak. In the area of competition policy, there has been little consensus about desirable practices, and really no international organization (except perhaps the Organization of Economic Cooperation and Development (OECD)) has addressed these issues.

Perhaps it is not surprising then that South Korea has made the greatest progress in international trade liberalization, arguably the next best performance in financial reform, and probably the least achievement in the largely "domestic" arenas of labor and competition policy. The reason is straightforward: the existence of international norms gives policymakers a goal at which to aim, and the existence of the international institutions (and other avenues of international diplomatic pressure) help in overcoming the historical weakness and parochialism of South Korean political institutions.
A second lesson is that rules are better than discretion. Economist typically regard simple transparent rules as preferable to discretion on the part of the policymakers, in that rules tend to reduce uncertainties about future policies. The stabilization of expectations then enables decision-making on the part of private agents, and thereby contributing to more efficient economic outcomes.

Such rules-based systems are difficult to develop in political systems with weak political institutions, yet the pay-off can be considerable. In the aftermath of the crisis, the relatively liberal government of President Kim Dae-jung has, at time, undertaken relatively illiberal policies to promote economic restructuring and recovery, most notably in its promotion of so-called "Big Deals" the government's attempt to engineer a restructuring of the chaebol by pressuring them to swap business assets and consolidate production in particular industries. The prime example was pressure to put on LG to sell its semiconductor business to Hyundai. DRAM prices subsequently dropped and the Hyundai group encountered financial difficulties, at least in part attributable to its assumption of the LG semiconductor business at government behest. To some observers, this in turn created a moral obligation for the government to bailout Hynix (née Hyundai Electronics) in the Hyundai disintegration.4

In this environment, it is desirable to promote rules-based changes that involve foreigners and foreign institutions whenever possible. The emphasis on rules and the inclusion of non-Korean actors should help overcome the weaknesses of South Korean political institutions and push change in a constructive direction.

Old Economy, Old Problems

The 1997 crisis, though triggered by external events, was largely a product of internal problems, relating at base, to a weak system of corporate governance, a dysfunctional financial system, and poor labor relations (Noland 2000, Krueger and Yoo 2001). South Korea has made considerable progress (at significant cost) since then. In the financial sector, prudential regulation has been strengthened through the creation of the Financial Supervisory Commission and the introduction of new regulatory practices, approaches, and standards. The government has been forced to inject 155 trillion won (roughly 30 percent of national income) into banks and other financial institutions, while shutting down 498 non-viable financial institutions, reducing the number of commercial banks from 33 to 11, with a consequence reduction of financial sector employment of roughly one-third.5 In the corporate sector, South Korea has experienced the largest corporate bankruptcy in history (Daewoo) and has come close to another (Hyundai). South Korean chaebol have embarked on a process of restructuring encouraged by market forces, political prodding, and legal changes, but to date, their actions have consisted largely of disengaging from uneconomic activities rather than implementing forward-looking strategic plans to enhance shareholder value. In the labor market, the government has greatly broadened and strengthened the social safety net, but employers still face militant behavior on the part of unions. Given the state's prominent role in the economy, labor unrest has been an impediment to public sector reform, and has inhibited the process of denationalization or privatization of public corporations. Labor market problems have also deterred foreign investment.

Nevertheless, South Korea has arguably made better progress on economic reform in the last four years than the other heavily affected Asian crisis countries, or Japan for that matter. Yet the lack of a stable, forward-looking political coalition for reform, President Kim's premature announcement in December 1999 (the second anniversary of the IMF agreement) that the crisis was over, and the cyclical rebound of 1999-2000 have impeded reform and increased public disenchantment with subsequent events. The result is a lingering inability to address unresolved issues.

South Korea's financial system remains weak. McKinsey (2001), on the basis of 1999 data, estimated that firms with interest coverage ratios of less than one (that is earnings do not cover interest costs) accounted for 64 percent of total debt outstanding, and that non-performing loans (NPLs) could eventually reach 245 trillion won, necessitating writing off 150 trillion won (net of recoveries). The economic recovery since 1999 has surely improved the health of some of those borrowers and their debts (under a much more narrow official definition, NPLs in 2001 were 4 percent of commercial bank loans outstanding, down from a peak of 14 percent in 1998), but the situation remains worrisome. After falling in 1999 and 2000, chaebol leverage is again rising, and according to the FSS, 11 of the top 15 chaebol had interest coverage ratios of less than one. On a scale of A to E, with A indicating a system of exceptional financial strength and E indicating a system with very weak intrinsic financial strength and in which many banks will likely require outside support such as from the government, in 2001 the ratings agency Moody's assigned the South Korean banking system an D-, worse than Mexico's and on the same level as Thailand's and the Philippines'.6

