Paper prepared for presentation at the Federation of Korean Industries, Seoul, Korea, November 26, 1996. This paper grew out of a project begun by Jeff Frankel while he was a visiting fellow at the Institute. I would like to thank Li-Gang Liu for research assistance, and Morris Goldstein for helpful comments on an earlier draft, though he is in no way responsible for the resulting product.
Financial Repression and Financial Liberalization
Financial systems in many developing countries are said to be "financially repressed". The government intervenes heavily in the economy, segmenting financial markets, placing artificial ceilings on interest rates, and directly allocating credit among enterprises as it sees fit. The likely result is that the total amount of savings is lower than it should be, and the allocation of the total among its possible uses is inefficient. Disequilibrium in the financial markets generates rents which may be allocated through corruption. These distortions become severe when the real economy develops rapidly and profitable real investment opportunities abound, and yet the financial system lags behind.
The symptoms of financial repression include low rates of return to savers, banking sector inefficiency manifested by high spreads between lending and deposit rates, poor allocation of funds across alternative uses, politization of lending decisions, and the existence of large informal and unregulated credit markets ("the curb market").
The harmful effects manifest themselves in primarily four forms. First, financial repression tends to retard the development of the economy by discouraging the accumulation of capital. Savers are offered low rates of return, while firms face a high cost of capital for their investment needs.
At the same time financial repression impedes the efficient allocation of what capital is accumulated. Projects are typically not funded according to their rates of return, but rather on the basis of noneconomic considerations, which may include political connections or bribery of the relevant officials. In the case of Korea, this is reflected in the low average rate of return on bank assets, which is among the lowest of those observed in emerging markets (Goldstein and Turner 1996, table 5). More generally, government intervention in the financial markets erodes the autonomy of the private sector which becomes increasingly vulnerable to policy decisions by government officials. Detailed regulations governing corporate finance, for example, can create uncertainty with respect to the policy environment and wreck havoc with investment planning. The result is income growth that is slower than needs be.
A related problem concerns information and transparency. Financial systems in which economic decisions are made for noneconomic reasons, tend also to be lax in terms of accounting, disclosure requirements, and the overall transparency and availability of economically relevant information. Markets cannot work efficiently in the absence of reliable information. Simply think of the problem of trying to value shares in the stock market under such conditions.
Lastly, financial repression acts as an implicit tax on holders of government debt. By restricting capital flows, the government can in effect force domestic residents to accept government debt at lower interest rates than would be the case if there were no controls on capital. In the case of Korea, Giovanni and deMelo (1993) estimate that for the period 1975- 1987, this implicit tax rate was more than 5 percent, amounting to 0.25 percent of national income, or 1-2 percent of actual tax revenues.
There are two sorts of financial liberalization: the removal of domestic distortions--barriers separating savers from users of funds--and the removal of border distortions--barriers separating domestic residents from international capital markets. The removal of domestic barriers allows domestic savers to earn a fair rate of return on their savings, which can result in a greater total supply of savings. This means that there will be a larger supply of funds available to borrowers, particularly to firms wishing to finance investment in productive plant and equipment. A higher rate of investment in turn results in a higher rate of growth of the national economy (without running into inflationary constraints).(1)
The removal of international barriers allows investors to diversify abroad. More importantly, in the case of a newly industrializing country, it allows firms and other borrowers to raise funds abroad more cheaply than they could at home, where savings are scarce. Thus they can finance a higher rate of investment and, again, the result will be a higher rate of growth of the national economy.
Liberalization of domestic finance can accomplish three things. First, financial liberalization and the creation of a more efficient financial system internally provides better rates of return and opportunities for diversification for savers, and typically leads to more saving. This increases the amount of domestic capital available for investment, and the rate of economic growth.
Second, it improves the efficiency of investment. From the standpoint of the formal sector, the discipline of domestic competition forces financial institutions to concentrate on economic criteria when making decisions about how and where to invest capital. Capital is allocated in a more economically rational manner among alternative uses. The discipline imposed by domestic competition makes it more difficult to invest in noneconomical politically favored projects or politically connected borrowers. Elimination of regulations on corporate finance creates a more stable environment for decision making, reduces uncertainty, and can lead to higher and more productive investment.
The liberalization of domestic financial markets causes a convergence in borrowing rates across the formal credit and informal curb markets. As a consequence, small firms and new entrants have improved access to credit. To the extent that these firms may use capital more efficiently than larger, more privileged firms, the economy-wide rate of return on investment increases. And, to the extent that new entrants are more technologically innovative than incumbent firms, this can also contribute to the technological advance of the economy.
Third, the creation of a competitive environment alters the operating behavior of the financial firms themselves. They are forced to economize on resources. Concretely, this means that resources can no longer be squandered internally on consumption within the firm in the form of things like abnormally high salaries or entertainment expenses. It means that firms face incentives to adopt cost-reducing technologies such as information technology. Finally, in a competitive environment, financial firms are forced to increase the quality of service provided to both borrowers and lenders. For example, in the case of banks this might include things like faster clearing of payments, more rapid processing of loan applications, and extended hours for customers.
In summary, domestic financial liberalization can increase the rate of domestic capital formation, increase the efficiency of investment, and reduce the resources absorbed by the financial system itself.(2)
Additional benefits can be obtained through international financial liberalization. Relative to the rest of the world, newly industrializing countries tend to have high rates of return on investment. When barriers between domestic and international financial markets are removed, two things happen: capital tends to flow from capital-abundant economies where the rate of return on investments is low to capital-scarce countries where the rate of return is high, and differences in interest rates across countries tend to narrow. From the standpoint of the newly industrializing country, this means that there is more capital available for investment at a lower cost to domestic firms. If the foreign capital inflow is invested efficiently, it is possible that the economy can enjoy both higher levels of consumption both in the present and in the future, than it could if it had relied solely on domestic capital for investment.(3) The reason is that the opening of the financial market to international investment has increased the overall amount of resources available for domestic investment in the present. The higher rate of current investment, leads to greater output in the future, more than enough to pay off foreign debts while still increasing domestic consumption and welfare. The enhanced opportunities for intertemporal consumption-smoothing may be particularly important in a country like Korea which is prospectively subject to major financial shocks such as the need to finance unification.(4)
These gains can be captured purely through the increased availability of low-cost capital. Additionally the opening of financial markets internationally permits greater portfolio diversification and a reduction in risk for both borrowers and lenders. Economic shocks and rates of return on capital are imperfectly correlated (indeed sometimes negatively correlated) across different markets internationally. From the standpoint of savers, the opportunity to hold assets denominated in both home and foreign currencies represents an opportunity to at least partially insulate oneself from shocks to the domestic economy and improve the risk-return trade-off. (It may also afford savers the opportunity to invest in instruments not available at home due to incomplete markets, further enhancing risk management.) From the standpoint of borrowers in a newly industrializing economy, the opportunity to borrow abroad reduces the cost of capital, facilitates portfolio diversification across both lenders and instruments, and can at least partially insulate the firm from economic shocks, especially shocks to the domestic economy.
Exposure to the operations of foreign competitors through both inward and outward direct investment may convey additional benefits to the domestic economy. Inward foreign direct investment can benefit the economy by exposing domestic firms to new technologies, management techniques etc. introduced by foreign investors. (Foreign direct investors may also discipline anti-competitive tendencies of domestic firms, especially in markets where domestic production is concentrated and domestic firms can exercise market power.) Likewise, outward foreign investment by domestic firms may not only expose them to innovative products and processes, but give them a better understanding of world markets and their foreign customers.
Inward direct investment by foreign firms may have special economic benefits in the financial sector in a newly industrializing country. Again, the demonstration effect of exposing domestic firms to new products and management techniques can improve the performance of domestic firms and the overall efficiency of the domestic financial system. Relative to other countries, not only is the Korean banking system highly concentrated, but the role of foreign firms is quite limited.
Beyond this the presence of foreign financial institutions helps reduce systemic risk by increasing the diversification of the financial system. For example, banks in newly industrialized countries are typically not very diversified in terms of either deposits or lending, and newly industrializing economies tend to be more volatile (particularly with regard to terms of trade shocks) than larger, more mature economies. In the case of Korea, this volatility appears to be even more pronounced than those experienced by other economies in Asia (table 1). The presence of foreign banks, therefore provides a national banking system with banks that tend to be more diversified internationally and tend to have a different (and lower) risk profile (in terms of national and sectoral exposure) than the existing domestic banks. Data from the BIS indicates that actual risk-based capital ratio of Korean banks is among the lowest of all developing countries, and significantly lower than that of the United States (Table 2).
Table 1: Volatility of macroeconomic indicators and banking aggregates(1)
|Bank Credit to Private Sector(2)
1. Measured as the standard deviation of annual percentage changes, 1980-1995. 2. Measured as a percentage of nominal GDP.
Source: Goldstein and Turner 1996.
Table 2: Required and actual capital ratios (in percentages)
|Capital Adequacy Ratio (national requirements)
|Actual Risk-based Capital Ratio (1995)
Source: Goldstein and Turner 1996.
Similarly, direct investment in more open, competitive, markets abroad may force domestic firms to learn efficiency enhancing lessons which can be applied in their domestic operations for the benefit of the entire economy.