Due to nationalizations of failing banks, at the height of the financial crisis in 1998, the state directly owned more than three-quarters of the banking system, and it now appears to be reluctant to give up control. In September 1999, significant foreign competition was introduced into the South Korean financial services sector, when, after months of contentious negotiations, the government sold the failed Korea First Bank to Newbridge Capital for $415 million, after indemnifying the firm against debts hidden by opaque, and at times, illegal, accounting practices. The government was severely criticized for the indemnification, despite the fact that it was permitted under South Korean regulations and is used in intra-Korean deals, and though the new American owners' stewardship of the bank appears to have been a success, after the Newbridge takeover, things slowed down considerably.

As Thomas Byrne of Moody's has observed, the government missed 10 deadlines in three years to sell nationalized Seoul Bank, allowing negotiations, first with HSBC, the with Deutsche Bank, to collapse. In October 2001, the Ministry of Finance and Economy eased restrictions on chaebol ownership of financial institutions, and now speak of engineering an intra-Korean merger as a solution to Seoul Bank's problems-an outcome that one suspects many preferred all along. In a similar case, negotiations between the government and US insurer AIG over the disposition of Hyundai Securities and two other affiliates broke down after 18 months of negotiations. In the case of Cho Hung Bank, the government has indicated its interest in selling a 30 percent stake next year through the issuance of global depository receipts and a strategic partnership, yet this would leave the government with 50 percent ownership and effective control of the bank. Similarly, its plans to sell off half of Woori Financial Holdings (the product of the merger of five failed banks) would leave it in effective control.7

Similar obstacles have been encountered on the corporate side, involving the dispositions nationalized firms such as Hanbo Iron and Steel, public corporations such as the Korea Electric Power Company (KEPCO), and private firms effectively in state receivership.

Daewoo Motor is a case in point. The company has been kept alive by its creditors, most notably banks under direct or indirect state control. As a string of scandals have revealed, those financial institutions have continued to channel capital to politically preferred borrowers. The new loans extended to Daewoo Motors in the fall of 2000 temporarily preserved 50,000 jobs, at a cost of $80,000 per job. Even with this infusion of cash, internal documents indicated that Daewoo Motor would have to shed more than one-third of its workforce.8

The problem for South Korea, of course, is that as restructuring in the financial and corporate sectors is delayed, the ultimate cost rises. In retrospect, it is clear that the government should have accepted General Motors' 1999 bid for the failed automaker. Since then, the government has engaged in a fruitless negotiation with Ford, and is now again negotiating with GM. This delay has cost beyond the obvious one cited above.

Firms are more than collections of machinery. As time has elapsed, the value of the automaker to any purchaser has declined. Talented staff have departed the firm. New product models have not been developed. The retail distribution system has atrophied. Whoever takes over the remains of Daewoo Motor in 2002 will possess assets worth considerably less than what they were worth in 1999.

This problem is not limited to Daewoo Motor. The lack of transparency imposes a penalty on financial transactions in the South Korean market ("the Korean discount"), inhibiting the ability of good firms to access capital. In the 2001 Transparency International "corruptions perceptions index," South Korea ranked 42nd out of 91, tied with Greece, and lagging such countries as Malaysia, Costa Rica, and Jordan. In the more narrow "bribe payers index," a measure of bribe-taking by senior public officials, South Korea ranked 18th out of 19, surpassed only by China on the sleaze meter. The transparency risk premium, separate from and in addition to conventional country and currency risk, inhibits investment in the South Korean economy.

The impact on foreign direct investment (FDI) is particularly acute. In the 2001 A.T. Kearney annual survey of corporate executives, South Korea was placed 17th in the "FDI confidence index" lagging such countries as Poland, the Czech Republic, and Thailand. The consulting firm PricewaterhouseCoopers actually calculates an "opacity index." South Korea ranked 31st out of 34, beating out Russia, Turkey, and Indonesia, but trailing countries such as Egypt and Romania.

These perceptions of South Korea as not fully hospitable to foreign direct investment have real repercussions. South Korea experienced a surge of foreign direct investment (FDI) in 1998-99, but a substantial part of this took the form of a one-time boost due to foreign firms buying out their South Korean joint venture partners. Even with this surge however, South Korea was still only placed 18th as a destination for FDI. In 2000, with opportunities for this relatively easy FDI largely exhausted, inward FDI slowed, and in 2001 fell by 25 percent. According to PwC's econometric model, if South Korea could achieve the average transparency level of the United States, Chile, the UK, and Singapore (the least opaque economies in North America, South America, Europe, and Asia, respectively), admittedly a tall order, it would triple its FDI inflow. This is more than just theory or an econometric exercise. For example, in its internal evaluations, one large institutional investor places South Korea in its "tier three/semi-transparent" category, and imputes a significant "transparency risk premium" in its calculations of hurdle rates for investment in the South Korean economy.9

Sadly, a portion of what capital is available for use in South Korea is sucked up by dying businesses such as Daewoo Motor and Hyundai Engineering and Construction (HEC). Despite repeated assurances that "this will be the last time," the government time and again bailed out the Hyundai group, extending preferential treatment to HEC, Hynix, and Hyundai Petroleum.10 In the queue are literally thousands of other unprofitable firms with similarly dubious prospects.

The unwillingness of creditors (ultimately, the government) to impose hard budget constraints on these firms contributes to union militancy: organized labor will not compromise on wages or job security until it is convinced that the government will allow enterprises to fail and jobs to be lost. As long as the government bails out managements, any union leader who would compromise would, in American parlance, be a chump. Ergo, as long as bail-outs continue, so will labor turmoil.

The Promise of the New Economy

The implicit costs of this misallocation of the nation's wealth are obvious. It is apparent that the world is in the midst of a technological revolution that is having a profound impact on productivity, organizational relationships within and among firms, and the distribution of income and wealth.11 South Korea has adopted information technology faster than any other economy in Asia. More than one-third of the population regularly uses the internet, a higher figure than for other high-income economies such as Japan, Taiwan, or Hong Kong, and average monthly usage is 18.1 hours, the highest in the world. South Korea boasts the highest broadband penetration rate in the world, double that of Canada, its closest rival.12 More than three million South Korean homes have high-speed internet access, double the number in Japan. Internet access costs only one-third as much as in Japan, and South Korea websites are generally more sophisticated than those in Japan. In the stock market, nearly two-thirds of all share transactions by value, and a third by number, are now conducted on-line, again, the highest in the world.13 South Korean firms arguably lead the world in third generation mobile telephony.

The advent of information technology is changing the structure of the South Korean economy. Given the rigidities and uncertain futures of the chaebol, there has been an upsurge in start-up activity and initial public offerings in the stock market. In 2000, according to a survey jointly conducted by the London Business School and Babson College, nine percent of adults in South Korea were owning or managing new firms, by far the highest in the world.14 (The United States was second at less than 5 percent.) Admittedly, not all of these new firms were in high technology, and the creative destruction of 1997-98 may have generated a temporary surge in new incorporations, these figures nevertheless suggest that business does not end with the chaebol.

These new firms tend not to be path-breaking, pioneering, companies, but they do appear to have successfully carved out global market niches, many spending more than 20 percent of their revenues on research and development. Kodicom, for example, makes multi-channel digital security camera systems built around software-based sensors, so when movement is detected on the monitor screen, it triggers recording to the hard disk drive. This product should face growing demand in the security-conscious post-September 11 world. Likewise, the three listed South Korean digital video recorder companies (together with a few unlisted ones) supposedly have an 80 percent share of the world market.15 In the internet sector, firms such as Commerce21 Corp., Serome Technology Inc., and Internet Auction Co. (acquired by eBay in January 2001) are cracking the Japanese market.

These new firms are changing South Korean corporate culture as well. In contrast to the secrecy that has characterized the chaebol, the managements of the publicly-listed firms, hold regular meetings with institutional investors. In contrast to the strict seniority-based formulas that characterize chaebol renumeration practices, firms such as Locus, a supplier of communications and internet services, have introduced incentive-based pay and stock option schemes. The developments are partly due to generational change, as the ranks of South Korean corporate management are swelled by Western-educated business school graduates.