Lastly, it is questionable how effective capital controls are. Mathieson and Rojas-Suarez (1993) present persuasive evidence that private agents routinely attempt to evade capital controls through under- and over-invoicing arms-length transactions and transfer pricing intrafirm transactions, as well as time shifting dates of settlement. One is left with the impression that the net result of the imposition of controls is to both distort and corrupt economic life.
These are more than theoretical arguments. Extensive cross- country econometric research has shown that the size and sophistication of financial markets are positively associated with the future growth of real per capita income.(5) Financial market development both increases saving and improves the productivity of investment.(6) Moreover, there appear to be separate and distinct roles for different financial institutions (such as banks and stock markets) in this process.(7)
Indeed, researchers have identified the theoretically predicted gains associated with both domestic and international financial liberalization. For example, in the case of the United States, individual states place restrictions on interstate banking activities. Jayaratne and Strahan (1996) found that the removal of these restrictions systematically improved the quality of banks' loan portfolios in the affected states. Competition forced banks to apply more rigorous standards, and those that were slow to adjust were taken over by their more efficient brethren. The result was a more efficient banking system for the United States. In the case of international financial liberalization, the opening of emerging market stock markets has led to systematically higher price-earning ratios permitting firms to increase capital investment and raise the rate of growth (Claessens and Rhee 1994).
Through domestic and external financial market liberalization Korea can obtain these benefits and more. For example, econometric research by Chung (1995) indicates that the Korean commercial banking sector is already responding to the current domestic liberalization efforts. With respect to international liberalization, the opening of newly industrializing stock markets should lead to increases in both turnover and capitalization, reducing liquidity risk and thereby reducing required rates of return and the cost of capital. In theory, foreign participation could lead to an increase or decrease in volatility, but in practice, opening has been associated with less stock market volatility in emerging markets (Kim and Singal 1995). The Korean stock market is "mildly segmented" from the rest of the world (Claessen and Rhee 1994; Watanabe 1996), and the correlation between movements in the Korean and foreign markets may even be declining, demonstrating a prime opportunity for portfolio diversification (Jun 1995). As would be expected, the current policy of opening the stock market to international investment has led to an increase in the stock market index, price-earning ratios, and a reduction of volatility.(8) Although it is sometimes argued that foreign investment in the stock market amounts to "hot money", the actual behavior of foreign investors has been to re-invest sales as part of the process of portfolio realignment (Jun 1995). Foreign purchases (both gross and net) have made statistically significant positive contributions to the performance of sectoral indexes for chemicals, basic metals, machinery and equipment, fishing, wood and wood products, transport and storage, construction, and wholesale trade.
These examples are not meant to be exhaustive. Rather they are to establish that a growing body of evidence derived from both the experience of Korea and other countries indicates that there are real gains to domestic and international financial market liberalization. The remainder of this report will examine the Korean case, identify a number of salient issues which Korea will have to confront, and finally suggest some recommendations for restructuring the Korean financial system for greater competitiveness.
The Case of Korean Financial Market Liberalization
Korea inherited a legacy of financial repression from Japanese colonial occupation which was carried into the period of independence. Economic policy in the South after the war lacked any overarching rationale or coherence. The maintenance of negative interest rates inhibited the development of the banking sector, which was permitted little freedom from government control, and encouraged the channeling of capital to large politically influential borrowers. The result was misallocation of capital and recurrent balance of payments crises. The trade regime was characterized by considerable barriers, including an import licensing system and multiple exchange rates for different activities. These policies, together with an export-import-link system encouraged rent-seeking behavior and the development of giant conglomerates. A military government under General Park Chung Hee seized control in 1961. After two years of poor economic performance the government began a fundamental reversal of policy in 1963. The basic philosophy underlying their revised First Five-Year Plan reflected a strong commitment to industrialization and an important role for the state in this process. The government would set the basic economic development goals and would selectively intervene to insure their attainment. Although most economic activity would still be carried out by private firms, the state would complement or replace them as needed. The single most important reform was the unification of the exchange rate and the devaluation of the currency in 1964. Financial reform began in 1965, when interest rates were raised encouraging saving and financial deepening as well as more efficient use of capital. The national saving rate rose from 7.4 percent of GNP in 1965 to 15.7 percent in 1970, and the ratio of M2 (a broad definition of the money supply) to GNP increased from 12.1 percent in 1965 to 32.2 percent in 1970 (Cho 1994, table 6.1).
In 1972, General Park, who had been reelected for a third term, pushed through the Yushin (Revitalization) constitution which essentially made him president-for-life. To strengthen the regime's political legitimacy, economic development efforts were redoubled, and the Third Five-Year Plan was introduced. The financial liberalization policy was reversed in 1972, when interest rates were lowered and direct government control of the banking system was increased in order to channel capital to preferred sectors, projects, or firms. The government had earlier implemented industrial promotion policies for selected industries, but in the 1970s these efforts were intensified. In order to finance large-scale projects, special public financial institutions were established, and private commercial banks were instructed to make to strategic projects on a preferential basis. By the late 1970s the share of these "policy loans" had risen to 60 percent (Yoo 1994).(9) These loans carried, on average, negative real interest rates, and the annual interest subsidy grew from about 3 percent of GNP in 1962-71 to approximately 10 percent of GNP on average between 1972 and 1979 (Pyo 1989). The detrimental impact of credit rationing was moderated by short-term foreign capital inflows and the existence of a large curb market, which provided nopreferred customers with capital, albeit at high interest rates (figure 1). As might be expected, allocative efficiency declined, and the marginal product of capital was lower in the favored sectors throughout the 1970s (Yoo 1994).
The Fifth Five-Year Plan (1982-86) marked a movement away from the interventionist strategy. The government undertook a liberalization of the financial sector. Commercial banks were denationalized, but the state retained the right to appoint boards of directors and senior officers. There was, however, an easing of direct government control of banks and nonbank financial institutions. The share of "policy loans" in domestic credit was reduced, and commercial banks were required to extend at least 35 percent of their loans to small and medium-sized firms, to compensate for the effects of the earlier policy. Interest rates were deregulated, and the economy experienced considerable financial deepening, as the ratio of M3 to GNP increased from 51 percent in 1982 to 87 percent in 1987 (Nam 1992).
The Sixth Five-Year Plan (1987-91) reinforced the trend toward financial sector liberalization. The deregulation of banks and nonbank financial institutions, together with the growth in stock and bond markets, has led to a withering of the curb market, which now accounts for less than 10 percent of domestic credit. Financial liberalization received a further boost in 1993 with the introduction of multiyear financial plans, the most recent of which was promulgated in 1995 and runs through 1999.
Despite this progress the financial system remains relatively repressed. The government maintains considerable involvement in the banking system. It continues to issue detailed regulations regarding corporate financial decisions, including restrictions on overseas investments, restrictions on equity finance, and restrictions on overseas finance. Participants in the financial markets are subject to a positive list system which inhibits the introduction of innovative financial instruments and practices. The pervasive pattern of government intervention creates a symbiotic relationship between the government and the private sector, eroding private sector autonomy, and facilitating the corruption of the political system.
Banks, which had previously been government owned, have been privatized. Yet most bankers have not changed their habits. They still set interest rates in an administered way, rather than by competition in an open marketplace. They still make loans to sectors favored by the government, rather than to borrowers that are independently judged to represent profitable investment opportunities with good credit risks. In part this is because the appointment of bank presidents still begins with the recommendations of a committee of the Ministry of Finance and Economy (MFE).(10) The banks retain a somewhat bureaucratic character, manifested by overstaffing and an implicit guarantee of lifetime employment. Returns on assets are low, relative both to returns observed in other countries, and to the returns on assets of foreign banks operating in the Korean market.
Outside of the banking system, there has been more progress. An equity market has developed, for example. But liquidity is insufficient, and there is currently a large backlog of companies waiting to be listed, more than 360 according to some press accounts.(11) Money markets and bond markets are still underdeveloped, with only a limited range of maturities.
In all markets, there still exist heavy restrictions on international inflow and outflow. Foreign investors are subject to equity ownership ceilings in listed Korean companies and even are more severely restricted in the bond market. The result of these restrictions is that Korean interest rates are far above world interest rates, and the prices of shares in Korean companies held by foreign investors are above those in the domestic stock market (though this gap has narrowed in recent years). Thus the cost of capital to Korean corporations is higher than it would be if there was a full financial opening. Additional government interventions in the market drive up the cost of capital further still.(12)
Korean reluctance to liberalize undoubtedly reflects a mixture of motivations. Some observers genuinely believe that the benefits to be gained through more efficient financial markets are outweighed by the potential destabilizing macroeconomic effects, or that Korean financial firms are not yet ready to compete with foreign firms (e.g., Park 1995), Park and Song (1996).(13) Others probably oppose liberalization out of self- interest, since liberalization would erode their privileged position within the Korean financial system. Likewise, some foreign calls for Korean financial market opening are surely motivated by similar self-interest.
The Structure of Banking
Korean financial institutions include banks and nonbank deposit taking institutions, investment and insurance firms, and equity markets (figure 2). Commercial banks account for 36 percent of deposits, specialized banks for 13 percent, and nonbank financial institutions (including state development banks, the trust activities of commercial banks, credit associations, investment and insurance companies), the remainder (OECD 1996). On the lending side, Korean banks face some competition from an underdeveloped commercial paper market, and some consumer lending institutions such as in automobile finance. Foreign banks' activities are restricted, although they are now allowed to open multiple branches, and the government has announced plans to permit them to establish wholly-owned subsidiaries around late 1998.(14)
Figure 2: Structure of the Korea Financial System
Note: Figures refer to the share of each group of institutions in total lending of all institutions in 1993. Figures in parentheses are numbers of institutions in 1994. Source: Bank of Korea.