Paradoxically, this strong move into high technology, especially IT, is both a source of long-run strength and short-run vulnerability, the latter due to South Korea's deepening integration with the United States through both trade and financial market channels. In the short-run, the integration of South Korean firms into high tech supplier networks makes South Korea increasingly vulnerable to a slowdown in US investment demand as occurred in 2001.

In addition to this conventional direct trade channel, South Korean equity markets have become more integrated with those elsewhere. In part this increase reflects the natural integration of markets following the removal of restrictions on foreign ownerships of South Korean stocks (and the removal of restrictions on South Korean residents' ability to invest abroad). At the same time, the prominence of high technology stocks in various national market indices has increased. As a result, price movements in the South Korean market exhibit greater covariance with those foreign markets. The linkages between NASDAQ and KOSDAQ, and even the broader KOSPI, are particularly notable. This simply means that with technological upgrading and advance, South Korea is more vulnerable to downturns in the US market than it was at times in the past.

At the same time as the South Korean economy is becoming more integrated with the US economy in the technology area, it is becoming a cultural products leader in the rest of Asia. Today, South Korean pop culture (film, music, and fashion) trends are followed as, if not more, keenly throughout Asia than Japanese styles. South Korean firms are aware of this and are attempting to build franchise value on the back of the country's cultural cache, both at home and abroad. Whether the K-POP boom will amount to a long-lasting cultural development with significant commercial implications, like the 1960s British invasion in popular music that spawned numerous record labels and ultimately two global conglomerates (Virgin and EMI) or will more closely resemble a transitory fad like 1970s ABBA phenomenon when that singing group's recordings accounted for a significant share of Swedish exports, remains to be seen. My pop culture instincts tell me that Naughty Diva, however alluring, are unlikely to be the future of the South Korean economy, but in any event, it should be fun watching this development unfold.

The Search for Solutions

This is the core issue facing the South Korean economy today: the nation can allocate its saving to the innovative firms of the new economy or it can invest in zombie businesses, bankrupt firms that somehow defy death. The choice is that simple. Every won of investment that goes into failing firms is a won that productive firms cannot access. Every won of investment that goes to the zombies helps perpetuate dead-end jobs with no future and impedes the creation of new jobs with vastly better prospects.

What can be done? Enhanced financial transparency is key. This requires improved accounting practices and truly independent accounting firms capable of auditing accounts. The production of consolidated financial statements under improved accounting rules is a positive move, though more progress is needed to bring South Korean practices up to internationally accepted principles.16 The imposition of sanctions on firms producing substandard or fraudulent audits is a step in the right direction. In September 2000, the Financial Supervisory Commission threw the book at Santong, one of Daewoo's main accounting firms, for conniving with its clients to falsify audits. In February 2001, facing expiring statutes of limitation, Seoul prosecutors charged 34 Daewoo executives and accountants, including former chairman, Kim Woo-choong, with fraud, though there are questions as to how serious the government is about tracking down the fugitive industrialist.17 In March 2002, financial regulators accused seven of the largest accounting firms with malpractice regarding practices involving 13 corporate clients. The Securities and Futures Commission has sought criminal charges against two of the accounting firms and recommended the suspension of 26 auditors.18

With improvements in transparency, it becomes possible to impose capital market discipline on corporate management. Two institutional developments would facilitate this. The establishment of outside boards of directors would create an "inside" check on management abuse. As in other cases, South Korea has successfully put new laws on the books regarding corporate boards, but the problem has been in implementation as in a number of cases incumbent managements have stuffed the boards with pliant cronies or even government officials.

A second desirable development would be the growth of institutional investors capable of monitoring management. To the extent that such institutional investors exist in South Korea, they tend to be affiliated with the major chaebol, though some foreign institutional investors and the nascent shareholder rights movement have exerted some salutary influence. Proposed legislation to expand minority shareholders' rights is a step in the right direction and could strengthen the hands of foreign investors and the domestic good governance groups. It would be desirable to separate financial and industrial groups, but this is unlikely to happen, and in fact, the October 2001 easing of restrictions on chaebol ownership of financial institutions goes in precisely the opposite direction.19 Short of wholesale restructuring, incremental improvements in regulatory oversight, for example, through the introduction of "Forward Looking Criteria" in asset classification standards for financial institutions, are positive steps.

Improved information is essential to resolving remaining problems in the financial sector. The primary tasks are to recognize financial losses, repair balance sheets, and recruit new investors. Already the government is allocating additional funds to recapitalize the banks. Similar problems remain in other sectors of the financial system. Beyond this balance sheet issue there it he critical requirement that financial intermediaries change their behavior and make investment decisions on economic, not political, grounds. There are grounds for optimism on this score: some of the measures introduced in the wake of the crisis appear to be having at least a modest impact in reducing the extent of cross-company financial links among chaebol firms, thus permitting investors to better separate good from bad chaebol businesses.20

The introduction of a partial insurance system should encourage the reallocation of saving toward better-managed intermediaries within the financial system itself. Increased foreign participation in the financial system, which can be accomplished through a variety of institutional arrangements, should also contribute to improving the quality of lending. Without improved financial information, a willingness to recognize losses on past investments, and a change in behavior with regard to future investments, the South Korean financial system will continue to hemorrhage.

Already one hears talk of a "credit crunch," and indeed, a reduction of credit due to financial disintermediation by distressed financial institutions is undesirable.21 This is not the whole story, though. Paradoxically, a "credit crunch" may be a good thing if it means that undeserving firms are no longer able to access capital on the favorable terms available in the past. The demand-side counterparts to improvements in the financial system are reforms to separate distressed though viable businesses from the capital-eating zombies. Like the situation with regard to the banks, with a few exceptions, the overall financial health of the chaebol appears to be bad. According to FSS figures in mid-2001, 11 of the top 15 chaebol had interest coverage ratios of less than one (i.e. technically bankrupt), the major exception being Samsung. As might be expected, Hyundai was the worst off, with a debt-equity ratio of nearly 500 percent.

South Korea needs a real market for corporate control and bankruptcy procedures that can actually kill off zombie enterprises, something like America's Chapter 11, which would permit insolvent businesses to restructure while protecting the interests of their creditors. The introduction of the corporate restructuring vehicle (CRV) and pre-packaged bankruptcy (PB) are steps in the right direction. Adoption of proposed further reforms of the bankruptcy and corporate reorganization system are desirable. Ultimately what is required is the political will to see that firms are forced to restructure according to these rules and procedures, not through a politicized process of negotiations with state-dominated creditors, a process that former Prime Minister Nam Duck-woo has memorably described as "akin to having some [hospital] patients assume responsibility for the treatment of other patients" (Woo, 2000, p.37).

The process of reconciliation with the North adds an additional layer of complexity to this problem. The fundamental issue is that as long as the state maintains direct and indirect influence over specific capital allocation decisions by financial intermediaries, it will be tempted to use this influence to promote its policy toward the North. Concern centered on Hyundai, the prime contractor in two of the government's high profile initiatives in the North, the Mt. Kumgang tourism venture, and the construction of an industrial park in the North Korean city of Kaesong. The Hyundai group reportedly last nearly $400 million on its Mt. Kumgang tourist venture, required an infusion of emergency loans to avert bankruptcy in November 2000, and beginning in December 2000 was unable to make its $12 million monthly payment to the North. It appealed to the South Korean government for assistance, and in the end, the government chose to subsidize the project directly through the national tourism authority. Not the first-best solution perhaps, but surely preferable to another response rumored at the time, namely saddling Samsung with the money-losing venture.22 The parastatal KOLAND effectively assumed responsibility for the development of the now stalled Kaesong industrial park project. State encouragement of economic integration with the North is not a bad thing-the government of South Korea has a legitimate national interest in promoting economic integration with the North. However, this could be done in a more efficient and transparent manner through the tax system in comparison to the current opaque and ad hoc approach.23

These problems relate to capital markets. There are problems in the labor market as well. Despite the fact that fewer than 11 percent of the South Korean workforce is unionized (less than that is the United States by point of comparison), the unions appear to have a disproportionate impact on economic policy. In August 1998, the government intervened in the Hyundai Motors strike and encouraged management to back down on its plan to release workers was regarded as a victory for the union. Since then, union opposition has blocked or slowed restructuring in the financial sector (Woori), in the corporate sector (Daewoo), and in the public sector (KEPCO). Foreign investors have cited labor unrest as the primary impediment to investing in South Korea. For many, the government is seen as beholden to, or intimidated by, organized labor.