The trend in the development of Korean financial institutions has been of a diminution of state involvement. The share of state banks in lending has fallen over time, and now account for only 13 percent of loans. Policy loans, which contain a significant subsidy element, have become less important over time, now accounting for 18 percent of bank credit and 5 percent of all lending.(15) Moreover, these loans are increasingly concentrated in the public financial sector, with the share of these loans originating in the public financial sector now 39 percent and rising. However the commercial banking sector is still more dependent on policy lending than the rest of the nonstate financial system with policy loans accounting for 18 percent of commercial bank lending.
In parallel to the reduced state capital channeling efforts, the commercial banks have been privatized, and there has been a movement away from the government directly appointing senior bank managers, though the government still does not permit complete autonomy in either the selection of senior management or operational decisions regarding portfolio allocation. The legacy of state involvement is further manifested by overstaffing and an implicit guarantee of lifetime employment. As noted earlier, returns on assets are low, relative both to returns observed in other countries, and to the returns achieved by foreign banks operating in the Korean market.
Perhaps as a consequence of continued state involvement with the banks, it is widely believed that the government will not permit a bank to fail, and indeed none has ever done so.(16) Recently a deposit insurance scheme involving nonrisk adjusted uniform premiums has been introduced. (The possible moral hazards created by the implicit state guarantee and the provision of risk unadjusted insurance will be taken up below.)
Commercial banks are supervised by the Monetary Board, the governing body of the Bank of Korea and the Office of Bank Supervision which also regulates other financial institutions under the delegated authority of the MFE. (Securities and insurance are supervised by similar boards under the MFE.)
The core commitments of Korean bank regulation is the adoption of the Bank of International Settlement (BIS) capital adequacy guidelines, and the CAMEL system (Capital adequacy, Asset quality, Management ability, Earnings quality, andLiquidity level) based on US regulatory practices. The 1993 introduction of a "real name" law represents a significant step forward in that it should give regulatory officials much greater information with which to combat malfeasance by bank insiders. As mentioned earlier, a system of uniform premium deposit insurance has also been created for commercial banks.
The potential problem with the system is the implicit guarantee that banks not be allowed to fail; this together with deposit insurance, simultaneously creates an incentive for banks to seek risk, while it relieves depositors of the incentive to monitor bank health. This problem is compounded by nonperforming loan reporting requirements that the OECD describes as "weaker" than in many OECD countries. Although the banking sector is probably in better shape than in some times in the past, there has been an increase in unsecured loan defaults in recent years. The Office of Banking Supervision reports that bad loans at commercial banks totalled 2.7 trillion won through the first six months of 1996, up 17 percent from the same period in the previous year. Moreover, the Korean definition of bad loans is more narrow than that commonly used abroad, and foreign bankers estimate the true bad loan problem may be three times as large as admitted.(17) The commercial banking sector may be significantly exposed to risks associated with lending to property developers and construction companies during the stock and real estate asset bubble during the late 1980s, as well as the restructuring of small and medium sized enterprises (SMEs) in labor-intensive manufacturing sectors.(18) Concerns about the banking system are further aggravated by the MFE's dual function as a promoter and supervisor of financial institutions, and legitimate questions can be raised about the degree of independence of the regulatory authorities.
Banks are unique in that their assets are typically less liquid than other financial assets and as a consequence, it is harder to assess the financial health of banks; further, they also play a payments intermediation function. The first characteristic means that they are subject to runs if the limited information on their health indicates that it is poor; the second characteristic means that problems in the banking sector are conveyed to the rest of the economy. That is to say that problems in the banking sector can generate negative externalities economy-wide.
The potential costs of a banking crisis are gigantic. Caprio and Klingenbiel (1996) identify a dozen cases in which the direct clean-up costs exceeded 10 percent of national income, underlining the potential gains to heading off a crisis before it occurs.(19) These crises have multiple origins. First, banks in repressed financial markets are typically subject to greater risk because of a lack of portfolio diversification, and also because of the greater relative magnitude of shocks that newly industrializing countries are subject to. (The recent collapse in semiconductor memory chip prices and the adverse movement in the Korean terms of trade is an example.) Restrictions on foreign bank activities further reduces potential diversification from the standpoint of the national economy. As a consequence, Goldstein concludes that the BIS capital adequacy guidelines are probably not sufficient for the banking sectors of newly industrialized countries. Indeed, the data reported in table 2 indicate that the actual risk-adjusted capital ratio of Korean banks is rather low.
The second characteristic of banking crises are lending booms, especially in real estate and equities as part of an asset bubble. Again, the experience of Korea over the last decade gives cause for concern. The third contributing factor is government involvement in the financial system, giving rise to politicization of lending decisions, moral hazard problems etc. This has certainly been a characteristic of the Korean financial system, though arguably less so now than in the past. A fourth factor is liquidity-maturity balance sheet mismatches. These problems tend to be magnified by weak reporting standards and provisioning for bad loans. Again, there is some concern about this issue with respect to Korea.
Fifth, Goldstein cites incentives systems that do not give managers "enough to lose" and that thereby encourage inappropriate risk-taking behavior. The implicit guarantee of bail-outs, and the risk-unadjusted form of commercial bank deposit insurance in Korea, arguably are creating these kinds of incentives for Korean bank managers.
Sixth, Goldstein identifies inadequate preparation for financial liberalization. In this regard, Korean preparation would have to be termed deliberate. If there is one thing that should be scrutinized in the Korean process, it is the possibility that public officials who will be charged with supervising the liberalized system will undergo inadequate retraining. Current staff, who have spent their professional careers operating in the environment of a repressed system, may need retraining, and additional resources (such as new informational technology) will have to be extended to the regulatory bodies. By way of an analogy, airplanes, when properly operated, are a safe and efficient form of transportation. However, one would not permit anyone with an automobile driver's license to pilot an airplane. Additional training is necessary to move from driving a car to flying a jet.
Last comes the maintenance of a disequilibrium nominal exchange rate peg. This does not appear to be a problem in the Korean case, though it potentially could be if the government mismanages capital inflows associated with external liberalization as discussed below.
The bottom line is that Korea should be concerned about the strength of its banking system, and much of this concern is related to domestic financial repression and is unrelated to the issue of external financial liberalization. Market discipline does not work when there is a lack of information, or when the notion that banks cannot fail is widely held. The appropriate responses are to deal with the structural problems of the banking system (which are likely to involve both domestic and international liberalization together with strengthened prudential supervision by public authorities) to strengthen public disclosure requirements, and to signal limits on public bail-outs.
Interest rates have been deregulated over time. Now only 17 percent of bank deposits, (less than 5 percent of total deposits), and 3 percent of domestic loans are subject to direct rate regulation. Deregulation appears to have had real effects on interest rates. There has been a narrowing of the differential between interest rates and corporate bond rates as shown in figure 2. Moreover, according to the OECD, Korean government bond yields do not appear to be out of line with yields in other OECD countries given the historical record with respect to inflation and exchange rate movements. Yet the impression remains that though interest rates have been formally deregulated, the commercial banking sector is still subject to administrative guidance. The expectation is that additional international capital market liberalization should further reduce rates, though there may be Korea-specific risk factors (such as potential conflict with North Korea) that will prevent the complete equalization of interest rates internationally. Yet it is likely that real rates will continue to gradually decline with international opening as the capital stock grows and the marginal product of capital declines (figure 1).
Long-term capital markets are large, though some government policies inhibit there further development. (Short-term capital markets are relatively small and underdeveloped.) Daily turnover in the stock market is the sixth largest in the world, and stock market capitalization as a share of national income is higher than in some OECD countries. This development has occurred despite practices that at times have encouraged debt over equity finance.
Nevertheless, due to concerns over the recent depressed state of stock prices, since 1990 the government established a quarterly quota on new issues, and reportedly more than 360 firms are waiting for permission to issue stock.(20) This repression of the normal functions of the capital market has given rise to corruption as firms have resorted to bribery to get their shares listed.(21) At the core of this is a positive list system in which anything not explicitly permitted is prohibited. This has hampered the introduction of new instruments throughout the financial sector. The MFE has indicated that it will end the quota system, has permitted the listing of a stock futures contract, is widening the permissible daily trading bounds for individual stocks, will abolish fixed commissions on stock trades, and is clarifying the rules on mergers and acquisitions. Nevertheless, it prevents the introduction of derivative instruments which would enhance firms' ability to manage risk in both the foreign exchange and equity markets.
Foreign participation in the stock market is also limited. The government restricts the amount of shares that foreigners can hold in individual stocks. Initially this was set at 10 percent in January 1992, and subsequently raised to 12 percent in December 1994, 15 percent in July 1995, and 18 percent in April 1996. In June 1996, the government announced a further phased opening that would increase the ceiling to 20 percent in 1996, and three additional percentage points annually thereafter to 29 percent by 1999.(22) As a consequence of this segmentation, the shares held by foreigners often trade at a premium over the shares held by domestic residents. The government has not permitted screen-based trading for foreign held shares, nor does it allow publication of stock market price indices for those shares, creating an illiquid market that conveys abnormal profits to dealers with price information.(23)
The long-term bond market is large, with the corporate bond market five times as large as the domestic bond market. The government has discouraged the development of an efficient auction and secondary market for government bonds, and no swap, bond or interest futures markets exist. Foreigners are only eligible to purchase a limited number of corporate bond issues. The government announced in August 1996 that foreign investors would be allowed to invest in convertible bonds issued by large corporations beginning in 1998, but that full opening of the bond market would be delayed until the differential between Korean and overseas interest rates, currently 6-7 percent, narrows to 2 percentage points.(24) There is no necessity of this ever occurring.
Participation in Korean capital markets by foreign firms is also limited. Foreign securities firms have been permitted to own up to 10 percent of the paid-in capital of Korean securities firms, and in 1995, they were allowed to establish branch offices or joint ventures. In June 1996 the MFE announced a new proposal to eliminate the 10 percent limit on ownership, and permit foreign firms to open wholly owned subsidiaries in December 1998.(25)
On the outflow side, capital outflow by residents has been largely liberalized, though some restrictions remain. Domestic residents are permitted to invest in foreign stocks in the 13 largest markets through mutual funds, though actual investments have been minuscule, and Korean residents' portfolios appear to be highly concentrated in won-denominated assets.
The Current Plan
The current plan breaks down some barriers within the domestic market, emphasizes the liberalization of long-term capital markets before short-term capital markets, and liberalizes capital outflows before capital inflows. Assuming that the plan is implemented as specified domestic residents will be free to purchase foreign securities by 1996, and establish foreign currency bank accounts in 1998. Domestic firms will no longer be required to obtain prior approval to be allowed to issue foreign currency denominated equity-related securities (warrants), but rather will be subject only a reporting requirement.
Nonresidents will be allowed to issue won-denominated securities, and the ceiling on nonresidential purchases of equities will continue to be raised, and friendly takeovers permitted by 1997. Restrictions on foreign purchases in the bond market will likewise be partially removed. In respect to short- term capital flows, nonresidents will be allowed to open won- denominated accounts at overseas branches of Korean banks.
Restrictions on both inward and outbound direct investment rules are to be partially eased. Foreigners are to be allowed to buy land freely in some sectors (though they will still need the permission of local authorities in others); limits on outboard foreign direct investment (FDI) will gradually be lifted.
With regard to the participation of foreign financial institutions in Korean markets, foreign banks and securities firms will be allowed to establish more branches and offices, respectively, foreign insurance companies will be permitted to hold own-currency denominated cash or securities as well as won- denominated assets, investment trust and asset management businesses will be opened in a controlled manner to foreign participation and foreign firms are to be completely free in their operation by 1998.
In short, the plan continues the liberalization process on a variety of fronts, though many of its provisions leave the government with significant discretion, and it is unclear what controls will remain in 1999.(26) At the end of 1995 domestic market interest rates had largely been freed (indeed, a year a head of schedule). However, the government still regulates the portfolios of commercial banks. It still owns a large number of financial institutions (of which the Korea Development Bank is the largest) and state-owned financial institutions dominate some markets (such as mortgage lending). According to the OECD, there are restrictions that impede the flow of capital from commercial banks to other financial institutions, including the privately owned nonbank institutions, which it identifies as the most dynamic part of the Korean financial sector. Government control of the introduction of new instruments has retarded the adoption of innovations in the securities market. Despite the decline of policy loans, the central bank still acts as a source of subsidized lending to preferred borrowers. Foreign participation in Korean financial markets is circumscribed, and access by residents to international capital markets is still restricted.
A major source of reluctance to remove barriers to capital inflows is the fear that inflows of reserves will increase the money supply excessively, and lead to real exchange rate appreciation, either through inflation, or alternatively through nominal appreciation of the currency. It is true that a country undergoing industrialization and liberalization must consider its monetary policy carefully and guard against inflation. But this requires that the central bank adapt to the changing structure of the economy, not that it adhere rigidly to old rules.
Most countries try to steer a balance between the dangers of excessive monetary expansion, leading to inflation, on the one hand, and inadequate money creation, inhibiting growth, on the other hand. There are several ways that a country can design its institutions so as to place top priority on preventing inflation, if it wishes to do so. One is to legislate the independence of the central bank, insulating it from the control of the finance ministry, the rest of the government, and the entire political process.(27) Another way is for the central bank to commit to rules for monetary policy, rather than exercising complete discretion from quarter to quarter.(28)
An example, which was adopted by many central banks in response to the global inflation of the 1970s, is the monetarist rule: allow the money supply to grow at a rigid growth rate, say 3 percent per year. (Indeed, in the case of Korea, the practice of the Bank of Korea has been to target M2, and the relatively primitive state of Korean financial markets has facilitated its use of direct controls to do precisely that.)
But the changing structure of financial markets has rendered monetarism obsolete. The reason is that the relationship between the rate of growth of the money supply and the inflation rate has broken down. A rigid commitment to a money supply target implies unacceptably large fluctuations in output and prices, due to the large fluctuations in money demand. In the case of Korea, the empirical evidence indicates that demand for M2 has become unstable, with income velocity fluctuating seasonally (in contrast, M3 is more stable, and its standard deviation of velocity less than half that of the standard deviation in M2).(29) The consequence of M2 targeting has been to increase volatility of short-run interest rates, which is more than 4 times that of OECD countries. In the past this did not have serious implications for exchange rate determination since the authorities could keep the domestic money markets and the currency market segmented. Now, however, gyrations in domestic interest rates could be reflected in exchange rate movements and indeed could actually prompt the short-run international capital movements that the authorities appear to fear.
More generally, changes in financial structure fundamentally complicate the conduct of monetary policy. For example, Stiglitz (1996) observes that the close substitutability of short-term commercial paper for bank loans for means that as the commercial paper market develops, a given reduction in reserves might have a smaller impact on interest rates. The reason is that a smaller shift would be necessary to cause a given share of bank borrowers and depositors to shift to other intermediaries or to cause banks to move a given share of funding and lending off balance sheet. Consequently, to accomplish a given increase in interest rates, a larger reduction in bank reserves could be required, and a larger subsequent contraction in the size of the banking sector would therefore result. The more volatile swings in the size of the banking sector could hurt the banking industry by making banks less reliable sources of funds, and the distributional implications could be adverse for borrowers such as SMEs that remain dependent on bank credit. In effect, the larger cyclical contractions in banking could force parts of the economy to bear the brunt of macroeconomic adjustment.
To whatever extent the central bank wishes to commit to arule for monetary policy, other targets make more sense than the money supply. Two better alternatives are a target for nominal GDP and a target for the exchange rate. A target for the exchange rate makes more sense for an economy where trade is a high proportion of GDP. But there are disadvantages. One disadvantage, for a country that has many important trading partners, is that pegging the currency to one partner creates fluctuations vis-à- vis the others. The obvious alternative is to adopt a basket peg, a crawling peg, or target zones. In the first case, one links the value of the domestic currency to a "basket" of foreign currencies. The crawling peg extends the basket peg by explicitly changing the pegged rate in a uniform manner over time to accomplish a gradual appreciation or depreciation. A target zone system could be implemented by establishing a notional rate and then intervening in the currency markets to maintain the exchange rate within a range of values around the notional rate.
However, unless an economy is highly open and has very flexible labor markets (like, for example, Hong Kong), or unless economic shocks primarily take the form of productivity or supply shocks and policymakers place a great weight on price level objectives to the exclusion of output or employment goals, it is doubtful that exchange rate targeting should be the preferred method of guiding monetary policy. For economies such as Korea, with significant nontraded sectors and less than full wage flexibility, targeting inflation or nominal GDP is likely to dominate any exchange rate targeting when the objective functions policymakers optimize are the conventional ones relating to output and/or employment.(30) However, monetary authorities only observe prices and output with a lag, so to do this one needs an observable intermediate target. One possibility is to follow the "Taylor rule", setting interest rates automatically based on a comparison of actual and potential output of the economy. Implementation of such a policy would be facilitated by a movement away from emphasis on attempting to use the banking system to directly control the quantity of money, toward a policy of indirect control through the use of open market operations. (This simply underscores the desirability of invigorating the government bond market.) In either event, a key issue for Korea will be how to handle the changes in the domestic money supply associated with international capital movements, as will be addressed in the next section.
Possible Pitfalls of Financial Liberalization (and How to Avoid Them)
There certainly exist pitfalls in financial liberalization. A country should "go in with its eyes open," aware of possible dangers. Those who have failed to do this have sometimes been subject to financial crises, leading in many cases to recession and a reversal of the liberalization. The key is to avoid an excessive level of national indebtedness, particularly if foreign borrowing is going to finance consumption or--worse yet-- government consumption. The composition of capital inflows also needs to be monitored, avoiding, for example, an excessive dependence on short-term borrowing. Foreign direct investment appears to be a relatively more stable source of finance.