A skeptic might rightly ask: if things are so bad and the zombies are chewing up a significant share of capital investment, then why does the economy continue to grow at 5 percent a year? At this point in time the answer is intrinsically speculative but probably contains the following elements. First, while the zombies do continue to eat up capital, at the margin, the allocative efficiency of investment has probably improved. The trend since 1997 has been away from indirect finance and many more firms have been able to access the deregulated equity markets. (As a point of comparison, in the United States, the banking sector supplies about 20 percent of corporate capital; for South Korea the figure is well over 50 percent (Brown, 2002).) When the crisis broke in 1997, literally hundreds of firms were waiting to be listed, and in a number of cases had to pay bribes to officials for their IPOs to go forward (Noland 2000). The increase in IPO activity has been one of the success stories of the economic recovery. And even within the banking sector, anecdotal evidence suggests that after the obligatory policy lending is made, at the margin bankers are behaving in a more rational way.

Second, South Korea has benefited from positive (and possibly transitory) terms of trade effects. Chip prices are up and oil prices are down. South Korean firms have profited greatly from in the US auto boom, increasing their exports to the United States 27 percent in 2001, and supplanting the EU as the second largest exporter to the US market after Japan. Conversely, any weakening of prices in either consumer electronics or autos, or an oil price hike, could take the wind out of the sails South Korea's net exports. The possibility of a significant yen depreciation associated with Japan's ongoing economic travails, is another cloud looming on the horizon of South Korea's external relations.
Third, South Korea is in the midst of a tremendous consumer spending boom that appears to be in significant part driven by high-end consumers. How durable this up-tick will prove is an open question.


Kim Dae-jung is the most classically liberal president South Korea has ever had. And yet despite his well-deserved accolades, one hopes that his charismatic leadership style recedes into history. At the start of a new millennium, South Korea needs strengthened economic and political institutions suitable to a mature democratic market economy. It needs political parties that are more than personal entourages or Japanese-style factional amalgamations based on corrupt fund raising. It needs inclusive parties capable of mobilizing citizens and channeling mass interests into effective democratic action. It needs a strengthened judiciary and rule of law. It needs transparent, rules-based government, capable of resisting narrow special interest and maintaining state autonomy, composed of officials accountable for their actions and their performance.

There is hope that the South Korean political system is moving in this direction. Half of the electorate is made up of voters under the age of 40 (the so-called 386 generation), and they exhibit some significant attitudinal differences from their forebears (Mo, 2000). On the one hand, they are more issue-oriented and reformist than their elders, while at the same time, like their counterparts elsewhere around the globe, their participation rates tend to be relatively low. These younger citizens comprise an important membership component of South Korea's rapidly emerging non-governmental organizations (NGOs). The prospect of someday incorporating North Korea's residents into a unified Korean polity underscores the urgency of strengthening South Korea's democratic institutions.

A similar need for strengthened institutions exists in the economics sphere. For the South Korean economy to continue to prosper, it must improve its mechanisms of resource, mobilization, allocation, and management. First and foremost this means increasing financial transparency. Better information enables improved allocation of capital. Improved accounting, the introduction of experienced, independent outside directors, the development of independent institutional investors, will improve corporate governance and encourage better management of resources. The development of efficient exit mechanisms is needed so that failing enterprises do not suck the life's blood away from efficient ones. Similar reforms are needed in labor and product markets. It is these structural reforms, not the quick fixes of monetary and fiscal stimulus, which will bring lasting prosperity to the South Korea economy.

Throughout Asia, political leaders have been asked to undertake actions that, at least in the short-run, will increase economic distress in their societies. While the experts assure them that in the long-run the policy castor oil will contribute to their economies' rejuvenation, political leaders are asked to make big decisions on the basis of essentially theoretical (if not theological) arguments about the behavior of markets. No elected politician could be expected to take on the painful task of economic restructuring with much enthusiasm, and it is not surprising the market participants are always on the lookout for backsliding. Yet South Korean politicians have a great advantage over their counterparts in the rest of Asia-the saplings of the high-productivity new economy are in overwhelming evidence. For them, to a much greater extent than their foreign counterparts, envisioning the gains from economic restructuring need not be an act of faith or exercise in imagination-they need only look out their office windows to see the future.


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1. Andrew Ward, Financial Times, 19 March 2002.

2. IMF External Relations Department, Morning Press, 13 November 2001.

3. Bilateral and regional pressures have contributed to liberalization as well (Noland 1993, 1998; Yang 2000).

4. For a highly informative analysis of the Hynix situation, see Manyin and Cooney (2002). As part of another "big deal," Hyundai Petroleum took over Inchon Oil Refining, formerly Hanwha Energy, from the Hanwha group. Hyundai Petroleum, too, subsequently received favorable treatment from the government.