It is possible to draw broad lessons from both the debt crises of the 1980s and the more recent Mexico debacle of 1994- 95.(31) First, maintaining the domestic savings rate is important, and to the extent that financial liberalization promotes domestic saving, liberalization creates a virtuous circle. Of more direct concern and control of policymakers, however, is to avoid excessive government deficits, especially if these are for public consumption, and doubly if they are financed through external borrowing.(32) The reasons are multiple. Easier availability of capital through lower domestic interest rates and access to foreign borrowing tends to mute the warning signals of macroeconomic disequilibrium and may dull the responsiveness of both policymakers, and more generally, pluralistic political systems, to emerging crises.(33)
More specifically, the fear in many countries is that external liberalization will be accompanied by net capital inflows that generate real exchange rate appreciation, pricingthe traded goods sector out of world markets, and potentially setting off a boom in the nontraded goods sector. (This latter phenomenon is sometimes associated with bank failures as noted earlier.) In this respect, government deficits facilitate capital inflows by creating a supply of sovereign debt for foreign investors. Indeed, unless public deficits are offset with private surpluses, government deficits contribute to net borrowing which is a necessary condition for net (as opposed to gross) foreign capital inflows. Some go so far as to argue that it is desirable to tighten fiscal policy while undergoing external liberalization, to reduce domestic interest rates and the supply of sovereign debt in order to discourage large capital inflows during the initial opening and avoid the possibility of exchange rate overshoot. As a practical matter though, as Park and Song (1996) observe, fiscal policy is for the most part set according to medium- to long-run investment needs, and in any event probably cannot be changed rapidly to deal with sudden shifts in capital flows.
The second, and related, lesson is to avoid excessive real exchange rate appreciation. The reasons are three-fold: First, there are adjustment costs associated with shifting resources between the traded and nontraded goods sectors and sudden movements in the real exchange rate may impose costs on the economy in terms of unemployed resources. Second, one wants to maintain export competitiveness to generate hard currency earnings to repay foreign debt. Third, because of the existence of foreign competitors, and the potential for goods arbitrage, the traded goods sector is typically subject to a greater degree of competitive discipline than the nontraded goods sector. As a consequence, a sudden appreciation of the real exchange rate that results in resources being shifted into the nontraded sector risks the development of asset price bubbles, especially real estate bubbles, which have been associated with banking crises in a number of countries including the United States and Japan, among others.
One way of avoiding excessive appreciation is to sterilize the capital inflows. Korean policymakers largely sterilized inflows in the 1980s and 1990s by forcing domestic financial institutions to purchase Monetary Stabilization Bonds (MSBs) to offset the expansionary impact on the money supply of foreign capital inflows. Sterilization may be advisable in the short-run, but it is doubtful whether this is a good long-run policy: such a policy generates quasi-fiscal costs as long as the interest rate on the MSBs exceeds the return on holding foreign exchange (in the case of comparable Latin American countries, Leiderman (1995) estimated their annual costs at 0.25 percent to 0.50 percent of national income); in any event, this policy only postpones the convergence of foreign and domestic interest rates.(34) Indeed, since domestic rates are higher than foreign rates, it would be desirable to reduce domestic rates and obtain the benefits of higher investment and growth. Moreover, as domestic financial markets become more complex, the ability of the Bank of Korea to exercise monetary control through administrative guidance and MSBs will be increasingly less possible, underscoring the advisability of developing the capacity for indirect control through open market operations. In fact, research cited by Park (1995) indicates that the optimal policy from a Korean standpoint would be a mixture of exchange rate adjustment and sterilization.(35)
If it is not possible to adequately sterilize or otherwise offset inflows, and the inflows are going to consumption (instead of investment), one might want to consider reintroducing some controls on capital inflows, presumably in the form of "Tobin taxes" that would throw some sand in the external financial market wheels.(36) Park (1995) and Park and Song (1996) have devoted considerable effort to thinking about this in the Korean context. They raise two possibilities, which they appear to regard as temporary measures for extreme situations. The first is a variable deposit requirement (VDR), in which reserve or deposit requirements are imposed on capital inflows, with the deposit varying according to type of inflow and investor. It is possible, in principle, that the reserve requirement could be set exactly so that the opportunity cost of the deposit sitting in a noninterest bearing Bank of Korea account could exactly offset the international interest rate differential. Apparently the legal framework exists for the imposition of this deposit requirement, and the existing procedures would make it feasible to impose this on foreigners. The main problem (beyond damage to future credibility with foreign investors) would appear to be that this would also most certainly raise hackles with foreign governments and depending on its implementation, possibly amount to a violation of Korea WTO commitments.
The alternative to controlling quantity (in terms of setting the size of the deposit), would be to control price, and Park and Song raise the issue of a transaction tax, for which, like the VDR, the necessary legal framework apparently already exists. The transactions tax could be confined to capital account transactions, and in principle could be imposed solely on foreigners. Like the VDR, this would surely raise hackles with foreign firms and governments. Moreover, although the won cannot legally trade outside of Korea, it is hard to see why interested parties could not simply move their activities offshore and avoid the tax. More generally, the market for the won is already relatively thin, and it is not clear that reducing the volume of transactions is desirable.
A final issue relates to encouraging capital outflows. At first blush, encouraging outflows to offset inflows would appear to be the natural response to concerns about excessive net inflows. However, there are two arguments as to why encouraging outflows may actually exacerbate the problem. First, barriers to outflows create an element of irreversibility to foreign investors, and if there is uncertainty about the future conduct of economic policy, then this irreversibility may deter investment. Elimination of irreversibility through the removal of capital controls could reduce foreign investor caution and paradoxically lead to higher net inflows. Second, since barriers to external flows are sometimes maintained to facilitate the collection of financial repression taxes, the removal of the impediments may be regarded as a signal of a lower permanent rate of taxation on capital, and thus can induce capital inflow. It is unclear whether either of these arguments carries much force in the Korean case.
Setting aside these potentially perverse cases, it is noticeable that Korean authorities appear to be proceeding more rapidly with liberalization on outbound flows than on inbound flows. To the extent that one believes that for conventional portfolio diversification reasons, domestic residents wish to hold foreign currency assets and have been prevented from doing so, the elimination of these impediments will generate capital outflow. If the fundamental concern about external financial liberalization is that it will lead to destabilizing net inflows, the Korean policy amounts to firing the guns before the enemy is in sight. This possibility raises more technical issues related to sequencing.
Some Technical Specifics on Financial Liberalization
There are many details and technical issues involved in designing a good program of financial liberalization. One set of issues concerns the best order of liberalization: should domestic regulations be removed more quickly than international regulations, or the other way around? Another set of issues concerns which model of market capitalism to adopt: an Anglo- American style system, with a heavy emphasis on securities markets, or a German-Japanese style system, with a heavy emphasis on large banks that have close ties to industry (ownership, monitoring, and management).
Liberalization should not mean that the government plays no role in the financial system. As the government deregulates the financial system, it must not abandon prudential regulation of banks and securities markets. Indeed, prudential regulation of banks and of securities markets is as necessary in a rapidly- growing liberalizing country as ever, perhaps more so. In this way, some of the crises experienced by other countries can be avoided.
Enormous effort has been devoted to understanding the issue of sequencing reforms, stemming initially from the disappointing experiences of the Southern Cone countries of Latin America in the 1980s, and later the experiences of economies making the transition from central planning to the market. The consensus that emerged was that product market liberalization (the removal of trade barriers) should precede financial market liberalization, as has been the case in Korea.(37) Domestic financial market liberalization should, in turn, precede the liberalization of external financial controls. If capital controls are removed when domestic interest rates are still low or negative due to repression, then an outflow of capital (capital flight) will occur. Hence domestic financial reforms, which would raise rates of return on saving closer to world levels, need to be undertaken before the loosening of external controls. The situation is more complicated in high inflation situations, necessitating the maintenance of strict fiscal discipline, but this does not appear to be an important consideration in the case of Korea.(38) Some also argue that liberalization of the banking sector should precede liberalization of other parts of the financial system. The reason is that a well-functioning banking system is needed for both its payments clearing function, and to do things like provide liquidity in times of stock market distress.(39)
A related issue is the sustainability of liberalization and the credibility of government commitments to reform. For example, if a country liberalizes trade and capital controls, but the public believes that these reforms may be reversed, the public may borrow money from abroad to finance the importation of durable goods during the expected window of opportunity, leading to "overimportation" and a welfare loss. Similarly, marginally profitable firms, rather than going bankrupt due to import competition, may borrow from abroad hoping that the trade reforms will be reversed, and the firms will be restored to profitability, a pattern of behavior that would generate sub- optimally high capital inflows. Korea has made substantial (if uneven) progress in liberalizing its economy over the past 15 to 20 years. Its ratification of the WTO agreement and its prospective accession to the OECD both signal its commitment to reform, and act as precommitment mechanisms to prevent future governments from backsliding. Lack of sustainability and credibility should not be major obstacles to further reform in Korea.
An alternative sequencing of reforms has been observed in some Asian countries, however. In the case of Indonesia, financial reform in substantial measure preceded product market reforms, and the liberalization of external controls occurred while the domestic financial system was still quite underdeveloped.(40) Historically, the financial sector was dominated by state-owned enterprises which effectively exercised a monopsony position in funds market and a monopoly in the credit market. Further distortions were created by a variety of interest ceilings and direct credit rationing systems. Tax regulations discouraged raising capital through alternative channels such as equity markets, and instead forced firms to rely on bank finance. As would be expected, this induced rent-seeking on a massive scale, as close relationships with the government regulatory and financial bureaucracies was essential to business success.
The capital account was initially opened in 1971. Financial reforms undertaken in 1983 abolished the interest rate ceilings, resulting in a sharp increase in interest rates and a large increase in bank deposits. However, the shallowness of Indonesia's domestic financial markets meant that the government was unable to use domestic bond finance and instead relied on foreign borrowing to finance its budget deficits. Not only did this heavy reliance on foreign borrowing imply transfers from domestic residents to foreigners, it also increased Indonesia's exposure to terms of trade shocks. Trade reforms were begun in 1985, and FDI regulations were liberalized in 1986.
Further financial reforms were undertaken in 1988 to increase competition within the domestic financial sector (both by increasing competition within the banking sector and by promoting equity finance as an alternative to bank finance) and to integrate the domestic financial system with the international market.
It is beyond the scope of this paper to comprehensively evaluate the Indonesian experience. Nonetheless, the Indonesian case shows that it is possible to adopt heterodox sequencing without disastrous results, in an economy which was certainly far more distorted than Korea's is today.(41) Similarly, Japan has followed a policy that in certain respects has amounted to liberalizing external controls prior to domestic liberalization, and at times deliberately encouraging inflows by liberalizing restrictions on inflows before removing controls on outflows.(42) Again, a comprehensive evaluation of Japanese policies is beyond the scope of this paper, but sufficed to say, these policies have contributed to significant real exchange rate movements in the real exchange rate with questionable effects on Japanese and world welfare. As Williamson (1990, 411) concluded in an overview of the Latin American experience, "the best sequence would seem to be a function of political realities, administrative capacities, and country-specific economic circumstances, rather than being subject to general regularities that economic analysis can hope to establish".
Models of Financial Structure
A casual glance around the world indicates that the relative importance of bank and equity finance, as well as the institutional relationships among financial and nonfinancial firms vary greatly across countries. In its crudest form this is sometimes described as the difference between the Anglo-American equity-centered model and the German-Japanese bank centered model. (One might be tempted to posit a third possibility, the family-centered firm, at least in the initial stages of development, but the origins of the chaebol notwithstanding, this is of dwindling relevance to Korea.) These represent alternative approaches to imposing capital market discipline in the management of modern firms. Each are said to offer certain advantages, and neither research nor markets have established the dominance of one over the other.
The Anglo-American model puts an emphasis on securities. Through the issuance of stocks and bonds, firms are able to raise capital in the form of risky liquid assets which investors can trade as they see fit. Bond finance allows firms (or countries) to raise large amounts of long-term capital. It is especially well-suited for major infrastructural projects where the size of the necessary capital investment and the length of the investment period makes arranging bank loans difficult. Stock finance effectively transfers risk from the borrower to the lender who agrees to assume the risk for a share of the returns. Securitization also facilitates portfolio diversification through the holding of small shares of a number of different assets. This is one reason that a security oriented financial system is arguably better at raising venture capital for start-up firms where potential gains are large but the likelihood of success may be low or hard to evaluate.
The drawback of securities-centered financial system is that ownership is highly dispersed, and it is argued that relatively dispersed, uninformed stock and bond holders do a poor job of monitoring firm management. This lack of monitoring may contribute to poor decision-making within the firm, or worse yet, self-interested behavior by the professional managers.
The German-Japanese bank-centered system is supposed to do a better job of addressing this principal-agent problem, by creating a class of investors with an intimate understanding and stake in the fortunes of the firm. Moreover, freed from the fear of hostile take-over, managers are free to concentrate on long-run strategic decisions.(43) However, research conducted in both Germany and Japan indicate that bank-affiliated firms are not systematically more profitable than their competitors.(44)
Probably the most reasonable conclusion that can be reached on this issue is the agnostic one that each of these institutional arrangements provides a mechanism for control, and there is more than one way to skin a cat.(45) (Indeed, Black and Moersch  were unable to uncover any systematic differences in the growth performance of economies based on the relative importance of bank finance and stock markets.) What one can say is that there is a presumption that more complete markets are preferable to less complete markets. In the case of Korea, the development of these institutions will reflect historical circumstances, and will probably reflect a mixture of these approaches, with bank lending dominating some types of finance and securities predominating in others.
Presumably the most controversial issue is to what extent big businesses should own financial institutions, specifically banks. The risk (as has been demonstrated in the case of Chile) is that there may be a temptation for the industrial owners of banks to use them for ready cash in times of distress. This can have disastrous effects on the economy as the experience of Chile shows.(46) In the case of Korea, current practice places an extremely low ceiling on ownership of bank equity (4 percent). This inhibits privatization, since given the concentrated character of the industrial sector, the large industrial conglomerates are the most obvious domestic potential buyers of state assets. One possible solution would be to raise the ceiling on individual equity ownership to something like 15 percent, with this ownership share computed on the basis of consolidated balance sheets (including cross-shareholdings and subsidiaries in the case of the large conglomerates). Allowing employees of the big businesses, banned from serving as bank directors under legislation currently under review might also be considered.
Issues of Regulatory Policy
As financial liberalization proceeds, domestic and international regulatory authorities will be confronted with issues of increasing complexity. It is important that financial market liberalization be accompanied by increased attention and resources (including new technologies and retraining) devoted to regulatory efforts. Deregulation does not mean no regulation.
Banks are at the center of the financial system (or at least are at the center of Korea's financial system today). They serve as deposit-taking and lending institutions, as well as providing a payments clearing function. With regard to the former, the distinction between bank loans and public offerings is blurring under the influence of deregulation and improved information technology (at least in the United States). Increasingly, banks may be more important for their ability to assess credit and screen loans, than for their ability to finance the loans per se. (On current trends, the US mutual fund industry will surpass the banking sector in size within a decade.) And as long as firms have bank debt, financial markets will care about banks' evaluation of these firms' prospects.
Although Korean financial markets have not moved so far along this path, developments in the US suggest some possible lessons for Korea. The most obvious is that judgement, the ability to screen and monitor loans, demands a lower premium in a repressed market than in a competitive market, as the US learned to its chagrin during the 1980s. Given the Korean banking industry's long history of heavy government regulation and the prominence of policy loans in credit, it may be legitimate to question the ability of Korean banks to fulfill this critical role efficiently. This potential difficulty is compounded by the apparently cozy relationship between the banks and the MFE. This suggests that Korea should probably devote extraordinary vigilance to bank regulation in the course of financial liberalization.
One can identify four principal goals of bank regulation: First, maintain the safety and soundness of the banking system, especially with respect to systemic risk. It is essential that the government not create perverse incentives.(47) In the US Saving and Loan (S&L) crisis, a combination of both lax regulation and a risk unadjusted deposit insurance system encouraged S&Ls with low capital adequacy requirements to seek risks ("gambling for resurrection"). The United States now has in place a risk-based deposit insurance system, but only after the net expenditure of more than $100 billion in direct clean up costs, as well as the indirect costs of poor capital allocation. In relative terms, the cost to Japan of the jusen crisis will be even larger. And as mentioned earlier, Caprio and Klingenbiel have identified a dozen cases in which clean up costs have exceeded 10 percent of national income, including several in which the costs were more than a quarter of national income. Banking crises are a big deal.
In this regard, regulation needs to focus on the existence of management systems capable of assessing overall risk accurately. (Internal management failures were a necessary condition in the recent scandals involving massive losses by the Barings Bank, Sumitomo trading company, and the Morgan-Grenfell asset management firm, a subsidiary of Deutsche Bank.)
Additionally, the regulatory system must provide a strong incentive for both internal and external disclosure by firms to regulatory authorities and by regulatory authorities to their counterparts abroad. (Again, the recent Daiwa scandal points to regulatory failure in the United States, as both Daiwa and the Japanese Ministry of Finance concealed potentially criminal violations of US security law from the relevant US authorities.) Respect for foreign authorities will increasingly become an issue as Korean banks expand their operations outside Korea. The maintenance of good working relationships with counterparts in other countries will also become more important as Korea opens its financial markets externally.
Finally, deregulation does not mean no regulation. There is no free lunch in the sense that under optimal decision-making, higher returns cannot be obtained without greater risks. Countries may choose to maintain controls on some activities. Stiglitz (1996) raises the example of whether small pension funds should be permitted to buy derivatives that do not appear to relate to the funds' core activities and risks.
In the case of Korea, policymakers will have to keep their eyes on at least three things in this regard. First, is the possibility, asserted by Park and Song, that domestic and external liberalization could increase the volatility of interest rates, complicating the management of banks. (Of course, it is also possible that international capital inflows would dampen the volatility of domestic interest rates.) Second, as Korean banks go abroad they will be subject to different operating environments, regulatory frameworks, and risks. Third, the introduction of uniform premium deposit insurance could encourage the adoption of inappropriate levels of risk in the banking sector.
The second goal of regulation should be to broadly promote competition among banks and other financial institutions to capture the efficiency gains outlined at the start of this paper.
Third, regulators need to protect consumers from misleading or unfair practices, beyond the obvious case of fraud. In the United States, for example, practices involving "red-lining" (the refusal to lend in a certain area) or racial discrimination in lending have become issues. Presumably some concerns over fairness (possibly relating to lending to SMEs) exist in the Korean context.