5. The 155 trillion won figure is a gross expenditure figure. The recovery rate thus far has been just over 25 percent.

6. On an individual basis, the two strongest banks in South Korea (those that were not around during the HCI drive or did not lent to the chaebol) are rated D+. The Korea Development Bank is rated E.

7. Not all the news is bad, however. Germany's Commerzbank was permitted to take a controlling stake in the Korean Exchange Bank, and a consortium of the Carlyle Group and JPMorgan's banking fund, JPMorgan Corsair has taken a controlling stake in Koram Bank. See John Larkin, Far Eastern Economic Review, 28 March 2002.

8. Tim Burt, Financial Times, 5 March 2001.

9. See LaSalle Investment Management, "Opportunities in the Recovering Asian Real Estate Market," 23 January 2001, processed. Lack of transparency and labor militancy are not the only impediments to inward FDI. Many South Korean firms license technology from abroad, and many of the agreements contain clauses that nullify the agreement if ownership of the licensee firm changes.

10. In the case of Hynix, the state-run Korea Development Bank, agreed to purchase hundreds of millions of dollars of otherwise un-sellable bonds. In the case of HEC, it provided a $400 million payment guarantee. In the case of Hyundai Petroleum, state-dominated creditors extended the terms of existing loans and provided an infusion of new money as well. In doing so the South Korean government risked incurring the wrath of its trade partners: the US government has threatened to file a WTO case against South Korea for a Korea Development Bank financial program that the US claims, in effect, subsidizes dumped exports of Hynix. In December 2001 the immediate threat was set aside when Hynix entered into merger negotiations with the US firm Micron Technologies. If Hynix and Micron are unable to reach a mutually acceptable modus vivendi the WTO case could come back onto the agenda. Ssangyong, another deeply troubled chaebol, would be another beneficiary of the bond purchase scheme. See Choi (2001) and Manyin (2002) for an overview of South Korea-US trade issues.

11. For a comprehensive analysis of the "New Economy," see Economic Report of the President, Washington: Council of Economic Advisers, January 2001. Although this report is oriented toward the US economy, its insights have a broad applicability to South Korea. See Yusuf and Evenett (2001) for an Asia-centric discussion of the same issues.

12. Andrew Ward, Financial Times, 18 March 2002.

13. The Economist, 10 February 2001.

14. The Economist, 13 January 2001.

15. Chinese banks which purchase these systems reportedly demand higher frames per second rates than other buyers because the cameras are set not to catch intruders, but rather tellers with their hands in the till!

16. To cite an example: if a bank sells an NPL with a provision that if the loan does not meet certain performance rules the selling bank will buy back the loan from the purchaser, under South Korean accounting rules the bank is allowed to completely remove the loan from its books, despite the contingent liability associated with the buy-back provision.

17. Thus far, the government has not referred Kim's case to Interpol, and instead has merely asked South Korean embassies in countries where the fugitive industrialist is thought to be hiding. Many believe that he would implicate large parts of the South Korean political elite in the web of corruption.

18. Five of the accused firms have partnerships with the Big Five global accountancy groups, including Arthur Andersen of Enron fame. The accused clients included subsidiaries of the LG and SK groups. See Andrew Ward, Financial Times, 16 March 2001.

19. See Graham (1999) for an interesting proposal to use pension fund money to create independent institutional investors.

20. The disintegration of the Hyundai group, accelerated by the death of founder Chung Ju-yung, is a prime example. As SaKong (2000-1) observed, the Hyundai self-rescue plan actually facilitated the disintegration of the group by encouraging the liquidation of cross-affiliate shareholdings and guarantees.

21. See, for example, "Economic Policy Direction for the Year 2001," Economic Bulletin, January 2001, Seoul, Ministry of Finance and Economy, Center for Economic Information, Korea Development Institute.

22. Cross-debt guarantees to the Hyundai subsidiary responsible for the Mt. Kumgang venture subsequently became an issue in the disintegration of the Hyundai group.

23. See Noland (2000) for a proposal along these lines. Given the Kim Dae-jung government's commitment to engagement with the North, some have gone so far to argue that Hyundai's activities were undertaken with the intent that they would create a moral hazard problem for the South Korean government which would be unable to resist bailing out the chaebol should it encounter economic difficulties.

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