Fourth, the goal of regulation should be to broadly support an efficient set of financial institutions. In this regard, it should be recognized that there may be divergences between private and public interests and that these will be at the heart of the regulatory process. To cite some illustrative examples, it might be in a private operator's interest (though not the public's) if the government were to grant the firm a monopoly in the provision of certain kinds of finance. Or, as happened in the United States, banks were not permitted to offer interest-bearing accounts, but firms outside the regulatory framework of the banking industry were. In these cases, what might be profitable to a particular private firm or class of firms, might not be optimal from an economy-wide standpoint. Striking the balance between special interests and the public interest may prove to be quite difficult in Korea, given the history of heavy state involvement in the financial sector, and the close relationship between the financial industry and the MFE.
Recommendations for Policy
The paper has examined the issue of financial market liberalization with the intent of deriving some possible lessons for Korea. Historically, Korean financial markets have been repressed. This has inhibited the proper functioning of the financial system with deleterious effects on the competitiveness of the nonfinancial sector. Financial repression has facilitated state interference in the decision-making of private firms and has contributed to corruption in the political system.
The first lesson for Korea is to relax: financial liberalization is something that is undertaken out of self- interest to address the problems noted above, not something that is done solely at the behest of foreigners. Although the process of liberalization carries risks, there are rewards, and they should be appreciated and enjoyed.
More complete markets are presumptively superior to less complete markets, and liberalization of the domestic financial markets should proceed apace. This means encouraging the development of a more flexible banking system, and more robust money, bond, and stock markets. Specifically, the state should continue to reduce its direct meddling in the financial sector through the imposition of policy loans on the banks, restrictions on bank management autonomy including restrictions on bank ownership and management, and detailed guidelines on corporate finance, to name a few. Indeed, it would be desirable for the government to move from a positive list system (what is not explicitly permitted is forbidden) to a negative list system (if it is not forbidden it is permitted). Such a change in practice would go a long way to eliminating the brake placed by the state on innovation by Korean firms. This change has already occurred to a great extent in the goods markets (with respect to international trade, for instance) without exposing the Korean economy to undue risk.
In parallel to these changes in policy, foreign firms should be more fully integrated into the financial markets. The increased presence of foreign firms will reinforce reforms by providing more competition to domestic financial institutions whose operations still reflect a legacy of state involvement and protection. The trends on both the policy and foreign involvement fronts are favorable. The trends should be accelerated.
At the same time, deregulation does not mean no regulation, and the case has been made that Korean bank regulation is probably inadequate thereby creating a higher likelihood of systemic crisis than is either necessary or advisable. The problems appear to be too cozy a relationship between the banks and the government (creating implicit bail-out guarantees) together with risk unadjusted deposit insurance which tempts banks to take on inappropriate risks. Add to this the legacy of the asset price bubble and relatively weak bad loan reporting requirements, and one has a recipe for a potential disaster. Concretely, the government should increase the independence of the bank supervisors, and promulgate capital adequacy requirements that are more strict than those of the BIS. More generally, increased attention and resources should be devoted to prudential supervision.
These issues relate largely to domestic financial liberalization. The conventional wisdom is that domestic liberalization should proceed before external controls are lifted, though in the context of today's reality it is questionable whether this distinction can be maintained. In any event Korea has proceeded in the conventional fashion, liberalizing direct investment more rapidly than portfolio investment, and long-term portfolio investment before short-term portfolio investment. Nothing controversial here. The main fear with regard to external liberalization is that the economy will experience large "hot money" inflows which will be destabilizing, leading to real exchange rate overshooting and damage to the traded-goods sector. This is the apparent motivation for the government's position that certain liberalizations should be delayed until the gap between domestic and international interest rates have narrowed.
Two things should be kept in mind. First, the status quo situation in which Korean firms have to borrow money at far higher rates of interest than their competitors abroad potentially puts them at a crippling competitive disadvantage. A goal of liberalization should be to facilitate borrowing by Korean firms at the lower interest rates available internationally--this will increase the rates of investment and economic growth. Moreover, the country may need to be able to raise large sums of money quickly in case of sudden unification or collapse in the North. The point is simply that liberalization should be undertaken because it is in Korea's interests to do so.
Second, it is by no means inevitable that the process of international capital market liberalization will be accompanied by macroeconomic destabilization if macropolicies are handled correctly. With regard to monetary policy, current developments in the domestic financial markets, let alone prospective developments with respect to international finance, mean that the Bank of Korea's traditional policy of targeting M2 is increasingly outdated, and indeed may actually be counterproductive, and could possibly even exacerbate problems associated with short-run capital inflows. Instead, the monetary authorities should focus on M3 and target nominal income or inflation.
Moreover, given concerns about net capital inflows and in light of Korea's widening current account deficit, it may be advisable to tighten fiscal policy temporarily, to give the monetary authorities additional room to maneuver.
If, with a relaxation of external controls, the country still experiences large capital inflows, then sterilization can be undertaken, at least as a transitory measure. If a real crisis is encountered, the legal framework exists to impose more direct capital controls in the unlikely eventuality that the situation deteriorated this far.
This raises the final issue of the propitiousness of the current environment for liberalization. In reality there is never a best time to liberalize, and any slowing or reversal of the liberalization process would raise issues of credibility that Korea has thus far been able to avoid. There is understandable hesitancy to move forward with financial liberalization in light of the current account deficit. But it should be recognized that the deficit in and of itself is not necessarily a bad thing if it is being used to finance investment as it appears to be (that is to say that Korea is not yet a natural capital exporter). Moreover, the proximate cause is a decline in domestic saving which domestic financial liberalization could help address through increasing the rate of return to saving, and policy levers (including fiscal tightening) are available to address the saving issue. In any event, the current deficit may prove transitory.
A related issue involves Korea's application to join the OECD which is currently before the National Assembly. To reiterate, financial liberalization should be undertaken out of self-interest, not because it is something that foreigners want. Having said that, it would be a horrible signal to the rest of the world if the National Assembly were to reject OECD accession. Korea would be like the bridegroom who after extensive negotiations and preparations leaves the bride standing at the alter. Such suitors are generally not highly regarded by either the bride or her family.
Technical Appendix 1: Gains from Domestic Liberalization
Repressed financial systems are characterized by distortions which raise costs to borrowers and lower returns to savers, reducing the volume of transactions. Two alternative interpretations of the microeconomics of a repressed system can be illustrated with appendix figure 1.
Suppose that the government declares an interest ceiling at level il. Savers will provide Sl of saving. However, borrowers will demand Ib of investment capital. Since the demand for capital greatly exceeds the supply, the market is in disequilibrium and some nonmarket mechanism is necessary for allocating capital.
One possibility is that the investors with projects with highest rates of return will bribe whomever is allocating capital (presumably bankers or government officials) to gain access to capital at the ceiling rate il. They will be willing to make transfers equal to rectangles 1 and 2 in order to get access to the Sl capital available. That is the rents created by the interest ceiling are transferred to whomever is allocating the capital. Another possibility is that the authorities simply allocate capital in some arbitrary noneconomic way at interest rate il. In this case the rents go to whichever investors are lucky. One difference with the bribery allocation however, is that it presumably preserves a modicum of efficiency in the allocation of capital across alternative uses. In the arbitrary allocation scheme, some low pay-off projects (one which might be profitable at il, but not a higher interest rate (such as i*) are undertaken, while projects which would be profitable at even higher interest rates are not. The overall efficiency of capital is reduced.
Suppose now that the government eliminates the interest ceiling. The market equilibrates at a higher interest rate i*, and the volume of transactions rises from Sl to S*=I*. The rents (rectangles 1 and 2) are absorbed in consumer and producer surplus, and the economy experiences a deadweight gain equal to triangles 3 and 4.
The increase in saving and investment raises the steady- state level of output of the economy as shown in appendix figure 2. The increase in the saving rate causes the growth rate of labor relative to capital (gl/s) to fall, leading to a higher steady-state capital-labor ratio (K/L) and a higher steady-state level of per capita income (Q/L).
Technical Appendix 2: Gains to International Liberalization
Consider an economy that can either produce goods for today (consumption) or produce goods to be used for output in the future (investment). More consumption today means less investment and less consumption in the future. Such an economy will face a continuum of options for allocating consumption between present and future goods as illustrated by the intertemporal production/consumption possibilities frontier in appendix figure 3.
Where the economy locates itself on this continuum will be determined by the terms of trade between present and future consumption, that is by the interest rate. In the case of a capital-scarce internationally closed industrializing economy, competitive behavior will lead this economy to produce at equilibrium A associated with interest rate id and utility level U0.
If this economy is opened to international borrowing and lending, the interest rate will fall from id to iw. The economy will reallocate production away from the consumption of current goods and toward the production of future goods at equilibrium B. However, the returns to investment in the production of future goods is sufficiently high, that at interest rate iw, the economy can afford to consume at equilibrium C associated with utility level U1. The open economy level of utility is higher than the closed economy utility, and indeed as drawn in appendix figure 3, the economy can consume both more goods in the present and more goods in the future compared to closed economy equilibrium A.
In addition to these intertemporal gains from trade, there are improvements in welfare associated with portfolio diversification into different assets as well.
1. See, for example, DeLong and Summers (1991). Technical appendix 1 contains a brief technical exposition of this idea.
2. A brief technical exposition of these ideas is contained in appendix 1.
3. This is illustrated in appendix 2.
4. According to Noland (1996), the cost of unification (defined as the addition to the North Korean capital stock necessary to raise North Korean per capita incomes to 60 percent those of the South) is on the order of $750 billion to $1.5 trillion, with the costs nearly doubling every five years. So, for example, if unification had begun in 1995, it would have taken around 18 years and the unified Korea would have averaged a current account deficit of 8 percent of national income over this period. If the process does not begin until 2000, the costs are higher, the time period is longer, and the current account deficits are larger.
5. See, for example, King and Levine (1993a), DeGregorio and Guidotti (1994), and Levine and Zervos (1995).
6. On the former point see Bencivenga and Smith (1991) and Japelli and Pagano (1993). Fernandez and Galetovic (1994), Greenwood and Jovanovic (1990), and King and Levine (1993b) confirm the latter.
7. See Levine and Zervos (1996).
8. On the first two points see Jun (1995) on the latter see Folkerts-Landau et al. (1995), and Park and Song (1996).
9. The definition of "policy loans" is imprecise and various sources report significantly different figures. See Cho (1994) for a discussion of this issue.
10. In September 1996, the Ministry of Finance and the Economy proposed legislation to revise the Banking Act to end the current "rubber stamp" bank president selection committees and increase the role of outside nonstanding directors. Under the proposed system, the nonstanding directors will be authorized to recommend bank officers and decide on major managerial issues. Those working for the top 10 big businesses would not be eligible to be outside directors.
11. Economist, 20 July 1996. This issue is taken up more fully below.
12. For example, in October 1995, the government announced that, in the case of direct investments abroad by Korean corporations of $100 million or more, at least one fifth of the funds must be raised at home, where the cost is higher (Economist, 14 October 1995, 44; 11 November 1995, 62; Financial Times, 10 October 1995. A year later, the government partially reversed itself, announcing that large corporations would be permitted to borrow foreign currency denominated loans from domestic banks to buy Korean-made capital goods (Financial Times, 10 October 1995).
13. For example Park and Song (1996, 14) write that "Korean policymakers have been reluctant to liberalize the capital account rapidly. There is concern that devastating macroeconomic instability would result from a sudden opening up of financial markets. In contrast, efficiency gains to the economy from liberalization are considered to be relatively small, possibly even insignificant, and at best realized in the long-run". Park (1995, 7) states that "domestic financial institutions have little competitive advantage over their foreign counterparts. At best Korea's financial sector remains an infant industry and may need market protection".
14. Korea Newsreview, 22 June 1996. The government is also apparently willing to allow them into the credit card business in the future (Korea Times, 21 September 1996).
15. As noted above, figures on policy loans vary from source to source due to the imprecise definition of policy loan. The figures cited are from the Bank of Korea as reported by the OECD. Some Korean analysts report significantly higher figures.
16. Legislation proposed in October 1996 would authorize regulatory authorities to order poorly managed financial institutions to merge with other financial institutions. The MFE and or the deposit insurance agencies would also be authorized to force poorly managed firms to take self-defense measures such as increasing capital and selling-off stock holdings.
17. Financial Times, 15 November 1996.
18. Folkerts-Landau et al. (1995) indicate that the amount of nonperforming loans in Korea compare "unfavorably" with several industrial countries which recently had banking problems.
19. Four recent cases have been Venezuela (18 percent), Bulgaria (14 percent), Mexico (12 to 15 percent), and Hungary (10 percent). In several earlier cases (Argentina, Chile, and Cote d'Ivoire) losses exceeded 25 percent of national income.
20. Korea Times, 13 July 1996; Economist, 20 July 1996.
21. In June 1996, the governor of the Securities and Exchange Commission (SEC) and a director of the MFE were arrested for taking bribes to get firms listed. Six other SEC executives were forced to resign.
22. The MFE added that it might abolish the ceiling entirely in 2000 if "economic circumstances" were appropriate (Financial Times, 19 June 1996).
23. In an attempt to invigorate the over-the-counter (OTC) market, the government announced that it will begin to allow foreign investors to purchase shares "directly" in addition to the current practice of investing "indirectly" through a mutual fund reserved for foreigners. The OTC market, established in 1987, has a yearly trading volume roughly equal to the daily volume on the Seoul stock exchange (Korea Newsreview, 14 September 1996).
24. Financial Times, 3 August 1996.
25. Financial Times, 19 June 1996; Korea Newsreview, 22 June 1996.
26. One issue, the liberalization of outflows prior to inflows will be taken up below.
27. It is argued that in pluralistic democracies, the incentives faced by incumbent politicians may lead to the adoption of systematically suboptimal policies, and there is indeed some evidence that central bank independence from political influence is associated with stronger macroeconomic performance (cf. Cukierman, Webb, and Neyapti 1992).
28. Monetary rules are believed to improve macroeconomic performance for a number of reasons, most notably the problem faced by policymakers in precommiting themselves to the optimal long-run policy (this is also known as the time inconsistency problem). It is argued that announcement of a rule helps establish policy maker credibility and provides an anchor for private agent expectations. (Bryant 1980) has likened this to Ulysses filling his sailors' ears with wax and having them lash him to the ship's mast as the ship passed the Sirens' rocks.) See Fisher (1990) for an overview of these issues.
29. See OECD (1996) for details.
30. See Bryant, Hooper, and Mann (1993). A recent debate has emerged as to whether policymakers should set zero inflation as their goal (i.e., price stability) or if a low, positive level of inflation is desirable. See Akerlof, Perry, and Dickens (1996) and associated comments. In some sense this debate is moot--the low level inflation target that Akerlof, Perry, and Dickens espouse would imply a reduction in Korea's historical rate of inflation.
31. See Montiel (1996) for an overview.
32. The experience of Chile during its reforms in the early 1980s indicates that there may also be an autonomous increase in private demand for both investment and consumption, as private agents interpret financial liberalization as signalling an increase in perceived wealth and permanent income (Edwards 1987). This increase in demand, combined with the continued segmentation of domestic financial markets, prevented the narrowing of interest rate differentials and contributed to the maintenance of high real interest rates after the removal of capital controls. This effect was reinforced by the government's attempt to maintain a nominal exchange rate peg to the dollar. These macroeconomic effects, together with a lax banking supervision and malfeasance in the operations of the banks eventually led to a banking crisis.
33. This is simply the obverse of the potential gains to investors of access to additional international capital for investment at relatively low costs. If the capital is invested productively the economy can emerge clearly better off than it would have without liberalization. If the borrowed money is wasted, it could end up worse off.
34. Park (1995) suggests central bank swaps a as possible alternative to sterilization. When central bank foreign exchange holdings get too high, the central bank would sell foreign exchange to domestic financial institutions to invest abroad. At the end of a specified time, the swap would be reversed, and the central bank would compensate financial institutions for losses due to interest rate differentials and exchange rate movements. The problem is that the quasi-fiscal cost could be high.
35. In this respect, the exchange rate environment may play some role in countries' ability to manage external financial market liberalization. Southeast Asian countries who liberalized in the late 1980s, benefitted from having tied their currencies to the US dollar and then ridden it down against the Japanese yen. Something similar could happen in the Korean case.
36. If the foreign capital inflows were going into productivity- enhancing investment, the proper response is to allow the exchange rate to appreciate with productivity gains, and allow the capital inflows to continue.
37. Trade liberalization accomplishes two things: first it contributes to real exchange rate depreciation; second it insures that foreign capital flows into its most productive uses thereby eliminating the possibility of immizerising capital inflows.
38. For a discussion of the high inflation case see Edwards (1985).
39. See, for example, Blommestein and Spencer (1994).
40. See Noland (1990) for a more detailed discussion.
41. The possible reason that Indonesia was able to pursue such unorthodox policies was that the government controlled a considerable share of foreign exchange earnings through its ownership of the oil industry. As privately produced manufactured exports have increased, and non-oil producers have gained international standing and access to the international capital markets, the impact of international capital flows on the domestic money supply have become more pronounced. See Fischer and Reisen (1994).
42. See Frankel (1984).
43. The obverse of this is that there is not a market for corporate control, which can facilitate the entrance of new players, especially foreign players, into the market.
44. In the case of Germany, Chirinko and Elston (1996) found that bank finance does not lower the cost of capital or result in higher profitability. In the case of Japan, Nakatani (1984) found that bank-affiliated firms had lower, though more stable, profits. He interprets bank or keiretsu affiliation as acting as an insurance scheme. This conclusion is reinforced by recent research by Kawai, Hashimoto, and Izumida (1996), which finds that distressed firms with main bank connections pay a significantly lower interest rate premia than do firms without main banks.
45. There also a related issue of Continental-style universal banks versus the more specialized banking structures existing in the United States, Japan, and Korea. The experience of Japan demonstrates that it is possible to run a bank-centered financial system without universal banking, so universal banks are not a necessary condition for the bank-centered financial system. At the same time, technological progress and the changing structure of financial markets means that it will be increasingly difficult (and of questionable utility) for regulators to maintain the functional distinctions among banks. In the case of Korea, its history of financial repression mitigates against the development of universal banks. Movement in this direction might be considered as part of a broader policy of financial deregulation and liberalization.
46. See Galves and Tybout (1985).
47. One could come up with a similar regulatory framework for other parts of the financial system.
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